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913443_1999.txt | 913443_1999 | 1999 | 913443 | Item 1. Business
Cambridge Heart, Inc. ("Cambridge Heart" or the "Company") is engaged in the research, development and commercialization of products for the non-invasive diagnosis of cardiac disease, the leading cause of death in the United States and many other developed countries. Using innovative technologies, including proprietary disposable sensors, the Company is addressing such key problems in cardiac diagnosis as (i) the identification of those at risk of sudden cardiac arrest, accounting for approximately 50% of all deaths due to heart attack, (ii) the early detection of coronary artery disease and (iii) the prompt and accurate diagnosis of heart attack. The Company's lead product, the CH 2000 Alternans System incorporates the Company's proprietary technology to non- invasively measure low levels of T-wave alternans, a beat-to-beat alternation in a portion of a patient's electrocardiogram. Clinical research published to date has demonstrated that by measuring T-wave alternans the CH 2000 Alternans System can assess vulnerability to the ventricular arrhythmias responsible for sudden cardiac death to a degree comparable to electrophysiology testing, the most accurate invasive test. The CH 2000 Alternans System is also able to perform conventional cardiac stress tests. Sudden cardiac arrest accounts for approximately one-half of all cardiac related deaths, or about 300,000, in the United States each year, and is the leading cause of death in people between the ages of 45 and 65.
The Company's CH 2000 Alternans System and Hi-Resolution sensors have received 510(k) clearance from the U.S. Food and Drug Administration for sale in the United States, have received the CE mark for sale in Europe and have been approved for sale by the Ministry of Health in Japan. The 510(k) clearance for the CH 2000 Alternans System includes the claim that the CH 2000 Alternans System can measure T-wave alternans and the presence of T-wave alternans in patients with known, suspected or at risk of ventricular tachyarrhythmia predicts increased risk of ventricular tachyarrhythmia or sudden death.
Company Overview
Research using the Company's T-wave alternans technology and High-Resolution sensors to predict increased risk of ventricular tachyarrhythmias, indicates that the Company's CH 2000 Alternans System has the following advantages:
. Accuracy--Clinical studies to date indicate that the presence of T-wave alternans in patients with known, suspected or at risk of ventricular tachyarrhythmia predicts increased risk of a cardiac event (ventricular tachyarrhythmia or sudden death). The predictive capabilities of the Company's technology exceed those of other non-invasive tests and is comparable to the results of an invasive electrophysiology study.
. Non-invasive--Unlike electrophysiology studies which require the insertion of electrical catheters into the patient's heart and the administration of local anesthesia, the CH 2000 Alternans System requires only the placement of High-Resolution sensors on the patient's chest.
. Broad Applicability--Approximately six million standard stress tests and three million imaging stress tests are performed in the United States each year. The CH 2000 Alternans System is able to perform both of these tests and to simultaneously assess the risk of sudden cardiac death due to ventricular arrhythmias and with only a modest increase in the total cost of the procedure.
. Non-Hospital Setting--Unlike electrophysiology studies and other tests which require a hospital setting, the CH 2000 Alternans System can be used in a physician's office.
. Procedure Cost Advantages--An alternans test with the CH 2000 Alternans System cost approximately $400 per procedure, compared with approximately $3,000 to $4,000 for an electrophysiology study.
. System Affordability--A fully equipped CH 2000 alternans System is priced in the United States starting at approximately $29,000, The Company has established several financing programs available to customers aimed at minimizing the amount of initial upfront capital investment required to acquire a CH 2000 Alternans System in return for a commitment to purchase Hi-Resolution sensors at a fixed price.
The Company is also conducting research into the detection of ischemic heart disease using its cardiac electrical imaging technology. Cardiac electrical imaging provides an image of the electrical activity of the heart that is highly sensitive to changes resulting from ischemia, the lack of oxygen caused by coronary artery disease or acute myocardial infarction. The Company is conducting research to determine the extent to which this technology provides for enhanced detection and localization of coronary artery disease during a standard exercise stress test.
The Company was incorporated in Delaware in 1990. The Company's executive offices are located at 1 Oak Park Drive, Bedford, Massachusetts 01730.
Principal Products and Applications
The CH 2000 Alternans System
The CH 2000 Alternans System is designed to perform a broad range of standard cardiac stress tests, as well as to measure T-wave alternans. The Company's proprietary T-wave alternans technology permits evaluation, computation and recording of T-wave alternans during exercise, atrial pacing or pharmacological stress. Because of the need to record very small variations in electric signals for precise T-wave alternans measurement, the CH 2000 Alternans System incorporates the Company's proprietary Hi-Resolution sensors and proprietary signal processing algorithms to minimize noise levels resulting from patient movement.
The Company's CH 2000 Alternans System is a fully-featured diagnostic system which includes a cart-mounted computer with proprietary software, integral electrocardiogram system display, keyboard and output devices which can be configured for both hospital and office settings. This system is designed to support a broad range of standard and physician-customized protocols for the conduct and measurement of cardiac stress tests and is compatible with both standard electrodes and with the Company's Hi-Resolution sensors for T-wave alternans measurement. The CH 2000 Alternans System is capable of controlling both treadmill and bicycle ergometers and is well suited for standard, nuclear or echocardiogram stress tests. During the Fiscal years ended December 31, 1997, 1998, and 1999 revenues from the sale of the CH 2000 Alternans System have accounted for 94%, 96% and 86% of total Company revenues, respectively.
The CH 2000 Alternans System provides a broad range of special features, including:
. Expandable, Pentium-based computer architecture that simplifies operation, facilitates serviceability and provides a clear software and hardware upgrade path.
. Exclusive pre-test impedance lead check and optimizing signal processing that identifies problematic leads and minimizes noisy ECG waveforms to ensure a good test before it starts.
. Patented diagnostic screen displays that provide the ability to view all 12 leads simultaneously throughout a test and make immediate on-screen interpretations.
. Unique ST segment displays that superimpose waveforms for all 12 leads over median beats for clear identification of dangerous ST depression or elevation.
. Comprehensive review capability of every test, reducing the physician's risk of missing a critical arrhythmia or losing an important record and thereby freeing them to focus on the patient.
T-wave Alternans and Ventricular Arrhythmias: Clinical Studies
The association between ventricular arrhythmia and the presence of extremely low levels of T-wave alternans not detectable by visual inspection of the ECG was unknown until the early 1980s. Research conducted in Dr. Richard Cohen's laboratory at The Massachusetts Institute of Technology indicated that the presence of microvolt (one-millionth of a volt) levels of T-wave alternans was predictive of vulnerability to ventricular arrhythmias responsible for sudden cardiac arrest. Dr. Cohen, a founder, director of, and consultant to, the Company, and his associates developed the technology to quantify this electrical conduction pattern which has been exclusively licensed to the Company and which forms the basis of the Company's proprietary technology.
In a study of 83 patients conducted at Massachusetts General Hospital in collaboration with Dr. Cohen's laboratory at The Massachusetts Institute of Technology, published in the New England Journal of Medicine in December 1994, the detection of T-wave alternans at certain levels in patients referred for electrophysiology studies was shown to be as accurate as invasive electrophysiology testing in predicting sudden cardiac arrest and life- threatening ventricular arrhythmias. In the high risk population studied for up to 20 months following the procedure, an actuarial analysis involving 66 patients indicated that 81% of those testing positive for T-wave alternans died or suffered a life-threatening arrhythmia within 20 months of the test; only 6% of the patients testing negative for T-wave alternans did so. These results were comparable to those obtained with invasive electrophysiology testing and were more predictive than those that have been reported using other non-invasive methods.
Another study was conducted by Professor Stefan Hohnloser of J.W. Goethe University, Frankfurt, Germany, the results of which, were published in December 1998 in the Journal of Cardiovascular Electrophysiology In this study, 95 patients receiving an implantable cardioverter-defibrillator underwent electrophysiology testing and most of the other accepted non- invasive risk stratification tests, including T-wave alternans testing utilizing the CH 2000 Alternans System. Professor Hohnloser reported that the detection of the presence of T-wave alternans was found to be the more accurate than all other invasive and non-invasive tests in predicting recurrences of ventricular tachycardia and ventricular fibrillation, the abnormal heart rhythms associated with sudden cardiac arrest.
During 1998, the Company completed a multi center study that was included in the 510(k) application submitted to the U.S. Food and Drug Administration in August 1998 to obtain expansion of the Company's labeling claim. The primary endpoint was a ventricular tachyarrhythmic event which was defined as sudden cardiac death, appropriate firing of an implantable cardioverter-defibrilator or resuscitated sustained ventricular tachycardia or fibrillation. In 337 consecutive patients referred for electrophysiology study to evaluate known, suspected or risk of arrhythmias, T-wave alternans was a highly significant predictor of a ventricular tachyarrhythmic event and was somewhat more predictive than electrophysiology, with a relative risk of 10.92 for T-wave alternans versus 7.07 for electrophysiology. The secondary endpoint was a ventricualr tachyarrhythmic event plus all death due to any cause. T-wave alternans was a highly significant predictor of this endpoint and was also more predictive of than electrophysiology, with a relative risk of 13.93 versus 4.69 for electrophysiology. Relative risk is the chance of having a cardiac event if the test is positive divided by the chance of having a cardiac event if the test is negative. The greater the number, the more predictive the test.
T-wave alternans was also evaluated as a predictor of electrophsyiology study in a protocol that enrolled a subset of 242 patients. There were no material differences in patient characteristics between this subset and the total 337 patients. In 140 patients who completed all study procedures in accordance with the protocol and had determinate results for both T-wave alternans and electrophysiology, T-wave alternans predicted the results of electropysiology with a sensitivity of 76%, a specificity of 65% and a relative risk of 3.93.
Marketing and Sales
Prior to 1999, the Company had been engaged in selling and marketing its CH 2000 Alternans System as a standard stress test system in the U.S. and, as a result, the Company was primarily dependent on the sale of standard stress test systems for the majority of its U.S. revenue. The standard stress market is currently a capital equipment market with limited annual unit growth, small gross profits and selling prices that are subject to significant competitive pressure. During 1999, the Company received clearance from FDA of its 510(k) application for expansion of its labeling claims. This provided the Company with the opportunity to focus its U.S. marketing and sales efforts on potential customers interested in the clinical use of its Alternans test and proprietary disposable sensors. The Company anticipates that the percentage of revenue generated by the sale of Alternans products will continue to increase while the percentage of revenue generated from the sale of standard stress test equipment will decline.
During 2000, the Company intends to expand its product offerings with two new products. The first is an OEM product that will allow major manufacturers of stress test systems to incorporate the Company's alternans technology into their new systems . The second is an add-on product that will allow existing installed stress test systems to be used to measure T-wave alternans. Both products are intended to increase the installed base of systems capable of using the Company's disposable sensors.
The Company believes that the keys to the adoption of its proprietary T-wave alternans technology as the standard of care for the diagnosis of heart disease are reimbursement by third party insurers to healthcare providers for performance of the test, publication of clinical study results in medical journals and continued positive clinical experience with the CH 2000 Alternans System. The Company believes that the trend toward management of health care costs in the United States will lead to increased awareness of and emphasis on early detection and prevention of heart disease, and as a result, will increase demand for cost-effective diagnostic tests. The commercial success of the Company's proprietary technologies will require marketing, educational and sales efforts to encourage cardiologists and other medical professionals to utilize the test for the measurement of T-wave alternans in their medical practices. The Company has trained and expects to continue to train well- respected clinicians and their professional staff in the use of T-wave alternans testing as a means of identifying patients at risk of sudden cardiac arrest. The Company has funded studies to further demonstrate the efficiency of its technologies and intends to continue to encourage the presentation of the results of these studies at major national and international medical symposia and the publication of clinical and scientific reports of such results in major peer-reviewed publications. The Company also supports educational seminars regarding the benefits of T-wave alternans testing and will continue to participate in industry trade shows and academic conferences.
In May 1999, the Company entered into cooperative marketing agreements with both Guidant Corporation and Medtronic, Inc. The agreements provide for the inclusion of T-wave alternans experts to speak at national and regional seminars and symposia in the U.S. sponsored by Guidant and Medtronic aimed at providing additional education to cardiologists about the benefits of alternans testing.
The Company markets its products and services to customers in the United States through a combination of in-house marketing, sales and clinical education support staff and independent manufacturers representatives. The Company is currently represented by 14 independent manufacturers representatives organizations with 39 representatives. The Company maintains a small but experienced in-house Service Department to answer customer questions and provide guidance, advice and troubleshooting regarding use of the CH 2000 Alternans System. The Company also employs three clinical specialist who work with customers to assist with installation of the CH 2000 Alternans System and to train health care professionals in its use.
The Company markets its products internationally through independent distributors. The Company has entered into distribution agreements with distributors for the sale of its products in Europe, the Middle East, Japan and Australia. During the years ended December 31, 1997, 1998 and 1999, sales to international distributors comprised 62%, 46% and 49%, respectively, of the Company's revenue. The Company's international independent distributors provide comprehensive marketing and sales services including
identification of potential purchasers, consummating sales and providing ongoing educational and support services to customers. The exclusive distribution agreement between the Company and its distributor in Japan, Fukuda Denshi Co., Ltd. expires March 31, 2001 and the agreements with the Company's distributor in Germany and England, Reynolds Medical, Ltd. and distributor in Italy, Oxford Instruments, expire March 31, 2000 and the agreement with the Company's distributor in Australia, APS, expires June 30, 2000. The Company expects that it will be able to negotiate new agreements with these distributors as they expire.
Manufacturing
The Company performs final assembly of hardware and software components, and testing of its products, at its corporate headquarters in Bedford, Massachusetts. The Company believes its facility will be adequate to meet its needs through the end of 2000. The Company is required to meet and adhere to all applicable requirements of U.S. and international regulatory agencies, including Good Manufacturing Practices and Quality System Regulation requirements. The Company's manufacturing facilities are subject to periodic inspection by both U.S. and international regulatory agencies.
The Company underwent a Quality System Regulation audit, conducted by the U.S. Food and Drug Administration, in January 1999. A response to the FDA's observations was submitted and accepted by the Agency in February 1999. No regulatory action was required.
The manufacturing process consists primarily of final assembly of purchased components, testing operations and packaging. Components are purchased according to the Company's specifications and are subject to inspection and testing. The Company relies on outside vendors to manufacture certain major components used in the CH 2000 System, including its Hi-Resolution sensors. A number of components are currently supplied by sole source vendors, although the Company believes that it could locate additional sources of these components in a timely fashion, if necessary.
Research and Development
A substantial portion of the Company's research and development investment is focused on its efforts in the areas of clinical research and the development of enhancements to its T-wave alternans technology. The Company's clinical research is focused on gathering substantial clinical data demonstrating the efficacy of the T-wave alternans technology and its results as a predictor of patient risk of ventricular tachyarrhythmia or sudden death.
The Company is currently developing a new product that may be combined with any standard stress test system and will allow such system to measure T-wave alternans when utilizing the Company's Hi-Resolution sensors. The Company believes that this product will provide it with increased access to the entire installed base of standard stress test systems and increase the utilization of the Company's disposable, higher margin sensors. The new product is expected to have a lower cost of manufacture than the Company's CH 2000 Alternans System and is expected to carry a selling price below the current price of a standard stress test system. The Company expects the product to be available during the year 2000.
On March 31, 2000, the Company submitted a 510(K) to the Food and Drug Administration seeking clearance to market its new Alternans Add-on Module. This device utilizes the Company's previously cleared proprietary T-wave Alternans technology and Hi-Resolution disposable sensors to allow cardiologists to conduct an Alternans tests using already installed standard stress test systems.
When cleared, this product will open up the market to potential customers who are interested in performing alternans tests but who are not in the market for a new stress test system. There are approximately 23,000 stress test systems installed in the U.S. but only fewer than 2,300 new systems sold new each year. The Company anticipates that the availability of this product will have a positive impact on its efforts to accelerate the rate of clinical use of its alternans technology.
The Company is also conducting research into systems to detect ischemic heart disease based upon its cardiac electrical imaging technology, which provides an image of the electrical activity of the heart. Animal studies and initial human studies indicate that Cardiac Electrical Imaging ("CEI") is highly sensitive to changes
resulting from ischemia, the lack of oxygen caused by coronary artery disease or acute myocardial infarction. The Company is conducting research to determine the extent to which this technology provides for enhanced detection and localization of coronary artery disease during a standard exercise stress test. The Company is evaluating the incorporation of its CEI technology into the CH 2000 Alternans System, and is continuing to conduct clinical studies of this technology.
The Company's research and development expenses were $3,587,000 in 1997, $3,595,000 in 1998, and $2,850,400 in 1999. The Company expects research and development expenses in 2000 to be comparable to 1999, they are expected to increase in the future as it develops additional products and funds clinical trials on its products. As of December 31, 1999 the Company had 10 employees engaged in research and development activities.
Patents, Trade Secrets and Proprietary Rights
The computer algorithms that allow the CH 2000 Alternans System to measure T-wave alternans and certain aspects of the Company's cardiac electrical imaging technology, including the cardiac electrical imaging sensors, are covered by U.S. patents issued to The Massachusetts Institute of Technology that are licensed exclusively to the Company. The Company holds a U.S. patent covering the use of exercise or any other non-invasive means in the measurement of T-wave alternans. During 1998, the Company was issued a U.S. patent covering additional proprietary signal processing algorithms and its Hi-Resolution sensors for use in the measurement of T-wave alternans. Corresponding foreign patents are pending in both cases. The failure to obtain such patents could have a material adverse effect on the Company's business, financial condition and results of operations. The Company owns or is the exclusive licensee of fourteen issued or allowed and six patents pending in the United States, with 17 corresponding foreign patents issued or pending with respect to its technology.
The Company and MIT have entered into three license agreements (the "MIT License Agreements"), pursuant to which the Company is the exclusive licensee of certain technologies upon which the Company's current and future products are based, including certain patents associated therewith. Two of the MIT License Agreements that cover the T-wave alternans measurement technology incorporated in the Company's CH 2000 Alternans System and that relate to cardiac electrical imaging are of material importance to the Company. These licenses are exclusive until 2007; thereafter, each license will convert to a nonexclusive license, and will last for the life of the applicable patents, unless extension of exclusivity is agreed to by MIT. These license agreements impose various commercialization, sublicensing, insurance, royalty, product liability indemnification and other obligations on the Company. Failure of the Company to comply with these requirements could result in conversion of the licenses from being exclusive to nonexclusive in nature or, in some cases, termination of the license. The loss of the Company's exclusive rights to the T-wave alternans and cardiac electrical imaging technologies, licensed under two of the MIT License Agreements or the termination of either or both of such agreements would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company believes that its intellectual property and expertise, as originally licensed from MIT and thereafter developed at the Company, constitute an important competitive resource, and the Company continues to evaluate markets and products which are most appropriate to exploit the expertise licensed by, and developed at, the Company. In addition, the Company maintains an active program of intellectual property protection, both to assure that the proprietary technology developed by the Company is appropriately protected, and, where necessary, to assure that there is no infringement of the Company's proprietary technology by competitive technologies.
The Company's future success will depend, in part, on its ability to continue to develop patentable products, enforce its patents and obtain patent protection for its products both in the United States and in other countries. However, the patent positions of medical device companies, including the Company, are generally uncertain and involve complex legal and factual questions. No assurance can be given that patents will issue from any patent applications owned by or licensed to the Company or that, if patents do issue, the claims allowed will be sufficiently broad to protect the Company's technology. In addition, no assurance can be given that any issued patents owned by or licensed to the Company will not be challenged, invalidated or circumvented, or that the rights granted thereunder will provide competitive advantages to the Company.
The commercial success of the Company will also depend in part on its neither infringing patents issued to others nor breaching the licenses upon which the Company's products are based. The Company has licensed significant technology and patents from third parties, including patents and technology relating to T-wave alternans and cardiac electrical imaging licensed from MIT. The Company's licenses of patents and patent applications impose various commercialization, sublicensing, insurance, royalty and other obligations on the Company. Failure of the Company to comply with these requirements could result in conversion of the licenses from being exclusive to nonexclusive in nature or, in some cases, termination of the license.
The Company also relies on unpatented trade secrets to protect its proprietary technology, and no assurance can be given that others will not independently develop or otherwise acquire substantially equivalent technologies or otherwise gain access to the Company's proprietary technology or disclose such technology or that the Company can ultimately protect meaningful rights to such unpatented proprietary technology. The Company relies on confidentiality agreements with its collaborators, employees, advisors, vendors and consultants to protect its trade secrets. There can be no assurance that these agreements will not be breached, that the Company would have adequate remedies for any breach or that the Company's trade secrets will not otherwise become known or be independently developed by competitors. Failure to obtain or maintain patent and trade secret protection for the Company's products, for any reason, would have a material adverse effect on the Company's business, financial condition and results of operations.
Although the Company is not currently aware of any potential litigation regarding its intellectual property rights, the medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights. Litigation, which would likely result in substantial cost to Cambridge Heart, may be necessary to enforce any patents issued or licensed to the Company and/or to determine the scope and validity of others' proprietary rights. The Company also may have to participate in interference proceedings declared by the United States Patent and Trademark Office, which could result in substantial cost, to determine the priority of inventions. Furthermore, the Company may have to participate at substantial cost in International Trade Commission proceedings to abate importation of products which would compete unfairly with our products.
Competition
The cardiac diagnostic medical device market is characterized by intensive development efforts and rapidly advancing technology. The future success of the Company will depend, in large part, upon its ability to anticipate and keep pace with advancing technology and competitive innovations. However, there can be no assurance that the Company will be successful in identifying, developing and marketing new products or enhancing its existing products. In addition, there can be no assurance that new products or alternative diagnostic techniques will not be developed that will render the Company's current or planned products obsolete or inferior. Rapid technological development by competitors may result in the Company's products becoming obsolete before the Company recovers a significant portion of the research, development and commercialization expenses incurred with respect to such products. Alternative technologies exist today in each of the areas being addressed by the Company, including electrocardiograms, Holter monitors, ultrasound tests and systems for measuring cardiac late potentials. However, the Company's CH 2000 Alternans System and Hi-Resolution sensors is currently the only FDA cleared system for the non-invasive measurement of T-wave alternans.
Competition from medical devices which help to diagnose cardiac disease is intense and likely to increase. The Company's competitors include manufacturers of ECG stress test equipment, including major multinational companies. Many of the Company's competitors and potential competitors have substantially greater capital resources, name recognition, research and development experience and regulatory, manufacturing and marketing capabilities. Many of these competitors offer well established, broad product lines and ancillary services not offered by the Company. Some of the Company's competitors have long-term or preferential supply arrangements with hospitals that may act as a barrier to market entry. Other large health care companies may enter the non-invasive cardiac diagnostic product market in the future. Competing companies may succeed in developing products that are more efficacious or less costly than any that may be developed by the Company, and such companies also may be more successful than the Company in producing and marketing such products. There can be no assurance that the Company will be able to compete successfully with existing or new competitors.
Government Regulation
The manufacture and sale of medical devices intended for commercial distribution are subject to extensive governmental regulation in the United States. Medical devices are regulated in the United States by the FDA and generally require pre-market clearance or pre-market approval prior to commercial distribution. In addition, certain material changes or modifications to medical devices also are subject to FDA review and clearance or approval. The FDA regulates the research, testing, manufacture, safety, labeling, storage, record keeping, advertising and distribution of medical devices in the United States. Noncompliance with applicable requirements can result in failure of the government to grant pre-market clearance or approval for devices, withdrawal of approval, total or partial suspension of production, fines, injunctions, civil penalties, recall or seizure of products, and criminal prosecution.
Medical devices are classified into one of three classes, Class I, II or III, on the basis of the controls deemed by the FDA to be necessary to reasonably ensure their safety and effectiveness. Class I devices are subject to general controls (e.g., labeling, pre-market notification and adherence to GMP standards). Class II devices are subject to general controls and special controls (e.g., performance standards, post-market surveillance, patient registries and FDA guidelines). Generally, Class III devices are those that must receive pre-market approval by the FDA to ensure their safety and effectiveness (e.g., life-sustaining, life-supporting and implantable or new devices which have not been found to be substantially equivalent to legally marketed devices), and require clinical testing to ensure safety and effectiveness and FDA approval prior to marketing and distribution. The FDA also has the authority to require clinical testing of Class I and Class II devices. A Pre Market Approval ("PMA") application must be filed if a proposed device is not substantially equivalent to a legally marketed predicate device or if it is a Class III device for which the FDA has called for such application.
Generally, before a new device can be introduced into the market in the United States, the manufacturer or distributor must obtain FDA clearance of a 510(k) notification submission or approval of a PMA application. If a medical device manufacturer or distributor can establish that a device is "substantially equivalent" to a legally marketed Class I or Class II device, or to a Class III device for which the FDA has not called for PMAs, the manufacturer or distributor may seek clearance from the FDA to market the device by filing a 510(k) notification. The 510(k) notification may need to be supported by appropriate data establishing the claim of substantial equivalence to the FDA. The FDA recently has been requiring a more rigorous demonstration of substantial equivalence.
Following submission of the 510(k) notification, the manufacturer or distributor may not place the device into commercial distribution until an order clearing the 510(k) is issued by the FDA. At this time, the FDA typically responds to the submission of a 510(k) notification within 90 to 200 days. An FDA order may declare that the device is substantially equivalent to a legally marketed device and allow the proposed device to be marketed in the United States. The FDA, however, may determine that the proposed device is not substantially equivalent or requires further information, including clinical data, to make a determination regarding substantial equivalence. Such determination or request for additional information generally delays market introduction of the product that is the subject of the 510(k) notification.
Any products manufactured or distributed by the Company are subject to pervasive and continuing regulation by the FDA including record keeping requirements, reporting of adverse experience with the use of the device, post-market surveillance, post-market registry and other actions deemed necessary by the FDA. A 510(k) submission is also required when a medical device manufacturer makes a change or modification to a legally marketed device that could significantly affect the safety or effectiveness of the device, or where there is a major change or modification in the intended use of the device. When any change or modification is made to a device or its intended use, the manufacturer is expected to make the initial determination as to whether the change or modification is of a kind that would necessitate the filing of a new 510(k) application. The FDA's regulations provide only limited guidance for making this determination. The FDA's regulations also require agency approval of a 510(k) supplement for certain changes to a device if they affect the safety and effectiveness of the device, including, but not limited to, new indications for use, labeling changes, the use of a different facility to manufacture, process or package the device, changes in manufacturing methods or quality control
systems and changes in performance or design specifications. Failure by the Company to receive approval of a supplement regarding the use of a different manufacturing facility or any other change affecting the safety or effectiveness of an approved or cleared device on a timely basis, or at all, would have a material adverse effect on the Company's business, financial condition and results of operations.
Sales of medical device products outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain approvals required by foreign countries may be longer or shorter than that required for FDA approval, and requirements for licensing may differ from FDA requirements. Failure to comply with regulatory requirements could have a material adverse effect on the Company's business, financial condition and results of operations. The current regulatory environment in Europe for medical devices differs significantly from that in the United States. There is currently no universally accepted definition of a medical device in Europe and there is no common approach to medical device regulation among the various countries. There are several different regulatory regimes operating within the different European countries. Regulatory requirements for medical devices range from no regulations in some countries to rigorous regulations approaching the requirements of the FDA's regulations for Class III medical devices. Several countries require that device safety be demonstrated prior to approval for commercialization. The regulatory environment in certain European countries is expected to undergo major changes as a result of the creation of medical directives by the European Union.
The CH 2000 Alternans System and the Hi-Resolution sensors have received 510(k) clearance from the FDA for sale in the United States. The 510(k) clearance for the CH 2000 System includes the claim that the CH 2000 System can measure T-wave alternans, and the presence of T-wave alternans in patients with known, suspected or at risk of ventricular tachyarrhythmia predicts increased risk of ventricular tachyarrhythmmia or sudden death.
Internationally, the CH 2000 Alternans System has received the CE mark for sale in Europe and is approved for sale by the Ministry of Health in Japan.
Employees
As of December 31, 1999, the Company had 34 full-time employees, of whom one holds a Ph.D. degree and six others hold other advanced degrees. None of the Company's employees are represented by a collective bargaining agreement, nor has the Company experienced work stoppages. The Company believes that its relations with its employees are good.
Reimbursement
The Company believes that the availability and level of third party reimbursement will influence the decision of physicians, clinics, and hospitals to purchase and use the Company's products and thereby affect pricing of the Company's products. The Company has initiated efforts to address the issue of reimbursement from third party payers for the performance of an alternans test by healthcare providers. Obtaining reimbursement for a new medical procedure is a multi-year process that will be pursued at both the local and national levels. The Company will pursue both fronts:
. Seek coverage and reimbursement from individual public and private third party payers for the alternans test through provider advocacy and top- down payer lobbying, and
. Obtain a unique national procedure code and payment amount from the American Medical Association for the alternans test and a national coverage policy from the Health Care Financing Administration.
At the local level, the Company has developed a strategy for seeking third- party payer coverage and reimbursement for alternans testing. The Company will target regional Medicare policymakers where concentrations of alternans users exist and seek coverage through the development of local advocates. Private
payers also will be approached both at national and local levels with requests for review of the alternans technology for coverage. As of December, the company already has seen evidence of paid claims for alternans testing at multiple insurers.
At the national level, the Company is pursuing a unique national procedure code and payment level with the American Medical Association with a submission of a coding application in October 2000. The Company will seek support from the American College of Cardiology and North American Society of Pacing and Electrophysiology's Coding and Nomenclature Committees this fall. The earliest possible date that the Company could receive a unique national code for the alternans test is January 2002. There can be no assurance that these efforts will be successful.
The Company continues to support providers with claims submissions and appeals through the development of billing guidelines and a reimbursement guarantee program that provides for the possible payment of $90.00 for each alternans test performed, up to a maximum of 50 per calendar quarter, in which a claim for reimbursement is submitted to a third party payer within prescribed guidelines and is ultimately denied coverage after appeal. Providers who accept the $90.00 payment from the Company may not accept duplicate payment from the third party payer under any circumstances. Once the third party payer has initiated coverage for the alternans test, the $90.00 reimbursement assistance is no longer available. This program is effective through June 30, 2001 or until a national code has been established for the alternans test, whichever comes first. There can be no assurance that any of these efforts will gain reimbursement for the alternans test or increase the number of alternans test performed.
Item 2.
Item 2. Properties
The Company's facilities consist of approximately 11,000 square feet of office, research and manufacturing space located at 1 Oak Park Drive, Bedford, Massachusetts. The Company has a lease for a total of 22,000 square feet which expires in November 2000. The Company believes that suitable additional space will be available to it, when needed, on commercially reasonable terms.
Item 3.
Item 3. Legal Proceedings
The Company is not party to any material legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
The Company held a special meeting of stockholders on December 21, 1999. At that meeting, the Company's stockholders approved (i) an amendment to the Company's 1996 Equity Incentive Plan increasing the number of shares of the Company's common stock reserved for issuance from 1,000,000 to 1,300,000, and (ii) the continuation of the Company's 1996 Equity Incentive Plan. Holders of 9,463,223 shares of the Company's common stock voted in favor of the proposal, holders of 584,740 shares voted against the proposal and holders of 51,767 shares abstained.
Executive Officers of the Registrant
The following table sets forth (i) the names and ages of the current executive officers of the Company; (ii) the position(s) presently held by each person named; and (iii) the principal occupations held by each person named for at least the past five years.
Jeffrey M. Arnold. Mr. Arnold has served as President and Chief Executive Officer of the Company since September 1993. Mr. Arnold was appointed Chairman of the Board of Directors in August 1997. Mr. Arnold was formerly the President and Chief Executive Officer and a director of Molecular Simulations Inc., a supplier of software for rational drug design. Mr. Arnold has also served as a Vice President of Operations for Datascope Corporation and has held senior marketing and research and development positions for Becton Dickinson and Co. Mr. Arnold holds a B.S. in Electrical Engineering from MIT.
Robert B. Palardy. Mr. Palardy became Vice President, Finance and Administration and Chief Financial Officer of the Company in November 1997. From 1990 to February 1997, Mr. Palardy was Vice President, Finance and Information Services of Smith & Nephew Endoscopy, a company involved in the development, manufacture and sale of medical devices for arthroscopy. From February 1997 through October 1997, Mr. Palardy was an independent financial consultant. Mr. Palardy is a Certified Public Accountant and holds a B.S. degree in Accounting from LaSalle University.
Eric Dufford. Mr. Dufford became Vice President, Sales and Marketing and Secretary of the Company in August 1997. From January 1990 to May 1994, Mr. Dufford was Director of International Sales for St. Jude Medical, Inc. From May 1994 to August 1997, Mr. Dufford was Division President of Quest Medical Inc.'s Cardiovascular Systems Division. Mr. Dufford earned a B.A. in International Business/Marketing from the University of Colorado and an MBA from Emory University.
James Sheppard. Mr. Sheppard became Vice President, Operations of the Company in August 1999. From 1996 to 1998, Mr. Sheppard was Vice President, Operations for Nitinol Medical Technology, Inc. From 1995 to 1996, Mr. Sheppard served as Director of Manufacturing for Summit Technology and from 1982 to 1994 he served in several senior management positions at C.R. Bard, Inc. Mr. Sheppard holds a BS in Industrial Engineering from Virginia Tech.
Executive officers of the Company are elected by and serve at the discretion of the Board of Directors. There are no family relationships among any executive officers or directors of the Company.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters
Market Information and Holders
Shares of the Company's Common Stock have been traded on the Nasdaq National Market under the symbol "CAMH" since August 2, 1996. Prior to August 2, 1996, the Shares were not publicly traded. The Common Stock is not traded on any market, foreign or domestic, other than the Nasdaq National Market. The following table sets forth, for the periods indicated, the high and low sales prices of the Common Stock as reported on the Nasdaq National Market during the two most recent fiscal years.
The depositary for the Common Stock is American Stock Transfer and Trust Company, 40 Wall Street, New York, New York 10005. On March 15, 2000, the closing price of the Company's Common Stock on the Nasdaq National Market was $5.00. On March 15, 2000, the Company had approximately 100 holders of Common Stock of record. This number does not include shareholders for whom shares are held in a "nominee" or "street" name.
Dividends
The Company has never declared or paid cash dividends on its Common Stock and does not anticipate paying cash dividends in the foreseeable future. Payment of future dividends, if any, will be at the discretion of the Company's Board of Directors after taking into account various factors, including the Company's financial condition, operating results, restrictions imposed by financing arrangements, if any, legal and regulatory restrictions on the payment of dividends, current and anticipated cash needs and other factors the Board of Directors deem relevant.
Item 6.
Item 6. Selected Financial Data
The following data, insofar as it relates to the years 1995, 1996, 1997, 1998 and 1999, have been derived from the Company's audited financial statements, including the balance sheet as of December 31, 1998 and 1999 and the related statements of operations and of cash flows for the three years ended December 31, 1999 and notes thereto appearing elsewhere in this Annual Report on Form 10-K. This data should be read in conjunction with the Financial Statements and the Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results of operations to be expected in the future. This data is in thousands, except per share data.
- -------- (1) All potential Common Stock (including options, warrants and convertible preferred stock) has been excluded from the calculation of diluted earnings per share as it is anti-dilutive for all periods presented.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
The Company is engaged in the research, development and commercialization of products for the non-invasive diagnosis of cardiac disease. Using innovative technologies, the Company is addressing such key problems in cardiac diagnosis as the identification of those at risk of sudden cardiac arrest, the early detection of coronary artery disease, and the prompt and accurate diagnosis of heart attack. Clinical research conducted to date has demonstrated that the presence of T-wave alternans in patients with known, suspected or at risk of ventricular tachyarrhythmia predicts increased risk of a cardiac event (ventricular tachyarrhythmia or sudden death). Sudden cardiac death accounts for approximately one-half of all cardiac related deaths, or about 300,000, in the United States each year.
Results of Operations
The Company's principal products are the CH 2000 Alternans System and Hi- Resolution sensors. Both products have received 510(k) clearance from the Food and Drug Administration ("FDA") for sale in the United States. Internationally, the CH 2000 System has received the CE mark for sale in Europe and has been approved for sale by the Ministry of Health in Japan.
In April 1999, the Company was successful in obtaining clearance from the FDA of its 510(k) submission for expansion of its labeling allowing for claims stating that "The presence of T-wave alternans in patients with known, suspected or at risk of ventricular tachyarrhythmia predicts increased risk of a cardiac event (ventricular tachyarrhythmia or sudden death)".
During September 1999 the Company was able to address a major impediment to the widespread clinical use of its Alternans test, when it introduced a new version of its Alternans technology allowing the physician to use a treadmill to exercise patients during an Alternans test. Prior to this innovation, exercise with a bicycle was the recommended method for testing patients for Alternans. Most physicians in the U.S. utilize a treadmill to exercise patients during a standard stress test.
In December 1999, the first clinical T-wave alternans test was reimbursed by a third party payor, Blue Shield of California and Delta Health Systems. The total test reimbursement was $453.30. Earlier in the year, the Company had engaged Peer Review Network, a provider of services to insurers to assist in the adjudication of claims for new technologies, to perform an independent review of the Company's Alternans technology and report its findings to its insurance company clients as well as a list of national subscribers. The report, published in the October 1999 edition of "PRN Newsletter," recommended reimbursement of the Company's T-wave Alternans Test by third party payors. The availability of adequate reimbursement by insurers to physicians is critical to broad acceptance of the Alternans Test as a standard of care.
During the second quarter of 1999, the Company initiated a planned strategic transition away from its previous sales focus on standard stress systems to one primarily focused on potential customers interested in the clinical use of its Alternans test and proprietary disposable sensors. The result of this change in focus was a 71% reduction in sales of standard stress systems in the U.S. during the second half of Fiscal 1999 when compared to the same period of Fiscal 1998. During the same period, sales of Alternans systems and disposable sensors in the U.S. increased 31%.
During Fiscal 1999 the Company raised gross proceeds totaling $10.4 million ($9.5 million net of issuance costs) from the sale of 2,998,576 shares of Common Stock in two separate private placement transactions. In addition warrants for the purchase of 504,651 shares of Common Stock were issued. As a result of this activity, the Company ended Fiscal 1999 with $9.2 million of cash, equivalents and marketable securities on the balance sheet. A third closing on $2.1 million of Common Stock ($2.075 million net of issuance costs) was completed in January 2000. A total of 600,000 shares of Common Stock and warrants to purchase 120,000 shares of Common Stock were issued in this transaction. All proceeds will be used to fund the Company's operating costs.
Fiscal 1999 Compared to Fiscal 1998
Revenues were $2,136,000 during the twelve month period ended December 31, 1999 ("Fiscal 1999") and $2,096,900 during the twelve month period ended December 31, 1998 ("Fiscal 1998"), an increase of 2%. Revenue from the sale of capital equipment and other miscellaneous products was $2,017,000 and $2,032,100 for Fiscal 1999 and Fiscal 1998 respectively, a decline of 1%. Revenue from the sale of disposable sensors was $119,400 and $64,600 for Fiscal 1999 and Fiscal 1998 respectively, an increase of 85% due primarily to increase in unit sales in the United States.
Revenue from the sale of the CH 2000 Alternans System and the Company's proprietary disposable sensors increased 12% during Fiscal 1999 while revenue from the sale of standard stress systems declined 28% during the same period. These results reflect the Company's planned transition away from its previous sales focus on standard stress systems to one primarily focused on potential customers interested in the clinical use of its Alternans test and proprietary disposable sensors.
U.S. revenue from the sale of the CH 2000 Alternans System and disposable sensors increased 46% during Fiscal 1999 while revenue from the sale of standard stress test systems declined 47%.
International revenue from the sale of the CH 2000 Alternans System and disposable sensors declined by 2% during Fiscal 1999. Sales of Alternans product to Japan declined 13%. The Company's Japanese distributor Fukuda Denshi, Ltd reduced their purchases during the year in an effort to reduce on hand inventories. Sales to all other international customers increased 116% during Fiscal 1999. Sales of standard stress test systems increased 211%, while revenue from the sale of the CH 2000 System with the Alternans Option and disposable sensors increased 109% during the same period. The Company believes that its decision to change distribution partners in Europe during Fiscal 1998 has resulted in an improved focus and commitment to sale of the Company's standard stress test and T-wave alternans products.
Gross profits declined to 6% of total revenue in Fiscal 1999 from 12% for Fiscal 1998. The decrease is due to the effect of the strong increase in the sale of product to the Company's European distributors at industry standard distributor pricing, which is lower than commercial pricing, had a major effect on the gross profit percentage.
Research and development costs were $2,850,400 in Fiscal 1999 compared to $3,594,900 in Fiscal 1998, a decrease of 21%. Fiscal 1998 included approximately $900,000 of costs associated with the Company's 337 patient multi center clinical study supporting the 510(k) filed with FDA in August 1998 and cleared in April 1999, for expansion of its labeling claims for T- wave alternans. These costs are partially offset by an increase in development costs associated with the Company's new add-on module scheduled for introduction in 2000.
Selling and marketing costs were $3,211,500 in Fiscal 1999 compared to $2,178,100 in Fiscal 1998, an increase of 47%. The growth in Fiscal 1999 expenditures reflects spending on initiatives targeted at increased awareness of the Company's proprietary T-wave alternans technology and the clinical use of its Alternans test, as well as, programs supporting obtaining reimbursement from third-party payors for clinicians performing Alternans tests
Administrative costs were $1,734,000 in Fiscal 1999 compared to $1,575,200 in Fiscal 1998, an increase of 10% reflecting increased cost in support of the Company's expanded information systems infrastructure and employee education and training programs.
Interest income was $331,100 in Fiscal 1999 compared to $562,500 in Fiscal 1998, a decrease of 59%. The reduction primarily reflects the impact of lower interest rates during Fiscal 1999 on the Company's short-term cash investments partially offset by increased cash and marketable securities balances from the private placement of Common stock in June 1999 and October 1999.
Fiscal 1998 Compared to Fiscal 1997
Revenues were $2,096,900 in Fiscal 1998 and $1,448,300 for the fiscal year ended December 31, 1997 ("Fiscal 1997"), an increase of 45%. Sales of the Company's CH 2000 System and accessories accounted for 97% of total revenues in Fiscal 1998 compared to 94% in Fiscal 1997. The remainder of the revenues were from the sale of the Company's proprietary, disposable sensors.
Revenues from products sold outside the United States were $967,600 in Fiscal 1998, an increase of $66,700 or 7% over the previous fiscal year. Revenues from products sold to Japan were $744,100 in Fiscal 1998 compared to $674,600 in Fiscal 1997, an increase of 10%. Revenues from products sold to the remaining international customers were $223,500 in Fiscal 1998 compared to $242,600 in Fiscal 1997, a decrease of 8%. At the end of Fiscal 1997, the Company changed distribution partners in Europe due to the former distribution partners' failure to meet contract terms. A new distributor was appointed, effective April 1, 1998. The Company believes this transition accounted for the decline in revenues during Fiscal 1998. Sales to all international customers accounted for 46% of the Company's total revenues in Fiscal 1998 compared to 67% in Fiscal 1997. Sales to U.S. customers were $1,129,200 in Fiscal 1998 compared to $547,400 in Fiscal 1997, an increase of 106%. The increase in U.S. revenues results from improvement in the efficiency and effectiveness of the Company's sales organization, which was expanded during 1997. The Company employs 5 direct sales managers in the U.S. and had 35 independent manufacturers' sales representatives under contract at the end of Fiscal 1998.
Cost of goods sold was $1,848,200, or 88% of total revenues, in Fiscal 1998 and $1,386,600, or 96% of total revenues, in Fiscal 1997. The improved ratio of costs to product sales during Fiscal 1998 is the result of the Company's product cost reduction programs targeted at reducing the cost of direct materials and the impact of increases in production volumes on the allocation of fixed overhead costs. The continued increase in percentage of revenues from U.S. customers, which have a higher margin, has favorably affected the overall cost of sales ratio. The Company anticipates that these factors together with increases in revenues of its Hi-Resolution disposable sensors will continue to favorably effect the overall gross margin.
Research and development costs were $3,594,900 in Fiscal 1998 compared to $3,587,000 in Fiscal 1997. The Company incurred incremental costs totaling $266,700 during Fiscal 1998 to complete its clinical studies supporting the 510(k) filed with FDA for expansion of its labeling claims for its T-wave alternans technology. These costs were partially offset by a reduction in 1998 of $84,700 in the amount of compensation expense recorded relating to stock options granted to non-employees for services rendered and an increase during Fiscal 1998 over Fiscal 1997 of $200,100 in the amount of software development costs capitalized under Statement of Financial Accounting Standards No. 86 "Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed."
Selling, general and administrative expenses were $3,753,300 in Fiscal 1998 compared to $3,391,700 in Fiscal 1997, an increase of 11%. The increase is primarily the result of the costs associated with compensation paid to U.S. sales representatives' associated with the increase in revenues during Fiscal 1998.The Company continues to increase its marketing efforts targeted at the rapid adoption of T-wave alternans testing by clinical cardiologists and other medical professionals. Additionally, during Fiscal 1997, the Company experienced several changes in management personnel. As a result, the Company recorded $230,500 of termination costs associated with these changes.
Interest income for Fiscal 1998 was $562,500 compared to $869,300 for Fiscal 1997. The decrease is primarily the result of the net reduction in the Company's cash and marketable securities balances by $6,265,900 during Fiscal 1998.
Inflation and Income Taxes
Inflation did not have a significant effect on the Company's results of operations for any of the years in the period ended December 31, 1999.
The Company has not recorded a provision for income taxes for the years 1995, 1996, 1997, 1998 and 1999 because it incurred net losses in each of such years. At December 31, 1999, the Company had net operating loss carryforwards of $30,500,000 as well as $910,000 and $540,000 of federal and state tax credit carryforwards, respectively, available to offset future taxable income and income tax liabilities, respectively. These carryforwards generally expire in the years 2007 through 2019 and may be subject to annual limitations as a result of changes in the Company's ownership. There can be no assurance that changes in ownership in future periods or continuing losses will not significantly limit the Company's use of net operating loss and tax credit carryforwards.
The Company has generated taxable losses from operations since inception and, accordingly, has no taxable income available to offset the carryback of net operating losses. In addition, although management's operating plans anticipate taxable income in future periods, such plans provide for taxable losses over the near term and make significant assumptions which cannot be reasonably assured including approval of the Company's products by the FDA and market acceptance of these products by customers. The Company has provided a full valuation allowance ($30,500,000 at December 31, 1999) for its deferred tax assets since, in the opinion of management, realization of these future benefits is not sufficiently assured (defined as a likelihood of slightly more than 50 percent).
Liquidity and Capital Resources
During Fiscal 1999, the Company raised gross proceeds of $10,333,000 ($9,472,800 net of issuance costs) from the sale of common stock. In addition, the Company utilized $206,700 of a $500,000 line of credit secured by selected customer accounts receivable at the end of Fiscal 1999. These financing activities offset cash used to fund the increased level of operations, with corresponding increases in most balance sheet accounts. Cash, cash equivalents and marketable securities increased by $2,686,000 from December 31, 1998 to December 31, 1999, consistent with the Company's net loss for Fiscal 1999 net of total financing activities. Accounts receivable, net, increased slightly by $21,165 during the year, reflecting increased sales activity and the broadening of the Company's customer base. Inventory levels have increased slightly from $426,500 to $460,900 during the year. Fixed asset additions during the year primarily represent increased sales demonstration, clinical research units and additional information systems infrastructure.
The proceeds of the equity offerings have been used primarily to fund operating losses of $29,035,800 reflecting expenditures to support research, new product development and clinical trials activities, to support a marketing and sales organization, and to support an administrative infrastructure and the investment of approximately $1,332,400 in property and equipment through December 31, 1999. As of December 31, 1999, the Company had cash, cash equivalents and marketable securities of $9,176,300.
In January 2000, the Company raised and additional $2.075 million (net of issuance costs) from the sale of 600,000 shares of common stock. This amount is not included in the above amounts.
The Company expects its capital expenditures to increase as it continues to commercialize its products, particularly in connection with the introduction of its "add-on" module during Fiscal 2000. The Company does not expect capital expenditures to exceed an aggregate of $2,000,000 over the next two years.
Under the terms of various license, consulting and technology agreements, the Company is required to pay royalties on sales of its products. Minimum license maintenance fees under these license agreements, which are creditable against royalties otherwise payable for each year, range from $20,000 to $40,000 per year in total through 2008. The Company is committed to pay an aggregate of $360,000 of such minimum license maintenance fees subsequent to December 31, 1999. As part of these agreements, the Company is also committed to meet certain development and sales milestones, including a requirement to spend a minimum of $200,000 in any two-year period for research and development, clinical trials, marketing, sales and/or manufacturing of products related to certain technology covered by the consulting and technology agreements.
The Company anticipates that its existing capital resources will be adequate to satisfy its capital requirements through 2000.
Factors Which May Affect Future Results
This Annual Report on Form 10-K (the "Annual Report") contains forward- looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects," "intends" and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company's actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below and elsewhere in this Annual Report. In this section, "we", "us" and "our" refer to Cambridge Heart, Inc. (unless the context otherwise requires).
Risks Related to Our Operations
We may never generate substantial revenues
We are engaged primarily in the commercialization, manufacture, research and development of products for the non-invasive diagnosis of heart disease. We have incurred substantial and increasing net losses through December 31, 1999. We may never generate substantial revenues or achieve profitability on a quarterly or annual basis. We believe that our research and development expenses will increase in the future as we develop additional products and fund clinical trials of our product candidates. Our research and development expenses may also increase in the future as we supplement our internal research and development with additional third party technology licenses and potential acquisition of complementary products and technologies. We also expect that our selling, general and administrative expenses will increase significantly in connection with the continued expansion of our sales and marketing activities. Revenues generated from the sale of our products will depend upon numerous factors, including:
. the timing of regulatory actions;
. progress of product development;
. the extent to which our products gain market acceptance;
. varying pricing promotions and volume discounts to customers;
. competition; and
. the availability of third-party reimbursement.
Our technology may never achieve market acceptance
We believe that our future success will depend, in large part, upon the successful commercialization and market acceptance of our T-wave alternans technology. Market acceptance will depend upon our ability to demonstrate the diagnostic advantages and cost-effectiveness of this technology and upon our ability to obtain third party reimbursement for users of our technology. We can give no assurance that we will be able to successfully commercialize or achieve market acceptance of our T-wave alternans technology or that our competitors will not develop competing technologies that are superior to our technology.
The results of future clinical studies may not support the usefulness of our technology
We have sponsored and are continuing to sponsor clinical studies relating to our T-wave alternans technology and Hi-Resolution sensors to establish the predictive value of such technology. Although studies on high risk patients to date have indicated that the measurement of T-wave alternans to predict the vulnerability to ventricular arrhythmia is comparable to electrophysiology testing, we do not know whether the results of such studies, particularly studies involving patients who are not high risk, will continue to be favorable. Any clinical studies or trials which fail to demonstrate that the measurement of T-wave alternans is at least comparable in accuracy to alternative diagnostic tests, or which otherwise call into question the cost- effectiveness, efficacy or safety of our technology, would have a material adverse effect on our business, financial condition and results of operations.
We may have difficulty responding to changing technology
The medical device market is characterized by rapidly advancing technology. Our future success will depend, in large part, upon our ability to anticipate and keep pace with advancing technology and competitive innovations. However, we may not be successful in identifying, developing and marketing new products or enhancing our existing products. In addition, there can be no assurance that new products or alternative diagnostic techniques may be developed that will render our current or planned products obsolete or inferior. Rapid technological development by competitors may result in our products becoming obsolete before we recover a significant portion of the research, development and commercialization expenses incurred with respect to such products.
We have significant competition from a variety of sources
Competition from competitors' medical devices that diagnose cardiac disease is intense and likely to increase. We compete with manufacturers of electrocardiogram stress tests, the conventional method of diagnosing ischemic heart disease, as well as with manufacturers of other invasive and non- invasive tests, including EP testing, electrocardiograms, Holter monitors, ultrasound tests and systems of measuring cardiac late potentials. Many of our competitors and prospective competitors have substantially greater capital resources, name recognition, research and development experience and regulatory, manufacturing and marketing capabilities. Many of these competitors offer broad, well-established product lines and ancillary services not offered by Cambridge Heart. Some of our competitors have long-term or preferential supply arrangements with physicians and hospitals which may act as a barrier to market entry.
We depend heavily on independent manufacturers' representatives and foreign distributors
We currently market our products in the United States through a small direct sales force and independent manufacturers' representatives. We may not be able to continue to recruit and retain skilled sales management, direct sales persons or independent manufacturers' representatives. We market our products internationally through independent distributors. These distributors also distribute competing products under certain circumstances. The loss of a significant international distributor could have a material adverse effect on our business if a new distributor, sales representative or other suitable sales organization could not be found on a timely basis in the relevant geographic market. To the extent that we rely on sales in certain territories through distributors, any revenues we receive in those territories will depend upon the efforts of our distributors. Furthermore, there can be no assurance that a distributor will market our products successfully or that the terms of any future distribution arrangements will be acceptable to us.
Risks Related to the Market for Cardiac Diagnostic Equipment
Our business could be subject to product liability claims
The testing, manufacture, marketing and sale of medical devices entails the inherent risk of liability claims or product recalls. Although we maintain product liability insurance in the United States and in other countries in which we conduct business, including clinical trials and product marketing and sales, such coverage may not be adequate. Product liability insurance is expensive and in the future may not be available on acceptable terms, if at all. A successful product liability claim or product recall could inhibit or prevent commercialization of the CH 2000 Alternans System or cause a significant financial burden on Cambridge Heart, or both, and could have a material adverse effect on our business, financial condition and ability to market the CH 2000 Alternans System as currently contemplated.
Our business could be adversely affected if we are unable to protect our proprietary technology
Our success will depend, in large part, on our ability to develop patentable products, enforce our patents and obtain patent protection for our products both in the United States and in other countries. However, the patent positions of medical device companies, including Cambridge Heart, are generally uncertain and involve complex legal and factual questions. We can give no assurance that patents will issue from any patent applications we own or license or that, if patents do issue, the claims allowed will be sufficiently broad to protect our proprietary technology. In addition, any issued patents we own or license may be challenged, invalidated or circumvented, and the rights granted under issued patents may not provide us with competitive advantages. We also rely on unpatented trade secrets to protect our proprietary technology, and we can give no assurance that others will not independently develop or otherwise acquire substantially equivalent techniques, or otherwise gain access to our proprietary technology, or disclose such technology or that we can ultimately protect meaningful rights to such unpatented proprietary technology.
Others could claim that we infringe their intellectual property rights
Our commercial success will depend in part on our neither infringing patents issued to others nor breaching the licenses upon which our products might be based. Our licenses of patents and patent applications impose various commercialization, sublicensing, insurance, royalty and other obligations on our part. If we fail to comply with these requirements, licenses could convert from being exclusive to nonexclusive in nature or could terminate.
We could become involved in litigation over intellectual property rights
The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights. Litigation, which would likely result in substantial cost to us, may be necessary to enforce any patents issued or licensed to us and/or to determine the scope and validity of others' proprietary rights. In particular, our competitors and other third parties hold issued patents and are assumed to hold pending patent applications which may result in claims of infringement against us or other patent litigation. We also may have to participate in interference proceedings declared by the United States Patent and Trademark Office, which could result in substantial cost, to determine the priority of inventions. Furthermore, we may have to participate at substantial cost in International Trade Commission proceedings to abate importation of products which would compete unfairly with our products.
We may not be able to protect our trade secrets
We rely on confidentiality agreements with our collaborators, employees, advisors, vendors and consultants. We can give no assurance that these agreements will not be breached, that we would have adequate remedies for any, breach or that our trade secrets will not otherwise become known or be independently developed by competitors. Failure to obtain or maintain patent and trade secret protection, for any reason, could have a material adverse effect on Cambridge Heart.
We may not be able to obtain third-party reimbursement
Our revenues currently depend and will continue to depend, to a significant extent, on sales of the CH 2000 Alternans System. Our ability to successfully commercialize the CH 2000 Alternans System depends in part on the availability of, and our ability to obtain, adequate levels of third-party reimbursement for use of the CH 2000 Alternans System. Reimbursement is not currently available for the use of the CH 2000 Alternans System for measuring T-wave alternans.
The amount of reimbursement in the United States that will be available for clinical use of the CH 2000 Alternans System, if any, is uncertain and may vary. In the United States, the cost of medical care is funded, in substantial part, by government insurance programs, such as Medicare and Medicaid, and private and corporate health insurance plans. Third-party payors may deny reimbursement if they determine that a prescribed device has not received appropriate FDA or other governmental regulatory clearances, is not used in accordance with cost-effective treatment methods as determined by the payor, or is experimental, unnecessary or inappropriate. Our ability to commercialize the CH 2000 Alternans System successfully will depend, in large part, on the extent to which appropriate reimbursement levels for the cost of the use of the CH 2000 Alternans System and associated sensors are obtained from government authorities, private health insurers and other organizations, such as health maintenance organizations.
We do not know whether reimbursement in the United States or foreign countries will be available for the CH 2000 Alternans System, or if available, will not be decreased in the future or that reimbursement amounts will not reduce the demand for, or the price of, the CH 2000 Alternans System. The unavailability of third-party reimbursement or the inadequacy of the reimbursement for medical tests using the CH 2000 Alternans System would have a material adverse effect on Cambridge Heart.
Item 7A.
Item 7A. Qualitative and Quantitative Disclosures about Market Risk
In January 1997, the Securities and Exchange Commission issued Financial Reporting Release No. 48, which expands the disclosure requirements for certain derivatives and other financial instruments. The Company does not utilize derivative financial instruments.
See Notes 1 and 2 to the Financials Statements for a description of the Company's use of other financial instruments. The carrying amounts reflected in the balance sheet of cash and cash equivalents, trade receivables, and trade payables approximates fair value at December 31, 1999 due to the short maturities of these instruments.
Item 8.
Item 8. Financial Statements and Supplementary Data
CAMBRIDGE HEART, INC.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Cambridge Heart, Inc.
In our opinion, the accompanying balance sheets and the related statements of operations, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Cambridge Heart, Inc. at December 31, 1998 and 1999, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
Boston, Massachusetts February 14, 2000
CAMBRIDGE HEART, INC.
BALANCE SHEET
The accompanying notes are an integral part of these financial statements.
CAMBRIDGE HEART, INC.
STATEMENT OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
CAMBRIDGE HEART
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
CAMBRIDGE HEART, INC.
STATEMENT OF CASH FLOWS INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
The accompanying notes are an integral part of these financial statements.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS
1. The Company
Cambridge Heart, Inc. (the "Company") was incorporated in Delaware on January 16, 1990 and is engaged in the research, development and commercialization of products for the non-invasive diagnosis of cardiac disease. The Company sells its products primarily to hospitals, research institutions and cardiovascular specialists.
The Company anticipates that its existing capital resources, including the amounts raised in the January financing offering, will be adequate to satisfy its capital requirements through December 2000. Thereafter, the Company may require additional funds to support its operating requirements or for other purposes and may seek to raise such additional funds through public or private equity financing or from other sources. There can be no assurance that additional financing will be available at all or that, if available, such financing would be obtainable on acceptable terms to the Company.
2. Summary of Significant Accounting Policies
Significant accounting policies followed by the Company are as follows:
Cash Equivalents and Marketable Securities
The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. The Company invests its excess cash primarily in money market accounts, securities of state government agencies and short-term commercial paper of companies with strong credit ratings and in diversified industries. The securities of state government agencies are redeemable at their face value, and bear interest at variable rates which are adjusted on a frequent basis. Accordingly, these investments are subject to minimal credit and market risk. The money market accounts and short-term commercial paper, totaling $4,064,300 and $6,518,924 at December 31, 1998 and 1999, respectively, are classified as held to maturity, and mature within one year. The securities of state government agencies, totaling $2,447,700 and $2,150,000 at December 31, 1998 and 1999, respectively, are classified as available for sale. All of these investments have been recorded at amortized cost, which approximates fair market value. No realized or unrealized gains or losses have been recognized.
Financial Instruments
The carrying amounts of the Company's financial instruments, which include cash and cash equivalents, marketable securities, accounts receivable, accounts payable, and accrued expenses approximate their fair values at December 31, 1998 and 1999.
Inventories
Inventories, consisting primarily of purchased components, are stated at the lower of cost or market. Cost is determined using the first-in, first-out method.
Fixed Assets
Fixed assets are stated at cost, less accumulated depreciation. Depreciation is provided using the straight-line method based on estimated useful lives. Repair and maintenance costs are expensed as incurred.
Segment
The Company is engaged principally in one industry segment that represents all of the revenues. See Note 11 with respect to significant customers and with respect to sales in other geographic areas.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Revenue Recognition
Revenue is recognized upon shipment of goods, provided that all obligations of the Company have been fulfilled and collection of the related receivable is probable.
Research and Development and Capitalized Software Development Costs
Research, engineering and product development costs, except for certain software development costs, are expensed as incurred. Capitalization of software development costs begins upon the establishment of technological feasibility of both the software and related hardware as defined by Statement of Financial Accounting Standards No. 86, "Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed," and ceases upon the general release of the products to the public. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenues, estimated economic life and changes in software and hardware technologies.
The Company amortizes software development costs on a straight-line basis over the estimated economic life of the product.
Costs capitalized at December 31, 1999, which are included in other assets in the accompanying balance sheet, totaled $395,000 ($343,000 at December 31, 1998), net of $283,000 of accumulated amortization ($78,500 at December 31, 1998).
Licensing Fees and Patent Costs
The Company has entered into licensing agreements which give the Company the exclusive rights to certain patents and technologies and the right to market and distribute any products developed, subject to certain covenants. Payments made under these licensing agreements and costs associated with patent applications have generally been expensed as incurred, because recovery of these costs is uncertain. However, certain costs associated with patent applications for products and processes which have received regulatory approval and are available for commercial sale have been capitalized and are being amortized over their estimated economic life of 5 years. Amounts capitalized at December 31, 1999 totaled $110,000 ($100,000 at December 31, 1998), net of $58,000 of accumulated amortization ($39,000 at December 31, 1998), which are included in other assets in the accompanying balance sheet.
Stock-Based Compensation
The Company accounts for employee awards under its stock plans in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. The Company adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), for disclosure purposes only (Note 6).
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingencies at December 31, 1998 and 1999, and the reported amounts of revenues and expenses during the three years in the period ended December 31, 1999. Actual results could differ from these estimates.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Net Loss Per Share
Statement of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings per Share," requires dual presentation of basic and diluted earnings per share on the face of the statement of operations for all entities with complex capital structures. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share includes dilutive potential common stock (such as options, warrants and convertible preferred stock).
As a result of the Company's net loss both basic and diluted earnings per share are computed by dividing the net loss available to common shareholders by the weighted average number of shares of common stock outstanding.
New Accounting Pronouncements
In June 1998, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. We are required to adopt SFAS No.133, as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Dates of FASB Statement 133," on a prospective basis for interim periods and fiscal years beginning January 1, 2001. Had we implemented SFAS No. 133 in the current period, financial position and results of operations would not have been affected.
SEC Staff Accounting Bulletin No. 100, "Restructuring and Impairment Charges," issued in November 1999, expresses views of the Staff regarding the accounting for and disclosure of certain expenses commonly reported in connection with exit activities and business combinations. This includes accrual of exit and employee termination costs pursuant to Emerging Issues Task Force (EITF) Issues No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring), and No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination, and the recognition of impairment charges pursuant to Accounting Principles Board (APB) Opinion No. 17, Intangible Assets and Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of.
In December 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements." SAB 101 summarizes the SEC's views in applying generally accepted accounting principles to selected revenue recognition issues.
3. Fixed Assets
Fixed assets consist of the following:
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
4. Accrued Expenses
Accrued expenses consist of the following:
5. Line of Credit
The Company has a line of credit facility in place which provides a borrowing base of 80% of eligible accounts receivable as defined, up to a maximum borrowing of $500,000, payable on demand. Interest is payable monthly in arrears at the bank's prime rate plus .5% (9% at December 31, 1999). The line of credit is collateralized by all of the eligible accounts receivable as defined. This line of credit is scheduled to expire on March 31, 2000. The Company is negotiating an extension.
6. Stockholders' Equity
Preferred Stock
The Company's Board of Directors has authorized 3,000,000 shares of the Company's $0.001 par value preferred stock. The preferred stock may be issued at the discretion of the Board of Directors of the Company (without stockholder approval) with such designations, rights and preferences as the Board of Directors may determine from time to time. This preferred stock may have dividend, liquidation, redemption, conversion, voting or other rights which may be more expansive than the rights of the holders of the common stock.
Common Stock
In private placement transactions completed in June 1999 and October 1999, the Company raised gross proceeds totaling $10.4 million ($9.5 million net of issuance costs) from the sale of 2,468,759 shares of Common Stock. Both transactions include provisions stipulating that if the Company sells Common Stock in a capital raising transaction at a lower price per share over the next 24 months and 12 months respectively, the investors have the right to receive additional shares to adjust the price of their transaction. As a result of the October 1999 transaction, the Company issued 529,817 of additional shares of Common Stock to investors that participated in the June 1999 sale of Common Stock. These shares are in addition to the total number of shares above. In January 2000, the Company completed an additional private placement transaction in which it raised an additional $2.1 million from the sale of 600,000 shares of Common Stock. This transaction contained all of the same terms included in the October 1999 transaction.
Warrants
During 1999, warrants to purchase a total of 504,652 shares of common stock were issued in connection with the sale of 2,998,576 of common stock. Investors received warrants to purchase 95,238 shares of common stock at $3.71 per share, and warrants to purchase 303,269 shares of common stock at $3.50 per share. In addition, the Company's selling agent received warrants to purchase 106,144 shares of common stock at $4.20 per share.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The value of the above warrants was estimated by management and determined not to be material to the Company's results of operations and financial position.
Warrants outstanding at December 31, 1999 are as follows:
7. Stock Plans
1993 Incentive and Non-Qualified Stock Option Plan
During 1993, the Company adopted the 1993 Incentive and Non-Qualified Stock Option Plan (the "1993 Plan"). The 1993 Plan provides for the granting of incentive and non-qualified stock options to management, other key employees, consultants and directors of the Company. The total number of shares of common stock that may be issued pursuant to the exercise of options granted under the 1993 Plan is 1,688,663. Incentive stock options may not be granted at less than fair market value of the Company's common stock at the date of grant and for a term not to exceed ten years. For holders of more than 10% of the Company's total combined voting power of all classes of stock, incentive stock options may not be granted at less than 110% of the fair market value of the Company's common stock at the date of grant and for a term not to exceed five years. The exercise price under each non-qualified stock option shall be specified by the stock option committee, but shall in no case be less than the par value of the common stock subject to the non-qualified stock option.
1996 Equity Incentive Plan
During 1996, the Board of Directors authorized the 1996 Equity Incentive Plan (the "Incentive Plan"), providing for the issuance of up to 1,000,000 shares of the Company's common stock to eligible employees, officers, directors, consultants and advisors of the Company. Under the Incentive Plan, the Board of Directors may award incentive and non-qualified stock options, stock appreciation rights, performance shares and restricted and unrestricted stock with terms to be defined therein except that the exercise and transfer of stock appreciation rights granted in tandem with stock options is limited by the terms of the related options.
In December 1999, at a Special Shareholders' Meeting, the Stockholders voted to increase the number of shares authorized under the plan to 1,300,000 shares.
1996 Director Option Plan
During 1996, the Board of Directors authorized the issuance of up to 100,000 shares of the Company's common stock pursuant to its 1996 Director Option Plan (the "Director Plan"). Under the Director Plan, outside directors of the Company who are not otherwise affiliated with the Company are entitled to receive options to purchase 10,000 shares of common stock upon their initial election to the Board of Directors. All option grants made under the Director Plan have exercise prices equal to the fair market value of the Company's common stock on the date of grant, and will vest in three annual installments on the anniversary date of the grant. Director options will become immediately exercisable upon the occurrence of a change in control (as defined in the Director Plan).
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
All options granted during 1997, 1998 and 1999 have exercise prices equal to the fair market value of the common stock at the date of grant. Transactions under the Company's stock option plans during the years ended December 31, 1997, 1998 and 1999 are summarized as follows:
In October 1998, the Company repriced unexercised options to purchase a total of 396,250 shares of Common stock previously granted to employees and options to purchase a total of 40,000 shares of Common stock previously granted to members of the Company's Scientific Advisory Board ("SAB"). All vesting in the surrendered options was forfeited. The new employee options vest at a rate of 25% per year and the SAB options vest at a rate of 33% per year. The Company recorded $6,584 and $21,775 of deferred compensation in 1998 and 1999 respectively relating to this repricing.
During 1999, the Board of Directors granted non qualified options to purchase a total of 85,000 shares of Common stock to advisors to the Company not covered by an existing plan (50,000 shares and 35,000 shares). These options have exercise prices equal to the fair market value of the common stock at the date of grant. They are not included in the chart above.
The following table summarizes information about stock options outstanding under the Company's stock option plans at December 31, 1999:
At December 31, 1999, 1,705,450 shares of common stock are reserved for issuance upon exercise of the options issued under the Company's stock option plans and there are 327,550 options available for future grant. Outstanding options generally vest on a pro rata basis over a period of two to five years.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The Company has recorded compensation expense related to options granted to non-employee consultants for services rendered totalling $100,000 in 1997, $6,584 in 1998 and $20,428 in 1999. In addition, the Company recorded compensation expense of $91,875 related to the cashless exercise of 15,000 options by an employee in 1997.
1996 Employee Stock Purchase Plan
During 1996, the Board of Directors authorized the 1996 Employee Stock Purchase Plan (the "Purchase Plan"). The Purchase Plan provides for the issuance of up to 100,000 shares of the Company's common stock to eligible employees. Under the Purchase Plan, the Company is authorized to make one or more offerings during which employees may purchase shares of common stock through payroll deductions made over the term of the offering. The term of individual offerings, which are set by the Board of Directors, may be for periods of twelve months or less and may be different for each offering. The per-share purchase price at the end of each offering is equal to 85% of the fair market value of the common stock at the beginning or end of the offering period (as defined by the Purchase Plan), whichever is lower. The Company issued 8,560, 11,929 and 14,857 shares of common stock at an average price of $8.02, $5.72 and $3.68 during 1997, 1998 and 1999 respectively. At December 31, 1999, the Company had 64,654 shares of common stock reserved for issuance under the Purchase Plan.
Fair Value Disclosures
As discussed in Note 2, the Company has elected to adopt SFAS 123 through disclosure only. Had compensation cost for the Company's option plans and employee stock purchase plan been determined based on the fair value of the options at the grant dates, as prescribed in SFAS 123, for options granted in 1997, 1998 and 1999 the Company's net loss and net loss per share would have been as follows:
The fair value of each option grant under SFAS 123 was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 1997, 1998 and 1999, respectively: (i) dividend yield of 0% for all periods; (ii) expected volatility of 0%, 0%-50%; and 60%; (iii) risk free interest rates of 5.8%-6.8%, 6.1%-6.9% and 4.58%; and (iv) expected option terms of 4 to 7 years for 1997, 5 years for 1998 and xxxxxx for 1999. SFAS 123 requires that volatility be considered in the calculation of the fair value of an option grant only for grants made when an entity has publicly traded securities or has filed a registration statement to do so. Accordingly, a volatility of 0% was utilized for options granted by the Company prior to the initial filing of its Registration Statement on Form S-1.
The above pro forma disclosures reflect options granted during 1996, 1997 and 1998 only. Because additional option grants are expected to be made each year and options vest over several years, the above pro forma disclosures are not necessarily representative of the pro forma effects of reported net income (loss) for future years.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
7. Income Taxes
The income tax benefit consists of the following:
Deferred tax assets (liabilities) are comprised of the following:
The Company has generated taxable losses from operations since inception and, accordingly, has no taxable income available to offset the carryback of net operating losses. In addition, although management's operating plans anticipate taxable income in future periods, such plans provide for taxable losses over the near term and make significant assumptions which cannot be reasonably assured including approval of the Company's products and labeling claims by the U.S. Food and Drug Administration and market acceptance of the Company's products by customers. Based upon the weight of all available evidence, the Company has provided a full valuation allowance for its deferred tax assets since, in the opinion of management, realization of these future benefits is not sufficiently assured (defined as a likelihood of slightly more than 50 percent).
Approximately $1,080,000 of the deferred tax asset attributable to net operating loss carryforwards was generated by the exercise of certain non- qualified stock options. Any future utilization of this amount will be credited directly to additional paid-in-capital, and not the income tax provision.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Income taxes computed using the federal statutory income tax rate differs from the Company's effective tax rate primarily due to the following:
As of December 31, 1999, the Company has approximately $30,500,000 of net operating loss carryforwards and $910,000 and $540,000 of federal and state research and development credits, respectively, which may be used to offset future federal and state taxable income and tax liabilities, respectively. The credits and carryforwards expire in various years ranging from 2007 to 2019.
An ownership change, as defined in the Internal Revenue Code, resulting from the Company's issuance of additional stock may limit the amount of net operating loss and tax credit carryforwards that can be utilized annually to offset future taxable income and tax liabilities. The amount of the annual limitation is determined based upon the Company's value immediately prior to the ownership change. The Company has determined that ownership changes have occurred at the time of the Series A Preferred Stock issuance in 1993 and the Series B Preferred Stock issuance in 1995, but has not yet determined the amount of the annual limitations. However, management does not believe that such limitations would materially impact the Company's ability to ultimately utilize its carryforwards, provided sufficient taxable income is generated in future years, although the limitations may impact the timing of such utilization. Subsequent significant changes in ownership could further affect the limitations in future years.
8. Savings Plan
In January 1995, Cambridge Heart adopted a retirement savings plan for all employees pursuant to Section 401(k) of the Internal Revenue Code. Employees become eligible to participate on the first day of the calendar quarter following their hire date. Employees may contribute any whole percentage of their salary, up to a maximum annual statutory limit. The Company is not required to contribute to this plan. The Company made no contributions to this plan in 1997, 1998 or 1999.
9. Commitments
Operating Leases
The Company has various noncancelable operating leases for office space, equipment and furniture which expire through 2001. Certain of these leases provide the Company with various renewal options. Total rent expense under all operating leases was approximately $159,700, $178,600 and $202,500 for the years ended December 31, 1997, 1998 and 1999, respectively.
At December 31, 1999, future minimum rental payments under the noncancelable leases are as follows:
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
License Maintenance Fees
Pursuant to certain license arrangements, the Company must pay license maintenance fees ranging from $5,000 to $20,000 per year through 2008 to maintain its license rights. The Company is also required to meet certain development and sales milestones as specified in the agreements. Should the Company fail to meet such milestones, the license arrangements may be terminated at the sole option of the licensor. License maintenance fees paid during 1997, 1998 and 1999 amounted to $20,000 in each year. The future minimum license maintenance fee commitments at December 31, 1999 are approximately as follows:
During the term of these license agreements, the Company is obligated to pay a royalty (ranging from 1.5% to 2.0%) based on net sales of any products developed from the licensed technologies. The license maintenance fees described above are creditable against royalties otherwise payable for such year.
10. Related Party Transactions, Including Royalty Obligations
License Agreement/Consulting and Technology Agreement
In February 1993, the Company entered into a license agreement with a member of the Company's Board of Directors. This individual is also Chairman of the Company's Scientific Advisory Board and a faculty member at the institution with which the Company has entered into certain other license agreements. In exchange for exclusive patented technology licensing rights, the Company is required to pay this individual a royalty based on 3% of net sales of products developed from such technology. If the Company chooses to sublicense this product to an unrelated party, the royalty will be based on 20% of the gross revenue two-year period for research and development, clinical trials, marketing, sales and/or manufacturing of products related to this technology. Because the Company has chosen not to invest in this technology as required by the license agreement, the license agreement may be canceled at the sole option of the licensor at any time.
Also in February 1993, the Company entered into a consulting and technology agreement with this individual. This agreement, which has been extended to May 31, 2000, requires the Company to pay a monthly consulting fee of $10,000, as stipulated in the agreement. Total payments made during 1997, 1998 and 1999 were approximately $112,600, $118,000 and $121,300 respectively, and are included in research and development expense. The Company is also required to remit to this individual a royalty of 1% of net sales of products developed from certain other technology licensed from the institution described above. If the Company chooses to sublicense such products to an unrelated party, the royalty will be based on 7% of the gross revenue received from the unrelated party for products developed from such technology. In connection with this consulting and technology agreement, a warrant to purchase 109,634 shares of common stock was issued to this individual. This warrant was exercised during 1998, and 85,510 shares of common stock were issued.
Operations through December 31, 1999 did not result in the recognition of any material royalty expense in connection with these agreements.
CAMBRIDGE HEART, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
12. Major Customers, Export Sales and Concentration of Credit Risk
Revenues from the Company's Japanse distributor accounted for 47%, 36% and 27% of total revenues during 1997, 1998 and 1999 respectively and 40%, 37% and 16% of the accounts receivable balance at December 31, 1997, 1998 and 1999 respectively. Company policy does not require collateral on accounts receivable balances.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The response to this item is contained in part under the caption "EXECUTIVE OFFICERS OF THE REGISTRANT" in Part I hereof, and the remainder is contained in the Company's Proxy Statement for the Annual Meeting of Stockholders to be held on May 31, 2000 (the "2000 Proxy Statement") under the caption "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The response to this item is contained in the 2000 Proxy Statement under the captions "Compensation of Directors," "Executive Compensation," and "Severance and Other Agreements," and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The response to this item is contained in the 2000 Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management" and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The response to this item is contained in the 2000 Proxy Statement under the caption "Transactions with Directors," and is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a)1. Financial Statements
The Company's financial statements listed in the Index to Financial Statements in Item 8 hereof are filed as part of this Annual Report on Form 10-K.
(a)2. Financial Statement Schedules
All applicable information is readily determinable from the notes to the Company's financial statements.
(a)3. Listing of Exhibits
- -------- (1) Incorporated herein by reference to the Company's Registration Statement on Form S-1, as amended (File No. 333-04879). (2) Incorporated herein by reference to the Company's Form 10-K, as amended, for the fiscal year ended December 31, 1997. (3) Incorporated herein by reference to the Company's Form 10-Q, as amended, for the quarter ended June 30, 1998. (4) Incorporated herein by reference to the Registrant's Form 10-Q, as amended, for the quarter ended June 30, 1999. (5) Incorporated herein by reference to the Registrant's Form 10-Q, as amended, for the quarter ended September 30, 1999 (6) Incorporated herein by reference to the Registrant's Current Report on Form 8-K filed August 19, 1998. (7) Incorporated herein by reference to the Registrant's Amendment No. 1 to Current Report on Form 8-K/A filed September 4, 1998. *Confidential treatment has been granted as to certain portions. # Management contract or compensatory plan or arrangement filed as an exhibit to this Form pursuant to Items 14(a) and 14(c) of Form 10-K.
(b) No Current Reports on Form 8-K were filed by the Company during the last quarter of the period covered by this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 30, 2000.
CAMBRIDGE HEART, INC.
/s/ Jeffrey M. Arnold By:__________________________________ Jeffrey M. Arnold Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. | 16,994 | 112,568 |
46195_1999.txt | 46195_1999 | 1999 | 46195 | ITEM 1. BUSINESS
Pacific Century Financial Corporation (Pacific Century) is a bank holding company, which through its banking subsidiaries is engaged primarily in the business of commercial and retail banking. Pacific Century was organized on August 12, 1971, as the first bank holding company in the State of Hawaii. Originally organized as Hawaii Bancorporation, Inc., its name was changed in 1979 to Bancorp Hawaii, Inc. and in 1997 changed to Pacific Century Financial Corporation. The latter change in name was made to provide a more distinctive and descriptive identity that reflects the Company's strategic goals to expand its activities beyond Hawaii to Asia, the West and South Pacific, and the U.S. Mainland. In April 1998, Pacific Century changed its state of incorporation from Hawaii to Delaware, by merging into a new wholly-owned subsidiary formed for that purpose.
Pacific Century groups its principal revenue-producing businesses into the following four market regions: Hawaii, the South and West Pacific, Asia, and the U.S. Mainland. Pacific Century offers a broad range of customary commercial and consumer banking products and services that include, but are not limited to, lending, leasing, deposit services, trust and investment activities, and trade financing. The majority of Pacific Century's operations are conducted through its banking subsidiaries. The principal subsidiaries of Pacific Century are Bank of Hawaii and Pacific Century Bank, N.A.
At December 31, 1999, Pacific Century and its subsidiaries had approximately 4,700 full-time and part-time employees.
Acquisitions
In January 1999, Pacific Century completed the acquisition of Triad Insurance Agency, Inc. (Triad). Triad is a Hawaii-based property/casualty insurance agency. The acquisition was accounted for under the purchase method of accounting.
Organization Structure
Pacific Century's organization structure as of December 31, 1999 is included in Exhibit 21.1. All subsidiaries are wholly-owned except as otherwise noted for certain banks in the South Pacific and for those entities whose directors own qualifying shares.
Subsidiaries
Provided below is a brief description of each of Pacific Century's subsidiaries.
Bank of Hawaii was organized under the laws of Hawaii on December 17, 1897. Its headquarters are in Honolulu, Hawaii, and its deposits are insured by the Federal Deposit Insurance Corporation (FDIC). Bank of Hawaii is the largest full-service financial institution headquartered in the State of Hawaii with a statewide network of 74 traditional and in-store branches. It is not a member of the Federal Reserve System.
Pacific Century and 14 directors of Bank of Hawaii (each of whom holds 125 qualifying shares each) own 100% of the outstanding shares. There are six directors of Bank of Hawaii who do not hold qualifying shares. The legal requirement for directors of Hawaii banks to hold qualifying shares was eliminated in 1993.
Bank of Hawaii provides customary commercial banking services through branch offices in the State of Hawaii and branches or representative offices in Bahamas (Nassau), Republic of Fiji (Suva, Nadi, and Lautoka), Hong Kong, Japan (Tokyo), South Korea (Seoul), Philippines (Manila, Cebu, and Davao), Singapore, Taiwan (Taipei), American Samoa, Commonwealth of the Northern Mariana Islands (Saipan), Federated States of
Micronesia (Pohnpei, Kosrae, and Yap), Guam, Republic of the Marshall Islands (Majuro), and Republic of Palau (Koror). In addition, Bank of Hawaii maintains a presence in the South Pacific through subsidiary banks located in French Polynesia, New Caledonia, Papua New Guinea, and Vanuatu, and through affiliate banks located in Samoa, Solomon Islands, and Tonga. Pacific Century Trust, a division of Bank of Hawaii, operates offices in Hawaii, California, Arizona and Guam. Trust assets under administration at year-end 1999 were $13.8 billion.
As of December 31, 1999, wholly-owned direct subsidiaries of Bank of Hawaii included Pacific Century Leasing, Inc.; Bank of Hawaii International, Inc.; Bank of Hawaii International Corporation, New York; Pacific Century Life Insurance Corporation; Triad Insurance Agency, Inc.; Bankoh Insurance Agency; Pacific Century Investment Services, Inc.; Pacific Century Insurance Services, Inc.; Bankoh Corporation and Pacific Century Advisory Services, Inc. A brief discussion of these direct Bank subsidiaries follows:
Pacific Century Leasing, Inc. (PCL), formerly Bancorp Leasing of Hawaii, Inc., formed in 1973, provides leasing and leasing services, mainly to the commercial sector in Hawaii. PCL has several subsidiaries that are "specific purpose leasing vehicles." At December 31, 1999, these subsidiaries included S.I.L., Inc.; Pacific Century Leasing International, Inc.; and BNE Airfleets Corporation. In September 1999, Arbella Leasing Corp., a specific purpose leasing subsidiary was sold. On a consolidated basis, PCL's assets represented 2.2% of Pacific Century's total assets at year-end 1999.
Bank of Hawaii International, Inc. (BOHI) was formed in 1968. BOHI's primary business purpose is to hold an equity interest in the following foreign financial institutions (in the percentages indicated): Bank of Hawaii-Nouvelle Caledonie--96%; Bank of Hawaii (PNG) Ltd.--100%; Banque de Tahiti--95%; Banque d'Hawaii (Vanuatu), Ltd.--100%; National Bank of Solomon Islands--51%; Pacific Commercial Bank, Ltd.-- 43%; and Bank of Tonga--30%. At December 31, 1999, total assets of BOHI and its subsidiaries accounted for 8.4% of the consolidated total of Pacific Century.
Bank of Hawaii International Corporation, New York (BOHICNY) was organized in 1982 as an Edge Act corporation. BOHICNY provides payment, clearing, and settlement services with the New York Clearing House and Clearing House Interbank Payment Service for both affiliated and unaffiliated banks. At December 31, 1999, total assets of BOHICNY represented 0.8% of consolidated total assets of Pacific Century.
At December 31, 1999, Bank of Hawaii's retail insurance subsidiaries held in the aggregate total assets representing 0.1% of the consolidated total assets of Pacific Century. Provided below is a brief description of these subsidiaries.
. Pacific Century Life Insurance Corporation, formerly Bancorp Life Insurance Company of Hawaii, Inc., was incorporated in 1981 in the State of Arizona to underwrite, as a reinsurer, the credit life and credit accident and health insurance sold in conjunction with Bank of Hawaii's short-term consumer lending activities.
. Triad Insurance Agency, Inc. (Triad), a Hawaii based property/casualty insurance agency, and its subsidiary Insurance Agents Group, Inc. (IAG) were acquired in January 1999. Triad represents a number of large U.S. property/casualty insurance companies in Hawaii, for whom it acts as a servicing agent.
. In 1999 Bankoh Insurance Agency emerged as the remaining entity from the consolidation of Pacific Century Agency, Inc., Pacific Century Insurance Agency, Inc. and IAG. This reorganization was implemented to streamline the insurance structure.
A brief description of Bank of Hawaii subsidiaries that provide investment, captive insurance and other services is set forth below. The aggregate total assets of these subsidiaries as of December 31, 1999 was 0.1% of consolidated total assets of Pacific Century.
. Pacific Century Investment Services, Inc. formerly Bancorp Investment Group, Ltd., was organized in 1991 to provide full service brokerage and other investment services originally as a subsidiary of Pacific Century and, since 1994, as a wholly-owned subsidiary of Bank of Hawaii.
. Pacific Century Insurance Services, Inc. (Pacific Century Insurance), formerly Bancorp Hawaii Insurance Services, Ltd. was established in 1989 as a wholly-owned captive insurance company. With the formation of Pacific Century Insurance, Pacific Century became the first Hawaii corporation to establish a Hawaii captive insurance company for its self- insurance needs. Pacific Century Insurance provides bankers professional liability insurance and workers compensation insurance exclusively to Pacific Century and its subsidiaries and affiliates. These services provide Pacific Century with greater flexibility and stability in managing insurance coverages and premium costs. Additionally, Pacific Century Insurance also provides Pacific Century with the opportunity to design self-insurance programs not otherwise available in the conventional insurance market. In 1999 Pacific Century Insurance became a wholly-owned subsidiary of Bank of Hawaii.
. Bankoh Corporation was originally incorporated in 1984 as Hawaiian Hong Kong Holdings, Ltd. and remained inactive until 1994. In 1994, the name was changed to Bankoh Corporation, with minimal activity since its name change.
. Pacific Century Advisory Services, Inc., formerly Bankoh Investment Advisory Services Ltd., was reactivated in 1991 to provide advisory services for businesses seeking to operate in Hawaii. The activity of this company remained limited during 1999.
Pacific Century also holds all of the outstanding stock of the corporations listed below:
Pacific Century Bank, N.A. (PCB) is headquartered in Encino, California, and its business primarily consists of providing commercial banking products and services in Southern California and the State of Arizona. PCB is organized under the laws of the United States. It is a member of the Federal Reserve System and its deposits are insured by the FDIC. PCB's operations are conducted through 19 branch offices in the State of California and 9 branch offices in the State of Arizona. PCB's total assets represented 7.8% of Pacific Century's consolidated total at December 31, 1999.
First Savings and Loan Association of America, F.S.A. (First Savings), a wholly-owned subsidiary of Pacific Century, was acquired in 1990. First Savings is engaged primarily in the business of providing retail financial services in the territory of Guam. Operations are conducted primarily through three full-service branches and three in-store locations. Its deposits are insured by the FDIC. First Savings' assets represented 1.3% of Pacific Century's total assets at December 31, 1999.
Pacific Century Small Business Investment Company, Inc., formerly Bancorp Hawaii Small Business Investment Company, Inc., was formed in September 1983 in the State of Hawaii as a small business investment company. At the end of 1999, total assets of this subsidiary were not significant.
PCFC Hawaii Corporation was formed in 1998 for the single purpose of holding a real estate investment. The investment was sold in late 1998 and the company was dissolved in 1999.
REGULATION AND COMPETITION
Effect of Governmental Policies
The earnings of Pacific Century and its principal subsidiaries are affected not only by general economic conditions, both domestically and internationally, but also by the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve System, and foreign governments and their agencies. The monetary policies of the Federal Reserve System influence to a significant extent the overall growth of loans, investments, and deposits; the level of interest rates earned on assets and paid for liabilities; and interest rates charged on loans and paid on deposits. The nature and impact of future changes in monetary policies are often not predictable.
Competition
Pacific Century and its subsidiaries are subject to substantial competition in all aspects of the businesses in which they engage from banks (both domestic and foreign), savings associations, credit unions, mortgage companies, finance companies, mutual funds, brokerage firms, insurance companies and other providers of financial services. Pacific Century also competes with certain non-financial institutions and governmental entities that offer financial products and services. Many of Pacific Century competitors are not subject to the same level of extensive regulations and oversight that are required of banks, bank holding companies and savings associations.
Supervision and Regulation
Pacific Century is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the BHC Act) and, as such, is subject to the Act and regulations issued thereunder by the Board of Governors of the Federal Reserve System (the Board of Governors). Pacific Century is also registered as a bank holding company under the Hawaii Code of Financial Institutions (the Code) and, as such, is subject to the registration, reporting, and examination requirements of the Code.
The BHC Act requires prior approval of the Board of Governors of the acquisition by Pacific Century of more than 5% of the voting shares of any bank or any other bank holding company. Subject to certain limits, the BHC Act allows adequately capitalized and adequately managed bank holding companies to acquire control of banks in any state. Thus, assuming it is judged to be adequately capitalized and adequately managed, Pacific Century may acquire control of banks in any state, and bank holding companies whose operations are principally conducted in states other than Hawaii may acquire control of Pacific Century. An interstate acquisition may not be approved, however, if immediately before the acquisition the acquirer controls an FDIC-insured institution or branch in the state of the institution to be acquired, and if immediately following the acquisition the acquirer would control 30 percent or more of the total FDIC-insured deposits in that state; but a state may waive the 30 percent limitation by statute, regulation, or order, or by certain nondiscriminatory administrative approvals.
An adequately capitalized and adequately managed bank may apply for permission to merge with an out-of-state bank and convert all branches of both parties into branches of a single bank. An interstate merger may not be approved, however, if immediately before the acquisition the acquirer controls an FDIC-insured institution or branch in the state of the institution to be acquired, and if immediately following the acquisition the acquirer would control 30 percent or more of the total FDIC-insured deposits in that state; but a state may waive the 30 percent limitation by statute, regulation, or order, or by certain nondiscriminatory administrative approvals. Banks are also permitted to open newly established branches in any state that expressly permits all out-of-state banks to open newly established branches, if the law applies equally to all banks.
Hawaii has enacted a statute which authorizes out-of-state banks to engage in "interstate merger transactions" with (mergers and consolidations with and purchases of all or substantially all of the assets and branches of) Hawaii banks, following which any such out-of-state bank may operate the branches of the Hawaii bank it has acquired. The Hawaii bank must have been in continuous operation for at least five years prior to such an acquisition, unless it is subject to or in danger of becoming subject to certain types of supervisory action. This statute does not permit out-of-state banks to acquire branches of Hawaii banks other than through an "interstate merger transaction" (except in the case of a bank that is subject to or in danger of becoming subject to certain types of supervisory action) nor to open branches in Hawaii on a de novo basis.
The BHC Act prohibits, with certain exceptions, Pacific Century from acquiring direct or indirect control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in any activity other than those of banking, managing or controlling banks or other subsidiaries authorized under the BHC Act, or furnishing services to or performing services for its subsidiaries. Among the permitted activities is the ownership of shares of any company the activities of which the Board of Governors determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making this determination, the Board of Governors is required to weigh the expected benefits
to the public, such as greater convenience, increased competition, or gains in efficiency, against the risks of possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. The Board of Governors has adopted regulations that specify various activities as being so closely related to banking or managing or controlling banks as to be a proper incident thereto. The exact nature and scope of such activities have been the subject of intense national debate, and thus, they may change and become broader as they evolve over time.
Effective March 11, 2000, pursuant to authority granted under the Gramm- Leach-Bliley Act, a bank holding company may elect to become a financial holding company and thereby to engage in a broader range of financial and other activities than are permissible for traditional bank holding companies. In order to qualify for the election, all of the depository institution subsidiaries of the bank holding company must be well capitalized and well managed, as defined by regulation, and all of its insured depository institution subsidiaries have achieved a rating of "satisfactory" or better with respect to meeting community credit needs. Pursuant to the Gramm-Leach- Bliley Act, financial holding companies will be permitted to engage in activities that are "financial in nature" or incidental or complementary thereto, as determined by the Federal Reserve Board. The Gramm-Leach-Bliley Act identifies several activities as "financial in nature," including, among others, insurance underwriting and agency, investment advisory services, merchant banking and underwriting, and dealing or making a market in securities. Pacific Century has not, at this time, made any decision with respect to whether it will elect to become a financial holding company under the Act.
Under the policies of the Board of Governors, Pacific Century is expected to act as a source of financial strength to its subsidiary banks and to commit resources to support its subsidiary banks in circumstances where it might not do so absent such a policy. It is the policy of the Board of Governors that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks.
By virtue of Section 23A of the Federal Reserve Act and Section 18(j) of the Federal Deposit Insurance Act, Pacific Century and its subsidiaries are "affiliates" of Bank of Hawaii and PCB and are subject to the provisions of Section 23A, which limit the amount of and require substantial security for loans and extensions of credit by Bank of Hawaii or PCB to, and investments in, Pacific Century or certain of its subsidiaries and the amount of advances to third parties collateralized by the securities and obligations of Pacific Century or certain of its subsidiaries. Sections 23A and 18(j) are designed to assure that the capital of depository institutions such as Bank of Hawaii and PCB is not put at risk to support their non-bank affiliates. Also, Pacific Century and its subsidiaries are prohibited from engaging in certain "tie-in" arrangements in connection with extensions of credit or provision of property or services.
Bank of Hawaii is subject to supervision and examination by the FDIC and the Department of Commerce and Consumer Affairs of the State of Hawaii. PCB is subject to supervision and examination by the Comptroller of the Currency and in certain respects the FDIC.
Banks, including Bank of Hawaii and PCB, are subject to extensive federal and (in the case of Bank of Hawaii) state statutes and regulations that significantly affect their business and activities. Banks must file reports with their regulators concerning their activities and financial condition and obtain regulatory approval to enter into certain transactions. Banks are also subject to periodic examinations by their regulators to ascertain compliance with various regulatory requirements. Other applicable statutes and regulations relate to insurance of deposits, allowable investments, loans, acceptance of deposits, trust activities, mergers, consolidations, payment of dividends, capital requirements, reserves against deposits, establishment of branches and certain other facilities, foreign and international operations, limitations on loans to one borrower and loans to affiliated persons, and other aspects of the business of banks. Federal legislation has instructed federal agencies to adopt standards or guidelines governing banks' internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and benefits, asset quality, earnings and stock valuation, and other matters. Regulatory authorities have broad authority to implement
standards on asset quality, earnings, and stock valuation and to initiate proceedings designed to prohibit depository institutions from engaging in unsafe and unsound banking practices.
The FDIC has adopted a premium schedule under which the actual assessment rate for a particular institution depends in part upon the risk classification the FDIC assigns to that institution. The FDIC may raise an institution's insurance premiums or terminate insurance altogether upon a finding that the institution has engaged in unsafe and unsound practices.
The Federal Deposit Insurance Corporation Improvements Act of 1991 (FDICIA) requires the federal banking regulators to take "prompt corrective action" in respect to depository institutions that do not meet minimum capital requirements and imposes certain restrictions upon banks which meet minimum capital requirements but are not "well capitalized" for purposes of FDICIA. FDICIA generally prohibits a depository institution from paying any dividend or making any capital distribution or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized institutions are subject to regulatory monitoring and may be required to divest themselves of or liquidate subsidiaries. Holding companies of such institutions may be required to divest themselves of such institutions or divest themselves of or liquidate nondepository affiliates. Critically undercapitalized institutions are prohibited from making payments of principal and interest on subordinated debt and are generally subject to the mandatory appointment of a conservator or receiver.
Further, a bank that is not well capitalized is generally subject to various restrictions on "pass through" insurance coverage for certain of its accounts and is generally prohibited from accepting brokered deposits and offering interest rates on any deposits significantly higher than the prevailing rate. Such banks and their holding companies are also required to obtain regulatory approval before retaining senior executive officers.
Subject to certain exceptions, FDICIA (as modified in 1992) restricts certain investments and activities by state banks (including Bank of Hawaii) and requires the federal banking regulators to prescribe standards for extensions of credit secured by real estate or made to finance improvements to real estate, loans to bank insiders, regulatory accounting and reports, internal control reports, independent audits, and other matters, and requires that insured depository institutions generally be examined on-site by federal or state personnel at least once every twelve months.
Under the Gramm-Leach-Bliley Act, subject to limitations on investment, a national bank that is well capitalized and well managed, as defined by regulation, and has a satisfactory or better community reinvestment rating, may through a financial subsidiary of the bank engage in activities that are financial in nature or incidental thereto, excluding, among others, insurance underwriting, insurance company portfolio investment, real estate development and real estate investment. In addition to the above qualifications, each depository institution affiliate of the national bank must be well capitalized and well managed, the aggregate consolidated total assets of all financial subsidiaries of the national bank may not exceed the lesser of 45 percent of the consolidated total assets of the parent bank or $50 million and, if the bank is one of the 100 largest insured banks, it must meet specified debt rating criteria. An insured state-chartered bank may, through a qualifying subsidiary, also engage in activities as principal that would only be permissible for a national bank to conduct through a financial subsidiary. To qualify, a state-chartered bank and each of its insured depository institution affiliates must be well capitalized and it must comply with certain deduction and financial disclosure requirements, financial and operational safeguards and limitations on inter-affiliate transfers comparable to those applicable to national banks. Existing authority of the Office of the Comptroller of the Currency and the FDIC to review subsidiary activities are preserved. No decision has, at this time, been made with respect to the establishment of new financial subsidiaries of either Bank of Hawaii or PCB.
The Gramm-Leach-Bliley Act does not significantly alter the regulatory regimes under which Pacific Century, Bank of Hawaii and PCB currently operate, as described above. While certain business combinations not currently permissible will be possible after March 11, 2000, we cannot predict at this time resulting changes in the competitive environment or the financial condition of Pacific Century, Bank of Hawaii or PCB. Using the
financial holding company structure, insurance companies and securities firms may acquire bank holding companies, such as Pacific Century, and may compete more directly with banks or bank holding companies.
Various legislation, including proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies, is from time to time introduced in the Congress. This legislation may change banking statutes and the operating environment of the combined company and its subsidiaries in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions and other financial institutions. Pacific Century cannot accurately predict whether any of this potential legislation will ultimately be enacted, and, if enacted, the ultimate effect that it, or implementing regulations, would have upon the financial condition or results of operations of itself or any of its subsidiaries.
ITEM 2.
ITEM 2. PROPERTIES
Pacific Century and its subsidiaries own and lease premises primarily consisting of branch and operating facilities, the majority of which are located in Hawaii, California, Arizona, Asia, and the West and South Pacific. Bank of Hawaii owns five significant properties, the largest of which are condominium units in the Financial Plaza of the Pacific (FPP) in which the Bank's main branch and administrative offices are located. Portions of the FPP are owned in fee simple or leased. The capital leases are for portions (less than 12%) of the FPP. Details of the capital leases are included in Note G to the Consolidated Financial Statements. Additionally, Bank of Hawaii owns a five story office building in downtown Honolulu, the former headquarters of First Federal Savings and Loan of America; a two-story building near downtown Honolulu which houses data processing and certain other operational functions; a parcel of land in downtown Honolulu; and Hale O Kapolei, a 248,000 square feet operations facility in the Kapolei area on Oahu.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
See Note J to the Audited Financial Statements included in Item 8 of this report.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of 1999 to a vote of security holders through the solicitation of proxies or otherwise.
Executive Officers of Registrant:
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Common Stock Listing
The common stock of Pacific Century Financial Corporation, is traded over the counter on the New York Stock Exchange (NYSE Symbol: BOH) and quoted daily in leading financial publications.
Market Prices, Book Values, and Common Stock Dividends--See Table 2 included in Item 7 of this report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Summary of Selected Consolidated Financial Data--See Table 24 included in Item 7
Item 7 of this report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
OVERVIEW
Performance Highlights
Net income at Pacific Century Financial Corporation (Pacific Century) was $133.0 million in 1999, reflecting an increase of 24.3% over the $107.0 million reported in 1998. Financial results for both years were impacted by special items that included restructuring charges of $22.5 million in 1999 and $19.4 million in 1998 and an increase in the 1998 loan loss provision in light of financial volatility in Asia (for additional information refer to sections on "Restructuring and Redesign Program" and "Reserve for Loan Losses").
Basic earnings per share were $1.66 in 1999, up from $1.33 in 1998. On a diluted per share basis, operating earnings were $1.64 in 1999, compared to $1.32 last year.
In 1999, return on average assets (ROAA) and return on average equity (ROAE) increased to 0.91% and 10.99%, respectively. Comparatively, ROAA was 0.72% and ROAE was 9.22% in 1998.
Financial results under a tangible basis excludes from reported earnings the after tax impact of amortization of all intangibles, including goodwill. On a tangible basis, Pacific Century's earnings were $149.7 million in 1999 and $121.7 million in 1998. On a per share basis, tangible diluted earnings per share were $1.85 in 1999, compared to $1.50 in 1998.
Tangible ROAA for Pacific Century was 1.04% in 1999 improving from 0.83% in 1998. Tangible ROAE was 15.02% and 12.84% in 1999 and 1998, respectively.
On a taxable equivalent basis, net interest income was $575.4 million in 1999, down $1.8 million from 1998. In 1999 lower average net assets reduced net interest income by $3.3 million. This impact was partially offset by a wider net interest margin, that caused net interest income to rise by $1.5 million in 1999.
Average assets in 1999 were $14.6 billion, down 1.9% from $14.9 billion in 1998. Most of this decline resulted from discretionary reductions in the investment portfolio. Average net loans for 1999 were $9.4 billion, reflecting a marginal increase over 1998.
Non-performing assets, exclusive of accruing loans past due 90 days or more, were $149.9 million, or 1.54% of total loans, at year-end 1999, compared to $137.5 million, or 1.40% of total loans, at year-end 1998.
Net loan charge-offs in 1999 increased to $73.8 million from $65.7 million in 1998. Included in the 1999 amount are charge-offs of $19.5 million connected with a South Korean conglomerate and its related group of companies. For additional information, see "Foreign Operations" and "Reserve for Loan Losses."
PERFORMANCE HIGHLIGHTS
TABLE 1
- -------- /1/ Tangible basis calculations exclude the effect of all intangibles including goodwill, core deposit and trust intangibles, and other intangibles.
MARKET PRICES, BOOK VALUES AND COMMON STOCK DIVIDENDS
TABLE 2
Restructuring and Redesign Program
In February 1998, Pacific Century announced a two-phase restructuring and redesign plan to improve efficiency, accelerate expense reduction and enhance revenues. In the initial phase, the primary initiatives included rationalizing Pacific Century's corporate structure by merging First Federal Savings & Loan Association of America with Bank of Hawaii, consolidating the branch network in Hawaii, merging the two U.S. Mainland banking subsidiaries, outsourcing credit card operations and reincorporation and charter changes. In conjunction with this phase, a pre-tax restructuring charge of $19.4 million was taken against second quarter 1998 earnings. By year-end 1998, all of these actions had been substantially completed.
Phase two of the plan consists of the redesign portion, which is targeted to improve the delivery of financial services, generate revenue growth from new and existing sources, and reduce expenses by simplifying and streamlining business processes. The idea generation and assessment phase of the redesign was completed in September 1999. When fully implemented in the fourth quarter of 2000, the redesign is expected to contribute an annualized increase in revenues of $21 million and annualized reduction in operating expenses of $43 million. Related to the redesign, Pacific Century recorded a restructuring charge of $22.5 million in the third quarter of 1999.
Acquisitions and Strategic Alliances
In January 1999, Pacific Century acquired Triad Insurance Agency, Inc. (Triad), a major Hawaii-based property/casualty insurance agency. In Hawaii, Triad represents a number of large U.S. property/casualty insurance companies for whom it acts as a servicing agent. The merger expands Pacific Century's range of financial services that it can offer to customers.
In August 1999, Pacific Century completed the purchase of 5.8 million shares, or approximately 10%, of the outstanding shares of the Bank of Queensland Limited (Bank of Queensland) in Australia. This transaction was in addition to a 1998 purchase of 5.4 million convertible notes of the Bank of Queensland. Pacific Century has entered into a strategic alliance with Bank of Queensland that broadens its geographic reach in the Pacific Rim and enhances business growth opportunities.
Forward-Looking Statements
This report contains forward-looking statements regarding Pacific Century's beliefs, estimates, projections and assumptions, which are provided to assist in the understanding of certain aspects of Pacific Century's anticipated future financial performance. Pacific Century cautions readers not to place undue reliance on any forward-looking statement. Forward-looking statements are subject to significant risks and uncertainties, many of which are beyond Pacific Century's control. Although Pacific Century believes that the assumptions underlying its forward-looking statements are reasonable, any assumption could prove to be inaccurate and actual results may differ from those contained in or implied by such forward-looking statements for a variety of reasons. Factors that might cause differences to occur include, but are not limited to, economic conditions in the markets Pacific Century serves including those in Hawaii, the U.S. Mainland, Asia and the South Pacific; shifts in interest rates; fluctuations in currencies of Asian Rim and South Pacific countries relative to the U.S. dollar; changes in credit quality; changes in applicable federal, state, and foreign income tax laws and regulatory and monetary policies; and increases in competitive pressures in the banking and financial services industry, particularly in connection with product delivery and pricing. In addition, factors that could significantly differ from estimates relative to Pacific Century's redesign program include the following: expected cost savings from the redesign program cannot be fully realized or realized within the expected timeframe; income or revenues from the redesign are lower or operating or implementation costs are higher than expected; business disruption related to implementation of the redesign programs or methodologies; inability to achieve expected customer acceptance of revised pricing structures and strategies; and other unanticipated occurrences which could delay or adversely impact the implementation of all or part of the redesign. Pacific Century does not undertake and specifically disclaims any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
LINE OF BUSINESS FINANCIAL REVIEW
Pacific Century is a financial services organization that maintains a broad presence throughout the Pacific region and operates through a unique trans- Pacific network of locations. Pacific Century's activities are conducted primarily through 182 branches and representative and extension offices (including branches of affiliate banks). Its staff of approximately 4,700 employees provides diverse financial products and services to individuals, businesses, governmental agencies and financial institutions.
Pacific Century assesses the financial performance of its operating components in accordance with geographic and functional areas of operations. Geographically, Pacific Century has aligned certain of its operations into four major segments: Hawaii, the Pacific, Asia, and the U.S. Mainland. In addition, the Treasury and Other Corporate segment includes corporate asset and liability management activities and the unallocated portion of various administrative and support units.
Business segment results are determined based on Pacific Century's internal financial management reporting process and organization structure. The financial management reporting process uses various techniques to allocate and transfer balance sheet and income statement amounts between business segments, including allocations for overhead, economic provision, and capital. In its business segment financial reporting process, Pacific Century utilizes certain accounting practices that differ from accounting principles generally accepted in the United States. These practices and other key elements of Pacific Century's business segment financial reporting process are described in Note Q to the Consolidated Financial Statements.
The table in Note Q presents business segment financial information for each of Pacific Century's major market segments for the years ended December 31, 1999 and 1998. Because business segment financial reports are prepared in accordance with accounting practices that could differ from accounting principles generally accepted in the United States, certain amounts reflected therein may not agree with corresponding amounts contained in the Consolidated Financial Statements and Management Discussion and Analysis of Operations.
Pacific Century also utilizes risk-adjusted return on capital (RAROC) as an additional measurement to assess business segment performance. RAROC is the ratio of net income to risk-adjusted equity. Equity is
allocated to business segments based on various risk factors inherent in the operations of each segment. Another performance measurement that Pacific Century utilizes is net income after capital charge (NIACC). NIACC is net income available to common shareholders less a charge for allocated capital. The cost of capital is based on the estimated minimum rate of return expected by the financial markets. The minimum rate of return consists of the long-term government bond rate plus an additional level of return for the average risk premium of an equity investment adjusted for the company's market risk. Over the past few years the cost of capital has fluctuated between 12% to 15%.
Hawaii Market
Pacific Century's oldest and largest market is Hawaii, where operations are conducted primarily through its principal subsidiary, Bank of Hawaii. Bank of Hawaii was established in 1897, and today it is the largest bank headquartered in the State of Hawaii offering a wide array of financial products and services. Bank of Hawaii operates through 74 branches in Hawaii, including both traditional branches and in-store locations.
The Hawaii segment includes retail, commercial, and insurance operating units. Retail operating units sell and service a broad line of consumer financial products. These units include consumer deposits, consumer lending, residential real estate lending, auto financing, credit cards, and private and institutional services (trust, mutual funds, and stock brokerage).
In addition to offering traditional branch banking services, Bank of Hawaii has actively introduced new electronic based products and services that provide enhanced customer convenience. In 1999 Bank of Hawaii expanded e- Bankoh, its internet banking product, to include an on-line trust service and 401(k) program. In addition e-Bankoh clients can have 24-hour access to a wide range of financial products and services, including checking, savings and time deposit accounts, credit cards, and investments.
In the business banking area, Bank of Hawaii is a major commercial lender and maintains a significant presence throughout the State. Commercial operating units in the Hawaii market include small business, corporate banking, commercial products and commercial real estate.
For the year ended December 31, 1999, the Hawaii segment contributed $54.9 million in net income, up 12.9% from $48.6 million in 1998. RAROC for this segment was 15% in 1999 and 13% in 1998. Total assets in the Hawaii segment were $5.3 billion at year-end 1999, reflecting a marginal rise over year-end 1998.
Pacific Market
Pacific Century has maintained a presence in the Intra-Pacific region for 40 years, where it offers financial products and services to both retail and commercial customers. Today, this market spans island nations across the West and South Pacific. Pacific Century is the only United States financial institution to have such a broad presence in this region. This unique franchise positions Pacific Century for future growth.
Pacific Century serves the West Pacific through branches of both Bank of Hawaii and First Savings and Loan Association of America, F.S.A. (First Savings). Bank of Hawaii's operation in the West Pacific consists of three branches in Guam and two branches in the Commonwealth of the Northern Mariana Islands (Saipan), as well as branches in the Federated States of Micronesia (Yap, Pohnpei, and Kosrae), the Republic of the Marshall Islands (Majuro) and the Republic of Palau (Koror). First Savings operates in Guam from three traditional and three in-store branch locations.
Pacific Century's presence in the South Pacific includes branches of Bank of Hawaii and subsidiary and affiliate banks. The Bank of Hawaii locations in this region consist of three branches in Fiji and two branches in American Samoa. Pacific Century's subsidiary banks in the South Pacific are located in French Polynesia, New Caledonia, Papua New Guinea, and Vanuatu. Additionally, Pacific Century maintains an investment in affiliate banks located in Samoa, Solomon Islands and Tonga. As of December 31, 1999, these subsidiary and affiliate
banks had a total of 29 and 20 branches, respectively. In Australia, Pacific Century maintains a strategic alliance with the Bank of Queensland that involves an investment as well as providing opportunities to expand markets in the region. Pacific Century's largest markets in the South Pacific are in French Polynesia and New Caledonia.
For the year ended December 31, 1999, net income in the Pacific segment was $22.5 million, which was marginally lower than 1998. RAROC, including the amortization of intangibles, for this segment was 11% for both 1999 and 1998. Total assets in the Pacific segment stood at $2.5 billion at year-end 1999, reflecting a 1.4% increase over year-end 1998.
Asia Market
Asia is a market that Pacific Century has developed for more than 20 years. Pacific Century operates in Asia through Bank of Hawaii branches in Hong Kong, Japan, Singapore, South Korea and Taiwan and a representative office with extensions in the Philippines.
Pacific Century's business focus in Asia is correspondent banking and trade financing. Activities include letters of credit, remittance processing, foreign exchange, cash management, export bills collection, and working capital loans. The lending emphasis is on short-term loans based on cash flows. Pacific Century's network of locations in the Pacific and its presence on the U.S. Mainland help customers facilitate the flow of business and investment transactions across the Asia-Pacific region.
For the year ended December 31, 1999, net income in the Asia segment was $5.9 million, down 57.2% from 1998. The drop in 1999 earnings largely is accounted for by a $14.5 million increase in the economic provision relative to last year. The higher 1999 economic provision for Asia reflects adjustments for normalized loss factors resulting from the company's assessment of reform measures initiated to deal with the financial turmoil in the region. Prior to 1999, economic provisions for uncertainty in the region were reflected in the provision for Treasury. RAROC for Asia declined to 7% in 1999 from 14% in 1998. Total assets in the Asia segment were $1.4 billion at year-end 1999 reflecting a 3.6% decrease from year-end 1998.
For additional information on Asia, see "Foreign Operations" in this report.
U.S. Mainland Market
Pacific Century operates in the U.S. Mainland primarily through its banking subsidiary Pacific Century Bank, N.A. (PCB). PCB provides financial products and services through 19 branches in Southern California and 9 branches in Arizona. PCB's emphasis is on providing asset based lending and related services for small and middle market businesses. Additionally, PCB also assists Pacific Century in expanding relationships with customers who have ties to the Asia-Pacific region.
In addition to the operations of PCB, the U.S. Mainland segment also includes business units for corporate banking and leasing. The corporate banking unit primarily targets large corporate clients that have interests in the Asia-Pacific region as well as companies in the media and communications industries. Leasing activities consist of providing financing to businesses largely for aircraft, vehicles and equipment.
In 1999, net income for the U.S. Mainland segment increased 40.3% to $37.6 million from $26.8 million in 1998. Several non-recurring items contributed to the increase in 1999's earnings that included an after-tax gain of approximately $4.0 million from the sale of newly issued securities acquired relative to leasing transactions and a $1.3 million after-tax gain from the sale of a special purpose leasing subsidiary. Income taxes for this segment were reduced in 1999 and 1998 by $14.0 million and $13.5 million, respectively for low income housing tax credits and investment tax credits. RAROC, which includes the amortization of intangibles, rose to 14% in 1999 from 10% in 1998. As of December 31, 1999, total assets in the U.S. Mainland segment were $2.7 billion, up 2.2% over year-end 1998.
Treasury and Other Corporate
Treasury consists of corporate asset and liability management activities including investment securities, federal funds purchased and sold, government deposits, short and long-term borrowings, and derivative activities for managing interest rate and foreign currency risks. Additionally, the net residual effect of transfer pricing assets and liabilities is included in Treasury, as is any corporate-wide interest rate risk.
Other corporate items included in this segment consist of the operations of certain non-bank subsidiaries, unallocated overhead expenses, and the residual effect of reconciling the economic provision with the provision in the consolidated financial statements.
The Treasury and Other Corporate segment reflected net income of $12.1 million in 1999, compared with a net loss of $5.2 million in 1998. Impacting operating results of both years was a pre-tax restructuring charge of $22.5 million in 1999 and $19.4 million in 1998. At year-end 1999, this segment held $2.6 billion in total assets, most of which were in Treasury, compared to $3.3 billion at the same year ago date. The lower total assets in part, reflects discretionary reductions in the investment portfolio.
STATEMENT OF INCOME ANALYSIS
Comparability between periods in the Consolidated Statements of Income is impacted by the January 1999 acquisition of Triad Insurance Agency, Inc., the May 1998 acquisitions of Banque Paribas Pacifique and Banque Paribas Polynesie, the July 1997 purchase of California United Bank, the March 1997 acquisition of Indosuez Niugini Bank, Ltd., and the March 1997 acquisition of deposits from Home Savings of America.
Net Interest Income
Net interest income on a taxable equivalent basis was $575.4 million in 1999, down slightly from $577.2 million in 1998, but up from $524.3 million in 1997. For 1999, the reduction in net interest income from the prior year is attributed to a decline in average earning assets that was partially offset by a wider net interest margin. The increase relative to 1997 is largely due to the acquisitions.
Average earning assets were $13.4 billion in 1999, compared to $13.7 billion in 1998 and $13.2 billion in 1997. On a year-over-year basis, average earning assets in 1999 reflected a 1.6% decrease from the prior year primarily due to lower average balances for interest bearing deposits and available-for-sale investment securities.
In 1999, the average net interest margin on earning assets rose to 4.28% from 4.22% in 1998 and 3.98% in 1997. The improvement in 1999's net interest margin relative to a year ago resulted primarily from a drop in the average rate paid on interest-bearing liabilities. In 1999, the average rate on interest-bearing liabilities decreased 44 basis points to 4.13% from 4.57% in 1998, which reflects the low interest rate environment during the first part of 1999. This benefit was partially offset by a 33 basis points decline in the average yield on earning assets to 7.64% from 7.97% in 1998. Presented in Table 3 are the average balances, yields, and rates paid for the years ended December 31, 1999, 1998 and 1997.
Consolidated Average Balances, Income and Expense and Yields and Rates (Taxable Equivalent)
Table 3
- -------- /1/ Includes non-accrual loans. /2/ Based upon a statutory tax rate of 35%.
Provision for Loan Losses
The provision for loan losses was $60.9 million in 1999, compared to $84.0 million in 1998 and $30.3 million in 1997. For 1999, net loan charge-offs of $73.8 million exceeded the provision for loan losses by approximately $13 million. This difference is partially explained by charge-offs taken in 1999 relative to certain Asian borrowers who have continued to experience difficulties in adjusting to reforms measures that were initiated to deal with the Asian economic crisis. In 1998, as a result of evaluating the impact of the financial volatility in Asia, the provision for loan losses and the related reserve were increased to provide for the risk associated with this event. The provision for loan losses reflects management's assessment of the adequacy of the reserve for loan losses, considering the current risk characteristics of the loan portfolio along with economic and other relevant factors. For further information on credit quality, refer to the section on "Reserve for Loan Losses."
Non-Interest Income
Non-interest income in 1999 increased to $265.6 million from $211.8 million in 1998 and $187.8 million in 1997. On a year-over-year basis non-interest income increased 25.4% in 1999 and 12.8% in 1998. For 1999, non-interest income included nonrecurring credits that contributed $18.3 million to other income and $12.1 million to investment securities gains as discussed in greater detail below. Additionally, the Triad acquisition contributed incremental non-interest income of approximately $8.4 million in 1999. Comparing 1998 with 1997, the acquisitions accounted for approximately $15.0 million of the increase between these periods. Table 4 presents the details of non-interest income for the last five years.
Trust income for 1999 totaled $60.7 million, up from $55.9 million in 1998 and $52.2 million in 1997. Revenue categories that generated the largest year- over-year gains were mutual fund fees, brokerage fees and trust and agency fees. While trust income showed an 8.6% increase in 1999, total trust assets administered by Pacific Century Trust increased to $13.8 billion at year-end 1999, up from $12.9 billion at year-end 1998 and $12.1 billion at year-end 1997. The Pacific Capital family of mutual funds and Hawaiian Tax Free Trust, which are managed by Pacific Century Trust, have continued to experience growth. At December 31, 1999, the aggregate balance of these funds stood at $3.7 billion, compared to $3.1 billion and $2.6 billion at year-end 1998 and 1997, respectively.
Service charges on deposit accounts were $34.3 million for the year ended December 31, 1999, compared to $35.5 million in 1998 and $29.4 million in 1997. These fees have remained relatively constant over the last two years. The increase in these fees compared to 1997 was largely driven by the acquisitions.
Fees, exchange and other service charges increased to $88.8 million in 1999, from $77.9 million in 1998 and $67.1 million in 1997. Included in these fees were income generated from international activities relative to letters of credit and acceptance fees, profit on foreign currency, and exchange fees. Collectively, income from these sources totaled $34.5 million in 1999, an 18.6% increase over 1998.
Mortgage servicing fees increased to $8.8 million in 1999 from $7.9 million in 1998 and $7.1 million in 1997. This increase reflects Bank of Hawaii's emphasis on residential mortgage lending and secondary market sales activities. Pacific Century's mortgage servicing portfolio grew to $2.5 billion at year-end 1999 from $2.1 billion at year-end 1998.
Also included in fees, exchange and other service charges are fees earned through Pacific Century's ATM network. ATM fees reflected a 51.9% increase during 1999, which mainly resulted from an increase in the ATM fee structure. During 1999, Pacific Century's ATM network continued to expand, ending the year with 510 machines, an increase from 492 at year-end 1998. Fees generated by this network totaled $15.8 million in 1999, compared to $10.4 million in 1998, and $9.6 million in 1997.
Other operating income in 1999 was $67.7 million, an increase of 76.1% from $38.4 million in 1998. For the year ended December 31, 1999, other operating income included $14.0 million from the sale of Arbella
Leasing Corp. (Arbella), a specific purpose leasing subsidiary and $4.3 million from the termination of a venture capital limited partnership. The net impact on earnings of the Arbella sale was $1.3 million after providing for income taxes of $12.7 million. The increase in 1999 other operating income is also impacted by insurance commissions from the Triad acquisition. With a higher level of recoveries recorded in 1999, cash basis interest increased to $3.2 million from $1.3 million in 1998. Comparatively, cash basis interest was $3.7 million in 1997. Cash basis interest includes interest collected on loans written-off or interest collected on non-accrual loans that relate to prior years.
Net investment securities gains in 1999 were $14.1 million, significantly higher than net gains of $4.1 million and $3.1 million in 1998 and 1997, respectively. Included in 1999 were gains of $6.5 million from the sale of newly issued equity securities acquired in conjunction with leasing transactions and $5.6 million from the disposition of a venture capital investment.
NON-INTEREST INCOME
TABLE 4
Non-Interest Expense
For the years ended December 31, 1999, 1998 and 1997 non-interest expense totaled $553.7 million, $540.7 million and $462.9 million, respectively. Non- interest expense increased 2.4% in 1999 and 16.8% in 1998 from the respective prior year. Comparability between periods is impacted by restructuring charges of $22.5 million in 1999 and $19.4 million in 1998. Additionally, non-interest expense in 1999 and 1998 include incremental increases of approximately $7.2 million and $34.2 million, respectively, resulting from acquisitions, including the amortization of intangibles.
Salaries and pensions and other employee benefits totaled $254.0 million, $250.5 million and $226.7 million in 1999, 1998 and 1997, respectively. Approximately $3.1 million and $14.6 million of the increase relative to 1999 and 1998, respectively, is accounted for by the acquisitions. Excluding the effects of the acquisitions, the year-over-year increase would have been 0.2% in 1999 and 4.1% in 1998. The Year 2000 project also contributed to the increase in salaries and employee benefits for 1999 and 1998.
Net occupancy and equipment expense for 1999 totaled $96.6 million, compared to $95.8 million in 1998 and $85.2 million in 1997. Included in the 1998 and 1997 totals were $1.7 million and $2.7 million, respectively, relating to write-offs of equipment and premises.
Other operating expense increased to $180.1 million in 1999 from $174.6 million in 1998 and $149.5 million in 1997. Approximately $3.5 million and $14.8 million of the year-over-year increase relative to 1999 and 1998, respectively, was due to the acquisitions, including the amortization of intangibles. Large one-time costs included in other operating expense were $2.3 million in 1999 and $6.4 million in 1998.
Legal and professional fees were $32.4 million in 1999, $35.8 million in 1998 and $23.4 million in 1997. The higher fees in 1999 and 1998 relative to 1997 is primarily attributed to consulting and other professional fees including those related to the Year 2000 project.
All systems at Pacific Century transitioned to the new millennium without significant incident. Pacific Century's total cost relative to Year 2000 readiness was $36.1 million, of which $10.7 million was incurred in 1999, $22.2 million in 1998 and $3.2 million in 1997. The total budget for the Year 2000 project was $41 million. Year 2000 related costs included expenditures for technology and program management staff, staff retention, consultants, software and hardware, and customer education and training.
Pacific Century utilizes the efficiency ratio as a tool to manage non- interest income and expense. The efficiency ratio is derived by dividing non- interest expense by net operating revenue (net interest income plus non- interest income before securities transactions). For 1999, 1998 and 1997, the efficiency ratio was 67.0%, 69.0% and 65.4%, respectively. Comparison of this ratio between periods is affected by the restructuring charges in 1999 and 1998 and the sale of Arbella in 1999.
NON-INTEREST EXPENSE
TABLE 5
Income Taxes
The tax structure at Pacific Century is complex given the various foreign and domestic locations in which it operates. In 1999, provision for taxes reflected an effective tax rate of 41.1%, compared to 34.6% and 36.0% in 1998 and 1997, respectively. The higher 1999 effective tax rate is largely explained by the Arbella sale that generated $14.0 million in income and $12.7 million in income tax expense. For 1998, the effective tax rate was impacted by an equipment lease termination loss of $2.7 million that provided an equivalent amount of tax benefits. Excluding the effects of the above items, the effective tax rate for 1999 and 1998 would have been 37.6% and 35.7%, respectively.
Pacific Century primarily utilizes low income housing tax credits and lease financing to manage its tax liability. As of December 31, 1999, Pacific Century's low income housing investments totaled $74.3 million, compared to $69.6 million at year-end 1998. These investments provided tax credits of $13.7 million and $10.0 million in 1999 and 1998, respectively.
Pacific Century also continued to pursue lease financing to defer tax payments. Consisting of both direct and leveraged leases, the leasing portfolio grew 13.2% during 1999.
Tax planning at Pacific Century is structured to minimize the impact of the alternative minimum tax (AMT). At the end of 1999, Pacific Century was not subject to the AMT.
BALANCE SHEET ANALYSIS
Loans
Loans comprise the largest category of earning assets for Pacific Century and produce the highest level of income. At December 31, 1999, loans outstanding were $9.7 billion, a 1.4% decrease from $9.9 billion at year-end 1998. This decline primarily is accounted for by a $197 million reduction in foreign loans, that partially is attributed to foreign currency translation adjustments in the South Pacific.
Pacific Century's objective is to maintain a diverse loan portfolio in order to spread credit risk and reduce exposure to economic downturns that may impact different markets and industries. The composition of the loan portfolio is regularly monitored to ensure diversity as to loan type, geographic distribution, and industry and borrower concentration.
Table 6 presents the composition of the loan portfolio by major loan categories.
LOAN PORTFOLIO BALANCES
TABLE 6
Commercial and Industrial Loans
At December 31, 1999, commercial and industrial loans (C&I) totaled $2.5 billion, down 3.4% from year-end 1998. The proportion of C&I loans to the total portfolio was 25.7% at year-end 1999, compared to 26.2% at year-end 1998.
C&I loans consist of loans made for commercial, financial, and agricultural purposes and involves lending on both a secured and unsecured basis. Collateral requirements vary, but are based on Pacific Century's underwriting and collateral policies to ensure that consistent credit quality standards are maintained.
Geographically C&I loans are concentrated in the U.S. Mainland and Hawaii representing 54% and 37%, respectively, of the total C&I portfolio as of year- end 1999. In Hawaii, Bank of Hawaii is a major commercial lender and maintains a significant presence throughout the State. Bank of Hawaii supports the business community in Hawaii by offering a wide range of products and services. At year-end 1999, C&I loans in Hawaii were $930.8 million. In the U.S. Mainland market, C&I lending totaled $1.3 billion at year-end 1999, down 12.4% from year-end 1998, and is comprised largely of small and middle market business loans that were originated by Pacific Century's U.S. Mainland subsidiary bank, as well as loans to Fortune 500 industrial and service companies and the media and communication industry.
Real Estate Loans
At year-end 1999, Pacific Century's total real estate loans (excluding construction) were $3.9 billion, 1.3% above year-end 1998. This portfolio consists of loans that are secured by residential as well as commercial properties. Real estate mortgage loans continue to comprise the largest portion of the loan portfolio, representing 40.0% of total loans at year-end 1999, compared to 39.0% at year-end 1998.
The largest component of the real estate loan portfolio consists of loans secured by 1-to-4 family residential properties. At $2.6 billion, this portfolio declined modestly from year-end 1998, and represented 27.2% of total loans outstanding at the end of 1999. Approximately 90% of these loans are secured by real estate in Hawaii (see Table 7). Pacific Century originates residential mortgages on both a fixed-rate and adjustable-rate basis. Most of the fixed-rate products are sold in the secondary mortgage market, while adjustable-rate mortgages are generally held in Pacific Century's loan portfolio. Included in the residential mortgage total at year-end 1999 were $136 million in available for sale loans. In recent years, Pacific Century has focused on residential mortgage lending in Hawaii as an attractive line of business. In 1999, residential mortgage originations by Bank of Hawaii totaled $0.98 billion, compared to a record $1.06 billion in 1998.
Also included in the residential real estate portfolio are home equity credit lines. The total available credit under these lines was $506 million at year-end 1999, compared to $477 million at year-end 1998. Outstandings increased marginally to $267 million at year-end 1999 from $261 million at year-end 1998. Home equity credit lines are underwritten primarily based on the borrower's repayment ability rather than the value of the underlying property.
The commercial real estate portfolio (excluding construction loans) totaled $1.2 billion at year-end 1999, up 9.3% from year-end 1998. Approximately 59% and 24% of these loans were secured by commercial real estate in Hawaii and the U.S. Mainland, respectively, with the remainder mostly in the West Pacific. The commercial real estate portfolio is diversified in the type of property securing the obligations, including loans secured by commercial offices, hotels, retail facilities, industrial properties and warehouses.
Total commercial construction loans increased to $315.1 million at year-end 1999, compared to $276.3 million at year-end 1998. These loans are secured primarily by properties located in the U.S. Mainland and Hawaii, which accounted for 50% and 45%, respectively, of such loans at December 31, 1999. Because construction lending is considered to generally involve greater risk than financing on improved properties, Pacific Century utilizes tighter underwriting and disbursement standards. The majority of these loans are underwritten based on the projected cash flows of the completed project, rather than the value of the underlying property, and generally require a committed source for permanent financing.
Installment Loans
Total installment loans (excluding residential mortgages and home equity loans) ended 1999 at $756.1 million, relatively unchanged from year-end 1998. As of December 31, 1999, installment loans consisted of credit cards and consumer loans (e.g., auto loans and unsecured credit lines). Consumer loans totaled $503.5 million at December 31, 1999, compared to $485.0 million at December 31, 1998.
The credit card portfolio balance was $252.6 million at year-end 1999, a decrease of 9.1% from year-end 1998. At year-end 1999, 0.91% of the credit card portfolio (based on balances) were more than 90 days delinquent, compared to 0.77% at year-end 1998.
Leasing Activities
At year-end 1999, leases outstanding increased to $627.6 million, up 13.2% from year-end 1998. Pacific Century's lease portfolio is diversified, consisting primarily of leases on equipment, automobiles, trucks, ships, aircraft, and computers.
Lending in Asia and the South Pacific
Pacific Century's international business predominately consists of Asia where the business emphasis is primarily on correspondent banking activities and undertaking credit risk relating to and resulting from trade activities, trade finance and working capital loans for companies that have business interests in the Asia-Pacific markets. The majority of loans in Asia are short-term and are largely based on Pacific Century's traditional focus on cash flow lending. The South Pacific market largely consists of the operations of subsidiary banks in French Polynesia, New Caledonia, Papua New Guinea, and Vanuatu, and to a lesser degree, through affiliate banks and Bank of Hawaii branches in the region. Foreign loans in both Asia and the South Pacific totaled $1.6 billion at the end of 1999, down 10.8% from year-end 1998. At year-end 1999 foreign loans represented 16.7% of the total loan portfolio, compared to 18.5% at year-end 1998.
Foreign loans in the South Pacific totaled $0.9 billion at December 31, 1999, a decrease of 13.7% from $1.1 billion at year-end 1998. To a large degree, this decline is attributed to a 16% reduction during 1999 in the conversion rate of the Pacific franc, the currency of French Polynesia and New Caledonia, relative to the U.S. dollar. A large portion of the South Pacific loan portfolio is concentrated in two subsidiary banks, Banque de Tahiti and Bank of Hawaii--Nouvelle Caledonie, which in the aggregate held total loans of $871 million at the end of 1999.
At December 31, 1999, outstanding loans to borrowers in Asia totaled $644.8 million, down from $690.5 million and $818.6 million at December 31, 1998 and 1997, respectively. Outstanding commitments represented by letters of credit and unused loan commitments relative to borrowers in Asia were approximately $267 million at year-end 1999, compared to $367 million at year-end 1998. Additional information on Asian credit exposure and recent Asian economic events are contained in the "Foreign Operations" section of this report.
Geographic Distribution of the Loan Portfolio
A geographic distribution of the loan portfolio is presented in Table 7 based on the geographic location of borrowers. The highest geographic lending concentration is in Hawaii constituting 50.3% of the total loan portfolio at December 31, 1999, compared to 50.2% at December 31, 1998. At year-end 1999, the percentage of U.S. Mainland loans to total loans was 23.9%, compared to 23.1% at year-end 1998.
The amounts reflected in the West Pacific include Guam and other locations in the region where both Bank of Hawaii and First Savings have branches. Loan balances in the South Pacific reflect the U.S. dollar equivalent balances of subsidiary banks in French Polynesia, New Caledonia, Papua New Guinea, Vanuatu and Bank of Hawaii branches in Fiji. Loan balances in American Samoa make up the remainder of loans in the South Pacific region.
GEOGRAPHIC DISTRIBUTION OF LOAN PORTFOLIO/1/
TABLE 7
- -------- /1/ Loans are classified based upon the geographic location of borrowers.
Investment Securities
Pacific Century's investment portfolio is managed to provide liquidity and interest income, offset interest rate risk positions and provide collateral for cash management needs. At December 31, 1999, available-for-sale securities totaled $2.5 billion reflecting a $476 million decrease from December 31, 1998. Most of this decline was in the mortgage backed securities portfolio and to a lesser degree in the U.S. government and agency debt securities portfolio. Securities held to maturity were $796 million at year-end 1999, up $143 million from year-end 1998. Purchases of U.S. government and agency mortgage-backed securities accounted for most of this increase.
Table 18 presents the maturity distribution, market value and weighted- average yield to maturity of securities.
Deposits
As of December 31, 1999, total deposits were $9.4 billion, down 1.9% from the year earlier date. During 1999, domestic deposits decreased $294 million, while foreign deposits saw an increase of $112 million. With respect to domestic deposits, the non-interest bearing and interest bearing demand categories experienced the largest declines. Competition for deposits by banks and other financial institutions, as well as securities brokerage firms, continues to impact the ability to attract and retain deposits.
Table 22 presents average deposits by type for the five years ended December 31, 1999.
Borrowings
Short-term borrowings, including funds purchased and securities sold under agreements to repurchase (repos), totaled $2.8 billion at December 31, 1999, compared to $3.3 billion at year-end 1998. The largest portion of short-term borrowings consist of repos. Repos are offered to governmental entities as an alternative to deposits and are supported by the same type of collateral. At year-end 1999, repos were $1.5 billion, down from $2.0 billion at year-end 1998. Included in short-term borrowings at December 31, 1999, were $97 million in commercial paper and $150 million in Federal Home Loan Bank of Seattle (FHLB) advances.
Long-term debt on December 31, 1999 totaled $728 million, up from $586 million on December 31, 1998. A new $125 million issue of subordinated notes that mature in 2009 largely explains the rise in long-term debt for 1999. Subordinated notes also included $119 million issued in 1993 that mature in 2003. All subordinated notes bear a fixed interest rate of 6.875%. Also outstanding, as of December 31, 1999, were $100 million in 8.25% Capital Securities that mature in 2026. FHLB borrowings totaled $247 million at December 31, 1999, compared to $223 million at December 31, 1998. Private placement notes totaled $90 million at both year-end 1999 and 1998.
FOREIGN OPERATIONS
Pacific Century maintains an extensive presence in the Asia-Pacific region that provides opportunities to take part in lending, correspondent banking and deposit-taking activities in these markets. These activities are facilitated through Bank of Hawaii branches, a representative office with extensions and full service subsidiary/affiliate banks. This network of locations across Asia-Pacific enables customers of Pacific Century to facilitate trade and investment between the U.S., Asia and the Pacific Islands.
Through its Asia Division, the Bank of Hawaii offers international banking services to its corporate and financial institution customers in most of the major Asian financial centers with support from its New York and Honolulu operations. Bank of Hawaii's offices that offer these services are located in Hong Kong, the Philippines (Manila, Cebu, and Davao), Seoul, Singapore, Tokyo and Taipei. The Asia Division continues to focus on correspondent banking and trade-related financing activities and lending to customers with which it has a direct relationship.
The South Pacific Division in Honolulu oversees subsidiary banks in French Polynesia, New Caledonia, Papua New Guinea, Vanuatu, and Bank of Hawaii branch operations in Fiji and American Samoa. Since American Samoa is U.S. dollar based, its operation is included as domestic. Additionally, Bank of Hawaii has an equity interest in affiliate banks located in Samoa, Solomon Islands and Tonga.
The operations of subsidiaries and affiliates are evaluated on a similar basis as branch offices. Exposure to foreign currency fluctuations is in large measure limited to the unhedged positions of Pacific Century's capital investment in these subsidiaries (see "Market Risk"). The largest South Pacific subsidiary operations are in the French territories of French Polynesia and New Caledonia.
The West Pacific Division includes Bank of Hawaii branches in Guam and in other locations in the region. Since the U.S. dollar is used in these locations, Pacific Century's operations in the West Pacific are not considered foreign for financial reporting purposes.
Table 8 provides a summary of assets, liabilities, operating revenue, and net income for Pacific Century's foreign operations for the last three years. Operating results in 1999 reflected a net loss of $1.4 million, compared to net loss of $0.8 million in 1998. The loss for both years reflect significantly higher foreign loan loss provisions in comparison to historical levels (see "Reserve for Loan Losses").
SUMMARY OF INTERNATIONAL ASSETS, LIABILITIES, AND INCOME AND PERCENT OF CONSOLIDATED TOTALS
TABLE 8
Pacific Century controls its foreign lending risk exposure by evaluating the political and economic factors that bear on a country's ability to meet its foreign debt obligations. Based on these analyses, credit limits are established for each country to control risk in the foreign portfolio. These credit limits are monitored and reviewed on a regular basis so that risks and exposures are understood and properly assessed. Pacific Century's strategy for foreign lending is to deal, on a direct basis, primarily with countries and companies that have trade activity in the Asia-Pacific region and investment interest in Hawaii and the West and South Pacific.
Pacific Century's foreign lending consists of both local currency and cross- border lending. Local currency loans are those that are funded and will be repaid in the currency of the borrower's country. Cross-border lending, on the other hand, involves loans that will be repaid in a currency other than that of the borrower's country. This type of lending involves greater risk because the borrower's ability to repay is additionally dependent on changes in the currency exchange rate.
Cross-border interbank placements and loans were $885.0 million at year-end 1999. Table 9 presents, for the last three years, a geographic distribution of international assets for which Pacific Century has cross-border exposure exceeding 0.75% of total assets.
The countries to which Pacific Century maintains its largest credit exposure on a cross-border basis include Japan, South Korea, and France. At December 31, 1999, cross-border credit exposure in Japan, South Korea, and France were $320 million, $294 million and $195 million, respectively, compared to $356 million, $265 million and $36 million, respectively, at December 31, 1998. The rise in cross-border exposure to France resulted from an increase in interbank placements with French banks.
Beginning in mid-1997, a number of countries in Asia experienced financial difficulties that included significant devaluation of their currency, higher interest rates and general tightening of credit. In view of the risks, Pacific Century increased its provision for loan losses in 1998. By the end of 1999, the economies and financial environment in most Asian countries had improved in terms of currency exchange rate stability, interest rates and gross domestic product growth. However, in spite of the improving economic trend, the impact of government and corporate restructuring in the region is still being felt. For Pacific Century the impact was greatest in South Korea. While South Korea has made tremendous strides in improving its economy and financial markets, certain Korean corporations have had difficulties in adjusting to mandated and advisable reforms.
The most notable impact to Pacific Century was $33.7 million in exposure to a South Korean conglomerate of which $30.2 million was outstanding. During the third quarter of 1999, the borrower suspended debt service payments and began negotiations with its domestic and foreign bank creditors. At the end of 1999, those negotiations had not produced a definitive resolution of the matter with foreign lenders. Consequently, Pacific Century charged off credits of $19.5 million and placed $10.7 million on non-performing status. Negotiations with the conglomerate and its creditors are in process. For additional information, see "Reserve for Loan Losses."
Pacific Century continues to monitor its international activities on a country by country basis as events evolve and will adjust activities and take such actions in the region as appropriate.
GEOGRAPHIC DISTRIBUTION OF CROSS-BORDER INTERNATIONAL ASSETS/1/
TABLE 9
- -------- /1/ This table details by country cross-border outstandings that individually amounted to 0.75% or more of consolidated total assets as of year-end 1999, 1998 and 1997. Cross-border outstandings are defined as foreign monetary assets that are payable to Pacific Century in U.S. dollars or other non-local currencies, plus amounts payable in local currency but funded with U.S. dollars or other non-local currencies. Cross-border outstandings include loans, acceptances, interest-bearing deposits with other banks, other interest-bearing investments, and other monetary assets. /2/ Includes U.S. dollar advances to foreign branches and affiliate banks which were used to fund local currency transactions. Totals at December 31, 1999, 1998 and 1997 were $378.2 million, $411.1 million and $419.9 million, respectively. /3/ At December 31, 1999, the all others category included cross-border outstandings of $77.7 million in French Polynesia and $47.1 million in New Caledonia. The currency of both of these countries is the Pacific franc.
CORPORATE RISK PROFILE
Credit Risk
Non-Performing Assets and Past Due Loans
Non-performing assets (NPAs) consist of non-accrual loans, restructured loans and foreclosed real estate. These assets, which generally have more than a normal risk of loss, totaled $149.9 million at year-end 1999, compared to $137.5 million at the end of 1998, and $97.1 million at the end of 1997.
At December 31, 1999, the ratio of NPAs to outstanding loans rose to 1.54%. Comparatively the ratio was 1.40% and 1.02% for 1998 and 1997, respectively.
In order to minimize credit losses, Pacific Century strives to maintain high underwriting standards, identify potential problem loans early and work with borrowers to cure delinquencies. Moreover, charge-offs, if required, are taken promptly and reserve levels are maintained at adequate levels. Pacific Century's policy is to place loans on non-accrual status when a loan is over 90 days delinquent, unless collection is likely based on specific factors such as the type of borrowing agreement and/or collateral. At the time a loan is placed on non-accrual, all accrued but unpaid interest is reversed against current earnings.
Total non-accrual loans rose to $145.3 million at year-end 1999, up 10.2% over year-end 1998. Higher non-accrual balances in the foreign and commercial real estate categories accounted for this increase. Non-accrual loans in the C&I and residential real estate portfolios reflected a decline from year-end 1998.
At December 31, 1999, foreign loans on non-accrual were $67.4 million, compared to $57.5 million at December 31, 1998 and $39.9 million at December 31, 1997. The 1999 increase partially results from placing $10.7 million of loans to a South Korean conglomerate on non-accrual status. Total non-accrual loans in Asia rose to $32.3 million at December 31, 1999, from $8.6 million at December 31, 1998. Additional information relative to Asian exposure is contained in "Foreign Operations."
C&I loans classified as non-accrual totaled $23.7 million at year-end 1999, compared to $28.2 million and $10.7 million at year-end 1998 and 1997, respectively.
At December 31, 1999, non-accrual loans secured by real estate totaled $49.8 million, or 34.3% of total non-accrual loans.
Commercial real estate loans on non-accrual status were $19.0 million at December 31, 1999, up from $5.4 million at the end of 1998. This increase is mainly due to the transfer of several large Hawaii-based commercial real estate loans to non-accrual in the first quarter of 1999. Non-performing residential mortgages (excluding construction loans) totaled $29.7 million at year-end 1999, compared to $36.4 million at year-end 1998, reflecting a year- over-year decline of $6.7 million.
Because residential mortgages are secured by real estate, the credit risk on these loans are lower than unsecured lending. Most of the Company's residential loans are owner-occupied first mortgages and were generally underwritten to provide a loan-to-value ratio of no more than 80% at origination. Additionally, the risk in this portfolio is also moderated by the smaller average loan balance compared to commercial lending.
Foreclosed real estate declined to $4.6 million at year-end 1999, from $5.6 million at year-end 1998. At December 31, 1999, the foreclosed real estate portfolio consisted of 38 properties, mostly located in Hawaii. The largest property represented 14% of the total. In 1999, sales of foreclosed real estate resulted in a net loss of $152,000, compared to a net losses of $871,000 and $523,000 in 1998 and 1997, respectively.
Accruing loans past due 90 days or more totaled $18.5 million at year-end 1999, declining $2.3 million from $20.8 million at year-end 1998. Lower delinquencies in the foreign portfolio and, to a lesser degree, improvements in the installment portfolio largely explains this decline. The C&I loan portfolio reflected a $5.5 million increase in past due loans over the prior year.
Table 10 presents a five-year history of non-performing assets and accruing loans past due 90 days or more.
NON-PERFORMING ASSETS AND ACCRUING LOANS PAST DUE 90 DAYS OR MORE
TABLE 10
FOREGONE INTEREST ON NON-ACCRUALS
TABLE 11
Reserve for Loan Losses
Pacific Century maintains the reserve for loan losses at a level that it believes is adequate to absorb estimated inherent losses on all loans. The reserve level is determined based on a continuing assessment of problem credits, recent loss experience, changes in collateral values, and current and anticipated economic conditions. Pacific Century's credit administration procedures emphasizes the early recognition and monitoring of problem loans in order to control delinquencies and minimize losses. For loans other than consumer loans, a line driven risk rating system is used. Loans are graded based on the degree of risk at origination by the lending officer and thereafter, are reviewed periodically as appropriate. An independent evaluation of this process is performed by the Credit Review department to ensure compliance of the risk grades and timeliness of grade changes.
Pacific Century performs a comprehensive quarterly analysis to determine the adequacy of its reserve for loan losses. This analysis incorporates risk migration modeling and transfer risk. Pacific Century utilizes a methodology that establishes both specific and general reserves. Commercial loans and leases are individually reviewed according to specified criteria to determine specific loss exposure. Loans for which a specific reserve allocation is not established are placed in loan pools for purposes of determining the general reserve allocation.
At Pacific Century, general reserve allocations for various loan pools are determined based on a risk migration analysis component and a subjective factors component. The migration model determines potential loss factors based on historical loss experience for homogeneous loan portfolios and based on risk grades for risk-rated portfolios. The subjective factors component includes an evaluation of the changes in the nature and volume of the portfolio, delinquency and non-accrual trends, lending policies and procedures, and other relevant general factors. For foreign credits, general reserves are further stratified to address transfer risk. General reserve allocations for transfer risk are determined based on the type of credit facility and internal country risk ratings.
The reserve for loan losses ended 1999 at $194.2 million, declining $17.1 million from the prior year level of $211.3 million. Net charge-offs in 1999 were $73.8 million or 0.78% of average loans, compared to $65.7 million, or 0.70% of average loans in 1998 and $30.2 million, or 0.34% of average loans in 1997. The ratio of reserves to loans outstanding at year-end 1999 was 2.05%, compared to 2.19% at year-end 1998 and 1.88% at year-end 1997. A summary of the activity in the reserve for loan losses for the last five years is presented in Table 12.
At year-end 1999, the reserve for loan losses provided coverage of 130% of non-performing loans, compared to 154% coverage at year-end 1998 and 180% at year-end 1997. Additionally, the ratio of year-end reserves to gross charge- offs was 1.9 times, 2.6 times, and 3.2 times for 1999, 1998, and 1997, respectively.
Gross charge-offs in 1999 totaled $103.3 million, representing 1.09% of average loans outstanding. Comparatively, this ratio was 0.87% and 0.62% in 1998 and 1997, respectively. The increase in gross charge-offs in 1999 is partly attributed to a rise in the foreign category to $45.8 million from $34.8 million in 1998. Of this amount, $19.5 million is associated with charge-offs pertaining to a South Korean conglomerate. For further discussion, see "Foreign Operations" and "Provision for Loan Losses."
Gross charge-offs as a percentage of the reserve for loan losses were 53.2%, 38.8% and 31.6% in 1999, 1998 and 1997, respectively.
Excluding foreign loans, gross charge-offs in 1999 were mostly concentrated in the installment and C&I portfolios. Gross charge-offs on installment loans in 1999 were $25.1 million, marginally lower than last year. With respect to C&I loans, gross charge-offs rose to $18.5 million in 1999 from $15.3 million in 1998.
In 1999, recoveries of previously charged-off loans increased to $29.5 million from $16.3 million in 1998. C&I loan recoveries of $14.0 million accounted for most of 1999's increase and was driven by a $7.0 million recovery of a U.S. Mainland loan. Installment and foreign loan recoveries in 1999 of $7.6 million and $5.6 million, respectively, were relatively level with last year.
RESERVE FOR LOAN LOSSES
TABLE 12
- -------- /1/ Includes balance transfers, reserves acquired, and foreign currency translation adjustments.
Table 13 presents an allocation of the loan loss reserve for the last five years. At year-end 1999, the reserve allocation for foreign loans was $78.4 million, compared to $86.6 million at December 31, 1998. On a percentage of outstanding loan basis, reserves allocated to the foreign portfolio represented 4.83% of outstandings at year-end 1999, which was marginally above year-end 1998. For year-end 1999, the allocation of reserves to the commercial real estate category increased to $17.3 million from $3.3 million at December 31, 1998, which reflects the rise in non-performing loans in this portfolio. The lower reserve allocation in the C&I portfolio is partially attributed to a decline in non-performing C&I loans. Lower reserves allocated to the installment category is due to improvements in the risk characteristics of this portfolio that reflects both a decline in delinquencies and charge-offs.
ALLOCATION OF RESERVE FOR LOAN LOSSES
TABLE 13
Market Risk
At Pacific Century, assets and liabilities are managed to maximize long term risk adjusted returns to shareholders. Pacific Century's asset and liability management process involves measuring, monitoring, controlling and managing financial risks that can significantly impact the company's financial position and operating results. Financial risks in the form of interest rate sensitivity, foreign exchange fluctuations, liquidity exposure, and capital adequacy are balanced with expected returns to maximize earnings performance and shareholder value, while limiting the volatility of each. The activities associated with these financial risks are categorized into "other than trading" or "trading."
Other Than Trading Activities
In the normal course of business, elements of Pacific Century's balance sheet are exposed to varying degrees of market risk. Market risk arises from movements in interest rates and foreign exchange rates. A key element in the process of managing market risk involves oversight by the Board of Directors and senior management as to the level of such risk assumed by Pacific Century in its balance sheet. The Board reviews and approves risk management policies, including risk limits and guidelines and delegates to the Asset Liability Management Committee (ALCO) oversight functions. The ALCO, consisting of the Managing Committee and senior business and finance officers, monitors Pacific Century's market risk exposure and as market conditions dictate, modifies balance sheet positions or directs the use of derivative instruments.
Interest Rate Risk. Pacific Century's balance sheet is sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from Pacific Century's normal business activities of making loans and taking deposits. Many other factors also affect Pacific Century's exposure to changes in interest rates. These factors include general economic and financial conditions, customer preferences, and historical pricing spread relationships.
A key element in Pacific Century's ongoing process to measure and monitor interest rate risk is the utilization of a net interest income (NII) simulation model. This model is used to estimate the amount that NII will change over a one-year time horizon under various interest rate scenarios. These estimates are based on numerous assumptions that include loan and deposit volumes and pricing, prepayment speeds on mortgage-related assets, and principal amortization and maturities on other financial instruments. While such assumptions are inherently uncertain, management believes that these assumptions are reasonable. As a result, the NII simulation model provides a sophisticated estimate rather than a precise prediction of NII's exposure to higher or lower interest rates.
Table 14 presents as of December 31, 1999, 1998 and 1997, the estimate of the change in NII from a gradual 200 basis point increase or decrease in interest rates, moving in parallel fashion for the entire yield curve, over the next 12-month period relative to what the NII would have been if interest rates did not change. The resulting estimate in NII exposure is well within the approved ALCO guidelines and presents a balance sheet exposure that is slightly liability sensitive. A liability sensitive exposure would imply an unfavorable short-term impact on NII in periods of rising interest rates.
Market Risk Exposure to Interest Rate Changes
Table 14
To enhance and complement the results from the NII simulation model, Pacific Century also reviews other measures of interest rate risk. These measures include the sensitivity of market value of equity and the exposure to basis risk and non-parallel yield curve shifts. There are inherent limitations to these measures but used along with the NII simulation model, Pacific Century gets a better overall insight for managing its exposure to changes in interest rates.
In managing interest rate risks, Pacific Century uses several approaches, both on- and off-balance sheet, to modify its risk position. Approaches that are used to shift balance sheet mix or alter the interest rate characteristics of assets and liabilities include changing product pricing strategies, modifying investment portfolio strategies, or using financial derivatives. The use of financial derivatives, as detailed in Note O to the Consolidated Financial Statements, has been limited over the past several years. During this period, Pacific Century has relied more on the use of on-balance sheet alternatives to manage its interest rate risk position.
Foreign Currency Risk. Pacific Century's broad area of operations throughout the South Pacific and Asia has the potential to expose the Company to foreign currency risk. In general, however, most foreign currency denominated assets are funded by like currency liabilities, with imbalances corrected through the use of various hedge instruments as disclosed in Note O to the Consolidated Financial Statements. By policy, the net exposure in those balance sheet activities described above is insignificant.
On the other hand, Pacific Century is exposed to foreign currency exchange rate changes from the capital invested in its foreign subsidiaries and branches located throughout the South Pacific and Asian Rim. These investments are designed to diversify Pacific Century's total balance sheet exposure. While a portion of the capital investment in French Polynesia and New Caledonia is offset by a borrowing denominated in euro or foreign exchange currency hedge transactions, the remainder of these capital positions, aggregating $87.6 million at December 31, 1999, is not hedged.
Pacific Century uses a value-at-risk (VAR) calculation to measure the potential loss from foreign currency exposure. Pacific Century's VAR is calculated at a 95% confidence interval and assumes a normal distribution. Pacific Century utilizes the variance/covariance approach to estimate the probability of future changes in foreign exchange rates. Under this approach, equally weighted daily closing prices are used to determine the daily volatility for the last 10, 30, 50, and 100 days. Pacific Century uses the highest daily volatility of the four trading periods in its VAR calculation.
To estimate the potential loss in its net investment in foreign subsidiaries and branches, Pacific Century takes the daily volatility and annualizes it by multiplying by the number of trading days in a year. Therefore, the VAR determines the potential one-year loss within a 95% confidence interval of the net investment in subsidiaries. In other words, a loss greater than VAR has approximately a 5% probability of occurring.
Table 15 presents as of December 31, 1999 and 1998 Pacific Century's foreign currency exposure from its net investment in subsidiaries and branch operations that are denominated in a foreign currency as measured by the VAR.
Market Risk Exposure From Changes in Foreign Exchange Rates
Table 15
- -------- /1/ The average value-at-risk for the Japanese yen, Korean won, Pacific franc, and other currencies was $2.0 million, $5.5 million, $4.7 million and $15.3 million, respectively for the year ended December 31, 1999 and was $2.6 million, $13.2 million, $4.1 million, and $14.0 million, respectively, for the year ended December 31, 1998. /2/ The book value of net investments in foreign subsidiaries and branches is net of a $40 million and $46 million borrowing at December 31, 1999 and 1998, respectively, denominated in euro and foreign exchange hedge transactions of $23 million and $26 million at December 31, 1999 and 1998, respectively.
Trading Activities
Pacific Century's trading activities include foreign currency and foreign exchange contracts that expose Pacific Century to a minor degree of foreign currency risk. These transactions are executed on behalf of customers and for the Company's own account. Pacific Century, however, manages its trading account such that it does not maintain significant foreign currency open positions. To measure the exposure of these open positions, Pacific Century uses the VAR methodology described above. The VAR measurement for trading activities as of year-end 1999 continues to be immaterial.
Liquidity Management
Liquidity is managed to ensure that Pacific Century has continuous access to sufficient, reasonably priced funding to conduct its business in a normal manner. Pacific Century's ALCO monitors sources and uses of funds and modifies asset and liability positions as liquidity requirements change. This process combined with Pacific Century's ability to raise funds in money and capital markets and through private placements provides flexibility in managing the exposure to liquidity risk.
To ensure that its liquidity needs are met, Pacific Century actively manages both the asset and liability sides of the balance sheet. The primary sources of liquidity on the asset side of the balance sheet are available-for-sale investment securities, interest bearing deposits, and cash flows from loans and investments, as well as the ability to securitize certain assets. With respect to liabilities, liquidity is generated through growth in deposits and the ability to obtain wholesale funding in national and local markets through a variety of sources.
Pacific Century obtains short-term wholesale funding through federal funds purchased, repos, and commercial paper. Pacific Century issues commercial paper in various denominations with maturities of generally 90 days or less. During 1999, Pacific Century issued commercial paper only in the Hawaii marketplace.
Repos are financing transactions, whereby securities are pledged as collateral for short-term borrowings. Nearly all of Pacific Century's repos consist of transactions with governmental entities. Pacific Century's balance sheet is unique given the high level of state and local government funding. Historically, these governmental entities have provided a stable source of funds.
Pacific Century maintained a $25 million, annually renewable line of credit for working capital purposes. Fees are paid on the unused balance of the line. During 1999, the line was not drawn upon.
Bank of Hawaii and First Savings are both members of the Federal Home Loan Bank of Seattle. The FHLB provides these institutions with an additional source for short and long-term funding.
Additionally, Bank of Hawaii maintains a $1 billion senior and subordinated bank note program. Under this facility, Bank of Hawaii may issue additional notes provided that at any time the aggregate amount outstanding does not exceed $1 billion. At December 31, 1999, there was $125 million outstanding under this program represented by the issuance of subordinated notes in 1999.
Capital Management
Pacific Century manages its capital level to optimize shareholder value, support asset growth, reflect risks inherent in its markets, provide protection against unforeseen losses and comply with regulatory requirements. Capital levels are reviewed periodically relative to Pacific Century's risk profile and current and projected economic conditions. Pacific Century's objective is to hold sufficient capital on a regulatory basis to exceed the minimum guidelines of a "well capitalized" institution.
At year-end 1999, Pacific Century's shareholders' equity grew to $1.2 billion, an increase of 2.3% over year-end 1998. The source of growth in shareholders' equity in 1999 included retention of earnings and issuance of common stock under the dividend reinvestment plan and various stock-based employee benefit plans.
Offsetting these increases were cash dividends paid of $54.6 million and treasury stock purchases of $21.8 million and unrealized valuation adjustments of $43.6 million.
Pacific Century's regulatory capital ratios at year-end 1999 were: Tier 1 Capital Ratio of 10.28%, Total Capital Ratio of 13.22%, and Leverage Ratio of 8.31%. All three capital ratios exceeded the federal bank regulators' minimum threshold levels for an institution to qualify as well capitalized. The regulatory standards for well capitalized are as follows: Tier 1 Capital 6%; Total Capital 10%; and the Leverage Ratio 5%. These standards represent minimum guidelines and Pacific Century manages its capital base in accordance with the attributes noted at the beginning of this section. Table 16 presents a five-year history of activities and balances in Pacific Century's capital accounts along with key capital ratios.
As of December 31, 1999, $100 million of 8.25% Capital Securities that mature in 2026 were outstanding. These securities qualify as Tier I Capital for regulatory accounting purposes, but are classified as long-term debt in the statement of condition. In addition, Pacific Century had subordinated debt of $195.8 million at the end of 1999 that qualified as total capital for regulatory purposes.
Over the past few years, Pacific Century has repurchased shares under various stock repurchase programs in order to maintain its capital position at a desired level. In 1999, Pacific Century's Board of Directors approved a share repurchase program that authorizes the repurchase of up to 300,000 shares of common stock per quarter beginning in the fourth quarter of 1999. During 1999's fourth quarter, Pacific Century repurchased approximately 271,000 shares under this program.
Equity Capital
Table 16
- -------- /1/ Includes profit sharing; stock options and directors' restricted shares and deferred compensation plans; and unrealized valuation adjustments for investment securities, foreign currency translation and pension liability.
FOURTH QUARTER RESULTS AND OTHER MATTERS
Earnings in 1999's fourth quarter were $37.6 million, an increase of 7.4% over the $35.0 million reported in the fourth quarter of 1998. Basic earnings per share were $0.47 and $0.44 in the fourth quarter of 1999 and 1998, respectively. Diluted earnings per share were $0.47 and $0.43 in the same respective periods.
Net interest income on a tax equivalent basis totaled $143.2 million in the fourth quarter of 1999, almost level with the same period in 1998. The net interest margin in 1999's fourth quarter was 4.31%, compared to 4.15% in the fourth quarter of 1998. This improvement primarily was driven by a 15 basis points drop in the average rate on interest bearing liabilities for the quarter from the same year earlier period. Additionally a 5 basis points rise in the average yield on earning assets in 1999's fourth quarter relative to the same period last year also contributed to the wider net interest margin.
In the fourth quarter of 1999, provision for loan losses was $20.9 million, up from $13.0 million in the same year ago quarter. The current quarter loan loss provision was less than net charge-offs of $36.8 million, that included charge-offs of $19.5 million relative to a South Korean conglomerate. Certain Asian borrowers have continued to experience difficulties arising from the financial volatility in Asia. In 1998, Pacific Century increased its reserve for loan losses primarily through a second quarter provision of $42.0 million as a result of its evaluation of the inherent risk associated with the Asian economic crisis.
Non-interest income in the final quarter of 1999 increased to $69.4 million from $55.4 million in 1998's comparable period. During the current quarter the disposition of two venture capital related assets contributed $4.3 million to other income and $5.6 million to investment securities gains.
Non-interest expense totaled $131.1 million, relatively unchanged from 1998's fourth quarter and $2.0 million less than reported in 1999's third quarter, exclusive of the restructuring charge. Large non-recurring items that impacted fourth quarter 1999 non-interest expense included a $2.3 million reduction in accruals for deferred compensation and post retirement medical benefits, and approximately $2.3 million in increased one-time costs for various other operating expense items.
Cost savings from the redesign are primarily reflected in compensation expense, which after adjusting for one-time items, would have ended the quarter at $60.9 million, down from $62.4 million in 1998's fourth quarter and down from $64.2 million in 1999's third quarter.
CONSOLIDATED QUARTERLY RESULTS OF OPERATIONS
TABLE 17
SUPPLEMENTARY DATA
MATURITY DISTRIBUTION, MARKET VALUE AND WEIGHTED-AVERAGE YIELD TO MATURITY OF SECURITIES
TABLE 18
- -------- /1/ Contractual maturities do not anticipate reductions for periodic paydowns. /2/ Tax equivalent at 35% tax rate. /3/ The weighted-average yields on available for sale securities are based on amortized cost.
AVERAGE ASSETS
TABLE 19
AVERAGE LOANS
TABLE 20
MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES/1/
TABLE 21
- -------- /1/ Based on contractual maturities. /2/ As of December 31, 1999, loans maturing after one year consisted of $2,896.0 million with floating rates and $3,575.6 million with fixed rates.
AVERAGE DEPOSITS
TABLE 22
INTEREST DIFFERENTIAL
TABLE 23
- -------- /1/ The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA/1/
TABLE 24
- -------- /1/ Comparisons between years is affected by business combinations. See Note A to the Consolidated Financial Statements. /2/ Tangible basis calculations exclude the effect of all intangibles including goodwill, core deposit and trust intangibles, and other intangibles. /3/ The number of common shareholders is based on the number of record holders.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated Quarterly Results of Operations--See Narrative and Table 17 included in Item 7 of this report.
REPORT OF INDEPENDENT AUDITORS
Shareholders and Board of Directors Pacific Century Financial Corporation
We have audited the accompanying consolidated statements of condition of Pacific Century Financial Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Century Financial Corporation and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Honolulu, Hawaii January 21, 2000
PACIFIC CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
See Notes to Consolidated Financial Statements.
PACIFIC CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
See Notes to Consolidated Financial Statements.
PACIFIC CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
See Notes to Consolidated Financial Statements.
PACIFIC CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- -------- /1/ During the years ended December 31, 1999, 1998 and 1997, Pacific Century Financial Corporation made interest payments of $442,882,000, $513,784,000 and $528,361,000, respectively, and paid income taxes of $122,150,000, $94,298,000 and $81,404,000, respectively.
See Notes to Consolidated Financial Statements.
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting principles followed by Pacific Century Financial Corporation and its subsidiaries (Pacific Century), and the methods of applying those principles conform with accounting principles generally accepted in the United States and general practices within the banking industry. The preparation of financial statements in conformity with these accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates and such differences could be material to the financial statements. Certain accounts in prior years have been reclassified to conform with the 1999 presentation. The significant accounting policies are summarized below.
Organization/Consolidation
Pacific Century is a bank holding company providing a broad range of financial products and services to customers in Hawaii, the Pacific, Asia and the U.S. Mainland. The majority of Pacific Century's operations consist of customary commercial and consumer banking services including, but not limited to, lending, leasing, deposit services, trust and investment activities and trade financing. The principal subsidiaries of Pacific Century are Bank of Hawaii, Pacific Century Bank, N.A. and First Savings and Loan Association of America, F.S.A. (First Savings). The consolidated financial statements include the accounts of Pacific Century and all significant majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation and minority interests have been recognized.
Accounting Changes
Effective January 1, 1998, Pacific Century adopted Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting and displaying comprehensive income and its components in a full set of financial statements. The Statement requires that all items that meet the definition of components of comprehensive income be reported in a financial statement for the period in which they are recognized. With the adoption of SFAS No. 130, the format of the Consolidated Statements of Shareholders' Equity has changed to provide the required disclosures, and prior years have been reclassified to conform with the statement. The adoption of SFAS No. 130 had no material effect on Pacific Century's financial position or results of operations.
On December 31, 1998, Pacific Century implemented SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for the reporting of financial information about operating segments in annual financial statements to stockholders, and requires certain selected segment information in interim reports. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. The adoption of SFAS No. 131 had no material impact on Pacific Century's financial position or results of operations.
On December 31, 1998, Pacific Century adopted SFAS No. 132 "Employers' Disclosure about Pensions and Other Postretirement Benefits." This statement standardizes, to the extent practicable, disclosure requirements and requires additional information on changes in benefit obligations, fair value of plan assets and certain other disclosures. The implementation of SFAS No. 132 had no impact on Pacific Century's financial position or results of operations.
In July 1999, the Financial Accounting Standards Board issued SFAS No. 137 "Deferral of the Effective Date of SFAS No. 133," that delays the effective date of SFAS No. 133 until fiscal years beginning after June 15, 2000. SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" standardizes the accounting for derivative instruments by requiring the recognition of those instruments as assets or liabilities measured at fair value in the statement of financial condition. Gains or losses resulting from changes in the fair values of derivatives would be accounted for depending on the use of the derivatives and whether they qualify for hedge accounting. In order to qualify for hedge accounting, the hedging relationship must be highly effective
in achieving offsetting changes in fair value or cash flows. SFAS No. 133 requires matching the timing of gain or loss recognition on derivative instruments with the recognition of the changes in the fair value of the hedged asset or liability that is attributed to the hedged risk or the effect on earnings of the hedged forecasted transaction. The adoption of SFAS No. 133 is not expected to have a material impact on Pacific Century's financial position or results of operations.
Restructuring Charges
In the third quarter of 1999, Pacific Century recorded a restructuring charge of $22.5 million in connection with a redesign program to enhance revenues, improve efficiencies and reduce expenses. The implementation phase of this project will cover the twelve month period ending September 30, 2000. Included in the restructuring charge are direct and incremental costs associated with the redesign consisting of accruals for staff reduction of $6.1 million and occupancy and equipment of $0.5 million. In addition, the restructuring charge included period costs of $15.9 million that were directly related to completing the project. Staffing costs relate to projected severance payments associated with the termination of exempt employees. Severance amounts are determined based on the redesign severance payment program and are paid out at time of termination. The occupancy and equipment portion consists of estimated lease termination costs and losses on the disposal of fixed assets. Project costs include costs relative to the assessment phase of the redesign project.
At December 31, 1999, the restructuring accrual balance was $4.3 million, of which $3.8 million related to staffing. In 1999 payments were made relative to all of the project costs. Pacific Century believes the restructuring accrual as of December 31, 1999 remains adequate to complete the planned initiatives.
In the second quarter of 1998, Pacific Century recognized a $19.4 million restructuring charge in connection with its strategic actions to improve efficiencies through consolidating subsidiaries, closing branches, and outsourcing activities. The restructuring charge included expected direct and incremental costs associated with termination of lease obligations, disposal of premises and equipment, staff reduction, and data processing and other costs. Details of the 1998 restructuring charge follow:
Acquisitions
In January 1999, Pacific Century acquired Triad Insurance Agency, Inc. (Triad), a Hawaii-based property/casualty insurance agency. In Hawaii, Triad represents a number of large U.S. property/casualty insurance companies for whom it acts as a servicing agent. The merger, accounted for as a purchase, has expanded Pacific Century's range of financial services offered to customers. Goodwill resulting from the acquisition of approximately $4 million is being amortized over 15 years on a straight-line basis.
In August 1999, Pacific Century concluded the transaction to increase its ownership by acquiring 5.8 million shares, or approximately 10%, of the outstanding shares of the Bank of Queensland Limited in Australia. This transaction is in addition to a 1998 purchase of 5.4 million convertible notes of the Bank of Queensland Limited.
In May 1998, Pacific Century concluded an agreement to acquire the interest of Group Paribas in Banque Paribas Pacifique in New Caledonia and Banque Paribas Polynesie in French Polynesia. As of the acquisition date, Banque Paribas Pacifique and Banque Paribas Polynesie had total assets of approximately $238 million and $83 million, respectively. The acquired banks were merged into other Pacific Century subsidiaries in the region. The acquisitions were accounted for under the purchase method and the combined goodwill of approximately $17.1 million is being amortized over 15 years on a straight-line basis.
On July 3, 1997, Pacific Century acquired all of the outstanding common stock of CU Bancorp and its subsidiary, California United Bank (CUB), for a purchase price of $185,421,000, which consisted of $56,092,000 in cash and 2,318,000 shares of Pacific Century common stock. As of the acquisition date, CUB had total assets of approximately $786,000,000. The acquisition was accounted for as a purchase, and the resulting goodwill of $100,700,000 is being amortized over 25 years on a straight-line basis. In August 1998, Pacific Century merged its two U.S. Mainland operations, CUB and Pacific Century Bank, located in Arizona, into one nationally-chartered entity, Pacific Century Bank, N.A. based in Southern California.
In March 1997, Pacific Century Bank, N.A. purchased approximately $251,300,000 in deposits in Arizona from Home Savings of America. Pacific Century paid approximately $17,976,000 for the core deposit intangible, which is being amortized over 15 years on a straight-line basis.
In March 1997, Bank of Hawaii International, Inc. acquired 100% of Indosuez Niugini Bank, Ltd. in Papua New Guinea, for approximately $5.6 million. Indosuez Niugini Bank, Ltd. has been renamed Bank of Hawaii (PNG) Ltd. The acquisition was accounted for as a purchase, resulting in $3,328,000 in goodwill, which is being amortized over 15 years on a straight-line basis. As of the acquisition date, Indosuez Niugini Bank, Ltd. had approximately $93,000,000 in total assets.
In conjunction with these acquisitions, the following table discloses assets acquired and liabilities assumed for the years ended December 31, 1999, 1998 and 1997:
Advertising Costs
The nature of Pacific Century's marketing programs generally do not include direct-response advertising. Pacific Century, therefore, recognizes its advertising costs as incurred. Advertising costs were $5,360,000, $7,633,000 and $10,612,000 in 1999, 1998 and 1997, respectively.
Cash and Non-Interest Bearing Deposits
For purposes of reporting cash flows, cash and cash equivalents include cash and non-interest bearing deposits, which consist of amounts due from other financial institutions as well as in-transit clearings. Under the terms of the Depository Institutions Deregulation and Monetary Control Act, Pacific Century is required to place reserves with the Federal Reserve Bank based on the amount of deposits held. During 1999 and 1998, the average amount of these reserve balances was $137,008,000 and $133,316,000, respectively.
Credit Card Costs
Pacific Century issues its own VISA and Mastercard credit cards for which all costs are recognized as period costs. In 1996, Pacific Century entered into certain arrangements with third parties to originate VISA cards in specific target markets. As of year-end 1999 and 1998, the unamortized capitalized origination costs totaled
$648,000 and $1,167,000, respectively. These costs are being amortized over the anticipated life of the cards, currently five years.
Earnings Per Share
Basic earnings per share (EPS) is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the dilutive impact of stock options and stock appreciation rights and uses the average share price during the period in determining the number of incremental shares to be added to the weighted average number of common shares outstanding. For the years ended December 31, 1999, 1998 and 1997 there were no adjustments to net income (the numerator) for purposes of computing basic EPS. A reconciliation of the weighted average common shares outstandings for computing diluted EPS for 1999, 1998 and 1997 follows:
On December 12, 1997, a two-for-one stock split in the form of a 100% stock dividend was distributed to shareholders. Prior period average outstanding shares, stock options, and per common share data in the consolidated financial statements have been retroactively adjusted to reflect the stock split.
Income Taxes
Pacific Century files a consolidated federal income tax return with the Bank of Hawaii and its other domestic subsidiaries. Deferred income taxes are provided to reflect the tax effect of temporary differences between financial statement carrying amounts and the corresponding tax basis of assets and liabilities. Deferred taxes are calculated by applying enacted statutory tax rates and tax laws to future years in which temporary differences are expected to reverse. The impact on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that the rate change is enacted. A deferred tax valuation reserve is established if it is more likely than not that a deferred tax asset will not be realized.
Pacific Century's tax sharing policy provides for the settlement of income taxes between each relevant subsidiary as if the subsidiary had filed a separate return. Payments are made to Pacific Century by subsidiaries with tax liabilities, and subsidiaries that generate tax benefits receive payments for those benefits as used.
For lease arrangements that are accounted for by the financing method, investment tax credits are deferred and amortized over the lives of the respective leases.
Intangible Assets and Amortization
Intangible assets include goodwill and identifiable intangible assets such as core deposits resulting from acquisitions accounted for under the purchase method and certain servicing assets. Goodwill and core intangibles are being amortized using the straight-line method over periods of 15 to 25 years. These intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Amortization of goodwill and core intangibles are included in other operating expense and totaled $16,229,000, $15,614,000 and $12,668,000 in 1999, 1998 and 1997, respectively. As of December 31, 1999 and 1998, the unamortized balance of these intangibles were $190,693,000 and $204,354,000, respectively.
Servicing assets are recognized when mortgage loans are originated and sold or securitized with servicing rights retained. The capitalized cost of servicing assets is amortized over the estimated life of the related loans. The fair value of servicing assets is estimated based on a review of servicing right values of loans with similar characteristics. An impairment analysis is performed on a periodic basis and includes a review of prepayment
trends, delinquency and other relevant factors. For purposes of measuring impairment, servicing assets are stratified by product type. Impairment is recognized when the carrying value of the servicing assets for a stratum exceed its fair value.
Interest Rate/Foreign Currency Risk Management
Pacific Century utilizes off-balance sheet derivative financial instruments, primarily as an end-user in connection with its risk management activities and, to a lesser extent, as a service to accommodate the needs of customers. Most of Pacific Century's derivative transactions consist of interest rate swaps and foreign exchange contracts. Other derivative instruments may be employed, from time to time, but in the aggregate, the use of these instruments are limited.
Pacific Century utilizes interest rate swaps for purposes other than trading to manage its exposure to interest rate risks. Interest rate swaps are contractual agreements that generally require the exchange of fixed and floating rate payments based on specified financial indices and the underlying notional amount over the life of the agreements.
The accrual method is used to account for interest rate swaps. Under this method, the differential between interest to be paid and received is accrued and recognized as an adjustment to interest income or expense of the designated asset or liability. The fair value of these agreements is not recorded in the consolidated financial statements. Changes in the fair value of swap contracts are not recognized as long as the hedge correlation continues to exist. If the hedge correlation ceases to exist based on effectiveness tests, any existing gain or loss is amortized over the remaining term of the agreement, and future changes in fair value are accounted for on a mark-to-market basis. If the designated asset or liability matures, or is extinguished, any unrealized gain or loss on the related derivative instrument is recognized immediately.
A foreign exchange contract is a commitment to exchange foreign currency at a contracted price on a specified date. These derivative instruments are used for purposes other than trading primarily for asset and liability management activities, and changes in the fair value of both the foreign exchange contracts and related assets or liabilities hedged are offset and not included in the financial results.
Derivative instruments entered into for trading purposes consist of foreign exchange contracts that are used to offset foreign currency positions taken on behalf of customers and for Pacific Century's own account. These derivatives are carried at fair value, and the associated unrealized gains and losses are recognized currently in the statement of income.
International Operations
International operations include certain activities located domestically in the International Banking Group, as well as branches and subsidiaries domiciled outside the United States. The operations of Bank of Hawaii and First Savings located in the West and South Pacific which are denominated in U.S. dollars are classified as domestic. Pacific Century's international operations are primarily concentrated in Japan, South Korea, Singapore, Hong Kong, Taiwan, French Polynesia and New Caledonia.
Investment Securities
Investment securities held to maturity are those securities, which Pacific Century has the ability and positive intent to hold to maturity. These securities are stated at cost adjusted for amortization of premiums and accretion of discounts. Restricted equity securities represent Federal Home Loan Bank and Federal Reserve Bank shares, recorded at par, which also reflects fair value. In 1999, 1998 and 1997, there were no transfers from investment securities held to maturity.
Investment securities available for sale are recorded at fair value with unrealized gains and losses recorded as an unrealized valuation adjustment in equity, net of taxes.
Trading securities are those securities that are purchased for Pacific Century's trading activities and are expected to be sold in the near term. Securities in the trading portfolio are carried at fair value with unrealized holding gains and losses recognized currently in income. Trading securities were $8,345,000 and $2,318,000 as of December 31, 1999 and 1998, respectively. During 1999, 1998 and 1997, the net gain (loss) from the trading securities portfolio was $361,000, $(358,000) and $1,612,000, respectively, and is recognized as a component of investment securities gains in the income statement. Income from trading securities was $247,000, $220,000 and $60,000 during 1999, 1998 and 1997, respectively, and is included as part of other operating income.
Pacific Century uses the specific identification method to determine the cost of all investment securities sold.
Loans
Loans are carried at the principal amount outstanding. Interest income is generally recognized on the accrual basis. Net loan fees are deferred and amortized as an adjustment to yield.
Pacific Century's policy is to place loans on non-accrual when a loan is over 90 days delinquent, unless collection is probable based on specific factors such as the type of borrowing agreement and/or collateral. At the time a loan is placed on non-accrual, all accrued but unpaid interest is reversed against current earnings. Subsequent payments received are generally applied to reduce the principal balance.
Other Real Estate
Other real estate consists of properties acquired through foreclosure proceedings, acceptance of a deed-in-lieu of foreclosure, and abandoned bank premises. These properties are carried at the lower of cost or fair value based on current appraisals less selling costs. Losses arising at the time of acquiring such property are charged against the reserve for loan losses. Subsequent declines in property value are recognized through charges to operating expense.
Premises and Equipment
Premises and equipment are stated at cost less allowances for depreciation and amortization. Depreciation is computed using the straight-line method over lives of two to fifty years for premises and improvements, and three to ten years for equipment.
Reserve for Loan Losses
The reserve for loan losses is established through provisions that are charged against income. Loans deemed to be uncollectible are charged against the reserve for loan losses, and subsequent recoveries, if any, are credited to the reserve.
The reserve for loan losses is maintained at a level believed adequate by management to absorb estimated inherent losses. Management's periodic evaluation of the adequacy of the reserve is based on Pacific Century's past loan loss experience, known and inherent risks in the portfolio, adverse conditions that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of expected cash flows that may be susceptible to significant changes.
A loan is considered impaired when it is probable that all amounts due according to the contractual terms of the loan will not be collected. Impairment is measured based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. Cash receipts on impaired loans generally are applied to reduce the carrying value of the loan. Large groups of smaller balance homogeneous loans, such as residential mortgages and consumer loans are evaluated collectively for impairment based primarily on the historical loss experience for each portfolio.
Stock-Based Compensation
Pacific Century's accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25 (APB No. 25) and related interpretations. SFAS No. 123 "Accounting for Stock-Based Compensation," permits companies to elect to recognize stock-based compensation expense based on the estimated fair value of the awards on the grant date or to continue to use the accounting under APB No. 25. Included in Note L is the impact of the fair value of employee stock-based compensation plans on net income and earnings per share on a pro forma basis for awards granted in 1999, 1998 and 1997.
NOTE B--INVESTMENT SECURITIES
The following presents the details of the investment securities portfolio:
The following presents an analysis of the contractual maturities of the investment securities portfolio as of December 31, 1999:
Proceeds from sales and maturities of investment securities available for sale were $1,267,473,000, $2,392,831,000 and $909,975,000 in 1999, 1998 and 1997, respectively. Gross gains of $16,562,000 and gross losses of $2,867,000 were realized with respect to 1999 sales. Taxes related to 1999 gains and losses were $5,627,000. The cumulative investment securities valuation reserve was $43,065,000 (net of taxes) as of December 31, 1999.
Investment securities carried at $3,090,325,000 and $3,324,126,000 were pledged to secure deposits of certain public (governmental) entities, repurchase agreements and swap agreements at December 31, 1999 and 1998, respectively. The December 31, 1999 amount included investment securities with a carrying value of $1,649,665,000 and a market value of $1,611,101,000 which were pledged as collateral for repurchase agreements.
NOTE C--LOANS
Loans consisted of the following at December 31, 1999 and 1998:
Commercial and mortgage loans totaling $837,519,000 and $932,467,000 were pledged to secure certain public deposits and Federal Home Loan Bank advances at December 31, 1999 and 1998, respectively.
Included in the Mortgage--Residential category were $136,097,000 and $259,507,000 of available for sale loans as of December 31, 1999 and 1998, respectively. These loans were recorded at the lower of cost or market on an aggregate basis.
Servicing assets are summarized in the following table:
As of December 31, 1999 and 1998, Pacific Century's loan servicing portfolio totaled $2,471,743,000 and $2,046,299,000, respectively.
Pacific Century's lending activities are concentrated in its primary geographic markets of Hawaii, the U.S. Mainland, Asia, and the West and South Pacific.
Certain directors and executive officers of Pacific Century, its subsidiary companies, companies in which they are principal owners, and trusts in which they are involved, have loans with Pacific Century subsidiaries. These loans were made in the ordinary course of business at normal credit terms, including interest rate and collateral requirements. Such loans at December 31, 1999 and 1998 amounted to $22,429,000 and $19,813,000,
respectively. During 1999, the activity in these loans included new borrowings of $8,193,000, repayments of $5,174,000, and other changes of $403,000. Other changes relate to new and retiring directors or companies and trusts in which they are involved.
Transactions in the reserve for loan losses were as follows:
The following table presents information on impaired loans as of December 31, 1999 and 1998:
NOTE D--PREMISES AND EQUIPMENT
The following is a summary of premises and equipment:
Depreciation and amortization (including capital lease amortization) included in non-interest expense were $42,068,000, $38,156,000 and $33,641,000 in 1999, 1998 and 1997, respectively.
Pacific Century leases certain branch premises and data processing equipment. Most of the leases for premises provide for a base rent over a specified period with renewal options thereafter. Portions of certain properties are subleased for periods expiring in various years through 2007. Lease terms generally provide for the lessee to pay taxes, maintenance and other operating costs.
Future minimum payments, by year and in the aggregate, for noncancelable operating leases with initial or remaining terms of one year or more and capital leases consisted of the following at December 31, 1999:
Minimum future rentals receivable under subleases for noncancelable operating leases at December 31, 1999, amounted to $3,299,000.
Rental expense for all operating leases for the years ended December 31, 1999, 1998 and 1997 is presented below:
NOTE E--DEPOSITS
Interest on deposit liabilities for the years ended December 31, 1999, 1998 and 1997 consisted of the following:
Time deposits with balances of $100,000 or more totaled $1,831,544,000 at December 31, 1999. Of this amount, $93,287,000 consisted of deposits of public (governmental) entities, which require collaterization by acceptable securities. The majority of deposits in the foreign category were in denominations of $100,000 or more.
Maturities of time deposits of $100,000 or more at December 31, 1999, are summarized as follows:
NOTE F--SHORT-TERM BORROWINGS
Details of short-term borrowings for 1999, 1998 and 1997 were as follows:
- -------- /1/ Average rates for the year are computed by dividing actual interest expense on borrowings by average daily borrowings.
Funds purchased generally mature on the day following the date of purchase. Commercial paper is issued by the parent corporation in various denominations generally maturing 90 days or less from date of issuance.
Securities sold under agreements to repurchase are accounted for as financing transactions and the obligations to repurchase these securities are recorded as liabilities in the Consolidated Statements of Condition. The securities underlying the agreements to repurchase continue to be reflected as an asset of Pacific Century
and are delivered to and held in collateral accounts with third party trustees. At December 31, 1999, the weighted average contractual maturity of these agreements was 182 days and consisted of transactions with public (governmental) entities, primarily the State of Hawaii ($0.9 billion) and local municipalities ($0.5 billion). A schedule of maturities of repurchase agreements follows:
A line of credit totaling $25,000,000 is maintained for working capital purposes. At December 31, 1999 there was no amount drawn on this line. Fees related to this line were $26,000 in 1999.
At December 31, 1999, other short-term borrowings consisted mainly of Federal Home Loan Bank advances and Treasury Tax and Loan balances. The Federal Home Loan Bank advances totaling $150.0 million bear interest at rates from 5.77% to 5.80% and mature within 90 days. Treasury Tax and Loan balances represent tax payments collected on behalf of the U.S. government, which are callable at any time and bear market interest rates.
NOTE G--LONG-TERM DEBT
Amounts outstanding as of December 31, 1999 and 1998 were as follows:
The $100 million 8.25% Capital Securities (the Securities) were issued in 1996 by Bancorp Hawaii Capital Trust I, a grantor trust wholly-owned by Pacific Century. The Securities bear a cumulative fixed interest rate of 8.25% and mature on December 15, 2026. Interest payments are semi-annual. In addition, Pacific Century has entered into an expense agreement with the trust obligating Pacific Century to pay any costs, expenses or liabilities of the trust, other than obligations of the trust to pay amounts due pursuant to the terms of the Securities. The sole assets of the trust are Junior Subordinated Debt Securities (the Debt) issued by Pacific Century to the trust. The Debt is redeemable prior to the stated maturity at Pacific Century's option. The Securities are subject to mandatory redemption upon repayment of the related Debt at their stated maturity dates or their earlier redemption at a redemption price equal to their liquidation amount plus accrued distributions to the date fixed for redemption and the premium, if any, paid by Pacific Century upon concurrent repayment of the related Debt. Pacific Century has issued guarantees for the payment of distributions and payments on liquidation or redemption of the Securities, but only to the extent of funds held by the trust. The guarantees are junior subordinated obligations of Pacific Century. Distributions to securities holders may be deferred for up to five consecutive years. During any such deferred period Pacific Century's ability to pay dividends on its common
shares will be restricted. The Federal Reserve has announced that certain cumulative preferred securities, having the characteristics of the Securities, qualify as minority interest, which is included in Tier 1 capital for bank holding companies.
Privately placed notes issued by Pacific Century totaled $90 million at December 31, 1999. No new notes were issued in 1999. These notes carry seven year terms and bear floating interest rates which are tied to the three-month LIBOR rate.
Federal Home Loan Bank (FHLB) advances bear interest at rates from 5.38% to 8.00% and mature from 2000 through 2005. At December 31, 1999, loans totaling $475,854,000 were pledged to secure these advances along with all FHLB stock.
Subordinated notes issued by Bank of Hawaii include $118,846,000 issued in 1993 and $124,535,000 issued in 1999 that mature in 2003 and 2009, respectively. These notes bear a fixed interest rate of 6.875%.
Foreign debt is comprised of a private placement borrowing denominated in euro. This debt has a fixed interest rate of 3.28% and matures in 2001.
Capitalized lease obligations are for certain condominium units in the Financial Plaza of the Pacific. The lease began in 1993 and has a 60 year term. Lease payments are fixed at $7,000 per year until 2002; $605,000 per year from 2003 to 2007 and $665,000 per year from 2008 to 2012 and are negotiable thereafter.
In 1998, Bank of Hawaii converted its existing revolving note program into a $1 billion revolving senior and subordinated note program. Under the terms of this program Bank of Hawaii may issue additional notes provided that at any time the aggregate amount outstanding does not exceed $1 billion. At December 31, 1999, there were no outstanding balances under this program.
Long-term debt maturities for the five years succeeding December 31, 1999, are $38,875,000 in 2000, $210,537,000 in 2001, $12,670,000 in 2002, $126,846,000 in 2003 and $96,000,000 in 2004.
Interest paid on long-term debt in 1999, 1998 and 1997 totaled $41,200,000, $43,820,000 and $57,144,000, respectively.
NOTE H--SHAREHOLDERS' EQUITY
Certain of Pacific Century's consolidated banking subsidiaries (including Bank of Hawaii, Pacific Century Bank, N.A., and First Savings) are subject to federal regulatory restrictions that limit cash dividends and loans to Pacific Century. As of December 31, 1999, approximately $530,500,000 of undistributed earnings of Pacific Century's consolidated subsidiaries were available for distribution to Pacific Century without prior regulatory approval.
In evaluating capital adequacy, federal regulators require bank holding companies and insured depository institutions to maintain three capital ratios at specific minimum levels. Tier 1 Capital (common shareholders' equity reduced by certain intangibles and increased for qualifying preferred shares and minority interests) expressed as a percentage of average risk weighted assets is the Tier 1 Capital Ratio. Total Capital (Tier 1 capital plus qualifying portions of the reserve for loan losses) expressed as a percentage of average risk weighted assets is the Total Capital Ratio. The third ratio is the Leverage Ratio which is Tier 1 Capital divided by average assets. The table below presents the minimum Capital levels that an institution must maintain to qualify as "well capitalized" as it applies to Pacific Century and its subsidiaries Bank of Hawaii, Pacific Century Bank, N.A. and First Savings.
The Federal Deposit Insurance Corporation Improvements Act of 1991 requires federal banking regulators to take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. For purposes of applying the prompt corrective action framework, federal bank regulators group
institutions into five categories based on their capital ratios: "well capitalized," "adequately capitalized," "under capitalized," "significantly undercapitalized" and "critically undercapitalized." Institutions that fail to meet the applicable capital requirements are subject to increased regulatory monitoring and certain other enforcement actions that could include restricting dividend payments.
As of December 31, 1999, Pacific Century, Bank of Hawaii, Pacific Century Bank, N.A. and First Savings were all well capitalized under the regulatory provisions for prompt and corrective action. There were no conditions or events since year-end that management believes have changed Pacific Century's or its subsidiaries' capital rating. The table below sets forth regulatory capital for Pacific Century and its depository subsidiaries at December 31, 1999 and 1998:
The following is a breakdown of the components of accumulated other comprehensive income as of December 31, 1999, 1998 and 1997:
The schedule below presents for the years ended December 31, 1999, 1998 and 1997 the disclosure of the reclassification amount to adjust for gains and losses on available for sale investment securities that were included in net income and that have also been included in other comprehensive income as unrealized holding gains in the period in which they arose.
The amount of income tax allocated to each component of comprehensive income for the years ended December 31, 1999, 1998 and 1997 is provided below:
In April 1998, Pacific Century changed its state of incorporation from Hawaii to Delaware. The Delaware Certificate of Incorporation authorizes 500,000,000 shares of Common Stock and reduces the par value to $.01 per share from $2.00 per share under the Hawaii Restated Articles of Incorporation.
NOTE I--INTERNATIONAL OPERATIONS
The following table provides selected financial data for Pacific Century's international operations for the years ended December 31, 1999, 1998 and 1997:
Average assets include short-term interest-bearing deposits with foreign branches of U.S. banks and large international banks. On average, these deposits were $577,257,000, $494,325,000 and $558,739,000 during 1999, 1998 and 1997, respectively.
To measure international profitability, Pacific Century maintains an internal transfer pricing system that makes certain income and expense allocations, including interest expense for the use of domestic funds. Interest rates used in determining charges on advances of funds are based on prevailing deposit rates. Overhead is allocated based on services rendered by administrative units to profit centers.
NOTE J--CONTINGENT LIABILITIES
Pacific Century is a defendant in various legal proceedings and, in addition, there are various other contingent liabilities arising in the normal course of business. After consultation with legal counsel, management does not anticipate that the disposition of these proceedings and contingent liabilities will have a material effect upon the consolidated financial statements.
NOTE K--PROFIT SHARING, RETIREMENT AND POSTRETIREMENT BENEFIT PLANS
A deferred-compensation profit sharing plan (Profit Sharing Plan) is provided for the benefit of all employees of Pacific Century and its subsidiaries who have met the Profit Sharing Plan's eligibility requirements. The Profit Sharing Plan provides for annual contributions based on a schedule of performance levels. The schedule establishes the percentage of adjusted net income to be contributed based on Pacific Century's adjusted return on equity. Participants in the Profit Sharing Plan receive up to 50% of their annual allocation in cash. The remaining amounts are deferred and may be invested in various options including mutual funds, a collective trust, and common shares of Pacific Century. In 1998, the portion of the Profit Sharing Plan consisting of the Pacific Century Stock Fund was converted to an employee stock ownership plan. Pacific Century's contributions to the
Profit Sharing Plan totaled $6,849,000 in 1999, $8,472,000 in 1998 and $9,723,000 in 1997. The Profit Sharing Plan provides for a company match of $1.25 for each $1.00 in 401(k) contributions made by qualified employees up to a maximum of 2% of the employee's compensation. For 1999, 1998 and 1997, matching contributions under this plan totaled $3,176,000, $2,981,000 and $2,882,000, respectively.
Pacific Century has a defined-contribution money purchase plan (Money Purchase Plan) under which it contributes 4% of an employee's compensation for employees meeting certain eligibility and vesting requirements. The Money Purchase Plan has a one year eligibility requirement and a five year vesting period. For 1999, 1998 and 1997, Pacific Century contributed $5,898,000, $5,192,000 and $4,943,000, respectively, to the Money Purchase Plan.
Pacific Century also has an Excess Profit Sharing Plan and an Excess Money Purchase Plan, which cover certain employees for amounts exceeding the limits under those plans.
In 1995, Pacific Century froze its non-contributory, qualified defined- benefit retirement plan (Retirement Plan) and excess retirement plan (Excess Plan), which covered employees of Pacific Century and participating subsidiaries who met certain eligibility requirements. Pacific Century's funding policy is to contribute annually an amount that falls within the minimum and maximum range deductible for income tax purposes. Retirement Plan assets are managed by investment advisors in accordance with investment policies established by the plan trustees.
Retirement Plan investments primarily consist of marketable securities including stocks, U.S. Government agency securities, a money market fund, mutual funds, and a collective investment fund. The assets of the Retirement Plan include securities of related parties (Pacific Capital Funds, a Pacific Century Trust collective investment fund, and a Pacific Century Trust money market fund). Pacific Century Trust is a division of Bank of Hawaii and either manages or advises the Pacific Capital Funds and Pacific Century Trust collective investment fund and money market fund. The fair value of securities of related parties as of December 31, 1999 was $24,924,000.
The Excess Plan is a non-qualified excess retirement benefit plan which covers certain employees of Pacific Century and participating subsidiaries. The unfunded Excess Plan recognizes the liability to participants for amounts exceeding the limits allowed under the Retirement Plan.
Pacific Century's Postretirement Benefit Plans provide retirees with group life, dental and medical insurance coverage. The cost of providing postretirement benefits are "shared costs" where both the employer and former employees pay a portion of the premium. Most employees of Pacific Century and its subsidiaries who have met the eligibility requirements are covered by this plan. Beginning in 1993, Pacific Century is recognizing the transition obligation over 20 years. Pacific Century has no segregated assets to provide postretirement benefits.
The following table sets forth the change in benefit obligation, change in fair value of plan assets, funded status, and net amount recognized in the Consolidated Statements of Financial Condition for the aggregated pension plans (Retirement Plan and Excess Plan) and Postretirement Benefit Plans for the years ended December 31, 1999 and 1998.
- -------- /1/ Participants' contributions relative to the Postretirement Benefits Plan are offset against employer benefits paid in the above table. For the years ended December 31, 1999 and 1998, participants' contributions for postretirement benefits totaled $817,000 and $824,000, respectively. There were no participants' contributions in the pension plans.
For the Excess Plan, the accumulated benefit obligation exceeded the plan assets. The projected benefit obligation and accumulated benefit obligation for the Excess Plan were $7.8 million and $7.7 million, respectively, as of December 31, 1999 and $7.9 million and $7.4 million, respectively, as of December 31, 1998. The accrued benefit liability as of December 31, 1999 and 1998 was $7.7 million and $7.4 million, respectively. Because the Excess Plan is unfunded, it has no plan assets.
Components of net periodic benefit cost for the aggregated pension plans and the Postretirement Benefit Plans are presented in the following table for the years ended December 31, 1999, 1998 and 1997.
The medical cost trend rate for employees under the age of 65 was revised at December 31, 1998 to 8.0% for 1999 and leveling thereafter to 6.0%. The medical cost trend rate for employees over the age of 65 and the dental cost trend rate were both revised at December 31, 1998 to a flat rate of 6.0% per year. A one percent change in this assumption (with all other assumptions remaining constant) would impact the service and interest cost components of the net periodic postretirement benefit cost and the postretirement benefit obligation for 1999 as follows:
NOTE L--STOCK OPTION PLANS
The Pacific Century Stock Option Plans (the Plans) are administered by the Compensation Committee which is composed entirely of non-employee directors. The Plans provide participants with the option to purchase shares of common stock at a specified exercise price beginning one year after the date the option was granted and expiring ten years from the date of grant. The exercise price is the fair market value of the shares on the date the option was granted. The Plans also provide certain participants with stock options in tandem with stock appreciation rights (SAR). A SAR entitles an optionee, in lieu of exercising the stock option, to receive cash equal to the excess of the market value of the shares as of the exercise date over the option price. The Compensation Committee has limited the exercise of SARs to $1 million per year, allocated among the participants. The expense for the SARs recognized in the Consolidated Statements of Income was $370,000 in 1999, $614,000 in 1998 and $1,000,000 in 1997.
Pacific Century has a Director Stock Option Plan that grants restricted common shares to directors and requires directors to retain shares exercised throughout the service period as a director. The plan automatically
grants annually an option for 1,000 shares to each Pacific Century director who is also a director of Bank of Hawaii and an option for 500 shares to directors who are only directors of Pacific Century or Bank of Hawaii. The exercise price is based on the closing market price of the shares on the date that the option was granted. Each option expires on the tenth anniversary date of its grant and is generally not transferable. If an optionee ceases to serve as a director for any reason other than death, the option immediately terminates and any restricted shares that were previously acquired are subject to redemption at a price equal to the market value of the shares at the time of grant. As of December 31, 1999, 67,000 options were outstanding under this plan.
The following information relates to options outstanding as of December 31, 1999:
The following table presents the activity of Stock Option Plans for the years ended December 31, 1999, 1998 and 1997:
- -------- /1/ The price per share of options exercised on an actual exercise price basis ranged between $7.24 and $21.13 for 1999, $7.44 and $21.88 for 1998, and $6.04 and $21.13 for 1997.
The following table presents for the years ended December 31, 1999, 1998 and 1997 the pro forma disclosures of the impact that option grants would have had on net income and earnings per share had the grants been measured using the fair value of accounting prescribed by SFAS No. 123:
- -------- /1/ The Black-Scholes option pricing model was used to develop the fair values of the grants.
NOTE M -- OTHER OPERATING EXPENSE
Other operating expense for the years ended December 31, 1999, 1998 and 1997 was as follows:
NOTE N -- INCOME TAXES
The significant components of the provision for income taxes for the years ended December 31, 1999, 1998 and 1997 are as follows:
The current income tax provision includes taxes on gains and losses on the sale of securities of $5,776,000, $1,415,000 and $1,107,000 for 1999, 1998 and 1997, respectively. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Pacific Century's deferred tax liabilities and assets as of December 31, 1999 and 1998 reclassified based on the tax returns as filed, are as follows:
For financial statement purposes, Pacific Century had deferred investment tax credits for property purchased for lease to customers of $2,646,000, $2,977,000 and $5,620,000 at December 31, 1999, 1998 and 1997, respectively. In 1999, 1998 and 1997, investment tax credits included in the computation of the provision for income taxes were $331,000, $2,643,000 and $383,000, respectively.
The following analysis reconciles the Federal statutory income tax rate to the effective consolidated income tax rate for the years ended December 31, 1999, 1998 and 1997:
- -------- /1/ For 1999 income taxes associated with the sale of a special purpose leasing subsidiary increased the effective tax rate by 3.5%.
For financial statement purposes, no deferred income tax liability has been recorded for tax bad debt reserves that arose in tax years beginning before December 31, 1987. Such tax bad debt reserves total approximately $18.2 million for which no provision for federal income taxes has been provided. If these amounts are used for purposes other than to absorb bad debt losses, they will be subject to federal income taxes at the then applicable rates.
NOTE O--FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
Pacific Century is a party to financial instruments with off-balance sheet risk in the normal course of its business to meet the financing needs of customers and to manage its own exposure to fluctuations in interest and foreign exchange rates. These financial instruments include commitments to extend credit, standby letters of credit, foreign exchange contracts, interest rate swaps and interest rate options. To varying degrees, these instruments involve elements of credit and interest rate risk in excess of the amount recognized in the statements of condition. The contract or notional amounts of these instruments reflect the extent of involvement that Pacific Century has in each class of financial instrument. The FASB has categorized certain of these off-balance sheet financial instruments that include foreign currency contracts and interest rate swaps as derivative financial instruments. FASB has further categorized these derivative financial instruments into "held or issued for purposes other than trading" or "trading."
Pacific Century's exposure to off-balance sheet credit risk is defined as the possibility of sustaining a loss due to the failure of the counterparty to perform in accordance with the terms of the contract. Credit risks associated with off-balance sheet financial instruments are similar to those relating to on-balance sheet financial instruments. Pacific Century manages off-balance sheet credit risk with the same standards and procedures applied to its commercial lending activity.
Traditional Off-Balance Sheet Risk Instruments
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of the terms or conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since commitments may expire without being drawn, the total commitment amount does not necessarily represent future cash requirements. Pacific Century evaluates each customer's credit worthiness on an individual basis. The amount of collateral obtained is based on management's credit evaluation of the customer. The type of collateral varies, but may include cash, accounts receivable, inventory, and property, plant, and equipment.
Standby letters of credit are conditional commitments issued by Pacific Century to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support borrowing agreements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Pacific Century holds cash and deposits as collateral on those commitments for which collateral is deemed necessary.
Derivative Financial Instruments Held for Trading
Foreign exchange contracts are contracts for delayed delivery of a foreign currency in which the seller agrees to make delivery at a specified future date at a specified price. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in currency rates. Collateral is generally not required for these transactions. At December 31, 1999, the notional amount of foreign exchange contracts held for trading totaled $686.7 million, with a fair value of $3.7 million, compared to $555.9 million, with a fair value of $4.3 million at December 31, 1998. Pacific Century uses foreign exchange contracts to offset foreign currency positions taken on behalf of its customers and for its own account. Pacific Century does not maintain significant net open positions in its foreign exchange trading account.
Derivative Financial Instruments Held or Issued for Other Than Trading
At December 31, 1999, the notional amount of foreign exchange contracts held for other than trading totaled $229.3 million with a fair value of $(3.0) million, compared to $318.1 million at December 31, 1998 with a fair value of $(11.1) million. Pacific Century uses these foreign exchange contracts primarily for asset and liability management activities. Pacific Century does not maintain significant net open foreign exchange positions in its other than trading account.
Interest rate options, which primarily consist of caps and floors, are interest rate protection instruments that involve the obligation of the seller to pay the buyer an interest rate differential in exchange for a premium paid by the buyer. This differential represents the difference between current interest rates and an agreed-upon rate applied to a notional amount. Exposure to loss on these options will increase or decrease over their respective lives as interest rates fluctuate. Pacific Century transacts interest rate options on behalf of its customers and does not maintain significant open positions.
From time to time Pacific Century utilizes interest-rate swaps in managing its exposure to interest-rate risk. These financial instruments require the exchange of fixed and floating rate interest payments based on the notional amount of the contract for a specified period. Pacific Century has used swap agreements to effectively convert portions of its floating rate loan portfolio to fixed rate. At December 31, 1999, no swaps were in effect.
Pacific Century's credit risk exposure on interest-rate swaps is equal to the total market value of those instruments with gains. As of December 31, 1999 Pacific Century had no credit risk exposure from swaps. At year-end 1998 the aggregate credit risk of swaps were $0.3 million and the net market value of all positions was $0.3 million. Net expense on interest rate swap agreements totaled $0.1 million, $1.5 million and $2.5 million for 1999, 1998 and 1997, respectively.
The table below summarizes by notional amounts the activity for each major category of interest-rate swaps in 1999. Pacific Century had no deferred gains or losses relating to terminated swap contracts in 1999 and 1998.
NOTE P--FAIR VALUES OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced liquidation sale. When possible, fair values are measured based on quoted market prices for the same or comparable instruments. Because many of Pacific Century's financial instruments lack an available market price, management must use its best judgment in estimating the fair value of those instruments based on present value or other valuation techniques. Such techniques are significantly affected by estimates and assumptions, including the discount rate, future cash flows, economic conditions, risk characteristics, and other relevant factors. These estimates are subjective in nature and
involve uncertain assumptions and, therefore, cannot be determined with precision. Many of the derived fair value estimates cannot be substantiated by comparison to independent markets and could not be realized in immediate settlement of the instrument. Certain financial instruments and all non- financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of Pacific Century.
The following methods and assumptions were used by Pacific Century in estimating fair values of financial instruments:
Cash and Cash Equivalents: The carrying amounts reported in the balance sheet for cash and short-term investments approximate the fair value of these assets.
Investment Securities Held to Maturity, Investment Securities Available for Sale and Trading Securities: Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Loans: Fair values of loans are determined by discounting the expected future cash flows of pools of loans with similar characteristics. Loans are first segregated by type such as commercial, real estate, consumer, and foreign and are then further segmented into fixed and adjustable rate and loan quality categories. Expected future cash flows are projected based on contractual cash flows, adjusted for estimated prepayments.
Deposit Liabilities: Fair values of non-interest bearing and interest bearing demand deposits and savings deposits are equal to the amount payable on demand (e.g., their carrying amounts) because these products have no stated maturity. Fair values of time deposits are estimated using discounted cash flow analyses. The discount rates used are based on rates currently offered for deposits with similar remaining maturities.
Short-Term Borrowings: The carrying amounts of securities sold under agreements to repurchase, funds purchased, commercial paper, and other short-term borrowings approximate their fair values.
Long-Term Debt: Fair values of long-term debt are estimated using discounted cash flow analyses, based on Pacific Century's current incremental borrowing rates for similar types of borrowings.
Off-Balance Sheet Instruments: Fair values of off-balance sheet instruments (e.g., commitments to extend credit, standby letters of credit, commercial letters of credit, foreign exchange and swap contracts, and interest rate swap agreements) are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing, current settlement values or quoted market prices of comparable instruments.
The following table presents the fair values of Pacific Century's financial instruments at December 31, 1999 and 1998.
- -------- /1/ Includes all loans, net of unearned income and reserve for loan losses, and excludes net leases. /2/ Includes both held to maturity and available for sale securities. /3/ Includes interest-bearing deposits, funds sold and trading securities. /4/ Includes securities sold under agreements to repurchase, funds purchased and short-term borrowings. /5/ Excludes capitalized lease obligations.
NOTE Q--BUSINESS SEGMENTS
Pacific Century is a financial services organization that maintains a broad presence throughout the Pacific region. The financial performance of individual operating components are assessed by the chief operating decision maker of Pacific Century in accordance with geographic and functional area of operations. Geographically, Pacific Century has aligned its operations into four major segments: Hawaii, the Pacific, Asia, and the U.S. Mainland. In addition, the Treasury and Other Corporate segment includes corporate asset and liability management activities and the unallocated portion of various administrative and support units.
Business segment results are determined based on Pacific Century's internal financial management reporting process and organization structure. The financial management reporting process uses various techniques to assign and transfer balance sheet and income statement amounts between business units. In measuring line of business financial performance, Pacific Century utilizes certain accounting practices that differ from generally accepted accounting principles. Accordingly, certain balances reflected in the line of business report differ from the corresponding amounts in the consolidated financial statements. Accounting practices and other key elements of Pacific Century's line of business financial management reporting process follows:
. Economic Provision--Business units are allocated an economic provision for loan losses that reflects the expected normalized loss determined by a statistically applied approach that considers risk factors, including historical loss experience, within a given portfolio. The economic provision is different from the method used to determine Pacific Century's consolidated provision for loan losses, which is based on an evaluation of the adequacy of the reserve for loan losses.
. Net Interest Income--Pacific Century relies primarily on net interest income as the relevant revenue measure in assessing segment financial performance. Interest revenue and interest expense are allocated to business units using a funds transfer pricing process.
. Non-Interest Expense--Expenses for centrally provided services are based on estimated usage of those services using various allocation techniques.
. Income Taxes--Income taxes are charged to business units based on Pacific Century's consolidated effective tax rate, exclusive of tax benefits. Tax benefits resulting from permanent differences between book and tax income are allocated to the business segment to which they relate.
From time to time, Pacific Century's line of business management reporting process may change based on refinements in segment reporting policies or changes in organizational structure, accounting systems, product lines or information systems. These changes could result in a realignment of business lines or modifications to allocation and transfer methodologies. When material changes are made to the financial management reporting process prior period reports would be restated.
Presented below is the financial results for each of Pacific Century's business segments for the years ended December 31, 1999 and 1998.
BUSINESS SEGMENT SELECTED FINANCIAL INFORMATION
- -------- /1/ The economic provision for loan losses reflects the expected normalized loss determined by a statistically applied approach that considers risk factors, including historical loss experience, within a given portfolio. The economic provision differs from the provision determined under generally accepted accounting principles. The difference between the sum of the economic provision for business segments and the provision in the consolidated financial statements is included in Treasury and Other Corporate. /2/ The economic provision for Asia in 1999 reflects adjustments for normalized loss factors resulting from the company's assessment of reform measures initiated to deal with the financial turmoil in the region. Prior to 1999, economic provisions for uncertainty in the region were reflected in the provision for Treasury. /3/ Non-interest expense for the Treasury and Other Corporate segment in 1999 and 1998 included a restructuring charge of $22.5 million and $19.4 million, respectively. /4/ Tax benefits are allocated to the business segment to which they relate. In 1999 and 1998, income taxes for the U.S. Mainland segment included $14.0 million and $13.5 million, respectively, in tax benefits from low income housing tax credits and investment tax credits. /5/ Income taxes in 1999 included $12.7 million relative to the sale of a special purpose leasing subsidiary, which generated $14.0 million in gains.
The Hawaii segment includes both retail and commercial operating units. Retail operating units sell and service a broad line of consumer financial products. These units include consumer deposits, consumer lending, residential real estate lending, auto financing, credit cards, and private and institutional services (trust, mutual funds, and stock brokerage). With respect to the commercial component, operating units in Hawaii include small business, corporate banking, commercial products and commercial real estate.
In the Pacific segment, Pacific Century offers financial products and services to both retail and commercial customers. This segment includes operations in the West and South Pacific.
Pacific Century serves the West Pacific through Bank of Hawaii branches in Guam, the Commonwealth of the Northern Mariana Islands, the Federated States of Micronesia, the Republic of the Marshall Islands and the Republic of Palau. Additionally, First Savings maintains branches in Guam.
Pacific Century's presence in the South Pacific includes branches of Bank of Hawaii and various subsidiary and affiliate banks. The Bank of Hawaii branches in this region are in Fiji and American Samoa. Pacific Century's subsidiary banks in the South Pacific are located in French Polynesia, New Caledonia, Papua New Guinea, and Vanuatu. Additionally, Pacific Century maintains an investment in affiliate banks located in Samoa, Solomon Islands and Tonga.
Pacific Century operates in Asia through Bank of Hawaii branches in Hong Kong, Japan, Singapore, South Korea and Taiwan and a representative office with extensions in the Philippines. Pacific Century's business focus in Asia is correspondent banking and trade financing. The activities include letters of credit, remittance processing, foreign exchange, cash management, export bills collection, and working capital and relationship lending. The lending emphasis is on short-term loans based on cash flows.
In the U.S. Mainland segment, consumer and business financial products and services are provided through Pacific Century Bank, N.A. (PCB), which has branches in Southern California and Arizona. PCB's emphasis is to develop a niche in the small and middle business markets and expand relationships with customers who have an interest in the Asia-Pacific region.
In addition to the operations of PCB, this segment also includes operating units for large corporate lending and leasing. The large corporate lending unit targets businesses that have interests in the Asia-Pacific region and companies in certain targeted industries. Leasing activities consist of providing financing to businesses largely for aircraft, vehicles and equipment.
The operations in the Treasury and Other Corporate segment, consist of corporate asset and liability management activities including investment securities, federal funds purchased and sold, institutional deposits, short and long-term borrowings, and derivative activities for managing interest rate and currency risks. Additionally, the net residual effect of transfer pricing assets and liabilities also is included in Treasury.
Other items in this segment consist of the following:
. The operations of certain non-bank subsidiaries.
. The residual effect of unallocated expenses for support and administrative units.
. The difference between the sum of the economic provisions allocated to business segments and the provision in the consolidated financial statements.
. The difference between the sum of the equity allocated to business segments and total equity in the consolidated financial statements.
. Significant nonrecurring income and expense items.
NOTE R--PARENT COMPANY FINANCIAL STATEMENTS
Condensed financial statements of Pacific Century Financial Corporation (Parent only) follow:
Condensed Statements of Income
Condensed Statements of Condition
Condensed Statements of Cash Flows
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
The following information required by the Instructions to Form 10-K is incorporated herein by reference (except as otherwise indicated below) from various pages of the Pacific Century Financial Corporation Proxy Statement for the annual meeting of shareholders to be held on April 28, 2000, as summarized below:
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Board of Directors on pages 6-8. Section 16(a) Beneficial Ownership Reporting Compliance on page 24.
For information relative to executive officers of the Registrant, see "Executive Officers of the Registrant" at the end of Part I of this report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Executive Compensation on pages 13-23.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Beneficial Ownership on pages 11-12.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Certain Transactions with Management and Others on page 24.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial Statements and Schedules
The following consolidated financial statements of Pacific Century Financial Corporation and subsidiaries are included in Item 8 of this report:
Consolidated Statements of Condition--December 31, 1999 and 1998
Consolidated Statements of Income--Years ended December 31, 1999, 1998, and
Consolidated Statements of Shareholders' Equity--Years ended December 31, 1999, 1998, and 1997
Consolidated Statements of Cash Flows--Years ended December 31, 1999, 1998, and 1997
Notes to Consolidated Financial Statements
All other schedules to the consolidated financial statements stipulated by Article 9 of Regulation S-X and all other schedules to the financial statements of the registrant required by Article 5 of Regulation S-X are not required under the related instructions or are inapplicable and, therefore, have been omitted.
Financial statements (and summarized financial information) of (1) unconsolidated subsidiaries or (2) 50% or less owned persons accounted for by the equity method have been omitted because they do not, considered individually or in the aggregate, constitute a significant subsidiary.
EXHIBIT INDEX
- -------- * Management contract or compensatory plan or arrangement
(b) Registrant filed no Form 8-Ks during the quarter ended December 31, 1999.
(c) Response to this item is the same as Item 14(a).
(d) Response to this item is the same as Item 14(a).
STATISTICAL DISCLOSURES CONTENTS AND REFERENCE
The following statistical disclosures required by the Instructions to Form 10-K are summarized below:
Item I. Distribution of Assets, Liabilities, and Shareholders' Equity; Interest Rates and Interest Differential
Interest Differential--Table 23 included in Item 7 of this report.
Consolidated Average Balances, Income and Expense Summary, and Yields and Rates--Taxable Equivalent--Table 3 included in Item 7 of this report.
Average Loans--Table 20 included in Item 7 of this report.
Average Deposits--Table 22 included in Item 7 of this report.
Item II. Investment Portfolio
Note B to the Audited Financial Statements included in Item 8 of this report.
Maturity Distribution, Market Value and Weighted-Average Yield to Maturity of Securities--Table 18 included in Item 7 of this report.
Item III. Loan Portfolio
Loan Portfolio Balances--Table 6 included in Item 7 of this report.
Maturities and Sensitivities of Loans to Changes in Interest Rates-- Table 21 included in Item 7 of this report.
Non-Performing Assets and Accruing Loans Past Due 90 Days or More-- Table 10 included in Item 7 of this report.
Foregone Interest on Non-Accruals--Table 11 included in Item 7 of this report.
Geographic Distribution of Cross-Border International Assets--Table 9 included in Item 7 of this report.
Item IV. Summary of Loan Loss Experience
Reserve for Loan Losses--Table 12 included in Item 7 of this report.
Allocation of Loan Loss Reserve--Table 13 included in Item 7 of this report.
Narrative discussion of "Reserve for Loss Losses" included in Item 7 of this report.
Item V. Deposits
Consolidated Average Balances, Income and Expense and Yields and Rates--Taxable Equivalent--Table 3 included in Item 7 of this report.
Note E to the Audited Financial Statements included in Item 8 of this report.
Item VI. Return on Equity and Assets
Item VII. Short-Term Borrowings
Note F to the Audited Financial Statements included in Item 8 of this report.
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
Date: February 29, 2000 Pacific Century Financial Corporation
/s/ Lawrence M. Johnson By: _________________________________ Lawrence M. Johnson, Chairman of the Board and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT IN THE CAPACITIES AND ON THE DATE INDICATED.
Date: February 29, 2000
/s/ Lawrence M. Johnson /s/ H. Howard Stephenson - ------------------------------------- ------------------------------------- Lawrence M. Johnson, H. Howard Stephenson, Director Director
/s/ Peter D. Baldwin /s/ Martin A. Stein - ------------------------------------- ------------------------------------- Peter D. Baldwin, Martin A. Stein, Director Director
/s/ Mary G. F. Bitterman /s/ Fred E. Trotter - ------------------------------------- ------------------------------------- Mary G. F. Bitterman, Fred E. Trotter, Director Director
/s/ Richard J. Dahl /s/ Stanley S. Takahashi - ------------------------------------- ------------------------------------- Richard J. Dahl, Stanley S. Takahashi, Director Director
/s/ David A. Heenan /s/ Donald M. Takaki - ------------------------------------- ------------------------------------- David A. Heenan, Donald M. Takaki, Director Director
/s/ Stuart T. K. Ho /s/ David A. Houle - ------------------------------------- ------------------------------------- Stuart T. K. Ho, David A. Houle, Director Chief Financial Officer
/s/ Herbert M. Richards, Jr. /s/ Denis K. Isono - ------------------------------------- ------------------------------------- Herbert M. Richards, Jr., Denis K. Isono, Director Chief Accounting Officer | 27,547 | 183,988 |
1109544_1999.txt | 1109544_1999 | 1999 | 1109544 | ITEM 1. BUSINESS.
The Massachusetts RRB Special Purpose Trust BEC-1 ("the Trust") was established on July 27, 1999 as a Delaware business trust. The Massachusetts Development Finance Agency and the Massachusetts Health and Educational Facilities Authority formed the Trust to issue bonds pursuant to certain provisions of Chapter 164 of the Acts of the Massachusetts General Court of 1997 (the "Electric Industry Restructuring Act"). The Trust issued $725,000,000 of Rate Reduction Certificates ("certificates") on July 29, 1999 for the purpose of acquiring related notes from BEC Funding LLC (the "Note Issuer"). The Massachusetts Development Finance Agency, the Massachusetts Health and Educational Facilities Authority and The Bank of New York (Delaware), a Delaware banking corporation, acting as the Delaware Trustee, entered into a Declaration of Trust to form the Trust. The Trust is not an agency nor instrumentality of The Commonwealth of Massachusetts. The Trust has minimal assets other than the notes. The Declaration of Trust does not permit the Trust to engage in any activities other than holding the notes, issuing the certificates, and engaging in other related activities.
Each class of certificates represents a fractional undivided beneficial interest in a related class of notes issued by BEC Funding LLC, including all amounts due and to become due under the related class of notes, and represents the right to receive the payments on the related class of notes.
The Note Issuer, the Massachusetts Development Finance Agency, the Massachusetts Health and Educational Facilities Authority, the Trust, the Delaware Trustee and the certificate trustee have entered into a fee and indemnity agreement under which the Note Issuer pays the Delaware trustee's and the certificate trustee's reasonable compensation and reasonable fees and expenses. The fee and indemnity agreement further provides that the Note Issuer will indemnify the Trust, the Delaware trustee, the certificate trustee, the Massachusetts Development Finance Agency, the Massachusetts Health and Educational Facilities Authority and the Executive Office for Administration and Finance of The Commonwealth of Massachusetts for, and hold them harmless against, among other things, any loss, liability or expense incurred by them arising from the failure of any party to perform its obligations under various transaction documents. Neither the certificates, the notes or the property securing the notes is an obligation of The Commonwealth of Massachusetts or any governmental agency, authority or instrumentality of The Commonwealth of Massachusetts or of Boston Edison Company or any of its affiliates, except for BEC Funding LLC, which is an affiliate of Boston Edison Company.
The fiscal year of the Trust is the calendar year. Substantially all expenses of the Trust are paid by the Note Issuer, BEC Funding LLC.
ITEM 2.
ITEM 2. PROPERTIES
The Trust has no physical property. Its primary assets are the notes issued by BEC Funding LLC.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
None.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Trust does not have equity securities.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The Trust was established on July 27, 1999 and commenced operations on July 29, 1999.
Total assets at December 31, 1999 amounted to $745,133,819.
Total Certificate obligations outstanding at December 31, 1999 amounted to $725,000,000, of which $78,441,458 of Certificates are due within one year; of this latter amount, $40,000,000 of Class A-1 certificates were redeemed in full on their scheduled maturity date together with all accrued interest.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION FOR THE PERIOD JULY 29, 1999 (DATE OF INCEPTION) TO DECEMBER 31, 1999.
The Massachusetts RRB Special Purpose Trust BEC-1 was formed on July 27, 1999, and issued certificates in the amount of $725,000,000 on July 29, 1999. The net proceeds from the issuance of certificates were remitted to BEC Funding LLC in exchange for $725,000,000 of Notes. BEC Funding LLC then remitted net proceeds of approximately $719,837,000 to BECo in exchange for certain transition property.
As of February 29, 2000, BECo has remitted to BEC Funding LLC approximately $72,940,000 of non-bypassable reimbursable transition cost ("RTC") charges collected. Such funds are held by the Note Trustee and are restricted in their ultimate use for the debt service of BEC Funding LLC. Collections of RTC charges billed by BECo and remitted to BEC Funding LLC are in accordance with original estimates and are in an amount sufficient to meet debt service requirements due on March 15, 2000. BEC Funding LLC redeemed $40,000,000 of its outstanding Class A-1 certificates on their scheduled maturity date and simultaneously, the Trust redeemed $40,000,000 of its outstanding Class A-1 Notes on their scheduled maturity date. The Trust relies on timely remittances of adequate RTC collections from BEC Funding LLC (which in turn relies on timely remittances of RTC collections from BECo) in order to meet its debt service obligations; the Trust believes it will continue to receive timely and adequate remittances of RTC funds in order to meet all debt service obligations.
BEC Funding LLC is a special purpose, single member limited liability company whose sole member is BECo, a provider of electric distribution services. BEC Funding LLC is a wholly-owned subsidiary of BECo, which is a wholly-owned subsidiary of BEC Energy, which is a wholly-owned subsidiary of NSTAR. NSTAR is a holding company that was created through a merger between BEC Energy, headquartered in Boston, Massachusetts, and Commonwealth Energy System, headquartered in Cambridge, Massachusetts, effective August 25, 1999. BEC Funding LLC had no significant activities in the period January 29, 1999 to July 29, 1999.
BEC Funding LLC was organized on January 29, 1999 under the laws of the State of Delaware for the sole purpose of acquiring and holding transition property and issuing notes secured by the transition property. The transition property is a property right created under Massachusetts law that includes the right to access and collect a non-bypassable charge, called an RTC charge, from customers of BECo. The acquisition of such transition property was accomplished by BEC Funding LLC issuing $725,000,000 of Notes to the Trust on July 29, 1999. The notes were issued under an indenture between
BEC Funding LLC and The Bank of New York, as note trustee (the "Note Trustee").
The separate financial statements of BEC Funding LLC present results of operations and its financial condition as it operated as a subsidiary of BECo. Those financial statements may not be indicative of the results that would have been achieved had BEC Funding LLC operated as an unaffiliated entity.
BEC Funding LLC's is limited by its organizational documents from engaging in any activities other than owning the transition property, issuing the notes secured by the transition property and other limited collateral, and related activities thereto. Accordingly, income statement effects were limited primarily to income generated from the transition property, interest expense on the notes and incidental interest income. The Trust is limited by its organizational documents from engaging in any activities other than owning the notes, issuing Rate Reduction Certificates secured by the notes, and activities related thereto. Accordingly, income statement effects were limited primarily to income generated from the notes and interest expense on the certificates.
The organizational documents and note indenture covenants also require that BEC Funding LLC be operated in a manner intended to reduce the likelihood that it would be consolidated in BECo's bankruptcy estate if BECo became a debtor in a bankruptcy case.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Trust has exposure to credit risk for its notes receivable from the Note Issuer, BEC Funding LLC, which is a wholly-owned subsidiary of BECo, which is a wholly-owned subsidiary of BEC Energy, which is a wholly-owned subsidiary of NSTAR. Neither the notes nor the property securing the notes is an obligation of The Commonwealth of Massachusetts, or any governmental agency, authority or instrumentality of The Commonwealth of Massachusetts or of BECo or any of its affiliates, except for BEC Funding LLC. BEC Funding LLC is legally separate from BECo. The assets and revenues of BEC Funding LLC, including, without limitation, the transition property, are not available to creditors of BECo, BEC Energy or NSTAR.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
STATEMENT OF NET ASSETS AVAILABLE FOR TRUST ACTIVITIES
December 31, 1999
The accompanying notes are an integral part of the financial statements.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
STATEMENT OF CHANGES IN NET ASSETS AVAILABLE FOR TRUST ACTIVITIES
for the period from July 27, 1999 (date of inception) to December 31, 1999
The accompanying notes are an integral part of the financial statements.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
NOTES TO FINANCIAL STATEMENTS
A. OVERVIEW
The Massachusetts RRB Special Purpose Trust BEC-1 ("the Trust") was established on July 27, 1999 as a Delaware business trust. The Massachusetts Development Finance Agency and the Massachusetts Health and Educational Facilities Authority formed the Trust to issue bonds pursuant to certain provisions of Chapter 164 of the Acts of the Massachusetts General Court of 1997 (the "Electric Industry Restructuring Act"). The Trust issued $725,000,000 of Rate Reduction Certificates ("certificates") on July 29, 1999 for the purpose of acquiring related notes from BEC Funding LLC (the "Note Issuer"). The Massachusetts Development Finance Agency, the Massachusetts Health and Educational Facilities Authority and The Bank of New York (Delaware), a Delaware banking corporation, acting as the Delaware Trustee, entered into a Declaration of Trust to form the Trust. The Trust is not an agency nor instrumentality of The Commonwealth of Massachusetts. The Trust has minimal assets other than the notes. The Declaration of Trust does not permit the Trust to engage in any activities other than holding the notes, issuing the certificates, and engaging in other related activities.
Each class of certificates represents a fractional undivided beneficial interest in a related class of notes issued by BEC Funding LLC, including all amounts due and to become due under the related class of notes, and represents the right to receive the payments on the related class of notes.
The Note Issuer, the Massachusetts Development Finance Agency, the Massachusetts Health and Educational Facilities Authority, the Trust, the Delaware Trustee and the certificate trustee have entered into a fee and indemnity agreement under which the Note Issuer pays the Delaware trustee's and the certificate trustee's reasonable compensation and reasonable fees and expenses. The fee and indemnity agreement further provides that the Note Issuer will indemnify the Trust, the Delaware trustee, the certificate trustee, the Massachusetts Development Finance Agency, the Massachusetts Health and Educational Facilities Authority and the Executive Office for Administration and Finance of The Commonwealth of Massachusetts for, and hold them harmless against, among other things, any loss, liability or expense incurred by them arising from the failure of any party to perform its obligations under various transaction documents. Neither the certificates, the notes or the property securing the notes is an obligation of The Commonwealth of Massachusetts or any governmental agency, authority or instrumentality of The Commonwealth of Massachusetts or of BEco or any of its affiliates, except for BEC Funding LLC, which is an affiliate of BECo.
The fiscal year of the Trust is the calendar year.
BASIS OF PRESENTATION
Substantially all expenses of the Trust are paid by the Note Issuer, BEC Funding LLC. Revenues and expense are recorded on the accrual basis.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
REVENUE AND EXPENSE RECOGNITION
The Trust recognizes revenues, interest income and interest expense on the notes, which are the only assets and liabilities of the Trust, on the accrual basis.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
NOTES TO FINANCIAL STATEMENTS, CONTINUED
INCOME TAXES
The Trust is considered to be a grantor trust for income tax purposes and accordingly there is no provision for income taxes.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
CONCENTRATION OF CREDIT RISK
The Trust has exposure to credit risk for its notes receivable from the Note Issuer. BEC Funding LLC is a wholly-owned subsidiary of BECo, which is a wholly-owned subsidiary of BEC Energy, which is a wholly-owned subsidiary of NSTAR. Neither the notes nor the property securing the notes is an obligation of The Commonwealth of Massachusetts, or any governmental agency, authority or instrumentality of The Commonwealth of Massachusetts or of BECo or any of its affiliates, except for BEC Funding LLC.
C. CERTIFICATES
The Trust issued $725,000,000 of Rate Reduction Certificates on July 29, 1999 pursuant to the certificate indenture among the Trust, the Delaware trustee, and the certificate trustee. The certificates were issued in minimum denominations of $1,000 and in integral multiples of that amount. The certificates consist of five classes as summarized in the table below:
The scheduled final distribution date for a class of certificates is the date by which the Trust expects to distribute in full all interest on and principal of that class of certificates. The final termination date for a class of certificates is the legal maturity date of that class. The failure to distribute principal of any class of certificates in full by the final termination date for that class is an event of default, and the certificate trustee may, and with the written direction of the holders of at least a majority in principal amount of all outstanding certificates shall, declare the unpaid principal amount of all outstanding notes and accrued interest to be due and payable.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
NOTES TO FINANCIAL STATEMENTS, CONTINUED
Interest on each class of certificates will accrue from its issuance date at the interest rate set forth in the table above. Beginning March 15, 2000, the trust is required to distribute interest semiannually on March 15 and September 15 (or, if any distribution date is not a business day, the following business day) of each year. On each distribution date, the certificate trustee will distribute interest to the extent paid on the related class of notes to the holders of each class of certificates as of the close of business on the record date. The record date for any distribution of interest on and principal of the certificates will be the business day immediately before the distribution date. Each distribution date will also be a payment date for interest on and principal of the notes.
On each distribution date, the certificate trustee will distribute principal as paid on the related class of notes to the holders of each class of certificates as of the close of business on the record date.
Long-term Rate Reduction Certificate redemptions due in the years ended December 31 in each of the next five years ended December 31, 2000, 2001, 2002, 2003, and 2004, are scheduled to be $78,441,458 (of which a scheduled $40,000,000 payment was made on the scheduled maturity date), $62,428,264, $70,225,942, $68,014,173, and $68,740,411, respectively. The estimated fair market values at December 31, 1999 of the Class A-1, Class A-2, Class A-3, Class A-4 and Class A-5 Rate Reduction Certificates was $108,022,600, $168,613,702, $101,436,089, $168,022,077 and $167,659,776, respectively, based upon quoted market prices for similar issues.
D. NOTES RECEIVABLE
BEC Funding LLC, the Note Issuer, has issued to the Trust notes in the principal amount of $725,000,000, in exchange for the net proceeds from the sale of the certificates by the Trust. Each class of notes secures the payment of the related class of certificates and has the same principal balance, interest rate, amortization schedule and legal maturity date as its related class of certificates. The notes consist of five classes, in the initial principal amounts and bearing the interest rates and having the scheduled maturity and final maturity dates set forth in the table below:
The scheduled maturity date for a class of notes is the date by which the note issuer expects to distribute in full all interest on and principal of that class of notes. The final maturity date for a class of notes is the legal maturity date of that class.
INTEREST
Interest on each class of notes accrues from its issuance date at the interest rate set forth in the table above. Beginning March 15, 2000, the Note Issuer is required to pay interest semiannually on March 15
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
NOTES TO FINANCIAL STATEMENTS, CONTINUED
and September 15 (or, if any payment date is not a business day, the following business day) of each year, to the Trust. The Note Issuer will pay interest on the notes prior to paying principal of the notes.
On each payment date, the Note Issuer will pay interest as follows:
- if there has been a payment default, any unpaid interest payable on any prior payment dates, together with interest at the applicable note interest rate on any of this unpaid interest; and
- accrued interest on the principal balance of each class of notes as of the close of business on the preceding payment date, or the date of the original issuance of the class of notes if applicable, after giving effect to all payments made on the preceding payment date, or the date of the original issuance of the class of notes if applicable.
If there is a shortfall in the amounts necessary to make these interest payments, the note trustee will distribute interest pro rata to each class of notes based on the outstanding principal amount of that class and the applicable interest rate. The Note Issuer will calculate interest on the basis of a 360-day year of twelve 30-day months.
PRINCIPAL
The Note Issuer will pay principal on each payment date to the holders of the notes in accordance with the expected amortization schedule as set forth in the prospectus.
The Note Issuer will not, however, pay principal on a payment date on any class of notes if making the payment would reduce the principal balance of a class to an amount lower than that specified in the expected amortization schedule for that class on that payment date. If an event of default under the note indenture has occurred and is continuing, the note trustee may declare the unpaid principal amount of all outstanding notes and accrued interest to be due and payable.
The expected amortization schedule for the principal of each class of notes gives effect to the payments expected to be made on each payment date and is based upon the issuance date of the notes on July 29, 1999 and also the following:
- payments on the certificates are made on each distribution date, commencing March 15, 2000;
- the servicing fee equals 0.05 percent annually of the initial principal amount of the notes, or $362,500;
- there are no net earnings on amounts on deposit in the collection account;
- the administration fee (which is $75,000 per year, payable semiannually) and other ongoing operating expenses are estimated to be approximately $220,000 per annum, and these amounts are payable in arrears, and;
- payments arising from the property securing the notes are deposited in the collection account as expected.
There can be no assurance that the principal balances of the classes of notes receivable and the related classes of certificates outstanding will be reduced at the rates expected. The actual rates of reduction in class principal balances may be slower (but cannot be faster) than the expected amortization schedule.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 (A SPECIAL PURPOSE ENTITY)
NOTES TO FINANCIAL STATEMENTS, CONTINUED
UNAMORTIZED DEBT DISCOUNT
Unamortized debt discount in the amount of $225,995 is included (net) in both Notes receivable and Certificates outstanding on the accompanying Statement of Net Assets Available for Trust Activities.
The note trustee has established a collection account to hold amounts remitted by the servicer of the property securing the notes. The notes are secured primarily by transition property of the note issuer, which is the right to assess and collect all revenues arising from a portion of the transition charge included in the bills of all classes of retail users of BECo's electric distribution system within its geographic service territory as in effect on July 1, 1997. This portion of the transition charge, which is a usage-based charge, is referred to as the reimbursable transition costs ("RTC") charge. As of December 31, 1999, the RTC charge is approximately 1.10 cents per kilowatt-hour.
THE NOTE ISSUER
BEC Funding LLC is a special purpose, single member limited liability company whose sole member is BECo. BEC Funding LLC is a wholly-owned subsidiary of BECo, which is a wholly-owned subsidiary of BEC Energy, which is a wholly-owned subsidiary of NSTAR.
BEC Funding LLC was organized on January 29, 1999 under the laws of the State of Delaware for the sole purpose of acquiring and holding transition property which BEC Funding LLC acquired on July 29, 1999 from BECo. The purchase price of such transition property was paid from net proceeds of the notes issued to the Trust. The assets of BEC Funding LLC consist primarily of transition property acquired from BECo.
Both BEC Funding LLC's organizational documents and covenants in the note indenture restrict its business activities to financing, purchasing, owning and managing transition property. The organizational documents and note indenture covenants also require that BEC Funding LLC be operated in a manner intended to reduce the likelihood that it would be consolidated in BECo's bankruptcy estate if BECo became a debtor in a bankruptcy case.
BEC Funding LLC is legally separate from BECo. The assets and revenues of BEC Funding LLC, including, without limitation, the transition property, are not available to creditors of BECo nor BEC Energy nor NSTAR.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Bank of New York (Delaware), a Delaware banking corporation, acts as the Delaware Trustee, pursuant to the Declaration of Trust that formed the Trust in July 1999. The Trust has no executive officers or directors.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Not applicable.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF BENEFICIAL OWNERS AND MANAGEMENT
Not applicable.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K.
a) The following designated documents and exhibits are filed herewith and/or incorporated by reference:
Statement of Net Assets Available for Trust Activities as of December 31, 1999; and Statement of Changes in Net Assets Available for Trust Activities for the period July 27, 1999 (date of inception) to December 31, 1999.
Exhibit 3.1 - Declaration of Trust (A)
Exhibit 4.1 - Note Indenture of BEC Funding LLC (A)
Exhibit 4.2 - Certificate Indenture (A)
Exhibit 4.3 - Rate Reduction Certificates (A)
Exhibit 10.1 - Transition Property Purchase and Sale Agreement (A)
Exhibit 10.2 - Transition Property Servicing Agreement (A)
Exhibit 10.3 - Note Purchase Agreement (A)
Exhibit 10.4 - Administration Agreement (A)
Exhibit 10.5 - Fee and Indemnity Agreement (A)
Exhibit 27.1 - Financial Data Schedule for the period July 27, 1999 (date of inception) to December 31, 1999.
Exhibit 99.1 - Issuance Advice Letter (A)
Exhibit 99.2 - Report of Independent Accountants
------------ (A) Incorporated by reference to the similarly titled exhibit to the current report on Form 8-K filed by BEC Funding LLC on August 13, 1999.
b) Reports on Form 8-K
There were no reports on Form 8-K filed in the fourth quarter of 1999.
SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MASSACHUSETTS RRB SPECIAL PURPOSE TRUST BEC-1 --------------------------------------------- (Registrant)
By: The Bank of New York (Delaware), as Delaware Trustee
Date: March 28, 2000 /s/ Thomas J. Provenzano --------------------------------- Name: Thomas J. Provenzano Title: Vice President | 4,050 | 25,700 |
1074078_1999.txt | 1074078_1999 | 1999 | 1074078 | Item 1. Business - -----------------
General
References in this document to the "Bank," "we," "us," and "our" refer to 1st State Bank. Where appropriate, "us" or "our" refers collectively to 1st State Bancorp, Inc. and 1st State Bank. References in this document to the "Company" refer to 1st State Bancorp, Inc. As a result, portions of this discussion as of dates and for periods prior to April 23, 1999 relate to the financial condition and results of operations of 1st State Bank.
1st State Bancorp, Inc. We organized 1st State Bancorp in November 1998 to be the holding company for 1st State Bank, following its conversion from mutual to stock form (the "Stock Conversion"), and then as a bank holding company of 1st State Bank following its conversion from a North Carolina-chartered savings bank to a North Carolina commercial bank (the "Bank Conversion"). 1st State Bancorp is primarily engaged in the business of directing, planning and coordinating the business activities of 1st State Bank. In the future, 1st State Bancorp may conduct operations or acquire or organize other operating subsidiaries, including other financial institutions, though we have no current plans in this regard. Currently, 1st State Bancorp does not maintain offices separate from those of 1st State Bank nor employ any persons other than its officers who are not separately compensated for their service.
1st State Bank. Founded in 1914, 1st State Bank is a community and customer oriented North Carolina-chartered commercial bank headquartered in Burlington, North Carolina. We have six full service offices located in north central North Carolina on the Interstate 85 corridor between the Piedmont Triad and Research Triangle. We conduct most of our business in Alamance County, North Carolina.
Our business consists principally of attracting deposits from the general public and investing these funds in loans secured by single-family residential and commercial real estate, secured and unsecured commercial loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of the interest we pay on deposits and borrowed funds. We also earn income from miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds.
Market Area
We conduct most of our business in Alamance County in north central North Carolina, located on the Interstate 85 corridor between the Piedmont Triad and Research Triangle. Historically, the Alamance County economy has been heavily dependent on the textile industry. During the past 20 years, the economy has diversified to some extent, with increasing employment in the areas of insurance, banking, manufacturing and services. Major employers in the area include LabCorp, Burlington Industries, Alamance County Schools, Glenraven Mills and Alamance Health Services. Nevertheless, the economy in Alamance County continues to be heavily dependent on the textile industry.
Lending Activities
Loan Portfolio Composition. At September 30, 1999, our gross loan portfolio totaled $206.2 million and represented 61.9% of total assets. The following table sets forth information relating to the composition of our loan portfolio by type of loan at the dates indicated. At September 30, 1999, we had no concentrations of loans exceeding 10% of gross loans other than as disclosed below. Excluded from this table are mortgage loans held for sale, which are presented separately on our consolidated balance sheets and in "Selected Consolidated Financial Information and Other Data" in the Annual Report.
Loan Maturity Schedule. The following table sets forth certain information at September 30, 1999 regarding the dollar amount of loans maturing in our portfolio based on their contractual terms to maturity, including scheduled repayments of principal. Demand loans, loans having no stated schedule of repayments, such as lines of credit, and overdrafts are reported as due in one year or less. The table does not include any estimate of prepayments which significantly shorten the average life of mortgage loans and may cause our repayment experience to differ from that shown below.
The following table sets forth at September 30, 1999, the dollar amount of all loans due one year or more after September 30, 1999 which have predetermined interest rates and have floating or adjustable interest rates.
Scheduled contractual principal repayments of loans do not reflect the actual life of the loans. The average life of loans can be substantially less than their contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give us the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan market rates are substantially lower than rates on existing mortgage loans.
Originations, Purchases and Sales of Loans. We generally have authority to originate and purchase loans secured by real estate located throughout the United States. Consistent with our emphasis on being a community-oriented financial institution, we concentrate our lending activities in Alamance County.
The following table sets forth certain information with respect to our loan origination, purchase and sale activity for the periods indicated.
- ------------------ (1) All loans sold were whole loans.
We obtain our loan originations from a number of sources, including referrals from depositors, borrowers and realtors, repeat customers, advertising and calling officers, as well as walk-in customers. We also advertise in local media and participate in various community organizations and events. Real estate loans are originated by our loan officers. All of our loan officers are salaried and are eligible to receive commissions for loans originated. We accept loan applications at our offices and do not originate loans on an indirect basis such as through arrangements with automobile dealers. In all cases, we have final approval of the application. Historically, we have purchased limited quantities of loans. During the years ended September 30, 1999, 1998 and 1997, virtually all loans purchased were small participation interests in multi-family residential real estate loans to finance low income housing.
In recent years, and particularly during the years ended September 30, 1999 and 1998, we have sold an increasing amount of fixed-rate, single-family mortgage loans that we originated. During the years ended September 30, 1999, 1998 and 1997, we sold $39.8 million, $27.6 million and $9.2 million, respectively, of such loans. Typically, in the current low interest rate environment, we have been selling fixed-rate, single-family mortgage loans with terms
of 15 years or more except in cases where the interest rate is sufficient to compensate us for the risk of retaining a long-term, fixed-rate loan in our portfolio. Most loans have been sold to private purchasers with servicing released. In addition, we sell a smaller amount of loans in the secondary market to the Federal Home Loan Mortgage Corporation. We retain servicing on loans sold to the Federal Home Loan Mortgage Corporation.
Loan Underwriting Policies. We have established written, non-discriminatory underwriting standards and loan origination procedures. We obtain detailed loan applications to determine the borrower's ability to repay, and verify the more significant items on these applications through the use of credit reports, financial statements and confirmations. Individual officers have been granted authority by the board of directors to approve mortgage, consumer and commercial loans up to varying specified dollar amounts, depending upon the type of loan. A loan committee consisting of our President, Executive Vice President, Chief Financial Officer, senior credit officer and head of mortgage lending has authority to approve any loan in an amount exceeding individual lending authorities where our total loans to that borrower would not exceed $350,000. Our executive committee, which consists of the Chairman of the Board, the President, two additional board members that serve on a permanent basis and one board member selected on a rotating basis that serves for a three-month period, has authority to approve any loan where our total loans to that borrower would not exceed $1.0 million. Loans above that amount may not be made unless approved by the full board of directors. These authorities are based on aggregate borrowings of an individual or entity. On a monthly basis, the Executive Committee reviews the actions taken by the loan committee and the full board of directors reviews the actions taken by the Executive Committee.
Applications for single-family real estate loans are underwritten and closed in accordance with the standards of Federal Home Loan Mortgage Corporation. Generally, upon receipt of a loan application from a prospective borrower, we order a credit report and verifications to verify specific information relating to the loan applicant's employment, income and credit standing. If a proposed loan is to be secured by a mortgage on real estate, we usually obtain an appraisal of the real estate from an appraiser approved by us and licensed by the State of North Carolina. Except when we become aware of a particular risk of environmental contamination, we generally do not obtain a formal environmental report on real estate at the time a loan is made.
Our policy is to record a lien on the real estate securing a loan and to obtain title insurance which insures that the property is free of prior encumbrances and other possible title defects. Borrowers must also obtain hazard insurance policies prior to closing and, when the property is in a flood plain as designated by the Department of Housing and Urban Development, pay flood insurance policy premiums.
On single-family residential mortgage loans, we make a loan commitment of between 30 and 60 days for each loan approved. If the borrower desires a longer commitment, we may extend the commitment for good cause. We guarantee the interest rate for the commitment period.
We are permitted to lend up to 95% of the lesser of the appraised value or the purchase price of the real property securing a mortgage loan. However, if the amount of a residential loan originated or refinanced exceeds 80% of the appraised value, our policy generally is to obtain private mortgage insurance at the borrower's expense on that portion of the principal amount of the loan that exceeds 80% of the appraised value of the property. We will make a single-family residential mortgage loan with up to a 95% loan-to-value ratio if the required private mortgage insurance is obtained. We generally limit the loan-to-value ratio on commercial real estate mortgage loans to 80%, although the loan-to- value ratio on commercial real estate loans in limited circumstances has been as high as 85%. We limit the loan-to-value ratio on multi-family residential real estate loans to 80%.
Under applicable law, with certain limited exceptions, loans and extensions of credit by a financial institution to a person outstanding at one time and not fully secured by collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 15% of net worth plus the general loan loss reserve. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of net worth. Applicable law additionally authorizes financial institutions to make loans to one borrower, for any purpose:
. in an amount not to exceed $500,000;
. in an amount not to exceed the lesser of $30,000,000 or 30% of net worth to develop residential housing, provided (a) the purchase price of each single-family dwelling in the development does not exceed $500,000 and (b) the aggregate amount of loans made under this authority does not exceed 150% of net worth; or
. loans to finance the sale of real property in satisfaction of debts previously contracted in good faith, not to exceed 50% of net worth.
Under these limits, our loans to one borrower were limited to $7.7 million at September 30, 1999. At that date, we had no lending relationships in excess of the loans-to-one-borrower limit. At September 30, 1999, our ten largest lending relationships ranged in size from $2.1 million to $4.6 million.
Single-Family Residential Real Estate Lending. We historically have been and continue to be an originator of single-family, residential real estate loans in our market area. At September 30, 1999, single-family, residential mortgage loans, excluding home equity loans, totaled $90.9 million, or 44.1%, of our gross loan portfolio.
We originate fixed-rate mortgage loans at competitive interest rates. At September 30, 1999, $59.2 million, or 28.7%, of our gross loan portfolio was comprised of fixed-rate, single-family mortgage loans. Generally, in the currently low interest rate environment, we have been retaining fixed-rate mortgages with maturities of ten years or less while fixed-rate loans with longer maturities are being sold in the secondary market.
We also offer adjustable-rate residential mortgage loans. The adjustable- rate loans we currently offer have interest rates which adjust every one, three or five years from the closing date of the loan or on an annual basis commencing after an initial fixed-rate period of three or five years in accordance with a designated index, plus a stipulated margin. The primary index we utilize is the weekly average yield on the one year U.S. Treasury securities adjusted to a constant comparable maturity equal to the loan adjustment period, as made available by the Federal Reserve Board (the "Treasury Rate"). The maximum adjustment on the bulk of our loans is 2% per adjustment period with a maximum aggregate adjustment of 6% over the life of the loan. We offer adjustable-rate mortgage loans that provide for initial rates of interest slightly below the rates that would prevail when the index used for repricing is applied, i.e., "teaser" rates. All of our adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not permit any of the increased payment to be added to the principal amount of the loan, or so-called negative amortization. At September 30, 1999, $31.7 million, or 34.9%, of our single-family residential mortgage loans were adjustable-rate loans.
The retention of adjustable-rate loans in our portfolio helps reduce our exposure to increases or decreases in prevailing market interest rates. However, there are unquantifiable credit risks resulting from potential increases in costs to borrowers in the event of upward repricing of adjustable-rate loans. It is possible that during periods of rising interest rates, the risk of default on adjustable-rate loans may increase due to increases in interest costs to borrowers. Further, although adjustable-rate loans allow us to increase the sensitivity of our interest-earning assets to changes in interest rates, the extent of this interest sensitivity is limited by the initial fixed-rate period before the first adjustment and the lifetime interest rate adjustment limitations. Accordingly, yields on our adjustable-rate loans may not fully adjust to compensate for increases in our cost of funds.
Commercial Real Estate Lending. Our commercial real estate loan portfolio includes loans secured by small office buildings, commercial and industrial buildings and small apartment buildings. These loans generally range in size from $100,000 to $3.3 million. At September 30, 1999, our commercial real estate loans totaled $40.8 million, which amounted to 19.8%, of our gross loan portfolio. We originate commercial real estate loans for terms of up to 15
years and with interest rates that adjust daily based on our prime rate plus a negotiated margin typically up to 1% or that carry predetermined rates fixed for one, three or five years.
Commercial real estate lending entails significant additional risks as compared with single-family residential property lending. Commercial real estate loans typically involve larger loan balances to single borrowers or groups of related borrowers. The payment experience on such loans typically is dependent on the successful operation of the real estate project, retail establishment, apartment building or business. These risks can be significantly affected by supply and demand conditions in the market for office, retail and residential space, and, as such, may be subject to a greater extent to adverse conditions in the economy generally. To minimize these risks, we generally originate loans secured by collateral located in our market area or to borrowers with which we have prior experience or who are otherwise known to us. It has been our policy to obtain annual financial statements of the business of the borrower or the project for which commercial real estate loans are made. In addition, in the case of commercial mortgage loans made to a partnership or a corporation, we seek, whenever possible, to obtain personal guarantees and annual financial statements of the principals of the partnership or corporation.
Home Equity Loans. At September 30, 1999, we had approximately $18.9 million in home equity line of credit loans, representing approximately 9.2% of our gross loan portfolio. Our home equity lines of credit generally have adjustable interest rates tied to our prime interest rate plus a margin, although we currently are offering a program where the interest rate on home equity loans will be fixed for one or two years. Home equity lines of credit must be repaid in 15 years or less and require monthly interest payments. Home equity lines of credit generally are secured by subordinate liens against residential real property. We require that fire and extended coverage casualty insurance and, if appropriate, flood insurance, be maintained in an amount at least sufficient to cover the loan. Home equity loans generally are limited so that the amount of such loans, along with any senior indebtedness, does not exceed 80% of the value of the real estate security.
Construction Lending. We offer residential and commercial construction loans, with a significant portion of such loans originated to date being for the construction of owner-occupied, single-family dwellings in our market area. Residential construction loans are offered primarily to individuals building their primary or secondary residence, as well as to selected local developers to build single-family dwellings. In addition, on occasion, we make acquisition and development loans to local developers to acquire and develop land for sale to builders who will construct single-family residences. At September 30, 1999, $16.5 million, or 8.0%, of our gross loan portfolio consisted of construction loans.
Generally, we originate loans to owner/occupants for the construction of owner-occupied, single-family residential properties in connection with the permanent loan on the property, and these loans have a construction term of six to 12 months. Loans are offered on an adjustable-rate basis. Interest rates on residential construction loans made to the owner/occupant have interest rates during the construction period equal to our prime rate. Upon completion of construction, the loan is converted into a one-year adjustable-rate loan, and the owner may lock in a fixed-rate loan at any time during the one-year period.
We make construction loans to builders on either a pre-sold or speculative basis. However, we limit the number of outstanding loans on unsold homes under construction to individual builders, with the amount dependent on the financial strength of the builder, the present exposure of the builder, the location of the property and prior sales of homes in the development. At September 30, 1999, speculative construction loans amounted to $3.0 million. At September 30, 1999, the largest amount of construction loans outstanding to one builder was $500,000, all of which was for speculative construction. Interest rates on residential construction loans to builders are typically set at our prime rate plus a margin typically up to 1% and adjust with changes in the prime rate, and are made for terms of up to 24 months.
Interest rates on commercial construction loans are based on the prime rate plus a negotiated margin typically up to 1%, and adjust with changes in our prime rate, and are made for terms of up to 24 months, with construction terms generally not exceeding 12 months.
We make acquisition and development loans at a rate that adjusts daily, based on our prime rate plus a negotiated margin, for terms of up to three years. Interest only is paid during the term of the loan, and the principal balance of the loan is paid down as developed lots are sold to builders. At September 30, 1999, $6.3 million of our gross loan portfolio consisted of acquisition and development loans. We had ten such loans. All acquisition and development loans were performing in accordance with their terms at such date.
Prior to making a commitment to fund a construction loan, we require an appraisal of the property by appraisers approved by our board of directors. We also review and inspect each project at the commencement of construction and periodically during the term of the construction loan. We may charge a construction fee and/or an inspection fee on construction loans. Advances are made on a percentage of completed basis.
We consider construction financing generally to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost, including interest, of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate and the borrower is unable to meet our requirements of putting up additional funds to cover extra costs or change orders, then we will demand that the loan be paid off and, if necessary, institute foreclosure proceedings or refinance the loan. If the estimate of value proves to be inaccurate, the collateral may not have sufficient value to assure full repayment. We have sought to minimize this risk by limiting construction lending to borrowers based in Alamance County and who satisfy all credit requirements and whose loans satisfy all other underwriting standards which would apply to our permanent mortgage loan financing for the subject property. On loans to builders, we work only with selected builders with whom we have experience and carefully monitor the creditworthiness of the builders.
Commercial Lending. We originate commercial loans to small and medium sized businesses in our market area. Our commercial borrowers are generally small businesses engaged in manufacturing, distribution or retailing, or professionals in healthcare, accounting and law. Commercial loans generally are made to finance the purchase of inventory, new or used equipment or commercial vehicles and for short-term working capital. Such loans generally are secured by equipment and inventory, and, if possible, cross-collateralized by a real estate mortgage, although commercial loans are sometimes granted on an unsecured basis. Commercial loans generally are made for terms of five years or less, depending on the purpose of the loan and the collateral, with loans to finance operating expenses made for one year or less, with interest rates that adjust at least annually at a rate equal to our prime rate plus a margin typically up to 2%. Generally, we make commercial loans in amounts ranging between $50,000 and $1.0 million. At September 30, 1999, commercial loans totaled $32.5 million, or 15.8%, of our gross loan portfolio.
We underwrite commercial loans on the basis of the borrower's cash flow and ability to service the debt from earnings rather than on the basis of underlying collateral value, and we seek to structure such loans to have more than one source of repayment. The borrower is required to provide us with sufficient information to allow us to make our lending determination. In most instances, this information consists of at least two years of financial statements, a statement of projected cash flows, current financial information on any guarantor and any additional information on the collateral. For loans with maturities exceeding one year, we require that borrowers and guarantors provide updated financial information at least annually throughout the term of the loan.
Our commercial loans may be structured as term loans or as lines of credit. Commercial term loans are generally made to finance the purchase of assets and have maturities of five years or less. Commercial lines of credit are typically made for the purpose of providing working capital and are usually reviewed on an annual basis but may be called on demand. We also offer standby letters of credit for commercial borrowers. Standby letters of credit are written for a maximum term of one year.
Commercial loans are often larger and may involve greater risk than other types of lending. Because payments on commercial loans are often dependent on successful operation of the business involved, repayment of such loans may
be subject to a greater extent to adverse conditions in the economy. We seek to minimize these risks through our underwriting guidelines, which require that the loan be supported by adequate cash flow of the borrower, profitability of the business, collateral and personal guarantees of the individuals in the business. In addition, we limit this type of lending to our market area and to borrowers with which we have prior experience or who are otherwise well known to us.
Consumer Lending. In recent years, we have gradually increased our portfolio of consumer loans. Our consumer loans include automobile loans, savings account loans, unsecured lines of credit and miscellaneous other consumer loans, including unsecured loans. At September 30, 1999, our consumer loans totaled $6.7 million, or 3.2%, of our gross loan portfolio.
We generally underwrite automobile loans in amounts up to 80% of the lesser of the purchase price of the automobile or, with respect to used automobiles, the loan value as published by the National Automobile Dealers Association. The terms of most such loans do not exceed 60 months. We require that the vehicles be insured and that we be listed as loss payee on the insurance policy.
We make savings account loans for up to 90% of the depositor's savings account balance. The interest rate is normally 2.5% above the annual percentage yield paid on the savings account. The account must be pledged as collateral to secure the loan. Interest generally is paid on a monthly basis.
Consumer lending affords us the opportunity to earn yields higher than those obtainable on single-family residential lending. However, consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans which are unsecured, as is the case with lines of credit, or secured by rapidly depreciable assets such as automobiles. Repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by events such as job loss, divorce, illness or personal bankruptcy. Further, the application of various state and federal laws, including federal and state bankruptcy and insolvency law, may limit the amount which may be recovered. In underwriting consumer loans, we consider the borrower's credit history, an analysis of the borrower's income and ability to repay the loan, and the value of the collateral.
Loan Fees and Servicing. We receive fees in connection with late payments and for miscellaneous services related to our loans and deposits. We also charge fees in connection with loan originations. These fees can consist of origination, discount, application, construction and/or commitment fees, depending on the type of loan. We generally do not service loans for others except for mortgage loans we originate and sell with servicing retained. Mortgage servicing rights were not material for any of the periods presented.
Nonperforming Loans and Other Problem Assets. We continually monitor our loan portfolio to anticipate and address potential and actual delinquencies. When a borrower fails to make a payment on a loan, we take immediate steps to have the delinquency cured and the loan restored to current status. Loans which are delinquent more than 15 days incur a late fee of 4% of the monthly payment of principal and interest due. As a matter of policy, we will contact the borrower after the loan has been delinquent 15 days. If payment is not promptly received, we contact the borrower again, and we try to formulate an affirmative plan to cure the delinquency. Generally, after any loan is delinquent 45 days or more, we send a default letter to the borrower. If the default is not cured after 30 days, we commence formal legal proceedings to collect amounts owed.
Generally we charge off or reserve through an allowance account interest on loans, including impaired loans, that are contractually 90 days or more past due. The allowance is established by a charge to interest income equal to all interest previously accrued. In certain circumstances, interest on loans that are contractually 90 days or more past due is not charged off or reserved through an allowance account when we believe that the loan is both well secured and
in the process of collection. If amounts are received on loans for which the accrual of interest has been discontinued, we decide whether payments received should be recorded as a reduction of the principal balance or as interest income depending on our analysis of the collectibility of principal. The loan is returned to accrual status when we believe the borrower has demonstrated the ability to make periodic interest and principal payments on a timely basis.
We classify real estate acquired as a result of foreclosure as real estate acquired in settlement of loans until such time as it is sold and is recorded at the lower of the estimated fair value of the underlying real estate or the carrying amount of the loan. Subsequent costs directly related to development and improvement of property are capitalized, whereas costs related to holding property are expensed. We charge any required write-down of the loan to its fair value less estimated selling costs upon foreclosure against the allowance for loan losses. See Note 1 of Notes to Consolidated Financial Statements.
The following table sets forth information with respect to our nonperforming assets at the dates indicated. At the dates shown, we had no restructured loans within the meaning of Statement of Financial Accounting Standards No. 114, as amended.
____________________ (1) Payments received on a nonaccrual loan are either applied to the outstanding principal balance or recorded as interest income, depending on management's assessment of the collectibility of the loan. (2) Other nonperforming assets consist of property acquired through foreclosure or repossession.
During the years ended September 30, 1999, 1998 and 1997, gross interest income of $27,000, $10,000 and $27,000, respectively, would have been recorded on loans accounted for on a nonaccrual basis if the loans had been current throughout the year. Interest on such loans included in income during the years ended September 30, 1999, 1998 and 1997 amounted to $13,000, $15,000 and $16,000, respectively.
At September 30, 1999 there were no loans which are not currently classified as nonaccrual, 90 days past due or restructured but where known information about possible credit problems of borrowers causes management to have serious concerns as to the ability of the borrowers to comply with present loan repayment terms and may result in disclosure as nonaccrual, 90 days past due or restructured. See " -- Classified Assets" for information regarding classified assets.
At September 30, 1999, an analysis of our portfolio did not reveal any impaired loans that needed to be classified under Statement of Financial Accounting Standards No. 114.
At September 30, 1999, we had $366,000 of nonaccrual loans, which consisted of five single-family mortgage loans, three commercial loans and four consumer loans. At September 30, 1999, we did not have any real estate owned.
Classified Assets. Regulations require that we classify our assets on a regular basis. In addition, in connection with examinations of insured institutions, examiners have authority to identify problem assets and if appropriate, classify them in their reports of examination. There are three classifications for problem assets: "substandard," "doubtful" and "loss." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Assets classified as substandard or doubtful require a financial institution to establish general allowances for loan losses. If an asset or portion thereof is classified loss, a financial institution must either establish a specific allowance for loss in the amount of the portion of the asset classified loss, or charge off such amount. 1st State Bank regularly reviews its assets to determine whether any assets require classification or re-classification. At September 30, 1999, we had $700,000 in classified assets consisting of $698,000 in assets classified as substandard, $2,000 in assets classified as doubtful and no assets classified as loss.
In addition to regulatory classifications, we also classify as special mention or watch assets that are currently performing in accordance with their contractual terms but may be classified or nonperforming assets in the future. At September 30, 1999 we have identified approximately $4.7 million in assets classified as special mention.
Allowance for Loan Losses. Our policy is to establish reserves for estimated losses on delinquent loans when we determine that losses are expected to be incurred on such loans. We maintain the allowance for losses on loans at a level we believe to be adequate to absorb potential losses in the portfolio. Our determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income.
Although we believe we use the best information available to make determinations with respect to the allowance for losses and believe such allowances are adequate, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used in making the initial determinations. We anticipate that our allowance for loan losses will increase in the future as we implement the board of directors' strategy of continuing existing lines of business while gradually expanding commercial and consumer lending, which loans generally entail greater risks than single-family residential mortgage loans.
During 1999 we decreased our provision for loan losses to account for the slower loan growth and the mix in our loan portfolio. During 1999 and 1998, we increased commercial and consumer loans. At September 30, 1999, 1998 and 1997, commercial loans comprised 15.8%, 12.2% and 11.3%, respectively, of total loans, and consumer loans comprised 3.2%, 3.1% and 2.7%, respectively, of total loans. These loans carry a higher inherent credit risk than single family residential mortgage loans.
During 1999 we experienced a decrease in asset based loans, construction loans and acquisition and development loans. These loan types carry a higher incremental risk of loss than other loans. Net loan chargeoffs for 1999 were $19,000 and year-end nonperforming loans were $366,000. The allowance for loan losses was $3.5 million at September 30, 1999, an increase of $227,000 over September 30, 1998. The ratio of the allowance for loan losses to loans was 1.74% at September 30, 1999 and 1.61% at September 30, 1998.
Banking regulatory agencies, including the FDIC, have adopted a policy statement regarding maintenance of an adequate allowance for loan and lease losses and an effective loan review system. This policy includes an arithmetic formula for checking the reasonableness of an institution's allowance for loan loss estimate compared to the average loss experience of the industry as a whole. Examiners will review an institution's allowance for loan losses and compare it against the sum of:
. 50% of the portfolio that is classified doubtful;
. 15% of the portfolio that is classified as substandard; and
. for the portions of the portfolio that have not been classified, including those loans designated as special mention, estimated credit losses over the upcoming 12 months given the facts and circumstances as of the evaluation date.
This amount is considered neither a "floor" nor a "safe harbor" of the level of allowance for loan losses an institution should maintain, but examiners will view a shortfall relative to the amount as an indication that they should review management's policy on allocating these allowances to determine whether it is reasonable based on all relevant factors.
We have our own allowance for loan loss model which is similar to the FDIC model. Our model indicated that the allowance for loan losses was adequate at September 30, 1999.
The following table sets forth an analysis of our allowance for loan losses for the periods indicated.
The following table allocates the allowance for loan losses by loan category at the dates indicated. The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any category.
Investment Activities
General. Interest income from investment securities generally provides our second largest source of income after interest on loans. Our board of directors has authorized investment in U.S. Government and agency securities, state government obligations, municipal securities, obligations of the FHLB, mortgage- backed securities issued by Federal National Mortgage Association, the Government National Mortgage Association and Federal Home Loan Mortgage Corporation. Our objective is to use these investments to reduce interest rate risk, enhance yields on assets and provide liquidity. At September 30, 1999, the amortized cost of our investment securities portfolio amounted to $95.5 million, which included $87.2 million of U.S. Government and agency securities, $3.0 million of short-term money market instruments, $1.2 million of mortgage-backed securities and $68,000 of collateralized mortgage obligations ("CMO's"). In addition, at September 30, 1999, we had a $4.0 million investment in two mutual funds that invest in U.S. Government and agency securities and mortgage-backed securities. At that date, we had an unrealized loss of $123,000, net of deferred taxes, with respect to our investment securities classified as available for sale.
The board of directors has established an investment policy that sets forth investment and aggregate investment limitations and credit quality parameters of each class of investment security. Securities purchases are subject to the oversight of our Executive Committee. The President has authority to make specific investment decisions within the parameters determined by the board of directors.
Pursuant to Statement of Financial Accounting Standards No. 115, we had securities with an aggregate cost of $11.2 million and an approximate fair value of $11.0 million at September 30, 1999 as available for sale. The impact on our financial statements was an after-tax decrease in shareholders' equity of approximately $123,000 as of September 30, 1999. The net unrealized losses at September 30, 1999 in our portfolio of investment securities and mortgage-backed securities were due to increases in interest rates after we bought the securities. Upon acquisition, we classify securities as to our intent. Securities designated as "held to maturity" are those assets which we have the ability and intent to hold to maturity. The held to maturity investment portfolio is not used for speculative purposes and is carried at amortized cost. Securities designated as "available for sale" are those assets which we may not hold to maturity and thus are carried at fair value with unrealized gains or losses, net of tax effect, recognized in shareholders' equity.
We periodically evaluate investment securities for other than temporary declines in value and record any losses through an adjustment to earnings. During the year ended September 30, 1999, we did not recognize any losses.
At September 30, 1999, we had $6.0 million of U.S. Government and agency securities classified as available for sale, which carry unrealized after-tax losses of $133,000, and $81.2 million of U.S. Government and agency securities classified as held to maturity. We attempt to maintain a high degree of liquidity in our investment securities portfolio by choosing those that are readily marketable. As of September 30, 1999, the estimated weighted average life of our U.S. Government and agency securities was approximately 4.5 years, and the average yield on our portfolio of U.S. Government and agency securities was 6.04%. In addition, at September 30, 1999, we had $1.3 million of FHLB of Atlanta stock.
Mortgage-Backed and Related Securities. Included in our portfolio of investment securities are mortgage-backed and mortgage-related securities. Mortgage-backed securities represent a participation interest in a pool of single-family or multi-family mortgages, the principal and interest payments on which are passed from the mortgage originators through intermediaries that pool and repackage the participation interest in the form of securities to investors. Such intermediaries may include quasi-governmental agencies such as Federal Home Loan Mortgage Corporation, Federal National Mortgage Association and Government National Mortgage Association which guarantee the payment of principal and interest to investors. Mortgage-backed securities generally increase the quality of our assets by virtue of the guarantees that back them, are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations.
The Federal Home Loan Mortgage Corporation is a public corporation chartered by the U.S. Government and owned by the 12 FHLBs and federally insured savings institutions. The Federal Home Loan Mortgage Corporation issues participation certificates backed principally by conventional mortgage loans. The Federal Home Loan Mortgage Corporation guarantees the timely payment of interest and the ultimate return of principal on participation certificates. The Federal National Mortgage Association is a private corporation chartered by the U.S. Congress with a mandate to establish a secondary market for mortgage loans. The Federal National Mortgage Association guarantees the timely payment of principal and interest on Federal National Mortgage Association securities. Federal Home Loan Mortgage Corporation and Federal National Mortgage Association securities are not backed by the full faith and credit of the United States, but because the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association are U.S. Government-sponsored enterprises, these securities are considered to be among the highest quality investments with minimal credit risks.
The Government National Mortgage Association is a government agency within the Department of Housing and Urban Development which is intended to help finance government-assisted housing programs. Government National Mortgage Association securities are backed by FHA-insured and VA-guaranteed loans, and the timely payment of principal and interest on Government National Mortgage Association securities is guaranteed by the Government National Mortgage Association and backed by the full faith and credit of the U.S. Government.
Because the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association and the Government National Mortgage Association were established to provide support for low- and middle-income housing, there are limits to the maximum size of loans that qualify for these programs. The limit for Federal National Mortgage Association and Federal Home Loan Mortgage Corporation currently is $240,000.
Mortgage-backed securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and having varying maturities. The underlying pool of mortgages can be composed of either fixed-rate or adjustable- rate loans. As a result, the risk characteristics of the underlying pool of mortgages, whether fixed-rate or adjustable-rate, as well as prepayment risk, are passed on to the certificate holder. The life of a mortgage-backed pass- through security thus approximates the life of the underlying mortgages.
Mortgage-backed securities generally yield less than the loans which underlie such securities because of their payment guarantees or credit enhancements which offer nominal credit risk. In addition, mortgage-backed securities are more liquid than individual mortgage loans and may be used to collateralize borrowings in the event that we determined to utilize borrowings as a source of funds. Mortgage-backed securities issued or guaranteed by the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation generally are weighted at no more than 20% for risk-based capital purposes, compared to a weight of 50% to 100% for residential loans. See "Regulation -- Depository Institution Regulation -- Capital Requirements" as to how we assign a risk weight to assets under the risk-based capital regulations.
Our mortgage-backed and related securities portfolio consists primarily of seasoned fixed-rate, mortgage-backed and related securities. We make these investments in order to manage cash flow, diversify assets, obtain yield and to satisfy certain requirements for favorable tax treatment.
At September 30, 1999, the weighted average contractual maturity of our mortgage-backed securities, all of which carried fixed rates, was approximately 4.7 years. The actual maturity of a mortgage-backed security varies, depending on when the mortgagors prepay or repay the underlying mortgages. Prepayments of the underlying mortgages may shorten the life of the investment, thereby adversely affecting its yield to maturity and the related market value of the mortgage-backed security. The yield is based upon the interest income and the amortization of the premium or accretion of the discount related to the mortgage-backed security. Premiums and discounts on mortgage-backed securities are amortized or accreted over the estimated term of the securities using a level yield method. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of
the mortgage-backed security, and we review these assumptions periodically to reflect the actual prepayment. The actual prepayments of the underlying mortgages depend on many factors, including the type of mortgage, the coupon rate, the age of the mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates. The difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates is an important determinant in the rate of prepayments. During periods of falling mortgage interest rates, prepayments generally increase, and, conversely, during periods of rising mortgage interest rates, prepayments generally decrease. If the coupon rate of the underlying mortgage significantly exceeds the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgages.
At September 30, 1999, mortgage-backed securities with an amortized cost of $1.2 million and a carrying value of $1.3 million were held as available for sale. No mortgage-backed securities were classified as held to maturity. Mortgage-backed securities classified as available for sale are carried at fair value. Unrealized gains and losses on available for sale mortgage-backed securities are recognized as direct increases or decreases in shareholders' equity, net of applicable income taxes. See Notes 1 and 3 of the Notes to Consolidated Financial Statements for a description of our accounting policies. At September 30, 1999, our mortgage-backed securities had a weighted average yield of 8.3%.
Mortgage-related securities, which include CMOs, are typically issued by a special purpose entity, which may be organized in a variety of legal forms, such as a trust, a corporation or a partnership. The entity aggregates pools of pass- through securities, which are used to collateralize the mortgage-related securities. Once combined, the cash flows can be divided into "tranches" or "classes" of individual securities, thereby creating more predictable average lives for each security than the underlying pass-through pools. Accordingly, under this security structure, all principal paydowns from the various mortgage pools are allocated to a mortgage-related securities' class or classes structured to have priority until it has been paid off. These securities generally have fixed interest rates, and, as a result, changes in interest rates generally would affect the market value and possibly the prepayment rates of such securities.
Some mortgage-related securities instruments are like traditional debt instruments due to their stated principal amounts and traditionally defined interest rate terms. Purchasers of certain other mortgage-related securities instruments are entitled to the excess, if any, of the issuer's cash flows. These mortgage-related securities instruments may include instruments designated as residual interest and are riskier in that they could result in the loss of a portion of the original investment. Cash flows from residual interests are very sensitive to prepayments and, thus, contain a high degree of interest rate risk. We do not purchase residual interests in mortgage-related securities.
At September 30, 1999, we had within our investment securities portfolio CMOs with an amortized cost of $68,000, representing less than 0.02% of total assets. Our CMOs had a weighted average yield of 5.9% at September 30, 1999.
The following table sets forth the carrying value of our investment securities portfolio at the dates indicated.
_____________ (1) Consists of an investment in two mutual funds.
The following table sets forth the scheduled maturities, carrying values, amortized cost and average yields for our investment securities and mortgage- backed securities portfolio at September 30, 1999.
_______________ (1) Consists of an investment in two mutual funds.
Deposit Activity and Other Sources of Funds
General. Deposits are our primary source of funds for lending, investment activities and general operational purposes. In addition to deposits, we derive funds from loan principal and interest repayments, maturities of investment securities and interest payments thereon. Although loan repayments are a relatively stable source of funds, deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds, or on a longer term basis for general operational purposes. We have access to FHLB of Atlanta advances.
Deposits. We attract deposits principally from within Alamance County by offering a variety of deposit instruments, including checking accounts, money market accounts, passbook and statement savings accounts, Individual Retirement Accounts, and certificates of deposit which range in maturity from seven days to five years. Deposit terms vary according to the minimum balance required, the length of time the funds must remain on deposit and the interest rate. Maturities, terms, service fees and withdrawal penalties for our deposit accounts are established by us on a periodic basis. We review our deposit pricing on a weekly basis. In determining the characteristics of our deposit accounts, we consider the rates offered by competing institutions, lending and liquidity requirements, growth goals and applicable regulations. We believe we price our deposits comparably to rates offered by our competitors. We do not accept brokered deposits.
We compete for deposits with other institutions in our market area by offering competitively priced deposit instruments that are tailored to the needs of our customers. Additionally, we seek to meet customers' needs by providing convenient customer service to the community, efficient staff and convenient hours of service. Substantially all of our depositors are North Carolina residents. To provide additional convenience, we participate in the STAR and CIRRUS Automatic Teller Machine networks at locations throughout the world, through which customers can gain access to their accounts at any time. To better serve our customers, we have installed automatic teller machines at five office locations.
Our savings deposits at September 30, 1999 consisted of the various types of savings programs described below.
________________ (1) These certificates of deposit do not carry a penalty for early withdrawal. As a result, we believe that should interest rates increase materially after September 30, 1999, borrowers may withdraw funds invested in these certificates prior to maturity, causing our cost of funds to increase.
The following table sets forth the distribution of our deposit accounts at the dates indicated and the change in dollar amount of deposits in the various types of accounts we offer between the dates indicated.
The following table sets forth the average balances and average interest rates based on daily balances for various types of deposits at the dates indicated for each category of deposits presented.
The following table sets forth our time deposits classified by rates at the dates indicated.
The following table sets forth the amount and maturities of our time deposits at September 30, 1999.
The following table indicates the amount of our certificates of deposit of $100,000 or more by time remaining until maturity as of September 30, 1999. At that date, such deposits represented 16.0% of total deposits and had a weighted average rate of 4.99%.
We estimate that more than $24.0 million of certificates of deposit in amounts of $100,000 or more maturing within one year of September 30, 1999 were held by our retail and commercial customers, while the remainder of such deposits were from schools, municipalities and other public entities and were obtained through competitive rate bidding. We believe certificates of deposits held by our retail and commercial customers are more likely to be renewed upon maturity than certificates of deposit obtained through competitive bidding.
The following table sets forth our savings activities for the periods indicated.
Borrowings. Savings deposits historically have been the primary source of funds for our lending, investments and general operating activities. We are authorized, however, to use advances from the FHLB of Atlanta to supplement our supply of lendable funds and to meet deposit withdrawal requirements. The FHLB of Atlanta functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB System, we are required to own stock in the FHLB of Atlanta and are authorized to apply for advances. Advances are obtained pursuant to several different programs, each of which has its own interest rate and range of maturities. We have a Blanket Agreement for advances with the FHLB under which we may borrow up to 16% of assets subject to normal collateral and underwriting requirements. Advances from the FHLB of Atlanta are secured by our stock in the FHLB of Atlanta and other eligible assets.
In February 1998, we obtained $20.0 million in fixed-rate FHLB of Atlanta advances. These advances were structured with maturities estimated to coincide with the expected repricing of $20.0 million of loans. Through this strategy, we were able to establish a positive interest rate spread on the $20.0 million of assets and FHLB of Atlanta advances.
The following table sets forth certain information regarding our short-term borrowings at the dates and for the periods indicated:
- ------------------------- (1) Based on month-end balances.
Subsidiary Activities
In prior years, we had one subsidiary, First Capital Services, Inc., a North Carolina corporation ("First Capital"), that engaged in sales of annuities, mutual funds and insurance products on an agency basis. In September 1997, that corporation transferred its assets and liabilities to a newly formed North Carolina limited liability company, First Capital Services Company, LLC (the "LLC"), and the corporation was dissolved. 1st State Bank is the sole member of the LLC, and since the transfer of assets and liabilities, the LLC has conducted the activities previously conducted by First Capital. We earned $326,000, $262,000 and $232,000 on a pre-tax basis from the activities of the LLC and First Capital during the years ended September 30, 1999, 1998 and 1997, respectively.
Competition
We face strong competition in originating real estate, commercial business and consumer loans and in attracting deposits. We compete for real estate and other loans principally on the basis of interest rates, the types of loans we originate, the deposit products we offer and the quality of services we provide to our customers. We also compete by offering products which are tailored to the local community. Our competition in originating real estate loans comes primarily from savings institutions, commercial banks, mortgage bankers and mortgage brokers. Commercial banks, credit unions and finance companies provide vigorous competition in consumer lending. Competition may increase as a result of the continuing reduction of restrictions on the interstate operations of financial institutions.
We attract our deposits through our branch offices primarily from the local communities. Consequently, competition for deposits is principally from savings institutions, commercial banks, credit unions and brokers in our primary market area. We compete for deposits and loans by offering what we believe to be a variety of deposit accounts at competitive rates, convenient business hours, a commitment to outstanding customer service and a well-trained staff. We believe we have developed strong relationships with local realtors and the community in general.
We consider our primary market area for gathering deposits and originating loans to be Alamance County in north central North Carolina, which is the county in which our offices are located. Based on data provided by a private marketing firm, we estimate that at June 30, 1998, we had 15.0% of deposits held by all banks and savings institutions in our market area.
Employees
As of September 30, 1999, we had 71 full-time and 13 part-time employees, none of whom were represented by a collective bargaining agreement. We believe that our relationship with our employees is good.
Depository Institution Regulation
General. We are a North Carolina-chartered commercial bank and a member of the FHLB of Atlanta, and our deposits are insured by the FDIC through the Savings Association Insurance Fund of the FDIC. 1st State Bank is subject to supervision, examination and regulation by the North Carolina Banking Commission and the FDIC and to North Carolina and federal statutory and regulatory provisions governing such matters as capital standards, mergers, subsidiary investments and establishment of branch offices. We are also subject to the FDIC's authority to conduct special examinations. 1st State Bank is required to file reports with the North Carolina Banking Commission and the FDIC concerning its activities and financial condition and is required to obtain regulatory approvals prior to entering into certain transactions, including mergers with, or acquisitions of, other depository institutions.
As a federally insured depository institution, 1st State Bank is subject to various regulations promulgated by the Federal Reserve Board, including Regulation B (Equal Credit Opportunity), Regulation D (Reserve Requirements), Regulation E (Electronic Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of Funds and Collection of Checks) and Regulation DD (Truth in Savings).
The system of regulation and supervision applicable to us establishes a comprehensive framework for our operations and is intended primarily for the protection of the FDIC and our depositors. Changes in the regulatory framework could have a material effect on us and our operations.
Recently Enacted Legislative and Regulatory Changes. On November 12, 1999, President Clinton signed legislation which could have a far-reaching impact on the financial services industry. The Gramm-Leach-Bliley ("G-L-B") Act authorizes affiliations between banking, securities and insurance firms and authorizes bank holding companies and national banks to engage in a variety of new financial activities. Among the new activities that will be permitted to bank holding companies are securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Federal Reserve Board, in consultation with the Department of Treasury, may approve additional financial activities. National bank subsidiaries will be permitted to engage in similar financial activities but only on an agency basis unless they are one of the 50 largest banks in the country. National bank subsidiaries will be prohibited from insurance underwriting, real estate development and merchant banking. The G-L-B Act, however, prohibits future acquisitions of existing unitary savings and loan holding companies by firms that are engaged in commercial activities and prohibits the formation of new unitary holding companies.
The G-L-B Act imposes new requirements on financial institutions with respect to customer privacy. The G-L-B Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further
required to disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the G-L-B Act. The G-L-B Act directs the federal banking agencies, the National Credit Union Administration, the Secretary of the Treasury, the Securities and Exchange Commission and the Federal Trade Commission, after consultation with the National Association of Insurance Commissioners, to promulgate implementing regulations within six months of enactment. The privacy provisions will become effective six months thereafter.
The G-L-B Act contains significant revisions to the Federal Home Loan Bank System. The G-L-B Act imposes new capital requirements on the Federal Home Loan Banks and authorizes them to issue two classes of stock with differing dividend rates and redemption requirements. The G-L-B Act expands the permissible uses of Federal Home Loan Bank advances by community financial institutions (under $500 million in assets) to include funding loans to small businesses, small farms and small agri-businesses.
The G-L-B Act contains a variety of other provisions including a prohibition against ATM surcharges unless the customer has first been provided notice of the imposition and amount of the fee. The G-L-B Act reduces the frequency of Community Reinvestment Act examinations for smaller institutions and imposes certain reporting requirements on depository institutions that make payments to non-governmental entities in connection with the Community Reinvestment Act. The G-L-B Act eliminates the SAIF special reserve and authorizes a federal savings association that converts to a national or state bank charter to continue to use the term "federal" in its name and to retain any interstate branches.
The Company is unable to predict the impact of the G-L-B Act on its operations at this time. Although the G-L-B Act reduces the range of companies with which the Company may affiliate, it may facilitate affiliations with companies in the financial services industry.
Capital Requirements. The Federal Reserve Board and the FDIC have established guidelines with respect to the maintenance of appropriate levels of capital by bank holding companies with consolidated assets of $150 million or more and state non-member banks, respectively. The regulations impose two sets of capital adequacy requirements: minimum leverage rules, which require bank holding companies and state non-member banks to maintain a specified minimum ratio of capital to total assets, and risk-based capital rules, which require the maintenance of specified minimum ratios of capital to "risk-weighted" assets. The regulations of the FDIC and the Federal Reserve Board require bank holding companies and state non-member banks, respectively, to maintain a minimum leverage ratio of "Tier 1 capital" to total assets of 3%. Tier 1 capital is the sum of common stockholders' equity, certain perpetual preferred stock, which must be noncumulative with respect to banks, including any related surplus, and minority interests in consolidated subsidiaries; minus all intangible assets other than certain purchased mortgage servicing rights and purchased credit card receivables, identified losses and investments in certain subsidiaries. As a Savings Association Insurance Fund of the FDIC-insured, state-chartered bank, we must also deduct from Tier 1 capital an amount equal to our investments in, and extensions of credit to, subsidiaries engaged in activities that are not permissible for national banks, other than debt and equity investments in subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities or in subsidiary depository institutions or their holding companies. Although setting a minimum 3% leverage ratio, the capital regulations state that only the strongest bank holding companies and banks, with composite examination ratings of 1 under the rating system used by the federal bank regulators, would be permitted to operate at or near such minimum level of capital. All other bank holding companies and banks are expected to maintain a leverage ratio of at least Tier 1 capital to total asset of not less than 4%. Any bank or bank holding companies experiencing or anticipating significant growth would be expected to maintain capital well above the minimum levels. In addition, the Federal Reserve Board has indicated that whenever appropriate, and in particular when a bank holding company is undertaking expansion, seeking to engage in new activities or otherwise facing unusual or abnormal risks, it will consider, on a case-by-case basis, the level of an organization's ratio of tangible Tier 1 capital to total assets in making an overall assessment of capital.
In addition to the leverage ratio, the regulations of the Federal Reserve Board and the FDIC require bank holding companies and state-chartered nonmember banks to maintain a minimum ratio of qualifying total capital to risk-weighted assets of at least 8% of which at least 4% must be Tier 1 capital. Qualifying total capital consists of Tier 1 capital plus Tier 2 or "supplementary" capital items which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and preferred stock with a maturity of 20 years or more, certain other capital instruments and up to 45% of unrealized gains on equity securities. The includable amount of Tier 2 capital cannot exceed the institution's Tier 1 capital. Qualifying total capital is further reduced by the amount of the bank's investments in banking and finance subsidiaries that are not consolidated for regulatory capital purposes, reciprocal cross-holdings of capital securities issued by other banks and certain other deductions. The risk-based capital regulations assign balance sheet assets and the credit equivalent amounts of certain off-balance sheet items to one of four broad risk weight categories. The aggregate dollar amount of each category is multiplied by the risk weight assigned to that category based principally on the degree of credit risk associated with the obligor. The sum of these weighted values equals the bank holding company or the bank's risk- weighted assets.
The federal bank regulators, including the Federal Reserve Board and the FDIC, have revised their risk-based capital requirements to ensure that such requirements provide for explicit consideration of interest rate risk. Under the rule, a bank's interest rate risk exposure would be quantified using either the measurement system set forth in the rule or the bank's internal model for measuring such exposure, if such model is determined to be adequate by the bank's examiner. If the dollar amount of a bank's interest rate risk exposure, as measured under either measurement system, exceeds 1% of the bank's total assets, the bank would be required under the rule to hold additional capital equal to the dollar amount of the excess. We believe that the interest rate risk component does not have a material effect on our capital. Further, the FDIC has adopted a regulation that provides that the FDIC may take into account whether a bank has significant risks from concentrations of credit or non- traditional activities in determining the adequacy of its capital. We have not been advised that we will be required to maintain any additional capital under this regulation. The interest rate risk component does not apply to bank holding companies on a consolidated basis.
In addition to FDIC regulatory capital requirements, the North Carolina Commissioner of Banks requires us to have adequate capitalization which is determined based upon each bank's particular set of circumstances. We are subject to the North Carolina Bank Commissioner's capital surplus regulation which requires commercial banks to maintain a capital surplus of at least 50% of common capital. Common capital is defined as the total of the par value of shares times the number of shares outstanding.
At September 30, 1999, we complied with each of the capital requirements of the FDIC and the North Carolina Banking Commission.
Prompt Corrective Regulatory Action. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), the federal banking regulators are required to take prompt corrective action if an insured depository institution fails to satisfy certain minimum capital requirements. All institutions, regardless of their capital levels, are restricted from making any capital distribution or paying any management fees if the institution would thereafter fail to satisfy the minimum levels for any of its capital requirements. An institution that fails to meet the minimum level for any relevant capital measure, known as an "undercapitalized institution," may be:
. subject to increased monitoring by the appropriate federal banking regulator;
. required to submit an acceptable capital restoration plan within 45 days;
. subject to asset growth limits; and
. required to obtain prior regulatory approval for acquisitions, branching and new lines of businesses.
A "significantly undercapitalized" institution may be subject to statutory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations on interest rates paid on deposits, asset growth and other activities, possible replacement of directors and officers, and restrictions on capital distributions by any bank holding company controlling the institution. Any company controlling the institution could also be required to divest the institution or the institution could be required to divest subsidiaries. The senior executive officers of a significantly undercapitalized institution may not receive bonuses or increases in compensation without prior regulatory approval and the institution is prohibited from making payments of principal or interest on its subordinated debt. If an institution's ratio of tangible capital to total assets falls below a "critical capital level," the institution will be subject to conservatorship or receivership within 90 days unless periodic determinations are made that forbearance from such action would better protect the deposit insurance fund.
Federal banking regulators have adopted regulations implementing the prompt corrective action provisions of FDICIA. Under these regulations, the federal banking regulators generally will measure a depository institution's capital adequacy on the basis of:
. the institution's total risk-based capital ratio;
. Tier 1 risk-based capital ratio; and
. leverage ratio.
Under the regulations, an institution that is not subject to an order or written directive by its primary federal regulator to meet or maintain a specific capital level will be deemed "well capitalized" if it also has:
. a total risk-based capital ratio of 10% or greater;
. a Tier 1 risk-based capital ratio of 6% or greater; and
. a leverage ratio of 5% or greater.
An "adequately capitalized" depository institution is an institution that does not meet the definition of well capitalized and has:
. a total risk-based capital ratio of 8% or greater;
. a Tier 1 risk-based capital ratio of 4% or greater; and
. a leverage ratio of 4% or greater, or 3% or greater if the depository institution has a composite 1 CAMELS rating.
An "undercapitalized institution" is a depository institution that has:
. a total risk-based capital ratio less than 8%; or
. a Tier 1 risk-based capital ratio of less than 4%; or
. a leverage ratio of less than 4%, or less than 3% if the institution has a composite 1 CAMELS rating.
A "significantly undercapitalized" institution is defined as a depository institution that has:
. a total risk-based capital ratio of less than 6%; or
. a Tier 1 risk-based capital ratio of less than 3%; or
. a leverage ratio of less than 3%.
A "critically undercapitalized" institution is defined as a depository institution that has a ratio of "tangible equity" to total assets of less than 2%. Tangible equity is defined as core capital plus cumulative perpetual preferred stock and related surplus less all intangibles other than qualifying supervisory goodwill and certain purchased mortgage servicing rights.
The appropriate federal banking agency may reclassify a well capitalized depository institution as adequately capitalized and may require an adequately capitalized or undercapitalized institution to comply with the supervisory actions applicable to institutions in the next lower capital category, but may not reclassify a significantly undercapitalized institution as critically under- capitalized, if it determines, after notice and an opportunity for a hearing, that the institution is in an unsafe or unsound condition or that the institution has received and not corrected a less-than-satisfactory rating for any CAMELS rating category. At September 30, 1999, we were classified as "well capitalized" under FDIC regulations.
Safety and Soundness Guidelines. Under FDICIA, as amended by the Riegle Community Development and Regulatory Improvement Act of 1994 (the "CDRI Act"), each federal banking agency was required to establish safety and soundness standards for institutions under its authority. The interagency guidelines require depository institutions to maintain internal controls and information systems and internal audit systems that are appropriate for the size, nature and scope of the institution's business. The guidelines also establish certain basic standards for loan documentation, credit underwriting, interest rate risk exposure, and asset growth. The guidelines further provide that depository institutions should maintain safeguards to prevent the payment of compensation, fees and benefits that are excessive or that could lead to material financial loss, and should take into account factors such as comparable compensation practices at comparable institutions. If the appropriate federal banking agency determines that a depository institution is not in compliance with the safety and soundness guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the guidelines. A depository institution must submit an acceptable compliance plan to its primary federal regulator within 30 days of receipt of a request for such a plan. Failure to submit or implement a compliance plan may subject the institution to regulatory sanctions. Management believes that 1st State Bank meets all the standards adopted in the interagency guidelines.
Community Reinvestment Act. 1st State Bank, like other financial institutions, is subject to the Community Reinvestment Act ("CRA"). The purpose of the CRA is to encourage financial institutions to help meet the credit needs of their entire communities, including the needs of low- and moderate-income neighborhoods. During our last compliance examination, we received a "satisfactory" rating for CRA compliance. Our CRA rating would be a factor considered by the Federal Reserve Board and the FDIC in considering applications to acquire branches or to acquire or combine with other financial institutions and take other actions and, if such rating was less than "satisfactory," could result in the denial of such applications.
The federal banking regulatory agencies have implemented an evaluation system that rates institutions based on their actual performance in meeting community credit needs. Under the regulations, a bank will first be evaluated and rated under three categories: a lending test, an investment test and a service test. For each of these three tests, the bank will be given a rating of either "outstanding," "high satisfactory," "low satisfactory," "needs to improve," or "substantial non-compliance." A set of criteria for each rating has been developed and is included in the regulation. If an institution disagrees with a particular rating, the institution has the burden of rebutting the presumption by clearly establishing that the quantitative measures do not accurately present its actual performance, or that demographics, competitive conditions or economic or legal limitations peculiar to its service area should be considered. The ratings received under the three tests will be used to determine the overall composite CRA rating. The composite ratings will be the same as those that are currently given: "outstanding," "satisfactory," "needs to improve" or "substantial non-compliance."
Federal Home Loan Bank System. The FHLB System consists of 12 district FHLBs subject to supervision and regulation by the Federal Housing Finance Board ("FHFB"). The FHLBs provide a central credit facility primarily for member institutions. As a member of the FHLB of Atlanta, we are required to acquire and hold shares of capital stock in the FHLB of Atlanta in an amount at least equal to 1% of the aggregate unpaid principal of home mortgage loans, home purchase contracts, and similar obligations at the beginning of each year, or 1/20 of advances from the FHLB of Atlanta, whichever is greater. We were in compliance with this requirement with investment in FHLB of Atlanta stock at September 30, 1999 of $1.3 million. The FHLB of Atlanta serves as a reserve or central bank for its member institutions within its assigned district. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It offers advances to members in accordance with policies and procedures established by the FHFB and the board of directors of the FHLB of Atlanta. Long-term advances may only be made for the purpose of providing funds for residential housing finance. At September 30, 1999, we had $22 million in advances outstanding from the FHLB of Atlanta.
Reserves. Under Federal Reserve Board regulations, we must maintain average daily reserves against transaction accounts. Reserves equal to 3% must be maintained on transaction accounts of between $5.0 million and $44.3 million, plus 10% on the remainder. This percentage is subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cash or in a non-interest bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution's interest-earning assets. As of September 30, 1999, we met our reserve requirements.
We are also subject to the reserve requirements of North Carolina commercial banks. North Carolina law requires state non-member banks to maintain, at all times, a reserve fund in an amount set by regulation of the North Carolina Banking Commission. As of September 30, 1999, we met our reserve requirements.
Deposit Insurance. We are required to pay assessments based on a percentage of insured deposits to the FDIC for insurance of our deposits by the Savings Association Insurance Fund of the FDIC. Under the FDIC's risk-based deposit insurance assessment system, the assessment rate for an insured depository institution depends on the assessment risk classification assigned to the institution by the FDIC, which is determined by the institution's capital level and supervisory evaluations. Based on the data reported to regulators for the date closest to the last day of the seventh month preceding the semi-annual assessment period, institutions are assigned to one of three capital groups -- well capitalized, adequately capitalized or undercapitalized -- using the same percentage criteria as in the prompt corrective action regulations. See "-- Prompt Corrective Regulatory Action" for definitions and percentage criteria for the capital group categories. Within each capital group, institutions are assigned to one of three subgroups on the basis of supervisory evaluations by the institution's primary supervisory authority and such other information as the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance fund. Subgroup A consists of financially sound institutions with only a few minor weaknesses. Subgroup B consists of institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration of the institution and increased risk of loss to the deposit insurance fund. Subgroup C consists of institutions that pose a substantial probability of loss to the deposit insurance fund unless effective corrective action is taken. The assessment rate for SAIF members ranges from zero for well capitalized institutions in Subgroup A to 0.27% of deposits for undercapitalized institutions in Subgroup C. Both Bank Insurance Fund of the FDIC and Savings Association Insurance Fund of the FDIC members are assessed an amount for the Financing Corporation Bond payments. Bank Insurance Fund of the FDIC members are assessed approximately 1.3 basis points while the Savings Association Insurance Fund of the FDIC rate is approximately 6.4 basis points until January 1, 2000. At that time, Bank Insurance Fund of the FDIC and Savings Association Insurance Fund of the FDIC members will begin pro rata sharing of the payment at an expected rate of 2.43 basis points.
Although 1st State Bank, as a North Carolina commercial bank, would qualify for insurance of deposits by the Bank Insurance Fund of the FDIC, substantial entrance and exit fees apply to conversions from Savings Association Insurance Fund of the FDIC to Bank Insurance Fund of the FDIC insurance. Accordingly, we remain a member of the Savings Association Insurance Fund of the FDIC, which insures our deposits to a maximum of $100,000 for each depositor.
Liquidity Requirements. FDIC policy requires that banks maintain an average daily balance of liquid assets in an amount which it deems adequate to protect safety and soundness of the bank. Liquid assets include cash, certain time deposits, bankers' acceptances and specified United States government, state, or federal agency obligations. The FDIC currently has no specific level which it requires.
North Carolina banks must maintain a reserve fund in an amount and/or ratio set by the North Carolina Banking Commission to account for the level of liquidity necessary to assure the safety and soundness of the State banking system. At September 30, 1999, our liquidity ratio exceeded the North Carolina regulations.
Dividend Restrictions. Under FDIC regulations, we are prohibited from making any capital distributions if after making the distribution, we would have:
. a total risk-based capital ratio of less than 8%;
. a Tier 1 risk-based capital ratio of less than 4%; or
. a leverage ratio of less than 4%.
Our earnings appropriated to bad debt reserves and deducted for Federal income tax purposes are not available for payment of cash dividends or other distributions to stockholders without payment of taxes at the then current tax rate on the amount of earnings removed from the pre-1988 reserves for such distributions. We intend to make full use of this favorable tax treatment and do not contemplate use of any earnings in a manner which would create federal tax liabilities.
We may not pay dividends on our capital stock if our regulatory capital would thereby be reduced below the amount then required for the liquidation account established for the benefit of certain depositors at the time of the conversion.
1st State Bancorp is subject to limitations on dividends imposed by the Federal Reserve Board.
Transactions with Related Parties. Transactions between a state non-member bank and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a state non-member bank is any company or entity which controls, is controlled by or is under common control with the state non- member bank. In a holding company context, the parent holding company of a state non-member bank, such as 1st State Bancorp, and any companies which are controlled by the parent holding company are affiliates of the savings institution or state non-member bank. Generally, Sections 23A and 23B (i) limit the extent to which an institution or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions. In addition to the restrictions imposed by Sections 23A and 23B, no state non-member bank may (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, or (ii) purchase or invest in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates which are subsidiaries of the state non-member bank.
State non-member banks also are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the Federal Reserve Board's Regulation O thereunder on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, executive officer and to a greater than 10% stockholder of a state non-member bank and certain affiliated interests of such persons, may not exceed, together with all other outstanding loans to such person and affiliated interests, the institution's loans-to-one-borrower limit and all loans to such persons
may not exceed the institution's unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and greater than 10% stockholders of a financial institution, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the institution with any "interested" director not participating in the voting. Regulation O prescribes the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required as being the greater of $25,000 or 5% of capital and surplus up to $500,000. Further, Section 22(h) requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons. Section 22(h) also generally prohibits a depository institution from paying the overdrafts of any of its executive officers or directors.
State non-member banks also are subject to the requirements and restrictions of Section 22(g) of the Federal Reserve Act on loans to executive officers and the restrictions of 12 U.S.C. (S)1972 on certain tying arrangements and extensions of credit by correspondent banks. Section 22(g) of the Federal Reserve Act requires loans to executive officers of depository institutions not be made on terms more favorable than those afforded to other borrowers, requires approval by the board of directors of a depository institution for extension of credit to executive officers of the institution, and imposes reporting requirements for and additional restrictions on the type, amount and terms of credits to such officers. Section 1972 (i) prohibits a depository institution from extending credit to or offering any other services, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or certain of its affiliates or not obtain services of a competitor of the institution, subject to certain exceptions, and (ii) prohibits extensions of credit to executive officers, directors, and greater than 10% stockholders of a depository institution by any other institution which has a correspondent banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.
Additionally, North Carolina statutes set forth restrictions on loans to executive officers of state-chartered banks, which provide that no bank may extend credit to any of its executive officers nor a firm or partnership of which such executive officers is a member, nor a company in which such executive officer owns a controlling interest, unless the extension of credit is made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions by the bank with persons who are not employed by the bank, and provided further that the extension of credit does not involve more than the normal risk of repayment.
Restrictions on Certain Activities. Under FDICIA, state-chartered banks with deposits insured by the FDIC are generally prohibited from acquiring or retaining any equity investment of a type or in an amount that is not permissible for a national bank. The foregoing limitation, however, does not prohibit FDIC-insured state banks from acquiring or retaining an equity investment in a subsidiary in which the bank is a majority owner. State- chartered banks are also prohibited from engaging as principal in any type of activity that is not permissible for a national bank and subsidiaries of state- chartered, FDIC-insured state banks may not engage as principal in any type of activity that is not permissible for a subsidiary of a national bank unless in either case the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and the bank is, and continues to be, in compliance with applicable capital standards.
The FDIC has adopted regulations to clarify the foregoing restrictions on activities of FDIC-insured state-chartered banks and their subsidiaries. Under the regulations, the term activity refers to the authorized conduct of business by an insured state bank and includes acquiring or retaining any investment other than an equity investment. An activity permissible for a national bank includes any activity expressly authorized for national banks by statute or recognized as permissible in regulations, official circulars or bulletins or in any order or written interpretation issued by the Office of the Comptroller of the Currency ("OCC"). In its regulations, the FDIC indicates that it will not permit state banks to directly engage in commercial ventures or directly or indirectly engage in any insurance underwriting activity other than to the extent such activities are permissible for a national bank or a national bank subsidiary or except for certain other limited forms of insurance underwriting permitted under the regulations. Under the regulations, the
FDIC permits state banks that meet applicable minimum capital requirements to engage as principal in certain activities that are not permissible to national banks including guaranteeing obligations of others, activities which the Federal Reserve Board has found by regulation or order to be closely related to banking and certain securities activities conducted through subsidiaries.
Regulation of 1st State Bancorp, Inc.
General. 1st State Bancorp, as the sole shareholder of 1st State Bank, is a bank holding company and is registered as such with the Federal Reserve Board. Bank holding companies are subject to comprehensive regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the regulations of the Federal Reserve Board. As a bank holding company, 1st State Bancorp is required to file with the Federal Reserve Board annual reports and such additional information as the Federal Reserve Board may require, and is subject to regular examinations by the Federal Reserve Board. The Federal Reserve Board also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries, including its bank subsidiaries. In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. 1st State Bancorp is also required to file certain reports with, and comply with the rules and regulations of the Securities and Exchange Commission under the federal securities laws.
Under the BHCA, a bank holding company must obtain Federal Reserve Board approval before:
. acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares, unless it already owns or controls the majority of such shares;
. acquiring all or substantially all of the assets of another bank or bank holding company; or
. merging or consolidating with another bank holding company.
Satisfactory financial condition, particularly with respect to capital adequacy, and a satisfactory CRA rating generally are prerequisites to obtaining federal regulatory approval to make acquisitions.
The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non bank activities which, by statute or by Federal Reserve Board regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the Federal Reserve Board includes, among other things:
. operating a savings institution, mortgage company, finance company, credit card company or factoring company;
. performing certain data processing operations;
. providing certain investment and financial advice;
. underwriting and acting as an insurance agent for certain types of credit-related insurance;
. leasing property on a full-payout, non-operating basis;
. selling money orders, travelers' checks and United States Savings Bonds;
. real estate and personal property appraising;
. providing tax planning and preparation services; and,
. subject to certain limitations, providing securities brokerage services for customers.
Presently, we have no plans to engage in any of these activities.
Under the BHCA, any company must obtain approval of the Federal Reserve Board prior to acquiring control of 1st State Bancorp or 1st State Bank. For purposes of the BHCA, "control" is defined as ownership of more than 25% of any class of voting securities of 1st State Bancorp or 1st State Bank, the ability to control the election of a majority of the directors, or the exercise of a controlling influence over management or policies of 1st State Bancorp or 1st State Bank. In addition, the Change in Bank Control Act and the related regulations of the Federal Reserve Board require any person or persons acting in concert to file a written notice with the Federal Reserve Board before such person or persons may acquire control of 1st State Bancorp or 1st State Bank. The Change in Bank Control Act defines "control" as the power, directly or indirectly, to vote 25% or more of any voting securities or to direct the management or policies of a bank holding company or an insured bank.
The Federal Reserve Board has adopted guidelines regarding the capital adequacy of bank holding companies, which require bank holding companies to maintain specified minimum ratios of capital to total assets and capital to risk-weighted assets.
Interstate Banking. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act") was enacted to ease restrictions on interstate banking. Effective September 29, 1995, the Act allows the Federal Reserve Board to approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than such holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve Board may not approve the acquisition of a bank that has not been in existence for a minimum of five years, regardless of a longer minimum period specified by the statutory law of the host state. The Riegle-Neal Act also prohibits the Federal Reserve Board from approving an application if the applicant and its depository institution affiliates control or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. The Riegle-Neal Act does not affect the authority of states to limit the percentage of total insured deposits in the state which may be held or controlled by a bank or bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% statewide concentration limit contained in the Riegle-Neal Act.
Additionally, the federal banking agencies are authorized to approve interstate merger transactions without regard to whether such transaction is prohibited by the law of any state, unless the home state of one of the banks opts out of the Riegle-Neal Act by adopting a law, which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of- state banks, after the date of enactment of the Riegle-Neal Act and prior to June 1, 1997. North Carolina has enacted legislation permitting interstate banking transactions. Interstate acquisitions of branches will be permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions will also be subject to the nationwide and statewide insured deposit concentration amounts described above.
The Riegle-Neal Act authorizes the FDIC to approve interstate branching de novo by state banks only in states which specifically allow for such branching. Pursuant to the Riegle-Neal Act, the appropriate federal banking agencies have adopted regulations which prohibit any out-of-state bank from using the interstate branching authority primarily for the purpose of deposit production. These regulations include guidelines to ensure that interstate branches operated
by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the communities which they serve.
Dividends. The Federal Reserve Board has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve Board's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve Board also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt corrective action regulations adopted by the Federal Reserve Board pursuant to FDICIA, the Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding company's bank subsidiary is classified as "undercapitalized". For a definition of "undercapitalized" institution, see "-- Depository Institution Regulation -- Prompt Corrective Regulatory Action."
Bank holding companies are required to give the Federal Reserve Board prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the their consolidated retained earnings. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve Board order, or any condition imposed by, or written agreement with, the Federal Reserve Board. Bank holding companies whose capital ratios exceed the thresholds for "well-capitalized" banks on a consolidated basis are exempt from the foregoing requirement if they were rated composite 1 or 2 in their most recent inspection and are not the subject of any unresolved supervisory issues.
TAXATION
General
1st State Bancorp files a federal income tax return based on a calendar year. 1st State Bank files its tax returns based on a calendar year ending September 30. They file separate returns.
Federal Income Taxation
Financial institutions such as 1st State Bank are subject to the provisions of the Internal Revenue Code in the same general manner as other corporations. Through tax years beginning before December 31, 1995, institutions such as 1st State Bank which met certain definitional tests and other conditions prescribed by the Internal Revenue Code benefitted from certain favorable provisions regarding their deductions from taxable income for annual additions to their bad debt reserve. For purposes of the bad debt reserve deduction, loans are separated into "qualifying real property loans," which generally are loans secured by interests in certain real property, and "nonqualifying loans", which are all other loans. The bad debt reserve deduction with respect to nonqualifying loans must be based on actual loss experience. The amount of the bad debt reserve deduction with respect to qualifying real property loans may be based upon actual loss experience (the "experience method") or a percentage of taxable income determined without regard to such deduction (the "percentage of taxable income method"). Under the experience method, the bad debt deduction for an addition to the reserve for qualifying real property loans was an amount determined under a formula based generally on the bad debts actually sustained by a savings institution over a period of years. Under the percentage of taxable income method, the bad debt reserve deduction for qualifying real property loans was computed as 8% of a savings institution's taxable income, with certain adjustments. We generally elected to use the method which has resulted in the greatest deductions for federal income tax purposes in any given year.
Legislation that is effective for tax years beginning after December 31, 1995 requires institutions to recapture into taxable income over a six taxable year period the portion of the tax loan reserve that exceeds the pre-1988 tax loan
loss reserve. As a result of changes in the law, institutions were required to change to either the reserve method or the specific charge-off method that applied to banks.
We are not required to provide a deferred tax liability for the tax effect of additions to the tax bad debt reserve through 1987, the base year. Retained income at September 30, 1998 includes approximately $4.2 million for which no provision for federal income tax has been made. These amounts represent allocations of income to bad debt deductions for tax purposes only. Reduction of such amounts for purposes other than tax bad debt losses could create income for tax purposes in certain remote instances, which would be subject to the then current corporate income tax rate.
Our federal income tax returns have not been audited since 1993.
For additional information on our policies regarding tax and accounting matters, see our consolidated financial statements and related notes, which you can find beginning on page of this document.
State Income Taxation
Under North Carolina law, the corporate income tax currently is 7.25% of federal taxable income as computed under the Internal Revenue Code, subject to certain prescribed adjustments. This rate will be reduced to 7.00% for 1999 and 6.9% for 2000 and thereafter. In addition, for tax years beginning in 1991, 1992, 1993 and 1994, corporate taxpayers were required to pay a surtax equal to 4%, 3%, 2% and 1%, respectively, of the state income tax otherwise payable. An annual state franchise tax is imposed at a rate of .15% applied to the greatest of the institution's (i) capital stock, surplus and undivided profits, (ii) investment in tangible property in North Carolina, or (iii) appraised valuation of property in North Carolina.
For additional information regarding taxation, see Notes 1 and 11 of the Notes to the Consolidated Financial Statements, which you can find beginning on page of this document.
Item 2.
Item 2. Properties - -------------------
The following table sets forth the location and certain additional information regarding our offices at September 30, 1999.
__________ (1) Land and building only. (2) Land is leased. Lease expires on July 5, 2009, with options to extend for three five-year periods.
The book value of our investment in premises and equipment was $7.3 million at September 30, 1999. See Note 7 of Notes to Consolidated Financial Statements elsewhere in this document.
Item 3.
Item 3. Legal Proceedings. - -------------------------
From time to time, we are a party to various legal proceedings incident to its business. There currently are no legal proceedings to which we are a party, or to which any of our property was subject, which were expected to result in a material loss. There are no pending regulatory proceedings to which we are a party or to which any of our properties is subject which are expected to result in a material loss.
Item 4.
Item 4. Submission of Matters to Vote of Security Holders. - ---------------------------------------------------------
Not applicable.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholders' - --------------------------------------------------------------------------- Matters - -------
The information contained under the sections captioned "Market Information" in the Company's Annual Report to Stockholders for the Fiscal Year Ended September 30, 1999 (the "Annual Report") filed as Exhibit 13 hereto is incorporated herein by reference.
Item 6.
Item 6. Selected Financial Data - --------------------------------
The information contained in the table captioned "Selected Consolidated Financial and Other Data" on page 3 in the Annual Report is incorporated herein by reference.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations - -------------
The information contained in the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 5 through 20 in the Annual Report is incorporated herein by reference.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk - -------------------------------------------------------------------
The information contained under the sections captioned "Market Risk" on page 10 in the Annual Report is incorporated herein be reference.
Item 8.
Item 8. Financial Statements and Supplementary Data - ----------------------------------------------------
The Consolidated Financial Statements, Notes to Consolidated Financial Statements, Independent Auditors' Report and Selected Financial Data contained on pages 21 through 52 in the Annual Report, which are listed under Item 14 herein, are incorporated herein by reference.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and - ------------------------------------------------------------------------ Financial Disclosure - --------------------
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant - -----------------------------------------------------------
The information contained under the sections captioned "Proposal I -- Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement for the Company's 2000 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation - -------------------------------
The information contained under the sections captioned "Proposal I -- Election of Directors -- Executive Compensation," in the Proxy Statement is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management - -----------------------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners. Information required by this item is incorporated herein by reference to the section captioned "Voting Securities and Security Ownership" in the Proxy Statement.
(b) Security Ownership of Management. Information required by this item is incorporated herein by reference to the sections captioned "Voting Securities and Security Ownership" and "Proposal I --Election of Directors" in the Proxy Statement.
(c) Changes in Control. Management of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the registrant.
Item 13.
Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------
The information required by this item is incorporated herein by reference to the section captioned "Proposal I -- Election of Directors -- Transactions with Management" in the Proxy Statement.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - ------------------------------------------------------------------------
(a) List of Documents Filed as Part of this Report ----------------------------------------------
(1) Financial Statements. The following consolidated financial statements are incorporated by reference from Item 8 hereof (see Exhibit 13):
Independent Auditors' Report Consolidated Balance Sheets as of September 30, 1999 and 1998 Consolidated Statements of Income for the Years Ended September 30, 1999, 1998 and 1997 Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Years Ended September 30, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the Years Ended September 30, 1998, 1997 and 1996 Notes to Consolidated Financial Statements
(2) Financial Statement Schedules. All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements and related notes thereto.
(3) Exhibits. The following is a list of exhibits filed as part of this Annual Report on Form 10-K and is also the Exhibit Index.
No. Description -- -----------
3.1 Articles of Incorporation of 1st State Bancorp, Inc. (Incorporated herein by reference from Exhibit 3.1 to the Company's Registration Statement on Form S-1 (File No. 333-68091)) 3.2 Bylaws of 1st State Bancorp, Inc. (Incorporated herein by reference from Exhibit 3.2 to the Company's Registration Statement on Form S-1 (File No. 333-68091)) 4 Form of Common Stock Certificate of 1st State Bancorp, Inc. (Incorporated herein by reference from Exhibit 4 to the Company's Registration Statement on Form 8-A)) 10.1 Proposed 1st State Bancorp, Inc. 1999 Stock Option and Incentive Plan (Incorporated herein by reference from Exhibit 10.1 to the Company's Registration Statement on Form S-1 (File No. 333-68091)) 10.2 Proposed 1st State Bancorp, Inc. Management Recognition Plan (Incorporated herein by reference from Exhibit 10.2 to the Company's Registration Statement on Form S-1 (File No. 333-68091)) 10.3 Employment Agreements by and between 1st State Bank and James C. McGill, A. Christine Baker and Fairfax C. Reynolds (Incorporated herein by reference from Exhibit 10.3 to the Company's Registration Statement on Form S-1 (File No. 333-68091))
10.4 Form of Guaranty Agreement by and between 1st State Bancorp, Inc. and James C. McGill, A. Christine Baker and Fairfax C. Reynolds (Incorporated herein by reference from Exhibit 10.4 to the Company's Registration Statement on Form S-1 (File No. 333-68091)) 10.5 1st State Bank Deferred Compensation Plan (Incorporated herein by reference from Exhibit 10.5 to the Company's Registration Statement on Form S-1 (File No. 333-68091)) 13 Annual Report to Stockholders 21 Subsidiaries of the Registrant 23 Consent of KPMG LLP 27 Financial Data Schedule
(b) Reports on Form 8-K. None. -------------------
(c) Exhibits. The exhibits required by Item 601 of Regulation S-K are either -------- filed as part of this Annual Report on Form 10-K or incorporated by reference herein.
(d) Financial Statements and Schedules Excluded from Annual Report. There are -------------------------------------------------------------- no other financial statements and financial statement schedules which were excluded from the Annual Report to Stockholders pursuant to Rule 14a-3(b) which are required to be included herein.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
1ST STATE BANCORP, INC.
December 23, 1999 By: /s/ James C. McGill -------------------------- James C. McGill President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ James C. McGill December 23, 1999 - --------------------------------- James C. McGill President, Chief Executive Officer and Director (Principal Executive Officer)
/s/ A. Christine Baker December 23, 1999 - --------------------------------- A. Christine Baker Executive Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Richard C. Keziah December 23, 1999 - --------------------------------- Richard C. Keziah Chairman of the Board
/s/ James A. Barnwell, Jr. December 23, 1999 - --------------------------------- James A. Barnwell, Jr. Director
/s/ Bernie C. Bean December 23, 1999 - --------------------------------- Bernie C. Bean Director
/s/ James G. McClure December 23, 1999 - --------------------------------- James G. McClure Director
/s/ T. Scott Quakenbush December 23, 1999 - -------------------------------- T. Scott Quakenbush Director
/s/ Richard H. Shirley December 23, 1999 - ------------------------------ Richard H. Shirley Director
/s/ Virgil L. Stadler December 23, 1999 - ------------------------------ Virgil L. Stadler Director | 18,341 | 120,146 |
26324_1999.txt | 26324_1999 | 1999 | 26324 | Item 1. Business. - ----------------- Curtiss-Wright Corporation was incorporated in 1929 under the laws of the State of Delaware. During 1998, the Company adopted the Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information." (SFAS No. 131). Consistent with the requirements of SFAS No. 131, the Company now reports its operations in three Segments: Motion Control (formerly known as "Actuation and Control Products & Services Segment"), Metal Treatment (formerly known as "Precision Manufacturing Products & Services Segment"), and Flow Control (formerly known as "Flow Control Products & Services").
Motion Control - --------------- The Corporation designs, develops and manufactures flight control actuation systems and components for the aerospace industry. Manufactured products offered consist of electro-mechanical and hydro-mechanical actuation components and systems, which are designed to position aircraft control surfaces, or to operate canopies, cargo doors, weapons bay doors or other devices used on aircraft. They include actuators and control systems for the Boeing 737, 747, 757, 767 and 777 jet airliners, the Lockheed Martin Falcon fighter, the Boeing F/A-18 fighter, the Raptor fighter jointly developed by Lockheed Martin and Boeing, the Bell Boeing V-22 Osprey, and the Sikorsky Black Hawk and Seahawk helicopters. The Corporation also is developing wing flap actuators for business jet and small cargo aircraft. During 1999, the Corporation consolidated certain operations, relocating substantially all of its manufacturing from the Corporation's Fairfield, New Jersey facility into its Shelby, North Carolina facility. Accordingly, these operations are mainly conducted from the Corporation's facility in Shelby, North Carolina.
With the acquisition on December 31, 1998 of SIG Antriebstechnik AG*, the Company also offers electro-mechanical and electro-hydraulic actuation components and systems including electronic controls to the military tracked and wheeled vehicle, high speed railroad train, and commercial marine propulsion markets. These products which are designed and manufactured at the Corporation's facility in Neuhausen am Rheinfall, Switzerland, primarily consist of drives and suspension systems for armored military vehicles sold to defense equipment manufacturers, and tilting systems for high speed railway car applications, in each case to overseas markets.
The actuation and control products and services of this Segment are marketed directly to customers by employees of the Corporation. These products are sold in competition with a number of other system suppliers, most of which have broader product lines and financial, technical, and human resources greater than those of the Company. Competition is primarily on the basis of engineering capability, quality and price and is directed to the placement of systems to perform control and actuation functions on the limited number of new production programs.
As a related service within this Segment, Curtiss-Wright also provides commercial airlines, the military and general aviation customers with component overhaul and repair services. The Corporation overhauls a variety of hydraulic, pneumatic, mechanical, electro-mechanical, electrical and electronic components found on Boeing, Lockheed Martin, Airbus and other aircraft. The Corporation provides these services from facilities in Gastonia, North Carolina, Miami, Florida, Karup, Denmark, and a marketing and distribution facility in Singapore.
- ----------------- * Merged into Curtiss-Wright Antriebstechnik GmbH (Curtiss-Wright Drive Technology) effective March 19, 1999.
This Segment's overhaul services are sold in competition with a number of other overhaul and repair providers. Competition in the overhaul business is based upon quality, delivery and price. Marketing is accomplished through sales representatives and by direct sales.
The Company sells a commercial rescue tool using its "Power Hinge"(TM) aerospace technology under the trademark Power Hawk(R). Various accessories and related equipment are also offered. The primary use for this tool is the extrication of automobile accident victims.
Sales by this Segment to the Boeing Company in 1999, 1998, and 1997 were $42.9, $39.3, and $32.0 million, respectively. The loss of the Boeing Company as a customer would have a material adverse affect on this Segment. U.S. Government direct and end use sales of this Segment in 1999, 1998 and 1997 were $17.4, $19.7, and $20.1 million, respectively. The loss of this business would have a material adverse effect on this Segment.
The backlog of this Segment as of January 31, 2000 was $164.4 million as compared with $143.0 million as of January 31, 1999. Of the January 31, 2000 amount, approximately 52% is expected to be shipped during 2000. None of the business of this Segment is seasonal. Raw materials are generally available in adequate quantities from a number of suppliers.
Metal Treatment - ------------------ Curtiss-Wright provides approximately 50 metal-treating services in this Segment, with its principal services being "shot peening" and "heat treating." "Shot peening" is the process by which durability of metal parts are improved by the bombardment of the part's surface with spherical media such as steel shot, ceramic or glass beads to compress the outer layer of the metal. "Heat treating" is a metallurgical process of subjecting metal objects to heat and/or cold or otherwise subsequently treating the material to change the physical and/or chemical characteristics or properties of the material. An overview of the metal treating services is provided on page 7 in the Company's Annual Report, such description being incorporated by reference in this Form 10-K. These processes are used principally to improve the service life, strength and durability of metal parts. They are also used to form curvatures in metal panels, which are assembled as wingskins of commercial and military planes, and to manufacture valve reeds used in compressors. The Corporation provides these services for a broad spectrum of customers in various industries, including aerospace, automotive, construction equipment, oil, petrochemical, metal working, and other industries. Operations are conducted from 37 facilities located in the United States, Canada, England, France, Germany, and Belgium.
The services and products of this Segment are marketed directly by employees of the Company. Although numerous companies compete with the Company in this field, and many customers for the services provided have the resources to perform such services themselves, Curtiss-Wright believes that its greater technical know-how and superior quality provide it with a competitive advantage. The Corporation also competes on the basis of quality, service and price.
The backlog of this Segment as of January 31, 2000 was $1.2 million, as compared with $1.4 million as of January 31, 1999. All of such backlog is expected to be shipped in the first quarter of 2000. The business of this Segment is not seasonal. Raw materials are generally available in adequate quantities from a number of suppliers, and the Segment is not materially dependent upon any single source of supply. No single customer accounted for 10% or more of total sales in 1999, 1998 and 1997 and the active customer base numbers in excess of 5,000.
Flow Control - -------------- At its facility located in East Farmingdale, New York, the Corporation designs, manufactures, refurbishes and tests highly engineered valves of various types and sizes, such as motor operated and solenoid operated globe, gate, control and safety relief valves. These valves are used to control the flow of liquids and gases and to provide safety relief in high-pressure applications. It also supplies actuators and controllers for its own valves as well as for valves manufactured by others. The primary customers for these valves are the U.S. Navy, which uses them in nuclear propulsion systems, and owners and operators of commercial power utilities who use them in new and existing nuclear and fossil fuel power plants. All of the new nuclear plants are outside the U.S. and recent sales for such plants have been to Korea and Taiwan. Sales are made by responding directly to requests for proposals from customers. The production of valves for the U.S. Navy and for new power plants is characterized by long lead times from order placement to delivery.
Through its Enertech operation, the Company also designs, manufactures and distributes additional flow control products for sale into global commercial nuclear power markets, and it also distributes products made by others from its facility in Brea, California. Enertech's product lines include: snubbers, advanced valves, valve actuators, test and diagnostic equipment, as well as related diagnostic services. In addition, the Company now provides training, on-site services, staff augmentation and engineering programs relating to nuclear power plants. The Company also provides hydraulic power units and components primarily for the automotive and entertainment industries.
In August 1999, the Company further expanded its product lines and distribution base through the acquisitions of Farris Engineering ("Farris") and Sprague Products ("Sprague"), two former business units of Teledyne Fluid Systems, Inc. As a result of acquiring Farris, one of the world's leading manufacturers of spring-loaded and pilot operated pressure-relief valves, the Company expanded its customer base into the processing industries. Farris' primary customers are refineries, petrochemical/chemical plants and pharmaceutical manufacturing facilities. Farris products are manufactured in Brecksville, Ohio and Brantford, Ontario. A service and distribution center is located in Edmonton, Alberta. Sprague, also located in Brecksville, Ohio, manufactures and provides specialty hydraulic and pneumatic valves, air-driven pumps and gas boosters under the "Sprague" and "PowerStar" trade names. Sprague products are used generally in various industrial applications as well as directional control valves for truck transmissions and car transport carriers.
Strong competition in flow control products and services is encountered primarily from a large number of domestic and foreign sources in the commercial market. Sales to commercial users are accomplished through independent marketing representatives and by direct sales. These products and services are sold to customers who are sophisticated and demanding. Performance, quality, technology, delivery and price are the principal areas of competition.
The backlog of this Segment as of January 31, 2000 was $67.3 million as compared with $55.2 million as of January 31, 1999. Of the January 31, 2000 amount, approximately 47% is expected to be shipped during 2000. Approximately 25% of this Segment's backlog is composed of orders with the U.S. Navy through its prime contractor, the Plant Apparatus Division of Bechtel National, Inc. a unit of Bechtel Group, Inc. The loss of this customer would have a significant adverse impact on the business of this Segment.
None of the business of this Segment is seasonal. Raw materials are generally available in adequate quantities from a number of suppliers.
Other Information - ------------------------------
Government Sales - ---------------- In 1999, 1998 and 1997, direct sales to the United States Government and sales for United States Government end use aggregated approximately 17%, 17% and 20% respectively, of total sales for all Segments. United States Government sales, both direct and subcontract, are generally made under one of the standard types of government contracts, including fixed price and fixed price-redeterminable.
In accordance with normal practice in the case of United States Government business, contracts and orders are subject to partial or complete termination at any time, at the option of the customer. In the event of a termination for convenience by the Government, there generally are provisions for recovery by the Corporation of its allowable incurred costs and a proportionate share of the profit or fee on the work done, consistent with regulations of the United States Government. Subcontracts for Navy nuclear valves usually provide that Curtiss-Wright must absorb most of any overrun of "target" costs. In the event that there is a cost underrun, however, the customer is to recoup a portion of the underrun based upon a formula in which the customer's portion increases as the underrun exceeds certain established levels.
It is the policy of the Corporation to seek customary progress payments on certain of its contracts. Where such payments are obtained by the Corporation under United States Government prime contracts or subcontracts, they are secured by a lien in favor of the Government on the materials and work in process allocable or chargeable to the respective contracts. (See Notes 1.C, 4 and 5 to the Consolidated Financial Statements, on pages 23, 26 and 27 of the Annual Report, which notes are incorporated by reference in this Form 10-K Annual Report.) In the case of most valve products for United States Government end use, the subcontracts typically provide for the retention by the customer of stipulated percentages of the contract price, pending completion of contract closeout conditions.
Research and Development - ------------------------ Research and development expenditures sponsored by the Corporation amounted to $2,801,000 in 1999 as compared with $1,346,000 in 1998 and $1,877,000 in 1997. The Corporation owns and is licensed under a number of United States and foreign patents and patent applications, which have been obtained or filed over a period of years. Curtiss-Wright does not consider that the successful conduct of its business is materially dependent upon the protection of any one or more of these patents, patent applications or patent license agreements under which it now operates.
Environmental Protection - ------------------------ The effect of compliance upon the Corporation with present legal requirements concerning protection of the environment is described in the material in Notes 1.H and 11 to the Consolidated Financial Statements which appears on pages 24 and 31 of the Registrant's Annual Report and is incorporated by reference in this Form 10-K Annual Report.
Employees - --------- At the end of 1999, the Corporation had 2,267 employees, 172 of which were represented by labor unions and are covered by collective bargaining agreements.
Certain Financial Information - ----------------------------- The industry segment information is described in the material in Note 14 to the Consolidated Financial Statements, which appears on pages 33 to 35 of the Registrant's Annual Report, and is incorporated by reference in this Form 10-K Annual Report. It should be noted that in recent years a significant percentage of the pre-tax earnings from operations of the Corporation have been derived from foreign operations. The Company does not regard the risks attendant to these foreign operations to be materially greater than those applicable to its business in the U.S.
Item 2.
Item 2. Properties. - ----------------------- The principal physical properties of the Corporation and its subsidiaries are described below:
Owned/ Location Description(1) Leased Principal Use
East Farmingdale, 215,000 sq. ft. Owned(2) Flow Control New York on 11 acres
Chester, Wales 175,666 sq. ft. Leased Metal Treatment United Kingdom
Shelby, 137,440 sq. ft. Owned Motion Control North Carolina on 29 acres
Brampton, 87,000 sq. ft. on Owned Metal Treatment Ontario, Canada 8 acres
Deeside, Wales 81,000 sq. ft. Owned Metal Treatment United Kingdom on 2.2 acres
Columbus, Ohio 75,000 sq. ft. Owned Metal Treatment on 9 acres
Brecksville, Ohio 68,000 sq. ft Owned Flow Control on 5.56 acres
Miami, Florida 65,000 sq. ft. Leased Motion Control on 2.6 acres
Fort Wayne, 62,589 sq. ft. Owned Metal Treatment Indiana on 3.2 acres
Gastonia, 52,860 sq. ft. Owned Motion Control North Carolina on 7.5 acres
Pine Brook, 45,000 sq. ft. within Leased Motion Control New Jersey a business complex
Neuhausen am, 40,100 sq. ft. within Leased Motion Control Rheinfall a business complex Switzerland
York, 32,396 sq. ft. Owned Metal Treatment Pennsylvania on 3.6 acres
Brea, California 30,550 sq. ft. Leased Flow Control on 1.76 acres
Brantford, 21,000 sq. ft Owned Flow Control Ontario, Canada on 8.13 acres
(1) Sizes are approximate. Unless otherwise indicated, all properties are owned in fee, are not subject to any major encumbrance and are occupied primarily by factory and/or warehouse buildings.
(2) The Suffolk County Industrial Development Agency in connection with the issuance of an industrial revenue bond holds title to approximately six acres of land and the building located thereon.
In addition to the properties listed above, the Corporation leases an aggregate of approximately 360,000 square feet of space at twenty-two different locations in the United States and England and owns buildings encompassing about 371,704 square feet in seventeen different locations in the United States, France, Germany, Belgium and England. None of these properties individually is material to the Company's business. It also leases approximately 8,000 square feet of space in Karup, Denmark, for Motion Control; 2,000 square feet of space in Suwanee, Georgia, for Flow Control; 1,150 square feet of space in Singapore for Motion Control; and 600 square feet of warehouse and office space in Edmonton, Alberta, Canada, for Flow Control.
The Corporation also owns a multi-tenant industrial rental facility located in Wood-Ridge, New Jersey encompassing 2,322,000 square feet on 144 acres. The former manufacturing facility has approximately 2,264,000 square feet leased to other parties with the remaining 58,000 square feet vacant and available for lease. Additionally, Curtiss-Wright leases approximately 14,000 square feet of office space in Lyndhurst, New Jersey, for its corporate office.
The buildings on the properties referred to in this Item are well maintained, in good condition, and are suitable and adequate for the uses presently being made of them.
The following tracts of property, owned by the Registrant, are not attributable to a particular Segment and are being held for sale: Hardwick Township, New Jersey (the "Hardwick Property"), 21 acres; Fairfield, New Jersey, 39.8 acres (the "Fairfield Property"); and Perico Island, Florida, 112 acres, the bulk of which is below water (the "Perico Island Property"). In June 1999, the Company entered into a contract to sell the Perico Island Property. The contract is contingent on the purchaser obtaining necessary governmental approvals. The purchaser has until May 18, 2000 to obtain the necessary approvals. The Company is also currently engaged in negotiations to sell the Hardwick Property and the Fairfield Property. The Corporation also owns approximately 7.4 acres of land in Lyndhurst, New Jersey, which is leased, on a long-term basis, to the owner of the commercial building located on the land.
Item 3.
Item 3. Legal Proceedings. - --------------------------------
In the ordinary course of business, the Corporation and its subsidiaries are subject to various pending claims, lawsuits and contingent liabilities. The Corporation does not believe that disposition of any of these matters will have a material adverse effect on the Corporation's consolidated financial position or results of operations.
In December 1999, the Corporation entered into a settlement agreement with the Borough of Wood-Ridge (the "Borough"), resolving a long standing tax appeal challenging the accuracy of the Borough's property value assessments for tax years 1994 through 1999 on the Corporation's industrial rental facility referred to above. Under the terms of the settlement, the assessments for the years in question were reduced and the Corporation received a refund for taxes paid in excess of those reduced assessments. A significant portion of the tax refund was passed through to the tenants of the complex. See the information contained in the Registrant's Annual Report on page 17 under the caption "Other Revenues" in the Management's Discussion and Analysis of Financial Condition and Results of Operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders. - --------------------------------------------------------------------------
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Stock And Related Stockholder Matters. - ----------------------------------------------------------
See the information contained in the Registrant's Annual Report on the inside back cover under the captions "Common Stock Price Range," "Dividends," and "Stock Exchange Listing" which information is incorporated herein by reference. The approximate number of record holders of the Common Stock, $1.00 par value, of Registrant was 3,822 as of March 1, 2000.
Item 6.
Item 6. Selected Financial Data. - --------------------------------------- See the information contained in the Registrant's Annual Report on page 14 under the caption "Consolidated Selected Financial Data," which information is incorporated herein by reference.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. - ---------------------------------------------------------- See the information contained in the Registrant's Annual Report at pages 15 through 17, under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," which information is incorporated herein by reference.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk. - -------------------------------------------------------------------- The Corporation is exposed to certain market risks from changes in interest rates and foreign currency exchange rates as a result of its global operating and financing activities. However, the Corporation seeks to minimize the risks from these interest rate and foreign currency exchange rate fluctuations through its normal operating and financing activities and, when deemed appropriate, through the use of derivative financial instruments. The Corporation did not use such instruments for trading or other speculative purposes and did not use leveraged derivative financial instruments during the year ended December 31, 1999. Information regarding the Corporation's accounting policy on financial instruments is contained in Note 1.G to the Consolidated Financial Statements on page 24 of the Annual Report, which is incorporated by reference in this Form 10-K Annual Report.
The Corporation's market risk for a change in interest rates relates primarily to the debt obligations. Approximately 49% of the Corporation's debt at December 31, 1999 and 46% of the December 31, 1998 debt is comprised of Industrial Revenue Bond financing. As described in Note 8 to the Consolidated Financial Statements on page 29 of the Annual Report, which is incorporated by reference in this Form 10-K Annual Report, the Corporation borrowed variable rate debt under its short-term credit agreement and revolving credit agreement aggregating 31,000,000 Swiss Francs arising out of the December 31, 1998 purchase of SIG Antriebstechnik AG to mitigate its currency exposure.
Financial instruments expose the Corporation to counter-party credit risk for nonperformance and to market risk for changes in interest and currency rates. The Corporation manages exposure to counter-party credit risk through specific minimum credit standards, diversification of counter-parties and procedures to monitor concentrations of credit risk. The Corporation monitors the impact of market risk on the fair value and cash flows of its investments by considering reasonably possible changes in interest rates and by limiting the amount of potential interest and currency rate exposures to amounts that are not material to the Corporation's consolidated results of operations and cash flows
Item 8.
Item 8. Financial Statements and Supplementary Data. - ------------------------------------------------------------------ The following Consolidated Financial Statements of the Registrant and its subsidiaries, and supplementary financial information, are included in the Registrant's Annual Report, which information is incorporated herein by reference.
Consolidated Statements of Earnings for the years ended December 31, 1999, 1998 and 1997, page 19.
Consolidated Balance Sheets at December 31, 1999 and 1998, page 20.
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997, page 21.
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997, page 22.
Notes to Consolidated Financial Statements, pages 23 through 35, inclusive, and Quarterly Results of Operations on page 14.
Report of Independent Accountants for the three years ended December 31, 1999, 1998 and 1997, page 18.
Item 9.
Item 9. Changes in and Disagreements with Accountants On Accounting and Financial Disclosure. - --------------------------------------------------------------------- Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers Of the Registrant. - ---------------------------------------------------- Information required in connection with directors and executive officers is set forth below, as well as under the caption "Election of Directors," in the Registrant's Proxy Statement with respect to the Corporation's 2000 Annual Meeting of Stockholders (the "Proxy Statement"), which information is incorporated herein by reference.
Executive Officers of the Registrant ------------------------------------- The following table sets forth the names, ages, and principal occupations and employment of all executive officers of Registrant. The period of service is for at least the past five years and such occupations and employment are with Curtiss-Wright Corporation, except as otherwise indicated:
Principal Occupation Name and Employment Age
David Lasky Chairman (since May 1995); 67 formerly President from 1993 to April 1999(1)
Martin R. Benante President and Chief Operating 47 Officer since April 1999; formerly Vice President of the Corporation from April 1996 to April 1999; President of Curtiss-Wright Flow Control Corporation, a wholly-owned Subsidiary from March 1995 to April 1999
Gerald Nachman Executive Vice President; 70 President of Metal Improvement Company, Inc., a wholly owned subsidiary, since May 1970
Principal Occupation Name and Employment Age
George J. Yohrling Vice President of Curtiss-Wright Corporation; 59 President, Curtiss-Wright Flight Systems, Inc., a wholly-owned subsidiary, since April 1998; Executive Vice President for Aerospace Operations of Curtiss-Wright Flight Systems, Inc. from April 1997 to April 1998, Senior Vice President from July 1996 to April 1997 of Curtiss-Wright Flight Systems, Inc.; previously Vice President and General Manager of Curtiss-Wright Flight Systems/Shelby, Inc., then a wholly-owned subsidiary.
Robert A. Bosi Vice President-Finance since January 1993 44
Brian D. O'Neill Secretary, General Counsel since April 1999; 50 formerly Assistant General Counsel from December 1997 until April 1999; formerly Staff Attorney and Associate General Counsel from December 1980 to December 1997
Gary J. Benschip Treasurer since February 1993 52
Kenneth P. Slezak (2) Controller since 1991 48
The executive officers of the Registrant are elected annually by the Board of Directors at its organization meeting in April and hold office until the organization meeting in the next subsequent year and until their respective successors are chosen and qualified.
There are no family relationships among these officers, or between any of them and any director of Curtiss-Wright Corporation, nor any arrangements or understandings between any officer and any other person pursuant to which the officer was elected.
- ----------------------------------------------------------------------- (1) On February 3, 2000, Mr. Lasky announced his retirement following the Corporation's Annual Meeting of Stockholders to be held on April 2000.
(2) Mr. Slezak resigned from his position with the Corporation effective February 22, 2000.
Section 16(a) Beneficial Ownership Reporting Compliance ---------------------------------------------------------------------- Information required by Item 405 of Regulation S-K is set forth in the Proxy Statement under the heading "Section 16(a) Beneficial Ownership Reporting Compliance," which information is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation. - ------------------------------------------ Information required by this Item is included under the captions "Executive Compensation" and in the "Summary Compensation Table" in the Registrant's Proxy Statement, which information is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------------------------------------------------------------- See the following portions of the Registrant's Proxy Statement, all of which information is incorporated herein by reference: (i) the material under the caption "Security Ownership and Transactions with Certain Beneficial Owners" and (ii) the material included under the caption "Election of Directors."
Item 13.
Item 13. Certain Relationships and Related Transactions. - --------------------------------------------------------------------- Information required by this Item is included under the captions "Executive Compensation" and "Security Ownership and Transactions with Certain Beneficial Owners" in the Registrant's Proxy Statement, which information is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - ---------------------------------------------------- (a)(1) Financial Statements:
The following Consolidated Financial Statements of Registrant and supplementary financial information, included in Registrant's Annual Report, are incorporated herein by reference in Item 8:
(i) Consolidated Statements of Earnings for the years ended December 31, 1999, 1998 and 1997
(ii) Consolidated Balance Sheets at December 31, 1999 and 1998
(iii) Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997
(iv) Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997
(v) Notes to Consolidated Financial Statements
(vi) Report of Independent Accountants for the years ended December 31, 1999, 1998 and 1997
(a)(2) Financial Statement Schedules:
The items listed below are presented herein on pages 22 and 23 of this Form 10-K.
Report of Independent Accountants on Financial Statement Schedule
Schedule II - Valuation and Qualifying Accounts
Schedules other than those listed above have been omitted since they are not required, are not applicable, or because the required information is included in the financial statements or notes thereto.
(a)(3) Exhibits:
(2) Plan of acquisition, reorganization, arrangement, liquidation, or succession
(2)(i) Asset Purchase and Sale Agreement dated July 23, 1999 between Teledyne Industries, Inc., Teledyne Industries Canada Limited and Curtiss-Wright Corporation (incorporated by reference to Exhibit 2.1 to Registrant's Current Report on Form 8-K, filed September 15, 1999).
(3) Articles of Incorporation and By-laws of the Registrant
(3)(i) Restated Certificate of Incorporation as amended May 8, 1987 (incorporated by reference to Exhibit 3(a) to Registrant's Form 10-Q Report for the quarter ended June 30, 1987). Restated Certificate of Incorporation as amended through April 18, 1997 (incorporated by reference to Exhibit 3(i) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997).
(3)(ii) By-laws as amended through April 30, 1999, filed herewith.
(4) Instruments defining the rights of security holders, including indentures
(4)(i) Agreement to furnish to the Commission upon request, a copy of any long term debt instrument where the amount of the securities authorized thereunder does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis (incorporated by reference to Exhibit 4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985).
(4)(ii) Revolving Credit Agreement dated December 20, 1999 between Registrant, the Lenders parties thereto from time to time, the Issuing Banks referred to therein and Mellon Bank, N.A., filed herewith.
(4)(iii) Short-Term Credit Agreement dated as of December 20, 1999 between Registrant, the Lender Parties and Mellon Bank, N.A., as Agent, filed herewith.
(10) Material Contracts:
(i) Modified Incentive Compensation Plan, as amended November 9, 1989 (incorporated by reference to Exhibit 10(a) to Registrant's Form 10-Q Report for the quarter ended September 30, 1989).*
(ii) Curtiss-Wright Corporation 1995 Long-Term Incentive Plan (incorporated by reference to Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 95602114 filed December 15, 1995).*
(iii) Standard Severance Agreement with Officers of Curtiss-Wright (incorporated by reference to Exhibit 10(iv) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991).*
(iv) Retirement Benefits Restoration Plan as amended April 15, 1997 (incorporated by reference to Exhibit 10 to Registrant's Form 10-Q Report for the quarter ended June 30, 1997).*
(v) Curtiss-Wright Corporation Retirement Plan as amended through August 1, 1997 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997); Fourth Amendment to the Curtiss-Wright Corporation Retirement Plan dated October 20, 1997 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997); Fifth Amendment to the Curtiss-Wright Corporation Retirement Plan dated January 1, 1998 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997); Amendments to Curtiss-Wright Retirement Plan dated April 1, 1998, April 20, 1998, April 30, 1998 and June 30, 1998 (incorporated by reference to Exhibit a(ii) to Registrant's Quarterly Report for the quarter ended June 30, 1998).*
(vi) Curtiss-Wright Corporation Savings and Investment Plan dated March 1, 1995 (incorporated by reference to Exhibit (10)(vii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1994).*
(vii) Curtiss-Wright Corporation 1996 Stock Plan for Non-Employee Directors (incorporated by reference to Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 96583181, filed June 19, 1996).*
(viii)Curtiss-Wright Corporation Executive Deferred Compensation Plan effective November 18, 1997 (incorporated by reference to Exhibit (10)(viii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997).*
(ix) Standard Severance Protection Agreement dated June 19, 1998 between the Registrant and Officers of the Registrant (incorporated by reference to Exhibit A(i) to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1998).*
(x) Trust Agreement dated January 20, 1998 by and between Curtiss-Wright Corporation and PNC Bank, National Association (incorporated by reference to Exhibit 10(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998).*
(13) Annual Report to Stockholders for the year ended December 31,
(21) Subsidiaries of the Registrant
(23) Consents of Experts and Counsel - see Consent of Independent Accountants
(27) Financial Data Schedule - ----------- *Management contract or compensatory plan or arrangement
(b) Reports on Form 8-K
No report on Form 8-K was filed during the three months ended December 31, 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CURTISS-WRIGHT CORPORATION (Registrant)
By: /s/ David Lasky --------------------- David Lasky Chairman and CEO
Date: March 20, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Date: March 20, 2000 By: /s/ Robert A. Bosi --------------------- Robert A. Bosi Vice President - Finance
Date: March 20, 2000 By: /s/ Gary R. Struening ------------------------ Gary R. Struening Assistant Controller
Date: March 20, 2000 By: /s/ Martin R. Benante ------------------------- Martin R. Benante Director
Date: March 20, 2000 By: /s/ Thomas R. Berner ------------------------ Thomas R. Berner Director
Date: March 20, 2000 By: /s/ James B.Busey ------------------------ James B. Busey IV Director
Date: March 20, 2000 By: /s/ David Lasky ------------------------ David Lasky Director
Date: March 20, 2000 By: /s/ William B. Mitchell ------------------------- William B. Mitchell Director
Date: March 20, 2000 By: /s/ John R. Myers ------------------------- John R. Myers Director
Date: March 20, 2000 By: /s/ William W. Sihler ------------------------- William W. Sihler Director
Date: March 20, 1999 By: /s/ J. McLain Stewart -------------------------- J. McLain Stewart Director
PRICEWATERHOUSECOOPERS LLP [LOGO]
PricewaterhouseCoopers LLP 400 Campus Drive P.O. Box 988 Florham Park, NJ 07932 Telephone (973) 236 4000 Facsimile (973) 236 5000
REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
To the Board of Directors of Curtiss-Wright Corporation:
Our audits of the consolidated financial statements referred to in our report dated January 31, 2000 in the 1999 Annual Report to Shareholders of Curtiss-Wright Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/PricewaterhouseCoopers LLP PRICEWATERHOUSECOOPERS LLP Florham Park, New Jersey January 31, 2000
EXHIBIT INDEX
The following is an index of the exhibits included in this report or incorporated herein by reference.
Exhibit Name Page No.
(3)(i) Restated Certificate of Incorporation as amended May 8, 1987 * (incorporated by reference to Exhibit 3(a) to Registrant's Form 10-Q Report for the quarter ended June 30, 1987). Restated Certificate of Incorporation as amended through April 18, 1997 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997).
(3)(ii) By-laws as amended through April 30, 1999, filed herewith.
(4)(i) Agreement to furnish to the Commission upon request, a copy * of any long term debt instrument where the amount of the securities authorized thereunder does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis (incorporated by reference to Exhibit 4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985).
(4)(ii) Revolving Credit Agreement dated December 20, 1999 between Registrant, the Lenders parties thereto from time to time, the Issuing Banks referred to therein and Mellon Bank, N.A., filed herewith.
(4)(iii) Short-Term Credit Agreement dated as of December 20, 1999 Registrant, the Lenders parties thereto from time to time, the Issuing Banks referred to therein and Mellon Bank, N.A., filed herewith.
10(i)** Modified Incentive Compensation Plan, as amended November * 9, 1989 (incorporated by reference to Exhibit 10(a) to Registrant's Form 10-Q Report for the quarter ended September 30, 1989).
(10)(ii)** Curtiss-Wright Corporation 1995 Long-Term Incentive Plan * (incorporated by * reference to Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 95602114 filed December 15, 1995).
(10)(iii)** Standard Severance Agreement with Officers of Curtiss-Wright * (incorporated by reference to Exhibit 10(iv) to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1991).
(10)(iv)** Curtiss-Wright Corporation Retirement Benefits Restoration * Plan as amended April 15, 1997 (incorporated by reference to Exhibit 10 to Registrant's Report on Form 10-Q Report for the quarter ended June 30, 1997).
(10)(v)** Curtiss-Wright Corporation Retirement Plan as amended through * August 1, 1997(incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997); Fourth Amendment to the Curtiss-Wright Corporation Retirement Plan dated October 20, 1997 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1997); Fifth Amendment to the Curtiss-Wright Corporation Retirement Plan dated January 1, 1998 (incorporated by reference to Registrant's Annua Report on Form 10-K for the year ended December 31, 1997); Amendments to Curtiss-Wright Retirement Plan dated April 1, 1998, April 20, 1998, April 30, 1998 and June 30, 1998 (incorporated by reference to Exhibit a(ii) to Registrant's Quarterly Report for the quarter ended June 30, 1998).
(10)(vi)** Amended Curtiss-Wright Corporation Savings and Investment * Plan dated March 1, 1995 (incorporated by reference to Exhibit (10)(vii) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994).
(10)(vii)** Curtiss-Wright Corporation 1996 Stock Plan for Non-Employee * Directors (incorporated by reference to Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 96583181 filed June 19, 1996).
(10)(viii)**Curtiss-Wright Corporation Executive Deferred Compensation * Plan effective November 18, 1997 (incorporated by reference to Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 96583181, filed June 19, 1996).
(10)(ix)** Standard Severance Protection Agreement dated June 19, 1998 * between the Registrant and Officers of the Registrant (incorporated by reference to Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 96583181, filed June 19, 1996).
(10)(x)** Trust Agreement approved April 17, 1998 dated as of January * 30, 1998 by and between Registrant and PNC Bank, National Association (incorporated by reference to Exhibit 10(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998).
(13) Annual Report to Stockholders for the year ended December 31, 1999 (only those portions expressly incorporated herein by reference in this document are deemed "filed.")
(21) Subsidiaries of the Registrant
(23) Consents of Experts and Counsel - see Consent of Independent Accountants
(27) Financial Data Schedule - --------------------------
* Incorporated by reference as noted. ** Management contract or compensatory plan or arrangement. | 6,315 | 43,286 |
912027_1999.txt | 912027_1999 | 1999 | 912027 | Item 1 of this Report. These securities were exempt from registration with the Securities and Exchange Commission pursuant to Section 4(2) of the Securities Act of 1933 as amended.
In December 1999, the Company agreed to issue 4,633,922 shares of common stock in connection with a settlement with the manufacturer of its Top Eliminator(R) attraction relating to past and future orders of the attraction. These shares were issued in February 2000 and were exempt from registration with the Securities and Exchange Commission pursuant to Section 4(2) of the Securities Act of 1933 as amended.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item will be set forth under the caption "Certain Relationships and Related Transactions" in the Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Form 10-K:
1. Financial Statements: The list of financial statements required by this item is set forth in Item 8 | 172 | 1,083 |
1057507_1999.txt | 1057507_1999 | 1999 | 1057507 | ITEM 1. BUSINESS
I. GENERAL
ResortQuest is the first company to offer vacation condominium and home rentals, sales and property management services under a national brand name and is a leading provider of vacation rentals in premier destination resorts throughout the United States and in Canada. Through the consolidation of leading vacation rental and property management companies, the development of a national brand and marketing initiative and best practices management systems, we offer vacationers a branded network of high quality, fully furnished, privately-owned condominium and home rentals. In addition, we provide property owners with superior management services by combining local management expertise with the marketing power and resources of a leading brand, which work to enhance a property's value and marketability.
We commenced operations on May 26, 1998, concurrent with our initial public offering and the acquisition of 12 leading vacation rental and property management companies and the industry's leading management software company (collectively, the "Founding Companies"). Since that time, we have completed 18 additional vacation rental and property management acquisitions, five in 1998 and 13 in 1999 (together with the Founding Companies, the "Operating Companies"). Our 1999 acquisitions added more than 4,000 rental units to our portfolio of vacation rental condominiums and homes and introduced the ResortQuest brand to several new markets, including Orlando, Florida, the number one tourist destination in the world. We currently manage approximately 17,000 condominiums and homes in 40 premier destination resort locations throughout the United States and in Canada.
Most vacationers seeking to rent a condominium or home at a popular destination resort typically have relied on local vacation rental and property management firms to inquire about availability and make reservations. Vacationers made rental choices with limited information and, as a result, faced great uncertainty concerning the quality of their rental. To address this need, we established the ResortQuest brand to provide vacationers with access to quality condominium and home rentals intended to consistently meet their expectations. The ResortQuest brand is designed to ensure that a vacation rental meets customer expectations by providing a standardized, basic level of products and services throughout our extensive national network of quality condominiums and homes in premier destination resorts and by consistently categorizing accommodations based on quality, appearance and features.
We also offer vacationers a single source from which they can easily access information about and make reservations for our condominium and home rentals. RESORTQUEST.COM, one of the most comprehensive web sites in the vacation industry, enables vacationers to search through all of our vacation home and condominium rentals, view extensive information about each rental property, including photographs and floor plans, take virtual tours of our condominium and home rental units and popular attractions in all of our resort locations, check availability and rental rates and make real-time reservations directly on line. Pursuant to our recent strategic alliance with Target Travel, visitors to RESORTQUEST.COM also can complete their travel itineraries by pairing our rental accommodations with Target Travel's competitively priced airline and car
rental reservations. In addition, for customers interested in buying or selling a vacation home, RESORTQUEST.COM provides multiple location real estate listings for homes and condominiums located in 24 of our resort locations. Vacationers also have the option of obtaining information from and making reservations through our 24-hour toll-free reservations line, which is staffed by agents who are familiar with our managed condominiums and homes.
Our primary source of revenue is property rental fees, which are charged to the property owners as a percentage of the vacationer's total rental rate. Fee percentages for condominiums and homes range from approximately 3% to over 40% of rental rates depending on:
- the market;
- the type of services provided to the property owner;
- the type of rental unit managed; and
- which party bears responsibility for certain operating expenses.
For the year ended December 31, 1999, we generated total revenues of approximately $127.9 million, which includes $65.8 million of revenues from property management fees, and net income of $4.4 million. We believe that our national brand and superior management services, which are designed to enhance rental income for property owners, will provide us with a competitive advantage in attracting additional high quality condominiums and homes in our markets.
A. Industry Overview
The United States is the largest market in the world for the travel and tourism business, representing an estimated 20% of total worldwide travel and tourism expenditures. From 1987 to 1997, the U.S. market consistently grew at a compounded annual rate of 6.1%. In 1997, expenditures for tourism in the United States reached approximately $482 billion, or approximately 6% of 1997's gross domestic product, making the U.S. travel and tourism industry one of the largest sectors in the U.S. economy. Expenditures for tourism are expected to continue to increase and reach $594 billion by 2001.
The travel and tourism industry can be segmented into a number of categories depending on the purpose of travel. The two primary categories are business travel, including both personal and work related, and pleasure travel. According to the Department of Transportation's 1995 American Travel Survey, pleasure travel represented 63% of total trips taken by Americans. We focus on a subsegment of the pleasure travel area, specifically the leisure segment. The leisure segment represents all trips taken for vacation purposes other than those trips to visit family or friends. Within the leisure segment, the total market for vacation condominium, home and apartment rentals, which are marketed predominantly by vacation rental and property management companies, was over $10 billion in 1996, representing over 20 million vacation property rentals. Rental revenues grew 8.7% from 1995 to 1996, and we believe that this growth has been, and will continue to be, driven by two primary factors: the overall growth in the leisure travel and tourism industry, which reflected a 16.1% increase in revenues from 1995 to 1997, and the increasing number of vacationers seeking to rent vacation condominiums and homes. We believe this data reflects the most recently available industry information.
Destination resort vacationers primarily have three alternatives for overnight accommodations: commercial lodging establishments, timeshare resorts and privately-owned vacation condominiums and homes. For many vacationers, particularly those with families, a lengthy stay at a quality commercial lodging establishment can be expensive. Vacation condominium and home rentals generally offer families greater space and convenience than a resort hotel room, including separate living, sleeping and eating quarters. As a result, families generally have more privacy and greater flexibility in a vacation condominium or home. Furthermore, by utilizing the full kitchens available in most properties, vacationers can also save on dining costs in a vacation condominium or home rental. In addition, vacation condominium and home rentals frequently include access to private yards, swimming pools, tennis courts and other recreational facilities, and generally offer a greater variety of locations, accommodations and price ranges within a market to meet a vacationer's desires.
Vacation property rentals are also a less expensive and more flexible alternative to timeshare interests. Unlike vacation property rentals, timeshare interests require the purchase of an ownership interest in a vacation residence and continuing annual maintenance payments. A timeshare owner has the right to use the same vacation residence for the same length of time each year. Subject to availability and the payment of a membership fee and a variable exchange fee to join a timeshare exchange program, a timeshare owner may request that his timeshare interval be exchanged for a timeshare interval at another participating resort. Owners are generally limited to timeshare intervals at participating resorts and to those units which have been assigned an equal or lower rating by the exchange program based on the location, size and quality of the unit, the quality of the resort and the time of year requested.
Most vacation condominiums and homes are second homes with absentee owners who are unable to manage the rental process easily. Vacation rental and property management companies facilitate the rental process by handling all interactions with vacationers, including:
- accepting reservations;
- collecting rental payments, security deposits and other fees;
- operating check-in and check-out locations; and
- arranging for inspections, security and maintenance.
The publishing of catalogs, print advertising and other marketing activities of a successful vacation rental and property management company also can enhance the vacation condominium or home's occupancy rate and increase rental income to the property owner.
The vacation rental and property management industry is highly fragmented, with an estimated 3,000 vacation rental and property management companies in the United States. Most vacation rental condominiums and homes are managed by and booked through local vacation rental and property management firms, whose principal means of attracting property owners and vacationers are by referral, word of mouth, limited local advertising and direct mailings. Before ResortQuest, there was no central reservations service for vacationers or travel agents to obtain information regarding most condominium or home rental opportunities at popular destination resorts nationwide or for booking such rentals once a destination was selected. We believe the vacation rental and property management industry remains highly inefficient and presents a significant market opportunity for a well-capitalized company offering a national, branded
network of high-quality vacation condominiums and homes with superior levels of customer service.
B. Business Strategy
Our objective is to enhance our position as a leading provider of premier condominium and home rentals in destination resorts by pursuing the following elements of our business strategy:
CONTINUE TO BUILD THE RESORTQUEST BRAND. Prior to ResortQuest, there was no national brand for vacation condominium and home rentals, no industry standards for quality and a general lack of access to reliable information regarding rental opportunities for vacationers. We have increased the information available to vacationers, established the only national brand in the fragmented vacation rental industry and continue to provide vacationers with high quality condominium and home rentals. The ResortQuest brand is designed to ensure that a vacation rental meets customer expectations by providing a basic, standardized level of products and services and by consistently categorizing accommodations based on quality, appearance and amenities.
CAPITALIZE ON TECHNOLOGY. We believe that our investment in technology, especially that related to the Internet, will create a significant competitive advantage and be critical in building our national brand, increasing revenue, reducing costs and managing vacationer, owner, employee and investor expectations. Our commitment to technology is evidenced by (1) RESORTQUEST.COM, our comprehensive web site which enables consumers to search through our vacation rentals, to take virtual tours of rental properties and popular attractions at our resort locations, to check availability and to make vacation property, airline and car rental reservations on-line, and (2) First Resort Software, which is a leading provider of integrated software for the vacation rental and property management industry. We plan to use First Resort Software to link our existing and future acquired companies' property management databases in order to enhance our cross-selling and direct marketing efforts. We also intend to develop proprietary data mining tools to enhance our cross-selling and direct marketing efforts.
OFFER VACATIONERS SUPERIOR CUSTOMER SERVICE. We believe that maintaining superior levels of customer service is critical to maintaining a reputation for high quality condominiums and homes and for attracting new customers. Vacationers typically rent vacation condominiums and homes for greater space and flexibility, but these customers also frequently desire many of the amenities and services of hotel accommodations. As a result, we require each Operating Company to deliver a standardized, basic level of amenities and services designed to enhance the vacationer's overall experience. We have established a detailed listing of basic standards relating to conveniently located check-in and check-out locations, efficient check-in and check-out procedures, extended front desk hours, cleanliness of units and access to emergency contact and maintenance personnel. We also strive to offer maximum flexibility to meet the varied needs of our vacationers and in most markets can arrange for services such as golf tee times, bicycle rentals, ski lift tickets, grocery delivery or restaurant reservations. By offering the convenience and accommodations of a condominium or home while providing many of the amenities and services of a hotel, we believe we will continue to strengthen the loyalty of our existing customers and attract new vacationers into the vacation condominium and home rental market.
ENHANCE VALUE FOR PROPERTY OWNERS. We provide property owners with superior management services by combining local management expertise with the marketing power and resources of a leading brand, which work to increase rental income through increased occupancy and rental rates. Since substantially all of the condominiums and homes managed by us are second homes with absentee owners, we offer a range of high quality vacation rental and property management services designed to meet the broad real estate needs of these owners. In most markets, we will assume broad responsibility for the condominium or home, from marketing and coordinating all aspects of renting the individual condominium or home to managing common areas and homeowners' associations. In addition, we provide owners with concise, timely and accurate monthly statements and payments for the rental and management of their condominiums and homes. We believe that our reputation for high quality, comprehensive management services will be a key competitive advantage in increasing the number of condominiums and homes under our management within our existing markets.
CAPITALIZE ON THE EXPERIENCE OF SENIOR MANAGEMENT. Our senior management team has the breadth of experience necessary to execute our business plan effectively.
- DAVID L. LEVINE, President and Chief Executive Officer, is the former President and Chief Operating Officer of Equity Inns, Inc., a leading real estate investment trust specializing in hotel acquisitions. Concurrently he served as President and Chief Operations Officer of Trust Management, Inc. which operated Equity Inns properties.
- JAMES S. OLIN, Chief Operations Officer, is the former President of Abbott Resorts, our largest Operating Company, and Vice President for ResortQuest's Gulf Coast Region. He has over 12 years of experience in the travel and tourism industry.
- J. MITCHELL COLLINS, Senior Vice President and Chief Financial Officer, is a former senior manager with Arthur Andersen LLP and was head of real estate and hospitality services for Andersen's Mid-South practice. He has over a decade of financial consulting experience with significant experience with mergers and acquisitions and special expertise in the integration of multiple reporting functions for large hospitality companies.
- FREDERICK L. FARMER, Senior Vice President and Chief Information Officer, has more than 20 years of experience working for Fortune 500 companies. Mr. Farmer most recently spent 12 years with Marriott International as Senior Vice President, Internet and Desktop Services and was responsible for positioning Marriott for Internet commerce.
- PAUL N. MANTERIS, Senior Vice President, Homeowner Relations/Operations, is the former Manager of Training and Special Projects for Premier Resorts, Inc., a hospitality management company operating primarily in the Western United States and Hawaii. He has over 21 years of experience in the hospitality industry.
- W. MICHAEL MURPHY, Senior Vice President and Chief Development Officer, leads our mergers and acquisitions effort. Mr. Murphy has been involved with real estate acquisition businesses and the hospitality industry for more than 25 years.
LEVERAGE LOCAL RELATIONSHIPS AND EXPERTISE. Our local management teams have extensive experience in their respective resort areas, and many of the individuals are very active in their
local communities. The management teams have a valuable understanding of their respective markets and businesses and have developed strong local relationships. These relationships are critical in attracting additional condominiums and homes for rental and enable us to provide additional concierge-type services to our vacationers. Accordingly, our decentralized management strategy is designed to allow local managers to utilize their knowledge and expertise about the condominiums and homes available for rent, the offerings of local competitors and the desires of vacationers in their areas to provide superior customer service to both property owners and vacationers.
C. Growth Strategy
We believe we can enhance our position as a leading provider of vacation condominium and home rentals in premier destination resorts by growing both internally and by selectively pricing strategic acquisitions.
1. Internal Growth
The primary elements of our internal growth strategy include:
FULLY IMPLEMENT OUR NATIONAL MARKETING STRATEGY. We have implemented a multi-faceted national marketing program designed to increase vacationer awareness of the ResortQuest brand, while promoting the unique characteristics of our individual resorts. This comprehensive marketing program targets consumers and the travel trade through high-profile advertising, direct mail, e-mail marketing, public relations, promotional programs and RESORTQUEST.COM. In order to maximize the online exposure of RESORTQUEST.COM and our approximately 17,000 vacation rental properties, we formed strategic alliances in 1999 with WORLDRES.COM, an online hotel distribution network for leisure travel with a proprietary network of Internet-based distribution partners, and VACATIONSPOT.COM, the vacation lodging directory for Microsoft Expedia. Vacationers have access to all of our vacation rentals through these two additional online distribution channels. Our marketing program is designed to attract new customers as well as to cross-sell additional services and locations to existing customers, thereby increasing customer loyalty by offering customers similar properties and services in our other resorts that meet the vacationer's expectations based, in part, on their previous experiences with us. We believe the integrated marketing efforts of our Operating Companies will increase customer awareness of the ResortQuest brand, lead to an increased demand for our rentals and result in higher occupancy and rental rates for our condominium and home owners. We also believe that the anticipated increase in rental income for owners will ultimately be a competitive advantage in attracting new property owners.
INCREASE MARKET SHARE WITHIN EXISTING MARKETS. A key element of our growth strategy is to increase our selection of condominiums and homes in order to expand our market share and strengthen the local brands of each of our Operating Companies. We intend to attract new property owners by achieving high occupancy rates through effective national and regional marketing, cross-selling and offering additional incentives to property owners, such as QuestClub, our travel benefits program for owners of properties we manage. In addition, in order to capture a higher portion of the rental business from new condominiums and homes being built
in our markets, we will focus on building and strengthening our relationships with both local and national resort developers as well as real estate brokerage companies.
EXPAND PROFIT MARGINS. Through the implementation of the best management practices of our Operating Companies, we believe there are numerous opportunities to improve our overall profit margins. We continue to improve the efficiency of certain basic services such as reservations, housekeeping and laundry. We also believe that larger inventories of condominiums and homes in our markets will provide certain economies of scale in advertising, check-in locations, management, housekeeping and other services. We have already achieved savings through company-wide contracts for long distance telephone service, credit card fees and insurance. We believe that enhanced efficiency and economies of scale will reduce overall operating costs and allow us to achieve increased margins by spreading operating and corporate overhead costs over a larger revenue base. In addition, several of our Operating Companies have developed unique additional revenue opportunities, such as assisting property owners in refurbishing their properties, offering trip cancellation insurance and charging fees for certain concierge-type services, several of which can be replicated by our other Operating Companies.
USE ADDITIONAL MARKETING CHANNELS. Historically, most vacationers have located vacation condominiums and homes through referrals, word-of-mouth, limited local advertising and direct mailings. We believe there are significant opportunities to expand the use of additional marketing channels. We plan to capitalize on our extensive market presence by increasing the use of other marketing channels such as the Internet, travel agents and national print media, which are difficult for local vacation rental and property management companies to use in a cost-effective manner. Given our size and presence in premier destination resorts, we believe we are an attractive partner to travel agents, tour package operators and other travel providers. These relationships should continue to be a significant source of new customers and, in particular, will be a valuable marketing channel for off-peak seasons.
2. Selectively Pursue Strategic Acquisitions
Since we commenced operations in May 1998 with the acquisition of the 13 Founding Companies, we have acquired 18 additional vacation rental and property management companies. For the foreseeable future, we intend to focus primarily on further integrating these acquisitions and implementing our internal growth strategy. We will however, selectively pursue strategic acquisitions in new markets and tuck-in acquisitions through which we can expand our selection of rental inventory in our existing markets.
We believe that we provide acquisition candidates with a number of significant benefits, including:
- affiliation with a national brand;
- the ability to cross-sell to customers of other vacation rental and property management companies within the ResortQuest network;
- the ability to increase liquidity as a result of our financial strength as a public company and access to additional sources of capital; and
- the ability to increase profitability as a result of our centralization of certain administrative functions and other economies of scale.
D. Markets
We currently manage condominiums and homes in 40 premier Hawaiian, mountain, beach and desert resorts throughout the United States and in Canada. The table below sets forth the resort locations at which we manage vacation condominium and home properties and the aggregate number of properties managed in each of the following states at December 31, 1999.
E. Services Offered
SERVICES OFFERED TO VACATIONERS. We provide services to vacationers during all stages of the rental process from the selection and reservation of a condominium or home to the vacationers' arrival and throughout their stay. To make the selection and reservation process as simple and convenient as possible, RESORTQUEST.COM, our on-line, single-source, interactive web site, provides consumers with instant access to our inventory of approximately 17,000 vacation rental properties. Vacationers can check availability and rental rates, view extensive information about each property, including photographs and floor plans, take virtual tours of our condominium and home rental units and popular attractions in all of our resort locations, obtain information about special offers and promotions and make real-time reservations directly on-line. Vacationers can customize their searches of our rental inventory based upon either type of resort destination, including beach, mountain, island and desert, or type of activity, including golf, skiing, tennis and fishing. Vacationers also can search for rental units in several different resort locations simultaneously. Pursuant to our recent strategic alliance with Target Travel, visitors to RESORTQUEST.COM also can complete their travel itineraries by pairing our accommodations with
Target Travel's competitively priced airline and car rental reservations. Since the inception of RESORTQUEST.COM, monthly user sessions and the percentage of on-line bookings have increased from 40,000 and 1.6% in January 1999 to 150,000 and 9.2% in December 1999.
In addition to on-line access to our rental properties, we also provide vacationers with catalogs containing color photographs and descriptions of available condominiums or homes in most of our resort locations. Also, vacationers may choose to make reservations through our 24-hour toll-free reservations line staffed by agents who are familiar with the specific condominiums and homes at all of our resort locations.
Because of the variety of our resort locations and the diversity of rental prices throughout our rental portfolio, we are able to target a broad range of vacationers, including families, couples and individuals. For vacationers, we offer the convenience and accommodations of a condominium or home, while providing many of the amenities and services of a hotel. Vacation condominium and home rentals generally offer greater space and convenience than resort hotel rooms, including separate living, sleeping and eating quarters. As a result, vacationers generally have more privacy and greater flexibility in a vacation condominium or home.
Upon the vacationer's arrival, we offer conveniently located check-in and check-out locations, many of which are located on-site at the front desk of our condominium properties. Off-site check-in locations are typically centrally located and easily accessible in their respective resort communities. In most destination resort communities, we maintain multiple conveniently located check-in facilities. During their stay, vacationers at most locations are offered frequent cleaning and housekeeping services and access to emergency contact and maintenance personnel. In most locations, we offer more specialized concierge services such as bicycle and ski equipment rentals, ski lift tickets sales, shuttles to ski areas, golf tee times and restaurant reservations. We typically receive a fee for providing these services.
To help ensure that vacationers' expectations are met, we implemented a comprehensive quality standard program. As part of this program, each of our Operating Companies is required to deliver a standardized, basic level of products and services that affect the overall experience of vacationers. We have established a detailed listing of standards relating to:
- the reservation, check-in and check-out processes;
- the provisions included in each rental unit;
- the services and amenities provided during the vacationer's stay;
- the maintenance of the grounds and facilities surrounding the rental unit; and
- the response of employees to problems raised by vacationers.
To promote consistency across all of our locations, we have evaluated, based on our proprietary rating criteria, substantially all of our vacation condominiums and homes and segmented them into the following five proprietary accommodation categories:
Quest Home: an exclusive group of extraordinary accommodations which are so luxurious and unique that they are in a class of their own;
Platinum: exceptional accommodations marked by unique design that offers superior quality furnishings, luxury features, designer appointments and top-of-the-line kitchens, baths and amenities;
Gold: upscale, well-appointed accommodations with a designer touch that feature excellent furnishings, special features and top-quality kitchens, baths and amenities;
Silver: inviting, pleasing accommodations that are tastefully decorated and feature quality furnishings and contemporary kitchens and baths; and
Bronze: comfortable, pleasant accommodations that provide many of the comforts and conveniences of home.
We have developed specific, detailed criteria for each of our accommodation categories, based on quality, appearance and features of the rental properties including property furnishings, soft goods, flooring, kitchen/appliances, televisions and stereos, bathrooms, decor and other features such as swimming pools and exercise facilities. Similarly, we have standardized the use of property location descriptions. We perform annual on-site reviews of each of our rental properties to update our accommodation category ratings.
SERVICES OFFERED TO CONDOMINIUM AND HOME OWNERS. We provide condominium and home owners a comprehensive set of high-quality vacation rental and property management services by combining local management expertise and attention with the marketing resources of a national brand. In most markets, we will assume complete responsibility for rental management of the condominium or home, including marketing, renting and maintaining the specific property as well as managing the common areas and homeowners' associations. We currently engage in extensive marketing activities, including our interactive web site, RESORTQUEST.COM, print advertising in high-profile national publications and e-mail marketing, as well as direct catalog mailings to prior and prospective vacationers and direct solicitations of travel agents and wholesalers. We also handle all interaction with vacationers, including accepting reservations, collecting rental payments and security deposits, operating check-in and check-out locations and offering linen, housekeeping and other services. Property owners are paid rental income each month for rental activity in the preceding month and are given a concise, timely and accurate monthly statement which details the rental activity and management of their condominiums and homes.
Property maintenance services are provided by both our employees and third party independent contractors. Services are either regularly scheduled, or provided on an "as needed" basis, depending on the service and resort location. In most markets, we perform periodic inspections and make recommendations to property owners for maintenance, refurbishments and renovations necessary to maintain the quality of their condominiums and homes. In several of our destination resort markets, we provide professional interior design and refurbishment services to property owners to assist with the upkeep and appearance of their condominiums and homes. We include routine maintenance services, such as replacing light bulbs or broken china, as part of an all-inclusive commission structure in certain locations. In other markets, we collect
fees from property owners for maintenance services through service and maintenance agreements and fees for service arrangements.
For owners desiring to sell their vacation condominium or home, we offer traditional real estate brokerage services in 24 resort locations, including listing and showing the property. Also, RESORTQUEST.COM provides multiple location real estate listings for these resort locations. We believe that providing real estate brokerage services gives us a competitive advantage in identifying and securing properties for our rental management services and allows us to meet all of the needs of vacation property owners.
Owners of condominiums and homes we manage may participate in QuestClub, our exclusive travel benefits program. QuestClub members receive a 70% savings on vacation condominium and home rentals for stays of up to 28 days each year at other QuestClub member properties. The availability of QuestClub privileges is limited during extremely popular times to preserve the revenue potential for each participating homeowner.
F. Marketing
The marketing efforts of traditional vacation rental and property management companies are primarily through word of mouth, including both vacationers and property owners, print advertising primarily in local newspapers and regional magazines and direct mail solicitations and catalogs sent to prior customers. Potential customers typically call as a result of a referral or in response to an advertisement or other promotion and are assisted by reservation agents in selecting the appropriate vacation property and making the reservation.
In addition to local and regional promotional campaigns designed to drive occupancy rates, our marketing strategy is aimed at building awareness of the ResortQuest brand name and image, cross-selling our destinations and promoting RESORTQUEST.COM. Since our initial public offering, we have developed a comprehensive, national marketing campaign targeting consumers and the travel trade through direct mail, e-mail marketing, public relations, promotional programs and high-profile print advertising in publications such as CONDE NAST TRAVELER, TRAVEL & LEISURE, SKI, GOLF MAGAZINE, SOUTHERN LIVING and SUNSET. We also market to travel agents primarily through advertisements in trade publications and attendance at national and regional travel industry trade shows. Tour package operators typically combine transportation to a destination resort with our vacation condominiums and homes and a car rental. Tour packages are distributed almost exclusively through travel agents.
We believe that our most important marketing resource is our web site, RESORTQUEST.COM. For the first time, consumers can use a single source to visit resort destinations throughout the United States and in Canada, view photographs and floor plans and make real-time reservations directly on-line. Pursuant to our alliance with Target Travel, visitors to RESORTQUEST.COM also can complete their travel itinerary by securing economical airline and car rental reservations.
According to Forrester Research, consumers are adopting online travel faster than any other retail segment of the burgeoning e-commerce field. Online travel is expected to reach nearly $3 billion in 1999, and $8.9 billion by 2002. In order to maximize the online exposure of RESORTQUEST.COM and our approximately 17,000 vacation rental properties, we formed strategic
alliances in 1999 with WORLDRES.COM, an online hotel distribution network for leisure travel with a proprietary network of Internet-based distribution partners, and VACATIONSPOT.COM, the vacation lodging directory for Microsoft Expedia. Vacationers have access to all of our vacation rentals through these two additional online distribution channels.
We believe that a national marketing campaign should increase the effectiveness of the existing Operating Companies and those to be acquired in the future, and expand the universe of potential customers for each resort location in which we operate.
We intend to capitalize on our extensive market presence and further increase our use of the Internet, travel agents and print media. We believe that our extensive selection of vacation condominiums and homes make us an attractive partner to travel agents, tour package operators and other travel providers. These relationships should continue to be a significant source of new customers and, in particular, will be a valuable marketing channel for off-peak seasons.
G. First Resort Software
First Resort Software is a leading provider of integrated management, reservations and accounting software for the vacation rental and property management industry. Twenty-five of our Operating Companies and over 600 other vacation rental and property management companies use the software programs developed by First Resort Software. These programs were developed to overcome problems encountered by rental property managers in attempting to use software programs developed for the hotel industry. The basic software developed by First Resort Software allows vacation rental and property management companies to automate and computerize their reservations, billings, rental management and accounting tasks. Vacation rental and property management companies can use the software developed by First Resort Software to enter current rates on individual condominiums and homes and access specific descriptions of those condominiums and homes for potential customers. The software also allows companies to generate monthly revenue reports for property owners and to coordinate maintenance and housekeeping schedules. First Resort Software also offers additional modules and interfaces, including a work order generator, activities management system, credit card interface and on-line booking interface through the Internet. First Resort Software is developing a JAVA Client/Server based graphical reservations application that will allow users of its software to completely integrate their reservations systems with the Internet, as well as a JAVA Client/Server based version of all of its existing software applications.
We intend to rely on the products and management expertise of First Resort Software to enhance our technology strategy. We believe that investment in technology is critical in building a national, branded vacation rental and property management company for premier destination resorts and will provide us with a significant competitive advantage in the future. The software developed by First Resort Software will allow us to quickly link our existing and future acquired companies' databases. We also intend to develop proprietary data mining tools in order to enhance our cross-selling and direct marketing efforts.
H. Year 2000 compliance
During 1999, we took steps to ensure that any significant adverse impact from the advent of year 2000 would be averted. These steps included evaluation of property management systems (guest services and back-office accounting); reservation/inventory management systems; hardware BIOS (software encoded into hardware components that runs "beneath" the operating system); analysis and/or management reporting tools; and various non-IT components' embedded control systems (HVAC, elevator controls, etc.). In addition, we developed contingency plans including items such as offsite and/or manual reservations/inventory management, property management (guest services, back-office functions, work order administration), financial accounting and reporting, and management reporting. The cost of assessment and remediation of our systems and the alternative development for contingency plans was approximately $500,000.
Upon the arrival of year 2000 we took additional steps to assess all systems and determine the actual impact of year 2000, if any. To date, we have noted no year 2000-related issues that constitute a significant adverse impact upon our systems and processes, and have discovered no issues that may be expected to have a significant adverse impact in the future.
I. Competition
The vacation rental and property management industry is highly competitive and has low barriers to entry. The industry has two distinct customer groups: vacation property renters and vacation property owners. We believe that the principal competitive factors in attracting vacation property renters are:
- market share and visibility;
- quality, cost and breadth of services and properties provided; and
- long-term customer relationships.
The principal competitive factors in attracting vacation property owners are the ability to generate higher rental income and to provide comprehensive management services at competitive prices. We compete for vacationers and property owners primarily with approximately 3,500 vacation rental and property management companies that typically operate in a limited geographic area. Some of our competitors are affiliated with the owners or operators of resorts in which such competitors provide their services. Certain of these smaller competitors may have lower overhead cost structures and may be able to provide their services at lower rates.
We also compete for vacationers with large hotel and resort companies. Many of these competitors have greater financial resources than we have, enabling them to finance acquisition and development opportunities, to pay higher prices for the same opportunities or to develop and support their own operations. In addition, many of these companies can offer vacationers services not provided by vacation rental and property management companies, and they may have greater name recognition among vacationers. These companies might be willing to sacrifice profitability to capture a greater portion of the market for vacationers or pay higher prices than we would for the same acquisition opportunities. Consequently, we may encounter significant competition in our efforts to achieve our internal and acquisition growth objectives as well as our
operating strategies focused on increasing the profitability of our existing and subsequent acquisitions.
J. Employees
As of December 31, 1999 we had approximately 3,900 total employees. We rely significantly on temporary employees to meet peak season demands. In the course of performing service and maintenance work, we also utilize the services of independent contractors. We believe our relationships with our employees and independent contractors are good.
FACTORS THAT MAY AFFECT FUTURE RESULTS
OUR DISCLOSURE AND ANALYSIS IN THIS REPORT AND IN OUR 1999 ANNUAL REPORT TO SHAREHOLDERS CONTAIN SOME FORWARD-LOOKING STATEMENTS. FORWARD-LOOKING STATEMENTS GIVE OUR CURRENT EXPECTATIONS OR FORECASTS OF FUTURE EVENTS. YOU CAN IDENTIFY THESE STATEMENTS BY THE FACT THAT THEY DO NOT RELATE STRICTLY TO HISTORICAL OR CURRENT FACTS. THEY USE WORDS SUCH AS "ANTICIPATE," "ESTIMATE," "EXPECT," "PROJECT," "INTEND," "PLAN," "BELIEVE," AND OTHER WORDS AND TERMS OF SIMILAR MEANING IN CONNECTION WITH ANY DISCUSSION OF FUTURE OPERATING OR FINANCIAL PERFORMANCE. IN PARTICULAR, THESE INCLUDE STATEMENTS RELATING TO FUTURE ACTIONS, FUTURE PERFORMANCE OR RESULTS OF CURRENT AND ANTICIPATED SERVICES, SALES EFFORTS, EXPENSES, AND FINANCIAL RESULTS. FROM TIME TO TIME, WE ALSO MAY PROVIDE ORAL OR WRITTEN FORWARD-LOOKING STATEMENTS IN OTHER MATERIALS WE RELEASE TO THE PUBLIC.
ANY OR ALL OF OUR FORWARD-LOOKING STATEMENTS IN THIS REPORT, IN THE 1999 ANNUAL REPORT AND IN ANY OTHER PUBLIC STATEMENTS WE MAKE MAY TURN OUT TO BE WRONG. THEY CAN BE AFFECTED BY INACCURATE ASSUMPTIONS WE MIGHT MAKE OR BY KNOWN OR UNKNOWN RISKS AND UNCERTAINTIES. MANY FACTORS MENTIONED IN THE DISCUSSION ABOVE WILL BE IMPORTANT IN DETERMINING FUTURE RESULTS. CONSEQUENTLY, NO FORWARD-LOOKING STATEMENT CAN BE GUARANTEED. ACTUAL FUTURE RESULTS MAY VARY MATERIALLY.
WE UNDERTAKE NO OBLIGATION TO PUBLICLY UPDATE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE. YOU ARE ADVISED, HOWEVER, TO CONSULT ANY FURTHER DISCLOSURES WE MAKE ON RELATED SUBJECTS IN OUR 10-Q, 8-K AND 10-K REPORTS TO THE SEC. ALSO NOTE THAT WE PROVIDE THE FOLLOWING CAUTIONARY DISCUSSION OF RISKS, UNCERTAINTIES AND POSSIBLY INACCURATE ASSUMPTIONS RELEVANT TO OUR BUSINESSES. THESE ARE FACTORS THAT WE THINK COULD CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM EXPECTED AND HISTORICAL RESULTS. OTHER FACTORS BESIDES THOSE LISTED HERE COULD ALSO ADVERSELY AFFECT RESORTQUEST. THIS DISCUSSION IS PROVIDED AS PERMITTED BY THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
OUR REPORTED FINANCIAL RESULTS MAY NOT BE INDICATIVE OF FUTURE PERFORMANCE BECAUSE THEY COVER A PERIOD DURING WHICH OUR OPERATING COMPANIES CONDUCTED BUSINESS AS INDEPENDENT ENTITIES.
Prior to the time we completed our acquisition of our Operating Companies, each company operated as a separate, privately-held entity. For financial reporting, we currently rely on the existing reporting systems of each of these Operating Companies. The consolidated financial information covers periods when the Operating Companies and ResortQuest were not under
common control or management. Consequently, they may not be indicative of our future financial or operating results.
WE MAY NOT BE ABLE TO INTEGRATE SUCCESSFULLY ANY FUTURE ACQUISITION.
We cannot assure you that our management group will be able to continue to manage effectively the combined entity or implement effectively our operating and growth strategies. If we are unable to integrate successfully the existing Operating Companies and any future acquisitions, it would have a material adverse effect on our business and financial results.
Our Operating Companies offer a variety of different services to property owners and vacationers, apply different sales and marketing techniques to attract new customers, use different fee structures and target different customer segments. In addition, almost all of our Operating Companies operate in different geographic markets with varying levels of competition, development plans and local market dynamics. These differences increase the risk inherent in successfully completing the integration of our Operating Companies.
WE MAY NOT BE ABLE TO COMPLETE SUCCESSFULLY OUR PLANNED EXPANSION.
We intend to continue to expand the markets we serve and increase the number of properties we manage, in part, through selective strategic acquisitions of additional vacation rental and property management companies. We cannot assure you that we will be able to identify, acquire or profitably manage additional businesses or successfully integrate acquired businesses into our existing operations without substantial costs, delays or other operational or financial problems. It is possible that competition may increase for companies we might seek to acquire. In such event, there may be fewer acquisition opportunities available to us, as well as higher acquisition prices.
Acquisitions also involve a number of special risks that could have a material adverse effect on our business and financial results. These risks include the following:
- failure of acquired companies to achieve expected financial results;
- diversion of management's attention;
- failure to retain key personnel;
- amortization of acquired intangible assets; and
- increased potential for customer dissatisfaction or performance problems at a single acquired company to affect adversely our reputation and brand name.
We may also seek international acquisitions that may be subject to additional risks associated with doing business in such countries. We continually review various strategic acquisition opportunities and have held discussions with a number of such acquisition candidates.
WE MAY NOT BE ABLE TO FINANCE FUTURE ACQUISITION.
We seek to use shares of our common stock to finance a portion of the consideration for acquisitions. If our common stock does not maintain a sufficient market value, or the owners of businesses we may seek to acquire are otherwise unwilling to accept shares of common stock as part of the consideration for the sale of their businesses, we may be required to use more of our cash resources in order to implement our acquisition strategy. If we have insufficient cash resources, our ability to pursue acquisitions could be limited unless we are able to obtain additional funds through debt or equity financing. Our ability to obtain debt financing may be constrained by existing or future loan covenants, the satisfaction of which may be dependent upon our ability to raise additional equity capital through either offerings for cash or the issuance of stock as consideration for acquisitions. We cannot assure you that our cash resources will be sufficient, or that other financing will be available on terms we find acceptable. If we are unable to obtain sufficient financing, we may be unable to implement fully our acquisition strategy.
OUR BUSINESS MAY BE NEGATIVELY AFFECTED IF WE ARE UNABLE TO MANAGE OUR GROWTH EFFECTIVELY.
We plan to continue to grow internally and through selective acquisitions. We will expend significant time and effort in expanding the existing Operating Companies and in identifying, completing and integrating selective acquisitions. We cannot assure you that our systems, procedures and controls will be adequate to support our operations as they expand. Any future growth also will impose significant added responsibilities on members of senior management, including the need to identify, recruit and integrate new managers and executives. We cannot assure you that we will be able to identify and retain such additional management. If we are unable to manage our growth efficiently and effectively, or we are unable to attract and retain additional qualified management, it could have a material adverse effect on our business and financial results.
OUR STOCK PRICE MAY BE ADVERSELY AFFECTED BY MARKET VOLATILITY.
The following factors, among others, may cause the market price of our common stock to significantly increase or decrease:
- our failure to meet financial research analysts' estimates of our earnings;
- variations in our annual or quarterly financial results or the financial results of our competitors;
- changes by financial research analysts in their estimates of our earnings;
- conditions in the general economy, or the vacation and property rental management or leisure and travel industries in particular;
- unfavorable publicity about us or our industry; and
- significant price and volume volatility in the stock market in general for reasons unrelated to us.
THE NUMBER OF SHARES AVAILABLE FOR SALE COULD CAUSE OUR STOCK PRICE TO DECLINE.
The market price of our common stock could drop as a result of the sale of substantial amounts of our common stock in the public market, or the perception that such sales could occur. We had 18,715,447 shares of our common stock outstanding as of December 31,1999. The 6,670,000 shares of our common stock sold in our initial public offering are freely tradable unless held by our affiliates. Simultaneous with the closing of the acquisition of the 13 Founding Companies, the stockholders of the 13 Founding Companies received 6,119,656 shares, and our management and founders received 3,134,630 shares. These 9,254,286 shares have not been registered under the Securities Act of 1933, and, therefore, may not be sold unless registered under the Securities Act of 1933 or sold pursuant to an exemption from registration, such as the exemption provided by Rule 144.
We have issued 2,787,725 shares in connection with the 18 acquisitions that closed since the initial public offering. All of these shares were registered under the Securities Act and 837,329 of these shares are subject to certain contractual transfer restrictions expiring between January 5, 2000 and August 6, 2000.
OUR BUSINESS AND FINANCIAL RESULTS DEPEND UPON FACTORS THAT AFFECT THE VACATION RENTAL AND PROPERTY MANAGEMENT INDUSTRY.
Our business and financial results are dependent upon various factors affecting the vacation rental and property management industry. Factors such as the following could have a negative impact on our business and financial results:
- reduction in the demand for vacation properties, particularly for beach, island and mountain resort properties;
- adverse changes in travel and vacation patterns;
- adverse changes in the tax treatment of second homes;
- a downturn in the leisure and tourism industry;
- an interruption of airline service;
- increases in gasoline or airfare prices; and
- adverse weather conditions or natural disasters, such as hurricanes, tidal waves or tornadoes.
OUR OPERATING RESULTS ARE HIGHLY SEASONAL.
Our business is highly seasonal. The financial results of each of our Operating Companies have been subject to quarterly fluctuations caused primarily by the combination of seasonal variations and when revenue is recognized in the vacation rental and property management industry. Peak seasons for our Operating Companies depend upon whether the resort is primarily a summer or winter destination. During 1999, we derived approximately 24.7% of our revenues and 45.8% of our operating income in the first quarter and 32.9% of our revenues and 86.8% of our operating income in the third quarter. Although the seasonality of our financial results may
be partially mitigated by the geographic diversity of the existing Operating Companies and any future acquisitions, we expect a significant seasonal factor with respect to our financial results to continue.
Our quarterly financial results may also be subject to fluctuations as a result of the timing and cost of acquisitions, the timing of real estate sales, changes in relationships with travel providers, extreme weather conditions or other factors affecting leisure travel and the vacation rental and property management industry. Unexpected variations in our quarterly financial results could adversely affect the price of our common stock which in turn could adversely affect our proposed acquisition strategy.
OUR BUSINESS DEPENDS UPON THE EFFORTS OF THIRD PARTIES TO MAINTAIN RESORT FACILITIES AND TO MARKET OUR HAWAIIAN PROPERTIES.
We manage properties that are generally located in destination resorts that depend upon third parties to maintain resort amenities such as golf courses and chair lifts. The failure of third parties to continue to maintain resort amenities could have a material adverse effect on the rental value of our properties and, consequently, on our business and financial results.
We also depend on travel agents, package tour providers and wholesalers for a substantial portion of our revenues. During 1999, we derived approximately 21% of our revenues from sales made through travel intermediaries. Failure of travel intermediaries to continue to recommend or package our vacation properties could result in a material adverse effect on our business and financial results.
OUR BUSINESS COULD BE HARMED IF THE MARKET FOR LEISURE AND VACATION TRAVEL DOES NOT CONTINUE TO GROW.
Although travel and tourism expenditures in the United States grew at a compounded annual rate of 6.1% between 1987 and 1997, there have been years in which spending has declined. We cannot assure you that we or the total market for vacation property rentals will continue to experience growth. Factors affecting our ability to continue to experience internal growth include our ability to:
- maintain existing relationships with property owners;
- expand the number of properties under management;
- increase rental rates and cross-sell among our Operating Companies; and
- sustain continued demand for our rental inventory.
OUR OPERATIONS ARE CONCENTRATED IN THREE GEOGRAPHIC AREAS.
We manage properties that are significantly concentrated in beach and island resorts located in Florida and Hawaii and mountain resorts located in Colorado. The following table sets forth the December 31, 1999 consolidated revenues and percentage of total revenues derived from each region (dollars in thousands).
(1) Includes revenues of First Resort Software.
Adverse events or conditions which affect these areas in particular, such as economic recession, changes in regional travel patterns, extreme weather conditions or natural disasters, would have a more significant adverse effect on our operations, than if our operations were more geographically diverse.
OUR BUSINESS DEPENDS ON ATTRACTING AND RETAINING HIGHLY CAPABLE MANAGEMENT AND EMPLOYEES.
Our business substantially depends on the efforts and relationships of David L. Levine, President and Chief Executive Officer, the other executive officers of ResortQuest and the senior management of our Operating Companies. Furthermore, we will likely be dependent on the senior management of any businesses acquired in the future. If any of these persons becomes unable or unwilling to continue in his or her role, or if we are unable to attract and retain other qualified employees, it could have a material adverse effect on our business and financial results. Although we have entered into employment agreements with each of our executive officers and the majority of the managers of our Operating Companies, we cannot assure you that any of these individuals will continue in his or her present capacity for any particular period of time.
POTENTIAL CHANGES IN REQUIRED ACCOUNTING METHODOLOGY COULD NEGATIVELY IMPACT OUR FUTURE REPORTED FINANCIAL RESULTS.
In April 1999, the Financial Accounting Standards Board preliminarily agreed to eliminate the use of the pooling-of-interests method of accounting for business combinations. Additionally, the Financial Accounting Standards Board is considering substantially reducing the amortization period for goodwill. We expect that these changes in accounting treatment will apply to any acquisition closed after January 1, 2001. The Financial Accounting Standards Board issued an Exposure Draft in September of 1999, and expects a final standard to be issued in the fourth quarter of 2000 that will likely be effective January 1, 2001. Both of these positions, when issued, could have an adverse effect on our ability to make future acquisitions and could have a material negative effect on our future financial results, which in turn could have a material adverse effect on the market price of our common stock.
THE SUBSTANTIAL AMOUNT OF GOODWILL RESULTING FROM OUR ACQUISITIONS COULD ADVERSELY AFFECT OUR FINANCIAL AND OPERATING RESULTS.
Approximately $175.2 million or 68.0% of our total assets at December 31, 1999 is net goodwill, which represents the excess of what we paid over the estimated fair market value of the net assets we acquired in business combinations accounted for as purchases. We amortize goodwill on a straight-line basis over a period of 40 years, except for First Resort Software, whose goodwill is being amortized over 15 years. The amount of goodwill amortized in a particular period constitutes a non-cash expense that reduces our net income.
Amortization of goodwill resulting from substantially all of our past acquisitions, and additional goodwill recorded in certain future acquisitions, may not be deductible for tax purposes. In addition, we periodically evaluate the recoverability of goodwill by reviewing the anticipated undiscounted future cash flows from operations and comparing such cash flows to the carrying value of the associated goodwill. If goodwill becomes impaired, we would be required to write down the carrying value of the goodwill and incur a related charge to our income. A reduction in net income resulting from a write-down of goodwill would currently affect our financial results and could have a material adverse impact upon the market price of our common stock.
IF VACATION RENTAL PROPERTY OWNERS DO NOT RENEW A SIGNIFICANT NUMBER OF PROPERTY MANAGEMENT CONTRACTS OUR BUSINESS WOULD BE ADVERSELY AFFECTED.
We provide rental and property management services to property owners pursuant to management contracts which generally have one year terms. The majority of such contracts contain automatic renewal provisions but also allow property owners to terminate the contract at any time. If property owners do not renew a significant number of management contracts or we are unable to attract additional property owners, it would have a material adverse effect on our business and financial results. In addition, although most of our contracts are exclusive, industry standards in certain geographic markets dictate that rental services be provided on a non-exclusive basis. Less than 1% of our revenues for 1999 were derived from rental services provided on a non-exclusive basis. We are unable to determine the percentage of the national rental services market that is provided on a non-exclusive basis.
IF HOMEOWNERS' ASSOCIATIONS TERMINATE MANAGEMENT AGREEMENTS, WE COULD LOSE SOME OF OUR COMPETITIVE ADVANTAGE IN THESE MARKETS.
We currently provide management services at numerous condominium developments pursuant to contracts with the homeowners' associations. We frequently provide rental management services for a significant percentage of the condominiums within these developments. Providing management services for homeowners' associations frequently leads the associations to request that we manage and control the front desk operations, laundry facilities and other related services of the condominium developments. Controlling these services often gives us a competitive advantage over other vacation rental and property management companies in retaining the condominiums we currently manage and in attracting new property owners.
We cannot assure you that a homeowners' association will not terminate its management agreement with us. If a homeowners' association terminates a management agreement, we could lose control or management of the front desk and related services in that condominium development, thereby eliminating our competitive advantage in that development. If a number of terminations occur, it could have a material adverse effect on our business and financial results.
COMPETITION COULD RENDER OUR SERVICES UNCOMPETITIVE.
The vacation rental and property management industry is highly competitive and has low barriers to entry. The industry has two distinct customer groups: vacation property renters and vacation property owners. We compete for vacationers and property owners primarily with local vacation rental and property management companies located in our markets. Some of these competitors are affiliated with the owners or operators of resorts where these competitors provide their services. Certain of these competitors may have lower cost structures and may provide their services at lower rates.
We also compete for vacationers with large hotel and resort companies. Many of these competitors are large companies that have greater financial resources than we do, enabling them to finance acquisition and development opportunities, pay higher prices for the same opportunities or develop and support their own operations. In addition, many of these companies can offer vacationers services not provided by vacation rental and property management companies, and they may have greater name recognition among vacationers. If such companies chose to compete in the vacation rental and property management industry, they would constitute formidable competition for our business. Such competition could cause us to lose management contracts, increase expenses or reduce management fees which could have a material adverse effect on our business and financial results.
EXISTING MANAGEMENT, DIRECTORS AND THEIR AFFILIATES OWN ENOUGH SHARES TO EXERCISE SUBSTANTIAL INFLUENCE OVER MATTERS REQUIRING A VOTE OF STOCKHOLDERS.
Management, directors and affiliated entities, as of January 1, 2000, owned shares of common stock representing approximately 25.0% of the total voting power of the common stock. They would own approximately 26.2% of the voting power of the common stock if all shares of voting-restricted common stock, which are entitled to one-half vote per share, were converted into unrestricted common stock. These persons, if acting together, will likely be able to exercise substantial influence over the election of the directors and the disposition of any matter submitted to a vote of stockholders.
ANY ADVERSE CHANGE IN THE REAL ESTATE MARKET COULD ADVERSELY AFFECT OUR FINANCIAL AND OPERATING RESULTS.
We derived approximately 10.4% of our consolidated revenues for 1999 from net real estate brokerage commissions. Any factors which adversely affect real estate sales, such as a downturn
in general economic conditions or changes in interest rates, the tax treatment of second homes or property values, could have a material adverse effect on our business and financial results.
WE ARE SUBJECT TO GOVERNMENTAL REGULATION OF THE VACATION RENTAL AND PROPERTY MANAGEMENT INDUSTRY.
Our operations are subject to various federal, state, local and foreign laws and regulations, including licensing requirements applicable to real estate operations and the sale of alcoholic beverages, laws and regulations relating to consumer protection and local ordinances. Many states have adopted specific laws and regulations which regulate our activities, such as:
- anti-fraud laws;
- real estate and travel services provider license requirements;
- environmental laws;
- telemarketing laws;
- labor laws; and
- the Fair Housing Act.
We believe that we are in material compliance with all federal, state, local and foreign laws and regulations to which we are currently subject. However, we cannot assure you that the cost of qualifying under applicable regulations in all jurisdictions in which we desire to conduct business will not be significant or that we are actually in compliance with all applicable federal, state, local and foreign laws and regulations. Compliance with or violation of any current or future laws or regulations could require us to make material expenditures or otherwise have a material adverse effect on our business and financial results.
TRANSACTIONS BETWEEN OUR OPERATING COMPANIES AND THEIR AFFILIATES MAY RESULT IN CONFLICTS OF INTEREST.
Several lease agreements, management contracts and other agreements with stockholders of our Operating Companies and entities controlled by them continued after the closing of the acquisitions of our Operating Companies. We have also entered into certain similar agreements that became effective upon such acquisitions. In addition, we may enter into similar agreements in the future. Other than a loan agreement with the former principal stockholder of Aston Hotels & Resorts, a Founding Company, we believe existing agreements with related persons are, and that all future agreements will be, on terms no less favorable to us than we could obtain from unrelated third parties. Conflicts of interests may arise between us and these related persons.
At December 31, 1999, the former principal stockholder of Aston owed us approximately $4.9 million, either directly or through entities controlled by him, including properties managed by Aston. The full amount is fully collateralized by certain real estate owned by the former principal stockholder.
DELAWARE LAW, OUR CHARTER DOCUMENTS AND STOCKHOLDER RIGHTS PLAN CONTAIN PROVISIONS THAT MAY HAVE AN ANTI-TAKEOVER EFFECT.
We are subject to Section 203 of the Delaware General Corporation Law, which generally prohibits us from engaging in a broad range of business combinations with an interested stockholder for a period of three years after such a person first becomes an interested stockholder. Interested stockholders include our affiliates, associates and anyone who owns 15% or more of our outstanding voting stock. The provisions of Section 203 could delay or prevent a change of control of ResortQuest.
Provisions of our certificate of incorporation could make it more difficult for a third party to acquire control of ResortQuest, even if such change in control would be beneficial to stockholders. The directors are allowed to issue preferred stock without stockholder approval. Such issuances could make it more difficult for a third party to acquire ResortQuest. Our bylaws contain provisions that may have an anti-takeover effect, such as the requirement that we must receive notice of nomination of directors not less than 60 nor more than 90 days prior to the date of the annual meeting.
On February 25, 1999, our board of directors adopted a stockholder rights plan designed to protect our stockholders in the event of takeover action that would deny them the full value of their investment. Under this plan, a dividend distribution of one right for each share of common stock was declared to holders of record at the close of business on March 15, 1999. The rights will also attach to common stock issued after March 15, 1999. The rights will become exercisable only in the event, with certain exceptions, an acquiring party accumulates 15% or more of our voting stock, or if a party announces an offer to acquire 15% or more of our voting stock. The rights will expire on March 15, 2009. Each right will entitle the holder to buy one one-hundredth of a share of a new series of preferred stock at a price of $87.00. In addition, upon the occurrence of certain events, holders of the rights will be entitled to purchase either our stock or shares in an "acquiring entity" at half of market value. We generally will be entitled to redeem the rights at $0.01 per right at any time until the date on which a 15% position in our voting stock is acquired by any person or group.
The rights plan is designed to prevent the use of coercive and/or abusive takeover techniques and to encourage any potential acquiror to negotiate directly with our board of directors for the benefit of all stockholders. In addition, the rights plan is intended to provide increased assurance that a potential acquiror would pay an appropriate control premium in connection with any acquisition of ResortQuest. Nevertheless, the rights plan could be utilized, under certain circumstances, as a method of discouraging, delaying or preventing a change of control.
ITEM 2.
ITEM 2. PROPERTIES
ResortQuest has 151 properties located in 40 cities in 17 states and provinces in the United States and Canada. These properties consist principally of offices and maintenance, laundry and storage facilities. We own 22 of these facilities and lease the remaining 129 properties. ResortQuest considers all of its owned and leased properties to be suitable and adequate for the conduct of its business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
ResortQuest is involved in various legal actions arising in the ordinary course of its business. ResortQuest does not believe that any of these actions will have a material adverse effect on its business, financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
EXECUTIVE OFFICERS OF RESORTQUEST
As of March 21, 2000, the following executive officers of ResortQuest hold the offices indicated until their successors are chosen and qualified after the next annual meeting of shareholders:
DAVID C. SULLIVAN became the Chairman of ResortQuest in December 1999. From May 1998 to December 1999, he was the Chairman and Chief Executive Officer of ResortQuest. From April 1995 to December 1997, Mr. Sullivan was the Executive Vice President and Chief Operating Officer, and a director, of Promus Hotel Corporation, a publicly traded hotel franchiser, manager and owner of hotels whose brands include Hampton Inn, Homewood Suites and Embassy Suites. From 1993 to 1995, Mr. Sullivan was the Executive Vice President and Chief Operation Officer of the Hotel Division of The Promus Companies Incorporated ("PCI"). He was the Senior Vice President of Development and Operations of the Hampton Inn/Homewood Suites Hotel Division of PCI from 1991 to 1993. From 1990 to 1991, Mr. Sullivan was the Vice President of Development of the Hampton Inn Hotel Division of PCI. Mr. Sullivan will retire as Chairman effective on May 11, 2000.
DAVID L. LEVINE became the President and Chief Executive Officer of ResortQuest in December 1999. From May 1998 to December 1999, he was the President and Chief Operations Officer of ResortQuest. Mr. Levine was President and Chief Operating Officer of Equity Inns, Inc., a real estate investment trust that specializes in hotel acquisitions, from June 1994 to April 1998. Mr. Levine was also President and Chief Operations Officer of Trust Management Inc., which operated Equity Inns properties, from June 1994 until November 1996. Prior to that, he was President of North American Hospitality, Inc., a hotel management and consulting company, which he formed in 1985. Mr. Levine has been elected by the Board of Directors to succeed Mr. Sullivan as Chairman effective on May 11, 2000.
JAMES S. OLIN became the Chief Operations Officer of ResortQuest in January 2000. He was the President of Abbott Resorts, our largest Operating Company, from 1992 to January 2000. ResortQuest acquired Abbott Resorts in September 1998. From February 1999 to January 2000, he also served as Vice President for ResortQuest's Gulf Coast Region, covering 14 resort areas in Florida and along the Gulf Coast. Prior to joining Abbott Resorts, Mr. Olin was the Executive Director of the Destin, Florida, Chamber of Commerce from 1989 to 1992.
J. MITCHELL COLLINS became Senior Vice President and Chief Financial Officer of ResortQuest in March 2000. Mr. Collins was employed with Arthur Andersen LLP from July 1990 to February 2000 where he was a Senior Manager and head of real estate and hospitality services for Andersen's Mid-South practice. He also served on Andersen's global real estate and hospitality services team.
FREDERICK L. FARMER became Senior Vice President and Chief Information Officer of ResortQuest in May 1998. Mr. Farmer was Senior Vice President for Internet and Desktop Services of Marriott International from November 1996 to April 1998. He also served as Vice President of Data Resources & Services for Marriott International from March 1992 to November 1996.
PAUL N. MANTERIS became Senior Vice President, Homeowner Relations/Operations Support in January 2000. From September 1988 to January 2000, he was Vice President of Operations for ResortQuest. From November 1997 to September 1998, Mr. Manteris opened and operated a bagel franchise on the island of Maui, Hawaii. He was Manager of Training and Special Projects for Premier Resorts Inc., a hospitality management company operating primarily in the West and Hawaii, from 1993 to 1997. From 1989 to 1993 Mr. Manteris was employed with Village Resorts, Inc, a property management company, as general manager of various resorts including, Radisson Picacho Plaza, Santa Fe, N.M., Wildwood Lodge, Snowmass Village, Co., The Aspen County Inn, Aspen, Co. and Lakeland Village Beach & Ski Resort, S. Lake Tahoe, CA.
W. MICHAEL MURPHY became the Senior Vice President and Chief Development Officer of ResortQuest in May 1998. Mr. Murphy was President of Footprints International, a company involved in the planning of resort properties in the Bahamas, from 1996 to 1997. From 1994 to 1996, he was a Senior Managing Director of Geller & Co., a Chicago-based hotel advisory and asset management firm. Prior to joining Geller & Co. he acted as a hotel consultant from 1992 to
1994. Mr. Murphy was a founding partner of the hotel investment firm of Moeckel Murphy (1990-1992) and a founding general partner of Metric Partners (1981-1990), a real estate investment company that was a joint venture between the partners of The Fox Group and Metropolitan Life Insurance Company. Prior to that time, he was the Director of Real Estate for Holiday Inns, Inc. from 1973 to 1981.
PART II
ITEM 5.
ITEM 5. MARKET FOR RESORTQUEST'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The principal market for our Common Stock is the New York Stock Exchange. Information required by this item concerning quarterly sales price data is incorporated by reference from the table STOCK PRICE on page 39 of the 1999 Annual Report to Shareholders.
The following is certain information concerning all sales of securities by ResortQuest during the year ended December 31, 1999 that were not registered under the Securities Act of 1933:
In June of 1999, ResortQuest issued a total of $50 million of Senior Secured Notes due June 16, 2004. The offer and sale of these notes was exempt from registration under the Securities Act in reliance on Section 4(2) thereof because, among other things, the offers and sales were made to a small number of sophisticated institutional investors who had access to information about ResortQuest and were able to bear the economic risk of loss of their investment.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Financial information required by this item is incorporated by reference from the SELECTED FINANCIAL DATA on page 39 of the 1999 Annual Report to Shareholders.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Information required by this item is incorporated by reference from the MANAGEMENT'S DISCUSSION AND ANALYSIS on pages 13 through 20 of the 1999 Annual Report to Shareholders.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ResortQuest is exposed to market risk, primarily through changes in interest rates impacting borrowing rates on our debt. For a more detailed discussion of the interest rates on our long-term borrowings, see "NOTE 7-LONG-TERM DEBT" on page 32 of the 1999 Annual Report, which information is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information required by this item is incorporated by reference from the REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS found on page 38, from the consolidated financial statements and supplementary data on pages 23 through 37 of the 1999 Annual Report to Shareholders.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF RESORTQUEST
Information about Directors of ResortQuest is incorporated by reference from the discussion under Item 1 of our Proxy Statement for the 2000 Annual Meeting of Shareholders. The balance of the response to this item is contained in the discussion entitled EXECUTIVE OFFICERS OF RESORTQUEST in Part I of this report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information about executive compensation is incorporated by reference from the discussion under the heading COMPENSATION OF EXECUTIVE OFFICERS in our Proxy Statement for the 2000 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information about security ownership of certain beneficial owners and management is incorporated by reference from the discussion under the heading SECURITY OWNERSHIP OF MANAGEMENT AND PRINCIPAL STOCKHOLDERS in our Proxy Statement for the 2000 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information about certain relationships and transactions with related parties is incorporated herein by reference from the discussion under the heading CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS under Item 1 of our Proxy Statement for the 2000 Annual Meeting of Shareholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
14(a)(1) FINANCIAL STATEMENTS
RESORTQUEST INTERNATIONAL, INC. The following consolidated financial statements, related notes and report of independent public accountants, from the 1999 Annual Report to Shareholders, are incorporated by reference into Item 8 of Part II of this report.
14(a)(2) FINANCIAL STATEMENT SCHEDULES
Schedules are omitted because they are not required or the information is given elsewhere in the financial statements. The financial statements of unconsolidated subsidiaries are omitted because they are not applicable.
14(a)(3) EXHIBITS
THESE EXHIBITS ARE AVAILABLE UPON REQUEST AT A CHARGE OF TEN CENTS PER PAGE. REQUESTS SHOULD BE DIRECTED TO SECRETARY, RESORTQUEST INTERNATIONAL, INC., 530 OAK COURT DRIVE, SUITE 360, MEMPHIS, TN 38117
2.1 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., HCP Acquisition Corp., and Hotel Corporation of the Pacific, Inc. and Andre S. Tatibouet (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.2 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., B&B Acquisition Corp., Brindley Acquisition Corp., B&B On The Beach, Inc., Brindley and Brindley Realty and Development, Inc., Douglas R. Brindley and Betty Shotton Brindley (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.3 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Coastal Realty Acquisition LLC, Coastal Management Acquisition Corp. and Coastal Resorts Realty LLC, Coastal Resorts Management, Inc., Joshua M. Freeman, T. Michael McNally and CMF Coastal Resorts, L.L.C. (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.4 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc. and Collection of Fine Properties, Inc., Ten Mile Holdings, Ltd., Luis Alonso, Domingo R. Moreira, Brenda M. Lopez Ibanez and Ana Maria Moreira (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.5 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc. and Houston and O'Leary Company and Heidi O'Leary Houston (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.6 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Jupiter Acquisition Corp. and Jupiter Property Management at Park City, Inc. and Jon R. Brinton (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.7 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Maui Acquisition Corp. and Maui Condominium and Home Realty, Inc., Daniel C. Blair and Paul T. Dobson (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.8 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Maury Acquisition Corp. and The Maury People, Inc. and Sharon Benson Doucette (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.9 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Priscilla Acquisition Corp., Realty Consultants Acquisition Corp., Realty Consultants, Inc., and Howey Acquisition, Inc., Charles O. Howey and Dolores C. Howey (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.10 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., RPM Acquisition Corp. and Resort Property Management, Inc., Daniel L. Meehan, Kimberlie C. Meehan and Nancy Hess (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.11 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Telluride Acquisition Corp., and Telluride Resort Accommodations, Inc. and Steven A. Schein, Michael E. Gardner, Park Brady, Daniel Shaw, Carolyn S. Shaw, Virginia C. Gordon, Joyce Allred, Ronald D. Allred, A.J. Wells, Forrest Faulconer, Thomas McNamara, Donald J. Peterson, Nancy McNamara, Charles E. Cobb, Jr., Sue M. Cobb, Stephen A. Martori, Anthony F. Martori, Arthur John Martori and Alan Mishkin (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.12 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Trupp Acquisition Corp., Management Acquisition Corp. and Trupp-Hodnett Enterprises, Inc., THE Management Company, Hans F. Trupp, Roy K. Hodnett, Pat Hodnett Cooper and Austin Trupp (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.13 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., Whistler Holding Corp. and Whistler Chalets Ltd. and J. Patrick McCurdy (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.14 - Agreement and Plan of Organization, dated as of March 11, 1998, by and among Vacation Properties International, Inc., FRS Acquisition Corp., First Resort Software, Inc., Thomas A. Leddy, Evan H. Gull and Daniel Patrick Curry (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
2.15 - Stock Purchase Agreement dated September 11, 1998 by and among ResortQuest International, Inc., Abbott Realty Services, Inc., Tops'L Sales Group, Inc., William W. Abbott, Jr., Stephen J. Abbott, James R. Steiner, Charles H. Van Driver, Sue C. Van Driver and Angus G. Andrews, (PREVIOUSLY FILED ON OCTOBER 16, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-56703) AND INCORPORATED HEREIN BY REFERENCE).
3.1 - Certificate of Incorporation, as amended (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
3.2 - Bylaws of the Company, Amended as of February 10, 1999 (PREVIOUSLY FILED ON MARCH 30, 1999 AS AN EXHIBIT TO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1999 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
3.3 - Certificate of Amendment of Certificate of Incorporation of Company, dated April 23, 1998 (changing the name of the Company from Vacation Properties International, Inc. to ResortQuest International, Inc.) (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
3.4 - Certificate of Amendment of Certificate of Incorporation of the Company, dated May 11, 1998 (PREVIOUSLY FILED ON MAY 12, 1998 AS AN EXHIBIT TO AMENDMENT NO. 3 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
4.1 - Specimen Common Stock Certificate (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
4.2 - Form of Registration Rights Agreements between the Company and each of Alpine Consolidated II, LLC, Capstone Partners, LLC, John Przywara, David Marshall, Douglas W. Comfort, Robert G. Falcone, Wayne Heller, Dwain Wall, Stephen J. Garchik, John Shaw, David Sullivan, Jeffery M. Jarvis, Frederick L. Farmer, W. Michael Murphy, Jules S. Sowder, John K. Lines, Brian S. Sullivan, John D. Sullivan, the Sullivan Grandchildren's Trust, the David L. Levine Irrevocable Children's Trust Under Agreement dated April 27, 1998 f/b/o Whitney Monica Levine, the David L. Levine Irrevocable Children's Trust Under Agreement dated April 27, 1998 f/b/o Ross Michael Levine, the David L. Levine Irrevocable Children's Trust Under Agreement dated April 27, 1998 f/b/o Keith Phillip Levine and the David L. Levine Revocable Trust Under Agreement dated April 27, 1998 (PREVIOUSLY FILED ON MAY 26, 1998 AN EXHIBIT TO THE COMPANY'S CURRENT REPORT ON FORM 8-K (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
4.3 Rights Agreement, dated as of February 25, 1999 between ResortQuest International, Inc. and American Stock Transfer & Trust Company, as Rights Agent (PREVIOUSLY FILED ON MARCH 30, 1999 AS AN EXHIBIT TO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1999 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
4.4 - Summary of Plan Description for the ResortQuest Savings and Retirement Plan (PREVIOUSLY FILED AS EXHIBIT 4.1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-8 FILED ON MAY 21, 1999).
10.1 - Form of 1998 Long-Term Incentive Plan of the Company (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.2 - Form of Employment Agreement between the Company and David C. Sullivan (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.3 - Form of Employment Agreement between the Company and Jeffery M. Jarvis (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.4 - Form of Employment Agreement between the Company and W. Michael Murphy (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.5 - Form of Employment Agreement between the Company and Jules S. Sowder (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.6 - Form of Employment Agreement between the Company and David L. Levine (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.7 - Form of Employment Agreement between the Company and John K. Lines (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.8 - Form of Employment Agreement between the Company and Frederick L. Farmer (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE
COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.9 - Form of Employment Agreement between the Company and Luis Alonso (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.10 - Form of Employment Agreement between the Company and Douglas R. Brindley (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.11 - Form of Employment Agreement between the Company and Paul T. Dobson (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.12 - Form of Employment Agreement between the Company and Sharon Benson Doucette (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.13 - Form of Employment Agreement between the Company and Evan H. Gull (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.14 - Form of Employment Agreement between the Company and Heidi O'Leary Houston (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.15 - Form of Employment Agreement between the Company and Daniel L. Meehan (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.16 - Form of Management Services Agreement between the Company and J. Patrick McCurdy (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.17 - Form of Employment Agreement between the Company and Andre S. Tatibouet (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION
STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.18 - Form of Employment Agreement between the Company and Hans F. Trupp (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.19 - Form of Officer and Director Indemnification Agreement (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.20 - Form of Consulting Agreement between the Company and Park Brady (PREVIOUSLY FILED ON APRIL 27, 1998 AS AN EXHIBIT TO AMENDMENT NO. 1 TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.21 - Promissory Note (PREVIOUSLY FILED ON MARCH 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-47867) AND INCORPORATED HEREIN BY REFERENCE).
10.22 - Credit Agreement dated as of May 26, 1998, in the amount of $30 million, among ResortQuest International, Inc. as Borrower and the Financial Institutions named thereon and NationsBank, N.A. as agent for the Financial Institutions (PREVIOUSLY FILED ON JUNE 12, 1998 AS AN EXHIBIT TO THE COMPANY'S REGISTRATION STATEMENT ON FORM S-1 (FILE NO. 333-56703) AND INCORPORATED HEREIN BY REFERENCE).
10.23 - First Amendment to Credit Agreement, dated September 30, 1998 (PREVIOUSLY FILED ON NOVEMBER 16, 1998 AS EXHIBIT 10.1 TO THE COMPANY'S QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 1998 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.24 - Promissory Note, dated September 30, 1998, in the amount of $5.0 million, between ResortQuest International, Inc. and NationsBank, N.A. (PREVIOUSLY FILED ON NOVEMBER 16, 1998 AS EXHIBIT 10.2 TO THE COMPANY'S QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 1998 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.25 Consulting Agreement dated September 10, 1998 by and among Abbott Realty Services, Inc. and William W. Abbott, Jr. (PREVIOUSLY FILED ON MARCH 30, 1999 AS AN EXHIBIT TO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1999 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.26 - Form of Officer and Director Indemnification Agreement, as amended (PREVIOUSLY FILED ON MARCH 30, 1999 AS AN EXHIBIT TO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1999 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.27 - Second Amendment to Credit Agreement, dated December 7, 1998 (PREVIOUSLY FILED ON MARCH 30, 1999 AS AN EXHIBIT TO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1999 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.28 - Form of Section 401(k) Profit Sharing Plan Adoption Agreement (PREVIOUSLY FILED ON MARCH 30, 1999 AS AN EXHIBIT TO THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE PERIOD ENDED DECEMBER 31, 1999 (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.29 - Third Amendment to Credit Agreement, dated as of April 16, 1999 (PREVIOUSLY FILED ON MAY 28, 1999 AS EXHIBIT 10.29 TO THE COMPANY'S POST-EFFECTIVE AMENDMENT (FILE NO. 333-56703) AND INCORPORATED HEREIN BY REFERENCE).
10.30 - Fourth Amendment to Credit Agreement, dated as of June 1, 1999(PREVIOUSLY FILED ON JULY 16, 1999 AS EXHIBIT 10.30 TO THE COMPANY'S FORM S-4 REGISTRATION STATEMENT (FILE NO. 333-83059) AND INCORPORATED HEREIN BY REFERENCE).
10.31 - Note Purchase and Guarantee Agreement, dated as of June 1, 1999(PREVIOUSLY FILED ON JULY 16, 1999 AS EXHIBIT 10.31 TO THE COMPANY'S FORM S-4 REGISTRATION STATEMENT (FILE NO. 333-83059) AND INCORPORATED HEREIN BY REFERENCE).
10.32 - Intercreditor and Collateral Agency Agreement dated as of June 1, 1999(PREVIOUSLY FILED ON JULY 16, 1999 AS EXHIBIT 10.32 TO THE COMPANY'S FORM S-4 REGISTRATION STATEMENT (FILE NO. 333-83059) AND INCORPORATED HEREIN BY REFERENCE).
10.33 - Amended and Restated 1998 Long-Term Incentive Plan of the Company (PREVIOUSLY FILED ON APRIL 6, 1999 AS AN EXHIBIT TO THE COMPANY'S PROXY STATEMENT (FILE NO. 001-14115) AND INCORPORATED HEREIN BY REFERENCE).
10.34 - Fifth Amendment to Credit Agreement, dated as of December 31, 1999.
10.35 - Employment Agreement between the Company and J. Mitchell Collins dated as of March 13, 2000.
10.36 - Employment Agreement between the Company and Paul Manteris dated as of January 3, 2000.
10.37 - Employment Agreement between the Company and James Olin dated as of January 4, 2000.
10.38 - Form of First Amendment to Employment Agreement between the Company and each of David C. Sullivan, David L. Levine, Frederick L. Farmer and W. Michael Murphy, dated as of July 29, 1999.
10.39 - Second Amendment to Employment Agreement between the Company and David L. Sullivan, dated as of December 15, 1999.
10.40 - Second Amendment to Employment Agreement between the Company and David L. Levine, dated as of December 15, 1999.
13 - The 1999 Annual Report to Shareholders, which, except for those portions expressly incorporated herein by reference, is furnished solely for the information of the Commission and is not to be deemed "filed."
21 - Subsidiaries of the Company.
23 - Consent of Arthur Andersen LLP.
27 - Financial Data Schedule for the Period Ended December 31, 1999.
14(b) REPORTS ON FORM 8-K
The Company did not file a report on Form 8-K during the last quarter of 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
RESORTQUEST INTERNATIONAL, INC.
By: /s/ David L. Levine ------------------------------------ David L. Levine, President and Chief Executive Officer
Dated: March 29, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. | 15,069 | 100,156 |
353569_1999.txt | 353569_1999 | 1999 | 353569 | Item 1. BUSINESS
Quidel (the "Company") is a worldwide leader in developing, manufacturing and marketing of point-of-care ("POC") rapid diagnostic tests for the detection and management of a variety of medical conditions and illnesses. These products provide health care professionals with accurate and cost-effective information to quickly diagnose the patient's condition and determine proper treatment before the patient leaves the office. Quidel's technology platform and core competencies address the diagnostic categories of women's health and infectious diseases. Quidel's products are sold to professionals for use in physician's offices, hospitals, clinical laboratories, and wellness screening centers. Quidel also manufactures a line of products sold to consumers through organizations that provide store branded products.
Quidel commenced its operations in 1979 and launched its first products, dipstick-based pregnancy tests, in 1984. The product base has expanded through internal development and acquisitions of other products in the areas of pregnancy and ovulation, infectious disease, allergy, autoimmune diseases, osteoporosis and urinalysis for professional, research and home use.
Quidel's strategy is to become a major health management solutions provider for women, as women continue to play a greater role in health care decisions for themselves and their families. From pregnancy to osteoporosis, Quidel intends to create a life-long link with women by providing diagnostic products and health care information that spans the course of their lives.
Quidel markets its products in the United States through a network of national and regional distributors, supported by a direct sales force and, when strategically appropriate, niche focused contract sales organizations. In Europe and the rest of the world, Quidel sells and markets from regionally based subsidiaries in the United Kingdom, Italy and Germany, and through a sales management team in Australia (encompassing the Pacific Rim) and Latin America by channeling products through distributor organizations and sales agents.
The Company's executive offices are located at 10165 McKellar Court, San Diego, California 92121, and its telephone number is (858) 552-1100.
RECENT DEVELOPMENTS
During late 1998, Quidel developed a new strategic plan. This plan included provisions for improving the financial performance of the existing operations, as well as identifying licensing and acquisition opportunities, and forming additional collaborations with pharmaceutical and other health care companies. Quidel acted upon this new plan during the second half of 1999 by way of acquiring Metra Biosystems, Inc. ("Metra"), a leader in the diagnosis and management of metabolic bone diseases and disorders. Metra, now globally integrated into Quidel, offers two key product categories that provide critical information in determining bone health. In addition, Quidel acquired a POC urine test strip business from Dade Behring Marburg GmbH ("Dade Behring").
During the quarter ended September 30, 1999, Quidel began daily operations with a sophisticated enterprise resource planning computerized operating system. With this new system, the operations of the business are expected to become more efficient due to the streamlining of processes and procedures, in manufacturing, planning and financial reporting, many of which previously were performed manually. The information to be provided from this system will assist management with day-to-day operating decisions.
Finally, during December 1999, the Company closed a sale and leaseback transaction of its corporate headquarters facility and real estate. The facility and real estate was sold for $15 million. The Company will lease the 73,000 square foot facility for fifteen years, with options to extend the lease for up to two additional five-year periods. The sale was an all cash transaction, netting the Company approximately $7 million. The Company is a limited partner holding approximately 25% interest in the limited partnership that acquired the facility and real estate.
DIAGNOSTIC TEST KIT INDUSTRY OVERVIEW THE OVERALL MARKET FOR IN-VITRO DIAGNOSTICS
The worldwide market for IN-VITRO Diagnostic ("IVD") products, of approximately $18 billion for the year ended December 31, 1998, is segmented by the particular technology platform used in the utilization of the test. The largest segments are instrument-based clinical chemistry and immunodiagnostics testing, which account for approximately 25% and 30% of the total IVD market, respectively. Geographically, approximately 40% of the IVD revenues are generated in the United States, while Europe, Japan and the rest of the world account for approximately 33%, 13% and 14% respectively.
Customers for IVD products are dominated by large centralized laboratories, either independent reference laboratories or hospital-based facilities. In the U.S., these central laboratories represent less than 10% of total number of testing facilities, but account for 70% of test volume and 80% of revenues.
The diagnostic testing process typically involves obtaining a specimen sample of blood, urine or other fluid from the patient and sending the sample from the health care provider's office to a central laboratory. The patient is sent home and typically receives the results several hours or days later. The result of this process is that the patient leaves the physician without confirmation of the diagnosis and the ability to begin immediate care.
Three basic factors have driven the market for central laboratory testing: 1) technical requirements for accurate testing often require sophisticated and expensive equipment; 2) the cost to run a test on large scale instruments is low; and 3) the Clinical Laboratory Improvement Act of 1988 ("CLIA") and subsequent Health Care Financing Administration regulations subject all laboratories, regardless of size, to strict standards and licensing requirements. Many physicians and smaller laboratories found these regulations prohibitively expensive and reduced testing in-house. Although this trend is slowly reversing, these factors have led to the current dominance of centralized laboratories in diagnostic testing.
The over-the-counter ("OTC") market for IVD self-testing has not been affected by these trends. The United States OTC market was estimated to be approximately $1.9 billion in 1998 and is estimated to grow to $3.5 billion in five years. Two test categories, pregnancy and glucose monitoring for diabetes, dominate this market.
THE POINT-OF-CARE MARKET
Point-of-care testing for certain diagnostic parameters has become an accepted adjunct to central laboratory and self-testing. The POC market is comprised of two general segments: hospital testing (Emergency Rooms and bedside) and decentralized testing in non-institutional settings. Hospital POC testing is accepted and growing, and is generally an extension of the hospital's central laboratory and is generally instrument-based. The largest segments of rapid turnaround POC diagnostics include tests for urinalysis, strep throat and pregnancy.
Decentralized testing sites consist of physician's office laboratories, nursing homes, pharmacies and other non-institutional, ambulatory settings in which health care providers perform diagnostic tests. The decentralized POC market encompasses a large variety of IVD products ranging from moderate sized instrumented diagnostic systems serving larger group practices to single-use, disposable tests for smaller practice physicians' offices. POC testing in both the hospital and decentralized segments are increasing in popularity due to their clinical benefit and cost-effectiveness.
Overall, the POC market worldwide was estimated to be about $900 million in 1998, with 60% of the market in the United States, 25% in Europe and 15% in the rest of the world including Asia and Japan. The segment where Quidel currently participates, the rapid non-instrument-based POC market, is estimated to have manufacturers realized revenue of approximately $345 million. The growth in POC testing is in part the result of evolving technological improvements creating easy-to-use, high quality tests capable of being excluded from CLIA regulations ("waived"), and thereby available to the estimated over 80,000 office laboratories approved to conduct CLIA-waived tests. In 1998, 93% of family practice physicians reported providing some level of POC tests in their offices and the number of physicians using the CLIA-waived POC tests is increasing by approximately 500 laboratories a year.
BUSINESS STRATEGY
Quidel believes that the trend among health care providers to adopt POC testing is increasing, and demographic changes, reimbursement policies and manageable regulations, and the availability of clinically valuable tests will increase growth in this diagnostic category. More and more employers, health plans, and payers are recognizing that POC is the most cost-effective means for improving the quality of care and patient satisfaction. Continuous improvements in technology are resulting in a growing number of new diagnostic tests that combine high levels of accuracy with rapid, easy-to-use product formats. It is Quidel's mission to establish a significant global leadership position in POC rapid diagnostics. In order to accomplish this mission, Quidel has defined the following strategic goals:
- - Improve profit margins through improved product pricing and operational efficiencies, - - Secure a stronger new product pipeline from internal research and development, - - Pursue licensing and acquisitions opportunities, when financially and strategically attractive, such as the acquisition of Metra and the acquisition of the urine test strip business from Dade Behring, - - Launch the urine test strip business under the QuickVue brand by leveraging marketing and distribution strength in the United States, and maximize worldwide sales through current and newly identified sales channels in Europe and rest of world, - - Gain worldwide market share leadership position with its QuickVue Influenza test, - - Launch a new and improved CLIA waived H. pylori test worldwide, - - Launch two herpes simplex virus ("HSV") POC rapid diagnostic tests on a worldwide basis in conjunction with our development partner, Glaxo Group, Ltd., ("Glaxo Wellcome") a wholly owned subsidiary of Glaxo Wellcome, plc, - - Launch the QUS-2 ultrasonometer worldwide for the measurement of bone mineral density, - - Expand development and marketing collaborations with large pharmaceutical and other health care companies, - - Identify business development opportunities in the form of product or company acquisitions to enhance product portfolio and further leverage distribution channels worldwide, - - Expand international sales through external alliances, collaborations and sales focus.
TECHNOLOGY
Quidel incorporates antibody-antigen (immunoassay) technology and biochemistry combined into uniquely designed and engineered rapid diagnostic products. Quidel has developed or licensed four primary delivery system formats: test strips, flow-through cassettes, microwell plate tests and a one-step lateral flow delivery system. Although each is based on the general principal of antibody-antigen based reactions, the four formats differ in terms of speed, ease-of-use and sensitivity. As a result, each of these formats addresses a particular need of a Quidel end-use customer. The general antibody-antigen based approach uses commercially produced protein molecules, or antibodies, which react with or bind to specific antigens, such as viruses, bacteria, hormones, drugs, and other antibodies. The antibodies, produced in response to particular antigens, bind specifically to that antigen. This characteristic allows antibodies to be used in a wide range of diagnostic applications.
The ability to detect the binding of antibodies to target antigens forms the basis for immunoassay testing used in Quidel's products. In immunoassays, antibodies or antigens are typically deposited onto a particle or solid surface. A chemical label is then either incorporated onto the solid substrate or added separately once the solid substrate has been exposed to the test sample. If the target antigen or antibody is present in the test sample, the chemical label produces a visually identifiable color change in response to the resulting reaction. This provides a clear color endpoint for easy visual verification of the test results without the need for instrumentation.
PRODUCTS
Quidel provides rapid point-of-care diagnostic tests under the following brand names: Q-TEST-Registered Trademark-, QUICKVUE-Registered Trademark-, OVUQUICK-Registered Trademark-, CONCEIVE-Registered Trademark-, CARDS-Registered Trademark-, OVUKIT-Registered Trademark-, RAPIDVUE-Registered Trademark-, BLUETEST HCG-Registered Trademark-, METRA-Registered Trademark-, PYRILINKS-Registered Trademark-, QUS-Registered Trademark--2, ALKPHASE-B-Registered Trademark-, NOVOCALCIN-Registered Trademark-, CHONDREX-Registered Trademark-, RAPIGNOST-Registered Trademark-, and RAPIDMAT - -Registered Trademark-. Quidel's rapid POC diagnostic tests and the Metra biochemical bone markers and ultrasonometer participate in the following medical and wellness categories:
- - PREGNANCY TESTS. The early detection of pregnancy allows the physician and patient to institute proper care, helping to ensure the health of both the woman and the developing embryo. Pregnancy tests are also used to
"rule out" pregnancy before conducting certain clinical procedures or administering certain medications. Pregnancy test sales, including tests sold to physicians, other health care organizations and through private store brand labels, represented approximately 39% of the Company's total net sales for the nine months ended December 31, 1999. - - OVULATION PREDICTION. Tests in this category are for women affected by infertility or the desire to control the timing of their pregnancies. These tests predict or confirm the occurrence of ovulation and are used by primary care physicians, fertility specialists and the consumer. Ovulation prediction test sales, including tests sold OTC, to physicians, and to other health care organizations, represented approximately 4% of the Company's net sales for the nine months ended December 31, 1999. - - GROUP A STREPTOCOCCUS. Each year millions of people in the United States are tested for Group A streptococcal infections, commonly referred to as "strep throat." Group A streptococci are bacterium that typically cause illnesses such as tonsillitis, pharyngitis and scarlet fever which, if left untreated, can progress to complications such as rheumatic fever. Sales of strep A products represented approximately 24% of the Company's net sales for the nine months ended December 31, 1999. - - INFLUENZA A/B. This diagnostic test was developed through a fully funded collaboration with Glaxo Wellcome for the diagnosis and treatment of influenza at the POC. The test is a rapid, single step, diagnostic test for the detection of influenza A and B, the two most common types of the virus. The test received United States Food and Drug Administration ("FDA") clearance in September 1999 and began selling in December 1999. Influenza test sales represented approximately 2% of the Company's net sales for the nine months ended December 31, 1999. - - H. PYLORI. HELICOBACTER PYLORI ("H. PYLORI") is the bacterium believed to be associated with 80% of the five million peptic ulcers in the United States. H. PYLORI is implicated in chronic gastritis and is recognized by the World Health Organization as a Class 1 carcinogen that may increase a person's risk of developing stomach cancer. Once the H. PYLORI infection is detected, antibiotic therapy is administered to kill the organism and promote a cure of the ulcer condition. Quidel's rapid test utilizes whole blood samples from a finger prick. It is a serological test that measures antibodies circulating in the blood caused by the H. PYLORI infection. Quidel's H. PYLORI test, which was the first to receive CLIA-waived status, has progressively increased in sales and accounted for approximately 9% of the Company's net sales for the nine months ended December 31, 1999. Quidel will launch a new and improved H.PYLORI test mid year 2000. - - OTHER INFECTIOUS DISEASE PRODUCTS, INCLUDING CHLAMYDIA AND MONONUCLEOSIS. The chlamydia organism is responsible for the most widespread sexually transmitted disease in the United States. Over one-half of infected women do not have symptoms, and if left untreated, chlamydia can cause sterility. Infectious mononucleosis can be severely debilitating to immune-suppressed groups, including the elderly, if not diagnosed and treated promptly. Quidel's other infectious disease products represented approximately 5% of the Company's net sales for the nine months ended December 31, 1999. - - METABOLIC BONE MARKERS. According to the National Osteoporosis Foundation, osteoporosis afflicts over 28 million Americans and over 200 million people worldwide. Osteoporosis is a disorder characterized by a decrease in bone mass that leads to increased susceptibility to fracture. One parameter for diagnosing and monitoring bone health is to measure the metabolic process of bone turnover (resorption and formation) or "rate" of change. Metabolic bone markers are used by physicians to monitor the effectiveness of therapy and are extensively used in pharmaceutical research. Sales of metabolic bone markers since the acquisition of Metra represented approximately 9% of the Company's net sales for the nine months ended December 31, 1999. - - QUS-2. The second parameter critical to assessing bone health is the measurement of the density of bone. Imaging technologies provides this information referred to as the "state" of bone health. The QUS-2 is a portable ultrasonometer that scans the heel of the foot to accurately determine the health of the bone. The "state and rate" assessment provides the most complete picture of bone health. Over 100 systems have been placed outside the United States. The United States launch is expected mid-year 2000. Sales of the QUS-2 since the acquisition of Metra represented approximately 1% of the Company's net sales for the nine months ended December 31, 1999. - - URINE TEST STRIP PRODUCTS. Urinalysis testing using chemical test strips is the single most widely ordered diagnostic test in the world. The total worldwide market is over $500 million and used by nearly every health care provider customer segment. Initially, Quidel will aggressively launch into the visual-read segment (non-instrument based) which represents a $70 million opportunity in the United States. A secondary strategy includes the identification of a replacement instrument for the existing Dade Behring RapiMat instrument. The Dade Behring brand of test strips, Rapignost, and the RapiMat instrument will be retained in certain countries and transitioned over time to Quidel QuickVue branded products and instruments. Sales of the urine test strip
products since the acquisition of this product line represented 1% of the Company's net sales for the nine months ended December 31, 1999. - - OTHER PRODUCTS. The remaining 6% of net sales for the nine months ended December 31, 1999, include allergy screening tests, clinical laboratory tests used in the measurement of circulating immune complexes and veterinary products produced under outside contracts and collaborations.
PRODUCTS UNDER DEVELOPMENT
- - HERPES SIMPLEX VIRUS ("HSV") ANTIGEN AND ANTIBODY 1 AND 2. The HSV 1 and 2 antibody and antigen tests, being developed under a funded research collaboration with Glaxo Wellcome, will detect the presence or absence of the HSV antibody in the blood, and the presence of the antigen directly from a genital or oral lesion. HSV is epidemic, spreading at an estimated rate of a half million people per year. One in six people in the United States between the ages of 15 and 74 is infected with HSV type 2, the virus commonly associated with genital herpes. The HSV diagnostic tests are designed to be used in conjunction with a Glaxo Wellcome therapeutic product, and applications for FDA clearance for both the antibody and antigen tests are expected to be filed in 2001. In return for funding this development, Glaxo Wellcome will receive royalties on the sales of these products.
- - HELICAL PEPTIDE. A microassay to measure urinary helical peptide, a possible new marker of bone resorption is being developed at the Company's Mountain View facility. The release of this for-research-use-only version of the marker is expected to be in late 2000.
PRODUCT LIFE CYCLES
Quidel's operating results can be significantly affected by the phase-out of older products near the end of their product life cycles, as well as the timing and success of new product introductions. The ability to compete successfully in the rapid diagnostics market depends on the continual development and introduction of new products and the improvement of existing products.
SEASONALITY
Sales levels for several products are affected by seasonal demand trends. Group A strep and Influenza tests, for example, are used primarily in the fall and winter. As a result of these demand trends, Quidel generally achieves lower operating results in the second and third quarters of a calendar year, and have higher operating results in the first and fourth quarters of the calendar year.
RESEARCH AND DEVELOPMENT
Quidel is focusing its research and development efforts on two areas: 1) the creation of improved products and new products for its existing markets and 2) products developed under pharmaceutical company sponsorship and other collaborations for new markets. These collaborations are being undertaken with the goal of creating differential diagnostics for use in identifying patients most likely to benefit from the relevant therapeutic products. With this approach, it is believed that costs related to inappropriate therapy can be avoided, while increasing the effectiveness of patient treatment.
MARKETING AND DISTRIBUTION
In contrast to the central laboratory market, the United States POC market is highly fragmented, with many small or medium-sized customers. Quidel has designed its business strategy around serving the needs of this market segment. To reach these customers, a network of national and regional distributors, along with a focused contract sales organization, is utilized and supported by Quidel's sales force. In 2000, Quidel will begin sales of certain products to niche professionals and small distributors on the Internet as a component of its e-commerce initiative.
Quidel has developed priority status with many of the major distributors in the United States, resulting in many of its products being the preferred products offered by these distributors.
Internationally, the use of rapid POC diagnostic tests, the acceptance of testing outside the central laboratory and the consumer interest in OTC and self-test products differ considerably. Quidel's international sales are substantially lower than domestic sales as a percentage of its total business. Some of this difference is due the POC market being more developed in the United States relative to the overall IVD market in other countries. Also, Quidel's ability to address the international markets is reduced due to limited resources and capital.
MANUFACTURING
Quidel's manufacturing facility, located in San Diego, California, consists of laboratories devoted to tissue culture, cell culture, protein purification and immunochemistry, and production areas dedicated to assembly and packaging. In the manufacturing process, biological, chemical and packaging supplies and equipment are used, which are generally available from several competing suppliers.
Quidel's manufacturing is conducted in compliance with the Quality System Requirements ("QSR") (formerly Good Manufacturing Practices) of the FDA governing the manufacture of medical devices. The manufacturing facility has been registered with the FDA and the Department of Health Services of the State of California, and has passed routine federal and state inspections confirming compliance with the QSR regulatory requirements for IVD products. The manufacture of medical diagnostic products is difficult, particularly with respect to the stability and consistency of complex biological components. Because of these complexities, manufacturing difficulties occasionally occur that delay the introduction of products, result in excess manufacturing costs or require the replacement of products already introduced into the distribution channel.
Quidel has an additional manufacturing operation, located in Mountain View, California, consisting of fully integrated systems of antibody production, reagent purification, reagent and microtiter plate processing, filling, labeling, packaging and distribution. In September 1996, this site received ISO 9001 certification for its quality management systems. ISO 9001 certification is officially recognized by European and North American authorities and is accepted worldwide, and will become a requirement for doing business in some countries in the future.
Quidel is in the process of preparing its San Diego manufacturing facility for ISO 9001 certification, which is expected by the end of 2000.
GOVERNMENT REGULATION
The testing, manufacture and sale of Quidel's products are subject to regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the FDA regulates the preclinical and clinical testing, manufacture, labeling, distribution and promotion of medical devices. A company will not be able to commence marketing or commercial sales in the United States of new products under development until it receives clearance or approval from the FDA, which can be a lengthy, expensive and uncertain process. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the FDA to grant premarket clearance or premarket approval for devices, withdrawal of marketing clearances or approvals and criminal prosecution. The FDA also has the authority to request a recall, repair, replacement or refund of the cost of any device manufactured or distributed in the United States.
In the United States, medical devices are classified into one of three classes (Class I, II or III) on the basis of the controls deemed necessary by the FDA to reasonably ensure their safety and effectiveness. Class I devices are subject to general controls (e.g., labeling, premarket notification and adherence to the QSR); Class II devices are subject to special controls (e.g., performance standards, premarket notification, postmarket surveillance, and adherence to the QSR); and, generally, Class III devices are those which must receive premarket approval by the FDA to ensure their safety and effectiveness (e.g., life sustaining, life supporting and implantable devices or new devices which have been found not to be substantially equivalent to legally marketed devices).
Before a device can be introduced in the U.S. market, the manufacturer must obtain FDA clearance through a premarket notification ("510(k)") submission or FDA approval of a premarket approval ("PMA") application. A PMA application must be filed if a device is a new device not substantially equivalent to a legally marketed Class I or Class II device, or if it is a pre-amendment Class III device for which the FDA has called for a PMA, or if the device raises new questions of safety and effectiveness. A 510(k) premarket clearance will be granted if a device
establishes "substantially equivalent" to a legally marketed Class I or Class II medical device or to a pre-amendment Class III medical device for which the FDA has not called for a PMA.
The FDA has been requiring more rigorous demonstration of substantial equivalence as part of the 510(k) process, including submission of extensive clinical data. It generally takes from three to twelve months from 510(k) submission to obtain clearance, but may take longer. The FDA may determine that a proposed device is not substantially equivalent to a legally marketed device or that additional information is needed before a substantial equivalence determination can be made. A "not substantially equivalent" determination, or a request for additional information, could prevent or delay the market introduction of new products that fall into this category. For any devices that are cleared through the 510(k) process, modifications or enhancements that could significantly affect safety or effectiveness, or constitute a major change in the intended use of the device, will require new 510(k) submissions, although there can be no assurance that the FDA will grant clearance. A PMA application must be supported by valid scientific evidence to demonstrate the safety and effectiveness of the device, typically including the results of clinical investigations, bench tests, laboratory and animal studies. The PMA approval process can be expensive, uncertain and lengthy, and a number of devices for which FDA approval has been sought by other companies have never been granted approval.
The Company may not be able to obtain the necessary regulatory approvals or clearances for its products on a timely basis, if at all. Delays in receipt of or failure to receive such approvals or clearances, or failure to comply with existing or future regulatory requirements would have a material adverse effect on the business, financial condition and results of operations.
Before the manufacturer of a device can submit the device for FDA approval or clearance, it generally must conduct a clinical investigation of the device. Although clinical investigations of Class III devices are subject to the investigational device exemption ("IDE") requirements, clinical investigations of Class I and Class II IVD tests, such as many of the Company's products under development, are exempt from the IDE requirements, provided the testing is noninvasive, does not require an invasive sampling procedure that presents a significant risk, does not intentionally introduce energy into the subject, and is not used as a diagnostic procedure without confirmation by another medically established test or procedure.
Any devices manufactured or distributed by Quidel pursuant to FDA clearance or approvals are subject to pervasive and continuing regulation by FDA and certain state agencies. Manufacturers of medical devices for marketing in the United States are required to adhere to QSR, which includes testing, control, documentation, and other quality assurance requirements. Manufacturers must also comply with Medical Device Reporting ("MDR") requirements that a manufacturer report to the FDA any incident in which its product may have caused or contributed to a death or serious injury, or in which its product malfunctioned and, if the malfunction were to recur, it would be likely to cause or contribute to a death or serious injury. Labeling and promotional activities are subject to scrutiny by the FDA and, in certain circumstances, by the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses.
Quidel is subject to routine inspection by the FDA and certain state agencies for compliance with QSR requirements, MDR requirements and other applicable regulations. Changes in existing requirements or adoption of new requirements could have a material adverse effect on Quidel's business, financial condition and results of operations. Quidel may incur significant costs to comply with laws and regulations in the future, and the laws and regulations may have a material adverse effect upon the business, financial condition and results of operations.
Quidel also is subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. Quidel may incur significant costs to comply with laws and regulations in the future, and such laws or regulations may have a material adverse effect upon the business, financial condition and results of operations.
Quidel's products are also subject to CLIA and related federal and state regulations which provide for regulation of laboratory testing. The scope of these regulations includes quality control, proficiency testing, personnel standards and federal inspections. CLIA categorizes tests as "waived," "moderately complex" or "highly complex," on the basis of specific criteria. Future amendment of CLIA or the promulgation of additional regulations impacting laboratory testing may have a material adverse effect on the ability to market products and may have a material adverse effect upon Quidel's business, financial condition or results of operations.
PATENTS AND TRADE SECRETS
The healthcare industry has traditionally placed considerable importance on obtaining and maintaining patent and trade secret protection for significant new technologies, products and processes. Quidel and other companies engaged in research and development of new diagnostic products using advanced biomedical technologies are actively pursuing patents for their technologies, which they consider novel and patentable. However, important legal issues remain to be resolved as to the extent and scope of available patent protection in the United States and in other important markets worldwide. The resolution of these issues and their effect upon the long-term success of Quidel and other biotechnology firms cannot be determined.
It has been Quidel's policy to file for patent protection in the United States and other countries with significant markets, such as Western European countries and Japan, if the economics are deemed to justify such filing and Quidel's patent counsel determines that a strong patent position can be obtained. No assurance can be given that patents will be issued to Quidel pursuant to its patent applications in the United States and abroad or that patent portfolio will provide Quidel with a meaningful level of commercial protection.
A large number of individuals and commercial enterprises seek patent protection for technologies, products and processes in fields related to Quidel's areas of product development. To the extent such efforts are successful, Quidel may be required to obtain licenses in order to exploit certain of its product strategies. Licenses may not be available to Quidel at all, or if so, on acceptable terms.
Quidel is aware of certain issued and filed patents, issued to various developers of diagnostic products with potential applicability to Quidel's diagnostic technology. Quidel has licensed certain rights from companies such as Syntex and Becton Dickinson to assist with the manufacturing of certain products. There can be no assurance that Quidel would prevail if a patent infringement claim were to be asserted against Quidel.
Quidel currently has certain licenses from third parties and in the future may require additional licenses from other parties in order to refine its products further and to allow its collaborators to develop, manufacture and market commercially viable products effectively. There can be no assurance that such licenses will be obtainable on commercially reasonable terms, if at all, that any patents underlying such licenses will be valid and enforceable, or that the proprietary nature of any patented technology underlying such licenses will remain proprietary.
Quidel seeks to protect its trade secrets and nonproprietary technology by entering into confidentiality agreements with employees and third parties (such as potential licensees, customers, joint ventures and consultants). In addition, Quidel has taken certain security measures in its laboratories and offices. Despite such efforts, no assurance can be given that the confidentiality of Quidel's proprietary information can be maintained. Also, to the extent that consultants or contracting parties apply technical or scientific information independently developed by them to Quidel projects, disputes may arise as to the proprietary rights to such data.
Under certain of its distribution agreements, Quidel has agreed to indemnify the distributor against costs and liabilities arising out of any patent infringement claim by a third party relating to products sold under those agreements. In some cases, the distributor has agreed to share the costs of defending such a claim and will be reimbursed for the amount of its contribution if the infringement claim is found to be valid.
COMPETITION
Competition in the development and marketing of diagnostic products is intense, and diagnostic technologies have been subject to rapid change. Quidel believes that the competitive factors in the rapid diagnostic market include convenience, price and product performance as well as the distribution, advertising, promotion and brand name recognition of the marketer. Quidel's success will depend on its ability to remain abreast of technological advances, to introduce technologically advanced products, and to attract and retain experienced technical personnel, who are in great demand. The majority of diagnostic tests used by physicians and other health care providers are performed by independent clinical reference laboratories. Quidel expects that these laboratories will continue to compete vigorously to maintain their dominance of the testing market. In order to achieve market acceptance for its products, Quidel will be required to demonstrate that its products provide cost-effective and time saving alternatives to tests performed by clinical reference laboratory procedures. This will require physicians to change their established means of having these tests performed.
Many of Quidel's current and prospective competitors, including several large pharmaceutical and diversified health care companies, have substantially greater financial, marketing and other resources than Quidel. These competitors include Abbott Laboratories, Beckman Coulter Primary Care, and Becton Dickinson. Quidel's competitors may succeed in developing or marketing technologies or products that are more effective or commercially attractive than Quidel current or future products, or that would render Quidel's technologies and products obsolete. Moreover, Quidel may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully in the future. In addition, competitors, many of which have made substantial investments in competing technologies, may be more effective than Quidel's technologies, or may prevent, limit or interfere with Quidel's ability to make, use or sell its products either in the United States or in international markets.
HUMAN RESOURCES
As of December 31, 1999, Quidel had 333 employees, none of whom are represented by a labor union. Quidel has experienced no work stoppages and believes that employee relations are good.
BUSINESS RISKS
In this section, all reference to "we," "our," and "us" refer to Quidel.
OPERATING RESULTS MAY FLUCTUATE, WHICH WOULD HAVE A NEGATIVE EFFECT ON THE PRICE OF OUR COMMON STOCK
Quidel has only been profitable for a limited time and we may not continue our revenue growth or profitability. Operating results may continue to fluctuate, in a given quarter or annual period, from prior periods as a result of a number of factors, many of which are outside of our control, including:
- - seasonal fluctuations in our sales of strep throat and influenza tests which are generally highest in fall and winter, - - changes in the level of competition, - - changes in the economic conditions in both our domestic and international markets, - - delays in shipments of our products to customers or from our suppliers, - - manufacturing difficulties and fluctuations in our manufacturing output, including those arising from constraints in our manufacturing capacity, - - actions of our major distributors, - - adverse product reviews or delays in product reviews by regulatory agencies, - - the timing of significant orders, - - changes in the mix of products we sell; and - - costs, timing and the level of acceptance of new products.
Fluctuations for any reason that decrease sales or profitability, including those listed, could cause our growth or operating results to fall below the expectations of investors and securities analysts, and our stock price to decline.
OUR PRODUCTS AND MARKETS REQUIRE CONSIDERABLE RESOURCES TO DEVELOP, WHICH RESOURCES MUST BE RECOUPED IN ADDITIONAL SALES
The development, manufacture and sale of diagnostic products requires a significant investment of resources. Our increased investment in sales and marketing activities, manufacturing scale-up and new product development is continuing to increase our operating expenses, and our operating results would be adversely affected if our sales and gross profits do not correspondingly increase, or if our product development efforts are unsuccessful or delayed.
Development of new markets also requires a substantial investment of resources and, if adequate resources, including funds, are not available, we may be required to delay or scale back market developments.
DELAYS IN PRODUCT MANUFACTURING COULD REQUIRE CONSIDERABLE RESOURCES AND HARM CUSTOMER RELATIONSHIPS
If we experience significant demand for our products, we may require additional capital resources to meet such demands. If we are unable to develop necessary manufacturing capabilities, our competitive position and financial condition could be adversely affected. Failure to increase production volumes, if required, in a cost-effective
manner, or lower than anticipated yields or production constraints encountered as a result of changes in the manufacturing process, could result in shipment delays as well as increased manufacturing costs, which could have a material adverse effect on our business, financial condition and results of operations.
The majority of raw materials and purchased components used to manufacture our products are readily available. However, certain of these materials are obtained from a sole supplier or a limited group of suppliers. The reliance on sole or limited suppliers and the failure to maintain long-term agreements with other suppliers involves several risks, including the inability to obtain an adequate supply of required raw materials and components and reduced control over pricing, quality and timely delivery. Although we attempt to minimize our supply risks by maintaining an inventory of raw materials and continuously evaluating other sources, any interruption in supply could have a material adverse effect on our business, financial condition and results of operations.
THE LOSS OF KEY DISTRIBUTORS OR AN UNSUCCESSFUL EFFORT TO DIRECTLY DISTRIBUTE OUR PRODUCTS COULD SIGNIFICANTLY DISRUPT OUR BUSINESS
We rely primarily on a small number of key distributors to distribute our products. The loss or termination of our relationship with any of these key distributors could significantly disrupt our business unless suitable alternatives can be found. Finding a suitable alternative may pose challenges in the industry's competitive environment. Another suitable distributor, with whom we can negotiate a new distribution or marketing agreement on satisfactory terms, may not be found. We could expand our efforts to distribute and market our products directly, however, this would require an investment in additional sales and marketing resources, including hiring additional field sales personnel, which would significantly increase our future selling, general and administrative expenses. In addition, our direct sales, marketing and distribution efforts may not be successful.
WE MAY NOT ACHIEVE EXPECTED MARKET ACCEPTANCE OF OUR PRODUCTS AMONG PHYSICIANS AND OTHER HEALTH CARE PROVIDERS
Significant competitors for our products are clinical reference laboratories and hospital-based laboratories, which provide the majority of diagnostic tests used by physicians and other health-care providers. Our estimates of future sales depend on, among other matters, the capture of sales from these laboratories, and if we do not capture sales as expected our operating results may fall below expectations. We expect that these laboratories will compete vigorously to maintain their dominance of the testing market. Moreover, even if we can demonstrate that our products are more cost-effective or save time, physicians and other health care providers may resist changing their established source for such tests.
INTENSE COMPETITION IN THE DIAGNOSTIC MARKET POSES CHALLENGES TO OUR PROFITABILITY
The diagnostic test market is highly competitive. We have a large number of multinational and regional competitors making investments in competing technologies. If our competitors' products are more effective or more commercially attractive than ours our business and financial results could be adversely affected. Competition also negatively impacts our product prices and profit margins.
A number of our competitors have a potential competitive advantage because they have substantially greater financial, technical, research and other resources, and larger, more established marketing, sales, distribution and service organizations than ours. Moreover, some competitors offer broader product lines and have greater name recognition than Quidel.
TO REMAIN COMPETITIVE WE MUST CONTINUE TO DEVELOP OR OBTAIN PROPRIETARY TECHNOLOGY RIGHTS
Our operating results can be significantly affected by the phase out of older products near the end of their product life cycles, as well as the success of new product introduction. Our ability to compete successfully in the diagnostic market depends upon continued development and introduction of new proprietary technology and the improvement of existing technology.
Our competitive position is heavily dependent upon obtaining and protecting our proprietary technology or obtaining licenses from others. If we cannot continue to obtain and protect such proprietary technology our competitive position could be adversely affected. Moreover, our current and future licenses may not be adequate for the operation of our business.
Our ability to obtain patents and licenses, and their benefits, are uncertain. We have a number of issued patents and additional applications are pending. However, our pending patent applications may not result in the issuance of any patents, or if issued, the patents may not have priority over others' applications, or, may not offer protection against competitors with similar technology. Moreover, any patents issued to us may be challenged, invalidated or circumvented in the future. Also, we may not be able to obtain licenses for technology patented by others or on commercially reasonable terms. A failure to obtain necessary licenses could prevent us from commercializing some of our products under development.
WE MAY BE INVOLVED IN INTELLECTUAL PROPERTY INFRINGEMENT DISPUTES WHICH ARE COSTLY AND COULD LIMIT OUR ABILITY TO USE SOME TECHNOLOGIES IN THE FUTURE
There are a large number of patents and patent applications in our product areas, and we believe that there may be significant litigation in our industry regarding patent and other intellectual property rights. Our involvement in litigation to determine rights in proprietary technology could adversely effect our business and financial results because:
- - it consumes a substantial portion of managerial and financial resources; - - its outcome is inherently uncertain and a court may find the third-party claims valid and that we have no successful defense to such claims; - - an adverse outcome could subject us to significant liability; - - failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop; and - - protection of our rights may not be available under the law or may be inadequate.
THE UNCERTAINTY AND COST OF REGULATORY APPROVAL FOR OUR PRODUCTS MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND OPERATIONS
The testing, manufacture and sale of our products are subject to regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies. Our estimates of future performance depend on, among other matters, our estimates as to when and at what cost we will receive regulatory approval for new products. However, complying with laws and regulations of these regulatory agencies can be a lengthy, expensive and uncertain process making the timing and costs of approvals difficult to predict. Our operating results may be adversely affected by unexpected actions of regulatory agencies, including delays in the receipt of or failure to receive approvals or clearances, the loss of previously received approvals or clearances, and the placement of limits on the use of the products.
We are also subject to numerous laws relating to such markers as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. It is also impossible to reliably predict the full nature and impact of future legislation or regulatory developments relating to our industry. To the extent the costs and procedures associated with meeting new requirements are substantial, our business and results of operations could be adversely affected.
UNCERTAINTY RELATING TO THIRD PARTY REIMBURSEMENT AND POTENTIAL COST CONSTRAINTS
In the United States, health care providers that purchase diagnostic products, such as hospitals and physicians, generally rely on third party payors, principally private health insurance plans, federal Medicare and state Medicaid, to reimburse all or part of the cost of the procedure. We believe that the overall escalating cost of medical products and services has led to and will continue to lead to increased pressures on the health care industry, both foreign and domestic, to reduce the cost of products and services, including our products. Given the efforts to control and reduce health care costs in the United States in recent years, there can be no assurance that currently available levels of reimbursement will continue to be available in the future for Quidel's existing products or products under development. Quidel could be adversely affected by changes in reimbursement policies of governmental or private health care payors, particularly to the extent any such changes affect reimbursement for procedures in which Quidel's products are used. Third party reimbursement and coverage may not be available or adequate in either U.S. or foreign markets, current reimbursement amounts may be decreased in the future and future legislation, regulation or reimbursement policies of third-party payors may adversely affect the demand for Quidel's products or its ability to sell its products on a profitable basis.
IF WE ARE NOT ABLE TO MANAGE OUR GROWTH STRATEGY OUR BUSINESS AND RESULTS OF OPERATIONS MAY BE ADVERSELY IMPACTED
We anticipate increased growth in the number of employees, the scope of operating and financial systems and the geographic area of our operations as new products are developed and commercialized. This growth may divert management's attention from other aspects of our business, and will place a strain on existing management, and operational, financial and management information systems. To manage this growth, we must continue to implement and improve our operational and financial systems and to train, motivate, retain and manage our employees. Furthermore, we may expand into markets in which we have less experience or incur higher costs. Should we encounter difficulties in managing these tasks, our growth strategy may suffer and anticipated sales could be adversely effected.
LOSS OF KEY PERSONNEL OR OUR INABILITY TO HIRE QUALIFIED PERSONNEL COULD NEGATIVELY IMPACT OUR BUSINESS
Our future success depends in part on our ability to retain our key technical, sales, marketing and executive personnel, and our ability to identify and hire additional qualified personnel. Competition for such personnel is intense and if we are not able to retain existing key personnel, or identify and hire additional qualified personnel, our business could be negatively impacted.
WE ARE EXPOSED TO RISKS OF SIGNIFICANT PRODUCT LIABILITY, WHICH IF NOT COVERED BY INSURANCE COULD HAVE AN ADVERSE EFFECT ON OUR PROFITABILITY
There is a risk of product liability claims against us arising from our testing, manufacturing and marketing of medical diagnostic devices, both those currently being marketed, as well as those under development. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of our policy. Furthermore, if we are held liable, our existing insurance may not be renewed at the same cost and level of coverage as presently in effect, or may not be renewed at all. If we are held liable for a claim against which we are not indemnified or for damages exceeding the limits of our insurance coverage, that claim could have a material adverse effect on our business, financial condition and result of operations.
WE MAY EXPERIENCE DIFFICULTIES INTEGRATING ACQUIRED COMPANIES OR TECHNOLOGIES AFTER THE ACQUISITION
We may experience difficulties integrating our operations with those of companies or technologies we may acquire, and there can be no assurance that we will realize the benefits and cost savings that we believe the acquisition will provide or that such benefits will be achieved within the time frame we anticipate. The acquisitions may distract management from day-to-day business and may require other substantial resources. We may incur restructuring and integration costs from combining other operations or technologies with ours. These costs may be substantial and may include costs for employee severance, relocation and disposition of excess assets and other acquisition related costs.
Item 2.
Item 2. PROPERTIES
Quidel's executive, administrative, manufacturing and research and development facility is located in San Diego, California. Quidel leases the 73,000 square-foot facility. Quidel also leases an approximately 17,000 square-foot administrative facility in San Diego, California, which it will occupy in March 2000. The Company also leases space in the United Kingdom, Italy and Germany under operating leases which expire at various times.
Metra currently leases approximately 30,600 square feet of laboratory and office space at two facilities in Mountain View, California. The Company leases these facilities under operating leases which last through May 2001, each with a renewal option that, if exercised, should extend the term of the lease through May 2003. Currently, one of the facilities is being subleased such that the rent being received offsets a portion of the rent being paid by Metra for these two facilities.
Item 3.
Item 3. LEGAL PROCEEDINGS
Quidel received a letter dated April 24, 1992 from the United States Environmental Protection Agency (the "EPA") notifying Quidel that it is a potentially responsible party for cleanup costs at a federal Superfund site, the Marco of Iota Drum Site (the "Marco Site"), near Iota, Louisiana. Documents gathered in response to such letter indicate that
Quidel sent a small amount of hazardous waste to facilities in Illinois. It is possible that subsequently, such waste could have been transshipped to the Marco Site. The EPA letter indicates that a similar notice regarding the Marco Site was sent by the EPA to over 500 other parties. At this time, Quidel does not know how much of its waste may have reached the Marco Site, the total volume of waste at the Marco Site or the likely site remediation costs. There is, as in the case of most environmental litigation, the theoretical possibility of joint and several liability being imposed upon Quidel for damages that may be awarded.
Quidel is involved in litigation matters from time to time in the ordinary course of business. Management believes that any and all such actions, in the aggregate, will not have a material adverse effect on Quidel. Quidel maintains insurance, including coverage for product liability claims, in amounts which management believes appropriate given the nature of Quidel's business.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
Item 5.
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
COMMON STOCK PRICE RANGE
Quidel's common stock is traded on the Nasdaq National Market System under the symbol "QDEL". The following table sets forth the range of high and low closing prices for the Company's common stock for the periods indicated since January 1, 1998.
In addition, Quidel has 950,000 warrants that are traded on the Nasdaq National Market System under the symbol "QDELW". These warrants were issued in April 1992 and expire April 30, 2002. The common stock underlying the warrants is in the process of being registered, pursuant to registration rights in the Warrant Agreement, to allow warrantholders the ability to exercise such warrants. The following table sets forth the range of high and low closing prices for the Company's warrants for the periods indicated since January 1, 1998.
No cash dividends have been paid on the common stock and Quidel does not anticipate paying any dividends in the foreseeable future. As of December 31, 1999, the Company had 935 common stockholders of record and 739 warrantholders of record.
Item 6.
Item 6. SELECTED FINANCIAL DATA
During October 1999, the Company changed its fiscal year from a March 31 fiscal year-end to a December 31 fiscal year-end. In addition, during the nine month period ended December 31, 1999, the Company was involved in three major financial transactions; the acquisition of Metra Biosystems, Inc., the acquisition of a urine test strip business from Dade Behring Marburg GmbH, and the sale and leaseback of the corporate headquarters facility. The following selected financial data are derived from the financial statements of Quidel Corporation and should be read in conjunction with the consolidated financial statements, related notes and other financial information included herein.
*RESULTING FROM THE ACQUISITION OF METRA BIOSYSTEMS, INC. (SEE NOTE 6 OF NOTES TO CONSOLIDATED FINANCIAL STATEMENTS)
**RESULTING FROM THE PREPAYMENT OF DEBT ON CORPORATE HEADQUARTERS. (SEE NOTE 8 OF NOTES TO CONSOLIDATED FINANCIALS STATEMENTS)
Item 7.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
FUTURE UNCERTAINTIES
This discussion contains forward-looking statements within the meaning of the federal securities laws that involve material risks and uncertainties. Many possible events or factors could affect our future financial results and performance, such that our actual results and performance may differ materially. As such, no forward-looking statement can be guaranteed. Differences in operating results may arise as a result of a number of factors, including, without limitation, seasonality, adverse changes in the competitive and economic conditions in domestic and international markets, actions of our major distributors, manufacturing and production delays or difficulties, adverse actions or delays in product reviews by the Food and Drug Administration ("FDA"), and the lower acceptance of our new products than forecast. Forward-looking statements typically are identified by the use of terms such as "may", "will", "should", "might", "expect", "anticipate", "estimate" and similar words, although some forward-looking statements are expressed differently. The risks described under "Business Risks" and in other sections of this report and in other reports and registration statements of the Company filed with the Securities and Exchange Commission from time to time should be carefully considered. The following should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K.
OVERVIEW
Quidel Corporation ("the Company") discovers, develops, manufactures and markets rapid diagnostic products for point-of-care detection. These products provide simple, accurate and cost-effective diagnoses for acute and chronic conditions. Products are sold worldwide to professionals in the physician's office and clinical laboratories, and to consumers through organizations that provide private label, store brand products.
There were many significant events that occurred during the nine month period ending December 31, 1999, including, the acquisition of Metra Biosystems, Inc. ("Metra"), a leader in the diagnosis and detection of bone loss for the management of osteoporosis and other bone diseases, and the acquisition of a urine test strip business from Dade Behring Marburg GmbH ("Dade Behring"). In addition, the Company launched the QuickVue(R) Influenza point-of-care diagnostic test to assist physicians in diagnosing influenza types A and B within ten minutes. Also, the Company implemented a new enterprise resource planning business operating system to allow operations of the business to become more efficient. Finally, the Company completed a sale and leaseback of its corporate headquarters to provide cash to assist with the acquisitions previously noted. During the quarter ended December 31, 1999, the Company also experienced a significant increase in the order rate of several core products which resulted in the Company moving to a 24 hour, 7 days a week, three shift manufacturing operation to meet increased product demand. Based on these events, Quidel completed this abbreviated fiscal year optimistic that the operating tasks accomplished and strategic investments made will significantly benefit the Company in the years ahead.
CHANGE IN FISCAL YEAR END
During October 1999, the Company changed its fiscal year from a March 31 fiscal year-end to a December 31 fiscal year-end.
ENTERPRISE COMPUTING SYSTEM
During September 1999, the Company began daily operations with a sophisticated enterprise resource planning business operating system. With this new system, the operations of the business are expected to become more efficient due to the streamlining of processes and procedures, many of which were being performed manually. The information to be provided from this system will assist management with day-to-day operating decisions. During the start-up of the system, the Company encountered difficulties that led to additional manufacturing costs and production backlog at December 31, 1999. These issues are expected to be resolved during 2000. Costs incurred during the application development stage were approximately $l.8 million and have been capitalized since the inception of this project. These costs will be depreciated over the software's estimated useful life.
INFLUENZA DIAGNOSTIC TEST
During September 1999, the Company received clearance from the FDA to market a rapid, point-of-care diagnostic test to detect influenza A and B. The QuickVue(R) Influenza test is designed to assist health care providers in identifying patients infected with influenza who would benefit from immediate diagnosis and intervention. The test was developed through a product development collaboration with Glaxo Group, Ltd., ("Glaxo Wellcome"), a wholly owned subsidiary of Glaxo Wellcome, plc. The Company is marketing the test worldwide, and began to ship the product in the United States during December 1999.
ACQUISITION OF METRA BIOSYSTEMS, INC.
During the quarter ended September 30, 1999, Quidel acquired all of the outstanding stock of Metra for approximately $22.7 million, or $1.78 per share, based upon 12,732,826 shares outstanding, in an all cash tender offer. Metra is a leader in the diagnosis and detection of bone loss for the management of osteoporosis and other bone diseases. The total cost of the transaction to the Company was approximately $7.1 million, net of cash acquired from Metra of approximately $19 million. The tender offer was financed from cash reserves, proceeds from a short-term bank loan and proceeds from a revolving line of credit. The short-term bank loan was repaid with the cash acquired from Metra.
ACQUISITION OF DADE BEHRING ASSETS
During November 1999, the Company entered into an Asset Sale Agreement with Dade Behring, a German corporation, for the purchase of Dade Behring's Rapignost(R) urine test strip business.
The purchase price for the assets was $5.75 million. Of that amount, $5 million was paid at closing, $500,000 will be paid in December 2000 and $250,000 will be paid in December 2001 upon successful completion of certain milestones. In addition to the aggregate purchase price for the assets, the Company agreed to pay Dade Behring a royalty on the combined global sales of Rapignost for five years after the closing, up to a maximum of $3 million. The funds used to complete the purchase came from the Company's existing bank line of credit. The Company was subsequently credited approximately $200,000 due to the inventory on hand at Dade Behring at the closing being less than the negotiated amount.
The acquired assets include: Dade Behring's inventory of Rapignost urine test strips, product manufacturing equipment, information and know-how, trademarks, vendor and customer contracts, distributor agreements, and assignments of certain license agreements. Dade Behring will continue to manufacture urine test strips for the Company for up to two years on a contract basis.
SALE AND LEASEBACK OF FACILITY
During December 1999, the Company completed a sale and leaseback transaction of its corporate headquarters facility and real estate. The facility and real estate was sold for $15 million, of which $3.75 million was capital contributed by the Company. As a part of this transaction, the Company paid off the mortgage on the facility of approximately $3 million and was assessed a pre-payment penalty of approximately $891,000. The Company will lease the 73,000 square foot facility for fifteen years, with options to extend the lease for up to two additional five-year periods. The sale was an all cash transaction, netting the Company approximately $7 million. The Company is a 25% limited partner in the partnership that acquired the facility and real estate.
The transaction was deemed a financing transaction under Statement of Financial Accounting Standards No. 98 "Accounting for Sales of Real Estate". As such, the assets sold remain on the books of the Company and will continue to be depreciated over the estimated useful life. The Company recorded $11.25 million as the present value of the net lease payments as a capital lease obligation.
RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED DECEMBER 31, 1999 AND
Net income for the three months ended December 31, 1999 was $397,000, or $.02 per share, compared to net income of $946,000, or $.04 per share, for the quarter ended December 31, 1998. The Company's results for this period in 1999 were impacted by investment decisions made to capitalize on the expected growth in the coming years. These changes included the market launch of the QuickVue Influenza Test, the acquisition of a urinalysis
business from Dade Behring, and the increase in staffing associated with the ramp up of production to a 24 hour, 7 days per week, three shift operation to meet increased product demand. In addition, the Company incurred a one-time mortgage prepayment penalty of $891,000 associated with the sale and leaseback of its corporate facility.
For the nine months ended December 31, 1999, the Company incurred a net loss of $1.5 million, or $.06 per share, compared to a net income of $248,000, or $.01 per share, for the same period in 1998. In addition to the items noted above for the three month period in 1999, the Company also had a one-time charge of $820,000 during the quarter ended September 30, 1999, related to the write off of acquired in-process research and development as a part of the acquisition of Metra.
NET SALES TRENDS BY MAJOR SALES CHANNELS
Net sales increased 22% for the quarter and 15% for the nine months ended December 31, 1999 compared to the same periods in 1998. Professional sales for the three months ended December 31, 1999 increased 33% in the Company's core products and also include Metra's domestic bone marker sales of $1.1 million, or 8% of net sales. Professional sales for the nine months ended December 31, 1999 increased 16% over the prior year and include Metra's domestic bone marker sales of $2 million, or 5% of net sales.
Over the counter ("OTC"), original equipment manufacture ("OEM") and clinical lab sales decreased by 1% for the quarter, but grew by 27% for the nine months ended December 31, 1999 compared to the same periods in 1998. The decrease for the quarter was due to the loss of an OTC contract during 1999. The change for the nine month period was also due to the loss of the OTC contract, but the loss was offset by sales of a partnered retail store brand program for distribution of pregnancy tests that commenced late 1998 and was in place for the full nine month period ended December 31, 1999.
International sales increased by 23% for the quarter and 4% for the nine months ended December 31, 1999 over the same periods in 1998. This increase in international sales is primarily due to the acquisition of Metra and its three European subsidiaries.
REVENUE FROM RESEARCH CONTRACTS, LICENSE FEES AND ROYALTIES
Contract research and development revenue is principally related to funding provided by Glaxo Wellcome for two separate multi-year, development programs for a rapid, point-of-care influenza A and B diagnostic test, which commenced in March 1996, and two rapid, point-of-care diagnostic tests to detect herpes simplex virus ("HSV"), which commenced in October 1997. In May 1999, a 510(k) application was filed with the FDA for marketing clearance of the influenza A and B point-of-care test. The 510(k) clearance was received in September 1999. The Company anticipates filing a 510(k) application for clearance for the HSV tests in 2001.
License fee income for the nine months ended December 31, 1999 included a $1 million milestone payment Metra earned from Sumitomo Pharmaceuticals Co., Ltd. due to the Metra bone markers becoming eligible for reimbursement in Japan.
COST OF SALES AND GROSS PROFIT
Gross profit as a percentage of sales for the three and nine months ended December 31, 1999 increased as a percent of sales from the same periods in 1998. This increase in profit margin is due to the Company improving its procedures for the procurement of raw materials and other initiatives intended to increase manufacturing efficiency and to reduce overall product costs. In addition, the Company is also reviewing its credit and rebate policies to identify potential increases in product sale profitability.
OPERATING EXPENSES
OPERATING EXPENSES (CONTINUED)
Operating expenses increased to $22.7 million for the period ended December 31, 1999 from $17.8 million for the same period in 1998. This increase includes a write-off of acquired in-process research and development of $820,000, and a recurring goodwill amortization charge of $267,000, both relating to the acquisition of Metra. The recurring annual amortization of goodwill acquired from Metra and technology purchased from Dade Behring is expected to be approximately $1.2 million. The balance of the increase in operating expenses is due to the reorganization of the sales and marketing teams at both the Company and Metra.
Sales and marketing expenses increased to 30% of net sales for the period ended December 31, 1999. Both international and domestic sales and marketing expenses increased due to new personnel and programs that were not present for the same period in 1998, consisting of an extensive worldwide sales and marketing function, including subsidiaries in the United Kingdom, Germany and Italy acquired through the acquisition of Metra.
Research and development expenses decreased to 14% of net sales for the period ended December 31, 1999 as efforts in several collaborative product development programs declined or were completed. The Glaxo Wellcome influenza A and B and HSV programs, previously discussed, are the largest of these projects. Contract research direct costs represented 33% of the Company's total research and development investment in the period ended December 31, 1999.
General and administrative expenses decreased to 12% of sales for the period ended December 31, 1999 as compared to the same period in 1998 primarily as a result of decreased outside consulting costs.
RESULTS OF OPERATIONS FOR THE YEARS ENDED MARCH 31, 1999 AND 1998
For the year ended March 31, 1999, net income was $7.7 million, or $.32 per share, compared to a net income of $1.1 million, or $.05 per share, for the year ended March 31, 1998. The most significant difference in net income for the year ended March 31, 1999 compared to the year ended March 31, 1998 was a deferred tax benefit of $6.4 million recorded in the fourth quarter of fiscal 1999 associated with the accumulated tax benefit of prior operating losses. A similar tax benefit of $2.7 million was recorded in fiscal 1998. The amount of the net deferred tax asset
estimated to be recoverable was based on our assessment of the likelihood of near-term operating income and that the realization of net operating loss carryforward was more likely than not.
Operating income for the year ended March 31, 1999 was approximately $1.2 million, or $.05 per share, compared to an operating loss of approximately $1.5 million, or $.06 per share, for fiscal 1998. Included in the results of operations for fiscal 1999 and 1998 were charges of $440,000 and $3.1 million, respectively, associated with the write down and closure of certain European subsidiaries.
NET SALES TRENDS BY MAJOR SALES CHANNELS
OEM product sales increased dramatically in the year ended March 31, 1999 due to the distribution of veterinary products for the full year compared to only a few months in fiscal 1998, as well as to the launch of a new partnered retail store brand program for distribution of pregnancy tests.
In the year ended March 31, 1998, we reassessed our international sales strategy and in the year ended March 31, 1999, completed the closure of European subsidiaries located in France, the Netherlands and Spain. As a result, international sales declined, except sales in the German subsidiary increased $983,000 for the year ended March 31, 1999 to approximately $2.7 million due to new distributor programs in Europe.
REVENUE FROM RESEARCH CONTRACTS, LICENSE FEES AND ROYALTIES
Contract research and development revenue principally related to funding provided by Glaxo Wellcome as noted previously.
COST OF SALES AND GROSS PROFIT
Gross profit declined approximately two percentage points to 45% of sales for the year ended March 31, 1999 from the prior year level. The shift in product mix toward sales of our OEM pregnancy tests, which provide a lower direct margin contribution, increased direct costs as a percent of sales. Manufacturing overhead cost increases for the year ended March 31, 1999 related to increased production capacity, the purchase of automation equipment, and the addition of purchasing and engineering support staff.
OPERATING EXPENSES
Sales and marketing efficiencies improved for the year ended March 31, 1999 as the overall cost declined to 20% of sales. Domestic OTC and OEM sales and marketing expenses continued to decline as these expenses were assumed by outside distributors. These savings partially offset the lower margin on domestic OTC/OEM products from reduced sales prices under these distribution agreements. International sales and marketing expenses declined due to the closure of our European subsidiaries and represented approximately 27% of total international sales.
Research and development remained constant for the year ended March 31, 1999 compared to the year ended March 31, 1998 as we continued our efforts in several collaborative product development programs. The Glaxo Wellcome influenza A and B and HSV programs, previously discussed, are the largest of these projects. Contract research expense represented 48% of the Company's total research and development investment for the year ended March 31, 1999.
General and administrative expenses increased significantly for the year ended March 31, 1999. This increase contained $1.3 million of non-recurring restructuring costs, including employee severance costs, legal fees and consulting costs. Without these non-recurring costs, general and administrative costs would have decreased by approximately $300,000 from the year ended March 31, 1998.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1999, the Company had cash and cash equivalents of approximately $4.7 million compared to $6.6 million at March 31, 1999. The change in cash and cash equivalents from March 31, 1999 was significantly impacted by the receipt of cash from the sale and leaseback of the corporate headquarter facility being offset by acquisition costs relating to the purchase of Metra, the purchase of the Dade Behring urine test strip business, the payoff of a $3.0 million real estate loan balance, the $891,000 pre-payment penalty related to the loan, the acquisition and implementation of the enterprise business operating system, and the purchase of manufacturing and other equipment.
As a part of the acquisition of Metra, the Company entered into a $10 million bank line of credit to assist with the financing of the transaction. The line was increased twice during the year up to $14.5 million to assist with the acquisition of the urine test strip business from Dade Behring and the sale and leaseback of the corporate headquarters facility. Upon the completion of those two transactions, and using the proceeds from the facility sale to repay a portion of the line of credit, the outstanding balance on the line of credit was reduced to $3.8 million as of December 31, 1999. The total available line of credit was also reduced to $7.5 million at December 31, 1999. Certain of the Company's assets collateralize the line of credit.
The principal requirements for cash are for working capital, including capital equipment additions, and the costs to continue implementation of the Company's new computer operating system. Cash requirements are expected to be funded by the results of operations. The Company also intends to continue searching for acquisition and technology licensing candidates. As such, the Company may need to incur additional debt, or sell additional equity, to successfully complete these acquisitions. Cash requirements fluctuate as a result of numerous factors, such as the extent to which the Company generates cash in operations, progress in research and development projects, competition and technological developments and the time and expenditures required to obtain governmental approval of our products. Based on the current cash position and the current assessment of future operating results, we believe that the existing sources of liquidity should be adequate to meet operating needs during fiscal 2000.
RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements." SAB No. 101 summarized the SEC's view in applying generally accepted accounting principles to revenue recognition in financial statements. SAB No. 101 is effective for all registrants during the first quarter of fiscal 2000. Management has reviewed the impact of SAB No. 101 on the Company's financial statements, and expects to record a cumulative effect pre-tax charge of approximately $1 million when the Company adopts the provisions of SAB No. 101 in January 2000.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quidel does not and did not invest in market risk sensitive instruments in 1999. Quidel had and has no exposure to market risk with regard to changes in interest rates. Quidel does not and has not used derivative financial instruments for any purposes, including hedging or mitigating interest rate risk.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and supplementary data of the Company required by this item are set forth at the pages indicated in Item 14(a)(1).
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
In July 1999, Quidel changed certifying accountants, with the firm of Arthur Andersen LLP replacing the firm of Ernst & Young LLP. There were no disagreements with Ernst & Young at the time of the change.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item (with respect to Directors) is incorporated by reference from the information under the captions "Election of Directors" and "Other Matters" contained in the Company's Proxy Statement to be filed with the Securities and Exchange Commission.
EXECUTIVE OFFICERS OF THE REGISTRANT
The names, ages and positions of all executive officers of Quidel as of December 31, 1999 are listed below, followed by a brief account of their business experience during the past five years. Officers are normally appointed annually by the Board of Directors at a meeting of the Board of Directors immediately following the Annual Meeting of Stockholders. There are no family relationships among these officers, nor any arrangements or understandings between any officer and any other person pursuant to which an officer was selected. None of these officers has been involved in any court or administrative proceeding within the past five years adversely reflecting on the officer's ability or integrity.
Andre de Bruin, 53, was appointed President and Chief Executive Officer of Quidel in June 1998. Since June 1997, Mr. de Bruin has been Vice Chairman of the Board and a part-time employee of the Company. Prior to joining Quidel, Mr. de Bruin was President and Chief Executive Officer of Somatogen, Inc. ("Somatogen"), a biopharmaceutical company, since July 1994. He was elected Chairman of the Board of Somatogen in January 1996. Baxter International, Inc., acquired Somatogen in May 1998. Prior to joining Somatogen, Mr. de Bruin was Chairman, President and Chief Executive Officer of Boehringer Mannheim Corporation, a U.S. subsidiary of Corange Ltd., a private, global health care corporation. He held that position since 1989. Mr. de Bruin serves on the Board of Directors of Diametrics Medical, Inc., a public company that manufactures and markets proprietary critical care blood and tissue analysis systems, and Metabolex, Inc., a privately held company founded to develop therapeutics for diabetes and related metabolic diseases. He has been involved in the global health care industry for more than twenty-eight years in pharmaceuticals, devices and diagnostics.
Charles J. Cashion, 49, Senior Vice President, Corporate Operations, Chief Financial Officer and Secretary, joined Quidel in December 1998. Mr. Cashion has more than twenty years of general management experience in the health care industry and was most recently Senior Vice President, Finance, Secretary, Treasurer and Chief Financial Officer of The Immune Response Corporation, a biopharmaceutical company. Mr. Cashion previously held positions at Smith Laboratories, Inc., Baxter International, Inc., and Motorola, Inc. Mr. Cashion received his M.B.A. and B.S. from Northern Illinois University.
Mark E. Paiz, 38, is Senior Vice President, Product Development and Supply Operations. From June 1998 to August 1999, Mr. Paiz was Vice President, Operations. Mr. Paiz joined Quidel in December 1997 as Senior Director, Manufacturing. Mr. Paiz has fifteen years experience in manufacturing, quality assurance and product development. From 1995 to 1997, Mr. Paiz served as Director of Research and Development and Project Manager at Medtronic Interventional Vascular, responsible for the development and manufacture of catheter and coronary
stent delivery devices. From 1992 to 1995, he served as a manager at Hybritech, Inc. with various responsibilities including quality engineering, materials management, supplier development and inspection. Mr. Paiz received his B.S. degree in Engineering from the University of Colorado and his M.B.A. from West Coast University.
John D. Tamerius, Ph.D., 54, is Vice President, Autoimmune and Complement and General Manager, Metra Operations. From August 1998 to August 1999, Dr. Tamerius was Vice President, Research & Development. Dr. Tamerius joined Quidel in August 1989 as Vice President of Clinical and Regulatory Affairs. In 1994, Dr. Tamerius assumed responsibility as Vice President of Quidel's Clinical Laboratory Business (including research and development, manufacturing and sales). Dr. Tamerius received his M.S. and Ph.D. degrees in Microbiology and Immunology from the University of Washington.
Robin G. Weiner, 44, Vice President, Clinical Development and Regulatory Affairs, joined Quidel in March 1982. Ms. Weiner has over fifteen years experience in regulatory affairs and has held numerous management positions at Quidel in operations, clinical/regulatory and quality assurance. From December 1992 to July 1995, Ms. Weiner was Senior Director of Clinical, Regulatory and Quality Systems. Ms. Weiner received her B.A. degree in Biochemistry from the University of California, San Diego and her M.B.A. from National University.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the information and under the caption "Compensation of Executive Officers and Directors" contained in the Company's Proxy Statement to be filed with the Securities and Exchange Commission.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the information under the caption "Stock Ownership of Certain Beneficial Owners and Management" contained in the Proxy Statement to be filed with the Securities and Exchange Commission.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the information under the caption "Certain Transactions" contained in the Proxy Statement to be filed with the Securities and Exchange Commission.
PART IV
Item 14.
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K
(a) (1) Financial Statements
The consolidated financial statements required by this item are submitted in a separate section beginning on page of this report.
(2) Financial Statement Schedules
Schedules have been omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or the notes thereto.
(3) Exhibits with each management contract or compensatory plan or arrangement required to be filed identified. See paragraph (c) below.
(b) Reports on Form 8-K
Reports on Form 8-K filed by the Company during the quarter ended December 31, 1999.
On October 26, 1999, Quidel filed a Form 8-K to report a change in fiscal year from a March 31 fiscal year-end to a December 31 fiscal year-end.
On November 12, 1999, Quidel filed a Form 8-K to report that it entered into a Letter of Intent with Dade Behring Marburg GmbH for the acquisition of the Dade Behring Urine Test Strip business.
On December 7, 1999, Quidel filed a Form 8-K to report that it entered into an Asset Sale Agreement dated as of November 26, 1999 with Dade Behring Marburg GmbH for the purchase of Dade Behring's Urine Test Strip business. The asset purchase closed on December 7, 1999, and was effective as of November 30, 1999.
On December 20, 1999, Quidel filed a Form 8-K to report it had completed the sale and leaseback of its corporate headquarters facility and real estate.
(c) Exhibits
3.1 Certificate of Incorporation, as amended. (Incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K dated February 26, 1991.)
3.2 Amended and Restated Bylaws. (Incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K dated June 16, 1995.)
10.1 Registrant's 1983 Employee Stock Purchase Plan, as amended. (Incorporated by reference to Exhibit 10.1 to the Registrant's Current Report on Form 8-K dated February 26, 1991.)
10.2 Form of Indemnification Agreement - Corporate Officer. (Incorporated by reference to Exhibit 10.2 to the Registrant's Form 10-K dated March 31, 1995.)
10.2.1 Form of Indemnification Agreement - Corporate Director. (Incorporated by reference to Exhibit 10.2.1 to the Registrant's Form 10-K dated March 31, 1995.)
10.3 Form of Warrant Agreement between Registrant and American Stock Transfer & Trust Company. (Incorporated by reference to Exhibit 10.3 to the Registrant's Form 10-K dated March 31, 1995.)
10.4 Registrant's 1990 Employee Stock Option Plan. (Incorporated by reference to Exhibit 10.3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990.)
10.5 Registrant's 1990 Director Option Plan. (Incorporated by reference to Exhibit 10.4 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990.)
10.6 Registrant's Amended and Restated 1982 Incentive and Nonstatutory Stock Option Plans, including Form of Option Agreement. (Incorporated by reference to Exhibit 10.28 to the Registrant's Registration Statement No. 33-38324 on Form S-4 filed on December 20, 1990.)
10.7 Form of Registration Rights Agreement of the Registrant. (Incorporated by reference to Appendix C to the final Joint Proxy Statement/Prospectus dated January 4, 1991 included within Amendment No. 2 to the Registrant's Registration Statement No. 33-38324 on Form S-4 filed on January 4, 1991.)
10.8 Assumption Agreement dated January 31, 1991. (Incorporated by reference to Exhibit 10.52.1 to the Registrant's Current Report on Form 8-K dated February 26, 1991.)
10.9 Trademark License Agreement dated October 1, 1994 between the Registrant and Becton Dickinson and Company regarding the Q-Test trademark. (Incorporated by reference to Exhibit 10.15 to the Registrant's Form 10-K dated March 31, 1995.)
10.10 Stock Purchase Agreement dated January 5, 1995 between Registrant and Eli Lilly & Company for the sale of all the outstanding capital stock of Pacific Biotech, Inc. (Incorporated by reference to Exhibit 2.1 to the Registrant's Form 8-K dated January 5, 1995.)
10.11 Settlement Agreement effective April 1, 1997 between the Registrant and Becton Dickinson and Company. (Incorporated by reference to Exhibit 10.18 to the Registrant's Form 10-K dated March 31, 1997)
10.12 Campbell License Agreement effective April 1, 1997 between the Registrant and Becton Dickinson and Company. (Incorporated by reference to Exhibit 10.19 to the Registrant's Form 10-K dated March 31, 1997)
10.13 Rosenstein License Agreement effective April 1, 1997 between the Registrant and Becton Dickinson and Company. (Incorporated by reference to Exhibit 10.20 to the Registrant's Form 10-K dated March 31, 1997)
10.14 Employment agreement dated June 9, 1998 between the Registrant and Andre de Bruin. (Incorporated by reference to Exhibit 10.23 to the Registrant's Form 10-Q dated June 30, 1998.)
10.15 Stock option agreement dated June 9, 1998 between the Registrant and Andre de Bruin. (Incorporated by reference to Exhibit 10.24 to the Registrant's Form 10-Q dated June 30, 1998.)
10.16 Employment agreement dated December 14, 1998 between the Registrant and Charles J. Cashion. (Incorporated by reference to Exhibit 10.28 to the Registrants Form 10-Q dated December 31, 1998.)
10.17 Offer to Purchase for Cash all outstanding shares of common stock of Metra Biosystems, Inc. by MBS Acquisition Corporation, a wholly-owned subsidiary of Quidel Corporation at $1.78 net per share. (Incorporated by reference to Metra's Schedule 14D-1 dated June 9, 1999.)
10.18 Business Loan Agreement, dated as of July 12, 1999, by and between Bank of America National Trust and Savings Association and Quidel Corporation. (Incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K dated July 12, 1999.)
10.19 Security Agreement, dated as of July 12, 1999, by and among Bank of America National Trust and Savings Association, Quidel Corporation, MBS Acquisition Corporation, and Pacific Biotech, Inc. (Incorporated by reference to Exhibit 10.2 to the Registrant's Form 8-K dated July 12, 1999.)
10.20 Subsidiary Guaranty, dated as of July 12, 1999, by MBS Acquisition Corporation and Pacific Biotech, Inc. (Incorporated by reference to Exhibit 10.3 to the Registrant's Form 8-K dated July 12, 1999.)
10.21 Cash Collateral Agreement, dated as of July 12, 1999, by and between Bank of America National Trust and Savings Association and Pacific Biotech, Inc. (Incorporated by reference to Exhibit 10.4 to the Registrant's Form 8-K dated July 12, 1999.)
10.22 Form of Asset Sale Agreement - Rapignost(R)Urine Test Strip Business. (Incorporated by reference to Exhibit 10.5 to the Registrant's Form 8-K dated December 7, 1999.)
10.23 Form of Purchase and Sale Agreement and Escrow Instructions. (Incorporated by reference to Exhibit 10.6 to the Registrant's Form 8-K dated December 20, 1999.)
10.24 Form of Single Tenant Absolute Net Lease. (Incorporated by reference to Exhibit 10.7 to the Registrant's Form 8-K dated December 20, 1999.)
21.1* Subsidiaries of the Registrant
23.1* Consent of Arthur Andersen LLP, Independent Public Accountants
23.2* Consent of Ernst & Young LLP, Independent Auditors
27* Financial Data Schedule
* Filed Herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
QUIDEL CORPORATION
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Quidel Corporation:
We have audited the accompanying consolidated balance sheet of Quidel Corporation (a Delaware corporation) and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for the nine months then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Quidel Corporation and subsidiaries as of December 31, 1999, and the results of their operations and their cash flows for the nine months then ended in conformity with generally accepted accounting principles in the United States.
/s/ ARTHUR ANDERSEN LLP
San Diego, California February 11, 2000
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders Quidel Corporation
We have audited the accompanying consolidated balance sheet of Quidel Corporation as of March 31, 1999, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two years in the period ended March 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Quidel Corporation at March 31, 1999, and the consolidated results of its operations and its cash flows for each of the two years in the period ended March 31, 1999, in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
San Diego, California May 14, 1999
QUIDEL CORPORATION
CONSOLIDATED BALANCE SHEETS
SEE ACCOMPANYING NOTES.
QUIDEL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
SEE ACCOMPANYING NOTES.
QUIDEL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
SEE ACCOMPANYING NOTES.
QUIDEL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
QUIDEL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(CONTINUED)
SEE ACCOMPANYING NOTES.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION RELATING TO THE NINE MONTHS ENDED DECEMBER 31, 1998 IS UNAUDITED)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Quidel Corporation (the "Company") commenced operations in 1979. The Company operates in one business segment which develops, manufactures and markets point-of-care ("POC") rapid diagnostics for detection of human medical conditions and illnesses. These products provide simple, accurate and cost-effective diagnoses for acute and chronic conditions in the areas of women's health and infectious diseases. The Company's products are sold to professionals for use in the physician's office and clinical laboratory through a network of national and regional distributors, and to consumers through organizations that provide store brand products. In July 1999, the Company acquired substantially all of the assets and liabilities of Metra Biosystems, Inc. ("Metra") in an effort to broaden its diagnostic product line and customer base (see note 6). Metra develops and manufactures diagnostics for bone loss detection for the management of osteoporosis and other bone diseases. Also, in December 1999, the Company acquired the Rapignost(R) urine test strip business of Dade Behring Marburg GmbH ("Dade Behring") (see note 7).
CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
CHANGE IN FISCAL YEAR During October 1999, the Company changed its fiscal year from a March 31 fiscal year-end to a December 31 fiscal year-end. The Company is reporting the nine months ended December 31, 1999 as a transition to its new fiscal year-end of December 31. Results of operations for the nine months ended December 31, 1999 are not necessarily indicative of the results to be expected for the Company's fiscal year ending December 31, 2000.
INTERIM FINANCIAL INFORMATION (UNAUDITED) The unaudited interim statements of operations and cash flows and related notes for the nine months ended December 31, 1998 have been prepared on the same basis as the audited financial statements and, in the opinion of management, include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Results for the interim period are not necessarily indicative of results to be expected for the full fiscal year.
REVENUE RECOGNITION Revenue from product sales are recorded net of estimated returns at the time the product is shipped. Revenues from contracts to perform research and development and license fees are recorded as earned based on the performance requirements of the agreements. Revenue from the licensing of distribution rights is recorded when earned under the terms of the related license agreements.
CASH AND CASH EQUIVALENTS The Company considers cash equivalents to be highly liquid investments with an original maturity of three months or less.
ACCOUNTS RECEIVABLE The balance of accounts receivable is net of allowances of $1.6 million at December 31, 1999 and $587,000 at March 31, 1999.
OTHER RECEIVABLES The balance in other receivables is primarily related to a $1 million payment owed to Metra from Sumitomo Pharmaceuticals Co., Ltd. due to the Metra bone markers becoming eligible for reimbursement in Japan. Metra received this payment in January 2000.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
INVENTORIES Inventories are stated at lower of cost (first-in, first-out method) or market. The Company reviews the components of its inventory on an annual basis for excess, obsolete and impaired inventory and makes appropriate dispositions as obsolete stock is identified.
PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated over the estimated useful lives of the assets (3 to 15 years) using the straight-line method. Amortization of leasehold improvements is computed on the straight-line method over the shorter of the lease term or the estimated useful lives of the assets. Maintenance and repairs are charged to operations as incurred. When assets are sold, or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in the statements of operations.
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1 "Accounting for Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 requires companies to capitalize qualifying computer software costs that are incurred during the application development stage and amortize such costs over the software's estimated useful life. SOP 98-1 is effective for fiscal years beginning after December 15, 1998. The Company adopted SOP 98-1 effective January 1, 1999 and capitalized software costs for a total of $1.8 million and $697,000 for the nine months ended December 31, 1999 and the year ended March 31, 1999, respectively.
Property and equipment consists of the following:
INTANGIBLE ASSETS Intangible assets, representing primarily patents, trademarks and license agreements, are recorded at cost and amortized on a straight-line basis over estimated useful lives of 5 to 15 years. The excess of cost over the fair value of the net tangible assets purchased arose from the Company's 1999 acquisition of its wholly-owned subsidiary, Metra, as well as the purchase of technology from Dade Behring. The goodwill acquired from Metra is being amortized over five years, while the technology purchased from Dade Behring is being amortized over ten years. Patent filing costs are capitalized and amortized upon the issuance of the related patent.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Intangible assets consist of the following:
IMPAIRMENT OF LONG-LIVED ASSETS Periodically, the Company reviews for possible impairment of its long-lived assets and certain identifiable intangibles to be held and used by comparing the carrying value of an asset to its estimated undiscounted future cash flows. Whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable, asset values are adjusted accordingly.
In April 1998, the Company's Board of Directors approved a plan under which the operations of certain of the Company's foreign subsidiaries would be disposed of through abandonment. In accordance with SFAS No. 121, management assessed the recoverability of those assets by comparing the expected cash flows to be generated by those assets to their carrying amounts. This analysis concluded that the carrying amounts of the assets were not recoverable. Accordingly, in 1998, the Company wrote down the assets to their fair value, which was determined to be minimal.
RESEARCH AND DEVELOPMENT COSTS All research and development costs are charged to operations as incurred.
INCOME TAXES Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
FOREIGN CURRENCY TRANSLATION The consolidated balance sheet accounts of the Company's foreign operations are translated from their respective foreign currencies into U.S. dollars at the exchange rate in effect at the balance sheet date, and revenue and expense accounts are translated using an average exchange rate during the period of recognition. The effects of translation are recorded as a separate component of stockholders' equity. Exchange gains and losses arising from transactions denominated in foreign currencies are recorded using the actual exchange differences on the date of the transaction and are included in the consolidated statements of operations.
FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of the Company's financial instruments, including cash, receivables, accounts payable, accrued liabilities and the line of credit approximate their fair values due to their short term nature. The Company's long-term debt approximates fair value as it carries a fair market rate of interest. Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of trade accounts receivable. The Company believes it is not exposed to any significant credit risk on its accounts receivable.
COMPUTATION OF EARNINGS PER SHARE Basic earnings per share was computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if the income were divided by the weighted-average number of common shares and potentially dilutive common shares from outstanding stock options and warrants. Potential dilutive common shares were calculated using the treasury stock method and represent incremental shares issuable upon exercise of the Company's outstanding options and warrants. Potentially dilutive securities are not considered in the calculation of net loss per share as their impact would be antidilutive.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following table reconciles the shares used in computing basic and diluted earnings per share in the respective periods:
COMPREHENSIVE INCOME Comprehensive income represents the impact of any fluctuations in the Company's foreign currency translation adjustments.
USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
RECLASSIFICATION Certain amounts from the prior year have been reclassified to conform to the December 31, 1999 presentation.
RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements." SAB No. 101 summarized the SEC's view in applying generally accepted accounting principles to revenue recognition in financial statements. SAB No. 101 is effective for all registrants during the first quarter of fiscal 2000. Management has reviewed the impact of SAB No. 101 on the Company's financial statements, and expects to record a cumulative effect pre-tax charge of approximately $1 million when the Company adopts the provisions of SAB No. 101 in January 2000.
NOTE 2. EXPORT SALES, FOREIGN OPERATIONS AND PRODUCT LINE INFORMATION
Export sales were as follows:
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Sales and operating income (loss) for the nine months ended December 31, 1999 and 1998, and the years ended March 31, 1999 and 1998, and identifiable assets at the end of each of those years, classified by geographic area, were as follows:
Intercompany sales to affiliates totaled approximately $1.6 million, $1.4 million and $2.4 million for the nine months ended December 31, 1999 and the two years ended March 31, 1999 and 1998, respectively. Intercompany sales prices are established with consideration of each entity's contribution to the overall gross profit generated. Intercompany revenue and gross profit in inventory are eliminated upon consolidation.
The products that contributed at least 10 percent to consolidated net sales for the nine months ended December 31, 1999 and 1998, and the years ended March 31, 1999 and 1998 were:
NOTE 3. LINE OF CREDIT As a part of the acquisition of Metra, the Company entered into a $10 million bank line of credit to assist with the financing of the transaction. The line was increased twice during the year up to $14.5 million to assist with the acquisition of the urine test strip business from Dade Behring and the sale and leaseback of the corporate headquarters facility. Upon the completion of those two transactions, and using the proceeds from the facility sale to repay a portion of the line of credit, the outstanding balance on the line of credit was reduced to $3.8 million as of December 31, 1999. The total available line of credit was also reduced to $7.5 million at December 31, 1999. Certain of the Company's assets collateralize the line of credit.
NOTE 4. LEASE COMMITMENTS
Rent expense under operating leases totaled $243,000, $294,000 and $247,000 for the nine months ended December 31, 1999 and the two years ended March 31, 1999 and 1998, respectively.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Cost and accumulated depreciation of equipment under capital leases in the accompanying consolidated balance sheets at December 31, 1999 are $18.6 million and $7.1 million, respectively, and at March 31, 1999 are $181,000 and $124,000, respectively. Depreciation of equipment under capital lease agreements is included in depreciation expense in the accompanying consolidated statements of operations.
NOTE 5. LONG-TERM DEBT AND CAPITAL LEASES
Long-term debt and capital leases consist of the following:
Future principal debt payments for years ended after December 31, 1999 are as follows (in thousands):
NOTE 6. STOCKHOLDERS' EQUITY
COMMON STOCK WARRANTS. Outstanding warrants to purchase shares of common stock at December 31, 1999, are as follows:
During December 1999, 124,379 warrants were exercised, resulting in proceeds to the Company of approximately $460,000. Subsequent to December 31, 1999, 213,121 warrants were exercised, resulting in proceeds to the Company of approximately $940,000.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company's 950,000 publicly traded warrants (QDELW) were issued in April 1992 and expire April 30, 2002. The common stock underlying the warrants is in the process of being registered pursuant to registration rights in the Warrant Agreement to allow the warrantholders the ability to exercise such warrants.
STOCK OPTIONS The Company has stock options outstanding which were issued under various stock option plans to certain employees, consultants and directors. The options have terms ranging up to ten years, have exercise prices ranging from $1.81 to $6.56, and generally vest over four years. All options are issued at 100% of fair market value.
In July 1998, the Company's stockholders authorized the establishment of the 1998 Stock Incentive Plan which provides for the grant of options to purchase up to 3,000,000 shares of common stock. In addition, the stockholders also authorized an amendment to the Company's 1996 Non-Employee Directors Stock Option Plan which increased the total number of shares reserved for issuance under the plan by 80,000 shares to bring the total shares authorized under this plan to 400,000 shares.
The following table summarizes option activity in terms of thousands of shares and the weighted average exercise per share:
At December 31, 1999, there were 1,291,386 shares exercisable, with a weighted average remaining contractual life of 8.13 years. At December 31, 1999, 1,311,343 shares remained available for grant under the plans.
The Company has elected to follow Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations, in accounting for its employee stock options. Under APB No. 25, because the exercise price of the Company's employee stock options equals the estimated market price of the underlying stock on the date of grant, no compensation has been recognized.
The estimated weighted average fair value of options granted during the nine months ended December 31, 1999 and the years ended March 31, 1999 and 1998 was $2.12, $2.16 and $2.01, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants for the nine months ended December 31, 1999 and the years ended March 31, 1999 and 1998, respectively: risk-free interest rate of 6.3%, 5.0% and 6.0%; expected option life of 5.6, 5.8 and 5.0 years; expected volatility of .78, .72 and .75; and a dividend rate of zero for all three periods.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Because the Company's employee stock option plans have characteristics significantly different from those of traded options, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards for the nine months ended December 31, 1999 and the years ended March 31, 1999 and 1998 consistent with the provisions of SFAS No. 123, the Company's net income (loss) and income (loss) per share would have been as indicated below:
EMPLOYEE STOCK PURCHASE PLAN In fiscal 1998, the number of shares authorized to be issued under the Employee Stock Purchase Plan ("the Plan") was increased by 100,000 to a total of 600,000 shares of common stock. Under the Plan, full-time employees are allowed to purchase common stock through payroll deductions (which cannot exceed 10% of the employee's compensation) at the lower of 85% of fair market value at the beginning or end of each six-month option period. As of December 31, 1999, 504,270 shares had been sold under the Plan, leaving 95,730 shares available for future issuance.
At December 31, 1999, approximately 7.3 million shares of common stock were reserved for the exercise of stock options and warrants, and purchases under the Employee Stock Purchase Plan.
NOTE 7. ACQUISITION OF METRA BIOSYSTEMS, INC.
During the quarter ended September 30, 1999, the Company completed the acquisition of all the outstanding stock of Metra for approximately $22.7 million, or $1.78 per share, based upon 12,732,826 shares outstanding, in an all cash tender offer. Metra's business activities consist of the diagnosis and detection of bone loss for the management of osteoporosis and other bone diseases. The total cost of the transaction to the Company was approximately $7.1 million, net of cash acquired from Metra of approximately $19 million. The tender offer was financed from cash reserves, proceeds from a short-term bank loan and proceeds from a revolving line of credit. The short-term bank loan was repaid with the cash acquired from Metra.
ACCOUNTING TREATMENT OF ACQUISITION The transaction was accounted for under the purchase method of accounting and, accordingly, the assets and liabilities were recorded based on their fair values at the date of acquisition. The results of operations of Metra have been included in the financial statements for the periods subsequent to acquisition.
The Company allocated the fair values of the net assets acquired between acquired in-process research and development of $820,000 and the purchase price in excess of identifiable assets of approximately $3.1 million. The $820,000 allocated to acquired in-process research and development was written off at the time of the acquisition. In addition, approximately $3.1 million of intangible assets were capitalized and are being amortized over five years.
The value of the acquired in-process research and development was computed using a discounted cash flow analysis on the anticipated income stream of the related product sales. The value assigned to acquired in-process research and development was determined by estimating the costs to develop the acquired in-process research and development into commercially viable products, estimating the resulting net cash flows from the projects and discounting the net cash flows to their present value. With respect to the acquired in-process research and development, the calculations of value were adjusted to reflect the value creation efforts of Metra prior to the close of the acquisition.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The nature of the efforts required to develop acquired in-process research and development into commercially viable products principally relates to the completion of all planning, designing and testing activities that are necessary to establish that the products can be produced to meet their design requirements, including functions, features and technical performance requirements. If the research and development project and technologies are not completed as planned, they will neither satisfy the technical requirements of a changing market nor be cost effective. No assurance can be given, however, that the underlying assumptions used to estimate expected product sales, development costs or profitability, or the events associated with such projects, will transpire as estimated.
The Company continues to work toward the completion of the research and development of the projects acquired. The majority of the projects are on schedule, but delays may occur due to changes in technological and market requirements for the Company's products. The risks associated with these efforts are still considered high and no assurance can be made that any upcoming products will meet with market acceptance. Delays in the introduction of certain products may adversely affect the Company's revenues and earnings in future quarters.
PRO FORMA FINANCIAL INFORMATION (UNAUDITED) The following table presents the unaudited pro forma results assuming the Company had acquired Metra as of April 1, 1999 and 1998, respectively. Net loss and basic and diluted loss per share amounts have been adjusted to exclude the acquired in-process research and development write-off of $820,000 and net interest income of $357,000 and $1 million for the nine months ended December 31, 1999 and 1998, respectively, and to include additional goodwill amortization of $208,000 and $468,000 for the nine months ended December 31, 1999 and 1998, respectively. This information may not necessarily be indicative of the future combined results of the Company.
NOTE 8. ACQUISITION OF DADE BEHRING ASSETS
During November 1999, the Company entered into an Asset Sale Agreement with Dade Behring for the purchase of Dade Behring's Rapignost(R) urine test strip business.
The purchase price for the assets was $5.75 million. Of that amount, $5 million was paid at closing, $500,000 will be paid in December 2000 and $250,000 will be paid in December 2001, upon successful completion of certain milestones. The Company believes that the $250,000 payable upon successful completion of certain milestones is determinable beyond a reasonable doubt and have therefore accounted for the $250,000 as a long-term liability as of December 31, 1999. In addition to the aggregate purchase price for the assets, the Company agreed to pay Dade Behring a royalty on the combined global sales of the urine test strips for five years after the closing, up to a maximum of $3 million. The funds used to complete the purchase came from the Company's existing bank line of credit. The Company was subsequently credited approximately $200,000 due to the inventory on hand at Dade Behring at the closing being less than the negotiated amount.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The acquired assets include Dade Behring's inventory of urine test strips, valued at $170,000, product manufacturing equipment, valued at $100,000, and information and know-how, trademarks, vendor and customer contracts, distributor agreements, and assignments of certain license agreements, valued at approximately $5.4 million. Dade Behring will continue to manufacture the urine test strips for the Company for up to two years on a contract basis.
NOTE 9. SALE AND LEASEBACK OF FACILITY
During December 1999, the Company completed a sale and leaseback transaction of its corporate headquarters facility and real estate. The facility and real estate was sold for $15 million, of which $3.75 million was capital contributed by the Company. As a part of this transaction, the Company paid off the mortgage on the facility of approximately $3 million and was assessed a pre-payment penalty of approximately $891,000. The Company will lease the 73,000 square foot facility for fifteen years, with options to extend the lease for up to two additional five-year periods. The sale was an all cash transaction, netting the Company approximately $7 million. The Company is a 25% limited partner in the partnership that acquired the facility and real estate.
The transaction was deemed a financing transaction under SFAS No. 98 "Accounting for Sales of Real Estate". As such, the assets sold remain on the books of the Company and will continue to be depreciated over the estimated useful life. The Company recorded $11.25 million as the present value of the net lease payments as a capital lease obligation.
NOTE 10. INCOME TAXES
For financial reporting purposes, income before income taxes and extraordinary item includes the following components:
Significant components of the provision for income taxes attributable to continuing operations are as follows:
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Significant components of the Company's deferred tax assets as of December 31, 1999 and March 31, 1999 are shown below. During the year ended March 31, 1999, the Company decreased the valuation allowance for deferred tax assets by approximately $11.8 million. Of this amount, approximately $6.4 million resulted from the determination that the realization of net operating loss carryforwards was more likely than not and the remainder related to other decreases in deferred tax assets.
At December 31, 1999, the Company had Federal income tax net operating loss carryforwards of approximately $66.0 million. The Federal income tax net operating loss carryforwards began to expire in 1999.
The Company also has federal investment tax, research and development and alternative minimum tax credit carryforwards of approximately $1.1 million and California research and development, manufacturers' investment and alternative minimum tax credit carryforwards of $439,000 which began to expire in 1999.
The reconciliation of income tax computed at the Federal statutory rate to the provision for income taxes is as follows:
NOTE 11. COMMITMENTS
RESEARCH AND DEVELOPMENT AGREEMENTS
During 1998 and 1997, the Company entered into agreements to perform research and development with Glaxo Wellcome plc ("Glaxo Wellcome"). Under these agreements, specified costs related to the performance of research and development for certain diagnostic test products are reimbursed by Glaxo Wellcome. The agreements provide for total funding up to approximately $12.1 million. The Company recorded revenue equal to the sum of the direct costs incurred under the agreements, plus a permitted overhead surcharge, of approximately $1.8 million in the nine months ended December 31, 1999, and $4.0 million and $3.2 million for the years ended March 31, 1999 and 1998, respectively. In exchange for the funding provided by Glaxo Wellcome under these agreements, upon successful completion of the planned products, the Company will be required to pay royalties on sales of the developed products to Glaxo Wellcome.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12. EMPLOYEE BENEFIT PLAN
The Company has a defined contribution 401(k) plan (the "Plan") covering all employees who are eligible to join the Plan upon employment. Employees may contribute up to 20% of their compensation per year (subject to a maximum limit by federal law). The Company began matching contributions to the Plan during the nine months ended December 31, 1999, and such contribution amounted to $125,000.
NOTE 13. BECTON DICKINSON LICENSE AGREEMENT
In June 1997, the Company entered into a license agreement with Becton Dickinson and Co. ("BD") in exchange for a cash license fee, a royalty on net sales of certain of its pregnancy and ovulation products, and a license of the Company's Q-Laboratory technology back to BD (with a royalty on future net sales). The license fee paid of $2.3 million was capitalized and is being amortized over 7.5 years, the term of the agreement. Royalty expense applicable to this agreement totaled approximately $1.7 million and $1.6 million for the nine months ended December 31, 1999 and 1998, respectively, and approximately $1.9 million and $1.7 million for the years ended March 31, 1999 and 1998, respectively.
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14. PRO FORMA STATEMENTS OF OPERATIONS (UNAUDITED)
As noted in note 1, the Company changed its fiscal year to a December 31 year-end. The following is a pro forma statements of operations showing the results of operations of the Company as if the Company was on a December 31 year-end for each of the three years ended December 31, 1999. The pro forma financial information is based on the actual information for the nine months ended December 31, plus the actual information for the three months ended March 31.
Quidel Corporation Consolidated Statements of Operations
QUIDEL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
The following is a summary of unaudited quarterly results for the twelve months ended December 31, 1999 and 1998.
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Basic and diluted net income per share are the same for all quarterly periods. The net income (loss) for the quarters ended March 31, 1999 and 1998, included an income tax benefit of approximately $6.6 million and $2.7 million, respectively. | 19,499 | 128,930 |
885067_1999.txt | 885067_1999 | 1999 | 885067 | ITEM 1. BUSINESS
OVERVIEW
Intermedia operates in two business segments. Through its Integrated Communications Services segment, the Company provides integrated data and voice communications services, including enterprise data solutions (frame relay and ATM), Internet connectivity, private line data , local and long distance, and systems integration services to approximately 90,000 business and government customers throughout the United States. Digex, a publicly-traded subsidiary of the Company, ("Digex") is a leading provider of managed Web hosting services to businesses operating mission-critical, multi-functional Websites. Intermedia's integrated service portfolio allows the Company to meet the sophisticated telecommunications needs of its business customers and maximizes its network efficiencies.
As of December 31, 1999, Intermedia is:
- a Tier One Internet service provider through its nationwide data network of 69 points-of-presence, as well as peering arrangements with the world's largest ISPs. Intermedia is currently upgrading its network with an OC-48 fiber optic backbone to service the increasing bandwidth requirements of its customers;
- the fourth largest nationwide frame relay provider in the United States (based on frame relay revenues) with 185 data switches installed, 48,973 frame relay nodes in service and 881 network-to-network interfaces ("NNIs") deployed with many leading communications companies, including BellSouth, US West, Sprint, GTE, Bell Atlantic, Ameritech, SBC and SNET;
- through Digex, a leading and rapidly growing provider of managed Web site and application hosting services to large corporations and Internet companies, with state-of-the-art data centers strategically positioned on the east and west coasts of the United States;
- the largest provider of building centric telecommunications services in the United States with in-building distribution networks in 650 class A commercial office buildings representing approximately 195 million square feet in major metropolitan areas, and access rights to more than 12,800 additional properties nationwide;
- the largest independent provider of competitive local services in the United States (based on revenues) with 501,094 local access line equivalents in service, 29 voice switches and 1,457 sales and sales support staff in 64 cities throughout the United States. Intermedia recently introduced its unifiedvoice.net(SM) service, which provides integrated local and long distance with high speed Internet access over a common access facility and on a single bill to small and medium size businesses; and
- a leading provider of systems integration services in the United States. Intermedia engineers, installs, operates and maintains business telephony customer premise equipment for its customers from leading vendors, including Nortel and NEC.
The Company is able to directly address a $100 billion telecommunications market opportunity. Intermedia believes that it has a substantial business opportunity due to the following industry dynamics: (i) business customers are demanding integrated telecommunications service offerings; (ii) data and internet services are growing more rapidly than voice services; (iii) the demand for value-added differentiated
applications and telecommunications solutions is increasing; and (iv) regulatory initiatives are creating enhanced opportunities for competitive entrants.
Intermedia's mission is to be the premier provider of integrated data and voice communications solutions to business customers. To achieve this objective, Intermedia's strategy focuses on the following key principles: (i) deliver fully integrated service solutions, including data (frame relay, ATM, Internet connectivity and managed Web site and application hosting) and voice (local and long distance) to business customers over a network that it controls from end to end; (ii) concentrate sales and marketing efforts on high growth, high margin service offerings, including Internet, local access and managed Web site and application hosting; (iii) target communication-intensive small and medium size businesses in geographic markets with dense concentrations of corporate customers; (iv) deploy a network infrastructure that drives customer responsiveness, facilitates service innovation and supports service customization; and (v) strive to become a low-cost provider of telecommunications services by deploying capital efficiently, controlling costs and leveraging marketing partnerships to expand channels of distribution and efficiently add traffic on its network at low marginal cost.
THE COMPANY'S COMPETITIVE STRENGTHS
Intermedia has core competencies in data and Internet. The Company's data network is pervasive -- consisting of 185 data switches, 881 NNIs interfaces, 48,973 frame relay nodes, 69 Internet points-of-presence and 49,523 fiber miles. The Company's network enables it to provision nationwide frame relay, ATM and Internet related services and to take advantage of several of the highest growth segments in the telecommunications industry.
Intermedia offers a fully integrated portfolio of service offerings. Intermedia's integrated service offerings (including, enterprise data solutions, Internet connectivity, private line data, managed Web site and application hosting, and local and long distance) enable the Company to provide comprehensive end-to-end integrated services, thereby managing its customer's total telecommunications requirements. The Company's integrated approach results in higher revenue per customer, improved gross margins, lower customer acquisition costs and lower churn.
Intermedia has a leading and rapidly growing managed Web site and application hosting business. With approximately 2,300 dedicated Windows NT and Unix-based servers on-line as of December 31, 1999, Digex delivers mission critical managed Web site and application hosting solutions to large corporations and internet companies. The scaleability of its systems allows Digex to differentiate itself from competitors, by rapidly and cost-efficiently implementing and expanding its customers' Web site hosting initiatives. Digex provides Intermedia with a platform to take advantage of the rapid growth in the managed Web site and application hosting market, projected to increase from $875.0 million in 1998 to approximately $14.6 billion in 2003.
Intermedia has the largest building centric telecommunications business in the United States. Through the Company's contracts with Real Estate Investment Trusts ("REITs") and landlords of large office buildings throughout the country, Intermedia owns and operates in-building distribution networks in 650 class A commercial office buildings. Intermedia also has access rights to more than 12,800 additional properties across the United States. These key access points enable the Company to cost effectively and efficiently sell and provision its integrated telecommunications offerings to high concentrations of small and medium size business customers in major metropolitan areas. This "building-centric" approach, which the Company operates under Intermedia's Advanced Building Networks brand, allows customers to benefit from a broad service offering without the expense and risk of deploying their own telecommunications equipment.
Intermedia benefits from strategic partnerships and alliances. As a result of the Company's ability to provision nationwide data services, Intermedia has been selected as a preferred provider for out-of-region data services by several incumbent local exchange carriers, including Bell Atlantic, US West and Ameritech. The Company also has partnerships for provisioning nationwide data services with SBC, BellSouth, Williams and NTT America. These relationships provide the Company with an extended sales channel for its high-margin data services, including Internet access, frame relay and ATM. In addition, Intermedia's strategic alliances with NorthPoint Communications ("Northpoint") and Rhythms NetConnections provide the Company with
accelerated access to the most extensive DSL deployment in the United States and position the Company to provide its customers with value-added broadband data services while minimizing Intermedia's capital requirements.
Intermedia's "smart build" network strategy allows it to control the key strategic elements of its network. Owning the intelligent components of its network, including switches, customer connections, building entries and other "first mile" elements, allows the Company to be responsive to customer needs and enhances the utilization of the Company's network. This strategy also allows Intermedia to pursue success based capital deployment, adding revenue producing customers before incurring the costs and risks of build-out.
RECENT DEVELOPMENTS
Public Offering of Our Managed Web Site and Application Hosting Subsidiary. In August 1999, Digex, our managed Web site and application hosting subsidiary, sold 11.5 million shares of its Class A common stock in an initial public offering. The net proceeds from the offering were approximately $178.9 million and may be used by Digex to purchase telecommunications related assets due to restrictions in our debt instruments.
In February 2000, Digex completed a second public offering of 12,650,000 shares of its Class A Common Stock. Pursuant to that offering, Digex offered 2,000,000 shares of its Class A common stock, and the Company sold 10,650,000 shares of Digex Class A common stock it then owned. The shares of Class B common stock of Digex sold by the Company automatically converted into shares of Digex class A common stock at the closing of the offering. As a result, the Company now owns approximately 62.0% of the outstanding Digex common stock. However, since each share of Digex Class B common stock has ten votes and each share of Digex Class A common stock has one vote, Intermedia retains approximately 94.2% voting interest in Digex. The net proceeds to the Company were approximately $913.8 million and will be used to reduce the Company's outstanding debt and to purchase telecommunications related assets.
Credit Facility. On December 22, 1999, Intermedia secured a five-year $100.0 million Revolving Credit Agreement (the "Credit Agreement") with Bank of America N.A., the Bank of New York, and Toronto Dominion (Texas), Inc. The Revolving Credit Facility ("Credit Facility") may be repaid and reborrowed from time to time in accordance with the terms and provisions of the agreement and is guaranteed by each of the Company's subsidiaries. The Credit Facility is also secured by a pledge of the stock of each of the Company's subsidiaries, and is secured by substantially all of the assets of the Company and its subsidiaries. In addition, Intermedia recently received a commitment from the banks to increase the size of the Credit Facility, although it is under no obligation to do so.
In January 2000, Microsoft and a subsidiary of Compaq made a $100.0 million equity investment in Digex, of which $85.0 million was paid in cash and $15.0 million was paid in the form of equipment credits from Compaq. Digex also entered into strategic development agreements and joint marketing arrangements with both companies.
In February 2000, an affiliate of Kohlberg Kravis Roberts & Co. ("KKR") made a $200 million equity investment in the Company in a private placement transaction. At closing, two representatives of KKR joined the board of directors of Intermedia. The proceeds from this investment will be used for general corporate purposes, including the funding of working capital and the purchase of telecommunications assets.
SERVICE OFFERINGS
The Company operates its business through two reportable business segments: Integrated Communications Services and Digex. The Integrated Communications Services segment provides three groups of service offerings to business and government customers. Digex is a separate public company, which provides managed Web site and application hosting services to large companies and Internet companies operating mission-critical, multi-functional Web sites and Web-based applications. Each of these segments has separate management teams and operational infrastructures. The discussion below contains a summary description of
the Digex business segment. Additional information about the business of Digex can be found in Digex's Annual Report on Form 10-K for the year ended December 31, 1999.
Intermedia offers one of the most comprehensive telecommunications service portfolios in the industry. The Company's integrated portfolio of services fall into three major categories: (i) data, Internet and Web hosting, which includes frame relay, ATM, high speed Internet, dedicated private line (interlata and intralata), and managed Web site and application hosting services; (ii) local access and voice, which includes local exchange and interexchange (long distance); and (iii) integration services, which include the design, installation, sale and on-going maintenance of customer premise equipment such as private branch exchanges ("PBXs") and key systems.
Intermedia's current and prospective customers demand quality telecommunications services with simplified vendor interfaces and highly cost-effective solutions to solve their complex communications challenges. By offering an integrated package, Intermedia believes it can access a larger market, improve customer retention, achieve higher total margin, leverage its sales force and deployed capital, and reduce the cost of acquiring new customers.
The Company's service offerings are more fully described below:
Data and Internet
Intermedia's data services are provided over its frame relay, ATM and Internet Protocol ("IP") based networks. These services enable customers with multiple business locations to economically and securely transmit large volumes of data from one site to another. All of the customer's locations, whether domestic or international, are monitored by the Company and can be serviced through Intermedia's own facilities or through use of interconnected networks.
As the fourth largest frame relay provider in the United States, Intermedia provides end-to-end guaranteed performance of a customer's entire network, including the local loop. Intermedia is able to extend this level of guaranteed performance since it has one of the most highly distributed frame relay networks in the United States, extending the self-healing benefits of frame relay to most first, second, and third tier cities throughout the nation. At December 31, 1999, Intermedia served 48,973 frame relay nodes across a nationwide network utilizing 185 data switches and 881NNIs.
Intermedia's ATM services provide business customers with greater network capacity; bandwidth on demand to support high-speed applications; broader, more universal and flexible connectivity; universal application support to enable a single architectural solution for data, voice and video; and cost efficiencies that enable network growth and architectural scalability. These services are designed for high capacity customers requiring the flexibility of serving single or multiple locations from one originating location.
Intermedia is also well positioned to continue to capitalize on the rapidly growing Internet services segment of the communications market. Intermedia is a nationally recognized Tier One service provider of Internet connectivity and application services. (Tier One providers are generally recognized as those companies that own and operate their own national IP backbones which have both public and private peering arrangements, allowing the delivery of IP traffic to other Tier One Internet providers.) Intermedia has value-added applications such as on-site firewall installation and integration, IP enabled faxing capabilities, and other Web-enabled administrative support tools such as Web based email systems and high speed connectivity. In addition, in the third quarter of 1999, the Company began expanding its capacity to its Internet backbone to OC-48 to serve the increasing bandwidth requirements of its business customers, placing Intermedia in a select group of communications companies with a backbone of this size.
Digex Web Hosting Segment
Through Digex, the Company is a leading and rapid growing provider of managed Web site and application hosting services to large corporations and Internet companies operating mission-critical, multi-functional Web sites and Web-based applications. The Company provides the hardware, software, network technology and systems management necessary to provide its customers with comprehensive, managed Web
site hosting and application outsourcing solutions. Digex also provides related enterprise services such as firewall management, stress testing and consulting services, including capacity and migration planning and database optimization. With state-of-the-art data centers strategically positioned on the east and west coasts of the United States, Digex provides hands-on technical expertise, proactive customer service/support and value-added solutions to companies with specialty Web-intensive needs. Digex provides such services and expertise necessary to ensure secure, scalable, high-performance operations of mission-critical Websites and applications 24 hours a day. As of December 31, 1999, Digex was managing approximately 2,300 Windows NT and UNIX-based web servers.
In 1999, the Company's data, Internet, and Web hosting services accounted for approximately 39.9% (or approximately $361.5 million) of Intermedia's total revenue, compared to approximately 36.7% (or approximately $261.4 million) of total revenue in 1998. According to industry sources, the market for Internet, frame relay and ATM transport services will total nearly $15.5 billion by 2000, of which Internet services will represent 50%, or $7.7 billion. Further, the Web hosting market is predicted to increase to $14.6 billion in 2003. There can be no assurance, however, that such market growth will be realized or that the assumptions underlying such projections are reliable. For financial reporting purposes, the Company combines its operations in Web hosting with its data and Internet services.
Local Access and Voice
Intermedia's local exchange services are built around a key service bundle comprised of full-featured local dial tone, integrated long distance services and Internet access. Combining these services over a single wide-band facility enables Intermedia to increase its revenue generating product mix without having to acquire additional transport facilities, providing a more integrated and therefore more valuable service package for its target customers. The Company recently introduced its unifiedvoice.net(SM) service, which provides integrated local and long distance with high speed Internet access over a common access facility and on a single bill to small and medium size businesses.
Intermedia has offered long distance services since December 1994. Long distance services include outbound service, inbound (800 or 888) service, and calling card telephone service. In 1999, local access and voice accounted for approximately 45.7% (or approximately $414.2 million) of the Company's total revenue, compared to approximately 49.1% (or approximately $350.1 million) of total revenue in 1998. Intermedia believes the revenue from local access and voice services will continue to grow through the introduction of new service and service enhancements, as well as increased penetration within existing markets and entry into new geographic markets.
Integration Services
As part of its integration services, the Company engineers, installs, operates and maintains PBXs, key systems and other customer premise communications equipment for thousands of customers nationwide, developing specialized solutions for customers' specific telecommunications needs. Intermedia believes such services increase the level of linkage with the customer, thereby increasing value that Intermedia delivers to its customer. Target customers for integration services include medium to large commercial businesses, hotels, government agencies and hospitals. The Company believes the demand for integration services will continue to grow as businesses take advantage of emerging technologies and increasingly leverage communications service. In 1999, integration services accounted for approximately 14.4% (or approximately $130.3 million) of the Company's total revenue, compared to 14.2% (or approximately $101.4 million) of total revenue in 1998.
MARKETS SERVED
The following table sets forth the Company's estimates, based upon an analysis of industry sources, including industry projections and FCC data, of the market size nationally of certain of the services described above. Only a limited amount of direct information is currently available and therefore a significant portion of the information set forth below is based upon estimates and assumptions made by the Company. Intermedia believes that its estimates are based upon reliable information and that its assumptions are reasonable. There
can be no assurance, however, that the estimates will not vary from the actual market data and that these variances will not be substantial.
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(1) Enhanced Data Services do not include Internet and managed Web site and application hosting services market size data. This estimate represents frame relay and ATM services only. (2) The Company is currently permitted to offer these services in 38 states and the District of Columbia.
The market sizes set forth in the above table are not intended to provide an indication of the Company's total addressable market or the revenue potential for the Company's services. Intermedia has obtained all certifications necessary to permit the Company to provide local exchange service in 38 states and the District of Columbia. In addition, the Company's ability to offer services in its territory is limited by the size and coverage of its network. The Company derives its addressable market estimates by multiplying the total national market size estimated above by the percentage of the population (as derived from U.S. Census Bureau information) residing in the Company's market areas. This estimate assumes that per capita telecommunications services usage is the same in various regions of the United States. The Company estimates that its addressable market, computed under this methodology, is approximately $100 billion.
Digex has a large and diverse customer base ranging from Fortune 50 companies to small and medium-size businesses that rely heavily on the Internet. Its customers are primarily in the United States, total over 550, and cover most major industries, including financial services and insurance, media and entertainment, manufacturing, retail and distribution, technology and communications healthcare, travel and hospitality and governmental agencies.
FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS
Financial information about the Company's business segments for each of the last three fiscal years is provided in Footnote 15 to the consolidated financial statements of the Company provided elsewhere in the Annual Report on Form 10-K.
SALES, MARKETING AND SERVICE DELIVERY STRATEGY
The Company builds long-term relationships with its customers by providing a broad portfolio of integrated services, and by leveraging one or more of its services into a partnership with the customer in which Intermedia becomes the single source provider of all of the customer's telecommunications needs.
Intermedia approaches the market through segmentation of its addressable markets -- defining clusters of potential customers with similar needs that can be addressed profitably by the Company. By tailoring solutions to select market segments, rather than selling services at large, Intermedia endeavors to create value for its customers and a distinct advantage for itself.
Intermedia focuses on five major market categories:
Enterprise Business Segment. These businesses generate significant amounts of data and voice communications traffic, and include financial service firms (e.g., banks, securities/brokerage firms,
insurance companies, real estate companies, etc.), retail stores and call center operations, and have needs for multi-location data networks.
Small Multi-Application Businesses. Intermedia targets small and medium sized businesses in information intensive industries (e.g., professional services, light manufacturing, etc.) that have relatively high telecommunications usage ($10,000 to $100,000 per year). Management believes these customers are easy to identify, typically make purchasing decisions locally, and recognize the value of quality integrated communications technology in their businesses. These customers have also shown a preference for a single bill and single point of contact for their communications needs.
Tenants of Large Commercial Office Buildings. Intermedia targets high concentrations of business customers in locations where network, labor, and selling efficiencies can make Intermedia the low cost provider of telecommunications services. These high concentrations are found in multi-tenant commercial office buildings (200,000 square feet and larger) in major metropolitan areas. Customers benefit from the breadth of data and voice services offered through Intermedia's on-site facilities and technical staff -- without the expense, risks and responsibilities of direct ownership of high technology equipment. To access this market efficiently, the Company obtains contracts with REITs and other landlords of class A office buildings to provide telecommunications services to business tenants throughout the country. This "building centric" approach, which operates under Intermedia's Advanced Building Networks brand, provides a cost effective platform for the Company to acquire business customers.
Strategic Partners. This category is represented by the partnering arrangements Intermedia has with communications companies such as Bell Atlantic, US West, Ameritech, Williams, and NTT America, as well as the informal alliances it has with BellSouth and SBC to provide enhanced data service to their customers. The result is an integrated extension of the operational and service delivery functions of Intermedia and its partners, all transparent to the end user customer. Intermedia benefits from the reduced cost of acquiring customers through an indirect, extended sales channel, while the partners benefit from expanding their product portfolios.
Internet Service Providers. Intermedia's goal is to target Internet service providers and other aggregators of Internet services, focusing on the top 100 Internet service providers that connect into Intermedia's IP and voice network.
As the Company enters a market, the sales force has clearly defined geographic boundaries based on the margins attainable from delivering the Company's integrated services. Intermedia's sales force is compensated with higher incentives when they sell higher margin services and when they sell a bundled package offering. Sales agents are also compensated for referrals to other Intermedia marketing specialists which result in sales of additional services. Intermedia's sales force is backed by highly experienced technical personnel, including sales engineers and project managers, who are deployed throughout Intermedia's service territory. Intermedia's service delivery staff is organized around the delivery of total solutions to each customer. This includes the proper coordination of service components provided by supporting vendors, the preparation of the customer's site, if needed, and the installation, testing and delivery to the customer of the service solution. Thereafter, Intermedia monitors and maintains the quality and integrity of the service through its customer service and technical support staff, available 24 hours per day, 365 days per year. Services are monitored at locations in Tampa, Florida; Albany, New York; and suburban Washington, D.C.
The Company is creating a culture of cross-selling because it recognizes the benefits of increasing revenues faster than costs and increasing customer loyalty. Management believes there is also a greater likelihood of customer loyalty when the customer uses multiple services. In all cases, Intermedia utilizes its initial service relationship with a customer to cross-sell the other components of its fully integrated services portfolio.
To reach its targeted customers, Intermedia will continue to introduce new service offerings and further penetrate markets previously accessed. Intermedia expects to continue to gain market share by following its segmentation approach and focusing on the geographic areas where it can attain critical mass and economies of scale.
Digex focuses on market segments that have a high propensity to outsource and to deploy complex, mission-critical Web sites. Services are sold directly through a highly skilled professional sales force and through referrals received through an extensive network of business partners. The direct sales force consisted of 70 experienced, quota-bearing sales representatives as of December 31, 1999. The sales force is organized into three units major accounts, mid-market/Web centric, and alternate channel. The major accounts unit focuses on Fortune 2000 companies. The mid-market/Web centric unit addresses the large and growing number of mid-size businesses requiring mission-critical hosting services. The alternate channel sales group works closely with Digex's extensive network of business alliance partners.
NETWORK STRATEGY
Transport and Access
As one of the earliest implementors of a "smart build" strategy, Intermedia focuses its capital deployment on the areas of its infrastructure that it believes will provide the highest revenue and cash flow potential and the greatest intercity long-term competitive advantage. This prudent capital deployment strategy, which has been applied to its metro and intercity networks, has provided Intermedia with a high level of revenue per dollar of gross telecommunications equipment, achieving revenue of $0.48 per dollar of gross telecommunications equipment (calculated as an average of gross telecommunications equipment balances as of the year ended December 31, 1998 and 1999) for the year ended December 31, 1999.
In general, Intermedia believes that owning the intelligent components of the network, including switches (optical, IP, voice), customer connections, building entries and other "first mile" elements, allows the Company to be responsive to customer needs and enhances the utilization of the Company's network. Intermedia believes that its deployment of switching technology and advanced network electronics enables the Company to better configure its network to provide cost-effective and customized solutions to its customers.
In cases where the Company believes ownership of the network is not mandatory, Intermedia utilizes leased facilities to:
- meet customers' needs more rapidly;
- improve the utilization of Intermedia's existing network;
- add revenue producing customers before building out network, thereby reducing the risks associated with speculative network construction or emerging technologies; and
- focus capital expenditures in areas where network construction or acquisition will provide a competitive advantage and clear economic benefit.
In those markets where Intermedia chooses to deploy broadband fiber, the Company's strategy is to deploy these network facilities to reach two sets of targets:
- the ILEC central offices to which the majority of that market's business access lines connect; and
- the office buildings, office parks or other such high concentrations of business access lines and potential business customers.
Intermedia chooses to build collocation space only in the highest customer density ILEC central offices. This allows Intermedia to derive the maximum benefit from changes in the regulatory environment (i.e. access to Unbundled Network Elements and Enhanced Extended Loops), as well as enables Intermedia to utilize new technologies such as Digital Subscriber Line to drive down access costs. In addition, on high volume intercity routes, Intermedia will increasingly migrate services to owned fiber, using Dense Wave Division Multiplexing equipment (DWDM) to drive economies of scale and enable rapid capacity upgrades. This approach allows the Company to expend the least capital to reach the greatest number of customers and prospects. Facilities constructed in this manner may also be combined with facilities leased from another provider.
As of December 31, 1999, the Company had fiber optic networks in service in 14 major markets, including Orlando, Tampa/ St. Petersburg, Miami, and Jacksonville, Florida; Atlanta, Georgia; Cincinnati, Ohio; Raleigh-Durham, North Carolina; Huntsville, Alabama; and St. Louis and Kansas City, Missouri; New York, New York; Chicago, Illinois; and Houston and Dallas, Texas; with a smaller fiber optic presence in certain secondary markets, including Daytona, Ft. Lauderdale, Gainesville, Pensacola, Tallahassee, and Winter Park, Florida. Intermedia's city-based networks generally are comprised of fiber optic cables, integrated switching facilities, advanced electronics, data switching equipment, transmission equipment and associated wiring and equipment. Intermedia continues to expand these networks as needed to reach customers and targeted ILEC central offices.
Switching
The Company has undertaken a significant network expansion to satisfy the demands of its market driven growth in data and voice offerings, and has deployed resources, primarily switching equipment, to develop an extensive network to provide these services. By year end 1999, Intermedia completed the deployment of a fully meshed network of Nortel DMS 500 voice switches, enabling the Company to deliver local and long distance services in most major markets throughout the United States. As of December 31, 1999, Intermedia's network infrastructure included 29 voice switches and 501,094 local access line equivalents ("ALEs") in service.
Intermedia's data services are provided over its frame relay, ATM and IP based networks. Data, Internet, and Web hosting services include specialized communications services for customers needing to transport various forms of digital data among multiple locations. As of December 31, 1999, Intermedia had deployed a network of 185 Frame Relay and ATM data switches, which support 48,973 frame relay nodes. Intermedia pioneered the interconnection of its frame relay network with those of the ILECs, allowing pervasive, cost-efficient termination for its customers. The Company has implemented 881 NNIs, including those with BellSouth, US West, Sprint, GTE, Bell Atlantic, SBC, Ameritech and SNET. Intermedia has such NNIs in over 90% of the nation's Local Access Transport Areas ("LATAs"). A LATA is a geographic area in which a local exchange carrier is permitted to offer switched telecommunications services, including long distance (local toll).
Intermedia believes that an important aspect of satisfying its customers is its ability to provide and support services from end to end. This requires network interconnection with other carriers and operational support systems and tools to "manage" the customer's total service. Intermedia has deployed, and continues to integrate, network monitoring and control tools to insure high levels of service quality and reliability. Among these, Intermedia's ViewSPAN(SM) service allows the Company and its frame relay network service customers to have full end-to-end visibility of network performance, even across interconnections with other carrier's networks.
As of December 31, 1999, the Company had deployed 69 IP points-of-presence. Each of these points-of-presence typically consists of a series of Cisco GSR 12000 and Cisco 7206VXR routers, which are interconnected via fiber at OC-3, OC-12 and/or OC-48 speeds. In addition, 34 IP enabled ATM switches have been deployed throughout the United States, the majority of which are connected directly to the Company's IP backbone. This, in addition to the nationwide deployment of frame relay switches, allows Intermedia to deploy integrated communications services quickly and efficiently, at speeds much greater than traditional networks. Also, Intermedia has begun deploying DWDM equipment, which allows for the rapid deployment of additional bandwidth by simply inserting cards into equipment, requiring no field or outside plant engineering work to increase network capacity.
Intermedia also has a significant asset in its public and private peering arrangements with all of the major Tier One Internet service providers and others. These peers are spread over the country between the metro areas of Washington, San Francisco, Dallas, Chicago, New York, Los Angeles and Atlanta, allowing efficient delivery of traffic to the Internet.
TECHNOLOGY DIRECTION
The Company's telecommunications equipment vendors actively participate in planning and developing electronic equipment for use in Intermedia's network. The Company does not believe it is dependent on any single vendor for equipment, choosing to work instead with a number of the major vendors as strategic partners in order to develop and exploit new technology. Due to this approach, Intermedia's research and development expenditures are not material.
Intermedia has deployed a fiber optic backbone network that is being upgraded to allow all network applications, data and voice, to be carried over a single infrastructure utilizing an IP based architecture. Intermedia believes that extending IP based transport and switching to the edges of its network will provide for both economic advantage and innovative service offerings. A single access circuit carrying data and voice traffic in packets from the customer location to the Intermedia network can replace several less efficient circuits. Once a packet reaches the Intermedia network, it can be efficiently switched and transported through the IP backbone network, and converted by strategically placed gateways only when needed to interface with the public telephone network.
Intermedia expects to continue to realize economies of scale on its intercity network having completed the deployment of its local and long distance voice switches to serve its rapidly growing customer base, and by combining long distance voice traffic between switches with intercity enhanced data and Internet traffic on common transport facilities. Intermedia already uses its extensive ATM backbone network to transport its long haul frame relay, and increasingly, voice traffic which is delivered via Intermedia's network of Nortel DMS 500 switches. Over the next few years, Intermedia expects IP to become the protocol of choice, through mechanisms such as Multi Protocol Label Switching (MPLS), with ATM becoming dominant at the edge of the network.
By the end of 2000, Intermedia plans to deliver a new class of voice services which utilize data protocols ("packet/cell switching") to deliver voice traffic over Intermedia's network. Intermedia believes that deployment of its packet/cell switching network will allow it to achieve a cost of service advantage over the incumbent telephone companies, whose substantial size advantage over Intermedia is offset in part by the costs, time, operational difficulty, and inherent challenges that they would have to overcome to replace their entire network fabric with one such as Intermedia's integrated platform. However, the timing of such offering will depend on a number of factors, including the maturation of industry standards and the regulatory environment, and no assurance can be given that the Company will not experience delays in launching this new product offering. These services will provide a competitive service offering to customers seeking a more cost-efficient and flexible alternative to voice services provided over traditional circuit switched telecommunications networks. Intermedia believes that packet/cell switching networks will displace a significant portion of the national telecommunications market that is currently served over traditional circuit switched networks. Intermedia believes this new service offering, when implemented, will accelerate its penetration of the traditional voice services market and provide improved returns on its network investment.
INFORMATION SYSTEMS
Intermedia believes the customer experience and the breadth and quality of its services will differentiate it in the industry. The Company has addressed this by implementing web based, customer facing applications which are standards driven for interoperable communications with customers, partners, and staff. Intermedia's business processes, including accepting a service order, implementing the service, providing ongoing technical and customer support and invoicing and collecting payment for the service are a highly repetitive, data- oriented set of tasks. Intermedia's information systems are supported by an underlying data centric architecture which promotes application sharing of common data repositories. By creating a flexible, unified database and establishing industry standards-based software, Intermedia expects to allow all customer support functions (order entry, billing, service implementation, network management, etc.) efficient access to data. External applications, such as Access Service Request (ASR), an industry standards based system used by the ILECs for service orders and billing, have the ability to electronically interface and interact with this architecture. This integrated system will enhance Intermedia's ability to deliver and support an integrated
package of services. Intermedia believes this architecture will offer cost performance, flexibility and scalability that will support its rapid growth, provide for high staff productivity, and support its strategy of offering fully integrated services to its customers.
COMPETITION
Intermedia faces significant competition in each of its three service categories: data, internet and web hosting; local access and voice services, and integration services.
Intermedia believes that various legislative initiatives, including the Telecommunications Act, have removed many of the remaining legislative barriers to local exchange competition. Rules adopted to carry out the provisions of the Telecommunications Act, however, remain subject to pending administrative and judicial proceedings which could materially affect local exchange competition. Moreover, in light of the passage of the Telecommunications Act, regulators are providing ILECs with increased pricing flexibility as competition increases. If ILECs are permitted to lower their rates substantially or engage in excessive volume or term discount pricing practices for their customers, the net income or cash flow of integrated communication providers and CLECs, including Intermedia, could be materially adversely affected. In addition, while Intermedia currently competes with AT&T, MCI WorldCom, Sprint and others in the interexchange services (commonly referred to as long distance) market, the Telecommunications Act permits the RBOCs to provide long distance service in the same areas they are now providing local service once certain criteria are met. Once the RBOCs begin to provide such services, they will be in a position to offer single source local and long distance service similar to that being offered by Intermedia. Furthermore, through acquisitions, AT&T and MCI Worldcom have entered the local exchange services market, and other interexchange carriers ("IXCs") have announced their intent to enter the local exchange services market which is facilitated by the Telecommunications Act's requirement that ILECs permit others to use their local exchange facilities to provide service to customers. Intermedia cannot predict the number of competitors that will emerge as a result of existing or new federal and state regulatory or legislative actions but increased competition with respect to interexchange services and local exchange services from existing and new entities could have a material adverse effect on Intermedia's business, financial condition, results of operations and prospects.
Competition in each of the service categories provided by Intermedia is discussed below.
Data, Internet and Web hosting Services. Intermedia faces competition in its high-speed data services from IXCs, ILECs, cable operators and other telecommunications companies. Many of Intermedia's existing and potential competitors have financial and other resources significantly greater than those of Intermedia.
Intermedia competes with the larger IXCs on the basis of service responsiveness and a rapid response to technology and service trends, and a regional focus borne of early market successes. All of the major IXCs, including AT&T, MCI WorldCom and Sprint, offer frame relay, ATM and IP based transport services, and several of the major IXCs have announced plans to provide Internet services. Intermedia believes it competes favorably with these providers in its markets based on the features and functions of its services, the high density of its networks, its relatively greater experience and its in-house expertise. Continued aggressive pricing is expected to support continued rapid growth, but will place increasing pressure on operating margins.
Many of the ILECs now offer services similar to Intermedia's data, internet, and web hosting service. Because the RBOCs have not yet been authorized to provide interexchange service inside the regions where they provide local exchange service, they may offer these services only on an intraLATA basis within their operating regions. The FCC, however, as a condition of the merger between SBC and Ameritech, permitted the merged entity to provide advanced data services using a separate subsidiary. The merged RBOC is forbidden to favor its subsidiary over competing CLECs and is required to provide data CLECs with discounted loops and other measures to enhance competition. Other RBOCs presumably would be able to do the same. Out-of-region RBOCs may also offer these data services on an interLATA basis. While the RBOCs generally cannot interconnect their frame relay networks with each other, Intermedia has interconnected its frame relay network with those of various RBOCs. As a result, Intermedia can use certain RBOC services to keep its own costs down when distributing into areas that cannot be more economically serviced on its own network. Intermedia expects the RBOCs to aggressively expand their data, internet, and web hosting services
as regulatory developments permit them to deploy in-region interLATA long distance networks. When the RBOCs are permitted to provide such services, they will be in a position to offer single source service similar to that being offered by Intermedia. As part of its various interconnection agreements, Intermedia has negotiated favorable rates for unbundled ILEC frame relay service elements. Intermedia expects such negotiations to decrease its costs, improving margins for this service.
Intermedia faces competition in its Internet services from various technology and Internet related companies, including cable-based services. Some of these companies have financial and other resources significantly greater than those of Intermedia. Intermedia competes in this highly competitive market based on its high service level agreements, broad technical expertise, strong customer service and value-added applications.
The market for managed Web site and application hosting conducted by Digex is highly competitive. There are few substantial barriers to entry and many of Digex's current competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than it possesses. Current and potential competitors in the market include Web hosting service providers, Internet service providers, commonly known as ISPs, telecommunications companies and large information technology outsourcing firms. Competitors may operate in one or more of these areas and include companies such as AT&T, Cable & Wireless, Concentric Network, Data Return, EDS, Exodus Communications, Frontier/GlobalCenter, Globix, GTE, IBM, Intel, Level 3 Communications, MCI WorldCom, Navisite, PSINet, Qwest Communications International, and US internetworking. Digex may be unable to achieve its operating and financial objectives due to the significant competition in the Web hosting industry.
Local Access and Voice Services. In each of its geographic markets, Intermedia faces significant competition for the local services it offers from RBOCs and other ILECs, which currently maintain dominant market shares in their local telecommunications markets. These companies all have long-standing relationships with their customers and have financial, personnel and technical resources substantially greater than those of Intermedia. Some of these companies also have indicated their intent to offer services as CLECs in markets outside of their current territory.
Intermedia also faces competition in most markets in which it operates from one or more CLECs or integrated communication providers operating fiber optic networks. Other local service providers without their own fiber networks have operations or are initiating operations within one or more of Intermedia's service areas. MCI WorldCom, AT&T and certain cable television providers, either alone or jointly with AT&T or another carrier, have entered some or all of the markets that Intermedia presently serves. Intermedia also understands that other telecommunications companies have indicated their desire to enter the local exchange services market within specific metropolitan areas served or targeted by Intermedia. Other potential competitors of Intermedia include utility companies, other long distance carriers, wireless carriers and private networks built by individual business customers. Many of these entities are substantially larger and have substantially greater financial resources than Intermedia. Intermedia cannot predict the number of competitors that will emerge as a result of existing or any new federal and state regulatory or legislative actions.
Competition in all of Intermedia's geographic market areas is based on quality, reliability, customer service and responsiveness, service features and price. Intermedia has kept its prices at levels competitive with those of the ILECs while providing, in the opinion of Intermedia, a higher level of service and responsiveness to its customers.
Although the ILECs are generally subject to greater pricing and regulatory constraints than other local network service providers, ILECs, as noted above, are achieving increased pricing flexibility for their local services as a result of recent legislative and regulatory action designed to increase competition in the local exchange market. The ILECs have continued to lower rates, resulting in downward pressure on the price of certain dedicated and switched access transport services offered by Intermedia and other CLECs. This price erosion has decreased operating margins for these services. However, Intermedia believes this effect will be more than offset by the increased revenues available as a result of access to customers provided through Intermedia's interconnection co-carrier agreements (see "Agreements") and the opening of local exchange
service to competition. In addition, Intermedia believes that lower rates for dedicated access will benefit other services offered by Intermedia.
Intermedia currently competes with AT&T, MCI WorldCom, Sprint and others in the long distance services market. Many of Intermedia's competitors have longstanding relationships with their customers and have financial, personnel and technical resources substantially greater than those of Intermedia. When, as expected, the RBOCs are permitted to provide long distance services within their operating regions they may provide substantial new competition to long distance providers. In providing long distance services, Intermedia focuses on quality, service and price to distinguish itself in a very competitive marketplace and has built a loyal customer base by emphasizing its customer service and fully integrated product portfolio.
Integration Services. Intermedia faces competition in its systems integration business from equipment manufacturers, RBOCs and other ILECs, long distance carriers and systems integrators, many of which have financial and other resources significantly greater than those of Intermedia. Intermedia competes in this market on the basis of its broad based technical expertise and strong customer service.
GOVERNMENT REGULATION
Overview. Intermedia's telecommunications services are subject to varying degrees of federal, state and local regulation. The FCC and state utility commissions regulate telecommunications common carriers. A telecommunications common carrier is a company which offers telecommunications services to the public or to all prospective users on standardized rates and terms. Intermedia's local exchange, interexchange and international and frame relay services are all common carrier services. Intermedia's systems integration business and Internet services are not considered to be common carrier services, although regulatory treatment of Internet services is evolving and it may become subject, at least in part, to some form of common carrier regulation.
The FCC exercises jurisdiction over telecommunications common carriers, and their facilities and services, to the extent they are providing interstate or international communications. International authorities also may seek to regulate international telecommunications services originating in the United States. The various state regulatory commissions retain jurisdiction over telecommunications carriers, and their facilities and services, to the extent they are used to provide communications that originate and terminate within the same state. The degree of regulation varies from state to state.
In recent years, the regulation of the telecommunications industry has been in a state of transition as the United States Congress and various state legislatures have passed laws seeking to foster greater competition in telecommunications markets. The FCC and state utility commissions have adopted many new rules to implement this legislation and encourage competition. These changes, which have not been fully implemented, have created new opportunities and challenges for Intermedia and its competitors. The following summary of regulatory developments and legislation does not purport to describe all present and proposed federal, state and local regulations and legislation affecting the telecommunications industry. Certain of these and other existing federal and state regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals which could change, in varying degrees, the manner in which this industry operates. Neither the outcome of these proceedings, nor their impact upon the telecommunications industry or Intermedia can be predicted at this time.
The regulatory status of telephone service over the Internet is presently uncertain. Intermedia is unable to predict what regulations may be adopted in the future or to what extent existing laws and regulations may be found by state and federal authorities to be applicable to such services or the impact such new or existing laws and regulations may have on the Company's business. Specific statutes and regulations addressing this service have not been adopted at this time and the extent to which current laws and regulations at the state and federal levels will be interpreted to include such Internet telephone services has not been determined. The FCC has indicated, for example, that voice telecommunications carried over the Internet between two telephone sets using the public switched network may be subject to payment of Universal Service funding obligations, while voice telecommunications using computers rather than telephone sets may not be subject to such obligations. There can be no assurance that new laws or regulations relating to these services or a
determination that existing laws are applicable to them will not have a material adverse effect on the Company's business.
Federal Regulation. Although Intermedia is currently not subject to price cap or rate of return regulation at the federal level and is not currently required to obtain FCC authorization for the installation, acquisition or operation of its domestic interexchange network facilities, it nevertheless must comply with the requirements of common carriage under the Communications Act of 1934 (the "Communications Act"), as amended. Pursuant to the Communications Act, Intermedia is subject to the general requirement that its charges and regulations for communications services must be "just and reasonable" and that it may not make any "unjust or unreasonable discrimination" in its charges or regulations. The FCC also has jurisdiction to act upon complaints against any common carrier for failure to comply with its statutory obligations. The Communications Act also requires prior approval for the assignment of an FCC radio license, such as the microwave licenses Intermedia holds, and for the assignment of an authorization to provide international service (but not domestic interexchange service) or the transfer of control (for example, through the sale of stock) of a company holding radio licenses or an international authorization. The FCC generally has the authority to modify or terminate a common carrier's authority to provide domestic interexchange or international service for failure to comply with federal laws or the rules of the FCC. Fines or other penalties also may be imposed for such violations. Carriers such as Intermedia also are subject to a variety of miscellaneous regulations that, for instance, govern the documentation and verifications necessary to change a consumer's long distance carrier, require the filing of periodic reports, and restrict interlocking directors and management. Certain other specific regulations applicable to Intermedia are discussed below.
Comprehensive amendments to the Communications Act were made by the Telecommunications Act, which was signed into law on February 8, 1996. The Telecommunications Act effected plenary changes in regulation at both the federal and state levels that affect virtually every segment of the telecommunications industry. The stated purpose of the Telecommunications Act is to promote competition in all areas of telecommunications. While it will take years for the industry to feel the full impact of the Telecommunications Act, it is already clear that the legislation provides Intermedia with both new opportunities and new challenges.
The Telecommunications Act requires ILECs to provide access to their networks by competing carriers. Among other things, the Telecommunications Act requires the ILECs to: (i) provide physical collocation, which allows companies such as Intermedia and other interconnectors to install and maintain their own network equipment in ILEC central offices, and virtual collocation only if requested or if physical collocation is demonstrated to be technically infeasible; (ii) unbundle components of their local service networks so that other providers of local service can compete for a wider range of local services customers; (iii) establish "wholesale" rates for their services to promote resale by CLECs and other competitors; (iv) establish number portability, which will allow a customer to retain its existing phone number if it switches from the ILEC to a competitive local service provider; (v) establish dialing parity, which ensures that customers will not detect a quality difference in dialing telephone numbers or accessing operators or emergency services; and (vi) provide nondiscriminatory access to telephone poles, ducts, conduits and rights-of-way. In addition, the Telecommunications Act requires ILECs to compensate competitive carriers for traffic originated by the ILECs and terminated on the competitive carriers' networks.
The FCC is charged with establishing national guidelines to implement certain portions of the Telecommunications Act. The FCC did so in its Interconnection Order on August 8, 1996. On July 18, 1997, however, the United States Court of Appeals for the Eighth Circuit issued a decision vacating the FCC's pricing rules, as well as certain other portions of the FCC's interconnection rules, on the grounds that the FCC had improperly intruded into matters reserved for state jurisdiction. On January 25, 1999, the Supreme Court largely reversed the Eighth Circuit's order, holding that the FCC has general jurisdiction to implement the local competition provisions of the Telecommunications Act. This action reestablishes the validity of many of the FCC rules vacated by the Eighth Circuit. Although the Supreme Court affirmed the FCC's authority to develop pricing guidelines, the Supreme Court did not evaluate the specific pricing methodology adopted by the FCC and has remanded the case to the Eighth Circuit for further consideration. In its decision moreover, the Supreme Court also vacated the FCC's rule that identifies the unbundled network elements that ILECs
must provide to CLECs. The Supreme Court found that the FCC had not adequately considered certain statutory criteria for requiring ILECs to make those network elements available to CLECs and must reexamine the matter. On November 5, 1999, the FCC released an order reaffirming and clarifying the obligation of ILECs to provide most of the unbundled network elements it had previously identified, including local loops, network interface devices and operations support systems. The FCC also required ILECs to provide additional elements, not previously widely available. These elements include but are not limited to new types of loops (including xDSL capable loops, sub loop elements and dark fiber loops), interoffice dark fiber and high capacity transport and inside wire. These rules are subject to appeal and many require implementing action by state regulatory agencies. The Company is unable to predict whether the ILECs or other parties will challenge this ruling or the outcome of any other proceedings relating to it.
In order to obtain access to an ILEC's network, a competitive carrier is required to negotiate an interconnection agreement with the ILEC covering the network elements it desires to use. In the event the parties can not agree, the matter is submitted to the state public utility commission for binding arbitration. To date, the Company has successfully negotiated interconnection agreements with many of the ILECs in the areas the Company serves. These interconnection agreements are of fixed duration, however, and several have expired or will expire in the near future. These agreements must be renegotiated or re-arbitrated. Expired agreements continue in effect as interim agreements until replaced by new agreements. When the new agreements take effect they will supercede the expired agreements and may be applied retroactively.
In addition, on November 18, 1999, the FCC ordered ILECs to share their telephone lines with providers of high speed Internet access and other data services. This action permits CLECs to obtain access to the high-frequency portion of the local loop from the ILECs over which the ILEC, provide voice services. As a result, CLECs will be able to provide DSL-based services over the same telephone lines simultaneously used by the ILEC for its voice services, and will no longer need to purchase a separate local loop from the ILEC in order to provide DSL services. This ruling may make it easier for CLECs, including the Company and its competitors to provide DSL services.
As a result of the pro-competitive provisions of the Telecommunications Act, the Company has taken the steps necessary to be a provider of local exchange services and has positioned itself as a full service, integrated telecommunications services provider. The Company has obtained local certification in 38 states and the District of Columbia. The Company is also taking the steps necessary to exercise its rights to interconnection, collocation and unbundled network elements under the Telecommunications Act.
The Telecommunications Act's interconnection requirements apply to interexchange carriers and to all other providers of telecommunications services, although the terms and conditions for interconnection provided by these carriers are not regulated as strictly as interconnection provided by the ILECs. This may provide the Company with the ability to reduce its access costs by interconnecting directly with non-ILECs, but may also cause the Company to incur additional administrative and regulatory expenses in replying to interconnection requests from other carriers.
As another part of its pro-competitive policies, the Telecommunications Act frees the RBOCs from the judicial orders that prohibited their provision of interLATA services. Specifically, the Telecommunications Act permits RBOCs to provide long distance services outside their local service regions immediately, and will permit them to provide in-region interLATA service upon demonstrating to the FCC and state regulatory agencies that they have adhered to the FCC's local exchange service interconnection regulations. Some RBOCs have filed applications with various state public utility commissions and the FCC seeking approval to offer in-region interLATA service. Some states have denied these applications while others have approved them but, until recently, the FCC has denied each of the RBOCs' applications brought before it because it found that the RBOC had not sufficiently made its local network available to competitors. In December of 1999, however, the FCC approved a Bell Atlantic application for in region service in New York, and SBC has recently filed an application for in region interLATA service in Texas. The FCC is also considering a proposal to permit RBOCs to offer immediately high speed, interLATA data services within their operating regions if they do so through a separate subsidiary, without first having to demonstrate that they have adhered to the FCC interconnection regulations discussed above. In the interim, the FCC, as a condition of the merger
between SBC and Ameritech, permitted the merged entity to provide advanced data services using a separate subsidiary. A similar condition was accepted by Bell Atlantic as part of the process of obtaining in-region interLATA service authority in New York. In both these cases, the RBOC is forbidden to favor its subsidiary over competing CLECs and is required to provide data CLECs with discounted loops and other measures to enhance competition. Other RBOCs presumably would be able to do the same.
The Telecommunications Act provides the FCC with the authority to forebear from imposing any regulations it deems unnecessary, including requiring non-dominant carriers such as the Company to file tariffs. On November 1, 1996, in its first major exercise of regulatory forbearance authority granted by the Telecommunications Act, the FCC issued an order detariffing domestic interexchange services. The order required mandatory detariffing and gave carriers such as Intermedia nine months to withdraw federal tariffs and move to contractual relationships with their customers. This order subsequently was stayed by a federal appeals court, and it is unclear at this time whether the detariffing order will be implemented. Until further action is taken by the FCC or the courts, Intermedia will continue to maintain tariffs for these services. In June 1997, the FCC issued another order stating that non-dominant carriers, such as Intermedia, could withdraw their tariffs for interstate access services. While the Company has no immediate plans to withdraw its tariff, this FCC order allows the Company to do so. The FCC does require the Company to obtain authority to provide service between the United States and foreign points and to file tariffs on an ongoing basis for international service.
The Telecommunications Act also directs the FCC, in cooperation with state regulators, to establish a Universal Service Fund that will subsidize to carriers that provide service to under-served individuals and in high cost areas. A portion of carriers' contributions to the Universal Service Fund also will be used to provide telecommunications related facilities for schools, libraries and certain rural health care providers. The FCC released its order in June 1997. This order requires Intermedia to contribute to the Universal Service Fund, but may also allow Intermedia to receive payments from the Fund if it is deemed eligible. Through September 30, 1999, Intermedia's contribution resulting from these regulations was $6.3 million. For the last quarter of 1999, the FCC established payment rates for all interexchange carriers, including the Company, that amount to 5.8% of eligible interstate, and international long distance end user service revenues for the corresponding period of the previous year. The FCC allows all interexchange carriers, including the Company, to recover the international and interstate portions of these payments by passing the charges through to their customers. In November 1999, the FCC revised its proposed methodology for subsidizing service in certain high cost areas which may result in increases in the subsidy program. The FCC's implementation of universal service requirements remains subject to judicial and additional FCC review.
The FCC has fundamentally restructured the "access charges" that ILECs charge to interexchange carriers and end user customers to connect to the ILEC's network to permit ILECs subject to the FCC's price cap rules increased pricing flexibility as competition becomes established in their markets. In August 1999, the FCC adopted an order providing additional pricing flexibility to ILECs subject to price cap regulation in their provision of interstate access services, particularly special access and dedicated transport. Some of the actions taken by the FCC would immediately eliminate rate scrutiny for "new services" and permit the establishment of additional geographic zones within a market that would have separate rates. Additional and more substantial pricing flexibility will be given to ILECs as specified levels of competition in a market are reached through the collocation of competitive carriers and their use of competitive transport. This flexibility will include, among other items, customer specific pricing, volume and term discounts for some services and streamlined tariffing.
As part of the same August order the FCC initiated another proceeding to consider increased pricing flexibility proposals for ILECs access charges. This proceeding also will consider the reasonableness of CLEC access rates and seeks comment on whether the FCC should adopt rules to regulate CLEC access charges. In addition, the FCC's rulemaking is examining whether any statutory or regulatory constraints prevent an IXC from declining to accept a CLEC's access services, and if so under what circumstances. The outcome of this rulemaking is not possible to predict. Currently, certain IXCs have refused to pay the Company's access charges or are doing so at a reduced rate. Other CLEC's have experienced similar problems and the FCC has ruled on a complaint against AT&T that it must pay such access charges at he CLEC's tariffed rate.
On May 21, 1999, a United States court of appeals reversed an FCC order that had established the factors that are currently used to set the annual price cap for ILEC access charges. The court ordered the FCC to further explain the methodology it used in establishing those factors. This proceeding also is ongoing.
On November 9, 1999, the FCC released a decision which concluded that advanced services, such as Digital Subscriber Line Service, sold by ILECs to Internet service providers and bundled by the Internet service provider with its other services are not subject to the resale obligations of the Act. This decision will allow ILECs to provide ISPs with special rate packages for DSL on terms and conditions not available to the Company in its activity as a CLEC. The Company's Internet subsidiaries may obtain such special pricing, however.
A dispute has arisen over the provision of the Telecommunications Act requiring ILECs to compensate CLECs for local calls originating on the ILEC's network but terminating on the CLEC's network. Most ILECs argue that they are not obligated to pay CLECs -- including Intermedia -- for local calls made to Internet service providers. This dispute has resulted in ILECs withholding approximately $109.9 million in payments to Intermedia through December 31, 1999. Intermedia and other CLECs have asked state regulatory commissions to resolve this dispute.
On February 25, 1999, the FCC ruled that Internet service provider traffic is interstate traffic within the FCC's jurisdiction but that its current rules neither require nor prohibit the payment of reciprocal compensation for these calls. The FCC determined that state commissions have authority to interpret and enforce the reciprocal compensation provisions of existing interconnection agreements and to determine the appropriate treatment of Internet service provider traffic in arbitrating new agreements. The FCC also requested comment on federal rules to govern compensation for these calls in the future.
Prior to the FCC decision, 30 state commissions and several federal and state courts ruled that reciprocal compensation arrangements under existing interconnection agreements apply to calls to Internet service providers. Four states, however, have ruled that in certain situations reciprocal compensation arrangements are not applicable to calls to Internet service providers under at least some agreements entered before the FCC decision. Some regional Bell operating companies have asked state commissions to reopen decisions requiring the payment of reciprocal compensation on Internet service provider calls. Subsequent to the FCC decision, at least 19 state commissions have reaffirmed their prior determinations or ruled for the first time that reciprocal compensation was due under interconnection agreements existing prior to the FCC decision. In some states where state commissions have ruled that reciprocal compensation should be paid, the amount of such payment is being disputed by the ILEC. In addition, there are ongoing disputes concerning the appropriate treatment of Internet service provider traffic under new interconnection agreements. These likely will be resolved in arbitration proceedings or by new FCC rules.
In 1994 Congress adopted the Communications Assistance for Law Enforcement Act to insure the law enforcement agencies would be able to conduct properly authorized electronic surveillance over the new digital and wireless media as well as traditional wireline carriers. An interim technical standard was released in 1997 and the FCC recently required carriers to have additional capabilities requested by law enforcement authorities and directed that the interim standard be revised. Some in the industry believe that the cost of providing these additional capabilities are unreasonably high and the FCC's decision has been appealed. The Company is not able to predict the outcome of this litigation or the cost of compliance with whatever standards are ultimately developed.
State Regulation. To the extent that Intermedia provides telecommunications services which originate and terminate within the same state, it is subject to the jurisdiction of that state's public service commissions. Intermedia currently provides some intrastate telecommunication services in all 50 states and is subject to varying degrees of regulation by the public service commissions of those states. Intermedia is currently certified (or certification is not required) in all 50 states and the District of Columbia to provide interexchange services. Intermedia is certified as a CLEC in 38 states and the District of Columbia. Intermedia is constantly evaluating the competitive environment and may seek to further expand its intrastate certifications into additional jurisdictions. Intermedia is not subject to price cap or rate of return regulation in any state in which it is currently certified to provide local exchange service.
The Telecommunications Act preempts state statutes and regulations that restrict the provision of competitive local services. As a result of this sweeping legislation, Intermedia will be free to provide the full range of intrastate local and long distance services in all states in which it currently operates, and in any states into which it may wish to expand. While this action greatly increases Intermedia's addressable customer base, it also increases the amount of competition to which Intermedia may be subject.
Although the Telecommunications Act's prohibition of state barriers to competitive entry took effect on February 8, 1996, various legal and policy matters still must be resolved before the Telecommunications Act's policies promoting local competition are fully implemented. Intermedia continues to support efforts at the state government level to encourage competition in its markets under the federal law and to permit integrated communication providers and CLECs to operate on the same basis and with the same rights as the ILECs. Despite the still uncertain regulatory environment, Intermedia so far has been successful in its pursuit of local certificates from state commissions and in negotiating interconnection agreements with the ILECs which permit Intermedia to meet its business objectives. However, the Company is now engaged in negotiations and arbitrations for new interconnection agreements and the outcome of these negotiations and arbitrations can not now be predicted.
In most states, Intermedia is required to file tariffs setting forth the terms, conditions and prices for services classified as intrastate (local, intrastate interexchange and intrastate frame relay). Most states require Intermedia to list the services provided and the specific rate for each service. Under different forms of regulatory flexibility, Intermedia may be allowed to set price ranges for specific services, and in some cases, prices may be set on an individual customer basis. Some states also require Intermedia to seek the approval of the local public service commission for the issuance of debt or equity securities or other transactions which would result in a lien on Intermedia's property used to provide intrastate service within those states. Many states also require approval for the sale or acquisition of a telecommunications company and require the filing of reports and payments of various fees. Like the FCC, most states also consider complaints relating to a carrier's services or rates within their jurisdictions.
Local Government Authorizations. Intermedia may be required to obtain from municipal authorities street opening and construction permits to install and expand its fiber optic networks in certain cities. In some cities, local partners or subcontractors may already possess the requisite authorizations to construct or expand Intermedia's network.
In some of the areas where Intermedia provides service, it may be subject to municipal franchise requirements and may be required to pay license or franchise fees based on a percentage of gross revenue or other formula. There are no assurances that certain municipalities that do not currently impose fees will not seek to impose fees in the future, nor is there any assurance that, following the expiration of existing franchises, fees will remain at their current levels. In many markets, other companies providing local telecommunications services, particularly the ILECs, currently are excused from paying license or franchise fees or pay fees that are materially lower than those required to be paid by Intermedia. The Telecommunications Act requires municipalities to charge nondiscriminatory fees to all telecommunications providers, but it is uncertain how quickly this requirement will be implemented by particular municipalities in which Intermedia operates or plans to operate or whether it will be implemented without a legal challenge initiated by Intermedia or another integrated communications provider or CLEC. If any of Intermedia's existing network agreements were terminated prior to their expiration date and Intermedia was forced to remove its fiber optic cables from the streets or abandon its network in place, even with compensation, such termination could have a material adverse effect on Intermedia.
Intermedia also must obtain licenses to attach facilities to utility poles to build and expand facilities. Because utilities that are owned by cooperatives or municipalities are not subject to federal pole attachment regulation, there is no assurance that Intermedia will be able to obtain pole attachment from these utilities at reasonable rates, terms and conditions.
AGREEMENTS
Interconnection Co-carrier Agreements. The Company has interconnection co-carrier agreements with BellSouth, SBC, US West, GTE, Sprint, Bell Atlantic, Cincinnati Bell, Inc., SNET and Ameritech. These agreements were executed over the past few years and have terms ranging from two to three years. The BellSouth agreement expired on December 31, 1999 and by its terms is continuing on a month to month basis until replaced by a new agreement. Intermedia is currently negotiating and/or arbitrating a new agreement with BellSouth. Substantial modification of the current agreement terms could materially adversely affect the Company's operations in the applicable markets. Intermedia expects to follow similar procedures in connection with the expiration of its other interconnection agreements. Depending on the terms of the new agreements, some provisions may be retroactive back to the termination date of the prior contract. Each of these agreements, among other things, provides for mutual and reciprocal compensation, local interconnection, resale of local exchange services, access to unbundled network elements, service provider number portability and access to 911 service, as provided for in the Telecommunications Act. The agreements further provide that additional terms and conditions will be set by negotiation between the parties relating to issues which arise that were not originally contemplated by the agreements. A dispute has arisen over the reciprocal compensation provisions of these interconnection agreements with most ILECs arguing that they are not obligated to pay CLECs -- including Intermedia -- for local calls made to Internet service providers. This dispute has resulted in two ILECs withholding approximately $109.9 million in payments to Intermedia through December 31, 1999. Intermedia and other CLECs have asked state regulatory commissions to resolve this dispute. To date, 30 state commissions and several federal courts have ruled on the issue finding that ILECs must pay compensation to competitive carriers for local calls to Internet service providers located on competitive carriers' networks. Three state commissions, however, have ruled that reciprocal compensation for service to Internet service providers is not due under at least some interconnection agreements. Other states have ongoing proceedings to consider the matter and the FCC also has initiated a proceeding to deal with reciprocal compensation issues.
Network Agreements. The Company has built its digital fiber optic networks pursuant to various rights-of-way, conduit and dark fiber leases, utility pole attachment agreements and purchase arrangements (collectively, the "Network Agreements"). Substantially all of the Network Agreements (other than utility pole attachment agreements, which typically can be terminated on 90 days notice) are long-term and include renewal options.
Although none of the Network Agreements are exclusive, the Company believes that conduit space, fiber availability and other physical constraints make it unlikely that the lessors under the various Network Agreements could easily make similar arrangements available to others. The Company believes that its relationships with its lessors are satisfactory. Certain of the Network Agreements require Intermedia to make revenue sharing payments or, in some cases, to provide a fixed price alternative or dark fiber to the lessor without an additional charge. In addition, the Company has various other performance obligations under its Network Agreements, the breach of which could result in the termination of such agreements. Further, actions by governmental regulatory bodies could, in certain instances, also result in the termination of certain Network Agreements. The cancellation of any of the material Network Agreements could materially adversely affect the Company's business in the affected metropolitan area. See "Risk Factors -- Risk of Termination, Cancellation or Non-Renewal of Interexchange Agreements, Network Agreements, Licenses and Permits."
Interexchange Agreements. Intermedia, from time to time, enters into purchase agreements with interexchange carriers for the transport and/or termination of long distance calls outside of its territory. These contracts are typically two years in duration and customarily include minimum purchase amounts. The agreement with Williams is the Company's largest interexchange carrier agreement to date and provided a 20 year indefeasible right of use for high bandwidth on Williams' nationwide fiber optic network. The Company believes that the Williams agreement has allowed it to reduce its unit cost for interexchange transport capacity by up to 50% from previous levels.
EMPLOYEES
As of December 31, 1999, Intermedia employed a total of 5,073 full-time employees. The Company believes that its future success will depend in large part on its continued ability to attract and retain highly skilled and qualified personnel. The Company also regularly uses the services of contract technicians for the installation and maintenance of its network. Intermedia believes that its relations with its employees are good.
RISK FACTORS
Substantial Debt
Substantial Debt. Although the Company has recently announced its intention to reduce its outstanding debt, Intermedia has a significant amount of debt. As of December 31, 1999, the Company had outstanding approximately $3.2 billion of debt and other liabilities (including capital lease obligations, minority interest and current liabilities) and approximately $916.8 million of obligations with respect to four outstanding series of preferred stock. As a result, the Company paid cash interest of approximately $186.1 million in 1999 on its outstanding obligations. This amount will increase in 2001 and again in 2002 as well as in 2004 when certain of the Company's outstanding debt which does not currently pay cash interest is required to pay cash interest.
Insufficient Cash Flow. Historically, Intermedia's cash flow from operations has been insufficient to cover its operating and investing expenses and payment of cash dividends on preferred stock. The Company expects this situation will continue for the next several years. Therefore, unless the Company develops additional sources of cash flow, it may not be able to pay interest on its debt and cash dividends on its preferred stock or repay its obligations at maturity. As an alternative, the Company may refinance all or a portion of its outstanding debt. However, there can be no assurance that the Company will be able to refinance its debt or develop additional sources of cash flow.
Possible Additional Debt. While the terms of Intermedia's outstanding debt and Credit Facility limit the additional debt the Company may incur, the terms do not prohibit Intermedia from incurring more debt. The Company may incur substantial additional debt during the next few years to finance the construction of networks and purchase of network electronics or for general corporate purposes, including to fund working capital and operating losses.
Financing Change of Control Offer. Upon the occurrence of certain specific kinds of change of control events, Intermedia will be required to offer to repurchase all of its outstanding debt and certain outstanding series of preferred stock. However, it is possible that the Company will not have sufficient funds at the time of the change of control to make the required repurchase.
Consequences of Debt. Intermedia's level of debt could have important consequences to holders of its common stock. For example, it could:
- require the Company to dedicate a substantial portion of its future cash flow from operations to the payment of the principal and interest on its debt, and dividends on and the redemption of its preferred stock, thereby reducing the funds available for other business purposes;
- make the Company more vulnerable if there is a downturn in its business;
- limit the Company's ability to obtain additional financing for working capital, capital expenditures, acquisitions or other purposes; and
- place the Company at a competitive disadvantage compared to competitors who have less debt than Intermedia.
HISTORY OF NET LOSSES; LIMITED OPERATIONS OF CERTAIN SERVICES; NEED FOR ADDITIONAL CAPITAL
History of Net Losses. Intermedia has incurred significant operating losses during the past several years while it has developed its business and expanded its networks. Although the Company's revenues have increased in each of the last three years, it has incurred net losses attributable to common stockholders of
approximately $284.9 million, $577.6 million and $650.9 million for the years ended December 31, 1997, 1998, and 1999, respectively. The Company expects net losses to continue for the next several years.
Limited Operations of Certain Services. Intermedia began operations in 1986. The Company has recently initiated several new services and expanded the availability of new and existing services in new market areas. The Company also expects to increase the size of its operations in the near future. Therefore, there is limited historical financial information upon which to base an evaluation of the Company's performance and its ability to compete successfully in the telecommunications business.
Need for Additional Capital. Intermedia will require significant amounts of capital to expand its existing networks and services and to develop new networks and services. In addition, the Company may need additional capital in order to repay its outstanding debts when they become due. See "-- Substantial Debt." The Company expects to fund its capital needs by using available cash, joint ventures, debt or equity financing, credit availability and internally generated funds. The Company expects that its cash requirements will be satisfied into the second half of 2001. However, the Company's future capital needs depend upon a number of factors, certain of which it can control (such as marketing expenses, capital expenditures, staffing levels and customer growth) and others which it cannot control (such as competitive conditions and government regulation). Moreover, the Company's outstanding debt (including the Credit Facility with Bank of America, N.A.) and preferred stock restrict its ability to incur additional debt or issue additional preferred stock. Depending on market conditions, the Company may decide to raise additional capital earlier. However, there can be no assurance that the Company will be successful in raising sufficient debt or equity on terms that are considered acceptable. If the Company cannot generate sufficient funds, it may be required to delay or abandon some of its planned expansion or expenditures. This likely would affect the Company's growth and its ability to repay its outstanding debt as well.
RISKS ASSOCIATED WITH ACQUISITIONS AND EXPANSION
Possible Future Acquisitions or Dispositions. Consistent with Intermedia's strategy, it is currently evaluating and often engaging in discussions regarding various acquisition or disposition opportunities. However, the Company has not reached any agreement or agreement in principle to effect any material acquisition or disposition. There can be no assurance that the Company will be able to identify, finance and complete suitable acquisition opportunities on acceptable terms. Any future acquisitions could be funded with cash on hand and/or by issuing additional securities. It is possible that one or more of such possible future acquisitions or dispositions, if completed, could adversely affect the Company's funds from operations or cash available for distribution, in the short term, in the long term, or both, or increase the Company's debt, or could be followed by a decline in the market value of the Company's outstanding securities, including its common stock.
Failure to Obtain Third Party Consents in Connection with an Acquisition or Merger. Intermedia consummated a number of acquisitions over the past two years. The Company may not have obtained or may have elected not to seek, and in connection with future acquisitions may elect not to seek, all required consents from third parties with respect to acquired contracts. While the failure to obtain required third party consents does not give rise to an action to rescind the acquisition or merger, the third party could assert a breach of the acquired contract. The Company believes the failure to obtain any such third party consents should not result in any material adverse consequences. However, there can be no assurance that no material adverse consequences will result from any such breach of contract claims.
Expansion Risk. Intermedia has expanded rapidly and expects this rapid expansion to continue in the near future. This growth has increased the Company's operating complexity, as well as the level of responsibility for both existing and new management personnel. In order to manage its expansion effectively, the Company must continue to implement and improve its operational and financial systems and expand, train and manage its employee base.
Need to Obtain Permits and Rights-of-Way to Implement Network Expansion. Intermedia is continuing to expand its existing networks to pursue market opportunities. To expand the Company's networks requires it to, among other things, acquire rights-of-way, pole attachment agreements and any required permits and to
finance such expansion. There can be no assurance that the Company will be able to obtain the necessary permits, agreements or financing to expand its existing networks on a timely basis. If the Company cannot expand its existing networks in accordance with its plans, the growth of its business could be materially adversely affected.
Risk of New Service Acceptance by Customers. Intermedia has recently introduced and will continue to introduce new services, which it believes are important to its long-term growth. The success of these services will be dependent upon, among other things, the willingness of customers to accept the Company as the provider of such services. The lack of such acceptance could have a material adverse effect on the growth of the Company's business.
Potential Diminishing Rate of Growth. During the period from 1995 through 1999, Intermedia's revenues grew at a compound annual growth rate of approximately 120.1% (including the effect of acquisitions). While the Company expects to continue to grow, as its size increases, it is likely the Company's rate of growth will decrease.
RISKS RELATED TO INTERNET SERVICES
Maintenance of Peering Relationships. The Internet is comprised of many Internet service providers who operate their own networks and interconnect with other Internet service providers at various peering points. Intermedia's peering relationships with other Internet service providers permit it to exchange traffic with other Internet service providers without having to pay settlement charges. Although the Company meets the industry's current standards for peering, there is no guarantee that other national Internet service providers will maintain peering relationships with the Company. In addition, the requirements associated with maintaining peering relationships with the major national Internet service providers may change. There can be no assurance that the Company will be able to expand or adapt its network infrastructure to meet any new requirements on a timely basis, at a commercially reasonable cost, or at all.
Potential Liability of On-Line Service Providers. The law in the United States relating to the liability of on-line service providers and Internet service providers for information carried on, disseminated through or hosted on their systems is currently unsettled. If liability for materials carried on or disseminated through their systems is imposed on Internet service providers, Intermedia would likely implement measures to reduce its exposure to such liability. Such measures could require the Company to expend substantial resources or discontinue certain product or service offerings. In addition, increased attention on liability issues, as a result of lawsuits, legislation and legislative proposals, could adversely affect the growth of Internet use.
Potential Exposure of Digex to Lawsuits for Customers' Lost Profits or Other Damages. Because Digex's Web hosting services are critical to its customers' businesses, any significant interruption in its services could result in lost profits or other indirect or consequential damages to its customers. Digex's customers are required to sign server order forms which incorporate its standard terms and conditions. Although these terms disclaim its liability for any such damages, a customer could still bring a lawsuit against Digex claiming lost profits or other consequential damages as the result of a service interruption or other Web site problems that the customer may ascribe to it. There can be no assurance a court would enforce any limitations on its liability, and the outcome of any lawsuit would depend on the specific facts of the case and legal and policy considerations. Although Digex believes it may have meritorious defenses to any such claims, there can be no assurance it would prevail. In such cases, Digex could be liable for substantial damage awards. Such damage awards might exceed its liability insurance by unknown but significant amounts, which would seriously harm its business.
DEPENDENCE UPON NETWORK INFRASTRUCTURE
To successfully market its services to business and government users, Intermedia's network infrastructure must provide superior reliability, capacity and security. The Company's networks are subject to physical damage, power loss, capacity limitations, software defects, breaches of security (by computer virus, break-ins or otherwise) and other factors, certain of which have caused, and will continue to cause, interruptions in service or reduced capacity for its customers. Interruptions in service, capacity limitations or security breaches
could have a material adverse effect on the Company's business, financial condition, results of operations and prospects.
RAPID TECHNOLOGICAL CHANGES
Communications technology is changing rapidly. While Intermedia believes, for the foreseeable future, these changes will not materially affect the continued use of its fiber optic networks or materially hinder its ability to acquire necessary technologies, the effect of technological changes, such as changes relating to emerging wire line and wireless transmission technologies, including software protocols, on the Company's business cannot be predicted.
COMPETITION
In each of Intermedia's markets, when selling local services, the Company competes with incumbent local exchange carriers ("ILECs"), which currently dominate their local telecommunications markets. ILECs have longstanding relationships with their customers which may create competitive barriers. ILECs also may have the potential to subsidize their competitive services from revenues they earn from their monopoly services. The Company also faces competition in most markets in which it operates from one or more integrated communications providers or competitive local exchange carriers ("CLECs"). Through acquisitions, AT&T and MCI WorldCom have entered the local services market, and other long distance carriers have announced their intent to enter the local services market. A continuing trend toward business combinations and alliances in the telecommunications industry may create significant new or larger competitors. The mergers of WorldCom and MCI, AT&T and Teleport Communications Group, AT&T and Tele-Communications and SBC Communications and Ameritech, as well as the proposed mergers of Bell Atlantic and GTE and MCI WorldCom and Sprint are examples of this trend.
Recent legislative initiatives, including the Telecommunications Act of 1996 (the "Telecommunications Act"), have removed many of the remaining legislative barriers to local competition. Rules adopted to carry out the provisions of the Telecommunications Act, however, remain subject to pending administrative and judicial proceedings. Intermedia cannot predict the impact future regulatory developments may have on its ability to compete. However, if ILECs are permitted to substantially lower their rates or offer significant volume or term discount pricing, the Company's net income and/or cash flow could be materially adversely affected.
Intermedia's data, internet, and web hosting services compete with services offered by ILECs, long distance carriers, very small aperture terminal (satellite dish) providers, Internet service providers, cable operators and others. In particular, the market for Internet services is extremely competitive, and there are limited barriers to entry. When offering long distance services, the Company competes with AT&T, MCI WorldCom, Sprint and others. The Telecommunications Act permits the regional Bell operating companies ("RBOCs") to provide long distance services in the same areas where they now provide local service once certain criteria are met. Once the RBOCs begin to provide such services, they will be in a position to offer single source local and long distance service similar to that being offered by Intermedia. The Company's integration services compete with those offered by equipment manufacturers, RBOCs and other ILECs long distance carriers and systems integrators.
The market for managed Web site and application hosting conducted by our subsidiary, Digex, is highly competitive. There are few substantial barriers to entry and many of Digex's current competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than it possesses. Current and potential competitors in the market include Web hosting service providers, Internet service providers, telecommunications companies and large information technology outsourcing firms. Intermedia's competitors may operate in one or more of these areas and include companies such as AT&T, Cable & Wireless, Concentric Network, Data Return, Exodus Communications, Frontier/GlobalCenter, Globix, GTE, IBM, Intel, Level 3 Communications, MCI WorldCom, PSINet, Qwest Communications International and
US internetworking. Digex may be unable to achieve its operating and financial objectives due to this significant competition in the Web hosting industry.
The Company cannot predict the number of competitors that will emerge as a result of existing or new federal and state regulatory or legislative actions, but increased competition from existing and new entities could have a material adverse effect on the Company's business. Many of the Company's existing and potential competitors have financial, personnel and other resources significantly greater than the Company's which could effect its ability to compete.
REGULATION
Intermedia is subject to federal, state and local regulation of its telecommunications business as more fully described below. See "Business -- Government Regulation." In general, regulation of the telecommunications industry is in a state of transition. With the passage of the Telecommunications Act, Congress sought to foster competition in the telecommunications industry. The Telecommunications Act attempted to create a framework for companies, such as Intermedia, to offer local exchange service for business and residential customers in competition with existing local telephone companies. The Telecommunications Act also sought to open up the long distance market to additional competition by permitting RBOCs to engage in the long distance business, under certain conditions, in the same regions where they now offer local service. These and many other regulations are the subject of ongoing administrative proceedings at the state and federal levels, litigation in federal and state courts, and legislation in federal and state legislatures. The outcome of the various proceedings, litigation and legislation cannot be predicted and might adversely affect our business and operations.
The Telecommunications Act and the issuance by the Federal Communication Commission ("FCC") of rules governing local competition, particularly those requiring the interconnection of all networks and the exchange of traffic among the ILECs and CLECs, as well as pro-competitive policies already developed by state regulatory commissions, have caused fundamental changes in the structure of the markets for local exchange services. On January 25, 1999, the Supreme Court largely reversed earlier decisions of the Eighth Circuit Court of Appeals and held that the FCC has general jurisdiction to implement the local competition provisions of the Telecommunications Act. The Supreme Court stated that the FCC has authority to set guidelines for CLECs to use various portions of the ILEC's network necessary for the CLECs to provide service. These portions of the ILEC's network are called "Unbundled Network Elements" or "UNEs." The Supreme Court also affirmed the FCC's authority to prevent ILECs from refusing to sell to CLECs the ILEC's existing combinations of network elements. The Supreme Court approved the FCC's establishment of "pick and choose" rules regarding interconnection agreements between ILECs and CLECs (which would permit a CLEC to "pick and choose" among various terms of service in different interconnection agreements between the ILEC and other CLECs). The Supreme Court's decision re-establishes the validity of many of the FCC rules vacated by the Eighth Circuit. Although the Supreme Court affirmed the FCC's authority to develop pricing guidelines, the Court did not evaluate the specific pricing methodology adopted by the FCC and has remanded the case to the Eighth Circuit for further consideration. In its decision, the Supreme Court also vacated the FCC's rule that identifies the unbundled network elements that ILECs must provide to CLECs. The Supreme Court found that the FCC had not adequately considered certain statutory criteria for requiring ILECs to make those network elements available to CLECs. The FCC recently issued an Order reaffirming in most respects and clarifying its earlier decision on which UNE's are to be made available and added several new ones. This ruling, however, also is subject to further administrative and judicial review and implementing actions by state commissions. While the Telecommunications Act and the FCC rules implementing it greatly enhance the opportunity for companies such as Intermedia to compete with ILECs, the FCC recently also has granted ILECs greater flexibility in pricing their services to permit them to better compete with CLECs.
Although the passage of the Telecommunications Act should result in increased opportunities for companies that are competing with ILECs, no assurance can be given that changes in current or future regulations adopted by the FCC or state regulators or other legislative or judicial initiatives relating to the telecommunications industry would not have a material adverse effect on the Company.
The Company believes it is entitled to receive reciprocal compensation from ILECs for the transport and termination of Internet traffic as local traffic pursuant to various existing interconnection agreements. Some ILECs have not paid and/or have disputed these charges, arguing the Internet service provider traffic is not local traffic as defined by the various agreements. On February 26, 1999, the FCC ruled that Internet service provider traffic is interstate traffic within the FCC's jurisdiction but that its current rules neither require nor prohibit the payment of reciprocal compensation for these calls. The FCC determined that state commissions have authority to interpret and enforce the reciprocal compensation provisions of existing interconnection agreements and to determine the appropriate treatment of Internet service provider traffic in arbitrating new agreements. The FCC also requested comment on federal rules to govern compensation for these calls in the future.
Prior to the FCC decision, 30 state commissions and several federal and state courts ruled that reciprocal compensation arrangements under existing interconnection agreements apply to calls to Internet service providers. However, one state has ruled that reciprocal compensation arrangements are not applicable to calls to Internet service providers under such agreements. Subsequent to the FCC decision, at least 19 state commissions have reaffirmed their prior determinations or ruled for the first time that reciprocal compensation was due under interconnection agreements existing prior to the FCC decision. There are ongoing disputes concerning the appropriate treatment of Internet service provider traffic under new interconnection agreements which will be resolved by state commission and the FCC if the parties cannot agree.
The Company accounts for reciprocal compensation with the ILECs, including activity associated with Internet traffic, as local traffic pursuant to the terms of our interconnection agreements. Accordingly, revenue is recognized in the period that the traffic is terminated. The circumstances surrounding the disputes, including the status of cases that have arisen by reason of similar disputes, is considered by management periodically in determining whether reserves against unpaid balances are warranted. As of December 31, 1999, provisions for reserves have not been considered necessary by management. However, there can be no assurance that management will not determine that a reserve is necessary at some point in the future or that ultimately these receivables will be collected. As of December 31, 1999, approximately $109.9 million of the Company's receivables are related to such reciprocal compensation. As the Company's Internet service provider traffic grows, these amounts are expected to increase and will be accounted for in the manner described above. Traffic arising under new interconnection agreements will be accounted for consistent with those agreements.
The regulatory status of telephone service over the Internet is presently uncertain. Intermedia is unable to predict what regulations may be adopted in the future or to what extent existing laws and regulations may be found by state and federal authorities to be applicable to such services or the impact such new or existing laws and regulations may have on the Company's business. Specific statutes and regulations addressing this service have not been adopted at this time and the extent to which current laws and regulations at the state and federal levels will be interpreted to include such Internet telephone services has not been determined. The FCC has indicated, for example, that voice telecommunications carried over the Internet between two telephone sets using the public switched network may be subject to payment of Universal Service funding obligations, while voice telecommunications using computers rather than telephone sets may not be subject to such obligations. There can be no assurance that new laws or regulations relating to these services or a determination that existing laws are applicable to them will not have a material adverse effect on the Company's business.
RISK OF TERMINATION, CANCELLATION OR NON-RENEWAL OF INTEREXCHANGE AGREEMENTS, NETWORK AGREEMENTS, LICENSES AND PERMITS
Intermedia leases and/or purchases agreements for rights-of-way, utility pole attachments, conduits and dark fiber for its fiber optic networks. Although the Company does not believe any of these agreements will be canceled in the near future, cancellation or non-renewal of certain of such agreements could materially adversely affect the Company's business in the affected metropolitan area. In addition, the Company has certain licenses and permits from local government authorities. The Telecommunications Act requires local government authorities to treat telecommunications carriers and most utilities, including most ILECs and
electric companies, in a competitively neutral, non-discriminatory manner to afford alternative carriers access to their poles, conduits and rights-of-way at reasonable rates on non-discriminatory terms and conditions. There can be no assurance that the Company will be able to maintain its existing franchises, permits and rights or to obtain and maintain the other franchises, permits and rights needed to implement its strategy on acceptable terms. The Company and Williams entered into an agreement in March 1998 which, as amended in March 1999, provides the Company with a 20 year indefeasible right of use from Williams for high capacity transport of the Company's integrated voice and data services, connecting major markets throughout the continental United States. The indefeasible right of use may be terminated by Williams if the Company fails to make the required payments and, in the event of a bankruptcy of Williams, the indefeasible right of use may be rejected by Williams in a bankruptcy proceeding.
DEPENDENCE ON KEY PERSONNEL
Intermedia's continued success depends on the continued employment of certain members of its senior management team and on its continued ability to attract and retain highly skilled and qualified personnel. The Company does not have long-term employment agreements with any of its key employees. The loss of the services of key personnel or the inability to attract additional qualified personnel could have a material adverse impact on the Company's business, financial condition, results of operations and prospects.
BUSINESS COMBINATIONS
Intermedia has from time to time held, and continues to hold, preliminary discussions with (i) potential investors (both strategic and financial) who have expressed an interest in making an investment in or acquiring the Company and (ii) potential joint venture partners looking toward the formation of strategic alliances that would expand the reach of the Company's networks or services without necessarily requiring an additional investment in the Company. In addition to providing additional growth capital, the Company believes that an alliance with an appropriate strategic investor would provide operating synergy to, and enhance the competitive positions of both the Company and the investor within the rapidly consolidating telecommunications industry. There can be no assurance that agreements for any of the foregoing will be reached.
LACK OF DIVIDEND HISTORY
Intermedia has never declared or paid any cash dividends on its common stock, and the Company does not expect to declare any such dividends in the foreseeable future. Payment of any future dividends will depend upon the Company's earnings and capital requirements, debt and other factors. The Company intends to retain earnings, if any, to finance the development and expansion of its business. In addition, the terms of the Company's outstanding debt and preferred stock restrict the payment of dividends on its common stock.
ANTI-TAKEOVER PROVISIONS
Intermedia's Certificate of Incorporation and Bylaws, the provisions of the Delaware General Corporation Law and the terms of the Company's outstanding debt and preferred stock may make it difficult to effect a change of control and replace the Company's incumbent management. In addition, stockholders, pursuant to a Stockholders' Rights Plan, have the right to acquire a series of preferred stock, exercisable upon the occurrence of certain events. The existence of these provisions may have a negative impact on the price of the Company's common stock, may discourage third parties from making a bid for the Company or may reduce any premiums paid to stockholders for their common stock. In addition, the Company's board of directors has the authority to fix the rights and preferences of, and to issue shares of, the Company's preferred stock, which may have the effect of delaying or preventing a change in control without action by the Company's stockholders.
SHARES ELIGIBLE FOR FUTURE SALE
Future sales of shares of Intermedia's common stock by existing stockholders or the issuance of shares of the Company's common stock upon exercise of options or warrants or conversions of convertible securities, could materially adversely affect the market price of the Company's common stock and could impair its future ability to raise capital through an offering of equity securities. Substantially all of the Companys shares of outstanding common stock are covered by effective registration statements or are transferable without restrictions under the Securities Act. The Company cannot make any predictions as to the effect market sales of such common stock or the availability of such common stock for future sale will have on the market price of the Company's common stock from time to time.
YEAR 2000 DATE CONVERSION
The Year 2000 issue is the result of computer-controlled systems using two digits rather than four to define the applicable year. For example, computer programs that have time-sensitive software may recognize a date ending in "00" as the year 1900 rather than the year 2000. This could result in system failure or miscalculations causing disruptions of operations including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. To ensure that our computer systems and applications function properly in 2000, through Intermedia, we have implemented a Year 2000 program. To date, we have not experienced any significant Year 2000 problems.
The Company has substantially completed its Year 2000 program and has made the necessary modifications to and/or replacements of the impacted software and hardware. While the Company believes its plan is substantially complete, the discovery of additional IT or Non-IT systems requiring remediation could adversely impact the current plan and the resources required to implement the plan.
FORWARD-LOOKING STATEMENTS
Some of the statements in this Annual Report that are not historical facts are "forward-looking statements" (as such term is defined in the Private Securities Litigation Reform Act of 1995). Forward-looking statements can be identified by the use of words such as "estimates," "projects," "anticipates," "expects," "intends," "believes" or comparable terminology, the negative thereof or other variations thereon or by discussions of strategy that involve risks and uncertainties. Examples of forward-looking statements include discussions of the Company's plans to expand its existing networks, introduce new products, build and acquire networks in new areas, install switches or provide local services, the estimate of market sizes and addressable markets for the Company's services and products, the market opportunity presented by larger metropolitan areas, the Company's ability to successfully complete its year 2000 remediation project and statements regarding the development of the Company's businesses, anticipated capital expenditures and regulatory reform.
Management wishes to caution you that all forward-looking statements contained in this Annual Report are only estimates and predictions. Actual results could differ materially from those anticipated in this Annual Report as a result of risks facing us or actual events differing from the assumptions underlying such statements. Such risks and assumptions include, but are not limited to, those discussed above. Readers are cautioned not to place undue reliance on any forward-looking statements contained in this report. The Company undertakes no obligation to publish the results of any adjustments to these forward-looking statements that may be made to reflect events on or after the date of this report or to reflect the occurrence of unexpected events.
ITEM 2.
ITEM 2. PROPERTIES
Intermedia leases its principal administrative, marketing, warehouse and service development facilities in Tampa, Florida and leases other space for storage of its electronics equipment and for administrative, sales and engineering functions in other cities where the Company operates networks and/or performs sales functions. Intermedia believes that its properties are adequate and suitable for their intended purposes.
As of December 31, 1999, the Company's total telecommunications and equipment in service consisted of telecommunications equipment (54%), fiber optic cable (23%), furniture and fixtures (11%), leasehold improvements (4%) and construction in progress (8%). Such properties do not lend themselves to description by character and location of principal units. Fiber optic cable plant used in providing service is primarily on or under public roads, highways or streets, with the remainder being on or under private property. Substantially all of the Company's telecommunications equipment is housed in multiple leased facilities in various locations throughout the metropolitan areas served by Intermedia.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to any pending legal proceedings other than various claims and lawsuits arising in the normal course of business. The Company does not believe that these normal course of business claims or lawsuits will have a material effect on the Company's business, financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock trades on The Nasdaq Stock Market under the symbol "ICIX". As of December 31, 1999, based upon 195 holders of record of the Common Stock and an estimate of the number of individual participants represented by security position listings, there are approximately 17,242 beneficial holders of the Common Stock. The approximate high and low bid prices for the Common Stock tabulated below are as reported by The Nasdaq Stock Market and represent inter-dealer quotations which do not include retail mark-ups, mark-downs or commissions. Such prices do not necessarily represent actual transactions. The Company completed a two-for-one stock split (effected as a stock dividend) on June 15, 1998. Where applicable, the prices have been adjusted to give effect to the split.
Holders of shares of Common Stock are entitled to dividends, when and if declared by the Board of Directors, out of funds legally available therefor. Intermedia has never declared or paid cash dividends on its Common Stock. Intermedia intends to retain its earnings, if any, to finance the development and expansion of its business, and therefore does not anticipate paying any dividends on its Common Stock in the foreseeable future. In addition, the terms of the Company's outstanding indebtedness and preferred stock restrict the payment of dividends until certain conditions are met. When such restrictions no longer exist, the decision whether to pay dividends will be made by the Board of Directors in light of conditions then existing, including the Company's results of operations, financial condition and capital requirements, business conditions and other factors. The payment of dividends on the Common Stock is also subject to the preference applicable to the outstanding shares of the Company's preferred stock and to the preference that may be applicable to any shares of the Company's preferred stock issued in the future.
RECENT SALES OF UNREGISTERED SECURITIES
On February 17, 2000, KKR made a $200.0 million equity investment in the Company. In exchange for this investment, the Company issued 200,000 shares of Series G Junior Convertible Preferred stock (the Series G Preferred Stock) (aggregate liquidation preference $200.0 million) in a private placement transaction. Dividends on the Series G Preferred Stock accumulate at a rate of 7% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. At the Company's option, dividends are payable in cash, issuance of shares of Common Stock of the Company, or by some combination thereof. The Series G Preferred stock is redeemable, at the option of the Company, at any time on or after February 17, 2005 at rates commencing with 103.5% declining to 100% on February 17, 2008. Net proceeds to the Company were approximately $188.0 million. The proceeds from this investment will be used for general corporate purposes, including the funding of working capital and operating losses, and the funding of a portion of the cost of acquiring or constructing telecommunications related assets.
In addition, KKR received warrants to purchase 1,000,000 shares of the Company's Common Stock at $40 per share and warrants to purchase 1,000,000 shares of the Company's Common Stock at $45 per share. Based upon representations by the purchasers, the issuances were made in reliance on the exemption from the
registration provided by Section 4(2) of the Securities Act, as a transaction by an issuer not involving a public offering.
ITEM 6.
ITEM 6. SELECTED FINANCIAL AND OTHER OPERATING DATA
The selected financial data and balance sheet data presented below as of and for the five years in the period ended December 31, 1999 have been derived from the consolidated financial statements of the Company, which financial statements have been audited by Ernst & Young LLP, independent certified public accountants.
The following financial information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business" and the Consolidated Financial Statements of the Company and the notes thereto, included elsewhere in this report.
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(1) A one time charge to earnings was recorded as a result of the purchase of in process research and development ("R&D") in connection with the acquisition of DIGEX of $60,000 and with the acquisition of Shared of $63,000. (2) Restructuring charges include costs associated with management's plan to transform its separate operating companies into one integrated communications provider. (3) The Company incurred extraordinary charges in 1995 and 1997 related to early retirement of debt. (4) EBITDA before certain charges consists of earnings (net loss before minority interest) before interest expense, interest and other income, income taxes, depreciation, amortization, deferred compensation, charges for in-process R&D, business integration, restructuring and other costs associated with the Program. EBITDA before certain charges does not represent funds available for management's discretionary use and is not intended to represent cash flow from operations. EBITDA before certain charges should not be considered as an alternative to net loss as an indicator of the Company's operating performance or to cash flows as a measure of liquidity. In addition, EBITDA before certain charges is not a term defined by generally accepted accounting principles and, as a result, the EBITDA before certain charges presented herein may not be comparable to similarly titled measures used by other companies. The Company believes that EBITDA before certain charges is often reported and widely used by analysts, investors and other interested parties in the telecommunications industry. Accordingly, this information has been disclosed herein to permit a more complete comparative analysis of the Company's operating performance relative to other companies in the industry. (5) Amounts reflected in the table are based upon information contained in the Company's operating records. (6) Beginning in January 1997, Intermedia changed its definition of "Buildings connected" to include buildings connected to Intermedia's network via facilities leased by Intermedia in addition to those connected to Intermedia's network via facilities constructed by or otherwise owned by Intermedia. Intermedia believes the new definition is consistent with industry practice.
(7) Amount represents an individual point of origination and termination of data served by the Company's enhanced network. (8) Cash and cash equivalents excludes investments of $26,675, $6,853, $7,930 and $10,252 in 1996, 1997, 1998 and 1999, respectively, restricted under the terms of various notes and other agreements. (9) Working capital includes the restricted investments referred to in Note 8 above whose restrictions either lapse within one year or will be used to pay current liabilities.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Intermedia provides integrated data and voice communications services, including enterprise data solutions (frame relay and ATM), Internet connectivity, private line data, managed Web site and application hosting, local and long distance, and integration services to approximately 90,000 business and government customers. As of December 31, 1999, Intermedia is the fourth largest nationwide frame relay provider in the United States (based on frame relay revenues), a leading Tier One Internet service provider, the largest domestic independent provider of competitive local services (based on revenues), the largest provider of shared tenant telecommunications services, and a leading domestic provider of systems integration services. Intermedia is also a leading and rapidly growing provider of managed Web site and application hosting services to large corporations and Internet companies through Digex, its subsidiary. As more fully discussed in the notes to the financial statements, the Company operates in primarily two segments, integrated communications provider and Web and application hosting services. The Company uses a management approach to report its financial and descriptive information about its operating segments. Where significant, the revenue, profitability, and cash needs of the Web and applications hosting segment are discussed below.
Intermedia believes it is well positioned to take advantage of technical, regulatory and market dynamics that currently promote demand for a fully integrated set of communications services. Intermedia's services include high quality guarantees, customer service and technical support for design, implementation, and operations. Through a combination of internally generated growth and targeted acquisitions, the Company has expanded its service territory and substantially increased its customer base since its inception in 1986.
The Company delivers its local access and voice services, primarily through Company owned local and long distance switches, over a digital transport network. The Company offers its data and Internet services to its customers on an extensive inter-city network that connects its customers to locations nationwide. Through its 881 "NNIs" and 185 data switches, Intermedia has established one of the most densely deployed frame relay switching networks in the nation. The Company's nationwide interexchange network carries both its data and voice traffic.
During 1998, Intermedia entered into enhanced data services agreements with US West, Ameritech and Williams. Pursuant to the agreements with US West and Ameritech, Intermedia was selected as the preferred provider for out-of-region data services. Williams has agreed to use Intermedia's enhanced data services in areas where it does not have data switching capability.
In March 1998, the Company and Williams executed a Capacity Purchase Agreement which, as amended in March 1999, provides the Company with the right to purchase transmission capacity on a non-cancelable indefeasible right of use basis on the Williams fiber network for 20 years. The agreement covers approximately 14,000 route miles.
On March 10, 1998, the Company completed its acquisition of Shared Technologies Fairchild, Inc. ("Shared"), a shared tenant communications services provider. Aggregate cash consideration for the acquisition was approximately $782.6 million and was funded with the Company's existing cash reserves in March 1998. For convenience, the operating results of Shared are included in the Company's consolidated financial statements commencing on January 1, 1998.
On March 31, 1998, the Company acquired Long Distance Savers group of companies (collectively, "LDS"), a regional interexchange carrier. Aggregate consideration for the acquisition was approximately $15.7 million in cash, plus 5,320,048 shares of the Company's common stock, valued at approximately $137.2
million, the retirement of $15.1 million in LDS's long-term debt and acquisition related expenses of $3.3 million. The cash portion of the acquisition was funded with the Company's existing cash reserves in March 1998. The operating results of LDS for the one day of ownership during the first quarter of 1998 are considered immaterial. The operating results of LDS are included in the Company's consolidated financial statements commencing on April 1, 1998.
On April 30, 1998, the Company completed the acquisitions of privately held National Telecommunications of Florida, Inc. and NTC, Inc. (collectively, "National"), an emerging switch-based competitive local exchange carrier and established interexchange carrier. Aggregate consideration for the acquisition was approximately $59.5 million in cash, plus 2,909,796 shares of the Company's common stock, valued at approximately $88.7 million, the retirement of $2.8 million in National's long-term debt, and $2.6 million in acquisition related costs. The cash portion of the acquisition was funded with the Company's existing cash reserves in April 1998. The operating results of National are included in the Company's consolidated financial statements commencing on April 1, 1998.
On April 29, 1998, the Company announced that it had committed resources to a restructuring program (the "Program"), a plan to implement the integration of acquired businesses to maximize the synergies that will be realized and to reduce future costs. During the second quarter of 1998, the Company developed and began implementation of the Program which was designed to streamline and refocus the Company's operations and transform Intermedia's five separate operating companies into one integrated communications provider. The significant activities included in the Program include (i) consolidation, rationalization and integration of network facilities, collocations, network management and network facility procurement; (ii) consolidation and integration of the sales forces of the Company and its recent acquisitions, including the integration of the Company's products and services and the elimination of redundant headcount and related costs; (iii) centralization of accounting and financial functions, including the elimination of redundant headcount and related costs; (iv) development and integration of information systems, including the integration of multiple billing systems and the introduction and deployment of automated sales force and workflow management tools; (v) consolidation of office space and the elimination of unnecessary legal entities; and (vi) exiting non-strategic businesses, including the elimination of headcount and related costs.
In connection with the adoption of the Program, the Company recorded a restructuring charge during the second quarter of 1998 of approximately $32.3 million, which was reduced in the third and fourth quarters of 1998 by $13.5 million, upon renegotiation of a contract and other changes. The Company also expensed other business restructuring and integration costs associated with the Program of $34.7 million during 1998. Business restructuring and integration expense associated with the program of approximately $27.9 million was recorded by the Company during 1999. The Company expects the Program to continue through June 2000.
In April 1999, the Company announced that it has entered into strategic alliances with two DSL (digital subscriber line) companies, NorthPoint and Rhythms NetConnection. These agreements will allow the Company to purchase DSL transport to provide additional telecommunications services such as high speed Internet access, local and long distance services, and frame relay to Intermedia's small and medium sized customers on a more economical basis. Intermedia has implemented DSL technology using its own network facilities for its shared tenant services (Advanced Building Networks) buildings to provide greater bandwidth for data, voice and Internet access. The NorthPoint and Rhythms alliances will enable the Company to increase its existing market coverage for DSL services.
Due to its ability to provision nationwide data services, the Company announced in August 1999 that it was selected by Bell Atlantic to provide frame relay services to Bell Atlantic's out-of-region customers. The Company believes this arrangement will offer customers a single point of contact for sales and customer care and will enable Intermedia to benefit from Bell Atlantic's customer relationships and distribution abilities and thereby sell additional frame relay services. (This is in addition to the preferred provider partnerships Intermedia entered into with US West and Ameritech in 1998 to provide out-of-region data services.) The Company expects a continued positive revenue impact from the strategic partnerships referred to above.
In August 1999, Digex sold 11.5 million shares of its Class A common stock in an initial public offering. In February 2000, Digex completed a second public offering of 12,650,000 shares of its Class A Common Stock. Digex offered 2,000,000 shares of its Class A Common Stock and the Company sold 10,650,000 shares of Digex Class A Common Stock it then owned. Intermedia owns approximately 62.0% of the outstanding Common Stock of Digex. However, since each share of Digex Class B common stock has ten votes and each share of Digex Class A has one vote, Intermedia retains approximately 94.2% voting interest in Digex. The net proceeds from the Digex offering to Intermedia were approximately $913.8 million and can be used to purchase telecommunications related assets or reduce outstanding debt due to restrictions in Intermedia's debt instruments.
In the third quarter of 1999, the Company expanded its unifiedvoice.net(SM) (uv.net) service, which provides integrated local, long distance and high-speed Internet access, to 39 cities. While the Company has offered integrated services in the past, uv.net will enable Intermedia to increase its addressable market from 15% to over 85% of the business lines in the markets it serves and offer a more economical and technologically advanced package of telecommunications services to small and medium businesses.
PLAN OF OPERATION
The Company believes its revenue growth will be generated primarily from its data, internet, and web hosting, and local exchange services. Based on the Company's analysis of Federal Communications Commission market data and its knowledge of the industry, the Company estimates that the market for enhanced data, local exchange and interexchange services currently exceeds $100.0 billion within its service territory.
RESULTS OF OPERATIONS
The following table presents, for the periods indicated, certain information derived from the Consolidated Statements of Operations of the Company expressed in percentages of revenue:
Year Ended December 31, 1999 Compared to Year Ended December 31, 1998
The Company's revenue grew from $712.8 million to $906.0 million or 27.1% from 1998 to 1999. Revenue in 1998 and 1999 for each of the Company's product lines were as follows:
The overall increase in revenue was partially due to the acquisitions of the affiliated entities known as the LDS on March 31, 1998 and National on April 30, 1998. The operating results of LDS and National are included in the Company's consolidated financial statements commencing April 1, 1998. The Company has also continued its efforts to introduce new services and increase the focus of the Company's sales force on offering a full suite of telecommunications services to an expanding market. The Company's core strategic revenue categories continue to grow, and the Company plans to maintain its emphasis on sales of key enhanced services such as data, Internet connectivity and managed Web site and application hosting, and local access services.
Data, Internet and Web hosting revenue increased 38.3% to $361.5 million in 1999 compared to $261.4 million in 1998. This increase was principally a result of the expansion of the Company's frame relay and ATM networks as well as strong growth in Internet and managed Web site application and hosting services. Intermedia's data network expanded by 201 NNI connections, 13,705 frame relay nodes, and 8 data switches since December 31, 1998. In addition, the Company experienced an increase in sales of frame relay services as a result of its data agreements with US West, Ameritech, and Bell Atlantic. The Company also experienced increased sales in Internet and managed Web site and application hosting services due to new customer additions and sales of additional services to existing customers. As of December 31, 1999, the Company had 2,311 Web servers on line, an increase of 1,263 from December 31, 1998.
Local access and voice revenue increased 18.3% to $414.2 million in 1999 compared to $350.0 million in 1998. This increase was partially due to the acquisition of LDS on March 31, 1998 and National on April 30, 1998, and the continued rollout of local exchange services into additional markets. In addition, the number of voice switches increased from 23 at December 31, 1998 to 29 at December 31, 1999 as Intermedia expanded its voice switch network into new geographic markets. The number of access line equivalents increased by 153,510 from December 31, 1998 through December 31, 1999. The additional access line equivalents were primarily on-switch. These on-switch access line equivalents contribute to improved gross margins and allow the Company to offer a more economical package of telecommunications services to its customers. The Company has also continued its efforts to reduce its base of local customers who utilize resale lines, which have historically yielded low margins for Intermedia. In addition, the Company was certified as a CLEC in 38 states and the District of Columbia at the end of 1999. The increases in local access and voice described above were offset by decreases in long distance voice sales over 1998. The decrease was primarily due to the Company's decision during the second quarter of 1998 to begin its exit of the low margin wholesale long distance business, as well as per minute long distance pricing declines in the industry. While the Company is no longer focusing its marketing efforts on sales of long distance services on a stand alone basis, the Company believes that its integrated business strategy (including sales of higher margin products such as uv.net) should more than compensate for the decrease in long distance voice revenue and should result in an increase in higher overall margins in future periods.
Integration revenue increased 28.5% to $130.3 million in 1999 compared to $101.4 million in 1998. This increase was principally due to an increased demand for the installation and sale of telecommunications equipment in 1999 compared to 1998 resulting from Year 2000 upgrades and the successful expansion of the Company's sales force on the West Coast.
Revenue from the Digex Web hosting segment, increased 164.6% to $59.8 million in 1999 compared to $22.6 million in 1998. The $37.2 million increase in revenue was a result of the segment's increased marketing efforts and market acceptance of our new products, resulting in growth in our number of customers. Digex also experienced increases in revenue from customers through upgrade and value-added services. This translated into higher average revenues per server.
Operating expenses in total increased 17.6% to $1,211.1 million in 1999 compared to $1,030.1 million in 1998. Operating expenses decreased to 133.7% of revenue in 1999 compared to 144.5% of revenue in 1998. The 1998 operating expenses include a $63.0 million charge for in-process research and development in connection with the acquisition of Shared. In addition, business restructuring and integration expenses (discussed below) decreased to $27.9 million in 1999 compared to $53.5 million in 1998. These decreases were offset by increases in other operating expenses, including increased support costs relating to the significant expansion of the Company's owned and leased networks and the increase in personnel to sustain and support the Company's growth, as well as accelerating growth in Digex Web hosting segment which became a separate public company in August 1999. Depreciation increased in 1999 compared to 1998 as a result of the Company's telecommunications equipment additions. During 1999, the Company made improvements in its business processes through implementation of various automated systems including sales order tracking, switch translation, enterprise resource planning, and continued integration of its billing systems. The Company has realized savings from these efforts through improved sales and back office productivity and decreased provisioning time.
Network expenses increased 9.9% to $371.2 million in 1999 compared to $337.6 million in 1998. The Company has incurred increased expenses in leased network capacity associated with the growth of local access and voice as well as data and Internet service revenues. These increases were partially offset by reduced network expenses, as a percentage of revenue, resulting from the Company's integrated business strategy. The Company has also benefited from several network agreements, including the Company's network agreement with Williams. The Williams agreement, executed in March 1998 (and amended in 1999), positively impacted network expenses as a result of the Company's continued efforts to consolidate traffic through the Williams backbone network, as well as through the Company's existing networks in an efficient and cost effective manner. Finally, the Company has focused its selling efforts on on-switch access lines, which have better gross margins and improved provisioning time.
Facilities administration and maintenance expenses increased 56.4% to $103.4 million in 1999 compared to $66.1 million in 1998. The increase resulted from support costs related to the expansion of the Company's owned and leased network capacity, increased maintenance expenses due to network expansion and increased payroll expenses related to additional engineering and operations staff necessary to support and service the Company's expanding network, as well as the accelerating growth in the Digex Web hosting segment. These increases were partially offset by administrative cost efficiencies and synergies that were realized from the successful completion of the restructuring and integration program, including the integration of the Company's acquired businesses.
Cost of goods sold increased 28.1% to $83.4 million in 1999 compared to $65.1 million in 1998. This increase was principally due to the increase in integration services revenue as a result of greater demand for telecommunications equipment in 1999 compared to 1998 resulting from Year 2000 upgrades and the successful expansion of the Company's sales force on the West Coast.
Selling, general and administrative expenses increased 38.2% to $294.4 million in 1999 compared to $213.0 million in 1998. The Company's core growth strategy required increases in sales and marketing efforts and other support costs, including a substantial increase in the number of employees required to support the Company's managed Web site and application hosting segment. The Company's sales and marketing related expenses increased approximately $36.7 million, management information services increased approximately $4.8 million, customer operations increased approximately $15.3 million, and other general administrative costs to support the administrative departments and corporate development increased approximately $24.6 million.
Deferred compensation decreased 28.6% to $1.5 million in 1999 compared to $2.1 million in 1998. The Company recorded deferred compensation for the Company's Stock Award Plan (discussed further in note 10 to the financial statements) and for below-market stock options granted to certain employees in connection with the initial public offering of the Company's web site and application hosting subsidiary during 1999. The decrease in deferred compensation expense over 1998 relates to a change in the qualifying vesting period for the Stock Award Plan during 1999.
Depreciation and amortization expenses increased 43.4% to $329.3 million in 1999 compared to $229.7 million in 1998. This increase was principally due to depreciation of telecommunications equipment placed in service during 1999 as a result of ongoing network expansion (including the irrevocable right of use acquired from Williams). Depreciation expense is expected to increase in future periods based on the Company's plans to continue expanding its network and facilities, including its new managed Web site and application hosting facilities on the East and West Coasts.
The charge for in-process R&D of $63.0 million in the first quarter of 1998 represents the amount of purchased in-process R&D associated with the purchase of Shared. This allocation represents the estimated fair value based on risk-adjusted cash flows related to the incomplete projects. At the date of acquisition, the development of these projects had not yet reached technological feasibility and in-process R&D had no alternative future uses. Accordingly, these costs were expensed as of the acquisition date and were recorded as a one-time charge to earnings in the first quarter of 1998. In making its purchase price allocation, the Company relied on present value calculations of income and cash flows, an analysis of project accomplishments and completion costs and an assessment of overall contribution, as well as project risk. The amounts
assigned to the in-process R&D were determined by identifying significant research projects for which technological feasibility had not been established. In-process R&D included the development and deployment of an innovative multi-service access platform ("MSAP") which will enable Shared to provision new data services. These projects were completed by December 31, 1999.
Development efforts for these in-process R & D projects included various phases of design, development, and testing. As of December 31, 1999, the Company has deployed digital subscriber loop access management (DSLAMs) as the MSAP in 272 shared tenant (Advanced Building Networks) buildings. These DSLAMs provide customers with high speed Internet access. While voice and data services are not currently provided through this single MSAP, the DSLAMs provide the infrastructure for future phases of this technological development.
Business restructuring and integration expense of approximately $27.9 million was recorded by the Company during 1999 compared to $53.5 million during 1998. During 1998, the Company recorded a one-time charge of $18.8 million comprised primarily of network integration, back office accounting integration and information systems integration cost and costs associated with positions eliminated as a result of the Program. Additional costs of $29.3 million and $34.7 million were recorded during the year ended December 31, 1999 and 1998, respectively, representing incremental, redundant, or convergence costs that result directly from implementation of the Program but which are required to be expensed as incurred. Such costs were substantially in line with the amounts expected by management. The Company expects the Program to continue until June 2000 due to the extension of completion dates of certain projects. The restructuring program reserve and related restructuring expenses were adjusted during the Program due to changes in estimates relating to various restructuring projects.
Interest expense increased 43.8% to $295.9 million in 1999 compared to $205.8 million in 1998. This increase primarily resulted from interest expense on approximately $300.0 million principal amount at maturity of 9.5% Senior Notes and $364.0 million principal amount at maturity of 12.25% Senior Subordinated Discount Notes issued in February 1999. In addition, the increase partially resulted from increased interest expense on $500.0 million principal amount of 8.6% Senior Notes issued in May 1998. Interest cost capitalized in connection with the Company's construction of telecommunications equipment amounted to approximately $10.4 million and $7.2 million for the years ended December 31, 1999 and 1998, respectively.
Interest and other income remained constant at $35.8 million in 1999 and 1998. Interest income decreased slightly due to comparatively higher level of average cash balances during 1998 as compared to 1999. The Company issued approximately $500.0 million for 8.6% Senior Notes in May 1998 and approximately $200.0 million for Series F Depositary Shares in August 1998, compared to approximately $300.0 million for 9.5% Senior Notes and approximately $364.0 million for 12.25% Senior Subordinated Discount Notes early in 1999. In addition, Digex completed its initial public offering, which raised approximately $178.9 million net proceeds during August 1999. This decrease in interest and other income was offset by increases in customer finance charges during 1999 as compared to 1998.
Net loss before minority interest increased 16.0% to $(565.2) million in 1999 compared to $(487.2) million in 1998. Factors contributing to the increase in the Company's net loss are described above.
A minority interest in net loss of subsidiary of $6.8 million was recorded by the Company in 1999. The minority interest in net loss of subsidiary is approximately 18.7% of the net losses incurred by Digex subsequent to the August 4, 1999 initial public offering. The Company expects this amount to increase in 2000 as the Company decreases its ownership in the subsidiary.
Preferred stock dividends and accretions increased 2.4% to $92.5 million in 1999 compared to $90.3 million in 1998. The slight increase was due to the dividends accrued on the Series F Preferred Stock that was issued in August 1998. The increase was offset by conversion of approximately 15,000 shares of the Company's Series D Preferred Stock and approximately 15,000 shares of the Company's Series E Preferred Stock into common stock in July and August of 1998. The Company recorded a preferred stock dividend charge of
approximately $11.0 million during the third quarter of 1998 representing the market value of the inducement feature of the conversions.
EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, increased $22.8 million to $53.7 million in 1999 compared to $30.9 million in 1998. The integration of recent acquisitions contributed to improved EBITDA before certain charges as a result of consolidating sales forces and introducing the Company's products into additional markets. Gross margin, inclusive of network expenses, facilities administration and maintenance expenses and cost of goods sold, increased to $348.1 million in 1999 compared to $244.0 million in 1998 as a result of the Company's continued efforts to consolidate traffic through the Williams backbone network, as well as through the Company's existing networks in an efficient and cost effective manner. In addition, the Company has been successful in selling more of its access lines "on switch," improving customer provisioning time, rolling out new products and services, and increasing its mix of higher margin products. Partially offsetting the favorable increase in gross margin was a $81.4 million increase in selling, general and administrative expenses. The Company has made significant strides in restructuring back-office and administrative functions and has integrated its information systems and resources and expects the Program to continue until June 2000. However, the Company's core growth strategy and accelerated growth in Digex required increases in sales and marketing efforts and other support costs which contributed to the overall increase in selling, general and administrative expenses.
EBITDA before certain charges consists of earnings (net loss before minority interest) before interest expense, interest and other income, income taxes, depreciation, amortization, deferred compensation, charges for in-process R&D, business integration, restructuring and other costs associated with the Program. EBITDA before certain charges does not represent funds available for management's discretionary use and is not intended to represent cash flow from operations. EBITDA before certain charges should not be considered as an alternative to net loss as an indicator of the Company's operating performance or to cash flows as a measure of liquidity. In addition, EBITDA before certain charges is not a term defined by generally accepted accounting principles and, as a result, the EBITDA before certain charges presented herein may not be comparable to similarly titled measures used by other companies. The Company believes that EBITDA before certain charges is often reported and widely used by analysts, investors and other interested parties in the telecommunications industry. Accordingly, this information has been disclosed herein to permit a more complete comparative analysis of the Company's operating performance relative to other companies in the industry.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
The Company's revenue grew from $247.9 million to $712.8 million or 187.5% from 1997 to 1998. Revenue in 1997 and 1998 for each of the Company's product lines were as follows:
The overall increase in revenue was principally the result of the acquisitions of Shared and LDS in the first quarter of 1998, the acquisition of National in the second quarter of 1998, the introduction of new services and the increased focus of the Company's sales force on offering a full suite of communications services to an expanding market. A portion of the revenue increase was also attributable to the inclusion of DIGEX (included both Internet connectivity and Web hosting business units prior to carve out of Digex in 1999) for 12 months in 1998 compared to six months in 1997. In addition, the Company has been integrating its acquisitions throughout 1998, and the Company offers a fully integrated portfolio to a larger customer base.
Data, Internet and Web hosting revenue increased 65.4% to $261.4 million in 1998 compared to $158.0 million in 1997. This increase was principally due to the acquisition of LDS during the first quarter of 1998 and the expansion of the Company's enhanced data network, as well as the inclusion of the operating results of DIGEX for 12 months in 1998 compared to six months in 1997. The data network was expanded by 41 switches, 294 NNI connections, and 15,059 new frame relay nodes. In addition, the Company experienced a significant increase in sales of frame relay, Internet and Web hosting services during 1998.
Local access and voice revenue increased 317.6% to $350.0 million in 1998 compared to $83.8 million in 1997. This increase was principally due to the acquisition of Shared during the first quarter of 1998, the acquisitions of LDS and National during the second quarter of 1998, and the continued rollout of local exchange services into additional markets. The number of access line equivalents increased by 266,235 from December 31, 1997 through December 31, 1998. The Company was certified as a competitive local exchange carrier ("CLEC") in 37 states and the District of Columbia as of December 31, 1998, versus 36 states and the District of Columbia as of December 31, 1997. Increases in long distance voice revenue resulted principally from the acquisitions of Shared and LDS during the first quarter of 1998 and the acquisition of National during the second quarter of 1998, which were partially offset by the Company's second quarter decision to exit the wholesale long distance business. However, the Company also experienced strong growth in long distance switched revenue and steady growth in interLATA transport.
Integration services revenue increased 1,549.6% to $101.4 million in 1998 compared to $6.1 million for the same period in 1997. This increase was principally due to the acquisition of Shared during the first quarter of 1998.
Revenue from the Company's operating segment, Digex Web hosting, increased 94.9% to $22.6 million in 1998 compared to $11.6 million in 1997. The $11.0 million increase in revenue was a result of the Company's increased marketing efforts, and market acceptance of its new products, resulting in growth in the number of customers. The Company also experienced increases in revenue from existing customers through upgrades and value-added services. This translated into higher average revenues per server.
Operating expenses in total increased 150.4% to $1,030.1 million in 1998 compared to $411.4 million in 1997. This increase was principally due to the acquisition of Shared and LDS during the first quarter of 1998, the acquisition of National during the second quarter of 1998 and the inclusion of DIGEX's operating results for the full 12 months in 1998 versus the six months included in 1997. The increase also resulted from the costs associated with the significant expansion of the Company's owned and leased network and the continued increase in personnel to sustain and support the Company's growth. Of the increase, $53.5 million was related to expenses recorded in connection with the Program and $63.0 million was related to a one time in-process R&D charge (discussed below).
Network expenses increased 105.3% to $337.6 million in 1998 compared to $164.5 million in 1997. The increase resulted principally from the acquisitions of Shared and LDS in the first quarter of 1998 and the acquisition of National in the second quarter of 1998. The Company incurred increased expenses in leased network capacity associated with the growth of local network service, data service and interexchange service revenues. The Williams agreement positively impacted network operations expenses in 1998 by eliminating certain backbone network costs that were previously accounted for as operating leases. This positive impact was substantially offset by depreciation expense associated with the underlying irrevocable right of use.
Facilities administration and maintenance increased 108.5% to $66.1 million in 1998 compared to $31.7 million in 1997. The increase in the combined costs of facilities administration and maintenance and cost of goods sold was principally the result of the acquisitions of Shared and LDS in the first quarter of 1998 and the acquisition of National in the second quarter of 1998. The increase also resulted from support costs relating to the expansion of the Company's owned and leased network capacity, increases in maintenance expense due to network expansion, and increased payroll expenses related to hiring additional engineering and operations staff to support and service the expanding network, including the increase in anticipated volume relating to the US West, Ameritech, and Bell Atlantic agreements.
Cost of goods sold increased 2,070% to $65.1 million in 1998 compared to $3.0 million in 1997. The increase in cost of goods sold was principally due to the acquisition of Shared during the first quarter of 1998.
Selling, general and administrative expenses increased 119.6% to $213.0 in 1998 compared to $97.0 in 1997. The increase was principally due to the acquisitions of Shared and LDS in the first quarter of 1998 and the acquisition of National in the second quarter of 1998. The acquisitions of Shared, LDS, and National contributed to the increase by approximately $38.4 million, $12.1 million, and $7.1 million, respectively. In addition, the Company has experienced continued personnel growth, represented by departmental expense increases in sales of approximately $42.2 million, marketing of approximately $10.0 million, management information services of approximately $7.0 million and customer operations of approximately $12.5 million. The growth in headcount was related to the expansion in all of the Company's service lines.
Depreciation and amortization expense increased 328.5% to $229.7 million in 1998 compared to $53.6 million in 1997. This increase primarily resulted from additions to telecommunications equipment placed in service during 1997 and 1998 relating to ongoing network expansion (including the irrevocable right of use acquired from Williams), as well as the acquisitions of Shared, LDS, and National which contributed $662.8 million, $143.1 million, and $146.7 million, respectively, of intangible assets in 1998. In addition, the acquisition of DIGEX in July 1997 contributed approximately $113.4 million of intangible assets. The amortization related to the DIGEX acquisition was included as part of amortization expense for 12 months in 1998 compared to six months in 1997.
Deferred compensation expense increased 31.3% in 1998 to $2.1 million compared to $1.6 million in 1997. The Company recorded increased deferred compensation expense in 1998 related to the Company's Stock Award Plan (discussed further in Note 10 to the financial statements) as compared to 1997.
The charge for in-process R&D of $63.0 million in the first quarter of 1998 represents the amount of purchased in-process R&D associated with the purchase of Shared. This allocation represents the estimated fair value based on risk-adjusted cash flows related to the incomplete projects. At the date of acquisition, the development of these projects had not yet reached technological feasibility and in-process R&D had no alternative future uses. Accordingly, these costs were expensed as of the acquisition date and were recorded as a one-time charge to earnings in the first quarter of 1998. In making its purchase price allocation, the Company relied on present value calculations of income and cash flows, an analysis of project accomplishments and completion costs and an assessment of overall contribution, as well as project risk. The amounts assigned to the in-process R&D were determined by identifying significant research projects for which technological feasibility had not been established. In-process R&D included the development and deployment of an innovative multi-service access platform ("MSAP") which will enables Shared to provision new data services. These projects were completed by December 31, 1999.
Development efforts for these in-process R&D projects included various phases of design, development, and testing. The Company has deployed digital subscriber loop access management (DSLAMs) as the MSAP in 272 shared tenant (Advanced Building Networks) buildings in 17 markets. These DSLAMs provide customers with high speed Internet access. While voice and data services are not currently provided through this single MSAP, the DSLAMs provide the infrastructure for future phases of this technological development.
Charge for in-process R&D of $60 million represents the amount of purchased in-process R&D associated with the purchase of DIGEX. In connection with this acquisition, the Company allocated $60 million of the purchase price to in-process R&D projects. This allocation represents the estimated fair value based on risk-adjusted cash flows related to the incomplete products. At the date of acquisition, the development of these projects had not yet reached technological feasibility and the in-process R&D had no alternative future uses. Accordingly, these costs were expensed as a one-time charge to earnings in the third quarter of 1997.
In making its purchase price allocation, the Company relied on present value calculations of income, an analysis of project accomplishments and completion costs and an assessment of overall contribution and project risk. The amounts assigned to the in-process R&D were determined by identifying significant research
projects for which technological feasibility had not been established. These projects included development, engineering, and testing activities associated with specific and substantial network projects including new router technology related to traffic management and very high speed data streams, as well as value-added services such as multicasting and new advanced web management capabilities.
The value assigned to purchased in-process R&D was determined by estimating the costs to develop the purchased in-process R&D into commercially viable products and services, estimating the resulting net cash flows from the projects, and discounting the net cash flows to their present value.
Remaining development efforts for these in-process R&D projects included various phases of design, development, and testing. These projects were completed by December 31, 1999. The estimated costs to complete the projects were approximately $2.4 through December 31, 1998.
Business restructuring and integration expense of approximately $53.5 million was recorded by the Company during the twelve months ended December 31, 1998. As more fully discussed in Note 3 of the Consolidated Financial Statements, these costs arose from businesses exited, contract terminations and integration and other restructuring activities and costs, including incremental, redundant or convergence costs that result directly from implementation of the Program. Additional incremental, redundant and convergence costs were be expensed as incurred over the Program implementation period, which will be continued until June 2000.
Interest expense increased 239.2% to $205.8 million in 1998 compared to $60.7 million in 1997. This increase primarily resulted from interest expense on approximately $1.2 billion of senior notes issued from the fourth quarter of 1997 and in 1998 and the non-cash imputed interest charges of $5.1 million and $1.0 million related to the acquisitions of Shared and National, respectively. In addition, the Company recorded interest expense of $40.3 million during the year ended December 31, 1998, related to the capital lease with Williams. Included in 1998 interest expense is $156.3 million of debt discount amortization and $4.5 million of deferred loan cost amortization, both of which are non-cash items. Interest expense capitalized in connection with the Company's construction of telecommunications equipment amounted to approximately $7.2 million and $5.0 million for the years ended December 31, 1998 and 1997, respectively.
Interest and other income increased 33.6% to $35.8 million in 1998 compared to $26.8 million in 1997. This increase was primarily the result of interest earned on the cash available from the proceeds of the issuance of securities in 1997 and 1998.
Loss from operations from the Company's operating segment, Digex Web hosting, decreased by $12.4 million in 1998 from $16.7 million compared to $29.1 million in 1997. The increase is primarily attributable to the segment's allocated portion (approximately $15 million) of the in-process R&D as more fully discussed above. The decrease was partially offset by an increase in costs associated with this segment's growth strategy. Costs associated with the administration and maintenance of the new data centers and increased selling, general and administrative costs represent a large portion of this segment's expenses during its expansion in 1998
Extraordinary loss of $43.8 million in 1997 consisted of pre-payment penalties relating to the early retirement of certain outstanding indebtedness of the Company from the proceeds of a new issuance of senior notes and the write-off of the unamortized deferred financing costs associated with the retired indebtedness.
Preferred stock dividends and accretions increased 106.5% to $90.3 million in 1998 compared to $43.7 million for 1997. The increase was attributable to the dividend payments on the two series of preferred stock issued during October 1997 and August 1998 and the conversion of approximately $75 million liquidation preference of outstanding preferred stock into Common Stock. The Company recorded a preferred stock dividend charge of approximately $11.0 million during the third quarter of 1998 representing the market value of the inducement feature of the conversions. Preferred stock dividends were paid in the form of Common Stock and preferred stock. Management does not expect to pay cash dividends in the foreseeable future.
EBITDA before certain charges, as defined below, increased to $30.9 million in 1998 compared to $(48.2) million for the same period in 1997. The increase was principally the result of the acquisitions of
Shared and LDS in the first quarter of 1998 and the acquisition of National in the second quarter of 1998. The acquisitions also contributed to improved EBITDA before certain charges by consolidating sales forces and introducing the Company's products into additional markets. The Company has continued its efforts to consolidate traffic through the Williams backbone network, as well as through the Company's existing networks in an efficient manner. In addition, the Company has been successful in selling more of its access lines "on switch" and increasing its mix of higher margin products. The business restructuring and integration program has yielded benefits by rationalizing and integrating the recent acquisitions, including eliminating redundant costs. In addition, the Company has reduced network operation expenses, facilities administration and maintenance expenses and selling, general and administrative expenses as a percentage of revenue in 1998 compared to 1997.
EBITDA before certain charges consists of earnings (loss) before extraordinary loss on early extinguishment of debt, interest expense, interest and other income, income taxes, depreciation, amortization, deferred compensation, charges for in-process R&D, business restructuring, integration and other costs associated with the restructuring program. EBITDA before certain charges does not represent funds available for management's discretionary use and is not intended to represent cash flow from operations. EBITDA before certain charges should not be considered as an alternative to net loss as an indicator of the Company's operating performance or to cash flows as a measure of liquidity. In addition, EBITDA before certain charges is not a term defined by generally acceptable accounting principles and as a result the measure of EBITDA before certain charges presented herein may not be comparable to similarly titled measures used by other companies. The Company believes that EBITDA before certain charges is often reported and widely used by analysts, investors and other interested parties in the telecommunications industry. Accordingly, this information has been disclosed herein to permit a more complete comparative analysis of the Company's operating performance relative to other companies in the industry.
LIQUIDITY AND CAPITAL RESOURCES
The Company's operations have required substantial capital investment for the purchase of telecommunications equipment and the design, construction and development of the Company's networks. Cash payments for capital assets for the Company were approximately $260.1 million, $492.0 million, and $602.3 million for the years ended December 31, 1997, 1998 and 1999, respectively, excluding capital leases and telecommunications equipment acquired in connection with business acquisitions. The Company expects that it will continue to have substantial capital requirements in connection with the (i) expansion and improvement of the Company's existing networks, (ii) design, construction and development of new networks, primarily on a demand driven basis, (iii) connection of additional buildings and customers to the Company's networks, and (iv) continued expansion of data centers related to the development of the Digex Web hosting segment.
The substantial capital investment required to build the Company's network has resulted in negative cash flow after consideration of investing activities over the last five years. The Company expects to continue to experience negative cash flow after investing activities for the next several years due to the continuous expansion and the development of the Company's networks. With respect to the Digex Web hosting segment, the Company anticipates significant cash requirements for several years for data center capacity, increasing the employee base to support expanding operations and investing in its marketing and research and development efforts. Until sufficient cash flow after investing activities is generated, the Company will be required to utilize its current and future capital resources, including the issuance of additional debt and/or equity securities, to meet its cash flow requirements.
In February 1999, the Company sold $300.0 million principal amount of 9.5% Senior Notes and $364.0 million principal amount at maturity of 12.25% Senior Subordinated Discount Notes in a private placement transaction. Net proceeds to the Company amounted to approximately $488.4 million from both issuances. The proceeds of the offering of the 9.5% Senior Notes cannot be used for working capital purposes and can solely be used to fund up to 80% of the cost of acquiring or constructing telecommunications related assets. The proceeds from the offering of the 12.25% Senior Subordinated Discount Notes will be used for general corporate purposes, including the funding of working capital and operating losses, and the funding of a portion of the cost of acquiring or constructing telecommunications related assets.
In August 1999, Digex, sold 11.5 million shares of its Class A common stock in an initial public offering. The shares sold represented approximately 18.7% of the aggregate number of shares of Digex common stock outstanding. However, the Company retained a 97.8% voting interest in Digex during 1999. The net proceeds from the Digex initial public offering were approximately $178.9 million and can be used to purchase telecommunications related assets due to restrictions in Intermedia's debt instruments. The Company reduced its ownership in Digex in 2000 as explained below.
On December 22, 1999, the Company had secured a five-year $100.0 million Revolving Credit Agreement (the "Credit Agreement") outstanding with three financial institutions. The Revolving Credit Facility ("Credit Facility") may be repaid and reborrowed from time to time in accordance with the terms and provisions of the agreement, and is guaranteed by each of the Company's subsidiaries. The Credit Facility is secured by a pledge of the stock of each of the Company's subsidiaries, and is secured by substantially all of the assets of the Company and its subsidiaries. The interest rate on the revolving credit facility is based on either a LIBOR or an alternative base rate option, and is paid quarterly in arrears. The Credit Agreement contains covenants customary for facilities of this nature, including limitations on incurrence of additional debt, asset sales, acquisitions, investments, amount others. At December 31, 1999, the Company had $50.0 million outstanding under the credit facility which was repaid in February 2000. In addition, the Company has recently received a commitment from the banks to increase the size of the Credit Facility, although it is under no obligation to do so.
On January 12, 2000, Digex sold 100,000 shares of its preferred stock, designated as Series A Convertible Preferred Stock (the "Preferred Stock"), with detachable warrants to purchase 1,065,000 shares its Class A common stock (the "Warrants"), for an aggregate of $100 million, of which $15 million was in the form of equipment purchase credits. The Preferred Stock has an aggregate liquidation preference of $100 million, and is convertible into approximately 1,462,000 shares of Class A Common Stock. The Warrants can be exercised at any time over their three-year term at a price of $57 per share (the fair value of the Company's common stock on the transaction commitment date). The proceeds from the offering will be allocated between the Preferred Stock and the Warrants based upon their relative fair values, which have not yet been determined by the Company. Following the allocation, the Preferred Stock will be accreted up to its liquidation preference through charges to accumulated deficit.
On February 16, 2000, Digex completed its second public offering of 12,650,000 shares of its Class A common stock. Digex offered 2,000,000 shares of its Class A common stock, and the Company sold 10,650,000 shares of Digex Class A common stock. Intermedia now owns approximately 62.0% of the outstanding Common Stock of Digex. However, since each share of Digex Class B common stock has ten votes and each share of Digex Class A has one vote, Intermedia retains approximately 94.2% voting interest in Digex. The net proceeds to Intermedia were approximately $913.8 million and will be used to reduce the Company's outstanding debt and to purchase telecommunications related assets.
On February 17, 2000, the KKR made a $200 million equity investment in the Company in a private placement transaction. In exchange for this investment, the Company issued 200,000 shares of Series G Junior Convertible Preferred Stock (the Series G Preferred Stock) (aggregate liquidation preference $200 million) in a private placement transaction. Dividends on the Series G Preferred Stock accumulate at a rate of 7% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. At the Company's option, dividends are payable in cash, issuance of shares of common stock of the Company, or by some combination thereof. The Series G Preferred Stock is redeemable, at the option of the Company, at any time on or after February 17, 2005 at rates commencing with 103.5% declining to 100% on February 17, 2008. At closing, two representatives of KKR joined the board. Net proceeds to the Company were approximately $188.0 million. The proceeds from this investment will be used for general corporate purposes, including the funding of working capital and operating losses, and the funding of a portion of the cost of acquiring or constructing telecommunications related assets.
In addition, KKR received warrants to purchase 1,000,000 shares of the Company's Common Stock at $40 per share and warrants to purchase 1,000,000 shares of the Company's Common Stock at $45 per share.
The Company believes that its business plan will be funded into the second half of 2001. However, the Company's future capital needs depend upon a number of factors, certain of which it controls (such as marketing expenses, staffing levels, customer growth and capital costs) and others which it cannot control (such as competitive conditions and government regulation). Moreover, the terms of the Company's outstanding indebtedness (including the Credit Facility with Bank of America, N.A.) and preferred stock impose certain restrictions upon the Company's ability to incur additional indebtedness or issue additional preferred stock. Depending on market conditions, the Company may decide to raise additional capital before such time. There can be no assurance, however, that the Company will be successful in raising sufficient debt or equity on terms that it will consider acceptable.
The Company has from time to time held, and continues to hold, preliminary discussions with (i) potential investors (i.e. strategic investors in the same or a related business and financial investors) who have expressed an interest in making an investment in or acquiring the Company, (ii) potential joint venture partners looking toward formation of strategic alliances that would expand the reach of the Company's network or services without necessarily requiring an additional investment in or by the Company and (iii) companies that represent potential acquisition opportunities for the Company. There can be no assurance that any agreement with any potential strategic or financial investor, joint venture partner or acquisition target will be reached nor does management believe that any such transaction is necessary to successfully implement its strategic plans.
IMPACT OF YEAR 2000
The Year 2000 issue is the result of computer-controller systems using two digits rather than four to define the applicable year. For example, computer programs that have date-sensitive software may recognize a date ending in "00" as the year 1900 rather than the year 2000. To date, the Company has not experienced any significant Year 2000 problems.
As of December 31, 1999, the Company had spent $15.6 million on external costs, $4.8 million on internal costs, and $7.3 million on hardware and software costs pursuant to our compliance program. The internal costs are comprised of employee hours, and external costs are comprised of outside consultant costs. The costs presented do not include system upgrades that would otherwise result as part of the Company's capital expenditure program.
INCOME TAXES
The Company recorded no current net income tax expense in 1999. At December 31, 1999, a full valuation allowance was provided on net deferred tax assets of $446.1 million based upon the Company's history of losses over the past several years and the uncertainty surrounding the Company's ability to recognize such assets. The valuation allowance relates primarily to net operating losses and high yield debt obligations. Due to the sale of Digex stock in February 2000, the Company will recognize a gain on sale of stock and could utilize net operating losses in the future.
IMPACT OF INFLATION
Inflation has not had a significant impact on Intermedia's operations over the past three years.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
While all of the Company's long term debt bears fixed interest rates, the fair market value of the Company's fixed rate long-term debt is sensitive to changes in interest rates. The Company runs the risk that market rates will decline and the required payments will exceed those based on current market rate. Under its current policies, the Company does not use interest rate derivative instruments to manage its exposure to interest rate changes.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements listed in Item 14 are included in this report beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 is incorporated by reference from the information captioned "Proposal One: Election of Directors" and "Executive Officers" to be included in the Company's proxy statement to be filed in connection with the annual meeting of stockholders, to be held on May 25, 2000 (the "Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated by reference from the information captioned "Executive Compensation," "Compensation Committee Interlocks and Insider Participation" and "Comparative Stock Performance" to be included in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item 12 is incorporated by reference from the information captioned "Beneficial Ownership" to be included in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by the Item 13 is incorporated by reference from the information captioned "Certain Relationships and Related Transactions" to be included in the Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
FINANCIAL STATEMENT AND FINANCIAL STATEMENT SCHEDULES
The following consolidated financial statements of the Company and the notes thereto, the related reports thereon of the independent certified public accountants, and financial statement schedules, are filed pursuant to Item 8 of this Report:
All other financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission (the "Commission") are not required pursuant to the instructions to Item 8 or are inapplicable and therefore have been omitted.
INTERMEDIA REPORTS ON FORM 8-K
The following reports on Form 8-K were filed during the fourth quarter of 1999:
Intermedia filed a Current Report on Form 8-K, dated November 3, 1999, reporting under Item 5 the issuance of a press release discussing the Company's third quarter results. The Company also reported under Item 7 the filing of the press release as an exhibit to the Form 8-K.
Intermedia filed a Current Report on Form 8-K, dated December 29, 1999, reporting under Item 5 that the Company entered into a Revolving Credit Agreement with Bank of America N.A., the Bank of New York, and Toronto Dominion (Texas), Inc.
EXHIBIT INDEX
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
INTERMEDIA COMMUNICATIONS INC. (Registrant)
By: /s/ DAVID C. RUBERG ------------------------------------ David C. Ruberg Chairman of the Board, President and Chief Executive Officer
March 20, 2000
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
GLOSSARY
Access Charges -- The charges paid by a carrier to a LEC for the origination or termination of the carrier's traffic.
Access Line -- A circuit that connects a telephone user (customer) to the public switched network. The access line can connect directly to a telephone at the customer's end, or to a customer's key system or PBX.
Access Line Equivalents ("ALEs") -- Represents Intermedia's method of quantifying its local exchange service by estimating end user customer stations connected to the Intermedia network. ALEs are calculated by adding the number of "line service" local switch ports (those connecting to a telephone instrument or equivalent device) to the product of 2.5 to 4 times the number of "trunk service" ports (those connecting to a PBX, Key System, modem bank, or similar device) depending on what combination of PSTN access and terminating equipment the customer has in service.
ATM (Asynchronous Transfer Mode) -- A modern information transfer standard that allows "packets" of voice and data to share a transmission circuit. ATM provides much greater efficiency than the traditional method of transmitting voice signal over a Circuit Switched Network.
Bandwidth -- The bit rate of digital signals that can be supported by a circuit or device. The bandwidth of a particular circuit is generally determined by the medium itself (wire, fiber optic cable, etc.) and the device that transmits the signal to the transmission medium (laser, audio amplifier, etc.).
Central Office -- The switching center and/or central circuit termination facility of a local telephone company.
Centrex -- A central office based business telephone service that roughly provides the user with the same services as a PBX, without the capital investment in the PBX. Centrex services include station to station dialing (2 through 5 digits), customized long distance call handling and user-input authorization codes.
Circuit Switched Network -- A telecommunications network that establishes connections by linking together physical telecommunications circuits, either as pairs of wires or dedicated channels on high capacity transport facilities such as fiber optic systems. These connections are maintained for the duration of the call through one or more telephone switches, as opposed to packet or cell switched connections, which are virtual, often utilizing many physical paths or routes to connect the communicating parties. Traditional voice telephone networks are circuit switched networks.
CLEC (Competitive Local Exchange Carrier) -- A telephone service provider (carrier) that offers services similar to the former monopoly local telephone company. A CLEC may also provide other types of telecommunications services (long distance, data, etc.).
CLEC Certification -- Granted by a state public service commission or public utility commission, this certification provides a telecommunications services provider with the legal standing to offer local exchange telephone services in direct competition with the ILEC and other CLECs. Such certifications are granted on a state by state basis.
Collocation -- A location serving as the interface point for the interconnection of a CLEC's network to the network of an ILEC or another CLEC. Collocation can be 1) physical, where the CLEC "builds" a fiber optic network extension into the ILEC's or CLEC's central office, or 2) virtual, where the ILEC or CLEC leases a facility, similar to that which it might build, to affect a presence in the ILEC's or CLEC's central office.
Communications Act of 1934 -- The first major federal legislation that established rules for broadcast and non-broadcast communications, including both wireless and wire line telephone service.
Connected Building -- A building that is connected to a carrier's network via a non-switched circuit that is managed and monitored by that carrier.
CPE (Customer Premises Equipment) -- The devices and systems that interface a customer's voice or data telecommunications application to a provider's network. CPE includes devices and systems such as PBXs, key systems, routers and ISDN terminal adapters.
Dedicated Access -- A circuit, not shared among multiple customers, that connects a customer to a carrier's network.
DSL (Digital Subscriber Line) -- A modern telephone technology that allows high-speed voice and data traffic to travel over ordinary copper telephone wires.
DWDM (Dense Wavelength Division Multiplexing) -- A technology that allows multiple optical signals to be combined so that they can be aggregated as a group and transported over a single fiber to increase capacity.
Enhanced Data Services -- Data networking services provided on a sophisticated, software managed transport and switching network, such as a frame relay or ATM data network.
Ethernet -- A popular standard for local area networks. The Ethernet connects servers and clients within a building or within other proximate areas. Ethernets typically pass data at 10 million bits per second (Mbs) or 100 Mbs.
Dark Fiber -- Fiber which does not have connected to it the electronics required to transmit data on such fiber.
FCC (Federal Communications Commission) -- The U.S. Government organization charged with the oversight of all public communications media.
Frame Relay -- A transport technology that organizes data into units called frames, with variable bit length, designed to move information that is "bursty" in nature.
ICP (Integrated Communications Provider) -- A telecommunications carrier that provides packaged or integrated services from among a broad range of categories, including local exchange service, long distance service, enhanced data service, Internet service and other communications services.
ILEC (Incumbent Local Exchange Carrier) -- The local exchange carrier that was the monopoly carrier, prior to the opening of local exchange services to competition.
Integration Services -- The provision of specialized equipment to meet specific customer needs, as well as the services to implement and support this equipment.
Interconnection (co-carrier) Agreement -- A contract between an ILEC and a CLEC for the interconnection of the two's networks, for the purpose of mutual passing of traffic between the networks, allowing customers of one of the networks to call users served by the other network. These agreements set out the financial and operational aspects of such interconnection.
Interexchange Services -- Telecommunications services that are provided between two exchange areas, generally meaning between two cities. These services can be either voice or data.
ISDN (Integrated Services Digital Network) -- A modern telephone technology that combines voice and dataswitching in an efficient manner.
ISP (Internet Service Provider) -- A telecommunications service provider who provides access to the Internet, for dial access, and/or dedicated access.
IXC (Interexchange Carrier) -- A provider of telecommunications services that extend between exchanges (LATAS), or cities, also called long distance carrier.
Kbps -- Kilobits per second, or thousands of bits per second, a unit of measure of data transmission.
Key System -- A device that allows several telephones to share access to multiple telephone lines and to dial each other with abbreviated dialing schemes (1 to 4 digits). Modern key sets often include features such as speed dial, call forward, and others.
LAN (Local Area Network) -- A connection of computing devices within a building or other small area, which may extend up to a few thousand feet. The LAN allows the data and applications connected to one computer to be available to others on the LAN.
LATA (Local Access Transport Area) -- A geographic area inside of which a LEC can offer switched telecommunications services, including local toll service. There are 161 LATAs in the continental United States.
LEC (Local Exchange Carrier) -- Any telephone service provider offering local exchange services.
Local Exchange -- An area inside of which telephone calls are generally completed without any toll, or long distance charges.Local exchange areas are defined by the state regulator of telephone services.
Local Exchange Services -- Telephone services that are provided within a local exchange. These usually refer to local calling services (dial tone services). Business local exchange services include Centrex, access lines and trunks, and ISDN.
Mbps -- Megabits per second, or millions of bits per second, a unit of measure for the transmission of data.
Number Portability -- The ability of a local exchange service customer of an ILEC to keep their existing telephone number, while moving their service to a CLEC.
Packet/Cell Switching Network -- A method of transmitting messages as digitized bits, assembled in groups called packets or cells. These packets and cells contain industry-standard defined numbers of data bits, along with addressing information and data integrity bits. Packet/Cell Switching networks, originally used only for the transmission of digital data, are being implemented by carriers such as Intermedia to transport digitized voice, along with other data. The switching (or routing) of the packets or cells of data replace the "circuit-switching" of traditional voice telephone calls. Packet and cell switching is considered to be a more cost efficient method of delivering voice and data traffic.
PBX (Private Branch Exchange) -- A telephone switching system designed to operate on the premises of the user. The PBX functions much like a telephone company central office. A PBX connects stations (telephones) to each other and to lines and trunks that connect the PBX to the public network and/or private telephone networks. A PBX usually provides telephone service to a single company, but, as in the case of shared tenant services, a PBX can be operated within a building to provide service to multiple customers.
Peering -- The commercial practice under which nationwide ISPs exchange traffic without the payment of settlement charges.
Peering Points -- A location at which ISPs exchange traffic.
Point of Presence -- A location where a carrier, usually an IXC, has located transmission and terminating equipment to connect its network to the networks of other carriers, or to customers.
Public Switched Network -- The collection of ILEC, CLEC and IXC telephone networks (switches and transmission routes) that allow telephones and other devices to dial a standardized number and reach any other device connected to the public network. This is contrasted to private networks, access to which is limited to certain users, typically offices of a business or governmental agency.
RBOC (Regional Bell Operating Company) -- One of the ILECs created by the court ordered divestiture of the local exchange business by AT&T. These are BellSouth, Bell Atlantic, Ameritech, US West, and SBC.
Shared Tenant Services -- The provision of telecommunications services to multiple tenants within a building or building complex by allowing these users to have shared access to telephone lines and other telephone services, for the purpose of reducing the user's need to own and operate its own telecommunications equipment and to reduce cost.
Special Access Service -- Private, non-switched connections between an IXC and a customer, for the purpose of connecting the customer's long distance calls to the IXC's network, without having to pay the LEC's access charges.
Tier-one national ISP -- An Internet services provider whose network connects directly to other such Internet providers at the nation's six major peering points.
VSAT (Very Small Aperture Terminal) -- A satellite communication system that comprises a small diameter (approximately 1 meter in diameter) antennae and electronics to establish a communications terminal, used mostly for data. VSAT networks compete with other, land-line based networks such as private lines and frame relay.
Web Site -- A server connected to the Internet from which Internet users can obtain information.
World Wide Web or Web -- A collection of computer systems supporting a communications protocol that permits multi-media presentation of information over the Internet.
REPORT OF INDEPENDENT AUDITORS
Board of Directors Intermedia Communications Inc.
We have audited the accompanying consolidated balance sheets of Intermedia Communications Inc. and Subsidiaries as of December 31, 1998 and 1999, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Intermedia Communications Inc. and Subsidiaries at December 31, 1998 and 1999, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material aspects the information set forth therein.
/s/ ERNST & YOUNG LLP
Tampa, Florida February 15, 2000
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (IN THOUSANDS, EXCEPT SHARE DATA)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Intermedia Communications Inc. and Subsidiaries ("Intermedia" or "the Company") provides integrated data and voice communications, including enterprise data solutions (including frame relay and ATM), Internet connectivity, private line data, managed Web site and application hosting, local and long distance and integration services to business and government customers. The Company offers its full product package of telecommunications services to business customers throughout the United States.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its majority and wholly owned subsidiaries. The consolidated financial statements include 100% of the assets and liabilities of these subsidiaries and the ownership interests of minority participants are recorded as "minority interest." All significant intercompany transactions and balances have been eliminated in consolidation.
SALE OF SUBSIDIARY COMMON STOCK
The Company has accounted for the initial public offering of common shares of its Digex subsidiary as a financing transaction. As such, no gain has been recorded in the accompanying financial statements related to that sale.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
CASH EQUIVALENTS
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
RESTRICTED INVESTMENTS
Restricted investments consist of certificates of deposit which are restricted to collateralize certain letters of credit required by the different municipalities to ensure the Company's performance related to network expansion.
TELECOMMUNICATIONS EQUIPMENT
Telecommunications equipment is stated at cost. Equipment held under capital leases is stated at the lower of fair value of the asset or the net present value of the minimum lease payment at the inception of the lease. Depreciation expense is generally calculated using the straight-line method over the estimated useful lives of the assets as follows:
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Leasehold improvements are amortized using the straight-line method over the shorter of the term of the lease or the estimated useful life of the improvements.
The Company constructs certain of its own transmission systems and related facilities. Internal costs related directly to the construction of such facilities, including interest, overhead costs and salaries or certain employees, are capitalized.
INTANGIBLE ASSETS
Intangible assets arose in connection with business combinations. They are stated at cost and include purchased customer lists, developed technology, workforce, tradenames and goodwill. Identifiable intangible assets are amortized using the straight-line method over their estimated useful lives ranging from two to ten years. Goodwill is amortized using the straight-line method over periods of eight to forty years, with a weighted average life of approximately nineteen years at December 31, 1999.
IMPAIRMENT OF LONG-LIVED ASSETS
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of (SFAS 121), the Company reviews its long-lived assets for impairment when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. This review consists of a comparison of the carrying value of the asset with the asset's expected future undiscounted cash flows without interest costs. Estimates of expected future cash flows represent management's best estimate based on reasonable and supportable assumptions and projections. If the expected future cash flow exceeds the carrying value of the asset, no impairment is recognized. If the carrying value of the asset exceeds the expected future cash flows, an impairment exists and is measured by the excess of the carrying value over the fair value of the asset. Any impairment provisions recognized are permanent and may not be restored in the future. Impairment expense of $0, $2,800 and $0 was recognized in 1997, 1998 and 1999, respectively, and were included as a component of business restructuring, integration and other charges in the accompanying consolidated statement of operations.
FINANCIAL INSTRUMENTS
The carrying value of the Company's financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, note payable and capital lease obligation approximate their fair market values.
DEBT ISSUANCE COSTS
Debt issuance costs are amortized using the effective interest method over the term of the debt agreements. The related amortization is included as a component of interest expense in the accompanying consolidated statements of operations. Debt issuance costs included in other assets were $43,500 and $50,493 at December 31, 1998 and 1999, respectively. Amortization of debt issuance costs amounted to $1,918, $4,721 and $5,937 in 1997, 1998 and 1999, respectively.
REVENUE RECOGNITION
The Company recognizes revenue in the period the service is provided or the goods are shipped for equipment product sales. Unbilled revenue included in accounts receivable represent revenues earned for telecommunications services which will be billed in the succeeding month and totaled $29,920 and $35,590 as of December 31, 1998 and 1999, respectively. The Company invoices customers one month in advance for recurring services resulting in advance billings at December 31, 1998 and 1999 of $12,858 and $21,832, respectively.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Revenue for the Company's Web site and application hosting services segment consists of installation fees and monthly service fees charged to customers under contracts having terms that typically range from one to three years. Installation fees are recognized upon the customer-approved completion of the managed Web hosting solution. Monthly service fees are recognized in the month the service is rendered over the contract period. Certain customer payments for managed Web hosting services received in advance of service delivery are deferred until the service is performed. Additional services are recognized in the month the services are performed.
A portion of the Company's revenues are also related to the sale and installation of telecommunications equipment and services and maintenance after the sale. For these systems installations, which usually require three to five months, the Company uses the percentage-of-completion method, measured by costs incurred versus total estimated cost at completion. The Company bills certain equipment rentals, local telephone access service, and maintenance contracts in advance. The deferred revenue is relieved when the revenue is earned. Systems equipment sales are recognized at time of shipment.
INCOME TAXES
The Company has applied the provisions of SFAS No. 109, Accounting for Income Taxes, which requires an asset and liability approach in accounting for income taxes for all years presented. Deferred income taxes are provided for in the consolidated financial statements and principally relate to net operating losses and basis differences for intangible assets and telecommunications equipment. Valuation allowances are established to reduce the deferred tax assets to the amounts expected to be realized.
LOSS PER SHARE
The Company has applied the provisions of SFAS No. 128, Earnings Per Share (SFAS 128), which establishes standards for computing and presenting earnings per share. Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. The calculation of diluted earnings per share includes the effect of dilutive common stock equivalents. No dilutive common stock equivalents existed in any year presented.
CONCENTRATIONS OF CREDIT RISK
The Company's financial instruments that are exposed to concentrations of credit risk, as defined by SFAS No. 105, Disclosure of Information About Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, are primarily cash and cash equivalents and accounts receivable.
The Company places its cash and temporary cash investments with high-quality institutions. As of December 31, 1999, cash equivalents totaling approximately $228,800 were held by three financial institutions. Such amounts were primarily government treasury instruments and liquid cash accounts.
Accounts receivable are due from residential and commercial telecommunications customers. Credit is extended based on evaluation of the customer's financial condition and generally collateral is not required. Anticipated credit losses are provided for in the consolidated financial statements and have been within management's expectations.
STOCK-BASED COMPENSATION
The Company accounts for employee stock-based compensation in accordance with APB No. 25, Accounting for Stock Issued to Employees, and related Interpretations, because the alternative fair value accounting provided under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), is not required. Accordingly, in cases where exercise prices equal or exceed fair market value, the Company
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
recognizes no compensation expense for the stock option grants. In cases where exercise prices are less than fair value, compensation expense is recognized over the period of performance or the vesting period.
The Company accounts for non-employee stock-based compensation in accordance with SFAS 123. Pro forma financial information, assuming that the Company had adopted the measurement standards of SFAS 123 for all stock-based compensation, is included in Note 10.
STOCK SPLIT
All share and per share information presented herein, and in the Company's Consolidated Financial Statements, has been retroactively restated to reflect a two-for-one stock split of the Company's Common Stock, par value $.01 per share ("Common Stock"), which occurred on June 15, 1998. The stock split was paid in the form of a stock dividend to holders of record on June 1, 1998.
SEGMENT REPORTING
During 1998, the Company adopted the SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). SFAS 131 uses a management approach to report financial and descriptive information about a Company's operating segments. The Company adopted this standard in 1998.
COMPREHENSIVE INCOME
In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income (SFAS 130). SFAS 130 requires that total comprehensive income be disclosed with equal prominence as net income. Comprehensive income is defined as changes in stockholders' equity exclusive of transactions with owners such as capital contributions and dividends. The Company adopted this Standard in 1998. The Company did not report any comprehensive income items in any of the years presented.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). The Statement will require the recognition of all derivatives on the Company's consolidated balance sheet at fair value. In June 1999, the FASB issued Statement of Accounting Standards No. 137, which deferred the effective date of SFAS 133 to all fiscal quarters of the fiscal year beginning after June 15, 2000. The Company does not anticipate that the adoption of this Statement will have a significant effect on its results of operations or financial position.
On January 22, 1999, the Company repriced its outstanding stock options to the current fair market value on that date. On March 31, 1999 the FASB issued an exposure draft, Accounting for Certain Transactions involving Stock Compensation, an Interpretation of APB No. 25. If the exposure draft is issued in its current form, the options that were repriced by the Company (2,046,455 options) would be accounted for as a variable grant from the effective date of the new Interpretation.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the 1999 presentation.
2. BUSINESS ACQUISITIONS
During July 1997, the Company acquired Business Internet, Inc. (previously known as DIGEX, Incorporated), a leading nationwide business Internet services provider, including the Web site and application hosting unit. Aggregate cash consideration for the acquisition was approximately $160,000. In
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
addition, the Company issued options and warrants for 1,177,837 shares of Common Stock valued at $19,380, which was included as a component of the purchase price, to replace outstanding DIGEX options. The acquisition was accounted for by the purchase method of accounting, with the purchase price allocated to the fair value of assets acquired and liabilities assumed.
The original purchase price allocation for Business Internet was as follows:
On April 26, 1999, the Company's majority owned subsidiary, Digex, Incorporated (the Web site and application hosting unit known as "Digex") was incorporated, under the laws of the State of Delaware.
The total amount allocated to in-process R&D ($60,000) was recorded as a one-time charge to operations in 1997 because the technology was not fully developed and had no future alternative use. In connection with the incorporation and subsequent carve-out IPO and contribution of assets to Digex during 1999, the original $60,000 in-process R&D was allocated between the two subsidiaries.
The acquired in-process R&D represents the proprietary projects for the development of technologies associated with creating significant infrastructure and high bandwidth connections so that the Company can offer a range of advanced Internet services. These projects were completed by December 31, 1999. A brief description of the three categories of in-process R&D projects is presented below:
R&D Related to Next Generation Routers. These R&D projects are related to the development of technology embedded in various components of the network's connection points, primarily routers, to support greater transmission capacity. These projects were valued at approximately $36,000. These proprietary projects include the development of VIP2/40 based technology, CT3 technology, and the realization of a new routing architecture design for national deployment. The estimated costs to complete the project were approximately $1,500.
R&D Related to Next Generation Web Management Services. These R&D projects are related to the development of DIGEX's next generation of Web management services, and were valued at approximately $12,000. The estimated costs to complete the project were approximately $500.
Multicasting. These R&D projects are related to the development of multicasting services, and were valued at approximately $12,000. The estimated costs to complete the project were approximately $500.
The components of developed technologies acquired in the DIGEX acquisition were (i) router technologies within the existing network infrastructure and (ii) Web management technologies. The developed technologies were designed to provide basic Internet services and did not have the capability to provide the sophisticated, value-added services required by high-end corporate users. The developed technologies were characterized by inherent weaknesses which made them unable to support future growth requirements and continuously expanding customer operations. The following points further expand upon the nature of the developed technology.
Web Management. The developed technology acquired in this category was related only to the group of servers hosting customers' Websites located at DIGEX's Beltsville headquarters. This site was inadequate to service the increasing number of sites under management by the Company. The software used in the Beltsville headquarters at the time of acquisition had limited functionality and required the
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
integration of more sophisticated tools to handle complex network management activities. The in-process R&D was considered to be a significant step forward since it involved the development, construction, and integration of an additional Web site management facility and a back-up operations center on the west coast. This technologically advanced Web site management facility will incorporate new software arising from Digex's joint development efforts with Microsoft Corporation. Additionally, this facility will incorporate the next generation routers. These advancements will ultimately result in faster and easier installation of customers and efficient traffic management with significantly less overhead.
Multicasting Services. Multicasting services enable a user to send a transmission to multiple recipients at the same time. The technology involved avoids the redundancy of sending separate packets to each recipient, which results in the use of less bandwidth. The developed technology was unable to handle multicasting.
On November 20, 1997, the Company, through Moonlight Acquisition Corp., a wholly-owned subsidiary of the Company, entered into a definitive merger agreement with Shared Technologies Fairchild, Inc. ("Shared"). The total purchase price for Shared was approximately $782,151 including $62,300 of certain transaction expenses and fees relating to certain agreements. The Company initially purchased 1,100,000 shares, or 6% of Shared for $16,300 on November 20, 1997. The initial investment was recorded using the cost method.
On December 30, 1997, an additional 4,000,000 shares were purchased for $60,000, increasing the Company's ownership percentage to 28%. Accordingly, accounting for the investment was changed to the equity method. At December 31, 1997, the Company's investment in Shared also included $62,800 for convertible preferred stock of Shared; $175,000 for Senior Subordinated Discount Notes of Shared; a warrant valued at $1,455 redeemable for 100,000 shares of common stock of Shared issued as compensation for consulting services related to the acquisition and advances of $88,000 used by Shared to retire previously outstanding Special Preferred Stock and pay certain fees related to termination of a previous merger agreement.
On March 10, 1998, the Company completed its acquisition of Shared, a shared tenant communications services provider. The operating results of Shared are included in the Company's consolidated financial statements commencing on January 1, 1998. Imputed interest of $5,130 was recorded based on the cash consideration paid after the effective date of the acquisition in the first quarter of 1998, and the cost for Shared was reduced accordingly. Aggregate consideration for the acquisition was approximately $589,800 in cash, plus the retirement of $175,600 in Shared's long-term debt, and acquisition related expenses of $17,200. The acquisition was accounted for by the purchase method of accounting, with the purchase price allocated to the fair value of assets acquired and liabilities assumed, principally goodwill.
The purchase price allocation was as follows:
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The allocation of purchase price to goodwill and identifiable intangibles and estimated lives are:
The amount allocated to in-process R&D ($63,000) was recorded as a one-time charge to operations in the accompanying consolidated statements of operations because the technology was not fully developed and had no future alternative use. The developed technology was comprised of an intelligent infrastructure which integrated a host of telecommunications systems, including infrastructure (network hardware and software), service provider networks, and inter-building communications networks. The acquired in-process R&D represents the development of technologies associated with creating infrastructure and the associated systems so that the Company can offer a wide range of data telecommunications services. These proprietary projects included the development of a multi-service access platform ("MSAP"). The MSAP enables the client provisioning of multiple data services as well as the realization of Shared's existing voice services. A brief description of the three categories of in-process R&D projects is presented below:
Access Technology Development. These R&D projects were related to the development of access technology, including copper connectivity and deployment, DSL technology development and development of T-1 interfaces. These projects were valued at approximately $47,000. The estimated costs to complete the project were approximately $1,800.
R&D Related to Networking and Networking Management. These R&D projects are related to the development of systems related to networking management, and were valued at approximately $15,000. The estimated costs to complete the project were approximately $600.
Advanced Networking. These R&D projects are related to the development of advanced networking functions, and were valued at approximately $1,000. The estimated costs to complete the project were approximately $200.
The distinction between developed technology and acquired in-process R&D is basically the difference between legacy voice technologies and the emerging data technologies that are required by Intermedia's high-end corporate users; these are very different technologies from a telecommunications perspective. The completion of the in-process R&D will enable Shared to provide new data services (asynchronous transfer mode, frame relay, Internet, and others) through Shared's existing architecture. Prior to the acquisition, Shared's services portfolio did not include data products. Historically, Shared could provide its customer base with local access and long distance voice services and customer premise equipment products. However, Shared lost data revenue opportunities to its competitors.
The amortization period for the customer lists was determined based on historical customer data, including customer retention and average sales per customer. The basis for the life assigned to assembled workforce was annual turnover rates.
On March 31, 1998, the Company acquired the Long Distance Savers group of companies (collectively, LDS, a regional interexchange carrier). The operating results of LDS are included in the Company's consolidated financial statements commencing on April 1, 1998. Aggregate consideration for the acquisition was approximately $15,700 in cash, plus 5,320,048 shares of the Company's Common Stock valued at approximately $137,176, the retirement of $15,100 of LDS's long-term debt, and acquisition related expenses
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of $3,300. The acquisition was accounted for by the purchase method of accounting, with the purchase price to be allocated to the fair value of assets acquired and liabilities assumed, principally goodwill ($144,300). This goodwill is being amortized over its estimated useful life of 20 years.
On April 30, 1998, the Company completed the acquisition of privately held National Telecommunications of Florida, Inc. and NTC, Inc. (collectively, National), an emerging switch-based competitive local exchange carrier and established interexchange carrier. The operating results of National are included in the Company's consolidated financial statements commencing on April 1, 1998. Aggregate consideration for the acquisition was approximately $59,500 in cash, plus 2,909,796 shares of the Company's Common Stock, valued at approximately $88,749, the retirement of $2,800 in National's long-term debt, and $2,600 in acquisition related costs. The acquisition was accounted for by the purchase method of accounting, with the purchase price allocated to the fair value of assets acquired and liabilities assumed, principally goodwill ($147,100). This goodwill is being amortized over its estimated useful life of 20 years.
The 20 year amortization period assigned to the goodwill arising from the Company's acquisitions of Shared, LDS and National is based on the Company's analysis of their businesses. The Company considered the general stability of these companies (i.e. the length of time that these three entities have already successfully conducted business operations) particularly during periods of increasing competition and technological developments.
The following unaudited pro forma results of operations present the consolidated results of operations as if the acquisitions of LDS, National, and Shared had occurred at the beginning of the respective periods. These pro forma results do not purport to be indicative of the results that actually would have occurred if the acquisition had been made as of these dates or of results which may occur in the future.
3. BUSINESS RESTRUCTURING AND INTEGRATION PROGRAM
During the second quarter of 1998, management committed to and commenced implementation of the restructuring program (the Program) which was designed to streamline and refocus the Company's operations and facilitate the transformation of the Company's five separate operating companies into one an integrated communications provider. The significant activities included in the Program include (i) consolidation, rationalization and integration of network facilities, collocations, network management and network facility procurement; (ii) consolidation and integration of the sales forces of the Company and its recent acquisitions, including the integration of the Company's products and services and the elimination of redundant headcount and related costs; (iii) centralization of accounting and financial functions, including the elimination of redundant headcount and related costs; (iv) development and integration of information systems including the integration of multiple billing systems and the introduction and deployment of automated sales force and workflow management tools; (v) consolidation of office space and the elimination of unnecessary legal entities; and (vi) exiting non-strategic businesses including the elimination of headcount and related costs. The Company expects the Program to continue until June 2000.
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The following table sets forth the significant components and activity in the restructuring program reserve since the inception of the Program:
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(i) This activity consists primarily of the consolidation, rationalization and integration of network facilities, collocations, network management and network facility procurement. Contract terminations represent the estimated costs of terminating two contracts with MCI Communications Corporation. (ii) This activity consists primarily of the consolidation and integration of the sales forces of the Company and its recent acquisitions, including the integration of the Company's products and services and the elimination of redundant headcount and related costs. (iii)This activity consists of the centralization of accounting and financial functions, including the reduction of redundant headcount and related costs. (iv) This activity consists of the development and integration of information systems, including the integration of multiple billing systems and the introduction and deployment of automated sales force and workflow management tools. The only costs included in this category in the table above relate to the termination of certain employees as described in (vii) below. (v) This activity relates to the consolidation of office space. Contract termination costs represent the estimated costs of lease terminations for property exited as part of the Program. (vi) This activity consists of the exiting of non-strategic businesses including the elimination of redundant headcount and related costs. Contract termination costs include the estimated cost to cancel a switched services contract with WorldCom, Inc. (WorldCom) ($10,100) and lease termination payments. On September 30, 1998, the Company amended its agreement with WorldCom to provide the Company with an option for an earlier termination date and lower monthly minimum usage amounts. On October 27, 1998, the Company exercised its option, and, in connection therewith, paid $3,300 to WorldCom. As a result, restructuring charges were reduced by $10,100 during the third quarter of 1998. The option payment of $3,300 was recorded in October 1998 as a deferred charge and is being amortized into operations over the remaining period of the contract. Asset impairments relate to $9,200 of accounts receivable balances from four customers that were reserved as a result of the Company's exit of the wholesale long-distance business. In addition, this category also includes $2,800 related to equipment write-downs. The impaired assets consist of terminal servers with an estimated fair value of $400 as of June 30, 1998. The fair value estimate was based on the Company's review of the historical operations and cash flows of the related Internet business that such assets support. The impairment loss of $2,800 was recognized in connection with the Company's decision to outsource these services and to dispose of
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these assets. The remaining life of the assets of six months correlates to the time required to migrate the business to the third party provider. The revenue generated from operations that the Company has exited amounted to $17.0 for the period during the year ended December 31, 1998 that such business was operated. No revenue was generated in 1999 from operations exited by the Company. (vii) The total number of employees affected by the restructuring program was 280. The terminated employees were notified that their termination was involuntary and of their associated benefit arrangements, prior to June 30, 1998. (viii) The remaining accrual at December 31, 1999 resulted from the timing of certain payments that are part of the conclusion of the Program. These amounts will be paid in 2000.
As provided for in the Program, the Company also expensed other business restructuring and integration costs that were incurred during 1998 and 1999. These costs represent incremental, redundant, or convergence costs that resulted directly from implementation of the Program, but that are required to be expensed as incurred.
The following table summarizes total Program costs and sets forth the components of all business restructuring and integration costs that were expensed as incurred during 1998 and 1999:
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(A) Consists primarily of redundant network expense, with some employee salary costs of severed employees through their severance date. (B) Consists of branding, training and relocation expenses. (C) Consists of consultant costs and some employee salary costs. (D) Consists of losses on divested businesses, employee salary costs, legal, accounting and consulting costs and facilities integration.
4. TELECOMMUNICATIONS EQUIPMENT
Telecommunications equipment consisted of:
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Depreciation expense totaled $43,960, $155,711 and $252,932 in 1997, 1998, and 1999, respectively.
Telecommunications equipment and construction in progress included $562,207 and $530,482 of equipment recorded under capitalized lease arrangements at December 31, 1998 and 1999, respectively. Accumulated depreciation of assets recorded under capital leases amounts to $56,053 and $108,408 at December 31, 1998 and 1999, respectively. Amortization of these assets is included in depreciation expense for the years ended December 31, 1998 and 1999.
During 1998, the Company entered into two agreements to purchase capacity from other telecommunications companies. The agreements allow the Company to utilize the purchased capacity for a 20 year period. Total payments related to these agreements were $7,600 and $1,133 during 1998 and 1999, respectively.
5. INTANGIBLE ASSETS
Intangible assets consisted of:
Amortization of intangible assets amounted to $9,653 in 1997, $74,036 in 1998 and $76,371 in 1999.
6. LONG-TERM DEBT
Long-term debt consisted of:
During June 1995, Intermedia issued $160,000 principal amount of 13.5% Senior Notes due 2005 (13.5% Senior Notes) and warrants to purchase 700,800 shares of the Company's Common Stock at $5.43 per share. The Company allocated $1,051 of the proceeds to the warrants, representing the estimated fair value at the
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date of issuance. During 1997, the Company used a portion of the proceeds of the 11.25% Senior Discount Notes, described below, to retire the 13.5% Senior Notes. This retirement resulted in an extraordinary loss, as shown in the accompanying 1997 consolidated statement of operations, of approximately $43,834.
During May 1996, the Company issued $330,000 principal amount of 12.5% Senior Discount Notes, due May 15, 2006 (the 12.5% Senior Discount Notes). The original issue discounted price for each $1,000 face value 12.5% Senior Discount Note was $545. Net proceeds to the Company amounted to approximately $171,000. The original issue discount is being amortized over the term of the 12.5% Senior Discount Notes using the effective interest method. Commencing on November 15, 2001, cash interest on the 12.5% Senior Discount Notes will be payable semiannually in arrears on May 15 and November 15 at a rate of 12.5% per annum. The 12.5% Senior Discount Notes are redeemable at the option of the Company after May 15, 2001, at a premium declining to par in 2004 and are on a parity with all other senior indebtedness.
On July 9, 1997, the Company sold $606,000 principal amount at maturity of 11.25% Senior Discount Notes due 2007 (11.25% Senior Discount Notes) in a private placement transaction. Subsequent thereto, the over-allotment option with respect to the 11.25% Senior Discount Notes was exercised and the Company sold an additional $43,000 principal amount at maturity of 11.25% Senior Discount Notes. The issue price of the 11.25% Senior Discount Notes was $577.48 per $1,000 principal amount at maturity of the 11.25% Senior Discount Notes. Net proceeds to the Company amounted to approximately $363,000. The original issue discount is being amortized over the term of the 11.25% Senior Discount Notes using the effective interest method. Cash interest will not accrue on the 11.25% Senior Discount Notes prior to July 15, 2002. Commencing January 15, 2003, cash interest on the 11.25% Senior Discount Notes will be payable semi-annually in arrears on July 15 and January 15 at a rate of 11.25% per annum. The 11.25% Senior Discount Notes will be redeemable, at the Company's option at any time on or after July 15, 2002 and are on a parity with all other senior indebtedness.
On October 30, 1997, the Company sold $250,000 principal amount of 8.875% Senior Notes due 2007 (8.875% Senior Notes) in a private placement transaction. Subsequent thereto, the over-allotment option with respect to the 8.875% Notes was exercised and the Company sold an additional $10,250 principal amount at maturity of 8.875% Notes. Net proceeds to the Company amounted to approximately $253,000. Cash interest on the 8.875% Senior Notes is payable semi-annually in arrears on May 1 and November 1 at a rate of 8.875% per annum. The 8.875% Senior Notes will be redeemable, at the Company's option at any time on or after November 1, 2002 and are on a parity with all other senior indebtedness.
On December 23, 1997, the Company sold $350,000 principal amount of 8.5% Senior Notes due 2008 (8.5% Senior Notes) in a private placement transaction. Subsequent to December 31, 1997, the over-allotment option with respect to the 8.5% Senior Notes was exercised and the Company sold an additional $50,000 principal amount at maturity of 8.5% Senior Notes. Net proceeds to the Company amounted to approximately $390,000. Cash interest on the 8.5% Senior Notes is payable semi-annually in arrears on January 15 and July 15. The 8.5% Senior Notes, which mature on January 15, 2008, will be redeemable at the option of the Company at any time on or after January 15, 2003 and are on a parity with all other senior indebtedness.
On May 27, 1998, the Company sold $450,000 principal amount of 8.6% Senior Notes due 2008 (8.6% Senior Notes) in a private placement transaction. Subsequent thereto, the over-allotment option with respect to the 8.6% Senior Notes was exercised and the Company sold an additional $50,000 principal amount at maturity of 8.6% Senior Notes. Net proceeds to the Company amounted to approximately $488,900. Cash interest on the 8.6% Senior Notes is payable semi-annually in arrears on June 1 and December 1. The 8.6% Senior Notes, which mature on June 1, 2008, are redeemable at the option of the Company at various rates as set forth in the indenture governing the 8.6% Senior Notes and at any time on or after June 1, 2003 and are on a parity with all other senior indebtedness.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On February 24, 1999, the Company sold $300,000 principal amount of 9.5% Senior Notes due 2009 (the "9.5% Senior Notes") and $364,000 principal amount at maturity of 12.25% Senior Subordinated Discount Notes due 2009 (the "12.25% Senior Subordinated Discount Notes") in a private placement transaction. Net proceeds to the Company amounted to approximately $488,200 from both issuances.
Cash interest on the 9.5% Senior Notes is payable semi-annually in arrears on March 1 and September 1 of each year, commencing September 1, 1999. The proceeds of the offering of the 9.5% Senior Notes cannot be used for working capital purposes and can only be used to fund up to 80% of the cost of acquiring or constructing telecommunications related assets. The 9.5% Senior Notes are redeemable at the option of the Company at any time at various prices as set forth in the indenture governing the 9.5% Senior Notes. The 9.5% Senior Notes rank on par with all of the other outstanding senior indebtedness of the Company.
The 12.25% Senior Subordinated Discount Notes will accrete in value through March 1, 2004 at a fixed annual rate of 12.25%, compounded every six months. After March 1, 2004, the 12.25% Senior Subordinated Discount Notes will accrue interest at an annual rate of 12.25%, payable in cash every six months on March 1 and September 1, commencing September 1, 2004. The proceeds from the offering of the 12.25% Senior Subordinated Discount Notes will be used for general corporate purposes, including the funding of working capital and operating losses, and the funding of a portion of the costs of acquiring or constructing telecommunications related assets. The 12.25% Senior Subordinated Discount Notes will be redeemable at the option of the Company at any time at various prices as set forth in the indenture governing the 12.25% Senior Subordinated Discount Notes.
At December 22, 1999, the Company entered into five-year secured $100,000 Revolving Credit Agreement (the "Credit Agreement") outstanding with three financial institutions. The Revolving Credit Facility ("Credit Facility") may be repaid and reborrowed from time to time in accordance with the terms and provisions of the agreement, and is guaranteed by each of the Company's subsidiaries. The Credit Facility is secured by a pledge of the stock of each of the Company's subsidiaries, and is secured by substantially all of the assets of the Company and its subsidiaries. The interest rate on the revolving credit facility is based on either a LIBOR or an alternative base rate option, and is paid quarterly in arrears. The Credit Agreement contains covenants customary for facilities of this nature, including limitations on incurrence of additional debt, asset sales, acquisitions, investments, among others. At December 31, 1999, the Company had $50,000 outstanding under the credit facility which was repaid in Feburary 2000. The Credit Agreement extends to 2004.
Long-term debt maturities as of December 31, 1999 for the next five years are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts and fair values of the Company's financial instruments at December 31 are as follows:
The following methods and assumptions are used in estimating fair values for financial instruments:
Cash and cash equivalents: The fair value of cash equivalents is based on negotiated trades for the securities.
Investments: These investments are classified as held-to-maturity, in accordance with SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. At December 31, 1999, the fair value of these investments approximates their carrying amounts.
Accounts receivable and accounts payable: The carrying amounts reported in the consolidated balance sheets for accounts receivable and accounts payable approximate their fair value.
Long-term and short-term debt: The estimated fair value of the Company's borrowing is based on negotiated trades for the securities as provided by the Company's investment banker or by using discounted cash flows at the Company's incremental borrowing rate.
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8. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted loss per common share:
Unexercised options to purchase 7,066,262, 7,553,690 and 8,885,973 shares of Common Stock for 1997, 1998 and 1999, respectively, and unexercised convertible preferred stock outstanding convertible into 7,741,872, 17,076,495 and 17,012,228 shares of Common Stock for 1997, 1998 and 1999, respectively, were not included in the computations of diluted loss per share because assumed conversion would be antidilutive.
9. REDEEMABLE PREFERRED STOCK
On March 7, 1997, the Company sold 30,000 shares (aggregate liquidation preference $300,000) of its Series A Redeemable Exchangeable Preferred Stock due 2009 (Series A Preferred Stock) in a private placement transaction. Net proceeds to the Company amounted to approximately $288,000. On June 6, 1997, the Company issued 300,000 shares (aggregate liquidation preference $300,000) of its 13.5% Series B Redeemable Exchangeable Preferred Stock due 2009 (Series B Preferred Stock) in exchange for all outstanding shares of the Series A Preferred Stock pursuant to a registered exchange offer. Dividends on the Series B Preferred Stock accumulate at a rate of 13.5% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. Dividends are payable in cash or, at the Company's option, by the issuance of additional shares of Series B Preferred Stock having an aggregate liquidation preference equal to the amount of such dividends. The Series B Preferred Stock is subject to mandatory redemption at its liquidation preference of $1,000 per share, plus accumulated and unpaid dividends on March 31, 2009. The Series B Preferred Stock will be redeemable at the option of the Company at any time after March 31, 2002 at rates commencing with 106.75%, declining to 100% on March 31, 2007.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company is accreting the Series B Preferred Stock to its liquidation preference through the due date of the Series B Preferred Stock. The accretion for the year ended December 31, 1999 was approximately $911.
During 1997, 1998 and 1999 the Company issued 34,417, 47,484 and 54,226 additional shares, respectively, of Series B Preferred Stock, in lieu of cash, with an aggregate liquidation preference of $34,417, $47,484 and $54,226 as payment of the required quarterly dividends.
On July 9, 1997, the Company sold 6,000,000 Depositary Shares (Series D Depositary Shares) (aggregate liquidation preference $150,000) each representing a one-hundredth interest in a share of the Company's 7% Series D Junior Convertible Preferred Stock (Series D Preferred Stock), in a private placement transaction. Subsequent thereto, the over-allotment option with respect to the Series D Depositary Shares was exercised and the Company sold an additional 900,000 Series D Depositary Shares (aggregate liquidation preference of $22,500). Net proceeds to the Company amounted to approximately $167,000. Dividends on the Series D Preferred Stock will accumulate at a rate of 7% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. Dividends are payable in cash or, at the Company's option, by the issuance of shares of Common Stock of the Company. The Series D Preferred Stock will be redeemable at the option of the Company at any time on or after July 19, 2000 at rates commencing with 104%, declining to 100% on July 19, 2004.
The Series D Preferred Stock is convertible, at the option of the holder, into Common Stock of the Company at a conversion price of $19.45 per share of Common Stock, subject to certain adjustments. Further, in the event of a change in control, the holder may compel the Company to redeem the Series D Preferred Stock at a price equal to 100% of liquidation preference or $2,500 per share.
The Company is accreting the Series D Preferred Stock to its liquidation preference through the due date of the Series D Preferred Stock. The accretion for the year ended December 31, 1999 was approximately $597.
On October 30, 1997, the Company sold 7,000,000 Depositary Shares (Series E Depositary Shares) (aggregate liquidation preference $175,000) each representing a one-hundredth interest in a share of the Company's 7% Series E Junior Convertible Preferred Stock (Series E Preferred Stock), in a private placement transaction. Subsequent thereto, the over-allotment option with respect to the Series E Depositary Shares was exercised and the Company sold an additional 1,000,000 Series E Depositary Shares (aggregate liquidation preference $25,000). Net proceeds to the Company amounted to approximately $194,000. Dividends on the Series E Preferred Stock will accumulate at a rate of 7% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. Dividends are payable in cash or, at the Company's option, by the issuance of shares of Common Stock of the Company. The Series E Preferred Stock will be redeemable at the option of the Company at any time on or after October 18, 2000 at rates commencing with 104%, declining to 100% on October 18, 2004.
The Series E Preferred Stock is convertible, at the option of the holder, into Common Stock of the Company at a conversion price of $30.235 per share of Common Stock, subject to certain adjustments. Further, in the event of a change in control, the holder may compel the Company to redeem the Series E Preferred Stock at a price equal to 100% of liquidation preference or $2,500 per share.
The Company is accreting the Series E Preferred Stock to its liquidation preference through the due date of the Series E Preferred Stock. The accretion for the year ended December 31, 1999 was approximately $642.
On August 18, 1998, the Company sold 8,000,000 Depositary Shares (the Series F Depositary Shares) (aggregate liquidation preference $200,000) each representing a one-hundredth interest in a share of the Company's 7% Series F Junior Convertible Preferred Stock (the Series F Preferred Stock), in a private placement transaction. Net proceeds to the Company amounted to approximately $193,500. Dividends on the Series F Preferred Stock accumulate at a rate of 7% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. Dividends are payable in cash or, at the Company's option, by issuance of shares
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of Common Stock of the Company. The Series F Preferred Stock is redeemable, at the option of the Company, in whole or part, at any time on or after October 17, 2001, at rates commencing with 104%, declining to 100% on October 17, 2005.
The Series F Preferred Stock is convertible, at the option of the holder, into Common Stock of the Company at a conversion price of $42.075 per share of Common Stock, subject to certain adjustments. Further, in the event of a change in control, the holder may compel the Company to redeem the Series F Preferred Stock at a price equal to 100% of liquidation preference or $2,500 per share.
The Company is accreting the Series F Preferred Stock to its liquidation preference through the due date of the Series F Preferred Stock. The accretion for the year ended December 31, 1999 was approximately $827.
During July and August 1998, the Company exchanged (a) approximately 2,029,000 shares of its Common Stock for approximately 1,487,000 Series D Depositary Shares and (b) approximately 1,423,000 shares of its Common Stock for approximately 1,511,000 Series E Depositary Shares, pursuant to exchange agreements with certain holders. In connection with the conversion of shares, the Company recorded additional preferred stock dividends of approximately $10,980 during the third quarter of 1998 representing the market value of the inducement feature of the conversions. During July, September and December 1999, the Company exchanged approximately 51,500 shares of its Common Stock for approximately 40,000 Series D Depositary Shares. During July and September 1999, the Company exchanged approximately 23,800 shares of its Common Stock for approximately 40,000 Series F Depositary Shares.
10. STOCKHOLDERS' EQUITY
Stock Options: The Company has a 1992 Stock Option Plan and a 1996 Long-Term Incentive Plan (the Plans) under which options to acquire or award covering an aggregate of 2,692,000 shares and 10,000,000 shares, respectively, of Common Stock may be granted to employees, officers, directors and consultants of the Company. The Plans authorize the Board of Directors (the Board) to issue incentive stock options (ISOs), as defined in Section 422A(b) of the Internal Revenue Code, and stock options that do not conform to the requirements of that Code section (Non-ISOs). The Board has discretionary authority to determine the types of stock options to be granted, the persons among those eligible to whom options will be granted, the number of shares to be subject to such options, and the terms of the stock option agreements. Options may be exercised in the manner and at such times as fixed by the Board, but may not be exercised after the tenth anniversary of the grant of such options.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table summarizes the transactions for the three years ended December 31, 1999 relating to the Plans:
The Board of Directors has reserved 608,776 shares of Common Stock for issuance in connection with stock warrants, and 8,284,563 shares of Common Stock for issuance to employees, officers, directors, and consultants of the Company pursuant to stock options and stock award plans as may be determined by the Board of Directors.
Pro forma information regarding net income and earnings per share is required by SFAS 123, which also requires that the information be determined as if the Company had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method set forth in SFAS 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows:
The following table summarizes the weighted average exercise prices of option activity for the years ended December 31, 1997, 1998 and 1999.
As of December 31, 1999, the weighted average exercise price of exercisable options was $11.71. Outstanding options as of December 31, 1999 had a weighted average remaining contractual life of 8.1 years. The per share weighted average fair value of options granted during the years ended December 31, 1997, 1998 and 1999 were $14.25, $14.84 and $12.01, respectively.
Stock Award Plans: The Company has entered into restricted share agreements with certain executive officers that provide stock award incentives. Pursuant to the agreements, up to an aggregate of 900,000 restricted shares of Common Stock have been contingently awarded to the respective officers which awards become effective upon the attainment of certain stock price milestones ranging from $10 to $20. The unvested shares also partially vest upon the achievement of specific financial results and upon the purchase of five percent or more of the Company's stock by a strategic investor. Shares awarded under these arrangements vest over a period from two to twenty years following the award. During 1997, 1998, and 1999, 330,000, 5,000 and 10,000 shares were awarded with a fair value of $4,950, $98 and $150, respectively. These amounts are being amortized over the vesting periods.
Stock Warrants: At December 31, 1999, warrants to purchase the following shares of the Company's Common Stock were outstanding:
As further discussed in Note 6, the Company issued warrants to purchase 700,800 shares of Common Stock in connection with the issuance of the 13.5% Senior Notes. These warrants will expire on June 1, 2000. The Company also has a warrant outstanding that has been issued for consulting services that will allow the holder to purchase 200,000 shares of the Company's Common Stock.
Shareholder Rights Plan: On March 7, 1996, the Board of Directors adopted a Shareholder Rights Plan and declared a dividend of one common stock Purchase Right (a Right) for each outstanding share of Common Stock to shareholders of record on March 18, 1996. Such Rights only become exercisable, or transferable apart from the Common Stock, ten business days after a person or group (an Acquiring Person) acquires beneficial ownership of, or commences a tender or exchange offer for, 15% or more of the Company's Common Stock.
Each Right then may be exercised to acquire 1/1000th of a share of the Company's Series C preferred stock at an exercise price of $200. Thereafter, upon the occurrence of certain events, the Rights entitle holders
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
other than the Acquiring Person to acquire the existing Company's preferred stock or Common Stock of the surviving company having a value of twice the exercise price of the Rights.
The Rights may be redeemed by the Company at a redemption price of $.01 per Right at any time until the 10th business day following public announcement that a 15% position has been acquired or ten business days after commencement of a tender or exchange offer.
11. INCOME TAXES
At December 31, 1998 and 1999, the Company had temporary differences between amounts of assets and liabilities for financial reporting purposes and such amounts measured by tax laws. The Company also has net operating loss (NOL) carryforwards available to offset future taxable income. Significant components of the Company's deferred tax assets and liabilities as of December 31 are as follows:
At December 31, 1999, the Company's net operating loss carryforward for federal income tax purposes is approximately $1,100,000, expiring in various amounts from 2003 to 2019. Limitations apply to the use of the net operating loss carryforwards.
RATE RECONCILIATION
12. EMPLOYEE BENEFIT PLAN
The Company has established a 401(k) profit-sharing plan. Employees 21 years or older with at least three months of service are eligible to participate in the plan. Participants may elect to contribute, on a tax-deferred basis, up to 15% of their compensation, not to exceed $10 in 1998. The Company will match one-half
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of a participant's contribution, up to a maximum of 7% of the participant's compensation. The Company's matching contribution fully vests after three years of service. The Company's contributions to the plan were approximately $735, $3,823 and $4,337 in 1997, 1998 and 1999, respectively.
13. COMMITMENTS
The Company is a party to various other capital lease agreements for fiber optic cable, underground conduit equipment and utility poles which extend through the year 2018.
In March 1998, the Company and Williams Communications, Inc. (Williams) executed a Capacity Purchase Agreement which provides the Company with right to purchase transmission capacity on a non-cancelable indefeasible right of use basis on the Williams fiber network. The agreement, as amended in 1999, covers approximately 14,000 route miles of network facilities. The capitalized asset, consisting of the Company's rights to use network facilities, including, but not limited to, fiber, optronics/electronics, digital encoders, telephone lines and microwave facilities, in the amount of $426,300, is being depreciated over the 20-year estimated useful life of the primary underlying network asset, the fiber.
Future minimum lease payments for assets under capital leases (including the Williams agreement) at December 31, 1999 are as follows:
Certain executory costs, principally maintenance, associated with capital leases are being expensed as incurred.
The Company also leases fiber optic cable, terminal facility space, and office space under operating lease arrangements. The leases generally contain renewal options which range from one year to fifteen years, with certain rights-of-way and cable conduit space being renewable indefinitely after the minimum lease term subject to cancellation notice by either party to the lease. Lease payments in some cases may be adjusted for related revenues, increases in property taxes, operating costs of the lessor, and increases in the Consumer Price Index. Operating lease expense was $9,857, $36,273 and $34,305 for 1997, 1998 and 1999, respectively.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Future minimum lease payments under non-cancelable operating leases with original terms of more than one year as of December 31, 1999 are as follows:
14. CONTINGENCIES
The Company is not a party to any pending legal proceedings except for various claims and lawsuits arising in the normal course of business. The Company does not believe that these normal course of business claims or lawsuits will have a material effect on the Company's financial condition, results of operations or cash flows.
The Company maintains interconnection agreements with incumbent local exchange carriers ("ILECs") in Florida, Georgia, North Carolina, Tennessee, and in numerous other states across the country. These contracts govern the reciprocal amounts to be billed by competitive carriers for terminating local traffic to Internet service providers ("ISPs") in each state. During 1997 and 1998, the Company recognized aggregate revenue from these ILECs of approximately $47.0 million for these services. During the year ended December 31, 1999, the Company recognized approximately $97.8 million in revenue for these services. As of December 31, 1999, $109.9 million has not been collected.
The Company accounts for reciprocal compensation with the ILECs, including the activity associated with the disputed ISP traffic, as local network services, fully subject to reciprocal compensation, pursuant to the terms of the Company's interconnection agreements. Accordingly, revenue is recognized in the period that the traffic is terminated. A number of ILECs have refused to pay these reciprocal compensation amounts in whole or in part, however, citing a variety of legal theories. The circumstances surrounding the disputes, including the status of cases that have arisen by reason of similar disputes referred to below, are considered by management periodically in determining whether reserves against unpaid balances are warranted. As of December 31, 1999, such provisions have not been considered necessary by management.
Management believes the issue related to reciprocal compensation for Internet traffic to be an industry wide matter that will ultimately be resolved on a state-by-state basis. As of December 31, 1999, 30 state commissions had issued final orders finding that ILECs must pay reciprocal compensation to competitive carriers for local calls to ISPs located on competitive carriers' networks, and no state commission had ruled to the contrary. A February 25, 1999 decision by the FCC generated some uncertainties about mutual compensation. The FCC's order declared that ISP-bound traffic is predominantly "interstate" traffic that is subject to federal jurisdiction.
Most current interconnection agreements -- including Intermedia's agreements with BellSouth -- provide that compensation is owed for the termination of "local" traffic, and the FCC's order established that, for purposes of determining jurisdiction, dial-up calls to ISPs are not local. As a result, many ILECs asked state commissions to overturn their earlier decisions that called for payment of compensation for this traffic. However, while the FCC's order did find that most ISP-bound traffic is jurisdictionally interstate, the FCC went on to clarify that this jurisdictional determination does not preclude parties from including ISP-bound
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
traffic within the scope of the reciprocal compensation provisions included in their interconnection agreements.
Subsequent to the FCC's February 25th order, at least 19 states have reaffirmed prior determinations or affirmed for the first time that ILECs are required to compensate competitive local exchange carriers ("CLECs") for terminating ISP-bound traffic under existing agreements. Florida, Georgia, North Carolina, and Tennessee are among the states that have confirmed that reciprocal compensation must be paid. To date, nine courts have also upheld state decisions requiring compensation under the interconnection agreements for traffic terminated to ISPs.
This trend in state decisions is no longer unanimous, however. Two state commissions, the Massachusetts Department of Telecommunications and Energy and the Missouri Public Service Commission, have issued orders that raise questions as to whether a CLEC may receive reciprocal compensation for ISP-bound traffic under specific interconnection agreements, but these decisions do not positively determine whether or not a CLEC has the right to collect such compensation. The New Jersey Board of Public Utilities and the Louisiana Public Service Commission have issued orders which found that reciprocal compensation is not due in certain situations. To date, these are the only two state commissions in the country to expressly rule against reciprocal compensation for Internet-bound traffic under existing interconnection agreements, although the New Jersey holding may not apply to all existing agreements. The South Carolina Public Service Commission has ruled that reciprocal compensation for ISP-bound traffic is not required for agreements subsequent to the FCC's order.
Despite the decisions by the New Jersey, Louisiana, and South Carolina commissions, management believes that the overall pattern of decisions, including decisions that have been reached subsequent to the FCC's February 25th order, are strong evidence of a trend suggesting that other state commissions will take the same position as those that require the payment of reciprocal compensation, though the Company cannot predict with certainty what the outcome of future decisions will be. Management is pursuing this matter vigorously and believes that the ILECs will ultimately pay all amounts due in full. Information contained herein reflects decisions relevant to the Company's existing agreements and does not include decisions that may affect the Company prospectively or that may relate to future agreements entered into by the Company with ILECs.
15. SEGMENT INFORMATION
During 1998, the Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS 131 uses a management approach to report financial and descriptive information about a Company's operating segments. The Company has determined, based on different products and customer bases, that it has two reportable segments.
The Company's core business is its integrated communications services segment which provides three principal groups of service offerings to business and government customers, as reported in the Company's statements of operations. The Company also owns an 81.3% interest in Digex, (which was reduced to 62% in February 2000) a separate public company, which provides managed Web site and application hosting services to large businesses and Internet companies operating mission-critical, multi-functional Web sites and Web-based applications. Each of these segments has separate management teams and operational infrastructures. Substantially all of the Company's revenue is attributable to customers in the United States. Additionally, all of the Company's assets are located within the United States. During the periods presented below, no single customer accounted for 10% or more of the Company's total revenue.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The table below summarizes the Company's segment reporting data (in millions). Eliminations include intersegment revenues, receivables and investment related accounts.
16. INITIAL PUBLIC OFFERING OF SUBSIDIARY AND MINORITY INTEREST
In August 1999, the Company's managed Web site and application hosting subsidiary, Digex, sold 11.5 million shares of its Class A Common Stock in an initial public offering (the "Digex Offering"). The shares sold represented approximately 18.7% of the aggregate number of shares of Digex Common Stock outstanding. After the Digex offering, the Company retained a 97.8% voting interest in Digex. The net proceeds from the Digex Offering were approximately $178,903 and may be used only to purchase telecommunications related assets due to restrictions in the Company's debt instruments. The Company includes the accounts of the majority-owned subsidiary in its consolidated financial statements and presents the 18.7% ownership by the minority shareholders as minority interest in the accompanying balance sheet.
17. RELATED PARTY
A director of the Company has an indirect financial interest in an organization engaged by the Company during 1998 to support the implementation of an enterprise-wide information system. The organization engaged to perform the implementation was selected by a task force of Company employees from among several proposing organizations. During 1998, no amounts were paid or payable under a $450 services contract. The Company paid approximately $7,100 to this organization during 1999.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
18. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1998 and 1999.
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(a) Results of first quarter reflect the acquisition of Shared effective January 1, 1998 and a resulting $63,000 in-process R&D charge. (b) Results of second quarter reflect the acquisitions of LDS and National effective March 31, 1998 and April 1, 1998, respectively.
19. SUBSEQUENT EVENTS
On January 12, 2000, Digex sold 100,000 shares of its preferred stock, designated as Series A Convertible Preferred Stock (the "Digex Series A Preferred Stock"), with detachable warrants to purchase 1,065,000 shares of its Class A Common Stock (the "Warrants"), for an aggregate of $100,000, of which $15,000 was in the form of equipment purchase credits. The Digex Series A Preferred Stock has an aggregate liquidation preference of $100,000, and is convertible into approximately 1,462,000 shares of Class A Common Stock of Digex. The Digex Warrants can be exercised at any time over their three-year term at a price of $57 per share (the fair value of the Digex's common stock on the transaction commitment date). The proceeds from the offering will be allocated between the Digex Series A Preferred Stock and the Warrants based upon their relative fair values, which have not yet been determined by the Digex. Following the allocation, the Digex Series A Preferred Stock will be accreted up to its liquidation preference through charges to accumulated deficit.
On February 16, 2000, Digex completed its second public offering of 12,650,000 shares of its Class A Common Stock. Digex offered 2,000,000 shares of its Class A Common Stock and received net proceeds of approximately $171,718. Also, as part of that offering, the Company sold 10,650,000 shares of Digex's Class B Common Stock. The Class B Common Stock sold by the Company automatically converted into Class A Common Stock at the closing of the offering. Intermedia now owns approximately 62.0% of the outstanding Common Stock of Digex. In addition, the Company retains approximately 94.2% voting interest in Digex. The net proceeds were approximately $913,800 and will be used to reduce the Company's outstanding debt and to purchase telecommunications related assets. Due to the sale of Digex stock in February 2000, the Company will recognize a gain on sale of stock and could utilize net operating losses.
On February 17, 2000, the Company completed its $200,000 agreement to receive capital investment funds from an investment bank ("the investor") . In exchange for this investment, the Company issued
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
200,000 shares of Series G Junior Convertible Preferred Stock (the Series G Preferred Stock) (aggregate liquidation preference $200,000) in a private placement transaction. Dividends on the Series G Preferred Stock accumulate at a rate of 7% of the aggregate liquidation preference thereof and are payable quarterly, in arrears. At the Company's option, dividends are payable in cash, issuance of shares of Common Stock of the Company, or by some combination thereof. The Series G Preferred Stock is redeemable, at the option of the Company, at any time on or after February 17, 2005 at rates commencing with 103.5% declining to 100% on February 17, 2008. Net proceeds to the Company were approximately $188,000. The proceeds from this investment will be used for general corporate purposes, including the funding of working capital and operating losses and the funding of a portion of the cost of acquiring or constructing telecommunications related assets.
In addition, the investor received warrants to purchase 1,000,000 shares of the Company's Common Stock at $40 per share and warrants to purchase 1,000,000 shares of the Company's Common Stock at $45 per share.
INTERMEDIA COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
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(1) Amount represents allowance for accounts purchased in the Shared and National business combinations. (2) Uncollectible accounts written off, net of recoveries. (3) Amounts represent accruals, payments and other reductions as disclosed in the Notes to the Company's Consolidated Financial Statements. | 41,531 | 280,833 |
24071_1999.txt | 24071_1999 | 1999 | 24071 | ITEM 1. BUSINESS
INTRODUCTION AND HISTORY OF THE COMPANY
Continental Information Systems Corporation ("the Company") currently has three main lines of business:
- leasing, sales and management of commercial aircraft and aircraft engines ("the Air Group Business");
- providing other financing services, including commercial real estate financing ("the Finance Business"); and,
- developing and commercializing an Internet-enabled portal to facilitate securities trading for institutional equity traders ("the Electronic Execution Portal Business").
The Company is in the initial stages of developing its Electronic Execution Portal Business. Although the Company will continue to operate its Air Group and Finance Businesses, a substantial percentage of its resources will be shifted to the Electronic Execution Portal Business during the coming fiscal quarters. As part of this transition, changes will and have occurred in the Company's business focus, management, employees and allocation of other resources. (See "Business Strategy"; "Employees"; and "Financing".)
The Company is a New York corporation that was organized in 1968. In January 1989, the Company and nine of its affiliated subsidiaries filed for protection under chapter 11 of the United States Bankruptcy Code. The Company emerged from chapter 11 pursuant to a Plan of Reorganization in November 1994. In 1997, the Board of Directors undertook a restructuring of senior management. The new management included the appointment of a representative of the Company's largest shareholder as Chief Executive Officer. After conducting a review of the Company's operations, management undertook to focus on and expand upon the Company's core Air Group Business. In connection with this, the Company disposed of or discontinued other unrelated lines of business, including telecommunications-related business units and its laser printing business. In August 1999, the Board of Directors authorized the Company to focus on developing and commercializing the Electronic Execution Portal Business. (See "Electronic Execution Portal Business"). In connection with this strategic decision, the Company has begun to wind down portions of its other businesses. Also in August 1999, the Company announced that it would no longer enter into new equipment leases (See "Equipment Leasing Business".)
AIR GROUP BUSINESS
Through its wholly owned subsidiary, CIS Air Corporation, a Delaware corporation ("CIS Air"), the Company participates in the worldwide market for the sale and leasing of used, commercial aircraft and aircraft engines. In recent periods, CIS Air's activities have consisted primarily of acquiring aircraft engines and then selling, leasing or selling them subject to lease. CIS Air finances its portfolio acquisitions with cash flow from operations or through borrowings under CIS Air's revolving credit facility.
Engines, which are acquired from brokers, airlines, and dealers, are in various states of used condition and frequently need substantial repair or refurbishing. The Company, when necessary, contracts with outside vendors to complete this upgrade process before reselling or leasing the equipment to its customers. Aircraft acquired by the Company may be in various stages of airworthiness. Repairs and upgrades may be required to the aircraft prior to leasing the aircraft. CIS Air's leases require the lessee to maintain the aircraft in accordance with FAA-approved maintenance programs and contain specific return conditions.
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CIS Air conducts its sales and leasing activities of aircraft and engines through in-house sales personnel, brokers and consignees. The Company typically enters into short-term triple net operating leases typically with terms of up to two years. Air Group Business customers are primarily small to medium-sized commercial air carriers inside and outside the United States.
In addition to CIS Air's sales and leasing activities, a subsidiary of CIS Air, CIS Aircraft Partners, Inc., has managed a portfolio of commercial aircraft on behalf of two publicly held limited partnerships, JetStream, L.P. and JetStream II, L.P. since their inception in 1987 and 1988 respectively. As managing general partner, CIS Aircraft Partners, Inc. acquired the portfolio on behalf of the partnerships, arranged leases of the aircraft and engages in ongoing management activities including remarketing to preserve and protect the value of the portfolio. The payment of management fees to CIS Aircraft Partners, Inc. from Jet Stream, L.P. was suspended in December 1997, and the payment of management fees from JetStream II, L.P. was suspended in September 1998, because under the terms of the respective limited partnership agreements, these fees are subordinate in right of payment to a preferred rate of return to the limited partners.
The general partners of the JetStream partnerships have developed a plan to sell the Partnerships' remaining aircraft and subsequently terminate the Partnerships. This liquidation plan will require the approval of more than 50% of the unitholders entitled to vote. It is anticipated that a consent solicitation statement requesting such approval will be forwarded to investors during the third or fourth quarter of this year.
The Company is also the owner of a Boeing 737-200 aircraft and has two 737-200 airframes on consignment for part out. The Company has financed aviation related spare part purchases for others, taking back notes collateralized by the financed inventory.
BUSINESS STRATEGY. The Company's operating strategy is to employ its expertise in the aviation, leasing and finance industries to expand and actively manage its aircraft and aircraft engine portfolio. Its focus is to identify segments of the engine resale market that management believes offer greater potential for profitable sales and leasing opportunities. The Company utilizes its existing relationships with other aviation industry participants, a diverse customer base as well as its technical expertise, to identify and evaluate acquisitions, sales and leasing opportunities. The availability of its revolving credit facility allows the Company to leverage its investments in the business. The Company in August 1999 replaced its Air Group management team including the executive in charge of the Air Group and certain other employees and restructured its Air Group business operations. The success of the Air Group Business will be dependent on the ability of a new management team to broaden the customer base and profitably acquire, lease, and trade engines, the economic environment, the aviation idustry in general and aircraft supply and demand, among other factors. The Company will manage the Air Group Business out of its New York City headquarters.
In the normal course of business CIS Air may sell, lease, and finance to customers with credit histories that are below AAA, including a number of foreign companies with less stringent record keeping controls than their counterparts in the United States. While the Company believes that these credits offer higher yields than larger, more creditworthy customers do, they also present an inherent degree of collection difficulty. Leasing, financing or selling on account to foreign companies that operate outside the United States may also present regulatory or administrative obstacles to repossession of engines in the event of default. Management has established guidelines to minimize the risk of lessee defaults. Under these guidelines, the Company conducts initial and ongoing analyses of each lessee's creditworthiness and the economic environment in the countries in which they operate.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES - -------------------------------------------------------------------------------
INDUSTRY CONDITIONS. The commercial aviation industry has recently experienced a period of sustained growth and record-breaking financial performance. Historically, air traffic demand has increased as economic activity increases and real income levels rise. Traffic demand has risen despite higher prices of air transportation. In 1997, the latest full year for which data is publicly available, international scheduled traffic climbed 7.0% and domestic traffic rose 4% over the previous year. Because a substantial portion of business and especially leisure airline travel is discretionary, the industry has tended to suffer during economic downturns. The Company's business remains dependent upon the overall economic condition of the airline industry, which historically has been volatile.
Leasing aircraft engines and aircraft offers CIS Air customers the opportunity to lower their overhead or working capital requirements. Some carriers who do not wish to maintain a pool of spare engines use short-term leases of engines to manage their fleet. Many larger carriers are increasing their use of leased aircraft or engines as they upgrade their fleets, and many of the new carriers have limited capital resources and therefore prefer to lease rather than own engines.
FEDERAL REGULATION.
AGING AIRCRAFT MAINTENANCE. The Federal Aviation Administration (the "FAA"), has adopted a series of Airworthiness Directives ("ADs"). ADs are mandates requiring the airline to perform a specific maintenance task within a specified period of time. The FAA imposes strict requirements governing aircraft inspection and certification, maintenance, equipment requirements, corrosion control, noise levels and general operating and flight rules. In negotiating future leases or in selling aircraft or engines CIS Air may be required to bear some or all of the costs of compliance with future ADs or ADs that have been issued but which did not mandate action during the previous lessee's lease term or in respect of which the previous lessee failed to comply. The aggregate effect of compliance with these standards is not determinable at this time and will depend upon a variety of factors, including, but not limited to, the state of the commercial aircraft market, the extent of the AD, the availability of capable repair facilities and the effect, if any, that such compliance may have on the service lives of the affected aircraft or engines. As described above, the cost of such compliance may be reduced to the extent that current or future lessees of aircraft or engines effect such modifications under the terms of the current or future operating leases.
Aircraft Noise. Effective November 6, 1990, Congress passed the Airport Noise and Capacity Act of 1990 (the "Act"), which required the development of a National Noise Policy. On September 25, 1991, final regulations (the "Regulations") were announced and became effective immediately. The Regulations provide generally, among other things, for the phase-out of aircraft which do not comply with Stage 2 of the noise abatement standards ("Stage 2 aircraft") in the United States by December 31, 1999, unless hushkitted. Only Stage 3 or Stage 2 hushkitted aircraft will be allowed to fly in the United States after December 31, 1999. In addition to FAA activity in noise abatement, other countries have adopted or are considering adopting noise compliance standards which would have a similar effect of reducing the ability of an airline to operate Stage 2 aircraft in such jurisdictions. These regulations may disrupt the market for Stage 2 aircraft at December 31, 1999. CIS Air believes its current portfolio will not be materially affected by these regulations.
Since many of CIS Air's assets are subject to operating leases, CIS Air will be required to re-lease or sell such assets after the expiration of the current lease terms. Such sale or re-lease must be done in a timely manner to minimize off-lease time and allow speedier recovery of CIS Air's investment. The ability to renew leases or to sell the aircraft owned by CIS Air is dependent upon among other factors: (a) general economic and market conditions at lease end; (b) regulatory changes; (c) cost to refurbish the asset, (d) technological changes; (e) any cost required to conform the aircraft to future Stage 3 noise restrictions; and (f) competition. It is possible that CIS Air may therefore not realize the residual value anticipated or alternatively it may only be able to re-lease assets at lower lease rates.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES - -------------------------------------------------------------------------------
FINANCE BUSINESS
The Company diversified into real estate financing as an extension of its historical aircraft and equipment financing business. On July 3, 1997, the Company announced that it had entered into a Joint Investment Agreement (the "Emmes Agreement") with Emmes Investment Management Co. LLC ("Emmes") to provide up to $8 million to be invested in high-yield, short-term financing for commercial real estate transactions. At May 31, 1999, the Company's investment in such transactions was approximately $862,000. Due to increased availability of real estate financing from more traditional sources that makes the financing structured by Emmes less rewarding, the Company does not anticipate making substantial additional investments under the Emmes Agreement in the near future. Changes in market conditions however, may result in additional investments.
From time to time the Company makes loans to borrowers with profiles that do not meet the requirements of traditional lending institutions. The Company's determination whether to make the loan will depend on a number of factors, some of which include: an evaluation of the borrower, the purpose of the loan, collateral held by the Company, if any, the nature of the Company's security interest and the time expected to repayment. Based on the unique nature of the loan the Company may receive fees, equity interests or other forms of remuneration in addition to traditional interest.
EQUIPMENT LEASING BUSINESS
In August 1999, the Company announced that its subsidiary, CIS Corporation would no longer enter into new equipment leases. Additionally, the Company has sold a substantial portion of its remaining lease portfolios. The Company has retained certain leases in its portfolio and will continue to administer those for as long as is economically advantageous for it to do so.
ELECTRONIC EXECUTION PORTAL BUSINESS
On August 8, 1999, the Company announced that the Board of Directors had authorized the Company to focus on developing and commercializing the Electronic Execution Portal Business. Through its newly created subsidiary, CIS Portal Corporation, a New York corporation, the Company will design, develop and market an Internet-based software interface service, the "Electronic Execution Portal Business". The Electronic Execution Portal will allow institutional securities traders and buy-side personnel to find the best prices for their trades on a real-time basis and to route their trades to the best priced settlement facility through Internet-based direct access to various trading platforms. The Company intends that the Electronic Execution Portal will automate essentially all steps of the trading process across various trading platforms. The Electronic Execution Portal, in its current formulation, will be designed to support an existing trading environment and to interface with virtually any trading system via Internet-based direct access. The Company envisions that users will benefit not only from the ability to find prices efficiently on a real-time basis, but also from the elimination of paper flow, double entry of data and redundant terminals. The Company believes that these benefits will reduce trading risks and errors while more efficiently managing the trading process.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES - -------------------------------------------------------------------------------
CUSTOMERS AND MARKETING
The Company obtains its customers from many sources including in-house sales, brokers, vendor relationships and advertising. The Company's management believes that its business is not dependent on any single customer or any single source for the engines marketed by the Company. One customer in fiscal 1999 accounted for 18.5% of the Company's revenues.
In connection with the establishment of the Electronic Execution Portal Business, the Company may seek to engage in strategic market relationships with other vendors, brokers, dealers or other market participants. There can be no assurance, however, that the Company will be able to establish the necessary strategic market relationships, or, if such relationships are established, that they will be successful.
The market for Internet-based trading facilitation services, such as the Electronic Execution Portal, is in its initial stage of development. Demand and market acceptance for newly introduced, Internet-based products and services are subject to a high level of uncertainty. Sales of the Electronic Execution Portal service will depend on the Company's ability to successfully develop and market the Electronic Execution Portal and to attract institutional users. Demand for the Electronic Execution Portal will depend on target users adopting the Internet as a preferred method for facilitating securities trades. The Company plans to devote a significant amount of its administrative, operational, financial and other resources over the next twelve month period to product and market development.
The technologies and computer programs associated with the Electronic Execution Portal system are in development and have not been subject to real-world performance conditions. There can be no assurance that the Electronic Execution Portal system will ultimately function as the Company envisions.
FINANCING
The Company's financing strategy had been primarily to use its own capital, periodically sell leases to selected institutions on a non-recourse basis, and develop relationships with financial organizations to provide lease financing on a recourse and non-recourse basis. The Company's decision to discontinue origination of new leases will reduce this source of financing going forward.
The Company also has a secured, revolving loan agreement with another institution to provide lease and inventory financing for aircraft engines for CIS Air in the amount of $10,000,000. The facility bears interest at prime plus 1/4% and expires in December 2000.
The Company's expansion into a new line of business may place significant demands on its current financial resources. The Company may need to arrange for additional financing to aid in the development and commercialization of the Electronic Execution Portal.
CONCENTRATION OF CREDIT RISK
The Company extends credit through financing and leasing transactions to its customers located both within and outside the United States. The underlying collateral secures the financing of direct financing and operating leases.
The Company's notes receivable balance of $3,205,000 at May 31, 1999, is with two companies in the airline industry. Thus, the Company is directly affected by the well being of these two companies and the airline industry in general. The credit risk associated with these customers is mitigated by the Company's policy requiring collateral on all airline transactions; however a substantial portion of such collateral is outside the United States, thereby creating potential difficulties of recovery of collateral in case of default.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES - -------------------------------------------------------------------------------
COMPETITION
The Company competes with other companies in each aspect of its business.
The aircraft leasing industry is competitive and the success of any lessor is dependent upon many factors (See "Air Group Business"). The Air Group Business competes with distributors, leasing companies, financial institutions and other parties engaged in leasing, managing, and marketing engines. Such competitors may lease or sell engines at lower rates or prices than CIS Air and provide benefits, such as engine management programs and support services, which CIS Air cannot provide.
The Electronic Execution Portal Business may face competition from systems developed by other, much larger companies and its success may depend on the ability of the Company to position itself as the preferred Internet-based trading facilitation service provider for institutional users. This, in turn, will depend on the speed with which the Company can develop and commercialize the Electronic Execution Portal to its target users. Larger competitors may have access to greater resources or better technology.
The Company's continued ability to compete effectively is also materially affected by its ability to attract and retain well-qualified personnel and by the availability of financing at competitive interest rates. Many of the Company's competitors have substantially greater financial resources, economies of scale and lower capital costs than the Company and, as a result, no assurance can be given that the Company will be successful in operating profitably or in obtaining access to competitive capital sources or other means of financing its product development.
The Company believes it competes primarily on the basis of price, capability to meet customer needs, flexibility in structuring transaction terms, reliability in meeting commitments and the degree of knowledge and competence of key employees and advisors.
PROPRIETARY RIGHTS
The Company currently has no patents or registered trademarks. The Company utilizes software licensed from third parties for certain of its financing and leasing operations. In connection with the Electronic Execution Portal Business, the Company believes that its success and ability to compete will be dependent on the development of related proprietary technologies. These proprietary technologies will require the Company to secure patents and trademarks to protect its systems and services.
EMPLOYEES
As of June 30, 1999, the Company had 18 full-time employees, none of whom were employed under a collective bargaining agreement. Ten of these employees worked in administration, and eight were engaged in sales and sales support. Of the employees engaged in sales and sales support, three were marketing representatives who are compensated substantially on a commission basis. As of August 30, 1999, eight of the Company's employees had received notices of termination. The Company has hired a managing director for its new Electronic Execution Portal Business. The Company anticipates adding 10 employees for its Electronic Execution Portal Business phased in over the first year of development.
ITEM 2.
ITEM 2. PROPERTIES
The Company's executive offices are located in New York, New York. The Company maintains offices located in Syracuse, New York and in Los Angeles, California. The Company leases these offices, which
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occupy approximately 12,000 square feet,under short-term leases for an aggregate monthly rental of approximately $20,000.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company has been engaged in litigation with the former owners and executives of its discontinued LaserAccess business. The complaint, as amended, sought damages for various claims, including defamation. This litigation was settled in June 1999. In consideration of a cash payment, the Company received a complete release of all claims against it and released all claims against the owners and executives. As a result, all litigation pending between the parties was dismissed with prejudice. The Company had previously reserved amounts believed sufficient to cover the estimated settlement cost. The actual settlement was for less than the amount reserved and the Company has reversed to income from discontinued operations the excess of such accrual or $1,086,000, after taxes.
On June 1, 1999, CIS Air commenced an action against EastWind Airlines, Inc. seeking $840,329 in damages resulting from EastWind's failure to pay monies owed under a lease of one Boeing-737 Aircraft and two jet engines. On July 20, 1999, EastWind answered the complaint and denied liability. Thereafter, CIS moved to amend its complaint to seek $1,325,261 in damages for the aircraft lease arrearage and $287,500 for monies owed under these leases, each lease being for one commercial jet engine. The amendment also seeks to add EastWind's corporate parent, UM Holdings, Inc. as a party defendant responsible to pay whatever liability is assessed against EastWind. The Company also filed suit in the Superior Court of Guilford County, North Carolina for return of the aircraft and engines. The Company has reached agreement with Eastwind for return of the aircraft and engines, without prejudice to its monetary claims. As the market value of the aircraft is less than its carrying value, failure to collect on the monetary claim against Eastwind would result in a loss.
CIS Air is currently in litigation with Interglobal, Inc. ("Interglobal") and Aero California S.A. de C.V. ("Aero California") in the Superior Court of the State of California for the County of Orange. Aero California and Interglobal filed separate actions on April 13 and 14, 1999 seeking damages for an alleged breach of warranty of merchantability for an aircraft which Interglobal leased to Aero California on an "as is - where is" basis and for an alleged breach of contract for failing to negotiate in good faith to sell a second aircraft to Interglobal. CIS filed a cross-complaint against Aero California seeking to recover lease and maintenance payments which have not been made and against Interglobal for the accelerated amount due on the note and to foreclose on certain security pledged to secure the debts. The cases were consolidated. On July 1, 1999, the court found that CIS' claims are probably valid and issued a right to attach order permitting the marshal to seize assets of Interglobal and Aero California to secure the debt. The parties are currently engaged in settlement negotiations, but no agreement has been reached.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's shareholders during the fourth quarter of its fiscal year.
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PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock trades on the Nasdaq Small-Cap Market under the symbol CISC. The high and low bid information for the last two fiscal years is as follows:
As of June 30, 1999, there were 1,289 record holders of the Company's Common Stock. No cash dividends have been paid on the Common Stock to date and the Company does not anticipate paying a dividend in the foreseeable future, as the Board of Directors intends to retain earnings for use in the business. Any future determination of dividends will depend upon any dividend restrictions applicable to the Company, the Company's financial condition, the Company's results of operations and such other factors, as the Board of Directors deems relevant.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA:
The following table sets forth a summary of selected consolidated financial data for the Company and its Subsidiaries as of the dates and for each of the periods stated. To distinguish between the operations of the Company after reorganization (sometimes referred to as the "Reorganized Company") and operations prior to reorganization, the term "Predecessor Company" will be used when reference is made to the pre-reorganization periods. Due to the application of "Fresh Start" accounting as of November 30, 1994 (the "Fresh Start Date"), the financial data as of and for the fiscal year ended May 31, 1995 is presented in two parts: the six month period commencing after October 1, 1994 and ending May 31, 1995 and the six month period ending on the Fresh Start Date, which was the end of the Predecessor Company's second fiscal quarter.
This information should be read in conjunction with the Company's historical consolidated financial statements, the related notes, and the other information contained herein, including the information set forth in "ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion and analysis of the financial condition and results of operations of the Company should be read in conjunction with the consolidated financial statements and the notes thereto which appear elsewhere in this Form 10-K.
All statements contained herein that are not historical facts, including but not limited to, statements regarding anticipated future capital requirements, the Company's future development and acquisition plans, the Company's ability to obtain additional debt, equity or other financing, and the Company's ability to generate cash from operations and further savings from existing operations, are based on current expectations. These statements are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: the availability of sufficient capital to finance the Company's business plan on terms satisfactory to the Company; competitive factors, such as the introduction of new technologies and competitors into the commercial aircraft industries; risks described above attendant to the Company's Electronic Execution Portal Business, the risks attendant to real estate finance generally, including the risks of leverage, risks of borrower default, general economic and real estate market conditions, and competition for attractive real estate finance investments; pricing pressures which could affect demand for the Company's services; changes in labor, equipment and capital costs; future acquisitions; general business, economic and regulatory conditions; and the other risk factors described from time to time in the Company's reports filed with the Securities and Exchange Commission ("SEC"). The Company wishes to caution readers not to place undue reliance on any such forward looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.
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RESULTS OF OPERATIONS
CONTINUING OPERATIONS
REVENUES For the three fiscal years being reviewed, total revenues decreased to $16.8 million in fiscal 1999 from $18.4 million in fiscal 1998, while decreasing from $26.2 million in fiscal 1997. Equipment sales followed the same pattern, decreasing to $7 million in fiscal 1999 from $10.8 million in fiscal 1998, and decreasing from $16.4 million in fiscal 1997. With the discontinuation of lease originations in August, 1999, equipment sales are expected to be immaterial in fiscal 2000. The significant decrease (35.1%) in sales during the fiscal year 1998 is in part due to the sale of the Telecommunications Business Unit on August 31, 1997. Additionally, sales of equipment in conjunction with the Leasing Business Unit's trading activity decreased for the fiscal year 1998 because of a greater focus on lease originations. Sales by Air Group decreased by $3.9 million for the current fiscal year. The average selling price was much lower during the current period as a result of slightly older engines sold in fiscal 1999 as compared to fiscal 1998. Air group revenues increased by $2.0 million in 1998 as compared to fiscal 1997.
Equipment rentals and income from direct financing leases increased to $8.3 million in fiscal 1999 from $5.4 million in fiscal 1998 and from $5.0 million in fiscal 1997. The increase in fiscal 1999 is chiefly attributable to an increase in Leasing Group and Air Group rentals to the extent of approximately $3 million and $1 million respectively for the fiscal year 1999. Also an increase in net investment in direct finance leases made in fiscal 1998 fourth quarter contributed to the increase in fiscal 1999 as only 3 months income was recorded in fiscal 1998 as compared to 12 months in fiscal 1999.
Interest, fees and other income decreased to $1.2 million in fiscal 1999 from $2.1 million in fiscal 1998, and from $1.9 million in fiscal 1997. The decrease in fiscal 1999 is principally due to decline in Equipment Management Income fee and other fee income for CIS Air as a result of the suspension of management fees from the Jet Stream Partnerships in fiscal 1999 to $170,000 as compared to $637,000 in fiscal 1998.
COSTS AND EXPENSES Costs and expenses increased to $19.3 million in fiscal 1999 from $17.4 million in fiscal 1998 and decreased from $23.4 million in fiscal 1997. Cost of Sales decreased to $6.4 million in fiscal 1999 from $9.6 million in fiscal 1998 and from $13.5 million in fiscal 1997. The decrease is a direct result of the 35.1% decrease in sales. Significant decrease in cost of sales occurred in CIS Air to the extent of $3.5 million in fiscal 1999. Cost of sales as a percentage of sales for the fiscal years ended May 31, 1999, 1998 and 1997 was 91.0%, 88.1% and 81.9%, respectively. These variances are directly related to the results of operations of the Air Group Business Unit and reflect the competitive conditions in the used engine marketplace. Revenues and earnings from the aircraft business are likely to continue to vary quarter-to-quarter, based on a number of factors, including the volume of transactions and the age of engines. In fiscal 1999 the average selling price was lower due to the cyclical nature of the market environment and slightly older engines.
Depreciation of rental equipment increased to $5.4 million in fiscal 1999 from $2.6 million in fiscal 1998 and from $2.1 million in fiscal 1997. This increase is directly related to the addition of $7.6 million in rental equipment in March 1998 resulting in an increase in depreciation of $2.2 million in fiscal 1999.
Interest expense increased to $513,000 in fiscal 1999 from $438,000 in fiscal 1998 and decreased from $670,000 in fiscal 1997. These variances reflect the changes in the average debt outstanding during the respective periods. In fiscal 1999 $1.6 million debt was paid off in conjunction with an equipment sale.
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Other operating expenses increased to $2,195,000 in fiscal 1999 from $922,000 in fiscal 1998 and from $1,207,000 in fiscal 1997. These expenses, which are principally related to leased equipment, will vary from period to period based on the timing and volume of leasing transactions. In fiscal 1999, an inventory write off of $719,000 and a bad debt expense of $200,000 were due to the bankruptcy of Geotek, a large lessee of the Company; CIS Air sublease expense was $460,000 for 1999 as compared to $180,000 for 1998, and operating incentives was $225,000 for 1999 as compared to $204,000 for 1998, which contributed to the increase in the other operating expenses. With the discontinuation of lease originations in August, 1999, operating expenses associated with leased equipment are expected to be immaterial in fiscal 2000.
Selling, general and administrative expenses increased to $4,783,000 in fiscal 1999 from $3,957,000 in fiscal 1998 and decreased from $5,946,000 in fiscal 1997. The increase in fiscal 1999 is due to payments made for state franchise taxes in the amount of $675,000. These decreases in 1998 were principally due to cost containment efforts and staff reductions between the periods.
INCOME TAXES For the fiscal years ended May 31, 1999, 1998 and 1997, a provision for deferred income tax expense on income from continuing operations, was recorded in the amounts of $5,414,000, $371,000 and $1,056,000, respectively. For the fiscal years ended May 31, 1998 and 1997, a deferred income tax benefit on income from discontinued operations was recognized in the amounts of $371,000 and $390,000, respectively offsetting the related expenses.
In connection with applying "Fresh Start" accounting upon its reorganization in bankruptcy, the Company had recognized deferred tax assets of approximately $5 million, net of valuation allowance of $7 million, relating principally to net operating loss (NOL) carryforwards. The Company recognized additonal deferred tax assets as a result of subsequent net operating losses. The value of these deferred tax assets is dependent on the Company generating future operating earnings, the income taxes on which would be offset by the Company's NOL carryforwards. The Company provided a full valuation allowance for these deferred tax assets as of May 31, 1999, since, in management's opinion, the future realizability of the deferred tax assets is uncertain in light of its actual operating results since reorganization. This action does not inmpair the availability of the NOL carryforwards to offset the future operating earnings. The pre-reorganization NOL carryforwards expire during the years 2004 to 2010. Utilization of the pre-reorganization NOL carryforwards is limited to approximately $2 million per year. The Company periodically reviews the adequacy of the valuation allowance for NOL carryforwards and will recognize benefits only if a reassessment indicates that it is more likely than not that the benefits will be realized.
DISCONTINUED OPERATIONS
On May 29, 1998, the Company announced its decision to discontinue and liquidate its LaserAccess laser printing business. The Company recorded a provision of $4,955,000 in the quarter ended May 31, 1998, relative to the disposal of LaserAccess' assets, including the write-off of goodwill in the amount of $3,258,000, and other charges related to the discontinuance of the business unit. See "ITEM 3. LEGAL PROCEEDINGS" for a discussion of litigation related to LaserAccess. As a result of the settlement of this litigation, the Company reversed previously recorded accruals in the amount of $1,086,000, net of taxes, representing the amount by which the Company's reserves exceeded the amount of the settlement.
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A summary of the results of operations of the discontinued LaserAccess Business Unit follows (in thousands):
EQUIPMENT LEASING BUSINESS
In August 1999, the Company announced that its subsidiary, CIS Corporation would no longer enter into new equipment leases. Additionally, the Company has sold a substantial portion of its remaining lease portfolios. The Company will continue to administer its remaining leases for as long as is economically advantageous for it to do so.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES
Cash provided by operations for the fiscal year ended May 31, 1999 of $842,000 was composed of cash from continuing operations of $957,000 with $115,000 being used in discontinued operations. Cash provided by continuing operations for the fiscal year ended May 31, 1998 was $9.0 million and cash used in continuing operations for the fiscal year ended May 31, 1997, was $2.0 million. In fiscal 1999 deferred lease revenues had a negative impact of $3.3 million on cash flows as compared to positive cash flow of $5.9 million in fiscal 1998. An increase of inventory levels of $3.2 million had a negative effect on cash flow for 1999. A decrease in inventory levels of $720,000 had a positive effect on cash flows in fiscal 1998, where as an increase in inventory levels of approximately $3.6 million had a negative effect on the cash flows in fiscal 1997 as compared to fiscal 1998. The significant increase in cash provided by continuing operations for the fiscal year 1998 was primarily due to deferred lease revenue of $5.9 million generated by prepaid lease transactions. The proceeds were used to purchase rental equipment.
INVESTING ACTIVITIES
Purchases of rental equipment decreased to $4.3 million in fiscal 1999 from $23.8 million in fiscal 1998 and from $11.4 million in fiscal 1997. During fiscal 1999 rental equipment was purchased by CIS Air, consisting of engines for lease. During fiscal 1999 net proceeds from mortgage participation notes amounted to $850,000, whereas during the fiscal 1998 period, the Company invested approximately $1.3 million in mortgage participation notes under the Emmes Agreement. Net cash provided by investing activities in fiscal 1999 amounted to $1.1 million as compared to net cash used in investing activities during fiscal 1998 in the amount of $15.0 million. Net cash provided by investing activities was $15.5 million for fiscal 1997. The decrease in fiscal 1998 reflects additional equipment acquired with the proceeds of the prepaid lease transactions,proceeds from the sale of equipment subject to leases, and the purchase of rental equipment. In fiscal 1997,
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significant cash was generated by two sales of equipment subject to lease in the aggregate amount of $8.7 million in the second and third quarters. In addition to the cash payments and a short-term note of approximately $560,000, the buyer assumed approximately $12.8 million of the Company's related outstanding non-recourse lease rental borrowings and approximately $379,000 of the Company's related outstanding recourse lease rental borrowings were paid off. The sales of this leased equipment accelerated the earnings and cash flow from the leases, which would have been received over time, into the second and third quarters of the 1997 fiscal year.
FINANCING ACTIVITIES
Proceeds from lease, bank and institution financings for the fiscal years ended May 31, 1999, 1998 and 1997, were $17.5 million, $14.1 million and $8.2 million, respectively, while payments on lease, bank and institution financings for the fiscal years ended May 31, 1999, 1998 and 1997, were $16.8 million, $12.7 million and $17.3 million, respectively.
On May 27, 1997, the Company announced that its Board of Directors had authorized the expenditure of up to $500,000 for the repurchase of its common stock. The Company commenced a voluntary odd lot repurchase program through June 30, 1997, which was extended through July 31, 1997. Shareholders owning less than 100 shares of the Company's common stock were offered the opportunity to sell all their shares at the closing price of the common stock on the Nasdaq Small-Cap Market on May 23, 1997, which was $2.25 per share. Approximately 20,000 shares were repurchased by the Company at an aggregate cost of approximately $45,000. Subsequent to the odd lot repurchase program, the Company repurchased from time to time additional shares of its common stock up to the balance of $500,000 remaining after the odd lot program. The Company may repurchase the additional shares at prevailing prices in the open market or in negotiated or other permissible transactions at the discretion of management. In February 1999, the Company announced that its Board of Directors had authorized the expenditure of an additional $500,000 for the repurchase of its common stock. The Company will hold all repurchased shares of common stock in its treasury. As of May 31, 1999, approximately 217,000 shares had been repurchased by the Company in this manner at an aggregate cost of approximately $463,000.
The Company expects that operations will generate sufficient cash to meet its operating expenses and current obligations for the foreseeable future. The Company has a revolving loan agreement (the "CIS Air Loan Facility") with an institution to provide lease and inventory financing for aircraft engines for its operating subsidiary CIS Air, in the amount of $10,000,000. The facility has a three-year term and permits borrowing equal to a percentage of the appraised value of the aircraft engines financed. Substantially all of the assets of CIS Air are pledged as collateral for the loan. At May 31, 1999, $7,515,000 of this facility was being utilized. The CIS Air Loan Facility bears interest at prime plus 1/4% and expires in December 2000. A revolving loan agreement to provide inventory financing in the amount of $2,500,000, for the discontinued LaserAccess laser printing business was terminated on July 31, 1998. At May 31, 1998, $428,000 of this facility was being utilized; this outstanding balance was paid in full by July 31, 1998. In 1998, the Company had invested approximately $10.9 million in capital (equity and intercompany advances) in the Air Group Business, which has invested those funds in aircraft and aircraft engines. The Company's ability to invest in other activities is constrained by its ability to upstream funds from CIS Air, which is limited by certain covenants in the CIS Air Loan Facility.
The Company has authorized in its first year of development the expenditure of $3 million in start up operating expenses for its Electronic Execution Portal Business. During such period the Company does not anticipate generating any revenue in connection with such business. The Company currently has adequate funds on hand to finance such activities. There can be no assurance that additional funds will not be
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necessary to continue the operation prior to revenue being generated. The Company may need to finance such additional expenses or may seek to issue debt or equity securities. Alternatively, the Company may choose to seek outside strategic investors in return for equity stakes in its portal subsidiary.
YEAR 2000
As the year 2000 approaches, a critical issue has emerged for all companies, including the Company, with respect to whether application software programs and operating systems utilized by a company and the companies with which it does business can accommodate this date value. In brief, many existing application software products in the marketplace were designed only to accommodate a two-digit date position which represents the year (e.g., "95" is stored on the system and represents the year 1995). As a result, the year 1999 (i.e., "99") could be the maximum date value these systems will be able to process accurately.
The Company engaged in a review of the software and information systems it uses in an effort to determine whether it or its operations may be materially adversely affected by this so-called "Year 2000" conversion. As a result of that review, the Company upgraded and replaced its hardware systems with systems that are Year 2000 compliant. In addition, the Company has completed conversion to the updated release of its vendor's lease billing software and new accounting software, which are year 2000 compliant. The Company has inquired of, and generally obtained the assurances of, the providers of such software with respect to its being Year 2000 compliant. Based on its review the Company does not presently believe that Year 2000 compliance issues with respect to its software and systems will cause any material disruptions, malfunctions or failures of its business. However, no assurances can be given that such review uncovered every potential adverse effect of the Year 2000 conversion in connection with any of such software or systems.
With respect to assets other than its computer hardware and software systems, the Company is aware that some of the equipment it leases may have embedded technology that is not Year 2000 compliant. Under the terms of the leases, however, the Company is not responsible for the maintenance and repair of this equipment, and the leases are non-cancelable. Failure to achieve Year 2000 compliance may materially adversely affect the residual value of such equipment. No assurance can be given that such decrease in residual value would not have a material adverse effect on the Company's business or results of operations. The Company has concluded its review of whether the software and systems of the vendors, financing sources, customers, equipment manufacturers or distributors or other parties with which it deals may, as a result of the Year 2000 conversion, have a materially adverse effect on the Company or its operations. As part of this review, the Company has obtained assurances from each of such parties, whose dealings with
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the Company are material to the Company or its operations, that such party does not and will not utilize software or systems that may interfere with the Company, or are or will be important to the operations of such party, that may cause problems to such party or the Company as a result of the Year 2000 conversion. However, no assurances can be given that the information obtained by the Company is accurate from such parties so as such to determine whether it may be materially adversely affected by the software or systems of such parties.
The Company currently believes that its systems will be Year 2000 compliant during the remainder of 1999 and therefore has not developed a contingency plan. Nevertheless, the Company will maintain an ongoing effort to recognize and evaluate potential exposure relating to the Year 2000 conversion arising from its use of software supplied by other parties or its dealings with other parties. The total cost to the Company of these Year 2000 compliance activities has not been, and is not anticipated to be, material to its financial position or results of operations in any given year.
NEW ACCOUNTING PRONOUNCEMENT, ISSUED BUT NOT YET EFFECTIVE
On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (June 1, 2001 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair market value. Changes in the value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. The Company does not presently have derivative instruments and does not believe that the adoption of FAS 133 will have a significant impact on its earnings or statement of financial position.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK DISCLOSURES
The Company is exposed to risks associated with interest rate changes. The Company does not foresee any significant changes in its exposure to fluctuations in interest rates in the near future. At May 31, 1999, the Company's total outstanding debt consisted of a secured, revolving loan facility in the amount of $7,515,000. The facility has a floating interest rate of prime plus 1/4% and expires in December 2000. If interest rates were to rise dramatically, the cost of servicing this loan would also increase. Based on weighted average borrowings outstanding under the credit facility during fiscal year 1999, a 1/8 percentage point change in the weighted average interest rate would have caused the interest expense to increase or decrease by approximately $6,000.
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ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Continental Information Systems Corporation
In our opinion, the consolidated financial statements listed in the accompanying index on page 18 hereof present fairly, in all material respects, the financial position of Continental Information Systems Corporation and its subsidiaries (the "Company") at May 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended May 31, 1999, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when considered in relation to the basic consolidated financial statements taken as a whole. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
August 18, 1999 Syracuse, New York
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CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES IN THOUSANDS (EXCEPT PER SHARE DATA) - ------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
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1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Continental Information Systems Corporation and its Subsidiaries (the "Company") is a specialized financial services company that is engaged in the leasing, sales and management of commercial aircraft and engines and other financing activities, including commercial real estate financing. The Company is in the initial stage of developing an Electronic Execution Portal System. Although the Company will continue to operate its Air Group and Finance Businesses, a substantial percentage of its resources will be shifted to the Electronic Execution Portal business during the coming fiscal quarters. As part of this transition, changes have and will continue to occur in the Company's business focus, management, employees and allocation of its resources. Demand and market acceptance for newly introduced, Internet-based products and services are subject to a high level of uncertainty. Sales of the Electronic Execution Portal service will depend on the Company's ability to successfully develop and market and to attract institutional users to its product. Demand for the Electronic Execution Portal will depend on target users adopting the Internet as the preferred method for facilitating securities trades. The technologies and computer programs associated with the Electronic Execution Portal are in development and have not been subject to real-world performance conditions. There can be no assurance that the Electronic Execution Portal system will ultimately function as the Company envisions, or that the Company will be successful in marketing the product profitably and in obtaining access to competitive capital sources or other means of financing its product development.
Additionally, in August 1999, the Company announced that it would no longer enter into new equipment leases, and that it sold a substantial portion of its remaining equipment lease portfolio in CIS Corporation, its equipment lease subsidiary, and terminated employees in this segment.
CONSOLIDATION The accompanying consolidated financial statements include the accounts of Continental Information Systems Corporation and its wholly owned subsidiaries. All intercompany accounts have been eliminated in consolidation.
CASH AND CASH EQUIVALENTS Cash and cash equivalents include checking and money market accounts with financial institutions having original maturities of 90 days or less.
CONCENTRATION OF CREDIT RISK The Company extends credit through financing and leasing transactions to its customers located both within and outside of the United States. The underlying lease assets collateralize the financing of direct financing and operating leases.
The Company's notes receivable balance of $3,205,000 at May 31, 1999, is with two companies in the airline industry. Thus, the Company is directly affected by the well being of these two companies and the airline industry in general. The credit risk associated with these customers is mitigated by the Company's policy requiring collateral on all airline transactions, however a substantial portion of such collateral is outside the United States thereby creating potential difficulties of recovery of collateral in case of default.
One customer in fiscal 1999 accounted for 18.5% of the Company's revenues.
INVESTMENT IN MORTGAGE PARTICIPATION NOTES Investment in mortgage participation notes represents investments and are carried at the lower of cost or market in high-yield, short-term commercial real estate transactions. Interest income on the notes is recorded monthly using the weighted average estimated yields on these investments.
INVENTORY AND RELATED REVENUE RECOGNITION Inventory consists of various aircraft equipment purchased for future sale or lease and is stated at the lower of cost or market, cost being determined on a specific identification basis. Revenues from the sale of equipment and the related cost of the equipment are reflected in earnings at the time title to the equipment passes to the customer.
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The Company performs ongoing analyses, at least quarterly, of the carrying value of inventories on a specific identification basis and records adjustments, as considered necessary, to reduce the carrying value of inventories to estimated market value in the period such determination is made. These adjustments are recorded as direct writedowns in the carrying value of the inventory.
LEASE ACCOUNTING POLICIES Statement of Financial Accounting Standards No. 13 requires that a lessor account for each lease by the direct financing method, sales-type method or operating method. Presently, the Company has primarily direct financing and operating leases; the dollar value and number of sales-type leases are considered immaterial. Net investment in direct financing leases consists of the future minimum lease payments plus unguaranteed residual less unearned income net of unamortized initial direct costs. At the end of the lease term, the recorded residual value of equipment under direct financing leases is reclassified to rental equipment and is depreciated over its estimated remaining useful life, if the related asset is released.
Unearned income is amortizated to lease income by the interest method using a constant periodic rate over the lease term.
Rental equipment consists of equipment under operating leases. Rental equipment are depreciated on a straight-line basis to their estimated residual value over the remaining useful lives of such equipment. Operating lease revenues consist of the contractual lease payments which are recognized on a straight-line basis over the lease term. Costs associated with operating leases principally consist of depreciation of the equipment.
The Company makes adjustments to the carrying value of leased assets, if necessary, when market conditions have resulted in values that are below net book value. At the time assets are disposed of, cost and accumulated depreciation as to each investment are removed from the accounts and the difference, net of proceeds, are recognized as a gain or loss.
DEFERRED COMMISSIONS AND INITIAL DIRECT COSTS Commissions and other initial direct costs related to lease transactions are capitalized as a component of the corresponding investment in direct financing leases or rental equipment and amortized over the estimated average lease term. Costs relating to direct financing leases are amortized using the interest method and costs relating to operating lease equipment are amortized using the straight-line method.
PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are recorded at cost and are being depreciated using the straight-line method over the estimated useful lives of such assets. Leasehold improvements are depreciated over three to seven years. Computer equipment and software is depreciated over three to five years and furniture, fixtures and office equipment over seven years and aircraft engines over seven years from the date of purchase.
INCOME TAXES
The Company accounts for income taxes under the asset and liability method required by Financial Accounting Standard No. 109 (SFAS 109), ACCOUNTING FOR INCOME TAXES. SFAS 109 requires the recording of deferred tax assets and liabilities for the future tax effects of temporary differences between the bases of all assets and liabilities for financial reporting purposes and tax purposes. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. The Company periodically reviews the adequacy of the valuation allowance and will recognized benefits only if reassessment indicates that it is more likely than not that the benefits will be realized. A valuation allowance for the full amount of deferred tax assets was provided for in income tax expense in 1999.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
NET INCOME (LOSS) PER SHARE
EARNINGS PER SHARE, are calculated in accordance with Financial Accounting Standard No. 128 (SFAS 128), EARNINGS PER SHARE, which specifies standards for computing and disclosing net income (loss) per share. Basic and diluted net income (loss) per share for the fiscal years ended May 31, 1999, 1998 and 1997, was computed based on the weighted average number of shares of common stock outstanding during the periods. As of May 31, 1999, the Company had issued and outstanding options to purchase 421,674 shares of common stock (see Note 11). The effect of these options is antidilutive in the computation of diluted net income (loss) per share.
ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
RECLASSIFICATIONS Certain prior period balances in the financial statements have been reclassified to conform to the current period financial statement presentation.
RECENT ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 130, REPORTING COMPREHENSIVE INCOME. This statement establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. This statement requires that an entity (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. At May 31, 1999, the Company does not have any items of comprehensive income and therefore, the adoption of this Statement did not have an impact on the Company's financial statements.
2. DISCONTINUED OPERATIONS
On May 29, 1998, the Company announced its decision to discontinue and liquidate its LaserAccess laser printing business. The Company recorded a provision of $4,955,000 in the quarter ended May 31, 1998, relative to the disposal of LaserAccess' assets, including the write-off of goodwill, in the amount of $3,258,000, and other charges related to the discontinuance of the business unit.
In June 1999, the Company settled litigation with the former owners and executives of its discontinued LaserAccess business (See note 17).
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
The actual settlement was for less than the amount reserved and the Company has reversed to income from discontinued operations the excess of such revenue, or $1,086,000, after taxes.
The Consolidated Balance Sheet and Statements of Operations for all periods presented have been reclassified to report the results of discontinued operations separately from those of continuing operations. A summary of the financial position and results of discontinued operations follows (in thousands):
3. NOTES RECEIVABLE
Notes receivable include $2,530,000 from Interglobal/AeroCalifornia, which is subject to litigation (See note 17). Also included is $675,000 representing the balance remaining from the Company's financing of a McDonnell Douglas DC-10 spare parts inventory purchased by a third party aircraft parts supplier. The loan is collateralized by the inventory. The original loan balance bears interest at 11%, increasing to 20% after one year from the date of
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
funding. The Company receives 80% of net sales proceeds of the inventory until the loan is repaid. After the loan is paid in full the Company has a 50% equity interest in any future sales proceeds.
4. INVESTMENT IN MORTGAGE PARTICIPATION NOTES
On July 3, 1997, the Company announced that it had entered into a Joint Investment Agreement with Emmes Investment Management Co. LLC to provide up to $8 million in high-yield, short-term financing for commercial real estate transactions. At May 31, 1999, the Company's investment in such transactions was approximately $862,000. Due to increased availability of real estate financing from more traditional sources, the financing structured by Emmes is less rewarding. Consequently, the Company does not anticipate making substantial additional investments under the Emmes Agreement in the near future. Changes in market conditions, however, may result in additional investments.
5. NET INVESTMENT IN DIRECT FINANCING LEASES (SEE ALSO NOTE 8)
The components of the net investment in direct financing leases as of May 31 are as follows (in thousands):
Future minimum lease payments to be received under direct financing leases for fiscal years ending May 31 are as follows (in thousands):
6. RENTAL EQUIPMENT (SEE ALSO NOTE 8)
Rental equipment consists of the following as of May 31 (in thousands):
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------ Rental equipment includes $4.1 million in two-year prepaid leases with a large public company covering computer equipment. The leases which expire in April 2000 amortize to $1.7 million, which represents the Company's equity investment in such leases. At the end of the lease term the lessee may return the equipment, buy selected portions of the equipment, or ask for lease extensions. There can be no assurance that the Company will be able to realize the carrying value of the equipment at lease termination.
Future minimum lease payments to be received under operating leases for the fiscal years ended May 31 are as follows (in thousands):
Approximately 17% of these future lease streams are pledged to lenders as collateral under financing agreements.
7. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following as of May 31 (in thousands):
8. DISCOUNTED LEASE RENTAL BORROWINGS
The Company financed certain leases by assigning the rentals to various lending institutions at fixed rates on a recourse and non-recourse basis. Discounted lease rental borrowings represent the present value of the lease payments discounted at the rate charged by the lending institution and are reduced on a monthly basis as the corresponding lease rental stream is collected (generally by the lending institutions). Amounts due under recourse borrowings are obligations of the Company, which are collateralized by the leased equipment and assignments of lease receivables. Amounts due under non-recourse borrowings are collateralized by the leased equipment and assignments of lease receivables with no recourse to the general assets of the Company.
Discounted lease rental borrowings as of May 31 are as follows (in thousands):
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
The Company paid interest related to discounted lease borrowings of $126,000, $272,000 and $652,000 for the fiscal years ended May 31, 1999, 1998 and 1997, respectively.
Discounted lease rental borrowings for the fiscal years ending May 31 are payable as follows (in thousands):
In August 1999, CIS Corporation sold substantially all of its general equipment leasing portfolio to a third party for $1,694,000 in cash and recorded a gain on sale of $174,000. As a result of such sale, the above borrowings were repaid either through assumption by the purchaser or direct payment by the Company.
9. NOTE PAYABLE TO INSTITUTION
The Company has a revolving loan agreement with an institution to provide lease and inventory financing for aircraft engines for CIS Air Corporation (a wholly owned subsidiary), in the amount of $10,000,000. The revolving facility has a three-year term and permits borrowing equal to a specified percentage of the appraised value of the aircraft engines financed. Substantially all of the assets of CIS Air Corporation are pledged as collateral for the loan. At May 31, 1999, $7,515,000 of this facility was being utilized. Interest on the facility is at 1/4% above the prime rate (8.0% at May 31, 1999). The Company paid interest related to this facility of $387,000, $166,000 and $127,000 in fiscal 1999, 1998 and 1997, respectively. The loan agreement for the line of credit contains various covenants, including limitations on incurring additional liens and encumbrances and prohibiting certain transactions with affiliates or subsidiaries.
10. COMMON STOCK
On May 27, 1997, the Company announced that its Board of Directors had authorized the expenditure of up to $500,000 for the repurchase of its common stock. The Company commenced a voluntary odd lot program through June 30, 1997, which was extended through July 31, 1997. Shareholders owning less than 100 shares of the Company's common stock were offered the opportunity to sell all their shares at the closing price of the common stock on the Nasdaq Small-Cap Market on May 23, 1997, which was $2.25 per share. Approximately 20,000 shares were repurchased by the Company at an aggregate cost of approximately $45,000. Subsequent to the odd lot repurchase program, the Company repurchased from time to time additional shares of its common stock up to the balance of $500,000 remaining after the odd lot program. As of May 31, 1999, approximately 217,000 shares had been repurchased by the Company in this manner at an aggregate cost of approximately $463,000. In February 1999, the Company announced that its Board of Directors had authorized the expenditure of an additional $500,000 for the repurchase of its common stock. The Company may repurchase the additional shares at prevailing prices in the open market or in negotiated or other permissible transactions at the discretion of management. The Company will hold all repurchased shares of common stock in its treasury.
Each share of common stock entitles the holder to one vote on all matters submitted to a vote of shareholders. The Company does not anticipate the payment of dividends on the common stock for the foreseeable future.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
11. STOCK OPTION PLAN
In 1995, the Board of Directors adopted and the stockholders approved the Continental Information Systems Corporation 1995 Stock Compensation Plan (the "1995 Plan"). The 1995 Plan provides for the issuance of options covering up to 1,000,000 shares of common stock and stock grants of up to 500,000 shares of common stock to non-employee directors of the Company and, at the discretion of the Compensation Committee or the Board of Directors, employees of and independent contractors and consultants to the Company. Options granted to non-employee directors of the Company in any year become exercisable at the next annual stockholders' meeting while those granted to employees of and independent contractors and consultants to the Company are subject to vesting periods determined by the Compensation Committee or the Board of Directors. Options granted to employees in fiscal 1999 become exercisable in installments of 33 1/3 percent at the grant date and at each subsequent fiscal year end except for options granted to two executive officers which become fully exercisable one year from the grant date. The Company applies APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for the 1995 Plan. Accordingly, no compensation cost has been charged against income for the stock option plan. Had compensation cost for the 1995 Plan been determined based on the fair value at the grant dates for awards under the Plan, consistent with the requirements of FASB Statement No. 123, "Accounting for Stock-Based Compensation," the Company's net income (loss) and net income (loss) per share would have reflected the pro forma amounts indicated below:
The fair value of each stock option grant has been estimated on the date of each grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
The weighted-average grant date fair values of options granted during fiscal 1999, 1998 and 1997 were $.67, $.92 and $.80 per share, respectively.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
A summary of the status of the 1995 Plan as of May 31, 1997, 1998 and 1999, and changes during the years ending on those dates is presented below:
The following table summarizes information about stock options outstanding at May 31, 1999:
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
12. INCOME TAXES
The components of the provision for income taxes are as follows (in thousands):
The difference between the effective income tax rate and the provision resulting from the application of the federal statutory income tax rate is primarily due to utilization of net operating losses, state and local taxes and the change in the valuation allowance in 1999.
A reconciliation of income tax expense (benefit) at the statutory rate to reported income tax expense (benefit) for continuing operations follows (in thousands):
The income tax effect of the significant temporary differences and carryforwards which give rise to deferred tax assets and (liabilities) are as follows as of May 31 (in thousands):
A full valuation allowance was provided for such deferred tax assets since, in management's opinion, the realizability of such assets was uncertain in light of the Company's actual operating results since reorganization. The Company periodically reviews the adequacy of the valuation allowance and will recognize benefits
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
only if a reassessment indicates that it is more likely than not that the benefits will be realized. The net change during the year in the total valuation allowance was a increase of $5,905,000. As of May 31, 1999, the Company had a net operating loss carry-forwards for future tax, taxable income in the amount of approximately $43 million which will expire in 2005 thru 2011.
13. EMPLOYEE BENEFIT PLANS
The Company maintains a defined contribution 401(k) plan covering substantially all of its employees under which it is obligated to make matching contributions at the rate of 50% of the first 6% of participant earnings contributed to the plan and which provides for an annual discretionary contribution based on participants' eligible compensation. Matching and discretionary contributions made by the Company vest over a five-year period. Company contributions to the plan for the fiscal years ended May 31, 1999, 1998 and 1997, were $21,000, $38,000 and $92,000, respectively.
14. COMMITMENTS AND CONTINGENCIES
RENTAL COMMITMENTS
The Company has various operating lease agreements for offices and office equipment. These leases generally have provisions for renewal at varying terms. The Company recorded rental expense of $279,000, $243,000 and $442,000 in the fiscal years ended May 31, 1999, 1998 and 1997, respectively.
The future minimum lease payments required under operating leases for the fiscal years ended May 31 are as follows (in thousands):
CONTINGENCIES The Company is involved in certain legal proceedings more fully described in note 17.
15. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
CASH AND CASH EQUIVALENTS, NOTES RECEIVABLE AND INVESTMENT IN MORTGAGE PARTICIPATION NOTES - The carrying value approximates fair value because of the short maturity of those instruments.
DISCOUNTED LEASE RENTAL BORROWINGS AND NOTE PAYABLE TO INSTITUTION - Fair value of discounted lease rental borrowings and note payable to institution are based on the borrowing rates currently available to the Company for bank loans with similar terms and average maturities. At May 31, 1999 and 1998, the fair value of such borrowings approximate their carrying values.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
The estimated fair values of the Company's financial instruments at May 31, 1999 and 1998 are as follows (in thousands):
16. SEGMENT FINANCIAL DATA The Company adopted SFAS No. 131, DISCLOSURE ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, as required, in fiscal 1999. The Company's operating subsidiaries are classified into two principal operating segments on the basis of strategic business units within the operating subsidiaries, which require different investment and marketing strategies.
AIR GROUP BUSINESS: Through its wholly owned subsidiary, CIS Air Corporation, a Delaware Corporation ("CIS Air"), the Company participates in the worldwide market for the sale and leasing of used, commercial aircraft and aircraft engines.
EQUIPMENT LEASING BUSINESS: The Company's Equipment Leasing Business, which was conducted through its operating subsidiary CIS Corporation, a New York Corporation ("CIS"), leased a wide range of equipment, including computers, printers and telecommunications equipment. The Company participated in the leasing market principally by originating new leases and financing other equipment brokers. In August 1999, the Company announced CIS would no longer enter into new equipment leases.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------
17. SUBSEQUENT EVENTS
The Company has been engaged in litigation with the former owners and executives of its discontinued LaserAccess business. The complaint, as amended, sought damages for various claims, including defamation. This litigation was settled in June 1999. In consideration of a cash payment, the Company received a complete release of all claims against it and released all claims against the owners and executives. As a result, all litigation pending between the parties was dismissed with prejudice. The Company had previously reserved amounts believed sufficient to cover the estimated settlement cost. The actual settlement cost was for less than the amount reserved and the Company has reversed to income from discontinued operations the excess of such accrual or $1,086,000, after taxes.
CONTINENTAL INFORMATION SYSTEMS CORPORATION AND ITS SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
On June 1, 1999, CIS Air commenced an action against EastWind Airlines, Inc. seeking $840,329 in damages resulting from EastWind's failure to pay monies owed under a lease of one Boeing-737 Aircraft and two jet engines. On July 20, 1999, EastWind answered the complaint and denied liability. Thereafter, CIS moved to amend its complaint to seek $1,325,261 in damages for the aircraft lease arrearage and $287,500 for monies owed under four leases, each lease being for one commercial jet engine. The amendment also seeks to add EastWind's corporate parent, UM Holdings, Inc., as a party defendant responsible to pay whatever liability is assessed against EastWind.
The Company also filed suit in the Superior Court of Gilford County, North Carolina for return of the aircraft and engines. The Company has reached agreement with Eastwind for return of the aircraft and engines, without prejudice to its monetary claims. As the market value of the aircraft is less than its carrying value, failure to collect on the market monetary claim against Eastwind would result in a loss.
CIS Air is currently in litigation with Interglobal, Inc. ("Interglobal") and Aero California S.A. de C.V. ("Aero California") in the Superior Court of the State of California for the County of Orange. Aero California and Interglobal filed separate actions on April 13 and 14, 1999 seeking damages for an alleged breach of warranty of merchantability for an aircraft which Interglobal leased to Aero California on an "as is - where is" basis and for an alleged breach of contract for failing to negotiate in good faith to sell a second aircraft to Interglobal. CIS filed a cross-complaint against Aero California seeking to recover lease and maintenance payments which have not been made and against Interglobal for the accelerated amount due on the note and to foreclose on certain security pledged to secure the debts. The cases were consolidated. On July 1, 1999, the court found that CIS' claims are probably valid and issued a right to attach order permitting the marshal to seize assets of Interglobal and Aero California to secure the debt. The parties are currently engaged in settlement negotiations, but no agreement has been reached.
SCHEDULE II
CONTINENTAL INFORMATION SYSTEMS CORPORATION VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED MAY 31, 1999 (DOLLARS IN THOUSANDS)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Company incorporates herein by reference the information concerning directors and executive officers contained in its Notice of Annual Meeting of Stockholders and Proxy Statement to be filed within 120 days after the end of the Company's fiscal year (the "1999 Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Company incorporates herein by reference the information concerning executive compensation contained in the 1999 Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The Company incorporates herein by reference the information concerning security ownership of certain beneficial owners and management contained in the 1999 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company incorporates herein by reference the information concerning certain relationships and related transactions contained in the 1999 Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Annual Report:
Financial Statements. See "ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for Index to Financial Statements and Schedules included in this Form 10-K.
27.1 Financial Data Schedule.
- ----------
* Filed as an exhibit to the Company's amended Form 10 Registration Statement (Commission File No. 0-25104), originally filed November 10, 1994 and incorporated herein by reference.
** Incorporated by reference.
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the fiscal year 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
CONTINENTAL INFORMATION SYSTEMS CORPORATION
BY: /s/ MICHAEL L. ROSEN --------------------------------------------- Michael L. Rosen President, Chief Executive Officer and Director
BY: /s/ JONAH M. MEER --------------------------------------------- Jonah M. Meer Senior Vice President, Chief Operating Officer and Chief Financial Officer
Dated: August 30, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and the dates indicated:
SIGNATURE TITLE DATE --------- ----- ----
/s/ JAMES P. HASSETT Director and Chairman of the Board August 30, 1999 - ----------------------- James P. Hassett
/s/ GEORGE H. HEILBORN Director August 30, 1999 - ---------------------- George H. Heilborn
/s/ PAUL M. SOLOMON Director August 30, 1999 - ----------------------- Paul M. Solomon | 13,158 | 88,629 |
881788_1999.txt | 881788_1999 | 1999 | 881788 | Item 1. Business
General Development of Business
ICON Cash Flow Partners, L.P., Series E (the "Partnership") was formed in November 1991 as a Delaware limited partnership. The Partnership commenced business operations on its initial closing date, July 6, 1992, with the admission of 13,574.17 limited partnership units. Between July 7, 1992 and December 31, 1992, 236,021.97 additional units were admitted and from January 1, 1993 to July 31, 1993 (the final closing date), 360,815.37 additional units were admitted bringing the final admission to 610,411.51 units totaling $61,041,151 in capital contributions. From 1994 through 1998, the Partnership redeemed 2,556 limited partnership units. The Partnership did not redeem limited partnership units in 1999, leaving 607,855.51 limited partnership units outstanding at December 31, 1999. The sole general partner is ICON Capital Corp. (the "General Partner").
The Partnership's reinvestment period ended July 31, 1998. The disposition period began on August 1, 1998. During the disposition period the Partnership has and will continue to distribute substantially all distributable cash from operations and equipment sales to the partners and begin the orderly termination of its operations and affairs. The Partnership has not and will not invest in any additional finance or lease transactions during the disposition period. During the disposition period the Partnership expects to recover, at a minimum, the carrying value of its assets.
Narrative Description of Business
The Partnership is an equipment leasing income fund. The principal investment objective of the Partnership is to obtain the maximum economic return from its investments for the benefit of its limited partners. To achieve this objective, the Partnership has: (1) acquired a diversified portfolio of leases and financing transactions; (2) made monthly cash distributions to its limited partners from cash from operations, commencing with each limited partner's admission to the Partnership, (3) re-invested substantially all undistributed cash from operations and cash from sales in additional equipment and financing transactions during the reinvestment period; and (4) begun to sell the Partnership's investments and distribute the cash from sales of such investments to its limited partners.
The equipment leasing industry is highly competitive. In initiating its leasing transactions the Partnership competed with leasing companies, manufacturers that lease their products directly, equipment brokers and dealers and financial institutions, including commercial banks and insurance companies. Many competitors are larger than the Partnership and have greater financial resources.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
The Partnership has no direct employees. The General Partner has full and exclusive discretion in management and control of the Partnership.
Lease and Financing Transactions
For the years ended December 31, 1999 and 1998, the Partnership purchased and leased or financed $0 and $53,254,390 of equipment, respectively, with a weighted average initial transaction term of 0 and 44 months, respectively, and invested $84,535 and $87,185 in joint ventures in 1999 and 1998, respectively. Included in the summary of equipment cost by category below is 100% of the equipment cost acquired by two joint ventures in which the Partnership has a 99% and 75% interest. The Partnership accounts for these investments by consolidating 100% of the assets and liabilities of the joint ventures and reflecting, as a liability, the related minority interests. The equipment purchased by three other joint ventures in which the Partnership has a less than 50% interest are not included in this table. At December 31, 1999, the weighted average initial transaction term of the portfolio was 50 months. A summary of the portfolio equipment cost by category held at December 31, 1999 and 1998 is as follows:
The Partnership has one lease which individually represents greater than 10% of the total portfolio equipment cost at December 31, 1999. The lease is with Aerovias de Mexico, S.A. de C.V. ("Aero Mexico"). The underlying equipment is an aircraft and the asset represented 20.1% of the total portfolio cost at December 31, 1999.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 2.
Item 2. Properties
The Partnership neither owns nor leases office space or equipment for the purpose of managing its day-to-day affairs.
Item 3.
Item 3. Legal Proceedings
The Partnership is not a party to any pending legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 1999.
PART II
Item 5.
Item 5. Market for the Registrant's Securities and Related Security Holder Matters
The Partnership's limited partnership interests are not publicly traded nor is there currently a market for the Partnership's limited partnership interests. It is unlikely that any such market will develop.
Number of Equity Security Holders Title of Class as of December 31, - -------------- --------------------------------- 1999 1998 ---- ----
Limited partners 3,753 3,736 General Partner 1 1
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 6.
Item 6. Selected Consolidated Financial and Operating Data
Years Ended December 31, ------------------------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ----
Total assets ... $64,830,618 $86,918,230 $66,917,017 $77,934,170 $95,508,881 =========== =========== =========== =========== ===========
Partners' equity $14,692,389 $16,876,070 $23,689,694 $29,192,964 $34,807,701 =========== =========== =========== =========== ===========
The above selected consolidated financial data should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 7.
Item 7. General Partner's Discussion and Analysis of Financial Condition and Results of Operations
The Partnership's portfolio consisted of a net investment in finance leases, financings, operating leases and equity investments in joint ventures representing 48%, 25%, 26% and 1% of total investments at December 31, 1999, respectively, and 50%, 28%, 20% and 2% of total investments at December 31, 1998, respectively.
Results of Operations
Years Ended December 31, 1999 and 1998
For the year ended December 31, 1999 the Partnership did not purchase any new equipment investments. For the year ended December 31, 1998, the Partnership purchased and leased or financed equipment with an initial cost of $53,254,390 to 177 lessees or equipment users.
Revenues for the year ended December 31, 1999 were $10,203,685, representing an increase of $116,018 from 1998. The increase in revenues resulted primarily from an increase in finance income of $463,085 and an increase in gain on sales of equipment of $248,841. The increases were partially offset by a decrease in interest income and other of $317,254 and a decrease in income from equity investments in joint ventures of $290,954. The net gain on sales of equipment increased due to an increase in the number of leases maturing in which the underlying equipment was sold. The decrease in interest income and other was due primarily to decreased average levels of debt outstanding in 1999 versus 1998.
Expenses for the year ended December 31, 1999 were $7,961,175, representing a decrease of $1,078,786 from 1998. The decrease in expenses resulted primarily from decreases in interest expense of $389,060, provision for bad debts of $275,089, management fees of $278,814, administrative expense reimbursements of $117,474 and in amortization of initial direct costs of $202,107. These decreases were partially offset by increases in general and administrative expense of $127,122, depreciation expense of $41,708 and minority interest expense in joint ventures of $14,928.
Interest expense decreased due to a decrease in the average debt outstanding from 1998 to 1999. As a result of the ongoing analysis of delinquency trends, loss experience and an assessment of overall credit risk, the Partnership recorded provisions for bad debts of $1,000,000 and $1,275,089 for 1999 and 1998. Management fees and administrative expense reimbursements decreased due to a decrease in the average size of the portfolio from 1998 to 1999. Amortization of initial direct costs decreased due to a decrease in the average size of the portfolio subject to initial direct costs from 1998 to 1999.
Net income for the years ended December 31, 1999 and 1998 was $2,242,510 and $1,047,706, respectively. The net income per weighted average limited partnership unit was $3.65 and $1.71 for 1999 and 1998, respectively.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Years Ended December 31, 1998 and 1997
For the years ended December 31, 1998 and 1997, the Partnership purchased and leased or financed equipment with an initial cost of $53,254,390 and $23,112,295, respectively, to 177 and 447 lessees or equipment users, respectively.
Revenues for the year ended December 31, 1998 were $10,087,667, representing an increase of $2,476,374 or 33% from 1997. The increase in revenues resulted primarily from an increase in finance income of $2,796,741 or 83%, an increase in rental income of $436,325 or 22%, and an increase in income from equity investments in joint ventures of $232,086 or 217%. These increases were partially offset by a decrease in net gain on sales or remarketing of equipment of $557,256 or 46% and a decrease in interest income and other of $431,522 or 46%. Finance income increased due to an increase in the average size of the finance lease portfolio from 1997 to 1998. The Partnership's operating lease with Alaska Air terminated in April 1997 and the asset was subsequently released to Aero Mexico in June 1997. Rental income increased due to contractual rents under the new Aero Mexico lease being greater than contractual rents under the Alaska Air lease. The Partnership contributed equipment lease and finance receivables, residuals and cash totaling $16,287,305 to ICON Receivables 1997-A L.L.C. ("1997-A"), a joint venture, in September 1997. Income from the equity investments in joint ventures for 1997 includes three months of income related to the 1997-A investment compared to twelve months for 1998. The net gain on sales or remarketing of equipment decreased due to a decrease in the number of leases maturing in which the underlying equipment was sold or remarketed, for which the proceeds received were in excess of the average carrying value of the equipment. The decrease in interest income and other was due primarily to the decrease in interest income related to a loan from the Partnership to an affiliate, ICON Asset Acquisition L.L.C. The loan was repaid in August 1997.
Expenses for the year ended December 31, 1998 were $9,039,961, representing an increase of $3,797,253 or 72% from 1997. The increase in expenses resulted primarily from an increase in interest expense of $2,024,584 or 82%, an increase in the provision for bad debts of $1,275,088, an increase in management fees of $288,032 or 31%, an increase in administrative expense reimbursements of $171,074 or 35%, an increase in general and administrative expense of $187,820 or 51%, an increase in depreciation expense of $69,884 or 15% and an increase in minority interest in joint ventures of $7,088 or 12%. These increases were partially offset by a decrease in amortization of initial direct costs of $226,318 or 49%.
Interest expense increased due to an increase in the average debt outstanding from 1997 to 1998. As a result of the ongoing analysis of delinquency trends, loss experience and an assessment of overall credit risk, the Partnership recorded a $1,275,089 provision for bad debt. Management fees, administrative expense reimbursements and general and administrative expenses increased due to an increase in the average size of the portfolio from 1997 to 1998. Depreciation expense increased due to the Partnership's 1998 restructuring and releasing of its operating lease. Minority interest expense increased as a result of an increase in the net income of its consolidated joint venture, ICON Receivables 1997-B ("1997-B"). Although 1997-B increased its bad debt provision significantly in 1998, the entity's net income increased due to the increase in finance income related to the increase in the average size of the finance lease portfolio from 1997 to 1998. Amortization of initial direct costs decreased due to a decrease in the average size of the portfolio subject to initial direct costs from 1997 to 1998.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Net income for the years ended December 31, 1998 and 1997 was $1,047,706 and $2,368,585, respectively. The net income per weighted average limited partnership unit was $1.71 and $3.85 for 1998 and 1997, respectively.
Liquidity and Capital Resources
The Partnership's reinvestment period ended July 31, 1998. The disposition period began on August 1, 1998. During the disposition period the Partnership has and will continue to distribute substantially all distributable cash from operations and equipment sales to the partners and begin the orderly termination of its operations and affairs. The Partnership has not and will not invest in any additional finance or lease transactions during the disposition period. During the disposition period the Partnership expects to recover, at a minimum, the carrying value of its assets.
As a result of the Partnership's entering into the disposition period, future monthly distributions are expected to fluctuate depending on the amount of asset sale and re-lease proceeds received during that period.
The Partnership's primary sources of funds in 1999, 1998 and 1997 were net cash provided by operations of $11,671,010, $12,745,950 and $20,898,350, respectively, proceeds from sales of equipment of $3,776,513, $2,476,110 and $15,313,194, respectively, proceeds from a warehouse line of credit of $20,703,918 in 1998 and proceeds from securitization debt of $41,175,000 in 1998. These funds were used to purchase equipment in 1997 and 1998, and to provide for cash distributions and debt repayments in 1997, 1998 and 1999.
Cash distributions to the limited partners for the years ended December 31, 1999, 1998 and 1997, which were paid monthly, totaled $4,381,933, $7,755,553 and $7,768,316, respectively of which $2,220,085, $1,037,229 and $2,344,899 was investment income and $2,161,848 and $6,718,324 and $5,423,417 was a return of capital, respectively. The monthly annualized cash distribution rate to limited partners for the years ended December 31, 1999, 1998 and 1997 was 7.21%, 12.75% and 12.75%, of which 3.65%, 1.71% and 3.85% was investment income and 3.56%, 11.04% and 8.90% was a return of capital, respectively, calculated as a percentage of each partners' initial capital contribution.
As of December 31, 1999, except as noted above, there were no known trends or demands, commitments, events or uncertainties which are likely to have a material effect on liquidity. As cash is realized from operations and sales of equipment, the Partnership will distribute substantially all available cash, after retaining sufficient cash to meet its reserve requirements and recurring obligations.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
Page Number
Independent Auditors' Report 12
Consolidated Balance Sheets as of December 31, 1999 and 1998 13-14
Consolidated Statements of Operations for the Years Ended December 31, 1999, 1998 and 1997 15
Consolidated Statements of Changes in Partners' Equity for the Years Ended December 31, 1999, 1998 and 1997 16
Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997 17-19
Notes to Consolidated Financial Statements 20-29
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Financial Statements
December 31, 1999
(With Independent Auditors' Report Thereon)
INDEPENDENT AUDITORS' REPORT
The Partners ICON Cash Flow Partners, L.P., Series E:
We have audited the accompanying consolidated balance sheets of ICON Cash Flow Partners, L.P., Series E (a Delaware limited partnership) as of December 31, 1999 and 1998, and the related consolidated statements of operations, changes in partners' equity and cash flows for each of the years in the three-year period ended December 31, 1999. These consolidated financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1, the Partnership's reinvestment period ended July 31, 1998. The disposition period began on August 1, 1998. During the disposition period the Partnership has and will continue to distribute substantially all distributable cash from operations and equipment sales to the partners and begin the orderly termination of its operations and affairs.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ICON Cash Flow Partners, L.P., Series E as of December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles.
/s/ KPMG LLP KPMG LLP
March 28, 2000 New York, New York
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Balance Sheets
December 31,
(continued on next page)
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Balance Sheets (continued)
(unaudited)
See accompanying notes to consolidated financial statements.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Statements of Operations
For the Years Ended December 31,
See accompanying notes to consolidated financial statements.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Statements of Changes in Partners' Equity
For the Years Ended December 31, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Statements of Cash Flows
For the Years Ended December 31,
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Consolidated Statements of Cash Flows (continued)
For the Years Ended December 31,
See accompanying notes to consolidated financial statements.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Statements of Cash Flows (Continued)
Supplemental Disclosures of Cash Flow Information
Interest expense of $4,106,569, $4,495,629 and $2,471,045 for the years ended December 31, 1999, 1998 and 1997 consisted of: interest expense on non-recourse financing accrued or paid directly to lenders by lessees of $2,165,742, $2,484,621 and $1,443,747, respectively; interest on revolving credit facility of $0, $0, and $866,922, respectively, interest on the 1997-B warehouse facility of $951,005, $985,698 and $160,376, respectively; other interest of $0, $132 and $0, respectively; interest on securitized debt of $989,822, $1,025,178 and $0, respectively.
For the years ended December 31, 1999, 1998 and 1997, non-cash activities included the following:
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements
December 31, 1999
1. Organization
ICON Cash Flow Partners, L.P., Series E (the "Partnership") was formed on November 7, 1991 as a Delaware limited partnership with an initial capitalization of $2,000. It was formed to acquire various types of equipment, to lease such equipment to third parties and, to a lesser degree, to enter into secured financing transactions. The Partnership's offering period commenced on June 5, 1992 and by its final closing on July 31, 1993, 610,411.51 units had been admitted into the Partnership with aggregate gross proceeds of $61,041,151. From 1994 through 1997, the Partnership redeemed 1,966 limited partnership units. The Partnership redeemed 590 limited partnership units in 1998 leaving 607,856 limited partnership units outstanding at December 31, 1999 and 1998.
The Partnership's reinvestment period ended July 31, 1998. The disposition period began on August 1, 1998. During the disposition period the Partnership has and will continue to distribute substantially all distributable cash from operations and equipment sales to the partners and begin the orderly termination of its operations and affairs. The Partnership has not and will not invest in any additional finance or lease transactions during the disposition period. During the disposition period, the Partnership expects to recover, at a minimum, the carrying value of its assets.
The General Partner of the Partnership is ICON Capital Corp. (the "General Partner"), a Connecticut corporation. The General Partner manages and controls the business affairs of the Partnership's equipment leases and financing transactions under a management agreement with the Partnership.
ICON Securities Corp., an affiliate of the General Partner, received an underwriting commission on the gross proceeds from sales of all units. The total underwriting compensation paid by the Partnership, including underwriting commissions, sales commissions, incentive fees, public offering expense reimbursements and due diligence activities was limited to 13 1/2% of the gross proceeds received from the sale of the units. Such offering costs aggregated $8,240,555 (including $3,362,551 paid to the General Partner or its affiliates) and were charged directly to limited partners' equity.
Profits, losses, cash distributions and disposition proceeds are allocated 99% to the limited partners and 1% to the General Partner until each limited partner has received cash distributions and disposition proceeds sufficient to reduce its adjusted capital contribution account to zero and receive, in addition, other distributions and allocations which would provide a 10% per annum cumulative return, compounded daily, on its outstanding adjusted capital contribution account. After such time, the distributions will be allocated 90% to the limited partners and 10% to the General Partner.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
2. Significant Accounting Policies
Basis of Accounting and Presentation - The Partnership's records are maintained on the accrual basis. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. In addition, management is required to disclose contingent assets and liabilities.
Consolidation - The consolidated financial statements include the accounts of the Partnership and its majority owned subsidiaries, ICON E Corp., ICON Cash Flow Partners L.L.C. I ("ICON Cash Flow LLC I") and ICON Receivables 1997-B L.L.C. ("1997-B"). All inter-company accounts and transactions have been eliminated. The Partnership accounts for its interests in less than 50% owned joint ventures under the equity method of accounting. In such cases, the Partnership's original investments are recorded at cost and adjusted for its share of earnings, losses and distributions thereafter.
Leases - The Partnership accounts for owned equipment leased to third parties as finance leases or operating leases, as appropriate. For finance leases, the Partnership records, at the inception of the lease, the total minimum lease payments receivable, the estimated unguaranteed residual values, the initial direct costs related to the leases and the related unearned income. Unearned income represents the difference between the sum of the minimum lease payments receivable plus the estimated unguaranteed residual minus the cost of the leased equipment. Unearned income is recognized as finance income over the terms of the related leases using the interest method. For operating leases, equipment is recorded at cost and is depreciated on the straight-line method over the lease terms to their estimated fair market values at lease terminations. Related lease rentals are recognized on the straight-line method over the lease terms. Billed and uncollected operating lease receivables, net of allowance for doubtful accounts, are included in other assets. Initial direct costs of finance leases are capitalized and are amortized over the terms of the related leases using the interest method. Initial direct costs of operating leases are capitalized and amortized on the straight-line method over the lease terms. The Partnership's leases have terms ranging from two to eight years. Each lease is expected to provide aggregate contractual rents that, along with residual proceeds, return the Partnership's cost of its investments along with investment income.
Investment in Financings - Investment in financings represent the gross receivables due from the financing of equipment plus the initial direct costs related thereto less the related unearned income. The unearned income is recognized as finance income, and the initial direct costs are amortized, over the terms of the receivables using the interest method. Financing transactions are supported by a written promissory note evidencing the obligation of the user to repay the principal, together with interest, which will be sufficient to return the Partnership's full cost associated with such financing transaction, together with some investment income. Furthermore, the repayment obligation is collateralized by a security interest in the tangible or intangible personal property.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
Disclosures About Fair Value of Financial Instruments - Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures about Fair Value of Financial Instruments" requires disclosures about the fair value of financial instruments. Separate disclosure of fair value information as of December 31, 1999 and 1998 with respect to the Company's assets and liabilities is not provided because (i) SFAS No. 107 does not require disclosures about the fair value of lease arrangements, (ii) the carrying value of financial assets, other than lease related investments, and payables approximates market value and (iii) fair value information concerning non-recourse debt obligations is not practicable to estimate without incurring excessive costs to obtain all the information that would be necessary to derive a market interest rate.
Redemption of Limited Partnership Units - The General Partner consented to the partnership redeeming 590 limited partnership units during 1998. The redemption amount was calculated following the specific redemption formula in accordance with the Partnership agreement. Redeemed units have no voting rights and do not share in distributions. The Partnership agreement limits the number of units which can be redeemed in any one year and redeemed units may not be reissued. Redeemed limited partnership units are accounted for as a deduction from partners' equity.
Allowance for Doubtful Accounts - The Partnership records a provision for bad debts to provide for estimated credit losses in the portfolio. The allowance for doubtful accounts is based on the ongoing analysis of delinquency trends, loss experience and an assessment of overall credit risk. The Partnership's write-off policy is based on an analysis of the aging of the Partnership's portfolio, a review of the non-performing receivables and leases, and prior collection experience. An account is fully reserved for or written off when the analysis indicates that the probability of collection of the account is remote.
Impairment of Estimated Residual Values -- The Partnership's policy with respect to impairment of estimated residual values is to review, on a periodic basis, the carrying value of its residuals on an individual asset basis to determine whether events or changes in circumstances indicate that the carrying value of an asset may not be recoverable and, therefore, an impairment loss should be recognized. The events or changes in circumstances which generally indicate that the residual value of an asset has been impaired are (i) the estimated fair value of the underlying equipment is less than the Partnership's carrying value or (ii) the lessee is experiencing financial difficulties and it does not appear likely that the estimated proceeds from disposition of the asset will be sufficient to satisfy the remaining obligation to the non-recourse lender and the Partnership's residual position. Generally in the latter situation, the residual position relates to equipment subject to third party non-recourse notes payable where the lessee remits their rental payments directly to the lender and the Partnership does not recover its residual until the non-recourse note obligation is repaid in full.
The Partnership measures its impairment loss as the amount by which the carrying amount of the residual value exceeds the estimated proceeds to be received by the Partnership from release or resale of the equipment. Generally, quoted market prices are used as the basis for measuring whether an impairment loss should be recognized.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
Income Taxes - No provision for income taxes has been made as the liability for such taxes is that of each of the partners rather than the Partnership.
New Accounting Pronouncements - In June 1998 the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires that an entity recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value. SFAS No. 133 as amended, is effective for all quarters of fiscal years beginning after June 15, 2000. The adoption of SFAS No. 133 is not expected to have a material effect on the Partnership's net income, partners' equity or total assets.
3. Investments in Joint Ventures
The Partnership and affiliates formed five joint ventures for the purpose of acquiring and managing various assets.
The two joint ventures described below are majority owned and are consolidated with the Partnership.
ICON Cash Flow Partners L.L.C. I
In September 1994 the Partnership and an affiliate, ICON Cash Flow Partners L.P. Six ("L.P. Six"), formed a joint venture, ICON Cash Flow LLC I, for the purpose of acquiring and managing an aircraft which was on lease to Alaska Airlines, Inc. The Partnership and L.P. Six contributed 99% and 1% of the cash required for such acquisition, respectively, to ICON Cash Flow LLC I. ICON Cash Flow LLC I acquired the aircraft, assuming non-recourse debt and utilizing contributions received from the Partnership and L.P. Six. The lease is an operating lease. Profits, losses, excess cash and disposition proceeds are allocated 99% to the Partnership and 1% to L.P. Six. The Partnership's consolidated financial statements include 100% of the assets and liabilities of ICON Cash Flow LLC I. L.P. Six's investment in ICON Cash Flow LLC I has been reflected as "Minority interest in joint venture." The original lease term expired in April 1997 and Alaska Airlines, Inc. returned the aircraft. In June 1997 ICON Cash Flow LLC I released the aircraft to Aero Mexico. The new lease is an operating lease which expires in October 2002.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
ICON Receivables 1997-B L.L.C.
In August 1997 the Partnership, L.P. Six and ICON Cash Flow Partners L.P. Seven ("L.P. Seven") formed 1997-B, a special purpose entity formed for the purpose of originating leases and securitizing its portfolio. The Partnership, L.P. Six and L.P. Seven contributed $2,250,000 (75.00% interest), $250,000 (8.33% interest) and $500,000 (16.67% interest), respectively to 1997-B. In order to fund the acquisition of leases, 1997-B obtained a warehouse borrowing facility from Prudential Securities Credit Corporation. In October 1998, 1997-B completed an equipment securitization. The net proceeds from the securitization of these assets were used to pay-off the remaining 1997-B warehouse facility balance and any remaining proceeds were distributed to the 1997-B members in accordance with their membership interests. The Partnership's consolidated financial statements include 100% of the assets and liabilities of 1997-B. L.P. Six and L.P. Seven's interests in 1997-B have been reflected as "minority interests in consolidated joint ventures."
The three joint ventures described below are less than 50% owned and are accounted for following the equity method.
ICON Cash Flow Partners L.L.C. II
In March 1995 the Partnership and an affiliate, L.P. Six, formed ICON Cash Flow Partners L.L.C. II, ("ICON Cash Flow LLC II"), for the purpose of acquiring and managing an aircraft which was on lease to Alaska Airlines, Inc. The Partnership and L.P. Six contributed 1% and 99% of the cash required for such acquisition, respectively, to ICON Cash Flow LLC II. ICON Cash Flow LLC II acquired the aircraft, assuming non-recourse debt and utilizing contributions received from the Partnership and L.P. Six. The lease is an operating lease. Profits, losses, excess cash and disposition proceeds are allocated 1% to the Partnership and 99% to L.P. Six. The Partnership's investment in the joint venture is accounted for under the equity method. The original lease term expired in April 1997 and Alaska Airlines, Inc. returned the aircraft. In June 1997 ICON Cash Flow LLC II released the aircraft to Aero Mexico. The new lease is an operating lease which expires in September 2002.
Information as to the financial position and results of operations of ICON Cash Flow LLC II is summarized below:
December 31, 1999 December 31, 1998 ----------------- -----------------
Assets $15,508,243 $16,133,442 =========== ===========
Liabilities $ 9,602,139 $11,161,002 =========== ===========
Equity $ 5,906,100 $ 4,972,440 =========== ===========
Partnership's share of equity $ 59,061 $ 49,724 =========== ===========
Net income $ 933,664 $ 675,034 =========== ===========
Partnership's share of net income $ 9,337 $ 6,750 =========== ===========
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
ICON Cash Flow Partners L.L.C. III
In December 1996 the Partnership and an affiliate, L.P. Seven, formed ICON Cash Flow Partners L.L.C. III ("ICON Cash Flow LLC III"), for the purpose of acquiring and managing an aircraft currently on lease to Continental Airlines, Inc. The Partnership and L.P. Seven contributed 1% and 99% of the cash required for such acquisition, respectively, to ICON Cash Flow LLC III. ICON Cash Flow LLC III acquired the aircraft, assuming non-recourse debt and utilizing contributions received from the Partnership and L.P. Seven. Profits, losses, excess cash and disposition proceeds are allocated 1% to the Partnership and 99% to L.P. Seven. The Partnership's investment in the joint venture is accounted for under the equity method.
Information as to the financial position and results of operations of ICON Cash Flow LLC III is summarized below:
December 31, 1999 December 31, 1998 ----------------- ----------------- Assets $9,240,416 $10,166,470 ========== ===========
Liabilities $5,394,669 $ 6,810,691 ========== ===========
Equity $3,845,747 $ 3,355,779 ========== ===========
Partnership's share of equity $ 38,457 $ 33,558 ========== ===========
Net income $ 489,968 $ 461,083 ========== ===========
Partnership's share of net income $ 4,900 $ 4,611 ========== ===========
ICON Receivables 1997-A L.L.C.
In March 1997 three affiliates of the Partnership, ICON Cash Flow Partners, L.P., Series D ("Series D"), L.P. Six and L.P. Seven, contributed and assigned equipment lease and finance receivables and residuals to ICON Receivables 1997-A L.L.C.("1997-A"), a special purpose entity created for the purpose of originating leases, managing existing contributed assets and securitizing its portfolio. In September 1997 the Partnership, L.P. Six and L.P. Seven contributed and assigned additional equipment lease and finance receivables and residuals to 1997-A. The Partnership, Series D, L.P. Six and L.P. Seven received a 31.19%, 17.81%, 31.03% and 19.97% interest, respectively, in 1997-A based on the present value of their related contributions. The Partnership's contributions amounted to $15,547,305 in assigned leases and $740,000 of cash in 1997, $87,185 of cash in 1998 and $84,535 of cash and $98,474 in assigned leases in 1999. In September 1997, 1997-A securitized substantially all of its equipment leases and finance receivables and residuals. 1997-A became the beneficial owner of a trust. The Partnership's original investment was recorded at cost and is adjusted by its share of earnings, losses and distributions thereafter.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
Information as to the financial position and results of operations of 1997-A is summarized below:
December 31, 1999 December 31, 1998 ----------------- ----------------- Assets $17,967,441 $31,845,710 =========== ===========
Liabilities $14,701,353 $27,065,004 =========== ===========
Equity $ 3,266,388 $ 4,780,706 =========== ===========
Partnership's share of equity $ 720,673 $ 1,180,866 =========== ===========
Net income $ 108,923 $ 1,050,957 =========== ===========
Partnership's share of net income $ 33,974 $ 327,804 =========== ===========
Distributions $ 2,171,133 $ 2,367,147 =========== ===========
Partnership's share of distributions $ 677,198 $ 722,760 =========== ===========
4. Receivables Due in Installments
Non-cancelable minimum annual amounts receivable on finance leases and financings are as follows:
Finance Year Leases Financings Total
2000 $11,636,224 $ 7,311,890 $18,948,114 2001 7,995,160 5,285,500 13,280,660 2002 3,121,993 3,482,731 6,604,724 2003 1,003,699 - 1,003,699 2004 2,841,260 2,134,367 4,975,627 ----------- ----------- ----------- $26,598,336 $18,214,488 $44,812,824 =========== =========== ===========
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
5. Investment in Operating Lease
The investment in operating lease at December 31, 1999, 1998 and 1997 consisted of the following:
6. Allowance for Doubtful Accounts
The Allowance for Doubtful Accounts related to the investments in finance leases, financings and operating lease consisted of the following:
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
7. Notes Payable
As discussed in Note 3, in order to fund the acquisition of additional leases, 1997-B obtained a warehouse borrowing facility from Prudential Securities Credit Corporation (described herein as notes payable-warehouse line of credit). In October 1998, 1997-B completed an equipment securitization resulting in net proceeds of $41,175,000. These proceeds were used to pay-off $36,804,788 outstanding under the 1997-B warehouse line of credit. The remaining proceeds were distributed to the 1997-B members in accordance with their membership interests. The new securitized debt bears interest at a fixed rate of 6.19% and is payable from receivables related to the portfolio that secures it. At December 31, 1999, there was $25,691,428 outstanding under the notes payable-securitized debt.
Notes payable, bearing interest at rates ranging from 5.2% to 16.5%, mature as follows:
Notes Payable Notes Payable Year Securitized Debt Non-Recourse
2000 $10,424,554 $ 6,564,147 2001 7,954,324 3,569,954 2002 5,542,926 7,408,430 2003 1,598,263 3,553,136 2004 171,361 32,143 ----------- -----------
$25,691,428 $21,127,810 =========== ===========
Included in notes payable - non-recourse above is $1,224,266 in notes payable due to various third parties in conjunction with the purchase and assignment of lease transactions as they relate to residual sharing agreements. The notes are payable only to the extent certain residuals are realized
8. Related Party Transactions
Fees and other expenses paid or accrued by the Partnership to the General Partner or its affiliates for the years ended December 31, 1999, 1998 and 1997 are as follows: Charged to Operations
Management fees ..................... $ 919,728 Administration expense reimbursements 486,253 ----------
Year ended December 31, 1997 ........ $1,405,981 ==========
Management fees ..................... $1,207,760 Administrative expense reimbursements 657,327 ----------
Year ended December 31, 1998 ........ $1,865,087 ==========
Management fees ..................... $ 928,946 Administrative expense reimbursements 539,853 ----------
Year ended December 31, 1999 ........ $1,468,799 ==========
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
Notes to Consolidated Financial Statements - Continued
The Partnership has investments in five joint ventures with other partnerships sponsored by the General Partner. See Note 3 for additional information relating to the joint ventures.
9. Security Deposits, Deferred Credits and Other Payables
Security deposits, deferred credits and other payables at December 31, 1999 and 1998 include $1,000,000 and $1,330,615, respectively, of proceeds received on residuals, which will be applied upon final remarketing of the related equipment.
10. Subsidiary
In December 1994, the Partnership formed a wholly owned subsidiary, ICON E Corp., a Massachusetts corporation formed for the purpose of managing equipment under lease located in the state of Massachusetts. Massachusetts partnerships are taxed on personal property at a higher rate than corporations, and therefore, to mitigate such excess property tax, certain leases are being managed by ICON E Corp., a corporation. The Partnership's consolidated financial statements include 100% of the accounts of ICON E Corp. As of December 31, 1999, there was no federal tax liability for ICON E Corp.
11. Commitments and Contingencies
The Partnership has entered into remarketing and residual sharing agreements with third parties. In connection therewith, remarketing or residual proceeds received in excess of specified amounts will be shared with these third parties based on specified formulas. For the years ended December 31, 1999, 1998 and 1997, the Partnership paid $70,842, $1,701 and $67,895 to third parties as their share of the proceeds.
12. Tax Information (Unaudited)
The following reconciles net income for financial reporting purposes to income for federal income tax purposes for the years ended December 31:
1999 1998 1997 ---- ---- ----
Net income per financial statements $ 2,242,510 $ 1,047,706 $ 2,368,585
Differences due to: Direct finance leases .......... 4,842,466 5,618,432 7,067,155 Depreciation ................... (5,719,775) (7,028,534) (8,068,232) Provision for losses ........... (40,171) (33,272) (331,712) Loss on sale of equipment ...... (392,115) 2,971,331 478,364 Other .......................... (135,838) (887,487) (532,585) ----------- ----------- -----------
Partnership income (loss) for federal income tax purposes .... $ 797,077 $ 1,688,176 $ 981,575 =========== =========== ===========
As of December 31, 1999, the partners' capital accounts included in the financial statements totaled $14,692,389 compared to the partners' capital accounts for federal income tax purposes of $18,462,366 (unaudited). The difference arises primarily from commissions reported as a reduction in the partners' capital for financial reporting purposes but not for federal income tax purposes, and temporary differences related to direct finance leases, depreciation and provision for losses.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant's General Partner
The General Partner, a Connecticut corporation, was formed in 1985. The General Partner's principal offices are located at 111 Church Street, White Plains, New York 10601-1505, and its telephone number is (914) 993-1700. The officers of the General Partner have extensive experience with transactions involving the acquisition, leasing, financing and disposition of equipment, including acquiring and disposing of equipment subject to leases and full financing transactions.
The manager of the Registrant's business is the General Partner. The General Partner is engaged in a broad range of equipment leasing and financing activities. Through its sales representatives and through various broker relationships throughout the United States, the General Partner offers a broad range of equipment leasing services.
The General Partner is performing or causing to be performed certain functions relating to the management of the equipment of the Partnership. Such services include the collection of lease payments from the lessees of the equipment, re-leasing services in connection with equipment which is off-lease, inspections of the equipment, liaison with and general supervision of lessees to assure that the equipment is being properly operated and maintained, monitoring performance by the lessees of their obligations under the leases and the payment of operating expenses.
The officers and directors of the General Partner are as follows:
Beaufort J.B. Clarke Chairman, Chief Executive Officer and Director
Paul B. Weiss President and Director
Thomas W. Martin Executive Vice President and Director
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Beaufort J. B. Clarke, age 54, has been Chairman, Chief Executive Officer and Director of the General Partner since 1996. Prior to his present position, Mr. Clarke was founder and the President and Chief Executive Officer of Griffin Equity Partners, Inc. Mr. Clarke formerly was an attorney with Shearman and Sterling and has over 20 years of senior management experience in the United States leasing industry.
Paul B. Weiss, age 39, is President and Director of the General Partner. Mr. Weiss has been exclusively engaged in lease acquisitions since 1988 from his affiliations with the General Partner since 1996, Griffin Equity Partners (as Executive Vice President from 1993-1996); Gemini Financial Holdings (as Senior Vice President-Portfolio Acquisitions from 1991-1993) and Pegasus Capital Corporation (as Vice President-Portfolio Acquisitions from 1988-1991). He was previously an investment banker and a commercial banker.
Thomas W. Martin, age 46, has been Executive Vice President of the General Partner since 1996. Prior to his present position, Mr. Martin was the Executive Vice President and Chief Financial Officer of Griffin Equity Partners, Inc. (1993-1996), Gemini Financial Holdings (as Senior Vice President from 1992-1993) and Chancellor Corporation (as Vice President-Syndications from 1985-1992). Mr. Martin has 17 years of senior management experience in the leasing business.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 11.
Item 11. Executive Compensation
The Partnership has no directors or officers. The General Partner and its affiliates were paid or accrued the following compensation and reimbursement for costs and expenses for the years ended December 31, 1999, 1998 and 1997.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
(a) The registrant is a limited partnership and therefore does not have voting shares of stock. No person of record owns, or is known by the Partnership to own beneficially, more than 5% of any class of securities of the Partnership.
(b) As of March 24, 2000, Directors and Officers of the General Partner do not own any equity securities of the Partnership.
(c) The General Partner owns the equity securities of the Partnership set forth in the following table:
Title Amount Beneficially Percent of Class Owned of Class -------- ------------------- -------- General Partner Represents initially a 1% and potentially a 100% Interest 10% interest in the Partnership's income, gain and loss deductions.
Profits, losses, cash distributions and disposition proceeds are allocated 99% to the limited partners and 1% to the General Partner until each investor has received cash distributions and disposition proceeds sufficient to reduce its adjusted capital contribution account to zero and receive, in addition, other distributions and allocations which would provide a 10% per annum cumulative return, compounded daily, on the outstanding adjusted capital contribution account. After such time, the distributions will be allocated 90% to the limited partners and 10% to the General Partner.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
Item 13.
Item 13. Certain Relationships and Related Transactions
See Item 11 for a discussion of the Partnership's reimbursable management fees and administrative expenses.
See Note 3 for a discussion of the Partnership's related party investments in joint ventures.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) 1. Financial Statements - See Part II, Item 8 hereof.
2. Financial Statement Schedule - None.
Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Financial Statements or Notes thereto.
3. Exhibits - The following exhibits are incorporated herein by reference:
(i) Form of Dealer-Manager Agreement (Incorporated by reference to Exhibit 1.1 to Amendment No. 2 to Form S-1 Registration Statement No. 33-44413 filed with the Securities and Exchange Commission on June 4, 1992)
(ii) Form of Selling Dealer Agreement (Incorporated by reference to Exhibit 1.2 to Amendment No. 2 to Form S-1 Registration Statement No. 33-44413 filed with the Securities and Exchange Commission on June 4, 1992)
(iii)Amended and Restated Agreement of Limited Partnership (Incorporated herein by reference to Exhibit A to Amendment No. 2 to Form S-1 Registration Statement No. 33-44413 filed with the Securities and Exchange Commission on June 4, 1992)
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Partnership during the quarter ended December 31, 1999.
ICON Cash Flow Partners, L.P., Series E (A Delaware Limited Partnership)
December 31, 1999
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ICON CASH FLOW PARTNERS, L.P., Series E File No. 33-44413 (Registrant) By its General Partner, ICON Capital Corp.
Date: March 29, 2000 /s/ Beaufort J.B. Clarke ------------------------ Beaufort J.B. Clarke Chairman, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
ICON Capital Corp. sole General Partner of the Registrant
Date: March 29, 2000 /s/ Beaufort J.B. Clarke ------------------------ Beaufort J.B. Clarke Chairman, Chief Executive Officer and Director
Date: March 29, 2000 /s/ Paul B. Weiss ----------------- Paul B. Weiss President and Director
Date: March 29, 2000 /s/ Thomas W. Martin -------------------- Thomas W. Martin Executive Vice President (Principal Financial and Accounting Officer)
Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) of the Act by Registrant which have not Registered Securities Pursuant to Section 12 of the Act
No annual report or proxy material has been sent to security holders. An annual report will be sent to the limited partners and a copy will be forwarded to the Commission. | 8,035 | 53,922 |
1041864_1999.txt | 1041864_1999 | 1999 | 1041864 | ITEM 1. BUSINESS
GENERAL
SDG&E Funding LLC (the "Note Issuer") is a special-purpose, single-member limited liability company organized under the laws of the State of Delaware. San Diego Gas & Electric Company ("SDG&E"), as the sole member of the Note Issuer, owns all of the equity securities of the Note Issuer. The Note Issuer was organized in July 1997 for the limited purposes of holding and servicing the Transition Property (as described below) and issuing notes secured by the Transition Property and other limited collateral and related activities, and is restricted by its organizational documents from engaging in other activities. The Note Issuer's organizational documents require it to operate in a manner such that it should not be consolidated in the bankruptcy estate of SDG&E in the event SDG&E becomes subject to such a proceeding.
The only material business conducted by the Note Issuer has been the acquisition of Transition Property and the issuance on December 16, 1997 of $658,000,000 in principal amount of the SDG&E Funding LLC Notes, Series 1997-1, Class A-1 through Class A-7 (the "Notes"), with scheduled maturities ranging from one year to ten years and final maturities ranging from three to twelve years. The specific interest rate and maturity of each class of Notes is specified in Note C of the Notes to Financial Statements herein. The Notes were issued pursuant to an Indenture between the Note Issuer and Bankers Trust Company of California, N.A., as trustee (the "Indenture"). The Note Issuer sold the Notes to the California Infrastructure and Economic Development Bank Special Purpose Trust SDG&E-1, a Delaware business trust (the "Trust"), which issued certificates corresponding to each class of Notes (the "Certificates") in a public offering.
The Note Issuer has no employees. It has entered into a servicing agreement (the "Servicing Agreement") with SDG&E, pursuant to which SDG&E is required to service the Transition Property on behalf of the Note Issuer. In addition, the Note Issuer has entered into an Administrative Services Agreement with SDG&E pursuant to which SDG&E performs administrative and operational duties for the Note Issuer.
TRANSITION PROPERTY
The California Public Utilities Code (the "PU Code") provides for the creation of "Transition Property." A financing order dated September 3, 1997 (the "Financing Order") issued by the California Public Utilities Commission (the "CPUC"), together with the related Issuance Advice Letter, establishes, among other things, separate nonbypassable charges (the "FTA Charges") payable by residential electric customers and small commercial electric customers in an aggregate amount sufficient to repay in full the Certificates, fund the Overcollateralization Subaccount established under the Indenture and pay all related costs and fees. Under the PU Code and the Financing Order, the owner of the Transition Property is entitled to collect FTA Charges until such owner has received amounts sufficient to retire all outstanding series of Certificates and cover related fees and expenses and the Overcollateralization Amount described in the Financing Order. The Transition Property is a property right under California law that includes, without limitation, ownership of the FTA Charges and any adjustments thereto as described in the next paragraph.
In order to enhance the likelihood that actual collections with respect to the Transition Property are neither more nor less than the amount necessary to amortize the Notes in accordance with their expected amortization schedules, pay all related fees and expenses, and fund certain accounts established pursuant to the Indenture as required, the Servicing Agreement requires SDG&E, as the servicer of the Transition Property (in such capacity, the "Servicer"), to seek, and the Financing Order and the PU Code require the CPUC to approve, periodic adjustments to the FTA Charges. Such adjustments will be based on actual collections with respect thereto and updated assumptions by the Servicer as to future usage of electricity by specified customers, future expenses relating to the Transition Property, the Notes and the Certificates, and the rate of delinquencies and write-offs. The FTA Charges will be adjusted at least annually if there is a material shortfall or overage in collections.
THE TRUST
The Trust was organized in November 1997 solely for the purpose of purchasing the Notes and issuing the Certificates. It will not conduct any other material business activities.
ITEM 2.
ITEM 2. PROPERTIES
The Note Issuer and the Trust have no tangible properties. The primary assets of the Note Issuer and the Trust are the Transition Property and the Notes, respectively, as described above in Item 1. Collections related to the Transition Property and the related payments on the Notes in 1999 and 1998 are shown on the Statements of Cash Flows included in this Annual Report.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS None.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Omitted with respect to the Note Issuer pursuant to Instruction I of Form 10-K.
No matters were submitted for a vote or consent of holders of Certificates in 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) There is no established public trading market for the Note Issuer's equity securities. All of the Note Issuer's equity is owned by SDG&E. On August 11, 1997, SDG&E transferred $400,000 to the Note Issuer as an initial capital contribution, and SDG&E made capital contributions to the Note Issuer aggregating to $3,290,000. The sale of such membership interest was exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(2) thereof. The Note Issuer has made no other sales of unregistered securities.
The Indenture prohibits the Note Issuer from making any distributions to the sole member from the amounts allocated to the Note Issuer unless no default has occurred and is continuing thereunder and the book value of the remaining equity of the Note Issuer, after giving effect to such distribution, is equal to at least 0.5% of the original principal amount of all series of Notes which then remains outstanding. As of December 31, 1999, the original principal amount of all series of Notes which then remained outstanding was $526,400,000. As of December 31, 1999, the Note Issuer has not made any distributions to SDG&E. The Note Issuer intends to make distributions to the sole member from time to time in the future as permitted by the Indenture.
The registered owner for each class of the Certificates is Cede & Co., as nominee of The Depository Trust Company ("DTC"). DTC has informed the Note Issuer that as of March 27, 2000, there were approximately 100 beneficial holders of Certificates. The Certificates are not registered and do not trade on any established trading market.
(b) The Note Issuer's Amendment No. 4 to the Registration Statement No. 333-30761 on Form S-3, as filed with the Securities and Exchange Commission (the "Commission") on November 21, 1997 (the "Registration Statement") for the sale of the Notes and the Certificates was declared effective by the Commission on November 24, 1997. The Certificates were offered for sale beginning on December 4, 1997. Certificates in the aggregate amount of $658,000,000 were sold on December 16, 1997. In connection with the offering of the Certificates, Morgan Stanley, Inc. and Lehman Brothers Inc. acted as the managing underwriters. The Trust purchased the Notes from the Note Issuer on December 16, 1997, pursuant to a private sale in the aggregate amount of $658,000,000. Notes and Certificates in the aggregate principal amount of $800,000,000 were authorized and $658,000,000 have been offered and sold to date. All of the Notes offered in the sale were purchased. The amount of each class of Notes and Certificates registered and the respective sale prices, which exclude the original issue discount, are as follows:
The net offering proceeds to the Trust were $654,728,789: the $658,000,000 received in the sale of the Certificates less $3,125,498 of underwriting discount and commission, and $145,713 of original issue discount. The Trust used all of the net proceeds from the sale of Certificates to purchase the Notes from the Note Issuer. The net offering proceeds to the Note Issuer were used to purchase the Transition Property. Compensation paid to the independent director of the Note Issuer was $3,800. Other than the payment to the independent director, no additional net offering proceeds were used to pay, either directly or indirectly, any director, officer or affiliate of the Note Issuer.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Omitted pursuant to Instruction I ("Omission of Information by Certain Wholly Owned Subsidiaries") of Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following analysis of the Note Issuer's results of operations is in an abbreviated format pursuant to Instruction I of Form 10-K.
As discussed above under "Item 1. Business", the Note Issuer was established in July 1997 for limited purposes. As discussed above under Item 5 (Market for Registrant's Common Equity and Related Stockholder Matters), on December 16, 1997, the Note Issuer issued Notes in order to purchase Transition Property. The Note Issuer is restricted by its organizational documents from engaging in activities other than those described in Item 1.
The Note Issuer expects to use collections with respect to the Transition Property to make scheduled principal and interest payments on the Notes. Interest income earned on the Transition Property is expected to offset (1) interest expense on the Notes, (2) amortization of debt- issuance expenses and the discount on the Notes, and (3) the fees charged by SDG&E for servicing the Transition Property and providing administrative services to the Note Issuer. (These agreements are discussed in greater detail in Note D to the Financial Statements attached hereto.)
Collections of FTA Charges since inception of the program have met expectations. For 1999, collections of $101,401,000 resulted in an undercollection of $1,526,000 after deducting scheduled principal and interest payments of $101,077,000, payments of $1,521,000 for servicing fees and other expenses, and $329,000 retained to fund the Overcollateralization Account established under the Notes' indenture. The undercollection was deducted from the previous surplus collections. For 1998, collections of $115,360,000 resulted in an overcollection of $6,423,000 after deducting scheduled principal and interest payments of $106,556,000, payments of $2,051,000 for servicing fees and other expenses, and $330,000 retained to fund the Overcollateralization Account established under the Notes' indenture. The remaining excess collections will be applied toward future payments on the Notes. Management believes that it is reasonable to expect future collections of FTA Charges to be sufficient to make scheduled payments on the Notes and pay related expenses on a timely basis. The FTA Charges will be adjusted at least annually if there is a material shortfall or overage in collections.
The Note Issuer has no computer systems of its own and relies on certain systems of SDG&E for information. There were only a few, very minor Year 2000 interruptions to SDG&E's automated systems and applications with suppliers and customers.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable to the Note Issuer or the Trust.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and related financial information required to be filed hereunder are indexed on page 10 of this Annual Report.
Since the Trust is a pass-through entity with no assets other than the Notes, financial statements for the Trust are not included. In addition, Exhibit 99.1 contains financial information regarding collections of FTA Charges by the Servicer for the fourth quarter of 1999.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable with respect to the Note Issuer or the Trust.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Omitted pursuant to Instruction I of Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Omitted pursuant to Instruction I of Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Omitted pursuant to Instruction I of Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Omitted with respect to the Note Issuer pursuant to Instruction I of Form 10-K.
Not applicable to the Trust.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1. Financial Statements.
The following financial statements of the Note Issuer and report of independent auditors are included in Item 8:
Independent Auditors' Report Statements of Operations and Changes in Member's Equity Balance Sheets Statements of Cash Flows Notes to Financial Statements
2. Financial Statement Schedules.
None.
3. Exhibits.
The following exhibits are filed as a part of this report:
Exhibit Description ------- -----------
3.1 Certificate of Formation. (1) 3.2 Limited Liability Company Agreement. (1) 3.3 Amended and Restated Limited Liability Company Agreement. (1) 4.1 Note Indenture. (2) 4.2 Amended and Restated Declaration and Agreement of Trust. (1) 4.3 Series Supplement. (2) 4.4 Form of Note. (1) 4.5 First Supplemental Trust Agreement. (2) 4.6 Form of Rate Reduction Certificate. (2) 10.1 Transition Property Purchase and Sale Agreement. (2) 10.2 Transition Property Servicing Agreement. (2) 10.3 Note Purchase Agreement. (2) 10.4 Fee and Indemnity Agreement. (2) 23.1 Consent of Deloitte & Touche LLP. 27.1 Financial Data Schedule. 99.1 Quarterly Servicer's Certificate dated December 13, 1999. ____________________________ (1) Incorporated by reference to the same-titled exhibit to the Note Issuer and Trust's Registration Statement on Form S-3, as amended, File No. 333-30761.
(2) Incorporated by reference to the same-titled exhibit to the Note Issuer and Trust's Current Report on Form 8-K filed with the Commission on December 23, 1997.
(b) Reports on 8-K.
There were no reports on Form 8-K filed after September 30, 1999.
FINANCIAL STATEMENT INDEX
Independent Auditors' Report.............................. 11
Statements of Operations and Changes In Member's Equity... 12
Balance Sheets............................................ 13
Statements of Cash Flows.................................. 14
Notes to Financial Statements............................. 15
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of SDG&E Funding LLC:
We have audited the accompanying balance sheets of SDG&E Funding LLC as of December 31, 1999 and 1998, and the related statements of operations and changes in member's equity and cash flows for the years ended December 31, 1999 and 1998 and for the period from July 1, 1997 (inception) to December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of SDG&E Funding LLC as of December 31, 1999 and 1998, and the results of their operations and their cash flows for the years ended December 31, 1999 and 1998 and for the period from July 1, 1997 (inception) to December 31, 1997 in conformity with generally accepted accounting principles.
/s/ DELOITTE & TOUCHE LLP
San Diego, California February 4, 2000
See notes to financial statements.
See notes to financial statements.
See notes to financial statements.
NOTES TO FINANCIAL STATEMENTS
A. Nature of Operations
The financial statements include the accounts of SDG&E Funding LLC (SDG&E Funding), a Delaware special-purpose limited-liability company, whose sole member is San Diego Gas & Electric Company (SDG&E), a provider of electric and natural gas services. SDG&E is a wholly owned subsidiary of Sempra Energy. SDG&E Funding was formed on July 1, 1997, in order to effect the issuance of notes (the Underlying Notes) intended to support a 10-percent electric-rate reduction. This reduction is provided to SDG&E's residential and small commercial customers in connection with the electric industry restructuring mandated by California Assembly Bill 1890.
SDG&E Funding was organized for the limited purposes of issuing the Underlying Notes and purchasing Transition Property. Transition Property is the right to be paid a specified amount from a nonbypassable charge levied on residential and small commercial customers. The nonbypassable charge has been authorized by the California Public Utility Commission (CPUC) pursuant to electric restructuring legislation.
SDG&E Funding is restricted by its organizational documents from engaging in any other activities. In addition, SDG&E Funding's organizational documents require it to operate in such a manner that it should not be consolidated in the bankruptcy estate of SDG&E in the event that SDG&E becomes subject to such a proceeding.
SDG&E Funding is legally separate from SDG&E. The assets of SDG&E Funding are not available to creditors of SDG&E or Sempra Energy. SDG&E Funding will cease to exist upon the maturation or retirement of the Underlying Notes.
B. Summary of Accounting Policies
Restricted Funds
SDG&E Funding is required to maintain funds of approximately $3 million. These funds are to be used to make scheduled payments on the Underlying Notes and to pay other expenses of SDG&E Funding in the event that collections of the nonbypassable charge provide insufficient funds to make such payments.
Unamortized Debt Issuance Expense
The expenses associated with the issuance of the Underlying Notes have been capitalized and are being amortized over the life of the Underlying Notes.
Income Taxes
SDG&E Funding is a single-member limited-liability company. Accordingly, all federal income tax effects and all material State of California franchise tax effects of SDG&E Funding's activities accrue to SDG&E.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the reporting period. Actual results could differ from these estimates.
C. Long-Term Debt
In December 1997, SDG&E Funding issued $658 million of the Underlying Notes to the California Infrastructure and Economic Development Bank Special Purpose Trust (the Trust). The Trust, in turn, issued pass- through certificates known as "rate-reduction bonds" with an original principal amount equal to the original principal amount of the Underlying Notes. SDG&E Funding used the proceeds from the Underlying Notes to purchase the Transition Property from SDG&E.
The Underlying Notes are secured solely by the Transition Property and other assets of SDG&E Funding. Scheduled maturities and interest rates for the Underlying Notes at December 31 are as follows:
Scheduled 1999 1998 Maturity Interest Amount Amount Class Date Rate (Dollars in thousands) - --------------------------------------------------------------------- A-2 March 25, 2000 6.04% $ 16,839 $ 82,639 A-3 March 25, 2001 6.07% 66,231 66,231 A-4 March 25, 2002 6.15% 65,672 65,672 A-5 September 25, 2003 6.19% 96,538 96,538 A-6 September 25, 2006 6.31% 197,584 197,584 A-7 December 26, 2007 6.37% 83,536 83,536 ----------- ---------- 526,400 592,200 Less current portion (65,800) (65,800) ----------- ----------- Long-term debt $460,600 $526,400 =========== ===========
The carrying amounts and fair values of the Underlying Notes are $526 million and $511 million, respectively, at December 31, 1999, and $592 million and $607 million, respectively, at December 31, 1998. The fair values of the Underlying Notes are estimated based on quoted market prices for them or for similar issues.
The source of repayment is the nonbypassable charge authorized by the CPUC. This nonbypassable charge is collected by SDG&E, as Servicer, from its residential and small commercial customers. Collections of the nonbypassable charge are deposited on a monthly basis by SDG&E with SDG&E Funding in an account maintained by the trustee (Bankers Trust Company). Each quarter such monies are used to make principal and interest payments on the Underlying Notes. The debt service requirements include an overcollateralization amount that is retained for the benefit of the holders of the Underlying Notes. Any amounts not required for debt service will be returned to SDG&E Funding.
D. Significant Agreements and Related Party Transactions
Under a Transition Property Servicing Agreement, SDG&E, the Servicer, is required to manage and administer the Transition Property of SDG&E Funding and to collect the nonbypassable charge from electric customers on behalf of SDG&E Funding. SDG&E Funding pays a servicing fee equal to 0.25% of the outstanding principal amount of the Underlying Notes. The Servicer is also entitled to receive as compensation any interest earnings on nonbypassable charge collections prior to remittance to the Trust and any late payment charges collected from SDG&E's customers.
The Trust was created for the limited purposes of purchasing the Underlying Notes from SDG&E Funding, issuing the rate-reduction bonds, and applying the proceeds from the Underlying Notes to the payment of the rate-reduction bonds. Under a Fee and Indemnity Agreement, SDG&E Funding is responsible for paying all fees and expenses incurred by the Certificate Trustee (Bankers Trust Company) and the Delaware Trustee (Bankers Trust Delaware).
E. Quarterly Financial Data (Unaudited) Quarter ended ----------------------------------------------- Dollars in millions March 31 June 30 September 30 December 31 - ---------------------------------------------------------------------- Income $ 9,349 $ 8,965 $ 8,849 $ 8,721
Expenses 9,349 8,965 8,849 8,721 ----------------------------------------------- Net income (loss) $ 0 $ 0 $ 0 $ 0 ===============================================
Income $ 12,112 $ 10,172 $ 9,925 $ 9,820
Expenses 12,115 10,172 9,925 9,820 ----------------------------------------------- Net income (loss) $ (3) $ 0 $ 0 $ 0 ===============================================
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SDG&E Funding LLC, as Registrant
By: /s/ Charles A. McMonagle ------------------------------ Name: Charles A. McMonagle Title: President and Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Signature Title Date - ---------- ----- ----
/s/ Charles A. McMonagle President, Chief Executive March 27, 2000 - ------------------------- Officer and Director Charles A. McMonagle
/s/ James P. Trent Chief Financial Officer, March 27, 2000 - ------------------------ Chief Accounting Officer James P. Trent and Director
/s/ Donald J. Puglisi Director March 27, 2000 - ------------------------ Donald J. Puglisi | 3,685 | 24,318 |
1003481_1999.txt | 1003481_1999 | 1999 | 1003481 | ITEM 1. BUSINESS
COMPANY INTRODUCTION
We are the leading global provider of thermal management solutions for electronic products and the leading developer and marketer of CFD software. Each of these businesses has an established reputation for high product quality, service excellence and engineering innovation in its market. We design, manufacture and distribute on a worldwide basis thermal management products that dissipate unwanted heat, which can degrade system performance and reliability, from microprocessors and industrial electronics products. Our products, which include heat sinks, interface materials and attachment accessories, fans, heat spreaders and liquid cooling and phase change devices that we configure to meet customer-specific needs, serve the critical function of conducting, convecting and radiating away unwanted heat. CFD software is used in complex computer-generated modeling of fluid flows, heat and mass transfer and chemical reactions. Our CFD software is used in a variety of industries, including the automotive, aerospace, chemical processing, power generation, material processing, electronics and HVAC industries.
We believe the demand for thermal management products and CFD software is growing. The increase in unwanted heat generated in electronic and other products is primarily a result of more powerful semiconductors and the growing number of semiconductors being used in individual products. The growing demand for our thermal management products is driven by the need to dissipate the increasing amount of heat generated by electronic products, as well as strong unit growth. The increase in heat requires more complex thermal solutions, which in turn is driving the trend among our customers and other electronics manufacturers to outsource development of thermal management solutions. Through our product design capabilities and customer relationships, we lead the thermal management industry in meeting this growing demand. The demand for CFD software is driven by the need to reduce product development costs, minimize time-to-market for new products and improve product performance. Through our technological leadership in CFD software, we will continue to develop software to meet the needs of our customers and others in this growing market. These trends have contributed to the growth in our net sales.
Our thermal management products are used in a wide variety and growing number of computer and networking and industrial electronics applications, including computer systems (desktops, laptops, disk drives, printers and peripheral cards), network devices (servers, routers, set top boxes and local area networks), telecommunications equipment (wireless base stations, satellite stations and PBXs), instrumentation (semiconductor test equipment, medical equipment and power supplies), transportation and motor drives (braking and traction systems) and consumer electronics (stereo systems and video games). Our CFD software is used for a wide variety of computer-based analyses, including the design of electronic components and systems, automotive design, combustion systems modeling and process plant troubleshooting. We have longstanding relationships with a highly diversified base of more than 3,500 national and international customers, including original equipment manufacturers (commonly referred to as OEMs), electronics distributors and contract manufacturers. Our customers include Acer, Apple, Arrow, AT&T, Cisco Systems, Compaq Computer, DaimlerChrysler, Dell, Dow Chemical, Ericsson, Ford, Fujitsu, General Electric, Harmon-Kardon, Hewlett-Packard, IBM, Intel, Lockheed Martin, Lucent, Motorola, Nortel, Rockwell Automation, Rolls Royce, SCI Systems, Siemens, Silicon Graphics, Solectron and Sun Microsystems.
In October 1999, we completed the acquisition of the Thermalloy Division of Bowthorpe plc ("Thermalloy") for a total purchase price of $84.6 million (including transaction costs of $2.8 million). Thermalloy designs, manufactures and sells a wide variety of standard and proprietary heat sinks and associated products, similar to those designed and manufactured by Aavid Thermal Products, our thermal management business, within the computer and networking and industrial electronics (including telecommunications) industries. Thermalloy has manufacturing facilities in Dallas, Texas; Monterrey, Mexico; Corby and Swindon, England; Bologna, Italy; and Malacca, Malaysia. As part of this acquisition from Bowthorpe, we acquired 65.2%, representing Bowthorpe's entire shareholding, of Curamik Electronics GmbH ("Curamik"), as well as an additional 20.2% of Curamik from two minority shareholders for approximately $2.7 million, thereby increasing our ownership to 85.4%. Curamik is a German corporation that manufactures direct bonded copper substrates used in the packaging and cooling of high power electronic devices.
On August 23, 1999, we entered into an Agreement and Plan of Merger ("Merger Agreement") with Heat Holdings Corp., a corporation newly formed by Willis Stein & Partners II, L.P. ("the Purchaser"), and Heat Merger Corp., a wholly owned subsidiary of the Purchaser ("Merger Sub"), providing for the merger of the Merger Sub with and into Aavid ("the Merger"), with Aavid being the surviving corporation. The Merger was approved by the Company's stockholders on January 29, 2000 and consummated on February 2, 2000. Pursuant to the Merger, Aavid stockholders received $25.50 in cash for each outstanding share of common stock, and outstanding stock options and warrants were cashed out. The Merger will be accounted for using the purchase method. In connection with the Merger, we consolidated our business into two operating segments: Aavid Thermalloy LLC, which designs, manufacturers and distributes
thermal management products that dissipate unwanted heat from microprocessors and industrial electronics products, and include Applied Thermal Technologies, Inc.'s thermal design, validation and consulting services; and Fluent, which develops and markets CFD software.
INDUSTRY OVERVIEW(1)
THERMAL MANAGEMENT
In today's electronic environment, microprocessors and their associated power supplies, hard drives, advanced video chips and other peripheral devices draw large amounts of power and, consequently, must dissipate a significant amount of heat. The same heat generation occurs in semiconductors and integrated circuits in motor controls, telecommunications switches and other electronics. Because these electronic components can only operate efficiently in narrow temperature bands, heat is an absolute constraint in electronic system design. The excessive heat generated within a component not only degrades semiconductor and system performance and reliability, but can also cause semiconductor and system failure.
Increasingly, neither externally generated off-the-shelf thermal management products nor internally designed and produced parts have been able to effectively address the expanding complexity of thermal management problems resulting from the increasing amount of heat required to be dissipated by electronic products. The complexity of thermal management problems has been intensified by reductions in system size, shorter time-to-market, shorter product life cycles and more demanding operating environments.
These factors have led to the development and growth of the thermal management industry. We estimate that the size of the worldwide thermal management market was approximately $4.1 billion in 1999. This $4.1 billion market can be broken down into eight industry types as illustrated in the table below. We further estimate that the worldwide thermal management market will grow at a compound annual growth rate of approximately 12.8% to $6.6 billion in 2003.
The worldwide electronic thermal management market is divided between solutions that are internally designed and produced by OEMs (i.e., "in-house" thermal solutions) and those that are externally supplied by thermal management companies (i.e., "outsourced" thermal solutions). Based on our experience in the industry and industry data, we estimate that the size of the in-house thermal solutions market is approximately $1.2 billion and the size of the outsourced thermal solutions market is approximately $2.9 billion, or 72% of the worldwide electronic thermal management market. As thermal management problems become increasingly complex, we believe that manufacturers will increasingly outsource their thermal management design and production in order to focus on their core competencies. We further believe that the market for the types of thermal management products and services we offer in our existing geographic locations comprises only 45% of the $2.9 billion outsourced thermal solutions market. We believe that, as the market leader, we will benefit from the expected growth in the worldwide electronic thermal management market and that, through geographic and product expansion, we have a significant opportunity to address a larger portion of the outsourced segment of this market than we currently address.
Electronics manufacturers seek to respond to end user demands and increasing competition by offering new products with improved performance (functionality and speed) and greater reliability in smaller forms and at lower prices. This greater functionality, speed and the miniaturization of component housing has resulted in an increase in unwanted heat generated by electronics products. The demand for thermal management products is driven by the need to dissipate the increasing amount of heat generated by electronic products.
We believe that future growth of the thermal management products market will be driven by the following factors:
- Inherent unit growth in end-user products, such as desktop computers, laptops and telecommunications equipment. In particular, the volume of microprocessors and support chip units is increasing on an absolute and on a per product basis.
- The wider use of electronic controls in numerous areas due to the general increase in automation.
- ----------------------------- (1) Unless otherwise indicated, all industry data and statistics relating to the thermal management industry and its segments contained in this Annual Report on Form 10-K are management estimates that are based on its experience and independent reports on the electronics industry periodically issued by Electronics Industry Outlook, together with a study on thermal content in electronics products conducted by International Interconnection Intelligence for Aavid in 1996. Information relating to the existing computational fluid dynamics, or CFD, software market is based on publicly available information about our key competitors and internal management estimates; and information relating to the potential CFD software market is based on a study we conducted at the time we acquired our CFD software business. Although we believe the information on which we have based our estimates is reliable, we cannot guarantee the accuracy or completeness of such information and have not independently verified any of it.
- The increasing use of microprocessors in industrial electronics applications, fueling the need for thermal management products to manage the different operating temperature characteristics of these devices.
- The increased need for reliable power supplies. The quality of power can be adversely affected by thermal overload arising from ineffective thermal management. This is becoming increasingly important within the industrial, computer and telecommunications sectors where "irregular" power surges can damage equipment and cause productivity loss.
- The complexity of thermal management problems, which has been intensified by the increasing amount of heat to be dissipated, reductions in system size, shorter time-to-market product cycles and more demanding temperature operating environments.
COMPUTATIONAL FLUID DYNAMICS SOFTWARE
CFD software is used in a wide range of industries for complex computer-based analysis of engineering designs involving fluid flows, heat and mass transfer, chemical reaction and other fluid flow phenomena. CFD software tools allow the analysis and evaluation of design modifications without the physical prototyping of each design modification, thereby reducing engineering cost, improving product performance and decreasing time-to-market for new products. Specific uses of CFD-based flow analysis include the design of electronic components and systems, automotive design, combustion systems modeling and process plant troubleshooting.
Over the past decade, increases in computing power have made CFD-based computer analysis of complex fluid flows feasible on computers that are readily available to research and development and engineering departments. Development of CFD software technology is expanding that market beyond its traditional user base of Ph.D-level engineers in corporate research and development centers to the larger base of design engineers working in product development. Finally, CFD software tools are part of the growing trend toward improved engineering efficiency through computer-aided analysis and design by integrating CFD software with geometric modeling and design.
The CFD software market has been growing rapidly during the past decade. Based on publicly available information from a number of our key competitors and internal management estimates, we believe that in 1998 the size of the developed market for CFD software applications was approximately $100 million. We further believe that this market has grown approximately 20% annually since 1992 and we expect to benefit from the anticipated continued growth of this market. Based on a market study we conducted in connection with our acquisition of Fluent, we estimate that the size of the potential market for CFD software products is currently approximately $500 million. We also believe that, through Fluent, we have approximately 40% of the developed market for CFD software applications.
We expect that future growth of the CFD software market will be driven by the following factors:
- The ability of customers using CFD software to reduce their product development costs, minimize time-to-market for their new products and improve product performance.
- The ability to analyze fluid flows is becoming increasingly important across a wide range of industries.
- The development of more powerful and affordable computers that are capable of running CFD software.
- The growing trend among customers to improve the engineering efficiency of product development and improvement through computer-aided analysis and design.
- Expansion of the traditional user base for CFD software beyond Ph.D.-level engineers in corporate research and development centers to the larger base of design engineers.
COMPETITIVE STRENGTHS
We believe that the following competitive strengths have enabled us to become a worldwide leader in both the thermal management market and the CFD software market.
TOTAL INTEGRATED SOLUTIONS PROVIDER
The increasing complexity of heat dissipation problems and the growing trend among manufacturers to outsource development of thermal management solutions has stimulated demand for total integrated solutions. We provide total integrated solutions by analyzing customers' thermal management problems at the device-, board- and system-level, designing, simulating and prototyping thermal management solutions and manufacturing, distributing and supporting these solutions worldwide.
VALUE-ADDED PARTNERING WITH OUR CUSTOMERS
We work closely with our customers to develop customized thermal management solutions. We believe that our close relationships with customers and their design and development teams, as well as our worldwide manufacturing capabilities, allow us to anticipate customers' needs and, through our engineering expertise and experience, provide quality product solutions more quickly than our competitors.
WORLDWIDE LOW COST MANUFACTURER
We have state-of-the-art manufacturing operations in the United States, Canada, Mexico, Europe and Asia, including China. As an increasing number of electronics systems are being manufactured outside the United States, our low cost foreign manufacturing operations enable us to supply products directly to our customers at their geographically dispersed manufacturing locations.
LEADERSHIP IN CFD TECHNOLOGY
We believe that we are the technology leader in CFD software. As a result of our technological leadership, we develop software that enables our customers to generate the increasingly complex computer models they demand for more cost-efficient product design. This factor, as well as the relative ease-of-use and predictive accuracy of our CFD software, are of primary importance to our customers.
RECURRING REVENUES FROM SOFTWARE BUSINESS
Our CFD software business is characterized by high customer retention and recurring revenues. In recent years, approximately 80% of our annual software license revenue was renewed in the following year. This is driven by the significant value added by our CFD software to the design process and the high cost of switching to a competitor's software.
EXPERIENCED MANAGEMENT TEAM
Our senior management team has extensive operating and marketing experience in the thermal management and CFD software markets. This management team has grown our business, both organically and through strategic acquisitions, and has been responsible for improving operating efficiencies. Bharatan R. Patel, our chief executive officer who founded our CFD software business, has 27 years of experience in the area of fluid flows and thermal management, George P. Dannecker, president of our thermal management business, has 27 years of electronics industry experience, and H. Ferit Boysan, president of our CFD software business, has 20 years of experience in the area of fluid flows and CFD software.
BUSINESS STRATEGY
Our business strategy is to continue to be the market leader in both the thermal management and CFD software markets. We intend to continue this business strategy and strengthen our competitive position through the following initiatives:
CAPITALIZE ON STRONG THERMAL MANAGEMENT INDUSTRY GROWTH
We believe that our existing thermal management markets will continue to experience strong growth. Growth will be driven by the need to dissipate the increasing amount of heat being generated by electronic products, as well as unit growth in these products. We believe our competitive strengths position us to capitalize on these growth trends.
TAKE ADVANTAGE OF OUTSOURCING TREND
The increasing complexity of heat dissipation problems is driving a trend among manufacturers to outsource the development of thermal management solutions to companies with high levels of expertise in solving these problems. We intend to capitalize on this trend by leveraging our technical expertise in designing thermal management products and through continuing to partner with our customers in creating customized solutions.
EXPAND OUR ADDRESSED THERMAL MANAGEMENT MARKET
We believe we have significant opportunities to expand the portion of the outsourced thermal management market that we address. Our strategy is to expand into the $1.6 billion part of the outsourced thermal management market that we do not currently serve by entering into new geographic markets and introducing new products that complement our existing product offerings.
ACCELERATE GROWTH IN THE COMPUTATIONAL FLUID DYNAMICS SOFTWARE MARKET
Growth in the CFD software market will be driven by customers' needs to reduce product development costs, minimize the time-to-market for their new products and improve product performance, as well as by increasing applications for CFD software. We intend to grow our CFD software business through internal product development and possibly strategic acquisitions to leverage our core technological competence in the development of computerized design and simulation software. Our goal is to further expand this market beyond its traditional user base of Ph.D.-level engineers in corporate research and development centers to the larger base of design engineers by providing them relatively easy-to-use industry-specific software.
PROVIDE TOTAL THERMAL MANAGEMENT SOLUTIONS ON A GLOBAL BASIS
We intend to continue capitalizing on our state-of-the-art worldwide manufacturing capabilities and to further leverage our expertise and technology to offer our customers a complete global solution to their thermal management problems. The increasing number of electronics systems manufactured outside of the United States has forced many electronics manufacturers to seek a highly integrated, worldwide provider of thermal solutions. We plan to continue to expand our quick-ramp, high-volume manufacturing and our design, sales and distribution activities globally as our customers continue to expand their operations overseas.
LEVERAGE OUR TECHNOLOGICAL LEADERSHIP
Our approximately 100 Ph.D.s and 230 engineers focus on new technology initiatives as well as developing new and enhancing existing products, processes and materials to address the evolving needs of our customers. We seek to enhance our internal research and development activities through collaborations with our customers and third parties in order to gain access to, or to pursue the development of, new technologies for thermal management applications and CFD software.
MARKETS AND CUSTOMERS
We sell our thermal management products and services to a highly-diversified base of customers across a wide range of industries and applications. We currently sell our thermal management products and services to over 2,500 customers. The following chart shows our largest customers for thermal management products and services by market sector:
Except for Intel, no customer represented more than 5% of our thermal management net sales during 1999, 1998 or 1997. Intel accounted for approximately 3%, 22% and 15% of net sales during 1999, 1998 and 1997, respectively.
We currently have more than 2,000 licensees of our CFD software. License revenue is diversified by market sector and geographical market. The following chart shows our largest customers for CFD software applications by market sector:
THERMAL MANAGEMENT PRODUCTS AND SERVICES
We provide total integrated solutions to our thermal management customers. We have the thermal design know-how to first analyze customers' thermal management problems at the device-, board- and system-level, to then design, simulate and prototype thermal management solutions and to finally manufacture, distribute and support these solutions around the world.
Our design and applications engineers work concurrently with our customers' design teams to develop optimal thermal solutions, which are increasingly being outsourced by our customers. Working as an extension of the product design team, Applied Thermal Technologies' engineers give customers easy access to our system design expertise in thermal management on a time-and-materials consulting basis. Additionally, Applied Thermal Technologies provides for a smooth transition from system design and validation to complete outsourced product solutions provided by Aavid Thermalloy.
We design, manufacture and sell both standard and customized thermal management products. We seek to become a strategic supplier to our customers and to differentiate ourselves from our competitors by offering a higher level of service. We currently offer heat sinks, interface materials and attachment accessories, fans, heat spreaders and liquid cooling and phase change devices that we configure to meet customer-specific needs. The prices for our thermal management products (including attachment devices and interface materials), depend primarily on cost, the technology used to make the part and its value in the customer's application. Because of the continued shrinking time-to-market for most new products and the corresponding contraction of design cycles, we also offer simulation and modeling software to assist our customers in handling the complexity of the design of a thermal solution. The following is a brief description of our thermal management products and services:
COMPUTATIONAL FLUID DYNAMICS SOFTWARE PRODUCTS
We are the leading provider of general purpose CFD software used to predict fluid flow, heat and mass transfer, chemical reaction and related phenomena. We provide CFD-based flow analysis software and consulting services that are used by engineers in corporations worldwide for the design and analysis of products and processes. Our software and services help engineers reduce engineering and product development costs, improve product performance and reduce time-to-market for new products.
We currently license our software products to more than 2,000 licensees worldwide. In North America, we typically license our software products under one year, renewable agreements. In Europe and the Far East, a significant portion of our CFD software sales are derived from licenses of this software for one-time fees; in such situations, we also typically receive annual maintenance and support fees.
We have also introduced CFD-based industry-specific products, such as Icepak, for use by designers and engineers in the electronics cooling industry, and Mixsim, for use by designers and engineers in the chemical mixing industry. We believe that our relatively easy-to-use, industry-specific products are expanding the CFD total market beyond its traditional user base of Ph.D.-level engineers in corporate research and development centers to the larger base of design engineers.
We also market engineering consulting services. With over 15 years of CFD and engineering consulting experience, our worldwide team of CFD professionals supports clients with senior engineering consultants, experienced CFD analysts, leading CFD software developers and mesh generation experts. Support services include expertise in the physics of heat, fluid flow and related phenomena, in CFD modeling and analysis, and in selection of engineering design solutions. In addition to providing CFD software expertise and access to high-performance computing systems, our CFD software consulting group works under contract to develop software with specific features required by individual clients.
We provide a complete suite of CFD software products, with each product designed for a specific task or for optimal performance on a specific class of problems. The following is a brief description of our CFD software products:
SALES AND SUPPORT
We sell our thermal management products and CFD software primarily through a global network of direct sales personnel, manufacturers' representatives, agents and a network of independent distributors. We provide support services to our customers, particularly in the CFD software area where we believe that high-quality support service is critical to the success of the CFD software business. Aavid Thermalloy (including Applied Thermal Technologies) and Fluent both have their own sales, support and marketing personnel, all of whom cross-sell each other's products and services where appropriate. We currently employ approximately 240 sales, support and marketing personnel.
TECHNOLOGY
We believe that technology leadership is essential to our growth strategy and have focused our approximately 100 Ph.D.s and 230 engineers on the development of technology in two areas:
THERMAL MANAGEMENT TECHNOLOGY
We believe that we are a technology leader in thermal management due to our extensive design expertise, technical manufacturing capabilities and process technology. We intend to develop new technologies and to enhance existing technologies in order to meet our customers' needs for higher performance products on a timely basis.
We have developed proprietary software tools (analytical models) which enable fast approximation answers for a large class of thermal management problems which, in turn, permits quicker design and prototyping of thermal solutions. We have extensive prototyping capabilities and state-of-the-art thermal laboratory facilities, including a wind tunnel which allows us to test and validate the design of thermal solutions.
As part of Aavid Thermalloy, Applied Thermal Technologies leverages Aavid Thermalloy's capabilities and Icepak's technology to assist customers in analyzing their thermal problems at the device-, board- and system-levels and to efficiently design, simulate and prototype thermal management solutions. By entering into the customer relationship at the onset of the product design cycle, Applied Thermal Technologies greatly enhances our knowledge of future industry trends, including technology development and acceptance. Additionally, Applied Thermal Technologies provides a smooth transition from design and validation to outsourced manufacturing with Aavid Thermalloy.
COMPUTATIONAL FLUID DYNAMICS SOFTWARE TECHNOLOGY
We believe that we are the technology leader in CFD software. Fluent's CFD software includes:
- automatic unstructured mesh generation, which allows the automatic creation of meshes,
- numerical algorithms for the accurate solution of fluid flow equations on structured and unstructured meshes,
- solution adaptive mesh which allows for interactive mesh refinement to provide improved solution accuracy,
- state-of-the-art physical models for important fluid flow phenomena such as turbulence, turbulence-chemistry interactions, free surface flows and multiphase flows,
- algorithms for efficient execution on multi-processor computers and distributed computer networks,
- interactive client/server architecture with a flexible and customizable user interface, and
- post-processing and data analysis tools.
PRODUCT DEVELOPMENT
Our thermal management product development activities are focused on lowering production costs, improving thermal characteristics and ease of attachment of conventional heat sinks, and developing new thermal management products and technologies to address the emerging and anticipated thermal management problems of our customers. We are developing new products, both internally as well as through collaborative efforts with third parties. These development efforts are directed toward: heat sink characterization and optimization; fan designs; air flow management; boundary layer optimization and focused flow; recirculating passive and active cooling systems including heat pipes; thermoelectric coolers, which use electricity to create a temperature difference across an interface between the electronic device and a heat sink; liquid and sub-ambient cooling systems; tab and surface mount heat sink attachment methods; vacuum die casting; engineered materials and net shape part manufacturing technology; direct chip mounting to extruded heat sinks; and highly thermally conductive adhesive and interface systems.
Our CFD product development activities are focused on enhancing the capabilities of its solvers, implementing new physical models to increase the range of applications and developing front-end user interfaces that are easy to use for engineers in specific industries. We are also focusing on various application and industry-specific CFD software projects which we believe will enable us to penetrate the design engineering market.
SUPPLIERS
We purchase raw aluminum, aluminum extrusion, aluminum coil and various components from a limited number of outside sources. We purchase substantially all of our aluminum coil stock from a single supplier. We believe that purchasing aluminum extrusion and coil stock from a limited number of suppliers is necessary to obtain lower prices and to consistently achieve the tolerances and design and delivery flexibility that we require.
For raw aluminum extrusion and coil stock, we typically make purchasing commitments to key suppliers of up to 24 months. In return, these suppliers commit to maintaining local inventory and to reserving run-time on their critical machines. The cost of aluminum extrusion is generally negotiated annually, with the price adjusted monthly, based upon the changes in the price of aluminum ingot, which has historically been highly cyclical. In addition, we produce approximately 50% of our domestic aluminum extrusion requirements at our extrusion facility in Franklin, New Hampshire, which has two extrusion presses.
COMPETITION
Our thermal management products business competes with a number of major providers of thermal management products located in the United States, Asia and Europe. Two of our most significant competitors are Hon Hai Precision Components Manufacturing (d/b/a Foxconn) and Wakefield Engineering, Inc. Foxconn is a Taiwan-based company that sells thermal management products as part of its broader electronic components products portfolio. Wakefield is a subsidiary of publicly traded Alpha Technologies Group, Inc. and mainly focuses on thermal management products for industrial electronics applications.
In addition, there are a large number of smaller heat sink companies, as well as hundreds of machine shops, that fabricate heat sinks, usually under subcontract with an OEM customer. Further, some aluminum die casters offer cast heat sinks, and a number of aluminum extruders sell heat sink products and fabrication capability, including aluminum extruders serving the automotive industry and the power conversion market.
Fluent currently competes with a number of privately held companies, primarily on the basis of product performance. To the extent that Fluent expands into additional application and industry-specific markets, it will encounter additional competition from software companies already serving such specific markets. In addition, certain CFD software is available in the public domain.
BACKLOG AND LICENSE RENEWAL
Our hardware products typically are produced and shipped within two months of the receipt of orders and, accordingly, we operate with little backlog. As a result, net sales in any quarter generally are dependent on orders booked and shipped in that quarter. All orders are subject to cancellation or rescheduling by customers. Because of our quick turn of orders to shipments, the timing of orders, delivery intervals, customer and product mix and the possibility of customer changes in delivery schedules, we do not believe our backlog at a particular date is a reliable indicator of actual sales for any succeeding period.
Our software products are typically sold under annual license agreements. In recent years, approximately 80% of our annual software license revenue was renewed in the following year.
EMPLOYEES
As of December 31, 1999 we had a total of 3,012 employees including approximately 790 contract employees in China. Except for the employees in our newly acquired manufacturing facility in Mexico, none of our employees is represented by labor unions or collective bargaining units. We believe that our relationship with our employees is good.
RISK FACTORS
This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements regarding our expected future financial position, results of operations, cash flows, financing plans, business strategy, competitive position, plans and objectives and words such as "anticipate," "believe," "estimate," "expect," "intend," "plan" and other similar expressions are forward-looking statements. Such forward looking statements are inherently uncertain, and holders of our securities must recognize that actual results could differ materially from those projected or contemplated in the forward-looking statements as a result of a variety of factors, including the factors set forth below. Holders of our securities should not place undue reliance on these forward-looking statements.
The forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. In addition, we cannot assess the effect of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
RISKS RELATING TO OUR BUSINESS
WE MAY FAIL TO SUCCESSFULLY INTEGRATE THERMALLOY.
The success of the Thermalloy acquisition will depend, in part, on our ability to fully integrate the operations and management of Thermalloy. A successful integration requires, among other things, the integration of Thermalloy's product offerings and technology into ours and the coordination of their sales and marketing and financial reporting efforts with ours. We cannot provide assurance that we will accomplish the integration smoothly or successfully. Therefore, we cannot provide assurance that we will realize the anticipated benefits of the Thermalloy acquisition. The success of the integration will require the dedication of management and other personnel resources, which may temporarily distract their attention from our day-to-day business and could adversely affect our financial results. We may experience reductions in our combined revenue as a result of potential customer dislocation and loss due to the integration of Thermalloy's operations with ours, plant closures and the merger.
WE MAY NOT BE ABLE TO EFFECTIVELY MANAGE OUR INTERNAL GROWTH.
We have recently experienced substantial growth in our thermal management products business and have significantly expanded our operations through manufacturing capacity additions, the acquisition of Thermalloy and geographic expansion. We intend to continue to increase our thermal products and software businesses overseas, expand the products and services we offer, and possibly make selective acquisitions. This growth and expansion has placed, and will continue to place, a significant strain on our production, technical, financial and other management resources. To manage growth effectively, we must maintain a high level of manufacturing quality, efficiency, delivery and performance and must continue to enhance our operational, financial and management systems, and attract, train, motivate and manage our employees. We may not be able to effectively manage this expansion, and any failure to do so could have a material adverse effect on our business and financial condition.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
Our quarterly and annual operating results are affected by a wide variety of factors, many of which are outside our control, that have in the past and could in the future materially and adversely affect our net sales, gross margins and profitability. These factors include:
- the volume and timing of orders received; - competitive pricing pressures; - the availability and cost of raw materials; - changes in the mix of products and services sold; - potential cancellation or rescheduling of orders; - changes in the level of customer inventories of our products; - the timing of new product and manufacturing process technology introductions by us or our competitors; - the availability of manufacturing capacity; and - market acceptance of new or enhanced products introduced by us.
Additionally, our growth and results of operations have in the past been, and would in the future be, adversely affected by downturns in the semiconductor or electronics industries. Our ability to reduce costs quickly in response to revenue shortfalls is limited, and this limitation will be exacerbated to the extent we continue to add additional manufacturing capacity. The need for continued investment in research and development could also limit our ability to reduce expenses accordingly. As a result of these factors, we expect our operating results to continue to fluctuate. Results of operations in any one quarter should not be considered indicative of results to be expected for any future period, and fluctuations in operating results may also cause fluctuations in the market price of the senior notes. We cannot provide assurance that the overall thermal management market, the segments of the market served by us or we will continue to grow in the future. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
OUR BUSINESS IS DEPENDENT ON THE SEMICONDUCTOR MARKET.
A significant portion of our net sales has been, and is expected to continue to be, dependent upon sales of thermal management products for industrial electronics applications, consisting primarily of integrated circuits. However, a significant portion of the recent growth in our net sales has been, and is expected to continue to be, dependent upon sales of thermal management products for computer and networking applications, consisting primarily of microprocessors and related chip sets. Our sales for industrial electronics applications accounted for approximately 34%, 37% and 44% of our net sales (excluding sales of a special product we manufactured for Intel (the "Intel Special Product")), in 1999, 1998 and 1997, respectively. Our sales for computer and networking applications (excluding sales of the Intel Special Product) accounted for approximately 41%, 38% and 33% of our net sales in 1999, 1998 and 1997, respectively. The thermal management market for computer and networking applications is characterized by rapid technological change, short product life cycles, greater pricing pressure and increasing foreign and domestic competition as compared to the thermal management market for industrial electronics applications.
Our continued growth will, to a significant extent, depend upon increased demand for semiconductor devices and products that require thermal solutions. The semiconductor industry (both computer and networking and industrial) has historically been cyclical and subject to significant economic downturns characterized by diminished product demand and eroding average selling prices. A decrease in demand for semiconductor products would reduce demand for our products and have an adverse impact on our results of operations. Further, semiconductor manufacturers and their customers, in developing and designing new products, typically seek to eliminate or minimize thermal problems, and such efforts could have the effect of reducing or eliminating demand for certain of our products. Additionally, we believe that many of our OEM customers compete in intensely competitive markets characterized by declining prices and low margins.
These OEMs apply continued pricing pressure on their component suppliers, including us. We cannot provide assurance that we will not be adversely affected by cyclical conditions in the semiconductor and electronics industries.
CHANGES IN THE AVAILABILITY OR PRICE OF ALUMINUM CAN SIGNIFICANTLY AFFECT OUR BUSINESS AND RESULTS OF OPERATIONS.
Aluminum is the principal raw material used in our products and represents a significant portion of our cost of goods sold. We purchase raw aluminum, aluminum extrusion, aluminum coil and various components from a limited number of outside sources. During the years ended December 31, 1999 and 1998, we purchased a significant portion of our aluminum coil stock from a single
supplier. We believe that purchasing aluminum extrusion and coil stock from a limited number of suppliers is necessary in order to obtain lower prices and to achieve, consistently, the tolerances and design and delivery flexibility that we require. If the available supply of aluminum declines, or if one or more of our current suppliers is unable for any reason to meet our requirements, is acquired by a competitor or determines to compete with us, we could experience cost increases, a deterioration of service from our suppliers, or interruptions, delays or a reduction in raw material supply that may cause us to fail to meet delivery schedules to customers. Although we believe that viable alternate suppliers exist for the aluminum coil stock and components, any unanticipated interruption of supply would have a short-term material adverse effect on us.
In addition, our ability to pass price increases for aluminum or other raw materials along to our customers may be limited by competitive pressures, customer resistance and price adjustment limitations in our product purchase contracts with our customers. Even if we are able to pass along all or a portion of raw material price increases, there is typically a lag of three to twelve months between the actual cost increase of raw material and the corresponding increase in the prices of our products. We cannot provide assurance that in the future we will be able to recover increased aluminum or other raw material costs through higher prices to our customers. Market prices for raw aluminum, which have historically been cyclical and highly volatile, have a significant effect on our gross margin. An increase in the market price for aluminum could have a material adverse effect upon our results of operations and business. See "Our operating results may fluctuate significantly."
WE SUPPLY PRODUCTS AND SERVICES TO INDUSTRIES THAT EXPERIENCE RAPID TECHNOLOGICAL CHANGE, WHICH MAY MAKE OUR PRODUCTS OBSOLETE.
The markets for our products are characterized by rapidly changing technology, frequent new product introductions and enhancements and rapid product obsolescence. Our future success will be highly dependent upon our ability to continually enhance or develop new thermal and software products, materials, manufacturing processes and services in order to keep pace with the technological advancements of our customers and their corresponding increasingly complex thermal management and computational fluid dynamics software needs. We may not be able to identify new product trends or opportunities, develop and bring to market new products or respond effectively to new technological changes or product announcements by others, develop or obtain access to advanced materials, or achieve commercial acceptance of our products. In addition, other companies, including our customers, may develop products or technologies which render our products or technologies noncompetitive or obsolete.
WE FACE INTENSE COMPETITION, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MAINTAIN OR INCREASE SALES OF OUR PRODUCTS.
The markets for thermal management products and computational fluid dynamics software are highly competitive. Certain of our competitors, which include divisions or subsidiaries of large companies, may have greater technical, financial, research and development and marketing resources than we do. Further, we expect that as the trend toward outsourcing continues, a number of new competitors may emerge, some of which may have greater technical, financial, research and development and marketing resources than we do. Our ability to compete successfully depends upon a number of factors, including price, customer acceptance of our products, cost effective high-volume manufacturing, proximity to customers, lead times, ease of installation of our products, new product and manufacturing process technology introductions by us and our competitors, access to new technologies and general market and economic conditions. We cannot provide assurance that we will be able to compete successfully in the future against existing or potential competitors, or that our operating results will not be adversely affected by increased price competition. In addition, our customers for thermal management and software products may manufacture or develop such products internally or actively support new entrants into our market rather than purchase thermal products from us. Further, many of our customers like to maintain dual sources for thermal management products. To the extent that we and Thermalloy serve as the two sources of supply for customers, it is possible that these customers will use one of our competitors as a second source of supply and our combined business with these customers may decrease.
OUR BUSINESS EXPERIENCES SEASONAL VARIATIONS.
Our CFD software business has experienced and is expected to continue to experience significant seasonality due to, among other things, the second and third quarter slowdown in software revenues primarily due to the purchasing and budgeting patterns of Fluent's software customers. In addition, our thermal management business has experienced slight seasonal variations due to the slowdown during the third quarter's summer months which historically has occurred in the electronics industry. Typically, our revenues are lowest during the second and third quarters of the fiscal year, which ends in December.
WE DEPEND ON KEY PERSONNEL AND SKILLED EMPLOYEES WHO MAY NOT REMAIN WITH US IN THE FUTURE.
Our success depends to a large extent upon the continued services of our senior management and technical personnel. Ronald Borelli resigned from his position as Chief Executive Officer when his employment agreement expired in December 1999. Additionally, we cannot provide assurance that our senior management will remain with us following the merger. The loss of such personnel, particularly before Thermalloy's operations are integrated with ours, could have a material adverse effect on our business and our ability to realize the benefits of the Thermalloy acquisition. Our business also depends upon our ability to retain skilled and semi-skilled employees. There is intense competition for qualified management and skilled and semi-skilled employees and our failure to recruit, train and retain such employees could adversely affect our business.
OUR INTERNATIONAL OPERATIONS EXPOSE US TO ADDITIONAL RISKS.
We have been expanding our manufacturing capacity internationally to better service our customers, many of whom have moved their manufacturing operations and expanded their business overseas. Our acquisition of Thermalloy significantly increases the scope of our international operations. We have had only limited experience to date operating outside the United States. We cannot provide assurance that the expansion of our international operations will be successful. International operations are subject to a number of risks, including:
- greater difficulties in controlling and administering business; - less familiarity with business customs and practices; - increased reliance on key local personnel; - the imposition of tariffs and import and export controls; - changes in governmental policies (including U.S. policy toward these countries); - difficulties caused by language barriers; - increased difficulty in collecting receivables; - availability of, and time required for, the transportation of products to and from foreign countries; - political instability; - foreign currency fluctuations; and - expropriation and nationalization.
The occurrence of any of these or other factors may have a material adverse effect on our results of operations and could have an adverse effect on our relationships with our customers. Furthermore, the occurrence of certain of these factors in countries in which we operate could result in the impairment or loss of our investment in such countries. The trend by our customers to move manufacturing operations and expand their business overseas may have an adverse impact on our sales of domestically manufactured products.
WE DEPEND ON A LIMITED NUMBER OF MANUFACTURING FACILITIES.
A significant part of our net sales is currently derived from products manufactured at our manufacturing facility in Guang Dong Province in The People's Republic of China. We commenced manufacturing at this facility in early 1998 and have expanded this facility to 120,000 square feet. This facility has grown to generate significant revenues for us, representing 6.4% of net sales in 1998 and 14.0% of net sales in 1999. We only have limited experience in managing operations in China and, although we have focused significant management resources on this operation, we cannot provide assurance that this business will be successful. Because of the growth of our operations in China and the increasing percentage of net sales from China, an inability to successfully manage this business or an interruption in the operations at this facility could have a material adverse effect on our overall financial performance until we are able to obtain substitute production capability with similar low operating costs.
We produce approximately 50% of our domestic aluminum extrusion requirements on two presses at our extrusion facility in Franklin, New Hampshire. Any extended interruptions to the operation of the presses could have a material adverse on our business and results of operations.
WE MAY BE UNABLE TO PROTECT OUR PROPRIETARY TECHNOLOGY.
Our success depends in part on our proprietary technology. We attempt to protect our proprietary technology through patents, copyrights, trademarks, trade secrets and license agreements. We believe, however, that our success will depend to a greater extent upon innovation, technological expertise and distribution strength. We cannot provide assurance that we will be able to protect
our technology, or that our competitors will not be able to develop similar technology independently. We cannot provide assurance that the claims allowed on any patents held by us will be sufficiently broad to protect our technology. In addition, no assurance can be given that any patents issued to us will not be challenged, invalidated or circumvented, or that the rights granted thereunder will provide competitive advantages to us. In addition, effective patent, copyright and trade secret protection may be unavailable or limited in certain foreign countries in which we conduct business. Although we believe that our products and technology do not infringe upon proprietary rights of others, there can be no assurance that third parties will not assert infringement claims in the future. Moreover, litigation may be necessary in the future to enforce our patents, copyrights and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our financial condition and results of operations.
WE ARE SUBJECT TO EXTENSIVE ENVIRONMENTAL AND OTHER REGULATIONS.
We are subject to a variety of United States and foreign environmental laws and regulations, including those relating to the use, storage, treatment, discharge and disposal of hazardous materials, substances and wastes used to manufacture our products and remediation of soil and groundwater contamination. Public attention has increasingly been focused on the environmental impact of operations that use hazardous materials. Some of the environmental laws impose strict, and in certain cases joint and several, liability for response costs at contaminated properties on their owners or operators, or on persons who arranged for the disposal of regulated materials at these properties. Our operations are also governed by laws and regulations relating to workplace safety and worker health, principally the Occupational Safety and Health Act and regulations thereunder which, among other requirements, establish noise and dust standards. We believe we are in material compliance with applicable environmental, health and safety requirements. Our failure to comply with present or future laws or regulations could result in substantial liability to us. We cannot predict the nature, scope or effect of legislation or regulatory requirements that could be imposed or how existing or future laws or regulations will be administered or interpreted with respect to products or activities to which they have not previously applied. Enactment of more stringent laws or regulations, as well as more vigorous enforcement policies of regulatory agencies or discovery of previously unknown conditions requiring remediation, could require substantial expenditures by us and could adversely affect our results of operations.
RISKS RELATED TO OUR INDEBTEDNESS
OUR SUBSTANTIAL DEBT COULD ADVERSELY AFFECT OUR FINANCIAL CONDITION AND PREVENT US FROM FULFILLING OUR OBLIGATIONS UNDER THE SENIOR NOTES.
We have a substantial amount of debt. The following chart shows certain important credit statistics and is presented assuming we had completed the merger pursuant to which we became a subsidiary of Heat Holdings Corp. and related financing transactions as of the date specified below and applied the proceeds as intended:
Our substantial indebtedness could have important consequences to holders of our senior notes. For example, it could: - make it more difficult for us to satisfy our obligations with respect to the senior notes and our obligations under our amended and restated credit facility; - require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, which will reduce amounts available for working capital, capital expenditures, research and development and other general corporate purposes; - limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; - increase our vulnerability to general adverse economic and industry conditions; - place us at a competitive disadvantage compared to our competitors with less debt; and - limit our ability to borrow additional funds.
The terms of the indenture governing our senior notes do not fully prohibit us or our subsidiaries from incurring substantial additional debt in the future. Our amended and restated credit facility also permits additional borrowing. All of the borrowings under the amended and restated credit facility are senior to the senior notes. If new debt is added to our current debt levels, the related risks that we now face could intensify.
In addition, a portion of our debt, including debt incurred under our amended and restated credit facility, bears interest at variable rates. An increase in the interest rates on our debt will reduce the funds available to repay the senior notes and our other debt and for operations and future business opportunities and will intensify the consequences of our leveraged capital structure. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for a description of our amended and restated credit facility and the senior notes.
TO SERVICE OUR DEBT, WE WILL REQUIRE A SIGNIFICANT AMOUNT OF CASH, WHICH DEPENDS ON MANY FACTORS BEYOND OUR CONTROL.
Our ability to make payments on and to refinance our debt, including the senior notes and the amended and restated credit facility, will depend on our ability to generate cash in the future. This, to an extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.
We cannot provide assurance that our business will generate sufficient cash flow or that future borrowings will be available to us in an amount sufficient to enable us to pay our debt, including the senior notes, or to fund our other liquidity needs. If our future cash flow from operations and other capital resources are insufficient to pay our obligations as they mature or to fund our liquidity needs, we may be forced to reduce or delay our business activities and capital expenditures, sell assets, obtain additional equity capital or restructure or refinance all or a portion of our debt, including the senior notes, on or before maturity. We cannot assure noteholders that we will be able to refinance any of our debt, including the senior notes, on a timely basis or on satisfactory terms if at all.
In addition, the terms of our existing debt, including the senior notes and the amended and restated credit facility, and other future debt may limit our ability to pursue any of these alternatives.
OUR AMENDED AND RESTATED CREDIT FACILITY AND THE INDENTURE IMPOSE OPERATIONAL AND FINANCIAL RESTRICTIONS ON US.
Our amended and restated credit facility and the indenture under which our senior notes were issued include restrictive covenants that, among other things, restrict our ability to:
- incur more debt; - pay dividends and make distributions; - issue stock of subsidiaries; - make certain investments; - repurchase stock; - create liens; - enter into transactions with affiliates; - enter into sale-leaseback transactions; - merge or consolidate; and - transfer and sell assets.
Our amended and restated credit facility also requires us to maintain financial ratios. All of these restrictive covenants may restrict our ability to expand or to pursue our business strategies. Our ability to comply with these and other provisions of our indenture and amended and restated credit facility may be affected by changes in our business condition or results of operations, adverse regulatory developments or other events beyond our control. The breach of any of these covenants would result in a default under our debt. If we default, we could be prohibited from making payments with respect to the senior notes until the default is cured or all debt under the amended and restated credit facility or other senior debt is paid in full. This default could allow our creditors to accelerate the related debt, as well as any other debt to which a cross-acceleration or cross-default provision applies. If our indebtedness were to be accelerated, we cannot provide assurance that we would be able to repay it. In addition, a default could give the lenders the right to terminate any commitments they had made to provide us with further funds.
RISKS RELATED TO THE SENIOR NOTES
OUR CONTROLLING STOCKHOLDER, WILLIS STEIN, MAY HAVE INTERESTS THAT CONFLICT WITH HOLDERS OF THE SENIOR NOTES.
We are a wholly owned subsidiary of Heat Holdings Corp., whose equity securities are held by Willis Stein and some co-investors. Through its controlling interest in Aavid and pursuant to the terms of the security holders' agreement among the equity investors, Willis Stein has the ability to control the operations and policies of Aavid. Circumstances may occur in which the interests of Willis Stein, as the controlling equity holder, could be in conflict with the interests of the holders of the senior notes. In addition, the equity investors may have an interest in pursuing acquisitions, divestitures or other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve risks to the holders of the senior notes.
THE SENIOR NOTES ARE CONTRACTUALLY SUBORDINATED IN RIGHT OF PAYMENT TO OUR SENIOR DEBT.
The senior notes are senior subordinated obligations of Aavid ranking junior to all of our existing and future senior debt, equal in right of payment with all of our existing and future senior subordinated debt and senior in right of payment to any of our subordinated debt. The senior notes are contractually subordinated in right of payment to borrowings under our amended and restated credit facility.
As of December 31, 1999, on a pro forma basis, we would have had $54.7 million of senior debt outstanding, all of which would have been secured debt. The indenture limits, and in some (but not all) instances prohibits, the incurrence of additional debt.
In addition, all payments on the senior notes will be blocked in the event of a payment default under the amended and restated credit facility and may be blocked for up to 179 consecutive days in any given year in the event of non-payment defaults on senior debt. In the event of a default on the senior notes and any resulting acceleration of the senior notes, the holders of senior debt then outstanding will be entitled to payment in full in cash of all obligations in respect of such senior debt before any payment or distribution may be made with respect to the senior notes.
In a bankruptcy, liquidation or reorganization or similar proceeding relating to us, holders of the senior notes will participate with trade creditors and all other holders of subordinated debt in the assets remaining after we have paid all of the senior debt. However, because the indenture requires that amounts otherwise payable to holders of the senior notes in a bankruptcy or similar proceeding be paid to holders of senior debt instead, holders of the senior notes may receive proportionately less than holders of trade payables in any such proceeding. In any of these cases, we cannot provide assurance that sufficient assets will remain to make any payments on the senior notes.
WE ARE A HOLDING COMPANY AND OUR ONLY SOURCE OF CASH TO PAY INTEREST ON AND THE PRINCIPAL OF THE SENIOR NOTES IS DISTRIBUTIONS FROM OUR SUBSIDIARIES.
We are a holding company with no business operations of our own. Our only significant asset is and will be our equity interests in our subsidiaries. We conduct all of our business operations through our subsidiaries. Accordingly, our only source of cash to make payments of interest on and principal of the senior notes is distributions with respect to our ownership interest in our subsidiaries from the net earnings and cash flows generated by such subsidiaries.
WE MAY NOT HAVE THE ABILITY TO RAISE THE FUNDS NECESSARY TO FINANCE THE CHANGE OF CONTROL OFFER REQUIRED BY THE INDENTURE.
If we undergo a "change of control," as defined in the indenture under which the senior notes were issued, we must offer to buy back the senior notes for a price equal to 101% of the principal amount, plus interest that has accrued but has not been paid as of the repurchase date. We cannot assure note holders that we will have sufficient funds available to make the required repurchases of the senior notes in that event, or that we will have sufficient funds to pay our other debts. In addition, our amended and restated credit facility prohibits us from repurchasing the senior notes after a change of control until we have repaid in full our debt under such credit facility. If we fail to repurchase the senior notes upon a change of control, we will be in default under both the senior notes and our amended and restated credit facility. Any future debt that we incur may also contain restrictions on repurchases in the event of a change of control or similar event.
THE SENIOR NOTES AND THE GUARANTEES COULD BE VOIDED OR SUBORDINATED TO OUR OTHER DEBT IF THE ISSUANCE OF THE SENIOR NOTES OR THE GUARANTEES CONSTITUTED A FRAUDULENT CONVEYANCE.
If a bankruptcy case or lawsuit is initiated by our unpaid creditors, the debt represented by the senior notes and the guarantees of the senior notes by certain of our subsidiaries may be reviewed under the federal bankruptcy laws and comparable provisions of state fraudulent transfer laws. Under these laws, the debt could be voided, or claims in respect of the senior notes and the guarantees
could be subordinated to all other debts of Aavid or its subsidiaries if, among other things, the court found that, at the time we incurred the debt represented by the senior notes and the subsidiaries incurred the debt represented by the guarantee, we or any subsidiary: - received less than reasonably equivalent value or fair consideration for the incurrence of such debt; and - were insolvent or rendered insolvent by reason of such incurrence; or - were engaged in a business or transaction for which the remaining assets constituted unreasonably small capital; or - intended to incur, or believed that we or a subsidiary executing a guarantee thereof would incur, debts beyond the ability to pay such debts as they matured; or - intended to hinder, delay or defraud creditors.
The measure of insolvency for purposes of fraudulent transfer laws varies depending on the law applied. Generally, however, a debtor would be considered insolvent if:
- the sum of its debts, including contingent liabilities, were greater than the fair saleable value of all of its assets; or - the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or - it could not pay its debts as they become due.
EFFECT OF ORIGINAL ISSUE DISCOUNT ON HOLDERS OF THE SENIOR NOTES.
The senior notes are considered to have been issued with original issue discount. Holders of the senior notes are required to include the accretion of the original issue discount in gross income for U.S. federal income tax purposes in advance of receipt of the cash payments to which such income is attributable. If a bankruptcy case is commenced by or against us under the United States Bankruptcy Code, the claim of a holder of senior notes with respect to the principal amount thereof may be limited to an amount equal to the sum of (i) the purchase price and (ii) that portion of the original issue discount which has been amortized as of the date of any such bankruptcy filing.
ITEM 2.
ITEM 2. PROPERTIES
A key element of our business strategy has been to expand internationally. Many of our customers have short product cycles that demand facilities to support quick-ramp, high-volume, high-quality manufacturing at their geographically dispersed manufacturing locations. Our acquisition of Thermalloy, which has manufacturing facilities in Italy, Malaysia, Mexico and the United Kingdom, significantly expands our manufacturing operations outside the United States. We plan to continue to build or acquire additional manufacturing facilities overseas to better service our customers, many of whom have moved manufacturing operations and expanded their business overseas.
There can be no assurance that our expansion of our foreign operations will be successful. Foreign operations are subject to a number of risks including: work stoppages; transportation delays and interruptions; expropriation; nationalization; misappropriation of intellectual property; imposition of tariffs and import and export controls; changes in governmental policies (including U.S. policy toward these countries); and other factors which could have an adverse effect on our business. In addition, we may be subject to risks associated with the availability of, and time required for, the transportation of products to and from foreign countries. The occurrence of any of these factors may delay or prevent the delivery of goods ordered by customers, and such delay or inability to meet customers' requirements would have a materially adverse effect our results of operations and could have an adverse effect on the our relationships with our customers. Furthermore, the occurrence of certain of these factors in countries in where we own or operate manufacturing facilities could result in the impairment or loss of our investment in such countries.
Aavid Thermalloy has a total of approximately 1,335,000 square feet of manufacturing facilities with locations in Laconia and Franklin, New Hampshire; Santa Ana, California; Dallas and Terrell, Texas; Mexico; the United Kingdom (3 facilities); Italy; Germany (Curamik facility); Malaysia; Singapore; Taiwan; China; and Toronto, Canada. We employ a broad range of aluminum fabrication and processing capabilities. Manufacturing operations consist of extrusion, cutting, stamping, machining, assembling and finishing, including anodizing capabilities. We have a substantial in-house tool and die capability that enables us to create our own extrusion and progressive stamping dies and other production tooling.
Aavid Thermalloy closed down its manufacturing facility in Manchester, New Hampshire at the end of 1998 due to a change in product mix at a major customer. Fluent's total sales, marketing, development, and support facilities consist of approximately 94,000 square feet.
We operate in the following locations:
- -----------
* Indicates facility acquired in the Thermalloy acquisition. ** Indicates facility expected to be closed in 2000.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Following the public announcement of the merger with Heat Merger Corp., lawsuits were filed against us, Willis Stein, our directors, and one former director in the Court of Chancery of the State of Delaware by certain of our stockholders. The complaints allege, among other things, that our directors have breached their fiduciary duties and seek to enjoin, preliminarily and permanently, the merger and also seek compensatory damages. The stockholder plaintiffs, on behalf of our public stockholders, also seek class action certification for their lawsuits. We believe the actions to be without merit and intend to contest the actions vigorously. See "Item 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On January 29, 2000, a special meeting of our stockholders was held to consider and approve the proposed merger pursuant to which we would become a wholly-owned subsidiary of Heat Holdings Corp. The Merger was approved, with 6,622,985 shares voted in favor, 132,812 shares voted against and 430 shares abstained.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
MARKET PRICES OF AAVID COMMON STOCK
Our Common Stock traded on the Nasdaq National Market under the symbol "AATT" until February 2, 2000, the date we were acquired by Heat Holdings. As a result of the merger, our Common Stock is no longer publicly traded. Our Common Stock was initially offered to the public on January 29, 1996 at a price of $9.50 per share. The following table sets forth, for the fiscal periods indicated, the range of high and low sales prices of our Common Stock as reported on the Nasdaq National Market:
We have never paid a cash dividend on our Common Stock, and we currently intend to retain all earnings for use in our business and do not anticipate paying cash dividends in the foreseeable future. Our current credit facility and senior notes indenture contain restrictive covenants which, among other things, impose limitations on the payment of dividends.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following tables set forth selected statement of operations and balance sheet data derived from the consolidated financial statements of the Company for the periods indicated. The following tables should be read in conjunction with "Management Discussion and Analysis of Financial Condition and Results of Operations," the Consolidated Financial Statements, and related Notes thereto of the Company included elsewhere herein.
NOTES TO SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA (amounts in thousands)
(1) Includes the results of operations of Fluent from August 24, 1995 (the date of the acquisition of Fluent).
(2) Includes the results of operations of Fluid Dynamics International from May 16, 1996 (the date of the acquisition of Fluid Dynamics International).
(3) Includes the results of operations of Thermalloy and Curamik from October 21, 1999 (the date of acquisition of Thermalloy).
(4) Represents the expense for (a) the buyout in 1995 of a portion of the expected future payments required under the employment agreement with Mr. Beane, our former President and Chief Executive Officer, and the bonus-based portion of the management fee due Sterling Venture Limited, each of which was established at the time of the acquisition of Aavid Thermalloy in October 1993, and (b) in 1998 (i) the charge related to the estimated restructuring costs incurred with our closure of our Manchester, New Hampshire facility, (ii) the termination of the management agreement with Sterling Ventures and (iii) a bonus due Mr. Beane based on profits in excess of certain thresholds. The 1999 credit of $630 relates to the reversal of excess restructuring reserves which were no longer required upon the completion of the Manchester restructuring in the fourth quarter of 1999.
(5) Represents a non-recurring charge equal to the amount of the purchase price allocated to technology acquired in the acquisition of Fluent in 1995 and the acquisition of Fluid Dynamics International in 1996, which was not fully commercially developed and had no alternative future use at the time of acquisition.
(6) Represents charge related to early retirement of debt, net of related tax effect.
(7) Represents net income before interest, income taxes, depreciation and amortization and extraordinary items, each of which can significantly affect our results of operations and liquidity and should be considered in evaluating our financial performance. EBITDA is included because we understand that such information is considered to be an additional basis on which to evaluate our ability to pay interest, repay debt and make capital expenditures. EBITDA is not intended to represent and should not be considered more meaningful than, or as an alternative to, measures of performance, profitability or liquidity determined in accordance with generally accepted accounting principles.
(8) Represents EBITDA as a percentage of net sales.
(9) Balance sheet data at December 31, 1999 does not give effect to the merger pursuant to which we became a wholly-owned subsidiary of Heat Holdings Corp. and the related financing transactions. On a pro forma basis, after giving effect to the merger and the related financing transactions as if they had occurred as of December 31, 1999, our working capital, total assets, total long term debt (including current portion) and stockholder's equity would have been $34,550, $415,755, $201,203 and $155,431, respectively.
ITEM 7.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion of our financial condition and results of operations together with the financial statements and the notes to such statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based on our current expectations, assumptions, estimates and projections about us and our industries. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements, as more fully described in "Item 1. Business - Risk Factors". We undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
OVERVIEW
We are the leading global provider of thermal management solutions for electronic products and the leading developer and marketer of CFD software. Historically, we were organized as three operating segments: Aavid Thermal Products, Fluent and Applied Thermal Technologies; however, in connection with the merger, we consolidated our business into two operating units: Aavid Thermal Products (including Applied Thermal Technologies), which following the merger is known as Aavid Thermalloy, and Fluent. Aavid Thermalloy designs, manufactures and distributes thermal management products that dissipate unwanted heat from microprocessors and industrial electronics products. Fluent develops and markets CFD software that is used in complex computer-generated modeling of fluid flows, heat and mass transfer and chemical reactions for a variety of industries including, among others, the automotive, aerospace, chemical processing, power generation, material processing, electronics and HVAC industries. Applied Thermal Technologies offers thermal design, validation and consulting services, leveraging on technical and manufacturing capabilities gained from both Fluent and Aavid Thermalloy, to develop, test and validate Thermal solutions for third parties.
We and our predecessors have been engaged in the development and manufacture of heat sinks and related thermal management products since 1964. In August 1995, we acquired all the outstanding capital stock of Fluent for $12.8 million. In February 1996, we completed our initial public offering, whereby we sold an aggregate of 2,645,000 shares of common stock at a price of $9.50 per
share, from which we received net proceeds of approximately $21.7 million. During 1996, we further expanded our operations through the acquisitions of (1) Fluid Dynamics International, Inc., a provider of computational fluid dynamics software, (2) an aluminum extrusion manufacturing facility located in Franklin, New Hampshire and (3) Beaver Industries, a manufacturer of heat sinks and related thermal management products for electrical and electronics parts, components, ensembles and systems in Toronto, Canada.
On October 21, 1999, the Company purchased all of the stock of the Thermalloy Division of Bowthorpe plc (Thermalloy) and 85.4% of the stock of Curamik Electronics Gmbh (Curamik) (the Thermalloy acquisition) for a cash purchase of $84.6 million, including transaction costs of $2.8 million. Thermalloy designs, manufactures and sells a wide variety of standard and proprietary heat sinks and associated products, similar to those produced by Aavid Thermal Products, our thermal management business, within the computer and networking and industrial electronics (including telecommunications) industries. Curamik is a German corporation that manufactures direct bonded copper ceramic substrates that are used in the power semiconductor and other industrial electronics industries. Aavid used $12.6 million of its cash on hand and $84.6 million of borrowings under its new credit facility to complete the Thermalloy acquisition, repay $12.6 million of outstanding debt, and pay transaction costs. The new credit facility is further described in footnote I., "Debt Obligations". We believe the acquisition of Thermalloy will create significant opportunities to realize cost savings through certain plant closings, the elimination of duplicative selling, general and administrative functions and the reduction of unnecessary corporate expenses. The increased goodwill amortization and other purchase accounting adjustments resulting from our acquisition of Thermalloy decreased our net income in the fourth quarter of 1999 and will decrease our net income in 2000 as compared to the respective prior year periods. Following the acquisition of Thermalloy, we changed the name of Aavid Thermal Products to Aavid Thermalloy. See Note C. of notes to our consolidated financial statements for pro forma information for the acquisition.
Our future success will depend, in part, on our ability to fully integrate the operations and management of the Thermalloy acquisition with Aavid. A successful integration requires, among other things, the integration of Thermalloy's product offerings and technology into Aavid's and the coordination of their sales and marketing and financial reporting efforts with Aavid's. There can be no assurance that we will accomplish the integration smoothly or successfully or that we will realize the anticipated benefits of this acquisition. The success of the integration will require the dedication of management and other personnel resources, which may temporarily distract their attention from our day-to-day business.
On August 23, 1999, we entered into an Agreement and Plan of Merger (the "Merger Agreement") by and among the Company, Heat Holdings Corp., a corporation newly formed by Willis Stein & Partners II, L.P. (the "Purchaser"), and Heat Merger Corp., a wholly owned subsidiary of the Purchaser (the "Merger Sub"), providing for the merger of the Merger Sub with and into Aavid (the "Merger"), with Aavid being the surviving corporation. The Merger was approved by the Company's stockholders on January 29, 2000 and consummated on February 2, 2000. Pursuant to the merger, Aavid stockholders received $25.50 in cash for each outstanding share of common stock, and outstanding stock options and warrants were cashed out. The Merger will be accounted for using the purchase method.
RESULTS OF OPERATIONS
The following table is derived from our consolidated statements of operations and sets forth the percentage relationship of certain items to net sales for the periods indicated:
1999 COMPARED WITH 1998
Our results of operations in 1999 include the operations of Thermalloy and Curamik from October 21, 1999, the date of acquisition of the business.
Net sales for 1999 were $214.2 million, an increase of $5.1 million, or 2.4%, compared with $209.1 million for 1998. This increase in net sales was the result of $19.4 million from Thermalloy's operations for the period October 21, 1999 (the date of acquisition) through December 31, 1999 which are included in our 1999 results and organic revenue growth of approximately $30.1 million offset in large part by the result of the impact of the one-time reduction in sales volume of $44.4 million for the Intel Special Product.
Aavid Thermalloy's net sales were $165.0 million for 1999, a decrease of $5.8 million, or 3.4%, compared with $170.8 million for 1998. This decrease was the result of the one-time reduction in sales volume of $44.4 million for the Intel Special Product, which was offset by revenues of $19.4 million from Thermalloy's operations for the period October 21, 1999 through December 31, 1999 which are included in Aavid Thermalloy's 1999 results, as well as $19.2 million of organic revenue growth.
Net sales from computer and networking products (excluding the Intel Special Product) showed strong growth in the year ended December 31, 1999, increasing 41.0% over the year ended December 31, 1998. Of the increase, $11.5 million, or 45% resulted from revenues from the Thermalloy division from the date of acquisition through year end. Industrial electronics net sales increased 21.3% for the year ended December 31, 1999 compared to the year ended December 31, 1998. Industrial electronics net sales were significantly
impacted in the third quarter and fourth quarters of 1998 and to a lesser extent in the first quarter of 1999 by the Asian economic slowdown.
Fluent's net sales were $49.2 million for 1999, an increase of $10.9 million, or 28.5%, over $38.3 million for 1998. Of this increase, approximately 28% was the result of net sales by Fluent's new subsidiary in Japan, which became operational in the first quarter of 1999. The remaining 72% increase was spread among all product offerings due primarily to increased sales to new customers for computational fluid dynamics software, as well as the success of application-specific products.
Excluding net sales for the Intel Special Product, international net sales (which include North American exports) increased to 37.7% of net sales for the year ended December 31, 1999 as compared with 36.4% for the year ended December 31, 1998.
Our gross profit in 1999 was $75.7 million, an increase of $5.1 million, or 7.1% higher than $70.6 million in 1998. Our gross margin increased from 33.8% in 1998 to 35.3% in 1999. Our gross margin in the fourth quarter of 1999 was negatively impacted by certain purchase accounting and acquisition related adjustments which decreased gross profit by $3.8 million. Excluding these purchase accounting and acquisition related adjustments, gross margin for 1999 was 37.1%. This increase in gross margin resulted from a decrease in the percentage of overall gross profit derived from the Intel Special Product (which had a lower gross margin than our other products) and an increase in the percentage of overall gross margin derived from Fluent, which has significantly higher overall gross margin percentages than Aavid Thermalloy.
Our selling, general and administrative expenses were $52.0 million, or 24.3% of net sales, for 1999 as compared to $43.8 million, or 20.9% of net sales, for 1998. The increase in selling, general and administrative expenses resulted from $4.3 million from Thermalloy's operations for the period October 21, 1999 through December 31, 1999 which are included in Aavid Thermalloy's 1999 results, an increase of $6.4 million at Fluent which was partially offset by a decline at Aavid Thermalloy of $2.5 million resulting from cost reductions in response to lower sales from the loss of the Intel Special Product.
Our research and development expenses consist primarily of funding for internal product development activities as well as product development activities conducted by third parties on our behalf. Research and development expenses also include the costs of obtaining patents on the technology developed in research and development activities. Research and development expenses were $7.5 million, or 3.5% of net sales, in 1999 as compared to $6.8 million, or 3.2% of net sales, in 1998. The increase in research and development expenses was primarily due to increased expenditures at Fluent.
In 1997, we opened a facility in Manchester, New Hampshire specifically for the production of a special heat dissipating plate for Intel Corporation (the "Intel Special Product"). In the second half of July 1998, Intel notified us of significant reductions in expected purchases of the Intel Special Product. As a result, during the third quarter of 1998, we decided to close our Manchester facility and we recorded a non-recurring pre-tax charge of $4.9 million, reflecting the costs associated with such closure. The non-recurring revenues related to the Intel Special Product were approximately $2.6 million, or 1% of net sales in 1999, $47.0 million, or 22% of net sales in 1998, and approximately $24.7 million, or 15% of sales in 1997. The Intel Special Product had a lower gross margin than our other thermal management products. Intel remains one of our major customers, although sales to Intel in 1999 were less than 5% of total sales. No customer generated more than 5% of sales in 1999.
Our income from operations in 1999 was $16.8 million, a decline of $3.3 million, or 16.4%, from $20.1 million in 1998 (excluding non-recurring charges (credits)). Our income from operations as a percentage of net sales was 7.8% in 1999 as compared with 9.6% in 1998 (excluding non-recurring charges). The decrease in income from operations as a percentage of net sales is primarily the result of the $3.8 million in purchase accounting and related adjustments discussed above, recorded as a reduction in gross profit in the fourth quarter of 1999, as well as $0.4 million of goodwill amortization recorded in selling, general and administrative expenses related to the Thermalloy acquisition. The impact of these additional expenses was mitigated somewhat because the percentage of overall operating profit derived from Fluent increased in 1999. Income from operations as a percentage of net sales at Aavid Thermalloy for the year ended December 31, 1999 was 6.0%, compared with 8.0% in 1998. This decrease in margin was the direct result of the purchase accounting effects and increased amortization discussed above. Fluent's income from operations as a percentage of net sales decreased to 15.3% in 1999, compared with 16.0% in 1998. Fluent's operating margins decreased primarily because selling, general and administrative expenditures grew at a faster rate than sales.
Our interest charges were $1.6 million in 1999, a $0.3 million increase over interest charges of $1.3 million in 1998. Interest charges in the fourth quarter of 1999 were $1.4 million, a $1.2 million increase over the fourth quarter of 1998. This increase in interest charges resulted from the $88.2 million of indebtedness incurred in connection with the Thermalloy acquisition. Future interest charges are expected to be significantly higher as a result of the $150 million senior subordinated notes issued subsequent to year end.
The effective tax rate for the year ended December 31, 1999 was 57.5% compared with 35.1% for 1998. The primary reason for the increase in effective tax rates occurred because we had to record a tax provision on certain foreign earnings which are expected to be repatriated into the U.S. to service debt incurred subsequent to year end. Because the Company is in a net operating loss carryforward position for U.S. tax purposes, the Company will not receive any tax benefit from foreign tax credits. However, the Company will receive a deduction for cash paid related to foreign taxes and this benefit has been reflected in the 1999 tax provision. These repatriated earnings will therefore incur both foreign income taxes and U.S. income taxes, effectively doubling up the tax rate. The significant net operating loss carryforwards in the U.S. will help offset the actual cash paid for taxes in the U.S. when the foreign earnings are repatriated. In addition, a small portion of the increase in the effective tax rate resulted from the increase in non-deductible goodwill amortization expense resulting from the Thermalloy acquisition.
1998 COMPARED WITH 1997
Our net sales for 1998 were $209.1 million, an increase of $41.4 million, or 24.7%, compared with $167.7 million for 1997. The increase in net sales was primarily the result of the strong growth of both Aavid Thermalloy and Fluent.
Net sales for Aavid Thermalloy were $170.8 million in 1998, an increase of $35.6 million, or 26.3%, compared with $135.2 million in 1997. This growth was primarily the result of increasing net sales of computer and networking thermal management products, both to Intel and other customers. Net sales in the industrial electronics markets were lower in 1998 than 1997 primarily due to customer inventory reductions in the second half of 1998, reflecting less favorable economic conditions.
Despite the well publicized personal computer industry inventory correction experienced in the first half of 1998, net sales for computer and networking products (excluding the Intel Special Product) showed strong growth in 1998, increasing 31.6% over 1997 primarily due to market share gains. Industrial electronics net sales performed well in the first half of 1998, increasing 13.8% over the first half of 1997. However, the Asian economic slowdown in 1998 caused a sharp correction of customer inventories in the second half of 1998, leaving total industrial electronics net sales down 3.8% in 1998 over 1997. Net sales of the Intel Special Product grew strongly in the first half of 1998 reaching $15.0 million for the second quarter of the year. Following Intel's decision to phase out the Intel Special Product in July 1998, net sales to Intel declined from $15.0 million for the second quarter of 1998 to $10.8 million and $8.6 million for the third and fourth quarters, respectively.
Fluent's net sales were $38.3 million in 1998, an increase of $5.8 million, or 17.8%, over $32.5 million in 1997. Strong growth in North America and Europe was marginally offset by lower growth in the Far East. In general, increases were seen in all product offerings due primarily to increased sales to new customers in the market for CFD design software, as well as the success of application-specific products.
Excluding sales of the Intel Special Product, international net sales (which include North American exports) increased to 36.4% of net sales for 1998 compared with 34.7% in 1997. This increase in the level of international net sales is primarily the result of both additional product manufactured within North America and shipped to customers' offshore manufacturing and assembly operations and higher product net sales from our expanded Far East manufacturing operations.
Our gross profit for 1998 was $70.6 million, an increase of $10.3 million, or 17.1%, over $60.3 million in 1997. Our gross margin as a percentage of net sales decreased from 36.0% in 1997 to 33.8% for 1998. Approximately two-thirds of this change was
derived from a higher proportion of lower gross margin business related to the Intel Special Product in 1998 than in 1997. The remaining one-third of this decrease was predominantly due to reduced levels of higher gross margin industrial electronics sales in the second half of 1998.
Our selling, general and administrative expenses were $43.8 million, or 20.9% of net sales, for 1998 as compared to $36.7 million, or 21.9% of net sales, for 1997. The decrease in selling, general and administrative expense as a percentage of net sales resulted principally from the faster rate of growth in net sales at Aavid Thermalloy, which has a lower selling, general and administrative expense as a percentage of net sales, than at Fluent.
Our research and development expenses were $6.8 million, or 3.2% of net sales, in 1998 as compared to $6.9 million, or 4.1% of net sales, in 1997. The decrease in research and development expenses as a percentage of net sales is primarily due to lower research and development expenditures at Aavid Thermalloy.
Our 1998 income from operations of $20.1 million (excluding the non-recurring charge) was $3.4 million, or 20.4%, higher than $16.7 million in 1997. Our income from operations as a percentage of net sales for 1998 (prior to the non-recurring charge) was 9.6% as compared with 10.0% for the prior year. Fluent's income from operations as a percentage of net sales for 1998 dropped to 16.0% from 17.0% in 1997. Aavid Thermalloy's income from operations as a percentage of net sales for 1998 was 8.0%, compared to 8.4% for 1997. Substantially all of this decrease was the result of an approximate 1% reduction in operating margin in the second half of 1998, which resulted from lower sales volume of the Intel Special Product.
Our interest charges were $1.3 million in 1998, a $0.9 million, or 38.4%, decrease over interest charges of $2.2 million for 1997, reflecting lower levels of indebtedness. Our effective tax rate in 1998 was 35.1%, compared with 36.2% in 1997.
Our net income for 1998 prior to non-recurring charges was $11.7 million, an increase of $3.2 million over our 1997 net income of $8.5 million.
During the first quarter of 1998, we recorded a non-recurring pre-tax charge of $1.9 million, which related to the termination of a management agreement and an obligation to pay a former director a bonus based on 1998 profits in excess of certain thresholds.
During the third quarter of 1998, we recorded a non-recurring pre-tax charge of $4.9 million, reflecting the costs associated with the closure of our Manchester, New Hampshire facility. We incurred charges of $0.7 million related to this plant closure during 1998. The charge was offset by a $1.0 million reduction in the previous estimate of obligations to pay a former director a bonus, paid on profits in excess of certain thresholds, as discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Historically, we have used internally generated funds and proceeds from financing activities to meet our working capital and capital expenditure requirements. As a result of the Thermalloy acquisition and the merger, we have significantly increased our cash requirements for debt service relating to the notes and our amended and restated credit facility. We intend to use amounts available under our amended and restated credit facility, future debt and equity financings and internally generated funds to finance our working capital requirements, capital expenditures and potential acquisitions.
Net cash provided by operating activities for the year ended December 31, 1999 was $15.8 million compared to $28.9 million for the year ended December 31, 1998. We had $47.1 million in working capital as of December 31, 1999 compared with $30.6 million for the prior year period. At December 31, 1999, accounts receivable days sales outstanding ("DSO") were 71 days, which compares with 56 days at December 31, 1998. While the number of days sales outstanding increased from the end of 1998, average DSO over 1999 is approximately 3 days higher than 1998, reflecting the increase in revenues in the Far East which have a higher DSO, in addition to the fact that due to purchase accounting, the Company is only reflecting Thermalloy sales from October 21, 1999 through year end, while the balance sheet reflects the full value of outstanding receivables. At December 31, 1999, inventory turns were 6 times, which compares with 7.7 times at December 31, 1998. This reduction in turns is primarily the result of the elimination of high turnover business related to the Intel Special Product. In addition, due to purchase accounting, cost of sales related to Thermalloy is recorded on our books only from October 21 through year end, yet the full value of Thermalloy inventory is recorded on the balance sheet.
During the year ended December 31, 1999, we made capital expenditures of $12.4 million compared with $10.4 million in 1998.
As of December 31, 1999 Aavid Thermalloy had committed to approximately $1.7 million of leasehold improvements related to a new leased facility in Concord, N.H. In addition, Fluent had committed to a $2.3 million addition to their corporate headquarters in Lebanon, N.H.
In connection with the Merger, pursuant to which we became a wholly-owned subsidiary of Heat Holdings Corp., we repaid all outstanding debt under our existing credit facility, which aggregated approximately $88.2 million at February 2, 2000 and amended and restated this credit facility to, among other things, add Heat Holdings as a guarantor, permit the issuance of the senior notes and amend certain of the financial ratios and restrictive covenants to reflect such issuance. The amended and restated credit facility, which replaced our $100 million revolving credit and term loan facility, consists of a $53 million term loan facility (the "Term Facility") and a $22 million revolving credit facility, including a $2 million letter of credit subfacility (the "Revolving Facility"). The Term Facility, all of which was borrowed on February 2, 2000 to repay amounts outstanding under our existing credit facility, matures on March 31, 2005, and will be amortized in 18 consecutive quarterly installments, commencing December 31, 2000, as follows: five quarterly payments of $2 million each; four quarterly payments of $2.5 million each; four quarterly payments of $2.75 million each; two quarterly payments of $3.2 million each; two quarterly payments of $3.9 million; and a final payment of $7.8 million. The Revolving Facility matures on March 31, 2005. The Credit Facility bears interest at a rate equal to, at our option, either (1) in the case of Eurodollar loans, the sum of (x) the interest rate in the London interbank market for loans in an amount substantially equal to the amount of borrowing and for the period of borrowing selected by us and (y) a margin of between one and one-half percent and two and one-quarter percent (depending on our consolidated leverage ratio (as defined in the credit agreement)) or (2) the sum of (A) the higher of (x) Canadian Imperial Bank of Commerce's prime or base rate or (y) one-half percent plus the latest overnight federal funds rate plus (y) a margin of between one quarter percent and one percent (depending on our consolidated leverage ratio). The Credit Facility may be prepaid at any time in whole or in part without penalty, and must be prepaid to the extent of certain equity or asset sales and excess cash flow.
The Credit Facility limits our ability to incur debt, to sell or dispose of assets, to create or incur liens, to make additional acquisitions, to pay dividends, to purchase or redeem our stock and to merge or consolidate with any other person. In addition, the Credit Facility requires that we meet certain financial ratios, and provides the banks with the right to require the payment of all amounts outstanding under the facility, and to terminate all commitments thereunder, if we undergo a change in control. The Credit Facility is guaranteed by Heat Holdings Corp., Heat Holdings II Corp. and all of our subsidiaries and secured by our assets (including the assets and stock of our domestic subsidiaries and a portion of the stock of our foreign subsidiaries), and a pledge of our stock by Heat Holdings.
On February 2, 2000, as part of the transactions relating to the Merger, we issued 150,000 units (the "Units"), consisting of $150 million aggregate principal amount of our 12 3 /4 % Senior Subordinated Notes due 2007 (the "Notes") and warrants (the "Warrants") to purchase an aggregate of 60 shares of our Class A Common Stock, par value $0.01 per share, and 60 shares of our Class H Common Stock, par value $0.01 per share. The Notes are fully and unconditionally guaranteed on a joint and several basis by each of our domestic subsidiaries. The senior notes were issued pursuant to an Indenture (the "Indenture") among us, the subsidiary guarantors and Bankers Trust Company, as trustee. Approximately $4.6 million of the proceeds from the sale of the Units was allocated to the fair value of the Warrants and approximately $143.7 million was allocated to the Notes, net of original issue discount of approximately $1.7 million.
The Indenture limits our ability to incur additional debt, to pay dividends or make other distributions, to purchase or redeem our stock or make other investments, to sell or dispose of assets, to create or incur liens, and to merge or consolidate with any other person. The Indenture also contains provisions requiring additional equity investments by Willis Stein & Partners in the event the Company does not achieve certain leverage to EBITDA ratios, as defined, in years 2000 and 2001. The Indenture provides that upon a change in control of Aavid, we must offer to repurchase the Notes at 101% of the face value thereof, together with accrued and unpaid interest. The Notes are subordinated in right of payment to amounts outstanding under the Credit Facility and certain other permitted indebtedness.
We believe that existing sources of liquidity and funds expected to be generated from operations will be sufficient to meet our debt service, capital expenditure and working capital requirements for the foreseeable future. Further expansion of our business or the completion of any material strategic acquisitions may require additional funds which, to the extent not provided by internally generated sources, could require us to seek access to debt and equity markets.
YEAR 2000
The year 2000 problem was to have resulted from computer programs and devices that did not differentiate between the year 1900 and the year 2000 because they were written using two digits rather than four to define the applicable year. As a result, computer systems that have time-sensitive calculations potentially would not properly recognize the year 2000. This could have resulted in system failures or miscalculations causing disruptions of our operations. The year 2000 problem potentially affected us across our worldwide
locations and within substantially all of our business activities. We believe that as a result of our year 2000 remediation and planning programs, the year 2000 problem has not, as of March 30, 2000, had a material adverse effect on our operations or financial results. As of December 31, 1999, we estimate that we had incurred approximately $0.2 million in our year 2000 efforts, including without limitation, outside consulting fees and computer systems upgrades, but excluding internal staff costs, all of which has been expensed. It is possible that we will experience year 2000 related problems in the future, particularly with our non-business critical systems, which may result in failures or miscalculations resulting in inaccuracies in computer output or disruptions of operations. However, we believe that the year 2000 problem will not pose significant operational problems for our business critical computer systems and equipment. The financial impact of future remediation activities that may become necessary, if any, cannot be known precisely at this time, but is not expected to be material.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Upward or downward changes in market interest rates and their impact on the reported interest expense of the Company's variable rate borrowings will affect the our future earnings; however, a ten percent change in 1999 effective interest rates would have an approximate $0.7 million impact on our earnings for 2000, based on debt composition and rates in effect at December 31, 1999.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial Statements and supplementary data required pursuant to this Item begin on page 43 of this Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS
The following table sets forth the names of each of the our directors as of March 31, 1999, their ages, the year in which each became a director and their principal occupations during the past five years:
Prior to the Merger, our directors were Ronald F. Borelli, Bharatan Patel, Charles Dickinson, M. William Macey, Jr., Frank Pipp and David Steadman. Mr. Borelli served as Chairman of the Board.
MEETINGS OF THE BOARD OF DIRECTORS
Our business affairs are managed under the direction of the Board of Directors. Members of the Board are kept informed through various reports and documents sent to them, through operating and financial reports routinely presented at Board and committee meetings by the Chairman and other officers, and through other means. In addition, our directors discharge their duties throughout the year not only by attending Board meetings, but also through personal meetings and other communications, including considerable telephone contact, with the Chairman of the Board and others regarding matters of interest and concern to Aavid.
During the fiscal year ended December 31, 1999, our Board of Directors held 22 formal meetings, a substantial majority of which related to our acquisition of Thermalloy and the sale of Aavid. Each director attended at least 75% of the meetings of the Board of Directors held during 1999 and of all committees of the Board of Directors on which he served during 1999.
BOARD COMMITTEES
Our Board of Directors has a Compensation and Stock Plans Committee and an Audit Committee but does not have a nominating committee. The members of each committee are appointed by the Board of Directors.
Compensation and Stock Plans Committee. The Compensation and Stock Plans Committee reviews and approves overall policy with respect to compensation matters, including such matters as compensation plans for employees and employment agreements and compensation for executive officers. The Compensation and Stock Plans Committee also administers the Company's Stock Plans. The Compensation and Stock Plans Committee consisted of Messrs. Steadman and Dickinson during 1999. The Compensation and Stock Plans Committee met 2 times during 1999.
Audit Committee. The Audit Committee recommends to the Board of Directors the auditing firm to be selected each year as independent auditors of our financial statements and to perform services related to the completion of such audit. The Audit Committee also has responsibility for: (i) reviewing the scope and results of the audit; (ii) reviewing our financial condition and results of operations with management; (iii) considering the adequacy of our internal accounting and control procedures; and (iv) reviewing any non-audit services and special engagements to be performed by the independent auditors and considering the effect of such performance on the auditors' independence. Messrs. Steadman and Pipp served as members of the Audit Committee during 1999. The Audit Committee met 3 times during 1999.
Acquisitions Committee. In connection with the possible sale of Aavid, the Board of Directors appointed an Acquisitions Committee to conduct negotiations with the interested parties. The Acquisitions Committee consisted of Messrs. Borelli, Macey and Steadman. The committee had numerous informal meetings and discussions during the sale process.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
The Securities and Exchange Commission (the "Commission") has comprehensive rules relating to the reporting of securities transactions by directors, executive officers and stockholders who beneficially own more than 10% of our Common Stock (collectively, the "Reporting Persons"). Based solely on a review of reports filed pursuant to Section 16 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), received by us from Reporting Persons and written representations from our executive officers and directors, we believe that no Reporting Person has failed to file a Section 16 report on a timely basis during the most recent fiscal year. We have no knowledge of whether Alan Beane, whom we believe beneficially owned more than 10% of our Common Stock during 1999, had any transactions required to be reported pursuant to Section 16.
EXECUTIVE OFFICERS
Our executive officers are as follows:
RONALD F. BORELLI served as Chairman of the Board from October 15, 1996 to February 2, 2000. He was our Chief Executive Officer and Chief Executive Officer of Aavid Thermalloy from October 15, 1996 until December 31, 1999. He served as one of our directors from October 1993 to February 2, 2000, and served as our President and President of Aavid Thermalloy from October 15, 1996 to October 15, 1997. From March 1989 until he joined Aavid, Mr. Borelli was the Chief Executive Officer and a Director of Spectra, Inc., a hot melt ink jet company focusing on color printers. From 1982 to March 1989 Mr. Borelli was a Senior Vice President of SCI Systems. Prior to that he spent 20 years at Honeywell in a variety of engineering and management positions.
BHARATAN R. PATEL, PH.D. became our Chief Executive Officer on January 1, 2000. He served as one of our directors from April 1996 to February 2, 2000, our President since October 15, 1997 and Chief Executive Officer of Fluent since he helped form it in 1988 as a subsidiary of Creare, Inc. He served as our Chief Operating Officer from October 15, 1997 until December 31, 1999. Dr. Patel worked at Creare, Inc., an engineering consulting firm, from 1976 to 1988, serving in various capacities including Principal Engineer and Vice President. From 1971 to 1976, Dr. Patel was employed as a Senior Engineer in the Power Systems Group of Westinghouse Electric Corporation.
BRIAN BYRNE joined Aavid Thermal Technologies, Inc. in April, 2000 as its Chief Financial Officer. Brian comes to Aavid from Jabil Circuits, Inc., where he served as Operations Manager. Prior to his position at Jabil, Mr. Byrne served as the Vice President for Altron Incorporated's (subsequently Sanmina Corporation) Business Development and its Massachusetts' printed circuit assembly division for 3 years. Prior to that, he spent 20 years at Compangnie Des Machines Bull in increasingly senior financial and executive positions, most recently as Division General Manager of Bull Electronics.
JOHN W. MITCHELL joined us in December 1995 as Vice President and General Counsel. From 1979 until he joined us, Mr. Mitchell was a corporate and business attorney at Sulloway & Hollis, a Concord, New Hampshire law firm, where he served as Aavid Thermalloy' principal outside legal counsel since May 1985.
H. FERIT BOYSAN, PH.D. became Chief Operating Officer of Fluent in July 1997 and President of Fluent in December 1998. Since 1991, he had been Managing Director of Fluent's European operations, headquartered in Sheffield, England. From 1986 to 1991, Dr. Boysan was the Managing Director of Flow Simulations, Ltd., the European distributor of Fluent products until the formation of Fluent Europe in 1991. Dr. Boysan was one of the original developers of Fluent's CFD software.
GEORGE P. DANNECKER became President and Chief Operating Officer of Aavid Thermalloy (now Aavid Thermalloy LLC) in October 1997. Prior to that appointment, he had been Vice President-Marketing and Sales of Aavid Thermalloy since February 1994. Prior to joining Aavid Thermalloy, Mr. Dannecker was employed by Concord Communications, Inc., a telecommunications software company, where he was Vice President-Sales and Service from March 1986 to February 1994.
PETER CHRISTIE joined Fluent in 1998 as its Vice President and Chief Financial Officer. From 1984 to 1998, Mr. Christie held several senior management positions, including President and Chief Financial Officer, at Verax Corporation, a bioprocessing company. Prior to joining Verax, Mr. Christie was employed at Creare Inc., an engineering consulting firm, where he held the position of Chief Financial Officer from 1973 to 1978 and was President and founder of Creare Products Inc., a medical instruments manufacturer, from 1978 to 1984.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
COMPENSATION OF EXECUTIVE OFFICERS
The following table summarizes all compensation earned by or paid to our Chief Executive Officer and the four other most highly paid executive officers whose annual salary and bonus exceeded $100,000 (collectively, the "Named Executive Officers") for services rendered in all capacities to Aavid during the fiscal years indicated.
SUMMARY COMPENSATION TABLE
(1) Mr. Borelli served as Aavid's President from October 15, 1996 to October 15, 1997 and as Aavid's Chief Executive Officer from October 15, 1996 to December 31, 1999 and as our Chairman of the Board from October 15, 1996 to February 2, 2000.
(2) Mr. Patel became President and Chief Operating Officer of Aavid in October 1997, and became Chief Executive Officer of Aavid on January 1, 2000.
(3) Mr. Dannecker became President and Chief Operating Officer of Aavid Thermalloy in October 1997.
(4) Mr. Boysan became President of Fluent in December 1998.
OPTION GRANTS IN FISCAL 1999
(1) Based upon options to purchase 320,714 shares granted to all employees in 1999. (2) The 5% and 10% assumed annual compound rates of stock price appreciation are mandated by the Commission and do not represent the Company's estimate or projection of the future Common Stock prices. Actual gains, if any, on stock option exercises will depend on the future price of the Common Stock and overall stock market conditions. The 5% and 10% rates of appreciation over the 10 year option term of the $13.00 stock price on the date of the grant would result in a stock price of $21.18 and $33.72, respectively. The 5% and 10% rates of appreciation over the 10 year option term of the $15.88 stock price on the date of the grant would result in a stock price of $25.87 and $41.19, respectively. There is no representation that the rates of appreciation reflected in this table will be achieved.
All of these options were cashed out in connection with the merger pursuant to which we became a wholly-owned subsidiary of Heat Holdings Corp.
The following table sets forth information with respect to (i) stock options exercised in 1999 by the Named Executive Officers and (ii) unexercised stock options held by such individuals at December 31, 1999.
AGGREGATED OPTION EXERCISES IN FISCAL 1999 AND 1999 FISCAL YEAR-END OPTION VALUES
(1) Calculated on the basis of $24.56 per share, the closing sale price of the Common Stock as reported on the NASDAQ National Market on December 31, 1999, minus the exercise price.
All of these options were cashed out in connection with the Merger pursuant to which we became a wholly-owned subsidiary of Heat Holdings Corp.
EMPLOYMENT AGREEMENTS
Aavid has entered into an employment agreement with Mr. Mitchell, which currently expires on December 5, 2001. Aavid Thermalloy has entered into an employment agreement with Mr. Dannecker, which currently expires on June 30, 2000; and Fluent has entered into an employment agreement with Mr. Patel, which currently expires on May 1, 2001, and with Mr. Boysan, which currently expires on August 24, 2000. Each of these employment agreements provides for automatic renewal for successive two year terms (one year in the case of Mr. Dannecker) unless either party gives written notice to the other to the contrary at least 180 days prior to its expiration; however, each of Messrs. Mitchell, Dannecker, Patel and Boysan are entitled to terminate his employment at any time by giving 90 days' notice to Aavid.
The employment agreements require each employee to devote his full business time and best efforts, business judgment, skill and knowledge exclusively to the advancement of the business and interests of Aavid. The employment agreements currently provide for the payment of a base salary to Messrs. Patel, Boysan, Mitchell and Dannecker equal to $250,000, $180,000, $195,000, and $212,000, respectively, subject to increase at the discretion of the board of directors of their respective employers. Each employment agreement provides that the employee will continue to receive his base salary, bonuses, benefits and other compensation for a specified period in the event their respective employers terminate their employment other than for "cause" or under certain other circumstances.
Each of Messrs. Dannecker, Mitchell, Boysan and Patel is entitled to an annual bonus based on Aavid's performance. Mr. Patel is entitled to a target annual bonus of $125,000 based upon achievement in each fiscal year. Mr. Dannecker is entitled to receive a target annual bonus of $100,000 based on Aavid Thermalloy's actual performance measured against budgeted performance. Mr. Mitchell is entitled to receive an annual bonus of up to $65,000 based on his management of our legal expenses. Mr. Boysan is entitled to an annual bonus based on our actual performance against budgeted performance. We may renegotiate our obligation to make the payments under those employment agreements in connection with certain public offering or acquisition transactions.
The employment agreements contain non-competition covenants, waivable by us, which survive the termination of each employee's employment with us until two years from the date the employee's employment terminates (the "non-competition period"). In addition to other compensation payable to each of Messrs. Dannecker, Mitchell, Patel and Boysan under their agreements, during the non-competition period we are required to pay each employee one-half (75% of base salary in the case of Mr. Boysan and $10,000 per month in the case of Mr. Patel) of his highest prior base salary per annum.
COMPENSATION OF DIRECTORS
Prior to the Merger, each of our non-employee directors received an annual fee of $10,000 and $500 for each Board of Directors and committee meeting attended. All directors are reimbursed for all reasonable expenses incurred by them in acting as a director or as a member of any committee of the Board of Directors. In addition, directors who are not employees of the Company are compensated through stock options under the Directors' Plan. We adopted the 1995 Non-Employee Director Stock Option Plan (the "Directors' Plan") to promote our interests by attracting and retaining highly skilled, experienced and knowledgeable non-employee directors. An aggregate of 200,000 shares of Common Stock were reserved for issuance under the Directors' Plan. Options granted under the Directors' Plan did not qualify as incentive stock options within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). The Directors' Plan provided for an automatic grant of an option to purchase 10,000 shares of Common Stock effective upon initial election or appointment to the Board of Directors of a non-employee director, and an automatic grant of an option to purchase an additional 2,500 shares of Common Stock on each anniversary of the date of his or her election or appointment to the Board of Directors.
In addition, the Directors' Plan provided for the automatic grant to each of Messrs. Borelli and Macey, as well as Messrs. Edward Glassmeyer, Douglas Newhouse, and William L. Selden, at the time non-employee directors of Aavid, of: (i) an option to purchase 10,000 shares of Common Stock in February 1996 (the "Initial Options") following the consummation of our initial public offering at an exercise price of $9.50 per share, the initial public offering price of the Common Stock; and (ii) on April 21st of each year, commencing April 21, 1996, an automatic grant of an option to purchase an additional 2,500 shares of Common Stock, provided such individual received Initial Options and was serving as a non-employee director at the close of business on April 21st of such year. The options had an exercise price of 100% of the fair market value of the Common Stock on the date of grant and had a ten-year term. Initial Options became exercisable in their entirety six months after the date of the grant. All other options granted under the Directors' Plan became fully exercisable on the first anniversary of the grant date.
Each outstanding option was subject to acceleration in the event of a change of control of Aavid (as defined in the Directors' Plan). The options could be exercised by payment in cash, check or shares of Common Stock. On April 10, 1997, Mr. Dickinson was granted an option to purchase 10,000 shares of Common Stock at an exercise price of $11.375 upon his election as a director. On April 15, 1997 Mr. Steadman was granted an option to purchase 10,000 shares of Common Stock at an exercise price of $11.25 upon his becoming a non-employee director. On April 21, 1997, each of Messrs. Glassmeyer, Macey, Newhouse and Selden was granted an option to purchase an additional 2,500 shares of Common Stock at an exercise price of $11.25; on April 21, 1998, each of Messrs. Glassmeyer, Macey and Newhouse was granted an option to purchase an additional 2,500 shares at an exercise price of $32.375; and on April 21, 1999, Mr. Macey was granted an option to purchase an additional 2,500 shares at an exercise price of $16.50. On each of April 10, 1998 and 1999, Mr. Dickinson was granted an option to purchase an additional 2,500 shares of Common Stock at an exercise price of $30.125 and $16.50, respectively. On each of April 15, 1998 and 1999, Mr. Steadman was granted an option to purchase an additional 2,500 shares of Common Stock at an exercise price of $32.25 and $16.50, respectively. On June 14, 1999 Mr. Pipp was granted an option to purchase an additional 2,500 shares of common stock at an exercise price of $20.89. On June 19, 1998, Mr. Pipp was granted an option to purchase 10,000 shares of Common Stock at an exercise price of $30.13 upon his election as a Director. These options were cashed out in the merger to the extent they remained outstanding at the time.
Messrs. Macey and Steadman, who together with Mr. Borelli constituted the committee appointed by the Board to negotiate with the interested buyers of Aavid, each received $75,000 for their service on the committee, regardless of whether a transaction was consummated. In addition, Mr. Steadman received a fee of $50,000 for his work on the Thermalloy transaction, which fee was not contingent on the consummation of the transaction.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
BENEFICIAL OWNERSHIP OF COMMON STOCK
Heat Holdings Corp. currently owns all of the issued and outstanding stock of Aavid (excluding detachable warrants, sold to noteholders in connection with the sale of the senior notes, to acquire, in the aggregate, 60 shares of Class A common stock and 60 shares of Class H common stock, representing 3% of the common stock of Aavid (on a fully diluted basis)).
The following table sets forth certain information regarding the beneficial ownership of the issued and outstanding common stock of Holdings as of March 1, 2000. None of our executive officers or directors own any Holdings securities, except as set forth below.
BENEFICIAL OWNERSHIP(1)
(1) "Beneficial ownership" generally means any person who, directly or indirectly, has or shares voting or investment power with respect to a security or has the right to acquire such power within 60 days. Unless otherwise indicated, we believe that each holder has sole voting and investment power with regard to the equity interests listed as beneficially owned.
(2) For each beneficial owner listed in the table above, the percentage of outstanding Holdings' Class A common stock, Class B common stock and total common stock owned by such holder is the same.
(3) Consists of 4,641,572.5 shares of each of Class A common stock and Class B common stock directly beneficially held by Willis Stein & Partners II, L.P. and 296,927.5 shares of each of Class A common stock and Class B common stock directly beneficially held by Willis Stein & Partners Dutch, L.P. Willis Stein & Partners Management II, L.L.C. is the general partner of both partnerships and may be deemed to beneficially own such shares. Avy H. Stein and Daniel H. Blumenthal, as managing directors of Willis Stein & Partners Management II, L.L.C., may be deemed to beneficially own the shares of common stock beneficially owned by the partnerships and their general partner. Messrs. Stein and Blumenthal disclaim beneficial ownership of any of such shares. Willis Stein's address is 227 West Monroe Street, Suite 4300, Chicago, Illinois 60606.
(4) The Chase Manhattan Bank acts as the trustee for the First Plaza Group Trust, a trust under and for the benefit of certain employee benefit plans of General Motors Corporation ("GM"), its subsidiaries and unrelated employers. These shares may be deemed to be owned beneficially by General Motors Investment Management Corporation ("GMIMCo"), a wholly-owned subsidiary of GM. GMIMCo's principal business is providing investment advice and investment management services with respect to the assets of certain employee benefit plans of GM, its subsidiaries and unrelated employers, and with respect to the assets of certain direct and indirect subsidiaries of GM and associated entities. GMIMCo is serving as the trust's investment manager with respect to these shares and in that capacity it has the sole power to direct the trustee as to the voting and disposition
of these shares. Because of the trustee's limited role, beneficial ownership of the shares by the trustee is disclaimed. First Plaza Group Trust's address is c/o GMIMCo, 767 Fifth Ave., 16th Floor, New York, NY 10153.
(5) Consists of 480,455.0 shares of each of Class A common stock and Class B common stock directly beneficially held by Nassau Capital Partners III L.P. and 3,712.0 shares of each of Class A common stock and Class B common stock directly beneficially held by NAS Partners I L.L.C. Such funds' address is 22 Chambers Street, Princeton, New Jersey 08542.
(6) Consists of 378,255.5 shares of each of Class A common stock and Class B common stock directly beneficially held by Abbott Capital 1330 Investors II, L.P., 75,651.0 shares of each of Class A common stock and Class B common stock directly beneficially held by Abbott Capital Private Equity Fund III, L.P. and 30,260.5 shares of each of Class A common stock and Class B common stock directly beneficially held by BNY Partners Fund, L.L.C. The address of such funds is c/o Abbott Capital Management, LLC, 1330 Avenue of the Americas, Suite 2800, New York, New York 10019.
(7) BancBoston's address is 175 Federal Street, 10th Floor, Boston, Massachusetts 02110.
Each of the stockholders listed in the table above currently holds an equivalent percentage interest in the Class A common stock and Class B common stock of Heat Holdings Corp. II, which holds 95% of the outstanding common membership interests in Aavid Thermalloy, LLC. At the time the Merger was completed, all options to purchase shares of Aavid common stock held by members of management were converted into the right to receive cash equal to the product of the number of shares subject to each option times the excess, if any, of $25.50 per share over the exercise price per share for such option.
Willis Stein has advised us that it typically makes available, to management and key employees of its portfolio companies, up to 10% of the fully-diluted common equity of the portfolio company and the opportunity to co-invest in the portfolio company on the same economic terms as Willis Stein. No agreements, arrangements or understandings have been reached between Willis Stein and our management and key employees in this regard.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Our Board of Directors established the Compensation Committee in November 1993 and combined it with the Stock Plans Committee in 1997 to form the Compensation and Stock Plans Committee. Both Messrs. Steadman and Dickinson served as members of the Compensation and Stock Plans Committee during fiscal 1999. In 1999, each of Messrs. Steadman and Dickinson received options to purchase 2,500 shares of Common Stock pursuant to the Directors' Plan. See "Item 11. Executive Compensation - Compensation of Directors."
Messrs. Macey and Steadman, who together with Mr. Borelli constituted the committee appointed by the Board to negotiate with the interested buyers of Aavid, each received $75,000 for their service on the committee, regardless of whether a transaction was consummated. In addition, Mr. Steadman received a fee of $50,000 for his work on the Thermalloy transaction, which fee was not contingent on the consummation of the transaction.
In October 1993, we entered into an agreement with Materials Innovation, Inc. ("MII") pursuant to which MII, Mr. Alan Beane, formerly both a director and the Company's chief executive officer and a more than 10% holder of our Common Stock until the Merger, and Mr. Glenn Beane, Alan Beane's brother, granted to us exclusive worldwide rights and licenses under certain patents and technology owned by them to develop, make, have made, use and sell certain products used to attach certain heat dissipation products ("Clamp Products") and heat sinks manufactured by a vacuum die cast process ("Heat Sink Products"). Under the agreement, we are required to pay MII an annual royalty for the Clamp Products sold by us equal to the greater of: (i) $0.05 per Clamp Product; or (ii) 15% of the net selling price for such Clamp Products, with a minimum royalty of $40,000 per annum. In addition, under the agreement we must pay MII an annual royalty for the Heat Sink Products sold by us equal to the greater of (i) 10% of the net selling price; and (ii) 25% of the net selling price minus servicing cost. During the term of the agreement, we are required to reimburse MII for its direct costs incurred in sourcing and testing clamps required and requested by us. The agreement provides that prior to October 14, 2003, MII, Alan Beane and Glenn Beane may not directly or indirectly, in any capacity whatsoever: (i) sell any heat dissipation product of the type produced by us (other than products whose principal purpose is not heat dissipation and products for one specified customer); (ii) license, sell, transfer, provide or make available to any business which is competitive with us any products, technology or other intellectual property which may be useful in the manufacture or sale of our heat dissipation products, except that MII is permitted to sell raw materials to entities which are not our direct competitors; or (iii) provide any kind of services to any business which is competitive with us with respect to its heat dissipation products. In addition, we may not prior to October 14, 2003, in any capacity whatsoever, engage in the manufacture, distribution, sale or licensing of particle level heterogeneous materials and other materials created from powders and particles, except adhesives and compliant inter-face materials, or pursuant to a license from MII. We must give MII primary consideration as a supplier of such materials created from powders and particles if MII can supply such materials on terms which are competitive with those otherwise available in the market. The agreement grants us a right of first refusal in the event of a transfer of MII's interest in the technology covered by the agreement. In addition, the agreement provides that MII may not, and may not permit Glenn Beane or any affiliate to, transfer all or any part of its interest in the patents or technology covering the Clamp Products or Heat Sink Products, unless, prior to the transfer, the transferee has executed an agreement acknowledging that it takes such interest subject to the provisions of the agreement between MII and Aavid. The agreement terminates upon the last to expire of the licensed patents covering the Clamp Products and the Heat Sink Products, although we may terminate the agreement at any time effective immediately upon written notice to MII. In 1999, royalty payments and expense reimbursement by us to MII were not material and there were no sales of MII products and development services to us. We believe that Mr. Alan Beane is the chairman and an owner of approximately 41.5% of MII.
On March 4, 1998, MII and Messrs. Alan Beane and Glenn Beane filed a petition for declaratory judgment against Aavid Thermalloy in Grafton County (New Hampshire) Superior Court. The petitioners have asked the court to declare as terminated an agreement between Petitioners and Aavid dated October 14, 1993. Petitioners claim that Aavid Thermalloy has failed to pay royalties associated with the vacuum die cast patent. The petition does not seek monetary damages from Aavid.
On January 29, 1999, the Grafton County Superior Court granted our motion to dismiss the Petitioner's declaratory judgment petition. The petitioners appealed that dismissal but then subsequently withdrew that appeal. Materials Innovation then commenced arbitration of the same issue; however, the arbitration and a related declaratory judgment action brought by us to have the Materials Innovation vacuum die cast patent declared invalid was stayed by agreement pending completion or termination of the merger. Although we believe that the termination of the agreement with Materials Innovation would not have a materially adverse effect on our business, there can be no assurance it will not have such a materially adverse effect in the future.
Under the terms of Mr. Beane's former employment agreement with Aavid, Mr. Beane was permitted to pursue scientific research, patent inventions and business ventures with MII so long as such activities did not interfere with Mr. Beane's obligations to Aavid. We have no rights to any intellectual property resulting from such permitted activities. Our relationship with MII is regulated by the terms of an agreement between MII, its principals and Aavid, which prohibits MII from competing with us in the markets for heat sinks and other products whose principal purpose is to dissipate heat from electronic devices. MII is pursuing the development of certain products and advanced materials which, if successfully developed, would have application to our business. However, MII is not obligated to license such technology to Aavid, and there can be no assurance that Aavid will benefit from the relationship with MII or will be able to license any intellectual property from MII, if desirable, on acceptable terms or at all. There can be no assurance that a conflict of interest will not develop between Aavid and MII.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 10-K
(a) Financial Statements and Financial Schedules
(1) and (2) See "Index to Consolidated Financial Statements" beginning on page 42. Schedule II - Valuation and Qualifying Accounts and the Financial Data Schedule are filed herewith. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.
(3) The following exhibits are filed or incorporated by reference as part of this Annual Report are management contracts, compensatory plans or arrangements: Exhibits 10.9, 10.10, 10.11, 10.18, 10.21 and 10.22
(1) Incorporated by reference to Exhibits to the Company's Current Report on Form 8-K dated August 23, 1999. (2) Incorporated by reference to Exhibits to the Company's Registration Statement on Form S-4 (No. 333-33126). (3) Incorporated by reference to Exhibits to the Company's Current Report on Form 8-K dated February 2, 2000. (4) Incorporated by reference to Exhibits to the Company's Registration Statement on Form S-1 (No. 33-99232). (5) Incorporated by reference to Exhibits to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999. (6) Incorporated by reference to Exhibits to the Company's Current Report on Form 8-K dated October 21, 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
AAVID THERMAL TECHNOLOGIES, INC.
By: /s/ Bharatan R. Patel ----------------------------- Bharatan R. Patel President and Chief Executive Officer April 13, 2000
Dated April 13, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO AAVID THERMAL TECHNOLOGIES, INC.:
We have audited the accompanying consolidated balance sheets of Aavid Thermal Technologies, Inc. and subsidiaries (a Delaware Corporation) as of December 31, 1999 and 1998, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Aavid Thermal Technologies, Inc. and subsidiaries as of December 31, 1999 and 1998 and the results of their operations and their cash flows for each of the the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subject to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
/S/ ARTHUR ANDERSEN LLP BOSTON, MASSACHUSETTS April 10, 2000
AAVID THERMAL TECHNOLOGIES, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
AAVID THERMAL TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
AAVID THERMAL TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
AAVID THERMAL TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
AAVID THERMAL TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (in thousands, except share and per share data)
A. OPERATIONS
Aavid Thermal Technologies, Inc. (the "Company" or "Aavid") is the leading global provider of thermal management solutions for electronic products and the leading developer and marketer of CFD software. Each of these businesses has an established reputation for high product quality, service excellence and engineering innovation in its market. We design, manufacture and distribute on a worldwide basis thermal management products that dissipate unwanted heat, which can degrade system performance and reliability, from microprocessors and industrial electronics products. Our products, which include heat sinks, interface materials and attachment accessories, fans, heat spreaders and liquid cooling and phase change devices that we configure to meet customer-specific needs, serve the critical function of conducting, convecting and radiating away unwanted heat. CFD software is used in complex computer-generated modeling of fluid flows, heat and mass transfer and chemical reactions. Our CFD software is used in a variety of industries, including the automotive, aerospace, chemical processing, power generation, material processing, electronics and HVAC industries.
Overall, the Company services a highly diversified base of more than 3,500 national and international customers including OEMs, distributors, and contract manufacturers through a highly integrated network of software, development, manufacturing, sales and distribution locations throughout North America, Europe, and the Far East.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All material intercompany transactions have been eliminated.
RECLASSIFICATIONS
Certain reclassifications have been made to 1998 and 1997 financial statements to conform to the 1999 presentation.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to significant concentration of credit risk consists principally of trade accounts receivable. The risk is limited due to the relatively large number of customers comprising the Company's customer base and their dispersion across many industries within the United States, Europe, and Asia. The Company performs ongoing credit evaluations of its customers' financial condition and generally requires no collateral from its customers. The Company maintains an allowance for uncollectible accounts receivable based upon expected collectibility of all accounts receivable. The Company's write-offs of accounts receivable have not been significant during the periods presented. At December 31, 1999 and 1998, accounts receivable for one customer represented 0.4% and 12.1%, respectively, of the total accounts receivable balance. The Company's sales have been primarily denominated in U.S. dollars, and the effects of foreign exchange fluctuations are not considered to be material.
INCOME TAXES
The Company accounts for income taxes under Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Under this method, the amount of deferred tax liabilities or assets is calculated by applying the provisions of enacted tax laws to determine the amount of taxes payable or refundable currently or in future years. SFAS No. 109 requires a valuation allowance against deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realizable.
RESEARCH AND DEVELOPMENT
Research and development costs are charged to operations as incurred. SFAS No. 86, "Accounting for the Costs of Computer Software To Be Sold, Leased, or Otherwise Marketed," requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company's product development process, technological feasibility is established upon completion of a working model. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release have not been material. Accordingly, all research and software development costs have been expensed.
CASH AND CASH EQUIVALENTS AND FINANCIAL INSTRUMENTS
For purposes of the consolidated statements of cash flows, cash and cash equivalents consist of highly liquid investments with original maturities of three months or less.
The estimated fair value of the Company's financial instruments including accounts receivable, accounts payable and cash equivalents equals carrying value. The fair value of the Company's long-term debt instruments is also estimated at carrying value due to their variable interest rates and relatively short maturities.
INVENTORIES
For the year ending December 31, 1999 and 1998, inventories were valued at the lower of cost or market (first-in, first-out), and consist of materials, labor and overhead.
PROPERTY, PLANT AND EQUIPMENT
Property, plant, and equipment are stated at cost. The Company depreciates property, plant and equipment over their estimated remaining useful lives (buildings -- 30 to 40 years; machinery and equipment, -- 1 to 10 years; and vehicles -- 4 to 5 years) using both the straight-line and accelerated methods of depreciation.
Repairs and maintenance are charged against income when incurred; renewals and betterments are capitalized. When property, plant, and equipment are retired or sold, their cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in other income.
INTANGIBLES
Costs incurred in connection with the issuance of the Company's debt obligations have been deferred and are being amortized over the term of the respective debt obligations.
Other intangibles, which consist principally of goodwill, prepaid rent and deferred financing fees are being amortized on a straight-line basis over 5 to 20 years.
IMPAIRMENT OF LONG-LIVED ASSETS
In March 1995, the Financial Accounting Standards Board issued SFAS No. 121, "Accounting For the Impairment of Long-Lived Assets and For Long-Lived Assets To Be Disposed Of." This statement addresses the accounting for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to assets to be held and used, and for long-lived assets and certain identifiable intangibles to be disposed of.
This statement requires that long-lived assets, including intangibles, be reviewed for impairment whenever events or changes in circumstances, such as a change in market value, indicate that the asset carrying amounts may not be recoverable. In performing the review for recoverability, if future undiscounted cash flows (without interest charges) from the use and ultimate dispositions of the assets are less than its carrying value, an impairment loss is recognized. Impairment losses are to be measured based on the fair value of the asset. To date, the Company has not experienced any such impairments.
REVENUE RECOGNITION
THERMAL PRODUCTS
Revenue is recognized when products are shipped. The Company records an estimate at that time for returns and warranty costs to be incurred.
SOFTWARE
The Company recognizes software revenue in accordance with Statement of Position (SOP) 97-2, "Software Revenue Recognition" and SOP 98-9, "Modification of SOP 97-2; Software Revenue Recognition, With Respect to Certain Transactions." These statements provide specific industry guidance and stipulate that revenue recognized from software arrangements is to be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, upgrades, enhancements, post-contract customer support, installation or training. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for each element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered. Revenue allocated to software products, specified upgrades and enhancements is generally recognized upon delivery of the related products, upgrades and enhancements. Revenue allocated to post-contract customer support is generally recognized ratably over the term of the support, and revenue allocated to service elements is generally recognized as the services are performed. SOP 97-2 was adopted by the Company effective January 1, 1998 and has not had a material effect on revenue recognition.
The Company licenses its software products under both annual and perpetual license arrangements. Software license revenue is recognized upon the execution of the license arrangements and shipment of the product, provided that no significant vendor post-contract support obligations remain outstanding, and collection of the resulting receivable is deemed probable. The Company recognizes revenue from post-contract support, which consists of telephone support and the right to software upgrades, ratably over the period of the post-contract arrangement.
NET INCOME PER SHARE
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings Per Share," which specifies the computation, presentation, and disclosure requirements for earnings per share ("EPS") and became effective for both interim and annual periods ending after December 15, 1997. All prior period EPS data has been restated to conform with the provisions of SFAS No. 128. Basic earnings per share excludes dilution and is computed by dividing net earnings by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed based upon the weighted average number of common shares outstanding and dilutive common stock equivalents. For purposes of this calculation, outstanding stock options and warrants are considered common stock equivalents (using the treasury stock method). The following table is a reconciliation of the numerators and denominators used to calculate earnings per share in the Consolidated Statements of Operations:
Options and warrants to purchase 332,117, 343,268 and 61,500 shares of common stock were outstanding at December 31, 1999, 1998 and 1997, respectively, but were not included in the computation of diluted earnings per share because the exercise prices exceeded the average market price of common shares and these were antidilutive to the EPS calculation.
USE OF ACCOUNTING ESTIMATES
The preparation of the consolidated financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the reported amounts of revenues and expenses during the reporting period, and to disclose contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates.
TRANSLATION OF FOREIGN CURRENCY
The financial statements of the Company's foreign subsidiaries are translated in accordance with SFAS 52, "Foreign Currency Translation". The financial statements of the Company's subsidiaries are translated from their functional currency into U.S. dollars utilizing the current rate method.
Accordingly, assets and liabilities are translated at exchange rates in effect at the end of the year, and revenues and expenses are translated at the weighted average exchange rate during the year. All cumulative translation gains and losses from the translation into U.S. dollars are included as a separate component of stockholder's equity in the consolidated balance sheets. Transaction gains and losses are included in the consolidated income statements and have not been material.
RECENT ACCOUNTING PRONOUNCEMENTS
In June, 1998 the Financial Accounting Standards Board issued SFAS 133, "Accounting for Derivative Instruments and Hedging Activities". This statement requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the value of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. SFAS 133, as amended by SFAS 137, is required to be adopted by the Company in 2001. Although management is currently reviewing the impact of the statement, it believes this statement will not have a significant impact on the Company. The Company did not enter into foreign currency forward exchange contracts or any other derivatives during 1999, 1998, or 1997.
In December, 1999 the Securities and Exchange Commission released Staff Accounting Bulletin (SAB) no. 101, Revenue Recognition in Financial Statements. SAB 101 provides interpretative guidance on the recognition, presentation and disclosure of revenue. SAB 101 must be applied to financial statements no later than the second quarter of calendar 2000. The Company does not believe that the application of SAB 101 will have a material effect on the Company's financial position or results of operations.
C. ACQUISITION OF BUSINESSES
On October 21, 1999, the Company purchased all of the stock of the Thermalloy Division of Bowthorpe plc (Thermalloy) and 85.4% of the stock of Curamik Electronics Gmbh (Curamik) (the Thermalloy acquisition) for a cash purchase price of $84,593, including transaction costs of $2,804.
Thermalloy designs, manufactures and sells a wide variety of standard and proprietary heat sinks and associated products, similar to those produced by our thermal management business, within the computer and networking and industrial electronics (including telecommunications) industries. Curamik is a German corporation that manufactures direct bonded copper ceramic substrates that are used in the power semiconductor and other industrial electronics industries. Aavid used $12,619 of its cash on hand and $84,593 of borrowings under its new credit facility to complete the Thermalloy acquisition, repay $12,619 of outstanding debt, and pay transaction costs. The new credit facility is further described in footnote I., "Debt Obligations".
The Thermalloy acquisition has been accounted for under the purchase method of accounting. The results of operations for Thermalloy and Curamik since October 21, 1999 have been presented in the accompanying consolidated statement of income for the year ended December 31, 1999. Goodwill acquired will be amortized over 20 years on a straight-line basis starting on October 21, 1999. Management does not believe the final purchase price allocation will produce materially different results than those reflected herein. The fair value of assets acquired and liabilities assumed at October 21, 1999 was as follows:
Approximately $2,130 has been recorded as restructuring charges in connection with the acquisition. The restructuring plans include initiatives to integrate the operations of the Company and Thermalloy and reduce overhead. The primary components of these plans relate to (a.) the closure of duplicative operations in Hong Kong and the United Kingdom, (b.) the elimination of duplicative selling, general and administration functions on a global basis and (c.) the termination of certain contractual obligations. The Company expects these activities to result in a workforce reduction of approximately 165 individuals. Management is in the process of finalizing its restructuring plans related to Thermalloy, and, accordingly, the amounts recorded are based on management's current estimates of those costs. The Company will finalize these plans during 2000 and the majority of the restructuring activities is expected to be completed by the end of 2000. There were no amounts charged against the Thermalloy restructuring accrual in the fourth quarter of 1999.
The following table presents selected unaudited pro forma financial information for Aavid, Thermalloy and Curamik, assuming the companies had combined on January 1, 1998:
UNAUDITED PROFORMA CONDENSED STATEMENTS OF INCOME
The pro forma results are not necessarily indicative of either actual results of operations that would have occurred had the acquisition been made on January 1, 1998 or future results. The resolution of any uncertainties and contingencies that exist at the acquisition date will result in an adjustment to goodwill in 2000 but is not expected to be material.
D. ACCOUNTS RECEIVABLE
The components of accounts receivable at December 31, 1999 and 1998 are as follows:
E. INVENTORIES
The components of inventories at December 31, 1999 and 1998 are as follows:
F. PROPERTY, PLANT, AND EQUIPMENT
Property, plant, and equipment, recorded at cost, by major classification as of December 31, 1999 and 1998 consist of the following:
Substantially all property, plant, and equipment serve as collateral under the Company's borrowing arrangements.
G. OTHER ASSETS
Other long-term assets as of December 31, 1999 and 1998 consist principally of the following intangible assets:
H. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
Included in accrued expenses at December 31, 1999 and 1998 are the following:
I. DEBT OBLIGATIONS
Debt obligations as of December 31, 1999 and 1998 consist of the following:
On October 21, 1999, in connection with the Thermalloy acquisition, the Company entered into a $100,000 revolving credit and term loan facility with Canadian Imperial Bank of Commerce, as Administrative Agent, and certain other lenders (the Credit
Facility). The Credit Facility consists of an $80,000 term loan facility (the Term Facility) and a $20,000 revolving credit facility, including a $2,000 letter of credit sub-facility (the Revolving Facility). The Term Facility, all of which was borrowed on October 21, 1999 to pay the purchase price for Thermalloy, pay transaction costs and provide working capital to Thermalloy, matures on September 30, 2004, and will be amortized in 19 consecutive quarterly installments, commencing March 31, 2000, as follows: four quarterly payments of $2,000 each; four quarterly payments of $3,000 each; four quarterly payments of $4,000 each; four quarterly payments of $5,000 each; and three quarterly payments of $8,000 each. The Revolving Facility matures on September 30, 2004. The Credit Facility bears interest at a rate equal to, at the Company's option, either (1) in the case of Eurodollar loans, the sum of (x) the interest rate in the London interbank market for loans in an amount substantially equal to the amount of borrowing and for the period of borrowing selected by Aavid and (y) a margin of between one and one-half percent and two percent (depending on the Company's consolidated leverage ratio (as defined in the credit agreement)) or (2) the sum of (A) the higher of (x) Canadian Imperial Bank of Commerce's prime or base rate of (y) one-half percent plus the latest overnight federal funds rate plus (z) a margin of between one quarter percent and three quarters percent (depending on the Company's consolidated leverage ratio). At December 31, 1999, the interest rate on the Term Facility was 8.47% and the interest rate on the Revolving Credit Facility was 8.48%. The Credit Facility may be prepaid at any time in whole or in part without penalty, and must be prepaid to the extent of certain equity or asset sales.
The Credit Facility limits the Company's ability to incur additional debt, to sell or dispose of assets, to create or incur liens, to make additional acquisitions, to pay dividends, to purchase or redeem its stock and to merge or consolidate with any other person other than the previously announced merger with an entity formed by Willis Stein & Partners. In addition, the Credit Facility requires that the Company meet certain financial ratios, and provides the banks with the right to require the payment of all amounts outstanding under the facility, and to terminate all commitments thereunder, if there is a change in control of Aavid other than as contemplated by the merger agreement with entities formed by Willis Stein & Partners. The Company was in compliance with all covenants at December 31, 1999. The Credit Facility is guaranteed by all of the Company's domestic subsidiaries and secured by the Company's assets (including the assets and stock of its domestic subsidiaries and a portion of the stock of its foreign subsidiaries).
The Company incurred approximately $1,719 in bank and legal fees in connection with the obtainment of the Credit Facility. These costs have been capitalized as deferred financing costs and are being amortized over the life of the debt (five years), beginning October 21, 1999.
The Company was also contingently liable at December 31, 1999 and 1998 for $45 and $200, respectively, related to outstanding letters of credit.
Debt maturities payable for the five years and thereafter subsequent to December 31, 1999 are as follows:
As discussed in Note P., the $80,000 term loan and the $20,000 revolver facility were refinanced subsequent to December 31, 1999.
J. EQUITY
PREFERRED STOCK
The Company has authorized the issuance of 4,000,000 shares of $0.01 par value Preferred Stock, none of which is outstanding as of December 31, 1999 and 1998. The Preferred Stock shall have designations, preferences, powers, and rights as may be authorized by the Board of Directors.
SALE OF COMMON STOCK
On November 14, 1997, the Company sold an aggregate of 297,872 shares of Common Stock and a warrant to purchase 50,000 shares of Common Stock for $7,000,000 to a corporate investor. The warrant has an exercise price of $23.50 per share and expires on November 14, 2000 and remained outstanding at December 31, 1999. The Company granted this investor certain demand and "piggyback" registration rights with respect to the purchased shares (including the shares underlying the warrant), although the investor had agreed not to exercise these rights for a period of one year. The Company used the proceeds for general corporate purposes, including working capital. As further discussed in Note P., in connection with the Merger, all common stock and this warrant were cashed out on February 2, 2000 for $25.50 a share.
STOCK OPTIONS
During 1993, an officer of the Company was granted non-qualified stock options to acquire 249,205 shares of Common Stock at an exercise price of $0.19 per share, and 1,268,795 shares of Common Stock at an exercise price of $2.20 per share. These options vested and became exercisable as to 25% of the applicable shares immediately, with the remainder ratably in October 1994, 1995, and 1996, respectively. During 1999, 1998 and 1997, respectively, 268,000, 1,025,000 and 225,000 options were exercised. There were no outstanding options held by this officer at December 31, 1999. In addition, since 1993, the Company has issued 556,875 non-qualified stock options to Directors of the Company and certain executives outside of the plans discussed below, at exercise prices ranging from $0.19 to $16.50. As of December 31, 1999, 453,375 of these options were outstanding and 411,188 were exercisable. The exercise price of all these options equaled or exceeded the fair market value on the date of grant, as determined by the Board of Directors for issuances prior to its initial public offering or market prices thereafter.
STOCK OPTIONS (CONTINUED)
During 1994, the Company's Board of Directors adopted and approved a stock option plan for officers and key employees (1994 Stock Option Plan). The 1994 Stock Option Plan provides for the grant to officers and key employees of the Company of stock options intended to qualify as incentive stock options under the applicable provisions of the Internal Revenue Code, as well as non-qualified options. The Company has reserved 894,326 shares of its Common Stock for issuance under this plan. As of December 31, 1999, 821,629 options were outstanding, of which 446,148 were exercisable.
The 1994 Stock Option Plan provides that the exercise price of all options shall be at least equal to the fair market value of the Company's shares, as of the date on which the grant is made. The term of options issued under the plan cannot exceed ten years. Options are generally exercisable in installments beginning on the date of grant. With respect to incentive stock options granted to a participant owning more than 10% of the Company's shares, the exercise price thereof is at least 110% of the fair market value of the Company's stock.
During 1995, the Company's Board of Directors adopted and approved a stock option plan for non-employee directors (Directors' Plan). The Company has reserved 200,000 shares of its Common Stock for issuance under this plan. The Directors' Plan provides for the automatic grant to non-employee directors of options to purchase shares of Common Stock reserved for issuance under the Directors' Plan. Options granted under the Directors' Plan do not qualify as incentive stock options under the applicable provisions of the Internal Revenue Code. The options have an exercise price of 100% of the fair market value of the Common Stock on the date of grant and have a ten-year term. Initial options become fully exercisable six (6) months after the date of grant. All other options granted under the Directors' Plan become fully exercisable from and after the first anniversary of the grant date. As of December 31, 1999, 116,250 options were outstanding, of which 58,750 were exercisable.
During 1995, the Company's Board of Directors adopted and approved an employee stock purchase plan (Purchase Plan). Under the Purchase Plan, the Company will grant rights to purchase shares of Common Stock to eligible employees on a date or series of dates designated by the Board of Directors. The Company has reserved 250,000 shares of its Common Stock for issuance under this plan. The price per share with respect to each grant of rights under the Purchase Plan is the lesser of:
(i) 85% of the fair market value on the offering date on which such rights were granted, or
(ii) 85% of the fair market value on the date such right is exercised.
The Purchase Plan is intended to qualify as an employee stock purchase plan under the applicable provisions of the Internal Revenue Code. During 1999, 1998 and 1997, the Company sold 45,561, 34,282, and 41,604 shares under this plan, respectively.
A summary of all stock option activity follows:
At December 31, 1999, 1998 and 1997 options for 916,086, 932,602 and 1,814,021 shares were exercisable, respectively, with weighted average exercise prices of $13.20, $8.53 and $4.11, respectively.
During 1995, the Financial Accounting Standards Board issued SFAS No. 123, "Accounting for Stock-Based Compensation", which defines a fair value based method of accounting for employee stock options, or similar equity instruments, and
encourages all entities to adopt that method of accounting for all of their employee stock compensation plans; however, it also allows an entity to continue to measure compensation costs for those plans using the intrinsic method of accounting prescribed by APB Opinion 25. Entities electing to remain with the accounting in APB Opinion 25 must make pro forma disclosures of net income and earnings per share as if the fair value based method of accounting defined in SFAS No. 123 has been applied.
The Company has elected to account for its stock-based compensation plan under APB Opinion 25; however, the Company has computed, for pro forma disclosure purposes, the value of all options granted during 1999, 1998, and 1997 using the Black-Scholes option-pricing model as prescribed by SFAS No. 123, using the following weighted-average assumptions for grants in 1999, 1998, and 1997:
The weighted average fair value of options granted in 1999, 1998 and 1997 were $8.43, $14.29, and $7.61, respectively.
The total value of options granted during 1995 through 1999 would be amortized on a pro forma basis over the vesting period of the options. Options generally vest equally over two to four years. Because the SFAS No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation costs may not be representative of that to be expected in future years. If the Company had accounted for these plans, including the Employee Stock Purchase Plan, in accordance with SFAS No. 123, the Company's net income and net income per share would have decreased or increased, as reflected in the following pro forma amounts:
Set forth is a summary of options outstanding and exercisable as of December 31, 1999:
As further discussed in Note P., all stock options outstanding at February 2, 2000 became immediately vested and were cashed out at $25.50 per share in connection with the Merger with Willis Stein & Partners.
K. INCOME TAXES
Income before income taxes and minority interest for domestic and foreign operations are as follows:
The income tax provision included in the consolidated statements of operations, consists of the following:
The Company is in a net operating loss carryforward position for US tax purposes due to the tax benefit associated with stock options which totaled $124, $8,861 and $3,726 for 1999, 1998 and 1997, respectively, and was credited directly to stockholders' equity. The Company has approximately $17,500 of U.S. federal net operating loss carryforwards available to reduce future taxable income, if any. These net operating loss carryforwards expire through 2020, and are subject to the review and possible adjustment by the Internal Revenue Service. Section 382 of the Internal Revenue Code also contains provisions that could place annual limitations on the utilization of these net operating loss carryforwards in the event of a change in ownership, as defined. A reconciliation of the income tax expense at the statutory federal income tax rate to the Company's actual income tax expense (benefit) is as follows:
Deferred tax assets and liabilities are measured as the difference between the financial statement and the tax bases of assets and liabilities at the applicable enacted tax rates. In 1999, the Company provided for U.S. income taxes on $8,400 of undistributed earnings from its foreign subsidiaries as it is the Company's intention to only repatriate those earnings from its foreign operations in future years.
The components of the net deferred asset consist of the following:
L. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases various equipment and facilities under the terms of non-cancelable operating leases. Future lease commitments are as follows:
Lease expense was approximately $5,634, $3,141 and $2,556 for the years ended December 31, 1999, 1998 and 1997, respectively.
LITIGATION
Following the public announcement of the merger with Heat Merger Corp., lawsuits were filed against us, Willis Stein, our directors and one former director in the Court of Chancery of the State of Delaware by certain of our stockholders. The complaints allege, among other things, that our directors have breached their fiduciary duties and seek to enjoin, preliminarily and permanently, the merger and also seek compensatory damages. The stockholder plaintiffs, on behalf of our public stockholders, also seek class action certification for their lawsuits. We believe the actions to be without merit and intend to contest the actions vigorously.
On March 4, 1998, Materials Innovation, Inc. of Lebanon, New Hampshire and two of its principals, Alan Beane and Glenn Beane, filed a petition for declaratory judgment against Aavid Thermalloy in Grafton County (New Hampshire) Superior Court. The petitioners have asked the court to declare as terminated an agreement between Petitioners and Aavid dated October 14, 1993. Petitioner Alan Beane was formerly our Chief Executive Officer and one of our directors, who, we believe, beneficially owned more than 10% of our common stock at December 31, 1999.
The agreement grants to Aavid Thermalloy licenses for two patents, one involving a clamp for attaching heatsinks to semiconductors, and the other involving a process to make heatsinks by vacuum die casting. The agreement also provides Aavid Thermalloy with rights to potential technology of Materials Innovation relating to its thermal products business, and prohibits Petitioners from competing against Aavid Thermalloy for the ten-year term of the Agreement. Petitioners claim that Aavid Thermalloy has failed to pay royalties associated with the vacuum die cast patent. The petition does not seek monetary damages from Aavid.
On January 29, 1999, the Grafton County Superior Court granted our motion to dismiss the Petitioner's declaratory judgment petition. The petitioners appealed that dismissal but then subsequently withdrew that appeal. Materials Innovation then commenced arbitration of the same issue; however, the arbitration and a related declaratory judgment action brought by us to have the Materials Innovation vacuum die cast patent declared invalid was stayed by agreement pending completion or termination of the merger, described in Note P, below. Although we believe that the termination of the agreement with Materials Innovation would not have a materially adverse effect on our business, there can be no assurance it will not have such a materially adverse effect in the future.
We are involved in various other legal proceedings that are incidental to the conduct of our business, none of which we believe could reasonably be expected to have a materially adverse effect on our financial condition.
PURCHASE COMMITMENT
The Company has an obligation to purchase from one of its key suppliers a minimum quantity of aluminum coil stock. The Company believes that purchasing aluminum coil stock from this supplier is necessary to achieve consistently low tolerances, design, delivery flexibility, and price stability. Under the terms of this agreement, which expires on February 28, 2001, the Company has agreed to purchase certain minimum quantities which approximates $1,026.
M. 401(k) PROFIT SHARING PLAN
The Company has profit sharing plans, which permit participants to make contributions by salary reduction pursuant to Section 401(k) of the Internal Revenue Code. Employee eligibility is based on a minimum age and employment requirement. Annual employer contributions are determined by the Board of Directors, but cannot exceed the amount allowable for federal income tax purposes. The Company's contribution was approximately $535, $280 and $202 for the years ended December 31, 1999, 1998 and 1997, respectively.
N. SEGMENT REPORTING
Aavid provides thermal management solutions for microprocessors and integrated circuits ("ICs") for digital and power applications. The Company consists of three distinct reportable segments: thermal management products, computational fluid dynamics ("CFD") software, and thermal design services. Aavid's thermal management products consist of products and services that solve problems associated with the dissipation of unwanted heat in electronic and electrical components and systems. The Company develops and offers CFD software for computer modeling and fluid flow analysis of products and processes that reduce time and expense associated with physical models and the facilities to test them. The Company also provides thermal design services to customers who choose to outsource their thermal design needs.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies.
The Company accounts for inter-segment sales and transfers as if the sales or transfers were to third parties, that is, at current market prices.
Aavid's reportable segments are strategic business units that offer different products and services. They are managed separately because each segment requires different marketing and sales strategies. Most of the businesses were acquired as a unit and the management at the time of acquisition has generally been retained.
The following summarizes the operations of each reportable segment for the years ending December 31, 1999, 1998 and 1997:
The following table provides geographic information about the Company's operations. Revenues are attributable to an operation based on the location the product was shipped from. Long-lived assets are attributable to a location based on physical location.
Revenues from one customer of Aavid's thermal products division represents approximately $7,220, $47,000 and $24,700 of the Company's consolidated revenues for the years ending December 31, 1999, 1998 and 1997, respectively. Due to a change in product mix at this customer during 1998, revenues from this customer are expected to be less than 5% of total revenues in future years.
O. MANCHESTER RESTRUCTURING AND BUYOUT OF COMPENSATION ARRANGEMENTS
During the first quarter of 1998, the Company recorded a non-recurring pre-tax charge of $1,858, which related to financial obligations arising from the Company's restructuring in 1993 and comprised two elements. First, the Company terminated an arrangement with certain venture investors, under which it was obligated to pay fixed management fees until at least the year 2000. Second, the Company provided for an obligation to pay a former director a bonus based on profits in excess of certain thresholds.
During the third quarter of 1998, the Company recorded a non-recurring pre-tax charge of $4,882 reflecting the costs associated with the closure of the Company's Manchester, New Hampshire, facility. This facility was dedicated to manufacturing a specific large volume product for a single customer. Following a change in product design by the customer, demand significantly decreased during the fourth quarter of 1998 to $8,600, from a level of $15,000 in the second quarter of 1998. The Manchester restructuring was concluded at the end of 1999.
The costs associated with the closure of the Manchester facility include the write-down and disposal of surplus equipment, totaling $2,823, settlement of certain purchase commitments of $1,127, provisions for leased property expenses of $382, and employee separation costs of $550. While the number of employees has been significantly reduced through natural attrition, the plan included the termination of 120 employees comprised of 90 direct and 30 indirect employees. The charge is offset by a $1,000 reduction in the previous estimate of obligations to pay a former director a bonus, paid on profits in excess of certain thresholds.
The following amounts have been provided to and charged against the Manchester restructuring reserves as of December 31, 1999 and 1998:
In the fourth quarter of 1999, the Company completed its restructuring of the Manchester facility. As a result, excess reserves totaling $630 were reversed into income. The balance of the reserve represents expected loss on subletting the facility which occurred in October, 1999.
P. SUBSEQUENT EVENTS
On August 23, 1999, we entered into an Agreement and Plan of Merger ("the Merger Agreement") with Heat Holdings Corp., a corporation newly formed by Willis Stein & Partners II, L.P. ("the Purchaser"), and Heat Merger Corp., a wholly owned subsidiary of the Purchaser ("the Merger Sub"), providing for the merger of the Merger Sub with and into Aavid ("the Merger"), with Aavid being the surviving corporation. The Merger was approved by the Company's stockholders on January 29, 2000 and consummated on February 2, 2000. Pursuant to the merger, Aavid stockholders received $25.50 in cash for each outstanding share of common stock, and outstanding stock options and warrants were cashed out. The Merger will be accounted for using the Purchase Method.
In connection with the Merger, the Company repaid all of the outstanding term loan and revolving line of credit under its existing credit facility, which aggregated approximately $88,200 at December 31, 1999, and entered into an amended and restated credit facility ("the Amended and Restated Credit Facility"). The Amended and Restated Credit Facility provides for a $22,000 revolving credit facility ("the Revolving Facility") (of which $1,700 was drawn at the closing of the Merger) and a $53,000 term loan
facility ("the Term Facility") (which was fully drawn at the closing of the Merger). Subject to compliance with the terms of the Amended and Restated Credit Facility, borrowings under the Revolving Facility are available for working capital purposes, capital expenditures and future acquisitions. The Revolving Facility will terminate, and all amounts outstanding thereunder will be payable, on March 31, 2005. Principal on the Term Facility is required to be repaid in quarterly installments commencing December 31, 2000 and ending March 31, 2005 as follows: five installments of $2,000; four installments of $2,500; four installments of $2,750; two installments of $3,200; two installments of $3,900; and a final installment of $7,800. In addition, commencing with our fiscal year ending December 31, 2001, we are required to apply 50% of our excess cash flow to permanently reduce the Term Facility. The Amended and Restated Credit Facility bears interest at a rate equal to, at the Company's option, either (1) in the case of Eurodollar loans, the sum of (x) the interest rate in the London interbank market for loans in an amount substantially equal to the amount of borrowing and for the period of borrowing selected by Aavid and (y) a margin of between 1.50% and 2.25% (depending on the Company's consolidated leverage ratio (as defined in the Amended and Restated Credit Facility)) or (2) the sum of (A) the higher of (x) Canadian Imperial Bank of Commerce's prime or base rate or (y) one-half percent plus the latest overnight federal funds rate plus (y) a margin of between .25% and 1.00% (depending on the Company's consolidated leverage ratio).
The Amended and Restated Credit Facility may be prepaid at any time in whole or in part without penalty, and must be prepaid to the extent of certain equity or asset sales. The Amended and Restated Credit Facility limits the Company's ability to incur additional debt, to sell or dispose of assets, to create or incur liens, to make additional acquisitions, to pay dividends, to purchase or redeem its stock and to merge or consolidate with any other person. In addition, the Amended and Restated Credit Facility requires that the Company meet certain financial ratios, and provides the lenders with the right to require the payment of all amounts outstanding under the facility, and to terminate all commitments thereunder, if there is a change in control of Aavid. The Amended and Restated Credit Facility is guaranteed by each of Holdings Corp. and Heat Holdings II Corp., and all of the Company's domestic subsidiaries and secured by the Company's assets (including the assets and stock of its domestic subsidiaries and a portion of the stock of its foreign subsidiaries).
Units
On February 2, 2000, as part of the transactions relating to the Merger, the Company issued 150,000 units (the "Units"), consisting of $150,000 aggregate principal amount of its 12 3 /4 % Senior Subordinated Notes due 2007 (the "Notes") and warrants (the "Warrants") to purchase an aggregate of 60 shares of the Company's Class A Common Stock, par value $0.01 per share, and 60 shares of the Company's Class H Common Stock, par value $0.01 per share. The Notes are fully and unconditionally guaranteed on a joint and several basis by each of the Company's domestic subsidiaries (the "Subsidiary Guarantors"). The Notes were issued pursuant to an Indenture (the "Indenture") among the Company, the Subsidiary Guarantors and Bankers Trust Company, as trustee. Approximately $4,600 of the proceeds from the sale of the Units was allocated to the fair value of the Warrants and approximately $143,700 was allocated to the Notes, net of original issue discount of approximately $1,700.
The Indenture limits the Company's ability to incur additional debt, to pay dividends or make other distributions, to purchase or redeem its stock or make other investments, to sell or dispose of assets, to create or incur liens, and to merge or consolidate with any other person. The Indenture also contains provisions requiring additional equity investments by Willis Stein & Partners in the event the Company does not achieve certain leverage to EBITDA ratios, as defined, in years 2000 and 2001. The Indenture provides that upon a change in control of Aavid, we must offer to repurchase the Notes at 101% of the face value thereof, together with accrued and unpaid interest. The Notes are subordinated in right of payment to amounts outstanding under the Credit Facility and certain other permitted indebtedness.
Q. QUARTERLY DATA (UNAUDITED)
Following is a summary of the quarterly results of operations for the years ended December 31, 1999 and 1998:
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (in thousands)
ALLOWANCE FOR DOUBTFUL ACCOUNTS:
MANCHESTER RESTRUCTURING RESERVES:
THERMALLOY RESTRUCTURING RESERVES: | 29,175 | 190,123 |
711404_1999.txt | 711404_1999 | 1999 | 711404 | ITEM 1. BUSINESS.
INTRODUCTION
The Cooper Companies, Inc. (the "Company," "Cooper" or "we" and similar pronouns), through its principal subsidiaries, develops, manufactures and markets healthcare products. CooperVision ("CVI") markets a range of contact lenses to correct visual defects, specializing in toric lenses that correct astigmatism. Its leading products are disposable-planned replacement toric and spherical lenses. CVI also markets conventional toric and spherical lenses and lenses for patients with more complex vision disorders. CooperSurgical ("CSI") markets diagnostic products, surgical instruments and accessories to the women's healthcare market.
FORWARD-LOOKING STATEMENTS
This report contains "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995. To identify forward-looking statements, look for words like "believes," "expects," "may," "will," "should," "seeks," "approximately," "intends," "plans," "estimates" or "anticipates" and similar words or phrases. Discussions of strategy, plans or intentions often contain forward-looking statements. These, and all forward-looking statements, necessarily depend on assumptions, data or methods that may be incorrect or imprecise.
Events, among others, that could cause actual results and future actions to differ materially from those described by or contemplated in the forward-looking statements include major changes in business conditions and the economy, loss of key senior management, major disruptions in the operations of Cooper's manufacturing facilities, new competitors or technologies, significant disruptions caused by third parties failing to address the year 2000 issue, or by problems with our year 2000 compliance program, the impact of an undetected virus on our computer systems, acquisition integration costs, foreign currency exchange exposure, investments in research and development and other start-up projects, dilution to earnings per share from acquisitions or issuing stock, regulatory issues, significant environmental clean-up costs above those already accrued, litigation costs, costs of business divestitures, and other factors described in Cooper's Securities and Exchange Commission filings, including the "Business" section in this Form 10-K for the year ended October 31, 1999 and the related portions of the Company's 1999 Annual Report to Stockholders ("1999 Annual Report") incorporated here by reference. The 1999 Annual Report is included as Exhibit 13 to this Form 10-K.
GENERAL DESCRIPTION AND DEVELOPMENT OF BUSINESSES
The information required for this item is incorporated here by reference to the caption "Letter to Shareholders" and the additional "CooperVision" section in the 1999 Annual Report.
RESEARCH AND DEVELOPMENT
Company-sponsored research and development expenditures during the fiscal years ended October 31, 1999, 1998 and 1997 were $2 million, $1.9 million and $1.7 million, respectively. During fiscal 1999, CooperVision spent about 52% and CooperSurgical spent about 48% of the total. Cooper did not conduct any customer-sponsored research and development programs.
Cooper employs 28 people in its research and development and manufacturing engineering departments. Outside specialists in lens design formulation science, polymer chemistry, microbiology and biochemistry support product development and clinical research for CooperVision products. CooperSurgical conducts research and development in-house and also employs outside surgical specialists, including members of its surgical advisory board.
GOVERNMENT REGULATION
The U.S. Food and Drug Administration ("FDA"), other federal agencies and foreign ministries of health regulate the development, testing, production and marketing of the Company's products. The Federal Food, Drug and Cosmetic Act and other statutes and regulations govern the testing, manufacturing, labeling, storage, advertising and promotion of such products. If applicable regulations are not followed, companies are subject to fines, product recall or seizure, suspension of production and criminal prosecution.
Cooper develops and markets medical devices under different levels of FDA regulation depending upon the classification of the device. Class III devices, such as flexible and extended wear contact lenses, require extensive premarket testing and approval, while Class I and II devices require substantially lower levels of regulation.
Before a new contact lens can be sold commercially, CooperVision ("CVI") must complete these steps: (1) compile data on its chemistry and toxicology, (2) determine its microbiological profile and (3) define the proposed manufacturing process. This data must be submitted to the FDA to support an application for an Investigational Device Exemption. Once this is granted, clinical trials can begin. These are subject to review and approval by an Institutional Review Board and, where a lens is determined to have a significant risk, the FDA. After the clinical trials are completed, a Premarket Approval Application must be submitted and approved by the FDA.
In connection with some of Cooper's new products, it can submit an expedited procedure known as a 510(k) application for premarket notification to the FDA. Any product that can demonstrate that it is substantially equivalent to another device marketed before May 28, 1976 can use this procedure. If the new product is not substantially equivalent to a preexisting device or if the FDA rejected a claim of substantial equivalence, FDA approval to market would require extensive preclinical and clinical testing. This would increase the cost and would delay product marketing substantially.
FDA and state regulations also require the Company to adhere to applicable "good manufacturing practices" ("GMP"). They require detailed quality assurance and record keeping and periodic unscheduled regulatory inspections. The Company believes it is in substantial compliance with GMP regulations.
Health authorities in foreign countries regulate Cooper's human device clinical trials and medical device sales. The regulations vary widely from country to country. Even if the FDA has approved a product, the regulatory agencies in each country must approve new products before they are marketed.
These regulatory procedures require considerable resources and usually result in a substantial time lag between new product development and marketing. Cooper cannot assure that all necessary approvals will be obtained, or obtained in a timely manner. If the Company does not maintain compliance with regulatory standards or if problems occur after marketing, product approval may be withdrawn.
ISO 9000 CERTIFICATION AND CE MARK APPROVAL
In addition to the FDA regulatory requirements, the Company also maintains ISO 9000 certification and CE Mark approvals for all lens products. These quality programs and approvals are required by the European Medical Device Directive and must be maintained for all products intended to be sold in the
European market. In order to maintain these prestigious quality benchmarks, the Company is subjected to rigorous biannual reassessment audits of their quality systems and procedures by globally recognized notified bodies and agencies.
RAW MATERIALS
In general, CVI's raw materials consist of various polymers and packaging materials. There are alternative supply sources of all of these materials. Raw materials used by CSI or its suppliers are generally available from more than one source. However, because some products require specialized manufacturing procedures, CSI could experience inventory shortages if it needed an alternative manufacturer on short notice.
MARKETING AND DISTRIBUTION
In the United States, Canada and certain European countries, CVI markets its products through its field sales representatives, who call on ophthalmologists, optometrists, opticians and optical chains. In the United States, field sales representatives also call on distributors. In Japan and certain European counties, CVI uses distributors and has given them the exclusive right to market our products.
CSI's products are marketed worldwide by a network of field sales representatives and distributors. In the United States, Cooper augments its sales and marketing activities by employing telemarketing, direct mail, advertising in professional journals, and CSI uses a direct mail catalog.
PATENTS, TRADEMARKS AND LICENSING AGREEMENTS
Cooper owns or licenses a variety of domestic and foreign patents which, in total, are material to its businesses. The names of certain of Cooper's products are protected by trademark registrations in the United States Patent and Trademark Office and, in some cases, also in foreign trademark offices. Applications are pending for additional trademark registrations. Cooper aggressively enforces and defends its patents and other proprietary technology.
DEPENDENCE ON CUSTOMERS
Cooper's business does not materially depend on any one customer or any one affiliated group of customers.
GOVERNMENT CONTRACTS
Cooper's business is not materially subject to profit renegotiation or termination of contracts or subcontracts at the election of the United States government.
COMPETITION
Each of Cooper's businesses operates in a highly competitive environment. Competition in the healthcare industry revolves around the search for technological and therapeutic innovations in the prevention, diagnosis and treatment of illness or disease. Cooper competes primarily on the basis of product quality, program differentiation, technological benefit, service and reliability.
Many companies develop and manufacture contact lenses. CVI competes primarily on its product quality, service and reputation among medical professionals and by participating in specialty niche markets. It sponsors clinical studies to generate medical information to improve its lenses. Major competitors have greater financial resources and larger research and development and sales forces than CVI. Many of these competitors offer a greater range of contact lenses and a variety of other eyecare products, including lens care products and ophthalmic pharmaceuticals, which may give them a competitive advantage in marketing their lenses to high volume contract accounts.
In the surgical segment, competitive factors include technological and scientific advances, product quality, price and effective communication of product information to physicians and hospitals. CSI believes that it benefits, in part, from the technological advantages of certain of its products and from developing new medical procedures that can create new markets for equipment and instruments. CSI competes by focusing on distinct niche markets and by supplying these with high quality equipment, instruments and disposable products. For certain procedures, medical practitioners can obtain all of the equipment, instruments and disposable products from CSI. As CSI develops products for new medical procedures, it offers to train medical professionals to perform them. CSI competes with a number of manufacturers in each of its niche markets, including larger manufacturers with greater financial and personnel resources who sell a substantially larger number of product lines.
BACKLOG
Backlog is not a material factor in Cooper's businesses.
SEASONALITY
CVI's contact lens sales in the first fiscal quarter are generally lower than subsequent quarters, as fewer patients visit practitioners during the holiday season.
COMPLIANCE WITH ENVIRONMENTAL LAWS
Federal, state and local provisions that regulate the discharge of materials into the environment, or relate to the protecting of the environment, do not currently materially effect Cooper's capital expenditures, earnings or competitive position. See "Environmental" in Note 11 of Notes to Consolidated Financial Statements of the Company included in the 1999 Annual Report, regarding certain anticipated remediation costs, which is incorporated here by reference.
WORKING CAPITAL
Cooper's businesses have not required any material working capital arrangements in the past five years.
FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS, GEOGRAPHIC AREAS, FOREIGN OPERATIONS AND EXPORT SALES
The information required for this item is incorporated here by reference to Note 12 "Business Segment Information" of Notes to Consolidated Financial Statements of the Company included in the 1999 Annual Report.
EMPLOYEES
On October 31, 1999, Cooper employed approximately 1,750 persons. The Company believes that its relations with its employees are good.
ITEM 2.
ITEM 2. PROPERTIES.
The following are the principal facilities of Cooper as of October 31, 1999:
The Company believes its properties are suitable and adequate for its businesses.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The information required for this item is incorporated here by reference to "GT Labs" in Note 11 of Notes to Consolidated Financial Statements of the Company included in the 1999 Annual Report.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
During the fourth quarter of fiscal 1999, the Company did not submit any matters to a vote of the Company's security holders.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The information required for this item is incorporated here by reference to the caption "Quarterly Common Stock Price Range" in the 1999 Annual Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The information required for this item is incorporated here by reference to the caption "Five Year Financial Highlights" in the 1999 Annual Report.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The information required for this item is incorporated here by reference to the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the 1999 Annual Report.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company is primarily exposed to market risks that relate to changes in interest rates, foreign currency fluctuations and in the market value of its long-term debt obligations. The Company's policy is to minimize, to the extent reasonable and practical, its exposure to the impact of changing interest rates and foreign currency fluctuations by entering into interest rate swaps and foreign currency forward exchange contracts, respectively. In general, the Company does not enter into derivative financial instrument transactions for speculative purposes. Additional information for this item is included under the caption "Derivatives" in Note 1 "Summary of Significant Accounting Policies" and in Note 7 "Financial Instruments" in the 1999 Annual Report, which is incorporated here by reference.
LONG-TERM DEBT
Proceeds from the sale of HGA were used to pay down debt carrying an average interest rate of approximately 7%. Total debt was reduced to $62 million at October 31, 1999 from $90.2 million at October 31, 1998:
On an annualized basis the debt reduction would result in a decrease in interest expense of approximately $2 million, assuming we do not raise debt for other purposes.
The following table sets forth as of October 31, 1999, the Company's long-term debt obligations, excluding capitalized leases, principal cash flows by scheduled maturity, weighted average interest rates and estimated fair market value.
INTEREST RATE EXPOSURES
The Company enters into interest rate swap agreements to minimize the impact of changes in interest rates on its variable rate long-term debt obligations. The Company currently has three interest rate swap agreements on a total of $24.3 million of its outstanding variable rate debt obligations. These instruments have the effect of converting variable rate instruments to fixed rate instruments. The interest rate swap agreements assure that the Company will pay 6.19%, 4.88% and 7.13% on the aforementioned $24.3 million long-term debt obligations for the periods ending November 2002 (principal amount $17.4 million), January 2012 (principal amount $2.7 million) and April 2003 (principal amount $4.2 million), respectively. The table below shows the notional amount and weighted average interest rates of each of the Company's interest rate swaps by maturity. The receive rate is based on October 31, 1999 rates, and projected based on the consumer price index. Notional amounts are used to calculate the contractual payments to be made under the contracts.
FOREIGN CURRENCY EXPOSURES
The Company uses forward exchange contracts to minimize the effect of foreign currency fluctuations on its long-term debt obligations denominated in Great Britain Pounds ("GBP"), incurred to fund a portion of the Company's acquisition of Aspect Vision Care Ltd. (see caption "Aspect Acquisition" in Note 2 "Acquisitions" in the 1999 Annual Report, which is incorporated here by reference). The following table provides information on the Company's foreign currency forward exchange contracts. The information is provided in U.S. Dollar equivalent amounts, which is the way it is presented in the Company's financial statements. The table shows the notional amounts at the contract exchange rates and the weighted average contractual foreign currency exchange rates by expected maturity dates.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required for this item is incorporated here by reference to the captions "Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Cash Flows," "Consolidated Statements of Comprehensive Income," "Notes to Consolidated Financial Statements," "Independent Auditors' Report" and "Two Year Quarterly Financial Data" in the 1999 Annual Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information included under the heading "Election of Directors" and "Executive Officers of the Company" in the Company's Proxy Statement for the Annual Meeting of Stockholders to be held on March 28, 2000 (the "2000 Proxy Statement") is incorporated by reference with respect to each of the Company's directors and the executive officers who are not also directors of the Company.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information included under the subheadings "Executive Compensation" and "Compensation of Directors" of the "Election of Directors" section of the 2000 Proxy Statement is incorporated by reference with respect to the Company's chief executive officer, the four other most highly compensated executive officers of the Company and the Company's directors.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information included under the subheadings "Securities Held by Management" and "Principal Security Holders" of the "Election of Directors" section of the 2000 Proxy Statement is incorporated by reference with respect to certain beneficial owners, the directors and management.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required for this item is incorporated here by reference to the heading "Aspect Acquisition" in Note 2 "Acquisitions" in the 1999 Annual Report.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Documents filed as part of this report:
1. Accountants' Consent and Report on Schedule.
2. Financial Statement Schedule of the Company.
SCHEDULE NUMBER DESCRIPTION -------- ----------- Schedule II Valuation and Qualifying Accounts
3. Exhibits
The exhibits listed on the accompanying Exhibit Index are filed as part of this report.
All other schedules which are included in the applicable accounting regulations of the Securities and Exchange Commission are not required here because they are not applicable.
(b) Reports filed on form 8-K at end of Exhibit List:
Cooper filed the following reports on Form 8-K during the period August 1, 1999 through October 31, 1999.
August 9, 1999--Item 5. Other Events. August 26, 1999--Item 5. Other Events. October 4, 1999--Item 5. Other Events.
ACCOUNTANTS' CONSENT AND REPORT ON SCHEDULE
The Board of Directors THE COOPER COMPANIES, INC.
The audits of the consolidated financial statements of The Cooper Companies, Inc. and subsidiaries referred to in our report dated December 9, 1999, which is incorporated herein by reference, included the related financial statement schedule for each of the years in the three-year period ended October 31, 1999 as listed in Item 14 of the Annual Report on Form 10-K. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We consent to incorporation by reference in Registration Statement Nos. 33-50016, 33-11298, 333-22417, 333-25051, 333-27639 and 333-80795 on Forms S-3 and Registration Statement Nos. 333-10997, 33-27938, 33-36325, 33-36326 and 333-58839 on Forms S-8 of The Cooper Companies, Inc. of our reports dated December 9, 1999, relating to the consolidated balance sheets of The Cooper Companies, Inc. and subsidiaries as of October 31, 1999 and 1998 and the related consolidated statements of income, comprehensive income and cash flows for each of the years in the three-year period ended October 31, 1999, and related schedule, which reports appear in or are incorporated by reference to the October 31, 1999 Annual Report on Form 10-K of The Cooper Companies, Inc.
KPMG LLP
San Francisco, California January 27, 2000
SCHEDULE II
THE COOPER COMPANIES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED OCTOBER 31, 1999
(1) Principally uncollectible accounts written off, net of amounts recovered that were previously written off.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on January 28, 2000.
THE COOPER COMPANIES, INC.
By: /s/ A. THOMAS BENDER -------------------------- A. THOMAS BENDER PRESIDENT, CHIEF EXECUTIVE OFFICER AND DIRECTOR
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the dates set forth opposite their respective names.
EXHIBIT INDEX
LOCATION OF EXHIBIT IN EXHIBIT SEQUENTIAL NUMBER DESCRIPTION OF DOCUMENT NUMBER SYSTEM - ------ ----------------------- -------------
3.1 -- Restated Certificate of Incorporation, as partially amended, incorporated by reference to Exhibit 4(a) to the Company's Registration Statement on Form S-3 (No. 33-17330) and Exhibits 19(a) and 19(c) to the Company's Quarterly Report on Form 10-Q for the Fiscal Quarter ended April 30, 1988....................................
3.2 -- Certificate of Amendment of Restated Certificate of Incorporation dated September 21, 1995 incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1995....................................................
3.3 -- Amended and Restated By-Laws dated December 16, 1999....
4.1 -- Certificate of Elimination of Series A Junior Participating Preferred Stock of The Cooper Companies, Inc. filed with the Delaware Secretary of State on October 30, 1997, incorporated by reference to Exhibit 4.1 on Form 10-K for fiscal year ended October 31, 1997.
4.2 -- Rights Agreement, dated as of October 29, 1997, between the Company and American Stock Transfer & Trust Company, incorporated by reference to Exhibit 4.0 to the Company's Current Report on Form 8-K dated October 29, 1997....................................................
4.3 -- Amendment No. 1 to Rights Agreement dated September 26, 1998, incorporated by reference to Exhibit 99.1 of the Company's Current Report on Form 8-K dated September 25, 1998....................................................
4.4 -- Certificate of Designations of Series A Junior Participating Preferred Stock of The Cooper Companies, Inc., incorporated by reference to Exhibit 4.0 of the Company's Current Report on Form 8-K dated October 29, 1997....................................................
10.1 -- 1998 Long-term Incentive Plan, incorporated by reference to Exhibit A of the Company's Proxy Statement for its 1998 Annual Meeting of Shareholders held on April 2, 1998....................................................
10.2 -- Amendment No. 1 to 1998 Long-term Incentive Plan of The Cooper Companies, Inc. dated April 2, 1998, incorporated by reference to Exhibit 4.7 to the Company's post-effective Amendment No. 1 to Form S-8 Registration Statement filed on January 20, 1999.....................
10.3 -- Severance Agreement entered into as of June 10, 1991, by and between CooperVision, Inc. and A. Thomas Bender, incorporated by reference to Exhibit 10.26 to Amendment No. 1 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1992..................
10.4 -- Letter dated March 25, 1994, to A. Thomas Bender from the Chairman of the Compensation Committee of the Company's Board of Directors, incorporated by reference to Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1994.........
10.5 -- Severance Agreement entered into as of April 26, 1990, by and between Nicholas J. Pichotta and the Company incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-K for fiscal year ended October 31, 1995..................................
10.6 -- Letter Agreement dated November 1, 1992, by and between Nicholas J. Pichotta and the Company incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1995.
10.7 -- Severance Agreement entered into as of August 21, 1989, by and between Robert S. Weiss and the Company, incorporated by reference to Exhibit 10.28 to Amendment No. 1 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1992..................
LOCATION OF EXHIBIT IN EXHIBIT SEQUENTIAL NUMBER DESCRIPTION OF DOCUMENT NUMBER SYSTEM - ------ ----------------------- -------------
10.8 -- 1996 Long-term Incentive Plan for Non-Employee Directors of The Cooper Companies, Inc., incorporated by reference to the Company's Proxy Statement for its 1996 Annual Meeting of Stockholders.................................
10.9 -- Amendment No. 1 to 1996 Long-term Incentive Plan for Non-Employee Directors of The Cooper Companies, Inc., dated October 10, 1996, incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.........
10.10 -- Amendment No. 2 to 1996 Long-term Incentive Plan for Non-Employee Directors of The Cooper Companies, Inc., dated October 29, 1997, incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.........
10.11 -- Agreement dated as of September 28, 1993, among Medical Engineering Corporation, Bristol-Myers Squibb Company and the Company, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated October 1, 1993.........................................
10.12 -- Amendment No. 3 to 1996 Long-term Incentive Plan for Non-Employee Directors of The Cooper Companies, Inc., dated October 29, 1999..................................
10.13 -- Change in Control Agreement dated as of October 14, 1999 between The Cooper Companies, Inc., and Carol R. Kaufman
11* -- Calculation of Earnings per share.......................
13 -- 1999 Annual Report to Stockholders. The following portions of such report are incorporated by reference in this document and are deemed "filed." Letter to Shareholders, the additional "CooperVision" section and Financial Section which includes: Five Year Financial Highlights, Two Year Quarterly Information, Quarterly Common Stock Price Range, Management's Discussion and Analysis of Financial Condition and Results of Operations, the Consolidated Financial Statements and the Notes thereto, and the Independent Auditors' Report.
21 -- Subsidiaries............................................
27 -- Financial Data Schedule.................................
* The information required in this exhibit is incorporated here by reference to Note 4, "Earnings Per Share," in the 1999 Annual Report. | 4,195 | 28,924 |
880958_1999.txt | 880958_1999 | 1999 | 880958 | Item 1. BUSINESS
(a) General Development of Business. Dean Witter Global
Perspective Portfolio L.P. (the "Partnership") is a Delaware
limited partnership organized to engage primarily in the
speculative trading of futures and forward contracts, options on
futures contracts, physical commodities and other commodity
interests (collectively, "futures interests").
The general partner is Demeter Management Corporation
("Demeter"). The non-clearing commodity broker is Dean Witter
Reynolds Inc. ("DWR") and an unaffiliated clearing commodity
broker, Carr Futures Inc. ("Carr"), provides clearing and
execution services. Both Demeter and DWR are wholly-owned
subsidiaries of Morgan Stanley Dean Witter & Co. ("MSDW"). The
trading advisors for the Partnership are ELM Financial, Inc., EMC
Capital Management, Inc. and Millburn Ridgefield Corporation (the
"Trading Advisors").
The Partnership's Net Asset Value per unit of limited partnership
interest ("Unit(s)") as of December 31, 1999, was $970.18,
representing a decrease of 9.8 percent from the Net Asset Value
per Unit of $1,076.00 on December 31, 1998. For a more detailed
description of the Partnership's business, see subparagraph (c).
(b) Financial Information about Industry Segments. For financial
information reporting purposes, the Partnership is deemed to
engage in one industry segment, the speculative trading of
futures interests. The relevant financial information is
presented in Items 6 and 8.
(c) Narrative Description of Business. The Partnership is in the
business of speculative trading of futures interests, pursuant to
trading instructions provided by its Trading Advisors. For a
detailed description of the different facets of the Partnership's
business, see those portions of the Partnership's prospectus,
dated December 31, 1991, (the "Prospectus"), incorporated by
reference in this Form 10-K, set forth below.
Facets of Business
1. Summary 1. "Summary of the Prospectus" (Pages 1-6 of the Prospectus).
2. Commodity Markets 2. "The Commodities Markets" (Pages 66-73 of the Prospectus).
3. Partnership's Commodity 3. "Trading Policies" (Page Trading Arrangements and 61 of the Prospectus). Policies "The Trading Advisors" (Pages 32-60 of the Prospectus).
4. Management of the Part- 4. "The Management Agreement" nership (Pages 63-66 of the Prospectus). "The General Partner" (Pages 28-30 of the Prospectus). "The Commodity Broker" (Pages 61-63 of the Prospectus) and "The Limited Partnership Agreement" (Pages 75- 78 of the Prospectus).
5. Taxation of the Partner- 5. "Material Federal Income ship's Limited Partners Tax Considerations" and "State and Local Income Tax Aspects" (Pages 81- 89 of the Prospectus).
(d) Financial Information About Foreign and Domestic Operations and Export Sales.
The Partnership has not engaged in any operations in foreign
countries; however, the Partnership (through the commodity
brokers) enters into forward contract transactions where foreign
banks are the contracting party and trades in futures interests
on foreign exchanges.
Item 2.
Item 2. PROPERTIES The executive and administrative offices are located within the
offices of DWR. The DWR offices utilized by the Partnership are
located at Two World Trade Center, 62nd Floor, New York, NY
10048.
Item 3.
Item 3. LEGAL PROCEEDINGS
The class actions first filed in 1996 in California and in New
York State courts were each dismissed in 1999. However, in the
New York State class
action, plaintiffs appealed the trial court's dismissal of their
case on March 3, 2000.
On September 6, 10, and 20, 1996, and on March 13, 1997,
purported class actions were filed in the Superior Court of the
State of California, County of Los Angeles, on behalf of all
purchasers of interests in limited partnership commodity pools
sold by DWR. Named defendants include DWR, Demeter, Dean Witter
Futures & Currency Management Inc. ("DWFCM"), MSDW, certain
limited partnership commodity pools of which Demeter is the
general partner, (all such parties referred to hereafter as the
"Morgan Stanley Dean Witter Parties") and certain trading
advisors to those pools. On June 16, 1997, the plaintiffs in the
above actions filed a consolidated amended complaint, alleging,
among other things, that the defendants committed fraud, deceit,
negligent misrepresentation, various violations of the California
Corporations Code, intentional and negligent breach of fiduciary
duty, fraudulent and unfair business practices, unjust
enrichment, and conversion in the sale and operation of the
various limited partnership commodity pools. The complaints seek
unspecified amounts of compensatory and punitive damages and
other relief. The court entered an order denying class
certification on August 24, 1999. On September 24, 1999, the
court entered an order dismissing the case without prejudice on
consent. Similar purported class actions were also filed on
September 18 and 20, 1996, in the Supreme Court of the State of
New York,
New York County, and on November 14, 1996 in the Superior Court
of the State of Delaware, New Castle County, against the Morgan
Stanley Dean Witter Parties and certain trading advisors on
behalf of all purchasers of interests in various limited
partnership commodity pools sold by DWR. A consolidated and
amended complaint in the action pending in the Supreme Court of
the State of New York was filed on August 13, 1997, alleging that
the defendants committed fraud, breach of fiduciary duty, and
negligent misrepresentation in the sale and operation of the
various limited partnership commodity pools. The complaints seek
unspecified amounts of compensatory and punitive damages and
other relief. The New York Supreme Court dismissed the New York
action in November 1998, but granted plaintiffs leave to file an
amended complaint, which they did in early December 1998. The
defendants filed a motion to dismiss the amended complaint with
prejudice on February 1, 1999. By decision dated December 21,
1999, the New York Supreme Court dismissed the case with
prejudice.
In addition, on December 16, 1997, upon motion of the plaintiffs,
the action pending in the Superior Court of the State of Delaware
was voluntarily dismissed without prejudice.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
Item 5.
Item 5. MARKET FOR THE REGISTRANT'S PARTNERSHIP UNITS AND RELATED SECURITY HOLDER MATTERS
(a) Market Information
There is no established public trading market for Units of the
Partnership.
(b) Holders
The number of holders of Units at December 31, 1999 was
approximately 1,975.
(c) Distributions
No distributions have been made by the Partnership since it
commenced trading operations on March 1, 1992. Demeter has sole
discretion to decide what distributions, if any, shall be made to
investors in the Partnership. Demeter currently does not intend
to make any distribution of Partnership profits.
Item 7.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Liquidity - The Partnership deposits its assets with DWR as non-
clearing broker and Carr as clearing broker in separate futures
trading accounts established for each Trading Advisor, which
assets are used as margin to engage in trading. The assets are
held in either non-interest-bearing bank accounts or in
securities and instruments permitted by the Commodity Futures
Trading Commission ("CFTC") for investment of customer segregated
or secured funds. The Partnership's assets held by the commodity
brokers may be used as margin solely for the Partnership's
trading. Since the Partnership's sole purpose is to trade in
futures, forwards, and options, it is expected that the
Partnership will continue to own such liquid assets for margin
purposes.
The Partnership's investment in futures, forwards, and options
may, from time to time, be illiquid. Most U.S. futures exchanges
limit fluctuations in prices during a single day by regulations
referred to as "daily price fluctuations limits" or "daily
limits". Trades may not be executed at prices beyond the daily
limit. If the price for a particular futures or options contract
has increased or decreased by an amount equal to the daily limit,
positions in that futures or options contract can neither be
taken nor liquidated unless traders are willing to effect trades
at or within the limit. Futures prices have occasionally moved
the daily limit for several consecutive days with little or
no trading. These market conditions could prevent the
Partnership from promptly liquidating its futures or options
contracts and result in restrictions on redemptions.
There is no limitation on daily price moves in trading forward
contracts on foreign currencies. The markets for some world
currencies have low trading volume and are illiquid, which may
prevent the Partnership from trading in potentially profitable
markets or prevent the Partnership from promptly liquidating
unfavorable positions in such markets and subjecting it to
substantial losses. Either of these market conditions could
result in restrictions on redemptions.
The Partnership has never had illiquidity affect a material
portion of its assets.
Capital Resources. The Partnership does not have, or expect to
have, any capital assets. Redemptions of Units in the future
will affect the amount of funds available for investments in
futures interests in subsequent periods. It is not possible to
estimate the amount and therefore, the impact of future
redemptions of Units.
Results of Operations.
General. The Partnership's results depend on its Trading
Advisors and the ability of each Trading Advisors' trading
programs to take advantage of price movements or other profit
opportunities in the futures, forwards, and options markets. The
following presents a summary of the Partnership's operations for
the three years ended December 31, 1999 and a general discussion
of its trading activities during each period. It is important to
note, however, that the Trading Advisors trade in various markets
at different times and that prior activity in a particular market
does not mean that such market will be actively traded by the
Trading Advisors or will be profitable in the future.
Consequently, the results of operations of the Partnership are
difficult to discuss other than in the context of its Trading
Advisors' trading activities on behalf of the Partnership as a
whole and how the Partnership has performed in the past.
At December 31, 1999, the Partnership's total capital was
$14,845,767, a decrease of $4,141,476 from the Partnership's
total capital of $18,987,243 at December 31, 1998. For the year
ended December 31, 1999, the Partnership generated a net loss of
$1,674,974 and total redemptions aggregated $2,466,502.
For the year ended December 31, 1999, the Partnership recorded
total trading revenues, including interest income, of $268,597
and posted a decrease in Net Asset Value per Unit. The most
significant losses of approximately 7.02% were
experienced from global interest rate futures trading as the
volatile and choppy price movement experienced during the year
limited the ability to capitalize on trends. During the fourth
quarter, most global bond markets dropped on a resurgence of
inflation and interest rate fears initiated by consistently
strong U.S. economic data, evidence of rising inflation in
Germany and increases in oil prices. Additional losses of
approximately 5.40% were recorded in the global stock index
futures markets primarily from short European stock index
futures, particularly German, as prices in these markets were
boosted higher by gains on Wall Street and in Japan early in the
year. As a result of a widespread contraction of a number of
major stock markets, some downward price trends became
established in the late summer/early fall that caused the
Partnership's trend-following managers to establish short
positions. Given the upward snapback exhibited in many of these
markets, especially the U.S., these previously existing short
positions were negatively impacted during the fourth quarter.
Smaller losses of 1.71% and 1.65% were recorded in the
agricultural markets and soft commodities markets, respectively.
A portion of the Partnership's overall losses for the year were
offset by gains of approximately 0.85% recorded in the energy
markets from long crude oil futures positions as oil prices
increased on supply cuts by oil producing nations. Total
expenses for the year were $1,943,571, resulting in a net loss of
$1,674,974. The value of a Unit decreased from $1,076.00 at
December 31, 1998 to $970.18 at December 31, 1999.
At December 31, 1998, the Partnership's total capital was
$18,987,243, a decrease of $1,981,552 from the Partnership's
total capital of $20,968,795 at December 31, 1997. For the year
ended December 31, 1998, the Partnership generated net income of
$2,022,979 and total redemptions aggregated $4,004,531.
For the year ended December 31, 1998, the Partnership recorded
total trading revenues, including interest income, of $4,169,027
and posted an increase in Net Asset Value per Unit. In 1998, the
Partnership recorded gains of approximately 14.75% in the global
interest rate markets primarily as prices moved higher during
August and September. The most significant gains were recorded
from German, U.S. and Japanese interest rate futures as investors
sought the safety of fixed income investments in response to a
decline in the global equity markets amid political and economic
turmoil in Russia, Asia and Latin America. These gains were
partially offset by losses of approximately 5.62% experienced in
the currency markets and approximately 5.04% experienced in the
metals markets, as prices in these markets moved in a short-term
volatile pattern during a good portion of the year as investors
nervously shifted their capital from market to market in an
effort to limit risk and increase return in the face of global
economic uncertainty. Total expenses for the year were
$2,146,048, resulting in net income of $2,022,979. The value of
a Unit increased from $967.23 at December 31, 1997 to $1,076.00
at December 31, 1998.
At December 31, 1997, the Partnership's total capital was
$20,968,795, a decrease of $674,210 from the Partnership's total
capital of $21,643,005, at December 31, 1996. For the year ended
December 31, 1997, the Partnership generated net income of
$2,420,203 and total redemptions aggregated $3,094,413.
For the year ended December 31, 1997, the Partnership recorded
total trading revenues, including interest income, of $4,917,569
and posted an increase in Net Asset Value per Unit. Overall, the
Partnership recorded net profits for the year. Gains of
approximately 8.75% were recorded in the currency markets
primarily as a result of sustained price trends throughout much
of the year. A portion of the Partnership's overall gains were
offset by losses of approximately 1.50% recorded in the global
interest rate futures markets primarily due to a sharp trend
reversal in international interest rate futures prices during the
fourth quarter and as a result of short-term volatility in
domestic bond and stock index futures. Offsetting gains were
recorded from long global interest rate futures positions during
July. Additionally, the Partnership's diversification over a
variety of market complexes allowed the Partnership to record
smaller trading gains of approximately 0.14% in traditional
commodities, the agricultural markets. Total expenses for the
year were $2,497,366, resulting in net income of $2,420,203. The
value of a Unit increased from $870.11 at December 31, 1996 to
$967.23 at December 31, 1997.
The Partnership's overall performance record represents varied
results of trading in different futures interests markets. For a
further description of 1999 trading results, refer to the letter
to the Limited Partners in the accompanying Annual Report to
Limited Partners for the year ended December 31, 1999, which is
incorporated by reference to Exhibit 13.01 of this Form 10-K.
The Partnership's gains and losses are allocated among its
partners for income tax purposes.
Credit Risk.
Financial Instruments. The Partnership is a party to financial
instruments with elements of off-balance sheet market and credit
risk. The Partnership may trade futures, forwards, and options
in a portfolio of agricultural commodities, energy products,
foreign currencies, interest rates, precious and base metals,
soft commodities, and stock indices. In entering into these
contracts, the Partnership is subject to the market risk that
such contracts may be significantly influenced by market
conditions, such as interest rate volatility, resulting in such
contracts being less valuable. If the markets should move
against all of the positions held by the Partnership at the same
time, and if the Trading Advisors were unable to offset positions
of the Partnership, the Partnership could lose all of its assets
and investors would realize a 100% loss.
In addition to the Trading Advisors' internal controls, each
Trading Advisor must comply with the trading policies of the
Partnership. These trading policies include standards for
liquidity and leverage with which the Partnership must comply.
The Trading Advisors and Demeter monitor the Partnership's
trading activities to ensure compliance with the trading
policies. Demeter may require the Trading Advisors to modify
positions of the Partnership if Demeter believes they violate the
Partnership's trading policies.
In addition to market risk, in entering into futures, forwards,
and options contracts there is a credit risk to the Partnership
that the counterparty on a contract will not be able to meet its
obligations to the Partnership. The ultimate counterparty or
guarantor of the Partnership for futures contracts traded in the
United States and the foreign exchanges on which the Partnership
trades is the clearinghouse associated with such exchange. In
general, a clearinghouse is backed by the membership of the
exchange and will act in the event of non-performance by one of
its members or one of its member's customers, which should
significantly reduce this credit risk. For example, a
clearinghouse may cover a default by drawing upon a defaulting
member's mandatory contributions and/or non-defaulting members'
contributions to a clearinghouse guarantee fund, established
lines or letters of credit with banks, and/or the clearinghouse's
surplus capital and other available assets
of the exchange and clearinghouse, or assessing its members. In
cases where the Partnership trades off-exchange forward contracts
with a counterparty, the sole recourse of the Partnership will be
the forward contracts counterparty.
There is no assurance that a clearinghouse or exchange will meet
its obligations to the Partnership, and Demeter and the commodity
brokers will not indemnify the Partnership against a default by
such parties. Further, the law is unclear as to whether a
commodity broker has any obligation to protect its customers from
loss in the event of an exchange or clearinghouse defaulting on
trades effected for the broker's customers. Any such obligation
on the part of a broker appears even less clear where the default
occurs in a non-U.S. jurisdiction.
Demeter deals with these credit risks of the Partnership in
several ways. First, it monitors the Partnership's credit
exposure to each exchange on a daily basis, calculating not only
the amount of margin required for it but also the amount of its
unrealized gains at each exchange, if any. The commodity brokers
inform the Partnership, as with all their customers, of its net
margin requirements for all its existing open positions, but do
not break that net figure down, exchange by exchange. Demeter,
however, has installed a system which permits it to monitor the
Partnership's potential margin liability, exchange by exchange.
As a result, Demeter is able to monitor the
Partnership's potential net credit exposure to each exchange by
adding the unrealized trading gains on that exchange, if any, to
the Partnership's margin liability thereon.
Second, the Partnership's trading policies limit the amount of
its Net Assets that can be committed at any given time to futures
contracts and require, in addition, a minimum amount of
diversification in the Partnership's trading, usually over
several different products. One of the aims of such trading
policies has been to reduce the credit exposure of the
Partnership to a single exchange and, historically, the
Partnership's exposure to any one exchange has typically amounted
to only a small percentage of its total Net Assets. On those
relatively few occasions where the Partnership's credit exposure
may climb above such level, Demeter deals with the situation on a
case by case basis, carefully weighing whether the increased
level of credit exposure remains appropriate. Material changes
to the trading policies may be made only with the prior written
approval of the limited partners owning more than 50% of Units
then outstanding.
Third, Demeter has secured, with respect to Carr acting as the
clearing broker for the Partnership, a guarantee by Credit
Agricole Indosuez, Carr's parent, of the payment of the "net
liquidating value" of the transactions (futures, options and
forward contracts) in the Partnership's account.
With respect to forward contract trading, the Partnership trades
with only those counterparties which Demeter, together with DWR,
have determined to be creditworthy. At the date of this filing,
the Partnership deals only with Carr as its counterparty on
forward contracts. The guarantee by Carr's parent, discussed
above, covers these forward contracts.
See "Financial Instruments" under Notes to Financial Statements
in the Partnership's Annual Report to Limited Partners for the
year ended December 31, 1999, which is incorporated by reference
to Exhibit 13.01 of this Form
10-K.
Year 2000. Commodity pools, like financial and business
organizations and individuals around the world, depend on the
smooth functioning of computer systems. The Year 2000 issue
arose since many of the world's computer systems (including those
in non-information technology systems) traditionally recorded
years in a two-digit format. If not addressed, such computer
systems may have been unable to properly interpret dates beyond
the year 1999, which may have led to business disruptions in the
U.S. and internationally. Such disruptions could have adversely
affected the handling or determination of futures trades and
prices and other services for the Partnership. Accordingly,
Demeter has fully participated in a firmwide initiative
established by MSDW to address issues associated with the Year
2000. As part of this initiative, MSDW reviewed its global
software and hardware infrastructure for mainframe, server
and desktop computing environments and engaged in extensive
remediation and testing. The Year 2000 initiative also
encompassed the review of agencies, vendors and facilities for
Year 2000 compliance.
Since 1995, MSDW prepared actively for the Year 2000 issue to
ensure that it would have the ability to respond to any critical
business process failure, to prevent the loss of workspace and
technology, and to mitigate any potential financial loss or
damage to its global franchise. Where necessary, contingency
plans were expanded or developed to address specific Year 2000
risk scenarios, supplementing existing business policies and
practices. In conjunction with MSDW's Year 2000 preparations,
Demeter monitored the progress of Carr and each Trading Advisor
throughout 1999 in their Year 2000 compliance and, where
applicable, tested its external interfaces, with Carr and the
Trading Advisors. In addition, Demeter, the commodity brokers,
the Trading Advisors and all U.S. futures exchanges were
subjected to monitoring by the CFTC of their Year 2000
preparedness, and the major foreign futures exchanges engaged in
market-wide testing of their Year 2000 compliance during 1999.
MSDW and Demeter consider the transition into the Year 2000
successful from the perspective of their internal systems and
global external interactions. Over the millennial changeover
period, no material issues were encountered, and MSDW, Demeter
and the Partnership conducted business as usual.
Risks Associated With the Euro. On January 1, 1999, eleven
countries in the European Union established fixed conversion
rates on their existing sovereign currencies and converted to a
common single currency (the euro). During a three-year
transition period, the sovereign currencies will continue to
exist but only as a fixed denomination of the euro. Conversion
to the euro prevents the Trading Advisors from trading those
sovereign currencies and thereby limits their ability to take
advantage of potential market opportunities that might otherwise
have existed had separate currencies been available to trade.
This could adversely affect the performance results of the
Partnership.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Introduction
The Partnership is a commodity pool involved in the speculative
trading of futures interests. The market-sensitive instruments
held by the Partnership are acquired for speculative trading
purposes only and, as a result, all or substantially all of the
Partnership's assets are at risk of trading loss. Unlike an
operating company, the risk of market-sensitive instruments is
central, not incidental, to the Partnership's main business
activities.
The futures interests traded by the Partnership involve varying
degrees of market risk. Market risk is often dependent upon
changes in the level or volatility of interest rates, exchange
rates, and prices of financial instruments and commodities.
Fluctuations in market risk based upon these
factors result in frequent changes in the fair value of the
Partnership's open positions, and, consequently, in its earnings
and cash flow.
The Partnership's total market risk is influenced by a wide
variety of factors, including the diversification among the
Partnership's open positions, the volatility present within the
markets, and the liquidity of the markets. At different times,
each of these factors may act to increase or decrease the market
risk associated with the Partnership.
The Partnership's past performance is not necessarily indicative
of its future results. Any attempt to numerically quantify the
Partnership's market risk is limited by the uncertainty of its
speculative trading. The Partnership's speculative trading may
cause future losses and volatility (i.e. "risk of ruin") that far
exceed the Partnership's experiences to date or any reasonable
expectations based upon historical changes in market value.
Quantifying the Partnership's Trading Value at Risk
The following quantitative disclosures regarding the
Partnership's market risk exposures contain "forward-looking
statements" within the meaning of the safe harbor from civil
liability provided for such statements by the Private Securities
Litigation Reform Act of 1995 (set forth in Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange
Act of 1934).
All quantitative disclosures in this section are deemed to be
forward-looking statements for purposes of the safe harbor,
except for statements of historical fact.
The Partnership accounts for open positions using mark-to-market
accounting principles. Any loss in the market value of the
Partnership's open positions is directly reflected in the
Partnership's earnings, whether realized or unrealized, and its
cash flow. Profits and losses on open positions of exchange-
traded futures interests are settled daily through variation
margin.
The Partnership's risk exposure in the market sectors traded by
the Trading Advisors is estimated below in terms of Value at Risk
("VaR"). The VaR model used by the Partnership includes many
variables that could change the market value of the Partnership's
trading portfolio. The Partnership estimates VaR using a model
based upon historical simulation with a confidence level of 99%.
Historical simulation involves constructing a distribution of
hypothetical daily changes in the value of a trading portfolio.
The VaR model takes into account linear exposures to price and
interest rate risk. Market risks that are incorporated in the
VaR model include equity and commodity prices, interest rates,
foreign exchange rates, and correlation among these variables.
The hypothetical changes in portfolio value are based on daily
percentage changes observed in key market indices or other market
factors ("market risk factors") to which the portfolio is
sensitive. The historical observation
period of the Partnership's VaR is approximately four years. The
one-day 99% confidence level of the Partnership's VaR corresponds
to the negative change in portfolio value that, based on observed
market risk factors, would have been exceeded once in 100 trading
days.
VaR models, including the Partnership's, are continuously
evolving as trading portfolios become more diverse and modeling
techniques and systems capabilities improve. Please note that
the VaR model is used to numerically quantify market risk for
historic reporting purposes only and is not utilized by either
Demeter or the Trading Advisors in their daily risk management
activities.
The Partnership's Value at Risk in Different Market Sectors
The following tables indicates the VaR associated with the
Partnership's open positions as a percentage of total Net Assets
by primary market risk category as of December 31, 1999 and 1998.
As of December 31, 1999 and 1998, the Partnership's total
capitalization was approximately $15 million and $19 million,
respectively.
Primary Market December 31, 1999 December 31, 1998 Risk Category Value at Risk Value at Risk
Interest Rate (1.06)% (1.58)%
Currency (1.08) (.99)
Equity (.90) (.72)
Commodity (.60) (1.07)
Aggregate Value at Risk (1.89)%
(2.15)%
Aggregate Value at Risk represents the aggregate VaR of all the
Partnership's open positions and not the sum of the VaR of the
individual Market Categories listed above. Aggregate VaR will be
lower as it takes into account correlation among different
positions and categories.
The table above represents the VaR of the Partnership's open
positions at December 31, 1999 and 1998 only and is not
necessarily representative of either the historic or future risk
of an investment in the Partnership. Because the Partnership's
only business is the speculative trading of futures interests,
the composition of its trading portfolio can change significantly
over any given time period, or even within a single trading day.
Any changes in open positions could positively or negatively
materially impact market risk as measured by VaR.
The table below supplements the year end VaR by presenting the
Partnership's high, low and average VaR, as a percentage of total
Net Assets for the four quarterly reporting periods from January
1, 1999 through December 31, 1999.
Primary Market Risk Category High Low
Average
Interest Rate (2.35)% (.91)% (1.40)%
Currency (2.06) (1.08)
(1.69)
Equity (1.09) (.62) (.87)
Commodity (1.24) (.60) (.94)
Aggregate Value at Risk (4.10)% (1.89)% (2.65)%
Limitations on Value at Risk as an Assessment of Market Risk
The face value of the market sector instruments held by the
Partnership is typically many times the applicable margin
requirements. Margin requirements generally range between 2% and
15% of contract face value. Additionally, the use of leverage
causes the face value of the market sector instruments held by
the Partnership to typically be many times the total
capitalization of the Partnership. The value of the
Partnership's open positions thus creates a "risk of ruin" not
typically found in other investments. The relative size of the
positions held may cause the Partnership to incur losses greatly
in excess of VaR within a short period of time, given the effects
of the leverage employed and market volatility. The VaR tables
above, as well as the past performance of the Partnership, gives
no indication of such "risk of ruin". In
addition, VaR risk measures should be viewed in light of the
methodology's limitations, which include the following:
past changes in market risk factors will not always result
in accurate predictions of the distributions and correlations of
future market movements;
changes in portfolio value in response to market movements
may differ from those of the VaR model;
VaR results reflect past trading positions while future risk
depends on future positions;
VaR using a one-day time horizon does not fully capture the
market risk of positions that cannot be liquidated or hedged
within one day; and
the historical market risk factor data used for VaR
estimation may provide only limited insight into losses that
could be incurred under certain unusual market movements.
The VaR tables above present the results of the Partnership's VaR
for each of the Partnership's market risk exposures and on an
aggregate basis at December 31, 1999 and for the end of the four
quarterly reporting periods during calendar year 1999. Since VaR
is based on historical data, VaR should not be viewed as
predictive of the Partnership's future financial performance or
its ability to manage or monitor risk. There can be no assurance
that the
Partnership's actual losses on a particular day will not exceed
the VaR amounts indicated above or that such losses will not
occur more than 1 in 100 trading days.
Non-Trading Risk
The Partnership has non-trading market risk on its foreign cash
balances not needed for margin. These balances and any market
risk they may represent are immaterial. The Partnership also
maintains a substantial portion (approximately 82%) of its
available assets in cash at DWR. A decline in short-term
interest rates will result in a decline in the Partnership's cash
management income. This cash flow risk is not considered
material.
Materiality, as used throughout this section, is based on an
assessment of reasonably possible market movements and any
associated potential losses, taking into account the leverage,
optionality and multiplier features of the Partnership's market
sensitive instruments.
Qualitative Disclosures Regarding Primary Trading Risk Exposures
The following qualitative disclosures regarding the Partnership's
market risk exposures - except for (A) those disclosures that are
statements of historical fact and (B) the descriptions of how the
Partnership manages its primary market risk exposures -
constitute forward-looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the
Securities Exchange Act. The Partnership's primary market risk
exposures as well as the strategies
used and to be used by Demeter and the Trading Advisors for
managing such exposures are subject to numerous uncertainties,
contingencies and risks, any one of which could cause the actual
results of the Partnership's risk controls to differ materially
from the objectives of such strategies. Government
interventions, defaults and expropriations, illiquid markets, the
emergence of dominant fundamental factors, political upheavals,
changes in historical price relationships, an influx of new
market participants, increased regulation and many other factors
could result in material losses as well as in material changes to
the risk exposures and the risk management strategies of the
Partnership. Investors must be prepared to lose all or
substantially all of their investment in the Partnership.
The following were the primary trading risk exposures of the
Partnership as of December 31, 1999, by market sector. It may be
anticipated however, that these market exposures will vary
materially over time.
Interest Rate. The primary market exposure in the Partnership is
in the interest rate sector. Exposure was spread across the
U.S., Japanese, European, German and British interest rate
sectors. Interest rate movements directly affect the price of
the sovereign bond futures positions held by the Partnership and
indirectly affect the value of its stock index and currency
positions. Interest rate movements in one country as well as
relative interest rate movements between countries materially
impact the Partnership's
profitability. The Partnership's primary interest rate exposure
is generally to interest rate fluctuations in the United States
and the other G-7 countries. The G-7 countries consists of
France, U.S., Britain, Germany, Japan, Italy and Canada.
However, the Partnership also takes futures positions in the
government debt of smaller nations - e.g. Australia. Demeter
anticipates that G-7 and Australian interest rates will remain
the primary interest rate exposure of the Partnership for the
foreseeable future. The changes in interest rates, which have
the most effect on the Partnership, are changes in long-term, as
opposed to short-term, rates. Most of the speculative futures
positions held by the Partnership are in medium-to long- term
instruments. Consequently, even a material change in short-term
rates would have little effect on the Partnership, were the
medium-to long-term rates to remain steady.
Currency. The second largest market exposure in the fourth
quarter was in the currency complex. The Partnership's currency
exposure is to exchange rate fluctuations, primarily fluctuations
which disrupt the historical pricing relationships between
different currencies and currency pairs. Interest rate changes
as well as political and general economic conditions influence
these fluctuations. The Partnership trades in a large number of
currencies, including cross-rates - i.e., positions between two
currencies other than the U.S. dollar. For the fourth quarter of
1999, the Partnership's major exposures were in the euro currency
crosses and outright U.S. dollar
positions. (Outright positions consist of the U.S. dollar vs.
other currencies. These other currencies include the major and
minor currencies). Demeter does not anticipate that the risk
profile of the Partnership's currency sector will change
significantly in the future. The currency trading VaR figure
includes foreign margin amounts converted into U.S. dollars with
an incremental adjustment to reflect the exchange rate risk
inherent to the dollar-based Partnership in expressing VaR in a
functional currency other than dollars.
Equity. The primary equity exposure is to equity price risk in
the G-7 countries. The stock index futures traded by the
Partnership are by law limited to futures on broadly based
indices. As of December 31, 1999, the Partnership's primary
exposures were in the Nikkei (Japan), Hang Seng (China) and FT-SE
(Britain) stock indices. The Partnership is primarily exposed to
the risk of adverse price trends or static markets in the U.S.,
European and Japanese indices. (Static markets would not cause
major market changes but would make it difficult for the
Partnership to avoid being "whipsawed" into numerous small
losses).
Commodity.
Metals. The Partnership's primary metals market exposure is to
fluctuations in the price of gold. Although certain Trading
Advisors will from time to
time trade base metals such as aluminum, copper, zinc and nickel,
the principal market exposures of the Partnership have
consistently been in precious metals. A reasonable amount of
exposure was evident in the gold market as the price of gold
retreated during the fourth quarter. Demeter anticipates that
gold will remain the primary metals market exposure for the
Partnership.
Energy. On December 31, 1999, the Partnership's energy exposure
was shared by futures contracts in the oil and natural gas
markets. Price movements in these markets result from political
developments in the Middle East, weather patterns, and other
economic fundamentals. As oil prices have increased
approximately 100% this year, and, given that the agreement by
OPEC to cut production is approaching expiration in March 2000,
it is possible that volatility will remain on the high end.
Significant profits and losses have been and are expected to
continue to be experienced in this market. Natural gas, also a
primary energy market exposure, has exhibited more volatility
than the oil markets on an intra-day and daily basis and is
expected to continue in this choppy pattern.
Soft Commodities and Agriculturals. On December 31, 1999, the
Partnership had a reasonable amount of exposure in the markets
that comprise these sectors. Most of the exposure, however, was
in the cotton, sugar and soybeans markets.
Supply and demand inequalities, severe weather disruption and
market expectations affect price movements in these markets.
Qualitative Disclosures Regarding Non-Trading Risk Exposure
The following was the only non-trading risk exposure of the
Partnership as of December 31, 1999:
Foreign Currency Balances. The Partnership's primary foreign
currency balances are in euros, British pounds and Hong Kong
dollars. The Partnership controls the non-trading risk of these
balances by regularly converting these balances back into dollars
upon liquidation of the respective position.
Qualitative Disclosures Regarding Means of Managing Risk Exposure
The Partnership and the Trading Advisors, separately, attempt to
manage the risk of the Partnership's open positions in
essentially the same manner in all market categories traded.
Demeter attempts to manage market exposure by diversifying the
Partnership's assets among different Trading Advisors, each of
whose strategies focus on different market sectors and trading
approaches, and monitoring the performance of the Trading
Advisors daily. In addition, the Trading Advisors establish
diversification guidelines, often set in terms of the maximum
margin to be committed to positions in any one market sector or
market-sensitive instrument.
Demeter monitors and controls the risk of the Partnership's non-
trading instrument, cash. Cash is the only Partnership
investment directed by Demeter, rather than the Trading Advisors.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements are incorporated by reference to the
Partnership's Annual Report, which is filed as Exhibit 13.01
hereto.
Supplementary data specified by Item 302 of Regulation S-K
(selected quarterly financial data) is not applicable.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Directors and Officers of the General Partner
The directors and officers of Demeter are as follows:
Robert E. Murray, age 39, is Chairman of the Board, President and
a Director of Demeter. Mr. Murray is also Chairman of the Board,
President and a Director of DWFCM. Effective as of the close of
business on January 31, 2000, Mr. Murray replaced Mr. Hawley as
Chairman of the Board of Demeter and DWFCM. Mr. Murray is
currently a Senior Vice President of DWR's Managed Futures
Department. Mr. Murray began his career at DWR in 1984 and is
currently the Director of the Managed Futures Department. In this
capacity, Mr. Murray is responsible for overseeing all aspects of
the firm's Managed Futures Department. Mr. Murray currently
serves as Vice Chairman and a Director of the Managed Funds
Association, an industry association for investment professionals
in futures, hedge funds and other alternative investments. Mr.
Murray graduated from Geneseo State University in May 1983 with a
B.A. degree in Finance.
Mitchell M. Merin, age 46, is a Director of Demeter. Mr. Merin
is also a Director of DWFCM. Mr. Merin was appointed the Chief
Operating Officer of Individual Asset Management for MSDW in
December 1998 and the President and Chief Executive Officer of
Morgan Stanley Dean Witter Advisors in February
1998. He has been an Executive Vice President of DWR since 1990,
during which time he has been director of DWR's Taxable Fixed
Income and Futures divisions, Managing Director in Corporate
Finance and Corporate Treasurer. Mr. Merin received his
Bachelor's degree from Trinity College in Connecticut and his
M.B.A. degree in finance and accounting from the Kellogg Graduate
School of Management of Northwestern University in 1977.
Joseph G. Siniscalchi, age 54, is a Director of Demeter. Mr.
Siniscalchi joined DWR in July 1984 as a First Vice President,
Director of General Accounting and served as a Senior Vice
President and Controller for DWR's Securities Division through
1997. He is currently Executive Vice President and Director of
the Operations Division of DWR. From February 1980 to July 1984,
Mr. Siniscalchi was Director of Internal Audit at Lehman Brothers
Kuhn Loeb, Inc.
Edward C. Oelsner, III, age 57, is a Director of Demeter. Mr.
Oelsner is currently an Executive Vice President and head of the
Product Development Group at Morgan Stanley Dean Witter Advisors,
an affiliate of DWR. Mr. Oelsner joined DWR in 1981 as a Managing
Director in DWR's Investment Banking Department specializing in
coverage of regulated industries and, subsequently, served as
head of the DWR Retail Products Group. Prior to joining DWR, Mr.
Oelsner held positions at The First Boston Corporation as a
member of the Research and Investment Banking Departments from
1967 to 1981. Mr. Oelsner
received his M.B.A. in Finance from the Columbia University
Graduate School of Business in 1966 and an A.B. in Politics from
Princeton University in 1964.
Lewis A. Raibley, III, age 37, is Vice President, Chief Financial
Officer and a Director of Demeter. Mr. Raibley is also a
Director of DWFCM. Mr. Raibley is currently Senior Vice
President and Controller in the Individual Asset Management Group
of MSDW. From July 1997 to May 1998, Mr. Raibley served as
Senior Vice President and Director in the Internal Reporting
Department of MSDW and prior to that, from 1992 to 1997, he
served as Senior Vice President and Director in the Financial
Reporting and Policy Division of Dean Witter Discover & Co. He
has been with MSDW and its affiliates since June 1986.
Richard A. Beech, age 48, is a Director of Demeter. Mr. Beech
has been associated with the futures industry for over 23 years.
He has been at DWR since August 1984, where he is presently
Senior Vice President and head of Branch Futures. Mr. Beech
began his career at the Chicago Mercantile Exchange, where he
became the Chief Agricultural Economist doing market analysis,
marketing and compliance. Prior to joining DWR, Mr. Beech also
had worked at two investment banking firms in operations,
research, managed futures and sales management.
Ray Harris, age 43, is a Director of Demeter. Mr. Harris is
currently Executive Vice President, Planning and Administration
for Morgan Stanley Dean
Witter Asset Management and has worked at DWR or its affiliates
since July 1982, serving in both financial and administrative
capacities. From August 1994 to January 1999, he worked in two
separate DWR affiliates, Discover Financial Services and Novus
Financial Corp., culminating as Senior Vice President. Mr.
Harris received his B.A. degree from Boston College and his
M.B.A. in finance from the University of Chicago.
Mark J. Hawley, age 56, served as Chairman of the Board and a
Director of Demeter and DWFCM throughout 1999. Mr. Hawley joined
DWR in February 1989 as Senior Vice President and served as
Executive Vice President and Director of DWR's Product Management
for Individual Asset Management throughout 1999. In this
capacity, Mr. Hawley was responsible for directing the activities
of the firm's Managed Futures, Insurance, and Unit Investment
Trust Business. From 1978 to 1989, Mr. Hawley was a member of
the senior management team at Heinold Asset Management, Inc., a
commodity pool operator, and was responsible for a variety of
projects in public futures funds. From 1972 to 1978, Mr. Hawley
was a Vice President in charge of institutional block trading for
the Mid-West at Kuhn Loeb & Company. Mr. Hawley resigned
effective January 31, 2000.
All of the foregoing directors have indefinite terms.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The Partnership has no directors and executive officers. As a
limited
partnership, the business of the Partnership is managed by
Demeter, which is responsible for the administration of the
business affairs of the Partnership but receives no compensation
for such services.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
(a) Security Ownership of Certain Beneficial Owners - As of
December 31, 1999, there were no persons known to be beneficial
owners of more than 5 percent of the Units.
(b) Security Ownership of Management - At December 31, 1999,
Demeter owned 215.962 Units of General Partnership Interest in
the Partnership, representing a 1.41 percent interest in the
Partnership.
(c) Changes in Control - None
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Refer to Note 2 - "Related Party Transactions" of "Notes to
Financial Statements", in the accompanying 1999 Annual Report to
Limited Partners, which is incorporated by reference to Exhibit
13.01 of this Form 10-K. In its capacity as the Partnership's
retail commodity broker, DWR received commodity brokerage
commissions (paid and accrued by the Partnership) of $1,203,533
for the year ended December 31, 1999.
PART IV
Item 14.
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K
(a) 1. Listing of Financial Statements
The following financial statements and report of independent
auditors, all appearing in the accompanying Annual Report to
Limited Partners for the year ended December 31, 1999 are
incorporated by reference to Exhibit 13.01 of this Form 10-K:
- - Report of Deloitte & Touche LLP, independent auditors, for the years ended December 31, 1999, 1998 and 1997. - - Statements of Financial Condition as of December 31, 1999 and 1998. - - Statements of Operations, Changes in Partners' Capital, and Cash Flows for the years ended December 31, 1999, 1998 and 1997. - - Notes to Financial Statements.
With the exception of the aforementioned information and the
information incorporated in Items 7, 8, and 13, the Annual Report
to Limited Partners for the year ended December 31, 1999 is not
deemed to be filed with this report.
2. Listing of Financial Statement Schedules
No financial statement schedules are required to be filed with
this report.
(b) Reports on Form 8-K
No reports on Form 8-K have been filed by the Partnership during
the last quarter of the period covered by this report.
(c) Exhibits
Refer to Exhibit Index on Page E-1.
SIGNATURES
Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DEAN WITTER GLOBAL PERSPECTIVE PORTFOLIO L.P. (Registrant)
BY: Demeter Management Corporation, General Partner
March 30, 2000 BY: /s/ Robert E. Murray Robert E. Murray, Director, Chairman of the Board and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Demeter Management Corporation.
BY: /s/ Robert E. Murray _____ March 29, Robert E. Murray, Director, Chairman of the Board and President
/s/ Joseph G. Siniscalchi _______ March 29, Joseph G. Siniscalchi, Director
/s/ Edward C. Oelsner III ________ March 29, Edward C. Oelsner III, Director
/s/ Mitchell M. Merin ______ March 29, 2000 Mitchell M. Merin, Director
/s/ Richard A. Beech ______ March 29, 2000 Richard A. Beech, Director
/s/ Ray Harris _____ March 29, Ray Harris, Director
/s/ Lewis A. Raibley, III __________ March 29, 2000 Lewis A. Raibley, III, Director, Chief Financial Officer and Principal Accounting Officer
EXHIBIT INDEX
ITEM METHOD OF FILING
3.01 Limited Partnership Agreement of the Partnership, dated as of November 7, 1991. (1)
10.01 Management Agreements among the Partnership, Demeter and A.O. Management, (2) Inc., Chang Crowell and Millburn each dated as of December 31, 1991.
10. 02 Management Agreement among the Partnership, Demeter Management Corporation and ELM Financial Incorporated dated as of May 1, 1994. (4)
10. 03 Management Agreement among the Partnership, Demeter Management Corporation and EMC Capital Managements, Inc. dated as of June 1, 1994. (5)
10. 04 Amended and Restated Customer Agreement, dated as of December 1, 1997, between the Partnership and Dean Witter Reynolds Inc. (6)
10.05 Customer Agreement, dated as of December 1, 1997, among the Partnership, Carr Futures, Inc., and Dean Witter Reynolds Inc. (7)
10. 06 International Foreign Exchange Master Agreement, dated as of August 1, 1997, between the Partnership and Carr Futures, Inc. (8)
13.01 Annual Report to Limited Partners for the year ended December 31, 1999. (9)
21. 01 Supplement (dated April 27, 1992) to the Prospectus. (3)
(1) Incorporated by reference to Exhibit 3.01 and Exhibit 3.02 of the Partnership's Registration Statement on Form S-1.
(2) Incorporated by reference by Exhibit 10.02 of the Partnership's Registration Statement on Form S-1.
(3) Incorporated by reference to the Partnership's Registration Statement on Form S-1, Post Effective Amendment Number 1.
(4) Incorporated by reference to Exhibit 10.03 of the Partnership's Annual Report on Form 10-K for the fiscal year ended December 31, 1994.
(5) Incorporated by reference to Exhibit 10.04 of the Partnership's Annual Report on Form 10-K for the fiscal year ended December 31, 1994.
(6) Incorporated by reference to Exhibit 10.04 of the Partnership's Form 10-K (File No. 0-19901) for fiscal year ended December 31, 1998.
(7) Incorporated by reference to Exhibit 10.05 of the Partnership's Form 10-K (File No. 0-19901) for fiscal year ended December 31, 1998.
(8) Incorporated by reference to Exhibit 10.06 of the Partnership's Form 10-K (File No. 0-19901) for fiscal year ended December 31, 1998.
(9) Filed herewith.
Global Perspective Portfolio
December 31, 1999 Annual Report
MORGAN STANLEY DEAN WITTER
Demeter Management Corporation Two World Trade Center 62nd Floor New York, NY 10048 Telephone (212) 392-8899
Dean Witter Global Perspective Portfolio L.P. Annual Report
Dear Limited Partner:
This marks the eighth annual report for the Dean Witter Global Perspective Portfolio L.P. (the "Fund"). The Fund began the year trading at a Net Asset Value per Unit of $1,076.00 and finished 1999 at a Net Asset Value per Unit of $970.18, a net loss of 9.8%. The Fund has decreased by 3.0% since its inception of trading in March 1992 ( a compound annualized return of -0.4%).
Overall, the Fund recorded a decrease in Net Asset Value per Unit during 1999. The most significant losses were experienced from global interest rate futures trading as the volatile and choppy markets experienced during the year limited the ability to capitalize on trends. During the fourth quarter, most global bond markets dropped on a resurgence of inflation and interest rate fears ini- tiated by consistently strong U.S. economic data, evidence of rising inflation in Germany and increases in oil prices. Additional losses were recorded in the global stock index futures markets from short European stock index futures, particularly German, as prices in these markets were boosted higher by gains on Wall Street and in Japan earlier in the year. Given the widespread contraction of a number of major stock markets, some downward price trends became estab- lished in the late summer/early fall that caused the Fund's trend-following managers to establish short positions. Given the upward snapback exhibited in many of these markets, especially the U.S., these previously existing short po- sitions were negatively impacted during the fourth quarter. Smaller losses were recorded in the agricultural and soft commodities markets. A portion of the Fund's overall losses for the year were offset by gains recorded in the energy markets from long crude oil futures positions as oil prices increased on cuts by oil producing nations.
While we are disappointed that the Fund had a difficult year in 1999, we remind investors that managed futures funds such as Global Perspective Portfolio are designed to provide diversification and non-correlation, that is the ability to perform independently, of global equities and bonds. Managed futures have his- torically performed independently of traditional investments, such as stocks and bonds. This is referred to as non-correlation, or the potential for managed futures to perform when traditional markets such as stocks and bonds may expe- rience difficulty performing. Of course, managed futures funds will not auto- matically be profitable during unfavorable periods for these traditional in- vestments and vice versa. The degree of non-correlation of any given managed futures fund will vary, particularly as a result of market conditions, and some funds will have significantly lesser degrees of non-correlation (i.e., greater correlation) with stocks and bonds than others. 1999 proved to be another strong year for equities, due in large part to continued growth and stability in most major world economies accompanied by low inflation. This environment, while strong for equities, provided few major sustained price trends in the world's futures and currency markets, and as such, proved to be a difficult trading environment for the money managers in this Fund whose trading strate- gies rely on the existence of longer-term price trends for trading opportuni- ties. Nevertheless, we remain confident in the role that managed futures in- vestments play in the overall investment portfolio, and we believe this confi- dence is well-founded based on the longer-term diversified non-correlated re- turns of this alternative investment. Demeter Management Corporation, as Gener- al Partner to the Fund, has been and continues to be an active investor with more than $18 million invested among the 24 managed futures funds to which we act as General Partner.
Should you have any questions concerning this report, please feel free to con- tact Demeter Management Corporation at Two World Trade Center, 62nd Floor, New York, NY 10048, or your Morgan Stanley Dean Witter Financial Advisor.
I hereby affirm, that to the best of my knowledge and belief, the information contained in this report is accurate and complete. Past performance is not a guarantee of future results.
Sincerely,
/s/ Robert E. Murray Robert E. Murray Chairman Demeter Management Corporation General Partner
Dean Witter Global Perspective Portfolio L.P. Independent Auditors' Report
The Limited Partners and the General Partner:
We have audited the accompanying statements of financial condition of Dean Wit- ter Global Perspective Portfolio L.P. (the "Partnership") as of December 31, 1999 and 1998 and the related statements of operations, changes in partners' capital, and cash flows for each of the three years in the period ended Decem- ber 31, 1999. These financial statements are the responsibility of the Partner- ship's management. Our responsibility is to express an opinion on these finan- cial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing stan- dards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of materi- al misstatement. An audit includes examining, on a test basis, evidence sup- porting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement pre- sentation. We believe that our audits provide a reasonable basis for our opin- ion.
In our opinion, such financial statements present fairly, in all material re- spects, the financial position of Dean Witter Global Perspective Portfolio L.P. at December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in con- formity with generally accepted accounting principles.
/S/ Deloitte & Touche LLP
February 14, 2000 (March 3, 2000 as to Note 6) New York, New York
Dean Witter Global Perspective Portfolio L.P. Statements of Financial Condition
The accompanying notes are an integral part of these financial statements.
Dean Witter Global Perspective Portfolio L.P. Statements of Operations
Statements of Changes in Partners' Capital For the Years Ended December 31, 1999, 1998 and 1997
The accompanying notes are an integral part of these financial statements.
Dean Witter Global Perspective Portfolio L.P. Statements of Cash Flows
The accompanying notes are an integral part of these financial statements.
Dean Witter Global Perspective Portfolio L.P. Notes to Financial Statements
1. Summary of Significant Accounting Policies
Organization--Dean Witter Global Perspective Portfolio L.P. (the "Partnership") is a limited partnership organized to engage primarily in the speculative trad- ing of futures and forward contracts, options on futures contracts, physical commodities and other commodity interests (collectively, "futures interests").
The general partner is Demeter Management Corporation ("Demeter"). The non- clearing commodity broker is Dean Witter Reynolds Inc. ("DWR") and an unaffili- ated clearing commodity broker, Carr Futures Inc. ("Carr"), provides clearing and execution services. Both Demeter and DWR are wholly-owned subsidiaries of Morgan Stanley Dean Witter & Co. ("MSDW").
On May 31, 1997, Morgan Stanley Group Inc. was merged with and into Dean Wit- ter, Discover & Co. ("DWD"). At that time DWD changed its corporate name to Morgan Stanley, Dean Witter, Discover & Co. ("MSDWD"). Effective February 19, 1998, MSDWD changed its corporate name to Morgan Stanley Dean Witter & Co.
The trading advisors for the Partnership are ELM Financial, Inc. ("ELM"), EMC Capital Management, Inc. ("EMC"), and Millburn Ridgefield Corporation ("Millburn"), (the "Trading Advisors").
Prior to February 28, 1997, Abacus Asset Management Inc. ("AAM") was also a trading advisor in the Partnership. Effective March 1, 1997 AAM was removed as a trading advisor to the Partnership and assets previously managed by AAM were reallocated among the remaining trading advisors.
Demeter is required to maintain a 1% minimum interest in the equity of the Partnership and income (losses) are shared by Demeter and the limited partners based upon their proportional ownership interests.
Use of Estimates--The financial statements are prepared in accordance with gen- erally accepted accounting principles, which require management to make esti- mates and assumptions that affect the reported amounts in the financial state- ments and related disclosures. Management believes that the estimates utilized in the preparation of the financial statements are prudent and reasonable. Ac- tual results could differ from those estimates.
Revenue Recognition--Futures interests are open commitments until settlement date. They are valued at market on a daily basis and the resulting net change in unrealized gains and losses reflected in the change in unrealized profit (loss) on open contracts from one period to the next in the statements of oper- ations. Monthly, DWR pays the Partnership interest income based upon
Dean Witter Global Perspective Portfolio L.P. Notes to Financial Statements--(Continued)
80% of its average daily Net Assets for the month at a rate equal to the aver- age yield on 13-week U.S. Treasury bills. For purposes of such interest pay- ments, Net Assets do not include monies due the Partnership on futures inter- ests, but not actually received.
Net Income (Loss) per Unit--Net income (loss) per unit of limited partnership interest ("Unit(s)") is computed using the weighted average number of Units outstanding during the period.
Equity in Futures Interests Trading Accounts--The Partnership's asset "Equity in futures interests trading accounts," reflected in the statements of finan- cial condition consists of (A) cash on deposit with DWR and Carr to be used as margin for trading; (B) net unrealized gains or losses on open contracts, which are valued at market, and calculated as the difference between original con- tract value and market value, and (C) net option premiums, which represent the net of all monies paid and/or received for such option premiums.
The Partnership, in the normal course of business, enters into various con- tracts with Carr acting as its commodity broker. Pursuant to brokerage agree- ments with Carr, to the extent that such trading results in unrealized gains or losses, the amounts are offset and reported on a net basis on the Partnership's statements of financial condition.
The Partnership has offset the fair value amounts recognized for forward con- tracts executed with the same counterparty as allowable under terms of the mas- ter netting agreement with Carr, the sole counterparty on such contracts. The Partnership has consistently applied its right to offset.
Brokerage Commissions and Related Transaction Fees and Costs--The Partnership accrues brokerage commissions on a half-turn basis at 80% of DWR's published non-member rates. Transaction fees and costs are accrued on a half-turn basis. Brokerage commissions and transaction fees combined are capped at 13/20 of 1% per month (a maximum 7.8% annual rate) of Net Assets.
Operating Expenses--The Partnership bears all operating expenses related to its trading activities, to a maximum of 1/4 of 1% annually of the Partnership's av- erage month-end Net Assets. These include filing fees, clerical, administra- tive, auditing, accounting, mailing, printing, and other incidental operating expenses as permitted by the Limited Partnership Agreement. In addition, the Partnership incurs a monthly management fee and may incur an incentive fee. Demeter bears all other operating expenses.
Redemptions--Limited Partners may redeem some or all of their Units at 100% of the Net Asset Value per
Dean Witter Global Perspective Portfolio L.P. Notes to Financial Statements--(Continued)
Unit as of the last day of any month upon five business days advance notice by redemption form to Demeter.
Distributions--Distributions, other than redemptions of Units, are made on a pro-rata basis at the sole discretion of Demeter. No distributions have been made to date.
Income Taxes--No provision for income taxes has been made in the accompanying financial statements, as partners are individually responsible for reporting income or loss based upon their respective share of the Partnership's revenues and expenses for income tax purposes.
Dissolution of the Partnership--The Partnership will terminate on December 31, 2025, or at an earlier date if certain conditions set forth in the Limited Partnership Agreement occur.
2. Related Party Transactions
The Partnership pays brokerage commissions to DWR as described in Note 1. The Partnership's cash is on deposit with DWR and Carr in futures interests trading accounts to meet margin requirements as needed. DWR pays interest on these funds as described in Note 1.
3. Trading Advisors
Compensation to ELM, EMC and Millburn consists of a management fee and an in- centive fee as follows:
Management Fee--The Partnership pays a monthly management fee equal to 1/4 of 1% per month (a 3% annual rate) of the Partnership's adjusted Net Assets, as defined in the Limited Partnership Agreement, as of the last day of each month.
Incentive Fee--The Partnership pays a quarterly incentive fee to each Trading Advisor equal to 17.5% of trading profits experienced by the Net Assets allo- cated to such Trading Advisor as of the end of each calendar quarter. Trading profits represent the amount by which profits from futures, forward and options trading exceed losses, after brokerage commissions, management fees, transac- tion fees and costs and administrative expenses are deducted. If a Trading Ad- visor has experienced trading losses with respect to its allocated Net Assets at the time of any supplemental closing, the Trading Advisor must earn back such losses plus a pro rata amount related to the funds allocated to the Trad- ing Advisor at such supplemental closing to be eligible for an incentive fee. Such incentive fee is accrued in each month in which trading profits occur. In those months in which trading profits are negative, previous accruals, if any, during the incentive period will be reduced. In those instances in which a lim- ited partner redeems Units, the incentive fee (earned through a redemption date) is paid to such Trading Advisor on those Units redeemed in the month of such redemptions.
Dean Witter Global Perspective Portfolio L.P. Notes to Financial Statements--(Continued)
4. Financial Instruments
The Partnership trades futures and forward contracts, options on futures con- tracts, physical commodities and other commodity interests. Futures and for- wards represent contracts for delayed delivery of an instrument at a specified date and price. Risk arises from changes in the value of these contracts and the potential inability of counterparties to perform under the terms of the contracts. There are numerous factors which may significantly influence the market value of these contracts, including interest rate volatility.
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of SFAS No. 133," which defers the required implementation of SFAS No. 133 until fiscal years beginning after June 15, 2000. However, the Partnership had previously elected to adopt the provisions of SFAS No. 133 beginning with the fiscal year ended December 31, 1998. SFAS No. 133 supersedes SFAS No. 119 and No. 105, which required the disclosure of average aggregate fair values and contract/notional values, respectively, of derivative financial instruments for an entity which carries its assets at fair value. The application of SFAS No. 133 does not have a significant effect on the Partnership's financial statements.
The net unrealized gains on open contracts are reported as a component of "Eq- uity in futures interests trading accounts" on the statements of financial con- dition and totaled $987,025 and $1,810,981 at December 31, 1999 and 1998, re- spectively.
Of the $987,025 net unrealized gain on open contracts at December 31, 1999, $957,815 related to exchange-traded futures contracts and $29,210 related to off-exchange-traded forward currency contracts.
Of the $1,810,981 net unrealized gain on open contracts at December 31, 1998, $2,079,747 related to exchange-traded futures contracts and ($268,766) related to off-exchange-traded forward currency contracts.
Exchange-traded futures contracts held by the Partnership at December 31, 1999 and 1998 mature through June 2000 and September 1999, respectively. Off- exchange-traded forward currency contracts held by the Partnership at December 31, 1999 and 1998 mature through March 2000 and March 1999, respectively.
Dean Witter Global Perspective Portfolio L.P. Notes to Financial Statements--(Continued)
The Partnership has credit risk associated with counterparty nonperformance. The credit risk associated with the instruments in which the Partnership is in- volved is limited to the amounts reflected in the Partnership's statements of financial condition.
The Partnership also has credit risk because DWR and Carr act as the futures commission merchants or the counterparties, with respect to most of the Part- nership's assets. Exchange-traded futures and futures-styled options contracts are marked to market on a daily basis, with variations in value settled on a daily basis. Each of DWR and Carr, as a futures commission merchant for all of the Partnership's exchange-traded futures and futures-styled options contracts, are required, pursuant to regulations of the Commodity Futures Trading Commis- sion to segregate from their own assets, and for the sole benefit of their com- modity customers, all funds held by them with respect to exchange-traded futures and futures-styled option contracts including an amount equal to the net unrealized gain on all open futures and futures-styled options contracts, which funds, in the aggregate, totaled $15,055,871 and $19,288,585 at December 31, 1999 and 1998, respectively. With respect to the Partnership's off-ex- change-traded forward currency and option contracts, there are no daily settle- ments of variations in value nor is there any requirement that an amount equal to the net unrealized gain on open forward and option contracts be segregated. With respect to those off-exchange-traded forward currency contracts, the Part- nership is at risk to the ability of Carr, the sole counterparty on all of such contracts, to perform. The Partnership has a netting agreement with Carr. This agreement, which seeks to reduce both the Partnership's and Carr's exposure on off-exchange-traded forward currency contracts, should materially decrease the Partnership's credit risk in the event of Carr's bankruptcy or insolvency. Carr's parent, Credit Agricole Indosuez, has guaranteed to the Partnership pay- ment of the net liquidating value of the Partnership's account with Carr (in- cluding foreign currency contracts).
5. Legal Matters
The class actions first filed in 1996 in California and in New York State courts were each dismissed in 1999. On September 6, 10, and 20, 1996, and on March 13, 1997, purported class actions were filed in the Superior Court of the State of California, County of Los Angeles, on behalf of all purchasers of in- terests in limited partner- ship commodity pools sold by DWR. Named defendants include DWR, Demeter, Dean Witter Futures & Currency Management Inc., MSDW, certain limited partnership commodity pools of which Demeter is the general partner (all such parties referred to hereafter as the "Mor-
Dean Witter Global Perspective Portfolio L.P. Notes to Financial Statements--(Concluded)
gan Stanley Dean Witter Parties") and certain trading advisors to those pools. On June 16, 1997, the plaintiffs in the above actions filed a consolidated amended complaint, alleging, among other things, that the defendants committed fraud, deceit, negligent misrepresentation, various violations of the Califor- nia Corporations Code, intentional and negligent breach of fiduciary duty, fraudulent and unfair business practices, unjust enrichment, and conversion in the sale and operation of the various limited partnership commodity pools. The complaints seek unspecified amounts of compensatory and punitive damages and other relief. The court entered an order denying class certification on August 24, 1999. On September 24, 1999, the court entered an order dismissing the case without prejudice on consent. Similar purported class actions were also filed on September 18 and 20, 1996, in the Supreme Court of the State of New York, New York County, and on November 14, 1996 in the Superior Court of the State of Delaware, New Castle County, against the Morgan Stanley Dean Witter Parties and certain trading advisors on behalf of all purchasers of interests in various limited partnership commodity pools sold by DWR. A consolidated and amended complaint in the action pending in the Supreme Court of the State of New York was filed on August 13, 1997, alleging that the defendants committed fraud, breach of fiduciary duty, and negligent misrepresentation in the sale and oper- ation of the various limited partnership commodity pools. The complaints seek unspecified amounts of compensatory and punitive damages and other relief. The New York Supreme Court dismissed the New York action in November 1998, but granted plaintiffs leave to file an amended complaint, which they did in early December 1998. The defendants filed a motion to dismiss the amended complaint with prejudice on February 1, 1999. By decision dated December 21, 1999, the New York Supreme Court dismissed the case with prejudice.
In addition on December 16, 1997, upon motion of the plaintiffs, the action pending in the Superior Court of the State of Delaware was voluntarily dis- missed without prejudice.
6. Subsequent Event
On March 3, 2000, the plaintiffs in the New York action referred to in Note 5 filed an appeal of the order dismissing the consolidated complaint.
MORGAN STANLEY DEAN WITTER & CO. Two World Trade Center 62nd Floor New York, NY 10048
Presorted First Class Mail U.S. Postage Paid Brooklyn, NY Permit No. 148 | 11,818 | 77,027 |
910415_1999.txt | 910415_1999 | 1999 | 910415 | Item 1. Description of Business
(a) General Development of Business
PM Management Systems, Inc. (the Company or Registrant) was incorporated under the laws of the State of Colorado on March 13, 1992, as Processed Based Management, Inc. The Company was a management consulting service selling its services to business and industry specializing in selling (i) management computer software, (ii) advertising and marketing services, and (iii) general business management advice wherein it relates to computer software.
On September 5, 1994 the Company acquired all of the outstanding ownership interests in Ad-A-Cab America, LLC, a Wyoming Limited Liability Company. To affect the reorganization pursuant to Section 368(a) (1) (B) of the Internal Revenue Code, the Company Issued 7,980,000 shares of its previously authorized but unissued common stock. Ad-A- Cab America, LLC had entered into a license agreement with Ad-A-Cab Limited, a Hong Kong corporation for the exclusive North American rights for a rooftop mounted advertising system.
On December 18, 1995, the Companys directors concluded that, in spite of some success in Australia, the Ad-A-Cab concept was not feasible in the North American market. As result of this conclusion, the directors decided to write off the investment in Ad-A-Cab America, LLC. The aforementioned decision was reported on Form 8K dated December 18, 1995 (filed with the US Securities and Exchange Commission February 15, 1999).
On January 22, 1996, the company returned both outstanding Ownership Units, representing 100% of the ownership of Ad-A-Cab America, LLC in exchange for the return of 7,980,000 share of the Companys no-par value common stock, for cancellation. This transaction was reported on Form 8K dated January 22, 1996 (filed with the US Securities and Exchange Commission February 15, 1999).
On April 10, 1996, the Company determined that it would cease to actively pursue its previous business and look for other opportunities. The Companys Board of Directors concluded that they would seek out a company or companies that would see an advantage in joining forces with the Company either through merger or takeover.
On February 8, 2000 (subsequent to its year end of December 31, 1999) the Company entered into a purchase and employment agreement with Richard E. Surran of Scottsdale, Arizona for the exclusive world-wide rights and the underlying technology for an original device for the detection of plastic buried underground. Consideration was one million (1,000,000) restricted shares of the Companys common stock and a payment of fifty thousand dollars ($50,000) no later than ninety days after the Company commences publicly trading on a recognized exchange or quotation service. Under the terms of an employment contract executed on February 8, 2000, Mr. Surran is also to receive a monthly salary of six thousand dollars ($6,000) and a royalty of four percent (4%) of the gross sales of the device.
Originally developed to detect buried plastic pipes carrying natural gas, it became evident that there is another very valuable application of the technology: namely, the accurate safe detection of land mines. There are literally millions of buried anti- personnel land mines all over the world. Some are placed currently; others remain from past hostilities. These land mines are almost all made from plastic. The Company and Mr. Surran believe that this detection technology can be utilized by a device the approximate size of a cigarette package - and at a price that would permit every foot soldier to have one as a part of his basic equipment. The detection and disarming of these buried hazards and the banning of further proliferation has been the subject of a high profile effort, previously headed up by the late Princess Diana, Duchess of Windsor.
A copy of the purchase and employment contracts with Mr. Surran are incorporated in this report by reference.
The Company continues to seek out other targets for acquisition or merger.
(b) Financial Information About Industry Segments
The Company may be considered a development stage company. Although profitable during its first year of operation, the Company has been in business since March, 1992 and has had minimal revenues. The Company has generated no revenues from the last twelve months of operations and does not anticipate generating revenues during its next fiscal year.
(c) Narrative Description of Business
1) ( PM Management Systems, Inc.
During the first two years of its existence the Company attempted to establish a business of providing tools to support business process improvement projects. Business process improvement is the identification, analysis and streamlining of business operations for client companies. This could include, for example, simplifying and reducing costs for payroll processing.
In September, 1994 the Company acquired all of the ownership interests of Ad-A-Cab America, LLC, a Wyoming Limited Liability Company that held the exclusive North American marketing rights for a taxicab roof-top advertising system. Ad-A-Cab was not able to market its product and, consequently, did not generate any revenues. The officers of the company, established offices in Vancouver, B. C., Canada and Denver, Colorado. Neither of these offices were able to generate any revenues and after an expenditure of approximately two hundred thousand dollars, the directors determined to cease the Companys marketing efforts and to write off its investment.
General Business Plan
(1) PM Management Systems, Inc.
The Company has been engaged in the business of providing specialized business consulting software to mid to large sized businesses (revenues in excess of $50million per year) and governmental agencies.
The Company then attempted to establish a successful advertising business through its acquisition of ownership of Ad-A-Cab North America LLC.
During the past year, the Company has received no revenues, has acquired one asset and continues to seek other opportunities to increase the value of the Company on behalf of all of the stockholders.
Because the Company presently has little or no overhead or other material financial obligations, management of the Company believes that the Companys short term cash requirements can be satisfied. What little cash might be needed in the future could be supplied by the issuance of the Companys common stock or by loans from directors or shareholders.
Item 2
Item 2 Description of Property
The Company acquired the exclusive rights to a plastic sniffing technology from Mr. Robert E. Surran of Scottsdale, Arizona on December 28, 1999 In exchange, Mr. Surran received one million restricted shares of the Companys common stock, a royalty of four percent on gross sales and an employment contract. Copies of the final acquisition contract and employment contract dated February 8, 2000 are incorporated into this report by reference.
Item 3
ITEM 3. CHANGE OF COMPANY NAME.
RESOLVED: THAT THE BOARD OF DIRECTORS BE AUTHORIZED TO CHANGE THE NAME OF THE COMPANY TO RF TECHNOLOGY INC.
FOR ________AGAINST ________ABSTAIN ________
ITEM 4.
ITEM 4. CHANGE IN CAPITALIZATION
RESOLVED: THAT THE COMPANYS BOARD OF DIRECTORS BE AUTHORIZED TO TAKE WHAT ACTION IS NECESSARY TO INCREASE THE PRESENT AUTHORIZED CAPITAL OF PM MANAGEMENT SYSTEMS, INC. TO 100,000,000 SHARES OF COMMON STOCK AND 10,000,000 SHARES OF PREFERRED STOCK.
FOR ________AGAINST_________ABSTAIN________
ITEM 5.
ITEM 5. FORWARD SPLIT IN COMPANY'S ISSUED AND OUTSTANDING STOCK.
RESOLVED: THAT THE BOARD OF DIRECTORS BE AUTHORIZED TO TAKE WHAT ACTION IS NECESSARY TO FORWARD SPLIT THE COMPANY'S ISSUED AND OUTSTANDING SHARES ON A 3_1 BASIS.
FOR ________ AGAINST _________ABSTAIN ________
PROXY
Date: ____________, 2000
The undersigned, the record owner of______________shares of stock of PM
Management Systems, Inc. authorizes______________________________to vote the
aforementioned shares at the January 10, 2000 Annual Meeting of PM Management
Systems, Inc. to be held at 518 17th Street, Suite 566, Denver, CO at 11:00 AM.
My proxy is hereby instructed to (please mark one of the following):
a) to vote my shares as indicated on the enclosed Ballot or
(b) to have the right to vote for the election of directors and on any other matters and on any other business that may properly come before the meeting.
Signed: ___________________________
EXHIBIT 3
Form 8 K
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
FORM 8-K
Current Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934
Date of Report (Date of earliest event reported) January 10, 2000.
RF TECHNOLOGY, INC. (Formerly PM Management Systems, Inc.)
Colorado 0-22678 84-1193941 (State or other (Commission (IRS Employer jurisdiction of File Number) Identification No.) incorporation)
PO Box 2270, Kalispell, Montana 59903 (Address of Principal Executive offices)
Registrants telephone number, including area code: (406) 257-1085
Item 1. Changes in Control of Registrant
On January 10, 2000 at a special shareholders meeting, a quorum being present all votes present (either by proxy or in person): the following measures were carried:
1) Anthony Feimann the Companys Secretary and director was reelected for an additional term of one year; 2) Ronald Lambrecht and Eberhard Mueller were elected as directors and at a Board of Directors meeting held immediately after the election, were named President and Treasurer respectively; Mr. Feimann was re-appointed Secretary. 3) All issued and outstanding Preferred shares were cancelled without opposition
Item 2. Acquisition or Disposition of Assets
Acquisition of the plastic sniffing technology was confirmed. Shareholders approved the issuance of 2,000,000 shares of pre-forward- split stock for this technology. Prior to the meeting, the acquisition was re-negotiated to 1,000,000 shares of post-forward-split stock plus a 4 percent royalty. (See exhibit A ).
Item 3. Bankruptcy or receivership
Not Applicable.
Item 4. Changes in Registrants Certifying Public Accountant
Not Applicable.
Item 5. Other Events
At the Special Meeting of Shareholders held January 10, 2000, the stockholders authorized the change in capitalization of the Company from 10,000,000 common shares and 1,000,000 preferred shares authorized, to 100,000,000 million common and 10,000,000 preferred shares authorized;
A 3-1 forward split of the issued and outstanding shares was authorized, from 2,020,000 shares of common stock to 6,060,000 shares issued and outstanding;
The name of the Company was changed to RF Technology, Inc. and the mailing address of the Company was changed to: PO Box 2270, Kalispell MT 59903.
Item 6.
Item 6. Resignation of Registrants Directors
Resignations of Edward Duncan and Timothy Sewell, dated Dec 28, 1999 were accepted. (See Exhibit B)
Item 7.
Item 7. Financial Statements and Exhibits
Exhibits A and B are attached to this filing for reference.
Item 8.
Item 8. Change in Fiscal Year
Not Applicable.
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has caused this report to be signed in its behalf by the undersigned, hereunto duly authorized.
Dated: February 10, 2000 RF Technology, Inc.
S/S___Ronald T. Lambrecht Ronald T. Lambrecht, President
EXHIBIT A
RF TECHNOLOGIES, INC./R.E. SURRAN
PURCHASE AND EMPLOYMENT AGREEMENT
PURCHASE AND SALE AGREEMENT
THIS AGREEMENT is made and entered into this 8th day of February, 2000 by and between RF Technologies, Inc., a Colorado corporation (herein RF or Purchaser), and R. E. Surran, an individual (herein Surran or Seller). WHEREAS Surran has developed certain technology for manufacture of a radio-frequency device for locating plastic buried underground (the Technology); and WHEREAS RF desires to acquire the rights to the Technology in order to manufacture and market devices for locating plastic buried underground using the Technology (the Devices); and NOW THEREFORE, based on the terms and conditions outlined herein, Surran and RF agree to the following:
1. The Rights. Surran agrees to sell the exclusive world-wide rights to the Technology and the exclusive world-wide rights to market the Device to RF for the Consideration, as herein defined. 2. Consideration. 1. a) Shares. RF agrees to issue Surran a certificate evidencing ownership of one million (1,000,000) shares of RF common stock (the Shares). Surran acknowledges that the Shares are subject to Rule 144 and will bear a legend restricting their sale.
b) Funds. RF agrees to pay Surran the amount of Fifty Thousand US Dollars (US $50,000) not later than ninety (90) days from the inception of trading of RF shares in the public market.
2. Royalty. RF agrees to pay Surran a royalty of 4% of gross sales of the Device (the Royalty). The Royalty will be paid by the thirtieth day of the month following any sale of Device(s). The obligations of this Section 2 will survive the termination of any business or employment relationship between the parties. 3. Employment Contract. RF agrees to enter into an employment contract with Surran for a term of one year, automatically renewable for additional one year terms absent written 30-day notice provided by either party to the other, for a salary of $6,000 per month plus reasonable expenses approved by RF. A copy of the employment contract is appended hereto as Exhibit A. 4. Obligations of Purchaser. Purchaser agrees to fund the marketing and manufacture of the Device for both military and civilian applications. Purchaser further agrees to use its best efforts to market the Device to both military and civilian buyers. 5. Sellers Obligations. Seller agrees to provide to Purchaser all technical specifications, drawings, methodology and the like necessary for the manufacture of the Device. Seller agrees to assist Purchaser in designing and setting up the manufacture of the Device. Seller agrees to assist Purchaser in filing for a patent on the Device, which patent upon issuance shall be the property of Purchaser. Any design improvements, changes, adaptations, or the like made by Surran or by any employee of RF shall be the property of RF. A description of the Technology is appended hereto as Exhibit B. 6. Confidential Information. RF and Surran are the owners of certain products, technology, information, customer lists, services, processes, financial information, pending or prospective transactions/proposals, operating and marketing plans and procedures, designs, product formulas, specifications, manufacturing methods, ideas, prototypes, software, patent, trademark and copyright applications or registrations and other similar data relating to each partys business which data is not publicly known and derives economic value from not being publicly known (collectively Confidential Information). Each party agrees that it will not use or disclose to third parties any Confidential Information it receives from the other, except as may be contemplated by this Agreement. Each party agrees that it will take all reasonable precautions to assure that no Confidential Information is conveyed to any officer, employee, agent, manufacturer, or other third party who does not have a need to know such Confidential Information. The obligations created by this Section 6 shall survive the termination of this Agreement or any business relationship between the parties. Any Confidential Information contained in any writing will be returned to the other party promptly upon written request, together with any reproductions thereof. 7. Breach of Agreement. In the event of a material breach of this Agreement, the non-breaching party may provide written notice of such breach to the breaching party. Upon receipt, the breaching party shall have 30 days to correct such breach, after which the termination shall be effective if not so corrected. 8. Notice. Any notice required or permitted to be given under this Agreement shall be in writing and sent by telecopy, personal delivery, or certified mail, return receipt requested, as follows:
If to RF: RF Technologies, Inc. P. O. Box 2270 Kalispell MT 59903-2270 Fax: 406-752-5563
If to Surran: R. E. Surran 9934 East Wood Drive Scottsdale AZ 95260 Fax: 602-451-4459
IN WITNESS WHEREOF, the parties have caused this Agreement to be executed as of the date herein first above written.
RF Technologies, Inc.
By: S/S R.E. Surran By: S/S Ronald T. Lambrecht R.E. Surran Ronald T. Lambrecht, President
EXHIBIT A EMPLOYMENT CONTRACT
On February 8, 2000, RF TECHNOLOGIES, INC., a Colorado corporation ("Employer"), and RICHARD E. SURRAN (Employee") agree as follows: 1. TERM. Employer hereby employs Employee and Employee hereby accepts employment on the terms and conditions hereinafter set forth. The term of this Agreement shall commence on the date hereof and shall terminate on February 7, 2001. Unless written notice is given by either Employee or Employer at least thirty (30) days prior to the end of the term (including any renewal pursuant to this sentence) this Agreement shall automatically renew for consecutive one (1) year periods. Said term may be sooner terminated as hereinafter provided, and if the term is so terminated, all references herein to the term of this Agreement shall mean the original term as so shortened, except where the context otherwise requires. 2. DUTIES. Employee agrees to serve Employer as head of Its "Don't Panic" division or in such other capacities as may be requested from time to time by the President of Employer. Employer shall periodically prepare timetables of tasks to be performed by Employee. During the term of this Agreement, Employee will devote his full time and exclusive attention to, and use his best efforts to advance, the business and welfare of Employer. During the term of this Agreement, Employee will not engage in any other employment activities for any direct or indirect remuneration without the prior written consent of Employer. Employee shall not be required to relocate from Maricopa County, Arizona, but agrees to undertake all reasonable travel required by Employer to be conducted In connection with the performance of his duties. 3. SALARY AND BENEFITS. 3.1. Base Salary. During the term of this Agreement Employer shall pay Employee a salary at the rate of Seventy-Two Thousand Dollars ($72,000) per year, or such greater amount as may be established by Employers President, payable in appropriate installments to conform with the regular payroll dates for salaried personnel of Employer and subject to payroll deductions as may be necessary or customary in respect of such salaried personnel. 3.2. Incentive Compensation. In addition to the base salary to which Employee is entitled pursuant to Section 3.1, Employer will pay to Employee additional compensation (a "Bonus"), at the discretion of Employer's President, in relation to the value of any products, business opportunities or services provided by Employee to Employer which exceed the scope of this Agreement. It is the expectation, although not the commitment, of Employer and Employee, that his total compensation will exceed One Hundred Thousand Dollars ($100,000) per year. 3.3. Vacations. Employee shall be entitled to four (4) weeks of paid vacation in each year during the term of this Agreement. 3.4. Medical Insurance and Other Benefits. During the term of this Agreement Employer shall furnish Employee with the same medical and hospital insurance, death, corporate expense account, stock participation and other benefits furnished to other executive employees of Employer. Employer agrees to provide Employee with a term life insurance policy for Key Man insurance payable to both Employer and to Employees family. 4. CONFIDENTIAL INFORMATION AND RESTRICTED ACTIVITIES. 4.1. Non-disclosure and Non-use Of Confidential information. Employee acknowledges that Employer continually develops Confidential Information (as defined in Section 4.7), that Employee may develop Confidential information for Employer and that Employee may learn of Confidential information during the course of his employment. Employee will comply with Employer's policies and procedures for protecting Confidential Information and, except as required by the nature of his duties, Employee will never, directly or indirectly, use or disclose any Confidential Information without the prior written consent of Employer's President. Employee understands that this restriction will continue to apply after his employment terminates. 4.2. Use and Return of Property and Documents. Employee will protect the integrity of Confidential Information and keep confidential all documents, customer lists, records of research, proposals, reports memoranda, computer software and programming, financial information, and other materials ("Documents") including any copies thereof, in which Confidential Information may be contained. Employee will not copy any Documents except as required by the nature of his duties. Employee will not remove any Documents or copies from Employer's premises unless authorized by Employer's President. Employee will return to Employer immediately after his employment terminates all Documents and copies and any other property of Employer then in his possession or control. 4.3. Assignments of Rights. Employee will promptly and fully disclose all Company Property (as defined in Section 4.7) to Employer. Employee hereby assigns and agrees to assign to Employer (or as otherwise directed by Employer) his full right, title and interest to all Company Property. Employee agrees to execute any and all applications for domestic and foreign patents, copyrights or other proprietary rights and do such other acts (including, among others, the execution and delivery of instruments of further assurance or confirmation) requested by Employer to assign the Company Property to Employer and to permit Employer to enforce any patents, copyrights or other proprietary rights In the Company Property. Employee will not charge Employer for his time spent in complying with these obligations. All copyrightable works that Employee creates shall be considered works made for hire. Employee acknowledges that he has read and understands California Labor Code Section 2870, which reads as follows: (a) Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall not apply to an invention that the employee developed entirely on his or her own time without using the employer's equipment, supplies, facilities or trade secret information except for those inventions that either: (1) Relate at the time of conception or reduction to practice of the invention to the employers business, or actual or demonstrably anticipated research or development of the employer. (2) Result from any work performed by the employee for the employer. (b) To the extent a provision in an employment agreement purports to require an employee to assign an invention otherwise excluded the provision is against the public policy of this state and is unenforceable. Employee and Employer agree to be bound by the terms of this California Labor Code Section 2870 as respects their rights to any invention. Employee understands that his obligations under this Agreement do not apply to an invention which qualifies fully under the provisions of Section 2870. 4.4. Non-Recruitment. For a period of one (1) year after his employment with Employer terminates, Employee will not, and will not assist anyone else to, hire any employee of Employer or seek to persuade any employee of Employer to discontinue employment or to become employed in any business directly or indirectly competitive with Employer's business, nor seek to persuade any independent contractor or supplier or Employer to discontinue its relationship or violate any agreement with Employer. 4.5. Restricted Activities. Employee agrees that some restrictions on his activities during and after his employment are necessary to protect the goodwill, Confidential Information and other legitimate interests of Employer. While Employee is employed by Employer and for a period of one (1) year after his employment terminates Employee will not compete, directly or indirectly, with Employer whether as an employee, consultant, agent, partner, principal, investor or otherwise. Specifically. but without limiting the foregoing, Employee agrees not to engage in any manner in any activity that is directly or indirectly competitive or potentially competitive with the business of Employer as conducted at any time during his employment. Restricted activity shall include accepting employment or a consulting position with any person who is, or at any time within one year prior to Employee's termination has been, a customer of Employer. For purposes of this provision, the business shall include all services offered by the Company in any manner. The foregoing restrictions shall not prevent Employee's owning one percent (1%) or less of the equity securities of any publicly traded company. 4.6. Notification Requirement. Until three (3) months after the period set forth in Section 4.5, Employee will notify Employer in writing of any change in his address and of each new job or other business activity in which he plans to engage, at least fifteen (15) days prior to beginning such job or activity. Such notice shall state the name and address of any new employer and the nature of Employee's position. 4.7. Definition. For the purposes of this Agreement, the following definitions shall apply: Company Property shall mean developments, methods of doing business, compositions, works, concepts and ideas (whether or not patentable or copyrightable or constituting trade secrets) conceived, made, created, developed or reduced to writing or practice by Employee (whether alone or with others, and whether or not during normal business hours or on or off Employer's premises) during Employee's employment that relate to either the services provided by, business of, or any prospective activity of, Employer known to Employee as a result of his employment. Confidential Information shall mean any and all Information of Employer that Is not generally known in the radio frequency products business or that is not generally known by others with whom Employer does or plans to compete or do business. Confidential information includes, without limitation, such information relating to (i) Employer's development, research and marketing activities, (ii) Employer's financial statements and strategic plans, (iii) the identity and special needs of Employer's customers and (iv) people and organizations with whom Employer has business relationships and those relationships. Confidential information also includes such information that Employer may receive or have received belonging to customers or others who do business with Employer and, except to the extent disclosed by Employer on a non- confidential basis, the Company Property. 4.8. Remedies. Employee acknowledges that, were he to breach the provisions of this Section 4, the harm to Employer would be irreparable. Employee therefore agrees that, in addition to damages and attorneys' fees, Employer shall be entitled to obtain (and Employee will not contest) preliminary and permanent injunctive relief against any such breach, without having to post a bond. 5. EXPENSES. Employer will pay or reimburse Employee for such reasonable travel, entertainment or other expenses as he may incur at the request of Employer during the term of this Agreement In connection with the performance of his duties hereunder. Employee shall furnish Employer with such evidence that such expenses were incurred as Employer may from time to time reasonably require or request. 6. PARTIAL DISABILITY OF EMPLOYEE. If Employee becomes disabled by reason of illness or other incapacity extending for a period of more than twelve (12) consecutive weeks during which Employee is unable to perform his duties hereunder on a full-time basis but Is able to perform his duties hereunder on a part-time basis, all amounts otherwise payable to Employee shall be proportionately reduced with respect to the period commencing at the end of said twelve (12) week period to reflect the extent to which Employee's working time is reduced below a level which would result in Employee working one thousand eight hundred (1,800) hours per year. In determining when Employee becomes disabled, the same criteria shall be applicable as are used in the disability insurance policy Employer maintains for its employees. 7. TERMINATION. This Agreement, and all obligations of Employer to pay base salary, Bonuses and benefits to Employee, shall terminate on the first to occur of the following: (a) The death of Employee; (b) The permanent disability of Employee (which, for purposes hereof, shall have the same meaning as In Employer's disability insurance policy or, in the absence of such a policy, the continuous loss of one-half () or more of the time spent by Employee in the usual daily performance of his duties as a result of physical or mental illness for a period In excess of ninety (90) consecutive days); (c) At such time, if any, as Employer ceases to conduct business for any reason whatsoever; or (d) At the election of Employer, for good cause (as defined in Section 9). 8. GOOD CAUSE. The term good cause is defined as any one or more of the following occurrences: (a) Employee's breach of any of the covenants contained in Section 4 of this Agreement; (b) Employee's conviction by, or entry of a plea of guilty or nolo contendere in a court of competent and final jurisdiction for any crime Involving moral turpitude or punishable by imprisonment in the jurisdiction involved; (c) Employees commission of an act of fraud, whether prior to or subsequent to the date hereof upon Employer; (d) Employee's continuing failure or refusal to perform his duties as required by this Agreement (including the failure to complete tasks in accordance with a reasonable timetable presented to Employee as described in Section 2), provided, that termination of Employee's employment pursuant to this paragraph (d) shall not constitute valid termination for cause unless Employee shall have first received written notice from the President of Employer stating with specificity the nature of such failure or refusal and affording Employee at least ten (10) days to correct the act or omission complained of; (e) Gross negligence, insubordination, material violation by Employee of any duty of loyalty to Employer or any other material misconduct on the part of Employee, provided that termination of Employee's employment pursuant to this paragraph (e) shall not constitute valid termination for cause unless Employee shall have first received written notice from the President of Employer stating with specificity the nature of such failure or refusal and affording Employee at least ten (10) days to correct the act or omission complained of; or (f) Employee's commission of any act which Is detrimental to Employer's business or goodwill. 9. MISCELLANEOUS. 9.1. Modification and Waiver of Breach. No waiver or modification of this Agreement shall be binding unless it is in writing signed by the parties hereto. No waiver of a breach hereof shall be deemed to constitute a waiver of a future breach, whether of a similar or dissimilar nature. 9.2. Assignment. The rights of Employer under this Agreement may, without the consent of Employee, be assigned by Employer, in its sole and unfettered discretion (a) to any person, firm, corporation, or other business entity which at any time, whether by purchase, merger, or otherwise, directly or indirectly, acquires all or substantially all of the assets or business of Employer, or (b) to any subsidiary or affiliate of Employer, or any transferee, whether by purchase, merger or otherwise, which directly or indirectly acquires all or substantially all of the assets of Employer or such subsidiary or affiliate. 9.3. Notices. All notices and other communications required or permitted under this Agreement shall be in writing, served personally on, or mailed by certified or registered United States mail to, the party to be charged with receipt thereof. Notices and other communications served by mail shall be deemed given hereunder 72 hours after deposit of such notice or communication in the United States Post Office as certified or registered mail with postage prepaid and duly addressed to whom such notice or communication is to be given, in the case of (a) Employer, to: RF Technologies, Inc., P. O. Box 2270, Kalispell, MT 59903-2270; or (b) Employee, to: Richard E. Surran, 9934 East Wood Drive, Scottsdale, Arizona, 88260. Any such party may change said party's address for purposes of this Section by giving to the party intended to be bound thereby, in the manner provided herein, a written notice of such change. 9.4. Counterparts. This instrument may be executed In one or more counter-parts, each of which shall be deemed an original, but all of which together shall constitute one and the same Agreement. 9.5. Construction of Agreement. This Agreement shall be construed in accordance with, and governed by, the laws of the State of Colorado applicable to agreements executed and to be performed in Colorado. 9.6. Complete Agreement. This Agreement contains the entire agreement between the parties hereto with respect to the transactions contemplated by this Agreement and supersedes all previous oral and written and all contemporaneous oral negotiations, commitments, writings, and understandings. 9.7. Non-Transferability of Interest. None of the rights of Employee to receive any form of compensation payable pursuant to this Agreement shall be assignable or transferable except through a testamentary disposition or by the laws of descent and distribution upon the death of Employee. Any attempted assignment, transfer, conveyance, or other disposition (other than as aforesaid) of any interest in the rights of Employee to receive any form of compensation to be made by Employer pursuant to this Agreement shall be void. 9.8. Legal Fees. If any legal action, arbitration or other proceeding is brought for the enforcement of this Agreement, or because of any alleged dispute, breach, default or misrepresentation in connection with this Agreement, the successful or prevailing party shall be entitled to recover reasonable attorneys' fees and other costs it Incurred in that action or proceeding, in addition to any other relief to which it may be entitled. IN WITNESS WHEREOF, the undersigned have executed this Agreement on the day and year first above written. EMPLOYEE: EMPLOYER: RF TECHNOLOGIES, INC. S/S Richard E. Surran S/S Ronald T. Lambrecht Richard E. Surran Ronald T. Lambrecht, President
EXHIBIT B
DIRECTORS' RESIGNATIONS
December 28,
Board of Directors PM Management Systems, Inc. 404 Scott Point Drive Salt Spring Island, BC V8K 2R2
Sirs:
I hereby tender my resignation as a director and officer of PM Management Systems, Inc.
Thank You.
Yours Truly,
S/S Edward D. Duncan Edward D. Duncan
December 28,
Board of Directors PM Management Systems, Inc. 404 Scott Point Drive Salt Spring Island, BC V8K 2R2
Sirs:
I hereby tender my resignation as a director and officer of PM Management Systems, Inc.
Thank You.
Yours Truly,
S/S Timothy Sewell Timothy Sewell | 5,507 | 35,496 |
833795_1999.txt | 833795_1999 | 1999 | 833795 | Item 1. Business. - -----------------
THE COMPANY
Introduction
HomeFed Corporation ("HomeFed" or the "Company") was incorporated in Delaware in 1988. The Company is engaged, directly and through subsidiaries, in the investment in and development of residential real estate projects in the State of California. The principal executive office of the Company is located at 1903 Wright Place, Suite 220, Carlsbad, California 92008.
The Company's development projects consist of two master planned communities located in San Diego County, California: San Elijo Hills, and a portion of the larger Otay Ranch planning area.
As development manager for these projects, the Company is responsible for the completion of a wide range of activities, including design engineering, grading raw land, constructing public infrastructure such as streets, utilities and public facilities, and finishing individual lots for home sites or other facilities. The Company will develop its communities in phases to allow the Company flexibility to sell finished lots to suit market conditions and to enable it to create stable and attractive neighborhoods. Consequently, at any particular time, the various phases of a project will be in different stages of land development and construction.
For any master-planned community, plans must be prepared that provide for infrastructure, neighborhoods, commercial and industrial areas, educational and other institutional or public facilities as well as open space. Once preliminary plans have been prepared, numerous governmental approvals, licenses, permits and agreements, referred to as "entitlements," must be obtained before development and construction may commence, often involving a number of different governmental jurisdictions and agencies, challenges through litigation, considerable risk and expense, and substantial delays. Unless and until the requisite entitlements are received and substantial work has been commenced in reliance upon such entitlements, a developer generally does not have any "vested rights" to develop a project. In addition, as a precondition to receipt of building-related permits, master-planned communities such as San Elijo Hills typically are required in California to pay impact and capacity fees, or to otherwise satisfy mitigation requirements.
Current Development Projects
San Elijo Hills. In August 1998, the Company entered into a Development Management Agreement (the "Development Agreement") with San Elijo Hills Development Company, LLC, an indirect subsidiary of Leucadia National Corporation (together with its subsidiaries, "Leucadia") that owns certain real property located in the City of San Marcos, in San Diego County, California. Pursuant to the Development Agreement, this project, which is known as San Elijo Hills, will be a master-planned community of approximately 3,400 homes and
apartments as well as commercial properties expected to be completed during the course of the next ten years. As a result of the recertification of its environmental impact report, San Elijo Hills is fully entitled. The Company is the development manager of this project with responsibility for the overall management of the project, including, among other things, preserving existing entitlements and obtaining any additional entitlements required for the project, arranging financing for the project, coordinating marketing and sales activity, and acting as the construction manager. The Development Agreement provides that the Company will participate in the net profits of the project, and that the Company will receive fees for the field overhead, management and marketing services it is to provide, based on the revenues of the project. For additional information, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of this Report.
During the first quarter of 2000, 189 residential sites in two neighborhoods were sold to builders for aggregate net consideration of $20,770,000. Three neighborhoods, consisting of 296 residential sites, are under contract for sale for aggregate consideration of $45,100,000. While the Company expects that some of these neighborhoods will close during 2000, these contracts are subject to various closing conditions and termination rights if the closing conditions are not satisfied. Therefore, no assurances can be given that any of these sales under contract will occur. Two additional neighborhoods, consisting of approximately 252 residential sites, comprise the balance of the seven neighborhoods presented for sale in 1999.
An additional 6 neighborhoods, consisting of 987 residential sites, have been presented for sale during the first quarter 2000.
Otay Ranch. On October 14, 1998, the Company and Leucadia formed Otay Land Company, LLC (the "Otay Land Company") for the purpose of purchasing 4,800 non-adjoining acres of land located within the larger 22,900-acre Otay Ranch master planned community south of San Diego, California. Otay Land Company acquired this land for $19,500,000. The Company has contributed $11,300,000 as capital and Leucadia has contributed $10,000,000 as a preferred capital interest; the Company will act as development manager of this project.
The City of Chula Vista and the County of San Diego have approved a general development plan for the larger planning area. Although there is no minimum time within which implementation of the general development plan must be completed, it is expected that full development of the larger planning area will take decades. This general development plan establishes land use goals, objectives and policies within the larger planning area. Any development within the larger Otay Ranch master planned community must be consistent with this general development plan. The general development plan for the larger planning area contemplates home sites, a golf-oriented resort and residential community, commercial retail centers, a proposed university site and a network of infrastructure, including roads and highways, a rail transportation system, park systems and schools. Actual development of any of these will require that further entitlements and approvals be obtained. Because the larger planning area will be developed by several independent developers, in addition to the Company, an inability to coordinate with other developers could adversely affect the Company's development.
Of the 4,800 acres owned by Otay Land Company, 1,200 acres are developable and 3,600 acres are zoned as various qualities of non-developable "open space mitigation land." The Company has entered into an option agreement to sell 85 acres of developable land for a sales price of $4,100,000. The Company has received a non-refundable payment of $500,000 for this option, which is scheduled to expire in December 2000, subject to extension. The Company has not yet determined whether it will develop or sell the remaining developable land and, accordingly, it does not yet know the nature or extent of the entitlements or approvals that may be necessary.
Under the general development plan, approximately 1.2 acres of open space mitigation land must be set aside for each 1.0 acre of developable land. Some owners of developable land have adequate or excess mitigation land, while
other owners lack sufficient acreage of mitigation land. The Company expects to have substantially more mitigation land than it would need to develop its property at this project. A market for the Company's open space mitigation land exists among buyers in the San Diego County Region. The Company believes that a market for this land is likely to develop within the larger Otay Ranch development area as well.
The Company continues to evaluate how best to maximize the value of this investment. The Company believes its current cash resources will be sufficient for property maintenance, management and marketing costs pending its determination of how to proceed with this project. Until the Company determines its objectives, and, if necessary, secures additional entitlements and coordinates its development activities with other developers, the Company cannot predict when, or if, any revenues will be derived from this project.
Other Projects
Paradise Valley. The Company owns two clustered housing development sites, which are under contract to be sold for anticipated net proceeds of $1,450,000, and a school site at the Paradise Valley project, a community located in Fairfield, California. The school site (which is subject to a purchase option held by the local school district) and clustered housing development sites have a combined book value at December 31, 1999 of $2,500,000.
The Company has certain continuing obligations with respect to this project, including the obligation to construct a recreation center. Construction of this recreation center began during 1999 and is expected to cost approximately $1,200,000. Cash of $1,000,000 was deposited in an escrow account that is being drawn upon as the recreation center is being completed. At December 31, 1999, $868,000 remained in escrow.
Competition
Real estate development is a highly competitive business. There are numerous residential real estate developers and development projects operating in the same geographic area in which the Company operates. Competition among real estate developers and development projects is determined by the location of the real estate, the market appeal of the development master plan, and the developer's ability to build, market and deliver project segments on a timely basis. Residential developers sell to homebuilders, who compete based on location, price, market segmentation, product design and reputation.
Government Regulation
The residential real estate development industry is subject to increasing environmental, building, zoning and real estate regulations that are imposed by various federal, state and local authorities. In developing a community, the Company must obtain the approval of numerous governmental agencies regarding such matters as permitted land uses, housing density, the installation of utility services (such as water, sewer, gas, electric, telephone and cable television) and the dedication of acreage for open space, parks, schools and other community purposes. Regulations affect homebuilding by specifying, among other things, the type and quality of building material that must be used, certain aspects of land use and building design and the manner in which homebuilders may conduct their sales, operations, and overall relationships with potential home buyers. Furthermore, changes in prevailing local circumstances or applicable laws may require additional approvals, or modifications of approvals previously obtained.
Timing of the initiation and completion of development projects depends upon receipt of necessary authorizations and approvals. Delays could adversely affect the Company's ability to complete its projects, significantly increase the costs of doing so or drive potential customers to purchase competitors' products.
Environmental Compliance
Environmental laws may cause the Company to incur substantial compliance, mitigation and other costs, may restrict or prohibit development in certain areas and may delay completion of the Company's development projects. To date, environmental laws have not had a material adverse effect on the Company, and management is not currently aware of any environmental compliance matters that would have a material adverse effect on the Company. Delays arising from compliance with environmental laws and regulations could adversely affect the Company's ability to complete its projects, significantly increase the costs of doing so or drive potential customers to purchase competitors' products.
Relationship with Leucadia; Administrative Services Agreement
Since emerging from bankruptcy in 1995, administrative services and managerial support have been provided to HomeFed by a subsidiary of Leucadia. Leucadia funded HomeFed's bankruptcy plan by purchasing stock and debt of the Company. For additional information, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
In 1999, Leucadia completed the distribution of HomeFed Common Stock to shareholders of Leucadia. As a result, Joseph S. Steinberg, Chairman of the Board of HomeFed, and Ian M. Cumming, a director of HomeFed, together with their respective family members (excluding trusts for the benefit of Mr. Steinberg's children) beneficially own approximately 12.7% and 13.9%, respectively, of the outstanding Common Stock. Mr. Steinberg is also President and a director of Leucadia and Mr. Cumming is Chairman of the Board of Leucadia. At March 13, 2000, they each beneficially owned (together with their respective family members but excluding trusts for the benefit of Mr. Steinberg's children) approximately 17.9% and 16.4%, respectively, of Leucadia's outstanding common shares.
Under the current administrative services agreement, which extends through February 28, 2002, Leucadia provides the services of Mr. Paul J. Borden, HomeFed's President, and Ms. Corinne A. Maki, HomeFed's Treasurer and Secretary, in addition to various administrative functions. Mr. Borden and Ms. Maki each are officers of Leucadia or its subsidiaries. The annual fee paid to Leucadia under this agreement aggregated $296,000, payable monthly, through February 29, 2000. The parties are currently negotiating the annual fee to be paid under this agreement commencing March 1, 2000.
Item 2.
Item 2. Properties. - -------------------
The Company owns approximately 20 acres at the Paradise Valley project and approximately 4,800 non-adjoining acres at the Company's Otay Ranch project, as described under Item 1 - "Business." Land held for development and sale has an aggregate book value of $23,707,000 at December 31, 1999.
The Company's corporate headquarters are located at 1903 Wright Place, Suite 220, Carlsbad California 92008 in part of an office building sub-leased from Leucadia for a monthly amount equal to its share of Leucadia's cost for such space and furnishings. The agreement pursuant to which the space and furnishings are provided extends through February 28, 2005 (coterminous with Leucadia's occupancy of the space) and provides for a monthly rental of $15,865, effective March 1, 2000.
Item 3.
Item 3. Legal Proceedings. - --------------------------
The Company is not a party to legal proceedings other than ordinary, routine litigation, incidental to its business or not material to the Company's consolidated financial position or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------
The following matters were submitted to a vote at the Company's 1999 Annual Meeting of stockholders held on December 14, 1999.
a) Election of Directors.
Number of Shares For Withheld
Patrick D. Bienvenue.............................. 42,409,438 560,538 Paul J. Borden................................... 42,703,040 266,936 Timothy M. Considine.............................. 42,702,241 267,735 Ian M. Cumming.................................... 42,702,899 267,077 Michael A. Lobatz................................. 42,408,850 561,126 Joseph S. Steinberg............................... 42,701,501 268,475
b. Approval of the Company's 1999 Stock Incentive Plan.
For........................................................... 39,079,482 Against....................................................... 3,002,942 Abstentions................................................... 887,550 Broker non-votes.............................................. --
c. Ratification of PricewaterhouseCoopers LLP, as independent auditors for the year ended December 31, 1999.
For........................................................... 42,792,079 Against....................................................... 88,240 Abstentions................................................... 89,656 Broker non-votes.............................................. --
Item 10..Executive Officers of the Registrant. - ----------------------------------------------
As of March 17, 2000, the executive officers of the Company, their ages, the positions held by them and the periods during which they have served in such positions are as follows:
Name Age Position with HomeFed Office Held Since - ---- --- --------------------- -----------------
Paul J. Borden 51 President 1998
Corinne A. Maki 43 Secretary and Treasurer 1995
Curt R. Noland 43 Vice President 1998
The officers serve at the pleasure of the board of directors of HomeFed.
The recent business experience of our executive officers is summarized as follows:
Paul J. Borden. Mr. Borden has served as a director and President of HomeFed since May 1998. Mr. Borden has been a Vice President of Leucadia since August 1988, responsible for overseeing many of Leucadia's real estate investments.
Corinne A. Maki. Ms. Maki, a certified public accountant, has served as Treasurer of HomeFed since February 1995 and Secretary since February 1998. Prior to that, Ms. Maki served as an Assistant Secretary of HomeFed since August 1995. Ms. Maki has also been a Vice President of Leucadia Financial Corporation, a subsidiary of Leucadia, holding the offices of Controller, Assistant Secretary and Treasurer since October 1992. Ms. Maki has been employed by Leucadia since December 1991.
Curt R. Noland. Mr. Noland has served as Vice President of HomeFed since October 1998. He spent the last 20 years in the land development industry in San Diego County as a design consultant, merchant builder and a master developer. From November 1997 until immediately prior to joining HomeFed, Mr. Noland was employed by the prior development manager of San Elijo Hills and served as Director of Development for San Elijo Hills. Prior to November 1997, Mr. Noland was employed for eight years by Aviara, a 1,000-acre master planned resort community in Carlsbad, California. He is also a licensed civil engineer and real estate broker.
PART II
Item 5.
Item 5. Market for the Registrant's Common Stock and Related Stockholder - -------------------------------------------------------------------------------- Matters. - --------
The following table sets forth certain information concerning the market price of the Company's Common Stock for each quarterly period within the two most recent fiscal years.
High Low ---- --- Year ended December 31, 1998 First Quarter $ .3125 $ .0625 Second Quarter .3125 .03125 Third Quarter .3125 .0100 Fourth Quarter .4375 .03125
Year ended December 31, 1999 First Quarter $ .3000 $ .03125 Second Quarter .7500 .03125 Third Quarter 1.0000 .0100 Fourth Quarter 1.0000 .1500
Year ended December 31, 2000 First Quarter (through March 17, 2000) $ .8300 $ .5200
The Company's Common Stock is traded in the over-the-counter market. The Company's Common Stock is not listed on any stock exchange, and price information for the Common Stock is not regularly quoted on any automated quotation system. The prices above are based on bid quotations, as published by the National Association of Securities Dealers OTC Bulletin Board Service, and represent interdealer prices without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions. On March 17, 2000, the closing bid price for the Company's Common Stock was $.77 per share. As of this date, there were 14,047 stockholders of record. The Company did not declare dividends on its Common Stock during 1998 or 1999 and it does not anticipate that it will pay dividends for the foreseeable future.
The Company's Common Stock does not currently meet the minimum requirements for listing on a national securities exchange or inclusion on the Nasdaq Stock Market. If the Company's Common Stock becomes eligible to be listed or included on the Nasdaq Stock Market, the Company will consider its alternatives with respect to the trading market for the Company's Common Stock.
The transfer agent for the Company's Common Stock is American Stock Transfer & Trust Company, 40 Wall Street, New York, New York 10005.
Item 6.
Item 6. Selected Financial Data. - --------------------------------
The following selected financial data have been summarized from the Company's consolidated financial statements and are qualified in their entirety by reference to, and should be read in conjunction with, such consolidated financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations," contained in Item 7
Item 7. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. - --------------
The purpose of this section is to discuss and analyze the Company's consolidated financial condition, liquidity and capital resources and results of operations. This analysis should be read in conjunction with the consolidated financial statements and related notes which appear elsewhere in this report.
Liquidity and Capital Resources
For the year ended December 31, 1999, net cash was used in operating activities, principally to fund the San Elijo Hills project and Otay Ranch project. For the years ended December 31, 1998 and 1997, net cash was provided by operating activities, principally from sales of real estate. The Company's principal sources of funds are dividends or borrowings from its subsidiaries and any fee income earned from the San Elijo Hills project. The Company is dependent upon the cash flow, if any, from the sale of real estate and management fees in order to pay its expenses, including debt service payments.
The Company expects that its cash on hand, together with cash generated from sales at its Paradise Valley project, will be sufficient to meet its cash flow needs for the foreseeable future. However, the Company's ability to provide services required under the Development Agreement will depend significantly upon the receipt of fees under the Development Agreement as described below. If at any time in the future the Company's cash flow is insufficient to meet its then current cash requirements, the Company could sell real estate projects held for development or seek to borrow funds. However, because all of the Company's assets are pledged to Leucadia to collateralize its $26,462,000 borrowing from Leucadia, it may be unable to obtain financing at favorable rates from sources other than Leucadia.
Effective September 20, 1999, Otay Land Company has been included in the Company's consolidated financial statements. Prior to its consolidation, the Company invested $850,000 and $10,125,000 in 1999 and 1998, respectively.
In July 1999 (pursuant to stock purchase agreements entered into in 1998), the Company issued an aggregate of 46,557,826 shares of Common Stock for aggregate consideration of $8,380,400, of which $6,710,300 was advanced in 1998. As a result of such issuance, the Company's outstanding Common Stock increased to 56,557,826 shares.
Under the Development Agreement, the Company is responsible for the overall management of the San Elijo Hills project, including arranging financing, coordinating marketing and sales activity, and acting as construction manager. The Development Agreement provides that the Company will receive certain fees in connection with the project. These fees consist of marketing, field overhead and management service fees. These fees are based on a fixed percentage of gross revenues of the project, less certain expenses allocated to the project, and are expected to cover the Company's cost of providing services under the Development Agreement. During the first quarter of 2000, the Company received $878,000 in fees under the Development Agreement. The Development Agreement also provides for a success fee to the Company out of the project's net cash flow, if any, as described below, up to a maximum amount. Whether the success fee, if it is earned, will be paid to the Company prior to the conclusion of the project will be at the discretion of the project owner. The project owner's obligation or ability to purchase bonds providing infrastructure financing to the San Elijo Hills project could adversely affect the timing of the payment of any success fee.
To determine "net cash flow" for purposes of calculating the success fee, all cash expenditures of the project will be deducted from total revenues of the project. Examples of "expenditures" for these purposes include land development costs, current period operating costs, and indebtedness, either collateralized by the project ($31,483,000 at December 31, 1999, which is non-interest bearing), or owed by the project's owner to Leucadia ($64,853,000 at December 31, 1999) (collectively, "Indebtedness"). As a success fee, the Company is entitled to receive payments out of net cash flow, if any, up to the aggregate amount of the Indebtedness. The balance of the net cash flow, if any, will be paid to the Company and the project owner in equal amounts. However, the amount of the success fee cannot be more than 68% of net cash flow minus the amount of the Indebtedness. There can be no assurance, however, that the Company will receive any success fee at all for this project. The Company believes that any success fee that it may receive will be its principal source of net income
earned through its participation in the San Elijo Hills project pursuant to the Development Agreement.
As of December 31, 1999, the Company owed $26,462,000 principal amount to Leucadia. This amount is payable on December 31, 2004 and bears interest at 6% per year. This obligation is reflected in the consolidated balance sheet, net of debt discount, at $20,552,000 as of December 31, 1999. During the year ended December 31, 1999, the Company paid to Leucadia $1,588,000 in interest. In addition, Leucadia has invested $10,000,000 as a preferred capital interest in Otay Land Company, LLC, a consolidated subsidiary of the Company. Distributions of net income, if any, from Otay Land Company first will be paid to Leucadia until it has received an annual cumulative preferred return of 12% on, and repayment of, its preferred investment. Any remaining funds will be distributed to the Company.
During 1999, the Company sold the remaining 75 residential lots and one clustered housing site at its Paradise Valley project for net proceeds of $2,487,000. In 1998, the Company sold 61 residential lots at the Paradise Valley project for net proceeds of $2,612,000. In 1999, the Company entered into a contract to sell its two remaining clustered housing sites at Paradise Valley for aggregate net proceeds of $1,450,000. This sale is expected to close during the first half of 2000. The Company has certain continuing obligations with respect to this project, including the obligation to construct a recreation center. Construction of this recreation center began during 1999 and is expected to cost $1,200,000. Cash of $1,000,000 was deposited in an escrow account that is being drawn upon as the recreation center is being completed. At December 31, 1999, $868,000 remained in escrow.
In connection with an indemnity agreement to a third party surety entered into in 1990 in connection with the construction of infrastructure improvements in a development located in La Quinta, California., a subsidiary of the Company is required to maintain a minimum net worth of $5,000,000 and a minimum cash balance of $400,000. Failure to meet both of these requirements would trigger the subsidiary's obligation to provide an irrevocable letter of credit of approximately $460,000 based upon current estimates. The subsidiary currently meets the minimum cash balance requirement.
As of December 31, 1999, the Company has net operating loss carryovers ("NOLs") of $275,584,000 available to reduce its future federal income tax liabilities and NOLs of $34,480,000 available to reduce its future state income tax liabilities. Most of these NOLs are not available to reduce federal alternative minimum taxable income, which is currently taxed at the rate of 20%. As a result, the Company expects to pay federal income tax at a rate of 20% during future periods, even if these NOLs are available to reduce regular taxable income.
Results of Operations
Sales of residential properties decreased in 1999 as compared to 1998. In 1999, the Company sold 75 lots and one clustered housing development site at the Paradise Valley project, while in 1998, the Company sold 97 lots in the Company's Silverwood project and 61 lots at the Paradise Valley project. Sales of residential properties increased in 1998 as compared to 1997 due to the greater proportion of lot sales in 1998, with 82 lots and two finished homes sold in the Paradise Valley project in 1997.
Land and real estate held for development and sale is carried at the lower of cost or fair value less costs to sell. The provision for losses for the years ended December 31, 1999, 1998 and 1997 reflect the Company's estimates to reduce the carrying value of real estate investments to fair value and, for the years ended December 31, 1999 and 1998, includes $335,000 and $119,000, respectively, for estimated additional costs to build the Paradise Valley recreational center. As a result of recording write-downs of carrying values during each of the last three years, gross profit (loss) upon sale has been insignificant. Actual cost of sales recorded during these periods reflects the level of sales activity, as well as provisions for losses.
Interest expense for all years presented primarily reflects the interest due on indebtedness to Leucadia, including interest of $377,000 for 1998 and $2,208,000 for 1997, which was not paid and was added to the principal balance of the obligation. Interest expense for 1999, 1998 and 1997 also reflects interest of $1,588,000, $2,162,000 and $789,000, respectively, due to Leucadia, which was paid by the Company. Interest expense also includes $ 816,000 and $ 289,000 for 1999 and 1998, respectively, for amortization of debt discount related to the indebtedness due to Leucadia.
The increase in general and administrative expenses in 1999 and 1998 reflects approximately $2,504,000 and $618,000, respectively, in 1999 and 1998 of increased costs for operating expenses attributable to the San Elijo Hills project and Otay Ranch project.
Income tax expense for all years presented relates to state franchise taxes. The Company has not recognized any income tax benefit for its operating losses due to the uncertainty of sufficient future taxable income which is required in order to recognize these tax benefits.
Inflation
The Company, as well as the real estate development and homebuilding industry in general, may be adversely affected by inflation, primarily because of either reduced rates of savings by consumers during periods of low inflation or higher land and construction costs during periods of high inflation. Low inflation could adversely affect consumer demand by limiting growth of savings for down payments, ultimately affecting demand for real estate and the Company's revenues. In addition, higher mortgage interest rates may significantly affect the affordability of permanent mortgage financing to prospective purchasers. High inflation also increases the Company's costs of labor and materials. The Company would attempt to pass through to its customers any increases in its costs through increased selling prices. To date, high or low rates of inflation have not had a material adverse effect on the Company's results of operations. However, there is no assurance that high or low rates of inflation will not have a material adverse impact on the Company's future results of operation.
Interest Rates
The Company's operations are interest-rate sensitive. Overall housing demand is adversely affected by increases in interest costs. If mortgage interest rates increase significantly, this may negatively impact the ability of a home buyer to secure adequate financing. This could adversely affect the Company's revenues, gross margins and profitability.
Cautionary Statement for Forward-Looking Information
Statements included in this Report may contain forward-looking statements. Such forward-looking statements are made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements may relate, but are not limited, to projections of revenues, income or loss, capital expenditures, plans for growth and future operations, competition and regulation as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, many of which cannot be predicted or quantified. When used in this Report, the words "estimates", "expects", "anticipates", "believes", "plans", "intends" and variations of such words and similar expressions are intended to identify forward-looking statements that involve risks and uncertainties. Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements. The factors that could cause actual results to differ materially from those suggested by any such statements include, but are not limited to, those discussed or identified from time to time in the Company's public filings, including changes in general economic and market conditions, changes in domestic laws and government regulations or requirements, changes in real estate pricing environments, regional or general changes in asset valuation, demographic and economic changes in the United States generally and California in particular, increases in real estate taxes and other local government fees, significant competition from other real estate developers and homebuilders, decreased consumer spending for housing, delays in
construction schedules and cost overruns, availability and cost of land, materials and labor, increased development costs beyond the Company's control, damage to properties or condemnation of properties, the occurrence of significant natural disasters, the inability to insure certain risks economically, the adequacy of loss reserves, changes in prevailing interest rate levels, and changes in the composition of the Company's assets and liabilities through acquisitions or divestitures. Undue reliance should not be placed on these forward-looking statements, which are applicable only as of the date hereof. The Company undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this Report or to reflect the occurrence of unanticipated events.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk. - -------------------------------------------------------------------
The Company does not have material market risk exposures.
Item 8.
Item 8. Financial Statements and Supplementary Data. - ----------------------------------------------------
Financial Statements and supplementary data required by this Item 8 are set forth at the pages indicated in Item 14(a) below.
Item 9.
Item 9. Disagreements on Accounting and Financial Disclosure. - -------------------------------------------------------------
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant. - ------------------------------------------------------------
The information to be included under the caption "Nominees for Election as Directors" in HomeFed's definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the 1934 Act in connection with the 2000 annual meeting of stockholders of HomeFed (the "Proxy Statement") is incorporated herein by reference. In addition, reference is made to Item 10 in Part I of this Report.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors, and persons who beneficially own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Based solely upon a review of the copies of such forms furnished to the Company and written representations from the Company's executive officers, directors and greater than 10% beneficial shareholders, the Company believes that during the year ended December 31, 1999, all persons subject to the reporting requirements of Section 16(a) filed the required reports on a timely basis.
Item 11.
Item 11. Executive Compensation. - --------------------------------
The information to be included under the caption "Executive Compensation" in the Proxy Statement is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------------------------------------------------------------------------
The information to be included under the caption "Present Beneficial Ownership of Common Stock" in the Proxy Statement is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions. - --------------------------------------------------------
The information to be included under the caption "Executive Compensation - Certain Relationships and Related Transactions" in the Proxy Statement is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. - --------------------------------------------------------------------------
Schedules are omitted because they are not required or are not applicable or the required information is shown in the financial statements or notes thereto
(b) Reports on Form 8-K. None.
(c) Exhibits
2.1 Amended Disclosure Statement to the Company's Fourth Amended Plan of Reorganization Dated July 15, 1994 (incorporated by reference to Exhibit 2.1 to the Company's current report on Form 8-K dated June 14, 1995).
2.2 The Company's Fourth Amended Plan of Reorganization Dated July 15, 1994 (incorporated by reference to Exhibit 2.2 to the Company's current report on Form 8-K dated June 14, 1995).
2.3 Order Modifying and Confirming the Company's Fourth Amended Plan of Reorganization Dated July 15, 1994 (incorporated by reference to Exhibit 2.3 to the Company's current report on Form 8-K dated June 14, 1995).
3.1 Restated Certificate of Incorporation, as restated July 3, 1995 of the Company (incorporated by reference to Exhibit 3.1 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1995).
3.2 By-laws of the Company as amended through December 14, 1999.
10.1 Loan Agreement dated July 3, 1995 between the Company and Leucadia Financial Corporation ("LFC") and Form of 12% Secured Convertible Note due July 3, 2003 (incorporated by reference to Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1995).
10.2 Paradise Valley Unit 1 First Closing Purchase Agreement and Escrow Instructions, dated October 3, 1996, between Paradise Valley Communities No. 1 and The Forecast Group (Registered Trade Name), L.P. (incorporated by reference to Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996).
10.3 Paradise Valley Unit 2 First Closing Purchase Agreement and Escrow Instructions, dated October 3, 1996, between Paradise Valley Communities No. 1 and The Forecast Group (Registered Trade Name), L.P. (incorporated by reference to Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996).
10.4 Paradise Valley Unit 1 Second Closing Purchase Agreement and Escrow Instructions, dated October 3, 1996, between Paradise Valley Communities No. 1 and The Forecast Group (Registered Trade Name), L.P. (incorporated by reference to Exhibit 10.3 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996).
10.5 Paradise Valley Unit 2 Second Closing Purchase Agreement and Escrow Instructions, dated October 3, 1996, between Paradise Valley Communities No. 1 and The Forecast Group (Registered Trade Name), L.P. (incorporated by reference to Exhibit 10.4 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996).
10.6 Paradise Valley Unit 3 Option to Purchase Real Property and Escrow Instructions, dated October 3, 1996, between Paradise Valley Communities No. 1 and The Forecast Group (Registered Trade Name), L.P. (incorporated by reference to Exhibit 10.5 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996).
10.7 Paradise Valley Unit 4 Option to Purchase Real Property and Escrow Instructions, dated October 3, 1996, between Paradise Valley Communities No. 1 and The Forecast Group (Registered Trade Name), L.P. (incorporated by reference to Exhibit 10.6 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1996).
10.8 Real Estate Purchase Agreement and Escrow Instructions between Southfork Partnership and Northfork Communities (incorporated by reference to Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1998).
10.9 Purchase and Sale Agreement and Escrow Instructions, dated as of September 21, 1999, by and between Paradise Valley Communities No. 1 and Western Pacific Housing, Inc. (incorporated by reference to Exhibit 10 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1999).
10.10 Amended and Restated Loan Agreement between the Company and LFC, dated as of August 14, 1998 (incorporated by reference to Exhibit 10.2 to the Company's report on Form 8-K dated August 14, 1998).
10.11 Development Management Agreement between the Company and Provence Hills Development Company, LLC, dated as of August 14, 1998 (incorporated by reference to Exhibit 10.3 to the Company's report on Form 8-K dated August 14, 1998).
10.12 Stock Purchase Agreement between the Company and Leucadia National Corporation, dated as of August 14, 1998 (incorporated by reference to Exhibit 10.1 to the Company's report on Form 8-K dated August 14, 1998).
10.13 Amended and Restated Limited Liability Company Agreement of Otay Land Company, LLC, dated as of September 20, 1999, between the Company and Leucadia National Corporation (incorporated by reference to Exhibit 10.16 to the Company's Registration Statement on Form S-2 (No. 333-79901) (the "Registration Statement").
10.14 Stock Purchase Agreement, dated as of October 20, 1998, between the Company and Leucadia National Corporation (incorporated by reference to Exhibit 10.1 to the Company's report on Form 10-Q for the quarter ended September 30, 1998).
10.15 Administrative Services Agreement, dated as of March 1, 1999, between LFC, the Company, HomeFed Resources Corporation and HomeFed Communities, Inc. (incorporated by reference to Exhibit 10.14 to the Company's report on Form 10-K for the year ended December 31, 1998).
10.16 Transitional Management Agreement, dated as of August 14, 1998, by and between HomeFed and Accretive Investments, LLC (incorporated by reference to Exhibit 10.17 to the Registration Statement).
10.17 Option and Purchase Agreement and Escrow Instructions, dated as of October 15, 1999, by and between Otay Land Company, LLC and Lakes Kean Argovitz Resorts-California, LLC.
10.18 First Amendment to Option and Purchase Agreement and Escrow Instructions, dated as of December 8, 1999, by and between Otay Land Company, LLC and Lakes Kean Argovitz Resorts-California, LLC.
10.19 Second Amendment to Option and Purchase Agreement and Escrow Instructions, dated as of December 14, 1999, by and between Otay Land Company, LLC and Lakes Kean Argovitz Resorts-California, LLC.
10.20 Purchase and Sale Agreement and Joint Escrow Instructions, dated as of September 30, 1998, by and between Paradise Valley Communities No. 1 and Richmond American Homes of California, Inc. (incorporated by reference to Exhibit 10.15 to the Registration Statement).
21 Subsidiaries of the Company.
27 Financial Data Schedule.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HOMEFED CORPORATION
Date: March 29, 2000 By /s/ CORINNE A. MAKI ------------------------------ Corinne A. Maki Secretary and Treasurer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Date: March 29, 2000 By /s/ JOSEPH S. STEINBERG ----------------------------------- Joseph S. Steinberg, Chairman of the Board and Director
Date: March 29, 2000 By /s/ PAUL J. BORDEN ------------------------------ Paul J. Borden, President and Director (Principal Executive Officer)
Date: March 29, 2000 By /s/ CORINNE A. MAKI --------------------- Corinne A. Maki Secretary and Treasurer (Principal Financial and Accounting Officer)
Date: March 29, 2000 By /s/ PATRICK D. BIENVENUE -------------------------- Patrick D. Bienvenue, Director
Date: March 29, 2000 By /s/ TIMOTHY CONSIDINE ----------------------- Timothy Considine, Director
Date: March 29, 2000 By /s/ IAN M. CUMMING ------------------- Ian M. Cumming, Director
Date: March 29, 2000 By /s/ MICHAEL A. LOBATZ ----------------------- Michael A. Lobatz, Director
================================================================================
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of HomeFed Corporation:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in stockholders' deficit, and cash flows present fairly, in all material respects, the financial position of HomeFed Corporation and Subsidiaries (the "Company") as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP March 7, 2000 Salt Lake City, Utah
NY2:\888898\03\76830.0194
HOMEFED CORPORATION AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1999 and 1998 (Dollars in thousands, except par value)
1999 1998 --------- --------- ASSETS - ------
Land and real estate held for development and sale $ 23,707 $ 5,008 Cash and cash equivalents 2,795 3,120 Restricted cash 868 1,127 Investment in Otay Land Company, LLC -- 9,917 Other investments -- 79 Deposits and other assets 158 164 --------- ---------
TOTAL $ 27,528 $ 19,415 ========= =========
LIABILITIES - -----------
Note payable to Leucadia Financial Corporation $ 20,552 $ 19,736 Recreation center liability 970 875 Accounts payable and accrued liabilities 1,905 299 --------- ---------
Total liabilities 23,427 20,910 --------- ---------
COMMITMENTS AND CONTINGENCIES - -----------------------------
MINORITY INTEREST 11,208 -- - ----------------- --------- ---------
COMMON STOCK SUBSCRIPTION - -------------------------
Advance under common stock subscription -- 6,710 --------- ---------
STOCKHOLDERS' DEFICIT - --------------------- Common stock, $.01 par value, 100,000,000 shares authorized; 56,557,826 and 10,000,000 shares outstanding 566 100 Additional paid-in capital 354,833 346,919 Accumulated deficit (362,506) (355,224) --------- ---------
Total stockholders' deficit (7,107) (8,205) --------- ---------
TOTAL $ 27,528 $ 19,415 ========= =========
The accompanying notes are an integral part of these consolidated financial statements.
HOMEFED CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations For the years ended December 31, 1999, 1998 and 1997 (Dollars in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
HOMEFED CORPORATION AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Deficit For the years ended December 31, 1999, 1998 and 1997 (Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
HomeFed Corporation and Subsidiaries Consolidated Statements of Cash Flows For the years ended December 31, 1999, 1998 and 1997 (Dollars in thousands)
(continued)
The accompanying notes are an integral part of these consolidated financial statements.
HomeFed Corporation and Subsidiaries Consolidated Statements of Cash Flows (continued) For the years ended December 31, 1999, 1998 and 1997 (Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
HOMEFED CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The accompanying consolidated financial statements include the accounts of HomeFed Corporation (the "Company"), Otay Land Company, LLC ("Otay Land Company"), and the Company's wholly-owned subsidiaries, HomeFed Communities, Inc. ("HomeFed Communities") and HomeFed Resources Corporation. The Company is engaged, directly and through its subsidiaries, in the investment in and development of residential real estate properties in California. All significant intercompany balances and transactions have been eliminated in consolidation.
During the third quarter of 1999, the limited liability agreement governing Otay Land Company was amended and as a result, the Company now has the ability to control Otay Land Company. Accordingly, effective September 20, 1999, Otay Land Company has been included in the Company's consolidated financial statements. The Company previously had accounted for this investment under the equity method of accounting; the noncash effects on the consolidated financial statements were a decrease in the investment in Otay Land Company of $9,988,000, an increase in minority interest of $10,928,000 and an increase in land and real estate held for development and sale of $20,976,000.
Certain amounts for prior periods have been reclassified to be consistent with the 1999 presentation.
Land and Real Estate Held for Development and Sale - Land and real estate held for development and sale is carried at the lower of cost or fair value less costs to sell. The cost of land and real estate held for development and sale includes all expenditures incurred in connection with the acquisition, development and construction of the property, including interest and property taxes. Revenue from incidental operations relating specifically to property under development is treated as a reduction of capitalized costs. Land costs included in land and real estate held for development and sale are allocated to lots based on relative fair values prior to development and are charged to cost of sales at the time of sale.
Cash and Cash Equivalents - Cash and cash equivalents include short-term, highly liquid investments that are readily convertible to cash. The majority of the Company's cash and cash equivalents are held by one financial institution in Salt Lake City, Utah.
Restricted Cash - Restricted cash consists of amounts held in escrow to fund the building of a recreation center at the Paradise Valley project.
Revenue Recognition - Revenue from the sale of real estate is recognized at the time title is conveyed to the buyer at the close of escrow, minimum down payment requirements are met, the terms of any notes received satisfy continuing payment requirements, and there are no requirements for continuing involvement with the properties. When it is determined that the earning process is not complete, income is deferred using the installment, cost recovery or percentage of completion methods of accounting, as appropriate.
Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities at the date of the financial statements and (iii) the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, continued: ------------------------------------------
Provisions for Losses on Real Estate Investments - Management periodically assesses the recoverability of its real estate investments by comparing the carrying amount of the investments with their fair value less costs to sell. The process involved in the determination of fair value requires estimates as to future events and market conditions. This estimation process assumes the Company has the ability to complete development and dispose of its real estate properties in the ordinary course of business based on management's present plans and intentions. When management determines that the carrying value of specific real estate investments should be reduced to properly record these assets at fair value less costs to sell, this write-down is recorded as a charge to current period operations.
Capitalization of Interest and Real Estate Taxes - Interest and real estate taxes attributable to land and home construction are capitalized and added to the cost of those properties while the properties are being actively developed.
2. LAND AND REAL ESTATE HELD FOR DEVELOPMENT AND SALE
A summary of land and real estate held for development and sale by project follows:
December 31, -------------------------------- 1999 1998 ----------- -----------
Paradise Valley $ 2,522,000 $ 5,008,000
Otay Ranch 21,185,000 -- ----------- -----------
Total $23,707,000 $ 5,008,000 =========== ===========
No interest was capitalized in land and real estate held for development and sale during 1999 and 1998.
All land and real estate held for development and sale is property in California and is pledged as collateral under the Amended and Restated Loan Agreement.
3 NOTES PAYABLE
As of August 14, 1998, the Company and Leucadia Financial Corporation ("LFC"), a subsidiary of Leucadia National Corporation ("Leucadia") entered into an Amended and Restated Loan Agreement pursuant to which the Company and LFC amended the original loan agreement dated July 3, 1995 and restructured the Company's outstanding 12% Secured Convertible Note due 2003 ("Convertible Note") held by LFC. The restructured note dated August 14, 1998 (the "Restructured Note") has a principal amount of approximately $26,462,000 (reflecting the original $20,000,000 principal balance of the Convertible Note, together with additions to principal resulting from accrued and unpaid interest thereon to the date of the restructuring, as allowed under the terms of the Convertible Note), extends the maturity date from July 3, 2003 to December 31, 2004, reduces the interest rate from 12% to 6% and eliminates the convertibility feature of the Convertible Note. The Restructured Note is collateralized by a perfected first priority security interest in all assets of the borrower, whether now owned or hereafter acquired. No principal payments are due under the Restructured Note until its maturity date.
3. NOTES PAYABLE, continued: -------------
As a result of the restructuring of the Convertible Note, the Restructured Note was recorded at fair value and the approximate $7,015,000 difference between the fair value of the Restructured Note and the carrying value of the Convertible Note was reflected as additional paid-in capital. This difference will be amortized as interest expense over the term of the Restructured Note using the interest method. Approximately $816,000 and $289,000 was amortized to interest expense during 1999 and 1998, respectively. The carrying amount of this Restructured Note, net of debt discount, was $20,552,000 and $19,736,000 at December 31, 1999, and 1998, respectively.
Interest accrued during 1998 and 1997 of $377,000, and $2,208,000, respectively, was not paid and was added to the principal balance. Additional interest of $1,588,000, $2,162,000 and $789,000 accrued during 1999, 1998 and 1997, respectively, was paid by the Company.
4. INCOME TAXES
The income tax expense for all years presented principally relates to state franchise taxes. The Company has not recognized any tax benefit from its operating losses in all years presented.
In 1997, the Internal Revenue Service granted the Company a favorable ruling on the Company's private letter ruling request and the Company received permission to reattribute a portion of the net operating losses from HomeFed Bank, F.S.B. ("HomeFed Bank") and its subsidiaries to the Company. The amount of net operating loss ("NOL") carryforwards reattributed was approximately $219,324,000.
The Company and its wholly-owned subsidiaries have NOL carryforwards available for federal income tax purposes of $275,584,000 as of December 31, 1999, including the NOLs reattributed to the Company from HomeFed Bank and its subsidiaries. These carryforwards were generated during 1985-1999 and expire during 2000-2019. For state income tax purposes, available NOLs as of December 31, 1999 total $34,480,000 and expire in 2000-2014.
At December 31, the net deferred tax asset consisted of the following:
1999 1998 ------------- -------------
NOL carryforwards $ 99,402,000 $ 95,789,000 Land basis 1,799,000 3,081,000 Other 31,000 28,000 ------------- ------------- 101,232,000 98,898,000 Valuation allowance (101,232,000) (98,898,000) ------------- ------------- $ 0 $ 0 ============= =============
The valuation allowance has been provided on the total amount of the deferred tax asset due to the uncertainty of future taxable income necessary for realization of the deferred tax asset. The valuation allowance increased by $2,334,000, $3,197,000 and $76,100,000 in 1999, 1998 and 1997, respectively.
5. PROVISION FOR LOSSES ON REAL ESTATE INVESTMENTS
For the years ended December 31, 1999, 1998 and 1997, the Company recorded losses of $365,000, $425,000 and $153,000, respectively, due to the revaluation of the residential properties and the increase in estimates to build the recreation center at the Paradise Valley project.
6. EARNINGS PER SHARE
Basic loss per share of Common Stock for 1999 was calculated by dividing net loss by 32,577,357 weighted shares of Common Stock outstanding. Basic loss per share of Common Stock for 1998 and 1997 was calculated by dividing net loss by 10,000,000 shares of Common Stock.
Diluted loss per share of Common Stock were calculated as described above. The number of shares used to calculate diluted loss per share was 32,577,357, 10,000,000 and 10,000,000 for each of the years ended December 31, 1999, 1998 and 1997, respectively. The calculation of diluted loss per share does not include Common Stock equivalents of 49,647,893 and 54,073,383 for 1998 and 1997, respectively, which are antidilutive.
7. COMMITMENTS AND CONTINGENCIES
One of the Company's wholly-owned subsidiaries, HomeFed Communities, must maintain a net worth of $5,000,000 and a cash balance of $400,000 in order to ensure its ability to pay amounts which may become due under an indemnity agreement with a third-party surety which provided security for certain obligations of the partnership in which HomeFed Communities was a partner. Failure to meet both of these requirements would trigger Homefed Communities' obligation to provide an irrevocable letter of credit in the amount of 50% of the face value of the bonds issued by the surety. This letter of credit amount is currently estimated to be approximately $460,000. Homefed Communities currently meets the minimum cash balance requirement.
8. RELATED PARTY TRANSACTIONS
The Company has entered into the following related party transactions with Leucadia and its subsidiary, LFC.
(a) Amended Loan Agreement. As of August 14, 1998, the Company and LFC entered into an Amended and Restated Loan Agreement, pursuant to which the Company and LFC amended the original loan agreement dated July 3, 1995 and restructured the outstanding Convertible Note held by LFC. The Restructured Note has a principal amount of approximately $26,462,380 (reflecting the original $20,000,000 principal balance of the Convertible Note, together with additions to principal resulting from accrued and unpaid interest thereon to the date of the restructuring, as allowed under the terms of the Convertible Note), extends the maturity date from July 3, 2003 to December 31, 2004, reduces the interest rate from 12% to 6% and eliminates the convertibility feature of the Convertible Note. Interest only on the Restructured Note is paid quarterly and all unpaid principal is due on the maturity date. During the year ended December 31, 1999, the Company paid to LFC approximately $1,588,000 in interest on the Restructured Note.
As a result of the restructuring of the Convertible Note, the Restructured Note was recorded at fair value and the approximate $7,015,000 difference between such amount and the carrying value of the Convertible Note was reflected as additional paid-in capital. The $7,015,000 difference between the fair value of the Restructured Note and the carrying value of the Convertible Note will be amortized over the term of the Restructured Note using the interest method. Approximately $1,105,000 has been amortized to date ($816,000 in 1999).
(b) Stock Purchase Agreements. In August and October 1998, the Company entered into stock purchase agreements (the "Stock Purchase Agreements") with Leucadia, pursuant to which the Company agreed to sell an aggregate of 46,557,826 additional shares of its Common Stock to Leucadia for an aggregate purchase price of $8,380,000. In connection with the Stock Purchase Agreements, in 1998 Leucadia advanced to the Company $6,710,000 of the total purchase price. The balance of the purchase price was paid at the closing on July 8, 1999. In 1998, Leucadia assigned the Stock Purchase Agreements to the Leucadia Trust. In 1999, the Leucadia Trust distributed to its beneficial holders all of the Company's Common Stock owned by the Trust and the Trust was terminated.
8. RELATED PARTY TRANSACTIONS, continued: --------------------------
(c) Development Agreement. As of August 14, 1998, the Company entered into a Development Management Agreement ("Development Agreement") with an indirect subsidiary of Leucadia that owns certain real property located in the City of San Marcos, County of San Diego, California, to develop a master-planned residential project on such property. The project, known as San Elijo Hills, is intended to be developed into a community of approximately 3,400 homes over the next ten years. The Development Agreement provides that the Company will act as the development manager with responsibility for the overall management of the project, including arranging financing for the project, marketing and sales activity, and acting as the construction manager. The Development Agreement provides for the Company to receive a profit participation (as determined in accordance with the Development Agreement), and fee income for project management and marketing services based on the revenues derived from the project.
(d) Otay Land Company, LLC. As of October 14, 1998, the Company and Leucadia formed Otay Land Company. The Company has contributed $11,300,000 as capital and Leucadia has contributed $10,000,000 as a preferred capital interest. The Company is the manager of Otay Land Company. Otay Land Company has acquired, for approximately $19,500,000, approximately 4,800 acres of land which is part of a 22,900-acre project located south of San Diego, California, known as Otay Ranch.
All distributions by Otay Land Company shall be distributed to the Company and Leucadia in the following order of priority: (i) to pay Leucadia an annual minimum cumulative preferred return of 10% on all preferred capital contributed by Leucadia; (ii) to pay Leucadia an annual cumulative preferred return of 2% on all preferred capital provided by Leucadia, but payable only out of and to the extent there are profits; (iii) to repay all preferred capital provided by Leucadia; and (iv) any remaining funds are to be distributed to the Company.
(e) Administrative Services Agreement. Pursuant to administrative services agreements, LFC provides administrative services to the Company, including providing the services of two of the Company's three executive officers. Administrative fees paid to LFC in 1999, 1998 and 1997 were $296,000, $138,000, and $80,000, respectively. Effective March 1, 1999, the Company and LFC entered into a new three year administrative services agreement pursuant to which the Company will pay LFC an administrative fee of $296,101 for the first annual period, with the fee for subsequent annual periods to be negotiated. The parties are currently negotiating the fee for the annual period beginning March 1, 2000.
The Company's corporate headquarters is located at 1903 Wright Place, Suite 220, Carlsbad, California in part of an office building sub-leased from a subsidiary of Leucadia for a monthly amount equal to its share of the Leucadia subsidiary's cost for such space and furnishings. The agreement pursuant to which the space and furnishings are provided extends through February 28, 2005 (coterminous with Leucadia's occupancy of the space) and provides for a monthly rental of $15,865 effective March 1, 2000.
9. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's material financial instruments include cash and cash equivalents, restricted cash, investments and notes payable. In all cases, the carrying amount of such financial instruments approximates their fair values. In cases where quoted market prices are not available, fair values are based on estimates using present value techniques.
10. STOCK OPTIONS, STOCK APPRECIATION RIGHTS AND RESTRICTED STOCK
Under the HomeFed Corporation 1999 Stock Incentive Plan, the Company may grant stock options, stock appreciation rights and restricted shares of the Company's stock to directors, certain of its officers and key employees and certain officers and key employees of any subsidiary corporation, parent corporation or affiliated corporation (as defined in the Plan) of the Company. The Plan provides that up to one million shares of Common Stock may be acquired pursuant to the exercise of options or rights or issued as restricted stock. The exercise price of any incentive stock option issued under the Plan is required to be not less than the fair market value per share at the date the option is granted. Options may be granted from time to time at the discretion of the Board of Directors and will vest over periods of one to five years from the grant date. The aggregate number of shares with respect to which options, rights or shares of restricted stock may be granted under the Plan to any grantee in any one taxable year is 300,000. No stock options, appreciation rights or shares of restricted stock were granted in 1999.
On March 8, 2000 options to purchase an aggregate of 150,000 shares of Common Stock were granted to eligible participants under the Plan at an exercise price of $.75 per share and an aggregate of 250,000 shares of restricted stock were issued to eligible participants under the Plan.
EXHIBIT INDEX
E-2 | 10,146 | 68,452 |
941548_1999.txt | 941548_1999 | 1999 | 941548 | ITEM 1. BUSINESS.
Cooper Cameron Corporation ("Cooper Cameron" or the "Company") is a leading international manufacturer of oil and gas pressure control equipment, including valves, wellheads, controls, chokes, blowout preventers and assembled systems for oil and gas drilling, production and transmission used in onshore, offshore and subsea applications. Cooper Cameron is also a leading manufacturer of centrifugal air compressors, integral and separable reciprocating engines, compressors and turbochargers.
Cooper Cameron's business of manufacturing petroleum production equipment and compression and power equipment began in the mid-1800's with the manufacture of steam engines that provided power for plants and textile or rolling mills. By 1900, with the discovery of oil and gas, Cooper Cameron moved into the production of natural gas internal combustion engines and gas compressors. The Company added to its product offering through various acquisitions, in particular the acquisitions of The Bessemer Gas Engine Company (gas engines and compressors); Pennsylvania Pump and Compressor (reciprocating air and gas compressors); Ajax Iron Works (compressors); Superior (engines and compressors); Joy Petroleum Equipment Group (valves, couplings and wellheads); Joy Industrial Compressor Group (compressors); and Cameron Iron Works (blowout preventers, ball valves, control equipment and McEvoy-Willis wellhead equipment and choke valves).
Cooper Cameron, a Delaware corporation, was incorporated on November 10, 1994. The Company operated as a wholly-owned subsidiary of Cooper Industries, Inc. ("Cooper") until June 30, 1995, the effective date of the completion of an exchange offer with Cooper's stockholders resulting in the Company becoming a separate stand-alone company. The common stock of Cooper Cameron is trading on the New York Stock Exchange under the symbol "CAM".
In June 1996, Cooper Cameron purchased the assets and assumed certain operating liabilities of Ingram Cactus Company for approximately $100.5 million in cash. The business acquired manufactures and sells wellheads, surface systems, valves and actuators used primarily in onshore oil and gas production operations, and owned manufacturing facilities in Oklahoma City, Oklahoma and Broussard, Louisiana, as well as in the United Kingdom and Austria. The Company also acquired interests in the Ingram Cactus joint ventures in Venezuela and Malaysia. The operations have now been integrated into those of the Cameron division.
In October 1996, Cooper Cameron acquired, for its Cameron division, certain assets and assumed certain liabilities of Tundra Valve & Wellhead Corp., a Canadian manufacturer of wellheads, trees and valves, for approximately Canadian $9.8 million. Also, during 1996, Cooper Cameron acquired, for its Cooper Energy Services division, certain assets of a developer and provider of ignition systems for gas engines, particularly those used in large-scale gas transmission installations, for approximately $6.1 million.
During 1997, the Company's Cameron division made three small product line acquisitions totaling $6.3 million.
During 1998, the Company made four acquisitions of companies offering aftermarket products and services at a cash cost of approximately $15 million. In April 1998, the Company acquired Orbit Valve International, Inc. ("Orbit(R)") for approximately $104 million in cash and debt. Orbit became part of the Cooper Cameron Valves organization. Orbit manufactures and sells high- performance valves and actuators for the oil and gas and petrochemical industries. Orbit's primary manufacturing facility is located in Little Rock, Arkansas with a sales, marketing, assembly, test and warehousing base at Livingston, Scotland in the United Kingdom.
During 1999, the Company sold its rotating compressor product line business to Rolls-Royce plc for approximately $200 million. The operations that were sold had primary facilities in Liverpool, United Kingdom, Hengelo in the Netherlands and Mt. Vernon, Ohio. The Company decided to divest this product line because it did not control the key technology of the business (the engine which Rolls-Royce provides) and had limited aftermarket opportunities.
Also during 1999, the Company's Cameron division acquired the remaining interest in a joint venture located in Venezuela in which it previously held a 49% equity interest.
BUSINESS SEGMENTS -----------------
MARKETS AND PRODUCTS
The Company's operations are organized into four separate business segments which are Cameron, Cooper Cameron Valves, Cooper Energy Services and Cooper Turbocompressor, each of which is also a division. For additional industry segment information for each of the three years in the period ended December 31, 1999, see Note 13 of the Notes to Consolidated Financial Statements, which Notes are incorporated herein by reference in Part II, Item 8 hereof ("Notes to Consolidated Financial Statements.")
Cameron Division
Cameron manufactures pressure control equipment used at the wellhead in the drilling for and production and transmission of oil and gas, both onshore and offshore. The primary products include wellheads, drilling valves, blowout preventers ("BOPs") and control systems and are marketed under the well-known brand names Cameron(R), W-K-M(R), McEvoy(R), Willis(R), and Ingram Cactus(R). The equipment is manufactured in a variety of sizes and to various specifications with working pressure ratings up to 30,000 pounds per square inch ("p.s.i."). The wellhead equipment is designed to support the casing and production tubulars and includes casing head housings, casing heads and tubing heads. Valves of different sizes and design are assembled with other components into an assembly known as a "christmas tree," which is mounted on the wellhead equipment and is used to control the flow of oil and gas from a producing well. Most christmas trees are custom designed to meet individual customer requirements.
Cameron also manufactures subsea production systems, which consist of equipment used to complete an oil or gas well on the sea floor. Subsea systems tend to be sophisticated and generally require a high degree of technological innovation.
In 1993, Cameron introduced its patented SpoolTree(TM) subsea production system for use in oil and gas fields with subsea completions that require frequent retrieval of downhole equipment. With the SpoolTree system, well completion and workover activities can be performed without a workover riser or removal of the christmas tree and under conventional blowout preventer control, thereby reducing the time and equipment needed to perform such activities.
Cameron's drilling-related equipment includes ram and annular BOPs. Cameron has experienced a dramatic increase in its BOP sales over the past few years due to an increased market focus on and, up until the second half of 1998, improving fundamentals in the drilling business. Although order levels declined during the latter part of 1998 and into 1999, a backlog of orders linked to rig upgrades and new-build construction resulted in increased drilling-related revenues in 1999. Cameron also produces other drilling-related equipment, the most important of which are choke manifolds, drilling risers and control systems.
Additionally, Cameron provides complete integrated elastomer research, development and manufacturing. These products are used in pressure and flow control equipment. This technology also supports the petroleum, petrochemical, rubber molding and plastics industries in the development and testing of elastomer and plastic products.
The Cameron Willis Chokes business unit was formed in late 1997 to focus resources on the choke product line with the goal of enhancing Cameron's performance in this product line. Cameron Willis manufactures production chokes, control valves, drilling choke systems, actuators, and pigging and production automation systems. The Company's primary choke manufacturing operations have now been consolidated into its Longford, Ireland facility.
The Cameron Controls business unit was created in late 1996 with a primary goal of expanding Cameron's role as a provider of controls equipment. Drilling and production equipment used on the ocean floor operates from a platform or other remote location through hydraulic or electronic connections that allow the operator to measure and control the pressures and throughput associated with these installations. Cameron Controls' two primary manufacturing assembly and testing facilities are located in Celle, Germany and Houston, Texas.
The Cameron division has established an aftermarket business unit with a comprehensive worldwide aftermarket organization that provides replacement parts, field service, major repairs and overhauls, unit installation assistance and Total Vendor Management contracts. Cameron also provides an inventory of repair parts, service personnel, planning services and inventory and storage of customers' idle equipment.
Cameron primarily markets its petroleum production equipment products directly to end-users through a worldwide network of sales and marketing employees, supported by agents in some international locations. Due to the extremely technical nature of many of the products, the
marketing effort is further supported by a staff of engineering employees. The balance of Cameron's products are sold through established independent distributors.
Cameron's primary customers include major oil and gas exploration and production companies, independent oil and gas exploration and production companies, foreign national oil and gas companies, engineering and construction companies, drilling contractors and rental equipment companies.
Cooper Cameron Valves Division
Cooper Cameron Valves ("CCV") manufactures valves ranging in sizes from 1/4 inch to 60 inches in diameter and related systems primarily used to control pressures and direct oil and gas as they are moved from individual wellheads through flow lines, gathering lines and transmission systems to refineries, petrochemical plants and industrial centers for processing. Large diameter valves are used primarily in natural gas transmission lines. Smaller valves are used in oil and gas gathering and processing systems and in various types of industrial processes in refineries and petrochemical plants.
Gate valves, ball valves, butterfly valves, Orbit valves, rotary process valves, block and bleed valves, plug valves, actuators, chokes and aftermarket parts are marketed under the brand names Cameron(R), W-K-M(R), Orbit(R), Demco(R), Foster(R) and Thornhill Craver(TM).
CCV markets its equipment and services through a worldwide network of combined sales and marketing employees, carefully selected distributors and agents in selected international locations. Due to the extremely technical nature of many of the products, the marketing effort is further supported by a staff of engineering employees. CCV's primary customers include major and independent oil and gas exploration and production companies, foreign national oil and gas companies, pipeline companies, refining companies and a wide range of industrial, petrochemical and processing industry companies.
In early 2000, CCV will launch a "Valve Advisor" on the Internet to facilitate the purchase of engineered products over the web. Customers and distributors will have ready access to product information, including detailed technical drawings, product availability and pricing. In addition, this service will allow CCV to tap into markets that are not covered via existing distribution channels.
Cooper Energy Services Division
Cooper Energy Services ("CES") provides products and services to the oil and gas production and transmission, process and power generation markets. The primary products include engines, integral engine compressors, reciprocating compressors, turbochargers and aftermarket parts and service. CES markets its products worldwide under the well-known brand names Ajax(R), Cooper-Bessemer(R), Superior(R), Enterprise(R), C-B Turbocharger(R), PPC(R), Service Solutions(TM) and Texcentric(R).
CES's reciprocating products include engines and compressors in both "integral" and "separable" configurations. CES also manufactures four-cycle, natural gas-fueled, reciprocating power engines in both "in-line" and "V" configurations.
CES provides the Ajax integral engine-compressors (140 to 880 horsepower), which combine the engine and compressor on a single drive shaft and are used for gas re-injection and storage, as well as smaller gathering and transmission lines. In addition, a line of rotary screw compressors powered by natural gas engines and electric motor drives was introduced in 1997. CES is continuing to work on a proprietary 1,150 psi high-pressure rotary screw system.
The Superior internal combustion engines (500 to 3,200 horsepower) are manufactured by CES to drive compressors for gas compression, generators to provide power sources, and pumps used for various liquid applications. During 1999, the high speed Superior 2400G engines, available in six, eight, twelve or sixteen-cylinder configurations, were enhanced with the addition of more user- friendly controls, detonation-sensing technology and low-compression power pistons. Development of the Superior HG engine, a new high-horsepower engine for the compression market, was also initiated during the year.
The Superior reciprocating compressors (400 to 9,000 horsepower) are used primarily for natural gas applications, including production, storage, withdrawal, processing and transmission, as well as petrochemical processing. The new Superior WG compressor series has been introduced in 2000 for large project applications up to 9,000 horsepower. These high speed separable compressor units can be matched with either natural gas engine drivers or electric motors and provide a significant installed cost advantage over competitive equipment in the same power range.
There is a significant base of Cooper-Bessemer engines and compressors (up to 30,000 horsepower) for which CES provides replacement parts and service on a worldwide basis.
During 1999, CES organized into four business units in order to better focus on the strategic growth, product development, and technical support unique to its product offerings and to better serve its customers' needs. The four business units consist of the Superior Engine, Ajax and Superior Compressor, Aftermarket Parts, and Aftermarket Service business units.
CES also made the decision in 1999 to sell all of its current offering of new compression equipment domestically through a network of independent distributors rather than on a direct basis with the end user. These distributors are offered varying levels of pricing and support depending on their volume of purchases and whether the products purchased are for their own rental fleets or for resale. CES expects to have substantially completed its network of distributors for domestic compression equipment by mid-2000. CES is offering its power generation equipment domestically through a separate group of independent distributors and continues to sell both its compression and power equipment internationally direct to end-users through a network of sales and marketing employees supported by agents in some locations.
In addition to the sale of the rotating business previously described, CES initiated a significant level of restructuring aimed at improving the productivity of its manufacturing processes. In June 1999, CES announced the closing of the Grove City, Pennsylvania plant and foundry. Most of the activity previously conducted at that location is being outsourced to third parties or relocated to other CES or Cooper Cameron facilities. In June 1999, the relocation of the central warehouse in Mt. Vernon, Ohio to Houston, Texas was announced as well as the relocation of the compressor plant in Mt. Vernon, Ohio to Waller, Texas. All of these restructuring activities are expected to be substantially completed in 2000. CES will also continue to outsource other manufacturing activity during 2000 where significant cost savings can be achieved.
The primary customers for compression and power equipment include the major oil and gas companies, large independent oil and gas producers, gas transmission companies, equipment leasing companies, petrochemical and refining divisions of oil companies, independent power producers, non-utility generators and chemical companies.
Cooper Turbocompressor Division
Cooper Turbocompressor ("CTC") markets its products under the brand names of TurboAir(R), Quad 2000(R), and MSG(R). This division manufactures the integrally geared centrifugal air compressors of the Joy Industrial Compressor Group. The compressors are used by industrial plants as a source of power for the operation of tools, actuation of control devices and to power automatic and semi-automatic production equipment. These compressors are used in industries such as automotive, electronic, textile, chemical, food and beverage and general manufacturing.
In addition, CTC also manufactures integrally geared centrifugal compressors for process air and gas applications. In these cases, the compressor is an integral part of the process in industries such as air separation, chemical, pharmaceutical, fermentation, petrochemical, refining and synthetic fuel.
The process and plant air centrifugal compressors manufactured by CTC deliver oil-free compressed gas to the customer, thus preventing oil contamination of the finished products. Industrial markets worldwide increasingly prefer oil-free air for quality, safety, operational and environmental reasons.
CTC provides aftermarket service and repairs on all equipment it produces through a worldwide network of service centers and field service technicians utilizing an extensive inventory of parts, including Genuine Joy(R) parts. Replacement parts are made to the same high quality standards as those used in new compressors.
CTC expanded its service organization with added training and certification of its domestic and international distributors in the plant air market. CTC provides installation and maintenance service labor, parts and factory repairs and upgrades to its worldwide customers for plant air and process gas compressors. Aero performance and microprocessor-based control system upgrades, as well as refurbishing and re-warranting used compressors, was a significant area of CTC's aftermarket business in 1999.
CTC primarily sells its products through sales representatives and independent distributors supported by a staff of trained product specialists. Regional application centers, located world-wide, support our customers locally.
CTC is actively expanding its product range through the addition of new compressor frames (TA 6000 and TA 11000) and the addition of trademark accessories such as Dry Pac(R) heat compression dryers and Turboblend(R) hydro- cracked turbomachinery lubricating oil. CTC is also continuing its efforts to focus on superior customer service.
MARKET ISSUES
Cooper Cameron, through its segments, is one of the market leaders in the global market for petroleum production equipment. Cooper Cameron believes that it is well positioned to serve these markets. Plant and service center facilities around the world in major oil producing regions provide a broad, global breadth of market coverage.
The international market is expected to be a major source of growth for Cooper Cameron. The desire of both the developed and the developing countries to expand their oil and gas transmission capacity for both economic and political reasons will be one of the primary factors affecting market demand. Additionally, establishment of industrial infrastructure in the developing countries will necessitate the growth of basic industries that require plant air and process compression equipment. Production and service facilities in North and South America, Europe and the Far East provide the Company with the ability to serve the global marketplace.
In each of Cooper Cameron's business segments, a large population of installed engines, compression equipment, and gas and oil production equipment exists in both the U.S. and international market segments. The rugged, long- lived nature of the equipment that exists in the field provides a predictable and profitable repair parts and service business. The Company expects that as increasing quantities of new units are sold into the international markets, there will be a continuing growth in market demand for aftermarket parts and service.
NEW PRODUCT DEVELOPMENT
As petroleum exploration activities have increasingly been focused on subsea locations, the Cameron division has directed much of its new product development efforts toward this market. In subsea exploration, customers are particularly concerned about safety, environmental protection and ease of installation and maintenance. Cameron's reputation for high quality and high dependability has given it a competitive advantage in the areas of safety and environmental protection. A patented subsea production system called the SpoolTree, which was introduced in 1993, offers substantial cost reduction to the customer as it is based upon a novel concept that eliminates the need for a workover riser or removal of the christmas tree during workover. Cameron has pioneered this concept and has developed similar products for land and platform applications, which significantly reduce customer costs.
Cameron has also introduced the MOSAIC(TM) (Modular Subsea And Integrated Completions) system. MOSAIC includes a suite of pre-engineered elements with standard interfaces that can be combined in a fashion to allow customers to configure a system to meet their specific needs. Cameron believes that it has chosen to standardize components at a level low enough to give customers the required customization while providing engineering and manufacturing efficiencies. Cameron has realigned its engineering and marketing resources to further develop and market the MOSAIC subsea system and other stand-alone standardized subsea products, such as christmas trees and wellheads.
Several new drilling products were introduced in 1998 and 1999. These new products included the 3.5 million-pound load capacity LoadKing(TM) riser system, which set the industry standard for drilling in 10,000-foot water depths; a new lightweight and lower-cost locking mechanism for subsea BOPs; and a new generation of variable-bore ram packers. Additionally, Cameron's Freestanding Drilling Riser, introduced in 1999, was a winner of the Petroleum Engineer International Special Meritorious Award for Engineering Innovation.
In May 1998, Cameron opened a new Research Center in Houston, Texas. The 53,000 sq. ft. Research Center is one of the largest product development facilities in the oil service sector. The facility has 10 specially designed test bays to test and evaluate Cameron's products under realistic conditions. These include environmental test chambers to simulate extreme pressures and temperatures, high-strength fixtures for the application of multi-million pound tensile and bending loads, high pressure gas compressors and test enclosures, a hyperbaric chamber to simulate the external pressures of deep water environments, and two circulation loops for erosion and flow testing. This Research Center is instrumental in providing Cameron's customers with innovative and cost-effective products.
In 1997, Cameron Controls successfully launched a new electro-hydraulic drilling control system that was favorably received in the market. A new subsea production control system was developed and launched in 1998. This successful product launch has significantly enhanced the subsea systems offerings for the company.
In response to customer needs, CES has introduced the new, higher-horsepower, Superior HG engine. This natural gas-fueled engine is rated at 5,000 HP (550 HP higher than the nearest competition) and will serve high-end gas compression and power generation markets worldwide.
As a complement to the HG engine, CES has also initiated the development of the Superior WG compressor series. These high-speed separable compressor units can be matched with either natural gas engine drivers (like the HG engine) or electric motors for upstream production, mid-stream processing and gas transmission markets. The speed, power and versatility of the WG series provide a significant installed cost advantage over competitive equipment in the same power range. CES' first sale of the new unit was for an electric motor-driven dual gas boosting application, and is to be installed in the third quarter of 2000.
CTC focused product development resources to further expand its high efficiency plant air compressor line and to provide custom compressors matched to the latest requirements of its
industrial gas customers. The latter is being achieved by advances in aerodynamic and rotor dynamic analytical design capability.
The early 2000 introduction of the TA 6000 and the planned introduction of the TA 11000 in the fourth quarter of 2000 will extend the CTC standard product range up to 2,500 horsepower. These new products position CTC as a state-of-the art supplier of turbo plant air compressors in a wide range of horsepowers.
Other new products include the updated Quad 2000 Controller with state-of- the-art communication capabilities, heat of compression dryer systems, branded lubrication oil, and improved aerodynamic compressor stages.
COMPETITION
Cooper Cameron competes in all areas of its operations with a number of other companies, some of which have financial and other resources comparable to or greater than those of Cooper Cameron.
Cooper Cameron believes it has a leading position in the petroleum production equipment markets, particularly with respect to its high-pressure products. In these markets, Cooper Cameron competes principally with FMC Corporation, Varco International, Inc., Masterflo, Kvaerner Oil and Gas, Vetco Gray Inc. (a subsidiary of Asea Brown Boveri), Dril-Quip, Inc. and Hydril Company. The principal competitive factors in the petroleum production equipment markets are technology, quality, service and price. Cooper Cameron believes that several factors give it a strong competitive position in these markets. Most significant are Cooper Cameron's broad product offering, its worldwide presence and reputation, its service and repair capabilities, its expertise in high pressure technology and its experience in alliance and partnership arrangements with customers and other suppliers.
Cooper Cameron believes it also has a leading position in the compression and power equipment markets. In these markets, Cooper Cameron competes principally with Dresser Rand of Ingersoll-Rand Company, Caterpillar Inc., Ariel Corporation, Waukesha Engine Division of Halliburton Company's Dresser Equipment Group and Atlas-Copco AB. The principal competitive factors in the compression and power equipment markets are engineering and design capabilities, product performance, reliability and quality, service and price. Cooper Cameron believes that its competitive position is based on several factors. Cooper Cameron has a broad product offering and, unlike many of its competitors, manufactures and sells both engines and compressors (both as separate units and packaged together as a single unit). Cooper Cameron led the industry in the introduction of low emission engine technology and continues today as an industry leader in this technology. Cooper Cameron has a highly competent engineering staff and skilled technical and service representatives, with service centers located throughout the world.
In all of its markets, Cooper Cameron's products have strong brand recognition and Cooper Cameron has an established reputation for quality and service. Cooper Cameron has a significant base of previously-installed products, which provides a strong demand for aftermarket parts and service. Cooper Cameron has modern manufacturing facilities and state-of-the-art testing capabilities.
MANUFACTURING
Cooper Cameron has manufacturing facilities worldwide that conduct a broad variety of processes, including machining, fabrication, assembly and testing using a variety of forged and cast alloyed steels and stainless steel as the primary raw materials. In recent years, Cooper Cameron has rationalized plants and products, closed various manufacturing facilities, moved product lines to achieve economies of scale, and upgraded the remaining facilities. Manufacturing processes have been improved and significant capital expenditures have been made. Cooper Cameron maintains advanced manufacturing, quality assurance and testing equipment geared to the specific products that it manufactures and uses extensive process automation in its manufacturing operations. The manufacturing facilities utilize computer aided numeric controlled tools and manufacturing techniques that concentrate the equipment necessary to produce similar products in one area of the plant in a configuration commonly known as a manufacturing cell. One operator in a manufacturing cell can monitor and operate several machines, as well as assemble and test products made by such machines, thereby improving operating efficiency and product quality while reducing the amount of work-in-process and finished product inventories.
Cooper Cameron believes that its test capabilities are critical to its overall process. The Company has the capability to test most equipment at full load, measuring all operating parameters, efficiency and emissions. All process compressors for air separation and all plant air compressors are given a mechanical and aerodynamic test in a dedicated test center prior to shipment.
All of Cooper Cameron's European manufacturing plants are ISO certified and API licensed. Most of the U.S. plants are ISO certified and certification is in process for the remainder. ISO is an internationally recognized verification system for quality management.
BACKLOG
Cooper Cameron's backlog was approximately $513 million at December 31, 1999, (approximately 92% of which is expected to be shipped during 2000) as compared to $790 million at December 31, 1998, and $786 million at December 31, 1997. Backlog consists of customer orders for which a purchase order has been received, satisfactory credit or financing arrangements exist and delivery is scheduled.
PATENTS, TRADEMARKS AND OTHER INTELLECTUAL PROPERTY
Cooper Cameron believes that the success of its business depends more on the technical competence, creativity and marketing abilities of its employees than on any individual patent, trademark or copyright. Nevertheless, as part of its ongoing research, development and manufacturing activities, Cooper Cameron has a policy of seeking patents when appropriate on inventions concerning new products and product improvements. Cooper Cameron owns 260 unexpired United States patents and 683 unexpired foreign patents. During 1999, 80 new patent applications were filed, more than the last three years combined.
Although in the aggregate these patents and Cooper Cameron's trademarks are of considerable importance to the manufacturing and marketing of many of its products, Cooper Cameron does not consider any single patent or trademark or group of patents or trademarks to be material to its business as a whole, except the Cameron and Cooper-Bessemer trademarks. Other important trademarks used by Cooper Cameron include Ajax, Superior, TurboAir, MSG, Quad 2000, C-B Turbocharger, Enterprise, ENOX, Texcentric, Orbit, W-K-M, McEvoy, Willis, Demco, PPC, Thornhill Craver and Foster. Cooper Cameron has the right to use the trademark Joy on aftermarket parts until November 2027. Cooper Cameron has registered its trademarks in the countries where such registration is deemed material.
Cooper Cameron also relies on trade secret protection for its confidential and proprietary information. Cooper Cameron routinely enters into confidentiality agreements with its employees and suppliers. There can be no assurance, however, that others will not independently obtain similar information or otherwise gain access to Cooper Cameron's trade secrets.
EMPLOYEES
As of December 31, 1999, Cooper Cameron had approximately 7,200 employees, of which approximately 1,314 were represented by labor unions. Cooper Cameron believes its current relations with employees are good. A labor contract expired during December 1999 covering 126 hourly employees at the Cameron division in the United Kingdom. Negotiations have now been completed with respect to a new three-year contract with these employees. The only other significant labor contracts expiring during 2000 cover 582 Cameron and CCV hourly and non-exempt employees at locations in France, Mexico, Singapore, the United Kingdom and Venezuela and 154 hourly employees at the Turbocompressor division plant in Buffalo, New York. The Turbocompressor employees are represented by the Machinists Union (IAM) and are covered by a labor agreement that expires July 30, 2000. Negotiations with the Machinists Union will begin in the second quarter of 2000.
ITEM 2.
ITEM 2. PROPERTIES
The Company operates manufacturing plants ranging in size from approximately 9,500 square feet to approximately 541,000 square feet of manufacturing space. The Company also owns and leases warehouses, distribution centers, aftermarket and storage facilities, and sales offices. The Company leases its corporate headquarters and its Cameron division headquarters office space in Houston, Texas.
The Company manufactures, markets and sells its products and provides services throughout the world, operating facilities in numerous countries. On December 31, 1999, the significant facilities used by Cooper Cameron throughout the world for manufacturing, distribution, aftermarket services, machining, storage and warehousing contained an aggregate of approximately 7,656,736 square feet of space, of which approximately 6,676,962 square feet (87%) was owned and 979,774 (13%) was leased. Of this total, approximately 5,251,698 square feet (69%) are located in the United States and 1,546,021 square feet (20%) are located in Europe. The table below lists the significant manufacturing, warehouse and distribution facilities by industry segment and geographic area. Cameron and Cooper Cameron Valves share space in certain facilities and, thus, are being reported together.
Cooper Cameron believes its facilities are suitable for their present and intended purposes and are adequate for the Company's current and anticipated level of operations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Cooper Cameron is a party to various legal proceedings and administrative actions, including certain environmental matters discussed below, all of which are of an ordinary or routine nature incidental to the operations of the Company. In the opinion of Cooper Cameron's management, such proceedings and actions should not, individually or in the aggregate, have a material adverse effect on the Company's results of operations or financial condition.
Environmental Matters
Cooper Cameron is subject to numerous federal, state, local and foreign laws and regulations relating to the storage, handling and discharge of materials into the environment, including the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"), the Clean Water Act, the Clean Air Act (including the 1990 Amendments) and the Resource Conservation and Recovery Act. Cooper Cameron believes that its existing environmental control procedures are adequate and it has no current plans for substantial capital expenditures in this area. Cooper Cameron has a proactive environmental management program aimed at compliance with existing environmental regulations and elimination or significant reduction in the generation of pollutants in its manufacturing processes. Cooper Cameron management intends to continue these policies and programs.
Cooper Cameron has been identified as a potentially responsible party ("PRP") with respect to five sites designated for cleanup under CERCLA or similar state laws, which impose liability for cleanup of certain waste sites and for related natural resource damages without regard to fault or the legality of waste generation or disposal. Persons liable for such costs and damages generally include the site owner or operator and persons that disposed or arranged for
the disposal of substances found at those sites. Although CERCLA imposes joint and several liability on all PRPs, in application, the PRPs typically allocate the investigation and cleanup costs based upon the volume of waste contributed by each PRP. Settlements often can be achieved through negotiations with the appropriate environmental agency or the other PRPs. PRPs that contributed less than one percent of the waste are often given the opportunity to settle as a "de minimis" party, resolving liability for a particular site.
Cooper Cameron owns only one of the sites on which it has been identified as a PRP. With respect to the remaining four sites, Cooper Cameron's share of the waste volume is estimated and believed to be less than one percent. Cooper Cameron is the major PRP at one site, the Osborne Landfill in Grove City, Pennsylvania, which it owns. Cooper Cameron's facility in Grove City disposed of wastes at the Osborne Landfill from the early 1950s until 1978. A remediation plan was developed and then accepted by the U.S. Environmental Protection Agency as the preferred remedy for the site. The construction phase of the remediation was completed in 1997 and the remaining costs relate to ground water treatment and monitoring.
Cooper Cameron has accruals in its balance sheet to the extent costs are known for the five sites. Although estimates of the cleanup costs have not yet been made for certain of these sites, Cooper Cameron believes, based on its preliminary review and other factors, that the Company's share of the costs relating to these sites will not have a material adverse effect on its results of operations, financial condition or liquidity. However, no assurance can be given that the actual costs will not exceed the estimates of the cleanup costs once determined.
Cooper Cameron does not currently anticipate any material adverse effect on its results of operations, financial condition or competitive position as a result of compliance with Federal, state, local or foreign environmental laws or regulations or cleanup costs of the sites discussed above. However, some risk of environmental liability and other costs is inherent in the nature of Cooper Cameron's business, and there can be no assurance that material environmental costs will not arise. Moreover, it is possible that future developments, such as promulgation of regulations implementing the 1990 amendments to the Clean Air Act and other increasingly strict requirements of environmental laws and enforcement policies thereunder, could lead to material costs of environmental compliance and cleanup by Cooper Cameron.
The cost of environmental remediation and compliance generally has not been an item of material expense for Cooper Cameron during any of the periods presented, other than with respect to the Osborne Landfill described above. Cooper Cameron's balance sheet at December 31, 1999, includes accruals totaling approximately $1.3 million for environmental remediation activities.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of 1999.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The common stock of Cooper Cameron, par value $.01 per share (together with the associated Rights to Purchase Series A Junior Participating Preferred Stock), is traded on The New York Stock Exchange ("NYSE"). No dividends were paid during 1999.
The following table indicates the range of trading prices on the NYSE from January 2, 1998 through December 31, 1998 and January 4, 1999 through December 31, 1999.
Price Range ($) ------------------------------------- High Low Last -------- --------- ---------- First Quarter.............. 35 7/8 22 1/4 33 7/8 Second Quarter............. 41 5/16 27 3/4 37 1/16 Third Quarter.............. 44 7/16 32 9/16 37 3/4 Fourth Quarter............. 50 33 9/16 48 15/16
First Quarter.............. 66 45 60 3/8 Second Quarter............. 71 49 3/4 51 Third Quarter.............. 53 3/4 20 1/8 28 1/2 Fourth Quarter............. 38 1/8 21 15/16 24 1/2
As of March 1, 2000, the approximate number of stockholders of record of Cooper Cameron common stock was 2,666. In addition, there were approximately 25,000 beneficial holders of the common stock, representing persons whose stock is in nominee or "street name" accounts through brokers.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information set forth under the caption "Selected Consolidated Historical Financial Data of Cooper Cameron Corporation" on page 55 in the 1999 Annual Report to Stockholders is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The information set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition of Cooper Cameron Corporation" on pages 25-33 in the 1999 Annual Report to Stockholders is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information for this item is set forth in the section entitled "Market Risk Information" on pages 30-32 in the 1999 Annual Report to Stockholders and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following consolidated financial statements of the Company and the independent auditors' report set forth on pages 34-54 in the 1999 Annual Report to Stockholders are incorporated herein by reference:
Report of Independent Auditors.
Consolidated Results of Operations for each of the three years in the period ended December 31, 1999.
Consolidated Balance Sheets as of December 31, 1999 and 1998.
Consolidated Cash Flows for each of the three years in the period ended December 31, 1999.
Consolidated Changes in Stockholders' Equity for each of the three years in the period ended December 31, 1999.
Notes to Consolidated Financial Statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III --------
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information on Directors of the Company is set forth in the section entitled "The Nominees and Continuing Directors" on pages 11-12 in the Proxy Statement of the Company for the Annual Meeting of Stockholders to be held on May 11, 2000, which section is incorporated herein by reference. Information regarding executive officers of the Company is set forth below.
There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. Officers are appointed
or elected annually by the Board of Directors at its first meeting following the Annual Meeting of Stockholders, each to hold office until the corresponding meeting of the Board in the next year or until a successor shall have been elected, appointed or shall have qualified.
Section 16(a) Beneficial Ownership Reporting Compliance
The information concerning compliance with Section 16(a) is set forth in the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" on page 24 in the Proxy Statement of the Company for the Annual Meeting of Stockholders to be held on May 11, 2000, which section is incorporated herein by reference.
CURRENT EXECUTIVE OFFICERS OF THE REGISTRANT
Present Principal Position and Other Name and Age Material Positions Held During Last Five Years - ------------ ----------------------------------------------
Sheldon R. Erikson (58) President and Chief Executive Officer since January 1995. Chairman of the Board from 1988 to January 1995 and President and Chief Executive Officer from 1987 to January 1995 of The Western Company of North America.
Thomas R. Hix (52) Senior Vice President of Finance and Chief Financial Officer since January 1995. Senior Vice President of Finance, Treasurer and Chief Financial Officer of The Western Company of North America from 1993 to January 1995.
Franklin Myers (47) Senior Vice President since April 1995. General Counsel and Secretary from April 1995 to July 1999. President of the Cooper Energy Services division since August 1998. Senior Vice President and General Counsel from 1994 to April 1995 of Baker Hughes Incorporated.
Joseph D. Chamberlain (53) Vice President and Corporate Controller since April 1995. Controller - Financial Reporting from 1994 to April 1995, of Cooper Industries, Inc.
A. John Chapman (58) Vice President since May 1998. President, Cooper Cameron Valves division since 1995. Managing director of Joy Manufacturing Co. Australia Pty. Ltd., a subsidiary of Joy Technologies Inc. from February 1990 to June 1995.
Jane L. Crowder (49) Vice President, Human Resources since May 1999. Vice President, Compensation and Benefits from 1996 to 1999, and Director, Compensation and Benefits from 1995 to 1996. Vice
President, Human Resources of the CES division from September 1998 to October 1999. Vice President, Human Resources of The Western Company of North America from 1994 to 1995.
William C. Lemmer (55) Vice President, General Counsel and Secretary since July 1999. Vice President, General Counsel and Secretary of Oryx Energy Company from 1994 to 1999.
E. Fred Minter (64) Vice President from November 1996. Chairman from August 1999 and President from 1988 to August 1999 of the Cooper Turbocompressor division.
Dalton L. Thomas (50) Vice President since July 1998. President, Cameron division since July 1998. Vice President, Eastern Hemisphere for Cameron from 1995 until July 1998. Vice President of Manufacturing and Support Services, Western Company of North America from 1989 to 1995.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information for this item is set forth in the section entitled "Executive Compensation Tables" on pages 17-20 in the Proxy Statement of the Company for the Annual Meeting of Stockholders to be held on May 11, 2000, which section is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information concerning security ownership of certain beneficial owners and management is set forth in the sections entitled "Security Ownership of Certain Beneficial Owners" on page 23 and "Security Ownership of Management" on pages 12-13 in the Proxy Statement of the Company for the Annual Meeting of Stockholders to be held on May 11, 2000, which sections are incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
None
PART IV -------
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT:
(1) FINANCIAL STATEMENTS:
All financial statements of the Registrant as set forth under Item 8 of this Annual Report on Form 10-K.
(2) FINANCIAL STATEMENT SCHEDULES:
Financial statement schedules are omitted because of the absence of conditions under which they are required or because all material information required to be reported is included in the consolidated financial statements and notes thereto.
(3) EXHIBITS:
3.1 Amended and Restated Certificate of Incorporation of Cooper Cameron Corporation, dated June 30, 1995, filed as Exhibit 4.2 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 33-94948), and incorporated herein by reference.
3.2 Certificate of Amendment to the Restated Certificate of Incorporation of Cooper Cameron Corporation, filed as Exhibit 4.3 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 333-57995), and incorporated herein by reference.
3.3 First Amended and Restated Bylaws of Cooper Cameron Corporation, as amended December 12, 1996, filed as Exhibit 3.2 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
4.1 Form of Rights Agreement, dated as of May 1, 1995, between Cooper Cameron Corporation and First Chicago Trust Company of New York, as Rights Agent, filed as Exhibit 4.1 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 33-94948), and incorporated herein by reference.
4.2 First Amendment to Rights Agreement between Cooper Cameron Corporation and First Chicago Trust Company of New York, as Rights Agent, dated November 1, 1997, filed as Exhibit 4.2 to the Annual Report on Form 10-K for 1997 of Cooper Cameron Corporation, and incorporated herein by reference.
4.3 Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 4, 1998 (Registration Statement No. 333-51705) incorporated herein by reference.
10.1 Amended and Restated Cooper Cameron Corporation Long-Term Incentive Plan, incorporated by reference to the Cooper Cameron Corporation Proxy Statement for the Annual Meeting of Stockholders held on May 8, 1997.
10.2 First Amendment to the Amended and Restated Cooper Cameron Corporation Long-Term Incentive Plan, effective February 12, 1998.
10.3 Second Amendment to the Amended and Restated Cooper Cameron Corporation Long-Term Incentive Plan, effective May 13, 1999.
10.4 Cooper Cameron Corporation Second Amended and Restated 1995 Stock Option Plan for Non-Employee Directors (Registration Statement on Form S-8 No. 333-79787), incorporated herein by reference.
10.5 Cooper Cameron Corporation Retirement Savings Plan, as Amended and Restated, effective April 1, 1996, filed as Exhibit 10.10 to the Annual Report on Form 10-K for 1997 of Cooper Cameron Corporation, and incorporated herein by reference.
10.6 Cooper Cameron Corporation Employee Stock Purchase Plan (Registration Statement No. 33-94948), incorporated herein by reference.
10.7 Cooper Cameron Corporation Supplemental Excess Defined Benefit Plan, filed as Exhibit 10.4 to the Registration Statement on Form S-4 of Cooper Cameron Corporation (Commission File No. 33-90288), and incorporated herein by reference.
10.8 First Amendment to Cooper Cameron Corporation Supplemental Excess Defined Benefit Plan, effective as of January 1, 1996, filed as Exhibit 10.7 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.9 Cooper Cameron Corporation Supplemental Excess Defined Contribution Plan, filed as Exhibit 10.5 to the Registration Statement on Form S-4 of Cooper Cameron Corporation (Commission File No. 33-90288), and incorporated herein by reference.
10.10 First Amendment to Cooper Cameron Corporation Supplemental Excess Defined Contribution Plan, effective April 1, 1996, filed as Exhibit 10.9 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.11 Cooper Cameron Corporation Compensation Deferral Plan (formerly the Cooper Cameron Corporation Management Incentive Compensation Deferral Plan), effective January 1, 1996, filed as Exhibit 10.10 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.12 First Amendment to the Cooper Cameron Corporation Compensation Deferral Plan, effective July 1, 1998.
10.13 Second Amendment to the Cooper Cameron Corporation Compensation Deferral Plan, effective January 1, 1999.
10.14 Third Amendment to the Cooper Cameron Corporation Compensation Deferral Plan, effective January 1, 2000.
10.15 Cooper Cameron Corporation Directors Deferred Compensation Plan, filed as Exhibit 10.7 to the Registration Statement on Form S-4 of Cooper Cameron Corporation (Commission File No. 33-90288), and incorporated herein by reference.
10.16 Employment Agreement by and between Sheldon R. Erikson and Cooper Cameron Corporation, effective as of August 13, 1999.
10.17 Employment Agreement by and between Thomas R. Hix and Cooper Cameron Corporation, effective as of September 1, 1999.
10.18 Employment Agreement by and between Franklin Myers and Cooper Cameron Corporation, effective as of September 1, 1999.
10.19 Form of Change in Control Agreement, effective November 11, 1999, by and between Scott Amann, Joe Chamberlain, John Chapman, Jane Crowder, William Givens, Daniel Keenan, William Lemmer, Robert Rajeski, and Dalton Thomas.
10.20 1995 Management Incentive Compensation Plan of Cooper Cameron Corporation, dated as of November 14, 1995, as amended, filed as Exhibit 10.15 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.21 1996 Management Incentive Compensation Plan of Cooper Cameron Corporation, dated as of February 19, 1996, filed as Exhibit 10.16 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.22 1997 Management Incentive Compensation Plan of Cooper Cameron Corporation, dated as of December 9, 1996, filed as Exhibit 10.17 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.23 Cooper Cameron Corporation Management Incentive Compensation Plan, as amended, incorporated herein by reference to the Cooper Cameron
Corporation Proxy Statement for the Annual Meeting of Stockholders held on May 8, 1997.
10.24 1998 Management Incentive Compensation Plan for Cooper Cameron Corporation, dated as of January 1, 1998, filed as Exhibit 10.25 to the Annual Report on Form 10-K for 1997 of Cooper Cameron Corporation, and incorporated herein by reference.
10.25 1999 Management Incentive Compensation Plan for Cooper Cameron Corporation, dated as of January 1, 1999, filed as Exhibit 10.27 to the Annual Report on Form 10-K for 1998 of Cooper Cameron Corporation, and incorporated herein by reference.
10.26 Change in Control Policy of Cooper Cameron Corporation, approved February 19, 1996, filed as Exhibit 10.18 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.27 Executive Severance Program of Cooper Cameron Corporation, approved February 19, 1996, filed as Exhibit 10.19 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.28 Credit Agreement, dated as of June 30, 1995, among Cooper Cameron Corporation and certain of its subsidiaries and the banks named therein and First National Bank of Chicago, as agent, filed as Exhibit 4.5 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 33-94948), and incorporated herein by reference.
10.29 Amended and Restated Credit Agreement dated as of March 20, 1997, among Cooper Cameron Corporation and certain of its subsidiaries and the banks named therein and First National Bank of Chicago, as agent, filed as Exhibit 10.21 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.30 Amendment No. 2 to the Amended and Restated Credit Agreement, among Cooper Cameron Corporation and certain of its subsidiaries and the banks named therein and First National Bank of Chicago, as agent, dated as of July 21, 1999.
10.31 Individual Account Retirement Plan for Hourly-Paid Employees at the Cooper Cameron Corporation Mount Vernon Plant, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-58005), incorporated herein by reference.
10.32 Individual Account Retirement Plan for Bargaining Unit Employees at the Cooper Cameron Corporation Missouri City, Texas Facility, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-57995), incorporated herein by reference.
10.33 Individual Account Retirement Plan for Bargaining Unit Employees at the Cooper Cameron Corporation Buffalo, New York Plant, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-57991), incorporated herein by reference.
10.34 Individual Account Retirement Plan for Cooper Cameron Corporation Hourly Employees, UAW, at the Superior Plant, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-57997), incorporated herein by reference.
10.35 Individual Account Retirement Plan for Bargaining Unit Employees at the Cooper Cameron Corporation Grove City Facility, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-58003), incorporated herein by reference.
10.36 Cooper Cameron Corporation Savings-Investment Plan for Hourly Employees, filed as Exhibit 4.7 to the Registration Statement on Form S-8 (Registration No. 333-77641), incorporated herein by reference.
13.1 Portions of the 1999 Annual Report to Stockholders are included as an exhibit to this report and have been specifically incorporated by reference elsewhere herein.
21.1 Subsidiaries of registrant.
23.1 Consent of Independent Auditors.
27.1 Financial Data Schedule.
(b) REPORTS ON FORM 8-K
The Company filed a Form 8-K, dated October 1, 1999, including, as an exhibit, a press release dated October 1, 1999 issued by Rolls-Royce plc announcing that Rolls-Royce has completed the purchase of the rotating products interests of Cooper Energy Services, a part of Cooper Cameron Corporation.
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, ON THIS 24TH DAY OF MARCH, 2000.
COOPER CAMERON CORPORATION REGISTRANT
BY: /s/ JOSEPH D. CHAMBERLAIN --------------------------------------- (JOSEPH D. CHAMBERLAIN) Vice President and Corporate Controller (Principal Accounting Officer)
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED ON THIS 24TH DAY OF MARCH, 2000, BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES INDICATED.
SIGNATURE TITLE --------- -----
/s/ Nathan M. Avery Director - -------------------------------- (Nathan M. Avery)
/s/ C. Baker Cunningham Director - -------------------------------- (C. Baker Cunningham)
/s/ Grant A. Dove Director - -------------------------------- (Grant A. Dove)
/s/ Sheldon R. Erikson Chairman, President and Chief Executive - -------------------------------- Officer (principal executive officer) (Sheldon R. Erikson
/s/ Michael E. Patrick Director - -------------------------------- (Michael E. Patrick)
/s/ David Ross III Director - -------------------------------- (David Ross III)
/s/ Michael J. Sebastian Director - -------------------------------- (Michael J. Sebastian)
/s/ Thomas R. Hix Senior Vice President of Finance and - -------------------------------- Chief Financial Officer (Thomas R. Hix) (principal financial officer)
EXHIBIT INDEX
EXHIBIT SEQUENTIAL NUMBER DESCRIPTION PAGE NO. - ------ ------------------------------------------------------- ----------
3.1 Amended and Restated Certificate of Incorporation of Cooper Cameron Corporation, dated June 30, 1995, filed as Exhibit 4.2 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 33-94948), and incorporated herein by reference.
3.2 Certificate of Amendment to the Restated Certificate of Incorporation of Cooper Cameron Corporation, filed as Exhibit 4.3 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 333-57995), and incorporated herein by reference.
3.3 First Amended and Restated Bylaws of Cooper Cameron Corporation, as amended December 12, 1996, filed as Exhibit 3.2 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
4.1 Form of Rights Agreement, dated as of May 1, 1995, between Cooper Cameron Corporation and First Chicago Trust Company of New York, as Rights Agent, filed as Exhibit 4.1 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 33-94948), and incorporated herein by reference.
4.2 First Amendment to Rights Agreement between Cooper Cameron Corporation and First Chicago Trust Company of New York, as Rights Agent, dated November 1, 1997, filed as Exhibit 4.2 to the Annual Report on Form 10-K for 1997 of Cooper Cameron Corporation, and incorporated herein by reference.
4.3 Registration Statement on Form S-3 filed with the Securities and Exchange Commission on May 4, 1998 (Registration Statement No. 333-51705) incorporated herein by reference.
10.1 Amended and Restated Cooper Cameron Corporation Long- Term Incentive Plan, incorporated by reference to the Cooper Cameron Corporation Proxy Statement for the Annual Meeting of Stockholders held on May 8, 1997.
10.2 First Amendment to the Amended and Restated Cooper Cameron Corporation Long-Term Incentive Plan, effective February 12, 1998.
10.3 Second Amendment to the Amended and Restated Cooper Cameron Corporation Long-Term Incentive Plan, effective May 13, 1999.
10.4 Cooper Cameron Corporation Second Amended and Restated 1995 Stock Option Plan for Non-Employee Directors (Registration Statement on Form S-8 No. 333-79787), incorporated herein by reference.
10.5 Cooper Cameron Corporation Retirement Savings Plan, as Amended and Restated, effective April 1, 1996, filed as Exhibit 10.10 to the Annual Report on Form 10-K for 1997 of Cooper Cameron Corporation, and incorporated herein by reference.
10.6 Cooper Cameron Corporation Employee Stock Purchase Plan (Registration Statement No. 33-94948), incorporated herein by reference.
10.7 Cooper Cameron Corporation Supplemental Excess Defined Benefit Plan, filed as Exhibit 10.4 to the Registration Statement on Form S-4 of Cooper Cameron Corporation (Commission File No. 33-90288), and incorporated herein by reference.
10.8 First Amendment to Cooper Cameron Corporation Supplemental Excess Defined Benefit Plan, effective as of January 1, 1996, filed as Exhibit 10.7 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.9 Cooper Cameron Corporation Supplemental Excess Defined Contribution Plan, filed as Exhibit 10.5 to the Registration Statement on Form S-4 of Cooper Cameron Corporation (Commission File No. 33-90288), and incorporated herein by reference.
10.10 First Amendment to Cooper Cameron Corporation Supplemental Excess Defined Contribution Plan, effective April 1, 1996, filed as Exhibit 10.9 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.11 Cooper Cameron Corporation Compensation Deferral Plan (formerly the Cooper Cameron Corporation Management Incentive Compensation Deferral Plan), effective January 1, 1996, filed as Exhibit 10.10 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.12 First Amendment to the Cooper Cameron Corporation Compensation Deferral Plan, effective July 1, 1998.
10.13 Second Amendment to the Cooper Cameron Corporation Compensation Deferral Plan, effective January 1, 1999.
10.14 Third Amendment to the Cooper Cameron Corporation Compensation Deferral Plan, effective January 1, 2000.
10.15 Cooper Cameron Corporation Directors Deferred Compensation Plan, filed as Exhibit 10.7 to the Registration Statement on Form S-4 of Cooper Cameron Corporation (Commission File No. 33-90288), and incorporated herein by reference.
10.16 Employment Agreement by and between Sheldon R. Erikson and Cooper Cameron Corporation, effective as of August 13, 1999.
10.17 Employment Agreement by and between Thomas R. Hix and Cooper Cameron Corporation, effective as of September 1, 1999.
10.18 Employment Agreement by and between Franklin Myers and Cooper Cameron Corporation, effective as of September 1, 1999.
10.19 Form of Change in Control Agreement, effective November 11, 1999, by and between Scott Amann, Joe Chamberlain, John Chapman, Jane Crowder, William Givens, Daniel Keenan, William Lemmer, Robert Rajeski, and Dalton Thomas.
10.20 1995 Management Incentive Compensation Plan of Cooper Cameron Corporation, dated as of November 14, 1995, as amended, filed as Exhibit 10.15 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.21 1996 Management Incentive Compensation Plan of Cooper Cameron Corporation, dated as of February 19, 1996, filed as Exhibit 10.16 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.22 1997 Management Incentive Compensation Plan of Cooper Cameron Corporation, dated as of December 9, 1996, filed as Exhibit 10.17 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.23 Cooper Cameron Corporation Management Incentive Compensation Plan, as amended, incorporated herein by reference to the Cooper Cameron Corporation Proxy Statement for the Annual Meeting of Stockholders held on May 8, 1997.
10.24 1998 Management Incentive Compensation Plan for Cooper Cameron Corporation, dated as of January 1, 1998, filed as Exhibit 10.25 to the Annual Report on Form 10-K for 1997 of Cooper Cameron Corporation, and incorporated herein by reference.
10.25 1999 Management Incentive Compensation Plan for Cooper Cameron Corporation, dated as of January 1, 1999, filed as Exhibit 10.27 to the Annual Report on Form 10-K for 1998 of Cooper Cameron Corporation, and incorporated herein by reference.
10.26 Change in Control Policy of Cooper Cameron Corporation, approved February 19, 1996, filed as Exhibit 10.18 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.27 Executive Severance Program of Cooper Cameron Corporation, approved February 19, 1996, filed as Exhibit 10.19 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.28 Credit Agreement, dated as of June 30, 1995, among Cooper Cameron Corporation and certain of its subsidiaries and the banks named therein and First National Bank of Chicago, as agent, filed as Exhibit 4.5 to the Registration Statement on Form S-8 of Cooper Cameron Corporation (Commission File No. 33-94948), and incorporated herein by reference.
10.29 Amended and Restated Credit Agreement dated as of March 20, 1997, among Cooper Cameron Corporation and certain of its subsidiaries and the banks named therein and First National Bank of Chicago, as agent, filed as Exhibit 10.21 to the Annual Report on Form 10-K for 1996 of Cooper Cameron Corporation, and incorporated herein by reference.
10.30 Amendment No. 2 to the Amended and Restated Credit Agreement, among Cooper Cameron Corporation and certain of its subsidiaries and the banks named therein and First National Bank of Chicago, as agent, dated as of July 21, 1999.
10.31 Individual Account Retirement Plan for Hourly-Paid Employees at the Cooper Cameron Corporation Mount Vernon Plant, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-58005), incorporated herein by reference.
10.32 Individual Account Retirement Plan for Bargaining Unit Employees at the Cooper Cameron Corporation Missouri City, Texas Facility, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-57995), incorporated herein by reference.
10.33 Individual Account Retirement Plan for Bargaining Unit Employees at the Cooper Cameron Corporation Buffalo, New York Plant, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-57991), incorporated herein by reference.
10.34 Individual Account Retirement Plan for Cooper Cameron Corporation Hourly Employees, UAW, at the Superior Plant, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-57997), incorporated herein by reference.
10.35 Individual Account Retirement Plan for Bargaining Unit Employees at the Cooper Cameron Corporation Grove City Facility, filed as Exhibit 4.6 to the Registration Statement on Form S-8 (Registration No. 333-58003), incorporated herein by reference.
10.36 Cooper Cameron Corporation Savings-Investment Plan for Hourly Employees, filed as Exhibit 4.7 to the Registration Statement on Form S-8 (Registration No. 333-77641), incorporated herein by reference.
13.1 Portions of the 1999 Annual Report to Stockholders are included as an exhibit to this report and have been specifically incorporated by reference elsewhere herein.
21.1 Subsidiaries of registrant.
23.1 Consent of Independent Auditors.
27.1 Financial Data Schedule. | 10,102 | 69,211 |
71180_1999.txt | 71180_1999 | 1999 | 71180 | ITEM 1. BUSINESS
The information in this Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements relate to anticipated financial performance, management's plans and objectives for future operations, business prospects, outcome of regulatory proceedings, market conditions and other matters. Words such as "anticipate," "believe," "estimate," "expect," "intend," "plan" and "objective" and other similar expressions identify those statements that are forward-looking. These statements are based on management's beliefs and assumptions and on information currently available to management. Actual results could differ materially from those contemplated by the forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with such statements, factors that could cause Sierra Pacific Power Company's (SPPC's) actual results to differ materially from those contemplated in any forward-looking statement include, among others, the following: (1) the pace and extent of the ongoing restructuring of the electric and gas industries in Nevada and California; (2) the outcome of regulatory and legislative proceedings and operational changes related to industry restructuring; (3) the amount SPPC is allowed to recover from customers for certain costs that prove to be uneconomic in the new competitive market; (4) the outcome of ongoing and future regulatory proceedings; (5) management's ability to integrate the operations of Nevada Power Company (NVP) and SPPC, and to implement and realize anticipated cost savings from the merger of SPR and NVP; (6) industrial, commercial and residential growth in the service territory of SPPC; (7) fluctuations in electric, gas and other commodity prices and the ability to manage such fluctuations successfully; (8) changes in the capital markets and interest rates affecting the ability to finance capital requirements; (9) the loss of any significant customers; (10) the weather and other natural phenomena; and (11) changes in the business of major customers that may result in changes in the demand for services of SPPC. Other factors and assumptions not identified above may also have been involved in deriving these forward-looking statements, and the failure of those other assumptions to be realized, as well as other factors, may also cause actual results to differ materially from those projected. SPPC assumes no obligation to update forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.
SIERRA PACIFIC POWER COMPANY
Sierra Pacific Power Company, hereinafter known as the Company or SPPC, is a Nevada corporation organized in 1965 as a successor to a Maine corporation organized in 1912. The Company became a wholly owned subsidiary of Sierra Pacific Resources (SPR) on May 31, 1984. Its mailing address is Post Office Box 10100 (6100 Neil Road), Reno, Nevada 89520-0400.
The Company has four primary, wholly owned subsidiaries: Pinon Pine Corp. (PPC), Pinon Pine Investment Co. (PPIC), GPSF-B, and Sierra Pacific Power Capital I (the Trust). PPC and PPIC own 25% and 75% of a 38% interest in Pinon Pine Company, L.L.C. GPSF-B, a Delaware corporation formerly owned by General Electric Capital Corporation and now owned by the Company, owns the remaining 62%. The LLC was formed to take advantage of federal income tax credits associated with the alternative fuel (syngas) produced by the coal gasifier available under (S) 29 of the Internal Revenue Code. The Trust was created to issue trust securities in order to purchase the Company's junior subordinated debentures .
The Company is a public utility primarily engaged in the distribution, transmission, generation, purchase and sale of electric energy. It provides electricity to approximately 302,000 customers in a 50,000 square mile service area including western, central and northeastern Nevada, including the cities of Reno, Sparks, Carson City, Elko, and a portion of eastern California, including the Lake Tahoe area. In 1999, electric revenue was 79.8% of total revenue.
The Company also provides natural gas service in Nevada to approximately 110,000 customers in an area of about 600 square miles in Reno/Sparks and environs. It supplies water service in Nevada to about 70,600 customers in the Reno/Sparks metropolitan area. In 1999, natural gas revenues were 13.1% and water revenues were 7.1% of total revenues.
The Company used diverse resources to meet its 1999 electric energy requirements, including gas and oil generation (28.4%), coal generation (17.4%), and purchased power (53.8%). The Company has no ownership interest in, nor does it operate, any nuclear generating units.
In 1999, the Company's average electric customer count grew by 2.8%; its average natural gas customer count increased by 4.3%; and its average water customer count increased by 4.8%. Many factors account for this growth including population growth in the Company's service areas.
The Company had 1,430 regular employees as of December 31, 1999; this is a 1.1% decrease from 1998. The Company's current contract with the International Brotherhood of Electrical Workers, which represents 58.0% of the workforce, was renegotiated in 1997 and is in effect until December 31, 2000. The three-year contract provides for a 2.75% general wage increase for most bargaining unit employees beginning January 1, 1998, with 2.75% increases in both 1999 and 2000. In addition, the contract provides for bargaining unit employees to participate in the incentive compensation program. Nevada is a "right-to-work" state.
For a discussion of results of operations refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
Business Outlook And Overview
ELECTRIC INDUSTRY TRENDS - ------------------------
On July 28, 1999, SPR completed its merger with NVP. More than 30 other mergers of electric and/or gas companies were pending, announced, or completed in 1999. Merger and acquisition activity is expected to continue into the next decade, as companies position themselves for continued electric restructuring throughout the United States.
The Company announced its plan to divest its generation assets in June 1998. A stipulation on the Divestiture Plan was approved by the PUCN in February 2000. This stipulation will clear the way for the Divestiture process to begin. See Generation Divestiture for further information.
Federal and state legislation is moving the electric utility industry toward competition. Federal and state regulators play critical roles in establishing a competitive marketplace. Currently, 21 states have passed restructuring bills, and 19 more states are considering legislation to restructure their electric markets. In addition, the U.S. Congress is considering national legislation that would implement electric restructuring across the nation. Passage of a comprehensive federal bill is expected within the next several years. Regulatory changes generally focus on the unbundling of utility functions into separate products and services. The major product being opened to competition is energy (e.g., kilowatt hours). Other services such as meter reading and billing are also being opened to competition in some states, including California and Nevada.. The delivery of energy (e.g., transmission and distribution) to businesses and homes remains a utility product regulated by the Federal Energy Regulatory Commission and state regulators.
On December 15, the FERC issued Order No. 2000, a long awaited rule on Regional Transmission Organizations (RTO's). The implementation of Order No. 2000 is expected to have major long-term effects on the electric power markets by promoting regionalization of the transmission grid.
The Company is subject to California, Nevada and the FERC regulatory jurisdiction. Federal and state regulation will continue to play an active role in the Company's utility business. The Company's electric system demand exceeds the import capabilities of its transmission system. Accordingly, some of the Company's generation capacity has been identified as "must run" in order to meet load. Tariffs governing the availability and pricing of "must run" facilities after the divestiture of generation have been filed with the FERC. See Generation Divestiture. The FERC will also regulate the Company's electric transmission system. The states will continue to regulate those retail distribution services determined to be non-competitive.
Approximately 67% of SPPC's operating revenues is related to electric sales in Nevada. Nevada passed Assembly Bill 366 (AB366) in July 1997, as enabling legislation to implement electric industry restructuring in Nevada. This legislation was modified in June 1999 by Senate Bill 438 (SB438). SB438 provides for competition to be implemented in the Nevada electric utility industry. See Electric Restructuring Activities. On February 28, 2000, the governor of Nevada postponed the expected March 1, 2000 opening date. No new date has been set, but competition could begin later in 2000 or possibly in 2001. SB438 allows the PUCN to authorize full recovery of costs that it determines to be stranded as a result of restructuring, and provides criteria for recovery of costs associated with purchase power obligations. In addition SB438 provides the electric distribution utility will be the provider of last resort (PLR) until alternate methods go into effect, no sooner than July 1, 2001; under rates which will be capped until March 1, 2003.
In August 1997, the PUCN opened an investigatory docket of the issues to be considered as a result of restructuring the electric industry under AB366 and SB438. The Company is a participant in this docket in which new regulations for the restructured marketplace have been developed. These regulations include standards of conduct, consumer protection, stranded costs and licensing provisions for alternative sellers. Implementation of some of the regulations, including unbundling of services, stranded costs and provider of last resort, has already posed or is expected to pose financial risks to the Company. The Company is working to mitigate these risks by changing its business strategies, actively pursuing regulatory remedies and, if necessary, pursuing legal remedies. See further discussion regarding restructuring activities and potential risks in Item 7, Nevada Matters.
California accounts for approximately 6% of the Company's electric revenue. California opened retail access in 1998. California customers may choose to continue to take service from their incumbent utility at tariff rates, purchase energy from marketers or contract directly with a generator. Any customers choosing to purchase energy from marketers or generators will pay a distribution fee for their use of the Company's transmission and distribution systems. To date no California customers have opted for retail open access. Operating results should not be materially impacted by these regulatory changes because of the continued use of the Company's transmission /distribution facilities and the Company's limited exposure in California.
For more information regarding regulatory changes affecting SPPC, see Item 7, Nevada Matters, California Matters, FERC Matters and Note 2 of the Company's consolidated financial statements.
SIERRA PACIFIC RESOURCES AND NEVADA POWER COMPANY MERGER - --------------------------------------------------------
As previously mentioned, the merger between SPR and NVP was finalized on July 28, 1999 following receipt of all regulatory approvals. The PUCN gave unanimous approval of a stipulation among the merging companies, the PUCN staff and the Utility Consumer Advocate, regarding the merger.
As part of the stipulation approved by the PUCN, the companies were required to re-file the plan to divest their generating assets, and file a final Independent System Administrator (ISA) proposal with the PUCN and the FERC. In January 2000, the FERC approved the ISA proposal; the PUCN's decision is still pending. See Generation Divestiture and Item 7, Nevada Matters for more information.
As part of the conditions for the merger SPPC was required to file a general rate case and unbundle costs. In April 1999, Phase I of the revenue requirement and unbundling study was filed with the PUCN. In September 1999, the PUCN issued an interim order on revenue requirements. In October 1999,
Phase II regarding rate design was filed. Hearings were conducted in November 1999. Phase III will be filed 15 days following the PUCN decision on Phases I and II and will include full proposed tariffs for distribution service and all other noncompetitive services. SPPC is also required to file a general rate case three years after the start of retail competition in the state of Nevada. The filing would give the Company the opportunity to recover certain costs of the merger, provided it can be demonstrated that merger savings exceed certain merger costs. Merger costs are to be split among non-competitive and potentially competitive services or businesses. An opportunity to recover the non-competitive portion of the merger costs will be addressed in the rate case that follows the start of competition in Nevada. The burden is to prove that merger savings exceed merger costs.
GENERATION DIVESTITURE - ----------------------
In June 1998, SPR announced a plan to divest the generation assets of its NVP and SPPC subsidiaries. This business strategy was described in the SPR/NVP merger applications filed with the PUCN and the FERC in July 1998.
The FERC, Department of Justice, and SEC approved the merger. The PUCN conditionally approved the merger in December 1998, and one of the conditions was the filing of the divestiture plan with the PUCN. The plan was filed in April 1999, and included details about the auction process, market power mitigation, sale of the assets in described bundles, description of the proposed generation tariffs, description of the proposed independent system administrator, and the description of the proposed power purchase contracts.
In June 1999, the PUCN approved a stipulation in the Merger docket with several conditions. Some of those conditions were: re-file the divestiture plan with the PUCN; file the generation aggregation tariffs (GAT) at the FERC; file the proposal for the ISA at the FERC; file proposals for the buyback or purchase power contracts; and file proposals for mitigation of the qualifying facilities and purchase power contracts.
A revised Divestiture Plan was filed with the PUCN in October 1999. The PUCN held a hearing on December 28, 1999 and a stipulation was offered to the Commission for approval. Approval of the stipulation was received in February 2000.
In accordance with the approved stipulation, SPR will be offering for sale generation assets with peak capacity of approximately 2,985 megawatts (MW) with approximately 1,045 MW owned by SPPC and approximately 1,940 MW owned by NVP. Potential buyers will be allowed to offer bids for different combinations of assets or for a consolidated asset. The plants utilize either coal, natural gas, or oil as fuel and are a mix of base load or peaking units consisting of conventional steam turbines, combined-cycle, or combustion turbines. SPR anticipates closing the sales of the generation assets during a period beginning in the fourth quarter 2000 and ending in 2003.
ELECTRIC BUSINESS - -----------------
Business and Competitive Environment - ------------------------------------
Transmission
The FERC issued Order 2000 in December 1999. The order requires all investor-owned utilities in the United States who own interstate transmission to file their plans regarding Regional Transmission Organizations (RTOs) by October 15, 2000. Utilities must file by that date, either by joining an RTO or stating why they are not joining one. The RTOs must be operational by December 15, 2001 with congestion management in place one year later.
The FERC has required that RTOs be operated by independent entities that are not participants in the energy market. The RTO must accommodate broad participation by both private and public utilities, provide customer efficient price signals and be independent of market participants (i.e., sellers of energy to end use customers). In addition, RTO rates must eliminate pancaking (multiple rates on a transmission path), manage congestion and internal parallel flows, deal effectively with non-RTO transmission owning entities (not under the FERC jurisdiction) and provide correct investment incentives. The FERC has offered the possibility of incentive ratemaking to RTOs that meet all the criteria for a large-scale regional entity.
The Company will explore strategic transmission options, using the guidelines included in Order 2000. The Company's response will be filed before the October 15, 2000 deadline. The FERC filings for the start of Nevada restructuring and the PGE acquisition will anticipate this October 2000 RTO filing.
Distribution
The Company's electric business contributed $609 million (78.8%) of 1999 operating revenues. Electric system peaks typically occur in the summer, while winter peaks run nearly as high. The system has an annual load factor of approximately 70.9%, which is higher than the industry norm of 50-55%.
Winter peak loads are due to shorter daylight hours, colder temperatures (which affect space heating requirements) and ski resort demands (snowmaking, hotels, lifts, etc.). Summer peak loads result from air-conditioning, cooling equipment and irrigation pumping. The Company's peak load increased an average of 5% annually over the past five years, reaching 1,470 MW on July 12, 1999. The Company's total electric megawatt-hour (MWh) sales have increased an average of 7.65% annually over the past five years.
A significant part of the growth in the Company's electric sales has resulted from growth in the residential area, mining and manufacturing industry in northern Nevada.
SPPC's electric customers by class contributed the following toward 1999 and 1998 megawatt-hour sales:
According to the Nevada Mining Association statistics, Nevada leads the nation in gold production, accounting for approximately 74% of all U.S. production and 10% of world production, ranking it the third largest gold producer in the world behind South Africa and Australia. It is estimated that Nevada gold production for 1999 was approximately 8.2 million ounces. A majority of Nevada's gold mines are customers of the Company. Currently, known gold reserves at existing mines in Nevada total approximately 87 million ounces, the majority of the nation's known gold reserves. These reserves are sufficient to continue production at current rates for the next decade.
During 1999, world gold prices ranged from about $253 per ounce to $326 per ounce. Production costs continue to vary greatly at Nevada mines, along with profitability. Industry reports indicate many Nevada gold mines have a production cost of less than $300 per ounce, with some of the larger mines producing within the $192 to $240 per ounce range. When compared to world production costs, Nevada remains below the worldwide average. While Nevada's gold mines have the lowest costs in the world, investments in exploration and development have fallen, and may continue to fall. In addition, low gold prices may shorten the expected mine lives of certain Nevada properties as lower grade ore becomes uneconomic to mine.
The Company's territory also has a variety of other mineral producing mines. Approximately 19.5 million ounces of silver were produced in 1999, worth approximately $102 million, with over 123 million ounces of silver resources identified in the State. Silver demand has been exceeding new supply for most of the decade, drawing down inventories built up in the 1980's. As this situation continues, we will see continued upward pressure on silver prices. Other minerals produced in Nevada include copper, lithium, mercury, barite, diatomite, gypsum, and lime, valued at over $108 million.
The Company has seven long-term power sales agreements with major mining customers with terms of at least five years. The final contract expires in 2005. One of these customers has provided SPPC with two years' notice of termination. Five of these agreements have been reviewed and approved by the PUCN as part of the Company's new tariff structure designed for major customers. These mining agreements secure over 223 megawatts of present and future mining load, or approximately $74 million in annual revenues, which is 12.2% of the 1999 electric operating revenues. The agreements require that customers maintain minimum demand and load factor levels, and include termination charge provisions to recover all of the Company's customer-specific facilities investment. Sales to the mining sector grew at approximately the same percentage as overall system sales (3.8%).
The resorts and recreation group is comprised of hotels, casinos, and ski resorts. This major customer segment comprises 7.5% of the total electric system retail MWh sales. Tourism and gaming continue to be key contributors to the local economy. Several of the largest gaming customers are expanding their properties to differentiate the Reno/Tahoe market by creating a more desirable resort location. These same large gaming customers increased their 1999 electric load by 7,902 MWh (1.0%) over 1998.
Gaming has substantial potential for growth with the recent purchases and reopening of several smaller casinos. In addition, several closed properties have been razed and have plans for new properties to be built in their place.
The advent of increased competition in 1999, particularly "Indian gaming" in key feeder markets and the continuing expansion in Las Vegas, has not had a negative impact on the Northern Nevada market share and ultimately energy sales. The passing of Proposition 5 in California, which liberalizes Indian reservation gaming operations, had been predicted to cause a decline in Reno's gaming revenues once implemented. Northern Nevada casinos are evaluating and implementing competitive strategies to expand their entertainment portfolio. The key to this strategy is packaging entertainment value, customer comfort, and reasonable pricing, with the natural attraction of the Sierra Nevada geographic location.
The Company's industrial and large commercial customers continue their interest in the electric supply source options potentially available to them under regulatory reforms currently being considered in Nevada and in place in California. The Company continues to prepare for a more competitive environment and has actively participated in regulatory reform deliberations in Nevada. Upon opening the market to retail access, one of the most significant regulations that will impact the distribution business is the requirement to be the provider of last resort for customers who do not choose a competitive supplier or who are unable to secure a new supplier. Due to the SB438 requirement that the provider of last resort be placed into a separate affiliate, recent PUCN decisions regarding recovery of fuel expenses, and the stringent proposed regulations, significant detrimental financial impacts are expected to occur. As a result, the Company is determined to exit the provider of last resort requirement as quickly as possible. First the Company would seek to exit the energy supply portion of the provider of last resort. Then, if current legislation and regulation do not change, the Company would plan to exit other services, including metering, billing and customer service functions. See Item 7, Nevada Matters, California Matters, and FERC Matters for further discussion.
Over the past five years, MWh sales to wholesale customers have increased at a rate of 39.4%. During 1999, firm and non-firm sales to wholesale customers comprised about 14.8% of total energy sales. The wholesale market is very competitive and sales into this market are typically made at very low margins. This market is maturing and will become even more competitive in the future. The Company utilizes wholesale sales to better manage fuel and purchase power costs.
While the wholesale sales in 1999 represented 14.8% of sales they represent only 8.6% of electric revenues.
MAJOR PROJECTS - ---------------
The following major projects have been approved in previous resource plans and may have been financed utilizing internally generated cash and/or the proceeds from various forms of debt and preferred securities:
Pinon Pine Project
The Pinon Pine Project is a cooperative agreement with the U.S. Department of Energy (DOE) for the construction of a coal-gasification power plant. Total project costs incurred by the Company through December 31, 1999, were $170.0 million. Actual costs incurred by the Company in 1999 were $.4 million.
Alturas Intertie Project
The Alturas Intertie Project, which went into service in December 1998, is a 345 kilovolt (kV) transmission line from Northern California to Reno. Total project costs incurred through December 31, 1999 were $153.2 million. Actual costs incurred in 1999 were $9.1 million. Estimated costs for 2000 are $1.0 million.
Falcon Transmission Project
The Falcon Transmission Project is a 345kV transmission line within Northern Nevada. Total project costs incurred through December 31, 1999 were $2.4 million. Actual costs incurred in 1999 were $2.1 million. Estimated costs for 2000 are $4.0 million.
The Company's construction program and estimated expenditures are subject to continuing review, and are revised from time to time due to various factors, including the rate of load growth, escalation of construction costs, availability of fuel types, changes in environmental regulations, adequacy of rate relief, and the Company's ability to raise necessary capital.
FINANCING PROGRAMS - ------------------
Current estimated cash construction expenditures for 2000 are $137.7 million. The Company may utilize internally generated cash and the proceeds from the issuance of securities to meet capital expenditure requirements through 2000. Internally generated funds provided 35% of all construction expenditures in 1999.
On July 28, 1999, the Company put into place a $150 million 364-day unsecured revolving credit facility that is convertible at the Company's election into a one-year term loan. This facility replaced the Company's previous credit facility and may be used for working capital and general corporate purposes, including commercial paper backup.
On April 9, 1999, The Company sold the Transition Property (See California Matters in Rate Proceedings, later) to SPPC Funding LLC, a Delaware special purpose limited liability company whose sole member is the Company, in exchange for the proceeds of the SPPC Funding LLC Notes, Series 1999-1 (the "Underlying Notes"). SPPC Funding LLC then issued and sold the Underlying Notes to the California Infrastructure and Economic Development Bank Special Purpose Trust SPPC-1 (the "Trust") in exchange for the proceeds of the sale of the Trust's $24.0 million 6.4% Rate Reduction Certificates, Series 1999-1 (the "Certificates"). The Trust, which had been established by the California Infrastructure and Economic Development Bank, issued and sold the Certificates in a private placement pursuant to Rule 144A under the Securities Act of 1933, as amended. The Certificates are one of a series of rate reduction certificates that may be issued from time to time by the Trust and sold to investors upon terms determined at the time of sale.
On July 12, 1999, $10 million of the Company's 6.86% medium-term notes matured. On July 6, 1999, $20 million of the Company's 6.83% medium-term notes matured.
On September 17, 1999, the Company issued $100 million of floating rate notes ("Notes") due October 13, 2000. Interest on the Notes, payable quarterly, commenced on December 15, 1999. The interest rate on the Notes for each interest period to maturity is a floating rate, subject to adjustment every three months. The quarterly rate is equal to the London Interbank Offered Rate (LIBOR) for three-month U.S. dollar deposits plus a spread of 0.75%. The Notes will not be entitled to any sinking fund and will be redeemable, in whole, at the option of the Company beginning on March 15, 2000 and on the 15th day of each month thereafter.
On November 1, 1999 the Company redeemed Preferred Stock, Series A, $2.44 Dividend (4.88%), Series B, $2.36 Dividend (4.72%) and Series C, $3.90 Dividend (7.80%).
FACILITIES AND OPERATIONS - -------------------------
Total System
As of December 31, 1999, the Company's electric transmission facilities consisted of approximately 4,000 overhead pole line miles and 81 substations. Its distribution facilities consisted of approximately 9,000 overhead pole line miles, 4,500 underground cable miles and 178 substations.
The Company continues to maintain a wide variety of resources in its generation system. During 1999, the Company generated 46.2% of its total electric energy requirements in its own plants, purchasing the remaining 53.8% as shown below:
The Company's decision to purchase spot market energy is based on the economics of purchasing "as-available" energy when it is less expensive than the Company's own generation. At the time of the 1999 system peak, the Company had purchased firm capacity under long-term contracts with other utilities and qualifying facilities (QFs) equal to 17% of total peak hour capacity. In 1999, most of the Company's non-utility generation came from QFs, except for 14,951 megawatt hours, which came from two small power producers.
Risk Management
Over the past several years, SPPC recognized that the management of energy commodity (electricity, natural gas, coal, and oil) price risk was an essential component of SPPC's efforts to manage revenues and expenses. In 1998, SPPC's board of Directors approved a Risk Management Policy & Procedure Manual that governed price risk management activities. With the merger of SPR and NVP, the Board of Directors requested that management review and consolidate the Risk Management Programs of the two utilities. SPPC and NVP engaged the services of a leading energy risk management consulting company to review existing policies and procedures, make any recommendations to the existing Program, and implement the revised Program. That project led the companies to adapt revised policies and procedures, implement new IT systems to track any commodity price exposures, as well as focus on potential "Earnings-at-Risk" which measures the amount of exposure that the companies have to energy prices at any point.
Load and Resources Forecast
The electric customer growth rate was 2.8%, 2.8%, and 3.1% in 1999, 1998 and 1997, respectively. Annual electricity retail sales reached 8,412,853 megawatt-hours in 1999. Peak electric demand rose from 1,423 megawatts in 1998 to 1,470 megawatts in 1999.
The Nevada Legislature mandated retail access to alternative electric suppliers. While the opening date of competition is not yet known, once access begins, the Company will continue to be required to supply electricity to customers as the "provider of the last resort". It is expected that some customers will elect to receive their electric supply from other suppliers, however, reasonable estimates of the number and timing of customers switching are not yet available. The proposed "provider of last resort" regulations have highlighted the Company's exposure to fuel price risks. Consequently, if the proposed regulations are adopted, the Company will exit the provider of last resort function as quickly as possible, beginning with energy supply. The projections shown below are forecasts of the load to be provided to all of the Company's current customers, and therefore, include demand that may actually be met by other electric suppliers.
As part of the merger agreement with the PUCN, the Company has committed to divest its generation facilities to enhance competition in a deregulated environment. Current plans call for the divestiture to occur in the year 2000. Until such time, the Company will continue to provide energy through generation and purchase power to meet both summer and winter peak loads. The Company's actual total system capability and peak loads for 1999, and as estimated for summer peak demand through 2001 (assuming no curtailment of supply or load and normal weather conditions), are indicated below:
(1) Assumes divestiture is complete by peak season 2001. (2) Value net of losses. (3) Includes potential short-term firm purchases that are not under contract. Values shown represent purchases within existing transmission system limits.
(4) The system peak shown for 1999 is the actual system peak of 1,470 MW, which occurred on July 12, 1999.
The Company plans its system consistent with the Western System Coordinating Council guidelines, which recommends planning reserves in excess of required operating reserves. The "Additional Required" represents the difference between the planning reserves and the operating reserves needed for the system. These additional reserves will be met, if needed, by short-term purchases through 2001.
Generation
The following is a list of the Company's generation plants including their megawatt (MW) summer peak capacity, the type/fuel that they use to generate, and the year(s) that the unit(s) was (were) installed:
(1) SPPC is the operator and owns an undivided 50 percent interest in the Valmy plant. Idaho Power Company (Idaho Power) owns the remainder. The capacities shown above for the Valmy plant represent the Company's share only. The Company owns 100 percent of all of its remaining electric generation plants.
(2) Includes the generation capacity of the 100% SPPC-owned power island portion of the Pinon Pine Power Project. Pinon's current summer peak capacity is 89 MW when operating on natural gas.
(3) Four of the Company's hydro generation units are located on the Truckee River, which runs approximately 100 miles from Lake Tahoe, through Reno/Sparks, to Pyramid Lake. A 2 MW facility located on the Truckee River at Farad was damaged by the January 1997 flood and was not available for generation during the 1999 summer peak.
Purchased Power
The Company continues to manage a diverse portfolio of contracted and spot market supplies, as well as its own generation, to minimize its net average system operating costs. During 1999, the Company witnessed a leveling of off- system energy prices compared to the previous year, but energy forecasts indicate steadily increasing prices as load appears to outpace additional supply.
The Company is a member of the Northwest Power Pool and Western Systems Power Pool. These pools have provided the Company further access to spot market power in the Pacific Northwest and the Southwest. In turn, the Company's generation facilities provide a backup source for other pool members who rely heavily on hydroelectric systems. The Company has an agreement with PacifiCorp's Utah division and Idaho Power in which a portion of the energy purchased by the Company from PacifiCorp is transmitted through the Idaho Power system. The agreement also provides added access to spot market power.
The Company purchases hydro- and thermally-produced spot market energy, by the hour, based upon economics and system import limits. Also purchased during peak load periods is firm energy as required to supply load and maintain adequate operating reserve margins. As off-system energy costs increase, the Company supplies a higher percentage of its native load utilizing its fossil fuel generation but is still required to buy peaking energy from the market. Also, market conditions throughout the West are in flux with regions approaching deregulation using different methods. Each change results in different market pricing characteristics.
Currently, the Company has contracted for a total of 165 MW of long-term firm purchased power from the utility suppliers listed below. Several of the Company's firm purchase power contracts contain minimum purchase obligations. Meeting these minimums has not been a problem for the Company in the past, and is not expected to be a problem in the future.
(1) The Company has provided notice to terminate the PacifiCorp/Utah contract effective April 30, 2000.
According to the Public Utility Regulatory Policies Act, the Company is obligated, under certain conditions, to purchase the generation produced by small power producers and co-generation facilities at costs determined by the appropriate state utility commission. Generation facilities that meet the specifications of the regulations are known as qualifying facilities (QFs). As of December 31, 1999, the Company had a total of 109 MW of maximum contractual firm capacity under 15 contracts with QFs. The Company also had contracts with three projects at fluctuating short-term avoided cost rates. All QF contracts currently delivering power to the Company at long-term rates have been approved by either the PUCN or the California Public Utility Commission (CPUC), and have QF status as approved by the FERC. One long-term QF contract terminates in 2006, one terminates in 2039, and the remainder terminate between 2014 and 2022.
Energy purchased by the Company from QFs constituted 10% of the net system requirements during 1999. These contracts continue to provide useful diversity for the Company in meeting its peak load. All the QFs from which the Company makes firm purchases are either geothermal (87%), hydroelectric or biomass.
The actual QF firm capacity output under contract was 64 MW during the summer of 1999. The actual QF output for all non-utility generator deliveries during the summer 1999 peak was 83 MW. The table on page 13 reflects actual performance during the 1999 summer peak period. A difference exists between the non-utility generator figures and the table on page 13 because the 1999 figure is actual and the remaining years are forecasts. Any capacity shortfall created by under-performance was included in the Company's 1999 amended resource plan.
Transmission
In planning its transmission capacity, the Company considers generation and purchased power options, as well as the requirements for providing retail and wholesale transmission services.
The Company's existing transmission lines extend some 300 miles from the crest of the Sierra Nevada in eastern California, northeast to the Nevada-Idaho border at Jackpot, Nevada, and 250 miles from the Reno area south to Tonopah, Nevada. A 230 kV transmission line connects the Company to facilities near the Utah-Nevada state line, which in turn interconnects the Company to Utah Power facilities. A 345 kV transmission line connects the Company to Idaho Power facilities at the Idaho-Nevada state line. The Company also has two 120 kV lines and one 60 kV line which interconnect with Pacific Gas and Electric (PG&E) on the west side of the Company's system at Donner Summit, California. Two 60 kV transmission ties allow wheeling of up to 14 MW of power from the Beowawe Geothermal Project, which is located within the Company's service area, to Southern California Edison. These two minor interties are available for use during emergency conditions affecting either party.
The Company's transmission intertie system provides access to regional energy sources.
The Falcon Project is a 185-mile 345kV line connecting the Company's Falcon Substation to the Company's Gonder Substation. The Project improves system import and export capabilities and enables the Company to provide transmission service between Idaho, Utah, and the Northwest. A Right-of-Way application was submitted to the Bureau of Land Management (BLM) on December 17, 1998, and Electric Resource Plan approval was received from the PUCN on April 8, 1999. On October 5, 1999, the Company received a letter from the BLM requiring the preparation of an Environmental Impact Statement (EIS). Current activities include completion of environmental field surveys, hiring a consultant to prepare the EIS, and WSCC rating studies. The EIS process should continue until July 2001, which should translate to a project in-service date in June 2003. Annual costs for 1999 are $2.25 million, total costs as of December 31, 1999 are $2.28 million, and the estimated net cash total cost is $98.2 million.
The Company completed construction of the Alturas Intertie transmission line in December 1998. The Alturas Intertie was built to enhance service to existing load, to expand service to new customers and to increase significantly the Company's access to lower cost resources in the Pacific Northwest. This 345 kV line originates west of Alturas, California and extends 165 miles south to Reno.
Certain Northern California public power groups have challenged the Company's filing with the FERC of the interconnection and operating agreements related to the Alturas Intertie in December 1998 and January 1999. The California groups alleged that the potential reduction in imports into California constitutes an impairment of reliability and therefore seek to force reductions in use of the Alturas Intertie during peak periods. These allegations have already been rejected by the Western Systems Coordinating Council, which determined the capacity rating of the Alturas Intertie. The Company (supported by Bonneville Power Administration and PacifiCorp) has filed testimony before the FERC that the Alturas Intertie does not adversely affect reliability and that, under the FERC's Order No. 888, customers in Nevada are entitled to compete with customers in California for transmission capacity in the Pacific Northwest on a first-come, first-served basis. The FERC staff has agreed with the Company's position on this matter.
One of the California groups, the Transmission Agency of Northern California ("TANC"), also initiated proceedings in the United States District Court for the Eastern District of California and the United States Court of Appeals for the Ninth Circuit, in each case alleging that Bonneville's construction of a small portion of the Alturas Intertie violated the Northwest Power Preference Act and requesting an injunction prohibiting operation of the Alturas Intertie. The case before the Eastern District was dismissed for lack of jurisdiction. The case before the Ninth Circuit was dismissed for TANC's failure to prosecute. In December 1999, TANC filed suit in the Superior Court of the State of California, Sacramento County, seeking an injunction against operation of the Alturas Intertie based on numerous allegations under state law, including inverse condemnation, trespass, private nuisance, and conversion.
Fuel Availability
The Company's 1999 fuel requirements for electric generation were provided by natural gas, coal, and oil. During 1999 natural gas remained the fuel of choice, over oil, for generation plants other than Valmy, which is a coal-fired plant.
The average costs of coal, gas and oil for energy generation per million British thermal units (MMBtu) for the years 1995-1999, along with the percentage contribution to total fuel requirements were as follows:
For a discussion of the change in fuel costs, see Item 7, Management Discussion and Analysis.
The Company's long-term contract with Black Butte Coal Company (Black Butte) for coal shipments to Valmy from the mine near Rock Springs, Wyoming, remains in effect until June 30, 2007, or until all volume requirements under the contract are delivered and/or canceled. Due to previous accelerated purchases and cancellations and continuing cancellations of minimum monthly volume obligations (described below), the Company projects it will fully satisfy all volume requirements and that termination of the contract will occur sometime in early to mid-2002.
Beginning in June 1996, the Company, along with its joint-ownership partner (Idaho Power Company), implemented an economic cancellation strategy that essentially buys down minimum tonnage requirements under the Black Butte contract rather than taking physical delivery of the coal. Canceling the Black Butte tonnage creates various economic and operating benefits, primarily the opportunity to buy lower-cost spot market coal and reduce overall fuel costs. In June 1996, the Company and Idaho Power expended $5 million ($2.5 million each) to cancel all minimum volume requirements for the 1996-97 contract year. The Company agreed with Idaho Power to satisfy even more volume requirements in the fall of 1996 and in June 1997 by matching the dollar cost of Black Butte tonnage purchased by Idaho Power for delivery to Idaho's coal-fired Jim Bridger plant. The Company expended $3.8 million for these matching cancellations. Since July 1997, the Company and Idaho Power have canceled (or delivered to the Bridger plant) minimum Black Butte volume requirements on a monthly basis. During the third quarter 1998 and in September through November 1999, minimum contract quantities were delivered to Idaho Power's Bridger plant, with these deliveries credited to Valmy requirements under the Black Butte contract.
The Company's long-term coal contract with Canyon Fuel Company, LLC (Canyon), which provides coal for Valmy from Canyon's SUFCO mine in Central Utah, expires on June 30, 2003. This contract also contains minimum volume requirements that the Company expects to meet each year until termination. The current owner of the SUFCO mine is Arch Coal, Inc., which acquired ARCO Coal (the previous owner of the Canyon Fuel properties, including SUFCO) on June 1, 1998.
During 1999, several short-term agreements for the purchase of spot market coal were executed, with two of these agreements extending into 2001. The source of this coal is the Uinta Basin of Utah. These spot market purchases supplement base volume requirements under the Company's long-term coal contracts at a cost approximately one-half that of contract coal.
The total amount of coal burned at the Valmy Power Plant during 1999 was 1.55 million tons. As of December 31, 1999, the coal inventory level was 383,053 tons, or approximately 67.0 days of consumption at 100% capacity. The Company normally targets an average annual coal stockpile sufficient to provide 30 days' supply at full load. For 1999, however, the Company made the decision to increase storage to approximately 60 days' supply by December 31 as part of its Y2K contingency plans. The Company has adjusted its operations toward reaching the normal 30 days' supply by the end of 2000.
During 1999, transportation of coal to Valmy was provided by the Union Pacific Railroad (UP) under a 3-year agreement effective June 1, 1998. This agreement was negotiated as a resolution to the Company's previously filed complaint with the Surface Transportation Board alleging unreasonable rate levels being charged by the UP.
During 1999, the Company operated the Pinon Pine facility exclusively on natural gas. Although no coal was purchased in 1998 for synthetic gas production in the plant's coal gasification facility, approximately 19,000 tons were purchased in 1997 and 450 tons in 1999. This inventory has been more than sufficient to fuel the gasifier during its limited operation during the last two years. Total coal burned in the gasifier during 1999 was 679 tons. Petroleum coke (used for gasifier startup) purchased in 1999 was 220 tons, with 169 tons being burned. Due to operational problems caused by high levels of fine particles inherent in the coal used at Pinon, about 450 tons of stoker coal, which is a sized and harder product, was purchased in November 1999 as an attempt to reduce the effects of filter clogging in the gasifier.
The Company meets its needs for residual oil for generation through purchases on the spot market. With no other mitigating factors, the Company's residual oil inventory policy is to maintain 50,000 to 75,000 barrels at each of its Tracy and Ft. Churchill generating plants. Based on Y2K contingency plans, the Company increased storage at its Ft. Churchill plant to full capacity this past summer and also increased Tracy storage to over 100,000 barrels which, in total, will provide over 10 days' supply at full load operation. The Company has adjusted its operations toward reaching normal inventory levels in 2000. Storage levels were not increased to full capacity at Tracy because of favorable natural gas availability estimates from the gas supply industry. The actual residual oil inventory level at these two sites was 232,134 barrels as of December 31, 1999, which is equal to 10.5 days' supply at full load operation. Total residual oil consumption in 1999 was 37,425 barrels. No residual oil was burned in the month of December, with natural gas supply being sufficient to fuel both the Tracy and Ft. Churchill steam units.
NATURAL GAS BUSINESS - --------------------
The Company's natural gas business is a local distribution company (LDC) in the Reno/Sparks area that accounted for $100.2 million in 1999 operating revenues or 13.1% of total Company operating revenues. Growth in the Company's service territory continues to be strong. Residential customer growth during 1999 was 4.3%. The overall natural gas customer growth rate was 4.3% for the year. The Company's total customer count increased 5,131 customers to 111,843 customers at the end of 1999.
Natural gas offers significant economic and environmental advantages over other energy sources for space heating, water heating and other uses in residential, commercial and industrial applications. Growth in all sectors is expected to continue as new developments in the Company's distribution service area are planned.
Contracts established during the last three years under the Company's Value Based Service Tariff (VBST) are being successfully renewed as the old contracts expire. During 1999, two contracts were renewed under the VBST tariff, which is designed to enable the Company to compete with competitive service options for its largest customers. As of December 31, 1999, the Company had seven VBST contracts in place with customers.
The Company's natural gas LDC business is subject to competition from other suppliers and other forms of energy available to its customers. Large customers with fuel switching capability compare natural gas prices on an interruptible basis to alternative energy source prices. Seven customers now secure their own gas supplies, with the Company providing transportation service on its distribution system.
The Company has contracted for firm winter-only and annual gas supplies with 13 Canadian and domestic suppliers to meet the firm requirements of its LDC and electric operations. The contracts total 157,500 decatherms per day through March 2000 and 95,000 decatherms per day for April through October 2000.
The Company's firm natural gas supply is supplemented with natural gas storage services and supplies from a Northwest Pipeline Co. facility located at Jackson Prairie in southern Washington and a liquefied natural gas (LNG) storage from a facility located near Lovelock, Nevada. The LNG facility is operated by Paiute Pipeline Company and is used for meeting peak demand. The Jackson Prairie and LNG facilities can contribute a total of approximately 48,000 decatherms per day of peaking supplies.
Starting November 1, 1996, the Company entered an agreement to sell winter seasonal peaking capacity supplies to another company over a seven-year period. The contract provides for the payment to the Company of a monthly reservation charge, reimbursement of pipeline capacity charges during the winter, and a volumetric commodity charge based on the market price for natural gas. The Company was able to enter into this agreement due to the ability of its power plants to utilize alternative fuels and its power importation option.
Following is a summary of the transportation and approximate storage capacity of the Company's current gas supply program. Firm transportation capacity on the Northwest/Paiute system exists to serve primarily the LDC. Firm transportation capacity on the PGT/Tuscarora system exists primarily to serve the Company's electric generating plants. Storage capacity is generally used for the peaking requirements of the LDC.
The Company plans to sell its gas fired generation by the end of 2000. As part of this sale the Company will be transferring portions of its firm pipeline and the winter peaking supply agreement, described above, to the buyers of the Ft. Churchill and Tracy generation bundles. The final allocation of capacity to the buyers is still being determined but will meet the divestiture stipulation requirement that Sierra maintain the availability and reliability of natural gas to its local gas distribution company.
Total LDC decatherm supply requirements in 1999 and 1998 were 13.4 million decatherms and 14.9 million decatherms, respectively. Electric generating fuel requirements for 1999 and 1998 were 31.6 million decatherms and 35.0 million decatherms, respectively.
As of December 31, 1999, the Company owned and operated 1,439 miles of three-inch equivalent natural gas distribution piping.
WATER BUSINESS - --------------
The water distribution business contributed $54.3 million (7.1%) to the Company's 1999 operating revenues. Water production in 1999 totaled 24.97 billion gallons. 3.99 billion gallons were produced from the Company's groundwater wells. The remaining 20.98 billion gallons were treated through the Company's two water treatment facilities, the Chalk Bluff Water Treatment Plant and the Glendale Water Treatment Plant. The Company's peak day send-out of water during 1999 was 133.1 million gallons (135.2 including the Silver Lake acquisition described below), a 0.5% decrease over the 133.8 million gallon peak set in 1998. The stability in peak day demand was due to mild summer temperatures which offset additional new customer demands. Overall weather conditions during the year produced an above average snow pack with a warm lingering fall; thus annual production was up 11.5%.
The Company's water supplies are from both surface and groundwater sources, with the addition of drought storage and refill provisions sufficient to withstand prolonged drought conditions. The surface water source is the Truckee River, which originates in Lake Tahoe and flows north and east through the cities of Reno and Sparks to Pyramid Lake, located northeast of Reno.
The Company's groundwater comes from 25 supply wells located around the Reno/Sparks area. Man-made contaminants, perchloroethylene, from local business operations have been found at levels exceeding the drinking water standards in five of these wells. All five of these wells have now been fit with treatment equipment that allows them to be returned to operation and deliver water to the system that meets federal standards. The Washoe County remediation district is expected to reimburse the Company for the cleanup of this groundwater contaminant in these five wells beginning in 2000.
Additionally, the Company has four wells which currently exceed the federal drinking water standard for naturally occurring arsenic concentrations. Production from three of these wells continues by blending water treated at the Glendale Water Treatment Plant. The fourth well is out of service pending treatment. The Company's water laboratory research staff is developing options to assure that the Company is prepared to meet new arsenic standards. The new Arsenic regulations will be promulgated in 2000 and the proposed regulation is expected to require action on 17 of the 25 wells serving the Company's system. Depending upon final rules from the EPA, the Company may incur between $70 million and $98 million by 2004 to meet the new standards.
A favorable piece of legislation, AB380, was passed in the 1999 State legislature that resolved more than a decade of litigation over water rights and addressed the issues of forfeiture and abandonment. The legislation creates a special fund for the acquisition of water rights in question and clears the future for conversion of agricultural rights to urban uses without the cloud of forfeiture or abandonment protests.
The Company continues to pursue the Negotiated Settlement that has been under development for several years. The Company is currently operating under a Preliminary Settlement Agreement (PSA) and interim storage contract until negotiations are completed and the final Truckee River Operating Agreement (TROA) is completed. Based on comments received from the initial release, the environmental impact statement (EIS) will be redone and resubmitted for comments following the final TROA drafting. This is expected to occur during 2000. The Negotiated Settlement is a complex set of agreements on Truckee River issues involving the United States, California and Nevada governments, the Pyramid Lake Paiute Tribe and the Company. It is expected the agreement will be finalized this year. During 1999, many details of the TROA and language of the draft have been solidified. Once in effect, the new agreement will allow the Company use of federal reservoirs for drought reserve storage.
The Company plans to rebuild the Farad dam and put the Farad Hydro plant back into service in 2001. The Company is designing and obtaining the appropriate permits to construct the replacement project. The dam was destroyed during a flood in 1997. The water rights associated with the hydro facilities are part of the Negotiated Settlement and provide for river flows to the water division, and therefore the four Truckee River hydro plants will stay with the Company's water business even after generation divestiture. See Merger/Generation Divestiture discussion.
As a condition of the Negotiated Settlement, the Company's unmetered residential water customers must be converted to metered service. A meter retrofit program was approved by the PUCN and began in 1995. Funding for the program is provided by business developers and administered by the Company. Meter installation costs are significantly lower if a meter box is already in place. Accordingly, meter boxes without meters are installed when roads and sidewalks are replaced. Since the program's inception, 5,533 meters (14% of 1995 unmetered customers) and 10,911 boxes without meters (41% of 1995 customers without facilities for meter installation) have been installed. During 1999, 671 meters and 3,611 boxes were installed with contributed funds. At this time, only customers who volunteer for the program may have meters installed. Water meters have been required in all new construction since 1986.
The Company has made application to the PUCN to transfer retail water customers in the Double Diamond area to Washoe County and serve these and other customers in the South Truckee Meadows as wholesale customers through the County. This option minimizes the need for duplicate and costly facilities.
In addition, the Company was successful in acquiring the assets of the Silver Lake Water Company and received approval by the PUCN. The Company began operation of the two Silver Lake wells, metering, billing, and customer services in October 1999. As a result of this acquisition, the Company increased its customer base by approximately 1600 customers, and more importantly, avoided costly capital expenditures.
CONSTRUCTION PROGRAM - --------------------
Gross construction expenditures for 1999, including allowance for funds used during construction (AFUDC) and contributions in aid of construction, were $142.3 million and for the period 1995 through 1999 were $820.8 million. Estimated construction expenditures for 2000 and the period 2001-2004 are as follows (dollars in thousands):
Total construction expenditures estimated for 2000 and the 2001-2004 period, for each segment of the Company's business, consist of the following (dollars in thousands):
GENERAL REGULATION - ------------------
The Company is subject to the jurisdiction of the PUCN and the CPUC with respect to rates, standards of service, siting of, and necessity for, generation and certain transmission facilities, accounting, issuance of securities and other matters with respect to electric operations. The Company submits integrated resource plans regarding its electric, gas, and water business operations to the PUCN for approval.
Under federal law, the Company is subject to certain jurisdictional regulation, primarily by the FERC. The FERC has jurisdiction under the Federal Power Act with respect to rates, service, interconnection, accounting, and other matters in connection with the Company's sale of electricity for resale and the transmission of energy for others. The FERC also has jurisdiction over the natural gas pipeline companies from which the Company takes service.
As a result of regulation, many of the fundamental business decisions of the Company, as well as the rate of return it is permitted to earn on its utility assets, are subject to the approval of governmental agencies.
The Company is also subject to regulation by environmental authorities. See Environment.
Rate Proceedings - ----------------
During 1999, 85% of the Company's revenues were from retail sales of electricity, natural gas and water in Nevada, 5% from retail sales of electricity in California and 10% from sales of electricity and gas for resale.
Nevada Matters - --------------
Electric Industry Restructuring
During the 1997 session, the Nevada Legislature passed Assembly Bill 366 (AB 366). AB 366 was a comprehensive bill that introduced competition for electric and gas retail services. Since the fall of 1997, the PUCN has been developing regulations to implement AB 366. In the 1999 session, the legislature passed Senate Bill 438 (SB 438) that significantly modified many provisions of AB 366. These two pieces of legislation substantially alter the way the Company is regulated and how it will serve its customers.
Non-price Terms and Conditions for Distribution Service
On February 2, 1999, the Company filed its non-price terms and conditions for unbundled distribution service pursuant to the PUCN regulations. A stipulation resolving most issues and agreeing to further filings on unresolved issues was filed with the PUCN on April 9, 1999, and subsequently approved by the PUCN on April 22, 1999. Settlements regarding the unresolved issues were subsequently filed and approved by the PUCN.
Unbundling of Utility Services
On April 1, 1999, in accordance with the merger order and the implementation of AB 366, the Company filed a revenue requirements and unbundling study with the PUCN (the "Compliance Filing"). The Compliance Filing included the development of an electric revenue requirement for the test period 1998. The Compliance Filing regulation requires the revenue requirement development to be in the form used for rate cases. In the unbundling study, the revenue requirement was assigned and allocated to a number of service components including generation, aggregation, transmission, distribution, metering, billing, and customer services. On September 23, 1999, the PUCN issued an interim order on the Company's April 1, 1999 Compliance Filing. The Order contained the PUCN's decision on revenue requirements, return on equity, depreciation, and the unbundling study. The Company did not utilize the order's revenue requirement, return on equity or depreciation rates in Phase II of this case because SP438 legally mandated that the Company use its July 1, 1999 revenue requirement in Phase II.
Pricing of Distribution Service
On October 8, 1999, the Company filed final versions of the approved non- price terms and conditions and rates reflecting a revenue requirement in accordance with SB 438. Hearings were held in early November. A decision is expected in 2000.
Earnings Sharing
On April 30, 1999 the Company filed an earnings sharing refund request, based on 1999 earnings of $7.0 million for electric customers and $1.9 million for gas customers. On August 19, 1999, the PUCN approved a stipulation between the Company, Staff, and the Utilities Consumer Advocate, which resulted in a $7.4 million and a $2.0 million refund to electric and gas customers, respectively. Based on 1999 operating results, the Company anticipates it may make refunds to customers. Appropriate reserves have been recorded to reflect any anticipated refunds.
Generation Divestiture
In October 1999, the Company filed with the PUCN its request for approval to sell its generation plants. Hearings were held in November 1999 and a stipulation was approved in February 2000.
California Matters - ------------------
Rate Reduction Bonds
California's electricity restructuring statute (Assembly Bill 1890, Chapter 854, California Statutes of 1996, as amended) permits California investor-owned utilities, including the Company, to finance the recovery of a reduction in electricity rates for residential and small commercial customers through the issuance of rate reduction certificates. Transition costs consist of the costs of generation-related assets and obligations that may become uneconomic as a result of a competitive generation market, together with certain other costs associated therewith.
In order for the Company to recover transition and associated costs, the CPUC authorized the establishment of non-bypassable, usage-based, per kilowatt- hour charges ("FTA Charges") to be included in the regular utility bills of residential and small commercial consumers located in the historical service territory of the Company in California. The right to receive payments made in respect of the FTA Charges is referred to as Transition Property.
On April 9, 1999, the Company sold the Transition Property to SPPC Funding LLC, a Delaware special purpose limited liability company whose sole member is the Company, in exchange for the proceeds of the SPPC Funding LLC Notes, Series 1999-1 (the "Underlying Notes"). SPPC Funding LLC then issued and sold the Underlying Notes to the California Infrastructure and Economic Development Bank Special Purpose Trust SPPC-1 (the "Trust") in exchange for the proceeds of the sale of the Trust's $24.0 million 6.4% Rate Reduction Certificates, Series 1999- 1 (the "Certificates"). The Trust, which had been established by the California Infrastructure and Economic Development Bank, issued and sold the Certificates in a private placement pursuant to Rule 144A under the Securities Act of 1933, as amended. The Certificates are one of a series of rate reduction certificates that may be issued from time to time by the Trust and sold to investors upon terms determined at the time of sale.
On January 10, 2000, the Commission approved the Company's annual true-up of the FTA charges effective January 1, 2000.
Revenue Cycle Unbundling
On February 18, 1999, the CPUC approved the Company's proposed Revenue Cycle Services Credits (RCSC) application filed February 2, 1998. The RCSC addresses meter ownership, meter services, meter reading, and billing and applies to customers who select their own provider of a revenue cycle service. On April 9, 1999, the Company made a compliance tariff filing which reflects the approved credits.
Direct Access Tariffs
On April 5, 1999, the CPUC approved the Company's compliance filing, effective back to March 18, 1998, which proposed tariff changes to implement direct access.
Rate Unbundling
On April 5, 1999, the CPUC approved the Company's proposed unbundled rates effective back to June 1, 1998.
Distribution Competition
The CPUC has opened a docket item to solicit comments and proposals on distributed generation and competition in electric distribution service. The Company is actively participating in the on-going workshops. It is too early to determine how this proceeding may affect the Company.
Generation Divestiture
The Company has filed with the CPUC its request for approval to sell its generation plants. The Company filed a revised application requesting an exemption. A decision is expected in the first half of 2000.
Distribution Performance-Based Rate-making (PBR)
On January 3, 2000, the Company filed a distribution PBR proposal to become effective January 1, 2001 through 2003. The proposal includes rate indexing and earnings sharing mechanisms as well as performance indicators for employee safety, customer satisfaction and system reliability. The Company will submit a 2001 Cost of Capital filing in May 2000 and a Distribution PBR 2001 Cost of Service filing in June 2000.
FERC Matters - ------------
On March 30, 1999, the Company filed an application with the FERC to increase its Open Access Transmission rates. On October 12, 1999, the Company filed an Offer of Partial Settlement which resolved all issues but pricing to the Mines and to the City of Fallon. A status report on the two remaining issues was filed on January 11, 2000. On January 31, 2000, the FERC approved the Partial Settlement.
On March 31, 1999, the Company filed with the FERC for approval of generation tariffs that contain the rates, terms and conditions under which the new owners of the Company's generation would operate after divestiture. The FERC dismissed the tariffs on November 1, 1999, apparently misinterpreting the agreement reached with the PUCN on the tariffs. The Company filed a request for rehearing of the FERC's November 1, 1999 order dismissing the tariff. The rehearing request explains how the FERC erred in dismissing the tariff. On December 17, 1999, the Commission issued an Order Granting Rehearing for Further Consideration. A decision is expected in 2000.
On July 23, 1999, the Company and Nevada Power Company submitted a filing to create the Mountain West Independent Scheduling Administrator. The filing is made to request approval of certain of the tariffs and agreements with respect to the transmission services of the Company and Nevada Power Company. On January 27, 2000, the FERC issued an order approving with modifications the Mountain West ISA proposal. The PUCN is continuing to review aspects of the filing, including funding for the Mountain West ISA.
ENVIRONMENT - -----------
General
As with other utilities, the Company is subject to federal, state, and local regulations governing air and water quality, hazardous and solid waste, land use, and other environmental considerations. These considerations affect the construction and operation of electric, gas, and water utility facilities.
Nevada's Utility Environmental Protection Act requires approval of the PUCN prior to the construction of major utility generation and transmission facilities. The United States Environmental Protection Agency (EPA) and Nevada's Division of Environmental Protection (NDEP) administer regulations involving air quality; water pollution; and solid, hazardous, and toxic waste.
The Company's board of directors has a comprehensive environmental policy, and a separate board committee on environmental compliance that oversees corporate performance and achievements related to the environment. The Company's corporate environmental policy emphasizes environmental stewardship.
1999 Activities - ---------------
As part of the Generation Divestiture process, the Company conducted Phase I and Phase II Environmental Assessments for its Ft. Churchill, Tracy and Valmy Power Plants. The Anticipated remediation cost is $150,000.
In 1995, the Company identified one site formerly used for manufacturing gas from oil. This site was sold in 1997 with full disclosure to the buyer. Shortly after the sale, the buyer notified the Company of its intent to file legal action. In July 1998, the Company entered into an agreement with the buyer to mitigate the contamination on site to an acceptable level. In 1999, soil contamination was remediated in full compliance with the settlement agreement and the site case was closed by the local regulatory agency. No further action is required at this site.
In September 1994, Region VII of EPA notified the Company that the Company was being named as a potentially responsible party (PRP) regarding the past improper handling of Polychlorinated Biphenyls (PCBs) by PCB Treatment, Inc., located in Kansas City, Kansas, and Kansas City, Missouri (the Sites). The EPA is requesting that the Company voluntarily pay an undefined (pro rata) share of the ultimate clean-up costs at the Sites. A number of the largest PRP's formed a steering committee, which is chaired by the Company. The responsibility of the Committee is to direct clean-up activities, determine appropriate cost allocation, and pursue actions against recalcitrant parties, if necessary. The EPA issued an administrative order on consent requiring signatories to perform certain investigative work at the Sites. The steering committee retained a consultant to prepare an analysis regarding the Sites. The site evaluations have been completed. EPA is developing an allocation formula to allocate the remediation costs.
The Company has recorded preliminary liability for the Sites of $650,000, of which approximately $150,000 has been spent through December 31, 1999. Once evaluations are completed, the Company will be in a better position to estimate and record the ultimate liabilities for the Sites.
The Company continued and initiated several actions in accordance with its policy to be an environmental leader in principle and practice. These actions have (1) Resulted in reduced pollutant and greenhouse gas emission rates at power plants; (2) Demonstrated stewardship of wildlife and waterfowl habitat on and adjacent to Company property; (3) Improved water quality conditions; and (4) Lowered the cost of compliance with environmental regulations.
During 1999, the Company was awarded bonus sulfur dioxide emission allowances by the EPA for its use of geothermal energy, a renewable resource. Under the Acid Rain Rule of the Clean Air Act, bonus emission allowances are generated to utilities that have avoided sulfur dioxide emissions by using renewable energy to generate electricity. In 1999 the Company received 4,907 bonus allowances.
GENERAL - FRANCHISES - --------------------
The Company has nonexclusive local franchises or revocable permits to carry on its business in the localities in which its respective operations are conducted in Nevada and California. The franchise and other governmental requirements of some of the cities and counties in which the Company operates provide for payments based on gross revenues. During 1999, the Company collected $8.8 million in franchise or other fees based on gross revenues. It also paid and recorded as expense $1.0 million of fees based on net profits.
The Company applies for renewal of franchises in a timely manner prior to their respective expiration dates.
GENERAL - RESEARCH AND DEVELOPMENT - ----------------------------------
The Company participates in several utility associations, including the Electric Power Research Institute and Gas Research Institute.
ITEM 2.
ITEM 2. PROPERTIES
The general character of the Company's principle facilities is discussed in Item 1, Business.
Substantially all utility plant is subject to the lien of the Indenture of Mortgage, dated December 1, 1940, and supplemental indentures thereto between the Company and State Street Bank and Trust, as trustee, securing the Company's outstanding first mortgage bonds.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company, through the course of its normal business operations, is currently involved in a number of legal actions, none of which has had or, in the opinion of management, is expected to have a significant impact on its financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company is a wholly-owned subsidiary of Sierra Pacific Resources and, as such, its common stock is not publicly traded and no market exists for it. Cash dividends declared by SPPC on its common stock were as follows (dollars in thousands):
After provisions for payment of dividends on all outstanding shares of preferred stock, and subject to limitations in the Company's restated articles of incorporation and its indentures, dividends may be paid on the common stock out of any funds legally available for that purpose when declared by the board of directors. As of December 31, 1999, approximately $76.0 million of retained earnings were available for the payment of dividends on common stock under the most restrictive of these limitations.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS - ---------------------
Net income before preferred dividends in 1999 was $71.7 million, a decrease of $14.3 million compared to 1998. The Company was authorized to earn a return on equity of 12% in its Nevada electric operations and 12% and 11.25%, respectively, in its Nevada gas and water operations. The Company may have earned in excess of its allowed regulated returns for its electric and gas operations and therefore, under its currently effective rate settlement, the Company anticipates it may make refunds to customers reflecting one half of the excess earnings. Appropriate reserves have been recorded to reflect any anticipated refunds. California operations were authorized to earn a return on common equity of 11.6% in 1999. See Regulatory Matters for more discussion of these issues.
Nevada, the Company's primary jurisdiction, uses a marginal cost method for setting electric and gas rates by customer class. As a result, changes in sales mix can result in variations in revenues, regardless of changes in total consumption.
The components of gross margin are set forth (dollars in thousands):
The causes for significant changes in specific lines comprising the results of operations for the years ended are provided (dollars thousands):
In 1999, residential, commercial and industrial electric revenues increased due to a 3% increase in both residential and commercial customers and a 7.8% increase in industrial customers. The increase in residential and industrial revenues was partially offset by lower use per customer. Residential use per customer was lower due to milder weather in 1999. Industrial use per customer was lower primarily because of reduced production by several of the Company's gold mining customers as a result of lower gold prices in 1999. The average retail revenue per MWh was lower for 1999 because of higher revenues from customers that are charged lower rates per MWh. Other electric revenues were higher due to a $19.4 million increase in wholesale electric sales. This increase was partially offset by a $4.3 million reclassification from operating expense to a contra-revenue in order to reflect a refund resulting from the 1997 earnings sharing decision by the Public Utilities Commission of Nevada. Also, the increase in 1999 revenues was partially offset by a higher provision for customer refunds and also losses from the Company's Pinon Pine subsidiaries.
In 1998, residential and commercial revenues increased due to 2% and 3% increases in customers, respectively. Industrial revenues were higher in 1998 because of higher use per customer, primarily in the mining industry where several of the Company's customers expanded operations during 1998. The increases in revenues for residential, commercial and industrial were all partially offset by a rate reduction that went into effect March 1997. The increase in other revenues primarily resulted from higher wholesale electric sales and a smaller charge for customer refunds. Higher wholesale sales in 1998, $33.1 million compared to $13.3 in 1997, reflect an increased focus on this business opportunity.
Residential, commercial and industrial gas revenues were lower in 1999 because of lower per customer use resulting from milder weather in 1999. Lower gas revenues in 1999 were partially offset by additional customers in all categories. Wholesale gas revenues were higher due to several large gas sales contracts in the first quarter of 1999.
Residential, commercial and industrial gas revenues increased in 1998 because of a 4% increase in customers and colder than normal weather during the year. The increase in wholesale revenues reflected the Company's increased focus on this business opportunity.
Water revenues increased during 1999 due to a 5% increase in total customers and higher use per customer as a result of less precipitation in 1999.
Water revenues were higher in 1998 because of a 3% increase in customers and an April 1998 price increase.
Purchased power costs were higher in 1999 primarily because the Company fulfilled more of its total energy requirements with less expensive purchased power and reduced its own generation. Purchased power costs were also higher during 1999 due to increased wholesale sales. The higher costs were partially offset by lower average unit prices for purchased power.
Purchased power costs were significantly higher in 1998 due mostly to the costs associated with higher wholesale electric sales as discussed previously. To a lesser extent system load growth also contributed to higher purchased power costs.
Fuel for generation costs were comparable with the prior year despite a 9.5% reduction in the volume of electric generation. Higher gas prices and the absence of Department of Energy co-funding of fuel costs at the Pinon Pine project contributed to the higher average cost per MWh of generated power. As, previously discussed, the Company was able to replace electricity from generation with less expensive purchased power.
The costs of fuel for generation increased in 1998 because of higher generation requirements needed to meet continued customer growth and greater use per customer.
The cost of gas purchased for retail sales increased in 1999 because of higher unit prices. The increase in gas unti prices is attributable to increased demand for gas in the Pacific Northwest and additional transportation fees.
Consistent with the increase in retail gas revenues from customer growth and colder weather in 1998, retail gas purchases (decatherms) were higher in 1998. The average cost per decatherm for all purchases was also higher because of an increase in the unit cost of firm and spot purchases.
The total allowance for funds used during construction (AFUDC) was lower in 1999 because of construction completed in June and December 1998 for the Pinon and Alturas projects, respectively. Also, the 1999 amounts reflect an adjustment to reverse amounts previously charged to AFUDC of $2.3 million. This adjustment resulted from a refinement of amounts assigned to specific components of facilities that were completed at various times and that used differing AFUDC rates.
AFUDC was slightly lower in 1998 than 1997. The 1998 amount was lower due to the completion of the Pinon Pine power project in June 1998.
Other operating expense for 1999 includes a $4.5 million adjustment, which increased expense and reduced revenue related to a rate reserve established in 1998. This was offset by other reductions. Other operating expense was lower in 1998 due to lower costs for stock compensation, post-retirement benefits, fuel buyouts, lower accruals for delays in the construction of Pinon, and no flood damage costs.
Maintenance expense for 1999 was comparable to the prior year. Maintenance expense was lower in 1998 because of additional electric plant maintenance performed during the previous year.
Depreciation and amortization expense increased for 1999 due to the completion of the Alturas intertie in December 1998 and the Pinon post- gasification facilities in June 1998. Depreciation expense increased in 1998 because of the Pinon Pine facilities completed in 1998. Also, 1998 depreciation was higher due to water division additions and other customer improvements added to plant in service late in 1997.
Operating income taxes were less in 1999 due to lower operating income before income taxes and a lower effective tax rate for the year. Operating income taxes increased in 1998 due to increases in pre-tax income and the effective tax rate. See Note 5 for more information.
Interest on long term debt was slightly higher in 1999 due to higher average long-term debt balances over the prior year. Interest on long-term debt was lower in 1998 because of the redemption of $5 million of 8.65% medium-term notes on June 18, 1998. See Note 6 to the consolidated financial statements for more information related to long-term debt.
Interest charges-other were higher for 1999 because of a Public Utilities Commission of Nevada's decision to assess partial interest on amounts payable in the 1997 earnings sharing case and higher average short-term borrowing in 1999. Interest charges-other increased in 1998 because of higher short-term debt balances utilized to partially finance the Alturas transmission project.
Liquidity and Capital Resources
Overall net cash flows decreased during 1999, as compared to 1998, due to lower net cash flows from operating activities and to a lesser extent greater cash used in investing activities. The decrease in cash flows from operating and investing activities was partially offset by cash provided from financing activities. The decrease in cash provided from operating activities was primarily due to cash utilized for customer refunds and merger related cash requirements. The increase in cash used for investing activities was due to the Company's acquisition of General Electric Capital Corporation's interest in
Pinon Pine Company L.L.C., GPSF-B. Net cash provided by financing activities resulted from the issuance of $24 million of California rate reduction bonds in April 1999, and $100 million floating rate notes issued on September 17, 1999. See "Regulatory Matters" for more details regarding the California bonds.
Overall net cash flows increased slightly during 1998, as compared to 1997, due to higher net cash flows from operating and financing activities which were mostly offset by more cash used in investing activities. The increase in cash flows from operating activities was mainly due to higher operating income as a result of increased revenues from customer growth. The increase in cash used in investing activities was primarily due to increased construction expenditures. The increase in net cash provided by financing activities was mainly due to increased long-term and short-term borrowings.
CONSTRUCTION EXPENDITURES AND FINANCING - ---------------------------------------
The table below provides cash construction expenditures and net internally generated cash for 1997 through 1999 (dollars in thousands):
SPPC's estimated cash construction expenditures for 2000 through 2004 are $680 million. SPPC estimates that 63% of its 2000 cash expenditures of approximately $125 million will be provided by internally generated funds, with the remainder being provided by the issuance of long-term debt, short-term debt, and parent contributions.
SPPC's estimated level of internally generated cash utilized for construction of 63% anticipates that SPPC will pay all of its net income in dividends to SPR. SPPC anticipates receiving $28 million of capital contribution from SPR in 2000.
CAPITAL STRUCTURE - -----------------
As of December 31, 1999 SPPC had $110 million commercial paper issued and outstanding. SPPC's commercial paper is rated A2 and P2 by Standard and Poor's and Moody's, respectively.
SPPC's actual capital structure at December 31, 1999, 1998, and 1997 was as follows (dollars in thousands):
(1) Including current maturities of long-term debt and preferred stock.
The indenture under which the SPPC's first mortgage bonds are issued, prescribes certain coverage ratios that must be met before additional bonds may be issued. At December 31, 1999, these coverage provisions would allow for the issuance of approximately $511 million in additional first mortgage bonds at an assumed interest rate of 8.0%. The indenture also limits the amount of first mortgage bonds that SPPC may issue to 60 percent of unfunded property plus the amount of any previously issued bonds that have since been retired. Based on certifications to the trustee as of December 31, 1999, these indenture provisions would have allowed for the issuance of approximately $845 million in additional first mortgage bonds.
SPPC's secured long-term debt is rated A-, A3 by Standard & Poor's and Moody's, respectively. SPPC's pre-tax interest coverages for 1999, 1998 and 1997 were 3.15%, 3.87% and 3.86%, respectively.
REGULATORY - -----------
Restructuring - -------------
Electric Restructuring Activities
In 1997, the Governor of Nevada signed into law Assembly Bill 366 (AB366) that provided for competition to be implemented in the electric utility industry. In 1999 the Governor signed into law Senate Bill 438 (SB438) that amended AB 366. SB 438 contains the following major provisions:
. In addition to generation, metering and billing are declared to be potentially competitive services. . The start date for competition is March 1, 2000 or such other start date determined to be in the public interest by the Governor. . The electric distribution utility is the provider of last resort (PLR) until alternate methods go into effect, no sooner than July 1, 2001. PLR rates are capped until March 1, 2003 at the rates in effect as of July 1, 1999, as adjusted for any deferred energy cases filed with the PUCN prior to October 1, 1999. . Allows the use of the net proceeds of generation divestiture to pay for certain reductions in PLR revenues until March 1, 2003, arising from the departure of customers who select new suppliers. . Repeals deferred energy for electric utilities on October 1, 1999. . Permits alternative sellers to submit bids to provide PLR service after July 1, 2001, subject to a PUCN public interest finding and a PUCN-held auction. . Provides for the recovery of Past Costs, often referred to as stranded costs, including specific criteria for recovery of purchase power costs.
The PUCN has conducted a number of hearings associated with AB366 and SB438. In February 2000 the Governor of Nevada delayed the start date of competition indefinitely. Electric competition may begin later in 2000 or 2001. Generally, restructuring regulations have proceeded slowly. Currently, many important regulations, including the affiliate regulations and the PLR, are not complete. In their present form several of the proposed regulations could have potentially significant negative financial ramifications. These regulations and the potential risks are described below. The Company's management is actively working to modify these regulations. Several key Nevada restructuring issues have also arisen in other states, been litigated, and resolved in favor of the utility. If final regulations are not modified to remove the financial risk exposures, The Company will likely pursue legal action to resolve these issues. As a final option, the Company will seek an injunction to the start of competition or to overturn portions of SB438.
Affiliate Transaction Regulation
While SB438 allows for the use of name and logo, the affiliate regulation has not yet been modified to reflect this change. In addition, the Company has requested that the PUCN modify the rule related to sharing services, sharing officers and directors, and transfer pricing. To date the PUCN has not acted on this request. On March 30, 1999, SPPC and the Company filed with the District Court a "Complaint and Petition for Declaratory and Injunctive Relief and for Judicial Review" relating to the Affiliate Transaction Rules. SPPC and the Company asked that the court find that the rules "violate plaintiff's federal and state constitutional guarantees, are unlawful and invalid because they were enacted in violation of the procedural and substantive provisions of the Administrative Procedures Act, and are unlawful and invalid because they exceed the authority of the PUCN and are unsupported by the evidence." SPPC and NVP asked that the court order the PUCN "to cease and desist from enforcing the regulations."
Past Costs
Past costs, commonly referred to as stranded costs in other jurisdictions, were the subject of several hearings in 1999. AB366/ SB438 permit the recovery of costs associated with potentially competitive services such as generation and purchased power pursuant to specified legal criteria. In the hearings, various topics were discussed including the characteristics that define recoverable past costs, criteria for evaluating the effectiveness of mitigation efforts, options for cost recovery mechanisms, and applicable tax and accounting issues.
On December 29, 1999 the PUCN adopted the past cost regulation. This regulation requires the utility to file for past costs 45 days after the adoption of the regulation or issuance of the final order in the compliance plan filing. The regulation requires estimates of book values and market values as of the opening date of competition. In addition, the Company must provide documentation relative to criteria in the law such as mitigation efforts, conduct relative to other states, and efforts to minimize taxes. The PUCN will take these criteria into consideration in determining allowable past costs. During comments related to this rule, the Company raised a number of legal issues including treatment of purchase power agreements, ability to true up initial estimates of past costs to actual results, and ability to recover costs to implement restructuring. The Company has not completed an estimate of its past costs, since such a calculation is dependent on a variety of issues related to restructuring which are not resolved at this time. However based upon the current regulation and the positions taken by other parties to the rulemaking, several risk areas have been identified including:
. SB438 criteria provide latitude for the PUCN to reduce the Company's stranded cost claim.
. Purchase power agreements are the largest category of past costs. Federal and state laws provide protection to federally mandated power purchase contracts. The Company believes that the PUCN regulation provides less security to recover purchase power costs than provided by federal and state laws.
. Because the regulation does not provide a guaranteed true up to actual results, it is possible that stranded cost recovery could be set too low to recover all stranded costs.
. The stranded cost proceeding will establish the gain or loss on the divestiture sale of generation assets; the regulation provides that any gain on divestiture would be utilized to reduce stranded costs. Some elements of the calculation may be controversial. In addition the regulation does not address other claims to generation gain, such as recovery of certain revenue shortfalls as allowed by SB438, which may arise as customers leave the PLR.
The Company is currently evaluating challenges to the regulation and will actively pursue changes in the regulatory process or, if necessary, pursue legal challenges in the federal and or state courts. The Company believes that based upon the content of the regulation and the applicable law, legal challenge relative to purchase power agreements has a strong possibility of being successful.
Provider of Last Resort
The provider of last resort (PLR) will provide electric service to customers who do not select an electricity provider and to customers who are not able to obtain service from an alternative seller after the date competition begins. SB 438 provides for the electric distribution utility (EDU) to provide PLR services until July 1, 2001. The PUCN has conducted several workshops and hearings on the PLR regulations. This rule is not expected to be finalized until mid-2000. The current draft proposed regulation includes standards of conduct relative to distribution and provider of last resort functions, which require segregation of operating functions and constraints on sharing of common services. As part of their comments during development of the proposed regulation, the Company raised concerns regarding the financial impacts of the proposed regulations that place into question the financial viability of the PLR. For instance the current regulations restrict the PLR from relying on distribution assets or revenues to obtain credit. Second, the current regulations provide no financial reward potential for the significant fuel price risks that the PLR may face during the PLR rate cap period which ends March 1, 2003. Third, the proposed standards of conduct for the EDU and PLR will increase costs as a result of the loss of economies of scale and scope.
In addition to these impacts, the proposed regulation does not address two important areas associated with the PLR. Regulations have yet to be developed that fairly compensates the utility for recovery of revenue shortfalls allowed under SB438 which arise as customers leave the PLR for new suppliers. Regulations also do not address how the Company will be able to collect the costs, allowed by SB438, which will be incurred to serve customers who leave the PLR and later return.
In the ongoing rulemaking process the Company is working to address these serious concerns and modify the PLR regulation. If the proposed regulations are adopted in their current form, the Company will seek to transition out of the PLR function. In addition, if necessary, the Company is prepared to pursue legal remedies to mitigate any significant financial exposures associated with the final PLR regulation.
Independent Scheduling Administrator
The Company has participated in interim Independent Scheduling Administrator (iISA) working groups which are developing iISA standards, protocols and procedures. The PUCN has held hearings regarding entities interested in performing the iISA function, the timeline, the functions to be performed, the costs and how these entities will adhere to the PUCN iISA principles. To date the Company has not agreed to provide funding for the iISA because the PUCN has not provided a mechanism for the Company to recover costs associated with iISA. However in February 2000 the PUCN opened an investigatory docket to consider the funding and other transmission access issues. See FERC Matters for further discussion.
Gas Restructuring
To comply with Nevada AB 366 for natural gas deregulation, the PUCN has developed some new natural gas rules. In 1999, little gas restructuring activity occurred. Two new regulations, gas licensing and gas licensing fees were adopted by the PUCN in 1999.
Nevada Matters - --------------
Non-price Terms and Conditions for Distribution Service
On February 1, 1999, the Company filed its non-price terms and conditions for unbundled distribution service pursuant to the PUCN regulations. A stipulation resolving most issues and agreeing to further filings on unresolved issues was filed with the PUCN on April 9, 1999, and subsequently approved by the PUCN on April 22, 1999. Settlements regarding the unresolved issues were subsequently filed and approved by the PUCN.
Unbundling of Utility Services
On April 1, 1999, the Company filed the revenue requirements and unbundling study portions of the Compliance Filing with the PUCN. The filing included the development of an electric revenue requirement for the test period 1998. The compliance filing regulation requires the revenue requirement development to be in the form used for rate cases. In the unbundling study, the revenue requirement was assigned and allocated to a number of service components including generation, aggregation, transmission, distribution, metering, billing, and customer services. On September 23, 1999, The PUCN issued an interim order on the Company's April 1 compliance filing. The order contained the PUCN's decision on revenue requirements, return on equity, depreciation, and the unbundling study. The Company did not utilize the order's revenue requirement, return on equity or depreciation rates from Phase II of the case because SB438 legally mandated that the Company use its July 1, 1999 revenue requirement.
Pricing of Distribution Service
On October 8, 1999, the Company filed final versions of the approved non- price terms and conditions and rates reflecting a revenue requirement thought by the Company to be correct and in accordance with SB 438. Hearings were held in early November. A decision is expected in 2000.
Merger of SPR and Nevada Power Company
On April 8, 1999, SPR and NVP filed a joint application with the PUCN for approval of their proposed merger. On January 4, 1999, the PUCN issued the final order in the merger case. On December 31, 1998, the PUCN voted 3-0 to approve the merger, with conditions. The conditions include, among others, requirements to divest generation, file the divestiture plan with the PUCN for approval, file an ISA proposal at the FERC, file a generation tariff at the FERC, file a rate case and unbundle costs in 1999, file a subsequent rate case three years after retail competition, and submit an application to recover stranded costs.
Earnings Sharing
On April 30, 1999, the Company filed its second compliance filings related to the 1997 rate stipulation The filings provide a calculation of Sierra's electric and gas earnings in excess of a 12% return on equity (ROE). Any earnings in excess of 12% ROE are shared 50/50 between shareholders and customers. On August 19, 1999, the PUCN approved a stipulation between SPPC, Staff, and the UCA that rebated $7.37 million and $1.98 million to electric and gas customers, respectively in 1999. Based on 1999 operating results, SPPC anticipates it may make refunds to customers. Appropriate reserves have been recorded to reflect any anticipated refunds.
Generation Divestiture
The Company has filed with the PUCN its request for approval to sell its generation plants on October 12, 1999. On February 18, 2000, the PUCN approved an application to sell the generation plants of both SPPC and NVP. The revised divestiture plan was approved unanimously by the PUCN. Under the terms of the approved plan, both utilities will sell all of their power plants through an auction process.
CALIFORNIA MATTERS - ------------------
Rate Reduction Bonds
California's electricity restructuring statute (Assembly Bill 1890, Chapter 854, California Statutes of 1996, as amended), permits California investor-owned utilities, including the Company, to finance the recovery of a reduction in electricity rates for residential and small commercial customers through the issuance of rate reduction certificates. Transition costs consist of the costs of generation-related assets and obligations that may become uneconomic as a result of a competitive generation market, together with certain other costs associated therewith.
In order for the Company to recover transition and associated costs, the California Public Utilities Commission (CPUC) authorized the establishment of non-bypassable, usage-based, per kilowatt hour charges ("FTA Charges"), to be included in the regular utility bills of residential and small commercial consumers located in the historical service territory of the Company in California. The right to receive payments made in respect of the FTA Charges is referred to as Transition Property.
On April 9, 1999, the Company sold the Transition Property to SPPC Funding LLC, a Delaware special purpose limited liability company whose sole member is the Company, in exchange for the proceeds of the SPPC Funding LLC Notes, Series 1999-1 (the "Underlying Notes"). SPPC Funding LLC then issued and sold the Underlying Notes to the California Infrastructure and Economic Development Bank Special Purpose Trust SPPC-1 (the "Trust") in exchange for the proceeds of the sale of the Trust's $24.0 million 6.4% Rate Reduction Certificates, Series 1999- 1 (the "Certificates"). The Trust, which had been established by the California Infrastructure and Economic Development Bank, issued and sold the Certificates in a private placement pursuant to Rule 144A under the Securities Act of 1933, as amended. The Certificates are one of a series of rate reduction certificates that may be issued from time to time by the Trust and sold to investors upon terms determined at the time of sale.
On January 10, 2000, the CPUC approved the Company's annual true-up of the FTA charges effective January 1, 2000.
Revenue Cycle Unbundling
On February 18, 1999, the CPUC approved the Company's proposed Revenue Cycle Services Credits (RCSC) application filed February 2, 1998. The RCSC addresses meter ownership, meter services, meter reading, and billing and applies to customers who select their own provider of a revenue cycle service. On April 9, 1999, the Company made a compliance tariff filing which reflects the approved credits.
Direct Access Tariffs
On April 5, 1999, the CPUC approved the Company's compliance filing, effective back to March 18, 1998, which proposed tariff changes to implement direct access.
Rate Unbundling
On April 5, 1999, the CPUC approved the Company's proposed unbundled rates effective back to June 1, 1998.
Distribution Competition
The CPUC has opened a docket item to solicit comments and proposals on distributed generation and competition in electric distribution service. The Company is actively participating in the on-going workshops. It is too early to determine how this proceeding may affect the Company.
Generation Divestiture
The Company has filed with the CPUC its request for approval to sell its generation plants. The Company plans to file a revised application during the first half of 2000.
Distribution Performance-Based Rate-making (PBR)
On January 3, 2000, the Company filed a distribution PBR proposal to become effective January 1, 2001 through 2003. The proposal includes rate indexing and earnings sharing mechanisms as well as performance indicators for employee safety, customer satisfaction and system reliability. The Company will submit a 2001 Cost of Capital filing in May 2000 and a Distribution PBR 2001 Cost of Service filing in June 2000.
FERC Matters - ------------
Regional Transmission Organizations
On May 13, 1999, the FERC issued a Notice of Proposed Rulemaking on Regional Transmission Organizations (RTOs). the FERC proposed characteristics of an RTO and also the requirement for utilities to form or join RTOs.
On August 23, 1999, the Company filed comments on the proposed rule along with numerous other parties. On December 15, 1999, the FERC approved the final rule on RTOs.
Merger
On April 14, 1999, the FERC voted to approve the merger of SPR and NVP, as proposed. In approving the merger the FERC required the companies to divest of their generation facilities (as proposed by the companies) and required Nevada Power to file an update of its transmission rates (also proposed by the companies).
On May 17th, TDPUD filed a Petition for Rehearing of the FERC's order approving the merger. TDPUD claims the FERC violated its own policy by allowing the merger to be consummated prior to divestiture of generation assets. The Company and Nevada Power filed an answer to TDPUD's Petition for Rehearing in May. On July 14, 1999, the FERC denied all aspects of TDPUD's petition.
Transmission Rate Case
On March 30, 1999, the Company filed with the FERC to increase its open access transmission rates. The Company requested an increase of $16 million in the annual revenue requirement for network service. The point-to-point rate would increase from $2.80 /kW-mo. to $3.21 /kW-mo. This filing incorporates the Alturas intertie, completed in December 1998, and the reclassification of transmission and distribution facilities approved by the PUCN last summer.
On May 28, 1999, as expected, the FERC issued an order setting the rate case for hearing. The proposed rates are accepted subject to refund and suspended until November 1, 1999. On June 14, 1999, as required by the May 28 order, the Company filed additional information on the proposed transmission and distribution (T&D) reclassification. The Company also requested that the FERC accept the filing and approve the T&D split. On July 29, 1999 the FERC accepted the Company's proposed T&D reclassification.
On October 12, 1999, the Company filed an Offer of Partial Settlement which resolved all issues but pricing to the Mines and to the City of Fallon. On November 3, the Partial Settlement was certified to the FERC. A status report on the two remaining issues was filed on January 11, 2000. On January 31, 2000, the FERC approved the Partial Settlement.
Generation Tariffs
On March 31, 1999, the Company filed Docket No. ER99-2332 with the FERC for approval of generation tariffs that contain the rates, terms and conditions under which the new owners of the Company's generation would operate after divestiture. The tariffs permit market-based rates after the offering of capacity under a cost-based recourse approach.
Motions to intervene and protest in the Company's generation tariffs rate case were due on April 20, 1999. Newmont, City of Fallon, and TDPUD filed motions to intervene and protest. Barrick (a mining company) filed a motion to intervene with comments. Several other parties also filed interventions. The PUCN filed motion to intervene and protest one day after the date established by the FERC. The PUCN requested the FERC to hold the proceedings in abeyance to allow the PUCN more time to review SPPC's divestiture plan filing.
The Company filed an Answer to the protests filed on the tariff on May 5, 1999. In response to the PUCN request, the Company requested that the FERC rule on the Company's tariff by November 30, 1999 (rather than September 30, 1999) to allow the PUCN more time. The Company also provided clarification in response to other protests.
On July 20, 1999, the Company filed a motion to expedite the FERC's consideration of the tariff. The motion requested that the FERC approve the tariff by September 30, 1999 since the PUCN issues were resolved.
On November 1, the FERC dismissed the tariffs, apparently misinterpreting the agreement reached with the PUCN on the tariffs. On November 22, 1999 the Company filed a request for rehearing of the FERC's November 1 order dismissing the tariffs. The rehearing request explains how the FERC erred in dismissing the tariff. On December 17, 1999, the FERC issued an Order Granting Rehearing for Further Consideration. A decision is expected in 2000.
Independent Scheduling Administrator (ISA)
On July 23, 1999, the Company and Nevada Power submitted a filing to establish the Mountain West ISA (Docket ER97-3719). The proposal centers on the formation of an interim ISA called Mountain West ISA, which will ensure the non- discriminatory treatment of transmission customer in two wholesale electricity markets; one in northern Nevada and one in southern Nevada. The formation of the ISA is viewed as an interim step in the move to broader regional restructuring of the electric service industry in the western United States.
Fifteen parties filed to intervene in the ISA filing. On September 17, 1999, the Company, Nevada Power and the Mountain West ISA filed answers to the protests filed on the ISA filing. The California ISO filed an answer to the Company's and Nevada Power's response to their protest on September 28, 1999.
On January 27, 2000, the FERC issued an order approving with modifications the Mountain West ISA proposal. The PUCN is continuing to review aspects of the filing, including funding for the Mountain West ISA.
YEAR 2000 ISSUES - ----------------
The Company uses business application software programs and relies on computing infrastructure that includes embedded systems that have a Year 2000 (Y2K) affect on the Company. In many cases, the Company's software programs and embedded systems used two-digit years that recognized a date using `00' as the year 1900 rather than the year 2000. This could have resulted in the computer or device shutting down, performing incorrect computations, or performing in an inconsistent manner.
In 1996, the Company established its Y2K project to address Y2K issues. The project's scope included: (1) business application systems (including, but not limited to, customer information and billing) and financial systems (including time reporting, payroll, general ledger, accounts payable and purchasing, and end-user developed systems); (2) embedded systems (including equipment that operates or controls operating facilities such as power plants, electric transmission and distribution, water, gas, telecommunications, and information technology systems); (3) customer, vendor, and supplier relationships; and (4) testing and contingency planning.
Business Application Systems
The initial focus for the Y2K project team was on the business application systems. In the fall of 1996 the Company purchased software assessment tools and completed its inventory and code assessment for its mainframe business systems. The Company developed and strictly adhered to a Y2K methodology that included unit, system wide and Y2K date specific testing. As of November 1999 the Company had completed the assessment and modification of 100% of its business systems.
The Company experienced few business systems errors due to Y2K in the first week of 2000. The Company utilized quick action response teams and corrected all known problems without any material impact to its customers.
Embedded Systems
The Company hired an outside engineering consultant, Network Systems Engineering Corporation (NSEC), to assist the Company's staff in conducting a thorough and comprehensive inventory of its embedded systems at the component level. All systems were inventoried and assessed for Y2K date impacts. This inventory identified over 2,500 potentially date sensitive items. The Company and NSEC contacted all manufacturers of those components that they have identified as critical to operations and continues to contact other manufacturers of embedded system components to determine if their components were Y2K ready. As of June 30, 1999, 100% of the Company's mission critical embedded systems were Y2K ready.
Vendors and Suppliers
The Company contacted, in writing, all vendors and suppliers of products and services that it considered critical to its operations. These contacts included, but were not limited to, suppliers of interstate transportation capacity for coal supplies, natural gas producers, financial institutions, and telephone service providers. The Company met one on one with several of its critical vendors and suppliers to assess their Y2K readiness. From these meetings, the Company felt that these vendors and suppliers had a viable Y2K program.
There were no major vendor or supplier problems related to Y2K. During the first week of 2000, there were two vendor software licensing date problems and were corrected the same day they occurred.
Major Customers
The Company met face to face with many of its major customers to share its progress on Y2K. Also discussed at these meetings was the customer's Y2K readiness. There were no major customer issues related to the Y2K date rollover.
Contingency Planning
The Company's Y2K strategies included contingency planning for both business and embedded systems. The planning effort included critical Company areas such as electric generation, water, gas, telecommunications, building facilities, information technology, networks, vendors, suppliers, and operations personnel. Quick action response teams and additional Company personnel were available for the century rollover. Additionally, the Company's Emergency Operations Center (EOC) was activated for the century rollover. All Company contingency plans were completed as of September 30, 1999.
As the result of a non-eventful year 2000 rollover, it was not necessary to invoke Company contingency plans.
As part of its normal business practice, the Company maintains plans to follow during emergency circumstances.
Potential Risks
With respect to its internal operations, those over which the Company has direct control, the Company believed the most significant potential risks from Y2K problems were: (1) its ability to use electronic devices to control and operate its generation, gas, water, telecommunication, transmission and distribution systems, (2) its ability to render timely bills to its customers, and (3) the ability to maintain continuous operations of its computer systems.
Based upon the smooth transition to year 2000, the Company believes the continued probability of such failures is low. The Company is monitoring the progress of these critical entities and contingency plans will remain in place to address the potential failure of an external party.
Effect on Operations
The Company had no significant impacts on fourth quarter 1999 operations as a result of Y2K problems.
The Company experienced no significant interruptions to operations or business systems related to Y2K problems during the actual date rollover period.
The Company feels that there will be minimal risks during the year 2000 and that any Y2K related problems will be minor and corrected immediately without effect on operations.
Financial Implications
With 100% of mission critical components tested, the Company anticipated and proved that the transition through critical Y2K dates had minimal impact on the Company's Electric, Gas, and Water
operations during year 2000 rollover period and during year 2000 and beyond. These results are reflected in reduced costs discussed below.
The Company had estimated that its total incremental expenditures for the Y2K effort, since it began identification of Y2K cost, would be approximately $5.9 million. This estimate has been reduced from amounts previously reported based on updated assessments of the project costs. Y2K costs include assessment, remediation, testing, and contingency planning activities. Of the total project costs $5.4 million was incurred through December 31, 1999.
Approximately $4.0 million of the expenditures are operating and maintenance expenses, and $1.4 million are capital expenditures. The Company anticipates that the remaining Y2K expenditures will be approximately $100,000 for the 2000 business year. Final archiving of hard copy and electronic documentation, project review, and project shutdown will be completed in the first quarter of 2000.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has evaluated its risk related to financial instruments whose values are subject to market sensitivity. The only such instruments are Company issued fixed-rate and variable-rate debt, and preferred securities obligations which were as follows as of December 31, 1998 and 1999.
Long-term debt (Dollars in Thousands):
* Weighted daily average rate for month ended December 31, 1998 and 1999
Commodity Price Risk
SPPC is exposed to commodity price risk primarily related to changes in the market price of electricity as well as changes in fuel costs incurred to generate electricity. Although the potential exists for market risk within these contracts, the future costs are expected to be covered in the rate making process. SPPC's gas local distribution company is also protected by deferred energy accounting procedures (See Note 1 to the Financial Statements). These risks are not expected to expose SPPC to significant market risks related to commodity price fluctuations. As a result of the merger of SPR and NVP, the Board of Directors of the combined company requested that management review and consolidate the Risk Management Programs of the two utilities. SPPC and NVP engaged the services of a leading energy risk management consulting company to review existing policies and procedures, make any recommendations to the existing Program, and implement the revised Program. That project led SPPC to adopt revised policies and procedures, implement new IT systems to track any commodity price exposures, as well as focus on potential "Earnings-at-Risk" which measures the amount of exposure that SPPC have to energy prices at any point in time.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholder of Sierra Pacific Power Company Reno, Nevada
We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of Sierra Pacific Power Company and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of income, common shareholder's equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP Reno, Nevada February 29, 2000
SIERRA PACIFIC POWER COMPANY CONSOLIDATED BALANCE SHEETS (Dollars in Thousands)
The accompanying notes are an integral part of the financial statements.
SIERRA PACIFIC POWER COMPANY CONSOLIDATED STATEMENTS OF INCOME (Dollars in Thousands)
The accompanying notes are an integral part of the financial statements.
SIERRA PACIFIC POWER COMPANY CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDER'S EQUITY (Dollars in Thousands)
The accompanying notes are an integral part of the financial statements.
SIERRA PACIFIC POWER COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands)
The accompanying notes are an integral part of the financial statements.
SIERRA PACIFIC POWER COMPANY CONSOLIDATED STATEMENTS OF CAPITALIZATION (Dollars in Thousands)
The accompanying notes are an integral part of the financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The significant accounting policies for both utility and non-utility operations are as follows:
General
Sierra Pacific Power Company (SPPC or the Company), a wholly-owned subsidiary of Sierra Pacific Resources (SPR), is a regulated public utility engaged principally in the generation, purchase, transmission, distribution, and sale of electric energy. It provides electricity to approximately 302,000 customers in a 50,000 square mile territory including western, central, and northeastern Nevada, including the cities of Reno, Sparks, Carson City and Elko, and a portion of eastern California, including the Lake Tahoe area. SPPC also provides water and gas service in the cities of Reno and Sparks, Nevada, and environs. In 1995, SPPC formed two subsidiaries for the specific purpose of forming a partnership to operate the Pinon Pine gasifier facility. These subsidiaries are Pinon Pine Corporation and Pinon Pine Investment Company. In February 1999, SPPC purchased GPSF-B, which owned the portion of the gasifier facility that was not already owned by SPPC. On July 29, 1996, SPPC formed a wholly-owned subsidiary, Sierra Pacific Power Capital I (Trust), for the purpose of completing a public offering of trust originated preferred securities. These subsidiaries are consolidated into the financial statements of SPPC, with all significant intercompany transactions eliminated. Refer to Note 4 of SPPC's consolidated financial statements for the stock issuance and Note 3 for the Pinon Pine Power Project.
SPPC maintains its accounts for electric and gas operations in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission, and for water operations, in accordance with the Uniform System of Accounts prescribed by the National Association of Regulatory Utility Commissioners.
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities. These estimates and assumptions also affect the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of certain revenues and expenses during the reporting period. Actual results could differ from these estimates.
Certain reclassifications have been made for comparative purposes but have not affected previously reported net income or common shareholder's equity.
Utility Plant
In addition to direct labor and material costs, the Company also charges the following to the cost of constructing utility plants: the cost of time spent by administrative employees in planning and directing construction work, property taxes, employee benefits (including such costs as pensions, postretirement and post-employment benefits, vacations and payroll taxes), and an allowance for funds used during construction (AFUDC).
The original cost of plant retired or otherwise disposed of and the cost of removal less salvage is generally charged to the accumulated provision for depreciation. The cost of current repairs and minor replacements is charged to operating expenses when incurred. The cost of renewals and betterments is capitalized.
Allowance For Funds Used During Construction and Capitalized Interest
As part of the cost of constructing utility plant, the Company capitalizes AFUDC. AFUDC represents the cost of borrowed funds and, where appropriate, the cost of equity funds used for construction purposes in accordance with rules prescribed by the FERC and the Public Utilities Commission of Nevada . AFUDC is capitalized in the same manner as construction labor and material costs, with an offsetting credit to "other income" for the portion representing the cost of equity funds and as a reduction of interest charges for the portion representing borrowed funds. Recognition of this item as a cost of utility plant is in accordance with established regulatory rate-making practices. Such practices permit the utility to earn a fair return on, and recover in rates charged for utility services, all capital costs. This is accomplished by including such costs in the rate base and in the provision for depreciation. The AFUDC rates used during 1999, 1998, and 1997 were 6.09%, 7.69% and 8.30%, respectively. As specified by the PUCN, certain projects were assigned a lower AFUDC rate due to specific low-interest-rate financings directly associated with those projects.
Depreciation
Depreciation is calculated using the straight-line composite method over the estimated remaining service lives of the related properties. The depreciation provision for 1999, 1998 and 1997, as authorized by the PUCN and stated as a percentage of the original cost of depreciable property, was approximately 3.14%, 3.31%, and 3.16%, respectively.
Cash and Cash Equivalents
Cash is comprised of cash on hand and working funds. Cash equivalents consist of high quality investments in money market funds. SPPC had no short- term investments in money market funds at December 31, 1999 and $12.4 million of short-term investments in money market funds at December 31, 1998.
Regulatory Accounting and Other Regulatory Assets
The Company's rates are currently subject to the approval of the PUCN and are designed to recover the cost of providing generation, transmission and distribution services. As a result, the Company qualifies for the application of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation", issued by the Financial Accounting Standards Board (FASB). This statement recognizes that the rate actions of a regulator can provide reasonable assurance of the existence of an asset and requires the capitalization of incurred costs that would otherwise be charged to expense where it is probable that future revenue will be provided to recover these costs. SFAS No. 71 prescribes the method to be used to record the financial transactions of a regulated entity. The criteria for applying SFAS No. 71 include the following: (i) rates are set by an independent third party regulator, (ii) approved rates are intended to recover the specific costs of the regulated products or services, and (iii) rates that are set at levels that will recover costs can be charged to and collected from customers. SFAS No. 101, "Regulated Enterprises-Accounting for the Discontinuation of Application of FASB Statement No. 71," requires that an enterprise whose operations cease to meet the qualifying criteria of SFAS No. 71, discontinue the application of that statement by eliminating the effects of any actions of regulators that had been previously recognized.
In 1997, the Emerging Issues Task Force (EITF) released Issue 97-4. In doing so, it reached a consensus that a utility subject to a deregulation plan for its generation business should stop applying SFAS No. 71 to the generating portion of its business no later than the date when a deregulation plan with sufficient detail is known. EITF 97-4 also reached a consensus that regulatory assets and liabilities that originated in a portion of the business that is discontinuing its application of SFAS No. 71, should be evaluated on the basis of where (that is, the portion of the business in which) the regulated cash flows to realize and settle them will be derived. The result of the consensus is that there is no elimination of regulatory assets which the deregulatory legislation or rate order specifies collection of, if the regulatory assets are recoverable through a portion of the business which remains subject to SFAS No. 71.
In conformity with SFAS No. 71, the accounting for the Company conforms to generally accepted accounting principles as applied to regulated public utilities and as prescribed by the agencies and commissions of the jurisdictions in which they operate. In accordance with these principles, certain costs that would otherwise be charged to expense or capitalized as plant costs are deferred as regulatory assets based on expected recovery from customers in future rates. Management's expected recovery of deferred costs is based upon specific rate- making decisions or precedent for each item. The following other regulatory assets were included in the consolidated balance sheets as of December 31 (dollars in thousands):
* Under the terms of the merger stipulation with the PUCN, three years after the start of retail competition in the State of Nevada, the Company is required to file a general rate case that would give the Company the opportunity to recover the costs of the merger. The amortization period for these costs will be determined at the time of the general rate case filing.
Currently, the electric utility industry is predominantly regulated on a basis designed to recover the cost of providing electric power to its retail and wholesale customers. If cost-based regulation were to be discontinued in the industry for any reason, including competitive pressure on the cost-based prices of electricity, profits could be reduced, and utilities might be required to reduce their asset balances to reflect a market basis less than cost. Discontinuance of cost-based regulation would also require affected utilities to write off their associated regulatory assets. Management cannot predict the potential impact, if any, of these competitive forces on the Company's future financial position and results of operations.
Deferral of Energy Costs
Nevada and California statutes permit regulated utilities to, from time-to- time, adopt deferred energy accounting procedures, which record as deferred energy costs the difference between actual fuel expense and fuel revenues. Under regulations adopted by the PUCN, deferred energy rates are revised at least every 12 months to recapture the accumulated deferred balance over a future period. The intent of these procedures is to ease the effect of fluctuations in the cost of purchased gas, fuel and purchased power.
During 1999 SPPC did not employ deferred energy accounting procedures, but has resumed those procedures for natural gas operations as of January 1, 2000.
Federal Income Taxes and Investment Tax Credits
SPR and its subsidiaries file a consolidated federal income tax return. Current income taxes are allocated based on SPR's and each subsidiary's respective taxable income or loss and investment tax credits as if each subsidiary filed a separate return. Deferred taxes are provided on temporary differences at the statutory income tax rate in effect as of the most recent balance sheet date.
SPPC accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires recognition of deferred tax liabilities and assets for the future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.
For regulatory purposes, SPPC is authorized to provide for deferred taxes on the difference between straight-line and accelerated tax depreciation on post-1969 utility plant expansion property, deferred energy, and certain other differences between financial reporting and taxable income, including those added by the Tax Reform Act of 1986 (TRA). In 1981, SPPC began providing for deferred taxes on the benefits of using the Accelerated Cost Recovery System for all post-1980 property. In 1987, the TRA required SPPC to begin providing deferred taxes on the benefits derived from using the Modified Accelerated Cost Recovery System.
Investment tax credits are no longer available to SPPC. The deferred investment tax credits are being amortized over the estimated service lives of the related properties.
Revenues
Operating revenues include unbilled utility revenues earned (service has been delivered, but not yet billed by the end of the accounting period). These amounts are also included in accounts receivable.
Recent Pronouncements of the FASB
In June 1998, the FASB issued SFAS No. 133, entitled "Accounting for Derivative Instruments and Hedging Activities". This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position, and measure those instruments at fair value. In May 1999, members of the FASB agreed to delay the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000, and accordingly, the Company is required to adopt the statement effective January 1, 2001. The Company is still assessing the impact of SFAS No. 133 on its financial condition and results of operations.
NOTE 2. REGULATORY ACTIONS
Nevada Matters
On April 30, 1999, the Company filed its second compliance filings related to the 1997 rate stipulation The filings provide a calculation of the Company electric and gas earnings in excess of a 12 % return on equity (ROE). Any earnings in excess of 12 % ROE are shared 50/50 between shareholders and customers. On August 19, 1999, the Commission approved a stipulation between the Company, Staff, and the UCA, which rebated in 1999 $7.34 million and $2.0 million to electric and gas customers, respectively. Based on 1999 operating results, the Company anticipates it may make refunds to customers. Appropriate reserves have been recorded to reflect any anticipated refunds.
California Matters
On February 18, 1999, the California Public Utility Commission (CPUC) approved the Company's proposed Revenue Cycle Services Credits (RCSC) application filed February 2, 1998. The RCSC addresses meter ownership, meter services, meter reading, and billing and applies to customers who select their provider of a revenue cycle service.
On April 9, 1999, the Company made a compliance tariff filing which reflects the approved credits.
On April 5, 1999, the CPUC approved the Company's proposed unbundled rates effective back to June 1, 1998.
FERC Matters
On March 30, 1999, the Company filed an application with the FERC to increase its Open Access Transmission rates. On October 12, 1999, the Company filed an Offer of Partial Settlement which resolved all issues with the exception of pricing to the Mines and to the City of Fallon. On November 3, the Partial Settlement was certified to the FERC. A status report on the two remaining issues was filed on January 11, 2000. On January 31, 2000, the FERC approved the Partial Settlement.
On March 31, 1999, the Company filed an application with the FERC for approval of generation rates, terms and conditions under which the new owners of the Company's generation would operate after divestiture. The FERC dismissed the application on November 1, 1999, apparently misinterpreting the agreement reached between the Company and the PUCN. The Company filed a request for rehearing and on December 17, 1999, the FERC issued an Order Granting Rehearing for Further Consideration. A decision is expected in 2000.
NOTE 3. JOINTLY OWNED FACILITIES
Valmy
SPPC and Idaho Power Company each own an undivided 50% interest in the Valmy generating station, with each company being responsible for financing its share of capital and operating costs. SPPC is the operator of the plant for both parties.
SPPC's share of direct operation and maintenance expenses for Valmy is included in the accompanying consolidated statements of income.
The following schedule reflects SPPC's 50% ownership interest in jointly owned electric utility plant at December 31, 1999 (dollars in thousands):
Pinon Pine
Pinon Pine Corp. and Pinon Pine Investment Co., subsidiaries of SPPC, own 25% and 75% of a 38% interest in Pinon Pine Company, L.L.C. GPSF-B, a Delaware corporation formerly owned by General Electric Capital Corporation (GECC) and now owned by SPPC, owns the remaining 62% as of February 1999. The LLC was formed to take advantage of federal income tax credits associated with the alternative fuel (syngas) produced by the coal gasifier available under (S) 29 of the Internal Revenue Code. The entire project, which includes an LLC-owned gasifier and an SPPC-owned power island and post-gasification facility to partially cool and clean the syngas, is referred to collectively as the Pinon Pine Power Project.
SPPC has a funding arrangement with the Department of Energy (DOE). Under the agreement, the DOE will provide funding towards the construction of the project, and towards the operating and maintenance costs of the facility. The DOE has committed $168 million of funding for Pinon construction and operation costs. The DOE provided funding for approximately 53% of the estimated construction cost and half of the operating and fuel expenses through December 31, 1999. Additional funding will be provided until the commitment is expended. A dispute has arisen with the DOE regarding the historical and future funding of natural gas costs. In February 1999, the DOE informed SPPC it will not fund the remaining $14 million under the cooperative agreement until the dispute is resolved. On November 2, 1999, SPPC reached final agreement with the DOE regarding the allowability of previously incurred natural gas costs. The agreement also redefines the cooperative agreement performance period and the responsibilities of both parties through the remainder of the
agreement. The period of performance is extended until January 1, 2001 or until the facility is sold or operational control is transferred. The DOE agrees to share past fuel costs and future natural gas costs used to fuel the gas combustion turbine during periods when air extraction from the process is directed to the gasifier island. Estimated construction start-up and commissioning costs for Pinon, including the DOE's portion are approximately $301.5 million, which includes permitting taxes, start-up commissioning, operator training and Allowance for Funds Used During Construction. DOE funding for construction through December 1999 is $161.4 million.
Construction began on the project in February 1995, following resource plan approval and the receipt of all permits and other approvals. The natural gas portion (combined cycle combustion turbine) was satisfactorily completed and placed in service December 1, 1996. The balance of the plant was completed in June 1998. The construction of the gasifier portion of the project overran the fixed contract price by approximately 12% or $12.6 million. The overrun is primarily due to redesign issues, resolving technical issues relative to start up and other costs due to a later than anticipated completion date. To date, SPPC has not been successful in obtaining sustained operation of the gasifier but work continues to identify problem areas and redesign solutions which will likely require additional capital expenditures. Due to the problems noted above, SPPC and Foster Wheeler settled on a portion of the cost overrun and have entered into an alternative dispute resolution.
SPPC had to satisfy certain performance requirements as part of the construction agreement with the LLC. The initial performance warranty required that the gasifier attain an average capacity factor of 30% during 1997, regardless of delays in the in-service date. Since the gasifier was not in service in 1997, the certain performance warranties required by the contract were not met. Consequently, SPPC paid GECC $2.8 million as satisfaction of the performance obligation.
NOTE 4. PREFERRED STOCK AND PREFERRED SECURITIES
All issues of preferred stock are superior to SPR common stock with respect to dividend payments (which are cumulative) and liquidation rights. SPPC's Restated Articles of Incorporation, as amended on August 19, 1992, authorize an aggregate total of 11,780,500 shares of preferred stock at any given time.
On July 29, 1996, the Trust, a wholly-owned subsidiary of SPPC, issued $48.5 million (1,940,000 shares) of 8.60% Trust Originated Preferred Securities (the Preferred Securities). SPPC owns all the common securities of the Trust; 60,000 shares totaling $1.5 million (Common Securities). The Preferred Securities and the Common Securities (the Trust Securities) represent undivided beneficial ownership interests in the assets of the Trust. The existence of the Trust is for the sole purpose of issuing the Trust Securities and using the proceeds thereof to purchase from SPPC its 8.60% Junior Subordinated Debentures due July 30, 2036, in a principal amount of $50 million. The sole asset of the Trust is SPPC's junior subordinated debentures. SPPC's obligations provide a full and unconditional guarantee of the Trust's obligations under the Preferred Securities.
The Preferred Securities of Sierra Pacific Power Capital I are redeemable only in conjunction with the redemption of the related 8.60% junior subordinated debentures. The junior subordinated debentures will mature on July 30, 2036, and may be redeemed, in whole or in part, at any time on or after July 30, 2001, or at any time in certain circumstances upon the occurrence of a tax event. A tax event occurs if an opinion has been received from tax counsel that there is more than an insubstantial risk that: the Trust is, or will be subject to federal income tax with respect to interest accrued or received on the junior subordinated debentures; the Trust is, or will be subject to more than a de minimis amount of other taxes, duties or other governmental charges; interest payable by SPPC to the Trust on the junior subordinated debentures is not, or will not be, deductible, in whole or in part for federal income tax purposes.
Upon the redemption of the junior subordinated debentures, payment will simultaneously be applied to redeem preferred securities having an aggregate liquidation amount equal to the aggregate principal amount of the Junior Subordinated Debentures. The preferred securities are redeemable at $25 per preferred security plus accrued dividends.
On November 1, 1999, SPPC paid $23.5 million, par value and premium, to redeem Series A, $2.44 Dividend (4.88%), Series B, $2.36 Dividend (4.72%) and Series C, $3.90 Dividend (7.8%).
The following table indicates the number of shares outstanding at December 31 of each year and the dollar amount thereof. The difference between total shares authorized and the amount outstanding represents undesignated shares authorized but not issued.
NOTE 5. TAXES
The net deferred federal income tax liability consists of deferred federal income tax liabilities less related deferred federal income tax assets, as shown (in thousands of dollars):
The Company's balance sheets contain a net regulatory tax asset of $27.7 million at December 31, 1999 and $26.7 million at December 31, 1998. The net regulatory asset consists of future revenue to be received from customers (a regulatory tax asset) of $65.5 million at December 31, 1999 and $65.6 million at December 31, 1998, due to flow through of the tax benefits of temporary differences. Offset against these amounts are future revenues to be refunded to customers (a regulatory tax liability), consisting of $17.9 million at December 31, 1999 and $18.5 million at December 31, 1998, due to temporary differences for liberalized depreciation at rates in excess of current tax rates, and $20.0 million at December 31, 1999 and $20.4 million at December 31, 1998 due to temporary differences caused by the investment tax credit. The regulatory tax liability for temporary differences related to liberalized depreciation will continue to be amortized using the average rate assumption method required by the Tax Reform Act of 1986. The regulatory tax liability for temporary differences caused by the investment tax credit will be amortized ratably in the same fashion as the deferred investment credit.
NOTE 6. LONG-TERM DEBT
Substantially all utility plant is subject to the lien of the SPPC indenture under which the first mortgage bonds are issued.
On June 17, 1998, SPPC redeemed $5 million of 8.65% First Mortgage Bonds before the 2002 due date.
In December 1998, SPPC issued $35 million principal amount of collateralized Medium-Term Notes, Series D, consisting of a three year non- callable note, due in 2001, with an interest rate of 5.47% and five year non- callable notes, due in 2003, with interest rate ranging from 5.50% to 5.59%. For all notes, interest is payable in semi-annual payments. The proceeds to SPPC from the sale of the notes was used for general corporate purposes including but not limited to: the acquisition of property; the construction, completion, extension or improvement of facilities; or discharge or refunding of obligations, including short-term borrowings.
On April 9, 1999, the Company sold the right to receive payments made in respect of Transition Property as defined by the Offering Circular dated March 30, 1999, to SPPC Funding LLC, a Delaware special purpose limited liability company whose sole member is the Company, in exchange for the proceeds of the SPPC Funding LLC Notes, Series 1999-1 (the Underlying Notes). SPPC Funding LLC then issued and sold the Underlying Notes to the California Infrastructure and Economic Development Bank Special Purpose Trust SPPC-1 (the Trust) in exchange for the proceeds of the sale of the Trust's $24.0 million 6.4% Rate Reduction Certificates, Series 1999-1 (the Certificates). The Trust, which had been established by the California Infrastructure and Economic Development Bank, issued and sold the Certificates in a private placement pursuant to Rule 144A under the Securities Act of 1933, as amended. The Certificates are one of a series of rate reduction certificates that may be issued from time to time by the Trust and sold to investors upon terms determined at the time of sale.
On July 12, and July 16, 1999, respectively, $10 million of the 6.86% and $20 million of the 6.83% of the Series C, collateralized Medium-Term Notes matured.
On September 17, 1999, the Company issued $100,000,000 Floating Rate Notes, due October 13, 2000. Interest on the Notes is payable quarterly commencing on December 15, 1999. The interest rate on the Notes for each interest period to maturity is a floating rate, subject to adjustment every three months. The quarterly rate is equal to the London InterBank Offered Rate for three-month U.S. dollar deposits (LIBOR) plus a spread of 0.75%. These Notes will not be entitled to any sinking fund and will be redeemable in whole, without premium at the option of the Company, beginning on March 15, 2000 and on the 15th day of each month thereafter. The proceeds of this financing were used to pay down commercial paper.
SPPC's annual amount of maturities for long-term debt is as follows (dollars in thousands):
2000 $102,755 2001 19,620 2002 2,626 2003 20,632 2004 2,621 ---------- 2000-2004 148,254 Thereafter 579,931 -----------
Total $728,185
NOTE 7. FAIR VALUE OF FINANCIAL INSTRUMENTS
The December 31, 1999 carrying amount for cash and cash equivalents, current assets, accounts receivable, accounts payable and current liabilities approximates fair value due to the short-term nature of these instruments.
The total fair value of SPPC's long-term debt at December 31, 1999, is estimated to be $607.1 million (excluding current portion) based on quoted market prices for the same or similar issues or on the current rates offered to SPPC for debt of the same remaining maturities. The total fair value (excluding current portion) was estimated to be $641.9 million as of December 31, 1998.
NOTE 8. SHORT-TERM BORROWINGS
In January of 1999 the Company revised its credit facilities resulting in a $150 million 364-day bank facility, and a $50 million revolving credit facility to support commercial paper activity.
On July 28, 1999 the Company revised its credit facilities resulting in a $150 million 364-day credit facility to support commercial paper activity. This facility may be used for working capital and general corporate purposes, including commercial paper backup. This credit facility will expire on July 28, 2000.
At December 31, 1999, SPPC's short-term debt was $109.6 million comprised entirely of commercial paper at an average interest rate of 6.54%.
The other subsidiaries of SPPC have no outstanding short-term borrowings at this time.
NOTE 9. DIVIDENDS
The Restated Articles of Incorporation of SPPC and the indentures relating to the various series of its First Mortgage Bonds contain restrictions as to the payment of dividends on its common stock. Under the most restrictive of these limitations, approximately $76 million of retained earnings were available at December 31, 1999 for the payment of common stock cash dividends.
NOTE 10. STOCK COMPENSATION PLANS
At December 31, 1999, Sierra Pacific Resources (SPR), SPPC's parent company, had several stock-based compensation plans, which are described below. The Company applies Accounting Principals Board Opinion No. 25, Accounting for Stock Issued to Employees in accounting for its stock option plans. Accordingly, no compensation cost has been recognized for nonqualified stock options and the employee stock purchase plan. The total compensation cost that has been charged against income for the performance shares, dividend equivalents and the non-employee director stock plans was $0.7 million, $0.5 million, and $1.4 million for 1999, 1998 and 1997, respectively. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock Based Compensation. Had compensation cost for SPR's nonqualified stock options and the employee stock purchase plan been determined based on the fair value at the grant dates for awards under those plans consistent with the provisions of SFAS No. 123, SPPC's income applicable to common stock would have been decreased to the pro forma amounts indicated below:
SPR's executive long-term incentive plan for key management employees, which was approved by shareholders on May 16, 1994, provides for the issuance of up to 750,000 of SPR's common shares to key employees through December 31, 2003. The plan permits the following types of grants, separately or in combination: nonqualified and qualified stock options, stock appreciation rights, restricted stock, performance units, performance shares, and bonus stock. During 1999, 1998 and 1997, the Company issued only nonqualified stock options and performance shares under the long-term incentive plan.
Nonqualified stock options granted during 1999, 1998 and 1997 were granted at an option price not less than market value at the date of the grant (August 1, and January 1, 1999, January 1, 1998 and January 1, 1997, respectively). The January 1 options for 1999, 1998 and 1997 vest to the participants 33 1/3% per year over a three year period from the grant date, and may be exercised for a period not exceeding ten years from the date of the grant. The August 1, 1999 options vest to the participants 33 1/3% per year over a three year period beginning January 1, 2000, and may be exercised for a period not exceeding ten years from the date of the grant. The options may be exercised using either cash or previously acquired shares valued at the current market price, or a combination of both.
As a result of the merger with NVP on August 1, 1999, all shares outstanding as of that date, for January 1, 1999 grants and prior, were converted at a 1.44:1 ratio. The subsequent change in the exercise prices and the outstanding shares is reflected in all numbers shown for the applicable grants.
The fair value of each nonqualified option has been estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants issued in 1999, 1998, and 1997:
A summary of the status of SPR's nonqualified stock option plan as of December 31, 1999, 1998 and 1997, and changes during those years is presented below:
1. As a result of the merger, all options outstanding prior to August 1, 1999 were converted at a 1.44:1 ratio. The historical information has been adjusted to account for the related increase in shares.
The following table summarizes information about nonqualified stock options outstanding at December 31, 1999:
During 1999, 1998 and 1997, SPR granted performance shares in the following numbers and initial values, respectively: 27,765, 23,778 and 17,726 shares; and $26.00, $24.22 and $24.93 per share. These numbers reflect a 1.44:1 conversion as a result of the August 1, 1999 merger with Nevada Power Company. The actual number of shares earned by each participant is dependent upon SPR achieving certain financial goals over three-year performance periods. The value of performance shares, if earned, will be equal to the market value of SPR's common shares as of the end of the performance periods. SPR, at its sole discretion, may pay earned performance shares in the form of cash or in shares, or a combination thereof.
Simultaneous with the grant of both the nonqualified options and performance shares above, each participant was granted dividend equivalents for all performance share grants, and for 1996 and prior nonqualified option grants. Each dividend equivalent entitles the participant to receive a contingent right to be paid an amount equal to dividends declared on shares originally granted from the date of grant through the exercise date, or, in the case of performance shares, throughout the performance period. Additionally, in order for dividend equivalents to be paid on the performance shares, certain financial targets must be met. Dividend equivalents will be forfeited if options expire unexercised.
Under SPR's employee stock purchase plan, SPR is authorized to issue up to 400,162 shares of common stock to all of its employees with minimum service requirements. Under the terms of the plan, employees can choose twice each year to have up to 15% of their base earnings withheld to purchase SPR's common stock. The purchase price of the stock is 90% of the market value on the offering commencement date. Employees can withdraw from the plan at any time prior to the exercise date. Under the plan, SPR sold 21,888, 15,282 and 17,822 shares to employees in 1999, 1998 and 1997, respectively. Proforma compensation cost has been estimated for the employees' purchase rights on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for 1999, 1998 and 1997, respectively.
SPPC and SPR share the same directors and, as a result, the directors are compensated according to the SPR non-employee director stock plan. The plan provides that a portion of the outside directors' annual retainer be paid in SPR stock. Under the current plan the annual retainer for non-employee directors is $30,000, and the minimum amount to be paid in stock is $20,000 per director. During 1999, 1998 and 1997, SPR granted the following total shares and related compensation to directors in SPR stock, respectively: 4,741, 6,391 and 8,208 shares; and $150,000, $233,250, and $230,833. Nevada Power directors, who were appointed to the SPR Board of Directors after the merger, were not issued any stock options for 1999. Stock options were granted only to the remaining SPR directors. In 2000, all directors will be eligible for stock option grants. The Company also paid out phantom stock shares to retiring directors in the amount of $1,222,110.
NOTE 11. RETIREMENT PLAN AND POST RETIREMENT BENEFITS
Pension and other postretirement benefit plans
SPR has pension plans covering substantially all employees. Benefits are based on years of service and the employee's highest compensation prior to retirement. SPR also has a postretirement plan, which provides medical and life insurance benefits for certain retired employees. The following table provides a reconciliation of benefit obligations, plan assets and the funded status of the plans. The non-qualified Supplemental Executive Retirement Plan (SERP) is included as part of pension benefits. This reconciliation is based on a September 30 measurement date and reflects the merger of SPR and NVP during 1999 under purchase accounting. SPPC is a member of the controlled group in the multi-employer plans.
The following amounts pertain to the non-qualified SERP plan covering certain current and former employees. The projected benefit obligation and accumulated benefit obligation for pension plans with accumulated benefit obligations in excess of the plan assets were $18.5 million and $15.7 million, respectively, at the end of the year and $9.7 million and $8.3 million, respectively, at the beginning of the year.
Amounts for pension and postretirement benefits recognized in the consolidated balance sheets consist of the following:
The weighted-average actuarial assumptions as of December 31 were as follows:
The Company has assumed a health care cost trend rate of 6% for 1999 and all future years.
Net periodic pension and other postretirement benefit costs include the following components:
A regulatory asset was booked to offset the net effect of special termination benefits and curtailment costs incurred in connection with the merger of the two companies. The portion of the net periodic benefit cost recognized for pension benefits by SPPC during 1999 was $.9 million. The portion for other postretirement benefits recognized by SPPC was $.9 million.
The assumed health care cost trend rate has a significant effect on the amounts reported. A one percentage point change in the assumed health care cost trend rate would have had the following effects on 1999 service and interest costs and the accumulated postretirement benefit obligation at year end:
NOTE 12. POSTEMPLOYMENT BENEFITS
During 1999, SPPC offered a severance program to non-bargaining-unit employees which provided for severance pay and medical benefits continuation totaling $6.4 million and $0.2 million respectively. As of December 31, 1999, as approved by the PUCN, this cost was deferred as a regulatory asset. The order approving the merger of SPR and NVP, by the PUCN, directed SPR to defer merger costs (including severance and related benefits) for a three year period. The deferral of these costs is intended to allow adequate time for the anticipated savings from the merger to develop. At the end of the three year period, the order instructs the Company to propose an amortization period for these costs, and allows the Company to recover the costs to the extent that they are offset by merger savings. At December 31, 1999, the remaining liability for unpaid severance was $3.0 million.
NOTE 13: COMMITMENTS AND CONTINGENCIES
The Company's estimated cash construction expenditures for the year 2000 and the five-year period 2000-2004 are $137.7 million and $679.8 million, respectively.
The Company has several long-term contracts for the purchase of electric energy and/or capacity. These contracts expire in years ranging from 2000 to 2009. Estimated future commitments under non-cancelable agreements with initial terms of one year or more at December 31, 1999 were as follows (dollars in thousands):
The Company has several long-term contracts for the purchase and transportation of coal and gas. These contracts expire in years ranging from 2000 to 2015. Estimated future commitments under non-cancelable agreements with initial terms of one year or more at December 31, 1999 were as follows (dollars in thousands):
The Company has an operating lease for its corporate headquarters building. The primary term of the lease is 25 years, ending in 2010. The current annual rental is $5.4 million, which amount remains constant until the end of the primary term. The lease has renewal options for an additional 50 years.
The total rental expense under all operating leases, excluding fuel transportation contracts, was approximately $10.0 million in 1999, $7.0 million in 1998 and $6.9 million in 1997.
Estimated future minimum cash payments, including the Company's headquarters building, under non-cancelable operating leases with initial terms of one year or more at December 31, 1999 were as follows (dollars in thousands):
In September 1994, Region VII of the United States Environmental Protection Agency (EPA) notified the Company that the Company was being named as a potentially responsible party (PRP) regarding the past improper handling of Polychlorinated Biphenyls (PCBs) by PCB Treatment, Inc., located in Kansas City, Kansas, and Kansas City, Missouri (the Sites). The EPA is requesting that the Company voluntarily pay an undefined (pro rata) share of the ultimate clean-up costs at the Sites. A number of the largest PRP's formed a steering committee, which is chaired by the Company. The responsibility of the Committee is to direct clean-up activities, determine appropriate cost allocation, and pursue actions against recalcitrant parties, if necessary. The EPA issued an administrative order on consent requiring signatories to perform certain investigative work at the Sites. The steering committee retained a consultant to prepare an analysis regarding the Sites. The site evaluations have been completed. The EPA is developing an allocation formula to allocate the remediation costs. The Company has recorded preliminary liability for the Sites of $650,000, of which approximately $150,000 has been spent through December 31, 1999. Once evaluations are completed, the Company will be in a better position to estimate and record the ultimate liabilities for the Sites.
Additionally, the Company has four wells which currently exceed the federal drinking water standard for naturally occurring arsenic concentrations. Production from three of these wells continues by blending water treated at the Glendale Water Treatment Plant. The fourth well is out of service pending treatment. The Company's water laboratory research staff is developing options to assure that the Company is prepared to meet new arsenic standards. The new Arsenic regulations will be promulgated in 2000 and the proposed regulation is expected to require action on 17 of the 25 wells serving the Company's system. Depending upon final rules from the EPA, the Company may incur between $70 million and $98 million by 2004 to meet the new standards.
As part of the Generation Divestiture process, SPPC conducted Phase I and Phase II Environmental Assessments for its Ft. Churchill, Tracy and Valmy Power Plants. Anticipated remediation cost is $150,000.
See Notes 1, 3, 4, 6, 8, 11, and 12 of SPPC's consolidated financial statements for additional commitments and contingencies.
SPPC, through the course of its normal business operations, is currently involved in a number of other legal actions, none of which has had or, in the opinion of management, is expected to have a significant impact on its financial position or results of operations.
NOTE 14. SEGMENT INFORMATION
The Company adopted FASB statement No. 131, Disclosure about Segments of an Enterprise and Related Information for its annual reports as of December 31, 1998. The Company operates three business segments providing regulated electric, natural gas and water service. Electric service is provided to northern Nevada and the Lake Tahoe area of California. Natural gas and water services are provided in the Reno-Sparks area of Nevada. Other segment information includes segments below the quantitative threshold for separate disclosure.
Information as to the operations of the different business segments is set forth below based on the nature of products and services offered. The Company evaluates performance based on several factors, of which the primary financial measure is business segment operating income. The accounting policies of the business segments are the same as those described in the summary of significant accounting policies (Note 1). Intersegment revenues are not material.
Financial data for business segments is as follows (in thousands):
The reconciliation of segment assets to the consolidated total includes the following unallocated amounts:
NOTE 15. QUARTERLY FINANCIAL DATA (unaudited)
(Dollars in thousands):
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
(a) Directors
The following is a listing of all the current directors of SPPC and their ages as of December 31, 1999. There are no family relationships among them. Directors serve three-year terms with four (or five) terms of office expiring at each Annual Meeting, or until their successors have been elected and qualified.
Directors whose terms expire in 2000:
Edward P. Bliss, 67
Consultant to Scudder Kemper Investments Co; retired partner, Loomis, Sayles & Company, Inc., an investment counsel firm in Boston, Massachusetts. He is also a Director of Seaboard Petroleum, Midland, Texas. Mr. Bliss has served as a Director of SPR since 1991, of SPPC since 1991, and was elected a Director of NVP in July 1999.
Mary Kaye Cashman, 48
Chief Executive Officer and Vice Chairman of the Board since 1995 of Cashman Equipment Company, one of the oldest and largest Caterpillar dealers in North America. She serves on the boards of the Nevada Test Site Development Corporation; Mackay School of Mines Advisory Board at the University of Nevada, Reno; Bishop Gorman High School Endowment Foundation; and McCaw Elementary School of Mines Foundation. Ms. Cashman has served as a Director of NVP since 1997, and was elected a Director of SPR and SPPC in July 1999. Ms. Cashman tendered her resignation as a Director on March 8, 2000.
Mary Lee Coleman, 62
President of Coleman Enterprises, a developer of shopping centers and industrial parks. She is also a director of First Dental Health. Ms. Coleman has served as a Director of NVP since 1980, and was elected a Director of SPR and SPPC in July 1999.
Jerry E. Herbst, 61
Chief Executive Officer of Terrible Herbst, Inc., a gas station, car wash, convenience store chain; and Herbst Supply Co., Inc., a wholesale fuel distributor; family-owned businesses for which he has worked since 1959. He is also a partner of the Coast Resorts (hotel and casino industry). Mr. Herbst has served as a Director of NVP since 1990, and was elected a Director of SPR and SPPC in July 1999.
Directors whose terms expire in 2001:
Theodore J. Day, 50
Senior Partner, Hale, Day, Gallagher Company, a real estate brokerage and investment firm. Mr. Day has served as a Director of SPPC since 1986, of SPR since 1987, and was elected a Director of NVP in July 1999. He is also a Director of the W.M. Keck Foundation.
James R. Donnelley, 64
Vice Chairman of the Board, R.R. Donnelley & Sons Company, since July 1990, and a Director of that company since 1976. Mr. Donnelley was R.R. Donnelley and Sons' Group President, Corporate Development from June 1987 to July 1990, and Group President, Financial Printing Services Group from January 1985 to January 1988. He is also a Director of Pacific Magazines & Printing Limited, and Chairman of National Merit Scholarship Corporation. Mr. Donnelley has served as a Director of SPR since 1987, of SPPC since 1992, and was elected a Director of NVP in July 1999.
John L. Goolsby, 57
Retired President and Chief Executive Officer of The Howard Hughes Corporation, a real estate investment and land development company. Mr. Goolsby became affiliated with The Howard Hughes Corporation in 1980 and served as President from 1988-1998. He is also a director of America West ---------------------------------- Holdings Corporation and Tejon Ranch Company. Mr. Goolsby has served as a ----------------------- Director of NVP since 1991, and was elected a Director of SPR and SPPC in July 1999.
Malyn K. Malquist, 47, President and Chief Executive Officer
Mr. Malquist was elected President, Chief Operating Officer, and a Director of SPR, and President, Chief Executive Officer, and a Director of NVP and SPPC upon the close of SPR's merger with NVP in July 1999. He was previously elected President and Chief Executive Officer of SPR and SPPC in January 1998. In February 1998, Mr. Malquist was elected to the additional position of Chairman. Mr. Malquist continued to hold the positions of Chairman and Chief Executive Officer until SPR's merger with NVP in July 1999. He was Senior Vice President - Distribution Services Business Group and Principal Operations Officer from August 1996 to January 1998. He served as Senior Vice President and Chief Financial Officer of SPR and SPPC from April 1994, when he joined SPR, until August 1996. Prior to joining SPR, Mr. Malquist was with San Diego Gas and Electric, where from 1978 he held various financial positions, including Treasurer and Vice President.
John F. O'Reilly, 54
Chairman and Chief Executive Officer of the law firm of Keefer, O'Reilly, Ferrario and Lubbers. Mr. O'Reilly is also Chairman and Chief Executive Officer of the O'Reilly Gaming Group and is Chairman of the Nevada Test Site Development Corporation. Mr. O'Reilly has served as a Director of NVP since 1995, and was elected a Director of SPR and SPPC in July 1999.
Directors whose terms expire in 2002:
Krestine M. Corbin, 62
President and Chief Executive Officer of Sierra Machinery, Incorporated since 1984 and a director of that company since 1980. She also serves on the Federal Reserve Bank Twelfth District Head Board. Ms. Corbin has served as a Director of SPR since 1991, of SPR since 1989, and was elected a Director of NVP in July 1999.
Fred D. Gibson, Jr., 72
Retired Chairman, President and Chief Executive Officer, but remains as a director, of American Pacific Corporation, a manufacturer of chemicals and pollution abatement equipment and a real estate developer. Mr. Gibson has been affiliated with American Pacific Corporation and its predecessor, Pacific Engineering & Production Co., since 1956. He is also a director of Cashman Equipment Company. Mr. Gibson has served as a Director of NVP since 1978, and was elected a Director of SPR and SPPC in July 1999.
James L. Murphy, 70
Certified Public Accountant and retired partner of and consultant to Grant Thornton L.L.P., an international accounting and management consulting firm. Mr. Murphy is the owner, independent trustee and general partner of several real estate development projects and numerous rental properties. He is also a retired Colonel in the United States Air Force Reserve. Mr. Murphy has served as a Director of SPPC since 1990, of SPR since 1992, and was elected a Director of NVP in July 1999.
Michael R. Niggli, 50, Chairman and Chief Executive Officer
Mr. Niggli was elected Chairman and Chief Executive Officer of SPR, and Chairman of NVP and SPPC, upon the close of SPR's merger with NVP in July 1999. He joined NVP as President and Chief Operating Officer in February 1998. He was appointed by NVP's Board of Directors as Chief Executive Officer effective February 23, 1999 and as Chairman on June 10, 1999. Prior to joining NVP, Mr. Niggli was Senior Vice President of the Custom Accounts Market Unit for Entergy, a New Orleans-based global energy company. Beginning in 1988, he also served at Entergy as Senior Vice President of Marketing and in Vice President positions for areas including fuels, strategic planning and customer service.
Dennis E. Wheeler, 57
Chairman, President and Chief Executive Officer of Coeur d'Alene Mines Corporation since 1986. Mr. Wheeler has served as a Director of SPR since 1990, of SPPC since 1992, and was elected a Director of NVP in July 1999.
All of the present Directors are Directors of SPR. Messrs. Malquist and Murphy are Directors of Lands of Sierra, Inc.; Messrs. Day and Malquist are Directors of Tuscarora Gas Pipeline Co.; Mr. Niggli is a Director of Sierra Pacific Communications; Mr. Malquist is a Director of Sierra Water Development Company, Sierra Gas Holdings Co., Pinon Pine Corp., and Pinon Pine Investment Co. All of the above listed companies are affiliates of SPPC with the exception of GPSF-B, Pinon Pine Corp., and Pinon Pine Investment Co, which are subsidiaries.
(b) Executive Officers
The following are current executive officers of the companies indicated and their ages as of December 31, 1999. There are no family relationships among them. Officers serve a term which extends to and expires at the annual meeting of the Board of Directors or until a successor has been elected and qualified:
Michael R. Niggli, 50, Chairman, Board of Directors
See description under Item 10(a), "Directors," page 83
Malyn K. Malquist, 47, President and Chief Executive Officer
See description under Item 10(a), "Directors," page 82.
Steven W. Rigazio, 45, Senior Vice President, Energy Delivery
Mr. Rigazio was elected Senior Vice President, Energy Delivery, in July 1999, and holds the same position with NVP. Previously he was Vice President, Finance and Planning, Treasurer, and Chief Financial Officer for NVP effective October 1993. Other NVP management positions include Vice President and Treasurer, Chief Financial Officer; Vice President, Planning; Director of System Planning; Manager of Rates and Regulatory Affairs; and Supervisor of Rates and Regulations. Mr. Rigazio has been with NVP since 1984.
William E. Peterson, 52, Senior Vice President, General Counsel and Corporate Secretary
Mr. Peterson was elected to his present position in January 1994, and holds the same positions with the Company's parent, SPR, and with NVP. He was previously Senior Vice President, Corporate Counsel for SPPC from July 1993 to January 1994. Prior to joining the Company in 1993, he served as General Counsel and Resident Agent for SPR since 1992, while a partner in the Woodburn and Wedge law firm. He was a partner in the Woodburn and Wedge law firm since 1982.
Mark A. Ruelle, 38, Senior Vice President, Chief Financial Officer and Treasurer
Mr. Ruelle was elected to his present position March 1, 1997, and holds the same positions with SPR and NVP. Prior to joining the Company, Mr. Ruelle was President of Westar Energy, a subsidiary of Western Resources in 1996, and before that, served as Vice President, Corporate Development for Western Resources in 1995. Mr. Ruelle was with Western Resources since 1987 and served in numerous positions in regulatory affairs, treasury, finance, corporate development, and strategy planning.
David G. Barneby, 54, Vice President, Generation
Mr. Barneby was elected Vice President, Generation, in July 1999, and holds the same position with NVP. Previously he was elected Vice President, Power Delivery for NVP effective October 1993. Mr. Barneby has been with NVP since 1965, and other management positions include Vice President, Generation; Manager, Generation Engineering and Construction; and Superintendent and Project Manager, Reid Gardner Unit 4.
Jeffrey L. Ceccarelli, 45, Vice President, Distribution Services, New Business
Mr. Ceccarelli was elected Vice President, Distribution Services, New Business, in July 1999, and holds the same position with NVP. He was elected Vice President, Distribution Services in February 1998. Prior to this, he served as Executive Director, Distribution Services. From January 1996 through January 1998, Mr. Ceccarelli was Director, Customer Operations. A civil engineer, Mr. Ceccarelli has been with the Company since 1972 and has held numerous management positions in operations, customer service, design and engineering.
Gloria T. Banks Weddle, 50, Vice President, Corporate Services
Ms. Weddle was elected Vice President, Corporate Services of the Company in July 1999, and was elected to the same position with NVP in January 1996. Previously she was Vice President, Human Resources and Corporate Services for NVP effective October 1993. Other NVP management positions include Vice President, Human Resources; Director of Human Resources; and Manager of Compensation and Benefits. Ms. Weddle has been with NVP since 1973.
Matt H. Davis, 44, Vice President, Distribution Services, Operations and Maintenance
Mr. Davis was elected Vice President, Distribution Services, Operations and Maintenance in July 1999, and holds the same position with NVP. Previously he was Director, System Planning and Division Director, System Planning and Operations for NVP. Mr. Davis has been with NVP since 1978 and has held various positions in the distribution, transmission, power contracts, and land services departments.
Mary O. Simmons, 44, Controller
Ms. Simmons was elected to her current position in June 1997, and holds the same position with SPR and NVP. Her previous positions include: Director, Water Policy and Planning; Director, Budgets and Financial Services; and Assistant Treasurer, Shareholder Relations for SPR. Ms. Simmons, a certified public accountant, has been with the Company since 1985.
Douglas R. Ponn, 52, Vice President, Governmental and Regulatory Affairs
Mr. Ponn was elected Vice President, Governmental and Regulatory Affairs in July 1999, and holds the same position with NVP. Previously he was Executive Director, Governmental and Regulatory Affairs. Mr. Ponn has been with the Company since 1986.
Mary Jane Reed, 53, Vice President, Human Resources
Ms. Reed was elected Vice President, Human Resources of the Company in January 1997, and was named to the same position with NVP in July 1999. She was previously Vice President, Human Resources Network Group for Bell Atlantic Corporation. Ms. Reed was with Bell Atlantic from 1968 - 1996 and in addition to the Vice President's position, served as Director of Human Resources, Assistant to the President for Consumer Affairs, and several other managerial positions.
Although all outstanding shares of the Company's common stock are held by SPR and it is SPR's common stock which is traded on the New York Stock Exchange, SPPC has four series of non-voting preferred stock still outstanding and registered under the Securities Exchange Act of 1934 ("the Act"). As a technical matter, the Company is thus deemed an "issuer" for purposes of the Act whose officers are required to make filings with respect to beneficial ownership, if any, of those non-voting preferred securities. The Company's officers, all of whom are currently reporting pursuant to Section 16(a) of the Act with respect to SPR's common stock, have now filed reports with respect to the Company's preferred stock, which reports show no past or current beneficial ownership of such preferred stock.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Table
The following table sets forth information about the compensation of each Chief Executive Officer that served in that position during 1999, and each of the four most highly compensated officers for services in all capacities to SPR and its subsidiaries.
1. Mr. Malquist was Chairman, President and Chief Executive Officer of Sierra Pacific Resources until the August 1, 1999 merger, at which time Mr. Malquist was named President and Chief Executive Officer of SPPC, and President and Chief Operating Officer of the parent, SPR; and Mr. Niggli was appointed Chairman of the Board of Directors and Chief Executive Officer of the parent, SPR, and Chairman of the Board of Directors of SPPC. 2. The amounts presented for 1999, and those for SPR executives in 1998 and 1997, represent incentive pay received pursuant to SPR's "pay for performance" team incentive plan approved by stockholders in May, 1994. The 1998 and 1997 amounts for the NVP executives represent pay received according to the NVP Short-Term Incentive Plan. 3. For the executives listed, with the exceptions noted below, these amounts represent Personal Time Off payouts. For Mr. Rigazio and Ms. Banks-Weddle, the Personal Time Off payouts were $17,881 and $5,596 respectively. Also included for these executives is the amount of those perquisites, which in the aggregate, exceeded the lesser of $50,000 or 10% of their salary and bonus. Due to a change in policies after the merger, the NVP executives were either given their company vehicle, or allowed to purchase it at a bargain price. The fair market value and the related tax gross-up, less any amount paid by the executive, if applicable, was included as compensation for the executives. Mr.
Rigazio and Ms. Banks-Weddle received, as compensation for their automobiles, $42,774 and $35,762 respectively. 4. As a result of the August 1, 1999 merger with Nevada Power Company, all SPR nonqualifying stock options outstanding as of that date were converted at a ratio of 1.44:1. For the pre-merger SPR executives, the 1999 option amounts include the number of new shares issued during the year, as well as the total number of shares that were converted for that employee. For 1998 and 1997, the amounts are the same as those presented in prior years and do not reflect the conversion. 5. The Long-term incentive payouts for the SPR executives, for the three-year period January 1, 1997 to December 31, 1999, was not approved for payment by the SPR Board of Directors; therefore, zero amounts are shown in 1999 for the pre-merger SPR executives. Nevada Power executives received a lump sum payout of all their performance shares as a result of the August 1, 1999 merger. 6. Amounts for All Other Compensation include the following for 1999:
Options/SAR Grants in Last Fiscal Year
The following table shows all grants of options to the named executive officers of SPR in 1999. Pursuant to Securities and Exchange Commission (SEC) rules, the table also shows the present value of the grant at the date of grant.
1. Under the SPR executive long-term incentive plan, the 1999 grants of nonqualifying stock options were made on January 1. One third of these grants vest annually commencing one year after the date of the grant. An additional grant of nonqualifying stock options was made on August 1, 1999, following the merger with Nevada Power Company. One third of these grants vest annually commencing January 1, 2001. 2. As a result of the August 1, 1999 merger with Nevada Power Company, all SPR nonqualifying stock options outstanding as of that date were converted at a ratio of 1.44:1. This resulted in the repricing of each grant and a change in the number of outstanding shares for each employee. According to SEC regulations, these repriced options are listed above as grants issued during the year. The vesting periods and expiration dates of the grants were not changed. 3. The total number of nonqualifying stock options granted to all employees in 1999 was 832,983. 4. The hypothetical grant date present values are calculated under the Black- Scholes Model. The Black-Scholes Model is a mathematical formula used to value options traded on stock exchanges. The assumptions used in determining the option grant date present value listed above include the stock's average expected volatility (17.77%), average risk free rate of return (5.94%), average projected dividend yield (4.30%), the stock option term (10 years), and an adjustment for risk of forfeiture during the vesting period (3 years at 3%). No adjustment was made for non- transferability.
Aggregated Option/SAR Exercises in Last Fiscal Year and FY-End Option/SAR Values
The following table provides information as to the value of the options held by the named executive officers at year end measured in terms of the closing price of Sierra Pacific Resources common stock on December 31, 1999.
(e) Pre-tax gain. Value of in-the-money options based on December 31, 1999 closing trading price of $17.31 less the option exercise price.
Long-Term Incentive Plans-Awards in Last Five Years
The executive long-term incentive plan (LTIP) provides for the granting of stock options (both nonqualified and qualified), stock appreciation rights (SARs), restricted stock performance units, performance shares and bonus stock to participating employees as an incentive for outstanding performance. Incentive compensation is based on the achievement of pre-established financial goals for SPR. Goals are established for total shareholder return (TSR) compared against the Dow Jones Utility Index and annual growth in earnings per share (EPS).
The following table provides information as to the performance shares granted to the named executive officers of Sierra Pacific Power Company in 1999. Nonqualifying stock options granted to the named executives as part of the LTIP are shown in the table "Option/SAR Grants in Last Fiscal Year."
1. The threshold represents the level of TSR and EPS achieved during the cycle which represents minimum acceptable performance and which, if attained, results in payment of 50% of the target award. Performance below the minimum acceptable level results in no award earned.
2. The target represents the level of TSR and EPS achieved during the cycle which indicates outstanding performance and which, if attained, results in payment of 100% of the target award. 3. The maximum represents the maximum payout possible under the plan and a level of TSR and EPS indicative of exceptional performance which, if attained, results in a payment of 175% of the target award.
All levels of awards are made with reference to the price of each performance share at the time of the grant.
Pension Plans
The following table shows annual benefits payable on retirement at normal retirement age 65 to elected officers under the Company's defined benefit plans based on various levels of remuneration and years of service which may exist at the time of retirement.
The Company's noncontributory retirement plan provides retirement benefits to eligible employees upon retirement at a specified age. Annual benefits payable are determined by a formula based on years of service and final average earnings consisting of base salary and incentive compensation. Remuneration for the named executives is the amount shown under "Salary" and "Incentive Pay" in the "Summary Compensation Table. Pension costs of the retirement plan to which the Company contributes 100% of the funding are not and cannot be readily allocated to individual employees and are not subject to Social Security or other offsets.
Years of credited service for the named executives are as follows: Mr. Niggli, 0.9; Mr. Malquist, 4.6; Mr. Rigazio, 14.5; Mr. Ruelle, 1.8; Mr. Peterson, 12.5; and Ms. Banks-Weddle, 19.8.
A supplemental executive retirement plan (SERP) and an excess plan are also offered to the named executive officers. The SERP is intended to ensure the payment of a competitive level of retirement income to attract, retain and motivate selected executives. The excess plan is intended to provide benefits to executive officers whose pension benefits under the Company's retirement plan are limited by law to certain maximum amounts.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Voting Stock
SPR owns 100% of the voting stock of SPPC.
The table below sets forth the shares of Sierra Pacific Resources Common Stock beneficially owned by each director, nominee for director, the Chief Executive Officer, and the four other most highly compensated executive officers. No director, nominee for director or executive officer owns, nor do the directors and executive officers as a group own, in excess of one percent of the outstanding Common Stock of SPR. Unless otherwise indicated, all persons named in the table have sole voting and investment power with respect to the shares shown.
(1) Mr. Malquist was Chairman, President and Chief Executive Officer of Sierra Pacific Resources until the August 1, 1999 merger, at which time Mr. Malquist was named President and Chief Executive Officer of SPPC, and President and Chief Operating Officer of the parent, SPR, and Mr.
Niggli was appointed Chairman of the Board of Directors and Chief Executive Officer of the parent, SPR, and Chairman of the Board of Directors of SPPC.
(a) Includes shares acquired through participation in the Employee Stock Purchase Plan and/or the 401(k) plan.
(b) The number of shares beneficially owned includes shares which the Executive Officers currently have the right to acquire pursuant to stock options granted, and performance shares earned under the Executive Long-Term Incentive Plan. Share beneficially owned pursuant to stock options granted to Messrs. Niggli, Malquist, Rigazio, Peterson, Ruelle, Banks-Weddle, and directors and executive officers as a group are 34,797, 151,365, 7,766, 50,668, 32,799 3,433, and 369,503 shares, respectively.
(c) Included in the shares beneficially owned by the Directors are 45,913 shares of "phantom stock" representing the actuarial value of the Director's vested benefits in the terminated Retirement Plan for Outside Directors. The "phantom stock" is held in an account to be paid at the time of the Director's departure from the Board.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
SPR entered into an agreement with Hale Day Gallagher Co., a real estate brokerage and investment company, to act as broker for the sale of a property owned by Lands of Sierra, Inc., a subsidiary of SPR. The sale of the property resulted in Hale Day Gallagher Co. receiving a standard brokerage commission of 5% of the selling price. Mr. T.J. Day, a senior partner of Hale Day Gallagher Co. and a Director of the Company, did not participate in any discussions or voting to retain the firm, had no relationship with, or interest in, the transaction, will receive no part of the commission, and no direct or indirect benefit from the transaction.
Mr. Peterson, formerly a partner with the law firm of Woodburn and Wedge, became Senior Vice President and General Counsel for Sierra Pacific Resources in 1993. Woodburn and Wedge, which has performed legal services for Sierra Pacific Power Company since 1920 and for Sierra Pacific Resources and all of its subsidiaries from their inception, continues to perform legal work for the Company. Mr. Peterson's spouse, an equity partner in the firm since 1982, has performed work for the Company since 1976 and continues to do so from time to time.
Susan Oldham, a former employee of SPPC specializing in water resources law, planning and policy accepted the Company's voluntary severance offering in December 1995. Ms. Oldham is the spouse of Steven C. Oldham, Vice President Transmission Business Group and Strategic Development for Sierra Pacific Power Company. Ms. Oldham, a licensed attorney in Nevada and California, has continued to perform specialized legal services in the water resources area for the Company on a contract basis.
In 1999, SPPC purchased all of the plant assets of the Silver Lake Water Company. The stock is owned 50% by the Lear Family Trust and 50% by Moya Olsen Lear. Mr. Murphy, a Director of SPPC, and Mr. Dayton, a former director of SPPC and a director at the time of purchase, are trustees of the Lear Family Trust. Neither Mr. Murphy nor Mr. Dayton participated in any of the Company's discussions or deliberations to purchase the Silver Lake Water Company and neither received any benefit, either directly or indirectly, from the transaction.
Change in Control Agreement
Employment Agreements - ---------------------
Sierra Pacific Resources has entered into Employment Agreements with Messrs. Niggli and Malquist. Messrs. Niggli and Malquist are sometimes hereinafter individually referred to as the "Executive." The Employment Agreements became effective on July 28, 1999, and have an initial term of three years, which term would automatically be extended in the event of a Change in Control (as defined in the Agreements) to the third anniversary of the Change in Control (or the consummation of the Change in Control, if later). The extended term is subject to further extension on the occurrence of an additional Change in Control event.
Pursuant to the Employment Agreements, Mr. Niggli will serve as Chairman and Chief Executive Officer of Sierra Pacific Resources, and Mr. Malquist will serve as President and Chief Operating Officer of Sierra Pacific Resources and Chief Executive Officer of Nevada Power Company and SPPC.
Each Executive's Employment Agreement provides that he will receive annual base salary commensurate with his position and level of responsibility, as determined by the Sierra Pacific Board (or compensation committee thereof), but not less than the Executive's annual base salary as in effect immediately prior to the Merger. Base salary may not be decreased. Each Employment Agreement also provides that the Executive will be eligible to participate in any annual incentive and long-term cash incentive plans applicable to executive and management employees that are authorized by the Sierra Pacific Board (or compensation committee thereof), with such participation, subject to achievement of applicable performance measures, to be at annual target payout or grant levels, respectively, of not less than a percentage of the Executive's annual base salary equal to the corresponding target percentage of annual base salary in effect for the Executive under the Nevada Power or Sierra Pacific plans in which the Executive participated immediately prior to the Merger; provided, however, that the target percentages for one Executive shall in no event be less than the target percentages for the other Executive. The Executives also are entitled to participate in all employee benefit plans in which senior executives of Sierra pacific are entitled to participate, in certain fringe benefits and in the supplemental retirement plans in which they participated immediately prior to the Merger.
If during the term of the Employment Agreement Sierra Pacific terminates the employment of the Executive for reasons other than cause (as defined in each Employment Agreement), death or disability or the Executive terminates his employment for good reason (as defined in each Employment Agreement), the Executive will receive, in addition to all compensation earned through the date of termination and coverage and benefits under all benefit and incentive compensation plans to which he is entitled pursuant to the terms thereof, a severance payment equal to three times the sum of his annual base salary and target annual bonus. In addition, the Executive will continue to receive health benefits (i.e., medical insurance, etc.) and life benefits on the same terms and conditions as prior to his termination for 36 months following his termination (the "Continuation Period").
The Executive has no duty to mitigate, but the health and life benefits listed above will be offset by any benefits payable to the Executive during the Continuation Period from another employer. Under the Employment Agreements, Sierra Pacific will pay any additional amounts sufficient to hold the Executive harmless for any excise tax that might be imposed as a result of the Executive being subject to the federal excise tax on "excess parachute payments" or similar taxes imposed by state or local law in connection with receiving any compensation or benefits pursuant to his Employment Agreement or otherwise that is considered contingent on a change in control. If the Executive dies, is terminated due
to permanent disability, is terminated for cause, or terminates for other than good reason, in each case during the term of the Employment Agreement, Sierra Pacific will pay to the Executive or the Executive's beneficiaries or estate, as the case may be, all compensation earned through the date of termination and benefits payable under applicable benefit and incentive compensation plans.
A Change in Control for purposes of the Employment Agreements occurs (i) if Sierra Pacific merges or consolidates, or sells all or substantially all of its assets, and less than 65% of the voting power of the surviving corporation is owned by those stockholders who were stockholders of Sierra Pacific immediately prior to such merger or sale; (ii) any person acquires 20% or more of Sierra Pacific's voting stock; (iii) Sierra Pacific enters into an agreement or Sierra Pacific or any person announces an intent to take action, the consummation of which would otherwise result in a Change in Control, or the Board of Directors of Sierra Pacific adopts a resolution to the effect that a Change in Control has occurred; (iv) within a two-year period, a majority of the directors of Sierra Pacific at the beginning of such period cease to be directors; or (v) the stockholders of Sierra Pacific approve a complete liquidation or dissolution of Sierra Pacific.
Severance Agreements - --------------------
Nevada Power Company
On March 13, 1998, Gloria Banks Weddle, David G. Barneby, and Steven W. Rigazio entered into employment agreements with Nevada Power Company for a three-year term which would automatically be extended in the event of a Change in Control to the third anniversary of the Change in Control (or the consummation of the Change in Control, if later). The extended term is subject to further extension on the occurrence of a further Change in Control event. The announcement of the execution of the Merger Agreement constituted a Change in Control under the employment agreements, and the consummation of the Mergers constituted an additional change in control event. If during the term of the employment agreement Nevada Power terminates the employment of an executive officer for reasons other than cause (as defined in each employment agreement), death or disability, or the executive officer terminates his or her employment for good reason (as defined in each employment agreement), the executive officer will receive, in addition to all compensation earned through the date of termination and coverage and benefits under all benefit and incentive compensation plans to which the executive officer is entitled pursuant to the terms thereof, a severance payment equal to two times the sum of his or her annual base salary and target annual bonus. In addition, the executive officer will continue to receive health benefits (i.e., medical insurance, etc.) and life benefits which will be offset by any benefits payable to the executive officer during the applicable benefit continuation period from another employer. Under the employment agreements, the executive officer will receive additional amounts sufficient to hold the executive harmless for any excise tax that might be imposed by state or local law in connection with receiving any compensation or benefits pursuant to the employment agreement or otherwise that is considered contingent on a Change in Control.
The annual incentive plans, 1993 Long-Term Incentive Plan and the Supplemental Executive Retirement Plan of Nevada Power, contained provisions relating to Change in Control. Under the annual incentive plans, after a Change in Control, eligible participants, whether or not the participants are terminated, including executive officers and participants who terminated prior to the Change in Control by reason of normal or early retirement or death, will have a right to an immediate cash payment of their annual awards, on a pro-rated basis, based on annual base salary and on the assumption that established targets at 100% achievement level for the year had been met. Under the 1993 Long-Term Incentive Plan, after a Change in Control, incentive compensation unit awards for outstanding performance periods will be immediately paid to participating executive officers in the
amount of one share of Nevada Power Common Stock for each incentive compensation unit. Under the Supplemental Executive Retirement Plan, the accrued benefit of each executive officer participating therein will become fully vested on the occurrence of a Change in Control. The consummation of the Mergers constituted a "Change in Control" under all the plans described above.
Sierra Pacific Power Company
In February 1997, SPR entered into severance agreements with Jeffrey L. Ceccarellli, Steven C. Oldham, William E. Peterson, Douglas R. Ponn, Mark A. Ruelle, Mary O. Simmons, and Mary Jane Reed. These agreements provide that, upon termination of the executive's employment within twenty-four months following a change in control of SPR (as defined in the agreements) either (a) by SPR for reasons other than cause (as defined in the agreements), death or disability, or (b) by the executive for good reason (as defined by the agreement, including a diminution of responsibilities, compensation, or benefits (unless, with respect to reduction in salary or benefits, such reduction is applicable to all senior executives of SPR and the acquirer)), the executive will receive certain payments and benefits. These severance payments and benefits include (i) a lump sum payment equal to three times the sum of the executive's base salary and target bonus, (ii) a lump sum payment equal to the present value of the benefits the executive would have received had be continued to participate in SPR's retirement plans for an additional 3 years (or, in the case of SPR's Supplemental Executive Retirement Plan only, the greater of three years or the period from the date of termination until the executive's early retirement date, as defined in such plan), and (iii) continuation of life, disability, accident and health insurance benefits for a period of thirty-six (36) months immediately following termination of employment. The agreements also provide that if any compensation paid, or benefit provided, to the executive, whether or not pursuant to the change-in-control agreements, would be subject to the federal excise tax on "excess parachute payments," payments and benefits provided pursuant to the agreement will be cut back to the largest amount that would not be subject to such excise tax, if such cutback results in a higher after-tax payment to the executive. The Board of Directors entered into these agreements in order to attract and retain excellent management and to encourage and reinforce continued attention to the executives' assigned duties without distraction under circumstances arising from the possibility of a change in control of SPR. In entering into these agreements, the Board was advised by Towers Perrin, the national compensation and benefits consulting firm described above, and Skadden, Arps, Slate, Meager & Flom, an independent outside law firm, to insure that the agreements entered into were in line with existing industry standards and provided benefits to management consistent with those standards.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedules and Exhibits
All other schedules have been omitted because they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules have been omitted because the information is not applicable.
3. Exhibits: Exhibits are listed in the Exhibit Index on pages 100-107
(b) Reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SIERRA PACIFIC POWER COMPANY
By /S/ Malyn K. Malquist ---------------------- Malyn K. Malquist President, Chief Operating Officer and Director March 22, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 22nd day of March 2000.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholder of Sierra Pacific Power Company Reno, Nevada
We have audited the consolidated financial statements of Sierra Pacific Power Company and subsidiaries (the Company") as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated February 29, 2000; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedule listed in Item 14. This consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLC Reno, Nevada February 29, 2000
Schedule II - Consolidated Valuation and Qualifying Accounts For The Years Ended December 31, 1999, 1998 and 1997 (Dollars in Thousands)
SIERRA PACIFIC POWER COMPANY 1999 FORM 10-K EXHIBIT INDEX
Exhibits filed with this Form 10-K are denoted with an asterisk (*). The other listed exhibits have been previously filed with the Securities and Exchange Commission and are incorporated herein by reference.
(3) . Restated Articles of Incorporation of the Company dated May 19, 1987 (Exhibit (3)(A) to the 1993 Form 10-K)
. Certificate of Amendments dated August 26, 1992 to Restated Articles of Incorporation of the Company dated May 19, 1987, in connection with the Company's preferred stock (Exhibit 3.1 to Form 8-K dated August 26, 1992)
. Certificate of Designation, Preferences and Rights dated August 31, 1992 to Restated Articles of Incorporation of the Company dated May 19, 1987, in connection with the Company's Class A Series 1 Preferred Stock (Exhibit 4.3 to Form 8-K dated August 26, 1992)
. By-laws of the Company, as amended through November 13, 1996 (Exhibit (3)(A) to Form 10-K for the year ended December 31, 1996)
. Articles of Incorporation of Pinon Pine Corp., dated December 11, 1995 (Exhibit (3)(A) to Form 10-K for the year ended December 31, 1995)
. Articles of Incorporation of Pinon Pine Investment Co., dated December 11, 1995 (Exhibit (3)(B) to Form 10-K for the year ended December 31, 1995)
. Agreement of Limited Liability Company of Pinon Pine Company, L.L.C., dated December 15, 1995, between Pinon Pine Corp., Pinon Pine Investment Co. and GPSF-B INC 1995 (Exhibit (3)(C) to Form 10-K for the year ended December 31, 1995)
. *(A) Amended and Restated Limited Liability Company Agreement of SPPC Funding LLC dated as of April 9, 1999, in connection with the issuance of California rate reduction bonds
(4) . Mortgage Indentures of the Company defining the rights of the holders of the Company's First Mortgage Bonds: Original Indenture (Exhibit 7-A to Registration No. 2-7475); Ninth Supplemental Indenture (Exhibit 2-M to Registration No. 2-59509); Tenth Supplemental Indenture (Exhibit 4-K to Registration No. 2-23932); Eleventh Supplemental Indenture (Exhibit 4-L to Registration No. 2-26552); Twelfth Supplemental Indenture (Exhibit 4-L
to Registration No. 2-36982); Sixteenth Supplemental Indenture (Exhibit 2-Y to Registration No. 2-53404); Nineteenth Supplemental Indenture (Exhibit (4)(A) to the 1991 Form 10-K); Twentieth Supplemental Indenture (Exhibit (4)(B) to the 1991 Form 10-K); Twenty-Seventh Supplemental Indenture (Exhibit (4)(A) to the 1989 Form 10-K); Twenty-Eighth Supplemental Indenture (Exhibit (4)(A) to the 1992 Form 10-K); Twenty-Ninth Supplemental Indenture (Exhibit D to Form 8-K dated July 15, 1992); Thirtieth Supplemental Indenture (Exhibit (4)(B) to the 1992 Form 10-K); Thirty-First Supplemental Indenture (Exhibit (4)(C) to the 1992 Form 10-K); Thirty-Second Supplemental Indenture (Exhibit 4.6 to Registration No.33-69550); Thirty-Third Supplemental Indenture (Exhibit C to Form 8-K dated October 20, 1993); Thirty-Fourth Supplemental Indenture (Exhibit C to Form 8-K dated March 11, 1996) Thirty-Fifth Supplemental Indenture (Exhibit C to Form 8-K dated March 10, 1997).
. Collateral Trust Indenture dated June 1, 1992 between the Company and Bankers Trust Company, as Trustee, relating to the Company's medium-term note program (Exhibit B to Form 8-K dated July 15, 1992 in connection with the Company's medium-term note program); First Supplemental Indenture dated June 1, 1992 (Exhibit C to Form 8-K dated July 15, 1992); Second Supplemental Indenture dated October 1, 1993 (Exhibit B to Form 8-K dated October 20, 1993); Third Supplemental Indenture dated as of February 1, 1996 (Exhibit B to Form 8-K dated March 11, 1996); and Fourth Supplemental Indenture dated as of February 1, 1997 (Exhibit B to Form 8-K dated March 10, 1997).
. Form of Medium-Term Global Fixed Rate Note, Series A (Exhibit E to Form 8-K dated July 15, 1992 in connection with the Company's medium-term note program)
. Form of Medium-Term Global Fixed Rate Note, Series B (Exhibit D to Form 8-K dated October 25, 1993 in connection with the Company's medium-term note program)
. Form of Medium-Term Global Fixed-Rate Note, Series C (Exhibit D to Form 8-K dated March 11, 1996 in connection with the Company's medium-term note program)
. Form of Medium-Term Global Fixed-Rate Note, Series D (Exhibit D to Form 8-K dated March 10, 1997 in connection with the Company's medium-term note program)
. *(A) Fiscal and Paying Agency Agreement dated as of September 14, 1999 between the Company and Bankers Trust Company, relating to the Company's money market note program
. *(B) Form of Global Floating Rate Note due October 13, 2000
. *(C) Indenture dated as of April 9, 1999 between SPPC Funding LLC and Bankers Trust Company of California, N.A. in connection with the issuance of California rate reduction bonds
. *(D) First Series Supplement dated as of April 9, 1999 to Indenture between SPPC Funding LLC and Bankers Trust Company of California, N.A. in connection with the issuance of California rate reduction bonds
. *(E) Form of SPPC Funding LLC Notes, Series 1999-1, in connection with the issuance of California rate reduction bonds
. Amended and Restated Declaration of Trust of Sierra Pacific Power Capital I (the Trust) dated July 24, 1996 in connection with the offering of the Preferred Securities of the Trust. (Exhibit 4.1 to Form 8-K dated August 2, 1996)
. Indenture between the Company and IBJ Schroder Bank and Trust Company as Trustee dated July 1, 1996 in connection with the offering of the Preferred Securities of the Trust. (Exhibit 4.2 to Form 8-K dated August 2, 1996)
. First Supplemental Indenture to the Indenture used in connection with the issuance of Junior Subordinated Debentures dated July 24, 1996 in connection with the offering of the Preferred Securities of the Trust. (Exhibit 4.3 to Form 8-K dated August 2, 1996).
. Guarantee with respect to Preferred Securities dated July 29, 1996 in connection with the offering of the Preferred Securities of the Trust. (Exhibit 4.4 to Form 8-K dated August 2, 1996).
. Guarantee with respect to Common Securities dated July 29, 1996 in connection with the offering of the Preferred Securities of the Trust. (Exhibit 4.5 to Form 8-K dated August 2, 1996).
(10)
. Coal Sales Agreement dated May 16, 1978 between the Company and Coastal States Energy Company (confidential portions omitted and filed separately with the Securities and Exchange Commission) (Exhibit 5-GG to Registration No. 2-62476)
. Amendment No. 1 dated November 8, 1983 to Coal Sales Agreement dated May 16, 1978 between the Company and Coastal States Energy Company (Exhibit (10)(B) to Form 10-K for the year ended December 31, 1991)
. Amendment No. 2 dated February 25, 1987 to Coal Sales Agreement dated May 16, 1978 between the Company and Coastal States Energy Company (Exhibit (10)(A) to Form 10-K for the year ended December 31, 1993)
. Amendment No. 3 dated May 8, 1992 to Coal Sales Agreement dated May 16, 1978 between the Company and Coastal States Energy Company (Exhibit (10)(B) to Form 10-K for the year ended December 31, 1992; confidential portions omitted and filed separately with the Securities and Exchange Commission)
. Coal Purchase Contract dated June 19, 1986 between the Company, Black Butte Coal Company and Idaho Power Company (Exhibit (10)(C) to the Form 10-K for the year ended December 31, 1992)
. Settlement Agreement and Mutual Release dated May 8, 1992 between the Company and Coastal States Energy Company (Exhibit (10)(D) to Form 10-K for the year ended December 31, 1992; confidential portions omitted and filed separately with the Securities and Exchange Commission)
. Interconnection Agreement dated May 29, 1981 between the Company and Idaho Power Company (Exhibit (10)(C) to Form 10-K for the year ended December 31, 1991)
. Amendatory Agreement dated February 14, 1992 to Interconnection Agreement dated May 29, 1981 between the Company and Idaho Power Company (Exhibit (10)(D) to Form 10-K for the year ended December 31, 1991)
. Agreement dated February 23, 1989 between the Company and Idaho Power Company for the supply of power and energy (Exhibit (10)(A) to Form 10-K for the year ended December 31, 1988)
. Cooperative Agreement dated July 31, 1992 between the Company and the United States Department of Energy in connection with the Pinon Pine Integrated Coal Gasification Combined Cycle Project (Exhibit (10)(H) to Form 10-K for the year ended December 31, 1992)
. Revised Intercompany Pool Agreement dated July 19, 1982 pertaining to the Company's membership (Exhibit (10)(E) to Form 10-K for the year ended December 31, 1991)
. Agreement dated November 7, 1986 between the Company and Western Systems Power Pool (Exhibit (10)(C) to Form 10-K for the year ended December 31, 1988)
. Memorandum dated October 1, 1988 to Agreement dated November 7, 1986 between the Company and Western Systems Power Pool (Exhibit (10)(D) to Form 10-K for the year ended December 31, 1988)
. General Transfer Agreement dated February 25, 1988 between the Company and the United States of America Department of Energy acting by and through the Bonneville Power Administration (Exhibit (10)(E) to Form 10-K for the year ended December 31, 1988)
. Rail Transportation Contract dated June 30, 1986 between the Company and Idaho Power Company as shippers and Union Pacific and Western Pacific Railroad Companies as carriers (Exhibit (10)(C) to Form 10-K for the year ended December 31, 1993)
. Addendum dated October 9, 1993 to Rail Transportation Contract dated June 30, 1986 between the Company and Idaho Power Company as shippers and Union Pacific Railroad Companies as carriers (Exhibit (10)(D) to Form 10-K for the year ended December 31, 1993)
. Financing Agreement dated March 1, 1987 between the Company and Humboldt County, Nevada relating to the Humboldt County, Nevada Variable Rate Demand Pollution Control Refunding Revenue Bonds (Sierra Pacific Power Company Project) Series 1987 (Exhibit (10)(E) to Form 10-K for the year ended December 31, 1993)
. Financing Agreement dated March 1, 1987 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Variable Rate Demand Gas and Water Facilities Refunding Revenue Bonds (Sierra Pacific Power Company Project) Series 1987 (Exhibit (10)(F) to Form 10-K for the year ended December 31, 1993)
. Financing Agreement dated June 1, 1987 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Variable Rate Demand Water Facilities Revenue Bonds (Sierra Pacific Power Company Project) Series 1987 (Exhibit (10)(G) to Form 10-K for the year ended December 31, 1993)
. Financing Agreement dated December 1, 1987 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Variable Rate Demand Gas Facilities Revenue Bonds (Sierra Pacific Power Company Project) Series 1987 (Exhibit (10)(H) to Form 10-K for the year ended December 31, 1993)
. Financing Agreement dated September 1, 1990 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Gas
Facilities Revenue Bonds (Sierra Pacific Power Company Project) Series 1990 (Exhibit (10)(C) to Form 10-K for the year ended December 31, 1990)
Financing Agreement dated December 1, 1990 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Water Facilities Revenue Bonds (Sierra Pacific Power Company Project) Series 1990 (Exhibit (10)(E) to Form 10-K for the year ended December 31, 1990)
. First Amendment dated August 12, 1991 to Financing Agreement dated December 1, 1990 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Water Facilities Revenue Bonds (Sierra Pacific Power Company Project) Series 1990 (Exhibit (10)(J) to Form 10-K for the year ended December 31, 1991)
. Letter of Credit, Reimbursement and Security Agreement dated December 12, 1990 between the Company and Union Bank of Switzerland relating to the Washoe County, Nevada Water Facilities Revenue Bonds (Sierra Pacific Power Company Project) Series 1990 (Exhibit (10)(F) to Form 10-K for the year ended December 31, 1990)
. Financing Agreement dated June 1, 1993 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Water Facilities Refunding Revenue Bonds (Sierra Pacific Power Company Project) Series 1993A (Exhibit (10) (I) to Form 10-K for the year ended December 31, 1993)
. Financing Agreement dated June 1, 1993 between the Company and Washoe County, Nevada relating to the Washoe County, Nevada Gas and Water Facilities Refunding Revenue Bonds (Sierra Pacific Power Company Project) Series 1993B (Exhibit (10) (J) to Form 10- K for the year ended December 31, 1993)
. *(A) Credit Agreement dated as of June 24, 1999 among the Company, Mellon Bank, N.A., First Union Bank and Wells Fargo Bank, N.A. relating to $150,000,000 credit facility
. *(B) Transition Property Purchase and Sale Agreement dated as of April 9, 1999 between Sierra Pacific Power Company and SPPC Funding LLC in connection with the issuance of California rate reduction bonds
. *(C) Transition Property Servicing Agreement dated as of April 9, 1999 between Sierra Pacific Power Company and SPPC Funding LLC in connection with the issuance of California rate reduction bonds
. *(D) Administrative Services Agreement dated as of April 9, 1999 between Sierra Pacific Power Company and SPPC Funding LLC in connection with the issuance of California rate reduction bonds
. Agreement dated May 1, 1991 between the Company and the Inter- national Brotherhood of Electrical Workers (Exhibit (10)(K) to Form 10-K for the year ended December 31, 1991)
. Ratified changes to the Agreement between the Company and the International Brotherhood of Electrical Workers dated October 31, 1994 (Exhibit (10)(B) to Form 10-K for the year ended December 31, 1994)
. Agreement dated January 1, 1998 between the Company and the International Brotherhood of Electrical Workers. (Filed as Exhibit 10(B) to Form 10-K for the year ended December 31, 1997)
. Lease dated January 30, 1986 between the Company and Silliman Associates Limited Partnership relating to the Company's corporate headquarters building (Exhibit (10)(I) to Form 10-K for the year ended December 31, 1992)
. Letter of Amendment dated May 18, 1987 to Lease dated January 30, 1986 between the Company and Silliman Associates Limited Partnership relating to the Company's corporate headquarters building (Exhibit (10) (K) to Form 10-K for the year ended December 31, 1993)
. Natural gas Transportation Service Agreement, dated January 11, 1995 between the Company and Tuscarora Gas Transmission Company (Filed with Form 10-K for the year ended December 31, 1995)
. Fixed-Price Turn-Key Construction Agreement, dated December 15, 1995 between the Company and Pinon Pine Company, L.L.C (Filed with Form 10-K for the year ended December 31, 1995)
. Operation and Maintenance Agreement, dated December 15, 1995 between the Company and Pinon Pine Company, L.L.C. (Filed with Form 10-K for the year ended December 31, 1995)
. Syngas Purchase Agreement, dated December 15, 1995 between the Company and Pinon Pine Company, L.L.C. (Filed with Form 10-K for the year ended December 31, 1995)
. The Amended and Restated Nonqualified Deferred Compensation Plan in which any director or any executive officer of the Company may participate. The Plan was amended and restated January 1, 1996 (Filed as Exhibit 10(B) with Form 10-K for the year ended December 31, 1996)
. Change in Control Agreement dated February 18, 1997 by and among Sierra Pacific Resources and the following officers (individually): Gerald W. Canning, Jeffrey L. Ceccarelli, Randy G. Harris, Malyn K. Malquist, Steven C. Oldham, Victor H. Pena, William E. Peterson, Mark A. Ruelle, Mary O. Simmons, Doug Ponn, and Mary Jane Willier (filed as Exhibit 10(A) to Form 10-K for the year ended December 31, 1997)
. Notice of Termination of Power Purchase from PacifiCorp under the Interconnection Agreement of May 19, 1971 (filed as Exhibit 10(C) to Form 10-K for the year ended December 31, 1997)
(11) . The Company is a wholly owned subsidiary and, in accordance with Paragraph 6 of SFAS No. 128 (Earnings Per Share), earnings per share data have been omitted.
(12) . *(A) Calculation of Pre-Tax Interest Coverages for the Periods 1999, 1998 and 1997.
(21) . Subsidiaries of the Registrant: Pinon Pine Company, a Nevada Corporation Pinon Pine Investment Company, a Nevada Corporation GPSF-B, a Delaware Corporation SPPC Funding LLC, a Delaware Limited Liability Company Sierra Pacific Power Capital Trust I (The Trust)
(27) . *(A) The Financial Data Schedule containing summary financial information extracted from the consolidated financial statements filed on Form 10-K for the year ended December 31, 1999. | 34,971 | 225,189 |
881895_1999.txt | 881895_1999 | 1999 | 881895 | Item 1. Business
Overview
The discussion set forth below as well as other documents incorporated by reference herein and oral statements made by officers of the Company relating thereto, may contain forward looking statements. Such comments are based upon information currently available to management and management's perception thereof as of the date of this Form 10-K. Actual results of the Company's operations could materially differ from those forward looking statements. Such differences could be caused by a number of factors including, but not limited to, potential adverse affects of regulation; changes in competition and the effects of such changes; increased competition; changes in fuel prices; changes in used tractor and trailer values; changes in economic, political or regulatory environments; litigation involving the Company; changes in the availability of a stable labor force; ability of the Company to hire drivers meeting Company standards; changes in driver compensation rates; changes in management strategies; environmental or tax matters; increases in interest rates and availability of affordable financing; and risks described from time to time in reports filed by the Company with the Securities and Exchange Commission. Readers should take these factors into account in evaluating any such forward looking statements.
The Company
OTR Express, Inc., a Kansas corporation organized in 1985 (the "Company" or "OTR") operates primarily as a dry van, truckload carrier and logistics company. The Company transports a diversified mix of general commodities for a large base of customers (currently over 1,000) throughout the continental United States. OTR is headquartered in Olathe, Kansas, a suburb of Kansas City, Missouri. The Company also provides non-asset based third party logistics services to its customers, including rail, truckload, and less-than- truckload services.
Operating Strategy
OTR's business philosophy is to provide high quality transportation services at a low cost. The Company has historically achieved this by (1) focusing on technology; (2) operating premium, late model equipment; (3) hiring experienced drivers; and (4) maintaining an efficient cost structure. From its founding in 1985 until 1995, the Company's operating strategy differed from that of most truckload carriers in that OTR serviced a large base of customers with no long-term contracts or commitments. This strategy allowed the Company to obtain the most profitable loads available on a spot basis. To identify the most profitable loads, the Company utilized its internally developed, proprietary Freight Optimization System - a next-move probability based freight system. The Freight Optimization System enables the Company to analyze historical data to prioritize customers most likely to have freight that will produce the most profitable combination of rates and destinations. The Freight Optimization System was designed to maximize freight opportunities, maximize revenue per mile and minimize empty miles, but had become dependent to some extent on freight brokers offering opportunities in the spot market. In mid-1995, using the system, the Company received as much as 55% of its freight opportunities from freight brokers who typically pay 10% to 15% less per mile than direct shippers.
In 1996, due to changing market conditions, the Company determined that it was necessary to change its operating strategy to market to larger national accounts and away from the lower priced spot freight market and its reliance on freight brokers. The objective of OTR's new operating strategy was to improve revenue per mile, equipment utilization, stability of the customer base and reduce reliance on freight brokers. These larger shippers are capable of offering increased load counts at higher revenue rates. The larger shippers require additional
services, including guaranteed equipment availability, drop trailers and fifty-three foot trailers. Additionally, in 1996, the Company began offering Qualcomm satellite communications on every truck and electronic data interchange (EDI) for load status information to serve the Company's larger national accounts. The Company is working to integrate these larger shippers into the Company's existing operating strategy effectively, providing a higher mix of more profitable shipper freight. In this new operating strategy, the Company will be able to utilize its Freight Optimization System which will work in conjunction with the Company's national accounts program to identify opportunities on non-national account freight and backhaul opportunities on national account freight.
OTR has regional short-haul operations in Kansas City, Chicago, and Dallas/Houston to meet customer demand. Based on management's analysis of the market size, cost of entry and potential long-term profitability, the Company expects to make further investments in the short-haul division.
This flexible operating strategy has contributed to the Company's growth during the five year period ending December 31, 1999, with revenue increasing to $80.5 million in 1999 from $42.8 million in 1994 (a compound annual growth rate of 13.5%), and a corresponding increase in its fleet to 588 tractors (505 company-owned tractors and 83 owner operators) from 394 during such period.
Customers and Marketing
OTR has a large customer base that is diversified in terms of geographic location and types of commodities shipped. The Company markets its services based on dependable, time definite delivery and service.
The Company obtains freight in three different manners: directly from shippers ("OTR Shippers"), through Company agents ("Agent Shippers") and from freight brokers. OTR Shippers are marketed directly by OTR sales representatives. Agent Shippers are marketed by the Company's outside sales agents. The Company's customer database includes approximately 500 OTR Shippers, 300 Agent Shippers and 400 freight brokers. In 1999, OTR Shippers accounted for 68% of OTR's revenue miles, Agent Shippers accounted for 13% and freight brokers accounted for 19%.
The freight obtained from OTR Shippers and Agent Shippers is generally more profitable than freight obtained from brokers, having freight rates which average 10% to 15% more than brokered freight. To maximize this more profitable revenue base by generating new OTR Shippers, OTR increased the number of its sales representatives and customer service representatives to twenty-one at February 29, 2000 from three at December 31, 1994. From the Company's inception through 1995, sales representatives operated primarily through direct telemarketing efforts.
During 1998, the Company divided its operations and sales departments into seven regional teams to better serve customers in those regions. In order to capitalize on this structure, the Company has regional sales managers in the Kansas City, Dallas, Baltimore, Cleveland, Chicago and Atlanta metropolitan areas. The focus of these regional sales managers is to enhance freight opportunities with current customers and to add new national account customers.
The Company's brokered freight is obtained through a network of freight brokers who contract for freight directly from shippers and re-contract with the Company to transport the freight. A freight broker helps carriers obtain loads in areas where the carrier does not typically have a large number of customers, thereby minimizing the empty miles of the carrier. Freight brokers typically earn a margin based on a percentage of the carrier's freight fee. The Company has developed a network of approximately 400 freight brokers. The Company expects to reduce the percentage of revenue miles from freight brokers in the future.
For the year ended December 31, 1999, the Company's 20, 10 and five largest customers accounted for 28.3%, 19.6% and 13.3%, respectively, of the Company's operating revenue. The largest customer accounted for 3.9% of the Company's operating revenue for that period.
Logistics Division
To better serve its customers, OTR has developed a logistics division which brokers loads to other carriers. The Company contracts with other trucking companies to haul freight on their equipment for OTR's customers. The Company is able to increase its profitability while satisfying its customers' shipping needs without utilizing Company owned equipment.
In 1998, OTR formed a rail logistics department within its OTR Logistics division. The intermodal logistics department contracts with rail carriers to move freight on rail equipment for customers and is currently based in Salt Lake City, Utah. The department currently employs eight professionals. OTR expects to utilize its information technology to improve the operating efficiency and capacity for the intermodal logistics department. OTR's internal computer programmers have developed a proprietary load order system specifically for intermodal logistics services which is integrated with the Company's current system and will substantially reduce the amount of time it takes to coordinate the movement of a load. The intermodal logistics division operates as a non-asset based transportation service provider and the Company expects that it will not require the purchase of transportation equipment.
Logistics division revenue increased to $9.7 million in 1999 from $4.5 million in 1998. OTR expects to expand the rail logistics department in the future.
Drivers, Other Employees and Owner-Operator Drivers
Recruiting and retaining professional, experienced drivers is critical to the Company's success, and all of the Company's drivers must meet specific guidelines relating primarily to safety record, driving experience and personal evaluation, including drug and alcohol testing. OTR's drivers have an average age of 46.0 years and average 12.5 years of driving experience. Within the Company, drivers are considered "managers" and are given a high level of responsibility to manage the profitability of their equipment.
The Company's Driver Incentive Management System allows experienced drivers to earn higher compensation than prevailing industry wages. The Company provides incentive programs for its drivers based on number of miles driven, fuel efficiency, safety record and profitability. OTR considers each tractor and its driver to be a separate profit center, with profit center reports, including the actual revenue and expense of the equipment and fixed expense components for administration, taxes and depreciation, generated monthly. Under the Company's "profit center" program, on a quarterly basis, a distribution approved by management is distributed to the drivers based on the profitability of their respective profit centers. The program is designed to give OTR's drivers the incentive to improve their individual productivity, minimize costs and thereby increase overall Company profitability.
Driver recruitment and retention is essential to the maintenance of high equipment utilization, particularly during periods of rapid fleet growth. OTR's drivers are given recruiting bonuses for the referral of new drivers to the Company. In order to attract and retain highly qualified drivers and to promote safe operations, the Company purchases premium quality tractors and equips the tractors with optimal comfort and safety features, such as on-board satellite communications, high quality interiors, power steering, automatic braking systems, engine brakes and oversized sleepers. As a result of management's attention to driver retention, the Company's driver turnover rate was 75% in 1999, which management believes to be below the industry average.
At December 31, 1999, the Company's ratio of tractors to non- driving employees was 4.78 to one, which management believes is well above industry standards. At February 29, 2000, the Company had 624 employees, of whom 503 were drivers and 121 were management and administrative personnel. At February 29, 2000, the Company also had contracts with independent contractors (owner-operators) for the services of 97 tractors that provide both a tractor and a qualified driver. The Company's employees are not represented by a collective bargaining unit. Employees may participate in OTR's 401(k) program and in Company-sponsored health, life and dental plans. The Company does not have any employees who are receiving post retirement benefits and does not anticipate offering any post retirement benefits in the future. Management considers relations with its employees to be very good.
In 1997, the Company began contracting with owner-operators to haul freight for the Company's customers. The Company recognizes that carefully selected owner-operators complement its company drivers. Owner-operators supply their own tractor and driver, and are responsible for their operating expenses. Because owner- operators provide their own tractors, less capital is required from the company for growth and they provide the Company with another source of drivers to support its growth. The Company expects to continue to recruit owner-operators, as well as company drivers.
Revenue Equipment
The Company believes that a key to the successful retention of drivers is the use of standardized, fuel efficient, late-model tractors and trailers. The Company purchases all new tractors, primarily with driver comfort, fuel efficiency, safety and overall economy in mind. To recruit and retain high-quality drivers, all the tractors owned by the Company have deluxe interiors and oversized sleepers. The average age of OTR's tractors and trailers at December 31, 1999 was 1.4 years and 2.9 years, respectively. The Company plans its trade cycle based on engine warranties and routinely replaces its tractors after forty to forty-five months of use (approximately 450,000 miles).
At December 31, 1999 the Company owned 271 Navistar tractors and 234 Peterbilt tractors. The tractors include engines which are fully electronic and manufactured by Detroit Diesel and Caterpillar. Trailers in the fleet at year-end were manufactured by Pines, Utility, Stoughton and Trailmobile. All of the Company's trailers have a 110 inch inside and are 102 inches wide, the maximum width generally allowed by law. The trailer fleet at December 31, 1999 included 797 fifty-three foot trailers and 265 forty-eight foot trailers. The Company owns only dry van trailers.
The following table shows the age of Company-owned equipment in service at December 31, 1999.
Acquisition Year Tractors Trailers
1999 261 20 1998 84 280 1997 150 292 1996 10 205 1995 - 130 1994 - 120 1993 - 15
Total 505 1,062
The Company's preventive maintenance program focuses on early diagnosis of problems and contracting maintenance out to third-party providers. In addition to annual Department of Transportation ("DOT") inspections, tractors are inspected when they pass through the Company's diagnostic facilities at its headquarters. Almost all tractors are still under warranty and are generally traded in before their engine warranties expire. The exclusive use of third-party maintenance providers, coupled with the effective utilization of manufacturers' warranties and the Company's trade-in policy, allows the Company to minimize its maintenance costs. Owner-operator tractors are inspected prior to acceptance by the Company for compliance with operational and safety requirements of the Company and the Department of Transportation. These tractors are then periodically inspected, similar to company-owned tractors, to monitor continued compliance.
Fuel Availability and Cost
The Company actively manages its fuel costs through a five component fuel management system which incorporates: wholesale purchasing for the Company's unmanned fuel facilities, mileage pay rates based upon fuel economy, the "profit center" incentive driver compensation program, fuel hedging, and equipment specifications. See "-Drivers and Other Employees."
The Company owns five automated fuel facilities, one located at the Company's headquarters in Kansas and one each located on major traffic lanes in Arizona, Ohio, Texas and Wyoming. Each of the four remote unmanned fuel facilities consists of an above-ground fuel tank, pump and a computer modem linking it directly to the Company's computers. In 1999, the Company purchased 16.0% of its fuel in bulk for distribution through its automated fuel facilities. These facilities allow the Company to purchase fuel at wholesale prices.
As a way to protect the Company against major fuel price increases, since October 1994 the Company has engaged in a fuel hedging strategy. Pursuant to this program, the Company buys four- or-six month call options within ten cents of current market prices, to buy futures contracts for #2 heating oil, in amounts equal to approximately 20% of the Company's anticipated fuel purchases for such period.
All of the Company's tractors have fully electronic engines, which typically deliver enhanced fuel economy compared to tractors with mechanically governed engines.
Environmental Matters
The Company's operations are subject to federal, state and local laws and regulations concerning the environment. There is the possibility of environmental liability as a result of the Company's use of fuels, from the fuel storage tanks installed at its fuel facilities and also from the cargo it may transport. The Company's only underground storage tanks are two fiberglass tanks installed at its headquarters facility. One tank was installed in 1988 and the other in 1995. The tanks have overfill protection hardware, spill containment manhole covers and leak detection equipment. The Company believes that the use of above-ground storage tanks at its remote fuel facilities minimizes both potential liability and the cost of compliance with environmental regulations. The Company occasionally transports environmentally hazardous substances in accordance with hazardous material guidelines. To date, the Company has experienced no material claims for hazardous substance shipments. The Company believes that its environmental practices comply with applicable federal, state and local environmental laws and regulations. In the event the Company should fail to comply with applicable regulations, the Company could be subject to substantial fines or penalties and to civil or criminal liability.
Competition
The truckload industry is extremely competitive and highly fragmented, with numerous regional,
inter-regional and national truckload carriers, none of which dominates the market. The Company competes primarily with other long-haul truckload carriers, rail-truck intermodal transportation, railroads and, to a lesser degree, with less-than-truckload ("LTL") carriers. Most of OTR's larger truckload competitors utilize "core carrier" or "lane density" marketing concepts, which emphasize greater individualized service to a smaller number of shippers. Many long haul truck load carriers utilize driver teams which allow them to provide expedited service while complying with DOT regulations concerning driver's duty hours. OTR's drivers consist principally of single drivers. Intermodal transportation and railroads typically have created downward pressure on the truckload industry's pricing structure. The Company competes for freight based primarily on freight rates, service and reliability.
Seasonality
Seasonality causes variations in the operations of the Company as well as industry-wide operations. Demand for the Company's service is generally the highest during the summer and fall months. Historically, expenses are greater during the winter months when fuel costs are generally higher and fuel efficiency is lower.
Governmental Regulation
The Company is a contract and common motor carrier subject to the authority of federal and state agencies. These regulatory authorities have broad powers, but the rates and charges of the Company are not directly regulated by these authorities. OTR, as primarily a contract carrier, negotiates competitive rates directly with its customers as opposed to adhering to scheduled tariffs.
The trucking industry is subject to regulatory and legislative changes such as increasingly stringent environmental regulations and limits on weight and size that can affect the economics of the industry by requiring changes in operating practices or influencing the demand for, and the costs of providing, services to shippers.
In August 1994, the Federal Aviation Administration Authorization Act of 1994 (the "1994 FAA Act") became law. Effective January 1, 1995, the 1994 FAA Act preempted certain state and local laws regulating the prices, routes or services of motor carriers (other than household carriers). State agencies may continue to impose tax, license, bonding and insurance requirements. The 1994 FAA Act does not limit the authority of a state or other political subdivision to impose safety regulations or highway route limitations or controls based on the size or weight of the motor vehicle, the hazardous nature of cargo being transported by motor vehicles or minimum financial responsibility requirements relating to insurance and self-insurance authorization.
The Negotiated Rates Act of 1993 ("NRA"), in tandem with the Trucking Industry Regulatory Reform Act of 1994 ("TIRRA"), further redefined the regulatory structure applicable to interstate transportation of goods. The NRA provided further regulation governing interstate transportation, including prohibitions on off- bill discounting, certain re-regulation of contract shipping arrangements, and, with respect to common carriers, regulation regarding the collection of undercharge claims, and applicable defenses and exceptions to such claims. The TIRRA further deregulated the trucking industry by partially repealing the "filed- rate" doctrine previously applicable to common carriers. Under the TIRRA, while collectively-made bureau rates must still be published in tariffs, individually negotiated rates are not.
The Company's drivers must be licensed as "commercial drivers" pursuant to requirements established by the Federal Highway Administration ("FHA") of the DOT. In addition to the knowledge and driving skills tests required to obtain a commercial driver's license (a "CDL"), there are various disqualifying offenses set forth in the FHA rules, which, if committed, could result in suspension or termination of the operator's CDL, as well as potential civil or criminal liabilities. Also, DOT regulations impose mandatory drug testing of drivers and the Company has
its own ongoing drug-testing program. DOT alcohol testing rules require certain tests for alcohol levels in drivers and other safety personnel.
Motor carrier operations are also subject to safety, equipment and operators' hours of service requirements prescribed by the DOT. The Company currently has a satisfactory rating from the DOT based upon the DOT's most recent audit of the Company.
Safety
The Company maintains a program for training and supervising personnel to keep safety awareness at its highest level. The emphasis on safety begins in the hiring and training process. A minimum of 2.0 years of over-the-road driving experience is required for new company drivers. OTR also verifies the driving records of all new drivers before they begin employment. Prospective employees are given physical examinations and drug tests, and newly hired drivers are trained in the Company's safety procedures. In general, any driver who violates the Company's safety standards will receive a warning letter, and any driver who has more than two such violations within certain periods of time is subject to termination. The Company continuously monitors driver performance and has final authority regarding employment and retention of drivers. OTR currently has a "satisfactory" safety and fitness rating from the DOT. See "-Governmental Regulation."
Item 2.
Item 2. Properties.
The Company owns real estate in Olathe, Kansas, where the Company is headquartered. The property includes a 22,000 square foot office facility and a 9,400 square foot diagnostic and inspection facility. The property also includes approximately 258,000 square feet of parking space and the Kansas fuel facility. Additionally, the Company owns tracts, each approximately one acre in size, in Arizona, Ohio, Texas and Wyoming, on which its remote fuel facilities are located. See "Item 1 Fuel-Availability and Cost."
Item 3.
Item 3. Legal Proceedings.
The Company is routinely a party to litigation incidental to its business, primarily involving claims for personal injuries and property damage incurred in the transportation of freight. The Company believes that all litigation in which the Company is currently involved is covered by the Company's liability insurance (personal injury, physical damage and cargo) or workers' compensation insurance. The Company believes the ultimate outcome of current litigation will not have a material adverse effect on its financial position or results of operations.
The Company maintains liability insurance (including umbrella coverage) in the amount of $10 million per occurrence for personal injury, property damage and cargo. Under the terms of the policy, the Company retains the first $50,000 of losses paid and loss adjusting expense. The Company is self-insured for workers' compensation insurance. The Company is responsible for claims up to $250,000 per occurrence and $900,000 aggregate per year. The Company carries excess insurance to cover losses over $250,000, subject to a maximum coverage of $5 million per occurrence.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
The information required by this Item is incorporated by reference from the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1999, under the caption "Price Range of Stock."
Item 6.
Item 6. Selected Financial Data.
The information required by this Item is incorporated by reference from the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1999, under the caption "Financial Highlights."
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
The information required by this Item is incorporated by reference from the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1999 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Item 8.
Item 8. Financial Statements and Supplementary Data.
The information required by this Item is incorporated by reference from the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1999 under the caption "Financial Statements" and "Quarterly Financial Data."
Annual Report Page
Report of Independent Public Accountants 11 Balance Sheets 12 Statements of Operations 13 Statements of Stockholders' Equity 14 Statements of Cash Flows 15 Notes to Financial Statements 16 Supplemental Financial Information 24
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information required by this Item is incorporated by reference from the Company's definitive Proxy Statement dated March 30, 2000 under the headings "Proposal One: Election of Class B Directors- Nominees," "The Board of Directors-Continuing Directors," "Executive Officers-Information About Other Executive Officers" and "Miscellaneous-Section 16 Reporting" to be filed with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K.
Item 11.
Item 11. Executive Compensation.
The information required by this Item is incorporated by reference from the Company's definitive Proxy Statement under the heading "Executive Compensation and Other Information" to be filed with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required by this Item is incorporated by reference from the Company's definitive Proxy Statement dated March 30, 2000 under the heading "Stock Ownership of Certain Beneficial Owners and Management" to be filed with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information required by this Item is incorporated by reference from the Company's definitive Proxy Statement dated March 30, 2000 under the heading "Certain Relationships and Other Transactions" to be filed with the Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) List of documents filed as part of this Report on Form 10-K.
(1) Financial Statements All financial statements of the Registrant as set forth under Item 8 of this Report on Form 10-K.
(2) Financial Statement Schedules
Page of Schedule Number Description 1999 10-K
II Valuation and Qualifying Accounts 16
The report of the Registrant's independent public accountants with respect to the above listed financial statements and financial statement schedules appears on page 15 of this Annual Report on Form 10-K.
All other financial statement schedules not listed above have been omitted since the required information is included in the financial statements or the notes thereto, or is not applicable or required.
(b) Reports on Form 8-K
No reports on Form 8-K were filed for the year ended December 31, 1999.
Exhibits
Exhibit Page Number or Incorporation Number Description By Reference To
3(a)(1) Articles of Incorporation, as amended Exhibit 3(a) to Annual Report prior to July 10, 1998 for the year ended Dec 31, 1994 on Form 10-K (SEC File No. 1-19773)
3(a)(2) Amendment to Articles of Incorporation, Exhibit 3(a)(2) to Annual filed July 13, 1998 Report for the year ended Dec 31, 1998 on Form 10-K (SEC File No. 1-19773)
3(b) Restated By-Laws Exhibit 3(b) to Annual Report for the year ended Dec 31, 1995 on Form 10-K (SEC File No. 1-19773)
4 The Registrant, by signing this Report, agrees to furnish the Securities and Exchange Commission, upon its request, a copy of any instrument which defines the rights of holders of long-term debt of the Registrant.
4(a) Specimen Common Stock Certificate Exhibit 4(a) to Amendment No. 1 to Registration Statement on Form S-18(SEC File No. 33-44422FW)
10(a) 1991 Incentive Stock Option Plan of Exhibit 10(a) to Registration OTR Express, Inc. Statement on Form S-18 (SEC File No. 33-44422FW)
10(b) Mortgage note dated January 10, 1995 Exhibit 10(xx) to Annual between Registrant and Report for the year ended Toni J. Waggoner and Robert E. Dec 31, 1994 on Form Waggoner , as Trustees 10-K (SEC File No. 1-19773)
10(c) OTR Express, Inc. 1996 Stock Option Exhibit 10(bbb) to Annual Plan Report for the year ended Dec 31, 1995 on Form 10-K (SEC File No. 1-19773)
10(d) OTR Express, Inc. 1996 Directors' Exhibit 10(ccc) to Annual Stock Option Plan Report for the year ended Dec 31, 1995 on Form 10-K (SEC File No. 1-19773)
10(e) Loan and Security Agreement dated Exhibit 10(ddd) to Quarterly June 11, 1997 between Report for the period ended Registrant and HSBC June 30, 1997 on Form 10-Q (SEC File No. 1-19773)
10(f) Guaranty Agreement dated February 27, Exhibit 10(q) to Quarterly 1998 between Registrant and Report for the period ended HSBC Business Loans, Inc.- Steven W. March 31, 1998 on Form Ruben 10-Q (SEC File No. 1-19773)
10(g) Stock Purchase Assistance Agreement Exhibit 10(s)to Quarterly dated February 27, 1998 between the Report for the period ended Registrant and Steven W. Ruben March 31, 1998 on Form 10-Q (SEC File No. 1-19773)
10(h) Guaranty Agreement dated June 8, 1998 Exhibit 10(t) to Quarterly between Registrant and Report for the period ended HSBC Business Loans, Inc.- Jeffrey T. June 30, 1998 on Form 10-Q Brown (SEC File No. 1-19773)
10(i) Stock Purchase Assistance Agreement Exhibit 10(v) to Quarterly dated June 8, 1998 between the Report for the period ended Registrant and Jeffrey T. Brown June 30, 1998 on Form 10-Q (SEC File No. 1-19773)
10(j) Contract to Purchase Tractors in 1999 Exhibit 10(v) to Quarterly between Registrant and Kansas Report for the period ended City Peterbilt March 31,1999 on Form 10-Q (SEC File No. 1-19773)
10(k) Contract to Purchase Tractors in 1999 Exhibit 13(b) to Annual between Registrant and KCR Report for the year ended International Trucks, Inc. December 31, 1998 on Form 10-K/A (SEC File No. 1-19773)
10(l) Form of Carrier/Shipper Transportation Page 17 of sequentially Contract* numbered pages
10(m) Amended Loan and Security Agreement dated Page 21 of sequentially February 24, 2000 between Registrant and numbered pages HSBC*
11 Statement re: Computation of Earnings Page 26 of sequentially per Share* numbered pages
13(a) Annual Report to Stockholders for the Exhibit 13(b) to Annual year ended December 31, 1998 Report for the year ended December 31, 1998 on Form 10-K (SEC File No. 1-19773)
13(b) Annual Report to Stockholders for the Page 27 of sequentially year ended December 31, 1999* numbered pages
23 Consent of Arthur Andersen LLP* Page 55 of sequentially numbered pages
* Filed herewith.
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registration has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OTR EXPRESS, INC.
Date: March 27, 2000 /s/ WILLIAM P. WARD Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date
/s/ WILLIAM P. WARD President, Principal Executive March 27, 2000 William P. Ward Officer and Chairman of the Board
/s/ JANICE K. WARD Vice President and Director March 27,2000 Janice K. Ward
/s/ STEVEN W. RUBEN Vice President Finance March 27, 2000 Steven W. Ruben Principal Financial Officer and Principal Accounting Officer
/s/ CHRISTINE D. SCHOWENGERDT Treasurer and Secretary March 27, 2000 Christine D. Schowengerdt
/s/ JAMES P. ANTHONY Director March 27, 2000 James P. Anthony
/s/ DEAN W. GRAVES Director March 27, 2000 Dean W. Graves
/s/ RALPH E. MACNAUGHTON Director March 27, 2000 Ralph E. MacNaughton
/s/ TERRY G. CHRISTENBERRY Director March 27, 2000 Terry G. Christenberry
/s/ CHARLES M. FOUDREE Director March 27, 2000 Charles M. Foudree
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES
To the Board of Directors and Stockholders of OTR Express, Inc.:
We have audited in accordance with generally accepted auditing standards, the financial statements included in OTR Express, Inc.'s annual report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 24, 2000. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. Schedule II-Valuation and Qualifying Accounts is the responsibility of the company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audit of the basic financial statements, and, in our opinion, fairly states in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP Arthur Andersen LLP
Kansas City, Missouri February 24, 2000
CORPORATE INFORMATION
Corporate Offices Common Stock Listing OTR Express, Inc. OTR Express, Inc's common 804 N. Meadowbrook Drive stock trades on The American Olathe, Kansas 66062 Stock Exchange under the (913) 829-1616 symbol OTR
Mailing address: PO Box 2819 Olathe, Kansas 66063-0819 | 5,449 | 36,230 |
801451_1999.txt | 801451_1999 | 1999 | 801451 | ITEM 1. DESCRIPTION OF BUSINESS
Other than historical and factual statements, the matters and items discussed in this Annual Report on Form 10-K are forward-looking statements that involve risks and uncertainties. Actual results of the Company may differ materially from the results discussed in the forward-looking statements. Certain factors that could contribute to such differences are discussed with the forward-looking statements throughout this report.
General
Corporate Background
Pre-Cell Solutions, Inc. (the "Company") was organized under the laws of the State of Colorado on July 20, 1981 under the name Oil Field Service Company, Inc. ("Oil Field"). On January 2, 1986, Oil field changed its name to Transamerican Petroleum Company ("Transamerican") by virtue of a certificate of amendment from the Secretary of State of Colorado. At the time, Transamerican was a wholly owned subsidiary of PTP Resource Corporation, a Canadian Corporation whose stock was traded on the Vancouver Stock Exchange and Nasdaq. Pursuant to a request filed with the Chief Counsel, division of Corporate Finance, of the United States Securities and Exchange Commission ("SEC"), on March 27, 1986 permission was granted for the stock of Transamerican to be distributed on a pro-rated bases to all shareholders of PTP Resource Corporation. The stock was issued on April 24, 1986.
In the past, the Company had provided a vehicle to take advantage of business opportunities which management believed from time to time were in the best interest of the Company's shareholders.
Acquisition of Pre-Cell Solutions, Inc.
On December 1, 1998, The Company acquired Pre-Cell Solutions, Inc, a Florida corporation. ("Pre-Cell") through the issuance of 32,156,000 shares of its common stock (see "certain transactions"). On December 6, 1998, the Company filed an amendment to its Article of Incorporation changing its name from Transamerican to Pre-Cell Solutions, Inc. The business of Pre-Cell has become the business of the Company. The Company anticipates that the acquisition of Pre-Cell will significantly increase its revenues and provide it with an opportunity to acquire market share in an emerging industry.
The Company is a non-facilities based provider of prepaid telecommunications services primarily to residential customers. The Company currently offers pre-paid residential local and long distance telecommunications services to consumers who reside in the state of Florida. The Company markets its services to consumers who are unable to obtain credit from the Incumbent Local Exchange Carrier ("ILEC") or other Competitive Local Exchange Carriers ("CLECs"). In particular, a significant number of low-income individuals are unable to obtain local telephone service from the ILEC or other CLECS because of a bad credit history or no credit history at all. Most ILECs and CLECs provide local exchange and/or long distance telecommunications services strictly on a credit basis. The Company provides its telecommunications services to these consumers only on a pre-paid basis.
Because no credit is involved, the Company can provide these services without risk even when a security deposit cannot be provided by the consumer (which is generally required by the ILEC or other CLECs when service is requested by low-income, credit deprived consumers). The Company's services are immediately available to the customer after the establishment of an account and appropriate payment. The
service is ideal for consumers with limited income who are unable to obtain credit from the ILEC or other CLEC, but who desire to place telephone calls from their home.
Pre-paid phone service is available to certain ILEC and CLEC customers for their local exchange services, however, these providers do not customarily provide a combined full service local and long distance exchange service. The Company believes that it is the only CLEC that has developed the capability of bundling these services into a single carrier product offering the non-credit worthy consumer market.
The Company has an agreement to purchase local exchange telecommunications services from BellSouth Telecommunications, Inc. ("BellSouth") in each of the eleven states where BellSouth provides local exchange services. Additionally, the Company acquires domestic and international long distance telecommunication services from Sprint. The Company provides its customers domestic and international long distance services through a proprietary switching and customer account based software application, furnished by a third party Florida based interconnection switching facility.
The company has designed its services to meet the basic telecommunication needs of the unique customers in its niche target markets while maintaining a fully featured array of telephone services. Management believes that Pre-Cell's sensitivity to consumer demands coupled with its customer care personnel will enable it to tailor its service offerings to meet customers' needs and to creatively package its services to provide "one-stop shopping" solutions for those customers.
Local Exchange Services.
Pre-Cell offers local telephone services, including local dial tone as well as other features such as:
o call forwarding; o call waiting; o caller ID; o voice mail; o 3 way calling; o speed dial; o repeat dial; and o call return and call block.
Long Distance Services.
Pre-Cell offers a full range of domestic long distance services, such as:
o interLATA, which are calls that pass one "Local Access and Transport Area" or "LATA" to another, and such calls must be carried across the LATA boundary by a long-distance carrier; and
o international long distance services.
These services including "1+" outbound calling, and such complementary services as travel cards and operator assistance.
The Company is pursuing a growth strategy to capitalize on its early entrance into the emerging and expanding markets for prepaid telecommunications services. Significant components of the Company's strategy include: (i) expand its customer base within the state of Florida; (ii) expand its customer base to include consumers who reside in the ten other states where BellSouth provides local exchange services where the Company has an agreement to acquire and re-sell local exchange services; (iii) expand its customer base to include consumers who reside in non-BellSouth states where it can negotiate favorable re-sale agreements with the ILEC or other facilities based CLECs; (iv) offer its customers a variety of other prepaid telecommunications products and services, including, prepaid cellular, prepaid paging, prepaid Internet access and other enhanced prepaid telecommunications services; and (v) pursue the acquisition of companies that fit within the Company's business strategy.
Market Overview
Telecommunications Services
The traditional U.S. market for telecommunications services can be divided into three basic sectors: (1) long distance services, (2) local exchange services and (3) Internet access services. It is estimated that in 1999 that local exchange services market accounted for revenues of $92.4 billion, long distance services market generated revenues of $104.6 billion and Internet services market revenues totaled $6.3 billion. Revenues for both local exchange and long distance services include amounts charged by long distance carriers and subsequently paid to ILECs (or, where applicable, CLECs) for long distance access.
Long Distance Services. A long distance telephone call can be envisioned as consisting of three segments. Starting with the originating customer, the call travels along an ILEC or CLEC network to a long distance carrier's point of presence ("POP"). At the POP, the call is combined with other calls and sent along a long distance network to a POP on the long distance carrier's network near where the call will terminate. The call is then sent from this POP along an ILEC or CLEC network to the terminating customer. Long distance carriers provide only the connection between the two local networks, and pay access charges to LECs for originating and terminating calls.
Local Exchange Services. A local call is one that does not require the services of a long distance carrier. In general, the local exchange carrier does provide the local portion of most long distance calls.
Internet Services. Internet services are generally provided in at least two distinct segments. A local network connection is required from the ISP customer to the ISP's local facilities. For residential users, these connections are generally connections through the public switched telephone network obtained on a dial-up access basis as a local exchange telephone call. Once a local connection is made to the internet service provider's ("ISP") local facilities, information can be transmitted and obtained over a packet-switched internet protocol data network, which may consist of segments provided by many interconnected networks operated by a number of ISPs. This collection of interconnected networks makes up the Internet. A key feature of Internet architecture and packet switching is that a single dedicated channel between communication points is never established, which distinguishes Internet-based services from the public switched telephone network.
Strategy
The Company is pursuing a growth strategy to capitalize on its early entrance into the emerging and expanding markets for prepaid telecommunications services. The Company intends to focus its sales and
marketing efforts on the credit-challenged consumer. Additionally, the Company intends to pursue individual and business consumers who desire to utilize the Company's prepaid products and services as a mechanism to budget their telecommunications costs.
Significant components of the Company's strategy include: (i) expand its customer base within the state of Florida; (ii) expand its customer base to include consumers who reside in the ten other states where BellSouth provides local exchange services where the Company is pursuing a growth strategy to capitalize on its early entrance into the emerging and expanding markets for prepaid telecommunications services. Significant components of the Company's strategy include: (i) expand its customer base within the state of Florida; (ii) expand its customer base to include consumers who reside in the ten other states where BellSouth provides local exchange services where the Company already has an agreement in place to acquire and re-sell local exchange services; (iii) expand its customer base to include consumers who reside in non-BellSouth states where it can negotiate favorable re-sale agreements with the ILEC or other facilities based CLECs; (iv) offer its customers a variety of other prepaid telecommunications products and services, including, prepaid cellular, prepaid paging, prepaid Internet access and other enhanced prepaid telecommunications services; and (v) pursue the acquisition of companies that fit within the Company's business strategy.
Trademarks
None
Sales And Marketing
Distribution Strategy. The Company's distribution strategy is to utilize alternative distribution channels to sell and market its products and services. Through the combination of a direct sales force and alternative distribution channels, the Company believes that it will be able to more rapidly access markets and increase revenue-producing traffic.
As part of its distribution strategy, the Company is developing several alternative distribution channels. These include agents and resellers. Agents are independent organizations that sell the Company's products and services under the Pre-Cell brand name to end-users in exchange for revenue based commissions. The Company recruits agents that specialize in marketing products and services to consumers with demographic characteristics similar to those of the Company's unique customers. The Company's agents may not necessarily be well versed in telecommunications, because they are generally convenience stores, drugstores or supermarkets that offer the Company's products to their retail customers. Sales through this alternative distribution channel require the Company to provide the same type of services that would be provided in the case of sales through its own direct sales force such as order fulfillment, billing and collections, customer care and direct sales management.
Resellers are independent companies, including other competitive local exchange companies, that purchase the Company's products and services and then "repackage" these services for sale to their customers under their own brand name. Resellers generally require access to certain of the Company's business operating systems in connection with the sale of the Company's services to the resellers' customers. Sales through this distribution channel generally do not require the Company to provide order fulfillment, billing and collection and customer care.
Government Regulation
Federal
The Telecommunications Act was intended to remove some of the barriers between the long distance and local telecommunications markets, allowing service providers from each of these sectors (as well as cable television operators and others) to compete in all communications markets. The FCC must issue regulations to address various requirements of the Telecommunications Act. For instance, the Telecommunications Act generally requires ILECs to (1) allow competitors such as the Company to interconnect with the ILECs'
networks and (2) give competitors nondiscriminatory access to the ILEC's networks on more favorable terms than have been available in the past. In August 1996, the FCC adopted regulations intended to detail the requirements of the Telecommunications Act relating to interconnection (the "Interconnection Order"). The Interconnection Order includes detailed provisions regarding the interconnection of ILEC networks with those of new competitors as well as requirements that the ILECs make certain of their network elements and services available to competitors.
In October 1996, portions of the Interconnection Order were stayed by the United States Court of Appeals for the Eighth Circuit. This court later invalidated certain of those provisions, including ones in which the FCC asserted jurisdiction over the pricing of interconnection elements and the "pick-and-choose" provisions which allow carriers to adopt select provisions of other carriers' interconnection agreements. The FCC appealed this decision to the United States Supreme Court. In January 1999, the Supreme Court reversed a majority of the Eighth Circuit's decision, upholding in many respects the FCC's local competition rules as set out in the Interconnection Order. Some of the key elements of the Supreme Court's decision are:
(1) The Court upheld the FCC's pricing authority with regard to interconnection, resale of ILEC services and competitors' use of unbundled network elements (i.e., individual elements, features and functions of an ILEC's network infrastructure such as access lines, transport lines, operator service and switching features);
(2) The Court upheld the FCC's "pick and choose" rules (allowing requesting carriers to select from among individual provisions of interconnection agreements approved by state commissions);
(3) The Court upheld the FCC's jurisdiction to require all local phone companies to implement intra LATA presubscription, the process by which local telephone customers pre-select interexchange carriers for short-haul long distance calls; and
(4) The Court remanded for further consideration the FCC's rule that defines those network elements which, under the Telecommunications Act, must be unbundled by the ILECs and made available to competitors.
The Court found that the FCC did not impose the limiting standard required by the Telecommunications Act, which mandates a determination as to whether those elements are necessary for competitors or the failure to obtain access to them would impair competitors' ability to provide service. The Supreme Court's decision has added uncertainty to the regulatory landscape in which other CLECs and we operate. For example, the FCC is commencing a new and potentially lengthy rulemaking proceeding to determine which unbundled network elements the ILECs must make available to competitors. This uncertainty may adversely impact CLECs, such as the Company, which rely on the facilities of the ILECs to deliver their telecommunications services.
The FCC recently issued an order addressing the manner in which dial-up calls to ISPs are to be treated for both jurisdictional and reciprocal compensation purposes. The FCC ruled that dial-up calls to ISPs constitute a single call that is interstate in nature and subject to FCC jurisdiction. The FCC stated, however, that its decision was not intended to impact previous decisions by state regulators that had declared inter-carrier reciprocal compensation applicable to these calls. This order has been appealed to the FCC and several ILECs have requested that state regulators reverse their prior rulings and hold that dial-up ISP traffic is not subject to reciprocal compensation under extant interconnection agreements. It is unclear at this time how such proceedings will conclude. However, in light of the limited amount of revenues we have generated from reciprocal compensation for ISP traffic, we do not expect the resolution of this issue to have a material impact on our ongoing operations in most markets.
The FCC also recently issued an order (the "Collocation Order") expanding the options available to competitive providers for collocation and access to unbundled loops from the ILECs. In the Collocation Order, the FCC significantly expanded the rights of competitive carriers to collocate with ILECs through a variety of methods, including cage less and shared space collocation. As a result, the FCC has expanded the manner in which unbundled local loops could be accessed from the ILECs. The FCC has also issued orders under the Telecommunications Act reforming LEC access charges and universal service requirements. Under the access reform order, ILECs that are subject to price cap regulation are required to reduce the rates they charge long
distance service providers for interstate switched local access. In October 1998, AT&T filed a petition with the FCC seeking a ruling that long distance carriers may elect not to purchase switched access services offered under tariff by CLECs. This could also cause increased FCC scrutiny and regulation of CLEC interstate access rates. The petition is pending.
Under the FCC's universal service order, all telecommunications service providers are required to pay for universal service support based on a percentage of their end user telecommunications revenues to be established quarterly by the FCC.
Providers of telecommunications services are coming under intensified regulatory scrutiny for marketing activities that result in alleged unauthorized switching of customers from one service provider to another, particularly in the long distance sector. The FCC and a number of state authorities have begun adopting more stringent regulations to curtail the intentional or erroneous switching of customers, which include, among other things, the imposition of fines, penalties and possible operating restriction son entities which engage or have engaged in unauthorized switching activities. In addition, the FCC has adopted regulations imposing procedures for verifying the switching of customers and additional remedies on behalf of carriers for unauthorized switching of their customers.
The FCC also oversees the administration and assigning of local telephone numbers. It has designated Lockheed Martin as the numbering plan administrator. Extensive regulations have been adopted governing telephone numbering, area code designation, dialing procedures that may be imposed by the ILECs and the imposition of related fees by the ILECs. In addition, carriers are required to contribute to the cost of numbering administration through a formula based on their revenues. In 1996, the FCC permitted businesses and residential customers to keep their numbers when changing local phone companies (referred to as number portability). The availability of number portability is important to competitive carriers like us since customers, may be less likely to switch to a competitive carrier if they cannot retain their existing telephone numbers. The FCC has been working with industry groups and companies to address potential problems stemming from the depletion in certain markets of the pool of telephone numbers which telecommunications companies can make available to their customers. If a sufficient amount of telephone numbers are not available in the market, our operations in that market may be adversely affected or we may be unable to enter that market until sufficient numbers become available.
State
Some of the Company's services are classified as intrastate and therefore are subjected to state regulation, generally administered by the state's PUC. The nature of these regulations varies from state to state and in some cases may be more extensive than FCC regulations. In most instances, the Company is required to obtain certification from a state PUC before providing services in that state. We are certified to provide intrastate non-switched service and switched local (i.e., CLEC) services in the State of Florida. We expect that as our business and product lines expand and as more pro-competitive regulation of the local telecommunications industry is implemented, we will offer additional intrastate services.
Interstate and intrastate regulatory requirements are changing rapidly and will continue to change.
Pre-Cell being a reseller of telecommunications services is protected by the Telecommunications Act of 1996 (the "Telecom Act") which mandated significant changes in the then regulation of the telecommunications industry. The Telecom Act is intended to increase competition, to promote competitive development of new service offerings, to expand public availability of telecommunications services and to streamline regulation of the industry. The Act opened the local services market to companies such as Pre-Cell by requiring ILECs to permit interconnection to their networks and establishing ILEC obligations with respect to:
o Reciprocal Compensation - Requires all local exchange carriers to complete calls originated by competing local exchange carriers under reciprocal arrangements at prices based on tariffs or negotiated prices.
o Resale - Requires all ILECs and CLECs to permit resale of their telecommunications services without unreasonable restrictions or conditions. In addition, ILECs are required to offer wholesale versions of all retail services to other telecommunications carriers for resale at discounted rates, based on the costs avoided by the ILEC in the wholesale offering.
o Interconnection - Requires all ILECs and CLECs to permit their competitors to interconnect with their facilities. Requires all ILECs to permit interconnection at any technically feasible point within their networks, on nondiscriminatory terms, at prices based on cost, which may include a reasonable profit. At the option of the carrier seeking interconnection, collocation of the requesting carrier's equipment in the ILECs' premises must be offered, except where an ILEC can demonstrate space limitations or other technical impediments to collocation.
o Unbundled Access - Requires all ILECs to provide nondiscriminatory access to unbundled network elements including, network facilities, equipment, features, functions, and capabilities, at any technically feasible point within their networks, on nondiscriminatory terms, at prices based on cost, which may include a reasonable profit.
o Number Portabilty - Requires all ILECs and CLECs to permit users of telecommunications services to retain existing telephone numbers without impairment of quality, reliability or convenience when switching from one telecommunications carrier to another.
o Dialing Parity - Requires all ILECs and CLECs to provide "1+" equal access to competing providers of telephone exchange service and toll service, and to provide nondiscriminatory access to telephone numbers, operator services, directory assistance, and directory listing with no unreasonable dialing delays.
o Access to Rights-of-Ways - Requires all ILECs and CLECs to permit competing carriers access to poles, ducts, conduits and rights-of-way at regulated prices.
ILECs are required to negotiate in good faith with carriers, such as the Company, requesting any or all of the above arrangements. If the negotiating carriers cannot reach agreement within a prescribed time, either carrier may request binding arbitration of the disputed issues by the state regulatory commission. Where an agreement has not been reached, ILECs remain subject to interconnection obligations established by the FCC and state telecommunication regulatory commissions.
The Telecommunications Act codifies the ILECs' equal access and nondiscrimination obligations and preempts inconsistent state regulation. The Telecommunications Act also contains special provisions that replace prior antitrust restrictions that prohibited the regional Bell operating companies from providing long distance services and engaging in telecommunications equipment manufacturing. The Telecommunications Act permitted the regional Bell operating companies to enter the out-of-region long distance market immediately upon its enactment. Further, provisions of the Telecommunications Act permit a regional Bell operating company to enter the long distance market in its in-region states if it satisfies several procedural and substantive requirements, including:
o obtaining FCC approval upon a showing that the regional Bell operating company has entered into interconnection agreements or, under some circumstances, has offered to enter into such agreements in those states in which it seeks long distance relief;
o the interconnection agreements satisfy a 14-point "checklist" of competition requirements; and
o the FCC is satisfied that the regional Bell operating company's entry into the long distance markets is in the public interest.
To date, several petitions by regional Bell operating companies for such entry have been denied by the FCC, and non have been granted. However, it is likely that additional petitions will be filed in 1999 and it is possible that regional Bell operating companies may receive approval to offer long distance services in one or more states. This may have an unfavorable effect on Pre-Cell's business. Pre-Cell is legally able to offer its customers both long distance and local exchange services, which the regional Bell operating companies currently cannot. This ability to offer "one-stop shopping" gives Pre-Cell a marketing advantage that it would no longer enjoy if the regional Bell operating companies receive approval to offer long distance services on one or more states.
Competition
The telecommunications market is intensely competitive and currently is dominated by the ILECs and the large, established long distance companies. We have not obtained significant market share nor do we expect to, given the size of the telecommunications services market, the intense competition and the diversity of customer requirements. The ILECs and the large, established long distance companies have long-standing relationships with their customers and have the potential to subsidize competitive services with revenues from a variety of business services (to the extent lawful). While legislative and regulatory changes have provided us and other competitive providers with increased business opportunities, these changes have also given the incumbent providers flexibility in the pricing of their services. This may allow the ILECs and the large, established long distance companies to offer special discounts to potential customers. Further, as competition increases in the telecommunications market, we expect general pricing competition and pressures to increase significantly.
In addition, the Telecommunications Act establishes procedures under which an RBOC may compete in the long distance business in its region. These procedures include compliance with a 14-point competitive checklist designed to open the RBOC's local market to competition. Once an RBOC is authorized to compete in the long distance business in its region, it may be an even more significant competitor. In addition to competition from the incumbent providers, we also face competition from a growing number of other companies.
We also may face competition from cable companies, electric utilities, ILECs operating outside their current local service areas, long distance carriers and other entities in the provision of local telecommunications services. Moreover, the consolidation of telecommunications companies and the formation of strategic alliances within the telecommunications industry, which are expected to accelerate, could give rise to significant new or stronger competitors. We believe that the principal competitive factors affecting our market share are (i) direct customer contact; (ii) customer service; (iii) pricing;(iv) quality of service; and (v) a variety of offered services. Our ability to compete effectively will depend also upon our ability to continue to provide a broad range of high capacity telecommunications services at attractive prices.
Employees
The Company currently has 2 executive employees. All other services utilized by the Company are obtained through an Administrative Services Agreement with Pre-Paid Solutions, Inc. (see "Certain Relationships and Related Transactions")
The Company's address and telephone number are: 255 East Drive, Suite C, Melbourne, Florida 32904, (321) 308-2900.
The Company's SEC filings are available to the public over the Internet at the SEC's website at http://www.sec.gov. You may also read and copy any document the Company files at the SEC's public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
The Company currently subleases approximately 750 square feet of office space at its Melbourne, Florida corporate headquarters from Pre-Paid Solutions, Inc. (see "Certain Relationships and related Transactions"). Its monthly lease payments are $463.75. The remaining term of the lease is two years, commencing June 15, 1999 and ending June 14, 2001.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not party to any material litigation
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is traded on the OTC Bulletin Board under the symbol "TDCM." In December 1998, the Company changed it trading symbol to "TDCM" from "TAMP." The following table sets forth the high and low bid quotations for the common stock for the calendar periods indicated as reported by Nasdaq. These quotations reflect prices between dealers, do not include retail mark-ups, markdowns, commissions and may not necessarily represent actual transactions. This table gives retroactive effect to reverse stock splits at the rates of 1:7 effected in December 1998.
Calendar Period High Low - --------------- ---- --- Second Quarter ended 6/30/97 .21 .14 Third Quarter ended 9/30/97 .28 .14 Fourth Quarter ended 12/31/97 .28 .035 First Quarter ended 3/31/98 .035 .035
Second Quarter ended 6/30/98 .035 .035 Third Quarter ended 9/30/98 .28 .035 Fourth Quarter ended 12/31/98 .25 .20 First Quarter ended 3/31/99 .29 .02
As of October 25, 1999, there were approximately 584 holders of record of the 33,852,730 shares of common stock that were issued and outstanding. The transfer agent for the common stock is Interstate Transfer Company, (801) 281-9746.
The Company has never paid cash dividends on its common stock, and presently intends to retain future earnings, if any, to finance the expansion of its business and does not anticipate that any cash dividends will be paid in the foreseeable future. The future dividend policy will depend on the Company's earnings, capital requirements, expansion plans, financial condition and other relevant factors.
The Securities and Exchange Commission has adopted regulations which generally define a "penny stock" to be any equity security that has a market price (as defined) of less than $5.00 per share, subject to certain exceptions. The Company's common stock may be deemed to be a "penny stock" and thus will become subject to rules that impose additional sales practice requirements on broker/dealers who sell such securities to persons other than established customers and accredited investors, unless the common stock is listed on The Nasdaq SmallCap Market. Consequently, the "penny stock" rules may restrict the ability of broker/dealers to sell the Company's securities, and may adversely affect the ability of holders of the Company's common stock to resell their shares in the secondary market.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations," each of which is included elsewhere in this Form 10-K. The consolidated statements of operations data for the fiscal year ended April 30, 1999, and the balance sheet data at April 30, 1999, are derived from audited financial statements included elsewhere in this Form 10-K. The consolidated statement of operations data for the fiscal years ended April 30, 1998, 1997, 1996, and 1995, and the balance sheet data at April 30, 1998, 1997, 1996, and 1995, are derived from audited financial statements not included in this Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward-looking statements. The forward-looking statements contained in this Report are subject to certain risks and uncertainties. Actual results could differ materially from current expectations. Among the factors that could affect the Company's actual results and could cause results to differ from those contained in the forward-looking statements contained herein is the Company's ability to implement its business strategy successfully, which will depend on business, financial, and other factors beyond the Company's control. There can be no assurance that the Company will continue to be successful in implementing its business strategy. Other factors could also cause actual results to vary materially from the future results covered in such forward-looking statements. Words used in this Report such as "expects," "believes," "estimates" and "anticipates" and variations of such words and similar expressions are intended to identify such forward-looking statements.
The following should be read in conjunction with the Financial Statements of the Company and the notes thereto included elsewhere in this report.
OVERVIEW
Since 1995, the Company was inactive but structured to take advantage of business opportunities which management believed would be in the best interest of the Company's shareholders. In December 1998, the Company acquired Pre-Cell Florida through the issuance of 32,156,000 shares of its common stock and changed its name to Pre-Cell Solutions, Inc. The Company currently offers pre-paid residential local and long distance telecommunications services to customers who reside in the state of Florida.
Results of Operations
The operating results as reported the Company's financial statements for the year ended April 30, 1999 are all the result of acquisition of Pre-Cell Solutions, Inc. the Florida corporation. Since the Company had been inactive for the year ended April 30, 1998 there is no comparative analysis for these two periods.
Liquidity and Capital Resources
For the year ended April 30, 1999, net cash used in operating activities was $44,644. As of April 30, 1999, the Company had cash and cash equivalents of approximately $3,500 and a net working capital deficit of approximately $340,000. The Company's ability to meet its future obligations in relation to the orderly payment of its recurring, general and administrative expenses on a current basis is totally dependent on its ability to expand its current customer base and secure and develop new business opportunities through acquisitions or other venture opportunities. Since the Company has no current source of liquidity, the Company is unable to predict how long it may be able to survive without a significant infusion of capital from outside sources and it is further unable to predict whether such capital infusion, if available, will be on terms and conditions favorable to the Company.
In order to generate future operating activities, the Company intends to implement its plan to expand its business and search for, investigate and attempt to secure and develop business opportunities through acquisitions, mergers or other business combinations and strategic alliances. There can be no assurance that the Company will be successful in its plan to expand its customer base or locate businesses in the same or similar industry for acquisition. Although the Company engages in these discussions from time to time, it is not at present party to any agreement or contract.
YEAR 2000 COMPLIANCE
The Company is aware of the issues associated with the programming code in existing computer systems as the year 2000 approaches. The Year 2000 issue relates to whether computer systems will properly recognize and process information relating to dates in and after the year 2000. These systems could fail or produce erroneous results if they cannot adequately process dates beyond the year 1999 and are not corrected. Significant uncertainty exists in the software industry concerning the potential consequences that may result from the failure of software to adequately address the Year 2000 issue. The Company has analyzed software and hardware used internally by the Company in all support systems to determine whether they are Year 2000 compliant. The Company believes that all of its software has already been upgraded by the manufacturers thereof or was recently developed or purchased and is Year 2000 compliant. The Company does not believe that the aggregate cost for the Year 2000 issue will be material due to the nature of its business. The Company, however, cannot predict the effect of the Year 2000 issue on entities with which the Company transacts business, and there can be no assurance that the effect of the Year 2000 issue on such entities will not have a material adverse effect on the Company's business, financial condition or results of operations.
Any new software, hardware or support systems implemented in the future will be Year 2000 compliant or will have updates or upgrades or replacements available before the Year 2000 to enable the system to be Year 2000 compliant.
The Company is dependent on BellSouth to provide local exchange services and Sprint for long distance services. To the extent these service providers fail to address Year 2000 issues which might interfere with their ability to fulfill their obligations to the Company, such interference could have a material adverse effect on
future operations. If other telecommunication carriers are unable to resolve Year 2000 issues, it is likely that the Company will be affected to a similar degree as others in the telecommunications industry.
ITEM 7A.
ITEM 7A. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
None.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
The financial statements required by this report are appended hereto commencing on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
None
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS
The following table sets forth the names, positions with the Company and ages of the executive officers and directors of the Company. Officers are elected by the Board and their terms of office are governed by employment contract, at the discretion of the Board.
Name Age Positions Held
Thomas E. Biddix 30 Director, Chief Executive Officer, President, Treasurer
Timothy F. McWilliams 36 Director, Chief Operating Officer, Secretary
Thomas E. Biddix. Since December 1998, Mr. Biddix has served as Chairman of the Company's Board of Directors, Chief Executive Officer, and President of the Company. From May 1997 until December 1998, Mr. Biddix served as Chairman of the Board of Directors, Chief Executive Officer, and President of Pre-Cell. Currently Mr. Biddix also serves as the Chairman of the Board of Directors, Chief Executive Officer and President of Pre-Paid Solutions, Inc. ("Pre-Paid"), a nationwide provider of prepaid cellular products and services. From February, 1996 until October, 1996, Mr. Biddix was General Manager of Suntree Cellular, Inc., a Florida based AT&T Authorized Cellular Dealer. From March, 1994 until June, 1996, Mr. Biddix was a real estate salesman for RE/MAX Alternative Realty.
Timothy McWilliams. Since December 1, 1998, Mr. McWilliams has served as a Director, Chief Operating Officer and Secretary of the Company. From May 1997 through December 1998, Mr. McWilliams served as Chief Operating Officer, Secretary and a Director of Pre-Cell. Currently, Mr. McWilliams is also Chief Operating Officer of Pre-Paid, a nationwide provider of prepaid cellular products and services. From March, 1994 to December, 1999, Mr. McWilliams was President of RE/MAX Alternative Realty and RE/MAX Alternative II, Florida based real estate brokerages. Since January 1994 to the present, Mr. McWilliams has also served as President of Ventana Development Company, Inc., a developer of single family residential developments
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Cash Compensation
The following table shows, for the year ended April 30, 1999, the cash and other compensation paid by the Company to its Chief Executive Officer and to each of the executive officers of the Company who had annual compensation in excess of $100,000.
Employment Agreements
The Company has entered into an employment agreement with each of Thomas Biddix, its Chairman of the Board, Chief Executive Officer and President and Timothy McWilliams, its Chief Operating Officer and Secretary. Each of Mr. Biddix's and Mr. McWilliams employment agreement provides for an initial term of three years commencing December 1, 1998 and requires Mr. Biddix and Mr. McWilliams to devote a sufficient portion of his business time, energies and attention to the performance of his duties. Mr. Biddix's employment agreement provides for an annual base salary of $180,000. Mr. McWilliams' employment agreement provides for a base annual salary of $95,000. The Company has accrued its salary obligations to each of Messrs. Biddix and McWilliams as a part of its financial statements but has not paid either of them since inception.
Option Grants in Last Fiscal Year
In connection with their employment agreements, Mr. Biddix and Mr. McWilliams were granted options to purchase 4,000,000 and 3,000,000 shares, respectively, of the Company's common stock at an exercise price of $.04 per share.
The following table summarizes the number of shares and the terms of stock options granted to the Named Executive Officers during the fiscal year ended April 30, 1999.
The following table summarizes the number of exercisable and unexercisable options held by the Named Executive Officers at April 30, 1999, and their value at that date if such options were in the money.
(1) Represents the difference between the aggregate market value at April 30, 1999, of the common stock underlying the options (based on a last sale price of $.04 on that date) and the options' aggregate exercise price.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding the Company's common stock, par value $.01 beneficially owned as of October 1, 1999 for (i) each stockholder known by the Company to be the beneficial owner of five (5%) percent or more of the Company's outstanding common stock, (ii) each of the Company's directors, (iii) each named executive officer, and (iv) all executive officers and directors as a group. At October 1, 1999 there were 33,844,426 shares of common stock outstanding.
Name and Address of Amount and Nature of Percent Beneficial Owner(1) Beneficial Ownership(2) of Class - ------------------- ----------------------- -------- Thomas E. Biddix 29,485,353(3) 87% Timothy McWilliams 3,000,0004) 9% All directors and officers as a group (4 persons)(5) 96% - ---------------------- (1) Unless otherwise indicated, the address of each of the persons named in the table is 255 East Drive, Suite C, Melbourne, Florida 32904. Unless otherwise noted, the Company believes that each of the persons named in the table have sole voting and dispositive power with respect to all the shares of common stock of the Company beneficially owned by such person.
(2) A person is deemed to be the beneficial owner of securities that can be acquired by such person within 60 days upon the exercise of warrants or options or the conversion of convertible securities. Each beneficial owner's percentage ownership is determined by assuming that warrants or options that are held by such person (but not those held by any other person) and that are exercisable within 60 days have been exercised.
(3) All of shares owned by Mr. Biddix were acquired in connection with the acquisition of Pre-Cell Florida. (See "Certain Relationships and Related Transactions.") Includes an option to acquire 4,000,000 shares granted to Mr. Biddix as provided in Mr. Biddix's Employment Agreement with the Company. (See "Executive Compensation")
(4) Includes an option to acquire 3,000,000 shares granted to Mr. McWilliams as provided in Mr. McWilliams' Employment Agreement with the Company. (See "Executive Compensation")
(5) Includes those individuals whose holdings are described in notes 3 and 4, above.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In December 1998, the Board of Directors of the Company approved an amendment to its certificate of Incorporation to effect a one-for-seven reverse stock split. All per share data and references to the numbers of shares have been retroactively restated to give effect to the reverse stock split.
The company entered into a Share Exchange Agreement as of December 1, 1998 pursuant to which it acquired all of the issued and outstanding capital shares of Pre-Cell Florida in exchange for 32,156,000 shares of the Company's common stock. Thomas Biddix, the Company's Chairman of the Board, Chief Executive Officer and President, was the sole shareholder of Pre-Cell Florida.
Also on December 1, 1998, the company entered into an Administrative Services Agreement with Pre-Paid Solutions, Inc. ("Pre-Paid") pursuant to which Pre-Paid performs all of the administrative functions of the company, such as accounting, legal, tax compliance and all other administrative functions. Pursuant to the Administrative Services Agreement, the Company pays Pre-Paid $1,000 per month. Pre-Paid is controlled by Thomas Biddix, the Company's Chairman of the Board, Chief Executive Officer and President.
The Company subleases its corporate headquarters from Pre-Paid, a company controlled by Thomas Biddix. The Company subleases 750 square feet of space at a current rental rate of $486.95 per month. The Company has an option to extend the sublease commencing on June 15, 2000 and terminating on June 14, 2001 at the monthly rental rate of $511.26.
ITEM 14.
ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
(a) Index to Exhibits
Exhibits Description of Documents
10.1 Share Exchange Agreement entered into between the Company and Pre-Cell Solutions, Inc., a Florida corporation
10.2 Employment Agreement between the Company and Thomas E. Biddix
10.3 Stock Option Agreement between the Company and Thomas E. Biddix
10.4 Employment Agreement between the Company and Timothy F. McWilliams
10.5 Stock Option Agreement between the Company and Timothy F. McWilliams
10.6 Administrative Services Agreement between the Company and Pre-Paid Solutions, Inc.
10.7 Sublease between the Company and Pre-Paid Solutions, Inc. for the property located at 255 East Drive, Suite C, Melbourne, Florida
SIGNATURES
In accordance with Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PRE-CELL SOLUTIONS, INC. (Registrant)
Date: December 30, 1999 By: /s/ Thomas E. Biddix ----------------------------------- Thomas E. Biddix Chief Executive Officer/Director
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
Date: December 30, 1999
By:/s/ Timothy McWilliams -------------------------------- Timothy McWilliams, Director
CONTENTS
PAGE
INDEPENDENT AUDITOR'S REPORT
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF OPERATIONS
CONSOLIDATED STATEMENTS OF CASH FLOWS
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITOR'S REPORT
Pre-Cell Solutions, Inc. Melbourne, Florida
We have audited the accompanying consolidated balance sheets of Pre-Cell Solutions, Inc. (A Colorado corporation) as of April 30, 1999 and 1998, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of April 30, 1999 and 1998, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Certified Public Accountants
November 12, 1999
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
PRE-CELL SOLUTIONS, INC. (A COLORADO CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended April 30, 1999 and 1998
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS - Pre-Cell Solutions, Inc. (the Company) f/k/a Transamerican Petroleum Corporation ("Transamerican"), was incorporated in Colorado in 1981. The Company, located in Melbourne, Florida, operates as a competitive local exchange carrier (CLEC), utilizing Bell South interconnection services. Such local telephone service is provided throughout Florida. Prior to December 1, 1998, the Company had been virtually inactive since 1995.
PRINCIPLES OF CONSOLIDATION - These consolidated financial statements present the Company and its wholly-owned subsidiary, Pre-Cell Solutions, Inc., a Florida corporation. All intercompany transactions and balances have been eliminated.
USE OF ESTIMATES - The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates.
CASH - Cash consists of bank deposits, which at times may exceed federally insured limits.
EQUIPMENT - Equipment is recorded at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, generally five years. Expenditures for repairs and maintenance are charged to operations as incurred.
GOODWILL - The excess of purchase price over net liabilities acquired in a business combination is accounted for as goodwill, which is being amortized over fifteen years utilizing the straight-line method.
INCOME TAXES - The Company accounts for income taxes pursuant to Statement of Financial Accounting Standards No. 109 (SFAS 109). SFAS 109 requires the recognition of deferred tax assets and liabilities and adjustments to deferred tax balances for changes in tax law and rates. In addition, future tax benefits such as net operating loss carryforwards are recognized to the extent recognition of such benefits is more likely than not.
PRE-CELL SOLUTIONS, INC. (A COLORADO CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended April 30, 1999 and 1998
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
EARNINGS OR LOSS PER SHARE - Earnings or loss per share is computed based on the weighted average number of common shares outstanding. The number of shares used in computing the loss per common share at April 30, 1999 and 1998 was 14,999,623 and 11,846,985, respectively.
NOTE 2 ACQUISITION
On December 1, 1998, the Company exchanged 31,328,910 shares of its common stock for the outstanding common stock of Pre-Cell Solutions, Inc., a Florida corporation in a transaction accounted for as a purchase. The total purchase price approximated $1,523,000. The excess of the purchase price over the net liabilities assumed is accounted for as goodwill.
NOTE 3 INCOME TAXES
At April 30, 1999 and 1998, the Company has approximately $370,000 of net operating loss carryforwards expiring through 2014, which would have resulted in a deferred tax asset of approximately $275,000 at April 30, 1999 and 1998. The Company has not recognized the deferred tax asset applicable to the carryforward as the balance is offset by a valuation allowance.
NOTE 4 RELATED PARTY TRANSACTIONS
The Company leases its offices from a related party under a sublease. The agreement calls for monthly rental payments totaling approximately $500 with annual renewal options through June, 2001. Total rent for the year ended April 30, 1999 approximated $4,600 and is included in current liabilities at April 30, 1999.
The Company has entered into an administrative services agreement with a related party totaling $1,000 per month through June 30, 2001. Total fees under this agreement for the year ended April 30, 1999 totaled $10,000 and is included in current liabilities at April 30, 1999.
PRE-CELL SOLUTIONS, INC. (A COLORADO CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended April 30, 1999 and 1998
NOTE 4 RELATED PARTY TRANSACTIONS - Continued
The Company has entered into employment agreements with two stockholders/officers. Such agreements require annual payments totaling $180,000 and $95,000, respectively, to each executive per year through June 30, 1999. Fees under this agreement totaled $330,000 and are included in current liabilities. Additionally, the agreements provide for the executives to receive a total of 4,000,000 and 3,000,000 options, respectively to purchase common stock at $.04 per share. These options vest on December 1, 1999 and are exercisable for a term of five years.
NOTE 5 CONTINGENCIES
The Company is an over-the-counter (OTC) bulletin board company. In July, 1999, the Company changed its trading symbol from TAMP to TDCM. However, the Company remains delinquent in its S.E.C. filings; the last Form 10-K was filed for the year ended June 30, 1995.
Additionally, the Company is delinquent in its filings with the Internal Revenue Service.
The effects, if any, of any penalties relating to the above are not reflected in these consolidated financial statements.
NOTE 6 YEAR 2000 (UNAUDITED)
Management has assessed the Company's exposure to date sensitive computer hardware and software programs that may not be operative subsequent to 1999 and has implemented a requisite course of action to minimize Year 2000 risk and ensure that neither significant costs nor disruption of normal business operations are encountered. However, because there is no guarantee that all systems of outside vendors or other entities affecting the Company's operations will be 2000 compliant, the Company remains susceptible to consequences of the Year 2000 Issue. | 8,580 | 57,407 |
892482_1999.txt | 892482_1999 | 1999 | 892482 | ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Rimage Corporation (together with its subsidiaries, "Rimage" or the "Company") designs, manufactures and markets CD recordable ("CD-R") and DVD duplication and production equipment. The Company's Producer line of CD-R production systems provides turnkey premastering, recording and label printing in a single machine that may be used alone or on a network to allow the user to record and label large volumes of digital information for information distribution, archiving and other applications. The Perfect Image(R) CD Printer and Autoprinter are fast, affordable manual and unattended systems for professional quality color printing on the surface of both CD's and DVD's.
The Company was incorporated as IXI, Inc. in Minnesota in February 1987 and changed its name to Rimage Corporation in April 1988. Rimage acquired the assets of a company that produced diskette duplication equipment in 1987 and of a California-based manufacturer of duplication equipment in 1988. The Company's operations through 1995 consisted primarily of the design, manufacture and sale of diskette and tape duplication equipment. In 1992, Rimage created a formal presence in Europe, forming Rimage Europe GmbH as a wholly owned subsidiary to conduct sales and service. In December 1993, Rimage acquired Duplication Technology, Inc. (Rimage Boulder); a company located in Boulder, Colorado that manufactured tape and CD-R duplication equipment and provided duplication services. In September 1994, the Company acquired a company in California, Knowledge Access International, which provided customized browser and archiving software. The Company formed a separate division in early 1996, Rimage Optical Systems, to act as a distributor of CD-ROM stamping presses manufactured by a European Company.
In September 1995, Rimage acquired Dunhill Software Services, Inc., an affiliated corporation that was formed in 1988 and that offered diskette duplication and production services. Dunhill was merged into the Company and, together with a portion of Duplication Technology, represented most of the Company's Services Division operations. The Company operated in two divisions: 1) Systems and 2) Services until June 1999, at which time its Services Division was discontinued. Accordingly, the operations of the discontinued Services Division are stated separately on the financial statements included herein.
In early 1997, the Company shutdown Knowledge Access and ceased operations of its Optical Systems division. During the third quarter of 1998, the Company ceased operations of its Bloomington, Minnesota Service Division (previously known as Dunhill Software Services, Inc.) and sold the equipment and inventory associated with its operations. Also, on June 30, 1999, the Company ceased operations of its Rimage Boulder subsidiary and sold all the assets associated with its operations. These changes, together with increased distribution and market acceptance of its CD-R products, resulted in record earnings for the 1999 calendar year.
The Company's operations during the past five years have been affected by the timing of the foregoing acquisitions and subsequent phasing out of unprofitable operations, new product introductions and the expenses associated with development of such new products, by changes in preferred formats for media storage, and by increasing competition in the services businesses. The shift from diskette to CD-R storage technologies precipitated the introduction of the Company's new CD-R products in 1995. These new CD-R products continued to generate significant, sales increases in 1997, 1998 and 1999.
PRODUCTS
The Company's sales of CD-R production equipment comprised 68%, 68% and 46% of the Company's revenue from continuing operations during the 1999, 1998, and 1997 calendar years, respectively. The Company's other major sources of revenue consist of consumables, maintenance contracts and diskette equipment sales.
The Company's core products are the Perfect Image line of automated CD-R publishing and duplication systems, the Perfect Image CD-R Printer and the Perfect Image CD-R Autoprinter.
The Perfect Image CD-R product line consists of a growing family of products that cover a broad range of requirements for the publishing and duplication of CD-R's. The Company has developed a comprehensive line of CD-R
hardware and software solutions specifically for customers interested in publishing large amounts of information and data onto a compact disc. The Rimage Perfect Image Producer product line gives customers the capability to produce multiple CD-R's in minutes, using automated loading systems, multiple recorders, and in line printing. This product line serves a wide range of office networks, industry production and retail environments.
The Rimage CD-R Printer is a unique product in the industry that provides laser quality color printing on standard CD-R media for in-house, customized printing. The CD-R Printer has allowed Rimage to better position itself in the rapidly expanding and highly competitive CD marketplace. The Company also manufactures the Rimage CD Autoprinter. The Autoprinter automates the process of printing laser quality color prints on standard CD media using the Rimage CD-R Printer.
The Company's products are designed to automate manual processes, resulting in a reduction of labor and training costs for users of the products. The principal benefits to users of the Company's products are reduced operational costs, higher throughput than alternative systems, and higher quality. One of the essential elements of the Company's marketing and development is to provide users with a path for upgrading to future enhancements and additional capabilities. The Company has made a long-term commitment to its customers by providing maintenance service contracts, replacement parts, and repair service to customers for current as well as past products.
MARKETING AND DISTRIBUTION
The Company utilizes three principal means of distribution for its products: an international and domestic distributor network, a value added reseller (VAR) network, and inside sales.
The Company's sales force focuses primarily on building and supporting the distribution channel; the distributor network sells to and supports all size users; the VAR network is used to distribute the CD-R products within industry specific environments; and inside sales focuses on the sale of maintenance contracts and consumables.
During 1999, the Company derived 11% of its revenues from New Wave Technologies, a third party distributor.
The Company conducts foreign sales and services through its subsidiary in Germany, Rimage Europe GmbH. Foreign sales constituted approximately 31%, 31%, and 23% of the Company's revenue from continuing operations for the years ended December 31, 1999, 1998 and 1997, respectively.
COMPETITION
The Company competes with a growing number of manufacturers of CD-R production equipment and related products. Rimage is able to compete effectively in the sale of CD-R production equipment because of technological leadership in automated solutions and its early start within the CD-R production equipment industry. Rimage believes that the thermal quality printing capabilities for CD-R, its transporter mechanisms and its software differentiate its products from those of competitors.
MANUFACTURING
The Company's manufacturing operations consist primarily of the assembly of products from components purchased from third parties. Some parts are stock "off-the-shelf" components and others are manufactured to the Company's specifications. The Company's employees at its facility in Edina, Minnesota conduct final assembly operations. Components include CD-R drives, circuit boards, electric motors, and machined and molded parts.
Although the Company believes it has identified alternative assembly contractors for most of its subassemblies, an actual change in such contractors would likely require a period of training and test. Accordingly, a sudden interruption in a supply relationship or the production capacity of one or more of such contractors could result in the Company's inability to deliver one or more products for a period of several months.
RESEARCH AND DEVELOPMENT
There are approximately 20 people involved in research and development at the Company's various locations. This staff, with software, electronic, mechanical and drafting capabilities engages in research and development of new products, and development of enhancements to existing products.
The microcomputer industry served by the Company is subject to rapid technological changes. Alternate data storage media exist or are under development, including high capacity hard drives, new CD technologies, file servers accessible through computer networks, and the Internet. All these forces may affect the usage of CD-R and DVD media. The Company believes that it must continue to innovate and anticipate advances in the storage media industry in order to remain competitive.
The Company's expenditures for engineering and development were $2,612,000, $1,902,000, and $1,904,000 in 1999, 1998 and 1997 (or 7.2%, 6.7%, and 9.1% of revenues from continuing operations), respectively. The Company intends to maintain its level of investment in research and development to match the percentage in 1999.
PATENTS AND GOVERNMENT REGULATION
The Company is the owner of thirteen patents, has three patents pending and has license rights to another six patents. In addition, the Company protects the proprietary nature of its software primarily through copyright and license agreements and through close integration with its hardware offerings. It is the Company's policy to protect the proprietary nature of its new product developments whenever they are likely to become significant sources of revenue. No guarantee can be given that the Company will be able to obtain patent or other protection for other products.
As the number of the Company's products increase and the functionality of those products expands, the Company believes that it may become increasingly subject to attempts by others to duplicate its proprietary technology and to the possibility of infringement claims. In addition, although the Company does not believe that any of its products infringe the rights of others, there can be no assurance that third parties will not assert infringement claims against the Company in the future or that any such assertion will not require the Company to enter into a royalty arrangement or result in litigation.
The FCC requires some of the Company's equipment meet radio frequency emission standards. The Company has the necessary certification.
EMPLOYEES
At December 31, 1999, the Company had 120 full-time employees, of whom approximately 20 were involved in research and development, 50 in manufacturing, assembly, testing and customer service, and 50 in sales, administration and management. None of the Company's employees are represented by a labor union or are covered by a collective bargaining agreement.
ITEM 2.
ITEM 2. PROPERTIES
The Company headquarters are located in a leased facility of 43,000 square feet at 7725 Washington Avenue South, Edina, Minnesota 55439. In September 1998, the Company restructured its existing capital lease into an operating lease containing a sixty-two month term for this facility, which is owned by a related party (see note 8 to the consolidated financial statements). Rent is $6.95 per square foot per year, plus taxes and common area charges of $2.98 per square foot per year. The Systems Division also leases a facility in Frankfurt, Germany. These facilities are used for manufacturing, engineering, service and sales.
The Company also leases a 28,440 square foot facility in Bloomington, Minnesota. In September 1998, the Company restructured its existing capital lease into an operating lease containing a sixty month term for this facility, which is owned by a related party (see note 8 to the consolidated financial statements). Rent is $4.40 per square foot per year, plus taxes and common area charges of $2.16 per square foot per year. It is the intent of the Company to sublease this facility by the end of June 2000.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to any litigation that may have a material adverse effect on the Company, its business, or its financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matters to a vote of security holders during the last quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is traded on the NASDAQ National Market under the symbol "RIMG". The following table sets forth, for the periods indicated, the range of low and high prices for the Company's common stock as reported on the NASDAQ System.
Low High --- ---- Calendar Year 1998:
1st Quarter................ $3.666 $5.166
2nd Quarter................ 5.416 8.750
3rd Quarter................ 6.750 11.083
4th Quarter................ 7.666 14.500
Calendar Year 1999:
1st Quarter................ 11.625 18.250
2nd Quarter................ 11.500 16.000
3rd Quarter................ 13.500 19.250
4th Quarter................ 15.000 17.250
SHAREHOLDERS
At March 3, 2000, there were 142 record holders of the Company's common stock, and management believes that there are approximately 1,475 beneficial holders of the Company's common stock.
DIVIDENDS
The Company has never paid or declared any cash dividends on its common stock and does not intend to pay cash dividends on its common stock in the foreseeable future. The Company presently expects to retain its earnings to finance the development and expansion of its business. The payment by the Company of dividends, if any, on its common stock in the future is subject to the discretion of the Board of Directors and will depend on the Company's continued earnings, financial condition, capital requirements and other relevant factors.
On March 22, 2000, the Company's Board of Directors declared a three for two stock split in the form of a 50% stock dividend payable on April 7, 2000 to all holders of record on April 1, 2000. The accompanying financial statements do not reflect the effects of the stock dividend.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Rimage develops, manufactures and distributes high performance CD-Recordable (CD-R) and DVD-Recordable (DVD-R) publishing and duplication systems and continues to support its long-term involvement in diskette duplication and publishing equipment.
Until June 1999, Rimage had two primary divisions: The Systems Division and the Services Division. On June 30, 1999, the Company discontinued its Services Division with the sale of the assets of its Rimage Boulder subsidiary. The consolidated financial statements reflect the net operating results of the Services Division net of applicable income taxes, as "Income (loss) from operations of discontinued Services Division"; the net assets of the Services Division as "Net assets of discontinued operations", and the net cash flows of the Services Division within the section "Net cash provided by operating activities". The comments herein pertain to the Company's continuing operations (its Systems Division), unless otherwise stated.
1999 COMPARED TO 1998
Revenues increased by $7,784,000 or 27.3% from 1998 to 1999. This increase was primarily due to the Company's expanding distribution network during 1999 creating an increase in CD-R equipment sales and related peripheral products. CD-R equipment sales totaled $24,809,000 during 1999 compared to $19,493,000 during 1998.
Gross margin as a percentage of revenues was 50.6% and 51.6% during 1999 and 1998, respectively. This decrease was due to strong sales of a product during 1999 carrying slightly lower margins than the Company's existing line of products. An increase in sales of low margin consumables during 1999 also contributed to the slight decrease in gross margin. CD-R equipment sales comprised 68.3% of total revenues during both 1999 and 1998.
Operating expenses as a percent of revenues were 26.4% and 29.8% during 1999 and 1998, respectively. This decrease was primarily a result of 1999 sales expenses remaining relatively consistent with 1998 levels. During 1999, the Company maintained its 1998 sales work force level by increasing the utilization of the sales force of its expanding distribution channel. The Company also modified the incentive programs provided to its distributors and VAR's. These events were primary causes of the Company's sales and marketing expense as a percent of revenues to decrease from 15.6% during 1998 to 12.8% during 1999. The Company's research and development expenses increased from $1,902,000 or 6.7% of revenues during 1998 to $2,612,000 or 7.2% of revenues during 1999. This increase is a result of an increase in personnel and development materials needed to manage the increase in the number of projects the Company has undertaken during 1999.
Operating earnings were $8,780,000 and $6,232,000 during 1999 and 1998, respectively. This improvement was primarily due to increased sales coupled with stable sales expenses from 1998 to 1999.
1998 COMPARED TO 1997
Revenues increased by $7,518,000 or 35.8% from 1997 to 1998. This increase was primarily due to the implementation of a distribution network during 1997 creating an increase in CD-R equipment sales and related peripheral products. CD-R equipment sales totaled $19,493,000 during 1998 compared to $9,578,000 during 1997.
Gross margin as a percentage of revenues was 51.6% and 45.5% during 1998 and 1997, respectively. This increase was due to the continued shift to sales of higher margin CD-R products from sales of diskette equipment. CD-R equipment sales as a percent of total revenues increased from 45.6% during 1997 to 68.3% during 1998.
Operating expenses as a percent of revenues were 29.8% and 28.2% during 1998 and 1997, respectively. This increase was primarily a result of increased sales and marketing expenses. During 1998, the Company continued to expand its distribution network, both domestically and internationally, for its CD-R related products and has focused efforts on the promotion of joint marketing campaigns with distributors and value added resellers. These steps were primary causes of the Company's sales and marketing expense to increase from $2,490,000 or 11.9% of revenues during 1997 to $4,453,000 or 15.6% of revenues during 1998. Partially offsetting the Company's increased sales and marketing expense was a decrease in its general and administrative expense due to the consolidation of
certain administrative duties. Research and development expenses remained relatively constant from 1997 to 1998, but decreased slightly as a percentage of revenue due to higher sales in 1998.
Operating income from continuing operations were $6,232,000 and $3,638,000 during 1998 and 1997, respectively. This improvement was primarily due to the increased sales of higher margin CD-R related products.
LIQUIDITY AND CAPITAL RESOURCES
The Company expects to fund its anticipated cash requirements (including the anticipated cash requirements of its capital expenditures) with internally generated funds and, if required, from the Company's existing credit agreement.
On June 30, 1999, the Company completed the sale of the assets of its Rimage Boulder subsidiary to Advanced Duplication Services, Inc. for $2,050,000 in cash. Also, on July 31, 1998, the Company completed the sale of a substantial portion of its CD-ROM duplicating equipment and a portion of its diskette duplication equipment used in its Bloomington, Minnesota services business to Advanced Duplication Services, Inc. for $1,900,000 in cash.
Current assets are $22,016,000 as of December 31, 1999 as compared to $16,037,000 as of December 31, 1998, primarily reflecting the increase in cash from increased sales of CD-R products. The allowance for doubtful accounts as a percentage of receivables increased from 3% as of December 31, 1998 to 6% as of December 31, 1999. This increase occurred as a result of adjustments to the sales returns allowance during 1999. Current liabilities increased approximately 5% to $4,708,000 as of December 31, 1999 from $4,502,000 as of December 31, 1998, reflecting normal increases in accounts payable and accruals.
Net cash provided by operating activities was $5,788,238 and $4,638,630 during 1999 and 1998, respectively. The increase in cash flow from operating activities from 1998 to 1999 was greatly impacted by increased sales of CD-R products.
Net cash used in investing activities of $868,000 during 1999 primarily reflect purchases of equipment for research and development purposes. Net cash used in investing activities of $174,000 during 1998 primarily reflect capital expenditures offset by receipts from the Company's sales-type leases. At December 31, 1999 the Company had no significant commitments to purchase additional capital equipment.
Net cash used in financing activities of $618,000 during 1999 primarily reflected payments to acquire Company stock netted with proceeds from stock option exercises. Net cash used in financing activities of $575,000 during 1998 principally reflect the payment of the Company's remaining long-term debt netted with proceeds from stock option exercises.
The Company believes that inflation has not had a material impact on its operations or liquidity to date.
YEAR 2000 ISSUES
To date, we have experienced no significant systems or other year 2000 problems in connection with the transition to the year 2000. We will continue to monitor for any year 2000 issues.
NEW EUROPEAN CURRENCY
On January 1, 1999, eleven of the fifteen member countries of the European Union established fixed conversion rates between their existing currencies and the euro, a new European currency, and adopted the euro as their common legal currency (the "Euro Conversion"). Either the euro or a participating country's present currency will be accepted as legal tender through January 1, 2002, from which date forward only the euro will be accepted.
The Company has customers located in European Union countries participating in the Euro Conversion. Such customers will likely have to upgrade or modify their computer systems and software to comply with the euro requirements. The amount of money the Company anticipates spending in connection with product development related to the Euro Conversion is not expected to have a material adverse effect on the Company's results of operations or financial condition. The Euro Conversion may also have competitive implications for the Company's pricing and marketing strategies, which could be material in nature; however, any such impact is not known at this time.
The Company has also modified its internal systems (such as payroll, accounting and financial reporting) to deal with the Euro Conversion. There is no assurance, however, that all problems related to the Euro Conversion will be foreseen and corrected, or that no material disruptions of the Company's business will occur.
NEW ACCOUNTING PRONOUNCEMENTS
In June of 1999, the FASB issued Statement of Financial Accounting Standard No. 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" which delays the effective date of Statement No. 133 until fiscal years beginning after June 15, 2000. Statement No. 133 establishes new standards for recognizing all derivatives as either assets or liabilities, and measuring those instruments at fair value. At the present time, the Company does not anticipate that SFAS No. 133 will have a material impact on its financial position or results of operations.
In December 1999, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements". This bulletin summarizes certain interpretations and practices followed by the SEC in administering the disclosure requirements of the Federal securities laws in applying generally accepted accounting principles to revenue recognition in financial statements. Although we have not fully assessed the implications of SAB No. 101, our management does not believe adoption of this bulletin will have a material impact on our consolidated financial position, results of operations or cash flows.
FORWARD LOOKING STATEMENTS
Certain statements in this Annual Report and in the Company's press releases and oral statements made by or with the approval of the Company's executive officers constitute or will constitute "forward looking statements". All forward looking statements involve risks and uncertainties, and actual results may be materially different. The following factors are among those that could cause the Company's actual results to differ materially from those set forth in such forward looking statements. The Company's ability to succesfully identify and incorporate new technologies into new and enhanced products and to develop and maintain compatibility and interoperability with the products of others, as well as new product introductions by competitors and the continuing availability of intellectual property licenses on commercially available terms, may impact the Company's ability to increase demand for its products. The success of the Company's sales force to provide for broader account coverage through channel partners, better utilization of existing resources and to control selling expense may be impacted by the expertise and commitment of the affected personnel, market acceptance of new and existing products and competitive market conditions. The unanticipated need to enhance or modify products due to changing market requirements, the success of current product programs, and the need to meet unanticipated product opportunities The Company's ability to generate revenue as presently expected, unexpected expenses and the need for additional funds to react to changes in the marketplace, including unexpected increases in personnel and product development expenses, may affect whether the Company has sufficient cash resources to fund its operating plans and capital requirements through at least 2000.
Other factors that could cause the results of the Company to differ materially from those contained in any such forward looking statments include general economic conditions, costs and availability of components and fluctuations in exchange rates. In addition, the markets for the Company's products are characterized by significant competition, and the Company's results may be adversely affected by the actions of existing and future competitors, including the development of new technologies, the introduction of new products and the reduction of prices by such competitors to gain or retain market share. The Company assumes no obligation to publicly release the results of any revision or updates to these forward looking statements to reflect future events or unanticipated occurrences.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of December 31, 1999 and 1998, the Company did not invest in any market risk sensitive instruments including any derivative financial instruments.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS
Page in 1999 Annual Report to Shareholders ------------
Independent Auditors' Report.............. 11
Consolidated Balance Sheets, as of December 31, 1999 and 1998................ 12-13
Consolidated Statements of Operations, for the years ended December 31, 1999, 1998 and 1997............................. 14
Consolidated Statements of Stockholders' Equity and Comprehensive Income, for the years ended December 31, 1999, 1998 and 1997...................................... 15
Consolidated Statements of Cash Flow, for the years ended December 31, 1999, 1998 and 1997............................. 16-17
Notes to Consolidated Financial Statements................................ 18-32
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Rimage Corporation and Subsidiaries:
We have audited the accompanying consolidated balance sheets of Rimage Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Rimage Corporation and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles.
/s/ KPMG LLP
Minneapolis, Minnesota February 8, 2000, except as to note 13, which is as of February 25, 2000
RIMAGE CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1999 and 1998
See accompanying notes to consolidated financial statements.
RIMAGE CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations Years Ended December 31, 1999, 1998 and 1997
See accompanying notes to the consolidated financial statements
RIMAGE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity and Comprehensive Income
Years Ended December 31, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
RIMAGE CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows, Continued
See accompanying notes to the consolidated financial statements
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1) Nature of Business and Summary of Significant Accounting Policies
Basis of Presentation and Nature of Business
The consolidated financial statements include the accounts of Rimage Corporation and Rimage Europe GmbH, collectively hereinafter referred to as Rimage or the Company. All material intercompany accounts and transactions have been eliminated upon consolidation.
The Company develops, manufactures and distributes high performance CD-Recordable (CD-R) publishing and duplication systems, and continues to support its long-term involvement in diskette duplication and publishing equipment.
On June 30, 1999, the Company sold the fixed assets, inventory and intangible assets of its wholly owned subsidiary A/G Systems, Inc. d/b/a Duplication Technology, Inc. (Rimage Boulder). This sale, in conjunction with the August 31, 1998 sale of the fixed assets and inventory used in its Bloomington, Minnesota services operation, constitutes the discontinued operations of the Company's Services Division (see note 11). During March 1997, the Company completed the shutdown of its Knowledge Access subsidiary. The Company also completed shutdowns of its Asia facility and Televaulting division in February and June 1997, respectively.
The Company extends unsecured credit to its customers as well as credit to a limited number of authorized distributor wholesalers, who in turn provide warehousing, distribution, and credit to a network of authorized value added resellers. These distributors and value added resellers sell and service a variety of hardware and software products.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Revenue Recognition
Revenue is recognized at the time of shipment on all equipment and service orders. The Company provides maintenance services under long-term maintenance contracts. Revenue associated with these contracts is deferred and recognized on a straight-line basis over the terms of the respective contracts.
Accounting Estimates
The preparation of financial statements in conformity with generally accepted accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.
Cash Equivalents
All short-term investments with original maturities of three months or less at date of purchase are considered cash equivalents.
Inventories
Inventories are stated at the lower of cost, determined on a first-in, first-out (FIFO) basis, or market.
Property and Equipment
Property and equipment are stated at cost and depreciated on a straight-line basis over periods of two to seven years. Leasehold improvements are amortized using the straight-line method over the terms of the respective leases. Repairs and maintenance costs are charged to operations as incurred.
Stock Based Compensation
The Company accounts for stock based compensation under Accounting Principles Board Opinion No. 25 (APB No. 25), ACCOUNTING FOR STOCKS ISSUED TO EMPLOYEES. Accordingly, no compensation expense had been recognized for its stock-based compensation plans. The Company has adopted the disclosure requirements under Statement of Financial Accounting Standards (SFAS) No. 123, ACCOUNTING AND DISCLOSURE OF STOCK-BASED COMPENSATION.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Software Development Costs
Capitalization of software development costs begins upon the establishment of technological feasibility of the product. The establishment of technological feasibility and the ongoing assessment of the recoverability of these costs require considerable judgment by management with respect to certain external factors, including, but not limited to, anticipated future gross product revenues, estimated economic life, and changes in software and hardware technology.
The Company capitalizes software development costs between the date when project technological feasibility is established (beta stage) and the date when the product is ready for normal production release. Research and development costs related to software development are expensed as incurred. Software development costs are amortized over the estimated economic life of the product, which ranges from two to five years. Amortization expense is included in cost of goods sold. Included in other noncurrent assets are capitalized software costs of $367,836 as of December 31, 1999 and 1998. Accumulated amortization at December 31, 1999 and 1998 was $338,437 and $313,238, respectively.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Net Income (Loss) Per Share
Basic income (loss) per share is calculated as income (loss) available to common stockholders divided by the weighted average number of common shares outstanding for the period. Diluted income per share is calculated by dividing the weighted average number of common and assumed conversion shares outstanding during each period. Assumed conversion shares result from dilutive stock options and warrants computed using the treasury stock method.
Translation of Financial Statements in Foreign Currencies
The assets and liabilities for the Company's international subsidiary are translated into U.S. dollars using current exchange rates. The resulting translation adjustments are recorded in the foreign currency translation adjustment account in equity. Statement of operations items are translated at average exchange rates prevailing during the period. Foreign currency transaction gains or losses are included in net income.
Goodwill
Goodwill represents the excess of the purchase price over the fair value of net assets acquired and is amortized on a straight-line basis over 15 years. Goodwill balances are reviewed periodically to determine that the unamortized balances are recoverable. In evaluating the recoverability, the following factors, among others, are considered: a significant change in the factors used to determine the amortization period, an adverse change in legal factors or in the business climate, a transition to a new product or services strategy, a significant change in the customer base, and/or a realization of failed marketing efforts. If the unamortized balance is believed to be unrecoverable, the Company recognizes an impairment charge necessary to reduce the unamortized balance to the present value of cash flows expected to be generated over the remaining life. The amount of impairment, if any, is charged to income as a part of general and administrative expenses in the current period. As a result of the sale of the fixed assets, inventory, and intangible assets of Rimage Boulder on June 30, 1999 (see Note 11), goodwill is $0 as of December 31, 1999.
Comprehensive Income
Comprehensive income consists of the Company's net income and foreign currency translation adjustment and is presented in the consolidated statements of stockholders' equity and comprehensive income.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Reclassification
Certain prior year amounts have been reclassified to conform with the current year presentation.
2) Fair Value of Financial Instruments
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments.
Cash and cash equivalents: The carrying amount approximates fair value because of the short maturity of those instruments.
Trade accounts receivables and accounts payable: The carrying amount approximates fair value because of the short maturity of those instruments.
3) Inventories
Inventories consist of the following as of December 31:
1999 1998 - --------------------------------------------------------------------------------
Finished goods and demonstration equipment $ 1,117,638 894,291 Work-in-process 100,737 162,943 Purchased parts and subassemblies 1,068,492 818,829 - -------------------------------------------------------------------------------- $ 2,286,867 1,876,063 ================================================================================
4) Note Payable To Bank
On December 31, 1997, the Company entered into a term note agreement (the Credit Agreement) with a bank. The Credit Agreement allows for advances under a revolving loan based on various percentages of qualified asset (primarily accounts receivable and inventory) amounts, up to a maximum advance of $5,000,000 and is effective until June 30, 2000. There were no outstanding borrowings under this revolving loan as of December 31, 1999.
The Credit Agreement contains various covenants pertaining to minimum tangible net worth and current, leverage and fixed charge coverage ratios. The company is in compliance with all covenants at December 31, 1999.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5) Income Taxes
The provision for income tax expense consists of the following:
Total tax expense differs from the expected tax expense, computed by applying the federal statutory rate of 35% to earnings before income taxes as follows:
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The tax effects of temporary differences that give rise to significant portions of deferred tax assets as of December 31, are presented below:
A reconciliation of the valuation allowance for deferred taxes as of December 31 is as follows:
A valuation allowance is provided when it is more likely than not that all or a portion of the deferred tax asset may not be recognized. The Company periodically evaluates the need for the valuation allowance. As a result of continued earnings and other positive business factors during 1998 the Company determined that it was more likely than not that the deferred tax asset would be realized. Therefore, the valuation allowance of $1,461,000 was reduced to zero.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6) Stockholders' Equity
Stock Options
Rimage adopted a stock option plan on September 24, 1992 which allows for the granting of options to purchase shares of common stock to certain key administrative, managerial and executive employees and the automatic periodic grants of stock options to non-employee directors. Options under this plan may be either incentive stock options or non-qualified options. Pursuant to this plan, the following options are currently issued and outstanding:
Weighted Shares average available Options exercise for grant outstanding price - --------------------------------------------------------------------------------
Balance at December 31, 1996 262,575 435,675 $ 4.58 Additional shares available 750,000 -- -- Granted (630,750) 630,750 2.02 Exercised -- (10,203) 2.00 Canceled 85,281 (85,281) 4.92 - --------------------------------------------------------------------------------
Balance at December 31, 1997 467,106 970,941 2.11 Granted (326,700) 326,700 4.51 Exercised -- (239,144) 2.42 Canceled 4,000 (4,000) 2.75 - --------------------------------------------------------------------------------
Balance at December 31, 1998 144,406 1,054,497 2.78 Granted (103,000) 103,000 13.69 Exercised -- (171,126) 2.49 Canceled 1,750 (1,750) 9.18 - --------------------------------------------------------------------------------
Balance at December 31,1999 43,156 984,621 $ 3.96
At December 31, 1999, 948,047 of the options outstanding were exercisable. Outstanding options had exercise prices ranging between $2.00 and $15.00 per share and a weighted average contractual life of 7.5 years.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following table calculates the fair market value of options granted on the date of grant using the Black-Scholes option pricing model:
The Company applies APB No. 25 and related interpretations in accounting for its plans. Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's 1999, 1998 and 1997 net income and basic and diluted earnings per share would have been adjusted to the proforma amounts stated below:
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7) Net Income Per Share
The components of net income per basic and diluted share are as follows:
Weighted Average Shares Per Share Net Income Outstanding Amount ------------- ------------- ------------- 1999: Basic $ 6,343,250 5,057,990 $ 1.25 Dilutive effect of stock options -- 762,110 (.16) ------------- ------------- ------------- Diluted $ 6,343,250 5,820,100 $ 1.09 ============= ========= =============
1998: Basic $ 5,052,695 4,769,009 $ 1.06 Dilutive effect of stock options -- 869,131 (.16) ------------- ------------- ------------- Diluted $ 5,052,695 5,638,140 $ .90 ============= ========= =============
1997: Basic $ 1,925,073 4,629,431 $ .42 Dilutive effect of stock options -- 285,368 (.03) ------------- ------------- ------------- Diluted $ 1,925,073 4,914,799 $ .39 ============= ========= =============
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8) Leases
During September 1998, the Company renegotiated its existing capital leases for both the Edina and Bloomington Minnesota facilities, which resulted in reclassification to operating leases and a gain of $512,192.
Also, in connection with the August 31, 1998 sale of its Bloomington, Minnesota services operation, the Company paid $1,385,528 to satisfy debt associated with a capital lease on certain CD-ROM equipment.
The future minimum lease payments excluding operating expenses and real estate taxes as of December 31, 1999 are:
Related Third party party Total operating operating operating Year ending December 31 leases leases leases - -------------------------------------------------------------------------------- 2000 $ 426,996 57,018 484,014 2001 436,026 57,018 493,044 2002 445,199 57,018 502,217 2003 301,004 57,018 358,022 2004 -- 57,018 57,018 - --------------------------------------------------------------------------------
Net minimum lease payments $ 1,609,225 285,090 1,894,316 =========== ============ ============
Rent expense under operating leases amounted to approximately $708,000, $544,000, and $333,000, respectively, for the years ended December 31, 1999, 1998, and 1997.
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9) Profit Sharing and Savings Plan
Rimage has a profit sharing and savings plan under Section 401(k) of the Internal Revenue Code. The plan allows employees to contribute up to 16% of pretax compensation. The Company's discretionary contributions totaled $142,957, $123,621 and $137,150 in 1999, 1998 and 1997, respectively.
10) Major Customers
The Company derived approximately $4,167,873 of its 1999 sales from an unaffiliated customer and had a receivable balance from this customer in the approximate amount of $222,000 as of December 31, 1999.
11) Discontinued Operations, Restructuring Expenses and Related Reserves
On June 30, 1999, the Company sold the remaining assets of its Services Division. The consolidated financial statements of the Company have been reclassified to reflect the dispositions of the companies that comprised the Company's Services Division business segment. This segment included the Company's Bloomington, Minnesota services operation and Rimage Boulder. Accordingly, the revenues, costs and expenses, assets and liabilities, and cash flows of the Services Division have been excluded from the respective captions in the Consolidated Statements of Operations, Consolidated Balance Sheets and Consolidated Statements of Cash Flows. The net operating results of the Services Division have been reported, net of applicable income taxes, as "Income (loss) from operations of discontinued Services Division"; the net assets of the Services Division have been reported as "Net assets of discontinued operations", and the net cash flows of the Services Division have been reported within the section "Net cash provided by operating activities" and after the section "Net cash used in financing activities".
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Summarized financial information for the discontinued operation, is as follows:
For the years ended December 31 (in thousands) 1999 1998 1997 - -------------------------------------------------------------------------------
Revenues $ 2,322 $ 8,854 $ 17,867 Income from discontinued operations net of income tax expense (benefit) of $105, $(217), and $(82) for 1999, 1998, and 1997, respectively $ 186 $ (541) $ (1,311) Gain on disposal, net of income tax expense of $609 $ 303 $ -- $ -- ===============================================================================
At December 31 (in thousands) 1998 - -----------------------------------------------------------------
Current assets $ 683 Total assets $ 1,026 - -----------------------------------------------------------------
Current liabilities $ 439 Total liabilities $ 439 - -----------------------------------------------------------------
Net assets of discontinued operations $ 587 =================================================================
12) Commitments and Contingencies
The Company is exposed to a number of asserted and unasserted claims encountered in the normal course of business. In the opinion of management, the resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations.
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13) Subsequent Event
On February 25, 2000, the Company entered an Agreement and Plan of Merger (the "Agreement") with Cedar Technologies, Inc ("Cedar"). According to the Agreement, the Company will issue 331,664 shares of its common stock for all the outstanding common stock of Cedar and the Company will issue 268,028 shares of its common stock in exchange for outstanding options and warrants of Cedar. This business combination will be accounted for as a pooling-of-interests combination and, accordingly, the Company's historical consolidated financial statements presented in future reports will be restated to include the accounts and results of operations of Cedar.
The following unaudited pro forma data summarizes the combined results of operations of the Company and Cedar as if the combination had been consummated on December 31, 1999.
(Amounts in thousands, except per share data)
Years Ended December 31 -------------------------------------------- 1999 1998 1997 ------------ ------------- ------------
Revenues $ 41,354 $ 31,366 $ 21,012 ============ ============= ============
Income from continuing operations $ 5,962 $ 5,793 $ 3,236 ============ ============= ============
Diluted Earnings per share $ 0.94 $ 0.99 $ 0.66 ============ ============= ============
(Continued)
RIMAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14) Supplemental Quarterly Data - Unaudited (dollars in thousands, except per share data)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding directors, executive officers, promoters and control persons of the Company is set forth under "Election of Directors" in the Company's definitive proxy statement for its 2000 Annual Meeting of Shareholders, to be filed by April 29, 2000 and is incorporated herein by reference.
Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 by the directors, executive officers and beneficial owners of more than ten percent of the common stock of the Company is set forth under "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement for its 2000 Annual Meeting of Shareholders, to be filed by April 29, 2000, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding compensation of directors and executive officers of the Company is set forth in the section entitled "Board Committee and Actions" under "Election of Directors" and the sections entitled "Summary Compensation Table", "Stock Options", and "Retirement Savings Plan" under "Executive Compensation" in the Company's definitive proxy statement for its 2000 Annual Meeting of Shareholders, to be filed by April 29, 2000, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information regarding security ownership of certain beneficial owners and management is set forth under "Beneficial Ownership of Common Stock" in the Company's definitive proxy statement for its 2000 Annual Meeting of Shareholders, to be filed by April 29, 2000, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions is set forth in the section entitled "Certain Transactions" under "Executive Compensation" in the Company's definitive proxy statement for its 2000 Annual Meeting of Shareholders, to be filed by April 29, 2000, and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS. See Part II, Item 8 of this report.
(2) FINANCIAL STATEMENT SCHEDULES.
Page in this Form 10-K ---------
Independent Auditors' Report on Financial Statement Schedule ................................... 34
Schedule II - Valuation and Qualifying Accounts ...... 35
(3) EXHIBITS. See Index to Exhibits on page 37 of this report.
(b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed during the last quarter of the fiscal year.
(c) See Exhibit Index and Exhibits.
(d) See the Financial Schedule included at the end of this report.
INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULE
The Board of Directors and Stockholders Rimage Corporation and Subsidiaries:
Under date of February 8, 2000, except as to note 13, which is as of February 25, 2000, we reported on the consolidated balance sheets of Rimage Corporation and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 1999, as contained in the 1999 annual report to stockholders. These consolidated financial statements and our report thereon are included in the annual report on Form 10-K for the year 1999. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedule as listed in Item 14(a)(2). This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statement schedule based on our audits.
In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
Minneapolis, Minnesota February 8, 2000 except as to note 13, which is as of February 25, 2000
SCHEDULE II
RIMAGE CORPORATION VALUATION AND QUALIFYING ACCOUNTS
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereto duly authorized.
RIMAGE CORPORATION
By: /s/ Bernard P. Aldrich ---------------------- Bernard P. Aldrich Chief Executive Officer
Dated: 3/20/00
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - --------- ----- ----
/s/ Bernard P. Aldrich Chief Executive Officer, President, 3/20/00 - --------------------------- Director (principal executive and Bernard P. Aldrich financial officer)
/s/ David J. Suden Chief Technical Officer & Director 3/20/00 - --------------------------- David J. Suden
/s/ Robert M. Wolf Treasurer (principal accounting officer) 3/20/00 - --------------------------- Robert M. Wolf
/s/ James L. Reissner Director 3/20/00 - --------------------------- James L. Reissner
/s/ Ronald R. Fletcher Director 3/20/00 - --------------------------- Ronald R. Fletcher
/s/ Richard F. McNamara Director 3/20/00 - --------------------------- Richard F. McNamara
/s/ George E. Kline Director 3/20/00 - --------------------------- George E. Kline
INDEX TO EXHIBITS
EXHIBIT
NO. DESCRIPTION
2.1 Agreement and Plan of Merger dated February 25, 2000 by and between Rimage Corporation and Cedar Technologies, Inc. [Filed as Exhibit 2.1 to the Company's Form 8-K Report (File No. 0-20728) and incorporated herein by reference].
2.2 Escrow Agreement dated February 25, 2000 by and between Rimage Corporation and all the shareholders of Cedar Technologies, Inc. [Filed as Exhibit 2.2 to the Company's Form 8-K Report (File No. 0-20728) and incorporated herein by reference].
3.1 1992 Restated Articles of Incorporation of Rimage Corporation [Filed as Exhibit 3.1 to the Company's Registration Statement on Form SB-2 (Registration No. 33-22558) and incorporated herein by reference].
3.2 Bylaws of Rimage Corporation [Filed as Exhibit 3.2 to the Company's Registration Statement on Form SB-2 (Registration No. 33-22558) and incorporated herein by reference].
10.1 Rimage Corporation 1992 Stock Option Plan [Filed as Exhibit 10.5 to the Company's Registration Statement on Form SB-2 (Registration No. 33-22558) and incorporated herein by reference].
10.2 Lease dated July 28, 1992, between Rimage Corporation and 7725 Washington Avenue Corporation [Filed as Exhibit 10.6 to the Company's Registration Statement on Form SB-2 (Registration No. 33-22558) and incorporated herein by reference].
10.3 Credit Agreement dated December 31, 1997 between Rimage Corporation and First Bank, National Association.
10.4 1992 Stock Option Plan
21.1 Subsidiaries of Rimage Corporation.
23.1 Independent Auditors' Consent.
27.1 Financial Data Schedules for 1999, 1998 and 1997 Year Ends.
RIMAGE CORPORATION 7725 Washington Avenue South Minneapolis, MN 55439 TEL: 612-944-8144 FAX: 612-944-7808
RIMAGE EUROPE, GMBH Hans - Boekler - Str. 7 6057 Dietzenbach, Germany TEL: 011-49-6074-8521-0 FAX: 011-49-6074-8521-21 | 8,493 | 58,852 |
776848_1999.txt | 776848_1999 | 1999 | 776848 | ITEM 1 - BUSINESS
Premier National Bancorp, Inc. (the "Company") is a New York corporation with headquarters and principal executive offices at 1100 Route 55, Lagrangeville, New York. The Company's principal subsidiary, accounting for 99% of the consolidated assets and 90% of consolidated equity, is Premier National Bank (the "Bank").
The Company is registered with the Board of Governors of the Federal Reserve System (the "Reserve Board") as a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHCA"). As a bank holding company, it is required to file annual reports and other information regarding its business operations and those of its subsidiaries with the Reserve Board. See "REGULATION AND SUPERVISION - Bank Holding Company Regulation."
The Bank was chartered under the National Bank Act in 1863 and is a member of the Federal Reserve System. It operates through its main office at 289-291 Main Mall, Poughkeepsie, New York, and thirty-three other branch offices and six offsite automated teller machines in Dutchess, Ulster, Putnam, Sullivan, Rockland, Westchester and Orange Counties. Its deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") to the extent permitted by law. The Bank is subject to comprehensive regulation, supervision, and examination by the Office of the Comptroller of the Currency ("Comptroller"), the Reserve Board, and the FDIC.
The Bank conducts a general commercial banking and trust business. It offers retail and wholesale banking services including demand, savings and time deposits, commercial, mortgage and installment loans, consumer banking, and trust services. Services offered by the Bank's Trust Department include trust administration, investment management, and custody services. The Company's principal business strategy is to provide its clients with "relationship banking", based on personalized service from dedicated account managers who are positioned to deliver the full range of the Bank's products to its target markets.
As of December 31, 1999, the Company, on a consolidated basis, had total assets of approximately $1.6 billion, total deposits of $1.4 billion and stockholders' equity of $142.0 million. At December 31, 1999, the Company and the Bank employed 506 employees on a full-time equivalent basis.
FORWARD-LOOKING STATEMENTS
The Company has made, and may continue to make, various forward-looking statements with respect to earnings, credit quality and other financial and business matters for 1999 and, in certain instances, subsequent periods. The Company cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, and that statements for subsequent periods are subject to greater uncertainty because of the increased likelihood of changes in underlying factors and assumptions. Actual results could differ materially from forward-looking statements.
In addition to those factors previously disclosed by the Company and those factors identified elsewhere herein, the following factors could cause actual results to differ materially from such forward-looking statements; pricing pressures on loan and deposit products; actions of competitors; changes in local and national economic conditions; the extent and timing of actions of the Reserve Board or the Comptroller; customer deposit disintermediation; changes in customers' acceptance of the Company's products and services; and the extent and timing of legislative and regulatory actions and reform, estimated cost savings from recent or anticipated acquisitions and mergers cannot be fully realized within the expected time frame, revenues following such transactions are lower than expected, and costs or difficulties related to the integration of acquired and existing businesses are greater than expected.
The Company's forward-looking statements speak only as of the date on which such statements are made. By making any forward-looking statements, the Company assumes no duty to update them to reflect new, changing or unanticipated events or circumstances.
LENDING
GENERAL. The Bank engages in a variety of lending activities which are primarily categorized as residential and commercial mortgage, consumer/installment, and commercial lending. At December 31, 1999, the Bank's gross loan portfolio totaled approximately $993.8 million. Of this amount, real estate mortgage, consumer/installment, and commercial loans comprised 73.6%, 14.4%, and 11.9%, respectively, of the Bank's loan portfolio.
At December 31, 1999, the Bank's unsecured lending limit to one borrower under applicable regulations was approximately $22.0 million.
In managing the growth of its loan portfolio, the Bank has focused on: (i) the application of its established underwriting criteria, (ii) establishment of management lending authorities well below the Bank's legal lending authority, (iii) establishment of industry concentration limits, (iv) involvement by senior management and the Board of Directors in the loan approval process for designated categories of loans, and (v) monitoring of loans for timely payment and to seek to identify potential problem loans.
A material factor in assessing the Company's loan portfolio is the ability of the Company's loan officers to discriminate between acceptable and unacceptable credit risks and to identify changes in a borrower `s financial condition that affect the borrower's ability to perform in accordance with loan terms. Lending policies and procedures place an emphasis on assessing consolidated financial risk and income flows as well as collateral values. Further, the Company has developed aging systems which assist in monitoring delinquency of loans and at varying points either the collection department, loan officer or loan workout department, or a combination of the above, are involved in collection efforts on past due loans. Additional collateral or guarantees may be requested if difficulties remain unresolved.
An independent loan review department reviews each of the Bank's credit portfolios and grades each individual credit it reviews. At December 31, 1999, approximately 93% of the Company's commercial and consumer portfolio were graded by loan review. Additionally, approximately 85% of residential and home equity loans, which represent homogenous pools of loans, were graded. The grades associated with reviewed loans are a primary determinant of the allocations to the allowance for loan losses.
The Bank's regulators require a quarterly assessment of the adequacy of the allowance for loan losses. The Company's assessment methodology includes, among other things, the results of the Company's continuous loan review process, trends in economic conditions, the maturity characteristics of the loan portfolio, volume, growth and composition of the loan portfolio, past loss history and current delinquency and loss trends by portfolio type, and the trends in classified loans.
For information regarding the performance of the loans in the Bank's portfolio and the amount and composition of the Bank's allowance for loan losses, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset Quality and Provisions for Loan Losses" and Item 8, Financial Statements -- Notes to Consolidated Financial Statements.
RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS. Residential mortgage loans are comprised primarily of loans on one-to-four family residential units, construction and land development loans, home equity lines of credit, and special purpose loans (loans satisfying the objectives of the Community Reinvestment Act). A particular, but not extensive portion of the Company's residential mortgage lending, consists of so called "non-conforming" loans which, while meeting the Company's underwriting standards, do not fully comply with the underwriting criteria of FNMA and FHLMC. Such loans are written primarily as ARM's to be held in the Company's loan portfolio. Residential mortgage loans are originated by both Company employees on a commission basis or by approved mortgage brokers.
In underwriting residential mortgage loans, the Bank evaluates both the prospective borrower's ability to make payments on the loan when due and the value of the property securing the loan. As required by banking regulations, an appraisal of the real estate intended to secure the loan is generally undertaken by an independent New York State licensed or certified appraiser previously approved by the Bank. Residential mortgages are generally underwritten up to 80% loan-to-value ("LTV") ratio. However, the Bank has made loans greater than 80% LTV, up to 95% LTV, with private mortgage insurance generally required for loans in excess of the 80% LTV ratio.
The Bank offers fixed rate and adjustable rate residential mortgage loans with a maximum term of 30 years. The Bank generally offers a three year adjustable rate loan (and, more selectively, one and five year adjustable rate loans). This loan provides for adjustments in the interest charged to an amount usually equal to 2.5% - 3% over the applicable constant maturity U.S. Treasury securities index. Adjustable rate loans are generally retained in the Bank's portfolio in order to increase the percentage of loans in its portfolio with greater repricing frequencies than fixed rate loans. Interest rates and origination fees on adjustable rate loans are priced to be competitive in the Bank's market area. Periodic adjustments of the interest rate on an adjustable rate loan is usually limited to not more than 2% per adjustment, with an interest rate ceiling over the life of the loan, depending on the rate at origination, ranging from 11% to 15%. Fixed rate loans are generally underwritten according to FNMA/FHLMC criteria in order to qualify for sale in the secondary market. Individual fixed rate loans are usually sold promptly after closing without recourse to the Bank. The Bank continues to service these loans.
In 1999, the Company sold, but retained the servicing rights on, $5.2 million of fixed rate residential mortgage loans. Total loans serviced for other investors were $130.5 million at December 31, 1999.
The Bank also offers a 30 year "convertible" adjustable rate mortgage, which provides the borrower an option to convert a one year adjustable rate mortgage to a fixed rate mortgage at then prevailing market rates at the end of five years. The originations of these loans are also usually sold into the secondary market when the loan has been converted into a fixed rate, with servicing rights retained.
The Bank offers three types of home equity mortgage loans. The first is an "express loan" subject to a limit of $25,000 with a five or seven year full payout amortization, as a substitute for a consumer loan but with possible tax deductibility of interest. The Bank places a second mortgage on the property with assessed value used as the principal basis for collateral valuation. The second is an open-end revolving line of credit, which is an adjustable rate loan with a term, depending on the size of the loan, of up to twenty years. During the revolving period, which varies from five to ten years based on the size of the loan, the borrower is only required to make interest payments. Thereafter, payments are for both principal and interest. The third type is a closed-end fixed rate home equity loan with maturities of up to 15 years. All home equity loans are limited to one-to-four family owner-occupied residences. The Bank restricts its home equity loans to a maximum of 80% of the appraised value of the collateral property including the balance of the first mortgage loan on such property, if any, and executes a second mortgage as collateral. Open-end lines of credit not yet advanced totaled $27.3 million at December 31, 1999. Loans secured by residential mortgages totaled $408.2 million at December 31, 1999, of which $351.0 million were first and $57.2 million were second mortgages.
Commercial real estate loans are offered by the Bank generally on a fixed or variable rate basis with a three to five and exceptionally seven year balloon maturity, although the amortization basis generally range from 10 to 20 and exceptionally to 30 years. These loans are typically related to commercial business loans and are secured by the underlying real estate used in these businesses. The maximum loan-to-value ratio on commercial real estate loans is 75%, with the valuation of the collateral for loans in excess of $250,000 being based on independent appraisals. The Bank typically requires personal guarantees of the principals of corporations to which it lends. Commercial real estate loans are often larger and may involve greater risks than other types of lending. Because payments on such loans are often dependent upon the successful operation of the business involved, repayment of such loans may be negatively impacted to a greater extent by adverse changes in economic conditions. Loans secured by commercial mortgages totaled $261 million at December 31, 1999.
CONSTRUCTION LOANS. The Bank makes short-term construction loans secured by land, residential, and non-residential properties. At December 31, 1999, total construction loans aggregated approximately $62.6 million and amounts not yet advanced totaled $30.6 million. While the Bank does finance residential developments for local builders, the Bank has no major commitments to lend for developments of significant multi-unit residential or commercial projects, and does not intend to actively engage in this type of lending.
Construction loans are generally only made for the purpose of site improvement and building owner occupied dwellings or buildings, and are usually for terms of 6 months but can be up to 24 months. Funds for construction loans are disbursed as phases of construction are completed. The Bank's residential construction loan underwriting procedure generally limits the loan amount to 80% LTV ratio with an LTV of up to 90% allowed where private mortgage insurance on the amount over 80% is provided with respect to the permanent mortgage. Nonresidential construction lending is
generally limited to owner-occupied properties and generally limited to not greater than 75% LTV. The Bank does not generally fund construction loans for single family homes or commercial real estate built by investors until the builder has a firm sales contract for the residence or building to be constructed, although in certain larger projects, "showhouse" construction may be financed within the overall site improvement financing package.
COMMERCIAL LOANS. The Bank's commercial loan portfolio consists primarily of commercial business loans to small and medium sized businesses. At December 31, 1999, the Bank's commercial business loans outstanding totaled $118.5 million with an additional $55.6 million available under committed lines and letters of credit.
Commercial business loans are usually made to finance the purchase of inventory or new or used equipment or for other short-term working capital purposes. Generally, these loans are secured, but are also offered on an unsecured basis. Commercial business loans for the purchase of new or used equipment are normally written on an installment basis with a term of between one and seven years. Loans for the purchase of inventory or other working capital purposes are structured as demand or time loans with a term of 12 months or less. In granting commercial loans, the Bank looks primarily to the borrower's cash flow as the principal source of repayment of the loan. Collateral and personal guarantees may be secondary sources of repayment. The Bank generally requires commercial borrowers to have a debt service coverage ratio of 125% or higher. Commercial business loans are often larger and may involve greater risks than other types of lending. Payments on such loans are often dependent upon the successful operation of the underlying business involved and, therefore, repayment of such loans may be negatively impacted by adverse changes in economic conditions.
CONSUMER, INSTALLMENT, AND OTHER LOANS. The Bank offers a full range of consumer/installment loans. Such loans include financing for new and used cars, wholesale and indirect financing programs for autos and other vehicle dealerships in addition to, on a direct basis, personal loans for consumer goods, home improvement, overdraft checking, and debt consolidation. Wholesale dealer loans (secured by dealer inventories) are structured as one-year lines of credit and are reviewed annually. Consumer loans are made on both a secured and unsecured basis. Maturities for consumer loans are generally for periods of 12 to 60 months, excluding secured home improvement loans, which are usually written as home equity loans. Interest rates for consumer products are structured either at fixed or variable rates. Leasing services are offered directly by the Bank. Both debit and credit cards are available. At December 31, 1999, installment, consumer, and all other loans totaled $143.5 million, of which $121.4 million represents loans generated from the indirect (dealer) loan program. Indirect automobile financing is subject to aggressive price competition, which can impact future profitability. It can also carry a higher risk of loss than direct financing. Such risk is taken into account in management's evaluation of the adequacy of the Allowance for Loan Losses. At December 31, 1999, overdraft lines of credit and credit card lines not advanced totaled $16.8 million.
For additional information concerning asset/liability management, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations -- "Asset/Liability Management" and "Results of Operations". The following tables show (1) the Company's loan distribution (exclusive of loans held for sale) at the end of each of the last five years, (2) the maturity of loans (excluding construction, consumer, installment, and other miscellaneous loans and expected amortization) outstanding as of December 31, 1999, and (3) the amounts due for loans as previously stated in (2) after one year classified according to their sensitivity to changes in interest rates.
1) LOAN DISTRIBUTION EXCLUDING LOANS HELD FOR SALE IN 1997, 1996, AND 1995 (DOLLARS IN THOUSANDS):
2) MATURITY OF LOANS AT DECEMBER 31, 1999:
(DOLLARS IN THOUSANDS):
Exclusive of consumer, installment and other loans, the maturities of loans are summarized as follows:
(A) Demand loans are categorized as due within one year.
3) RATE SENSITIVITY OF ABOVE LOANS MATURING AFTER ONE YEAR: (DOLLARS IN THOUSANDS)
SECURITIES
The Company records its investment in securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement requires that unrealized gains and losses on securities classified "available for sale" be recorded, net of taxes, in the "accumulated other comprehensive income" component of stockholders' equity. The net balance of unrealized gains (loss) recorded in stockholders' equity was $(6.6) million, $1.5 million and $1.6 million at December 31, 1999, 1998 and 1997, respectively. The related tax asset (liability) recorded in other assets offsetting other deferred tax assets was $4.6 million, ($1.1) million, and ($1.2) million at December 31, 1999, 1998 and 1997, respectively.
See Note A and Note B to the 1999 Consolidated Financial Statements, included herein at Item 8, for discussion of accounting policies related to securities and for information as to the amortized cost and fair value of securities at December 31, 1999 and 1998:
The table below sets forth the carrying amounts of securities at the dates indicated (dollars in thousands):
The following table sets forth certain information concerning the maturities of debt securities, other than regulatory and equity securities, amortized cost, and the weighted average yields of such securities (calculated on the basis of their cost and effective yields) at December 31, 1999. Tax-equivalent adjustments (using a 35% rate) have been made in calculating yields on obligations of states and political subdivisions (dollars in thousands):
(1) Includes $14.3 million of adjustable rate securities (2) Includes $36.2 million of adjustable rate securities (3) Includes $50.6 million of adjustable rate securities (4) Includes $32.4 million of adjustable rate securities (5) For purposes of this schedule, mortgage-backed securities consisting of mortgages guaranteed by U.S. Government agencies and SBA participation certificates totaling $65.0 million have been included based upon the estimated average lives of the securities. Prepayments were estimated based on 1999 levels.
The Company has established written investment, liquidity, and asset/liability management policies, which are reviewed annually by the Board of Directors. These policies identify investment criteria and state specific objectives in terms of risk, interest rate sensitivity, and liquidity. The policies are administered by the Investment Committee of the Board of Directors. The Company does not have a trading portfolio. At December 31, 1999, the Company had no investments in which the aggregate cash value of the securities held by the Company exceeded 10% of stockholders' equity, except for investments in the securities of or those guaranteed by the U.S. Government and other U.S. Government agencies and corporations.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133). The Company adopted SFAS 133 in the third quarter 1998. In connection with the adoption of SFAS 133, the Company transferred securities with a carrying value of approximately $96.0 million from held to maturity to available for sale. This transfer of securities resulted in an increase in unrealized gains (losses) on securities available for sale, comprehensive income, accumulated other comprehensive income and stockholders= equity of approximately $576,000 net of income taxes of $407,000. Except as discussed above, the adoption of SFAS 133 did not have a material effect on the consolidated financial position, results of operations or liquidity of the Company.
See "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations" for additional information regarding securities and interest rate risk.
DEPOSITS
The Company has developed a variety of deposit products ranging in maturity from demand-type accounts to certificates of deposit with maturities of up to five years. The Company also offers several multi-product Arelationship@ accounts to its depositors. The Company's deposits are primarily derived from the areas where its banking offices are located. It does not solicit deposits outside its market area and does not pay fees to others to obtain deposits for the Company. From time to time, the Company has used premiums, promotions or special products to attract depositors to branch offices.
The Company influences the flow of deposits primarily by pricing its accounts to remain generally competitive with other financial institutions in its market area, although the Company does not necessarily seek to match the highest rates paid by competing institutions. The Company has established an Asset/Liability Management Committee which meets monthly to review interest rates on all deposit and consumer loan products. Periodic changes are made to the rates and product features based on liquidity needs, competition, and general economic conditions. While the Company has $380.0 million in time deposits maturing in 2000, the Company=s previous experience indicates that a significant portion will "roll over" on maturity. Of this amount, $164.5 million represent time deposits over $100,000 (primarily municipalities whose deposits are collateralized) which are generally considered to be more volatile than "core" deposits. This amount increased from $90.9 million in 1998 as the Company built up cash to meet its Y2K liquidity needs rather than borrowings to meet potential year-end cash out flows. Management operates under a formal liquidity policy intended to provide adequate cash equivalents and other liquid assets to meet unforeseen outflows of time deposits, as well as outflows from other deposit products that the Company offers. Demand deposit growth has more than kept pace with overall deposit growth. For further information regarding the Company's deposits, see Item 7. "Management's Discussion and Analysis of Financial Condition -- Results of Operations."
The average amount and the average rates paid on deposits are summarized in the following table (dollars in thousands):
The maturities of time deposits under $100,000 and time deposits of $100,000 or more outstanding at December 31, 1999, are summarized for the periods indicated in the following table (balances in thousands):
TRUST SERVICES
The Bank maintains a Trust Department which offers a wide range of custodial, investment management, and investment advisory services to the Bank=s customers. The Trust Department also offers the administration of personal trusts and estates in a fiduciary capacity, self-directed IRA and Keogh accounts and pension accounts. At December 31, 1999, customer assets under administration totaled approximately $294.8 million, representing approximately 626 accounts.
NON-DEPOSIT INVESTMENT PRODUCTS
Although the Company has offered fixed rate annuities for some time, during 1998 the Company began offering a wide range of non-deposit investment products to its customers, through appropriately licensed representatives, under a third party agency relationship. Such products include mutual funds and variable rate annuities. Total sales of non-deposit products for 1999 was $32.0 million.
COMPETITION
The Bank principally competes in a market area of seven New York counties (Dutchess, Putnam, Orange, Sullivan, Westchester, Rockland and Ulster). As of June 1999 (the latest available data), such market area included 24 commercial banks (299 branches) with deposits of $10.2 billion, 35 thrift institutions (101 branches) with deposits of $4.9 billion, and 69 credit unions (69 branches) with deposits of $2.1 billion. Total market deposits aggregated $17.2 billion as of such date. As of that date, the Bank had the largest share of the total commercial bank deposits in combined Dutchess and Putnam counties (12%), and was second in market share for Ulster County with 11%.
Management believes that the Bank is a prominent financial institution in its market area. Although the Bank faces competition for deposits from other financial institutions and other investment vehicles offered by securities firms, management believes the Bank has been able to compete effectively for deposits because of its image as a community-oriented bank and the high level of service it offers its local customers. Many of the Bank=s competitors have substantially greater resources and lending limits, and as such may offer a greater array of products and services. The Bank has emphasized personalized banking and the advantage of local decision-making in its banking business, which strategy appears to have been well received in the Bank's market area. The Bank does not rely upon any individual, group, or entity for a material portion of its deposits.
In addition, the Bank is a significant provider of credit in its market area. Although the Bank faces competition for loans from mortgage banking companies, savings banks, savings and loan associations, other commercial banks, insurance companies, and other institutional lenders, including manufacturers, management believes that the Bank's business strategy gives it a competitive advantage within the market segments it serves. Other factors which affect loan growth include the general availability of lendable funds and general and local economic conditions, and current interest rate levels.
RISK MANAGEMENT
In the normal course of business, the Company is subject to various risks, the most significant of which are credit, liquidity and interest rate. Although it cannot eliminate these risks, the Company has risk management processes designed to provide for risk identification, measurement, monitoring and control.
CREDIT RISK. Credit risk represents the possibility that a customer or counterparty may not perform in accordance with contractual terms. Credit risk results from extending credit to customers, purchasing securities and entering into certain off-balance-sheet financial transactions. Risk associated with the extension of credit includes general risk, which is inherent in the lending business, industry risk, and risk specific to individual borrowers. The Company seeks to manage credit risk through portfolio diversification, underwriting policies and procedures, and loan monitoring practices.
LIQUIDITY RISK. Liquidity represents an institution's ability to generate cash or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and demands of depositors and debtholders, and to invest in strategic initiatives. Liquidity risk represents the likelihood the Company would be unable to generate cash or otherwise obtain funds at reasonable rates for such purposes. Liquidity is managed through deposit and loan pricing and the coordination of the relative maturities and liquidity of assets, liabilities and off-balance-sheet positions and is enhanced by the ability to raise funds in capital markets through securities sales, direct borrowing or securitization of assets, such as mortgage loans.
INTEREST RATE RISK. Interest rate risk arises primarily through the Company's normal business activities of extending loans and taking deposits. Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the timing, magnitude and frequency of changes in interest rates. Interest rate risk results from various repricing frequencies and the maturity structure of assets, liabilities, and off-balance-sheet positions. Interest rate risk also results from, among other factors, changes in the relationship or spread between interest rates. Many factors, including economic and financial conditions, general movements in market interest rates and consumer preferences, affect the spread between interest earned on assets and interest paid on liabilities. The Company uses a number of measures to monitor and manage interest rate risk, including income simulation and interest sensitivity ("gap") analyses.
For additional information relating to the Company's risk management processes, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations.
REGULATION AND SUPERVISION
Bank holding companies and banks are extensively regulated under both Federal and State law. The following information describes certain aspects of that regulation. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the particular provisions. The following is not intended to be an exhaustive description of the statutes and regulations applicable to the business of the Company or the Bank.
BANK HOLDING COMPANY REGULATION
The Company is a registered bank holding company under the BHCA and is subject to Reserve Board regulations, examination, supervision, and reporting requirements. Under the BHCA, a bank holding company must obtain Reserve Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of a bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares. Reserve Board approval also must be obtained before any bank holding company acquires all or substantially all of the assets of another bank or bank holding company or merges or consolidates with another bank holding company. The George Gale Foster Corporation ("GGF"), which controls approximately 5.73% of the Company's Common Stock, is also a registered bank holding company of the Bank under the BHCA. As a result, GGF may have to obtain Reserve Board approval prior to the Company being able to undertake certain activities.
Under the Change in Bank Control Act, persons who intend to acquire control of a bank holding company, whether acting directly or indirectly or through or in concert with one or more persons, must give 60 days prior written notice to the Reserve Board, unless the transaction is subject to prior Reserve Board approval under the BHCA. "Control" exists when the acquiring party has voting control of at least 25% of any class of the bank holding company's voting securities or the power to direct the management or policies of such company. Under the Reserve Board regulations, a rebuttable
presumption of control arises with respect to an acquisition where, after the transaction, the acquiring party has ownership, control, or the power to vote at least 10% (but less than 25%) of any class of the Company's voting securities. The Reserve Board may disapprove proposed acquisitions of control on certain specified grounds.
Under New York State Banking Law, the Company must obtain the prior approval of the New York State Banking Board before acquiring, directly or indirectly, 5% or more of the voting stock of another banking institution located in New York State. Federal law permits adequately capitalized and adequately managed bank holding companies to acquire banks and bank holding companies in any state, subject to certain conditions, including certain nationwide and statewide concentration limits. Consequently, subject to such conditions, the Company has the authority to acquire any bank or bank holding company, and can be acquired by any bank or bank holding company located anywhere in the United States. Federal law permits banks, subject to certain provisions, including state opt-out provisions, to merge with banks in other states, or to acquire, by acquisition or merger, branches outside its home state. The establishment of new interstate branches also is possible in those states with laws that expressly permit it. Branches of interstate banks are subject to various host state laws, including laws relating to intrastate branching, consumer protection, fair lending, community reinvestment, and taxation (unless in the case of national banks such laws are preempted by Federal law or discriminatory in effect). Competition has increased as banks branch across state lines and enter new markets.
The BHCA prohibits a bank holding company, with certain limited exceptions, from acquiring or retaining direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank or a bank holding company, and from engaging in any activities other than those of banking, managing or controlling banks, or activities which the Reserve Board has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto.
The recently enacted Gramm-Leach-Bliley Act ("GLB Act") permits a qualifying bank holding company to become a financial holding company and thereby to affiliate with a broader range of financial companies than has previously been permitted for a bank holding company. Permitted affiliates include securities brokers, underwriters and dealers, investment managers, insurance companies and companies engaged in other activities that are declared by the Reserve Board, in cooperation with the Treasury Department, to be "financial in nature or incidental thereto" or declared by the FRB unilaterally to be "complementary" to financial activities. A bank holding company may elect to become a financial holding company if each of its subsidiary banks is "well capitalized," is "well managed," and has at least a "satisfactory" CRA rating.
As a bank holding company, the Company is required to file with the Reserve Board an annual report and any additional information as the Reserve Board may require pursuant to the BHCA. The Reserve Board also makes examinations of the Company and the Bank, and possesses cease and desist powers over bank holding companies and their non-bank subsidiaries if their actions represent unsafe or unsound practices.
The Company has registered its common stock with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended (the "Exchange Act"). As a result of such registration, the proxy and tender offer rules, periodic reporting requirements and insider trading restrictions and reporting requirements, as well as certain other requirements of the Exchange Act, are applicable to the Company. Because the Company's stock is listed on the American Stock Exchange (the "AMEX"), the Company is also subject to the rules and regulations of the AMEX. The Company also may, from time to time, be subject to regulation by various state securities commissions with respect to the offer and sale of its securities.
The Company is a legal entity separate and distinct from the Bank and any non-bank subsidiaries thereof. Accordingly, the right of the Company, and consequently the right of creditors and stockholders of the Company, to participate in any distribution of the assets or earnings of any subsidiary is necessarily subject to the prior claims of creditors of the subsidiary, except to the extent that claims of the Company in its capacity as a creditor may be recognized.
BANK REGULATION
As a national bank, the Bank is subject to the supervision of, and is regularly examined by, the Comptroller and is required to furnish quarterly reports to the Comptroller under the National Bank Act. In addition, the Bank is insured by and subject to certain regulations of the FDIC. The Bank is also subject to various requirements and restrictions under Federal and State law, including requirements to maintain reserves against deposits, restrictions on the types, amounts, terms and conditions of loans that may be granted and limitations on the types of investments that may be made, the activities that may be engaged in, and the types of services that may be offered. Various consumer laws and regulations also affect the
operations of the Bank. The approval of the Comptroller is required for the establishment of additional branch offices by any national bank, subject to applicable state law restrictions. New York State Banking Law precludes a bank from establishing a de novo branch in any city or village with a population of 50,000 or less in which the principal office of another bank or trust company is located (other than a bank which is a subsidiary of a bank holding company or is itself a bank holding company).
CAPITAL
The Company and the Bank are subject to substantially similar minimum capital requirements. The capital adequacy guidelines provide for three types of capital: (I) Tier 1 capital (or core capital), (ii) Tier 2 capital (or supplementary capital), and (iii) total capital. Tier 1 capital primarily includes common stockholders' equity, and qualifying perpetual preferred stock and related surplus less goodwill and certain disallowed tangibles.
Tier 2 capital generally includes allowances for credit losses in an amount up to 1.25% of risk-weighted assets, other perpetual preferred stock and any related surplus, certain hybrid capital instruments, and subordinated and other qualifying debt, subject to certain limitations. Total capital generally includes Tier 1 capital, plus qualifying Tier 2 capital, minus investments in unconsolidated subsidiaries and other adjustments. At least 50% of total capital must consist of Tier 1 capital.
Under current capital adequacy guidelines, bank holding companies and banks must maintain minimum leverage ratios of Tier 1 capital to adjusted average total consolidated assets of 3.0% for bank holding companies and banks meeting certain specified criteria, which include having the highest composite regulatory examination rating, and 4.0% for all other bank holding companies and banks, such as the Company and Bank. Bank holding companies and banks must also maintain minimum ratios of total risk based capital to risk-weighted assets of 8.0%, including a minimum ratio of Tier 1 capital to risk-weighted assets of 4.0%. The risk-weighted asset base is determined by assigning each asset and the credit equivalent amount of off-balance sheet items to one of several broad risk categories, after which the aggregate dollar value of the items in each category is multiplied by a weight (ranging from 0% to 100%) assigned to each asset category and totaled. The federal bank regulatory agencies may set higher capital requirements when particular circumstances warrant. Regulators also consider interest rate risk, concentrations of credit risk and the risk arising from non-traditional activities, as well as the ability to manage these risks, as important factors in assessing overall capital adequacy. Exposure to a decline in the economic value of capital due to changes in interest rates is also considered in evaluating capital adequacy.
At December 31, 1999, the Company and Bank exceeded all minimum capital requirements. The Company had a ratio of Tier I capital to total average assets of 9.25%, a ratio of Tier 1 capital to risk-weighted assets of 12.54%, and a ratio of total capital to risk-weighted assets of 13.79%. The Bank had a ratio of Tier 1 capital to total assets of 8.17%, a ratio of Tier 1 capital to risk-weighted assets of 11.39%, and a ratio of total capital to risk-weighted assets of 12.64%.
The Company's ability to pay dividends and expand business can be restricted if capital falls below minimum requirements. In addition, the Comptroller has established levels at which a national bank is well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, and is required to take prompt corrective action with respect to banks that fall below minimum capital standards. In addition, the Comptroller may determine that a national bank should be classified in a lower category based on other information, such as the institution's examination report, after written notice. The degree of regulatory intervention is tied to an insured institution's capital category. The prompt corrective actions for undercapitalized institutions include increased monitoring and periodic review of capital compliance efforts, a requirement to submit a capital plan, restrictions on dividends and total asset growth, and limitations on certain new activities (such as opening new branch offices and engaging in acquisitions and new lines of business). At December 31, 1999, the Bank met the requirements for a "well-capitalized" institution based on its capital ratios as of such date.
In connection with the submission of a capital restoration plan, a company that has control of an undercapitalized institution must guarantee that the institution will comply with the plan and provide appropriate assurances of performance. The aggregate liability of any such controlling company under such guaranty is limited to the lesser of (i) 5% of the institution's assets at the time it became undercapitalized, or (ii) the amount necessary to bring the institution into capital compliance at the time it failed to comply with its capital plan. If the Bank becomes undercapitalized, the Company will be required to guarantee performance of the capital plan as a condition of the approval of the plan by the Comptroller.
TRANSACTIONS WITH AFFILIATES
The Bank is also subject to federal law that limits its transactions to or on behalf of the Company and to or on behalf of any nonbank subsidiaries. Such transactions are individually limited to 10 percent of the Bank's capital and surplus and, with respect to the Company and all nonbank subsidiaries, to an aggregate of 20 percent of the Bank's capital and surplus. Further, loans and extensions of credit to or on behalf of the Company or non-bank subsidiaries generally are required to be secured by eligible collateral in specified amounts. Federal law also prohibits the Bank from purchasing "low-quality" assets from affiliates.
DEPOSIT INSURANCE
The deposits of the Bank are insured by the FDIC up to the limits set forth under applicable law. Most of the deposits of the Bank are subject to deposit insurance assessments of the Bank Insurance Fund ("BIF") of the FDIC. However, approximately $11.3 million in deposits are subject to assessments of the Savings Association Insurance Fund ("SAIF") of the FDIC.
The assessment rates imposed on all FDIC deposits for deposit insurance ranges from 0 to 27 basis points per $100 of insured deposits, depending on the institution's capital position and other supervisory factors. The rate does not differ between BIF and SAIF-insured deposits. However, because legislation enacted in 1996 requires all FDIC-insured institutions to bear the cost of bonds issued by the Financing Corporation ("FICO"), the FDIC is currently assessing an additional 2.12 basis points per $100 of insured deposits, on an annualized basis, to cover those obligations. The Bank's current assessment rate is 0 basis points before the FICO assessment.
FEDERAL RESERVE SYSTEM
The Bank is a member of the Federal Reserve Bank of New York, which is one of 12 regional Federal Reserve Banks comprising the Federal Reserve System. The Federal Reserve Bank of New York provides a central credit facility for member institutions. As a member bank, the Bank is required to own shares of Federal Reserve Bank capital stock in an amount equal to 6% of the Bank's paid-up capital and surplus. The Bank is in compliance with this requirement with an investment in Federal Reserve Bank of New York stock at December 31, 1999 of 34,212 shares. The Reserve Board also requires depository institutions to maintain non-earning reserves against certain transaction accounts (primarily checking accounts) and non-personal time deposits (those which are transferable or held by a person other than a natural person). At December 31, 1999, the Bank was in compliance with these requirements.
RESTRICTIONS ON THE PAYMENT OF DIVIDENDS
The principal source of the Company's revenue and cash flows is dividends from the Bank. The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Company. As of January 2000, the amount available for payment of dividends to the Company by the Bank totaled $5.0 million. In addition, the Comptroller has authority to prohibit the Bank from paying dividends, depending upon the Bank's financial condition if such payment is deemed to constitute an unsafe or unsound practice. The Comptroller and the Reserve Board have indicated their view that it generally would be an unsafe and unsound practice to pay dividends except out of current operating earnings. The ability of the Bank to pay dividends could be further influenced by bank regulatory and supervisory policies.
Under New York law, the Company may declare and pay dividends on its outstanding common stock out of available surplus, unless such payment would render the Company insolvent. As of December 31, 1999, the Company had $39.8 million in "available surplus" for such purposes.
Under Reserve Board policy, a bank holding company is expected to act as a source of financial strength to its subsidiary bank and to commit resources to support the bank. Consistent with its "source of strength" policy for subsidiary banks, the Reserve Board has stated that, as a matter of prudent banking, a bank holding company generally should not pay cash dividends unless its net income available to common shareholders has been sufficient to fund fully the dividends, and the prospective rate of earnings retention appears to be consistent with the corporation's capital needs, asset quality, and overall financial condition.
COMMUNITY REINVESTMENT
Bank holding companies and their subsidiary banks are subject to the provisions of the Community Reinvestment Act of 1977, as amended (the "CRA"). A bank's record in meeting the credit needs of its community, including low-and moderate-income neighborhoods is evaluated as part of the examination process, as well as when an institution applies to undertake a merger, acquisition, or to open a branch facility. The Bank received a satisfactory CRA rating during its 1999 OCC examination.
GOVERNMENT POLICIES
Bank holding companies and their subsidiaries are affected by the credit and monetary polices of the Reserve Board. An important function of the Reserve Board is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Reserve Board to implement its objectives are open market operations in U.S. Government securities, changes in the discount rate on bank borrowings, and changes in reserve requirements on bank deposits.
These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments and deposits, the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets, and the level of inflation. The monetary policies of the Reserve Board are expected to continue to have a significant effect on the operating results of banking institutions. It is not possible to predict the nature or timing of future changes in monetary and fiscal policies, or the effect that they may have on the Company's business and earnings.
LEGISLATIVE PROPOSALS AND REFORM
The GLB Act was enacted in 1999, and permits qualifying bank holding companies to become financial holding companies and thereby to affiliate with securities brokers, underwriters and dealers, investment managers, insurance companies and companies engaged in certain other financial activities. Qualifying bank holding companies are required to file a declaration with the Reserve Board to become financial holding companies. Similarly, the GLB Act authorized qualifying national banks to file a certification with the OCC to engage in expanded activities through the formation of a "financial subsidiary." A national bank may have a "financial subsidiary" engaged in any activity that is financial in nature or incidental to a financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking. In order to qualify to establish or acquire a financial subsidiary, a national bank and each of its depository institution affiliates, must be "well-capitalized" and "well-managed," and may not have a less than satisfactory CRA rating. The total assets of all financial subsidiaries of a national bank may not exceed the lesser of $50 billion or 45% of the parent bank's total assets.
The GLB Act also contains provisions requiring financial institutions to protect the privacy of customer information and allowing customers, subject to certain exceptions, to opt out of institutions providing customer information to unaffiliated third parties for marketing purposes.
No assurance can be given as to whether any additional legislation will be enacted or as to the effect of such legislation on the business of the Company.
EMPLOYEES
As of December 31, 1999, the Company had 461 full-time and 90 part-time employees. The employees are not represented by a collective bargaining agreement. The Company believes its relationship with its employees to be satisfactory.
EXECUTIVE OFFICERS OF THE COMPANY
The following table sets forth the name, age and position for each executive officer of the Company and the Bank and the business experience of these individuals for the past five years. Each executive officer held the position indicated or a similar position with the same entity or one of its predecessors for the past five years, unless otherwise indicated.
(a) AS OF FEBRUARY 29, 2000
ITEM 2.
ITEM 2. PROPERTIES
The Company owns the land and a two-story 20,000 square foot building at 20 Mill Street, Rhinebeck, New York, which houses the Bank's largest branch (approximately 3,200 square feet are leased to tenants).
In addition, the Company owns two buildings at Route 55 in Lagrangeville, New York. The complex is two parcels of land comprising 23 acres, of which approximately 18 acres are undeveloped. The buildings house the Company's executive offices as well as several administrative support services and a branch facility. The facilities contain approximately 36,000 square feet of which approximately 70% is occupied by the Company and the remaining 30% is leased to tenants. These properties represent approximately 15% the value of the premises and equipment owned by the Company.
The Company's operations center is a 44,000 square foot facility located on Route 52, Fishkill, New York. This owned building houses the Bank's processing, services and several other support services. This property represents approximately 10% of the value of the premises and equipment owned by the Company.
Further, the Company owns a 12,600 square foot two-story office building located at 289-291 Main Mall in Poughkeepsie, New York. This building houses certain administrative support functions and the Bank's Trust department as well as a banking office.
The Company, through the Bank, also owns 15 other banking premises which are used almost exclusively for conducting commercial banking business. Similarly, the Bank leases 17 other branch banking premises for conducting its commercial banking business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
As the nature of the Bank's business involves providing certain financial services, the collection of loans and the enforcement and validity of security interests, mortgages and liens, the Bank is plaintiff or defendant in various legal proceedings which may be considered as arising in the ordinary course of its business. Neither the Company nor the Bank are presently involved in any legal proceedings the outcome of which management or counsel to the Company believe to be material to its financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of shareholders of Premier National Bancorp, Inc. during the fourth quarter of 1999.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock has been listed on American Stock Exchange (AMEX), since August 4, 1997, and currently trades under the symbol "PNB". On March 15, 2000, there were approximately 2,200 shareholders of record of Common Stock and 16,088,948 shares of Common Stock issued and outstanding.
The following table sets forth the cash dividends declared by the Company on its Common Stock and the range of high and low prices of the Common Stock during the two most recent years based on high and low sale prices as quoted by the AMEX, since January 1, 1998. This table has been adjusted retroactively to give effect to the 10% stock dividends paid January 15, 1999 and January 14, 2000.
The declaration and payment of future dividends is at the sole discretion of the Board of Directors and the amount, if any, depends upon the earnings, financial condition and capital needs of the Company and the Bank and other factors, including restrictions arising from federal banking laws and regulations to which the Company and the Bank are subject. The ability of the Bank to pay cash dividends to the Company on its capital stock is subject to, among other matters, the restrictions set forth in federal statutes and regulations. For additional information, see Note N - "Restriction on Subsidiary Dividends and Loans to Affiliates" of the Notes to Consolidated Financial Statements under Item 8.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) - -------------------------------------------------------------------------------- THE FOLLOWING SELECTED FINANCIAL DATA FOR THE FIVE YEARS ENDED DECEMBER 31, 1999 IS DERIVED FROM THE CONSOLIDATED FINANCIAL STATEMENTS OF PREMIER NATIONAL BANCORP INC. THE INFORMATION PRESENTED HAS BEEN RESTATED FOR ALL YEARS TO REFLECT THE MERGER OF PROGRESSIVE BANK INC. WITH AND INTO HUDSON CHARTERED BANCORP, INC. TO BECOME PREMIER NATIONAL BANCORP, INC. ON JULY 17, 1998. THE MERGER HAS BEEN ACCOUNTED FOR UNDER THE POOLING-OF-INTERESTS METHOD. THE DATA SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS, RELATED NOTES, AND OTHER FINANCIAL INFORMATION INCLUDED HEREIN AT ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA AT OR FOR THE YEAR ENDED DECEMBER 31,
*INCLUDES AFTER TAX MERGER EXPENSE OF $5,316,000, $314,000, AND $145,000 IN 1998, 1997 AND 1995 RESPECTIVELY. (1)INFORMATION HAS BEEN ADJUSTED RETROACTIVELY TO GIVE EFFECT TO THE 10% STOCK DIVIDENDS DECLARED IN DECEMBER 1995, DECEMBER 1996, DECEMBER 1998 AND DECEMBER 1999, AS WELL AS A 50% STOCK DIVIDEND DECLARED SEPTEMBER 1997. (2)AS TO 1995 INCLUDES THE DILUTIVE EFFECT OF SERIES B CONVERTIBLE PREFERRED STOCK OF APPROXIMATELY 880,000 SHARES. (3)THE 1996 TOTALS REFLECT A TAX BENEFIT OF $2.4 MILLION RELATED TO SETTLEMENT OF AUDITS OF CERTAIN PRIOR YEARS' TAX RETURNS.
ITEM 7
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion is to be read in conjunction with the Company's consolidated financial statements, presented elsewhere in this report under Item 8.
FINANCIAL CONDITION
The following table compares the changes in major categories of the Company's balance sheet from December 31, 1998 to December 31, 1999 (dollars in thousands):
Financial Condition
December 31, 1999 compared to December 31, 1998
Total assets in 1999 increased by $21.5 million from year end 1998 or 1.4%. Such increases were principally in net loans of $19.5 million and securities of $91.9 million. These increases were offset by declines of $95.7 million in cash and cash equivalents. Of the change in loans, residential mortgages, principally ARM's, and construction loans held by the Bank and Home Equity loans decreased $19.2 million or 4.5% and consumer and other decreased $15.4 million or 8.1%. Although the balances of residential mortgages held by the Bank declined, new originations of such loans totaled approximately $78.7 million of which approximately $4.7 million were sold into the secondary market reflecting the Company's interest rate risk management policy. These decreases were offset by growth in commercial mortgage loans which increased by $18.9 million or 7.8%, commercial and industrial loans which increased $4.8 million or 4.2%, and indirect loans which increased $6.9 million or 6.1%.
Taxable non-corporate securities decreased by $15.6 million, or 8.5%, at year end while municipal holdings increased by $38.1 million or 33.2%. This shift was made principally by investing in "bank-qualified" bonds within New York State, where the tax equivalent yields are significantly higher (and market price volatility value risks lower) than other securities of comparable maturity. Corporate securities also increased by $71.4 million or 71.2% reflecting the Company's leverage strategy, principally funded by $75 million of borrowed funds (Federal Home Loan Bank advances and short-term repurchase agreements).
Deposits decreased by $39.3 million principally reflecting the Company's interest rate policies in light of its high liquidity. While noninterest bearing deposits increased by $10.9 million, interest bearing deposits declined by $50.2 million. Of the decrease in interest bearing deposits, $69.0 million of growth in time deposits was largely offset by declines in savings accounts of $55.8 million, NOW accounts $8.8 million, and money market accounts of $54.6 million. Decline in savings and money market accounts reflect the Company's decision to not "price up" its basic products and instead to compete for funds using special term CDs, municipal deposits and other promotional products. For additional information regarding deposits, see "Item 1 - BUSINESS--Deposits".
Additionally, net investments in premises and equipment decreased by $1.7 million due principally to sales of bank properties of $.9 million. Other assets increased $7.5 million, primarily due to higher levels of accrued interest income receivable and deferred taxes.
The allowance for loan losses grew by $.5 million to $21.8 million or a 2.4 % increase, as provisions for loan losses of $2.0 million exceeded net charge-offs of $1.5 million. The allowance for loan losses represented 2.19% of total loans for 1999 compared to 2.18% in 1998. Further, the allowance for loan losses was 290% of nonperforming loans at December 31, 1999 compared to 226% at December 31, 1998, as nonperforming loans decreased from $9.4 million at year end 1998 to $7.5 million at year end 1999.
Stockholders' equity decreased $14.1 million or 9.0% in 1999 compared to year-end 1998. Credits of $20.6 million from net income and $6.5 million from the sale of additional shares of stock through the Company's dividend reinvestment and employee stock option plans, were offset by cash dividends declared of $9.0 million, treasury stock repurchases of $24.1 million and $8.1 million from the net change in the unrealized loss on securities available for sale, after tax.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity management involves the ability to meet the cash flow requirements of customers who may be depositors wishing to withdraw funds or borrowers who need to draw funds under their available credit facilities.
As detailed in the Company's Consolidated Statement of Cash Flows included in the financial statements, cash flows are derived from three sources: cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. Net cash provided by operating activities was $23.2 million in 1999. Investing activities (primarily purchases and sales of securities and the funding of loans) utilized $127.0 million in 1999 as purchases of securities of $264.6 million exceeded sales, maturities, and prepayment of loans and securities of $162.9 million. Financing activities provided $8.1 million as proceeds of new common stock issuances of $6.5 million and net borrowings of $73.6 million were offset by $39.3 million decrease in deposits, cash dividends paid of $8.6 million and stock repurchases and redemptions of $24.1 million. The overall result was that cash and cash equivalents decreased $95.7 million at December 31, 1999. The Company's liquidity ratio (defined as cash and cash equivalents plus securities available-for-sale [$530.7 million] to total assets) was 33.3% at year-end 1999. The average life of the available-for-sale portfolio, on a rate sensitivity basis, is slightly over three years. These liquid assets, together with maturing loans, are deemed by management to be more than adequate to meet expected liquidity needs. In addition, the Bank is a member of the Federal Home Loan Bank and has the ability to borrow substantial further funds ($55 million) under its secured advance program.
The Holding Company's own liquidity needs are chiefly for paying dividends. The principal sources of income for the Company are investment income and dividends and rents received from the Bank. Dividends from the Bank are subject to certain regulatory limitations at year-end. The Company had ample cash and liquid investments at the holding company level [$8.8 million] to meet its reasonably anticipated cash needs in 2000.
Financial institutions' assets are monetary in nature and are thus impacted by inflation, interest rate and credit considerations. This results in the need to maintain an appropriate equity to assets ratio. In addition, the Company and the Bank are subject to regulatory requirements to maintain minimum capital levels. These capital requirements and the actual levels maintained by the Bank and the Company are summarized in Note O to the Consolidated Financial Statements, included herein under Item 8. The capital levels of both the Bank and the Company exceed all regulatory requirements and regulatory agencies have informed management that, as of December 31, 1998, the Bank qualifies for "well capitalized" status under the appropriate regulatory definitions. Further, the Company believes that the capital levels maintained are more than adequate to meet its currently foreseeable needs and that additional capital resources would be required only for exceptional investment opportunities.
Pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991, the Bank's regulator developed risk-based capital standards that take account of interest-rate risk, concentration of credit risk, the risk of nontraditional activities and the actual performance and expected risk of loss on multi-family mortgages. Such standards may have the effect of increasing the level of regulatory capital that the Company and Bank are required to maintain. The Company's risk based capital ratio as of December 31, 1999 was 13.79%.
In February 1999, the Board of Directors approved a stock repurchase program and authorized management to purchase up to 1,250,000 shares (approximately 7.9%) of the Company's common stock from the market. This program was completed in December 1999. The Company's Board of Directors approved a further 1,000,000 shares (approximately 6.8%). At the current market prices at the time of the approval, the total second repurchase program would utilize approximately $11 - $15 million offset by Dividend Reinvestment Plan issuances estimated to total approximately $2.5 million and an unknown amount of employee stock option exercises over the period. The purpose of the repurchase program is to offset the effects of new stock issuances under the Company's dividend reinvestment and stock option plans and for other general corporate purposes. The Company has sufficient cash and securities and plans to effect this repurchase program over the next two years.
YEAR 2000
During 1999, the Company completed the process of preparing for the year 2000 date change event. This process involved reviewing, modifying and replacing existing hardware and software, as necessary. The Company also assessed the year 2000 preparedness of third parties such as vendors, customers, governmental entities and others. Contingency plans, subject to oversight and regulation by certain federal bank regulatory authorities, for year 2000 issues were maintained. Business continuity plans were reviewed and strengthened to address year 2000 implications.
The estimated total cumulative cost to become year 2000 ready through December 31, 1999, which has been expensed as incurred, was approximately $300,000. No significant outlays were made to replace existing systems solely for year 2000 reasons, although approximately $400,000 was spent in 1999 to upgrade the Bank's personal computer network during the year.
The Company to date has not encountered any materially significant problems associated with its mission critical systems or service providers as a result of the date change event.
Unanticipated issues associated with the year 2000 date change event could still occur that may have an adverse impact on the financial condition and results of operations of the Company, its customers and service providers. To the extent that customers' financial positions are weakened due to year 2000 issues, credit quality could be adversely affected. It is not possible to predict with certainty all of the adverse effects that could result from a failure of third parties to address year 2000 issues or whether such effects could have a material adverse impact on the Company.
ASSET/LIABILITY MANAGEMENT
The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest-sensitive earning assets and interest-bearing liabilities and capital resources. The Company's Investment Committee of the Board monitors, and the Bank, through its treasury division, controls the rate sensitivity of the balance sheet while maintaining an appropriate level of net interest income contribution to the operations of the Company. The Company's net interest revenue is affected by fluctuations in market interest rates as a result of timing differences in the repricing of its assets and liabilities. These repricing differences are quantified in specific time intervals and are referred to as interest rate sensitivity gaps. The Company manages the interest rate risk of current and future earnings to a level that is consistent with its mix of businesses and seeks to limit such risk exposure to appropriate percentages of both earnings and the imputed value of stockholders' equity. The objective in managing interest rate risk is to support the achievement of business strategies, while controlling earnings variability and ensuring appropriate liquidity.
The following chart (in thousands) provides a quantification of the Company's interest rate sensitivity gap as of December 31, 1999, based upon the known repricing dates of certain assets at amortized cost and liabilities and the assumed repricing dates of others. As shown in the chart below, at December 31, 1999, assuming no management action, the Company's principal interest rate risk is to a rising rate environment within the one-year time frame and a declining interest rate risk beyond the one year time frame. That is, net interest revenue would be expected to be adversely affected by an increase in interest rates above the rates embedded in the current yield curve, principally due to the higher level of liabilities ($1,036 million) that would reprice relative to similarly situated assets ($666.0 million) in that time frame. This exposure would be mitigated over the longer term as the Company has $686.6 million more in repriceable interest earning assets than interest bearing liabilities beyond one year. Demand deposits (approximately 20% of total assets) and capital serves to mitigate the effects of increases in interest rates and reduces the average cost of total liabilities.
This chart displays only a static view of the Company's interest rate sensitivity gap and does not capture the dynamics of rate and spread movements nor management's actions that may be taken to manage this risk (dollars in thousands).
NOTES TO CHART:
(1) INTEREST RATE SENSITIVITY GAPS ARE DEFINED AS THE FIXED RATE POSITIONS (ASSETS LESS LIABILITIES) FOR A GIVEN TIME PERIOD. THE GAPS MEASURE THE TIME WEIGHTED DOLLAR EQUIVALENT VOLUME OF POSITIONS FIXED FOR A PARTICULAR PERIOD. THE GAP POSITIONS REFLECT A REPRICING DATE AT WHICH DATE FUNDS ARE ASSUMED TO "MATURE" AND REPRICE TO A CURRENT MARKET RATE FOR THE ASSET OR LIABILITY. THE TABLE DOES NOT INCLUDE LOANS ON NONACCRUAL STATUS OR NET UNREALIZED LOSSES RECORDED ON "AVAILABLE-FOR-SALE" SECURITIES AS OF DECEMBER 31, 1999.
(2) VARIABLE RATE BALANCES ARE REPORTED BASED ON THEIR REPRICING FORMULAS. FIXED RATE BALANCES ARE REPORTED BASED ON THEIR SCHEDULED CONTRACTUAL MATURITY DATES, EXCEPT FOR CERTAIN INVESTMENT SECURITIES AND LOANS SECURED BY 1-4 FAMILY RESIDENTIAL PROPERTIES THAT ARE BASED ON ANTICIPATED CASH FLOWS.
(3) SAVINGS ACCOUNTS: ONE HALF OF THE LEVEL OF "MERIT" SAVINGS ACCOUNTS, WHICH REPRICE AGAINST CHANGES IN THE FEDERAL RESERVE DISCOUNT RATE, ARE CLASSIFIED AS THREE MONTH TO SIX MONTH MATURITIES. THE BALANCE OF THESE ACCOUNTS ARE BEYOND ONE YEAR REPRICING CATEGORY. MANAGEMENT'S' ANALYSIS OF CHANGES IN LEVELS INDICATE THAT CHANGES IN THIS RATE ARE APPROXIMATELY HALF AS OFTEN AS CHANGES IN OTHER MARKET RATES. OTHER SAVINGS ACCOUNTS ARE CLASSIFIED AS FOUR MONTHS TO ONE YEAR MATURITIES, REFLECTING THE LAGGING PERIOD THAT HISTORICALLY EXISTS IN RATES PAID ON PASSBOOK AND SAVINGS ACCOUNTS. OTHER DEPOSITS: TIME DEPOSITS ARE CLASSIFIED BY CONTRACTUAL MATURITY OR REPRICING FREQUENCY. NOW ACCOUNTS ARE CLASSIFIED AS FOUR MONTHS TO ONE-YEAR MATURITIES. THE BALANCE OF DEPOSITS ARE CONSIDERED LESS THAN THREE MONTHS, INCLUDING ALL MONEY MARKET DEPOSIT ACCOUNTS. THE INTEREST RATE SENSITIVITY ASSUMPTIONS PRESENTED FOR THESE DEPOSITS ARE BASED ON HISTORICAL AND CURRENT EXPERIENCES REGARDING BALANCE RETENTION AND INTEREST RATE REPRICING BEHAVIOR.
(4) NON-INTEREST BEARING DEPOSIT LIABILITIES WERE APPROXIMATELY $252.0 MILLION AT DECEMBER 31, 1999.
INTEREST RATE RISK
Management of interest rate risk focuses on both tactical (one year or less) and structural (beyond one year) time frames. The Company has established interest rate risk limits based on an Earnings at Risk (EAR) concept and on an imputed market value of portfolio equity (MVPE). EAR measures the potential adverse impact on earnings from a given change in the yield curve, while the MVPE risk limit is set in terms of changes in the economic present value of future cash flow streams. To effectively measure and manage interest rate risk, the Company uses simulation analysis to determine the impact on EAR and MVPE under various interest rate scenarios. From these simulations, interest rate risk is quantified and appropriate strategies are developed and implemented. Model parameters are determined based on past interest rate movements and are periodically updated. EAR is calculated by multiplying the gap between asset and liability maturities/repricings by given changes in the yield curve. MVPE is calculated by subtracting the net present value of deposits and other interest bearing liabilities from the net present value of interest earning assets using the same yield curve model. Both MVPE and EAR are measured assuming a parallel change in market interest rates up 300 basis points and down 300 basis points over a one-year shock.
While the Company principally utilizes the parallel rate shift model for monitoring its compliance with its interest rate risk limits, it also periodically reviews and assesses its rate risk exposure to non-parallel yield curve changes (including inversion). Compliance with established limits is monitored by the Investment Committee and the Company's interest rate risk profile is presented quarterly to the Board of Directors. Both MVPE and EAR assess the Company's interest rate risk based on the Company's current asset and liability mix. Such limit for MVPE changes is a maximum 50% change in the excess of the Company's current MVPE over the Company's GAAP equity value. At year-end 1999, this limit was $43.8 million. For EAR, the limit is not greater than a $15 million (pre-tax) change in EAR.
The following table presents an analysis of the sensitivity inherent in the Company's net interest income and market value of portfolio equity (market value of assets, less liabilities). The interest rate scenarios presented in the table are based on interest rates at December 31, 1999 adjusted by instantaneous parallel rate changes upward and downward of up to 300 basis points. Each rate scenario reflects unique prepayment and repricing assumptions.
Since there are limitations inherent in any methodology used to estimate the exposure to changes in market interest rates, this analysis is not intended to be a forecast of the actual effect of a change in market interest rates on the Company. The net interest income variability reflects the Company's negative interest rate sensitivity gap. The MVPE is significantly impacted by the estimated effect of prepayments on the value of loans, and amortizing investment securities. Further, this analysis is based on the Company's present profile of assets, liabilities and equity and does not reflect any actions the Company might undertake in response to changes in market interest rates. This action could minimize the change in both EAR and MVPE in the various rate scenarios (in thousands).
MORTGAGE-BACKED AND SBA SECURITIES OF U.S. GOVERNMENT AGENCIES
The Company currently invests in mortgage-backed securities (FHLMC, FNMA, and GNMA) and SBA pooled loans in connection with its asset/liability management strategy. As of December 31, 1999, the Company had $39.6 million in fixed rate securities and $51.3 million in adjustable rate securities of this nature. These securities are all guaranteed by U.S. Government agencies and are, therefore, of the highest investment grade. These securities are subject to varying monthly payments due to varying prepayments by the borrowers on the underlying loans. As a general rule, when interest rates rise, prepayments slow down, extending the anticipated maturities of the fixed rate securities. Conversely, when interest rates decline, prepayments rise, as many of the borrowers refinance their loans at lower rate levels. The Company may not be able to reinvest the proceeds of prepayments in securities or other earning assets with comparable yields, which can adversely affect net interest income. Prepayment levels affect the contractual repayment profile of the securities.
These uncertainties cause more volatile market value shifts than do serial or single payment bonds, particularly as interest rates rise. The Company manages this portion of its investment portfolio by only investing in such fixed rate securities with expected average lives of 2-4 years but not greater than 5 years, or in adjustable rate securities which evidence lower price volatility due to their adjustable rate feature.
RESULTS OF OPERATIONS
The table that follows sets forth the major components of net income for each of the three years ended December 31, 1999, 1998 and 1997. Net income increased $7.5 million in 1999 over 1998, although the 1998 period included after-tax merger-related expenses of $5.3 million vs. none in 1999. The Company experienced a decrease in net interest income of $1.8 million, an increase in other income of $.8 million, reductions in the provisions for loan losses of $3.9 million and excluding merger expenses virtually unchanged operation expense levels. Reported diluted earnings per share increased by $.47 per share to $1.21. Net income for 1998 was $13.1 million or $.74 per diluted share compared to net income for 1997 of $17.6 million or $1.01 per diluted share. Excluding merger-related expenses, net income would have been $18.4 million in 1998 or $1.05 per diluted share compared to $18.0 million or $1.03 per diluted share in 1997.
Return on average assets was 1.33%, .80% and 1.10% in 1999, 1998 and 1997, respectively. The return on average equity was 13.91%, 8.53% and 12.44% in 1999, 1998 and 1997, respectively. Excluding merger-related expense, return on average assets would have been 1.13% and 1.12% in 1998 and 1997, respectively, and return on average equity would have been 12.01% and 12.66% for 1998 and 1997, respectively.
(*) BASED UPON THE WEIGHTED-AVERAGE NUMBER OF DILUTED SHARES OF COMMON STOCK OUTSTANDING DURING EACH OF THE PERIODS, ADJUSTED RETROACTIVELY FOR 10% STOCK DIVIDENDS DECLARED DECEMBER 1998 AND 1999 AND THE 50% STOCK DIVIDEND DECLARED SEPTEMBER 1997.
Net interest income is the primary component of the Company's earnings and is derived from interest income earned on loans and securities offset by interest expense paid on deposits and other interest-bearing liabilities.
The following table presents, for each of the years 1999, 1998 and 1997, the average balances of the various categories of the Company's balance sheet and the related interest income on earning assets and interest expense on interest-bearing deposits and liabilities. Also presented are the related average tax equivalent interest yields and interest rates paid on the Company's interest-earning assets and interest-bearing liabilities.
AVERAGE BALANCES, INTEREST, AND AVERAGE YIELDS/COSTS FOR THE YEAR ENDED DECEMBER 31, (DOLLARS IN THOUSANDS):
(1) AVERAGE BALANCES INCLUDE NON-ACCRUAL LOANS.
(2) YIELDS ON TAX-EXEMPT SECURITIES BASED ON A FEDERAL TAX RATE OF 35% IN 1999 AND 1998, AND 34% IN 1997.
The Company's net interest margin (tax equivalent net interest income divided by average earning assets) has continued to improve over the period from 4.50% in 1997 to 4.51% in 1998 and 4.61% in 1999 reflecting the Company's efforts to improve the quality of its core net interest income. The improved interest margin is primarily due to downward pricing of interest paid on interest bearing deposits and other interest bearing liabilities.
The table below details the changes in interest income and interest expense for the periods indicated due to both changes in average outstanding balances and changes in average interest rates (in thousands):
(1) THE CHANGE IN INTEREST DUE TO BOTH RATE AND VOLUME HAS BEEN ALLOCATED TO VOLUME AND RATE CHANGES IN PROPORTION TO THE RELATIONSHIP OF THE ABSOLUTE DOLLAR AMOUNTS OF THE CHANGE IN EACH TO THE TOTAL CHANGE.
(2) YIELDS ON TAX EXEMPT SECURITIES BASED ON A FEDERAL TAX RATE OF 35% IN 1999 AND 1998 AND 34% IN 1997.
1999 vs. 1998 net interest income was positively impacted by $.4 million due to changes in rates. The primary component was decreases in rates paid on deposits of $7.0 million which offset falling yields on assets. However, the decline in loan volume led to an overall decline in net interest income as lower liability volume savings did not fully absorb the loss of lower loan volume income.
In 1998 vs. 1997, net interest income was positively impacted by $1.5 million, due to changes in rates. The primary components were decreases in rates paid on deposits of $2.5 million offsetting declines in investment portfolio yields. However, overall gross interest income was negatively impacted due to changes in volume. While the average loan interest volume decline of $4.0 million was offset by increases in the size of securities portfolio, the average changes in the volume of interest-bearing liabilities reduced interest income by $.2 million. After the effects of taxes, net interest income declined by $.5 million overall due to volume changes.
ASSET QUALITY AND PROVISIONS FOR LOAN LOSSES
The following table presents details of the Company's nonperforming assets and restructured loans. The accrual of interest income is generally discontinued when a loan becomes 90 days past due as to interest or principal or, with respect to "current" loans, if management has doubts about the ability of the borrower to regularly pay interest and/or principal on a timely basis. When interest accruals are discontinued, any interest income credited to the current year which has not been collected is reversed, and any uncollected interest accrued in the prior year is charged to the allowance for loan losses. Management may elect to continue the accrual of interest when the loan is in the process of collection and the estimated fair value of the collateral is sufficient to cover the principal and accrued interest. If payments on nonaccrual loans are made, income is recorded when received unless management has reason to doubt the ultimate collectibility of the principal remaining on the loan in which case all payments are applied to principal. Loans are returned to accrual status once doubt concerning collectibility has been removed and the borrower has demonstrated performance in accordance with the loan terms and conditions.
The table below summarizes the Company's non-performing assets and restructured loans for the years indicated (in thousands):
(1) Nonaccrual status denotes loans on which, in the opinion of management, the collection of interest or principal is unlikely, or loans that meet other nonaccrual criteria as established by regulatory authorities. Payments received on loans classified as nonaccrual are either applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of the collectibility of the loan.
(2) Includes loans and mortgages secured by residential real estate of $0, $224, $128, $457 and $406 at December 31, 1999, 1998, 1997, 1996, and 1995, respectively.
Non-performing assets decreased by $1.1 million to $8.9 million at December 31, 1999. Of the amount of non-performing loans outstanding at December 31, 1999, $6.3 million is collateralized by real estate (approximately 83.8%). At December 31, 1998, the Company had $9.4 million in non-performing loans of which $8.3 million (88%) was collateralized by real estate compared to December 31, 1997 non-performing loans total $9.0 million (93% being collateralized by real estate). Other real estate owned (OREO) totaling $1.4 million, comprised eleven properties at December 31, 1999 of which five were commercial properties and six were residential properties. During the year the Company disposed of OREO properties totaling $2.2 million.
For a discussion of the allowance for loan losses, concentrations of credit risk and impaired loans, see Notes A, C and D to the 1999 Consolidated Financial Statements, under Item 8 contained herein. At December 31, 1999, there were no commitments to lend additional funds to borrowers whose loans were classified as non-performing.
If the Company's nonaccrual loans had been current in accordance with the original loan terms, $971,000 in gross interest income would have been recorded in 1999 vs. $892,000 in 1998 and $858,000 in 1997. The actual amount of interest income on nonaccrual loans recorded in interest income for 1999 was $319,000 vs. $100,000 in 1998 and $273,000 in 1997.
At December 31, 1999, the Company had a total of approximately $22.9 million in loans classified as substandard, in addition to the nonperforming assets noted above. Of this amount, $15.5 million are loans collateralized by real estate. Such loans may be classified as nonperforming in the future, if present concerns about the borrower's ability to comply with repayment terms become clearly evident. The following table details changes in the Allowance for Loan Losses for the years ended December 31 (in thousands):
The provision for loan losses, which is charged to operations, is based on both the amount of net loan losses incurred and management's ongoing evaluation of the level and composition of risk in the loan portfolio. The evaluation considers, in addition to the results of a continuous program of individual loan assessment, factors including, but not limited to, and the effect of general economic conditions on its borrowers and recent trends, loan portfolio composition, the level of nonperforming assets, prior loan loss experience and trends, growth of the portfolio and management's statistical estimate of losses inherent in the portfolio. The Company has not been involved in any foreign loans or highly leveraged transactions, which are generally considered high-risk loans. The provision for loan losses decreased by $3.9 million or 66.3% in 1999 compared to an increase of $1.4 million or 32.5% in 1998. This decrease was substantially attributable to the reduced levels of charge-offs from the levels experienced in 1998 and to a special provision of $1.4 million taken in June 1998 to conform the provisioning policy of the constituent banks in the July 1998 merger.
The ratio of allowance for loan losses to total loans has increased from 1.75% in 1995 to 2.19% in 1999 which increase is also reflected in an increased ratio of the loan loss allowance to nonperforming loans. The Company's loan loss allowance model reflects the risk potential of both performing and non-performing loans. Net charge-offs of loans were $1.5 million in 1999 as compared to $4.0 million in 1998 and $3.7 million in 1997.
The following table shows, at the dates indicated, the allocation of the allowance for loan losses, by category, and the percentage of loans in each category to total gross loans:
Management believes the allowance for loan losses is adequate to cover credit risk inherent in the portfolio but no assurance can be given that the current apparent stabilization of the local economy will not be unsettled by future events. Such developments could be expected to adversely affect the financial performance of the Company.
NONINTEREST INCOME
The following table details the components of noninterest income for the years ended December 31 (dollars in thousands):
Noninterest income increased in 1999 compared to 1998 as increases in trust income of $.2 million and service charge income of $.5 million was offset by a decrease in net gains on sales of loans ($.4 million) and net realized gains on securities (of $.2 million). Other non-interest income of $.6 million reflects gains on sales of redundant premises of $.3 million. Noninterest income increased $.1 million in 1998 compared to 1997. 1998 service charge income reflects little impact from the introduction of new service charge schedules which did not become fully effective until year end and declined $.2 million, which was offset by increases in trust income and other miscellaneous income.
NONINTEREST EXPENSE
The following chart outlines the major changes in noninterest expense for the years ended December 31, 1999, 1998 and 1997, respectively (dollars in thousands):
Salaries and benefits expense decreased in 1999 compared to 1998 by $1.5 million, as a result of a lower headcount reflecting further efficiencies achieved as a result of the merger. Salaries and benefits expense decreased in 1998 by $.1 million compared to 1997 as reductions in salary expense in connection with the merger were substantially offset by increases in staff in the four new branches, general salary increases during 1998, and temporary staff costs incurred in connection with the data processing conversion.
Occupancy and equipment expenses increased by $.2 million in 1998 vs. 1997 primarily due to the expense of four new branches opened in 1999. Although the Company consolidated seven branches in connection with the merger, the occupancy cost associated with these long established branches was modest compared to the costs of the newer branches.
Other expenses increased by $1.3 million in 1999, mainly due to increases in consulting fees of $1.3 million, data processing expense of $.7 million, miscellaneous losses of $.3 million and telephone expense of $.2 million being partially offset by decreases in legal fees ($.4 million), advertising expense ($.2 million), audit fees ($.2 million), postage ($.1 million) and loan processing expense ($.1 million). Other expenses decreased by $.2 million in 1998 over 1997 levels, of which $.4 million represents savings achieved in the levels of expense for postage, supplies, advertising, foreclosure expense and consultant fees, somewhat offset by increases in data processing, telephone and miscellaneous losses of $.6 million. Exclusive of merger expenses, the Company's efficiency ratio for 1999 was 56.54% vs. 55.65% for 1998, and 56.47% for 1997.
Income taxes increased by $2.8 million in 1999 to $10.4 million compared to $7.7 million in 1998 and $10.0 million in 1997, reflecting pretax income of $31.0 million, $20.7 million and $27.6 million in 1999, 1998 and 1997, respectively. The Company's effective tax rates were 33.6%, 37.0% and 36.2% in 1999, 1998 and 1997, respectively. The Company's effective tax rate in 1998 particularly reflects $1.6 million in nondeductible merger-related expense. For further information regarding income taxes, see Note J to the Consolidated Financial Statements under Item 8.
SELECTED QUARTERLY FINANCIAL DATA
The following table shows selected quarterly financial data of the Company for the three month periods indicated. The information contained in the table does not purport to be complete and is qualified in its entirety by the more detailed financial information contained elsewhere herein.
(Dollars in thousands, except share data)
*Earnings per share have been retroactively adjusted to give effect to the 10% stock dividends, declared December 1998 and December 1999. (1)The merger related expense charge of $5.3 million reduced third quarter 1998 income by $3.7 million after tax and reduced diluted earnings per share by $.21 (2)The merger-related expense charge of $1.6 million reduced second quarter net income by $1.2 million after tax and reduced diluted earnings per share by $.07. (3)The merger-related expense charge of $.6 million reduced first quarter net income by $.4 million after tax and reduced diluted earnings per share by $.02.
Item 7A.
Item 7A. QUANTITIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations "Asset/Liability Management".
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following are included in this item beginning on the pages indicated:
Selected quarterly financial data of the Company for 1999 and 1998 are reported in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Selected Quarterly Financial Data."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEMS 10 THROUGH 13.
Information required by Part III (Items 10 through 13) of this Form 10-K is incorporated by reference to the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 11, 2000, which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year to which this report relates.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) List of Documents Filed as Part of This Report.
(1) Financial Statements Filed:
1. Independent Auditors' Report
2. Consolidated Balance Sheets at December 31, 1999 and 1998
3. Consolidated Statements of Income and Expense for each of the three years in the period ended December 31, 1999
4. Consolidated Statements of Changes in Stockholders' Equity for each of the three years in the period ended December 31, 1999
5. Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1999
6. Consolidated Statements of Comprehensive Income for each of the three years in the period ended December 31, 1999
7. Notes to Consolidated Financial Statements
(2) Financial Statement Schedules. All schedules are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements or related notes.
(3) Exhibits. The exhibits listed on the Exhibit Index on page 37 of this Form 10-K are filed herewith or are incorporated herein by reference.
(b) Reports on Form 8-K
None.
EXHIBIT INDEX
- ---------------------- + MANAGEMENT CONTRACT OR COMPENSATORY PLAN. * FILED HEREWITH.
REPORT OF MANAGEMENT TO THE STOCKHOLDERS
January 27, 2000
CONSOLIDATED FINANCIAL STATEMENTS
The management of Premier National Bancorp, Inc. and subsidiaries, (the "Company"), is responsible for the preparation, integrity, and fair presentation of its published financial statements and all other information presented in this Annual Report. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and, as such, include amounts based on informed judgments and estimates made by management.
INTERNAL CONTROL
Management is responsible for establishing and maintaining effective internal control over financial reporting, including safeguarding of assets, for financial presentations in conformity with generally accepted accounting principles and for the Company's bank subsidiary, Premier National Bank, in conformity with the Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income ("Call Report instructions"). The internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.
THERE ARE INHERENT LIMITATIONS IN THE EFFECTIVENESS OF ANY INTERNAL CONTROL, INCLUDING THE POSSIBILITY OF HUMAN ERROR AND THE CIRCUMVENTION OR OVERRIDING OF CONTROLS. ACCORDINGLY, EVEN EFFECTIVE INTERNAL CONTROL CAN PROVIDE ONLY REASONABLE ASSURANCE WITH RESPECT TO FINANCIAL STATEMENT PREPARATION. FURTHER, BECAUSE OF CHANGES IN CONDITIONS, THE EFFECTIVENESS OF INTERNAL CONTROL MAY VARY OVER TIME.
Management assessed the Company's internal control over financial reporting, including safeguarding of assets, for financial presentations in conformity with generally accepted accounting principles and, for Premier National Bank, in conformity with the Call Report Instructions as of December 31, 1999. This assessment was based on criteria for effective internal control over financial reporting, including safeguarding of assets, established in INTERNAL CONTROL--INTEGRATED FRAMEWORk issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that the Company maintained effective internal control over financial reporting, including safeguarding of assets, presented in conformity with generally accepted accounting principles and, for Premier National Bank, in conformity with the Call Report instructions, as of December 31, 1999.
AUDIT COMMITTEE
The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of the Company's management. The Audit Committee is responsible for recommending to the Board of Directors the selection of independent auditors, which selection is then ratified by the stockholders. The Audit Committee meets periodically with management, the independent auditors, and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company in addition to reviewing the Company's financial reports. The independent auditors and the internal auditors have full and free access to the Audit Committee, with or without the presence of management, to discuss the adequacy of internal control for financial reporting and any other matters which they believe should be brought to the attention of the Audit Committee.
COMPLIANCE WITH LAWS AND REGULATIONS
Management is also responsible for ensuring compliance with the federal laws and regulations concerning loans to insiders and the federal and state laws and regulations concerning dividend restrictions, both of which are designated by the Federal Deposit Insurance Corporation (FDIC) as safety and soundness laws and regulations.
Management assessed Premier National Bank's compliance with the designated safety and soundness laws and regulations and has maintained records of its determinations and assessments as required by the FDIC. Based on this assessment, management believes that Premier National Bank has complied, in all material respects, with the designated safety and soundness laws and regulations for the year ended December 31, 1999.
T. Jefferson Cunninghan III Paul A. Maisch Chairman of the Board and CEO Treasurer & Chief Financial Officer
INDEPENDENT ACCOUNTANTS' REPORT
To the Audit Committee Premier National Bancorp, Inc.
We have examined management's assertion, included in the accompanying Report of Management to the Stockholders, that Premier National Bancorp., Inc. and subsidiaries, (the "Company") maintained effective internal control over financial reporting, including safeguarding of assets, presented in conformity with generally accepted accounting principles and, for the Company's bank subsidiary, Premier National Bank, in conformity with the Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income as of December 31, 1999 based on the criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO report). Management is responsible for maintaining effective internal control over financial reporting. Our responsibility is to express an opinion on management's assertion based on our examination.
Our examination was conducted in accordance with attestation standards established by the American Institute of Certified Public Accountants and, accordingly, included obtaining an understanding of internal control over financial reporting, testing, and evaluating the design and operating effectiveness of the internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due to error or fraud may occur and not be detected. Also, projections of any evaluation of internal control over financial reporting to future periods are subject to the risk that the internal control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assertion that the Company maintained effective internal control over financial reporting, including safeguarding of assets, presented in conformity with generally accepted accounting principles and, for Premier National Bank, in conformity with the Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income as of December 31, 1999, is fairly stated, in all material respects, based on the criteria established in the COSO report.
January 27, 2000
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Premier National Bancorp, Inc.
We have audited the consolidated balance sheets of Premier National Bancorp, Inc. and subsidiaries (the "Company") as of December 31, 1999 and 1998 and the related consolidated statements of income and expense, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The consolidated financial statements give retroactive effect to the merger of Progressive Bank, Inc. and Hudson Chartered Bancorp, Inc., which has been accounted for as a pooling of interests as described in note a to the consolidated financial statements. We did not audit the statements of income, stockholders' equity and cash flows of Progressive Bank, Inc. for the year ended December 31, 1997, which statements reflect net interest income of $34 million for the year ended December 31, 1997. Those statements were audited by other auditors whose unqualified report dated February 2, 1998 has been furnished to us, and our opinion, insofar as it relates to the amounts included for Progressive Bank, Inc. For 1997, is based solely on the report of such other auditors.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of Premier National Bancorp, Inc. and subsidiaries at December 31, 1999 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles.
January 27, 2000
PREMIER NATIONAL BANCORP, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
PREMIER NATIONAL BANCORP, INC.
CONSOLIDATED STATEMENTS OF INCOME AND EXPENSE (dollars in thousands, except share data)
(1) Adjusted for 10% stock dividends declared in December 1998 and 1999 and 3 for 2 stock split in the form of a 50% stock dividend declared in September 1997.
See notes to consolidated financial statements.
PREMIERNATIONAL BANKCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (dollars in thousands)
See notes to consolidated financial statements.
PREMIER NATIONAL BANCORP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (dollars in thousands, except share data)
* Adjusted for 10% stock dividends declared in December 1998 and 1999 and 3 for 2 stock splits in the form of 50% dividend declared in September 1997. See Note O. (1) Treasury shares not adjusted for 50% stock dividend declared in Sept. 1997. The effect of such shares reissued prior to the 50% stock dividend included in the shares (adjusted for the stock dividend) for the "stock reinvestment and purchase plan" and "options exercised" is 53,304 shares
See notes to consolidated financial statements.
PREMIER NATIONAL BANCORP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (dollars in thousands)
See notes to consolidated financial statements
PREMIER NATIONAL BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, unless otherwise indicated, except share data)
NOTE A - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
Premier National Bancorp, Inc. is a New York State bank holding company which operates 34 branches in Dutchess, Ulster, Sullivan, Orange, Westchester, Putnam and Rockland counties of Southeastern New York State through its commercial banking subsidiary, Premier National Bank (Bank). Collectively, these entities are referred to herein as the "Company". The Bank is principally engaged in a variety of lending activities and deposit gathering activities within the above noted market place. As such, its future growth and profitability are dependent, in large part, on the performance of the local economy and the value of local real estate. The Bank competes with a significant number of other financial institutions. Diversity of product lines, availability of funds, interest rates charged on loans and offered on deposits, responsiveness and customer convenience are all factors in competing effectively with these other financial institutions. The local economy is heavily dependent on employment levels of two large employers, IBM and New York State and local government. Although present conditions are stable, the local economy was weakened, in recent years, from large employment cutbacks from these employers. Approximately 75% of the Company's loans outstanding are collateralized by real estate. The Company also has made commitments to lend additional funds also collateralized by real estate in the amount of approximately $77.6 million.
The Company does not presently engage in hedging activities, utilize derivative financial instruments or maintain a trading portfolio.
MERGER
Effective July 17, 1998, Progressive Bank, Inc. ("PBI") was merged with and into Hudson Chartered Bancorp, Inc. ("HCB") under the name of Premier National Bancorp, Inc. Each share of PBI common stock was converted into 1.82 shares of the Company's common stock. Approximately 7,954,316 common shares were issued for the outstanding common stock of PBI. At the same time, Pawling Savings Bank ("Pawling"), a subsidiary of PBI, was merged with and into First National Bank of the Hudson Valley ("Hudson Valley"), a subsidiary of HCB, under the name Premier National Bank.
The transaction was accounted for using the pooling-of-interests method and accordingly, all historical financial data has been restated to include both entities for all periods presented. Direct costs of mergers accounted for by the pooling-of-interests method are expensed as incurred. Merger related costs expensed in 1997 aggregated $541 ($314 net of tax), and in 1998 aggregated $7,511 ($5,316 net of tax). These merger expenses include legal, accounting, regulatory and severance costs as well as integration costs such as conversions, abandonments and relocations. The following table presents summary results of operations for the companies for the year prior to the merger.
BASIS OF PRESENTATION
The Company's consolidated financial statements include the accounts of Premier National Bancorp, Inc., its commercial banking subsidiary, Premier National Bank, and Hudson Chartered Realty, Inc., a company utilized to hold title to certain foreclosed real estate properties. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation. Assets held in an agency or fiduciary capacity for trust department customers totaling $294.8 million at year end 1999 and mortgages serviced for others by the Bank totaling $130.5 million at year end 1999 are not included in the consolidated financial statements.
In preparing financial statements, management is required to make estimates and assumptions, particularly in determining the adequacy of the allowance for loan losses, that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the consolidated balance sheet and the results of operations for the period. Actual results could differ significantly from those estimates.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the credit quality of the portfolio, past loan loss experience and current loan loss trends, local and regional economic conditions, the volume, growth and composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged against income and by recoveries of loans previously charged off.
While management uses available information to determine possible loan losses, future additions to the allowance may be necessary based on changes in economic conditions, particularly in real estate values and employment levels in Company's primary market area, Dutchess, Ulster, Sullivan, Orange, Westchester, Putnam and Rockland counties of Southeastern New York State. In addition, regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination. A regulatory examination of the bank was conducted in 1999 and no increase in the allowance was required as a result of the examination.
IMPAIRED LOANS
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan", as amended by SFAS No. 118, "Accounting for Impairment of a Loan - Income Recognition and Disclosures" a loan is recognized as impaired when it is probable that principal and/or interest are not collectible in accordance with the contractual terms of the loan. Income is recorded using the income recognition principles outlined below. Measurement of impairment is based on the present value of expected future cash flows discounted at the loan's effective interest rate or at the loan's observable market price or at the fair value of the collateral, if the loan is collateral dependent. Smaller homogenous performing loans, principally residential mortgages, consumer loans, and credit cards, are not separately reviewed for impaired status. Separate allocations of the allowance for loan losses for these loans are made based upon trends and prior loss experience and composition of credit risk in these types of loans. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change.
If the fair value of an impaired loan is less than the related recorded amount, a specific valuation allowance is established or, if the impairment is considered to be permanent, a write down is charged against the allowance for loan losses.
INCOME RECOGNITION
Interest on loans is determined using the level yield method. Under this method, discount accretion and premium amortization on loans are recorded in interest income.
The accrual of interest income generally is discontinued when its receipt is in doubt, which typically occurs at or prior to the date when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, any interest credited to income in the current year which has not been collected is reversed, and any interest accrued in the prior year is charged to the allowance for loan losses. If payments on nonaccrual loans are made, income is recorded as received unless management has reason to doubt the ultimate collectibility of the principal remaining on the loan. When the ultimate collectibility of the loan principal is in doubt, all of such payments are applied to reduce the principal balance of the loan. Management may elect to continue the accrual of interest when a loan is in the process of collection and the estimated fair value of collateral is clearly sufficient to cover the principal balance and accrued interest. Loans are returned to accrual status once the doubt concerning collectibility has been removed and the borrower has demonstrated performance in accordance with the loan terms and conditions.
OTHER REAL ESTATE OWNED (OREO)
OREO includes properties for which the Bank has obtained title through foreclosure or deed in lieu of foreclosure. These properties are recorded at the lower of cost or estimated fair value (net of estimated disposal costs). If a valuation loss exists when properties are acquired, the loss is recorded as a charge to the allowance for loan losses. Management periodically monitors the value of such OREO properties. If, due to further reductions in estimated fair value, further losses are anticipated, such losses are recorded as OREO expense. Any gains on disposition of such properties reduce OREO expense. Holding costs on properties are included in current operations, while costs that improve such properties may be capitalized. If the Bank lends funds in conjunction with dispositions of OREO, such loans are required to meet normal loan underwriting criteria.
LOAN ORIGINATION FEES
Loan origination and commitment fees and direct loan origination costs are deferred and the net amount is amortized or accreted as an adjustment of interest income using the level yield method. These deferrals are amortized over the expected lives or commitment period of the respective categories, which generally vary from one to twelve years.
SECURITIES
Securities include U.S. Treasury, mortgage-backed and other U. S. Government Agency, municipal and corporate bonds, regulatory and equity securities. Those debt securities which management has the positive intent and ability to hold until maturity are classified as held to maturity and are carried at amortized cost (specific identification) with amortization of premiums and accretion of discounts determined using the level yield method to the earlier of the call or maturity date, respectively. Held to maturity securities primarily include local municipal bonds purchased from smaller municipalities in the Company's market area, and certain other securities with yield and/or maturity characteristics such that management intends to retain them until maturity. Equity securities principally include modest investments in the common stock of certain banks in the Company's market area. Regulatory securities include equity investments required for membership in the Federal Reserve System, Federal Home Loan Bank, and New York State Business Development Corporation. Such investments are carried at cost unless considered impaired, in which case a writedown would be taken and charged to income.
Securities which have been identified as assets for which there is not a positive intent to hold to maturity are classified as available for sale. Dispositions of such securities may be appropriate for either liquidity or interest rate risk management. Available for sale securities are reported at fair value with unrealized gains and losses (net of tax) excluded from operations and reported in the "Accumulated Other Comprehensive Income" component of stockholders' equity. At December 31, 1999, 1998 and 1997, the net unrealized gains (loss), after tax, on available for sale securities were ($6,581), $1,521 and $1,647, respectively. Realized gains and losses from sales of securities are recognized on the trade date by specific identification of the security sold.
RELATED PARTY TRANSACTIONS
It is the policy of the Company that loans and other business transactions with directors, officers and other related parties be made on terms and conditions no more favorable than those with unrelated parties.
LOANS HELD FOR SALE
Loans held for sale are carried at the lower of cost or market value as determined on an aggregate basis. There were no loans held for sale at December 31, 1999 or 1998.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed on the straight-line method based on estimated useful lives ranging from, dependent on asset type, 3 to 40 years. Leasehold improvements are amortized over the shorter of the terms of the respective leases, including available extensions, or the estimated useful lives of the assets. Maintenance and repair costs are charged to operating expenses as incurred.
INCOME TAXES
The provision for income taxes is based on income as reported in the financial statements. Deferred taxes are provided for financial reporting purposes using an asset-liability approach for recognizing the tax effects of temporary differences between the basis of assets and liabilities for tax and financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is recognized if, based on analysis of available evidence, management determines that some or all of the deferred tax asset is not "more likely than not" to be realized. Adjustments to increase or decrease the valuation allowance are charged or credited, respectively, to income tax expense. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the income statement in the period the change is enacted.
POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS
SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," requires the recognition of the cost of these benefits over an employee's working career on an accrual basis. SFAS No. 112, "Employers' Accounting for Postemployment Benefits" establishes standards for accounting and reporting the cost of benefits provided by an employer to its former or inactive employees after employment but before retirement. SFAS No. 112 requires an employer to recognize an obligation for such benefits if certain conditions are met. SFAS Nos. 106 and No. 112 resulted in postretirement benefit liabilities of $1,647 and $1,713 at December 31, 1999 and 1998, respectively.
EARNINGS PER COMMON SHARE
In accordance with SFAS No. 128 "Earnings Per Share", basic earnings per common share is computed by dividing net income, adjusted for any preferred stock dividends, by the weighted average number of common shares outstanding. Diluted earnings per common share includes the additional dilutive effect of stock options using the treasury stock method based on the average market price of the Company's common stock for the period.
MORTGAGE SERVICING RIGHTS
The Company's mortgage servicing portfolio totaled $130.5 million, $146.0 million and $150.6 million for the benefit of third party investors (primarily Federal Home Loan Mortgage Corporation and Federal National Mortgage Association) at December 31, 1999, 1998 and 1997, respectively, and it recorded servicing fee income of $333, $418 and $458 for the years ended December 31, 1999, 1998 and 1997. The Company records the sale of loans in which servicing is retained on the basis of the relative fair values of the loans and the servicing rights. The Company sold loans of $5.2 million, $22.6 million and $21.5 million in 1999, 1998 and 1997, respectively, with servicing rights retained, and at December 31, 1999, 1998 and 1997 servicing rights outstanding totaled $288, $434 and $426, respectively. The value of servicing rights must be evaluated for impairment on a quarterly basis and a valuation allowance established if fair value is lower than the recorded amounts.
The cost of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. The amount of impairment recognized is the amount by which the capitalized mortgage servicing rights exceed their fair value. No impairment of servicing assets was experienced in 1999, 1998 or 1997.
When participating interests in loans sold have an average contractual interest rate, adjusted for servicing fees, that differs from the agreed yield to the purchaser, gains or losses are recognized equal to the present value of such differential over the estimated remaining life of such loans. The resulting Amortgage servicing receivables" or "deferred servicing revenue" is amortized over the estimated life using a method approximating the interest method.
Quoted market prices are not available for the mortgage servicing receivables. Thus, the mortgage servicing receivables and the amortization thereon are periodically evaluated in relation to estimated future servicing revenues, taking into consideration changes in interest rates, current prepayment rates, and expected future cash flows. The Company evaluates the carrying value of the mortgage servicing receivables by estimating the future servicing income of the mortgage servicing receivables based on management's best estimate of remaining loan lives and discounted at the original discount rate.
BRANCH PURCHASE PREMIUM
The purchase premium paid in connection with the 1996 acquisition of two branches has been capitalized as an intangible asset. The premium is being amortized on a straight-line basis over seven years (the estimated average remaining life of the acquired customer base). The unamortized premium is reviewed for impairment if events or changes in circumstances indicate that the carrying amount may not be fully recoverable.
STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation", encourages but does not require, companies to record compensation cost from stock-based employee compensation plans at fair value. As permitted, the Company has elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock.
TRANSFERS AND SERVICING OF FINANCIAL ASSETS
The Company utilizes the provisions of SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," in determining the transfer and services of financial assets and was adopted by the Company as of January 1, 1997 and had no significant effect on the Company's consolidated financial statements. This standard specifies accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities and for distinguishing whether a transfer of financial assets in exchange for cash or other consideration should be accounted for as a sale or as a pledge of collateral in a secured borrowing.
COMPREHENSIVE INCOME
SFAS No. 130, "Reporting Comprehensive Income" (SFAS No. 130), was adopted by the Company on January 1, 1998 and financial statements for earlier periods have been reclassified to reflect the application of the provisions of this standard. Comprehensive income is defined as "the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. The Company's only current source of other comprehensive income is net unrealized gains and losses on available for sale securities which, in accordance with prior accounting standards, had been directly included, net of tax, in a separate component of stockholders' equity. Under SFAS No. 130, all items that are recognized as components of comprehensive income are required to be reported in a financial statement that is displayed with the same prominence as other financial statements. Adoption of this standard had no effect on the Company's financial condition or results of operations.
SEGMENT INFORMATION
SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information"(SFAS No. 131), which became effective for the Company as of January 1, 1998, establishes standards for the way public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company has determined it operates as one reportable segment, "Community Banking." All of the Company's activities are interrelated, and each activity is dependent and assessed based on how each of the activities of the Company supports the others. For example, commercial lending is dependent upon the ability of the Bank to fund itself with retail deposits and other borrowings and to manage interest rate and credit risk of the portfolio and related funding. This situation is also similar for personal and residential mortgage lending. Accordingly, all significant operating decisions are based upon analysis of the Company as one operating segment or unit. Although the Company's trust department is managed as a relatively distinct unit, its impact on the assets, liabilities and net income of the Company is not material.
General information required by SFAS No. 131 is disclosed in the Consolidated Financial Statements and accompanying notes. The Company operates in only the U.S. domestic market, specifically the Hudson Valley, which includes the counties of Dutchess, Rockland, Westchester, Orange, Putnam, Sullivan and Ulster, New York, as well as Long Island, New York and southern Connecticut. For the year ended December 31, 1999, 1998 and 1997, no customer accounted for more than 10% of the Company's revenue.
EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS
Effective 1998, the Company adopted Statement of Financial Accounting Standards No. 132 (SFAS 132), "Employers' Disclosures about Pensions and Other Postretirement Benefits". The statement revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans, but requires additional information on changes in the benefit obligations and fair values of plan assets.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In the third quarter of 1998, the Company adopted Statement of Financial Accounting Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities". The Statement requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be recorded at fair value through earnings. If the derivative qualifies as a hedge, depending on the nature of the exposure being hedged, changes in the fair value of derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is recognized in earnings. The adoption of this standard did not have a material effect on the Company's financial statements. In connection with the adoption of SFAS No. 133, the Company, as permitted, transferred, at fair value, securities having a fair value of $96,985 and a carrying amount of $95,993 from its held to maturity portfolio to its available for sale portfolio during 1998. The effect of this increase was to increase stockholders' equity after tax by $576.
CASH FLOW INFORMATION
Cash and cash equivalents include federal funds sold, which generally are available to the Company on one day's notice, and other highly liquid instruments with an original term of three months or less.
RECLASSIFICATIONS
Certain reclassifications have been made to prior years' financial statements to conform to the presentation of 1999 financial information.
NOTE B - SECURITIES
SECURITIES CONSIST OF THE FOLLOWING:
At December 31, 1999, the net unrealized loss on securities "available for sale" (net of tax effect at a rate of 41.1% or $4,580) that was included in the "Accumulated Other Comprehensive Income" component of stockholders' equity was $6,581.
At December 31, 1998, the net unrealized gain on securities "available for sale" (net of tax effect at a rate of 42% or $1,094) that was included in the "Accumulated Other Comprehensive Income" component of stockholders' equity was $1,521.
In the third quarter of 1998, the Company transferred, at fair value, mortgage-backed securities having a fair value of $96,985 (carrying value of $95,993) from its "held to maturity" portfolio to its portfolio of "available for sale" securities. This was done to enhance the Company's ability to respond to changes in the interest rate environment. This transfer was made in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". Concurrent with the adoption of this statement, corporations were permitted to reclassify their "available for sale" and "held to maturity" securities without calling into question the past intent of an entity to hold securities to maturity. The effect of this transfer, after tax, was a $576 increase in stockholders' equity.
Subsequent changes in unrealized gains or losses on these transferred securities have been reflected in the "Accumulated Other Comprehensive Income" component of the Company's equity accounts, on an after-tax basis. If any of the transferred securities are sold, the realized gains or losses would be reflected in the Company's results of operations.
The Company has no plans to establish a trading account.
The Company's mortgage-backed securities at year end 1999 are all classified as "available for sale" and are principally pass-through securities issued by Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae).
The contractual maturities at December 31, 1999 of the Company's available for sale and held to maturity debt securities other than mortgage-backed and SBA securities are summarized in the following table. Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call premiums.
Gross realized gains from sales of securities were $ 241, $537 and $338 in 1999, 1998 and 1997, respectively, and gross realized losses were $106, $164 and $9.
At December 31, 1999, securities with a carrying amount of $162.5 million were pledged as collateral for municipal deposits and other purposes. Municipal deposits so collateralized totaled $137.8 million at the same date.
NOTE C - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK
The Company utilizes financial instruments with off-balance-sheet risk to accommodate the financing needs of its customers. These instruments involve varying degrees of credit or interest-rate risk which are not recognized on the balance sheet. Credit risk is defined as the possibility of sustaining a loss because the other parties to a financial instrument fail to perform in accordance with the terms of the contract, whereas interest-rate risk arises from changes in the market value of positions stemming from movements in interest rates. In order to minimize credit risk, the Company subjects such commitments to its lending policy which includes a formal credit approval and monitoring process. This lending policy requires collateral where the customer credit evaluation determines that the inherent risk in the transaction warrants such collateral. In order to minimize interest-rate risk, the Company has established an asset/liability management policy, adherence to which is monitored by the Bank's Investment Committee of the Board. The contract amounts of the instruments referred to in the chart below reflect the extent of involvement in particular classes of financial instruments.
UNUSED COMMITMENTS AND STANDBY LETTERS OF CREDIT
Unused commitments include loan origination commitments, which are legally binding agreements to lend at a specified interest rate for a specified purpose, usually containing an expiration date, and lines of credit, which represent loan agreements under which the lender has an obligation, subject to certain conditions, to lend funds up to a particular amount, whereby the borrower may repay and re-borrow at any time within the contractual period. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.
The Company's maximum exposure to accounting loss related to the contract amounts of these financial instruments, assuming they are fully funded, all borrowers default and any collateral proves to be worthless, at December 31, 1999 is as follows:
The Company lends primarily in the Dutchess, Ulster, Sullivan, Orange, Westchester, Putnam and Rockland counties of Southeastern New York State. The Company also originates larger one-to-four family mortgage and commercial mortgage loans in the Connecticut counties of Fairfield, Hartford, New Haven and Litchfield and larger one-to-four family mortgage loans in the New York counties of Nassau and Suffolk. The ability of borrowers to make principal and interest payments in the future will depend upon, among other things, the level of overall economic activity and real estate market conditions prevailing within the Company's lending region.
Approximately 75% of the company's loans (commercial, residential and personal) are collateralized by real estate. In addition to such loans outstanding, as shown on the balance sheet, the Company has standby letters of credit and other off-balance sheet credit risk exposure related to real estate loans. The Company generally requires collateral on all real estate related facilities and loan to value ratios not exceeding 75% to 80%. Private mortgage insurance is generally required on residential mortgages with loan to value ratios above 80%.
NOTE D - NONPERFORMING ASSETS, PAST DUE LOANS AND IMPAIRED LOANS
The following table presents nonperforming assets outstanding at December 31:
Information concerning interest income on nonperforming loans and restructured troubled debt is summarized below:
At December 31, 1999 there were no commitments to lend additional funds to the borrowers associated with the nonperforming assets noted above.
Loans past due 30-89 days were as follows at December 31:
As described in Note A, the Company applies the guidelines in SFAS No. 114 to loans individually evaluated for impairment (principally commercial mortgage, commercial and industrial, construction loans and nonaccrual residential mortgages). Generally, the fair value of impaired loans was determined using the fair value of underlying collateral. Additional impaired residential mortgages might have been identified if the impairment identification procedures of SFAS No. 114 were required to be applied to homogenous loan portfolios. In the opinion of management, the amount of any such additional impaired loans would not be significant to the Company's consolidated financial position or results of operations.
Information regarding the recorded investment in impaired loans at December 31 and for the year then ended consists of the following:
NOTE E - LOANS AND ALLOWANCE FOR LOAN LOSSES
The following table outlines the balances, including related deferred loan fees and costs, of loan categories at December 31:
Changes in the allowance for loan losses for the years ended December 31 were as follows:
Substantially all newly originated fixed rate residential mortgage loans with 20 and 30 year terms are sold in the secondary market. The net realized gains on these sales were $79, $443 and $453 in 1999, 1998 and 1997, respectively.
NOTE F - PREMISES AND EQUIPMENT
Premises and equipment is comprised of the following at December 31:
NOTE G - DEPOSITS
The following table outlines balances at December 31, for interest bearing accounts:
At December 31, 1999 and 1998, certificates of deposit of $100 or more included in time deposits totaled $203,704 and $110,291 respectively. The Company does not accept brokered deposits. Interest expense on deposits was as follows:
The maturities of time deposits outstanding at December 31, 1999 and 1998 are summarized for the periods indicated in the following table:
In April 1996, Pawling completed the acquisition of two branch offices located in Rockland County, New York and assumed deposit liabilities of approximately $152.8 million. Assets recorded in the acquisition were principally cash and a deposit purchase premium. The unamortized purchase premium of $4.5 and $5.9 million at December 31, 1999 and 1998, respectively, is included in intangible assets in the consolidated balance sheets.
NOTE H- EMPLOYEE BENEFIT PLANS At the date of the Merger, all predecessor plans were carried forward to the Company. The existing plans are described below. The Company is in the process of implementing amended benefit plans to present uniform coverage. For purposes of this note, employees of the predecessor companies continue to be described as being employees of those entities.
THRIFT PLAN
The Premier National Bancorp, Inc. Retirement and Thrift Plan is a qualified 401(k) defined contribution plan covering substantially all full time employees who have attained age 21 and have at least one year of service. Employee contributions vest immediately, while plan contributions vest as follows: 40% after 2 years, 60% after 3 years, 80% after 4 years and 100% after 5 years of service. For the profit sharing component of the plan, Hudson Chartered Bancorp previously determined, at the end of each fiscal year, an annual amount of profit sharing to be funded. However, as a result of the utilization of the CASH BALANCE PLAN described below, profit sharing contributions were suspended in 1998 and 1999. For the thrift component of the plan, Hudson Chartered matched employee contributions under deferred salary reduction agreements dollar for dollar up to 4% of eligible compensation. As of the date of the merger, the plan was amended to match two-thirds dollar for each dollar contributed under a salary reduction agreement up to 6% of eligible compensation. Employees can contribute up to 10% by way of such salary reduction agreements and, in addition, can voluntarily contribute up to an additional 10% of their eligible compensation. (PBI also maintained a qualified 401(k) defined contribution plan. Eligible employees could elect to contribute up to 8% of their compensation. PBI made contributions equal to 50% of the first 5% of a participant's contribution for non-highly compensated employees, and 50% of the first 3% for highly-compensated employees. Contributions to this plan were suspended as of the date of the merger.) Upon completion of all required approvals, the PBI 401(k) plan is intended to be merged into the Premier National Bancorp, Inc. Retirement and Thrift Plan. Expense for these plans was $747, $754 and $768 for 1999, 1998 and 1997, respectively.
CASH BALANCE PLAN
A retirement plan established by PBI covers substantially all employees of PBI who meet certain age and length of service requirements. Prior to October 1, 1997, the plan was a defined benefit plan providing for benefits based on the employees' years of accredited service and their average annual three years' earnings, as defined by the plan. Plan benefits were funded through PBI contributions at least equal to the amounts required by law. Effective October 1, 1997, the defined benefit plan was amended and restated as a "cash balance" plan. The annual service credit under the cash balance plan equals 5% of annual compensation (8% for those employees who were 50 years of age or older with at least 10 years of service as of September 30, 1997), and the actual earnings credit on employee balances is the rate on the 30 year Treasury bond prevailing at the beginning of each plan year. After the merger, the former Hudson Chartered Bancorp employees were included in this plan with benefits calculated retroactively back to October 1, 1997, and vesting requirements were changed to mirror the ongoing thrift plan.
The following are reconciliations of the benefit obligations and the fair value of plan assets of the Cash Balance plan, the amounts not recognized in the statements of financial position, and the amounts recognized in the statement of financial position as of December 31, 1999 and 1998:
The plan assets are primarily invested in a money market fund, stocks, and bonds. Valuation of the cash balance plan as shown above was conducted as of December 31, 1999 and 1998. Assumptions used by the Company in the determination of cash balance plan information consisted of the following:
The components of net periodic benefit cost consisted of the following for the years ended December 31:
OTHER RETIREMENT PLANS
Both HCB and PBI had certain employment arrangements which include supplemental retirement benefits for certain key executives that offset the reduction in benefits due to certain limitations imposed under the federal income tax laws. These arrangements are unfunded and are a general liability of the Company. The unfunded liability at December 31, 1999 was $300.
HCB also maintained an Executive Supplemental Income Plan ("ESI Plan"), a nonqualified plan that provides certain employees with supplemental retirement benefits. The ESI Plan utilizes life insurance contracts for indirect funding of preretirement benefits. Related expense was $25, $74 and $117 in 1999, 1998 and 1997, respectively. These plans also provide that, in the event of a "change in control", employees who have attained age 55 may retire and are immediately eligible to receive benefits without prior board approval and without satisfying any minimum years of service requirement. Other covered employees who are terminated, without just cause, or who voluntarily terminate employment, after a change in control, are entitled to receive their retirement benefits upon reaching normal retirement age. This plan has not been offered by the Company since 1994 and its provisions covers five employees.
In 1999, the Company approved an additional supplemental retirement plan for the Chairman of the Board. The plan allows for the payment of 20% of his final annual salary, payable upon retirement, annually, for 10 years plus payment of medical benefits for the same period. The accumulated benefit obligation at December 31, 1999 was $25.
PBI also maintained a non-qualified, unfunded retirement and severance plan for members of its Board of Directors of its banking subsidiary. The plan was modified in 1999 to allow former Hudson Chartered Bancorp directors to join the plan. Under this plan, each member retiring the Board after at least five years of service is entitled to a benefit consisting of the annual retainer fee of $5,000 per annum at the time of departure multiplied by the director's number of years of service, up to 15 years, maximum $75,000. The annual cost of this plan was $133, $113 and $80 in 1999, 1998 and 1997, respectively. All of the present non-officer directors of the Company are currently covered by this plan. The accumulated benefit obligation was $354 at December 31, 1999.
The Company maintains a deferred compensation plan for directors and executive officers that allows for the individual to defer compensation into a variety of funded vehicles or phantom stock of the Company. The phantom stock component is unfunded, and the Company has recorded a liability of $445 as of December 31, 1999.
POSTRETIREMENT BENEFITS
PBI provided certain postretirement health care benefits. Substantially all PBI employees became eligible for postretirement benefits if they met certain age and length of service requirements. PBI accrued the cost of these benefits as they were earned by active employees. Effective with the merger, non-retiree benefits were frozen at levels earned and such future benefit will only be paid should the employee retire. As a result of this change, the Company recorded a credit to compensation expense of $169 in 1998. The liability for these non-retired employees is accrued on an actuarial basis. The liability at December 30, 1999 is $188.
The following are reconciliations of the benefit obligation and the fair value of plan assets, the funded status of the plan, the amounts not recognized in the statement of financial position, and the amounts recognized in the statement of financial position.
Valuations of the post retirement health insurance plan as shown above were conducted as of December 31, 1999, 1998 and October 1, 1997. Assumptions used by the Company in the determination of post retirement benefit plan information consisted of the following:
The components of net periodic benefit cost consisted of the following for the years ended December 31:
At December 31, 1999, the assumed rate of increase in future health care costs was 6.5% for 2000, gradually decreasing to 5.0% in the year 2003 and remaining at that level thereafter. Increasing the assumed health care cost trend rate by 1.0% in each future year would increase the accumulated benefit obligation as of December 31, 1999 by $ 114 and the aggregate of the service and interest cost by $9 for the year then ended.
EMPLOYMENT AGREEMENTS PNB has entered into employment and change in control agreements with certain key executives. The agreements range in period from one to three years, expiring from 2000 through 2002, and contain specified conditions for extension or expiration, either annually or prior to expiration. In certain cases, conditions exist which allow for lump sum payments in connection with defined changes in control, termination without cause or failure to extend. The maximum liability under these contracts, at December 31, 1999, if such payments were required for all executives, would be approximately $3.2 million.
SEVERANCE PLANS The company has adopted a change in control severance pay plan on behalf of employees not covered by individual agreements. The plan provides employees with certain rights and benefits upon termination following a change in control as defined in the plan. Benefits range from a minimum of three weeks of salary to a maximum of 104 weeks of salary depending on years of service and position. No liability has been recorded under this plan.
In connection with the merger, the Company adopted the former PBI severance pay plan for all employees employed by the Company prior to January 14, 1998. Those employees terminated within two years of the merger date (July 17,1998) may be eligible for severance benefits ranging eight weeks of salary to a maximum of nine months of salary plus continuation of medical insurance for periods ranging from six to nine months, depending on length of service and position.
NOTE I - LEASES
Total rental expense for operating leases for 1999, 1998 and 1997 was $891, $989 and $857, respectively. Future minimum payments, under non-cancelable operating leases with initial or remaining terms of one year or more, consisted of the following at December 31, 1999:
The Company leases a portion of its buildings to tenants for various terms with varying renewal periods. Rental income received was $335, $381 and $348 in 1999, 1998 and 1997, respectively.
NOTE J - INCOME TAXES
The following is a reconciliation between the effective income tax rate and the statutory federal tax rate:
The valuation allowance applicable to the Company's state deferred tax asset was eliminated in 1998, resulting in a reduction in income taxes of $238.
The components of income tax expense (benefit) are as follows for the years ended December 31:
The tax effects of temporary differences that give rise to deferred tax assets and deferred tax liabilities at December 31, are as follows:
As a thrift institution, Pawling was subject to special provisions in the federal and New York State tax laws regarding its allowable tax bad debt deductions and related tax bad debt reserves. These deductions historically were determined using methods based on loss experience or a percentage of taxable income. Tax bad debt reserves are maintained equal to the excess of allowable deductions over actual bad debt losses and other reserve reductions. These reserves consisted of a defined base-year amount, plus additional amounts ("excess reserves") accumulated after the base year. SFAS No. 109 requires recognition of deferred tax liabilities with respect to such excess reserves, as well as any portion of the base-year amount which is expected to become taxable (or "recaptured") in the foreseeable future.
Certain amendments to the federal and New York State tax laws regarding bad debt deductions were enacted in 1996. The federal amendments included elimination of the percentage of taxable income method for tax years beginning after December 31, 1995 and imposition of a requirement to recapture into taxable income (over a six-year period) the bad debt reserves in excess of the base-year amounts. Pawling established a deferred tax liability with respect to such excess federal reserves. The New York State amendments redesignated all of Pawling's state bad debt reserves as the base-year amount.
As a result of the merger described in Note A, the Company was required to immediately recapture Pawling's state base-year reserve and recorded a net expense of $752 under merger expenses to reflect its tax liability to the State in the 1998 financial statements. Under the present tax laws, however, Pawling's federal base-year reserve was not subject to immediate recapture.
In accordance with SFAS No. 109, the Company has not recognized deferred tax liabilities with respect to Pawling's federal base-year tax bad debt reserves of $8.8 million. The unrecognized deferred tax liability at December 31, 1999 with respect to the federal base-year reserves was $3.0 million. This reserve could be recognized as taxable income and create a current and/or deferred tax liability using the income tax rates then in effect if one of the following occur: (1) the Company's retained earnings represented by this reserve are used for dividends or distributions in liquidation or for any other purpose other than to absorb losses from bad debts., (2) the Company fails to qualify as a Bank as provided by the Internal Revenue Code, or (3) there is a change in federal tax law.
NOTE K - OTHER COMMITMENTS AND CONTINGENCIES
The financial statements do not reflect various commitments, contingent liabilities and fiduciary liabilities for assets held in trust, which arise in the normal course of business. Trust Department assets under administration total approximately $294.8 million at December 31, 1999.
The Bank regularly sells certain types of long-term fixed rate mortgages to a United States agency which are under recourse arrangements for four months. As of December 31, 1999, $2.5 million of these sales are subject to such recourse.
The Bank is required to maintain an interest free deposit balance with the Federal Reserve Bank, which averaged approximately $8.1million during 1999; the Bank does not earn interest or other income on such deposited funds.
The Bank is a party to various legal proceedings in the normal course of business, the ultimate outcome of which, in management's opinion, will not have a material adverse effect on the Company's consolidated financial position or results of operations.
NOTE L - RELATED PARTY TRANSACTIONS
The Bank has granted loans to officers and directors of the Company and to their associates. The following table summarizes activity associated with these loans.
The Bank leases premises from an affiliate of a director which lease will expire in December 2000. Payments made to this affiliate in 1999, 1998 and 1997 were $141, $112 and $142, respectively. Entities in which directors have interests provide automotive, insurance and legal services to the Company. The total cost of such services aggregated $985, $705 and $713 in 1999, 1998 and 1997, respectively.
NOTE M - OTHER INTEREST BEARING LIABILITIES
During 1999, the Bank entered into a leverage strategy of approximately $100.0 million. The funding for this strategy consisted of Federal Home Loan Bank advances in the amounts of $20.0 million and $25.0 million, securities sold under agreements to repurchase of $30.0 million and $25.0 million from local municipal certificates of deposit.
The Federal Home Loan Bank advances for $20 million and the repurchase agreements of $55 million considered short-term borrowings with original maturities of two months and four months, respectively, and rates ranging between 5.72% to 6.13%.
Long-term borrowings consist of $25 million in FHLB advances which will mature in 2004. The rate paid on this borrowing adjusts quarterly. The rate as of December 31, 1999 was 6.16%.
Additional information regarding the Bank's short-term and long-term borrowings are summarized as follows as of December 31:
From time to time, the Company has purchased federal funds. These borrowings generally mature within one to four days of the transaction date. Although outstanding borrowings at December 31, 1999 were $300 the Company also on the same date had sold Fed Funds of $31.8 million. There were no such borrowings at any time during 1998 or 1997.
The Bank maintains a $100 million line of credit with the Federal Home Loan Bank and, at December 31, 1999, had immediate access to additional liquidity in the amount of $55 million under FHLB's secured advance program. Additionally, the Bank maintains a federal funds secured line of credit in the amount of $5 million with one of its correspondents. There were no borrowings under the federal funds secured line of credit in 1999 or 1998.
NOTE N - RESTRICTION ON SUBSIDIARY DIVIDENDS AND LOANS TO AFFILIATES
Dividends are paid by the Company from its liquid assets which are mainly provided by dividends from the Bank. Certain restrictions exist regarding the ability of the Bank to transfer funds to the Company in the form of cash dividends, loans or advances. The approval of the Office of the Comptroller of the Currency is required to pay dividends in excess of earnings retained in the current year plus retained net earnings for the preceding two years. After December 31, 1999, $5.0 million is available for distribution to the Company as dividends without prior regulatory approval (in addition to the 2000 results of operations of the Bank).
Under Federal Reserve regulations, the Bank also is limited as to the amount it may loan to its affiliates, including the Company, unless such loans are collateralized by specific obligations. At December 31, 1999, the maximum amount available for lending by the Bank to the Company or its affiliates in the form of loans approximated 20% of consolidated net assets with a maximum per affiliate limit of 10%. The parent company has a mortgage loan from the Bank at December 31, 1999 of $759. Interest is payable at the prime rate plus one percent (9.50% at December 31, 1999). Such amounts eliminate in consolidation.
NOTE O - STOCKHOLDERS' EQUITY
COMMON STOCK - ------------ In both December 1998 and 1999, the Board of Directors approved 10% stock dividends, payable in January 1999 and 2000, respectively. The Board also declared a three for two stock split in September 1997, payable October 1997 in the form of a 50% stock dividend. Shares and share prices have been retroactively adjusted to reflect the issuance of the stock dividends and the stock splits for September 1997, December 1998 and December 1999. The 1998 and 1999 financial statements reflect the capitalization of $24.4 million and $26.5 million, respectively, of retained earnings
reflecting a market value of $14.36 and $17.05 per adjusted share on the respective dates of declaration of the 10% stock dividends. In connection with the merger, the equity accounts of PBI have been retroactively restated to reflect the 1.82 exchange ratio.
Common stock has a par value of $0.80 per share. The following table summarizes the number of shares at December 31:
(1) Number of shares at December 31, 1998 have not been restated to reflect the 10% stock dividend declared December 1999.
Under its Certificate of Incorporation as amended and restated in the Merger, Premier National Bancorp, Inc. is authorized to issue 50,000,000 shares of common stock, par value $0.80 per share.
DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN - --------------------------------------------- The Company has a Dividend Reinvestment and Stock Purchase Plan that allows participating common stockholders to reinvest cash dividends in additional shares of common stock (at market value) in lieu of cash dividends and gives participants the right to elect to make optional cash payments to purchase up to five thousand dollars per quarter of shares of common stock (at market value), subject to the terms and limitations of the plan.
PREFERRED STOCK - --------------- The Company has authorized a total of 5,000,000 shares of preferred stock, $.01 par value, which the Board of Directors has the authority to divide into series and to fix the dividends, rights and preferences of any series so established. There was no outstanding preferred stock at December 31, 1999 or 1998.
TREASURY STOCK PURCHASE PROGRAM - ------------------------------- On February 25, 1999, the Board of Directors approved a stock repurchase program and authorized management to repurchase, over the next two years, up to 1,250,000 shares (approximately 7.9%) of the Company's Common stock in the open market to fund the Company's dividend reinvestment and purchase plan and option exercises. Having completed the plan, on November 18, 1999, the Board of Directors approved an additional stock repurchase program for 1,000,000 shares as of December 31, 1999, there were 921,275 shares remaining to be purchased under the program. In connection with its 10% stock dividend declared in December 1999, the Company reissued 841,412 shares of treasury stock, leaving only 3,600 shares at December 31, 1999.
STOCK COMPENSATION PLANS
HCB INCENTIVE STOCK OPTION PLAN
Under the HCB 1990 Incentive Option Plan (Plan I), options to purchase shares of common stock were granted to key personnel of a predecessor company based upon their performance for terms up to 10 years at exercise prices not less than the fair value of the shares at the date of grant. Such options vest and are exercisable on a cumulative basis at 20% per year with a maximum exercise period of 5 years from date of vesting. Stock purchased under the plan is subject to certain resale restrictions and HCB retains the right to redeem outstanding shares at book value for employees terminating prior to retirement. No new options have been granted under this plan since 1994.
In 1995, HCB established the HCB 1995 Incentive Stock Plan (Plan II). Incentive and nonqualified stock options are utilized to assist in attracting, retaining and providing incentives to key officers and employees. In 1999, the plan was amended to include directors and to increase the authorized shares by 627,913. Grants under the plan may be in the form of incentive stock options, nonqualified stock options, restricted stock or stock appreciation rights. Stock options may be granted with the stock appreciation rights or the stock appreciation rights may be issued separately. Options may not be granted at less than 100% of the fair market value on the date of grant. Options vest no less than six months after the date they were granted and expire no later than 10 years from the grant date. The determination and grant of an incentive stock option, nonqualified stock option, a stock appreciation right or restricted stock is determined solely at the discretion of the Personnel and Compensation Committee of the Board of Directors. The maximum number of shares of common stock with respect to which options or rights may be outstanding to any eligible employee under the plan (or any other HCB plans) is 220,000 shares. The plan was amended in 1999 to add directors. At December 31, 1999, shares available for future grants totaled 669,903. In 1999, options of 326,583 were granted at an exercise price of $17.12.
PBI EMPLOYEES AND DIRECTORS STOCK OPTION PLANS
PBI established stock option plans for its employees and directors. Under the plans, the option exercise price may not be less than the fair market value of the common stock at the date of the grant. Options granted pursuant to the employees' plan are generally exercisable any time within ten years of the date of grant. Unexercised options generally expire either 90 days or one year (options granted after 1996) after termination of an employee's continuous employment by the Company, except in connection with severance arrangements which provide employees up to nine months to exercise the options. Options granted pursuant to the directors' non-qualified stock option plans have ten-year terms, and vest and become fully exercisable six months after the date of grant. The plans were not merged with the Hudson Chartered Bancorp 1995 Incentive Stock Plans and no new options will be granted under the plans.
COMBINED OPTION PLAN INFORMATION
In connection with the merger of HCB and PBI, all of the outstanding PBI options were converted into options to purchase common stock of the Company. Consolidated transactions under the Company's Stock Option Plans, including SAR's, for the years ended December 31, 1999, 1998 and 1997, are presented below:
The following table summarizes information about the Company's stock options outstanding and exercisable at December 31, 1999:
The fair value of each option grant was estimated on the date of grant by PNB, HCB and PBI, respectively, using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1999, 1998 and 1997.
The weighted average fair value of options granted in 1999, 1998 and 1997 were $5.28, $4.21 and $4.98, respectively.
The Company maintains stock option plans as described above. The Company applies APB No. 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans. Had compensation cost for the Company's stock option based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below for the years ended December 31:
The effects of applying SFAS No. 123 for disclosing compensation cost under this pronouncement may not be representative of the effects on reported net income for future years.
EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)
As of December 31, 1999, the ESOP owned 134,169 shares of the Company's common stock (all of which were available to participants and considered in total issued and outstanding shares). The Company recorded compensation expense of $113 in 1999 and $ 129 in 1997. There was no compensation expense associated with 1998.
CAPITAL ADEQUACY
Both Premier National Bancorp, Inc. and Premier National Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on their financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, they must meet or exceed specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank and its parent company to maintain or exceed minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 1999 and 1998, that both the Bank and its parent company meet all capital adequacy requirements to which they are subject.
As of December 31, 1999, the most recent notification from the Bank's primary regulator (the Office of the Comptroller of the Currency) as to Premier National Bank categorized the Bank as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized" a bank must maintain or exceed minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since those notifications that management believes have changed either institution's category.
CAPITAL RATIOS
THE FOLLOWING SUMMARIZES THE MINIMUM CAPITAL REQUIREMENTS AND THE ACTUAL CAPITAL POSITION AT DECEMBER 31, 1998 AND 1999:
NOTE P - PARENT COMPANY ONLY FINANCIAL INFORMATION BALANCE SHEETS
STATEMENTS OF INCOME AND EXPENSE
STATEMENTS OF CASH FLOWS
NOTE Q - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", requires that the Company disclose estimated fair values for certain financial instruments. Estimated fair values are as of December 31, 1999 and December 31, 1998, respectively, and have been determined using available market information and various valuation estimation methodologies. Considerable judgment is required to interpret the effects on fair value of such items as future expected loss experience, current economic condition, risk characteristics of various financial instruments and other factors. The estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. Also, the use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair values.
The fair value estimates presented above are based on pertinent information available to management as of December 31, 1999 and December 31, 1998. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since December 31, 1999 and, therefore, current estimates of fair value may differ significantly from the amounts presented above.
FAIR VALUE METHODS AND ASSUMPTIONS ARE AS FOLLOWS:
CASH AND CASH EQUIVALENTS - The estimated fair value is based on current rates for similar assets. SECURITIES - The fair value of securities is estimated based on quoted market prices or dealer quotes, or if not available, estimated using quoted market prices for similar securities. Regulatory securities are recorded at carrying value. LOANS - The fair value of fixed rate loans has been estimated by discounting projected cash flows using current rates for similar loans. For other loans, which reprice frequently to market rates, the carrying amount approximates the estimated fair value. The fair value of nonaccrual loans having a net carrying value of approximately $5,996 and $6,626 in 1999 and 1998, respectively, are not estimated because it was not practical to reasonably assess the timing of the cash flows or the credit adjustment that would be applied in the market-place for such loans. The total amount of loans included has been reduced by the allowance for loan losses of $19,969 and $19,028 in 1999 and 1998, respectively. DEPOSITS WITHOUT STATED MATURITIES - Under the provision of SFAS No. 107, the estimated fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings accounts, now accounts, money market and checking accounts, is equal to the amount payable on demand as of December 31, 1999 and December 31, 1998. TIME DEPOSITS - The fair value of certificates of deposits is based on the discounted value of contractual cash flows. The discount rates used are the rates currently offered for deposits of similar remaining maturities. The excess of the estimated fair value of time deposits over their recorded amounts represents the discounted value of contractual rates over rates currently being offered. BORROWINGS - The estimated fair value for short-term advances and repurchase agreements in which applicable interest rates reprice based on changes in market rates is equal to the amount payable at the reporting date.
Financial Instruments with Off-Balance Sheet Risk - As described in Note C, the Company was a party to financial instruments with off-balance sheet risk at December 31, 1999 and 1998. Such financial instruments consist of commitments to extend permanent financing and letters of credit. If the options are exercised by the prospective borrowers, these financial instruments will become interest-earning assets of the Company. If the options expire, the Company retains any fees paid by the counterparty in order to obtain the commitment or guarantee. The fair value of commitments is estimated based upon fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate commitments, the fair value estimation takes into consideration an interest rate risk factor. The fair value of guarantees and letters of credit is based on fees currently charged for similar agreements. The fair value of these off-balance sheet items at December 31, 1999 and 1998, respectively, approximates the recorded amounts of the related fees, which are not material. The Company has not engaged in hedge transactions such as interest rate futures contracts or interest rate swaps.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PREMIER NATIONAL BANCORP, INC.
BY:
/s/ T. Jefferson Cunningham III Chairman of the Board
Date: March 23, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Principal Executive Officer:
/s/ T. Jefferson Cunningham III March 23, 2000 Chairman of the Board & CEO
Principal Financial and Accounting Officer:
/s/ Paul A. Maisch March 23, 2000 Treasurer
Directors: /s/ Elizabeh P. Allen March 23, 2000 /s/ Thomas C. Aposporos March 23, 2000 /s/ Robert M. Bowman March 23, 2000 /s/ H. Todd Brinckerhoff March 23, 2000 /s/ Edward VK. Cunningham Jr. March 23, 2000 /s/ T. Jefferson Cunningham III March 23, 2000 /s/ Tyler Dann March 23, 2000 /s/ Thomas C. DeBenedictus March 23, 2000 /s/ R. Abel Garraghan March 23, 2000 /s/ Richard T. Hazzard March 23, 2000 /s/ Richard Novik March 23, 2000 /s/ Lewis J. Ruge March 23, 2000 /s/ Roger W. Smith March 23, 2000 /s/ David A. Swinden March 23, 2000 /s/ Peter Van Kleeck March 23, 2000 /s/ John C. VanWormer March 23, 2000 | 26,664 | 173,743 |
1022671_1999.txt | 1022671_1999 | 1999 | 1022671 | ITEM 1. BUSINESS
THIS REPORT CONTAINS FORWARD LOOKING STATEMENTS.
Throughout this report, or in other reports or registration statements filed from time to time with the Securities and Exchange Commission under the Securities Exchange Act of 1934, or under the Securities Act of 1933, as well as in press releases or oral statements made to the market by our officers or representatives, we may make statements that express our opinions, expectations, or projections regarding future events or future results, in contrast with statements that reflect historical facts. These expressions, which we generally precede or accompany by such typical conditional words as "anticipate," "intend," "believe," "estimate," "plan," "seek," "project" or "expect," or by the words "may," "will," or "should," are intended to operate as "forward looking statements" of the kind permitted by the Private Securities Litigation Reform Act of 1995. That legislation protects such predictive statement by creating a "safe harbor" in the event that a particular prediction does not turn out as anticipated.
Accordingly, many of the statements in this Annual Report on Form 10-K regarding our business plans, our construction projects, our product developments, our anticipated financial needs or our financings, especially but not exclusively in the sections entitled "Company Overview" (page 2), "Competitive Strengths" (page 3), "Business Strategy" (page 5), "Existing Projects" (page 6) and "Description of Business" (page 9), including the subsection therein entitled "Risk Factors That May Affect Future Operating Results" (pages 18-24), and in the "Management's Discussion and Analysis of Financial Condition and Results of Operation" section (pages 38-42) are forward looking statements. By their very nature, forward looking statements involve some known and many unknown risks and uncertainties. Therefore, actual results, performance, or achievements may differ materially from those that may have been expressed or implied in such forward looking statements. While we always intend to express our best judgment when we make statements about what we believe will occur in the future, and although we base these statements on circumstances that we believe to be reasonable when made, things can happen to cause our actual results and experience to differ materially from those we thought would occur.
The following listing represents some, but not necessarily all of the factors that may cause actual results to differ from those predicted:
- cyclical changes in market supply and demand for steel; general economic conditions; U.S. or foreign trade policy affecting steel imports or exports; and governmental monetary or fiscal policy in the U.S. and other major international economies;
- risks and uncertainties involving new technologies, in which the process itself or certain critical elements thereof may not work at all, may not work as well as expected, or may turn out to be uneconomic;
- cyclical effects of changes in the availability and costs of steel scrap, steel scrap substitute materials and other raw materials or supplies which we use in our production processes, as well as availability and cost of electricity and other utilities;
- unanticipated and extraordinary operating expenses, unplanned equipment failures and plant outages;
- actions by our domestic and foreign competitors, loss of business from our major customers and new or existing production capacities that enter or leave the marketplace;
- labor unrest, work stoppages and/or strikes involving our own workforce, those of our important suppliers or customers, or those affecting the steel industry in general;
- the effect of the elements upon our production or upon our important suppliers or customers;
- the impact of changes in environmental laws or in the application of other legal and regulatory requirements, including actions by government agencies on pending or future environmentally related construction or operating permits;
- pending, anticipated or unanticipated private or governmental claims or litigation, or the impact of any adverse outcome of any such litigation on the adequacy of our reserves, the adequacy or availability of insurance coverage, or on our very business and assets;
- changes in interest rates or other borrowing costs, or the availability of credit;
- changes in our business strategies or development plans, and any difficulty or inability to successfully consummate or implement as planned any of our projects, acquisitions, joint ventures or strategic alliances;
- the impact of governmental approvals, litigation, construction delays, cost overruns or technology risk upon our ability to complete or start-up a project when expected, or to operate it as anticipated;
- potential failure of our computer systems or those of our major suppliers, customers or service providers to be Year 2000 compliant in all respects.
We also believe that the discussion we have placed under the subsection entitled "Risk Factors That May Affect Future Operating Results" at pages 18 through 24 of this Form 10-K should be read in conjunction with and to better understand the risks and uncertainties underlying any forward looking statements.
Any forward looking statements which we make in this report or in any other report, press releases, or oral statement speak only as of the date of such statement, and we undertake no ongoing obligation to update such statements. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data.
(a) COMPANY OVERVIEW
We are one of the fastest growing and most profitable electric furnace mini-mill steel producers in the United States. Since 1996, our compounded annual growth rates for revenues and EBITDA have been approximately 43% and 60%, respectively. In addition, our 1998 EBIT and EBITDA margins were approximately 14% and 20%, among the best in the industry. In 1998, we had net sales of $514.8 million and EBITDA of $100.8 million. In 1999, we had net sales of $618.8 million and EBITDA of $125.9 million.
We currently operate two facilities and are preparing to build a third. Our primary facility is a technologically advanced flat rolled steel mini-mill on an 840-acre site in Butler, Indiana, which began commercial production in January 1996. Our Butler mill has an annual production capacity of 2.2 million tons, and produces a broad range of high quality flat rolled carbon steel products.
We sell a large variety of hot rolled, cold rolled and coated steel products, including:
- mild and medium carbon hot rolled bands;
- high strength low alloy hot rolled bands;
- high strength low alloy 80,000 minimum yield hot rolled sheet;
- hot rolled and cold rolled hot dipped galvanized sheet; and
- fully processed cold rolled sheet.
WE SELL OUR PRODUCTS DIRECTLY TO END USERS AND THROUGH STEEL SERVICE CENTERS PRIMARILY IN THE MIDWESTERN UNITED STATES. OUR PRODUCTS ARE USED IN NUMEROUS SECTORS, INCLUDING:
- automotive;
- appliance;
- manufacturing;
- consumer durable goods; and
- industrial machinery
Our second facility is operated by our subsidiary, Iron Dynamics, Inc. and is contiguous to our Butler mill. It is a 520,000 metric tonne annual capacity plant equipped to produce direct reduced iron. We will then convert this direct reduced iron into approximately 470,000 metric tonnes of liquid pig iron, which we will then combine with scrap to produce high quality steel for use in our Butler mill's meltshop. Construction of this facility began in October 1997. We produced our first direct reduced iron material in November 1998, produced our first tap of liquid pig iron in March 1999 and commenced initial production in August 1999. During preliminary start-up, however, we encountered a number of unanticipated delays, primarily attributable to some equipment failures or design deficiencies, and this has required us to undertake certain redesign work and to effect some equipment replacement or retrofitting. Much of this work has been accomplished, but some of it remains to be done. While this corrective work is being done, however, we are operating the facility at substantially reduced levels. We estimate that the necessary remaining redesign and equipment replacement or retrofitting will continue throughout 2000 and should be completed during the fourth quarter of 2000.
Our third planned facility is a structural and rail mill to be located in Whitley County, Indiana. Our financing is in place, all plans are ready to go, most of the equipment has been ordered and much of it has already arrived, and virtually all preparatory site work has been done. However, we have been unable to formally commence actual plant construction due to the continued pendency of several appeals of the government's approval of our required construction permit by certain groups that are opposed to our structural mill project. We continue to remain optimistic that our opponents' appeal, which has been fully briefed and ready for decision for many months, will not be successful and that the permit will be issued promptly. Our current estimate is that we should be able to complete the structural and rail mill in the first half of 2001. We plan to manufacture structural steel beams, pilings and trusses, as well as roof and floor decking materials for the construction markets and steel rails for the railroad industry.
December 1999, we terminated our advisory and technical assistance relationship with Nakornthai Strip Mill Public Company, Ltd, a Thailand mini-mill steelmaker. While we retained our 10% equity interest in that facility during 1999, it retains minimal value in light of the financial restructuring of that facility's debt that has been recently effected among its banks, bondholders and other creditors. We have also been sued in a number of different actions, together with certain of the investment banks that assisted NSM in its issuance of bonds during March 1998, by certain bondholders who purchased bonds in that offering and who are claiming, based on various legal theories, that we are jointly and severally liable to make good their losses. We have denied liability in each of such cases and are defending ourselves against such claims. See "Legal Proceedings" under "Risk Factors That May Affect Future Operating Results" in this Item 1 and again at Item 3 of this Report.
In September 1999, we acquired a controlling interest in New Millennium Building Systems, LLC, a new Indiana enterprise, which is in the process of building a manufacturing facility in Butler, Indiana for the production of steel joists, girders and trusses, as well as steel roof and floor decking materials for use primarily in the construction of commercial, industrial and institutional buildings. An unrelated company, New Process Steel Holding Co., Inc. also acquired a voting interest. The balance of New Millennium's ownership is non-voting and is in the hands of New Millennium's management. New Millennium estimates a completion and start-up for this new 250,000 square foot facility to be during the first half of 2000.
(b) COMPETITIVE STRENGTHS
We believe that we have certain competitive strengths that help distinguish us from other steelmakers. These include:
HIGHLY SUCCESSFUL EARLY STAGE PERFORMANCE
Our financial and operational results have been among the strongest in the industry over the past 24 months:
- in 1999, our revenue increased approximately 20% over 1998;
- in 1999, we were able to produce steel using only 0.41 man-hours per ton, while in 1998, our man-hours per ton was 0.55, already one of the lowest in the industry;
- in 1998, our revenue growth rate increased approximately 23%; and
- in 1999, our operating profit per ton shipped was $58, and for 1998, our operating profit per ton shipped was $50, one of the best in the industry.
This performance occurred despite the significant stresses in both the domestic and foreign steel industry in 1998 and early 1999 caused by the impact of illegal dumping and the resulting decline in steel prices.
Additionally, our new cold mill ran at its capacity of approximately 1.0 million tons per year for a good part of 1999. It is being fully supported by our second furnace battery, caster, tunnel furnace and coiler, all of which ran at near capacity. We also produced at capacity in our hot mill for most of 1999. Also, during 1999, we had an increase in cold mill and in hot mill production of approximately 43% and 36%, respectively. We are continuing to use a greater portion of hot band production for the cold mill, producing higher value-added cold rolled and coated products.
We believe that our financial and operational performance should continue to improve as a result of what we view as increased demand for domestic steel as well as the cost efficiencies that we anticipate from using scrap substitutes from our Iron Dynamics facility once it is fully operational.
LEADING MINI-MILL MANAGEMENT TEAM
Our senior management team, which consists of Keith E. Busse, Mark D. Millett and Richard P. Teets, Jr., pioneered the development of thin-slab flat rolled technology and directed the construction and successful operation in the late 1980s of the world's first thin-slab flat rolled mini-mill in Crawfordsville, Indiana. After founding Steel Dynamics in 1993, our senior management team designed, built and started-up our Butler mini-mill under budget and in fourteen months, which we believe is the shortest construction period for a facility of this kind. They followed this by just as efficiently and under budget designing, building and successfully starting up a cold finishing facility addition to our Butler plant, which became fully operational in January 1998. This management team brought our Butler mini-mill to a positive cash flow position in April 1996, just four months after start-up, and brought our facility to a positive after tax net income position in July 1996, just seven months after start-up. As a general matter, we believe that our senior management team's extensive experience within the thin-slab flat-rolled compact strip production or "CSP" technology arena enables us to design and build CSP mini-mill plants and to operate them with greater efficiency, at lower costs and yielding higher quality production than our competitors.
We have also recruited, trained and placed into critical divisional and operational management positions an exceptionally talented group of senior and mid-level managers, many of whom have come to us with extensive mini-mill experience. In addition, our four most senior managers are substantial shareholders of our company.
RELIABLE ACCESS TO LOW COST METALLICS
We have two primary raw material needs: steel scrap and steel scrap substitute material. Our principal raw material is steel scrap, which represented approximately 50% of our total cost of goods sold during 1998 and 49% of our total cost of goods sold during 1999. We secure steel scrap and plan to secure our steel scrap substitute material through two primary sources. First, we have a long-term steel scrap purchasing agreement with OmniSource Corporation, one of the largest scrap processors and brokers in the Midwest, which requires OmniSource to obtain scrap for us at the lowest available market prices. Second, as an assumed lower cost substitute for and alternative to scrap, our Iron Dynamics facility adjacent to our Butler mill plans to produce liquid pig iron for direct feed into our electric furnaces. This liquid pig iron has many benefits over traditional scrap, such as low sulfur, residuals and nitrogen levels. In addition, it will allow us to reduce the time we must keep the power on in our meltshop by, on average, more than one-third. This vertical integration of a critical raw material resource, through our Iron Dynamics facility, will enable us to better control a significant portion of our potentially volatile resource costs. In addition, we believe that these dual sources of steel scrap and steel scrap substitutes will enable us to maintain the lowest overall raw material costs relative to our competitors.
STRATEGIC LOCATIONS
Our Butler mill is located within 300 miles of our major steel customers, steel service centers and other end users. This location gives us numerous pricing advantages as a result of freight savings, including inbound scrap and other raw material resources as well as outbound steel products destined for our customers. Of our total net sales during 1999, approximately 69% were to customers within 300 miles of our Butler mill. In addition, seven of the top ten structural steel consuming states are located within a 500-mile radius of our planned Whitley County structural mill. Both of these facilities are located within a seven-state region that accounts for a majority of the total scrap produced in the U.S., which results in scrap cost advantages due to freight savings. All of our production sites have excellent access to highway and rail transportation networks and are also in areas of reasonably priced and available energy supplies. The Butler mini-mill and Iron Dynamics facility have access to the east-west and the north-south rail lines of Norfolk Southern Corporation and the east-west lines of the CSX Transportation railway through our internal railroad infrastructure. The planned Whitley County structural mill will have access to the CSX Transportation and the Norfolk Southern Corporation railways.
A SOLID BASELOAD OF HOT BAND SALES
In order to ensure consistent and efficient hot band plant utilization, we have entered into a multi-year "off-take" sales and distribution agreement with Heidtman Steel Products, Inc. This agreement guarantees us a minimum sale of 30,000 tons of flat-rolled products per month at prevailing market prices. During 1999, Heidtman purchased approximately 402,000 tons of flat-rolled steel products, which amounted to 22% of our total net tons shipped for that period. During 1998, Heidtman's purchases amounted to approximately 333,000 tons of flat-rolled steel products, or 24% of our total net tons shipped for that period. Through our distribution relationship with Heidtman, we have also been able to access the automobile market by having our products sold to automobile manufacturers, such as Daimler Chrysler, Inc.
(c) BUSINESS STRATEGY
The principal components of our business strategy are as follows.
ACHIEVE THE LOWEST CONVERSION COSTS IN THE INDUSTRY
Due to our pioneering and successful mini-mill experience, we have been able to build facilities with lower capital costs that incorporate technological innovation in thin-slab electric furnace steelmaking. We have also developed extensive operational know-how and have implemented an entrepreneurial management style that rewards initiative, teamwork and efficiency. These capabilities have allowed us to continue to focus on low cost, highly efficient operations, thereby helping us achieve what we believe is a lower cost of converting scrap and scrap substitutes into high quality steel than most of our competitors.
FOCUS ON HIGHER MARGIN VALUE-ADDED PRODUCTS
Due in part to our start-up of a seventh stand in our rolling mill in early 1999, we can now produce low and medium-carbon as well as high strength low alloy 80,000 minimum yield steel products with a higher quality and lighter gauge than many other mills. Our steel has consistently better shape characteristics than most other flat-rolled products and competes favorably with certain more expensive cold rolled products. Furthermore, since the completion of our cold mill in 1998, we are increasingly dedicating a substantial portion of our hot rolled products to the production of higher margin, value-added coated products, as well as thinner gauge cold rolled products. During 1998, approximately 681,000 tons, or 48% of our hot band production went into our cold mill, while during 1999, approximately 997,000 tons, or 51% of our hot band production went into our cold mill. We are continuing to focus on dedicating a growing portion of our hot rolled products to the cold rolled mill, thereby enhancing our overall operating margin and further differentiating the quality of our products. We believe that this ongoing shift to more value-added steel production will result in higher overall margins and greater cash flow in the future.
OFFER SUPERIOR PRODUCT QUALITY
We believe that product quality is a key factor in the selection of a flat-rolled product supplier. Our commitment to quality is evidenced by the fact that we were the first flat-rolled mini-mill to achieve ISO 9002 and QS 9000 certifications. These certifications enable us to target a broader range of customers and end users, including larger automotive companies, such as General Motors, and appliance companies, which historically have been almost exclusively serviced by integrated steel producers. During 1998, our percentage of prime grade material to off-quality material, or "seconds," was 95.3%. During 1999 it was 94.2%. We believe that this relatively constant rate represents one of the highest "prime-ton percentages" in the mini-mill sector.
PROVIDE BROAD EMPLOYEE INCENTIVES
100% of our employees participate in incentive plans designed to enhance overall productivity. Our incentive plans utilize bonuses based on criteria specific to an employee's position and area of expertise.
The productivity of our employees is measured by focusing on groups of employees and not individual performance. Three groups of employees participate in the bonus program: production, administrative and clerical. Our department managers and officers are also eligible to participate. Each group of employees has its own bonus program or programs.
Production employees are eligible to participate in two cash bonus programs, the production bonus and the conversion cost bonus programs. The production bonus is based on the quantity of prime product produced in a given week. The conversion cost bonus is determined and paid on a monthly basis based on the costs of converting raw materials into finished product. The program is intended to reward employee efficiency in converting raw materials into finished steel, or, in the case of cold mill employees, converting hot rolled bands into value-added products.
We also have a cash bonus plan for non-production employees, including accountants, engineers, secretaries, accounting clerks and receptionists. Bonuses under this plan are based on our divisional return on assets. We believe that this compensation structure more clearly aligns our employees' interests with ours, unlike many of our competitors. In addition, these bonuses comprise a significant portion of our employees' compensation: more than 40% of an employee's total compensation may be performance based.
PURSUE FUTURE GROWTH OPPORTUNITIES.
We plan to continue to develop our business through greenfield projects, joint ventures, strategic alliances or acquisitions in order to secure long-term future growth and profitability. We also believe that due to our management team's established reputation within the steel industry, we benefit from a broader range of external growth opportunities than many of our competitors. We further believe that ongoing developments in technology as well as current market conditions, provide significant opportunities for internal growth. These opportunities include penetrating new markets, such as markets for roof and deck, structural, special bar quality, stainless and other specialty steels.
(d) 1999 DEVELOPMENTS
EXISTING PROJECTS
SEVENTH FINISHING STAND. In January 1999, we completed the installation and start-up of a seventh finishing stand in our hot rolling mill. This allows us to reduce the rolling loads among the six other finishing stands, while enabling us to produce steel with even better shape and profile performance. It also allows us to roll considerably lighter gauges than was previously possible.
IRON DYNAMICS. During preliminary start-up testing during 1999, we encountered a number of design deficiencies or equipment failures that combined to delay our projected ramp-up to full production by more than a year from what we originally anticipated and resulted in excess capital costs over those originally budgeted of approximately $12.0 million. Many of these problems, such as various material handling issues at the rotary hearth furnace and thus related to the production of direct reduced iron, have already been resolved.
Our submerged arc furnace, however, which is essential in the conversion of the direct reduced iron into liquid pig iron, our intended end product, has required some critical design modifications and equipment replacements or retrofitting primarily involving vessel lining and cooling concerns, in order to attain full functionality. This process has been ongoing for several months, the result of extensive additional research and development activities based upon our actual experience in the field, and we believe that these changes, when implemented, should enable us to achieve the output and the product quality that we originally sought. This redesign and replacement work is expected to continue throughout 2000, culminating in a planned shutdown of the submerged arc furnace during the fourth quarter of 2000 in order to permit us to install and commission the replacement equipment. In the meantime, we are producing direct reduced iron and liquid pig iron in a curtailed mode, approximately 7,600 tons of liquid pig iron in February 2000 and a targeted average of 14,200 tons for March through August. We plan to continue in this mode until completion of the repair and redesign work. Product quality and metallization rates appear to be excellent. We have also ordered two briquetters, and we expect to install and commission these briquetters during the fourth quarter of 2000. The briquetters will enable us to compress the direct reduced iron into a solid, dense briquette, which, contrary to loose direct reduced iron, will not re-oxidize. The solid briquettes can therefore be stored until needed for direct introduction in our electric arc furnaces, or sold on the open market as a commodity to other users of direct reduced iron. The addition of the briquetters will allow Iron Dynamics to bypass the submerged arc furnace without losing valuable production during its planned down time for repairs in the fourth quarter of 2000, as well as during any future down time.
OUR STRUCTURAL AND RAIL MILL
Our planned structural and rail manufacturing mini-mill will be located on a 470-acre site immediately south of U.S. Highway 30 between County Road 700 East and County Road 800 East in Whitley County, Indiana. This mill is expected to have an annual production capacity of between 900,000 and 1,100,000 tons, depending on product mix, for the manufacture of structural steel beams and pilings and certain other steel building components for the construction market, as well as for the manufacture of steel rails for the railroad industry.
We expect to commence construction as soon as our "Prevention of Significant Deterioration" construction permit or ("air permit") becomes final, which will not occur until after disposition of appeals lodged by opponents of the project, including United Association of Plumbers & Steamfitters, Local Union 166 and Citizens Organized Watch, Inc. The Indiana Department of Environmental Management issued our permit on July 7, 1999. Three appeals by opponents were lodged and are now pending before the Indiana Department of Environmental Adjudication in Indianapolis, Indiana, and two additional appeals are pending before the federal Environmental Appeal Board in Washington, D.C.
The issues raised before the Environmental Appeal Board have been heavily briefed by the parties. On December 7, 1999, the Environmental Appeal Board entered an order stating that as of December 20, 1999, the matter will be considered fully briefed and that no further briefing would be allowed except by order of the Board. Accordingly, barring any special circumstances warranting additional filings, we are now awaiting a decision as to whether the Environmental Appeal Board will grant or deny review of United Association of Plumbers & Steamfitters, Local Union 166's and Citizens Organized Watch, Inc.'s request for review. The permit will become effective if the Environmental Appeal Board denies review, although judicial review of that decision is also available. Unfortunately, the Environmental Appeal Board is not constrained by any deadlines and is not required to indicate how or when it will rule and, therefore, while we are hopeful that a favorable decision is imminent, there is no way to accurately predict when any decision will be rendered. However, we believe that the permit was properly issued and that the issuance of the permit will be upheld on appeal.
The Indiana Department of Environmental Adjudication is presently deferring its full consideration of the issues until the Environmental Appeal Board rules. However, on January 19, 2000, the Indiana Department of Environmental Adjudication entered an order granting our motion to dismiss the United Association of Plumbers & Steamfitters, Local Union 166's and Citizens Organized Watch, Inc.'s request for a state stay of the permit's effectiveness. On February 16, 2000, the United Association of Plumbers & Steamfitters, Local Union 166 filed a petition for judicial review of the Department of Environmental Adjudication's order, and on February 18, 2000, the Citizens Organized Watch, Inc. filed a similar petition. These petitions are currently pending before a Marion County, Indiana, court. As with the Environmental Appeal Board action, we cannot accurately predict when the decision will be rendered. However, we believe that the permit was properly issued and that the issuance of the permit will be upheld on appeal.
We anticipate that final disposition of the administrative appeals will occur sometime within the next two to three months, although it could take longer. As soon as the appeal process has been concluded and assuming that our permit has become final, we will immediately commence construction of this mill. Construction is expected to take approximately 13 to 14 months. Accordingly, we still hope to be able to produce our first products in the first half of 2001.
We also anticipate that the structural mill will have a capital cost of approximately $265 million. We plan to produce a broad range of structural products, primarily aimed at the construction market. Contracts for the major pieces of equipment have long since been awarded, including the electric arc furnace and transformers, the ladle furnaces, the three-strand caster, reheat furnace, rolling mill, rolling mill electrical package, charge and ladle cranes, overhead cranes, and the level II computer system. In all, total expended capital costs on the structural mill, as of December 31, 1999, was approximately $132 million.
In addition, once we are able to proceed, we intend to construct a $40-$50 million rail manufacturing addition to our planned structural mill, which will enable us to take advantage of additional available melting capacity in our structural mill meltshop. The rail addition is in the design, preliminary engineering and equipment specification and selection phase. We anticipate that this process will take approximately six months, after which we plan to place equipment orders and begin construction work on this additional facility. This additional facility will not necessitate further permits. Completion of the rail manufacturing addition is not a precondition for the start-up and commencement of operations of our structural mill, and we anticipate a start-up for the rail project shortly following the start-up of the structural mill.
METALSITE, LP
In November 1998, we acquired a minority limited partnership interest in MetalSite, LP, a Delaware limited partnership. At the time, Weirton Steel Corp. owned a controlling interest in the limited partnership and LTV Steel Company, Inc. was another minority interest limited partner. Since that time, other steel companies such as Bethlehem Steel and Ryerson-Tull, and investors such as Internet Capital Group have acquired equity interests in the venture. We also plan to increase our minority ownership interest by exercising a warrant that was issued to us upon formation of MetalSite, LP
MetalSite is a new electronic Web-based marketplace for the on-line purchase of metal products from various sources. Initially, MetalSite dealt primarily with secondary and excess prime steel, both hot and cold rolled. Since then, MetalSite has expanded its scope to include all kinds of steel and other metals. MetalSite has indicated that it will be open to any seller who wishes to become authorized to sell on-line. Buyers will eventually be able to access a multi-company catalog of products. There is also an on-line auction service through which a seller may solicit bids for a particular product, privately review the bids, and then award the sale.
NEW PROJECTS
NEW MILLENNIUM BUILDING SYSTEMS, LLC. In September 1999, we and New Process Steel Holding Co., Inc., a major processor and distributor of coated flat-rolled products, each acquired a 50% voting interest in New Millennium Building Systems, LLC, an Indiana limited liability company that was organized on June 25, 1999. However, pursuant to the Operating Agreement, our vote is determinative on all material matters requiring an affirmative vote, except for certain matters specifically requiring a unanimous vote.
In 1999, New Millennium purchased approximately 74 acres of land from us, located near our flat-rolled mini-mill in Butler, Indiana, and it purchased approximately 22 acres from a third party. New Millennium is in the process of building a 225,000 square foot manufacturing facility and an approximately 16,000 square foot office building on that site. Construction of the facility began in late fall 1999 and as of March 1, 2000, construction was 60% complete. New Millennium has indicated an anticipated completion of the manufacturing facility in late April 2000, completion of the office building in June 2000, and a start-up date for production in June 2000.
New Millennium plans to purchase flat-rolled steel from us and other steel manufacturers and processors, including Heidtman Steel. The New Millennium facility will have direct rail deliveries from our mill as well as from Heidtman Steel. New Millennium will process that steel to manufacture steel joists, girders and trusses, as well as steel roof and floor decking material. These products will be used primarily in the construction of commercial, industrial and institutional buildings, such as factories, warehouses, shopping centers and schools.
We presently anticipate that a significant portion of New Millennium's sales will be out-of-state, with a concentration in the Upper Midwest area of the United States. The Upper Midwest presently enjoys the highest non-residential building spending in the country. New Millennium's main competitors at a national level are expected to be Vulcraft, a division of Nucor; Canam; and, SML, a division of Commercial Metals. New Millennium also has a number of competitors on a regional basis, located in the Upper Midwest, including Canam, Socar and Gooder-Henderson, as well as several local suppliers with facilities located in Pittsburgh, Cleveland, Detroit, Indianapolis, Chicago and Milwaukee. However, New Millennium believes that it will have several advantages over its competitors, including low material costs and low freight costs, as well as excellent product quality.
The project is expected to create 235 new jobs and represents a total capital investment of approximately $22.5 million. We anticipate this project will begin generating substantial cash flow for itself within four years of commencement of its operations. New Millennium has indicated that it plans to use that cash flow to expand and target other centers of high construction activity, to add other complementary metal building components to its product mix, and to provide a return to investors.
(e) INDUSTRY SEGMENTS
Under Statement of Financial Accounting Standards No. 131 "Disclosures About Segments of an Enterprise and Related Information," we operate in two business segments: "Steel Operations" and "Steel Scrap Substitute Operations."
(f) DESCRIPTION OF BUSINESS
INDUSTRY OVERVIEW
The steel industry has historically been and continues to be highly cyclical in nature, influenced by a combination of factors, including periods of economic growth or recession, strength or weakness of the U.S. dollar, worldwide production capacity and levels of steel imports and applicable tariffs. The industry has also been affected by various company-specific factors such as a company's ability or inability to adapt to technological change, plant inefficiency and high labor costs. Steelmaking companies are particularly sensitive to trends in the automotive, oil and gas, gas transmission, construction, commercial equipment, rail transportation, agriculture and durable goods industries. These industries are significant markets for steel products and are themselves highly cyclical. Steel, regardless of product type, is a commodity affected by supply and demand. Steel prices have been and may continue to be volatile and fluctuate in reaction to general and industry specific economic conditions. Under such conditions, a steel company, if it is to survive and prosper, must constantly strive to be and remain a high quality low cost producer.
Domestic steel producers, including us, have historically faced significant competition from foreign producers. From time to time, as occurred during 1998 and is continuing, albeit to a lesser extent today, the domestic steel producers have been adversely affected by what we believe was and continues to be unfairly traded imports. The intensity of this foreign competition is also substantially affected by the relative strength of foreign economies and fluctuation in the value of the United States dollar against foreign currencies, with steel imports tending to increase when the value of the dollar is strong in relation to foreign currencies (some of which were significantly devalued during 1998 and 1999). The situation was exacerbated by reason of a weakening of certain economies during 1998 and 1999, particularly in Eastern Europe, Asia, and in Latin America. Because of the ownership, control or subsidization of some foreign steel producers by their governments, decisions by such producers with respect to their production and sales are often influenced to a greater degree by political and economic policy consideration then by prevailing market conditions.
Imports of flat-rolled products increased significantly during each of the last three years, surging to record levels during 1998, before declining in 1999 as a result of the successful trade cases in which we participated and which are discussed below. Based on AISI reports for 1998 and 1997, imports of flat-rolled products (excluding semi-finished steel) totaled 20 million and 14 million tons, respectively, or approximately 25% of total domestic steel consumption in 1998 and approximately 19% in 1997.
In September 1998, complaints were filed with the U.S. International Trade Commission and the U.S. Department of Commerce by a number of U.S. steel companies, including us, as well as the United Steel Workers of America, seeking determinations that Japan, Brazil and Russia were dumping hot rolled carbon steel in the U.S. market at below fair market prices. In April 1999, the Department of Commerce issued a final determination that imports of hot rolled steel from Japan were dumped at margins ranging from 17% to 65%, and in June, the U.S. International Trade Commission reached a final determination that imports of hot rolled sheet from Japan caused injury to the U.S. steel industry. In July 1999, the Department of Commerce issued suspension agreements and final dumping duty determinations as to imports of hot rolled sheet from Brazil and Russia, and a suspension agreement and final countervailing duty determination as to imports of hot rolled sheet from Brazil. The DOC also announced countervailing duty findings of approximately 7%, and anti-dumping duties of approximately 40%, as to imports from Brazil. The U.S. International Trade Commission made a final affirmative injury determination. The Department of Commerce also announced final dumping duties ranging from 57% to 157% and the suspension agreement against Brazil and Russia will remain in effect for five years.
We expect that the success of these hot rolled cases will curtail imports from these countries from 7 million tons in 1998 to between 500,000 and 1 million tons per year for 1999 and the five following years. However, it is possible that imports of hot rolled sheet from other countries will increase significantly. We and other petitioners in the suits plan to continue to vigorously monitor such imports and plan to take further action if warranted.
On June 2, 1999, we, together with other domestic producers and the United Steel Workers of America, also filed a complaint with the U.S. International Trade Commission and Department of Justice seeking determination that cold rolled steel products from Argentina, Brazil, China, Indonesia, Japan, Slovakia, South Africa, Taiwan, Thailand, Turkey, and Venezuela, were being dumped in the U.S. market at below fair market prices. On July 19, 1999, the U.S. International Trade Commission made unanimous affirmative preliminary determinations of a reasonable indication of injury by reason of such imports. The Department of Commerce announced preliminary dumping determinations, which required the posting of dumping duties in November and December of 1999. In January 2000, the Department of Commerce issued a determination that imports of cold rolled steel from six
of the countries were dumped at margins ranging from 17% to 81%. We were ultimately not successful in these cold rolled cases, however, and on March 3, 2000, the U.S. International Trade Commission made negative final injury determinations against these six countries, and we expect final negative determinations in all six cases. Therefore, these negative outcomes are likely to result in a continuation of the depressed cold rolled prices caused by these unfair practices.
The Flat Rolled Market
The flat rolled market represents the largest steel product group, accounting for approximately 62% of the total 1998 U.S. steel shipments of approximately 102.4 million tons. Flat rolled products consist of hot rolled, cold rolled and coated sheet and coil. The following table shows the U.S. flat rolled shipments, in net tons, by hot rolled, cold rolled and coated production, as reported by the AISI, for the last five years.
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(1) Includes pipe/tube, sheet, strip and plate in coils.
(2) Includes blackplate, sheet, strip and electrical.
(3) Includes tin coated, hot dipped, galvanized, electrogalvanized and all other metallic coated.
Hot Rolled Products. All coiled flat rolled steel is initially hot rolled, a process that consists of passing an ingot or a cast slab through a multi-stand rolling mill to reduce its thickness to less than 1/2 inch. Hot rolled steel is minimally processed steel coil that is used in the manufacture of various non-surface critical applications such as automobile suspension arms, frames, wheels, and other unexposed parts in auto and truck bodies, agricultural equipment, construction products, machinery, tubing, pipe, tools, lawn care products and guard rails. The U.S. market for hot rolled steel in 1998 was approximately 25.3 million tons, excluding imports.
Aggregate domestic shipments of hot rolled steel for 1998 and for the two prior years, according to AISI, were approximately 25.3, 29.0 and 27.0 million tons, respectively. For the same period, imports of hot rolled steel increased substantially, from approximately 9.9 million tons in 1996 to 11.1 million tons in 1997, reaching 17.5 million tons in 1998. Largely as a result of the trade cases brought by us and certain other producers of flat rolled steel against illegally dumped hot rolled steel from Japan, Russia, and Brazil, imports from these three countries decreased from their 1998 levels.
Cold Rolled Products. Cold rolled steel is hot rolled steel that has been further processed through a pickler and then successively passed through a rolling mill without reheating until the desired gauge, or thickness, and other physical properties have been achieved. Cold rolling reduces gauge and hardens the steel and, when further processed through an annealing furnace and a temper mill, improves uniformity, ductility and formability. Cold rolling can also impart various surface finishes and textures. Cold rolled steel is used in applications that demand higher quality or finish, such as exposed automobile and appliance panels. As a result, cold rolled prices are typically higher than hot rolled. The U.S. market for cold rolled steel in 1998 was approximately 15.8 million tons, excluding imports.
Aggregate domestic shipments of cold rolled steel for 1998 and for the two prior years, according to AISI, were approximately 15.8, 15.2 and 15.8 million tons, respectively. For the same period, imports of cold rolled steel increased substantially, from approximately 3.4 million tons in 1996 to 4.2 million tons in 1997, reaching 4.6 million tons in 1998.
Coated Products. Coated steel substrate can be either hot rolled or cold rolled steel that has been coated with zinc to render it corrosion-resistant and to improve its paintability. Hot-dipped galvanized, galvannealed, electrogalvanized and aluminized products are types of coated steels. These are also the highest value-added sheet products because they require the greatest degree of processing and tend to have the strictest quality requirements. Coated steel is used in high volume applications such as automotive, household appliances, roofing and siding, heating and air conditioning equipment, air ducts, switch boxes, chimney flues, awnings, garbage cans and food containers. The use of coated steels in the U.S. has increased dramatically over the last 40 years. The U.S. market for coated steels in 1998 was approximately 22.8 million tons, excluding imports.
Aggregate domestic shipments of coated steel for 1998 and for the two prior years, according to AISI, were approximately 22.8, 22.0 and 19.7 million tons, respectively. For the same period, imports of coated steel increased from approximately 2.3 million tons in 1996 to 2.5 million tons in 1997, reaching 2.6 million tons in 1998.
The Structural and Rail Market
Structural Products. The U.S. market for the structural shapes and products that we intend to produce in our planned Whitley County structural mill amounted to approximately 5.6 million tons, excluding imports, for 1998.
Rail Products. The marketplace for steel rails in the U.S. and Canada is relatively small and specialized, with only approximately six railroad purchasers: Burlington Northern/Santa Fe, Union Pacific, Canadian Pacific Railway, Norfolk Southern, CSX Transportation and Canadian National Railway. These purchasers control an aggregate of approximately 150,000 miles of track in North America. The annual tonnage of rails sold in the U.S. and Canada averaged approximately 1.0 million tons for the past three years. It is further estimated that approximately 45% of that tonnage was for "premium" rail.
OUR PRODUCTION PROCESSES
There are generally two kinds of primary steel producers, "integrated mills" and "mini-mills."
Steel manufacturing by an "integrated" producer involves a series of distinct but related processes, often separated in time and in plant geography. The process involves ironmaking, followed by steelmaking, followed by billet or slab making, followed by reheating and further rolling into steel plate or bar, or flat-rolling into sheet steel or coil. These processes may be followed by various finishing processes, including cold rolling, or various coating processes, including galvanizing. With integrated producer steelmaking, coal is converted to coke in a coke oven, then combined in a blast furnace with iron ore/pellets and limestone to produce pig iron, which is then combined with scrap in a "basic oxygen" or other furnace to produce raw or liquid steel. Once produced, the liquid steel is metallurgically refined and then either poured as ingots for later reheating and processing or transported to a continuous caster for casting into a billet or slab. It is then reheated and hot rolled into its final form. Typically, though not always, and whether by design or as a result of downsizing or re-configuration, many of these processes take place in separate facilities.
In contrast, a mini-mill uses an electric arc furnace to directly melt scrap or scrap substitutes, thus entirely eliminating the energy-intensive blast furnace. A mini-mill unifies the melting, casting, and in many cases, the hot rolling, into a continuous process.
As a group, mini-mills are generally characterized by lower costs of production and higher productivity than integrated mills. This is due, in part, to lower capital costs and to lower operating costs resulting from their streamlined melting process and smaller, more efficient plant layouts. Moreover, mini-mills have tended to employ a management culture, such as ours, that emphasizes flexible, incentive-oriented non-union labor practices and have tended to be more willing to adapt to newer, more innovative and aggressive management styles, featuring decentralized decision-making. The smaller plant size of a mini-mill also permits greater flexibility in the choice of location for locating the mill in order to optimize access to scrap supply, energy costs, infrastructure and markets, as is the case with our Butler mill, our Iron Dynamics facility and our planned Whitley County structural and rail mill, our Iron Dynamics facility and our planned Whitley County structural and rail mill. Furthermore, a mini-mill's more efficient plant size and layout, which incorporates the melt shop, metallurgical station, casting, and rolling in a unified continuous flow under the same roof, have reduced or eliminated costly re-handling and re-heating of partially finished product. They have also adapted quickly to the use of new and cost effective equipment, thereby translating technological advances in the industry into efficient production.
THE HOT MILL
Our Butler mill's melting process begins with the charging of a furnace vessel with scrap steel, carbon and lime, or with a combination of scrap and a scrap substitute or alternative iron product. The vessel's top is swung into place, the electrodes lowered into the furnace through holes in the roof, and electricity is then applied to melt the scrap. To the extent any liquid pig iron or other scrap substitutes are used, such material is typically injected directly into the melt mix. The liquid steel is then checked for chemistry and the necessary metallurgical adjustments are made, typically while the steel is still in the melting furnace but, as is the case in our Butler mill, which has a separate metallurgical adjustment area, the material is transported in a ladle by overhead crane to an area commonly known as the ladle metallurgy station. There, the steel is kept in a molten state, while metallurgical testing, refining, alloying and desulfurizing takes place. The liquid steel is then transported to the casting deck, where it is emptied into a reservoir, which controls the flow of the liquid steel into the water-cooled copper-lined mold from which it exits as an externally solid billet or slab.
In an integrated mill, where the slab is cast, the billet is then cut to length and either shipped as billets or stored until needed for further rolling or processing, or it may be sent directly into the rolling process, after which it may then be cut to length, straightened, or stacked and bundled. In the case of mini-mill thin-slab casting, however, and, in particular, in our Butler mill, the less than 2 inch thick ribbon or slab proceeds directly into a tunnel furnace, which maintains and equalizes the slab's temperature and then, after descaling, the slab is transported into the first stand of the rolling mill operation. In this rolling process, the steel is progressively reduced in thickness. The sheet steel is then wound into coils and measured for thickness and flatness. For part of our "hot band" production, the steel coils or hot bands are sold either directly to end users or to intermediate steel processors or service centers, where they may be pickled, cold rolled, annealed, tempered, or galvanized. For the rest of our hot band output, however, the hot band coils are directed through our cold mill where we add value to this product through our own pickling, cold rolling, annealing, tempering, or galvanizing processes.
THE COLD MILL
Typically, products produced in our cold mill are those that require gauges, properties or surfaces that cannot be achieved in our Butler hot mill mini-mill. Cold rolled sheet produced in our Butler mini-mill is hot rolled sheet that has been further processed through a continuous pickle line and then successively passed through a rolling mill without reheating until the desired gauge and other physical properties have been achieved. Cold rolling reduces gauge and hardens the steel and, when further processed through an annealing furnace and temper mill, improves uniformity, ductility and formability. Cold rolling can also add a variety of finishes and textures to the surface of the steel.
Our cold mill consists of a continuous pickle line, a two-stand reversing mill, thirty-two batch anneal bases, a single-stand temper mill, a cold rolled galvanizing line and a hot rolled galvanizing line. The continuous pickle line begins at the existing hot strip mill building and delivers pickled product to a coil storage facility centrally located in the cold rolling and processing facility. Configuring the facility in this manner eliminates the need for equipment to transfer coils to the cold rolling facility. At the entry end of the continuous pickle line, we have two reels to unwind coils and a welder to join the coils together. We unwind the coils on alternate reels and attach them end to end by the welder, creating a continuous strip through the pickle tanks. The center section of the 700-foot pickle line consists of a scale breaker/tension leveler, the pickling tanks where the strip moves through a bath of hydrochloric acid that thoroughly cleans the strip in preparation for galvanizing and rolling operations, and the rinse tanks. At the delivery end of the line there is a reel for recoiling the pickled product. After recoiling, each coil is stored in the central coil storage facility.
From the central coil storage area, we move our coils in either of two directions. We immediately galvanize some coils on the hot rolled galvanizing line. The ability of the hot rolling mill to produce steel strip that is extremely thin allows for immediate galvanizing without the need for further rolling in the cold rolling mill. The hot rolled galvanizing line is designed to efficiently handle this type of material. We also process hot rolled coils that are not intended for immediate galvanizing on the cold rolling mill.
We move cold rolled product that requires galvanizing to the cold rolled galvanizing line, where it is annealed and coated. We heat the cold rolled coil in an annealing furnace and we dip the coil while still hot into a pot of molten zinc. As the coil leaves the pot, various coating controls ensure that the product matches the customer's requirements. We transport cold rolled product that does not require galvanizing directly to the batch annealing furnaces. The batch annealing furnaces heat and then cool the coils in a controlled manner to reduce the hardness of the steel that is created in the cold rolling process. We then temper-roll this product from the annealing furnaces. The temper mill introduces additional hardness into the product and further ensures the overall flatness and surface quality of the product.
We deliver product from both galvanizing lines and the temper mill directly from these processes to a common coil storage area, where it is then shipped by either truck or rail.
As in our hot mill, we have linked all facilities in the cold mill by means of business and process computers. We expanded our business systems to comprehend order entry of the additional cold mill products, and we accomplish all of our line scheduling in the business computer systems through schedules transmitted to the appropriate process related computers. We collect operating and quality data for analysis and quality control purposes, and for reporting product data to customers.
THE IRON DYNAMICS FACILITY
Our Iron Dynamics process, which utilizes state-of-the-art technology and some processes which we are developing ourselves, is composed of five process areas:
- raw material receiving;
- coal pulverizing;
- ore preparation and pelletizing;
- rotary hearth drying and reduction; and
- submerged arc furnace smelting.
We receive our iron ore concentrate from Eastern Canada. We feed the iron ore into a silo and then convey it to an ore dryer where we reduce its moisture content. We then beneficiate the ore, a process involving the reduction of the percentage of silica in the ore using magnetic separators and screens. We then feed the beneficiated ore into a roll press, where it is ground, after which we feed it into a storage bin and prepare it for mixing with coal from the Pinnacle Mine in West Virginia. We then feed the coal into a silo and convey it to the pulverizer. We mix the ground ore, coal and fluxstone with additional binders and water and feed the mixture into one of two disk pelletizers. We produce pellets with an average diameter of 11 mm and feed them into the pellet dryer.
We dry the wet pellets and then preheat to 150(degrees)C in a circular grate dryer. A vibrating conveyor charging system receives the dried pellets and layers them onto the rotary hearth furnace. The rotary hearth furnace then processes the dried pellets and discharges the hot direct reduced iron into one of three transport bottles on a rotating turntable. An additive facility introduces flux, coke, silica or other materials to the transport bottles to control slag chemistry in the submerged arc furnace.
We then transport the bottles from the rotary hearth furnace to the submerged arc furnace by means of a laser guided crane. The bottles discharge the hot direct reduced iron into the bins above the submerged arc furnace, at which time the feed mix falls into the slag layer by gravity and smelting takes place. We tap the molten iron into iron ladles and desulfurize it prior to transporting it to our Butler mill's meltshop, where we pour the liquid pig iron into our electric arc melting furnaces.
We anticipate that our liquid pig iron will have a chemistry of approximately 96% average metallic iron, in comparison with approximately 94%-95% iron content for standard pig iron and approximately 91% average iron content for direct reduced iron material. We also intend that our liquid pig iron will not contain any appreciable sulfur or gangue, in comparison with approximately 6%-7% gangue for direct reduced iron material.
Additionally, our planned use of liquid pig iron should enable us to lower electrical consumption in our steel manufacturing process, due primarily to the delivery of the already molten liquid pig iron to our electric arc furnaces, with an associated reduction in electrode consumption and increased unit productivity. We estimate these electricity consumption savings at approximately 15% to 20%, assuming a 25% pig iron input. Further, we expect that our liquid pig iron will not contain any iron oxide, which takes energy to reduce, in contrast to direct reduced iron which contains between 6% and 20% iron oxide. Other advantages which we believe are inherent in our Iron Dynamics process include the ability to use high or low silica fines, which are the cheapest iron ore units available, the lack of any necessity to have the fines sized or graded, in contrast to certain other alternative processes, and the use of coal as the reductant, which is an abundant raw material not affected by global shortages of gas (a primary input in certain other alternative iron processes). In addition, our Iron Dynamics process may allow for the cost effective use of steel mill by-products as raw material inputs, such as electric arc furnace dust and mill scale. In fact, we may also be able to procure steel mill by-products from other area mini-mills. Mill scale itself is a potentially excellent source of iron, with a 70% to 75% iron content, which is higher than most ores.
In connection with the development of our Iron Dynamics process, we have applied for and have been granted some U.S. and international patents and are awaiting action on others. The construction of our first Iron Dynamics facility in Butler, Indiana, has not, however, been without its hurdles and pitfalls. We have been delayed by approximately a year from our original timetable and have incurred some $12.0 million in extra capital costs that we did not anticipate, primarily because of some equipment failures that have required down time, redesign and replacement of various parts of our system. In several instances, we believe that the cause of the problem lies with our vendor and supplier, and we have aggressively pursued, and believe that we will be successful in recovering, a substantial portion of our direct costs in effecting the corrections. In others, however, we recognize that we are
learning as we go and are developing a better process, with an advanced "learning curve," which will enable us to build subsequent systems more cheaply and efficiently. On the whole, we remain optimistic that we are pioneering some refinements in ironmaking technology that will meet or exceed our original expectations.
THE PLANNED STRUCTURAL AND RAIL MILL
The planned Whitley County structural mill will be a mini-mill. As such, we will melt scrap and scrap substitutes in much the same way as in our Butler mill. After the heat from the electric arc furnace has been tapped, we will transport the molten metal to a separate ladle metallurgy furnace where, as in the Butler mill, we will adjust the mix for temperature and chemistry. However, we will then take the liquid steel to the continuous casting machine, where we will convert it into various semi-finished cast shapes rather than into a single ribbon or slab as in our Butler mill. After exiting the mold, the multiple strands will continue through a series of sprays and roller supports to precisely cool and contain the cast product. Straightener rolls will then unbend the curved strands onto a horizontal pass-line, where they will be cut to length by automatic torches. The cast pieces will then be weighed and will be able to travel directly to the rolling mill via the reheat furnace or into the storage area for rolling at a later time. Once the pieces are sent to the rolling mill, they will be transferred on a roller table through a box to remove scale. The product will then pass through a breakdown stand for up to seven passes, depending upon the product, before being transferred to the tandem mill. Downstream of the tandem mill, a hot saw will cut the product to a maximum 24 inch length before entering the cooling bed. From there, the product will be straightened on a roller straightener, cut to length, and then piled and bundled.
For production of standard and premium rail products, the planned Whitley County structural mill will require additional finishing and handling equipment. Currently, the mill is designed to be capable of rolling widely consumed rail sections. However, to produce premium rail, we will be required to acquire head hardening equipment for our mill.
TECHNOLOGY AND EQUIPMENT
THE BUTLER MILL
Our flat-rolled steel mini-mill manufactures hot rolled, cold rolled and coated steel products. We commenced construction of our 1.4 million ton capacity steel mini-mill in October 1994. The mini-mill was commissioned in December 1995 and on January 2, 1996, our mill began production of commercial quality steel. The construction costs of this mini-mill were $280.0 million, which we believe to have been approximately $75.0 million, or 20%, less than the cost of comparable facilities.
At the end of 1997, we completed construction of a 550,000 square foot cold finishing facility contiguous to our Butler hot mill, with a 1.0 million ton annual capacity. We began design work and equipment specification for this project in November 1995 and began actual foundation work in August 1996. We completed work on this $180.0 million facility in 14 months.
In July 1998, we completed construction, installation and start-up of a second twin-shell melting furnace battery, thin-slab caster, tunnel furnace, and coiler, with necessary modifications to our meltshop buildings. This project, which we previously referred to as our "caster project," was completed in 11 months at a cost of $99.4 million, expanding our annual melting capacity of hot rolled steel from 1.4 million tons to approximately 2.2 million tons. This additional production capacity of hot rolled steel allows us to take full advantage of the 1.0 million ton rolling and finishing capacity of our cold mill.
In January 1999, we completed the installation and start-up of a seventh finishing stand in our hot rolling mill. This allows us to reduce the rolling loads among the other six finishing stands and enables us to produce steel with better shape and profile performance. It also allows us to roll considerably lighter gauges than was previously possible.
(a) THE HOT MILL
The principal steelmaking equipment in our thin-slab flat-rolling plant consists of two twin-shell electric arc melting furnaces, three ladle metallurgy stations, turrets, and thin-slab casters, two tunnel furnaces, and our rolling mill.
- - Electric Arc Furnaces. Both of our furnace batteries are twin-shell 165-ton capacity tap weight, i.e. 195-ton gross weight with a 30-ton "hot heel", furnaces. Each battery consists of two melting hearths working off of a single power source. The furnaces are high reactance AC-powered units, which save approximately 30% in energy costs over a DC-type unit and are designed to use smaller and less expensive electrodes. Furthermore, electrode consumption by our furnaces, a substantial operating cost, is designed to be less than a DC-powered unit. Our two furnace batteries have a combined annual production capacity of 2.4 million tons.
Our twin-shell furnace design results in virtually continuous melting and reduces tap-to-tap time, i.e. the length of time between successive melting cycles or "heats", thus yielding more heats and greater productivity per shift. While melting is being done on one side, the other vessel can be tapped and then refilled and readied for the next melt. For a small incremental capital cost of the second shell or melting vessel, there is an approximate 20% increase in overall productivity. Preheating of the scrap occurs in the idle vessel with both oxygen and natural gas, at a fairly low cost, and melting is further aided and electrical consumption reduced by a 30-ton "hot heel" of melted scrap which remains in the idle vessel after tapping. We expect to realize a further reduction in electrical consumption, electrode use and tap-to-tap time with the introduction of our Iron Dynamics liquid pig iron directly into the melt mix, because this additional molten material will further accelerate the scrap melting process. An additional feature of our twin-shell design is that if there is a maintenance problem requiring work on one vessel, melting can proceed in the other vessel without interruption.
- - Ladle Metallurgy Station. We have three (3) separate ladle metallurgy stations consisting of three (3) Fuchs furnaces and two (2) desulfurization stations. A separate ladle metallurgy station located away from our arc furnaces, allows metallurgical adjustments to be effected, while still maintaining the steel at a sufficiently high temperature during the refining stage at the ladle metallurgy station. This maximizes the time that the arc furnaces can be used for scrap melting, while enabling the molten steel to continue through metallurgical testing, stirring, alloying, desulfurization, reheating and other adjustments at the ladle metallurgy stations. Once the adjustment process has been completed, the refined metal is then transported by overhead crane to the casting deck where it is injected directly into the mold of the casting machine.
- - Thin-Slab Caster. Our continuous thin-slab casters were built by SMS Schloemann-Siemag AG and have a combined annual casting capacity of 2.3 million tons. The casters are equipped with a newly designed submerged entry nozzle, known as "SEN", the device which transfers the liquid steel into the mold. This new design permits the walls of the SEN to be thicker, resulting in longer SEN life and, in turn, enables us to run a "string" of up to 12 heats before the SEN requires replacement. These advantages are directly reflected in increased productivity. Within the newly designed SEN, we have also incorporated a new baffle design to modify the fluid flow of molten steel into the mold cavity, which slows and more evenly distributes the molten steel into the mold as compared to previous designs. This results in a quieter top surface of the liquid steel in the mold, a more uniform solidification of the shell and significantly reduces sub-surface inclusions.
- - Rolling Mill. Our rolling mill consists of two tunnel furnaces, a seven-stand rolling mill and two down coilers. The tunnel furnaces heat and transport the cast slabs from the casting machines to the hot rolling mill. The furnaces reheat the steel to approximately 2,000 degreesF while ensuring the slab is evenly heated through out its length. Our tunnel furnaces also restore heat lost during the casting process.
The rolling mill is a seven-stand rolling mill built by SMS Schloemann-Siemag AG. Each rolling stand is driven by a high-powered 10,000 horsepower mill drive motor. The hot rolling mill is equipped with a high pressure water descaling system to remove the mill scale after the steel emerges from the tunnel furnace just before entering the rolling mill. This system provides a clean surface while minimizing the cooling of the 2,000 degreesF slab. The rolling mill is equipped with the latest electronic and hydraulic controls to control such things as exit speeds of the steel strip as it moves along the run-out table to help prevent thinner steel strip from cobbling. Our newly added seventh rolling stand now allows us to further roll our sheet steel to even thinner gauges, down to 1 mm, with excellent surface quality, which will enable us to access markets previously available only to more costly cold finished material.
After existing the rolling mill, the strip is transported by a roller table through a water cooling zone to the down coilers. There, it is wrapped around a rotating mandrel. The coil form allows the strip to be easily handled and transported.
Throughout the rolling process, laser optical measuring equipment and multiple x-ray devices measure all strip dimensions, allowing adjustments to occur continuously and providing feedback information to the mill process controls and computers. The entire production process is monitored and controlled by both business and process computers. Production schedules are created based on order input information and transmitted to the mill computers by the plant business system. As the material is processed, operating and quality data are gathered and stored for analysis of operating performance and for documentation of product parameters to the customer. The system then coordinates and monitors the shipping process, and prints all relevant paper work for shipping when the coil leaves the plant.
(b) THE COLD MILL
The cold mill is located adjacent to the hot mill and has a 1.0 million ton annual production capacity. The cold mill consists of a continuous pickle line, a two-stand reversing cold rolling mill, thirty-two batch annealing bases, a single-stand temper mill, a cold rolled galvanizing line, and a hot rolled galvanizing line. The continuous pickle line consists of a dual payoff system, a scale, a breaker/tension leveler, a shallow bath pickling section, a rinse section, side trimmers and recoiler. The design of the pickle line allows for the production of a wide combination of gauges and widths, highlighted by its outstanding performance on the light gauge steel supplied by the hot mill. The terminal equipment was supplied by Davy International, while the polypropolene pickling tanks were supplied by Allegheny Plastics.
Hot rolled coils that are not intended for immediate galvanizing are processed on the cold rolling mill. Our cold rolling mill is unique in that it is a semi-tandem two-stand reversing cold rolling operation. This configuration provides considerably higher throughput than a conventional single-stand reversing mill, yet also takes advantage of considerably lower equipment costs than the conventional four to six-stand tandem cold rolling mill. The rolling mill is configured with multiple x-ray gauges, hydraulic bending systems, rolling solution controls, gauge controls and strip flatness controls used to produce an extremely high level of product quality parameters. The cold rolling mill also uses a process control computer using sophisticated mathematical models to optimize both quality and throughput. The cold reversing mill was supplied by Schloemann-Siemag AG (SMS).
The cold rolled galvanizing line is quite similar to the hot rolled galvanizing line, but has a more elaborate and larger strip heating furnace. This larger furnace is required to anneal cold rolled product, which is not necessary on hot rolled product. Designing the pickle line and the two galvanizing lines concurrently and procuring the equipment from the same manufacturer has allowed a high degree of commonality of parts between the three lines. This provides a high degree of flexibility and cost savings in the management of spare parts.
Cold rolled product that does not require galvanizing then proceeds to the batch annealing furnaces. The batch annealing furnaces heat and then cool the coils in a controlled manner to reduce the hardness of the steel that is created in the cold rolling process. The batch annealing furnaces heat the steel in a hydrogen environment that optimizes the efficiency of the heating process and produces a product that is superior to conventional batch annealing with regard to cleanliness and uniform metallurgical characteristics. Computer models heat and cool the coils based on current knowledge of heat transfers and steel characteristics.
Product from the annealing furnaces is then temper-rolled. The temper-rolling facility is a single stand four-high rolling mill designed for relatively light reduction of the product. The temper mill introduces a small amount of hardness into the product and further enhances the overall flatness and surface quality of the product. The temper mill also has an x-ray gauge to monitor strip thickness. This mill was purchased concurrently with the two-stand cold rolling mill from the same manufacturer. This provides a high degree of flexibility and cost savings with regard to management of spare parts.
Product from both galvanizing lines and the temper mill is delivered directly from the processes to a common coil storage area, where it is then shipped by either truck or rail.
As in its hot mill, all facilities in the cold mill are linked by means of business and process computers. Business systems were expanded to comprehend order entry of the additional cold mill products and all line scheduling is accomplished in the business computer systems, with schedules transmitted to the appropriate process related computers. Operating and quality data are also collected for analysis and quality control purposes, and for reporting product data to customers.
(c) THE IRON DYNAMICS FACILITY
This facility is contiguous to the Butler mill. It is a projected 520,000 metric tonne annual capacity plant equipped to produce direct reduced iron, which we will convert into approximately 470,000 metric tonnes of liquid pig iron. We intend to use this product as a high quality scrap substitute in our Butler mill's meltshop. Construction of this facility began in October 1997. We produced our first direct reduced iron material in November 1998 and produced our first tap of liquid pig iron in March of 1999. However, during preliminary start-up during 1999, it was determined that certain design modifications and equipment replacements would be required in order to attain full operating functionality. Accordingly, while Iron Dynamics has begun to achieve some stable operating results, these results are currently at lower than expected volumes due to the time frame that remains to fix the problems. We believe we have identified the necessary modifications to correct the problems, which includes some redesigning and replacement of equipment. We plan to perform the necessary redesign and equipment replacement throughout 2000, and we expect to shut down the submerged arc furnace during the fourth quarter of 2000 to install and commission the replacement
equipment. We believe that our equipment suppliers will absorb much of the cost of the equipment redesign and replacement. We anticipate operating in a curtailed mode until the completion of the redesign and repairs. However, we have also ordered two briquetters and we expect to install and commission the briquetters during the fourth quarter of 2000. The briquetters will compress the direct reduced iron into a solid, dense briquette. The solid briquettes can be stored, used by us for direct introduction in its electric arc furnace, or sold on the open market. The addition of the briquetters will allow Iron Dynamics to bypass the submerged arc furnace during its planned down time in the fourth quarter of 2000, as well as during any future down time. Other significant problems with the mixer, balling operations and rotary hearth furnace have been stabilized, with good metallurgical results to date. When the submerged arc furnace issues are resolved, we are optimistic that the process will yield excellent production with good economics. As of December 31, 1999, the total amount expended for our new Iron Dynamics facility was $101.3 million.
We expect that our process will be able to produce liquid pig iron at a pricing structure that is relatively fixed and is likely to be considerably less than prevailing scrap prices in all anticipated markets. If the plant proves to be successful, we would consider building a "next generation" Iron Dynamics process direct reduced iron/liquid pig iron plant adjacent to our planned Whitley County structural mill and would consider similar units as ancillary scrap substitute sources adjacent or in close proximity to other steelmaking meltshops that we might construct or acquire in the future. In addition, we have entered into a License Agreement with Sumitomo Corporation of America under the terms of which Sumitomo, in return for a royalty, is licensed to use the Iron Dynamics process in constructing its own scrap substitute facilities within its designated territory, which is worldwide except for the U.S. and Canada. In addition, it may sublicense others within the designated territory to do the same. We have retained the sole and exclusive right to use the Iron Dynamics process for our own facilities, now or in the future, or to license others to use it within the U.S. and Canada.
The Iron Dynamics process combines state-of-the-art grinding technology, using a high pressure roll press to grind iron ore, proven coal pulverizing equipment from William Patent Crusher Company, our own proprietary ore beneficiation technology, conventional disk pelletizing equipment, specialized designs for feeding and removing the materials from the rotary hearth, thermally efficient use of the rotary hearth furnace "off gases", and novel solutions to the scale-up challenges presented by the world's largest rotary hearth furnace. We have also adapted automated crane technology from the ocean shipping industry to perform the task of hot direct reduced iron transfer between the rotary hearth furnace and our submerged arc furnace, where the direct reduced iron is converted into liquid pig iron. The submerged arc furnace technology used is well developed from the ferralloy industries. Thermal efficiency is achieved by the hot transfer of direct reduced iron between the rotary hearth furnace and the submerged arc furnace.
In addition, the off gas system removes heat, dust, sulfur dioxide and nitrous oxides from the flue gas. An afterburner combusts any remaining carbon monoxide. The off gas is used to preheat combustion air, supply heat to the ore and coal dryers and to dry the pellets in the pellet dryer.
THE STRUCTURAL MILL
Our planned structural and rail manufacturing mini-mill will be located on a 470-acre site immediately south of U.S. Highway 30 between County Road 700 East and County Road 800 East in Whitley County. This mill is expected to have an annual production capacity of between 900,000 and 1,100,000, tons depending on product mix, for the manufacture of structural steel beams and pilings for the construction market. We expect to commence construction once our "Prevention of Significant Deterioration" or "air" construction permit becomes final, which will not occur until after disposition of appeals lodged by opponents of the project. The Indiana Department of Environmental Management issued the permit on July 7, 1999. As discussed in more detail earlier in this Report, three appeals are pending before the Department of Environmental Adjudication in Indianapolis, Indiana, and two additional appeals are pending before the federal Environmental Appeal Board in Washington, D.C. We believe that the permit was properly issued and that the issuance of the permit will be upheld on appeal. Presently, we are hopeful that final disposition of the administrative appeals will occur sometime within the next two or three months, although it could take longer. As soon as the appeal process has been concluded and our permit has become final, we will commence construction of this mill and expect to be able to produce our first structural steel product in the first half of 2001.
We intend to construct a $40 million to $50 million rail manufacturing addition to our planned structural mill that will enable us to take advantage of extra available melting capacity in our structural mill meltshop. The rail addition is in the design, preliminary engineering and equipment specification and selection phase. We anticipate that this process will take approximately six months, after which we plan to place equipment orders and begin construction work on this additional facility. Completion of the rail manufacturing addition is not a precondition for the start-up and commencement of operations of our structural mill, and we anticipate a start-up for the rail project shortly following the start-up for the structural mini-mill.
The combined structural mill and rail manufacturing facility will have a meltshop annual capacity of between 1.0 and 1.2 million tons, depending on product mix between structural and rail products. It will be able to produce a varying combination of structural and rail products to fit the market demand for each of these types of products, including structural shapes serving the building and construction, bridge construction, railroad car, barge and ship building, and machinery industries. We believe that this production flexibility will enable us to tailor our product output to the demands and opportunities of the marketplace.
- - Electric Arc Furnace. Scrap will be melted in much the same way as in our Butler mill's hot mill meltshop, except that the electric arc furnace for our structural mill will be of a single shell AC-powered design with a 120-ton tap capacity. While we plan to use 100% scrap as the primary raw material, the system will be configured to accept liquid pig iron product should we decide to place an Iron Dynamics module at the Whitley County plant site. The electric arc furnace, manufactured by Mannesmann-Demag, will be equipped with water-cooled sidewalls and a combination of five injection capable oxy-fuel burners and a supersonic water-cooled sidewall lance capable of operation in the conventional "pre-heat" firing mode to provide a concentrated stream of oxygen that deeply penetrates the liquid steel bath for purposes of decarburization but capable, also, of powdered carbon injection for foamy slag. This combination will enable us to create and sustain a foamy slag over more of the bath area than is otherwise possible and will permit us to employ a melting practice which is more thermally efficient. The furnace will also feature a removable shell that will enable us to do off-line repair and refractory relining, will come equipped with a unique quick-change roof configuration and will also feature a fast tap hole tube change configuration that will speed this periodic replacement process.
- - Caster. The caster will be built by SMS-Concast. Unlike our Butler mill that produces a single strand or ribbon of flat stock, our structural mill's machine will cast three strands, expandable to four, of blooms and beam blanks. The caster will utilize a curved mold, that will produce five sizes of material -- one bloom, which is rectangular shaped, and four beam blanks, which are dog bone shaped, in varying lengths of 17-46 feet. The caster is expected to be capable of producing 1.2 million tons per year in our initial set-up.
Our new caster design will feature a quick change nozzle system to optimize the continuous casting process to achieve the lowest possible operational costs per ton. Our tundish bottoms are designed to change from a bloom opening to any of four beam blank sizes to allow greater flexibility in product choice. We will have the ability to run different product sizes simultaneously on the caster to allow some product to be hot charged and other product to be placed on a storage bed for processing by the rolling mill during times when the meltshop is performing maintenance or is otherwise down. The caster service crane will also provide a dual hoist system to speed size change turn around by allowing two strands to be changed at one time.
- - Rolling Mill. Cast pieces exiting the casting machine will either be able to travel directly to the rolling mill or into a storage area for rolling at a later time. The reheat furnace, a 300 ton per hour hot charge "walking beam" furnace supplied by A.C. Leadbetter, will have a deep charge capability that will enable it to be used as a "buffer" for roll changes and mill delays.
Our rolling mill is an advanced four-stand (all reversing) mill built by SMS-AG, designed with an annual capacity of 1.6 million tons, capable of producing wide flange beams 6x4 inches to 36x12 inches, standard beams, piling sections, M-shape sections, sheet piling, channels, car building shapes, bulb angles and zee's. The selection of product mix will influence annual production; therefore, by rolling a larger share of heavier products, the annual production will be proportionately greater.
Once the bloom or beam blank is discharged from the reheat furnace it will be transferred on a roller table through a box to remove scale. The product will then pass through a breakdown stand for up to seven passes, depending upon the product, before being transferred to the 3-stand tandem mill. Between the breakdown mill and the tandem mill is a hot saw for cropping off the leading end if required. The tandem mill will consist of a universal rougher, an edger, and a universal finisher. The mill will be capable of operating in two modes, universal and two-high. In the universal mode the X-H rolling method will be used. The rougher stand will have an X-shape pass design and the finisher stand will have an H-shape depending upon the final product. The edger mill stand will be shiftable, which will allow for more than a single pass on a roll. The mill has been designed for quick roll changes of less than 25 minutes. In the 2-high mode, channels, angles and sheet piling will be rolled utilizing two pass lines within the tandem mill.
(d) RISK FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
This Form 10-K Annual Report contains numerous forward-looking statements, in addition to historical information. Such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Our actual results could differ materially from the results anticipated or expected by such forward-looking statements. See also the discussion on Forward-Looking Statements in this Item 1 at pages 1-2. Additional factors that could cause or contribute to such differences include the following:
FACTORS RELATING TO OUR COMPANY
OPERATING AND START-UP RISKS ASSOCIATED WITH OUR SCRAP SUBSTITUTE AND STRUCTURAL MILL PROJECTS COULD IMPEDE OR PREVENT US FROM REALIZING THE ANTICIPATED BENEFITS FROM THESE PROJECTS
Our scrap substitute project is the first of its kind, involves processes that are based on various technical assumptions and new applications of technologies and has not yet been commercially proven. We only began producing direct reduced iron and converting it into liquid pig iron in our Iron Dynamics facility in August 1999. Since that time, we have encountered various problems, including equipment failures and design deficiencies, which have required time and additional expense to fix, and we are operating in a limited mode pending certain additional repairs later this year. As a result, we cannot provide any assurance that our proprietary technology will work or that our Iron Dynamics facility will be able to produce the direct reduced iron and liquid pig iron in the quantities and at the favorable cost levels that we have anticipated. If we are unable to do so, we will have to obtain direct reduced iron, liquid pig iron or other scrap substitutes and/or additional scrap from alternate sources, and we cannot be assured that we will be able to access such sources or obtain such materials in the appropriate quantities or at a favorable cost, if at all. Other companies with resources greater than ours have tried and failed to develop a workable and cost effective scrap substitute, and those technologies that are operational throughout the world today are not the ones we are employing in our Iron Dynamics facility. In addition, because of equipment failure and related structural damage suffered in our Iron Dynamics facility during its initial start-up, we incurred significant costs due to the consequential shutdown of and related repair expenditures to this facility. We have no assurance that as our Iron Dynamics facility commences production on a commercial basis we will not experience additional material shutdowns or equipment failures or that any such shutdown or failure would not have a material adverse effect on our business, financial condition or results of operations.
We have not yet begun construction of our Whitley County structural steel mill because of pending appeals of the issuance of the air permit required for us to operate the facility. This action is only the latest in a series of actions over approximately the past twelve months in which various parties have sought to block or delay the project. We cannot be assured that the legality of the issuance of the air permit will be upheld on appeal or, even if this does occur, that there will not be additional delays or other actions that could threaten this project. Further delays could also result in increased construction costs.
If or when we are permitted to commence construction on this project, we will be subject to the risks associated with building, starting up and operating any new facility, such as construction delays, cost overruns or start-up difficulties beyond those normally encountered during a start-up process. We could also experience operational difficulties after start-up that could result in our inability to operate the facility at full or near-full capacity or at all. Any of these difficulties, to the extent they materialize, could adversely affect our business, results of operations and financial condition.
WE HAVE SUBSTANTIAL DEBT AND DEBT SERVICE REQUIREMENTS AND THIS MAY ADVERSELY AFFECT OUR FINANCIAL AND OPERATING FLEXIBILITY
We now have and expect to continue to have, a significant amount of indebtedness. At December 31, 1999, we had $449.9 million of indebtedness under our Steel Dynamics senior secured credit facility and Iron Dynamics separate credit facility.
Subject to the limitations contained in our credit agreements, we may incur additional indebtedness and, subject to lender approval, we may be able to make further borrowings at the subsidiary level.
The amount of our indebtedness could have important consequences. For example, it could:
- make it more difficult for us to perform our obligations with respect to payments on our secured bank indebtedness;
- increase our vulnerability and limit our ability to react to general adverse economic and industry conditions;
- limit our ability to use operating cash flow to fund operating expenses, working capital, capital expenditures and other general corporate purposes because we must dedicate a substantial portion of our cash flow to make payments on our debt;
- place us at a competitive disadvantage compared to some of our competitors that have less debt; and
- limit our ability to borrow additional funds.
Our ability to satisfy our debt obligations will depend upon our future operating performance, which in turn depends upon the successful implementation of our strategy and upon financial, competitive, regulatory, technical and other factors, many of which are beyond our control. If we are not able to generate sufficient cash from operations to make payments under our credit agreements or to meet our other debt service obligations, we will need to refinance our indebtedness. Our ability to obtain such financing will depend upon our financial condition at the time, the restrictions in the agreements governing our indebtedness and other factors, including general market and economic conditions. If such refinancing were not possible, we could be forced to dispose of assets at unfavorable prices. Even if we could obtain such financing, we cannot assure you that it would be on terms that are favorable to us. In addition, we could default on our debt obligations.
WE FACE LITIGATION RISKS IN CONNECTION WITH OUR TERMINATED THAILAND ADVISORY TRANSACTION
We have been sued in a total of eight separate but related lawsuits (one of which is a duplicative filing) in either state or federal courts in California, New York, New Jersey, Minnesota, Connecticut and Illinois, by various institutional investors which purchased certain high risk notes or "junk bonds" issued in March 1998 by two affiliates of Nakornthai Strip Mill Public Company, Ltd., or "NSM," a Thailand owner and operator of a steel mini-mill project. Our president, Keith E. Busse, has also been named as a defendant in the New Jersey and Connecticut (duplicative) cases. Under our company's bylaws and pursuant to authorization of our board of directors, Mr. Busse is entitled to be indemnified by us for any costs or expenses that he may incur, as well as in respect of any judgments that may be rendered against him in connection with this litigation, subject to applicable legal procedures required by the Securities and Exchange Commission for submission of any such indemnity claim, if asserted, to a court of appropriate jurisdiction for a determination of whether such indemnity claim is against public policy as expressed in the Securities Act of 1933. NSM has defaulted on the bonds.
Plaintiffs purchased some U.S. $240 million of a U.S. $452 million privately placed non-registered "Regulation D" offering to "Qualified Institutional Buyers," in which NatWest Capital Markets Limited, McDonald & Company Securities, Inc., PaineWebber Incorporated and ECT Securities Corp. acted as "initial purchasers" of the notes and then resold them to the plaintiffs and others pursuant to "Rule 144A."
Although we were neither an issuer, a guarantor, a seller or an investment banker with respect to these notes, did not draft any offering materials in connection with the offering, were not listed as an expert, did not render any reports or evaluations of NSM prior to the offering, and only had a contractual relationship with the NSM mini-mill project--as a technical advisor and consultant, with duties commencing only after conclusion of the note offering--we have nonetheless been named as a defendant in each of these cases on the basis of a variety of alleged state or federal common law or statutory claims, including fraud claims, that posit that the plaintiffs were misled into purchasing and overpaying for the notes by reason of various alleged misrepresentations or omissions either in the offering materials or at one or more "road shows" in connection with the offering.
We deny any liability in connection with these cases, believe we have ample legal and factual defenses, and will defend ourselves in each such case to the limit of our ability.
While we believe that the plaintiffs' claims are without factual or legal merit, we have no assurance that the courts will grant any of our currently pending or future pre-trial motions to dismiss, for judgment on the pleadings, for summary judgment or any other dispositive motions that we may file, or that the cases will eventually in fact be dismissed, or that, if not dismissed, eventual trials will result in verdicts in our favor. In addition, defending these lawsuits will be exceedingly costly and time consuming and, regardless of whether the outcome is favorable to us, will divert substantial financial, management and other resources from our business. It is possible that a judgment could be rendered against us for all or a substantial portion of the $240 million in the plaintiffs' claimed losses. Because we do not have applicable insurance coverage for this kind of claim, our business, results of operations and financial condition would be materially adversely affected in the event of such an outcome.
For additional details regarding these cases, as well as the identity of each of the cases, see Item 3, "Legal Proceedings" of this Form 10-K.
OUR DEBT AGREEMENTS CONTAIN OPERATING AND FINANCIAL RESTRICTIONS AND THESE MAY ADVERSELY AFFECT OUR FINANCIAL FLEXIBILITY
The operating and financial restrictions and covenants in our credit agreements and any future financing agreements may adversely affect our ability to finance future operations or capital needs or to engage in other business activities. Specifically, these debt agreements may restrict our ability to:
- incur additional indebtedness;
- pay dividends or make distributions with respect to our capital stock;
- repurchase or redeem capital stock;
- make investments;
- create liens and enter into sale and leaseback transactions;
- make capital expenditures;
- enter into transactions with affiliates or related persons;
- issue or sell stock of certain subsidiaries;
- sell or transfer assets; and
- participate in joint ventures, acquisitions or mergers.
Our ability to comply with these and other provisions of our credit agreements, and of any future financing agreements may be adversely affected by changes in business conditions or results of operations, adverse regulatory developments, or other events beyond our control. A breach of any of the restrictions or covenants in our debt agreements could trigger defaults under such agreements even though we might otherwise be able to meet our debt service obligations.
WE RELY UPON A SMALL NUMBER OF MAJOR CUSTOMERS FOR A SUBSTANTIAL PERCENTAGE OF OUR SALES AND OUR MAIN CUSTOMER IS A RELATED PARTY
We have a long-term "off-take" contract with Heidtman Steel Products, Inc. pursuant to which Heidtman has agreed to purchase an aggregate of at least 30,000 tons of our steel products each month. For the year ended December 31, 1998, Heidtman accounted for 21% of our total net sales, and our top five customers accounted for approximately 45% of our total net sales. For 1999, Heidtman accounted for 19% of our total net sales. Although we expect to continue to depend upon a small number of customers for a significant percentage of our net sales of flat rolled steel, we cannot be assured that any of them will continue to purchase steel from us. A loss of any such customer or group of customers could have a material adverse effect on our results of operations and financial condition. Heidtman is an affiliate of one of our large stockholders and the President and Chief Executive Officer of Heidtman serves as one of our directors. If the terms of the "off-take" contracts are or become burdensome to Heidtman, or if a dispute arises over the contract, Heidtman could be viewed as having a conflict of interest between what they perceive to be best for it as an "off-take" buyer and what is best for us as the product seller.
UNEXPECTED EQUIPMENT FAILURES MAY LEAD TO PRODUCTION CURTAILMENTS OR SHUTDOWNS
Our manufacturing processes are dependent upon critical pieces of steelmaking equipment, such as our furnaces, continuous casters and rolling equipment, as well as electrical equipment, which on occasion may be out of service due to routine scheduled maintenance or as the result of unanticipated equipment failures. We have experienced and may in the future experience material plant shutdowns in connection with equipment failures. For example, our Iron Dynamics subsidiary suffered a "breakout" in its submerged arc furnace in May 1999, and, although not our fault, caused delays and expense that have been frustrating and costly. Similarly, in August 1999, our cold mill suffered a catastrophic motor failure, again not our fault but costly in time and lost production, even though our motor vendor promptly repaired the motors and we were able to recoup some of our loss through insurance. Such interruptions in our production capabilities will inevitably adversely affect our results of operations.
WE COULD EXPERIENCE SYSTEM FAILURES AND SERVICE DISRUPTIONS AS A RESULT OF THE YEAR 2000 PROBLEM
The year 2000 problem results from the fact that computer programs, microprocessors and embedded date reliant systems use two digits rather than four to define the applicable year. Some of these systems and processors may interpret "00" incorrectly as the year 1900 instead of the year 2000. The failure of any of these systems to appropriately interpret the upcoming calendar year 2000 could result in major systems failures or miscalculations. We are highly dependent upon our own, our vendors' and customers' computer software programs and operating systems. If our efforts to address the Year 2000 compliance issues prior to year-end 1999, or our current efforts to continue to address these issues are not successful, or if our suppliers, customers and service providers have not fully addressed these issues, our business, results of operations and financial condition could be materially adversely affected.
WE RELY ON OUR KEY PERSONNEL AND WE MAY BE UNABLE TO REPLACE KEY EXECUTIVES IF THEY LEAVE
Our operations and prospects depend in large part on the performance of our senior management team, including Keith E. Busse, President and Chief Executive Officer, Mark D. Millett, Vice President and General Manager of our Flat Roll Division, Richard P. Teets, Jr., Vice President and General Manager of our Structural Division, Tracy L. Shellabarger, Vice President and Chief Financial Officer, John Nolan, Vice President, Sales and Marketing, and Larry Lehtinen, Vice President and General Manager of Iron Dynamics. Although these senior managers all have employment agreements with and are stockholders of Steel Dynamics, we cannot be assured that such individuals will remain with us as employees. In addition, we cannot be assured that we would be able to find qualified replacements for any of these individuals if their services were no longer available. The loss of the services of one or more members of our senior management team or our inability to attract, retain and maintain additional senior management personnel could have a material adverse effect on our business, financial condition and results of operations.
WE MAY FACE RISKS ASSOCIATED WITH POTENTIAL ACQUISITIONS, JOINT VENTURES OR STRATEGIC ALLIANCES
As part of our strategy, we may acquire other businesses, enter into joint ventures, or form strategic alliances that we believe will complement our existing business. These transactions will likely involve some or all of the following risks:
- the difficulty of assimilating the acquired operations and personnel;
- the potential disruption of our ongoing business;
- the diversion of resources;
- the possible inability of management to maintain uniform standards, controls, procedures and policies;
- the possible difficulty of managing our growth and information systems;
- the risk of entering markets in which we have little experience;
- the inability to work efficiently with joint venture or strategic alliance partners; and
- the difficulties of terminating joint ventures or strategic alliances.
These transactions might be required for us to remain competitive. We might not be able to obtain required financing for such transactions. Such transactions might not occur, and any that do might not be successfully integrated with our existing business or might not achieve expected results.
WE MAY MAKE SIGNIFICANT ADDITIONAL CAPITAL EXPENDITURES
Our business is capital intensive and will require substantial expenditures for, among other things, the purchase and maintenance of equipment used in our steelmaking and finishing operations and compliance with environmental laws. We may also require additional financing in the event we decide to enter into strategic alliances or joint ventures, make acquisitions or build additional plants. The extent of any additional financing will depend upon the success of our business. Borrowings under our credit agreement are conditioned upon our compliance with various financial and other covenants and other conditions set forth therein. As a result, there can be no assurance that such financing or additional financing, if needed, will be available to us or, if available, that it can be obtained on terms acceptable to us and within the limitations contained in our credit agreement or any future financing.
FACTORS RELATING TO THE STEEL INDUSTRY
THE STEEL INDUSTRY IS CYCLICAL, SUBJECT TO PERIODIC MARKET FLUCTUATIONS AND DEPENDENT UPON OTHER INDUSTRIES
The steel industry is highly cyclical in nature, sensitive to general economic conditions and dependent upon the continued operations and health of certain other industries. The price of steel and steel products may fluctuate significantly as a result of general economic conditions and other factors beyond our control. The demand for steel products is generally affected by macroeconomic fluctuations in the U.S. and global economies in which steel companies sell their products. From 1990 to 1992, substantial excess worldwide manufacturing capacity for steel products, combined with a worldwide economic slowdown, resulted in a substantial decrease in the demand for steel products, increased competition and a decline in the financial performance of the steel industry. In addition, during 1998, and for a good part of 1999, substantial excess worldwide manufacturing capacity for steel products combined with substantially high levels of steel imports into the U.S. adversely affected the prices for U.S. steel products, including ours. We are also particularly sensitive to trends and other factors such as strikes and labor unrest that may affect the automotive, oil and gas, gas transmission, construction, commercial equipment, rail transportation, appliance, agricultural and durable goods industries, because these industries are significant markets for our products and are themselves highly cyclical. A disruption in the business of any of these industries could have a material adverse effect upon our production, our sales, and our financial condition and results of operations.
Future economic downturns, increased productivity, a stagnant economy, a change in trade policy or practice, currency fluctuations or a disruption in critical sources of supply or in the level of steel ordered by or able to be transported to certain significant customers may again adversely affect domestic selling prices for steel products.
INTENSE COMPETITION IN THE STEEL INDUSTRY MAY CONTINUE TO EXERT DOWNWARD PRESSURE ON OUR PRICING
Competition within the steel industry, both domestically and worldwide, is intense and it is expected to remain so. We compete primarily on the basis of price, quality and the ability to meet our customers' product needs and delivery schedules. Our primary competitors are other mini-mills, which have cost structures and management cultures similar to ours. We also compete with many integrated producers of hot rolled, cold rolled and coated products, which are larger and have substantially greater capital resources. Over the last half of the decade, new mini-mills, some integrated mill expansions and improved production efficiencies have led to domestic steel manufacturing overcapacity and, especially during the latter half of 1998, the existing downward pressure on steel prices, including the prices of our products, brought about by this overcapacity was significantly exacerbated by a substantial increase in the level of imported steel. This downward pressure on prices resulted in a narrowing of gross margins in the steel industry. Although we do not expect steel prices to experience a further downward pressure over the next few years, as competition increases, we cannot assure you that such price declines will not again occur, or, if they occur, that steel prices will not decline more quickly than our production costs, which could have a substantial adverse effect on our gross margins. In addition, in the cases of certain product applications, steel competes with other materials, including plastic, aluminum, graphite composites, ceramics, glass, wood and concrete.
WE CANNOT CONTROL THE COST OF SCRAP AND OTHER RAW MATERIALS
Our principal raw material is scrap metal derived primarily from junked automobiles, industrial scrap, railroad cars and railroad track materials, agricultural machinery and demolition scrap from obsolete structures, containers and machines. The prices for scrap are subject to market forces largely beyond our control, including demand by U.S. and international steel producers, freight costs and speculation. The prices for scrap have varied significantly and may vary significantly in the future. In addition, our operations require substantial amounts of other raw materials, including various types of pig iron, alloys, refractories, oxygen, natural gas and electricity, the price and availability of which are also subject to market conditions. We may not be able to adjust our product prices, especially in the short-term, to recover the costs of increases in scrap and other raw material prices. Our future profitability may be adversely affected to the extent we are unable to pass on higher raw material and energy costs to our customers.
ENVIRONMENTAL REGULATION IMPOSES SUBSTANTIAL COSTS AND LIMITATIONS ON OUR OPERATIONS
We are subject to various federal, state and local environmental laws and regulations concerning such issues as air emissions, wastewater discharges and solid and hazardous waste disposal. These regulations are increasingly stringent. While we believe that our facilities are and will continue to be in material compliance with all applicable environmental laws and regulations, it is possible that future conditions may develop, arise or be discovered that create substantial environmental compliance or remediation liabilities and costs. For example, our steelmaking operations produce certain waste products, such as electric arc furnace dust, which is classified as hazardous waste and must be properly disposed of under applicable environmental laws. These laws impose clean up liability on generators of hazardous waste and other hazardous substances which are shipped off-site for disposal, regardless of fault or the legality of the disposal activities. While we believe that we can comply with environmental legislation and regulatory requirements and that the costs of doing so have been included within our budgeted cost estimates, it is possible that such restrictions will prove to be more limiting and costly than anticipated. In addition to potential liability for violation of applicable laws, regulations or administrative conditions, we may be subject to substantial monetary fines and penalties. We may also be subject from time to time to legal proceedings brought by private parties or governmental agencies with respect to environmental matters. In particular, opponents of our planned Whitley County, Indiana structural and rail facility have waged a battle to try to defeat or discourage us by mounting various challenges before state and federal governmental authorities over issuance of our required "air" permit.
UNPREDICTABLE MARKET CONDITIONS MAY LEAD TO UNCERTAIN FINANCIAL RESULTS
Our operations are substantially affected by variations in the realized sales prices of our products, which in turn depends on prevailing market prices for steel and actual demand for particular products. Operating results have been, and in the future will be, affected by numerous factors including the prices and availability of raw materials, particularly scrap and scrap substitutes, the demand for and prices of our products, the level of competition, the level of unutilized production capacity in the steel industry, our product mix, the timing and pricing of large orders and start-up difficulties and costs associated with new projects. These factors and other events or circumstances, such as seasonal factors like weather, disruptions in transportation, availability or cost of energy, downturns in our larger customers' business or industries, a general economic downturn or labor unrest could adversely affect our business, results of operations and financial condition.
PRODUCTS AND CUSTOMERS
EXISTING PRODUCTS AND CUSTOMERS
During 1999, our Butler facility produced hot rolled products that included a variety of high quality mild and medium carbon and high strength low alloy hot rolled bands in 40 inch to 62 inch widths and in thicknesses from .500 inch down to .040 inch. We also produced an array of lighter gauge hot rolled products, such as high strength low alloy, including 80,000 minimum yield and medium carbon steels made possible by the addition of a seventh hot rolling stand. These products are suitable for automobile, truck, trailer and recreational vehicle parts and components, mechanical and structural tubing, gas and fluid transmission piping, metal building systems, rail cars, ships, barges, and other marine equipment, agricultural equipment and farm implements, lawn, garden, and recreation equipment, industrial machinery and shipping containers. We believe that our basic production hot band material has shape characteristics that exceed those of the other thin-slab flat-rolled mini-mills and compares favorably with those of the integrated mills. In addition, as a result of our lighter gauge hot rolling capabilities, we are now able to produce hot rolled hot-dipped galvanized and galvannealed steel products. These products are capable of replacing products that have traditionally only been available as more costly cold rolled galvanized or cold rolled galvannealed steel.
The products produced in our cold mill during 1999, included:
- hot rolled pickled and oiled;
- hot rolled hot dipped galvanized;
- hot rolled galvannealed;
- cold rolled hot dipped galvanized;
- cold rolled galvannealed; and
- fully processed cold rolled sheet.
The addition of our cold rolled facility to our already-existing advanced flat-rolled hot mill in 1998 has enabled us to manufacture products for many new commercial, appliance, and automotive markets that were not previously available to us.
Our cold mill was designed to produce a high grade, high quality product at the lowest possible cost, and results during 1999 indicate that our two-stand reversing cold mill technology has exceeded the equipment's guarantees on strip gauge control, flatness, and yield loss. The mill was designed to produce gauges as light as .015 inch, but we have rolled gauges as light as .011 inch with excellent profile and shape performance.
Based on information we have gathered from our customers, the following chart represents our 1998 and 1999 flat rolled shipments, by market classification, according to the ultimate end user:
(e) NEW PRODUCTS
DIRECT REDUCED IRON AND LIQUID PIG IRON
We recently completed the basic plant construction of our new Iron Dynamics facility, which is designed for the production of direct reduced iron and the conversion of that product in a submerged arc furnace into liquid pig iron. Limited Production of liquid pig iron began in August 1999. Once operational, after currently ongoing modifications to certain equipment has been completed, we plan on consuming all of Iron Dynamics' liquid pig iron output (estimated at 470,000 metric tonnes) in our own steelmaking operations at our Butler mill.
STRUCTURAL AND RAIL SHAPES
When our planned structural mill is completed in Whitley County, which, if actual construction is able to commence within the next two or three months, we estimate will be during the first half of 2001, we intend to produce various structural steel products such as wide flange beams, American Standard beams, miscellaneous beams, "H" Piling material, sheet piling material, American Standard and miscellaneous channels, bulb angles, and "Zee's." The following listing shows each of our proposed structural mill products and their intended markets:
When our new rail manufacturing component of our Whitley County structural mill is completed, which we estimate will be during the first half of 2001, we intend to produce various rail products for use by domestic and Canadian railroads. Steel rail is typically sold "as rolled" to exacting dimensional tolerances in lengths of 80 feet. These lengths are then welded into quarter mile "strings" or "ribbons" and shipped in specialized rail trains to the point of installation. Rails for heavy payload and high speed service, or those for severe service applications such as eight degrees or more of curved trackage, can be "head hardened" during the manufacturing stage and are sold as "premium" rail in the marketplace.
Of our total net sales for 1999, 1998 and 1997, approximately 81%, 84% and 63%, respectively, were to steel processors or service centers. These steel processors and service centers typically act as intermediaries between primary steel producers and the various end user manufacturers that require further processing of hot bands. The additional processing performed by the intermediate steel processors and service centers include pickling, galvanizing, cutting to length, slitting to size, leveling, blanking, shape correcting, edge rolling, shearing and stamping. Even with the completion of our cold mill project, and our increased utilization in our cold finishing facility of a considerable portion of our hot band production, we expect that our intermediate steel processor and service center customers will remain an integral part of our future customer base and we plan to continue to sell our hot bands and other products to these customers.
Typically, our backlog and order book does not extend beyond the current quarter, if assessed early in the quarter, or beyond the following quarter, if assessed midway through or toward end of a quarter. As result, we tend to experience relatively little delay in realizing price changes occurring in the marketplace.
SOURCES AND AVAILABILITY OF RAW MATERIALS
Our principal raw material is scrap metal derived, among other sources, from junked automobiles, industrial scrap, railroad cars and railroad track materials, agricultural machinery and demolition scrap from obsolete structures, containers and machines. The prices for scrap, which typically include freight, are subject to market conditions beyond our control, including fluctuating demand by U.S. and international steel producers against available supply, affected occasionally by speculation. Historically, the prices for scrap have varied significantly and may vary significantly in the future. In addition, our operations require substantial amounts of other raw materials, including various types of pig iron, alloys, refractories, oxygen, natural gas and electricity, the price and availability of which are also subject to market conditions. We may not be able to adjust our product prices, especially in the short-term, to recover the costs of periodic increases in scrap and other raw material prices. Our future profitability may be adversely affected to the extent we are unable to pass on higher raw material and energy costs to our customers.
Scrap is the single most important raw material used in our steelmaking process, representing approximately 52% of the direct cost of a ton of hot rolled steel coil during 1999. The percentage of scrap used in our steelmaking operations may decline somewhat in future years, depending upon the proportion of liquid pig iron from our Iron Dynamics operations or other purchased scrap substitutes that may be used from time to time.
As it relates to final product quality, electric arc furnace steel producers, such as us, and without regard to the usage of purer forms of scrap substitutes such as liquid pig iron, can normally only tolerate a maximum .2% level of residual materials such as non-ferrous metallic contamination such as copper, nickel, tin, chromium, and molybdenum, which, once having been dissolved into steel cannot be refined out. In order for the scrap melt to provide this level of quality under present circumstances, the mill must use approximately 60% of "low residual" scrap or an equivalent material. Such low residual scrap generally takes the form of No. 1 dealer bundles, No. 1 factory bundles, busheling, and clips. We may then use various grades of higher residual, and thus less expensive, scrap, which it can then blend with its low residual scrap to keep within impurity tolerances. Many variables impact scrap prices, the most critical of which is U.S. steel production.
Generally, as steel demand increases, so does scrap demand and resulting prices. The reverse is also normally true, with scrap prices following steel prices downward where supply exceeds demand. During 1998 and 1999, this was particularly true, as the flood of imported steel, much of it unfairly traded, resulted in sharply reduced new steel production with corresponding decreases in the need for scrap. This corresponding decrease in the price of scrap mitigated somewhat the impact of sharply declining prices for our new steel products during 1998and 1999 and enabled us to maintain some modest profit margins despite the severe market dislocation. The precipitous decline in scrap prices in 1998 and 1999 caused dealers to retain their inventories and to withhold them from sale, thus causing some short-term supply shortages even in the face of a supply/demand inversion at the consumer levels.
Nonetheless, we believe that the demand for low residual scrap will rise more rapidly than the supply in the coming years, especially with the increased number of electric arc furnace mini-mills that have been built or commenced operations in recent years. As a result, in order to maintain an available supply of scrap at competitive market prices, we are attempting to secure a strong and dependable source through which to purchase scrap of all grades, including low residual scrap, and to develop our own "captive" scrap substitutes supply. We have accomplished these objectives through a long-term scrap purchase agreement with OmniSource Corporation and through the development of our Iron Dynamics direct reduced iron/liquid pig iron project. Although in the future the price of low residual scrap may approach or drop below the cost of production of various scrap substitutes, we anticipate that the manufacturing costs and level of purity of our Iron Dynamics liquid pig iron will cause it to be a lower cost and attractive scrap substitute.
SCRAP
We have a long-term contract with OmniSource Corporation, which extends to 2001. Pursuant to this agreement, OmniSource has agreed to act as our exclusive scrap purchaser and to use its best efforts to locate and secure for us such scrap supplies as we may from time-to-time wish to purchase, at the lowest then available market prices for material of like grade, quantity and delivery dates. The cost to us of OmniSource-owned scrap is the price at which OmniSource, in bona fide market transactions, can actually sell material of like grade, quality and quantity. With respect to general market scrap, the cost to us is the price at which OmniSource can actually purchase that scrap in the market, without mark-up or any other additional cost. For its services, OmniSource receives a commission per gross ton of scrap received by us at our mini-mill. All final decisions regarding scrap purchases belong to us, and we maintain the sole right to determine our periodic scrap needs, including the extent to which we may employ scrap substitutes in lieu of or in addition to scrap. No commission is payable to OmniSource for scrap substitutes purchased or manufactured by us.
During 1999, 1998 and 1997, we purchased approximately 1.3 million tons of scrap or 89% of our total scrap needs, 1.2 million tons of scrap or 74% of our total scrap needs, and 933,000 tons of scrap or 70% of our total scrap needs, respectively, from OmniSource. As a result of the completion of our caster project our total output in tons of flat rolled steel coil increased from 1.4 million to approximately 2.2 million. However, we expect that the availability of substantial quantities of scrap substitutes will somewhat mitigate our continued dependency on low residual scrap. We believe that our scrap purchasing relationship with OmniSource provides us with excellent access to available scrap within our primary scrap generation area.
IRON DYNAMICS LIQUID PIG IRON
We are building a state-of-the-art facility for the production of direct reduced iron and liquid pig iron. Direct reduced iron is a metallic product made from iron ore or iron ore "fines" that have been treated in a "direct reduction" furnace with either natural gas or coal to reduce the iron oxide to metallic iron, and liquid pig iron is a pure metal product intended to be produced by smelting the direct reduced iron in a submerged arc furnace. We recently completed the basic plant construction of our new Iron Dynamics facility, which is designed for the production of direct reduced iron and the conversion of that product in a submerged arc furnace into liquid pig iron, and are in the process of conducting limited production while we await completion of some necessary equipment replacement or retrofitting. We produced a limited amount of liquid pig iron in August 1999. We currently plan on consuming all of Iron Dynamics' liquid pig iron output, estimated at 470,000 tonnes, in our own steelmaking operations at our Butler mill, once full scale production commences, anticipated to be in the fourth quarter of 2000.
ENERGY RESOURCES
ELECTRICITY
During 1998, we modified our electric service contract with American Electric Power, known as "AEP" that extends through 2006. The contract designates only 200 hours annually as "interruptible service" and establishes an agreed fixed rate for the rest of our electrical usage. Interruptible service subjects us to the risk of interruption at any time in the operation of the AEP system, whether as a result of an AEP peak demand, or even if AEP were able to obtain a higher market price from an alternate buyer. Under our old contract, we had only the option of matching the spot market price of the alternate buyer in order to avoid interruption, and that price could be much higher than our normal rate. In prior years, due to the extremely hot weather and the unavailability of certain nuclear power and coal based generating facilities, our Butler mill was forced to cut back to a nighttime operating mode on a number of days throughout the summer because of the unacceptably high rates per kilowatt hour created by these extremes in overall demand for electricity in tandem with the reduced availability of supply. Our renegotiated electrical supply agreement with AEP greatly reduces our exposure to such uncertainties because it is a fixed price contract with a maximum of 200 hours per year of interruptiblility. The contract also provides us that the circumstances necessary to warrant any of the annual 200 hours of service interruptions must be of an emergency nature and not related to price and demand. We believe that this new contractual arrangement will substantially mitigate the dangers of such production cutbacks in the future.
GAS
We use approximately 8,000 decatherms of natural gas per day. A decatherm is equivalent to 1 million BTUs or 1,000 cubic feet of natural gas. We have a delivery contract on the Panhandle Eastern Pipeline that extends through April 2008. We are also currently negotiating a delivery contract with NIPSCO/NIFL/Crossroads that will extend through October 2005.
We maintain a liquid propane storage facility on site with sufficient reserves to sustain operations at the Butler mill for approximately one week in the event of an interruption in the natural gas supply.
OTHER
We use oxygen, nitrogen and argon for production purposes, which we purchase from Air Products and Chemicals, Inc., which built a plant on land adjacent to our Butler mill. Air Products uses its plant not only to supply us, but also to provide oxygen and other gases to other industrial customers. As a result, we have been able to effect very favorable oxygen and other gas purchase prices on the basis of Air Products' volume production.
PATENTS AND TRADEMARKS
We have a trademark for the mark "SDI" and an accompanying design of a steel coil and a chevron.
Our Iron Dynamics subsidiary has filed five patent applications with the U.S. Patent and Trademark Office relating to its methods of producing low sulfur liquid pig iron.
KEY CUSTOMERS
Our largest customers were, Heidtman Steel Products, Inc. and Preussag AG. Together they accounted for approximately 41%, 27% and 27% of our total net sales in 1997, 1998, and 1999, respectively. Heidtman accounted, individually, for more than 10% of our net sales in 1997, 1998 or 1999. Preussag individually accounted for more than 10% of our net sales in 1997.
Steel processors and service centers typically act as intermediaries between primary steel producers, such as us, and the many end user manufacturers that require further processing of hot bands. The additional processing performed by the intermediate steel processors and service centers include pickling, galvanizing, cutting to length, slitting to size, leveling, blanking, shape correcting, edge rolling, shearing and stamping. Notwithstanding the completion of our cold mill and our increased utilization in our own cold finishing facility of a considerable portion of our hot band production, we expect that our intermediate steel processor and service center customers will remain an integral part of our future customer base.
COMPETITION
The steel industry has historically been and continues to be highly cyclical in nature, influenced by a combination of factors, including periods of economic growth or recession, strength or weakness of the U.S. dollar, worldwide production capacity and levels of steel imports and applicable tariffs. The industry has also been affected by various company-specific factors such as ability or inability to adapt to technological change, plant inefficiency and high labor costs. Steelmaking companies are particularly sensitive to trends in the automotive, oil and gas, gas transmission, construction, commercial equipment, rail transportation, agriculture and durable goods industries. These industries are significant markets for steel products and are themselves highly cyclical. Steel, regardless of product type, is a commodity affected by supply and demand. Steel prices have been and may continue to be volatile and fluctuate in reaction to general and industry specific economic conditions. Under such conditions, a steel company must be a high quality low cost producer.
Domestic steel producers, including us, have historically faced significant competition from foreign producers. From time to time, as occurred during 1998 and is continuing, the domestic steel producers have been adversely affected by what we believe was unfairly traded imports. The intensity of this foreign competition is also substantially affected by the relative strength of foreign economies and fluctuation in the value of the United States dollar against foreign currencies, with steel imports tending to increase when the value of the dollar is strong in relation to foreign currencies, some of which were significantly devalued during 1998 and 1999. The situation was exasperated by reason of a weakening of certain economies during 1998 and 1999, particularly in Eastern Europe, Asia, and in Latin America. Because of the ownership, control or subsidation of some foreign steel producers by their governments, decisions by such producers with respect to their production and sales are often influenced to a greater degree by political and economic policy consideration then by prevailing market conditions.
Imports of flat-rolled products increased significantly during each of the last several years, surging to record levels during 1998, before declining in 1999 as a result of the successful cases detailed below. Based on AISI reports during 1998 and 1997, imports of flat-rolled products (excluding semi-finished steel) totaled approximately 20 million and 14 million tons, respectively, or approximately 25% of total domestic steel consumption in 1998 and approximately 19% in 1997.
In September 1998, complaints were filed with the U.S. International Trade Commission and the U.S. Department of Commerce by a number of U.S. steel companies, including us, as well as the United Steel Workers of America seeking determinations that Japan, Brazil and Russia were dumping hot rolled carbon steel in the U.S. market at below fair market prices. In April 1999, the Department of Commerce issued a final determination that imports of hot rolled steel from Japan were dumped at margins ranging from 17% to 65%, and in June, the U.S. International Trade Commission reached a final determination of imports of hot rolled sheet from Japan caused injury to the U.S. steel industry. In July 1999, the Department of Commerce issued suspension agreements and final dumping duty determinations as to imports of hot rolled sheet from Brazil and Russia, and a suspension agreement and final countervailing duty determination as to imports of hot rolled sheet from Brazil. The Department of Commerce also announced countervailing duty findings of approximately 7%, and anti-dumping duties of approximately 40%, as to imports from Brazil. The U.S. International Trade Commission made a final affirmative injury determination. The Department of Commerce also announced final dumping duties ranging from 57% to 157%, and the suspension agreement against Brazil and Russia will remain in effect for 5 years.
The success of these hot rolled cases will curtail imports from these countries from 7 million tons in 1998, to between 500,000 and 1 million tons for 1999 and for the next five years. However, it is possible that imports of hot rolled sheet from other countries will increase significantly. We and other petitioners in the suits plan to continue to vigorously monitor such imports and will take further action if warranted.
On June 2, 1999, we, together with other domestic producers and the United Steel Workers of America, filed a complaint with the U.S. International Trade Commission and Department of Commerce seeking determination that cold rolled steel products from Argentina, Brazil, China, Indonesia, Japan, Slovakia, South Africa, Taiwan, Thailand, Turkey, and Venezuela, were being dumped in the U.S. market at below fair market prices. On July 19, 1999, the U.S. International Trade Commission made unanimous affirmative preliminary determinations of a reasonable indication of injury by reason of such imports. The Department of Commerce announced preliminary dumping determinations, which required the posting of dumping duties in November and December of 1999. In January 2000, the Department of Commerce issued a determination that imports of cold rolled steel from six countries were dumped at margins ranging from 17% to 81%. On March 3, 2000, however, the U.S. International Trade Commission ruled against us, making negative final injury determinations against these six countries, and we expect negative determinations in all six cases. These negative outcomes are likely to result in a continuation of the depressed prices caused by these unfair practices.
GEOGRAPHIC MARKETPLACE FOR FLAT-ROLLED PRODUCTS
UNITED STATES. Our products compete with many integrated hot rolled coil producers, such as National Steel Corp.'s Great Lakes Steel Division, LTV Steel Co., Inc., Ispat/Inland Steel Co., Bethlehem Steel Corp., AK Steel, U.S. Steel, Acme Steel Co. and Beta Steel Corp., as well as a growing number of hot rolled mini-mills, such as Nucor's Crawfordsville, Indiana and Hickman, Arkansas facilities, Gallatin Steel Company's mini-mill in Ghent, Kentucky, BHP/Northstar's facility in Delta, Ohio and TRICO Steel's mini-mill in Alabama. These mini-mills have low cost structures and flexible production capabilities more closely akin to ours than to the integrated producers. Despite significant reductions in steel production capacity by major U.S. producers over the last decade, the U.S. industry continues to be adversely affected, from time to time, by excess world capacity. Recent improved production efficiencies also have further increased overall production capacity in the U.S. Increased industry overcapacity, coupled with economic recession, could intensify an already competitive environment.
Over the last decade, extensive downsizings have necessitated costly restructuring charges that, when combined with highly competitive market conditions, have resulted at times in substantial losses for some U.S. steel producers. A number of U.S. steel producers have gone through bankruptcy reorganization. These reorganizations have resulted in somewhat reduced capital costs for these producers and may permit them to price their steel products at levels below those that they could have otherwise maintained.
Our penetration into the total flat-rolled steel market is limited by geographic considerations, to some extent by gauge and width of product specifications, and by metallurgical and physical quality requirements. Based on product type and geographic location, we believe that we most closely compete with the following mini-mills: Nucor's Crawfordsville, Indiana facility, Gallatin Steel's Ghent, Kentucky facility, BHP/Northstar's Delta, Ohio facility, and, to a more limited extent, Nucor's Hickman, Arkansas facility, Nucor's Berkeley County, South Carolina facility, and TRICO Steel's facility in northern Alabama. Each of these mills will produce hot rolled product. However, only an affiliate of BHP/Northstar in Delta, Ohio is producing hot rolled galvanized product, and only Nucor's Crawfordsville, Indiana facility is producing cold rolled and cold rolled galvanized products.
NON-UNITED STATES. Our products compete with many foreign producers. Competition from foreign producers is typically strong, but during 1998 and 1999, domestic steel producers, including us, have been adversely affected by illegally dumped imports. As previously described herein, a number of U.S. steel companies, including us, as well as the United Steelworkers of America, filed complaints with the U.S. International Trade Commission and the U.S. Department of Commerce seeking determinations that hot rolled carbon steel and cold rolled steel products from various countries were being dumped in the U.S. market at below fair market prices. We were successful with respect to the hot rolled cases and as a result, we expect imports from Japan, Brazil and Russia to decrease from approximately 7 million tons in 1998, to between 500,000 and 1 million tons for 1999 and the next five years. We were unsuccessful with respect to the cold rolled cases and on March 3, 2000, the ITC made negative final injury determinations. These negative outcomes are likely to result in a continuation of the depressed prices caused by these unfair practices.
GEOGRAPHIC MARKETPLACE FOR STRUCTURAL PRODUCTS
UNITED STATES. Our structural products will compete with a sizable number of electric furnace steelmakers, some of which have cost structures and flexible management cultures similar to our own. Notable competitors include Nucor Steel in Berkeley, South Carolina; Nucor-Yamato Steel in Blytheville, Arkansas; TXI-Chapparal Steel in Midlothian, Texas and in Petersburg, Virginia; Birmingham Steel in Cartersville, Georgia; and Northwestern Steel and Wire in Sterling, Illinois. Unlike the market for flat rolled products, in which mills typically sell a higher percentage of their products in close proximity to the mill, the market for structural products is considered national in nature.
NON-UNITED STATES. During the late 1980's, structural steel imports averaged 1.7 million tons annually. While that average volume declined to less than 0.7 million tons during the first half of the 1990's, structural steel imports have risen steadily in recent years to 2.1 million tons in 1998 of which 1.6 million tons were imported from Germany, Japan, South Korea and Spain. The impact of these imports, and the question of whether these imports were traded fairly, has been directed to the International Trade Commission and the Department of Commerce by Nucor-Yamato Steel, Northwestern Steel and TXI-Chapparal Steel in a recently filed antidumping suit.
GEOGRAPHIC MARKETPLACE FOR RAIL
UNITED STATES. The rail market is presently served by two producers: Rocky Mountain Steel, a division of Oregon Steel Mills, Inc. in Pueblo, Colorado, and Pennsylvania Steel Technologies, a subsidiary of Bethlehem Steel Corporation in Steelton, Pennsylvania. Each of these producers has the capability to produce either standard or premium rail. Our rail products would compete with these producers.
NON-UNITED STATES. Our rail products would compete with similar products from a number of high quality integrated and electric furnace steel producers in Europe and Asia, including British Steel and Nippon Steel.
ENVIRONMENTAL MATTERS
Our operations are subject to substantial and evolving environmental laws and regulations concerning, among other things, emissions to the air, discharges to surface and ground water, noise control and the generation, handling, storage, transportation, treatment and disposal of toxic and hazardous substances. In particular, we are dependent upon both state and federal permits regulating discharges into the air or into the groundwater in order to be permitted to operate our facilities. Presently, we are not able to commence construction of our planned structure and rail mill facility in Whitley County, Indiana because opponents of that facility have appealed the issuance of a key air permit to us and we are not permitted to proceed until those appeals have been adjudicated. We believe that in all current respects our facilities are in material compliance with all provisions of federal and state laws concerning the environment and we do not believe that future compliance with such provisions will have a material adverse effect on our results of operations, cash flows or financial condition. Since environmental laws and regulations are becoming increasingly stringent, our environmental capital expenditures and costs for environmental compliance may increase in the future. In addition, due to the possibility of unanticipated regulatory or other developments, the amount and timing of future environmental expenditures may vary substantially from those currently anticipated. The cost for current and future environmental compliance may also place U.S. steel producers at a competitive disadvantage with respect to foreign steel producers, which may not be required to undertake equivalent costs in their operations.
Under CERCLA, the Environmental Protection Agency, known as the "EPA," has the authority to impose joint and several liability for the remediation of contaminated properties upon generators of waste, current and former site owners and operators, transporters and other potentially responsible parties, regardless of fault or the legality of the original disposal activity. Many states, including Indiana, have statutes and regulatory authorities similar to CERCLA and to the EPA. We have a hazardous waste hauling agreement with Autumn Industries. We also have a hazardous waste disposal agreement with Environsafe Services of Ohio, Inc. to properly dispose of our flue dust, ash, and other waste products of steelmaking, which are classified as hazardous, but there can be no assurance that, even though there has been no fault by us, we may not still be cited as a waste generator by reason of an environmental clean up at a site to which our waste products were transported.
EMPLOYEES
Our work force consisted of 644 employees at December 31, 1999, of which 62 were employed by Iron Dynamics. Our employees are not represented by labor unions. We believe that our relationship with our employees is excellent.
FOREIGN EXPORT SALES
Of our total net sales in 1999, 1998 and 1997, sales outside the continental United States accounted for less than 1%. We appointed Salzgitter AG, a successor to Preussag Stahl AG, as our preferred distributor for all sales to customers outside the United States, Canada and Mexico. Under the Salzgitter Purchasing Agreement, if we wish to sell in the Export Territory, we must notify Salzgitter of the products available for sale and the price of these products. Salzgitter must then use its best efforts to solicit these sales and to present us with any purchase orders for the product, which we may then accept or reject. Sales within the Export Territory are for Salzgitter's own account, regardless of whether Salzgitter is purchasing for its use or for resale. If we receive an unsolicited offer to purchase any products from a prospective customer in the Export Territory, we must notify Salzgitter of the terms and Salzgitter has a right of first refusal to effect the purchase. For sales in the Export Territory, Salzgitter is entitled to a sales commission in addition to any other applicable discounts or rebates.
We have also entered into a "second look" export sales agreement for such international sales with Sumitomo Corporation of America ("Sumitomo") for export sales not handled by Salzgitter. Sumitomo is also a stockholder in our company. Sumitomo has also entered into an agreement with our Iron Dynamics subsidiary under which Iron Dynamics has agreed to sell to or through Sumitomo up to 50% of any direct reduced iron that it manufactures starting in 1998 and which we do not retain for our own consumption.
In addition, our Iron Dynamics subsidiary has entered into a license agreement with Sumitomo pursuant to which Sumitomo is authorized, on an exclusive world-wide basis (except for the U.S. and Canada), and subject to certain exception, to sub-license others or to use any proprietary know-how or other intellectual property related to the project. Such license rights contemplate that Sumitomo will build and construct plants using this technology for itself or for others.
ITEM 2.
ITEM 2. PROPERTIES
NEW CORPORATE OFFICES
We currently lease 5,611 square feet of office space at 7030 Pointe Inverness Way, Suite 310, Fort Wayne, Indiana, on a year-to-year lease, as a corporate headquarters. During 1998, we purchased a 10-acre tract of land at the junction of Interstate 69 and Indiana State Road 14 in Aboite Township on the southwest side of Fort Wayne, on which we anticipate locating our new corporate offices. Recently, the building moratorium affecting all new construction in Aboite Township, relating to the current inadequacy of water and sewage service in the area, was lifted and we commenced construction in the fourth quarter of 1999 of a planned 50,000 square foot multi-story office building, of which we anticipate utilizing approximately 10,000 square feet for our own corporate purposes and leasing out the balance to commercial tenants. We anticipate completion of construction in the second half of 2001.
BUTLER MILL
Our plant and administrative offices that serve our Butler mill are located on approximately 840 acres, in Butler, DeKalb County, Indiana. The production facilities consist of a series of contiguous buildings that represent distinct production activities. The meltshop portion of the building consists of approximately 140,000 square feet and houses the melting and casting operations. The tunnel furnace consists of approximately 54,500 square feet, and the hot mill building that houses the rolling operations consists of approximately 290,000 square feet. The continuous pickle line building, which connects the hot mill building and the cold mill building, consists of approximately 51,000 square feet. The remaining portion of the cold mill building that houses two hot-dipped galvanizing lines, a semi-tandem two-stand reversing mill, batch annealing furnaces and a temper mill encompasses over 516,000 square feet. An addition to the meltshop building was added in 1998 to accommodate our second caster, a second tunnel furnace and coiler, and various other peripheral equipment.
Office buildings on site consist of a general administrative office building, a building for hot rolling, engineering and safety employees, a cold mill office building, a melting/casting office building, a shipping office and an employee services building.
Other support facilities include a bag house and a water treatment system with buildings located at various places in the plant. The bag house captures the gasses from the melting operation and cleans them to comply with all federal emission standards. The water treatment system cleans, cools and recirculates the water used by the plant in various processes.
We consider its manufacturing and operating facilities adequate for our needs for the foreseeable future.
IRON DYNAMICS FACILITY
Iron Dynamics's facility is located on approximately 26 acres that are leased from us under a long-term lease at nominal consideration. In addition, Iron Dynamics internally has constructed approximately two miles of railroad tracks, approximately one mile of which is devoted to creating a loop track so that an entire unit train, consisting of engines and no less than eighty rail cars, can cost effectively service the site.
There are five main buildings that comprise the Iron Dynamics facility. They are the coal plant, consisting of 6,500 square feet, the ore plant consisting of 30,000 square feet, the rotary hearth/submerged arc furnace building consisting of 75,000 square feet, and the utilities building which consists of 15,000 square feet. The rotary hearth furnace/submerged arc furnace building is served by an automated 100-ton capacity crane.
ADDITIONAL LAND IN BUTLER, INDIANA
Over the past year, we have purchased additional unimproved farmland contiguous or in close proximity to our Butler mill. This additional land consists of 135 acres.
WHITLEY COUNTY STRUCTURAL MILL
Our proposed Whitley County structural mill will be situated on a 470-acre tract of land in Whitley County, 30 acres of which have been set aside for use as wetland mitigation for the project. The new site is immediately south of U.S. Highway 30 between County Road 700 East and County Road 800 East. The southern boundary of the site is a CSX Transportation railroad line with access rights allowed to the Norfolk Southern Corporation railway.
The structural mill facility, when completed, will consist of two main buildings that will comprise the structural mill itself. The meltshop building will contain seven bays and is planned to be approximately 200,000 square feet. The meltshop building will contain the electric arc furnaces, ladle metallurgical furnaces and the caster. The meltshop building will be connected to the rolling mill building that will contain four bays and consist of approximately 500,000 square feet. The reheat furnace and the heavy section rolling mill will be located within the rolling mill building.
The rail manufacturing facility, when completed, will be added to the rolling mill building. We estimate that the additional facilities to house the rail manufacturing operation will consist of approximately 200,000 square feet.
Additional buildings planned for the structural mill include an administration office building and an employee service building, all of which are in the process of being designed.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We have been sued in a total of eight separate but related lawsuits, aggregating approximately $240 million in claims (one of which is a duplicative filing) in either state or federal courts in California, New York, New Jersey, Minnesota, Connecticut and Illinois. The suits have been brought by various institutional investors which purchased certain high risk notes or "junk bonds" issued in March 1998 by two affiliates of Nakornthai Strip Mill Public Company, Limited, or "NSM," a Thailand owner and operator of a steel mini-mill project. Our president, Keith E. Busse, has also been named as a defendant in the New Jersey and Connecticut (duplicative) cases. Under our company's bylaws and pursuant to authorization of our board of directors, Mr. Busse is entitled to be indemnified by us for any costs or expenses that he may incur, as well as in respect of any judgments that may be rendered against him in connection with this litigation, subject to applicable legal procedures required by the Securities and Exchange Commission for submission of any such indemnity claim, if asserted, to a court of appropriate jurisdiction for a determination of whether such indemnity claim is against public policy as expressed in the Securities Act of 1933.
The purchases were part of a U.S. $452 million financing marketed and sold to these and other institutional investors in a privately placed non-registered offering, pursuant to the SEC's Regulation D, and then resold by NatWest Capital Markets Limited, McDonald & Company Securities, Inc., PaineWebber Incorporated and ECT Securities Corp. pursuant to SEC Rule 144A.
Although we were neither an issuer, a guarantor, a seller or an investment banker with respect to these notes, did not draft any of the offering materials in connection with the offering, were not listed as an expert, did not render any reports or evaluations of NSM prior to the offering; and only had a contractual relationship with the NSM mini-mill project--as a technical and operational advisor and consultant from and after the close of the financing--we have nonetheless been named as defendants on the basis of a variety of alleged state or federal statutory and common law fraud and related claims that posit that the plaintiffs were misled into purchasing and overpaying for the notes by reason of various alleged misrepresentations or omissions in the offering materials, or at one or more of the "road shows" in connection with the offering (some of which were attended by Mr. Busse).
We deny any liability in connection with these cases, believe that we have ample legal and factual defenses and will defend ourselves in each such case to the limit of our ability.
The eight pending lawsuits include Farallon Capital Partners, LP, et al v. Gleacher & Co., Inc., et al filed in the Superior Court of the State of California for the County of Los Angeles - Central District in August 1999 as Case No. BC 215260 (involving a $33 million claim); Merrill Lynch Global Allocation Fund, Inc., et al v. Natwest Finance, Inc., et al filed in the Superior Court of New Jersey, Law Division - Middlesex County, as Case No. MID-L-8457-99 in September 1999 (involving an $85 million claim), which also names a number of individuals as defendants, including our president, Keith E. Busse; a duplicative lawsuit covering
approximately half of the claims in the Merrill Lynch New Jersey lawsuit, filed in the Superior Court for the Judicial District of Fairfield at Bridgeport, Connecticut, also in September 1999, under the caption Turnberry Capital Partners, LP, et al v. Natwest Finance, Inc. et al, which we anticipate will either be dismissed in its entirety or, if it proceeds, would transfer $42 million of the Merrill Lynch claims to Turnberry and would reduce the claim in the Merrill Lynch New Jersey litigation to $43 million; Zuri-Invest AG v. Nat West Finance, Inc., et al, filed in the United States District Court for the District of Minnesota, Fourth Division, as Civil File No. 99-CV-1452 DWF/AJB in September 1999 (involving an approximate $2 million claim); IDS Bond Fund, Inc., et al v. Gleacher Natwest, Inc., et al, also filed in the United States District Court for the District of Minnesota, Fourth Division, as Civil File No. 99-116 MJD/JGL (involving a $62 million claim); Gabriel Capital, LP, et al v. Natwest Finance, Inc., et al, filed in the United States District Court for the Southern District of New York in October 1999 as Cause No. 99-CV-10488 (SAS) (involving an approximate $15 million claim); Legg Mason Income Trust, Inc., et al v. Gleacher & Co., Inc., et al, filed in October 1999 in the Superior Court of the State of California for the County of Los Angeles - Central District as Case No. BC 218294 (a $5 million claim); and Kemper High Yield Series - Kemper High Yield Fund, et al v. Gleacher Natwest, Inc., et al, filed November 24, 1999 in the Circuit Court of Cook County, Illinois as Cause No. 99L13363 (a $42 million claim).
There is also a peripheral lawsuit pending in the Court of Common Pleas of Cuyahoga County (Cleveland) Ohio, as Case No. 385421, in which John W. Schultes, the former president and chief executive officer of NSM, has sued both McDonald and us for damages "in excess of $25,000," alleging that we bear contractual responsibility for causing his termination of employment and that we slandered his reputation. We deny that we have any liability to Mr. Schultes in connection with this lawsuit.
In several unrelated matters, our Iron Dynamics subsidiary has brought several lawsuits relating to the construction of its plant facility in Butler, Indiana:
In February 1999, we brought a lawsuit in the Superior Court of DeKalb County, Indiana, against Taft Contracting Company, Inc. The complaint is for damages and for a declaration of rights that a mechanic's lien for approximately $1.0 million filed in November 1998 by Taft, a former contractor working on the Iron Dynamics plant construction project, is invalid and should be declared null and void. The Taft lien covers alleged "extras," which Iron Dynamics contends are unsupportable under the contract, and we consider the lien to be entirely without merit. The lien was subsequently bonded and discharged.
Also, in January 2000, we brought a lawsuit in the United States District Court, Northern District of Indiana, Fort Wayne Division, against Dover Conveyer, Inc. The complaint is for damages and for a declaration that the iron ore, coal and limestone conveying system manufactured by Dover does not comply with contractual specifications. We seek an order requiring Dover to honor its warranty and cure the defects. Dover has filed a counterclaim for damages totaling approximately $200,000 for retainages and out-of-pocket expenses. Iron Dynamics contends that Dover's counterclaim is entirely unsupportable under the contract.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock trades on The Nasdaq Stock Market under symbol STLD. The table below sets forth, for the calendar quarters indicated, the reported high and low sales prices of the common stock:
As of March 24, 2000 we had 48,018,683 shares of common stock outstanding and held beneficially by approximately 16,550 stockholders. Because many of the shares were held by depositories, brokers and other nominees, the number of registered holders (approximately 900) is not representative of the number of beneficial holders.
On December 11, 1997, the Board of Directors authorized us to repurchase up to 5% of its Common Stock. Under the program, shares may be purchased from time to time at prevailing market prices. As of March 24, 2000, we had repurchased 1,294,100 shares at an average price of approximately $15 per share of which 1,219,100 shares were purchased during 1998. No shares were purchased during 1999.
We have never declared or paid cash dividends on our Common Stock. We anticipate all future earnings will be retained to finance the expansion of our business and do not anticipate paying cash dividends on our Common Stock in the foreseeable future. Any determination to pay cash dividends in the future will be at the discretion of our Board of Directors, after taking into account various factors, including our financial condition, results of operations, outstanding indebtedness, current and anticipated cash needs and plans for expansion. In addition, pursuant to our restated Credit Agreement dated as of June 30, 1997, with Mellon Bank, N.A. and other participating banks, we may only pay dividends in an aggregate cumulative amount not exceeding cumulative net income for the period from January 1, 1997 through the then most recently completed fiscal quarter.
In addition, Iron Dynamics, Inc., our wholly-owned subsidiary, is restricted pursuant to its credit agreement from declaring or making any dividends except in the event certain covenants are met, and then only in certain amounts.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth our audited consolidated financial data as of and for each of the five years in the period ended December 31, 1999. You should read the following data in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements appearing elsewhere in this Form 10-K.
You should read the following information in conjunction with the data in the table on the following page:
- Commercial grade production began January 2, 1996.
- Our 1996 extraordinary loss of $7.3 million consisted of prepayment penalties and the write off of capitalized financing costs associated with prepayment of our outstanding subordinated notes.
- Our 1997 extraordinary loss of $7.6 million (net of tax benefit of $5.1 million) consisted of prepayment penalties and the write off of capitalized financing costs associated with the amendment of our credit facility, effective June 30, 1997.
- Operating profit per ton represents operating income before start-up costs divided by net ton shipments.
- Hot band production refers to our total production of finished coiled product. Prime tons refer to hot bands produced, which meet or exceed quality standards for surface, shape and metallurgical properties.
- Yield percentage refers to tons of finished product divided by tons of raw materials.
- Effective capacity utilization is the ratio of tons produced for the operational month to the operational month's capacity. For the data disclosed in the periods ended December 31, 1996 and 1997, we used an annual capacity of 1.4 million tons for this calculation. For the data disclosed in the periods ended December 31, 1998 and 1999, we used an annual capacity of 2.2 million tons.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion contains forward-looking statements that involve risks and uncertainties, and our actual results could differ materially from those discussed in the forward-looking statement. Some of these risks and uncertainties are enumerated in the discussion under the headings "Forward Looking Statements" and "Risk Factors That May Affect Future Operations" set forth in Item 1, of this Report as well as incorporated by reference herein from "Exhibit 99.1" to this Report. You should also read the following discussion in conjunction with "Selected Financial Data" and our consolidated financial statements appearing elsewhere in this filing.
OVERVIEW
We operate a technologically advanced flat-rolled steel mini-mill in Butler, Indiana with an annual production capacity of 2.2 million tons. We manufacture and market a broad range of high quality flat-rolled carbon steel products. We sell hot rolled, cold rolled and coated steel products, including high strength low alloy and medium carbon steels. We sell these products directly to end users and through steel service centers primarily in the Midwestern United States. Our products are used for various applications, including automotive, appliance, manufacturing, consumer durable goods, industrial machinery and various other applications.
In addition to our flat-rolled mini-mill, we are completing a second facility, preparing to build a third and investing in a steel fabrication plant. Our second facility, operated by our subsidiary, Iron Dynamics Inc., involves the pioneering of a process to produce direct reduced iron, which is then converted into liquid pig iron, a high quality, lower-cost steel scrap substitute for use in our flat-rolled facility. Iron Dynamics is contiguous to our flat rolled mini-mill. During 1999, we determined that Iron Dynamics would require design modifications to obtain its fully intended operating functionality. The modifications are planned to occur during the second half of 2000, until which time Iron Dynamics will operate at limited production levels.
Our third facility, a planned structural and rail mill, and an investment in New Millennium Building Systems, LLC, (NMBS) provide an opportunity for further product diversification and market penetration. Upon completion of the structural and rail mill, which we estimate to be in the first half of 2001, we plan to manufacture structural steel beams, pilings and rails for the construction and railroad markets. In addition, our investment in New Millennium provides a like opportunity for our steel to access the non-residential construction markets with steel joists, trusses and girders and roof and floor decking products.
NET SALES
Our sales are a factor of net tons shipped, product mix and related pricing. Our net sales are determined by subtracting product returns, sales discounts, return allowances and claims from total sales. We charge premium prices for certain grades of steel, dimensions of product, or certain smaller volumes, based on our cost of production. We also provide further value-added products from our Cold Mill. These products include hot-rolled and cold-rolled galvanized products, along with cold-rolled products, allowing us to charge marginally higher prices compared to hot-rolled products.
In order to ensure consistent and efficient hot band plant utilization, we have entered into a multi-year "off-take" sales and distribution agreement with Heidtman Steel Products, Inc. which accounts for approximately 30,000 tons of our monthly flat-rolled production at prevailing market prices. We do not enter into material fixed price, long-term, exceeding one calendar quarter, contracts for the sale of steel. Although fixed price contracts may reduce risks related to price declines, these contracts may also limit our ability to take advantage of price increases.
COST OF GOODS SOLD
Our cost of goods sold represents all direct and indirect costs associated with the manufacture of our flat- rolled carbon steel, and hot-rolled, cold-rolled and coated products. The principal elements of these costs are:
- Alloys - Electricity - Natural gas - Oxygen - Argon - Electrodes - Steel scrap and scrap substitutes - Depreciation - Direct and indirect labor and benefits
Steel scrap and scrap substitutes represent the most significant component of our cost of goods sold.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses are comprised of all costs associated with the sales, finance and accounting, materials and transportation, and administrative departments. These costs include labor and benefits, professional services, financing cost amortization, property taxes, profit sharing expense and start-up costs associated with new projects.
INTEREST EXPENSE
Interest expense consists of interest associated with our senior credit facility and other debt agreements as described in our notes to financial statements, net of capitalized interest costs that are related to construction expenditures during the construction period of capital projects.
OTHER INCOME (EXPENSE)
Other income consists of interest income earned on our cash balance and any other non-operating income activity. Other expense consists of any non-operating costs, including permanent impairments of reported investments.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Net Sales. Our net sales were $618.8 million, with shipments of 1.9 million net tons for the year ended December 31, 1999, as compared to net sales of $514.8 million, with shipments of 1.4 million net tons for the year ended December 31, 1998, an increase in net sales of $104.0 million, or 20%. These increases were attributable in part to increased volumes of 453,000 net tons, or 32%, which were offset by a decrease of approximately $32, or 9% in our average price per ton, for the year ended December 31, 1999, as compared to the same period in 1998.
Approximately 19% and 21% of our net sales for 1999 and 1998, respectively, were purchased by Heidtman Steel Products, Inc. (or affiliates).
Cost of Goods Sold. Cost of goods sold was $487.6 million for the year ended December 31, 1999, as compared to $429.0 million for the year ended December 31, 1998, an increase of $58.6 million, or 14%. This increase was primarily attributable to increased volumes. Steel scrap represented approximately 49% and 50% of our total cost of goods sold for the year ended December 31, 1999 and 1998, respectively. Our costs associated with steel scrap averaged $25 per ton less during 1999 than during 1998; however, we began to experience rising scrap prices during the fourth quarter of 1999. As a percentage of net sales, cost of goods sold represented approximately 78% and 83% for the years ended December 31, 1999 and 1998, respectively, reflecting our constant focus on production efficiencies and cost savings.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $42.4 million for the year ended December 31, 1999, as compared to $20.6 million for the year ended December 31, 1998, an increase of $21.8 million, or 106 %. This increase was partially attributable to an increase in start-up costs related to our expansion projects. Start-up costs related to our structural mill project, NMBS project and IDI were $19.0 million for the year ended December 31, 1999, as compared to $5.8 million for the year ended December 31, 1998, an increase of $13.2 million.
In March 1998, we entered into a ten-year Reciprocal License and Technology Sharing Agreement with NSM. This agreement provided NSM with the right to use our technology in exchange for shares and warrants of NSM valued at $15.5 million and reimbursement for our costs related to withholding taxes of approximately $3.0 million. We deferred the income related to these agreements to be recognized into income ratably over the ten-year term of the agreements. Concurrently, we entered into a ten-year Management Advisory and Technical Assistance Agreement to provide training and advice to a management company under contract with NSM to manage NSM's mill. We were to receive $2.0 million annually for this service. This fee was recorded as a reduction to selling, general and administrative costs to offset our out-of-pocket expense incurred in performing these services. Effective December 31, 1998, we terminated our agreements with NSM, resulting in our recognition of the associated deferred revenue. At the same time, we recorded an impairment loss due to a decrease in the value of our NSM stock at December 31, 1998. The net effect of these transactions was immaterial to our results of operations during 1998. Our relationship with Nakornthai Strip Mill Public Co. Limited (NSM) also accounted for a $5.2 million nonrecurring reduction of 1998 selling, general and administrative expenses.
As a percentage of net sales, selling, general and administrative expenses represented approximately 7% and 4% for the years ended December 31, 1999 and 1998, respectively.
Interest Expense. Interest expense was $22.2 million for the year ended December 31, 1999, as compared to $17.5 million for the year ended December 31, 1998, an increase of $4.7 million, or 27%. This increase was the direct result of increased borrowings utilized to finance our past expansion projects and was partially offset by an increase in capitalized interest of $6.2 million, or 89%, for the year ended December 31, 1999 as compared to the same period in 1998.
Other Income (Expense). For the year ended December 31, 1999, other income was $818,000, as compared to $5.0 million for the year ended December 31, 1998, a decrease of $4.2 million, or 84%. This decrease represented 1998 non-recurring fees received by us in connection with NSM. We terminated our agreements with NSM in December 1998.
For the year ended December 31, 1999, other expense was $2.1 million, of which $1.8 million represented the write off of our cost-basis investment in Qualitech Steel Corporation (Qualitech). Qualitech filed a petition for relief under Chapter 11 of the Bankruptcy Code on March 22, 1999. It is our belief that our investment in Qualitech was permanently and fully impaired at June 30, 1999.
Federal Income Taxes. Our federal income tax provision was $25.8 million for the year ended December 31, 1999, as compared to $20.9 million for the year ended December 31, 1998. This tax provision reflects income tax expense at the statutory income tax rate.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Net Sales. Our net sales were $514.8 million, with shipments of 1.4 million net tons for the year ended December 31, 1998, as compared to net sales of $420.1 million, with shipments of 1.2 million net tons for the year ended December 31, 1997, an increase in net sales of $94.7 million, or 23%. The increase in net sales is attributable to increased volumes of 212,000 tons, or 18%, and an increase in our average price per ton of $16, or 4%, for the year ended December 31, 1998 as compared to the same period in 1997.
Approximately 27% and 41% of our net sales for 1998 and 1997, respectively, were purchased by Heidtman Steel Products, Inc. (or affiliates) and Salzgitter AG (or affiliates).
Cost of Goods Sold. Cost of goods sold was $428.9 million for the year ended December 31, 1998, as compared to $330.5 million for the year ended December 31, 1997, an increase of $98.4 million, or 30%. This increase was attributable to increased volumes and an increase in steel scrap prices during the first three quarters of 1998. Our costs associated with steel scrap increased almost $3 per ton during the first three quarters of 1998, then decreased in the fourth quarter.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $20.6 million for the year ended December 31, 1998, as compared to $24.4 million for the year ended December 31, 1997, a decrease of $3.8 million, or 16%. This decrease was partially attributable to a decrease in start-up costs related to our expansion projects. Start-up costs related to our cold mill project, caster project and IDI were $5.8 million for the year ended December 31, 1998, as compared to $6.9 million for the year ended December 31, 1997, a decrease of $1.1 million. Our relationship with NSM also accounted for a $5.2 million nonrecurring reduction of 1998 expense. As a percentage of net sales, selling, general and administrative expenses represented approximately 4% and 6% for the years ended December 31, 1998 and 1997, respectively.
Interest Expense. Interest expense was $17.5 million for the year ended December 31, 1998, as compared to $7.7 million for the year ended December 31, 1997, an increase of $9.8 million, or 128%. This increase was the direct result of increased borrowings utilized to finance our past expansion projects, in conjunction with a $1.1 million decrease in related interest capitalization.
Other Income (Expense). Other income was $5.0 million for the year ended December 31, 1998, as compared to $1.9 million for the year ended December 31, 1997, an increase of $3.1 million, or 161%. This increase was primarily the result of $4.6 million in fees we received for nonrecurring services provided in connection with the NSM agreements.
Federal Income Taxes. Our federal income tax provision was $20.9 million for the year ended December 31, 1998, as compared to $7.8 million for the year ended December 31, 1997, an increase of $13.1 million. The tax provision for 1998 reflected income tax expense at the maximum statutory income tax rates, whereas the provision for 1997 reflects income tax expense at 13%, as a result of the reduction in our deferred tax valuation allowance.
Extraordinary Loss. During 1997 we incurred an extraordinary loss of approximately $7.6 million, net of tax benefit of approximately $5.1 million, in connection with an amendment to our credit agreement, which we entered into on June 30, 1994. Effective June 30, 1997, this agreement was amended to replace our existing $345.0 million credit facility with a new $450.0 million facility. The extraordinary loss consisted of prepayment penalties and the write off of the capitalized financing costs associated with our originally negotiated credit facility.
LIQUIDITY AND CAPITAL RESOURCES
Our business is capital intensive and requires substantial expenditures for, among other things the purchase and maintenance of equipment used in our steelmaking and finishing operations and to remain compliant with environmental laws. Our short-term and long-term liquidity needs arise primarily from capital expenditures, working capital requirements and principal and interest payments related to our outstanding indebtedness. We have met these liquidity requirements with cash provided by operations, equity, long-term borrowings, state and local grants and capital cost reimbursements.
For the year ended December 31, 1999, we received benefits from state and local governments in the form of real estate and personal property tax abatements resulting in a net income effect of approximately $3.5 million. Based on our current abatements, we estimate the remaining annual effect on future operations, net of income tax, to be approximately $3.3 million, $2.8 million, $2.6 million, $2.3 million, $1.9 million, $953,000, $474,000, $358,000, $137,000, for the years ended December 31, 2000 through 2008, respectively.
For the year ended December 31, 1999, cash provided by operating activities was $114.8 million, as compared to cash used in operating activities of $51.1 million for the year ended December 31, 1998, an increase of $165.9 million. Decreased inventory levels, which were the result of elevated 1998 raw material levels, primarily drove this increase. Cash used in investing activities was $126.3 million, of which $126.7 represented capital investments, for the year ended December 31, 1999, as compared to $197.0 million, of which $194.1 million represented capital investments, for the year ended December 31, 1998. Approximately 64% of our capital investment costs incurred during 1999 were utilized in site preparation and other pre-construction activities for the structural mill. Cash provided by financing activities was $22.9 million for the year ended December 31, 1999, as compared to $244.7 million for the year ended December 31, 1998. This decrease in funds provided was the direct result of our utilization of increased cash from operations in relation to our additional borrowings.
At December 31, 1999, our amended credit agreement consisted of a $450.0 million credit facility, comprised of a $250.0 million five-year revolving credit facility (which is subject to a borrowing base), and two $100.0 million five-year term loans amortizable in eight equal quarterly installments beginning September 30, 2002.
During the first half of 1999, we received approval from our bank group to loan an additional $25.0 million to IDI for costs related to both the facility's completion and repairs and improvements resulting from the submerged arc furnace breakout which occurred in May 1999. As of December 31, 1999, we had distributed these approved funds to IDI in their entirety.
IDI has a credit agreement with a group of banks, consisting of a $65.0 million credit facility, as last amended in the "Fifth Amendment and Waiver to Credit Agreement" dated March 29, 2000, comprised of a $10.0 million, three-year revolving credit facility, subject to a borrowing base, and a $55.0 million eight-year senior term loan facility.
We have other various financing arrangements totaling $56.1 million at December 31, 1999, which are composed of state government municipal bond issues, electric utility development loans and other equipment obligation loans.
We believe the liquidity of our existing cash and cash equivalents, cash from operating activities and our available credit facilities will provide sufficient funding for our working capital and capital expenditure requirements during 2000. However, we may, if we believe circumstances warrant, increase our liquidity through the issuance of additional equity or debt to finance growth or take advantage of other business opportunities.
We have not paid dividends on our common stock.
INFLATION
We believe that inflation has not had a material effect on our results of operation.
ENVIRONMENTAL AND OTHER CONTINGENCIES
We have incurred, and in the future will continue to incur, capital expenditures and operating expenses for matters relating to environmental control, remediation, monitoring and compliance. We believe, apart from our dependence on environmental construction and operating permits for our existing and proposed manufacturing facilities, such as our planned structural and rail mill project in Whitley County, Indiana, that compliance with current environmental laws and regulations is not likely to have a material adverse effect on our financial condition, results of operations or liquidity; however, environmental laws and regulations have changed rapidly in recent years and we may become subject to more stringent environmental laws and regulations in the future.
RECENT ACCOUNTING PRONOUNCEMENTS
Statement of Financial Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities," was originally issued in June 1998 and then was amended by SFAS No. 137 in June 1999. SFAS No. 137 deferred the effective date of SFAS No. 133 to all fiscal quarters of all fiscal years beginning after June 15, 2000. (See Note 1 in the Notes to the Consolidated Financial Statements for further discussion).
IMPACT OF YEAR 2000
We did not experience any material adverse issues or business interruptions arising from the date change to January 1, 2000. During 1999, we completed the process of preparing for Year 2000 issues. As a result of our efforts to date, we have not incurred any material costs and do not expect to incur any future material costs in addressing the Year 2000 issue related to either our products or our business and process control systems, operating equipment with embedded chips or software and third party interfaces.
We have devoted and will continue to devote the resources necessary to ensure that all Year 2000 issues, if any should arise, are properly addressed. However, there can be no assurance that all Year 2000 issues have been detected. Although considered unlikely, unanticipated problems in our mission critical operating systems, including problems associated with non-compliant third parties and disruptions to our customers and suppliers could still occur despite efforts to date.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
In the normal course of business our market risk is limited to changes in interest rates. We utilize long-term debt as a primary source of capital. A portion of our debt has an interest component that resets on a periodic basis to reflect current market conditions. The following table represents the principal cash repayments and related weighted average interest rates by maturity date for our long-term debt as of December 31, 1999 (in millions):
We manage exposure to fluctuations in interest rates through the use of an interest rate swap. We agree to exchange, at specific intervals, the difference between fixed rate and floating rate interest amounts calculated on an agreed upon notional amount. This interest differential paid or received is recognized in the consolidated statements of operations as a component of interest expense.
At December 31, 1999, we had an interest rate swap agreement with a notional amount of $100.0 million. We agreed to make fixed rate payments at 6.935%, for which we will receive LIBOR payments. The maturity date of the interest rate swap agreement is July 2, 2001. A counter party has the right to extend the maturity date to July 2, 2004 at pre-determined interest rates. The fair value of the interest rate swap agreement was estimated to be a liability of $2.0 million, which represents the amount we would have to pay to enter into an equivalent agreement at December 31, 1999.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Steel Dynamics, Inc.
We have audited the consolidated balance sheet of Steel Dynamics, Inc. as of December 31, 1999, and the related consolidated statements of income, stockholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 1999 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Steel Dynamics, Inc. at December 31, 1999 and the consolidated results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States.
/S/ Ernst & Young LLP Fort Wayne, Indiana January 26, 2000, except for Note 3, as to which the date is March 29, 2000
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Steel Dynamics, Inc.
We have audited the accompanying consolidated balance sheets of Steel Dynamics, Inc. (the "Company") as of December 31, 1998, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Steel Dynamics, Inc. as of December 31, 1998, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
/S/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP Indianapolis, Indiana February 1, 1999
STEEL DYNAMICS, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
See notes to consolidated financial statements.
STEEL DYNAMICS, INC. CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT SHARE DATA)
See notes to consolidated financial statements.
STEEL DYNAMICS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
See notes to consolidated financial statements.
STEEL DYNAMICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See notes to consolidated financial statements.
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. DESCRIPTION OF THE BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Steel Dynamics, Inc. (SDI), together with its subsidiaries (the company) is a domestic manufacturer of steel products with operations in the following businesses.
Steel Operations. The company's core business operates a technologically advanced flat rolled steel mini-mill in Butler, Indiana with an annual production capacity of 2.2 million tons of high quality flat rolled carbon steel products, including hot rolled, galvanized and cold rolled products. The company distributes these products directly to end-users and through steel service centers located primarily in the Midwestern United States. In addition to the Butler facility, the company is constructing a structural and rail mill in Whitley County, Indiana. The company plans to manufacture structural steel beams, pilings and rails for the construction and railroad markets in this facility.
Steel Scrap Substitute and Other Operations. The company's wholly owned subsidiary, Iron Dynamics, Inc. (IDI), produces direct reduced iron, which is then converted into liquid pig iron. Liquid pig iron is a high quality steel scrap substitute used in the company's flat rolled steel mini-mill. During preliminary start-up in 1999, it was determined that IDI would require design modifications to attain its fully intended operating functionality. These modifications are planned to occur during the second half of 2000, until which time IDI will operate at limited production levels. Other steel processing services related to the production of steel joists, trusses, girders, and roof and floor decking will operate through the company's consolidated subsidiary, New Millennium Building Systems, LLC (NMBS), which is currently under construction and is expected to begin production in the first half of 2000.
SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation. The consolidated financial statements of the company include the accounts of SDI and its subsidiaries after elimination of the significant intercompany accounts and transactions. Minority interest represents the minority shareholders' proportionate share in the equity or income of NMBS.
Use of Estimates. The financial statements are prepared in conformity with generally accepted accounting principles and, accordingly, include amounts that are based on management's estimates and assumptions that affect the amounts reported in the financial statements and in the notes thereto. Actual results could differ from these estimates.
Revenue Recognition. Revenues from sales and allowances for estimated costs associated with returns from these sales are recognized upon shipment.
Cash and Cash Equivalents. Cash and cash equivalents include all highly liquid investments with a maturity of three months or less at the date of acquisition. Restricted cash is held by trustees in debt service funds for the repayment of principal and interest related to the company's municipal bonds and for use in certain property, plant and equipment purchases related to the company's revenue bonds.
Derivative Financial Instruments. The company has limited involvement with derivative financial instruments and does not use them for trading purposes. In an effort to manage the company's exposure to fluctuations in interest related to certain debt facilities, the company employs an interest rate swap agreement. The cost associated with the interest rate swap agreement is recognized as interest expense over the term of the hedged obligation.
Inventories. Inventories are stated at lower of cost (principally standard cost which approximates actual cost on a first-in, first-out basis) or market. Inventory consisted of the following at December 31 (in thousands):
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property, Plant and Equipment. Property, plant and equipment are stated at cost, which includes capitalized interest on construction-in-progress and is reduced by proceeds received from state and local government grants and other capital cost reimbursements. Depreciation is provided utilizing the units-of-production method for manufacturing plant and equipment and the straight-line method for non-manufacturing equipment. The estimated useful lives of assets range from 12 to 30 years. Repairs and maintenance are expensed as incurred.
In accordance with the methodology described in FAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", the company reviews long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Impairment losses are recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amounts. The impairment loss is measured by comparing the fair value of the asset to its carrying amount.
Foreign Currency Transactions. Realized gains and losses from foreign currency transactions incurred for the purchase of equipment denominated in a foreign currency are recorded in results from operations.
Concentration of Credit Risk. Financial instruments that potentially subject the company to significant concentrations of credit risk principally consist of temporary cash investments and accounts receivable. The company places its temporary cash investments with high credit quality financial institutions and limits the amount of credit exposure from any one institution. Generally, the company does not require collateral or other security to support customer receivables.
Earnings Per Share. Diluted earnings per share amounts are based upon the weighted average number of common and common equivalent shares outstanding during the year. Common equivalent shares are excluded from the computation in periods in which they have an anti-dilutive effect. The difference between basic and diluted earnings per share, for the company, is solely attributable to stock options. For the years ended December 31, 1999, 1998 and 1997, options to purchase 767,000, 669,000 and 107,000 shares, respectively, were excluded from diluted earnings per share because they were anti-dilutive.
Reclassifications. Certain reclassifications have been made to prior year financial statements to conform to the 1999 presentation, including changes in segment information. These reclassifications had no effect on net income as previously reported.
New Accounting Pronouncements. Statement of Financial Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instrument and Hedging Activities," was issued in June 1998 and then was amended by SFAS No. 137 in June 1999. SFAS No. 137 deferred the effective date of SFAS No. 133 to all fiscal quarters of all fiscal years beginning after June 15, 2000. This statement establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a fair value hedge, a cash flow hedge, or a hedge of foreign currency exposure. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. Management has not yet quantified the effect, if any, of the new standard on the financial statements.
NOTE 2. PROPERTY, PLANT AND EQUIPMENT
The company's property, plant and equipment at December 31, consisted of the following (in thousands):
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. DEBT
The company's borrowings at December 31, consist of the following (in thousands):
SDI Senior Secured Financing. The company has a $450.0 million bank credit agreement (SDI bank credit facility) with a syndicate of financial institutions and certain other lenders. The SDI bank credit facility is comprised of:
- a $250.0 million five-year revolving facility (subject to a borrowing base), which will mature on June 30, 2002, subject to the company's option to extend this maturity date to June 30, 2003, and then further to June 30, 2004, dependent upon certain leverage ratio restrictions.
- two $100.0 million five-year term loan facilities, each payable in eight equal quarterly installments beginning September 30, 2002, with the final installments due June 30, 2004.
Borrowings under the SDI bank credit facility bear interest at floating rates. The weighted average interest rate was 7.0% and 7.3% for the year ended December 31, 1999 and 1998, respectively. The company entered into an interest rate swap agreement with a notional amount of $100.0 million pursuant to which the company has agreed to make fixed rate payments at 6.935% and will receive LIBOR payments. The maturity date of the interest rate swap agreement is July 2, 2001. The counterparty has the right to extend the maturity date to July 2, 2004 at predetermined interest rates. The SDI bank credit facility is secured by liens on substantially all of the company's assets (other than those permitted to be excluded in order to secure the financing for IDI).
As a result of substantial modifications to the SDI credit agreement during 1997, the company incurred an extraordinary loss of approximately $7.6 million (net of a tax benefit of approximately $5.1 million) related to prepayment penalties and the accelerated amortization of the capitalized financing costs associated with the originally negotiated credit facility.
IDI Senior Secured Financing. IDI has a $65.0 million bank credit agreement with a syndicate of financial institutions and certain other lenders. This $65.0 million facility, as last amended in the "Fifth Amendment and Waiver to Credit Agreement" dated March 29, 2000, is comprised of:
- a $10.0 million three-year revolving facility (subject to a borrowing base), which matures on May 31, 2001, at which time IDI, subject to meeting certain requirements, may convert the revolving credit facility to a term loan, payable in 19 equal quarterly installments beginning May 30, 2001, with the final installment due November 30, 2005.
- a $55.0 million eight-year term loan facility, which is payable in semi-annual installments beginning November 30, 2000, with the final installment due November 30, 2005.
Borrowings under the IDI $65.0 million credit agreement bear interest at floating rates. The weighted average interest rate was 7.3% for the years ended December 31, 1999 and 1998. The IDI bank credit agreement is secured by liens on substantially all of IDI's assets and is further supported by an off-take agreement with SDI for all of IDI's direct reduced iron production, which expires June 30, 2007.
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
State Government Municipal Bond Issues. In May 1995, the company entered into a bond purchase agreement with the Indiana Development Finance Authority, under which was issued $21.4 million of bonds to finance, among other things, the acquisition, construction and equipment for certain sewage works, improvements, waste and water system improvements and other related facilities located at the Butler, Indiana mini-mill. The bonds bear interest at 8.01%, with payments of principal and interest due monthly through final maturity in August 2015. Approximately $3.0 million and $3.1 million, as of December 31, 1999 and 1998, respectively, of the bond proceeds is held by the bond trustee in a debt service reserve fund and is recorded as restricted cash. At December 31, 1999 and 1998, a $22.0 million stand-by letter of credit relating to the municipal bonds was outstanding.
In November 1998, the company received $10.0 million from Whitley County, Indiana representing proceeds from solid waste and sewage disposal revenue bonds to be used to finance certain solid waste and sewage disposal facilities located at the planned Whitley County, Indiana structural and rail mill. The bonds bear interest at 7.25%, with interest payable semi-annually and principal payments commencing November 2003 through final maturity in November 2018. At December 31, 1999 and 1998, respectively, approximately $3.7 million and $9.8 million of the bond proceeds are held by the bond trustee in a debt service reserve fund and is recorded as restricted cash.
Electric Utility Development Loan. In June 1994, the company entered into a loan agreement with Indiana Michigan Power Company for approximately $13.0 million to finance the company's portion of the cost to construct a substation at the Butler, Indiana facility. The loan bears interest at 8.0%, with equal monthly principal and interest payments required in amounts sufficient to amortize the substation facility loan over a period of 15 years. The outstanding principal balance on the substation facility loan was $11.6 million and $12.2 million, as of December 31, 1999 and 1998, respectively.
In addition, the company entered into another loan agreement with Indiana Michigan Power Company for approximately $7.8 million to finance the company's portion of the cost to construct a transmission line and certain related facilities. The loan bears interest at 8.0%, with equal monthly principal and interest payments required in amounts sufficient to amortize the transmission facility loan over a period of 20 years. The outstanding principal balance on the transmission facility loan was $7.1 million and $7.3 million as of December 31, 1999 and 1998, respectively.
During 1998, IDI entered into an agreement with American Electric Power Financial Services to provide a $6.5 million eight-year loan. This electric utility loan is secured by on-site power distribution and related equipment. The related interest rate is tied to 90-day commercial paper rates with an option to establish a fixed interest rate based on an average of the interest rates applicable to one, three and five year U.S. Treasuries. The weighted average interest rate was 7.8% and 7.1% for the years ended December 31, 1999 and 1998, respectively. The outstanding principal balance on the on-site power distribution facility was $6.2 million and $5.1 million as of December 31, 1999 and 1998, respectively.
The above credit agreements contain customary representations and warranties and affirmative and negative covenants, including, among others, covenants relating to financial and compliance reporting, capital expenditures, restricted dividend payments, maintenance of certain financial ratios, incurrence of liens, sale or disposition of assets and incurrence of other debt.
Maturities of outstanding debt as of December 31, 1999 are as follows (in thousands):
The company capitalizes interest on construction-in-progress assets. For the years ended December 31, 1999, 1998 and 1997, total interest costs incurred were $35.4 million, $23.4 million and $15.8 million, respectively, of which $13.2 million, $7.0 million and $8.1 million, respectively, were capitalized. Cash paid for interest was $33.7 million, $24.6 million and $13.8 million for the years ended December 31, 1999, 1998 and 1997, respectively.
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4. INCOME TAXES
The company files a consolidated federal income tax return. Cash paid for taxes was $12.6 million, $17.5 million and $8.7 million for the years ended December 31, 1999, 1998 and 1997, respectively. Included in cash paid for taxes for the year ended December 31, 1998 was a $3.0 million foreign withholding tax payment, which was substantially utilized as an alternative minimum tax foreign tax credit on the company's federal income tax return for 1998. The current and deferred federal and state income tax expense for the years ended December 31, are as follows (in thousands):
At December 31, 1996, recorded deferred tax assets were offset by a valuation allowance of $15.8 million. Due to the company's profitability in 1997 and future projected profitability, the company reversed this valuation allowance resulting in a corresponding reduction in tax expense for 1997.
A reconciliation of the statutory tax rates to the actual effective tax rates for the years ended December 31, are as follows:
Significant components of the company's deferred tax assets and liabilities at December 31 are as follows (in thousands):
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The deferred tax assets and liabilities reflect the net tax effects of temporary differences that are derived from the cumulative taxable or deductible amounts recorded in the consolidated financial statements in years different from that of the income tax returns. As of December 31, 1999, the company had available net operating loss carryforwards of approximately $25.0 million for federal income tax purposes, which expire in 2011. Also as of December 31, 1999, the company had available foreign tax credit carryforwards of approximately $3.0 million for federal income tax purposes, which expire in 2003.
NOTE 5. COMMON STOCK
During 1997, the company raised approximately $29.6 million, net of expenses, in a secondary public equity offering by issuing 1,255,971 shares at a net offering price of $24 per share. The offering was consummated as a result of registration rights that were exercised by original shareholders. Existing shareholders sold 7,144,029 shares and the over-allotment was exercised by the underwriting group, which allowed existing shareholders to sell 369,000 additional shares.
In 1997, the board of directors also authorized the company to repurchase up to 5% of the company's common stock. At December 31, 1999, the company had acquired 1,294,100 shares of the company's common stock in open market purchases at an average price per share of approximately $15, of which 1,219,100 shares were purchased during 1998 and 75,000 shares were purchased during 1997. The repurchased shares represent approximately 2.6% of the company's total issued shares. No additional shares were repurchased during 1999.
NOTE 6. INCENTIVE STOCK OPTION PLANS
1994 and 1996 Incentive Stock Option Plans. The company has reserved 2,505,765 shares of Class A Common Stock for issuance upon exercise of options or grants under the 1994 Incentive Stock Option Plan (1994 Plan) and the 1996 Incentive Stock Option Plan (1996 Plan). The 1994 Plan was adopted for certain key employees who are responsible for management of the company. Options granted under the 1994 Plan vest two-thirds six months after the date of grant and one-third five years after the date of grant, with a maximum term of ten years. All the company's employees are eligible for the 1996 Plan, with the options vesting 100% six months after the date of grant, with a maximum term of five years. Both plans grant options to purchase the company's Class A Common Stock at an exercise price of at least 100% of fair market value on the date of grant.
The company's combined stock option activity for the 1994 Plan and the 1996 Plan is as follows:
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes certain information concerning the company's outstanding options as of December 31, 1999:
Officer and Manger Cash and Stock Bonus Plan. Officers and managers of the company are eligible to receive cash bonuses based on predetermined formulas designated in the Officer and Manager Cash and Stock Bonus Plan. In the event the cash portion of the bonus exceeds the predetermined maximum cash payout, the excess bonus is distributed as common stock of the company. Any common stock issued pursuant to this plan vests ratably over four years from the date of distribution. A total of 450,000 shares have been reserved under this plan and as of December 31, 1999, no shares have been issued.
The company has elected to follow Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for its stock options. Under APB No. 25, no compensation expense is recognized for the plans because the exercise price of the company's employee stock options equals the market price of the underlying stock on the date of grant. However, SFAS No. 123, "Accounting for Stock-Based Compensation", requires presentation of pro forma information as if the company had accounted for its employee stock options granted subsequent to December 31, 1994, under the fair value method. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the vesting period. Under the fair value method, the company's net income and earnings per share would have been as follows (in thousands):
The estimated weighted average fair value of the individual options granted during 1999, 1998 and 1997 was $6.97, $6.93, and $6.94, respectively, on the date of grant. The fair values at the date of grant were estimated using the Black-Scholes option-pricing model with the following assumptions: no-dividend-yield, risk-free interest rates from 5.5% to 7.1%, expected volatility from 30% to 53% and expected lives from one and one-half to eight years.
NOTE 7. COMMITMENTS AND CONTINGENCIES
The company has executed a raw material supply contract with OmniSource Corporation (OmniSource) for the purchase of steel scrap resources (see Note 8). Under the terms of the contract, OmniSource will locate and secure, at the lowest then-available market price, steel scrap for the company in grades and quantities sufficient for the company to meet substantially all of its production requirements. The initial term of the contract is through October 2001. The company retains the right to acquire scrap from other sources if certain business conditions are present.
The company has executed finished goods off-take contracts with Heidtman Steel Products (Heidtman) and Preussag AG (Preussag) (see Note 8). Under the terms of the contracts, the company retains the right to sell its hot-rolled coils in the open market; however, the company is required to sell, and Heidtman and Preussag are required to purchase, a minimum of 30,000 and 12,000 tons, respectively, each month at the then-current market price the company is charging for similar products. The company is required to provide Heidtman and Preussag with a volume discount for all tons purchased each month in which Heidtman and Preussag purchase the minimum tons from the company. The initial term of the contracts for Heidtman and Preussag are through December 2001.
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The company purchases its electricity pursuant to a contract, which extends through 2005. Under the contract the company is subject to a monthly minimum charge. At December 31, 1999, the company's fixed and determinable purchase obligations for electricity are $7.5 million annually through 2005.
IDI has executed long-term requirements based raw material supply and transportation contracts for iron ore and coal. Purchases under the iron ore, coal, rail transportation and vessel transportation contracts were $447,000, $268,000, $232,000 and $213,000, respectively, during 1999 and $3.3 million, $.3 million, $.3 million and $1.4 million during 1998, respectively.
The company has outstanding construction-related commitments of $69.8 million at December 31, 1999, related to the Structural Mill Project.
During March 1998, the company entered into a ten-year Reciprocal License and Technology Sharing Agreement (the License Agreement) with Nakornthai Strip Mill Public Co. Limited (NSM) to provide NSM with the right to use the company's technology in exchange for equity ownership in NSM. Concurrently, the company entered into a ten-year Management Advisory and Technical Assistance Agreement (the Technical Assistance Agreement) in exchange for an annual management fee. Effective December 31, 1998, the company terminated the License and Technical Assistance Agreements in accordance with the company's termination rights under the provisions of these agreements. During 1999, the company was named a defendant, together with NSM's investment bankers and others, in eight separate lawsuits in state or federal courts in California, New Jersey, Connecticut (a duplicative filing), Minnesota, New York and Illinois, by various note-holders who purchased some $240.0 million of high risk "junk bonds" issued by affiliates of NSM in a privately placed non-registered offering by NSM and its investment bankers pursuant to SEC Rule 144A. The plaintiffs generally seek reversionary damages based upon their allegations of both common law and statutory securities fraud and other related theories, but the company denies all liability to all plaintiffs in each of these cases. The company was neither an issuer, guarantor, underwriter or seller of any of the notes, nor did the company draft any of the offering material or render any pre-offering reports, evaluations or opinions regarding NSM's plans or operations. While the company believes that it has ample legal and factual defenses to these claims and while it does not believe that these lawsuits will have a material adverse effect on the company's consolidated financial position or future operating results, there can be no assurance as to the ultimate outcome with respect to such lawsuits.
NOTE 8. TRANSACTIONS WITH AFFILIATED COMPANIES
The company sells hot-rolled coils to Heidtman and affiliates of Preussag, and purchases steel scrap resources from OmniSource. Heidtman and OmniSource are stockholders of the company. Preussag was a stockholder of the company during 1997 and a portion of 1998. Transactions with these affiliated companies for the years ended December 31 are as follows (in millions):
NOTE 9. FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable and accounts payable approximate fair, because of the relatively short maturity of these instruments. The carrying value of long-term debt, including the current portion, approximates fair value due to interest being at variable rates. The fair value of the interest rate swap agreement was estimated to be a liability of $2.0 million and an asset of $9.3 million at December 31, 1999 and 1998, respectively. The fair values are estimated by the use of quoted market prices, estimates obtained from brokers, and other appropriate valuation techniques based on references available.
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10. RETIREMENT PLANS
The company sponsors a 401(k) retirement savings plan for eligible employees, which is a "qualified plan" for federal income tax purposes. There are no service requirements for employees to become eligible to participate in the retirement savings plan. Generally, employees may elect to contribute up to 8% of their eligible compensation on a pre-tax basis, and the company matches employee contributions in an amount based on the company's return on assets, with a minimum contribution of 5% and a maximum contribution of 50%, subject to certain applicable tax law limitations. Employees are immediately 100% vested with respect to their contributions and the company's matching contributions, which were $132,000, $165,000 and $65,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
The company also established a profit sharing plan for eligible employees, which is a "qualified plan" for federal income tax purposes. Employees are eligible to participant upon completion of thirty days of employment and are entitled to the company's contribution allocation, if that person has worked at least 1,000 hours during the plan year. Each year, the company allocates an amount equal to 5% of the company's pre-tax profits to a profit sharing pool, which is used to fund the profit sharing plan as well as a separate cash profit sharing bonus, which is paid to employees in March of the following year. The allocation between the profit sharing plan contribution and the cash bonus amount is determined by the board of directors each year. The amount allocated to the profit sharing plan is subject to a maximum legally established percentage of compensation paid to participants. The company's total expense for the plan was $3.5 million, $2.5 million and $3.1 million for the years ended December 31, 1999, 1998 and 1997, respectively.
NOTE 11. SEGMENT INFORMATION
The company has two operating segments: Steel Operations and Steel Scrap Substitute Operations. Steel Operations include all revenues from the flat rolled steel mini-mill facility, which produces and sells hot rolled, cold rolled and galvanized sheet steel; and also includes all start-up costs associated with the structural and rail mill, which will produce structural steel and rail products. Steel Scrap Substitute Operations include revenues from IDI, which will provide liquid pig iron to the company. In addition, Corporate and Eliminations include certain unallocated corporate accounts, such as SDI senior bank debt and certain other investments, which include the start-up operations of NMBS. The company's operations are primarily organized and managed by operating segment. The company evaluates performance and allocates resources based on operating profit or loss before income taxes. The accounting policies of the operating segments are consistent with those described in Note 1 to the financial statements. Intersegment sales and transfers are accounted for at standard prices and are eliminated in consolidation. Segment results for the years ended December 31 are as follows (in thousands):
STEEL DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During 1997, the company had only one reportable segment, Steel Operations. The external net sales of the company's steel operations include sales to non-U.S. companies of $8.5 million, $2.3 million and $25.1 million, for the years ended December 31, 1999, 1998 and 1997, respectively.
NOTE 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED, IN THOUSANDS)
Earnings per share are computed independently for each of the quarters presented. Therefore, the sum of the quarterly earnings per share may not equal the total for the year.
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The appointment of Ernst & Young LLP, as independent auditors to conduct the company's Annual Audit for the fiscal year ending December 31, 1999 was approved by stockholders at our 1999 Annual Meeting.
The 1997 and 1998 Annual Audits were conducted by Deloitte & Touche LLP. On April 19, 1999, however, Deloitte & Touche LLP was dismissed as the Company's independent auditors for the 1999 Annual Audit, and the dismissal was approved by the Audit Committee. The reports of Deloitte & Touche LLP for the past two fiscal years did not contain any adverse opinion or any disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles. Furthermore, in connection with the audits of the Company" financial statements for the two fiscal years ended December 31, 1997 and December 31, 1998 and during the interim period through April 19, 1999, there were no disagreements with Deloitte & Touche LLP on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure. The Company did not at any time during the foregoing period prior to Ernst & Young's engagement consult with that firm regarding the application of any accounting principles to any specified transaction, the type of audit opinion that might be rendered, or with respect to any matter that was either the subject of a disagreement with the Company's prior auditors or that would constitute a reportable event within the scope of Item 304(a) of SEC Regulation S-K.
Reference is made hereby to Exhibit 16 attached to the company's Report on Form 8K/A, dated April 26, 1999, the same being a letter dated April 27, 1999 from Deloitte & Touche LLP, addressed to the Commission, setting forth their agreement with the manner in what we characterized the dismissal, as well as acknowledging that the company had requested it to furnish the required letter. Said Exhibit 16 is hereby incorporated by reference from such Form 8K/A into this Report on Form 10-K.
ITEM 10:
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required to be furnished pursuant to this item will be set forth under the caption "Nominees (including all executive officers) for election of Directors and alternate Directors" in the 1999 Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year with the Securities and Exchange Commission, and is incorporated herein by reference.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION
The information required to be furnished pursuant to this item will be set forth under the caption "Executive Compensation" in the 1999 Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year with the Securities and Exchange Commission, and is incorporated herein by reference.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required to be furnished for this item will be provided under the caption "Security Ownership" of certain beneficial owners and management in the 1999 Proxy Statement, which will be filed not later than 120 days after the end of our fiscal year with the Securities and Exchange Commission, and is incorporated herein by reference.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For the years ended December 31, 1999, 1998 and 1997, we sold 402,000 tons, 333,000 tons and 378,000 tons, respectively, of our hot bands to Heidtman Steel Products, Inc. (and its affiliated companies) for $120.1 million, $109.0 million and $131.9 million, respectively. These sales were effected pursuant to a six-year "off-take" agreement that expires in 2001. John Bates, a member of our board of directors, is the President and Chief Executive Officer of Heidtman and owns a controlling interest in Keylock Investments Limited, one of our substantial stockholders. Under the "off-take" agreement, Heidtman is obligated to buy, and we are obligated to sell to Heidtman, at least 30,000 tons of our hot band products per month. Heidtman also has priority purchase rights to our secondary and field claim material. Our pricing to Heidtman is determined by reference to the lowest prices charged by other thin-slab mini-mills or conventional mills for the same products, and we cannot charge Heidtman higher prices than the lowest prices at which we offer our products to any other customer. In 1995, we sold approximately 32 unimproved acres of our plant site to Heidtman for $96,000, which was used by Heidtman for the construction of a steel service center.
Pursuant to a scrap purchasing agreement with OmniSource Corporation, we purchased an aggregate of 1.3 million tons, 1.2 million tons and 933,000 tons of steel scrap in 1999, 1998 and 1997, respectively. OmniSource was paid $154.3 million, $164.5 million and $128.3 million in 1999, 1998 and 1997, respectively. Leonard Rifkin is the Chairman of the Board of OmniSource and is a member of our board of directors. OmniSource is also one of our substantial stockholders as of December 31, 1999. Pursuant to the OmniSource scrap purchasing agreement, OmniSource acts as the exclusive scrap purchasing agent for our scrap, which may involve sales of OmniSource's own scrap, at the prevailing market prices which OmniSource can get for the same product, or it
may involve brokering of general market scrap, for which we pay whatever is the lowest market price for which OmniSource can purchase that product. OmniSource is paid a commission per gross ton of scrap received by us. In addition, OmniSource maintains a scrap handling facility, with its own equipment and staff, on our plant site. OmniSource does not pay rent for this facility.
Iron Dynamics has entered into a license agreement with Sumitomo Corporation of America, pursuant to which Sumitomo is authorized, on an exclusive world-wide basis, except for the U.S. and Canada, and except for additional plants that Iron Dynamics may wish to construct for its own use or for our use, to sublicense to others or to use certain proprietary know-how or other intellectual property that constitutes Iron Dynamics' scrap substitute manufacturing process and which may be developed by Iron Dynamics in connection with the manufacture of direct reduced iron or liquid pig iron. Such license rights provide that Sumitomo will build and construct plants for the production of Direct reduced iron and liquid pig iron either for itself or for others within the licensed territory, for which Iron Dynamics is entitled to receive a one-time license fee from Sumitomo, based on each plant's rated production capacity, plus a negotiated royalty fee for the use of any Iron Dynamics' or our patents or certain know-how or processes that are not included within the one-time fee license grant. Any underlying royalties or fees that might have to be paid to third parties by Iron Dynamics or us would be passed through to Sumitomo or to its sublicensees. Iron Dynamics has also agreed to afford Sumitomo an opportunity to provide various raw materials and equipment supplies to Iron Dynamics, on a competitive basis that is intended to secure for Iron Dynamics the lowest and best prices for such supplies and products. As of December 31, 1999, Sumitomo had not licensed or sublicensed any facilities. Iron Dynamics has also agreed to sell to or through Sumitomo up to 50% of any Direct reduced iron that Iron Dynamics may manufacture and which we do not retain for our own consumption. Such sales would be at the then prevailing market prices, either for Sumitomo's own account or on a sales commission basis for sales to third parties. We also have a "second-look" export sales agreement with Sumitomo and its parent, Sumitomo Corporation of Japan, under which it has certain rights to handle export sales that we do not effect through another designated party. As of December 31, 1999, we had not effected any export sales of any kind. Sumitomo Corporation of America and Sumitomo Corporation was a substantial stockholder as of December 31, 1999. Mr. Kazuhiro Atsushi, who is a Vice President and General Manager of the Chicago Office and a Deputy General Manager of the Rolled Steel & Ferrous Raw Materials Division of Sumitomo Corporation of America, is a member of our board of directors.
We believe that all of the transactions described above are on terms no less favorable to us than could be obtained from unaffiliated third parties.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of Securities Exchange Act of 1934, Steel Dynamics, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
March 24, 2000
STEEL DYNAMICS, INC.
By: /S/ KEITH E. BUSSE ------------------------- KEITH E. BUSSE PRESIDENT AND CHIEF EXECUTIVE OFFICER
POWER OF ATTORNEY
Each person whose signature appears below constitutes and appoints Keith E. Busse and Tracy L. Shellabarger, either of whom may act without the joinder of the other, as his true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for him, and in his name, place and stead, in any and all capacities to sign any and all amendments, and supplements to this 1999 Annual Report on Form 10-K, filed pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, and to file the same, with all exhibits thereto, and all other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents full power and authority to do and performs each and every act and thing requisite and necessary to be done, as full to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or their substitute or substitutes may lawfully do or cause to be done by virtue thereof.
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS 1999 ANNUAL REPORT ON FORM 10-K HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF STEEL DYNAMICS, INC. AND IN THE CAPACITIES AND ON THE DATES INDICATED.
PART IV
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a.) The following documents are filed as part of this Report: I. Financial Statements:
See the Audited Consolidated Financial Statements of Steel Dynamics Inc. attached hereto and described in the Index on page 44 of this Report.
II. Financial Statement Schedules: None
III. Exhibits:
Exhibit No.
3.1a Amended and Restated Articles of Incorporation of Steel Dynamics, Inc. Filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1, SEC File No. 333-12521, effective November 21, 1996 ("1996 Form S-1") and incorporated by reference herein.
3.1b Articles of Incorporation of Iron Dynamics, Inc. Filed as Exhibit 3.1b to Registrant's 1996 Annual Report on Form 10-K, SEC File No. 0-21719 ("1996 Form 10-K"), filed March 31, 1997, and incorporated by reference herein.
3.2a Bylaws of Steel Dynamics, Inc. Filed as Exhibit 3.2 to the Company's 1996 Form S-1 and incorporated by reference herein.
3.2b Bylaws of Iron Dynamics, Inc. Filed as Exhibit 3.1b to Registrant's 1996 Annual Report on Form 10-K, SEC File No. 0-21719 ("1996 Form 10-K"), filed March 31, 1997, and incorporated by reference herein.
*10.1a(1) Amended and Restated Credit Agreement between Steel Dynamics, Inc. and Mellon Bank, N.A., et al. dated May 4, 1998.
10.1b Credit Agreement between IDI and Mellon Bank, N.A., et al., dated December 31, 1997. Filed as Exhibit 10.1b to Registrant's 1997 Annual Report on Form 10-K, SEC File No. 0-21719 ("1997 Form 10-K") filed March 25, 1998, and incorporated by reference herein.
10.1b(1) Amended and Restated Credit Agreement between IDI and Mellon Bank, N.A., et al; dated June 10, 1998. Filed as Exhibit 10.1b(1) to Registrant's March 31, 1999 Form 10-Q, SEC file No. 0-21719 ("March 1999 Form 10-Q") filed May 7, 1999, and incorporated by reference herein.
10.1b(2) Second Amended and Restated Credit Agreement between IDI and Mellon Bank, N.A., et al; dated March 15, 1999. Filed as Exhibit 10.1b(2) to Registrant's March 31, 1999 Form 10-Q, SEC file No. 0-21719 ("March 1999 Form 10-Q") filed May 7, 1999, and incorporated by reference herein.
10.1b(3) Third Amendment and Waiver to Credit Agreement between IDI and Mellon Bank, N.A., et al; dated June 30, 1999. Filed as Exhibit 10.1b(3) to Registrant's June 30, 1999 Form 10-Q, SEC file No. 0-21719 ("June 1999 Form 10-Q") filed August 10, 1999, and incorporated by reference herein.
*10.1b(4) Fourth Amendment and Restated Credit Agreement between IDI and Mellon Bank, N.A., et al; dated December 21, 1999.
*10.1b(5) Fifth Amendment and Restated Credit Agreement between IDI and Mellon Bank, N.A., et al; dated March 29, 2000.
10.2 Loan Agreement between Indiana Development Finance Authority and Steel Dynamics, Inc. re Taxable Economic Development Revenue bonds, Trust Indenture between Indiana Development Finance Authority and NBD Bank, N.A., as Trustee re Loan Agreement between Indiana Development Finance Authority and Steel Dynamics, Inc. Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.3 Contract for electric Service between Steel Dynamics, Inc. and American Electric Power Company Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.4 Industrial Gases Supply Agreement between Steel Dynamics, Inc. and Air Products and Chemicals, Inc. dated August 5, 1994 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.5 Interruptible Gas Supply Contract between Steel Dynamics, Inc. and Northern Indiana Trading Co. dated February 27, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.6 Gas Services Agreement between Steel Dynamics, Inc. and Northern Indiana Fuel & Light Company, Inc. dated April 3, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.7 Gas Services Agreement between Steel Dynamics, Inc. and Northern Indiana Trading Co. dated April 3, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.8 Gas Services Agreement between Steel Dynamics, Inc. and Crossroads Pipeline Company dated April 3, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.9 Panhandle Eastern Pipeline Agreement dated July 22, 1996 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.10 Natural Gas Purchase Agreement between Steel Dynamics, Inc. and PanEnergy Trading and Market Services, Inc. dated August 8, 1996 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.11 Agreement for Wastewater Services between the City of Butler, Indiana and Steel Dynamics, Inc. dated September 5, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.12 Slag Processing Agreement between Steel Dynamics, Inc. and Butler Mill Service Company dated February 3, 1995
Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.13 Agreement to provide Scrap Purchasing Services between Steel Dynamics, Inc. and OmniSource Corporation dated October 29, Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.14 Purchasing Agreement between Steel Dynamics, Inc. and Heidtman Steel Products, Inc. dated October 29, 1993 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.15 Iron Carbide Off Take Agreement between Steel Dynamics, Inc. and Qualitech Steel Corporation dated June 29, 1996 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.16 Purchasing, Domestic Sales and Export Distribution Agreement between Steel Dynamics, Inc. and Preussag AG dated December 14, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.17 Reciprocal Patent and Technical Information Transfer and License Agreement between Steel Dynamics, Inc. and Preussag AG dated December 14, 1995 Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.18 1994 Incentive Stock Option Agreement, as needed Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.19 1996 Incentive Stock Option Agreement Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.20 Employment Agreement between Steel Dynamics, Inc. and Keith Busse Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.21 Employment Agreement between Steel Dynamics, Inc. and Mark D. Millett Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.22 Employment Agreement between Steel Dynamics, Inc. and Richard P. Teets, Jr. Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.23 1996 Officer and Manager Cash and Stock Bonus Plan Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.24 Employment Agreement between Steel Dynamics, Inc. and Tracy L. Shellabarger Tracy L. Shellabarger Promissory Note and Stock Pledge Agreement Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.25 "Second Look" Export Distribution Agreement between Steel Dynamics, Inc. and Sumitomo Corporation of America Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.26 Sale of Excess Product Agreement between Iron Dynamics, Inc. and Sumitomo Corporation of America Filed as the identically numbered exhibit to the Company's 1996 Form S-1 and incorporated by reference herein.
10.38 Employment Agreement between Iron Dynamics, Inc. and Larry Lehtinen. Filed as Exhibit 10.38 to the Registrant's 1996 Form 10-K and incorporated by reference herein.
10.39 License Agreement between Iron Dynamics, Inc. and Sumitomo Corporation and Sumitomo Corporation dated June 5, 1997. Filed as Exhibit 10.39 to Registrant's 1997 Form S-1 and incorporated by reference herein.
*21.1 List of Registrants' Subsidiaries
*23.1 Consent of Ernst & Young LLP
*23.1a Consent of Deloitte & Touche LLP
*24.1 Power of Attorney (included in Signature pages)
*27.1 Financial Data Schedule
*99.1 Risk Factors That May Affect Future Operations
- -------------
* Filed herewith | 37,810 | 242,017 |
1080099_1999.txt | 1080099_1999 | 1999 | 1080099 | ITEM 1. BUSINESS
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Complete Analytic Solution
Informatica delivers an integrated solution that automates key processes for system deployment and management, including the steps required for accessing ERP and other transaction systems. Our solution includes a data integration platform as well as a set of analytic applications that cover the following key business areas: Customer Relationship Management (CRM), Business Operations and Procurement. We believe this packaged, complete approach significantly reduces the cost and time associated with deployment and management.
Our packaged solutions help extend our customers' systems investment by protecting them from discontinuous changes in their technology environment related to obsolescence and upgrades in hardware, operating systems, networks and applications. Over the lifetime of a solution deployed using our platform and business analytic products, these benefits are compounded, because ongoing system modifications and project-scope expansions can be addressed with minimal requirements for custom programming and consulting.
Informatica's analytic solution is based on our data-integration infrastructure software. Informatica Applications(TM) provide an analytic solution for gaining real-time business insight across the entire eBusiness value chain. Because our data integration platform provides the foundation for the analytic applications, customers can focus on deploying and enhancing our analytic tools without worrying about data access issues. Our integrated approach and our rules-based software allows our customers with systems to adapt to business changes, such as those resulting from mergers and acquisitions, currency fluctuations and ongoing regulatory change.
Incremental Deployment; Rapid Return on Investment
Unlike traditional, hand-coded decision support systems that are expensive and time-intensive to deploy, and unlike analytic tools targeted to niche transactions systems, we believe our solution allows users to achieve a faster return on investment through incremental, business-unit-size deployments and the ability to build analytic data models on top of proven data integration technology. These successful deployments can then be extended across the enterprise via a data integration hub.
The integrated analytic application suites permit customers to deploy analytic products independently but leverage the functionality in subsequent deployments -- the key business information that would be embedded in one analytic suite could be cross-referenced in any subsequent analytic application deployment. Today's Business to Business (B2B) eBusiness market requires scalable and integrated solutions for helping companies gain insight into key relationships and related activities that can determine profitability across both traditional "brick and mortar" and online sales channels. Our analytic solution permits the Global 2000 companies to perform cross-channel data analysis and establish full value chain "cause-effect" analysis between customer sales, supplier efficiency, and corporate profitability.
Multi-level Scalability
Our analytic solution addresses decision support scalability on many levels. This includes scaling from an early-stage, data mart-based analytic application to an enterprise-wide analytic solution deployment enabling the large data volume, high throughput, and heterogeneous source systems requirements for robust enterprise-wide analytic computing. Taking advantage of distributed, parallel processing technologies, our platform is designed to significantly improve performance by allowing users to bring multiple clusters of servers to bear on large, complex analytic problems.
Architecture Openness and Extensibility
Our open architecture gives users seamless access to data locked in various transactional systems, and enables our customers to address many different types of analytical requirements. Informatica's products permit users to add customized functions to extend our pre-programmed general purpose functions to address
specific business problems. Our analytic applications provide a solution that utilizes data integration capabilities of the platform product set and permits end-user extension of our analytic models.
Deployment Flexibility
Our solution is designed to support a wide range of computing platforms and applications typically found in large organizations, and to collect data from transaction sources employing varying combinations of computer hardware and database software. Our rules-based transformation engine resolves the idiosyncrasies of different operating systems, hardware and database platforms. In addition, our high-performance, customized software drivers are designed to leverage the strengths and mitigate the weaknesses of different vendors' platforms. All of our products run on UNIX (HP-UX, IBM AIX, Sun Solaris) and Microsoft NT servers, use Windows 95, Windows 98, and Windows NT clients, and support all major relational databases, including Oracle, IBM DB2/UDB, Informix, Sybase, and Microsoft SQL Server.
PRODUCTS AND SERVICES
Our products enable large, global organizations to build the necessary infrastructure for deploying and managing business intelligence and analytic applications across the enterprise. Since the acquisition of Influence Software in December 1999, our complete analytic solution enables companies to deploy integration analytic applications that leverage our data integration infrastructure. These products are designed to reduce the complexities of deploying, maintaining, and designing the required analytic solutions and to enhance the quality and performance of information analysis. Informatica is providing a complete solution for our customers to deploy a total solution for business analysis.
Our solution enables enterprises to implement multi-tier decision support architecture that can be as sophisticated -- or as simple -- as necessary. We provide our customers with the capabilities to deploy a complete analytic solution encompassing proven data integration platform along with integrated analytic applications that span CRM, Business Operations, and Procurement. Our customers can deploy our complete suite of analytic applications to examine the impact of suppliers' on time delivery, in the eProcurement suite, on corporate profitability, in the eBusiness Operations, and the correlation to customer satisfaction, within the eCRM solution. Large enterprises can use PowerCenter(TM), for instance, to create a data integration hub that will synchronize and manage wide-ranging decision support resources. Other organizations can start small, through PowerMart,(R) by creating independent line-of-business data warehouses and analytic systems. Then, as business needs grow and change, they can add the synchronization and sophisticated management capabilities of PowerCenter.
The following table summarizes the key features and benefits of our products:
Infrastructure Software
Informatica Applications
PowerCenter
As part of our solution, PowerCenter serves as an enterprise data integration hub for deploying and managing scalable decision support systems. Within PowerCenter, a global repository functions as the central synchronization point, extracting data from diverse operational sources, including mainframe, relational database and popular enterprise resource planning applications. PowerCenter transforms and distributes that data downstream to data warehouses and data marts in preparation for end-user analysis. PowerCenter includes software to design and manage the global repository, to set up data extraction processes from operational databases and to synchronize data sharing among distributed analytic applications.
PowerCenter has a number of innovative and essential features that enable it to function effectively as an enterprise data integration hub. PowerCenter's robust native mainframe file support allows mainframe database files to be imported directly into the PowerCenter hub, eliminating the need for, and the added expense of, additional software. Parallel processing capabilities within this product allow users to roll-out multiple instances of PowerCenter's transformation engine to maximize system performance for the most complex data extractions and transformations. PowerCenter's systems management capabilities are designed to allow administrators to more efficiently manage, monitor and control multiple repositories and servers in the network from a central console.
PowerCenter.e
PowerCenter.e offers a set of unique capabilities that extend the reach of PowerCenter to address eBusiness market requirements. PowerCenter.e has been designed to enable Informatica's customers to leverage their investment in our data integration infrastructure for their emerging eBusiness applications.
In addition to the features and functionality that have established Informatica software as a platform of choice for business insight, Informatica PowerCenter.e offers a set of key features that effectively extend PowerCenter's reach to address the eBusiness market:
- Near real-time eBusiness analytics -- By adding support for IBM's MQSeries, the industry's most widely adopted messaging product, PowerCenter.e provides near real-time support for extraction and loading of data from a company's message queue infrastructure.
- Business-to-business data exchange through support for XML standard -- XML (Extensible Markup Language) is rapidly emerging as the de facto standard for data exchange over the Internet. Because XML data is a hierarchically structured data type, it has been difficult to incorporate into an enterprise decision support system. With PowerCenter.e, eBusinesses can import their XML data into a relational format while importing the metadata about that XML file into the data warehouse repository.
- Ability to read Web log data -- PowerCenter.e eases the process of retrieving data from Web logs by providing tools to import and consolidate Web logs, and transform proprietary Web-log formats into standard, readable structures. PowerCenter.e supports sourcing and parsing of data from today's three leading Web server products from Microsoft, Netscape and Apache.
- Demographic profiling of customers -- Acxiom's Data Network service enables companies to access the most comprehensive collection of data on U.S. consumers, businesses, properties and telephone information available via the Internet. PowerCenter.e provides eBusinesses with a direct connection to this network, helping them achieve a greater amount of insight into their online customers.
- Support for popular Web language -- The most widely used language implemented by Web developers today is Practical Extraction Report Language (PERL). PowerCenter.e lets companies embed PERL within Informatica's transformation logic, allowing the reuse of pre-defined PERL scripts.
PowerMart
PowerMart is an integrated product suite for building and managing line-of-business data marts and analytic applications. PowerMart can be used in conjunction with PowerCenter, or it can be employed to create independent, standalone data marts and data warehouses. PowerMart features integrated warehouse-design, repository-design and management components that share a common, intuitive graphical user interface. Through a variety of software wizards and other productivity-enhancing tools, PowerMart supports the full life-cycle for data mart/data warehouse deployment, development, production and ongoing management.
The PowerMart integrated product suite includes five standard components:
- PowerMart Designer is a powerful, multi-faceted tool for visually defining mappings and transformations;
- PowerMart Repository is an open metadata store for definitions about mappings, transformations and other data mart details;
- PowerMart Repository Manager is a facility for managing user activities and metadata storage in the repository;
- PowerMart Server is a pipelined, multi-threaded server engine that is able to overlap data extraction, transformation and loading and
- PowerMart Server Manager is an administrative interface to the PowerMart Server for configuring data marts and scheduling jobs.
PowerMart includes a number of key features that enable organizations to implement data marts and analytic applications for a fraction of the cost of a large, centralized data warehouse. For example, PowerMart gives users the option of combining disk staging with in-memory server-side caching to fully leverage system resources and achieve peak performance during any stage of data processing. PowerMart also provides a "Deploy Folder" wizard that guides developers through a step-by-step process for moving from test to
development to full production. In addition, advanced session management facilities help data warehouse administrators maintain operational efficiency.
Analytic Business Components for SAP R/3
Our Analytic Business Components are pre-defined templates that provide fully documented building blocks, which include mappings, mapplets, source objects, targets and transformations, that support the rapid and easy development of data marts and analytic applications. These building blocks insulate data warehouse designers from the complexities of the operational system, and greatly simplify the tasks of data mart construction.
Complete Data Integration
We also market and sell two additional software products which extend the capabilities of our data integration platform. PowerConnect for DB2 is a mainframe software bridge that facilitates access to IBM DB2 databases running on IBM MVS and OS/390 systems. PowerConnect for SAP R/3 and PowerConnect for PeopleSoft provide our customers with native access to the two Enterprise Resource Planning (ERP) software products. With PowerConnect, organizations get fast, transparent access to operational data regardless of whether it resides on a mainframe or inside of an enterprise resource planning application.
PowerPlugs(TM) are third-party software programs that add functionality via open application programming interfaces that permit exchange of metadata and data transformation information.
Pricing Model
We have a server-based pricing model in which PowerCenter and PowerMart are priced according to the capabilities of the server upon which they will be running. Informatica's analytic applications are packaged and sold as complete product suites. Our value-based pricing produces higher license fees from a customer who will be using our products on higher capacity servers and higher license fees from those customers who deploy multiple analytic application suites.
Technology Differentiators
The following key technologies differentiate our products from other industry offerings, and we believe they are critical to deploying and managing systems that enable more effective business decision making:
- COMPLETE, INTEGRATED ANALYTICS -- The power of our analytic applications is that all data models are fully integrated and permit extensive "cause-effect" analysis and cross-channel business evaluations. The analytic applications are integrated at the analytic model and presentation layer as well as through our data integration platform and by reliance and utilization of Analytic Business Components.
- METADATA-BASED ARCHITECTURE -- Metadata is "data about data," in that it describes the business rules and cataloging information needed for the decision support applications to function. It also enables users to understand the context and meaning of data that they are analyzing. Through the global repository, PowerCenter permits synchronization and sharing of metadata among distributed repositories that are located in various enterprise departments and are used for different decision support applications. The global repository employs a system of shared folders and hotlinked pointers, available to all registered local repositories, to enable sharing of public metadata and specific data transformations.
For example, the enterprise customer may define certain key values, such as "customer" or "revenue," for use throughout all analytic applications. By keeping these values in shared folders, the system ensures that users throughout the enterprise will be working with consistent data definitions. Through the system of hotlinked pointers, shared information is automatically kept up to date.
Our products also feature open, distributed metadata exchange with other decision support products, such as back-end data modeling tools, front-end query and reporting tools and analytic applications. This contributes greatly to interoperability, quality of analysis and scalability.
- NATIVE CONNECTIVITY TO OPERATIONAL SOURCES -- We are an industry leader in source-database access capabilities. Through PowerCenter and PowerMart, users can access UNIX and Windows NT databases, IBM DB2 databases and leading enterprise resource planning systems. For instance, PowerCenter extends the effectiveness of SAP Business Information Warehouse(TM) by giving users access to all non-SAP data throughout their enterprise. In addition, PowerMart provides a similar capability to users of PeopleSoft's Enterprise Performance Management suite, giving users access to both PeopleSoft and non-PeopleSoft operational data.
- CENTRALIZED MANAGEMENT -- Architectures that enable more effective business decision making require the power of distributed, parallel servers combined with the convenience of centralized management. PowerCenter supports multiple parallel servers and provides a single interface for configuring and monitoring them. Additionally, PowerCenter provides a single interface for viewing and configuring metadata in the PowerCenter repository and any local, registered repositories.
- ENGINE-BASED PERFORMANCE -- The heart of our solution is a high-end performance server, or engine, that automates data movement and transformation. The server employs advanced techniques, such as parallel, overlapped operations, to give users the high-performance data throughput required for enterprise-class implementations. Our platform's engine-based high performance allows users to construct analytic applications and perform analyses according to their real business needs, without having to hand-code transformations or continually modify their objectives because of technology limitations.
Services
We offer comprehensive professional services in implementation consulting, as well as in customer support and training. As of December 31, 1999, we employed 77 people worldwide in services related activities.
Our professional services range from designing and deploying architectures that enable more effective business decision making to data transformation and performance tuning. Our professional services consultants possess expertise in databases and operating systems, enterprise resource systems, business process design and management and major vertical industry issues.
We offer high-quality, timely technical support to customers via phone, e-mail and the Internet. We also publish a comprehensive web-based journal on infrastructure issues, with technical detail that expands on existing documentation and presents implementation options. Additionally, we publish online versions of manuals, release notes and updates to existing documentation.
We provide a number of customer training programs in the United States and Europe. Courses cover topics such as designing target data tables, analyzing operational sources, tuning and troubleshooting and understanding systems used to support business decision making.
STRATEGIC PARTNERS
Our partners include industry leaders in enterprise software, query/analysis applications and systems integration. We pursue a comprehensive partnership program with major vendors in these areas so that they can provide complementary products and services to our joint customers with effective best-of-breed enterprise solutions. Our partnership program is called the PowerPartner Program, and our strategic partners include:
eBusiness Platform Partners
Ariba Broadvision InterWorld Kana Communications
Enterprise Software Partners
BMC Software NEON Systems IBM PeopleSoft Microsoft SAP
Query/Analysis Partners
Brio Technology Business Objects Hyperion Solutions Cognos MicroStrategy
Systems Integration Partners
American Management Systems Application Consulting Group Application Partners Apex Solutions Andersen Consulting Archer Decision Sciences Active Interest Advanced Paradigm Solutions Advisa Group Braun Technology Group BTG Technology Systems C3i Systems Integration Partners (continued)
Cambridge Technology Partners Case Logical Data Cap Gemini Clark Information Systems Client Server Associates Connect Systems Core Integration Partners Cotelligent CSC Ploenzke Daman Consulting Descartes Systems Group DEC Deloitte Touche DMR Consulting DSS Solution EDS Epsilon Encompass Business Solutions Gamut Technologies Geac Computers Grace Technologies Infocrest Solutions IPI GrammTech Knightsbridge Solutions KnowledgeBase Marketing KPMG Lancet Software Development LGS Group Logan/Britton Metamor Migration Software Systems Integration Partners (continued)
NetBase Computing New Technology Management Newport Technology Group NexGen SI Octet Consulting Parallogic Perot Systems PricewaterhouseCoopers Profound Solutions Retail Dynamics Inc. The Revere Group REZsolutions R&Z Software Saphir Saturn Business Systems Siemens Nixdorf Softmaster Software House International Softworks Consulting Solution Builders SQLiason Strategic Technologies Strategic Information Systems Sybertech Sysix Technologies Talent Software Services Tessera Enterprise Systems WebSoft Xenon Yaletown Technology ZYGA
CUSTOMERS
Our customers represent a wide, cross-industry spectrum of large global organizations, plus major governmental and educational institutions. A representative sampling of customers who have purchased at least $100,000 of software license since January 1996 includes:
Communications AirTouch Cellular* AT&T Corp.* Lucent Technologies* Pacific Bell Directory Qualcomm* Sprint Tele-Communications, Inc.* (TCI) Telenor*
Government Bureau of Land Management State of Texas U.S. Navy* US Postal Service*
Financial Services The Capital Group Companies* Charles Schwab SG Cowen* First Union National Bank* GM Acceptance Corp.* Invesco Funds Group Merrill Lynch* Oppenheimer Funds* J.P. Morgan* Providian Financial* Prudential Insurance* Salomon Smith Barney* Stein, Roe & Farnham UBS
High Technology 3Com* Autodesk* Automatic Data Processing* LSI Logic* Gateway* National Semiconductor Silicon Graphics* Internet Software-Service CompuServe e.spire Priceline.com* Netcentives Inktomi* C/NET StoreRunner.com Netscape* UUNET*
Insurance Abbey National* Allstate Insurance* The Equitable Companies* Hartford Insurance* John Hancock* Liberty Mutual Insurance Companies* MassMutual* MetLife Insurance* Mutual of Omaha* Zurich Insurance*
Utilities/Energy Commonwealth Edison Company* Chevron Corporation Entergy Services/Entergy Corporation* KN Energy* Philadelphia Power and Light* Southern Company Manufacturing/Distribution ABB* Avery-Dennison* Boeing* General Electric* Honeywell Lockheed Martin* Motorola* Thomson Publishing Toyota USA*
Media/Entertainment/ Hospitality Carlson Wagonlit Travel* Fox Entertainment Group* Hearst Corporation* Ultramar Diamond Shamrock* Warner Brothers* Yorkshire Cable
Pharmaceuticals/Health Care Amgen* American Home Products Corporation* Blue Cross Blue Shield* Dura Pharmaceuticals Genentech MedData Health Pharmacia & Upjohn* Zeneca (ICI)*
Retail/Consumer Packaged Goods Campbell Soup Dial* First Brands Benjamin Moore Long's Drug Stores* The Gap* Liz Claiborne Polo Ralph Lauren*
Transportation BAX Global* Roadway Express Ryder
Other Stanford University*
* Over $200,000 since January 1996.
RESEARCH AND DEVELOPMENT
As of December 31, 1999, we employed 74 people in our research and development organization. This team is responsible for the design, development and release of our products. The group is organized into four disciplines: development, quality assurance, documentation and program management. Members from each discipline, along with a product marketing manager from our marketing department, form separate product teams that work closely with sales, marketing, services, customers and prospects to better understand market needs and user requirements.
When appropriate, we also utilize third-parties to expand the capacity and technical expertise of our internal research and development team. On occasion, we have licensed third-party technology. We believe this approach shortens time to market without compromising competitive position or product quality, and we plan to continue to draw on third-party resources as needed in the future.
We have a well-defined software development methodology that we believe enables us to deliver products that satisfy real business needs for the global market while also meeting commercial quality expectations. Our methodology involves specifying and reviewing business requirements, functional requirements, prototypes, technical designs, test plans and documentation plans. We then perform iterative, scheduled quality assurance of code and documentation, followed by frequent stabilization of code and documentation. We test automation definition, instrumentation and execution as well as functions, components, systems, integration, performance, stress and international and Year 2000 compliance. A key component of our methodology is full product regression testing before beta or general availability releases and trial deployments in an internal production environment prior to release, external beta releases and general availability release. Failure to develop and introduce new products, or enhancements to existing products, in a timely manner in response to changing market conditions or customer requirements, may materially adversely affect our business, results of operations and financial condition.
We emphasize quality assurance throughout the software development life-cycle. We believe that a strong emphasis placed on analysis and design early in the project life reduces the number and costs of defects that may be found in later stages.
SALES, MARKETING AND DISTRIBUTION
We market and sell software and services through a direct sales force in the United States, the United Kingdom and Germany, as well as through distributors. As of December 31, 1999, we employed 145 people worldwide in our sales and marketing organization.
Marketing programs are focused on creating awareness as well as lead generation and customer references for our products. These programs are targeted at key executives such as chief executive officers, chief information officers and presidents of engineering, research and development, sales, service and marketing. Our marketing personnel engage in a variety of activities, including positioning our software products and services, conducting public relations programs, establishing and maintaining relationships with industry analysts and generating qualified sales leads, among others.
Our sales process consists of several phases: lead generation, initial contact, lead qualification, needs assessment, enterprise overview, product demonstration, proposal generation and contract negotiation. Although the typical sales cycle has been up to 120 days, certain sales cycles in the past have lasted substantially longer. In a number of instances, our relationships with systems integrators and other strategic partners have reduced sales cycles by generating qualified sales leads, making initial customer contacts and assessing needs prior to our introduction to the customer. Also, partners have assisted in the creation of presentations and demonstrations, which we believe enhances our competitive position.
We distribute our products through system integrators in the United States and distributors in Europe. Systems integrators typically possess expertise in vertical markets. They resell our products, bundling them in some cases with system-wide solutions. In other cases, they influence direct sales of our products. Distributors sublicense our products and provide service and support within their territories.
INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS
Our success depends upon our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret rights, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights. We have three patent applications pending and two patent applications allowed in the United States. It is possible that our pending applications will not be allowed or that competitors will successfully challenge the validity or scope of our allowed patent or any future allowed patents. Our patents alone may not provide us with any significant competitive advantage.
As part of our confidentiality procedures, we generally enter into non-disclosure agreements with our employees, distributors and corporate partners and into license agreements with respect to our software, documentation and other proprietary information. Despite these precautions, third parties could copy or otherwise obtain and use our products or technology without authorization, or develop similar technology independently. It is difficult for us to police unauthorized use of our products, and, although we are unable to determine the extent to which piracy of our software products exists, software piracy is a prevalent problem in our industry in general. Effective protection of intellectual property rights is unavailable or limited in certain foreign countries. The protection of our proprietary rights may be inadequate and our competitors could independently develop similar technology, duplicate our products or design around any patents or other intellectual property rights we hold.
As is common in the software industry, we may from time to time receive notices from third parties claiming infringement by our products of third-party patent and other proprietary rights. On April 7, 1999, we were notified by another company that it is evaluating our products to determine whether our products infringe its U.S. patent and has requested that we enter into discussions with them as to whether it is necessary or appropriate for us to obtain a license. Although this company has not filed litigation against us, this company has filed litigation against one of our competitors, alleging infringement of its patent. Third parties, including the company that has contacted us regarding our products, could claim that our current or future products infringe their patent or other proprietary rights. Any claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements, any of which could have a material adverse effect upon our business, financial condition and operating results. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, or at all. Legal action claiming patent infringement could be commenced against us, and we may not prevail in such litigation given the complex technical issues and inherent uncertainties in patent litigation. Moreover, the cost of defending patent litigation could be substantial, regardless of the outcome. In the event a patent claim against us was successful and we could not obtain a license on acceptable terms or license a substitute technology or redesign to avoid infringement, our business, financial condition and operating results would be materially adversely affected.
COMPETITION
The market for our products is highly competitive, rapidly evolving and subject to rapidly changing technology. We compete principally against providers of decision support, data warehousing and enterprise application software. Such competitors include Acta Technology, Inc., Informix Corporation, Broadbase Information Systems, Inc., E.piphany, Inc., Information Builders, Inc., and Sagent Technology, Inc. In addition, we compete or may compete against database vendors that currently offer, or may develop, products with functionalities that compete with our solutions. These products typically operate specifically with these competitors' proprietary databases. Such competitors include IBM Corporation, Microsoft Corporation and Oracle Corporation.
Many of our competitors have longer operating histories, substantially greater financial, technical, marketing or other resources, or greater name recognition than we do. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Competition could seriously impede our ability to sell additional products and services on terms favorable to us. Our current and potential competitors may develop and market new technologies that render our existing or future products obsolete, unmarketable or less competitive. We currently compete more on the basis of our
products' functionality than on the basis of price. If our competitors develop similar or superior functionality, we may have difficulty competing more substantially on the basis of price. Our current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with other solution providers, thereby increasing the ability of their products to address the needs of our prospective customers. Our current and potential competitors may establish or strengthen cooperative relationships with our current or future channel or strategic partners, thereby limiting our ability to sell products through these channels. Competitive pressures could reduce our market share or require us to reduce our prices, either of which could materially and adversely affect our business, results of operations or financial condition.
We compete on the basis of certain factors, including:
- product performance;
- product features;
- user scalability;
- open architecture;
- ease of use;
- product reliability;
- analytical capabilities;
- time to market;
- customer support and
- product pricing.
EMPLOYEES
As of December 31, 1999, we had a total of 332 employees, including 74 people in research and development, 145 people in sales and marketing, 77 people in consulting, customer support and training and 36 people in general and administrative services. None of our employees is represented by a labor union, and we consider employee relations to be good.
ITEM 2.
ITEM 2. PROPERTIES
Our headquarters are located in Palo Alto, California and consist of approximately 60,000 square feet of office space leased through January 2001. We signed a new lease and plan to occupy additional office space in June 2000 in a building near our headquarters which consists of approximately 30,000 square feet of office space and is leased through June 2007. To help meet our future expansion needs, we recently signed leases for two buildings in Redwood City, California which will become our new corporate headquarters in July 2001. These buildings are leased through 2013 and consist of approximately 286,000 square feet of office space.
The Company leases approximately 19,000 square feet of office space in San Francisco, California primarily for sales, marketing and professional services activities. This facility is leased through November 2006.
We also lease other office space in the United States and other various countries under operating leases.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Not applicable.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 1999.
EXECUTIVE OFFICERS AND DIRECTORS
The following table sets forth certain information concerning our executive officers and directors as of March 31, 2000:
- --------------- (1) Member of audit committee.
(2) Member of compensation committee.
Mr. Dhillon is one of the founders of Informatica and has been our Chief Executive Officer, our Secretary and a member of our board of directors since our inception. Prior to co-founding Informatica in February 1993, Mr. Dhillon was employed by Sterling Software, a software company, from December 1991 to November 1992, where his last position was project manager. Prior to that, he was a systems architect with Unisys Corporation. Mr. Dhillon holds a B.S.E.E. from Punjab University, India.
Mr. Nesamoney is also one of the founders of Informatica and has been a member of our board of directors and an officer since our inception. He is currently our Chief Operating Officer. Prior to co-founding Informatica in February 1993, Mr. Nesamoney was employed by Unisys Corporation from May 1988 to February 1993, where his last position was a development manager. Mr. Nesamoney holds an M.S.C.S. degree from Birla Institute of Technology & Science.
Mr. Harrison joined us in January 1996 as Senior Vice President, Sales and became Executive Vice President, Worldwide Sales in January 1999. Mr. Harrison held sales management responsibility at Oracle Systems from June 1995 to January 1996. From September 1989 to June 1995, he was Regional Vice President of Sales at Information Resources, an enterprise decision support software company. Mr. Harrison holds a B.S. degree in Operational Research and Economics from Aston University in England.
Mr. Fry has been our Chief Financial Officer and a Senior Vice President since December 1999. From November 1995 to November 1999, Mr. Fry was Vice President and Chief Financial Officer at Omnicell.com. From July 1994 to November 1995, he was Vice President and Chief Financial Officer at C*ATS Software, Inc. Mr. Fry holds a B.A. degree in Business Administration from the University of Hawaii and an M.B.A. degree in Finance and Marketing from Stanford University.
Mr. Pidwell has been one of our directors since February 1996. From January 1988 to January 1996, Mr. Pidwell was President and Chief Executive Officer of Rasna Corporation, a software company. Mr. Pidwell is currently a venture partner with Asset Management Associates and serves on the boards of directors of a number of private companies. Mr. Pidwell holds a B.S.E.E. in Electrical Engineering and an M.S.I.S.E. degree in Computer Systems Engineering from Ohio University.
Mr. Seawell has been one of our directors since December 1997. From January 1997 to August 1998, Mr. Seawell was Executive Vice President of NetDynamics, an internet applications server company. From March 1991 to January 1997, Mr. Seawell was Senior Vice President and Chief Financial Officer of Synopsys. Mr. Seawell holds a B.A. degree in Economics and an M.B.A. degree in Finance and Accounting from Stanford University. Mr. Seawell serves on the board of directors of NVIDIA Corporation, a 3D (three-dimensional) graphics processor company, and several privately held companies.
Mr. Worms has been one of our directors since September 1995. From 1982 to the present, Mr. Worms has served as Co-President of Partech International Capital Management, a venture capital firm that manages one of our investors. Mr. Worms holds an M.S. degree in Science from the Ecole Polytechnique in Paris, France and the Massachusetts Institute of Technology. Mr. Worms serves on the boards of directors of SangStat Medical Corporation and Business Objects, a software company, in addition to serving on the board of a number of private companies.
There are no family relationships among any of our directors or officers.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is quoted on the Nasdaq National Market under the symbol "INFA." The following table sets forth, for the periods indicated, the high and low sales prices of the common stock as reported by the Nasdaq National Market since the Company's initial public offering of common stock at $8.00 per share on April 29, 1999. Prior to April 29, 1999, there was no public trading market for the common stock.
As of December 31, 1999, there were approximately 223 stockholders of record. The last reported sale price per share of the Company's common stock on December 31, 1999 on the Nasdaq National Market was $53.19.
The above information has been restated to reflect a two-for-one stock split effected in the form of a stock dividend to each stockholder of record as of February 18, 2000.
The Company has not paid cash dividends on its common stock and does not plan to pay cash dividends in the near future.
In April 1999, the Company completed the initial public offering of its common stock and realized net proceeds from the offering of approximately $43.5 million. The proceeds from this offering have and will continue to be used for general corporate purchases, including working capital.
On December 15, 1999 and in connection with the acquisition of all of the outstanding capital stock of Influence Software, Inc. (Influence), the Company issued 1,299,084 shares of unregistered common stock to the former stockholders of Influence. As of February 29, 2000, the Company also issued an additional 63,746 shares of unregistered common stock related to the exercise of Influence stock options.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA(1)
- --------------- See Note 1 of Notes to Consolidated Financial Statements for an explanation of the determination of the number of shares used to compute basic and diluted net loss per share.
(1) Amounts and per share data for all periods presented have been retroactively restated to reflect the merger of Influence in a pooling-of-interests transaction effective December 15, 1999.
(2) Amounts have been restated to reflect a two-for-one stock split, effected in the form of a stock dividend to each stockholder of record as of February 18, 2000.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. All statements other than statements of historical fact are "forward-looking statements" for purposes of these provisions, including any statements referencing revenues and operating expenses as a percentage of total revenues; expected hiring of additional sales and marketing personnel; the sufficiency of our cash balances and cash flows for the next twelve months; the impact of recent changes in accounting standards; costs, liabilities, exposure, and plans related to the Year 2000 problem; our ability to mitigate risks associated with the Year 2000 problem; and assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as "may," "will," "expects," "intends," "plans," "anticipates," "estimates," "potential," or "continue," or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, these expectations or any of the forward-looking statements could prove to be incorrect, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to risks and uncertainties, including but not limited to the factors set forth below and in Item 7A
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
MARKET RISK
The following discusses our exposure to market risk related to changes in interest rates, foreign currency exchange rates and equity prices. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in "Factors That May Affect Future Results".
INTEREST RATE RISK
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. Our investments consist primarily of commercial paper. Due to the nature of our investments, we believe that there is no material risk exposure. All investments are carried at market value, which approximates cost.
FOREIGN CURRENCY RISK
We develop products in the United States and market our products in North and South America, Europe and the Asia-Pacific region. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. As our sales are primarily in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets.
FACTORS THAT MAY AFFECT FUTURE RESULTS
In addition to the other information contained in this Form 10-K, we have identified the following risks and uncertainties that may have a material adverse affect on our business, financial condition or results of operation. This section should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in this Form 10-K.
THE EXPECTED FLUCTUATION OF OUR QUARTERLY RESULTS COULD CAUSE OUR STOCK PRICE TO EXPERIENCE SIGNIFICANT FLUCTUATIONS OR DECLINES
Our quarterly operating results have fluctuated in the past and are likely to do so in the future. These fluctuations could cause our stock price to also significantly fluctuate or experience declines. Some of the factors which could cause our operating results to fluctuate include:
- the size and timing of customer orders, which can be affected by customer order deferrals in anticipation of future new product introductions or product enhancements and customer budgeting and purchasing cycles;
- market acceptance of our products;
- the length and variability of our sales cycle for our products;
- introduction or enhancement of our products or our competitors' products and changes in our or our competitors' pricing policies;
- our ability to develop, introduce and market new products on a timely basis;
- the mix of our products and services sold and the mix of distribution channels utilized;
- our success in expanding our sales and marketing programs;
- technological changes in computer systems and environments and
- general economic conditions, which may affect our customers' capital investment levels.
Our product revenues are not predictable with any significant degree of certainty. Historically, we have recognized a substantial portion of our revenues in the last month of the quarter. If customers cancel or delay orders, it can have a material adverse impact on our revenues and results of operations for the quarter. To the extent any such cancellations or delays are for large orders, this impact will be greater. To the extent that the average size of our orders increases, customers' cancellations or delays of orders will more likely have a material adverse impact on our revenues and results of operations.
Our quarterly product license revenues are difficult to forecast because we historically have not had a substantial backlog of orders, and therefore revenues in each quarter are substantially dependent on orders
booked and shipped in that quarter. Our product license revenues are also difficult to forecast because the market for our products is rapidly evolving, and our sales cycles, which may last many months, vary substantially from customer to customer and vary in general due to a number of factors over which we have little or no control. Nonetheless, our short-term expense levels are relatively fixed and based, in part, on our expectations of future revenues. The difficulty we have in predicting our quarterly revenue means revenues shortfalls are likely to occur at some time, and our inability to adequately reduce short-term expenses means such shortfalls will affect not only our revenue, but also our overall business, results of operations and financial conditions.
Due to the uncertainty surrounding our revenues and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. While we achieved significant quarter-to-quarter revenue growth in 1997, 1998 and 1999, you should not take these recent quarterly results to be indicative of our future performance. We do not expect to sustain this same rate of sequential quarterly revenue growth in future periods. Moreover, it is likely that in some future quarter, our operating results will fall below the expectations of stock analysts and investors. If this happens, the price of our common stock may fall.
IF THE MARKET IN WHICH WE SELL OUR PRODUCTS AND SERVICES DOES NOT GROW AS WE ANTICIPATE, IT WILL ADVERSELY AFFECT OUR REVENUES
The market for software solutions, including analytic applications, that enable more effective business decision making by helping companies aggregate and utilize data stored throughout an organization is relatively new and still emerging. Substantially all of our revenues are attributable to the sale of products and services in this market. If this market does not grow at the rate we anticipate, our business, results of operations and financial condition will be adversely affected. One of the reasons this market might not grow as we anticipate is that many companies are not yet fully aware of the benefits of using these software solutions to help make business decisions or the benefits of our specific product solutions. As a result, we believe large companies to date have deployed these software solutions to make business decisions on a relatively limited basis. Although we have devoted and intend to continue to devote significant resources promoting market awareness of the benefits of these solutions, our efforts may be unsuccessful or insufficient.
WE EXPECT SEASONAL TRENDS TO CAUSE OUR QUARTERLY REVENUES TO FLUCTUATE
We have experienced, and expect to continue to experience, seasonality with respect to product license revenues. In recent years, there has been a relatively greater demand for our products in the fourth quarter than in each of the first three quarters of the year, particularly the first quarter. As a result, we have historically experienced relatively higher bookings in the fourth quarter and relatively lighter bookings in the first quarter. While some of this effect can be attributed to the rapid growth of revenues in recent years, we believe that these fluctuations are caused by customer buying patterns (often influenced by year-end budgetary pressures) and the efforts of our direct sales force to meet or exceed year-end sales quotas. In addition, European sales may tend to be relatively lower during the summer months than during other periods. We expect that seasonal trends will continue for the foreseeable future. This seasonal impact may increase as we continue to focus our sales efforts on large corporations.
We were incorporated in 1993 and therefore have a limited operating history upon which investors can evaluate our operations, products and prospects. We have incurred significant net losses since our inception, and it is possible we may not achieve profitability. We incurred net losses of $1.5 million, $9.3 million and $8.0 million in 1999, 1998 and 1997, respectively. As of December 31, 1999, we had an accumulated deficit of $23.9 million. In addition, we intend to increase our operating expenses significantly in 2000; therefore, our operating results will be adversely affected if revenues do not increase significantly.
BECAUSE WE SELL A FEW MAIN PRODUCTS, IF THEY DO NOT ACHIEVE BROAD MARKET ACCEPTANCE, OUR REVENUES WILL BE ADVERSELY AFFECTED
In 1999 substantially all of our revenues were derived from our PowerCenter, PowerMart, PowerConnect, Analytic Business Components for SAP R/3, and Informatica Application Products and related services. We expect revenues derived from these products and related services to comprise substantially all of our revenues for the foreseeable future. Even if the emerging software market in which these products are sold grows substantially, if either of these products does not achieve market acceptance, our revenues will be adversely affected. Market acceptance of our products could be materially adversely affected if, among other things, applications suppliers integrate their products to such a degree that the utility of the data integration functionality that our products provide is minimized or rendered unnecessary.
RISKS ASSOCIATED WITH STRATEGIC ACQUISITIONS AND INVESTMENTS
In December 1999, we acquired Influence, a developer of analytic applications for e-business, in a transaction accounted for as a pooling-of-interests. There can be no assurance that this acquisition will be effectively assimilated into our business. The integration of Influence will place a burden on our management and infrastructure. Such integrations are subject to risks commonly encountered in making such acquisitions, including, among others, loss of key personnel of the acquired company, loss of key customers and business relationships of the acquired company, the difficulty associated with assimilating and integrating the personnel, operations and technologies of the acquired company, the potential disruption of our ongoing business, the maintenance of uniform standards, controls, procedures, employees and clients. There can be no assurance that we will be successful in overcoming these risks or any other problems encountered in connections with our acquisition of Influence.
From time to time, in the ordinary course of business, we may evaluate potential acquisitions of such businesses, products or technologies. In addition, future acquisitions could result in the issuance of dilutive equity securities, the incurrence of debt or contingent liabilities. Furthermore, there can be no assurance that any strategic acquisition of investment will succeed. Any future acquisition or investment could have a material adverse effect on our business, financial condition and results of operation.
Recently, the Financial Accounting Standards Board ("FASB") voted to eliminate pooling of interests accounting for acquisitions and the ability to write-off in-process research and development has been limited by recent pronouncements. The effect of these changes would be to increase the portion of the purchase price for any future acquisitions that must be charged to our cost of revenues and operating expenses in the periods following any such acquisitions. As a consequence, our results of operations in periods following any such acquisitions could be materially adversely affected. Although these changes would not directly affect the purchase price for any of these acquisitions, they would have the effect of increasing the reported expenses associated with any of these acquisitions. To that extent, these changes may make it more difficult for us to acquire other companies, product lines or technologies.
THE LOSS OF KEY PERSONNEL OR THE INABILITY TO ATTRACT AND RETAIN ADDITIONAL PERSONNEL COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR RESULTS OF OPERATIONS
We believe our future success will depend upon our ability to attract and retain highly skilled personnel, including Gaurav S. Dhillon, our Chief Executive Officer, and Diaz H. Nesamoney, our Chief Operating Officer, and other key members of management. We currently do not have any key-man life insurance relating to our key personnel, and these employees are at-will and not subject to employment contracts. We may not be successful in attracting, assimilating and retaining key personnel in the future.
As we seek to expand our operations, the hiring of qualified sales and technical personnel will be difficult due to the limited number of qualified professionals. Competition for these types of employees is intense. We have in the past experienced difficulty in recruiting qualified sales and technical personnel. Failure to attract, assimilate and retain personnel, particularly sales and technical personnel, would have a material adverse effect on our business, results of operations and financial condition.
OUR MARKET IS HIGHLY COMPETITIVE
The market for our products is highly competitive, rapidly evolving and subject to rapidly changing technology. Many of our competitors have longer operating histories, substantially greater financial, technical, marketing or other resources, or greater name recognition than we do. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Competition could seriously impede our ability to sell additional products and services on terms favorable to us. Our current and potential competitors may develop and market new technologies that render our existing or future products obsolete, unmarketable or less competitive. We believe we currently compete more on the basis of our products' functionality than on the basis of price. If our competitors develop products with similar or superior functionality, we may have difficulty competing on the basis of price. Our current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with other solution providers, thereby increasing the ability of their products to address the needs of our prospective customers. Our current and potential competitors may establish or strengthen cooperative relationships with our current or future channel or strategic partners, thereby limiting our ability to sell products through these channels. Competitive pressures could reduce our market share or require us to reduce our prices, either of which could materially and adversely affect our business, results of operations or financial condition.
We compete principally against providers of decision support, data warehousing and enterprise application software. Such competitors include Acta Technology, Inc., Informix Corporation, Broadbase Information Systems, Inc., E.piphany, Inc., Information Builders, Inc., and Sagent Technology, Inc. In addition, we compete or may compete against database vendors that currently offer, or may develop, products with functionalities that compete with our solutions. These products typically operate specifically with these competitors' proprietary databases. Such competitors include IBM Corporation, Microsoft Corporation and Oracle Corporation. See "Business -- Competition."
IF WE DO NOT MAINTAIN AND STRENGTHEN OUR RELATIONSHIPS WITH OUR CHANNEL AND STRATEGIC PARTNERS, OUR ABILITY TO GENERATE REVENUE WILL BE ADVERSELY AFFECTED
We believe that our ability to increase the sales of our products and our future success will depend in part upon maintaining and strengthening successful relationships with our current or future partners. In addition to our direct sales force, we rely on established relationships with a variety of channel partners, such as systems integrators, resellers and distributors, for marketing, licensing and support of our products in the United States and internationally. We also rely on relationships with strategic technology partners, such as enterprise resource planning providers, for the promotion of our solutions. In particular, our ability to market our products depends substantially on our relationships with such significant partners as KPMG, PeopleSoft, PricewaterhouseCoopers and Andersen Consulting. In addition, our channel partners may offer products of several different companies, including, in some cases, products that compete with our products. We have limited control, if any, as to whether these strategic partners devote adequate resources to promoting and selling our products.
We may not be able to maintain our channel or strategic partnerships or attract sufficient additional channel or strategic partners who are able to market our products effectively or who are qualified to provide timely and cost-effective customer support and service. Further, we can give no assurance that our relationships with our channel and strategic partners will generate enough revenue to offset the significant resources used to develop these channels.
THE LENGTHY SALES CYCLE FOR OUR PRODUCTS MAKES OUR REVENUES SUSCEPTIBLE TO FLUCTUATIONS
Our sales cycle is generally long because the expense, complexity, broad functionality and company-wide deployment of our products typically requires executive-level approval for investment in our products. In addition, to successfully sell our products, we frequently must educate our potential customers about the full benefits of our products, which can require significant time. Due to these factors, the sales cycle associated
with the purchase of our products is subject to a number of significant risks over which we have little or no control, including:
- customers' budgetary constraints and internal acceptance review procedures;
- the timing of budget cycles;
- concerns about the introduction of our or our competitors' new products or
- product enhancements and potential downturns in general economic conditions.
If our sales cycle lengthens unexpectedly, it could adversely affect the timing of our revenues. Our sales cycle may lengthen as we continue to focus our sales efforts on large corporations. To the extent that potential customers divert resources and attention to Year 2000 issues, the sales cycle could be further lengthened.
DIFFICULTIES WE MAY ENCOUNTER MANAGING OUR GROWTH COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS
We have experienced a period of rapid and substantial growth that has placed and, if such growth continues, will continue to place a strain on our administrative and operational infrastructure. If we are unable to manage this growth effectively, our business, results of operations or financial condition may be materially adversely affected. We increased the number of our employees from 50 at December 31, 1996, to approximately 332 at December 31, 1999. Our revenues increased from $2.1 million in 1996 to $62.4 million in 1999. Our ability to manage our operations and growth effectively requires us to continue to improve our operational, financial and management controls, reporting systems and procedures and hiring programs. We may not be able to successfully implement improvements to our management information and control systems in an efficient or timely manner and may discover deficiencies in existing systems and controls.
TECHNOLOGICAL ADVANCES AND EVOLVING INDUSTRY STANDARDS COULD ADVERSELY IMPACT OUR FUTURE PRODUCT SALES
The market for our products is characterized by continuing technological development, evolving industry standards and changing customer requirements. The introduction of products by our direct competitors or others embodying new technologies, the emergence of new industry standards or changes in customer requirements could render our existing products obsolete, unmarketable or less competitive. In particular, an industry-wide adoption of uniform open standards across heterogeneous analytic applications could minimize the importance of the integration functionality of our products and materially adversely affect the competitiveness and market acceptance of our products. Our success depends upon our ability to enhance existing products, to respond to changing customer requirements and to develop and introduce in a timely manner new products that keep pace with technological and competitive developments and emerging industry standards. We have in the past experienced delays in releasing new products and product enhancements and may experience similar delays in the future. As a result, some of our customers deferred purchasing the PowerMart product until this upgrade was released. Future delays or problems in the installation or implementation of our new releases may cause customers to forego purchases of our products and purchase those of our competitors instead. Failure to develop and introduce new products, or enhancements to existing products, in a timely manner in response to changing market conditions or customer requirements, will materially and adversely affect our business, results of operations and financial condition.
OUR INTERNATIONAL OPERATIONS EXPOSE US TO GREATER INTELLECTUAL PROPERTY, COLLECTIONS, REGULATORY AND OTHER RISKS
International revenues accounted for 18%, 12% and 6% of our total consolidated revenues in 1999, 1998 and 1997, respectively. Our international business is subject to a number of risks, including the following:
- greater difficulty in protecting intellectual property;
- greater difficulty in staffing and managing foreign operations;
- greater risk of uncollectible accounts;
- longer collection cycles;
- potential unexpected changes in regulatory practices and tariffs;
- potential unexpected changes in tax laws;
- sales seasonality;
- the impact of fluctuating exchange rates between the U.S. dollar and foreign currencies in markets where we do business and
- general economic and political conditions in these foreign markets.
It is difficult to predict the extent of the future impact of these conditions. These factors and other factors could have a material adverse effect on our future international revenues and consequently on our business, results of operations and financial condition.
RISK ASSOCIATED WITH GEOGRAPHIC EXPANSION
A majority of our revenue historically has been derived from clients located in the United States. Our ability to achieve significant future revenue growth will in large part depend on our ability to get new customers in the United States and internationally.
Growth and geographic expansion have resulted in new and increased responsibilities for management personnel and have placed and continue to place a strain on our management and operating and financial systems. We will be required to continue to implement and accommodate the increased complexities of international and multi currency transactions. Any failure to implement and improve our operating and financial systems or to hire appropriate personnel to manage the operations would have a material adverse effect on our business, financial condition and result of operations.
IF OUR PRODUCTS CONTAIN SIGNIFICANT DEFECTS, THESE DEFECTS COULD CAUSE US TO LOSE REVENUE AND EXPOSE US TO PRODUCT LIABILITY CLAIMS
The software products we offer are inherently complex and, despite extensive testing and quality control, have in the past and may in the future contain errors or defects, especially when we first introduce them. These defects and errors could cause damage to our reputation, loss of revenue, product returns, order cancellations or lack of market acceptance of our products. Accordingly, these defects and errors could have a material adverse effect on our business, results of operations or financial condition. We have in the past and may in the future need to issue corrective releases of our software products to fix these defects or errors.
Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. It is possible, however, that the limitation of liability provisions contained in our license agreements may not be effective as a result of existing or future national, federal, state or local laws or ordinances or unfavorable judicial decisions. Although we have not experienced any product liability claims to date, sale and support of our products entails the risk of such claims, which could be substantial in light of the use of our products in enterprise-wide applications. If a claimant successfully brings a product liability claim against us, it could have a material adverse effect on our business, results of operations or financial condition.
OUR INABILITY TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS
Our success depends upon our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret rights, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights. It is possible that our pending patent applications will not be allowed or that competitors will successfully challenge the validity or scope of our allowed patent or any future allowed patents. Our patents alone may not provide us with any significant competitive advantage.
Third parties could copy or otherwise obtain and use our products or technology without authorization, or develop similar technology independently. It is difficult for us to police unauthorized use of our products, and,
although we are unable to determine the extent to which piracy of our software products exists, software piracy is a prevalent problem in our industry in general. Effective protection of intellectual property rights is unavailable or limited in certain foreign countries. The protection of our proprietary rights may be inadequate and our competitors could independently develop similar technology, duplicate our products or design around any patents or other intellectual property rights we hold.
As is common in the software industry, we may from time to time receive notices from third parties claiming infringement by our products of third-party patent and other proprietary rights. On April 7, 1999, we were notified by another company that it is evaluating our products to determine whether our products infringe its U.S. patent and has requested that we enter into discussions with them as to whether it is necessary or appropriate for us to obtain a license. Although no litigation has been filed by this company against us this company has filed litigation against one of our competitors, alleging infringement of its patent. Third parties, including the company that has contacted us regarding our products, could claim that our current or future products infringe their patent or other proprietary rights. Any claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements, any of which could have a material adverse effect upon our business, financial condition and operating results. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, or at all. Legal action claiming patent infringement could be commenced against us, and we may not prevail in such litigation given the complex technical issues and inherent uncertainties in patent litigation. Moreover, the cost of defending patent litigation could be substantial, regardless of the outcome. In the event a patent claim against us was successful and we could not obtain a license on acceptable terms or license a substitute technology or redesign to avoid infringement, our business, financial condition and operating results would be materially adversely affected. See "Business -- Intellectual Property and Other Proprietary Rights."
YEAR 2000 ISSUES COULD NEGATIVELY AFFECT OUR BUSINESS
In prior years, we discussed the nature and progress of our plans to become Year 2000 ready. In late 1999, we completed our remediation and testing of systems. As a result of those planning and implementation efforts, we experienced no significant disruptions in mission critical information technology and non-information technology systems and believe those systems successfully responded to the Year 2000 date change. During 1999, we did not incur any material costs directly associated with our Year 2000 compliance efforts, except for the compensations expense associated with our salaried employees who devoted some of their time to our Year 2000 assessments and remediation efforts. We are not aware of any material problems resulting from Year 2000 issues, either with our products, our internal systems, or the products and services of third parties. We will continue to monitor our mission critical computer applications throughout the year 2000 to ensure that any latent Year 2000 matters that may arise are addressed promptly.
CERTAIN EXISTING STOCKHOLDERS CAN EXERT CONTROL OVER INFORMATICA
Our officers, directors and principal stockholders (i.e., greater than 5% stockholders) will together control approximately 27% of our outstanding common stock as of February 29, 2000. As a result, these stockholders, if they act together, will be able to control the management and affairs of Informatica and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control of Informatica and might affect the market price of our common stock.
OUR STOCK PRICE MAY FLUCTUATE SUBSTANTIALLY
The market price for the common stock will be affected by a number of factors, including the following:
- the announcement of new products or product enhancements by us or our competitors;
- quarterly variations in our or our competitors' results of operations;
- changes in earnings estimates or recommendations by securities analysts;
- developments in our industry and
- general market conditions and other factors, including factors unrelated to our operating performance or the operating performance of our competitors.
In addition, stock prices for many companies in the technology and emerging growth sectors have experienced wide fluctuations that have often been unrelated to the operating performance of such companies. Such factors and fluctuations, as well as general economic, political and market conditions, may materially adversely affect the market price of our common stock.
OUR CERTIFICATE OF INCORPORATION AND BYLAWS CONTAIN PROVISIONS THAT COULD DISCOURAGE A TAKEOVER
Our basic corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. These provisions might discourage, delay or prevent a change in the control of Informatica or a change in our management. Our amended and restated certificate of incorporation filed in connection with this offering provides that when we are eligible, we will have a classified board of directors, with each class of directors subject to re-election every three years. This classified board when implemented will have the effect of making it more difficult for third parties to insert their representatives on our board of directors and gain control of Informatica. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. The existence of these provisions could limit the price that investors might be willing to pay in the future for shares of the common stock.
CHANGES IN ACCOUNTING STANDARDS COULD AFFECT THE CALCULATION OF OUR FUTURE OPERATING RESULTS
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, Revenue in Financial Statements. SAB 101 provides guidance with respect to the recognition, presentation and disclosure of revenue in financial statements of all public registrants. We have not fully assessed the impact of the adoption of SAB 101 and has not determined the effect, if any, that it will have on our reported revenues or results of operations in future periods.
FORWARD-LOOKING STATEMENTS
Some of the statements under "Quantitative and Qualitative Disclosure About Market Risk," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business" and elsewhere in this Form 10-K constitute forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, among other things, those listed under "Quantitative and Qualitative Disclosure About Market Risk" and elsewhere in this Form 10-K.
In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "could," "expects," "plans," "intends," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of such terms and other comparable terminology.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor anyone else assumes responsibility for the accuracy and completeness of such statements. We are under no duty to update any of the forward-looking statements after the date of this Form 10-K.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders of Informatica Corporation
We have audited the accompanying consolidated balance sheets of Informatica Corporation as of December 31, 1999 and 1998, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Informatica Corporation at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
Palo Alto, California January 24, 2000
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INFORMATICA CORPORATION
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS
See accompanying notes.
INFORMATICA CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes.
INFORMATICA CORPORATION
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
INFORMATICA CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes.
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF THE COMPANY AND A SUMMARY OF ITS SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF THE COMPANY
Informatica Corporation (the "Company") was incorporated in California in February 1993 and reincorporated in Delaware in March 1999. The Company operates in one business segment which provides software solutions that help large companies deploy, manage, maintain and grow systems that enable more effective business decision making.
On December 15, 1999, the Company acquired all of the outstanding stock of Influence Software, Inc. (Influence), a developer of analytic applications for eBusiness. The transaction was recorded using the pooling-of-interests method of accounting, and as such, financial information for all dates and periods prior to the acquisition has been restated to reflect the acquisition.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
The functional currency of the Company's foreign subsidiaries is the local currency. The Company translates all assets and liabilities to U.S. dollars at the current exchange rates as of the applicable balance sheet date. Revenue and expenses are translated at the average exchange rate prevailing during the period. Gains and losses resulting from the translation for the foreign subsidiaries' financial statements are reported as a separate component of stockholders' equity. Net gains and losses resulting from foreign exchange transactions were not significant during any of the periods presented.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in these estimates and assumptions may have a material impact on the financial statements.
RECLASSIFICATIONS
Certain reclassifications have been made to prior year amounts to conform to the current year presentation.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents, which consist of cash and highly liquid short-term government securities with insignificant interest rate risk and original maturities of three months or less at date of purchase, are stated at cost, which approximates fair value.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost less accumulated depreciation. Depreciation is provided using the straight-line method over estimated useful lives of the related assets, generally three years or less.
SOFTWARE DEVELOPMENT COSTS
The Company accounts for software development costs in accordance with Financial Accounting Standards Board ("FASB") Statement No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed", under which certain software development costs incurred subsequent to the
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
establishment of technological feasibility are capitalized and amortized over the estimated lives of the related products. Technological feasibility is established upon completion of a working model. Through December 31, 1999, costs incurred subsequent to the establishment of technological feasibility have not been significant and all software development costs have been charged to research and development expense in the accompanying consolidated statements of operations.
CONCENTRATIONS OF CREDIT RISK AND CREDIT EVALUATIONS
Financial instruments which subject the Company to concentrations of credit risk consist primarily of trade accounts receivable. The Company performs ongoing credit evaluations of its customers, which are primarily located in the U.S., Europe and Canada, and generally does not require collateral. Allowances for credit risks and for estimated future returns are provided upon shipment. Returns to date have not been material. Actual credit losses and returns may differ from the Company's estimates and such differences could be material to the financial statements.
REVENUE RECOGNITION
The Company generates revenues through two sources, software licenses and services. The Company's license revenues are generated from licensing the Company's products directly to end users and indirectly through resellers and original equipment manufacturers. Service revenues are generated from maintenance contracts and training and consulting services performed for customers that license the Company's products directly and indirectly through resellers.
License revenues are recognized when a noncancelable license agreement has been signed, the product has been shipped, the fees are fixed and determinable, collectibility is probable and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. Vendor-specific objective evidence is based on the price charged when an element is sold separately. In the case of an element not sold separately, the price is established by authorized management. If an acceptance period is required, revenue is recognized upon customer acceptance or the expiration of the acceptance period. The Company also enters into reseller arrangements that typically provide for sublicense fees based on a percentage of list price. For direct sales, revenue is recognized upon shipment to the end user and when collectibility is probable. For sales through resellers, revenue is recognized upon shipment to the reseller and when collectibility is probable or upon cash collections based on credit history with the reseller. The Company's agreements with its customers and resellers do not contain product return rights.
Revenues from services, which consist of fees for ongoing support and product updates, are recognized ratably over the term of the contract, typically one year. Consulting revenues are primarily related to implementation services and product enhancements performed on a time-and-materials basis under separate service arrangements related to the installation of the Company's software products. Training revenues are generated from classes offered both on-site and at customer locations. Revenues from consulting and training services are recognized as the services are performed.
Deferred revenue includes deferred maintenance revenue and prepaid training and consulting fees. Deferred license revenue amounts do not include items which are both deferred and unbilled. The Company's practice is to net such deferred items against the related receivables balances. As of December 31, 1999 and 1998, there were $9.2 million and $3.3 million of unbilled receivables netted against deferred license revenue, respectively.
STOCK-BASED COMPENSATION
The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants in
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and, accordingly, recognizes no compensation expense for the stock option grants.
NET LOSS PER SHARE
Basic net loss per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution of securities by adding other common stock equivalents, including stock options, warrants and convertible preferred stock, to the weighted average number of common shares outstanding during the period, if dilutive. Potentially dilutive securities have been excluded from the computation of diluted net loss per share as their inclusion would be antidilutive.
The calculation of basic and diluted net loss per share is as follows:
If the Company had reported net income, the calculation of diluted earnings per share would have included the shares used in the computation of basic net loss per share as well as an additional 6,144,000, 4,480,000 and 3,372,000 common equivalent shares related to outstanding stock options and warrants not included in the calculations above (determined using the treasury stock method) for 1999, 1998 and 1997, respectively.
COMPREHENSIVE INCOME (LOSS)
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and displaying comprehensive income and its components in the financial statements. The only item of other comprehensive income (loss) which the Company currently reports is foreign currency translation adjustments, which are included in accumulated other comprehensive income (loss) in the consolidated statements of redeemable convertible preferred stock and stockholders' equity (deficit). Tax effects of comprehensive income (loss) are not considered material.
INCOME TAXES
The Company accounts for income taxes in accordance with FASB Statement No. 109, "Accounting for Income Taxes", which requires the use of the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce the deferred tax assets to the amounts expected to be realized.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. SAB 101 provides guidance with respect to the recognition, presentation and disclosure of revenue in financial statements of all public registrants. The company has not fully assessed the impact of the adoption of SAB 101 and has not determined the effect, if any, that it will have on the Company's reported revenues or results of operations in future periods.
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
Included in property and equipment are assets acquired under capital lease obligations with an original cost of approximately $927,000 as of December 31, 1999 and 1998. Accumulated amortization of these assets was $342,000 and $146,000 at December 31, 1999 and 1998, respectively. The related amortization is included with depreciation expense.
3. LEASE OBLIGATIONS
The Company had an equipment financing agreement which provided up to $564,000 for the purchase of property and equipment and expired in January 1998. In February 1998, the Company entered into another equipment financing agreement with the same lender which increased the line to $1,510,000 for the purchase of property and equipment. Borrowings under these agreements bear interest at a rate of 3.07% and 3.19%, respectively, for 36 months. The Company is also required to choose to either pay a supplemental additional interest portion of 20% of the original purchase price due and payable at the end of the agreement term or to extend the agreement term for an additional year at a monthly interest rate of 2.05% of the original purchase amount. As of December 31, 1999, total borrowings under these agreements amounted to $927,000 of which $216,000 was outstanding.
The Company leases its office facilities and certain office equipment under noncancelable lease agreements which require the Company to pay operating costs, including property taxes, normal maintenance and insurance. Rent expense amounted to $2,005,000, $1,653,000 and $501,000 for 1999, 1998 and 1997, respectively.
Future minimum lease payments under noncancelable operating and capital leases are summarized as follows:
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. STOCKHOLDERS' EQUITY
BRIDGE FINANCING AND WARRANTS
In connection with the issuance of short-term promissory notes in May 1996, the Company granted warrants to the lenders to purchase up to 410,000 shares of Series C preferred stock at $1.25 per share. The warrants expire May 1, 2001. The Company deemed the fair value of the warrants to be $55,000, which was recorded as a discount on the notes. The fair value was determined using a Black-Scholes option pricing model with the following assumptions: a risk-free interest rate of 6.0%, no dividend yield or volatility factor, and an expected life of the warrant of five years. This discount was amortized to interest expense over the term of the notes during 1996. Upon the Company's initial public offering the warrants were converted into warrants to purchase 410,000 shares of common stock. In fiscal 1999, the Company issued a net of 397,546 shares of common stock upon the exercise of warrants, a portion of which were exercised pursuant to net exercise provisions, for a total of $212,000.
COMMON STOCK
At December 31, 1999, the Company has reserved the following shares of its common stock for future issuance:
On April 29, 1999 the Company completed an initial public offering in which it sold 6,000,000 shares of Common Stock, including 500,000 shares in connection with the exercise of the underwriters' over-allotment option, at $8 per share. The Company received $43.5 million in cash, net of underwriting discounts, commissions and other offering costs.
STOCK SPLIT
On January 26, 2000, the Board of Directors approved a two-for-one split of its $.001 par value common stock to be effected in the form of a stock dividend. The stock split was effected by distribution to each stockholder of record as of February 18, 2000 of one share of the Company's common stock for each share of common stock held. All references in the financial statements to number of shares, per share amounts, stock option data and market prices of the Company's common stock have been restated for the effect of the stock split.
1993 AND 1996 FLEXIBLE STOCK INCENTIVE PLANS
The Company's 1993 and 1996 Flexible Stock Plans (the "Stock Plans"), in effect through our initial public offering, authorized the granting of 8,454,500 incentive and nonstatutory common stock options to employees, directors, and consultants at exercise prices no less than 100% and 85%, respectively, of the fair market value of the common stock on the grant date, as determined by the Board of Directors. Options granted are exercisable over a maximum term of ten years and generally vest over a period of up to four years. In the event optionholders cease to be employed by the Company, all unvested options are forfeited and all vested options may be exercised within a 90 day period after termination; under the restricted portion of the plans, the Company also has the right to repurchase at the original purchase price any unvested shares if the holder is no longer employed by the Company. As of December 31, 1999, no outstanding common shares are subject to such repurchase rights. Options that are canceled under the 1996 Stock Plan will be available for future grants under the 1999 Stock Incentive Plan. There were no shares available for option grants under the 1996 Stock Plan at December 31, 1999.
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1999 STOCK INCENTIVE PLAN
The stockholders approved the 1999 Stock Incentive Plan (the "Incentive Plan") in April 1999 under which 1,300,000 shares have been reserved for issuance. In addition, any shares not issued under the 1996 Flexible Stock Incentive Plan will also be available for grant. The number of shares reserved under the Incentive Plan will automatically increase annually beginning on January 1, 2000 by the lesser of 8,000,000 shares or 5% of the total amount of fully diluted shares of common stock outstanding as of such date. Under the Incentive Plan, eligible employees may purchase stock options, stock appreciation rights, restricted shares and stock units. The exercise price for incentive stock options and non-qualified options may not be less than 100% and 85%, respectively, of the fair value of common stock at the option grant date. Options granted are exercisable over a maximum term of 10 years from the date of the grant and generally vest over a period of four years. As of December 31, 1999, the Company has 386,200 options available for grant under the Incentive Plan.
In connection with the acquisition of Influence, as discussed in Note 10, the Company converted options to purchase shares of Influence common stock into options to purchase shares of the Company's common stock. The number of shares of the Company's common stock issuable under each option and the exercise price for each grant were adjusted by an exchange ratio. The Company assumed the Stock Incentive Plan ("Influence plan") under which the options had been originally granted, however, no further options will be granted under the Influence plan. The converted options continue to be subject to the terms of the Influence plan. The Influence plan provided for the granting of incentive stock options and nonstatutory stock options. The exercise price of all options granted prior to the acquisition were determined by the Influence board of directors and were not less than the fair market value on the date of the grant. The options generally expire seven years from the date of the grant and vest over a period of four years from the date of the grant.
1999 NON-EMPLOYEE DIRECTOR STOCK INCENTIVE PLAN
The stockholders adopted the 1999 Non-Employee Director Stock Option Plan (the "Directors Plan") in April 1999 under which 500,000 shares have been reserved for issuance. Each non-employee joining the Board of Directors following the completion of the initial public offering will automatically receive options to purchase 50,000 shares of common stock at an exercise price per share equal to the fair market value of the common stock. These options are exercisable over a maximum term of five years and will vest in four equal annual installments on each yearly anniversary from the date of the grant. In addition, each non-employee director, who has been a member of the Board for at least six months prior to each annual stockholders meeting, will automatically receive options to purchase 10,000 shares of common stock at each such meeting. Each option will have an exercise price equal to the fair value of the common stock on the automatic grant date, a maximum term of five years and will vest on the first anniversary of the grant date. As of December 31, 1999, there have been no shares issued under the Directors Plan and 500,000 shares are available for future issuance.
EMPLOYEE STOCK PURCHASE PLAN
The stockholders adopted the Employee Stock Purchase Plan (the "Purchase Plan") in April 1999 under which 800,000 shares have been reserved for issuance. The number of shares reserved under the Purchase Plan will automatically increase beginning on January 1 of each year by the lesser of 3,200,000 shares or 2% of the total amount of fully diluted common stock shares outstanding on such date. Under the Purchase Plan, eligible employees may purchase common stock in an amount not to exceed 10% of the employees' cash compensation. The purchase price per share will be 85% of the lesser of the common stock fair market value either at the beginning of a rolling two-year offering period or at the end of each 6 month purchase period within the two year offering period. As of December 31, 1999, there have been no shares issued under the Purchase Plan and 800,000 shares are available for future issuance.
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A summary of the Company's stock option activity is set forth below:
The following table summarizes information concerning currently outstanding and exercisable options at December 31, 1999:
The Company uses the intrinsic value method of accounting for its employee stock-based compensation plans. Accordingly, no compensation cost is recognized for any of its stock options when the exercise price of each option equals or exceeds the fair value of the underlying common stock as of the grant date for each stock option with respect to the options granted. From inception through December 1999, the Company recorded deferred stock based compensation of $3,730,000 for the difference at the grant date between the exercise price and the deemed fair value of the common stock underlying the options. This amount is included as a component of stockholders' equity and is being amortized on a graded vesting method by charges to operations over the vesting period of the options. Such amortization amounted to approximately $742,000, $98,000 and $2,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Pro Forma Effect of Stock-based Compensation
Pro forma information regarding results of operations and net loss per share is required by FASB Statement No. 123, "Accounting for Stock-Based Compensation," which also requires that the information be determined as if the Company had accounted for its employee stock options under the fair value method of FASB 123. For all grants that were granted prior to the Company's initial public offering in April 1999, the fair value of these options was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighed average assumptions: a risk-free interest rate of 5.5%, 5.0% and 6.0% for 1999, 1998 and 1997, respectively, no dividend yield or volatility factors of the expected market price of the Company's common stock and a weighted average expected life of the option of 5 years. The fair value for the options granted subsequent to the Company's initial public offering was estimated at the date of grant using a Black-Scholes option pricing model using the following weighted-average assumptions: a risk-free interest rate of 5.5%, no dividend yield, volatility factor of the expected market price of the Company's common stock of 100% and a weighted average expected life of the option of five years.
The option valuation models are developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected life of the options. Because the Company's employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Had compensation cost for the Company's stock-based compensation plans been determined using the fair value at the grant dates for awards under those plans calculated using the minimum value method of FASB 123, the Company's net loss and basic and diluted net loss per share would have been increased to the pro forma amounts indicated below:
The weighted average fair value of options granted, which is the value assigned to the options under FASB 123, was $18.16, $0.43, and $0.06 for options granted during the years ended December 31, 1999, 1998 and 1997, respectively.
The pro forma impact of options on the net loss for the years ended December 31, 1999, 1998 and 1997 is not representative of the effects on net loss for future years, as future years will include the effects of additional years of stock option grants.
5. NOTES RECEIVABLE FROM STOCKHOLDERS
During 1995, certain officers of the Company purchased a total of 800,000 shares of the Company's common stock in exchange for promissory notes. The notes bear interest at 7.12% per annum, with interest and principal payable on May 5, 2000. The notes are secured by the common shares purchased by these officers.
6. NOTES PAYABLE TO STOCKHOLDERS
In 1997 and 1998, the Company issued promissory notes to stockholders in exchange for cash advances and payment for services. These notes bear interest at the bank's prime interest rate (8.5% at December 31,
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1999) plus 2% per annum, with a maximum rate of 10% per annum. Principal and accrued interest on these notes at December 31, 1999 and 1998 was $3.4 million and $3.1 million, respectively. The principal and accrued interest on these notes was repaid in February 2000.
7. INCOME TAXES
The federal, state and foreign income tax provision for the year ended December 31, 1999 is summarized as follows (in thousands):
Due to operating losses and the inability to recognize the benefits therefrom, there is no income tax provision for 1997 and 1998.
Influence elected to be taxed as an S-corporation under Subchapter S of the Internal Revenue Code through December 15, 1999. Consequently, Influence's stockholders were taxed on their proportionate share of the taxable income and no provision for income taxes has been provided in the statement of operations for the period beginning January 1, 1999 through December 15, 1999 and for the years ended December 31, 1998 and 1997. Influence's S-corporation status was terminated on December 15, 1999 when it was acquired by the Company.
A reconciliation of the provision computed at the statutory federal income tax rate to the income tax provision is as follows:
Significant components of the Company's deferred tax assets are as follows:
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FASB 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes the Company's historical operating performance and the reported cumulative net losses in all prior years, the Company has provided a full valuation allowance against its net deferred tax assets. The valuation allowance increased by $4,747,000 and $3,360,000 during the years ended December 31, 1999 and 1998, respectively.
As of December 31, 1999, approximately $4,600,000 of the valuation allowance reflected above relates to the tax benefits of stock option deductions which will be credited to equity when realized.
At December 31, 1999, the Company had net operating loss carryforwards for federal and state tax purposes of approximately $18,800,000 and $4,400,000, respectively. The Company also had federal and state research and development tax credit carryforwards of approximately $1,072,000 and $692,000, respectively. The net operating loss and tax credit carryforwards will expire at various dates beginning in 2000, if not utilized.
Utilization of net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. The annual limitation may result in the expiration of the net operating loss and credit carryforwards before utilization.
8. PROFIT SHARING PLAN
The Company has a profit sharing plan and trust under Section 401(k) of the Internal Revenue Code which covers substantially all employees. Eligible employees may contribute amounts to the plan via payroll withholdings, subject to certain limitations. Contributions by the Company are at the discretion of the Board of Directors. No discretionary contributions have been made by the Company to date.
9. MAJOR CUSTOMERS AND REVENUES BY GEOGRAPHIC AREA
Revenue was derived from customers in the following geographic areas:
10. BUSINESS COMBINATION
In December 1999, the Company acquired Influence, a developer of analytic applications for eBusiness. The merger was accounted for using the pooling-of-interests method of accounting and as such the Company's historical financial results for all dates and periods prior to the merger have been restated to reflect the merger. In connection with the acquisition, the Company issued 1,299,084 shares of its common stock to Influence's shareholders in exchange for all of the outstanding common stock. All outstanding options to purchase Influence's capital stock were converted into options to purchase 287,052 shares of Informatica common stock. In connection with the business combination, the Company incurred merger related costs of approximately $2,082,000, which consisted primarily of fees for investment banking, legal and accounting services incurred in conjunction with the merger. Of this amount, $310,000 was paid before December 31, 1999. The balance of $1,772,000 is included in current liabilities on the consolidated balance sheet.
INFORMATICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following information represents revenue and net loss of the separate companies for the periods preceding the business combination:
12. SUBSEQUENT EVENTS (UNAUDITED)
On February 11, 2000, the Company signed a definitive agreement to acquire Delphi Solutions AG, a distributor of Informatica products in Switzerland. The agreement is structured as a share purchase and will be accounted for as a purchase transaction. The purchase price includes payments associated with 1999 revenues and projections for 2000 revenues, and the first payment of approximately $3.6 million was paid in February 2000.
On February 22, 2000, the Company entered into two lease agreements for new corporate headquarters in Redwood City, California. The facility is under construction and is expected to be completed in June 2001. The lease expires twelve years after occupancy. As part of these leases, the Company agreed to provide letters of credit totaling $12.0 million as a security deposit for the first year's lease payments until certain financial covenants are met.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to Directors is included under the caption "Proposal One-Election of Directors" in Informatica's Notice of Annual Meeting to be held on May 25, 2000 (the "Proxy Statement") and is incorporated herein by reference. Information with respect to Executive Officers is included under the heading "Executive Officers and Directors" in Part I hereof after Item 4.
Information regarding delinquent filers pursuant to Item 405 of Regulation S-K is included under the heading "Section 16(a) Beneficial Ownership Reporting Compliance" under the caption "Additional Information" in the Proxy Statement and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is included under the caption "Executive Compensation and Other Information" in the Proxy Statement and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is included under the heading "Security Ownership of Certain Beneficial Owners and Management" under the caption "Proposal One-Election of Directors" in the Proxy Statement and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is included under the caption "Proposal One-Election of Directors" in the Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Annual Report on Form 10-K:
1. FINANCIAL STATEMENTS
The following documents are included as Part II, Item 8, of this Annual Report on Form 10-K:
2. FINANCIAL STATEMENT SCHEDULE
The following schedule of the Company is included herein:
Valuation and Qualifying Accounts and Reserves (Schedule II)
All other schedules are omitted because they are not applicable or the amounts are immaterial or the required information is presented in the Consolidated Financial Statements or Notes thereto.
The following documents are included in Exhibit 23 hereto:
Exhibit 23.2 Consent of Ernst & Young LLP, Independent Auditors
3. EXHIBITS
See Item 14(c) below.
(b) REPORTS ON FORM 8-K
Report on Form 8-K, filed on December 29, 1999 for the purpose of filing the Company's press release announcing the Agreement and Plan of Merger dated December 15, 1999 by and among Informatica Corporation, I-1 Merger Corp., and Influence Software, Inc.
(c) EXHIBITS
See Exhibit Index.
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Palo Alto, State of California on this 30th day of March, 2000.
INFORMATICA CORPORATION
By: /s/ GAURAV S. DHILLON ------------------------------------ Gaurav S. Dhillon Chief Executive Officer, Secretary and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
INFORMATICA CORPORATION
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
PROVISION FOR DOUBTFUL ACCOUNTS
SALES AND RETURN ALLOWANCES
EXHIBIT INDEX
- --------------- (1) Incorporated by reference to identically numbered Exhibit to Amendment No. 1 of the Company's Registration Statement on Form S-1/A (Commission File No. 333-72677), which was filed on April 8, 1999.
(2) Incorporated by reference to identically numbered Exhibit to the Company's Registration Statement on Form S-1 (Commission File No. 333-72677), which was filed on February 19, 1999.
(3) Incorporated by reference to identically numbered Exhibit to the Company's Current Report on Form 8-K (Commission File No. 333-72677), which was filed on December 29, 1999. | 17,281 | 117,845 |
930364_1999.txt | 930364_1999 | 1999 | 930364 | Item 1. Business.
Forward-looking statement advisory
This Annual Report on Form 10-K, as with some other statements made by the Trust from time to time, has forward-looking statements. These statements discuss business trends, year 2000 remediation and other matters relating to the Trust's future results and the business climate and are found, among other places, at Items 1(c)(3), 1(c)(4), 1(c)(6)(ii) and 7. In order to make these statements, the Trust has had to make assumptions as to the future. It has also had to make estimates in some cases about events that have already happened, and to rely on data that may be found to be inaccurate at a later time. Because these forward-looking statements are based on assumptions, estimates and changeable data, and because any attempt to predict the future is subject to other errors, what happens to the Trust in the future may be materially different from the Trust's statements here.
The Trust therefore warns readers of this document that they should not rely on these forward-looking statements without considering all of the things that could make them inaccurate. The Trust's other filings with the Securities and Exchange Commission and its Confidential Memorandum discuss many (but not all) of the risks and uncertainties that might affect these forward-looking statements.
Some of these are changes in political and economic conditions, federal or state regulatory structures, government taxation, spending and budgetary policies, government mandates, demand for electricity and thermal energy, the ability of customers to pay for energy received, supplies of fuel and prices of fuels, operational status of plant, mechanical breakdowns, availability of labor and the willingness of electric utilities to perform existing power purchase agreements in good faith. Some of these cautionary factors that readers should consider are described below at Item 1(c)(4) - Trends in the Electric Utility and Independent Power Industries.
By making these statements now, the Trust is not making any commitment to revise these forward-looking statements to reflect events that happen after the date of this document or to reflect unanticipated future events.
(a) General Development of Business.
Ridgewood Electric Power Trust IV, the Registrant hereunder (the "Trust"), was organized as a Delaware business trust on September 8, 1994 to participate in the development, construction and operation of independent power generating facilities ("Independent Power Projects" or "Projects") and similar capital projects in the environmental and infrastructure areas (also "Projets"). Ridgewood Energy Holding Corporation ("Ridgewood Holding"), a Delaware corporation, is the Corporate Trustee of the Trust.
The Trust sold whole and fractional shares of beneficial interest in the Trust ("Investor Shares") at $100,000 per Investor Share, and terminated its private placement offering on September 30, 1996. It raised approximately $47,680,000. Net of offering fees, commissions and expenses, the offering provided approximately $39,500,000 for investments in the development and acquisition of Independent Power Projects and operating expenses. The Trust has 956 holders of Investor Shares (the "Investors"). As described below in Item 1(c)(2), the Trust has invested approximately $29.2 million of its funds to the acquisition of interests in four Independent Power Projects, capital equipment and in a used tire reprocessing facility.
The Trust is organized to be similar to a limited partnership. Ridgewood Power LLC (the "Managing Shareholder"), a Delaware corporation, is the Managing Shareholder of the Trust. For information about the merger of Ridgewood Power Corporation, the prior Managing Shareholder, into Ridgewood Power LLC, see Item 10(b) - Directors and Executive Officers of the Registrant - Managing Shareholder.
In general, the Managing Shareholder has the powers of a general partner of a limited partnership. It has complete control of the day-to-day operation of the Trust and as to most acquisitions. The Managing Shareholder is not regularly elected by the owners of the Investor Shares (the "Investors"). The Managing Shareholder and the Independent Trustees meet together as the Board of the Trust and take certain actions, such as approval of the management agreement with the Managing Shareholder and approval of acquisitions with related parties. The Board of the Trust also provides general supervision and review of the Managing Shareholder but does not have the power to take action on its own. The Independent Trustees do not have any management or administrative powers over the Trust or its property other than as expressly authorized or required by the Declaration of Trust (the "Declaration").
The Corporate Trustee acts on the instructions of the Managing Shareholder and is not authorized to take independent discretionary action on behalf of the Trust. See Item 10 - Directors and Executive Officers of the Registrant below for a further description of the management of the Trust.
The following chart summarizes some of these relationships.
Ridgewood Electric Power Trust IV and certain affiliates (some entities and relationships omitted)
Robert E. Swanson Family trusts x x (Mr. Swanson has Sole manager x x sole voting and Chief executive officer x x investment power) Owner of 46% of equity x x Owners of 54% of equity _________________X__________________X______________________________ x x x x x x x x x x x x x x x x x x Ridgewood Ridgewood Power Ridgewood Ridgewood Ridgewood Ridgewood Securities Management LLC Power LLC Energy Power VI Capital Corporation Holding LLC Management Corporation LLC
Operates power Corporate Manager Placement plants for five Managing Trustee Co-Managing of two agent power trusts Shareholder for all Shareholder venture ("Ridgewood ("RPMCo") of six six trusts (dormant) capital Securities") trusts x of the funds & ("Ridgewood x Growth Fund marketing Power") x ("Power VI Co") affiliate x x x ("Ridgewood x x x Capital") x x x x ______________________________x____________x_____________ x x x x x x x x x x x x x x x x x x Ridgewood Ridgewood Ridgewood Ridgewood Ridgewood The Ridgewood x Electric Electric Electric Electric Electric Power Growth x Power Trust Power Trust Power Trust Power Trust Power Trust Fund x I II III IV V (the x ("Power I") ("Power II") (Power III") (the ("Power V") " Growth x "Trust") Fund") x x ________________________________X__ x x x x Ridgewood Capital Ridgewood Capital Venture Partners Venture Partners II (the "Venture Capital Funds")
The Trust made an election to be treated as a "business development company" under the Investment Company Act of 1940, as amended (the "1940 Act"). On January 24, 1995, the Trust notified the Securities and Exchange Commission of such election and registered the Investor Shares under the Securities Exchange Act of 1934, as amended (the "1934 Act"). On March 24, 1995 the election and registration became effective. Effective October 3, 1996, the Trust, with the approval of the Investors, withdrew its election to be a business development company so that it could make investments together with other programs sponsored by the Managing Shareholder without requesting exemptive relief from the Securities and Exchange Commission. The Trust covenanted to comply with most of the substantive restrictions on business development companies, other than certain transactions with affiliated persons.
Unlike three prior investment programs that the Managing Shareholder has sponsored in the independent power industry, the Trust consolidates its subsidiaries' financial statements with its own for purposes of this Annual Report on Form 10-K.
(b) Financial Information about Industry Segments.
The Trust has been organized to operate in only one industry segment: independent power generation and similar facilities.
(c) Narrative Description of Business.
(1) General Description.
The Trust was formed to participate primarily in the development, construction and operation of independent electric power projects that generate electricity for sale to utilities and other users, and that might provide heat energy as well to users. The Trust was also authorized to invest in capital projects or processing plants that were anticipated to earn cash flows similar to those of independent electric power projects.
Historically, producers of electric power in the United States consisted of regulated utilities and of industrial users that produced electricity to satisfy their own needs. The independent power industry in the United States was created by federal legislation passed in response to the energy crises of the 1970s. The Public Utility Regulatory Policies Act of 1978, as amended ("PURPA"), requires utilities to purchase electric power from "Qualifying Facilities" (as defined in PURPA), including "cogeneration facilities" and "small power producers," and also exempts these Qualifying Facilities from most utility regulatory requirements. Under PURPA, Projects that are Qualifying Facilities are generally not subject to federal regulation, including the Public Utility Holding Company Act of 1935, as amended, and state regulation. Furthermore, PURPA generally requires electric utilities to purchase electricity produced by Qualifying Facilities at the utility's avoided cost of producing electricity (i.e., the incremental costs the utility would otherwise face to generate electricity itself or purchase electricity from another source). The Providence, Maine Hydro and Maine Biomass Projects are Qualifying Facilities.
(2) The Trust's Investments.
(i) Providence Project. The Trust and Ridgewood Electric Power Trust III, a similar investment program sponsored by the Managing Shareholder ("Ridgewood Power III"), acquired in April 1996 all of the equity interest in the Providence State Landfill Power Plant, located near Providence, Rhode Island. Ridgewood Power III invested $7.1 million in the Project and the Trust invested $12.9 million, which was the remainder of the $20 million investment in the Project. The acquisition cost of the Project was approximately $15.5 million (including a $3 million partial prepayment of Project debt as a condition of obtaining the lenders' consents and transaction costs) and the remainder of the investment by the programs represents funds applied to operating reserves, working capital and cash reserves for capital improvements and expansion. The Project is encumbered by $4.8 million of debt maturing in installments through 2004. Ridgewood Power Management Corporation ("RPMCo"), a service company under common control with the Managing Shareholder, as described below, operates the Project and the Trust reimburses it for its costs and expenses.
The Project burns methane gas (the major component of natural gas) generated by the decomposition of garbage in the landfill as fuel for a 13.8 Megawatt capacity electric generation plant. The facility has been in operation since 1990 and has a Power Contract for 12.0 Megawatts with New England Power Corporation with a 22 year term remaining.
The Project leases the right to use the landfill site from the Rhode Island Resource Recovery Corporation, a state agency, for a royalty of 15% of net Project revenues (increasing from 15% to 18% in 2006) until 2020. The Project in turn subleases those rights to Central Gas Limited Partnership ("Gasco"). Gasco, which is not affiliated with the Trust, operates and maintains the piping system and other facilities to collect the methane gas from the landfill and supply it to the Project. Gasco pays a fixed rent, computed on the basis of the Project's generating capacity, to the Project under the sublease, and the Project in turn buys its fuel from Gasco at a formula price per kilowatt-hour generated by the Project.
Since the Trust purchased the Project in April 1996, average output from the original eight engine-generator sets has risen by approximately 25% from 9.2 Megawatts in the first three months of 1996 to 12.2 Megawatts in December 1996 and 11.5 Megawatts in 1997. Since August 1997, sales have approached the 12.0 Megawatt maximum under the Power Contract. In order to increase output to the maximum and to allow engines to be rotated off-line for preventative maintenance, an additional engine and generator set were installed at the Project in spring 1997. Although this increased nominal Project capacity by approximately 12%, the actual benefit is the ability to have one engine off-line at any time for maintenance and still produce the entire 12.0 Megawatts that can be sold under the existing Power Contract. Net earnings from the Project (less the minority interest of Ridgewood Power III) for 1999 totalled $310,000, down from $530,000 for 1998. The decrease reflected higher 1999 expenditures for equipment maintenance and loss of income resulting from the unscheduled outage of two engines.
(ii) California Pumping Project
On December 31, 1995, the Trust purchased a package of 11 irrigation service engines which have an aggregate power output equivalent to 1.2 Megawatts (the "California Pumping Project") located in Ventura County, California, for a cash purchase price of approximately $354,000. The Trust purchased the Project from Ridgewood Power III for the same price paid by Ridgewood Power III for the assets to the unaffiliated seller. In 1996, the Trust bought 9 additional engines with a rated equivalent capacity of 1.2 Megawatts from unaffiliated sellers at a price of $344,000. The total investment in the Project at December 31, 1999, after accounting for depreciation, was $442,000.
The California Pumping Project has been operating since 1992 and uses 20 natural-gas-fired reciprocating engines to provide power for irrigation wells which furnish water for orchards of lemon and other citrus trees. The power is purchased by local farmers and farmers' co-operatives at a price which represents a discount from the equivalent price the customers would have paid to purchase electric power.
Until October 1998, the Trust had a management contract with the prior operator of the Project that provided that the operator's compensation was based on the amount of pumping power provided by each engine, computed on the basis of the equivalent amount of kilowatt-hours of electricity that would have been needed to provide that amount of pumping power. Until January 1998, the Trust received all cash flow from the engines up to $.02 per equivalent kilowatt-hour for the first 3,000 kilowatt-hours per year, and $.01 per additional kilowatt-hour in that year. The operator, who was responsible for all operating costs, received the remainder. Beginning in January 1998, the Trust received one-half of revenues after deduction of a 6/10 cent per equivalent kilowatt-hour maintenance fee and costs of fuel for the engines. In October 1998 the Trust and the operator terminated the management agreement and the Trust paid the operator $94,000 to reimburse it for installation costs advanced by the operator. RPMCo has operated the Project since that time.
Ridgewood Electric Power Trust II, a prior investment program sponsored by the Managing Shareholder ("Ridgewood Power II"), owns a package of similar engines located on different sites and operated under identical terms. The engines operate independently of each other and revenues and expenses for each Trust are segregated from those of the other.
(iii) Maine Hydro Projects
On December 23, 1996, the Trust purchased from Consolidated Hydro, Inc. a 50% interest in 14 small hydroelectric projects located in Maine. In order to increase diversification of the Trust's investments, the remaining 50% interest was purchased by Ridgewood Electric Power Trust V ("Ridgewood Power V"), a similar investment program organized in 1996 by the Managing Shareholder. Each Trust paid approximately $6,700,000 for its interest The jointly owned partnership that acquired the Project also assumed a lease obligation in the amount of $1,005,000.
The 14 hydroelectric projects have an aggregate rated capacity of 11.3 megawatts. All electricity generated by the projects over and above their own requirements is sold to either Central Maine Power Company or Bangor Hydro Company under long-term power purchase contracts. Eleven of the contracts expire at the end of 2008 and the remaining three expire in 2007, 2014 and 2017. Certain of the contracts are subject to price redeterminations in 2001 based on the Maine Public Utilities Commission's computations of avoided cost.
The Trust's net equity in the income of the Maine Hydro Projects for 1999 was $849,000 (a 15.0% return on equity), up from $658,000 (a 10.6% return on equity) in 1998.
The Trusts have entered into a five year operating and maintenance agreement with CHI Energy, Inc. under which a subsidiary of CHI Energy will manage and administer the projects for a fixed annual fee of $307,500 (adjusted upwards for inflation), plus an annual incentive fee equal to 50% of the excess of aggregate net cash flow over a target amount of $1.875 million per year. The maximum incentive fee is $112,500 per year; to the extent the annual net cash flow exceeds $2.1 million, the excess will be carried forward to future years; to the extent that the annual net cash flow is less than $1.875 million, the deficit will be carried forward to future years. In addition, the operator will be reimbursed for certain operating and maintenance expenses. In 1999, the operator was paid a total of $323,000 for operating and incentive fees, down from $429,000 in 1997. The agreements has a five-year term, expiring on June 30, 2001, and can be extended for two additional five-year terms by mutual consent.
(iv) Maine Biomass Projects
On July 1, 1997, the Trust and Ridgewood Power V purchased a preferred membership interest in Indeck Maine Energy, L.L.C., an Illinois limited liability company ("Indeck Maine") that owns two electric power generating stations fueled by waste wood at West Enfield and at Jonesboro, Maine. The Trust and Ridgewood Power V purchased the interest through a limited liability company owned equally by each. The Trust's share of the purchase price was $7,298,000 and Ridgewood Power V provided an equal amount of the total purchase price.
The junior membership interest in Indeck Maine is owned by Indeck Energy Services, Inc. ("Indeck"). The preferred membership interest entitles the Trust and Ridgewood Power V to receive all net cash flow from operations each year until they receive an 18% annual cumulative return on their capital contributions to Indeck Maine. Any additional net operating cash flow in that year is paid to Indeck until the total paid to it equals the amount of the 18% preferred return for that year, without cumulation. Any remaining net operating cash flow for the year is payable 25% to the Trust and Ridgewood Power V together and 75% to Indeck unless the Trust and Ridgewood Power V recover their capital contributions from proceeds of a capital event. Thereafter, these percentages change to 50% each. All non-operating cash flow, such as proceeds of capital events, is divided equally between (a) the Trust and Ridgewood Power V and (b) Indeck.
Under Indeck Maine's amended operating agreement, if the Trust and Ridgewood Power V did not receive annual distributions at least equal to the 18% preferred return requirement or if Indeck Maine, after a cure period, failed to make distributions to them in accordance with the operating agreement, they had the right to designate a majority of the managers of Indeck Maine. Under that arrangement, until March 1999 Indeck Operations, Inc., an affiliate of Indeck, managed the plant and was reimbursed for its costs. In addition, the three managers nominated by the original Indeck Maine members received aggregate annual fees of $300,000 and certain other fees were payable to Indeck affiliates. The management agreement could be terminated on notice if the Trust and Ridgewood Power V obtained the right to designate a majority of the managers of Indeck Maine.
The Trust, Power V and Indeck agreed, effective March 1, 1999, to terminate the arrangements described above and to transfer operating control of the Projects to the Trust and Ridgewood Power V. This has occurred and the Trust and Ridgewood Power V have engaged RPMCo to operate the two Projects. RPMCo is doing so and charges its expenses to Indeck Maine at its cost.
Each of the projects has a 24.5 megawatt rated capacity and uses steam turbines to generate electricity. The fuel is waste wood chips, bark, brush and similar biomass. Both projects are Qualifying Facilities. The Maine Biomass Projects are members of the New England Power Pool ("NEPOOL"), an association of New England generators, transmission utilities, distribution utilities, power marketers and others. NEPOOL's function is to run the New England electric grid in the most reliable way possible and to reduce electric costs and uncertainties. NEPOOL's control and market regulation responsibilities are managed by ISO-New England, Inc., an independent, non-profit management company.
Under current economic conditions, the Maine Biomass Projects would not be profitable if they were operated as "base load" plants that run most of the time. Instead, they are operated as peak load plants on those few days per year (typically during summer heat waves) when there are power and reserve shortages in New England. During the rest of the year, the Projects are shut down but are capable of being restarted on five to ten days' advance notice. Because the Projects are capable of providing electricity, they are entitled to sell their "installed capability," a measurement of the rated ability of a generating plant to create electric power. Plants are credited with installed capability whether or not they run. For an additional discussion of installed capability and other concepts related to electricity pricing, see (3) - Plant Operation, below. Each distribution utility that is a member of NEPOOL must own or purchase installed capability on a monthly basis that at least equals its expected load for the month (the maximum amount of power that its customers may demand) plus mandated reserves. Generating facilities may enter into contracts to sell installed capability or may auction it through the ISO. The Maine Biomass plants sold installed capability throughout 1999 under short-term bilateral contracts and thus earned revenues (approximately $733,000) without generating material amounts of electric power. Prices for installed capability have tended to decline slightly from 1999 to 2000, which may reflect seasonal variations in demand for capability but which may also reflect maturation of the market and the startup or anticipated startup of several new generating stations in New England, which would increase the supply of installed capability.
In addition, the Maine Biomass Projects operated on approximately seven days in June, July, October and December 1999 on dispatch by the ISO. As described below at Item 1(c)(3) - Plant Operation, the Projects have claimed that the ISO owes them approximately $14 million for the electricity products they provided on those days and the ISO has claimed that no material revenues at all are due to the Projects. A description of these disputes is found below.
The cost to the owners of Indeck Maine for maintaining the facilities in operable condition and for fixed costs such as taxes and insurance was approximately $2.5 million for both projects in 1999. Additional variable costs were incurred to run the Projects on the days they were dispatched by the ISO and on days on which capability or air quality tests were run.
Indeck Maine funded the approximately $2.2 million difference between the Maine Biomass projects' revenues and operating expenses by borrowing from its members. The Trust provided 25% of the loans ($525,000 in 1998), Ridgewood Power V also provided an equal 25% and the remaining 50% was provided by Indeck, all on the same terms. Indeck Maine issued demand promissory notes bearing interest at 5% per year to evidence the indebtedness. Neither Indeck nor its affiliates are affiliated with or has any material relationship with the Trust, Ridgewood Power V, their Managing Shareholder or their affiliates, directors, officers or associates of their directors and officers.
(v) Santee River Rubber Company
The Trust and Power V have purchased preferred membership interests in Santee River Rubber Company, LLC, a South Carolina limited liability company ("Santee River"). Santee River is building a waste tire and rubber processing facility (the "Facility") located in Berkeley County, South Carolina approximately 90 miles north of Charleston, South Carolina. The Trust and Power V purchased the interest through a limited liability company owned one-third by the Trust and two-thirds by Power V. The Trust's share of the $13,470,000 purchase price for the membership interest in Santee River was $4,490,000 and Power V provided the remaining $8,980,000 of the price.
The Facility is designed to receive and process waste tires and other waste rubber products and produce fine crumb rubber of various sizes. The Facility basically freezes the tires, using liquid nitrogen obtained from a nearby air-processing plant, shatters the frozen rubber into small pieces, and grinds and processes the pieces to remove tire cord, steel belts and other non-rubber materials. The product is crumb-like pieces of rubber. The processing system includes both ambient and cryogenic processing equipment using liquid nitrogen. In addition, magnets and other screening equipment will be used to separate and remove ferrous material and fibers from the rubber. Santee River believes that the final crumb rubber product will be fine enough for use in manufacturing new tires or to replace virgin rubber in many applications. The Facility is being constructed on an approximately 30-acre site (the "Site") in Berkeley County, South Carolina owned by Santee River. The Site is mortgaged as security for the bonds issued for the Facility.
Construction was substantially completed in February 2000 and the Facility is now undergoing testing. Some remedial work is underway and the Trust currently expects the testing period to end in early summer 2000, after which the Facility will go into limited operations. Operation at full capacity is expected to begin in late summer 2000.
Until January 2000, Santee River paid the Trust and Power V a fixed distribution of 12% per year on $11,500,000 of the total capital they contributed. The Trust and Power V are entitled to a cumulative annual distribution preference equal to 12% of contributed capital from January 2000 until operations begin. The Trust does not anticipate any payment of that preference until the Project has significant cash flow from operations. After operations begin, the preferred membership interest entitles the Trust and Power V to receive all available operating cash flow annually from Santee River after payment of debt service and other obligations until the Trust receives a cumulative 20% annual return on its capital investment. Thereafter, the Trust and Power V are entitled to receive 25% of any remaining operating cash flow available for distribution in that year from Santee River. All non-operating cash flow, such as proceeds of capital events, is divided equally between (a) the Trust and Power V and (b)the other owner of Santee River. All amounts and tax items the Trust and Power V receive from Santee River are shared one-third by the Trust and two-thirds by Power V, with neither having any preference over the other. The Trust and Power V have the joint right to designate two of the five managers of Santee River and have the further right to remove a third manager and designate a successor in the event of certain defaults under Santee River's Operating Agreement. The remaining equity interest in Santee River is owned by a wholly-owned subsidiary of Environmental Processing Systems, Inc. ("EPS") of Garden City, New York. EPS is the developer of the Facility. EPS contributed the contracts, permits, plans and other intangible property for the construction of the Facility that EPS generated prior to this transaction. Until a default, EPS has the right to designate three managers of Santee River.
Santee River estimates that approximately $52,680,000 will be needed to construct the Facility and begin operations. After paying costs of the financing (which included a $167,000 payment to the Trust and a $333,000 payment to Power V from Santee River to defray the trusts' transaction costs), Santee River had approximately $16,500,000 available. At the same time as it sold the Trust and Power V their membership interest, Santee River borrowed $16,000,000 through tax-exempt revenue bonds sold to institutional investors and another $16,000,000 through taxable convertible bonds sold to qualified institutional purchasers. It also obtained $4,500,000 of subordinated financing from the general contractor for the Facility, which is only repayable if the Facility meets specified construction and performance criteria.
The Facility is being constructed by Bateman Engineering, Inc. (the "Contractor") pursuant to a turnkey construction agreement between the Contractor and Santee River for a fixed price of $30.5 million. The Contractor's obligations under the Construction Contract will be guaranteed by its affiliate, Bateman Project Holdings Limited, a South African company. Pursuant to the Construction Contract, the Contractor has agreed to defer $4.5 million of its fixed construction price and to receive such amount during the initial 4 years of Facility operation. A pilot facility was completed in February 1999 for testing of the equipment and processes and product from the pilot facility met or exceeded specifications. Further testing is necessary before any conclusion can be drawn as to the feasibility of the equipment and processes.
Santee River has entered into long-term agreements for supply of its requirements of waste tires and other waste rubber as its raw material, of liquid nitrogen for cryogenic processing and of electricity (from a local electricity cooperative). Santee River intends to sell the crumb rubber manufactured at the Facility to various companies in the tire, plastics, rubber, building products, adhesives and paint industries.
EPS on behalf of Santee River has obtained short term crumb rubber sales contracts for approximately 30% of the Facility's expected output with several major rubber products manufacturers. Each contract is contingent upon successful testing of the Facility's output.
EPS provides administrative services to Santee River during the construction and operation of the Facility at its cost (including direct and indirect costs and allocable overhead). Neither Santee River nor EPS is otherwise affiliated with or has any material relationship with the Trust, Power V, their Managing Shareholder or their affiliates, directors, officers or associates of their directors and officers.
The Trust has substantially completed its investment program.
Project Operation.
The Trust, through the Managing Shareholder, operates the Providence Project, the California Pumping Project (since October 1, 1998) and the Maine Biomass Projects (since March 1, 1999). The Managing Shareholder has organized RPMCo to provide operating management for facilities operated by its investment programs. See Item 10 - Directors and Executive Officers of the Registrant for further information regarding the Operation Agreement and RPMCo. The Maine Hydro Projects are managed by their former owner, CHI Energy, Inc. (formerly known as Consolidated Hydro, Inc.), which owns other hydroelectric facilities in the region. Until October 1998, the California Pumping Project was managed by HEP, Inc., its former developer, and until March 1999 the Maine Biomass Plants were managed by their former owner, Indeck Maine.
The Trust's decisions to purchase electric generating Projects in New England were driven in part by the relatively high prices paid for energy in the region and a shortage of generating capacity caused in large part by the shutdown of four large nuclear power plants previously owned by Northeast Utilities, Inc. and other utilities for regulatory and safety violations. See the discussion at (4) - Trends in the Electric Utility and Independent Power Industries and (5) - Competition below for information regarding proposed capacity additions and cost factors that may offset that shortage.
The overall demand for electrical energy is somewhat seasonal, with demand usually peaking in the summertime as a result of the increased use of air conditioning. Peak periods in New England generally are limited to daytime and evening hours in the summer months (with a smaller peak in Maine for light and heating during the winter) and power prices are significantly higher during those periods.
(i) Providence and Maine Hydro Projects. The Providence and Maine Hydro Projects are Qualifying Facilities under PURPA and have entered into long-term power purchase agreements ("Power Contracts") with their local distribution utilities. Under the Power Contracts for the Providence and Maine Hydro Projects, the local utilities are obligated to purchase the entire output of the Projects (up to rated levels)at formula prices. No separate payments are made for capacity or capability and all payments under the Power Contracts are made for energy supplied.
The utility purchaser at the Providence Project, New England Power Company, pays 3.0 cents per kilowatt-hour for all power provided, adjusted for inflation based on changes in the consumer price index since 1989. In addition to that base amount, it pays a flat additional 3.5 cents per kilowatt-hour for peak period power and 1.5 cents for non-peak power. Additional adjustments are made to reduce payments in later years so as to levelize total amounts paid by the utility.
The Maine Hydro Projects are licensed or operated as "run-of-river" facilities, which means that the amount of water passing through the turbines is directly dependent upon the fluctuating level of flow of the river or stream. The Projects have a very limited ability to store water during high flows for use at low flow periods. As a result, these Projects are unable to earn capacity payments and are often unable to produce high output in the peak summer and winter months when spot electricity rates are highest. Instead, they produce electric energy and sell it as generated at the fixed rates provided in the Power Contracts. Distributions of net cash flow from the Maine Hydro Projects, whose financial statements are not consolidated with those of the Trust, are not treated as operating revenues. Instead they are considered to be income from investments to the extent of net earnings and as a return of capital otherwise.
The Providence and Maine Hydro Projects use landfill gas or hydroelectric energy and are not subject to fuel price changes or supply interruptions. Because the Maine Hydro Projects are "run-of-river" hydroelectric plants, their output is dependent upon rainfall and snowfall in the areas above the dams and output has varied in the range of 30% over or 25% below the average output from 1987 through 1997. Output is generally lowest in the summer months and in the winter and highest in the spring and fall.
(ii) Maine Biomass plants
The Maine Biomass Projects burn wood waste, including brush and chips from woodcutting or processing of raw wood at paper mills or sawmills. The price of wood waste fluctuates and is a primary determinant of whether the Projects can run profitably or not. The major causes of the fluctuation are changes in woodcutting or wood processing volumes caused by general economic conditions, increases in the use of wood waste by paper mills for their own cogeneration plants, changes in demand from competing generating plants using wood waste or paper mill refuse and weather conditions. The cost of wood waste is currently significantly in excess of that anticipated at the time the Maine Biomass Projects were purchased.
Although the Maine Biomass Projects are Qualifying Facilities, they do not have long-term Power Contracts and sell their capacity and output on the market. In 1999, NEPOOL instituted a somewhat competitive market, managed by the ISO, for generators to sell capacity and output to utilities and other entities that distribute electricity ("loads"). Generators may sell directly to loads on a bilateral basis, or they may sell to the ISO. The ISO dispatches generating plants and takes their power in accordance with offers and its estimate of the most economical means of providing sufficient reliable electricity. It computes the clearing price for each electrical product on an hourly basis (monthly for installed capability), bills loads for their shares of the products and is to pay generators in accordance with the generators' offers and the market rules. In 1999, seven "electrical products" were bought and sold on the ISO's market. In addition to installed capability and energy (the power actually used by consumers), the market included four types of reserves (basically, the ability to turn on or increase the operating rate of electric generators within specified times to provide additional power quickly) and automatic generation control (a related ability).
The Maine Biomass Projects submitted offers to sell their electrical products for the summer of 1999 at relatively high prices with the expectation that the plants would be called upon by ISO only in the most extreme conditions. This strategy was necessary because of the relatively high costs of operating the plants without a long-term base load contract. The ISO dispatched the plants to run on only three days during June 1999 when NEPOOL was short of resources and accepted the Projects' offered prices, which would have entitled the Projects to receive significant revenues for those three days.
In early July 1999, the ISO informed NEPOOL members that it would pay lower prices than those posted on its market Website on those three days in June. After considering ISO's stated reasons for reducing the posted prices and ISO's actions during June, RPMCo concluded that ISO was determined to intervene in the markets and to prevent prices from rising to clearing levels during shortage periods. This would prevent profitable operation of the Projects. Accordingly, RPMCo revised its offer strategy to hold the Maine Biomass Projects off the market for the remainder of the summer and made further revisions at the end of September.
In early October 1999, the ISO informed RPMCo that a scheduled transmission outage for October 16 and 17 required ISO to activate all possible generation in Maine. The Maine Biomass Projects, which had been shut down and which did not have full crews available, had a pre-existing offer to supply electric energy at an high price, reflecting the costs of restarting the plants, obtaining a crew on short notice and covering fixed costs. The ISO accepted the offer subject to its market rules and conditions. The Maine Biomass Plants operated as dispatched by the ISO on October 16 and, if they were paid in accordance with their offer terms, would have received in excess of $2.2 million. In November 1999, the ISO advised RPMCo that it would pay a total of $5,000 for the energy the Projects produced on October 16. The ISO has stated that, in its opinion, the Projects had monopoly-like market power on October 16 and that under the existing market rules it was only obligated to pay a rate based on variable costs unless the Projects could cost-justify a higher rate.
RPMCo is vigorously disputing all elements of the ISO's arguments for reducing the June and October payments and is preparing to bring a legal action in the appropriate forum.
The Maine Biomass Projects ran on approximately seven other days during 1999 in order to undergo NEPOOL capacity testing, testing for air pollution control permit requirements or modifications, and to meet ISO dispatch orders on three of those days. On each of the days, the ISO cancelled the orders just before the plants would have begun providing synchronized electricity to NEPOOL. As a result, the plants had to be crewed and restarted but no revenues were earned. RPMCo is also disputing these actions by the ISO.
(iii) California Pumping Project
Although drier weather in 1999 increased revenues for the California Pumping Project over 1998 levels, in late 1999 petroleum prices rose sharply because of supply reductions by the Organization of Petroleum Exporting Countries, continued high demand, cold weather and previous drawdowns of inventory. As often occurs when oil prices rise, natural gas fuel prices also rose. Increased demand for natural gas, including use as power station fuel, and cold weather also contributed to the price increases. The price of the Pumping Project's fuel has almost doubled since January 1999. As a result, the California Pumping Project is operating at a loss and is expected to continue at that level unless gas prices fall significantly. Hydrocarbon fuels, such as natural gas, have been generally available in recent years for use by Independent Power Projects, although there have been serious supply impairments for both oil and natural gas at times during the last 20 years. Market prices for natural gas and oil have fluctuated significantly over the last few years and those fluctuations are expected to continue.
(iv) Santee River Project
The Santee River Project is expected to begin full scale operation in summer 2000, assuming successful completion of performance tests. The primary raw materials for the Santee River Project are used tires, which are readily available, electricity (purchased from the local rural electric cooperative) and liquid nitrogen for freezing the tires (which is available, as described above, under a long-term contract from a producer of liquid oxygen). Accordingly, the Santee River Project is not currently expected to be subject to unexpected, adverse raw material price changes or supply interruptions.
(v) General considerations
Customers of Projects that accounted for more than 10% of annual revenues from operating sources to the Trust in each of the last three fiscal years are:
Calendar year 1999 1998 1997
New England power Corporation 89.4% 91.0% 90.0% (Providence Project)
Note that - the financial statements of the Maine Hydro Projects, the Maine Biomass Projects and the Santee River Project are not consolidated with those of the Trust and, accordingly, their revenues are not considered to be operating revenues.
The major costs of an independent power Project while in operation will be debt service (if applicable), fuel, taxes, maintenance and operating labor. The ability to reduce operating interruptions and to have a Project's capacity available at times of peak demand are critical to the profitability of a Project. Accordingly, skilled management is a major factor in the Trust's business.
Electricity produced by a Project is typically delivered to the purchaser through transmission lines which are built to interconnect with the utility's existing power grid, or in the case of the Maine Biomass Projects, via utility lines owned by Bangor Hydro-Electric Company ("Bangor Hydro") to the ISO's transmission facilities. Bangor Hydro's tariffs for transmission and for electricity demand (incurred by the need for start-up electricity at the Maine Biomass Projects) imposed a significant burden on their potential profitability. After extended investigation, the Managing Shareholder and Indeck Operations, Inc. concluded that the Projects were eligible under regulations of the New England Power Pool and ISO-New England to be considered as directly connected to the ISO's "pooled transmission facilities." That status would significantly reduce transmission charges for the Projects. Indeck Maine petitioned the New England Power Pool and ISO-New England to recognize the Projects as being connected to pooled transmission facilities and when those petitions were disapproved, brought administrative complaints in October 1998 before the Federal Energy Regulatory Commission ("FERC") alleging that the failures to recognize the Projects were anti-competitive, in violation of system rules approved by FERC actions and in violation of FERC deregulatory orders. Those complaints were rejected by FERC in February 2000 and RPMCo is considering whether further proceedings with other similarly situated NEPOOL members will be appropriate. Indeck Maine has negotiated a package of tariff amendments and special facilities agreements with Bangor Hydro that would remove most of the tariff disadvantages. Bangor Hydro filed a request for approval of the tariff changes with FERC in March 2000. The special facilities agreements will also require approval by the Maine Public Utility Commission.
The technology involved in conventional power plant construction and operations as well as electric and heat energy transfers and sales is widely known throughout the world. There are usually a variety of vendors seeking to supply the necessary equipment for any Project. So far as the Trust is aware, there are no limitations or restrictions on the availability of any of the components which would be necessary to complete construction and commence operations of any Project. Generally, working capital requirements are not a significant item in the independent power industry. The cost of maintaining adequate supplies of fuel is usually the most significant factor in determining working capital needs.
In order to commence operations, most Projects require a variety of permits, including zoning and environmental permits. Inability to obtain such permits will likely mean that a Project will not be able to commence operations, and even if obtained, such permits must usually be kept in force in order for the Project to continue its operations.
Compliance with environmental laws is also a material factor in the independent power industry. The Trust believes that capital expenditures for and other costs of environmental protection have not materially disadvantaged its activities relative to other competitors and will not do so in the future. Although the capital costs and other expenses of environmental protection may constitute a significant portion of the costs of a Project, the Trust believes that those costs as imposed by current laws and regulations have been and will continue to be largely incorporated into the prices of its investments and that it accordingly has adjusted its investment program so as to minimize material adverse effects. If future environmental standards require that a Project spend increased amounts for compliance, such increased expenditures could have an adverse effect on the Trust to the extent it is a holder of such Project's equity securities.
Of the 14 Maine Hydro Projects, six operate under existing hydroelectric project licenses from the Federal Energy Regulatory Commission ("FERC") and two have license applications pending. Changes to the six other, unlicensed Projects (which are currently exempt from licensing) may trigger a requirement for FERC licensing. FERC licensing requirements have become progressively more stringent and often require that output of a Project that is being licensed or relicensed be restricted in order to allow a more natural flow of water, that archaeological and historical surveys be undertaken, that public access to waterways be provided (sometimes requiring purchase of property rights by the hydroelectric licensee) and that various site improvements be made. These requirements can materially impair a project's profitability. See Item 1(c)(6) - Business - Narrative Description of Business Regulatory Matters.
Trends in the Electric Utility and Independent Power Industries
There are numerous references for further information on the electric power industry. Interested persons may particularly wish to refer to the U.S. Department of Energy's Annual Energy Outlooks and special studies, prepared by the department's Energy Information Administration (the "EIA"). Much of this information is available on EIA's World Wide Web site at http://www.eia.doe.gov under the "Electric" heading. Neither the Department of Energy nor EIA nor any other agency of the United States Government has endorsed or approved the Trust or the Investor Shares and the Trust takes no responsibility for the preparation or content of the Department of Energy's publications.
(i) Qualifying Facilities with long-term Power Contracts
The Trust is somewhat insulated from recent deregulatory trends in the electric industry because the Providence and Maine Hydro Projects are Qualifying Facilities with long-term formula-price Power Contracts. Each Power Contract now provides for rates in excess of current short-term rates for purchased power. There has been much speculation that in the course of deregulating the electric power industry, federal or state regulators or utilities would attempt to invalidate these power purchase contracts as a means of throwing some of the costs of deregulation on the owners of independent power plants.
To date, the Federal Energy Regulatory Commission and state authorities have ruled that existing Power Contracts will not be affected by their deregulation initiatives. The regulators have so far rejected the requests of a few utilities to invalidate existing Power Contracts. Instead, most state plans for deregulation of the electric power industry (including those in Maine) treat the value of long-term Power Contracts that are above current and anticipated market prices as "stranded costs" of the utilities. The utilities are to be allowed to recover those costs during a transition period. This is typically done by imposing a transition fee or surcharge on rates that is paid to the utility.
No action has yet been taken by federal or state legislators to date to impair Independent Power Projects' existing power sales contracts, and there are federal constitutional provisions restricting actions to impair existing contracts. There can not be any assurance, however, that the rapid changes occurring in the industry and the economy as a whole would not cause regulators or legislative bodies to attempt to change the regulatory structure in ways harmful to Independent Power Projects or to attempt to impair existing contracts. In particular, some regulatory agencies have urged utilities to construe Power Contracts strictly and to police Independent Power Projects' compliance with those Power Contracts vigorously.
Predicting the consequences of any legislative or regulatory action is inherently speculative and the effects of any action proposed or effected in the future may harm or help the Trust. Because of the consistent position of the regulatory authorities to date and the other factors discussed here, the Trust believes that so long as it performs its obligations under the Power Contracts, it will be entitled to the benefits of the contracts.
In recent years, many electric utilities have attempted to exploit all possible means of terminating Power Contracts with independent power projects, including requests to regulatory agencies and alleging violations of even immaterial terms of the Power Contracts as justification for terminating those contracts. If such an attempt were to be made, the Trust might face material costs in contesting those utility actions. Other utilities have from time to time made offers to purchase and terminate Power Contracts for lump sums. No such offer has been suggested or made to the Trust, although the Trust would entertain such an offer.
Finally, the Power Contracts are subject to modification or rejection in the event that the utility purchaser enters bankruptcy. There can be no assurance that the utility purchaser will stay out of bankruptcy.
After the Power Contracts for the Providence and Maine Hydro Projects expire at varying times from 2008 to 2020 or those contracts terminate for other reasons, those Projects under currently anticipated conditions would be free to sell their output on the competitive electric supply market, either in spot, auction or short-term arrangements or under long-term contracts if those Power Contracts could be obtained. There is no assurance that the Projects could then sell their output or do so profitably. While the Providence Project is not subject to natural gas price fluctuations and it may benefit from environmental requirements for utilities to purchase power from environmentally favorable sources, the supply of fuel gas from the landfill is not assured. Both it and the Maine Hydro Projects may have diseconomies of small scale. The Trust is unable to anticipate whether the Projects would have cost disadvantages or advantages after their Power Contracts expire. It is thus impossible to predict the profitability of those Projects after termination of the Power Contracts.
(ii) Maine Biomass Projects
The Maine Biomass Projects do not have long-term Power Contracts and are exposed to the newly-deregulating market for electricity generation. Those Projects are sometimes described as "merchant power plants" because they sell their output on the open market. As a consequence of federal and state moves to deregulate large areas of the electric power industry and the existence, spurred by PURPA, of private competitors to electric utilities in the market for generating electricity, a number of interrelated trends are occurring that will affect merchant power plants.
Continued Deregulation of the Generating Market
The Comprehensive Energy Policy Act of 1992 (the "1992 Energy Act") encourages electric utilities to expand their wholesale generating capacity by removing some, but not all, of the limitations on their ownership of new generating facilities that qualify as "exempt wholesale generators" ("EWG's") and on their ability to participate in merchant power plants. Many state electric utility regulators are considering plans to further encourage investment in wholesale generators and to facilitate utility decisions to spin off or divest generating capacity from the transmission or distribution businesses of the utilities. As a result, merchant power plants in the future will face competition not only from other independent power plants seeking to sell electricity on a wholesale basis but also from EWG's, electric utilities with excess capacity and independent generators spun off or otherwise separated from their parent utilities.
Wholesale-level Access to Transmission Capacity
The 1992 Energy Act empowered FERC to require electric utilities and power pools to transmit electric power generated by other wholesale generators to wholesale customers. This process is referred to as "wheeling" the electric power. Essentially, the generator contributes power to a utility or power pool and is credited with that contribution, and the utility or power pool serving the wholesale customer makes available that amount of electric power to the customer and debits the generator. Wheeling is effected between power pools on a similar basis.
Without access to transmission capacity, an independent power plant or other wholesale generator can only sell to the local electric utility or to a facility on which it is located (or, in some states, which adjoins its location). FERC has required that transmission capacity owners or the power pools that operate transmission facilities (such as NEPOOL through the ISO) provide transmission capacity to all generators and power marketers on a non-discriminatory basis pursuant to "open-access" tariffs. FERC in its recent Order 2000 has mandated improvements to the power pool systems. When combined with the increased competition in the generating area, this is likely to create an electricity supply market that may profoundly change the operations of electric utilities, consumers and independent power plants.
On April 24, 1996 the Federal Energy Regulatory Commission adopted Order 888, which requires electric utilities and power pools to provide wholesale transmission facilities and information to all power producers on the same terms, and endorses the recovery by utilities of uneconomic capital costs from wholesale customers who change suppliers. The utilities would also be required to furnish ancillary services, such as scheduling, load dispatch, and system protection, as needed. These rights, however, would apply only to sales of new electric power over and above existing utility supply arrangements. Non-utility wholesale deliveries of electricity have grown vigorously and according to the federal government grew at the rate of 21% per year in the ten years from 1986 to 1996.
The Maine Biomass Projects are dependent on wheeling power in order to sell their capacity or energy to purchasers other than Bangor Hydro, as described above. Order 888 takes no action to modify existing Power Contracts. The order intends to create a competitive national market in electricity generation and thus may create additional pressure on electric utilities to seek changes to long-term power purchase contracts, as described further below. State public utility regulatory agencies must also review and approve certain aspects of wholesale power deregulation, and those agencies are currently holding proceedings and making determinations. In addition to the FERC order or other Congressional or regulatory actions that may result in freer access to transmission capacity, agreements with Canada, and to a lesser extent with Mexico, are leading toward access for those countries' generators to U.S. markets. In particular, certain Canadian suppliers, such as HydroQuebec (the Quebec provincial utility) are already offering substantial amounts of electricity in New England, and more may be offered if sufficient transmission capacity can be approved and built. These agreements may also afford access to those countries' markets in the future for independent power plants. As a result, there is the possibility that a North American wholesale market will develop for electricity, with additional competitive pressures on U.S. generators.
Retail-level Competition
An even more radical prospect for the electric power industry is retail-level competition, in which generators would be allowed to sell directly to customers by using (and paying a fee for) the local utility's distribution facilities. Retail-level competition presupposes the ability to wheel power in the appropriate amounts at economic costs from the generating Project to the electric utility whose wires link to the retail customer (typically a large industrial, commercial or governmental unit) and the ability to use the local utility's facilities to deliver the electricity to the customer. In addition to the business and regulatory issues arising from wholesale wheeling, retail-level competition raises fundamental concerns as to the ability of utilities to recover stranded costs at the generating and distribution levels, the possibility that smaller customers will have less ability to demand pricing concessions, incentives for governmental agencies to act as intermediaries for consumers and the functions of state-level regulatory agencies in a price-competitive environment which may be inconsistent with their traditional price-setting and service-prescribing roles. Maine, Massachusetts and Connecticut are implementing retail competition in April 2000; Rhode Island has already done so.
Although retail deregulation is being implemented currently on a state-by-state basis, there are some common elements which are expected to be included in the Maine and Massachusetts deregulation plans. First, most deregulating states will require that local utilities will be the "suppliers of last resort," which are required to serve any customers in their existing territories who do not purchase generated electricity from another source and which are required to obtain adequate generating capacity to meet those needs. Second, most deregulating states are requiring that utilities and other suppliers of electricity work through "independent system operators" such as the ISO, which coordinate purchase, transmission and sale of electricity between generators and distribution utilities. Independent system operators will have significant responsibility for supply reliability.
Third, most deregulating states are requiring that utilities be compensated for stranded costs (which include long-term Power Contracts with Independent Power Projects that are above current and anticipated market prices) for a transition period. This is typically done by imposing a transition fee or surcharge on rates that is paid to the utility. In some states, utilities are being encouraged or ordered to issue bonds or other financial instruments to retire stranded cost assets or contracts, supported by transition charges. Fourth, many states are requiring local utilities to divest a large portion or all of their generating assets or to sell their rights under long-term Power Contracts. The states have cited concerns such as the anti-competitive effects of allowing the utilities, which retain a monopoly over the wires that take electricity the last stages to the customer, to own generating assets. Further, the sale of assets (or above-market Power Contracts) sets a market price for those assets and allows a somewhat objective computation of the stranded costs related to those assets or contracts. For example, the true stranded cost of a nuclear plant is approximately the difference between the value assigned to it under state regulation and the price someone will pay for it at auction.
Fifth, utilities having stranded costs are expected to mitigate those costs by buying out contracts or selling costly assets. Finally, many states are attempting to protect generators who use "renewable fuels" or that are considered to have environmental or social benefits. As discussed below, Maine and Massachusetts are doing so.
Price and Cost Pressures
The pricing pressures that retail and wholesale deregulation are bringing are expected to decrease the marginal cost of electricity. Competition will force utilities and generators to reduce overhead and administrative costs, to trim operation and maintenance costs and to more efficiently buy and use fuel. Further, wholesale and retail deregulation and new generating technologies discussed below are expected to significantly reduce capital costs. For example, electric utilities currently maintain large amounts of generating capacity in reserve to meet peak loads (for example, to serve customers during a heat wave in July). According to the federal government, competition may lead to pricing strategies that reduce these peak loads. Competition may also force utilities to stop maintaining high-cost reserve capacity and to take greater risks. The widening wholesale market for electricity may increase efficiency by allowing utilities and power consumers to obtain distant, lower-cost capacity for reserve purposes rather than maintain local, higher cost, underutilized reserve capacity. Finally, political and economic pressures may induce market regulators such as the ISO to manipulate prices downward. For these and other reasons, the federal government currently estimates that national average electricity rates in real terms (adjusted for inflation) will decline to about 6.3 cents per kilowatt-hour in 2015 from the 1996 average level of 7.1 cents per kilowatt-hour.
As these trends continue, high-cost generators will be disadvantaged and may fail. The Trust's small-scale generating plants have tended to have higher per-kilowatt hour costs (except for fuel) than new, large scale generating plants. The fuel cost advantages, if any, of landfill gas, hydroelectricity or waste biomass are thus critical to the competitiveness of the Trust's merchant power plants. To date, the cost of wood chips and other biomass suitable for use at the Maine Biomass Projects is not low enough to allow the Projects to compete for base load contracts.
Conversely, decreases in electricity costs may reduce Santee River's production costs, although Santee River's business plan does not assume any such decreases.
New Generating Technologies and New Industry Participants
Recent improvements in turbine technology, coupled with what is seen as the ample supply and relative cheapness of natural gas, have made gas turbines the favored technology for new electric generating plants. The federal government estimates that 80% of the new electric generating capacity to be added from 1995 to 2015 will be fueled by natural gas and that the amount of generation fueled by natural gas will increase from the current 10% to 29%. According to the federal government, new gas turbines only need 15 days per year of maintenance, on the average, compared with 30 days a year for steam turbines. Although gas turbines historically have been used to meet peak demand rather than baseload demand, new "combined cycle" units (which use heat from the turbine's exhaust to drive a second steam or gas turbine) have thermal efficiencies approaching 60% (60% of the theoretical maximum heat from the burning gas is converted to electricity) and can be used as baseload units. In contrast, steam turbines fired by coal have efficiencies in the 36% range and have operating and maintenance costs higher than those of combined cycle plants. Further, natural gas-fired turbines emit relatively low levels of sulfur dioxide, particulates and complex carbon compounds and thus may have lower environmental compliance costs than coal-fired or oil-fired plants. The federal government estimates that combined cycle gas turbine plants alone will account from 96,000 to 143,000 Megawatts of the 319,000 Megawatts of additional capacity to be added in the next 17 years.
The new emphasis on natural gas-fired generation is causing large natural gas transmission or brokering companies to enter the electricity generation market rapidly. They have access to large volumes of gas and have the ability to raise large amounts of capital. Accordingly, most new investment in combined cycle gas Projects and other large-scale gas turbine Projects is being made by these natural gas/energy companies or by large utilities that are entering the competitive generation industry.
A number of large participants in the independent generating industry have announced their intentions to build large gas turbine merchant power plants in Connecticut, Massachusetts and Maine in sizes from 250 to 750 Megawatts. The capacity of the proposed plants exceeds one-half of the total deficit in capacity caused by the shutdown of the Northeast Utilities nuclear power plants. If all or many of the announced plants were built, there might be a material increase in low-cost generation capacity in the New England area. There have also been reports, especially from the northeastern states, that large non-utility generating companies and utilities entering the competitive generating market outside their existing service territories are buying large numbers of older plants from local utilities with the intention of replacing them on site with new, large, natural gas-fueled plants. It is unclear whether many of the announced merchant power plants will actually be built, given the uncertainties of the market for electricity and the possibility that there may be insufficient gas pipeline capacity or supplies to fuel all of the recently announced plants.
Many companies, including affiliates of fuel suppliers and utilities, have applied to FERC to act as electric power marketers, because they anticipate that if wholesale wheeling becomes significant there will be strong demand for brokers or market makers in electric power. It is uncertain whether power marketers will become significant factors in the electric power market. A related development is the creation of derivative contracts for hedging of and speculation in electricity supplies, which may offer generators, utilities and large industrial or commercial consumers the ability to reduce the volatility of competitive prices. To date, the effects of derivative contracts on the market for electricity in the Northeast have not been material.
Renewable Power
The pressures of competition are expected to harm the "renewable power" segment of the industry, which includes the Maine Biomass Projects. "Renewable power" (often called "green power") is a catchphrase that includes Projects (such as solar, wind, small hydroelectric, biomass, geothermal and landfill-gas) that do not use fossil fuels or nuclear fuels. Renewable power plants typically have high capital costs and often have total costs that are well above current total costs for new gas-turbine production. Many observers believe that renewable power plants without existing Power Contracts (with the possible exception of biomass, hydroelectric and geothermal plants with very low or zero fuel costs) will be non-competitive in the new markets unless they are given governmental protection. A number of states, including Massachusetts, Connecticut and Maine, are requiring that retailers of electricity purchase a certain minimum amount of electricity (often between 5% to 30% of their total requirements) from renewable power sources. Although the Massachusetts and Connecticut requirements were to have gone into effect by spring 2000, delays in writing regulations defining renewable sources have effectively suspended the requirements. The Trust does not anticipate that Massachusetts and Connecticut or the other New England states that are considering such requirements will have requirements for loads to purchase renewable energy before 2001. Because there is yet no substantial enforced demand for renewable energy, these state requirements have not had a material effect on the price of renewable energy. Renewable energy is currently priced almost identically to that of non-renewable energy. It is possible that even after renewable energy requirements come into effect that the price for renewable power will not increase enough to make the Maine Biomass Projects profitable.
Initial Effects of Trends
Within the last 12 months, several negative trends have developed in the independent power sector. There have been industry-wide moves toward consolidation of participants. A number of utilities and equipment suppliers have proposed or entered into joint ventures to reduce risks and mobilize additional capital for the more competitive environment, while many electric utilities are in the process of combining, either as a means of reducing costs and capturing efficiencies, or as a means of increasing size as an organizational survival tactic.
A second trend has been the continuing divestiture of generating assets by utilities, creating a competitive generating market, especially in New England. Most of the divested plants have been acquired by subsidiaries or affiliates of utilities located outside New England. In effect, a game of musical assets has occurred, with utilities in one area selling their generating assets and using the proceeds, plus borrowings, to purchase the same types of generating assets in different areas of the United States.
These pressures to acquire suddenly divested assets and to enlarge organizations caused the prices of large generating stations or strategically located generating stations to rise sharply. The Trust elected not to purchase additional generating capacity in New England or elsewhere because the anticipated rates of return at the inflated prices were too low. The Trust currently believes that many owners of large generating stations in New England are currently operating at marginal or negative margins and there is intense pressure on prices for base load contracts as purchasers of power stations attempt to keep their stations running. The competitive pressures have been intensified by the importation of power at peak periods from HydroQuebec and the New York Power Pool and by the construction of several large gas turbine power plants in New England, which have increased base load capacity. The ISO's decision to allow these imports to reduce perceived demand for electricity and thus to depress quoted peak period prices for energy below the cost of the imported electricity has exacerbated these pressures.
Finally, the ISO's actions to cap prices of reserve products and energy during system peak demand periods have caused RPMCo to take the Maine Biomass Projects offline and have caused at least one other generator company to remove a power plant designed for peak usage periods from New England entirely. Paradoxically, although there is more generation capacity in New England now for non-emergency periods and prices for that capacity are depressed, there is less capacity available for meeting emergency peaks because of the effects of the capped prices. The Trust believes that continued interference with the power market could start a vicious circle of failure and additional price regulation, as emergency capacity shortages cause the ISO to add more controls and more mandatory runtimes to meet reliability needs.
This may already be occurring. In response to the high prices offered by the Trust and other generators for reserve products in the summer of 1999, and in response to what the ISO believed were flaws in the markets, the ISO requested and obtained approval from FERC in February 2000 to abolish the market for operable capability, to cap the price for other reserves at the energy price and to propose a restructuring of the electric products markets.
In the long term, there seem to be three primary strategies for non-utility generating plants to succeed in the United States: first, Projects that have existing, firm, long-term Power Contracts may do well for the life of those Contracts so long as regulatory or legislative actions do not abrogate the Contracts. Second, Projects that are low-cost producers of electricity, either from efficiencies or good management or as the result of successful cogeneration technologies, will have advantages in the market. Third, the viability of small Projects or Projects generating electricity from "renewable sources" will depend on favorable legislative and regulatory action unless electricity prices climb sharply.
(5) Competition
There are a large number of participants in the independent power industry. Several large corporations specialize in developing, building and operating independent power plants. Equipment manufacturers, including many of the largest corporations in the world, provide equipment and planning services and provide capital through finance affiliates. Many regulated utilities are preparing for a competitive market, and a significant number of them already have organized subsidiaries or affiliates to participate in unregulated activities such as planning, development, construction and operating services or in owning exempt wholesale generators or up to 50% of independent power plants. In addition, there are many smaller firms whose businesses are conducted primarily on a regional or local basis. Many of these companies focus on limited segments of the cogeneration and independent power industry and do not provide a wide range of products and services. There is significant competition among non-utility producers, subsidiaries of utilities and utilities themselves in developing and operating energy-producing projects and in marketing the power produced by such projects.
The Trust is unable to accurately estimate the number of competitors but believes that there are many competitors at all levels and in all sectors of the industry. Many of those competitors, especially affiliates of utilities and equipment manufacturers, are far better capitalized than the Trust.
Please also review the discussion of changes in the industry above at (4) - Trends in the Electric Utility and Independent Power Industries.
(6) Regulatory Matters.
Projects are subject to energy and environmental laws and regulations at the federal, state and local levels in connection with development, ownership, operation, geographical location, zoning and land use of a Project and emissions and other substances produced by a Project. These energy and environmental laws and regulations generally require that a wide variety of permits and other approvals be obtained before the commencement of construction or operation of an energy-producing facility and that the facility then operate in compliance with such permits and approvals. Since the Trust has agreed to comply with most of the requirements for "business development companies" under the 1940 Act, it also is contractually bound to comply with the requirements summarized below and others described at Exhibit 99 to this Annual Report on Form 10-K.
(i) Energy Regulation.
(A) PURPA. The enactment in 1978 of PURPA and the adoption of regulations thereunder by FERC provided incentives for the development of cogeneration facilities and small power production facilities meeting certain criteria. Qualifying Facilities under PURPA are generally exempt from the provisions of the Public Utility Holding Company Act of 1935, as amended (the "Holding Company Act"), the Federal Power Act, as amended (the "FPA"), and, except under certain limited circumstances, state laws regarding rate or financial regulation. In order to be a Qualifying Facility, a cogeneration facility must (a) produce not only electricity but also a certain quantity of heat energy (such as steam) which is used for a purpose other than power generation, (b) meet certain energy efficiency standards when natural gas or oil is used as a fuel source and (c) not be controlled or more than 50% owned by an electric utility or electric utility holding company. Other types of Independent Power Projects, known as "small power production facilities," can be Qualifying Facilities if they meet regulations respecting maximum size (in certain cases), primary energy source and utility ownership. Recent federal legislation has eliminated the maximum size requirement for solar, wind, waste and geothermal small power production facilities (but not for hydroelectric or biomass) for a fixed period of time.
In addition, PURPA requires electric utilities to purchase electricity generated by Qualifying Facilities at a price equal to the purchasing utility's full "avoided cost" and to sell back up power to Qualifying Facilities on a non discriminatory basis. Avoided costs are defined by PURPA as the "incremental costs to the electric utility of electric energy or capacity or both which, but for the purchase from the Qualifying Facility or Qualifying Facilities, such utility would generate itself or purchase from another source." While public utilities are not required by PURPA to enter into long-term Power Contracts to meet their obligations to purchase from Qualifying Facilities, PURPA helped to create a regulatory environment in which it has become more common for such contracts to be negotiated until recent years.
The exemptions from extensive federal and state regulation afforded by PURPA to Qualifying Facilities are important to the Trust and its competitors. The Trust believes that the Providence and Maine Hydro Projects, which sells electricity to public utilities, are Qualifying Facilities. Maintaining the Qualified Facility status of an electric generating Project is of utmost importance to the Trust. Such status may be lost if a Project does not meet the operational or ownership requirements of PURPA. For small power production facilities such as the Providence, Maine Hydro and Maine Biomass Projects, the requirements are limited to maximum size, fuel use and ownership requirements that are currently unlikely to be violated. Cogeneration Projects that are Qualifying Facilities have more stringent requirements, such as minimum operating efficiency standards and minimum use of thermal energy by customers of a cogeneration Project.
The Trust endeavors to comply with applicable PURPA requirements and does not believe that the Providence, Maine Hydro or Maine Biomass Projects are subject to any requirement that could jeopardize their statuses as Qualified Facilities. If the Trust were to invest in cogeneration Projects or certain other types of Qualifying Facilities, the PURPA standards could raise material compliance questions. In any event, there can be no assurance that a Project will maintain its Qualified Facility status. If a Project loses its Qualifying Facility status, the utility can reclaim payments it made for the Project's non-qualifying output to the extent those payments are in excess of current avoided costs (which are generally substantially below the Power Contract rates) or the Project's Power Contract can be terminated by the electric utility. States may require utilities to institute monitoring systems under which electric utilities continuously meter a cogeneration Project's performance.
(B) The 1992 Energy Act. The Comprehensive Energy Policy Act of 1992 (the "1992 Energy Act") empowered FERC to require electric utilities to make available their transmission facilities to and wheel power for Independent Power Projects under certain conditions and created an exemption for electric utilities, electric utility holding companies and other independent power producers from certain restrictions imposed by the Holding Company Act. Although the Trust believes that the exemptive provisions of the 1992 Energy Act will not materially and adversely affect its business plan, the act may result in increased competition in the sale of electricity.
The 1992 Energy Act created the "exempt wholesale generator" category for entities certified by FERC as being exclusively engaged in owning and operating electric generation facilities producing electricity for resale. Exempt wholesale generators remain subject to FERC regulation in all areas, including rates, as well as state utility regulation, but electric utilities that otherwise would be precluded by the Holding Company Act from owning interests in exempt wholesale generators may do so. Exempt wholesale generators, however, may not sell electricity to affiliated electric utilities without express state approval that addresses issues of fairness to consumers and utilities and of reliability.
(C) The Federal Power Act. The FPA grants FERC exclusive rate-making jurisdiction over wholesale sales of electricity in interstate commerce. The FPA provides FERC with ongoing as well as initial jurisdiction, enabling FERC to revoke or modify previously approved rates. Such rates may be based on a cost-of-service approach or determined through competitive bidding or negotiation. While Qualifying Facilities under PURPA are exempt from the rate-making and certain other provisions of the FPA, non-Qualifying Facilities are subject to the FPA and to FERC rate-making jurisdiction.
Companies whose facilities are subject to regulation by FERC under the FPA because they do not meet the requirements of PURPA may be limited in negotiations with power purchasers. However, since such projects would not be bound by PURPA's heat energy use requirement for cogeneration facilities, they may have greater latitude in site selection and facility size. If any of the Trust's electric power Projects failed to be a Qualifying Facility, it would have to comply with the FPA.
The FPA also provides that any hydroelectric facility that is located on a navigable stream or that affects public lands or water from a government dam may not be constructed or be operated without a license from FERC. Certain facilities that were operating before 1935 are exempt, if the waterway is non-navigable, or "grandfathered" and do not require licenses so long as the facilities are not modernized or otherwise materially altered. Licenses are granted for 30 to 50 year terms. All but two of the Maine Hydro Projects (with a rated capacity of 2.1 Megawatts) are subject to licensing. Of these 12 Projects, six (with a rated capacity of 6.4 Megawatts) have current licenses that expire from time to time between the years 2019 and 2037 and two (1.5 Megawatts) are currently in the licensing process, which can take from three to five years. The Trust believes that it will obtain licenses for each of these.
The proposed conditions for one pending license, at the Pittsfield Project on the Kennebec River (1.1 Megawatt), have been received. The Project will have to provide upstream fish passages no earlier than 2002 or, if later, the time when all dams further upstream have provided passage. The Project will also have to provide interim fish passage both upstream and downstream to the extent warranted by fishery studies; downstream mitigation measures may require the Project to restrict flow through its turbines during certain spring peak flow periods that could materially impair electricity output. Until studies are complete, it is not possible to estimate the effects of these conditions. Further, as noted above at Item 1(c)(3) - Business - Narrative Description of Business - Project Operation, the licenses may include other onerous conditions. The Trust is a member of the Kennebec Hydro Developers Group, which is negotiating with Maine agencies and environmental groups for watershed-wide studies and remediation programs.
Finally, six of the Maine Hydro Projects (with a rated capacity of 3.7 Megawatts) are exempt, grandfathered or are not otherwise subject to FERC licensing.
(D) Fuel Use Act. Projects that may be developed or acquired may also be subject to the Fuel Use Act, which limits the ability of power producers to burn natural gas in new generation facilities unless such facilities are also coal-capable within the meaning of the Fuel Use Act.
(E) State Regulation. State public utility regulatory commissions have broad jurisdiction over Independent Power Projects which are not Qualifying Facilities under PURPA, and which are considered public utilities in many states. In states where the wholesale or retail electricity market remains regulated, Projects that are not Qualifying Facilities may be subject to state requirements to obtain certificates of public convenience and necessity to construct a facility and could have their organizational, accounting, financial and other corporate matters regulated on an ongoing basis. Although FERC generally has exclusive jurisdiction over the rates charged by a non-Qualifying Facility to its wholesale customers, state public utility regulatory commissions have the practical ability to influence the establishment of such rates by asserting jurisdiction over the purchasing utility's ability to pass through the resulting cost of purchased power to its retail customers. In addition, states may assert jurisdiction over the siting and construction of non-Qualifying Facilities and, among other things, issuance of securities, related party transactions and sale and transfer of assets. The actual scope of jurisdiction over non-Qualifying Facilities by state public utility regulatory commissions varies from state to state.
(ii) Environmental Regulation.
The construction and operation of Independent Power Projects and the exploitation of natural resource properties are subject to extensive federal, state and local laws and regulations adopted for the protection of human health and the environment and to regulate land use. The laws and regulations applicable to the Trust and Projects in which it invests primarily involve the discharge of emissions into the water and air and the disposal of waste, but can also include wetlands preservation and noise regulation. These laws and regulations in many cases require a lengthy and complex process of renewing licenses, permits and approvals from federal, state and local agencies. Obtaining necessary approvals regarding the discharge of emissions into the air is critical to the development of a Project and can be time-consuming and difficult. Each Project requires technology and facilities which comply with federal, state and local requirements, which sometimes result in extensive negotiations with regulatory agencies. Meeting the requirements of each jurisdiction with authority over a Project may require extensive modifications to existing Projects.
In May 1999 the Providence Project settled the administrative proceedings against the Providence Project for violations of training, recordkeeping and signage requirements brought by the Environmental Protection Agency ("EPA"). The alleged violations and the proceedings are described at Item 3 - Legal Proceedings, below.
In February 2000, in response to complaints of odors from the Rhode Island landfill, the EPA ordered the Providence Project, the gas collection company and the state agency owing the landfill to jointly respond in an investigation of the landfill gas control system at the landfill, of which the Providence Project is a part. The Project's systems are performing within environmental requirements and the Trust does not believe that it will be responsible for any material liability. It is possible, however, that the EPA will require the other parties at the landfill to change their operations, which might have a material effect on the Trust. At this time, there is no indication of what action, if any, the EPA might take.
The Clean Air Act Amendments of 1990 contain provisions which regulate the amount of sulfur dioxide and oxides of nitrogen which may be emitted by a Project. These emissions may be a cause of "acid rain." Qualifying Facilities are currently exempt from the acid rain control program of the Clean Air Act Amendments. However, non-Qualifying Facility Projects will require "allowances" to emit sulfur dioxide after the year 2000. Under the Amendments, these allowances may be purchased from utility companies then emitting sulfur dioxide or from the EPA. Further, an Independent Power Project subject to the requirements has a priority over utilities in obtaining allowances directly from the EPA if (a) it is a new facility or unit used to generate electricity; (b) 80% or more of its output is sold at wholesale; (c) it does not generate electricity sold to affiliates (as determined under the Holding Company Act) of the owner or operator (unless the affiliate cannot provide allowances in certain cases) and (d) it is non-recourse project-financed. The market price of an allowance cannot be predicted with certainty at this time. In recent years, supply of allowances has tended to exceed demand, primarily because of improved control technologies and the increased use of natural gas.
Title V of the Clean Air Act Amendments added a new permitting requirement for existing sources that requires all significant sources of air pollution to submit new applications to state agencies. Title V implementation by the states generally does not impose significant additional restrictions on the Trust's Projects, other than requirements to continually monitor certain emissions and document compliance. The Trust has filed Title V applications with the appropriate states for the Providence and Maine Biomass Projects, and has been advised by EPS that an application has been approved for the Santee River Project, which are all the Projects that are required to file. The permitting process is voluminous and protracted and the costs of fees for Title V applications, of testing and of engineering firms to prepare the necessary documentation have increased. The Trust believes that all of its facilities will be in compliance with Title V requirements with only minor modifications such as the installation of an additional catalytic converter on some engines.
In July 1997 the Environmental Protection Agency adopted more stringent standards for levels of ozone and small particulate matter (particles less than 25 microns in diameter) in geographic areas. These new standards may cause some areas in which Projects are located to be classified as non-attainment areas. If so, states will be required to impose additional requirements for industries to reduce emissions. It is uncertain whether or how any reductions would be applied to small facilities such as the Trust's Projects. If reductions were required, the Trust might have to make significant capital investments to install new control technology or might have to reduce operations. In addition, many eastern states, including Maine, have organized in the Ozone Transport Assessment Group to require further restrictions on emissions of nitrogen oxides. The Environmental Protection Agency is considering the Group's recommendations as well as other proposals to reduce emissions of nitrogen oxides and other ozone-forming chemicals. If adopted, new regulations could require the Trust to install additional equipment to reduce those emissions or to change operations. Nitrogen oxide reductions can be difficult to achieve with add-on equipment and often require decreases in operating efficiency, both of which could cause material cost to the Trust. It is not possible at this time to estimate whether or not any potential regulatory changes would materially affect the Trust.
The Clean Air Act Amendments empower states to impose annual operating permit fees of at least $25 per ton of regulated pollutants emitted up to $100,000 per pollutant. To date, no state in which the Trust operates has done so. If a state were to do so, such fees might have a material effect on the Trust's costs of generation, in light of the relatively small size of the Trust's facilities as opposed to large utility generation plants that might benefit from the cap on fees.
The Trust's Projects must comply with many federal and state laws and regulations governing wastewater and stormwater discharges from the Projects. These are generally enforced by states under "NPDES" permits for point sources of discharges and by stormwater permits. Under the Clean Water Act, NPDES permits must be renewed every five years and permit limits can be reduced at that time or under re-opener clauses at any time. The Projects have not had material difficulty in complying with their permits or obtaining renewals. The Projects use closed-loop engine cooling systems which do not require large discharges of coolant except for periodic flushing to local sewer systems under permit and do not make other material discharges.
The Providence Project operates filtration and condensation equipment for the purpose of removing contaminants from the landfill gas supply. The condensate is further treated and then discharged to a local treatment plant under an NPDES permit. The contaminants removed from the condensate are incinerated at an approved facility. The Trust believes that these discharges and contaminants are being disposed of in compliance with NPDES and other requirements.
The Trust's Projects are subject to the reporting requirements of the Emergency Planning and Community Right-to-Know Act that require the Projects to prepare toxic inventory release forms. These forms list all toxic substances on site that are used in excess of threshold levels so as to allow governmental agencies and the public to learn about the presence of those substances and to assess potential hazards and hazard responses. The Trust does not anticipate that this requirement will result in any material adverse effect on it.
Based on current trends, the Managing Shareholder expects that environmental and land use regulation will become more stringent. The Trust and the Managing Shareholder have developed limited expertise and experience in obtaining necessary licenses, permits and approvals, which in the case of the Maine Hydro Project are the responsibility of Consolidated Hydro, Inc. The Trust will rely upon qualified environmental consultants and environmental counsel retained by it or by Project Sponsors to assist in evaluating the status of Projects regarding such matters.
(iii) The 1940 Act
Since its Shares are registered under the 1934 Act, the Trust is required to file with the Commission certain periodic reports (such as Forms 10-K (annual report), 10-Q (quarterly report) and 8-K (current reports of significant events) and to be subject to the proxy rules and other regulatory requirements of that act that are applicable to the Trust. The Trust has no intention to and will not permit the creation of any form of a trading market in the Shares in connection with this registration.
On January 24, 1995, the Trust notified the Securities and Exchange Commission (the "Commission") of its election to be a "business development company" and registered its Shares under the 1934 Act. On March 24, 1995, the election and registration became effective. As a "business development company," the Trust was subject to prohibitions and restrictions on transactions between business development companies and their affiliates as defined in that act, and required that a majority of the board of the company be persons other than "interested persons" as defined in the act.
In particular, Commission approval was required for certain transactions involving certain closely affiliated persons of business development companies, including many transactions with the Managing Shareholder and the other investment programs sponsored by the Managing Shareholder. The decision to co-invest in the Providence Project with Power III required approval of the Commission, which took more than eight months to obtain. The decision to co-invest in the Maine Hydro Projects with Power V would also have required approval of the Commission. There was no assurance that the necessary approval for that co-investment or others could be obtained.
Accordingly, in September 1996 the Managing Shareholder made a proxy solicitation requesting that the Investors in this Trust approve a proposal to end the Trust's status as a business development company. The purpose of the change was to allow the Trust to invest with other programs sponsored by the Managing Shareholder, with only the approval of the Trust's Independent Trustees. The Independent Trustees may not be "interested persons" (as defined by law) of the Trust or the Managing Shareholder. The Managing Shareholder advised the Investors of its belief that the change would end the delays and uncertainties of seeking approval from the Securities and Exchange Commission (the "Commission") for such transactions and therefore would increase opportunities for the Trust to diversify its investments and to increase the size and quality of the potential investment pool.
A majority in interest of the Investors approved an amendment to the Trust's Declaration of Trust by written consent. The amendment and the termination of business development company status became effective on October 3, 1996. In summary, the amendment authorized the Trust to withdraw the business development company election. It also defined a "Ridgewood Program Transaction" as a transaction with a Ridgewood Program, an entity controlled by a Ridgewood Program or Programs, or an entity in which a Ridgewood Program has invested, that would otherwise be prohibited by the 1940 Act. The amendment stated that Ridgewood Program Transactions will not be subject to any provision of the 1940 Act or rules thereunder that would restrict the Trust, or entities the Trust controls or has invested in, form entering into Ridgewood Program Transactions. Instead, a Ridgewood Program Transaction must be approved either by the Managing Shareholder and a majority of the Independent Trustees, or by a majority of the Independent Trustees and a Majority of the Investors. No express standards for approval are specified, although the Managing Shareholder and the Independent Trustees are subject to the fiduciary requirements of Delaware law in making their decisions.
The amendment also required the Trust to continue to comply with all other requirements of the 1940 Act as if the Trust continued to be a business development company, except that the Trust would not be required to file any reports required of business development companies with the Commission or any other regulatory agency. With regard to the requirements that the Trust will continue to adhere to, the Trust will not be able to request exemptive relief from or to take actions requiring approval by the Commission, and the Commission will not have the ability to regulate the Trust under the 1940 Act, because the Trust will no longer be subject to the Commission's authority over business development companies.
The requirements of the 1940 Act that the Trust has promised to comply with, and those that it will not be required to follow, are listed in Exhibit 99 to this Annual Report on Form 10-K. Some of those requirements that are particularly relevant to the Trust's acquisitions of Projects are described below.
The Trust may not acquire any asset other than a "Qualifying Asset" unless, at the time the acquisition is made, Qualifying Assets comprise at least 70% of the Trust's total assets by value. The principal categories of Qualifying Assets that are relevant to the Trust's activities are:
(A) Securities issued by "eligible portfolio companies" that are purchased by the Trust from the issuer in a transaction not involving any public offering (i.e., private placements of securities). An "eligible portfolio company" (1) must be organized under the laws of the United States or a state and have its principal place of business in the United States; (2) may not be an investment company other than a small business investment company licensed by the Small Business Administration and wholly-owned by the Trust and (3) may not have issued any class of securities that may be used to obtain margin credit from a broker or dealer in securities. The last requirement essentially excludes all issuers that have securities listed on an exchange or quoted on the National Association of Securities Dealers, Inc.'s national market system, along with other companies designated by the Federal Reserve Board. Except for temporary investments of the Trust's available funds, substantially all of the Trust's investments are expected to be Qualifying Assets under this provision.
(B) Securities received in exchange for or distributed on or with respect to securities described in paragraph (A) above, or on the exercise of options, warrants or rights relating to those securities.
(C) Cash, cash items, U.S. Government securities or high quality debt securities maturing not more than one year after the date of investment.
A business development company must make available "significant managerial assistance" to the issuers of Qualifying Assets described in paragraphs (A) and (B) above, which may include without limitation arrangements by which the business development company (through its directors, officers or employees) offers to provide (and, if accepted, provides) significant guidance and counsel concerning the issuer's management, operation or business objectives and policies.
A business development company also must be organized under the laws of the United States or a state, have its principal place of business in the United States and have as its purpose the making of investments in Qualifying Assets described in paragraph (A) above.
(d) Financial Information about Foreign and Domestic Operations and Export Sales.
The Trust has committed funds to Projects located in Rhode Island, Maine, South Carolina and California. The Trust has not acquired any Project located outside the United States.
(e) Employees.
The Trust has no employees. The persons described below at Item 10 - Directors and Executive Officers of the Registrant serve as executive officers of the Trust and have the duties and powers usually applicable to similar officers of a Delaware corporation in carrying out the Trust business.
Item 2.
Item 2. Properties.
Pursuant to the Management Agreement between the Trust and the Managing Shareholder (described at Item 10(c)), the Managing Shareholder provides the Trust with office space at the Managing Shareholder's principal office at The Ridgewood Commons, 947 Linwood Avenue, Ridgewood, New Jersey 07450.
The following table shows the material properties (relating to Projects) owned or leased by the Trust's subsidiaries or partnerships or limited liability companies in which the Trust has an interest.
Approximate Square Ownership Ground Approximate Footage of Description Interests Lease Acreage Project of Projects Location in Land Expiration of Land (Actual Project or Projected)
Provi- Providence, dence Rhode Leased 2020 4 10,000 Landfill Island gas-fired generation facility Maine Hydro 14 sites in Maine Owned n/a 24 n/a Hydro- by joint electric venture* facilities
Pump Ser- Ventura License n/a n/a nominal Natural- vices County, gas-fueled California engines for irrigation pumps located on various farms Maine West Enfield Owned n/a less 18,000 Wood waste- Bio- and Jonesboro, by joint than fired genera- mass Maine venture** 25 tion facility
Santee Berkeley Owned by n/a 30 Used tire River County, joint processing South venture*** facility Carolina
*Joint venture equally owned by Trust and Power V. ** Joint venture owned by Indeck, the Trust and Power V. *** Joint venture owned by EPS, the Trust and Power V.
Item 3.
Item 3. Legal Proceedings.
In September 1998, the Region I office of the U.S. Environmental Protection Agency (the "EPA") filed an administrative proceeding against Ridgewood Providence Power Partners, L.P. ("RPPP"), a subsidiary of the Trust, seeking to recover civil penalties of up to $190,000 for alleged violations of operational recordkeeping and training requirements at the Providence Project. The penalty was reduced to $86,000 and was paid by the Providence Project in June 1999.
In October 1998, Indeck Maine brought two administrative complaints before FERC, naming ISO-New England and the New England Power Pool as defendants, alleging that the defendants had violated their own rules and applicable FERC orders in denying pooled transmission facility status for the transmission links between Indeck Maine's two Projects and the ISO's other transmission facilities. In February 1999, FERC rejected the complaints. Indeck Maine is considering whether to bring a new action together with other NEPOOL members based on new facts.
In March 2000, Indeck Maine intervened in a complaint before FERC, Dighton Power Assoc., L.P. et. al. v. ISO-New England, Inc., Docket No. EL00-40-000, in which several generators alleged that the ISO had improperly capped operable capability prices during emergency conditions in NEPOOL. See Item 1(c)(3)(ii) - Plant Operation - Maine Biomass Projects, above. The complaint requests FERC to rule that the operable capability prices should be based on the highest bids on those dates. If this were successful, the Maine Biomass Projects might be entitled to substantial additional payments from the ISO. The matter is in the preliminary stages of pleading and motion practice. Indeck Maine intends to participate vigorously in the proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
The Trust has not submitted any matters to a vote of its security holders during the fourth quarter of 1999.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
(a) Market Information.
The Trust sold 476.8 Investor Shares of beneficial interest in the Trust in its private placement offering, which concluded on September 30, 1996. There is currently no established public trading market for the Investor Shares and the Trust does not intend to allow a public trading market to develop. As of the date of this Form 10-K, all such Investor Shares have been issued and are outstanding. There are no outstanding options or warrants to purchase, or securities convertible into, Investor Shares.
Investor Shares are restricted as to transferability under the Declaration, as well as under federal and state laws regulating securities. The Investor Shares have not been and are not expected to be registered under the Securities Act of 1933, as amended (the "1933 Act"), or under any other similar law of any state (except for certain registrations that do not permit free resale) in reliance upon what the Trust believes to be exemptions from the registration requirements contained therein. Because the Investor Shares have not been registered, they are "restricted securities" as defined in Rule 144 under the 1933 Act.
The Managing Shareholder is considering the possibility of a combination of the Trust and five other investment programs sponsored by the Managing Shareholder (Ridgewood Electric Power Trusts I, II, III and V and the Ridgewood Power Growth Fund) into a publicly traded entity. This would require the approval of the Investors in the Trust and the other programs after proxy solicitations complying with requirements of the Securities and Exchange Commission, compliance with the "rollup" rules of the Securities and Exchange Commission and other regulations, and a change in the federal income tax status of the combined entity from a partnership (which is not subject to tax) to a corporation. The process of considering and effecting a combination, if the decision is made to do so, will be very lengthy. There is no assurance that the Managing Shareholder will recommend a combination, that the Investors of the Trust or other programs will approve it, that economic conditions or the business results of the participants will be favorable for a combination, that the combination will be effected or that the economic results of a combination, if effected, will be favorable to the Investors of the Trust or other programs.
(b) Holders
As of the date of this Form 10-K, there are 956 record holders of Investor Shares.
(c) Dividends
The Trust made distributions as follows in 1998 and 1999:
Year ended December 31, 1998 1999 Total distributions to Investors $3,383,174 $ 1,859,871 Distributions per Investor Share 7,096 3,900 Distributions to Managing Shareholder $ 34,173 $ 18,787
Distributions are made on a quarterly basis in March, June, September and December. During 1999 the rate of distributions was decreased from 7% per year to 4% per year because of adverse financial results described below at Item 7, Management's Discussion and Analysis. The Trust's ability to make future distributions to Investors and their timing will depend on the net cash flow of the Trust and retention of reasonable reserves as determined by the Trust to cover its anticipated expenses.
The Trust has made distributions at the rates of 7.1% in 1998 and 3.9% in 1999 and does not anticipate that distributions during 2000 will be at a substantially higher rate. This is because distributions from the Maine Hydro Projects during 1998 reflected higher than average water flows, which may not recur, because the Maine Biomass Projects may continue to incur losses until at least 2001 and because the Santee River Project is not anticipated to begin operation before summer 2000 and may not show operating profits for some additional time after that. Further, if adverse events were to occur, the Trust may be required to reduce distributions from existing levels.
Occasionally, distributions may include funds derived from the release of cash from operating or debt service reserves. For purposes of generally accepted accounting principles, amounts of distributions in excess of accounting income may be considered to be capital in nature. Investors should be aware that the Trust is organized to return net cash flow rather than accounting income to Investors.
Item 6.
Item 6. Selected Financial Data.
The following data is qualified in its entirety by the financial statements presented elsewhere in this Annual Report on Form 10-K.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Introduction
The following discussion and analysis should be read in conjunction with the Trust's financial statements and the notes thereto presented below. Dollar amounts in this discussion are generally rounded to the nearest $1,000.
The consolidated financial statements include the accounts of the Trust and the limited partnerships owning the Providence and California Pumping Projects. The Trust uses the equity method of accounting for its investments in the Maine Hydro Projects, the Maine Biomass Projects and the Santee River Rubber Project, which are owned 50% or less by the Trust.
Outlook
The U.S. electricity markets are being restructured and there is a trend away from regulated electricity systems towards deregulated, competitive market structures. The States that the Trust's Projects operate in have passed or are considering new legislation that would permit utility customers to choose their electricity supplier in a competitive electricity market. The Providence and Maine Hydro Projects are "Qualified Facilities" as defined under the Public Utility Regulatory Policies Act of 1978 and currently sell their electric output to utilities under long-term contracts. The Providence contract expires in 2020 and eleven of the Maine Hydro contracts expire in 2008 and the remaining three expire in 2007, 2014 and 2017. During the term of the contracts, the utilities may or may not attempt to buy out the contracts prior to expiration. At the end of the contracts, the Projects will become merchant plants and may be able to sell the electric output at then current market prices. There can be no assurance that future market prices will sufficient to allow the Trust's Projects to operate profitably.
The Providence Project generates electricity from methane gas produced at the Central Landfill in Johnston, Rhode Island. Gas reserves are estimated to be in excess of the amount needed to generate the 12 Megawatt maximum under the Power Contract with New England Power Company. The price paid for the gas is a percentage (15% to 18%) of net revenue from power sales. Accordingly, the Providence Project is not affected by fuel cost price changes. The quality of the gas may vary from time to time. Poor quality gas may cause operating problems, down time and unplanned maintenance at the generating facility.
The Maine Hydro Projects have a limited ability to store water. Accordingly, the amount of revenue from electricity generation from these Projects is directly related to river water flows, which have fluctuated as much as 30% from the average over the past ten years. It is not possible to accurately predict revenues from the Maine Hydro Projects.
The Maine Biomass Projects sold electricity under short-term contracts during the months of July, August, October, November and December 1997. The Projects are currently shutdown and will not be operated (except for required tests) unless sales arrangements are obtained which would provide sufficient revenue to cover the Projects fixed and variable costs. Under current legislation, the electricity market in the State of Maine will be deregulated on March 1, 2000. Currently, the cost of biomass fuel and transportation costs are too high to allow the Maine Biomass Projects to compete on price alone. If fuel can be purchased at reasonable prices in the year 2001 and beyond, the Maine Biomass Projects might be among the low cost producers of environmentally friendly electricity in Maine and might be able to operate profitably in a competitive market environment or in a set-aside market for renewable power. In the meantime, the Trust intends to keep the Projects in an idle mode until market conditions become more favorable, and will seek short-term contracts to sell energy and installed capacity.
All power generation projects currently owned by the Trust produce electricity from renewable energy sources, such as landfill gas, hydropower and biomass ("green power"). In the State of Maine, as a condition of licensing, competitive generation providers and power marketers will have to demonstrate that at least 30% of their generation portfolio is green power sources. Other States in the New England Power Pool have or are expected to have similar green power licensing requirements, although the percentage of green power generation may differ from State to State. These green power licensing requirements should have a beneficial effect on the future profitability of the Maine Biomass Projects. Although the Providence and Maine Hydro Projects also produce green power, their output is committed under long-term Power Contracts at fixed prices.
The Santee River Rubber Project, which is currently in the construction phase, will process waste tires and is expected to generate high quality crumb rubber. Assuming that the plant functions as specified and that the price received for the crumb rubber from customers is as forecast, the Project should begin operations in the third quarter of 2000.
The California Pumping Project owns irrigation well pumps in Ventura County, California, which supply water to farmers. The demand for water pumped by the project varies inversely with rainfall in the area.
Additional trends affecting the independent power industry generally are described at Item 1 - Business.
Results of Operations
The year ended December 31, 1999 compared to the year ended December 31, 1998.
In 1999, the Trust had a net loss of $744,000 as compared to a net loss of $602,000 in 1998. The 1999 and 1998 net losses include the following results from projects:
Project 1999 1998 ----------- ----------- Providence Project ............. (1) $ 310,000 $ 535,000 Maine Hydro Projects ........... (2) 849,000 658,000 Maine Biomass Projects ......... (2) (1,007,000) (694,000) Santee River Rubber ............ (2) 49,000 182,000 California Pumping Project ..... (1) (155,000) (131,000)
(1) Earnings, net of minority interest. (2) Equity interest in income (loss) of the project.
Although revenues generated by the Providence Project in 1999 were similar to those of 1998, the decrease in income from the project reflects increased costs of engine maintenance resulting from the unanticipated outages of two engines.
The increase in income from the Maine Hydro Projects reflects higher revenues in 1999 compared to 1998. The improved revenues reflected higher-than-average rainfall and snowfall, which increased water flow through the hydroelectric dams.
The increase in the loss from the shutdown Maine Biomass Projects from 1998 to 1999 reflects the cost of periodically operating the plant more frequently in 1999 compared to 1998. As discussed at Item 1(c)(3)(ii) above, the projects are in dispute with the ISO over the payment of certain revenues related to the plants' operation in 1999. The disputed payments were not recorded as income by the projects pending resolution of the disputes.
The Trust income from the Santee River Rubber project in 1999 was lower than in 1998 reflecting the Trust's share of the cost of marketing and administration as the plant is constructed.
The loss from the California Pumping Project in 1999 was greater than the prior year's due to increased fuel prices, which more than offset the improvement in revenues caused by the absence of the extraordinary rainfall that occurred in the first half of 1998 and the absence of the 1998 cost of terminating the operating agreement with the third party manager.
The Trust-level expenses in 1999 and 1998 include management fees of $467,000 and $1,051,000, respectively. The decrease is a result of the Managing Shareholder's decision to waive 50% of the fee in 1999. To date, the Managing Shareholder has continued to waive 50% of the fee but it may end that waiver in its sole discretion at any time. Due diligence expenses related to unsuccessful potential investments of $205,000 in 1998 did not recur due to the Trust's completion of the investment of its available funds in 1998. Other Trust-level expenses in 1999 and 1998 were comparable.
The year ended December 31, 1998 compared to the year ended December 31, 1997.
In 1998, the Trust had a net loss of $602,000 as compared to a net loss of $403,000 in 1997. The 1998 and 1997 net losses include the following results from projects:
Project 1998 1997 - -------------------------------------- --------- --------- Providence Project ................ (1) $ 535,000 $ 964,000 Maine Hydro Projects .............. (2) 658,000 522,000 Maine Biomass Projects ............ (2) (694,000) (680,000) Santee River Rubber ............... (2) 182,000 -- California Pumping Project ........ (1) (131,000) 18,000
(1) Earnings, net of minority interest. (2) Equity interest in income (loss) of the project.
Although revenues generated by the Providence Project in 1998 were similar to those of 1997, the decrease in income from the project reflects an increase in the costs of periodic engine maintenance.
The increase in income from the Maine Hydro Projects reflects higher revenues in 1998 compared to 1997. The improved revenues reflected higher-than-average rainfall and snowfall, which increased water flow through the hydroelectric dams.
The loss from the shutdown Maine Biomass Projects in 1998 was similar to the loss incurred in 1997. However, the 1998 loss reflects twelve months of operations compared to six months in 1997. The lower loss per month in 1998 reflects a reduction in expenses as well as the sale of installed capability.
Income from the Santee River Rubber project reflects the Trust's share of interest income earned before the project entered the construction phase.
Demand for energy from the California Pumping Project suffered from the extraordinary rainfall that occurred in the first half of 1998.
The Trust-level expenses in 1998 and 1997 include management fees of $1,051,000 and $1,155,000, respectively. The decrease is a result of the decrease in the net assets of the Trust. Due diligence expenses related to unsuccessful potential investments declined from $669,000 in 1998 to $205,000 in 1998 as a result of the Trust's completing the investment of its available funds in 1998. Other Trust level expenses in 1998 and 1997 were comparable.
Liquidity and Capital Resources
In 1999 and 1998 the Trust's operating activities generated $974,000 and $478,0000 of cash, respectively. The higher level of cash from operations in 1999 primarily reflects decreases in working capital required at the Providence Project.
In 1999, the Trust's investing activities generated $908,000 of cash compared to a use of cash of $4,950,000 in 1998. The improvement was primarily a result of a $4,348,000 reduction in investments in projects and a $979,000 reduction in capital expenditures from the 1998 levels.
Cash used in financing activities decreased from $4,594,000 in 1998 to $3,010,000 in 1999 primarily due to a reduction of the distribution rate to shareholders from 6% per year in 1998 to 4% in 1999.
During 1997, the Trust and Fleet Bank, N.A. (the "Bank") entered into a revolving line of credit agreement, whereby the Bank provides a three year committed line of credit facility of $1,150,000. Outstanding borrowings bear interest at the Bank's prime rate or, at the Trust's choice, at LIBOR plus 2.5%. The credit agreement requires the Trust to maintain a ratio of total debt to tangible net worth of no more than 1 to 1 and a minimum debt service coverage ratio of 2 to 1. The credit facility was obtained in order to allow the Trust to operate using a minimum amount of cash, maximize the amount invested in Projects and maximize cash distributions to shareholders. There were no borrowings under the line of credit in 1999 or 1998. In January 2000, the Trust borrowed $400,000 under the line of credit to meet its working capital requirements.
Obligations of the Trust are generally limited to payment of Project operating expenses, repayment of borrowings under the line of credit, payment of a management fee to the Managing Shareholder, payments for certain accounting and legal services to third persons and distributions to shareholders of available operating cash flow generated by the Trust's investments. The Trust's policy is to distribute as much cash as it deems prudent to shareholders. Accordingly, the Trust has not found it necessary to retain a material amount of working capital. The amount of working capital retained is further reduced by the availability of the line of credit facility.
The Trust anticipates that during 2000 its cash flow from operations, unexpended offering proceeds and line of credit facility will be adequate to fund its obligations.
Year 2000 Remediation
The Managing Shareholder and its affiliates began year 2000 review and planning in early 1997. After initial remediation was completed, a more intensive review discovered additional issues and the Managing Shareholder began a formal remediation program in late 1997. All remediation and testing were completed by October 31, 1999 and no material malfunctions have been discovered through the date of this filing.
The accounting, network and financial packages for the Ridgewood companies are basically off-the-shelf packages that were remediated, where necessary, by obtaining patches or updated versions. The Managing Shareholder estimates that the Trust's allocable portion of the cost of upgrades that were accelerated because of the Year 2000 problem is less than $1,000.
The Managing Shareholder has two major systems affecting the Trust that rely on custom-written software, the subscription/investor relations and investor distribution systems, which maintain individual investor records and effect disbursement of distributions to Investors. These were remediated in 1999, including the elements of those systems used to generate internal sales reports and other internal reports. Although these were not designated mission-critical, they were also successfully remediated by October 31, 1999. Some subsystems are being remediated using the "sliding window" technique, in which two digit years less than a threshold number are assumed to be in the 2000's and higher two digit numbers are assumed to be in the 1900's. Although this will allow compliance for several years beyond the year 2000, eventually those systems will have to be rewritten again or replaced. The Managing Shareholder expects that the ordinary course of system upgrading will eventually cure this problem.
The Trust's share of the incremental cost for Year 2000 remediation of this custom written software and related items for 1998 and prior years was approximately $12,250 and was approximately $11,500 for 1999.
Each of the Trust's electric generating facilities was reviewed in 1999 by RPMCo personnel to determine if its electronic control systems contained software affected by the Year 2000 problem or contain embedded components that contain Year 2000 flaws. The Trust owns small electric generating facilities that rely on mechanical and analog systems that were not vulnerable to Year 2000 problems. The facilities use personal computers running packaged software for routine recordkeeping and data logging, which have been upgraded as described above. To date the Trust has discovered no systems having a material impact on output, environmental compliance, recordkeeping or any other material impact that have Year 2000 concerns. The Maine Biomass Projects contained certain embedded chips that were replaced before December 31, 1999 at a nominal cost. The Trust's share of the estimated costs of the review and of any minor upgrades or rehabilitation was less than $25,000.
The Managing Shareholder and its affiliates do not significantly rely on computer input from suppliers and customers and thus are not directly affected by other companies' Year 2000 compliance. No material adverse effects from customers' or suppliers' Year 2000 problems have occurred.
Based on its internal evaluations and the risks and contexts identified by the Commission in its rules and interpretations, the Trust believes that Year 2000 issues relating to its assets and remediation program will not have a material effect on its facilities, financial position or operations, and that the costs of addressing the Year 2000 issues will not have a material effect on its future consolidated operating results, financial condition or cash flows. However, this belief is based upon current information, and there can be no assurance that unanticipated problems will not occur or be discovered that would result in material adverse effects on the Trust.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Qualitative Information About Market Risk.
The Trust's investments in financial instruments are short-term investments of working capital or excess cash. Those short-term investments are limited by its Declaration of Trust to investments in United States government and agency securities or to obligations of banks having at least $5 billion in assets. Because the Trust invests only in short-term instruments for cash management, its exposure to interest rate changes is low. The Trust has limited exposure to trade accounts receivable and believes that their carrying amounts approximate fair value.
The Trust's primary market risk exposure is limited interest rate risk caused by fluctuations in short-term interest rates. The Trust does not anticipate any changes in its primary market risk exposure or how it intends to manage it. The Trust does not trade in market risk sensitive instruments.
Quantitative Information About Market Risk
This table provides information about the Trust's financial instruments that are defined by the Securities and Exchange Commission as market risk sensitive instruments. These include only short-term U.S. government and agency securities and bank obligations. The table includes principal cash flows and related weighted average interest rates by contractual maturity dates.
December 31, 1999 Expected Maturity Date (U.S. $)
Bank Deposits and Certificates of Deposit $ 893,383 Average interest rate 5.6%
Item 8.
Item 8. Financial Statements and Supplementary Data.
Report of Independent Accountants Balance Sheets at December 31, 1999 and 1998 Statement of Operations for Years Ended December 31, 1999, 1998 and 1997 Statement of Changes in Shareholders' Equity for Years Ended December 31, 1999, 1998 and 1997 Statement of Cash Flows for Years Ended December 31, 1999, 1998 and 1997 Notes to Financial Statements to
Financial Statements for Maine Hydro Projects Financial Statements for Maine Biomass Projects
All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
The financial statements are presented in accordance with generally accepted accounting principles for operating companies, using consolidation and equity method accounting principles. This differs from the basis used by the three prior independent power programs sponsored by the Managing Shareholder, which present the Trust's investments in Projects on the estimated fair value method rather than the consolidation and equity accounting method. Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Neither the Trust nor the Managing Shareholder has had an independent accountant resign or decline to continue providing services since their respective inceptions and neither has dismissed an independent accountant during that period. During that period of time no new independent accountant has been engaged by the Trust or the Managing Shareholder, and the Managing Shareholder's current accountants, PricewaterhouseCoopers LLP, have been engaged by the Trust.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
(a) General.
As Managing Shareholder of the Trust, Ridgewood Power LLC has direct and exclusive discretion in management and control of the affairs of the Trust (subject to the general supervision and review of the Independent Trustees and the Managing Shareholder acting together as the Board of the Trust). The Managing Shareholder will be entitled to resign as Managing Shareholder of the Trust only (i) with cause (which cause does not include the fact or determination that continued service would be unprofitable to the Managing Shareholder) or (ii) without cause with the consent of a majority in interest of the Investors. It may be removed from its capacity as Managing Shareholder as provided in the Declaration.
Ridgewood Holding, which was incorporated in April 1992, is the Corporate Trustee of the Trust.
(b) Managing Shareholder.
Ridgewood Power Corporation was incorporated in February 1991 as a Delaware corporation for the primary purpose of acting as a managing shareholder of business trusts and as a managing general partner of limited partnerships which are organized to participate in the development, construction and ownership of Independent Power Projects. It organized the Trust and acted as managing shareholder until April 1999. On or about April 21, 1999 it was merged into the current Managing Shareholder, Ridgewood Power LLC. Ridgewood Power LLC was organized in early April 1999 and has no business other than acting as the successor to Ridgewood Power Corporation.
Robert E. Swanson has been the President, sole director and sole stockholder of Ridgewood Power Corporation since its inception in February 1991 and is now the controlling member, sole manager and President of the Managing Shareholder. All of the equity in the Managing Shareholder is or will be owned by Mr. Swanson or by family trusts. Mr. Swanson has the power on behalf of those trusts to vote or dispose of the membership equity interests owned by them.
The Managing Shareholder has also organized Ridgewood Electric Power Trust I ("Ridgewood Power I"), Ridgewood Electric Power Trust II ("Ridgewood Power II"), Ridgewood Electric Power Trust III ("Ridgewood Power III"), Ridgewood Electric Power Trust V ("Ridgewood Power V") and The Ridgewood Power Growth Fund (the "Growth Fund") as Delaware business trusts to participate in the independent power industry. Ridgewood Power LLC is now also their managing shareholder. The business objectives of these five trusts are similar to those of the Trust.
A number of other companies are affiliates of Mr. Swanson and Ridgewood Power. Each of these also was organized as a corporation that was wholly-owned by Mr. Swanson. In April 1999, most of them were merged into limited liability companies with similar names and Mr. Swanson became the sole manager and controlling owner of each limited liability company. For convenience, the remainder of this Memorandum will discuss each limited liability company and its corporate predecessor as a single entity.
The Managing Shareholder is an affiliate of Ridgewood Energy Corporation("Ridgewood Energy"), which has organized and operated 48 limited partnership funds and one business trust over the last 17 years (of which 25 have terminated) and which had total capital contributions in excess of $190 million. The programs operated by Ridgewood Energy have invested in oil and natural gas drilling and completion and other related activities. Other affiliates of the Managing Shareholder include Ridgewood Securities LLC ("Ridgewood Securities"), an NASD member which has been the placement agent for the private placement offerings of the six trusts sponsored by the Managing Shareholder and the funds sponsored by Ridgewood Energy; Ridgewood Capital Management LLC ("Ridgewood Capital"), which assists in offerings made by the Managing Shareholder and which is the sponsor of four privately offered venture capital funds (the Ridgewood Capital Venture Partners and Ridgewood Capital Venture Partners II funds); Ridgewood Power VI LLC ("Power VI"), which is a managing shareholder of the Growth Fund, and RPMCo. Each of these companies is controlled by Robert E. Swanson, who is their sole director or manager.
Set forth below is certain information concerning Mr. Swanson and other executive officers of the Managing Shareholder.
Robert E. Swanson, age 53, has also served as President of the Trust since its inception in November 1992 and as President of RPMCo, Ridgewood Power I, Ridgewood Power II, Ridgewood Power III, Ridgewood Power V and the Growth Fund, since their respective inceptions. Mr. Swanson has been President and registered principal of Ridgewood Securities and became the Chairman of the Board of Ridgewood Capital on its organization in 1998. He also is Chairman of the Board of the Ridgewood Capital Venture Partners I and II venture capital funds. In addition, he has been President and sole or controlling owner of Ridgewood Energy since its inception in October 1982. Prior to forming Ridgewood Energy in 1982, Mr. Swanson was a tax partner at the former New York and Los Angeles law firm of Fulop & Hardee and an officer in the Trust and Investment Division of Morgan Guaranty Trust Company. His specialty is in personal tax and financial planning, including income, estate and gift tax. Mr. Swanson is a member of the New York State and New Jersey bars, the Association of the Bar of the City of New York and the New York State Bar Association. He is a graduate of Amherst College and Fordham University Law School.
Robert L. Gold, age 41, has served as Executive Vice President of the Managing Shareholder, RPMCo, Ridgewood Power I, the Trust, Ridgewood Power II, Ridgewood Power III, Ridgewood Power V and the Growth Fund since their respective inceptions, with primary responsibility for marketing and acquisitions. He has been President of Ridgewood Capital since its organization in 1998. As such, he is President of the Ridgewood Capital Venture Partners I and II funds. He has served as Vice President and General Counsel of Ridgewood Securities Corporation since he joined the firm in December 1987. Mr. Gold has also served as Executive Vice President of Ridgewood Energy since October 1990. He served as Vice President of Ridgewood Energy from December 1987 through September 1990. For the two years prior to joining Ridgewood Energy and Ridgewood Securities Corporation, Mr. Gold was a corporate attorney in the law firm of Cleary, Gottlieb, Steen & Hamilton in New York City where his experience included mortgage finance, mergers and acquisitions, public offerings, tender offers, and other business legal matters. Mr. Gold is a member of the New York State bar. He is a graduate of Colgate University and New York University School of Law.
Thomas R. Brown, age 45, joined the Managing Shareholder in November 1994 as Senior Vice President and holds the same position with the Trust, RPMCo and each of the other trusts sponsored by the Managing Shareholder. He became Chief Operating Officer of the Managing Shareholder, RPMCo and the Ridgewood Power I through V trusts in October 1996, and is the Chief Operating Officer of the Growth Fund. He is also Senior Vice President of Ridgewood Capital and of the two venture capital funds it manages. Mr. Brown has over 20 years' experience in the development and operation of power and industrial projects. From 1992 until joining the Managing Shareholder he was employed by Tampella Services, Inc., an affiliate of Tampella, Inc., one of the world's largest manufacturers of boilers and related equipment for the power industry. Mr. Brown was Project Manager for Tampella's Piney Creek project, a $100 million bituminous waste coal fired circulating fluidized bed power plant. Between 1990 and 1992 Mr. Brown was Deputy Project Manager at Inter-Power of Pennsylvania, where he successfully developed a 106 megawatt coal fired facility. Between 1982 and 1990 Mr. Brown was employed by Pennsylvania Electric Company, an integrated utility, as a Senior Thermal Performance Engineer. Prior to that, Mr. Brown was an Engineer with Bethlehem Steel Corporation. He has an Bachelor of Science degree in Mechanical Engineering from Pennsylvania State University and an MBA in Finance from the University of Pennsylvania. Mr. Brown satisfied all requirements to earn the Professional Engineer designation in 1985.
Martin V. Quinn, age 53, assumed the duties of Chief Financial Officer of the Managing Shareholder, the Trust, the prior four trusts organized by the Managing Shareholder and RPMCo in November 1996 under a consulting arrangement. He became a full-time officer of the Managing Shareholder and RPMCo in April 1997 and is now also Chief Financial Officer of the Growth Fund. He is also the Chief Financial Officer of Ridgewood Capital and of the Ridgewood Capital Venture Partners I and II funds.
Mr. Quinn has 32 years of experience in financial management and corporate mergers and acquisitions, gained with major, publicly-traded companies and an international accounting firm. He formerly served as Vice President of Finance and Chief Financial Officer of NORSTAR Energy, an energy services company, from February 1994 until June 1996. From 1991 to March 1993, Mr. Quinn was employed by Brown-Forman Corporation, a diversified consumer products company and distiller, where he was Vice President-Corporate Development. From 1981 to 1991, Mr. Quinn held various officer-level positions with NERCO, Inc., a mining and natural resource company, including Vice President- Controller and Chief Accounting Officer for his last six years and Vice President-Corporate Development. Mr. Quinn's professional qualifications include his certified public accountant qualification in New York State, membership in the American Institute of Certified Public Accountants, six years of experience with the international accounting firm of PricewaterhouseCoopers LLC, and a Bachelor of Science degree in Accounting and Finance from the University of Scranton (1969).
Mary Lou Olin, age 47, has served as Vice President of the Managing Shareholder, RPMCo, Ridgewood Capital, the Trust, Ridgewood Power I, Ridgewood Power II, Ridgewood Power III, Ridgewood Power V and the Growth Fund since their respective inceptions. She has also served as Vice President of Ridgewood Energy since October 1984, when she joined the firm. Her primary areas of responsibility are investor relations, communications and administration. Prior to her employment at Ridgewood Energy, Ms. Olin was a Regional Administrator at McGraw-Hill Training Systems where she was employed for two years. Prior to that, she was employed by RCA Corporation. Ms. Olin has a Bachelor of Arts degree from Queens College.
(c) Management Agreement.
The Trust has entered into a Management Agreement with the Managing Shareholder detailing how the Managing Shareholder will render management, administrative and investment advisory services to the Trust. Specifically, the Managing Shareholder will perform (or arrange for the performance of) the management and administrative services required for the operation of the Trust. Among other services, it will administer the accounts and handle relations with the Investors, provide the Trust with office space, equipment and facilities and other services necessary for its operation and conduct the Trust's relations with custodians, depositories, accountants, attorneys, brokers and dealers, corporate fiduciaries, insurers, banks and others, as required. The Managing Shareholder will also be responsible for making investment and divestment decisions, subject to the provisions of the Declaration.
The Managing Shareholder will be obligated to pay the compensation of the personnel and all administrative and service expenses necessary to perform the foregoing obligations. The Trust will pay all other expenses of the Trust, including transaction expenses, valuation costs, expenses of preparing and printing periodic reports for Investors and the Commission, postage for Trust mailings, Commission fees, interest, taxes, legal, accounting and consulting fees, litigation expenses and other expenses properly payable by the Trust. The Trust will reimburse the Managing Shareholder for all such Trust expenses paid by it.
As compensation for the Managing Shareholder's performance under the Management Agreement, the Trust is obligated to pay the Managing Shareholder an annual management fee described below at Item 13 -- Certain Relationships and Related Transactions.
The Board of the Trust (including both initial Independent Trustees) have approved the initial Management Agreement and its renewals. Each Investor consented to the terms and conditions of the initial Management Agreement by subscribing to acquire Investor Shares in the Trust. The Management Agreement will remain in effect until January 4, 2001 and year to year thereafter as long as it is approved at least annually by (i) either the Board of the Trust or a majority in interest of the Investors and (ii) a majority of the Independent Trustees. The agreement is subject to termination at any time on 60 days' prior notice by the Board, a majority in interest of the Investors or the Managing Shareholder. The agreement is subject to amendment by the parties with the approval of (i) either the Board or a majority in interest of the Investors and (ii) a majority of the Independent Trustees.
(d) Executive Officers of the Trust.
Pursuant to the Declaration, the Managing Shareholder has appointed officers of the Trust to act on behalf of the Trust and sign documents on behalf of the Trust as authorized by the Managing Shareholder. Mr. Swanson has been named the President of the Trust and the other executive officers of the Trust are identical to those of the Managing Shareholder. The officers have the duties and powers usually applicable to similar officers of a Delaware business corporation in carrying out Trust business. Officers act under the supervision and control of the Managing Shareholder, which is entitled to remove any officer at any time. Unless otherwise specified by the Managing Shareholder, the President of the Trust has full power to act on behalf of the Trust. The Managing Shareholder expects that most actions taken in the name of the Trust will be taken by Mr. Swanson and the other principal officers in their capacities as officers of the Trust under the direction of the Managing Shareholder rather than as officers of the Managing Shareholder.
(e) The Trustees.
The 1940 Act requires the Independent Trustees to be individuals who are not "interested persons" of the Trust as defined under the 1940 Act (generally, persons who are not affiliated with the Trust or with affiliates of the Trust). There must always be at least two Independent Trustees; a larger number may be specified by the Board from time to time. Each Independent Trustee has an indefinite term. Vacancies in the authorized number of Independent Trustees will be filled by vote of the remaining Board members so long as there is at least one Independent Trustee; otherwise, the Managing Shareholder must call a special meeting of Investors to elect Independent Trustees. Vacancies must be filled within 90 days. An Independent Trustee may resign effective on the designation of a successor and may be removed for cause by at least two-thirds of the remaining Board members or with or without cause by action of the holders of at least two-thirds of Shares held by Investors. Under the Declaration, the Independent Trustees are authorized to act only where their consent is required under the 1940 Act and to exercise a general power to review and oversee the Managing Shareholder's other actions. They are under a fiduciary duty similar to that of corporation directors to act in the Trust's best interest and are entitled to compel action by the Managing Shareholder to carry out that duty, if necessary, but ordinarily they have no duty to manage or direct the management of the Trust outside their enumerated responsibilities.
The Independent Trustees of the Trust are John C. Belknap, Dr. Richard D. Propper and Seymour Robin. They also serve as independent trustees for Power I and as independent panel members of the Growth Fund. Both are independent power programs sponsored by Ridgewood Power. Independent panel members must approve transactions between their program and the Managing Shareholder or companies affiliated with the Managing Shareholder, but have no other responsibilities. Set forth below is certain information concerning these individuals, who are not otherwise affiliated with the Trust, the Managing Shareholder or their directors, officers or agents.
John C. Belknap, age 53, has been chief financial officer of three national retail chains and their parent companies. He currently is an independent financial consultant associated with Dr. Propper. From July 1997 to August 1999, he was Executive Vice President and Chief Financial Officer of Richfood Holdings, Inc., a Virginia-based food manufacturer. From December 1995 to June 1997 Mr. Belknap was Executive Vice President and Chief Financial Officer of OfficeMax, Inc., a national chain of office supply stores. From February 1994 to February 1995, Mr. Belknap was Executive Vice President and Chief Financial Officer of Zale Corporation, a 1,200 store jewelry retail chain. From January 1990 to January 1994 and from February 1995 to December 1995, Mr. Belknap was an independent financial consultant. From January 1989 through May 1993 he aso served as a director of and consultant to Finlay Enterprises, Inc., an operator of leased fine jewelry departments in major department stores nationwide. Prior to 1989, Mr. Belknap served as Chief Financial Officer of Seligman & Latz, Kay Corporation and its subsidiary, Kay Jewelers, Inc.
From January 1990 until February 1994, Mr. Belknap consulted in a variety of strategic corporate transactions, including mergers and acquisitions, divestitures and refinancing. One such transaction involved the recapitalization and change of control of Finlay in May 1993. From 1979 to 1985, Mr. Belknap served as Chief Financial Officer of Kay Corporation ("Kay"), the parent of Kay Jewelers, Inc. ("KJI"), a national chain of jewelry stores and leased jewelry departments in major department stores. He served as Chief Financial Officer of KJI from 1974 to 1979 and as its Assistant Controller from 1973 to 1974. Between 1970 and 1973, Mr. Belknap was a senior auditor at Arthur Young & Company (now Ernst & Young), a national accounting firm. Mr. Belknap earned BA and MBA degrees from Cornell University.
Dr. Richard D. Propper, age 49, graduated from McGill University in 1969 and received his medical degree from Stanford University in 1972. He completed his internship and residency in Pediatrics in 1974, and then attended Harvard University for post doctoral training in hematology/oncology. Upon the completion of such training, he joined the staff of the Harvard Medical School where he served as an assistant professor until 1983. In 1983, Dr. Propper left academic medicine to found Montgomery Medical Ventures, one of the largest medical technology venture capital firms in the United States. He served as managing general partner of Montgomery Medical Ventures until 1993.
Dr. Propper is currently a consultant to a variety of companies for medical matters, including international opportunities in medicine. In June 1996 Dr. Propper agreed to an order of the Commission that required him to make filings under Sections 13(d) and (g) and 16 of the 1934 Act and that imposed a civil penalty of $15,000. In entering into that agreement, Dr. Propper did not admit or deny any of the alleged failures to file recited in that order. Dr. Propper is also an acquisition consultant for Ridgewood Capital Venture Partners, LLC and Ridgewood Institutional Venture Partners, LLC, the first two venture capital funds sponsored by Ridgewood Capital. He receives a fixed consulting fee from those funds and contingent compensation from Ridgewood Capital.
Seymour (Si) Robin, age 72, has been the Executive Vice President and CEO of Sensor Systems, Inc., an antenna manufacturing company located in Chatsworth, California. He has held this position since 1972. From 1949 to 1953, he owned and operated United Manufacturing Company, which specialized in aircraft and missile antennas. From 1953 to 1957, he managed Bendix Antenna Division, which specialized in aircraft and space antennas and avionics. In 1957, he started SRA Antenna Company as a manufacturer and technical consultant to worldwide manufacturers or commercial and military aircraft and space vehicles. He remained at SRA Antenna Company until 1971, at which time he became Executive Vice President and CEO of Sensor Systems, Inc.
Mr. Robin holds degrees in mechanical and electrical engineering from Montreal Technical Institute and U.C.L.A. He is an FAA-certified pilot (multi-engine, instrument, land and sea ratings) since 1966. He has received the AMC Airline Voltaire Award for the Most Outstanding Contribution to Airline Avionics in the Past 50 Years. He also owns significant interests in commercial and residential real estate in the southwest U.S. Mr. Robin was elected as an Independent Trustee by the two other Independent Trustees and Mr. Swanson in January 2000.
The Independent Trustess also serves as Independent Trustees of Trust I and of the Growth Fund.
The Corporate Trustee of the Trust is Ridgewood Holding. Legal title to Trust property is now and in the future will be in the name of the Trust, if possible, or Ridgewood Holding as trustee. Ridgewood Holding is also a trustee of Power I, Power II, Power III, Power V and the Growth Fund and of an oil and gas business trust sponsored by Ridgewood and is expected to be a trustee of other similar entities that may be organized by the Managing Shareholder and Ridgewood Energy. The President, sole director and sole stockholder of Ridgewood Holding is Robert E. Swanson; its other executive officers are identical to those of the Managing Shareholder. The principal office of Ridgewood Holding is at 1105 North Market Street, Suite 1300, Wilmington, Delaware 19899.
The Trustees are not liable to persons other than Shareholders for the obligations of the Trust.
The Trust has relied and will continue to rely on the Managing Shareholder and engineering, legal, investment banking and other professional consultants (as needed) and to monitor and report to the Trust concerning the operations of Projects in which it invests, to review proposals for additional development or financing, and to represent the Trust's interests. The Trust will rely on such persons to review proposals to sell its interests in Projects in the future.
(f) Section 16(a) Beneficial Ownership Reporting Compliance
All individuals subject to the requirements of Section 16(a) have complied with those reporting requirements during 1999.
(g) RPMCo.
As discussed above at Item 1 - Business, RPMCo assumed day-to-day management responsibility for the Providence Project in 1996 and has done so for the California Pumping Projects in October 1998 and for the Maine Biomass Projects in March 1999. Like the Managing Shareholder, RPMCo is wholly owned by Robert E. Swanson. It entered into an "Operation Agreement" with the Trust's subsidiary that owns the Project under which RPMCo, under the supervision of the Managing Shareholder, will provide the management, purchasing, engineering, planning and administrative services for the Providence Project. RPMCo will charge the Trust at its cost for these services and for the Trust's allocable amount of certain overhead items. RPMCo shares space and facilities with the Managing Shareholder and its affiliates. To the extent that common expenses can be reasonably allocated to RPMCo, the Managing Shareholder may, but is not required to, charge RPMCo at cost for the allocated amounts and such allocated amounts will be borne by the Trust and other programs. Common expenses that are not so allocated will be borne by the Managing Shareholder.
Initially, the Managing Shareholder does not anticipate charging RPMCo for the full amount of rent, utility supplies and office expenses allocable to RPMCo. As a result, both initially and on an ongoing basis the Managing Shareholder believes that RPMCo's charges for its services to the Trust are likely to be materially less than its economic costs and the costs of engaging comparable third persons as managers. RPMCo will not receive any compensation in excess of its costs.
Allocations of costs will be made either on the basis of identifiable direct costs, time records or in proportion to each program's investments in Projects managed by RPMCo; and allocations will be made in a manner consistent with generally accepted accounting principles.
RPMCo will not provide any services related to the administration of the Trust, such as investment, accounting, tax, investor communication or regulatory services, nor will it participate in identifying, acquiring or disposing of Projects. RPMCo will not have the power to act in the Trust's name or to bind the Trust, which will be exercised by the Managing Shareholder or the Trust's officers.
The Operation Agreement does not have a fixed term and is terminable by RPMCo, by the Managing Shareholder or by vote of a majority in interest of Investors, on 60 days' prior notice. The Operation Agreement may be amended by agreement of the Managing Shareholder and RPMCo; however, no amendment that materially increases the obligations of the Trust or that materially decreases the obligations of RPMCo shall become effective until at least 45 days after notice of the amendment, together with the text thereof, has been given to all Investors.
The executive officers of RPMCo are Mr. Swanson (President), Mr. Gold (Executive Vice President), Mr. Brown (Senior Vice President and Chief Operating Officer), Mr. Quinn (Senior Vice President and Chief Financial Officer) and Ms. Olin (Vice President). Douglas V. Liebschner, Vice President - Operations, is a key employee.
Douglas V. Liebschner, age 52, joined RPMCo in June 1996 as Vice President of Operations. He has over 27 years of experience in the operation and maintenance of power plants. From 1992 until joining RPMCo, he was employed by Tampella Services, Inc., an affiliate of Tampella, Inc., one of the world's largest manufacturers of boilers and related equipment for the power industry. Mr. Liebschner was Operations Supervisor for Tampella's Piney Creek project, a $100 million bituminous waste coal fired circulating fluidized bed ("CFB") power plant. Between 1989 and 1992, he supervised operations of a waste to energy plant in Poughkeepsie, N.Y. and an anthracite-waste-coal-burning CFB in Frackville, Pa. From 1969 to 1989, Mr. Liebschner served in the U.S. Navy, retiring with the rank of Lieutenant Commander. While in the Navy, he served mainly in billets dealing with the operation, maintenance and repair of ship propulsion plants, twice serving as Chief Engineer on board U.S. Navy combatant ships. He has a Bachelor of Science degree from the U.S. Naval Academy, Annapolis, Md.
Item 11.
Item 11. Executive Compensation.
Through 1995, the executive officers of the Trust and the Managing Shareholder were compensated by Ridgewood Energy. The Trust was not charged for their compensation; the Managing Shareholder remitted a portion of the fees paid to it by the Trust to reimburse Ridgewood Energy for employment costs incurred on Ridgewood Power's business. In 1996 and future years, the Managing Shareholder compensates its officers without additional payments by the Trust and will be reimbursed by Ridgewood Energy for costs related to Ridgewood Energy's business. The Trust will reimburse RPMCo at cost for services provided by RPMCo's employees; no such reimbursement per employee exceeded $60,000 in 1998 or 1999. Information as to the fees payable to the Managing Shareholder and certain affiliates is contained at Item 13 - Certain Relationships and Related Transactions.
As compensation for services rendered to the Trust, pursuant to the Declaration, each Independent Trustee is entitled to be paid by the Trust the sum of $5,000 annually and to be reimbursed for all reasonable out-of-pocket expenses relating to attendance at Board meetings or otherwise performing his duties to the Trust. Accordingly in January 1995 and following years the Trust paid each Independent Trustee $5,000 for his services. The Board of the Trust is entitled to review the compensation payable to the Independent Trustees annually and increase or decrease it as the Board sees reasonable. The Trust is not entitled to pay the Independent Trustees compensation for consulting services rendered to the Trust outside the scope of their duties to the Trust without prior Board approval.
Ridgewood Holding, the Corporate Trustee of the Trust, is not entitled to compensation for serving in such capacity, but is entitled to be reimbursed for Trust expenses incurred by it which are properly reimbursable under the Declaration.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The Managing Shareholder purchased for cash one full Investor Share. By virtue of its purchase of Investor Shares, the Managing Shareholder is entitled to the same ratable interest in the Trust as all other purchasers of Investor Shares. No other Trustees or executive officers of the Trust acquired Investor Shares in the Trust's offering. No person beneficially owns 5% or more of the Investor Shares.
The Managing Shareholder was issued one Management Share in the Trust representing the beneficial interests and management rights of the Managing Shareholder in its capacity as the Managing Shareholder (excluding its interest in the Trust attributable to Investor Shares it acquired in the offering). The management rights of the Managing Shareholder are described in further detail above at Item 1 - Business and below in Item 10. Directors and Executive Officers of the Registrant. Its beneficial interest in cash distributions of the Trust and its allocable share of the Trust's net profits and net losses and other items attributable to the Management Share are described in further detail below at Item 13
Item 13. Certain Relationships and Related Transactions.
The Declaration provides that cash flow of the Trust, less reasonable reserves which the Trust deems necessary to cover anticipated Trust expenses, is to be distributed to the Investors and the Managing Shareholder (collectively, the "Shareholders"), from time to time as the Trust deems appropriate. Prior to Payout (the point at which Investors have received cumulative distributions equal to the amount of their capital contributions), each year all distributions from the Trust, other than distributions of the revenues from dispositions of Trust Property, are to be allocated 99% to the Investors and 1% to the Managing Shareholder until Investors have been distributed during the year an amount equal to 14% of their total capital contributions (a "14% Priority Distribution"), and thereafter all remaining distributions from the Trust during the year, other than distributions of the revenues from dispositions of Trust Property, are to be allocated 80% to Investors and 20% to the Managing Shareholder. Revenues from dispositions of Trust Property are to be distributed 99% to Investors and 1% to the Managing Shareholder until Payout. In all cases, after Payout, Investors are to be allocated 80% of all distributions and the Managing Shareholder 20%.
For any fiscal period, the Trust's net profits, if any, other than those derived from dispositions of Trust Property, are allocated 99% to the Investors and 1% to the Managing Shareholder until the profits so allocated offset (1) the aggregate 14% Priority Distribution to all Investors and (2) any net losses from prior periods that had been allocated to the Shareholders. Any remaining net profits, other than those derived from dispositions of Trust Property, are allocated 80% to the Investors and 20% to the Managing Shareholder. If the Trust realizes net losses for the period, the losses are allocated 80% to the Investors and 20% to the Managing Shareholder until the losses so allocated offset any net profits from prior periods allocated to the Shareholders. Any remaining net losses are allocated 99% to the Investors and 1% to the Managing Shareholder. Revenues from dispositions of Trust Property are allocated in the same manner as distributions from such dispositions. Amounts allocated to the Investors are apportioned among them in proportion to their capital contributions.
On liquidation of the Trust, the remaining assets of the Trust after discharge of its obligations, including any loans owed by the Trust to the Shareholders, will be distributed, first, 99% to the Investors and the remaining 1% to the Managing Shareholder, until Payout, and any remainder will be distributed to the Shareholders in proportion to their capital accounts.
The Trust paid fees to the Managing Shareholder and its affiliates as follows:
Fee Paid to 1999 1998 1997 1996
management Managing fee Shareholder 467,268 $1,050,700 $1,154,758 $888,209 Cost reimbursements* RPMCo 404,055 401,290 467,881 337,228 Investment fee Managing Shareholder 0 0 0 627,561 Placement agent fee Ridgewood and sales commis- Securities sions Corporation 0 0 0 315,493 Organizational, Managing distribution and Shareholder offering fee 0 0 0 1,892,959
* These include all payroll, parts, routine maintenance and other expenses (except for royalties for landfill gas but including an allocation of RPMCo overhead) of the Providence Project.
The investment fee equaled 2% of the proceeds of the offering of Investor Shares and was payable for the Managing Shareholder's services in investigating and evaluating investment opportunities and effecting investment transactions. The placement agent fee (1% of the offering proceeds) and sales commissions were also paid from proceeds of the offering, as was the organizational, distribution and offering fee (5% of offering proceeds) for legal, accounting, consulting, filing, printing, distribution, selling, closing and organization costs of the offering.
The management fee, payable monthly under the Management Agreement at the annual rate of 3% of the Trust's net asset value, began on the date the first Project was acquired and compensates the Managing Shareholder for certain management, administrative and advisory services for the Trust. In addition to the foregoing, the Trust reimbursed the Managing Shareholder at cost for expenses and fees of unaffiliated persons engaged by the Managing Shareholder for Trust business and for payroll and other costs of operation of the Providence and California Pumping Projects. Beginning in 1996, these reimbursements were paid to RPMCo. The reimbursements to RPMCo, which do not exceed its actual costs and allocable overhead, are described at Item 10(g) - Directors and Executive Officers of the Registrant -- RPMCo.
Other information in response to this item is reported in response to Item 11. Executive Compensation, which information is incorporated by reference into this Item 13.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) Financial Statements.
See the Index to Financial Statements in Item 8 hereof.
(b) Reports on Form 8-K.
No Form 8-K was filed with the Commission by the Registrant during the quarter ending December 31, 1999.
(c) Exhibits
3A. Certificate of Trust of the Registrant is incorporated by reference to Exhibit 3A of Registrant's Registration Statement filed with the Commission on February 15, 1994.
3B. Declaration of Trust of the Registrant is incorporated by reference to Exhibit 3B of Registrant's Registration Statement filed with the Commission on February 19, 1994.
3C. Amendment No. 1 to Declaration of Trust is incorporated by reference to Exhibit 3C of Registrant's Annual Report on Form 10-K for the year ended December 31, 1996.
10A. Asset Acquisition Agreement by and among Northeast Landfill Power Joint Venture, Northeast Landfill Power Company, Johnson Natural Power Corporation and Ridgewood Providence Power Partners, L.P. , is incorporated by reference to Exhibit 2 of the Registrant's Current Report on Form 8-K filed with the Commission on May 2, 1996.
10B. Agreement of Merger, dated as of July 1, 1996, by and among Consolidated Hydro Maine, Inc., CHI Universal, Inc., Consolidated Hydro, Inc., Ridgewood Maine Power Partners, L.P. and Ridgewood Maine Hydro Corporation. Incorporated by reference to Exhibit 2.1 of the Registrant's Current Report on Form 8-K filed with the Commission on January 8, 1997.
10C. Letter, dated November 15, 1996, amending Agreement of Merger. Incorporated by reference to Exhibit 2.2 of Amendment No. 1 to the Registrant's Current Report on Form 8-K filed with the Commission on January 9, 1997
10D. Letter, dated December 3, 1996, amending Agreement of Merger. Incorporated by reference to Exhibit 2.3 of the Registrant's Current Report on Form 8-K filed with the Commission on January 8, 1997.
10E. Operation, Maintenance and Administration Agreement, dated November __, 1996, by and among Ridgewood Maine Hydro Partners, L.P., CHI Operations, Inc. and Consolidated Hydro, Inc. Incorporated by reference to Exhibit 10 of the Registrant's Current Report on Form 8-K filed with the Commission on January 8, 1997.
10F. Management Agreement, dated as of __________, 1996, between the Registrant and Ridgewood Power Corporation. Incorporated by reference to Exhibit 10F of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996.
10G. Operation Agreement, dated as of April 16, 1996, among the Registrant, Ridgewood Providence Corporation and Ridgewood Power Management Corporation. Incorporated by reference to Exhibit 10G of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996
10H. Agreement to Purchase Membership Interests, dated as of June 11, 1997, by and between Ridgewood Maine, L.L.C. and Indeck Maine Energy, L.L.C. Incorporated by reference to Exhibit 2.A. of Amendment No. 1 to Registrant's Current Report on Form 8-K dated July 1, 1997.
10I. Amended and Restated Operating Agreement ofIndeck Maine Energy, L.L.C., dated as of June 11, 1997. Incorporated by reference to Exhibit 2.B. of Amendment No. 1 to Registrant's Current Report on Form 8-K dated July 1, 1997.
The Registrant agrees to furnish supplementally a copy of any omitted exhibit or schedule to agreements filed as exhibits to the Commission upon request.
21. Subsidiaries of the Registrant Page
24. Powers of Attorney Page
27. Financial Data Schedule Page
99. Listing of Statutory Provisions that the Trust Agrees to Comply with. Incorporated by reference to Exhibit 99 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Signature Title Date
RIDGEWOOD ELECTRIC POWER TRUST IV (Registrant)
By:/s/ Robert E. Swanson President and Chief April 14, 2000 Robert E. Swanson Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
By:/s/ Robert E. Swanson President and Chief April 14, 2000 Robert E. Swanson Executive Officer
By:/s/ Martin V. Quinn Senior Vice President and Martin V. Quinn Chief Financial Officer April 14, 2000
By:/s/ Christopher Naunton Director of Accounting April 14, 2000 Christopher Naunton
RIDGEWOOD POWER LLC Managing Shareholder April 14, 2000
By:/s/ Robert E. Swanson President Robert E. Swanson
/s/ Robert E. Swanson * Independent Trustee April 14, 2000 John C. Belknap
/s/ Robert E. Swanson * Independent Trustee April 14, 2000 Richard D. Propper
/s/ Robert E. Swanson* Independent Trustee April 14, 2000 Seymour Robin
As attorney-in-fact for the Independent Trustee
Ridgewood Electric Power Trust IV
Consolidated Financial Statements
December 31, 1999, 1998 and 1997
Report of Independent Accountants
To the Shareholders and Trustees of Ridgewood Electric Power Trust IV:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Ridgewood Electric Power Trust IV (the "Trust") and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Trust's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP New York, NY March 24, 2000
Ridgewood Electric Power Trust IV Consolidated Balance Sheet - --------------------------------------------------------------------------------
December 31, ---------------------------- 1999 1998 ------------ ------------ Assets:
Cash and cash equivalents .................... $ 893,383 $ 2,021,168 Accounts receivable, trade ................... 613,002 617,973 Due from affiliates .......................... 442,432 377,710 Other assets ................................. 60,863 57,975 ------------ ------------
Total current assets ..................... 2,009,680 3,074,826
Investments: Maine Hydro Projects ......................... 5,663,505 6,217,289 Maine Biomass Projects ....................... 5,825,271 6,306,818 Santee River Rubber .......................... 4,090,601 4,501,357 Electric power equipment held for resale ..... 250,000 455,182
Plant and equipment .......................... 16,789,544 16,359,211 Accumulated depreciation ..................... (2,957,855) (2,073,744) ------------ ------------ 13,831,689 14,285,467 ------------ ------------
Electric power sales contract ................ 8,338,040 8,338,040 Accumulated amortization ..................... (2,057,950) (1,502,081) ------------ ------------ 6,280,090 6,835,959 ------------ ------------
Spare parts inventory ........................ 838,142 746,178 Debt reserve fund ............................ 666,346 637,108 ------------ ------------
Total assets ............................. $ 39,455,324 $ 43,060,184 ------------ ------------
Liabilities and Shareholders' Equity:
Liabilities: Current maturities of long-term debt ......... $ 716,995 $ 651,613 Accounts payable and accrued expenses ........ 611,750 563,685 Due to affiliates ............................ 341,018 441,614 ------------ ------------ Total current liabilities ................ 1,669,763 1,656,912
Long-term debt, less current portion ......... 3,479,460 4,196,455 Minority interest in the Providence Project .. 5,924,813 6,202,894
Commitments and contingencies
Shareholders' Equity: Shareholders' equity (476.8875 investor shares issued and outstanding) .............. 28,502,542 31,098,950 Managing shareholder's accumulated deficit (1 management share issued and outstanding) . (121,254) (95,027) ------------ ------------ Total shareholders' equity ............... 28,381,288 31,003,923 ------------ ------------
Total liabilities and shareholders' equity $ 39,455,324 $ 43,060,184 ------------ ------------
See accompanying notes to the consolidated financial statements.
Ridgewood Electric Power Trust IV Consolidated Statement of Operations
- --------------------------------------------------------------------------------
Year Ended December 31, ----------------------------------------- 1999 1998 1997 ----------- ----------- -----------
Net sales ....................... $ 7,179,229 $ 6,905,883 $ 6,810,911 Sublease income ................. 369,000 369,000 369,000 ----------- ----------- ----------- Total revenue .......... 7,548,229 7,274,883 7,179,911
Cost of sales, including depreciation and amortization of $1,439,980, $1,560,801 and $1,267,572 in 1999, 1998 and 1997 ........................... 6,347,905 5,638,396 4,879,962 ----------- ----------- -----------
Gross profit .................... 1,200,324 1,636,487 2,299,949
General and administrative expenses ....................... 709,722 709,715 537,371 Management fee paid to the managing shareholder 467,268 1,050,700 1,154,758 Write down equipment held in storage ........................ 205,182 -- -- Project due diligence costs ..... -- 204,579 668,554 ----------- ----------- ----------- Total other operating expenses . 1,382,172 1,964,994 2,360,683 ----------- ----------- -----------
Loss from operations ............ (181,848) (328,507) (60,734) ----------- ----------- ----------- Other income (expense): Interest income ................ 83,350 374,585 926,641 Interest expense ............... (437,238) (496,658) (572,660) Other income ................... 71,840 -- -- Loss from Maine Biomass Projects ...................... (1,006,797) (694,321) (680,109) Income from Maine Hydro Projects ...................... 849,456 657,989 521,710 Income from Santee River Rubber 49,244 181,675 -- ----------- ----------- ----------- Other income (expense), net .. (390,145) 23,270 195,582 ----------- ----------- -----------
(Loss) income before minority interest ...................... (571,993) (305,237) 134,848
Minority interest in the earnings of the Providence Project ...... (171,984) (296,854) (537,625) ----------- ----------- -----------
Net loss ........................ $ (743,977) $ (602,091) $ (402,777) ----------- ----------- -----------
See accompanying notes to the consolidated financial statements.
Ridgewood Electric Power Trust IV Consolidated Statement of Changes In Shareholders' Equity For the Years Ended December 31, 1999, 1998 and 1997 - --------------------------------------------------------------------------------
Managing Shareholders Shareholder Total ------------ ------------ ------------
Shareholders' equity, January 1, 1997 ..................... $ 38,764,199 $ (17,600) $ 38,746,599
Cash distributions ........... (3,287,256) (33,205) (3,320,461)
Net loss for the year ........ (398,749) (4,028) (402,777) ------------ ------------ ------------
Shareholders' equity, December 31, 1997 .................... 35,078,194 (54,833) 35,023,361
Cash distributions ........... (3,383,174) (34,173) (3,417,347)
Net loss for the year ........ (596,070) (6,021) (602,091) ------------ ------------ ------------
Shareholders' equity, December 31, 1998 .................... 31,098,950 (95,027) 31,003,923
Cash distributions ........... (1,859,871) (18,787) (1,878,658)
Net loss for the year ........ (736,537) (7,440) (743,977) ------------ ------------ ------------
Shareholders' equity, December 31, 1999 .................... $ 28,502,542 $ (121,254) $ 28,381,288 ------------ ------------ ------------
See accompanying notes to the consolidated financial statements.
Ridgewood Electric Power Trust IV Consolidated Statement of Cash Flows - --------------------------------------------------------------------------------
Year Ended December 31, -------------------------------------------- 1999 1998 1997 ------------ ------------ ------------
Cash flows from operating activities: Net loss ..................... $ (743,977) $ (602,091) $ (402,777) ------------ ------------ ------------
Adjustments to reconcile net loss to net cash flows from operating activities: Depreciation and amortization ............... 1,439,980 1,560,801 1,267,572 Minority interest in earnings of the Providence Project .. 171,984 296,854 537,625 Write down equipment held in storage ................. 205,182 -- -- Income from unconsolidated Maine Hydro Projects ....... (849,456) (657,989) (521,710) Loss from unconsolidated Maine Biomass Projects ..... 1,006,797 694,321 680,109 Income from unconsolidated Santee River Rubber ........ (49,244) (181,675) -- Changes in assets and liabilities: Decrease in maintenance reserve fund ............... -- -- 394,070 Decrease (increase) in accounts receivable, trade . 4,971 (58,209) 505,417 Increase in spare parts inventory .................. (91,964) (362,368) -- Increase (decrease) in accounts payable and accrued expenses ........... 48,065 179,152 (363,426) (Decrease) increase in due to/from affiliates, net ... (165,318) (429,813) 401,660 Other- net .................. (2,888) 39,478 157,081 ------------ ------------ ------------ Total adjustments ........... 1,718,109 1,080,552 3,058,398 ------------ ------------ ------------ Net cash provided by operating activities ....... 974,132 478,461 2,655,621 ------------ ------------ ------------ Cash flows from investing activities: Investment in Maine Hydro Projects ................... -- -- (265,953) Investment in Maine Biomass Projects ................... (525,250) (383,277) (7,297,971) Investment in Santee River Rubber ..................... -- (4,489,819) -- Distributions from Maine Hydro Projects ............. 1,403,240 1,135,526 1,006,257 Distributions from Santee River Rubber ............... 460,000 170,137 -- Capital expenditures ........ (430,333) (1,409,476) (3,060,284) Deferred due diligence costs -- 27,159 218,669 ------------ ------------ ------------ Net cash provided by (used in) investing activities ... 907,657 (4,949,750) (9,399,282) ------------ ------------ ------------ Cash flows from financing activities: Cash distributions to shareholders ............... (1,878,658) (3,417,347) (3,320,461) Payments to reduce long-term debt ....................... (651,613) (592,192) (538,191) Increase in debt reserve fund ....................... (29,238) (31,909) (29,758) Distributions to minority interest ................... (450,065) (552,376) (967,477) ------------ ------------ ------------ Net cash used in financing activities ................. (3,009,574) (4,593,824) (4,855,887) ------------ ------------ ------------ Net decrease in cash and cash equivalents ............ (1,127,785) (9,065,113) (11,599,548) Cash and cash equivalents, beginning of year ........... 2,021,168 11,086,281 22,685,829 ------------ ------------ ------------ Cash and cash equivalents, end of year ................. $ 893,383 $ 2,021,168 $ 11,086,281 ------------ ------------ ------------
See accompanying notes to the consolidated financial statements.
Ridgewood Electric Power Trust IV Notes to the Consolidated Financial Statements - --------------------------------------------------------------------------------
1. Organization and Purpose
Nature of Business Ridgewood Electric Power Trust IV (the "Trust") was formed as a Delaware business trust in September 1994, by Ridgewood Energy Holding Corporation acting as the Corporate Trustee. The managing shareholder of the Trust is Ridgewood Power LLC (formerly Ridgewood Power Corporation). The Trust began offering shares on February 6, 1995 and discontinued its offering of shares in March 1996. The Trust had no operations prior to the commencement of the share offering.
The Trust has been organized to invest in independent power generation and other capital facilities and in the development of these facilities. These independent power generation facilities will include cogeneration facilities, which produce both electricity and heat energy and other power plants that use various fuel sources (except nuclear). The power plants will sell electricity and, in some cases, heat energy to utilities and industrial users under long-term contracts.
Business Development Company Election The Trust initially made an election to be treated as a Business Development Company ("BDC") under the Investment Company Act of 1940 ("the 1940 Act"). On January 24, 1995, the Trust notified the Securities Exchange Commission of such election and registered its shares under the Securities Exchange Act of 1934 ("the 1934 Act"). On March 24, 1995, the election and registration became effective.
On September 9, 1996, through a proxy solicitation, the Trust requested investor consent to end the BDC status. As of October 2, 1996, more than 50% of the investor shares consented to the elimination of the BDC status. Accordingly, the Trust is no longer an investment company under the 1940 Act.
2. Summary of Significant Accounting Policies
Principles of consolidation and accounting for investment in power generation projects The consolidated financial statements include the accounts of the Trust and affiliates owned more than 50%. All material intercompany transactions have been eliminated.
The Trust uses the equity method of accounting for its investments in affiliates which are 50% or less owned because the Trust has the ability to exercise significant influence over the operating and financial policies of the affiliates but does not control the affiliate. The Trust's share of the earnings of the affiliates is included in the consolidated results of operations.
Use of estimates The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates.
Cash and cash equivalents The Trust considers all highly liquid investments with maturities when purchased of three months or less to be cash and cash equivalents. Cash and cash equivalents consist of commercial paper and funds deposited in bank accounts.
Plant and equipment Plant and equipment, consisting principally of electrical generating equipment, is stated at cost. Renewals and betterments that increase the useful lives of the assets are capitalized. Repair and maintenance expenditures that increase the efficiency of the assets are expensed as incurred. The Trust periodically assesses the recoverability of plant and equipment, and other long-term assets, based on their estimated future cash flows.
Depreciation is recorded using the straight-line method over the useful lives of the assets, which are 10 to 20 years. During 1999, 1998 and 1997, the Trust recorded depreciation expense of $884,111, $1,004,932 and $711,703, respectively.
Intangible asset A portion of the purchase price of the Providence Project was assigned to the Electric Power Sales Contract and is being amortized over the life of the asset (15 years) on a straight-line basis. During 1999, 1998 and 1997, the Trust recorded amortization expense of $555,869.
Electric power equipment held for resale The Trust owns certain used electric power equipment that is stated at cost, which approximates estimated net realizable value.
Revenue recognition Power generation revenue is recognized based on power delivered at rates stipulated in the power sales contract. Interest and dividend income is recorded when earned.
Income taxes No provision is made for income taxes in the accompanying financial statements as the income or losses of the Trust are passed through and included in the tax returns of the individual shareholders of the Trust.
Offering costs Costs associated with offering Trust shares (selling commissions, distribution and offering costs) are reflected as a reduction of the shareholders' capital contributions.
Due diligence costs relating to potential power projects Costs relating to the due diligence performed on potential project investments are initially deferred, until such time as the Trust determines whether or not it will make an investment in the project. Costs relating to completed projects are capitalized and costs relating to rejected projects are expensed at the time of rejection.
These costs consist of payments for consultants and other unaffiliated parties performing financial, engineering, legal and other due diligence procedures and negotiations. It also includes travel and other out-of-pocket costs incurred by employees of the managing shareholder and affiliates investigating potential project investments.
Reclassification Certain items in previously issued financial statements have been reclassified for comparative purposes.
3. Investments
The Trust has the following investments:
Investment at December 31, ----------------------------------- Project Name Accounting Method 1999 1998 - -------------------------- ------------- ----------- -----------
Providence Project ....... Consolidation $10,671,302 $11,181,794 California Pumping Project Consolidation 442,224 597,478 Electric Power Equipment . Consolidation 250,000 455,182 Maine Hydro Projects ..... Equity Method 5,663,505 6,217,289 Maine Biomass Projects ... Equity Method 5,825,271 6,306,817 Santee River Rubber ...... Equity Method 4,090,601 4,501,357 ----------- ----------- $26,942,903 $29,259,917 ----------- -----------
Providence Project In 1996, the Trust, through a subsidiary, Ridgewood Providence Power Partners, L.P., purchased substantially all of the net assets of Northeastern Landfill Power Joint Venture. The assets acquired include a 12.3 megawatt capacity electrical generating station, located at the Central Landfill in Johnston, Rhode Island (the "Providence Project"). In 1997, the capacity was increased to 13.8 megawatts. The Providence Project includes nine reciprocating electric generator engines, which are fueled by methane gas produced and collected from the landfill. The electricity generated is sold to New England Power Corporation under a long-term contract. The purchase price was $15,533,021 in cash, including transaction costs and repayment of $3,000,000 of principal on the senior secured non-recourse notes payable. In addition, Providence Power assumed the obligation to repay the remaining principal outstanding of $6,310,404 on the senior secured non-recourse notes payable.
The Trust owns 64.3% of the Providence Project and the remaining 35.7% is owned by Ridgewood Electric Power Trust III ("Trust III"). Ridgewood Power Corporation is the managing partner of the Trust and Trust III.
The acquisition of the Providence Project was accounted for as a purchase and the results of operations of the Providence Project have been included in the Trust's Consolidated Financial Statements since the acquisition date. The purchase price was allocated to the net assets acquired, based on their respective fair values. Of the purchase price, $8,338,040 was allocated to the Electric Power Sales Contract and is being amortized over 15 years.
California Pumping Project In 1995, the Trust acquired a package of natural gas and diesel fueled engines which drive deep irrigation well pumps in Ventura County, California from an affiliated trust. The engines' shaft horsepower-hours are sold to the operator at a discount from the equivalent kilowatt hours of electricity. Prior to September 30, 1998, the project was operated by a third party manager and the Trust received a distribution of $0.02 per equivalent kilowatt up to 3,000 running hours per year and $0.01 per equivalent kilowatt for each additional running hour per year. The operator paid for fuel, maintenance, repair and replacement. The initial acquisition included 11 engines with a rated capacity of 1.2 megawatts. On October 1, 1998, the Trust terminated the operating agreement with the third party manager and Ridgewood Power Management Corporation, an affiliate of the managing shareholder, began operating the project. The project paid $94,160 to the third party manager to terminate the operating agreement At December 31, 1999 and 1998, the Trust's total investment in the California Pumping Project was $442,224 and $597,478, respectively.
Electric Power Equipment Held for Resale The Trust purchased, from an affiliated entity, various used electric power generation equipment to be held for resale or, in the event a buyer is not found, for use in potential power generation projects. The equipment is held in storage. At December 31, 1998, the cost of such equipment was $455,182. In 1999, the Trust wrote down the equipment to its estimated fair value of $250,000 and recorded a charge against earnings of $205,182.
Maine Hydro Projects In 1996, Ridgewood Maine Hydro Partners, L.P. ("Ridgewood Hydro L.P.") was formed as a Delaware limited partnership and acquired 14 hydroelectric projects, located in Maine (the "Maine Hydro Projects"), from a subsidiary of Consolidated Hydro, Inc. The assets acquired include a total of 11.3 megawatts of electrical generating capacity. The electricity generated is sold to Central Maine Power Company and Bangor Hydro Company under long-term contracts. The purchase price was $13,628,395 cash, including transaction costs. In addition, Ridgewood Hydro L.P. assumed a long-term lease obligation of $1,004,679.
The Trust owns a 50% limited partnership interest in Ridgewood Hydro L.P. and 50% of the outstanding common stock of Ridgewood Maine Hydro Corporation, which is the sole general partner of Ridgewood Hydro L.P. The remaining 50% is owned by Ridgewood Electric Power Trust V ("Trust V"). Ridgewood Power LLC is the managing partner of the Trust and Trust V.
The Trust's 50% investment in the Maine Hydro Projects is accounted for under the equity method of accounting. The Trust's equity in the earnings of the Maine Hydro Projects has been included in the financial statements since acquisition.
The Maine Hydro Projects are operated by a subsidiary of CHI Energy, Inc. (formerly Consolidated Hydro, Inc.), under an Operation, Maintenance and Administrative Agreement. The annual operator's fee is $307,500, adjusted for inflation, plus an annual incentive fee equal to 50% of the net cash flow in excess of a target amount. The Maine Hydro Projects recorded $323,003, $429,714 and $429,430 of expense under this arrangement during the periods ended December 31, 1999, 1998 and 1997, respectively. The agreement has a five-year term, expiring on June 30, 2001, and can be renewed for two additional five-year terms by mutual consent. Summarized financial information for the Maine Hydro Projects is as follows:
Balance Sheet Information
December 31, 1999 December 31, 1998 ----------- -----------
Current assets .............. $ 1,573,177 $ 1,346,077 Electric power sales contract 10,105,173 11,165,469 Other non-current assets .... 1,270,396 1,057,892 ----------- ----------- Total assets ................ $12,948,746 $13,569,438 ----------- -----------
Current liabilities ......... $ 1,621,737 $ 438,443 Non-current liabilities ..... -- 696,418 Partners' equity ............ 11,327,009 12,434,577 ----------- ----------- Total liabilities and equity $12,948,746 $13,569,438 ----------- -----------
Statement of Operations Information
For the Year Ended December 31, ---------------------------------------- 1999 1998 1997 ----------- ----------- -----------
Revenue ................. $ 4,756,189 $ 4,511,361 $ 4,113,065 Total expenses .......... 3,002,245 3,217,846 2,952,589 Interest income (expense) (55,033) 22,464 (117,056) ----------- ----------- ----------- Net income .............. $ 1,698,911 $ 1,315,979 $ 1,043,420 ----------- ----------- -----------
The Maine Hydro Projects qualify as small power production facilities under the Public Utility Regulatory Policies Act ("PURPA"). PURPA requires that each electric utility company operating at the location of a small power production facility, as defined, purchase the electricity generated by such facility at a specified or negotiated price. The Maine Hydro Projects sell substantially all of their electrical output to two public utility companies, Central Maine Power Company ("CMP") and Bangor Hydro-Electric Company ("BHC"), under long-term power purchase agreements. Eleven of the twelve power purchase agreements with CMP expire in December 2008 and are renewable for an additional five-year period. The twelfth power purchase agreement with CMP expires in December 2007 with CMP having the option to extend the contract for three more five-year periods. The two power purchase agreements with BHC expire December 2014 and February 2017.
Maine Biomass Projects On July 1, 1997, through a subsidiary, the Trust purchased a preferred membership interest in Indeck Maine Energy, L.L.C. ("Maine Biomass Projects"), which owns two electric power generating stations fueled by waste wood. The aggregate purchase price was $7,297,971 and includes transaction costs of $297,971. Each project has 24.5 megawatts of electrical generating capacity. The Penobscot project is located in West Enfield, Maine and the Eastport project is located in Jonesboro, Maine. The Maine Biomass Projects had a power sales contract with the New England Power Pool, which expired on August 31, 1997. The facilities were shut down in September 1997 and were reactivated in November 1997 to sell capacity and energy to BHC on a month-to-month basis. The facilities were again shut down in January 1998. The facilities currently sell installed capacity and are periodically restarted for testing or for the sale of energy during peak periods of demand. The cost of maintaining the idled facilities in good condition is approximately $100,000 per month.
The preferred membership interest entitles the Trust to receive an 18% cumulative annual return on its $7,000,000 capital contribution to the Maine Biomass Projects from the operating net cash flow from the projects. Trust V also purchased an identical preferred membership interest in Indeck Maine. After payments in full to the preferred membership interests, up to $2,520,000 of any remaining operating net cash flow during the year is paid to the other Maine Biomass Project members. Any remaining operating net cash flow is payable 25% to the Trust and Trust V and 75% to the other Maine Biomass Project members.
In 1999 and 1998, the Trust loaned $525,250 and 375,000, respectively, to the Maine Biomass Projects. The loan is in the form of demand notes that bear interest at 5% per annum. Trust V made identical loans to the Maine Biomass Projects. The other Maine Biomass Project members also loaned $1,050,500 and $750,000 to the Maine Biomass Projects with the same terms in 1999 and 1998, respectively
The Trust's investment in the Maine Biomass Projects is accounted for under the equity method of accounting. The Trust's equity in the loss of the Maine Biomass Projects has been included in the financial statements since July 1, 1997.
The Penobscot and Eastport projects were operated by Indeck Operations, Inc., an affiliate of the members of Indeck Maine. The annual operator's fee is $300,000, of which $200,000 is payable contingent upon the Trusts receiving their cumulative annual return. The management agreement had a term of one year and automatically continued for successive one year terms, unless canceled by either the Maine Biomass Projects or Indeck Operations, Inc. The Maine Biomass Projects exercised their right to terminate the contract on March 1, 1999 because certain preferred membership interest payments have not been made. Under an Operating Agreement with the Trust, Ridgewood Power Management LLC ("Ridgewood Management"), formerly Ridgewood Power Management Corporation), an entity related to the managing shareholder through common ownership, began providing management, purchasing, engineering, planning and administrative services to the Maine Biomass Projects. Ridgewood Management charges the projects at its cost for these services and for the allocable amount of certain overhead items. Allocations of costs are on the basis of identifiable direct costs, time records or in proportion to amounts invested in projects.
From June thorough December 1999, the facilities periodically operated on dispatch from ISO-New England, Inc. (the "ISO") and also submitted offers to the ISO to run at high prices during power emergencies. The facilities have claimed the ISO owes them approximately $14 million for the electricity products they provided in those periods and the ISO has claimed that no material revenues at all are due to the projects. The facilities have not recorded any of the disputed revenues in their financial statements and it is too early to estimate the outcome of the dispute.
Summarized financial information for the Maine Biomass Projects is as follows:
Balance Sheet Information
December 31, 1999 December 31, 1998 ----------- -----------
Current assets: ............ $ 1,103,266 $ 668,228 Non-current assets ......... 3,154,813 3,339,584 ----------- ----------- Total assets ............... $ 4,258,079 $ 4,007,812 ----------- -----------
Current liabilities: ....... $ 4,394,990 $ 1,952,062 Members' equity ............ (136,911) 2,055,750 ----------- ----------- Total liabilities and equity $ 4,258,079 $ 4,007,812 ----------- -----------
Statement of Operations Information
For the period from inception For the Year Ended For the Year Ended (April 1, 1997) to December December 31, 1999 December 31, 1998 31, 1997 ----------- ----------- -----------
Revenue ...... $ 1,391,039 $ 1,430,296 $ 2,991,793 Total expenses 3,583,700 2,847,896 4,376,458 ----------- ----------- ----------- Net loss ..... $(2,192,661) $(1,417,600) $(1,384,665) ----------- ----------- -----------
Santee River Rubber In August 1998, the Trust and an affiliate, Trust V, purchased preferred membership interests in Santee River Rubber Company, LLC, a newly organized South Carolina limited liability company ("Santee River Rubber"). Santee River Rubber is building a waste tire and rubber processing facility located near Charleston, South Carolina. The facility is expected to begin full scale operations in July 2000. The Trust and Trust V purchased the interests through a limited liability company owned one-third by the Trust and two-thirds by Trust V. The Trust's share of the purchase price was $4,489,819 and Trust V's share of the purchase price was $8,979,639.
Until January 2000 or until the facility begins operations, which ever occurs first, Santee River Rubber will pay the Trust and Trust V interest at 12% per year on $11,000,000 of their investment. After operations begin, the Trusts are entitled to receive all cash flow after payment of debt and other obligations until the Trusts receive a cumulative 20% return on their total investment. Thereafter, the Trusts receive 25% of any remaining cash flow available for distribution. All cash distributions and tax allocations received from Santee River Rubber are shared one-third by the Trust and two-thirds by Trust V.
The Trusts have the right to designate two of the five members of Santee River Rubber and have the further right to remove a third member and designate a successor in the event of certain defaults under Santee River Rubber's operating agreement. The remaining equity interest is owned by a wholly-owned subsidiary of Environmental Processing Systems, Inc. of New York, a company not affiliated with the Trust.
At the same time as the Trusts purchased their membership interests, Santee River Rubber borrowed $16,000,000 through tax exempt revenue bonds and another $16,000,000 through taxable convertible bonds. It also obtained $4,500,000 of subordinated financing from the general contractor of the facility.
The project has been designed to receive and process waste tires and other waste rubber products and produce fine crumb rubber of various sizes. The processing will include both ambient and cryogenic processing equipment using liquid nitrogen. Santee River Rubber anticipates that the final product will be fine crumb rubber that can be used to manufacture new tires or to replace virgin rubber in many applications.
Santee River Rubber has entered into long-term agreements for the supply of its requirements for waste tires, electricity and liquid nitrogen. Santee River Rubber has entered into short-term (ranging from one to three years) crumb rubber sales contracts for a portion of the facility's output. The agreements are contingent upon successful testing of the facility's output.
The Trust's investment in Santee River Rubber is accounted for under the equity method of accounting. The Trust's equity in the loss of Santee River Rubber has been included in the financial statements since August 19, 1998.
Summarized financial information for Santee River Rubber is as follows:
Balance Sheet Information
December 31, 1999 December 31, 1998 ----------- -----------
Current assets ............. $ 1,910,190 $24,403,190 Construction in progress ... 32,899,358 15,392,656 Other non-current assets ... 4,685,995 4,761,119 ----------- ----------- Total assets ............... $39,495,543 $44,556,965 ----------- -----------
Liabilities ................ $34,576,964 $34,885,357 Members' equity ............ 4,918,579 9,671,608 ----------- ----------- Total liabilities and equity $39,495,543 $44,556,965 ----------- -----------
Statement of Operations Information
For the Period August For the year ended December 19, 1998 to December 31, 1999 31, 1998 ----------- -----------
Revenue .......... $ 7,975 $ -- Operating expenses 3,547,208 2,085,911 ----------- ----------- Net loss ......... $(3,539,233) $(2,085,911) ----------- -----------
4. Long-Term Debt
Following is a summary of long-term debt at December 31, 1999:
Senior secured non-recourse notes payable $ 4,196,455 Less - Current maturity (716,995) ----------------- Total long-term debt $3,479,460 -----------------
The senior secured non-recourse notes are due in monthly installments of $90,738, including interest at 9.6%. Final payment is due on October 15, 2004. The notes also provide for additional interest equal to 5% of the annual net cash flow of the Providence Project, as defined. No additional interest was due for the years ended December 31, 1999, 1998 and 1997. The notes are secured by a leasehold mortgage on Providence Power's landfill lease agreements and substantially all of the assets of Providence Power. In addition to the required monthly payments, mandatory prepayments may be required if certain events occur. The loan agreement also provides for a cash funded debt service reserve and maintenance reserve. At December 31, 1999 and 1998, the cash balance in these reserve accounts was $666,346 and $637,108, respectively. Additions and reductions to these reserve accounts are defined in the loan agreement. As of January 31, 1997, Providence Power's obligations to maintain a cash balance in the maintenance reserve account terminated and the cash balance in the reserve account ($394,070) was released to Providence Power. The loan agreement contains various covenants, including the maintenance of a specified debt service ratio.
Scheduled repayments of long-term debt principal for the next five years are as follows:
Year Ended December 31, Repayment
2000 $ 716,995 2001 788,937 2002 868,098 2003 955,202 2004 867,223
During the fourth quarter of 1997, the Trust and its principal bank executed a revolving line of credit agreement, whereby the bank will provide a three year committed line of credit facility of $1,150,000 for borrowings or letters of credit. Outstanding borrowings bear interest at the bank's prime rate or, at the Trust's choice, at LIBOR plus 2.5%. The credit agreement will require the Trust to maintain a ratio of total debt to tangible net worth of no more than 1 to 1 and a minimum debt service coverage ratio of 2 to 1. The Maine Hydro projects have an outstanding standby letter of credit totaling $99,250 which is covered by the line of credit facility. At December 31, 1999 and 1998, there were no borrowings outstanding under the credit facility. In January 2000, the Trust borrowed $500,000 under the line of credit facility.
5. Fair Value of Financial Instruments
At December 31, 1999 and 1998, the carrying value of the Trust's cash, accounts receivable, debt service reserve fund and accounts payable approximates their fair value. The fair value of the long-term debt, calculated using current rates for loans with similar maturities, also approximates its carrying value.
6. Electric Power Sales Contracts
Providence Power is committed to sell all of the electricity it produces to New England Power Corporation ("NEP") for prices as specified in the Power Purchase Agreement. The prices are adjusted annually for changes in the Consumer Price Index, as defined. The NEP agreement expires in the year 2020 and can be terminated by either party under certain conditions in 2010. At the time of the acquisition of the Providence Project, Providence Power was required under the NEP agreement to maintain in an escrow account cash to secure payment to NEP in the event of default. At April 16, 1996, the required escrow balance amounted to $1,065,989. In October 1996, the required escrow balance decreased to zero and the cash held in escrow was released to Providence Power. For the years ended December 31, 1999, 1998 and 1997, sales revenue under the NEP Power Purchase Agreement amounted to $6,751,802, $6,617,549 and $6,458,648, respectively.
7. Landfill Lease and Sublease
Providence Power leases the Central Landfill, located in Johnston, Rhode Island from Rhode Island Solid Waste Management Corporation ("RISWMC"). The lease expires in 2020 and can be extended for an additional 10 years. This operating lease requires Providence Power to pay a royalty equal to 15% of net revenues, as defined, for the first 15 years of the lease. For subsequent years, the royalty is 15% of net revenues for each month in which the average daily kilowatt hour production is less than 180,000 and 18% of net revenues for each month in which the average daily kilowatt hour production exceeds 180,000. For the years ended December 31, 1999, 1998 and 1997 royalty expense relating to the RISWMC lease amounted to $996,399, 986,224 and 951,767, respectively.
Providence Power subleases the Central Landfill to Central Gas Limited Partnership ("Gasco"). Gasco operates and maintains the landfill gas collection system and supplies landfill gas to the Providence Project. The sublease agreement is effective through December 31, 2010 and provides for the following:
Sublease Income - Gasco is to pay Providence Power an annual amount equal to the product of $30,000 times the assumed output capacity of each engine generator set in megawatts installed and operating by the joint venture. Income recorded under the sublease amounted to $369,000 for the years ended December 31, 1999, 1998 and 1997.
Fuel Expense - Providence Power agreed to purchase all the landfill gas produced by Gasco and pay on a monthly basis $.01183 per kilowatt hour for the first 4,000,000 kilowatt hours, $.005 per kilowatt hour for kilowatt hours in excess of 4,000,000 and $.05 per million BTU's of excess landfill gas. The price is adjusted annually for changes in the Consumer Price Index, as defined. Purchases from Gasco for the years ended December 31, 1999, 1998 and 1997 amounted to $907,950, $900,529 and $863,536, respectively.
8. Transactions With Managing Shareholder and Affiliates
The Trust pays to the managing shareholder a distribution and offering fee up to 6% of each capital contribution made to the Trust. This fee is intended to cover legal, accounting, consulting, filing, printing, distribution, selling and closing costs for the offering of the Trust. These fees were recorded as a reduction in the shareholders' capital contribution.
The Trust also pays to the managing shareholder an investment fee up to 2% of each capital contribution made to the Trust. The fee is payable to the managing shareholder for its services in investigating and evaluating investment opportunities and effecting transactions for investing the capital of the Trust.
The Trust entered into a management agreement with the managing shareholder under which the managing shareholder renders certain management, administrative and advisory services and provides office space and other facilities to the Trust. As compensation to the managing shareholder, the Trust pays the managing shareholder an annual management fee equal to 3% of the net asset value of the Trust payable monthly upon the closing of the Trust. For the years ended December 31, 1999, 1998 and 1997, the Trust paid an annual management fees to the managing shareholder of $467,268, $1,050,700 and $1,154,758, respectively. In 1999, the managing shareholder waived 50% of the management fees to which it was entitled.
The Trust reimburses the managing shareholder and affiliates for expenses and fees of unaffiliated persons engaged by the managing shareholder for fund business. The managing shareholder or affiliates originally paid all project due diligence costs, accounting and legal fees and other expenses shown in the statement of operation and were reimbursed by the Trust.
Under the Declaration of Trust, the managing shareholder is entitled to receive each year 1% of all distributions made by the Trust (other than those derived from the disposition of Trust property) until the shareholders have been distributed a cumulative amount equal to 14% per annum of their equity contribution. Thereafter, the managing shareholder is entitled to receive 20% of the distributions for the remainder of the year. The managing shareholder is entitled to receive 1% of the proceeds from dispositions of Trust properties until the shareholders have received cumulative distributions equal to their original investment ("Payout"). After Payout, the managing shareholder is entitled to receive 20% of all remaining distributions of the Trust.
Income is allocated to the managing shareholder until the cumulative profits equal cumulative distributions to the managing shareholder. Then, income is allocated to the investors, first among holders of Preferred Participation Rights until such allocations equal distributions from those Preferred Participation Rights, and then among Investors in proportion to their ownership of investor shares. If the Trust has net losses for a fiscal period, the losses are allocated 99% to the Investors and 1% to the managing shareholder.
Where permitted, in the event the managing shareholder or an affiliate performs brokering services in respect of an investment acquisition or disposition opportunity for the Trust, the managing shareholder or such affiliate may charge the Trust a brokerage fee. Such fee may not exceed 2% of the gross proceeds of any such acquisition or disposition. No such fees have been incurred through December 31, 1999.
The corporate trustee of the Trust, Ridgewood Energy Holding Corporation, an affiliate of the managing shareholder through common ownership, received no compensation from the Fund.
Amounts due to and from affiliates are non-interest bearing and are usually settled within thirty days. Such amounts arise from the delay between when expenses are paid by the Trust or affiliates and when reimbursement occurs.
The managing shareholder purchased one investor share of the Trust for $83,000 in 1995. Through the offering period of the Trust, commissions and placement fees of $172,674 were earned by Ridgewood Securities Corporation, an affiliate of the managing shareholder.
Under an Operating Agreement with the Trust, Ridgewood Power Management LLC (formerly Ridgewood Power Management Corporation, "Ridgewood Management"), an entity related to the managing shareholder through common ownership, provides management, purchasing, engineering, planning and administrative services to the Trust's power generation projects. Ridgewood Management charges the projects at its cost for these services and for the allocable amount of certain overhead items. Allocations of costs are on the basis of identifiable direct costs, time records or in proportion to amounts invested in projects managed by Ridgewood Management. During the years ended December 31, 1999, 1998 and 1997, Ridgewood Management charged Providence Power $404,055, $401,290 and $467,881, respectively. During the year ended December 31, 1999 and 1998, Ridgewood Management charged Pump Services $69,262 and $23,466, respectively. During the year ended December 31, 1999, Ridgewood Management charged the Maine Biomass projects $197,825. During the periods ended December 31, 1999 1998 and 1997, Ridgewood Management did not charge any amounts to the Maine Hydro projects or Santee River Rubber project.
9. Preferred Participation Rights
Preferred Participation Rights were given to each shareholder whose subscription was fully completed and paid for and accepted prior to September 30, 1995. Each Preferred Participation Right entitled the holder to an aggregate distribution priority of $1,000. The number of Preferred Participation Rights earned per investor share was equal to the number of whole or partial months from the date of the acceptance of the subscription to December 31, 1995. A total of 972.733 Preferred Participation Rights were issued.
During 1996, cash distributions were first allocated 99% to the holders of Preferred Participation Rights and 1% to the managing shareholder until shareholders received distributions equal to $1,000 for each Right earned.
10. Management Share
The Trust granted the managing shareholder a single Management Share representing the managing shareholder's management rights and rights to distributions of cash flow.
11. Administrative Proceeding at the Providence Project
In September 1998, the Region I office of the U.S. Environmental Protection Agency ("EPA") filed an administrative proceeding against Providence Power seeking to recover civil penalties of up to $190,000 for alleged violations of operational recordkeeping and training requirements at the Providence Project. In June 1999, Providence Power settled the administrative proceeding for approximately $86,000 which is recorded in cost of sales in the consolidated statement of operations.
Ridgewood Maine Hydro Partners, L.P.
Financial Statements
December 31, 1999, 1998 and 1997
Report of Independent Accountants
To the Partners of Ridgewood Maine Hydro Partners, L.P.:
In our opinion, the accompanying balance sheets and the related statements of operations, changes in partners' equity and of cash flows present fairly, in all material respects, the financial position of Ridgewood Maine Hydro Partners, L.P. (the "Partnership") at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Partnership's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP New York, NY March 24, 2000
Ridgewood Maine Hydro Partners, L.P. Balance Sheet - ------------------------------------------------------------------------------
December 31, --------------------------- 1999 1998 ------------ ----------- Assets: Cash and cash equivalents .................... $ 408,835 $ 607,119 Accounts receivable, trade ................... 1,021,480 574,022 Due from affiliates .......................... -- 87,369 Prepaid and other current assets ............. 142,862 77,567 ------------ ------------ Total current assets .................... 1,573,177 1,346,077
Property, plant and equipment ................ 1,349,024 1,089,248 Accumulated depreciation ..................... (78,628) (31,356) ------------ ------------ Property, plant and equipment, net ...... 1,270,396 1,057,892 ------------ ------------
Electric power sales contracts ............... 13,311,374 13,311,374 Accumulated amortization ..................... (3,206,201) (2,145,905) ------------ ------------ Electric power sales contracts, net ..... 10,105,173 11,165,469 ------------ ------------
Total assets ............................ $ 12,948,746 $ 13,569,438 ------------ ------------
Liabilities and Partners' Equity: Liabilities: Accounts payable and accrued expenses ........ $ 38,285 $ 197,799 Due to affiliates ............................ 799,905 -- Current portion of long-term lease obligations 783,547 240,644 ------------ ------------ Total current liabilities ............... 1,621,737 438,443
Non-current portion of long-term lease obligations .......................... -- 696,418 ------------ ------------
Commitments and contingencies
Partners' equity: General partner .............................. 103,548 114,624 Limited partners ............................. 11,223,461 12,319,953 ------------ ------------
Total partners' equity .................. 11,327,009 12,434,577 ------------ ------------
Total liabilities and partners' equity .. $ 12,948,746 $ 13,569,438 ------------ ------------
See accompanying notes to the financial statements.
Ridgewood Maine Hydro Partners, L.P. Statement of Operations - -------------------------------------------------------------------------------
Year Ended December 31, ----------------------------------------- 1999 1998 1997 ----------- ----------- -----------
Net sales ...................... $ 4,756,189 $ 4,511,361 $ 4,113,065 ----------- ----------- -----------
Operating expenses: Depreciation and amortization 1,107,568 1,089,969 1,062,838 Labor ....................... 565,015 592,812 549,289 Insurance ................... 177,333 194,458 246,665 Property taxes .............. 252,611 267,046 258,953 Contract management ......... 323,003 429,714 429,430 Other expenses .............. 576,715 643,847 405,414 ----------- ----------- ----------- 3,002,245 3,217,846 2,952,589 ----------- ----------- -----------
Income from operations ......... 1,753,944 1,293,515 1,160,476 ----------- ----------- -----------
Other income (expense): Interest income ................ 42,852 153,983 30,812 Interest expense ............... (112,885) (131,519) (147,868) Other income ................... 15,000 -- -- ----------- ----------- ----------- Other income (expense), net (55,033) 22,464 (117,056) ----------- ----------- -----------
Net income ..................... $ 1,698,911 $ 1,315,979 $ 1,043,420 ----------- ----------- -----------
See accompanying notes to the financial statements.
Ridgewood Maine Hydro Partners, L.P. Statement of Changes in Partners' Equity For the Years Ended December 31, 1999, 1998 and 1997 - --------------------------------------------------------------------------------
Limited General Partners Partner Total ------------ ------------ ------------ Partners' equity, January 1, 1997 ................. $ 13,692,976 $ 133,866 $ 13,826,842
Additional contributions . 531,906 -- 531,906
Cash distributions ....... (1,992,391) (20,125) (2,012,516)
Net income for the year .. 1,032,986 10,434 1,043,420 ------------ ------------ ------------ Partners' equity, December 31, 1997 ................ 13,265,477 124,175 13,389,652
Cash distributions ....... (2,248,343) (22,711) (2,271,054)
Net income for the year .. 1,302,819 13,160 1,315,979 ------------ ------------ ------------ Partners' equity, December 31, 1998 ................ 12,319,953 114,624 12,434,577
Cash distributions ....... (2,778,414) (28,065) (2,806,479)
Net income for the year .. 1,681,922 16,989 1,698,911 ------------ ------------ ------------ Partners' equity, December 31, 1999 ................ $ 11,223,461 $ 103,548 $ 11,327,009 ------------ ------------ ------------
See accompanying notes to the financial statements.
Ridgewood Maine Hydro Partners, L.P. Statement of Cash Flows - --------------------------------------------------------------------------------
Year Ended December 31, ----------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Cash flows from operating activities: Net income ........................ $ 1,698,911 $ 1,315,979 $ 1,043,420 ----------- ----------- ----------- Adjustments to reconcile net income to net cash flows from operating activities: Depreciation and amortization .... 1,107,568 1,089,969 1,062,838 Changes in assets and liabilities: (Increase) decrease in accounts receivable ..................... (447,458) (105,371) 529,205 (Increase) decrease in prepaid and other current assets ....... (65,295) 11,832 (41,716) Decrease (increase) in due to/from affiliates, net ........ 887,274 16,281 (303,259) (Decrease) increase in accounts payable and accrued expenses ... (159,514) 40,782 (505,122) ----------- ----------- ----------- Total adjustments ................. 1,322,575 1,053,493 741,946 ----------- ----------- ----------- Net cash provided by operating activities ....................... 3,021,486 2,369,472 1,785,366 ----------- ----------- -----------
Cash flows from investing activities: Payments to purchase Maine Hydro Projects ................... -- -- (323,217) Capital expenditures .............. (259,776) (752,613) (336,635) ----------- ----------- ----------- Net cash used in investing activities ....................... (259,776) (752,613) (659,852) ----------- ----------- -----------
Cash flows from financing activities: Cash contributed by partners ...... -- -- 531,906 Cash distributions to partners .... (2,806,479) (2,271,054) (2,012,516) Return of deposits ............... -- 800,000 -- Payments to reduce long-term lease obligations ................ (153,515) (134,894) (118,532) ----------- ----------- ----------- Net cash used in financing activities ....................... (2,959,994) (1,605,948) (1,599,142) ----------- ----------- -----------
Net (decrease) increase in cash and cash equivalents ............. (198,284) 10,911 (473,628)
Cash and cash equivalents, beginning of year ................ 607,119 596,208 1,069,836 ----------- ----------- ----------- Cash and cash equivalents, end of year .......................... $ 408,835 $ 607,119 $ 596,208 ----------- ----------- -----------
See accompanying notes to the financial statements.
Ridgewood Maine Hydro Partners, L.P. Notes to Financial Statements - --------------------------------------------------------------------------------
1. Organization and Business Activity
On September 5, 1996, Ridgewood Maine Hydro Partners, L.P. was formed as a Delaware limited partnership (the "Partnership"). Ridgewood Maine Hydro Corporation, a Delaware Corporation ("RMHCorp"), is the sole general partner of the Partnership and is owned equally by Ridgewood Electric Power Trust IV ("Trust IV") and Ridgewood Electric Power Trust V ("Trust V"), both Delaware business trusts (collectively, the "Trusts"). The Trusts are equal limited partners in the Partnership.
On December 23, 1996, in a merger transaction, the Partnership acquired 14 hydroelectric projects located in Maine (the "Maine Hydro Projects") from a subsidiary of Consolidated Hydro, Inc. The assets acquired include a total of 11.3 megawatts of electrical generating capacity. The electricity generated is sold to Central Maine Power Company and Bangor Hydro Company under long-term contracts.
2. Summary of Significant Accounting Policies
Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates.
Cash and cash equivalents The Partnership considers all highly liquid investments with maturities when purchased of three months or less as cash and cash equivalents.
Revenue recognition Power generation revenue is recognized based on power delivered at rates stipulated in the power sales contracts. Interest income is recorded when earned.
Plant and equipment Machinery and equipment, consisting principally of electrical generating equipment, is stated at cost. Renewals and betterments that increase the useful lives of the assets are capitalized. Repair and maintenance expenditures that increase the efficiency of the assets are expensed as incurred.
Depreciation is recorded using the straight-line method over the useful lives of the assets, which vary from 3 to 20 years. During the year ended December 31, 1999, 1998 and 1997, the Partnership recorded depreciation expense of $47,272, $29,673 and $1,683, respectively.
Intangible asset A portion of the purchase price of the Maine Hydro Projects was assigned to the Electric Power Sales Contracts and is being amortized over the duration of the contract (11 to 21 years) on a straight-line basis. Management periodically reviews intangibles for potential impairment. During the periods ended December 31, 1999, 1998 and 1997, the Partnership recorded amortization expense of $1,060,296, $1,060,296 and $1,061,155, respectively.
Income taxes No provision is made for income taxes in the accompanying financial statements as the income or loss of the Partnership is passed through and included in the tax returns of the individual partners.
Reclassification Certain items in previously issued financial statements have been reclassified for comparative purposes.
3. Obligation Under Capital Lease
The Partnership assumed a hydroelectric facility leased pursuant to a long-term lease agreement dated July 16, 1979, and as amended (the "Agreement"). Upon proper notice, the Partnership has the right to purchase all the equipment covered in the Agreement at Fair Market Value (as defined) or elect to extend the terms of the Agreement for up to three five-year periods at a rental equal to Fair Rental Value (as defined). In addition, the Partnership also has the right to terminate the Agreement and purchase the hydroelectric facility upon proper notice and payment of a scheduled close-out amount, which reduces to $750,000 at April 30, 2000. This lease is accounted for as a capital lease, and accordingly, the estimated lease obligation of $783,547 has been recorded in the accompanying balance sheet.
4. Lease Commitments
The Partnership leases the sites of two of its hydroelectric projects under operating leases expiring in June 2078. Total monthly payments in 1999 were the greater of $1,236 or a percentage of the revenue from the hydroelectric project. At December 31, 1999, the future minimum rental payments required under these leases are as follows:
2000 $ 14,832 2001 14,832 2002 14,832 2003 14,832 2004 14,832 Thereafter 1,090,152 ------------------ $ 1,164,312 ------------------
5. Power Generation Contracts
The Partnership operates facilities which qualify as small power production facilities under the Public Utility Regulatory Policies Act ("PURPA"). PURPA requires that each electric utility company, operating at the location of a small power production facility, as defined, purchase the electricity generated by such facility at a specified or negotiated price. The Partnership sells substantially all of its electrical output to two public utility companies, Central Maine Power Company ("CMP") and Bangor Hydro-Electric Company ("BHC"), pursuant to long-term power purchase agreements. Eleven of the twelve power purchase agreements with CMP expire in December 2008 and are renewable for an additional five year period. The twelfth power purchase agreement with CMP expires in December 2007 with CMP having the option to extend the contract three more five-year periods. The two power purchase agreements with BHC expire December 2014 and February 2017. The Partnership is required to maintain a standby letter of credit totaling $99,250 under the long-term power purchase agreement.
6. Fair Value of Financial Instruments
At December 31, 1999 and 1998, the carrying value of the Partnership's cash, accounts receivable and accounts payable approximates their fair value. The fair value of the long-term capital lease obligations, calculated using current rates for loans with similar maturities, also approximates its carrying value.
7. Management Agreement
The Maine Hydro Projects are operated by a subsidiary of CHI Energy, Inc. (formerly Consolidated Hydro, Inc.), under an Operation, Maintenance and Administrative Agreement. The annual operator's fee is $326,142 adjusted for inflation, plus an annual incentive fee equal to 50% of the net cash flow in excess of a target amount. The maximum incentive fee payable in a year is $112,500. The Partnership recorded $323,003, $429,714 and $429,430 of expense under this arrangement during the periods ended December 31, 1999, 1998 and 1997, respectively. The agreement has a five-year term expiring on June 30, 2001 and can be renewed for two additional five-year terms by mutual consent.
Indeck Maine Energy, L.L.C.
Financial Statements
December 31, 1999, 1998 and 1997
Report of Independent Accountants
To the Members of Indeck Maine Energy, L.L.C.:
In our opinion, the accompanying balance sheets and the related statements of operations, changes in members' (deficit) equity and of cash flows present fairly, in all material respects, the financial position of Indeck Maine Energy, L.L.C. (the "Company") at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 1999 and the period April 1, 1997 (inception) through December 31, 1997, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
As discussed in Note 4 to the financial statements, the Company has temporarily suspended operations and is dependent on the continuing financial support of the Members.
PricewaterhouseCoopers LLP New York, NY March 24, 2000
Indeck Maine Energy, L.L.C. Balance Sheet - --------------------------------------------------------------------------------
December 31, -------------------------- 1999 1998 ----------- ----------- Assets: Cash and cash equivalents ................ $ 656,442 $ 93,748 Accounts receivable ...................... 274,362 185,808 Inventories .............................. 145,198 278,704 Prepaid expenses ......................... 27,264 109,968 ----------- -----------
Total current assets .................. 1,103,266 668,228 ----------- -----------
Plant and equipment: Land .................................. 158,000 158,000 Power generation facilities ........... 3,203,217 3,203,217 Equipment and other ................... 56,646 56,646 ----------- ----------- 3,417,863 3,417,863 Accumulated depreciation .............. (435,869) (264,380) ----------- ----------- 2,981,994 3,153,483 ----------- -----------
Intangible assets ........................ 206,577 206,577 Accumulated amortization ................. (33,758) (20,476) ----------- ----------- 172,819 186,101 ----------- -----------
Total assets ........................ $ 4,258,079 $ 4,007,812 ----------- -----------
Liabilities and Members' (Deficit) Equity: Liabilities: Accounts payable and accrued expenses .... $ 426,001 $ 327,062 Due to affiliates ........................ 267,989 -- Management fee payable ................... 100,000 125,000 Notes payable to Members ................. 3,601,000 1,500,000 ----------- -----------
Total current liabilities ........... 4,394,990 1,952,062
Commitments and contingencies
Total Members' (deficit) equity .......... (136,911) 2,055,750 ----------- ----------- Total liabilities and members' (deficit) equity ................... $ 4,258,079 $ 4,007,812 ----------- -----------
See accompanying notes to the financial statement
Indeck Maine Energy, L.L.C. Statement of Operations - --------------------------------------------------------------------------------
For the period from inception For the For the April 1, year ended year ended 1997) to December December December 31, 1999 31, 1998 31, 1997 ----------- ----------- -----------
Revenues .................. $ 1,391,039 $ 1,430,296 $ 2,991,793
Operating expenses ........ 3,478,842 2,800,185 4,399,670 ----------- ----------- -----------
Loss from operations ... (2,087,803) (1,369,889) (1,407,877)
Other (expense) income, net (104,858) (47,711) 23,212 ----------- ----------- -----------
Net loss ............... $(2,192,661) $(1,417,600) $(1,384,665) ----------- ----------- -----------
See accompanying notes to the financial statements.
Indeck Maine Energy, L.L.C. Statement of Changes in Members' (Deficit) Equity For the Years Ended December 31, 1999 and 1998 and the period from inception (April 1, 1997) to December 31, 1997 - --------------------------------------------------------------------------------
Indeck Energy Ridgewood Services, Inc. Maine, LLC Total ----------- ----------- -----------
Initial contributions ............ $ 1,000 $ 4,857,015 $ 4,858,015
Net loss ......................... -- (1,384,665) (1,384,665) ----------- ----------- -----------
Members' equity, December 31, 1997 1,000 3,472,350 3,473,350
Net loss ......................... -- (1,417,600) (1,417,600) ----------- ----------- -----------
Members' equity, December 31, 1998 1,000 2,054,750 2,055,750
Net loss ......................... (1,000) (2,191,661) (2,192,661) ----------- ----------- -----------
Members' equity (deficit), December 31, 1999 ............... $ -- $ (136,911) $ (136,911) ----------- ----------- -----------
See accompanying notes to the financial statements.
Indeck Maine Energy, L.L.C. Statement of Cash Flows - --------------------------------------------------------------------------------
For the period from inception For the For the April 1, year ended year ended 1997) to December December December 31, 1999 31, 1998 31, 1997 ----------- ----------- ----------- Cash flows from operating activities Net loss ...................... $(2,192,661) $(1,417,600) $(1,384,665) ----------- ----------- ----------- Adjustments to reconcile net loss to net cash flows used in operating activities Depreciation and amortization 184,771 184,771 100,085 Changes in assets and liabilities: (Increase) decrease in accounts receivable ......... (88,554) 205,704 (391,512) Decrease (increase) in inventories ................. 133,506 71,955 (350,659) Decrease (increase) in prepaid expenses ............ 82,704 (91,424) (18,544) Increase (decrease) in accounts payable and accrued expenses .................... 98,939 (560,621) 887,683 Increase in due to affiliates 267,989 -- -- (Decrease) increase in management fee payable ...... (25,000) 100,000 25,000 ----------- ----------- ----------- Total adjustments ............ 654,355 (89,615) 252,053 ----------- ----------- ----------- Net cash used in operating activities .................... (1,538,306) (1,507,215) (1,132,612) ----------- ----------- -----------
Cash flows from investing activities Capital expenditures ........... -- -- (604,757) Acquisition of intangible assets -- -- (19,683) ----------- ----------- ----------- Net cash used in investing activities .................... -- -- (624,440) ----------- ----------- -----------
Cash flows from financing activities Capital contributions .......... -- -- 4,858,015 Payment of note payable - affiliate ..................... -- -- (3,300,000) Issuance of notes payable ...... 2,101,000 1,500,000 300,000 ----------- ----------- ----------- Net cash provided by financing activities .................... 2,101,000 1,500,000 1,858,015 ----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents .......... 562,694 (7,215) 100,963
Cash and cash equivalents, beginning of period ........... 93,748 100,963 -- ----------- ----------- -----------
Cash and cash equivalents, end of period ................. $ 656,442 $ 93,748 $ 100,963 ----------- ----------- -----------
Non-cash activities: On April 1, 1997, land, power generation facilities, equipment and intangible assets were acquired from Indeck Power Overseas Limited, a related entity, for $3,000,000 through the issuance of a note payable.
See accompanying notes to the financial statements.
Indeck Maine Energy, L.L.C. Notes to Financial Statements - --------------------------------------------------------------------------------
1. Description of Business
Indeck Maine Energy, L.L.C. (the "Company") is a limited liability company formed on April 1, 1997 for the purpose of acquiring, operating and managing two wood-fired electric generation facilities (the "Facilities"). The Facilities commenced operations on June 10, 1997. On June 11, 1997, Ridgewood Maine, LLC ("Ridgewood") contributed $4,857,015 for a membership interest.
a. Ridgewood's Priority Return from Operations: Ridgewood's Priority Return From Operations is an amount equal to 18% per annum of $14 million, increased by the amount of any additional contribution made by Ridgewood and reduced by the amount of distributions to Ridgewood of Net Cash Flow From Capital Events, as defined.
b. Allocation of Profits and Losses: In accordance with the Operating Agreement, profits and losses, as defined, are allocated as follows:
First, profits shall be allocated to each Member, other than Ridgewood, until the cumulative amount of profits allocated is equal to the amount of distributions made or to be made to each Member pursuant to the distributions provisions of the Operating Agreement.
Second, all remaining profits and losses shall be allocated to Ridgewood. Also, all depreciation shall be allocated to Ridgewood.
Losses and depreciation allocated to Members in accordance with the Operating Agreement may not exceed the amount that would cause such members to have an Adjusted Capital account Deficit, as defined, at the end of such year. All losses and depreciation in excess of this limitation shall be allocated to the remaining Members who will not be subject to this limitation, in proportion to and to the extent of their positive Capital Account Balances, as defined.
Also, if in any fiscal year a Member unexpectedly receives an adjustment, allocation or distribution as described in the Operating Agreement, and such allocation or distribution causes or increases an Adjusted Capital Account Deficit for such fiscal year, such Member shall be allocated items of income and gain in an amount and manner sufficient to eliminate such Adjusted Capital Account Deficit as quickly as possible.
c. Distributions of Net Cash Flows From Operations: For each Fiscal year, the Company shall distribute Net Cash Flow From Operations, as defined, to the Members as follows:
First, the Company shall distribute to Ridgewood 100% of Net Cash Flow From Operations until Ridgewood has received the full amount of any unpaid portion of Ridgewood's Priority Return From Operations, as defined, for any preceding fiscal year,
Second, the Company shall distribute to Ridgewood 100% of Net Cash Flow From Operations until Ridgewood has received Ridgewood's Priority Return From Operations for the current fiscal year.
Third, the Company shall distribute 100% of Net Cash Flow From Operations to the Members, other than Ridgewood, in accordance with the respective interests of such Members until such Members have collectively received an amount equal to the amount distributed to Ridgewood during the current fiscal year.
Fourth, the Company shall thereafter distribute any remaining balance of Net Cash Flow From Operations 25% to Ridgewood and 75% to the remaining Members, in accordance with the respective interest of such Members, until such time as Ridgewood has received aggregate distributions equal to Ridgewood's Initial Capital Contribution, as defined. At such time, the distribution percentages shall be amended to 50% Ridgewood and 50% to the remaining Members.
d. Distributions of Net Cash Flow From Capital Events: The Company shall distribute Net Cash Flow From Capital Events, as defined, 50% to Ridgewood and 50% to the remaining Members, in accordance with the respective interests of such Members.
2. Summary of Significant Accounting Policies
Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates.
Cash and cash equivalents The Company considers all highly liquid investments with maturities when purchased of three months or less as cash and cash equivalents.
Revenue recognition Revenue is recognized when the power is transmitted or the service is provided. Interest income is recorded when earned.
Inventories Inventories, consisting of wood and propane, are stated at cost, with cost being determined on the first-in, first-out method.
Plant and equipment Machinery and equipment, consisting principally of electrical generating equipment, is stated at cost. Renewals and betterments that increase the useful lives of the assets are capitalized. Repair and maintenance expenditures are expensed as incurred.
Depreciation is recorded using the straight-line method over the estimated useful life of the assets, ranging from 5 to 20 years. During the years ended December 31, 1999 and 1998 and the period from inception (April 1, 1997) to December 31, 1997, the Company recorded depreciation expense of $171,489, $171,489 and $92,891, respectively.
Intangible assets Intangible assets are amortized over 20 years on a straight-line basis. During the years ended December 31, 1999 and 1998 and the period from inception (April 1, 1997) to December 31, 1997, the Company recorded amortization expense of $13,282, $13,282 and $7,194.
Significant Customers During 1999, the Company's three largest customers accounted for 41%, 22% and 19% of total revenues. Other customers individually accounted for less than 10% of total revenues.
Income taxes No provision is made for income taxes in the accompanying financial statements as the income or loss of the Company is passed through and included in the tax returns of the partners.
3. Notes Payable
Notes payable consist of the following at December 31, 1999:
Note payable to Indeck Energy Services, Inc. (a Member), due on demand with interest at 5% ........................ $1,800,500
Note payable to Ridgewood Maine, LLC (a Member), due on demand with interest at 5% ................................. 1,800,500 ----------
$3,601,000 ----------
4. Operating Status
Both projects have temporarily suspended operations; one in December 1997 and the other in January 1998. It is management's intent not to operate these facilities, except during periods of peak demand, until profitable power sales contracts can be negotiated. Management is currently negotiating contracts with various utility companies and expects to commence operations in late 2000 or 2001. Based on forecasts related to these contracts, management believes that the Company will be able to recover the carrying value of its long-lived assets and meet its financial obligations. The Members intend to continue providing the necessary financial support to the Company for the foreseeable future and to not demand payment, within the next twelve months, of the notes payable discussed in Note 3.
5. Related Party transactions
The Company is required to pay certain Members a fee for management services of $50,000 in 1997 and $100,000 per year thereafter. Additional management fees of up to $200,000 per year may be payable contingent upon achieving Ridgewood's Priority Return from Operations, as defined. No contingent management fee has been accrued as of December 31, 1999 or 1998.
The Company incurred expenses of approximately $770,000 and $1,189,000 for the year ended December 31, 1998 and for the period from inception (April 1, 1997) through December 31, 1997, respectively, from Indeck Operations, Inc. and Indeck Energy Services, Inc., companies affiliated through common ownership, for the operation, maintenance and administration of the Company's facilities. At December 31, 1998, approximately $57,000 of these charges were in accounts payable.
Under an Operating Agreement with the Trusts, Ridgewood Power Management LLC (formerly Ridgewood Power Management Corporation, "Ridgewood Management"), an entity related to the managing shareholder of the Trusts through common ownership, provides management, purchasing, engineering, planning and administrative services to the Company. Ridgewood Management charges the Company at its cost for these services and for the allocable amount of certain overhead items. Allocations of costs are on the basis of identifiable direct costs, time records or in proportion to amounts invested in projects managed by Ridgewood Management. During the year ended December 31, 1999, Ridgewood Management charged the Company $197,825 for overhead items allocated based on time records and in proportion to the amount invested in projects managed. Ridgewood Management also charged the Company for all of the remaining direct operating and non-operating expenses incurred during the periods
6. Dispute with ISO
From June through December 1999, the Facilities periodically operated on dispatch from ISO-New England, Inc. (the "ISO") and also submitted offers to the ISO to run at high prices during power emergencies. The Facilities have claimed the ISO owes them approximately $14 million for the electricity products they provided in those periods and the ISO has claimed that no material revenues at all are due to the projects. The Company has not recorded any of the disputed revenues in the financial statements and it is too early to estimate the outcome of the dispute. | 37,683 | 252,525 |
1037390_1999.txt | 1037390_1999 | 1999 | 1037390 | ITEM 1. BUSINESS
Griffin Land & Nurseries, Inc. ("Griffin") and its subsidiaries comprise principally a landscape nursery and real estate business. At the end of its 1999 fiscal year Griffin engaged in two principal lines of business: (1) the landscape nursery products business, comprised of (x) the growing of containerized landscape nursery products for sale principally to garden center operators and landscape nursery mass merchandisers, and (y) the ownership and operation of wholesale sales and service centers whose principal customers are landscape contractors; and (2) the real estate business, comprised of (x) the ownership, construction and management of commercial and industrial properties and (y) the development of residential subdivisions on real estate owned by Griffin in Connecticut and Massachusetts. Griffin also owns an approximately 35% interest (33% fully diluted) in Centaur Communications, Ltd. ("Centaur"), a United Kingdom magazine and information services publisher, and has a lesser interest in Linguaphone Group plc ("Linguaphone"), a designer and distributor of language teaching materials based in the United Kingdom, which was accounted for under the cost method of accounting for investments for most of 1999 but which was reflected on an equity basis in prior periods.
LANDSCAPE NURSERY BUSINESS
The landscape nursery operations of Griffin are operated by its wholly-owned subsidiary, Imperial Nurseries, Inc. ("Imperial"). Imperial is a grower, distributor and, to a much lesser extent, broker of wholesale landscape nursery stock. The landscape nursery industry is extremely fragmented. Imperial believes that its volume places it among the twenty largest landscape nursery companies in the country.
Imperial's container growing operations are located on property owned by Griffin in Connecticut (400 acres) and in northern Florida (350 acres). Both the Connecticut and Florida growing operations are currently being expanded on adjacent lands owned by Griffin. The Florida farm is also improving its shipping docks and customer service facilities. The majority of Imperial's inventories are container-grown plants on those two farms. The largest portion of Imperial's container-grown product consists of broadleaf evergreens, including azaleas and rhododendron. Other major product categories include juniper and deciduous shrubs. Container-grown product is held principally from one to five years prior to its sale by Imperial. Imperial has substantially increased its production of perennials which have a much shorter growing cycle than most of Imperial's other products. During 1997, Imperial determined to terminate its own growing of field-grown product and recorded a loss accrual estimated to be sufficient to absorb the costs of terminating these operations. The termination of field operations was substantially completed during 1999 within the loss accrual. Imperial contracts with a grower in the Mid-Atlantic states to produce field-grown product for Imperial. The agreement provides for Imperial to purchase such product over a five year period and is part of a program intended to replace Imperial's previous investment in field-grown plants and to shorten its product growing cycles.
Imperial is also reviewing a variety of approaches to increase its return on assets in its growing operations including changes in the relative quantities of some products currently grown and proposed to be grown and also possible changes in the potting and growing cycles for some of its containerized production. Some of these programs are also directed at developing faster growing products and improved soil mixes. Imperial is also considering some other products and product sizes for both sales in its existing markets and expanding the market area served by the Florida farm. Any such changes, if successful, taking into account the growing cycles of the related plants, will take a substantial period to be reflected in results of operations to any material extent.
The growing operations serve a market comprised principally of retail chain store garden departments, retail nurseries and garden centers, wholesale nurseries, distributors, and to a lesser extent, landscapers as direct customers. Imperial-grown products are also distributed through its own
wholesale horticultural sales and service centers whose main customers are landscapers. Imperial's major markets are in the Northeast, Mid-Atlantic, the northern portion of the Southeast and the Midwest. Nursery sales are extremely seasonal, peaking in spring, and are strongly affected by commercial and residential building activity and are materially affected by weather conditions, particularly in the spring planting season.
Imperial operates seven wholesale horticultural sales and service centers, which sell a wide range of plant material, including a large portion purchased from growers other than Imperial, and horticultural tools and products to the trade. The largest portion of the sales of these centers is to professional landscapers. The centers, all of which are owned by Imperial, are located in Windsor, Connecticut; Aston and Pittsburgh, Pennsylvania; Columbus and Cincinnati, Ohio; White Marsh, Maryland; and Manassas, Virginia. The Cincinnati center was expanded in 1999 with the purchase of contiguous land. During 1999, results from these centers improved substantially. The centers have become the principal contributor to the operating results of Imperial. A site for a new center has been contracted for, subject to local approvals, in Somerset, New Jersey. Other sites for additional centers will also be considered for expansion in other areas.
Imperial's sales are made to a large variety of customers, none of whom represented more than 4% of annual sales in fiscal 1999, fiscal 1998 and fiscal 1997.
Containerized growing and shipping capacity has been increased to meet the potential volume and quality needs of Imperial's customers and to capitalize on expected growth in the Mid-Atlantic and Midwest markets. Imperial has also added to its sales coverage in these areas with additional sales personnel at the farms and an additional salesperson added in 1998 in the marketplace. In coming years a larger part of Imperial's shipping will probably be made on trucks outfitted with shelves, which may increase shipping expenses.
REAL ESTATE BUSINESS
Griffin is directly engaged in the real estate development business on portions of its land in Connecticut. Griffin develops portions of its properties for commercial, residential and industrial use. The headquarters for this operation is in Bloomfield, Connecticut.
During the last several years, the real estate market in the Hartford area, particularly that in the northwest quadrant where the majority of Griffin's acreage is located, has been depressed by a number of factors, including the decline of employment in the defense and insurance industries. The office portion of this market has been particularly weak. There can be no assurance that the condition of the real estate market in this region will improve in the near future. Despite the decline in the insurance and defense industries, the unemployment rate in the area is quite low. The development of Griffin's land is also affected by land planning issues, particularly in the town of Simsbury, Connecticut. In November 1999, Griffin filed plans for the creation of a residential community of 640 homes on a 363 acre site in Simsbury. One quarter of these homes would be deed restricted affordable housing under Connecticut statutes. The plan is subject to review and public hearings, conducted by the appropriate town commissions, including the planning, zoning, and conservation commissions, which are expected to continue well into the 2000 second quarter. The public hearings are focusing on the density of the proposed development, as well as sewer, wetlands and pollution issues arising from prior use of the land in farming, as a result of which certain pesticides remain in the upper portion of the soil. See--"Regulation: Environmental Matters." Griffin believes that its development plan for this site includes an appropriate method (which has received support from the Connecticut Department of Environmental Protection) for remediating the soils. The outcome of these hearings and the commissions' decisions, and any potential subsequent litigation, cannot be predicted except that some commission objections are anticipated. Griffin anticipates that obtaining subdivision approvals in many
of the towns where it holds land to be an extended process. During 1999 one parcel of land in Suffield, Connecticut, which was in the process of subdivision, was sold at a substantial profit.
A significant amount of Griffin's current commercial and industrial development efforts are focused on a 600 acre tract owned by Griffin near Bradley International Airport and Interstate 91 known as the New England Tradeport. To date, approximately 340,000 square feet of warehouse and light manufacturing space have been completed, which is approximately 70% occupied or committed, and a bottling and distribution plant has been built by the Pepsi Bottling Group ("Pepsi") on land sold to Pepsi by Griffin. The completed and leased space includes approximately 98,000 square feet completed and leased in 1998. The only currently vacant space is a warehouse of approximately 100,000 square feet that was built in 1999 on speculation, no part of which is yet leased. Griffin is considering an additional building for this park. A state traffic control certificate for the future development of 1.2 million square feet has been obtained for the New England Tradeport. Griffin intends to continue to direct its primary efforts toward the construction and leasing of light industrial and warehouse facilities at the New England Tradeport. Development at the New England Tradeport may require investment in off-site infrastructure on behalf of Windsor, Connecticut, and may require improvement of some state or town roads.
Griffin's most substantial development is the combination of Griffin Center in Windsor, Connecticut, and Griffin Center South in Bloomfield, Connecticut. Together these master planned developments comprise approximately 600 acres, half of which have been developed with nearly 1,750,000 square feet of office and industrial space. Griffin Center currently includes ten corporate office buildings built by Griffin. Griffin currently maintains only a 30% interest in two office buildings in the Griffin Center office complex, which have an aggregate of 160,000 square feet. In Griffin Center South, a 130-acre tract with fifteen buildings of industrial and research and development space, Griffin has retained for rental nine buildings, which are now fully rented. These buildings have an aggregate of approximately 175,000 square feet. Griffin is discussing additional building for this park and is also considering similar research and development space which might be constructed in a portion of Griffin Center.
Two additional Griffin parcels appropriate for office or industrial developments are available for development, including 28 acres in the Day Hill Technology Center in Windsor and 100 acres in the South Windsor Technology Center. State traffic certificates have been obtained for these parcels for 500,000 square feet and 200,000 square feet of development, respectively.
In 1988, a subsidiary of Griffin began infrastructure work at Walden Woods, a 153-acre site in Windsor, Connecticut, which was originally planned to contain more than 365 residential units. Prior to 1992 Griffin had built and sold 45 homes before discontinuing its home building operations at Walden Woods. Since then, two third-party home builders have completed an additional 64 homes. In 1999, Griffin entered into an agreement with a home builder to allow that builder to purchase and complete homes on 24 lots. Griffin is evaluating other of its lands for residential development over a period of years.
In addition, approximately 500 acres in Connecticut are leased for tobacco growing to General Cigar Co., Inc., at annual rentals approximating the land's annual carrying cost. The lease for these properties, which extends for 10 years, may be terminated as to 100 acres annually, on one year's prior notice.
EQUITY INVESTMENTS
CENTAUR
Griffin owns approximately 35% (33% fully diluted) of the outstanding common stock of Centaur, a privately-held publisher of business magazines in the United Kingdom and a compiler and supplier of
computerized financial information through a subsidiary, Perfect Information, Ltd. As a result of a repurchase of common stock by Centaur and an additional investment by Griffin in 1998, Griffin's interest in Centaur was increased. The agreements relating to that transaction provide for an offering of Centaur stock or sale of Centaur in three to four years; but, if circumstances are favorable, such an offering could occur earlier.
LINGUAPHONE
Griffin received in 1997 from Centaur a 25% interest in Linguaphone. Griffin's 1998 results included an equity loss from Linguaphone of approximately $1.1 million. In early 1999, a recapitalization of Linguaphone resulted in Griffin's interest being reduced to approximately 14% (11% fully diluted). Accordingly, Griffin now accounts for Linguaphone under the cost method of accounting for investments.
FINANCIAL INFORMATION REGARDING INDUSTRY SEGMENTS
See Note 2 to the Consolidated Financial Statements of Griffin included elsewhere herein for certain financial information regarding the landscape nursery business and the real estate business.
EMPLOYEES
Griffin employs 356 persons on a full-time basis, including 12 in its real estate business and 340 in its landscape nursery business. At present, none of these employees are represented by a union. Griffin believes that its relations with its employees are satisfactory.
COMPETITION
The nursery business is competitive, and Imperial competes against a number of other companies, including national, local and regional nursery businesses. Some of Imperial's competitors in the nursery industry are larger than Imperial. Numerous real estate developers operate in the portion of Connecticut and Massachusetts in which Griffin's holdings are concentrated. Some of such businesses may have greater financial resources than Griffin.
REGULATION: ENVIRONMENTAL MATTERS
Under various federal, state and local laws, ordinances and regulations, an owner or operator of real estate may be required to investigate and clean up hazardous or toxic substances or petroleum product releases at such property and may be held liable to a governmental entity or to third parties for property damage and for investigation and clean-up costs incurred by such parties in connection with contamination. The cost of investigation, remediation or removal of such substances may be substantial, and the presence of such substances, or the failure properly to remediate such substances, may adversely affect the owner's ability to sell or rent such property or to borrow using such property as collateral. In connection with the ownership (direct or indirect), operation, management and development of real properties, Griffin may be considered an owner or operator of such properties or as having arranged for the disposal or treatment of hazardous or toxic substances and, therefore, potentially liable for removal or remediation costs, as well as certain other related costs, including governmental fines and injuries to persons and property. In Simsbury, Connecticut, the value of Griffin's land is affected by the presence of chlordane on a portion of the land which is intended for residential use. Although Griffin believes its proposed method of reducing chlordane contamination to levels below those that would impede residential development of such properties is appropriate and feasible, the acceptance of the method by any town commission has not yet been obtained. In the event that Griffin is unable adequately to remediate this property, its ability to develop such property for its intended purposes would be materially affected.
Griffin periodically reviews its properties for the purpose of evaluating such properties' compliance with applicable state and federal environmental laws. Griffin does not anticipate experiencing, in the immediate future, material expense in complying with such laws.
ITEM 2.
ITEM 2. PROPERTIES
LAND HOLDINGS
Griffin is a major landholder in the State of Connecticut and also owns land in Massachusetts. In addition, Griffin owns approximately 1,000 acres in Florida, most of which is used for Imperial Nurseries' growing operations or is contiguous to such operations, and also owns sites for Imperial Nurseries' seven sales and service centers. Each such center typically has a warehouse/office facility and 10-15 acres of nursery stock.
The book value of undeveloped land holdings and capitalized development expenditures, owned by Griffin, principally in the Hartford, Connecticut area, is approximately $12,000,000. Griffin believes the fair market value of such land is substantially in excess of its book value, including land improvements.
A listing of the locations of Griffin's commercial and nursery real estate, a portion of which, principally in Bloomfield, East Granby and Windsor, has been developed, is as follows:
COMMERCIAL REAL ESTATE
NURSERY REAL ESTATE
Griffin also leases approximately 2,100 square feet in New York City for its Executive Offices.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
As discussed in Item 1, certain parts of Griffin's land in Simsbury, Connecticut, are affected by the presence of chlordane. Although the various federal, state and local agencies may have an interest in the matter, there are no proceedings known by Griffin to be contemplated by any of these agencies in connection with possible chlordane exceedences on such land.
The Company is involved, as a defendant, in various litigation matters arising in the ordinary course of business. In the opinion of management, based on the advice of legal counsel, the ultimate liability, if any, with respect to these matters will not be material.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
The following are the high and low prices of common shares of Griffin Land & Nurseries, Inc. as traded on the OTC Bulletin Board through April 28, 1998 and on the Nasdaq National Market subsequent to April 28, 1998:
On February 1, 2000, the number of record holders of common stock of Griffin was approximately 612, which does not include beneficial owners whose shares are held of record in the names of brokers or nominees. The closing market price as quoted on the Nasdaq National Market on such date was $10.375 per share. The information appearing in Notes 7 and 11 to the Consolidated Financial Statements is hereby incorporated by reference.
DIVIDEND POLICY
Griffin's current policy is to retain any earnings to finance the operations and expansion of its businesses.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected statement of operations data for fiscal years 1995 through 1999 and balance sheet data as of the end of each fiscal year.
(a) The Selected Financial Data presented above reflects CMS Gilbreth Packaging Systems, Inc., as a discontinued operation in 1995 and 1996. This business was sold in 1996.
(b) Griffin was a consolidated subsidiary of Culbro Corporation ("Culbro") through July 3, 1997. Accordingly, the per share results for 1997 presented above are on a pro forma basis because the Griffin common stock was not outstanding the entire period.
(c) Culbro's general long-term debt was included on Griffin's historical balance sheet through February 27, 1997, when such debt was assumed by Griffin's former affiliate, General Cigar Holdings, Inc., in connection with the distribution of Griffin's common stock to Culbro's shareholders.
(d) Prior to July 3, 1997, Griffin was a wholly-owned subsidiary of Culbro. Accordingly, the retained earnings and intercompany balances with its former parent are reflected in Culbro Investment prior to July 3, 1997.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The consolidated financial statements of Griffin include the accounts of Griffin's subsidiary in the landscape nursery business, Imperial, and Griffin's Connecticut and Massachusetts based real estate business ("Griffin Land"). Griffin also has an equity investment in Centaur, a magazine publishing business, based in the United Kingdom. On February 27, 1997, Culbro, Griffin, then a wholly-owned subsidiary of Culbro, and General Cigar Holdings, Inc. ("GC Holdings"), also a wholly-owned subsidiary of Culbro at that time, entered into a Distribution Agreement (the "Distribution Agreement") which provided for a tax-free distribution (the "Distribution") of Griffin's common stock to the existing shareholders of Culbro. The Distribution of the Griffin common stock to Culbro shareholders was completed on July 3, 1997. Subsequent to the Distribution, Griffin has operated as an independent stand-alone entity. Prior to March 18, 1997, Griffin was known as Culbro Land Resources, Inc.
The financial statements of Griffin reflect the results of the operations of Griffin's businesses and investments. Griffin's 1997 results include an allocation to Griffin from Culbro for corporate overhead of $1.0 million prior to the Distribution in July of that year. This allocation, which may not necessarily reflect the additional expenses Griffin would have incurred had it operated as a separate stand-alone entity prior to the Distribution, is deemed reasonable by Griffin management. Griffin's results of operations in 1997 also include interest expense of $0.7 million on Culbro general corporate debt. The Culbro debt was included in Griffin's financial statements through the 1997 first quarter, when that debt was assumed by GC Holdings pursuant to the Distribution Agreement. Such interest expense has not been part of Griffin's results of operations subsequent to the Distribution. Accordingly, there is no allocation of expenses from Culbro to Griffin reflected in Griffin's results subsequent to fiscal 1997.
RESULTS OF OPERATIONS
FISCAL 1999 COMPARED TO FISCAL 1998
In fiscal 1999, Griffin's net sales increased $11.7 million, or 23%, to $62.9 million from $51.2 million in fiscal 1998. Net sales increased at both Imperial and Griffin Land. Imperial's net sales increased $9.4 million, or 19%, to $57.6 million in fiscal 1999 from $48.2 million in fiscal 1998. The increased sales at Imperial reflect higher volume at its wholesale sales and service centers, which benefitted from favorable weather conditions in their markets throughout most of the year. Sales of containerized plants from Imperial's farm operations increased in fiscal 1999 as compared to fiscal 1998, more than offsetting the lower sales of field-grown product in fiscal 1999 as compared to fiscal 1998. The decrease in net sales of field-grown product in fiscal 1999 reflects the decision to discontinue a field-grown program. Net sales and other revenue at Griffin Land increased to $5.4 million in fiscal 1999 from $3.1 million in fiscal 1998. The revenue increase at Griffin Land principally reflected a land sale of $1.0 million in fiscal 1999 (there were no land sales in fiscal 1998) and an increase in rental revenue from its commercial properties, including the approximately 98,000 square foot warehouse built and partially leased in fiscal 1998 that became fully leased at the beginning of fiscal 1999. Rental revenue from Griffin Land's commercial properties increased to $3.6 million in fiscal 1999 from $2.6 million in fiscal 1998. Occupancy at Griffin Land's properties (excluding an approximately 100,000 square foot warehouse facility completed in fiscal 1999 and currently not occupied) was 96% as of the
end of fiscal 1999 (including full occupancy in its Griffin Center South commercial development) as compared to 91% at the end of fiscal 1998.
Griffin's consolidated operating profit (before interest) increased to $3.1 million in fiscal 1999 from $0.1 million in fiscal 1998. Operating profit at Imperial increased to $3.9 million in fiscal 1999 from $2.3 million in fiscal 1998. The increased operating profit at Imperial principally reflects the sales volume increase, which generated gross profit in 1999 of $17.0 million versus $13.9 million in fiscal 1998. Imperial's overall gross margins on sales increased to 29.5% in fiscal 1999 from 28.8% in fiscal 1998. Imperial's operating expenses increased to $13.1 million in fiscal 1999 from $11.6 million in fiscal 1998. The increased operating expenses were incurred principally to service the additional volume at its wholesale sales and service centers. Imperial's operating expenses were 22.7% of net sales in fiscal 1999 as compared to 24.1% of net sales in fiscal 1998.
Total operating profit at Griffin Land was $0.8 million in fiscal 1999 as compared to a total operating loss of $0.3 million incurred in fiscal 1998. The improved operating results principally reflect the profit on the land sale in fiscal 1999 and higher rental revenue, partially offset by higher operating expenses. Griffin Land's rental properties generated an operating profit, before depreciation, of $2.9 million in fiscal 1999 as compared to $2.1 million in fiscal 1998. The increase reflects the higher occupancy rate in fiscal 1999 and an increase in the amount of space being leased.
Interest expense at Griffin increased to $0.6 million in fiscal 1999 from $0.2 million in fiscal 1998. The higher interest expense reflects the increased debt in fiscal 1999, including an $8.2 million nonrecourse mortgage entered into by Griffin Land. Interest income was $0.1 million in fiscal 1999 as compared to $0.3 million in fiscal 1998. The lower interest income in the current year reflects the lower cash on hand throughout fiscal 1999 as compared to the prior year.
Equity income from Griffin's investee, Centaur, was $0.9 million in fiscal 1999 as compared to $1.1 million in fiscal 1998. The lower results from Centaur reflect higher interest expense in fiscal 1999 due to having outstanding loans for the entire year as compared to a partial year in fiscal 1998, and lower operating profit. As a result of transactions in the third quarter of fiscal 1998, Griffin's equity ownership of Centaur was 35% throughout the entire fiscal 1999 as compared to only part of fiscal 1998. In early fiscal 1999, Griffin's ownership interest in Linguaphone Group plc ("Linguaphone") was reduced and is now accounted for under the cost method of accounting for investments. Accordingly, Griffin did not recognize equity results of Linguaphone throughout most of fiscal 1999. Griffin's results in fiscal 1998 included an equity loss of $1.1 million from Linguaphone.
FISCAL 1998 COMPARED TO FISCAL 1997
In fiscal 1998, Griffin's net sales increased $4.9 million, or 11%, to $51.2 million from $46.3 million in fiscal 1997. The net sales increase was due to net sales at Imperial, which were $48.2 million in fiscal 1998 as compared to $42.6 million in fiscal 1997. The $5.6 million (13%) net sales increase at Imperial principally reflected increased volume and higher prices at the wholesale sales and service centers, which accounted for substantially all of Imperial's net sales increase.
Net sales in Griffin's real estate business, Griffin Land, decreased from $3.7 million in fiscal 1997 to $3.1 million in fiscal 1998. Net sales in fiscal 1997 included $0.7 million from sales of remaining residential lots from developments started in earlier years. There were no land sales in fiscal 1998. Excluding the residential lot sales, net sales at Griffin Land increased slightly in fiscal 1998 as compared to fiscal 1997. Rental revenue from Griffin Land's buildings increased to $2.6 million in fiscal 1998 from $2.1 million in fiscal 1997. The higher rental revenue principally reflected increased occupancy as the result of new leases. Occupancy in Griffin Land's properties, excluding the new warehouse constructed in 1998, increased from 80% at the end of fiscal 1997 to 91% at the end of fiscal 1998. Including new leases that became effective subsequent to the end of fiscal 1998, Griffin
Land's occupancy rate in its properties was approximately 95%, including full occupancy in its Griffin Center South development.
Griffin's consolidated operating profit (before interest) was $0.1 million in fiscal 1998 as compared to an operating loss of $3.2 million in fiscal 1997. The increased operating results principally reflected the effect of the $3.3 million charge incurred in fiscal 1997 by Imperial to reserve for certain plant inventories. Operating profit at Imperial increased to $2.3 million in fiscal 1998 as compared to $1.9 million (excluding the effect of the inventory charge) in fiscal 1997. Imperial's overall gross profit margins decreased slightly to 28.8% in fiscal 1998 from 29.4% in fiscal 1997, again excluding the effect of the inventory charge in 1997. The operating profit increase at Imperial reflects the effect of higher net sales in fiscal 1998, partially offset by higher operating expenses. As a percentage of net sales, operating expenses were 24.1% in fiscal 1998 as compared to 25.0% in fiscal 1997. The operating expense increase principally reflected higher selling expenses related to the increased volume at Imperial's wholesale sales and service centers.
Griffin Land incurred a total operating loss of $0.3 million in fiscal 1998 versus a total operating loss of $0.2 million in fiscal 1997. Operating results in fiscal 1998 include the settlement of a litigation initiated by Griffin Land for reimbursement of certain costs to repair two commercial buildings owned by Griffin Land. Proceeds from the settlement in excess of repair costs were approximately $0.2 million and are reflected as a reduction of Griffin Land's operating expenses. Excluding the effect of the benefit from the litigation settlement in fiscal 1998, operating results at Griffin Land decreased by $0.3 million, principally reflecting the effect of the residential land sales in fiscal 1997. Griffin Land's rental properties generated an operating profit, before depreciation, of $2.1 million in fiscal 1998 versus $1.8 million in fiscal 1997, reflecting the higher occupancy noted above and corresponding increase in rental revenue.
The decrease in Griffin's interest expense principally reflects the inclusion in the 1997 first quarter of interest expense of $0.7 million related to Culbro's general corporate debt that was assumed by GC Holdings at the end of the 1997 first quarter. The higher income tax rate principally reflects the effect of state and local taxes.
Income from Griffin's equity investments was lower in 1998 as a result of losses at Linguaphone which more than offset increased profit at Centaur. Centaur's 1998 results included one-time expenses aggregating approximately $1.1 million before taxes (approximately $0.3 million allocable to Griffin's interest) relating to the restructuring of Centaur's ownership. Additionally, increased operating profit of Centaur's magazine publishing operations was partially offset by operating losses incurred by Centaur's subsidiary, Perfect Information, Ltd., which operates a database service that provides financial information to its customers. During 1998, Griffin's common equity ownership of Centaur increased to approximately 35% (33% fully diluted) as a result of Griffin's purchase of Centaur common stock and Centaur's repurchase of common stock from other Centaur stockholders. See Note 9 of the consolidated financial statements included in Item 8. The equity loss for Linguaphone includes foreign currency exchange losses incurred by Linguaphone for which Griffin's allocable share was approximately $0.5 million in fiscal 1998.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $0.9 million in fiscal 1999 as compared to $0.6 million in fiscal 1998. The increase in cash provided reflects Griffin's higher net income and an income tax refund of $0.9 million received in the current year, partially offset by higher inventories at Imperial and an increase in Imperial's accounts receivable in the current year. Net cash used in investing activities declined to $6.6 million in fiscal 1999 from $9.8 million in fiscal 1998. The decrease reflects the effect of the $3.0 million additional investment in Centaur in fiscal 1998. In fiscal 1999, lower spending on real estate investments principally offset increased capital expenditures for property
and equipment at Imperial. The additional capital spending at Imperial in the current year principally reflects the acquisition of land adjacent to Imperial's Cincinnati wholesale sales and service center to expand that operation and the start of several capital projects to expand and improve Imperial's containerized plant production facilities in Florida and Connecticut.
Net cash provided by financing activities was $5.6 million in fiscal 1999 as compared to net cash used in financing activities of $0.2 million in fiscal 1998. In fiscal 1999, Griffin entered into an $8.2 million nonrecourse mortgage on several of its buildings in the New England Tradeport. Proceeds were used to reduce the amount then outstanding under the Imperial Credit Agreement and to repay an existing mortgage on certain of those properties. The new warehouse completed in 1999 is not mortgaged. Also in fiscal 1999, Griffin entered into a $20 million revolving credit line (the "Griffin Credit Agreement") to replace the $10 million revolving credit facility with Imperial. The Griffin Credit Agreement is an unsecured facility that terminates in May 2001 and will provide financing for working capital requirements of Griffin's landscape nursery and real estate businesses.
In the 1999 third quarter, Imperial started several capital projects to improve and expand its containerized plant production facilities in Florida and Connecticut. These projects are expected to be completed in fiscal 2000 at an estimated cost of approximately $3.5 million. Additionally, Imperial entered into an agreement to purchase land in central New Jersey for a new wholesale sales and service center. Completion of the land purchase is contingent upon receiving all required regulatory approvals to operate a wholesale sales and service center on that site. If such approval is received, expenditures for the land acquisition and required site work are projected to be approximately $2.5 million in fiscal 2000. Based on the future space requirements of certain of its tenants, Griffin Land may undertake construction of new buildings in fiscal 2000 to provide additional space, as needed. A portion of any new construction may be built on speculation.
Management believes that in the near term, based on the current level of operations and anticipated growth, its cash on hand, cash flow from operations and borrowings under the Griffin Credit Agreement will be sufficient to finance the working capital requirements and expected capital expenditures of its landscape nursery business and fund development of its real estate assets. Over the intermediate and long term, selective mortgage placements or additional bank credit facilities may also be required to fund capital projects.
YEAR 2000
In the 1999 fourth quarter, Griffin completed all necessary remediation steps to ensure all its systems are year 2000 ("Y2K") compliant. Subsequent to January 1, 2000, Griffin has not encountered any problems with its computer systems as a result of the Y2K issue. Costs attributed to modifying Griffin's systems to be Y2K compliant were less than $0.1 million in the aggregate.
Prior to December 31, 1999, Griffin initiated a company-wide review of major customers, vendors and other third parties to determine the extent, if any, to which Griffin would be vulnerable to those third parties' failure to remedy their own Y2K issues. Those third parties contacted indicated that they had Y2K readiness programs in place or that they were Y2K compliant before December 31, 1999. Subsequent to January 1, 2000, Griffin has not encountered any Y2K problems from any of its critical business partners. We will continue to monitor our critical business partners for Y2K issues.
Griffin believes that its efforts to address the Y2K issue have been successful. However, failure of critical third parties adequately to address their respective Y2K issues could have a material adverse effect on Griffin's business, financial condition and results of operations. Therefore, Griffin's program for Y2K compliance included the development of contingency plans for continuing operations in the event such problems arise. However, there can be no assurance that such contingency plans will be adequate to handle all problems which may arise.
FORWARD-LOOKING INFORMATION
The above information in Management's Discussion and Analysis of Financial Condition and Results of Operations includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Although Griffin believes that its plans, intentions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such plans, intentions or expectations will be achieved, particularly with respect to the opening of an additional sales and service center, the leasing of its warehouse constructed in 1999 and possible construction of additional facilities in the real estate business. The forward-looking information disclosed herein is based on assumptions and estimates that, while considered reasonable by Griffin as of the date hereof, are inherently subject to significant business, economic, competitive and regulatory uncertainties and contingencies, many of which are beyond the control of Griffin.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of changes in value of a financial instrument, derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates and equity prices. Changes in these factors could cause fluctuations in earnings and cash flows.
For fixed rate debt, changes in interest rates generally affect the fair market value of the debt instrument, but not earnings or cash flows. Griffin does not have an obligation to prepay any fixed rate debt prior to maturity, and therefore, interest rate risk and changes in the fair market value of fixed rate debt should not have a significant impact on earnings or cash flows until such debt is refinanced, if necessary. For variable rate debt, changes in interest rates generally do not impact the fair market value of the debt instrument, but do affect future earnings and cash flows. Griffin did not have any variable rate debt outstanding at November 27, 1999, but is expected to have such debt outstanding in the future.
Griffin is exposed to market risks from fluctuations in interest rates and the effects of those fluctuations on market values of Griffin's cash equivalent short-term investments. These investments generally consist of overnight investments that are not significantly exposed to interest rate risk, except to the extent that changes in interest rates will ultimately affect the amount of interest income earned and cash flow from these investments.
Griffin does not currently have any derivative financial instruments in place to manage interest costs, but that does not mean that Griffin will not use them as a means to manage interest rate risk in the future.
Griffin does not use foreign currency exchange forward contracts or commodity contracts and does not have foreign currency exposure in its operations. Griffin does have investments in companies based in the United Kingdom, and changes in foreign exchange rates could affect the results of equity investments in Griffin's financial statements, and the ultimate liquidation of those investments and conversion of proceeds into United States currency.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
GRIFFIN LAND & NURSERIES, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(a) 1997 per share results are pro forma. See Note 7.
See Notes to Consolidated Financial Statements.
GRIFFIN LAND & NURSERIES, INC.
CONSOLIDATED BALANCE SHEET
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
See Notes to Consolidated Financial Statements.
GRIFFIN LAND & NURSERIES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
See Notes to Consolidated Financial Statements.
GRIFFIN LAND & NURSERIES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(DOLLARS IN THOUSANDS)
See Notes to Consolidated Financial Statements.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying consolidated financial statements of Griffin Land & Nurseries, Inc. ("Griffin") include the accounts of Griffin's real estate division ("Griffin Land") and Griffin's wholly-owned subsidiary, Imperial Nurseries, Inc. ("Imperial"). On February 27, 1997, Culbro Corporation ("Culbro"), Griffin, then a wholly-owned subsidiary of Culbro, and General Cigar Holdings, Inc. ("GC Holdings"), also a wholly-owned subsidiary of Culbro at that time, entered into a Distribution Agreement (the "Distribution Agreement") which provided for a tax-free distribution (the "Distribution") of Griffin's common stock to the existing shareholders of Culbro. The Distribution of the Griffin common stock to Culbro shareholders was completed on July 3, 1997. Griffin has operated as an independent stand-alone entity subsequent to the Distribution. All intercompany transactions have been eliminated. Prior to March 18, 1997, Griffin was known as Culbro Land Resources, Inc.
Griffin accounts for its investments in Centaur Communications, Ltd. ("Centaur") and real estate joint ventures under the equity method. Results of real estate joint ventures are included in operating profit. As a result of the recapitalization in fiscal 1999 of Linguaphone Group plc ("Linguaphone"), Griffin's common equity ownership was reduced and Griffin now accounts for its investment in Linguaphone under the cost method of accounting for investments.
BUSINESS SEGMENTS
Griffin is engaged in the landscape nursery and real estate businesses. Imperial, Griffin's subsidiary in the landscape nursery segment, is engaged in growing plants which are sold principally to garden centers, wholesalers and merchandisers, and operating sales and service centers which sell principally to landscapers. Griffin's real estate segment, Griffin Land, builds and manages commercial and industrial properties and develops residential subdivisions on its land in Connecticut and Massachusetts.
FISCAL YEAR
Griffin's fiscal year ends on the Saturday nearest November 30. Fiscal years 1999, 1998, and 1997 each contained 52 weeks and ended November 27, 1999, November 28, 1998 and November 29, 1997, respectively.
INVENTORIES
Griffin's inventories are stated at the lower of cost (using the average cost method) or market. Nursery stock includes certain inventories which will not be sold or used within one year. It is industry practice to include such inventories in current assets.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost. Depreciation is determined on a straight-line basis over the estimated useful asset lives for financial reporting purposes and principally on accelerated methods for tax purposes.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) REAL ESTATE HELD FOR SALE OR LEASE
Real estate held for sale or lease is carried at depreciated cost, net of impairment write-downs, if any. Interest is capitalized during the construction period of major facilities. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the asset's useful life. Depreciation is determined on a straight-line basis over the estimated useful asset lives for financial reporting purposes and principally on accelerated methods for tax purposes.
REVENUE AND GAIN RECOGNITION
In the landscape nursery business, sales and the related cost of sales are recognized upon shipment of products. Sales returns are not material. In the real estate business, gains on real estate sales are recognized in accordance with SFAS No. 66, "Accounting for Sales of Real Estate", based upon the specific terms of the sale.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The amounts included in the financial statements for accounts receivable, accounts payable and accrued liabilities reflect their fair values because of the short-term maturity of these instruments. The fair values of Griffin's other financial instruments are discussed in Note 5.
STOCK OPTIONS
Griffin accounts for stock-based compensation under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees". The pro forma effect on earnings and earnings per share using the fair value method of accounting for stock-based compensation is disclosed in Note 7.
EARNINGS PER SHARE
In the 1998 first quarter, Griffin adopted SFAS No. 128, "Earnings Per Share". The new standard requires direct presentation of net income per common share and net income per common share assuming dilution on the face of the statement of operations.
Prior to July 3, 1997, Griffin was a wholly-owned subsidiary of Culbro. Accordingly, per share results for 1997 are presented on a pro forma basis.
RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform with the current year presentation.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the period reported. Actual results could differ from those estimates.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
2. INDUSTRY SEGMENT INFORMATION
Griffin's reportable segments are defined by their products and services, and are comprised of the landscape nursery and real estate segments (see Note 1). Griffin has no operations outside the United States. Griffin's export sales and transactions between segments are not material.
(A) RESULTS IN THE LANDSCAPE NURSERY SEGMENT IN 1997 INCLUDE A CHARGE OF $3.3 MILLION RELATING TO CERTAIN PLANT INVENTORIES. APPROXIMATELY 75% OF THE CHARGE RELATES TO FIELD-GROWN PLANT INVENTORIES IN WHICH IT WAS ESTIMATED AT THAT TIME THAT THE CARRYING COST WOULD NOT BE RECOVERED AS A RESULT OF HORTICULTURAL PROBLEMS AND MARKET CONDITIONS. AS OF NOVEMBER 27, 1999, IMPERIAL HAS SUBSTANTIALLY COMPLETED THE PHASEOUT OF ITS FIELD-GROWN PROGRAM. THE REMAINING PORTION OF THE CHARGE RELATES PRINCIPALLY TO CERTAIN CONTAINER GROWN PLANT INVENTORIES WHICH DID NOT MATURE PROPERLY.
See Note 9 for information on Griffin's equity investment in Centaur.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
3. RELATED PARTY TRANSACTIONS
Prior to the Distribution in 1997 (see Note 1), Griffin, as lessor, and General Cigar Co., Inc. ("General Cigar"), as lessee, entered into a lease for certain agricultural land in Connecticut and Massachusetts (the "Agricultural Lease"). At the time the Agricultural Lease was consummated, both Griffin and General Cigar were wholly-owned subsidiaries of Culbro. The Agricultural Lease is for approximately 500 acres of arable land held by Griffin for possible development in the long term, but which is being used by General Cigar for growing Connecticut Shade wrapper tobacco. General Cigar's use of the land is limited to the cultivation of cigar wrapper tobacco. The Agricultural Lease has an initial term of ten years and provides for the extension of the lease for additional periods thereafter. In addition, at Griffin's option, the Agricultural Lease may be terminated with respect to 100 acres of such land annually upon one year's prior notice. The annual rent payable by General Cigar under the Agricultural Lease is approximately equal to the annual aggregate amount of all taxes and other assessments payable by Griffin attributable to the land leased. In fiscal 1999 and fiscal 1998, General Cigar made rental payments of $108 and $80, respectively, to Griffin with respect to the Agricultural Lease.
Also prior to the Distribution in 1997, Griffin entered into a Services Agreement (the "Services Agreement") with Culbro. Pursuant to the Services Agreement, Culbro, and its successor GC Holdings, provided Griffin, for a period of one year after the Distribution, with certain administrative services, including internal audit, tax preparation, legal and transportation services. The Services Agreement was terminated with respect to all services provided by GC Holdings as of July 1998, except for certain transportation services, with respect to which the Services Agreement was amended and extended through June 1999. In fiscal 1999 and fiscal 1998, Griffin incurred expenses of $150 and $400, respectively, under the Services Agreement. As of November 27, 1999 and November 28, 1998 amounts due GC Holdings from Griffin with respect to the Services Agreement were $171 and $59, respectively.
In late 1997, subsequent to the Distribution, Griffin, as lessor, and General Cigar, as lessee, entered into a lease for approximately 40,000 square feet of office space in the Griffin Center South office complex in Bloomfield, Connecticut (the "Commercial Lease"). The Commercial Lease has an initial term of ten years and provides for the extension of the lease for additional annual periods thereafter. Griffin's rental revenue from the Commercial Lease in fiscal 1999 and fiscal 1998 was $464 and $437, respectively. Management believes the rent payable by General Cigar to Griffin under the Commercial Lease is at market rates.
4. INCOME TAXES
Griffin's income tax provisions and deferred tax assets and liabilities in the accompanying financial statements have been calculated in accordance with SFAS No. 109 "Accounting for Income Taxes". For all periods prior to the Distribution (see Note 1), Griffin's results of operations were included in Culbro's consolidated U.S. federal income tax returns, and all tax liabilities were paid by Culbro.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
4. INCOME TAXES (CONTINUED) Subsequent to the Distribution, Griffin has filed separate tax returns from its former parent company. The income tax provision (benefit) for fiscal 1999, fiscal 1998 and fiscal 1997 is summarized as follows:
The reasons for the difference between the United States statutory income tax rate and the effective rates are shown in the following table:
The significant components of Griffin's deferred tax asset-current and net deferred tax liability-long term are as follows:
As of November 27, 1999, Griffin has available for income tax purposes approximately $2.9 million in federal net operating loss carryforwards which may be used to offset future taxable income. These loss carryforwards begin to expire in fiscal year 2012.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
4. INCOME TAXES (CONTINUED) In connection with the Distribution, Culbro and Griffin entered into a Tax Sharing Agreement which provided, among other things, for the allocation between Culbro and Griffin of federal, state, local and foreign tax liabilities for all periods through the Distribution. With respect to the consolidated tax returns filed by Culbro, the Tax Sharing Agreement provides that Griffin will be liable for any amounts that it would have been required to pay with respect to deficiencies assessed, if any, generally as if it had filed separate tax returns.
5. LONG-TERM DEBT
Long-term debt includes:
The annual principal payment requirements under the terms of the mortgages for the years 2000 through 2004 are $112, $123, $136, $149 and $162, respectively.
On June 24, 1999, Griffin entered into a nonrecourse mortgage of $8.2 million on several of its buildings in the New England Tradeport. The mortgage has an interest rate of 8.54% and a ten year term, with payments based on a thirty year amortization schedule. Proceeds were used to reduce amounts then outstanding under the Imperial Nurseries, Inc., Credit Agreement (the "Imperial Credit Agreement") and to repay an existing mortgage on certain of those buildings. The existing mortgage had a balance of $1.9 million at the time of repayment and an interest rate of 8.63%. The book value of buildings under mortgage was $7.5 million at November 27, 1999.
On August 3, 1999, Griffin completed a new $20 million revolving Credit Agreement (the "Griffin Credit Agreement") to replace the $10 million Imperial Credit Agreement. The Griffin Credit Agreement is an unsecured facility with the same lender as the Imperial Credit Agreement and terminates in May 2001. Borrowings under the Griffin Credit Agreement may be, at Griffin's option, on an overnight basis or for periods of one, two, three or six months. Overnight borrowings bear interest at the lender's prime rate plus 1/4% per annum. Borrowings of one month and longer bear interest at the London Interbank Offerred Rate ("LIBOR") plus 1 3/4% per annum. There are no compensating balance agreements, and Griffin will pay a commitment fee of 1/4 of 1% per annum on unused borrowing capacity. Borrowings under the Griffin Credit Agreement will be used principally to finance working capital requirements at Griffin's landscape nursery and real estate businesses. The Griffin Credit Agreement includes financial covenants with respect to Griffin's debt service coverage (as defined), net worth, operating profit and capital expenditures. There were no borrowings under the Griffin Credit Agreement in 1999.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
5. LONG-TERM DEBT (CONTINUED) Management believes that the amounts reflected on the balance sheet for its mortgages reflect their current fair values based on market interest rates for comparable risks, maturities and collateral.
Future minimum lease payments under capital leases for transportation equipment and the present value of such payments as of November 27, 1999 were:
(A) INCLUDES CURRENT PORTION OF $208 AT NOVEMBER 27, 1999.
At November 27, 1999 and November 28, 1998, machinery and equipment included capital leases amounting to $476 and $493, respectively, which is net of accumulated amortization of $1,797 and $1,634, respectively, at November 27, 1999 and November 28, 1998. Amortization expense relating to capital leases in fiscal 1999, fiscal 1998 and fiscal 1997 was $250, $228, and $202, respectively.
6. RETIREMENT BENEFITS
SAVINGS PLAN
Griffin maintains the Griffin Land & Nurseries, Inc. 401(k) Savings Plan (the "Griffin Savings Plan") for its employees, a defined contribution plan whereby Griffin matches 60% of each employee's contribution, up to a maximum of 5% of base salary. Griffin's contributions to the Griffin Savings Plan and, prior to the Distribution, to the Culbro Corporation 401(k) Savings Plan (the "Culbro Savings Plan") in fiscal 1999, fiscal 1998 and fiscal 1997 were $236, $230 and $116, respectively. The matching percentage by Griffin of each employee's contribution is greater under the Griffin Savings Plan as compared to the Culbro Savings Plan.
DEFERRED COMPENSATION PLAN
In fiscal 1999, Griffin adopted a non-qualified deferred compensation plan (the "Deferred Compensation Plan") for selected employees who, due to Internal Revenue Service guidelines, cannot take full advantage of the Griffin Savings Plan. Contributions to the Deferred Compensation Plan started in fiscal 2000. Accordingly, there was no liability under the Deferred Compensation Plan at November 27, 1999. It is anticipated that the Deferred Compensation Plan will be unfunded, with benefits to be paid from Griffin's general assets.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
6. RETIREMENT BENEFITS (CONTINUED) POSTRETIREMENT BENEFITS
Griffin maintains a postretirement benefits program which provides principally health and life insurance benefits to certain of its retired employees. In accordance with the Distribution Agreement (see Note 1), the liabilities for Griffin employees who had retired prior to the Distribution and the liabilities for employees related to businesses no longer a part of Griffin were assumed in fiscal 1997 by GC Holdings. The liability for postretirement benefits for certain of Griffin's active employees at the time of the Distribution remains with Griffin and is included in other noncurrent liabilities on the consolidated balance sheet.
The components for Griffin's postretirement benefits expense is as follows:
Griffin's liability for postretirement benefits, as determined by the Plan's actuaries, is shown below. None of these liabilities were funded at November 27, 1999 and November 28, 1998.
Discount rates of 8.00% and 7.15% were used to compute the accumulated postretirement benefit obligations at November 27, 1999 and November 28, 1998, respectively. Because Griffin's obligation for retiree medical benefits is fixed, any increase in the medical cost trend would have no effect on the accumulated postretirement benefit obligation, service cost or interest cost.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
7. STOCKHOLDERS' EQUITY
PER SHARE RESULTS
Basic and diluted per share results were based on the information below. Per share results for 1997 are pro forma because Griffin was a wholly-owned subsidiary of Culbro during a portion of that year.
GRIFFIN STOCK OPTION PLAN
The Griffin Land & Nurseries, Inc., 1997 Stock Option Plan (the "Griffin Stock Option Plan"), adopted in 1997 and subsequently amended in 1999, makes available a total of 1,000,000 options to purchase shares of Griffin common stock. Options granted under the Griffin Stock Option Plan may be either incentive stock options or non-qualified stock options. Incentive stock options issued under the Griffin Stock Option Plan will satisfy certain Internal Revenue Code requirements applicable thereto. At the time of the Distribution (see Note 1), there were 438,202 Culbro stock options outstanding under various Culbro stock option plans and an employment agreement with an officer of Culbro. Upon completion of the Distribution in 1997, Culbro converted all employee stock options then outstanding under Culbro's stock option plans into options to purchase shares of common stock of Griffin, par value $0.01 per share, and options to purchase shares of common stock of Culbro. The number of outstanding options and exercise prices were adjusted to preserve the value of the Culbro options. A portion of the options outstanding under the Culbro plans were able to be exercised as incentive stock options, which under current tax laws will not provide any tax deductions to Griffin. All Culbro options held by Culbro employees who did not become employees of Griffin were vested as of the Distribution date. None of the options outstanding at November 27, 1999 may be exercised as stock appreciation rights.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
7. STOCKHOLDERS' EQUITY (CONTINUED) The Griffin Stock Option Plan is administered by the Compensation Committee of the Board of Directors of Griffin. A summary of the activity under the Griffin Stock Option Plan is as follows:
Options granted by Griffin in 1997, 1998 and 1999 vest in equal installments on the third, fourth and fifth anniversaries from the date of grant. At November 27, 1999, 140,607 options outstanding under the Griffin Stock Option Plan were vested with a weighted average price of $6.39 per share.
STOCK-BASED COMPENSATION
Griffin accounts for stock options under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and has adopted the disclosure provisions of SFAS No. 123 which require disclosing the pro forma effect on earnings and earnings per share of the fair value method of
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
7. STOCKHOLDERS' EQUITY (CONTINUED) accounting for stock-based compensation. Griffin's results would have been the following pro forma amounts under the method prescribed by SFAS No. 123.
The weighted average fair value of each option granted during fiscal 1999, fiscal 1998 and fiscal 1997 was $5.17, $5.57 and $6.10, respectively, estimated as of the date of grant using the Black-Scholes option-pricing model. The following weighted average assumptions were used in the model to calculate the fair value of each option: expected volatility of approximately 35% in all years; risk free interest rates in fiscal 1999, fiscal 1998 and fiscal 1997 of 4.91%, 5.45% and 6.15%, respectively; expected option term of 5 years; and no dividend yield for all options issued.
8. OPERATING LEASES
Future minimum rental payments for the next five years under noncancelable leases as of November 27, 1999 were:
Total rental expense for all operating leases in fiscal 1999, fiscal 1998 and fiscal 1997 was $518, $484 and $366, respectively.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
8. OPERATING LEASES (CONTINUED) As lessor, Griffin Land's real estate activities include the leasing of office and industrial space in Connecticut. Future minimum rentals to be received under noncancelable leases as of November 27, 1999 were:
Total rental revenue from all leases in fiscal 1999, fiscal 1998 and fiscal 1997 was $3,247, $2,287 and $1,851, respectively.
9. EQUITY INVESTMENTS
INVESTMENT IN CENTAUR
On August 4, 1998, Griffin purchased 500,000 shares of Centaur common stock from another stockholder of Centaur for approximately $2.9 million. Griffin's purchase was in connection with transactions whereby the stockholder who sold the Centaur common stock to Griffin also sold its remaining Centaur common stock to a third party, and Centaur purchased approximately 4.8 million shares of its common stock from certain of its other stockholders at the same per share price paid by Griffin. As a result of these transactions, Griffin now holds approximately 5.4 million shares of the 15.2 million shares of Centaur common stock outstanding after these transactions.
Substantially all of the book value of Griffin's investment in Centaur represents the excess of the cost of Griffin's investment over the book value of its equity in Centaur (representing the value of publishing rights and goodwill) and is being amortized on a straight-line basis over 30 to 40 years, which commenced in 1985.
Centaur reports on a June 30 fiscal year. The unaudited summarized financial data presented below was derived from Centaur's audited consolidated financial statements, adjusted to report on a fiscal year consistent with Griffin. Centaur's consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United Kingdom. Griffin's equity income reflects adjustments necessary to present Centaur's results in accordance with generally
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
9. EQUITY INVESTMENTS (CONTINUED) accepted accounting principles in the United States. Such adjustments include an expense in fiscal 1997 for stock option compensation of which Griffin's allocable share was $0.6 million.
REAL ESTATE JOINT VENTURES
Included in other assets at November 27, 1999, and November 28, 1998, is $3,110 and $3,128, respectively, for Griffin's 30% interest in a real estate joint venture that owns commercial properties in Connecticut. Results of this investment in fiscal 1999, fiscal 1998 and fiscal 1997 were $116, $106 and $27, respectively, and are included in operating profit.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
10. SUPPLEMENTAL FINANCIAL STATEMENT INFORMATION
INVENTORIES
Inventories consist of:
PROPERTY AND EQUIPMENT
Property and equipment consist of:
Total depreciation expense related to property and equipment in fiscal 1999, fiscal 1998 and fiscal 1997 was $1,323, $1,265 and $1,210, respectively.
REAL ESTATE HELD FOR SALE OR LEASE
Real estate held for sale or lease consists of:
Griffin capitalized interest in fiscal 1999 and fiscal 1998 of $103 and $111, respectively. There was no interest capitalized in fiscal 1997. Total depreciation expense related to real estate held for sale or lease in fiscal 1999, fiscal 1998 and fiscal 1997 was $869, $739 and $711, respectively.
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
10. SUPPLEMENTAL FINANCIAL STATEMENT INFORMATION (CONTINUED) ACCOUNTS PAYBLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of:
SUPPLEMENTAL CASH FLOW INFORMATION
Griffin incurred capital lease obligations in fiscal 1999, fiscal 1998 and fiscal 1997 of $239, $238 and $202, respectively.
In fiscal 1999 Griffin received a tax refund, net of income tax payments, of $654. In fiscal 1998 tax payments were $132. Interest payments, net of capitalized interest, were $626, $152 and $1,007 in fiscal 1999, fiscal 1998 and fiscal 1997, respectively, including interest payments of $730 in fiscal 1997 under Culbro's general corporate debt facilities that were transferred to GC Holdings pursuant to the Distribution Agreement (see Note 1). Prior to the Distribution in 1997, interest and tax payments were made by Culbro on behalf of Griffin. Griffin was included in Culbro's consolidated federal income tax returns through the Distribution (see Note 4). Accordingly, tax and interest payments made by Culbro through the Distribution are included in other financing activities on the consolidated statement of cash flows for fiscal 1997.
11. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Summarized quarterly financial data are presented below:
GRIFFIN LAND & NURSERIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
12. COMMITMENTS AND CONTINGENCIES
Imperial has entered into contract growing agreements with suppliers of field-grown plants. In accordance with these agreements, Imperial has agreed to purchase inventory as it becomes available with an aggregate purchase price of approximately $3.6 million over the next four years.
In 1999, Imperial entered into an agreement to purchase land for a new wholesale sales and service center. Completion of the land purchase is contingent upon receiving all required regulatory approvals to operate a sales and service center on that site. If such approval is received, expenditures for the land acquisition and required site work are expected to be approximately $2.5 million in fiscal 2000.
The Company is involved, as a defendant, in various litigation matters arising in the ordinary course of business. In the opinion of management, based on the advice of legal counsel, the ultimate liability, if any, with respect to these matters will not be material.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Stockholders and Directors of Griffin Land & Nurseries, Inc.
In our opinion, based on our audits and the report of other auditors, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Griffin Land & Nurseries, Inc. and its subsidiaries at November 27, 1999 and November 28, 1998, and the results of their operations and their cash flows for the fiscal years ended November 27, 1999, November 28, 1998 and November 29, 1997, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the management of Griffin Land & Nurseries, Inc.; our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the fiscal 1999 and fiscal 1998 financial statements of Centaur Communications, Ltd., an investment which is carried at equity in the consolidated financial statements (see Note 9) and represents approximately 15% and 15.4%, respectively, of consolidated assets. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Centaur Communications, Ltd. included in the consolidated financial statements for the years ended November 27, 1999, November 28, 1998 and November 29, 1997, is based on the report of the other auditors. We conducted our audits of these consolidated financial statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
February 9, 2000
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-30639) of Griffin Land & Nurseries, Inc. of our report dated February 9, 2000 which appears above in this Form 10-K of Griffin Land & Nurseries, Inc. for the fiscal year ended November 27, 1999. We also consent to the incorporation by reference of our report on the financial statement schedules, which appears in Exhibit 23.2 of this Form 10-K of Griffin Land & Nurseries, Inc. for the fiscal year ended November 27, 1999.
/s/ PricewaterhouseCoopers LLP
February 9, 2000
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE CORPORATION
The following table sets forth the information called for in this Item 10:
EDGAR M. CULLMAN has been the Chairman of the Board of Griffin since April 1997. He has been Chairman of the Board of General Cigar Holdings, Inc. ("GC Holdings"), since December 1996. From 1962 to 1996 he served as Chief Executive Officer of Culbro Corporation ("Culbro"). Mr. Cullman served as a Director of Culbro from 1961 until 1997 and has been Chairman of Culbro since 1975. He also is a Director of Centaur Communications, Ltd., and Bloomingdale Properties, Inc. ("Bloomingdale Properties"). Edgar M. Cullman is the uncle of John L. Ernst and the father-in-law of Frederick M. Danziger.
FREDERICK M. DANZIGER has been a Director and the President and Chief Executive Officer of Griffin since April 1997, and was a director of Culbro from 1975 until 1997. He was previously involved in the real estate operations of Griffin in the early 1980's. Mr. Danziger was Of Counsel to the law firm of Latham & Watkins from 1995 until 1997. From 1974 until 1995, Mr. Danziger was a Member of the law firm of Mudge Rose Guthrie Alexander & Ferdon. Mr. Danziger also is a director of Monro Muffler/Brake, Inc., Bloomingdale Properties, The Technology Group Inc., Centaur Communications, Ltd., and Linguaphone Group plc, and is a general partner of Ryan Instruments, L.P.
ANTHONY J. GALICI has been the Vice President, Chief Financial Officer and Secretary of Griffin since April 1997. Mr. Galici was Vice President-Assistant Controller of Culbro from 1995 until 1997. Prior to 1995, he was Assistant Controller of Culbro.
JOHN L. ERNST is a Director of Griffin and GC Holdings. He has been a Director of Griffin since April 1997 and a director of GC Holdings since December 1996. Mr. Ernst also was a Director of Culbro from 1983 until 1997. He is the Chairman of the Board and President of Bloomingdale Properties, an investment and real estate company. Mr. Ernst also is a director of the Doral Financial Corporation.
WINSTON J. CHURCHILL, JR. has been a Director of Griffin since April 1997. Mr. Churchill is also a member of the board of Cinemaster Luxury Theatres, Inc., Amkor Technology, Inc., and Freedom Securities. He is a managing general partner of SCP Private Equity Partners, L.P., a private equity fund sponsored by Safeguard Scientifics, Inc., and is Chairman of Churchill Investment Partners, Inc., and CIP Capital, Inc.
DAVID F. STEIN has been a Director of Griffin since November 1997. Mr. Stein is Vice Chairman of J&W Seligman & Co., Inc., an asset management firm, and a member of the board of Seligman Data Corp. He has been Vice Chairman since 1996. Mr. Stein was Managing Director of J&W Seligman & Co., Inc., from 1990 until 1996.
MARTHA COLLIER has been the Senior Vice President of Marketing and Leasing of the Griffin Land division of Griffin since 1997. From 1995 until 1997 she was a Vice President of Griffin Land and from 1989 until 1995 she was Controller of Griffin Land.
GREGORY M. SCHAAN has been the President and Chief Executive Officer of Imperial Nurseries, Inc. ("Imperial") since October 1999. From 1997 until 1999 he was Senior Vice President of Sales and Marketing of Imperial. From 1992 until 1997 he was Vice President of Sales and Marketing of Imperial.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth the annual and long-term compensation for Mr. Danziger, Griffin's President and Chief Executive Officer, and Mr. Galici, Griffin's Vice President, Chief Financial Officer and Secretary (the "Named Executive Officers"), as well as the total compensation paid by Griffin during 1999, 1998 and 1997 to the Named Executive Officers. Mr. Danziger and Mr. Galici were not employed by Griffin prior to 1997.
SUMMARY COMPENSATION TABLE
(1) Amounts shown under Other Annual Compensation include matching contributions made by Griffin under its Savings Plan and other miscellaneous cash benefits, but do not include funding for or receipt of retirement plan benefits. No Executive Officer who would otherwise have been includable in such table resigned or terminated employment during 1999.
(2) Includes $56,097 for reimbursement of relocation costs.
There were no stock options exercised by the Named Executive Officers in 1999. The following table presents the value of unexercised options held by the Named Executive Officers at November 27, 1999.
(1) The amounts presented herein have been calculated based upon the difference between the fair market value of $10.938 per share (the average of the high and low prices of Griffin's Common Stock on November 26, 1999) and the exercise price of each stock option.
COMPENSATION OF DIRECTORS
Members of the Board of Directors who are not employees of Griffin received $10,000 per year and $500 for each Board and Committee meeting attended in 1999. The 1997 Stock Option Plan, as amended, provides that non-employee Directors who are not members of the Cullman & Ernst Group receive annually options exercisable for 2,000 shares of Common Stock at an exercise price that is the market price at the time of grant. In 1999 Griffin granted Mr. Churchill and Mr. Stein each options exercisable for 2,000 shares of Common Stock, and expects to grant additional options to Messrs. Churchill and Stein in 2000 consistent with the 1997 Stock Option Plan, as amended.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires Griffin's officers and directors, and persons who own more than ten percent of its Common Stock, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Such persons are required by regulation to furnish Griffin with copies of all Section 16(a) forms they file. Based upon its involvement in the preparation of certain of such forms and a review of the copies of other such forms received by it, Griffin believes that with respect to 1999, all such Section 16(a) filing requirements were satisfied.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Messrs. Cullman, Danziger, and Ernst are members of the Board of Directors of Bloomingdale Properties, of which Mr. Ernst is Chairman and President and other members of the Cullman & Ernst Group are associated. Mr. Danziger also serves as trustee of the retirement plan for Bloomingdale Properties.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table lists the number of shares and options to purchase shares of Common Stock of Griffin beneficially owned or held by (i) each person known by Griffin to beneficially own more than 5% of the outstanding shares of Common Stock, (ii) the nominees for election as directors (who are all current directors), (iii) the Named Executive Officers (as defined in Item 11) and (iv) all directors and officers of Griffin, collectively. Unless otherwise indicated, information is provided as of November 27, 1999.
* Less than 1%
(1) Unless otherwise indicated, the address of each person named in the table is 641 Lexington Avenue, New York, New York 10022.
(2) This information reflects the definition of beneficial ownership adopted by the Securities and Exchange Commission (the "Commission"). Beneficial ownership reflects sole investment and voting power, except as reflected in footnote 3. Where more than one person shares investment and voting power in the same shares, such shares may be shown more than once. Such shares are reflected only once, however, in the total for all directors and officers. Includes options exercisable within 60 days granted to Directors pursuant to the 1997 Stock Option Plan. Excluded are shares held by charitable foundations and trusts of which members of the Cullman and Ernst families, including persons referred to in this footnote 2, are officers and directors. As of November 27, 1999, a group (the "Cullman and Ernst Group") consisting of Messrs. Cullman, direct members of their families and trusts for their benefit; Mr. Ernst, his sister and direct members of their families and trusts for their benefit; a partnership in which members of the Cullman and Ernst families hold substantial direct and indirect interests; and charitable foundations and trusts of which members of the Cullman and Ernst families are directors or trustees, owned an aggregate of approximately 2,327,295 shares of Common Stock (approximately 47.86% of the outstanding shares of Common Stock). Among others, Messrs. Cullman, Mr. Ernst and Mr. Danziger (who is a member of the Cullman & Ernst Group) hold investment and voting power or shared investment and voting power over such shares. Certain of such shares are pledged as security for loans payable under standard pledge arrangements. A form filed with the Commission on behalf of the Cullman & Ernst Group states that there is no formal agreement governing the group's holding and voting of such shares but that there is an informal understanding that the persons and entities included in the group will hold and vote together with shares owned by each of them in each case subject to any applicable fiduciary responsibilities. Louise B. Cullman is the wife of Edgar M. Cullman; Edgar M. Cullman, Jr. is the son of Edgar M. Cullman and Louise B. Cullman; Susan R.
Cullman and Lucy C. Danziger are the daughers of Edgar M. Cullman and Louise B. Cullman; and Lucy C. Danziger is the wife of Frederick M. Danziger.
(3) Included within the shares shown as beneficially owned by Edgar M. Cullman are 866,204 shares in which he holds shared investment and/or voting power; included within the shares shown as beneficially owned by Mr. Ernst are 411,321 shares in which he holds shared investment and/or voting power; and included within the shares shown as beneficially owned by Frederick M. Danziger are 209,778 shares in which he holds shared investment and/or voting power. Included within the shares shown as beneficially owned by Edgar M. Cullman, Jr. are 733,918 shares in which he holds shared investment and/or voting power; included with the shares owned by Louise B. Cullman are 743,765 shares in which she holds shared investment and/or voting power; included within the shares shown as beneficially owned by Susan R. Cullman are 670,842 shares in which she holds shared investment and/or voting power; and included within the shares shown as beneficially owned by Lucy C. Danziger are 962,150 shares in which she holds shared investment and/or voting power. Excluded in each case are shares held by charitable foundations and trusts in which such persons or their families or trusts for their benefit are officers and directors. Messrs. Cullman, Danziger and Ernst disclaim beneficial interest in all shares over which there is shared investment and/or voting power and in all excluded shares.
(4) The address of B. Bros. Realty Limited Partnership ("B. Bros.") is 641 Lexington Avenue, New York, New York 10022. Lucy C. Danziger and John L. Ernst are the general partners of B. Bros.
(5) The address of such person is Gabelli Funds, Inc., One Corporate Center, Rye, New York 10580. A form filed with the Securities and Exchange Commission in July 1997 by Gabelli Funds, Inc., as subsequently amended, indicates that the securities have been acquired by Gabelli Funds, Inc., and its wholly-owned subsidiaries on behalf of their investment advisory clients. Griffin has been informed that no individual client of Gabelli Funds, Inc., has ownership of more than 5% of Griffin's outstanding Common Stock.
(6) Excluding shares held by certain charitable foundations, the officers and/or directors of which include certain officers and directors of Griffin.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For the information of stockholders, attention is called to the following transactions between Griffin and other parties in which the persons mentioned below might have had a direct or indirect interest.
Messrs. Cullman, Danziger and Ernst are members of the Board of Directors of Bloomingdale Properties, of which Mr. Ernst is Chairman and President and other members of the Cullman & Ernst Group are associated. Real estate management and advisory services have been provided to Griffin by John Fletcher, an employee of Bloomingdale Properties, for which Mr. Fletcher receives compensation at a rate of approximately $50,000 per year.
Edgar M. Cullman, the Chairman of Griffin, is also the Chairman of GC Holdings, the successor to Culbro. In addition, certain members of the Cullman & Ernst Group who may be deemed to beneficially own more than five percent of Griffin's Common Stock (see Item 12) also may be deemed to beneficially own more than five percent of the Class B Common Stock of GC Holdings. Prior to the Distribution in 1997, Griffin, as lessor, and General Cigar Co., Inc. ("General Cigar"), a wholly-owned subsidiary of GC Holdings, as lessee, entered into a lease for certain agricultural land in Connecticut and Massachusetts (the "Agricultural Lease"). The Agricultural Lease is for approximately 500 acres of arable land held by Griffin for possible development in the long term, but which is being used by General Cigar for growing Connecticut Shade wrapper tobacco. General Cigar's use of the land is limited to the cultivation of cigar wrapper tobacco. The Agricultural Lease has an initial term of ten
years and provides for the extension of the lease for additional periods thereafter. In addition, at Griffin's option, the Agricultural Lease may be terminated with respect to 100 acres of such land annually upon one year's prior notice. In fiscal 1999 and fiscal 1998, General Cigar made rental payments of $108,000 and $80,000, respectively, to Griffin with respect to the Agricultural Lease.
Also prior to the Distribution in 1997, Griffin entered into a Services Agreement (the "Services Agreement") with Culbro. Pursuant to the Services Agreement, Culbro, and its successor GC Holdings, provided Griffin, for a period of one year after the Distribution, with certain administrative services, including internal audit, tax preparation, legal and transportation services. The Services Agreement was terminated with respect to all services provided by GC Holdings as of July 1998, except for certain transportation services, with respect to which the Services Agreement was amended and extended through June 1999. In fiscal 1999 and fiscal 1998, Griffin incurred expenses of $150,000 and $400,000, respectively, under the Services Agreement.
In late 1997, Griffin, as lessor, and General Cigar, as lessee, entered into a lease for approximately 40,000 square feet of office space in the Griffin Center South office complex in Bloomfield, Connecticut (the "Commercial Lease"). The Commercial Lease has an initital term of ten years and provides for the extension of the lease for additional annual periods thereafter. Griffin's rental revenue from the Commercial Lease in fiscal 1999 and fiscal 1998 was $464,000 and $437,000, respectively. Management believes the rent payable by General Cigar to Griffin under the Commercial Lease is at market rates.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements--see also Item 8
(2) Financial Statement Schedules and Financial Statements of Equity Investee.
The following financial statement schedules and financial statements of Griffin's equity investee should be read in conjunction with the financial statements in such 1999 Annual Report to Shareholders. Schedules not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
FINANCIAL STATEMENT SCHEDULES
(b) There were no reports on Form 8K filed by Griffin in the 1999 fourth quarter.
(c) Exhibits
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this annual report has been signed by the following persons on behalf of the Corporation and in the capacities indicated as of February 24, 2000.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (DOLLARS IN THOUSANDS)
Notes:
(1) Accounts receivable written off. (2) Inventories disposed.
S-1
Schedule III - Real Estate and Accumulated Depreciation (dollars in thousands)
(a) Properties are included in mortgage of $8,154 shown above.
S-2
SCHEDULE III-REAL ESTATE AND ACCUMULATED DEPRECIATION (CONTINUED) (DOLLARS IN THOUSANDS)
S-3
CENTAUR COMMUNICATIONS LIMITED
FINANCIAL STATEMENTS
FOR THE YEAR ENDED
JUNE 30, 1999
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of CENTAUR COMMUNICATIONS LIMITED Dear Sirs,
CENTAUR COMMUNICATIONS LIMITED ("THE COMPANY") AND ITS SUBSIDIARIES ("THE GROUP")
We have audited the accompanying consolidated balance sheet of Centaur Communications Limited and its subsidiaries as at June 30, 1999 and the related consolidated statements of operations, changes in shareholders' equity and cash flows for the year ended June 30, 1999.
RESPECTIVE RESPONSIBILITIES OF DIRECTORS AND AUDITORS
The company's directors are responsible for the preparation of the financial statements. It is our responsibility to form an independent opinion, based on our audit, on those financial statements and to report our opinion to you.
BASIS OF OPINION
We conducted our audit in accordance with auditing standards generally accepted in the United Kingdom and the United States.
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the financial statements.
OPINION
In our opinion the financial statements give a true and fair view of the state of affairs of the Group for the year ended June 30, 1999 and have been properly prepared in accordance with the Companies Act 1985.
United Kingdom accounting standards vary in certain important respects from accounting principles generally accepted in the United States. The application of the latter would have affected the determination of consolidated net profit for the year ended June 30, 1999 and the determination of consolidated shareholders' equity and consolidated financial position as at June 30, 1999 to the extent summarised in note 30 to the consolidated financial statements.
/s/ GRANT THORNTON - ------------------ GRANT THORNTON CHARTERED ACCOUNTANTS
LONDON 17 FEBRUARY 1999 (EXCEPT FOR NOTES 30 AND 31 AS TO WHICH DATE IS 10 FEBRUARY 1999)
PRINCIPAL ACCOUNTING POLICIES
BASIS OF PREPARATION
The financial statements have been prepared in accordance with applicable accounting standards and under the historical cost convention. The principal accounting policies are described below. The policies have remained unchanged from the previous year, apart from those relating to intangible assets and subscription income (see note 3).
BASIS OF CONSOLIDATION
The group financial statements consolidate those of the company and of its subsidiary undertakings (see note 12) drawn up to 30 June 1999. Profits or losses on intra-group transactions are eliminated in full. On acquisition of a subsidiary, all of the subsidiary's assets and liabilities which exist at the date of acquisition are recorded at their fair values reflecting their condition at that date, and the results of the subsidiary acquired are included from the date of acquisition.
As a matter of accounting policy, goodwill arising on consolidation first accounted for in accounting periods before 23 December 1998, the implementation date of Financial Reporting Standard No.10 (FRS10) "Goodwill and Intangible Assets", was written off to goodwill reserves immediately on acquisition. Such goodwill will be charged to the profit and loss account on the subsequent disposal of the business to which it relates. The goodwill reserve has been transferred into the profit and loss reserve by way of a prior year adjustment in accordance with FRS10 (see note 20).
INVESTMENTS
Investments are included at cost less amounts written off.
INTANGIBLE ASSETS AND GOODWILL
Intangible assets comprise magazine publishing rights, computer databases, customer lists, brand names and other intangible assets and are stated at cost. When such assets are acquired through the acquisition of businesses they are stated at fair value at acquisition which normally represents the excess of purchase price over net tangible assets of the business acquired and are therefore similar in nature to goodwill.
Intangible fixed assets are amortised through the company's profit and loss account over a maximum of 20 years, in accordance with FRS10. In prior years, the intangible assets were capitalised and reviewed annually for permanent impairment in value.
TURNOVER
Turnover represents sales of publications, subscriptions, advertising space and other revenue, exclusive of value added tax.
PRINCIPAL ACCOUNTING POLICIES
SUBSCRIPTION INCOME
The policy for recognition of subscription income has been reviewed by the directors during the year. A revised policy has been adopted in order to present a more accurate reflection of the provision of services to customers and a more appropriate matching of income and costs associated with subscriptions. Costs are expensed as incurred and a proportion of income, appropriate to the relevant product, is taken to profit and loss account on receipt. The balance is deferred and amortised over the period of the subscription.
In previous years, magazine income was deferred and amortised over the period of the subscription, except that for controlled circulation titles, where subscription income is incidental, the income was taken to profit on receipt.
NEW PRODUCT DEVELOPMENT
BUSINESS INFORMATION PUBLISHING
The trading results of new products which are in the course of development often include substantial launch and other promotional expenditure. These costs are written off in the profit and loss account in the period in which they are incurred. The results of new products in the course of development are shown separately in the profit and loss account until such time as they become established. A product is regarded as established after the commencement of trading at a profit.
DEPRECIATION
Depreciation of tangible assets is provided on a straight line basis at the following annual rates, based on the estimated useful lives of the assets:
Leasehold improvements - 5% or the length of the lease if shorter Fixtures and fittings - 10% Computer equipment - 20% Motor vehicles - 25%
DEFERRED TAXATION
Deferred taxation is provided on timing differences using the liability method, except where it can be demonstrated with reasonable probability that the timing differences will not reverse in the foreseeable future. Timing differences arise on items of income and expenditure which are recognised for tax purposes in different periods from those in which they are recognised in the profit and loss account.
STOCK AND WORK-IN-PROGRESS
Stocks are stated at the lower of cost and net realisable value after making provisions for any obsolete or slow moving items. The work-in-progress consists of cost relating to publications, exhibitions and conferences, the income of which has yet to be dealt with in the profit and loss account.
OPERATING LEASES
Rentals payable under operating leases are charged to the profit and loss account over the term of the lease.
PRINCIPAL ACCOUNTING POLICIES
CONTRIBUTION TO PENSION FUND
DEFINED CONTRIBUTION SCHEME
The pension costs charged against profits represent the amount of the contributions payable to the scheme in respect of the accounting period.
CONSOLIDATED PROFIT AND LOSS ACCOUNT
For the year ended JUNE 30, 1999
- ------------ The accompanying accounting policies and notes form an integral part of these financial statements.
CONSOLIDATED BALANCE SHEET AT JUNE 30, 1999
The financial statements were approved by the Board of Directors on 10 February 2000.
G T D Wilmot - Director
- ------------ The accompanying accounting policies and notes form an integral part of these financial statements.
COMPANY BALANCE SHEET AT JUNE 30, 1999
The financial statements were approved by the Board of Directors on 10 February 2000.
G.T.D. Wilmot Director - ------------ The accompanying accounting policies and notes form an integral part of these financial statements.
CONSOLIDATED CASH FLOW STATEMENT For the year ended JUNE 30, 1999
- ------------ The accompanying accounting policies and notes form an integral part of these financial statements.
OTHER PRIMARY STATEMENTS For the year ended JUNE 30, 1999
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
1. SEGMENTAL REPORTING
ANALYSIS BY BUSINESS SEGMENT
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
SEGMENTAL REPORTING (CONTINUED)
ANALYSIS BY GEOGRAPHICAL SEGMENT
Substantially all the operations are within the United Kingdom.
The net assets are all located in the United Kingdom.
2. PROFIT ON ORDINARY ACTIVITIES BEFORE TAXATION
The profit on ordinary activities before taxation is stated after charging/(crediting):
3. PRIOR YEAR ADJUSTMENTS
(i) Intangible fixed assets
Intangible fixed assets are amortised through the profit and loss account over a maximum period of 20 years, following adoption of FRS No. 10. The comparative figures have been adjusted to reflect the effect on prior years of this policy. In prior years intangible assets were capitalised and reviewed annually for permanent impairment in value.
The effect of the adoption of FRS 10 is to reduce the reported profit for the year to 30 June 1999 by L470,000, for the year to 30 June 1998 by L308,000 and the brought forward reserves at 1 July 1997 by L2,302,000.
(ii) Subscription Income
The policy for recognition of subscription income has been reviewed by the directors during the year. A revised policy has been adopted in order to present a more accurate reflection of the provision of services to customers and a more appropriate matching of income and costs associated with subscriptions. Costs are expensed as incurred and a proportion of income, appropriate to the relevant product, is taken to profit and loss account on receipt. The balance is deferred and amortised over the period of the subscription.
The effect of this change in accounting policy is to increase reported profit for the year to 30 June 1999 by L11,000, the year ended 30 June 1998 is decreased by L10,000 and the brought forward reserves at 1 July 1997 have been increased by L254,000 after taxation.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
4. STAFF COSTS AND NUMBER
Staff costs, including directors emoluments, were as follows:
The average number of persons employed by the group, including the directors, was as follows:
5. DIRECTORS' EMOLUMENTS
Remuneration in respect of directors was as follows:
During the year 3 directors (1998: 2 directors) participated in money purchase pension schemes.
Options have been granted to certain directors to subscribe for ordinary shares of 10p each in Centaur Communications Limited. Full details of the outstanding options are disclosed in the directors' report.
The amounts set out above include remuneration in respect of the highest paid director as follows:
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
6. INTEREST RECEIVABLE AND SIMILAR INCOME
7. INTEREST PAYABLE AND SIMILAR CHARGES
8. TAXATION
The charge for taxation comprises:
The effective rates of taxation are affected by the non allowance of amortisation. The 1998 effective rate is further affected by the non allowance of the demerger and other capital expenses.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
9. INTANGIBLE ASSETS
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
10. TANGIBLE ASSETS
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
11. INVESTMENTS
In the opinion of the directors the value of the group's and the company's investments is not less than the amount at which they are stated in the balance sheet. The movement in trade investments represents an addition at cost.
12. INVESTMENTS IN SUBSIDIARY UNDERTAKINGS
On 3 September 1997 the members ratified a de-merger of the Linguaphone group of companies. This transaction was effected by a dividend in specie of L17,304,000 with the existing members receiving two shares in Linguaphone Group Plc for every share held in Centaur Communications Limited.
The 1998 consolidated profit and loss account includes the results of the Linguaphone group for the period ended 3 September 1997. The results are shown in note 1.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
INVESTMENTS IN SUBSIDIARY UNDERTAKINGS (CONTINUED)
PRINCIPAL SUBSIDIARY UNDERTAKINGS AT 30 JUNE 1999
13. STOCKS
There is no significant difference between the replacement cost of the stock and its balance sheet value.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
14. DEBTORS
15. CREDITORS: AMOUNTS FALLING DUE WITHIN ONE YEAR
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
16. CREDITORS: AMOUNTS FALLING DUE AFTER MORE THAN ONE YEAR
The Term Loan was granted on 4 August 1998 and is guaranteed by the company's subsidiaries, Chiron Communications Limited, Ascent Publishing Limited, Hali Publications Limited and Your Business Magazine Limited. It is repayable in quarterly installments commencing 30 September 1999 and ending 30 June 2005. The interest rate is calculated by reference to formula and approximated to 7.1% per annum in 1999.
The Revolving Credit Facility was granted on 4 August 1998 and is guaranteed by the company's subsidiaries, Chiron Communications Limited, Ascent Publishing Limited, Hali Publications Limited and Your Business Magazine. The maximum facility allowed is L17,000,000 reducing quarterly from 30 September 1999 to zero at 30 June 2005. The interest rate is calculated by reference to formula and approximated to 6.9% per annum in 1999.
17. BORROWINGS
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
18. PROVISIONS FOR LIABILITIES AND CHARGES
The provision for deferred tax comprises the following amounts:
Unprovided deferred tax in respect of accelerated capital allowances for the group and the company is Lnil (1998: Lnil).
Unprovided deferred tax in respect of other timing differences for the group and the company is L357,000 (1998: L357,000).
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
19. SHARE CAPITAL AND SHARE PREMIUM AND CAPITAL REDEMPTION RESERVES
ALLOTMENTS DURING THE YEAR
On 3 August 1998 certain employees exercised their options to subscribe for 54,949 ordinary shares of 10p each at a price of L1 per share and 14,000 ordinary shares of 10p each at a price of L2.75 per share.
On 4 August 1998 the company purchased 4,828,004 of its own ordinary shares of 10p each at a price of L3.60 per share.
As at 30 June 1999 options have been granted and agreed to be granted to certain directors and employees to subscribe for a total of 1,902,396 ordinary shares of 10p each at varying times and prices up to August 2006. The directors' options are disclosed in the directors' report.
20. PROFIT AND LOSS ACCOUNTS
The company has taken advantage of section 230 of the Companies Act 1985 and has not included its own profit and loss account in these financial statements. The group profit for the year includes L207,000 (1998: L28,198,000) which is dealt with in the financial statements of the company.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
21. CAPITAL COMMITMENTS
The capital commitments at the year end were as follows:
22. ACQUISITIONS
(i) Engineering Portfolio
On 31 March 1999 the company acquired publishing rights and assets and liabilities from United News and Media Group Limited of its Engineering Portfolio for a consideration of L9,961,000 in cash. Goodwill arising on the acquisition has been capitalised and is being amortised over its estimated useful economic life of 20 years. The purchase of the Engineering Portfolio has been accounted for by the acquisition method of accounting.
The assets and liabilities of the Engineering Portfolio acquired were as follows:
Fair value adjustments were made for:
(i) Bringing subscription income into line with group accounting policy. (ii) Liability due to onerous contract.
Information in relation to periods prior to acquisition is not available in the form required by FRS 6. The results and cash flows arising from the assets acquired since acquisition are not considered to be material.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
ACQUISITIONS (CONTINUED)
(ii) CONSULTANCY EUROPE ASSOCIATES LIMITED
On 16 October 1998, the company acquired 100% of the shares in Consultancy Europe Associates Limited for consideration of L60,000 in cash. Goodwill arising on acquisition, amounting to L31,000, has been capitalised. The purchase of Consultancy Europe Associates Limited has been accounted for by the acquisition method of accounting.
(iii) PERFECT INFORMATION
On 3 August 1998, the company acquired an additional 3,750,000 ordinary 1p shares in Perfect Information Limited being 12.28% of its nominal share capital for a consideration of L3,832,000. Goodwill arising on the acquisition of these shares, amounting to L82,000, has been capitalised. The purchase of Perfect Information Limited has been accounted for by the acquisition method of accounting.
The consideration was satisfied by offsetting the intercompany loan of L3,750,000 and by a cash payment of L82,000.
23. OPERATING LEASE COMMITMENTS
The operating lease rentals which are payable within one year of the balance sheet date are as follows:
24. PENSION SCHEMES
The group contributes to individual and collective money purchase pension schemes in respect of directors and employees once they have completed the requisite period of service. The charge for the year in respect of these pension schemes is shown in note 4.
25. CONTINGENT LIABILITIES
GUARANTEES
The company has joined with its subsidiaries in granting a cross guarantee in favour of its bankers. The guarantee is secured by fixed and floating charges over the company's assets.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
26. RECONCILIATION OF OPERATING PROFIT TO NET CASH INFLOW FROM OPERATING ACTIVITIES
27. ANALYSIS OF CASH FLOWS FOR HEADINGS NETTED IN THE CASH FLOW STATEMENT
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
28. ANALYSIS OF NET FUNDS
29. RECONCILIATION OF NET CASH FLOW TO MOVEMENTS IN NET DEBT
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
30. RECONCILIATION TO US GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP)
The accompanying financial statements have been prepared in accordance with UK GAAP, which differs in certain material respect from US GAAP. Such differences involve methods for measuring the amounts shown in the financial statements, as well as additional disclosures required by US GAAP.
The effect on the company's retained (loss)/profit and shareholders' equity of applying the significant differences between UK GAAP and US GAAP is summarised in the reconciliation statements set out below:
Diluted earnings per share include the dilutive effects of share options. The incremental dilutive effect of share options was 1,363,000 and 1,108,000 for the years ended June 30, 1999 and 1998 respectively.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
30. RECONCILIATION TO US GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP) (CONTINUED)
(1) In compliance with UK GAAP intangible assets, representing publishing rights, are now being amortised over a maximum period of 20 years, following the adoption of FRS 10. The comparative figures have been adjusted to reflect the effect on prior years of this policy. In prior years intangible assets were capitalised and reviewed annually for permanent impairment in value. In accordance with US GAAP these assets are amortised over the estimated economic life of the asset. These assets are being amortised over 30 years.
(2) The Linguaphone Group of companies was de-merged from Centaur Communications Limited on September 3, 1998. This resulted in a distribution in specie of shares in Linguaphone Group Plc being allocated to the existing shareholders of Centaur Communications Limited.
In compliance with UK GAAP, the group has reflected this dividend in the profit and loss account. Under US GAAP this dividend is reflected through shareholders' equity.
(3) In compliance with UK GAAP, the group had previously written off certain goodwill to shareholders' equity. Under US GAAP, the goodwill was reinstated and is being amortised over 30 years.
(4) In compliance with UK GAAP, the deferred tax effects of timing differences existing at the balance sheet date are calculated under the liability method (using tax rates likely to apply in the future when the timing differences will reverse). However, the company is not required to record the full liability, and may elect to utilise the partial provision approach. Under the partial provision approach, the amount of deferred tax to be provided is the liability that is expected to arise in the future based on a projection of the extent to which the cumulative timing differences existing at the balance sheet date are expected to reverse. Under US GAAP deferred taxes are provided for on a full liability basis. Under the full liability method, deferred tax assets and liabilities are recognised between the financial and tax bases of assets and liabilities and for tax loss carry forwards at the statutory rate of each reporting date.
A valuation allowance is established when it is more likely than not that some portion or all of the deferred tax assets will not be realised.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
RECONCILIATION TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP) (CONTINUED)
There is a deferred tax liability of L357,000 relating to the settlement of intra group indebtedness and the interest thereon. For US GAAP purposes this amount could be shown as a deferred liability if expected to crystallise in future periods. As it is not expected to crystallise, a valuation allowance has been set up to offset this amount.
A subsidiary company of Centaur Communications Limited, Perfect Information Limited, has incurred significant losses which, up to April 1998, under UK tax law are carried forward indefinitely to be offset against taxable profits arising in the same trade. The company has not made a profit in the recent past and it is not anticipated that these losses will be utilised in the foreseeable future. As such a deferred tax asset has not been introduced to the balance sheet.
Losses incurred since April 1998 are available for offset against profits arising in other subsidiary companies of Centaur Communications Limited.
(5) In compliance with UK GAAP, remuneration expense relating to share options is not allowable for corporate tax purposes, thus has not been reflected in the profit and loss account. In compliance with US GAAP, the compensatory expense related to the stock options is recognised as an expense in the period when granted in accordance with SFAS 123.
(6) The group has changed its accounting policy in respect of recognition of subscription income as explained in note 3. The financial effect of this change is erradicated in accordance with US GAAP. Subscription income is deferred and amortised over the period of the subscription in accordance with US GAAP.
(7) CASH FLOW INFORMATION
In compliance with UK GAAP, the Cash Flow Statement is presented in accordance with UK Financial Reporting Standard No. 1, as revised (FRS1). The Statement prepared under FRS1 presents substantially the same information as that required under US GAAP as interpreted by SFAS No. 95. In compliance with UK GAAP, cash comprises cash in hand and at bank (including overnight deposits), net of bank overdrafts. In compliance with US GAAP, cash and cash equivalents include cash and short-term investments with original maturities of three months or less.
In compliance with UK GAAP, cash flows are presented for operating activities; returns on investments and servicing of finance; taxation; capital expenditure; acquisitions and disposals; equity dividends paid; management of liquid resources and financing. US GAAP requires the classification of cash flows as resulting from operating, investing and financing activities.
Cash flows in accordance with US GAAP in respect of interest received, interest paid, investment income and taxation would be included within operating activities. Capital expenditure and financial investment and cash flows from disposals would be included within investing activities under US GAAP. Dividends paid by subsidiary undertakings, minority interests, equity dividends paid, management of liquid resources and returns on investments and servicing of finance would be included within financing activities under US GAAP.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
RECONCILIATION TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP) (CONTINUED)
A summary of the Company's operating, investing and financing activities classified in accordance with US GAAP, is presented below. For purposes of this summary, cash and cash equivalents consist of cash at bank and in hand.
(8) SHARE BUY-IN
In accordance with UK GAAP, a capital redemption equivalent to the nominal value of the shares bought in is established. Under US GAAP such a reserve would not be established, total shareholders equity would not be affected however.
31. ADDITIONAL DISCLOSURE RELATING TO US GAAP
(i) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
Centaur Communications Limited is a holding company which also provides management services to the group. The principal activity of the group is the creation and dissemination of business and professional information through publications, the internet and on-line.
MANAGEMENT ESTIMATES
In preparing the summary of differences between UK and US GAAP, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of cash and cash equivalents, trade debtors, trade creditors are approximately equivalent to their carrying values due to the short maturity of these assets and liabilities.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
RECONCILIATION TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP) (CONTINUED)
(ii) RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998 the Financial Accounting Standards Board issued Statement No. 130 "Reporting Comprehensive Insurance" ("SFAS 130"). SFAS 130 is effective for fiscal years beginning after December 15, 1998. The company has considered the effects of this statement and does not believe it has any comprehensive income as defined by this statement.
In May 1998 the Financial Accounting Standards Board issued Statement No. 131 "Disclosure about Segments of an Enterprise and Related Information" ("SFAS 131"), SFAS 131 is effective for fiscal years beginning after December 15, 1998. The company believes that the effect of adoption of SFAS 131 will not be material.
In June 1999, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). The new standard required companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives will be reported in the statement of operations or as a deferred item, depending on the use of derivatives and whether they qualify for hedge accounting. The key criterion for hedge accounting is that the derivative must be highly effective in achieving offsetting changes in fair value or cash flows of the hedged items during the term of the hedge. The company has not yet determined the impact, if any, that the adoption of SFAS 133 will have on the consolidated financial statements.
(iii) STOCK COMPENSATION PLAN
At June 30, 1999 the Group had a Stock Option Plan for all employees. All share options vest over a maximum ten year period. The fair value of each option grant is estimated on the grant date using the minimum value pricing model with the following weighted-average assumptions used for grants in fiscal year 1999; risk free interest rate 6.5%; and expected life 7 years.
Option pricing models require the input of highly subjective assumptions. Also, the Company's employee stock options have characteristics significantly different from those of traded options including long-vesting schedules, and changes in the subjective input assumptions can materially affect the fair value estimate. Management believe the best input assumptions available were used to value the options and the resulting option values are reasonable.
NOTES TO THE FINANCIAL STATEMENTS For the year ended JUNE 30, 1999
RECONCILIATION TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP) (CONTINUED)
(iii) STOCK COMPENSATION PLAN (CONTINUED)
A summary of the status of the Group's stock option plan at June 30, 1999, and changes during the year is presented below:
The following table summarises information concerning options outstanding at June 30, 1999 | 18,147 | 117,922 |
872821_1999.txt | 872821_1999 | 1999 | 872821 | ITEM 1 - BUSINESS
General -------
Wilmington Trust Corporation, a Delaware corporation ("Wilmington Trust"), owns Wilmington Trust Company, a Delaware-chartered bank and trust company and Wilmington Trust's principal subsidiary ("WTC"). WTC was formed in 1903 and is the largest full-service bank in Delaware, with 48 branch offices at January 31, 2000. Wilmington Trust also owns two other financial institutions, Wilmington Trust of Pennsylvania, a Pennsylvania-chartered bank and trust company with seven branches ("WTPA"), and Wilmington Trust FSB, a Federally-chartered savings bank with six branches in Maryland and Florida and trust agency offices in New York, California, Maryland, and Nevada ("WTFSB"). (WTC, WTPA, and WTFSB sometimes are referred to herein as the "Banks"). Wilmington Trust also owns WT Investments, Inc., an investment holding company with interests in three asset management firms ("WTI").
Wilmington Trust's principal place of business is Rodney Square North, 1100 North Market Street, Wilmington, Delaware 19890. Its telephone number is (302) 651-1000. Its principal role is to supervise and coordinate the Banks' and WTI's activities and provide them with capital and services. Virtually all of Wilmington Trust's income historically has been from dividends from WTC. Wilmington Trust's current staff principally consists of its management, who are executive officers generally serving in similar capacities for WTC. Wilmington Trust utilizes WTC's support staff.
As of December 31, 1999, Wilmington Trust had total assets of $7.2 billion and total shareholders' equity of $498.2 million. On that date, 32,352,775 shares of Wilmington Trust's common stock were issued and outstanding, which were held by 9,617 shareholders of record. Wilmington Trust's total loans outstanding were approximately $4.8 billion on that date.
Private Client Advisory Services --------------------------------
Wilmington Trust is a major provider of trust and administrative services in a wide variety of capital market transactions, many of which utilize the benefits of Delaware's favorable tax and legal environment. Wilmington Trust has long been recognized as a global leader in leveraged leasing transactions for large capital equipment such as aircraft, vessels, and satellites, as well as projects such as power generating facilities, sports arenas, entertainment complexes, and corporate buildings. For decades, Wilmington Trust has provided trust and administrative services in asset securitization and structured financing transactions that permit companies seeking to move cash flow assets (such as mortgages, loans, royalty streams, and movie rights) off their balance sheets into special purpose entities. In addition, Wilmington Trust serves as trustee in high-yield debt/Rule 144A transactions, and provides restructuring services in workout situations. Wilmington Trust also services a variety of special purpose entities such as passive investment companies, business trusts, limited liability companies, and limited partnerships. These afford the opportunity to cross-sell Wilmington Trust's custody and asset management services. Wilmington Trust's Nevada office also provides these corporate trust services. In addition, Wilmington Trust provides trust and custody services for a variety of tax-qualified retirement plans and executive compensation arrangements.
Asset Management ----------------
Wilmington Trust provides institutional investment advisory services for clients across the country, including tax-qualified defined benefit and defined contribution plans, endowment and foundation funds, and taxable and tax-exempt cash portfolios. It also offers the proprietary family of The Wilmington Funds, which are mutual funds consisting of money market, bond, and small-cap and large-cap equity portfolios.
In January 1998, WTI acquired a 24% interest in Cramer Rosenthal McGlynn, LLC, an asset management firm with $4.5 billion under management and a value orientation. Cramer's capabilities also include special equity, limited partnerships, and high-yield investments. WTI has since increased its interest in that firm to 34%. In July 1998, WTI acquired an interest in California-based Roxbury Capital Management, LLC, an asset management firm with a growth orientation and $6 billion under management.
Through its personal investment centers, Wilmington Trust offers investment services throughout the Banks' branches.
As of December 31, 1999, Wilmington Trust in the aggregate had assets of $135 billion under trust, custody, and administration. Of that total, Wilmington Trust manages approximately $26 billion in discretionary assets and $109 billion in non-discretionary assets. Personal trust assets totaled $29 billion.
Lending Activities ------------------
The Banks historically have concentrated the lending activities described below in Delaware, Pennsylvania, Maryland, and Florida. The Banks generally receive fees for originating loans and for taking applications and committing to originate loans. In addition, they receive fees for issuing letters of credit, as well as late charges and other fees in connection with their lending activities.
Residential Mortgage Loans --------------------------
The Banks directly originate or purchase residential first mortgage loans. A third-party servicer generally services residential mortgage loans that are not resold.
The Banks maintain excellent relationships with correspondent lenders in their market areas from which they purchase residential mortgage loans. The Banks also foster public awareness of their residential mortgage loan products through television and newspaper advertising and direct mail. The Banks offer both fixed and adjustable interest rates on residential mortgage loans, with terms ranging up to 30 years.
Commercial Loans ----------------
The Banks also originate loans secured by mortgages on commercial real estate and multi-family residential real estate. The Banks seek to minimize risks of this lending in a number of ways, including:
o Limiting the size of their individual commercial and multi-family real estate loans; o Monitoring the aggregate size of their commercial and multi-family housing loan portfolios; o Generally requiring equity in the property securing the loan equal to a certain percentage of the appraised value or selling price; o Requiring in most instances that the financed project generates cash flow adequate to meet required debt service payments; and o Requiring that the Banks have recourse to the borrower and guarantees from the borrower's principals in most instances.
The Banks also make other types of commercial loans to businesses located in their market areas. The Banks offer lines of credit, term loans, and demand loans to finance working capital, accounts receivable, inventory and equipment purchases. Typically, these loans have terms of up to seven years, and bear interest either at fixed rates or at rates fluctuating with a designated interest rate. These loans frequently are secured by the borrower's assets. In many cases, they also are collateralized by guarantees of the borrower's owners and their principal officers.
Construction Loans ------------------
The Banks make loans and participate in financing to construct residences and commercial buildings. The Banks also originate loans for the purchase of unimproved property for residential and commercial purposes. In these cases, the Banks frequently provide the construction funds to improve the properties.
The Banks' residential and commercial construction loans generally have terms of up to 36 months, and interest rates that adjust from time to time in accordance with changes in a designated interest rate. The Banks disburse loan proceeds in increments as construction progresses and inspections warrant. The Banks finance the construction of individual, owner-occupied houses only if qualified professional contractors are involved and only on the basis of the Banks' underwriting and construction loan management guidelines. The Banks may underwrite and structure construction loans to convert to permanent loans at the end of the construction period. Analyzing prospective construction loan projects requires greater expertise than that required for residential mortgage lending on completed structures. Residential and commercial construction loans afford the Banks the opportunity to increase the interest rate sensitivity of their loan portfolios and receive yields higher than those obtainable on permanent residential mortgage loans.
Loans to Individuals --------------------
The Banks offer both secured and unsecured personal lines of credit, installment loans, home improvement loans, direct and indirect automobile loans, and credit card facilities. The Banks develop public awareness of their consumer loan products primarily through television and newspaper advertising and direct mail. Consumer loans generally have shorter terms and higher interest rates than residential first mortgage loans. Through their consumer lending, the Banks
attempt to enhance the spread between their average loan yields and their cost of funds, and their matching of assets and liabilities expected to mature or reprice in the same periods.
Underwriting Standards ----------------------
In determining whether to originate or purchase a residential mortgage loan, the Banks assess both the borrower's ability to repay the loan and the adequacy of the proposed information concerning the applicant's income, financial condition, employment, and credit history. The Banks require title insurance insuring the priority of their liens on most loans secured by first mortgages on real estate, as well as fire and extended coverage casualty insurance protecting the mortgaged properties. Loans are approved by various levels of management depending on the amount of the loan.
The Banks' underwriting standards relating to commercial real estate and multi-family residential loans are designed to ensure that the property securing the loan will generate sufficient cash flow to cover operating expenses and debt service. The Banks review the property's operating history and projections, comparable properties, and the borrower's financial condition and reputation. The Banks' general underwriting standards with respect to these loans include:
o Inspecting each property before issuing a loan commitment and before each disbursement; o Requiring an appraisal of the property; o Requiring recourse to the borrower; and o Requiring the personal guaranty of the borrower's principal(s).
The Banks monitor the performance of their construction loans by inspecting the property securing each loan regularly.
The Banks limit real estate secured commercial loans to individuals and organizations with a demonstrated capacity to generate cash flow sufficient to repay indebtedness under varied economic conditions. The borrower's cash flow is a critical component of the underwriting process for these loans. The Banks engage several experienced appraisers in connection with these loans.
The Banks require first or junior mortgages to secure home equity loans. Although this security influences the Banks' underwriting decisions, their primary focus in underwriting these loans, as well as their other loans to individuals, is on the applicant's financial ability to repay. In the underwriting process, the Banks obtain credit bureau reports and verify the borrower's employment and credit information. On home equity loans above a certain level, the Banks require an appraisal of the property securing the loan and, in certain instances, title insurance insuring the priority of their liens.
Deposit Activities ------------------
Deposit accounts are the primary source of the Banks' funds for use in lending and investment activities and general business purposes. The Banks also obtain funds from borrowings, the amortization and repayment of outstanding loans, earnings, and maturities of investment securities, among other sources.
The Banks' deposit accounts include demand checking accounts, term certificates of deposit, money market deposit accounts, NOW accounts, and regular savings and club accounts. The Banks also offer retirement plan accounts (including individual retirement accounts, Keogh accounts, and simplified employee pension plans) for investment in the Banks' various deposit accounts. The Banks attract consumer deposits principally from their primary market areas.
Other Activities ----------------
Interest and dividends on investments provide the Banks with a significant source of revenue. At December 31, 1999, the Banks' investment securities, including securities purchased under agreements to resell, totaled $1.7 billion, or 24% of their total assets. The Banks' investment securities are used to meet Federal liquidity requirements, among other purposes. Designated members of the Bank's management make investment decisions. The Banks have established limits on the types and amounts of investments they may make.
Financial information about Wilmington Trust's reporting segments is contained in Note 18 to the Consolidated Financial Statements contained in Wilmington Trust's Annual Report to Shareholders for 1999.
Subsidiaries ------------
WTC has 16 active wholly-owned subsidiaries, formed for various purposes. Those subsidiaries' results of operations are consolidated with Wilmington Trust for financial reporting purposes. They provide additional services to Wilmington Trust's customers, and include:
o Brandywine Insurance Agency, Inc., a licensed insurance agent and broker for life, casualty, and property insurance;
o Brandywine Finance Corporation, a finance company;
o Brandywine Life Insurance Company, Inc., a reinsurer of credit life insurance written in connection with closed-end consumer loans WTC makes;
o Delaware Corporate Management, Inc., which provides services for special purpose entities using Delaware's favorable tax and legal environment;
o Nevada Corporate Management, Inc., which provides services for special purpose entities using Nevada's favorable tax and legal environment;
o Rodney Square Management Corporation, a registered investment adviser that performs investment advisory services for certain of the mutual funds described above;
o WTC Corporate Services, Inc., a sales production company for corporate trust customers;
o Wilmington Brokerage Services Company, a registered broker-dealer and a registered investment adviser; and
o Wilmington Trust Global Services, Ltd., a sales production company for corporate trust customers.
Staff Members -------------
On December 31, 1999, Wilmington Trust and its subsidiaries had 2,434 full-time equivalent employees. Wilmington Trust considers its and its subsidiaries' relationships with these employees to be good. Wilmington Trust and the Banks provide a variety of benefit programs for these employees, including pension, profit-sharing, incentive compensation, thrift savings, stock purchase, and group life, health, and accident plans.
Risk Factors ------------
o Principal Interest Rate and Credit Risks Associated with Consumer and ---------------------------------------------------------------------- Commercial Lending. -------------------
The Banks offer fixed and adjustable interest rates on loans, with terms of up to 30 years. Although the majority of residential mortgage loans the Banks originate are fixed-rate, adjustable rate mortgage loans increase the responsiveness of the Banks' loan portfolios to changes in market interest rates. However, ARM loans generally carry lower initial interest rates than fixed-rate loans. Accordingly, they may be less profitable than fixed-rate loans during the initial interest rate period. In addition, since they are more responsive to changes in market interest rates than fixed-rate loans, ARM loans can increase the possibility of delinquencies in periods of high interest rates.
The Banks also originate loans secured by mortgages on commercial real estate and multi-family residential real estate. Since these loans usually are larger than one-to-four family residential mortgage loans, they generally involve greater risks than one-to-four family residential mortgage loans. In addition, since customers' ability to repay those loans often is dependent on operating and managing those properties successfully, adverse conditions in the real estate market or the economy generally can impact repayment more severely than loans secured by one-to-four family residential properties. Moreover, the commercial real estate business is subject to downturns, overbuilding, and local economic conditions.
The Banks also make construction loans for residences and commercial buildings, as well as on unimproved property. While these loans also enable the Banks to increase the interest rate sensitivity of their loan portfolios and receive higher yields than those obtainable on permanent residential mortgage loans, the higher yields correspond to the higher risks perceived to be associated with construction lending. Those include risks associated generally with loans on the type of property securing the loan. Consistent with industry practice, the Banks sometimes fund the interest on a construction loan by including the interest as part of the total loan. Moreover, commercial
construction lending often involves disbursing substantial funds with repayment dependent largely on the success of the ultimate project instead of the borrower's or guarantor's ability to repay. Again, adverse conditions in the real estate market or the economy generally can impact repayment more severely than loans secured by one-to-four family residential properties.
In the event of slow economic conditions or deterioration in commercial and real estate markets, we would expect increased nonperforming assets, credit losses, and provisions for loan losses.
o Increasing Competition for Deposits, Loans, and Assets Under ------------------------------------------------------------ Management. -----------
The Banks compete for deposits, loans, and assets under management. Many of the Banks' competitors are larger and have greater financial resources than Wilmington Trust. These disparities have been accelerated with increasing consolidation in the financial services industry. Savings banks, savings and loan associations, and commercial banks located in the Banks' principal market areas historically have provided the most direct competition for deposits. Dealers in government securities and deposit brokers also provide competition for deposits. Savings banks, savings and loan associations, commercial banks, mortgage banking companies, insurance companies, and other institutional lenders provide the principal competition for loans. This competition can increase the rates the Banks pay to attract deposits and reduce the interest rates they can charge on loans, and impact the Banks' ability to retain existing customers and attract new customers.
Banks, trust companies, investment advisers, mutual fund companies, and insurance companies provide the Banks' principal competition for trust and asset management business.
o Regulatory Restrictions. ------------------------
Wilmington Trust and its subsidiaries are subject to a variety of regulatory restrictions in conducting business by Federal and state authorities. These include restrictions imposed by the Bank Holding Company Act, the Federal Deposit Insurance Act, the Federal Reserve Act, the Home Owners' Loan Act, and a variety of Federal and state consumer protection laws. See "Regulatory Matters."
* Variances are calculated on a fully tax-equivalent basis, which includes the effects of any disallowed interest expense deduction.
1 Changes attributable to volume are defined as a change in average balance multiplied by the prior year's rate.
2 Changes attributable to rate are defined as a change in rate multiplied by the average balance in the applicable period for the prior year. A change in rate/volume (change in rate multiplied by change in volume) has been allocated to the change in rate.
The maturity distribution of Wilmington Trust's investment securities held to maturity follows:
The maturity distribution of Wilmington Trust's investment securities available for sale follows:
The following is a summary of period-end loan balances by loan category:
The following table sets forth the allocation of Wilmington Trust's reserve for loan losses for the past five years:
The maturity of Wilmington Trust's time deposits of $100,000 or more is as follows:
----------------------------------------- Certificates All other interest- December 31, 1999 (in thousands) of deposit bearing deposits - ------------------------------------------------------------------------------- Three months or less $ 793,999 $ 429,671 Over three through six months 665,723 -- Over six through twelve months 33,706 -- Over twelve months 22,360 -- - -------------------------------------------------------------------------------
Total $ 1,515,788 $ 429,671 ================================================================================
A summary of short-term borrowings at December 31 is as follows (in thousands):
The following table presents the percentage of Wilmington Trust's funding sources by deposit type:
------------------------------------- (based on daily average balances) 1999 1998 1997 - ----------------------------------------------------------------------------- Savings 6.97% 7.38% 7.85% Interest-bearing demand 23.33 22.22 21.32 Certificates of deposit 35.92 37.26 33.92 Short-term borrowings 19.28 19.56 23.49 Demand deposits 14.50 13.58 13.42 - ------------------------------------------------------------------------------ Total 100.00% 100.00% 100.00% ==============================================================================
The following table presents an analysis of Wilmington Trust's return on assets and return on equity over the last three years:
-------------------------------------- 1999 1998 1997 - ------------------------------------------------------------------------------ Return on assets 1.60% 1.83% 1.87% Return on stockholders' equity 20.18 21.70 22.15 Dividend payout 50.61 44.87 44.76 Equity to asset 7.95 8.42 8.43 ==============================================================================
Regulatory Matters ------------------
The following is a summary of laws and regulations applicable to Wilmington Trust and the Banks. It does not purport to be complete, and is qualified by reference to those laws and regulations.
General -------
Wilmington Trust is a bank holding company and a thrift holding company, and the Banks are depository institutions whose deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC"). Federal statutes applicable to Wilmington Trust and the Banks include the Federal Reserve Act, the Federal Deposit Insurance Act, and the Bank Holding Company Act (the "BHCA"). Wilmington Trust and the Banks are regulated and supervised at the Federal level by the Federal Reserve Board, the FDIC, and the Office of Thrift Supervision (the "OTS"). In addition, Wilmington Trust, WTC, and WTPA are subject to supervision and regulation by state authorities.
BHCA ----
Under the BHCA and the Federal Reserve Board's (the "FRB's") regulations, the FRB's approval is required before a bank holding company may acquire "control" of a bank. The BHCA defines "control" of a bank to include ownership or the power to vote 25% or more of any class of a bank's voting stock, the ability to otherwise control the election of a majority of a bank's directors or the power to exercise a controlling influence over a bank's management or policies. In addition, the FRB's prior approval is required for:
o Any action that causes a bank or other company to become a bank holding company;
o Any action that causes a bank to become a subsidiary of a bank holding company;
o The acquisition by a bank holding company of ownership or control of any voting securities of a bank or bank holding company, if that acquisition results in the acquiring bank holding company's control of more than five percent of the outstanding shares of any class of voting securities of the target bank or bank holding company;
o The acquisition by a bank holding company or one of its subsidiaries, other than a bank, of all or substantially all of a bank's assets; or
o The merger or consolidation of bank holding companies, including a merger through a purchase of assets and assumption of liabilities.
Accordingly, before obtaining "control" of Wilmington Trust, a potential bank holding company would need to obtain the FRB's prior approval under the BHCA or the FRB's regulations under the Federal Bank Control Act.
A bank holding company and its subsidiaries generally may not, with certain exceptions, engage in, acquire, or control voting securities or assets of a company engaged in any activity other than (1) banking or managing or controlling banks and other subsidiaries authorized under the BHCA and (2) any BHCA activity the FRB determines to be so closely related to banking or managing or controlling banks to be a proper incident thereto. These include any incidental activities necessary to carry on those activities, as long as the bank holding company has obtained the FRB's prior approval. The FRB has approved a lengthy list of activities permissible for bank holding companies and their non-banking subsidiaries. Those include:
o Making, acquiring, and servicing loans and other extensions of credit; o Performing functions a trust company can perform; o Acting as an investment or financial advisor; o Performing certain insurance agency and underwriting activities directly related to extensions of credit by the holding company or its subsidiaries and engaging in insurance agency activities in towns of 5,000 or less; o Performing appraisals of real estate and tangible and intangible personal property; o Acting as an intermediary for the financing of commercial and industrial income-producing real estate; o Providing certain securities brokerage services; o Underwriting and dealing in government obligations and money market instruments; and o Providing tax planning and preparation services.
Financial Services Modernization Legislation --------------------------------------------
The Gramm-Leach-Bliley Act, which was enacted in November 1999 and most provisions of which became effective in March 2000 (the "Act"), permits greater affiliation among banks, securities firms, insurance companies, and other companies under a new type of financial services company known as a "financial holding company." A financial holding company essentially is a bank holding company with significantly expanded powers. Financial holding companies can offer most types of financial services, including banking, securities underwriting, insurance, and merchant banking. The Act also permits the Federal Reserve and the Treasury Department to authorize additional activities for financial holding companies if they are "financial in nature" or "incidental" to financial activities. To become a financial holding company, each of a company's bank or thrift subsidiaries must be well-capitalized and well-managed and have a Community Reinvestment Act rating of at least "satisfactory."
A financial holding company may engage immediately in several activities previously deemed to be impermissible or subject to significant limitations, including:
o Underwriting and dealing in all types of securities;
o Selling and underwriting insurance;
o Organizing and sponsoring mutual funds; and
o Merchant banking.
A financial holding company must provide notice to the Federal Reserve within 30 days after commencing activities the Federal Reserve previously has determined to be permissible. The Act establishes the Federal Reserve as the primary regulator of financial services companies, but provides functional regulation for the constituent parts of financial holding companies.
Interstate Banking Act ----------------------
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Banking Act"), adequately capitalized and managed bank holding companies are permitted to acquire a bank in any state, subject to regulatory approval and certain limitations, and regardless of certain state law restrictions such as reciprocity requirements and regional compacts. States cannot "opt out" of these interstate acquisition provisions.
In addition, under the Interstate Banking Act, bank holding companies are permitted to merge banks operating in different states, subject to regulatory approval and certain limitations, as long as neither bank is headquartered in a state that "opted out" of those provisions before June 1, 1997.
Under the Interstate Banking Act, states may permit DE NOVO branching or acquisitions of existing branches by out-of-state banks within their borders. In 1995, Delaware opted in to the provisions of the Interstate Banking Act permitting banks operating in different states to be merged, but opted out of DE NOVO branching.
Safety and Soundness Limitations --------------------------------
As a bank holding company, Wilmington Trust is required to conduct its operations in a safe and sound manner. If the FRB believes that an activity of a bank holding company or control of a nonbank subsidiary, other than a nonbank subsidiary of a bank, presents a serious risk to the financial safety, soundness, or stability of a subsidiary bank of the bank holding company and is inconsistent with sound banking practices or the purposes of the BHCA or certain other Federal banking statutes, the FRB may require the bank holding company to terminate the activity or the holding company's control of the subsidiary.
Sections 23A and 23B of the Federal Reserve Act establish standards for the terms of, limit the amount of, and establish collateral requirements with respect to, loans and other extensions of credit to and investments in affiliates by the Banks. The Banks are "affiliates" of Wilmington Trust and each other for purposes of the Federal Reserve Act. In addition, the Federal Reserve Act and the FRB's regulations limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to directors, officers, and principal shareholders of Wilmington Trust and its subsidiaries, and to related interests of those persons.
Capital Standards -----------------
The FRB and the other Federal banking agencies have adopted "risk-based" capital standards to assist in assessing the capital adequacy of bank holding companies and banks under those agencies' jurisdiction. Those risk-based capital standards include both a definition of capital and a framework for calculating "risk-weighted" assets by assigning assets and off-balance-sheet items to broad, risk-weighted categories. An institution's risk-based capital ratio is calculated by dividing its qualifying capital by its risk-weighted assets. At least one-half of risk-based capital must consist of Tier 1 capital (generally including common stockholders' equity, qualifying cumulative and noncumulative perpetual preferred stock, and minority interests in consolidated subsidiaries). The FRB also adopted minimum leverage ratios of "Tier 1" capital to total assets. At December 31, 1999, Wilmington Trust and the Banks were all well-capitalized, with capital levels in excess of applicable risk-based and leverage thresholds.
FDIC Insurance and Regulation -----------------------------
The FDIC insures deposits in the Banks up to applicable limits. Neither Wilmington Trust nor its subsidiaries are required to pay FDIC insurance premiums.
`The FDIC may impose sanctions on any insured depository institution that does not operate in accordance with the FDIC's regulations, policies, or directives. The FDIC may institute cease-and-desist proceedings against an insured institution or holding company it believes to be engaged in unsafe and unsound practices, including violations of laws and regulations. The FDIC also has the authority to terminate deposit insurance coverage, after notice and hearing, if it determines that an insured institution is or has engaged in an unsafe or unsound practice that has not been corrected, is in an unsafe or unsound condition to continue operation or has violated any law, regulation, rule or order of, or condition imposed by, the FDIC. Wilmington Trust is not aware of any past or current practice, condition, or violation that might lead to termination of the deposit insurance coverage of any of the Banks or any proceeding against any of the Banks or any of their respective directors, officers, or staff members.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (the "Improvement Act") requires annual on-site examinations of insured depository institutions, and authorizes the Federal examining agency to take prompt corrective action to resolve an institution's problems. The nature and extent of the corrective action depends primarily on the institution's capital level. Options available include:
o Requiring recapitalization of or a capital restoration plan from the institution;
o Restricting transactions between the institution and its affiliates;
o Restricting interest rates, asset growth, activities, and investments in the institution's subsidiaries; and
o Ordering a new election of directors, dismissing directors or senior executive officers, and requiring the employment of qualified senior executive officers.
The holding company of a depository institution may be required to guarantee compliance with the institution's capital restoration plan and provide assurance of performance under such a plan.
Dividend Limitations --------------------
The FRB's policy generally is that banks and bank holding companies should not pay dividends unless the institution's prospective earnings retention rate is consistent with its capital needs, asset quality, and overall financial condition. FRB policy also is that bank holding companies should be a source of managerial and financial strength to their subsidiary banks. Accordingly, the FRB believes that those subsidiary banks should not be compromised by a level of cash dividends that places undue pressure on their capital.
The FDIC can prohibit a bank from paying dividends if it believes the dividend payment would constitute an unsafe or unsound practice. Federal law also prohibits dividend payments that would result in a bank failing to meet its applicable capital requirements. Delaware law restricts WTC from declaring dividends that would impair its stated capital.
OTS regulations limit capital distributions by a savings institution. A savings institution must give notice to the OTS at least 30 days before a proposed capital distribution. A savings institution that has capital in excess of all of its regulatory capital requirements before and after a proposed capital distribution and that is not otherwise restricted in making capital distributions may, after that prior notice but without the OTS's approval, make capital distributions during a calendar year equal to the greater of (1) 100% of its net income to date during the calendar year plus an amount that would reduce by one-half its "surplus capital ratio" (I.E., its excess capital over its capital requirements) at the beginning of the calendar year or (2) 75% of its net income for the previous four quarters. Any additional capital distributions require prior OTS approval.
Other Laws and Regulations --------------------------
The lending and deposit-taking activities of the Banks are subject to a variety of Federal and state consumer protection laws, including:
o The Truth-in-Lending Act (which principally mandates certain disclosures in connection with loans made for personal, family, or household purposes and imposes substantive restrictions with respect to home equity lines of credit);
o The Truth-in-Savings Act (which principally mandates certain disclosures in connection with deposit-taking activities);
o The Equal Credit Opportunity Act (which prohibits discrimination in all aspects of credit-granting);
o The Fair Credit Reporting Act (which requires a lender to disclose the name and address of the credit bureau from whom the lender obtained a report that resulted in a denial of credit);
o The Real Estate Settlement Procedures Act (which requires residential mortgage lenders to provide loan applicants with closing cost information shortly after the time of application and prohibits referral fees in connection with real estate settlement services);
o The Electronic Funds Transfer Act (which requires certain disclosures in connection with electronic funds transactions);
o The Expedited Funds Availability Act (which requires that deposited funds be made available for withdrawal in accordance with a prescribed schedule and that the schedule be disclosed to customers).
Under the Community Reinvestment Act and the Fair Housing Act, depository institutions are prohibited from certain discriminatory practices that limit or withhold services to individuals residing in economically depressed areas. In addition, the CRA imposes certain affirmative obligations to provide lending and other financial services to those individuals. CRA performance is considered by all of the Federal regulatory agencies in reviewing applications to relocate an office, mergers and acquisitions of financial institutions, and establishing new branch or deposit facilities.
Federal legislation has permanently pre-empted all state usury laws on residential first mortgage loans made by insured depository institutions in any state that did not override that preemption. Although some states overrode that preemption, Delaware, Florida, Maryland, and Pennsylvania did not. Accordingly, there is currently no limit on the interest rate that the Banks can charge on loans governed by the laws of these states. In addition, the usury limitations of the Banks' respective home states apply to all other loans the
Banks offer nationwide. In today's interest rate environment, those usury laws do not materially affect the Banks' lending programs.
Delaware Law ------------
Delaware's business and legal environments historically have contributed to the Banks' operating results. A substantial percentage of large pharmaceutical and chemical companies and other Fortune 500 companies are headquartered in Delaware. Delaware's Court of Chancery is widely recognized for its interpretations of corporate law.
In addition, Delaware law affords several advantages for trust administration that have helped contribute to Wilmington Trust's operating results. In general, a trust governed by Delaware law can be administered more economically, for a longer period of time, and with a more flexible investment philosophy than in many other jurisdictions. In addition, although some jurisdictions have attempted to impose taxes on Delaware trusts with beneficiaries resident in those jurisdictions, Delaware does not impose any tax on those trusts.
ITEM 2
ITEM 2 - PROPERTIES
Wilmington Trust owns and/or leases buildings that are used in the normal course of business by the Banks and its other subsidiaries. The main office of Wilmington Trust and WTC is located at Rodney Square North, 1100 North Market Street, Wilmington, Delaware 19890. Wilmington Trust and most of its subsidiaries occupy 265,000 square feet of space at this location, known as the Wilmington Trust Center. It is owned by Rodney Square Investors, L.P., in which WTC has a 50% ownership interest through one of its subsidiaries. WTC carries the mortgage for this facility, which had an outstanding balance of $29,666,371 at December 31, 1999.
A separate, unencumbered, 300,000-square foot operations facility known as the Wilmington Trust Plaza is owned by a subsidiary of WTC. This facility is located at 301 West Eleventh Street, Wilmington, Delaware 19801.
As of January 31, 2000, the Banks had 60 branches in the following locations:
o Twenty-six are in New Castle County, seven are in Kent County, and fifteen are in Sussex County, Delaware;
o Three are in Chester County, two are in Delaware County, and one is in each of Montgomery and Philadelphia Counties, Pennsylvania;
o One is in Wicomico County and two are in Worcester County, Maryland; and
o One is in each of Martin, Palm Beach, and Indian River Counties, Florida.
WTFSB also operates trust agency offices in leased facilities in New York City, New York, Easton, Maryland, Las Vegas, Nevada, and Santa Monica, California.
All of Wilmington Trust's reporting segments operate at Wilmington Trust Center. Wilmington Trust's fee and banking reporting segments primarily operate its branches, and its fee reporting segment operates its trust agency offices.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
Wilmington Trust and its subsidiaries are involved in various legal proceedings in the ordinary course of business. While it is not feasible to predict the outcome of all pending suits and claims, management does not believe that the ultimate resolution of any of these matters will have a material adverse effect on Wilmington Trust's consolidated financial condition.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders by solicitation of proxies or otherwise during the fourth quarter of 1999.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
Information required by this item is contained on page 28 of the Management's Discussion and Analysis portion of Wilmington Trust's Annual Report to Shareholders, which is incorporated by reference herein. See also "Item 1 - Business."
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The following table sets forth selected financial data for the last five years: (in thousands, except per share information)
1999 1998 1997 1996 1995 ---- ---- ---- ---- ----
Interest income $ 462,176 $ 456,939 $ 430,639 $ 402,850 $ 377,341
Net interest income 245,913 237,697 230,016 214,221 197,364
Provision for loan losses 17,500 20,000 21,500 16,000 12,280
Net income 107,297 114,325 106,044 97,278 90,031
Per share data:
Net income- basic 3.26 3.41 3.15 2.83 2.56
Net income- diluted 3.21 3.34 3.08 2.79 2.53
Cash dividends declared 1.65 1.53 1.41 1.29 1.17
Balance sheet at year-end:
Assets $7,201,944 $6,300,565 $6,122,351 $5,564,409 $5,372,198
Long-term debt 168,000 168,000 43,000 43,000 28,000 - -----------------------------------------------------------------------------
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
The information required by this item is contained on pages 17 to 31 of Wilmington Trust's Annual Report to Shareholders for 1999, which are incorporated by reference herein.
ITEM 7A
ITEM 7A - QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
The information required by this item is contained on pages 24 to 25 of Wilmington Trust's Annual Report to Shareholders for 1999, which is incorporated by reference herein.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following information required by this item is contained on the respective pages indicated of Wilmington Trust's Annual Report to Shareholders for 1999. Those pages are incorporated by reference herein.
Annual Report to Shareholders Page Number
Consolidated Statements of Condition as of December 31, 1999 and 1998 34
Consolidated Statements of Income for the years ended December 31, 1999, 1998, and 1997 35
Consolidated Statements of Changes in Stock- holders' Equity for the years ended December 31, 1999, 1998, and 1997 36
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998, and 1997 37
Notes to Consolidated Financial Statements - December 31, 1999, 1998, and 1997 38-59
Report of Independent Auditors 60
Unaudited Selected Quarterly Financial Data 55
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 401 of Regulation S-K is contained on pages 4 to 10 of Wilmington Trust's proxy statement for its Annual Shareholders' Meeting to be held on May 11, 2000 (the "Proxy Statement"), which are incorporated by reference herein.
Information required by Rule 405 of Regulation S-K is contained on page 20 of the Proxy Statement, which is incorporated by reference herein.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this item is contained on pages 13 to 19 of the Proxy Statement, which are incorporated by reference herein.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is contained on pages 11 and 12 of the Proxy Statement, which are incorporated by reference herein.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is contained on page 20 of the Proxy Statement, which is incorporated by reference herein.
PART IV
ITEM 14
ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The following documents are filed as part of this report:
1. Financial Statements. The following Consolidated Financial Statements and Report of Independent Auditors of Wilmington Trust are incorporated by reference in Item 8 above:
Annual Report to Shareholders Page Number
Consolidated Statements of Condition as of December 31, 1999 and 1998 34
Consolidated Statements of Income for each of the years in the three-year period ended December 31, 1999 35
Consolidated Statements of Changes in Stockholders' Equity for each of the years in the three-year period ended December 31, 1999 36
Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1999 37
Notes to Consolidated Financial Statements 38-59
Report of Independent Auditors 60
2. Financial Statement Schedules. No financial statement schedules are required to be filed as part of this report.
3. Financial Statement Exhibits. The exhibits listed below have been filed or are being filed as part of this report. Any exhibit will be made available to any shareholder upon receipt of a written request therefore, together with payment of $.20 per page for duplicating costs.
The Corporation filed a Form 8-K with the Securities and Exchange Commission on December 16, 1999 reporting certain developments under Item 5.
Exhibit Exhibit Number ------- - ------ 3.1 Amended and Restated Certificate of Incorporation of the Corporation8 3.2 Amended and Restated Bylaws of the Corporation 11 4.1 1991 Employee Stock Purchase Plan1 4.2 1996 Employee Stock Purchase Plan 8 4.3 2000 Employee Stock Purchase Plan11 4.4 1983 Employee Stock Option Plan1 4.5 1988 Long-Term Incentive Stock Option Plan1 4.6 1991 Long-Term Incentive Stock Option Plan1 4.7 1999 Long-Term Incentive Plan10 4.8 Thrift Savings Plan1 4.9 Employee Stock Ownership Plan1 4.10 Senior Executive Incentive Compensation Plan6 4.11 Executive Incentive Plan10 10.1 Purchase and Assumption Agreement dated June 18, 1991 by and between Wilmington Trust Company and Wilmington Savings Fund Society2 10.2 Agreement of Reorganization and Merger dated as of April 8, 1991 by and among Wilmington Trust Company, Wilmington Trust Corporation and The Sussex Trust Company3 10.3 Deposit Insurance and Transfer and Asset Purchase Agreement among the Federal Deposit Insurance Corporation in its capacity as receiver for The Bank of the Brandywine Valley, the Federal Deposit Insurance Corporation, and Wilmington Trust Company dated as of February 21, 19924 10.4 Agreement of Reorganization and Merger dated as of March 18, 1993 between Wilmington Trust Corporation and Freedom Valley Bank5 10.5 Rights Agreement dated as of January 19, 1996 between Wilmington Trust Corporation and Harris Trust and Savings Bank7 10.6 Supplemental Executive Retirement Plan8 10.7 Amended and Restated Supplemental Executive Retirement Plan11 10.8 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and Ted T. Cecala8 10.9 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and Robert J. Christian8 10.10 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and Howard K. Cohen8 10.11 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and William J. Farrell II8 10.12 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and David R. Gibson8
10.13 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and Robert V.A. Harra Jr.8 10.14 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and Hugh D. Leahy Jr.8 10.15 Severance Agreement dated as of February 29, 1996 between Wilmington Trust Company and Robert A. Matarese8 10.16 Severance Agreement dated as of July 18, 1996 between Wilmington Trust Company and Rita C. Turner9 10.17 Severance Agreement dated as of June 28, 1999 between Wilmington Trust Company and Rodney P. Wood11 11 Statement re computation of per share earnings11 13 1999 Annual Report to Shareholders of Wilmington Trust Corporation11 21 Subsidiaries of Wilmington Trust Corporation11 23 Consent of independent auditor11 27 Financial data schedule11
- ------------- 1 Incorporated by reference to the corresponding exhibit to Amendment No. 1 to the Report on Form S-8 of Wilmington Trust Corporation filed on October 31, 1991. 2 Incorporated by reference to the exhibit to the Current Report on Form 8-K of Wilmington Trust Corporation filed on January 2, 1992. 3 Incorporated by reference to the exhibit to the Current Report on Form 8-K of Wilmington Trust Corporation filed on February 3, 1992. 4 Incorporated by reference to the exhibit to the Current Report on Form 8-K of Wilmington Trust Corporation filed on February 25, 1992. 5 Incorporated by reference to the corresponding exhibit to the Annual Report on Form 10-K of Wilmington Trust Corporation filed on March 23, 1993. 6 Incorporated by reference to the corresponding exhibit to the Annual Report on Form 10-K of Wilmington Trust Corporation filed on March 31, 1993. 7 Incorporated by reference to the exhibit to the Report on Form 8-A of Wilmington Trust Corporation filed on January 31, 1995. 8 Incorporated by reference to the corresponding exhibit to the Annual Report on Form 10-K of Wilmington Trust Corporation filed on March 30, 1996. 9 Incorporated by reference to the corresponding exhibit to the Annual Report on Form 10-K of Wilmington Trust Corporation filed on March 28, 1997. 10 Incorporated by reference to Exhibit A to the proxy statement of Wilmington Trust Corporation dated March 22, 1999 filed on March 31, 1999. 11 Filed herewith.
Pursuant to the requirements of Sections 13 and 15(d) of the Securities Exchange Act of 1934, this Form has been signed by the following persons in the capacities and on the dates indicated.
/s/ Ted T. Cecala ---------------------------------- Ted T. Cecala Director, Chairman of the Board and Chief Executive Officer
(Date) March 16, 2000
/s/ Robert V. A. Harra, Jr. ---------------------------------- Robert V. A. Harra, Jr. Director, President, Chief Operating Officer and Treasurer
(Date) March 16, 2000
/s/ David R. Gibson ---------------------------------- David R. Gibson, Senior Vice President and Chief Financial Officer
(Date) March 16, 2000
/s/ Carolyn S. Burger ---------------------------------- Carolyn S. Burger Director
(Date) March 16, 2000
/s/ Richard R. Collins ---------------------------------- Richard R. Collins Director
(Date) March 16, 2000
/s/ Charles S. Crompton, Jr. ---------------------------------- Charles S. Crompton, Jr. Director
(Date) March 16, 2000
/s/ H. Stewart Dunn, Jr. ---------------------------------- H. Stewart Dunn, Jr. Director
(Date) March 16, 2000
---------------------------------- Edward B. du Pont Director
(Date) March 16, 2000
---------------------------------- R. Keith Elliott Director
(Date) March 16, 2000
/s/ Andrew B. Kirkpatrick, Jr. ---------------------------------- Andrew B. Kirkpatrick, Jr. Director
(Date) March 16, 2000
/s/ Rex L. Mears ---------------------------------- Rex L. Mears Director
(Date) March 16, 2000
/s/ Hugh E. Miller ---------------------------------- Hugh E. Miller Director
(Date) March 16, 2000
/s/ Stacey J. Mobley ---------------------------------- Stacey J. Mobley Director
(Date) March 16, 2000
---------------------------------- Leonard W. Quill Director
(Date) March 16, 2000
/s/ David P. Roselle ---------------------------------- David P. Roselle Director
(Date) March 16, 2000
/s/ H. Rodney Sharp, III ---------------------------------- H. Rodney Sharp, III Director
(Date) March 16, 2000
/s/ Thomas P. Sweeney ---------------------------------- Thomas P. Sweeney Director
(Date) March 16, 2000
/s/ Mary Jornlin Theisen ---------------------------------- Mary Jornlin Theisen Director
(Date) March 16, 2000
/s/ Robert W. Tunnell, Jr. ---------------------------------- Robert W. Tunnell, Jr. Director
(Date) March 16, 2000 | 7,754 | 53,492 |
786947_1999.txt | 786947_1999 | 1999 | 786947 | ITEM 1. BUSINESS.
GENERAL
The Company, a New York corporation established in 1935, and its subsidiaries, are engaged in the manufacture, sale and distribution of generic drugs. A generic drug is the chemical and therapeutic equivalent of a brand-name drug for which patent protection has expired. A generic drug may only be manufactured and sold if patents (and any additional government-granted exclusivity periods) relating to the brand-name equivalent of the generic drug have expired. A generic drug is usually marketed under its generic chemical name or under a brand name developed by the generic manufacturer. The Company sells its generic drug products under its Halsey label and under private-label arrangements with drugstore chains and drug wholesalers. While subject to the same governmental standards for safety and efficacy as its brand-name equivalent, a generic drug is usually sold at a price substantially below that of its brand-name equivalent.
The Company manufactures its products at facilities in New York and Indiana. During the last several years, the Company has sought to diversify its businesses through strategic acquisitions and alliances and through the development, manufacture and sale of bulk chemical products used by others as raw materials in the manufacture of finished drug forms.
RECENT EVENTS
Regulatory Compliance
During the past several years, the Company's business has been adversely affected by the discovery of various manufacturing and record keeping problems identified with certain products manufactured at its Brooklyn, New York plant. In October 1991, the U.S. Food and Drug Administration (the "FDA") placed the Company on the FDA's Application Integrity Policy list and its restrictions (collectively, the "AIP"). Under the AIP, the FDA suspended all of the parent company's applications for new drug approvals, including Abbreviate New Drug Applications ("ANDAs") and Supplements to ANDAs. During the period that followed, the U.S. Department of Justice ("DOJ") conducted an investigation into the manufacturing and record keeping practices at the Company's Brooklyn plant. As a consequence, on June 21, 1993, the Company entered into a plea agreement (the "Plea Agreement") with the DOJ to resolve the DOJ's investigation. Under the terms of the Plea Agreement, the Company agreed to plead guilty to five counts of adulteration of a single drug product shipped in interstate commerce and related record keeping violations. The Plea Agreement also required the Company to pay a fine of $2,500,000 over five years in quarterly installments of $125,000 commencing in September 1993. As of February 28, 1998, the Company was in default of the payment terms of the Plea Agreement and had made payments aggregating $350,000. On March 27, 1998, the Company and the DOJ signed a Letter Agreement serving to amend the Plea Agreement relating to the terms of the Company's satisfaction of the fine assessed under the Plea Agreement. The Letter Agreement provides, among other things, that the Company will satisfy the remaining $2,150,000 of the fine through the payment of $25,000 on a monthly basis commencing June 1, 1998, plus interest on the outstanding balance. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources" for a more detailed description of the Letter Amendment to the Plea Agreement between the DOJ and the Company.
On June 29, 1993, the Company entered into a consent decree (the "Consent Decree") with the U.S. Attorney for the Eastern District of New York on behalf of the FDA that resulted from the FDA's investigation into the Brooklyn plant's compliance with the FDA's Current Good Manufacturing Practices ("CGMP") regulations. Under the terms of the Consent Decree, the Company was enjoined from shipping any solid dosage drug products (i.e., excluding liquid drug formulations) manufactured at the Brooklyn plant until the Company established, to the satisfaction of the FDA, that the methods used in, and the facilities and controls used for, manufacturing, processing, packing, labeling and holding any drug, were established, operated, and administered in conformity with the Federal Food, Drug, and Cosmetic Act and all CGMP Regulations. As part of satisfying these requirements, the Company was required to validate the manufacturing processes for each solid dosage drug product prior to manufacturing and shipping the drug product.
On October 23, 1996, the Company withdrew four of its ANDAs, including its ANDA (the "Capsules ANDA") for
acetaminophen/oxycodone capsules (the "Capsules"), and halted sales of the affected products. Net sales derived from the withdrawn Capsule ANDA were approximately $3 million and $8 million for the years ended December 31, 1996 and December 31, 1995, respectively, and accounted for approximately 24% and 40% of the Company's total net sales during such twelve month periods. The Company instituted the withdrawal of the Capsule ANDA at the suggestion of the FDA and in anticipation of its release from the AIP. At the FDA's suggestion, the Company retained outside consultants to perform validity assessments of its drug applications. Thereafter, in October 1996, the FDA recommended that several applications, including the Capsule ANDA, be withdrawn. As a basis for its decision, the FDA cited questionable and incomplete data submitted in connection with the applications. The FDA indicated that the withdrawal of the four ANDAs was necessary for the release of the Company from the AIP. The FDA further required submission by the Company of a Corrective Action Plan, which was prepared and submitted by the Company and accepted by the FDA.
On December 19, 1996, the FDA released the Company from the AIP. As a consequence, for the first time since October 1991, the Company was permitted to submit ANDAs to the FDA for review. Since its release from the AIP in December 1996, through the fiscal year ended December 31, 1999, the Company submitted 9 ANDAs for review by the FDA, including a new ANDA with respect to the Capsules. During the period from the Company's release from the AIP to March 31, 2000, the Company received the following ANDA approvals, all of which relate to ANDA filings made with the FDA subsequent to the Company's release from the AIP:
- ----------------------------
(1) Registered trademark of Knoll Pharmaceutical Co.
(2) Registered trademark of Forest Laboratories, Inc.
(3) Registered trademark of McNeil Consumer Products Company
(4) Registered Trademark of DuPont Merck
(5) Registered Trademark of Muro Pharmaceuticals, Inc.
(6) Registered Trademark of Endo Pharmaceuticals, Inc.
During the fiscal year ended December 31, 1999, the Company submitted 1 ANDA for review by the FDA. The Company anticipates the submission during fiscal 2000 of 9 ANDA supplements or amendments. These supplements and amendments relate to the transfer of existing ANDAs from the Company's Brooklyn facility to its Congers facility as well as the transfer of certain ANDAs obtained from Barr Laboratories. Although the Company has been successful in receiving the ANDA approvals described above since its release from the AIP in December 1996, there can be no assurance that any of its newly submitted ANDAs, or supplements or amendments thereto or those contemplated to be submitted, will be approved by the FDA. The Company will not be permitted to market any new product unless and until the FDA approves the ANDA relating to such product. Failure to obtain FDA approval for the Company's pending ANDAs, or a significant delay in obtaining such approval, would adversely affect the Company's business operations and financial condition.
Strategic Alliance with Watson Pharmaceuticals
On March 29, 2000, the Company completed various strategic alliance transactions with Watson Pharmaceuticals, Inc. ("Watson"). The transactions with Watson provided for Watson's purchase of a certain pending ANDA from the Company, for Watson's rights to negotiate for Halsey to manufacture and supply certain identified future products to be developed by Halsey, for Watson's marketing and sale of the Company's core products and for Watson's extension of a $17,500,000 term loan to the Company.
The product acquisition portion of the transactions with Watson provided for Halsey's sale of a pending ANDA and related rights (the "Product") to Watson for aggregate consideration of $13,500,000 (the "Product Acquisition Agreement"). As part of the execution of the Product Acquisition Agreement, the Company and Watson executed ten year supply agreements covering the active pharmaceutical ingredient ("API") and finished dosage form of the Product pursuant to which Halsey, at Watson's discretion, will manufacture and supply Watson's requirements for the Product API and, where the Product API is sourced from the Company, finish dosage forms of the Product. The purchase price for the Product is payable in three approximately equal installments as certain milestones are achieved.
The Company and Watson also executed a right of first negotiation agreement providing Watson with a first right to negotiate the terms under which the Company would manufacture and supply certain specified APIs and finished dosage products to be developed by the Company. The right of first negotiation agreement provides that upon Watson's exercise of
its right to negotiate for the supply of a particular product, the parties will negotiate the specific terms of the manufacturing and supply arrangement, including price, minimum purchase requirements, if any, territory and term. In the event Watson does not exercise its right of first negotiation upon receipt of written notice from the Company as to its receipt of applicable governmental approval relating to a covered product, or in the event the parties are unable to reach agreement on the material terms of a supply arrangement relating to such product within sixty (60) days of Watson's exercise of its right to negotiate for such product, the Company may negotiate with third parties for the supply, marketing and sale of the applicable product. The right of first negotiation agreement has a term of ten years, subject to extension in the absence of written notice from either party for two additional periods of five years each. The right of first negotiation agreement applies only to API and finished dosage products identified in the agreement and does not otherwise prohibit the Company from developing APIs or finished dosage products for itself or third parties.
The Company and Watson also completed a manufacturing and supply agreement providing for Watson's marketing and sale of the Company's existing core products portfolio (the "Core Products Supply Agreement"). The Core Products Supply Agreement obligates Watson to purchase a minimum amount of approximately $18,363,000 (the "Minimum Purchase Agreement") in core products from the Company, in equal quarterly installments over a period of 18 months (the "Minimum Purchase Period"). At the expiration of the Minimum Purchase Period if Watson does not continue to satisfy the Minimum Purchase Amount, the Company may market and sell the core products on its own or through a third party. Pending the Company's development and receipt of regulatory approval for its APIs and finished dosage products currently under development, including, without limitation, the Product sold to Watson, and the marketing and sale of same, of which there can be no assurance, substantially all the Company's revenues will be derived from the Core Products Supply Agreement with Watson.
The final component of the Company's strategic alliance with Watson provided for Watson's extension of a $17,500,000 term loan to the Company. The loan will be funded in installments upon the Company's request for advances and the provision to Watson of a supporting use of proceeds relating to each such advance. The loan is secured by a first lien on all of the Company's assets, senior to the lien securing all other Company indebtedness, carries a floating rate of interest equal to prime plus two percent and matures on March 31, 2003. The net proceeds from the term loan will, in large part, be used to upgrade and equip the API manufacturing facility of Houba, Inc., the Company's wholly-owned subsidiary, to upgrade and equip the Company's Congers, New York leased facility, to satisfy approximately $3,300,000 in bridge financing provided by Galen Partners and for working capital to fund continued operations. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for a more detailed discussion of the $17,500,000 term loan from Watson.
Private Offering
On May 26, 1999, the Company consummated a private offering of securities for an aggregate purchase price of up to $22.8 million (the "Oracle offering"). The securities issued in the Oracle Offering consisted of five percent convertible senior secured debentures (the "1999 Debentures") and common stock purchase warrants (the "1999 Warrants"). The 1999 Debentures and 1999 Warrants were issued by the Company pursuant to a certain Debenture and Warrant Purchase Agreement dated May 26, 1999 (the "Oracle Purchase Agreement") by and among the Company, Oracle Strategic Partners, L.P. ("Oracle") and such other investors in the Company's March 10, 1998 offering electing to participate in the Oracle Offering (inclusive of Oracle, collectively, the "Oracle Investor Group").
The 1999 Debentures were issued at par and will become due and payable as to principle on March 15, 2003. Approximately $12.8 million in principle amount of the 1999 Debentures were issued on May 26, 1999. Interest on the principle amount of the 1999 Debentures, at the rate of 5% per annum, is payable on a quarterly basis.
The maximum principal amount of the 1999 Debentures are convertible into shares of the Company's common stock at a conversion price of $1.404 per share, for an aggregate of up to approximately 16,283,694 shares of the Company's common stock. The 1999 Warrants are exercisable for an aggregate of approximately 4,618,702 shares of the Company's common stock. Of such warrants, 2,309,351 warrants are exercisable at $1.404 per share and the remaining 2,309,351 warrants are exercisable at $2.279 per share. The 1999 Debentures and 1999 Warrants are convertible and exercisable, respectively, for an aggregate of approximately 20,902,396 shares of the Company's common stock.
Of the $22.8 million to be invested pursuant to the Oracle Purchase Agreement, $5,000,000 was funded by Oracle on May 26, 1999, the closing date of the Oracle Purchase Agreement, and an additional $5,000,000 was funded on July 27, 1999. On March 20, 2000, the Company and Oracle executed a Release Agreement releasing Oracle from its obligation to make the remaining investment of $5,000,000 pursuant to the Oracle Purchase Agreement. After giving effect to the Release Agreement with Oracle, the 1999 Debentures and 1999 Warrants are convertible and exercisable, respectively, for an aggregate of approximately 16,331,043 shares of the Company's common stock.
In addition to the $10,000,000 investment made by Oracle pursuant to the Oracle Purchase Agreement, approximately $7,037,000 of the 1999 Debentures issues pursuant to the Oracle Purchase Agreement were issued in exchange for the surrender of a like amount of principle and accrued interest outstanding under the Company's convertible promissory notes issued pursuant to various bridge loan transactions with Galen Partners, III, L.P., Galen Partners International, III, L.P., Galen Employee Fund, L.P. (collectively, "Galen Partners") and certain other investors, in the aggregate amount of $10,104,110 during the period from August, 1998 through and including May, 1999 (the "Galen Bridge Loans"). The remaining balance of the Galen Bridge Loans in the principal amount of $3,495,001 plus accrued and unpaid interest were satisfied with a portion of the proceeds of Oracle's second $5,000,000 installment on made July 27, 1999 pursuant to the Oracle Purchase Agreement.
Acquisition of Product ANDAs
On April 16, 1999, the Company completed an acquisition agreement with Barr Laboratories, Inc. ("Barr") providing for the Company's purchase of the rights to 50 pharmaceutical products (the "Barr Products"). Under the terms of the acquisition agreement with Barr, the Company acquired all of Barr's rights in the Barr Products, including all related governmental approvals (including ANDAs) and related technical data and information. In consideration for the acquisition of the Barr Products, the Company issued to Barr a common stock purchase warrant exercisable for 500,000 shares of the Company's common stock having an exercise price of $1.0625 per share (the fair market value of the Common Stock on the date of issuance) and having a term of five years. The acquisition agreement with Barr also allows Barr to purchase any of the Barr Products manufactured by the Company for a period of five years.
The Barr Products acquired by the Company were previously marketed by Barr, prior to its decision to strategically refocus its generic product portfolio several years ago. While the Barr Products cover a broad range of therapeutic applications and are the subject of approved ANDAs, the Company will be required to obtain approval from the U.S. Food and Drug Administration ("FDA") to permit manufacture and sale of any of the Barr Products, including site specific approval. The Company initially has identified 8 of the products for which it will devote substantial effort in seeking approval from the FDA for manufacture and sale. The Company estimates that certain of these Barr Product will be available for sale in the fourth quarter of 2000, although no assurance can be given that any of the Barr Products will receive FDA approval or that if approved, that the Company will be successful in the manufacture and sale of the such products. It is the Company's intention to continue to evaluate the remaining Barr Products on an ongoing basis to assess their prospects for commercialization and likelihood of obtaining regulatory approval.
Cessation and Relocation of Brooklyn, New York Operations
On March 22, 2000 the Company executed a Lease Termination and Settlement Agreement with the landlord of the Company's Brooklyn, New York manufacturing facility (the "Settlement Agreement"). The Settlement Agreement provides for the early termination of the lease covering the Brooklyn facility and provides the Company with the time necessary to transfer operations to the Company's Congers, New York facility and cease all manufacturing, research and development and warehouse operations currently conducted in Brooklyn. The Settlement Agreement provides for the termination of the Brooklyn facility lease on August 31, 2000, subject to the Company's right to extend the term to March 31, 2001. The original lease provided for a term expiring December 31, 2005 with a rental payment obligation of $6,715,000 during the period from September 1, 2000 through December 31, 2005.
The Settlement Agreement provided for the Company's payment of a termination fee of $1,150,000, the advance payment of rent through August 31, 2000 and the deposit of a restoration escrow of $200,000 to be used for facility repairs. The Company also deposited $390,600 in escrow with its counsel. This escrow amount represents the rental payments for the period September 1, 2000 through March 31, 2001 and will be returned to the Company in the event it vacates the
Brooklyn facility on or prior to August 31, 2000. The Company recorded a total charge against earnings of approximately $3,220,000 resulting from the elimination of its Brooklyn, New York operations. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for a more detailed discussion of this charge against earnings.
Lease of Congers, New York Facility
Effective March 22, 1999, the Company leased, as sole tenant, a pharmaceutical manufacturing facility located in Congers, New York (the "Congers Facility") from Par Pharmaceuticals, Inc. ("Par") pursuant to an Agreement to Lease (the "Lease"). The Congers Facility contains office, warehouse and manufacturing space and is approximately 35,000 square feet. The Lease provides for a term of three years, with a two year renewal option and provides for annual fixed rent of $500,000 per year during the primary term of the Lease and $600,000 per year during the option period. The Lease also covers certain manufacturing and related equipment previously used by Par in its operations at the Congers Facility (the "Leased Equipment"). In connection with the execution of the Lease, the Company and Par entered into a certain Option Agreement pursuant to which the Company may purchase the Congers Facility and the Lease Equipment at any time during the lease term for $5 million.
As part of the execution of the Lease, the Company and Par entered into a certain Manufacturing and Supply Agreement (the "M&S Agreement") having a minimum term of twenty seven months. The M&S Agreement provides for the Company's contract manufacture of certain designated products manufactured by Par at the Congers Facility prior to the effective date of the Lease. The M&S Agreement also provides that Par will purchase a minimum of $1,150,000 in product during the initial 18 months of the Agreement. The M&S Agreement further provides that the Company will not manufacture, supply, develop or distribute the designated products to be supplied by the Company to Par under the M&S Agreement to or for any other person for a period of three years.
PRODUCTS AND PRODUCT DEVELOPMENT
Generic Drug Products
The Company historically has manufactured and sold a broad range of prescription and over-the-counter drug products. The Company's pharmaceutical product list currently includes a total of approximately 31 products, consisting of 21 dosage forms and strengths of prescription drugs and 10 dosage forms and strengths of over-the-counter drugs. Each dosage form and strength of a particular drug is considered in the industry to be a separate drug product. The Company's drug products are sold in various forms, including liquid and powder preparations, compressed tablets and two-piece, hard-shelled capsules.
Most of the generic drug products manufactured by the Company can be classified within one of the following categories:
1. Antibiotics,
2. Narcotic analgesics,
3. Anti-infective and anti-tubercular drugs,
4. Antihistamines and antihistaminic decongestants,
5. Antitussives, or
6. Steroids
During fiscal 1999, sales of antibiotics and narcotic analgesics accounted for approximately 67% of total net sales during such year. The Company anticipates that sales of antibiotics and narcotic analgesics will continue to represent a significant portion of the Company's revenue.
The Company's development strategy for new drug products has been to focus on the development of a broad-range of generic form drugs, each of which (i) has developed a solid market acceptance with a wide base of customers, (ii) can be sold on a profitable basis notwithstanding intense competition from other drug manufacturers, and (iii) is no longer under patent protection. The Company has also diversified its current product line to include some less widely prescribed drugs as to which limited competition might be expected. While the Company will continue the development of its finished goods pharmaceutical business, including the rehabilitation of the product ANDAs acquired from Barr, the Company's will dedicate increasing resources to the expansion and enhancement of its operations devoted to the development and manufacture of APIs for use in the Company's finished dosage products as well as for sale to third party pharmaceutical companies, including Watson, in the form and API and finished dosage products.
Development activities for each new generic drug product begin several years in advance of the patent expiration date of the brand-name drug equivalent. This is because the profitability of a new generic drug usually depends on the ability of the Company to obtain FDA approval to market that drug product upon or immediately after the patent expiration date of the equivalent brand-name drug. Being among the first to market a new generic drug product is vital to the profitability of the product. As other off-patent drug manufacturers receive FDA approvals on competing generic products, prices and revenues typically decline. Accordingly, the Company's ability to attain profitable operations will, in large part, depend on its ability to develop and introduce new products, the timing of receipt of FDA approval of such products and the number and timing of FDA approvals for competing products.
Active Pharmaceutical Ingredients
In the last few years, the Company has increased its efforts to develop and manufacture APIs, also known as bulk chemical products. The development and sale of APIs generally is not subject to the same level of regulation as is the development and sale of drug products. Accordingly, APIs may be brought to market substantially sooner than drug products. As described under the caption "Recent Events - Strategic Alliance with Watson Pharmaceuticals" above, the Company is a party to agreements with Watson Pharmaceuticals providing for Watson's right to negotiate for a supply of select APIs currently in development and to be developed by the Company. In addition to its alliance with Watson, it is the Company's intention to develop APIs for its own manufacture and sale (both in API and finished dosage form) and in partnership with other pharmaceutical manufacturers. A significant portion of the net proceeds from the Watson loan transaction described above will be devoted to the upgrade of its Culver, Indiana manufacturing facility operated by its Houba subsidiary, including HVAC, equipment and operational upgrades. During fiscal 1999, all of the Company's revenues were delivered from the sale of finished dosage products. It is the Company's expectation that in connection with a strategic alliance with Watson and other API development efforts, in addition to assisting in the expansion of the Company's line of finished products, the Company will generate revenues from the sale of APIs starting in the latter part of 2000 and such revenue segment will likely increase thereafter as a percentage of total revenue.
RESEARCH AND DEVELOPMENT
The Company currently conducts research and development activities at each of its Brooklyn and Indiana facilities. Once the cessation and relocation of the Company's Brooklyn, New York operations are completed, the Company's research and development activities previously conducted in Brooklyn will be transferred to its Congers, New York facility. The Company's research and development activities consist primarily of new generic drug product development efforts and manufacturing process improvements, the development for sale of new chemical products and the development of APIs. New drug product development activities are primarily directed at conducting research studies to develop generic drug formulations, reviewing and testing such formulations for therapeutic equivalence to brand name products and additional testing in areas such as bioavailability, bioequivalence and shelf-life. For fiscal years 1999, 1998 and 1997, total research and development expenditures were $1,075,000, $651,000 and $979,000, respectively. During 2000, the Company's research and development efforts will cover finished dosage products and APIs in a variety of therapeutic applications.
As of March 31, 2000, the Company maintained a full-time staff of 11 in its Research and Development Departments.
MARKETING AND CUSTOMERS
The application of the AIP to the Company's operations until December 1996, combined with the Company's continuing operating losses and lack of adequate working capital during fiscal 1997 and the first quarter of 1998 resulted in the Company's inability to maintain sufficient raw materials and finish goods inventories to permit the Company to actively solicit customer orders, and when orders were received, to fill such orders promptly. Following the completion in March 1998 of the offering with Galen Partners (the "Galen Offering"), new Management adopted a marketing strategy focused on developing and maintaining sufficient raw materials and finish goods inventories so as to permit a targeted sales effort by the Company to a core customer group, with an emphasis on quality, prompt product delivery and excellent customer service.
The strategic alliance with Watson entered into on March 29, 2000 provides for the Company's core products portfolio to be sold by Watson's sales force under Watson's label. Accordingly, the Company intends to discontinue sales efforts of these products. The two companies are working together during the second quarter of 2000 to effect an orderly transition of existing sales agreements and orders from Halsey to Watson. The Company continues to perform limited contract manufacturing of certain non-core products for other pharmaceutical companies.
During 1999, the Company had net sales to two customers aggregating approximately 25.3% of total sales. The Company believes that the loss of these customers would have a material adverse effect on the Company. During 1998 the Company had net sales to two customers, aggregating 19.1% of total sales. During 1997, the Company had net sales to one customer in excess of 10% of total sales, aggregating 22.3% of total sales.
The estimated dollar amount of the backlog of orders for future delivery as of March 31, 2000 was approximately $800,000 as compared with approximately $500,000 as of March 15, 1999. Although these orders are subject to cancellation, management expects to fill substantially all orders by the second quarter of 2000. The increase in the Company's backlog as of March 31, 2000 compared to that in 1999 is largely a function of an increase in market penetration.
GOVERNMENT REGULATION
General
All pharmaceutical manufacturers, including the Company, are subject to extensive regulation by the Federal government, principally by the FDA, and, to a lesser extent, by state and local governments. Additionally, the Company is subject to extensive regulation by the U.S. Drug Enforcement Agency ("DEA") as a manufacturer of controlled substances. The Company cannot predict the extent to which it may be affected by legislative and other regulatory developments concerning its products and the healthcare industry generally. The Federal Food, Drug, and Cosmetic Act, the Generic Drug Enforcement Act of 1992, the Controlled Substance Act and other Federal statutes and regulations govern or influence the testing, manufacture, safe labeling, storage, record keeping, approval, pricing, advertising, promotion, sale and distribution of pharmaceutical products. Noncompliance with applicable requirements can result in fines, recall or seizure of products, criminal proceedings, total or partial suspension of production, and refusal of the government to enter into supply contracts or to approve new drug applications. The FDA also has the authority to revoke approvals of new drug applications. The ANDA drug development and approval process now averages approximately eight months to two years. The approval procedures are generally costly and time consuming.
FDA approval is required before any "new drug," whether prescription or over-the-counter, can be marketed. A "new drug" is one not generally recognized by qualified experts as safe and effective for its intended use. Such general recognition must be based on published adequate and well controlled clinical investigations. No "new drug" may be introduced into commerce without FDA approval. A drug which is the "generic" equivalent of a previously approved prescription drug also will require FDA approval. Furthermore, each dosage form of a specific generic drug product requires separate approval by the FDA. In general, as discussed below, less costly and time consuming approval procedures may be used for generic equivalents as compared to the innovative products. Among the requirements for drug approval is that the prospective manufacturer's methods must conform to the CGMPs. CGMPs apply to the manufacture, receiving, holding and shipping of all drugs, whether or not approved by the FDA. CGMPs must be followed at all times during which the drug is manufactured. To ensure full compliance with standards, some of which are set forth in regulations, the Company must continue to expend time, money and effort in the areas of production and quality control. Failure to so comply risks delays in approval of drugs, disqualification from eligibility to sell to the government, and possible FDA enforcement actions, such as an injunction against shipment of the Company's products, the seizure of noncomplying drug products, and/or, in serious
cases, criminal prosecution. The Company's manufacturing facilities are subject to periodic inspection by the FDA.
In addition to the regulatory approval process, the Company is subject to regulation under Federal, state and local laws, including requirements regarding occupational safety, laboratory practices, environmental protection and hazardous substance control, and may be subject to other present and future local, state, Federal and foreign regulations, including possible future regulations of the pharmaceutical industry.
Drug Approvals
There are currently three ways to obtain FDA approval of a new drug.
1. New Drug Applications ("NDA"). Unless one of the procedures discussed in paragraph 2 or 3 below is available, a prospective manufacturer must conduct and submit to the FDA complete clinical studies to prove a drug's safety and efficacy, in addition to the bioavailability and/or bioequivalence studies discussed below, and must also submit to the FDA information about manufacturing practices, the chemical make-up of the drug and labeling.
2. Abbreviated New Drug Applications ("ANDA"). The Drug Price Competition and Patent Term Restoration Act of 1984 (the "1984 Act") established the ANDA procedure for obtaining FDA approval for those drugs that are off-patent or whose exclusivity has expired and that are bioequivalent to brand-name drugs. An ANDA is similar to an NDA, except that the FDA waives the requirement of conducting complete clinical studies of safety and efficacy, although it may require expanded clinical bioavailability and/or bioequivalence studies. "Bioavailability" means the rate of absorption and levels of concentration of a drug in the blood stream needed to produce a therapeutic effect. "Bioequivalence" means equivalence in bioavailability between two drug products. In general, an ANDA will be approved only upon a showing that the generic drug covered by the ANDA is bioequivalent to the previously approved version of the drug, i.e., that the rate of absorption and the levels of concentration of a generic drug in the body are substantially equivalent to those of a previously approved equivalent drug. The principle advantage of this approval mechanism is that an ANDA applicant is not required to conduct the same preclinical and clinical studies to demonstrate that the product is safe and effective for its intended use.
The 1984 Act, in addition to establishing the ANDA procedure, created new statutory protections for approved brand-name drugs. In general, under the 1984 Act, approval of an ANDA for a generic drug may not be made effective until all product and use patents listed with the FDA for the equivalent brand name drug have expired or have been determined to be invalid or unenforceable. The only exceptions are situations in which the ANDA applicant successfully challenges the validity or absence of infringement of the patent and either the patent holder does not file suit or litigation extends more than 30 months after notice of the challenge was received by the patent holder. Prior to enactment of the 1984 Act, the FDA gave no consideration to the patent status of a previously approved drug. Additionally, under the 1984 Act, if specific criteria are met, the term of a product or use patent covering a drug may be extended up to five years to compensate the patent holder for the reduction of the effective market life of that patent due to federal regulatory review. With respect to certain drugs not covered by patents, the 1984 Act sets specified time periods of two to ten years during which approvals of ANDAs for generic drugs cannot become effective or, under certain circumstances, ANDAs cannot be filed if the equivalent brand-name drug was approved after December 31, 1981.
3. "Paper" NDA. An alternative NDA procedure is provided by the 1984 Act whereby the applicant may rely on published literature and more limited testing requirements. While that alternative sometimes provides advantages over the ANDA procedure, it is not frequently used.
Generic Drug Enforcement Act
As a result of hearings and investigations concerning the activities of the generic drug industry and the FDA's generic drug approval process, Congress enacted the Generic Drug Enforcement Act of 1992 (the "Generic Drug Act"). The Generic Drug Act confers significant new authority upon the FDA to impose debarment and civil penalties for individuals and companies who commit certain illegal acts relating to the generic drug approval process.
The Generic Drug Act requires the mandatory debarment of companies or individuals convicted of a federal felony for conduct relating to the development or approval of any ANDA, and gives the FDA discretion to debar corporations or
individuals for similar conduct resulting in a federal misdemeanor or state felony conviction. The FDA may not accept or review during the period of debarment (one to ten years in the case of mandatory, or up to five years in the case of permissive, debarment of a corporation) any ANDA submitted by or with the assistance of the debarred corporation or individual. The Generic Drug Act also provides for temporary denial of approval of generic drug applications during the investigation of crimes that could lead to debarment. In addition, in more limited circumstances, the Generic Drug Act provides for suspension of the marketing of drugs under approved generic drug applications sponsored by affected companies. The Generic Drug Act also provides for fines and confers authority on the FDA to withdraw, under certain circumstances, approval of a previously granted ANDA if the FDA finds that the ANDA was obtained through false or misleading statements. The Company was not debarred as a result of the FDA investigation and settlement and the Consent Decree with the FDA makes no provision therefor.
Healthcare Reform
Several legislative proposals to address the rising costs of healthcare have been introduced in Congress and several state legislatures. Many of such proposals include various insurance market reforms, the requirement that businesses provide health insurance coverage for all their employees, significant reductions in the growth of future Medicare and Medicaid expenditures, and stringent government cost controls that would directly control insurance premiums and indirectly affect the fees of hospitals, physicians and other healthcare providers. Such proposals could adversely affect the Company's business by, among other things, reducing the demand, and the prices paid, for pharmaceutical products such as those produced and marketed by the Company. Additionally, other developments, such as (i) the adoption of a nationalized health insurance system or a single payor system, (ii) changes in needs-based medical assistance programs, or (iii) greater prevalence of capitated reimbursement of healthcare providers, could adversely affect the demand for the Company's products.
COMPETITION
The Company competes in varying degrees with numerous companies in the health care industry, including other manufacturers of generic drugs (among which are divisions of several major pharmaceutical companies) and manufacturers of brand-name drugs. Many of the Company's competitors have substantially greater financial and other resources and are able to expend more money and effort than the Company in areas such as marketing and product development. Although a company with greater resources will not necessarily receive FDA approval for a particular generic drug before its smaller competitors, relatively large research and development expenditures enable a company to support many FDA applications simultaneously, thereby improving the likelihood of being among the first to obtain approval of at least some generic drugs.
One of the principal competitive factors in the generic pharmaceutical market is the ability to introduce generic versions of brand-name drugs promptly after a patent expires. The Company believes that it was at a competitive disadvantage until its release from the AIP program and the FDA's resumption of review of ANDAs submitted by the Company's Brooklyn plant. See "Government Regulation--Generic Drug Enforcement Act" above. Other competitive factors in the generic pharmaceutical market are price, quality and customer service (including maintenance of sufficient inventories for timely deliveries).
RAW MATERIALS
The raw materials essential to the Company's business are bulk pharmaceutical chemicals purchased from numerous sources. Raw materials are generally available from several sources. The Federal drug application process requires specification of raw material suppliers. If raw materials from a supplier specified in a drug application were to become unavailable on commercially acceptable terms, FDA supplemental approval of a new supplier would be required. During 1999 and 1998, the Company purchased approximately $1,107,000 and $2,583,000, respectively, of its raw materials (constituting 15% and 29%, respectively, of its aggregate purchases of raw materials) from Mallinckrodt. Although the Company is now able to submit supplements to the FDA in order to allow the Company to purchase raw materials from alternate sources, there can be no assurance that if the Company were unable to continue to purchase raw materials from this supplier, that the Company would be successful in receiving FDA approval to such supplement or that it would not face difficulties in obtaining raw materials on commercially acceptable terms. Failure to receive FDA approval for, and to locate, an acceptable alternative source of raw materials would have a material adverse effect on the Company.
The DEA limits the quantity of the Company's inventories of certain raw materials used in the production of controlled substances based on historical sales data. In view of the Company's recently depressed sales volume, these DEA limitations could increase the likelihood of raw material shortages and of manufacturing delays in the event the Company experiences increased sales volume or is required to find new suppliers of these raw materials.
SUBSIDIARIES
The Company's Indiana manufacturing operations are conducted by Houba, Inc., an Indiana corporation and wholly-owned subsidiary of the Company. Halsey Pharmaceuticals, Inc., a Delaware corporation, is a wholly-owned subsidiary which is currently inactive. The Company also has the following additional subsidiaries, each of which is currently inactive and anticipated to be dissolved during the remainder of the 2000 fiscal year: Indiana Fine Chemicals Corporation, a Delaware corporation, H.R. Cenci Laboratories, Inc., a California corporation, Cenci Powder Products, Inc., a Delaware corporation, Blue Cross Products, Inc., a New York corporation, and The Medi-Gum Corporation, a Delaware corporation.
EMPLOYEES
As of March 31, 2000, the Company had approximately 179 full-time employees. Approximately 39 employees are administrative and professional personnel and the balance are in production and shipping. Among the professional personnel, 11 are engaged in research and product development. Approximately 46 employees at the Company's Brooklyn facility are represented by a local collective bargaining unit. The collective bargaining agreement between the Company and the union was extended on March 5, 1998 (retroactive to July 2, 1997) and expires June 30, 2000. As discussed above under the caption "Recent Events - Cessation and Relocation of Brooklyn, New York Operations", the Company is in the process of ceasing operations at its leased facility in Brooklyn, New York. The Company estimates that it will complete its relocation of the operations conducted in Brooklyn to its Congers, New York facility by August 31, 2000. After giving effect to the cessation of operations in Brooklyn, New York, the Company estimates that it will have approximately 107 employees. Management believes that its relations with its employees are satisfactory.
ITEM 2.
ITEM 2. PROPERTIES.
Halsey leases, as sole tenant, a pharmaceutical manufacturing facility of approximately 35,000 square feet located at 77 Brenner Drive, Congers, New York. The Agreement of Lease, with an unaffiliated third party, contains a three year term with a two year renewal option and provides for annual fixed rent of $500,000 per year during the primary term of the Lease and $600,000 per year during the renewal period. The primary term of the Lease expires on March 21, 2002. The Leased facility houses a portion of the Company's manufacturing operations and includes office and warehouse space. The Lease also contains an option pursuant to which the Company may purchase the leased premises and improvements (including certain production and related equipment) for a purchase price of $5 million, exercisable at any time during the Lease term.
Halsey leases, as sole tenant, a total of approximately 147,000 square feet in three buildings on Pacific Street and Dean Street in Brooklyn, New York. Each of these leases is between Halsey and unaffiliated lessors. The approximate aggregate minimum rental commitments under these operating leases are as follows: $1,023,000 for the year 1999 and $781,000 for the year 2000. The leases of the Brooklyn, New York facility expire on August 31, 2000, subject to the Company's right to extend the lease term to March 31, 2001. The Company is in the process of ceasing and relocating its Brooklyn operations to its Congers, New York facility. See "Item 1. Business - Recent Events - Cessation and Relocation of Brooklyn, New York Operations."
Halsey leases approximately 4,700 square feet of office space located at 695 North Perryville Road, Building No. 2, Rockford, Illinois. The lease is between the Company and an unaffiliated lessor. The lease has a term of two years expiring August 31, 2000 and calls for annual rental, including maintenance and common area expense, of approximately $50,000 per year. The Company is currently in discussion with the landlord to extend the term of the lease of this facility. This leased facility houses the Company's principal executive offices, including its sales, administration and finance operations.
The Company's Houba, Inc. subsidiary owns approximately 45,000 square feet of building space on approximately 30 acres of land in Culver, Indiana, which includes a 15,000 square foot manufacturing facility. This manufacturing facility
houses separate plants for the production of certain raw materials, capsules and tablets. In 1996, in conjunction with a settlement with two former employees, the Company acquired real property, improved by a residential property, in Culver, Indiana adjacent to the manufacturing facility.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
GOVERNMENTAL PROCEEDINGS
Reference is also made to the discussion of the Company's Plea Agreement and Letter Agreement with the DOJ contained in "Item 1. Business--Recent Events" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
OTHER LEGAL PROCEEDINGS
Beginning in 1992, actions were commenced against the Company and numerous other pharmaceutical manufacturers in the Pennsylvania Court of Common Pleas, Philadelphia Division, in connection with the alleged exposure to diethylstilbestrol ("DES"). The defense of all of such matters was assumed by the Company's insurance carrier, and a substantial number have been settled by the carrier. Currently, several actions remain pending with the Company as a defendant, and the insurance carrier is defending each action. Similar actions were brought in Ohio, and have been dismissed based on Ohio law. The Company does not believe any of such actions will have a material impact on the Company's financial condition.
The Company has been named as a defendant in one additional action which has been referred to the Company's insurance carrier and has been accepted for defense. The action, Alonzo v. Halsey Drug Co., Inc. and K-Mart Corp., No. 64DOT-95111-CT-2736 (Indiana Superior Court, Porter County), was commenced on November 7, 1995 and involves a claim for unspecified damages relating to the alleged ingestion of "Doxycycline 100." The Company does not believe this action will have a material impact on the Company's financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET PRICE FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS.
MARKET AND MARKET PRICES OF COMMON STOCK
The Company's Common Stock is listed on the American Stock Exchange (the "Exchange") under the symbol "HDG." Set forth below for the periods indicated are the high and low sales prices for the Common Stock as reported on the Exchange.
The Company does not meet certain of the Exchange's criteria for continued listing. The Company was informed by the Exchange that it has determined to delist the Company's Common Stock as it does not meet the Exchange's criteria for continued listing. Such criteria include minimum levels of shareholders equity and the absence of years of net losses from continuing operations. The Company has exercised its right to appeal the Exchange's decision. There can be no assurance that the Company's common stock will remain listed on the Exchange. If the Common Stock should become delisted from the Exchange, trading, if any, in the Common Stock would continue on the OTC Bulletin Board, an NASD-sponsored inter-dealer quotation system, or in what is commonly referred to as the "Pink Sheets". In such event, a shareholder may find it more difficult to dispose of, or to obtain accurate quotations as to the market value of the Common Stock.
HOLDERS
There were 788 holders of record of the Company's common stock on March 31, 2000. This number, however, does not reflect the ultimate number of beneficial holders of the Company's common stock.
DIVIDEND POLICY
The payment of cash dividends from current earnings is subject to the discretion of the Board of Directors and is dependent upon many factors, including the Company's earnings, its capital needs and its general financial condition. The terms of the Company's 5% convertible senior secured debentures and the Term Loan Agreement with Watson Pharmaceuticals prohibit the Company from paying cash dividends. The Company does not intend to pay any cash dividends in the foreseeable future.
PRIVATE OFFERINGS
The Company secured bridge financing from Galen in the aggregate amount of approximately $1,500,000, funded through two separate bridge loan transactions in December, 1999 (collectively, the "Bridge Loans"). In consideration for the extension for the Bridge Loans, the Company issued common stock purchase warrants to purchase an aggregate of 75,000
shares of the Company's Common Stock having an exercise price equal to the fair market value of the Common Stock at the date of issuance.
Each of the lenders in the Bridge Loans are accredited investors as defined in Rule 501(a) of Regulation D promulgated under the Securities Act of 1933, as amended (the "Act"). The warrants issued in connection with the Bridge Loans were issued without registration under the Act in reliance upon Section 4(2) of the Act and Regulation D promulgated thereunder.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial data presented on the following pages for the years ended December 31, 1999, 1998, 1997, 1996 and 1995 are derived from the Company's audited Consolidated Financial Statements. The Consolidated Financial Statements as of December 31, 1999 and December 31, 1998, and for each of the years in the three year period ended December 31, 1999, and the report thereon, are included elsewhere herein. The selected financial information as of and for the years ended December 31, 1997, 1996 and 1995 are derived from the audited Consolidated Financial Statements of the Company not presented herein.
The information set forth below is qualified by reference to, and should be read in conjunction with, the Consolidated Financial Statements and related notes thereto included elsewhere in this Report and "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Certain statements set forth under this caption constitute "forward-looking statements" within the meaning of the Reform Act. See "Special Note Regarding Forward-Looking Statements " on page 1 of this Report for additional factors relating to such Statements.
OVERVIEW
The Company reported a net loss of $20,063,000 or $1.40 per share for the year ended December 31, 1999 as compared with the net loss of $12,724,000 or $ .92 per share for 1998. Included in the loss for 1999 is a one-time charge of $3,220,000 resulting from the Company's decision to shutdown its Brooklyn operation. Net Sales for the year ended December 31, 1999 were approximately $11,420,000 as compared to net sales of approximately $8,841,000 for 1998. Notwithstanding these results, the Company had the following achievements in 1999:
- - Obtained a state-of-the-art pharmaceutical facility by leasing a 35,000 square foot facility in Congers, NY.
- - Acquired rights to over 50 products from Barr Laboratories. Certain of these products will be systematically updated and introduced to the market over the next three years.
- - Received approval from the FDA of two ANDA's and submitted one other for approval.
- - Subsequent to year end, the Company completed various strategic alliance transactions with Watson Pharmaceuticals, Inc.
RESULTS OF OPERATIONS
The following chart reflects expenses, earnings, income, losses and profits expressed as a percentage of net sales for the years 1999, 1998 and 1997.
NET SALES
Net sales for 1999 of $11,420,000 represents an increase of $2,579,000 as compared to net sales for 1998. The increase is attributable to greater market penetration as well as the introduction of additional products, primarily prednisolone, which accounted for approximately $815,000 of new sales.
Net sales for 1998 of $8,841,000 represents a decrease of $247,000 as compared to net sales for 1997. The decrease is attributable in part to a reduction in toll manufacturing revenue from Mallinckrodt of approximately $878,000 from the prior year. Additionally, the Company was unable to market successfully to the retail pharmacy marketplace until the third quarter of 1998 because during fiscal 1996 and 1997, the Company had failed to pay required rebates to state Medicaid agencies. This caused those states to deny medicaid reimbursement to the retail pharmacies on their sales of the Company's products. Commensurate with the infusion of new capital and management in March, 1998, the Company began reestablishing itself in good standing with all states. In April 1998, the Company entered into a new contract with the Health Care Finance Authority ("HCFA") and paid outstanding rebates due to various states. The states completed the reinstatement of the Company on their medicaid reimbursement by July, 1998. The Company has been in good standing with HCFA and the individual states since July 1998 and expects this past non-compliance will have no impact on future results of operations or liquidity. Also during much of 1998, the Company experienced difficulty in obtaining certain raw materials which reduced sales. These shortages were remedied by December 31, 1998.
GROSS MARGINS
The Company's gross margin for 1999 improved to (34.1)% versus (43.8)% for 1998. The improvement in 1999 is due primarily to the leveraging effect of greater sales over certain fixed manufacturing expenses.
The Company's gross margin for 1998 of (43.8)% is a 38.7% improvement over gross margin for 1997. This improvement is due, in part, to the elimination of non-core manufacturing operations in California, tighter inventory controls and a general reduction in manufacturing labor. Additionally, the Company's revenues in 1998 from sales to Mallinckrodt under a toll manufacturing agreement decreased by approximately $878,000. The gross margins on these products were substantially less than on the Company's other products.
RESEARCH & DEVELOPMENT EXPENSES
For 1999, research and development expenses amounted to $1,075,000 as compared to $651,000 for 1998. The increase primarily reflects the costs of additional regulatory personnel hired during 1999 to perform work in conjunction with new product development and the transfer of certain Barr ANDAs acquired during 1999.
For 1998, research and development expenses amounted to $651,000 as compared to $979,000 for 1997. The decrease primarily reflects the costs of biostudies performed in 1997 that were not duplicated in 1998.
The Company expects research and development expenses to increase significantly in 2000 consistent with its plans to increase the number of Barr ANDA's transferred as compared to 1999 and to develop additional active pharmaceutical ingredients at its Culver, Indiana facility.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative costs were $7,383,000 (64.6% of net sales) for 1999 compared to $8,078,000 (91.4% of net sales) for 1998. This decrease is primarily due to the reduced legal expenses in 1999 as compared to 1998.
Selling, general and administrative costs were $8,078,000 (91.4% of net sales) for 1998 compared to $6,308,000 (69.4% of net sales) for 1997. This increase is primarily due to costs associated with legal expenses and settlement costs of certain litigation ($550,000), severance costs associated with personnel reductions ($250,000), installation of a new information system ($100,000) and costs associated with expanded regulatory and compliance departments ($300,000).
PLANT SHUTDOWN COSTS
In the fourth quarter of 1999, the Company decided to discontinue its Brooklyn operations. The total charge against earnings of approximately $3,220,000 resulting from eliminating the Brooklyn operation includes the lease termination payment of $1,150,000, a provision of $200,000 for plant repairs, the write-off of leasehold improvements of $1,778,000, severance and other costs for terminated employees of $730,000, less deferred rent previously expensed of $638,000.
INTEREST EXPENSE
Interest expense for 1999 increased by 121.9% over that of 1998 reflecting the issuance of an additional $17,800,000 of convertible debentures in 1999.
Interest expense for 1998 increased by 13% over that of 1997 reflecting the substantial new debt in the form of $25,800,000 of convertible debentures that was added in 1998.
AMORTIZATION OF DEFERRED DEBT DISCOUNT AND DEBT ISSUANCE COSTS
In 1999 and 1998 the Company issued warrants and incurred costs associated with private placements and bridge financings. The value of warrants issued in 1999 and 1998, as determined by use of the Black-Scholes valuation model, was $5,234,000 and $2,618,000, respectively. Additionally, the Company incurred approximately $907,000 and $1,516,000 of debt issuance costs in 1999 and 1998, respectively. These amounts are being amortized over the life of the underlying debentures which expire in March, 2003. Accordingly, the Company amortized $1,825,000 and $661,000 in 1999 and 1998, respectively.
OTHER INCOME
Included in other income for 1998 is $1,900,000 realized from the sale of certain assets to Mallinckrodt. This transaction was entered into in 1997 but the conditions for realization of the gain from the sale were not met until 1998.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1999, the Company had cash and cash equivalents of $786,000 as compared to $1,850,000 at December 31, 1998. The Company had a working capital deficit at December 31, 1999 of $(5,181,000).
On May 26, 1999, the Company consummated a private offering of securities for an aggregate purchase price of up to $22.8 million (the "Oracle Offering"). The securities issued in the Oracle Offering consisted of 5% convertible senior secured debentures (the "1999 Debentures") and common stock purchase warrants (the "1999 Warrants"), each of which are substantially similar to the debentures and warrants issued by the Company in the Galen Offering completed in March, 1998. Of the $22.8 million to be invested pursuant to the Oracle Offering, $5 million was funded by Oracle Strategic Partners, L.P. ("Oracle") on May 26, 1999, the closing date of the Oracle Offering, with an additional $10 million to be funded by Oracle in two (2) installments of $5 million each. The first installment of the additional $10 million Oracle investment was funded on July 27, 1999. Pursuant to an agreement reached between the Company and Oracle on March 20, 2000, the final $5 million investment to be made by Oracle has been waived.
In addition to the $10 million investment made by Oracle, approximately $7,037,000 of the 1999 Debentures issued pursuant to the Oracle Offering were issued in exchange for the surrender of a like amount of principal and accrued interest outstanding under the Company's convertible promissory notes issues pursuant to various bridge loan transactions with Galen Partners III, L.P., Galen Partners International III, L.P., Galen Employee Fund III, L.P. (collectively, "Galen") and certain other investors in the aggregate amount of $10,104,110 during the period from August 1998 through and including May, 1999 (the "1999 Galen Bridge Loans"). The remaining balance of the 1999 Galen Bridge Loans in the principal amount of $3,495,000 plus accrued and unpaid interest was satisfied with a portion of the proceeds of the second $5 million installment of Oracle's investment funded on July 27, 1999. After giving effect to the satisfaction of approximately $7 million of indebtedness under the 1999 Galen Bridge Loans through the issuance of a like principal amount of 1999 Debentures, the repayment of the balance of the 1999 Galen Bridge Loans in the principal amount of approximately $3.5 million plus accrued and unpaid interest, and the waiver by the Company of the final $5 million installment to be made by Oracle pursuant to the Oracle Offering, the Company received net cash proceeds from the Oracle Offering of approximately $7.3 million.
The net proceeds from the issuance of the 1999 Debentures and 1999 Warrants pursuant to the Oracle Offering, in addition to satisfying the principal and accrued interest under the 1999 Galen Bridge Loans, were used to fund working capital, including the purchase of raw materials, payroll expenses and other Company operating expenses.
During the period from May 1997 through July 1997, the Company borrowed approximately $3 million from Mylan Laboratories, Inc. pursuant to five unsecured, demand promissory notes. The advances made by Mylan Laboratories, Inc. were part of a proposed investment by Mylan Laboratories, Inc. in the Company, including the proposed purchase of the Company's Houba Indiana facility as well as a partial tender offer for the Company's common stock. The Company used the proceeds of these borrowings for working capital. To date, $621,000 has been paid by the Company to Mylan against such indebtedness in the form of product deliveries to Mylan. Pursuant to an agreement reached between the parties, the Company is required to satisfy interest on the outstanding indebtedness on an annual basis while the indebtedness remains outstanding and to satisfy the principal amount of such indebtedness in the form of product deliveries to Mylan until such time as the indebtedness is satisfied in full.
In addition to the 1999 Galen Bridge Loans, the Company secured bridge financing from Galen in the aggregate amount of approximately $3,300,000, funded through six separate bridge loan transactions during the period from December 8, 1999 through March 29, 2000 (collectively, the "2000 Galen Bridge Loans"). The principal amount of the 2000 Galen Bridge Loans and accrued and unpaid interest were satisfied in full with a portion of the proceeds of the Watson Term Loan (as described below). Prior to repayment, the 2000 Galen Bridge Loans accrued interest at the rate of 18% per annum and were secured by a first lien on all of the Company's assets. In consideration for the extension of the 2000 Galen Bridge Loans, the Company issued common stock purchase warrants to Galen to purchase an aggregate of 150,000 shares of the Company's common stock (representing warrants to purchase 50,000 shares of common stock for each $1,000,000 in
principal amount of the 2000 Galen Bridge Loans). The warrants issued pursuant to the 2000 Galen Bridge Loans have an exercise price equal to the fair market value of the Company's common stock on the date of issuance and are substantially identical to those issued by the Company in the Oracle Offering. The 2000 Galen Bridge Loans were obtained by the Company in order to provide necessary working capital prior to the completion of the Watson Term Loan as described below.
On March 22, 2000, the Company executed a Lease Termination and Settlement Agreement with the landlord of the Company's Brooklyn, New York manufacturing facility (the "Settlement Agreement"). The Settlement Agreement accelerates the termination of the lease covering the Company's Brooklyn facility and provides the Company with the time necessary to transfer operations to the Company's Congers, New York facility and cease all manufacturing, research and development and warehouse operations currently conducted in Brooklyn. The Settlement Agreement provided for the termination of the Brooklyn lease on August 31, 2000, subject to the Company's right to extend the lease term to March 31, 2001. The original lease provided for a term expiring December 31, 2005 with a rental payment obligation of $6,715,000 during the period from September 1, 2000 through December 31, 2005. The Settlement Agreement provided for the Company's payment of a lease termination fee of $1,150,000, the advance payment of rent through August 31, 2000 and a restoration escrow deposit of $200,000 for plant repairs. The Company also deposited in escrow with its counsel $390,600 which represents rental payments for the period September 1, 2000 through March 31, 2001. Such escrow amount will be returned to the Company in the event it vacates the Brooklyn facility on or prior to August 31, 2000. The Company funded the termination fee payment, the advance rental payment obligations and restoration amount required pursuant to the Settlement Agreement with the proceeds received from the Watson Term Loan described below.
In addition to the lease termination and escrow payments described above, the Company estimates that it will incur severance and other costs for terminated employees of approximately $730,000 which are expected to be paid in the third quarter of 2000. Also, the Company expects to incur capital costs of approximately $500,000 associated with the transfer of certain operations from Brooklyn to the Congers facility.
In addition to the other strategic alliance transactions with Watson Pharmaceuticals, Inc. ("Watson") completed on March 29, 2000 (see "Item 1. Business - Recent Events - Strategic Alliance with Watson Pharmaceuticals"), the Company and Watson executed a Loan Agreement providing for Watson's extension of a $17,500,000 term loan to the Company (the "Watson Term Loan"). The Watson Term Loan will be funded in installments upon the Company's request for advances and the provision to Watson of a supporting use of proceeds relating to each such advance. As of March 31, 2000, $9 million had been advanced by Watson to the Company under the Watson Term Loan. The Watson Term Loan is secured by a first lien on all of the Company's assets, senior to the liens securing all other Company indebtedness, carries a floating rate of interest equal to prime plus two percent and matures on March 31, 2003. At March 31, 2000, a portion of the net proceeds of the Watson Term Loan were used to satisfy in full the 2000 Galen Bridge Loans, to satisfy the Company's payment obligations under the Settlement Agreement with the landlord of its Brooklyn, New York facility and for working capital. The remaining net proceeds of the Watson Term Loan will, in large part, be used to upgrade and equip the API manufacturing facility of Houba, Inc., the Company's wholly-owned subsidiary, to upgrade and equip the Company's Congers, New York leased facility, to fund the relocation of the Company's research and development and manufacturing operations from its Brooklyn, New York facility to its Congers, New York facility and for working capital to fund continued operations.
The net proceeds from the Watson Term Loan has permitted the Company to satisfy its current liabilities and accounts payable. In addition, the net proceeds from the Watson Term Loan combined with the payments to be received by the Company from Watson under each of the Product Acquisition Agreement and the Core Products Supply Agreement will provide the Company with sufficient working capital to fund operations for at least the next twelve months.
CAPITAL EXPENDITURES
The Company's capital expenditures during 1999, 1998 and 1997 were $849,000 $1,545,000, and $85,000, respectively. The decrease in capital expenditures in 1999 as compared to prior years is attributable to the completion of certain equipment and facility upgrades that had been delayed in prior years due to the Company's cash conservation measures in those years. The Company has budgeted for capital expenditures approximately $2,500,000 in fiscal 2000. Such amounts will be funded from the net proceeds of the Watson Term Loan and the payments to be received by the Company pursuant to each of the Product Acquisition Agreement and Core Products Supply Agreement with Watson.
YEAR 2000 COMPLIANCE
In anticipation of the Year 2000, the Company installed a new information system, including hardware and software. To date, neither the Company nor any of its customers or suppliers has experienced any material Year 2000 failures relating to their computer systems.
IMPACT OF INFLATION
The Company believes that inflation did not have a material impact on its operations for the periods reported. Significant increases in labor, employee benefits and other expenses could have a material adverse effect on the Company's performance.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The response to this item is submitted as a separate section of this Report commencing on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by Item 10 will be included in the Company's Proxy Statement for the 2000 Annual Meeting of Shareholders, which will be filed within 120 days after the close of the Company's fiscal year ended December 31, 1999, and is hereby incorporated herein by reference to such Proxy Statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 will be included in the Company's Proxy Statement for the 2000 Annual Meeting of Shareholders, which will be filed within 120 days after the close of the Company's fiscal year ended December 31, 1999, and is hereby incorporated herein by reference to such Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by Item 12 will be included in the Company's Proxy Statement for the 2000 Annual Meeting of Shareholders, which will be filed within 120 days after the close of the Company's fiscal year ended December 31, 1999, and is hereby incorporated herein by reference to such Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by Item 13 will be included in the Company's Proxy Statement for the 2000 Annual Meeting of Shareholders, which will be filed within 120 days after the close of the Company's fiscal year ended December
31, 1999, and is hereby incorporated herein by reference to such Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Financial Statements--See Index to Financial Statements.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the last quarter of the fiscal year covered by this Annual Report on Form 10-K.
(c) Exhibits
The following exhibits are included as a part of this Annual Report on Form 10-K or incorporated herein by reference.
* Filed herewith. + A portion of this exhibit has been omitted pursuant to an application for confidential treatment pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HALSEY DRUG CO., INC.
By: /s/ MICHAEL REICHER ------------------- Michael Reicher, President and Chief Executive Officer (Principal Executive Officer)
Date: April 14, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Page ----
Report of Independent Certified Public Accountants
Consolidated Balance Sheets -
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity -
Consolidated Statements of Cash Flows -
Notes to Consolidated Financial Statements - REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors HALSEY DRUG CO., INC.
We have audited the accompanying consolidated balance sheets of Halsey Drug Co., Inc. and Subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Halsey Drug Co., Inc. and Subsidiaries as of December 31, 1999 and 1998, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
GRANT THORNTON LLP
New York, New York March 30, 2000
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
December 31, (in thousands)
The accompanying notes are an integral part of these statements.
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS (CONTINUED)
December 31, (in thousands)
The accompanying notes are an integral part of these statements.
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
Year ended December 31, (in thousands, except per share data)
The accompanying notes are an integral part of these statements.
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Years ended December 31, 1999, 1998 and 1997 (in thousands)
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (CONTINUED)
Years ended December 31, 1999, 1998 and 1997 (in thousands)
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (CONTINUED)
Years ended December 31, 1999, 1998 and 1997 (in thousands)
The accompanying notes are an integral part of this statement.
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended December 31, (in thousands)
Halsey Drug Co., Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
Year ended December 31, (in thousands)
Supplemental disclosures of noncash activities:
Year ended December 31, 1999
1. The Company issued 321,777 shares of common stock as payment for $526,779 in accrued interest.
2. The Company issued 26,106 shares of common stock as payment for $50,500 in legal fees and 9,846 shares of common stock as payment for $24,000 in trade payables.
3. The Company issued approximately 3,608,604 warrants (Note G) valued and recorded in the aggregate as $5,234,000 of unamortized debt discount and a reduction in the amount of the related obligation.
4. The Company converted approximately $6,609,000 of notes payable and approximately $428,000 of accrued interest on notes payable into convertible subordinated debentures.
5. The Company converted approximately $939,000 of accrued interest due from convertible subordinated debentures into additional debentures.
6. The Company issued 1,022,284 warrants for funding fees valued and recorded as $907,000 in deferred private issuance costs.
7. The Company issued 500,000 warrants to Barr Laboratories, Inc.(to purchase of the rights to 50 pharmaceutical products) valued and recorded as $350,000 for the acquisition of certain product rights.
Year ended December 31, 1998
1. The Company issued 262,836 shares of common stock as payment for $593,313 in accrued interest.
2. The Company reissued 20,000 shares of common stock as payment for $25,000 in legal fees and 20,000 shares of common stock as payment for $30,000 in trade payables.
3. The Company issued 110,658 shares of common stock as payment of outstanding notes payable in amounts of $214,000 and $1,782 in accrued interest.
4. The Company issued approximately 5,500,086 warrants (Note G) valued and recorded in the aggregate as $2,263,434 of unamortized debt discount and a reduction in the amount of the related obligation.
Year ended December 31, 1997
1. The Company issued 25,000 shares of common stock as payment for $225,452 in accrued interest.
2. The Company issued 642,407 shares of common stock to Zatpack, Inc. as payment for an outstanding note payable in the amount of $1,536,000.
3. The Company reissued 25,000 shares of treasury stock as payment for $30,000 in consulting fees and the receipt of $70,000 in cash.
4. The Company recorded the satisfaction of $1,400,000 of subordinated promissory notes, related accrued interest of $200,000 and accounts payable of $300,000 due to a supplier, in lieu of the supplier paying $1,900,000 owed to the Company as described in Note K.
The accompanying notes are an integral part of these statements.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999, 1998 and 1997
NOTE A - SUMMARY OF ACCOUNTING POLICIES
Halsey Drug Co., Inc. (the "Company" or "Halsey"), a New York corporation established in 1935, and its subsidiaries are engaged in the manufacture, sale and distribution of generic drugs. The Company sells its generic drug products under its Halsey label and under private-label arrangements with drug store chains and drug wholesalers throughout the United States.
A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows.
1. Principles of Consolidation and Basis of Presentation
The consolidated financial statements include 100% of the accounts of the Company and its wholly-owned subsidiaries, Blue Cross Products Co., Inc., Houba, Inc., Halsey Pharmaceuticals, Inc., Indiana Fine Chemicals Corporation, Cenci Powder Products, Inc., H.R. Cenci Laboratories, Inc., and The Medi-Gum Corporation. Except for Houba, Inc., all of the other subsidiaries are inactive. All material intercompany accounts and transactions have been eliminated.
2. Inventories
Inventories are stated at the lower of cost or market; cost is determined using the first-in, first-out method.
3. Property, Plant and Equipment
Property, plant and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided for in amounts sufficient to relate the cost of depreciable assets to operations over their estimated service lives, principally on a straight-line basis. The estimated lives used in determining depreciation and amortization are:
Leasehold improvements were written off during the year. (See Note J).
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE A (CONTINUED)
4. Deferred Debt Discount and Private Issuance Costs
Debt discount resulting from the issuance of stock warrants in connection with the issuance of subordinated debt (Note G) is recorded as a reduction of the related obligations and is amortized over the remaining life of the related obligations. Debt discount is determined by a calculation which is based, in part, by the fair valued ascribed to such warrants determined by an independent valuation or management's use of the Black-Scholes valuation model. Deferred private issuance costs resulting from the issuance of warrants in connection with the extension of bridge loan maturity dates are recorded as deferred assets and amortized as additional interest expense over the remaining life of the related obligations.
5. Income Taxes
The Company accounts for income taxes utilizing an asset liability method for financial accounting and reporting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
6. Statements of Cash Flows
For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. The Company paid no substantial income taxes for the years ended December 31, 1999, 1998 and 1997. In addition, the Company paid interest of approximately $720,000, $1,946,000 and $1,113,000, respectively, for the years ended December 31, 1999, 1998 and 1997.
7. Use of Estimates in Consolidated Financial Statements
In preparing consolidated financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE A (CONTINUED)
8. Research and Development Costs
All research and development costs, including payments related to licensing agreements on products under development and research consulting agreements are expensed when incurred.
9. Impairment of Long-Lived Assets
The Company reviews long-lived assets and certain identifiable intangibles held and used for possible impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. See Note J for the impairment charge related to the write-off of leasehold improvements of the Company's Brooklyn New York Plant.
10. Stock-Based Compensation
The Company accounts for stock-based compensation under Statement of Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation," and continues to apply APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans (Note M).
Equity instruments issued to nonemployees in exchange for goods and/or services are accounted for under the fair value method of SFAS No. 123.
11. Earnings (Loss) Per Share
The computation of basic earnings (loss) per share of common stock is based upon the weighted average number of common shares outstanding during the period. Diluted earnings per share is presented, and is equal to basic earnings per share for all years presented as the effect of other potentially dilutive securities would be antidilutive (Note M).
12. Revenue Recognition
Revenue is recognized from sales when title to product passes to customers.
13. Reclassifications
Certain reclassifications have been made to the 1998 and 1997 presentations to conform to the 1999 presentation.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE B - LIQUIDITY MATTERS
At December 31, 1999, the Company had a working capital deficiency of approximately $5,181,000, had an accumulated deficit of approximately $77,284,000 and had incurred a loss of approximately $20,063,000 for the year then ended.
During 1999 the Company used the net proceeds from its 1999 private issuances of debentures and warrants (Note G) to satisfy the principal and accrued interest requirements of prior issued debentures and in addition, used such proceeds to fund working capital, including the purchase of raw materials, payroll expenses and other Company operating expenses.
On March 29, 2000, the Company completed various strategic alliance transactions with Watson Pharmaceuticals, Inc. ("Watson"). The transactions with Watson provided for (i) Watson's purchase, for $13,500,000, of a certain pending ANDA from the Company, (ii) Watson's rights to negotiate for Halsey to manufacture and supply certain identified future products to be developed by Halsey, (iii) Watson's marketing and sale of the Company's core products and (iv) Watson's extension of a $17,500,000 term loan to the Company.
The net proceeds from the Watson Term Loan has permitted the Company to satisfy its current liabilities and accounts payable. In addition, management believes the net proceeds from the Watson Term Loan combined with the payments to be received by the Company from Watson under each of the Product Acquisition Agreement and the Core Products Supply Agreement will provide the Company with sufficient working capital to fund operations for at least the next twelve months.
NOTE C - FAIR VALUE OF FINANCIAL INSTRUMENTS
Long-term and Short-term Debt and senior convertible subordinated debentures
The fair value of the Company's long-term and short-term debt and Senior Convertible Subordinated Debentures cannot be made without incurring excessive costs.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE D - INVENTORIES
Inventories consist of the following:
NOTE E - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are summarized as follows:
Depreciation and amortization expense for the years ended December 31, 1999, 1998 and 1997 was approximately $914,000, $1,113,000 and $1,606,000, respectively.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE F- ACCRUED EXPENSES
Accrued expenses are summarized as follows:
At December 31, 1999, payroll taxes payable include approximately $1,467,000 and $31,000 of delinquent payroll taxes (including penalties and interest) due to the Internal Revenue Service and the State of New York, respectively, all of which liability was incurred in 1997 and 1996. The Company expects that the Federal liability will be partially offset by income tax refund claims which were filed and are pending before the IRS. Until such time as the IRS completes its review, the Company has not recorded any expected tax refund claims. The Company has negotiated a payment plan with the State of New York and the balance will be paid by the end of 2000.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE G - CONVERTIBLE SUBORDINATED DEBENTURES AND STOCK WARRANTS
At December 31, 1999 and 1998 convertible subordinated debentures outstanding and related debt discount related to the following issuances are discussed below:
(a) On August 6, 1996, the Company issued 250 units, at $10,000 per unit, in a private placement of its securities ("August Private Placement"). Each unit consisted of: (i) a 10% convertible subordinated debenture due August 6, 2001 in the principal amount of $10,000, interest payable quarterly, and convertible into shares of the Company's common stock at a conversion price of $3.25 per share, subject to dilution, and (ii) 461 redeemable common stock purchase warrants ("warrants"). Each warrant entitled the holder to purchase one share of common stock for $3.25, subject to adjustment during the five-year period commencing August 6, 1996.
(b) On March 10, 1998, the Company completed a private offering (the "Offering") of securities to an investor group ("Galen") consisting of 5% convertible senior secured debentures due March 15, 2003, and common stock purchase warrants (with a 7 year life) exercisable for 2,244,667 shares of the Company's common stock at an exercise price of $1.404 and 2,189,511 shares at an exercise price of $2.279. The debentures are convertible into shares of the Company's common stock at a conversion price of $1.404. The net proceeds to the Company from the Offering, after the deduction of related offering expenses of $1,518,000 for legal and investment banker fees, was approximately $19,300,000. These related offering costs are being amortized over the remaining five year life of the related debentures.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE G (CONTINUED)
(c) In accordance with the terms of the Offering, during June 1998, Galen invested an additional $5,000,000 in the Company in exchange for debentures and warrants having terms identical to those issued in the Offering (539,583 and 526,325 common stock purchase warrants with an exercise price of $1.404, respectively).
(d) On May 26, 1999, the Company consummated a private offering of securities for an aggregate purchase price of up to $22,800,000 (the "Oracle Offering"). The securities issued in the Oracle Offering consisted of 5% convertible senior secured debentures (the "1999 Debentures") and common stock purchase warrants (the "1999 Warrants"), each of which are substantially similar to the debentures and warrants issued by the Company in the Galen Offering completed in March, 1998. Of the $22,800,000 to be invested pursuant to the Oracle Offering, $5,000,000 was funded by Oracle Strategic Partners, L.P. ("Oracle") on May 26, 1999, the closing date of the Oracle Offering, with an additional $10,000,000 to be funded by Oracle in two installments of $5,000,000 each. The first $5,000,000 installment of the additional $10,000,000 Oracle investment was funded on July 27, 1999. Pursuant to an agreement reached between the Company and Oracle on March 20, 2000, the final $5,000,000 investment has been waived.
The 1999 Debentures were issued at par and will become due and payable as to principle on March 15, 2003. Approximately $12,800,000 in principle amount of the 1999 Debentures were issued on May 26, 1999. Interest on the principle of the 1999 Debentures is accrued at the rate of 5% per annum and is payable on a quarterly basis.
The 1999 Debentures are convertible into shares of the Company's common stock at a conversion price of $1.404 per share, for an aggregate of up to approximately 12,678,063 shares of the Company's common stock. The 1999 Warrants are exercisable for an aggregate of approximately 4,618,702 shares of the Company's common stock. Of such warrants, 2,309,351 warrants are exercisable at $1.404 per share and the remaining 2,309,351 warrants are exercisable at $2.279 per share. The 1999 Debentures and 1999 Warrants are convertible and exercisable, respectively, for an aggregate of approximately 17,296,765 shares of the Company's common stock.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE G (CONTINUED)
(e) Approximately $7,037,000 of the 1999 Debentures issued pursuant to the Oracle Offering were issued in exchange for the surrender of a like amount of principal and accrued interest outstanding under the Company's convertible promissory notes issued pursuant to various bridge loan transactions with Galen Partners III, L.P., Galen Partners International III, L.P., Galen Employee Fund III, L.P. (collectively, "Galen") and certain other investors in the aggregate amount of $10,104,110 during the period from August 1998 through and including May, 1999 (the "1999 Galen Bridge Loans"). In exchange for Galen and other investors granting extensions to maturity dates of the Company's convertible promissory notes, the Company issued 1,022,284 common stock purchase warrants at exercise prices ranging from $1.18 to $2.32. These warrants resulted in deferred private offering costs which are being amortized over the remaining 5 year life of the related obligations. The remaining balance of the 1999 Galen Bridge Loans in the principal amount of $3,495,000 plus accrued and unpaid interest was paid on July 27, 1999.
(f) In connection with certain 1995 amendments to a line of credit agreement then existing with a bank, the Company issued stock warrants to the bank, expiring July 17, 2000, to purchase shares of the Company's common stock at various exercise prices per share, subject to certain antidilution provisions. At December 31, 1999 the number of common stock warrants, as adjusted, equal 955,509 shares at exercise prices ranging from $1.48 to $1.51 per share. In March 1998, the Company completely satisfied its bank indebtedness and terminated the line of credit agreement.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE G (CONTINUED)
Debt discount resulting from the issuance of stock warrants in connection with the issuance of subordinated debt is recorded as a reduction of the related obligations at the warrants relative fair value and is amortized as additional interest expense over the remaining life of the related obligations. At December 31, 1999 outstanding warrants giving rise to debt discount for related debentures are as follows:
At December 31, 1999 outstanding warrants giving rise to deferred private offering costs are as follows:
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE H -NOTES PAYABLE
At December 31, 1999 and 1998, notes payable consisted of the following:
(a) At December 31, 1999 unsecured promissory demand notes consisted of $2,379,000 due to Mylan and $150,000 due to a former employee. During the period from May 1997 through July 1997, the Company borrowed approximately $3 million from Mylan Laboratories, Inc. ("Mylan") pursuant to five unsecured, demand promissory notes. The advances made by Mylan Laboratories, Inc. were part of a proposed investment by Mylan in the Company, including the proposed purchase of the Company's Indiana facility as well as a partial tender offer for the Company's common stock. To date, $620,000 has been paid by the Company to Mylan against such indebtedness in the form of product deliveries to Mylan. Pursuant to an agreement reached between the parties, the Company is required to satisfy interest on the outstanding indebtedness on an annual basis while the indebtedness remains outstanding and to satisfy the principal amount of such indebtedness in the form of product deliveries to Mylan until such time as the indebtedness is satisfied in full.
(b) In addition to the 1999 Galen Bridge Loans discussed in Note G, the Company secured bridge financing from Galen order to provide necessary working capital prior to the completion of the Watson Term Loan as described in Note Q. These bridge loans aggregated approximately $3,300,000 and were funded through six separate bridge loan transactions during the period from December 8, 1999 through March 29, 2000 (collectively, the "2000 Galen Bridge Loans"). At December 31, 1999 $1,509,000 relating to such bridge loans was outstanding. On March 31, 1999 the total principal amount of the 2000 Galen Bridge Loans and accrued and unpaid interest were satisfied in full with a portion of the proceeds of the Watson Term. Prior to repayment, the 2000 Galen Bridge Loans accrued interest at the rate of 18% per annum and were secured by a first lien on all of the Company's assets. In consideration for the extension of the 2000 Galen Bridge Loans, the Company issued common stock purchase warrants to Galen to purchase an aggregate of 125,000 shares of the Company's common stock.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE H (CONTINUED)
The warrants issued pursuant to the 2000 Galen Bridge Loans have an exercise price equal to the fair market value of the Company's common stock on the date of issuance and are substantially identical to those issued by the Company in the Oracle Offering (Note G).
NOTE I- INCOME TAXES
The actual income tax expense varies from the Federal statutory rate applied to consolidated operations as follows:
The Company has net operating loss carryforwards aggregating approximately $58,796,146, expiring during the years 2011 through 2019. In addition, certain of the Company's subsidiaries filed separate Federal income tax returns in prior years and have separate net operating loss carryforwards aggregating approximately $4,062,758 expiring during the years 1999 through 2018.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE I (CONTINUED)
The tax loss carryforwards of the Company and its subsidiaries are subject to limitation by Section 382 of the Internal Revenue Code with respect to the amount utilizable each year. This limitation reduces the Company's ability to utilize net operating loss carryforwards included above each year. The amount of the limitation has not been quantified by the Company.
The components of the Company's deferred tax assets (liabilities), pursuant to SFAS No. 109, are summarized as follows:
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE I (CONTINUED)
SFAS No. 109 requires a valuation allowance against deferred tax assets if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets may not be realized. The valuation allowance at December 31, 1999 primarily pertains to uncertainties with respect to future utilization of net operating loss carryforwards.
NOTE J - CESSATION AND RELOCATION OF BROOKLYN, NY PLANT OPERATIONS
The Company's formal decision to discontinue its Brooklyn operations was initiated in the fourth quarter of 1999 with notification to its union. The total charge of approximately $3,220,000 resulting from eliminating the Brooklyn operation includes the lease termination payment of $1,150,000, a provision of $200,000 for plant repairs, the write-off of leasehold improvements of $1,778,000, severance and other costs for terminated employees of $730,000, less deferred rent previously expensed of $638,000.
At December 31, 1999 the Company was obligated to pay rent through December 31, 2005 pursuant to a noncancellable lease obligation for its facility in Brooklyn, New York. Under a termination and settlement agreement consummated on March 22, 2000 (the "Settlement Agreement"), in exchange for a termination payment of $1,150,000, the termination of the lease has been accelerated to August 31, 2000. The total base rent payments that would have been required from September 1, 2000 to December 31, 2005, were approximately $6,715,000. The agreement does allow the Company to continue to lease the facility beyond August 31, 2000, but requires the Company to vacate the premises no later than March 31, 2001. In addition, the Settlement agreement provides for the advance payment of rent through August 31, 2000 and a restoration escrow deposit of $200,000 for plant repairs. The Company also deposited in escrow with its counsel $390,600 which represents rental payments for the period September 1, 2000 through March 31, 2001. Such escrow amount will be returned to the Company in the event it vacates the Brooklyn facility on or prior to August 31, 2000. The Company funded the termination fee payment, the advance rental payment obligations and restoration amount required pursuant to the Settlement Agreement with the proceeds received from the Watson Term Loan (Note Q).
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE K - SALE AND ACQUISITION OF ABBREVIATED NEW DRUG APPLICATIONS ("ANDA")
Sale of ANDA
On March 21, 1995, the Company sold its ANDA for 5mg Oxycodone HCL/325mg Acetaminophen Tablets ("Tablets") and certain equipment used in the production of the tablets. Pursuant to the agreement the Company recognized the final portion of the gain, $1,900,000, as other income in March 1998.
Acquisition of Barr Laboratories, Inc. ANDA
On April 16, 1999, the Company completed an acquisition agreement with Barr Laboratories, Inc. ("Barr") providing for the Company's purchase of the rights to 50 pharmaceutical products (the "Barr Products"). Under the terms of the acquisition agreement with Barr, the Company acquired all of Barr's rights in the Barr Products, including all related governmental approvals (including ANDAs) and related technical data and information. In consideration for the acquisition of the Barr Products, the Company issued to Barr a common stock purchase warrant exercisable for 500,000 shares of the Company's common stock having an exercise price of $1.0625 per share (the fair value of the Common Stock on the date of issuance) and having a term of five years. The Company valued the warrants at $350,000 using the Black Scholes option pricing model. Accordingly, the Company recorded a deferred charge to be amortized as an expense to the Company's operations over a 10 year period which is the estimated life of the related ANDA. The acquisition agreement with Barr also allows Barr to purchase any of the Barr Products manufactured by the Company for a period of five years.
NOTE L - PENSION EXPENSE
1. Management Pension Plan
The Company had maintained a defined benefit plan covering substantially all nonunion employees which was terminated in November 1996. Subsequently, all Plan assets were converted to cash and held in a money market fund (to continue the Trust) from which all vested participant interests were to be paid. In 1998, the Company received approval to terminate the Plan by the Pension Benefit Guarantee Corporation, all assets were distributed to the vested participants, the Trust was terminated and a final filing was made with the Internal Revenue Service.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE L (CONTINUED)
2. Employees' Pension Plan
The Company contributed approximately $67,872, $421,000, and $407,000, in 1999, 1998 and 1997, respectively, to a multiemployer pension plan for employees covered by collective bargaining agreements. This plan is not administered by the Company and contributions are determined in accordance with provisions of negotiated labor contracts. Information with respect to the Company's proportionate share of the excess, if any, of the actuarially computed value of vested benefits over the total of the pension plan's net assets is not available from the plan's administrator.
The Multiemployer Pension Plan Amendments Act of 1980 (the "Act") significantly increased the pension responsibilities of participating employers. Under the provision of the Act, if the plans terminate or the Company withdraws, the Company could be subject to a "withdrawal liability."
NOTE M - STOCK OPTION PLAN
In June 1998, the stockholders of the Company approved the adoption of a stock option and restricted stock purchase plan (the "1998 Option Plan). The 1998 Option Plan provides for the granting of (i) nonqualified options to purchase the Company's common stock at not less than the fair market value on the date of the option grant and (ii) incentive stock options to purchase the Company's common stock at not less than the fair market value on the date of the option grant. As of December 31, 1999, there was no exercise of any options to purchase any common stock under the 1998 Option Plan. The total number of shares which may be sold pursuant to options and rights granted under the 1998 Option Plan is 3,600,000. No option can be granted under the 1998 Option Plan after April, 2008 and no option can be outstanding for more than ten years after its grant.
The Company has adopted the disclosure provisions of Statement of Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation." It applies APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans and does not recognize compensation expense for its stock-based compensation plans other than for restricted stock. If the Company had elected to recognize compensation expense based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed by SFAS No. 123, the Company's net income and earnings per share would be reduced to the pro forma amounts indicated below:
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE M (CONTINUED)
These pro forma amounts may not be representative of future disclosures because they do not take into effect pro forma compensation expenses related to grants made before 1995. The fair value of these options was estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for the years ended December 31, 1999, 1998 and 1997, respectively: expected volatility of 73%, 67%, and 65%; risk-free interest rates of 6.8%, 5.6%, and 6.0%; and expected lives of 10 years, 10 years, and 4 years. At the date of grant, all exercise prices equaled the market value of the stock.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair market estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE M (CONTINUED)
Transactions involving stock options are summarized as follows:
The following table summarizes information concerning currently outstanding and exercisable stock options:
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE N - COMMITMENTS
The Company occupies plant and office facilities under noncancellable operating leases which expire in December 2005. These operating leases provide for scheduled base rent increases over the term of the lease, however, the total amount of the base rent payments will be charged to operations using the straight-line method over the term of the lease. The leases provide for payment of real estate taxes based upon a percentage of the annual increase. In addition, the Company rents certain equipment under operating leases, generally for terms of four years. Total rent expense for the years ended December 31, 1999, 1998 and 1997 was approximately $1,574,000, $1,243,000, $884,000, respectively. See Note J for information relating to the shutdown of the Brooklyn, New York facility.
Lease of Congers, New York Facility
Effective March 22, 1999, the Company leased, as sole tenant, a pharmaceutical manufacturing facility located in Congers, New York (the "Congers Facility") from Par Pharmaceutical, Inc. ("Par") pursuant to an Agreement to Lease (the "Lease"). The Congers Facility contains office, warehouse and manufacturing space. The Lease provides for a term of three years, with a two-year renewal option and provides for annual fixed rent of $500,000 per year during the primary term of the Lease and $600,000 per year during the option period. The Lease also covers certain manufacturing and related equipment previously used by Par in its operations at the Congers Facility (the "Leased Equipment"). In connection with the execution of the Lease, the Company and Par entered into a certain Option Agreement pursuant to which the Company may purchase the Congers Facility and the Leased Equipment at any time during the lease term for $5,000,000.
As part of the execution of the Lease, the Company and Par entered into a certain Manufacturing and Supply Agreement (the "M&S Agreement") having a term of two years. The M&S Agreement provides for the Company's contract manufacture of certain designated products. The M&S Agreement also provides that Par will purchase a minimum of $1,150,000 in product during the initial 18 months of the Agreement. The M&S Agreement further provides that the Company will not manufacture, supply, develop or distribute the designated products to be supplied by the Company to Par under the M&S Agreement to or for any other person for a period of three years.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE N (CONTINUED)
As of December 31, 1999, the approximate minimum rental commitments under these operating leases are as follows:
Employment Contracts
During March 1998, the Company entered into employment contracts with each of two new officers/employees of the Company which cover a five-year and a three-year period, respectively. The contracts provide for, among other things: (i) annual salaries of $170,000 and $140,000 to be paid over the five-year and three-year periods, respectively and (ii) an aggregate of 1,300,000 options (included in the 1998 grants - Note M) to purchase the Company's stock at an exercise price of $2.38 per common share that vest evenly over a three-to-five-year service period and expire in ten years.
NOTE O - CONTINGENCIES
American Stock Exchange
The Company has been advised by the American Stock Exchange ("Amex") that the Amex has determined to delist the Common Stock of the Company (stock symbol "HDG") as it does not meet the Amex's criteria for continued listing. Such criteria include minimum levels of shareholders' equity and the absence of years of net losses from continuing operations. In response to the Amex notice, the Company has exercised its right to appeal the Amex's decision and has requested a formal hearing in order to further consider the decision. There can be no assurance that the Company's common stock will remain listed on the Amex. In the event the Company is unsuccessful in its appeal to maintain the listing of the Company's Common Stock on the Amex, it is anticipated that the Company's Common Stock will trade on the Over the Counter Bulletin Board. In such event, a shareholder may find it more difficult to dispose of, or to obtain accurate quotations as to the market value of the Common Stock.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE O (CONTINUED)
Department of Justice ("DOJ") Settlement
On June 21, 1993, the Company entered into a Plea Agreement with the DOJ to resolve the DOJ's investigation into the manufacturing and record keeping practices of the Company's Brooklyn plant. The Plea Agreement required the Company to pay a fine of $2,500,000 over five years in quarterly installments of $125,000, commencing on or about September 15, 1993.
As of February 28, 1998, the Company was in default of the payment terms of the Plea Agreement and had made payments aggregating $350,000. On March 27, 1998, the Company and the DOJ signed the Letter Agreement serving to amend the Plea Agreement relating to the terms of the Company's satisfaction of the fine assessed under the Plea Agreement. Specifically, the Letter Agreement provided that the Company will satisfy the remaining $2,150,000 of the fine through the payment of $25,000 on a monthly basis commencing June 1, 1998, plus interest on such outstanding balance (at the rate calculated pursuant to 28 U.S.C Section 1961)(currently 5.319%). Such payment schedule will result in the full satisfaction of the DOJ fine in December, 2005. The Letter Agreement also provides certain restrictions on the payment of salary or compensation to any individual in excess of $150,000 without the written consent of the DOJ. In addition, the Letter Agreement requires the repayment of the outstanding fine to the extent of 25% of the Company's after-tax profit or the remaining balance owed and 25% of the net proceeds received by the Company on any sale of a capital asset for a sum in excess of $10,000. At December 31, 1999, the Company is current in its payment obligations with a remaining obligation of $1,675,000.
Other Legal Proceedings
Beginning in 1992, actions were commenced against the Company and numerous other pharmaceutical manufacturers in the Pennsylvania Court of Common Pleas, Philadelphia Division, in connection with the alleged exposure to diethylstilbestrol ("DES"). The defense of all of such matters was assumed by the Company's insurance carrier, and a substantial number have been settled by the carrier. Currently, several actions remain pending with the Company as a defendant, and the insurance carrier is defending each action. Similar actions were brought in Ohio, and have been dismissed based on Ohio law. The Company and its legal counsel do not believe any of such actions will have a material impact on the Company's financial condition. The ultimate outcome of these lawsuits cannot be determined at this time, and accordingly, no adjustment has been made to the consolidated financial statements.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE O (CONTINUED)
The Company has been named as a defendant in one additional action which has been referred to the Company's carrier and has been accepted for defense. This action, Alonzo v. Halsey Drug Co., Inc. and K-Mart Corp. was commenced on November 5, 1995 and involves a claim for unspecified damages relating to the alleged ingestion of "Doxycycline 100." The ultimate outcome of these lawsuits cannot be determined at this time, and accordingly, no adjustment has been made to the consolidated financial statements.
NOTE P - SIGNIFICANT CUSTOMERS AND SUPPLIERS
The Company sells its products to a large number of customers who are primarily drug distributors, drugstore chains and wholesalers and are not concentrated in any specific region. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. During 1999, the Company had net sales to one customer in excess of 10% of total sales, aggregating 16.3% of total sales. During 1998, the Company had net sales to one customer in excess of 10% of total sales, accounting for 17.6% of total sales. During 1997, the Company had net sales to one customer in excess of 10% of total sales, aggregating 22.3% of total sales.
During 1999 and 1998, the Company purchased approximately $1,107,000 and $2,583,000, respectively, of its raw materials, representing approximately 15% and 29%, respectively, of total raw material purchases from one supplier.
NOTE Q - SUBSEQUENT EVENT - STRATEGIC ALLIANCE WITH WATSON PHARMACEUTICALS
On March 29, 2000, the Company completed various strategic alliance transactions with Watson Pharmaceuticals, Inc. ("Watson"). The transactions with Watson provided for Watson's purchase of a certain pending ANDA from the Company, for Watson's rights to negotiate for Halsey to manufacture and supply certain identified future products to be developed by Halsey, for Watson's marketing and sale of the Company's core products and for Watson's extension of a $17,500,000 term loan to the Company.
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE Q (CONTINUED)
The product acquisition portion of the transactions with Watson provided for Halsey's sale of a pending ANDA and related rights (the "Product") to Watson for aggregate consideration of $13,500,000 (the "Product Acquisition Agreement"). As part of the execution of the Product Acquisition Agreement, the Company and Watson executed ten year supply agreements covering the active pharmaceutical ingredient ("API") and finished dosage form of the Product pursuant to which Halsey, at Watson's discretion, will manufacture and supply Watson's requirements for the Product API and, where the Product API is sourced from the Company, finish dosage forms of the Product. The purchase price for the Product is payable in three approximately equal installments as certain milestones are achieved. Management expects the last of these milestones to be achieved by no later than the end of the second fiscal quarter of year 2000.
The Company and Watson also executed a right of first negotiation agreement providing Watson with a first right to negotiate the terms under which the Company would manufacture and supply certain specified APIs and finished dosage products to be developed by the Company. The right of first negotiation agreement provides that upon Watson's exercise of its right to negotiate for the supply of a particular product, the parties will negotiate the specific terms of the manufacturing and supply arrangement, including price, minimum purchase requirements, if any, territory and term. In the event Watson does not exercise its right of first negotiation upon receipt of written notice from the Company as to its receipt of applicable governmental approval relating to a covered product, or in the event the parties are unable to reach agreement on the material terms of a supply arrangement relating to such product within sixty days of Watson's exercise of its right to negotiate for such product, the Company may negotiate with third parties for the supply, marketing and sale of the applicable product. The right of first negotiation agreement has a term of ten years, subject to extension in the absence of written notice from either party for two additional periods of five years each. The right of first negotiation agreement applies only to API and finished dosage products identified in the agreement and does not otherwise prohibit the Company from developing other APIs or finished dosage products for itself or third parties.
The Company and Watson also completed a manufacturing and supply agreement providing for Watson's marketing and sale of the Company's existing core products portfolio (the "Core Products Supply Agreement"). The Core Products Supply Agreement obligates Watson to purchase a minimum amount of approximately $18,363,000 (the "Minimum Purchase Amount") in core products from the Company, in equal quarterly installments over a period of 18 months (the "Minimum Purchase Period"). At the expiration of the Minimum Purchase Period, if Watson does not continue to satisfy the
Halsey Drug Co., Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1999, 1998 and 1997
NOTE Q (CONTINUED)
Minimum Purchase Amount, the Company may market and sell the core products on its own or through a third party. Pending the Company's development and receipt of regulatory approval for its APIs and finished dosage products currently under development, including, without limitation, the Product sold to Watson, and the marketing and sale of same, of which there can be no assurance, substantially all the Company's revenues expect to be derived from the Core Products Supply Agreement with Watson.
The final component of the Company's strategic alliance with Watson provided for Watson's extension of a $17,500,000 term loan to the Company. The loan will be funded in installments upon the Company's request for advances and the provision to Watson of a supporting use of proceeds relating to each such advance. The loan is secured by a first lien on all of the Company's assets, senior to the lien securing all other Company indebtedness, carries a floating rate of interest equal to prime plus two percent and matures on March 31, 2003. | 19,047 | 123,323 |
39092_1999.txt | 39092_1999 | 1999 | 39092 | ITEM 1. BUSINESS
Friedman Industries, Incorporated (the "Company"), a Texas corporation incorporated in 1965, is in the steel processing and distribution business. The Company has two product groups: coil processing (steel sheet and plate) and tubular products.
Significant financial information relating to the Company's product and service groups for the last three years is contained in Note 6 of the Consolidated Financial Statements of the Company's Annual Report to Shareholders for the fiscal year ended March 31, 1999, which is incorporated herein by reference elsewhere in this report.
Coil Processing
The Company purchases domestic and foreign hot-rolled steel coils, processes the coils into steel sheet and plate and sells these products on a wholesale, rapid-delivery basis in competition with steel mills, importers and steel service centers. The Company also processes customer-owned coils on a fee basis. The Company has coil processing plants located at Lone Star, Texas, Houston, Texas and Hickman, Arkansas. At each plant, the steel coils are processed through a cut-to-length line which levels the steel and cuts it to prescribed lengths. The Company's processing machinery is heavy, mill-type equipment capable of processing steel coils weighing up to 25 tons. Coils are processed to the specifications required for a particular order. Shipments are made via unaffiliated truckers or by rail and, in times of normal supply and market conditions, can generally be made within 48 hours of receipt of the customer's order.
At its Lone Star facility, the Company purchases hot-rolled steel coils primarily from Lone Star Steel Company ("LSS"), which is located approximately four miles from the Company's plant. The Lone Star plant purchases its supply of steel from LSS and other suppliers at competitive prices determined at the time of purchase. During fiscal 1999 and 1998, the Company purchased approximately 69% and 77%, respectively, of its tonnage for the Lone Star facility from LSS and was able to purchase sufficient tonnage at competitive prices from other suppliers to meet the requirements of this facility. Loss of LSS as a source of coil supply could have a material adverse effect on the Company's business.
At its Houston facility, the Company warehouses and processes hot-rolled steel coils, which are generally purchased on the open market at competitive prices from importers, trading companies and domestic steel mills.
At the Company's Hickman facility, the Company warehouses and processes steel coils which are purchased primarily from Nucor Steel Company ("NSC"). NSC is located approximately one-half mile from the Hickman facility. Loss of NSC as a source of coil supply could have a material adverse effect on the Company's business.
At the Lone Star facility, the Company maintains three cut-to-length lines and a coil-to-coil 2-Hi temper pass mill. This equipment is capable of processing steel up to 84 inches wide and up to one-half inch thick. At the Houston facility, the Company has a cut-to-length line and a rolling mill that are capable of processing steel up to 90 inches wide and up to one-half inch thick. The Hickman facility operates a cut to length line which has 84 inch wide and one-half inch thick capacity. In April 1999, the Company completed the installation of a 2-Hi temper pass mill at the Hickman facility that is capable of processing steel up to 74 inches wide and one-half inch thick in a coil-to-coil mode or directly from coil to cut-to-length processing. The Company believes the temper pass process improves product quality which expands sales opportunities while reducing scrap loss.
Tubular Products
Through its Texas Tubular Products ("TTP") operation in Lone Star, Texas, the Company purchases, markets, processes (e.g., sorting, end-beveling, threading, etc.) and manufactures tubular products.
TTP employs various pipe processing equipment including threading and beveling machines, pipe handling equipment and other related machinery. This machinery can process pipe up to 13 3/8 inches in outside diameter.
The TTP operation includes a pipe mill that is capable of producing pipe from 2 3/8 inches to 8 5/8 inches in outside diameter. The pipe mill is API-licensed to manufacture line and oil country pipe and also manufactures pipe for structural and piling purposes that meets recognized industry standards. The Company currently manufactures and sells substantially all of its line and oil country pipe to LSS pursuant to orders received from LSS. In addition, LSS sells pipe to the Company for structural applications for some sizes of pipe that are beyond the capability of the pipe mill.
The Company purchases a substantial portion of its annual supply of pipe and coil material used in pipe production from LSS. The Company can make no assurances as to the amounts of pipe and coil material that will be available from LSS in the future. Loss of LSS as a source of supply or as a customer could have a material adverse effect on the Company's business.
Marketing
The following table sets forth the approximate percentage of total sales contributed by each group of steel products during each of the Company's last three fiscal years:
Coil Processing (Steel Sheet and Plate). The Company's coil processing products and services are sold to approximately 400 customers located primarily in the midwestern, southwestern and southeastern sections of the United States. The Company's principal customers for these products and services are steel distributors and customers fabricating steel products such as storage tanks, steel buildings, farm machinery and equipment, construction equipment, transportation equipment, conveyors and other similar products. During each of the fiscal years ended March 31, 1999, 1998 and 1997, six, nine and seven customers, respectively, accounted for approximately 25% of the Company's sales of coil processing products. No coil processing customer accounted for as much as 10% of the Company's total sales during those years.
The Company sells substantially all of its coil processing products through its own sales force. At March 31, 1999, the sales force was comprised of a manager and five professional sales personnel under the direction of the senior vice president of sales and marketing. Salesmen are paid on a salary and commission basis.
Shipments of particular products are made from the facility offering the product desired. If the product is available at more than one facility, other factors such as location of the customer, productive capacity of the facility and activity of the facility enter into the decision regarding shipments. The Company regularly contracts on a quarterly basis with many of its larger customers to supply minimum quantities of steel.
Tubular Products. Tubular products are sold nationally to approximately 310 customers. The Company's principal customers of these products are steel and pipe distributors, piling contractors and LSS. Sales of pipe to LSS accounted for approximately 6% of the Company's total sales in fiscal 1999.
The Company sells its tubular products through its own sales force comprised of a manager and three professional sales personnel under the direction of the senior vice president of sales and marketing. Salesmen are paid on a salary and commission basis.
Competition
The Company is engaged in a non-seasonal, highly competitive business. The Company competes with steel mills, importers and steel service centers. The steel industry, in general, is characterized by a small number of extremely large companies dominating the bulk of the market and a large number of relatively small companies, such as the Company, competing for a limited share of such market.
The Company believes that in times of normal supply and market conditions its ability to compete is dependent upon its ability to offer steel products at prices competitive with or below those of other steel suppliers, as well as its ability to provide products meeting customer specifications on a rapid delivery basis.
Employees
At March 31, 1999, the Company had approximately 135 full-time employees.
Executive Officers of the Company
The following table sets forth the name, age, officer positions and family relationships, if any, of each executive officer of the Company and period during which each officer has served in such capacity:
Dale Ray was elected a vice president in March 1994. Prior thereto, Mr. Ray was a plant manager at the Company's Lone Star facility for more than five years.
ITEM 2.
ITEM 2. PROPERTIES
The principal properties of the Company are described in the following table:
- ---------------
(1) All of the Company's owned real estate, plants and offices are held in fee and are not subject to any mortgage or deed of trust.
(2) The real estate lease is with LSS and its affiliate, Texas & Northern Railway, Inc., and expires August 31, 2010. The lease provides for monthly payments of $1,667 adjusted each January 1 for changes in the Consumer Price Index. The Company has an exclusive option to purchase this property during a period beginning December 29, 1998 and ending December 31, 2002.
(3) The office lease is with a nonaffiliated party, expires April 30, 2001, and provides for an annual rental of $24,672.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to, nor is its property the subject of, any material pending legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The Company's Common Stock is traded principally on the American Stock Exchange (Symbol: FRD).
Reference is hereby made to the sections of the Company's Annual Report to Shareholders for the fiscal year ended March 31, 1999, entitled "Description of Business -- Range of High and Low Sales Prices of Common Stock" and "Description of Business -- Dividends Declared Per Share of Common Stock", which sections are hereby incorporated herein by reference.
The approximate number of shareholders of record of Common Stock of the Company as of May 28, 1999 was 670.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Information with respect to Item 6 is hereby incorporated herein by reference from the section of the Company's Annual Report to Shareholders for the fiscal year ended March 31, 1999, entitled "Selected Financial Data".
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Information with respect to Item 7 is hereby incorporated herein by reference from the section of the Company's Annual Report to Shareholders for the fiscal year ended March 31, 1999, entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations".
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements and notes thereto of the Company included in the Company's Annual Report to Shareholders for the fiscal year ended March 31, 1999, are hereby incorporated herein by reference:
Consolidated Balance Sheets -- March 31, 1999 and 1998
Consolidated Statements of Earnings -- Years ended March 31, 1999, 1998 and 1997
Consolidated Statements of Stockholders' Equity -- Years ended March 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows -- Years ended March 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements -- March 31, 1999
Report of Independent Auditors
Information with respect to supplementary financial information relating to the Company appears in Note 7 -- Summary of Quarterly Results of Operations (Unaudited) of the Notes to Consolidated Financial Statements incorporated herein by reference above in this Item 8 from the Company's Annual Report to Shareholders for the fiscal year ended March 31, 1999.
The following supplementary schedule for the Company for the year ended March 31, 1999, is included elsewhere in this report.
Schedule II -- Valuation and Qualifying Accounts
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to Item 10 is hereby incorporated herein by reference from the Company's proxy statement in respect of the 1999 Annual Meeting of Shareholders, definitive copies of which are expected to be filed with the Securities and Exchange Commission on or before 120 days after the end of the Company's 1999 fiscal year.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information with respect to Item 11 is hereby incorporated herein by reference from the Company's proxy statement in respect of the 1999 Annual Meeting of Shareholders, definitive copies of which are expected to be filed with the Securities and Exchange Commission on or before 120 days after the end of the Company's 1999 fiscal year.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with respect to Item 12 is hereby incorporated herein by reference from the Company's proxy statement in respect of the 1999 Annual Meeting of Shareholders, definitive copies of which are expected to be filed with the Securities and Exchange Commission on or before 120 days after the end of the Company's 1999 fiscal year.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with respect to Item 13 is hereby incorporated herein by reference from the Company's proxy statement in respect of the 1999 Annual Meeting of Shareholders, definitive copies of which are expected to be filed with the Securities and Exchange Commission on or before 120 days after the end of the Company's 1999 fiscal year.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents included in this report
- ---------------
* Management contract or compensation plan.
Copies of exhibits filed as a part of this Annual Report on Form 10-K may be obtained by shareholders of record at a charge of $.10 per page. Direct inquiries to: Benny Harper, Senior Vice President -- Finance, Friedman Industries, Incorporated, P. O. Box 21147, Houston, Texas 77226.
(b) Reports on Form 8-K filed in the fourth quarter of fiscal 1999:
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Friedman Industries, Incorporated has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Houston, and State of Texas, this 28th day of June, 1999.
FRIEDMAN INDUSTRIES, INCORPORATED
By: /s/ JACK FRIEDMAN ---------------------------------- Jack Friedman Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated on behalf of Friedman Industries, Incorporated in the City of Houston, and State of Texas.
FRIEDMAN INDUSTRIES, INCORPORATED HOUSTON, TEXAS
ANNUAL REPORT ON FORM 10-K YEAR ENDED MARCH 31, 1999
ITEM 14(A)1 AND 2
LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
FORM 10-K
ITEM 14(A)1 AND 2
FRIEDMAN INDUSTRIES, INCORPORATED LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
The following financial statements of the Company are set forth herewith in response to Item 14(a)1 and 2 of this report.
Consolidated Balance Sheets -- March 31, 1999 and 1998
Consolidated Statements of Earnings -- Years ended March 31, 1999, 1998 and 1997
Consolidated Statements of Stockholders' Equity -- Years end March 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows -- Years ended March 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements -- March 31, 1999
Report of Independent Auditors
The following financial statement schedule of the Company is included in this report.
S-1-Schedule II -- Valuation and Qualifying Accounts
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FRIEDMAN INDUSTRIES, INCORPORATED
- ---------------
(A) Accounts and notes receivable written off.
S-1
EXHIBIT INDEX
- ---------------
* Management contract or compensation plan.
Copies of exhibits filed as a part of this Annual Report on Form 10-K may be obtained by shareholders of record at a charge of $.10 per page. Direct inquiries to: Benny Harper, Senior Vice President -- Finance, Friedman Industries, Incorporated, P. O. Box 21147, Houston, Texas 77226.
(b) Reports on Form 8-K filed in the fourth quarter of fiscal 1999:
None | 2,689 | 17,057 |
28917_1999.txt | 28917_1999 | 1999 | 28917 | ITEM 1. BUSINESS.
General
Dillard's, Inc. ("Company" or "Registrant") is an outgrowth of a department store originally founded in 1938 by William Dillard. The Company was incorporated in Delaware in 1964. The Company operates retail department stores located primarily in the southwest, southeast and midwest.
The department store business is highly competitive. The Company has several competitors on a national and regional level as well as numerous competitors on a local level. Many factors enter into competition for the consumer's patronage, including price, quality, style, service, product mix, convenience and credit availability. The Company's earnings depend to a significant extent on the results of operations for the last quarter of its fiscal year. Due to holiday buying patterns, sales for that period average approximately one-third of annual sales.
For additional information with respect to the Registrant's business, reference is made to information contained on page 12 under the headings "Net Sales," "Net Income," "Total Assets" and "Number of Employees - Average," and page 32 of the Report, which information is incorporated herein by reference.
Executive Officers of the Registrant
The following table lists the names and ages of all Executive Officers of the Registrant, the nature of any family relationship between them, and all positions and offices with the Registrant presently held by each person named. All of the Executive Officers listed below have been in managerial positions with the Registrant for more than five years, except for Robin Sanderford, Paul J. Schroeder, Jr. and Charles Unfried. Mr. Sanderford has been employed by the Registrant as Vice President since August 1998. From 1995 throught 1998, Mr. Sanderford was the President of the Southeast Division for Mercantile Stores, Company, Inc.("Mercantile"). From 1993 through 1995, he served as Vice President & director of real estate and long range planning for Mercantile. Mr. Schroeder has been employed by the Registrant as Vice President since January 1998. Prior to that employment, he was a Partner in St. Louis based, international law firm Bryan Cave, LLP specializing in labor and employment law. Mr. Unfried has been employed by the Registrant as Vice President since August 1998. Prior to 1998, Mr. Unfried was President of Mercantile Credit Services and and Mercantile Stores National Bank, both subsidiaries of Mercantile.
Name Age Position and Office Family Relationships
William Dillard, II 54 Director; Chief Executive Son of Officer William Dillard
Alex Dillard 49 Director; President Son of William Dillard
Mike Dillard 47 Director; Executive Son of Vice President William Dillard
H. Gene Baker 60 Vice President None
Joseph P. Brennan 54 Vice President None
G. Kent Burnett 54 Vice President None
Drue Corbusier 52 Director; Executive Daughter of Vice President William Dillard
David M. Doub 52 Vice President None
James I. Freeman 49 Director; Senior Vice None President; Chief Financial Officer
Randal L. Hankins 48 Vice President None
T. R. Gastman 69 Vice President None
Robin Sanderford 52 Vice President None
Paul J. Schroeder, Jr. 50 Vice President None
Burt Squires 49 Vice President None
Charles Unfried 52 Vice President None
ITEM 2.
ITEM 2. PROPERTIES.
All of the Registrant's stores are owned or leased from a wholly- owned subsidiary or from third parties. The Registrant's third- party store leases typically provide for rental payments based upon a percentage of net sales with a guaranteed minimum annual rent, while the lease terms between the Registrant and its wholly-owned subsidiary vary. In general, the Company pays the cost of insurance, maintenance and any increase in real estate taxes related to these leases. At fiscal year end there were 335 stores in operation with gross square footage of 55 million. The Company owned or leased from a wholly owned subsidiary a total of 243 stores with 39 million square feet. The Company leased 92 stores from third parties, which totaled 16 million square feet. For additional information with respect to the Registrant's properties and leases, reference is made to information contained in Notes 2, 14 and 12, "Notes to Consolidated Financial Statements," on pages 25, 26 and 30 of the Report, which information is incorporated herein by reference.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company has no material legal proceedings pending against it.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
With respect to the market for the Company's common stock, market prices, and dividends, reference is made to information contained on page 33 of the Report, which information is incorporated herein by reference. As of March 31, 1999, there were 5,281 record holders of the Company's Class A Common Stock and 10 record holders of the Company's Class B Common Stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Reference is made to information under the heading "Table of Selected Financial Data" on pages 12 and 13 of the Report, which information is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Reference is made to information under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operation" on pages 14 through 17 of the Report, which information is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Reference is made to information under the heading "Quantitative and Qualitative Disclosures About Market Risk" on page 16 of the Report which information is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Reference is made to the consolidated financial statements and notes thereto included on pages 19 through 31 of the Report, which are incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
A. Directors of the Registrant.
Information regarding directors of the Registrant is incorporated herein by reference to the information on pages 5 through 7 under the heading "Nominees for Election as Directors" and page 14 under the heading "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement.
B. Executive Officers of the Registrant.
Information regarding executive officers of the Registrant is incorporated herein by reference to Item 1 of this report under the heading "Executive Officers of the Registrant." Reference additionally is made to the information under the heading "Section 16(a) Beneficial Ownership Reporting Compliance" on page 14 in the Proxy Statement, which information is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Information regarding executive compensation and compensation of directors is incorporated herein by reference to the information beginning on page 8 under the heading "Compensation of Directors and Executive Officers" and concluding on page 11 under the heading "Compensation Committee Interlocks and Insider Participation" in the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference to the information on page 4 under the heading "Principal Holders of Voting Securities" and page 4 under the heading "Nominees for Election as Directors" and continuing through footnote 16 on page 7 in the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions is incorporated herein by reference to the information on page 14 under the heading "Certain Relationships and Transactions" in the Proxy Statement and to the information regarding Mr. Davis on page 11 under the heading "Compensation Committee Interlocks and Insider Participation" in the Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1)Financial Statements
The following consolidated financial statements of the Registrant and its consolidated subsidiaries included in the Report are incorporated herein by reference in Item 8 of this report.
Consolidated Balance Sheets - January 30, 1999 and January 31, 1998 Consolidated Statements of Income - Fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997 Consolidated Statements of Stockholders; Equity - Fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997 Consolidated Statements of Cash Flows - Fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997 Notes to Consolidated Financial Statements - Fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997 (a)(2)Financial Statement Schedules
The following consolidated financial statement schedule of the Registrant and its consolidated subsidiaries is filed pursuant to Item 14(d) (this schedule appears immediately following the signature page):
Schedule II - Valuation and Qualifying Accounts
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
(a)(3)Exhibits and Management Compensatory Plans Exhibits
The following exhibits are filed pursuant to Item 14(c):
Number Description
* 3(a) Restated Certificate of Incorporation (Exhibit 3 to Form 10-Q for the quarter ended August 1, 1992 in 1-6140) * 3(b) By-Laws as currently in effect. (Exhibit 3(b) to Form 10-K for the fiscal year ended January 30, 1993 in 1-6140) * 4(a) Indenture between the Registrant and Chemical Bank, Trustee, dated as of October 1, 1985 (Exhibit (4) in 2-85556) * 4(b) Indenture between the Registrant and Chemical Bank, Trustee, dated as of October 1, 1986 (Exhibit (4) in 33-8859) * 4(c) Indenture between Registrant and Chemical Bank, Trustee, dated as of April 15, 1987 (Exhibit 4.3 in 33-13534) * 4(d) Indenture between Registrant and Chemical Bank, Trustee, dated as of May 15, 1988, as supplemented (Exhibit 4 in 33- 21671, Exhibit 4.2 in 33-25114 and Exhibit 4(c) to Current Report on Form 8-K dated September 26, 1990 in 1-6140) * 4(e) Indenture between Dillard Investment Co., Inc. and Chemical Bank, Trustee, dated as of April 15, 1987, as supplemented (Exhibit 4.1 in 33-13535 and Exhibit 4.2 in 33- 25113) *10(a) Retirement Contract of William Dillard dated March 8, 1997 10(b) 1998 Incentive and Nonqualified Stock Option Plan *10(c) Corporate Officers Non-Qualified Pension Plan (Exhibit 10(c) to Form 10-K for the fiscal year ended January 29, 1994 in 1- 6140) *10(d) Senior Management Cash Bonus Plan (Exhibit 10(d) to Form 10-K for the fiscal year ended January 28, 1995 in 1-6140) 12 Statement Re: Computation of Ratio of Earnings to Fixed Charges 13 Incorporated portions of the Annual Stockholders Report for the fiscal year ended January 30, 1999 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors ____________ * Incorporated herein by reference as indicated.
Management Compensatory Plans
Listed below are the management contracts and compensatory plans which are required to be filed as exhibits pursuant to Item 14(c):
Retirement Contract of William Dillard dated March 8, 1997 1998 Incentive and Nonqualified Stock Option Plan Corporate Officers Non-Qualified Pension Plan Senior Management Cash Bonus Plan
(b) Reports on Form 8-K filed during the fourth quarter:
None
(c) Exhibits
See the response to Item 14(a)(3).
(d) Financial statement schedules
See the response to Item 14(a)(2).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dillard's, Inc. Registrant
/s/ James I. Freeman Date April 30,1999 James I. Freeman, Senior Vice President and Chief Financial Officer (Principal Financial & Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacity and on the date indicated.
/s/William Dillard /s/Drue Corbusier William Dillard Drue Corbusier Chairman Executive Vice President and Director
/s/Calvin N. Clyde, Jr. /s/Robert C. Connor Calvin N. Clyde, Jr. Robert C. Connor Director Director
/s/Will D. Davis /s/Alex Dillard Will D. Davis Alex Dillard Director President and Director
/s/Mike Dillard /s/William Dillard, II Mike Dillard William Dillard, II Executive Vice President and Chief Executive Officer Director and Director (Principal Executive Officer)
/s/James I. Freeman /s/William H. Sutton James I. Freeman William H. Sutton Senior Vice President and Chief Director Financial Officer and Director
/s/John Paul Hammerschmidt /s/William B. Harrison, Jr. John Paul Hammerschmidt William B. Harrison, Jr. Director Director
/s/Jackson T. Stephens /s/John H. Johnson Jackson T. Stephens John H. Johnson Director Director
/s/E. Ray Kemp E. Ray Kemp Director Date April 30,1999
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Dillard's, Inc. Little Rock, Arkansas
We have audited the consolidated financial statements of Dillard's, Inc. and subsidiaries (the "Company") as of January 30, 1999 and January 31, 1998, and for each of the three years in the period ended January 30, 1999, and have issued our report thereon dated March 15, 1999; such consolidated financial statements and report are included in your 1998 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedule of Dillard's, Inc. and subsidiaries, listed in Item 14. This consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as whole, presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
New York, New York March 15, 1999
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
DILLARD'S, INC. AND SUBSIDIARIES
(DOLLAR AMOUNTS IN THOUSANDS)
(1) Represents the allowance for losses on accounts acquired.
(2) Accounts written off and charged to allowance for losses on accounts receivable (net of recoveries).
EXHIBIT INDEX
Number Description
* 3(a) Restated Certificate of Incorporation (Exhibit 3 to Form 10-Q for the quarter ended August 1, 1992 in 1-6140) * 3(b) By-Laws as currently in effect (Exhibit 3(b) to Form 10-K for the fiscal year ended January 30, 1993, in 1-6140) * 4(a) Indenture between the Registrant and Chemical Bank, Trustee, dated as of October 1, 1985 (Exhibit (4) in 2-85556) * 4(b) Indenture between the Registrant and Chemical Bank, Trustee, dated as of October 1, 1986 (Exhibit (4) in 33-8859) * 4(c) Indenture between Registrant and Chemical Bank, Trustee, dated as of April 15, 1987 (Exhibit 4.3 in 33-13534) * 4(d) Indenture between Registrant and Chemical Bank, Trustee, dated as of May 15, 1988, as supplemented (Exhibit 4 in 33-21671, Exhibit 4.2 in 33-25114 and Exhibit 4(c) to Current Report on Form 8-K dated September 26, 1990 in 1-6140) * 4(e) Indenture between Dillard Investment Co., Inc. and Chemical Bank, Trustee, dated as of April 15, 1987, as supplemented (Exhibit 4.1 in 33-13535 and Exhibit 4.2 in 33-25113) *10(a) Retirement Contract of William Dillard dated March 8,1997 10(b) 1998 Incentive and Nonqualified Stock Option Plan *10(c) Corporate Officers Non-Qualified Pension Plan (Exhibit 10(c) to Form 10-K for the fiscal year ended January 29, 1994 in 1-6140) *10(d) Senior Management Cash Bonus Plan (Exhibit 10(d) to Form 10-K for the fiscal year ended January 28, 1995 in 1-6140) 12 Statement Re: Computation of Ratio of Earnings to Fixed Charges 13 Incorporated portions of the Annual Stockholders Report for the fiscal year ended January 30, 1999 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors __________________ * Incorporated herein by reference as indicated. | 2,544 | 16,587 |
1053888_1999.txt | 1053888_1999 | 1999 | 1053888 | Item 1 Business
Not Applicable
Item 2
Item 2 Properties
See the Annual Report filed pursuant to Item 14 Below.
Item 3
Item 3 Legal Proceedings
None
Item 4
Item 4 Submission Of Matters To A Vote Of Security Holders
None
Part II
Item 5
Item 5 Market For Registrant's Common Equity And Related Stockholder Matters
Each of the Certificates, representing investors' interests in the Trust, are represented by a single certificate registered in the name of Cede & Co., the nominee of The Depository Trust Company. Accordingly, Cede & Co. is the sole holder of record of the Certificates, which it held on behalf of approximately 22 brokers, dealers, banks and other direct participants in the DTC system at December 31, 1999.
To the best knowledge of the Registrant, there is no established public trading market for the Certificates.
Item 6
Item 6 Selected Financial Data
Not Applicable
Item 7
Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations
Not Applicable
Item 8
Item 8 Financial Statements and Supplementary Data
Not Applicable
Item 9
Item 9 Changes In And Disagreements With Accountants On Accounting and Financial Disclosure
None
Part III
Item 10
Item 10 Directors and Executive Officers of the Registrant
Not Applicable
Item 11
Item 11 Executive Compensation
Not Applicable
Item 12
Item 12 Security Ownership Of Certain Beneficial Owners and Management
Each of the Certificates, representing investor's interests in the Trust, are represented by a single certificate registered in the name of Cede & Co., the nominee of the Depository Trust Company("DTC"), and an investor holding an interest in the Trust is not entitled to receive a Certificate representing such interest except in certain limited circumstances. Accordingly, Cede & Co. is the sole holder of record of the Certificates, which it held on behalf of approximately 22 brokers, dealers, banks and other direct participants in the DTC system at December 31, 1999. Such direct participants may hold Certificates for their own accounts or for the accounts of their customers. The following table sets forth, with respect to each of the Certificates, the identity of each direct DTC participant that holds positions in such Certificate in excess of 5% of the outstanding principal amount thereof at December 31, 1999.
$ 230,065,034.95 5.91% Auto Receivables Backed Certificates
Aggregate Amount of Percent Name Certificates Held of Class Bankers Trust Company 59,850,000 26.01% Boston Safe Deposit & Trust Co. 12,010,000 5.22% Chase Manhattan Bank, N.A. 52,185,000 22.68% Mercantile Bank of ST. Louis N.A. 15,000,000 6.52% State Street Bank and Trust Co. 38,675,000 16.81%
The address of each of the above participants is:
C/O The Depository Trust Company 7 Hanover Square, 22nd Floor New York, NY 10004
Item 13
Item 13 Certain Relationships and Related Transactions
None
Part IV
Item 14
Item 14 Exhibits, Financial Statement Schedules and Reports On Form 10-K
(a) The following documents are filed as part of this Report:
i) Summary of annual distributions on the Certificates to Certificateholders for the year ended December 31, 1999
ii) Annual Accountant's Report dated October 20, 1999 and related Report of Management dated October 20, 1999 relating to sufficiency of accounting controls.
No proxy soliciting material has been distributed by the Trust.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Chevy Chase Auto Receivables Trust 1997-4 By: Chevy Chase Bank, F.S.B. Originator of the Trust and Servicer
Date: 03/31/2000 By: _________________________________________ Joel A. Friedman Senior Vice President and Controller | 600 | 3,813 |
1041829_1999.txt | 1041829_1999 | 1999 | 1041829 | ITEM 1. BUSINESS - Plan of Operations.
Petroleum Exploration Permit PEP 38328 (40.0%)
The participants in the permit are the Registrant (40.0%), Trans-Orient Petroleum Ltd. (22.5%) and Boral Energy Resources Limited (37.5%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (62.5%). The Registrant is the operator. The permit area is 785,000 acres (1,226 square miles). The permit was granted on July 1, 1996.
The conditions of the first year of the permit were satisfied by drilling the Kereru-1 well in 1996 which recorded some gas shows, but was plugged and abandoned without testing.
Through the past acquisition of nearly 200 miles of new seismic, reprocessing of over 200 miles of existing seismic and the completion of a variety of geological studies, a number of exploration leads and prospects have been identified. These include an anticline feature in the north of PEP 38328 (the MaiMai Prospect), anticlinal features in the coastal area around and south of Napier (the Napier Lead, the Whakatu Prospect and the Haumoana Lead), and several features near the border of the two permits (the Rosearl Leads).
During the year the Registrant and its partners concentrated their exploration efforts within this permit on three prospects: the Napier, Whakatu and Mai Mai by collecting 25 miles of new seismic data over these areas. Subsequent processing and mapping of the seismic confirmed the Whakatu Prospect, located near the city of Hastings, as a drillable prospect with the other prospects also considered as possible future drilling sites. . The Whakatu-1 well was then drilled during January and February 2000 to test a large anticlinal structure located near the city of Hastings The well was drilled to a total depth of 4800 feet; and although there were some hydrocarbon indications during drilling, electric logging of the well did not reveal any reservoir zones worthy of flow testing, The. Whakatu-1 well was, therefore, plugged and abandoned in early February. The permit area has ongoing exploration potential, and other prospects and leads will be reviewed in the light of the results of Whakatu-1 before any further exploration program is defined.
Current gas consumption in this area is around 2.5 billion cubic feet per annum. This is supplied by an eight inch pipeline from the Taranaki area on the west coast of the North Island (220 miles from Hastings). This pipeline passes through the center of the PEP 38328 permit and the adjacent PEP 38332 permit area, giving Indo-Pacific excellent access to the national gas pipeline infrastructure as well as close proximity to the local market.
The drilling of the Whakatu-1 well fulfills all permit obligations to June 2001.
An operating agreement has been entered into among the participants. Among other things, the operating agreement provides that a participant may not sell, assign, transfer, mortgage, pledge, charge, encumber, lease, sub-lease, declare itself trustee of or otherwise dispose of or create a charge or encumbrance over all or part of its participating interest except to a "related body corporate" as that expression is defined in the Companies Act (NZ) if that related body corporate holds the participating interest for at least one year without either the consent of the other participants or first offering the participating interest proposed to be dealt with to the other participants.
For work planned to be done before December 31, 2000 on PEP 38328 and its estimated cost See ITEM 1. BUSINESS-Plan of Operations.
Petroleum Exploration Permit PEP 38332 (42.5%)
PPL 38332 was granted on June 24, 1997. The other participants are Trans-Orient Petroleum Ltd. (20.0%) and Boral Energy Resources Limited. (37.5%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (62.5%).The Registrant is the operator. The permit area is situated immediately south of PEP 38328 and is 999,700 acres in area.
Through the past acquisition of nearly 68 miles of new seismic, reprocessing of over 100 miles of existing seismic and the completion of a variety of geological studies, a number of exploration leads and prospects have been identified. During the year, the Registrant and the other participants acquired a further 43 miles of seismic data over the Tukipo Lead and other areas.. Subsequent processing and mapping of the seismic have ruled out the Tukipo Lead as a favorable drilling prospect. The Boar Hill Prospect which has been defined by earlier seismic mapping is being considered as a possible drilling target by the permit participants, as also are a number of seismic and surface geology leads, including Speedy, Waewaepa and Oparae A further four mile seismic line was acquired over Speedy in January 2000, and confirmed a closed structure, which is now being considered for drilling to about 3000 feet depth in mid 2000.
The Registrant and the other participants have completed the work program required for the first two and a half years, and have made the permit commitment required by December 24, 1999 to drill one exploration well prior to June 24, 2000, or surrender the permit. Other participants may be sought to fund drilling.
An operating agreement is being negotiated. Before execution of an operating agreement, the participants proceed in accordance with local industry conventions. Among other things, the operating agreement will provide that a participant may not sell, assign, transfer, mortgage, pledge, charge, encumber, lease, sub-lease, declare itself trustee of or otherwise dispose of or create a charge or encumbrance over all or part of its participating interest except to a "related body corporate" as that expression is defined in the Companies Act (NZ) if that related body corporate holds the participating interest for at least one year without either the consent of the other participants or offering the participating interest proposed to be dealt with to the other participants.
For work planned to be done before December 31, 2000 on PEP 38332 and its estimated cost see ITEM 1. BUSINESS-Plan of Operations.
New Zealand, Onshore Canterbury Basin, South Island
Petroleum Exploration Permit 38256 (35.0%)
The Canterbury Basin is located both onshore and offshore in the area surrounding Christchurch, on the east coast of the South Island. The total area of the Canterbury Basin is about twelve million acres with the 2,760,120 acre (4,312.7 square miles) PEP 38256 covering most of
the onshore area. The sediments in the Canterbury Basin range in age from Early Cretaceous to Quaternary. The participants in this permit are the Registrant (35%), Trans-Orient Petroleum Ltd. (35%) and AMG Oil Ltd. (30%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (70.0%).
PEP 38256 was granted on August 25, 1997 to the Registrant and to Trans-Orient Petroleum Ltd. The Registrant and Trans-Orient Petroleum Ltd. agreed to assign an interest of 20% to AMG Oil Ltd. (formerly Trans New Zealand Oil Company) and an interest of 10% to Gondwana Energy Ltd. This latter transaction was cancelled January 31, 1998. The Registrant is the operator.
The participants have completed all seismic acquisition requirements to February 25, 2000. The participants are required by August 25, 2000 to drill an exploration well to the lesser of 1,200 meters (3,940 feet) or economic basement.
An operating agreement dated June 25, 1998 has been entered into. Among other things, the operating agreement provides that a participant may not sell, assign, transfer, mortgage, pledge, charge, encumber, lease, sub-lease, declare itself trustee of or otherwise dispose of or create a charge or encumbrance over all or part of its participating interest except to a "related body corporate" as that expression is defined in the Companies Act (NZ) if that related body corporate holds the participating interest for at least one year without either the consent of the other participants or offering the participating interest proposed to be dealt with to the other participants.
The Registrant and Trans-Orient Petroleum Ltd. by agreement dated June 25, 1998 optioned up to 80% of the permit to AMG Oil Ltd. In August 1998 AMG Oil Ltd. earned 30% of the permit by paying the cost of a 120 mile seismic survey. To earn an additional 50%, AMG was required to elect before December 4, 1998 to pay the cost of any additional seismic required to define two drilling prospects and to pay the dry hole costs of drilling two wells to a maximum of about US$2,100,000. The option agreement was modified by three subsequent agreements dated December 3, 1998, October 26, 1999 and February 23, 2000 which extended the period of time in which the AMG must exercise its option to acquire up to a further 50% interest in the 38256 permit area to June 16, 2000. Additionally, the February 23, 2000 amendment provided AMG with a choice of committing to: ( Option A') to earn an additional 50% in PEP 38256 from the Registrant by funding all expenditure including an agreed program of seismic work leading up to and including the drilling of two exploration wells. Alternatively, AMG may, at its election, earn an additional 35% the Registrant in the permit by funding all work leading up to and including the drilling of one exploration well ( Option B'). In the event that the AMG exercises Option B, it shall acquire a further option ( Option C') to earn an additional 15% in the permit by funding all further work up to and including a second exploration well on a separate exploration target. Option C must be exercised within 30 days of reaching the predetermined target depth in the exploration well drilled pursuant to exercise of Option B.
In February 1999, The Registrant and its joint venture partners completed a 165 mile 2D seismic program as a second stage follow up survey to the joint venture's earlier 120 mile seismic survey. The second phase of seismic surveys were paid solely by AMG Oil Ltd. Field sampling and laboratory analysis has identified several potential source and reservoir rock sequences.
The participants have completed the interpretation and mapping of the recently acquired seismic, and a further 112 miles of seismic were acquired in March 2000 to further define the Ealing and Arcadia Prospects and the Chertsey South Lead for drilling in late 2000.
The Arcadia Prospect is a well defined four-way dip closed anticline in excess of 8000 acres as mapped at Oligocene level. The main targets are the Mt Brown Limestone at approximately 2,100 ft, Homebush Sandstones at 3,800 ft and Broken River Formation sandstones at 4,500 ft.
The Ealing Prospect is a large paleo-drape structure which is augmented by monoclinal flexure above a reactivated basement fault on its northern margin. The main targets are the Homebush and Broken River Sandstones.
For work planned to be done before December 31, 2000 on PEP 38256 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
Petroleum Exploration Permit PEP 38339, Cook Strait (50.0%)
PEP 38339 was granted on November 26, 1998 to the Registrant. The permit area encompasses onshore portions of the South Island and offshore portions of Cook Strait lying between the North and South Islands. The participants in this permit are the Registrant (50%) and Trans-Orient Petroleum Ltd. (50%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (100.0%).The Registrant is the operator.
The permit area is approximately 815,400 acres and encloses the southern part of a Miocene-Pliocene basin formed in response to movement along the Alpine Fault and associated plate boundary faults. No wells have been drilled and there is no previous onshore seismic data. However, surface geological mapping has identified the Blind River Anticline as a focus of exploration.
Before February 26, 2000 the participants are required to reprocess available offshore seismic data and collect additional gravimetric data, conduct rock sampling and evaluate the database to define the basin structure and identify prospects and leads for further evaluation. Before November 26, 2000, the participants are to collect and interpret a minimum of 12 miles of onshore seismic data and 30 miles of offshore seismic data. Any additional seismic data required to identify a drilling prospect is to be collected by May 2001 and a well is to be drilled before November 26, 2001. A work program for the remainder of the permit is then to be submitted for approval.
The initial focus of exploration on this permit has been the onshore Blind River Anticline, a feature that BP geologists mapped as an area of interest several decades ago. The Registrant. acquired 15 miles of new seismic data over the Blind River area in March 1999. The data was of poor quality, which has hindered interpretation. Further geological and geophysical work is being considered.
For work planned to be done before December 31, 2000 on PEP 38339 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
New Zealand, Onshore Taranaki Basin, North Island
The Taranaki Basin is located on the west coast of the North Island. The sediments in the Taranaki Basin range in age from Late Cretaceous to the Quaternary and encompass a depth of some 25,000 feet with complex structure and geology. Compression across the eastern portion of the Basin during the early Miocene period created a thrusted fold belt up to ten miles wide, which contains the McKee, Tariki, Ahuroa and Waihapa-Ngaere fields. Further west in the onshore region are the fault bounded Kapuni, Ngatoro and Kaimiro fields. All these fields are currently in production.
Petroleum Mining Permit PMP 38148 (5.0%)
Effective September 1, 1996 the Registrant bought the outstanding shares of Minora Energy (New Zealand) Limited for AUS$575,000 (CDN$478,755, US$348,790). The name of the company was changed to Ngatoro Energy Limited. Ngatoro Energy Limited owns a five percent participating interest and revenue interest in petroleum mining permit 38148, which has six producing oil wells and one producing gas well.
The permit area is 9,400 acres. The permit expires on December 23, 2010. Production is from turbidite sandstones of the Mount Messenger Formation at depths of 1,500 metres to 2,000 metres. The other participants are New Zealand Oil & Gas Ltd. (35.43%) and Fletcher Challenge Energy Taranaki Ltd. (59.57%). New Zealand Oil & Gas Ltd. is the operator. The Crown in right of New Zealand has reserved a royalty of the greater of five per cent of net sales revenue from the sale of petroleum products or 20% of accounting profits.
Oil and gas production and sales revenue during the Registrant's last three fiscal years:
Oil Sales Oil Revenue Gas Sales Gas Revenue Year (bbl) (US$) (000 scf) (US$)
1997 26,556 487,941 [1] 1998 20,628 224,921 27,688 9,247 1999 19,786 302,064 38,605 12,634
[1] To August 1998 gas was flared.
The Registrant entered into an oil sales contract dated November 9, 1997 with Fletcher Challenge Energy Taranaki Limited and a gas sales contract dated February 18, 1998 with Fletcher Challenge Energy Limited. Under the oil sales contract, the Registrant sells its share of production from the field at the monthly average of the mean of the Asian Petroleum Price Index published in Hong Kong. The agreement may be terminated on 30 days' notice on the occurrence of certain events. Gas sales began in the third quarter of 1998.
A workover of the Ngatoro-1 well was completed successfully in mid-June 1999, adding approximately 280 barrels of oil per day to production. The joint venture participants have also approved workovers of the Ngatoro-9, Ngatoro-11 and Ngatoro-1 production wells which should add at least 100 barrels of oil per day to production. At the 1999 year end, production from the field was averaging approximately 1100 barrels of oil per day and 2.6 million cubic foot of gas per day. Drilling of two new wells to test separate oil prospects is being considered.
For work planned to be done before December 31, 2000 on PMP 38148 and its estimated cost see ITEM 1. BUSINESS-Plan of Operations.
Petroleum Prospecting License PEP 38736 (100%)(includes the area formerly held under PPL 38706)
The Registrant has a 100% participating interest in Petroleum Exploration Permit 38736 ("PEP 38736") which was granted on July 14, 1999. The Registrant had a 7.75% participating interest in Petroleum Prospecting License 38706 ("PPL 38706") with Fletcher Challenge Energy Ltd. ("Fletcher Challenge"), as the operator, holding the remaining 92.25% participating interest. PPL 38706 required the participants to complete a work program including reprocessing 300 kilometers of seismic data by July 31, 1999 and drilling one exploration well by July 31, 2000. However, Fletcher Challenge relinquished its interest in PPL 38706 and as a result, the Registrant was permitted to add the acreage of PPL 38706 as part of PEP 38736, subject only to a slight increase in the work program required under PEP 38736.PEP 38736 now requires the Registrant to complete a work program including the following
i) prior to January 14, 2002, acquire, process and interpret eight kilometers of seismic data or equivalent 3D seismic data, reprocess ten kilometers of seismic data, and either commit to complete the next stage of the work program detailed below in (ii) or surrender the permit; and
ii) prior to July 14, 2002, drill one exploration well and either commit to a satisfactory work program for the remainder of the permit term or surrender the permit.
At December 31, 1999, PEP 38736 is in good standing with respect to its work commitments. For work planned to be done before December 31, 2000 on PEP 38706 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
Petroleum Exploration Permit PEP 38716 (23.8%)
PEP 38716 was granted on January 30, 1996. The participants are the Registrant (23.8%), Marabella Enterprises Ltd. (29.6%), Euro-Pacific Energy Pty. Ltd. (6.6%), Australia Worldwide Exploration NL (25.0%) and Antrim Energy Ltd. (15%).
PEP 38716 is situated in the eastern margin of the onshore Taranaki Basin and covers an area of approximately 67,000 acres. It is located adjacent to the Waihapa-Ngaere oil and gas field. The gathering station for the Waihapa-Ngaere oil and gas field is located within a few miles of the boundary of PEP 38716. The area consists of gently rolling hills with rural agriculture being the main activity. Previous exploration of PEP 38716 has resulted in the collection of several hundred miles of seismic data, and the drilling of several wells, all of which had oil shows. The Crown Prospect is located in the northern part of PEP 38716. The main target horizons in the Crown Prospect were prognosed as the Tikorangi limestones, at an estimated depth near 9,000 feet and the Tariki sandstones below about 11,500 feet, while Kapuni Group sandstones are expected to be encountered below 12,500 feet. The Crown Prospect was interpreted as a thrust block anticline, somewhat similar in geological style and size to the nearby Waihapa oil field.
On March 31, 1999, drilling of the Huinga-1 well on the Crown Prospect commenced. The Huinga-1 well was drilled to a total depth of 13,000 feet in order to test several target zones. The well was plugged and suspended as in order to allow a reassessment of the prospect, given that the geology drilled so far is somewhat different to that expected.
South of the Crown Prospect lies the Oru Prospect which targets the Miocene sandstones of the Mount Messenger Formation at depths of less than 5,000 feet. This is considered to be a secondary target within the permit area. The Waihapa-8 well, drilled on the very edge of the Oru structure, flow tested oil from the target sandstones at rates in excess of 750 barrels per day. Oru Prospect is a potential future drilling target.
For work planned to be done before December 31, 2000 on PEP 38716 and its estimated cost see ITEM 1. BUSINESS-Plan of Operations.
Petroleum Exploration Permit PEP 38720 (50.0%)
PEP 38720 was granted on September 2, 1996. The participants in this permit are the Registrant (50%) and Trans-Orient Petroleum Ltd. (50%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (100.0%).The permit is approximately 6,322 acres in area.The Registrant has completed the work program of seismic data collection, seismic reprocessing and modeling and reservoir engineering studies on offset wells required for the first two and a half years. The remaining work program required the Registrant to drill one exploration well prior to September 2, 1999 and either commit to a satisfactory work program for the remainder of the permit term or surrender the permit. The Clematis-1 well was spudded in early December 1999 to test the shallow potential of the Waitoriki
Structure. Clematis 1 well reached its Target Depth of 5900 feet on December 20, 1999. Following a review of electric logs from the well, the decision was made to plug and abandon the well, as it was not considered that any zones would flow hydrocarbons at commercially viable rates. At some later date, the structure's major gas potential in the deeper play zones to 13,000-foot depth are planned to be tested with a deep well.
An agreement has been entered into with Westech Energy (NZ) Ltd. whereby the Registrant will contribute NZ$50,000 to the cost of a 3D seismic survey which covers an area including about 1000 acres in the south of PEP 38720, for which the Registrant will receive approximately 2000 acres of 3D seismic data covering an area including that within PEP 38720. This survey was acquired in February 2000.
For work planned to be done before December 31, 2000 on PEP 38720 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
Petroleum Exploration Permit PEP 38723 (80%)
PEP 38723 was granted on October 30, 1997. The other participants in this permit are Trans-Orient Petroleum Ltd. (40%) and Gondwana Energy Ltd. (20.0%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (80.0%).The Registrant is the operator. The permit is 19,783 acres in area.
The Registrant and the other participants have completed the work program required, which included reprocessing and interpreting a minimum of 30 miles of seismic data. On June 2, 1999, the Ministry approved a change in conditions of the Permit such that the remaining work program requires the participants to collect a minimum of 5 miles of 2D seismic data prior to April 30, 2000 and either commit by April 30, 2000 to drill an exploration well by October 30, 2000 or surrender the permit. The Registrant has committed to the new stage of the seismic, which will be acquired in April 2000 over the Ratapiko Prospect. The Ratapiko Prospect is a combination trap with the main target being Mt Messenger sandstones between 3,500 and 4,600 ft.
For work planned to be done before December 31, 2000 on PEP 38723 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
AUSTRALIA
Offshore exploration permits granted in Australia provide for the exclusive right to explore for petroleum for an initial term of six years, renewable for an unlimited number of five-year terms over one-half of the remaining area at each renewal. The participants are allowed to exceed the committed work programs for the permits or apply for extensions or reductions of such work programs for any particular year. Any production permits granted will be for a term of 21 years from the date of issue, renewable for a further 21 years. In addition to general Australian taxation provisions, most offshore permits, including all of the Company's Australian permits, are subject to
Petroleum Resource Rent Taxation at the rate of 40% on a project's net income after deduction of allowable project and exploration expenditures, with undeducted exploration expenditures compounded forward at the Long-Term Bank Rate ("LTBR") plus 15% and project expenditures at LTBR plus 5%.
Offshore Petroleum Exploration Permit Ashmore Cartier AC/P19 (65.0%), Timor Sea
A participating interest of 65.0% was acquired by the Registrant in AC/P19 in May, 1997. The other participant is Mosaic Oil NL (35.0%). The Registrant is the operator.
The AC/P19 Permit is approximately 364,500 acres and is located across the southern Ashmore Platform and Cartier Trough area in the Timor Sea. Fan sands are one reservoir objective, similar to those found in the Tenacious-1 well to the southeast of the permit. The Registrants earlier acquired the Corvus 2D seismic data, which has detailed the Ursa Prospect as a potential Plover Sands trap covering an area of up to 5,000 acres.
The Ursa Prospect's expected main reservoir, Middle Jurassic Plover Formation sandstones, are both sourced and sealed by organic-rich Oxfordian/Kimmeridgian syn-rift shales and mudstones of the Lower Vulcan Formation. The Plover sands are a proven high quality producer at Jabiru and other nearby fields.
By an agreement dated August 12, 1997 the participants granted an interest to Lonman Pty. Ltd. which is 5% of the premium obtained in farmout of the first well in the permit, unless previously converted to an equivalent participating interest by repayment of past costs. Upon commencement of production, there shall be reimbursement of past costs related to the carried interest payable out of 50% of attributable, net production revenue.
The Company has also committed to purchase20 sq. miles of 3D seismic from PGS Ltd. to further define prospects and identify new leads.
For work planned to be done before December 31, 2000 on AC/P19 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
Petroleum Permit Area AC/P31 (65%),
On September 12, 1999, the Northern Territory Department of Mines and Petroleum formally awarded permit AC/P31 in the Timor Sea to the Registrant as Operator (65%) and Mosaic Oil NL (35%). The permit, of approximately 18,000 acres, is adjacent to the much larger AC/P19, and is being explored in conjunction with the program in AC/P 19.
AC/P31 is awarded for six years subject to the Registrant fulfilling the following minimum work requirements:
(i) in the first year, these work requirements comprise the purchase of geological and geophysical data and the completion of geological and geophysical studies;
(ii) in the second year, they comprise the reprocessing of 18 miles of 2D seismic data and completion of AVO and pre-stack depth migration studies over a test line;
(iii) in the third year, they comprise the acquisition of 12 miles of new 2D seismic and their integration into and interpretation of the existing database;
(iv) in year four, the obligation is to acquire 12 miles of new 2D seismic to high grade prospects, and
(v) in the fifth year the participants must conduct a re- evaluation and re-interpretation of seismic data and prior to September 12, 2005, one exploration well must be drilled.
For work planned to be done before December 31, 2000 on AC/P31 and its estimated cost, see ITEM 1. BUSINESS-Plan of Operations.
Permit AC/P26, Offshore Bonaparte Basin,
Permit AC/P26 was granted under the Petroleum (Submerged Lands) Act 1967 on February 25, 1997 for a term of six years. The participants in the permit are the Trans-Orient Petroleum Ltd. (35.0%), West Oil N.L. (30.0%) and Mosaic Oil N.L. (35.0%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (35.0%). Mosaic Oil N. L. is the operator. The permit is situated in the Timor Sea on the eastern flank of the oil-rich Vulcan Graben, about 120 miles offshore from the Western Australia coastline and is administered by the state government of the Northern Territory, Australia. The water depth is about 300 feet. The permit area is 101,250 acres.
The Vulcan Basin is a northeast-trending, fault bounded to the northwest and the southeast by the high blocks of the Ashmore Platform and the Londonderry High. The basin is characterized by several prominent troughs and a horst and graben terrain. The grabens lie in an echelon distribution along the flanks of the basin. Pre-rift, rift, sag and collision phases are recognized in the structural and stratigraphic development of the area. Up to 30,000 feet of Upper Permian to Cenozoic sediments occur in the Basin. For the most part, Jurassic sediments are not present on the Londonderry High and Ashmore Platform.
Nearby commercial oil fields include the Jabiru, Challis and Skua oil fields with combined reserves of approximately 200 million barrels of oil. These have been profitable producers using low cost FPSO (floating production, storage and offloading) technology which enables profitable production even at low oil prices. Other mostly uneconomic discoveries including the Montara, Bilyara and Tahbilk (oil and gas) discoveries west of the permit area and the Talbot oil field adjacent to the permit area. Petroleum discoveries in the region have been made in Triassic and Lower to Mid Jurassic sandstones.
The occurrence of hydrocarbons at the Skua, Montara and Talbot fields has proved that hydrocarbons have been generated in this region. Migration pathways from potential Lower Cretaceous and upper Jurassic source shales can be traced on existing tectonic and detailed structural maps out of the Skua Trough and Northern Browse Basin into the permit area.
By an agreement dated May 5, 1998 the participants granted an interest to Lonman Pty. Ltd. which is 5% of the premium obtained in farmout of the first well in the permit, unless, previously converted to an equivalent participating interest by repayment of past costs. Upon commencement of production, there shall be reimbursement of past costs related to the carried interest payable out of 50% of attributable net production revenue.
The participants in the permit have completed the work program required for the first and second years. The remaining work program requires the participants to complete the following:
i) prior to February 25, 2001, drill one exploration well;
ii) prior to February 25, 2002, complete a work program which includes acquiring 100 kilometers of new 3D seismic data, or purchase of existing 3D data, or surrender the permit;
iii) prior to February 25, 2003, complete a work program which includes interpreting seismic data to define prospects, or surrender the permit; and
iv) prior to February 25, 2004, drill a second exploration well, or surrender the permit.
Two hydrocarbon traps along trend from the Talbot oil field have been identified and mapped from interpretation of a100 square mile 3D seismic survey purchased in 1998. Several other leads have been identified from interpretation of 2D seismic data, including a stratigraphic trap in the east of the permit. A large fault trap, the Rossini Prospect, has been identified as the most attractive drilling target. Presentations of the results at various industry forums are being conducted with a view to securing a farm out with third parties to fund the drilling of an exploration well, planned for late 2000.
An industry standard operating agreement is near finalization. Before execution of an operating agreement, the participants proceed in accordance with local industry conventions.
For work planned to be done before December 31, 2000 on AC/P26 and its estimated cost, see Item 1. Business- Plan of Operations.
Timor Gap Zone of Cooperation
Zone of Cooperation Area A Block 96-16, Australia and Indonesia
Trans-Orient Petroleum Ltd. acquired a 33 1/3% interest in a venture to explore the Zone of Cooperation Area A Block 96-16 ("ZOCA 96-16") in the Timor Gap Zone of Cooperation located between Australia and Indonesia. The permit area was originally 670,000 acres, however, pursuant to the terms of the permit grant, the participants were required to relinquish 25% of the permit area in November 1999. The other participants in ZOCA 96-16 are Norwest Energy N.L., as operator (33.33%) and West Oil N.L. (33.33%). The participants have entered into an agreement with Phillips Petroleum Ltd. which provides that Phillips will fund the drilling and testing of an exploration well on the Coleraine Prospect in the western part of the permit during year 2000. Under the terms of this agreement, Phillips earns a 66% interest in the permit by paying all costs through the drilling and testing of the exploration well, which will fulfil the year 2001 well obligation. Following completion of this well by Phillips Petroleum, the ZOCA 96-16 license interests will be Phillips Petroleum (66%), Norwest Energy NL (14%), West Oil NL (10%), and the Trans-Orient Petroleum Ltd. (10%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (10.0%).
The Timor Gap Zone of Cooperation was established in 1989 by treaty between Indonesia and Australia in settlement of a dispute between the two countries during the 1980's regarding the boundary between their respective economic zones, which had halted all exploration of this prospective area. ZOCA 96-16 lies within Area A of the Zone of Cooperation, which is now administered by the Australia-United Nations (on behalf of the Republic of East Timor) Joint Authority.
Following signature of the treaty, Area A was divided into a number of contract areas, most of which were awarded in 1991 and 1992. This initiated an active phase of exploration, in which many of the world's leading oil companies were involved, and some 25 exploration and ten appraisal wells have now been drilled in Area A, with several significant oil and gas discoveries having already been made. Companies currently involved in the area include Shell,, Phillips, , Woodside, , Santos, Mobil and others. Discoveries in the last few years include Elang (oil), Elang West (oil), Kakatua (oil), all now in production, Bayu (gas-condensate), and Undan (gas-condensate), now scheduled for development by Phillips Petroleum while the Laminaria and Buffalo oil discoveries, which recently commenced production, are located just outside Area A, some 25 miles west of ZOCA 96-16.
Discovery wells on two of the permits adjacent to ZOCA 96-16 have recorded flow rates in production testing exceeding 11,000 barrels of oil per day, while in the case of Bayu-1 a combined flow rate of 90 million cubic feet of gas per day, with an associated 5,250 barrels of condensate was achieved.
Of particular interest to the ZOCA 96-16 contract area are the Elang and Undan-Bayu discoveries. The Elang discovery was the first in Area A, made in February, 1994 when the Elang-1 well was flow tested at a rate of 5,800 barrels per day, and a 250 foot oil column was intersected in sandstones of the Montara Beds Formation, immediately underlying the 'Break-Up Unconformity' at a depth of 10,000 feet. Production from the combined Elang/Kakatua development commenced in 1998 at initial field production rates of 35,000 barrels a day, although production is now in decline. A recent new development well flowed 20,000 barrels per day. The development location is only five miles from the boundary of ZOCA 96-16 and enhances the value of the contract area by bringing infrastructure close to it.
Elang is also important to ZOCA 96-16 in that it demonstrates that oil is being generated in the Flamingo Syncline, which lies north of Elang and crosses the southern part of ZOCA 96-16, thus improving the chances of structures close to the syncline within ZOCA 96-16 being charged with oil. Seismic mapping of the area shows prospects and leads extending northeast from Elang across the Flamingo Syncline and into ZOCA 96-16. Other prospects are identified further east within ZOCA 96- 16, particularly on the Basilisk and Minotaur trends. Both Basilisk-1 and Minotaur-1 had extensive oil indications, as also did the third well in ZOCA 96-16, the Naga-1 well, and petrophysical review of Minotaur-1 strongly suggests that the well would have been capable of flowing oil from a similar level to that of the oil column in Elang, if it had been tested. The Coleraine Prospect is mapped directly along trend from Minotaur-1. The Foyle Prospect is mapped as a low relief structure covering an area of about 18 square miles, situated between Undan-Bayu and Coleraine.
The Undan-Bayu gas-condensate field was discovered by Phillips Petroleum with the drilling of Bayu-1 in early 1995, and then extended further west later in 1995 by the drilling of Undan-1 by BHP in the adjacent Contract Area. Appraisal drilling since that time has established a gas-condensate reserve of some three trillion cubic foot (TCF) of gas, and an associated 100-200 million barrels of condensate. The field covers an area of approximately 40,000 acres, some 15 miles southeast of ZOCA 96-16. Phillips Petroleum has purchased BHP's interest in the reserve, and is now proceeding to develop the field with an early production stage which strips the condensate from the reservoir and reinjects the gas for later production. The development of this field will also add value to ZOCA 96-16 due to the proximity of the Undan-Bayu production infrastructure.
ZOCA 96-16 is subject to an annual contract service fee of US$125,000 and a production sharing agreement with the Australia-Indonesia Joint Authority. For the first five years of production, the Joint Authority is entitled to 50% to 70% of the initial 10% of gross production, and of the initial 20% of gross production for each year thereafter. Any excess production, after deduction of allowable operating costs and investment credits of 127% of exploration expenditures, is shared with the Joint Authority at rates of 50% to 70%. In addition, any taxable income from the area is also subject to a combined tax regime, with an effective corporate tax rate of 42%. The production sharing agreement
has a stated term of 30 years but if no petroleum has been located in commercial quantities before November 14, 2002 the participants may by notice extend the term over the remaining area to November 14, 2006. If no petroleum has been discovered in commercial quantities by this date, the contract will terminate. Before November 14, 2002 the participants are required to relinquish a further 25% of the difference between the area granted in the production sharing contract less any area allocated to a commercial discovery. The production sharing contract requires the following minimum work to be done:
Year of Estimated Contract Description of Work Cost (US$)
One Data review $ 100,000 Two Data review 100,000 Three 1500 km of seismic survey 800,000 Four Data review 160,000 Five One exploration well 5,000,000 Six Data review 80,000
The work prescribed for the first three years has been completed. The Registrant has paid its one-third share of the above costs. The requirements of the remaining work program are as follows:
i) prior to November 14, 2000, complete a work program which includes seismic data review, or surrender the permit; prior to November 14, 2001, drill one exploration well, or surrender the permit; and
ii) prior to November 14, 2002, complete a work program which includes seismic data review, or surrender the permit.
Following the agreement with Phillips Petroleum Ltd, they will fund the drilling and testing of an exploration well in the permit during Year 2000, at no cost to the Registrant. This well will fulfill the Year 2001 well obligation.
The Registrant's equity in the permit is reduced to 10%, following Phillips entry and assumption of permit operatorship and the obligation to the other parties to drill the well during 2000.
After recovery of investment credits for exploration and capital costs and of operating costs, the value of production, if any, of petroleum is to be divided as follow;
(i) for average daily production up to 50,000 barrels, 50% to the Joint Authority and 50% to the participants;
(ii) for average daily production of between 50,001 and 150,000 barrels, 60% to the Joint Authority and 40% to the participants; and
(iii) for average daily production over 150,000 barrels, 70% to the Joint Authority and 30% to the participants;
and for any production of gas, after recovery of investment credits for exploration and capital costs and of operating costs, the value of production, if any, of gas is to be divided 50% to the Joint Authority and 50% to the participants.
An operating agreement exists among the participants. Among other things, the operating agreement provides that a participant may not sell, assign, transfer, charge, mortgage, or otherwise dispose of, deal with, encumber, make a declaration of trust or undertake any other act whereby any legal or equitable interest is created over all or part of its participating interest except to an "affiliated corporation" as that expression is defined in the production sharing contract of November 14, 1996 without the written consent of the other participants or permit a transfer or allotment of shares not outstanding on February 10, 1998 without the consent of the other participants.
A seismic grid totaling some 4,000 miles of data already existed within ZOCA 96-16, and under the terms of the ZOCA 96-16 Contract, the joint venture has carried out a reinterpretation of this data, together with a reanalysis of the wells in and around the Contract Area, and has now acquired an additional 1500 km of new seismic, which is presently being computer processed, prior to interpretation which will rank and risk the prospects.
For work planned to be done before December 31, 2000 on ZOCA 96-16 and its estimated cost see ITEM 1. BUSINESS-Plan of Operations.
Offshore Gippsland Basin, Bass Strait Permit VIC/P-39 (33.33% relinquished in 1999)
After extensive geological and geophysical work in this permit the participants determined that there is a lack of sufficient prospectivity in this permit area. This conclusion has resulted in the Joint Venture's formal offer to surrender the permit. The Joint Venture awaits a response from the Federal Government of Australia.
PAPUA NEW GUINEA
Petroleum Prospecting Licence PPL 192 (40.0%)
PPL 192 was granted in on January 28, 1997. The participants in the permit are the Registrant (40%), Trans-Orient Petroleum Ltd. (20%), Durum Cons. Energy Corp. (20%) and Mosaic Oil Niugini Pty. Ltd. (20%). After completing the purchase of Trans-Orient Petroleum Ltd.'s interest, the Registrant's interest will be (60.0%).The Registrant is the operator.
PPL 192 grants the exclusive right to explore for petroleum for an initial six year term commencing January 28, 1997, extendable for a further five year term over 50% of the original area, and the exclusive right to enter into a production agreement upon a discovery. A production agreement provides the right to produce any oil and gas discovered for a period of up to 30 years from discovery, subject to a
maximum 22.5% participating interest that can be acquired by the Government of Papua New Guinea and a two per cent participating interest that can be acquired by local landowners. See Item 2
ITEM 3. LEGAL PROCEEDINGS
There are no material legal proceedings to which the Registrant is subject or which are anticipated or threatened.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted for the vote of security holders in the fourth quarter of the year.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Market Price of and Dividends on the Registrant's Common Equity
The shares of the Registrant traded on the Vancouver Stock Exchange ("VSE") in Vancouver, British Columbia, Canada to September 12, 1996. Since January, 1996 the shares of the Registrant have traded and continue to trade on the OTC Bulletin Board under the symbol "INDX". Summary trading by quarter for the two most recently competed fiscal periods ending December 31, 1999: The Registrant believes that its market price is a reflection of actual sales and purchases. OTC BB quotations may reflect interdealer prices, without retail markup, markdown or commission and may not necessarily reflect actual transactions.
Year and Quarter High Low
First Quarter 3.563 2.406 Second Quarter 3.000 1.492 Third Quarter 1.813 0.563 Fourth Quarter 1.031 0.6875 First Quarter 1.281 0.42 Second Quarter 1.25 0.5625 Third Quarter 0.781 0.50 Fourth Quarter 0.656 0.3125 First Quarter [1] 0.875 0.3125
[1] Prices to March 16, 2000
As at March 27, 2000 there were 28,262,398 shares outstanding. At February 16, 2000 there were 213 shareholders of record resident in Canada holding 8,713,458 shares and 1,149 shareholders of record resident in the United States holding 19,316,901 shares.
No cash dividends have been declared by the Registrant nor are any intended to be declared. The Registrant is not subject to any legal restrictions respecting the payment of dividend (except that they may not be paid to render the Registrant insolvent). Dividend policy will be based on the Registrant's cash resources and needs and it is anticipated that all available cash will be needed for property development for the foreseeable future.
Recent Sales of the Registrant's Securities
No securities were issued by the Registrant during the 1999 fiscal year, however as part of the consideration to be paid by the Registrant to Trans-Orient Petroleum Ltd. for the purchase of Trans-Orient Petroleum Ltd.'s Assets, the Registrant will issue 4,184,224 Units. At March 27, 2000 these units have not yet been issued but it is expected that these units will be issued in the very near future upon formal closing of the asset purchase. The total value of the Trans-Orient Petroleum Ltd. Assets to be acquired by the Registrant were valued by the parties at $4,097,362. Each Unit consists of one common share and one "A" Warrant. Each "A" Warrant will entitle the holder to purchase one additional common share of the Registrant in consideration for $0.50 per common share exercisable up to the end of business on the date which is one year from their issuance and thereafter for $0.75 per common share up to the close of business on the date which is two years from the date of issuance. Upon the exercise of the "A" Warrants by Trans-Orient Petroleum Ltd. and subject to a commercial discovery having occurred on the Assets, the Registrant shall issue to Trans- Orient Petroleum Ltd. one "B" Warrant for each "A" Warrant exercised. The "B" Warrants shall be exercisable at a price of $1.50 for a period of one year from the date of issue of the "B" Warrants. The securities are to be issued pursuant to the exemptions from registration under the 1933 Securities Act contained with Regulation S (Rules 901-905).
Rights to Acquire Common Shares on Exercise of Options
No options to acquire the common shares of the Registrant were issued during the fiscal year ending December 31, 1999. At the Annual General Meeting of Shareholders held in June 1998, the Registrant did receive approval to grant options to directors, officers and employees. In March 1999 the registrant announced that it intended to cancel all previously granted but unexercised options and grant directors, officers and employees new options to acquire 5.6 million common shares in the capital stock of the Registrant at a price of US$0.85 per share. However the original options were not cancelled nor were the options to acquire 5.6 million shares granted to any individuals as of December 31, 1999. The names, holdings, exercise price and expiry date of outstanding options to acquire common shares of the Registrant are as follows:
Exercise Number Expiration Name Of Shares Price Date Under Option [1]
DJ and JM Bennett Family Trust [2][3][4] 200,000 $2.50 10/30/00 Alex Guidi [3][4] 500,000 $2.50 10/30/00 Brad Holland[3][5] 300,000 $2.50 05/13/00
[1] In the year ended December 31, 1999, no options to acquire shares were exercised.
[2] Beneficially owned by David Bennett and his spouse Jenni Bennett
[3] Term extended pursuant to agreements dated May 7, 1998.
[4] The options were originally granted on October 30, 1996.
[5] The option was originally granted on May 13, 1996.
Rights to Acquire Common Shares on Exercise of Warrants
No warrants to acquire the common shares of the Registrant were issued during the fiscal year ending December 31, 1999. The names, holdings, exercise price and expiry date of outstanding warrants to purchase common shares of the Registrant are as follows:
Number of Share Purchase Purchase Expiration Name Warrants [1] Price Date
Tracy Godoy[2] 160,000 $.90 05/27/00 Alex Guidi[2] 494,000 $.90 05/27/00 Peter Loretto[3][2] 146,000 $.90 05/27/00 1,000,000 $.90 07/03/00 Tanya Loretto[2] 150,000 $.90 05/27/00
[1] In the year ended December 31, 1999, no warrants to acquire shares were exercised.
[2] During the 1999 fiscal year the Registrant amended the exercise price from Cdn. $3.485 to US$.90 and extended the expiry date from May 27, 1999 to May 27, 2000.
[3] By an agreement dated June 2, 1997, Mr. Loretto purchased 1,000,000 units for Cdn. $1.80 per unit. Each unit is comprised of one common share and one non-transferable share purchase warrant. Each share purchase warrant entitles the holder to purchase a common share for Cdn. $1.90 before July 4, 1998, for Cdn. $2.00 from July 4, 1998 to July 3, 1999 and for Cdn. $2.10 from July 4, 1999 to July 3, 2000. During the 1999 fiscal year the Registrant amended the exercise price at which the holder may exercise his warrant from Cdn. $2.10 to US$.90.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following constitutes selected financial data for the Registrant prepared in accordance with United States generally accepted accounting principles for the last five completed financial periods. The information, expressed in United States dollars unless otherwise indicated, must be read in conjunction with the more detailed financial information contained in the accompanying audited financial statements.
[1] For the eleven month period ended December 31, 1995.
[2] For the year ended January 31, 1995.
Exchange Rates
On December 31, 1999 the buying rate for Canadian dollars was US$1.00: Cdn$1.4433. The following table sets out the buying rate for Canadian dollars for the period indicated. Rates of exchange are obtained from the Bank of Canada and believed by the Registrant to approximate closely the rates certified for customs purposes by the Federal Reserve Bank in New York.
[1] The high and low buying rate figures are selected from daily high and low figures.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Summary
The Registrant is in the exploration and evaluation stage on nearly all its oil and gas properties and hence has not yet achieved profitability or break even cash flow. The Registrant has experienced losses in each fiscal period reported on and expects to continue to incur losses for the upcoming fiscal year. Total losses incurred from incorporation to December 31, 1999 were $7,644,685. The level of future operations is limited by the availability of capital resources, the sources of which
are not predictable. The sales value of any oil and gas discovered by the Registrant will be largely dependent on factors beyond the Registrant's control such as the market value of the hydrocarbons produced.
Liquidity
As of December 31, 1999 the Registrant had $6,130,997 in working capital as compared with $8,890,218 as of December 31, 1998 and $10,827,096 as of December 31, 1997. For the upcoming fiscal year, the Registrant does not have sufficient capital to satisfy all the capital expenditures which are necessary to satisfy the prescribed work commitments contained within the Registrant permit license grants and joint venture agreements see ITEM 1 BUSINESS- Plan of Operations. The required permit expenditures for the upcoming fiscal year will, if fully committed to, exhaust the Registrant's current working capital with the result that the Registrant will not have sufficient working capital to continue its operations without further infusions of capital. The production revenue and interest income which the Registrant receives is not sufficient to satisfy the Registrant's operating expenses and as such these revenues will not improve the Registrant's anticipated deficiency in working capital. In order to satisfy the required capital expenditures for the upcoming fiscal year, the Registrant will need to raise additional capital from outside sources. The Registrant relies on its ability to raise additional capital through the issuance of common shares, which has a dilutive effect on the Registrant's shareholders. It is uncertain whether the Registrant will be able to secure outside sources of capital in an amount that is sufficient for it to continue with its current operations on its permits. Should the Registrant fail to raise sufficient capital, the Registrant will have to endeavor to enter into farm out arrangements with third parties to reduce its capital exposure on exploration drilling programs and/or withdraw and/or dispose of some or all of its permit interests in order to reduce the capital requirements attributable to the Registrant.
Capital Resources
For a description of the Registrant's material capital commitments for the upcoming fiscal year see ITEM 1 BUSINESS- Plan of Operations. The Registrant has no other anticipated capital expenditures of a material amount. However, the Registrant intends to acquire additional petroleum interests, which may give rise to further capital expenditures.
The Registrant's capital resources have been comprised primarily of private investors, including members of management, who are either existing contacts of the Registrant's management or who come to the attention of the Registrant through personal and business contacts, financial institutions and other intermediaries. The Registrant's management is of the view that conventional banking is unavailable to resource companies which are in the exploration stage. The Registrant's access to capital is always dependent upon general financial market conditions, especially those which pertain to venture capital situations such as oil and gas exploration companies. The Registrant
has no agreements with management, investors, shareholders or anyone else respecting additional financing at this time. Due to the speculative nature of the Registrant's business and its lack of revenue generating assets, potential investors are generally limited to those willing to accept a high degree of risk. Therefore the number of outside sources of capital for the Registrant are somewhat limited. Other than the foregoing, there are no other trends in the nature of its capital resources which could be considered predictable.
Results of Operations
The Registrant is an exploration company. The Registrant's primary focus as of December 31, 1999 is the investigation and acquisition of oil and gas properties. The Registrant's policy is to acquire interests and where possible, minimize its risk exposure by farming out or joint venturing these interests to other industry participants.
The Registrant's current property focus is on the acquisition and exploration of properties primarily in the Austral Pacific region with the objective of establishing a solid cash flow base and participating in high potential exploration blocks in under explored countries with attractive fiscal regimes.
Revenues for the year ended December 31, 1999 were $673,609 compared with $684,765 for the year ended December 31, 1998 and $870,059 for the year ended December 31, 1997. The revenue figures reported by the Registrant include both production revenues and interest income earned on the Registrant's cash and short-term deposits.
Except for the Registrant's interest in Petroleum Mining Permit ("PMP") 38148, the Registrant's petroleum permits are in the exploration stage and do not generate any production revenues. The Registrant holds a 5% participating interest and revenue interest in PMP 38148 located in the Taranaki Basin, North Island, New Zealand. PMP 38148 has six producing oil wells, four producing gas wells and two shut-in gas and oil wells.
Production revenue for the year ending December 31, 1999 was $314,698 compared with gross 1998 production revenue of $234,168. The increase is due to a rise in the average oil sale price of US$4.30 per barrel of oil to US$15.30 per barrel, partially offset by by a fall in production volume from 20,629 barrels to 19,786 barrels. The above includes revenue from gas production of $12,634 (year ended December 31, 1998: $9,247).
Costs and Expenses
In the year ended December 31, 1999 the Registrant incurred expenditures in the acquisition, exploration and development of petroleum interests of $1,923,921. The amount incurred in the acquisition, exploration and development of petroleum interests for the year ended December 31, 1998 was $1,901,030. The amount incurred in the acquisition, exploration and development of petroleum interests for the year ended December 31, 1997 was $1,064,976. The increase is largely attributable to the Registrant's participation in the drilling of the
Huinga-1 and Whakatu-1 and Clematis-1 wells, the acquisition of additional petroleum interests and development and implementation exploration programs. After the purchase of the Assets from Trans- Orient Petroleum Ltd. it is expected that costs attributable to the acquisition, exploration and development of petroleum interests will materially increase from those incurred in the past.
Depletion and amortization expense for the year ended December 31, 1999 was $176,855. For the year ended December 31, 1998 the depletion and amortization expense was $148,875 and for the year ended December 31, 1997 was $97,827.
General and administrative expenses for the year ended December 31, 1999 were $532,497. For the year ended December 31, 1998 the general and administrative expenses were $563,480 and for the year ended December 31, 1997 were $1,247,569.
Interest Expense
The Registrant finances its business primarily from the issuance of common shares and to a lesser extent from the receipt of petroleum revenues from its interest in the Ngatoro oil field, New Zealand. The Registrant has not effected any borrowing and has consequently not incurred any interest expense.
Interest Income
Interest income for the year ended December 31, 1999 was $358,911. Interest income for the year ended December 31, 1998 was $450,597 and for the year ended December 31, 1997 was $382,118.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Registrant operates in the international crude oil, refined product, natural gas and natural gas liquids markets and is exposed to fluctuations in hydrocarbon prices, foreign currency rates, and interest rates that can affect the revenues and cost of operating, investing and financing. The Registrant has not established any policies to protect against the foregoing risks.
Commodity Price Risk
The Registrant's policy is to generally be exposed to market pricing for commodity purchases and sales. The Company has not taken any steps to protect against the fluctuating market price of oil or gas and as such the Registrant's operating revenue will be affected by changes in the market price for oil & gas. All other things being equal, where the oil & gas prices decrease it can be expected that the Registrant's revenues will in turn be reduced, whereas where oil & gas prices increase it can be expected that the Registrant's revenues will in turn increase.
Currency Risk
The Registrant has foreign currency exchange rate risk resulting from operations in overseas countries in the south Pacific and Canada. The Registrant generally holds its cash reserves in Canadian dollars while its operations expenditures are incurred in Papua New Guinea, New Zealand and Australia dollars ("Foreign Currencies"). As such any strengthening of Foreign Currencies against the Canadian dollar will cause an increase in the Registrant's operating costs. The Registrant does not hedge its exposure to currency rate changes, although it may choose to selectively hedge exposure to foreign currency exchange rate risk. The Registrant, however, has no policies relating to the foregoing.
Interest Rate Risk
The Registrant believes that it has no material interest rate risk to manage, as the Registrant has not made use of debt as a means of financing its operations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS.
Financial statements begin on following page.
AUDITORS' REPORT
To the Shareholders of Indo-Pacific Energy Ltd.
We have audited the accompanying consolidated balance sheets of Indo- Pacific Energy Ltd. and its subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations and comprehensive income (loss), changes in stockholders' equity and cash flows for each of the years in the three year period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, these consolidated financial statements referred to above present fairly, in all material respects, the financial position of Indo-Pacific Energy Ltd. and its subsidiaries as of December 31, 1999 and 1998 and the results of their operations and cash flows for each of the years in the three year period ended December 31, 1999, in conformity with generally accepted accounting principles in the United States.
The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the financial statements, there is substantial doubt regarding the ability of the Company to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ SADOVNICK TELFORD & SKOV CHARTERED ACCOUNTANTS
Vancouver, British Columbia Canada March 28, 2000
INDO-PACIFIC ENERGY LTD. Consolidated Balance Sheets (Expressed in United States Dollars)
Approved by the Directors:
/s/ David Bennett /s/ Alex Guidi Director Director
See accompanying notes to the consolidated financial statements
INDO-PACIFIC ENERGY LTD. Consolidated Statements of Operations and Comprehensive Income (Loss) (Expressed in United States Dollars)
For the Years Ended December 31,
See accompanying notes to the consolidated financial statements
INDO-PACIFIC ENERGY LTD. Consolidated Statements of Changes in Stockholders' Equity (Expressed in United States Dollars) For the Years Ended December 31, 1999, 1998 and 1997
See accompanying notes to the consolidated financial statements
INDO-PACIFIC ENERGY LTD. Consolidated Statements of Cash Flows (Expressed in United States Dollars) For the Years Ended December 31,
See accompanying notes to the consolidated financial statements
b
INDO-PACIFIC ENERGY LTD. Consolidated Schedules of General and Administrative Expenses (Expressed in United States Dollars) For the Years Ended December 31,
See accompanying notes to the consolidated financial statements
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 1 - NATURE OF OPERATIONS AND CONTINGENCIES
The Company was incorporated under the Company Act (British Columbia) and continued its jurisdiction of incorporation to the Yukon Territory under the Business Corporations Act (Yukon).
The Company is primarily engaged in the acquisition, exploration and development of its oil and gas properties and, with the exception of PMP 38148, has yet to determine whether its properties contain oil and gas reserves that are economically recoverable. The recoverability of the amounts capitalized for oil and gas properties is dependent upon the completion of exploration work, the discovery of oil and gas reserves in commercial quantities and the subsequent development of such reserves.
The Company does not generate sufficient cash flow from operations to fund its entire exploration and development activities and has therefore relied principally upon the issuance of securities for financing. Additionally, the Company has periodically reduced its exposure in oil and gas properties by farming out to other participants. The Company intends to continue relying on these measures to finance its exploration and development activities to the extent such measures are available and obtainable under terms acceptable to the Company. Accordingly, the Company's consolidated financial statements are presented on a going concern basis.
Refer to Note 9
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a) Accounting Principles and Use of Estimates
These financial statements are prepared in conformity with generally accepted accounting principles in the United States and requires the Company's management to make informed judgements and estimates that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the year reported. Actual results could differ from these estimates.
Material differences between United States and Canadian generally accepted accounting principles which affect the Company are referred to in Note 16.
b) Basis of Consolidation
These consolidated financial statements include the accounts of Indo- Pacific Energy Ltd. and its wholly-owned subsidiaries, Indo Overseas Exploration Ltd., Indo-Pacific Energy Pty. Ltd., Indo-Pacific Energy (PNG) Limited, Source Rock Holdings Limited, Indo-Pacific Energy (NZ) Limited, Ngatoro Energy Limited and PEP 38716 Limited. All significant intercompany balances and transactions have been eliminated upon consolidation.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
c) Joint Operations
The Company's exploration and development activities are conducted jointly with other companies and accordingly, these financial statements reflect only the Company's proportionate interest in these activities.
d) Translation of Foreign Currencies
The Company's foreign operations through its subsidiaries are of an integrated nature and accordingly, the remeasurement method of foreign currency translation is used for conversion into United States dollars. Monetary assets and liabilities are translated into United States dollars at the rates prevailing on the balance sheet date. Other assets and liabilities are translated into United States dollars at the rates prevailing on the transaction dates. Revenues and expenses arising from foreign currency transactions are translated into United States dollars at the average rate for the year. Exchange gains and losses are recorded as income or expense in the year in which they occur.
e) Financial Instruments
The Company's financial instruments consist of current assets and current liabilities. The fair values of these assets and liabilities approximate the carrying amounts due to the short-term nature of these instruments.
f) Accounting Pronouncements Recently Issued
The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133: Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"), effective for fiscal periods beginning after June 15, 1999. SFAS 133 requires that the fair-market value of derivatives be reported on the balance sheet and any changes in the fair value of the derivative be reported in income or other comprehensive income, as appropriate. The Company does not expect adoption of this new standard to have a material effect on its financial reporting.
g) Cash and Short-Term Deposits
Cash and short-term deposits include government treasury bills and bankers' acceptances with original maturities of three months or less, together with accrued interest.
h) Property and Equipment
Property and equipment consist of furniture and office equipment and are recorded at cost and depreciated over their estimated useful lives on a declining-balance basis at annual rates of 10% to 20%.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
i) Oil and Gas Properties
The Company follows the full cost method of accounting for oil and gas operations whereby all costs associated with the acquisition, exploration and development of oil and gas reserves are capitalized in cost centers on a country-by-country basis. Such costs include property acquisition costs, geological and geophysical studies, carrying charges on non-producing properties, costs of drilling both productive and non- productive wells, and overhead expenses directly related to these activities.
Depletion is calculated for producing properties by using the unit-of- production method based on proved reserves, before royalties, as determined by management of the Company or independent consultants. Sales or dispositions of oil and gas properties are credited to the respective cost centers and a gain or loss is recognized when all properties in a cost center have been disposed of, unless such sale or disposition significantly alters the relationship between capitalized costs and proved reserves of oil and gas attributable to the cost center. Costs of abandoned oil and gas properties are accounted for as adjustments of capitalized costs and written off to expense.
A ceiling test is applied to each cost center by comparing the net capitalized costs to the present value of the estimated future net revenues from production of proved reserves discounted by 10%, net of the effects of future costs to develop and produce the proved reserves, plus the costs of unproved properties net of impairment, and less the effects of income taxes. Any excess capitalized costs are written off to expense. The calculation of future net revenues is based upon prices, costs and regulations in effect at each year end.
Unproved properties are assessed for impairment on an annual basis by applying factors that rely on historical experience. In general, the Company may write-off any unproved property under one or more of the following conditions:
i) there are no firm plans for further drilling on the unproved property; ii) negative results were obtained from studies of the unproved property; iii) negative results were obtained from studies conducted in the vicinity of the unproved property; or iv) the remaining term of the unproved property does not allow sufficient time for further studies or drilling.
j) Stock Options
In accordance with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, the Company elected to apply Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees to account for stock options and provide pro forma disclosures of net loss as if the fair value method had been applied.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
k) Income Taxes
The Company accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, all expected future events other than enactment of changes in the tax laws or rates are considered.
NOTE 3 - LOAN RECEIVABLE FROM RELATED PARTY
The Company is owed $1,062,211 including interest of $18,051 by Trans- Orient Petroleum Ltd. ("Trans-Orient") for payments relating to oil and gas exploration on behalf of Trans-Orient. This amount is unsecured with no fixed terms for repayment and accrues interest on a monthly basis at the average three-month bankers' acceptance rate plus 3%.
Refer to Note 8 and 15
NOTE 4 - MARKETABLE SECURITIES
Marketable securities comprise of 517,020 shares (December 31, 1998: 517,020 shares) of Trans-Orient Petroleum Ltd. acquired at a cost of $383,075 and recorded at an estimated market value of $222,319 (December 31, 1998: $694,875).
Refer to Notes 8 and 15
NOTE 5 - INVESTMENTS
Investments comprise of 1,800,000 shares (December 31, 1998: 1,000,000 shares) of AMG Oil Ltd. acquired at a cost of $650,000 (December 31, 1998: $250,000) and 600,000 shares (December 31, 1998: Nil) of Gondwana Energy, Ltd. acquired at a cost of $20,000 (December 31, 1998: Nil), recorded at estimated market values of $720,000 (December 31, 1998: $1,500,000) and $20,000 (December 31, 1998: Nil), respectively.
The Company holds an option to purchase a further 200,000 shares of AMG Oil Ltd. at a price of $0.50 per share expiring on December 31, 2000.
Refer to Note 8
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 6 - PROPERTY AND EQUIPMENT
Property and equipment are comprised as follows:
NOTE 7 - OIL AND GAS PROPERTIES
Oil and gas properties are comprised as follows:
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
NEW ZEALAND
Unless otherwise indicated, petroleum exploration permits granted in New Zealand provide for the exclusive right to explore for petroleum for an initial term of five years, renewable for a further five years over one-half of the original area. The participants can apply for extensions or reductions of the committed work programs for the permits under certain circumstances. Any production permits granted will be for a term of up to 40 years from the date of issue. The New Zealand government has reserved a royalty of the greater of 5% of net sales revenue or 20% of accounting profits from the sale of petroleum products.
a) PMP 38148 Ngatoro Oil Field
The Company has a 5% participating interest in Petroleum Mining Permit 38148 which includes seven producing oil and/or gas wells. The New Zealand government has reserved a royalty of the greater of 5% of net sales revenue or 20% of accounting profits from the sale of petroleum products amounting to $15,248 for the 1999 fiscal year (1998 fiscal year: $10,269).
At December 31, 1999, PMP 38148 is in good standing with respect to its work commitments and does not require the Company to incur minimum exploration expenditures for the 2000 fiscal year.
b) PEP 38256
The Company has a 35% participating interest in, and is the operator of, Petroleum Exploration Permit 38256 ("PEP 38256") which was granted on August 25, 1997. At least one-half of the original area must be relinquished by August 25, 2000 in addition to the area which would normally be required to be relinquished upon renewal of PEP 38256. The other participants of PEP 38256 are Trans-Orient Petroleum Ltd. (35%) and AMG Oil Ltd. (30%).
By an agreement dated June 25, 1998, AMG Oil Ltd. ("AMG") acquired a right to earn up to an 80% participating interest in PEP 38256 from Trans-Orient Petroleum Ltd. and the Company. In December 1998, AMG earned a 30% participating interest in PEP 38256 by funding all of the costs of acquiring, processing and interpreting 200 kilometers of seismic data. AMG has the right to earn an additional 50% participating interest by funding all of the costs of drilling two exploration wells including any further seismic data required prior to drilling. By agreements dated December 3, 1998 and October 26, 1999, this right has been extended to May 31, 2000.
The Company and the other participants have completed the work program required for the first two and a half years. PEP 38256 requires the participants to complete the remaining work program that includes committing by February 25, 2000 to drill one exploration well prior to August 25, 2000, or surrender the permit.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
At December 31, 1999, PEP 38256 is in good standing with respect to its work commitments. Upon committing to drill one exploration well prior to August 25, 2000, the Company's share of work commitments for the 2000 fiscal year requires an estimated $455,000 of exploration expenditures to be incurred.
Refer to Notes 8 and 15
c) PEP 38328
The Company has a 40% participating interest in, and is the operator of, Petroleum Exploration Permit 38328 ("PEP 38328") which was granted on June 19, 1996. The other participants of PEP 38328 are Boral Limited (37.5%) and Trans-Orient Petroleum Ltd. (22.5%).
The Company and the other participants have completed the work program required for the first four years that included drilling the Kereru-1 exploration well. PEP 38328 requires the participants to complete the remaining work program that includes committing by June 19, 2000 to drill one exploration well prior to June 19, 2001, or surrender the permit.
At December 31, 1999, PEP 38328 is in good standing with respect to its work commitments and does not require the Company to incur minimum exploration expenditures for the 2000 fiscal year.
Refer to Note 8
d) PEP 38330
The Company has a 34% participating interest in, and is the operator of, Petroleum Exploration Permit 38330 ("PEP 38330") which was granted on July 1, 1996. The other participants of PEP 38330 are Norwest Energy N.L. (33%) and Mosaic Oil N.L. (33%).
The Company and the other participants have completed the work program required for the first three years. PEP 38330 requires the participants to complete the remaining work program that includes acquiring, processing and interpreting 25 kilometers of seismic data and committing prior to July 1, 2000 to drill an exploration well by July 1, 2001, or surrender the permit.
At December 31, 1999, PEP 38330 is in good standing with respect to its work commitments and does not require the Company to incur minimum exploration expenditures for the 2000 fiscal year.
Refer to Note 15
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
e) PEP 38332
The Company has a 42.5% participating interest in, and is the operator of, Petroleum Exploration Permit 38332 ("PEP 38332") which was granted on June 24, 1997. The other participants of PEP 38332 are Boral Limited (37.5%) and Trans-Orient Petroleum Ltd. (20%).
The Company and the other participants have completed the work program required for the first two and a half years. PEP 38332 requires the participants to complete the remaining work program that includes drilling one exploration well prior to June 24, 2000.
At December 31, 1999, PEP 38332 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $268,000 of exploration expenditures to be incurred.
Refer to Note 8
f) PEP 38335
The Company has a 10% participating interest in Petroleum Exploration Permit 38335 ("PEP 38335") which was granted on November 29, 1998. The other participants of PEP 38335 are Westech Energy Corporation (70%), as the operator, Trans-Orient Petroleum Ltd. (15%) and Everest Energy Inc. (5%).
The Company and the other participants are required to complete the work program originally due by November 29, 1999 and extended to March 31, 2000 that includes acquiring, processing and interpreting 20 kilometers of seismic data or equivalent 3D seismic data. Additionally, PEP 38335 requires the participants to complete the remaining work program that includes the following:
i) prior to November 29, 2000, drill one exploration well and either commit to complete the next stage of the work program detailed below in ii) or surrender the permit; and iii) prior to November 29, 2001, evaluate the results of the exploration well drilled during the second year and either commit to a satisfactory work program for the remainder of the permit term or surrender the permit.
At December 31, 1999, PEP 38335 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $122,000 of exploration expenditures to be incurred.
Refer to Note 8
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
g) PEP 38339
The Company has a 50% participating interest in, and is the operator of, Petroleum Exploration Permit 38339 ("PEP 38339") which was granted on November 26, 1998. The other participant of PEP 38339 is Trans- Orient Petroleum Ltd. (50%).
The Company and the other participant have completed the work program required to February 26, 2000. PEP 38339 requires the participants to complete the remaining work program that includes the following:
i) prior to November 26, 2000, acquire, process and interpret a minimum of 20 kilometers of onshore and 50 kilometers of offshore seismic data, and either commit to complete the next stage of the work program detailed below in (ii) or surrender the permit; ii) prior to May 26, 2001, acquire, process and interpret additional seismic data and either commit to complete the next stage of the work program detailed below in (iii) or surrender the permit; and iii) prior to November 26, 2001, drill one onshore or offshore exploration well and either commit to a satisfactory work program for the remainder of the permit term or surrender the permit.
At December 31, 1999, PEP 38339 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $42,000 of exploration expenditures to be incurred.
Refer to Note 8
h) PEP 38716
The Company has a 23.8% participating interest in Petroleum Exploration Permit 38716 ("PEP 38716") which was granted on January 30, 1996. The other participants of PEP 38716 are Marabella Enterprises Ltd. (29.6%), as the operator, Australian Worldwide Exploration N.L. (25%), Antrim Oil and Gas Limited (7.5%), Swift Energy International Inc. (7.5%) and Euro-Pacific Energy Pty. Ltd. (6.6%).
In December 1999, Durum Cons. Energy Corp. relinquished its 4% participating interest in PEP 38716 in favor of the Company for no consideration.
By an agreement effective July 30, 1998 with Antrim Oil and Gas Limited ("Antrim"), the Company and one other participant agreed to assign a 15% participating interest in PEP 38716 to Antrim for a total amount of $450,000. The Company received $150,000 for assigning a 5% participating interest in PEP 38716 to Antrim.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
The Company and the other participants have completed the work program required to June 30, 1999 that included drilling the Huinga-1 exploration well. A work program has been submitted for approval for the remaining term of PEP 38716 which expires on January 30, 2001 unless renewed.
At December 31, 1999, PEP 38716 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year, if approved as submitted, requires an estimated $20,000 of exploration expenditures to be incurred.
Refer to Note 8
i) PEP 38720
The Company has a 50% participating interest in, and is the operator of, Petroleum Exploration Permit 38720 ("PEP 38720") which was granted on September 2, 1996. The other participant of PEP 38720 is Trans- Orient Petroleum Ltd. (50%).
The Company and the other participant have completed the work program required for the first three years that included drilling the Clematis- 1 exploration well. A work program has been submitted for approval for the remaining term of PEP 38720 which expires on September 2, 2001 unless renewed.
At December 31, 1999, PEP 38720 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year, if approved as submitted, requires an estimated $60,000 of exploration expenditures to be incurred.
Refer to Note 8
j) PEP 38723
The Company has a 40% participating interest in, and is the operator of, Petroleum Exploration Permit 38723 ("PEP 38723") which was granted on October 30, 1997. The other participants of PEP 38723 are Trans- Orient Petroleum Ltd. (40%) and Gondwana Energy, Ltd. (20%).
The Company and the other participants have completed the work program required to March 30, 1999. PEP 38723 requires the participants to complete the remaining work program that includes acquiring, processing and interpreting eight kilometers of seismic data and committing by April 30, 2000 to drill an exploration well by October 30, 2000 or surrender the permit.
At December 31, 1999, PEP 38723 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $316,000 of exploration expenditures to be incurred.
Refer to Note 8
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
k) PEP 38736 and PPL 38706
The Company has a 100% participating interest in Petroleum Exploration Permit 38736 ("PEP 38736") which was granted on July 14, 1999. The Company had a 7.75% participating interest in Petroleum Prospecting License 38706 ("PPL 38706") with Fletcher Challenge Energy Ltd. ("Fletcher Challenge"), as the operator, holding the remaining 92.25% participating interest. PPL 38706 required the participants to complete a work program that included reprocessing 300 kilometers of seismic data by July 31, 1999 and drilling one exploration well by July 31, 2000. However, Fletcher Challenge relinquished its interest in PPL 38706 and as a result, the Company was permitted to add the acreage of PPL 38706 as part of PEP 38736 and subject only to the work program required under PEP 38736. All costs associated with PPL 38706 have been written off during the 1999 fiscal year.
PEP 38736 requires the Company to complete a work program that includes the following:
i) prior to January 14, 2002, acquire, process and interpret eight kilometers of seismic data or equivalent 3D seismic data, reprocess ten kilometers of seismic data, and either commit to complete the next stage of the work program detailed below in (ii) or surrender the permit; and ii) prior to July 14, 2002, drill one exploration well and either commit to a satisfactory work program for the remainder of the permit term or surrender the permit.
At December 31, 1999, PEP 38736 is in good standing with respect to its work commitments and does not require the Company to incur minimum exploration expenditures for the 2000 fiscal year.
AUSTRALIA
Unless otherwise indicated, offshore exploration permits granted in Australia provide for the exclusive right to explore for petroleum for an initial term of six years, renewable for an unlimited number of five-year terms over one-half of the remaining area at each renewal. The participants can apply for extensions or reductions of the committed work programs for the permits under certain circumstances. Any production permits granted will be for a term of 21 years from the date of issue, renewable for a further 21 years. In addition to general Australian taxation provisions, most offshore permits, including all of the Company's Australian permits, are subject to Petroleum Resource Rent Taxation at the rate of 40% on a project's net income after deduction of allowable project and exploration expenditures, with undeducted exploration expenditures compounded forward at the Long-term Bank Rate ("LTBR") plus 15% and project expenditures at LTBR plus 5%.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
l) AC/P19
The Company has a 65% participating interest in, and is the operator of, Ashmore-Cartier Permit 19 ("AC/P19") which was granted on May 30, 1997. The other participant of AC/P19 is Mosaic Oil N.L. (35%). AC/P19 is subject to a maximum 5% carried interest to the original participants, convertible to an equivalent participating interest upon commencement of production through the reimbursement of past costs payable out of 50% of net production revenue.
The Company and the other participant have completed the work program required for the first two years. AC/P19 requires the participants to complete the remaining work program that includes the following:
i) prior to May 30, 2000, acquire, process and interpret 300 kilometers of seismic data; (ii) prior to May 30, 2001, acquire, process and interpret additional seismic data; (iii) prior to May 30, 2002, drill one exploration well; and (iv) prior to May 30, 2003, reinterpret and evaluate results.
The participants have the right to withdraw from AC/P19 at the end of each year's work program starting in the third year.
At December 31, 1999, AC/P19 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $108,000 of exploration expenditures to be incurred.
m) AC/P31
The Company acquired a 65% participating interest in, and is the operator of, Ashmore-Cartier Permit 31 ("AC/P31") which was granted on September 12, 1999. The other participant of AC/P31 is Mosaic Oil N.L. (35%).
AC/P31 requires the participants to complete a work program that includes the following:
(i) prior to September 12, 2000, conduct geological and geophysical studies; (ii) prior to September 12, 2001, reprocess 30 kilometers of seismic data; (iii) prior to September 12, 2002, acquire, process and interpret 20 kilometers of seismic data; (iv) prior to September 12, 2003, acquire, process and interpret 20 kilometers of seismic data; (v) prior to September 12, 2004, reinterpret and evaluate seismic data; and (vi) prior to September 12, 2005, drill one exploration well.
The participants have the right to withdraw from AC/P31 at the end of each year's work program starting in the third year.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
At December 31, 1999, AC/P31 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $13,000 of exploration expenditures to be incurred.
PAPUA NEW GUINEA
Petroleum prospecting licenses granted in Papua New Guinea provide for the exclusive right to explore for petroleum for an initial term of six years, renewable for a further five years over one-half of the original area, and the right to enter into a Petroleum Agreement upon a discovery. The Petroleum Agreement provides the right to produce any oil and gas discovered for a period of up to 30 years from discovery, subject to a maximum 22.5% participating interest that can be acquired by the Government of Papua New Guinea and a 2% participating interest that can be acquired by local landowners. The participants can apply for extensions or reductions of the committed work programs for the licenses under certain circumstances.
n) PPL 192
The Company has a 40% participating interest in, and is the operator of, Petroleum Prospecting License No. 192 ("PPL 192") which was granted on January 28, 1997. The other participants of PPL 192 are Trans- Orient Petroleum Ltd. (20%), Durum Cons. Energy Corp. (20%) and Mosaic Oil N.L. (20%).
The Company and the other participants have completed the work program required for the first three years. PPL 192 requires the participants to complete the remaining work program that includes the following:
i) prior to January 28, 2001, drill one exploration well. In addition, the participants must commit to a minimum work program prior to November 28, 2000 for the fifth and sixth years, or surrender the permit; ii) prior to January 28, 2002, acquire, process and interpret 400 kilometers of seismic data or equivalent 3D seismic data; and iii) prior to January 28, 2003, drill a second exploration well.
At December 31, 1999, PPL 192 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $2,045,000 of exploration expenditures to be incurred.
Refer to Note 8
o) PPL 215
The Company acquired a 40% participating interest in, and is the operator of, Petroleum Prospecting License No. 215 ("PPL 215") which was granted on May 6, 1999. The other participants of PPL 215 are Trans-Orient Petroleum Ltd. (40%) and Mosaic Oil N.L. (20%).
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 7 - OIL AND GAS PROPERTIES (continued)
PPL 215 requires the participants to complete a work program that includes the following:
i) prior to May 7, 2001, reprocess 200 kilometers of seismic data. In addition, the participants must commit to a minimum work program prior to March 7, 2001 for the third and fourth years, or surrender the permit; ii) prior to May 7, 2003, acquire, process and interpret 100 kilometers of seismic data. In addition, the participants must commit to a minimum work program prior to March 7, 2003 for the fifth and sixth years, or surrender the permit; and iii) prior to May 7, 2005, drill one exploration well.
At December 31, 1999, PPL 215 is in good standing with respect to its work commitments. The Company's share of work commitments for the 2000 fiscal year requires an estimated $35,000 of exploration expenditures to be incurred. Refer to Note 8
PEOPLE'S REPUBLIC OF CHINA
p) Nanling-Wuwei Blocks
By a Joint Study Agreement dated March 18, 1996 with China National Oil and Gas Exploration and Development Corp. ("CNODC"), the Company acquired a 50% participating interest to study the Nanling and Wuwei Blocks ("the Blocks"). The other participant in the Blocks was Moondance Energy Limited (50%).
The Company had an exclusive right to obtain partners to enter into a Production Sharing Contract which expired in July 1999. Accordingly, the Company has written off the Blocks in its entirety.
NOTE 8 - RELATED PARTY TRANSACTIONS
a) Prepaid Expenses
The Company prepaid $41,571 relating to general and administative expenses to DLJ Management Corp., a wholly-owned subsidiary of a company having directors, officers and/or principal shareholders in common with the Company.
b) Loan Receivable from Related Party
The Company is owed $1,062,211 (December 31, 1998: Nil) by Trans-Orient Petroleum Ltd., a company having directors, officers and/or principal shareholders in common with the Company. Refer to Note 3
c) Marketable Securities and Investments
Marketable securities and investments consist entirely of common shares of companies having directors, officers and/or principal shareholders in common with the Company. These companies are Trans-Orient Petroleum Ltd., AMG Oil Ltd. and Gondwana Energy, Ltd. Refer to Notes 4 and 5
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 8 - RELATED PARTY TRANSACTIONS
d) Due from Related Parties
At December 31, 1999, the Company is owed $62,667 (December 31, 1998: $46,161) by certain public companies with directors, officers and/or principal shareholders in common with the Company. This amount is non- interest bearing and has no fixed terms for repayment.
e) Oil and Gas Properties
Certain participants of oil and gas properties have directors, officers and/or principal shareholders in common with the Company. These participants are Trans-Orient Petroleum Ltd., AMG Oil Ltd., Durum Cons. Energy Corp. and Gondwana Energy, Ltd.
Refer to Note 7
f) Other
During the 1999 fiscal year, the Company incurred $60,899 (1998 fiscal year - $57,123, 1997 fiscal year - $132,214) in consulting fees and $27,177 (1998 fiscal year - $19,480, 1997 fiscal year - Nil) in rent to the President of the Company.
During the 1997 fiscal year, the Company paid $12,820 to a private company owned by a former director of the Company pursuant to a consulting agreement cancelled during the same year.
NOTE 9 - COMMITMENTS AND CONTINGENCIES
a) Work Commitments
The Company participates in oil and gas exploration and development activities as a joint venturer with third and related parties and is contractually committed under agreements to complete certain exploration programs.
The Company's management estimates that the total commitments under various agreements is approximately $3,484,000 of which a related party participant has farmed into PEP 38256 to contribute approximately $455,000.
b) Political Risks
Papua New Guinea is subject to political uncertainty and instability and the Company faces a number of risks and uncertainties which may adversely impact on its ability to pursue its exploration and development activities.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 9 - COMMITMENTS AND CONTINGENCIES (continued)
c) Environmental Laws and Regulations
The Company is not aware of any events of noncompliance in its operations with any environmental laws or regulations nor of any potentially material contingencies related to environmental issues. However, the Company cannot predict whether any new or amended environmental laws or regulations introduced in the future will have a material adverse effect on the future business of the Company.
NOTE 10 - COMMON STOCK
a) Authorized and Issued Share Capital
The authorized share capital of the Company is 100,000,000 shares of common stock without par value. At December 31, 1999 and 1998, there were 28,262,398 shares of common stock issued and outstanding.
b) Incentive Stock Options
The Company applies Accounting Principles Board Opinion No. 25: Accounting for Stock Issued to Employees ("APB 25") to account for all stock options granted. Further, Statement of Financial Accounting Standards No. 123: Accounting for Stock-Based Compensation ("SFAS 123") requires additional disclosure to reflect the results of the Company had it elected to follow SFAS 123. SFAS 123 requires a fair value based method of accounting for stock options using the Black-Scholes option pricing model. This model was developed for use in estimating the fair value of traded options and require the input of and are highly sensitive to subjective assumptions including the expected stock price volatility. Stock options granted by the Company have characteristics significantly different from those of traded options. In the opinion of management, the existing model does not provide a reliable single measure of the fair value of stock options granted by the Company.
In accordance with SFAS 123, the following is a summary of the changes in the Company's stock options for the 1999, 1998 and 1997 fiscal years:
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 10 - COMMON STOCK (continued)
There were no stock options granted during the 1999 and 1998 fiscal years thus no weighted-average fair values have been assigned. For the 1997 fiscal year, the weighted-average fair value for stock options granted was estimated at the date of grant or amendment using a Black- Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 6.23%; volatility factors of the expected market price of the Company's common stock of 0.66; option lives of 1.64 years; and no expected dividends. A stock option grant during the 1997 fiscal year to purchase 500,000 shares at a price of $2.50 per share has been excluded from the fair value calculations as this stock option was cancelled without exercise subsequent to the year.
The following is a summary of the Company's net loss and basic and diluted loss per share as reported and pro forma as if the fair value based method of accounting defined in SFAS 123 had been applied for the 1999, 1998, and 1997 fiscal years:
The following stock options are outstanding at December 31, 1999:
During the 1999 fiscal year, previously granted stock options to purchase 50,000 shares at a price of $2.50 per share, 6,000 shares at a price of $3.00 per share and 10,000 shares at a price of $3.125 per share expired without exercise. No stock options were granted or amended by the Company during the 1999 fiscal year.
During the 1998 fiscal year, previously granted stock options to purchase 832,000 shares exercisable at a price of $2.50 per share until May 13, 1998 were amended to 300,000 shares exercisable at a price of $2.50 per share until May 13, 2000 and previously granted stock options to purchase 700,000 shares exercisable at a price of $2.50 per share until October 30, 1998 were extended to October 30, 2000. Additionally, previously granted stock options to purchase 500,000 shares exercisable at a price of $2.50 per share until March 25, 1999 were cancelled. No stock options were granted by the Company during the 1998 fiscal year. INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 10 - COMMON STOCK (continued)
c) Share Purchase Warrants
The following share purchase warrants to purchase shares of the Company are outstanding at December 31, 1999:
During the 1999 fiscal year, previously issued share purchase warrants to purchase 950,000 shares exercisable at a price of Cdn$3.485 per share until May 27, 1999 were amended to 950,000 shares exercisable at a price of $0.90 per share until May 27, 2000. Additionally, previously issued share purchase warrants to purchase 1,000,000 shares exercisable at a price of $2.00 per share until July 3, 1999 and thereafter at a price of $2.10 per share until July 3, 2000 were amended to 1,000,000 shares exercisable at a price of $0.90 per share until July 3, 2000.
During the 1998 fiscal year, share purchase warrants to purchase 950,000 shares exercisable at a price of Cdn$3.485 per share until May 27, 1998 were extended to May 27, 1999.
d) Escrow Shares
During the 1998 fiscal year, 1,406,250 shares at a price of Cdn$0.00333 per share, subject to escrow restrictions, were cancelled. To replace these cancelled escrow shares, 1,406,250 shares at a price of Cdn$0.01 per share were issued by private placements.
NOTE 11 - LOSS PER SHARE
The following is a reconciliation of the numerators and denominators of the basic and diluted loss per share calculations for the 1999, 1998 and 1997 fiscal years:
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 11 - LOSS PER SHARE (continued)
Due to net losses incurred for the 1999, 1998 and 1997 fiscal years, stock options and share purchase warrants outstanding were not included in the computation of diluted loss per share as the inclusion of such securities would be antidilutive.
NOTE 12 - INCOME TAXES
There are no income taxes payable for the 1999 and 1998 fiscal years. At December 31, 1999, the Company has approximately CDN$1.62 million (December 31, 1998 - CDN$1.59 million) of resource and other unused tax pools to offset future taxable income derived in Canada. Additionally, the Company has non-capital losses of approximately CDN$1.28 million (December 31, 1998 - CDN$1.13 million) available for future deductions from taxable income derived in Canada, which expire as follows:
2000 CDN$ 10,071 2001 52,731 2002 251,664 2003 662,559 2004 - 2005 153,875 2006 153,478 ----------- CDN$ 1,284,378 ===========
The Company also has losses and deductions of approximately NZ$9.79 million (December 31, 1998: NZ$6.39 million) available to offset future taxable income derived in New Zealand, Australia and Papua New Guinea.
The benefits of these excess resource tax pools and non-capital loss carryforwards have been offset by a valuation allowance of the same amount.
NOTE 13 - COMPARATIVE FIGURES
Certain comparative figures have been reclassified to conform to the current year's presentation.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 14 - UNCERTAINTY DUE TO THE YEAR 2000
The year 2000 issue arises because many computerized systems use two digits rather than four to identify a year. Date-sensitive systems may recognize the year 2000 as the year 1900 or some other date, resulting in errors when information is processed using year 2000 dates. In addition, similar problems may arise in some systems which use certain year 1999 dates to represent something other than a date. Although the change in date has occurred, it is not possible to conclude that all aspects of the year 2000 issue affecting the Company, including those related to the efforts of suppliers and other third parties, have been fully resolved.
NOTE 15 - SUBSEQUENT EVENTS
a) PEP 38256
The participants of PEP 38256 have committed to drill one exploration well prior to August 25, 2000.
By an amended agreement dated February 23, 2000 between AMG Oil Ltd. ("AMG"), Trans-Orient Petroleum Ltd. and the Company, AMG will fund the acquisition of additional seismic data in return for an extension of AMG's right to earn up to an additional 50% participating interest in PEP 38256 to June 15, 2000. Additionally, AMG's right to increase its participating interest in PEP 38256 has been amended as follows:
i) earn an additional 50% participating interest in PEP 38256 by funding all of the costs of drilling two exploration wells including any further seismic data required prior to drilling; or ii) earn an additional 35% participating interest in PEP 38256 by funding all of the costs of drilling one exploration well including any further seismic data required prior to drilling and, at the option of AMG upon completion of the first exploration well, earn a further 15% participating interest in PEP 38256 by funding all of the costs of drilling a second exploration well including any further seismic data required prior to drilling.
b) PEP 38330
By a farmout agreement dated January 20, 2000, the participants of PEP 38330 assigned a 17.5% participating interest in PEP 38330 to Boral Limited ("Boral") in return for funding by Boral of certain survey costs up to NZ$385,000. The other participants of PEP 38330 are Norwest Energy N.L. (27.225%), Mosaic Oil N.L. (27.225%) and the Company (28.05%).
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 15 - SUBSEQUENT EVENTS
c) Purchase of Oil and Gas Properties
By a letter of intent dated January 30, 2000 and under an effective date of January 1, 2000 between Trans-Orient Petroleum Ltd. ("Trans-Orient") and the Company, the Company agreed to acquire all of Trans-Orient's onshore and offshore oil and gas interests located in New Zealand, Australia and Papua New Guinea at a purchase price of $4,097,360, representing an aggregate 20% premium of the total book value of the interests. At the request of the boards of directors of both Trans-Orient and the Company, an independent party reviewed the proposed transaction and determined that the transaction was fair to both companies. As part of the transaction, the loan receivable from Trans- Orient to the Company will be offset against the purchase price.
The Company will issue 4,184,224 units of the Company to Trans-Orient at a deemed value of $0.50 per unit for a total value of $2,092,112. Each unit consists of one common share of the Company, one Series A warrant and one Series B warrant. Each Series A warrant is exercisable to purchase one common share at a price of $0.50 during the first year and thereafter at a price of $0.75 during the second year. Each Series B warrant will, upon a commercial discovery on any one of the oil and gas interests in the transaction, replace each Series A warrant exercised and is exercisable to purchase one common share at a price of $1.50 until expiry during the first two years. Additionally, the Company will provide Trans-Orient with anti-dilution protection for a period of our year from the closing date if the aggregate amount raised is greater than $500,000 and the average price is less than $0.50 per share or unit.
The Company will provide Trans-Orient additional consideration for the transaction, as follows:
i) 1,800,000 common shares of AMG Oil Ltd. ("AMG Oil") acquired at a cost of $650,000 and valued at $720,000 for the transaction, including the option to purchase a further 200,000 shares of AMG Oil at a price of $0.50 per share expiring on December 31, 2000; ii) 600,000 shares of Gondwana Energy, Ltd. acquired at a cost of and valued at $20,000 for the transaction; iii) 517,020 shares of Trans-Orient Petroleum Ltd. acquired at a cost of $383,075 and valued at $222,319 for the transaction; and iv) gross overriding royalties, valued at $1 for the transaction, on all oil and gas interests purchased from Trans-Orient ranging from 1% to 5%.
This transaction is subject to approval by the shareholders of Trans- Orient and upon closing, will be subject to certain exchange gains or losses.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 16 - DIFFERENCES BETWEEN UNITED STATES AND CANADIAN GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
These financial statements have been prepared in accordance with United States generally accepted accounting principles ("U.S. GAAP") which conform in all material respects with Canadian generally accepted accounting principles ("Canadian GAAP") except for the following differences:
CONSOLIDATED BALANCE SHEETS
a) Assets
i) Marketable Securities
Under U.S. GAAP, the Company's marketable equity securities are classified as available-for-sale securities and reported at market value, with unrealized gains and losses included as a component of comprehensive income. Under Canadian GAAP, the Company's marketable equity securities are valued at the lower of cost or market value.
Total current assets under Canadian GAAP as at December 31, 1999 and 1998 are $6,408,980 and $8,735,314, respectively.
ii) Investments
Under U.S. GAAP, the Company's long-term investments are classified as available-for-sale securities and reported at market value, with unrealized gains and losses included as a component of comprehensive income. Under Canadian GAAP, the Company's long-term investments are valued at the lower of cost or market value.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 16 - DIFFERENCES BETWEEN UNITED STATES AND CANADIAN GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
Total assets under Canadian GAAP as at December 31, 1999 and 1998 are $10,879,165 and $11,939,336, respectively.
b) Stockholders' Equity
i) Common Stock
Under U.S. GAAP, compensation cost must be considered for all stock options granted requiring the Company to utilize both the intrinsic value-based and the fair value based methods of accounting and reporting stock-based compensation. Under Canadian GAAP, no such cost is recognized.
ii) Accumulated Deficit
The effects of Note 16(b)(i) on accumulated deficit are as follows:
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 16 - DIFFERENCES BETWEEN UNITED STATES AND CANADIAN GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
iii) Cumulative Comprehensive Adjustment
Under U.S. GAAP, the components of other comprehensive income (loss) are required to be reported as part of the basic financial statements. Under Canadian GAAP, no such requirement exists.
The effects of Note 16(a) on cumulative comprehensive adjustment are as follows:
As a result of these adjustments under Canadian GAAP, total stockholders' equity as at December 31, 1999 and 1998 are $10,601,182 and $11,782,440, respectively.
CONSOLIDATED STATEMENTS OF OPERATIONS
c) Net Loss for the Year
The following are the effects of Note 16 (b) on net loss for the 1999, 1998 and 1997 fiscal years:
d) Loss per Share
Under U.S. GAAP, shares held in escrow are excluded from the calculation of the weighted-average number of shares outstanding until such shares are released for trading. Under Canadian GAAP, shares held in escrow are included in the calculation of loss per share.
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 16 - DIFFERENCES BETWEEN UNITED STATES AND CANADIAN GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
The following is a reconciliation of the numerators and denominators of the basic and diluted loss per share calculations for the 1999, 1998 and 1997 fiscal years:
Due to net losses incurred for the 1999, 1998 and 1997 fiscal years, stock options and share purchase warrants outstanding were not included in the computation of diluted loss per share as the inclusion of such securities would be antidilutive.
CONSOLIDATED STATEMENTS OF CASH FLOWS
e) Operating Activities
The following are the effects of the adjustments required to reconcile from U.S. to Canadian GAAP for the 1999, 1998 and 1997 fiscal years:
INDO-PACIFIC ENERGY LTD. Notes to the Consolidated Financial Statements (Expressed in United States Dollars) For the Years Ended December 31, 1999 and 1998
NOTE 16 - DIFFERENCES BETWEEN UNITED STATES AND CANADIAN GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
CONSOLIDATED SCHEDULES OF GENERAL AND ADMINISTRATIVE EXPENSES
f) General and Administrative Expenses
The following are the effects of Note 16(b) on general and administrative expenses for the 1999, 1998 and 1997 fiscal years:
INDO-PACIFIC ENERGY LTD.
SUPPLEMENTARY INFORMATION ON OIL AND GAS PRODUCING ACTIVITIES (EXPRESSED IN UNITED STATES DOLLARS)
AS AT DECEMBER 31, 1999 (Unaudited - Prepared by Management)
PROVED PETROLEUM AND NATURAL GAS RESERVE QUANTITIES
12/31/99 12/31/98 12/31/97 12/31/96
PETROLEUM RESERVES
Proved developed reserves, end of period Oil (barrels) 70,400 90,000 110,500 70,000 Gas (billion cubic feet) 0.03 0.13 0.17 0.17
Proved reserves, end of period Oil (barrels) 70,400 90,000 110,500 145,000 Gas (billion cubic feet) 0.03 0.13 0.17 0.40
All petroleum and natural gas reserves are located in New Zealand.
Petroleum and natural gas reserves cannot be measured exactly. Reserve estimates are based on many factors related to reservoir performance which require evaluation by engineers interpreting available date, as well as price, costs and other economic factors. The reliability of these estimates at any point in time depends on both the quantity of the technical and economic data, the production performance of the reservoirs as well as extensive engineering judgement. Consequently, reserve estimates are subject to revision as additional data becomes available during the producing life of a reservoir. When a commercial reservoir is discovered, proved reserves are initially determined based on only limited data from the first well or wells. Further drilling may better define the extent of the reservoir and additional production performance, well tests and engineering studies will likely improve the reliability of the estimate.
Proved developed reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Proved reserves are reserves which geological and engineerying data demonstrate with reasonable certainty to be recoverable in future years from known reserves under existing economic and operating conditions. Reserves are considered proved if economic producibility is supported by either production or conclusive formation tests.
SF-1
INDO-PACIFIC ENERGY LTD.
SUPPLEMENTARY INFOMRATION ON OIL AND GAS PRODUCING ACTIVITIES (EXPRESSED IN UNITED STATES DOLLARS)
AS AT DECEMBER 31, 1999 (Unaudited - Prepared by Management)
STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVES
12/31/99 12/31/98 12/31/97 12/31/96
Future cash inflows $ 1,645,840 $ 1,222,000 $ 1,493,878 $ 850,040
Future production and development costs to abandonment at December 31, 2006 572,996 644,500 639,322 314,576
Future income taxes - - - - ----------- ----------- ----------- --------- 1,072,844 577,500 854,556 535,464 Discount at 10% annual rate for estimated timing of cash flows 202,174 117,000 169,983 54,025 ----------- ----------- ----------- --------- $ 870,670 $ 460,500 $ 684,573 $ 481,439 =========== =========== =========== =========
Undiscounted future net cash flows from proved producing oil and natural gas reserves is largely based on information provided by in-house reserve calculations. A discount factor of 10% was applied to estimated future cash flows to compute the estimated present value of proved oil and natural gas reserves. This valuation procedure does not necessarily result in an estimate of the fair market value of the Company's oil and natural gas properties.
There has been no provision for income taxes, as the Company has resource and other usused tax pools to offset future taxable income.
The only change in the standardized measure of future cash flows from production has been due to the purchase of Ngatoro Energy Limited (formerly Minora Energy (New Zealand) Limited), a company whose sole asset was a 5% interest in the producing Ngatoro oil field. This is the only interest the Company holds in a proven oil property. The standarized measure calculation for the property, at December 31, 1999, was $870,670, as compared to the Net Book Value of $374,417.
SF-2
INDO-PACIFIC ENERGY LTD.
RESULTS OF OPERATION FOR PRODUCING ACTIVITIES (EXPRESSED IN UNITED STATES DOLLARS)
FOR THE YEAR ENDED DECEMBER 31, 1999 (Unaudited - Prepared by Management)
Total New Zealand
REVENUES
Petroleum and natural gas $ 314,698 $ 314,698 ----------- ---------- Amortization and depletion 104,475 104,475 Production costs 50,598 50,598 Royalties 15,248 15,248 Write-down of petroleum properties 983,168 650,703 ----------- ---------- 1,153,489 821,024 ----------- ---------- RESULTS OF OPERATIONS FROM PRODUCING ACTIVITIES (excluding corporate overhead and interest costs) $ (838,791) $ (506,326) ============ ==========
SF-3
ITEM 9.
ITEM 9.
There have been no disagreements on accounting and financial disclosures during the last three fiscal years to the date of this annual report.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The names, municipality of residence, age and position held of the directors and officers of the Registrant are as follows:
Name Age Position Held
Dr. David Bennett[1] 54 President, Chief Executive Officer and Director
Ronald Bertuzzi[1][2] 63 Director
Alex P. Guidi[3] 41 Chairman of the Board and Director
Brad J. Holland[1] 43 Director
Mark Katsumata 34 Secretary
[1] Member of audit committee.
[2] Appointed on March 31, 1998.
[3] Subsequent to the year end, Mr. Guidi has stepped down as Chairman of the Registrant. David R. McDonald has joined the Board of Directors and has assumed the position of Chairman.
Dr. David Bennett has been a member of the board of directors and an officer since October, 1996. Dr. Bennett received a Bachelor of Arts (Natural Sciences) from Cambridge University in 1968 and a Master of Science in Exploration Geophysics from the University of Leeds in 1969. In 1973, Dr. Bennett received his doctorate in Geophysics from the Australian National University and from 1973 to 1975 conducted post- doctoral research at the University of Texas (Dallas). From 1975 to 1977, Dr. Bennett was a post-doctoral fellow and lecturer at the University of Wellington, New Zealand. From 1977 to 1982, Dr. Bennett was employed by the Department of Scientific and Industrial Research, Government of New Zealand and from 1982 to 1994 was employed as geophysicist, exploration manager and finally general manager by New Zealand Oil and Gas Ltd. Dr. Bennett was an independent consultant from 1994 to 1996 when he joined the Registrant and other associated companies. Dr. Bennett has been the president and a member of the board directors of the Registrant since October, 1996. Since November, 1996, Dr. Bennett has been a member of the board of directors, and since April, 1997 the president, of Trans-Orient Petroleum Ltd., since April, 1997 a member of the board of directors of Durum Cons. Energy Corp. and since June 25, 1998 a member of the board of directors of AMG Oil Ltd.
Mr. Bertuzzi was a member of the board of directors from October 2, 1992 to October 30, 1996 and was appointed on March 31, 1998 to fill the vacancy resulting from the passing of Mr. John Holland. Mr. Bertuzzi received a Bachelor of Arts from the University of British Columbia in 1965 and has worked in the medical sales and product development industries since that time. Mr. Bertuzzi is a member of the board of directors of several companies, including AMG Oil Ltd., of which he is president, and Gondwana Energy, Ltd., of which he is a member of the Board of Directors.
Mr. Alex Guidi has been a member of the board of directors and an officer since October 1996. Mr. Guidi has been involved in public markets since 1985 and since 1989 in the oil and gas sector. Mr. Guidi has organized and financed several oil and gas companies. Mr. Guidi has been chairman of the board and a member of the board of directors of the Registrant since October, 1996. From July, 1988 to December, 1995, Mr. Guidi was a member of the board of directors of Trans-Orient Petroleum Ltd. and was elected a member of the board of directors on January 28, 1998 and chairman on April 22, 1998. From December, 1990 to May, 1996, Mr. Guidi was a member of the board of directors of Durum Cons. Energy Corp. and was president from August, 1992 to May, 1996. From August 6, 1997 Mr. Guidi has been a member of the board of directors of AMG Oil Ltd.
Mr. Brad Holland was a member of the board of directors from May 1996 to February 1997, an officer from February 1997 to October 15, 1997 and was appointed a member of the board on October 15, 1997. Mr. Holland received a Bachelor of Science in Chemical Engineering from the University of Alberta in 1979. Mr. Holland was initially employed for two years by John Holland Consultants Ltd. in property valuation, production management, evaluation and financing for production acquisition. From 1982 to 1988, Mr. Holland was employed by Canadian Western Natural Gas, a natural gas utility. From 1988 to 1992, Mr. Holland was employed as a senior project engineer with Nova Corp. where he was responsible for the design and construction of large diameter pipeline projects. Since 1992, Mr. Holland has been employed by ARAMCOin Saudi Arabia in the construction of pipelines.
Mr. Mark Katsumata was a director and officer from December, 1994 to November, 1995 and an officer from November, 1995 to February, 1997. Mr. Katsumata was appointed Secretary on October 15, 1997. Mr. Katsumata is a certified general accountant who was in public practice from 1990 to 1994 in Vancouver, B.C. In 1994 Mr. Katsumata joined the Registrant. Mr. Katsumata is also the secretary of Trans-Orient Petroleum Ltd., Durum Cons. Energy Corp., AMG Oil Ltd. and Gondwana Energy, Ltd. Mr. Katsumata is also the Corporate Secretary and Chief Financial Officer of Verida Internet Corp.
All directors have a term of office expiring at the next annual general meeting of the Registrant to be scheduled in June 2000 unless re-elected or unless a director's office is earlier vacated in accordance with the by-laws of the Registrant or the provisions of the Business Corporations Act (Yukon). All officers have a term of office lasting until their removal or replacement by the board of directors.
Indemnification of Directors and Officers
Except with respect to an action by the Registrant to obtain a judgment, the constating documents of the Registrant provide for the indemnification of any director, officer, employee or agent of the Registrant if the person acted honestly and in good faith with a view to the best interests of the Registrant and, with respect to any criminal action or administrative proceeding, had reasonable grounds to believe that his action was lawful. The Registrant has not, however, entered into any agreement with a director and officer providing for the grant of a covenant of indemnity by the Registrant pursuant to this provision in the constating documents of the Registrant.
With respect to an action to obtain a judgment, the Registrant is required under the Business Corporations Act (Yukon) before performing its obligation to indemnify to obtain the approval of the Supreme Court (Yukon) of the indemnity and any payment to be made in connection with the indemnity.
To date, no agreements to contractually provide indemnities have been executed and delivered.
Compliance with Section 16(a) of the Securities Exchange Act of 1934.
Section 16(a) of the Securities and Exchange Act of 1934 requires officers, directors and persons who own more than ten percent of a registered class of a company's equity securities to file initial reports of beneficial ownership and to report changes in ownership of those securities with the Securities and Exchange Commission. They are also required to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledge, based solely on review of the copies of Forms 3, 4 and 5 furnished to the Company or written representations that no other transactions were required, the Company has determined that the pertinent officers, directors and principal shareholders have complied with all applicable Section 16(a) requirements during fiscal 1998.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth the aggregate compensation paid by the Company for services rendered during the period indicated:
SUMMARY COMPENSATION TABLE
[1] In fiscal 1998, 1,406,250 shares held in escrow and previously issued for CDN$4,688 in 1994 were cancelled. International Resource Management Corporation, a private company wholly-owned by Alex Guidi, held 1,361,250 of these shares with the remaining 45,000 shares held by two former directors. To replace the cancelled shares, 1,406,250 shares for total proceeds of CDN$14,063 were reallocated through private placements to International Resource Management Corporation as to 1,181,250 shares and to the DJ and JM Bennett Family Trust as to 225,000 shares.
[2] During the year Ms Jenni Lean, spouse of Dr. David Bennett, received $24,125 in salary. Ms Lean is the Corporate Affairs Manager for the Registrant
[3] David Bennett and Jenni Lean, via the DJ and JM Bennett Family Trust, own the building in which the Registrant's New Zealand office is located. During the year the Registrant paid $27,177 in office rental costs for the use of the building.
Cash Compensation.
During the year ended December 31, 1999 the Registrant had two executive officers: David Bennett, president and chief executive officer and Alex Guidi, chairman of the board. The aggregate cash compensation paid or payable by the Registrant and its subsidiaries to its executive officers during the year ended December 31, 1999 was $60,899 all of which was compensation paid to Dr. Bennett.
During the year ended December 31, 1998 the Registrant had two executive officers: David Bennett, president and chief executive officer and Alex Guidi, chairman of the board. The aggregate cash compensation paid or payable by the Registrant and its subsidiaries to its executive officers during the year ended December 31, 1998 was $57,123 all of which was compensation paid to Dr. Bennett.
During the year ended December 31, 1997 the Registrant had two executive officers: David Bennett, president and chief executive officer and Alex Guidi, chairman of the board. The aggregate cash compensation paid or payable by the Registrant and its subsidiaries to its executive officers during the year ended December 31, 1997 was $132,214 all of which was compensation paid to Dr. Bennett.
Compensation of Directors.
The Company's Board of Directors unanimously resolved that members receive no compensation for their services, however, they are reimbursed for travel expenses incurred in serving on the Board of Directors.
No other cash compensation, including salaries, fees, commissions, and bonuses, was paid or is to be paid to the directors and officers of the Registrant for services rendered for the financial years ended December 31, 1999.
No profit sharing, pension or retirement benefit plans have been instituted by the Registrant and none are proposed at this time. There are no arrangements for payments on termination of any member of management in the event of a change of control.
Aggregated Option/SAR Exercises and Fiscal 1999 Year-End Option/SAR Value Table.
The following table sets forth certain information with respect to each exercise of stock options and SARs during fiscal 1999 by each of the Named Executive Officers, and the fiscal 1999 year-end value of unexercised options and SARs. The dollar values are calculated by determining the difference between the exercise or base price of the options and the fair market value of the underlying stock at the time of exercise and at fiscal year-end if unexercised, respectively. The unexercised options, some of which may be exercisable, have not been exercised and it is possible they might never be exercised. Actual gains realized, if any, on stock option exercises and common stock holdings are dependent on the future performance and value of the Common Stock and overall stock market conditions. There can be no assurance that the projected gains and values shown in this Table will be realized.
AGGREGATED OPTION/SAR EXERCISES IN FISCAL 1999 AND OPTION/SAR VALUES AT DECEMBER 31, 1999
No Options were granted to the directors or executive officers during the 1999 fiscal year.
There were no directors' or senior officers' options exercised in the year ended December 31, 1999. There were no directors' or senior officers' options exercised in the year ended December 31, 1998. The aggregate value of directors' and senior officers' options exercised below the market price of the shares at the time of exercise for the year ended December 31, 1997 was $570,660. These benefits are calculated as the difference between the market price and option exercise price on the date of exercise. Actual proceeds of the disposition will usually vary from the date of the exercise to the date of actual disposition of such shares.
Long-Term Incentive Plan Awards.
The Company does not have any formalized long-term incentive plans, excluding restricted stock, stock option and SAR plans, which provide compensation intended to serve as incentive for performance to occur over a period longer than one fiscal year, whether such performance is measured by reference to financial performance of the Company or an affiliate, the Company's stock price, or any other measure.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Beneficial Holders of More Than Five Percent of Outstanding Shares
The following schedule sets forth the Common Stock ownership of each person known by the Company to be the beneficial owner of five percent or more of the Company's Common Stock, each director, individual, and all officers and directors of the Company as a group. Each person or entity has sole voting and investment power with respect to the shares of Common Stock shown, and all ownership is of record and beneficial.
Name and address Number of Percent of owner Shares Position of Class
David Bennett[1] 225,000 President, CEO 0.8% Karori, Wellington and Director New Zealand
Ronald Bertuzzi 1,790 Director 0.0% Vancouver, BC Canada
Alex Guidi 5,724,076 Chairman of Board 20.3% Vancouver, BC Canada
Brad Holland Nil Director Nil Dhahran, Saudi Arabia
Mark Katsumata 4,000 Secretary 0.0% Surrey, BC Canada
ALL OFFICERS AND DIRECTORS AS A GROUP (5 persons) 5,954,866 21.1%
[1] By an agreement dated April 15, 1998 the DJ and JM Bennett Family Trust purchased 225,000 shares at Cdn$0.01 per share, subject to release on board approval from time to time.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
No director or senior officer, and no associate or affiliate of the foregoing persons, and no insider has, or has had any material interest, direct or indirect, in any transactions, or in any proposed transaction which in either such case has materially affected or will materially affect the Registrant or its predecessors except as disclosed herein.
Mr. Alex Guidi is a member of the board of directors, the chairman and principal shareholder of the promoter of the Registrant. Mr. Guidi is the chairman, a member of the board of directors, principal shareholder and the promoter of Trans-Orient Petroleum Ltd. Mr. Guidi is the principal shareholder of Durum Cons. Energy Corp.
Mr. Guidi is a member of the member of the board of directors, the principal shareholder and the promoter of AMG. Oil Ltd. Mr. Guidi is the principal shareholder and promoter of Gondwana Energy Ltd. See below regarding shareholdings and options, warrants and rights to acquire shares beneficially held by Mr. Guidi.
Dr. David Bennett is the president, chief executive officer shareholder and a member of the boards of directors of the Registrant, Trans-Orient Petroleum Ltd. and Durum Cons. Energy Corp. Dr. Bennett is a member of the board of directors and shareholder of AMG Oil Ltd.
Mr. Ronald Bertuzzi is a member of the boards of directors and shareholder of the Registrant Trans-Orient Petroleum Ltd. and AMG Oil Ltd. Mr. Bertuzzi is also a member of the board of directors and shareholder of Gondwana Energy Ltd.
Mr. Brad Holland is a director of the Registrant and is a shareholder in Trans-Orient Petroleum Ltd., Durum Cons. Energy Corp., AMG Oil Ltd. and Gondwana Energy Ltd.
Mr. Mark Katsumata is the secretary and a shareholder of the Registrant, Trans-Orient Petroleum Ltd., Durum Cons. Energy Corp., AMG Oil Ltd. and Gondwana Energy Ltd.
The related transactions in the year ended December 31, 1999 are:
(a) On January 31, 2000 the Registrant announced that it had entered into a letter of intent to acquire all the Assets of Trans-Orient Petroleum Ltd. A formal agreement has been finalized with formal closing of the Agreement expected to occur on or about March 31, 2000 while the effective date of the Agreement is January 1, 2000. The Agreement is subject to ratification by the shareholders of Trans-Orient Petroleum Ltd. at a General Meeting of the shareholders of Trans-Orient Petroleum Ltd. which is to be held on May 23, 2000. In the event the Trans-Orient Petroleum Ltd. shareholders do not approve this Agreement by a requisite extraordinary majority or in the event that a sufficient number of Trans-Orient Petroleum Ltd. shareholders exercise dissent rights which, in the opinion of Trans-Orient Petroleum Ltd. acting reasonably, makes the transaction financially impractical then the parties agree that Trans-Orient Petroleum Ltd. and its affiliates who are parties hereto shall have the right, exercisable for seven days, to elect to rescind the transactions contemplated by the Agreement or alternatively to seek judicial direction as to those elements of the transaction which can be completed without requiring shareholders consent. Pending May 23, 2000 the parties shall not deal with the exchanged consideration in a way which makes effective rescission of the Agreement impossible and in particular Trans-Orient Petroleum Ltd. shall not deal
with the Registrant's securities received and the Registrant shall not sell, transfer, mortgage or otherwise encumber the Assets except with the consent of Trans-Orient Petroleum Ltd. which Trans-Orient Petroleum Ltd.will give for all transactions which can be said to be in the ordinary course of business. The value placed upon the Assets by the Registrant and Trans-Orient Petroleum Ltd. was $4,089,836 less an intercompany loan from the Registrant to Trans-Orient Petroleum Ltd. in the amount of $1,042,928; resulting in a net consideration payable by the Registrant to Trans-Orient Petroleum Ltd. of $3,054,434. See ITEM 1. BUSINESS for a description of the Assets acquired.
(b) At December 31, 1999, Trans-Orient Petroleum Ltd. owed a total of $1,062,211 including interest charges of $18,051 to the Registrant as a result of accrued joint venture permit expenditures which were paid by the Registrant on behalf of joint venture operations in which Trans-Orient Petroleum Ltd. was a participant with the Registrant. The majority of this amount relates to drilling the Whakutu-1 and Clematis-1 wells. The $1,062,211 outstanding was offset against the purchase price paid by the Registrant to Trans-Orient Petroleum Ltd. for the purchase of its permit interests.
(c) In December 1999. Durum Cons. Energy Corp. relinquished its (4%) interest in PEP 38716 in favor of the Registrant for no costs. After being assigned this interest the Registant holds a 23.8% interest in the permit.
(d) The Registrant and Trans-Orient Petroleum Ltd. by agreement dated June 25, 1998 optioned up to 80% of the permit to AMG Oil Ltd. In August 1998 AMG Oil Ltd. earned 30% of the permit by paying the cost of a 120 mile seismic survey. To earn an additional 50%, AMG was required to elect before December 4, 1998 to pay the cost of any additional seismic required to define two drilling prospects and to pay the dry hole costs of drilling two wells to a maximum of about US$2,100,000. The option agreement was modified by three subsequent agreements dated December 3, 1998, October 26, 1999 and February 23, 2000 which extended the period of time in which the AMG must exercise its option to acquire up to a further 50% interest in the 38256 permit area to June 16, 2000. Additionally, the February 23, 2000 amendment provided AMG with a choice of committing to: ( Option A') to earn an additional 50% in PEP 38256 from the Registrant by funding all expenditure including an agreed program of seismic work leading up to and including the drilling of two exploration wells. Alternatively, AMG may, at its election, earn an additional 35% the Registrant in the permit by funding all work leading up to and including the drilling of one exploration well ( Option B'). In the event that the AMG exercises Option B, it shall acquire a further option ( Option C') to earn an additional 15% in the permit by funding all further work up to and including a second exploration well on a separate exploration target. Option C must be exercised within 30 days of reaching the predetermined target depth in the exploration well drilled pursuant to exercise of Option B.
(e) On March 17, 1999 the Registrant partially exercised its share purchase option in AMG Oil Ltd. and acquired 800,000 common shares at a cost of $400,000.
(f) During the year ending December 31, 1999, the Registrant paid $27,177 in office rental fees to the DJ & JM Bennett Family Trust, which owns the building in which the Registrant's New Zealand office is located.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
All schedules are omitted because they are not applicable or the required information is included in the financial statements or notes thereto.
B. Reports on Form 8-K
During the 1999 fiscal year the Company filed no reports on Form 8-K.
C. Index to Exhibits
The following Exhibits are filed herewith:
Exhibit Number Document Description
27 Financial Data Schedule 99.1 PEP 38256 Option Amending Agreement 99.2 Change in conditions to permit PEP 38723 99.3 Farm-out Agreement on PEP38330
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report and any amendment thereto to be signed on its behalf by the undersigned, thereunto duly authorized.
INDO-PACIFIC ENERGY LTD.
By: /s/ David J. Bennett April 11, 2000 David J. Bennett, President and Chief Executive Officer
Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report and any amendment thereto to be signed on its behalf by the undersigned, thereunto duly authorized.
INDO-PACIFIC ENERGY LTD.
By: /s/ Alex Guidi April 11, 2000 Alex Guidi, Chairman of the Board of Directors
By: /s/ D. J. Bennett April 11, 2000 Dr. David Bennett, Member of the Board of Directors | 22,764 | 143,011 |
914169_1999.txt | 914169_1999 | 1999 | 914169 | ITEM 1. BUSINESS - ------- --------
Unless the context otherwise requires, the term "Company" refers to Canandaigua Brands, Inc. and its subsidiaries, and all references to "net sales" refer to gross revenue less excise taxes and returns and allowances to conform with the Company's method of classification. All references to "Fiscal 1999", "Fiscal 1998" and "Fiscal 1997" shall refer to the Company's fiscal year ended the last day of February of the indicated year.
Industry data disclosed in this Annual Report on Form 10-K has been obtained from Adam's Media Handbook Advance, NACM, AC Nielsen, The U.S. Wine Market: Impact Databank Review and Forecast and the Zenith Guide. The Company has not independently verified this data. References to positions within industries are based on unit volume.
The Company is a leading producer and marketer of branded beverage alcohol products in the United States and the United Kingdom. According to available industry data, the Company ranks as the second largest supplier of wine, the second largest importer of beer and the fourth largest supplier of distilled spirits in the United States. The Matthew Clark Acquisition (as defined below) established the Company as a leading British producer of cider, wine and bottled water and as a leading beverage alcohol wholesaler in the United Kingdom.
The Company is a Delaware corporation organized in 1972 as the successor to a business founded in 1945 by Marvin Sands, Chairman of the Board of the Company. The Company has aggressively pursued growth in recent years through acquisitions, brand development, new product offerings and new distribution agreements. The Matthew Clark Acquisition and the Black Velvet Acquisition (as defined below) continued a series of strategic acquisitions made by the Company since 1991 by which it has diversified its offerings and as a result, increased its market share, net sales and cash flow. The Company has also achieved internal growth by developing new products and repositioning existing brands to focus on the fastest growing sectors of the beverage alcohol industry.
The Company markets and sells over 170 national and regional branded products to more than 1,000 wholesale distributors in the United States. The Company also distributes its own branded products and those of other companies to more than 16,000 customers in the United Kingdom. The Company operates 20 production facilities in the United States, Canada and the United Kingdom and purchases products for resale from other producers.
RECENT ACQUISITIONS
MATTHEW CLARK ACQUISITION
On December 1, 1998, the Company acquired control of Matthew Clark plc ("Matthew Clark") and has since acquired all of Matthew Clark's outstanding shares (the "Matthew Clark Acquisition"). Matthew Clark grew substantially in the 1990s through a series of strategic acquisitions, including Grants of St. James's in 1993, the Gaymer Group in 1994 and Taunton Cider Co. in 1995. These acquisitions served to solidify Matthew Clark's position within its key markets and contributed to an increase in net sales to approximately $671 million for Matthew Clark's fiscal year ended April 30, 1998. Matthew Clark has developed a number of leading market positions, including positions as a leading independent beverage supplier to the on-premise trade, the number one producer of branded boxed wine,
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the number one branded producer of fortified British wine, the number one branded bottler of sparkling water and the number two producer of cider.
The Matthew Clark Acquisition strengthens the Company's position in the beverage alcohol industry by providing the Company with a presence in the United Kingdom and a platform for growth in the European market. The acquisition of Matthew Clark also offers potential benefits including distribution opportunities to market California-produced wine and U.S.-produced spirits in the United Kingdom, as well as the potential to market Matthew Clark products in the U.S.
ACQUISITION OF BLACK VELVET CANADIAN WHISKY BRAND AND RELATED ASSETS
On April 9, 1999, in an asset acquisition, the Company acquired several well-known Canadian whisky brands, including Black Velvet, the third best selling Canadian whisky and the 16th best selling spirits brand in the United States, production facilities located in Alberta and Quebec, Canada, case goods and bulk whisky inventories and other related assets from affiliates of Diageo plc (collectively, the "Black Velvet Acquisition"). Other principal brands acquired in the transaction were Golden Wedding, OFC, MacNaughton, McMaster's and Triple Crown. In connection with the transaction, the Company also entered into multi-year agreements with Diageo to provide packaging and distilling services for various brands retained by Diageo.
The addition of the Canadian whisky brands from this transaction strengthens the Company's position in the North American distilled spirits category, and enhances the Company's portfolio of brands and category participation. The acquired operations are being integrated with the Company's existing spirits business.
RECENT DEVELOPMENTS-PENDING ACQUISITIONS OF SIMI WINERY AND FRANCISCAN ESTATES
SIMI WINERY
On April 1, 1999, the Company entered into a definitive agreement with Moet Hennessy, Inc. to purchase all of the outstanding capital stock of Simi Winery, Inc. ("Simi"). (The acquisition of the capital stock of Simi is hereafter referred to as the "Simi Acquisition.") The Simi Acquisition includes the Simi winery (located in Healdsburg, California), equipment, vineyards, inventory and worldwide ownership of the Simi brand name. Founded in 1876, Simi is one of the oldest and best known wineries in California, combining a strong super-premium and ultra-premium brand with a flexible and well-equipped facility and high quality vineyards in the key Sonoma appellation.
FRANCISCAN ESTATES
On April 21, 1999, the Company entered into (i) a definitive purchase agreement with Franciscan Vineyards, Inc. ("Franciscan") and its shareholders to, among other matters, purchase all of the outstanding capital stock of Franciscan and (ii) definitive purchase agreements with certain parties related to Franciscan to acquire certain vineyards and related vineyard assets (collectively, the "Franciscan Acquisition"). Pursuant to the Franciscan Acquisition, the Company will: (i) acquire the Franciscan Oakville Estate, Estancia and Mt. Veeder brands; (ii) acquire wineries located in Rutherford, Monterey and Mt. Veeder, California; (iii) acquire vineyards in the Napa Valley, Alexander Valley, Monterey and Paso Robles appellations and additionally, will enter into long-term grape contracts with certain parties related to Franciscan to purchase additional grapes grown in the Napa and Alexander Valley appellations; (iv) acquire distribution rights to the Quintessa and Veramonte brands; and (v)
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acquire equity interests in entities that own the Veramonte brand, the Veramonte winery (which is located in the Casablanca Valley, Chile) and vineyards also located in the Casablanca Valley. Franciscan's net sales for its fiscal year ended December 31, 1998, were approximately $50 million on volume of approximately 600,000 cases.
Franciscan is one of the foremost super-premium and ultra-premium wine companies in California. While the super-premium and ultra-premium wine categories represented only 9% of the total wine market by volume in 1997, they accounted for more than 25% of sales dollars. More importantly, super-premium and ultra-premium wine sales grew at an annual rate of 10% between 1995 and 1997, and by more than 18% in 1998. Given its fiscal 1998 volume of approximately 600,000 cases sold, Franciscan has recorded a three-year compound annual growth rate of more than 17%.
When completed, the Simi and Franciscan Acquisitions will establish the Company as a leading producer and marketer of super-premium and ultra-premium wine. The Simi and Franciscan operations complement each other and offer synergies in the areas of sales and distribution, grape usage and capacity utilization. Together, Simi and Franciscan represent the sixth largest presence in the super-premium and ultra-premium wine categories. The Company intends to operate Simi and Franciscan, and their properties, together as a separate business segment. The Company's strategy is to further penetrate the super-premium and ultra-premium wine categories, which have higher gross profit margins than popularly-priced wine.
The agreements for the Simi and Franciscan Acquisitions are subject to certain customary conditions prior to closing, which the Company expects will be satisfied. The Company cannot guarantee, however, that those transactions will be completed upon the agreed upon terms, or at all.
PRIOR ACQUISITIONS
The Company made a series of significant acquisitions between 1991 and 1995, commencing with the acquisition of the Cook's, Cribari, Dunnewood and other wine brands and related wine production facilities in 1991. In 1993, the Company diversified into the imported beer and distilled spirits categories by acquiring Barton Incorporated, through which the Company acquired distribution rights with respect to Corona Extra and other Modelo brands, St. Pauli Girl and other imported beer brands, and the Barton, Ten High, Montezuma and other distilled spirits brands. Also in 1993, the Company acquired the Paul Masson, Taylor California Cellars and other wine brands and related production facilities. In 1994, the Company acquired the Almaden, Inglenook and other wine brands, a grape juice concentrate business and related facilities. In 1995, the Company acquired the Mr. Boston, Canadian LTD, Skol, Old Thompson, Kentucky Tavern, Glenmore and di Amore distilled spirits brands; the rights to the Fleischmann's and Chi-Chi's distilled spirits brands under long-term license agreements; the U.S. rights to the Inver House, Schenley and El Toro distilled spirits brands; and related production facilities and assets.
Through these acquisitions, the Company has become more competitive by diversifying its portfolio; developing strong market positions in the growing beverage alcohol product categories of varietal table wine and imported beer; strengthening its relationships with wholesalers; expanding its distribution and enhancing its production capabilities; and acquiring additional management, operational, marketing, and research and development expertise.
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BUSINESS SEGMENTS
The Company operates primarily in the beverage alcohol industry in the United States and the United Kingdom. The Company reports its operating results in four segments: Canandaigua Wine (branded wine and brandy, and other, primarily grape juice concentrate); Barton (primarily beer and spirits); Matthew Clark (branded wine, cider and bottled water, and wholesale wine, cider, spirits, beer and soft drinks); and Corporate Operations and Other (primarily corporate related items).
Information regarding net sales, operating income and total assets of each of the Company's business segments and information regarding geographic areas is set forth in Note 15 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K.
CANANDAIGUA WINE
Canandaigua Wine produces, bottles, imports and markets wine and brandy in the United States. It is the second largest supplier of wine in the United States and exports wine to approximately 65 countries from the United States. Canandaigua Wine sells table wine, dessert wine, sparkling wine and brandy. Its leading brands include Inglenook, Almaden, Paul Masson, Arbor Mist, Manischewitz, Taylor, Marcus James, Estate Cellars, Vina Santa Carolina, Dunnewood, Mystic Cliffs, Cook's, J. Roget, Richards Wild Irish Rose and Paul Masson Grande Amber Brandy. Most of its wine is marketed in the popularly-priced category of the wine market.
As a related part of its U.S. wine business, Canandaigua Wine is a leading grape juice concentrate producer in the United States. Grape juice concentrate competes with other domestically produced and imported fruit-based concentrates. Canandaigua Wine's other wine-related products and services include bulk wine, cooking wine, grape juice and Inglenook-St. Regis, a leading de-alcoholized line of wine in the United States.
BARTON
Barton produces, bottles, imports and markets a diversified line of beer and distilled spirits. It is the second largest marketer of imported beer in the United States and distributes five of the top 25 imported beer brands in the United States: Corona Extra, Modelo Especial, Corona Light, Pacifico and St. Pauli Girl. Corona Extra is the number one imported beer nationwide. Barton's other imported beer brands include Negra Modelo from Mexico, Tsingtao from China, Peroni from Italy and Double Diamond and Tetley's English Ale from the United Kingdom. Barton also operates the Stevens Point Brewery, a regional brewer located in Wisconsin, which produces Point Special, among other brands.
Barton is the fourth largest supplier of distilled spirits in the United States and exports distilled spirits to approximately fifteen countries from the United States. Barton's principal distilled spirits brands include Fleischmann's, Mr. Boston, Canadian LTD, Chi-Chi's prepared cocktails, Ten High, Montezuma, Barton, Monte Alban, Inver House and the recently acquired Black Velvet brand. Substantially all of Barton's spirits unit volume consists of products marketed in the price value category. Barton also sells distilled spirits in bulk and provides contract production and bottling services for third parties.
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MATTHEW CLARK
The Company acquired Matthew Clark in the fourth quarter of Fiscal 1999. Matthew Clark is a leading producer and distributor of cider, wine and bottled water and a leading drinks wholesaler throughout the United Kingdom. Matthew Clark also exports its branded products to approximately 50 countries from the United Kingdom.
Matthew Clark is the second largest producer and marketer of cider in the United Kingdom. Matthew Clark distributes its cider brands in both the on-premise and off-premise markets and these brands compete in both the mainstream and premium brand categories. Matthew Clark's leading mainstream cider brands include Blackthorn and Gaymer's Olde English. Blackthorn is the number two mainstream cider brand and Gaymer's Olde English is the UK's second largest cider brand in the take-home market. Matthew Clark's leading premium cider brands are Diamond White and K.
Matthew Clark is the largest supplier of wine to the on-premise trade in the United Kingdom. Its Stowells of Chelsea brand maintains a leading share in the branded boxed wine segment. Matthew Clark also maintains a leading market share position in fortified British wine through its QC and Stone's brand names. It also produces and markets Strathmore bottled water in the United Kingdom, the leading bottled sparkling water brand in the country.
Matthew Clark is a leading independent beverage supplier to the on-premise trade in the United Kingdom and has one of the largest customer bases in the United Kingdom, with more than 16,000 on-premise accounts. Matthew Clark's wholesaling business involves the distribution of branded wine, spirits, cider, beer and soft drinks. While these products are primarily produced by third parties, they also include Matthew Clark's cider and wine branded products.
CORPORATE OPERATIONS AND OTHER
Corporate Operations and Other includes traditional corporate related items and the results of an immaterial operation.
MARKETING AND DISTRIBUTION
UNITED STATES
The Company's products are distributed and sold throughout the United States through over 1,000 wholesalers, as well as through state alcoholic beverage control agencies. Both Canandaigua Wine and Barton employ full-time, in-house marketing, sales and customer service organizations to develop and service their sales to wholesalers and state agencies. The Company believes that the organization of its sales force into separate segments positions it to maintain a high degree of focus on each of its principal product categories.
The Company's marketing strategy places primary emphasis upon promotional programs directed at its broad national distribution network, and at the retailers served by that network. The Company has extensive marketing programs for its brands including promotional programs on both a national basis and regional basis in accordance with the strength of the brands, point-of-sale materials, consumer media advertising, event sponsorship, market research, trade advertising and public relations.
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During Fiscal 1999, the Company increased its advertising expenditures to put more emphasis on consumer advertising for certain wine brands, including newly introduced brands, and for its imported beer brands, primarily with respect to the Mexican brands. In addition, promotional spending for the Company's wine brands increased to address competitive factors.
UNITED KINGDOM
The Company's UK-produced branded products are distributed throughout the United Kingdom by Matthew Clark. The products are packaged at one of three production facilities. Shipments of cider and wine are then made to Matthew Clark's national distribution center for branded products. All branded products are then distributed to either the on-premise or off-premise markets with some of the sales to on-premise customers made through Matthew Clark's wholesale business. Matthew Clark's wholesale products are distributed through thirteen depots located throughout the United Kingdom. On-premise distribution channels include hotels, restaurants, pubs, wine bars and clubs. The off-premise distribution channels include grocers, convenience retail, cash and carry, and wholesalers.
Matthew Clark employs a full-time, in-house marketing and sales organization that targets off-premise customers for Matthew Clark's branded products. Matthew Clark also employs a full-time, in-house branded products marketing and sales organization that services specifically the on-premise market in the United Kingdom. Additionally, Matthew Clark employs a full-time, in-house marketing and sales organization to service the customers of its wholesale business.
TRADEMARKS AND DISTRIBUTION AGREEMENTS
The Company's products are sold under a number of trademarks, most of which are owned by the Company.
The Company also produces and sells wine and distilled spirits products under exclusive license or distribution agreements. Important agreements include (1) a long-term license agreement with Hiram Walker & Sons, Inc. (which expires in 2116) for the Ten High, Crystal Palace, Northern Light and Imperial Spirits brands; and (2) a long-term license agreement with the B. Manischewitz Company (which expires in 2042) for the Manischewitz brand of kosher wine. On September 30, 1998, under the provisions of an existing long-term license agreement, Nabisco Brands Company agreed to transfer to Barton all of its right, title and interest to the corporate name "Fleischmann Distilling Company" and worldwide trademark rights to the "Fleischmann" mark for alcoholic beverages. Pending the completion of the assignment of such interests, the license will remain in effect. The Company also has other less significant license and distribution agreements related to the sale of wine and distilled spirits with terms of various durations.
All of the Company's imported beer products are marketed and sold pursuant to exclusive distribution agreements with the suppliers of these products. These agreements have terms that vary and prohibit the Company from importing other beer from the same country. The Company's agreement to distribute Corona and its other Mexican beer brands exclusively throughout 25 primarily U.S. western states expires in December 2006 and, subject to compliance with certain performance criteria, continued retention of certain Company personnel and other terms under the agreement, will be automatically renewed for additional terms of five years. Changes in control of the Company or of its subsidiearies involved in importing the Mexican beer brands, changes in the position of the Chief Executive Officer of Barton Beers, Ltd. (including by death or disability) or the termination of the President of Barton Incorporated, may be a basis for the supplier, unless it consents to such changes, to terminate the
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agreement. The supplier's consent to such changes may not be unreasonably withheld. The Company's agreement for the importation of St. Pauli Girl expires in June 2003. The Company's agreement for the importation of Tetley's English Ale expires in December 2007. The Company's agreement for the exclusive importation of Tsingtao throughout the entire United States expires in December 1999 and, subject to compliance with certain performance criteria and other terms under the agreement, will be automatically renewed until December 2002. Prior to their expiration, these agreements may be terminated if the Company fails to meet certain performance criteria. The Company believes it is currently in compliance with its material imported beer distribution agreements. From time to time, the Company has failed, and may in the future fail, to satisfy certain performance criteria in its distribution agreements. Although there can be no assurance that its beer distribution agreements will be renewed, given the Company's long-term relationships with its suppliers the Company expects that such agreements will be renewed prior to their expiration and does not believe that these agreements will be terminated.
The Company owns the trademarks for most of the brands that it acquired in the Matthew Clark Acquisition. The Company has a series of distribution agreements and supply agreements in the United Kingdom related to the sale of its products with varying terms and durations.
COMPETITION
The beverage alcohol industry is highly competitive. The Company competes on the basis of quality, price, brand recognition and distribution. The Company's beverage alcohol products compete with other alcoholic and nonalcoholic beverages for consumer purchases, as well as shelf space in retail stores and marketing focus by the Company's wholesalers. The Company competes with numerous multinational producers and distributors of beverage alcohol products, some of which have significantly greater resources than the Company. In the United States, Canandaigua Wine's principal competitors include E & J Gallo Winery and The Wine Group. Barton's principal competitors include Heineken USA, Molson Breweries USA, Labatt's USA, Guinness Import Company, Brown-Forman Beverages, Jim Beam Brands and Heaven Hill Distilleries, Inc. In the United Kingdom, Matthew Clark's principal competitors include Halewood Vintners, H.P. Bulmer, Tavern, Waverley Vintners and Perrier. In connection with its wholesale business, Matthew Clark distributes the branded wine of third parties that compete directly against its own wine brands.
PRODUCTION
In the United States, the Company's wine is produced from several varieties of wine grapes grown principally in California and New York. The grapes are crushed at the Company's wineries and stored as wine, grape juice or concentrate. Such grape products may be made into wine for sale under the Company's brand names, sold to other companies for resale under their own labels, or shipped to customers in the form of juice, juice concentrate, unfinished wine, high-proof grape spirits or brandy. Most of the Company's wine is bottled and sold within eighteen months after the grape crush. The Company's inventories of wine, grape juice and concentrate are usually at their highest levels in November and December immediately after the crush of each year's grape harvest, and are substantially reduced prior to the subsequent year's crush.
The bourbon whiskeys, domestic blended whiskeys and light whiskeys marketed by the Company are primarily produced and aged by the Company at its distillery in Bardstown, Kentucky, though it may from time to time supplement its inventories through purchases from other distillers. Following the Black Velvet Acquisition, the majority of the Company's Canadian whisky requirements
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are produced and aged at its Canadian distilleries in Lethbridge, Alberta, and Valleyfield, Quebec. At its Albany, Georgia, facility, the Company produces all of the neutral grain spirits and whiskeys it uses in the production of vodka, gin and blended whiskey it sells to customers in the state of Georgia. The Company's requirements of Scotch whisky, tequila, mezcal and the neutral grain spirits it uses in the production of gin and vodka for sale outside of Georgia, and other spirits products, are purchased from various suppliers.
The Company operates three facilities in the United Kingdom that produce, bottle and package cider, wine and water. To produce Stowells of Chelsea, wine is imported in bulk from various countries such as Chile, Germany, France, Spain, South Africa and Australia, which are then packaged at the Company's facility at Bristol and distributed under the Stowells of Chelsea brand name. The Strathmore brand of bottled water (which is available in still, sparkling, and flavored varieties) is sourced and bottled in Forfar, Scotland. Cider production was consolidated at the Company's facility at Shepton Mallet, where apples of many different varieties are purchased from U.K. growers and crushed. This juice, along with European-sourced concentrate, is then fermented into cider.
SOURCES AND AVAILABILITY OF RAW MATERIALS
The principal components in the production of the Company's branded beverage alcohol products are packaging materials (primarily glass) and agricultural products, such as grapes and grain.
The Company utilizes glass and PET bottles and other materials such as caps, corks, capsules, labels and cardboard cartons in the bottling and packaging of its products. Glass bottle costs are one of the largest components of the Company's cost of product sold. The glass bottle industry is highly concentrated with only a small number of producers. The Company has traditionally obtained, and continues to obtain, its glass requirements from a limited number of producers. The Company has not experienced difficulty in satisfying its requirements with respect to any of the foregoing and considers its sources of supply to be adequate. However, the inability of any of the Company's glass bottle suppliers to satisfy the Company's requirements could adversely affect the Company's operations.
Most of the Company's annual grape requirements are satisfied by purchases from each year's harvest which normally begins in August and runs through October. The Company believes that it has adequate sources of grape supplies to meet its sales expectations. However, in the event demand for certain wine products exceeds expectations, the Company could experience shortages.
The Company purchases grapes from over 800 independent growers, principally in the San Joaquin Valley and Monterey regions of California and in New York State. The Company enters into written purchase agreements with a majority of these growers on a year-to-year basis. The Company currently owns or leases approximately 4,200 acres of vineyards, either fully bearing or under development, in California and New York. This acreage supplies only a small percentage of the Company's total needs. The Company continues to consider the purchase or lease of additional vineyards, and additional land for vineyard plantings, to supplement its grape supply.
The distilled spirits manufactured by the Company require various agricultural products, neutral grain spirits and bulk spirits. The Company fulfills its requirements through purchases from various sources through contractual arrangements and through purchases on the open market. The Company believes that adequate supplies of the aforementioned products are available at the present time.
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The Company manufactures cider, perry, light and fortified British wine from materials that are purchased either on a contracted basis or on the open market. In particular, supplies of cider apples are sourced through long term supply arrangements with owners of apple orchards. There are adequate supplies of the various raw materials at this particular time.
GOVERNMENT REGULATION
The Company's operations in the United States are subject to extensive Federal and state regulation. These regulations cover, among other matters, sales promotion, advertising and public relations, labeling and packaging, changes in officers or directors, ownership or control, distribution methods and relationships, and requirements regarding brand registration and the posting of prices and price changes. All of the Company's operations and facilities are also subject to Federal, state, foreign and local environmental laws and regulations and the Company is required to obtain permits and licenses to operate its facilities.
In the United Kingdom, the Company has secured a Customs and Excise License to carry on its excise trade. Licenses are required for all premises where wine is produced. The Company holds a license to act as an excise warehouse operator. Registrations have been secured for the production of cider and bottled water. Formal approval of product labeling is not required.
In Canada, the Company's operations are also subject to extensive federal and provincial regulation. These regulations cover, among other matters, advertising and public relations, labeling and packaging, environmental matters and customs and duty requirements. The Company is also required to obtain licenses and permits in order to operate its facilities.
The Company believes that it is in compliance in all material respects with all applicable governmental laws and regulations and that the cost of administration and compliance with, and liability under, such laws and regulations does not have, and is not expected to have, a material adverse impact on the Company's financial condition, results of operations or cash flows.
EMPLOYEES
The Company had approximately 2,300 full-time employees in the United States at the end of April 1999, of which approximately 870 were covered by collective bargaining agreements. Additional workers may be employed by the Company during the grape crushing season.
The Company had approximately 1,700 full-time employees in the United Kingdom at the end of April 1999, of which approximately 420 were covered by collective bargaining agreements. Additional workers may be employed during the peak season.
The Company had approximately 230 full-time employees in Canada at the end of April 1999, of which approximately 185 were covered by collective bargaining agreements.
The Company considers its employee relations generally to be good.
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ITEM 2.
ITEM 2. PROPERTIES - ------- ----------
Through the Company's four business segments, the Company currently operates wineries, distilling plants, bottling plants, a brewery, cider and water producing facilities, most of which include warehousing and distribution facilities on the premises. The Company also operates separate distribution centers under the Matthew Clark segment's wholesaling business. The Company believes that all of its facilities are in good condition and working order and have adequate capacity to meet its needs for the foreseeable future.
CANANDAIGUA WINE
Canandaigua Wine maintains its headquarters in owned and leased offices in Canandaigua, New York. It operates three wineries in New York, located in Canandaigua, Naples and Batavia and six wineries in California, located in Madera, Gonzales, Escalon, Fresno, and Ukiah. All of the facilities in which these wineries operate are owned, except for the winery in Batavia, New York, which is leased. Canandaigua Wine considers its principal wineries to be the Mission Bell winery in Madera, California; the Canandaigua winery in Canandaigua, New York; and the Monterey Cellars winery in Gonzales, California. The Mission Bell winery crushes grapes, produces, bottles and distributes wine and produces grape juice concentrate. The Canandaigua winery crushes grapes and produces, bottles and distributes wine. The Monterey Cellars winery crushes grapes and produces, bottles and distributes wine for Canandaigua Wine's account and, on a contractual basis, for third parties.
Canandaigua Wine currently owns or leases approximately 4,200 acres of vineyards, either fully bearing or under development, in California and New York.
BARTON
Barton maintains its headquarters in leased offices in Chicago, Illinois. It owns and operates four distilling plants, two in the United States and two in Canada. The two distilling plants in the United States are located in Bardstown, Kentucky; and Albany, Georgia; and the two distilling plants in Canada, which were acquired in connection with the Black Velvet Acquisition, are located in Valleyfield, Quebec; and Lethbridge, Alberta. Barton considers its principal distilling plants to be the facilities located in Bardstown, Kentucky; Valleyfield, Quebec; and Lethbridge, Alberta. The Bardstown facility distills, bottles and warehouses distilled spirits products for Barton's account and, on a contractual basis, for other participants in the industry. The two Canadian facilities distill, bottle and store Canadian whisky for Barton's own account, and distill and/or bottle and store Canadian whisky, vodka, rum, gin and liqueurs for third parties.
In the United States, Barton also operates a brewery and three bottling plants. The brewery is located in Stevens Point, Wisconsin; and the bottling plants are located in Atlanta, Georgia; Owensboro, Kentucky; and Carson, California. All of these facilities are owned by Barton except for the bottling plant in Carson, California, which is operated and leased through an arrangement involving an ongoing management contract. Barton considers the bottling plant located in Owensboro, Kentucky to be one of its principal facilities. The Owensboro facility bottles and warehouses distilled spirits products for Barton's account and also performs contract bottling.
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MATTHEW CLARK
Matthew Clark maintains its headquarters in owned offices in Bristol, England. It currently owns and operates two facilities in England that are located in Bristol and Shepton Mallet and one facility in Scotland, located in Forfar. Matthew Clark considers all three facilities to be its principal facilities. The Bristol facility produces, bottles and packages wine; the Shepton Mallet facility produces, bottles and packages cider; and the Forfar facility produces, bottles and packages water products. Matthew Clark also owns another facility in England, located in Taunton, the operations of which have now been consolidated into its Shepton Mallet facility. Matthew Clark plans to sell the Taunton property.
To distribute its products that are produced at the Bristol and Shepton Mallet facilities, Matthew Clark operates, in England, the National Distribution Centre, located at Severnside. This distribution facility is leased by Matthew Clark. To support its wholesaling business, Matthew Clark operates thirteen distribution centers located throughout the United Kingdom, all of which are leased. These thirteen distribution centers are used to distribute products produced by third parties, as well as by Matthew Clark. Matthew Clark has been and continues to consolidate the operations of its wholesaling distribution centers.
CORPORATE OPERATIONS AND OTHER
The Company maintains its corporate headquarters in offices leased in Fairport, New York.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS - ------- -----------------
The Company and its subsidiaries are subject to litigation from time to time in the ordinary course of business. Although the amount of any liability with respect to such litigation cannot be determined, in the opinion of management such liability will not have a material adverse effect on the Company's financial condition, results of operations or cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- ---------------------------------------------------
Not Applicable.
EXECUTIVE OFFICERS OF THE COMPANY
Information with respect to the current executive officers of the Company is as follows:
NAME AGE OFFICE HELD - ---- --- ----------- Marvin Sands 75 Chairman of the Board Richard Sands 48 President and Chief Executive Officer Robert Sands 40 Chief Executive Officer, International, Executive Vice President and General Counsel; and President and Chief Executive Officer of Canandaigua Wine Company, Inc. Peter Aikens 60 President and Chief Executive Officer of Matthew Clark plc Alexander L. Berk 49 President and Chief Executive Officer of Barton Incorporated George H. Murray 52 Senior Vice President and Chief Human Resources Officer Thomas S. Summer 45 Senior Vice President and Chief Financial Officer
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Marvin Sands is the founder of the Company, which is the successor to a business he started in 1945. He has been a director of the Company and its predecessor since 1946 and was Chief Executive Officer until October 1993. Marvin Sands is the father of Richard Sands and Robert Sands.
Richard Sands, Ph.D., has been employed by the Company in various capacities since 1979. He was elected Executive Vice President and a director in 1982, became President and Chief Operating Officer in May 1986 and was elected Chief Executive Officer in October 1993. He is a son of Marvin Sands and the brother of Robert Sands.
Robert Sands was appointed Chief Executive Officer, International in December 1998 and was appointed Executive Vice President and General Counsel in October 1993. He was elected a director of the Company in January 1990 and served as Vice President and General Counsel from June 1990 through October 1993. From June 1986 until his appointment as Vice President and General Counsel, Mr. Sands was employed by the Company as General Counsel. In addition, since the departure in April 1999 of the former President of Canandaigua Wine Company, Inc., a wholly-owned subsidiary of the Company, Mr. Sands has assumed, on an interim basis, the position of President and Chief Executive Officer of that company. In this capacity, Mr. Sands is in charge of the Canandaigua Wine segment, until a permanent successor is appointed. He is a son of Marvin Sands and the brother of Richard Sands.
Peter Aikens serves as President and Chief Executive Officer of Matthew Clark plc, a wholly-owned subsidiary of the Company. In this capacity, Mr. Aikens is in charge of the Company's Matthew Clark segment, and has been since the Company acquired control of Matthew Clark in December 1998. He has been the Chief Executive Officer of Matthew Clark plc since May 1990 and has been in the brewing and drinks industry for most of his career.
Alexander L. Berk serves as President and Chief Executive Officer of Barton Incorporated, a wholly-owned subsidiary of the Company. In this capacity, Mr. Berk is in charge of the Company's Barton segment. From 1990 until February 1998, Mr. Berk was President and Chief Operating Officer of Barton and from 1988 to 1990, he was the President and Chief Executive Officer of Schenley Industries. Mr. Berk has been in the alcoholic beverage industry for most of his career, serving in various positions.
George H. Murray joined the Company in April 1997 as Senior Vice President and Chief Human Resources Officer. From August 1994 to April 1997, Mr. Murray served as Vice President - Human Resources and Corporate Communications of ACC Corp., an international long distance reseller. For eight and a half years prior to that, he served in various senior management positions with First Federal Savings and Loan of Rochester, New York, including the position of Senior Vice President of Human Resources and Marketing from 1991 to 1994.
Thomas S. Summer joined the Company in April l997 as Senior Vice President and Chief Financial Officer. From November 1991 to April 1997, Mr. Summer served as Vice President, Treasurer of Cardinal Health, Inc., a large national health care services company, where he was responsible for directing financing strategies and treasury matters. Prior to that, from November 1987 to November 1991, Mr. Summer held several positions in corporate finance and international treasury with PepsiCo, Inc.
Executive officers of the Company hold office until the next Annual Meeting of the Board of Directors and until their successors are chosen and qualify.
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PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - ------- ---------------------------------------------------------------------- MATTERS -------
The Company's Class A Common Stock (the "Class A Stock") and Class B Common Stock (the "Class B Stock") trade on the Nasdaq Stock Market (registered trademark) under the symbols "CBRNA" and "CBRNB," respectively. The following tables set forth for the periods indicated the high and low sales prices of the Class A Stock and the Class B Stock as reported on the Nasdaq Stock Market (registered trademark).
CLASS A STOCK --------------------------------------------------------- 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER ----------- ----------- ----------- ----------- Fiscal 1998 High $ 32 1/4 $ 42 3/4 $ 53 1/2 $ 58 1/2 Low $ 21 7/8 $ 29 3/8 $ 39 1/2 $ 43 3/4 Fiscal 1999 High $ 59 3/4 $ 52 3/8 $ 52 1/8 $ 61 1/2 Low $ 45 9/16 $ 40 1/4 $ 35 1/4 $ 45 5/8
CLASS B STOCK --------------------------------------------------------- 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER ----------- ----------- ----------- ----------- Fiscal 1998 High $ 37 $ 43 $ 54 5/8 $ 57 3/4 Low $ 27 $ 35 1/2 $ 40 3/4 $ 45 Fiscal 1999 High $ 59 3/4 $ 51 1/2 $ 52 $ 62 1/4 Low $ 45 1/2 $ 40 3/4 $ 37 1/4 $ 46 7/8
At May 14, 1999, the number of holders of record of Class A Stock and Class B Stock of the Company were 977 and 290, respectively.
The Company's policy is to retain all of its earnings to finance the development and expansion of its business, and the Company has not paid any cash dividends since its initial public offering in 1973. In addition, the Company's current bank credit agreement, the Company's indenture for its $130 million 8 3/4% Senior Subordinated Notes due December 2003, its indenture for its $65 million 8 3/4% Series C Senior Subordinated Notes due December 2003 and its indenture for its $200 million 8 1/2% Senior Subordinated Notes due March 2009 restrict the payment of cash dividends.
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ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA - ------- -----------------------
For the fiscal years ended February 28, 1999 and 1998, see Management's Discussion and Analysis of Financial Condition and Results of Operations under Item 7
Item 7 of this Annual Report on Form 10-K and Notes to Consolidated Financial Statements as of February 28, 1999, under Item 8 of this Annual Report on Form 10-K. During January 1996, the Board of Directors of the Company changed the Company's fiscal year end from August 31 to the last day of February.
All periods presented have been restated to reflect the Company's change in inventory valuation method from LIFO to FIFO (see Note 1 in the Notes to Consolidated Financial Statements as of February 28, 1999, under Item 8 of this Annual Report on Form 10-K).
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS - ------- ----------------------------------------------------------------------- OF OPERATIONS -------------
INTRODUCTION - ------------
The following discussion and analysis summarizes the significant factors affecting (i) consolidated results of operations of the Company for the year ended February 28, 1999 ("Fiscal 1999"), compared to the year ended February 28, 1998 ("Fiscal 1998"), and Fiscal 1998 compared to the year ended February 28, 1997 ("Fiscal 1997"), and (ii) financial liquidity and capital resources for Fiscal 1999. This discussion and analysis should be read in conjunction with the Company's consolidated financial statements and notes thereto included herein.
The Company operates primarily in the beverage alcohol industry in the United States and the United Kingdom. The Company reports its operating results in four segments: Canandaigua Wine (branded wine and brandy, and other, primarily grape juice concentrate); Barton (primarily beer and spirits); Matthew Clark (branded wine, cider and bottled water, and wholesale wine, cider, spirits, beer and soft drinks); and Corporate Operations and Other (primarily corporate related items).
During the fourth quarter of Fiscal 1999, the Company changed its method of determining the cost of inventories from the last-in, first-out ("LIFO") method to the first-in, first-out ("FIFO") method. All previously reported results have been restated to reflect the retroactive application of this accounting change as required by generally accepted accounting principles. For further discussion of the impact of this accounting change, see Note 1 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K.
RECENT ACQUISITIONS
On December 1, 1998, the Company acquired control of Matthew Clark and has since acquired all of Matthew Clark's outstanding shares. Prior to the Matthew Clark Acquisition, the Company was principally a producer and supplier of wine and an importer and producer of beer and distilled spirits in the United States. The Matthew Clark Acquisition established the Company as a leading British producer of cider, wine and bottled water and as a leading beverage alcohol wholesaler in the United Kingdom. (See also the discussions regarding Matthew Clark under Item 1 "Business" of this Annual Report on Form 10-K.) The results of operations of Matthew Clark have been included in the consolidated results of operations of the Company since the date of acquisition, December 1, 1998.
On April 9, 1999, in an asset acquisition, the Company acquired several well-known Canadian whisky brands, including Black Velvet, production facilities located in Alberta and Quebec, Canada, case goods and bulk whisky inventories and other related assets from affiliates of Diageo plc. In connection with the transaction, the Company also entered into multi-year agreements with Diageo to provide packaging and distilling services for various brands retained by Diageo. The addition of the Canadian whisky brands from this transaction strengthens the Company's position in the North American distilled spirits category, and enhances the Company's portfolio of brands and category participation.
The Matthew Clark and Black Velvet Acquisitions are significant and the Company expects them to have a material impact on the Company's future results of operations.
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RECENT DEVELOPMENTS - PENDING ACQUISITIONS OF SIMI AND FRANCISCAN
On April 1, 1999, the Company entered into a definitive agreement with Moet Hennessy, Inc. to purchase all of the outstanding capital stock of Simi. The Simi Acquisition includes the Simi winery, equipment, vineyards, inventory and worldwide ownership of the Simi brand name.
On April 21, 1999, the Company entered into definitive purchase agreements with Franciscan and its shareholders, and certain parties related to Franciscan to, among other matters, purchase all of the outstanding capital stock of Franciscan and acquire certain vineyards and related vineyard assets. Pursuant to the Franciscan Acquisition, the Company will: (i) acquire the Franciscan Oakville Estate, Estancia and Mt. Veeder brands; (ii) acquire wineries located in Rutherford, Monterey and Mt. Veeder, California; (iii) acquire vineyards in the Napa Valley, Alexander Valley, Monterey and Paso Robles appellations and additionally, will enter into long-term grape contracts with certain parties related to Franciscan to purchase additional grapes grown in the Napa and Alexander Valley appellations; (iv) acquire distribution rights to the Quintessa and Veramonte brands; and (v) acquire equity interests in entities that own the Veramonte brand and the Veramonte winery and certain vineyards located in the Casablanca Valley, Chile.
The agreements for the Simi and Franciscan Acquisitions are subject to certain customary conditions prior to closing, which the Company expects will be satisfied. The Company cannot guarantee, however, that those transactions will be completed upon the agreed upon terms, or at all.
RESULTS OF OPERATIONS - ---------------------
FISCAL 1999 COMPARED TO FISCAL 1998
NET SALES
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 1999 and Fiscal 1998.
Fiscal 1999 Compared to Fiscal 1998 ----------------------------------------- Net Sales ----------------------------------------- %Increase/ 1999 1998 Decrease ---------- ---------- ---------- Canandaigua Wine: Branded $ 598,782 $ 570,807 4.9 % Other 70,711 71,988 (1.8)% ---------- ---------- Net sales $ 669,493 $ 642,795 4.2 % ---------- ---------- Barton: Beer $ 478,611 $ 376,607 27.1 % Spirits 185,938 191,190 (2.7)% ---------- ---------- Net sales $ 664,549 $ 567,797 17.0 % ---------- ---------- Matthew Clark: Branded $ 64,879 $ -- -- Wholesale 93,881 -- -- ---------- ---------- Net sales $ 158,760 $ -- -- ---------- ---------- Corporate Operations and Other $ 4,541 $ 2,196 106.8 % ---------- ----------
Consolidated Net Sales $1,497,343 $1,212,788 23.5 % ========== ==========
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Net sales for Fiscal 1999 increased to $1,497.3 million from $1,212.8 million for Fiscal 1998, an increase of $284.6 million, or 23.5%.
Canandaigua Wine ----------------
Net sales for Canandaigua Wine for Fiscal 1999 increased to $669.5 million from $642.8 million for Fiscal 1998, an increase of $26.7 million, or 4.2%. This increase resulted primarily from (i) the introduction of two new products, Arbor Mist and Mystic Cliffs, in Fiscal 1999, (ii) Paul Masson Grande Amber Brandy growth, and (iii) Almaden boxed wine growth. These increases were partially offset by declines in other wine brands and in the Company's grape juice concentrate business.
Barton ------
Net sales for Barton for Fiscal 1999 increased to $664.5 million from $567.8 million for Fiscal 1998, an increase of $96.8 million, or 17.0%. This increase resulted primarily from an increase in sales of beer brands led by Barton's Mexican portfolio. This increase was partially offset by a decrease in revenues from Barton's spirits contract bottling business.
Matthew Clark -------------
Net sales for Matthew Clark for Fiscal 1999 since the date of acquisition, December 1, 1998, were $158.8 million.
GROSS PROFIT
The Company's gross profit increased to $448.0 million for Fiscal 1999 from $343.8 million for Fiscal 1998, an increase of $104.3 million, or 30.3%. The dollar increase in gross profit resulted primarily from the sales generated by the Matthew Clark Acquisition completed in the fourth quarter of Fiscal 1999, increased beer sales and the combination of higher average selling prices and lower average costs for branded wine sales. As a percent of net sales, gross profit increased to 29.9% for Fiscal 1999 from 28.3% for Fiscal 1998. The increase in the gross profit margin resulted primarily from higher selling prices and lower costs for Canandaigua Wine's branded wine sales, partially offset by a sales mix shift towards lower margin products, particulary due to the growth in Barton's beer sales.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased to $299.5 million for Fiscal 1999 from $231.7 million for Fiscal 1998, an increase of $67.8 million, or 29.3%. The dollar increase in selling, general and administrative expenses resulted primarily from expenses related to the Matthew Clark Acquisition, as well as marketing and promotional costs associated with the Company's increased branded sales volume. The year-over-year comparison also benefited from a one time charge for separation costs incurred in Fiscal 1998 related to an organizational change within Barton. Selling, general and administrative expenses as a percent of net sales increased to 20.0% for Fiscal 1999 as compared to 19.1% for Fiscal 1998. The increase in percent of net sales resulted primarily from (i) Canandaigua Wine's investment in brand building and efforts to increase market share and (ii) the Matthew Clark Acquisition, as Matthew Clark's selling, general and administrative expenses as a percent of net sales is typically higher than for the Company's other operating segments.
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NONRECURRING CHARGES
The Company incurred nonrecurring charges of $2.6 million in Fiscal 1999 related to the closure of a production facility in the United Kingdom. No such charges were incurred in Fiscal 1998.
OPERATING INCOME
The following table sets forth the operating profit/(loss) (in thousands of dollars) by operating segment of the Company for Fiscal 1999 and Fiscal 1998.
Fiscal 1999 Compared to Fiscal 1998 ----------------------------------- Operating Profit/(Loss) ----------------------------------- %Increase/ 1999 1998 (Decrease) -------- -------- ---------- Canandaigua Wine $ 46,283 $ 45,440 1.9 % Barton 102,624 77,010 33.3 % Matthew Clark 8,998 -- -- Corporate Operations and Other (12,013) (10,380) (15.7)% -------- -------- Consolidated Operating Profit $145,892 $112,070 30.2 % ======== ========
As a result of the above factors, operating income increased to $145.9 million for Fiscal 1999 from $112.1 million for Fiscal 1998, an increase of $33.8 million, or 30.2%.
INTEREST EXPENSE, NET
Net interest expense increased to $41.5 million for Fiscal 1999 from $32.2 million for Fiscal 1998, an increase of $9.3 million or 28.8%. The increase resulted primarily from additional interest expense associated with the borrowings related to the Matthew Clark Acquisition.
EXTRAORDINARY ITEM, NET OF INCOME TAXES
The Company incurred an extraordinary charge of $11.4 million after taxes in Fiscal 1999. This charge resulted from fees related to the replacement of the Company's bank credit facility, including extinguishment of the Term Loan. No extraordinary charges were incurred in Fiscal 1998.
NET INCOME
As a result of the above factors, net income increased to $50.5 million for Fiscal 1999 from $47.1 million for Fiscal 1998, an increase of $3.3 million, or 7.1%.
For financial analysis purposes only, the Company's earnings before interest, taxes, depreciation and amortization ("EBITDA") for Fiscal 1999 were $184.5 million, an increase of $39.3 million over EBITDA of $145.2 million for Fiscal 1998. EBITDA should not be construed as an alternative to operating income or net cash flow from operating activities and should not be construed as an indication of operating performance or as a measure of liquidity.
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FISCAL 1998 COMPARED TO FISCAL 1997
NET SALES
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 1998 and Fiscal 1997.
Fiscal 1998 Compared to Fiscal 1997 --------------------------------------- Net Sales --------------------------------------- %Increase/ 1998 1997 (Decrease) ---------- ---------- ---------- Canandaigua Wine: Branded $ 570,807 $ 537,745 6.1 % Other 71,988 112,546 (36.0)% ---------- ---------- Net sales $ 642,795 $ 650,291 (1.2)% ---------- ---------- Barton: Beer $ 376,607 $ 298,925 26.0 % Spirits 191,190 185,289 3.2 % ---------- ---------- Net sales $ 567,797 $ 484,214 17.3 % ---------- ----------
Corporate Operations and Other $ 2,196 $ 508 332.3 % ---------- ----------
Consolidated Net Sales $1,212,788 $1,135,013 6.9% ========== ==========
Net sales for Fiscal 1998 increased to $1,212.8 million from $1,135.0 million for Fiscal 1997, an increase of $77.8 million, or 6.9%.
Canandaigua Wine ----------------
Net sales for Canandaigua Wine for Fiscal 1998 decreased to $642.8 million from $650.3 million for Fiscal 1997, a decrease of $7.5 million, or 1.2%. This decrease resulted primarily from lower sales of grape juice concentrate, bulk wine and other branded wine products, partially offset by an increase in table wine sales and brandy sales.
Barton ------
Net sales for Barton for Fiscal 1998 increased to $567.8 million from $484.2 million for Fiscal 1997, an increase of $83.6 million, or 17.3%. This increase resulted primarily from additional beer sales, largely Mexican beer, and additional spirits sales.
GROSS PROFIT
The Company's gross profit increased to $343.8 million for Fiscal 1998 from $322.2 million for Fiscal 1997, an increase of $21.5 million, or 6.7%. The dollar increase in gross profit resulted primarily from increased beer sales, higher average selling prices and cost structure improvements related to
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branded wine sales, higher average selling prices in excess of cost increases related to grape juice concentrate sales and higher average selling prices and increased volume related to branded spirits sales. These increases were partially offset by lower sales volume of grape juice concentrate and bulk wine. As a percent of net sales, gross profit decreased slightly to 28.3% for Fiscal 1998 from 28.4% for Fiscal 1997.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses increased to $231.7 million for Fiscal 1998 from $209.0 million for Fiscal 1997, an increase of $22.7 million, or 10.9%. The dollar increase in selling, general and administrative expenses resulted principally from marketing and selling costs associated with the Company's branded sales volume, and a one-time charge for separation costs related to an organizational change within the Barton segment. Selling, general and administrative expenses as a percent of net sales increased to 19.1% for Fiscal 1998 as compared to 18.4% for Fiscal 1997. The increase in percent of net sales resulted from the one-time charge for separation costs and from a change in the sales mix in the Canandaigua Wine segment towards branded products, which have a higher percent of marketing and selling costs relative to sales.
OPERATING INCOME
The following table sets forth the operating profit/(loss) (in thousands of dollars) by operating segment of the Company for Fiscal 1998 and Fiscal 1997.
Fiscal 1998 Compared to Fiscal 1997 ------------------------------------- Operating Profit/(Loss) ------------------------------------- %Increase/ 1998 1997 (Decrease) -------- -------- ----------- Canandaigua Wine $ 45,440 $ 51,525 (11.8)% Barton 77,010 73,073 5.4 % Corporate Operations and Other (10,380) (11,388) 8.9 % -------- -------- Consolidated Operating Profit $112,070 $113,210 (1.0)% ======== ========
As a result of the above factors, operating income decreased to $112.1 million for Fiscal 1998 from $113.2 million for Fiscal 1997, a decrease of $1.1 million, or 1.0%.
INTEREST EXPENSE, NET
Net interest expense decreased to $32.2 million for Fiscal 1998 from $34.1 million for Fiscal 1997, a decrease of $1.9 million or 5.5%. The decrease was primarily due to a decrease in the Company's average borrowings which was partially offset by an increase in the average interest rate.
PROVISION FOR INCOME TAXES
The Company's effective tax rate for Fiscal 1998 decreased to 41.0% from 41.7% for Fiscal 1997 as Fiscal 1997 reflected a higher effective tax rate in California caused by statutory limitations on the Company's ability to utilize certain deductions.
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NET INCOME
As a result of the above factors, net income increased to $47.1 million for Fiscal 1998 from $46.2 million for Fiscal 1997, an increase of $0.9 million, or 2.1%.
For financial analysis purposes only, the Company's earnings before interest, taxes, depreciation and amortization ("EBITDA") for Fiscal 1998 were $145.2 million, an increase of $0.2 million over EBITDA of $145.0 million for Fiscal 1997. EBITDA should not be construed as an alternative to operating income or net cash flow from operating activities and should not be construed as an indication of operating performance or as a measure of liquidity.
FINANCIAL LIQUIDITY AND CAPITAL RESOURCES - -----------------------------------------
GENERAL
The Company's principal use of cash in its operating activities is for purchasing and carrying inventories. The Company's primary source of liquidity has historically been cash flow from operations, except during the annual fall grape harvests when the Company has relied on short-term borrowings. The annual grape crush normally begins in August and runs through October. The Company generally begins purchasing grapes in August with payments for such grapes beginning to come due in September. The Company's short-term borrowings to support such purchases generally reach their highest levels in November or December. Historically, the Company has used cash flow from operating activities to repay its short-term borrowings. The Company will continue to use its short-term borrowings to support its working capital requirements. The Company believes that cash provided by operating activities and its financing activities, primarily short-term borrowings, will provide adequate resources to satisfy its working capital, liquidity and anticipated capital expenditure requirements for both its short-term and long-term capital needs.
FISCAL 1999 CASH FLOWS
OPERATING ACTIVITIES
Net cash provided by operating activities for Fiscal 1999 was $107.3 million, which resulted from $112.3 million in net income adjusted for noncash items, less $5.0 million representing the net change in the Company's operating assets and liabilities. The net change in operating assets and liabilities resulted primarily from post acquisition activity attributable to the Matthew Clark Acquisition resulting in a decrease in other accrued expenses and liabilities and accounts payable, partially offset by a decrease in accounts receivable.
INVESTING ACTIVITIES AND FINANCING ACTIVITIES
Net cash used in investing activities for Fiscal 1999 was $382.4 million, which resulted primarily from net cash paid of $332.2 million for the Matthew Clark Acquisition and $49.9 million of capital expenditures, including $7.0 million for vineyards.
Net cash provided by financing activities for Fiscal 1999 was $301.0 million, which resulted primarily from proceeds of $635.1 million from issuance of long-term debt, including $358.1 million of long-term debt incurred to acquire Matthew Clark. This amount was partially offset by principal
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payments of $264.1 million of long-term debt, repurchases of $44.9 million of the Company's Class A Common Stock, payment of $17.1 million of long-term debt issuance costs and repayment of $13.9 million of net revolving loan borrowings.
As of February 28, 1999, under the 1998 Credit Agreement, the Company had outstanding term loans of $625.6 million bearing interest at 7.6%, $83.1 million of revolving loans bearing interest at 7.3%, undrawn revolving letters of credit of $4.0 million, and $212.9 million in revolving loans available to be drawn.
Total debt outstanding as of February 28, 1999, amounted to $925.4 million, an increase of $500.2 million from February 28, 1998. The ratio of total debt to total capitalization increased to 68.0% as of February 28, 1999, from 50.0% as of February 28, 1998.
During June 1998, the Company's Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Common Stock. The repurchase of shares of common stock will be accomplished, from time to time, in management's discretion and depending upon market conditions, through open market or privately negotiated transactions. The Company may finance such repurchases through cash generated from operations or through the bank credit agreement. The repurchased shares will become treasury shares. As of May 28, 1999, the Company had purchased 1,018,836 shares of Class A Common Stock at an aggregate cost of $44.9 million, or at an average cost of $44.05 per share.
THE COMPANY'S CREDIT AGREEMENT
On December 14, 1998, the Company, its principal operating subsidiaries (other than Matthew Clark and its subsidiaries), and a syndicate of banks, for which The Chase Manhattan Bank acts as administrative agent, entered into a First Amended and Restated Credit Agreement (the "1998 Credit Agreement"), effective as of November 2, 1998, which amends and restates in its entirety the credit agreement entered into between the Company and The Chase Manhattan Bank on November 2, 1998. The 1998 Credit Agreement includes both US dollar and British pound sterling commitments of the syndicate banks of up to, in the aggregate, the equivalent of $1.0 billion (subject to increase as therein provided to $1.2 billion) with the proceeds available for repayment of all outstanding principal and accrued interest on all loans under the Company's bank credit agreement dated as of December 19, 1997, payment of the purchase price for the Matthew Clark shares, repayment of Matthew Clark's credit facilities, funding of permitted acquisitions, payment of transaction expenses and ongoing working capital needs of the Company.
The 1998 Credit Agreement provides for a $350.0 million Tranche I Term Loan facility due in December 2004, a $200.0 million Tranche II Term Loan facility due in June 2000, a $150.0 million Tranche III Term Loan facility due in December 2005, and a $300.0 million Revolving Credit facility (including letters of credit up to a maximum of $20.0 million) which expires in December 2004. Portions of the Tranche I Term Loan facility and the Revolving Credit facility are available for borrowing in British pound sterling. A brief description of the 1998 Credit Agreement is contained in Note 6 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K.
The Company expects to finance the purchase price for the Simi and Franciscan Acquisitions with borrowings under an amendment to the 1998 Credit Agreement.
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SENIOR SUBORDINATED NOTES
As of February 28, 1999, the Company had outstanding $195.0 million aggregate principal amount of 8 3/4% Senior Subordinated Notes due December 2003, being the $130.0 million aggregate principal amount of 8 3/4% Senior Subordinated Notes due December 2003 issued in December 1993 (the "Original Notes") and the $65.0 million aggregate principal amount of 8 3/4% Series C Senior Subordinated Notes due December 2003 issued in February 1997 (the "Series C Notes"). The Original Notes and the Series C Notes are currently redeemable, in whole or in part, at the option of the Company. A brief description of the Original Notes and the Series C Notes is contained in Note 6 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K.
On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 (the "$200 Million Notes"). The Company used the proceeds from the sale of the $200 Million Notes to fund the Black Velvet Acquisition ($185.5 million) and to pay the fees and expenses related thereto with the remainder of the net proceeds to be used for general corporate purposes or to fund future acquisitions. The $200 Million Notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. The Company may also redeem up to $70.0 million of the $200 Million Notes using the proceeds of certain equity offerings completed before March 1, 2002. A brief description of the $200 Million Notes is contained in Note 17 to the Company's consolidated financial statements located in Item 8 of this Annual Report on Form 10-K.
CAPITAL EXPENDITURES
During Fiscal 1999, the Company incurred $49.9 million for capital expenditures, including $7.0 million related to vineyards. The Company plans to spend approximately $49.6 million for capital expenditures, exclusive of vineyards, in fiscal 2000. In addition, the Company continues to consider the purchase, lease and development of vineyards. See "Business - Sources and Availability of Raw Materials" under Item 1 of this Annual Report on Form 10-K. The Company may incur additional expenditures for vineyards if opportunities become available. Management reviews the capital expenditure program periodically and modifies it as required to meet current business needs.
COMMITMENTS
The Company has agreements with suppliers to purchase various spirits and blends of which certain agreements are denominated in British pound sterling. The future obligations under these agreements, based upon exchange rates at February 28, 1999, aggregate approximately $17.2 million for contracts expiring through December 2002.
At February 28, 1999, the Company had open currency forward contracts to purchase various foreign currencies of $12.4 million which mature within twelve months. The Company's use of such contracts is limited to the management of currency rate risks related to purchases denominated in a foreign currency. The Company's strategy is to enter only into currency exchange contracts that are matched to specific purchases and not to enter into any speculative contracts.
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EFFECTS OF INFLATION AND CHANGING PRICES
The Company's results of operations and financial condition have not been significantly affected by inflation and changing prices. The Company has been able, subject to normal competitive conditions, to pass along rising costs through increased selling prices.
ACCOUNTING PRONOUNCEMENT
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. SFAS No. 133 requires that every derivative be recorded as either an asset or liability in the balance sheet and measured at its fair value. SFAS No. 133 also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company formally document, designate and assess the effectiveness of transactions that receive hedge accounting. The Company is required to adopt SFAS No. 133 on a prospective basis for interim periods and fiscal years beginning March 1, 2000. The Company believes the effect of adoption on its financial statements will not be material based on the Company's current risk management strategies.
YEAR 2000 ISSUE
For purposes of the following Year 2000 discussion, the information presented includes the effect of the Black Velvet Acquisition. The Company has in place detailed programs to address Year 2000 readiness in its internal systems and with its key customers and suppliers. The Year 2000 issue is the result of computer logic that was written using two digits rather than four to define the applicable year. Any computer logic that processes date-sensitive information may recognize the date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations or system failures.
Pursuant to the Company's readiness programs, all major categories of information technology systems and non-information technology systems (i.e., equipment with embedded microprocessors) in use by the Company, including manufacturing, sales, financial and human resources, have been inventoried and assessed. In addition, plans have been developed for the required systems modifications or replacements. With respect to its information technology systems, the Company has completed the entire assessment phase and approximately 75% of the remediation phase. With respect to its non-information technology systems, the Company has completed the entire assessment phase and approximately 64% of the remediation phase. Selected areas, both internal and external, are being tested to assure the integrity of the Company's remediation programs. The testing is expected to be completed by September 1999. The Company plans to have all internal mission-critical information technology and non-information technology systems Year 2000 compliant by September 1999.
The Company is also communicating with its major customers, suppliers and financial institutions to assess the potential impact on the Company's operations if those third parties fail to become Year 2000 compliant in a timely manner. While this process is not yet complete, based upon responses to date, it appears that many of those customers and suppliers have only indicated that they have in place Year 2000 readiness programs, without specifically confirming that they will be Year 2000 compliant in a timely manner. Risk assessment, readiness evaluation, action plans and contingency plans
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related to the Company's significant customers and suppliers are expected to be completed by September 1999. The Company's key financial institutions have been surveyed and it is the Company's understanding that they are or will be Year 2000 compliant on or before December 31, 1999.
The costs incurred to date related to its Year 2000 activities have not been material to the Company, and, based upon current estimates, the Company does not believe that the total cost of its Year 2000 readiness programs will have a material adverse impact on the Company's financial condition, results of operations or cash flows.
The Company's readiness programs also include the development of contingency plans to protect its business and operations from Year 2000-related interruptions. These plans should be complete by September 1999 and, by way of examples, will include back-up procedures, identification of alternate suppliers, where possible, and increases in inventory levels. Based upon the Company's current assessment of its non-information technology systems, the Company does not believe it necessary to develop an extensive contingency plan for those systems. There can be no assurances, however, that any of the Company's contingency plans will be sufficient to handle all problems or issues which may arise.
The Company believes that it is taking reasonable steps to identify and address those matters that could cause serious interruptions in its business and operations due to Year 2000 issues. However, delays in the implementation of new systems, a failure to fully identify all Year 2000 dependencies in the Company's systems and in the systems of its suppliers, customers and financial institutions, a failure of such third parties to adequately address their respective Year 2000 issues, or a failure of a contingency plan could have a material adverse effect on the Company's business, financial condition, results of operations or cash flows. For example, the Company would experience a material adverse impact on its business if significant suppliers of beer, glass or other raw materials, or utility systems fail to timely provide the Company with necessary inventories or services due to Year 2000 systems failures.
The statements set forth herein concerning Year 2000 issues which are not historical facts are forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. In particular, the costs associated with the Company's Year 2000 programs and the time-frame in which the Company plans to complete Year 2000 modifications are based upon management's best estimates. These estimates were derived from internal assessments and assumptions of future events. These estimates may be adversely affected by the continued availability of personnel and system resources, and by the failure of significant third parties to properly address Year 2000 issues. Therefore, there can be no guarantee that any estimates, or other forward-looking statements will be achieved, and actual results could differ significantly from those contemplated.
EURO CONVERSION ISSUES
Effective January 1, 1999, eleven of the fifteen member countries of the European Union (the "Participating Countries") established fixed conversion rates between their existing sovereign currencies and the euro. For three years after the introduction of the euro, the Participating Countries can perform financial transactions in either the euro or their original local currencies. This will result in a fixed exchange rate among the Participating Countries, whereas the euro (and the Participating Countries' currency in tandem) will continue to float freely against the U.S. dollar and other currencies of the non-participating countries. The Company does not believe that the effects of the conversion will have a material adverse effect on the Company's business and operations.
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ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - -------- ----------------------------------------------------------
The Company is exposed to market risk associated with changes in interest rates and foreign currency exchange rates. To manage the volatility relating to these risks, the Company periodically enters into derivative transactions including foreign currency exchange contracts and interest rate swap agreements. The Company has limited involvement with derivative financial instruments and does not use them for trading purposes. The Company uses derivative instruments solely to reduce the financial impact of these risks.
The fair value of long-term debt is subject to interest rate risk. Generally, the fair value of long-term debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of the Company's total long-term debt, including current maturities, was approximately $844.6 million at February 28, 1999. A hypothetical 1% increase from prevailing interest rates at February 28, 1999, would result in a decrease in fair value of long-term debt by approximately $7.7 million. Also, a hypothetical 1% increase from prevailing interest rates at February 28, 1999, would result in an approximate increase in cash required for interest on variable interest rate debt during the next five fiscal years as follows:
2000 $ 6.2 million 2001 $ 5.1 million 2002 $ 3.8 million 2003 $ 3.4 million 2004 $ 2.9 million
The Company periodically enters into interest rate swap agreements to reduce its exposure to interest rate changes relative to its long-term debt. At February 28, 1999, the Company had no interest rate swap agreements outstanding.
The Company has exposure to foreign currency risk as a result of having international subsidiaries in the United Kingdom. The Company uses local currency borrowings to hedge its earnings and cash flow exposure to adverse changes in foreign currency exchange rates. At February 28, 1999, management believes that a hypothetical 10% adverse change in foreign currency exchange rates would not result in a material adverse impact on either earnings or cash flow. The Company also has exposure to foreign currency risk as a result of contracts to purchase inventory items that are denominated in various foreign currencies. In order to reduce the risk of foreign currency exchange rate fluctuations resulting from these contracts, the Company periodically enters into foreign exchange hedging agreements. At February 28, 1999, the potential loss on outstanding foreign exchange hedging agreements from a hypothetical 10% adverse change in foreign currency exchange rates would not be material.
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ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- -------------------------------------------
CANANDAIGUA BRANDS, INC. AND SUBSIDIARIES -----------------------------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ AND --- SUPPLEMENTARY SCHEDULES -----------------------
FEBRUARY 28, 1999 -----------------
Page ---- The following information is presented in this Annual Report on Form 10-K:
Report of Independent Public Accountants............................. 28 Consolidated Balance Sheets - February 28, 1999 and 1998............. 29 Consolidated Statements of Income for the years ended February 28, 1999, 1998 and 1997................................ 30 Consolidated Statements of Changes in Stockholders' Equity for the years ended February 28, 1999, 1998 and 1997............ 31 Consolidated Statements of Cash Flows for the years ended February 28, 1999, 1998 and 1997................................ 32 Notes to Consolidated Financial Statements........................... 33 Selected Financial Data.............................................. 14 Selected Quarterly Financial Information (unaudited)................. 52
Schedules I through V are not submitted because they are not applicable or not required under the rules of Regulation S-X.
Individual financial statements of the Registrant have been omitted because the Registrant is primarily an operating company and no subsidiary included in the consolidated financial statements has minority equity interest and/or noncurrent indebtedness, not guaranteed by the Registrant, in excess of 5% of total consolidated assets.
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ARTHUR ANDERSEN LLP
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Canandaigua Brands, Inc.:
We have audited the accompanying consolidated balance sheets of Canandaigua Brands, Inc. (a Delaware corporation) and subsidiaries as of February 28, 1999 and 1998, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended February 28, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Canandaigua Brands, Inc. and subsidiaries as of February 28, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended February 28, 1999 in conformity with generally accepted accounting principles.
As explained in Note 1 to the financial statements, the Company has given retroactive effect to the change in accounting for inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method.
/s/ Arthur Andersen LLP
Rochester, New York April 22, 1999
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CANANDAIGUA BRANDS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data)
February 28, --------------------------- 1999 1998 ----------- ----------- ASSETS ------ CURRENT ASSETS: Cash and cash investments $ 27,645 $ 1,232 Accounts receivable, net 260,433 142,615 Inventories, net 508,571 411,424 Prepaid expenses and other current assets 59,090 26,463 ----------- ----------- Total current assets 855,739 581,734 PROPERTY, PLANT AND EQUIPMENT, net 428,803 244,035 OTHER ASSETS 509,234 264,786 ----------- ----------- Total assets $ 1,793,776 $ 1,090,555 =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ CURRENT LIABILITIES: Notes payable $ 87,728 $ 91,900 Current maturities of long-term debt 6,005 24,118 Accounts payable 122,746 52,055 Accrued Federal and state excise taxes 49,342 17,498 Other accrued expenses and liabilities 149,451 104,896 ----------- ----------- Total current liabilities 415,272 290,467 ----------- ----------- LONG-TERM DEBT, less current maturities 831,689 309,218 ----------- ----------- DEFERRED INCOME TAXES 88,179 59,237 ----------- ----------- OTHER LIABILITIES 23,364 6,206 ----------- ----------- COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY: Preferred Stock, $.01 par value- Authorized, 1,000,000 shares; Issued, none in 1999 and 1998 -- -- Class A Common Stock, $.01 par value- Authorized, 120,000,000 shares; Issued, 17,915,359 shares in 1999 and 17,604,784 shares in 1998 179 176 Class B Convertible Common Stock, $.01 par value- Authorized, 20,000,000 shares; Issued, 3,849,173 shares in 1999 and 3,956,183 shares in 1998 39 40 Additional paid-in capital 239,912 231,687 Retained earnings 281,081 230,609 Accumulated other comprehensive income- Cumulative translation adjustment (4,173) -- ----------- ----------- 517,038 462,512 ----------- ----------- Less-Treasury stock- Class A Common Stock, 3,168,306 shares in 1999 and 2,199,320 shares in 1998, at cost (79,559) (34,878) Class B Convertible Common Stock, 625,725 shares in 1999 and 1998, at cost (2,207) (2,207) ----------- ----------- (81,766) (37,085) ----------- ----------- Total stockholders' equity 435,272 425,427 ----------- ----------- Total liabilities and stockholders' equity $ 1,793,776 $ 1,090,555 =========== ===========
The accompanying notes to consolidated financial statements are an integral part of these balance sheets.
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CANANDAIGUA BRANDS, INC., AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FEBRUARY 28, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
DESCRIPTION OF BUSINESS - Canandaigua Brands, Inc., and its subsidiaries (the Company) operate primarily in the beverage alcohol industry. The Company is principally a producer and supplier of wine and an importer and producer of beer and distilled spirits in the United States. It maintains a portfolio of over 170 national and regional brands of beverage alcohol which are distributed by over 1,000 wholesalers throughout the United States and selected international markets. The Company is also a leading United Kingdom-based producer of its own brands of cider, wine and bottled water and a leading independent beverage supplier to the on-premise trade, distributing its own branded products and those of other companies to more than 16,000 on-premise establishments in the U.K.
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements of the Company include the accounts of Canandaigua Brands, Inc., and all of its subsidiaries. All intercompany accounts and transactions have been eliminated.
MANAGEMENT'S USE OF ESTIMATES AND JUDGMENT - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
FOREIGN CURRENCY TRANSLATION - The "functional currency" for translating the accounts of the Company's operations outside the U.S. is the local currency. The translation from the applicable foreign currencies to U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. The resulting translation adjustments are recorded as a component of accumulated other comprehensive income. Gains or losses resulting from foreign currency transactions are included in selling, general and administrative expenses.
CASH INVESTMENTS - Cash investments consist of highly liquid investments with an original maturity when purchased of three months or less and are stated at cost, which approximates market value. The amounts at February 28, 1999 and 1998, are not significant.
FAIR VALUE OF FINANCIAL INSTRUMENTS - To meet the reporting requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the Company calculates the fair value of financial instruments using quoted market prices whenever available. When quoted market prices are not available, the Company uses standard pricing models for various types of financial instruments (such as forwards, options, swaps, etc.) which take into account the present value of estimated future cash flows. The methods and assumptions used to estimate the fair value of financial instruments are summarized as follows:
ACCOUNTS RECEIVABLE: The carrying amount approximates fair value due to the short maturity of these instruments, the creditworthiness of the customers and the large number of customers constituting the accounts receivable balance. NOTES PAYABLE: These instruments are variable interest rate bearing notes for which the carrying value approximates the fair value. LONG-TERM DEBT: The carrying value of the debt facilities with short-term variable interest rates approximates the fair value. The fair value of the fixed rate debt was estimated by discounting cash flows using interest rates currently available for debt with similar terms and maturities.
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FOREIGN EXCHANGE HEDGING AGREEMENTS: The fair value of currency forward contracts is estimated based on quoted market prices. LETTERS OF CREDIT: At February 28, 1999 and 1998, the Company had letters of credit outstanding totaling approximately $4.0 million and $3.9 million, respectively, which guarantee payment for certain obligations. The Company recognizes expense on these obligations as incurred and no material losses are anticipated.
The carrying amount and estimated fair value of the Company's financial instruments are summarized as follows as of February 28:
INTEREST RATE FUTURES AND CURRENCY FORWARD CONTRACTS - From time to time, the Company enters into interest rate futures and a variety of currency forward contracts in the management of interest rate risk and foreign currency transaction exposure. The Company has limited involvement with derivative instruments and does not use them for trading purposes. The Company uses derivatives solely to reduce the financial impact of the related risks. Unrealized gains and losses on interest rate futures are deferred and recognized as a component of interest expense over the borrowing period. Unrealized gains and losses on currency forward contracts are deferred and recognized as a component of the related transactions in the accompanying financial statements. Discounts or premiums on currency forward contracts are recognized over the life of the contract. Cash flows from derivative instruments are classified in the same category as the item being hedged. The Company's open currency forward contracts at February 28, 1999, hedge purchase commitments denominated in foreign currencies and mature within twelve months.
INVENTORIES - During the fourth quarter of fiscal 1999, the Company changed its method of determining the cost of inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. The primary reasons for the change in accounting method are: management's belief that the FIFO method of accounting better matches revenues and expenses of the Company, and therefore, will result in a better measurement of operating results; and the FIFO method of accounting will provide improved financial comparability to other publicly-traded companies in the industry. All previously reported results have been restated to reflect the retroactive application of this accounting change as required by generally accepted accounting principles. The effect of this change was to increase current assets, current liabilities and retained earnings by $17.4 million, $7.1 million, and $10.3 million, respectively, as of February 28, 1998. The effect of the change increased net income for the year ended February 28, 1998, by $2.9 million, or $0.15 per share on a diluted basis, and increased net income for the year ended February 28, 1997, by $18.5 million, or $0.95 per share on a diluted basis. The effect of the change on the first quarter of fiscal 1999 was to decrease net income $0.5 million, or $0.02 per share on a diluted basis. The effect of the change on the second and third quarters of fiscal 1999 was to increase net income $1.0 million, or $0.05 per share on a diluted basis, and $0.5 million, or $0.03 per share on a diluted basis, respectively.
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Elements of cost include materials, labor and overhead and consist of the following as of February 28:
1999 1998 -------- -------- (in thousands) Raw materials and supplies $ 32,388 $ 14,439 Wine and distilled spirits in process 344,175 304,037 Finished case goods 132,008 92,948 -------- -------- $508,571 $411,424 ======== ========
A substantial portion of barreled whiskey and brandy will not be sold within one year because of the duration of the aging process. All barreled whiskey and brandy are classified as in-process inventories and are included in current assets, in accordance with industry practice. Bulk wine inventories are also included as work in process within current assets, in accordance with the general practices of the wine industry, although a portion of such inventories may be aged for periods greater than one year. Warehousing, insurance, ad valorem taxes and other carrying charges applicable to barreled whiskey and brandy held for aging are included in inventory costs.
PROPERTY, PLANT AND EQUIPMENT - Property, plant and equipment is stated at cost. Major additions and betterments are charged to property accounts, while maintenance and repairs are charged to operations as incurred. The cost of properties sold or otherwise disposed of and the related accumulated depreciation are eliminated from the accounts at the time of disposal and resulting gains and losses are included as a component of operating income.
DEPRECIATION - Depreciation is computed primarily using the straight-line method over the following estimated useful lives:
Depreciable Life in Years ------------------------- Buildings and improvements 10 to 33 1/3 Machinery and equipment 3 to 15 Motor vehicles 3 to 7
Amortization of assets capitalized under capital leases is included with depreciation expense. Amortization is calculated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.
OTHER ASSETS - Other assets, which consist of goodwill, distribution rights, trademarks, agency license agreements, deferred financing costs, prepaid pension benefits, cash surrender value of officers' life insurance and other amounts, are stated at cost, net of accumulated amortization. Amortization is calculated on a straight-line or effective interest basis over the following estimated useful lives:
Useful Life in Years -------------------- Goodwill 40 Distribution rights 40 Trademarks 40 Agency license agreements 16 to 40 Deferred financing costs 5 to 10
At February 28, 1999, the weighted average remaining useful life of these assets is approximately 38 years. The face value of the officers' life insurance policies totaled $2.9 million at both February 28, 1999 and 1998.
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LONG-LIVED ASSETS AND INTANGIBLES - In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," the Company reviews its long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable on an undiscounted cash flow basis. The statement also requires that long-lived assets and certain identifiable intangibles to be disposed of be reported at the lower of carrying amount or fair value less cost to sell. The Company did not record any asset impairment in fiscal 1999.
ADVERTISING AND PROMOTION COSTS - The Company generally expenses advertising and promotion costs as incurred, shown or distributed. Prepaid advertising costs at February 28, 1999 and 1998, are not material. Advertising and promotion expense for the years ended February 28, 1999, 1998, and 1997, were approximately $173.1 million, $111.7 million and $101.3 million, respectively.
INCOME TAXES - The Company uses the liability method of accounting for income taxes. The liability method accounts for deferred income taxes by applying statutory rates in effect at the balance sheet date to the difference between the financial reporting and tax basis of assets and liabilities.
ENVIRONMENTAL - Environmental expenditures that relate to current operations are expensed as appropriate. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities are recorded when environmental assessments and/or remedial efforts are probable, and the cost can be reasonably estimated. Generally, the timing of these accruals coincides with the completion of a feasibility study or the Company's commitment to a formal plan of action. Liabilities for environmental costs were not material at February 28, 1999 and 1998.
COMPREHENSIVE INCOME- During fiscal 1999, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130). This statement establishes rules for the reporting of comprehensive income and its components. Comprehensive income consists of net income and foreign currency translation adjustments and is presented in the Consolidated Statements of Changes in Stockholders' Equity. The adoption of SFAS No. 130 had no impact on total stockholders' equity. Prior year financial statements have been reclassified to conform with the SFAS No. 130 requirements.
EARNINGS PER COMMON SHARE - Basic earnings per common share excludes the effect of common stock equivalents and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period for Class A Common Stock and Class B Convertible Common Stock. Diluted earnings per common share reflects the potential dilution that could result if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted earnings per common share assumes the exercise of stock options using the treasury stock method and assumes the conversion of convertible securities, if any, using the "if converted" method.
2. ACQUISITIONS:
MATTHEW CLARK ACQUISITION - On December 1, 1998, the Company acquired control of Matthew Clark plc (Matthew Clark) and has since acquired all of Matthew Clark's outstanding shares (the Matthew Clark Acquisition). The total purchase price, including assumption of indebtedness, for the acquisition of Matthew Clark shares was approximately $475.0 million, net of cash acquired. Matthew Clark, founded in 1810, is a leading U.K.-based producer and distributor of its own brands of cider, wine and bottled water and a leading independent drinks wholesaler in the U.K.
The purchase price for the Matthew Clark shares was funded with proceeds from loans under a First Amended and Restated Credit Agreement (the "1998 Credit Agreement"), effective as of November 2, 1998, between the
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Company and The Chase Manhattan Bank, as administrative agent, and a syndicate of banks who are parties to the 1998 Credit Agreement.
The Matthew Clark Acquisition was accounted for using the purchase method; accordingly, the Matthew Clark assets were recorded at fair market value at the date of acquisition, December 1, 1998. The excess of the purchase price over the estimated fair market value of the net assets acquired (goodwill), 99.3 million British pound sterling ($164.3 million as of December 1, 1998), is being amortized on a straight-line basis over 40 years. The results of operations of the Matthew Clark Acquisition have been included in the Consolidated Statements of Income since the date of the acquisition.
During fiscal 1999, the Company incurred and paid approximately $2.6 million in nonrecurring charges related to the closing of a Matthew Clark cider production facility. The charges were part of a production facility consolidation program that was begun prior to the acquisition. The unaudited pro forma results of operations for fiscal 1999 (shown in the table below) reflect total nonrecurring charges of $21.5 million ($0.69 per share on a diluted basis) related to this facility consolidation program, of which $18.9 million was incurred prior to the acquisition.
The following table sets forth unaudited pro forma results of operations of the Company for the years ended February 28, 1999 and 1998. The unaudited pro forma fiscal 1999 results of operations give effect to the Matthew Clark Acquisition as if it occurred on March 1, 1998. The unaudited pro forma fiscal 1998 results of operations give effect to the Matthew Clark Acquisition as if it occurred on March 1, 1997. The unaudited pro forma fiscal 1999 and fiscal 1998 results of operations are presented after giving effect to certain adjustments for depreciation, amortization of goodwill, interest expense on the acquisition financing and related income tax effects. The unaudited pro forma results of operations are based upon currently available information and upon certain assumptions that the Company believes are reasonable under the circumstances. The unaudited pro forma results of operations do not purport to present what the Company's results of operations would actually have been if the aforementioned transactions had in fact occurred on such date or at the beginning of the period indicated, nor do they project the Company's financial position or results of operations at any future date or for any future period.
1999 1998 ----------- ----------- (in thousands, except per share data) Net sales $ 2,017,497 $ 1,883,813 Income before extraordinary item $ 49,126 $ 55,879 Extraordinary item, net of income taxes $ (11,437) $ -- Net income $ 37,689 $ 55,879
Earnings per common share: Basic: Income before extraordinary item $ 2.68 $ 2.99 Extraordinary item (0.62) -- ----------- ----------- Earnings per common share - basic $ 2.06 $ 2.99 =========== =========== Diluted: Income before extraordinary item $ 2.62 $ 2.92 Extraordinary item (0.61) -- ----------- ----------- Earnings per common share - diluted $ 2.01 $ 2.92 =========== =========== Weighted average common shares outstanding: Basic 18,293 18,672 Diluted 18,754 19,105
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3. PROPERTY, PLANT AND EQUIPMENT:
The major components of property, plant and equipment are as follows as of February 28:
1999 1998 --------- --------- (in thousands) Land $ 25,700 $ 15,103 Buildings and improvements 104,152 74,706 Machinery and equipment 380,069 244,204 Motor vehicles 20,191 5,316 Construction in progress 35,468 17,485 --------- --------- 565,580 356,814 Less - Accumulated depreciation (136,777) (112,779) --------- --------- $ 428,803 $ 244,035 ========= =========
4. OTHER ASSETS:
The major components of other assets are as follows as of February 28:
1999 1998 --------- --------- (in thousands) Goodwill $ 311,908 $ 150,595 Distribution rights, agency license agreements and trademarks 179,077 119,346 Other 53,779 23,686 --------- --------- 544,764 293,627 Less - Accumulated amortization (35,530) (28,841) --------- --------- $ 509,234 $ 264,786 ========= =========
5. OTHER ACCRUED EXPENSES AND LIABILITIES:
The major components of other accrued expenses and liabilities are as follows as of February 28:
1999 1998 -------- -------- (in thousands) Accrued advertising and promotions $ 38,604 $ 16,048 Accrued salaries and commissions 15,584 23,704 Other 95,263 65,144 -------- -------- $149,451 $104,896 ======== ========
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6. BORROWINGS:
Borrowings consist of the following as of February 28:
SENIOR CREDIT FACILITY - On December 14, 1998, the Company, its principal operating subsidiaries (other than Matthew Clark and its subsidiaries), and a syndicate of banks (the Syndicate Banks), for which The Chase Manhattan Bank acts as administrative agent, entered into the 1998 Credit Agreement, effective as of November 2, 1998, which amends and restates in its entirety the credit agreement entered into between the Company and The Chase Manhattan Bank on November 2, 1998. The 1998 Credit Agreement includes both U.S. dollar and British pound sterling commitments of the Syndicate Banks of up to, in the aggregate, the equivalent of $1.0 billion (subject to increase as therein provided to $1.2 billion) with the proceeds available for repayment of all outstanding principal and accrued interest on all loans under the Company's bank credit agreement dated as of December 19, 1997, payment of the purchase price for the Matthew Clark shares, repayment of Matthew Clark's credit facilities, funding of permitted acquisitions, payment of transaction expenses and ongoing working capital needs of the Company. The Company incurred an extraordinary loss of $19.3 million ($11.4 million after taxes) in the fourth quarter of 1999 resulting from fees related to the replacement of the bank credit agreement, including extinguishment of the Term Loan.
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The 1998 Credit Agreement provides for a $350.0 million Tranche I Term Loan facility due in December 2004, a $200.0 million Tranche II Term Loan facility due in June 2000, a $150.0 million Tranche III Term Loan facility due in December 2005, and a $300.0 million Revolving Credit facility (including letters of credit up to a maximum of $20.0 million) which expires in December 2004. Portions of the Tranche I Term Loan facility and the Revolving Credit facility are available for borrowing in British pound sterling.
The Tranche I Term Loan facility requires quarterly repayments, starting at $6.3 million in December 1999, increasing annually thereafter with a balloon payment at maturity of approximately $110.0 million. The Tranche II Term Loan facility requires no principal payments prior to the stated maturity. The Tranche III Term Loan facility requires quarterly repayments, starting at $0.4 million in December 1999 and increasing to approximately $18.0 million in March 2004. There are certain mandatory term loan prepayments, including those based on excess cash flow, sale of assets, issuance of debt or equity, and fluctuation in the U.S. dollar/British pound sterling exchange rate, in each case subject to baskets and thresholds which (other than with respect to those pertaining to fluctuations in the U.S. dollar/British pound sterling exchange rate, which were inapplicable under the previous bank credit agreement) are generally more favorable to the Company than those contained in its previous bank credit agreement.
The rate of interest payable, at the Company's option, is a function of the London interbank offering rate (LIBOR) plus a margin, federal funds rate plus a margin, or the prime rate plus a margin. The margin is adjustable based upon the Company's Debt Ratio (as defined in the 1998 Credit Agreement). The initial margin on LIBOR borrowings ranges between 1.75% and 2.50% and (other than for the Tranche II Term Loan facility) may be reduced after November 30, 1999, to between 1.125% and 1.50%, depending on the Company's Debt Ratio. Conversely, if the Debt Ratio of the Company should increase, the margin would be adjusted upwards to between 2.0% and 2.75% for LIBOR based borrowings. In addition to interest, the Company pays a facility fee on the Revolving Credit commitments, initially at 0.50% per annum and subject to reduction after November 30, 1999, to 0.375%, depending on the Company's Debt Ratio.
Each of the Company's principal operating subsidiaries (other than Matthew Clark and its subsidiaries) has guaranteed the Company's obligation under the 1998 Credit Agreement, and the Company and those subsidiaries have given security interests to the Syndicate Banks in substantially all of their assets. The Company and its subsidiaries are subject to customary secured lending covenants including those restricting additional liens, incurring additional indebtedness, the sale of assets, the payment of dividends, transactions with affiliates and the making of certain investments. The primary financial covenants require the maintenance of a debt coverage ratio, a senior debt coverage ratio, a fixed charges ratio and an interest coverage ratio. Among the most restrictive covenants contained in the 1998 Credit Agreement is the requirement to maintain a fixed charges ratio of not less than 1.0 at the last day of each fiscal quarter for the most recent four quarters.
As of February 28, 1999, under the 1998 Credit Agreement, the Company had outstanding term loans of $625.6 million bearing interest at 7.62% and $83.1 million of revolving loans bearing interest at 7.25%. The Company had average outstanding Revolving Credit Loans of approximately $75.5 million, $59.9 million and $88.8 million for the years ended February 28, 1999, 1998 and 1997, respectively. Amounts available to be drawn down under the Revolving Credit Loans were $212.9 million and $89.2 million at February 28, 1999 and 1998, respectively. The average interest rate on the Revolving Credit Loans was 6.23%, 6.57% and 6.58% for fiscal 1999, fiscal 1998, and fiscal 1997, respectively.
SENIOR SUBORDINATED NOTES - On December 27, 1993, the Company issued $130.0 million aggregate principal amount of 8.75% Senior Subordinated Notes due in December 2003 (the Original Notes). Interest on the Original Notes is payable semiannually on June 15 and December 15 of each year. The Original Notes are unsecured and subordinated to the prior payment in full of all senior indebtedness of the Company, which includes the 1998 Credit Agreement. The Original Notes are guaranteed, on a senior subordinated basis, by all of the Company's significant operating subsidiaries (other than Matthew Clark and its subsidiaries).
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The Trust Indenture relating to the Original Notes contains certain covenants, including, but not limited to, (i) limitation on indebtedness; (ii) limitation on restricted payments; (iii) limitation on transactions with affiliates; (iv) limitation on senior subordinated indebtedness; (v) limitation on liens; (vi) limitation on sale of assets; (vii) limitation on issuance of guarantees of and pledges for indebtedness; (viii) restriction on transfer of assets; (ix) limitation on subsidiary capital stock; (x) limitation on the creation of any restriction on the ability of the Company's subsidiaries to make distributions and other payments; and (xi) restrictions on mergers, consolidations and the transfer of all or substantially all of the assets of the Company to another person. The limitation on indebtedness covenant is governed by a rolling four quarter fixed charge ratio requiring a specified minimum.
On October 29, 1996, the Company issued $65.0 million aggregate principal amount of 8.75% Series B Senior Subordinated Notes due in December 2003 (the Series B Notes). In February 1997, the Company exchanged $65.0 million aggregate principal amount of 8.75% Series C Senior Subordinated Notes due in December 2003 (the Series C Notes) for the Series B Notes. The terms of the Series C Notes are substantially identical in all material respects to the Original Notes.
DEBT PAYMENTS - Principal payments required under long-term debt obligations during the next five fiscal years and thereafter are as follows:
(in thousands) 2000 $ 6,005 2001 224,972 2002 35,963 2003 42,876 2004 244,826 Thereafter 285,532 --------- $ 840,174 =========
7. INCOME TAXES:
The provision for income taxes consists of the following for the years ended February 28:
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A reconciliation of the total tax provision to the amount computed by applying the expected U.S. Federal income tax rate to income before provision for income taxes is as follows for the years ended February 28:
Deferred tax liabilities (assets) are comprised of the following as of February 28:
1999 1998 -------- -------- (in thousands) Depreciation and amortization $ 89,447 $ 70,303 LIFO reserve 16,546 6,469 Inventory reserves 6,975 6,974 Other accruals (15,009) (18,193) -------- -------- $ 97,959 $ 65,553 ======== ========
At February 28, 1999, the Company has state and U.S. Federal net operating loss (NOL) carryforwards of $5.4 million and $2.7 million, respectively, to offset future taxable income that, if not otherwise utilized, will expire as follows: state NOLs of $0.6 million and $4.8 million during fiscal 2002 and fiscal 2003, respectively, and Federal NOL of $2.7 million during fiscal 2011.
8. PROFIT SHARING RETIREMENT PLANS AND RETIREMENT SAVINGS PLAN:
Effective March 1, 1998, the Company's existing retirement savings and profit sharing retirement plans and the Barton profit sharing and 401(k) plan were merged into the Canandaigua Brands, Inc. 401(k) and Profit Sharing Plan (the Plan). The Plan covers substantially all employees, excluding those employees covered by collective bargaining agreements and Matthew Clark employees. The 401(k) portion of the Plan permits eligible employees to defer a portion of their compensation (as defined in the Plan) on a pretax basis. Participants may defer up to 10% of their compensation for the year, subject to limitations of the Plan. The Company makes a matching contribution of 50% of the first 6% of compensation a participant defers. The amount of the Company's contribution under the profit sharing portion of the Plan is in such discretionary amount as the Board of Directors may annually determine, subject to limitations of the Plan. Company contributions were $6.8 million, $5.9 million and $5.7 million for the years ended February 28, 1999, 1998 and 1997, respectively.
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The Company's subsidiary, Matthew Clark, currently provides for two pension plans: the Matthew Clark Group Pension Plan; and the Matthew Clark Executive Pension Plan (the Plans). The Plans are defined benefit plans with assets held by a Trustee who administers funds separately from the Company's finances. The following table summarizes the funded status of the Company's pension plans and the related amounts that are primarily included in "other assets" in the Consolidated Balance Sheets.
(in thousands) Change in benefit obligation: Benefit obligation at December 1, 1998 $ 165,997 Service cost 1,335 Interest cost 2,671 Plan participants' contributions 481 Benefits paid (1,517) Foreign currency exchange rate changes (5,287) --------- Benefit obligation at February 28, 1999 $ 163,680 ========= Change in plan assets: Fair value of plan assets at December 1, 1998 $ 194,001 Actual return on plan assets 7,935 Plan participants' contributions 481 Benefits paid (1,517) Foreign currency exchange rate changes (6,294) --------- Fair value of plan assets at February 28, 1999 $ 194,606 ========= Funded status of the plan as of February 28, 1999: Funded status $ 30,927 Unrecognized actuarial loss (3,950) --------- Prepaid benefit cost $ 26,977 ========= Assumptions as of February 28, 1999: Rate of return on plan assets 8.0% Discount rate 6.5% Increase in compensation levels 4.5%
Components of net periodic benefit cost for the three month period ended February 28, 1999: Service cost $ 1,335 Interest cost 2,671 Expected return on plan assets (3,848) --------- Net periodic benefit cost $ 158 =========
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9. STOCKHOLDERS' EQUITY:
COMMON STOCK - The Company has two classes of common stock: Class A Common Stock and Class B Convertible Common Stock. Class B Convertible Common Stock shares are convertible into shares of Class A Common Stock on a one-to-one basis at any time at the option of the holder. Holders of Class B Convertible Common Stock are entitled to ten votes per share. Holders of Class A Common Stock are entitled to only one vote per share but are entitled to a cash dividend premium. If the Company pays a cash dividend on Class B Convertible Common Stock, each share of Class A Common Stock will receive an amount at least ten percent greater than the amount of the cash dividend per share paid on Class B Convertible Common Stock. In addition, the Board of Directors may declare and pay a dividend on Class A Common Stock without paying any dividend on Class B Convertible Common Stock.
At February 28, 1999, there were 14,747,053 shares of Class A Common Stock and 3,223,448 shares of Class B Convertible Common Stock outstanding, net of treasury stock.
STOCK REPURCHASE AUTHORIZATION - In January 1996, the Company's Board of Directors authorized the repurchase of up to $30.0 million of its Class A Common Stock and Class B Convertible Common stock. The Company was permitted to finance such purchases, which became treasury shares, through cash generated from operations or through the bank credit agreement. Throughout the year ended February 28, 1997, the Company repurchased 787,450 shares of Class A Common Stock totaling $20.8 million. The Company completed its repurchase program during fiscal 1998, repurchasing 362,100 shares of Class A Common Stock for $9.2 million.
In June 1998, the Company's Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Convertible Common Stock. The Company may finance such purchases, which will become treasury shares, through cash generated from operations or through the bank credit agreement. During fiscal 1999, the Company repurchased 1,018,836 shares of Class A Common Stock for $44.9 million.
INCREASE IN NUMBER OF AUTHORIZED SHARES OF CLASS A COMMON STOCK- In July 1998, the stockholders of the Company approved an increase in the number of authorized shares of Class A Common Stock from 60,000,000 shares to 120,000,000 shares, thereby increasing the aggregate number of authorized shares of the Company to 141,000,000 shares.
LONG-TERM STOCK INCENTIVE PLAN - Under the Company's Long-Term Stock Incentive Plan, nonqualified stock options, stock appreciation rights, restricted stock and other stock-based awards may be granted to employees, officers and directors of the Company. Grants, in the aggregate, may not exceed 4,000,000 shares of the Company's Class A Common Stock. The exercise price, vesting period and term of nonqualified stock options granted are established by the committee administering the plan (the Committee). Grants of stock appreciation rights, restricted stock and other stock-based awards may contain such vesting, terms, conditions and other requirements as the Committee may establish. During fiscal 1999 and fiscal 1998, no stock appreciation rights were granted. During fiscal 1999, no restricted stock was granted and during fiscal 1998, 25,000 shares of restricted Class A Common Stock were granted. At February 28, 1999, there were 1,228,753 shares available for future grant.
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A summary of nonqualified stock option activity is as follows:
Weighted Weighted Shares Avg. Avg. Under Exercise Options Exercise Option Price Exercisable Price --------- -------- ----------- -------- Balance, February 29, 1996 1,093,725 $ 28.70 28,675 $ 4.44 Options granted 1,647,700 $ 22.77 Options exercised (3,750) $ 4.44 Options forfeited/canceled (1,304,700) $ 32.09 --------- Balance, February 28, 1997 1,432,975 $ 18.85 51,425 $ 10.67 Options granted 569,400 $ 38.72 Options exercised (117,452) $ 15.33 Options forfeited/canceled (38,108) $ 17.66 --------- Balance, February 28, 1998 1,846,815 $ 25.23 360,630 $ 25.46 Options granted 728,200 $ 50.57 Options exercised (203,565) $ 20.08 Options forfeited/canceled (116,695) $ 37.13 --------- Balance, February 28, 1999 2,254,755 $ 33.26 492,285 $ 24.55 =========
The following table summarizes information about stock options outstanding at February 28, 1999:
Options Outstanding Options Exercisable ------------------------------------- ---------------------- Weighted Avg. Weighted Weighted Remaining Avg. Avg. Range of Number Contractual Exercise Number Exercise Exercise Prices Outstanding Life Price Exercisable Price - --------------- ----------- ------------- -------- ----------- -------- $ 4.44 - $11.50 21,525 2.7 years $ 9.64 21,525 $ 9.64 $17.00 - $25.63 817,015 6.5 years $ 17.25 256,775 $ 17.57 $26.75 - $31.25 340,440 7.5 years $ 28.47 106,400 $ 27.37 $35.38 - $57.13 1,075,775 9.2 years $ 47.41 107,585 $ 41.39 --------- ------- 2,254,755 7.9 years $ 33.26 492,285 $ 24.55 ========= =======
The weighted average fair value of options granted during fiscal 1999, fiscal 1998 and fiscal 1997 was $26.21, $20.81 and $10.27, respectively. The fair value of options is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: risk-free interest rate of 5.3% for fiscal 1999, 6.4% for fiscal 1998 and 6.6% for fiscal 1997; volatility of 40.6% for fiscal 1999, 41.3% for fiscal 1998 and 42.7% for fiscal 1997; expected option life of 7.0 years for fiscal 1999, 6.9 years for fiscal 1998 and 4.7 years for fiscal 1997. The dividend yield was 0% for fiscal 1999, 1998 and 1997. Forfeitures are recognized as they occur.
INCENTIVE STOCK OPTION PLAN - Under the Company's Incentive Stock Option Plan, incentive stock options may be granted to employees, including officers, of the Company. Grants, in the aggregate, may not exceed 1,000,000 shares of the Company's Class A Common Stock. The exercise price of any incentive stock option may not be less than the fair market value of the Company's Class A Common Stock on the date of grant. The vesting period and term of incentive stock options granted are established by the Committee. The maximum term of incentive stock options is ten years. During fiscal 1999 and fiscal 1998, no incentive stock options were granted.
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EMPLOYEE STOCK PURCHASE PLAN - The Company has a stock purchase plan under which 1,125,000 shares of Class A Common Stock can be issued. Under the terms of the plan, eligible employees may purchase shares of the Company's Class A Common Stock through payroll deductions. The purchase price is the lower of 85% of the fair market value of the stock on the first or last day of the purchase period. During fiscal 1999, fiscal 1998 and fiscal 1997, employees purchased 49,850, 78,248 and 37,768 shares, respectively.
The weighted average fair value of purchase rights granted during fiscal 1999, fiscal 1998 and fiscal 1997 was $12.35, $11.90 and $8.41, respectively. The fair value of purchase rights is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: risk-free interest rate of 4.7% for fiscal 1999, 5.3% for fiscal 1998 and 5.6% for fiscal 1997; volatility of 33.5% for fiscal 1999, 35.1% for fiscal 1998 and 65.4% for fiscal 1997; expected purchase right life of 0.5 years for fiscal 1999, 0.5 years for fiscal 1998 and 0.8 years for fiscal 1997. The dividend yield was 0% for fiscal 1999, 1998 and 1997.
PRO FORMA DISCLOSURE - The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans. The Company adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123). Accordingly, no incremental compensation expense has been recognized for its stock-based compensation plans. Had the Company recognized the compensation cost based upon the fair value at the date of grant for awards under its plans consistent with the methodology prescribed by SFAS No. 123, net income and earnings per common share would have been reduced to the pro forma amounts as follows for the years ended February 28:
The pro forma effect on net income may not be representative of that to be expected in future years.
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10. EARNINGS PER COMMON SHARE:
The following table presents earnings per common share for the years ended February 28:
1999 1998 1997 -------- -------- -------- (in thousands, except per share data) Income before extraordinary item $ 61,909 $ 47,130 $ 46,183 Extraordinary item, net of income taxes (11,437) -- -- -------- -------- -------- Income applicable to common shares $ 50,472 $ 47,130 $ 46,183 ======== ======== ======== Weighted average common shares outstanding - basic 18,293 18,672 19,333 Stock options 461 433 188 -------- -------- -------- Weighted average common shares outstanding - diluted 18,754 19,105 19,521 ======== ======== ======== Earnings per common share: Basic: Income before extraordinary item $ 3.38 $ 2.52 $ 2.39 Extraordinary item (0.62) -- -- -------- -------- -------- Earnings per common share - basic $ 2.76 $ 2.52 $ 2.39 ======== ======== ======== Diluted: Income before extraordinary item $ 3.30 $ 2.47 $ 2.37 Extraordinary item (0.61) -- -- -------- -------- -------- Earnings per common share - diluted $ 2.69 $ 2.47 $ 2.37 ======== ======== ========
11. COMMITMENTS AND CONTINGENCIES:
OPERATING LEASES - Future payments under noncancelable operating leases having initial or remaining terms of one year or more are as follows during the next five fiscal years and thereafter:
(in thousands) 2000 $ 13,292 2001 11,478 2002 10,576 2003 10,109 2004 9,624 Thereafter 102,122 -------- $157,201 ========
Rental expense was approximately $8.2 million, $5.6 million and $4.7 million for fiscal 1999, fiscal 1998 and fiscal 1997, respectively.
PURCHASE COMMITMENTS AND CONTINGENCIES - The Company has agreements with three suppliers to purchase blended Scotch whisky through December 2002. The purchase prices under the agreements are denominated in British pound sterling. Based upon exchange rates at February 28, 1999, the Company's aggregate future obligation is approximately $17.2 million for the contracts expiring through December 2002.
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At February 28, 1999, the Company had two agreements with Diageo plc (Diageo) to purchase Canadian blended whisky through September 1, 2000, with a maximum obligation of approximately $4.9 million. The Company also had an agreement with Diageo to purchase Canadian new distillation whisky through December 1999 at purchase prices of approximately $1.4 million to $1.7 million. These agreements have been superseded as a result of the Company's definitive agreement with Diageo. See Note 17 - Subsequent Events. At February 28, 1999, the Company also had an agreement with a different supplier to purchase Canadian new distillation whisky through December 2005, with a maximum obligation of approximately $6.4 million.
All of the Company's imported beer products are marketed and sold pursuant to exclusive distribution agreements from the suppliers of these products. The Company's agreement to distribute Corona Extra and its other Mexican beer brands exclusively throughout 25 primarily western states was renewed effective November 22, 1996, and expires December 2006, with automatic five year renewals thereafter, subject to compliance with certain performance criteria and other terms under the agreement. The remaining agreements expire through December 2007. Prior to their expiration, these agreements may be terminated if the Company fails to meet certain performance criteria. At February 28, 1999, the Company believes it is in compliance with all of its material distribution agreements and, given the Company's long-term relationships with its suppliers, the Company does not believe that these agreements will be terminated.
In connection with previous acquisitions, the Company assumed purchase contracts with certain growers and suppliers. In addition, the Company has entered into other purchase contracts with various growers and suppliers in the normal course of business. Under the grape purchase contracts, the Company is committed to purchase all grape production yielded from a specified number of acres for a period of time ranging up to nineteen years. The actual tonnage and price of grapes that must be purchased by the Company will vary each year depending on certain factors, including weather, time of harvest, overall market conditions and the agricultural practices and location of the growers and suppliers under contract. The Company purchased $126.6 million of grapes under these contracts during fiscal 1999. Based on current production yields and published grape prices, the Company estimates that the aggregate purchases under these contracts over the remaining term of the contracts will be approximately $846.4 million.
The Company's aggregate obligations under bulk wine purchase contracts will be approximately $40.6 million over the remaining term of the contracts which expire through fiscal 2001.
EMPLOYMENT CONTRACTS - The Company has employment contracts with certain of its executive officers and certain other management personnel with remaining terms ranging up to two years. These agreements provide for minimum salaries, as adjusted for annual increases, and may include incentive bonuses based upon attainment of specified management goals. In addition, these agreements provide for severance payments in the event of specified termination of employment. The aggregate commitment for future compensation and severance, excluding incentive bonuses, was approximately $6.4 million as of February 28, 1999, of which approximately $1.8 million is accrued in other liabilities as of February 28, 1999.
EMPLOYEES COVERED BY COLLECTIVE BARGAINING AGREEMENTS - Approximately 32% of the Company's full-time employees are covered by collective bargaining agreements at February 28, 1999. Agreements expiring within one year cover approximately 5% of the Company's full-time employees.
LEGAL MATTERS - The Company is subject to litigation from time to time in the ordinary course of business. Although the amount of any liability with respect to such litigation cannot be determined, in the opinion of management such liability will not have a material adverse effect on the Company's financial condition, results of operations or cash flows.
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12. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK:
Gross sales to the five largest customers of the Company represented 25.2%, 26.4% and 22.9% of the Company's gross sales for the fiscal years ended February 28, 1999, 1998 and 1997, respectively. Gross sales to the Company's largest customer, Southern Wine and Spirits, represented 10.9%, 12.1% and 10.5% of the Company's gross sales for the fiscal years ended February 28, 1999, 1998 and 1997, respectively. Accounts receivable from the Company's largest customer represented 8.5%, 14.1% and 11.3% of the Company's total accounts receivable as of February 28, 1999, 1998 and 1997, respectively. Gross sales to the Company's five largest customers are expected to continue to represent a significant portion of the Company's revenues. The Company's arrangements with certain of its customers may, generally, be terminated by either party with prior notice. The Company performs ongoing credit evaluations of its customers' financial position, and management of the Company is of the opinion that any risk of significant loss is reduced due to the diversity of customers and geographic sales area.
13. SUMMARIZED FINANCIAL INFORMATION - SUBSIDIARY GUARANTORS:
The following table presents summarized financial information for the Company, the parent company, the combined subsidiaries of the Company which guarantee the Company's senior subordinated notes (Subsidiary Guarantors) and the combined subsidiaries of the Company which are not Subsidiary Guarantors, primarily Matthew Clark (Subsidiary Nonguarantors). The Subsidiary Guarantors are wholly owned and the guarantees are full, unconditional, joint and several obligations of each of the Subsidiary Guarantors. Separate financial statements for the Subsidiary Guarantors of the Company are not presented because the Company has determined that such financial statements would not be material to investors. The Subsidiary Guarantors comprise all of the direct and indirect subsidiaries of the Company, other than Matthew Clark and certain other subsidiaries which individually, and in the aggregate, are inconsequential. There are no restrictions on the ability of the Subsidiary Guarantors to transfer funds to the Company in the form of cash dividends, loans or advances.
14. ACCOUNTING PRONOUNCEMENT:
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. SFAS No. 133 requires that every derivative be recorded as either an asset or liability in the balance sheet and measured at its fair value. SFAS No. 133 also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company formally document, designate and assess the effectiveness of transactions that receive hedge accounting. The Company is required to adopt SFAS No. 133 on a prospective basis for interim periods and fiscal years beginning March 1, 2000. The Company believes the effect of adoption on its financial statements will not be material based on the Company's current risk management strategies.
15. BUSINESS SEGMENT INFORMATION:
Effective March 1, 1998, the Company has adopted the provisions of Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. Adoption of this statement had no impact on the Company's consolidated financial position, results of operations or cash flows. Comparative information for earlier years has been restated. The restatement of comparative information for interim periods in the initial year of adoption is to be reported for interim periods in the second year of application. The Company reports its operating results in four segments: Canandaigua Wine (branded wine and brandy, and other, primarily grape juice concentrate); Barton (primarily beer and spirits); Matthew Clark (branded wine, cider and bottled water, and wholesale wine, cider, spirits, beer and soft drinks); and Corporate Operations and Other (primarily corporate related items). Segment selection was based upon internal organizational structure, the way in which these operations are managed and their performance evaluated by management and the Company's Board of Directors, the availability of separate financial results, and materiality considerations. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on operating profits of the respective business units.
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Segment information for the years ended February 28, 1999, 1998 and 1997, is as follows:
(in thousands) 1999 1998 1997 ---------- ---------- ---------- CANANDAIGUA WINE: Net sales: Branded $ 598,782 $ 570,807 $ 537,745 Other 70,711 71,988 112,546 ---------- ---------- ---------- Net sales $ 669,493 $ 642,795 $ 650,291 Operating profit $ 46,283 $ 45,440 $ 51,525 Long-lived assets $ 191,762 $ 185,317 $ 185,298 Total assets $ 650,578 $ 632,636 $ 608,759 Capital expenditures $ 25,275 $ 25,666 $ 24,452 Depreciation and amortization $ 20,838 $ 21,189 $ 19,955
BARTON: Net sales: Beer $ 478,611 $ 376,607 $ 298,925 Spirits 185,938 191,190 185,289 ---------- ---------- ---------- Net sales $ 664,549 $ 567,797 $ 484,214 Operating profit $ 102,624 $ 77,010 $ 73,073 Long-lived assets $ 50,221 $ 51,574 $ 51,504 Total assets $ 478,580 $ 439,317 $ 410,351 Capital expenditures $ 3,269 $ 5,021 $ 4,988 Depreciation and amortization $ 10,765 $ 10,455 $ 9,453
MATTHEW CLARK: Net sales: Branded $ 64,879 $ -- $ -- Wholesale 93,881 -- -- ---------- ---------- ---------- Net sales $ 158,760 $ -- $ -- Operating profit $ 8,998 $ -- $ -- Long-lived assets $ 169,693 $ -- $ -- Total assets $ 631,313 $ -- $ -- Capital expenditures $ 10,444 $ -- $ -- Depreciation and amortization $ 4,836 $ -- $ --
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(in thousands) 1999 1998 1997 ---------- ---------- ---------- CORPORATE OPERATIONS AND OTHER: Net sales $ 4,541 $ 2,196 $ 508 Operating loss $ (12,013) $ (10,380) $ (11,388) Long-lived assets $ 17,127 $ 7,144 $ 12,750 Total assets $ 33,305 $ 18,602 $ 24,171 Capital expenditures $ 10,869 $ 516 $ 2,209 Depreciation and amortization $ 2,151 $ 1,517 $ 2,431
CONSOLIDATED: Net sales $1,497,343 $1,212,788 $1,135,013 Operating profit $ 145,892 $ 112,070 $ 113,210 Long-lived assets $ 428,803 $ 244,035 $ 249,552 Total assets $1,793,776 $1,090,555 $1,043,281 Capital expenditures $ 49,857 $ 31,203 $ 31,649 Depreciation and amortization $ 38,590 $ 33,161 $ 31,839
The Company's areas of operations are principally in the United States. Operations outside the United States consist of Matthew Clark's operations, which are primarily in the United Kingdom. No other single foreign country or geographic area is significant to the consolidated operations.
16. SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED):
A summary of selected quarterly financial information is as follows:
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17. SUBSEQUENT EVENTS:
DEBT OFFERING - On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 (the $200 Million Notes). The net proceeds of the offering (approximately $195.0 million) were used to fund the acquisition of the Black Velvet Canadian Whisky brand and other assets from affiliates of Diageo plc (see Acquisitions below) and to pay the fees and expenses related thereto with the remainder of the net proceeds to be used for general corporate purposes or to fund future acquisitions. Interest on the $200 Million Notes is payable semiannually on March 1 and September 1 of each year, beginning September 1, 1999. The $200 Million Notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. The Company may also redeem up to $70.0 million of the $200 Million Notes using the proceeds of certain equity offerings completed before March 1, 2002. The $200 Million Notes are unsecured and subordinated to the prior payment in full of all senior indebtedness of the Company, which includes the 1998 Credit Agreement. The $200 Million Notes are guaranteed, on a senior subordinated basis, by certain of the Company's significant operating subsidiaries.
The Indenture and Supplemental Indenture governing the $200 Million Notes contains certain covenants, including, but not limited to, (i) limitation on indebtedness; (ii) limitation on restricted payments; (iii) limitation on transactions with affiliates; (iv) limitation on senior subordinated indebtedness; (v) limitation on liens; (vi) limitation on sale of assets; (vii) limitation on guarantees by certain subsidiaries for indebtedness; (viii) limitation on certain subsidiary capital stock; (ix) limitation on the creation of any restriction on the ability of the Company's subsidiaries to make distributions and other payments; and (x) restrictions on mergers, consolidations and the transfer of all or substantially all of the assets of the Company to another person. The limitation on indebtedness covenant is governed by a rolling four quarter fixed charge ratio requiring a specified minimum.
ACQUISITIONS- On April 9, 1999, in an asset acquisition, the Company acquired several well-known Canadian whisky brands, including Black Velvet, production facilities located in Alberta and Quebec, Canada, case goods and bulk whisky inventories and other related assets from affiliates of Diageo plc. Other principal brands acquired in the transaction were Golden Wedding, OFC, MacNaughton, McMaster's and Triple Crown. In connection with the transaction, the Company also entered into multi-year agreements with Diageo to provide packaging and distilling services for various brands retained by Diageo. The purchase price was approximately $185.5 million and was financed by the proceeds from the sale of the $200 Million Notes.
On April 1, 1999, the Company entered into a definitive agreement with Moet Hennessy, Inc. to purchase all of the outstanding capital stock of Simi Winery, Inc. (the Simi Acquisition). The Simi Acquisition includes the Simi winery, equipment, vineyards, inventory and worldwide ownership of the Simi brand name. The Simi Acquisition
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is expected to close in the second quarter of fiscal 2000 and the purchase price is expected to be financed through the Company's bank credit facility.
On April 21, 1999, the Company entered into definitive purchase agreements with Franciscan Vineyards, Inc. (Franciscan) and its shareholders, and certain parties related to Franciscan to, among other matters, purchase all of the outstanding capital stock of Franciscan and acquire certain vineyards and related vineyard assets (collectively, the Franciscan Acquisition). Pursuant to the Franciscan Acquisition, the Company will: (i) acquire the Franciscan Oakville Estate, Estancia and Mt. Veeder brands; (ii) acquire wineries located in Rutherford, Monterey and Mt. Veeder, California; (iii) acquire vineyards in the Napa Valley, Alexander Valley, Monterey and Paso Robles appellations and additionally, will enter into long-term grape contracts with certain parties related to Franciscan to purchase additional grapes grown in the Napa and Alexander Valley appellations; (iv) acquire distribution rights to the Quintessa and Veramonte brands; and (v) acquire equity interests in entities that own the Veramonte brand and the Veramonte winery and certain vineyards located in the Casablanca Valley, Chile. The Franciscan Acquisition is expected to close in the second quarter of fiscal 2000 and the purchase price is expected to be financed through the Company's bank credit facility.
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ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------- ----------------------------------------------------------------------- FINANCIAL DISCLOSURE --------------------
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- --------------------------------------------------
The information required by this Item (except for the information regarding executive officers required by Item 401 of Regulation S-K which is included in Part I hereof in accordance with General Instruction G(3)) is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under those sections of the proxy statement titled "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance", which proxy statement will be filed within 120 days after the end of the Company's fiscal year.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION - -------- ----------------------
The information required by this Item is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under that section of the proxy statement titled "Executive Compensation" and that caption titled "Director Compensation" under "Election of Directors", which proxy statement will be filed within 120 days after the end of the Company's fiscal year.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - -------- --------------------------------------------------------------
The information required by this Item is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under those sections of the proxy statement titled "Beneficial Ownership" and "Stock Ownership of Management", which proxy statement will be filed within 120 days after the end of the Company's fiscal year.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- ----------------------------------------------
The information required by this Item is incorporated herein by reference to the Company's proxy statement to be issued in connection with the Annual Meeting of Stockholders of the Company to be held on July 20, 1999, under that section of the proxy statement titled "Executive Compensation", which proxy statement will be filed within 120 days after the end of the Company's fiscal year.
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PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------- ----------------------------------------------------------------
(a) 1. Financial Statements
The following consolidated financial statements of the Company are submitted herewith:
Report of Independent Public Accountants
Consolidated Balance Sheets - February 28, 1999 and 1998
Consolidated Statements of Income for the years ended February 28, 1999, 1998 and 1997
Consolidated Statements of Changes in Stockholders' Equity for the years ended February 28, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended February 28, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
The following consolidated financial information is submitted herewith:
Selected Financial Data
Selected Quarterly Financial Information (unaudited)
All other schedules are not submitted because they are not applicable or not required under Regulation S-X or because the required information is included in the financial statements or notes thereto.
Individual financial statements of the Registrant have been omitted because the Registrant is primarily an operating company and no subsidiary included in the consolidated financial statements has minority equity interests and/or noncurrent indebtedness, not guaranteed by the Registrant, in excess of 5% of total consolidated assets.
3. Exhibits required to be filed by Item 601 of Regulation S-K
The following exhibits are filed herewith or incorporated herein by reference, as indicated:
2.1 Asset Purchase Agreement dated August 3, 1994 between the Company and Heublein, Inc. (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K dated August 5, 1994 and incorporated herein by reference).
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2.2 Amendment dated November 8, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.2 to the Company's Registration Statement on Form S-3 (Amendment No. 2) (Registration No. 33-55997) filed with the Securities and Exchange Commission on November 8, 1994 and incorporated herein by reference).
2.3 Amendment dated November 18, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.8 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1994 and incorporated herein by reference).
2.4 Amendment dated November 30, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.9 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1994 and incorporated herein by reference).
2.5 Asset Purchase Agreement among Barton Incorporated (a wholly-owned subsidiary of the Company), United Distillers Glenmore, Inc., Schenley Industries, Inc., Medley Distilling Company, United Distillers Manufacturing, Inc., and The Viking Distillery, Inc., dated August 29, 1995 (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K, dated August 29, 1995 and incorporated herein by reference).
2.6 Recommended Cash Offer, by Schroders on behalf of Canandaigua Limited, a wholly-owned subsidiary of the Company, to acquire Matthew Clark plc (filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference).
2.7 Asset Purchase Agreement dated as of February 21, 1999 by and among Diageo Inc., UDV Canada Inc., United Distillers Canada Inc. and the Company (filed as Exhibit 2 to the Company's Current Report on Form 8-K dated April 9, 1999 and incorporated herein by reference).
3.1 Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference).
3.2 Amended and Restated By-Laws of the Company (filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference).
4.1 Indenture, dated as of December 27, 1993, among the Company, its Subsidiaries and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1993 and incorporated herein by reference).
4.2 First Supplemental Indenture, dated as of August 3, 1994, among the Company, Canandaigua West, Inc. (a subsidiary of the Company now known as Canandaigua Wine Company, Inc.) and The Chase Manhattan Bank (as
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successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Registration Statement on Form S-8 (Registration No. 33-56557) and incorporated herein by reference).
4.3 Second Supplemental Indenture, dated August 25, 1995, among the Company, V Acquisition Corp. (a subsidiary of the Company now known as The Viking Distillery, Inc.) and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1995 and incorporated herein by reference).
4.4 Third Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and The Chase Manhattan Bank (filed as Exhibit 4.4 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
4.5 Fourth Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and The Chase Manhattan Bank (filed as Exhibit 4.5 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference).
4.6 Fifth Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and The Chase Manhattan Bank (filed herewith).
4.7 Indenture with respect to the 8 3/4% Series C Senior Subordinated Notes due 2003, dated as of October 29, 1996, among the Company, its Subsidiaries and Harris Trust and Savings Bank (filed as Exhibit 4.2 to the Company's Registration Statement on Form S-4 (Registration No. 333-17673) and incorporated herein by reference).
4.8 First Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and Harris Trust and Savings Bank (filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
4.9 Second Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and Harris Trust and Savings Bank (filed as Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference).
4.10 Third Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and Harris Trust and Savings Bank (filed herewith).
4.11 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit
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4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference).
4.12 Indenture with respect to 8 1/2% Senior Subordinated Notes due 2009, dated as of February 25, 1999, among the Company, as issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference).
4.13 Supplemental Indenture No. 1, dated as of February 25, 1999, by and among the Company, as Issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference).
10.1 Barton Incorporated Management Incentive Plan (filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference).
10.2 Marvin Sands Split Dollar Insurance Agreement (filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference).
10.3 Letter agreement, effective as of October 7, 1995, as amended, addressing compensation, between the Company and Daniel Barnett (filed as Exhibit 10.23 to the Company's Transition Report on Form 10-K for the Transition Period from September 1, 1995 to February 29, 1996 and incorporated herein by reference).
10.4 Employment Agreement between Barton Incorporated and Alexander L. Berk dated as of September 1, 1990 as amended by Amendment No. 1 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated November 11, 1996 (filed as Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
10.5 Amendment No. 2 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated October 20, 1998 (filed herewith).
10.6 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference).
10.7 Long-Term Stock Incentive Plan, which amends and restates the Canandaigua Wine Company, Inc. Stock Option and Stock Appreciation Right Plan (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended May 31, 1997 and incorporated herein by reference).
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10.8 Amendment Number One to the Long-Term Stock Incentive Plan of the Company (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.9 Incentive Stock Option Plan of the Company (filed as Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.10 Amendment Number One to the Incentive Stock Option Plan of the Company (filed as Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.11 Annual Management Incentive Plan of the Company (filed as Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.12 Amendment Number One to the Annual Management Incentive Plan of the Company (filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
10.13 Lease, effective December 25, 1997, by and among Matthew Clark Brands Limited and Pontsarn Investments Limited (filed herewith).
10.14 Supplemental Executive Retirement Plan of the Company (filed herewith).
11.1 Statement re Computation of Per Share Earnings (filed herewith).
18.1 Letter re Change in Accounting Principles (filed herewith).
21.1 Subsidiaries of Company (filed herewith).
23.1 Consent of Arthur Andersen LLP (filed herewith).
27.1 Financial Data Schedule for fiscal year ended February 28, 1999 (filed herewith).
27.2 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1998 (filed herewith).
27.3 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1998 (filed herewith).
27.4 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1998 (filed herewith).
27.5 Restated Financial Data Schedule for the fiscal year ended February 28, 1998 (filed herewith).
27.6 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1997 (filed herewith).
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27.7 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1997 (filed herewith).
27.8 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1997 (filed herewith).
27.9 Restated Financial Data Schedule for the fiscal year ended February 28, 1997 (filed herewith).
99.1 1989 Employee Stock Purchase Plan of the Company, as amended by Amendment Number 1 through Amendment Number 5 (filed as Exhibit 99.1 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
99.2 Amendment Number 6 to the 1989 Employee Stock Purchase Plan of the Company (filed herewith).
(b) Reports on Form 8-K
The following Reports on Form 8-K were filed by the Company with the Securities and Exchange Commission during the fourth quarter of the fiscal year ended February 28, 1999:
(i) Form 8-K dated December 1, 1998. This Form 8-K reported information under Item 2 (Acquisition or Disposition of Assets) and Item 7 (Financial Statements and Exhibits). The following financial statements were filed with this Form 8-K:
The Matthew Clark plc Balance Sheets, as of 30 April 1998 and 1997, and the related Consolidated Profit and Loss Accounts and Consolidated Cash Flow Statements for each of the three years in the period ended 30 April 1998, and the report of KPMG Audit Plc, independent auditors, thereon, together with the notes thereto.
The pro forma condensed combined balance sheet (unaudited) as of August 31, 1998, and the pro forma condensed combined statement of income (unaudited) for the year ended February 28, 1998, and the pro forma condensed combined statement of income (unaudited) for the six months ended August 31, 1998, and the notes thereto.
(ii) Form 8-K/A dated December 1, 1998. This Form 8-K/A reported information under Item 7 (Financial Statements and Exhibits). The following financial statements were filed with this Form 8-K/A:
The Matthew Clark plc Balance Sheets, as of 30 April 1998 and 1997, and the related Consolidated Profit and Loss Accounts and Consolidated Cash Flow Statements for each of the three years in the period ended 30 April 1998, and the report of KPMG Audit Plc, independent auditor, thereon, together with the notes thereto.
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The Matthew Clark plc Balance Sheets (unaudited), as of October 31, 1998 and 1997 and the related Consolidated Profit and Loss Accounts (unaudited) and Consolidated Cash Flow Statements (unaudited) for the six month periods ended October 31, 1998 and 1997, together with the notes thereto.
The pro forma condensed combined balance sheet (unaudited) as of November 30, 1998, the pro forma combined statement of income (unaudited) for the year ended February 28, 1998, the pro forma combined statement of income (unaudited) for the nine months ended November 30, 1998, and the notes thereto, and the pro forma combined statement of income (unaudited) for the twelve months ended November 30, 1998, and the notes thereto.
(iii) Form 8-K dated December 2, 1998. This Form 8-K reported information under Item 5 (Other Events).
(iv) Form 8-K dated February 22, 1999. This Form 8-K reported information under Item 5 (Other Events).
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 CANANDAIGUA BRANDS, INC.
By:/s/ Richard Sands ---------------------------------- Richard Sands, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/ Richard Sands /s/ Thomas S. Summer - ---------------------------------- ---------------------------------- Richard Sands, President, Chief Thomas S. Summer, Senior Vice Executive Officer and Director President and Chief Financial (Principal Executive Officer ) Officer (Principal Financial Dated: June 1, 1999 Officer and Principal Accounting Officer) Dated: June 1, 1999
/s/ Marvin Sands /s/ Robert Sands - ---------------------------------- ---------------------------------- Marvin Sands, Chairman of the Board Robert Sands, Director Dated: June 1, 1999 Dated: June 1, 1999
/s/ George Bresler /s/ James A. Locke - ---------------------------------- ---------------------------------- George Bresler, Director James A. Locke, III, Director Dated: June 1, 1999 Dated: June 1, 1999
/s/ Thomas C. McDermott /s/ Paul L. Smith - ---------------------------------- ---------------------------------- Thomas C. McDermott, Director Paul L. Smith, Director Dated: June 1, 1999 Dated: June 1, 1999
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BATAVIA WINE CELLARS, INC.
By: /s/ Ned Cooper ---------------------------------- Ned Cooper, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Ned Cooper ---------------------------------- Ned Cooper, President (Principal Executive Officer)
Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Treasurer (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director
Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 CANANDAIGUA WINE COMPANY, INC.
By: /s/ Robert Sands ---------------------------------- Robert Sands, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, President, Chief Executive Officer and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Treasurer (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 CANANDAIGUA EUROPE LIMITED
By: /s/ Douglas Kahle ---------------------------------- Douglas Kahle, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Douglas Kahle ---------------------------------- Douglas Kahle, President (Principal Executive Officer)
Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Treasurer (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 CANANDAIGUA LIMITED
By: /s/ Robert Sands ---------------------------------- Robert Sands, Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Chief Executive Officer and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Finance Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 POLYPHENOLICS, INC.
By: /s/ Richard Keeley ---------------------------------- Richard Keeley, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Richard Keeley ---------------------------------- Richard Keeley, President and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, Vice President and Treasurer (Principal Financial Officer and Principal Accounting Officer)
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 ROBERTS TRADING CORP.
By: /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, President and Treasurer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Thomas S. Summer ---------------------------------- Thomas S. Summer, President and Treasurer (Principal Executive Officer, Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director
Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON INCORPORATED
By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President, Chief Executive Officer and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director
Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Director
Dated: June 1, 1999 /s/ Robert Sands ---------------------------------- Robert Sands, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON BRANDS, LTD.
By: /s/ Edward L. Golden ---------------------------------- Edward L. Golden, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, President and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON BEERS, LTD.
By: /s/ Richard Sands ---------------------------------- Richard Sands, Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Richard Sands ---------------------------------- Richard Sands, Chief Executive Officer and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director
Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON BRANDS OF CALIFORNIA, INC.
By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON BRANDS OF GEORGIA, INC.
By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON DISTILLERS IMPORT CORP.
By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Alexander L. Berk ----------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 BARTON FINANCIAL CORPORATION
By: /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, President, Secretary and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Charles T. Schlau ---------------------------------- Charles T. Schlau, Treasurer and Director (Principal Financial Officer and Principal Accounting Officer)
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 STEVENS POINT BEVERAGE CO.
By: /s/ James P. Ryan ---------------------------------- James P. Ryan, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ James P. Ryan ---------------------------------- James P. Ryan, President, Chief Executive Officer and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director
Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 MONARCH IMPORT COMPANY
By: /s/ James P. Ryan James P. Ryan, Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ James P. Ryan ---------------------------------- James P. Ryan, Chief Executive Officer (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, Director
Dated: June 1, 1999 /s/ William F. Hackett ---------------------------------- William F. Hackett, Director
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: June 1, 1999 THE VIKING DISTILLERY, INC.
By: /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Dated: June 1, 1999 /s/ Alexander L. Berk ---------------------------------- Alexander L. Berk, President and Director (Principal Executive Officer)
Dated: June 1, 1999 /s/ Raymond E. Powers ---------------------------------- Raymond E. Powers, Executive Vice President, Treasurer, Assistant Secretary and Director (Principal Financial Officer and Principal Accounting Officer)
Dated: June 1, 1999 /s/ Edward L. Golden ---------------------------------- Edward L. Golden, Director
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INDEX TO EXHIBITS
EXHIBIT NO. - -----------
2.1 Asset Purchase Agreement dated August 3, 1994 between the Company and Heublein, Inc. (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K dated August 5, 1994 and incorporated herein by reference).
2.2 Amendment dated November 8, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.2 to the Company's Registration Statement on Form S-3 (Amendment No. 2) (Registration No. 33-55997) filed with the Securities and Exchange Commission on November 8, 1994 and incorporated herein by reference).
2.3 Amendment dated November 18, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.8 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1994 and incorporated herein by reference).
2.4 Amendment dated November 30, 1994 to Asset Purchase Agreement between Heublein, Inc. and the Company (filed as Exhibit 2.9 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1994 and incorporated herein by reference).
2.5 Asset Purchase Agreement among Barton Incorporated (a wholly-owned subsidiary of the Company), United Distillers Glenmore, Inc., Schenley Industries, Inc., Medley Distilling Company, United Distillers Manufacturing, Inc., and The Viking Distillery, Inc., dated August 29, 1995 (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K, dated August 29, 1995 and incorporated herein by reference).
2.6 Recommended Cash Offer, by Schroders on behalf of Canandaigua Limited, a wholly-owned subsidiary of the Company, to acquire Matthew Clark plc (filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference).
2.7 Asset Purchase Agreement dated as of February 21, 1999 by and among Diageo Inc., UDV Canada Inc., United Distillers Canada Inc. and the Company (filed as Exhibit 2 to the Company's Current Report on Form 8-K dated April 9, 1999 and incorporated herein by reference).
3.1 Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference).
3.2 Amended and Restated By-Laws of the Company (filed as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1998 and incorporated herein by reference).
4.1 Indenture, dated as of December 27, 1993, among the Company, its Subsidiaries and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1993 and incorporated herein by reference).
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4.2 First Supplemental Indenture, dated as of August 3, 1994, among the Company, Canandaigua West, Inc. (a subsidiary of the Company now known as Canandaigua Wine Company, Inc.) and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Registration Statement on Form S-8 (Registration No. 33-56557) and incorporated herein by reference).
4.3 Second Supplemental Indenture, dated August 25, 1995, among the Company, V Acquisition Corp. (a subsidiary of the Company now known as The Viking Distillery, Inc.) and The Chase Manhattan Bank (as successor to Chemical Bank) (filed as Exhibit 4.5 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1995 and incorporated herein by reference).
4.4 Third Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and The Chase Manhattan Bank (filed as Exhibit 4.4 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
4.5 Fourth Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and The Chase Manhattan Bank (filed as Exhibit 4.5 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference).
4.6 Fifth Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and The Chase Manhattan Bank (filed herewith).
4.7 Indenture with respect to the 8 3/4% Series C Senior Subordinated Notes due 2003, dated as of October 29, 1996, among the Company, its Subsidiaries and Harris Trust and Savings Bank (filed as Exhibit 4.2 to the Company's Registration Statement on Form S-4 (Registration No. 333-17673) and incorporated herein by reference).
4.8 First Supplemental Indenture, dated as of December 19, 1997, among the Company, Canandaigua Europe Limited, Roberts Trading Corp. and Harris Trust and Savings Bank (filed as Exhibit 4.6 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
4.9 Second Supplemental Indenture, dated as of October 2, 1998, among the Company, Polyphenolics, Inc. and Harris Trust and Savings Bank (filed as Exhibit 4.8 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1998 and incorporated herein by reference).
4.10 Third Supplemental Indenture, dated as of December 11, 1998, among the Company, Canandaigua B.V., Canandaigua Limited and Harris Trust and Savings Bank (filed herewith).
4.11 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference).
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4.12 Indenture with respect to 8 1/2% Senior Subordinated Notes due 2009, dated as of February 25, 1999, among the Company, as issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference).
4.13 Supplemental Indenture No. 1, dated as of February 25, 1999, by and among the Company, as Issuer, its principal operating subsidiaries, as Guarantors, and Harris Trust and Savings Bank, as Trustee (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K dated February 25, 1999 and incorporated herein by reference).
10.1 Barton Incorporated Management Incentive Plan (filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference).
10.2 Marvin Sands Split Dollar Insurance Agreement (filed as Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 1993 and incorporated herein by reference).
10.3 Letter agreement, effective as of October 7, 1995, as amended, addressing compensation, between the Company and Daniel Barnett (filed as Exhibit 10.23 to the Company's Transition Report on Form 10-K for the Transition Period from September 1, 1995 to February 29, 1996 and incorporated herein by reference).
10.4 Employment Agreement between Barton Incorporated and Alexander L. Berk dated as of September 1, 1990 as amended by Amendment No. 1 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated November 11, 1996 (filed as Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
10.5 Amendment No. 2 to Employment Agreement between Barton Incorporated and Alexander L. Berk dated October 20, 1998 (filed herewith).
10.6 First Amended and Restated Credit Agreement, dated as of November 2, 1998, between the Company, its principal operating subsidiaries, and certain banks for which The Chase Manhattan Bank acts as Administrative Agent (filed as Exhibit 4.1 to the Company's Current Report on Form 8-K dated December 1, 1998 and incorporated herein by reference).
10.7 Long-Term Stock Incentive Plan, which amends and restates the Canandaigua Wine Company, Inc. Stock Option and Stock Appreciation Right Plan (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended May 31, 1997 and incorporated herein by reference).
10.8 Amendment Number One to the Long-Term Stock Incentive Plan of the Company (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.9 Incentive Stock Option Plan of the Company (filed as Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
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10.10 Amendment Number One to the Incentive Stock Option Plan of the Company (filed as Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.11 Annual Management Incentive Plan of the Company (filed as Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended August 31, 1997 and incorporated herein by reference).
10.12 Amendment Number One to the Annual Management Incentive Plan of the Company (filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
10.13 Lease, effective December 25, 1997, by and among Matthew Clark Brands Limited and Pontsarn Investments Limited (filed herewith).
10.14 Supplemental Executive Retirement Plan of the Company (filed herewith).
11.1 Statement re Computation of Per Share Earnings (filed herewith).
18.1 Letter re Change in Accounting Principles (filed herewith).
21.1 Subsidiaries of Company (filed herewith).
23.1 Consent of Arthur Andersen LLP (filed herewith).
27.1 Financial Data Schedule for fiscal year ended February 28, 1999 (filed herewith).
27.2 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1998 (filed herewith).
27.3 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1998 (filed herewith).
27.4 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1998 (filed herewith).
27.5 Restated Financial Data Schedule for the fiscal year ended February 28, 1998 (filed herewith).
27.6 Restated Financial Data Schedule for the fiscal quarter ended November 30, 1997 (filed herewith).
27.7 Restated Financial Data Schedule for the fiscal quarter ended August 31, 1997 (filed herewith).
27.8 Restated Financial Data Schedule for the fiscal quarter ended May 31, 1997 (filed herewith).
27.9 Restated Financial Data Schedule for the fiscal year ended February 28, 1997 (filed herewith).
99.1 1989 Employee Stock Purchase Plan of the Company, as amended by Amendment Number 1 through Amendment Number 5 (filed as Exhibit 99.1 to the Company's Annual Report on Form 10-K for the fiscal year ended February 28, 1998 and incorporated herein by reference).
99.2 Amendment Number 6 to the 1989 Employee Stock Purchase Plan of the Company (filed herewith). | 28,760 | 190,589 |
41023_1999.txt | 41023_1999 | 1999 | 41023 | ITEM 1. BUSINESS
General Development of Business
GeoResources, Inc. is a natural resources company engaged principally in the following two business segments: 1) oil and gas exploration, development and production; and 2) mining of leonardite (oxidized lignite coal) and manufacturing of leonardite based products which are sold primarily as oil and gas drilling mud additives. We were incorporated under Colorado law in 1958 and were originally engaged in uranium mining. We built our first leonardite processing plant in 1964 in Williston, North Dakota, and began participating in oil and gas exploration and production in 1969. In 1982, we completed construction of a larger leonardite processing plant in Williston that is in use today. Financial information about our two operating segments is presented in Note B to the Financial Statements in Item 8 of this report.
Information contained in this Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 which can be identified by the use of words such as "may," "will," "expect," "anticipate," "estimate" or "continue," or variations of these words or comparable terminology. In addition, all statements other than statements of historical facts that address activities, events or developments that we expect, believe or anticipate will or may occur in the future, and other such matters, are forward-looking statements.
Our future results may vary materially from those anticipated by management and may be affected by various trends and factors which are beyond our control. These risks include the competitive environment in which we operate; changing oil and gas prices; the demand for oil, gas and leonardite; availability of drilling rigs; dependence upon key management personnel and other risks described in this report.
Oil and Gas Exploration, Development and Production
Our oil and gas exploration and production efforts are concentrated on oil properties in the North Dakota and Montana portions of the Williston Basin. We typically generate prospects for our own exploitation, but when a prospect is believed to have substantial risk or cost, we may attempt to raise all or a portion of the funds necessary for exploration or development through farmouts, joint ventures, or other similar types of cost-sharing arrangements. The amount of interest retained by us in a cost-sharing arrangement varies widely and depends upon many factors, including the exploratory costs and the risks involved.
In addition to originating our own prospects, we occasionally participate in exploratory and development prospects originated by other individuals and companies. We also evaluate interests in various proved properties to acquire for further operation and/or development.
Where possible, we supervise drilling and production activities on new prospects and properties acquired. We do not own or have any plans to acquire any rotary drilling equipment. Thus, we use independent drilling contractors for the drilling of wells of which we are the operator. Therefore, our drilling activities can be subject to delays caused by shortages of drilling equipment or other factors beyond our control, including inclement weather.
As of December 31, 1999, we had developed oil and gas leases covering approximately 13,765 net acres in Montana and North Dakota, and during 1999 sold an average 503 net equivalent barrels of oil per day from 134 gross (104 net) productive wells located primarily in North Dakota.
We sell our crude oil to purchasers with facilities located near our wells. Our gas reserves are also contracted to purchasers in the area near our wells.
Mining and Manufacturing of Leonardite Products
We operate a leonardite mine and processing plant in Williston, North Dakota. Leonardite is mined from leased reserves and processed to make a basic product that can be sold as is, or blended with other substances to make several different powdered specialty products which are used primarily in the oil well drilling mud industry. Leonardite products act as a dispersant or thinner and provide filtration control when used as an additive in drilling muds. Leonardite is also sold by us for use in metal working foundries and in agricultural applications.
In 1999, our leonardite products were sold primarily to drilling mud companies located in coastal areas of the Gulf of Mexico. Demand for the plant's output is governed mainly by the level of oil and gas drilling activities, particularly in the gulf coast area, both onshore and offshore. Drilling activity has remained at relatively low levels for the past several years. We have no significant supply contracts with individual customers.
Status of Products, Services or Industry Segments in Development
We own 84% of the voting stock of Belmont Natural Resource Company, Inc. (BNRC), a Washington corporation formed for the purpose of exploiting natural gas opportunities in the Pacific Northwest. BNRC owns oil and gas leases covering 3,988 gross acres (3,754 net) on a gas prospect in the State of Washington. Activities in 1999 consisted of a small amount of geological field work in an effort to further define the prospect. We do not expect to devote any substantial resources to this project in 2000.
In addition to our two principal business segments, we own a nonproducing silver property in Arizona. (See Item 2.
ITEM 2. PROPERTIES
Our properties consist of four main categories: Office, oil and gas, leonardite plant and mine, and a nonproducing silver property. Certain of these properties are mortgaged to our bank. See Note E to the Financial Statements for further information.
Office
We own a 17,500 square foot office building which is located on a one-acre lot in Williston, North Dakota. We use about 6,000 square feet of the building and rent the remainder to unaffiliated businesses.
Oil and Gas Properties
We own developed oil and gas leases totaling 18,419 gross (13,765 net) acres as of December 31, 1999, plus associated production equipment. We also own a number of undeveloped oil and gas leases. The acreage and other additional information concerning our oil and gas operations are presented in the following tables.
Estimated Net Quantities of Oil and Gas and Standardized Measure of Future Net Cash Flows - All of our oil and gas reserves are located in the United States. Information concerning the estimated net quantities of all of our proved reserves and the standardized measure of future net cash flows from the reserves is presented as unaudited supplementary information following the Financial Statements in Item 14. The estimates are based upon the report of Broschat Engineering and Management Services, an independent petroleum engineering firm in Williston, North Dakota. We have no long-term supply or similar agreements with foreign governments or authorities, and we do not own an interest in any reserves accounted for by the equity method.
Net Oil and Gas Production, Average Price and Average Production Cost - The net quantities of oil and gas produced and sold by us for each of the last three fiscal years, the average sales price per unit sold and the average production cost per unit are presented below.
Oil & Gas
Average Average Net Net Net Oil Gas Average Oil Gas Oil & Gas Sales Sales Prod. Prod. Prod. Prod. Price Price Cost Per Year (Bbls) (MCF) (BOE)* Per Bbl Per MCF BOE**
1999 182,356 8,042 183,696 $ 14.70 $ 1.10 $ 6.61 1998 173,102 8,491 174,517 $ 9.54 $ 1.26 $ 5.33 1997 211,266 10,408 213,001 $ 16.15 $ 1.30 $ 6.27 _________________________ *Barrels of oil equivalent have been calculated on the basis of six thousand cubic feet (6 MCF) of natural gas equal to one barrel of oil equivalent (1 BOE). **Average production cost includes lifting costs, remedial workover expenses and production taxes.
Gross and Net Productive Wells - As of December 31, 1999, our total gross and net productive wells were as follows:
Productive Wells* Oil Gas Gross Wells Net Wells Gross Wells Net Wells
110 80.04 24 24.00 ________________________ *There are no wells with multiple completions. A gross well is a well in which a working interest is owned. The number of net wells represents the sum of fractional working interests we own in gross wells. Productive wells are producing wells plus shut-in wells we deem capable of production.
Gross and Net Developed and Undeveloped Acres - As of December 31, 1999, we had total gross and net developed and undeveloped oil and gas leasehold acres as set forth below. The developed acreage is stated on the basis of spacing units designated by state regulatory authorities.
Leasehold Acreage*
Developed Undeveloped Total Gross Net Gross Net Gross Net
Montana 9,000 7,637 17,137 17,179 26,137 24,816 North Dakota 9,419 6,128 30,019 10,976 39,438 17,104 Washington 0 0 3,988 3,754 3,988 3,754
ALL STATES 18,419 13,765 51,144 31,909 69,563 45,674 ________________________ *Gross acres are those acres in which a working interest is owned. The number of net acres represents the sum of fractional working interests we own in gross acres.
Exploratory Wells and Development Wells - For each of the last three fiscal years ended December 31, the number of net exploratory and development productive and dry wells drilled by us was as set forth below. Although we did not drill any productive or dry wells in 1999, we drilled 1.98 net service wells in order to attempt to increase production in a waterflood of an existing field.
Net Exploratory Net Development Total Net Productive Year Wells Drilled Wells Drilled or Dry Wells Drilled
Productive Dry Productive Dry
1999 0.00 0.00 0.00 0.00 0.00 1998 0.00 0.00 0.00 0.00 0.00 1997 0.00 0.02 1.67 0.00 1.69
Present Activities - From January 1, 2000, to March 15, 2000, we had no wells in the process of drilling.
Supply Contracts or Agreements - We are not obligated to provide a fixed or determinable quantity of oil and gas in the future under any existing contract or agreement, beyond the short term contracts customary in division orders and off lease marketing arrangements within the industry.
Reserve Estimates Filed with Agencies - No estimates of total proved net oil and gas reserves for the year ended December 31, 1999, have been filed by us with any federal authority or agency. Estimates of our total proved net oil and gas reserves were filed with the Energy Information Administration of the Department of Energy (DOE) in April 1999 for reserves at year-end 1998. The difference between the oil and gas reserves reported in this Form 10-K and those filed with the DOE did not exceed 1%. Other than the estimates of reserves at December 31, 1998, filed with the Securities and Exchange Commission, we did not file reserve reports with any other federal agencies within the past 12 months.
Leonardite Plant and Mine
The site of our leonardite plant covers about nine acres located one mile east of Williston in Williams County, North Dakota. We own this site and an additional 20 acres of undeveloped property. The plant has approximately 11,500 square feet of floor area consisting of warehousing and processing space. Within the plant is equipment able to process and ship approximately 3,000 tons of leonardite products per month. Finished product leonardite sales for the past three years are shown below.
Finished Average Products Sales Price Year (Tons) Per Ton
1999 7,736 $ 84.26 1998 7,772 $ 92.47 1997 8,094 $ 94.44
Our leonardite mining properties consist of a developed lease from private parties and one undeveloped lease from the United States Department of the Interior, Bureau of Land Management. The leased land is located about one mile from our plant site in Williams County, North Dakota. The private-party (fee) lease totals approximately 160 acres. The federal lease from the Bureau of Land Management (BLM) covers 160 undeveloped acres. In 1994, we formed a 240-acre logical mining unit (LMU), in accordance with BLM regulations, consisting of 80 acres of the fee lease and 160 acres of the BLM lease. This LMU allows current operations on the fee lease to satisfy diligent development and other requirements for 160 acres of the BLM lease. We believe that the leonardite contained in the 240-acre LMU is sufficient to supply our plant's raw material requirements for many years and that before these reserves were to be exhausted, we would be able to acquire other fee or federal coal leases in the same area.
Silver Property
We own seven patented mining claims and 15 unpatented mining claims in Pinal County, Arizona. These claims, known as the Reymert Silver Property, have produced silver sporadically since the 1880's. The property's last metal ore production was in 1989 under a lease arrangement. In 1999, we entered into a license agreement with another company to allow commercial rock production from the patented claims. Under the terms of this agreement, we will receive a 10% of gross selling price royalty on all rock products produced and sold from the property. The agreement also provides for a minimum royalty of $250 per month to continue the agreement in effect through its three-year term ending January 15, 2002. No metal ore mining activities are presently being conducted on this property. Management has no plans to devote significant financial resources to this property in 2000; however, it continues to investigate other ways to further exploit the property.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On May 12, 1989, we filed an action in Burleigh County District Court, North Dakota, against MDU Resources Group, Inc., a Delaware corporation, and Williston Basin Interstate Pipeline Company, a Delaware corporation. The complaint related to, among other things, breaches of a take or pay natural gas contract and attempts by the defendants to coerce us into modifying the contract. The defendants answered the complaint on June 1, 1989. Afterwards, no further materials were filed with the court, but we believed that the case remained pending. We contacted the attorney who filed the action to assess the status and request further prosecution of the case. After several months of inaction regarding the case, we contacted the court in September 1996 and were informed by the court that the case had been dismissed in 1991. On January 15, 1997, we refiled our action against MDU Resources Group, Inc. Management cannot predict the outcome of this action, although we intend to pursue its available remedies.
Other than the foregoing legal proceeding, we are not a party, nor are any of our properties subject, to any pending material legal proceedings. We know of no legal proceedings contemplated or threatened against us.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of 1999, no matter was submitted to a vote of our security holders through the solicitation of proxies or otherwise.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our Common Stock trades on the Nasdaq SmallCap Stock Market under the Symbol "GEOI". The following table sets forth for the period indicated the lowest and highest trade prices for our Common Stock as reported by the Nasdaq SmallCap Stock Market. These trade prices may represent prices between dealers and do not include retail markups, markdowns or commissions.
Trade Price
Calendar Lowest Highest
1999 1st Quarter $ .56 $ .83
2nd Quarter $ .85 $ 1.15
3rd Quarter $ 1.04 $ 1.25
4th Quarter $ 1.11 $ 1.43
1998 1st Quarter $ 1.92 $ 2.27
2nd Quarter $ 1.69 $ 2.02
3rd Quarter $ 1.19 $ 1.48
4th Quarter $ .83 $ 1.15
As of March 15, 2000, there were approximately 1,300 holders of record of our Common Stock. We believe that there are also approximately 750 additional beneficial owners of Common Stock held in "street name".
We have never declared or paid a cash dividend on our Common Stock nor do we anticipate that dividends will be paid in the near future. Further, certain of our financing agreements restrict the payment of cash dividends. See Note E to the Financial Statements for further information.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
1999 1998 1997 1996 1995
Operating Revenue $3,340,489 $2,380,651 $4,189,793 $3,806,790 $2,874,001
Net Income (Loss) 481,552 (1,605,218) 766,265 733,726 303,889
Net Income (Loss) Per Share .12 (.39) .19 .18 .08
AT YEAR END: Total Assets 7,328,840 6,704,724 8,032,328 7,909,965 6,690,285
Long-term Debt 1,610,008 1,625,004 666,000 998,097 958,330
Current Maturities 175,000 316,000 457,097 283,200 511,594
Working Capital 638,549 111,515 18,240 205,463 (171,949) (Deficit)
Stockholders' Equity 4,462,475 4,052,114 5,691,597 4,873,927 4,114,001
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
We operate through two primary segments: 1) oil and gas exploration and production; and 2) leonardite mining and processing. Our major leonardite products are oil and gas drilling mud additives. Each of our segments is discussed below.
BUSINESS ENVIRONMENT AND RISK FACTORS
This discussion and analysis of financial condition and results of operations, and other sections of this report, contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, that are based on management's beliefs, assumptions, current expectations, estimates and projections about the oil, gas and leonardite industry, the economy and about us. Words such as "may," "will," "expect," "anticipate," "estimate" or "continue," or comparable words are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, our actual results and outcomes may materially differ from what may be expressed or forecasted in our forward- looking statements. Furthermore, we undertake no obligation to update, amend or clarify forward-looking statements; whether as a result of new information, future events or otherwise.
Important factors that could cause actual results to differ materially from the forward-looking statements include, but are not limited to, changes in production volumes; worldwide supply and demand which affect commodity prices for oil; the timing and extent of our success in discovering, acquiring, developing and producing oil, natural gas and leonardite reserves; risks inherent in the drilling and operation of oil and natural gas wells and the mining and processing of leonardite products; future production and development costs; the effect of existing and future laws, governmental regulations and the political and economic climate of the United States; and conditions in the capital markets.
RESULTS OF OPERATIONS
Comparison of 1999 to 1998 Revenue and Gross Margin
Oil and gas sales were $2,689,000 in 1999 compared to $1,662,000 in 1998, an increase of $1,027,000 or 62%. This increase in revenue was due to a 54% advance in average oil prices and a 5% increase in the volume of oil and gas sold. The 1999 average oil price per barrel was $14.70 compared to an average of $9.54 in 1998. We periodically use various New York Mercantile Exchange (NYMEX) crude oil and energy products contracts and options to hedge against the risks of oil price declines. See Note J to the Financial Statements for further information. The volume of oil and gas sold in 1999 increased 9,000 barrels of oil equivalent (BOE) or 5% to 184,000 BOE from 175,000 BOE in 1998. The higher 1999 average oil price resulted from a rebound in world oil prices that occurred during the last half of 1999. The higher 1999 production volumes sold resulted about equally from three primary factors: (i) returning shut-in wells to production, (ii) production contributed by wells we acquired in 1998, and (iii) production held over in lease tanks as inventory at year-end 1998 and not sold until 1999. These three factors were enough to offset the normal production decline of all our wells resulting in an increase in the volumes sold even though we did not add any production from new wells during 1999. During a large part of 1998, we had shut in approximately 20 operated wells to reduce production costs; however, by July 1, 1999, these wells were returned to production as oil price advances made them economic to produce again.
Oil and gas production costs were $1,214,000 in 1999 compared to $930,000 in 1998, an increase of $284,000 or 31%. These higher costs were due to three primary factors: (i) additional production costs of $78,000 that were recognized in 1999 as costs associated with oil sold from inventory, (ii) higher state severance taxes that were directly related to higher oil revenue and (iii) generally higher costs associated with producing more wells which had been shut in during 1998 and modest start-up costs related to those wells. Production costs expressed on a per equivalent barrel basis increased $1.28 per BOE or 24% to average $6.61 for 1999 compared to $5.33 for 1998. The increase in per barrel costs occurred because we were able to produce more of our marginal (higher cost per barrel) wells in the oil price environment existing in 1999 than in 1998. The 1998 cost per barrel was actually an unusually low number and the costs for 1999 represented a return to a more historical normal range. Gross margin for 1999 oil and gas operations before deductions for depletion, a non-cash writedown of oil and gas properties in 1998 and selling, general and administrative (SG&A) expenses, increased to $1,474,000 or 55% of revenue compared to $732,000 or 44% of revenue for 1998.
Leonardite product sales were $652,000 in 1999 compared to $719,000 in 1998, a decrease of $67,000 or 9%. This decrease was entirely due to a 9% decrease in average price per ton for leonardite sold in 1999 resulting from less demand for our specialty products, which have higher selling prices. Production sold in 1999 was 7,736 tons at an average price of $84.26 compared to 7,772 tons at an average price of $92.47 for 1998.
Cost of leonardite sold was $563,000 in 1999 compared to $603,000 in 1998, a decrease of $40,000 or 7%. Average production costs per ton were $72.79 and $77.61 for 1999 and 1998, respectively. Costs per ton decreased approximately 6% for 1999 compared to 1998 due again to the lower sales of specialty products that also have higher processing costs.
Gross margin for 1999 leonardite operations before deductions for depreciation and selling, general and administrative expenses was $89,000 or 14% of revenue compared to $115,000 or 16% of revenue for 1998. The modest decline in 1999 gross margin also resulted from the lower specialty product sales discussed above.
Comparison of 1999 to 1998 Consolidated Analysis
Total revenue for 1999 increased $960,000 or 40% to $3,340,000 from $2,381,000 in 1998. This increase was primarily due to the substantially higher oil prices that existed during 1999 compared to 1998, and also due somewhat to modestly higher volumes of oil sold in 1999.
Total operating costs for 1999 decreased $1,356,000 or 33% to $2,720,000 compared to $4,076,000 in 1998. This decrease in total costs resulted entirely from an atypical non-cash charge to operating expenses in 1998 due to a write-down of oil and gas properties as prescribed by the Securities and Exchange Commission rules. Without the write-down, operating expenses in all the normal expense categories, totaled $2,720,000 for 1999 compared to $2,776,000 for 1998. Oil and gas production costs were higher and cost of leonardite lower for the reasons previously discussed. Depreciation, depletion and amortization expenses were lower due to the 1998 write-down that reduced our full cost pool which in turn reduced the amount to be depleted in 1999 and future years. Selling, general and administrative costs were lower due to salary reductions and other cost cutting measures, implemented in 1998 and continued through the third quarter 1999, in order to control costs in the face of low oil prices.
Higher 1999 total revenue and lower total operating costs resulted in an operating income of $620,000 for 1999 compared to operating loss of $1,696,000 in 1998. Nonoperating expenses increased $8,000, from $105,000 in 1998 to $113,000 in 1999, primarily due to higher interest expense, although some of this was offset by interest income on higher cash balances. This yielded an income before taxes of $508,000 in 1999 compared to a pretax loss of $1,800,000 in 1998.
Income tax expense in 1999 was $26,000 compared to a tax benefit of $195,000 in 1998. The amount for each year is primarily reflective of changes in our deferred-tax asset valuation allowance under the provisions of SFAS No. 109. The change in the valuation allowance is based upon projections of the future utilization of statutory depletion carryforwards. See Notes A and F to the Financial Statements for further information.
As a result of all the factors discussed above net income for 1999 was $482,000 or $.12 per share compared to a net loss of $1,605,000 or $.39 per share in 1998.
Comparison of 1998 to 1997 Revenue and Gross Margin
Oil and gas sales were $1,662,000 in 1998 compared to $3,425,000 in 1997, a decrease of $1,763,000 or 51%. This decrease in revenue was due to a 41% decrease in average oil prices and an 18% decline in the volume of oil and gas sold. The 1998 average oil price per barrel was $9.54 compared to an average of $16.15 in 1997. We periodically used various New York Mercantile Exchange (NYMEX) crude oil and energy products contracts and options to hedge against the risks of oil price declines. See Note J to the Financial Statements for further information. The volume of oil and gas sold in 1998 decreased 38,000 barrels or 18% to 175,000 barrels of oil equivalent (BOE) from 213,000 BOE in 1997. The lower 1998 average oil price resulted from a collapse in world oil prices that occurred during 1998. The lower 1998 production volumes resulted from our "shutting in" or curtailing production from numerous marginal wells in an effort to control production costs.
Oil and gas production costs were $930,000 in 1998 compared to $1,336,000 in 1997, a decrease of $406,000 or 30%. These lower costs were due to (i) the efforts to reduce costs by shutting in marginal wells as discussed above and (ii) lower production taxes resulting from lower oil prices. Production costs expressed on a per equivalent barrel basis declined $0.94 per BOE or 15% to average $5.33 for 1998 compared to $6.27 for 1997. The decrease in per barrel costs occurred because total production expenses declined by a higher percentage than the decline in the volume of oil and gas sales. Gross margin for 1998 oil and gas operations before deductions for depletion, a non-cash writedown of oil and gas properties and selling, general and administrative (SG&A) expenses, decreased to $732,000 or 44% of revenue compared to $2,090,000 or 61% of revenue for 1997.
Leonardite product sales were $719,000 in 1998 compared to $764,000 in 1997, a decrease of $46,000 or 6%. This decrease was due to a 4% decrease in tonnage sold in 1998 resulting from weaker demand for our oil and gas related drilling products during 1998. Production sold in 1998 was 7,772 tons at an average price of $92.47 compared to 8,094 tons at an average price of $94.44 for 1997.
Cost of leonardite sold was $603,000 in 1998 compared to $598,000 in 1997, an increase of $5,000 or 1%. Production costs per ton were $77.61 and $73.86 for 1998 and 1997, respectively. Costs per ton increased approximately 5% for 1998 compared to 1997 due in part to the lower production volumes that spread fixed costs over fewer tons.
Gross margin for 1998 leonardite operations before deductions for depreciation and selling, general and administrative expenses was $115,000 or 16% of revenue compared to $167,000 or 22% of revenue for 1997. The decline in 1998 gross margin resulted from the combination of the decline in leonardite sales and a slight increase in production costs previously discussed.
Comparison of 1998 to 1997 Consolidated Analysis
Total revenue for 1998 decreased $1,809,000 or 43% to $2,381,000 from $4,190,000 in 1997. This decrease was primarily due to the substantially lower oil prices that existed during 1998 and, to a lesser extent, the lower oil production, both previously discussed.
Total operating costs for 1998 increased $843,000 or 26% to $4,076,000 compared to $3,233,000 in 1997. These increased costs resulted entirely from a non-cash write-down of oil and gas properties charged to operating expenses in accordance with Securities and Exchange Commission rules. Without the write-down, operating expenses in all the normal expense categories, except cost of leonardite sold, declined such that total operating expenses would have been $2,776,000 for 1998 which was $457,000 or 14% less than the $3,233,000 for 1997. Normal operating expenses were lower due to the oil and gas cost cutting measures discussed above and to general efforts to reduce costs.
Lower 1998 total revenue and higher total operating costs resulted in an operating loss of $1,696,000 for 1998 compared to operating income of $957,000 in 1997. Nonoperating expenses increased $24,000, from $80,000 in 1997 to $105,000 in 1998, yielding a loss before taxes of $1,800,000 in 1998 compared to a pretax income of $876,000 in 1997.
The income tax benefit in 1998 was $195,000 compared to a tax expense of $110,000 in 1997. The amount for each year is reflective of the net changes in our deferred-tax assets and deferred-tax liabilities under the provisions of SFAS No. 109 and include only a small amount of income taxes currently paid. See Notes A and F to the Financial Statements for further information.
The net loss for 1998 was $1,605,000 or $.39 per share compared to net income of $766,000 or $.19 per share in 1997.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1999, we had current assets of $1,729,000 compared to current liabilities of $1,090,000 for a current ratio of 1.59 to 1 and working capital of $639,000. This compares to a current ratio of 1.13 to 1 at December 31, 1998, and working capital of $112,000. Cash was significantly higher at year-end 1999. Working capital at year-end 1999 was higher than year-end 1998, because of increased cash flows from operations caused by higher oil prices.
During the year ended December 31, 1999, we generated cash flows from operating activities of $1,085,000 which was $960,000 more than the amount generated during 1998. This increase was essentially due to substantially higher cash flow which was a result of the oil prices that existed in 1999. We anticipate that cash flows from operations and funds available under our $3,000,000 revolving line of credit will be sufficient to meet our short-term cash requirements. The line of credit, which had an available balance of $1,565,000 at December 31, 1999, allows borrowings until January 5, 2001, with repayment of any amounts borrowed to begin by that date. We can select a repayment schedule of up to a maximum of 48 months.
During 1999, our investing activities used $475,000 of cash which was primarily for additions to property, plant and equipment related to the drilling and completion of two service wells in our South Starbuck Madison Unit in Bottineau County, North Dakota. The additions to property and equipment consists of the approximate amounts as follows: Exploration and development costs of $503,000 included the paid portion of costs for drilling and completing the South Starbuck Madison Unit, proved property acquisition costs of $20,000 and unproved property costs of $21,000.
During 1999, our financing activities consisted of proceeds from borrowings of $160,000 and $316,000 of cash utilized for regularly scheduled principal payments under long-term debt agreements. In addition we used $71,000 of cash to purchase our Common Stock on the open market.
We estimate that our development costs for 2000 relating to our proved developed nonproducing and proved undeveloped oil and gas properties will be less than $1,000,000. Planned expenditures for 2000 consist of delay rentals and other exploration costs of approximately $100,000. Capital expected to be used for 2000 principal payments required under existing debt agreements is $175,000.
We expect to continue to evaluate possible future purchases of additional producing oil and gas properties and the further development of our properties. We believe our long-term cash requirements for such investing activities and the repayment of long-term debt can be met by future cash flows from operations and, if necessary, possible forward sales of oil reserves or additional debt or equity financing.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See "Index to Consolidated Financial Statements and Supplementary Data" on page 25.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following sets forth certain information concerning each of our directors and executive officers:
Position(s) with Period of Service as Name and Age the Company a Director or Officer
Jeffrey P. Vickers President and Since 1982 Age: 47 Director
Thomas F. Neubauer Vice President Since June 1992 Age: 65 of Leonardite Operations
Cathy Kruse Secretary, Since October 1981; Age: 45 Treasurer and October 1981 to May Director 1985 and since June 1990; since June 1996
H. Dennis Hoffelt Director From 1967 through June Age: 59 1986; and since June 1987
Paul A. Krile Director Since June 1997 Age: 72
Duane Ashley Director Since June 1999 Age: 52
All of the directors' terms expire at the next annual meeting of shareholders or when their successors have been elected and qualified. Our executive officers serve at the discretion of the Board of Directors. The Board of Directors has an audit committee consisting of Jeffrey P. Vickers, H. Dennis Hoffelt and Paul A. Krile.
Jeffrey P. Vickers received a Bachelor of Science degree in Geological Engineering with a Petroleum Engineering option from the University of North Dakota in 1978. Prior to obtaining his degree, Mr. Vickers served two years overseas with the U.S. Army. In 1979, Mr. Vickers joined Amerada Hess Corporation as an Associate Petroleum Engineer in the Williston Basin. In 1981, Mr. Vickers was employed by us as our Drilling and Production Manager where he was responsible for providing technical assistance and supervision of drilling and production operations and generated development drilling programs. He became our President on January 1, 1983. In June 1982, Mr. Vickers became a director.
Thomas F. Neubauer is Vice President of Leonardite Operations and our plant manager. Mr. Neubauer has been employed by us since July 1965.
Cathy Kruse is our Secretary, Treasurer and business office manager. Ms. Kruse graduated from the Atlanta College of Business in 1977 and was employed as a Legal Assistant for four years prior to her employment with us in May 1981. In June 1996, Ms. Kruse became a director.
H. Dennis Hoffelt has been President of Triangle Electric Inc., Williston, North Dakota, an electrical contracting firm, for over the past five years. He served as one of our directors from 1967 through June of 1986 and was elected as a director again in 1987.
Paul A. Krile has been one of our directors since June 1997. He has been the President and owner of Ranco Fertiservice, a manufacturer of dry fertilizer handling equipment, headquartered in Sioux Rapids, Iowa for more than the last five years.
Duane Ashley has been one of our directors since June 1999. He has been a Senior Salesman for GRACO Fishing and Rental Tools, Inc. since January 1999, and for Weatherford Enteerra, Inc. for over five years prior to that.
Cathy Kruse, our Secretary and Treasurer, is the sister-in-law of Jeffrey P. Vickers. No other family relationship exists between or among any of the above named persons. There are no arrangements or undertakings between any of the named directors and any other persons pursuant to which any director was selected as a director or was nominated as a director. Based solely upon a review of Forms 3, 4 and 5 furnished to us for 1999, no officer or director failed to file any of the above forms on a timely basis.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table presents the aggregate compensation which was earned by our Chief Executive Officer for each of the past three years. We do not have an employment contract with any of our executive officers. None of our employees earned total annual salary and bonus in excess of $100,000. There has been no compensation awarded to, earned by or paid to any employee required to be reported in any table or column in any fiscal year covered by any table, other than what is set forth in the following table.
Summary Compensation Table
Long Term Compensation Annual Compensation Awards Payouts All Other Restricted Securities Other Name and Annual Stock Underlying LTIP Compen- Principal Salary Bonus Compen- Award(s) Options Payouts sation Position Year ($) ($) sation ($) SARs(#) ($) ($)
Jeffrey 1999 $76,307 -0- -0- N/A -0- N/A $1,820 P. 1998 $82,596 -0- -0- N/A -0- N/A $4,130 Vickers, 1997 $82,596 25,000 -0- N/A 71,000 N/A $8,747 CEO
In the table above, the column titled "All Other Compensation" is comprised entirely of profit sharing amounts and the 401(k) Company matching funds discussed below.
If we achieve net income in a fiscal year, our Board of Directors may determine to contribute an amount based on our profits to the Employees' Profit Sharing Plan and Trust adopted in December 1978 (the "Profit Sharing Plan"). An eligible employee may be allocated from 0% to 15% of his compensation depending upon the total contribution to the Profit Sharing Plan. A total of 20% of the amount allocated to an individual vests after three years of service, 40% after four years, 60% after five years, 80% after six years and 100% after seven or more years. On retirement, an employee is eligible to receive the vested amount. On death, 100% of the amount allocated to an individual is payable to the employee's beneficiary. We made total contributions to the plan, matching and discretionary, for the years ended December 31, 1999, 1998 and 1997 of $44,989, $19,883, and $31,930, respectively. As of December 31, 1999, vested amounts in the Profit Sharing Plan for all officers as a group were approximately $440,000.
Effective July 1, 1997, we executed an Adoption Agreement Nonstandardized Code 401(k) Profit Sharing Plan that incorporated a 401(k) Plan into the existing Profit Sharing Plan. Eligible employees are allowed to defer up to 15% of their compensation and we match up to 5%.
Aggregated Option/SAR Exercises in last Fiscal Year and FY-End Option/SAR Values
Value of Number of Unexercised Unexercised In-the-Money Options/SARs Options/SARs Shares at FY-End(#) at FY-End($) Acquired on Value Exercisable/ Exercisable/ Name Exercise(#) Realized($) Unexercisable Unexercisable
Jeffrey P. Vickers, CEO -0- -0- 106,000/0 0/0
At our 1993 Annual Meeting of Shareholders, a 1993 Employees' Incentive Stock Option Plan (the "Plan") was approved by shareholders. The purpose of the Plan is to enable us to attract persons of training, experience and ability to continue as employees and to furnish additional incentive to them, upon whose initiative and efforts the successful conduct and development of the business largely depends, by encouraging them to become owners of our Common Stock.
The term of the Plan expires on February 17, 2003. If within the duration of an option, there is a corporate merger consolidation, acquisition of assets or other reorganization; and if this transaction affects the optioned stock, the optionee will thereafter be entitled to receive upon exercise of his option those shares or securities that he would have received had the option been exercised prior to the transaction and the optionee had been a stockholder with respect to such shares.
The Plan is administered by our Board of Directors. The exercise price of the Common Stock offered to eligible participants under the Plan by grant of an option to purchase Common Stock may not be less than the fair market value of the Common Stock at the date of grant; provided, however, that the exercise price will not be less than 110% of the fair market value of the Common Stock on the date of grant in the event an optionee owns 10% or more of the Common Stock. A total of 300,000 shares have been reserved for issuance pursuant to options to be granted under the Plan. Of the 300,000 reserved shares, options have been issued for 295,000 shares pursuant to the Plan.
Directors' Compensation
Our officers, who are also directors, receive no additional compensation for attendance at Board meetings. Directors, other than Jeffrey P. Vickers and Cathy Kruse, were paid $200 per month for Board service in 1999.
ITEM 12.
ITEM 12. SECURITES OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth the number of shares of our Common Stock beneficially owned by each of our officers and directors and by all directors and officers as a group, as of March 15, 2000. Unless otherwise indicated, the shareholders listed in the table have sole voting and investment powers with respect to the shares indicated.
Name of Person or Number of Amount of Class of Directors and Shares and Nature of Percent Securities Officers as a Group Beneficial Ownership of Class
Common Stock, Jeffrey P. Vickers 366,934-Direct and 9.2% $.01 par value Indirect(a)
Common Stock, Paul A. Krile 211,500-Direct(b) 5.3% $.01 par value
Common Stock, Cathy Kruse 14,700-Direct(d) (c) $.01 par value
Common Stock, Thomas F. Neubauer 20,500-Direct(e) (c) $.01 par value
Common Stock, H. Dennis Hoffelt 41,000-Direct and 1.0% $.01 par value Indirect(f)
Common Stock, Duane Ashley 0-Direct and (c) $.01 par value Indirect
Common Stock, Officers and 654,634-Direct and 16.4% $.01 par value Directors as Indirect a Group- (a)(b)(c)(d)(e)(f) (six persons) _______________________ (a) Includes 139,634 shares owned directly by Mr. Vickers, 2,500 in a self- directed individual retirement account, 72,000 shares held jointly with his wife, Nancy J. Vickers, 25,500 shares held directly by his wife, 1,300 shares in his wife's self-directed individual retirement account, and an aggregate 20,000 shares held by him as custodian for his two minor children. Also included are 106,000 shares which may be purchased by Mr. Vickers under presently exercisable stock options granted pursuant to our 1993 Employees' Incentive Stock Option Plan.
(b) Mr. Krile has sole voting and investment powers over these shares.
(c) Less than 1%.
(d) Included are 14,500 shares which may be purchased by Ms. Kruse under presently exercisable stock options granted pursuant to our 1993 Employees' Incentive Stock Option Plan.
(e) Included are 9,500 shares which may be purchased by Mr. Neubauer under presently exercisable stock options granted pursuant to our 1993 Employees' Incentive Stock Option Plan.
(f) Mr. Hoffelt has sole voting and investment power over 11,500 of shares and has shared voting and investment powers over the remaining 29,500 shares.
The following table sets forth information concerning persons known to us to be the beneficial owners of more than 5% of our outstanding Common Stock as of March 15, 2000.
Amount of Class of Name and Shares and Nature of Percent Securities Address of Person Beneficial Ownership of Class
Common Stock, Joseph V. Montalban 463,800-Direct(a) 11.6% $.01 par value Montalban Oil & Gas Operations, Inc. Box 200 Cut Bank, MT 59247
Common Stock, Jeffrey P. Vickers 366,934-Direct and 9.2% $.01 par value 1814 14th Ave. W. Indirect(b) Williston, ND 58801
Common Stock, Paul A. Krile 211,500-Direct(c) 5.3% $.01 par value P. O. Box 329 Sioux Rapids, IA 50585 ________________________ (a) This information was obtained from a Securities and Exchange Commission filing.
(b) See footnote (a) of the immediately preceding table.
(c) See footnote (b) of the immediately preceding table.
We are not aware of any arrangements which could, at a subsequent date, result in a change in control.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
There are no transactions or series of similar transactions since the beginning of our last fiscal year or any currently proposed transaction or series of similar transactions to which we were or are to be a party, and which the amount involved exceeds $10,000 and in which any director, executive officer, principal shareholder or any member of their immediate family had or will have a direct or indirect material interest.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as Part of this Report
(1) Financial Statements and Schedules See "Index to Consolidated Financial Statements and Supplementary Data" on next page. There are no financial statement schedules filed herewith.
(2) Disclosures About Oil and Gas Producing Activities - Unaudited See "Index to Consolidated Financial Statements and Supplementary Data" on next page.
(3) Exhibits See "Exhibit Index" on page 52.
(b) Reports on Form 8-K None.
(c) Exhibits required by Item 601 of Regulation S-K See (a)(3) above.
(d) Financial Statement Schedules required by Regulation S-X See (a)(1) above.
GEORESOURCES, INC., AND SUBSIDIARY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Page REPORT OF INDEPENDENT AUDITORS ON THE CONSOLIDATED FINANCIAL STATEMENTS 27
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated balance sheets 28 Consolidated statements of operations 29 Consolidated statements of stockholders' equity 30 Consolidated statements of cash flows 31 - 32 Notes to consolidated financial statements 33 - 46
UNAUDITED SUPPLEMENTARY INFORMATION
Disclosures about oil and gas producing activities 47 - 50
REPORT OF INDEPENDENT AUDITORS ON THE CONSOLIDATED FINANCIAL STATEMENTS
To the Board of Directors and Shareholders GeoResources, Inc.
We have audited the accompanying consolidated balance sheets of GeoResources, Inc., and Subsidiary as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years ended December 31, 1999, 1998 and 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of GeoResources, Inc., and Subsidiary as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the years ended December 31, 1999, 1998 and 1997, in conformity with generally accepted accounting principles.
/s/ Richey, May & Co., P. C. Englewood, Colorado February 26, 2000
GEORESOURCES, INC., AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND 1998
ASSETS
CURRENT ASSETS: 1999 1998
Cash and equivalents $ 423,361 $ 40,673 Trade receivables, net 991,153 524,132 Inventories 297,029 403,529 Prepaid expenses 17,257 26,468 Investments 106 4,319
Total current assets 1,728,906 999,121
PROPERTY, PLANT AND EQUIPMENT, at cost: Oil and gas properties, using the full cost method of accounting: Properties being amortized 19,664,222 19,139,363 Properties not subject to amortization 143,413 141,019 Leonardite plant and equipment 3,206,217 3,206,217 Other 709,443 704,357
23,723,295 23,190,956 Less accumulated depreciation, depletion, amortization and impairment (18,271,169) (17,635,373)
Net property, plant and equipment 5,452,126 5,555,583
OTHER ASSETS: Mortgage loans receivable, related party 103,321 103,321 Other 44,487 46,699
Total other assets 147,808 150,020
TOTAL ASSETS $ 7,328,840 $ 6,704,724
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES: Accounts payable $ 747,557 $ 472,345 Current maturities of long-term debt 175,000 316,000 Accrued expenses 167,800 99,261
Total current liabilities 1,090,357 887,606
LONG-TERM DEBT, less current maturities 1,610,008 1,625,004 DEFERRED INCOME TAXES 166,000 140,000
Total liabilities 2,866,365 2,652,610
CONTINGENCIES (NOTE H)
STOCKHOLDERS' EQUITY: Common stock, par value $.01 per share; authorized 10,000,000 shares; issued and outstanding, 4,005,352 and 4,071,652 shares, respectively 40,054 40,717 Additional paid-in capital 776,259 846,787 Retained earnings 3,646,162 3,164,610
Total stockholders' equity 4,462,475 4,052,114
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 7,328,840 $ 6,704,724
The accompanying notes are an integral part of these consolidated financial statements
GEORESOURCES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997 OPERATING REVENUE: Oil and gas sales $ 2,688,642 $ 1,661,977 $ 3,425,395 Leonardite sales 651,847 718,674 764,398
3,340,489 2,380,651 4,189,793
OPERATING COSTS AND EXPENSES: Oil and gas production 1,214,169 929,560 1,335,605 Cost of leonardite sold 563,081 603,208 597,813 Depreciation, depletion and amortization 635,797 830,871 850,599 Write-down of oil and gas properties -- 1,300,000 -- Selling, general and administrative 307,336 412,729 449,161
2,720,383 4,076,368 3,233,178
Operating income (loss) 620,106 (1,695,717) 956,615
OTHER INCOME (EXPENSE): Interest expense (165,395) (143,588) (125,007) Interest income 27,591 17,231 25,036 Other income and losses, net 25,250 21,856 19,621
(112,554) (104,501) (80,350)
Income (loss) before income taxes 507,552 (1,800,218) 876,265
INCOME TAX (EXPENSE) BENEFIT (26,000) 195,000 (110,000)
Net income (loss) $ 481,552 $ (1,605,218) $ 766,265
EARNINGS PER SHARE:
Net income (loss), basic and diluted $ .12 $ (.39) $ .19
Weighted average number of shares outstanding 4,040,425 4,080,092 4,076,284
Dilutive potential shares - Stock options -- -- 63,361
Adjusted weighted average shares 4,040,425 4,080,092 4,139,645
The accompanying notes are an integral part of these consolidated financial statements
GEORESOURCES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
Additional Common Stock Paid-in Retained Shares Amount Capital Earnings Total
Balance, December 31, 1996 4,060,714 $ 40,607 $ 829,757 $ 4,003,563 $ 4,873,927
Issuance of common stock as compensation 20,000 200 30,400 -- 30,600
Stock options exercised 16,500 165 20,640 -- 20,805
Net income -- -- -- 766,265 766,265
Balance, December 31, 1997 4,097,214 40,972 880,797 4,769,828 5,691,597
Purchase of common stock (56,562) (565) (95,351) -- (95,916)
Issuance of common stock for acquisition of oil and gas properties 31,000 310 61,341 -- 61,651
Net income (loss) -- -- -- (1,605,218) (1,605,218)
Balance, December 31, 1998 4,071,652 40,717 846,787 3,164,610 4,052,114
Purchase of common stock (66,300) (663) (70,528) -- (71,191)
Net income -- -- -- 481,552 481,552
Balance, December 31, 1999 4,005,352 $ 40,054 $ 776,259 $ 3,646,162 $ 4,462,475
The accompanying notes are an integral part of these consolidated financial statements
GEORESOURCES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997 CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 481,552 $ (1,605,218) $ 766,265 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation, depletion, amortization and valuation allowance 635,797 2,130,871 850,599 Deferred income taxes (benefit) 26,000 (195,000) 110,000 Other 2,192 7,192 2,364 Changes in assets and liabilities: Decrease (increase) in: Trade receivables (467,021) (2,198) 414,111 Inventories 106,500 (115,265) (36,765) Prepaid expenses and other 9,211 4,954 (13,221) Investments 4,213 21,647 31,805 Increase (decrease) in: Accounts payable 217,537 (109,569) 145,629 Accrued expenses 68,539 (13,169) (43,034)
Net cash provided by operating activities 1,084,520 124,245 2,227,753
CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant and equipment (484,095) (1,287,321) (2,707,097) Proceeds from sale of property and equipment 9,450 -- 357,236
Net cash used in investing activities (474,645) (1,287,321) (2,349,861)
CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term borrowings 160,000 1,275,000 425,000 Principal payments on long-term debt (315,996) (457,093) (583,200) Proceeds from issuance of common stock -- -- 20,805 Cost to purchase common stock (71,191) (95,916) -- Debt issue costs -- (8,627) (5,000)
Net cash provided by (used in) financing activities (227,187) 713,364 (142,395)
NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS 382,688 (449,712) (264,503)
CASH AND EQUIVALENTS, beginning of year 40,673 490,385 754,888
CASH AND EQUIVALENTS, end of year $ 423,361 $ 40,673 $ 490,385
The accompanying notes are an integral part of these consolidated financial statements
GEORESOURCES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid (received) for: Interest $ 165,435 $ 138,791 $ 124,245 Income taxes (10,752) 14,573 9,922
NONCASH INVESTING AND FINANCING ACTIVITIES
During 1998, the Company issued 31,000 shares of common stock valued at $61,651 as partial consideration of the purchase price of various oil and gas properties.
The accompanying notes are an integral part of these consolidated financial statements
GEORESOURCES, INC., AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. SIGNIFICANT ACCOUNTING POLICIES:
Nature of Operations and Principles of Consolidation The accompanying consolidated financial statements include the accounts of GeoResources, Inc., and its 84% owned subsidiary, Belmont Natural Resource Company, Inc. ("BNRC"). All material intercompany transactions and balances between the entities have been eliminated. The minority interest in BNRC is not presented, as the amount is immaterial.
GeoResources, Inc. (the "Company") is primarily involved in oil and gas exploration, development and production in North Dakota and Montana and the mining of leonardite and manufacturing of leonardite products in North Dakota to be sold to customers located primarily in the Gulf of Mexico coastal areas. BNRC was incorporated in 1991 to exploit natural gas opportunities in the Pacific Northwest. All properties of the Company and BNRC are located in the United States.
Reclassifications Certain accounts in the prior-year financial statements have been reclassified for comparative purposes to conform with the presentation in the current-year financial statements.
Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates used in preparing these financial statements include the unaudited quantity of oil and gas reserves which directly affects the computation of depletion of oil and gas properties. It is at least reasonably possible that the estimates used will change within the next year.
Cash Equivalents For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
Inventories Inventories are stated at the lower of cost (first-in, first-out method) or market.
Investments The Company's investments consist of marketable equity securities and various derivative financial instruments related to crude oil and other energy products.
Marketable equity securities are stated at market value. Securities acquired with the intent to resell in order to profit from short-term price movements are classified as trading account securities and related unrealized gains and losses are included in other income. Other securities are classified as assets available-for-sale and related unrealized gains or losses are recorded as a component of stockholders' equity. The specific security sold is used to compute realized gains or losses. All of the Company's securities are classified as trading account securities.
The Company periodically uses various derivative financial instruments to hedge a portion of future oil sales against the risk of possible decreases of crude oil prices. These instruments are accounted for as hedges and, accordingly, gains and losses are deferred and recognized when the future oil sales occur. Similarly, cash flows from such transactions are included in the statements of cash flows as cash flows from operating activities.
Oil and Gas Properties The Company utilizes the full cost method of accounting for oil and gas properties. Accordingly, all costs associated with the acquisition, exploration and development of oil and gas reserves (including costs of abandoned leaseholds, delay lease rentals, dry hole costs, geological and geophysical costs, certain internal costs associated directly with acquisition, exploration and development activities, and site restoration and environmental exit costs) are capitalized.
All capitalized costs of oil and gas properties, including the estimated future costs to develop proved reserves, are amortized on the unit-of- production method using estimates of proved reserves. Investments in unproved properties and major development projects are not amortized until proved reserves associated with the projects can be determined or until impairment occurs. If the results of an assessment indicate that the properties are impaired, the amount of the impairment is added to the capitalized costs to be amortized. The Company's oil and gas depreciation, depletion and amortization rate per equivalent barrel of oil produced was $2.99, $3.86 and $3.40 for 1999, 1998 and 1997, respectively.
In addition, the capitalized costs are subject to a "ceiling test" which basically limits such costs to the aggregate of the "estimated present value," discounted at a 10-percent interest rate, of future net revenues from proved reserves, based on current economic and operating conditions, plus the lower of cost or fair market value of unproved properties. During 1998, the selling prices of the Company's oil and gas products declined significantly, reaching their lowest point of the year in mid December with only a small increase through December 31, 1998, and some additional increase after year-end. As a result, the net capitalized costs of the Company's oil and gas properties exceeded their "estimated present value" based upon the "ceiling" limitation and consequently, the Company recognized a charge to operations of $1,300,000 or $0.32 per share.
Gains or losses are not recognized upon the sale or other disposition of oil and gas properties, except in extraordinary transactions.
Costs not being amortized at December 31, 1999, consist of the unevaluated, unimpaired cost of undeveloped oil and gas properties that were acquired during the following years:
1999 $ 10,953 1998 20,253 1997 31,999 1996 and prior 80,208
Total $ 143,413
It is expected that evaluation of the above properties will occur primarily over the next three years.
Other Property and Equipment Depreciation of other property and equipment is computed principally on the straight-line method over the following estimated useful lives:
Buildings 10-25 years Machinery and equipment 3-10 years
Impairment of Long-Lived Assets Potential impairment of long-lived assets (other than oil and gas properties) is reviewed whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable. Impairment is recognized when the estimated future net cash flows (undiscounted and without interest charges) from the asset are less than the carrying amount of the asset. No impairment losses have been recognized on long-lived assets for the years ended December 31, 1999, 1998 and 1997.
Operating Costs and Expenses Oil and gas production costs and the cost of leonardite sold exclude a provision for depreciation and depletion. Depreciation and depletion expense is shown in the aggregate in the accompanying statements of operations.
Income Taxes Provisions for income taxes are based on taxes payable or refundable for the current year and deferred taxes on temporary differences between the amount of taxable income and pretax financial income and between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. A valuation allowance is provided for deferred tax assets not expected to be realized.
Earnings Per Share of Common Stock Earnings per share has been computed based on the adjusted weighted average number of common shares outstanding. The effect of outstanding stock options was antidilutive in 1999.
Recently Issued Accounting Standards In 1998, the FASB issued SFAS No. 133-Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes standards for the accounting and reporting of all derivative instruments at their fair value as assets or liabilities on the balance sheet. SFAS No. 133 is effective for fiscal quarters of fiscal years beginning after June 15, 2000 and requires restatement of information presented for prior periods. The adoption of SFAS No. 133 will not have a material impact on these financial statements.
B. INDUSTRY SEGMENTS AND MAJOR CUSTOMER:
Segment information The Company assesses performance and allocates resources based upon its products and the nature of its production processes, which consist principally of oil and gas exploration and production and the mining and processing of leonardite. There are no sales or other transactions between these two operating segments and all operations are conducted within the United States. Certain corporate costs, assets and capital expenditures that are considered to benefit the entire organization are not allocated to the Company's operating segments. Interest income, interest expense and income taxes are also not allocated to operating segments. There are no significant accounting differences between internal segment reporting and consolidated external reporting. Presented below is information concerning the Company's operating segments for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 Revenue: Oil and gas $ 2,688,642 $ 1,661,977 $ 3,425,395 Leonardite 651,847 718,674 764,398
$ 3,340,489 $ 2,380,651 $ 4,189,793 Operating income (loss): Oil and gas $ 955,066 $ (1,279,105) $ 1,365,729 Leonardite (35,538) (8,975) 33,859 General corporate activities (299,422) (407,637) (442,973)
$ 620,106 $ (1,695,717) $ 956,615 Depreciation and depletion: Oil and gas $ 519,407 $ 711,522 $ 724,061 Leonardite 100,590 101,468 108,903 General corporate activities 15,800 17,881 17,635
$ 635,797 $ 830,871 $ 850,599 Identifiable assets, net: Oil and gas $ 4,894,495 $ 4,702,417 $ 5,452,759 Leonardite 1,417,100 1,347,521 1,452,847 General corporate activities 1,017,245 654,786 1,126,722
$ 7,328,840 $ 6,704,724 $ 8,032,328 Capital expenditures incurred: Oil and gas $ 544,049 $ 1,158,211 $ 1,920,470 Leonardite -- -- 43,498 General corporate activities 5,086 2,289 9,927
$ 549,135 $ 1,160,500 $ 1,973,895
Major Customer Sales to a major oil and gas customer were 60%, 54% and 71% of total revenue for the years ended December 31, 1999, 1998 and 1997, respectively. Accounts receivable from this major customer were 42% and 36% of total accounts receivable at December 31, 1999 and 1998, respectively.
C. TRADE RECEIVABLES AND INVENTORIES:
Trade receivables at December 31, 1999 and 1998 are comprised of the following:
1999 1998
Oil and gas purchasers $ 618,131 $ 353,607 Leonardite customers 384,438 181,941
1,002,569 535,548 Less allowance for doubtful accounts (11,416) (11,416)
$ 991,153 $ 524,132
As of December 31, 1999 and 1998, inventories by major classes are comprised of the following:
1999 1998
Crude oil $ 36,384 $ 114,464
Leonardite inventories: Finished products 91,863 108,951 Raw materials 86,567 90,167 Materials and supplies 82,215 89,947
Total leonardite inventories 260,645 289,065
$ 297,029 $ 403,529
D. MORTGAGE LOANS RECEIVABLE, RELATED PARTY
Mortgage loans receivable, related party represent mortgage loans on the residence of an officer/shareholder of BNRC purchased from a third party in November 1993, and are recorded at purchase cost. The mortgages require monthly payments of interest at 8% per annum with principal due January 14, 2002. The mortgage loans are expected to be repaid through sale of the residence prior to the maturity date. The Company's interest income from these loans was $8,100 for each of the years ended December 31, 1999, 1998 and 1997.
E. LONG-TERM DEBT:
Long-term debt at December 31, 1999 and 1998 consists of the following loans and a revolving line of credit (RLOC) which are all with one bank:
1999 1998 The 1993 Oil & Gas Loan, prime plus 1% (8.75% total rate at December 31, 1998), due in monthly installments of $16,000 plus interest, collateralized by oil and gas properties $ -- $ 141,000
The 1995 Oil & Gas Loan, prime plus 1% (9.50% total rate at December 31, 1999), due in monthly installments of $14,583 plus interest, due December 2001, collateralized by oil and gas properties 350,008 525,004
The 1997 Oil & Gas RLOC, $3,000,000 revolving line of credit, interest payable monthly at prime plus .75%, (9.5% total rate at December 31, 1999), expires January 5, 2005, collateralized by oil and gas properties 1,435,000 1,275,000
Total long-term debt 1,785,008 1,941,004
Less current maturities (175,000) (316,000) Long-term debt, less current maturities $ 1,610,008 $ 1,625,004
Aggregate maturities required on long-term debt at December 31, 1999, are as follows:
Year Ending December 31:
2000 $ 175,000 2001 533,758 2002 358,750 2003 358,750 2004 358,750 Thereafter --
$ 1,785,008
The Company's borrowing base for debt secured by oil and gas properties is limited by the net present value of future oil and gas production of the properties as determined annually by the bank.
The Company's long-term debt was obtained pursuant to financing agreements which include the following covenants: Maintain a current ratio of not less than 1.25 to 1 exclusive of current maturities of long- term debt; maintain debt to tangible net worth of not more than 1.5 to 1; not encumber certain of its assets; restrict borrowings from, and credit extensions to, other parties; restrict reorganization or mergers in which the Company is not the surviving corporation; and not pay cash dividends without the bank's consent.
F. INCOME TAXES:
The components of income tax expense for the years ended December 31, 1999, 1998 and 1997, are as follows:
1999 1998 1997 Current tax (expense) $ -- $ -- $ -- Deferred tax benefit (expense) (168,000) 685,000 (369,000) Decrease (increase) in deferred tax assets valuation allowance 142,000 (490,000) 259,000
Income tax (expense) benefit $ (26,000) $ 195,000 $ (110,000)
During 1998, the Company recorded a deferred tax benefit of $685,000. This resulted from a) the reversal of temporary differences related to oil and gas properties caused by the $1,300,000 write-down discussed in Note A, and b) the additional net loss incurred for which there are no currently refundable taxes. The Company also increased the deferred tax asset valuation allowance by $490,000 based upon the projection of utilizing less statutory depletion carryforwards in the future.
During 1999 and 1997, the Company recorded deferred tax expense of $168,000 and $369,000, respectively. This related primarily to net income that was not currently taxable due to the utilization of net operating loss carryforwards and the deduction of intangible drilling costs for tax purposes, respectively. The Company also decreased the deferred tax asset valuation allowance by $142,000 and $259,000 during 1999 and 1997, respectively, primarily based upon the projection of utilizing additional statutory depletion carryforwards in the future.
The tax effects of significant temporary differences and carryforwards which give rise to the Company's deferred tax assets and liabilities at December 31, 1999 and 1998, are as follows:
1999 1998 Deferred Tax Assets: Net operating loss carryforward $ 245,000 $ 454,000 Statutory depletion carryforward 1,205,000 1,252,000 Tax credit carryforwards 56,000 55,000 Other 35,000 46,000
1,541,000 1,807,000
Valuation Allowance: Beginning of year (982,000) (492,000) (Increase) decrease 142,000 (490,000)
End of year (840,000) (982,000)
Deferred Tax Liabilities: Accumulated depreciation and depletion (867,000) (965,000)
Net Deferred Tax Liability, long-term $ (166,000) $ (140,000)
The provision for income taxes does not bear a normal relationship to pre-tax earnings. A reconciliation of the U.S. federal income tax rate with the actual effective rate for the years ended December 31, 1999, 1998 and 1997 is as follows:
1999 1998 1997
Income tax expense (benefit) at statutory rate 35% (35)% 35% Change in valuation allowance (28) 27 (30) State income taxes and other (2) (3) 8
5% (11)% 13%
For income tax purposes, the Company has a statutory depletion carryover of approximately $3,765,000 that, subject to certain limitations, may be utilized to reduce future taxable income. This carryforward does not expire. The Company also has net operating loss carryovers and investment tax credit carryovers (accounted for using the flow-through method), which, if not utilized, expire as follows:
Investment Net operating tax credit Year of expiration loss carryover carryover
2000 $ -- $ 16,000 2003 16,000 -- 2008 115,000 -- 2009 237,000 -- 2017 342,000 -- 2018 55,000 --
Total $ 765,000 $ 16,000
G. STOCK OPTION AND PROFIT-SHARING PLANS:
Stock Option Plan In 1993, the Company adopted the 1993 Incentive Stock Option Plan, whereby 300,000 shares of the Company's common stock are reserved for options which may be granted pursuant to the terms of the plan. Under the terms of the plan, the option price may not be less than 100% of the fair market value of the Company's common stock on the date of grant, and if the optionee owns more than 10% of the voting stock, the option price per share shall not be less than 110% of the fair market value.
Information with respect to the stock option plan's activity is as follows:
Shares Shares Subject to Available Outstanding for Options Options
December 31, 1996 205,000 95,000 Grants (200,000) 200,000 Exercises -- (16,500)
December 31, 1997 5,000 278,500 Grants -- -- Exercises -- --
December 31, 1998 5,000 278,500 Grants -- -- Exercises -- --
December 31, 1999 5,000 278,500
Information with respect to the options outstanding and exercisable at December 31, 1999 and 1998, is as follows:
Number of shares Exercise Price Expiration Date
80,000 $1.15 November 2000 101,000 2.37 May 2002 97,500 2.31 December 2002
278,500
The average exercise price is $2.00 for options outstanding and exercisable at December 31, 1999.
As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, the Company continues to apply the provisions of APB Opinion 25 in accounting for its plan. Accordingly, no compensation cost was recognized for options granted. Had stock-based compensation cost been determined based upon the fair value of the options estimated on the date of grant the Company's 1997 net income and earnings per share would have been reduced to pro forma amounts of $598,065 and $.15, respectively. The fair value of the 1997 options on the date of grant is estimated using the Black-Scholes option-pricing model with the following assumptions:
Expected volatility 39% Risk free interest rate 5.71% Expected lives 3.5 years Expected dividends None
Profit-sharing plan The Company has a 401(k) profit sharing plan that covers all employees with one year of service who elect to enter the plan. Effective July 1, 1997, the Company amended the plan to provide for employee contributions. Employees may elect to contribute up to 15% of their compensation to a maximum of $10,000. The Company contributes an amount equal to each employee's contribution up to a maximum of 5% of the employee's compensation. The Company may also make additional discretionary contributions to the plan. The Company's total contributions to the plan, matching and discretionary, for the years ended December 31, 1999, 1998 and 1997 were $44,989, $19,883 and $31,930, respectively.
H. CONTINGENCIES:
All of the Company's operations are generally subject to federal, state or local environmental regulations. The Company's oil and gas business segment is affected particularly by those environmental regulations concerned with the disposal of produced oilfield brines and other wastes. The Company's leonardite mining and processing segment is subject to numerous state and federal environmental regulations, particularly those concerned with air quality at the Company's processing plant, and surface mining permit and reclamation regulations. The amount of future environmental compliance costs cannot be determined at this time.
I. OFFICE FACILITIES:
In 1991, the Company purchased an office building, one-third of which it occupies. The building is included in other property and equipment in the accompanying balance sheets and consists of the following at December 31, 1999 and 1998:
1999 1998
Building and improvements $ 163,834 $ 163,834 Accumulated depreciation (71,945) (63,754)
$ 91,889 $ 100,080
The Company leases the remainder of the building to unaffiliated businesses under cancelable lease agreements. During 1999, 1998 and 1997, the Company received $21,300, $21,300 and $22,200, respectively, in rental income from the building which is included in other income in the accompanying statements of operations.
J. FINANCIAL INSTRUMENTS:
The carrying amounts reflected in the consolidated balance sheets for cash and equivalents approximates their fair value due to the short maturity of the instruments. The carrying amount of marketable equity securities is fair value based on quoted market prices. The carrying value of mortgage loans receivable approximates fair value based on discounted future cash flows.
The Company uses derivative financial instruments to manage its crude oil commodity price risk. They are not used for trading purposes. The Company has in recent years hedged 5% to 35% of its crude oil sales using various financial instruments including "put" and "call" options and, to a lesser extent, actual future contracts on crude oil and energy products that trade on the New York Mercantile Exchange ("NYMEX"). The variation in types of instruments employed results from a strategy designed to provide primarily short to intermediate term protection (less than one year) from oil price declines that would occur in a wide range. Generally, the Company does not hedge against narrow-range oil price movements. Since these financial instruments correlate to crude oil and energy products price movements, gains or losses resulting from market changes will be offset by losses or gains on the Company's crude oil sales. Included in oil and gas sales are losses from hedging activities totaling $108,199, $37,849 and $30,269 for the years ended December 31, 1999, 1998 and 1997, respectively. At December 31, 1999 and 1998, the Company had no derivative financial instruments.
K. FOURTH QUARTER ADJUSTMENTS:
As discussed in Note A, the Company recorded a write-down of its oil and gas properties of $1,300,000 during the fourth quarter of 1998 as a result of significantly lower oil prices at that time.
During the fourth quarter of 1998, deferred income tax liabilities decreased $185,000 and income tax benefit increased $185,000 over the amounts reported at September 30, 1998, due to the write-down discussed above and the operating loss incurred.
GEORESOURCES, INC., AND SUBSIDIARY UNAUDITED SUPPLEMENTARY INFORMATION DISCLOSURES ABOUT OIL AND GAS PRODUCING ACTIVITIES
Net capitalized costs related to the Company's oil and gas producing activities are summarized as follows as of December 31, 1999, 1998 and 1997:
1999 1998 1997
Proved properties $ 19,664,222 $ 19,139,363 $ 17,997,596 Unproved properties 143,413 141,019 124,672
Total 19,807,635 19,280,382 18,122,268
Less accumulated depreciation, depletion, amortization and impairment (15,600,726) (15,081,319) (13,069,796)
Net capitalized costs $ 4,206,909 $ 4,199,063 $ 5,052,472
Costs incurred in oil and gas property acquisition, exploration and development activities, including capital expenditures are summarized as follows for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 Property acquisition costs: Proved $ 20,259 $ 236,058 $ 28,420 Unproved 21,159 37,756 55,230 Exploration costs 57,310 68,365 75,765 Development costs 445,321 816,032 1,761,055
$ 544,049 $ 1,158,211 $ 1,920,470
The Company's results of operations from oil and gas producing activities (excluding corporate overhead and financing costs) are presented below for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997
Oil and gas sales $ 2,688,642 $ 1,661,977 $ 3,425,395 Production costs (1,214,169) (929,560) (1,335,605) Depletion, depreciation and amortization (519,407) (711,522) (724,061)
955,066 20,895 1,365,729
Imputed income tax provision (104,000) -- --
$ 851,066 $ 20,895 $ 1,365,729
GEORESOURCES, INC., AND SUBSIDIARY UNAUDITED SUPPLEMENTARY INFORMATION DISCLOSURES ABOUT OIL AND GAS PRODUCING ACTIVITIES
The reserve information presented below is based upon reports prepared by the independent petroleum engineering firm of Broschat Engineering and Management Services. The Company emphasizes that reserve estimates are inherently imprecise and that estimates of new discoveries are more imprecise than those of mature producing oil and gas properties. Accordingly, these estimates are expected to change as future information becomes available.
Proved oil and gas reserves are the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under economic and operating conditions existing as of the end of each respective year. The year-end selling price of oil and gas is one of the primary factors affecting the determination of proved reserve quantities which fluctuate directly with that price. The selling price of oil was significantly lower at December 31, 1998, than at December 31, 1999 or 1997.
Presented below is a summary of the changes in estimated proved reserves of the Company, all of which are located in the United States, for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 Oil Gas Oil Gas Oil Gas (bbl) (mcf) (bbl) (mcf) (bbl) (mcf) Proved reserves, beginning of year 1,286,000 234,000 2,387,000 253,000 2,154,000 261,000
Purchases of reserves-in- place -- -- 78,000 -- 1,000 --
Sales of reserves -in-place -- -- -- -- (25,000) --
Extensions and discoveries -- -- -- -- 201,000 1,000
Improved recovery 44,000 -- 124,000 -- 350,000 --
Revisions of previous estimates 1,418,000 31,000 (1,130,000) (10,000) (83,000) 1,000
Production (182,000) (8,000) (173,000) (9,000) (211,000) (10,000)
Proved reserves, end of year 2,566,000 257,000 1,286,000 234,000 2,387,000 253,000
GEORESOURCES, INC., AND SUBSIDIARY UNAUDITED SUPPLEMENTARY INFORMATION DISCLOSURES ABOUT OIL AND GAS PRODUCING ACTIVITIES
Proved developed oil and gas reserves are those expected to be recovered through existing wells with existing equipment and operating methods. Proved developed reserves of the Company are presented below as of December 31:
Oil Gas (bbl) (mcf)
1999 2,566,000 257,000
1998 1,286,000 234,000
1997 1,640,000 253,000
Statement of Financial Accounting Standards No. 69 prescribes guidelines for computing a standardized measure of future net cash flows and changes therein relating to estimated proved reserves. The Company has followed these guidelines which are briefly discussed below.
Future cash inflows and future production and development costs are determined by applying year-end selling prices and year-end production and development costs to the estimated quantities of oil and gas to be produced. The limitations inherent in the reserve quantity estimation process, as discussed previously, are equally applicable to the standardized measure computations since these estimates are the basis for the valuation process. Estimated future income taxes are computed using current statutory income tax rates including consideration for estimated future statutory depletion, depletion carryforwards, net operating loss carryforwards, and investment tax credit carryforwards. The resulting future net cash flows are reduced to present value amounts by applying a 10% annual discount factor.
As shown on the next page, the future cash inflows as of December 31, 1998, were significantly lower than at December 31, 1999 or 1997. This is primarily due to the low oil price in effect on December 31, 1998.
The assumptions used to compute the standardized measure are those prescribed by the Financial Accounting Standards Board and, as such, do not necessarily reflect the Company's expectations of actual revenues or future net cash flows to be derived from those reserves nor their present worth.
GEORESOURCES, INC., AND SUBSIDIARY UNAUDITED SUPPLEMENTARY INFORMATION DISCLOSURES ABOUT OIL AND GAS PRODUCING ACTIVITIES
Presented below is the standardized measure of discounted future net cash flows as of December 31, 1999, 1998 and 1997:
1999 1998 1997
Future cash inflows $ 55,686,000 $ 11,274,000 $ 33,521,000 Future production costs (19,665,000) (6,141,000) (13,602,000) Future development costs (3,738,000) (242,000) (3,495,000) Future income tax expense (8,449,000) (241,000) (5,318,000)
Future net cash flows 23,834,000 4,650,000 11,106,000
Less effect of a 10% discount factor (10,106,000) (1,814,000) (4,587,000)
Standardized measure of discounted future net cash flows relating to proved reserves $ 13,728,000 $ 2,836,000 $ 6,519,000
The principal sources of change in the standardized measure of discounted future net cash flows are as follows for the years ended December 31, 1999, 1998 and 1997:
1999 1998 1997 Standardized measure, beginning of year $ 2,836,000 $ 6,519,000 $ 11,446,000
Sales of oil and gas produced, net of production costs (1,474,000) (732,000) (2,090,000)
Net changes in prices and production costs 7,219,000 (6,032,000) (6,612,000)
Purchases of reserves-in-place -- 134,000 1,000
Sales of reserves-in-place -- -- (120,000)
Extensions, discoveries and other additions, less related costs 351,000 295,000 2,654,000
Revisions of previous quantity estimates and other 11,321,000 (2,673,000) (713,000)
Development costs incurred during the year and changes in estimated future development costs (2,006,000) 1,904,000 (1,011,000)
Accretion of discount 200,000 447,000 1,595,000
Net change in income taxes (4,719,000) 2,974,000 1,369,000
Standardized measure, end of year $ 13,728,000 $ 2,836,000 $ 6,519,000
Signatures
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
GEORESOURCES, INC. (the "Registrant")
Dated: March 24, 2000 /s/ J. P. Vickers J. P. Vickers, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
(Power of Attorney)
Each person whose signature appears below constitutes and appoints J. P. VICKERS and DENNIS HOFFELT his true and lawful attorneys-in- fact and agents, each acting alone, with full power of stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, each acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in each acting alone, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof.
Signatures Title Date
/s/ J. P. Vickers President (principal executive 3/24/00 J. P. Vickers officer and principal financial officer) and Director
/s/ Cathy Kruse Secretary/Treasurer 3/24/00 Cathy Kruse and Director
/s/ Dennis Hoffelt Director 3/24/00 Dennis Hoffelt
/s/ Paul A. Krile Director 3/24/00 Paul A. Krile
/s/ Duane Ashley Director 3/24/00 Duane Ashley
SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549
GEORESOURCES, INC. (Commission File Number: 0-8041)
E X H I B I T I N D E X FOR Form 10-K for 1999 fiscal year.
Page Number in Sequential Numbering of all Form 10-K and Exhibit Exhibit Pages
3.1 Registrant's Bylaws, as amended, November 30, 1994 *
3.2 Registrant's Articles of Incorporation, as amended to date, incorporated by reference to Exhibit 3.1 of the Registrant's Form 10-K for fiscal year, 1983 *
10.1 Secured Form Loan and Revolving Credit Agreement dated April 29, 1993, by and between GeoResources, Inc. and Norwest Bank Billings, incorporated by reference to Exhibit 10.1 of the Registrant's Form 10-Q for fiscal quarter ended June 30, 1993 *
10.2 Mortgage, Security Agreement, Assignment of Production and Financing Statement dated April 29, 1993, by and between GeoResources, Inc., as Mortgagor and Norwest Bank Billings, as Mortgagee, incorporated by reference to Exhibit 10.2 of the Registrant's Form 10-Q for fiscal quarter ended June 30, 1993 *
10.3 The Registrant's 1993 Employees' Incentive Stock Option Plan, incorporated by reference as Exhibit A to the Registrant's definitive Proxy Statement dated May 5, 1993 *
10.4 Amended and Restated Secured Term Loan and Revolving Credit Agreement made as of September 1, 1995, by and between GeoResources, Inc. and Norwest Bank Montana *
10.5 First Amendment of Mortgage, Security Agreement, Assignment of Production and Financing Statement and Mortgage - Collateral Real Estate Mortgage dated September 1, 1995, by and between GeoResources, Inc. and Norwest Bank Montana *
10.6 Commercial Installment Note with addendum dated February 1, 1997, by and between GeoResources, Inc. and Norwest Bank Billings, incorporated by reference to Exhibit 10.13 of Registrant's Form 10-K for fiscal year ended December 31, 1997 *
10.7 Purchase Agreement for Volumetric Production Payment dated as of December 3, 1997, by and between GeoResources, Inc. and Koch Producer Services, Inc. and all related documents. *
10.8 Amended and Restated Secured Term Loan and Revolving Credit Agreement made as of December 5, 1997, by and between GeoResources, Inc. and Norwest Bank Montana, and all related documents. *
10.9 Mining Lease and Agreement dated May 14, 1998, by and between Roger C. Ryan, Executor for the Estate of Constance P. Ryan, and as a single man, Susan Ryan, Joseph W. Ryan and Charlotte Friis as Lessors, and GeoResources, Inc. as Lessee and all related documents *
10.10 License Agreement dated January 22, 1999, by and between GeoResources, Inc. and Silverado Landscape Materials, and all related documents *
27 Financial Data Schedule | 13,835 | 88,892 |
26780_1999.html | 26780_1999 | 1999 | 26780 | ITEM 1 - BUSINESS
Dana Corporation was incorporated in 1905. Today, we are one of the world’s largest independent suppliers of components and systems to vehicular manufacturers and the related aftermarkets. We are also a leading provider of lease financing services in certain markets through our wholly-owned subsidiary, Dana Credit Corporation.
Our operations are organized into the following seven market-focused Strategic Business Units (SBUs):
•
Automotive Systems Group (ASG) - This group serves the world’s light truck, sport utility vehicles and passenger car markets with light duty axles and driveshafts, structural products (such as engine cradles and frames), transfer cases, original equipment brakes and integrated modules and systems. The group has 93 facilities and employs 26,000 people in 20 countries. Its three largest customers, DaimlerChrysler AG, Ford Motor Company (Ford) and General Motors Corporation (GM), helped it attain sales of $4.5 billion in 1999.
•
Automotive Aftermarket Group (AAG) - The AAG sells hydraulic brake components and disc brakes for light vehicle applications, internal engine hard parts, chassis products and a complete line of filtration products for a variety of applications worldwide. In addition, it sells electrical, brake, power transmission, steering and suspension system components in the United Kingdom and continental Europe. The AAG has 142 facilities and 20,400 people in 27 countries. In 1999, its sales were $3.0 billion and its three largest customers were National Automotive Parts Association (NAPA), Carquest Corporation and Auto Parts Plus.
•
Engine Systems Group (ESG) - This group serves the automotive, light to heavy truck, leisure and outdoor power equipment and industrial markets (including nearly every major engine manufacturer in the world and related aftermarkets) with sealing products, internal engine hard parts, electronic modules and sensors. The group has 98 facilities and 15,600 people in 17 countries. In 1999, its sales were $1.4 billion and its three largest customers were Ford, GM and DaimlerChrysler.
•
Fluid Systems Group (FSG) - This group manufactures an extensive line of products focused on the pumping, routing and thermal management of fluid systems for a wide range of applications, from passenger cars to heavy trucks and off-highway vehicles. Its products include an extensive line of rubber hose and fluid products and management systems. FSG has 50 facilities and 10,300 people in 8 countries. Its 1999 sales were $1.2 billion to a customer base led by Ford, DaimlerChrysler and GM.
•
Heavy Truck Group (HTG) - The HTG, a major global supplier to the medium and heavy truck markets, produces heavy axles and brakes, power take-off units and commercial vehicle systems. It also assembles modules and systems for heavy trucks. The group has 40 facilities in 9 countries. In 1999, this group recorded sales of $1.9 billion while employing 7,200 people. Its largest customers were Mack Trucks, Inc., PACCAR Inc and Navistar International Corp.
•
Off-Highway Systems Group (OHSG) - This group produces axles and brakes, transaxles, power-shift transmissions, torque converters, electronic controls and hydraulic pumps, motors, valves, filters and electronic components. These products serve the construction, agriculture, mining, specialty chassis, outdoor power, material handling, forestry and leisure/utility equipment markets. OHSG has 16 facilities and 4,300 people in 5 countries. Its 1999 sales were nearly $800 million and CNH Global N.V. (Case and New Holland), Textron and AGCO were its three largest customers.
•
Leasing Services - DCC and its subsidiaries provide leasing services to selected markets in the U.S., Canada, the United Kingdom and continental Europe. DCC’s key products are middle ticket and capital markets leasing and other finance products. It also provides asset and real property management services. DCC has 8 facilities in two countries and employs approximately 300 people.
This SBU alignment reflects the elimination of the Industrial Systems Group (ISG) at the end of 1999. Portions of the ISG and of the ESG were combined to form the FSG. You can find more information in “Note 13. Business Segments” on pages 33 - 35 of our 1999 Annual Report.
RECENT PAST DEVELOPMENTS
In 1997 and 1998, we completed the five largest acquisitions in our history, adding operations that generated $5.3 billion in annualized sales. The largest transaction was our July 1998 merger with Echlin Inc., a worldwide supplier of automotive products. This acquisition was accounted for as a pooling of interests and all of our prior period financial statements were restated accordingly. Our other major acquisitions were:
•
The Clark-Hurth Components assets of Ingersoll-Rand Company in February 1997
•
The Sealed Power Division of SPX Corporation in February 1997
•
The heavy axle and brake business of Eaton Corporation in January 1998
•
The Glacier Vandervell Bearings Group and the AE Clevite North American aftermarket engine hard parts business from Federal-Mogul Corporation in December 1998
There is more information about these transactions in “Note 18. Acquisitions” on page 37 of our 1999 Annual Report.
We also completed several restructuring and rationalization plans during this period and divested a number of operations. The divestitures included our European aftermarket business, our worldwide vehicular clutch business, DCC’s Technology Leasing Group and several other non-core businesses. See “Note 19. Divestitures” on page 38 and “Note 20. Restructuring of Operations” on pages 38 - 39 of our 1999 Annual Report for more information about these transactions.
DEVELOPMENTS AND STRATEGY IN 1999
Our focus in 1999 was on integrating our newly acquired businesses and rationalizing our global operations. This included implementing the restructuring plans announced at the end of 1998, continuing various integration efforts, especially those related to the Echlin merger, and finalizing additional restructuring plans announced in 1999, the largest component of which is downsizing our Reading, Pa. structures facility. The operations and employees affected by these plans are described in “Note 20. Restructuring of Operations” on pages 38 - 39 of our 1999 Annual Report.
We announced a new strategy - our Five-Point Plan - in April 1999, which includes the following tactics:
•
Grow while focusing on returns and maintaining financial discipline;
•
Seek strategic, bolt-on acquisitions at reasonable valuations;
•
Divest non-strategic and non-performing operations;
•
Repurchase stock as we generate cash; and
•
Complete integration efforts and realize synergy savings.
Consistent with the objectives of the plan, we improved our gross margin from 16.2% in 1998 to 16.7% in 1999. Return on sales also improved from 4.7% to 5.1% when nonrecurring items are excluded.
One acquisition closed in 1999 and three more have closed in the first two months of 2000. These transactions are all consistent with our objective of making strategic acquisitions. The July 1999 acquisition of Innovative Manufacturing, Inc. added a machining operation that supplies machined castings to our Outdoor Power Equipment Components Division. We also increased our ownership in four subsidiaries, acquiring the shares previously held by minority interests. Thus far in 2000 we have announced definitive agreements to acquire the Invensys plc axle manufacturing operations in Australia and South Africa and a majority interest in the Tribometal a.s. engine bearings and metal-polymer bushings operations in Slovakia. We also completed the acquisition of the cardan-jointed propeller shaft business of GKN plc. and signed a related agreement to form a joint venture with GKN to develop advanced driveline systems and modular assemblies for all-wheel and four-wheel drive passenger cars, light trucks and sport utility vehicles. See “Note 18. Acquisitions” on page 37 of our 1999 Annual Report for more information on our recent acquisitions.
During 1999 we announced plans to divest operations with annual sales approximating $850 million. The sale of Coldform Special Products, a manufacturer of starter and suspension components and steering hubs, was completed in October and the sale of Sierra International Inc., a manufacturer and distributor of marine and power equipment engine, drive and hose products, was completed in November. During the first two months of 2000 we completed the sales of our Gresen Hydraulics operations, our constant velocity joint driveshaft business and most of our Warner Electric businesses. Additional information on divestitures completed in 1997 through 1999 can be found in “Note 19. Divestitures” on page 38 of our 1999 Annual Report.
Under a program authorized by our Board in April 1999, we repurchased nearly three million shares of our common stock in 1999 at a cost of $100 million. We have accelerated our activity in 2000 using the proceeds from the divestitures described above and expect to complete the initial $350 million program by the end of the first quarter of 2000. At its February 2000 meeting, the Board authorized additional repurchases of up to $250 million through the end of 2000.
We have realized savings from the integration of the Echlin and Glacier Vandervell operations in 1999 and have targeted further savings at these and other operations in the future. Integration efforts will also be initiated at the newly acquired business described previously.
GEOGRAPHICAL AREAS
We maintain administrative organizations in four regions - North America, Europe, South America and Asia Pacific - to facilitate financial and statutory reporting and tax compliance on a worldwide basis and to support the seven SBUs.
Our operations are located in the following countries:
Our non-U.S. subsidiaries and affiliates manufacture and sell a number of products similar to those produced in the U.S. In addition to normal business risks, operations outside the U.S. are subject to others such as changing political, economic and social environments, changing governmental laws and regulations, currency revaluations and market fluctuations.
Consolidated non-U.S. sales were $3.7 billion, or 28% of our 1999 sales. Including U.S. exports of $939 million, non-U.S. sales accounted for 36% of 1999 consolidated sales. Non-U.S. net income was $102 million, or 20% of consolidated 1999 net income. In addition, there was $28 million of equity in earnings of non-U.S. affiliates in 1999.
You can find more information about regional operating results in “Note 13. Business Segments” on pages 33 - 35 of our 1999 Annual Report.
CUSTOMER DEPENDENCE
We have thousands of customers around the world and have developed long-standing business relationships with many of them. Our attention to quality, delivery and service has been recognized by numerous customers who have awarded us with supplier quality awards. Ford and DaimlerChrysler were the only individual customers accounting for more than 10% of our consolidated sales in 1999. We have been supplying products to these companies and their subsidiaries for many years. Sales to Ford, as a percentage of total sales, were 15%, 15% and 16% in 1997, 1998 and 1999, and sales to DaimlerChrysler were 11%, 13% and 14%. Loss of all or a substantial portion of our sales to Ford, DaimlerChrysler or other large volume customers would have a significant adverse effect on our financial results until such lost sales volume could be replaced. There would be no assurance, in such event, that the lost volume would be replaced.
PRODUCTS
As a result of our internal development and acquisition activities in the past several years, we now have nine core products and services. During the past three years, our sales by core product were as follows:
We do not consider our leasing service revenue to be sales and none of our other products are core or account for 10% of sales.
MATERIAL SOURCE AND SUPPLY
Most raw materials (such as steel) and semi-processed or finished items (such as forgings and castings) are purchased from long-term suppliers located within the geographic regions of our operating units. Generally, these materials are available from numerous qualified sources in quantities sufficient for our needs. Temporary shortages of a particular material or part occasionally occur, but we do not consider the overall availability of materials to be a significant risk factor for our operations.
SEASONALITY
Our businesses are not seasonal. However, sales to our manufacturing customers are closely related to the production schedules of those manufacturers.
BACKLOG
Generally, our products are not on a backlog status. They are produced from readily available materials and have a relatively short manufacturing cycle. Each operating unit maintains its own inventories and production schedules and many of our products are available from more than one facility. We believe that our production capacity is adequate to handle current requirements and we regularly review anticipated growth in our product lines to determine when additional capacity may be needed.
COMPETITION
We compete worldwide with a number of other manufacturers and distributors which produce and sell similar products. These competitors include vertically-integrated units of our major original equipment (OE) customers and a number of independent U.S. and non-U.S. suppliers. Our traditional U.S. OE customers, facing substantial foreign competition, have expanded their worldwide sourcing of components to better compete with lower cost imports. In addition, these customers have been shifting research and development, design and validation responsibilities to their Tier 1 suppliers, focusing on stronger relationships with fewer suppliers. We have established operations throughout the world to enable us to meet these competitive challenges and to be a strong global supplier of our core products.
In the area of leasing services, we compete in selected markets with various international, national and regional leasing and finance organizations.
PATENTS AND TRADEMARKS
Our proprietary drivetrain, engine parts, chassis, structural components, fluid power systems and industrial power transmission product lines have strong identities in the markets which we serve. Throughout these product lines, we manufacture and sell our products under a number of patents and licenses which have been obtained over a period of years and expire at various times. We consider each of them to be of value and aggressively protect our rights throughout the world against infringement. Because we are involved with many product lines, the loss or expiration of any particular patent or license would not materially affect our sales and profits.
We own numerous trademarks which are registered in many countries, enabling us to market our products worldwide. Our Spicer®, Parish®, Perfect Circle®, Victor Reinz®, Wix®, Weatherhead®, Boston®, Raybestos®, Aimco®, Clevite®, Glacier® and Vandervell® trademarks, among others, are widely recognized in their respective industries.
RESEARCH AND DEVELOPMENT
Our objective is to be the leader in offering superior quality, technologically advanced products and systems to our customers at competitive prices. To enhance quality and reduce costs, we use statistical process control, cellular manufacturing, flexible regional production and assembly, global sourcing and extensive employee training.
In addition, we engage in ongoing engineering, research and development activities to improve the reliability, performance and cost-effectiveness of existing products and to design and develop new products for existing and new applications. Our spending on engineering, research and development and quality control programs was $248 million in 1997, $275 million in 1998 and $290 million in 1999.
EMPLOYMENT
Our worldwide employment (including consolidated subsidiaries) was approximately 84,200 at December 31, 1999.
ENVIRONMENTAL COMPLIANCE
We make capital expenditures in the normal course of business as necessary to ensure that our facilities are in compliance with applicable environmental laws and regulations. The cost of environmental compliance was not a material part of our capital expenditures and did not have a material adverse effect on our earnings or competitive position in 1999. We do not anticipate that future environmental compliance costs will be material. You can find more information in “Environmental Compliance and Remediation” under “Note 1. Summary of Significant Accounting Policies” on page 27 of our 1999 Annual Report.
EXECUTIVE OFFICERS
This table contains information about our current executive officers. Unless otherwise indicated, all positions are with Dana. The first six officers listed are the members of Dana’s Policy Committee.
Those officers who are designated in Dana’s By-Laws are elected by the Board annually at its first meeting after the annual meeting of shareholders. The others are appointed by the Board from time to time. None of the officers has a family relationship with any other Dana officer or director or an arrangement or understanding with any Dana officer or other person pursuant to which he was elected as an officer.
ITEM 2
ITEM 2 - PROPERTIES
As shown in the following table, we have nearly 500 manufacturing, distribution and service branch or office facilities worldwide. We own the majority of our manufacturing and larger distribution facilities. We lease a few manufacturing facilities and most of our smaller distribution outlets and financial service branches and offices.
Dana Facilities by Geographic Region
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
We are a party to various pending judicial and administrative proceedings arising in the ordinary course of business. After reviewing the proceedings that are currently pending (including the probable outcomes, reasonably anticipated costs and expenses, availability and limits of our insurance coverage, and our established reserves for uninsured liabilities), we do not believe that any liabilities that may result from these proceedings are reasonably likely to have a material adverse effect on our liquidity, financial condition or results of operations.
Under the rules of the Securities and Exchange Commission, we are required to report certain environmental proceedings involving governmental agencies that are not deemed to be routine proceedings incidental to our business. We are not currently a party to any such proceedings.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- None -
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is listed on the New York and Pacific Stock Exchanges. On February 25, 2000, there were 34,800 shareholders of record.
Dividends have been paid on our common stock every year since 1936. Quarterly dividends have been paid since 1942.
You can find more information in “Shareholders’ Investment” on page 50 of our 1999 Annual Report.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
You can find “Financial Highlights” under “Eleven Year History” on page 51 of our 1999 Annual Report.
ITEM 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You can find “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages 40 - 46 of our 1999 Annual Report.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
You can find information in “Financial Instruments,” “Derivative Financial Instruments” and “Marketable Securities” under “Note 1. Summary of Significant Accounting Policies” on page 27, in “Note 7. Interest Rate Agreements” on page 29 and in “Note 16. Fair Value of Financial Instruments” on page 37 of our 1999 Annual Report.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
You can find our financial statements and the report by PricewaterhouseCoopers LLP dated January 25, 2000, on pages 21 - 39 and “Unaudited Quarterly Financial Information” under “Shareholders’ Investment” on page 50 of our 1999 Annual Report.
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
- None -
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
You can find general information about our directors and executive officers in Part I, Item 1 of this Form 10-K and under “Election of Directors” on pages 1 - 2 in our 2000 Proxy Statement.
You can find information about the filing of reports by our directors, officers and 10% stockholders under Section 16(a) of the Securities Exchange Act of 1934 under “Section 16(a) Beneficial Ownership Reporting Compliance” on pages 16 - 17 in our 2000 Proxy Statement.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
You can find information about executive compensation in the following sections of our 2000 Proxy Statement: “Compensation” on pages 3 - 4 under “The Board and its Committees,” “Executive Compensation” on pages 6 - 13 and “Compensation Committee Report on Executive Compensation” on pages 13 - 16.
You can find information about our stock performance under “Comparison of Five-Year Cumulative Total Return” on page 16 of our 2000 Proxy Statement.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
You can find information about the stock ownership of our directors, officers and 5% stockholders under “Stock Ownership” on pages 4 - 5 of our 2000 Proxy Statement.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
You can find information about transactions between Dana and our directors, officers and 5% stockholders under “Transactions with Management” on page 21 of our 2000 Proxy Statement.
PART IV
ITEM 14
ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
Report of Independent Accountants on
Financial Statement Schedule
To the Board of Directors
of Dana Corporation
Our audits of the consolidated financial statements referred to in our report dated January 25, 2000 appearing in the 1999 Annual Report to Shareholders of Dana Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
PricewaterhouseCoopers LLP
Toledo, Ohio
January 25, 2000
DANA CORPORATION AND CONSOLIDATED SUBSIDIARIES
SCHEDULE II(a) - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
ALLOWANCE FOR DOUBTFUL ACCOUNTS RECEIVABLE
DANA CORPORATION AND CONSOLIDATED SUBSIDIARIES
SCHEDULE II(b) - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
ALLOWANCE FOR CREDIT LOSSES - LEASE FINANCING
(1)
Other items in 1998 include $(28,889,000) from the sale of the Technology Leasing Group portfolio.
DANA CORPORATION AND CONSOLIDATED SUBSIDIARIES
SCHEDULE II(c) - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
VALUATION ALLOWANCE FOR DEFERRED TAX ASSETS
DANA CORPORATION AND CONSOLIDATED SUBSIDIARIES
SUPPLEMENTARY INFORMATION TO FINANCIAL STATEMENTS
COMMITMENTS AND CONTINGENCIES
We are a party to various legal proceedings (judicial and administrative) arising in the normal course of business, including proceedings which involve environmental and product liability claims. You can find additional information in “Note 17. Commitments and Contingencies” on page 37 of our 1999 Annual Report.
With respect to environmental claims, we are involved in investigative and/or remedial efforts at a number of locations, including “on-site” activities at currently or formerly owned facilities and “off-site” activities at “Superfund” sites where we have been named as a potentially responsible party. You can find more information in “Environmental Compliance and Remediation” under “Note 1. Summary of Significant Accounting Policies” on page 27 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages 40 - 46 of our 1999 Annual Report.
With respect to product liability claims, we are named in proceedings involving alleged defects in our products. Such proceedings currently include a large number of claims (most of which are for relatively small damage amounts) based on alleged asbestos-related personal injuries. At December 31, 1999, approximately 82,000 such claims were outstanding, of which approximately 30,000 were subject to pending settlement agreements. We have agreements with our insurance carriers providing for the payment of substantially all of the indemnity costs and the legal and administrative expenses for these claims. We are also a party to a small number of asbestos-related property damage proceedings. Our insurance carriers are paying the major portion of the defense costs in connection with these cases and we have incurred minimal indemnity costs to date.
EXHIBIT INDEX
Note: Exhibits Nos. 10-A through 10-L are exhibits required to be filed pursuant to Item 14(c) of Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DANA CORPORATION
-------------------
(Registrant)
Date: March 10,
By: /S/ Martin J. Strobel
-------------------
Martin J. Strobel, Vice President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Date: March 10,
* /S/ Southwood J. Morcott
-------------------
Southwood J. Morcott, Chairman of the Board
Date: March 10, 2000
/S/ Joseph M. Magliochetti
-------------------
Joseph M. Magliochetti, Director
and Chief Executive Officer
Date: March 10, 2000
/S/ Robert C. Richter
-------------------
Robert C. Richter, Chief Financial Officer
Date: March 10, 2000
/S/ Charles W. Hinde
-------------------
Charles W. Hinde, Chief Accounting Officer
Date: March 10, 2000
* /S/ B.F. Bailar
-------------------
B.F. Bailar, Director
Date: March 10,
* /S/ A.C. Baillie
-------------------
A.C. Baillie, Director
Date: March 10, 2000
* /S/ E.M. Carpenter
-------------------
E.M. Carpenter, Director
Date: March 10, 2000
* /S/ E. Clark
-------------------
E. Clark, Director
Date: March 10, 2000
* /S/ G.H. Hiner
-------------------
G.H. Hiner, Director
Date: March 10, 2000
* /S/ M.R. Marks
-------------------
M. R. Marks, Director
Date: March 10, 2000
* /S/ R.B. Priory
-------------------
R. B. Priory, Director
*By: /S/ Martin J. Strobel
-------------------
Martin J. Strobel, Attorney-in-Fact | 4,090 | 26,915 |
1009918_1999.txt | 1009918_1999 | 1999 | 1009918 | ITEM 1. BUSINESS
Atlanta-based NOVA Corporation is a provider of integrated transaction-processing services, related software applications, and value-added services for over 500,000 merchant locations. NOVA's target customers include small to medium-sized business enterprises that require a full spectrum of processing services, as well as community banks and financial institutions that desire to provide their merchant customers with payment processing. NOVA has continued to focus on the processing sector comprised of primarily small to medium-sized merchants, because they have been historically overlooked and benefit from the advantages of value-added services usually offered only to large, nationally based merchants. NOVA provides transaction processing support for all major credit, charge and debit cards, including VISA, MasterCard, American Express, Discover, Diner's Club, and JCB, as well as check verification services. The aggregate dollar volume of VISA and MasterCard transactions NOVA processed in 1999 exceeded $57 billion.
NOVA provides merchants with a broad range of transaction processing services, including authorizing card transactions at the point-of-sale ("POS"), capturing and transmitting transaction data, effecting the
settlement of payments, and assisting merchants in resolving billing disputes with their customers. In addition, NOVA has developed several software applications that can be delivered to its customers and updated for enhancements via NOVA's proprietary telecommunications network (the "NOVA Network"). The NOVA Network, initially developed by NOVA in conjunction with MCI WorldCom, Inc. ("MCI WorldCom"), is the principal conduit through which NOVA provides its services. By combining its ability to employ technology effectively with the capabilities of the NOVA Network, NOVA is able to respond quickly and efficiently to the ever changing and diverse needs of its merchant customers.
NOVA was incorporated in Georgia in December 1995 pursuant to an alliance between NOVA and First Union Corporation ("First Union"). NOVA Information Systems, Inc. ("NOVA Information Systems"), a wholly-owned subsidiary of and predecessor to NOVA, was incorporated in Georgia in February 1991. On September 24, 1998, NOVA acquired PMT Services, Inc. ("PMT") in a merger transaction, whereby PMT became a wholly-owned subsidiary of NOVA (the "PMT Merger"). Unless the context otherwise requires, references in this Annual Report on Form 10-K to "NOVA" or "the Company" refer to NOVA Corporation and its subsidiaries.
SIGNIFICANT TRANSACTIONS, ALLIANCES AND MARKETING ARRANGEMENTS
CoreStates Portfolio. Pursuant to an agreement dated October 8, 1998, NOVA acquired the merchant processing portfolio of First Union National Bank of Delaware ("FUBD"), successor by merger to CoreStates Bank of Delaware, N.A. ("CoreStates"). FUBD is a wholly-owned subsidiary of First Union. The purchase included all right, title, and interest in and assumption of certain liabilities of CoreStates' merchant processing portfolio. The portfolio represented annualized credit and debit card processing volume of approximately $3.1 billion as of the date of the transaction.
PMT Merger. Effective September 24, 1998, NOVA acquired PMT in a merger transaction (the "PMT Merger") accounted for as a pooling of interests. Accordingly, the financial statements for all periods presented are restated to include the historical financial information of the combined operations for NOVA and PMT. PMT is an independent sales organization ("ISO") that markets and services electronic credit card authorization and payment systems to merchants located throughout the United States. PMT experienced significant growth by utilizing operating and growth strategies focused on expanding its customer base of small to medium-sized merchants through merchant portfolio purchases, trade and other association affiliations, telemarketing efforts, and subsidiary sales force acquisitions.
Key Merchant Services. In January 1998, NOVA purchased from KeyBank National Association a 51% interest in Key Merchant Services, LLC ("KMS"). Pursuant to this agreement, NOVA provides transaction processing services to the merchant customers of KMS and is responsible for its operation and management. Upon consummation of this transaction, the KMS merchant portfolio represented approximately $5.1 billion in annualized credit and debit card processing volume.
MBNA Portfolio Purchase. On December 30, 1997, NOVA purchased substantially all of the merchant portfolio of MBNA America Bank, N.A. ("MBNA"). In connection with the transaction, MBNA agreed to cooperate with NOVA in marketing NOVA's merchant transaction processing services and to refer exclusively to NOVA all merchants, trade associations, financial institutions, ISOs and other organizations that request or evidence an interest in merchant transaction processing services. NOVA, among other things, is required to pay to MBNA a fee for each merchant that enters into a merchant transaction processing contract with NOVA as a result of a referral from MBNA. NOVA is also required to pay to MBNA a percentage of the portfolio's net revenues. NOVA's marketing agreement with MBNA has an initial term expiring December 31, 2007 subject to automatic two-year extensions unless either party gives notice of termination at least seventy-five days prior to an expiration date. The MBNA portfolio represented annualized credit and debit card processing volume of approximately $1.0 billion on the date of the transaction.
Elan Merchant Services. Effective October 31, 1997, NOVA purchased from Firstar Bank U.S.A., N.A. ("Firstar") a 51% interest in Elan Merchant Services, LLC ("Elan"). Pursuant to this agreement, NOVA provides transaction processing services to the merchant customers of Elan and is responsible for its
operation and management. As of the date of purchase, the Elan portfolio represented annualized credit and debit card processing volume of approximately $3.0 billion.
INDUSTRY OVERVIEW
The transaction processing industry provides merchants with credit, charge and debit card and other payment processing services, as well as related information services. This industry has grown rapidly in recent years as a result of wider merchant acceptance and increased consumer use of such cards and advances in transaction processing and telecommunications technology. These factors, together with efficiencies derived from economies of scale, have resulted in the consolidation of transaction processing providers and the availability of more sophisticated products and services to all market segments.
Increased Growth in Card Use. The proliferation in the uses and types of credit, charge and debit cards, rapid technological advances in transaction processing, and financial incentives offered by credit card associations and issuers have contributed greatly to wider merchant acceptance and increased consumer use of such cards. For example, industry sources indicate that for the year ended December 31, 1998, charge volume of VISA and MasterCard and other credit cards grew at an annual growth rate of approximately 8%, to $1.2 trillion. Such sources project that the charge volume of general purpose cards will exceed $2.0 trillion by 2005. Industry sources also anticipate further increases in credit and charge card acceptances as the number of general purpose cardholders increases to an expected 166 million over the same period. In 1998, the expanded use of debit cards as an alternative to cash and checks at the point of sale increased 42% over 1997, to $168.5 billion. Industry sources anticipate that consumers increased usage of debit cards will eclipse the growth of credit cards in future years. In 1998, 73% of transactions processed were with credit cards. Industry sources further predict that by the year 2010 transactions processed with credit cards will decrease to 41% as a result of increasing debit card use. (The Nilson Report -- December 1999).
Technology. Rapid technological advances in transaction processing, particularly the transition from paper-based to electronic processing, have contributed greatly to wider merchant acceptance and increased consumer use of such cards. Electronic processing provides greater convenience to merchants and consumers, reduces fees charged to merchants, and facilitates faster and more accurate settlement of payments. Increased card acceptance and usage, coupled with technological advances in electronic processing, have created an opportunity for service providers to offer a variety of sophisticated processing and information services to a broader base of merchants.
At present, many large transaction processors continue to provide customer service and applications via legacy systems that often are difficult and costly to alter, enhance, or customize. Accordingly, transaction processors that continue to utilize these systems for customer service and applications may find it difficult to meet the increasing demands of small to medium-sized merchants for more sophisticated products and services tailored to their diverse and changing needs. In contrast to less flexible legacy systems, transaction processors utilizing less costly, scalable and networked computer systems, (including distributed client/server architecture and relational database management systems solutions), enjoy greatly improved flexibility and responsiveness in providing customer service and applications to its customer base. In addition, the use of fiber optic and advanced switching technologies in telecommunications networks and competition among long-distance carriers further enhance the ability of processors to provide faster and more reliable service at lower per-transaction costs than previously possible.
As a result of advances in personal computer and POS terminal technologies, transaction processors can provide merchants with expanded access to a greater array of sophisticated services at the POS, resulting in increased demand for such services. In addition, merchant use of increasingly sophisticated integrated cash registers and networked systems has created further demand for comparably advanced and sophisticated products and services accessible at the POS. These trends have created opportunity for transaction processors to leverage technologies by developing business management and other software application products and services.
Segmentation of Merchants and Service Providers. The transaction processing industry is characterized by a small number of large transaction processors that focus primarily on servicing large merchants and by
many smaller transaction processors that provide a limited range of services to small to medium-sized merchants. Large merchants (i.e., those with multiple locations and high volumes of card transactions) typically demand and receive the full range of transaction processing services as well as customized information services at low per-transaction costs. By contrast, transaction processors historically have not offered small to medium-sized merchants the same level of services as large merchants or relatively low per-transaction costs offered to larger merchants. The growth in card transactions and the transition from paper-based to electronic transaction processing, however, have caused small to medium-sized merchants increasingly to demand sophisticated transaction processing and information services similar to those provided to large merchants.
Community and regional banks and ISOs are the primary groups that market and sell transaction processing services to small to medium-sized merchants. Typically, these banks and ISOs outsource all or a portion of the transaction processing services they offer. It is difficult, however, for banks and ISOs to provide sophisticated value-added services or to customize transaction processing services for the small to medium-sized merchant on a cost-effective basis. Accordingly, services to small to medium-sized merchants historically have been characterized by basic transaction processing services without the availability of the more sophisticated processing, information-based services, or customer support offered to large merchants.
Consolidation. The transaction processing industry has undergone rapid consolidation over the last several years. The costs to convert from paper-based to electronic processing and merchant demand for improved customer service and additional customer applications have made it difficult for community and regional banks and ISOs to remain competitive. Many of these processors are unwilling or unable to invest the capital required to meet evolving market demands, and are increasingly exiting the transaction processing business, or otherwise seeking alliance partners to provide transaction processing to their customers. Despite this ongoing consolidation, the industry remains fragmented. Management believes that although the ten largest bankcard processors account for a significant portion of the total charge volume processed there are several hundred additional registered service providers marketing and selling transaction processing services to merchants . Management believes that these factors will result in continuing industry consolidation opportunities over the next several years.
MERCHANT SERVICES PROVIDED BY NOVA
Authorization Services. NOVA provides electronic transaction authorization services for all major credit, charge and debit cards. Authorization generally involves approving a cardholder's purchase at the POS, after verifying that the card has not been reported lost or stolen and that the purchase amount is within the cardholder's credit or account limit. The electronic authorization process for a credit card transaction begins when the merchant "swipes" the card through its POS terminal and enters the amount of the purchase. After capturing the data, the POS terminal transmits the authorization request via the NOVA Network to NOVA's switching center, where the data is routed to the appropriate credit card association for authorization. The credit card association then approves or declines the transaction and the response is transmitted back to NOVA's switching center, where it is routed to the appropriate merchant.
Data Capture and Reporting Services. At the time of authorization, data relating to the transaction, such as the purchase price and card number, is recorded electronically both at the merchant's POS terminal and by NOVA. This data replication maximizes NOVA's ability to reconcile transaction data with each merchant and to protect against potential loss of data. On a periodic basis throughout the day, the merchant aggregates and organizes this transaction data, using a software application that NOVA has programmed into the merchant's POS terminal, and transmits this information to NOVA where it is organized into various files. These files are generally transmitted to either Vital Processing Services L.L.C. ("Vital"), Mellon Bank ("Mellon"), or First Data Resources ("FDR") (collectively "merchant accounting vendors"), for merchant accounting as described below. NOVA maintains a file in its database from which NOVA runs "Witness," its proprietary fraud detection software program against each of the day's transactions processed via the NOVA Network. NOVA also utilizes this information to provide merchants with information services such as specialized management reports and to facilitate its other customer service operations. Merchants can access
this archived information through NOVA's customer service representatives or through applications such as NOVA ACS, which allow the merchant direct access to NOVA's database through a personal computer.
Settlement, Accounting and Clearing Services. NOVA assigns each of its merchant customers to a merchant accounting vendor which performs merchant accounting services on NOVA's behalf. At least once each day, NOVA forwards transaction data regarding its merchant customers to the merchant accounting vendors. The merchant accounting vendors reorganize and accumulate the data on a merchant-by-merchant and card issuer-by-card issuer basis and forward the data to the credit card associations for ultimate payment. On a monthly basis, each merchant accounting vendor sends statements to NOVA's merchant customers for whom they provide settlement and accounting services, detailing the previous month's transaction activity.
NOVA is registered with VISA and MasterCard as a certified processor and member service provider. Regions Bank, Bank of the West, Imperial Bank, First National Bank of Omaha ("FNBO"), Zions Bank, Firstar, KeyBank and First Union National Bank ("FUNB") a subsidiary of First Union, serve as the primary member clearing banks for NOVA. NOVA's clearing banks receive payment for merchant transactions from the credit card associations (net of fees payable to the credit card associations and card issuing banks), from which the clearing banks remit payment to the merchant for the gross amount of the merchant's transactions. Once each month, NOVA collects applicable merchant discount and other fees from each merchant for transactions effected and services provided during the preceding month.
Chargeback Services. In the event of a billing dispute between a cardholder and a merchant, NOVA assists the merchant in investigating and resolving the dispute. These billing disputes include, among others: (i) non-receipt of merchandise or services; (ii) unauthorized use of a credit card; and (iii) quality of the goods purchased or the services rendered. NOVA provides a sophisticated chargeback control system for its merchants and utilizes proprietary software programs to actively prescreen disputes. The chargeback control system enables NOVA to reduce the time and expense spent on cardholder requests for chargebacks. In the event a billing dispute between a cardholder and a merchant is resolved in favor of the cardholder, the transaction is "charged back" to the merchant and that amount is credited or otherwise refunded to the cardholder. If NOVA or its clearing banks are unable to collect such amounts from the merchant's account, and if the merchant refuses or is unable to reimburse NOVA for the chargeback, NOVA bears the loss for the amount of the refund paid to the cardholder.
Customer Service and Support. NOVA provides its merchant customers with a variety of customer services and support. These services include the provision of POS terminals (on a sale or lease basis), software application downloads for POS terminals, POS terminal maintenance and customized software for merchant development. In addition, NOVA maintains a 24-hour-a-day, seven-day-a-week helpline staffed by full-time customer service representatives.
TECHNOLOGY
One of NOVA's principal strategies is to utilize available technologies to deliver transaction processing and related software application products and services on a cost-effective basis. To effect this strategy, NOVA regularly adapts and uses technologies developed for applications outside the transaction processing industry. In particular, technologies developed for networked computing and the telecommunications market have been important to the NOVA Network and NOVA's service capabilities. In addition, NOVA exercises significant control over the development and enhancement of the combination of hardware, software and network services that comprise its transaction processing and information delivery system. This provides NOVA with greater control over the functionality, quality, reliability, cost and efficiency of its transaction processing services and related software application products and services.
The NOVA Network. The NOVA Network, initially developed in conjunction with MCI WorldCom, is NOVA's proprietary telecommunications platform and the principal conduit through which NOVA provides services to merchants. The NOVA Network's design provides efficient switching capabilities, resulting in rapid response time for transaction authorizations. The NOVA Network employs high speed switching and routing communications, supplying substantial capacity capable of supporting sophisticated value-added services. In working with MCI WorldCom, NOVA designed a network specifically tailored to the services NOVA desired
to provide, the equipment needed to furnish those services and the functionality those services were designed to achieve. As customer needs change and as technology improves, management believes that it will be able to adapt and customize the NOVA Network as necessary to achieve the functionality it desires. Currently, both MCI WorldCom and AT&T Corp. provide long-distance service as well as technical support for the NOVA Network. NOVA's long distance service and support agreement with MCI WorldCom expires in July 2001. The agreement is subject to earlier termination by NOVA if MCI WorldCom fails to meet certain agreed-upon performance objectives. Local access is provided by a subsidiary of MCI WorldCom and by BellSouth Corporation.
The NOVA Network utilizes Integrated Services Digital Network ("ISDN") and its associated Non-Facilities Associated Signaling ("NFAS") features. The NFAS features of the NOVA Network facilitate portability of the NOVA Network to long-distance and local telecommunications access. This enhanced portability enables NOVA to utilize alternate long-distance providers, and, therefore, to demand competitive tariffs. NOVA has developed and tested a network interface with other long-distance providers and management believes that, if necessary or convenient, NOVA could utilize the telecommunications access of other providers in connection with the NOVA Network. Management believes that transferring the NOVA Network to AT&T, or another telecommunications access provider, can be accomplished without sacrificing any significant performance or operational attributes of the NOVA Network, although such a transfer may increase NOVA's expenses for network services.
The reliability of the NOVA Network is enhanced by the backup service provided by AT&T. The existence and maintenance of this backup system, which is designed so no single element is shared with the principal MCI WorldCom system, enhances NOVA's ability to provide a high level of reliability in its network service. Through an agreement with Electronic Data Systems Corporation, NOVA maintains a voice authorization backup system. This backup system allows merchants to receive voice authorization of transactions in the event of a POS terminal malfunction, network outage or other similar circumstances.
Another advantage of the NOVA Network is its proprietary "TCP/IP" routing network, which provides greater resiliency and routing capabilities compared to transaction processing companies that employ a front-end processor switch and a back end switch. After a POS transaction reaches the NOVA Network via either MCI WorldCom or AT&T, it is immediately converted to TCP/IP protocol. Once converted, the transaction is switched and routed through the NOVA Network via the optimal path. NOVA maintains a fully redundant, three-tier meshed network utilizing 3COM Corporation switches and routers. In addition, NOVA uses Open Shortest Path First ("OSPF") routing protocol to ensure the optimal path is always utilized between the modems on the network front-end and the NOVA hosts that switch transactions to the credit and debit card networks. OSPF also ensures speedy network re-routing in the event of hardware failure.
Because the NOVA Network is TCP/IP based, and the Internet is a large, public TCP/IP network, processing Internet-originated transactions is a logical extension of NOVA's core competency.
Software Development for POS Terminals and PCs. NOVA continuously develops new software applications for POS terminals and PCs in an effort to improve existing and create additional product and service offerings. NOVA's software development capability is critical to its ability to respond flexibly to changing customer needs and improving technologies. NOVA has programmed most of the POS terminals utilized by its merchant customers with specific applications. By programming POS terminals, NOVA can avoid the limitations of the preexisting applications programmed into POS terminals, which are designed for broad applicability to a wide range of users, and can provide its merchant customers with specifically tailored applications at an increased level of functionality. Since NOVA generally distributes such software application products by downloading such applications over the NOVA Network, merchants are able to utilize NOVA's products and services quickly and inexpensively.
As NOVA's merchants increase their use of PCs and fully-integrated cash registers and payment systems, NOVA is extending its POS terminal software application product and service offerings to PCs and expanding the number of its products and services available for PC use or that otherwise allow the POS terminal to interface with a PC. For instance, NOVA ACS, PC Transact_It, and NOVA Shadow Pay are PC-based applications. While merchant use of such products and services currently is limited, and there can be no
assurance that such products and services will be widely accepted, NOVA expects such use to increase. NOVA and First Union are actively pursuing with KeyBank and other third parties initiatives relating to transaction processing via the Internet and procurement and purchasing cards. Management believes that these and other efforts may result in the development of additional software application products and value-added services.
NOVA actively encourages third party software developers to write applications to NOVA's specifications and network protocols. These applications, once certified by NOVA, allow integration of NOVA's transaction processing services with the business management software created by such developers for use at the merchant's POS. For example, NOVA recently developed NOVA TransPort, which consists of client and server software that encrypts transactions via the Internet. NOVA makes their client application programmer interface (API) software available to value-added resellers ("VARs"), such as GO Software, Inc., to integrate into their applications. GO Software, Inc. (now part of ShopNow.com's eBusiness unit), one of the first VARs to integrate this software into their application line, has several products capable of sending encrypted transactions via the Internet directly to NOVA for processing. Merchants enjoy dedicated, leased-line performance at Internet connection costs for transaction processing. In this way, VARs indirectly perform a marketing function for NOVA since they frequently market their software on a fully-integrated basis with NOVA's transaction processing services, creating additional opportunities to reach small to medium-sized merchants. NOVA has certified in excess of 200 third party software developers, including Aluim Payment Groups, Atomic Software, Southern DataCom, Inc., Datacap, Inc., Tellen Software Inc., and UniPay.
Use of Networked Systems for Customer Service. As a result of the information access and retrieval capabilities of networked systems, which provide real-time information to any of NOVA's customer service representatives, NOVA can provide a level of customer service and support to small to medium-sized merchants historically available only to much larger merchants. For example, any of NOVA's customer service representatives may access, on a real-time basis, all of the relevant information pertaining to any particular merchant that may call and ask for assistance. NOVA has also implemented an on-line, informational database that provides NOVA's customer service representatives user-friendly access to an array of additional information relative to NOVA's services, products and systems, which allows NOVA to more quickly and effectively resolve customer service inquiries. Additionally, the NOVA Network is highly automated and requires minimal staffing, which allows NOVA to contain costs and achieve greater operating efficiencies.
SOFTWARE APPLICATION PRODUCTS AND VALUE-ADDED SERVICES
In addition to card transaction processing, NOVA offers related software application products and value-added services to its merchant customers. NOVA designed these products and services to run on existing POS terminals and DOS-and Windows-based PCs. An integral part of NOVA's strategy is make available a broad range of products and services historically unavailable to small to medium-sized merchants. By doing so, NOVA seeks to differentiate itself among the banks and ISOs serving this portion of the market. Management believes that the quality and reliability of its products and services enhance NOVA's ability to attract and retain merchant customers.
NOVA currently offers a variety of software application products and value-added services, including the following core products and services that are basic to the NOVA Network:
NOVA Encompass. NOVA Encompass is the latest generation of NOVA's user interface. NOVA presently provides NOVA Encompass to all new merchant customers, and generally charges a one-time fee to upgrade existing merchants to NOVA Encompass. In addition to NOVA's core transaction processing services, NOVA Encompass enables merchants to access NOVA's software application products and value-added services, including those described below. NOVA Encompass also allows the merchant to access other business management applications, including customized end-of-day processing (allowing, for instance, the performance by the merchant of daily audit functions) and other review and reporting features (e.g., summary report generation). Designed as a flexible "modular" system, NOVA Encompass allows the merchant to add features and capability as its business needs evolve.
NOVA Shadow Pay. NOVA Shadow Pay addresses the increasing use by merchants of integrated and modem-enabled PCs. NOVA Shadow Pay eliminates the necessity of a traditional, stand-alone POS terminal. NOVA Shadow Pay is a PC application that allows the merchant's modem-enabled PC to capture the transaction data that is keyed or otherwise input into the cash register or PC, and transmits such data for authorization and processing, eliminating both the need for a stand-alone POS terminal and redundant keying of transaction data. In addition, NOVA Shadow Pay provides the merchant access to certain review and reporting features allowing, for instance, the merchant to more easily reconcile transaction activity for any given period with the data captured and stored by the merchant's PC. NOVA charges a one-time license fee for access to NOVA Shadow Pay.
NOVA Mass Transact and PC Transact_It. NOVA Mass Transact is a large-volume transaction processing application that NOVA developed specifically for businesses processing large numbers of credit card transactions on a batch basis. A merchant using NOVA Mass Transact (typically one that accepts a large number of credit card transactions by telephone or mail) assembles a batch file of transactions and the merchant's mainframe transmits that information to NOVA for processing. Insurance companies and magazine publishers, each of which process large numbers of transactions for recurring payments such as insurance premiums and subscription renewals, respectively, are examples of the type of merchant customers who currently utilize NOVA Mass Transact. PC Transact_It is a similar application that allows PCs, rather than mainframes, to process transactions on a batch basis. Merchants who subscribe to NOVA Mass Transact or PC Transact_It pay a one-time license fee and a percentage of the amount of each transaction processed.
InnResponse and NOVALodge. InnResponse and NOVALodge are transaction processing applications designed to address the special needs of the hospitality industry. InnResponse is a lodging solution for small hotels and motels and tracks check-in and check-out data by portfolio. NOVALodge is a PC-based application for larger hospitality facilities and accommodates multiple terminals at a front desk as well as multiple on-site locations such as restaurants, gift shops or golf facilities. Enhanced reporting provides totals and allows sorting by terminal or location.
NOVA Gratuit. NOVA Gratuit is a transaction processing application designed specifically for use by restaurants. NOVA Gratuit tracks server data and includes "tip" capability and enhanced reporting capabilities. Similar to NOVA Encompass, NOVA Gratuit software integrates a time clock into the software as well as a frequent diner program.
In addition to NOVA's core products and services, NOVA offers the following value-added software applications and services:
NOVA ACS. NOVA ACS (Automated Customer Service) is a PC-based system that enables NOVA's bank alliance and ISO partners to access NOVA's databases in order to track and compile the transaction processing activity of their respective merchant customers. Merchants also utilize NOVA ACS to access NOVA's databases to track and compile information regarding their own transaction activity. Through such access and related information retrieval capabilities, NOVA ACS expands greatly the banks', ISOs' and merchants' ability to design and obtain customized informational reports and, in the case of banks and ISOs, to perform for their merchant customers a variety of customer service related activities. NOVA ACS, which was introduced in 1997, incorporates retrieval and chargeback information as well as on-line statements. These enhancements give the ISO, bank or merchant the opportunity to retrieve information on-line.
Cellular Digital Packet Data. Cellular Digital Packet Data, marketed under the name "TRAVERSE," uses cellular airwaves, as opposed to traditional phone lines, enabling wireless transaction authorization and processing. NOVA currently has agreements with AT&T Wireless Services, GTE Corporation and Bell Atlantic NYNEX Mobile to provide cellular transmission services. TRAVERSE enables transaction authorization and processing in environments where traditional phone lines are unavailable, inconvenient and/or prohibitively expensive, affording merchants increased flexibility, mobility and security in processing card transactions. Further, TRAVERSE allows merchants that have relied on paper-based processing, where the ability to check if a card is stolen or credit limits exceeded is generally unavailable or inconvenient, to convert to electronic processing. In so doing, such merchants can also avoid the higher rates imposed by each of VISA and MasterCard for paper-based transactions.
BellSouth Wireless Data. NOVA also has wireless transaction services through BellSouth Wireless Data's MOBITEX service, a nationwide network covering approximately 93% of the metropolitan United States. This wireless service provides many of the same features and functions as the CDPD wireless networks -- also freeing the user from the traditional phone line. For instance, the BellSouth Wireless Network was chosen by 3COM's Palm division to power their Palm VII wireless Palm Pilots because of the nationwide coverage it provides. For NOVA's wireless Point of Sale customers this gives them the same mobile processing capabilities regardless of their geographical location. They can use their wireless POS terminal anywhere there is coverage without making any modifications to their terminal.
Internet Processing. NOVA is actively pursuing development initiatives relating to transaction processing services on the Internet and other forms of electronic commerce. NOVA is exploring with KeyBank and other third parties several Internet-related opportunities, which include processing transactions via the Internet, accepting merchant applications via the Internet and developing, on behalf of merchants, "home-pages" on the Internet. In addition, NOVA has entered into agreements with several companies which will provide to NOVA encryption services (a security measure) for transactions processed via the Internet. These Internet-related initiatives are still in formative stages and security is the prevailing issue and concern. NOVA, however, is active in the development process and management believes that the Internet may, ultimately, become another distribution channel for NOVA's products and services.
Electronic Gift Card. NOVA's Electronic Gift Card ("EGC") program is an automated application that encourages customer loyalty by allowing merchants to sell electronic gift cards redeemable for merchandise in their stores. The gift cards are activated for a pre-determined amount through a POS terminal and are available in disposable (one-time use) and re-loadable (additional value can be added) form.
CUSTOMER BASE
NOVA's merchant customer base consists primarily of small to medium-sized merchants, with a historic concentration in the restaurant, specialty retail, furniture, automobile repair and lodging industries. In addition, banks also are customers of NOVA insofar as those banks accept credit card cash advance transactions. While NOVA's merchants vary significantly in size, a typical merchant customer generates approximately $100,000 in annual charge volume. Although NOVA focuses on small to medium-sized merchants, NOVA also serves a significant number of large merchants and has in place the technical, operational and management infrastructure necessary to continue to serve large merchants. For the years ended December 31, 1999 and 1998, no merchant customer accounted for more than 2% of NOVA's revenues. At December 31, 1999, NOVA provided transaction processing services to more than 500,000 merchant locations nationwide.
NOVA generally enters into direct contractual relationships with its merchants, thereby reducing NOVA's financial risks in the event any of NOVA's bank alliance relationships terminate. In contrast to NOVA's approach, the typical transaction processor/bank relationship involves a processor negotiating with a bank to serve all of the bank's merchants, with the bank maintaining direct control over each merchant relationship. Such a structure exposes the processor to the risk that each of the merchant relationships, and the associated revenues, easily could be jeopardized if, for example, the bank were to sell its merchant business portfolio to an acquiror that provided its own transaction processing services.
MARKETING
NOVA markets its services through three principal channels:
- bank alliances, including joint ventures,
- ISO partnering, and
- direct sales and other marketing efforts.
In addition, NOVA engages in marketing efforts that include marketing agreements with various trade and other associations and marketing through value-added resellers that integrate NOVA's transaction processing services with specialized business management software.
Bank Alliances Through bank alliances, NOVA offers its services to merchants in cooperation with community and regional banks, allowing NOVA to capitalize on the banks' presence in particular geographic markets. NOVA's primary bank alliances are with First Union, Regions Bank, Bank of the West, Crestar Bank, MBNA, and, through NOVA's joint ventures, KeyBank and Firstar. These relationships provide NOVA the opportunity to further its market penetration and increase the size of its customer base through the marketing assistance, support and exclusive merchant referrals provided by the participating banks. NOVA's bank alliances consist of four types of relationships:
- "Acquisition Alliances" created as a result of NOVA's purchase of a bank's merchant portfolio, pursuant to which NOVA provides transaction processing services on a co-branded basis with such bank;
- "Joint Venture Alliances," generally in the form of a limited liability company owned jointly by NOVA and a bank, pursuant to which NOVA provides transaction processing services and the bank provides marketing and referral services to the joint venture;
- "Agent Bank Alliances" pursuant to which a bank purchases NOVA's services and markets and resells those services directly to merchants; and
- "Bank Referral Alliances" whereby a bank refers to NOVA merchants who desire or otherwise inquire about transaction processing services.
Pursuant to its Acquisition Alliances and Joint Venture Alliances, NOVA offers banks the opportunity to transfer management and operational responsibility for their merchant portfolios to NOVA either directly or through the joint venture. NOVA's Acquisition Alliance and Joint Venture Alliance partners continue to offer transaction processing services on a co-branded basis in cooperation with NOVA or the joint venture. In connection with Acquisition Alliances and Joint Venture Alliances, NOVA or the joint venture may maintain transaction processing salespersons on-site at the bank partner's branch locations. The salespersons service existing merchant customers and market and sell NOVA's processing services to new merchant customers. As a result of this structure, NOVA can often effect a nondisruptive transition of services from the merchants' perspective following the creation of the Acquisition or Joint Venture Alliance. To facilitate this transition process and to assist its Acquisition Alliance and Joint Venture Alliance partners, NOVA has created an intensive training program whereby NOVA's personnel train and educate its Acquisition Alliance and Joint Venture Alliance partners in all aspects of NOVA's transaction processing services, software application products and value-added services.
NOVA compensates its bank alliance partners through varying means. NOVA typically compensates its Acquisition Alliance partners by remitting to them a residual for each transaction that NOVA processes for merchants attributable to the alliance. NOVA compensates its Bank Referral Alliance partners typically by paying them a one-time referral fee. NOVA does not directly compensate its Agent Bank Alliance partners as they derive revenue by reselling NOVA's services to merchants at a price determined by the agent bank.
NOVA has expanded its alliance efforts through a marketing agreement with Kessler Financial Services L.P. ("Kessler"), an independent marketing organization. Pursuant to this agreement, Kessler identifies potential alliance or acquisition prospects for NOVA. NOVA's agreement with Kessler is scheduled to expire June 30, 2001, subject to renewal for two additional years unless either NOVA or Kessler gives notice of termination prior to the expiration of the initial term.
NOVA also employs a direct sales force that markets the services of NOVA on behalf of NOVA's alliance, ISO and joint venture partners. The internal sales force includes a national account sales team that supports Acquisition Alliances and Joint Venture Alliances in signing larger and more technologically sophisticated merchants.
ISO Partnering. With the acquisition of the merchant portfolio of the Bank of Boulder in December 1994, NOVA made its first significant entry into the ISO marketing channel. NOVA significantly expanded its presence in this channel through the PMT Merger. NOVA's ISO partners market NOVA's products in conjunction with other products offered by the ISO, such as card readers and related equipment. Generally, ISO partnering involves engaging an ISO to market and sell NOVA's products and services on a non-exclusive basis. An ISO that desires to refer a merchant customer to NOVA will procure the merchant's application and submit it to NOVA on the merchant's behalf. Thereafter, if the application is approved, the ISO will sell or lease point of sale terminals and related hardware and software to such merchant. NOVA compensates ISO's by paying them a residual for each transaction processed by NOVA for merchants referred to NOVA by the ISO. The ISO's determination of whether to refer a particular merchant to NOVA depends on a variety of factors, including the terms of the residual offered by NOVA and the industry in which the merchant conducts its business.
Other Marketing Efforts. In addition to bank alliances and ISO partnering, NOVA engages in other marketing efforts that management believes complement and diversify further NOVA's overall marketing strategy:
Association Marketing. NOVA has marketing agreements with approximately 300 trade and other associations. Through its association marketing program, NOVA negotiates and enters into marketing agreements whereby associations endorse and promote to their membership the transaction processing services provided by NOVA, creating additional opportunities for NOVA to reach small to medium-sized merchants.
Marketing Through Value-Added Resellers. NOVA's marketing efforts are diversified further through the integration of its transaction processing services with the specialized business management software of a growing number of value-added resellers. Value-added resellers perform a marketing function for NOVA since their software often is offered on a fully-integrated basis with NOVA's transaction processing services, creating additional opportunities for NOVA to satisfy the particular needs of its merchant customers.
Product Offerings. NOVA offers a suite of products and services tailored for the Retail, Hospitality, Lodging, Restaurant, Supermarket, Mail Order/Telephone Order, "Emerging" and Internet markets. NOVA merchants have a variety of products and service options all designed to streamline operations, offer customers choices, and increase operating efficiencies.
- Point-of Sale Solutions
- PC-Based Solutions
- Value- Added Services
- E-Commerce/Internet Solutions
- Credit Card Processing
- Debit, Checks and Other Payment Processing
- State Subsidized Programs (EBT)
- Corporate Purchasing Cards
- Credit Card Processing via Phone Batch Processing
- Connecting Multiple Locations
- PC/Terminal Integration
- PC Based Applications
- Wireless Credit Card Processing
- Detailed Transaction Reporting
- Customer Loyalty Programs
- Address and Card Verification
NOVA periodically reviews its marketing efforts and distribution channels to minimize channel conflict. Although channel conflict among bank alliances, ISO partnering, direct sales and other marketing efforts may occur, to date NOVA has not experienced any significant conflict while pursuing its overall sales strategy.
ACQUISITION STRATEGY
The transaction processing industry has undergone rapid consolidation over the last several years. The costs to convert from paper-based to electronic processing, merchant requirements for improved customer service, and the demands for additional customer applications have made it difficult for community and regional banks and ISOs to remain competitive. Many of these providers are unwilling or unable to invest the capital required to meet these demands, and increasingly are exiting the transaction processing business or otherwise seeking alliance partners to provide transaction processing for their customers. Since inception, NOVA has sought to capitalize on this trend by pursuing an active acquisition strategy and engaging in joint ventures and bank alliances.
NOVA intends to continue to pursue purchases of merchant portfolios and the formation of joint ventures and alliances with other financial institutions in order to facilitate growth, expand NOVA's distribution channels and achieve greater economies of scale. This strategy focuses on the merchant portfolios and related assets of banks and ISOs that no longer desire or are unable to provide efficient and cost-effective transaction processing services. NOVA attempts to structure its acquisitions, joint ventures and alliances both to increase its merchant base and to expand its distribution and marketing capabilities.
NOVA continues to evaluate potential joint ventures and alliances, purchases of merchant portfolios and purchases of ISOs. In addition, each of the First Union and the Crestar marketing relationships may create additional purchase opportunities for NOVA, as NOVA and each of First Union and Crestar have agreed that NOVA generally may, at its option and subject to agreement on price and other terms, purchase from First Union or Crestar any merchant portfolios purchased by First Union or Crestar through whole-bank or other acquisitions. For instance, in October 1998, NOVA acquired the merchant processing portfolio previously owned by CoreStates in connection with a merger transaction between First Union and CoreStates. There can be no assurances, however, (1) as to whether either of the First Union and Crestar relationships will provide future acquisition opportunities; (2) that any such acquisition opportunities can be completed on terms favorable to NOVA, if at all; or (3) as to the timing of such transactions.
RISK MANAGEMENT
NOVA views its risk management and fraud avoidance practices as integral to its operations and overall success because of NOVA's potential liability for merchant fraud, charge-backs and other losses. Risk management and fraud avoidance occur initially at the application stage when NOVA utilizes various criteria to accept or deny merchant applications and to determine the rate structure charged. Such criteria include the applicant's credit history and the industry in which the applicant conducts its business. For higher-risk merchants, NOVA may require a guarantee or an escrow deposit or place a maximum volume limitation on transactions processed.
NOVA's principal tool in its risk management and fraud avoidance program is "Witness," its proprietary rule-based fraud detection software program which allows NOVA to identify potentially fraudulent transactions before funds are transferred to the merchant. Witness runs against each of the day's transactions processed on the NOVA Network, resulting in a computer-generated identification of potentially fraudulent activity. Once identified, individuals analyze and review the suspect transactions to resolve potential problems. This can be accomplished before funds are transferred to the merchant in payment for such transactions. If NOVA needs more time to review a transaction or series of transactions, however, NOVA can specify that the
batches containing the identified transactions be withheld from further processing to allow additional time to attempt to verify the authenticity of such transactions. Witness also allows NOVA to review certain types of transactions on a real time basis. Consequently, NOVA has the ability to intercept and review potentially fraudulent transactions and stop payment or otherwise resolve them, as appropriate, prior to the time when financial liability for such transactions has shifted to NOVA. This ability is critical to NOVA's overall program to control fraud and manage risk and is an example of NOVA's strategy of leveraging available technologies, and the NOVA Network, to its competitive advantage.
Despite NOVA's risk management and fraud avoidance capabilities, NOVA is unable to identify all fraudulent transactions, thereby resulting in financial exposure to NOVA. Further, until NOVA converts each newly acquired merchant account to NOVA's merchant accounting vendors, NOVA is unable to apply fully its risk management and fraud avoidance practices to such merchant accounts.
In connection with portfolio purchases, NOVA reviews any merchant portfolio that it proposes to purchase and determines whether the portfolio meets NOVA's standards and guidelines and is otherwise a suitable acquisition target. The review process includes analyzing the composition of the portfolio, applying uniform standards and underwriting guidelines developed by NOVA to the portfolio and identifying any high-risk merchants contained in the portfolio. If NOVA decides to proceed with the acquisition, NOVA will focus on the high-risk merchants identified by its review and attempt to manage the risk associated with such merchants. Typically, NOVA will seek to exclude high-risk merchants from the portfolio purchase, require the seller of the merchant portfolio to establish a reserve account or require the seller to indemnify NOVA for any liability associated with such merchants. NOVA constantly seeks to refine its due diligence procedures and practices, and management expects to continue to improve its due diligence efforts. Nevertheless, the Company can give no assurance that its due diligence process will identify all high-risk merchants or that NOVA will otherwise properly assess the risk attributes of any purchased portfolio.
MERCHANT ACCOUNTING AND CLEARING BANK RELATIONSHIPS
NOVA relies upon third parties vendors to provide merchant accounting and clearing bank services to NOVA and its merchant customers. In each of these instances, NOVA has engaged multiple providers to safeguard against the loss of services or quality of any one of these providers.
Merchant accounting services consist of reorganizing and accumulating daily transaction data on a merchant-by-merchant and card issuer-by-card issuer basis, and forwarding this data to the credit card associations for ultimate payment. These services are provided by our merchant accounting vendors. In 1999, we implemented internal systems to provide our own merchant accounting services. As of December 31, 1999, approximately 6.5% of NOVA's total volume was being serviced internally.
Clearing Bank Arrangements. NOVA's clearing banks receive payment for merchant transactions from credit card associations (net of fees payable to the credit card associations and card issuing banks), from which the clearing banks remit payment to the merchant for the gross amount of the merchant's transactions. Once each month, NOVA collects applicable merchant discount and other fees from each merchant for transactions effected and services provided during the preceding month. NOVA, along with all other nonbank transaction processors that process VISA and MasterCard transactions, must be sponsored by a financial institution that is a principal member of the VISA and MasterCard credit card associations in order to process these bankcard transactions. Through each of Regions Bank, Bank of the West, Imperial Bank, FNBO, Zions Bank, Firstar, KeyBank and FUNB, which serve as member clearing banks for NOVA, NOVA is registered with VISA and MasterCard as a certified processor and member service provider. NOVA is registered at the highest level of designation for a merchant processor by VISA, Tier 1 Acquirer Processor, and MasterCard, Type I Third Party Processor. While NOVA's registration as a certified processor and member service provider is necessary in order for NOVA to process VISA and MasterCard transactions, management believes that the revocation of such registrations is unlikely and inconsistent to the objectives of both the credit card associations and the clearing banks because of the adverse effect such action would have on the continuity of credit card acceptance.
NOVA's agreements with its principal member clearing banks generally provide that the merchant relationship is controlled by NOVA. Accordingly, NOVA generally is not obligated to continue to utilize the clearing services of these banks, and may transfer the clearing functions to another principal member clearing bank (i.e., any member of the VISA and MasterCard associations), although there can be no assurance that NOVA would be able to find a financial institution to sponsor it on terms acceptable to NOVA.
CUSTOMER SERVICE AND SUPPORT
NOVA is dedicated to providing reliable and effective customer service and support to its merchant customers. The information access and retrieval capabilities of the NOVA Network, where real-time information is available to NOVA's customer service representatives, allow NOVA to provide a level of customer service and support to small to medium-sized merchants historically available only to much larger merchants. For example, any of NOVA's customer service representatives may access, on a real-time basis, all of the relevant information pertaining to any particular merchant that may call and ask for assistance. NOVA also has implemented an on-line, informational database that provides NOVA's customer service representatives user-friendly access to an array of additional information relative to NOVA's services, products and systems, which generally allows NOVA to more quickly and effectively resolve customer service inquiries.
NOVA maintains a 24-hour-a-day, seven-day-a-week helpline at its operations center in Knoxville, Tennessee. NOVA measures the efficiency of its customer service through certain quantitative data such as the number of rings prior to operator pick-up, the number of abandoned calls, the number of calls per day and the number of calls per customer service representative. NOVA has developed comprehensive programs and procedures for training its approximately 315 full-time customer service representatives to assist NOVA's merchant clients in a timely and efficient manner with any problems, issues or concerns they may have. Management is dedicated to providing outstanding customer service and support and continually reviews its policies and procedures in an effort to improve these services.
PROPRIETARY RIGHTS
NOVA has developed proprietary software for use in four principal areas: (i) applications for POS terminals and PCs; (ii) transaction switching; (iii) the NOVA Network; and (iv) customer service and charge-backs. NOVA regards its proprietary software as protected by trade secret, copyright, trademark and patent laws. NOVA attempts to safeguard its software through the protection afforded by the above-referenced laws, employee and third-party non-disclosure agreements, licensing agreements and other methods of protection. Despite these precautions, it may be possible for unauthorized third parties to copy, obtain or reverse engineer certain portions of NOVA's software or to otherwise obtain or use other information NOVA regards as proprietary. While NOVA's competitive position may be affected by its ability to protect its software and other proprietary information, management believes that the protection afforded by trade secret and copyright laws are less significant to NOVA's success than other factors such as the knowledge, ability and experience of NOVA's personnel and the continued pursuit and implementation of its operating strategies.
As the number of software application products in the transaction processing industry increases, and as the functionality of such products further overlaps, third parties could assert that NOVA's software application products infringe or may infringe the proprietary rights of such entities. These third parties may seek damages from NOVA as a result of such alleged infringement, demand that NOVA license certain proprietary rights from them or otherwise demand that NOVA cease and desist from its use and/or license of the allegedly infringing software. Although management is not currently aware of any alleged infringement issues, any such action, if it were to occur, may result in protracted and costly litigation or royalty arrangements or otherwise have a material adverse effect on NOVA's financial condition and results of operations.
NOVA currently licenses certain software from third parties to supplement its internal software and technology development and to shorten time-to-market software application product deliveries. For instance, NOVA licenses the software for NOVA Time. Management believes that it will be necessary to continue this practice in the future, although there can be no assurance that NOVA will be able to do so on favorable terms
or at all. NOVA's servicemarks include INNRESPONSE, INNSYNCHRA MASS TRANSACT, NOVA, NOVA INFORMATION SYSTEMS, NOVA-PERKS, NOVA ACS, NOVA REMOTE ACS, NOVA CLOCK, NOVA ENCOMPASS, NOVA GRATUIT, NOVALODGE, NOVA SHADOW PAY, NOVA TIME, NOVA TRANSPORT, NOVA WEBWAY, ON-SET, PC TRANSACT_IT, POS CONTROL, TRAVERSE. Additionally, NOVA-PERKS and ON-SET are registered with the U.S. Patent and Trademark Office (the "PTO"). As a result of acquisitions, NOVA also owns the following servicemarks: SBS, SBS and Design, SUPERIOR BANKCARD SERVICE and MERCHANT MILES CLUB. Both SBS and MERCHANT MILES CLUB are registered with the PTO, while the applications for SBS and Design, and SUPERIOR BANKCARD SERVICE are pending with the PTO. NOVA is also the owner of the following domain name registrations: merchantconnect.com, merchantconnect.net, novacorp.net, novainfo.com, novainfo.net, merchanttoolbox.com and merchanttoolbox.net.
COMPETITION AND CONSOLIDATION
The market for providing credit, charge and debit card transaction processing services to the small to medium-sized merchant segment served by NOVA is highly competitive. The level of competition has increased significantly since NOVA's inception, and this trend is expected to continue. NOVA competes in this market segment on the basis of price, the availability of related products and services, the quality of customer service and support, and transaction processing speed, quality and reliability. NOVA's principal competitors in this market segment include other smaller vertically integrated processors, community and regional banks and ISOs and, increasingly, the ten largest bankcard processors. Several of NOVA's competitors and potential competitors have greater financial, technological, marketing and personnel resources than NOVA, and there can be no assurance that NOVA will continue to be able to compete successfully with such entities. In addition, the competitive pricing pressures that would result from any increase in competition would adversely affect NOVA's margins and may have a material adverse effect on NOVA's financial condition and results of operations.
According to industry sources, the ten largest bankcard processors accounted for approximately 68% of the total charge volume processed in 1998, the latest year for which statistics are available. The largest bankcard processor accounted for approximately 16% of the total charge volume processed in 1999.
NOVA believes that it has reached a sufficient size whereby economies of scale allow it to offer competitive pricing. However, certain of NOVA's competitors may have lower costs which could potentially give them an advantage. As a result of its experience in payment processing, NOVA has been able to develop operating efficiencies that NOVA believes allow it to competitively bid for new business. In addition, NOVA has continually made technological improvements and is thus able to respond to the unique needs of merchants in various industries. Management believes that the quality, speed and reliability of the NOVA Network and the breadth, flexibility and user-friendliness of its software application products and services constitute a competitive advantage. NOVA intends to maintain its strategy of focusing on small to medium-sized merchants because management believes this market segment is somewhat less price sensitive than larger accounts.
NOVA faces increasing competition from other transaction processors for available acquisition opportunities. In addition, community and regional banks, which serve as a marketing channel for NOVA's services and whose transaction processing businesses have been NOVA's primary source of acquisition opportunities, have been undergoing extensive consolidation reflective of underlying trends in the financial institution industry and unrelated to their transaction processing businesses. As a result, smaller banks that may have sought to divest themselves of their transaction processing businesses may be acquired by banks that compete with NOVA or banks that have a relationship or alliance with one or more competitors of NOVA, thus potentially depriving NOVA of distribution channels and/or acquisition opportunities.
BANKING REGULATION
Because KeyBank and Firstar are nationally chartered banks, it was necessary to obtain written approval from the Office of the Comptroller of the Currency (the "OCC"), in its role as the regulatory body for
national banks, prior to consummation of the KMS and Elan joint ventures. Moreover, certain banking laws and regulations may be implicated in the event either NOVA or the limited liability companies enter into or acquire any other entity which is engaged in a business that is substantially different from the business activities NOVA, or the limited liability companies, currently conduct. As a consequence, NOVA may be required to take certain measures, such as applying for any required regulatory consent or assisting either KeyBank, Firstar, or the limited liability companies, as the case may be, to prepare such applications. If the required consents and approvals are not received, NOVA may not engage in the new business activity.
EMPLOYEES
As of February 25, 2000, NOVA had 1,625 full-time employees, and 55 part-time employees. Positive employee relationships are a hallmark of NOVA's business environment. NOVA's employees are not represented by a collective bargaining agreement nor has NOVA ever experienced any work stoppage.
NOVA has completed the conversion and consolidation of the majority of all PMT operations into the NOVA operations centers in Knoxville and Atlanta. As part of this consolidation, NOVA has moved PMT's Nashville, Tennessee operations to NOVA's existing facilities in Atlanta, Georgia and Knoxville, Tennessee.
CERTAIN RISKS ASSOCIATED WITH THE BUSINESS OF THE COMPANY
In addition to the risks and other considerations discussed elsewhere in this report, set forth below is a discussion of certain risk factors relating to the Company's business and operations. These risk factors are drafted in "Plain English" format in accordance with Rule 421 of the Securities Act. Accordingly, references to "we" and "our" refer to NOVA and its subsidiaries.
We are Dependent upon VISA and MasterCard Registration and Financial Institution Sponsors in Order to Conduct Our Business
We must be sponsored by a financial institution that is a principal member of the VISA and MasterCard credit card associations in order to process bankcard transactions. Our designation with VISA and MasterCard as a certified processor and our status as a member service provider are dependent upon the sponsorship of member clearing banks and our continuing adherence to the standards of the VISA and MasterCard credit card associations. The member financial institutions of VISA and MasterCard set these standards. Some of the member financial institutions of VISA and MasterCard provide transaction processing services in direct competition with our services. In the event we fail to comply with these standards, VISA or MasterCard could suspend or terminate our designation as a certified processor or our status as a member service provider. The termination of our member service provider registration or our status as a certified processor, or any changes in the VISA or MasterCard rules that prevent our registration or otherwise limit our ability to provide transaction processing and marketing services for VISA or MasterCard, would have a material adverse effect on our business, financial condition and results of operations. See "Business -- Merchant Accounting and Clearing Bank Relationships."
Increased Consolidation in the Marketplace Affects the Price and Availability of Acquisition, Joint Venture and Alliance Opportunities
Historically, our growth has been dependent upon the purchase of additional merchant portfolios and the acquisition of operating businesses and transaction processing assets. Going forward, we face increasing competition from other transaction processors for available acquisition, joint venture and alliance opportunities. As a result, we may not be able to negotiate new acquisitions, joint ventures and alliances on terms that are as favorable as terms negotiated in past transactions. In addition, the financial industry continues to undergo extensive consolidation. As a result, community and regional banks, which have historically been a primary source of new merchant portfolios for NOVA, may instead be acquired by financial institutions that either directly compete with us or that have a relationship or alliance with one or more of our competitors. Acquisitions such as these potentially deprive us of acquisition opportunities. Consequently, we cannot be sure (1) that the historical or current level of acquisition opportunities will continue to exist; (2) that we will be
able to locate and acquire merchant portfolios, operating businesses and transaction processing assets that satisfy our criteria; or (3) that such transactions will be on terms that are favorable to NOVA.
We May Not Accurately Analyze the Risks Associated with Purchased Merchant Portfolios, Joint Ventures or Business Combinations
When we evaluate the potential purchase of a merchant portfolio, a joint venture or a business combination, we conduct a review of the related merchant portfolio. The review process includes analyzing the composition of the merchant portfolio, applying our uniform standards and underwriting guidelines to the merchant portfolio and attempting to identify high-risk merchants included in the merchant portfolio. Even with such a review, it is not possible to properly identify and assess all of the risks associated with a merchant portfolio or otherwise identify all of the high-risk merchants. If we fail to accurately assess these risks or to identify all of the high-risk merchants in the portfolio, we may experience larger-than-expected losses from charge-backs or merchant fraud. See "Business -- Risk Management."
Delays in Conversion of Merchant Portfolios to Our Network May Decrease Our Anticipated Cost-Savings
Generally, merchants in a newly-acquired portfolio are not operating on the NOVA Network and may not use the same merchant accounting processors that we use. Until we convert each newly-purchased merchant to the NOVA Network and our merchant accounting processors, we do not fully realize the anticipated cost savings and synergies from the portfolio purchase, business combination or joint venture. For instance, until we convert the merchants to the NOVA Network, we have to pay third parties for processing services. Further, we have little, if any, control over the performance of the other networks and processors. Finally, we typically are not able to apply fully our risk management and fraud avoidance practices to these merchants, which increases the possibility of losses due to fraud.
Our Acquisition Strategy Will Require Substantial Capital Resources and Additional Indebtedness
Our acquisition strategy will require substantial capital resources and is likely to result in the need for additional indebtedness. We cannot be sure, however, that we will be able to obtain financing for future acquisitions on favorable terms.
The Success of Our Joint Ventures Is Dependent Upon the Continued Cooperation of Our Joint Venture Partners
The Elan joint venture and the KMS joint venture involved the formation of a limited liability company that we jointly own with Firstar and KeyBank, respectively. As a result, our continued cooperation with each of Firstar and KeyBank is important to the success of the joint ventures. We cannot give any assurance that our relationship with either Firstar or KeyBank will continue to be cooperative and, accordingly, there can be no assurance that we will realize the anticipated economic benefits from the joint ventures. In addition, we provide management and processing services to each of the joint ventures which imposes increased administrative, managerial and technological demands on our infrastructure and related systems, and there can be no assurance that we will meet successfully such material demands and requirements. See "-- Continued Consolidation in the Banking Industry May Adversely Affect Our Marketing Channels."
Termination of Our Joint Ventures with Firstar and KeyBank Could Have an Adverse Impact on Our Financial Condition and Results of Operations
Our joint ventures with Firstar and KeyBank were formed for a fixed time period (until August 2008 and January 2005, respectively, subject in each case to renewal provisions), but are subject to earlier termination by us or Firstar or KeyBank under a variety of circumstances. In the event of early termination, or upon termination of either joint venture upon expiration of its term, the then-current assets and merchant portfolio of the terminated joint venture are subject to "repurchase rights" by either us, or Firstar or KeyBank, depending upon the circumstances of termination. For example, each of the joint ventures imposes upon us certain standards with respect to the performance of our processing services. In the event we breach these
standards and do not cure the breach, Firstar or KeyBank, as the case may be, would have the right to purchase our interest in the respective joint venture. If either Firstar or KeyBank purchases our interest in the respective joint venture, we would experience a significant decrease in the number of merchant locations that we serve and the aggregate sales volume that we process. This type of decrease could have a material adverse effect on our financial condition and results of operations. Further, when we evaluated the joint ventures and established a purchase price in connection with our investment in the joint ventures, we assumed the continuance of each of the joint ventures for a minimum term. We may not realize the anticipated economic and marketing benefits from the joint ventures in the event one or both is terminated early.
Increasing Competition in the Transaction Processing Industry May Have a Material Adverse Effect on Our Business, Financial Condition and Results of Operations
The credit, charge and debit card transaction processing services business is highly competitive. The level of competition has increased significantly in recent years, and we expect this trend to continue. Several of our competitors and potential competitors have greater financial, technological, marketing and personnel resources, and we are uncertain whether we will continue to be able to compete successfully with such entities. In addition, our profit margins could decline because of competitive pricing pressures that may have a material adverse effect on our business, financial condition and results of operations.
Continued Consolidation in the Banking Industry May Adversely Affect Our Marketing Channels
We market our services through several different marketing channels, including through our joint ventures and alliances with banks. In the event that the trend toward consolidation in the banking industry continues, banks with which we have alliances may be acquired by banks with which we compete or that have a relationship with one or more of our competitors. This scenario could potentially result in the loss of a distribution channel.
Increased Merchant Attrition May Have a Material Adverse Effect on Our Business, Financial Condition and Results of Operations
We experience attrition in our merchant base in the ordinary course of business resulting from several factors, including business closures, losses to competitors and conversion-related losses. In addition, substantially all of our contracts with merchants may be terminated by us or the merchant upon prior notice of 30 days or less. Increased merchant attrition may have a material adverse effect on our financial condition and results of operations. We cannot give any assurances that we will not experience higher rates of merchant attrition in the future, particularly in connection with purchased merchant portfolios.
We Are Dependent Upon Our Merchant Accounting Relationships with Third Parties
We outsource certain merchant accounting services to our merchant accounting vendors. These services consist of reorganizing and accumulating daily transaction data on a merchant-by-merchant and card issuer-by-card issuer basis, and forwarding this data to the credit card associations for ultimate payment. If our Merchant Accounting Vendors do not continue to perform these services efficiently and effectively, our relationships with our merchant customers may be adversely affected and merchants may terminate their processing agreements. During 1999 we implemented internal systems to provide our own merchant accounting services, as of December 31, 1999, approximately 6.5% of NOVA's total volume was being serviced internally. We are continuing to develop the internal systems to provide the functionality necessary to service all of our merchant customers. However, if our Merchant Accounting Vendors terminate their agreements with us prior to achieving full functionality of our internal systems, we would have to seek alternative outsourcing arrangements to provide these merchant accounting services. We are not certain whether we could locate alternative outsourcing arrangements on terms as favorable to us as the existing contracts. Accordingly, termination of the agreement with any merchant accounting vendor could have a material adverse effect on our business, financial condition and results of operations.
Increases in Credit Card Association Fees May Adversely Affect Our Profitability
VISA and MasterCard have increased their respective fees, or "interchange rates," each year. Although we historically have reflected these increases in our pricing to merchants, there can be no assurance that merchants will continue to assume the entire impact of the future increases or that transaction processing volumes and merchant attrition will not be adversely affected by the increases.
Increases in Chargebacks May Adversely Affect Our Profitability
When a billing dispute between a cardholder and a merchant is resolved in favor of the cardholder, the transaction is "charged back" to the merchant's account and the amount of the transaction is credited to the cardholder. Reasons for billing disputes include, among others: (1) non-receipt of merchandise or services; (2) unauthorized use of a credit card; and (3) quality of the goods sold or the services rendered by that merchant. If the merchant does not have sufficient funds in its account to cover the chargeback, and if the merchant refuses or is not able due to bankruptcy or other reasons to reimburse us for the chargeback, we bear the loss for the amount of the refund paid to the cardholder. We attempt to reduce our exposure to such losses by (1) performing periodic credit reviews of our merchant customers; and (2) adjusting the rate we charge a merchant based, in part, on the merchant's credit risk, business or industry. However, we cannot give any assurances that we will not experience significant losses from chargebacks in the future. Increases in chargebacks not paid by merchants may have a material adverse effect on our business, financial condition and results of operations. See "Business -- Risk Management."
We Bear the Risk of Fraud Committed by Our Merchant Customers
We bear the risk of losses caused by fraudulent credit card transactions initiated by our merchant customers. Examples of merchant fraud include inputting false sales transactions or false credits. We monitor merchant transactions against a series of standards developed to detect merchant fraud. Despite our efforts to detect merchant fraud, however, it is possible that we will experience significant amounts of merchant fraud in the future, which may have a material adverse effect on our business, financial condition and results of operations. See "Business -- Risk Management" and "Business -- Customer Base."
We Are Dependent Upon MCI WorldCom for Telecommunications Services
Our proprietary telecommunications network, the NOVA Network, is a critical component of our transaction processing services. MCI WorldCom provides to us long-distance and local telecommunications access and technical support for the NOVA Network. This agreement has an initial term of three years which expires July 1, 2001, although we have the right to terminate the agreement earlier in the event of quality deficiencies in MCI WorldCom's service. The agreement will automatically renew for additional one-year terms unless either party gives the other party written notice at least 30 days prior to the end of the term. If the agreement is terminated or not renewed, we would be required to utilize the long-distance and local telecommunications access of another long-distance provider, which may increase our expenses for network services and consequently have a material adverse effect on our financial condition and results of operations. See "Business -- Technology."
We May Become Subject to Certain State Taxes That Currently Are Not Passed through to Our Merchants
We, like other transaction processing companies, may be subject to state taxation of certain portions of our fees charged to merchants for our services. Application of this tax is an emerging issue in the transaction processing industry and the states have not yet adopted uniform guidelines. If we are required to pay such taxes and are not able to pass this tax expense through to our merchant customers, our financial condition and results of operations could be adversely affected.
We Must Continue to Update and Develop Technological Capabilities and New Products in Order to Compete
The transaction processing industry, and the software application products and value-added services of the type that we offer, have been characterized by rapidly changing technology and the development of new products and services. We believe that our future success will depend, in part, on our ability to continue to improve our existing products and services and to offer our merchant customers new products and services. We cannot give any assurances that we will continue to improve existing products and services or to develop successful new products and services, nor can we be certain that our newly-developed products and services will perform satisfactorily or be widely accepted in the marketplace. See "Business -- Software Application Products and Value Added Services."
We Experience Fluctuations in Our Quarterly Operating Results
We have experienced, and expect to continue to experience, significant seasonality in our business, resulting in fluctuations in our quarterly operating results. We typically realize higher revenues in the third calendar quarter and lower revenues in the first calendar quarter, reflecting increased transaction volumes during the summer months and a significant decrease in transaction volume during the period immediately following the holiday season. The timing of purchases of merchant portfolios and joint ventures, and the timing and magnitude of expenses for merchant portfolio conversions, also affect our quarterly results. Fluctuations in operating results may result in volatility in the price of our common stock.
We Need to Retain the Services of Our Executive Management Team
Our success depends largely on the efforts and skills of our executive officers and key employees, particularly Edward Grzedzinski. The loss of the services of one or more of these persons could materially adversely affect our business, financial condition and results of operations. We have entered into employment agreements with Mr. Grzedzinski and other members of management.
A Significant Portion of Our Assets Consists of Intangible Assets
A substantial portion of our assets are intangible assets related to purchased merchant portfolios or business operations. A material decline in the revenues generated from any of our purchased merchant portfolios or business operations could reduce the fair value of the portfolio or operations. Consequently, we would be required to reduce the carrying value of the related intangible asset. Additionally, changes in accounting policies or rules that affect the way in which we reflect these intangible assets in our financial statements, or the way in which we treat the assets for tax purposes, could have a material adverse effect on our financial condition.
Agreements Limit Our Ability to Engage in Other Businesses and Impose Territorial Restrictions
Our joint venture agreements with Firstar and KeyBank provide that, to the extent required by applicable banking laws and regulations, we must take certain measures in the event we or the joint ventures enter into or acquire any other entity which is engaged in a business that is substantially different from our current business activities. These measures may include applying for any required regulatory consent, or assisting either KeyBank, Firstar, or our joint ventures in preparing the required applications. If the bank regulatory authorities do not grant the required consents and approvals, we may not engage in the new business activity.
In connection with our alliances with First Union and Crestar, and our joint ventures with Firstar and KeyBank, we agreed that we will not, without the prior consent of the affected entity, enter into certain marketing or, in certain instances, acquisition or purchase agreements with third parties located in specified geographic areas where, as of the date of such transactions, any of First Union, Crestar, Firstar or KeyBank maintain a significant banking presence. The effect of these territorial restrictions is to limit in certain respects our ability to directly seek or take advantage of certain business or marketing opportunities other than through a venture with our regional bank partners. The agreements generally do not prohibit us from pursuing transactions indirectly through the respective alliance or joint venture.
Our Articles of Incorporation and Shareholder Rights Plan May Impede a Takeover of NOVA
Some provisions of our Articles of Incorporation and Bylaws, and certain provisions of Georgia law, could have the effect of delaying, deferring or preventing an acquisition of our company. For example, our Articles of Incorporation permit the Board of Directors to issue up to 5,000,000 shares of preferred stock with such designations, powers, preferences and rights as it determines, without any further vote or action by our shareholders. The issuance of preferred stock could discourage bids for the outstanding shares of common stock at a premium and have a material adverse effect on the market price of the common stock.
We have also adopted a Shareholder Rights Plan (the "Rights Plan"). Under the Rights Plan, each of our shareholders (as of a certain date) received one stock purchase right ("Right") for each share of NOVA stock that they owned. If a third party acquires 10% or more of our outstanding stock, then the Rights become exercisable, and the holder of each Right is entitled to purchase additional shares of our common stock at a price that is lower than the then-current market price. In addition, if we are acquired after a third party acquired 10% or more of our outstanding stock, then each Right holder will be entitled to purchase, at the then-current price, a number of the acquiring party's shares equal in value to those obtainable if the Rights were exercisable in our stock. The Rights Plan could have the effect of making it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, control of us without negotiating with our board of directors.
The Price of Our Common Stock Has Been Volatile and Could Continue to Fluctuate Substantially
Our common stock is traded on the New York Stock Exchange. Since our initial public offering in May 1996, there has been and may continue to be significant volatility in the market for the common stock, based on a variety of factors, including the following:
- future announcements concerning us or our competitors;
- changes in quarterly operating results;
- the gain or loss of significant contracts;
- the entry of new competitors into our markets;
- changes in management;
- announcements of technological innovations or new products by us or our competitors; and
- other events and circumstances, some of which are beyond our control.
Future Sales of Our Common Stock Could Cause the Price of Our Shares to Decline
Sales of a substantial number of shares of our common stock in the public market could cause the price of the common stock to decline and could impair our ability to raise equity capital. As of March 20, 2000, we have outstanding approximately 69,491,465 shares of common stock. An additional 9,901,668 shares of common stock that may be issued in the future (upon exercise of options granted and to be granted under our stock option plans) have been or will be registered under the Securities Act and therefore will be freely tradeable when exercisable, subject to the volume and certain other conditions of Rule 144 promulgated under the Securities Act in the case of shares to be sold by our affiliates. Options and warrants for the purchase of approximately 8,821,399 shares of common stock were outstanding as of March 20, 2000, of which options and warrants for 2,182,395 shares were exercisable, with an additional 520,032 options to vest within sixty days of that date.
ITEM 2.
ITEM 2. PROPERTIES
NOVA's principal executive offices are located in Atlanta, Georgia and consist of approximately 38,000 square feet that are leased pursuant to an agreement scheduled to expire February 2002. All facilities are used
primarily for administrative, sales and marketing, and operational functions. The following table describes the principal facilities being used in connection with NOVA's operations:
- ---------------
* NOVA expects that the Dunwoody sales and operations center will be consolidated into the Atlanta, GA sales and operations center. ** The operations centers consist of 140,000 square feet in two primary buildings. The original 26,000 square foot facility is leased pursuant to a sublease agreement scheduled to expire September 1, 2003. NOVA expanded into its new 112,000 square foot operations center during the third quarter of 1998. During 1998, 84,000 square feet was utilized during initial occupancy, while the remaining 28,000 square feet has been renovated and scheduled for operation in February 2000. *** The corporate offices were the headquarters of PMT prior to the PMT Merger. As part of the consolidation plans completed during 1999, the facility has been vacated and was totally subleased effective in November of 1999.
NOVA believes that its facilities are suitable and adequate for its business needs for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
NOVA has been involved from time to time in litigation in the normal course of its business. While management is aware of and dealing with certain pending or threatened litigation, management does not believe that such matters, individually or in the aggregate, will have a material adverse effect on the financial condition of NOVA.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of NOVA's shareholders during the fourth quarter of the fiscal year ended December 31, 1999.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below, in accordance with General Instruction G(3) of Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K, is certain information regarding the executive officers of NOVA as of March 24, 2000.
Each executive officer will serve until a successor is elected or appointed and qualified, or until his earlier resignation, removal from office or death.
Edward Grzedzinski, 45, has served with NOVA or its predecessor since February 1991, most recently as Chairman of the Board, President and Chief Executive Officer. He co-founded NOVA's wholly-owned subsidiary and predecessor, NOVA Information Systems, as its Chief Operating Officer in 1991 and was named Chief Executive Officer in September 1995. Mr. Grzedzinski has over 13 years experience in the bankcard industry.
Pamela A. Joseph, 41, has served with NOVA or its predecessor since July 1994, most recently as director and President and Chief Operating Officer of NOVA Information Systems. Prior to joining NOVA,
Ms. Joseph served for over two years as Director, New Market Development, for VISA and for eight years in various management positions at Wells Fargo Bank.
Nicholas H. Logan, 39, has served with NOVA since September 1998, most recently as Senior Executive Vice President. Prior to joining NOVA, Mr. Logan served as Senior Group Vice President of Business Development for Cardservice International from 1995 to 1998. From 1994 to 1995, he held various executive level positions in sales and marketing with Harbridge Merchant Services and Card Establishment Services. Mr. Logan has over eleven years of experience in the bankcard industry.
Cherie M. Fuzzell, 36, has served with NOVA since February 1999, most recently as Senior Vice President, Secretary and General Counsel. Prior to joining NOVA, Ms. Fuzzell served for almost four years with Magellan Health Services, most recently as Vice President, Mergers & Acquisitions.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
NOVA Corporation Common Stock is traded on the New York Stock Exchange (its principal market) under the symbol NIS.
The following table provides the high and low sales prices of the common stock as reported for the periods indicated:
SHAREHOLDERS
As of March 20, 2000, there were approximately 145 shareholders of record of the Company's Common Stock and 69,491,465 shares outstanding.
DIVIDENDS
The Company has never paid cash dividends on its Common Stock. The Board of Directors' policy is to retain any available earnings for use in the operation and expansion of the Company's business. Therefore, no payment of cash dividends is likely in the foreseeable future. The Company's loan agreement restricts the payment of dividends. See Note 8 of the Consolidated Financial Statements.
RECENT SALES OF UNREGISTERED SECURITIES
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The section entitled "Selected Consolidated Financial Data" of the Company's 1999 Annual Report to Shareholders is incorporated herein by reference and filed as part of Exhibit 13 to this Report.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's 1999 Annual Report to Shareholders is incorporated herein by reference and filed as part of Exhibit 13 to this Report.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risk, including changes in interest rates, primarily related to long-term debt obligations and notes receivable. A discussion of our accounting policies for financial instruments and further disclosures relating to financial instruments is included in the Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements. We monitor the risks associated with interest rates and have established policies and business practices to protect against these and other exposures.
Based on the Company's long-term debt obligations and note receivable at December 31, 1999, a 1% increase in market interest rates would increase interest expense and interest income by $695,000 and $137,000, respectively.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements and Accompanying Notes to Consolidated Financial Statements and the section entitled "Report of Independent Auditors" of the Company's 1999 Annual Report to Shareholders are incorporated herein by reference and filed as part of Exhibit 13 to this Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
Certain information required by Part III is omitted from this report but is incorporated herein by reference to NOVA's definitive Proxy Statement for the 2000 Annual Meeting of Shareholders (the "Proxy Statement"). Such Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 1999.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
In accordance with General Instruction G(3) of the Form 10-K, the information relating to the directors of NOVA, including directors who are executive officers of NOVA, is set forth under the caption "Proposal 1 -- Election of Directors" in the Proxy Statement and is incorporated herein by reference. Pursuant to Instruction 3 of Item 401(b) of Regulation S-K and General Instruction G(3) of Form 10-K, information relating to the executive officers of NOVA is set forth under the caption "Executive Officers of the Registrant" in Part I, Item 4A of this Report.
Compliance with Section 16(a) of the Exchange Act: Section 16(a) of the Exchange Act, and the regulations of the Commission thereunder require NOVA's directors, officers and any persons who own more than 10% of NOVA's common stock, as well as certain affiliates of such persons, to file reports with the Commission with respect to their ownership of NOVA's common stock. Directors, officers and persons owning more than 10% of NOVA's common stock are required by Commission regulations to furnish NOVA with copies of all Section 16(a) reports they file. Based solely on its review of the copies of such reports received by it and representations that no other reports were required of those persons, NOVA believes that during fiscal 1999, all filing requirements applicable to its directors and officers were complied with in a timely manner.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
In accordance with General Instruction G(3) of Form 10-K, the information relating to executive compensation set forth under the caption "Executive Compensation" in the Proxy Statement is incorporated herein by reference; provided, such incorporation by reference shall not be deemed to include or incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
In accordance with General Instruction G(3) of Form 10-K, the information relating to security ownership by certain persons set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In accordance with General Instruction G(3) of Form 10-K, the information relating to certain relationships and related transactions set forth under the caption "Certain Relationships and Related Transactions" in the Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as a part of this Report:
1. Financial Statements
The consolidated financial statements of NOVA and the related reports of independent auditors thereon which are required to be filed as part of this Report are included in NOVA's 1999 Annual Report to Shareholders and are incorporated by reference herein. Such information is filed as part of Exhibit 13 to this Report. These consolidated financial statements are as follows:
Consolidated Balance Sheets at December 31, 1999 and 1998.
Consolidated Statements of Operations for the years ended December 31, 1999, and 1998, and 1997.
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1999, and 1998, and 1997.
Consolidated Statements of Cash Flows for the years ended December 31, 1999, and 1998, and 1997.
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
The following consolidated financial statement schedule of NOVA is included in Item 14(d):
Schedule II Valuation and Qualifying Accounts
Schedules not included above have been omitted because they are not applicable, not material, or the required information is given in the financial statements or notes thereto.
3. Exhibits
The following exhibits are incorporated by reference or filed herewith:
- ---------------
* Confidential treatment pursuant to 17 CFR ((S)(S)) 200.80 and 230.406 has been requested regarding certain portions of the indicated Exhibit, which portions have been filed separately with the Commission. ** Filed herewith. (1) Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-1788), and incorporated herein by reference. (2) Filed as an exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996, Commission File No. 1-14342, and incorporated herein by reference. (3) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996, filed on June 18, 1996, Commission File No. 1-14342, and incorporated herein by reference. (4) Filed as an exhibit to the Company's Current Report on Form 8-K filed June 12, 1997, Commission File No. 1-14342, and incorporated herein by reference.
(5) Filed as an exhibit to the Company's Current Report on Form 8-K filed November 14, 1997, Commission File No. 1-14342, and incorporated herein by reference. (6) Filed as an exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997, Commission File No. 1-14342, and incorporated herein by reference. (7) Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-45997), and incorporated herein by reference. (8) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998, Commission file No. 1-14342, and incorporated herein by reference. (9) Filed as an exhibit to the Company's Registration Statement on Form S-8 (Registration No. 333-64681), filed September 19, 1998 and incorporated herein by reference. (10) Filed as an exhibit to the Company's Registration Statement on Form S-8 (Registration No. 333-64683), filed September 19, 1998 and incorporated herein by reference. (11) Filed as an exhibit to the Company's Registration Statement on Form S-4 (Registration No. 333-61867), and incorporated herein by reference. (12) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, Commission File No. 1-14342, and incorporated herein by reference. (13) Filed as an exhibit to the Company's Annual Report on Form 10-K/A, Amendment No. 2, for the fiscal year ended December 31, 1998, Commission File No. 1-14342, filed with the SEC on May 11, 1999, and incorporated herein by reference. (14) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999, Commission File No. 1-14342, and incorporated herein by reference. (15) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, Commission File No. 1-14342, and incorporated herein by reference. (16) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1999, Commission File No. 1-14342, and incorporated herein by reference.
(b) Reports on Form 8-K
The Company did not file any Current Report(s) on Form 8-K during the quarter ended December 31, 1999.
(c) Exhibits
All exhibits required by Item 601 of Regulation S-K are incorporated herein by reference or are filed herewith.
(d) Financial Statement Schedules
The following financial statement schedules are filed herewith:
SCHEDULE II
NOVA CORPORATION, INC.
VALUATION AND QUALIFYING ACCOUNTS
- ---------------
(1) Uses of the merger and consolidation reserve include non-cash items of $1.9 million and $18.5 million during 1999 and 1998, respectively.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, NOVA has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 30th day of March, 2000.
By: /s/ Edward Grzedzinski ------------------------------------ Edward Grzedzinski Chairman of the Board, President and Chief Executive Officer
KNOW ALL MEN BY THESE PRESENTS that each person whose signature appears below constitutes and appoints Edward Grzedzinski and Henry C. Lyon, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or either of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of NOVA and in the capacities indicated on March 30, 2000.
Index of Exhibits
- ---------------
* Confidential treatment pursuant to 17 CFR ((S)(S)) 200.80 and 230.406 has been requested regarding certain portions of the indicated Exhibit, which portions have been filed separately with the Commission. ** Filed herewith. (1) Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-1788), and incorporated herein by reference. (2) Filed as an exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996, Commission File No. 1-14342, and incorporated herein by reference. (3) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996, filed on June 18, 1996, Commission File No. 1-14342, and incorporated herein by reference. (4) Filed as an exhibit to the Company's Current Report on Form 8-K filed June 12, 1997, Commission File No. 1-14342, and incorporated herein by reference. (5) Filed as an exhibit to the Company's Current Report on Form 8-K filed November 14, 1997, Commission File No. 1-14342, and incorporated herein by reference. (6) Filed as an exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997, Commission File No. 1-14342, and incorporated herein by reference. (7) Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-45997), and incorporated herein by reference. (8) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998, Commission file No. 1-14342, and incorporated herein by reference.
(9) Filed as an exhibit to the Company's Registration Statement on Form S-8 (Registration No. 333-64681), filed September 19, 1998 and incorporated herein by reference. (10) Filed as an exhibit to the Company's Registration Statement on Form S-8 (Registration No. 333-64683), filed September 19, 1998 and incorporated herein by reference. (11) Filed as an exhibit to the Company's Registration Statement on Form S-4 (Registration No. 333-61867), and incorporated herein by reference. (12) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, Commission File No. 1-14342, and incorporated herein by reference. (13) Filed as an exhibit to the Company's Annual Report on Form 10-K/A, Amendment No. 2, for the fiscal year ended December 31, 1998, Commission File No. 1-14342, filed with the SEC on May 11, 1999, and incorporated herein by reference. (14) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999, Commission File No. 1-14342, and incorporated herein by reference. (15) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, Commission File No. 1-14342, and incorporated herein by reference. (16) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1999, Commission File No. 1-14342, and incorporated herein by reference. | 16,121 | 108,908 |
842906_1999.txt | 842906_1999 | 1999 | 842906 | ITEM 1. BUSINESS
GENERAL
Treats International Enterprises, Inc. (the "Company") is an international franchisor carrying on the business of selling the right to market the Treats System. The Treats System entails the preparation and sale of cookies, muffins, gourmet and specialty coffees, related food and beverage products in retail stores (Micro Bakeries) using a system and methodology of marketing developed and designed by The Company and identified by the trademark TREATS.
The Company operates its business through its wholly-owned subsidiary Treats Inc. Treats Inc. is the parent company to a number of other entities, specifically:
CHOCOLATE GOURMET TREATS LIMITED ("CGTL") TREATS ONTARIO INC.("TOI") TREATS CANADA CORPORATION ("TCC")
As at June 30, 1999 there are 121 retail units in North America utilizing the Treats System: 117 of these units are owned and operated by franchisees; 4 are corporately managed. It franchises and operates these outlets in all provinces with the exception of Manitoba.
The Company grants both single unit franchises and area development franchises throughout Canada. While there are currently no operations outside of North America, it is the Company's intention to sell National Licenses in the future. The Company has taken no steps to comply with any other International government franchise regulatory agencies.
The Company markets essentially three variations on the Treats concept. The Treats Bakery, normally 250 - 500 square feet in size with no seating area of its own, the Treats Bakery Cafe, normally 500 - 2,000 square feet in size with its own seating arrangement and the Treats International Coffee Emporium, normally 500 - 2,000 square feet with its own seating arrangements.
Treats stores are found in a variety of locations including office complexes, shopping malls, mixed use properties (commercial location with a shopping area), street front locations, transportation terminals and universities. The Company seeks locations or sites in high pedestrian traffic areas, where high visibility prevails.
For substantially all single store franchises in Canada, the Company or one of its subsidiaries has entered into a lease (the "Head Lease") with the relevant landlord and the location is sub-leased at the same cost to the franchisee. The Head Lease is the lease agreement between the landlord and the entity which signs it ("Tenant"). The Tenant is bound by the terms and conditions thereof.
ITEM 1. BUSINESS (CONT'D)
Generally for stores opened by an Area Franchisee, the Area Franchisee enters into the Head Lease directly and the head lease is collaterally assigned to the Company. The collateral assignment means the Company does not have all the rights and obligations associated with entering into the Head Lease. It gives the Company the right, but not the obligation, to assume the franchisee's position under the Head Lease if the franchisee defaults under its obligations under the Area Franchise Agreement with the Company. Franchisee in this context means the person who enters into the Franchise Agreement in a location covered under an Area Franchise Agreement.
Treats' franchisees prepare their baked goods on site daily in order to ensure wholesomeness and to attract customers with provocative fresh baked smells. The Company's principal products are prepared according to proprietary recipes in many cases using dry mixes which have been manufactured to the Company's specifications by the Quaker Oats Company of Canada and coffees blended to Treats specifications by Nestle Canada. The Company has no vertical integration with any of the companies manufacturing its bakery mixes and coffee blends. Its proprietary products are primarily sold to the franchised stores only although the Company is in the process of examining other retail opportunities using E-Commerce.
The Company is a Delaware corporation and was organized in 1988.
INDUSTRY OVERVIEW
The market for muffins, cookies and related baked goods as well as coffee products, including gourmet and specialty coffees is large, fragmented and growing. The Specialty Coffee/Specialty Baking franchise concept has been a successful addition to fast-food franchising. The snack food or "break" food market-segment is experiencing continuous growth and the "Specialty Coffee" segment is enjoying unprecedented growth.
Management believes this growth has been driven by a much greater consumer awareness and appreciation of gourmet coffee and fresh baked goods as a result of their increasing availability as well as the increase in demand for all fresh premium food products where the price differential from the commercial brands is small compared to the improvement in product quality and taste. In the Coffee Bar segment a number of large national chains have established a strong presence in North America. The most significant chains are: Starbucks with approximately 1,300 corporately owned locations, Second Cup with 380 locations and Gloria Jean's with 220 locations. However there are a plethora of other large chains with strong regional and niche presence.
ITEM 1. BUSINESS (CONT'D)
While these competitors have already established a significant presence, they have also created a rapidly expanding market for coffee related concepts. Treats has a unique concept and a proven operating methodology that will allow it to compete favourably. Treats' strong emphasis on Specialty, Gourmet and Flavoured Coffees in both existing and new Treats locations, positions the concept for continued growth and expansion.
In Canada, the Specialty Baking segment is dominated by two major chains: Treats (120 plus locations) and MMMarvellous MMMuffins (100 plus locations). Several smaller concepts operate regionally and a number of US Franchisors, including Mrs. Fields Cookies have a national presence in Canada. Treats has successfully competed in Canada because of its strong commitment to quality, a significant operational support program and a very strong emphasis on Coffee.
Finally it must be recognized that there are many other concepts which compete in a very similar environment and market as Treats. The most significant of these concepts are the donut chains, which in Canada is dominated by Tim Horton's.
THE FLOUR MARKET - BAKED GOODS
The dominant factor for the continued growth in the baked goods market in North America is the health and diet conscious consumer seeking foods that are nutritious and fun to eat. New bakery products continue to be introduced at a rate which exceeds that of the overall food industry.
The North American per capita flour products consumption has risen from an average of 118 Lbs. in 1984 to 130 Lbs. in 1990 and is forecasted to reach 150 Lbs. by the year 2000. With In-Store and Wholesale bakery products accounting for most of the gains in the traditional baking products, (3% growth per annum) Treats is well positioned for continued growth.
THE COFFEE MARKET
According to the National Coffee Association's 1998 National Coffee Drinking Trends report, approximately 65% of all consumers (age 10+) drink coffee on a weekly basis, they drink an average of 3.0 cups per day, and the overall number of coffee drinkers has grown approximately 20%. The gourmet coffee segment of the industry has experienced strong growth over the past decade and is expected to continue to grow through the end of the century. Research from CREST, a market research firm, indicates specialty shop category traffic growth increased by 49%, 11%, 19% and 16%, annually, from 1995 through 1998.
ITEM 1. BUSINESS (CONT'D)
TRAINING AND DEVELOPMENT
The Company's strategy is to place strong emphasis on identifying and retaining qualified franchisees and employees, and invest substantial resources in training them in customer service, beverage and food preparation, and sales skills. The Company believes that the friendliness, speed and consistency of service and the product knowledge of the Company's franchisees and employees are critical factors in developing the Company's quality brand identity and to building a loyal customer base.
EXPANSION
A total of 2 franchised stores were opened during 1998-1999. The Company plans to open approximately 8 franchised stores in Canada in the current fiscal year, primarily in existing markets. The Company has adopted a policy of not developing stores for its own operation and is in the process of franchising all stores currently operated by the Company.
The ability of the Company to open new stores is affected by a number of factors. These factors include, the ability to attract suitable and qualified franchise owners, constraints among other things, selection and availability of suitable store locations, negotiation of suitable lease or financing terms, and construction of stores. Accordingly, there can be no assurance that the Company will be able to meet planned growth targets.
The Company's expansion strategy is to cluster stores in targeted markets, thereby increasing consumer awareness and enabling the Company to take advantage of operational, distribution and advertising efficiencies. The Company believes that market penetration through the opening of multiple stores within a particular market should result in increased average store sales in that market. In determining which new markets to develop, the Company considers many factors, including its existing store base, the size of the market, demographic and population trends, competition, availability and cost of real estate, and the ability to supply product efficiently.
ITEM 1. BUSINESS (CONT'D)
TRADEMARKS AND SERVICE MARKS
The Company's rights in its trademarks and service marks are a significant part of its business. The Company is the owner of the following Trade Marks:
- TREETS - CHOCOLATE GOURMET TREATS - CHOCOLATE GOURMET TREATS & design - LESBONS TREATS - TREATS & design - TREATS - TREATS BAKERY CAFE - NOBODY TREATS YOU BETTER - MONOGRAM COOKIES - TREATS BAKERY AND YOGURT EMPORIUM - CREPE ETC. - TREATS FROZEN YOGURT...HALF THE CALORIES, TWICE THE FUN - TREATS INTERNATIONAL COFFEE EMPORIUM & design - TREATSATIONS - BAGUETTE EXPRESS - TREATS (Word)
These trademarks are registered in Canada and some of these trademarks are registered in foreign countries including the U.S.A.
The Company is aware of a number of companies which use various combinations of the word Treats in their names and/or services. none of which, either individually or in the aggregate, are considered to materially impair the use by the Company of its mark. It is the Company's policy to vigorously oppose any infringement of its trademarks.
ITEM 1. BUSINESS (CONT'D)
COMPETITION
The coffee and muffin industries are intensely competitive and there are many well established competitors with substantially greater financial and other resources than the Company. Although competition in the specialty coffee market is currently fragmented, the Company continues to be and will continue to be competitive. The competition in the muffin and cookie market is also fragmented, the Company competes and, in the future will continue to compete with MMMarvelous MMMuffins, Company's Coming, Tim Horton's, a host of bagel concepts and other donut concepts. Current competitors, one or more new major competitors with substantially greater financial, marketing, and operating resources than the Company could enter the market at any time and compete directly against the Company. In addition, in virtually every major metropolitan area in which the Company operates or expects to enter, local or regional competitors already exist. The Company's coffee beverages compete directly with all restaurant and beverage outlets that serve coffee and a growing number of espresso stands, carts and stores. The Company's bakery products compete directly against all restaurant and bakery outlets that serve muffins, cookies and bagels, including the bakery section of supermarkets. The Company believes that its customers choose among retailers primarily on the basis of product quality, service and convenience and, to a lesser extent, on price. The Company also expects that competition for suitable sites for new stores will be intense. The Company competes against other specialty retailers and restaurants for these sites, and there can be no assurance that management will be able to continue to secure adequate sites at acceptable rent levels. The Company also competes with many franchisors of restaurants and other business concepts with respect to the sale of franchises.
EMPLOYEES
At June 30, 1999, the Company had 29 employees, of whom 14 were store personnel and 15 were corporate personnel. Most store personnel work part time and are paid on an hourly basis. The Company has never experienced a work stoppage and its employees are not represented by a labor organization. The Company believes that its employee relations are good.
ITEM 2
ITEM 2 PROPERTIES
N - A
ITEM 3
ITEM 3 LEGAL PROCEEDINGS
The Company is a defendant in several actions arising in the normal course of business. The Company settled most claims subject to certain terms in the amount of $1,250,000, which has been reflected in the statement of income.
As management is of the opinion that the balance of claims, counterclaims or appeals is not determinable at this time, no additional provision has been recorded.
ITEM 4
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of Security Holders in the fourth quarter.
PART II
ITEM 5
ITEM 5 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
- ---------------------------------------------------------------------------
The Company's securities, primarily the Units, Stock and Warrants, have been quoted in the over-the-counter market since August 1989. The number of record holders of The Company's Common Stock at June 30, 1999 was 1,259 and at June 30, 1998, was 1,241. Management does not know the number of beneficial holders of the shares of Common Stock. Commencing in January 1992, the Common Stock has been quoted separately. Management has no knowledge whether the volume of trading since January 31, 1992 constitutes an active market or whether an active market will develop.
Through December 31, 1991, the high and low bid and asked prices for The Company's Units were reported in the NASDAQ pink sheets.
Starting February 1992 to June 21, 1993, the Common Stock was quoted on the computerized bulletin board of NASDAQ under the symbol TRTN.
As of June 21, 1993, the Common Stock has been quoted on the computerized bulletin board of NASDAQ under the symbol TIEI.
The following table set forth the high and low bid and asked prices for The Company's stock. Prices represent quotations between dealers without adjustment for retail mark-ups, markdowns or commissions, and may not represent actual transactions.
ITEM 6
ITEM 6 SELECTED FINANCIAL DATA - ------------------------------------------------------------------------------- The following chart of selected financial data of the Company for five fiscal years are derived from the consolidated financial statements of the Company. The Company presents its financial results in Canadian dollars. For the convenience of the reader, the results for the year ended June 30, 1999, have been converted into U.S. dollars, at the prevailing rate of exchange.
(1) The Company's financial results are expressed in Canadian Dollars. For the convenience of the reader only, the results for the last fiscal year have been converted into United States Dollars at the Bank of Canada rate on: June 30, 1999 Conversion rate: One (1) (US) Dollar equals: $1.4905
ITEM 6 SELECTED FINANCIAL DATA (CONT'D)
(1) The Company's financial results are expressed in Canadian Dollars. For the convenience of the reader only, the results for the last fiscal year have been converted into United States Dollars at the Bank of Canada rate on: June 30, 1999 Conversion rate: One (1) (US) Dollar equals: 1.4905
(2) The Company has 19,024,598 shares outstanding. Net profit (loss) per share is calculated based on the weighted average number of shares outstanding for the period. (see Note 11, June 30, 1999).
ITEM 7
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ------------------------------------------------------------------------------- (All amounts are in Canadian $ unless otherwise noted)
GENERAL
- THE YEAR ENDED JUNE 30, 1999 COMPARED TO THE YEAR ENDED JUNE 30,
System-wide retail sales for the twelve months ended June 30, 1999 were $24,121,000 compared to $24,667,000 a decrease of $546,000 or 2.2% for the same period last year. The Company closed down 13 primarily non-performing locations or locations where the Company could not establish satisfactory lease terms with the landlord, during the past fiscal year. On average same store sales showed an increase in sales performance in excess of 5%.
RESULTS OF OPERATIONS
Total revenue for the year ended June 30, 1999 decreased $491,000 or 9.9% to $4,486,000 from $4,977,000 for the same period last year. The decrease in revenue resulted primarily from:
- The sales of corporately managed stores decreased by $127,000 or 15.5% to $690,000 from $817,000 for the same period last year. This is the result of the company's ongoing commitment to divest itself from corporately owned locations.
- Royalties increased $24,000 or 1.3% to $1,807,000 compared to $1,783,000 for the same period last year.
- Supplier incentives decreased $87,000 or 7.9% to $1,010,000 compared to $1,097,000 the same period last year.
- Franchising decreased $84,000 or 38.5% to $134,000 compared to $218,000 for the same period last year.
- Proprietary products sold to distributors for distribution to the franchised and corporately managed locations decreased $16,000 or 3.6% to $433,000 compared to $449,000 for the same period last year.
- Revenues from construction decreased $202,000 or 33.0% to $411,000 compared to $613,000 for the same period last year.
ITEM 7 MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT'D)
RESULTS OF OPERATIONS (CONT'D)
The Company made a number of fiscal decisions in the past fiscal year that have significantly impacted expenses and as a direct consequence the profitability of the Company. All of these changes were one-time charges and most represent non-cash charges. (See Management Plan note 15, page 43). The total increase in expenses is $8,660,000. However excluding the one-time charges which are described in detail below, the Company's expenses decreased by $778,000 or 16.3%. The variance in expenses relate to the following:
- Costs associated with Managed franchised stores decreased $52,000 or 7.3% to $662,000 from $714,000 as a direct result of the decrease in the number of corporately managed stores.
- Head office and administration expenses decreased $22,000 or 1.0% to $2,170,000 from $2,192,000 for the same period last year.
- The cost of purchasing certain proprietary products for resale to distributors decreased $25,000 or 6.3% to $372,000 from $397,000 for the same period last year.
- The cost of construction and renovation of stores decreased by $202,000 or 38.0% to $330,000 compared to $532,000 for the same period last year.
- As a result of the write-down of franchise rights to their estimated fair market value, amortization was $nil compared to $664,000 in the previous year.
- Interest expense increased by $135,000 or 121.6% to $246,000 from $111,000 last year. This was the result of interest on a mortgage on the building which houses the offices of the Company and which the Company acquired. In addition the Company recorded interest on a loan from 3193853 Canada Inc. In the previous year the interest portion of the funds owed to 3193853 Canada Inc. had been forgiven.
- There was a write-down of $1,525,000 of an investment in a US public company which had acquired the rights to develop the Treats concept in the U.S.A. for consideration of convertible preference shares. That company, however, has not been profitable, has not raised sufficient capital nor has it made the required number of new store openings. Management does not believe that there will be any improvement in the foreseeable future and that the asset has been permanently impaired.
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONT'D)
RESULTS OF OPERATIONS (CONT'D)
- In addition, management has permanently closed unprofitable stores it reacquired from franchisees in Canada. Accordingly, capital assets were written down to their estimated fair market value.
The write-downs have been recorded as non-cash restructuring costs, allocated as follows:
$
Franchise rights 5,228,388 Stores and equipment reacquired from franchisees 978,210 --------- 6,206,598 --------- ---------
- The Company is a defendant in several actions arising in the normal course of business. The Company settled most claims subject to certain terms in the amount of $1,250,000, which has been reflected in the statement of income. As management is of the opinion that the remaining claims, counterclaims or appeals is not determinable at this time, no additional provision has been recorded.
CAPITAL RESOURCES - June 30, 1999
The Company's projected capital asset requirements for the current fiscal year, are not very demanding and the Company does not anticipate having trouble meeting any of its obligations arising out of the normal course of business.
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT'D)
LIQUIDITY AND CASH FLOW - June 30, 1999
The working capital deficit at the year end increased by $41,000 to $(2,609,000). This was primarily due to the Company being in default of their loan covenants with 3193853 Canada Inc. and the Royal Bank of Canada. In addition, 3193853 Canada Inc. and the Royal Bank of Canada have not waived their rights to call the term loan and subordinated debenture at a future date and accordingly the debts are classified as current. (See note 7 (a) page 38).
The cash flow from operations during fiscal 1999 decreased by $2,469,000 to $(1,294,000) compared to $1,175,000 in the previous fiscal year this was primarily due to the Company incurring a net loss for the year in the amount of $8,945,000 compromised largely of non-cash write-downs as reflected in the statement of cash flows (see page 29) and in note 10 (see page 40-41). Management believes that these are one-time write-downs and will not be repeated in future years. As well the Company has taken actions to close a number of locations that were unprofitable and not considered likely to become profitable in the near future, and to reduce general and administrative expenses. Management has prepared cash flow projections for the next five years indicating positive cash flows and profitability. The projected cash flows were not audited, reviewed or compiled by the auditors, but were used by the independent appraiser (see note 6 page 35) in arriving at the valuation of franchise rights.
As well, Management is actively pursuing alternative financing to replace the subordinated debenture and term loan with more favourable terms.
Accordingly, based on actions taken and the company's operating plans for the year, the company expects that it will have sufficient cash to be able to continue operations and meet its long-term obligations due within the next fiscal year. (See note 15, Management Plan, page 43)
DEBT TO EQUITY - June 30, 1999
- As a result of the write-downs described above, as well as in various notes to the audited financial statements included, the debt to equity ratio is not included, as the ratio does not represent meaningful information.
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT'D)
IN THE YEAR:
The implementation of the "direct bank transfer" system which automatically withdraws royalty, advertising fund and receivable payments from franchise owners' bank accounts on a weekly basis has continued over the year. Currently 91% of the franchise owners use this method to make their weekly payments. By the end of this fiscal year the Company expects that 100% of all franchise owners will have been converted to the direct transfer system.
The Company continued to renovate existing stores using the new design criteria developed in the previous fiscal year. These renovations have in virtually every instance resulted in increased sales performance.
During the year, after extensive testing, a new line of premium cookies was introduced under the "TreatSations." label (Trade Mark registration for TreatSations is pending.) While the introduction of the initial line of TreatSations products was not as successful as Management had anticipated, the Company intends to continue to introduce new products using the TreatSations mark of quality. In January of 2000 the Company will introduce the second component of the TreatSations line, a variety of oatmeal bars.
The Company has upgraded most of its computer hardware and software as part of an effort to ensure that the Company will be able to address any issues pertaining to the Year 2000. The Year 2000 issue arises because many computerized systems use two digits rather than four to identify a year. The Company is making every effort to make sure that there will be no significant impact on operations as a result of any Year 2000 issue however it is not possible to be certain that all aspects of the Year 2000 issue affecting the Company, including those related to the efforts of entities the Company does business with or any third parties, will be fully resolved.
The Company renewed its long standing contract with Quaker Oats of Canada to supply all of its dry bakery mixes.
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(All amounts are in Canadian $ unless otherwise noted)
GENERAL
- THE YEAR ENDED JUNE 30, 1998 COMPARED TO THE YEAR ENDED JUNE 30,
System-wide retail sales for the twelve months ended June 30, 1998 were $24,667,000 compared to $26,903,000 a decrease of $2,236,000 or 8.31% for the same period last year. The sales decline can be attributed to the Company's decision to close down 7 locations during the past twelve months. The units closed down were primarily non-performing locations or locations where the Company could not establish satisfactory lease terms with the landlord.
RESULTS OF OPERATIONS
Total revenue for the year ended June 30, 1998 increased $348,000 or 7.5% to $4,977,000 from $4,629,000 for the same period last year. The increase in revenue resulted primarily from:
- The sales of corporately managed stores increased by $209,000 or 34.3% to $816,000 from $607,000 for the same period last year.
- Royalties increased $3,000 or 0.14% to $1,783,000 compared to $1,780,000 for the same period last year. (see note on Head office and administration expenses, below)
- Supplier incentives increased $71,000 or 6.9% to $1,097,000 compared to $1,026,000 the same period last year.
- Franchising increased $18,000 or 8.9% to $218,000 compared to $200,000 for the same period last year.
- Proprietary products sold to distributors for distribution to the franchised and corporately managed locations decreased $62,000 or 12.2% to $449,000 compared to $511,000 for the same period last year.
- In the fiscal year ended June 30, 1998 The Company amended its policy regarding the construction and renovation of stores. The revenues from constructions are recognized when the agreements are signed or the funds as been received. Revenues from construction were $613,000.
ITEM 7 MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT'D)
RESULTS OF OPERATIONS (CONT'D)
Expenses for the year ended June 30, 1998 increased $292,000 or 6.5% to $4,771,000 from $4,479,000 for the same period last year. The increase in expenses relate to the following:
- Costs associated with Managed franchised stores increased $240,000 a direct result of the increase in the number of corporately managed stores.
- Head office and administration expenses increased $298,000 or 15.7% to $2,192,000 from $1,894,000 for the same period last year. The increase is a direct result of the Company's decision to amend its policy with respect to royalty discounts. The difference between the actual amount paid and the amount required under the franchise agreement is credited to royalty revenue and charged to Head office expenses as a discount on royalties. The amount charged for royalty discount in the fiscal year was $384,000.
- The cost of purchasing certain proprietary products for resale to distributors decreased $43,000 or 9.8% to $397,000 from $440,000 for the same period last year.
- Interest expense decreased by $46,000 or 29% to $111,000 from $157,000 last year. This decrease is a direct result of 3193853 Canada Inc. having waived any interest payment required for fiscal 1998. (see note 8 page 28-30)
- The cost of construction and renovation of stores was $532,000.
- Net income for the year ended June 30, 1998 was $206,000 compared to a net income of $150,000 for the same period last year an increase of 37.3%.
CAPITAL RESOURCES - June 30, 1998
The Company's projected capital asset requirements for the current fiscal year, are not very demanding.
ITEM 7 MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT'D)
LIQUIDITY AND CASH FLOW - June 30, 1998
The working capital deficit at the year end decreased by $1,784,000 to $(2,567,000). This was primarily due to an increase of $1,814,000 in the current portion of the long-term debt.
The cash flow from operations during fiscal 1998 increased by $140,000 or 13.6% to $1,175,000 compared to $1,035,000 in the previous fiscal year.
DEBT TO EQUITY:
The ratio of debt to equity as at June 30, 1998 was .44 to 1 compared to .35 to 1 in the previous fiscal year.
IN THE YEAR:
The implementation of the "direct bank transfer" system which automatically withdraws royalty, advertising fund and receivable payments from franchise owners' bank accounts on a weekly basis has continued over the year. Currently 78% of the franchise owners use this method to make their weekly payments. By the end of this fiscal year the Company expects that more than 95% of all franchise owners will have been converted to the direct transfer system.
The Company also introduced a new design appearance for its stores. The new look has been well received by customers, landlords and franchise owners. The updated interior and exterior decor provides for a more comfortable and relaxing atmosphere.
A new line of sandwiches was introduced under the "Baguette Express" banner. Sandwiches are now available at a large number of Treats locations served on a variety of breads including a "baked fresh on site" baguette loaf. A Trade Mark for the new sandwich line has been applied for.
During the year extensive testing of a new line of premium baked goods and as a result the company plans to roll out a new line of cookies in the current fiscal year. The premium line of baked goods will be identified as "TreatSations." Trade Mark registration for TreatSations is pending.
The Company has received several enquiries about opportunities to franchise the Treats concept outside of North America. In June the Company entered into a National Licensing Agreement for Chile and Argentina.
ITEM 7 MANAGEMENTS'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT'D)
IN THE YEAR (CONT'D)
In December 1998 the EMC Group, Inc. from Lakeland, Florida acquired the National License to franchise the Treats concept throughout the United States. The president of EMC Group is a former Vice President of the Company.
ITEM 7 - A QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
n/a
ITEM 8
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TREATS INTERNATIONAL ENTERPRISES, INC.
Consolidated Financial Statements 1999 compared to 1998 Page 24 to 44
FINANCIAL STATEMENTS
CONSOLIDATED
TREATS INTERNATIONAL ENTERPRISES, INC
June 30, 1999 and 1998
TREATS INTERNATIONAL ENTERPRISES, INC.
CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS)
INDEX
Page
26 Auditors' Report
27 - 28 Consolidated Balance Sheets
29 Consolidated Statements of Income and Deficit
30 Consolidated Statements of Cash Flows
31 Consolidated Statements of Stockholders' Equity
32 - 44 Notes to the Consolidated Financial Statements
AUDITORS' REPORT
TO THE SHAREHOLDERS OF TREATS INTERNATIONAL ENTERPRISES, INC.
We have audited the consolidated balance sheets of TREATS INTERNATIONAL ENTERPRISES, INC. as at June 30, 1999 and 1998 and the consolidated statements of income and deficit, cash flows and stockholders' equity for the years ended June 30, 1999, 1998 and 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at June 30, 1999 and 1998 and the results of its operations and its cash flows for the years ended June 30, 1999, 1998 and 1997 in accordance with accounting principles generally accepted in Canada (which also conform in all material respects with accounting principles generally accepted in the United States).
Chartered Accountants
Toronto, Canada October 29, 1999
TREATS INTERNATIONAL ENTERPRISES, INC.
CONSOLIDATED BALANCE SHEETS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
Approved on behalf of the Board:
Director
-------------------------------
See the accompanying notes
TREATS INTERNATIONAL ENTERPRISES, INC.
CONSOLIDATED BALANCE SHEETS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
See the accompanying notes
TREATS INTERNATIONAL ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF INCOME AND DEFICIT
YEARS ENDED JUNE 30. 1999, 1998 AND 1997
(CANADIAN DOLLARS)
See the accompanying notes
TREATS INTERNATIONAL ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED JUNE 30, 1999, 1998 AND 1997
(CANADIAN DOLLARS)
See the accompanying notes
TREATS INTERNATIONAL ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NOTE 10)
YEARS ENDED JUNE 30, 1999, 1998 AND 1997
(CANADIAN DOLLARS)
See the accompanying notes
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS) - -----------------------------------------------------------------------------
1. BASIS OF FINANCIAL STATEMENT PRESENTATION
These consolidated financial statements comprise the accounts of the Company and its wholly-owned subsidiaries, as follows:
* Treats Inc. * Treats Ontario Inc. * Chocolate Gourmet Treats Limited * Treats Canada Corporation
All intercompany transactions and balances have been eliminated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in Canada (which also conform in all material respects with accounting principles generally accepted in the United States) and include the following significant accounting policies.
ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These estimates are reviewed periodically, and, as adjustments become necessary, they are reported in earnings in the period in which they become known.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS) - -----------------------------------------------------------------------------
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D)
REVENUE RECOGNITION
Franchise fees and construction revenue arises on the sale of national, area and store franchises. Franchise store revenue is recognized as income when the respective purchase and sale agreements have been signed, all material conditions relating to the sale have been substantially completed by the Company or the franchise store has commenced operations. Revenue from national and area franchise agreements is recognized when the area development agreement has been signed or all substantial obligations of the Company have been completed.
When payment for the sale of a national or area franchise is based on a contract over a period longer than twelve months, the Company recognizes revenue based on the assessment of collectibility. The total contract is recorded as deferred revenue, and revenue recognition commences when payments in excess of 25% of the total contract have been received and management has ascertained that there is a sufficient level of certainty that the balance of the contract is collectible.
Deposits that are non-refundable under the franchising agreement are recognized as franchising revenue when received.
Royalties are recognized when they are earned, based on a percentage of the franchisees' sales on a weekly basis.
Supplier incentives are recognized in the period to which they apply.
INVESTMENT IN PUBLIC COMPANY
The investment in public company is accounted for at cost. Under the cost method, the investment is recorded at its original cost, and earnings from the investment are recognized only to the extent of dividends received or receivable. When evidence indicates a permanent decline in value the investment is written down.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS) - -----------------------------------------------------------------------------
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D)
CAPITAL ASSETS AND AMORTIZATION
Capital assets are recorded at cost less accumulated amortization. Amortization is provided for at rates intended to write off the assets over their estimated economic lives, as follows:
Building - 20 years straight-line Furniture, fixtures and equipment - 5 years straight-line Corporate owned stores reacquired from franchisees - 5 years straight-line Corporate owned store equipment reacquired from former franchisees - 5 years straight-line
FRANCHISE RIGHTS
Franchise rights are carried at the lower of cost less accumulated amortization, and fair market value. Amortization is provided for on the straight-line basis over 10 years.
EARNINGS (LOSS) PER SHARE
Net earnings (loss) per share are calculated using the daily weighted average number of common shares outstanding during the fiscal year plus the net additional number of shares which would be issuable upon the exercise of stock options, assuming that the Company used the proceeds received to purchase additional shares at market value.
ADVERTISING COMMITMENT
The Company receives prescribed amounts from franchisees to fund and develop advertising and promotion campaigns regionally and nationally. The funds collected, net of costs incurred, are recorded as an asset/liability for future advertising and promotion.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS)
During the year, the Company wrote off $457,245 of notes, due to the closing of unprofitable stores (note 10).
4. INVESTMENT IN PUBLIC COMPANY
In 1998 the Company sold the U.S. area rights for consideration of 2,800,000 class "A" convertible preference shares in EMC Group Inc., a U.S. public company incorporated in the State of Florida, via a management buy-out by former employees of the company. The investment has been recorded at the cost of equipment and franchise rights transferred to EMC Group Inc. based on the available information at the time of the sale.
The preference shares are convertible to common stock for the equivalent of US$2,800,000 based on average market value of the common stock for the 60 days prior to the date of conversion, subject to approval of the board of directors of EMC Group Inc. EMC Group Inc. will only permit the conversion of preferred shares to common shares of EMC Group Inc as long as the conversion does not exceed 10% of the total number of outstanding common shares of EMC Group Inc.
Contrary to the agreement with the Company, since incorporation, EMC Group Inc. has not raised sufficient capital, nor has it made any significant additional store openings. In addition, EMC Group Inc. has not been profitable and management does not anticipate an improvement in operations in the U.S. in the foreseeable future. Based on the above, management believes that there has been a permanent impairment in value, and the asset has been written down to its market value in the current fiscal year.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS)
6. FRANCHISE RIGHTS
The Company obtained an independent appraisal from Scott Rankin, Gordon & Gardiner, Chartered Accountants, substantiating a valuation of franchise rights in the amount of $3,400,000 as at June 30, 1999.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS)
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS)
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998
(CANADIAN DOLLARS)
- -----------------------------------------------------------------------------
7. LONG-TERM DEBT (CONT'D)
(a) The Company is in default of their loan covenants with 3193853 Canada Inc. and Royal Bank Capital Corporation. 3193853 Canada inc. and Royal Bank Capital have not waived their rights to call the term loan and subordinated debenture at a future date and accordingly the debt are classified as current.
Interest expense for the year related to long-term debt was $246,005 (1998 - $111,163).
The minimum future principal repayments required over the next five years are as follows:
$
2000 2,743,495 2001 318,032 2002 300,710 2003 305,173 2004 247,000 Subsequent 565,855 ------------ 4,480,265 ------------ ------------
8. COMMITMENTS AND CONTINGENCIES
(a) The Company is a defendant in several actions arising in the normal course of business. The Company settled most claims subject to certain terms in the amount of $1,250,000, which has been reflected in the statement of income.
As management is of the opinion that the remaining claims, counterclaims or appeals is not determinable at this time, no additional provision has been recorded.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
- ------------------------------------------------------------------------------
8. COMMITMENTS AND CONTINGENCIES (CONT'D)
(b) The Company has lease commitments for corporate-owned stores and office premises. The Company also, as the franchisor, is the lessee in most of the franchisees' lease agreements. The Company enters into sublease agreements with individual franchisees, whereby the franchisee assumes responsibility for, and makes lease payments directly to, the landlord. The aggregate rental obligations under these leases over the next five years are as follows:
* Minimum payments have not been reduced by minimum sublease rentals for $10,726,677 due in future under non-cancellable subleases.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
- ----------------------------------------------------------------------------
9. RELATED PARTY TRANSACTIONS
(a) The Royal Bank of Canada and its subsidiary, Royal Bank Capital Corporation, are registered holders of 37.9% of the common stock. The Royal Bank Capital Corporation holds a subordinated debenture (see note 7) for which the related interest expense was $112,620 (1998 - $104,012).
Undeclared dividends for July 1, 1994 to June 30, 1999 on the preferred shares owned by the Royal Bank are $1,026,515.
(b) In the 1998 fiscal year, the Company has purchased its office premises, land and building at 418 Preston Street, Ottawa, from a trust of which the beneficiaries are the family of the Chief Executive Officer of the Company whose family owns approximately 32.6% of the common stock of the Company.
(c) The President of 3193853 Canada Inc. with whom the Company has a term loan payable, is a member of the family of the Chief Executive Officer of the Company. The related interest expense was $77,890 (1998 - $nil).
(d) Accounts payable includes $34,726 owed to 764719 Ontario Inc. whose owner is a member of the family of the Chief Executive Officer of the Company.
10. RESTRUCTURING COST
In conjunction with the permanent decline in the value of the investment in EMC Group Inc. (note 4), management has formalized a plan whereby the Company will not enter into the U.S. market and will focus expansion strictly in Canada. Accordingly, as there is no longer a value attributable to the U.S. franchise rights, a valuation based on this plan resulted in a write-down of the franchise rights (see note 6).
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
1999 1998 - -----------------------------------------------------------------------------
10. RESTRUCTURING COST (CONT'D)
In addition, management has permanently closed unprofitable stores it reacquired from franchisees in Canada. Accordingly, capital assets were written down to their estimated fair market value.
The write-downs have been recorded as non-cash restructuring costs, allocated as follows:
11. EARNINGS (LOSS) PER SHARE
The calculation of fully diluted earnings per common share assumes that, if a dilutive effect is produced, all convertible securities have been converted, all shares to be issued under contractual commitments have been issued and all outstanding options have been exercised at the later of the beginning of the fiscal period and the option issue date. If all conversions had occurred, the Company would have had to increase its maximum authorized common shares. Fully diluted earnings per share are not presented as they are anti-dilutive.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
- ----------------------------------------------------------------------------
12. FINANCIAL INSTRUMENTS
FAIR VALUE
The carrying amounts of accounts receivable, short-term notes receivable and accounts payable and accrued liabilities approximates their fair value because of the short-term maturities of these items.
The carrying amount of the long-term notes receivable, long-term subordinated debenture and term loans approximates their fair value because the interest rates approximate market rates.
The fair values of the other long-term debt due to non-arm's length parties are not determinable, as these amounts are interest-free and due on demand, and, accordingly, cannot be ascertained with reference to similar debt with arm's length parties.
13. UNCERTAINTY DUE TO THE YEAR 2000 ISSUE
The year 2000 Issue arises because many computerized systems use two digits rather than four to identify a year. Date-sensitive systems may recognize the year 2000 as 1900 or some other date, resulting in errors when information using year 2000 dates is processed. In addition, similar problems may arise in some systems which use certain dates 1999 to represent something other than a date. The effects of the Year 2000 Issue may be experienced before, on, or after January 1, 2000, and, if not addressed, the impact on operations and financial reporting may range from minor errors to significant systems failure which could affect an entity's ability to conduct normal business operations. It is not possible to be certain that all aspect of the Year 2000 Issue affecting the entity, including those related to the efforts of customers, suppliers, or other third parties, will be fully resolved.
14. COMPARATIVE FIGURES
Prior years figures have been reclassified to conform with the current year's presentation.
TREATS INTERNATIONAL ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998 (CANADIAN DOLLARS)
- ----------------------------------------------------------------------------
15. MANAGEMENT PLAN
As disclosed in the financial statements, the Company has incurred a net loss for the year in the amount of $8,945,044 compromised largely of non-cash write-downs as reflected in the statement of cash flows and in note 10. Management feels that these are one-time write-downs and will not be repeated in future years. As well the Company has taken actions to close a number of locations that were unprofitable and not considered likely to become profitable in the near future, and to reduce general and administrative expenses. Management has prepared cash flow projections for the next five years indicating positive cash flows and profitability. The projected cash flows were not audited, reviewed or compiled by the auditors, but were used by the independent appraiser (see note 6) in arriving at the valuation of franchise rights.
As well, the Company is in violation of certain debt covenants as discussed in note 7. While the lenders have never indicated an intention to demand payments as they have the right to do, the relevant long-term debt has been classified as a current liability the accompanying balance sheet. Management is actively pursuing alternative financing to replace the subordinated debenture and term loan with more favourable terms.
Accordingly, based on actions taken and the company's operating plans for the year, the company expects that it will have sufficient cash to be able to continue operations and meet its long-term obligations due within the next fiscal year.
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
- ----------------------------------------------------------------------------
- No Disagreements or changes.
PART III
ITEM 10
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following sets forth the names of the Company's Directors and Officers. The Directors of the Company are elected annually by the shareholders and the Officers are appointed annually by the Board of Directors.
The Company intends to expand the Board to five Directors.
PAUL J. GIBSON
Mr. Gibson is President, C.E.O. Chairman of the Board of The Company. Mr. Gibson has served as President and C.E.O. of TCC since its formation in 1988 and of Treats Inc. since July 1990. Mr. Gibson also serves in various capacities of The Company's wholly owned subsidiaries. From its formation in 1986 until the amalgamation of certain companies in 1993, he was President and C.E.O. of TMG, a predecessor company of Treats Inc.
JOHN A. DEKNATEL
Mr. Deknatel is C.O.O of The Company. He also serves in various capacities for The Company's wholly owned subsidiaries. Prior to joining The Company in 1991, Mr. Deknatel served as Vice President and General Manager of Manchu Wok U.S.A., a division of Scott's Hospitality, of Toronto, Ontario.
PETER-MARK BENNETT
Mr. Bennett was appointed Director December 16, 1994. Since 1998 he has served TELUS Advanced Communications (Calgary) as Manager of Internetworking Services. From August 1997 to October 1998 Mr. Bennett was Director of Marketing for Neptec Design Group Ltd. of Ottawa, From July 1994 to July 1997 Mr. Bennett was Director of Operations for Network Xcellence Ltd. (Ottawa). From July 1990 to June 1992 he was Vice-President of Treats Inc. Prior to July 1990 he was Managing Director of Widely Held Northern & Eastern Investments Ltd.
FRANCOIS TURCOT
Mr. Turcot has been Comptroller of The Company since May 1991 and has been promoted to Director of Finance in August 1996. Prior to joining The Company, Mr. Turcot held the position of Comptroller with a Transport Company in Hull, Quebec. From October 1986 to November 1989, Mr. Turcot was Comptroller at the Ramada Hotel in Hull, Quebec.
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION
Set forth in the table below, is the cash compensation paid to the C.E.O. of The Company and the total to all Executive Officers as a group:
- - There are no options or warrants granted to the present officers.
EMPLOYMENT AGREEMENT
On February 14, 1997 by way of a resolution of the Board of Directors severances for the three officers of The Company were amended to reflect the years of service, specifically 2 months of base compensation for every year of service. Once a Senior Officer reached 5 years of consecutive service, they are entitled to a minimum of 2 years compensation.
ITEM 12
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following sets forth as of the date of November 30, 1999, the number and percentage owned of record and beneficially, by each Officer and Director of The Company and by any other person owning 5% or more of the outstanding shares.
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (CONT'D)
NOTES
1. Paul J. Gibson may be deemed to be a promoter as such terms are defined under the Securities Act of 1933.
2. Access Investment Group Ltd. is a company controlled by Mr. P. Gibson and his immediate family.
3. RBCC is a wholly owned subsidiary of the Royal Bank of Canada. The Royal Bank of Canada is a widely held Canadian Chartered Bank. To the best of The Company's knowledge, no one entity controls more than 10% of all outstanding shares of the Royal Bank of Canada.
The shares are convertible at the option of the holder at a price equal to the lower of the weighted average trading price for TIEI for the previous 30 trading days using the average exchange rate for the period and US $0.30 per share.
(1) MAXIMUM SHARES AVAILABLE = 33,333,333
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
RELATED PARTY TRANSACTIONS
(a) The Royal Bank of Canada and its subsidiary, Royal Bank Capital Corporation, are registered holders of 37.9% of the common stock. The Royal Bank Capital Corporation holds a subordinated debenture (see note 7) for which the related interest expense was $112,620 (1998 - $104,012).
Undeclared dividends for July 1, 1994 to June 30, 1999 on the preferred shares owned by the Royal Bank are $1,026,515.
(b) The President of 319853 Canada Inc. with whom the Company has a term loan payable, is a member of the family of the Chief Executive Officer of the Company. The related interest expense was $77,890 (1998 - $nil).
(c) Accounts payable includes $34,726 owed to 764719 Ontario Inc. whose owner is a member of the family of the Chief Executive Officer of the Company.
PART IV
ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
INDEX
ITEM 14 SCHEDULES (CONT'D)
COMPUTATION OF EARNINGS PER SHARE - U.S. GAAP - TREASURY SHARE METHOD
ITEM 14 SCHEDULES (CONT'D)
COMPUTATION OF EARNINGS PER SHARE - U.S. GAAP - TREASURY SHARE METHOD
AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES
TO THE BOARD OF DIRECTORS OF TREATS INTERNATIONAL ENTERPRISES INC.
We have audited the consolidated balance sheet of Treats International Enterprises Inc. as at June 30, 1999, 1998 and the consolidated statements of income and deficit, cash flow and stockholders' equity for the years the year ended June 30, 1999, 1998 and 1997 and have issued our report thereon dated October 29, 1999; such consolidated financial statements and our report thereon are included elsewhere herein. Our examinations also comprehended the financial statement schedules of Treats International Enterprises Inc. listed in item 14 in its Report on Form 10-K. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements, present fairly in all material respects the information shown therein.
Horwath Orenstein LLP
Chartered Accountants
October 29, 1999
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
TREATS INTERNATIONAL ENTERPRISES, INC.
December 30, 1999 By: \s\ ----------------------------------- PAUL J. GIBSON Chairman of the Board President & Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
December 30, 1999 By: \s\ ----------------------------------- JOHN DEKNATEL Chief Operating Officer
December 30, 1999 By: \s\ ----------------------------------- FRANCOIS TURCOT Director of Finance | 8,931 | 57,940 |
70412_1999.txt | 70412_1999 | 1999 | 70412 | ITEM 1. BUSINESS
BACKGROUND OF COMPANY
e4L, Inc., formerly National Media Corporation, and its subsidiaries ("e4L") are principally engaged in the use of direct response transactional television programming (also known as infomercials), wholesale/ retail distribution and electronic commerce to sell consumer products. e4L manages all phases of direct marketing for the majority of its products in both the United States and international markets, which includes product selection and development, manufacturing by third parties, purchases of television media, production and broadcast of programming, order processing and fulfillment, and customer service.
e4L is engaged in direct marketing of consumer products in the United States through its wholly-owned subsidiary, Quantum North America, Inc. (formerly Media Arts International, Ltd. and d/b/a e4L North America), which e4L acquired in 1986, and internationally through its wholly-owned subsidiaries: Quantum International Limited, which e4L acquired in 1991; Prestige Marketing, Ltd. (a combination of the former Quantum Far East, Ltd. and Prestige Marketing Limited) ("Prestige"), through which e4L operates in New Zealand as well as all Asian countries other than Japan; Quantum International Japan Company Limited, which e4L formed in June 1995; and Suzanne Paul Holdings Pty Limited ("Suzanne Paul") which e4L acquired in July 1996 and which operates in Australia. e4L produces direct response transactional television programming through e4L Television (formerly Direct America Corp. d/b/a e4L Television), which e4L acquired in October 1995.
e4L is a Delaware corporation, with its principal executive offices located at 15821 Ventura Boulevard, 5(th) Floor, Los Angeles, California 91436. e4L's telephone number is (818) 461-6400.
RECENT DEVELOPMENTS
On June 7, 1999, e4L consummated an agreement with BuyItNow, Inc. ("BuyItNow") pursuant to which e4L and BuyItNow have formed a new global electronic commerce entity, BuyItNow.com LLC ("BuyItNow LLC"). BuyItNow LLC was formed through the contribution by BuyItNow of substantially all of its assets and liabilities; and the contribution by e4L of, among other things, e4L's (i.) on-line business of
"As Seen On TV" products, and (ii.) promotion of the new entity within e4L programs. Concurrent with the consummation of this agreement, e4L issued 500,000 warrants to purchase e4L common stock ("Common Stock") to BuyItNow. In addition, concurrent with the closing, Clear Channel Communications, Inc. acquired a 4.5% equity interest in BuyItNow LLC in exchange for a commitment to provide $12.5 million in radio broadcast media. On June 25, 1999, Xoom.com, Inc. and Snap.com, Inc. collectively acquired an aggregate 5.4% equity interest in BuyItNow LLC in exchange for a commitment to provide $15 million of Internet media. In exchange for its contribution, e4L currently owns 48.7% of the equity of BuyItNow LLC.
Members of e4L management will participate as members of the BuyItNow LLC Board of Directors and Management Committee. Stephen C. Lehman, e4L's Chairman and Chief Executive Officer, will serve as BuyItNow LLC's Chairman of the Board of Directors, and Daniel M. Yukelson, e4L's Executive Vice President and Chief Financial Officer, will serve as its Chief Financial Officer. Messrs. Lehman and Eric R. Weiss, e4L's Vice Chairman and Chief Operating Officer, will serve on BuyItNow LLC's board of directors.
On October 23, 1998, e4L announced the finalization of a definitive transaction (the "Transaction") pursuant to which, among other things, operational control of e4L was assumed by an investor group led by Messrs. Lehman, Weiss and Yukelson in August 1998. At a special meeting of e4L's stockholders held earlier on October 23rd, prior to consummation of the Transaction, e4L's stockholders approved the Transaction, elected nine directors, approved an amendment to e4L's 1991 Stock Option Plan and ratified the appointment of Ernst & Young LLP as e4L's auditors for the fiscal year ending March 31, 1999.
In connection with the Transaction, NM Acquisition Co., LLC, a Delaware limited liability company ("ACO"), invested $20,000,000 into e4L in exchange for shares of newly-created Series E Convertible Preferred Stock ("Series E Preferred Stock") which are convertible into 13,333,333 shares of e4L Common Stock. Until ACO's subsequent dissolution, ACO was managed by Temporary Media Co., LLC, a Delaware limited liability company ("TMC") of which Messrs. Lehman, Weiss and Yukelson are the managing members. As part of the Transaction, TMC was granted a five-year option to purchase up to 212,500 shares of Common Stock, subject to certain vesting requirements, at an exercise price of $1.32 per share, and warrants to purchase up to 3,762,500 shares of Common Stock at exercise prices ranging from $1.32 to $3.00 per share (1,000,000 of which may not be exercised by TMC or any employee or member of TMC). Financing for the Transaction was obtained through the private placement of equity interests in ACO. A portion of the $20,000,000 was used to repay in full e4L's obligations to its secured lender. The remainder of the funds was used to pay certain expenses of the Transaction (including ACO's expenses) and for working capital purposes.
In August 1998, holders of e4L's Series D Convertible Preferred Stock ("Series D Stock") sold to ACO $10.0 million face value of Series D Preferred shares and 992,942 warrants previously issued in connection with such shares (e.g., Series C Warrants and Series D Warrants).
As of the closing of the Transaction, members of ACO and TMC beneficially owned an aggregate of 26,619,854 shares of Common Stock (which included shares of Common Stock underlying the Series E Stock, the Series D Stock, the Series D Warrants and the Series C Warrants (collectively, the "Securities"), along with the TMC options and TMC warrants set forth above, which represented approximately 34% of the then outstanding Common Stock on a fully diluted basis. Immediately following consummation of the Transaction, ACO was dissolved and the Securities were distributed to its members according to their membership interests in ACO. In connection with the dissolution of ACO, each of its members granted TMC an irrevocable proxy to vote their respective shares with regard to any election of Directors.
Pursuant to the terms of the Transaction, (i.) the stockholders of e4L elected Messrs. Lehman, Weiss and Andrew M. Schuon to e4L's Board of Directors, (ii.) each of Albert R. Dowden, William M. Goldstein, Frederick S. Hammer, Robert N. Verratti and Jon W. Yoskin II, resigned from the Board of Directors, effective October 23, 1998, (iii.) the size of the Board of Directors was reduced from nine to seven members and (iv.) Stuart D. Buchalter, David E. Salzman and Robert W. Crawford were appointed to the
Board of Directors. Following consummation of the Transaction, Mr. Lehman was appointed Chairman of the Board of Directors and Chief Executive Officer, Mr. Weiss was appointed Vice Chairman of the Board of Directors and Chief Operating Officer, John W. Kirby was appointed President, and Mr. Yukelson was appointed Executive Vice President/Finance and Chief Financial Officer and Secretary of e4L.
STRATEGIES
e4L's goal is to leverage its television and radio direct response infrastructure to drive e-commerce and membership services. e4L is a global leader in direct marketing, wholesale/retail distribution and electronic commerce. Through direct response transactional television and radio programming and integrated consumer marketing techniques, e4L is pursuing a business strategy focused on: (i.) increasing the effective utilization and leveraging of its global presence and its media access to drive its direct response television, wholesale/retail, continuity, electronic commerce and membership services businesses; (ii.) continuing to develop and market innovative consumer products; and (iii.) engineering the most efficient business model for the conduct of its global operations.
LEVERAGING GLOBAL PRESENCE AND MEDIA ACCESS. e4L is continuing its efforts to expand its position as a worldwide leader in direct response marketing, wholesale/retail, continuity, electronic commerce and membership services businesses. Through its existing media access and order fulfillment operations, e4L has the ability to deliver its programming, commercials and products to over 270 million households worldwide via television and through the Internet. e4L also effectively utilizes and leverages its worldwide distribution reach, marketing capabilities, and its media access by providing such reach and capabilities to other consumer product distributors; by entering into alliances with companies that need or desire to reach the households that e4L's programming reaches; and by taking advantage of the product and brand awareness created by its programming in other methods of consumer distribution (i.e., wholesale/retail, Internet and continuity). In addition, e4L aggressively utilizes its assets, such as its customer lists, in order to generate revenue therefrom.
CONTINUE TO DEVELOP AND MARKET INNOVATIVE PRODUCTS. e4L continually seeks out and develops innovative consumer products that it can market and distribute profitably on a global basis. e4L has an in-house product development and marketing department responsible for researching, developing and analyzing products and product ideas. e4L often augments its product development activities through relationships with third parties.
e4L believes as a result of the opportunity and ability to leverage global media, its extensive international operations, its presence on the World Wide Web, and its experience in product sourcing, telemarketing, order fulfillment and customer service, that it maintains a significant competitive advantage over competitors desiring to enter its existing or new markets. While e4L incurs certain initial and ongoing costs in connection with adapting a product and programming for specific markets, the primary expenses are incurred when the product is first developed for its initial target market. Accordingly, as e4L decides to introduce a product into additional markets, it attempts to do so quickly, efficiently and relatively inexpensively.
ENGINEERING THE MOST EFFICIENT BUSINESS MODEL FOR E4L. e4L continues to explore methods to improve each step in the development and life cycle of a product, and to develop its expertise in, and refine its approach with regards to, among other things, product sourcing, in-bound telemarketing, order fulfillment, customer service, media and electronic commerce applications. e4L believes that its current competitive advantages of international media access, multi-country coverage and fully-integrated program production, product sourcing and order fulfillment, as well as certain strategic relationships, provide it with a strong base from which it can lower its costs and engineer a business model that is the most efficient for a direct marketing and electronic commerce business.
GLOBAL MEDIA ACCESS
An important part of e4L's ability to successfully market products is its access and ability to leverage global media time. An integral part of e4L's business operations is the availability of media time at a price that allows e4L to sell sufficient product units at targeted gross margins. Many factors, such as changing viewer patterns, cable company practices and competition have an impact on e4L's ability to properly manage this function. e4L's programming is presently available to more than 270 million households in over 70 countries worldwide.
During peak periods, e4L utilizes approximately 2,000 half-hours of cable and broadcast television time per week in the United States and approximately 1,000 half-hours per week internationally, most of which is satellite and terrestrial broadcast time, to broadcast its programs. For the most part, cable broadcast technology is not as prevalent internationally as it is in the United States. Historically, approximately one-half of e4L's cable air time in the United States and a majority of e4L's satellite and terrestrial air time internationally had been purchased under long-term contracts that had provided for specific time slots over the term of the respective contracts. Over the past 18 months, e4L has effectuated an intentional reduction in long-term media commitments to the point where less than 10 percent of its media time is currently purchased pursuant to long-term contracts.
UNITED STATES MEDIA
e4L purchases television media in the United States primarily through its in-house staff of media buyers. e4L purchases most of its cable television time directly from cable networks and their respective media representatives, rather than from multi-system operators. Presently, e4L has short-term commitments for cable television time slots for periods ranging from two weeks to three months. e4L believes that its programming is seen on at least one network which is carried by every local cable system carrier throughout the United States.
In addition to domestic television time purchased on cable networks, e4L also purchases broadcast television time from network affiliates and independent television stations. Broadcast television time segments are purchased primarily in 30-minute spots. e4L also purchases 60 and 120-second spots where economically feasible, and either adapts portions of its programs or develops specific products for airings in such spots. The time segments on broadcast television are purchased primarily on a quarterly basis based on the availability of broadcast time. In the event e4L determines that such time slots are not advantageous to e4L, e4L is generally able to terminate such agreements. e4L believes there is currently more than an adequate supply of broadcast television time available from sources in the United States to satisfy e4L's needs. During fiscal year 1999, approximately 48% (in dollar terms) of the media time purchased by e4L came from cable television and approximately 52% came from network affiliates and independent television stations. e4L's programs generally are broadcast in the United States between the hours of 12:00 a.m. and 6:00 p.m., Eastern Standard Time, seven days a week.
e4L generally has the right to resell any media time it purchases. During fiscal year 1999, e4L maintained a broker relationship with several companies to which it sold excess airtime. This ability to resell excess airtime can reduce some of the risk associated with large or longer-term purchases of media time.
As discussed above, e4L purchases a significant amount of its media time from cable television and satellite networks. These cable television and satellite networks assemble programming for transmission to multiple and local cable system operators. These local cable system operators may not be required to carry all the system's programming. e4L currently does not pay and is not paid for the "privilege" of being broadcast by these operators. It is possible that, if demand for airtime grows in the United States, these operators will begin to charge e4L to continue broadcasting e4L's programs or limit the amount of airtime available to e4L. e4L is dependent on having access to media time to televise its programs on cable networks, satellite networks, network affiliates and local broadcast stations.
During fiscal year 1999, e4L launched a weekly syndicated 3-hour radio program, "Everything4Less" which currently is broadcast in Los Angeles, California. The "Everything4Less" radio program showcases consumer products and highlights consumer issues in an entertaining talk show format, and features live on-radio and Internet auctions of consumer products. e4L will attempt to "roll-out" the radio program nationally in the United States during fiscal year 2000. As a syndicated radio program, e4L generally receives the program's broadcast time and an allotment of commercial "spots" within the radio program, at no cost, in exchange for providing the program's content to its radio station affiliates.
INTERNATIONAL MEDIA
Internationally, e4L's programs are broadcast on one or more of three technologies: (i.) satellite transmission direct to homes with satellite reception dishes, (ii.) cable operators who retransmit satellite broadcasts to cable-ready homes and (iii.) terrestrial broadcast television.
e4L's satellite airtime has historically been obtained through agreements with companies that own or lease satellite transponder time. At present, e4L is a party to contracts with pan-European satellite channels such as Euronews and the Science Fiction Channel. During the terms of these contracts, e4L is generally entitled to broadcast programming continuously for a specified period of time daily. Under some of these arrangements, e4L has rights of first refusal for any additional direct response broadcast time that becomes available.
During April 1998, e4L began a direct lease of a twenty-four hour transponder on a Eutelstat satellite, the "Hotbird IV" (the "Eutelstat Satellite") the coverage of which reaches across the European continent. e4L has incurred significant start-up costs in connection with the Eutelstat Satellite, which has increased its European media costs. The term of the Eutelstat Satellite lease is for the life of the satellite, estimated to be approximately 10-12 years. To date, household penetration of the Eutelstat Satellite has been less than anticipated and, as a result, e4L has sought alternative means (other than broadcasting its own programming) to mitigate the substantial cost of the Eutelstat Satellite lease, including subleasing certain channels and/or segments of time to other content providers. Accordingly, e4L has determined that the Eutelstat Satellite lease is unfavorable and recorded a portion as an unusual charge. See also "Management's Discussion and Analysis of Financial Condition and Results of Operations."
At present, in Japan and throughout most of Asia, e4L purchases the majority of its media time through Mitsui & Co., Ltd. ("Mitsui"). As a result of other media relationships, e4L's transactional television programming can be seen in the Middle East, South Africa, Asia, South Pacific Rim, South America and in most countries in Europe, and its products are available for purchase in over 70 countries. As e4L's media contracts expire, e4L expects that it could face increases in costs associated with their renewal, or could potentially lose these media contracts, which may or may not have a material adverse effect on e4L.
PRODUCT DEVELOPMENT
e4L's product development and sourcing department researches and develops new products that may be suited for direct response television marketing and subsequent marketing through non-television distribution channels. e4L's product development and sourcing staff reviews and develops new product concepts and ideas from or with a variety of sources, including inventors, suppliers, trade show participants, manufacturing and consumer products companies. In addition, e4L develops new products through its ongoing review of new developments within targeted product categories.
e4L does not invent new products but, as a result of e4L's prominence in the direct marketing industry, it often receives and reviews new product proposals from independent third parties who have invented or patented a product that they may wish to market through e4L. During the evaluation phase of product development, e4L analyzes the suitability of the product for television demonstration and explanation as well as the anticipated, perceived value of the product to consumers, determines whether an adequate and
timely supply of the product can be obtained, and analyzes whether the estimated profitability of the product satisfies e4L's criteria. e4L oversees the enhancement of products brought to it by these parties for purposes of targeting the products for a direct marketing audience. This effort may include actual changes to the product itself as well as alterations of tradename, packaging, etc.
In order to develop or acquire the rights to distribute or market new products, e4L sometimes works with other consumer products companies. A clear advantage of these relationships is that e4L's partner typically will underwrite the research and product development function, thereby reducing e4L's financial risk as well as its working capital requirements.
e4L reviews its products and product concepts on an ongoing basis to select those that it believes will be successful in North America, South America, Europe, Asia, South Pacific Rim and/or one of its other international markets. When a product which was initially sold in the United States is selected for international distribution, the program is dubbed, if necessary, and product literature is created in the appropriate foreign languages. In addition, a review of the product's and the program's compliance with local laws is completed, as necessary. e4L then begins airing the program internationally. Internationally, e4L markets products through programs which it produces, and also markets products of other independent direct marketing companies. e4L brought approximately 26 new products to market globally during fiscal year 1999, 15 of which were products marketed through programs produced by e4L.
e4L obtains the rights to new products created by third parties through various licensing arrangements generally involving a combination of up-front advances and/or royalties payable based upon sales or profits of the product. The amount of the royalty is negotiated and generally depends upon the level of involvement of the third party in the development and marketing of the product. e4L also obtains rights to sell products which have already been developed, manufactured and marketed through direct response television programming produced by other companies. e4L generally seeks exclusive worldwide rights to all products in all means of distribution. In some cases, e4L does not obtain rights to all marketing and distribution channels, but seeks to receive a royalty on sales made by the licensor pursuant to the rights that have been retained.
TEST MARKETING NEW PRODUCTS
Once e4L decides to bring a product to market, it arranges for the production of a television program or shorter commercial spot that can provide in-depth demonstrations and explanations of the product. e4L's programs have historically been approximately 28 minutes in length. e4L attempts to present a product in an entertaining and informative manner utilizing a variety of program formats, including live talk shows and live paid studio audience programs. e4L's programs are currently produced in-house or by independent production companies with experience in e4L's product categories both in the United States and in other countries. The cost of producing a program generally ranges from $200,000 to $500,000. In addition, producers, hosts and spokespersons generally receive advances and/or royalties based upon sales or profits of the product.
Following completion of the production, the program is then tested in the United States in specific time slots on both national cable networks and targeted broadcast stations. If a program achieves acceptable results during the market tests and a supply of product is available, it is generally aired on a rapidly increasing schedule on cable networks and broadcast channels. During this initial test phase, e4L may modify the creative presentation of the program and/or the pricing, depending upon viewer response. After the initial marketing phase, e4L may adjust the frequency of a program's airings to achieve a schedule of programs that it believes maximizes the profitability of all of e4L's products being marketed at a given time. In the past, e4L generally aired each successful program domestically for 4 to 10 months or more, before international airings began. International airings then would range from 12 to 24 months, or longer in some instances. e4L has more recently begun introducing products internationally soon after, or simultaneously with, its domestic introduction of the products.
SOURCING AND MANUFACTURING
e4L uses vendors in North America and several countries in Europe and Asia to manufacture products sold through its direct response television programming. e4L monitors the availability of its products and adjusts the amount of media time on a program for a particular product that cannot be adequately supplied. Additionally, e4L uses the services of a technical/engineering firm to assist in the coordination of the manufacturing of some of e4L's products in Asia, and to assist in the monitoring of the quality of the products manufactured in such countries. The same product manufacturing sources are generally utilized irrespective of whether e4L's program is being aired in the United States or internationally.
In general, when possible, before e4L acquires any sizeable inventory position in a product, e4L test markets the product. e4L then purchases additional inventory for a wider distribution and penetration of the product's program. Sometimes, due to issues of timing and costs relating to product sourcing, e4L does take an inventory position in a product before testing is completed.
IN-BOUND TELEMARKETING
e4L strives to provide a problem-free purchasing and fulfillment process for its customers. This process consists of in-bound telemarketing, order fulfillment and customer service. The first step in this process is the order-taking function known as in-bound telemarketing. Customers may order products marketed by e4L during or after the broadcast of the program by calling a telephone number (generally toll-free),which is shown periodically on the television screen during the broadcast. Both within the United States and in most cases internationally, e4L subcontracts its in-bound telemarketing function to one of various third parties that provide this service for a fee based on the number of telephone calls answered, the duration of calls, and/or sales generated. In Australia and New Zealand, e4L operates its own in-bound telemarketing call centers. In all instances in the United States, and in most instances internationally, in-bound telemarketers electronically transmit orders to order fulfillment centers where the product is packaged and shipped to the customer. In most cases, at the time of purchase, the in-bound telemarketers also promote, cross-sell and upsell complementary and/or additional products or services including product continuity programs and memberships in e4L's shopping service, "Everything4Less." Such sales efforts are orchestrated by e4L's marketing personnel who script the sales approaches of the telemarketing personnel.
The large majority of customer payments in the United States are made by credit cards over the telephone with the remainder (less than 1%) paid by check or money order. The trend in the direct response television industry, especially over the last few years, has been to sell products on a multi-payment basis whereby customers make installment payments over some predetermined period after having received the product. This practice is prevalent in the United States and the South Pacific Rim. In Europe, Asia and other areas of the world, products are generally delivered to consumers on a "cash on delivery" basis, where payment by check or cash at the time of delivery is not uncommon.
ORDER FULFILLMENT
Various aspects of e4L's order fulfillment in the United States is conducted by e4L through its leased facility in Phoenix, Arizona. Activities at this facility include receiving merchandise from manufacturers, inspecting merchandise for damages or defects, storing and assembling products for later delivery, packaging and shipping of products and processing of customer returns. During fiscal year 1999, substantially all orders for e4L's products sold in the United States were processed at e4L's Phoenix, Arizona fulfillment center. During the third quarter of fiscal year 1999, e4L began the process of outsourcing aspects of its fulfillment center operations in the United States, and has presently contracted with various independent third parties to handle warehousing, order fulfillment, returns processing and/or customer
service. See also "Managements' Discussions and Analysis of Financial Position and Results of Operations." e4L primarily uses bulk shippers to deliver products to customers in the United States. Each customer is charged a shipping and handling fee, which varies among products.
Throughout most of Europe and Asia, e4L operates the warehousing, order fulfillment, distribution and customer service functions of its business through independent third parties, each of which is responsible for a particular territory or country. In New Zealand and Australia, e4L performs these functions internally. European products are shipped by e4L or the manufacturer to independent warehouse and fulfillment centers throughout Europe that process e4L's European sales orders. In Asia, Mitsui, plays a key role in the warehousing and distribution of e4L's products. In the Middle East, South America, Africa and in many smaller Asian countries, e4L generally contracts with independent licensees who buy e4L's products outright and then sell them to consumers, both through use of e4L's programming and through other local distribution channels, under conditions and standards prescribed and monitored by e4L.
CUSTOMER SERVICE
An important aspect of e4L's marketing strategy is to maintain and improve the quality of customer service. In the United States, e4L operates toll-free customer service telephone numbers and maintains its own customer service department in Phoenix, Arizona to respond to customer inquiries, provide product information to customers and process product returns. Outside of the United States, customer service is generally provided on a contract basis through third parties whose operations are monitored by e4L. e4L's New Zealand and Australian subsidiaries perform these functions internally. e4L is presently in the process of outsourcing its customer service operations in the United States through independent third parties. See "Managements' Discussion and Analysis of Financial Condition and Results of Operations."
e4L generally offers an unconditional, 30-day money back return policy to purchasers of its products. In addition, products are generally covered by warranties offered by the manufacturer for defective products. The terms of such warranties vary depending upon the product and the manufacturer. The average return rate of e4L's products for each of fiscal years 1999, 1998, and 1997 was 17.8%, 15.7% and 9.6%, respectively. e4L believes that its overall return rate has increased as a result of, among other things, the following factors: (i.) sales of larger, more expensive products (e.g., fitness equipment); and (ii.) sales of more intellectual property based products (e.g., audio cassette and videotape) especially in the United States. European sales carry a higher average return rate than other international markets due to the "cash on delivery" terms of a significant portion of this business. In countries where e4L depends upon the postal system for deliveries on a "cash on delivery" basis, official return rates include instances where there is no answer at the attempted delivery address, and where a person at the delivery address does not have the cash on hand at the time of delivery. e4L believes that its return experience is within the customary range for its product mix within the direct marketing industry.
ELECTRONIC COMMERCE AND MEMBERSHIP SERVICES
e4L has positioned itself, principally through the leverage of its television and radio media, to effectively execute a transition from a direct response television marketing company to a global consumer products and electronic commerce and membership services company. During fiscal year 1999, e4L launched a strategy of marketing its direct response television products and other products and services through the Internet. In August 1998, e4L entered into an agreement with Broadcast.com, which provides it with Internet broadcasting capabilities for its direct response television programming, including ten (10) live, on-line channels.
During May 1999, e4L launched, in conjunction with Auction Universe, Inc. ("Auction Universe"), "Everything4Auction." Everthing4Auction offers more than 6,000 categories of products sold via on-line auctions over the Internet. On June 7, 1999, e4L consummated an agreement with BuyItNow pursuant to
which e4L and BuyItNow formed a new global electronic commerce entity. BuyItNow LLC is a multi-category Internet retailer that features eight individually branded, product-specialized electronic commerce retail stores. See also, "Recent Developments."
During the third quarter of fiscal year 1999, e4L launched its membership services program, "Everything4Less". By leveraging its television and radio infrastructure, "Everything4Less" memberships are sold via commercials within e4L's direct response television programming and inbound telemarketing to e4L customers.
ALTERNATIVE DISTRIBUTION CHANNELS
Based on the success of certain of its products in traditional retail markets, continuity channels, and electronic commerce, e4L believes that its transactional television programming is effective in branding and building consumer awareness for its products, as well as in positioning e4L to act as the media marketing partner for manufacturers of consumer products. e4L attempts to capitalize on its ability to create product awareness, and its ability to both act as a media marketing partner and extend the sales life of its products by shifting products from direct response television programming to alternative marketing and distribution channels such as continuity sales, wholesale/retail distribution, catalogs, direct mail, direct response print advertisements, television home shopping programs, credit card statement inserts, electronic commerce and other channels resulting from the development of strategic relationships. e4L believes that established manufacturers regard direct response marketing as a desirable vehicle to showcase their products, and to create and build brand awareness that can generate follow-up product sales through traditional retail outlets.
e4L intends to pursue the expansion of its wholesale/retail operations in order to capitalize on the consumer brand-awareness created by e4L's programs and reinforced by "As Seen On TV" in-store signage. e4L believes that the product exposure created by e4L's transactional television programming enables e4L and its distributors to utilize traditional wholesale/retail distribution channels without incurring any of the additional media and promotion costs that other consumer products companies may incur. In this manner, e4L believes that it will be able to market products to consumers who view its programming, but do not traditionally purchase products through direct response marketing. e4L owns and operates three retail locations in New Zealand, and one in Australia. In addition, e4L plans to pursue a strategy of developing and marketing products suitable for one of its continuity programs. Under its continuity programs, customers continue to reorder products on a periodic basis, after the initial product sale takes place.
In fiscal years 1999, 1998 and 1997, alternative distribution channels accounted for 16.3%, 9.3% and 6.6%, respectively, of e4L's net revenue. The increased percentage in fiscal year 1999 was primarily attributable to increased retail sales in Europe, Asia and South Pacific Rim, and greater continuity sales in the United States. Fiscal year 1997 included significant royalties earned from the sale of the Ab Roller Plus product in the retail marketplace.
PRODUCTS
e4L markets consumer products in a variety of product categories, including diet and fitness, personal care and housewares. During fiscal year 1999, e4L offered over 100 products to consumers in one or more geographic markets worldwide, of which, on a revenue basis, approximately 88.4% were products sold through e4L's produced programs and approximately 11.6% were products sold by e4L pursuant to license agreements with other direct response companies. Of the products sold through e4L's programs in fiscal year 1999, approximately 15 were products first introduced by e4L in fiscal year 1999 and approximately 39 were products that were originally offered in previous years. Through its global programming and distribution capabilities, e4L has brought to the international marketplace many of its products that had been successfully marketed in the United States.
e4L's five most successful products in each of fiscal years 1999, 1998 and 1997 accounted for approximately 40.9%, 40.3% and 41.2%, respectively, of e4L's net revenue for such periods. e4L continues to be dependent, in significant part, upon its ability to develop or obtain rights to new products to supplement and replace existing products as they mature through their product life cycles, and upon its ability to develop products and revenue sources with extended life cycles through wholesale/retail, continuity programs and electronic commerce. Historically, in the United States, the majority of e4L's products generate their most significant revenue in the first six to nine months following initial broadcast of the direct response television program. Internationally, however, products typically generate revenue more evenly over a longer period due, in part, to the introduction of such products into new markets each year and differing availability of media. Because e4L already markets its products in over 70 countries, e4L's ability to continue to expand into new markets each year may be limited.
COMPETITION
e4L competes directly with many other companies, large and small, which generate revenue from direct marketing, wholesale/retail, continuity and electronic commerce activities. e4L also competes with a large number of consumer products companies and retailers which have substantially greater financial, marketing and other resources than e4L, some of which presently conduct, or indicated their intent to conduct, direct response marketing. e4L also competes with companies that make imitations of e4L's products at substantially lower prices. Companies which imitate or "knockoff" e4L's products take advantage of the product category awareness, product development, and market positioning which e4L pays for when it develops a product and a direct response program. e4L seeks to protect itself from "knockoffs" through establishment and enforcement of its intellectual property rights. Products similar to e4L's products may be sold in department stores, pharmacies, general merchandise stores and through magazines, newspapers, direct mail advertising catalogs and the Internet.
MANAGEMENT INFORMATION SYSTEMS
e4L's network of management information systems features programs which allow e4L to manage its media time purchases and program scheduling, the flow of product order information among its telemarketers, its order fulfillment centers, its credit card clearing houses and the flow of shipping, billing and payment information. e4L believes that its management information systems are in need of improvement, and it is currently in the process of upgrading and evaluating potential upgrade of certain aspects of these systems it believes are most critical, including conducting a review of outsourcing portions of its information systems processing functions. See also "Managements' Discussion and Analysis of Financial Condition and Results of Operations."
GOVERNMENT REGULATION
Various aspects of e4L's business are subject to regulation and ongoing review by a variety of federal, state, local and foreign government agencies, including the Federal Trade Commission ("FTC"), the United States Post Office, the Consumer Products Safety Commission ("CPSC"), the Federal Communications Commission, ("FCC"), the Food and Drug Administration ("FDA"), various States' Attorneys General and other state, local and foreign consumer protection and health agencies. The statutes, rules and regulations applicable to e4L's operations, and to various products marketed by it, are numerous, complex and subject to change.
e4L's international business is subject to the laws and regulations of the United Kingdom, the European Union, Japan and various other countries in which e4L sells products, including, but not limited to, the various consumer and health protection laws and regulations in the countries where e4L markets its products. If any significant actions were brought against e4L or any of its subsidiaries in connection with a breach of such laws or regulations, including the imposition of fines or other penalties, or against one of the entities through which e4L obtains a significant portion of its media, e4L could be materially and
adversely affected. There can be no assurance that changes in the laws and regulations of any territory which forms a significant portion of e4L's market will not adversely affect e4L's business or results of operations.
In June 1996, e4L received a request from the FTC for additional information regarding one of e4L's direct response television programs in order to determine whether e4L was operating in compliance with certain of its consent orders. The FTC later advised e4L that it believed e4L had violated one of the consent orders by allegedly failing to substantiate certain claims made in one of its direct response television programs which it no longer broadcasts in the United States. e4L has entered into a settlement agreement with the FTC staff completely resolving all of the FTC staff's concerns.
In addition, during 1997, in accordance with applicable regulations, e4L notified the CPSC of breakages that were occurring in its Fitness Strider product. e4L also notified the CPSC that it had replaced certain parts of the product with upgraded components. The CPSC reviewed e4L's test results in order to assess the adequacy of the upgraded components. The CPSC also undertook its own testing of the product and, in November 1997, informed e4L that the CPSC compliance staff had made a preliminary determination that the Fitness Strider product and upgraded components present a substantial product hazard, as defined under applicable law. e4L and the CPSC staff have discussed voluntary action to address the CPSC's concerns, including replacement of the affected components. At present, management of e4L does not anticipate that any action agreed upon, or action required by the CPSC, will have any material adverse impact on e4L's results of operations or financial condition. e4L has also been contacted by Australian consumer protection regulatory authorities regarding the safety of the Fitness Strider product and another exercise product marketed by e4L only in Australia and New Zealand. At the present time, e4L cannot predict whether the outcome of these matters will have a material adverse impact upon e4L's results of operations or financial condition.
In August 1998, e4L received a notice from the New York Stock Exchange ("NYSE") that e4L did not meet the NYSE's standards for continued listing criteria. The NYSE requested that e4L provide information regarding any actions taken or proposed by e4L to restore e4L to compliance with the NYSE standards. e4L responded to the NYSE notification, and in November 1998, e4L received written notice from the NYSE that while the NYSE intends to monitor e4L's compliance with the NYSE listing standards, no further action will be taken with respect to this matter at this time.
e4L collects and remits sales tax in the states where it has a physical presence. Certain states in which e4L's only activity is direct marketing have attempted to require direct marketers, such as e4L, to collect and remit sales tax on sales to customers residing in such states. A 1995 United States Supreme Court decision held that Congress can legislate such a change. Thus far, Congress has taken no action to that effect. e4L is prepared to collect sales taxes for other states if laws are passed requiring such collection. e4L does not believe that a change in the laws requiring the collection of sales taxes will have a material adverse effect on e4L's financial condition or results of operations.
EMPLOYEES
As of June 15, 1999, e4L had approximately 320 full-time employees. e4L also utilizes contract/ part-time personnel on an as needed basis. None of e4L's employees is covered by collective bargaining agreements and management considers relations with its employees to be good.
TRADEMARKS AND PATENTS
e4L has a number of registered trademarks and other common law trademark rights for certain of its products and marketing programs. It is e4L's policy to seek to fully protect and vigorously defend its trademark rights in its products and programs, although e4L often will not actively seek to register certain trademarks in all jurisdictions where its sells its products. e4L does not hold any patents, but the products which e4L markets are often protected by patents (or the subject of pending patent applications) held by
the product's inventor or manufacturer. e4L seeks to have its product inventors and/or manufacturers holding a product's patent indemnify e4L against claims that the product being marketed by e4L does not infringe on a third party's patent rights.
ITEM 2.
ITEM 2. PROPERTIES
e4L currently leases approximately 23,200 square feet in Los Angeles, California for its corporate headquarters, and television post-production facility and production offices. The lease, which commenced in May 1997, runs for 126 months and requires payments at varying rates from $520,000 in the first year to $662,000 in the final year.
e4L currently leases approximately 25,200 square feet of office space pursuant to an eleven-year lease for its former executive offices in Philadelphia, Pennsylvania. The lease, which commenced in December 1996, provides for annual rent payments of $479,000 in years one through five, and $568,000 in years 6 through 11. In October 1998, e4L made a decision to close its corporate headquarters in Philadelphia, and relocate its headquarters to its offices in Los Angeles, California. e4L has subsequently subleased its former corporate offices for average annual rent payments of $337,000 for the remainder of the term of that lease.
e4L leases approximately 188,000 square feet in Phoenix, Arizona for warehousing, order fulfillment and customer service operations. The annual lease payments for this lease range from approximately $707,000 for fiscal year 2000 to $1.1 million for fiscal years 2010 through 2014. e4L is presently in the process of attempting to sublease all or a portion of this facility in connection with its restructuring plans for its North American operations.
e4L leases approximately 10,800 square feet of office space in London, England, approximately 3,600 square feet of which it currently sublets. The lease expires in February 2001. The lease requires annual rent payments of approximately $435,000. Additionally, pursuant to the terms of such lease, e4L must pay a basic service charge for services provided by the landlord. For the fiscal year ended March 31, 1999, e4L paid a basic service charge of approximately $116,000.
e4L leases an office building, warehouse, showroom facility and retail stores in Auckland, New Zealand. The main lease, which commenced on April 1, 1996, continues for ten years and currently requires annual payments of approximately $158,000. In addition, e4L entered into a three-year lease, beginning in August 1997, for its primary offices, warehouse and retail store in New South Wales, Australia. The lease requires annual payments of approximately $362,350. This amount includes approximately $77,616 per year for general area charges and maintenance.
e4L also leases retail stores in each of Christchurch and Wellington, New Zealand for aggregate annual payments of approximately $69,900.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
LITIGATION
In March, 1999, Intervention, Inc., a California non-profit corporation ("Intervention"), filed a complaint for false advertising against e4L in the Superior Court for Contra Costa County, alleging that e4L overstated the effectiveness of one of its home exercise products in its direct response television program. e4L is vigorously contesting the action. At this time, e4L cannot predict the outcome of this matter; however, even if Intervention were to succeed on all of its claims, e4L does not believe that such results would have a material adverse impact on e4L's results of operations or financial condition.
In February 1999, e4L filed a complaint against The Media Group, Inc. ("TMG"), a direct marketing company located in Stamford, Connecticut, for trademark infringement, declaratory relief, breach of written contract, breach of oral contract, and other causes of action in the United States District Court for
the Central District of California. e4L's complaint alleges, among other things, that TMG failed to pay to e4L its share of profits under a distribution agreement, infringed upon e4L's trademarks and intellectual property, and failed to pay for media airtime purchased on TMG's behalf. Shortly thereafter, TMG filed a separate complaint in the Pennsylvania Court of Common Pleas for the County of Philadelphia claiming that e4L allegedly breached a purported oral agreement to provide TMG with a right of first refusal to market all of e4L's products with a retail sale price of less than $99.00. TMG's state court action was removed to the United States District Court for the Eastern District of Pennsylvania. A written order is still pending. e4L is vigorously prosecuting its claims against TMG and contesting TMG's claims in both actions. At this time, e4L cannot predict the outcome of this matter; however, even if TMG were to succeed on all of its claims, e4L does not believe that such results would have a material adverse impact on e4L's results of operations or financial condition.
In March 1997, WWOR Television filed a complaint for breach of contract in the United States District Court for New Jersey against one of e4L's wholly-owned subsidiaries alleging, among other things, that the subsidiary wrongfully terminated a contract for the purchase of television broadcast time, seeking in excess of $1.0 million in compensatory damages and its attorneys' fees and costs. e4L entered into a settlement agreement with WWOR regarding this matter in June 1999.
e4L, in the normal course of business, is a party to litigation relating to trademark, patent and copyright infringement, product liability, contract-related disputes, and other actions. It is e4L's policy to vigorously defend all such claims and enforce its rights in these matters. e4L does not believe any of these actions, either individually or in the aggregate, will have a material adverse effect on e4L's results of operations or financial condition
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
e4L held a special meeting of stockholders on February 25, 1999 to consider and approve an amendment to its Certificate of Incorporation to change its name from "National Media Corporation" to "e4L, Inc." The proposal was approved by e4L's stockholders as follows:
PART II
ITEM 5.
ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
e4L's Common Stock is listed on the NYSE, and until June 23, 1999 was listed on the Philadelphia Stock Exchange ("PSE") at which time e4L elected to discontinue its PSE listing.
The following table sets forth the quarterly high and low last sales prices as reported on the NYSE for the last two fiscal years. e4L's common stock has been traded on the NYSE since September 14, 1990.
The number of record holders of e4L's Common Stock on June 15,1999 was approximately 825. e4L is currently restricted in its ability to pay dividends on its common stock under the terms of its credit facility or debt financing as more fully described in Note 5 to the consolidated financial statements. No dividends were declared in fiscal years 1999 and 1998.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
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(1) Net of loan discount of $0.9 million and $0.8 million as of March 31, 1998 and 1997, respectively.
(2) Net of loan discount of $1.3 million and $1.7 million as of March 31, 1996 and 1995, respectively.
(3) As more fully described in the notes to e4L's consolidated financial statements, fiscal year 1999 includes unusual charges of $20.2 million, an extraordinary gain on extinguishment of long-term debt
of $4.9 million, a gain of $6.5 million related to the sale of an investment in common stock, and a write-off of goodwill of $11.3 million.
(4) Fiscal year 1998 includes a $14.5 million write-off of impaired goodwill, which was determined to be unrecoverable, $1.9 million of unusual charges for compensation expense and a $6.5 million provision for inventory obsolescence.
(5) Fiscal year 1997 includes results of operations of certain subsidiaries for only a portion of that year as follows: Positive Response Television ("PRTV"), from May 17, 1996; and Prestige and Suzanne Paul (as defined below) from July 1, 1996. In addition, the fiscal year 1997 results of operations include a $8.7 million provision for inventory obsolescence; $5.7 million of bad debt expense; $13.3 million of legal fees and settlements; $2.5 million of amortization attributable to new acquisitions; $2.5 million of unusual charges attributable to severance of various former executives; a $4.4 million write-off of impaired goodwill of PRTV; and PRTV's significant operating loss. Fiscal year 1995 included $5.3 million of legal fees and settlements; $1.0 million of relocation costs; and $1.8 million of anti-takeover and aborted stock offering costs.
(6) The fiscal year 1999 loss per common share is net of an extraordinary gain on extinguishment of long-term debt of $0.18 per share.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
e4L has historically been engaged in the direct marketing of consumer products, primarily through direct response television programming (also know as "infomercials") and more recently through wholesale/retail distribution and electronic commerce on a global basis. In the United States, e4L has been dependent on a limited number of successful products to generate a significant portion of its net revenue. e4L's new strategies for future periods are designed to reduce the risk associated with relying on a limited number of successful products for a disproportionate amount of its revenue, expand e4L's leverage of its media expenditures and tailor e4L's operations in the United States to more efficiently deal with the cyclical nature of e4L's business.
In connection with the acquisition of a controlling equity interest by an investor group, which was approved by the stockholders in October 1998, e4L has revised its business model. A key strategy for e4L's future is the expansion of its global direct response and marketing capabilities, wholesale/retail, continuity, electronic commerce and membership services businesses, including the branding of its "Everything4Less" membership shopping club, expansion of BuyItNow LLC, and expanded deployment of continuity and wholesale/retail marketing strategies. e4L will do this by leveraging its substantial media expenditures, first in the United States and then internationally (i.e. using its media primarily as an advertising vehicle to build brand awareness). This strategy encompasses the more effective utilization and leveraging of its global marketing presence and media access, the continued development and marketing of innovative products to enhance its existing programs, the increased emphasis on developing other means of revenue generation such as the shopping club, as well as wholesale/retail, expanded up-sell programs, continuity programs and customer list rental. e4L's direct response television programming is now viewed as a vehicle to generate a customer base which will be utilized in various other revenue generating initiatives as opposed to the television direct response sale historically being the end result or merely a one-time sale. International expansion over the last five years has generally resulted in approximately 50% of e4L's revenue being generated outside of the United States. e4L takes advantage of product awareness created by its television direct response programming and also extends the sales life of its products through alternative distribution channels. These channels include wholesale/retail arrangements, continuity sales programs and Internet marketing, among others.
On August 13, 1998, e4L announced the execution of definitive agreements related to the Transaction pursuant to which an investor group led by Mr. Lehman agreed to acquire a substantial equity interest in, and operational control of, e4L through an investment of $30.0 million. In connection therewith, the investor group consummated the acquisition of $10.0 million of Series D convertible preferred stock along with 992,942 warrants to purchase common stock from two third party investors in e4L. On October 23, 1998, e4L announced consummation of the Transaction resulting in the purchase by the investor group of $20.0 million of newly issued Series E convertible preferred stock directly from e4L.
e4L's net revenue varies throughout the year. e4L's revenue has historically been highest in its third and fourth fiscal quarters and lowest in its first and second fiscal quarters due to fluctuations in the number of television viewers. These seasonal trends have been and may continue to be affected by the timing and success of new product offerings, expansion of its wholesale/retail and continuity programs, and the potential growth in e4L's electronic commerce businesses.
In the discussion and analysis that follows, e4L discusses its "EBITDA" and "EBITDA Margin." EBITDA consists of net income before interest, provision for income taxes, depreciation and amortization, extraordinary gain on extinguishment of debt, gain on sale of investment and unusual charges. EBITDA Margin represents EBITDA as a percentage of net revenue. EBITDA does not represent cash flows as defined by generally accepted accounting principles and does not necessarily indicate that cash flows are sufficient to fund all of e4L's liquidity requirements. EBITDA should not be considered in isolation or as a substitute for net income, cash from operating activities or other measures of liquidity determined in accordance with generally accepted accounting principles. e4L believes that EBITDA is a measure of financial performance widely used in the media and Internet/electronic commerce industries, and is useful to investors as a measure of e4L's financial performance.
RESULTS OF OPERATIONS
The following table sets forth operating data of e4L as a percentage of net revenue for the periods indicated below.
YEAR ENDED MARCH 31, 1999 AS COMPARED TO MARCH 31, 1998
NET REVENUE
Net revenue was $327.9 million for the year ended March 31, 1999, as compared to $278.5 million for the year ended March 31, 1998, an increase of $49.4 million or 17.7%.
Net revenue in the United States for the year ended March 31, 1999 was $197.6 million as compared to $123.6 million for the year ended March 31, 1998, an increase of $74.0 million or 59.9%. The increase was primarily attributable to a greater number of successful direct response television programs and products during fiscal year 1999. The year ended March 31, 1999 included five programs which generated over $20.0 million in net revenue and only one program which comprised over 15% of total net revenue. The comparable twelve month period of fiscal year 1998 included only two programs which generated in excess of $20.0 million of net revenue and three of which comprised over 15% of total net revenue. The top product in fiscal years 1999 and 1998 generated approximately 20.2% and 16.8% of total United States net revenue, respectively.
International net revenue for the year ended March 31, 1999 was $130.3 million as compared to $154.9 million for the year ended March 31, 1998, a decrease of $24.6 million or 15.9%. The decrease was primarily attributable to a 17.8% decline in net revenue in Japan. Approximately 4.2% of the annual net revenue decline was attributable to currency devaluation. The decline in Japanese net revenue was primarily attributable to the unfavorable economic climate in Japan in the first six months of fiscal year 1999. Japanese net revenue, however, increased in the last six months of fiscal year 1999 as compared to fiscal year 1998 due to the success of a wholesale/retail strategy and an improvement in the Japanese economy. In addition, e4L's operations in the South Pacific Rim continued to experience the negative impact of the economic downturn throughout that region, which resulted in a significant decline in consumer spending. This region also suffered from a lack of successful new products. e4L's South Pacific Rim net revenue for the year ended March 31, 1999 as compared to the year ended March 31, 1998 decreased approximately $14.9 million or 33.9%. Approximately 14.7% of the net revenue decline was attributable to currency devaluation. European net revenue was consistent with that of fiscal year 1998. During the fourth quarter of fiscal year 1999, European net revenue decreased 15.0% compared to fiscal year 1998 due to the loss of two significant media contracts during the quarter. While the loss of these media contracts may cause European net revenue to continue to decline in fiscal year 2000, e4L believes it can maintain or improve its overall European profitability by replacing the lost media and revenue with additional wholesale/retail sales and alternative media. The European operations generated an additional $2.8 million of wholesale/retail net revenue in fiscal year 1999 as compared to fiscal year 1998.
e4L's return rate was 17.8% and 15.7% in fiscal years 1999 and 1998, respectively. The increased overall return rate was attributable to an increase in the sale of higher priced products, increased percentage of intellectual property products and continuity sales. Sales of these types of product and nature have historically carried higher return rates. In addition, the increased product backlogs in the United States in fiscal year 1999 as compared to fiscal year 1998 resulted in increased returns.
OPERATING COSTS AND EXPENSES
Total operating costs and expenses were $379.2 million for the year ended March 31, 1999 as compared to $331.1 million for the year ended March 31, 1998, an increase of $48.1 million or 14.5%. Included in operating costs during fiscal years 1999 and 1998 are unusual and restructuring charges and write-offs of impaired goodwill. Excluding these amounts, operating costs for the year ended March 31, 1999 increased by $33.0 million or 10.5% as compared to operating costs for the year ended March 31, 1998. The fiscal year 1999 increase was primarily attributable to the increase in net revenue of 17.7%, which was partially offset by a reduction in direct costs as a percentage of net revenue and a decrease in selling, general and administrative expenses. The increase in operating costs is more fully described below.
MEDIA
Media purchases were $113.6 million for the year ended March 31, 1999 as compared to $91.9 million for the year ended March 31, 1998, an increase of $21.7 million or 23.6%. e4L's worldwide ratio of media purchases to net revenue increased to 34.6% for the year ended March 31, 1999 as compared to 33.0% for the year ended March 31, 1998. The increase in media purchases as a percentage of net revenue was attributable to the increased proportion of United States revenue to international revenue, which United States revenue carries greater media costs. United States net revenue represented 60.3% of total net revenue for the year ended March 31, 1999 as compared to only 44.4% for the year ended March 31, 1998.
PRODUCT AND OTHER DIRECT COSTS
Product and other direct costs consist of the cost of inventory and materials, freight, television and radio program production, commission and royalties, order fulfillment, in-bound telemarketing, credit card authorization and processing, warehousing, and royalties. Product and other direct costs were $189.4 million for the year ended March 31, 1999 as compared to $167.5 million for the year ended March 31, 1998, an increase of $21.8 million or 13.0%. The increase was primarily attributable to the 17.7% increase in net revenue. As a percentage of net revenue, product and other direct costs were 57.8% for the year ended March 31, 1999 as compared to 60.2% for the year ended March 31, 1998. The decrease as a percentage of net revenue was attributable to a reduction in both United States and international product and other direct costs.
The decrease in United States product and other direct costs as a percentage of net revenue was primarily attributable to increased United States net revenue and the nature of certain fixed costs associated with e4L's fulfillment center and television production activities. The decrease in foreign product and other direct costs as a percentage of net revenue was primarily attributable to European and Middle East operations, which were offset in part by increased costs of e4L's South Pacific Rim operations. Lower South Pacific Rim net revenue in relation to certain fixed and semi-variable costs associated with operations in this region resulted in increased costs in relation to net revenue. The decrease in European product and other direct costs as a percentage of net revenue in fiscal year 1999 as compared to fiscal year 1998 is attributable to the favorable impact of a higher average selling prices in relation to certain fixed fulfillment costs and a reduction in production costs.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expense was $37.9 million for the year ended March 31, 1999 as compared to $48.2 million for the year ended March 31, 1998, a decrease of $10.3 million or 21.2%. The decrease in selling, general and administrative expense reflects e4L's continued cost reduction and restructuring efforts. Selling, general and administrative expense as a percentage of net revenue decreased to 11.6% for the year ended March 31, 1999 to 17.3% for the year ended March 31, 1998, principally attributable to e4L's cost reduction and restructuring efforts combined with the 17.7% increase in net revenue.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization were $6.8 million for the year ended March 31, 1999 as compared to $7.1 million for the year ended March 31, 1998, a decrease of $0.3 million, or 3.9%. The decrease in depreciation and amortization was attributable to the write-off of goodwill and other intellectual properties associated with e4L's Positive Response Television, Inc. ("PRTV") subsidiary during the fourth quarter of fiscal year 1998 resulting in lower amortization expense during fiscal year 1999. This was offset by the acceleration of depreciation of certain assets over the estimated remaining useful life, resulting from the decision to outsource various aspects of the United States operations which resulted in increased depreciation expense during fiscal year 1999.
WRITE-OFF OF IMPAIRED GOODWILL
Fiscal year 1999 included a write-off of impaired goodwill of $11.3 million attributable to Prestige and Suzanne Paul, e4L's operations in New Zealand and Australia, respectively. The write-off was based upon an independent appraiser's valuation of the underlying goodwill and other intellectual properties in light of the current economic downturn being experienced in these markets.
UNUSUAL CHARGES
In connection with the Transaction, e4L adopted a revised business plan under the direction of its new management team and Board of Directors. As a result, e4L has undertaken specific actions to reduce its overall cost structure and transition its business model from a television direct marketing company to an electronic commerce and membership services company. Certain of these actions had resulted in pre-tax unusual and restructuring charges during the year ended March 31, 1999 of $20.2 million.
e4L is continuing to evaluate all areas of its business, however, as a result of the plans discussed below, e4L expects to remove approximately $10.0 to $20.0 million from its cost structure during fiscal year 2000 and beyond. These savings are predominantly due to wage related costs; reduced carrying costs of property, plant and equipment; reduced office rent and satellite leasing charges; and other miscellaneous cost savings.
The restructuring charges are primarily attributable to the following:
CLOSURE OF PHILADELPHIA, PENNSYLVANIA HEADQUARTERS. e4L made a decision to close its former corporate headquarters in Philadelphia, Pennsylvania and relocate its headquarters to its offices in Los Angeles, California. Included in restructuring charges are $3.8 million of costs associated with the termination of employees, loss on the subleasing of the existing office lease and other commitments, and the write-down of assets that are no longer in use. Such assets were sold or abandoned during the first quarter of fiscal year 2000. A total of 17 employees were terminated as part of e4L's plans to close its corporate offices. Of the 17 employees affected, 16 have been paid and/or left e4L as of March 31, 1999, and one (who was notified of his termination during fiscal year 1999) will receive his severance package and leave e4L during fiscal year 2000.
CONSOLIDATION OF NEW ZEALAND AND FAR EAST BUSINESS OFFICES, AND CLOSURE OF AUSTRALIAN RETAIL STORES. e4L made a decision to reduce the size of its New Zealand work force, by consolidating its previously separate New Zealand and Far East business offices within one location, and shutting down unprofitable Australian retail stores. The related restructuring charges of $0.7 million are primarily comprised of costs associated with the termination of employees, cancellation of leases and other commitments, and the write-down of assets no longer in use. Such assets had been sold or abandoned as of March 31, 1999. A total of 46 employees were terminated as part of e4L's plans to consolidate the two offices and close certain retail stores. Of the 46 employees effected, 32 have been paid and/or left e4L as of March 31, 1999, and 14 (who were notified of their termination during fiscal year 1999) shall receive his/her severance packages and leave e4L during the first quarter of fiscal year 2000.
OUTSOURCING OF CERTAIN OPERATIONS IN THE UNITED STATES. e4L is in the process of outsourcing various aspects of its Phoenix, Arizona fulfillment center, customer service operations, and media agency business. As a result, during the third quarter of fiscal year 1999 e4L disposed of its media agency subsidiary and is in the process of transitioning its fulfillment and customer service functions to third parties. The costs expensed as of March 31, 1999 of $3.4 million include costs primarily associated with the termination of employees, and the cancellation of leases and other commitments. This transition is expected to be completed by the end of the third quarter of fiscal year 2000.
CLOSURE OF CERTAIN ASIAN AND EASTERN EUROPEAN MARKETS. Due to the economic downturn in Asia and Eastern Europe, the forecasted sales and opportunities in these regions have decreased significantly from
e4L's original plans. Accordingly, e4L made a decision to exit certain Asian and Eastern European markets and/or transfer such markets to third party licensee arrangements. The costs included in the restructuring charges of $2.0 million are costs incurred in connection with the termination of 12 employees, all of which terminations were completed and paid as of March 31, 1999, and the write-down of certain assets in the affected markets.
WRITE-DOWN OF PREPAID PRODUCTION. Also included in the restructuring charge is $2.6 million of costs related to the write-down of certain prepaid costs attributable to the production of its direct response television programming. e4L made a fundamental change in its strategy involving the use of its programs. In connection with its revised business model, new electronic commerce platform and other initiatives, e4L has begun utilizing its programs not only for the sale of underlying products, but has begun leveraging its programs and television media to drive memberships in its membership shopping club, Everything4Less, to exploit a retail market and continuity programs for its products, and to create list rental opportunities with respect to its customer base.
Other unusual charges consist of the following:
SHOPPING CLUB START-UP COSTS. $1.2 million of start-up costs associated with the development and production of commercials related to e4L's Everything4Less membership shopping club.
EUTELSTAT SATELLITE CONTRACT. e4L entered into a long-term commitment to lease a transponder on the Eutelstat satellite for the life of the satellite. The satellite launched in April 1998, and e4L has an estimated commitment of 10 to 12 years. e4L has determined that the satellite contract is unfavorable, as it has estimated that it will be unable to recover certain costs relating to its lease. Accordingly, e4L has included in unusual charges $5.3 million relating to its inability to recover a portion of costs attributable to the Eutelstat Satellite lease.
CHANGE OF CONTROL PAYMENTS. As part of the Transaction, e4L recorded severance charges of $1.8 million associated with the waiver of the change of control provisions contained in the employment agreements of three former executive officers.
CONSULTING FEES. In connection with the Transaction, e4L recorded a non-cash charge of $0.2 million in connection with a five year option to purchase up to 212,500 shares of e4L common stock at an exercise price of $1.32 per share that were granted to a management company of which Messrs. Lehman, Weiss and Yukelson are managing members. In addition, e4L recorded $0.4 million related to the termination of a foreign media consulting agreement.
WRITE-OFF OF MERGER COSTS. In June 1998, e4L wrote-off capitalized costs of $0.7 million related to the termination of e4L's intended merger with ValueVision International, Inc. ("ValueVision").
NON-CASH EXECUTIVE COMPENSATION. e4L had previously recorded compensation expense of $1.9 million in connection with 750,000 stock options issued to e4L's former chief executive officer and two other former executive officers during fiscal year 1998. The stock options contained provisions that, upon the occurrence of certain triggering events prior to June 30, 1998, the exercise price of the stock options would be reduced. The previously recorded expense was reversed in the first quarter of fiscal year 1999 as no triggering events occurred as of the June 30, 1998 expiration date.
GAIN OF SALE OF INVESTMENT
During the year ended March 31, 1999, e4L recognized a gain on the sale of an investment in common stock of Earthlink Network, Inc. of $6.5 million.
INTEREST EXPENSE
Interest expense was $3.2 million for the year ended March 31, 1999, as compared to $3.5 million for the year ended March 31, 1998, a decrease of $0.3 million. This decrease was primarily attributable to a decrease in average outstanding indebtedness from $26.6 million during fiscal year 1998 to $20.3 million during fiscal year 1999.
INCOME TAXES
e4L recorded income tax expense of $0.4 million and $0.7 million for the years ended March 31, 1999 and 1998, respectively, attributable to certain of its international operations. Income tax benefits have not been recorded during the respective periods on United States and certain international losses. These benefits will be recorded when realized, reducing the effective tax rate on future United States and certain international earnings.
EXTRAORDINARY ITEM--GAIN ON EXTINGUISHMENT OF LONG-TERM DEBT
The extraordinary gain on extinguishment of long-term debt resulted from e4L's retirement of its approximately $21.5 million debt outstanding under a revolving credit and term loan agreement with its then principle lender at a twenty-five percent discount.
EARNINGS BEFORE INTEREST, DEPRECIATION AND AMORTIZATION (EBITDA)
EBITDA deficit exclusive of the unusual charges, gain on extinguishment of debt, write-off of impaired goodwill and gain on sale of investment, was $(13.0) million for the year ended March 31, 1999 as compared to an EBITDA deficit of $(29.1) million for the year ended March 31, 1998, an improvement of $16.1 million or 55.3%. EBITDA margin deficit, exclusive of the above items, was (4.0%) and (10.5%) for the years ended March 31, 1999 and 1998, respectively. The improvements in EBITDA and EBITDA margin deficit were primarily attributable to the improvement in e4L's United States, Japanese and European results of operations.
NET LOSS
e4L incurred a net loss of $43.6 million for the year ended March 31, 1999, as compared to a net loss of $56.8 million for the year ended March 31, 1998. The current fiscal year includes unusual charges of $20.2 million, a gain on sale of investment of $6.5 million, an extraordinary gain on extinguishment of debt of $4.9 million and a write-off of impaired goodwill of $11.3 million. Fiscal year 1998 included a write-off of impaired goodwill of PRTV of $14.5 million and unusual charges of $1.9 million. Excluding these items e4L incurred a net loss of $23.5 million for the year ended March 31, 1999 as compared to a net loss of $40.3 million for the year ended March 31, 1998. This represents a $16.9 million, or 41.8%, improvement as compared to the results of operations for the year ended March 31, 1998.
YEAR ENDED MARCH 31, 1998 AS COMPARED TO YEAR ENDED MARCH 31, 1997
NET REVENUE
Net revenue was $278.5 million for the year ended March 31, 1998 as compared to $358.2 million for the year ended March 31, 1997, a decrease of $79.7 million or 22.3%. Retail royalties were negligible during fiscal year 1998 as compared to $16.3 million during fiscal year 1997. The fiscal year 1997 retail royalties were primarily attributable to retail royalties generated from sales of e4L's Ab Roller Plus product.
Net revenue in the United States was $123.6 million for the year ended March 31, 1998 as compared to $188.5 million for the year ended March 31, 1997, a decrease of $64.9 million or 34.4%. This decrease
was attributable to the limited success of new products in comparison to the highly successful Ab Roller Plus, which performed strongly during fiscal year 1997 in all distribution channels. The Ab Roller Plus accounted for approximately 41.9% of United States net revenue in fiscal year 1997. Several fiscal year 1998 products and direct response television programs had been postponed due to production delays, timing issues related to product manufacturing and sourcing, and e4L's limited working capital and cash position which impacted, among other things, inventory purchasing and media spending. Approximately 63.0% of United States net revenue in fiscal year 1998 was attributable to sales of e4L's "Great North American Slim Down" (16.8%), Cyclone Cross-Trainer (16.6%), T-Fal Ingenio cookware (14.7%) and PVA 10-X Mop (14.1%) products. Fiscal year 1998 United States net revenue was also unfavorably impacted by increased return rates. The increased return rates were attributable to a change in product mix. In fiscal year 1998, e4L offered more higher priced products and intellectual property (e.g., printed materials, videocassette and audio-tape) products, which traditionally carry higher return rates.
International net revenue for the year ended March 31, 1998 was $154.9 million as compared to $169.7 million for the year ended March 31, 1997, a decrease of $14.8 million or 8.7%. Fiscal year 1998 international revenue included a full year of revenue from the Prestige and Suzanne Paul acquisitions as compared to approximately nine months in fiscal year 1997. In addition, e4L experienced a 12.6% increase in European net revenue attributable to its expansion into Eastern Europe. These revenue increases were partially offset by the approximate 40.3% decline in Asian net revenue. Japan, e4L's principal Asian market, experienced a 49.7% decline in fiscal year 1998 net revenue as compared to fiscal year 1997. The decline in Asian net revenue was primarily attributable to downturns in general economic conditions in that region, increased competition from traditional programming, other direct response television competition, and the limited availability of television media time. In addition, e4L's Asian and South Pacific Rim net revenue had been adversely impacted by significant currency devaluations within in these markets. Approximately 4.6% of the decline in Asian (principally Japan) net revenue was attributable to currency devaluation. These factors are expected to have a continuing adverse impact on these regions and e4L's results of operations in fiscal year 1999. e4L's South Pacific Rim net revenue and operating results during fiscal year 1998 were also adversely impacted by significant returns associated with its Fitness Strider product.
OPERATING COSTS
Total operating costs and expenses were $331.1 million for the year ended March 31, 1998 as compared to $400.4 million for the year ended March 31, 1997, a decrease of $69.3 million or 17.3%. The decrease was primarily attributable to a 22.3% decline in net revenue. Excluding the write-offs during fiscal years 1998 and 1997 of impaired goodwill of $14.5 million and $4.4 million, and the unusual charges of $1.9 million and $2.5 million total operating costs decreased by 20.0% during fiscal year 1998 as compared to fiscal year 1997.
MEDIA
Media purchases were $91.9 million for the year ended March 31, 1998 as compared to $131.1 for the year ended March 31, 1997, a decrease of $39.2 million or 29.9%. The decrease was primarily attributable to a 22.3% decline in net revenue in fiscal year 1998. During fiscal year 1998, e4L experienced a lack of successful new programs and products and, accordingly, purchased less media for program broadcasts. The ratio of media purchases to net revenue improved in fiscal year 1998 to 33.0% as compared to 36.6% in fiscal year 1997. The improvement in the ratio of media to net revenue was attributable to more favorable United States media rates resulting in a 5.0% decline over the prior fiscal year ratio. In addition, the ratio of media purchases to net revenue for fiscal year 1998 benefited from a higher percentage of overall net revenue outside of the United States, which generally carries more favorable media rates.
The international media to net revenue ratio increased slightly during fiscal year 1998 as compared to fiscal year 1997. Recent trends indicate an increase in international media costs due to increased competition and a trend towards a growing requirement for minimum guarantees and/or fixed media contracts. Higher media costs could result in a higher international media to net revenue ratio in the future. The Eutelstat Satellite launched in April 1998 at which time e4L began making monthly payments for the lease of the transponder. The cost of the Eutelstat Satellite may contribute to an increase in e4L's European ratio of media to net revenue in fiscal year 1999 and beyond.
PRODUCT AND OTHER DIRECT COSTS
Product and other direct costs consist of the cost of inventory and materials, freight, television program production, commissions and royalties, order fulfillment, in-bound telemarketing, credit card authorization and processing, warehousing and royalties. Direct costs were $167.5 million for the year ended March 31, 1998 as compared to $190.7 million for the year ended March 31, 1997, a decrease of $29.5 million or 14.9%. This decrease was primarily attributable to a decrease in net revenue of 22.3%. As a percentage of net revenue, direct costs were 60.2% in fiscal year 1998 as compared to 55.0% in fiscal year 1997. Direct costs as a percentage of net revenue increased in both e4L's United States and international operations. The expense for inventory obsolescence was $6.5 million (2.3% of net revenues) and $8.7 million (2.4% of net revenues) in fiscal years 1998 and 1997, respectively. The ratio of direct costs to net revenue in the United States was unfavorably impacted by the 34.4% decrease in net revenue, and the fixed and variable nature of direct costs. Lower revenue, especially in the first six months of fiscal year 1998, along with certain fixed costs associated with e4L's fulfillment center operations and a significant increase in United States return rates, negatively impacted the direct costs to net revenue ratio. In addition, fiscal year 1997 benefited from retail royalties ($0.7 million for fiscal year 1998 as compared to $16.3 million for fiscal year 1997), which revenue carries lower direct costs.
Internationally, the economic downturn and currency devaluation in the Asian and South Pacific Rim regions, change in product mix and increased program customization costs adversely impacted the international ratio of direct costs to net revenue. The currency devaluation, particularly in the last six months of fiscal year 1998, resulted in higher product costs. In response to the higher costs, e4L was unable to increase pricing sufficiently to offset the full impact of the significant decline in local currency values. In Japan, fulfillment and warehousing costs increased as a percentage of net revenue as a result of the lower net revenue and higher inventory levels.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expense was $48.2 million for the year ended March 31, 1998 as compared to $59.9 million for the year ended March 31, 1997, a decrease of $11.7 million or 19.6%. Fiscal year 1998 included approximately $2.0 million of additional selling, general and administrative expense associated with the operations of Prestige and Suzanne Paul which were acquired by e4L in July 1996, resulting in nine months of selling, general and administrative expense in fiscal year 1997 as compared to a full year of expense in fiscal year 1998. Fiscal year 1998 includes the benefit of a decrease in legal settlements and fees in excess of $10.0 million. Fiscal year 1997 included $9.4 million of legal settlements, including $6.0 million attributable to a settlement on the Ab Roller Plus product. In addition, fiscal year 1998 included bad debt expense of $2.2 million as compared to $5.7 million in fiscal year 1997, including $2.1 million of bad debt attributable to two specific customers. Fiscal year 1998 also included cost reductions associated with PRTV in the first half of that year. The above reductions more than offset higher consulting fees and higher occupancy expense. Selling, general and administrative expense as a percentage of net revenue increased to 17.3% in fiscal year 1998 from 16.7% in fiscal year 1997 as a result of a 22.3% decrease in net revenue.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization were $7.1 million for the year ended March 31, 1998 as compared to $5.5 million for the year ended March 31, 1997, an increase of $1.6 million or 26.9%. This increase was primarily attributable to higher depreciation expense associated with e4L's information systems, and increased amortization attributable to the acquisitions, which occurred during fiscal year 1997.
WRITE-OFF OF IMPAIRED GOODWILL
Fiscal year 1998 included a write-off of the remaining goodwill attributable to the acquisition of PRTV of $14.5 million. The write-off was based upon an independent appraiser's re-valuation of PRTV's goodwill in light of PRTV's unsuccessful business strategy. As a result, e4L does not anticipate any future benefit or cash flows from PRTV, and has determined that there is no remaining value attributable to PRTV's goodwill. Fiscal year 1997 included the write-off of approximately $4.4 million of PRTV goodwill based on a re-valuation performed by an independent appraiser.
UNUSUAL CHARGES
Fiscal year 1998 included unusual charges of $1.9 million associated with non-cash compensation expense attributable to options granted to three executive officers. Fiscal year 1997 included a $2.5 million unusual charge attributable to severance expense for five executive officers.
INTEREST EXPENSE
Interest expense was $3.5 million during for the year ended March 31, 1998 as compared to $1.5 million for the year ended March 31, 1997, an increase of $2.0 million. This increase was primarily attributable to an increase in e4L's average outstanding indebtedness from approximately $10.0 million in fiscal year 1997 to approximately $26.6 million in fiscal year 1998, and higher interest rates charged in connection with an amended loan agreement with e4L's principal lender.
INCOME TAXES
e4L recorded income tax expense of approximately $0.7 million for the year ended March 31, 1998 resulting from its Asian and South Pacific Rim businesses. Income tax benefits have not been recorded during the current period on United States and European losses. These benefits will not be recorded until it is likely that such benefits will be realized, thereby, reducing the effective tax rate on future United States and European taxable earnings. Approximately $1.9 million of income tax expense had been recorded for the year ended March 31, 1997 resulting from tax liabilities attributable to Asian and South Pacific Rim taxable earnings.
EARNINGS BEFORE INTEREST, INCOME TAXES, DEPRECIATION AND AMORTIZATION (EBITDA)
EBITDA deficit, exclusive of unusual charges and write-offs of impaired goodwill, was $(29.1) million for the year ended March 31,1998 as compared to an EBITDA deficit of $(29.8) million for the year ended March 31,1997, an improvement of $0.7 million or 2.3%. EBITDA margin deficit, exclusive of the above items, was (10.5%) and (8.3%) during the fiscal years 1998 and 1997, respectively.
NET LOSS
e4L incurred a net loss of $56.8 million for the year ended March 31, 1998, as compared to a net loss of $45.7 million for the year ended March 31,1997. As discussed above, fiscal years 1998 and 1997 included write-offs of impaired goodwill attributable to the PRTV acquisition of $14.5 million and $4.4 million, respectively.
LIQUIDITY AND CAPITAL RESOURCES
e4L's working capital was $13.2 million at March 31, 1999 as compared to a $9.4 million at March 31, 1998, an increase of $3.8 million. The increase was primarily attributable to the reduction of current debt with proceeds from the sale of Series E Preferred Stock and the exercise of stock options and warrants. e4L met its current period cash requirements primarily through the sale of inventory, funding under its new credit facility, proceeds from the sale of an investment, and cash proceeds from the aforementioned equity transactions. Operating activities for the years ended March 31, 1999 and March 31, 1998, resulted in a use of cash of $25.4 million and $19.6 million, respectively. e4L's cash flow from operations during the years ended March 31, 1999, and 1998 was adversely impacted by the net loss of approximately $43.6 million and $56.8 million, respectively.
Consolidated accounts receivable increased by $6.3 million, or 21.3%, primarily attributable to an increase in United States accounts receivable of $10.4 million which was offset by a decrease in international accounts receivable of $4.1 million. United States accounts receivable increased due to an increase in time payment receivables attributable to sales of higher priced products and extended time payment plans. International accounts receivable have decreased due to lower sales volume in the European and South Pacific Rim regions. Consolidated inventory decreased $5.0 million or 23.5%. This decrease was attributable to e4L's continued efforts to reduce global inventory levels and a write-down of certain Asian, South Pacific Rim and Latin American inventories.
The decrease in prepaid media and show production costs from $6.7 million at March 31, 1998 to $0.8 at March 31, 1999 is attributable to the revision to the e4L business model in connection with the Transaction. The direct response television program is being utilized to promote memberships in e4L's membership shopping club, to brand products for wholesale/retail distribution; to market product continuity programs, and to create list rental opportunities with respect to its customer base. As a result, television program production costs are now expensed as incurred.
The decrease in excess of cost over net assets of acquired businesses and other intangibles at March 31, 1999 is attributable to a write-off of impaired goodwill of $11.3 million of Prestige and Suzanne Paul, e4L's subsidiaries in New Zealand and Australia, respectively.
The increase in accrued expenses at March 31, 1999 is primarily attributable to a $7.7 million balance of unusual and restructuring charges recognized during the third quarter of fiscal year 1999.
In December 1998, e4L entered into a new, three-year credit agreement with a senior lender (the "Credit Agreement"). The Credit Agreement provides for a revolving credit facility with a maximum commitment of $20.0 million, of which up to $7.5 million may be in the form of outstanding letters of credit. Borrowings under the Credit Agreement are limited to a borrowing base consisting of certain eligible United States accounts receivable and inventory. Outstanding borrowings under the Credit Agreement bear interest, at the option of e4L, at the Prime rate plus one-quarter percent or the London Interbank Offered Rate (LIBOR) plus three percent, however, in no event shall the interest rate charged be less than seven percent per annum. A commitment fee of one-quarter percent per annum is paid on the unused portion of the Credit Agreement.
At March 31, 1999, e4L had $18.0 million in total availability under this facility of which $7.2 million was outstanding as borrowing and an additional $1.0 million in a letter of credit. At June 22, 1999, e4L had $17.2 million in total availability under this facility of which $14.0 million was outstanding as borrowings and $1.4 million in outstanding letters of credit.
On October 23, 1998, e4L received approximately $20.0 million in gross proceeds ($17.6 million in net proceeds) from the sale of $20.0 million face amount of newly issued Series E Preferred Stock, as more fully described in Note 6 to the consolidated financial statements. The Series E Preferred Stock carries a 4.0% coupon for one year and is convertible into 13,333,333 shares of e4L Common Stock based on a fixed conversion price of $1.50 per share (subject to normal anti-dilution adjustments). In connection with the
Transaction, e4L issued five year options and warrants to purchase up to 212,500 and 3,762,500 shares of e4L 's common stock, respectively, at exercise prices ranging from $1.32 to $3.00 per share. Approximately $16.1 million of the proceeds from the issuance of the Series E Preferred Stock was used to retire e4L's outstanding indebtedness to its principle lender at a twenty-five percent discount. The repayment of debt resulted in an extraordinary gain on extinguishment of debt of approximately $4.9 million which is recorded in e4L's statement of operations for the year ended March 31, 1999. The remaining proceeds were used for costs related to the Transaction and for working capital purposes.
In December 1998, e4L repaid a $10.0 million loan to ValueVision International, Inc. ("ValueVision") through working capital and proceeds of approximately $2.0 million from the exercise of 750,000 warrants to purchase e4L Common Stock held by ValueVision.
In June 1998, e4L announced the termination of its proposed merger with ValueVision. As a result, the maximum conversion price of e4L's Series D preferred stock ("Series D Stock") and the exercise price of the 1,489,413 warrants held by the Series D shareholders were automatically adjusted to $1.073125 per share, 101% of the closing price of e4L's common stock on the adjustment date. As a result of the Transaction and as more fully described in Note 6 to consolidated financial statements, the conversion price of the Series D Preferred Stock was subsequently fixed at $1.073125 per share. Based on such conversion price, the $18.6 million of outstanding Series D Preferred Stock at March 31, 1999 are convertible into 17,349,273 shares of Common Stock, not including shares of e4L Common Stock issuable upon conversion of any accrued premium. In addition, certain anti-dilution provisions of the Series B Convertible Preferred Stock and Loan Warrants ("Series B Warrants") have been triggered during fiscal year 1999, resulting in an increase in the number of shares of e4L common stock available upon exercise of the Series B Warrants outstanding increasing to approximately 9.5 million and the exercise price being reduced to approximately $2.37 per share.
e4L foreign revenue is subject to foreign exchange risk. To the extent e4L incurs expense in local currency that are based upon locally denominated sales volume (order fulfillment and media costs), this exposure is reduced significantly. e4L monitors exchange rate and/or forward contracts when and where appropriate. As a result of the aforementioned capital infusion and new credit facility, e4L has an ability to hedge its currency risk. During fiscal year 1999, e4L entered into forward contracts to hedge its Japanese Yen position resulting in an immaterial loss for fiscal year 1999. At March 31, 1999, e4L had outstanding forward contracts to hedge its Japanese Yen position in the amount of $4.7 million. These contracts mature through September 1999. In the long term, e4L has the ability to change the selling price of its products to a certain extent in order to react to major currency fluctuations; which may reduce a portion of the risk associated with local currency fluctuations. However, the significant currency devaluation and the economic downturn being experienced in certain foreign regions will have an adverse impact on e4L's operating results and cash flows in fiscal year 2000. Currently, e4L's major foreign currencies are the European Economic Union's Euro, German deutsche mark, Japanese yen, Australian dollar and New Zealand dollar, each of which has been subject to recent fluctuations.
As a result of e4L's current working capital position, available borrowings under its $20.0 million credit facility, and its $20.0 million equity infusion and corresponding repayment of indebtedness; management believes that based upon the implementation of its revised business plan and operating strategies, which have been designed, in part, to (i.) rebuild e4L's business, (ii.) introduce successful new direct response television programs and products, (iii.) leverage e4L's radio and television media in order to support its electronic commerce, membership services, and wholesale/retail distribution businesses, e4L will have sufficient liquidity to fund its working capital requirements through March 31, 2000.
YEAR 2000 IMPLICATIONS
e4L has reviewed the implications of Year 2000 (e.g., "Y2K") compliance and is presently undertaking the process to ensure that e4L's information systems and software applications will manage dates beyond
December 31, 1999. e4L believes that it has allocated adequate resources for this purpose and those planned software upgrades, which are underway and in the normal course of business, will address e4L's internal Year 2000 needs. While e4L expects that efforts on the part of current employees of e4L will be required to monitor Year 2000 issues, no assurances can be given that these efforts will be successful. e4L does not expect the cost of addressing any Year 2000 issue to be a material event or uncertainty that would have a material, adverse effect on future results of operations or financial condition.
The Year 2000 issue developed because most computer systems and programs were designed to record years (e.g. "1998") as two-digit fields (e.g. "98"). When the year 2000 begins, these systems may interpret "00" as the year 1900 and may stop processing date-related computations or process them incorrectly. To prevent this occurrence, e4L has begun examining its computer systems and programs, correcting the problems and testing the results. e4L on or before December 31, 1999 must achieve Year 2000 compliance. Also, due to the nature of e4L's time payment offers within its direct response television programs, certain systems currently refer to dates beyond December 31, 1999 and, therefore, require earlier compliance.
e4L, as with most direct marketing and electronic commerce companies, is heavily dependent upon computer systems for all phases of its operations. For this reason, it is aggressively addressing the Year 2000 issue to mitigate the effect on software performance. During late fiscal year 1998, e4L commenced a comprehensive effort to identify and correct the Year 2000 programming issues. By early fiscal year 1999 e4L had identified all potential Year 2000 hardware and software issues within both its mainframe processing systems and personal computers worldwide. e4L has initiated a project to address all of the identified Year 2000 issues within its systems, utilizing both internal and external resources.
Also during early fiscal year 1999, e4L formed a Year 2000 Compliance Task Force to oversee the project, address all related business issues, and facilitate communication with significant suppliers and service providers. The project was divided into the following phases: (i.) identification and inventorying of all systems and software with potential Year 2000 problems; (ii.) evaluation of scope of Year 2000 issues and assignment of priorities to each item based upon its importance in e4L's operations; (iii.) rectification of Year 2000 issues in accordance with assigned priorities, by correction, upgrade, replacement, or retirement; and (iv.) testing for and validation of Year 2000 compliance. Because e4L uses a variety of systems, internally developed and third party provided software, and embedded chip equipment, depending on the business function and location, various aspects of e4L's Year 2000 efforts are in different phases and are proceeding parallel.
e4L's operations are also dependent on the Year 2000 readiness of third parties that do business with e4L. In particular, e4L's systems interact with automated clearing-houses to handle the transfer of cash relating to the sale of e4L's receivables. e4L is also dependent on third-party suppliers of such infrastructure elements as, but not limited to, telephone services, electric power, and water. In addition, e4L depends upon various vendors that manufacture its products, are responsible for in-bound telemarketing, and fulfill customer orders.
e4L has identified and initiated formal communications with key suppliers, service providers and merchandise vendors to determine the extent to which e4L will be vulnerable to such parties' failures to address and resolve their Year 2000 issues. In addition, e4L now requires its vendors to provide representations and warranties in all new contracts that there are no Year 2000 issues that could impact vendor performance, and e4L also seeks to obtain indemnification for damages it may suffer due to a vendor's failure to comply with Year 2000 requirements. Although e4L is not aware of any known third party problem that will not be corrected, e4L has limited information concerning the Year 2000 readiness of third parties.
e4L estimates that its systems will be Year 2000 compliant by September 30, 1999. Aggregate costs for work related to e4L's entire Year 2000 efforts are anticipated to range from approximately $1 to $1.2 million. Operating costs related to the Year 2000 compliance project will be incurred over several
quarters and have been expensed as incurred. e4L incurred approximately $0.8 in expense during the year ended March 31, 1999 in connection with its Year 2000 compliance efforts.
e4L expects to implement the changes necessary to address the Year 2000 issue for systems and equipment used within e4L. e4L presently believes that, with modifications to existing software, conversions to new software, and appropriate replacement of equipment, the Year 2000 issue is not likely to pose significant operational problems. However, if unforeseen difficulties arise or such modification, conversions and replacements are not completed in a timely manner, or if e4L's vendors' or suppliers' systems are not modified to become Year 2000 compliant, the Year 2000 issue may have a material impact on the results of operations and financial condition of e4L. e4L is presently unable to assess the likelihood that it will experience significant operational problems due to unresolved Year 2000 problems of third parties. e4L's estimates of the costs of achieving Year 2000 compliance and the date by which Year 2000 compliance will be achieved are based on management's best estimates. These estimates are derived using numerous assumptions about future events including the continued availability of resources, third party modification plans and other factors. However, there can be no assurance that these estimates will be achieved, and actual results could differ materially from these estimates. Specific factors that might cause such differences include, but are not limited to, the availability and cost of personnel trained in Year 2000 issues, the ability to locate, correct, and test all relevant computer codes, the success achieved by e4L's suppliers in reaching Year 2000 readiness, the timely availability of necessary replacement equipment, and similar uncertainties.
e4L believes the most likely worst-case scenarios that it might confront with respect to the Year 2000 issues have to do with the possible failure in one or more geographic regions of third party systems over which e4L has no control, such as, but not limited to, power and telephone service, and vendors that supply manufactured products and services. e4L is developing a Year 2000 contingency plan, which it expects to complete during the first half of fiscal year 2000.
FACTORS THAT MAY EFFECT FUTURE PERFORMANCE
RECENT LOSSES; CASH FLOW
e4L incurred significant losses in four of its last five fiscal years. e4L also reported a net loss of approximately $43.6 million for fiscal year 1999. Because of e4L's historical financial condition, e4L developed a business plan and has begun implementing new initiatives designed to increase net revenue, reduce costs and return it to profitability. In addition e4L has entered into a new three year $20.0 million credit facility. However, if the business plan does not adequately address the circumstances and situations which resulted in e4L 's poor past performance, e4L would be required to seek alternative forms of financing, the availability of which is uncertain.
NATURE OF THE DIRECT RESPONSE MARKETING AND ELECTRONIC COMMERCE INDUSTRIES.
e4L experiences extreme competition for products, customers and media access in the direct response marketing and electronic commerce industries. Accordingly, to be successful, e4L must:
Accurately predict consumer needs, market conditions and competition;
Introduce successful products;
Produce compelling direct response television programs;
Acquire appropriate amounts of media time;
Manage its media time effectively;
Fulfill customer orders timely and efficiently;
Provide courteous and informative customer service;
Maintain adequate vendor relationships and favorable terms;
Enhance successful products to generate additional sales;
Expand the marketing and distribution channels for its products;
Expand in existing geographic markets; and
Integrate acquired companies and businesses efficiently.
e4L's recent operating results were primarily caused by delays in product introductions, a lack of successful new products, failure to adequately leverage global spending and deteriorating economic conditions in the Asian and South Pacific Rim markets. e4L actively seeks out new products, new sources of products and alternative distribution channels, including wholesale/retail and the Internet. e4L cannot be sure that inventors and product manufacturers will select it to market their products. Significant delays in product introductions or a lack of successful new products could prevent e4L from selling adequate amounts of its products and otherwise have a negative effect on e4L's business.
DEPENDENCE ON INTERNATIONAL SALES
e4L markets products to consumers in over 70 countries. In recent years e4L has derived approximately half of its net revenue from sales to customers outside the United States and Canada. e4L's largest international markets are Europe, Asia (primarily Japan) and the South Pacific Rim. The economic downturn in the Asian and South Pacific Rim regions has had and, for the foreseeable future, is expected to have, an adverse effect on e4L. e4L's international expansion has increased its working capital requirements due to the additional time required to deliver products abroad and receive payment from foreign countries.
While e4L's international operations have the advantage of marketing products that have already proven successful in the United States, as well as successful direct response television programs produced by other direct marketing companies with limited media access and distribution capabilities, there can be no assurance that e4L's international operations will continue to generate similar revenue or operate profitability. Competition in the international marketplace is increasing rapidly. In addition, e4L is subject to many risks associated with doing business abroad including: (i.) adverse fluctuations in currency exchange rates; (ii.) transportation delays and interruptions; (iii.) political and economic disruptions; (iv.) the imposition of tariffs and import and export controls; and (v.) increased customs or local regulations.
The occurrence of any of these risks could have an adverse effect on e4L's business.
ENTERING INTO NEW MARKETS
As e4L enters new markets, it is faced with the uncertainty of never having done business in that country's particular commercial, political and social environment. Accordingly, despite e4L's best efforts, likelihood of success is unpredictable for reasons particular to each new market. It is also possible that, despite e4L's apparently successful entrance into a new market, some unforeseen circumstance could arise which would limit e4L's ability to continue to do business, operate profitability or to expand in that new market.
DEPENDENCE ON SUCCESSFUL PRODUCTS; UNPREDICTABLE MARKET LIFE; INVENTORY MANAGEMENT AND PRODUCT RETURNS
e4L is dependent on its continuing ability to introduce successful new products to supplement or replace existing products as they mature through their product life cycles. e4L's five most successful products each year typically account for a substantial amount of e4L's annual net revenue. Generally, e4L's successful products change from year to year. Accordingly, e4L's future results of operations depend on its ability to introduce successful products consistently and to capture the full revenue potential of each product at all stages of consumer marketing and distribution channels during the product's life cycle.
In addition to a supply of successful new products, e4L's revenue and results of operations depend on a positive customer response to its direct response television programming, the effective management of
product inventory and other factors. Customer response to e4L's programming depends on many variables, including the appeal of the products being marketed, the effectiveness of the direct response television programming, the availability of competing products and the timing and frequency of program airings. There can be no assurance that e4L's programming will receive market acceptance.
e4L must have an adequate supply of inventory to meet consumer demand. Most of e4L's products have a limited market life, so it is extremely important that e4L generate maximum sales during this time period. If production delays or shortages, poor inventory management or inadequate cash flow prevent e4L from maintaining sufficient inventory, e4L could lose potential product sales, which may never be recouped. In addition, unanticipated obsolescence of a product may occur or problems may arise regarding regulatory, intellectual property, product liability or other issues which adversely affect future sales of a product even though e4L may still hold a large quantity of the product in inventory. Accordingly, e4L 's ability to maintain systems and procedures to effectively manage its inventory is of critical importance to e4L's cash flow and results of operations.
The average United States and international market life of a product is less than two years. Generally, products generate their most significant revenue in their first year of sale. In addition, e4L must adapt to market conditions and competition as well as other factors which may shorten a product's life cycle and adversely affect e4L's results of operations.
e4L offers a limited money-back guarantee on all of its products if the customer is not fully satisfied. Accordingly, e4L's results of operations may be adversely affected by product returns under e4L's guarantee, its product warranty or otherwise. Although e4L establishes reserves against product returns which it believes are adequate based on product mix and returns history, there can be no assurance that e4L will not experience unexpectedly high levels of product returns which exceed the reserves for that product. If product returns do exceed reserves, e4L's results of operations could be adversely affected.
DEPENDENCE ON THIRD PARTY MANUFACTURERS AND SERVICE PROVIDERS
Substantially all of e4L's products are manufactured by other domestic and foreign companies. In addition, e4L utilizes other companies to fulfill orders placed for e4L's products and to provide telemarketing services. If e4L's suppliers are unable, either temporarily or permanently, to deliver products to e4L in time to fulfill sales orders, it could have a material adverse effect on e4L's results of operations. Moreover, because the time from the initial approval of a product by e4L's product development department until the first sale of a product must be short, e4L must be able to cause its product manufacturers to quickly produce high-quality, reasonably priced products for e4L to sell. However, because e4L's primary product manufacturers are foreign companies which require longer lead times for products, any delay in production or delivery would adversely affect sales of the product and e4L's results of operations. In addition, utilization of foreign manufacturers further exposes e4L to the general risks of doing business abroad.
DEPENDENCE ON MEDIA ACCESS; EFFECTIVE MANAGEMENT OF MEDIA TIME
e4L must have access to media time to televise its direct response programming on cable and broadcast networks, network affiliates and local stations. e4L purchases a significant amount of media time from cable television and satellite networks, which assemble programming for transmission to cable system operators. If demand for air time increases, cable system operators and broadcasters may limit the amount of time available for these broadcasts. Larger multiple cable system operators have begun selling "dark' time (i.e., the hours during which a network does not broadcast its own programming) to third parties which may cause prices for such media to rise. Significant increases in the cost of media time or significant limitations in e4L's access to media could adversely impact e4L. In addition, periodic world events may limit e4L's access to media time and reduce the number of persons viewing e4L's direct response programming in one or more markets, which would adversely impact e4L for these periods.
Recently, international media suppliers have begun to negotiate for fixed media rates and minimum revenue guarantees, each of which increase e4L's cost of media and risk.
In addition to acquiring adequate amounts of media time, e4L's business depends on its ability to manage efficiently its acquisitions of media time, by analyzing the need for, and making purchases of, long form media and spot media. e4L must also properly allocate its available airtime among its current library of direct response television programs. Whenever e4L makes advance purchases and commitments to purchase media time, it must manage the media time effectively, because the failure to do so could negatively affect e4L's business. If e4L cannot use all of the media time it has acquired, it attempts to sell its excess media time to others. However, there can be no assurance that e4L will be able to use or sell its excess media time.
In April 1998, e4L began leasing a twenty-four hour transponder, the Eutelstat Satellite, which broadcasts across Europe. e4L has incurred significant start-up costs in connection with the transponder lease. If e4L is unable to sell the remaining transponder media time, e4L's results of operations could be adversely affected. During the year ended March 31, 1999, e4L has determined that the satellite contract is unfavorable, as it has estimated that it will be unable to recover certain costs relating to its lease, accordingly e4L's results of operations included $5.3 million of unusual charges attributable to this lease.
LITIGATION AND REGULATORY ACTIONS
There have been many lawsuits against companies in the direct marketing industry. In recent years, e4L has been involved in significant legal proceedings and regulatory actions by the FTC and CPSC, which have resulted in significant costs and charges to e4L. In addition, e4L, its wholly-owned subsidiary, PRTV, and PRTV's chief executive officer, are subject to FTC consent orders which require them to submit periodic compliance reports to the FTC. Any additional FTC or CPSC violations or significant new litigation could have an adverse effect on e4L's business.
In August 1998, e4L received notice from the NYSE that it did not meet the NYSE's standards for continued listing. Representatives from e4L met with the NYSE staff and proposed actions to the NYSE designed to restore its compliance with the listing standards. The NYSE reviewed e4L's compliance plan and informed e4L that, while it would continue to monitor e4L's compliance plan and performance, no action by the NYSE was presently contemplated. If e4L's common stock is delisted from trading on the NYSE, it would have severe negative effects on e4L and its stockholders.
PRODUCT LIABILITY CLAIMS
Products sold by e4L may expose it to potential liability from damages claims by users of the products. In certain instances, e4L is able to obtain contractual indemnification rights against these liabilities from the manufacturers of the products. In addition, e4L generally requires its manufacturers to carry product liability insurance. However, e4L cannot be certain that manufacturers will maintain this insurance or that their coverage will be adequate to cover all claims. In addition, e4L cannot be certain that it will be able to maintain its insurance coverage or obtain additional coverage on acceptable terms, or that its insurance will provide adequate coverage against all claims.
COMPETITION
e4L competes directly with companies which generate sales from direct response television programs and with other direct marketing, membership services and electronic commerce companies. e4L also competes with a large number of consumer product retailers, many of which have substantially greater financial, marketing and other resources than e4L. Some of these retailers have recently begun, or indicated that they intend to begin, selling products through direct response marketing methods, including sales in various e-commerce channels, such as via the Internet. e4L also competes with companies that
make imitations of e4L's products that are sold at substantially lower prices, which may be sold in the same distribution channels as e4L's own products.
DEPENDENCE ON KEY PERSONNEL
e4L's executive officers have substantial experience and expertise in direct response sales and marketing, electronic commerce, membership services and media. In particular, e4L is highly dependent on certain of its employees responsible for product development and production of direct response television programming. If any of these individuals leave e4L, e4L's business could be negatively affected.
YEAR 2000 ISSUES
The operation of e4L's business is dependent on its management information systems, computer hardware, software programs and operating systems. Computer technology is used in several key areas of e4L's business, including merchandise purchasing, inventory management, pricing, sales, shipping and financial reporting, as well as in various administrative functions. e4L has been evaluating its computer technology to identify potential Year 2000 compliance problems and has begun an implementation process with respect thereto. It is anticipated that modification or replacement of some of e4L's computer technology will be necessary to enable e4L's information systems to recognize the Year 2000. e4L does not expect that the costs associated with achieving Year 2000 compliance will have a significant effect on its business. In addition, e4L is also dependent on third-party suppliers and vendors and will be vulnerable to such parties failures to address and resolve their Year 2000 issues. While e4L is not aware of any known third party problems that will not be corrected, e4L has limited information concerning the Year 2000 readiness of third parties. If management is incorrect, Year 2000 problems could have a negative effect on e4L and its business.
SEASONALITY
e4L's revenue vary throughout the year. e4L's revenue have historically been highest in its third and fourth fiscal quarters and lower in its first and second fiscal quarters due to fluctuations in the number of television viewers. These seasonal trends have been and may continue to be affected by the timing and success of new product offerings and the potential growth in e4L's wholesale/retail, electronic commerce and membership services businesses.
CONVERTIBLE SECURITIES; SHARES FOR FUTURE SALE
Sales of a substantial number of shares of e4L's Common Stock in the public market could adversely affect the market price of e4L's Common Stock. There are currently approximately 32.4 million shares of e4L Common Stock outstanding, nearly all of which are freely tradable. In addition, approximately 47.6 million shares of e4L Common Stock are currently reserved for issuance upon the exercise of outstanding options and warrants and the conversion of convertible preferred stock. For example, approximately 17.3 million shares of Common Stock will be issued to holders of e4L's Series D Preferred Stock (based on a conversion price of $1.073125 per share) and approximately 13.3 million shares of Common Stock will be issued to holders of e4L's Series E Convertible Preferred Stock (based on a conversion price of $1.50 per share).
QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
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(1) Fiscal year 1999 includes unusual charges of $20.2 million, an extraordinary gain on extinguishment of long-term debt of $4.9 million, a gain of $6.5 million attributable to the sale of an investment in common stock, and a write-off of impaired goodwill of $11.3 million.
(2) The quarter ended March 31, 1998 includes unusual charges of $1.1 million and a write-off of $14.5 million of the remaining impaired PRTV goodwill which was determined to be unrecoverable.
(3) The quarter ended December 31, 1998 basic and diluted earnings per share includes the benefit of $0.19 due to an extraordinary gain on extinguishment of debt.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
e4L currently maintains a revolving credit facility which bears interest at variable rates. Accordingly, e4L's results of operations are impacted by changes in interest rates. Assuming the current level of borrowings at variable rates, and assuming a two percentage point increase in the average interest rate under these borrowings, it is estimated that the e4L's interest expense would have increased by $0.4 million. In the event of an adverse change in interest rates, management would likely take actions to further mitigate its exposure. However, due to the uncertainty of the actions that might be taken and their possible effects, the analysis assumes no such actions are taken. Further the analysis does not consider the effects of the change in the level of overall economic activity that could result in a higher interest rate environment.
e4L does not currently hedge interest rates with respect to its outstanding debt.
EQUITY PRICE RISK
The carrying value of the e4L's equity securities is affected by changes in the quoted market prices of e4L Common Stock. e4L has entered into an agreement with a former investment banker pursuant to which e4L has guaranteed the market price of its common stock underlying warrants issued to the
investment banker, subject to certain limitations. In the event the market price of its common stock is below the guaranteed price, e4L is required to pay any deficiency in cash. It is estimated that a 20% reduction in the current market price of e4L Common Stock would result in a cash payment of approximately $655,000 (based on the closing price for e4L Common Stock on June 15, 1999).
FOREIGN CURRENCY
All of e4L's foreign operations are measured in their local currencies. As a result, e4L's financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which e4L has operations. To the extent e4L incurs expenses paid in local currency (order fulfillment and media costs) that are based on locally denominated sales volume, this exposure is reduced significantly. e4L monitors exchange rate and/or forward contracts when and where appropriate.
To mitigate a portion of the exposure to risk of currency fluctuations throughout Europe, Asia and the South Pacific Rim, e4L enters into forward contracts to hedge its foreign currency positions. e4L has used this strategy in recent years only in connection with the Japanese yen. In the long term, e4L has the ability to change selling prices of its products to a certain extent in order to react to major currency fluctuations; which may reduce a portion of the risk associated with local currency fluctuations. However, the significant currency devaluation and economic downturn being experienced in certain foreign regions could have a negative impact on e4L's operating results and cash flows. Currently, e4L's major foreign currencies are the European Economic Union's Euro, the British Pound, the German Deutsche Mark, the Japanese Yen, the Australian Dollar and the New Zealand Dollar, each of which has been subject to recent fluctuations.
e4L maintains no other derivative instruments to mitigate the exposure to translation and transaction risk. However, this does not preclude e4L's adoption of specific hedging strategies in the future. e4L reported a net loss of $43.6 million for the year ended March 31, 1999. It is estimated that a 5% change in the value of the U.S. dollar to the Euro, Pound, Deutsche Mark, Yen, Australian Dollar and New Zealand Dollar would change e4L's net loss for the year ended March 31, 1999 by approximately $1.95 million.
The above analysis does not consider the implications that such fluctuations could have on the overall economic activity that could result in such an environment in the United States or the foreign countries, or on the results of operations of e4L's foreign operations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
This Item is submitted in a separate section of this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
Certain information concerning the present Directors and executive officers of e4L is set forth below. The term of office for each Director is one year or until the date of e4L's next meeting of shareholders, at which time elections are held for each seat on the Board of Directors.
The following is a summary of each director and executive officer's occupation during the last five years.
Stephen C. Lehman, age 47, has served as Chief Executive Officer of e4L since August 1998 and Chairman of the Board of Directors since October 1998. Prior thereto, from its formation in January 1987 until August 1998, Mr. Lehman served as President, Chief Executive Officer and Chairman of the Board of Premiere Radio Networks, Inc. ("Premiere") a producer and distributor of network radio programs and services. From 1984 to 1987, Mr. Lehman was President of Stephen Lehman Productions, a radio syndication company, while also serving as an on-air personality at KIIS-AM and FM/Los Angeles. From 1982 to 1984, he specialized in building radio networks for independent radio syndicates. From 1980 to 1981, Mr. Lehman was National Sales Manager for Innerview Radio Networks. From 1976 to 1980, Mr. Lehman was president of a promotion advertising agency. Mr. Lehman graduated cum laude from the University of Nevada at Las Vegas, with a degree in Communications. Mr. Lehman is also a Director of Video City, Inc, a video retailer. Mr. Lehman has served as a Director of e4L since August 1998.
Eric R. Weiss, age 41, has served as Vice Chairman and Chief Operating Officer of e4L since October 1998. Prior thereto, Mr. Weiss served as a Director of Premiere from January 1997 until August 1997. During 1996, Mr. Weiss served as Chairman and Chief Executive Officer of After MidNite Entertainment, Inc, a producer and distributor of network radio programs and services. From 1986 until 1995, Mr. Weiss served as an executive officer of Westwood One, Inc., a producer and distributor of network radio programs and services serving as Executive Vice President and Vice President/Business and Legal Affairs. Mr. Weiss completed his undergraduate studies at Rutgers University where he was elected Phi Beta Kappa and graduated with honors. Mr. Weiss received his Juris Doctorate from George Washington University's National Law Center. Mr. Weiss has served as a Director of e4L since August 1998.
John W. Kirby, age 39, has served as President of e4L since March 1998 and as President of Quantum Television (formerly d/b/a DirectAmerica Corporation) since e4L's acquisition of DirectAmerica in October 1995. Mr. Kirby also served as Executive Vice President of e4L from October 1995 until March 1998. Mr. Kirby previously served as Chairman of the Board, Chief Executive Officer and President
of California Production Group, Inc. ("CAPG") from January 1991 until e4L's acquisition of CAPG in October 1995. Mr. Kirby has served as a Director of e4L since March 1998.
Daniel M. Yukelson, age 36, has served as Executive Vice President/Finance and Chief Financial Officer, and Secretary of e4L since October 1998. Since November 1996, Mr. Yukelson has served as Senior Vice President/Finance and Chief Financial Officer and Secretary of Premiere. From June 1995 until November 1996, Mr. Yukelson served as Vice President and Chief Financial Officer of Premiere. From December 1993 until June 1995, Mr. Yukelson served as Assistant Vice President and Controller of Wherehouse Entertainment, Inc. and during 1993 he served as Vice President/Finance and Chief Financial Officer of Standard Brands Paint Company, Inc. Prior thereto, from 1985 to 1993, Mr. Yukelson served in various positions with Ernst & Young LLP, e4L's independent auditors, last serving as a Senior Manager in the Restructuring and Reorganization Practice. Mr. Yukelson earned his undergraduate degree in business administration at the California State University at Northridge. He is a Certified Public Accountant.
Anthony M. Vercillo, age 42, has served as Executive Vice President, Global Operations of e4L since May 1999. From November 1998 until May 1999, Mr. Vercillo served as Senior Vice President, Global Operations of e4L. Prior thereto, from August 1998 until November 1998, Mr. Vercillo served as a consultant to senior management of e4L. Prior to joining e4L, from January 1991 until November 1998, Mr. Vercillo was President and Chief Executive Officer of IFMC, a management consulting firm. Mr. Vercillo earned his undergraduate degree at Caldwell University and his masters in business administration at United States International University.
Stuart D. Buchalter, age 61, has been Of Counsel with the California law firm of Buchalter, Nemer, Fields & Younger, a Professional Corporation since August 1980. From August 1980 to June 1993, he served as Chairman of the Board of Directors and Chief Executive Officer of Standard Brands Paint Company, a paint retailer and manufacturer. Mr. Buchalter completed his undergraduate studies at the University of California at Berkeley, and earned an LLB at Harvard University Law School. Mr. Buchalter is a director of Authentic Fitness Corp., an athletic apparel manufacturer, Earl Scheib, Inc., an automotive painting company, Faroudja, Inc., a television image enhancement company, and City National Corp., the holding company for City National Bank. He is also Vice-Chairman of the Board of Trustees of Otis College of Art and Design. He has served as a Director of e4L since October 1998.
Robert W. Crawford, age 58, is currently engaged as a management consultant and since January 1987, he has been an executive of Premiere. Since July 1984, Mr. Crawford has also been President of Pro Active Management, Inc. From March 1983 until July 1997, Mr. Crawford served as Chairman of Crystal Springs Water Company. Mr. Crawford earned his undergraduate degree in foreign affairs and a bachelor of science in business administration from the University of Nevada at Reno. He is a certified public accountant and is a member of the American Institute of Certified Public Accountants. He has served as a Director of e4L since October 1998.
David E. Salzman, age 55, has served as Co-Chief Executive Officer of Quincy Jones-David Salzman Entertainment, a television, motion picture, music and interactive content joint venture with Time-Warner Entertainment, since its formation in 1993. Mr. Salzman has also served as Chief Executive Officer of David Salzman Enterprises, a television, film, live events and new media content producer, since June 1998. Mr. Salzman was a Director of Premiere from July 1995 to April 1997 and a Director of Lorimar Telepictures from April 1986 to January 1989. Mr. Salzman holds a bachelor of arts degree from Brooklyn College and a masters degree from Wayne State University. He has served as a Director of e4L since October 1998.
Andrew M. Schuon, age 34, has served as Executive Vice President/General Manager of Warner Brothers Music since May 1998. He served as Executive Vice President of Programming for MTV Music Television, a unit of Viacom, Inc. ("MTV") from November 1995 through May 1998. From May 1992 until November 1995, Mr. Schuon served in various capacities at MTV, starting as Vice President/Music, Programming and Promotion. From 1989 until 1992, Mr. Schuon served as the program director of radio
station KROQ-FM in Los Angeles, California. Mr. Schuon attended the University of Nevada. Mr. Schuon was a Director of Premiere from January 1997 until July 1997 and is currently a Director of Hot Topic, Inc. and Redwood Broadcasting. He has served as a Director of e4L since August 1998.
MEETINGS OF THE BOARD OF DIRECTORS AND ITS COMMITTEES
BOARD OF DIRECTORS. During the fiscal year ended March 31, 1999, there were 11 meetings of the Board of Directors. The Board of Directors also took action by unanimous written consent as permitted by Delaware law. All nominees attended at least 75% of the meetings held during their terms as Directors. e4L's Board of Directors has, among others, an Executive Committee, an Audit Committee and a Compensation/Stock Option Committee. Each such committees met at least once during the fiscal year ended March 31, 1999. All committee members attended at least 75% of all committee meetings held during their terms as members of such committees.
EXECUTIVE COMMITTEE. The Executive Committee was constituted in October 1998 and is composed of Messrs. Lehman (Chairperson), Weiss and Buchalter. This Committee has general responsibility and authority to manage the operations and affairs of e4L between meetings of the full Board of Directors, subject to direction and oversight by the Board of Directors. The Executive Committee met once during the year ended March 31, 1999.
AUDIT COMMITTEE. The Audit Committee is currently composed of three non-employee Directors. The current members of the Audit Committee are Messrs. Buchalter, Schoun (Chairperson) and Salzman. This committee meets with e4L's independent public accountants to review the scope and results of auditing procedures and e4L's accounting policies and controls. The Audit Committee also provides general oversight with respect to the accounting principles employed in e4L's financial reporting. The Audit Committee met once during the year ended March 31, 1999 and also took action by unanimous written consent on two occasions.
COMPENSATION/STOCK OPTION COMMITTEE. The Compensation Committee is composed of three non-employee Directors. The current members of the Compensation/Stock Option Committee are Messrs. Crawford (Chairperson), Salzman and Schuon. The Compensation/Stock Option Committee is responsible for determining and reviewing the compensation of the officers of e4L, including e4L's Chief Executive Officer. The Compensation/Stock Option Committee determines and reviews executive compensation matters and administers the terms and provisions of e4L's stock option plans. The Compensation Committee met four times during the year ended March 31, 1999.
COMPENSATION OF THE BOARD OF DIRECTORS
Each Director who is not an employee of e4L is granted an equity retainer consisting of options to purchase 15,000 shares of e4L Common Stock pursuant to the 1991 Stock Option Plan upon such Directors' appointment or election to the Board of Directors. The options vest over a three year period, with 5,000 options vesting on the date of grant and 5,000 options vesting at the end of each of years two and three following such Director's appointment or election to the Board of Directors. Each of Messrs. Buchalter, Crawford, Salzman and Schuon were granted such options on October 23, 1998 at an exercise price of $3.47 per share, which approximated the closing price of e4L's Common Stock on such date.
In addition to the equity retainer, each Director receives $500 per meeting attended in person and $250 per committee meeting attended in person, such fees to be paid only in the event that e4L achieves pre-tax profits for two consecutive quarters. During the fiscal year ended March 31, 1999, e4L incurred expenses of approximately $129,000 for Directors' fees, all of which represents payments to non-employee Directors for expenses incurred prior to the Transaction.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act requires e4L's directors, certain of its officers and persons who own more than ten percent (10%) of e4L's common stock (collectively the "Reporting Persons") to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission") and to furnish e4L with copies of these reports.
Based on e4L's review of the copies of these reports received by it, and representations received from Reporting Persons, e4L believes that, all filings required to be made by the Reporting Persons for the period April 1, 1998 through March 31, 1999 were made on a timely basis.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following Summary Compensation Table sets forth the cash compensation and certain other components of the compensation received by (i) Stephen C. Lehman, Chairman of the Board of Directors and Chief Executive Officer of e4L, (ii) Robert N. Verratti, former Chief Executive Officer of e4L, and (iii) the other three most highly compensated executive officers of e4L who were executive officers of e4L as of March 31, 1999 for each of the fiscal years ended March 31, 1999, 1998 and 1997.
SUMMARY COMPENSATION TABLE
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(1) Bonuses (which consist of cash payments) have been included in the year earned, portions of which were actually paid in the following fiscal year.
(2) Automobile allowance.
(3) Amounts for fiscal year 1999 consist of: a payment by e4L of $3,380 on behalf of Mr. Kirby on account of supplemental life insurance premiums and the forgiveness of $191,186 of debt owed by Mr. Kirby to e4L. Amounts for fiscal year 1998 consist of: a payment by e4L of $7,840 on behalf of Mr. Kirby on account of supplemental life insurance premiums. Amounts for fiscal year 1997 consist of a payment by e4L of $5,530 on behalf of Mr. Kirby on account of supplemental life insurance premiums, $25,000 on behalf of Mr. Kirby for moving expenses and $1,725 for Mr. Kirby's use of a company automobile.
(4) From August 11, 1998 until February 28, 1999, Messrs. Lehman, Weiss and Yukelson were compensated pursuant to a Consulting Agreement between e4L and TMC. Pursuant to the terms of the Consulting Agreement, TMC received $80,000 per month, a five-year option to purchase up to 212,500 shares of Common Stock at an exercise price of $1.32 per share and warrants to purchase up to 3,762,500 shares of Common Stock at exercise prices ranging from $1.32 per share to $3.00 per share. Pursuant to the Consulting Agreement, Messrs. Lehman, Weiss and Yukelson received $231,250, $190,184 and $111,891, respectively.
(5) Mr. Lehman was appointed acting Chief Executive Officer in August 1998 and Chairman of the Board of Directors and Chief Executive Officer in October 1998.
(6) Mr. Verratti joined e4L in May 1997 and served as e4L's Chief Executive Officer until August 1998, at which time Stephen C. Lehman was named acting Chief Executive Officer of e4L. In connection with Mr. Verratti's waiver of certain rights to severance, options to purchase 450,000 shares of Common Stock were repriced from $4.75 per share to $2.00 per share and the exercisability of options to purchase 700,000 shares of Common Stock was extended for one additional year to three years from the date of the termination of Mr. Verratti's employment with e4L in October 1998.
(7) Mr. Weiss was appointed Vice Chairman of the Board of Directors and Chief Operating Officer in October 1998.
(8) Mr. Yukelson was appointed Executive Vice President/Finance and Chief Financial Officer, and Secretary in October 1998.
EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL ARRANGEMENTS
CONSULTING AGREEMENT WITH TEMPORARY MEDIA CO., LLC
Pursuant to a Consulting Agreement, e4L engaged TMC for the period commencing August 11, 1998 to provide executive management consulting services to e4L. Consulting services were provided by current executive officers Messrs. Lehman, Weiss and Yukelson. The Consulting Agreement was terminated on February 28, 1999 in connection with the execution of employment agreements by each of Messrs. Lehman, Weiss and Yukelson. Under the terms of the Consulting Agreement, effective as of the execution of the Consulting Agreement on August 11, 1998, Mr. Lehman was designated Acting Chief Executive Officer of e4L, with the duties, responsibilities and authority associated with that office. As compensation for the consulting services pursuant to the Consulting Agreement, e4L paid TMC the sum of $80,000 per month and granted to TMC (i.) a five-year option to purchase up to 212,500 shares of Common Stock, subject to certain vesting requirements, at an exercise price of $1.32 per share; and (ii.) warrants to purchase up to 3,762,500 shares of Common Stock, at exercise prices ranging from $1.32 per share to $3.00 per share. 1,000,000 of the TMC Warrants were to be utilized to retain and attract personnel to e4L and neither TMC nor its affiliates are permitted to exercise such warrants.
e4L reimbursed TMC for reasonable and actual out-of-pocket business expenses incurred by TMC in performance of its responsibilities under the Consulting Agreement. e4L also indemnified TMC against all losses, claims, damages, liabilities and expenses to which TMC may have become liable arising out of TMC's acting for e4L pursuant to the Consulting Agreement, provided that e4L would not be held liable to the extent any loss, claimed damage, liability or expense is found to have resulted from TMC's gross negligence, bad faith, material breach of the Consulting Agreement, actions outside the scope of the authority granted to TMC or in contravention of specific instructions from the Board of Directors.
STEPHEN C. LEHMAN, CHAIRMAN OF THE BOARD OF DIRECTORS AND CHIEF EXECUTIVE OFFICER.
In addition to the compensation Mr. Lehman received pursuant to the Consulting Agreement described above, Mr. Lehman is currently compensated pursuant to an Employment Agreement entered into with e4L. On January 29, 1999, e4L entered into an Employment Agreement with Mr. Lehman pursuant to which Mr. Lehman serves as Chairman of the Board and Chief Executive Officer of e4L from March 1, 1999 through October 22, 2001 at an annual minimum base salary of $500,000. In addition to the base salary payable pursuant to the Employment Agreement, provided e4L is profitable on an EBITDA basis, Mr. Lehman is entitled to receive a bonus in an amount to be determined by the Compensation Committee of the Board of Directors or the Board of Directors. Mr. Lehman is also entitled to participate in all group medical and dental, hospitalization, health and accident, group life, travel, disability or similar plans or programs of e4L, and 401(k) and stock purchase programs and any other programs that e4L provides to other executives of e4L. Mr. Lehman is also entitled to certain fringe benefits, including personal financial and legal counseling, not to exceed the sum of $10,000 annually, and an automobile allowance of $15,000 per annum. Pursuant to the Employment Agreement, Mr. Lehman is eligible to participate in e4L's qualified and non-qualified stock option plan(s). To the extent that Mr. Lehman is granted stock options, such stock options shall have an exercise price equal to the closing price of e4L's
common stock on the date of grant, be exercisable for ten years, and vest on a schedule to be determined by the Compensation Committee of the Board of Directors or the Board of Directors, but in no event shall such vesting period be more than three years.
In the event of a Constructive Termination of the Employment Agreement (as defined in the Employment Agreement), e4L will be required to pay Mr. Lehman 2.99 times Mr. Lehman's base salary in effect on the date of such Constructive Termination. If Mr. Lehman's employment is terminated either by Mr. Lehman's voluntary action or "For Cause" (as defined in the Employment Agreement), e4L will pay Mr. Lehman's base salary that has accrued as of the date of termination, in addition to any bonus owed and accrued vacation pay. In the event of a Change of Control (as defined in the Employment Agreement), and if either (i.) the Change of Control results in the termination of Mr. Lehman's employment during the first 180 days after such Change of Control, or (ii.) following a Change of Control, e4L or any successor to e4L fails to assume, in writing, all obligations of e4L to perform the Employment Agreement, e4L shall pay Mr. Lehman 2.99 times Mr. Lehman's base salary in effect at the time of such Change of Control. In the event Mr. Lehman's employment is terminated as a result of a Change of Control or Constructive Termination, and the aggregate of all payments or benefits made or provided to Mr. Lehman under the Employment Agreement constitute a Parachute Payment (as defined by the Internal Revenue Code of 1986, as amended), e4L shall pay to Mr. Lehman an additional amount equal to 100% of the Excise Tax (as defined in the Employment Agreement) on the Parachute Payment.
Pursuant to the Employment Agreement, e4L has agreed to indemnify Mr. Lehman to the maximum extent permitted by law and to pay Mr. Lehman's expenses (including legal fees) in respect of Mr. Lehman's right to indemnification under the Employment Agreement, subject to a later determination as to Mr. Lehman's ultimate right to receive such payment.
ROBERT N. VERRATTI, FORMER CHIEF EXECUTIVE OFFICER.
In January 1998, e4L entered into an amended and restated employment agreement with Mr. Verratti pursuant to which Mr. Verratti was employed as Chief Executive Officer of e4L, at an annual minimum salary of $200,000. In October 1998, following consummation of the Transaction, Mr. Verratti's employment with e4L was terminated. During Mr. Verratti's tenure with e4L, Mr. Verratti was entitled to participate in e4L's Management Incentive Plan and its other executive compensation programs. e4L also maintained $1,000,000 of insurance for Mr. Verratti, which was payable to the beneficiaries designated by Mr. Verratti. Mr. Verratti also received an automobile allowance. Pursuant to Mr. Verratti's original employment agreement with e4L, Mr. Verratti was granted options to purchase 700,000 shares of Common Stock at an exercise price of $4.75 per share.
Under the terms of Mr. Verratti's employment agreement, upon consummation of the Transaction, Mr. Verratti could have elected to receive a cash payment in the amount of $600,000. In August 1998, Mr. Verratti agreed to waive the benefit of such provision and to relinquish the position of Chief Executive Officer to Mr. Lehman pending consummation of the Transaction. In exchange for such waiver and Mr. Verratti's agreement to terminate his employment with e4L upon consummation of the Transaction, 450,000 options to purchase Common Stock at an exercise price of $4.75 per share held by Mr. Verratti were repriced at $2.00 per share and the term of 700,000 stock options was extended for one additional year to three years from the date of termination of his employment with e4L.
ERIC R. WEISS, VICE CHAIRMAN OF THE BOARD OF DIRECTORS AND CHIEF OPERATING OFFICER.
In addition to the compensation Mr. Weiss received pursuant to the Consulting Agreement described above, Mr. Weiss is currently compensated pursuant to an Employment Agreement. On January 29, 1999, e4L entered into an Employment Agreement with Mr. Weiss pursuant to which Mr. Weiss serves as Vice Chairman of the Board of Directors and Chief Operating Officer of e4L from March 15, 1999 through October 22, 2001 at an annual minimum base salary of $387,000. In addition to the base salary payable
pursuant to the Employment Agreement, provided e4L is profitable on an EBITDA basis, Mr. Weiss is entitled to receive a bonus in an amount to be determined by the Compensation Committee of the Board of Directors or the Board of Directors. Mr. Weiss is also entitled to participate in all group medical and dental, hospitalization, health and accident, group life, travel, disability or similar plans or programs of e4L, and 401(k) and stock purchase programs and any other programs that e4L provides to other executives of e4L Mr. Weiss is also entitled to certain fringe benefits, including personal financial and legal counseling, not to exceed the sum of $10,000 annually, and an automobile allowance of $15,000 per annum. Pursuant to the Employment Agreement, Mr. Weiss is eligible to participate in e4L's qualified and non-qualified stock option plan(s). To the extent that Mr. Weiss is granted stock options, such stock options shall have an exercise price equal to the closing price of e4L's common stock on the date of grant, be exercisable for ten years, and vest on a schedule to be determined by the Compensation Committee of the Board of Directors or the Board of Directors, but in no event shall such vesting period be more than three years.
In the event of a Constructive Termination of the Employment Agreement (as defined in the Employment Agreement), e4L will be required to pay Mr. Weiss 2.99 times Mr. Weiss' base salary in effect on the date of such Constructive Termination. If Mr. Weiss' employment is terminated either by Mr. Weiss' voluntary action or For Cause (as defined in the Employment Agreement), e4L will pay Mr. Weiss' base salary that has accrued as of the date of termination, in addition to any bonus owed and accrued vacation pay. In the event of a Change of Control (as defined in the Employment Agreement), and if either (i) the Change of Control results in the termination of Mr. Weiss' employment during the first 180 days after such Change of Control, or (ii) following a Change of Control, e4L or any successor to e4L fails to assume, in writing, all obligations of e4L to perform the Employment Agreement, e4L shall pay Mr. Weiss 2.99 times Mr. Weiss' base salary in effect at the time of such Change of Control. In the event Mr. Weiss' employment is terminated as a result of a Change of Control or Constructive Termination, and the aggregate of all payments or benefits made or provided to Mr. Weiss under the Employment Agreement constitute a Parachute Payment (as defined by the Internal Revenue Code of 1986, as amended), e4L shall pay to Mr. Weiss an additional amount equal to 100% of the Excise Tax (as defined in the Employment Agreement) on the Parachute Payment.
Pursuant to the Employment Agreement, e4L has agreed to indemnify Mr. Weiss to the maximum extent permitted by law and to pay Mr. Weiss' expenses (including legal fees) in respect of Mr. Weiss' right to indemnification under the Employment Agreement, subject to a later determination as to Mr. Weiss' ultimate right to receive such payment.
JOHN W. KIRBY, PRESIDENT.
On March 20, 1998 e4L entered into an employment agreement with Mr. Kirby pursuant to which Mr. Kirby serves as President of e4L and Quantum Television at an annual minimum base salary of $325,000. In addition to the base salary payable pursuant to the agreement, Mr. Kirby is entitled to receive a minimum of $75,000 per annum in bonuses, which $75,000 is advanced pro rata during the year. Under the terms of the agreement, the increased base salary and bonus were deemed to have commenced as of October 1997. Mr. Kirby is not entitled to participate in e4L's Management Incentive Plan, the DirectAmerica Bonus Plan and e4L's other executive compensation plans; in lieu thereof, he is eligible to participate in e4L's Production Bonus Program. e4L reimburses Mr. Kirby for premiums associated with up to $1,000,000 of insurance on the life of Mr. Kirby, which is payable to beneficiaries designated by Mr. Kirby; and, pays Mr. Kirby an automobile allowance of $9,600 per annum. Pursuant to this employment agreement, Mr. Kirby was granted options to purchase up to 300,000 shares of Common Stock. The options were immediately exercisable at a price of $2.69 per share. Such options expire on January 28, 2008. Mr. Kirby's employment agreement expired on September 30, 1998. e4L is presently in negotiations with Mr. Kirby regarding an extension of his employment agreement. While e4L believes it will be able to reach an agreement with Mr. Kirby upon mutually agreeable terms, its ability to do so is not certain.
DANIEL M. YUKELSON, EXECUTIVE VICE PRESIDENT AND FINANCE, CHIEF FINANCIAL OFFICER, AND SECRETARY.
In addition to the compensation Mr. Yukelson received pursuant to the Consulting Agreement described above, Mr. Yukelson is currently compensated pursuant to an Employment Agreement entered into with e4L. On January 29, 1999, e4L entered into an Employment Agreement with Mr. Yukelson pursuant to which Mr. Yukelson serves as Executive Vice President/Finance, Chief Financial Officer and Secretary of e4L from March 1, 1999 through October 22, 2001 at an annual minimum base salary of $225,000. In addition to the base salary payable pursuant to the Employment Agreement, provided e4L is profitable on an EBITDA basis, Mr. Yukelson is entitled to receive a bonus in an amount to be determined by the Compensation Committee of the Board of Directors or the Board of Directors. Mr. Yukelson is also entitled to participate in all group medical and dental, hospitalization, health and accident, group life, travel, disability or similar plans or programs of e4L, and 401(k) and stock purchase programs and any other programs that e4L provides to other executives of e4L Mr. Yukelson is also entitled to certain fringe benefits, including personal financial and legal counseling, not to exceed the sum of $10,000 annually, and an automobile allowance of $15,000 per annum. Pursuant to the Employment Agreement, Mr. Yukelson is eligible to participate in e4L's qualified and non-qualified stock option plan(s). To the extent that Mr. Yukelson is granted stock options, such stock options shall have an exercise price equal to the closing price of e4L's common stock on the date of grant, be exercisable for ten years, and vest on a schedule to be determined by the Compensation Committee of the Board of Directors or the Board of Directors, but in no event shall such vesting period be more than three years.
In the event of a Constructive Termination of the Employment Agreement (as defined in the Employment Agreement), e4L will be required to pay Mr. Yukelson 2.99 times Mr. Yukelson's base salary in effect on the date of such Constructive Termination. If Mr. Yukelson's employment is terminated either by Mr. Yukelson's voluntary action or For Cause (as defined in the Employment Agreement), e4L will pay Mr. Yukelson's base salary that has accrued as of the date of termination, in addition to any bonus owed and accrued vacation pay. In the event of a Change of Control (as defined in the Employment Agreement), and if either (i.) the Change of Control results in the termination of Mr. Yukelson's employment during the first 180 days after such Change of Control, or (ii.) following a Change of Control, e4L or any successor to e4L fails to assume, in writing, all obligations of e4L to perform the Employment Agreement, e4L shall pay Mr. Yukelson 2.99 times Mr. Yukelson's base salary in effect at the time of such Change of Control. In the event Mr. Yukelson's employment is terminated as a result of a Change of Control or Constructive Termination, and the aggregate of all payments or benefits made or provided to Mr. Yukelson under the Employment Agreement constitute a Parachute Payment (as defined by the Internal Revenue Code of 1986, as amended), e4L shall pay to Mr. Yukelson an additional amount equal to 100% of the Excise Tax (as defined in the Employment Agreement) on the Parachute Payment.
Pursuant to the Employment Agreement, e4L has agreed to indemnify Mr. Yukelson to the maximum extent permitted by law and to pay Mr. Yukelson's expenses (including legal fees) in respect of Mr. Yukelson's right to indemnification under the Employment Agreement, subject to a later determination as to Mr. Yukelson's ultimate right to receive such payment.
STOCK OPTIONS GRANTED DURING FISCAL 1999
The following table sets forth certain information concerning options to purchase Common Stock of e4L granted to the executive officers named in the Summary Compensation Table in the fiscal year ended March 31, 1999.
OPTION GRANTS IN LAST FISCAL YEAR
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(1) The exercise price of each stock option was equal to the market price of the Common Stock on the date of grant. The actual value, if any, an option holder may realize will be a function of the extent to which the stock price exceeds the exercise price on the date the option is exercised and also will depend on the option holder's continued employment through the vesting period. The actual value to be reached by the option holder may be greater or less than the values estimated in this table.
(2) Options granted to TMC in connection with a consulting agreement between e4L and TMC.
The following table sets forth certain information concerning the exercise in the fiscal year ended March 31, 1999 of options to purchase Common Stock of e4L by the executive officers named in the Summary Compensation Table and the unexercised options to purchase Common Stock of e4L held by such individuals at March 31, 1999. Year-end values are based upon the closing market price per share of e4L's Common Stock on March 31, 1999 of $8.375.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION VALUES
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(1) Values are calculated by subtracting the exercise price from the fair market value as of the exercise date or fiscal year end, as appropriate. Values are reported before any taxes associated with exercise or subsequent sale of the underlying stock. The closing market price of e4L's common stock on March 31, 1999 was $8.375.
The following table sets forth certain information concerning the repricing of options for the ten-year period ending on March 31, 1999.
10-YEAR OPTION REPRICINGS
COMPENSATION COMMITTEE REPORT ON OPTION REPRICING FOR THE FISCAL YEAR ENDED MARCH 31, 1999
At a meeting of the Board of Directors held on July 10, 1998 to approve the terms of the Transaction, the Board of Directors approved an agreement with Mr. Verratti, the then current Chief Executive Officer of e4L, pursuant to which Mr. Verratti agreed to waive the provision in his employment agreement which would have entitled Mr. Verratti to receive a cash payment in the amount of $600,000 upon consummation of the Transaction. In consideration of such waiver, along with Mr. Verratti's agreement to relinquish the position of Chief Executive Officer to Mr. Lehman pending consummation of the Transaction, and to terminate his employment with e4L upon consummation of the Transaction, options to purchase 450,000 shares of common stock at an exercise price of $4.75 per share were repriced to $2.00 per share. In addition, the exercise period of all of Mr. Verratti's 700,000 stock options was extended for one additional year to three years from the date of termination of Mr. Verratti's employment by e4L.
The Board of Directors believed that the repricing of such stock options, in lieu of the cash payment described above, benefited e4L's stockholders in light of the financial position of e4L at the time of the Transaction. It is important to note that the undersigned members of e4L's current Compensation/Stock Option Committee of the Board of Directors did not participate in the negotiations and/or determinations made by e4L's prior Compensation Committee and Board of Directors with respect to Mr. Verratti.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
On June 15, 1999, there were outstanding and entitled to vote approximately 32,373,317 shares of Common Stock, 5,000 shares of Series B Preferred Stock (each share of which is entitled to 14.8 votes on all non-election matters), and 20,000 shares of Series E Convertible Preferred Stock (each share of which is entitled to 666 votes on all matters). The following table sets forth certain information at June 15, 1999 with respect to the beneficial ownership of shares of Common Stock by (i.) each of the members of the Board of Directors, (ii.) each executive officer of e4L and (iii.) all Directors and executive officers of e4L as a group. The address for each person listed in the following table is 15821 Ventura Boulevard, 5(th) Floor, Encino, California, 91436.
NUMBER OF ISSUED AND OUTSTANDING SHARES OF STOCK OWNED
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* Less than 1%.
(1) To e4L's knowledge, except as noted below, each Director and executive officer listed above has sole voting and investment power (with his spouse, in certain circumstances) with respect to all shares indicated as beneficially owned by such Director or executive officer.
(2) Includes shares which may be acquired upon the exercise of immediately exercisable outstanding employee stock options in accordance with Rule 13d-3 under the Exchange Act as follows: Mr. Lehman: 125,000; Mr. Weiss: 62,500; Mr. Kirby: 330,000; Mr. Yukelson: 25,000; Mr. Vercillo: 25,000; Mr. Crawford: 5,000; Mr. Salzman: 5,000; and Mr. Schuon: 5,000.
(3) Includes shares which may be acquired upon the exercise of immediately exercisable warrants in accordance with Rule 13d-3 under the Exchange Act as follows: Mr. Lehman: 2,010,641; Mr. Weiss: 481,517; Mr. Kirby: 112,579; Mr. Yukelson: 323,803; and Mr. Salzman: 27,010.
(4) All percentages are rounded to the nearest tenth of a percent.
(5) Based on 32,373,317 shares issued and outstanding as of June 15, 1999, as determined in accordance with Rule 13d-3.
(6) Based on 45,780,700 shares issued and outstanding as of June 15, 1999, including all shares of Common Stock owned and all shares of Common Stock issuable upon conversion of Series B Convertible Preferred Stock and Series E Convertible Preferred Stock owned, but not including options to purchase Common Stock or warrants exercisable into Common Stock.
(7) Includes shares of Common Stock held by Eric R. Weiss Charitable Remainder Trust.
NUMBER OF ISSUED AND OUTSTANDING SHARES OF STOCK OWNED
The following table sets forth certain information at June 15, 1999 with respect to each person, known by e4L to beneficially own more than 5% of the Common Stock as determined in accordance with Rule 13d-3. The information set forth below is derived, without independent investigation on the part of e4L, from the most recent filings made by such persons on Schedule 13D and Schedule 13G pursuant to Rule 13d-3. Capital Ventures International owns shares of Series D Convertible Preferred Stock and warrants which may, in certain circumstances, be converted into or exercised for a number of shares of Common Stock in excess of 4.9% of the number of outstanding shares of Common Stock.
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(1) To e4L's knowledge, except as otherwise indicated in the footnotes to this table, each of the persons named in this table has sole voting and investment power with respect to all shares of Common Stock reported as beneficially owned by such person.
(2) In accordance with Rule 13d-3, includes shares which may be acquired upon the exercise of immediately exercisable outstanding stock options and warrants and upon conversion of Series D Preferred Stock.
(3) In accordance with Rule 13d-3, includes shares of Common Stock issuable upon the conversion of Series B Preferred Stock and Series E Preferred Stock.
(4) All percentages are rounded to the nearest tenth of a percent.
(5) Based on 32,373,317 shares issued and outstanding as of June 15, 1999, as determined in accordance with Rule 13d-3.
(6) Based on 45,780,700 shares issued and outstanding as of June 15, 1999, which assumes conversion of all outstanding shares of Voting Preferred Stock, as determined in accordance with Rule 13d-3.
(7) Based on information contained in Schedule 13D dated November 3, 1998. Gruber and McBaine Capital Management, L.L.C. (the "LLC") is an investment adviser. Messrs. Gruber & McBaine are the managers of the LLC. Lagunitas Partners, L.P. and GMJ Investments, L.P. are investment limited partnerships. LLC is the general partner of the investment limited partnerships.
(8) Based on information contained in a Schedule 13G dated November 2, 1998. Jacor Communications Company is a wholly-owned subsidiary of Clear Channel Communications, Inc.
(9) Based on information contained in a Schedule 13G dated November 18, 1998 filed by Safeguard Scientifics, Inc. ("Safeguard") on December 31, 1998.
(10) Includes shares which may be acquired upon the exercise of immediately exercisable warrants in accordance with Rule 13d-3 under the Exchange Act.
(11) All shares listed as beneficially owned by Safeguard are held in the name of Safeguard Scientifics (Delaware), Inc. ("SSD"). SSD is a wholly owned subsidiary of Safeguard. Safeguard and SSD each have shared voting and investment power with respect to such shares.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Set forth below is a description concerning transactions which may not otherwise be described herein by and between e4L and/or its affiliates, and other persons or entities affiliated with e4L or its affiliates. e4L is of the view that each of such transactions was on terms no less favorable to e4L than would otherwise have been available to e4L in transactions with unaffiliated third parties, if available at all.
TMC CONSULTING AGREEMENT
In connection with the Transaction e4L entered into the Consulting Agreement with TMC pursuant to which TMC provided executive management services to e4L through February 1999. Pursuant to the terms of the Consulting Agreement, Messrs. Lehman, Weiss and Yukelson provided at least an aggregate of 100 hours per week of management services to e4L. Mr. Lehman, Mr. Weiss (through an entity controlled by Mr. Weiss) and Mr. Yukelson were members of TMC during the period that such consulting services were rendered. See "Employment Contracts, Termination of Employment and Change-in-Control Arrangements."
BROADCAST.COM AGREEMENT
On August 23, 1998, e4L entered into an exclusive services agreement with Broadcast.com pursuant to which Broadcast.com has agreed to provide complete Internet broadcasting services for e4L's direct response television programming. Pursuant to the terms of the service agreement, e4L is required to pay Broadcast.com (i) an advance fee of $250,000, (ii) a monthly fee of $41,666 for three months; (iii) a monthly fee of $83,333 for the remaining eighteen months of the agreement, and (iv) certain programming and encoding fees. Mark Cuban is the Chief Executive Officer of Broadcast.com and as also a member of the investor group which assumed operational control of e4L in October 1998. The agreement was ratified by the unanimous vote of the disinterested members of the Board of Directors.
IFMC, INC. CONSULTING AGREEMENT
In August 1998, e4L entered into a consulting agreement with IFMC, Inc. ("IFMC") a consulting firm of which Anthony M. Vercillo, e4L's current Executive Vice President, Global Operations, is the sole shareholder. The consulting agreement was terminated in November 1998 in connection with the hiring of Mr. Vercillo by e4L, however, e4L utilized IFMC's services subsequent to termination of the agreement in March 1999. During the fiscal year 1999, e4L paid an aggregate of $66,800 in fees to IFMC.
ALIGNE, INC. CONSULTING AGREEMENT
Aligne, Inc., an information systems consulting firm which is affiliated with Safeguard Scientifics, Inc., provided information systems consulting services to e4L through November 1998. e4L paid an aggregate of $250,000 during the fiscal year ended March 31, 1999.
LEGAL SERVICES
Stuart D. Buchalter is Of Counsel to the California law firm of Buchalter, Nemer, Fields and Younger, which from time to time provides legal services to e4L.
William Goldstein, a Director of e4L during the fiscal year ended March 31, 1999, is a partner at the Philadelphia, Pennsylvania law firm of Drinker, Biddle & Reath, LLP, which provided legal services to e4L during the fiscal year ended March 31, 1999.
MANAGEMENT INDEBTEDNESS
In March 1998, e4L entered into an employment agreement with John W. Kirby, pursuant to which Mr. Kirby serves as the President of e4L. The terms of the agreement included the forgiveness of a loan, including accrued interest, in the amount of $191,186 and the issuance of a new $545,000 loan to Mr. Kirby. The new loan bears interest at a rate equal to the Prime rate plus 1 1/2% per annum and is due May 30, 2000. Such funds were used by Mr. Kirby for personal purposes. As collateral for the indebtedness, Mr. Kirby has pledged 100,000 shares of Common Stock to e4L. As of March 31, 1999, principal and accrued interest thereon of approximately $600,000 was outstanding under such note.
Such amount represents the largest aggregate amount of indebtedness outstanding since the issuance of the promissory note. Mr. Kirby also held an allowance from e4L in the amount of $18,000, bearing no interest, which was advanced to him for personal reasons in November 1995. Mr. Kirby also acts as surety for debt owing to e4L in principal and accrued interest of approximately $42,176 which was outstanding as of March 31, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Financial Statements and Schedules
The following is a list of the consolidated financial statements of e4L and its subsidiaries and supplementary data submitted in a separate section of this report.
- Report of Independent Auditors.
- Consolidated Balance Sheets as of March 31, 1999 and 1998.
- Consolidated Statements of Operations for the years ended March 31, 1999, 1998 and 1997.
- Consolidated Statements of Shareholders' Equity for the years ended March 31, 1999, 1998 and 1997.
- Consolidated Statements of Cash Flows for the years ended March 31, 1999, 1998 and 1997.
- Notes to Consolidated Financial Statements
The following is a list of the schedules filed as part of this Form 10-K.
Schedule II Valuation and Qualifying Accounts
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
(b) Reports on Form 8-K filed in the fourth quarter of 1999:
None.
INDEX TO EXHIBITS
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(1) Incorporated by reference to Registrant's Registration Statement on Form S-1 (Reg. No. 33-26778) filed January 31, 1989.
(2) Incorporated by reference to Registrant's Current Report on Form 8-K dated October 23, 1998 filed October 3, 1998.
(3) Filed herewith.
(4) Incorporated by reference to Registrant's Registration Statement on Form S-3 (Reg. No. 33-35301) filed June 8, 1990.
(5) Incorporated by reference to Registrant's Annual Report on Form 10-K for fiscal year ended March 31, 1992 filed June 26, 1992.
(6) Incorporated by reference to Registrant's Annual Report on Form 10-K for fiscal year ended March 31, 1995 filed June 29, 1995.
(7) Incorporated by reference to Registrant's Annual Report on Form 10-K for fiscal year ended March 31, 1994 filed July 14, 1994.
(8) Incorporated by reference to Registrant's Current Report on Form 8-K dated September 18, 1997 filed September 24, 1997.
(9) Incorporated by reference to Registrant's Annual Report on Form 10-K for the fiscal year ended March 31, 1998 filed July 8, 1998.
(10) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended December 31, 1995 filed February 15, 1996.
(11) Incorporated by reference to Registrant's Registration Statement on Form S-3 (Reg. No. 333-48217) filed January 31, 1998.
(12) Incorporated by reference to Registrant's Proxy Statement in connection with Annual Meeting of Stockholders held on February 22, 1995.
(13) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended September 30, 1993 filed November 12, 1993.
(14) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1996 filed August 13, 1996.
(15) Incorporated by reference to Registrant's Current Report on Form 8-K dated August 7, 1996 filed August 26, 1996.
(16) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended September 30, 1997, as amended, filed January 23, 1998.
(17) Incorporated by reference to Registrant's Current Report on Form 8-K/A dated January 5, 1998 filed January 16, 1998.
(18) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended December 31, 1997 filed February 13, 1998.
(19) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended December 31, 1998 filed February 19, 1999.
ANNUAL REPORT ON FORM 10-K
ITEM 8, AND ITEM 14(A)(1) AND (2), (C) AND (D)
CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
LIST OF CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
CERTAIN EXHIBITS
FINANCIAL STATEMENT SCHEDULE FOR YEAR ENDED MARCH 31, 1999
E4L, INC. LOS ANGELES, CALIFORNIA
E4L, INC. CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT AUDITORS
Board of Directors e4L, Inc.
We have audited the accompanying consolidated balance sheets of e4L, Inc. (formerly National Media Corporation) as of March 31, 1999 and 1998, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended March 31, 1999. Our audits also included the financial statement schedule included in the Index at Item 14(a). These financial statements and schedule are the responsibility of e4L's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of e4L, Inc. at March 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Ernst & Young LLP
Los Angeles, California June 25, 1999
E4L, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
See accompanying notes.
E4L, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See accompanying notes.
E4L, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT NUMBER OF SHARES)
See accompanying notes.
E4L, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
E4L, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(IN THOUSANDS)
See accompanying notes.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1999
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
e4L, Inc., formerly National Media Corporation, and subsidiaries ("e4L") are engaged in the direct marketing and sale of consumer products, principally through direct response television programming, wholesale/retail distribution and electronic commerce. Primarily through its direct response television programming, e4L markets consumer products in more than 70 countries.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of e4L, Inc. and its wholly-owned subsidiaries consisting of: Quantum North America, Inc., (d/b/a, e4L North America) DirectAmerica Corporation (d/b/a, e4L Television), Quantum International Limited, Quantum International Japan Company Limited, Quantum Prestige Pty Limited and Suzanne Paul Pty Limited, and others. All significant inter-company accounts and transactions have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires that management make estimates and assumptions that affect the amounts reported in the consolidated financial statements and notes to the consolidated financial statements. Estimates are routinely made for, among other things, inventory obsolescence, goodwill, sales returns and allowances, valuations of stock options and warrants to purchase common stock, allowances for bad debts, and contingencies. Actual results could differ from these estimates.
REVENUE RECOGNITION AND ALLOWANCE FOR RETURNS
Product sales and retail royalty revenues are recognized when the product is shipped or the thirty (30) day "free trial" has expired, whichever is later. In many instances, e4L's policy is to unconditionally refund the total price of merchandise returned by customers within thirty (30) days of receipt. e4L provides an allowance, based upon experience, for merchandise returns.
e4L membership fee income is recognized upon expiration of the refund period.
CONCENTRATION OF CREDIT RISK
Financial instruments which potentially expose e4L to concentration of credit risk consist primarily of cash equivalents and accounts receivable. At times e4L maintains cash balances in excess of Federal Deposit Insurance Corporation or equivalent foreign insurance limits. e4L's accounts receivable balance consists primarily of a large number of insignificant customer balances and amounts due from wholesale customers. The Company monitors individual accounts in order to minimize the risk of loss and generally does not require collateral.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CASH AND CASH EQUIVALENTS
e4L considers all highly liquid debt instruments with a maturity of three months or less when purchased to be cash equivalents. Restricted cash represents cash pledged as collateral for an office lease and outstanding foreign exchange forward contracts.
INVENTORY
Inventory consists principally of products purchased for resale, and are stated at lower of cost (first-in, first-out) or market. The reserve for obsolete inventory was $4,913,000 and $6,519,000 at March 31, 1999 and 1998, respectively.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line method based on the lesser of the estimated useful lives of the assets or lease terms, generally 3 to 10 years.
EXCESS OF COST OVER NET ASSETS ACQUIRED AND OTHER INTANGIBLE ASSETS
Excess of cost over net assets acquired (e.g., "goodwill") is being amortized using the straight-line method, generally over periods of 10 to 20 years. Other intangible assets are being amortized using the straight-line method over periods of 2 to 5 years. Amortization expense for excess of cost over net assets acquired and other intangible assets was $2,141,000, $3,015,000, and $2,532,000 for the years ended March 31, 1999, 1998 and 1997, respectively.
The recoverability of excess cost over net assets acquired and other intangible assets is evaluated periodically, but not less than annually, by an analysis of operating results for each acquired business, significant events or changes in business-environment and, if necessary, independent appraisal.
Because indicators of impairment (losses, asset write-offs, etc.) existed during the year ended March 31, 1997, e4L engaged an independent appraiser to evaluate the carrying value of the assets of its wholly-owned subsidiary Positive Response Television, Inc. ("PRTV"). The independent appraiser used a combination of the income and market valuation approaches, and determined that the excess cost over net assets acquired balance had been impaired. Based on this evaluation, e4L wrote-off $4,392,000 of PRTV excess cost over net assets acquired during the year ended March 31, 1997. In connection with a subsequent evaluation of PRTV excess cost over net assets acquired during the year ended March 31, 1998, e4L's management determined there was no future benefit or likelihood of cash flows from PRTV. As a result, e4L wrote-off the remaining $14,546,000 of excess cost over net assets acquired during the year ended March 31, 1998.
During the year ended March 31, 1999, indicators of impairment (losses, changes in business environment, etc.) existed with respect to e4L's wholly-owned subsidiaries Prestige Marketing Limited and Prestige Marketing International Limited (collectively, "Prestige") and Suzanne Paul Holdings Pty Limited and its operating subsidiaries (collectively, "Suzanne Paul"). Accordingly, e4L engaged an independent appraiser to evaluate the underlying assets of these subsidiaries. The independent appraiser used a combination of income and market valuation approaches, and determined that the excess cost over net
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EXCESS OF COST OVER NET ASSETS ACQUIRED AND OTHER INTANGIBLE ASSETS (CONTINUED)
assets acquired had been impaired and, therefore, e4L wrote-off $11,300,000 of excess cost over net assets acquired attributable to the two subsidiaries during the year ended March 31, 1999.
SHOW PRODUCTION COSTS
In connection with a transaction pursuant to which an investor group acquired a controlling interest in e4L as more fully described in Note 6, (the "Transaction"), e4L substantially revised its business model and strategies. A key strategy in e4L's revised business model is the utilization of its television, radio and Internet media to market consumer products and services outside of its direct response television programming, including branding of products for distribution for wholesale/retail, electronic commerce, and continuity distribution channels. The direct response television program and associated show production cost is now a vehicle to generate a customer base, which will be utilized in various revenue generating initiatives as opposed to the direct response television program sale being the end result or merely a one-time sale. The direct response television program is, in part, being utilized to promote e4L's membership shopping club, "Everything4Less" and other electronic commerce initiatives, to brand products for wholesale/retail distribution, to market continuity programs, and to create list rental opportunities with respect to its customer base. As a result, show production costs are expensed as incurred.
Prior to the Transaction, costs related to the production of e4L's direct response television programs were capitalized and amortized over the estimated useful life of the related product, generally 12 to 24 months. The useful life of each television program was initially determined, and periodically adjusted based upon estimated future and actual sales. Show production costs were $14,767,000, $14,845,000 and $21,406,000 for the years ended March 31, 1999, 1998 and 1997, respectively. As more fully described in Note 10, the year ended March 31, 1999 included $2,621,000 of annual charges attributable to the write-down of certain prepaid show production costs due to the fundamental change in e4L's business model and strategies discussed above. For the years ended March 31, 1999, 1998 and 1997 product and other direct costs included $1,100,000, $1,608,000 and $10,811,000, respectively, attributable to writedowns of unsuccessful television programs.
DEFERRED REVENUE AND COSTS
Deferred revenue consists of funds received by e4L for products ordered, but not shipped and for membership fees received, but not recognized as income. Related media and certain direct costs are deferred and expensed as the orders are shipped. e4L also defers certain media and telemarketing costs on product orders where funds have not yet been received and expenses these costs as the orders are shipped.
INCOME TAXES
e4L uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities, and are measured using estimated statutory tax rates and laws that will be in effect when the differences are expected to reverse. Income tax benefits have not been recorded during the current period on United States and certain international losses. These benefits will be recorded when
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES (CONTINUED)
realized or at such time it is determined these benefits are likely to be realized, reducing the effective tax rate on future United States and certain international earnings.
PER SHARE AMOUNTS
Net loss per share has been computed in accordance with Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS No. 128"). In computing per share amounts, accrued dividends and the effect of beneficial conversion features on preferred stock have been deducted from net loss to arrive at net loss applicable to common shareholders.
FOREIGN CURRENCY TRANSLATION
Results of operations for e4L's foreign subsidiaries are translated using the average exchange rates in effect during the periods presented, while assets and liabilities are translated into United States dollars using the exchange rate in effect at the balance sheet date. Resulting translation adjustments are recorded as a component of other comprehensive income (loss) within shareholders' equity. Currency gains and losses relating to operations and intercompany transactions are recorded as selling, general and administrative expenses. Losses and (gains) recorded during the years ended March 31, 1999, 1998, and 1997 were $2,160,000, $1,833,000 and $(332,000), respectively.
Periodically, e4L enters into foreign exchange forward contracts to hedge the risks associated with certain anticipated transactions. These contracts are primarily in Japanese yen and generally have maturities that do not exceed one year. e4L defers recognition of gain or loss on changes in the market value of these contracts until such time as the hedge transaction is complete. At March 31, 1999 e4L had outstanding $4.7 million in notional foreign exchange contracts with maturity dates through September 1999. e4L does not hold or issue forward contracts for trading purposes.
STOCK OPTION PLANS
e4L accounts for employee stock options in accordance with Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees," and its related interpretations. No compensation expense is recognized for e4L's employee stock options which have an exercise price equal to or above the market price on the date of the grant.
COMPREHENSIVE INCOME
In April 1998, e4L adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." Comprehensive income is defined as the change in equity from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net income (loss) and comprehensive income (loss) results from foreign currency translation adjustments.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RECLASSIFICATIONS
Certain prior-year amounts have been reclassified to conform with current presentation.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
During 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of derivatives are accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. SFAS No. 133 is effective beginning in 2000. The adoption of SFAS No. 133 is not expected to have a material impact on the financial position or results of operations of e4L.
2. ACQUISITIONS
The value of the common stock issued in all acquisitions was based on the market price of e4L's common stock at the date a definitive agreement was reached, which typically included either the date of signing of a letter of intent or definitive agreement, which e4L believes is indicative of the fair value of the acquired businesses.
On May 17, 1996, e4L acquired all of the issued and outstanding capital stock of PRTV, a publicly traded direct marketing company and producer of direct response television programming, for 1,836,773 shares of e4L's common stock valued at $25.9 million. The acquisition was accounted for as a purchase and the results of PRTV are included in e4L's financial statements from the date of acquisition. A total of $39.1 million in assets were acquired, including goodwill of $18.6 million that was initially being amortized over 20 years. Under the terms of the purchase agreement, 181,949 of the shares held in escrow were returned to e4L because certain assets were not realized. e4L accounted for these shares as treasury stock and a reduction in goodwill of $2.6 million. During the year ended March 31, 1998, e4L wrote-off the remaining goodwill associated with PRTV as more fully described in Note 1.
On July 2, 1996, e4L acquired Prestige Marketing Limited and Prestige Marketing International Limited (collectively, "Prestige") and Suzanne Paul Holdings Pty Limited and its operating subsidiaries (collectively, "Suzanne Paul"). Prestige and Suzanne Paul are engaged in the marketing of consumer products through direct response television programming and wholesale/retail distribution. The aggregate consideration initially paid by e4L for Prestige and Suzanne Paul was approximately $4.2 million in cash, $2.8 million in a note payable due and paid on December 5, 1996, and 787,879 shares of e4L's common stock then valued at $14.7 million. The acquisition was accounted for as a purchase and the results of Prestige and Suzanne Paul are included in e4L's financial statements from the date of acquisition. A total of $33.8 million in assets were acquired, including goodwill of approximately $18.7 million that was initially being amortized over 20 years. The Prestige and Suzanne Paul acquisition agreements provided for the payment of additional purchase consideration, up to an aggregate of an additional $5.0 million in e4L common stock valued at the time of issuance, contingent upon the levels of net income achieved during the years ended March 31, 1998 and 1997 by Prestige and Suzanne Paul. During the year ended March 31, 1998, e4L amended the acquisition agreements accelerating the $5.0 million contingent purchase consideration and revising certain other provisions of the agreements. In connection with such amendments, e4L
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
2. ACQUISITIONS (CONTINUED) issued 909,091 shares of common stock to the former principals of Prestige and Suzanne Paul based on the closing price of e4L's common stock on the New York Stock Exchange on July 16, 1997. This additional amount represented an increase in purchase price. During the year ended March 31, 1999, e4L wrote-off $11.3 million of goodwill attributable to Prestige and Suzanne Paul as more fully described in Note 1.
On August 7, 1996, e4L acquired all of the issued and outstanding capital stock of Nancy Langston & Associates, Inc. ("Langston"), a media buying agency. The aggregate consideration consisted of 26,587 shares of e4L common stock then valued at $500,000, and a $390,000 promissory note payable. A total of $904,600 in assets were acquired, including goodwill of approximately $880,000, which was being amortized over 10 years. e4L sold Langston in October 1998, resulting in a loss on disposition of approximately $1.0 million.
The purchase price allocations for PRTV, Prestige, Suzanne Paul, and Langston were based on management's estimates of the fair value of assets acquired and liabilities assumed. Had the PRTV, Prestige, Suzanne Paul, and Langston acquisitions been made at April 1, 1996, pro forma unaudited condensed results of operations for the year ended March 31, 1997 would have been net revenue of $372,694; net loss of $45,468 and basic and diluted loss per share of $2.07. The pro forma information does not purport to be indicative of the results of operations that would have been reported had the acquisitions actually taken place on April 1, 1996 or of future results of operations.
3. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (in thousands):
Depreciation and amortization expense for property and equipment, including equipment acquired under capital leases, was $4,653,000, $4,058,000 and $3,042,000 for the years ended March 31, 1999, 1998 and 1997, respectively.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
4. ACCRUED EXPENSES
Accrued expenses include the following (in thousands):
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
5. LONG-TERM DEBT AND OBLIGATIONS UNDER CAPITAL LEASES
Long-term debt and obligations under capital leases consist of the following (in thousands):
e4L believes the carrying value of long-term debt and obligations under capital leases approximate fair value.
In December 1998, e4L entered into a new, three-year credit agreement with a senior lender (the "Credit Agreement"). The Credit Agreement provides for a revolving credit facility with a maximum commitment of $20.0 million, of which up to $7.5 million may be in the form of outstanding letters of credit. Borrowings under the Credit Agreement are limited to a borrowing base consisting of certain eligible United States accounts receivable and inventory, as defined. Outstanding borrowings under the Credit Agreement bear interest, at the option of e4L, at the United States Prime lending rate plus one-quarter percent or the London Interbank Offered Rate (LIBOR) plus three percent, however, in no event shall the interest rate charged be less than seven percent per annum. A commitment fee of one-quarter percent per annum is paid on the unused portion of the Credit Agreement. The effective interest rate on e4L's debt was approximately 15.9% and 13.0% for the years ended March 31, 1999 and 1998, respectively.
The Credit Agreement is collaterized by a lien on substantially all of the assets of e4L's United States subsidiaries, and a pledge of the stock of e4L's foreign subsidiaries. The Credit Agreement contains certain financial covenants, with respect to, among other matters, payment of dividends, maintenance of tangible net worth, and restrictions on borrowings and purchases of fixed assets.
In addition to outstanding borrowings of $7.2 million at March 31, 1999, the Company had a $1.0 million letter of credit outstanding, and approximately $9.8 million of remaining availability under the Credit Facility.
In October 1998, e4L repaid approximately $21.5 million of debt outstanding under a credit agreement with its former principle lender at a twenty-five percent discount. The repayment resulted in a $4.9 million gain on extinguishment of debt which is reflected in the statement of operations as an extraordinary item. In addition, in December 1998, e4L repaid a $10.0 million note payable due to ValueVision International, Inc. ("Value Vision").
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
5. LONG-TERM DEBT AND OBLIGATIONS UNDER CAPITAL LEASES (CONTINUED) Borrowings under the Credit Agreement are classified as current liabilities at March 31, 1999. The principal payments under various capital lease obligations are $87,000, $93,000 and $42,000 during each of the years ended March 31, 2000, 2001, and 2002, respectively.
6. CAPITAL TRANSACTIONS
SERIES E CONVERTIBLE PREFERRED STOCK
During the year ended March 31, 1999 e4L consummated a transaction pursuant to which, among other things, operational control of e4L was acquired by an investor group led by Stephen C. Lehman, e4L's Chairman of the Board of Directors and Chief Executive Officer. In connection therewith e4L sold to the investor group $20.0 million of newly issued shares of Series E Convertible Preferred Stock, $.01 par value per share ("Series E Preferred Stock") with a face value of $1,000 per share (the "Transaction"); after deducting related offering costs, net proceeds to e4L were approximately $17.6 million. The Series E Preferred Stock has a three-year term and is automatically converted into e4L common stock at maturity, if not converted prior thereto. The Series E Preferred Stock provides for a 4.0% coupon for one year and is convertible into shares of e4L's common stock at a fixed conversion price of $1.50 per share (subject to standard anti-dilution adjustments). The 4% premium is payable, at e4L's option, in cash or shares of e4L common stock, at the time of conversion or first anniversary date of issuance. The premium is being recorded as an accrued dividend. Based upon the $1.50 per share fixed conversion price, the Series E Preferred Stock is convertible into 13,333,333 shares of e4L's common stock at March 31, 1999. The beneficial conversion feature is being treated as a deemed dividend over the period from the date of issuance to the earliest conversion date, solely for the purpose of calculating earnings per share. As part of the Transaction, holders of e4L's Series D Convertible Preferred Stock ("Series D Preferred Stock") sold to the investor group $10.0 million of Series D Preferred stock and 992,942 warrants issued in connection with such shares, and agreed to certain limitations regarding the sale of the Series D Preferred Stock and e4L common stock issuable upon conversion and/or exercise of the Series D Preferred Stock and underlying warrants (collectively, "Series D Securities").
The Series E Preferred Stock is entitled to vote together with the holders of e4L common stock as a single class of capital stock. Each share of Series E Preferred Stock has 666 votes, which is equivalent to the number of shares of common stock into which the Series E Preferred Stock is convertible. The liquidation preference for the Series E Preferred Stock is equal to the face amount of $1,000 per share and is senior to e4L common stock and Series A Participating Preferred Stock, junior to e4L's Series B Convertible Preferred Stock ("Series B Preferred Stock") and pari passu with e4L's Series D Convertible Preferred Stock.
In connection with the Transaction, Temporary Media Co., LLC ("TMC"), a management company of which Mr. Lehman and two of his associates are managing members was granted a five-year option to purchase up to 212,500 shares of e4L's common stock, subject to certain vesting requirements, at an exercise price of $1.32 per share and five-year warrants to purchase up to 3,762,500 shares of e4L's common stock at exercise prices ranging form $1.32 to $3.00 per share. 1,000,000 of the warrants may not be transferred to Mr. Lehman, his associates or any employee of the management company. The granting of these warrants resulted in a non-cash compensation charge of $274,000 through March 31, 1999, which
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
6. CAPITAL TRANSACTIONS (CONTINUED)
SERIES E CONVERTIBLE PREFERRED STOCK (CONTINUED)
is included in selling, general and administrative expenses. The remaining $1,605,000 of value attributed to the granting of these warrants is being amortized through October 23, 2001, the vesting period.
SERIES C AND SERIES D CONVERTIBLE PREFERRED STOCK
On September 18, 1997, e4L sold to two institutional investors (the "Series C Investors") 20,000 shares of its Series C Convertible Preferred Stock, $.01 par value per share (the "Series C Preferred Stock"), with a face value of $1,000 per share, for an aggregate purchase price of $20,000,000, net of costs of $310,000. The Series C Preferred Stock had a four-year term and was to be automatically converted into e4L's common stock at maturity, if not converted earlier. Immediately upon issuance, each share of Series C Preferred Stock was convertible at the holder's option into such number of shares of e4L common stock, as determined by dividing the face value of the Series C Preferred Stock (plus a 6% per annum accrued premium as of the conversion date) by (i) if conversion occurred on or before March 17, 1998, a conversion price equal to $6.06 per share (subject to adjustment), or (ii) if conversion occurred after March 18, 1998, a conversion price equal to the lower of $6.06 per share (the "Fixed Conversion Price") or the lowest daily volume weighted average sale price during the five days immediately prior to such conversion. The $6.06 conversion price was equal to 120% of the volume weighted average sales price of e4L's common stock on the date of the initial public announcement of the sale of the Series C Preferred Stock (the "Announcement Date Price"). In connection with the investment, e4L also issued warrants to the Series C Investors to acquire an aggregate of 989,413 shares of e4L common stock at an initial exercise price of $6.82 per share (the "Series C Warrants"). Such warrants are exercisable until September 17, 2002.
In January 1998, in connection with the termination of a merger agreement with Value Vision ("Merger Agreement"), e4L entered into a Redemption and Consent Agreement with the Series C Investors, pursuant to which e4L agreed to exchange the Series C Preferred Stock for a newly issued Series D Preferred Stock containing terms substantially similar to those of the Series C Preferred Stock, but with a mechanism by which the fixed conversion price could be subject to reduction under certain circumstances. In addition, e4L granted additional five-year warrants to purchase up to 500,000 shares of e4L common stock to the Series C investors (the "Series D Warrants"). The warrants had an exercise price of $6.82 per share, but contained a mechanism by which the exercise price could be adjusted downward in certain circumstances. In exchange, the Series C Investors agreed, among other things, to waive their right to convert their Series D Preferred Stock into e4L's common stock at a per share price below $6.06 prior to the earliest of the termination of the Merger Agreement or June 1, 1998. The actual exchange of Series C Preferred Stock for Series D Preferred Stock took place on April 14, 1998.
Upon termination of the Merger Agreement on June 1, 1998. The fixed conversion price of the Series D Preferred Stock and the exercise price of the all of the Series D warrants were automatically adjusted to $1.07 per share, 101% of the closing bid price of the company's common stock at said date. As a result, the outstanding shares of Series D Preferred Stock as of March 31, 1999 are convertible into a minimum of 17,349,273 shares of e4L common stock, not including shares issuable upon conversion of any accrued premium.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
6. CAPITAL TRANSACTIONS (CONTINUED)
SERIES C AND SERIES D CONVERTIBLE PREFERRED STOCK (CONTINUED)
The Series D Preferred Stock carries a 6% annual premium payable, at e4L's option, in cash or e4L common stock at the time of conversion. Except under certain circumstances, no holder of the Series D Preferred Stock or the related warrants is entitled to convert or exercise such securities to the extent that the shares to be received by such holder upon such conversion or exercise would cause such holder to beneficially own more than 4.9% of e4L's common stock.
The Series D Preferred Stock carries no voting rights except as otherwise provided by Delaware General Corporation Law. Its liquidation preference is equal to the face amount plus any accrued premiums, and is senior to e4L's common stock and Series A Junior Participating Preferred Stock; junior to e4L's Series B Preferred Stock and pari passu with e4L's Series E Preferred Stock.
In connection with the Transaction, holders of the Series D Preferred Stock are prohibited from selling more than 12.5% of their interests during any 90-day period, and holders of the Series E preferred stock are prohibited from converting or selling any of their interests through October 23, 1999.
SERIES B CONVERTIBLE PREFERRED STOCK
In October 1994, e4L authorized the issuance of Series B Convertible Preferred Stock, par value $.01 per share, (the "Series B Preferred Stock") consisting of 400,000 authorized shares, of which a total of 255,796 shares were issued. At March 31, 1999, there were 5,000 shares of Series B Preferred Stock outstanding.
The 5,000 shares of Series B Preferred Stock outstanding at March 31, 1999 are valued at $40.00 per share for conversion purposes and are presently convertible, at the option of the holder, into 74,050 shares of e4L's common stock at a price of $2.70 per share (subject to adjustment). The holders of shares of Series B Preferred Stock shall be entitled to receive dividends declared on e4L's common stock and have voting rights (except as the election of directors) as if the shares of Series B Preferred Stock had been converted into common stock.
In connection with the sale of the Series B Preferred Stock, e4L issued 255,796 warrants, (the "Series B Preferred Stock warrants") each of which represent the right to purchase 12 shares (subject to adjustment) of e4L common stock. The warrants were initially exercisable at a price of $4.80 per share, except for those applicable to 3,546 warrants which were initially exercisable at a price of $5.74 per share. At March 31, 1999, 167,100 warrants to acquire 4,027,115 shares of e4L common stock were outstanding and exercisable, and expire between October 5, 2004 and December 19, 2004.
As a result of the Transaction and other matters, certain anti-dilution provisions of e4L's outstanding Series B Preferred Stock and the Series B Preferred Stock Warrants were triggered resulting in an increase in the total shares of common stock underlying the outstanding Series B Preferred Stock from 812,500 to approximately 1.2 million shares, and an increase in the total shares of common stock available upon exercise of the Series B Preferred Stock Warrants from approximately 2.7 million to approximately 5.3 million and a decrease in the exercise price from approximately $4.80 per share to approximately $2.37 per share.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
6. CAPITAL TRANSACTIONS (CONTINUED)
SERIES B CONVERTIBLE PREFERRED STOCK (CONTINUED)
STOCK PURCHASE RIGHTS
On January 13, 1994, e4L distributed one preferred share purchase right on each outstanding share of its common stock. The rights will become exercisable only if, without e4L's consent or waiver, a person or group acquires 15% or more of e4L's outstanding common stock or announces a tender offer, the consummation of which would result in ownership by a person or group of 15% or more of e4L's outstanding common stock. Each right will entitle shareholders to buy one one-hundredth of a share of a new series of junior participating preferred stock at an exercise price of $40. In addition, upon the occurrence of certain events, the holders of rights will have the right to receive, upon exercise at the then-current exercise price, common stock (or, in certain circumstances, cash, property, or other securities of e4L) having a value equal to two times the exercise price of such right. In the event that e4L is acquired in a merger or other business combination, or 50% or more of e4L's assets or earning power is sold, proper provision will be made so that each holder of such right will have an additional right to receive, upon exercise at the then current exercise price of such right, common stock of the acquiring or surviving company having a value equal to two times the exercise price of the right. Any rights that are, or were, under certain circumstances, beneficially owned by such 15% owner will immediately become null and void.
The holders of rights have no rights as stockholders of e4L. e4L has the ability to redeem the rights at $.001 per right until the occurrence of certain specified events.
WARRANTS
Warrants outstanding at March 31, 1999 are as follows:
Series B loan warrants were issued in connection with a $5.0 million term loan provided to e4L in October 1994 ("Series B Warrants"). As a result of the Transaction and other matters certain anti-dilution provisions of the Series B Warrants were triggered resulting in an increase in the number of shares of
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
6. CAPITAL TRANSACTIONS (CONTINUED)
WARRANTS (CONTINUED)
common stock available upon exercise of the outstanding Series B Warrants from approximately 2.3 million to 4.4 million and a decrease in the exercise price from $4.80 per share to approximately $2.37 per share.
In connection with a loan modification agreement dated September 18, 1997, between e4L and its former principal lender, e4L granted to its principal lender five-year warrants to acquire 125,000 shares of e4L's common stock at a price of $5.1875 per share, the market price of e4L's common stock as of the date of the grant.
At March 31, 1999 there were approximately 47,550,000 shares of e4L's common stock reserved for conversion of preferred stock, for exercise of stock options and warrants, and for issuance under e4L's Management Incentive Plan and 401(k) plan.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
7. STOCK OPTIONS
e4L applies the provisions of APB Opinion 25 "Accounting for Stock Issued to Employees", and related interpretations in accounting for its stock option plans. No compensation has been recognized for options which have an exercise price equal to or above the market price on the date of grant. The majority of options are granted at an exercise price equal to or greater than the market price of e4L's common stock at the date of grant. Had compensation cost attributable to stock options been determined using fair values at the grant dates as defined by SFAS No. 123, e4L's pro forma net loss and net loss per share would have been as follows:
Option valuation models use highly subjective assumptions to determine fair value of traded options with no vesting or trading restrictions. Because options granted by e4L have vesting requirements and cannot be traded, and because changes in the assumptions can materially affect the estimate of fair value, in management's opinion, the existing valuation models do not necessarily provide a reliable measure of the fair value of employee stock options.
For purposes of determining the pro forma disclosures, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for each year presented: dividend yield of 0%; and expected lives of 5 years. Expected volatility of 104.5%, 50.0% and 51.8%, and risk-free interest rates of 6.5%, 6.4% and 6.1% have been used in each of the years ended March 31, 1999, 1998 and 1997 respectively. In accordance with the transition provisions of SFAS No. 123, the pro forma disclosures presented above apply only to option grants and stock awards dated on or after April 1, 1995. Therefore, because option grants and awards generally vest over several years and additional awards are expected to be made in the future, the pro forma results of operations should not be considered representative of the effects on reported results of operations for future years.
A maximum of 8,865,000 shares of common stock may be issued upon exercise of incentive or nonincentive stock options, special options, or stock appreciation rights granted as of March 31, 1999. All employees of e4L, as well as directors, officers, and third parties providing services to e4L are eligible to participate in e4L's stock option plan.
During the year ended March 31, 1997, e4L recognized $491,000 in compensation expense related to the issuance of 30,000 shares of common stock to non-employee directors under its Director Stock Grant Plan. The Director Stock Grant Plan was terminated as of March 31, 1997. The shares were valued at closing price of e4L's common stock at the date of grant.
As an inducement to the execution of employment agreements with various officers of e4L who entered into employment agreements after August 31, 1991, as well as certain other agreements during the year ended March 31, 1998, the Board of Directors authorized the grant of options to purchase up to 2,686,750 shares of common stock at exercise prices equal to at least the market price at the time of grant with the exception of 700,000 stock options granted to a former Chief Executive Officer and 50,000 stock
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
7. STOCK OPTIONS (CONTINUED) options granted to two other former executive officers. These 750,000 stock options contained a provision that upon the occurrence of certain triggering events (such as a sale or merger of e4L, or significant investment), the executives could have realized a reduction of up to an aggregate of approximately $3.0 million in the exercise price of their options. This $3.0 million charge was amortized from November 13, 1997, the date of the agreement in principal with the former Chief Executive Officer and other former executive officers, through June 30, 1998. Results of operations for the year ended March 31, 1998 includes $1.9 million in non-cash compensation expense in connection with these stock option grants. The compensation expense charge, which was originally included in unusual charges in the consolidated statement of operations as of March 31, 1998, was reversed as part of unusual charges during the year ended March 31, 1999 as no triggering event occurred as of the June 30, 1998 expiration date. During the year ended March 31, 1999, 1,067,500 options were granted principally to employees at prices equal to or above the market price at the dates of grant. The 212,500 stock options granted to TMC resulted in compensation expense of $249,000 which has been included in unusual charges.
Stock options granted generally vest over a period ranging from the date of grant up to a maximum of four years. Options may be exercised up to a maximum of 10 years from date of grant. The weighted-average remaining contractual life of all outstanding options at March 31, 1999 is 6 years.
During the year ended March 31, 1997, 1,129,000 stock options originally issued to Company employees at an exercise price of $16.375 were canceled and 564,500 stock options with an exercise price of $8.325 were issued. During the year ended March 31, 1998, 716,500 stock options originally issued to Company employees, officers and directors were cancelled and 358,250 stock options with exercise prices ranging from $7.00 to $8.325 were issued.
A summary of e4L's stock option activity and related information is as follows:
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
7. STOCK OPTIONS (CONTINUED) 2,992,999 stock options have exercise prices ranging from $1.32 to $7.25 with a weighted average price of $4.62, and 846,262 stock options have exercise prices ranging from $8.25 to $20.00 with a weighted average price of $13.92. The weighted average fair value of stock options granted during the years ended March 31, 1999, 1998 and 1997 was $3.44, $2.58 and $7.59, respectively.
8. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):
Convertible preferred stock convertible into 30,756,658, 4,112,830 and 950,000 shares of common stock, and stock options and warrants to purchase common stock exercisable into 16,760,637, 11,565,000 and 8,592,000 shares of common stock for the years ended March 31, 1999, 1998 and 1997, respectively, were not included in the computation of diluted earnings per share because the losses incurred by e4L in each of those years would cause such instruments to therefore be antidilutive.
9. INCOME TAXES
The components of income tax expense are as follows (in thousands):
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
9. INCOME TAXES (CONTINUED) Loss before income taxes was taxed under the following jurisdictions (in thousands):
Significant components of e4L's deferred tax assets and liabilities are as follows (in thousands):
The increase in the valuation allowance is attributable to the increase in United States and foreign net operating loss carryforwards and other deferred tax assets from March 31, 1998 to March 31, 1999.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
9. INCOME TAXES (CONTINUED) A reconciliation of e4L's provision for income taxes to the provision for income taxes at the United States federal statutory rate of 35% is as follows (in thousands):
At March 31, 1999, e4L has the following loss and credit carryforwards for tax purposes (in thousands):
A portion of the United States net operating loss carryforward is attributable to the exercise of employee stock options. If that portion of the loss carryforward attributable to the exercise of stock options is realized, the resulting tax benefit will be recorded in shareholders' equity. For financial reporting purposes, a valuation allowance has been recognized to offset the deferred tax assets related to the entire United States net operating loss carryforward, because utilization of net operating loss carryforwards cannot be reasonably assumed. Such net operating loss carryforwards may be subject to limitation as a result of changes in the ownership of e4L.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
10. UNUSUAL CHARGES
In connection with the Transaction as more fully described in Note 6, e4L adopted revised business strategies that reflect a significant change in e4L's business model under the direction of its new management team and board of directors. As a result, e4L has undertaken specific actions to reduce its overall cost structure and transition its business model from a television direct marketing company to an electronic commerce and membership services company. Certain of these actions resulted in pre-tax unusual charges during the year ended March 31, 1999 of $20.2 million, including $12.5 million of restructuring charges.
The restructuring charges are primarily attributable to the following:
CLOSURE OF PHILADELPHIA, PENNSYLVANIA HEADQUARTERS. e4L made a decision to close its former corporate headquarters in Philadelphia, Pennsylvania and relocate its headquarters to its offices in Los Angeles, California. Included in restructuring charges are $3.8 million of costs associated with the termination of employees, loss on the subleasing of the existing office lease and other commitments, and the write-down of assets that are no longer in use. Such assets were sold or abandoned during the first quarter of fiscal year 2000. A total of 17 employees were terminated as part of e4L's plans to close its corporate offices. Of the 17 employees affected, 16 have been paid and/or left e4L as of March 31, 1999, and one (who was notified of his termination during the year ended March 31, 1999) will receive his severance package and leave e4L during fiscal year 2000.
CONSOLIDATION OF NEW ZEALAND AND FAR EAST BUSINESS OFFICES, AND CLOSURE OF AUSTRALIAN RETAIL STORES. e4L made a decision to reduce the size of its New Zealand work force, by consolidating its previously separate New Zealand and Far East business offices within one location, and shutting down unprofitable Australian retail stores. The related restructuring charges of $0.7 million are primarily comprised of costs associated with the termination of employees, cancellation of leases and other commitments, and the write-down of assets no longer in use. Such assets had been sold or abandoned as of March 31, 1999. A total of 46 employees were terminated as part of e4L's plans to consolidate the two offices and close certain retail stores. Of the 46 employees effected, 32 have been paid and/or left e4L as of March 31, 1999, and 14 (who were notified of their terminations during the year ended March 31, 1999) shall receive his/her severance packages and leave e4L during the first quarter of fiscal year 2000.
OUTSOURCING OF CERTAIN OPERATIONS IN THE UNITED STATES. e4L is in the process of outsourcing various aspects of its Phoenix, Arizona fulfillment center, customer service operations, and media agency business. As a result, during the third quarter of the year ended March 31, 1999, e4L disposed of its media agency subsidiary and is in the process of transitioning its fulfillment and customer service functions to third parties. The costs expensed as of March 31, 1999 of $3.4 million include costs primarily associated with the termination of employees, cancellation of leases and other commitments, and the write-down of certain assets to fair market value. This transition is expected to be completed by the end of the third quarter of the year ended March 31, 2000.
CLOSURE OF CERTAIN ASIAN AND EASTERN EUROPEAN MARKETS. Due to the economic downtown in Asia and Eastern Europe, the forecasted sales and opportunities in these regions have decreased significantly from e4L's original plans. Accordingly, e4L made a decision to exit certain Asian and Eastern European markets and/or transfer such markets to third party licensee arrangements.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
10. UNUSUAL CHARGES (CONTINUED) The costs included in the restructuring charges of $2.0 million are costs incurred in connection with the termination of 12 employees, all of which terminations were completed and paid as of March 31, 1999, the write down of certain assets and certain associated legal costs.
WRITE-DOWN OF PREPAID PRODUCTION. Also included in the restructuring charge is $2.6 million of costs related to the write-down of certain prepaid costs attributable to the production of direct response television programming. e4L made a fundamental change in its strategy involving the use of its programs. In connection with its revised business model, new electronic commerce platform and other initiatives, e4L has begun utilizing its programs not only for the sale of underlying products, but has begun leveraging its programs and television media to drive memberships in its membership shopping club, Everything4Less, to exploit a retail market and continuity programs for its products, and to create list rental opportunities with respect to its customer base.
Other unusual charges consist of the following:
SHOPPING CLUB START-UP COSTS. $1.2 million of start-up costs associated with the development and production of commercials related to e4L's Everything4Less membership shopping club.
EUTELSTAT SATELLITE CONTRACT. e4L entered into a long-term commitment to lease a transponder on the Eutelstat satellite for the life of the satellite. The satellite launched in April 1998, and e4L has an estimated commitment of 10 to 12 years. e4L has determined that the satellite contract is unfavorable, as it has estimated that it will be unable to recover certain costs relating to its lease. Accordingly, e4L has included in unusual charges $5.3 million relating to its inability to recover a portion of costs attributable to the Eutelstat Satellite lease.
CHANGE OF CONTROL PAYMENTS. As part of the Transaction, e4L recorded severance charges of $1.8 million associated with the waiver of the change of control provisions contained in the employment agreements of three former executive officers.
CONSULTING FEES. In connection with the Transaction, e4L recorded a non-cash charge of $0.2 million in connection with a five year option to purchase up to 212,500 shares of e4L common stock at an exercise price of $1.32 per share that were granted to TMC. In addition, e4L recorded $.4 million related to the termination of a foreign media consulting agreement.
WRITE-OFF OF MERGER COSTS. In June 1998, e4L wrote off capitalized costs of $0.7 million related to the termination of e4L's intended merger with ValueVision International, Inc. ("ValueVision").
NON-CASH EXECUTIVE COMPENSATION. e4L had previously recorded compensation expense of $1.9 million in connection with 750,000 stock options issued to e4L's former chief executive officer and two other former executive officers during fiscal year 1998. The stock options contained provisions that, upon the occurrence of certain triggering events prior to June 30, 1998, the exercise price of the stock options would be reduced. The previously recorded expense was reversed in the first quarter of the year ended March 31, 1999 as no triggering events occurred as of the June 30, 1998 expiration date.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
11. GAIN ON SALE OF SECURITIES
In January 1999, e4L sold its investment in the common stock of Earthlink Networks, Inc., ("Earthlink") which had a cost of $488,000, for net proceeds of $7.0 million, resulting in a gain of $6.5 million. The Earthlink stock was acquired in December 1998 through the exercise of warrants to purchase the stock.
12. COMMITMENTS AND CONTINGENCIES
e4L rents warehouses, retail stores and office space under various operating leases which expire through December 2013. Future minimum lease payments (exclusive of real estate taxes and other operating expenditures) as of March 31, 1999 under noncancelable operating leases with initial or remaining terms of one year or more are as follows as of each of the years ended March 31 (in thousands):
Rent expense under various operating leases aggregated $4,175,000, $4,833,000 and $4,233,000 during the years ended March 31, 1999, 1998 and 1997, respectively. Subleased building space rental income aggregated $369,500, $136,800 and $106,300 during the years ended March 31, 1999, 1998 and 1997, respectively.
In May 1999, e4L entered into two subleases related to its former Philadelphia office which will generate rental income of $130,500, $315,100, $330,500, $350,200 and $362,500 during each of the years ended March 31, 2000 to 2004 and $1,435,100 thereafter.
In August 1998, the Company entered into a two year service agreement with Broadcast.com in which Broadcast.com will host, digitize, stream and transmit direct response television and radio programs for e4L. The total payments due under this agreement are $2,000,000 of which $375,000 has been paid as of March 31, 1999, with the remainder due in equal monthly payments of $83,333.
e4L has entered into employment agreements with certain of its executive officers providing for base compensation, automobile allowance and other incentives. Commitments under these agreements for base compensation and automobile allowance are $1.2 million, $1.2 million and $.6 million in each of the years ending March 31, 2000, 2001 and 2002, respectively. Each employment agreement also provides for annual bonuses and stock option grants at the discretion of e4L's board of directors.
During the year ended March 31, 1999, e4L expended $113.5 million on media purchases, a portion of which were made under long-term agreements. In addition, e4L has long-term agreements with certain Pan-European satellite channels to purchase a specific number of television hours per week at a minimum guaranteed amount. These contracts expire at various dates over the next 4 years. In addition, e4L has a contract to lease a transponder which continues through the year 2010. Total commitments under these
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
12. COMMITMENTS AND CONTINGENCIES (CONTINUED) media contracts are: $4,830,000 during the year ended March 31, 2000, $4,443,000 in each of the years ending March 31, 2001, 2002, 2003 and 2004; and $24,963,000 thereafter.
e4L has entered into an agreement with a former investment banker pursuant to which e4L has guaranteed the market price of its common stock underlying certain warrants to purchase common stock issued to the investment banker, subject to certain limitations. In the event the market price of its common stock is below the guaranteed price, e4L has guaranteed minimum proceeds to the investment banker from the sale of the common stock upon exercise of the warrants, through November 14, 2000, of approximately $1.3 million, which deficiency, if any, e4L is required to pay in cash.
13. LITIGATION AND REGULATORY MATTERS
E4L LITIGATION
In March, 1999, Intervention, Inc., a California non-profit corporation ("Intervention"), filed a complaint for false advertising against e4L in the Superior Court for Contra Costa County, alleging that e4L overstated the effectiveness of one of its home exercise products in its direct response television program. e4L is vigorously contesting the action. At this time, e4L cannot predict the outcome of this matter; however, even if Intervention were to succeed on all of its claims, e4L does not believe that such results would have a material adverse impact on e4L's results of operations or financial condition.
In February 1999, e4L filed a complaint against The Media Group, Inc. ("TMG"), a direct marketing company located in Stamford, Connecticut, for trademark infringement declaratory relief, breach of written contract, breach of oral contract, and other causes of action in the United States District Court for the Central District of California. e4L's complaint alleges, among other things, that TMG failed to pay to e4L its share of profits under a distribution agreement, infringed upon e4L's trademarks and intellectual property, and failed to pay for media airtime purchased on TMG's behalf. Shortly thereafter, TMG filed a separate complaint in the Pennsylvania Court of Common Pleas for the County of Philadelphia claiming that e4L allegedly breached a purported oral agreement to provide TMG with a right of first refusal to market all of e4L's products with a retail sale price of less than $99.00. TMG's state court action was removed to the United States District Court for the Eastern District of Pennsylvania. A written order is still pending. e4L is vigorously prosecuting its claims against TMG and contesting TMG's claims in both actions. At this time, e4L cannot predict the outcome of this matter; however, even if TMG were to succeed on all of its claims, e4L does not believe that such results would have a material adverse impact on e4L's results of operations or financial condition.
In March 1997, WWOR-TV filed a complaint for a breach of contract in the United States District Court for New Jersey against one of e4L's subsidiaries alleging, among other things, that the subsidiary wrongfully terminated a contract for the purchase of media time, seeking in excess of $1,000,000 in compensatory damages. e4L has settled the matter.
REGULATORY MATTERS
During the year ended March 31, 1997, in accordance with applicable regulation, e4L notified the Consumer Products Safety Commission ("CPSC") of breakages that were occurring in its Fitness Strider product. e4L also notified the CPSC of its replacement of certain parts of the product with upgraded components. The CPSC reviewed e4L's test results in order to assess the adequacy of e4L's upgraded
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
REGULATORY MATTERS (CONTINUED)
components. The CPSC also undertook its own testing of the product and, in November 1997, informed e4L that the CPSC compliance staff had made a preliminary determination that the Fitness Strider product and upgraded components present a substantial product hazard, as defined under applicable law. e4L and the CPSC staff are discussing voluntary action to address the CPSC's concerns, including replacement of the affected components. At present, management of e4L does not anticipate that any action agreed upon, or action required by the CPSC, will have a material adverse impact on e4L's financial condition or results of operations. e4L has also been contacted by Australian consumer protection regulatory authorities regarding the safety and fitness of the Fitness Strider product and an exercise rider product marketed only in Australia and New Zealand. At the present time, management cannot predict whether the outcome of these matters regarding the Fitness Strider will have a material adverse impact upon e4L's financial condition or results of operations. In August 1998, e4L received a notice from the New York Stock Exchange ("NYSE") that e4L did not meet the NYSE's standards for continued listing criteria. The NYSE also requested that e4L provide information regarding any actions taken or proposed by e4L to restore e4L to compliance with the NYSE standards. e4L has responded to the NYSE notification, and in November 1998, e4L received written notice from the NYSE that, while the NYSE intends to monitor e4L's compliance with the NYSE listing standards, no action will be taken with respect to such matter at this time.
In June 1996, e4L received a request from the Federal Trade Commission ("FTC") for additional information regarding one of e4L's direct response television programs in order to determine whether e4L was operating in compliance with its consent orders. The FTC later advised e4L that it believed e4L had violated one of the consent orders by allegedly failing to substantiate certain claims made in one of its infomercials which it no longer airs in the United States. e4L, has entered into a settlement agreement with the FTC staff resolving all of the FTC staff's concerns. e4L does not believe that the final resolution of this matter will have a material adverse effect on e4L's results of operations or financial conditions.
OTHER MATTERS
e4L, in the normal course of business, is a party to litigation relating to trademark and copyright infringement, product liability, contract-related disputes, and other matters. It is e4L's policy to vigorously defend all such claims and enforce its rights in these matters. e4L does not believe any of these matters either individually or in the aggregate, will have a material adverse effect on e4L's results of operations or financial condition.
14. RETIREMENT PLAN
All of e4L's U.S. full-time employees may participate in a 401(k) defined contribution plan. e4L matches employee contributions at levels that depend on the return on equity of e4L each year. e4L recognized expense of $17,000, $13,000 and $22,000 for the years ended March 31, 1999, 1998 and 1997, respectively, in connection with this plan.
15. RELATED PARTY TRANSACTIONS
e4L leases an office building and retail store in New Zealand owned by a former officer of e4L which expires on March 31, 2006. Rental expense is $17,300 per month.
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
15. RELATED PARTY TRANSACTIONS (CONTINUED)
Included in accounts receivable at March 31, 1999 and 1998 is approximately $96,000 and $478,000 in notes receivable and advances to certain officers of e4L, respectively. The notes including accrued interest were due from two officers of e4L and ranged in amount from $172,000 to $39,000, respectively. The notes bore interest at a rate of 8% per annum with payment terms ranging from due on demand to December 1998. These notes were repaid during the year ended March 31, 1999. In March 1998, e4L entered into an employment agreement with its president which included the forgiveness of a loan, including accrued interest, in an amount of $190,000 and the issuance of a new $545,000 loan. The new loan was funded in April 1998, bears interest at the prime rate plus 1 1/2% and is repayable on May 30, 2000. As this loan is collateralized by shares of e4L company stock it is included in the equity section as a reduction of shareholder's equity. Interest of $55,000 is currently past due on this loan.
e4L also entered into transactions with companies affiliated with various board members and current and former executives for services including printing, consulting, show production and professional services. During the years ended March 31, 1999, 1998 and 1997, the total amount paid to these companies for such services was approximately $1,500,000, $501,000 and $1,187,000, respectively.
In accordance with provisions of e4L's stock option plan, during the year ended March 31, 1997, an officer of e4L delivered 25,220 shares of e4L's common stock with a fair market value of $473,000 to e4L in satisfaction of an outstanding note receivable.
16. SEGMENT AND GEOGRAPHIC INFORMATION
e4L operates in one industry segment and is engaged in the direct marketing of products principally through television. e4L evaluates performance and allocates resources based on several factors, of which the primary financial measure is EBITDA, or earnings before interest, taxes, depreciation and amortization. e4L excludes unusual charges and gain on sale of investments from EBITDA. Accounting policies of the business segments are the same as those described in the summary of significant accounting policies in Note 1. Business segment assets are the owned assets used in each geographic area. The production and corporate components of EBITDA include the costs incurred to produce shows, develop product and general and administrative expenses. Production and corporate assets primarily consist of corporate cash, fixed assets and goodwill.
Segment information for fiscal years 1998 and 1997 has been restated to conform to the current year presentation. The major difference is the change in the measure of segment profit (loss) to EBITDA as compared to operating income (loss) presented in prior years. In addition, the current year presentation does not reflect an allocation of production or corporate costs to the geographic segments, which is
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
16. SEGMENT AND GEOGRAPHIC INFORMATION (CONTINUED) consistent with management's review of its financial performance. Information with respect to to e4L's operations by geographic area, is set forth below (in thousands):
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
The reconciliation of EBITDA to loss before income taxes and extraordinary items is set forth below (in thousands):
17. SUBSEQUENT EVENTS
On June 7, 1999, e4L consummated an agreement with BuyItNow, Inc. ("BuyItNow") pursuant to which e4L and BuyItNow have formed a new global electronic commerce entity. BuyItNow.com LLC ("BuyItNow LLC"). BuyItNow LLC was formed through the contribution by BuyItNow of substantially all
E4L, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
MARCH 31, 1999
17. SUBSEQUENT EVENTS (CONTINUED) of its assets and liabilities, and the contribution by e4L of, among other things, e4L's (i) on-line business of "As Seen on TV" products, and (ii) promotion of the new entity within e4L programs. Concurrent with the consummation of this agreement, e4L issued 500,000 warrants to purchase e4L common stock to BuyItNow. Concurrent with the closing Clear Channel Communications, Inc. acquired a 4.5% equity interest in BuyItNow LLC in exchange for a commitment to provide $12.5 million of radio broadcast media. On June 25, 1999, Xoom.com, Inc. and Snap.com, Inc. collectively acquired a 5.4% equity interest in BuyItNow LLC in exchange for a commitment to provide $15.0 million of Internet media. In exchange for its contribution to BuyItNow, LLC, e4L currently owns 48.7% equity of BuyItNow, LLC.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates so indicated.
II-1
SCHEDULE II
E4L, INC. AND SUBSIDIARIES
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
(DOLLARS IN THOUSANDS)
- ------------------------
(1) Uncollectible accounts written off, net of recoveries and refunds on products sold.
(2) Obsolete inventory written off.
(3) Acquired through acquisitions. | 38,230 | 246,449 |
1080825_1999.txt | 1080825_1999 | 1999 | 1080825 | Item 1. Business
Omitted.
Item 2.
Item 2. Properties
Omitted.
Item 3.
Item 3. Legal Proceedings
The Registrant is not aware of any material legal proceeding with respect to a Pool, the Trustee, the Servicer or, Structured Asset Securities Corporation with respect to a Pool, other than ordinary routine litigation incidental to the duties of the Trustee or Servicer under the related Pooling and Servicing Agreement.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote or consent of holders of each Class of Offered Certificates during the fiscal year covered by this report.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Trust does not issue stock. There is currently no established secondary market for the Certificates. As of December 31, 1999, the number of holders of each Class of Offered Certificates was 14.
Item 6.
Item 6. Selected Financial Data
Omitted.
Item 7.
Item 7. Management's Discussion and Analysis of Financial condition and Results of Operations
Omitted.
Item 8.
Item 8. Financial Statements and Supplementary Data
Omitted.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There was no change of accountants or disagreement with accountants on any matter of accounting principles or practices or financial disclosure.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Omitted.
Item 11.
Item 11. Executive Compensation
Omitted.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Omitted.
Item 13.
Item 13. Certain Relationships and Related Transactions
No reportable transactions have occurred.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as part of this report:
(1) Financial Statements:
Omitted.
(2) Financial Statement Schedules:
Omitted.
(3) Exhibits:
Annual Servicer Statement of Compliance, filed as Exhibit 99.1 hereto. Annual Statement of Independent Accountants Report for the Servicer, filed as Exhibit 99.2 hereto.
(b) Reports on Form 8-K: The following Current Reports on Form 8-K were filed by the Registrant during the last quarter of 1999.
Current Reports on Form 8-K, dated, October 27, 1999, November 26, 1999 and December 27, 1999, were filed for the purpose of filing the Monthly Statement sent to the Holders of the Offered Certificates for payments made on the same dates. The items reported in such Current Report were Item 5 (Other Events).
(c) Exhibits to this report are listed in Item (14)(a)(3) above.
SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
THE CHASE MANHATTAN BANK, not in its individual capacity but solely as Trustee under the Agreement referred to herein
Date: March 30, 2000 By: /s/ Kimberly K Costa ----------------------------------- Kimberly K Costa Vice President
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT.
The registrant has not sent an annual report or proxy material to its security holders. The registrant will not be sending an annual report or proxy material to its security holders subsequent to the filing of this form.
EXHIBIT INDEX
Exhibit Description
99.1 Annual Statement of Compliance 99.2 Annual Independent Public Accountant's Servicing Report
EXHIBIT 99.1 - Servicer's Annual Statement of Compliance To be supplied upon receipt by the Trustee
EXHIBIT 99.2 - Annual Independent Public Accountant's Servicing Report To be supplied upon receipt by the Trustee | 604 | 3,849 |
801351_1999.txt | 801351_1999 | 1999 | 801351 | ITEM 1. BUSINESS.
(a) GENERAL DEVELOPMENT OF BUSINESS.
The Warnaco Group, Inc. (the 'Company'), a Delaware corporation, was organized in 1986 for the purpose of acquiring the outstanding shares of Warnaco Inc. ('Warnaco'). As a result of the Company's acquisition of Warnaco, Warnaco became a wholly-owned subsidiary of the Company.
The Company and its subsidiaries design, manufacture and market a broad line of women's intimate apparel, such as bras, panties, sleepwear, shapewear and daywear, and men's apparel, such as sportswear, underwear and accessories, all of which are sold under a variety of internationally recognized owned and licensed brand names. During fiscal 1998, the Company acquired the sub-license to produce Calvin Klein'r' jeans and jeans-related products for children in the United States, Mexico and Central and South America. The Company also acquired the sub-license to distribute Calvin Klein jeans, jeans-related products and khakis for men and women in Mexico, Central America and Canada. In addition, the Company discontinued several underperforming product lines and styles. During fiscal 1997, the Company acquired Designer Holdings Ltd. ('Designer Holdings'), which develops, manufactures and markets designer jeanswear and sportswear for men, women and juniors, and holds a 40-year extendable license from Calvin Klein, Inc. to develop, manufacture and market designer jeanswear and jeans related sportswear collections in North, South and Central America under the Calvin Klein Jeans'r', CK/Calvin Klein Jeans'r' and CK/Calvin Klein/Khakis'r' labels. During fiscal 1996, the Company made three strategic acquisitions, GJM, Lejaby and Bodyslimmers, designed to increase the breadth of the Company's product lines and increase the worldwide distribution of the Company's products. In March 1994, the Company acquired the worldwide trademarks, rights and business of Calvin Klein'r' men's underwear and licensed the Calvin Klein trademark for men's accessories. In addition, the acquisition included the worldwide trademarks and rights of Calvin Klein women's intimate apparel. In 1999, the Company entered into an exclusive license agreement with Weight Watchers International, Inc., to market shapewear and activewear for the mass market under the Weight Watchers label and acquired a 70% equity interest in Penhaligon's Ltd., a United Kingdom based retailer of perfumes, soaps, toiletries and other products for men and women.
The Company's growth strategy is to continue to capitalize on its highly recognized brand names worldwide while broadening its channels of distribution and improving manufacturing efficiencies and cost controls. The Company attributes the strength of its brand names to the quality, fit and design of its products which have developed a high degree of consumer loyalty and a high level of repeat business. The Company operates in three business segments, Intimate Apparel, Sportswear and Accessories and Retail Outlet Stores, which accounted for 48.4%, 44.9% and 6.7%, respectively, of net revenues in fiscal 1998, with the Intimate Apparel Division accounting for a larger percentage of the Company's gross profit for the same period.
The Intimate Apparel Division designs, manufactures and markets moderate to premium priced intimate apparel for women under the Warner's'r', Olga'r', Calvin Klein'r', Lejaby'r', Van Raalte'r', Fruit of the Loom'r' and Bodyslimmers'r' brand names. In addition, the Intimate Apparel Division designs, manufactures and markets men's underwear under the Calvin Klein brand name. The Intimate Apparel Division is the leading marketer of women's bras to department and specialty stores in the United States, as measured by the NPD Group, Inc. ('NPD'), accounting for 37.5% of women's bra market share in the 1998 calendar year, up 3.5% over 1997. The Warner's and Olga brand names, which are owned by the Company, are 125 and 58 years old, respectively.
The Intimate Apparel Division's strategy is to increase its channels of distribution and expand its highly recognized brand names worldwide. In February 1996, the Company purchased the GJM Group of Companies ('GJM') from Cygne Designs, Inc. GJM is a private label maker of sleepwear and intimate apparel. The acquisition provided the Company with design, marketing and manufacturing expertise in the sleepwear business, broadening the Company's product line and contributing to the Company's base of low cost manufacturing capacity. In June 1996, the Company purchased Bodyslimmers. Bodyslimmers is a leading designer and manufacturer of body slimming undergarments targeted at aging baby boomers, which also increased the Company's presence in a growing segment of the intimate apparel market. In July 1996, the Company acquired the Lejaby/Euralis Group of
Companies ('Lejaby'). Lejaby is a leading maker of intimate apparel in Europe. The Lejaby acquisition increased the size of the Company's operations in Western Europe and provides the Company with an opportunity to expand the distribution of its products in the critical European market.
In 1991, the Company entered into a license agreement with Fruit of the Loom, Inc. for the design, manufacture and marketing of moderate priced bras, daywear and other related items to be distributed through mass merchandisers, such as Wal-Mart and K-Mart, under the Fruit of the Loom brand name and has built its market share to 5.5% in the mass merchandise market as measured by NPD. This license was renewed by the Company in 1994 and was further extended and renewed in 1998. In late 1994, the Company purchased the Van Raalte trademark for $1.0 million and launched an intimate apparel line through Sears stores in July 1995.
The Sportswear and Accessories Division designs, manufactures, imports and markets moderate to premium priced men's apparel and accessories under the Chaps by Ralph Lauren'r', Calvin Klein and Catalina'r' brand names. In December 1997, the Company completed the acquisition of Designer Holdings which develops, manufactures and markets designer jeanswear and jeans related sportswear for men, women and juniors under the Calvin Klein Jeans, CK/Calvin Klein Jeans and CK/Calvin Klein/Khakis labels. The Calvin Klein Jeans, CK/Calvin Klein Jeans and CK/Calvin Klein/Khakis brands complement the Company's existing product lines, including Calvin Klein underwear for men and women and Calvin Klein men's accessories. During fiscal 1998, the Company expanded the Calvin Klein jeanswear business by acquiring the sub-license to produce Calvin Klein jeans and jeans-related products for children in the United States, Mexico and Central and South America. In addition, the company acquired the sub-license to distribute Calvin Klein jeans, jeans-related products and khakis for men and women in Mexico, Central America and Canada. Chaps by Ralph Lauren has increased its net revenues by approximately 800% since 1991 from $39.0 million to $351.0 million in 1998, predominantly by expanding product classifications and updating its styles. In 1995, the Company extended its Chaps by Ralph Lauren license through December 31, 2004. The Sportswear and Accessories Division's strategy is to build on the strength of its brand names and eliminate those businesses which generate a profit contribution below the Company's required return. Consistent with this strategy, the Company has eliminated several underperforming brands since 1992, including its Hathaway business, which was sold to a group of investors in November 1996.
The Company has been expanding its brand names throughout the world by increasing the activities of its wholly-owned operating subsidiaries in Canada, Europe and Mexico. International operations generated $320.9 million, or 16.5%, of the Company's net revenues in fiscal 1998, compared with $290.4 million, or 20.2%, of the Company's net revenues in fiscal 1997 and $212.4 million or 20.0% in fiscal 1996. The decrease in international shipments as a percentage of sales in fiscal 1998 reflects the impact of lower levels of international shipments for Calvin Klein Underwear, primarily in Russia and the Far East due to currency devaluations and economic downturns.
The Company's business strategy with respect to its Retail Outlet Stores Division is to provide a channel for disposing of the Company's excess and irregular inventory and to shift to more profitable intimate apparel stores to improve its margins. The Company does not manufacture or source products exclusively for its Retail Outlet Stores. The Company had 114 stores at the end of fiscal 1998 (including 3 stores in Canada, 12 stores in the United Kingdom, 1 in France and 1 in Spain) compared with 106 stores and 73 stores at the end of fiscal 1997 and fiscal 1996, respectively. During 1998, the Company announced plans to close 13 underperforming stores. Through January 2, 1999, two of the stores were closed and the remaining stores will be closed in the second quarter of 1999. In 1997, 35 stores were added as a result of the acquisition of Designer Holdings.
The Company continues to expand its channels of distribution to include electronic channels of distribution and is planning to commence marketing of its products on the Internet in fiscal 1999. To facilitate this opportunity, the Company in fiscal 1998 invested $5.0 million to acquire a 3% equity interest in Interworld Corporation, a leading provider of E-Commerce software systems and other applications for electronic commerce sites.
The Company's products are distributed to over 16,000 customers operating more than 26,000 department, specialty and mass merchandise stores, including such leading retailers in the United States as Dayton-Hudson, Macy's and other units of Federated Department Stores, J.C. Penney, The May Department Stores, Dillards, Sears, Kmart and Wal-Mart and such leading retailers in Canada as The
Hudson Bay Company and Zeller's. The Company's products are also distributed to such leading European retailers as House of Fraser, British Home Stores, Harrods, Galeries Lafayette, Au Printemps and El Corte Ingles.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
The Company operates within three business segments. One customer accounted for 10.2% of the Company's net revenues in the three years ended in fiscal 1998. While important, the loss of such customer would not have a material adverse effect on the Company taken as a whole. See Note 6 to the Consolidated Financial Statements on page.
(c) NARRATIVE DESCRIPTION OF BUSINESS.
The Company designs, manufactures and markets a broad line of women's intimate apparel, and men's apparel and accessories sold under a variety of internationally recognized brand names owned or licensed by the Company. The Company operates three divisions, Intimate Apparel, Sportswear and Accessories and Retail Outlet Stores, which accounted for 48.4%, 44.9% and 6.7% respectively, of net revenues in fiscal 1998.
INTIMATE APPAREL
The Company's Intimate Apparel Division designs, manufactures and markets women's intimate apparel, which includes bras, panties, sleepwear, shapewear and daywear. The Company also designs and markets men's underwear. The Company's bra brands accounted for 37.5% of women's bra market share in the 1998 calendar year in department and specialty stores in the United States, as measured by NPD. Management considers the Intimate Apparel Division's primary strengths to include its strong brand recognition, product quality and design innovation, low cost production, strong relationships with department and specialty stores and its ability to deliver its merchandise rapidly. Building on the strength of its brand names and reputation for quality, the Company has historically focused its intimate apparel products on the upper moderate to premium priced range distributed through leading department and specialty stores. In order to expand its market penetration in recent years, the Company (i) in 1991, entered into a license agreement with Fruit of the Loom, Inc. for bras and daywear and in June 1992, began to distribute moderate priced bras, daywear and other related items under this license through mass merchandise stores, (ii) in March 1994, acquired the worldwide trademarks, rights and businesses of Calvin Klein men's underwear and the worldwide trademarks, rights and businesses of Calvin Klein women's intimate apparel upon the expiration of an existing license on December 31, 1994, (iii) in late 1994, purchased the Van Raalte trademark for $1 million and launched an intimate apparel line through Sears stores in July 1995, (iv) in February 1996, acquired substantially all of the assets of GJM, a private label manufacturer of women's sleepwear and lingerie, (v) in fiscal 1996, acquired the stock and assets of the Lejaby/Euralis Group of Companies, a leading European manufacturer and marketer of intimate apparel, (vi) in June 1996, acquired the business of Bodyslimmers, a marketer of body slimming undergarments targeted at aging baby boomers, and (vii) in fiscal 1999 entered into a license agreement with Weight Watchers to market shapewear and activewear for the mass market.
The intimate apparel division markets its lines under the following brand names:
The Company owns the Warner's, Olga, Calvin Klein (underwear and intimate apparel), Lejaby, Bodyslimmers and Van Raalte brand names and trademarks which account for approximately 86% of the Company's Intimate Apparel net revenues. The Company licenses the other brand names under which it markets its product lines, primarily on an exclusive basis. The Company also manufactures intimate apparel on a private and exclusive label basis for certain leading specialty and department stores. The Warner's brand is 125 years old and the Olga brand is 58 years old.
In August 1991, the Company entered into an exclusive license agreement with Fruit of the Loom, Inc. ('Fruit of the Loom') for the design, manufacture and marketing of moderate priced bras which are distributed through mass merchandisers, such as Wal-Mart and Kmart, under the Fruit of the Loom brand name. The license agreement has since been extended to include bodywear, coordinating panties, fashion sleepwear, as well as coordinated fashion sets (bras and panties) and certain control bottoms. The Company began shipping Fruit of the Loom products in June 1992 and has built its current market share to 5.5% as measured by NPD in the mass merchandise market. The agreement with Fruit of the Loom has allowed the Company to enter the mass merchandise market, which is growing at a rate faster than the department and specialty store market.
In March 1994, the Company acquired the worldwide trademarks, rights and business of Calvin Klein men's underwear, and effective January 1, 1995, the worldwide trademark, rights and business of Calvin Klein women's intimate apparel. The purchase price was approximately $60.9 million and consisted of cash payments of $33.1 million in fiscal 1994, $5.0 million in fiscal 1995 and the issuance of 1,699,492 shares of the Company's Common Stock with a fair market value of $22.8 million for such shares. Since that time, the Company has acquired the business of several former international licensees and distributors of Calvin Klein underwear products including those in Canada, Germany, Italy, Portugal, Scandanavia and Spain. In addition, the Company entered into an exclusive worldwide license agreement to produce men's accessories and small leather goods under the Calvin Klein label. The Calvin Klein underwear brand accounted for net revenues of $308.7 million in fiscal 1998, a decrease of 3.1% over the $318.7 million recorded in fiscal 1997 due to lower international shipments (primarily in Russia and the Far East) but nearly 6 times greater than the $55.0 million recorded in fiscal 1994, the first year of the acquisition.
In fiscal 1996, the Company acquired GJM, a private label maker of sleepwear and intimate apparel. The acquisition provided the Company with design, marketing and manufacturing expertise in the sleepwear business, broadening the Company's product line and contributing to the Company's base of low cost manufacturing capacity. In June 1996, the Company purchased Bodyslimmers, a leading designer and manufacturer of body slimming undergarments targeted at aging baby boomers. The purchase of Bodyslimmers increased the Company's presence in a growing segment of the intimate apparel market. In July 1996, the Company acquired Lejaby. Lejaby is a leading maker of intimate apparel in Europe. The Lejaby acquisition increased the size of the Company's operations in Western Europe and provides the Company with an opportunity to expand the distribution of its products, including Calvin Klein, in the critical European market. These three acquisitions contributed $170.3 million in net revenues for fiscal 1998, 18.0% of the Company's Intimate Apparel net revenues.
The Company attributes the strength of its brands to the quality, fit and design of its intimate apparel, which has developed a high degree of customer loyalty and a high level of repeat business. The Company believes that it has maintained its leadership position, in part, through product innovation with accomplishments such as introducing the alphabet bra (A, B, C and D cup sizes), the first all-stretch bra, the body stocking, the use of two way stretch fabrics, seamless molded cups for smooth look bras, the cotton-Lycra bra and the sports bra. The Company also introduced the use of hangers and certain point-of-sale hang tags for in-store display of bras, which was a significant change from marketing bras in boxes, and enabled women, for the first time, to see the product in the store. The Company's product innovations have become standards in the industry.
The Company believes that a shift in consumer attitudes is stimulating growth in the intimate apparel industry. Women increasingly view intimate apparel as a fashion-oriented purchase rather than as a purchase of a basic necessity. The shift has been driven by the expansion of intimate apparel specialty stores and catalogs, and an increase in space allocated to intimate apparel by department stores. The Company believes that it is well-positioned to benefit from increased demand for intimate
apparel due to its reputation for forward-looking design, quality, fit and fashion and to the breadth of its product lines at a range of price points. Over the past five years, the Company has further improved its position by continuing to introduce new products under the Warner's and Olga brands in the better end of the market, by obtaining the license from Fruit of the Loom to produce bras, daywear and other related items, by acquiring the Calvin Klein trademarks for premium priced women's intimate apparel and better priced men's underwear, by purchasing the Van Raalte trademark for introduction of an intimate apparel line through Sears stores in July 1995, and by making strategic acquisitions to expand product lines and distribution channels such as GJM, Lejaby and Bodyslimmers in 1996. The Company has further improved its position by continuing to strengthen its relationships with its department store, specialty store and mass merchandise customers.
The Intimate Apparel Division's net revenues have increased at a compound annual growth rate of 15.7% since 1991, to $944.8 million in fiscal 1998, as the Company has increased its penetration with existing accounts, expanded sales to new customers such as Van Raalte to Sears and Fruit of the Loom to mass merchandisers such as Wal-Mart and Kmart and broadened its product lines to include men's underwear. The Company believes that it is one of the lowest-cost producers of intimate apparel in the United States, producing approximately eight million dozen intimate apparel products per year.
The Company's bras are sold primarily in the department and specialty stores, the Company's traditional customer base for intimate apparel. In June 1992, the Company expanded into a new channel of distribution, mass merchandisers, with its Fruit of the Loom product line, which offers a range of styles designed to meet the needs of the consumer profile of this market. The Company also sees opportunities for continued growth in the Intimate Apparel Division for bras specifically designed for the 'full figure' market, as well as in its panty and daywear product lines, and acquired Bodyslimmers in June 1996 to provide important brand name recognition in this growing segment of the intimate apparel market for department and specialty stores. In addition, in February 1999, the Company entered into a license agreement with Weight Watchers to market shapewear for the mass market.
The Intimate Apparel Division has subsidiaries in Canada and Mexico in North America, in the United Kingdom, France, Belgium, Ireland, Spain, Italy, Austria, Switzerland and Germany in Europe, in Costa Rica, the Dominican Republic and Honduras in Central America and in the Philippines, Sri Lanka, the People's Republic of China, Japan and Hong Kong in Asia. International sales accounted for approximately 31.1% of the Intimate Apparel Division's net revenues in fiscal 1998 compared with 30.1% in fiscal 1997 and 25.4% in fiscal 1996. The increase in international revenues in fiscal 1998 is due to higher Lejaby and Bodyslimmers revenues partially offset by lower shipment levels for Calvin Klein products in Russia and the Far East due to currency devaluations and economic downturns. The increase in international net revenues in fiscal 1997 is primarily attributable to the acquisition of Lejaby in July 1996 and increased net revenues for Calvin Klein Europe. The Company has acquired the businesses of several former distributors and licensees of its Calvin Klein underwear products in previous years, including those in Canada, Germany, Italy, Portugal and Spain. The Company's objective in acquiring its former licensees and distributors is to expand its business in foreign markets through a coordinated set of product offerings, marketing and pricing strategies and by consolidating distribution to obtain economies of scale. Net revenues attributable to the international divisions of the Intimate Apparel Division were $293.4 million, $282.9 million and $204.1 million in fiscal 1998, 1997 and 1996, respectively. Management's strategy is to increase its market penetration in Europe and to open additional channels of distribution.
The Company's intimate apparel products are manufactured principally in the Company's facilities in North America, Central America, the Caribbean Basin, the United Kingdom, France, Ireland, Morocco (joint venture), the Philippines, Sri Lanka and the People's Republic of China (joint venture). Over the last six years, the Company has opened or expanded 10 manufacturing facilities. In addition, to support anticipated future growth, the Company opened 2 new manufacturing facilities during 1998 for a total of 12 new facilities. A new cutting facility and a distribution facility will be opened in 1999. In connection with the start-up of these facilities, the Company incurred substantial direct and incremental plant start-up costs to recruit and train over 39,000 workers. Certain of these costs were capitalized and amortized over five years. The Company believes it takes approximately five years before new facilities achieve the manufacturing efficiencies of established plants. In fiscal 1998, the Company early adopted
the provisions of SOP 98-5 requiring that pre-operating costs be expensed as incurred. In the future, all such start-up costs will be charged against operations. See Note 1 to the Consolidated Financial Statements. Capitalized costs represented direct and incremental costs associated with a new facility and include site selection and site development, worker training costs, rent and other operating costs incurred prior to achieving full production in the facility.
Although the Intimate Apparel Division generally markets its product lines for three retail selling seasons (spring, fall and holiday), its sales and revenues are somewhat seasonal. Approximately 54% of the Intimate Apparel Division's net revenues and 57% of the division's operating income were generated during the second half of the 1998 fiscal year.
SPORTSWEAR AND ACCESSORIES
The Sportswear and Accessories Division designs, manufactures, imports and markets moderate to better priced sportswear, better to premium priced men's accessories and moderate to better priced dress shirts and neckwear. Management considers the Sportswear and Accessories Division's primary strengths to include its strong brand recognition, product quality, reputation for fashion styling, strong relationships with department and specialty stores and its ability to deliver merchandise rapidly.
The Sportswear and Accessories Division markets its lines under the following brand names:
The Calvin Klein, Chaps by Ralph Lauren and Catalina accessories brand names are licensed on an exclusive basis by the Company.
The Sportswear and Accessories Division's strategy is to build on the strength of its brand names, strengthen its position as a global apparel company and eliminate those businesses which generate a profit contribution below the Company's required return. In order to improve profitability, the Company (i) sold its Hathaway dress shirt business in November 1996, (ii) acquired Designer Holdings during the fourth quarter of 1997, (iii) acquired the sub-license to produce Calvin Klein jeans and jeans-related products for children in the United States, Mexico and Central and South America in June 1998, and (iv) acquired the sub-license to distribute Calvin Klein jeans, jeans-related products and khakis for men and women in Mexico, Central America and Canada in June 1998. The Company recorded losses associated with exiting the Hathaway business of approximately $46.0 million in 1996 and $10.6 million in fiscal 1997, consisting of losses related to the write-down of the Hathaway assets, including intangible assets and operating losses incurred prior to the disposition. The acquisition of Designer Holdings contributed $453.3 million and $133.3 million to net revenues in fiscal 1998 and 1997, respectively.
Despite its strategic decisions to discontinue approximately $140.0 million of annualized net revenues in underperforming brands since 1991, the Sportswear and Accessories Division's net revenues have increased at a compound annual growth rate of 25.3% since 1991 to $875.3 million in fiscal 1998. The reduction in net revenues from discontinued brands has been more than offset by the success of the Chaps by Ralph Lauren brand which has increased its net revenues by approximately 800% since fiscal 1991 to $351.0 million in fiscal 1998, and the addition of the Calvin Klein jeanswear and jeans related sportswear brands in 1997 and 1998.
Sportswear. In 1989, the Company began repositioning its Chaps by Ralph Lauren product lines by updating its styling, which has generated significant net revenue increases, as mentioned above. In 1993, the Company entered into a license agreement to design men's and women's sportswear and men's dress shirts and furnishings bearing the Catalina trademark. Catalina products are sold through the mass merchandise segment of the market, generating royalty income of approximately $4.9 million and $3.0
million in fiscal 1998 and 1997, respectively. In 1997, the Company acquired Designer Holdings Ltd., which develops, manufactures and markets Calvin Klein designer jeanswear and sportswear for men, women and juniors in North, South and Central America. During 1998, the Company expanded upon the Calvin Klein jeanswear business by acquiring sub-licenses to distribute Calvin Klein jeans and jeans-related products for children in the United States, Mexico and Central and South America and Calvin Klein jeans, jeans-related products and khakis for men and women in Mexico, Central America and Canada.
Accessories. The Sportswear and Accessories Division markets men's small leather goods and belts and soft side luggage under the Calvin Klein brand name pursuant to a worldwide license. The first shipments of Calvin Klein accessories were made in the third quarter of fiscal 1995 to United States customers. The line has already grown significantly, accounting for approximately $19.3 million and $17.3 million of net revenues in fiscal 1998 and 1997, respectively. Management believes that one of the strengths of its accessories lines is the high level of international consumer recognition associated with the Calvin Klein label. The Company's strategy is to expand the accessories business, which has consistently generated higher margins than other sportswear products.
International sales accounted for approximately 1.6% of net revenues of the Sportswear and Accessories Division in fiscal 1998, compared with 1.0% and 4.0% in fiscal 1997 and 1996, respectively. Net revenues attributable to international operations of the Sportswear and Accessories Division were $14.0 million, $4.1 million and $8.3 million in fiscal 1998, 1997 and 1996, respectively. The increase in international sales in fiscal 1998 reflects the continued expansion of CK Accessories as well as the acquisition of CK Jeans in Mexico. The Company expects to generate future revenue from international sales of base Calvin Klein accessories and jeanswear.
Sportswear apparel (knit shirts and sweaters and other apparel) is sourced principally from the Far East. Dress shirts are sourced from the Far East and the Caribbean Basin. Accessories are sourced from the United States, Europe and the Far East. Neckwear is sourced primarily from the United States.
The Sportswear and Accessories Division, similar to the Intimate Apparel Division, generally markets its apparel products for three retail selling seasons (spring, fall and holiday). New styles, fabrics and colors are introduced based upon consumer preferences, market trends and to coincide with the appropriate retail selling season. Sales of the Sportswear and Accessories Division's product lines follow individual seasonal shipping patterns ranging from one season to three seasons, with multiple releases in some of the division's more fashion-oriented lines. Consistent with industry and consumer buying patterns, approximately 59.0% of the Sportswear and Accessories Division's net revenues and 63% of the Sportswear and Accessories Division's operating income were generated in the second half of 1998, reflecting the strength of the fall and holiday shopping seasons.
RETAIL OUTLET STORES DIVISION
The Retail Outlet Stores Division primarily sells the Company's products to the general public. The Company's business strategy with respect to its retail outlet stores is to provide a channel for disposing of the Company's excess and irregular inventory. The Company does not manufacture or source products exclusively for the retail outlet stores. The Company's retail outlet stores are situated in areas where they generally do not conflict with the Company's principal channels of distribution. EBITDA for the Retail Outlet Stores Division in fiscal 1998 improved 120% over fiscal 1997 to $15.6 million. As of January 2, 1999, the Company operated 114 stores.
INTERNATIONAL OPERATIONS
The Company has subsidiaries in Canada and Mexico in North America and in the United Kingdom, France, Belgium, Ireland, Spain, Italy, Austria, Switzerland, the Netherlands and Germany in Europe and Hong Kong and Japan in Asia, which engage in sales, manufacturing and marketing activities. The results of the Company's operations in these countries are influenced by the movement of foreign currency exchange rates. With the exception of the fluctuation in the rates of exchange of the local currencies in which these subsidiaries conduct their business, the Company does not believe that the operations in Canada and Western Europe are subject to risks which are significantly different from
those of the domestic operations. Mexico has historically been subject to high rates of inflation and currency restrictions which may, from time to time, impact the Mexican operation. The Company also sells directly to customers in Mexico. Net revenues from these shipments represent approximately 1% of the Company's net revenues.
The Company maintains manufacturing facilities in Mexico, Honduras, Costa Rica, the Dominican Republic, Canada, Ireland, the United Kingdom, France, Morocco (joint venture), Sri Lanka, the People's Republic of China and the Philippines. The Company maintains warehousing facilities in Canada, Mexico, the United Kingdom, Spain, Belgium, Italy, Austria, Switzerland, France and Germany and contracts for warehousing in the Netherlands. The Intimate Apparel Division operates manufacturing facilities in Mexico and in the Caribbean Basin pursuant to duty-advantaged (commonly referred to as 'Item 807') programs. Over the last six years, the Company has opened or expanded 10 manufacturing facilities and, during 1998, opened 2 new manufacturing facilities, for a total of 12 new facilities. The Company's policy is to have many potential sources of manufacturing so that a disruption at any one facility will not significantly impact the Company.
The majority of the Company's purchases which are imported into the United States are invoiced in United States dollars and, therefore, are not subject to currency fluctuations. The majority of the transactions denominated in foreign currencies are denominated in the Hong Kong dollar, which currently is pegged to the United States dollar and therefore does not create any currency risk.
SALES AND MARKETING
The Intimate Apparel and Sportswear and Accessories Divisions sell to over 16,000 customers operating more than 26,000 department, mass merchandise and men's and women's specialty store doors throughout North America and Europe. One customer accounted for approximately 10.2% of the Company's net revenues during the fiscal year ended January 2, 1999. While important, the loss of such customer would not have a material adverse effect on the Company taken as a whole.
The Company's retail customers are served by approximately 300 sales representatives. The Company also employs marketing coordinators who work with the Company's customers in designing in-store displays and planning the placement of merchandise. The Company has implemented Electronic Data Interchange ('EDI') programs with most of its retailing customers which permit the Company to receive purchase orders electronically and, in some cases, to transmit invoices electronically. These innovations assist the Company in providing products to customers on a timely basis.
The Company utilizes various forms of advertising media. In fiscal 1998, the Company spent approximately $102.6 million, or 5.3% of net revenues, for advertising and promotion of its various product lines, compared with $86.2 million, or 6.0% of net revenues in fiscal 1997, and $59.5 million or 5.6% of net revenues in fiscal 1996. The increase in advertising costs in fiscal 1998 compared with fiscal 1997 reflects the Company's desire to maintain its strong market position in Calvin Klein underwear, Jeanswear and Accessories, Chaps by Ralph Lauren sportswear and Warner's, Olga, and Fruit of the Loom intimate apparel. The Company participates in advertising on a cooperative basis with retailers, principally through newspaper advertisements.
COMPETITION
The apparel industry is highly competitive. The Company's competitors include apparel manufacturers of all sizes, some of which have greater resources than the Company.
The Company also competes with foreign producers, but to date, such foreign competition has not materially affected the Intimate Apparel or Sportswear and Accessories Divisions. In addition to competition from other branded apparel manufacturers, the Company competes in certain product lines with department store private label programs. The Company believes that its manufacturing skills, coupled with its existing Central American and Caribbean Basin manufacturing facilities and selective use of off-shore sourcing, enable the Company to maintain a cost structure competitive with other major apparel manufacturers.
The Company believes that it has a significant competitive advantage because of high consumer recognition and acceptance of its owned and licensed brand names and its strong presence and market share in the major department, specialty and mass merchandise store chains.
A substantial portion of the Company's sales are of products, such as intimate apparel and men's underwear, that are basic and not very susceptible to rapid design changes. This relatively stable base of business is a significant contributing factor to the Company's favorable competitive and cost position in the apparel industry.
RAW MATERIALS
The Company's raw materials are principally cotton, wool, silk, synthetic and cotton-synthetic blends of fabrics and yarns. Raw materials used by the Intimate Apparel and Sportswear and Accessories Division are available from multiple sources.
IMPORT QUOTAS
Substantially all of the Company's Sportswear and Accessories Division's sportswear products, as well as Calvin Klein men's and women's underwear, are manufactured by contractors located outside the United States. These products are imported and are subject to federal customs laws, which impose tariffs as well as import quota restrictions established by the Department of Commerce. While importation of goods from certain countries may be subject to embargo by United States Customs authorities if shipments exceed quota limits, the Company closely monitors import quotas through its Washington, D.C. office and can, in most cases, shift production to contractors located in countries with available quotas or to domestic manufacturing facilities. The existence of import quotas has, therefore, not had a material effect on the Company's business. Substantially all of the Company's Intimate Apparel Division's products, with the exception of Calvin Klein men's and women's underwear, are manufactured in the Company's facilities located in Mexico, the Caribbean Basin, Europe and Asia. The Company's policy is to have many potential manufacturing sources so that a disruption at any one facility will not significantly impact the Company.
EMPLOYEES
As of January 2, 1999, the Company and its subsidiaries employ approximately 21,000 employees. Approximately 27% of the Company's employees, all of whom are engaged in the manufacture and distribution of its products, are represented by labor unions. The Company considers labor relations with employees to be satisfactory and has not experienced any significant interruption of its operations due to labor disagreements.
TRADEMARKS AND LICENSING AGREEMENTS
The Company has license agreements permitting it to manufacture and market specific products using the trademarks of others. The Company's exclusive license and design agreements for the Chaps by Ralph Lauren trademark expire on December 31, 2004. These licenses grant the Company an exclusive right to use the Chaps by Ralph Lauren trademark in the United States and Mexico. The Company's license to develop, manufacture and market designer jeanswear and jeans related sportswear under the Calvin Klein trademark in North, South and Central America extends for an initial term expiring on December 31, 2034 and is extendable at the Company's option for a further 10 year term expiring on December 31, 2044. The Company has an exclusive license agreement to use the Fruit of the Loom trademark in the United States of America, its territories and possessions, Canada and Mexico through December 31, 2004, subject to the Company's compliance with certain terms and conditions. The Company also has the right of first opportunity and negotiation with respect to other products and territories.
The Company's exclusive worldwide license agreement with Calvin Klein, Inc. to produce Calvin Klein men's accessories expires June 30, 2004. The Company has entered into license agreements with Authentic Fitness Corporation to produce and sell men's and women's sportswear and men's dress shirts
and furnishings under the Catalina label, women's and children's sportswear under the White Stag label, and certain intimate apparel under the Speedo label. The Company's exclusive license to use the Catalina trademark for these products worldwide expires in December 2013 and the Company's exclusive license to use the White Stag and Speedo names for intimate apparel products continues in perpetuity.
The Company recently entered into an exclusive licensing agreement for an initial term of 5 years, extendable for a further term of 5 years through July 2009 with Weight Watchers International, Inc., to manufacture and market shapewear and activewear for the mass market in the United States and Canada. The Company also has the right of first opportunity and negotiation with respect to other products and territories.
Although the specific terms of each of the Company's license agreements vary, generally such agreements provide for minimum royalty payments and/or royalty payments based on a percentage of net sales. Such license agreements also generally grant the licensor the right to approve any designs marketed by the licensee.
The Company owns other trademarks, the most important of which are Warner's, Olga, Calvin Klein men's underwear and sleepwear, Calvin Klein women's intimate apparel and sleepwear, Van Raalte, Lejaby, Rasurel, White Stag and Bodyslimmers.
The Company sub-licenses the White Stag and Catalina brand names to domestic and international licensees for a variety of products. These agreements generally require the licensee to pay royalties and fees to the Company based on a percentage of the licensee's net sales. The Company regularly monitors product design, development, quality, merchandising and marketing and schedules meetings throughout the year with third-party licensees to assure compliance with the Company's overall marketing, merchandising and design strategies, and to ensure uniformity and quality control. The Company, on an ongoing basis, evaluates entering into distribution or license agreements with other companies that would permit such companies to market products under the Company's trademarks. Generally, in evaluating a potential distributor or licensee, the Company considers the experience, financial stability, manufacturing performance and marketing ability of the proposed licensee. Royalty income derived from licensing was approximately $21.2 million, $12.2 million and $10.3 million in fiscal 1998, 1997 and 1996, respectively.
The Company believes that only the trademarks mentioned herein are material to the business of the Company.
BACKLOG
A substantial portion of net revenues is based on orders for immediate delivery and, therefore, backlog is not necessarily indicative of future net revenues.
(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES.
The information required by this portion of Item 1 is incorporated herein by reference to Note 6 to the Consolidated Financial Statements on pages to.
ITEM 2.
ITEM 2. PROPERTIES.
The principal executive offices of the Company are located at 90 Park Avenue, New York, New York 10016 and are occupied pursuant to a lease that expires in 2004. In addition to its executive offices, the Company leases offices in Connecticut, California and New York, pursuant to leases that expire in 1999, 2000 and 2007, respectively. The Company entered into a ten-year lease expiring in 2009 for its administrative offices in Connecticut.
The Company has nine domestic manufacturing and warehouse facilities located in Connecticut, Georgia, Pennsylvania, Tennessee, South Carolina, Massachusetts and New Jersey and 37 international manufacturing and warehouse facilities located in Canada, Costa Rica, the Dominican Republic, France, Germany, Honduras, Mexico, People's Republic of China, the Philippines, Sri Lanka, the United Kingdom, Ireland, Spain, Belgium, Italy, Switzerland, Holland and Austria. Certain of the Company's
manufacturing and warehouse facilities are also used for administrative and retail functions. The Company owns six of its domestic and three of its international facilities. The balance of the facilities are leased. Lease terms, except for month-to-month leases, expire from 1999 to 2020. No material facility is underutilized.
The Company leases sales offices in a number of major cities, including Dallas, Atlanta and New York in the United States; Brussels, Belgium; Dusseldorf and Frankfurt, Germany; Toronto, Canada; Lausanne, Switzerland; Milan, Italy; Paris, France; and Hong Kong. The sales office leases expire between 1999 and 2008 and are generally renewable at the Company's option. The Company also occupies offices in London, England subject to a freehold lease which expires in 2114. The Company leases 113 retail outlet store locations. Outlet store leases, except for two month-to-month leases, expire from 1999 to 2008 and are generally renewable at the Company's option.
All of the Company's production and warehouse facilities are located in appropriately designed buildings, which are kept in good repair. All such facilities have well maintained equipment and sufficient capacity to handle present volumes. Over the last six years, the Company has opened or expanded in Mexico and the Caribbean 10 manufacturing facilities and, during 1998, opened 2 new manufacturing facilities, for a total of 12 new facilities.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not a party to any litigation, other than routine litigation incidental to the business of the Company, that individually or in the aggregate is material to the business of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
EXECUTIVE OFFICERS OF THE COMPANY
The executive officers of the Company, their age and their position are set forth below.
Mrs. Wachner has been a Director, President and Chief Executive Officer of the Company since August 1987, and the Chairman of the Board since August 1991. Mrs. Wachner was a Director and President of the Company from March 1986 to August 1987. Mrs. Wachner held various positions, including President and Chief Executive Officer, with Max Factor and Company from December 1978 to October 1984. Mrs. Wachner also serves as a Director of the New York Stock Exchange, Applied Graphics Technologies, Inc. and Authentic Fitness Corporation.
Mr. Finkelstein has been Senior Vice President of the Company since May 1992 and Chief Financial Officer and Director of the Company since May 1995. Mr. Finkelstein served as Vice President and Controller of the Company from November 1988 until his appointment as Senior Vice President. Mr. Finkelstein served as Vice President of Finance of the Company's Activewear and Olga Divisions from March 1988 until his appointment as Controller of the Company. Mr. Finkelstein served as Vice President and Controller of SPI Pharmaceuticals Inc. from February 1986 to March 1988 and held various financial positions, including Assistant Corporate Controller with Max Factor and Company, between 1977 and 1985. Mr. Finkelstein also serves as a Director of Authentic Fitness Corporation.
Mr. Conologue has been Senior Vice President, Finance of the Company since May, 1998. Mr. Conologue joined the Company in July, 1997 as Senior Vice President and Controller. Prior to joining the Company, Mr. Conologue served as Vice President Finance and Control of Southern New England Telecommunications Corp. from 1995 through early 1997. Mr. Conologue held various financial positions with Avon Products, Inc. from 1989 to 1995, most recently as Group Vice President, Finance.
Mr. Silverstein has been Vice President, General Counsel and Secretary of the Company since December 1990. Mr. Silverstein served as Assistant Secretary of the Company from June 1986 until his appointment as Secretary in January 1987.
Mr. Deddens has been Vice President and Treasurer of the Company since March 1996. Prior to joining the Company, Mr. Deddens served as Vice President and Treasurer of Revlon, Inc. from 1991 to 1996 and as Assistant Treasurer from 1987 to 1991. Mr. Deddens held various financial positions with Allied-Signal Corporation and Union Texas Petroleum Corporation from 1981 to 1987.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Class A Common Stock, $0.01 par value per share (the 'Common Stock'), is listed on the New York Stock Exchange under the symbol 'WAC'. The table below sets forth, for the periods indicated, the high and low sales prices of the Company's Common Stock, as reported on the New York Stock Exchange Composite Tape.
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(1) On March 1, 1999, the Company declared its regular quarterly cash dividend of $0.09 per share payable on April 8, 1999 to stockholders of record as of March 11, 1999.
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As of March 26, 1999, there were 226 holders of the Common Stock, based upon the number of holders of record and the number of individual participants in certain security position listings.
In fiscal 1995, the Company initiated a regular cash dividend of $0.28 per share per annum. The initial cash dividend was paid on June 30, 1995. On February 20, 1997, the Company's Board of Directors approved an increase in the Company's quarterly cash dividend to $0.08 per share. On November 21, 1997, the Company's Board of Directors approved an increase in the quarterly cash dividend to $0.09 per share.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Set forth below is consolidated statement of income data with respect to the fiscal years ended January 4, 1997, January 3, 1998 and January 2, 1999, and consolidated balance sheet data at January 3, 1998 and January 2, 1999. The selected financial data is derived from, and qualified by reference to, the audited consolidated financial statements included herein and such data should be read in conjunction with those financial statements and notes thereto. The consolidated statement of income data for the fiscal years ended January 7, 1995 and January 6, 1996 and the consolidated balance sheet data at January 7, 1995, January 6, 1996 and January 4, 1997 are derived from audited consolidated financial statements not included herein.
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(a) In fiscal 1994, the Company recorded a $3.0 million pre-tax charge (or $0.04 per diluted share) related to the California earthquake.
(b) Income reflects the benefits of utilizing the Company's net operating loss carryforward to offset the Company's federal income tax provision. Income before non-recurring items, after giving effect to a full tax provision at the Company's effective income tax rate of 38.0%, was $41.1 million (or $1.00 per share) in fiscal 1994.
(c) Effective with the 1995 fiscal year, the Company adopted the provisions of SOP 93-7 which requires, among other things, that certain advertising costs which had previously been deferred and amortized against future revenues be expensed when the advertisement first runs. The Company incurred a pre-tax charge for advertising costs, previously deferrable, of $11.7 million ($7.3 million net of income tax benefits, or $0.16 per diluted share) in the fourth quarter of fiscal 1995.
(d) Fiscal 1995 includes a $3.1 million after-tax extraordinary charge ($0.07 per diluted share) to write-off deferred financing costs.
(footnotes continued on next page)
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(e) Fiscal 1996 includes pre-tax charges related to the sale of the Company's Hathaway dress shirt operations of $46.0 million, consolidation and realignment of the Company's Intimate Apparel Division of $72.1 million and other items of $20.4 million. Total non-recurring items were $138.5 million ($88.8 million net of income tax benefits, or $1.67 per diluted share).
(f) The fiscal 1996 and 1997 financial statements have been revised to reflect $57.0 million and $38.0 million, respectively, of certain start-up related production and inefficiency costs as described in Note 1 to the Consolidated Financial Statements.
(g) Fiscal 1997 reflects the acquisition of Designer Holdings during the fourth quarter and includes pre-tax charges related to the merger and integration of 1996 and 1997 acquisitions and the completion in 1997 of certain consolidation and restructuring actions announced in 1996. Total non-recurring items were $130.8 million ($81.1 million net of income tax benefits, or $1.48 per diluted share).
(h) Fiscal 1998 includes restructuring, special charges and other non-recurring items of $106.8 million ($69.1 million net of income tax benefits, or $1.10 per diluted share) relating to the continuing strategic review of facilities, products and functions and other items. Also included in fiscal 1998 operating earnings is the current year impact related to the change in accounting for pre-operating costs of $40.8 million ($26.4 million net of income tax benefits, or $ 0.42 per diluted share) and other start-up related production and inefficiency costs of $49.7 million ($32.1 million net of income tax benefits, or $0.51 per diluted share), see Note 1 to the Consolidated Financial Statements.
(i) Effective with the 1998 fiscal year, the Company early adopted the provisions of SOP 98-5 which requires, among other things, that certain pre-operating costs which had previously been deferred and amortized be expensed as incurred. The Company recorded the impact as the cumulative effect of a change in accounting principle of $46.3 million, net of income tax benefits, or $0.73 per diluted share.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
STRATEGIC ACTIONS
FISCAL 1998 -- RESTRUCTURING, SPECIAL CHARGES AND OTHER NON-RECURRING ITEMS
As a result of a strategic review of the Company's businesses, manufacturing and other facilities, product lines and styles and worldwide operations following significant acquisitions in 1996 and 1997, in the fourth quarter of 1998 the Company initiated the implementation of programs designed to streamline operations and improve profitability. As a result of the decision to implement these programs, the Company recorded restructuring and special charges of approximately $53.8 million ($34.8 million net of income tax benefits) related to costs to exit certain facilities and activities, asset impairments and employee termination and severance benefits. Of the total amount of the 1998 charges, $23.2 million is reflected in cost of goods sold and $30.6 million is reflected in selling, administrative and general expenses in the accompanying consolidated statement of operations. The detail of the charges recorded in 1998, including costs incurred and reserves remaining for costs estimated to be incurred through completion of the aforementioned programs, anticipated by the end of fiscal 1999, are summarized below:
See Note 3 to the Consolidated Financial Statements for further detail.
In addition and related to the above actions, the current year operations included $53.0 million ($34.3 million net of income tax benefits) related to the first nine months of losses on discontinued product lines, severance associated with reductions in headcount, incremental advertising, allowances and manufacturing variances. Of the total amount, $25.9 million is reflected in cost of goods sold and $27.1 million is reflected in selling, administrative and general expenses.
The total restructuring, special charges and other non-recurring items are $106.8 million ($69.1 million, net of income tax benefits or $1.10 per diluted share) for the year ended January 2, 1999. The Company anticipates that these programs will generate annual savings of $15.0 million pre-tax.
FISCAL 1997
During the fourth quarter of 1997, the Company reported a pre-tax charge of $130.8 million related to the acquisition and integration of Designer Holdings, the Intimate Apparel consolidation and realignment program initiated in 1996 and other items, including the final disposition of Hathaway assets (amounts in millions):
The charge consists primarily of a write-down of asset values, severance and other employee costs, costs related to manufacturing realignment and lease and other costs to combine existing retail outlet stores with those of Designer Holdings.
During the fourth quarter of 1997, the Company increased the scope of the consolidation and restructuring of the Intimate Apparel Division started in 1996, primarily as a result of increased production volumes and demand experienced throughout the year. Accordingly, additional products and styles were discontinued and slower moving inventory liquidated.
See Note 3 to the Consolidated Financial Statements for further detail.
FISCAL 1996
Following the acquisition of the GJM business in February 1996, which expanded the Company's product lines and significantly added to the Company's low cost sleepwear manufacturing capacity, the Company undertook a strategic review of its businesses and manufacturing facilities. The acquisitions of Bodyslimmers and Lejaby were also considered in this review. As a result of this review, the Company took the following steps which resulted in a non-recurring charge in fiscal 1996 as summarized below (in millions):
See Note 3 to the Consolidated Financial Statements for further detail.
RESULTS OF OPERATIONS
The consolidated statements of income for the Company are summarized below.
SELECTED DATA STATEMENT OF INCOME (DOLLARS IN MILLIONS)
DIVISIONAL SUMMARY (IN MILLIONS)
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(a) Includes restructuring, special charges and other non-recurring items of $37.9 million in fiscal 1996 related to the decision to exit the Hathaway business and the restructuring and realignment of the Intimate Apparel Division, $76.6 million in fiscal 1997 related to the acquisition of Designer Holdings and the completion of the 1996 consolidation and restructuring actions and $49.1 million in fiscal 1998 related to the continuing strategic review of facilities, products and functions. Also included in fiscal 1998 is the current year impact related to the change in accounting for pre-operating costs of $40.8 million and other start-up related production and inefficiency costs of $49.7 million, see Note 1 to the Consolidated Financial Statements.
(b) Includes restructuring, special charges and other non-recurring items of $100.6 million in fiscal 1996, $54.2 million in fiscal 1997 and $57.7 million in fiscal 1998 related to the write-off of certain deferred
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(footnotes continued from previous page) advertising costs, the sale of the Company's Hathaway dress shirt operation, consolidation and realignment of the Company's Intimate Apparel Division and other items and consolidation and restructuring of facilities, products and functions related to the Company's recent acquisitions. Also, fiscal 1997 includes $3.5 million attributable to minority interests in the income of Designer Holdings applicable to the period of less than 100% ownership by the Company.
(c) The fiscal 1996 and 1997 financial statements have been revised to reflect $57.0 million and $38.0 million, respectively, of certain start-up related production and inefficiency costs as described in Note 1 to the Consolidated Financial Statements.
COMPARISON OF FISCAL 1998 TO FISCAL 1997
Net revenues increased $514.6 million or 35.8% to $1,950.3 million in fiscal 1998 compared with $1,435.7 million in fiscal 1997. Incremental net revenues contributed by the 1997 and 1998 acquisitions of Calvin Klein Jeanswear and Kidswear were $415.5 million. In addition, the Company discontinued several underperforming brands during 1998. These discontinued brands accounted for a reduction in net revenues of $30.9 million in fiscal 1998. Excluding the impact of these items, net revenues from continuing brands were up 9.4%.
INTIMATE APPAREL DIVISION. Net revenues increased $3.6 million or 0.4% to $944.8 million in fiscal 1998 compared with $941.2 million in fiscal 1997. Discontinued brands accounted for a reduction in net revenues of $30.9 million in fiscal 1998. Excluding the impact of the discontinued brands, net revenues increased 3.9%. Core Warner's, Olga and private label business increased $29.3 million or 8.1% over fiscal 1997 results. Bra market share in Department and Specialty stores for the year was 37.5% compared with 34.0% in 1997. Fiscal 1998 net revenues were negatively affected by hurricanes in Costa Rica and Honduras which disrupted shipments during the 1998 fourth quarter. Calvin Klein net revenues declined 3.1% primarily on lower international shipments in Russia and the Far East due to currency devaluation and economic downturns.
SPORTSWEAR AND ACCESSORIES DIVISION. Net revenues increased $449.4 million or 105.5% to $875.3 million in fiscal 1998 compared with $425.9 million in fiscal 1997. Incremental net revenues in 1998 contributed by the 1997 and 1998 Calvin Klein acquisitions were $366.8 million. Excluding these acquisitions, net revenues increased $82.6 million or 28.2%. Improvements were recorded across all brands with Chaps up $78.7 million or 28.9% and Accessories up $2.0 million or 11.6%.
RETAIL OUTLET STORES DIVISION. Net revenues increased $61.6 million or 89.8% in fiscal 1998. Incremental net revenues in 1998 contributed by the 1997 Designer Holdings acquisition was $48.7 million. Excluding the acquisition, net revenues increased $12.9 million or 22.4%.
Gross profit increased $162.0 million or 43.2% on an as-reported basis to $537.2 million in fiscal 1998 compared with $375.2 million in fiscal 1997. The increase is due primarily to the 1997 and 1998 Calvin Klein acquisitions. Gross margins improved 1.4% to 27.5% from 26.1% resulting from a more favorable regular to off-price mix across all brands. Included in cost of sales in fiscal 1998 are restructuring and special charges of $23.2 million, other non-recurring items of $25.9 million (see discussion of Strategic Actions on pages 15-16) and the current year impact of the early adoption of SOP 98-5 of $40.8 million and start-up related production and inefficiency costs of $49.6 million. See Note 1 to the Consolidated Financial Statements. Excluding these items and the impact of the restructuring charges and start-up related inefficiencies in fiscal 1997, gross profit increased $167.9 million or 33.0% to $676.7 million compared with $508.8 million in fiscal 1997. Gross margins on this basis were 34.7% in 1998 compared with 35.4% in 1997. The decrease in gross margins from fiscal 1997 was caused by a higher mix of jeanswear and Chaps net revenues, which has lower gross margins than Intimate Apparel.
INTIMATE APPAREL DIVISION. Gross profit (excluding all non-recurring items described above) increased $9.7 million or 2.6% to $377.2 million in fiscal 1998 compared with $367.5 million in fiscal 1997. Gross margins were 39.9% in 1998 compared with 39.0% in 1997. The improvement in
margins resulted from a better regular price sales mix and cost savings initiatives implemented during the year.
SPORTSWEAR AND ACCESSORIES DIVISION. Gross profit (excluding all non-recurring items described above) increased $137.0 million or 117.5% to $253.6 million in fiscal 1998 compared with $116.6 million in fiscal 1997. The increase in gross profit was due to the 1997 and 1998 Calvin Klein acquisitions, which contributed an incremental $121.9 million of gross profit. Excluding acquisitions, gross profit was up $14.4 million compared with 1997 with most of the increase in Chaps. Gross margins in 1998 were 29.0% compared with 27.4% in 1997 with the improvement due to the addition of Calvin Klein Jeanswear.
RETAIL OUTLET STORES DIVISION. Gross profit increased $15.8 million or 64.0% to $40.5 million in fiscal 1998 compared with $24.7 million in fiscal 1997, with the increase attributable to the Designer Holdings acquisition.
Selling, administrative and general expenses increased $102.2 million to $451.6 million on an as-reported basis in fiscal 1998 compared with $349.4 million in fiscal 1997. Selling, administrative and general expenses as a percentage of sales improved to 23.1% in 1998 compared with 24.3% in 1997 on an as-reported basis. Included in fiscal 1998 results are restructuring and special charges of $30.6 million and other non-recurring items of $27.1 million (see discussion of Strategic Actions on pages 15-16). The Company anticipates that these programs will generate annual savings of approximately $15.0 million pre-tax. Excluding restructuring, special charges and other non-recurring items in 1998 and 1997, selling, administrative and general expenses were $393.9 million (20.2% of net revenues) in 1998 compared with $295.2 million (20.6% of net revenues) in 1997. The improvement in selling, administrative and general expenses is attributable to the leverage attained through increased net revenues of Calvin Klein Jeanswear.
Interest expense increased $17.9 million to $63.8 million in fiscal 1998 compared with $45.9 million in fiscal 1997. The increase was caused primarily by the company's stock buyback program and the Calvin Klein Jeanswear and Kidswear acquisitions in fiscal 1997 and 1998.
The income tax benefit in fiscal 1998 was $17.5 million consisting of a $7.7 million income tax expense on continuing operations and a $25.2 million income tax benefit on the cumulative effect of an accounting change, or an overall effective tax rate of 35.3%. The difference between the United States federal statutory rate of 35.0% and the Company's effective tax rate of 35.3% primarily reflects the impact of state income taxes (net of federal benefits), foreign income taxes at rates other than the U. S. statutory rate, the impact of non-deductible intangible amortization, and changes in valuation allowance. The Company has estimated United States net operating loss carryforwards of approximately $385.2 million at January 2, 1999 and foreign net operating loss carryforwards of approximately $18.3 million available to offset future taxable income. The United States and foreign loss carryforwards, which the Company expects to fully utilize, should result in future cash tax savings of approximately $151.9 million at current United States income tax rates and $3.8 million at current foreign income tax rates, respectively. The net operating loss carryforwards expire between 2003 and 2018.
Income on an as-reported basis before cumulative effect of the early adoption of SOP 98-5 improved $26.4 million to $14.1 million or $0.22 per diluted share in fiscal 1998 compared with a loss of $12.3 million or $0.23 per diluted share in fiscal 1997. Income before the effects of restructuring and special charges of $34.8 million, other non-recurring items of $34.3 million and the current year impact of the early adoption of SOP 98-5 and other start-up related production and inefficiency costs of $58.5 million, was $141.7 million or $2.25 per diluted share. Compared with fiscal 1997 net income (excluding non-recurring charges of $81.1 million and start-up related production and inefficiency costs of $35.4 million) of $104.1 million or $1.87 per diluted share, this represents an improvement of $37.6 million, or $0.38 per diluted share.
COMPARISON OF FISCAL 1997 TO FISCAL 1996
Net revenues increased $371.9 million or 35.0% to $1,435.7 million compared with $1,063.8 million in fiscal 1996. The acquisition of Designer Holdings during the fourth quarter of fiscal 1997 added net
revenues of $158.3 million. Excluding the impact of the Designer Holdings acquisition and the 1996 divestiture of the Hathaway dress shirt business, net revenues improved by $241.9 million or 23.4%.
INTIMATE APPAREL DIVISION. Net revenues increased $139.2 million or 17.4% to $941.2 million in fiscal 1997 compared with $802.0 million in fiscal 1996. The increase is due to the strength of the Calvin Klein and the core Warners and Olga brands coupled with the full year impact in fiscal 1997 of the acquisition of the Lejaby companies in fiscal 1996. Net revenues of Calvin Klein increased by $74.4 million due primarily to stronger sales in Europe. Warners and Olga brand net revenues improved by $28.8 million due to increased market penetration. Incremental net revenues contributed by Lejaby were $43.8 million in fiscal 1997.
SPORTSWEAR AND ACCESSORIES DIVISION. Net revenues increased $211.5 million or 98.6% to $425.9 million in fiscal 1997 compared with $214.4 million in fiscal 1996. The improvement is due in part to the acquisition of Designer Holdings during the fourth quarter of 1997, which added net revenues of $133.3 million. In addition, the increase is due to continued strength in Chaps by Ralph Lauren, which added $100.3 million in fiscal 1997, or an increase of 58.3% over fiscal 1996, and Calvin Klein accessories, which added $6.2 million, or an increase of 55.9% over fiscal 1996. These increases were partially offset by a decrease in net revenues due to the disposition of the Hathaway dress shirt operations in November 1996. On a comparable basis, excluding the Designer Holdings acquisition and the divested Hathaway operations, net revenues increased $106.5 million or 57.2% in fiscal 1997.
RETAIL OUTLET STORES DIVISION. Net revenues increased $21.2 million or 44.7% to $68.6 million in fiscal 1997 compared with $47.4 million in fiscal 1997. The improvement is due to the acquisition of Designer Holdings during the fourth quarter of 1997, with added net revenues of $25.0 million.
Gross profit increased 39.2% (excluding non-recurring items and start-up related production and inefficiency costs) to $508.8 million in fiscal 1997 compared with $365.6 million in fiscal 1996. Increases were experienced across all divisions. In connection with the acquisition of Designer Holdings and the completion in 1997 of certain consolidation and restructuring actions announced in 1996, the Company recorded non-recurring charges in fiscal 1997. On an as-reported basis, including the effects of the non-recurring charges in 1997 and 1996, gross profit increased 29.5%.
INTIMATE APPAREL DIVISION. Gross profit (excluding non-recurring items and start-up related production and inefficiency costs) increased 21.6% to $367.5 million in fiscal 1997 (39.0% of net revenues) from $302.4 million (37.7% of net revenues) in fiscal 1996. The increase in gross profit reflects higher revenues along with the full year impact in 1997 of the Lejaby acquisition.
SPORTSWEAR AND ACCESSORIES DIVISION. Gross profit (excluding non-recurring items) increased 160.9% to $116.6 million in fiscal 1997 (27.4% of net revenues) compared with $44.7 million (20.8% of net revenues) in fiscal 1996. The increase in gross profit is the result of higher Chaps by Ralph Lauren volume along with the acquisition of Designer Holdings during the fourth quarter of 1997. The Company also benefitted from the disposition, in fiscal 1996, of the Hathaway dress shirt business. On a comparable basis, excluding the results of Designer Holdings in 1997 and the Hathaway business in 1996, gross profit improved 74.6% or $35.6 million in fiscal 1997.
RETAIL OUTLET STORES DIVISION. Gross profit increased 33.5% to $24.7 million in fiscal 1997 compared with $18.5 million in fiscal 1996. The increase in gross profit is the result of the Designer Holdings acquisition.
Selling, administrative and general expenses (excluding non-recurring items) increased 46.8% to $295.2 million (20.6% of net revenues) in fiscal 1997 compared with $201.0 million (18.9% of net revenues) in fiscal 1996. The increase is due to higher sales volume and reflects the Company's commitment to invest in its brands through increased marketing and promotional activities. In fiscal 1997, such costs were $86.2 million (6.0% of net revenues) compared with $59.5 million (5.6% of net revenues) in fiscal 1996 with increased spending on the Calvin Klein and Lejaby brands of intimate apparel and Calvin Klein jeanswear and jeans related sportswear. Selling, administrative and general expenses also increased due to higher Calvin Klein royalties, higher goodwill amortization, the result of the acquisition of Designer Holdings and the Lejaby companies and the inclusion of $3.5 million
attributable to minority interests in the income of Designer Holdings applicable to the period of less than 100% ownership by the Company.
Interest expense increased 41.7% to $45.9 million in fiscal 1997 from $32.4 million in fiscal 1996. The increase results primarily from a full year of interest expense on funds borrowed to complete the 1996 acquisitions, principally Lejaby.
Income tax benefits on continuing operations were $7.8 million for fiscal 1997, or an effective tax rate of 38.7%. The difference between the United States federal statutory rate of 35.0% and the Company's effective tax rate of 38.7% (excluding the non-recurring charge and the minority interest) primarily reflects the impact of state income taxes (net of federal benefits), foreign income taxes at rates other than the U.S. statutory rate and the impact of non-deductible intangible amortization. For income tax purposes, the Company has estimated United States net operating loss carryforwards available to offset future taxable income of approximately $216.9 million at January 3, 1998. These carryforwards, which the Company expects to fully utilize, should result in future cash tax savings of approximately $85.8 million at current United States income tax rates. The net operating loss carryforwards expire between 2003 and 2012.
Net income before non-recurring items increased 29.2% to $104.1 million (or $1.87 per diluted share) in fiscal 1997 from $80.6 million (or $1.51 per diluted share) in fiscal 1996. This increase reflects higher sales volumes and gross margins partially offset by higher selling, administrative and general costs and interest costs, as previously discussed. On an as-reported basis, the net loss of $12.3 million in fiscal 1997 was an improvement of $19.1 million compared with a net loss of $31.4 million in fiscal 1996. Included in fiscal 1997 and 1996 net income are non-recurring charges of $81.1 million and $88.8 million, respectively.
CAPITAL RESOURCES AND LIQUIDITY
The Company's liquidity requirements arise primarily from its debt service and the funding of working capital needs, primarily inventory and accounts receivable and capital improvements programs. The Company's borrowing requirements are seasonal, with peak working capital needs generally arising at the end of the second quarter and during the third quarter of the fiscal year. The Company typically generates a substantial amount of its operating cash flow in the fourth quarter of the fiscal year, reflecting third and fourth quarter shipments and the sale of inventory built during the first half of the fiscal year.
During 1998, the Company acquired certain inventory and other assets as well as the sub-license to produce Calvin Klein jeans and jeans-related products for children in the United States, Mexico and Central and South America and the sub-license to produce Calvin Klein jeans and related products for children in Canada. Also during 1998, the Company acquired certain assets as well as the sub-license to distribute Calvin Klein jeans, jeans-related products and khakis for men and women in Mexico, Central America and Canada. The total purchase price of these acquisitions was approximately $53.1 million.
In December 1997, the Company completed the acquisition of Designer Holdings, which develops, manufactures and markets designer jeanswear and sportswear under a license from Calvin Klein, Inc. The purchase price consisted of the issuance of 10,413,144 shares of the Company's stock valued at $353.4 million. Net assets acquired included $55.8 million of cash of Designer Holdings.
In February 1996, the Company acquired substantially all of the assets (including certain subsidiaries) of GJM, a private label manufacturer of women's lingerie and sleepwear. The purchase price consisted of a cash payment of $12.5 million plus assumed liabilities.
In the third and fourth quarters of fiscal 1996, the Company acquired Lejaby, a leading European intimate apparel manufacturer, for approximately $79 million, including certain fees and expenses and assumed liabilities. Funds to consummate the transaction were provided by members of the Company's bank credit group. The terms of the bank loans are substantially the same as the terms of the Company's existing credit agreements and included a term loan totaling 370 million French Francs and revolving loan facilities totaling 150 million French Francs (the '1996 Bank Credit Agreements').
In July 1996, the Company acquired Bodyslimmers, for approximately $6.5 million and assumed liabilities. The acquisition of Bodyslimmers expanded the Company's product line to include body-slimming undergarments, a fast growing segment of the intimate apparel market targeting aging baby boomers. This acquisition enhanced the Company's leading position in the domestic intimate apparel market.
Cash provided by operations in fiscal 1998 was $333.7 million, compared with $143.9 million in fiscal 1997 and $27.0 million in fiscal 1996. Cash flow from operating activities increased $189.8 million in fiscal 1998 compared with fiscal 1997 primarily as a result of improved management of trade payables together with the favorable impact of the accounts receivable securitization. Cash flow from operating activities increased $116.9 million in fiscal 1997 compared with fiscal 1996, primarily as a result of a lower net loss and non-cash depreciation and amortization coupled with lower working capital requirements. The lower working capital requirements compared with 1996 were principally due to improved management of payables and reductions in prepaid expenses. The increase in payables was also due to higher inventory levels at year end in support of anticipated increased sales volume. Depreciation and amortization expense was $46.5 million, $47.4 million and $27.6 million in fiscal 1998, 1997 and 1996, respectively. The increase in depreciation and amortization expense in fiscal 1997 primarily reflects amortization of intangible assets related to the acquisitions completed in fiscal 1996.
Cash used in investing activities was $221.8 million in fiscal 1998 compared with $22.0 million in fiscal 1997 and $156.5 million in fiscal 1996. Fiscal 1998 includes $53.1 million related to the purchase of various Calvin Klein Jeanswear sub-licenses and $43.8 million related to the payment of acquired liabilities and acquisition accruals in connection with the Designer Holdings acquisition. Fiscal 1997 includes $55.8 million of cash acquired in connection with the acquisition of Designer Holdings for Company stock. Fiscal 1996 includes $85.6 million, net of cash acquired, related to the purchase of Lejaby, GJM and Bodyslimmers and $30.1 million related to the payment of acquired liabilities and acquisition accruals. Capital expenditures for new facilities, improvements to existing facilities and for machinery and equipment were approximately $142.8 million, $57.4 million and $33.8 million in the 1998, 1997 and 1996 fiscal years, respectively. Also, in fiscal 1998, intangibles and other assets include a $5.0 million investment in Interworld, a leading provider of E-Commerce software systems.
Cash (used in) provided by financing activities was $(116.3) million, $(125.2) million and $135.2 million in fiscal 1998, 1997 and 1996, respectively. During fiscal 1998 and 1997, debt repayments, including payments on credit facilities, were $25.8 million and $377.7 million, respectively. In 1997, the Company renegotiated its bank arrangements, including facilities for revolving credit, trade credit and letters of credit. Net proceeds under the revolving credit facility were $291.1 million in fiscal 1997. For the year ended January 2, 1999, the Company repurchased 4,869,755 shares of its common stock at a cost of $137.8 million and paid cash dividends of $22.3 million. For the year ended January 3, 1998, the Company repurchased 839,319 shares of its common stock at a cost of $26.5 million and paid cash dividends of $16.2 million. During fiscal 1996, the Company entered into the 1996 Bank Credit Agreements, proceeds from which were used to purchase Lejaby in fiscal 1996. In addition, the Company increased the outstanding balance on its revolving lines of credit by approximately $105.5 million in fiscal 1996.
In April 1998, the Company amended its 1996 Bank Credit Agreements (the 'Agreement') to increase its revolving loan facilities to 480 million French Francs from 120 million French Francs. Borrowings under the Agreement bear interest at LIBOR plus .35% and mature on April 17, 2003. In July 1998, the Company amended its $300 million Trade Letter of Credit Facility (the 'L/C Facility') to increase the size of the facility to $450 million, to extend the borrowing period for amounts due under the maturing letters of credit from 120 days to 180 days, to extend the maturity of the L/C Facility to July 29, 1999 and to eliminate certain restrictions relating to debt and investments. The amount of borrowings available under both the 1996 Bank Credit Agreements and the L/C Facility was increased to accommodate the internal growth of the Company's business as well as the increased demand for finished product purchases stemming from the acquisition of Designer Holdings in the fourth quarter of 1997 and the acquisition of the CK Kids business in the second quarter of 1998. In conjunction with the amendment of the L/C Facility, the Company also amended its $600 million revolving credit facility and
its $200 million 364-day credit facility to allow for the increase in the L/C Facility and the elimination of certain restrictions relating to debt and investments.
In October 1998, the Company entered into a $200 million revolving accounts receivable securitization facility. Under this facility, the Company entered into agreements to sell, for a period of up to five years, undivided participation interests in designated pools of U.S. trade receivables. Participation interests in new receivables may be sold as collections reduce previously sold participation interests. The participation interests are sold at a discount to reflect normal dilution. Net proceeds to the Company from the initial funding were $200 million, and were used primarily to temporarily repay long-term debt. At January 2, 1999, approximately $170.3 million was advanced under this facility.
The Company has paid a quarterly cash dividend since June 1995. The dividend payment was raised to $0.08 per share from $0.07 per share in February 1997 and increased to $0.09 per share in January 1998.
At January 2, 1999, the Company had approximately $511.1 million of additional borrowing availability under the revolving loan portions of its United States bank facilities. The Company also has bank credit agreements in Canada, Europe and Asia. At January 2, 1999, the Company had approximately $115.4 million of additional borrowing availability under these agreements. The Company believes that funds available under its various bank facilities, together with cash flow to be generated from future operations, will be sufficient to meet the capital expenditure requirements and working capital needs of the Company, including interest and debt principal payments for the next twelve months and for the next several years.
YEAR 2000 AND ECONOMIC AND MONETARY UNION ('EMU') COMPLIANCE
The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time-sensitive software may recognize a date using '00' as the year 1900 rather than the year 2000. These programs, including some that are critical to the Company's operations, could fail to properly process data that contain dates after 1999 unless they are modified or replaced.
Following a comprehensive review of current systems and future requirements to support international growth, the Company initiated a program to replace existing capabilities with enhanced hardware and software applications. The objectives of the program are to achieve competitive benefits for the Company, as well as assuring that all information systems will meet Year 2000 and EMU compliance. Full implementation of this program is expected to require expenditures of approximately $10.0 million over the next twelve months, primarily for Year 2000 compliance and system upgrades. Funding requirements have been incorporated into the Company's capital expenditure planning and are not expected to have a material adverse impact on financial condition, results of operations or liquidity. The implementation and testing processes are expected to be completed in mid-1999.
As a part of its Year 2000 process, the Company intends to test its Year 2000 readiness for critical business processes and application systems. The Company anticipates that minor issues will be identified during this test period and intends to address such issues during the first half of fiscal 1999. The Company has contacted key suppliers and vendors in order to determine the status of such third parties' Year 2000 remediation plans. Evaluation of suppliers and vendors readiness is currently on-going. The Company recognizes the need for Year 2000 contingency plans in the event that remediation is not fully successful or that the remediation efforts of its vendors, suppliers and governmental/regulatory agencies are not timely completed. This process was begun in fiscal 1998 and will be on-going throughout 1999. The Company's contingency planning consists of upgrading current information systems operating and application software to Year 2000 compliance. The upgrade of current systems, which the Company anticipates will be substantially complete by the end of the second quarter of fiscal 1999, will be accomplished with both internal and external resources. Such remediation costs will be charged to operations as incurred.
The Company recognizes that issues related to Year 2000 constitute a material known uncertainty. The Company also recognizes the importance of ensuring its operations will not be adversely affected by Year 2000 issues. It believes that the processes described above will be effective to manage the risks
associated with the problem. However, there can be no assurance that the process can be completed on the timetable described above or that the remediation process will be fully effective. The failure to identify and remediate Year 2000 problems or, the failure of key third parties who do business with the Company or governmental regulatory agencies to timely remediate their Year 2000 issues could cause system failures or errors and business interruptions.
Readers are cautioned that forward-looking statements contained in the Year 2000 update should be read in conjunction with the Company's disclosure under 'Statement Regarding Forward-looking Disclosures'.
In anticipation of the establishment of the European EMU and the introduction of a single European unit of currency (the 'Euro') scheduled for January 1, 1999, Warnaco formed a Steering Committee in December 1997 to (1) identify the related issues and their potential effect on Warnaco, and (2) develop an action plan for EMU compliance.
The steering committee completed development of and implemented an action plan which included preparation of banking arrangements for use of the Euro, development of dual currency price lists and invoices, modification of prices to mitigate the potential effects of price transparency and taking the necessary computer-related remediation steps. As a result of this plan, as of January 1, 1999, Warnaco was EMU compliant.
STATEMENT REGARDING FORWARD-LOOKING DISCLOSURE
This Report includes 'forward-looking statements' within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent the Company's expectations or beliefs concerning future events that involve risks and uncertainties, including those associated with the effect of national and regional economic conditions, the overall level of consumer spending, the performance of the Company's products within the prevailing retail environment, customer acceptance of both new designs and newly-introduced product lines, and financial difficulties encountered by customers. All statements other than statements of historical facts included in this Annual Report, including, without limitation, the statements under 'Management's Discussion and Analysis of Financial Condition,' are forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct.
SEASONALITY
The operations of the Company are somewhat seasonal, with approximately 56% of net revenues, 69% of operating income before restructuring, special charges and other non-recurring items and substantially all of the Company's net cash flow from operating activities generated in the second half of the year. Generally, the Company's operations during the first half of the year are financed by increased borrowings. The following sets forth the net revenues, operating income before restructuring and special charges and other non-recurring items and net cash flow from operating activities generated for each quarter of fiscal 1998 and fiscal 1997.
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(a) Before restructuring, special charges and other non-recurring items.
(b) Reflects adjustments in connection with the early adoption of the provisions of SOP 98-5 regarding the accounting for pre-operating costs and other start-up related production and inefficiency costs. See Notes 1 and 18 to the Consolidated Financial Statements.
INFLATION
The Company does not believe that the relatively moderate levels of inflation in the United States, Canada and Western Europe have had a significant effect on its net revenues or its profitability. Management believes that, in the past, the Company has been able to offset such effects by increasing prices or by instituting improvements in productivity. Mexico historically has been subject to high rates of inflation; however, the effects of inflation on the operation of the Company's Mexican subsidiaries have not had a material impact on the results of the Company.
IMPACT OF NEW ACCOUNTING STANDARDS
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, 'Accounting for Derivative Instruments and Hedging Activities' (SFAS No. 133). This statement, which is effective for the fiscal year beginning January 3, 2000, establishes accounting and reporting standards for derivative instruments and hedging activities. SFAS No. 133 requires the recognition of all derivatives as either assets or liabilities in the statement of financial position along with the measurement of such instruments at fair value. Management believes, based on current activities, that the implementation of SFAS No. 133 will not have a material impact on the Company's consolidated financial position, liquidity, cash flows or results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company is exposed to market risk related to changes in interest rates and foreign currency exchange rates, and selectively uses financial instruments to manage these risks. The Company does not enter into financial instruments for speculation or for trading purposes.
INTEREST RATE RISK
The Company is subject to market risk from exposure to changes in interest rates based primarily on its financing activities. The Company enters into interest rate swap agreements to reduce the impact of interest rate fluctuations on cash flow and interest expense. As of January 2, 1999, approximately $610.0 million of $879.7 million of interest-rate sensitive obligations were swapped to achieve a fixed rate of 5.99%, limiting the Company's risk to any future shift in interest rates. As of January 2, 1999, the net fair value liability of all financial instruments (primarily interest rate swap agreements) with exposure to interest rate risk was approximately $24.3 million. The potential decrease in fair value resulting from a hypothetical 10% shift in interest rates would be approximately $15.6 million.
FOREIGN EXCHANGE RISK
The Company has foreign currency exposures related to buying, selling and financing in currencies other than the functional currency in which it operates. These exposures are primarily concentrated in the Canadian dollar, Mexican peso, Hong Kong dollar, British pound and the Euro. The Company enters into foreign currency forward and option contracts to mitigate the risk of doing business in foreign currencies. The Company hedges currency exposures of firm commitments and anticipated transactions denominated in non-functional currencies to protect against the possibility of diminished cash flow and adverse impacts on earnings. As of January 2, 1999, the net fair value asset of financial instruments with exposure to foreign currency risk, which included only currency option contracts, was $0.2 million. The potential decrease in fair value resulting from a hypothetical 10% adverse change in quoted foreign currency exchange rates would be limited to $0.2 million, the fair value of these options.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by Item 8 of Part II is incorporated herein by reference to the Consolidated Financial Statements filed with this report. See Item 14 of Part IV.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by Item 10 is incorporated by reference from page 11 of Item 4 of Part I included herein and from the Proxy Statement of The Warnaco Group, Inc., relating to the 1999 Annual Meeting of Stockholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 is hereby incorporated by reference from the Proxy Statement of The Warnaco Group, Inc., relating to the 1999 Annual Meeting of Stockholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by Item 12 is hereby incorporated by reference from the Proxy Statement of The Warnaco Group, Inc., relating to the 1999 Annual Meeting of Stockholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by Item 13 is hereby incorporated by reference from the Proxy Statement of The Warnaco Group, Inc., relating to the 1999 Annual Meeting of Stockholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K.
(a) 1. The Consolidated Financial Statements of The Warnaco Group, Inc.
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission which are not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto.
(b) REPORTS ON FORM 8-K.
No reports on Form 8-K were filed during the 1998 fiscal year.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized in the City of New York, State of New York, on the 1st day of April, 1999.
THE WARNACO GROUP, INC.
By: /S/ LINDA J. WACHNER ------------------------------ Linda J. Wachner Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and on the dates indicated.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of The Warnaco Group, Inc.
In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 27 present fairly, in all material respects, the financial position of The Warnaco Group, Inc. and its subsidiaries at January 2, 1999 and January 3, 1998, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 2, 1999, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
As described in Note 1, pursuant to the adoption of SOP 98-5 the Company changed its accounting for deferred start-up costs effective the beginning of fiscal 1998 and revised its fiscal 1997 and 1996 consolidated financial statements with respect to accounting for other start-up related production and inefficiency costs.
PRICEWATERHOUSECOOPERS LLP New York, New York March 2, 1999
THE WARNACO GROUP, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCLUDING SHARE DATA)
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(1) Fiscal 1997 has been revised as described in Note 1.
This Statement should be read in conjunction with the accompanying Notes to Consolidated Financial Statements.
THE WARNACO GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCLUDING PER SHARE DATA)
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(1) Fiscal 1996 and 1997 have been revised as described in Note 1.
This Statement should be read in conjunction with the accompanying Notes to Consolidated Financial Statements.
THE WARNACO GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (IN THOUSANDS, EXCLUDING SHARE DATA)
- ------------ (1) Fiscal 1996 and 1997 have been revised as described in Note 1.
This Statement should be read in conjunction with the accompanying Notes to Consolidated Financial Statements.
THE WARNACO GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS INCREASE (DECREASE) IN CASH (IN THOUSANDS)
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(1) Fiscal 1996 and 1997 have been revised as described in Note 1.
This Statement should be read in conjunction with the accompanying Notes to Consolidated Financial Statements.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
NOTE 1 - NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization: The Warnaco Group, Inc. ('Company') was incorporated in Delaware on March 14, 1986 and on May 10, 1986 acquired substantially all of the outstanding shares of Warnaco Inc. ('Warnaco'). Warnaco is the principal operating subsidiary of the Company.
Nature of Operations: The Company designs, manufactures and markets a broad line of women's intimate apparel, designer jeanswear and jeans related sportswear for men, women, juniors and children, men's underwear and men's sportswear, accessories and dress furnishings under a number of owned and licensed brand names. The Company's products are sold to department and specialty stores, mass merchandise stores and catalog and other retailers throughout the United States, Canada, Mexico, Latin America, Western Europe and the Far East.
Basis of Consolidation and Presentation: The accompanying Consolidated Financial Statements include the accounts of the Company and all subsidiary companies for the years ended January 4, 1997 ('Fiscal 1996'), January 3, 1998 ('Fiscal 1997') and January 2, 1999 ('Fiscal 1998'). All intercompany transactions are eliminated.
Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses.
Translation of Foreign Currencies: Cumulative translation adjustments, arising primarily from consolidating the net assets and liabilities of the Company's foreign operations at current rates of exchange as of the respective balance sheet date, are applied directly to stockholders' equity and are included as part of accumulated other comprehensive income. Income and expense items for the Company's foreign operations are translated using monthly average exchange rates.
Inventories: Inventories are stated at the lower of cost or market, cost being determined on a first-in, first-out basis.
Property, plant and equipment: Property, plant and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided over the lesser of the estimated useful lives of the assets or term of the capital lease, using the straight-line method, as summarized below:
Assets under capital lease and related amortization of capitalized leases are included in property, plant and equipment and accumulated depreciation and the associated liability is included in debt. Depreciation expense was $18,541, $21,865 and $23,931 for fiscal years 1996, 1997 and 1998, respectively.
Intangible Assets: Intangible assets consist of goodwill, licenses, trademarks, deferred financing costs and other intangible assets. Goodwill represents the excess of cost over net assets acquired and is amortized on a straight-line basis over the estimated useful life, not exceeding 40 years. Deferred financing costs are amortized over the life of the related debt. Amortization expense, included in selling administrative and general expenses was $9,035, $10,021 and $22,569 for fiscal years 1996, 1997 and 1998, respectively. The Company periodically reviews the carrying value of intangibles for recoverability based on future (undiscounted) cash flow.
Income Taxes: The provision for income taxes, income taxes payable and deferred income taxes are determined using the liability method. Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured by applying enacted tax rates and laws to taxable years in which such differences are expected to reverse.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
Unremitted earnings of subsidiaries outside of the United States are considered to be reinvested indefinitely. If remitted, management believes they would be substantially free of additional taxes.
Revenue Recognition: The Company recognizes revenue when goods are shipped to customers, net of estimates for normal returns, discounts and allowances.
Stock Options: The Company accounts for options granted using the intrinsic value method. Because the exercise price of the Company's options equals the market value of the underlying stock on the date of grant, no compensation expense has been recognized for any period presented.
Financial Instruments: Derivative financial instruments are used by the Company in the management of its interest rate and foreign currency exposures. The Company also uses derivative financial instruments to execute purchases of its shares under its stock buyback program. The Company does not use derivative financial instruments for trading or speculative purposes. Gains and losses resulting from effective hedges of existing assets, liabilities or firm commitments are deferred and recognized when the offsetting gains and losses are recognized on the related hedged items. Income and expense are recorded in the same category as that arising from the related asset or liability being hedged. Changes in amounts to be received or paid under interest rate swap agreements are recognized as interest expense. Gains and losses realized on termination of interest rate swap contracts are deferred and amortized over the remaining terms of the original swap agreement.
A number of major international financial institutions are counterparties to the Company's financial instruments, including derivative financial instruments. The Company monitors its positions with, and the credit quality of, these counterparty financial institutions and does not anticipate non-performance of these counterparties. Management believes that the Company would not suffer a material loss in the event of nonperformance by these counterparties.
Equity Instruments Indexed to the Company's Common Stock: Proceeds received upon the sale of equity instruments and amounts paid upon the purchase of equity instruments are recorded as a component of stockholders' equity. Subsequent changes in the fair value of the equity instrument contracts are not recognized. Repurchases of common stock pursuant to the terms of the equity instruments are recorded as treasury stock, at cost. If the contracts are ultimately settled in cash, the amount of cash paid or received is recorded in additional paid-in capital.
Concentration of Credit Risk: The Company sells its products to department stores, specialty outlets, catalogs, direct sellers and mass merchandisers. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. Credit losses have been within management's expectations.
Computer Software Costs: Internal and external direct and incremental costs incurred in developing or obtaining computer software for internal use are capitalized in property and equipment and amortized, under the straight-line method, over the estimated useful life of the software, generally 5 to 7 years. General and administrative costs related to developing or obtaining such software are expensed as incurred.
Comprehensive Income: Comprehensive income consists of net income and cumulative foreign currency translation adjustments. Because such cumulative translation adjustments are considered a component of permanently invested unremitted earnings of subsidiaries outside the United States, no income taxes are provided on such amounts.
Start-Up Costs: In the fourth quarter of fiscal 1998, retroactive to the beginning of the year, the Company early adopted the provisions of SOP 98-5 requiring that pre-operating costs relating to the start-up of new manufacturing facilities, product lines and businesses be expensed as incurred. The Company recognized $46,250, after taxes, as the cumulative effect of a change in accounting to reflect the new accounting and write-off the balance of unamortized deferred start-up costs as of the beginning
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
of 1998. In addition, the Company recognized in fiscal 1998 earnings approximately $40,823, before taxes, related to current year costs that would have been deferred under the Company's start-up accounting policy prior to the adoption of SOP 98-5. Prior to the early adoption of SOP 98-5, start-up costs were deferred and amortized using the straight line method, principally over five years.
Adjustments, Reclassifications and Revisions: As noted above, the Company early adopted SOP 98-5 in fiscal 1998. In connection with the adoption of the new accounting standard, an extensive effort was undertaken to identify all start-up related production and inefficiency costs that had previously been deferred. Over the last six years, the Company has opened or expanded 10 manufacturing facilities. In addition, to support anticipated future growth, the Company opened 2 new manufacturing facilities during 1998 for a total of 12 new facilities. This resulted in the Company's incurring plant inefficiencies and other start-up related costs resulting from high turnover and related training and other costs. Such start-up related production and inefficiency costs have been classified in other assets and inventories. Because certain such costs identified in this process related to fiscal 1997 and 1996 activities, such prior year consolidated financial statements have been revised to reflect additional costs of goods sold of $57,017 in fiscal 1997 ($35,351 after tax or $0.65 per diluted share and $ 0.67 per basic share) and $37,983 in fiscal 1996 ($23,170 after tax or $0.45 per diluted and basic share). In fiscal 1997, income (loss) before income taxes, net income (loss), basic earnings per share and diluted earnings per share were $(20,100), $(12,319), $(0.23) and $(0.23), respectively. Before the revision, these amounts were $36,917, $23,032, $0.44 and $0.42, respectively. In fiscal 1996, income (loss) before income taxes, net income (loss), basic earnings per share and diluted earnings per share were $(44,443), $(31,409), $(0.61) and $(0.61), respectively. Before the revision, these amounts were $(6,460), $(8,239), $(0.16) and $(0.16), respectively. In addition, fiscal 1998 results have been similarly adjusted to recognize such current year costs in cost of goods sold ($49,668 or $32,135 after tax) (see Note 18).
Certain 1997 and 1996 amounts have been reclassified in the 1998 consolidated financial statements to conform to the current presentation.
NOTE 2 - ACQUISITIONS
In February 1996, the Company acquired substantially all of the assets (including certain subsidiaries) comprising the GJM Group of Companies ('GJM'). GJM was a private label manufacturer of women's lingerie and sleepwear and now also manufactures products for the Company's Intimate Apparel Division. The purchase price consisted of a cash payment of $12,500 plus assumed liabilities. In fiscal 1996, the Company acquired the Lejaby/Euralis group of companies ('Lejaby'), a leading European intimate apparel manufacturer, for approximately $79,249 plus assumed liabilities and certain fees and expenses. Also in fiscal 1996, the Company acquired Bodyslimmers, for approximately $6,500 plus assumed liabilities. Bodyslimmers designs and markets body slimming undergarments for women.
The GJM, Lejaby and Bodyslimmers acquisitions were accounted for as purchases. The results of operations of the acquired companies have been included in the consolidated results of operations of the Company since the respective dates of acquisition. The purchase price of the acquisitions was allocated to the fair value of the net assets acquired of $163,800 in aggregate, including certain trademarks and intangible assets of $90,500. These acquisitions did not have a material pro-forma impact on 1996 consolidated earnings and the final purchase prices did not materially differ from the amounts shown above.
In October 1997, the Company acquired 51.3% of Designer Holdings Ltd. ('Designer Holdings') outstanding common stock in exchange for 5,340,773 shares of the Company's common stock and agreed, subject to shareholder approval, to acquire the remaining shares outstanding at the same exchange ratio. In December 1997, the Company acquired the remaining 48.7% of the outstanding
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
common stock of Designer Holdings in exchange for 5,072,371 shares of the Company's common stock. Designer Holdings develops, manufactures and markets designer jeanswear and jeans related sportswear for men, women and juniors, and has a 40-year extendable license from Calvin Klein, Inc. to develop, manufacture and market designer jeanswear and sportswear collections in North, South and Central America under the Calvin Klein Jeans, CK/Calvin Klein Jeans and CK/Calvin Klein/Khakis labels.
The acquisition was accounted for as a purchase. Accordingly, the accompanying consolidated financial statements include the results of operations for Designer Holdings commencing in October 1997. The minority interest for periods of less than 100% ownership by the Company have been included in selling, administrative and general expenses. In connection with this acquisition, the Company issued a total of 10,413,144 shares of its common stock, with a fair market value of $353,396. The allocation of the total purchase price, exclusive of cash received of approximately $55,800, to the fair value of the net assets acquired is summarized as follows:
Included in intangible and other assets for the Designer Holdings acquisition are $130,000 for licenses and $222,100 of goodwill.
The final assessment of the purchase accounting was completed as of January 2, 1999. Adjustments to these estimates (primarily related to liabilities assumed in connection with completing actions pursuant to a plan established as of the closing date) increased the excess of cost over net assets acquired by approximately $63,100.
The following summarized unaudited pro forma information combines financial information of the Company with Designer Holdings for fiscals 1996 and 1997 assuming the acquisition had occurred as of January 7, 1996. The unaudited pro forma information does not reflect any cost savings or other benefits anticipated by the Company's management as a result of the acquisition.
The unaudited pro forma combined information is not necessarily indicative of the results of operations of the combined company had the acquisition occurred on the dates specified above, nor is it
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
indicative of future results of operations for the combined companies at any future date or for any future periods.
During 1998, the Company acquired certain inventory and other assets as well as the sub-license to produce Calvin Klein jeans and jeans-related products for children in the United States, Mexico and Central and South America and the sub-license to produce Calvin Klein jeans and related products for children in Canada. Also during 1998, the Company acquired certain assets as well as the sub-license to distribute Calvin Klein jeans, jeans-related products and khakis for men and women in Mexico, Central America and Canada. The total cost of these acquisitions, including related costs and expenses, was $53,100. A preliminary allocation of the purchase prices to the fair value of the assets acquired as of January 2, 1999 is summarized below:
In addition, the Company entered into a supply agreement with the seller whereby the Company will purchase, at a specified price, certain products for a period of eighteen months.
The acquisitions were accounted for as purchases and did not have a material pro-forma effect on 1998 consolidated results of operations. The allocation of the purchase price is subject to revision when additional information concerning the asset and liability valuations become available. Accordingly, the final purchase price allocation could differ from the amounts shown.
NOTE 3 - RESTRUCTURING, SPECIAL CHARGES AND OTHER NON-RECURRING ITEMS
1998 RESTRUCTURING AND SPECIAL CHARGES
As a result of a strategic review of the Company's businesses, manufacturing and other facilities, product lines and styles and worldwide operations following significant acquisitions in 1996 and 1997, in the fourth quarter of 1998 the Company initiated the implementation of programs designed to streamline operations and improve profitability. As a result of the decision to implement these programs, the Company recorded restructuring and special charges of approximately $53,800 ($34,800 net of income tax benefits) related to costs to exit certain facilities and activities, including charges related to inventory write-downs and valuations, asset impairments and employee termination and severance benefits. Of the total amount of the 1998 charges, $23,200 is reflected in cost of goods sold and $30,600 is reflected in selling, administrative and general expenses. The detail of the charges recorded in 1998, including costs incurred and reserves remaining for costs estimated to be incurred through completion of the aforementioned programs, anticipated by the end of fiscal 1999, are summarized below:
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
COSTS TO EXIT FACILITIES AND ACTIVITIES
In the fourth quarter of 1998, the Company announced plans to discontinue certain product lines and styles and also to close certain retail outlet stores. In addition, during 1998 the Company initiated plans to shutdown or realign certain manufacturing and warehouse operations.
DISCONTINUED PRODUCT LINES AND STYLES ($20,600)
Management's review of certain product lines resulted in the decision to discontinue the manufacture and marketing of certain unprofitable product lines during the fourth quarter of 1998, including the Valentino and Marilyn Monroe product lines, as well as certain private label brands. The decision to discontinue these product lines will enable the Company to focus its working capital on more profitable product lines and styles. Included in the amount above for discontinued product lines are charges for inventory write-downs for obsolete and excess raw materials and finished goods of $13,500, receivable write-off's of $1,800 and fourth quarter operating losses of these product lines and styles of $5,300. For fiscal 1998, discontinued product lines and styles contributed net revenues of $26,300 and operating losses of $13,400. Operating losses incurred for periods prior to management's decision to exit these product lines are not reflected in the charge.
FACILITY SHUTDOWNS AND REALIGNMENTS ($8,500)
Costs for facility shutdowns and realignments include charges for the relocation of the Company's administrative offices in Connecticut and costs for the realignment of factories and consolidation of warehouse and distribution facilities.
RETAIL OUTLET STORE SHUTDOWNS ($4,800)
In an effort to improve the overall profitability of the retail outlet store division, the Company announced plans to close 13 retail outlet stores. Included in the charge are costs for the write-down of inventory of discontinued product lines and styles which the Company intends to liquidate through these stores at close-out prices. Through January 2, 1999, the Company closed 2 stores and expects to close the remaining stores by the second quarter of 1999.
ASSET IMPAIRMENTS
Asset impairments consist of the write-off of uncollectible trade and other receivables, and the write-down of property and equipment no longer used in continuing operations and other assets.
EMPLOYEE TERMINATION AND SEVERANCE
The Company recorded charges of approximately $6,100 related to the cost of providing severance and benefits to approximately 500 employees terminated as a result of the closure of certain facilities and the relocation of other operations during the fourth quarter of 1998. In addition, charges were recorded for certain administrative headcount reductions made in the fourth quarter of 1998. Of the total charges recorded, approximately $2,500 was paid in 1998 and $3,600 will be paid during 1999.
1997 RESTRUCTURING CHARGE
During the fourth quarter of 1997, the Company reported a pre-tax charge of $130,804 related to the acquisition and integration of Designer Holdings, the Intimate Apparel consolidation and
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
realignment program initiated in 1996 and other items, including the final disposition of Hathaway assets:
The charge consists primarily of a write-down of asset values, severance and other employee costs, costs related to manufacturing realignment and lease and other costs to combine existing retail outlet stores with those of Designer Holdings.
During the fourth quarter of 1997, the Company increased the scope of the consolidation and restructuring of the Intimate Apparel Division started in 1996, primarily as a result of increased production volumes and demand experienced throughout the year. Accordingly, additional products and styles were discontinued and slower moving inventory liquidated.
MERGER RELATED INTEGRATION COSTS
Designer Holdings and the Company previously operated retail outlets in several common locations, which the Company elected to consolidate. As a result, the Company provided for anticipated lease termination costs, write-off of related fixed assets and the close-out of store inventories and surplus stocks not considered suitable for redirected marketing efforts in the new store format. The Company also reduced the number of new Designer Holdings retail stores previously planned. In addition, following the merger in December 1997, the Company consolidated the credit and collection functions of the companies and initiated a program of consolidating receivables from common customers, offering favorable settlement of prior balances to accelerate collection efforts.
The consolidation of other administrative functions for the Company and Designer Holdings, which is substantially complete, has resulted in workforce reductions and closure of office facilities and will generate $19,000 of annual savings. Additional reductions and closures are being considered to maximize savings.
A summary of the merger related integration costs follows:
CONSOLIDATION AND REALIGNMENT
The Company expanded the intimate apparel consolidation and realignment program initiated in 1996 to include other products and facilities. As a result, increased production volumes and demand was experienced throughout the year. Accordingly, additional products and styles were discontinued and slower moving inventory liquidated, incurring markdown losses to accommodate the increased volumes of higher margin merchandise. The consolidation of retail stores and related restocking plans was also a factor. Further reconfiguration of manufacturing facilities and the merger of Warner's Europe with Lejaby operations achieved a workforce reduction greater than originally anticipated but delayed
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
realization of anticipated efficiencies and resulted in additional costs including severance and termination costs, primarily expensed as incurred.
A summary of consolidation and realignment costs follows:
OTHER
The planned disposition of assets retained from the Hathaway sale was achieved on terms less favorable than expected. In addition, insurance recoveries related to a prior year customer bankruptcy were less than anticipated. As a result of the above, charges incurred in 1997 exceeded estimates previously accrued by $21,346 ($13,154 net of income tax benefits).
In the aggregate, the non-cash portion of the 1997 non-recurring item is $96,600 pre-tax and related primarily to the write-off of inventory, accounts receivable and other assets. The cash portion of $34,200 pre-tax relates to severance and other employee costs, remaining obligations under leases and facility costs, of which $29,000 was incurred and paid in 1997 and $5,200 is expected to be paid in fiscal 1998. The reserve balance at January 3, 1998 was $31,028 which includes the 1996 reserve balance of $3,000, primarily for lease termination costs less minor expenditures in 1997. These reserves were fully utilized during fiscal 1998.
1996 RESTRUCTURING CHARGE
In 1996, the acquisition of the GJM businesses significantly added to the Company's low cost manufacturing capacity and resulted in an immediate expansion of product lines. As a result of this and the acquisition of Bodyslimmers and Lejaby, the Company undertook a strategic review of its businesses and manufacturing facilities. The Company recorded non-recurring charges aggregating $138,540 ($88,804 net of income tax benefits) for actions taken as a result of this review, including disposition of the Hathaway men's dress shirt business. The balance of reserves related to this charge was fully utilized as of the end of fiscal 1998.
EXIT FROM THE HATHAWAY BUSINESS
On May 6, 1996, after a careful evaluation of the Company's Hathaway men's dress shirt operations, the Company announced that it had decided to cease manufacturing and marketing this brand. On November 12, 1996 the Company sold to an investor group, certain assets comprising the Hathaway dress shirt manufacturing operations in Waterville, Maine and Prescott, Ontario including certain inventory, property and equipment and other assets (the 'Hathaway Assets').
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
Losses recorded in fiscal 1996 related to the Hathaway business are summarized as follows:
INTIMATE APPAREL DIVISION CONSOLIDATION AND REALIGNMENT
In April 1996, the Company announced the consolidation and realignment of certain of its intimate apparel manufacturing, distribution, selling and administrative functions and facilities in the United States and Europe. The consolidation and realignment resulted in a non-recurring charge in fiscal 1996 of $46,198, net of income tax benefits of $25,875. The closing of several manufacturing facilities and consolidation of certain distribution operations resulted in the Company incurring certain integration costs in its remaining manufacturing facilities to reconfigure product assortments and retrain existing personnel. The costs attendant to the realignment and retraining incurred in fiscal 1996 amounted to approximately $16,100.
In order to maximize the cost savings and efficiencies made available through the consolidation of facilities and the additional volumes contemplated as a result of the Lejaby, GJM and Bodyslimmers acquisitions, the Company re-evaluated the viability of all product lines and styles. As a result, certain products and styles were discontinued to permit the investment of working capital in products and styles with greater returns. The liquidation of these products resulted in mark down losses of approximately $18,070 in fiscal 1996.
A summary of the total intimate apparel division consolidation and realignment charge follows:
OTHER
Other non-recurring items of $13,083, net of income tax benefits of $7,326, were incurred and paid in fiscal 1996.
The addition of the GJM manufacturing and administrative organization enabled the Company to begin manufacturing and direct sourcing certain products which had been previously outsourced through a buying agent. This has resulted in significant ongoing cost savings to the Company. The pre-tax cost of terminating the existing agency contract was $2,693.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
The Company has recognized other opportunities for further cost savings by consolidating certain administrative and sales functions in Europe following the Lejaby acquisition. Actions taken in fiscal 1996, primarily reductions in existing staff, resulted in a non-recurring pretax charge of $6,066.
In order to achieve an early resolution of the insurance claims related to the destruction of one of the Company's distribution centers as a result of the 1994 California earthquake, the Company accepted a cash settlement offer of approximately $19,000 and wrote-off the remaining receivable of $6,082. The Company also wrote off certain other claims of approximately $2,568. The write off of these amounts resulted in a pre-tax charge of $8,650.
In June 1996, the Company announced its intent to merge with Authentic Fitness Corporation. On July 25, 1996, the Company announced the termination of the merger. The Company incurred legal, accounting and investment advisory fees in connection with the proposed merger of $3,000.
NOTE 4 - SALE OF ACCOUNTS RECEIVABLE
In October 1998, the Company entered into a five-year revolving receivables securitization facility whereby it can sell up to a $200,000 undivided interest in a defined pool of its U.S. trade accounts receivable through a bankruptcy remote special purpose subsidiary. The amount of receivables sold varies based upon the availability of the designated pool of eligible receivables and is directly affected by changing business volumes. At January 2, 1999, accounts receivable are presented net of $170,500 of trade receivables sold. The sale is reflected as a reduction of accounts receivable and the proceeds received are included in cash flows from operating activities. Fees for this program are paid monthly and are based on variable rates indexed to commercial paper.
NOTE 5 - RELATED PARTY TRANSACTIONS
In 1990, the Company sold its Activewear Division to a newly formed company, Authentic Fitness Corporation ('Authentic Fitness'). Certain directors and officers of the Company are also directors and officers of Authentic Fitness. From time to time, the Company and Authentic Fitness jointly negotiate contracts and agreements with vendors and suppliers. In fiscal 1996, 1997 and 1998, Authentic Fitness paid the Company $5,446, $5,607 and $15,566, respectively for certain occupancy services related to leased facilities, computer services, laboratory testing, transportation and contract production services. In fiscal 1996, 1997 and 1998, the Company paid Authentic Fitness approximately $1,244, $1,299 and $462, respectively, for certain design and occupancy services. The Company also purchased inventory from Authentic Fitness for sale in its retail outlet stores of $15,531, $16,201 and $11,223 in fiscal 1996, 1997 and 1998, respectively. The net amount due (to) from Authentic Fitness at January 3, 1998 and January 2, 1999 was $2,607 and $(784), respectively. Outstanding balances were settled in fiscal 1997 and 1998, resulting in the write-off by the Company of $2,875 and $4,139, respectively.
In June 1995, the Company acquired for $1,000 a sub-license from Authentic Fitness to design, manufacture and distribute certain intimate apparel using the Speedo brand name. The Company recognized royalty expense of $469, $293 and $58 in fiscal 1996, 1997 and 1998, respectively.
A director and a stockholder of the Company is the sole stockholder, President and a director of The Spectrum Group, Inc. ('Spectrum'). The Company recognized consulting expenses of $500, $500 and $560 in fiscal 1996, 1997 and 1998, respectively, pursuant to a consulting agreement with Spectrum that expires in May 2000. A director of the Company provides consulting services to the Company from time to time and received $125 for such services in fiscal 1998. A director of the Company is a partner in a law firm which provides legal services to the Company from time to time.
The Company believes that the terms of the relationships and transactions described above are at least as favorable to the Company as could have been obtained from an unaffiliated third party.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
NOTE 6 - BUSINESS SEGMENTS AND GEOGRAPHIC INFORMATION
BUSINESS SEGMENTS
In fiscal 1998, the Company adopted SFAS No. 131, 'Disclosures about Segments of an Enterprise and Related Information.' SFAS 131 establishes standards for reporting information about operating segments and related disclosures about products and services, geographic areas and customers.
The Company designs, manufactures and markets apparel within the Intimate Apparel and Sportswear and Accessories markets and operates a Retail Outlet Store Division for the disposition of excess and irregular inventory.
The Intimate Apparel Division designs, manufactures and markets moderate to premium priced intimate apparel for women under the Warner's'r', Olga'r', Calvin Klein'r', Lejaby'r', Van Raalte'r', Fruit of the Loom'r' and Bodyslimmers'r' brand names, and men's underwear under the Calvin Klein'r' brand name.
The Sportswear and Accessories Division designs, manufactures, imports and markets moderate to premium priced men's apparel and accessories under the Chaps by Ralph Lauren'r' and Calvin Klein brand names.
The Retail Outlet Stores principally sell the Company's products to the general public through 114 outlets for the disposition of excess and irregular inventory and to shift to more profitable intimate apparel stores to improve its margins. The Company does not manufacture or source products exclusively for the retail outlet stores.
The accounting policies of the segments are the same as those described in the 'Summary of Significant Accounting Policies' in Note 1. Transfers to the Retail Outlet Stores occur at standard cost and are not reflected in net revenues of the Intimate Apparel or Sportswear and Accessories segments. The Company evaluates the performance of its segments based on earnings before interest, taxes, depreciation and amortization of intangibles and deferred financing costs and restructuring, special charges and other non-recurring items, as well as the effect of the early adoption of SOP 98-5 and other start-up related production and inefficiency costs ('Adjusted EBITDA').
Information by business segment is set forth below:
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
A reconciliation of total segment Adjusted EBITDA to total consolidated income (loss) before taxes and cumulative effect of a change in accounting principle for fiscal years 1996, 1997 and 1998 is as follows:
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* Includes Corporate items not allocated to business segments.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
GEOGRAPHIC INFORMATION
Included in the consolidated financial statements are the following amounts relating to geographic locations:
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(1) Long-lived assets represent net property, plant and equipment.
INFORMATION ABOUT MAJOR CUSTOMERS
The Company has one customer representing 10.2% of consolidated net revenues for the fiscal year ended January 2, 1999. Such revenues are included in the Intimate Apparel and Sportswear and Accessories segments. The Company does not believe that the loss of this one customer would have a material adverse effect on the Company.
NOTE 7 - INCOME TAXES
The following presents the United States and foreign components of income from operations before income taxes and the total provision (benefit) for United States federal and other income taxes:
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
The provision (benefit) for income tax is included in the financial statements as follows:
The following presents the reconciliation of the provision for income taxes to United States federal income taxes computed at the statutory rate:
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(1) Includes pre-tax impact of cumulative effect of accounting change of $71,483.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
The Company has estimated United States net operating loss carryforwards of approximately $385,200 and foreign net operating loss carryforwards of approximately $18,300 which, if unused, will expire from 2003 through 2018.
As of January 2, 1999 and January 3, 1998, the Company had total gross deferred tax assets of $203,616 and $138,008, respectively, and gross deferred tax liabilities of $124,671 (of which $3,727 relates to foreign entities) and $100,015, respectively. Valuation allowances at January 2, 1999 and January 3, 1998 were $6,802 (of which $6,399 relates to foreign entities) and $17,620 (of which $6,520 relates to foreign entities). During fiscal 1998, the Company reduced the income tax valuation allowance maintained with respect to certain of the deferred tax assets arising from its foreign operations by $10,818. Significant deferred tax assets at January 2, 1999 and January 3, 1998 were for operating costs not currently deductible for tax purposes, net operating loss carryforwards and postretirement benefits and totaled $187,931 and $112,623, respectively. Significant deferred tax liabilities at January 2, 1999 and January 3, 1998 were for operating costs previously deducted for tax purposes, depreciation and amortization differences, inventory and deferred expenses and totaled $110,063 and $85,416, respectively.
The change in net deferred tax assets between January 3, 1998 and January 2, 1999 is primarily the result of recording the tax effect of additional net operating loss carryforwards created during the year. At January 2, 1999, other current assets include current taxes receivable of $3,970 (of which $1,913 relates to foreign entities) and current liabilities include current deferred tax liabilities of $14,276. At January 3, 1998, other current assets include current tax receivables of $14,395 and current deferred income taxes of $809.
NOTE 8 - EMPLOYEE RETIREMENT PLANS
The Company has a defined benefit pension plan which covers substantially all non-union domestic employees (the 'Pension Benefit Plan'). The Plan is noncontributory and benefits are based upon years of service. The Company also has defined benefit health care and life insurance plans that provide postretirement benefits to retired employees and former directors ('Other Benefit Plans'). The Other Benefit Plans are contributory with retiree contributions adjusted annually.
The components of net periodic benefit cost is as follows:
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
A reconciliation of the balance of the benefit obligation is as follows:
A reconciliation of the change in the fair value of plan assets is as follows:
Pension Benefit Plan assets include fixed income securities and marketable equity securities, including 81,800, 212,000 and 340,000 shares of the Company's Class A Common Stock, which had a fair market value of $2,423, $6,652 and $8,585 at January 4, 1997, January 3, 1998 and January 2, 1999, respectively. The Pension Benefit Plan also owned 112,500 shares of Authentic Fitness' common stock at January 4, 1997 and January 3, 1998, respectively, and 502,800 shares at January 2, 1999. Such shares had a fair market value of $1,350, $2,095 and $9,176 at January 4, 1997, January 3, 1998 and January 2, 1999, respectively.
The Company contributes to a multi-employer defined benefit pension plan on behalf of union employees of its two manufacturing facilities and a warehouse and distribution facility, which amounts are not significant for the periods presented.
The weighted-average assumptions used in the actuarial calculations were as follows:
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
For measurement purposes, the weighted average annual assumed rate of increase in the per capita cost of covered benefits (health care cost trend rate) was 9% for the years through 2000 and 5% for the years 2001 and beyond. Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
The Company also sponsors a defined contribution plan for substantially all of its domestic employees. Employees can contribute to the plan, on a pre-tax and after-tax basis, a percentage of their qualifying compensation up to the legal limits allowed. The Company contributes amounts equal to 15.0% of the first 6.0% of employee contributions to the defined contribution plan. The maximum Company contribution on behalf of any employee is $1,350 in one year. Employees vest in the Company contribution over four years. Company contributions to the defined contribution plan totaled $300, $281 and $386 for the years ended January 4, 1997, January 3, 1998 and January 2, 1999, respectively.
NOTE 9 - INVENTORIES
NOTE 10 - DEBT
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
Approximate maturities of long-term debt as of January 2, 1999 are as follows:
In August and November 1997, the Company entered into Bank Credit Agreements ('1997 Bank Credit Agreements') with substantially the same lenders as those in the Company's previous bank credit agreements. The 1997 Bank Credit Agreements provided for a five year revolving credit facility in the amount of $600,000 (the 'Five Year Facility'), a 364 day credit facility in the amount of $200,000 (the '364 Day Credit Facility,' and together with the Five Year Facility, '1997 Revolving Credit Facilities') and a $300,000 Trade Letter of Credit Facility ('1997 L/C Facility'). The 364 Day Credit Facility is extendable for additional 364 day periods, and was extended as such in November 1998. In July 1998, the 1997 L/C Facility was increased to $450 million. These facilities are not limited to any borrowing base and are essentially unsecured.
Amounts outstanding under the 1997 Bank Credit Agreements bear interest at the Bank's base lending rate or at the Eurodollar rate plus a margin. The applicable margin and the commitment fee payable on the unused portion of the facilities decreases as the Company's implied senior debt rating improves. As of January 2, 1999, the Company was required to pay a margin of 0.35% over the Eurodollar rate on its borrowings under both the Five Year Facility and the 1997 L/C Facility, and 0.50% over the Eurodollar rate on its borrowings under the 364 Day Credit Facility. At January 2, 1999, the applicable commitment fee on the average unused portion was 0.090% per annum under the 1997 Revolving Credit Facilities and 0.075% per annum under the 1997 L/C Facility. At January 3, 1998 and January 2, 1999, the Company had additional credit available under the 1997 Bank Credit Agreements of $633,682 and $489,092, respectively.
The 1997 Bank Credit Agreements contain various financial and non-financial covenants related to additional debt, liens on Company property, mergers, investments in other entities, asset sales and other items. The Company was in compliance with all of the covenants under its credit agreements for the three fiscal years ended January 2, 1999.
The 1997 L/C Facility provides for the issuance of commercial letters of credit for the purchase of inventory from suppliers and offers the Company extended terms, for periods of up to 180 days ('Trade Drafts'). The Company classifies the 180 day Trade Drafts in trade accounts payable. As of January 3, 1998 and January 2, 1999, the amount of Trade Drafts outstanding was $111,172 and $308,806, respectively. Also at January 3, 1998 and January 2, 1999, the Company had outstanding letters of credit totaling approximately $64,037 and $129,802, respectively. Letters of credit issued under this facility are not recognized on the balance sheet.
The Company entered into credit agreements related to the purchase of Lejaby in the third quarter of 1996 with several members of its existing bank group ('1996 Bank Credit Agreements'). The terms of the 1996 Bank Credit Agreements are substantially the same as those of the 1997 Bank Credit Agreements and include a term loan facility of 370 million French Francs and revolving loan facilities of 120 million French Francs. The term loan is being repaid in annual installments which began in July 1997, with a final installment due on December 31, 2001. In addition, the 1996 Bank Credit Agreements included a 120 million French Franc revolving loan facility that originally was scheduled to mature in December 2001. In April 1998, the revolving loan facility was increased to 480 million French Francs and the maturity was extended to April 2003. Borrowings under the term loan and revolving loan
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
facility bear interest at LIBOR plus 0.35%. As of January 2, 1999, the Company had approximately $83,100 of additional credit available under the revolving loan portion of the 1996 Bank Credit Agreement.
The Company and certain of its foreign subsidiaries have entered into credit agreements that provide for revolving lines of credit and issuance of letters of credit ('Foreign Credit Facilities'). At January 2, 1999 and January 3, 1998, the total amounts of the Foreign Credit Facilities was approximately $94,300 and $71,300, respectively of which approximately $52,000 and $45,300, respectively was available.
In July 1998, the Company entered into a term loan agreement with a member of its existing bank group. The balance of this loan as of January 2, 1999 was $20,706 and carried a fixed interest rate of 6.8%. This loan is due to be repaid in installments beginning in 2001 with a final maturity date of July 2006. During the second half of 1998, two other members of the existing bank group made available to the Company, on an uncommitted basis, a total of $45,000 in short term credit facilities. As of January 2, 1999, the Company had no outstanding borrowings under these facilities.
As of January 3, 1998, the Company had four interest rate swap agreements in place which were used to convert variable interest rate borrowings of $356,500 to fixed interest rates. Under these agreements, borrowings of $150,000 were fixed at 5.67% until maturity in October 1998, borrowings of $6,500 were fixed at 6.60% until maturity in July 2006, borrowings of $125,000 were fixed at 5.76% until maturity in September 2002 and borrowings of $75,000 were fixed at 5.79%, until maturity in September 2002. During 1998, an additional swap agreement was added and two existing swaps were amended. As of January 2, 1999, the Company had four interest rate swap agreements in place which effectively converted $616,500 of variable rate borrowings to fixed interest rates. Under these new and amended agreements, borrowings of $610,000 were fixed at 5.99% until maturity in September 2004 and borrowings of $6,500 were fixed at 6.60% until maturity in July 2006. These swaps are utilized to convert floating rate to fixed rate obligations and are not entered into for speculative purposes. The counterparties to all of the Company's interest rate swap agreements are banks who are lenders in the 1997 Bank Credit Agreements. Differences between the fixed interest rate on each swap and the one month or three month LIBOR rate are settled at least quarterly between the Company and each counterparty. Pursuant to its interest rate swap agreements, the Company made payments totaling $524 in the year ended January 3, 1998 and received payments totaling $575 in the year ended January 2, 1999.
The Company's average interest rate on its outstanding debt, after giving effect to the interest rate swap agreements, was approximately 5.92% and 5.99% at January 3, 1998 and January 2, 1999, respectively.
NOTE 11 - MANDATORILY REDEEMABLE PREFERRED SECURITIES
In 1996, Designer Holdings issued 2.4 million Company-obligated mandatorily redeemable convertible preferred securities of a wholly owned subsidiary (the 'Preferred Securities') for aggregate gross proceeds of $120,000. The Preferred Securities represent preferred undivided beneficial interests in the assets of Designer Finance Trust ('Trust'), a statutory business trust formed under the laws of the State of Delaware in 1996. Designer Holdings owns all of the common securities representing undivided beneficial interests of the assets of the Trust. Accordingly, the Trust is included in the consolidated financial statements of the Company. The Trust exists for the sole purpose of (i) issuing the Preferred Securities and common securities (together with the Preferred Securities, the 'Trust Securities'), (ii) investing the gross proceeds of the Trust Securities in 6% Convertible Subordinated Debentures of Designer Holdings due 2016 ('Convertible Debentures') and (iii) engaging in only those
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
other activities necessary or incidental thereto. The Company indirectly owns 100% of the voting common securities of the Trust which is equal to 3% of the Trust's total capital.
Each Preferred Security is convertible at the option of the holder thereof into 0.6888 of a share of Common Stock, par value $.01 per share, of the Company, or 1,653,177 shares of the Company's Common Stock in the aggregate, at an effective conversion price of $72.59 per share of common stock, subject to adjustments in certain circumstances.
The holders of the Preferred Securities are entitled to receive cumulative cash distributions at an annual rate of 6% of the liquidation amount of $50.00 per Preferred Security, payable quarterly in arrears. The distribution rate and payment dates correspond to the interest rate and interest payment dates on the Convertible Debentures, which are the sole assets of the Trust. As a result of the acquisition of Designer Holdings by the Company, the Preferred Securities were adjusted to their estimated fair value at the date of acquisition of $100,500, resulting in a decrease in their recorded value of approximately $19,500. This decrease is being amortized, using the effective interest rate method to maturity of the Preferred Securities. As of January 2, 1999, the unamortized balance is $18,164. Such distributions and accretion to redeemable value are included in interest expense.
The Company has the right to defer payments of interest on the Convertible Debentures and distributions on the Preferred Securities for up to twenty consecutive quarters (five years), provided such deferral does not extend past the maturity date of the Convertible Debentures. Upon the payment, in full, of such deferred interest and distributions, the Company may defer such payments for additional five-year periods.
The Preferred Securities are mandatorily redeemable upon the maturity of the Convertible Debentures on December 31, 2016, or earlier to the extent of any redemption by the Company of any Convertible Debenture, at a redemption price of $50.00 per share plus accrued and unpaid distributions to the date fixed for redemption. In addition, there are certain circumstances wherein the Trust will be dissolved, with the result that the Convertible Debentures will be distributed pro-rata to the holders of the Trust Securities.
The Company has guaranteed, on a subordinated basis, distributions and other payments due on the Preferred Securities ('Guarantee'). In addition, the Company has entered into a supplemental indenture pursuant to which it has assumed, as a joint and several obligor with Designer Holdings, liability for the payment of principal, premium, if any, and interest on the Convertible Debentures, as well as the obligation to deliver shares of Common Stock, par value $.01 per share, of the Company upon conversion of the Preferred Securities as described above. The Guarantee, when taken together with the Company's obligations in respect of the Convertible Debentures, provides a full and unconditional guarantee of amounts due on the Preferred Securities.
The following is summarized financial information of Designer Holdings as of January 3, 1998 and January 2, 1999 and for each of the three fiscal years ended January 2, 1999, respectively.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
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(a) Certain amounts for the year ended December 31, 1996 have been reclassified to cost of goods sold to conform to the current year presentation.
(b) Excludes net revenues of $84.5 million now reported as Retail Division net revenues. As a result of the continuing integration of Designer Holdings into the operations of the Company, cost of goods sold and net income associated with these revenues cannot be separately identified.
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The summarized balance sheet information as of January 3, 1998 and January 2, 1999 reflects the effect of the acquisition by the Company. Stockholders' equity represents the purchase price paid plus earnings from the time of acquisition. The income statement information for the year ended December 31, 1996 and the nine months ended September 30, 1997 is presented on a historical basis and does not reflect the effect of the acquisition by the Company. The above information is not indicative of the future operating results primarily due to the integration of the operations of Designer Holdings with the operations of the Company, the redirected marketing efforts in the new store format and redirected marketing strategy.
NOTE 12 - STOCKHOLDERS' EQUITY
On June 30, 1995 the Company paid its first quarterly dividend on its Common Stock. Total dividends declared during fiscal years 1996, 1997 and 1998 were $14,532 ($0.28 per share), $17,265 ($0.32 per share) and $22,423 ($0.36 per share), respectively.
The Company has 10,000,000 shares of authorized and unissued preferred stock with a par value of $0.01 per share.
Stock Compensation Plans
The Board of Directors and Compensation Committee's thereof are responsible for administration of the Company's compensation plans and determine, subject to the provisions of the plans, the number of shares to be issued, the terms of awards, the sale or exercise price, the number of shares awarded and the rate at which awards vest or become exercisable.
1988 Employee Stock Purchase Plan
In 1988, the Company adopted the 1988 Employee Stock Purchase Plan ('Stock Purchase Plan') which provides for sales of up to 4,800,000 shares of Class A Common Stock of the Company to certain key employees. At January 3, 1998 and January 2, 1999, 4,521,300 shares were issued and outstanding pursuant to grants under the Stock Purchase Plan. All shares were sold at amounts determined to be equal to the fair market value. In addition, certain employees elected to pay for the shares granted by executing promissory notes payable to the Company. Notes totaling $5,971 were outstanding at January 3, 1998 and were repaid during fiscal 1998. Notes receivable from employees are deducted from stockholders' equity and were principally owed by an officer and director of the Company.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
1991 Stock Option Plan
In 1991, the Company established The Warnaco Group, Inc. 1991 Stock Option Plan ('Option Plan') and authorized the issuance of up to 1,500,000 shares of Class A Common Stock pursuant to incentive and non-qualified option grants to be made under the plan. The Option Plan limits the amount of qualified stock options that may become exercisable by any individual during a calendar year. Options generally expire 10 years from the date of grant and vest ratably over 4 years.
1993 Stock Plan
On May 14, 1993, the stockholders approved the adoption of The Warnaco Group, Inc. 1993 Stock Plan ('Stock Plan') which provides for the issuance of up to 2,000,000 shares of Class A Common Stock of the Company through awards of stock options, stock appreciation rights, performance awards, restricted stock units and stock unit awards. On May 12, 1994, the stockholders approved an amendment to the Stock Plan whereby the number of shares issuable under the Stock Plan is automatically increased each year by 3% of the number of outstanding shares of Class A Common Stock of the Company as of the beginning of each fiscal year. The exercise price of any stock option award may not be less than the fair market value of the Company's Common Stock at the date of the grant. Options generally expire 10 years from the date of grant and vest ratably over 4 years.
In accordance with the provisions of the Stock Plan, the Company granted 137,135 and 182,903 shares of restricted stock to certain employees, including certain officers of the Company, during the fiscal years ended January 3, 1998 and January 2, 1999, respectively. The restricted shares vest over four years. The fair market value of the restricted shares was $3,601 and $7,682 at the dates of grant, respectively. The Company recognizes compensation expense equal to the fair value of the restricted shares over the vesting period. Compensation expense for the fiscal years ended January 4, 1997, January 3, 1998 and January 2, 1999 was $2,502, $3,322 and $4,978, respectively. During 1997 and 1998, 18,250 and 16,177 shares, respectively, of non-vested restricted shares were canceled resulting in a reduction in unvested compensation of $481 and $667, respectively. Unvested stock compensation at January 3, 1998 and January 2, 1999 was $9,734 and $11,772, respectively, and is deducted from stockholders' equity.
1993 Non-Employee Director Stock Plan and 1998 Director Plan
In May 1994, the Company's stockholders approved the adoption of the 1993 Non-Employee Director Stock Plan ('Director Plan'). The Director Plan provides for awards of non-qualified stock options to non-employee directors of the Company. Options granted under the Director Plan are exercisable in whole or in part until the earlier of ten years from the date of the grant or one year from the date on which an optionee ceases to be a Director eligible for grants. Options are granted at the fair market value of the Company's Common Stock at the date of the grant. In May 1998, the Board of Directors approved the adoption of the 1998 Stock Plan for Non-Employee Directors ('1998 Director Plan', and together with the Director Plan, 'Combined Director Plan'). The 1998 Director Plan includes the same features as the Director Plan and provides for issuance of the Company's Common Stock held in treasury. The Combined Director Plan provides for the automatic grant of options to purchase (i) 30,000 shares of Common Stock upon a Director's election to the Company's Board of Directors and (ii) 20,000 shares of Common Stock immediately following each annual shareholders' meeting as of the date of such meeting.
1997 Stock Option Plan
In 1997, the Company's Board of Directors approved the adoption of The Warnaco Group, Inc. 1997 Stock Option Plan ('1997 Plan') which provides for the issuance of incentive and non-qualified
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
stock options and restricted stock up to the number of shares of common stock held in treasury. The Plan limits the amount of qualified stock options that may become exercisable by any individual during a calendar year and limits the vesting period for options awarded under the 1997 Plan.
A summary of the status of the Company's stock option plans are presented below:
Summary information related to options outstanding and exercisable at January 2, 1999 is as follows:
The Company has reserved 120,000 shares of Class A Common Stock for issuance under the Director Plan, Stock Plan and Option Plan as of January 2, 1999. In addition, there are 6,087,674 shares of Class A Common Stock in treasury stock available for issuance under the 1997 Plan.
The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
The Company's pro forma information is as follows:
These pro forma effects may not be representative of the effects on future years because of the prospective application required by SFAS No. 123, and the fact that options vest over several years and new grants generally are made each year.
Stock Buyback Program
On November 14, 1996, the Board of Directors approved a stock buyback program of up to 2.0 million shares. On May 14, 1997, the Company's Board of Directors approved an increase of this program to 2.4 million shares, and on February 19, 1998, the Company's Board of Directors authorized the repurchase of an additional 10.0 million shares. During fiscal 1996, 1997 and 1998, the Company repurchased 250,000, 839,319 and 4,794,699 shares of its common stock under the repurchase programs at a cost of $7,030, $26,537 and $135,416, respectively. At January 2, 1999, there were 6,440,926 shares available for repurchase under this program. On March 1, 1999, the Company's Board of Directors approved an additional 10.0 million share repurchase.
The Company uses equity instruments, consisting of put-call option combination contracts, to facilitate its repurchase of common stock. At January 2, 1999, the Company holds call options and has sold put options covering 1.5 million shares of common stock with an average forward price of $35.35 per share. The equity instruments are exercisable only at expiration of the contracts, with expiration dates ranging from the first through third quarters of fiscal 1999. The equity instruments are settled, at the election of the Company, through physical, net share or net cash settlement. During fiscal 1997 and 1998, the Company repurchased 140,350 shares and 1,790,455 shares of common stock at a cost of $4,475 and $65,899, which is reflected in treasury stock. In addition, the Company made net cash
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
settlement payments of $1,620 and received net cash settlement payments of $2,325 under these contracts in fiscal 1997 and 1998, respectively, which are reflected in additional paid-in-capital. If the arrangements were settled on a net cash basis at January 2, 1999, the Company would be obligated to pay $15,114 based on the closing market price of the Company's common stock.
NOTE 13 - EARNINGS (LOSS) PER SHARE
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(1) Fiscal 1996 and 1997 have been revised as described in Note 1.
Options to purchase 7,456,708 shares of common stock at prices ranging from $26.06 to $42.88 per share were outstanding during fiscal 1998 but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares. The options, which expire from April 2006 to November 2008, were still outstanding at the end of fiscal 1998. Incremental shares issuable on the assumed conversion of the Preferred Securities (1,653,177 shares) were not included in the fiscal 1997 and 1998 computation of diluted earnings per share as the impact would have been antidilutive for each period presented. Options to purchase 5,217,500 shares of common stock at a price of $25.25 per share were granted on January 4, 1999. Such options expire on January 4, 2009.
NOTE 14 - LEASE COMMITMENTS
During fiscal 1997, the Company sold certain fixed assets for net book value of approximately $33,223. The assets were leased back from the purchaser, under the terms of an operating lease, over a six-year period. In fiscal 1998, the Company sold certain equipment for cash proceeds of $21,713, which approximated net book value. The equipment was leased back from the purchaser under an operating lease with an initial term of three years and a one-year renewal option. Under the terms of certain
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
operating leases, the Company guarantees a portion of the residual value loss, if any, incurred by the lessors in remarketing or disposing the related assets upon lease termination or expiration. The Company believes, based on existing facts and circumstances and current values of such equipment, that a material payment pursuant to such guarantee is unlikely.
Rental expense was $19,923, $24,492 and $35,534 for the years ended January 4, 1997, January 3, 1998 and January 2, 1999, respectively.
The following is a schedule of future minimum rental payments required under operating leases with terms in excess of one year, as of January 2, 1999:
NOTE 15 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments.
Revolving, term loans and other borrowings. The carrying amounts of the Company's outstanding balances under its various Bank Credit Agreements and other outstanding debt approximate the fair value because the interest rate on the outstanding borrowings is variable and there are no prepayment penalties.
Redeemable preferred securities. These securities are publically traded on the New York Stock Exchange. The fair market value was determined based on the closing price on December 31, 1998, the last trading date prior to the end of the fiscal year.
Interest rate swap agreements. The Company has entered into interest rate swap agreements which have the effect of converting a portion of the Company's outstanding variable rate debt into fixed rate debt. The fair value of the Company's agreements to fix the interest rate on $616,500 of its outstanding debt is based upon quotes from brokers and represents the cash requirement if the existing agreements had been settled at year end.
Letters of credit. Letters of credit collateralize the Company's obligations to third parties and have terms ranging from 30 days to one year. The face amount of the letters of credit are a reasonable estimate of the fair value since the value for each is fixed over its relatively short maturity.
Equity option arrangements. These arrangements can be settled, at the Company's option, by the purchase of shares, on a net basis in shares of the Company's common stock or on a net cash basis. To the extent that the market price of the Company's common stock on the settlement date is higher or lower than the forward purchase price, the net differential can be paid or received by the Company.
Foreign currency transactions. During 1998, the Company entered into various foreign currency forward and option contracts which were used as hedges for various commercial transactions. As of January 2, 1999, the Company did not have any open foreign currency forward contracts. The fair value of open foreign currency option contracts is based upon quotes from brokers and reflects the cash benefit if the existing contracts had been sold.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
The carrying amounts and fair value of the Company's financial instruments as of January 3, 1998 and January 2, 1999, are as follows:
NOTE 16 - CASH FLOW INFORMATION
NOTE 17 - LEGAL MATTERS
The Company is not a party to any litigation or other claims or uncertainty, other than routine litigation incidental to the business of the Company, that individually or in the aggregate is material to the business of the Company.
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
NOTE 18 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Note: The sum of the quarters' per share amounts do not equal the full year amounts.
The Company's fiscal 1998 quarterly results of operations have been revised with respect to the effects of the early adoption of SOP 98-5 and the accounting for other start-up related inventory production and inefficiency costs, as described in Note 1. Gross profit, before revisions for the first, second, third and fourth quarters was $148,353, $150,930, $186,931 and $141,425, respectively. The revisions decreased gross profit by $28,803, $19,434, $26,539 and $15,648 and resulted in revised gross profit of $119,550, $131,496, $160,392 and $125,777 for the first, second, third and fourth quarters, respectively. Income (loss) before cumulative effect of a change in accounting before revisions for the first, second, third and fourth quarters was $24,723 ($0.39 per diluted share), $25,514 ($0.40 per diluted share), $44,115 ($0.70 per diluted share), and $(21,751) ($0.37 per diluted share), respectively. The revisions decreased income before the cumulative effect of a change in accounting by $18,635 ($0.29 per diluted share), $12,574 ($0.20 per diluted share), $17,171 ($0.27 per diluted share) and $10,124 ($0.17 per diluted share) and resulted in revised income (loss) before the cumulative effect of a change in accounting of $6,088 ($0.10 per diluted share), $12,940 ($0.20 per diluted share), $26,944 ($0.43 per diluted share) and $(31,875) ($0.54 per diluted share) for the first, second, third and fourth quarters, respectively. Net income (loss) before revisions for the first, second, third and fourth quarters was $24,723 ($0.39 per diluted share), $25,514 ($0.40 per diluted share), $44,115 ($0.70 per diluted share) and $(21,751) ($0.37 per diluted share), respectively. The revisions changed net income (loss) by $64,885 ($1.02 per diluted share), $12,574 ($0.20 per diluted share), $17,171 ($0.27 per diluted share) and $10,124 ($0.17 per diluted share) and resulted in a net loss of $40,162 ($0.63 per diluted share) for the first quarter and net income of $12,940 ($0.20 per diluted share) and $26,944 ($0.43 per diluted share)
THE WARNACO GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCLUDING SHARE DATA)
for the second and third quarters and a net loss of $31,875 ($0.54 per diluted share) for the fourth quarter, respectively.
Note: The sum of the quarters per share amounts do not equal the full year amounts.
The Company's fiscal 1997 quarterly results of operations have been revised with respect to accounting for other start-up related production and inefficiency costs as described in Note 1. Gross profit, before revisions for the first, second, third and fourth quarters was $92,742, $99,305, $124,003 and $116,171, respectively. The revisions decreased gross profit by $10,951, $15,009, $13,980 and $17,077, respectively and resulted in revised gross profit of $81,791, $84,296, $110,023 and $99,094 for the first, second, third and fourth quarters, respectively. Net income (loss) before revisions for the first, second, third and fourth quarters was $18,126, ($0.34 per diluted share), $17,155 ($0.32 per diluted share), $32,081 ($0.60 per diluted share) and ($44,330) ($0.77 per diluted share), respectively. The revisions decreased net income (loss) by $6,790 ($0.13 per diluted share), $9,306 ($0.17 per diluted share), $8,668 ($0.16 per diluted share) and $10,587 ($0.19 per diluted share) and resulted in net income (loss) of $11,336 ($0.21 per diluted share), $7,849 ($0.15 per diluted share), $23,413 ($0.44 per diluted share) and ($54,917) ($0.96 per diluted share), for the first, second, third and fourth quarters, respectively.
SCHEDULE II
THE WARNACO GROUP, INC VALUATION & QUALIFYING ACCOUNTS & RESERVES (DOLLARS IN THOUSANDS)
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(1) Allowances are primarily charged to income as incurred. The allowance is adjusted at the end of each period, by a charge or credit to income, for the estimated discounts and allowances applicable to the accounts receivable then outstanding.
(2) Amounts written-off, net of recoveries.
(3) Reserves related to assets acquired in fiscal 1996 through 1998, respectively.
The above reserves are deducted from the related assets in the consolidated balance sheets. Current presentation includes amounts for cash discounts and other allowances, aside from allowances for doubtful accounts previously disclosed.
S-1
STATEMENT OF DIFFERENCES
The registered trademark symbol shall be expressed as.......................'r' | 26,145 | 172,511 |
1068120_1999.txt | 1068120_1999 | 1999 | 1068120 | ITEM 2. DESCRIPTION OF PROPERTIES
GENERAL
We occupy approximately 8,360 square feet of office space at 13760 Noel Road, Suite 1030, Dallas, Texas, under a lease that expires in October, 2003. We also occupy approximately 2,000 square feet of space in Ottawa, Ontario for offices for certain of its executive officers located there under a lease that expires in August 2003. We also lease approximately 3,475 square feet of office space at 3500 Oak Lawn, Suite 380, Dallas, Texas under a lease that expires in November, 1999. We lease property for a rig yard in New Mexico.
OTHER
For a description of our oil and natural gas properties, oil and gas reserves, acreage, wells, production and drilling activity, see "Item 1. Business."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The landowner royalty on the J.C. Martin Field is currently subject to a lawsuit that may create uncertainty regarding the Company's title to its interest in the J.C. Martin Field. See "Item 1. Business - Risk Factors" .
No other legal proceedings are pending other than ordinary routine litigation incidental to us, the outcome of which management believes will not have a material adverse effect on our financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the last 3 months of the fiscal year ended June 30, 1999, no matter was submitted by us to a vote of its stockholders through the solicitation of proxies or otherwise.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Our preferred stock are not publicly traded. The Company's common stock is principally traded on the Nasdaq SmallCap Market under the symbol "QSRI." The common stock commenced trading on the Nasdaq SmallCap Market on May 22, 1997. Prior to that date the common stock was traded in the Over-The-Counter market. The Nasdaq SmallCap Market has proposed to delist the common stock from that market. We are appealing that determination. See "Item 1. Business - Risk Factors." The following table sets forth the high and low closing bid prices for the Company's Common Stock from July 1, 1996 through June 30, 1999, based upon quotations which reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
TRANSFER AGENT
The Transfer Agent for our common stock is Continental Stock Transfer & Trust Company, 2 Broadway, New York, New York 10004.
HOLDERS
The approximate number of record holders of our common stock as of September 1, 1999 was 890, inclusive of those brokerage firms and/or clearing houses holding our common stock for their clientele (with each such brokerage house and/or clearing house being considered as one holder).
CAPITAL STOCK ISSUANCES
During the three months ended June 30, 1999, pursuant to Section 3(a) of the Securities Act of 1933, we issued 348,118 shares of common stock for no additional consideration to stockholders who exercised repricing rights included with the private placement of July 8, 1998. The repricing rights were issued in connection with the July 1998 private placement and permit the holders to acquire shares of common stock without the payment of additional consideration if the common stock does not achieve certain price thresholds in excess of the original issuance price of the shares purchased by the holders in July 1998. The resale of these shares of common stock is registered pursuant to a registration statement on Form S-3 filed with the Commission.
Additionally, pursuant to the Section 3(a) of the Securities Act of 1933, the holders of Series C preferred stock converted 50 shares of Series C preferred stock into 569,089 shares of common stock. In conjunction with those conversions, we issued 39,378 shares of common stock in payment of stock dividends. The value of these stock dividends was $39,444. The resale of these shares of common stock is registered pursuant to a registration statement on Form S-3 filed with the Commission.
DIVIDENDS
We have not declared or paid any cash dividends on our common stock during the two year period ended June 30, 1999, and do not anticipate paying cash dividends on our common stock in the foreseeable future. In addition, our credit agreement and the indenture (the "Indenture") dated as of July 1, 1998 among parent company, certain of its subsidiaries and Harris Trust and Savings Bank, as Trustee (the "Trustee") currently prohibit it from paying cash dividends. We anticipate that any income generated in the foreseeable future will be retained for the development and expansion of our business. Furthermore, dividends on the common stock are limited by the terms of our Series A Participating Convertible Preferred Stock, par value $0.01 per share, and the terms of our Series C Convertible Preferred Stock, par value $0.01 per share, which prohibit cash dividends on common stock unless all accrued and unpaid dividends on such preferred stock have been paid. Future dividend policy is subject to the discretion of the Board of Directors and will depend upon a number of factors, including future earnings, debt service, capital requirements, restrictions in our credit agreement, the Indenture and our Restated Certificate of Incorporation, as amended, business conditions, our financial condition and other factors that the Board of Directors deems relevant.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth for the periods indicated certain of our summary historical consolidated financial information. The summary historical consolidated financial information for each of the years in the five years ended June 30, 1999 have been derived from our audited consolidated financial statements. We completed material acquisitions of producing properties in each of the periods presented which affects the comparability of the historical financial and operating data for all periods presented. The summary historical information below should be read in conjunction with "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
We are an independent energy company engaged in the acquisition, development and exploitation of oil and natural gas reserves. We focus on buying and developing on-shore oil and natural gas properties located in the United States. We also strive to maintain low operating expenses. Because of our growth strategy, we also seek to maintain financial flexibility so that we have funds to purchase properties when we consider the terms to be favorable.
Our strategy is to increase its reserves, production, earnings, cash flow and net asset value by:
1. acquiring strategic oil and natural gas properties in a disciplined manner, 2. developing, exploiting and exploring our properties, 3. achieving low operating costs, and 4. maintaining financial flexibility.
Our revenues, profitability and future growth rate also substantially depend on factors beyond our control, such as economic, political and regulatory developments and competition from other sources of energy. The energy markets historically have been very volatile, and oil and natural gas prices may fluctuate widely in the future. Sustained periods of low prices for oil and natural gas could materially and adversely affect our financial position, our results of operations, the quantities of oil and natural gas reserves that we can economically produce and our access to capital.
We use the full cost method of accounting for our investment in oil and natural gas properties. Under this method, we capitalize all acquisition, exploration and development costs incurred for the purpose of finding oil and natural gas reserves, including salaries, benefits and other related general and administrative costs directly attributable to these activities. We capitalized general and administrative costs of $931,000 in 1999, $721,000 in 1998 and $316,000 during 1997. We expense costs associated with production and general corporate activities in the period incurred. We capitalize interest costs related to unproved properties and properties under development. Sales of oil and natural gas properties are accounted for as adjustments of capitalized costs, with no gain or loss recognized, unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and natural gas.
We have experienced significant growth in reserves, production, revenue and cash flow since we began operations. You should read this section 'Management's Discussion and Analysis of Financial Condition and Results of Operations' in conjunction with our Consolidated Financial Statements. The following table sets forth certain operating information for the periods presented. We acquired certain significant producing oil and natural gas producing properties during certain of the periods presented which affects the comparability of the data for the periods presented.
The following discussion of the results of operations and financial condition should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included herein.
THE YEAR ENDED JUNE 30, 1999 COMPARED TO THE YEAR ENDED JUNE 30, 1998
The following discussion and analysis reflects the operating results as if the net profits interests were accounted for as working interests. We believe that this presentation will provide you with a more meaningful understanding of the underlying operating results and conditions for the period.
RESULTS OF OPERATIONS
Revenues. Total revenues during the year ended June 30, 1999 were $33.8 million, an increase of $21.1 million over the $12.7 million for the year ended June 30, 1998. Our revenues were derived from the sale of 13.0 Bcf of natural gas at an average price per Mcf of $2.13 and 500,000 barrels of oil at an average price per barrel of $12.37. During the year ended June 30, 1998 our revenues were derived from the sale of 3.4 Bcf of natural gas, at an average price per Mcf of $2.27, and 325,000 barrels of oil, at an average price per barrel of $15.52.
The two periods are not readily comparable because of our significant growth during the year ended June 30, 1998, primarily resulting from the April 1998 acquisition of the net profits interests. Production from properties owned throughout both periods was 1.0 Bcf of gas and 223,000 barrels of oil during the year ended June 30, 1999. This represents an increase of 0.1 Bcf(14%) over the 0.9 Bcf of gas, and an decrease of 26,000 barrels (11%) from the 250,000 barrels of oil produced during the year ended June 30, 1998. The increase in gas production is a reflection of our successful exploitation and development programs implemented during the year ended June 30, 1999, offset by the natural rate of depletion of the reservoirs associated with these properties. The decrease in oil production is a combination of the decision to temporarily reduce production from certain producing areas with relatively high production costs, due to the low price of oil received during the year combined with the natural rate of depletion of the reservoirs associated with these properties. The production of oil from those properties temporarily shut in during the period of low oil prices is being restored after oil prices returned to their current higher levels. Production from properties acquired during 1998 was 11.9 Bcf of gas and 276,000 barrels of oil during 1999 as compared to 2.4 Bcf of gas and 75,000 barrels of oil during 1998.
Costs and Expenses. Operating costs and expenses for the year ended June 30, 1999, exclusive of a non-cash ceiling test write-down of $35.0 million and an extraordinary charge of $3.5 million, were $43.0 million. Of this total, lease operating expenses and production taxes were $9.1 million, general and administrative expenses were $3.5 million, interest charges were $18.3 million and depletion, depreciation and amortization costs were $11.9 million. Operating costs and expenses for the year ended June 30, 1998, exclusive of a non-cash ceiling test write-down of $28.2 million, were $17.4 million. Of this total, lease operating expenses and production taxes were $6.3 million, general and administrative costs were $2.3 million, interest charges were $4.0 million, and depletion, depreciation and amortization costs were $4.8 million.
The increase in lease operating expenses and production taxes is a result of our increased levels of oil and natural gas production. When lease operating expenses and production taxes are compared on a cost per unit basis, the cost of producing an Mcfe during the year ended June 30, 1999 decreased by $0.62 per Mcfe (52%) to $0.57 from the $1.19 per Mcfe achieved during the year ended June 30, 1998. This decrease in production costs per unit is primarily the result of the acquisition of properties in April 1998 having lower operating costs per unit than our other properties.
General and administrative expenses have increased by $1.3 million as a result of the increased size of our requiring additional employees and incremental costs; however, on a per unit basis, general and administrative expenses for the year ended June 30, 1999 were $0.22 per Mcfe, a decrease of $0.21 per Mcfe (49%) from the $0.43 per Mcfe incurred during the year ended June 30, 1998. This per unit decline in general and administrative expenses is a result of our increased level of oil and natural gas production.
Interest expense for the year ended June 30, 1999 was $18.3 million. This is comprised of $17.0 million paid or payable in cash and $1.3 million of amortized deferred costs incurred at the time that the related debt obligations were incurred. During the year ended June 30, 1998 total interest expense was $4.0 million, being comprised of $3.9 million paid or payable in cash and $0.1 million of amortized deferred costs incurred at the time that the related debt obligations were incurred. The increase of $14.3 million in interest expense is due to an increase in the average interest bearing debt outstanding. During the year ended June 30, 1999 we had average interest bearing debt outstanding of $139.3 million, as compared to $48.5 million during the year ended June 30, 1998. On a per unit basis, cash interest expense for the year ended June 30, 1999 was $1.06 per Mcfe, as compared to $0.75 per Mcfe during the year ended June 30, 1998.
The increase in depletion, depreciation and amortization costs of $7.1 million is a result of the increased volume of crude oil and natural gas produced by us and the higher per unit cost of acquisition of the properties acquired during the year ended June 30, 1998. On a cost per Mcfe of reserves the depletion, depreciation and amortization costs decreased by $0.17 per Mcfe (29%), primarily due to the effects of the non-cash writedowns of $35.0 million and $28.2 million recorded at December 31, 1998 and June 30, 1998 respectively, to reflect the impact of lower oil and natural gas prices at those two dates.
Extraordinary Loss. As a result of the placement of the $125 million of 12.5% Senior Notes in July, 1998 we unwound an interest rate hedge contract related to existing floating interest rate bridge loans at a cost of $3,549,000. As the debt hedged was retired using the proceeds from the issuance of the Senior Notes, the costs of terminating the hedge was recognized as an extraordinary loss.
Net Loss. We have incurred losses since inception, including $47.5 million ($1.51 per common share) for the year ended June 30, 1999, compared to $32.8 million ($1.44 per share) for the year ended June 30, 1998. These losses are a reflection of the low oil and natural gas prices experienced during the year ended June 30, 1999 combined with our high leverage position. We believe, but cannot assure, that as a result of the acquisitions made during the year ended June 30, 1998 our revenues from natural gas and oil are sufficient to cover our production costs and operating expenses, subject to prevailing prices for crude oil and natural gas and the volumes thereof produced by us. We enter the 2000 fiscal year (July 1, 1999 to June 30, 2000) with a plan to improve production from the properties we had acquired through June 1998 and to acquire additional oil and natural gas producing properties to provide the revenue base required to generate additional positive cash flow from operations. Our revenues, profitability and future rate of growth are substantially dependent upon prevailing prices for crude oil and natural gas and the volumes of crude oil and natural gas produced by us. In addition, our proved reserves will decline as crude oil and natural gas are produced unless we are successful in acquiring properties containing proved reserves or conducts successful exploitation and development activities.
CASH FLOW DATA
From Operations. During the year ended June 30, 1999 we generated $9.5 million from operations. The reduction in the accounts receivable of $0.7 million is primarily a reflection of the impact of reduced commodity prices received by us from the sale of crude oil and natural gas during the period April through June 1999 as compared to the same period in 1998. Accrued liabilities of $9.7 million at June 30, 1999 includes $7.8 million in accrued interest charges due on July 1, 1999. In comparison, during the year ended June 30, 1998 we generated $1.0 million from operations.
Investing Activities. During the year ended June 30, 1999 we invested $11.5 million developing our existing properties. A further $171,000 was invested in operating equipment and office equipment during the year. In addition, we generated $10.0 million in net proceeds from the sale of certain oil and natural gas properties. During the year ended June 30, 1998 we invested $154.2 million in acquiring additional natural gas and crude oil producing properties and developing existing properties. Of this amount, a total of $146.3 million was expended in three acquisition transactions. The remaining $7.9 million was spent on developing existing properties. A further $100,000 was invested in operating equipment and office equipment during the year. There were no property sales during the year ended June 30, 1998.
Financing Activities. During July 1998 we issued $125.0 million of unsecured bonds ($120.5 million net of costs) and raised an additional $31.0 million ($28.4 million net of costs) by issuing common stock. The proceeds from these bonds and the common stock were used to repay $142.2 million of short-term debt, unwind an interest rate hedge contract at a cost of $3.5 million and redeem $1.3 million (2,350,000 DEM) of Deutchemark denominated bonds. The remaining $1.9 million was added to our working capital. During November 1998 we issued $2.5 million ($2.3 million net of costs) of common stock. The proceeds were used to repurchase $2.3 million of Series C preferred stock. During January 1999 we borrowed an additional $7.0 million against the $25.0 million then available under our credit agreement, to fund our capital expenditures incurred during the period July to December 1998. During the period January to June 1999 we repaid $9.3 million of our outstanding loans under our credit agreement. At June 30, 1999 the maximum amount available under the credit agreement was $8.0 million, which represented balance outstanding at that date. Also during the year, we repaid $80,000 of a capital lease. During the year ended June 30, 1998 we raised $14.4 million by issuing
preferred and common stock and $152.5 million in short-term loans. We also issued $121,000 in Deutchemark denominated subordinated bonds. During the year we repaid $8.1 million of bank debt and $70,000 of a capital lease.
BALANCE SHEET DATA
Total Assets. At June 30, 1999 we owned assets of $119.2 million, comprised of current assets of $14.0 million, investments in oil and gas producing properties, net of accumulated depletion, depreciation and amortization, of $97.2 million and deferred assets of $8.0 million. At June 30, 1998 we owned assets of $153.7 million, comprised of current assets of $6.4 million, investments in oil and gas producing properties, net of accumulated depletion, depreciation and amortization, of $142.5 million and deferred assets of $4.8 million.
Stockholders' Equity. At June 30, 1999 we had a net stockholders' deficit of $26.5 million, primarily as a result of a total of $63.2 million of non-cash ceiling test write-downs we recorded on June 30, 1998 and December 31, 1998. During July 1998 we received $7.0 million on the exercise of warrants for 2.5 million shares of common stock, for an average exercise price of $2.83 per common share. During July and November 1998, we privately placed a total of 3.8 million common shares for $28.5 million ($23.7 million net of costs) for an average issuance price of $6.89 per common share. We also issued 1.4 million shares of common stock for no additional consideration to stockholders who exercised repricing rights included in the private placements of common stock in July and November 1998. During the year ended June 30,1999 we repurchased 2,152 Series C preferred shares for $2.3 million. In addition, 2,546 Series C preferred shares were converted into 1.3 million common shares. An additional 78,000 common shares issued as a stock dividend pursuant to these conversions.
At June 30, 1998 we had a net stockholders' deficit of $6.8 million, primarily as a result of the $28.2 million non-cash ceiling test write-down recorded during 1998. During the year ended June 30, 1998 we privately placed and issued 2,160,715 common shares for $5.2 million, for an average cash issuance price of $2.40 per common share. During the year ended June 30, 1998 we issued 1,000,000 and 337,500 common shares in connection with an acquisition, which it valued at $3.125 per share ($3,125,000) and $5.00 per share ($1,687,500), respectively. Additionally, we issued 150,000 common shares in consideration for professional services rendered, which it valued at $2.00 per share ($300,000). We also issued 10,400 shares of Series C preferred stock for $9.5 million, net of costs.
THE YEAR ENDED JUNE 30, 1998 COMPARED TO THE YEAR ENDED JUNE 30, 1997
RESULTS OF OPERATIONS
Revenues. Total revenue during the year ended June 30, 1998 were $12.7 million, an increase of $8.3 million over 1997. Operating revenue from the sale of gas and oil was $6.3 million in 1998, while revenues from net profits interests and royalty interests acquired during 1998 provided additional revenues of $4.4 million. Our revenues are derived from the sale of 3.4 Bcf of natural gas, at an average price per Mcf of $2.27, and 324,557 barrels of oil, at an average price per barrel of $15.52. During the year ended June 30, 1997 we generated operating revenue of $4.4 million from the sale of natural gas and oil. The natural gas and oil revenues for the year ended June 30, 1997 were derived from the sale of 546.3 MMcf of natural gas, at an average price per Mcf of $2.31, and 150,546 barrels of oil, at an average price per barrel of $20.73.
The two periods are not readily comparable because of the significant growth that we experienced during the years ended June 30, 1998 and 1997. Production from properties owned throughout both periods was 467.2 MMcf of natural gas and 86,295 barrels of oil during the year ended June 30, 1998. This represents an increase of 60.3 MMcf (15%) over the 407.1 MMcf of natural gas, and a decrease of 17,682 barrels (17%) from the 103,977 barrels of oil produced during the year ended June 30, 1997. The increase in natural gas production is a reflection of the successful exploitation and development programs implemented by us during the year ended June 30, 1998. The decrease in oil production is a combination of the natural rate of depletion of the reservoirs associated with these properties and temporary reductions in production as certain properties were worked over. Production from properties acquired during the 1997 and 1998 periods were 2.9 Bcf of gas and 238,262 barrels of oil during 1998 as compared to 139.2 MMcf of natural gas and 46,569 barrels of oil during 1997.
Costs and Expenses. Operating costs and expenses for the year ended June 30, 1998, exclusive of a non-cash ceiling test write-down of $28.2 million, were $17.4 million. Of this total, lease operating expenses and production taxes were $4.5 million, general and administrative costs were $2.3 million, interest charges were $4.0 million, and depletion, depreciation and amortization costs were $4.8 million. Operating costs and expenses for the year ended June 30, 1997 were $6.3 million. Of this total, lease operating expenses and production taxes were $2.5 million, general and administrative expenses were $1.5 million, interest and financing charges were $878,000, and depletion, depreciation and amortization costs were $982,000.
The increase in lease operating expenses is a result of our increased levels of oil and gas production. When lease operating expenses are compared on a cost per unit basis, the cost of producing an Mcfe, including production taxes, decreased by $0.54 per Mcfe (42%) to $1.19. This decrease in lease operating costs per unit is primarily the result of the acquisition of properties having lower operating costs per unit during the comparable periods. General and administrative expenses have increased by $807,000 as a result of our increased size requiring additional employees; however, on a per unit basis, general and administrative expenses for the year ended June 30, 1998 were $0.43 per Mcfe, a decrease of $0.57 per Mcfe (57%). This per unit decline in general and administrative expenses is a result of our increased level of oil and natural gas production. The increase in depletion, depreciation and amortization costs of $3.8 million is a result of the increased volume of crude oil and natural gas produced by us and the higher per unit cost of acquisition of the properties acquired during the year ended June 30, 1998. On a cost per Mcfe of reserves the depletion, depreciation and amortization costs increased by $0.23 per Mcfe (34%).
Pursuant to Commission regulations, we recorded a $28.2 million non-cash write-down of the carrying value of our oil and natural gas properties to reflect the impact of low oil and natural gas prices at June 30, 1998. We were not required to record a similar write-down at June 30, 1997.
Net Loss. We have incurred losses since its inception, including $32.8 million ($1.44 per common share) for the year ended June 30, 1998, compared to $1.3 million ($0.05 per share) for the year ended June 30, 1997. These losses are a reflection of the start-up nature of our crude oil and natural gas production activities. We believe, but cannot assure, that as a result of the acquisitions we have made during the year ended June 30, 1998 that our revenues from natural gas and oil are sufficient to cover our production costs and operating expenses, subject to prevailing prices for crude oil and natural gas and the volumes thereof produced by us. We entered the 1999 fiscal year (July 1, 1998 to June 30, 1999) with a plan to improve production from the properties we acquired through June 1998 and to acquire additional oil and natural gas producing properties to provide the revenue base required to generate additional positive cash flow from operations. Our revenues, profitability and future rate of growth are substantially dependent upon prevailing prices for crude oil and natural gas and the volumes of crude oil and natural gas we produced. In addition, our proved reserves will decline as crude oil and natural gas are produced unless we are successful in acquiring properties containing proved reserves or conduct successful exploitation and development activities.
CASH FLOW DATA
From Operations. During the year ended June 30, 1998 we generated $1.0 million from operations. The growth in the accounts receivable of $4.6 million (a net consumption of cash from operations) is indicative of our growth and the related increase in demand for working capital. Similarly, the growth of $5.2 million in accounts payable (a net source of cash from operations) is also an indicator of our growth as we incurred higher expenses. In comparison, during the year ended June 30, 1997 we generated $263,000 from operations.
Investing Activities. During the year ended June 30, 1998 we invested $154.2 million in acquiring additional natural gas and crude oil producing properties and developing existing properties. Of this amount, a total of $146.3 million was expended in three acquisition transactions. The remaining $7.9 million was spent on developing existing properties. A further $100,000 were invested in operating equipment and office equipment during the year. During the year ended June 30, 1997 we invested $3.0 million in acquiring additional oil and gas producing properties and $1.2 million in developing existing properties.
Financing Activities. During the year ended June 30, 1998 we raised $14.4 million by issuing preferred and common stock and $152.5 million in short-term loans. We also issued $121,000 in Deutchemark denominated
subordinated bonds. During the year we repaid $8.1 million of bank debt and $70,000 of a capital lease. Between July 8 and 20, 1998 we issued $125.0 million of unsecured bonds ($120.5 million net of costs) and raised an additional $30.0 million by issuing common stock. The proceeds from these bonds and the common stock were used to repay $142.2 million of short-term debt, unwind an interest rate hedge contract at a cost of $3.5 million and redeem $1.3 million (2,350,000 DEM) of Deutchemark denominated bonds. The remaining $3.5 million were added to our working capital.
During the year ended June 30, 1997 we raised $802,000 of debt while repaying short-term notes payable of $1.4 million and $58,000 on its capital lease obligation, for a net decrease in debt of $663,000. On August 1, 1997 we entered into a loan agreement with Bank of Montreal. We drew down $12 million in loans, using $6 million to acquire certain crude oil and natural gas producing properties in New Mexico, Texas and Oklahoma. A further $4.9 million was used to retire outstanding loans with Comerica Bank Texas. The remaining $1,142,000 were retained for working capital purposes, with some of the funds used to reduce accounts payable. During the year ended June 30, 1997 we raised $5.0 million in preferred share equity and $4.0 million in common stock equity. Additionally, we collected $500,000 for a stock subscription receivable that was outstanding on June 30, 1996. (See Note 5 of the Notes to the Consolidated Financial Statements). We used $5.1 million of the cash equity raised to repurchase 9.6 million shares of common stock, for a net increase in cash equity of $4.4 million.
BALANCE SHEET DATA
Total Assets. At June 30, 1998 we owned assets of $153.7 million, comprised of current assets of $6.4 million, investments in oil and gas producing properties, net of accumulated depletion, depreciation and amortization, of $142.5 million and deferred assets of $4.8 million. At June 30, 1997 we had assets of $17.3 million, comprised of current assets of $1.1 million, investments in oil and gas producing properties, net of accumulated depletion, depreciation and amortization, of $16.2 million.
Stockholders' Equity. At June 30, 1998 we had a net stockholders' deficit of $6.8 million, primarily as a result of the $28.2 million non-cash ceiling test write-down recorded during 1998. During the year ended June 30, 1998 we privately placed and issued 2,160,715 common shares for $5.2 million, for an average cash issuance price of $2.40 per common share. During the year ended June 30, 1998 we issued 1,000,000 and 337,500 common shares in connection with an acquisition, which we valued at $3.125 per share ($3,125,000) and $5.00 per share ($1,687,500), respectively. Additionally, we issued 150,000 common shares in consideration for professional services rendered, which we valued at $2.00 per share ($300,000). We also issued 10,400 shares of Series C preferred stock for $9.5 million, net of costs.
At June 30, 1997 we had total stockholders' equity of $6.4 million. During the year ended June 30, 1997 we placed and issued privately 1,560,000 common shares for $2.50 per share, less 10% in commissions, ($3,510,000) and 200,000 common shares for $3.05 per share, less 10% in commissions, ($549,000). Additionally, during the year ended June 30, 1997 we issued 192,000 common shares pursuant to acquisitions which we valued at $0.18 per share ($34,560) for purposes of those transactions, and 1,237,500 common shares pursuant to acquisitions which we valued at $0.50 per share ($618,750) for purposes of those transactions. Additionally, we issued 116,000 common shares in partial settlement of obligations, which we valued at $0.18 per share ($20,880) for purposes of those transactions.
LIQUIDITY AND CAPITAL RESOURCES
GENERAL
Consistent with our strategy of acquiring and developing reserves, we have an objective of maintaining as much financing flexibility as is practicable. Since we commenced our oil and natural gas operations, we have utilized a variety of sources of capital to fund our acquisitions and development and exploitation programs, and to fund our operations.
Our general financial strategy is to use cash flow from operations, debt financings and the issuance of equity securities to service interest on our indebtedness, to pay ongoing operating expenses, and to contribute toward the further development of our existing proved reserves as well as additional acquisitions. There can be no assurance that cash from operations will be sufficient in the future to cover all such purposes.
We have planned development and exploitation activities for all of our major operating areas. In addition, we are continuing to evaluate oil and natural gas properties for future acquisition. Historically, we have used the proceeds from the sale of our securities in the private equity market and borrowings under our credit facilities to raise cash to fund acquisitions or repay indebtedness incurred for acquisitions, and we have also used our securities as a medium of exchange for other companies assets in connection with acquisitions. However, there can be no assurance that such funds will be available to us to meet our budgeted capital spending. Furthermore, our ability to borrow other than under the credit agreement is subject to restrictions imposed by such credit agreement. If we cannot secure additional funds for our planned development and exploitation activities, then we will be required to delay or reduce substantially both of such activities.
During the year ended June 30, 1999 we were in default under our credit agreement on four occasions. During each of the three months ended September 30, 1998, December 31, 1998 and March 31, 1999 we failed to achieve the minimum interest coverage ratios set out in the credit agreement. At June 30, 1999 we failed to meet the minimum required aggregate tangible net worth covenant set out in our credit agreement. On each occasion the lenders have waived and/or amended the credit agreement. However, they have limited our borrowing ability to $8.0 million of which we are fully drawn, and the maturity date has been accelerated to July 1, 2000. We are in the process of arranging additional capital to achieve a long term resolution of our defaults under the credit agreement. If we are not successful, our lenders may declare all amounts borrowed under the credit agreement, together with accrued interest, to be due and payable. If we do not repay the indebtedness promptly, our lenders could then foreclose against any collateral securing the payment of the indebtedness. Substantially all of our oil and gas interests secure our credit agreement.
SOURCES OF CAPITAL
Our principal sources of capital for funding our business activities have been cash flow from operations, debt financings and the issuance of equity securities. Our historical sources of funds from debt financings include funds available under the credit agreement, the ECT revolving credit agreement, bridge facilities, unsecured, senior bonds issued to North American investors, certain bonds issued to certain European investors and capital leases.
On April 17, 1998, we amended and restated our credit agreement with Bank of Montreal, as agent for the lenders party thereto. The credit agreement provides for borrowings up to $125.0 million (subject to borrowing base limitations) from such lenders to, among other things, fund development and exploitation expenditures, acquisitions and general working capital. The proceeds under the credit agreement were used to fund the property acquisitions in part. As of September 10, 1999, we were able to borrow up to $8.0 million under the credit agreement, all of which was outstanding as of September 10, 1999. The loan under the credit agreement matures on July 1, 2000. In the event of a default on the indebtedness under the credit agreement, not subsequently waived by the lenders, it is unlikely that we would be able to continue our business.
Indebtedness incurred under the credit agreement generally bears interest at bank prime plus 2.0%.
The loan under the credit agreement is secured by a first lien on our oil and natural gas properties, the title to which is held by a wholly owned subsidiary of Queen Sand Resources, and on the stock of two of our subsidiaries. In addition, the parent company and its operating subsidiaries, other than the subsidiary which is the borrower of record entered into guaranty agreements guaranteeing the repayment of the indebtedness under the credit agreement.
Pursuant to the credit agreement, we are subject to certain affirmative and negative financial and operating covenants that are usual and customary for transactions of this nature. The affirmative covenants include, but are not limited to, covenants to:
o provide annual audited and unaudited interim financial information; o provide notices of the occurrence of certain material events affecting us; o promptly provide notice of all legal or arbital proceedings affecting us or our subsidiaries which could reasonably be expected to have a material adverse effect; o maintain and preserve its existence and oil and gas properties and other material properties;
o implement and comply with certain environmental procedures; o perform our obligations under the credit agreement; o provide reserve reports; o deliver certain title information; o grant a security interest in oil and gas properties that are not currently subject to a lien under the credit agreement such that the mortgaged property includes at least 85% (with an obligation to use reasonable efforts to maintain 95%) of the SEC PV-10 of our total proved reserves; and o deliver certain information relating to compliance with ERISA laws and regulations.
The negative covenants include, but are not limited to, covenants:
o not to incur any indebtedness except as expressly permitted under the credit agreement; o not to incur any lien on any of its properties except as expressly permitted under the credit agreement; o not to make any loans or advances to or investments in any person except as expressly permitted under the credit agreement; o with respect to the parent company, not to declare or pay any dividends or redeem or otherwise acquire for value any capital stock of the parent company except for stock dividends and certain permitted repurchases of Series C preferred stock; o not to enter into sale and leaseback transactions; o not to materially change the character of our business as an independent oil and natural gas exploration and production company; o not to enter into lease agreements except as expressly permitted under the credit agreement; o not to merge with or sell all or substantially all of our property or assets to any other person; o not to permit the borrowed proceeds under the credit agreement to be used for any purpose except as expressly permitted under the credit agreement; o not to violate ERISA laws and regulations; o not to discount or sell any notes or accounts receivable; o not to maintain a working capital ratio of less than 1.0 to 1.0; o not to maintain a consolidated tangible net worth of less than $33.0 million; o to pay our trade accounts payable when due; o not maintain a fixed charge coverage ratio of less than 1.15 to 1.0; o not to sell, assign or otherwise transfer any interest in any oil or natural gas properties except as expressly permitted under the credit agreement; o not to violate environmental laws and regulations; o not to enter into transactions with affiliates other than those entered into in the ordinary course of business on fair and reasonable terms; o not to create any additional subsidiaries unless such subsidiaries guarantee the obligations under the credit agreement or issue stock of any subsidiaries to third parties; o not to enter into negative pledge agreements; o not to enter into any contracts which warrant production of oil and natural gas and not allow gas imbalances, take-or-pay or other prepayments which would require the delivery of oil or natural gas at some future time without receiving full payment therefor to exceed 5% of the current aggregate monthly gas production from the mortgaged oil and natural gas properties; o not to amend or modify any material agreements; o not to repay other indebtedness except as expressly permitted under the credit agreement; and o not make or pay capital expenditures more than specified amounts.
The credit agreement also contains usual and customary events of default and provides remedies to the lenders in the event of default. The events of default include:
o default in payment when due of any principal of or interest on indebtedness under the credit agreement; o default in payment when due of any principal of or interest on any other indebtedness aggregating $500,000 or more or an event shall occur which requires us to mandatorily redeem any of our existing preferred stock;
o breach of a representation and warranty under the credit agreement; o default in performance of obligations under the credit agreement; o our admitting in writing our inability to pay debts as they become due; o voluntary or involuntary bankruptcy; o a judgment in excess of $100,000 shall be entered and not vacated within 30 days; o the security agreements under the credit agreement shall cease to be in full force and effect; and o we discontinue our usual business or any person or group of persons (other than JEDI, Enron or its affiliates) shall have acquired beneficial ownership of 30% or more of the outstanding shares of voting stock the parent company or individuals who constitute the Board of Directors of the parent company cease to constitute a majority of the then-current Board of Directors of the parent company.
Although we believe that our cash flows and available sources of financing will be sufficient to satisfy the interest payments on our debt at currently prevailing interest rates and oil and natural gas prices, our level of debt may adversely affect our ability:
o to obtain additional financing for working capital, capital expenditures or other purposes, should we need to so do; or o to acquire additional oil and natural gas properties or to make acquisitions utilizing new borrowings.
There can be no assurances that we will be able to obtain additional financing, if required, or that such financing, if obtained, will be on terms favorable to us.
On September 30, 1998 and December 31, 1998 and March 31, 1999 we were not in compliance with the interest coverage ratio specified in the credit agreement. The lenders waived the September 30, 1998 and December 31, 1998 covenant violation solely with respect to these specific defaults. On May 14, 1999, the lenders waived our March 31, 1999 noncompliance with the interest coverage ratio. On the same date, the credit agreement was amended to reduce the interest coverage ratio to 1.15:1 for the quarter ending June 30, 1999 and for each quarter thereafter. We believe, but cannot assure, that we will be able to comply with all restrictive covenants in the future or obtain waivers from the bank with respect to noncompliance.
On June 30, 1999 we were not in compliance with the minimum tangible net worth covenant in the credit agreement. On October 13, 1999 the lenders waived this covenant violation and the credit agreement was amended to reduce the minimum tangible net worth covenant to $33.0 million. We are in the process of arranging additional capital to achieve a long-term resolution of our defaults under the credit agreement. If we are not successful, our lenders may declare all amounts borrowed under the credit agreement, together with accrued interest, to be due and payable. If we do not repay the indebtedness promptly, our lenders could then foreclose against any collateral securing the payment of the indebtedness. Substantially all of our oil and gas interests secure our credit agreement.
Effective December 29, 1997, we established the ECT revolving credit agreement with ECT, as a lender and as agent for the lenders thereto, to fund on a revolving basis capital costs incurred with future development projects and to fund further acquisitions. The ECT revolving credit agreement is subordinate to the credit agreement. The ECT revolving credit agreement provides for borrowings up to $10.0 million, on a revolving basis and subject to borrowing base limitations, which has been initially set at an amount equal to 40% of the borrowing base established from time to time under the credit agreement. This facility is designed to provide bridge financing for development projects and acquisitions to be completed on relatively short notice or until the affected assets are eligible to be included in the borrowing base for the credit agreement or financed with longer-term indebtedness or equity capital; provided, that the availability for acquisitions under the facility is limited to the lesser of $5.0 million or 50% of the borrowing base as in effect from time to time. There is no indebtedness outstanding under this facility as of the date of this Form 10-K. Borrowings in excess of certain amounts under the ECT Revolving credit agreement will reduce the available borrowing base under the credit agreement. The loan is secured by a second priority lien and security interest (behind the first lien position of the credit agreement) in approximately 95% of our oil and natural gas properties.
The ECT revolving credit agreement is subject to payment of interest at a fluctuating rate per annum equal to (i) the rate of 1% above the then highest rate of interest being paid on any portion of the indebtedness owed under the credit agreement or (ii) the rate of 15%, depending upon whether there is any indebtedness owed under the credit agreement outstanding or whether there has been a certain amount of indebtedness owed under the ECT revolving credit agreement for certain time periods.
The maturity date for the ECT revolving credit agreement is the earlier of December 30, 2002 or the date that is 60 days after we receive written notice that the lenders and their affiliates beneficially own in the aggregate less than 10% of the capital stock of the parent company entitled to vote in the election of directors. From March 31, 1998 through the maturity date, we must pay interest on the outstanding loans at quarterly intervals, on the last business day of every March, June, September and December. In addition, the ECT revolving credit agreement provides for certain voluntary prepayments and certain mandatory prepayments of amounts borrowed under the facility.
We are obligated to pay ECT, for the account of each lender under the ECT revolving credit agreement, a fee of 3/8% per annum on the daily average of the unadvanced portion of the facility, payable at the end of each quarter. This fee has been waived indefinitely since April 1998.
We are subject to various covenants under the ECT revolving credit agreement, which covenants are substantially similar to the covenants described above with respect to the credit agreement. In addition to the covenants, the ECT revolving credit agreement contains representations, warranties, covenants and default provisions customary for a facility of this type.
As of September 10, 1999 we have outstanding to investors in Europe Deutschemark denominated (DEM) 12% Bonds (the "12% Bonds") totaling DEM 1.6 million ($851,000). Under Regulation S of the Securities Act, we are prohibited from selling these Bonds to U.S. persons (as defined in Regulation S). In January 1998 we discontinued our efforts to sell any additional 12% Bonds. We are obligated to make periodic interest payments (January 15 and July 15 of each year) and to repay the principal when it comes due on July 15, 2000 in DEM. All interest payments have been paid in full at the time they came due. The funds generated by us from operations, which form the primary source of funds to pay the interest, are denominated in $US. We are exposed to the risk that, upon repayment, the exchange rate between DEM and $US may be less favorable than that which existed at the time that the bonds were issued. This would result in our having to repay a larger amount of $US than we received initially. Changes in the $US equivalent of the DEM bonds arising from changes to the DEM:$US exchange rate are recognized monthly. At June 30, 1999 we had recorded unrealized exchange rate gains of approximately $39,000 (at June 30, 1998 $141,000). However, there are no assurances that we will continue to realize gains related to favorable changes in the DEM:$US exchange rates in the future. Unfavorable changes to the DEM:$US exchange rate will result in us recording unrealized exchange rate losses related to the changes as they occur. We believe that we have the opportunity to enter into arrangements to manage its DEM:$US exchange rate risk. At this time, we have not entered into any such arrangements.
We have issued both preferred stock and common stock for cash to raise equity to finance our working capital, to repay existing indebtedness, repurchase Series C preferred stock and to fund acquisitions. In December 1997 we raised $10.0 million of gross proceeds through a private institutional placement of preferred stock. Since July 1, 1997 we have also received approximately $13.4 million of cash proceeds from the exercise of previously issued warrants and the exercise of certain anti-dilution rights of JEDI. In addition, we have also issued common stock as partial consideration when acquiring oil and natural gas producing properties.
On July 8, 1998, we completed a private placement (the "Note Offering") of $125,000,000 principal amount of 12 1/2% Senior Notes due 2008 (the "Notes"). In addition, on July 8, 1998 and July 20, 1998, we completed the private placement of $31.0 million of common stock. Pursuant to the Note Offering, we issued and sold the Notes to certain institutional buyers pursuant to Rules 144A and Regulation D promulgated under the Securities Act of 1933. The Notes mature on July 1, 2008, and interest on the Notes is payable semiannually on January 1 and July 1 of each year, commencing January 1, 1999 at the rate of 12 1/2% per annum. The payment of the Notes is guaranteed by the parent company's three operating subsidiaries. The net proceeds received by us from the Note Offering and the Private Equity Placement completed on July 8, 1998 of approximately $144.5 million and on July 20, 1998 of approximately
$6.9 million were used to repay indebtedness outstanding under the credit agreement, to repay indebtedness outstanding under the certain short term loans used to finance an acquisition of net profits and royalty interests, to redeem $1.3 million (2,350,000 DEM) of Deutchemark denominated bonds and to unwind an interest rate hedge contract at a cost of $3.5 million. With the exception of the Deutchemark denominated bonds, substantially all of this indebtedness was incurred to fund the April 20, 1998 acquisition of net profits and royalty interests.
We are in the process of negotiating a revolving loan in the amount of $50 million, to be secured by a first lien on our oil and natural gas properties. This loan is expected to bear interest at bank prime plus 2% when borrowings are less than $25 million and bank prime plus 4.5% if the amount outstanding is equal to or greater than $25 million. The funds available under this facility would be available for general corporate purposes, including the funding of the exploitation and development of our existing oil and natural gas properties. There is no assurance that these negotiations will be successful. In the event that these negotiations are successful, the new lender would acquire the existing notes from the current lending group and replace the existing credit agreement with an amended and restated credit agreement. As a consequence of no longer holding a security interest in our oil and natural gas properties, Bank of Montreal has asked us to unwind the ceiling price feature of our hedge agreements with them. The cost of unwinding these contracts is a function of the future market price of natural gas over the remaining life of the contracts, which expire December 31, 2003. There has been considerable volatility in the natural gas market during the month of October 1999 and therefore it is not possible to estimate the cost of unwinding the contract. It is possible that the cost could be material. At such time as the contracts are unwound we will treat the cost as an expense in the period in which it occurs. See "Changes in Prices and Hedging Activities."
We believe that we can generate sufficient cash flow from operations to pay the interest charges on all of our interest-bearing debt. The gas price hedging program currently in place provides a degree of protection against significant decreases in oil and gas prices. Furthermore, 94% of our interest-bearing debt is at fixed rates for extended periods, providing an effective hedge against increases in prevailing interest rates.
We do not have sufficient liquidity or capital to undertake significant potential acquisition prospects. Therefore, we will continue to be dependent on raising substantial amounts of additional capital through any one or a combination of institutional or bank debt financing, equity offerings, debt offerings and internally generated cash flow, or by forming sharing arrangements with industry participants. Although we have been able to obtain such financings and to enter into such sharing arrangements in certain of our projects to date, there can be no assurance that we will continue to be able to do so. Alternatively, we may consider issuing additional securities in exchange for producing properties. There can be no assurance that any such financings or sharing arrangement can be obtained. Therefore, notwithstanding our need for substantial amounts of additional capital, there can be no assurance that it can be obtained.
Further acquisitions and development activities in addition to those for which we are contractually obligated are discretionary and depend to a significant degree on cash availability from outside sources such as bank debt and the sale of securities or properties.
USES OF CAPITAL
Since commencing our oil and natural gas operations in August 1994 we have completed 19 acquisitions of oil and natural gas producing properties. Through June 30, 1999, we have expended a total of $178.4 million in acquiring, developing and exploiting oil and natural gas producing properties. Initially, our operations represented a net use of funds. As demonstrated in the operating results for the year ended June 30, 1999, we generate a positive cash flow from operations. We expect to spend $8.4 million on discretionary capital expenditures through June 2000 for exploitation and development projects, depending on the availability of funds. We are not contractually obligated to fund any capital expenditures through June 2000.
INFLATION
During the past several years, we have experienced some inflation in oil and natural gas prices with moderate increases in property acquisition and development costs. During the fiscal year ended June 30, 1999, we received
somewhat lower commodity prices for the natural resources produced from our properties. Our results of operations and cash flow have been, and will continue to be, affected to a certain extent by the volatility in oil and natural gas prices. Should we experience a significant increase in oil and natural gas prices that is sustained over a prolonged period, we would expect that there would also be a corresponding increase in oil and natural gas finding costs, lease acquisition costs, and operating expenses.
CHANGES IN PRICES AND HEDGING ACTIVITIES
We have a commodity price risk management (hedging) strategy that is designed to provide protection from low commodity prices while providing some opportunity to enjoy the benefits of higher commodity prices. We have a series of natural gas futures contracts with Bank of Montreal and with an affiliate of Enron. This strategy is designed to provide a degree of protection of negative shifts in natural gas prices (Henry Hub Nymex Index) on approximately 80% of our expected natural gas production from reserves currently classified as proved developed producing during the fiscal year ending June 30, 2000. At the same time, we are able to participate completely in upward movements in the Henry Hub Nymex Index to the extent of approximately 30% of our expected natural gas production for the fiscal year ending June 30, 2000, and up to $2.70 per MMBtu on approximately 73% of our expected natural gas production for the fiscal year ended June 30, 2000.
In addition to the natural gas contracts entered into on April 25, 1998, we were under contract with an affiliate of Enron for 10,000 Bbls of oil per month with a floor of $18.00 per Bbl and a ceiling of $20.40 per Bbl with participation on 50% of the price of WTI Nymex over $20.40 for the period from September 1, 1997 through August 31, 1998. We also had a contract for 50,000 MMBtu of natural gas per month with an affiliate of Enron, with a floor price of $1.90 per MMBtu and a ceiling price of $2.66 per MMBtu, with participation on 50% of the price of Henry Hub Nymex Index over $2.66 per MMBtu for the period from September 1, 1997 through August 31, 1998. In September 1998 we entered into a swap contract on 12,000 barrels of crude oil per month at $17.00 per barrel from October 1 through December 31, 1998. In March 1999 we entered into a swap contract on 10,000 barrels of crude oil per month at $13.50 per barrel from March 1 through August 31, 1999. We also entered into two additional swap contracts of 5,000 barrels of crude oil per month at $14.35 per barrel and $14.82 per barrel respectively from April 1 through September 30, 1999.
We have implemented a comprehensive hedging strategy for our natural gas production over the next five years. We have placed approximately 25% of the expected natural gas production from our proved developed producing reserves into a swap at $2.40 per MMBtu. Approximately 10% of the expected natural gas production from our proved developed producing reserves is hedged in a contract with a floor of $1.90 per MMBtu. We also hedged approximately
40% of the expected natural gas production from our proved developed producing reserves with a series of non-participating collars with ceilings that escalate from $2.70 per MMBtu to $2.90 per MMBtu over time.
The table below sets out volume of natural gas hedged with a floor price of $1.90 per MMBtu with Enron. The volumes presented in this table are divided equally over the months during the period:
The table below sets out volume of natural gas hedged with a swap at $2.40 per MMBtu with Enron. The volumes presented in this table are divided equally over the months during the period:
Effective May 1, 1998 through December 31, 2003 we have a contract involving the hedging of a portion of our future natural gas production involving floor and ceiling prices as set out in the table below. The volumes presented in this table are divided equally over the months during the period.
INTEREST RATE HEDGING
We entered into a forward LIBOR interest rate swap effective for the period June 30, 1998 through June 29, 2009 at a rate of 6.30% on $125.0 million. We entered into this interest rate swap at a time when interest rates were rising. Our objective was to mitigate the risk of our having to pay higher than expected interest rates on what eventually became our 12 1/2% Senior Notes due 2008. The swap would have also served as an interest hedge on our indebtedness under the credit agreement and certain short term loans used to finance the April 1998 acquisition of our net profit and royalty interests in the event that we failed to complete the private placement of the unsecured notes. Once the private placement of the 12 1/2% Senior Notes was completed we determined that the interest rate swap no longer had any on-going value to us. On July 9, 1998, we unwound this swap at a cost to us of approximately $3.5 million, using a portion of the proceeds from the Notes proceeds. This cost was expensed as an extraordinary loss during the year ended June 30, 1999.
YEAR 2000 COMPUTER ISSUE
General. We are addressing the potential impact of the Year 2000 ("Y2K") issue on our operations. A review of internal systems and a review of the state of readiness of significant suppliers and customers is nearing completion. We believe that appropriate remedial action can be completed in advance of the year 2000 and the costs of such action will not have a material affect on our financial condition or results of operations.
State of Readiness. We currently use commercially available software for our management information ('IT') systems including accounting, engineering evaluation, acquisition analysis and word processing. This software is warranted by the suppliers/manufacturers to be Y2K compliant. We have not taken any steps to independently verify the truth of such warranties but we have no reason to believe that the software is not as warranted. We are in the process of reviewing our non-IT systems, which we expect to complete by the end of October, 1999.
Costs of Compliance. We believe that the cost of compliance will be minimal. As our IT systems were warranted to be compliant when purchased, we have not incurred, nor do we expect to incur any significant incremental costs to modify or replace such systems to make them compliant. Non-IT systems are currently being evaluated to determine whether and to what extent they may be non-compliant. We do not currently believe that the amount of non-compliant equipment will be found to be significant nor will the cost to modify or replace such equipment be material. Our products do not contain any microprocessors.
We are seeking written verification from our major suppliers and customers that they will be Y2K compliant. The costs of seeking verification are minimal. We believe that it will not be practical to independently verify the responses because we do not believe that we would be given access to carry out such verification or that the costs of doing so would be affordable. The cost of replacing non-compliant or non-responsive suppliers and customers will not be possible to determine until the review process has been completed.
Risk. Any Y2K problems that do occur will likely manifest themselves in reduced production through equipment shut down or impaired liquidity through inability of customers to take delivery or process payment.
Contingency. We plan to establish contingency plans once its verification program is complete and the risks have been more fully quantified.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
HEDGES OF OIL AND NATURAL GAS PRODUCTION
To reduce our exposure to changes in the prices of oil and natural gas, we have entered into and may in the future enter into arrangements to hedge our crude oil and natural gas production, whereby gains and losses in the fair value of the derivative instruments are generally offset by price changes in the underlying commodity. The hedges that we
have entered into generally provide a 'floor' (or 'cap' and 'floor') on the prices paid for our oil and natural gas production over a period of time. Hedging arrangements may expose us to the risk of financial loss in some circumstances, including the following:
o our production does not meet the minimum production requirements under the agreement, o the other party to the hedging contract defaults on its contract obligations or o there is a change in the expected differential between the underlying price in the hedging agreement and actual prices received.
Due to our risk assessment procedures and internal controls, we believe that the use of such derivative instruments does not expose us to material risk, however, the use of derivative instruments for the hedging activities could affect our results of operations in particular quarterly or annual periods. The use of such instruments limits the downside risk of adverse price movements, but it may also limit our ability to benefit from favorable price movements.
Our hedging strategy is designed to provide protection from low commodity prices while providing some opportunity to enjoy the benefits of higher commodity prices. We have a series of natural gas futures contracts with Bank of Montreal and with an affiliate of Enron. This strategy is designed to provide a degree of protection of negative shifts in natural gas prices (Henry Hub Nymex Index) on approximately 80% of our expected natural gas production from reserves currently classified as proved developed producing during the fiscal year ending June 30, 2000. At the same time, we are able to participate completely in upward movements in the Henry Hub Nymex Index to the extent of approximately 30% of our expected natural gas production for the fiscal year ending June 30, 2000, and up to $2.70 per MMBtu on approximately 73% of our expected natural gas production for the fiscal year ended June 30, 2000.
In addition to our natural gas hedging agreements, at June 30, 1999, we have a swap contract on 10,000 barrels of crude oil per month at $13.50 per barrel from March 1 through August 31, 1999 as well as two additional swap contracts of 5,000 barrels of crude oil per month at $14.35 per barrel and $14.82 per barrel respectively from April 1 through September 30, 1999.
INTEREST RATES
At June 30, 1999, our exposure to interest rates relates primarily to borrowings under our credit agreement. As of June 30, 1999, we are not using any derivatives to manage interest rate risk. Interest is payable on borrowings under the credit agreement based on a floating rate. If short-term interest rates average 10% higher during our fiscal year 2000 than they were during 1999, our interest expense would increase by approximately $78,000. This amount was determined by applying the hypothetical interest rate change of 10% to our outstanding borrowings under the credit agreement at June 30, 1999.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For the Financial Statements required by Item 8, see the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There are no changes or disagreements required to be reported under this Item 9.
Queen Sand Resources, Inc. and Subsidiaries
Index to Consolidated Financial Statements
Report of Ernst & Young LLP, Independent Auditors
The Board of Directors and Stockholders Queen Sand Resources, Inc.
We have audited the accompanying consolidated balance sheets of Queen Sand Resources, Inc. and subsidiaries as of June 30, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity (net capital deficiency) and cash flows for each of the three years in the period ended June 30, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Queen Sand Resources, Inc. and subsidiaries as of June 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 1999, in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Dallas, Texas September 1, 1999, except for Note 3, as to which the date is October 13, 1999
Queen Sand Resources, Inc. and Subsidiaries
Consolidated Balance Sheets
See accompanying notes.
Queen Sand Resources, Inc. and Subsidiaries
Consolidated Statements of Operations
See accompanying notes.
Queen Sand Resources, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity (Net Capital Deficiency)
Years ended June 30, 1999, 1998 and 1997
See accompanying notes.
Queen Sand Resources, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity (Net Capital Deficiency) (continued)
Years ended June 30, 1999, 1998 and 1997
See accompanying notes.
Queen Sand Resources, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
See accompanying notes.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
June 30, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
Queen Sand Resources, Inc. (QSRI or the Company) was formed on August 9, 1994, under the laws of the State of Delaware. At June 30, 1999, EIBOC Investments Ltd. (EIBOC) held approximately 6,600,000 shares of the Company's common stock, par value $.0015 (Common Stock), representing approximately 7% of the Company's outstanding shares of Common Stock on a fully diluted basis. Certain officers of the Company have beneficial interests in EIBOC (see Note 5). Joint Energy Development Investments Limited Partnership (JEDI), an affiliate of Enron Corp. (Enron), holds approximately 28% of the Company's voting capital stock on a fully diluted basis.
The Company is engaged in one industry segment, the acquisition, exploration, development, production, and sale of crude oil and natural gas. The Company's business activities are carried out primarily in Kentucky, Louisiana, New Mexico, Oklahoma and Texas.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
PROPERTY AND EQUIPMENT
The Company follows the full cost method of accounting for its oil and gas activities under which all costs, including direct general and administrative expenses associated with property acquisition, exploration, and development activities, are capitalized. Capitalized general and administrative expenses directly associated with acquisitions, exploration, and development of oil and gas properties were approximately $931,000, $721,000, and $316,000 for the years ended June 30, 1999, 1998, and 1997, respectively. Capitalized costs are amortized by the unit-of-production method using estimates of proved oil and gas reserves prepared by independent engineers. The costs of unproved properties are excluded from amortization until the properties are evaluated. Sales of oil and gas properties are accounted for as adjustments to the capitalized cost center unless such sales significantly alter the relationship between capitalized costs and proved reserves of oil and gas attributable to the cost center, in which case a gain or loss is recognized.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Company limits the capitalized costs of oil and gas properties, net of accumulated amortization, to the estimated future net revenues from proved oil and gas reserves less estimated future development and production expenditures discounted at 10%, plus the lower of cost or estimated fair value of unproved properties, as adjusted for related estimated future tax effects. If capitalized costs exceed this limit (the full cost ceiling), the excess is charged to depreciation and amortization expense. During the years ended June 30, 1999 and 1998, the Company recorded full cost ceiling writedowns of $35,033,000 and $28,166,000, respectively.
Amortization of the capitalized costs of oil and gas properties and limits to capitalized costs are based on estimates of oil and gas reserves which are inherently imprecise. Accordingly, it is reasonably possible that such estimates could differ materially in the near term from amounts currently estimated.
Depreciation of other property and equipment is provided principally by the straight-line method over the estimated service lives of the related assets. Equipment under capital lease is recorded at the lower of fair value or the present value of future minimum lease payments and are depreciated over the lease term.
Costs incurred to operate, repair, and maintain wells and equipment are charged to expense as incurred.
The Company's oil and gas activities are conducted jointly with others and, accordingly, the financial statements reflect only the Company's proportionate interest in such activities.
The Company does not expect future costs for site restoration, dismantlement and abandonment, postclosure and other exit costs which may occur in the sale, disposal, or abandonment of a property to be material.
REVENUE RECOGNITION
The Company uses the sales method of accounting for oil and gas revenues. Under the sales method, revenues are recognized based on actual volumes of oil and gas sold to purchasers.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ENVIRONMENTAL MATTERS
The Company is subject to extensive federal, state, and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a noncapital nature are recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated.
INCOME TAXES
Income taxes are accounted for under the asset and liability method, under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is adjusted by a valuation allowance, if necessary, to recognize the extent to which based on available evidence, the future tax benefits more likely than not will be realized.
STATEMENT OF CASH FLOWS
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
During 1999, 1998, and 1997, the Company issued an aggregate of 8,740, 1,337,500, and 1,529,500 shares of Common Stock, respectively, valued at $65,000, $4,812,000, and $641,000, respectively, in connection with the acquisitions of certain interests in oil and gas properties. In 1998, in connection with certain promotional services rendered by an unrelated party, the Company issued 150,000 shares of Common Stock valued at $300,000. In 1997, in connection with the acquisitions of oil and gas properties, the Company issued notes payable to the sellers of the properties which were recorded at $2,473,000, net of issuance discount of $354,000.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NET LOSS PER COMMON SHARE
Net loss per common share is presented in accordance with Statement of Financial Accounting Standards No. 128, Earnings per Share. As the Company incurred net losses during each of the years ended June 30, 1999, 1998 and 1997, the loss per common share data is based on the weighted average common shares outstanding.
STOCK OPTIONS
The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) in accounting for its employee stock options. Under APB 25, if the exercise price of an employee's stock options equals or exceeds the market price of the underlying stock on the date of grant and certain other plan conditions are met, no compensation expense is recognized.
CONCENTRATIONS OF CREDIT RISK
For the year ended June 30, 1999, four oil and gas companies accounted for 30%, 12%, 11%, and 9%, respectively, of the Company's oil and gas sales. For the year ended June 30, 1998, two oil and gas companies accounted for 17% and 13%, respectively, of the Company's oil and gas sales. For the year ended June 30, 1997, five oil and gas companies accounted for 32%, 14%, 17%, 10% and 9%, respectively, of the Company's oil and gas sales. The Company does not believe that the loss of any of these buyers would have a material effect on the Company's business or results of operations as it believes it could readily locate other buyers. The Company's receivables are generally unsecured.
FOREIGN CURRENCY
Foreign currency transactions are translated into U.S. dollars at the rate of exchange on the date of the transaction. Amounts payable and receivable in foreign currency are translated at the exchange rate at the balance sheet date. Unrealized translation gains of $19,000, $18,000, and $300,000 were recognized during the years ended June 30, 1999, 1998, and 1997, respectively, and are included in interest and other income in the accompanying consolidated statements of operations.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates.
DERIVATIVES
The Company utilizes certain derivative financial instruments to hedge future oil and gas prices and interest rate risk (see Note 4). Gains and losses arising from the use of the instruments are deferred until realized. Gains and losses from hedges of oil and gas prices are reported as oil and gas sales. Gains and losses from interest rate hedges are reported in interest expense.
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, which is required to be adopted in years beginning after June 15, 2000. The Statement permits early adoption as of the beginning of any fiscal quarter after its issuance. The Company expects to adopt the new Statement effective July 1, 2000. The Statement will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet determined what the effect of Statement 133 will be on the earnings and financial position of the Company.
COMPREHENSIVE INCOME
As of July 1, 1998, the Company adopted Financial Accounting Standards Board Statement No. 130, Reporting Comprehensive Income. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Statement 130 establishes rules for the reporting and display of comprehensive income and its components. For 1998, 1997 and 1996, there were no differences between net earnings and total comprehensive income.
2. ACQUISITIONS
The consolidated financial statements include the results of operations of the acquired interests in oil and gas properties from their respective acquisition dates.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. ACQUISITIONS (CONTINUED)
On November 6, 1996, the Company acquired eight gross productive wells (three net productive wells), all located in various counties in Texas (the Frymire Purchase). In consideration for these properties the Company paid approximately $650,000 in cash, issued notes for $427,000, and issued 100,000 shares of Common Stock valued at $18,000.
On December 16, 1996, the Company acquired 15 gross productive wells (15 net productive wells), all located in New Mexico (the Trigg Federal Purchase). In consideration, the Company paid $100,000 in cash and issued 92,000 shares of Common Stock valued at approximately $16,000.
On February 5, 1997, the Company acquired 60 gross productive wells (48.4 net productive wells) and two developmental properties located in Mississippi, Louisiana, and Texas (the Core Properties). The adjusted purchase price consisted of cash of approximately $1,700,000, four notes payable totaling $2,400,000, and 659,000 shares of Common Stock valued at approximately $330,000. On March 13, 1997, the Company acquired one gross productive well (0.3375 net productive well) located in Louisiana (the Intercoastal Property). The purchase price consisted of cash of $562,500 and 578,500 shares of Common Stock valued at approximately $289,000. The cash portion of these acquisitions was funded through sales of 1,060,000 shares of Common Stock pursuant to Regulation S, resulting in net proceeds to the Company of $2,385,000 (the Equity Private Placements).
The following unaudited pro forma summary of the Company's consolidated results of operations for the year ended June 30, 1997, was prepared as if the acquisitions of the Core Properties, the Intercoastal Property, and the Equity Private Placements had occurred on July 1, 1996. The historical results of the Frymire Purchase and the Trigg Federal Purchase were not significant. The unaudited pro forma data is based on numerous assumptions and is not necessarily indicative of future operations or of results which would actually have occurred if the acquisitions and the Equity Private Placements had been made on July 1, 1996.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. ACQUISITIONS (CONTINUED)
On August 1, 1997, the Company acquired 77 productive wells (12.35 net productive wells) located in New Mexico, Oklahoma, and Texas (the Collins and Ware Properties). In consideration for these properties, the Company paid $6,000,000 in cash and issued 1,000,000 shares of Common Stock valued at $3,125,000. The cash portion of these acquisitions was funded with borrowings under the Company's credit facility.
On March 9, 1998, the Company purchased certain operated natural gas properties in western Kentucky for net cash consideration of $450,000 and 337,500 shares of the Company's Common Stock valued at approximately $1,687,000 (the NASGAS Property Acquisition). The acquired properties are comprised of interests in 21 gross wells (12.6 net) and 61,421 gross acres (36,858 net) (the NASGAS Properties).
On April 20, 1998, the Company acquired certain non-operated, net profits interests (NPIs) and royalty interests (RIs; together with the NPIs, the Morgan Properties) for net cash consideration of approximately $137.9 million from pension funds managed by J.P. Morgan Investments (the Morgan Property Acquisition). The Morgan Property Acquisition was financed with borrowings under the Credit Agreement and two subordinated bridge credit facilities (see Note 3).
The Company's interest in the Morgan Properties primarily takes the form of nonoperated net profits overriding royalty interests, whereby the Company is entitled to a percentage of the net profits from the operations of the properties. The oil and gas properties burdened by the Morgan Properties are primarily located in East Texas, South Texas, and the mid-continent region of the United States.
Presented below are the oil and gas sales and associated production expenses associated with the Morgan Properties, which are presented in the accompanying consolidated statements of operations for the years ended June 30, 1999 and 1998, respectively, as net profits and royalty interests revenues:
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. ACQUISITIONS (CONTINUED)
The following unaudited pro forma summary of the Company's consolidated results of operations for the years ended June 30, 1998 and 1997 was prepared as if the acquisitions of the Collins and Ware Properties, the NASGAS Properties and the Morgan Properties, including related borrowings, had occurred on July 1, 1996. The unaudited pro forma data is based on numerous assumptions and is not necessarily indicative of future operations or of results which would have actually occurred if the acquisitions and related borrowings had been made on July 1, 1996.
3. CURRENT AND LONG-TERM DEBT
A summary of current and long-term debt follows:
Effective August 1, 1997, the Company entered into a credit agreement with Bank of Montreal. This agreement provided for an initial borrowing base of $17,000,000 to be redetermined from time to time by Bank of Montreal based on engineering reports of oil and gas reserves. The Company was required to pay a commitment fee annually of .35% of the unused portion of the borrowing base.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. CURRENT AND LONG-TERM DEBT (CONTINUED)
On April 17, 1998, the Company entered into an amended and restated credit agreement with Bank of Montreal and certain affiliates of JEDI. The amended and restated agreement (the Credit Agreement) provides for borrowings up to $125,000,000 (subject to borrowing base limitations). As of June 30, 1999 and 1998, $8,000,000 and $92,500,000, respectively, were outstanding under the Credit Agreement. As of June 30, 1999, no additional borrowing capability was available to the Company under the terms of the Credit Agreement. The loan under the Credit Agreement matures on October 1, 2000.
Indebtedness incurred under the Credit Agreement generally bears interest under various interest rate pricing options based upon a Federal Funds rate (plus .5%), Prime Rate or LIBOR rate options. LIBOR rate loans bear an applicable margin over the LIBOR rate of (i) 2.25%, if greater than 90% of the available Borrowing Base has been drawn, (ii) 2%, if greater than 75% and not more than 90% of the available Borrowing Base has been drawn, (iii) 1.5%, if greater than 40% but not more than 75% of the available Borrowing Base has been drawn, and (iv) 1%, if not more than 40% of the available Borrowing Base has been drawn. On May 14, 1999 the Credit Agreement was amended to reflect an interest rate pricing of Base Rate plus 2.00%. The interest rate at June 30, 1999 and 1998 was 9.75% and 8.50%, respectively.
The loan under the Credit Agreement is secured by a first lien on the oil and gas properties of the Company. Pursuant to the Credit Agreement, the Company is subject to certain affirmative and negative financial and operating covenants that are usual and customary for transactions of this nature. On September 30, 1997, December 31, 1997, September 30, 1998, December 31, 1998 and March 31, 1999 the Company was not in compliance with its interest coverage ratio covenant. Bank of Montreal waived these covenant violations solely with respect to these specific defaults. At June 30, 1999, the Company was in default of its tangible net worth covenant which required the Company to maintain an aggregate tangible net worth of not less than $40.0 million. At June 30, 1999, the Company's aggregate tangible net worth, as calculated under the terms of the Credit Agreement, was $37.4 million. The Credit Agreement was amended on October 13, 1999 to reset the minimum aggregate tangible net worth covenant to $33.0 million. The Company believes, but cannot assure, that it will be able to comply with all restrictive covenants in the future or obtain waivers from the bank with respect to noncompliance.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. CURRENT AND LONG-TERM DEBT (CONTINUED)
Also in April 1998, in connection with the acquisition of the Morgan Properties, the company entered into a Variable Rate Senior Second Secured Note Purchase Agreement (the Debt Bridge Facility) in the amount of $30,000,000 and a Variable Rate Senior Third Secured Equity Bridge Note Purchase Agreement (the Equity Bridge Facility and collectively the Bridge Facilities), also in the amount of $30,000,000, with Bank of Montreal, Enron, and an affiliate of Enron. As of June 30, 1998, an aggregate of $58,860,000 was outstanding under the Bridge Facilities.
The Debt Bridge Facility bore interest at a rate of LIBOR plus 4% per annum (10% at June 30, 1998). The Equity Bridge Facility bore interest at a rate of LIBOR plus 6% per annum (12% at June 30, 1998).
On July 8, 1998, the Bridge Facilities were retired and approximately $82,200,000 of borrowings under the Credit Agreement were repaid, and the borrowing base of the Credit Agreement was revised to $25,000,000. The Credit Agreement was amended during the year ended June 30, 1999 to provide for a borrowing base of $8,000,000 as of June 30, 1999.
On July 8, 1998, the Company completed a private placement of $125,000,000 principal amount of 12 1/2% Senior Notes (the Notes) due July 1, 2008. Interest on the Notes is payable semiannually on January 1 and July 1 of each year, commencing January 1, 1999, at the rate of 12 1/2% per annum. The Notes are senior unsecured obligations of the Company and rank pari passu with any existing and future unsubordinated indebtedness of the Company. The Notes rank senior to all unsecured subordinated indebtedness of the Company. The Notes contain normal covenants that limit the Company's ability to incur additional debt, pay dividends, and sell assets of the Company. Substantially all of the proceeds from issuance of the Notes were used to retire the Bridge Facilities and repay borrowings under the Credit Agreement.
Effective December 29, 1997, the Company established the ECT Revolving Credit Agreement with ECT, an affiliate of Enron, to fund capital costs incurred with future development projects and to fund future acquisitions. The ECT Revolving Credit Agreement is subordinate to the Credit Agreement. The ECT Revolving Credit Agreement provides for borrowing up to $10.0 million, on a revolving basis and subject to borrowing base limitations, which has initially been set at an amount equal to 40% of the borrowing base established from time to time under the Credit Agreement. This facility is designed to provide bridge financing for development projects and acquisitions to be completed on relatively short notice or until the affected assets are eligible to be
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. CURRENT AND LONG-TERM DEBT (CONTINUED)
included in the borrowing base for the Credit Agreement or financed with longer-term indebtedness or equity capital; provided, that the availability for acquisitions under the facility is limited to the lesser of $5.0 million or 50% of the borrowing base as in effect from time to time. No indebtedness was outstanding under this facility as of June 30, 1999 and 1998. Borrowings in excess of certain amounts under the ECT Revolving Credit Agreement will reduce the available borrowing base under the Credit Agreement. The loan is secured by a second priority lien and security interest (behind the first lien position of the Credit Agreement) in substantially all of the oil and gas properties of the Company.
The ECT Revolving Credit Agreement is subject to payment of interest at a fluctuating rate per annum equal to (i) the rate of 1% above the then highest rate of interest being paid on any portion of the indebtedness owed under the Credit Agreement or (ii) 15%, under certain circumstances described in the agreement.
The maturity date for the ECT Revolving Credit Agreement is the earlier of December 30, 2002 or the date that is 60 days after the Company receives written notice that Enron and its affiliates beneficially own in the aggregate less than 10% of the capital through the maturity date. From March 31, 1998 the Company will pay interest on the outstanding loans at quarterly intervals, on the last business day of every March, June, September, and December. In addition, the ECT Revolving Credit Agreement provides for certain voluntary prepayments and certain mandatory prepayments of amounts borrowed under the facility.
The ECT Revolving Credit Agreement also provides that, commencing January 1999, during certain periods any indebtedness of the Company under the agreement may be exchanged for shares of the Company's Common Stock. The exchange ratio is based on a formula that is a function of the market price of the Common Stock at the time of exchange.
The Company is subject to various covenants under the ECT Revolving Credit Agreement, which covenants are substantially similar to the covenants described above with respect to the Credit Agreement. In addition to the covenants, the ECT Revolving Credit Agreement contains representations, warranties, covenants, and default provisions customary for a facility of this type.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. CURRENT AND LONG-TERM DEBT (CONTINUED)
The Company paid ECT a fee of $200,000 during 1998 in connection with the arrangement of the ECT Revolving Credit Agreement. In addition, commencing March 31, 1998, and on each payment date thereafter, the Company is obligated to pay ECT, for the account of each lender under the ECT Revolving Credit Agreement, a fee of 3/8% per annum on the daily average of the unadvanced portion of the facility for the period since January 12, 1998 or the previous payment date to such payment date. Payment of this fee has been waived by ECT indefinitely since April 12, 1998.
Beginning July 1995, the Company initiated private debt offerings whereby it may issue up to a maximum of 5,000,000 Deutschmark (DEM) denominated 12% notes due on July 15, 2000, of which DEM 3,950,000 was outstanding at June 30, 1998. On July 15, 1998, the Company redeemed notes totaling DEM 2,350,000 for approximately $1,300,000. At June 30, 1999, DEM 1,600,000 was outstanding. The notes may be redeemed at the option of the Company, in whole or in part, at any time prior to maturity date on or after December 15, 1997, at 101% of the principal amount, plus accrued interest to the redemption date. The notes are unsecured, general obligations of the Company, subordinated in right of payment to any senior and secured indebtedness of the Company including all other existing indebtedness. The note agreement contains covenants which place limitations on dividends and liens.
In February 1997, in connection with the acquisition of certain oil and gas properties, the Company issued four notes totaling $2,400,000 (the Acquisition Notes) secured by a first lien on the acquired properties. Two of these notes, totaling $400,000, bore no interest and were retired prior to June 30, 1997. The remaining two notes, totaling $2,000,000, were originally payable no later than February 4, 2000, and bore no interest for the first two years and 9% for the final year, payable in Common Stock of the Company. The terms of the remaining two notes were renegotiated, with the seller surrendering the first lien on the Core Properties in exchange for a note requiring a payment of $2,000,000 on January 31, 1998. As a result of the modification of the debt terms, in 1997 the Company recognized an extraordinary loss on modification of $171,000, the difference between the carrying value of the original notes (including accreted discount of approximately $72,000) and the present value of the new note. This note was retired during 1998.
Although the Company believes that its cash flows and available sources of financing will be sufficient to satisfy the interest payments on its debt at currently prevailing interest rates and oil and gas prices, the Company's level of debt may adversely affect the Company's ability: (i) to obtain additional financing for working capital, capital expenditures or other purposes, should it need to do so; or (ii) to acquire additional oil
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. CURRENT AND LONG-TERM DEBT (CONTINUED)
and gas properties or to make acquisitions utilizing new borrowings. There can be no assurances that the Company will be able to obtain additional financing, if required, or that such financing, if obtained, will be on terms favorable to the Company.
During 1999, 1998, and 1997, the Company made cash payments of interest totaling approximately $9,105,000; $3,946,000; and $765,000, respectively.
4. HEDGING ACTIVITIES
The Company had agreements with an affiliate of JEDI to hedge 50,000 MMBtu of natural gas production and 10,000 barrels of oil production monthly. The agreements, effective September 1, 1997, and terminating August 31, 1998, called for a natural gas and oil ceiling and floor price of $2.66 and $1.90 per MMBtu and $20.40 and $18.00 per barrel, respectively. If the average market price of oil and gas per month, as defined in the agreements, exceeds the ceiling price, the Company must pay the counterparty an amount equal to one-half the amount of the hedged quantities multiplied by the difference between the ceiling price and the market price. If the average market price, as defined, falls below the floor price, the counterparty will pay the Company an amount equal to the amount of the hedged quantities multiplied by the difference in the floor price and the market price. During the years ended June 30, 1999 and 1998, the Company recognized net hedging gains of approximately $85,000 and $120,000, respectively, relating to these agreements, which are included in oil and gas sales.
The Company has implemented a comprehensive hedging strategy for its natural gas production over the next few years. The table below sets out volumes of natural gas hedged with a floor price of $1.90 per MMBtu with Enron, an affiliate of JEDI, which received a fee of $478,000 during the year ended June 30, 1998 for entering into this agreement. The volumes presented in this table are divided equally over the months during the period:
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
4. HEDGING ACTIVITIES (CONTINUED)
The table below sets out volume of natural gas hedged with a swap at $2.40 per MMBtu with Enron. The volumes presented in this table are divided equally over the months during the period:
Effective May 1, 1998 through December 31, 2003, the Company has a contract involving the hedging of a portion of its future natural gas production involving floor and ceiling prices as set out in the table below. The volumes presented in this table are divided equally over the months during the period.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
4. HEDGING ACTIVITIES (CONTINUED)
During the years ended June 30, 1999 and 1998, the Company recognized hedging gains of approximately $1,690,000 and $122,000, respectively, relating to these agreements, which are included in net profits and royalty interests revenues.
During the year ended June 30, 1999, the Company entered into a swap agreement with an affiliate of JEDI to hedge 12,000 barrels of oil production monthly at $17.00 per barrel, for the months of October, November and December 1998. The Company recognized hedging gains of approximately $147,000 relating to this agreement which are included in net profits and royalty interests revenues.
During the year ended June 30, 1999, the Company entered into a swap agreement with an affiliate of JEDI to hedge 10,000 barrels of oil production monthly at $13.50 per barrel for the six months March through August, 1999, and for 5,000 barrels of oil production monthly at $14.35 per barrel, and for 5,000 barrels of oil production monthly at $14.82 per barrel for the six months April through September 1999. The Company recognized hedging losses of approximately $231,000 relating to this agreement which are included in net profits and royalty interests revenues.
The Company entered into a forward LIBOR interest rate swap effective for the period June 30, 1998 through June 29, 2009 at a rate of 6.30% on $125.0 million, which could be unwound at any time at the option of the Company. On July 9, 1998,as a result of the retirement of the Bridge Facilities and borrowings under the Credit Agreement, the Company terminated the agreement at a cost of $3,549,000. The cost of termination has been reflected as an extraordinary loss in the accompanying consolidated statement of operations for the year ended June 30, 1999.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY
GENERAL
On November 12, 1996, the Company entered into an agreement to sell 100,000 shares of Common Stock to an unrelated party for $2.50 per share.
During 1997, the Company's Certificate of Incorporation was amended to (i) authorize the issuance of 50,000,000 shares of preferred stock of the Company, par value $.01 per share (the Preferred Stock), of which 9,600,000 shares have been designated as Series A Preferred Stock, 9,600,000 shares have been designated as Series B Preferred Stock, and (ii) increase the number of authorized shares of Common stock from 40,000,000 shares to 100,000,000 shares. During 1998, 10,400 shares of Preferred Stock were designated and issued as Series C Preferred Stock.
Any authorized but unissued or unreserved Common Stock and undesignated Preferred Stock is available for issuance at any time, on such terms and for such purposes as the Board of Directors may deem advisable in the future without further action by stockholders of the Company, except as may be required by law or the Series A Certificate of Designation. The Board of Directors of the Company has the authority to fix the rights, powers, designations, and preferences of the undesignated Preferred Stock and to provide for one or more series of undesignated Preferred Stock. The authority will include, but not be limited to, determination of the number of shares to be included in the series; dividend rates and rights; voting rights, if any; conversion privileges and terms; redemption conditions; redemption values; sinking funds; and rights upon involuntary or voluntary liquidation.
CAPITAL STOCK PURCHASE AGREEMENTS
In March 1997, the Company entered into a Securities Purchase Agreement (the JEDI Purchase Agreement) with Joint Energy Development Investments Limited Partnership (JEDI), an affiliate of Enron Finance Corp. (EFC), and a Securities Purchase Agreement (the Forseti Purchase Agreement) with Forseti Investments Ltd. (Forseti).
Pursuant to the JEDI Purchase Agreement, in May 1997, JEDI acquired 9,600,000 shares of Series A Participating Convertible Preferred Stock, par value $0.01 per share, of the Company (the Series A Preferred Stock), certain warrants to purchase Common Stock and nondilution rights as in regard to future stock issuances. The aggregate consideration received by the Company consisted of $5,000,000 ($0.521 per share).
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
The JEDI nondilution rights resulted in JEDI receiving warrants, with a one year term, in connection with certain Company stock issuances prior to December 31, 1998. The exercise price of such warrants equals the price per share of the issuances.
In connection with the issuance of the Series A Preferred Stock, the Company granted JEDI certain maintenance rights and certain demand and piggyback registration rights with respect to the shares of Common Stock issuable upon conversion of the Series A Preferred Stock and the shares of Common Stock issuable upon exercise of the warrants.
Pursuant to the terms of the Series A Preferred Stock, JEDI may designate a number of directors to the Company's Board of Directors, such that the percentage of the number of directors that JEDI may designate approximates the percentage voting power JEDI has with respect to the Company's Common Stock. In addition, upon certain events of default (as defined in the Series A Certificate of Designation), JEDI will have the right to elect a majority of the directors of the Company and an option to sell the Series A Preferred Stock to the Company.
Pursuant to the Forseti Purchase Agreement, in May 1997, the Company repurchased 9,600,000 shares of Common Stock owned by Forseti in exchange for (i) $5,000,000 ($0.521 per share) cash, (ii) the issuance by the Company of Class A Common Stock Purchase Warrants to purchase 1,000,000 shares of Common Stock at an initial exercise price of $2.50 per share (the Class A Warrants) and Class B Common Stock Purchase Warrants to purchase 2,000,000 shares of Common Stock at an initial exercise price of $2.50 per share (the Class B Warrants, and together with the Class A Warrants, the Forseti Warrants), and (iii) certain contingent payments. Forseti had the option of either selling or exercising the Forseti Warrants or receiving the contingent payments. During the year ended June 30, 1998, Forseti elected to sell the warrants to a third party and thus lost the rights to receive any contingent payments.
The JEDI Purchase Agreement contains certain positive and negative covenants. The Company was in compliance with all of the applicable covenants at June 30, 1999 and 1998.
Pursuant to the JEDI Purchase Agreement, JEDI, EIBOC, and certain officers of the Company (Management Stockholders) entered into a Stockholders Agreement whereby JEDI, EIBOC, and the Management Stockholders agreed to certain restrictions on the transfer of shares of Common Stock held by EIBOC and the transfer of shares of Common Stock or securities convertible, exercisable, or exchangeable for shares of
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
Common Stock held by JEDI. The Stockholders Agreement will terminate on the earlier of (i) the fifth anniversary of the date of the Stockholders Agreement or (ii) the date on which JEDI and its affiliates beneficially own in the aggregate less than 10% of the voting power of the Company's capital stock.
SERIES A PREFERRED STOCK
The holders of shares of Series A Preferred Stock are generally entitled to vote (on an as-converted basis) as a single class with the holders of the Common Stock, together with all other classes and series of stock of the Company that are entitled to vote as a single class with the Common Stock, on all matters coming before the Company's stockholders.
For so long as at least 960,000 shares of Series A Preferred Stock are outstanding, the following matters require the approval of the holders of shares of Series A Preferred Stock, voting together as a separate class:
(i) the amendment of any provision of the Company's Certificate of Incorporation or the bylaws;
(ii) the creation, authorization, or issuance of, or the increase in the authorized amount of, any class or series of shares ranking on a parity with or prior to the Series A Preferred Stock either as to dividends or upon liquidation, dissolution, or winding up;
(iii) the merger or consolidation of the Company with or into any other corporation or other entity or the sale of all or substantially all of the Company's assets; or
(iv) the reorganization, recapitalization, or restructuring or similar transaction that requires the approval of the stockholders of the Company.
The holders of shares of Series A Preferred Stock have the right, acting separately as a class, to elect a number of members to the Company's Board of Directors. The number shall be a number such that the quotient obtained by dividing such number by the maximum authorized number of directors is as close as possible to being equal to the percentage of the outstanding voting power of the Company entitled to vote generally in the election of directors represented by the outstanding shares of Series A Preferred Stock at the relevant time.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
A holder of shares of Series A Preferred Stock has the right, at the holder's option, to convert all or a portion of its shares into shares of Common Stock at any time at an initial rate of one share of Series A Preferred Stock for one share of Common Stock.
The Series A Certificate of Designation provides for customary adjustments to the number of shares issuable upon conversion in the event of certain dividends and distributions to holders of Common Stock, certain reclassifications of the Common Stock, stock splits, and combinations and mergers and similar transactions.
The holders of the shares of Series A Preferred Stock are entitled to receive dividends (other than a dividend or distribution paid in shares of, or warrants, rights, or options exercisable for or convertible into or exchangeable for, Common Stock) when and if declared by the Board of Directors on the Common Stock in an amount equal to the amount each such holder would have received if such holder's shares of Series A Preferred Stock had been converted into Common Stock. The holders of Series A Preferred Stock will also have the right to certain dividends upon and during the continuance of an Event of Default.
Upon the liquidation, dissolution, or winding up of the Company, the holders of the shares of Series A Preferred Stock, before any distribution to the holders of Common Stock, are entitled to receive an amount per share equal to $.521 plus all accrued and unpaid dividends thereon (Liquidation Preference). The holders of the shares of Series A Preferred Stock will not be entitled to participate further in the distribution of the assets of the Company.
The Series A Certificate of Designation provides that an Event of Default will be deemed to have occurred if the Company fails to comply with any of its covenants in the JEDI Purchase Agreement, provided that the Company will have a 30-day cure period with respect to the non-compliance with certain covenants.
Upon the occurrence but only during the continuance of an Event of Default, the holders of Series A Preferred Stock are entitled to receive, in addition to other dividends payable to holders of Series A Preferred Stock, when and if declared by the Board of Directors, cumulative preferential cash dividends accruing from the date of the Event of Default in an amount per share per annum equal to 6% of the Liquidation Preference in effect at the time of accrual of such dividends, payable quarterly in arrears on or before the 15th day after the last day of each calendar quarter during which such dividends are payable. Unless full cumulative dividends accrued on shares of Series A Preferred Stock have been
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
or contemporaneously are declared and paid, no dividend may be declared or paid or set aside for payment on the Common Stock or any other junior securities (other than a dividend or distribution paid in shares of, or warrants, rights, or options exercisable for or convertible into or exchangeable for, Common Stock or any other junior securities), nor shall any Common Stock nor any other junior securities be redeemed, purchased, or otherwise acquired for any consideration, nor may any monies be paid to or made available for a sinking fund for the redemption of any shares of any such securities.
Upon the occurrence and during the continuance of an Event of Default resulting from the failure to comply with certain covenants, the holders of shares of Series A Preferred Stock have the right, acting separately as a class, to elect a number of persons to the Board of Directors of the Company that, along with any members of the Board of Directors who are serving at the time of such action, will constitute a majority of the Board of Directors.
Upon the occurrence of an Event of Default resulting from the failure to comply with certain covenants, each holder of shares of Series A Preferred Stock has the right, by written notice to the Company, to require the Company to repurchase, out of funds legally available therefor, such holder's shares of Series A Preferred Stock for an amount in cash equal to the Liquidation Preference in effect at the time of the Event of Default.
Concurrently with the transfer of any shares of Series A Preferred Stock to any person (other than a direct or indirect affiliate of JEDI or other entity managed by Enron Corp. or any of its affiliates), the shares of Series A Preferred Stock so transferred will automatically convert into a like number of shares of Series B Preferred Stock.
SERIES B PREFERRED STOCK
The Series B Certificate of Designation authorizes the issuance of up to 9,600,000 shares of Series B Preferred Stock. The terms of the Series B Preferred Stock are substantially similar to those of the Series A Preferred Stock, except that the holders of Series B Preferred Stock will not (i) have class voting rights except as required under Delaware corporate law, (ii) be entitled to any remedies upon an event of default, or (iii) be entitled to elect any directors of the Company, voting separately as a class.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
SERIES C PREFERRED STOCK
The holders of shares of Series C Preferred Stock are not entitled to vote with the holders of the Common Stock except as required by law or as set forth below. For so long as any shares of Series C Preferred Stock are outstanding, the following matters will require the approval of the holders of at least two-thirds of the then outstanding shares of Series C Preferred Stock, voting together as a separate class:
(i) alter or change the rights, preferences or privileges of the Series C Preferred Stock or any other capital stock of the Company so as to affect adversely the Series C Preferred Stock;
(ii) create any new class or series of capital stock having a preference over or ranking pari passu with the Series C Preferred Stock as to redemption, the payment of dividends or distribution of assets upon a Liquidation Event (as defined in the Series C Certificate of Designation) or any other liquidation, dissolution or winding up of the Company;
(iii) increase the authorized number of shares of Preferred Stock of the Company;
(iv) re-issue any shares of Series C Preferred Stock which have been converted in accordance with the terms hereof;
(v) issue any Senior Securities (other than the Company's Series B Preferred Stock pursuant to the terms of the Company's Series A Preferred Stock) or Pari Passu Securities (each, as defined in the Series C Certificate of Designation); or
(vi) declare, pay or make any provision for any dividend or distribution with respect to the Common Stock or any other capital stock of the Company ranking junior to the Series C Preferred Stock as to dividends or as to the distribution of assets upon liquidation, dissolution or winding up of the Company.
The holders of at least two-thirds (2/3) of the then outstanding shares of Series C Preferred Stock can agree to allow the Company to alter or change the rights, preferences or privileges of the shares of Series C Preferred Stock. Holders of the Series C Preferred Stock that did not agree to such alteration or change shall have the right for a period of thirty (30) days following such change to convert their Series C Preferred Stock to Common Stock.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
A holder of shares of Series C Preferred Stock has the right, at the holder's option, to convert all or a portion of its shares into shares of Common Stock at any time. The number of shares of Common Stock into which a share of Series C Preferred Stock may be converted will be determined as of the conversion date according to a formula set forth in the Series C Certificate of Designation. Generally, the conversion rate is equal to the aggregate stated value of the shares to be converted divided by a floating conversion price that may not exceed $7.35 per share. On December 24, 2001, all shares of Series C Preferred Stock that are then outstanding shall be automatically converted into shares of Common Stock.
The Series C Certificate of Designation provides for customary adjustments to the number of shares issuable upon conversion in the event of certain dividends and distributions to holders of Common Stock, certain reclassifications of the Common Stock, stock splits, combinations and mergers, and similar transactions and certain changes of control.
The holders of the shares of Series C Preferred Stock are entitled to receive cumulative dividends, when and if declared by the Board of Directors, subject to the prior payment of any accumulated and unpaid dividends to holders of Senior Securities, but before payment of dividends to holders of Junior Securities (as defined in the Series C Certificate of Designation), on each share of Series C Preferred Stock in an amount equal to the stated value of such share multiplied by 5%.
Upon the liquidation, dissolution or winding up of the Company, the holders of the shares of Series C Preferred Stock, before any distribution to the holders of Junior Securities, and after payments to holders of Senior Securities, will be entitled to receive an amount equal to the stated value of the Series C Preferred Stock (subject to ratable adjustment in the event of reclassification of the Series C Preferred Stock or other similar event) plus any accrued and unpaid dividends thereon.
The Company has the right to redeem all of the outstanding Series C Preferred Stock under certain conditions. Holders of Series C Preferred Stock have the right to tender shares for redemption upon the occurrence of certain events, which are in the control of management. During fiscal year 1999, the Company repurchased 2,152 shares of Series C Preferred Stock at a cost of $2,251,000.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
During fiscal year 1999, 3,550 shares of Series C Preferred Stock were converted into 1,328,639 shares of Common Stock. Additionally, 77,571 shares of Common Stock, representing accrued but unpaid dividends due to the converting Series C Preferred Stock holders, were issued upon conversion.
COMMON STOCK
During July 1998, the Company completed the private placement of an aggregate of 3,428,574 shares of the Company's Common Stock at $7 per share (the July Equity Offerings) which included certain repricing rights (the Repricing Rights) to acquire additional shares of Common Stock (Repricing Common Shares) and warrants (the Warrants) to purchase an aggregate of up to 1,085,000 shares of Common Stock (Warrant Common Shares). Additionally, JEDI exercised warrants to acquire an aggregate of 980,935 shares of Common Stock at $3.33 per share and nondilution rights to purchase 693,301 shares of the Company's Common Stock at $2.50 per share and another entity exercised warrants to acquire an aggregate of 800,000 shares of Common Stock at $2.50 per share (collectively, the Warrant Exercises).
During November 1998, the Company completed the private placement of an aggregate of 416,667 shares of the Company's Common Stock at $6 per share (the November Equity Offerings) which included certain repricing rights (the Repricing Rights) to acquire additional shares of Common Stock (Repricing Common Shares) and warrants (the Warrants) to purchase an aggregate of up to 206,340 shares of Common Stock (Warrant Common Shares).
The Repricing Rights allows the purchasers of the Common Shares under the Equity Offerings to receive Repricing Common Shares based on the following formula:
(Repricing Price - Market Price) X Common Shares -------------------------------- Market Price
The Repricing Price is a percentage increase in the purchase price paid for the Common Shares (up to 128% over the following 8 months). The Repricing Rights can only be exercised one time and the Company can repurchase the Repricing Rights under certain conditions. During the year ended June 30, 1999, 1,384,016 shares of Common Stock were issued upon exercise of Repricing Rights.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
Each holder of Repricing Common Shares or Repricing Rights has the right to require the Company to repurchase all or a portion of such holder's Repricing Common Shares or Repricing Rights upon the occurrence of a Major Transaction or a Triggering Event, both of which are under the control of management of the Company.
The Warrants are exercisable for three years commencing July 8, 1998 and November 23, 1998 at an exercise price equal to 110% of the Purchase Price. The Warrants provide for customary adjustments to the exercise price and number of shares to be issued in the event of certain dividends and distributions to holders of Common Stock, stock splits, combinations and mergers. The Warrants also include customary provisions with respect to, among other things, transfer of the Warrants, mutilated or lost warrant certificates, and notices to holder(s) of the Warrants.
WARRANTS
As of June 30, 1999, JEDI held warrants to purchase an aggregate of 2,569,746 shares of Common Stock at prices ranging from $3.54 to $7.44. The warrants held by JEDI expire at various times from August 19, 1999 through December 22, 1999. In addition, certain institutional investors hold warrants to purchase an aggregate of 4,275,138 shares of Common Stock at prices ranging from $1.50 to a floating rate based on market price at the time of exercise. The warrants held by the institutional investors expire at various times from September 30, 1999 through December 24, 2001.
RIGHTS
As of June 30, 1999, JEDI held rights to purchase an aggregate of 201,366 shares of Common Stock at $0.625. These rights expired unexercised during July 1999.
STOCK OPTIONS
Employee stock option activity for the years ended June 30, 1999,1998 and 1997 is as follows:
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
The weighted-average grant date fair value of stock options granted during 1999 and 1998 were $6.23 and $3.22, respectively. The grant date fair values were estimated at the date of grant using the Black-Scholes option pricing model. As of June 30, 1999, the weighted average remaining contractual life of outstanding stock options was 8.4 years.
Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation, (SFAS 123) requires the disclosure of pro forma net income and earnings per share information computed as if the Company had accounted for its employee stock options under the fair value method set forth in SFAS 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions, respectively: a risk-free interest rate of 6.00% and 5.88% during 1999 and 1998,respectively; a dividend yield of 0%; and a volatility factor of .792 and .51 during 1999 and 1998, respectively. In addition, the fair value of these options was estimated based on an expected weighted average life of 10 years and 7.5 years during 1999 and 1998, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. STOCKHOLDERS' EQUITY (CONTINUED)
estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows:
6. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. The carrying value of accounts receivable, accounts payable, and accrued liabilities approximates fair value because of the short maturity of those instruments. The estimated fair value of the Company's long-term obligations is estimated based on the current rates offered to the Company for similar maturities. At June 30, 1999 and 1998, the carrying value of long-term obligations approximates their fair values.
7. RELATED PARTY TRANSACTIONS
During 1997, the Company was charged a monthly fee by Capital House A Finance and Investment Corporation (Capital House) (owned by certain officers of the Company) for general and administrative costs. Such fee covered the services provided to the Company by certain employees of Capital House and amounted to $440,000 for the year ended June 30, 1997. The Company also reimbursed Capital House for certain direct general and administrative costs incurred by Capital House on behalf of the Company. The Company reimbursed Capital House approximately $129,000 for such costs for the year ended June 30, 1997. The Company capitalized $120,000 of the management fees and general and administrative costs paid to Capital House which were directly associated with oil and gas property acquisitions, exploration, and development for the year ended June 30, 1997. The agreement with Capital House was terminated effective May 31, 1997, at which time the Company purchased all existing assets of Capital House.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
7. RELATED PARTY TRANSACTIONS (CONTINUED)
The Company has entered into various hedging arrangements with affiliates of Enron. (see Note 4).
The Company has entered into a revolving credit facility with ECT, an affiliate of Enron. (see Note 3). During the year ended June 30, 1998, commitment fees of approximately $200,000 and interest totaling approximately $9,000 was paid to ECT in connection with this facility.
Enron, through its affiliates, participated in the Bridge Facilities and the Credit Agreement (see Note 3). During the years ended June 30, 1999 and 1998, Enron received fees of approximately $0 and $460,000, respectively, and interest payments of approximately $365,000 and $542,000, respectively, from the Company relating to its participation in these facilities.
The Company paid Enron approximately $100,000 during both of the years ended June 30, 1999 and 1998 under the terms of an agreement which allows the Company to consult, among other things, with Enron's engineering staff.
During the years ended June 30, 1999 and 1998, the Company paid approximately $38,000 and $26,000, respectively, to a company affiliated with a director of the Company for operating certain of the Company's properties.
8. INCOME TAXES
The Company's effective tax rate differs from the U.S. statutory rate for each of the years ended June 30, 1999, 1998, and 1997 due to losses for which no deferred tax benefit was recognized. The tax effects of the primary temporary differences giving rise to the deferred federal income tax assets and liabilities as determined under Statement of Accounting Standards No. 109, "Accounting for Income Taxes," at June 30, 1999 and 1998, follow:
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
8. INCOME TAXES (CONTINUED)
The net changes in the total valuation allowance for the years ended June 30, 1999 and 1998, were increases of $15,677,000 and $11,133,000, respectively. The Company's net operating loss carryforwards begin expiring in 2010.
9. OIL AND GAS PRODUCING ACTIVITIES
The following tables set forth supplementary disclosures for oil and gas producing activities in accordance with Statement of Financial Accounting Standards No. 69.
RESULTS OF OPERATIONS FOR PRODUCING ACTIVITIES
The following sets forth certain information with respect to results of operations from oil and gas producing activities for the years ended June 30, 1999 1998, and 1997:
Depreciation and amortization of oil and gas properties was $.74, $.89 and $.68 per Mcfe produced for the years ended June 30, 1999, 1998, and 1997, respectively.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
9. OIL AND GAS PRODUCING ACTIVITIES (CONTINUED)
CAPITALIZED COSTS
The following table summarizes capitalized costs relating to oil and gas producing activities and related amounts of accumulated depreciation and amortization at June 30, 1999 and 1998:
COSTS INCURRED
The following sets forth certain information with respect to costs incurred, whether expensed or capitalized, in oil and gas activities for the years ended June 30, 1999, 1998 and 1997:
10. SUPPLEMENTARY OIL AND GAS DATA (UNAUDITED)
RESERVE QUANTITY INFORMATION
The following table presents the Company's estimate of its proved oil and gas reserves, all of which are located in the United States. The Company emphasizes that reserve estimates are inherently imprecise and that estimates of new discoveries are more imprecise than those of producing oil and gas properties. Accordingly, the estimates are expected to change as future information becomes available. The estimates have been prepared by independent petroleum reservoir engineers.
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. SUPPLEMENTARY OIL AND GAS DATA (UNAUDITED) (CONTINUED)
STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVES (UNAUDITED)
The Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Oil and Gas Reserves (Standardized Measure) is a disclosure requirement under Statement of Financial Accounting Standards No. 69.
The Standardized Measure of discounted future net cash flows does not purport to be, nor should it be interpreted to present, the fair value of the Company's oil and gas reserves. An estimate of fair value would also take into account, among other things, the recovery of reserves not presently classified as proved, the value of unproved properties, and consideration of expected future economic and operating conditions.
Under the Standardized Measure, future cash flows are estimated by applying year-end prices, adjusted for fixed and determinable escalations, to the estimated future production
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. SUPPLEMENTARY OIL AND GAS DATA (UNAUDITED) (CONTINUED)
of year-end proved reserves. Future cash inflows are reduced by estimated future production and development costs based on period-end costs to determine pretax cash inflows. Future income taxes are computed by applying the statutory tax rate to the excess of pretax cash inflows over the Company's tax basis in the associated properties. Tax credits, net operating loss carryforwards, and permanent differences are also considered in the future tax calculation. Future net cash inflows after income taxes are discounted using a 10% annual discount rate to arrive at the Standardized Measure.
The Standardized Measure of discounted future net cash flows relating to proved oil and gas reserves as of June 30, 1999 and 1998, are as follows:
The weighted average price of oil and gas at June 30, 1999 and 1998, used in calculating the Standardized Measure were $17.11 and $12.80 per barrel, respectively, and $2.44 and $2.40 per MCF, respectively.
Changes in the Standardized Measure of discounted future net cash flows relating to proved oil and gas reserves for the years ended June 30, 1999, 1998, and 1997, are as follows:
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. SUPPLEMENTARY OIL AND GAS DATA (UNAUDITED) (CONTINUED)
The future cash flows shown above include amounts attributable to proved undeveloped reserves requiring approximately $18,811,000 of future development costs. If these reserves are not developed, the future net cash flows shown above would be significantly reduced.
Estimates of economically recoverable gas and oil reserves and of future net revenues are based upon a number of variable factors and assumptions, all of which are to some degree speculative and may vary considerably from actual results. Therefore, actual production, revenues, taxes, development, and operating expenditures may not occur as estimated. The reserve data are estimates only, are subject to many uncertainties, and are based on data gained from production histories and on assumptions as to geologic formations and other matters. Actual quantities of gas and oil may differ materially from the amounts estimated.
11. QUARTERLY FINANCIAL RESULTS (UNAUDITED)
Subsequent to March 31, 1999, the Company determined that the costs associated with the termination of the LIBOR interest rate swap agreement in the first quarter of fiscal year 1999 should have been expensed upon termination. The following interim financial information has been restated from the information contained in the Company's Form 10-Q's as filed with the Securities and Exchange Commission as if the costs of the LIBOR interest rate swap termination were expensed during the first quarter:
Queen Sand Resources, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. QUARTERLY FINANCIAL RESULTS (UNAUDITED) (CONTINUED)
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item will be set forth under the captions "Election of Directors," "Section 16(a) Beneficial Ownership Reporting Compliance," and "Executive Officers" of our proxy statement for our 1999 Annual Meeting of Stockholders (the "Proxy Statement") which will be filed with the Commission pursuant to Regulation 14A under the Exchange Act and is incorporated herein by reference. The Proxy Statement is expected to be filed on or prior to October 28, 1999.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is set forth under the caption "Executive Compensation" of our Proxy Statement which will be filed with the Commission pursuant to Regulation 14A under the Exchange Act and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" of our Proxy Statement which will be filed with the Commission pursuant to Regulation 14A under the Exchange Act and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is set forth under the captions "Executive Compensation", " Director Compensation" and "Certain Relationships and Related Party Transactions" of our Proxy Statement which will be filed with the Commission pursuant to Regulation 14A under the Exchange Act and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS
See Index to Consolidated Financial Statements following the signature page to this annual report on Form 10-K.
(a) (2) FINANCIAL STATEMENT SCHEDULES
All Schedules are omitted because the information is not required under the related instructions or is inapplicable or because the information is included in the Consolidated Financial Statements or related notes.
EXHIBIT DESCRIPTION
(a) (3) EXHIBITS
3.1 Restated Certificate of Incorporation, filed as Exhibit 4.5 to the Company's Registration Statement on Form S-3 (No. 333-47577) filed with the Securities and Exchange Commission on March 9, 1998, which Exhibit is incorporated herein by reference.
3.2 Certificate of Designation of Series C Convertible Preferred Stock, filed as an exhibit to the Company's Current Report on Form 8-K dated December 24, 1997, which Exhibit is incorporated herein by reference.
3.3 Amended and Restated Bylaws, filed as an Exhibit to the Company's Current Report on Form 8-K dated May 6, 1997, which Exhibit is incorporated herein by reference.
4.1 Stockholders' Agreement dated as of May 6, 1997, among the Company, Bruce I. Benn, Edward J. Munden, Ronald I. Benn, Robert P. Lindsay, EIBOC Investments Ltd. and Joint Energy Development Investments Limited Partnership (AJEDI@), filed as an Exhibit to the Company's Current Report on Form 8-K dated May 6, 1997, which Exhibit is incorporated herein by reference.
4.2 Indenture, dated July 1, 1998, in regard to 122% Senior Notes due 2008 by and among the Company and certain of its subsidiaries and Harris Trust and Savings Bank, as Trustee, filed as an Exhibit to the Company's Current Report on Form 8-K dated July 8, 1998, which Exhibit is incorporated herein by reference.
4.3 Form of 12% Notes due July 15, 2001, filed as an Exhibit to the Company's Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on August 12, 1996, which Exhibit is incorporated herein by reference.
4.4 Form of Common Stock Purchase Warrant dated December 24, 1997 and issued to certain institutional investors, filed as an Exhibit to the Company's Current Report on Form 8-K dated December 24, 1997, which Exhibit is incorporated herein by reference.
4.5 Form of Common Stock Purchase Warrant dated as of July 8, 1998 issued to certain institutional investors, filed as an Exhibit to the Company's Current Report on Form 8-K dated July 8, 1998, which Exhibit is incorporated herein by reference.
(a) (3) EXHIBITS
4.6 Registration Rights Agreement among the Company and certain institutional investors named therein, dated December 24, 1997, filed as an Exhibit to the Company's Current Report on Form 8-K dated December 24, 1997, which Exhibit is incorporated herein by reference.
4.7 Registration Rights Agreement by and between the Company and JEDI dated May 6, 1997, filed as an Exhibit to the Company's Current Report on Form 8-K dated May 6, 1997, which Exhibit is incorporated herein by reference.
4.8 Registration Rights Agreement dated as of December 29, 1997 among the Company, the ECT Agent and JEDI, filed as an Exhibit to the Company's Quarterly Report on Form 10-QSB for the quarter ended December 30, 1997, which Exhibit is incorporated herein by reference.
4.9 Registration Rights Agreement dated as of July 8, 1998 among the Company and the buyers signatory thereto, filed as an Exhibit to the Company's Current Report on Form 8-K dated July 8, 1998, which Exhibit is incorporated herein by reference.
4.10 Common Stock Purchase Warrant Representing Right to Purchase 80,108 Shares of Common Stock of the Company dated as of November 30, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.11 Common Stock Purchase Warrant Representing Right to Purchase 206,340 Shares of Common Stock of the Company dated as of November 23, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.12 Common Stock Purchase Warrant Representing Right to Purchase 18,836 Shares of Common Stock of the Company dated as of November 27, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.13 Common Stock Purchase Warrant Representing Right to Purchase 3,160 Shares of Common Stock of the Company dated as of November 25, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.14 Common Stock Purchase Warrant Representing Right to Purchase 162,955 Shares of Common Stock of the Company dated as of November 30, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.15 Registration Rights Agreement dated November 10, 1998 among Queen Sand Resources, Inc. and the buyers signatory thereto, filed as an Exhibit to the Company's Current Report on Form 8-K dated November 24, 1998, which Exhibit is incorporated herein by reference.
4.16 Form of Common Stock Purchase Warrant issued to certain investors as of November 10, 1998, filed as an Exhibit to the Company's Current Report on Form 8-K dated November 24, 1998, which Exhibit is incorporated herein by reference.
(a) (3) EXHIBITS
4.17 Common Stock Purchase Warrant Representing Right to Purchase 22,033 Shares of Common Stock of the Company dated as of December 28, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.18 Common Stock Purchase Warrant Representing Right to Purchase 12,380 Shares of Common Stock of the Company dated as of December 15, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.19 Common Stock Purchase Warrant Representing Right to Purchase 133,708 Shares of Common Stock of the Company dated as of December 14, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.20 Common Stock Purchase Warrant Representing Right to Purchase 37,141 Shares of Common Stock of the Company dated as of December 11, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.21 Common Stock Purchase Warrant Representing Right to Purchase 8,360 Shares of Common Stock of the Company dated as of December 9, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.22 Common Stock Purchase Warrant Representing Right to Purchase 10,973 Shares of Common Stock of the Company dated as of December 7, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.23 Common Stock Purchase Warrant Representing Right to Purchase 8,180 Shares of Common Stock of the Company dated as of December 4, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.24 Common Stock Purchase Warrant Representing Right to Purchase 13,335 Shares of Common Stock of the Company dated as of December 4, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.25 Common Stock Purchase Warrant Representing Right to Purchase 8,180 Shares of Common Stock of the Company dated as of December 2, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.26 Common Stock Purchase Warrant Representing Right to Purchase 21,331 Shares of Common Stock of the Company dated as of December 2, 1998 issued to JEDI, filed as an Exhibit to the Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.27 Common Stock Purchase Warrant Representing Right to Purchase 18,372 Shares of Common Stock of the Company dated as of November 30, 1998 issued to JEDI, filed as an Exhibit to the
(a) (3) EXHIBITS
Company's Registration Statement on Form S-3 initially filed on January 22, 1999 (No. 333-70993), which Exhibit is incorporated by reference.
4.28 Form of Common Stock Purchase Warrant issued to Northern Tier Asset Management, Inc. issued by the Company on April 9, 1999 and filed as an exhibit to the Company's Registration Statement on form S-3 (No. 333-78001) which exhibit is incorporated by reference.
4.29 Registration Rights Agreement dated as of April 9, 1999 between the Company and Northern Tier Asset Management, Inc. and filed as an exhibit to the Company's Registration Statement on form S-3 (No. 333-78001) which exhibit is incorporated by reference.
10.1 Purchase and Sale Agreement between Eli Rebich and Southern Exploration Company, a Texas corporation, and Queen Sand Resources, Inc., a Nevada corporation, dated April 10, 1996, filed as an Exhibit to the Company's Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on August 12, 1996, which Exhibit is incorporated herein by reference.
10.2 Purchase and Sale Agreement dated March 19, 1998 among the Morgan commingled pension funds and Queen Sand Resources, Inc., a Nevada corporation, filed as an Exhibit to the Company's Current Report on Form 8-K dated March 19, 1998, which Exhibit is incorporated herein by reference.
10.3 Securities Purchase Agreement dated as of March 27, 1997 between JEDI and the Company, filed as an Exhibit to the Company's Current Report on Form 8-K dated March 27, 1997, which Exhibit is incorporated herein by reference.
10.4 Securities Purchase Agreement among the Company and certain institutional investors named therein, dated December 22, 1997, filed as an Exhibit to the Company's Current Report on Form 8-K dated December 24, 1997, which Exhibit is incorporated herein by reference.
10.5** Queen Sand Resources 1997 Incentive Equity Plan, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, which Exhibit is incorporated herein by reference.
10.6** Employment Agreement dated December 15, 1997 between the Company and Robert P. Lindsay, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998 (No. 333-61403) which Exhibit is incorporated herein by reference.
10.7** Employment Agreement dated December 15, 1997 among the Company, Queen Sand Resources (Canada) Inc. and Bruce I. Benn, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, (No. 333-61403) which Exhibit is incorporated herein by reference.
10.8** Employment Agreement dated December 15, 1997 among the Company, Queen Sand Resources (Canada) Inc. and Ronald Benn, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, (No. 333-61403) which Exhibit is incorporated herein by reference.
10.9** Employment Agreement dated December 15, 1997 among the Company, Queen Sand Resources (Canada) Inc. and Edward J. Munden, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, (No. 333-61403) which Exhibit is incorporated herein by reference.
(a) (3) EXHIBITS
10.10 Subordinated Revolving Credit Loan Agreement dated as of December 29, 1997, executed by Queen Sand Resources, Inc., certain lenders now or hereafter parties thereto, and Enron Capital & Trade Resources Corp. ("ECT"), as agent ("ECT Agent") for the lenders ("ECT Lenders"), filed as an Exhibit to the Company's Quarterly Report on Form 10-QSB for the quarter ended December 30, 1997, which Exhibit is incorporated herein by reference.
10.11 First Amendment to Loan Agreement among Queen Sand Resources, Inc. as borrower, ECT Agent, and ECT Lenders, effective as of June 30, 1998, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, (No. 333-61403) which Exhibit is incorporated herein by reference.
10.12* Second Amendment to Loan Agreement among Queen Sand Resources, Inc. as borrower, ECT Agent, and ECT Lenders, effective as of November 24, 1998, filed as an Exhibit to the Company's Registration Statement on Form S-3 filed with the Securities and Exchange Commission on June 9, 1999, (No. 333-78001) which Exhibit is incorporated herein by reference.
10.13 Guaranty dated as of December 29, 1997, executed by Queen Sand Resources, Inc., a Delaware corporation, in favor of ECT Agent and the ECT Lenders, filed as an Exhibit to the Company's Quarterly Report on Form 10-QSB for the quarter ended December 30, 1997, which Exhibit is incorporated herein by reference.
10.14 Guaranty dated as of December 29, 1997, executed by Corrida Resources, Inc., a Nevada corporation, and Northland Operating Co., a Nevada corporation, in favor of ECT Agent and the ECT Lenders, filed as an Exhibit to the Company's Quarterly Report on Form 10-QSB for the quarter ended December 30, 1997, which Exhibit is incorporated herein by reference.
10.15 Subordination Agreement dated as of December 29, 1997, executed by the Agent in favor of the Bank of Montreal as agent for the senior lenders, Queen Sand Resources, Inc. and the Guarantors, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998 (No. 333-61403) which Exhibit is incorporated herein by reference.
10.16 Amended and Restated credit agreement, dated as of April 17, 1998, among the Company, Queen Sand Resources, Inc., a Nevada corporation, the Bank of Montreal and the lenders signatory thereto, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998 (No. 333-61403) which Exhibit is incorporated herein by reference.
10.17 First Amendment to Amended and Restated credit agreement dated effective as of July 1, 1998, among the Company, Queen Sand Resources, Inc., a Nevada corporation, the Bank of Montreal and the lenders signatory thereto, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998 (No. 333-61403) which Exhibit is incorporated herein by reference.
10.18* Second Amendment to Amended and Restated credit agreement dated effective as of November 10, 1998, among the Company, Queen Sand Resources, Inc., a Nevada corporation, the Bank of Montreal and the lenders signatory thereto, which Exhibit is attached hereto.
10.19* Third Amendment to Amended and Restated credit agreement dated effective as of November 13, 1998, among the Company, Queen Sand Resources, Inc., a Nevada corporation, the Bank of Montreal and the lenders signatory thereto, which Exhibit is which Exhibit is attached hereto.
(a) (3) EXHIBITS
10.20 Fourth Amendment to Amended and Restated credit agreement dated effective as of April 16, 1998, among the Company, Queen Sand Resources, Inc., a Nevada corporation, the Bank of Montreal and the lenders signatory thereto, filed as an Exhibit to the Company's Quarterly Report on form 10-Q for the quarter ended March 31, 1999, which Exhibit is incorporated herein by reference.
10.21 Amended and Restated Guaranty Agreement executed by the Company, in favor of the Bank of Montreal, as agent, dated as of April 17, 1998, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998 (No. 333-61403), which Exhibit is incorporated herein by reference.
10.22 Amended and Restated Guaranty Agreement executed by Northland Operating Co. in favor of the Bank of Montreal, as agent, dated as of April 17, 1998, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998 (No. 333-61403), which Exhibit is incorporated herein by reference.
10.23 Amended and Restated Guaranty Agreement dated as of August 1, 1997 executed by Corrida Resources, Inc., a Nevada corporation, in favor of the Bank of Montreal, as agent, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, which Exhibit is incorporated herein by reference.
10.24 Amended and Restated Security Agreement dated as of April 17, 1998 executed by Queen Sand Resources, Inc., a Nevada corporation, in favor of the Bank of Montreal, filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1998, which Exhibit is incorporated herein by reference.
10.25** Directors' Non-Qualified Stock Option Plan filed as Appendix A to the Company's Definitive Proxy Statement on Schedule 14A dated October 23, 1998, which Exhibit is incorporated herein by reference.
10.26 Amended and Restated Securities Purchase Agreement dated as of July 8, 1998 among the Company and the buyers signatory thereto, filed as an Exhibit to the Company's Current Report on Form 8-K dated July 8, 1998, as amended by the Current Report on Form 8-K/A-1 dated July 8, 1998, which Exhibit is incorporated herein by reference.
10.27 Securities Purchase Agreement dated as of November 10, 1998 among the Company and the buyers signatory thereto, filed as an Exhibit to the Company's Current Report on Form 8-K dated November 24, 1998.
21.1 List of the subsidiaries of the registrant filed as an Exhibit to the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on August 13, 1999 (No. 333-61403) which Exhibit is incorporated by reference
23.1* Consent of Ernst & Young LLP.
23.2* Consent of H.J. Gruy and Associates, Inc.
23.3* Consent of Harper & Associates, Inc.
23.4* Consent of Ryder Scott Company.
(a) (3) EXHIBITS
23.5* Financial Data Schedule
(b) Reports on Form 8-K filed in the fourth quarter 1998: None
(c) See sub-item (a) above.
(d) See sub-item (a) above.
* Filed herewith. **Denotes Management Contract.
GLOSSARY
The terms defined in this glossary are used throughout this Annual Report on Form 10-KSB.
average NYMEX price. The average of the NYMEX closing prices for the near month.
Bbl. One stock tank barrel, or 42 U.S. gallons liquid volume, used herein in reference to crude oil or other liquid hydrocarbons.
Bbl/d. Bbl per day.
Bcf. One billion cubic feet of natural gas.
Bcfe. One billion cubic feet of natural gas equivalents, converting one Bbl of oil to six Mcf of natural gas.
behind-the-pipe. Hydrocarbons in a potentially producing horizon penetrated by a well bore the production of which has been postponed pending the production of hydrocarbons from another formation penetrated by the well bore. The hydrocarbons are classified as proved but non-producing reserves.
BOE. Barrels of oil equivalent (converting six Mcf of natural gas to one Bbl of oil).
development well. A well drilled within the proved boundaries of an oil or natural gas reservoir to the depth of a stratigraphic horizon known to be productive.
dry well. A development or exploratory well found to be incapable of producing either oil or natural gas in sufficient quantities to justify completion as an oil or natural gas well.
exploratory well. A well drilled to find and produce oil or natural gas in an unproved area, to find a new reservoir in a field previously found to be productive of oil or natural gas in another reservoir, or to extend a known reservoir.
gross acres or gross wells. The total number of acres or wells, as the case may be, in which a working interest is owned.
LOE. Lease operating expenses are those expense directly associated with crude oil and/or natural gas producing or service wells.
MBbl. One thousand barrels of crude oil or other liquid hydrocarbons.
MBOE. One thousand barrels of oil equivalent (converting six Mcf of natural gas to one Bbl of oil).
Mcf. One thousand cubic feet of natural gas.
Mcf/d. Mcf per day.
Mcfe. One thousand cubic feet of natural gas equivalents, converting one Bbl of oil to six Mcf of gas.
MMBbl. One million barrels of crude oil or other liquid hydrocarbons.
MMBOE. One million barrels of all equivalent.
MMcfe. One million cubic feet of natural gas equivalents, converting one Bbl of oil to six Mcf of gas.
MMcf. One million cubic feet of natural gas.
net acres or net wells. The sum of the fractional working interests owned in gross acres or gross wells.
net profits interest. A share of the gross oil and natural gas production from a property, measured by net profits from the operation of the property that is carved out of the working interest. This is a non-operated interest.
NYMEX. New York Mercantile Exchange.
producing well, production well, or productive well. A well that is producing oil or natural gas or that is capable of production.
proved developed reserves, proved developed producing or PDP. Proved developed reserves are oil and natural gas reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Additional oil and natural gas expected to be obtained through the application of fluid injection or other improved recovery techniques for supplementing the natural forces and mechanisms of primary recovery should be included as 'proved developed reserves' only after testing by a pilot project or after the operation of an installed program has confirmed through production response that increased recovery will be achieved.
proved reserves. Proved reserves are the estimated quantities of crude oil, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions.
proved undeveloped reserves or PUD. Proved undeveloped reserves are oil and natural gas reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion. Reserves on undrilled acreage shall be limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units can be claimed only where it can be demonstrated with certainty that there is continuity of production from the existing productive formation. Under no circumstances should estimates for proved undeveloped reserves be attributable to any acreage for which an application of fluid injection or other improved recovery techniques is contemplated, unless such techniques have been proved effective by actual tests in the area and in the same reservoir.
Reserve Life Index. The estimated productive life of a proved reservoir based upon the economic limit of such reservoir producing hydrocarbons in paying quantities assuming certain price and cost parameters. For purposes of this Annual Report on Form 10-K, reserve life is calculated by dividing the proved reserves (on a Mcfe basis) at the end of the period by production volumes for the previous 12 months.
royalty interest. An interest in an oil and natural gas property entitling the owner to a share of oil and natural gas production free of costs of production.
SEC PV-10. The present value of proved reserves is an estimate of the discounted future net cash flows from each of the properties at June 30, 1998, or as otherwise indicated. Net cash flow is defined as net revenues less, after deducting production and ad valorem taxes, future capital costs and operating expenses, but before deducting federal income taxes. As required by rules of the Commission, the future net cash flows have been discounted at an annual rate of 10% to determine their 'present value.' The present value is shown to indicate the effect of time on the value of the revenue stream and should not be construed as being the fair market value of the properties. In accordance with Commission rules, estimates have been made using constant oil and natural gas prices and operating costs, at June 30, 1999, or as otherwise indicated.
secondary recovery. A method of oil and natural gas extraction in which energy sources extrinsic to the reservoir are utilized.
service well. A well used for water injection in secondary recovery projects or for the disposal of produced water.
Standardized Measure. Under the Standardized Measure, future cash flows are estimated by applying year-end prices, adjusted for fixed and determinable escalations, to the estimated future production of year-end proved reserves. Future cash inflows are reduced by estimated future production and development costs based on period-end costs to determine pretax cash inflows. Future income taxes are computed by applying the statutory tax rate to the excess of pretax cash inflows over the Company's tax basis in the associated properties. Tax credits, net operating loss carryforwards, and permanent differences are also considered in the future tax calculation. Future net cash inflows after income taxes are discounted using a 10% annual discount rate to arrive at the Standardized Measure.
undeveloped acreage. Lease acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas regardless of whether such acreage contains proved reserves.
working interest. The operating interest which gives the owner the right to drill, produce and conduct operating activities on the property and a share of production, subject to all royalties, overriding royalties and other burdens and to all costs of exploration to, development and operations and all risks in connection therewith.
SIGNATURE PAGE
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY ON THE 13TH OF OCTOBER, 1999.
QUEEN SAND RESOURCES, INC.
By: /s/ EDWARD J. MUNDEN --------------------------------------------- Name: Edward J. Munden Title: Chief Executive Officer, President and Chairman of the Board
In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 13th day of October, 1999.
EXHIBIT INDEX
* Filed herewith. **Denotes Management Contract. | 26,617 | 167,110 |
277158_1999.txt | 277158_1999 | 1999 | 277158 | ITEM 1. BUSINESS
SEMCO ENERGY, INC.
SEMCO Energy, Inc. is a diversified energy services and infrastructure holding company headquartered in southeastern Michigan. It was founded in 1950 as Southeastern Michigan Gas Company. SEMCO Energy, Inc. and its subsidiaries (the "Company") operate four business segments: (1) gas distribution; (2) pipeline construction services; (3) engineering services; and (4) propane, pipelines and storage. The latter three segments are sometimes referred to together as the "diversified businesses". The Company sold the subsidiary comprising its energy marketing business effective March 31, 1999. In addition, several business acquisitions were made during 1999. These acquisitions are discussed in the following business segment sections. The Company had approximately 1,632 employees at December 31, 1999.
GAS DISTRIBUTION
The Company's gas distribution business segment operates in Michigan and Alaska. The Alaska-based operation, which consists of ENSTAR Natural Gas Company and Alaska Pipeline Company (together known as "ENSTAR"), was acquired on November 1, 1999 for approximately $290,000,000. The acquisition of ENSTAR was accounted for as a purchase and therefore, the consolidated financial statements and the table below include the results of ENSTAR's operations since November 1, 1999. The success of the ENSTAR acquisition is, in part, dependent on the synergies obtained in combining ENSTAR with the Company's other gas distribution operations, the Company's ability to operate ENSTAR in accordance with its plans and the Company's ability to accomplish its permanent financing related to the ENSTAR acquisition in a timely and cost-effective manner in light of changing conditions in the capital markets.
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The Michigan gas distribution operation and ENSTAR are referred to together as the "Gas Distribution Business". The Michigan gas distribution operation and ENSTAR Natural Gas Company operate as divisions of SEMCO Energy, Inc. SEMCO Energy Gas Company, which had conducted the Michigan gas distribution operation, was merged into SEMCO Energy, Inc. on December 31, 1999. Alaska Pipeline Company operates as a subsidiary of SEMCO Energy, Inc. The Gas Distribution Business distributes and transports natural gas to residential, commercial and industrial customers and is the Company's largest business segment. Set forth in the table below is gas sales and transportation information for the past three years:
Refer to Note 12 of the Notes to the Consolidated Financial Statements on pages 60 and 61 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, for the Gas Distribution Business' operating revenues, operating income, assets and other financial information for the past three years.
GAS SALES - Gas sales revenue is generated primarily through the sale and delivery of natural gas to residential and commercial customers. These customers use natural gas mainly for space heating purposes. Consequently, weather has a significant impact on sales. Given the impact of weather on this business segment, most of its gas sales revenue is earned in the first and fourth quarters of the calendar year. Revenues from gas sales accounted for 50%, 26% and 28% of consolidated operating revenues in 1999, 1998 and 1997, respectively. If operating revenues from the Company's energy marketing business, which was sold effective March 31, 1999, are excluded, gas sales by the Gas Distribution Business would have accounted for 66%, 68% and 88% of consolidated operating revenues for those three years. Competition in the gas sales market arises from alternative energy sources such as electricity, propane and oil. However, this competition is inhibited because of the time, inconvenience and investment for residential and commercial customers to convert to an alternate energy source when the price of natural gas fluctuates. For more information on competition for the Gas Distribution Business, refer to the section titled "Outlook" on pages 29 and 30 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K. An aggregation tariff, which was effective April 1, 1998, provides all Michigan commercial and industrial customers the opportunity to purchase their gas from a third-party supplier, while allowing the Gas Distribution Business to continue charging the existing distribution fees and customer fees plus a gas load balancing fee. Refer to the sections titled "Gas Sales Margin" and "Gas Transportation Revenue" on pages 26 and 27 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, for further information regarding the impact of the aggregation tariff on gas sales and transportation revenue.
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TRANSPORTATION - The Gas Distribution Business provides transportation services to its large-volume commercial and industrial customers. This service offers those customers the option of purchasing natural gas directly from producers or marketing companies while utilizing the Gas Distribution Business' distribution network to transport the gas to their facilities. Alaska Pipeline Company ("APC") owns and operates the only natural gas transmission lines in its service area that are operated for utility purposes. APC's transmission system delivers natural gas from producing fields in southcentral Alaska to ENSTAR's Anchorage-based gas distribution system. APC's only customer is ENSTAR Natural Gas Company. The market price of alternate energy sources such as coal, electricity, oil and steam is the primary competitive factor affecting the demand for transportation. Certain large industrial customers have some ability to convert to another form of energy if the price of natural gas increases significantly. Partially offsetting the impact of price sensitivity has been the use of natural gas as an industrial fuel because of clean air legislation and the resultant pressures on industry and electric utilities to reduce emissions from their plants. As is the case with many gas distribution utilities, there has been downward pressure on transportation rates due to the potential risk for industrial customers and electric generating plants located in close proximity to interstate natural gas pipelines to bypass the Company and connect directly to such pipelines. However, management is currently unaware of any significant bypass efforts by the Company's customers. The Company has and would continue to address any such efforts by offering special services and contractual arrangements designed to retain these customers on the Company's system. Customers in ENSTAR's service territory are currently precluded from bypassing ENSTAR's transportation and distribution system due to the limited availability of gas transmission systems and the large distances between producing fields and the locations of current customers.
CUSTOMER BASE - At December 31, 1999, the Michigan gas distribution operation had approximately 255,000 customers. The largest concentration of customers, approximately 100,000, is located in southeastern Michigan. The remaining Michigan customers are located in and around the following communities: Battle Creek, Albion, Holland, Three Rivers, Niles, Marquette and Houghton. The Michigan customer base is diverse and includes residential, commercial and industrial customers. The largest customers include power plants, food production facilities, paper processing plants, furniture manufacturers and others in a variety of other industries. The average number of customers in Michigan has increased by an average of approximately 3% annually during the past three years. By contrast, the customer growth rate for the U.S. gas distribution industry has averaged approximately 1% annually during the past three years. At December 31, 1999, ENSTAR had approximately 102,000 customers in and around the Anchorage, Alaska area including the communities of Big Lake, Bird Creek, Butte, Chugiak, Eagle River, Eklutna, Girdwood, Houston, Indian, Kenai, Knik, Nikiski, Palmer, Peters Creek, Portage, Sterling, Soldotna, Wasilla and Whittier. ENSTAR is the sole distributor of natural gas to the greater Anchorage metropolitan area, and its service area encompasses approximately 50% of the population of Alaska. ENSTAR has two types of customers: gas sales and transportation. Gas sales customers are primarily residential and commercial. ENSTAR provides transportation service to power plant sites, a liquified natural gas plant, an ammonia plant, and hundreds of commercial locations on behalf of gas producers and gas marketers. The average number of customers at ENSTAR has increased by an average of approximately 3% annually during the past three years.
GAS SUPPLY - The Gas Distribution Business has agreements with TransCanada Gas Services, Inc. ("TransCanada"), under which TransCanada provides the Company's natural gas requirements and manages the Company's natural gas supply and the supply aspects of transportation and storage operations in Michigan for the three year period that began April 1, 1999. For additional information about this agreement, refer to Note 2 of the Notes to the Consolidated Financial Statements on pages 47 and 48 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K. The Gas Distribution Business owns underground storage facilities in Michigan with a working capacity of 5.0 billion cubic feet ("Bcf"). In addition, it leases 6.5 Bcf of storage from Eaton Rapids Gas Storage System and 4.5 Bcf from non-affiliates in Michigan. The owned and leased storage capacity equals 35% to 40% of the Company's average annual gas sales volumes in Michigan. SEMCO Gas Storage Company (an affiliated company) is a 50% owner of Eaton Rapids Gas Storage System.
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ENSTAR has a gas purchase contract (the "Marathon Contract") with Marathon Oil Company ("Marathon") that has been approved by the Regulatory Commission of Alaska ("RCA") and is a "requirements" contract with no specified daily deliverability or annual take-or-pay quantities. Marathon has agreed to deliver all of ENSTAR's gas requirements in excess of those provided for in other presently existing gas supply contracts, subject to certain exceptions, until the commitment has been exhausted. However, ENSTAR's purchase obligations and Marathon's delivery obligations are set at specified annual amounts after 2001. The contract has a base price and is subject to an annual adjustment based on changes in the price of certain traded oil futures contracts plus reimbursement for any severance taxes and other charges. ENSTAR also has an RCA-approved gas purchase contract with the Municipality of Anchorage, Chevron U.S.A., Inc. and ARCO Alaska, Inc. (the "Beluga Contract") which provides for the delivery of up to approximately 220 Bcf of gas through the year 2009. The pricing mechanism in the Beluga Contract is similar to that contained in the Marathon Contract. Based on gas purchases during the twelve months ended December 31, 1999, which are not necessarily indicative of the volume of future purchases, gas reserves committed to ENSTAR under the Marathon and Beluga Contracts are sufficient to supply all of ENSTAR's expected gas supply requirements through the year 2001. After that time supplies will still be available under the Marathon and Beluga contracts in accordance with their terms, but at least a portion of ENSTAR's requirements are expected to be satisfied outside the terms of these contracts, as currently in effect. The Michigan-based gas distribution operation is served by four major interstate pipelines: (1) Panhandle Eastern Pipe Line Company; (2) Northern Natural Gas Company; (3) Great Lakes Gas Transmission Company and (4) ANR Pipeline Company. Currently, ENSTAR's supply source, primarily though the Marathon and Beluga Contracts, is confined to the Cook Inlet area with no direct access to other natural gas pipelines. However, the Cook Inlet area is home to major gas producing fields, with proven and producing reserves of approximately 2.6 trillion cubic feet ("Tcf"). An additional 2.3 Tcf of undiscovered gas in the Cook Inlet area has been estimated by the United States Geological Survey and Minerals Management Service.
RATES AND REGULATION - The rates of gas distribution customers located in the City of Battle Creek, Michigan and surrounding communities are subject to the jurisdiction of the City Commission of Battle Creek. The Michigan Public Service Commission ("MPSC") authorizes the rates charged to all of the remaining Michigan customers. ENSTAR is subject to regulation by the RCA which has jurisdiction over, among other things, rates, accounting procedures, and standards of service. The RCA order approving the Company's acquisition of ENSTAR provides that ENSTAR's existing rates remain in effect on an interim basis and requires the Company to file revenue requirement and cost of service information by July 1, 2000. Management periodically reviews the adequacy of the Gas Distribution Business' rates and files requests for rate increases whenever it is deemed necessary and appropriate. However, a recent rate case includes provisions limiting the Company's ability to request a rate increase in Michigan during the three year period that began April 1, 1999. Refer to Note 2 of the Notes to the Consolidated Financial Statements on pages 47 through 49 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, for further information on regulatory matters including recent regulatory orders and rate cases.
ENVIRONMENTAL MATTERS - The Gas Distribution Business currently owns seven Michigan sites which formerly housed manufactured gas plants. In the earlier part of the 20th century, gas was manufactured from processes using coal, coke or oil. By-products of this process have left some contamination at these sites. The Gas Distribution Business has submitted plans to the appropriate regulatory authority in the State of Michigan to close one site and begin work at another site. For further information, refer to Note 14 of the Notes to the Consolidated Financial Statements on pages 62 and 63 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K.
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DIVERSIFIED BUSINESSES
The Company's diversified businesses have grown during the past three years primarily through acquisitions. The following table shows operating revenues for each of the diversified businesses, including intercompany revenues, for 1997 through 1999:
Refer to Note 12 of the Notes to the Consolidated Financial Statements on pages 60 and 61 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, for each of the diversified business' operating revenues, operating income, assets and other financial information for the past three years.
PIPELINE CONSTRUCTION SERVICES
The Company's pipeline construction services segment ("Construction Services") operates in the mid-western and southeastern areas of the United States and has offices in Michigan, Tennessee, Kansas, Iowa, Georgia, and Texas as of December 31, 1999. Its primary service is underground pipeline installation and replacement for the natural gas distribution industry. During 1999, the Company made four business acquisitions that not only expanded the geographic reach of Construction Services but also expanded underground construction service offerings in new industries such as telecommunications and water supply. As of December 31, 1999, Construction Services was comprised of six companies that were all acquired during the past three years: (1) Sub-Surface Construction Co.; (2) King Energy & Construction Co.; (3) K&B Construction, Inc.; (4) Iowa Pipeline Associates, Inc.; (5) Flint Construction Co.; and (6) Long's Underground Technologies, Inc. On December 31, 1999, King Energy & Construction Co. was merged into Flint Construction Co. There is additional information regarding these acquisitions in Note 3 of the Notes to the Consolidated Financial Statements on pages 49 through 51 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K. Construction Services had operating revenues, excluding intercompany transactions, of $49,965,000, $16,621,000, and $7,484,000 in 1999, 1998 and 1997, respectively. These operating revenues accounted for 17%, 7% and 3% of consolidated operating revenues, excluding energy marketing operating revenues, during those years. The natural gas construction services industry is comprised of a highly fragmented group of companies focused primarily on regional or local markets. The top six construction companies in the United States have less than 10% of the market. Approximately 30% of the market represents work done by utility companies' in-house construction operations with the remainder of the market being served by a large number of small and medium-size companies. For more information on competition for Construction Services, refer to the section titled "Outlook" on page 31 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K. Construction Services' business is seasonal in nature. Most of this segment's annual profits are made during the summer and fall months. Construction Services generally incurs losses during the winter months when underground construction is inhibited.
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ENGINEERING SERVICES
The Company's engineering services business segment ("Engineering Services") is comprised of two companies, Maverick Pipeline Services, Inc. ("Maverick") and Oilfield Materials Consultants, Inc. ("OMC"). Maverick was acquired in December 1997 and OMC was acquired in November 1998. Maverick purchased the assets and certain liabilities of Drafting Services, Inc. in September 1999 and Pinpoint Locators, Inc. in October 1999. These two businesses are being operated as divisions of Maverick. See Note 3 of the Notes to the Consolidated Financial Statements on pages 49 through 51 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, for information regarding acquisitions. Engineering Services has offices in New Jersey, Michigan, Louisiana and Texas and provides a variety of energy related engineering and quality assurance services in several states. Engineering Services had operating revenues, excluding intercompany transactions, of $14,841,000, $40,937,000, and $5,660,000 in 1999, 1998 and 1997, respectively. These operating revenues accounted for 5%, 17% and 2% of consolidated operating revenues, excluding energy marketing operating revenues, during those years. Engineering Services serves the natural gas distribution and transmission, oil products, exploration/production and telecommunication industries. The primary services provided include engineering design, distribution system design, construction project management, field surveys, global positioning surveys, inspection, testing, pipeline-mill quality assurance and full turn-key service. Engineering Services competes with regional, national and international firms as well as in-house engineering and field service departments. Refer to the section titled "Outlook" on page 32 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, for further discussion concerning competition in the engineering services industry. There has been a reduction in oil and gas production and related activities due to the downturn in oil prices in late 1998 and early 1999. There has also been a reduction or deferral of new engineering projects for the gas distribution industry due to the cash flow impact on the industry of the warm weather during the past two years. As a result, Engineering Services has experienced a reduction in the level of available projects. Management believes that the level of available projects will increase as gas distribution companies start releasing new engineering projects and as pipeline construction and inspection projects become available as a result of the recovery in oil prices in late 1999.
PROPANE, PIPELINES AND STORAGE
The Company's pipelines and storage operations consist of several pipelines and a gas storage facility. The Company has partial ownership interests or equity interests in certain of these operations. The pipelines and storage operations are all located in Michigan. Refer to Item 2
ITEM 2. PROPERTIES
SEMCO ENERGY, INC.
The properties of SEMCO Energy, Inc. consist of the net assets of the Michigan gas distribution operation and ENSTAR Natural Gas Company (both of which are divisions of SEMCO Energy, Inc.), equity investments in its subsidiaries, leasehold improvements and office equipment.
GAS DISTRIBUTION
The gas delivery system of the Michigan gas distribution operation included approximately 153 miles of gas transmission pipelines and 5,222 miles of gas distribution pipelines at December 31, 1999. The pipelines are located throughout the southern half of Michigan's lower peninsula (centered around the cities of Port Huron, Albion, Battle Creek and Holland) and also in the central and western areas of Michigan's upper peninsula. At December 31, 1999, ENSTAR's gas delivery system included approximately 394 miles of gas transmission pipelines and 2,244 miles of gas distribution pipelines. ENSTAR's pipelines are located in Anchorage and other communities around the Cook Inlet area of Alaska. The Gas Distribution Business' distribution system and service lines are, for the most part, located on or under public streets, alleys, highways and other public places, or on private property not owned by the Company with permission or consent, except to an inconsequential extent, of the individual owners. The distribution systems and service lines located on or under public streets, alleys, highways and other public places were all installed under valid rights and consents granted by appropriate local authorities. The Gas Distribution Business owns underground gas storage facilities in eight depleted salt caverns and two depleted gas fields together with measuring, compressor and transmission facilities. The storage facilities are all located in Michigan. The aggregate working capacity of the storage system is approximately 5.0 Bcf. The Gas Distribution Business also owns meters and service lines, gas regulating and metering stations, garages, warehouses and other buildings necessary and useful in conducting its business. It also leases a significant portion of its computer and transportation equipment.
PIPELINE CONSTRUCTION SERVICES
The tangible properties of Construction Services include equipment required for the installation, repair or replacement of underground pipelines or similar items. This includes primarily equipment necessary for excavation such as backhoes, trenchers, directional drills and dumptrucks. This equipment can be driven or carried on trailers from one worksite to another. Substantially all of Construction Services' equipment at December 31, 1999 was located in Georgia, Iowa, Kansas, Michigan, Tennessee and Texas.
ENGINEERING SERVICES
Engineering Services' properties include primarily computers, trucks, testing equipment and related devices required to perform engineering and related services. Much of the equipment is portable and is used by the Company's employees at customer worksites throughout several states.
PROPANE, PIPELINES AND STORAGE
The principal properties of this business segment include interests and operations in propane distribution, natural gas transmission and gathering and an underground gas storage system.
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Set forth in the following table are the equity investments of the propane, pipelines and storage business segment and its ownership percentage and equity investment at December 31, 1999:
The Company owns a 50% equity interest in the Eaton Rapids Gas Storage System. This system, located near Eaton Rapids, Michigan, became operational in March 1990 and consists of approximately 12.8 Bcf of underground storage capacity. The Gas Distribution Business leases 6.5 Bcf of the capacity. The Company also owns 50% of the Michigan Intrastate Pipeline System (MIPS") and the Michigan Intrastate Lateral System partnerships. The sole purpose of these partnerships is to hold a 10% ownership of the Saginaw Bay Pipeline Project, a 126-mile pipeline from Michigan's Saginaw Bay area to processing plants in Kalkaska, Michigan. The Company sold its MIPS investment effective January 1, 2000. The property of the propane distribution operation consists primarily of pressurized propane storage tanks used by customers to store propane purchased from the Company and trucks for transporting propane. The Company also owns large propane storage tanks that allow the Company to store up to 258,000 gallons of propane inventory. The propane distribution property is all located in Michigan's upper peninsula and northeast Wisconsin. The following table sets forth the pipeline operations wholly or partially owned by the Company, the total net property of the project, the Company's ownership percentage and net property at December 31, 1999:
The Litchfield Lateral is a 31-mile pipeline located in southwest Michigan. The line, which is leased entirely to ANR Pipeline Company, links the Eaton Rapids Gas Storage System with interstate pipeline supplies. The Litchfield Lateral began operations in February 1993. The Greenwood Pipeline, an 18-mile pipeline, was constructed in 1991, to serve Detroit Edison's Greenwood power plant located in Michigan's thumb area. The Company and Detroit Edison have entered into an agreement whereby Detroit Edison has contracted for the entire capacity of the line which amounts to 240 million cubic feet ("MMcf") per day. The Eaton Rapids Pipeline is a 7.1 mile pipeline constructed in 1990. It provides direct delivery of gas from the Eaton Rapids Gas Storage System to the Gas Distribution Business' systems in Battle Creek and Albion, Michigan. The Company previously owned a 40% interest in the Iosco-Reno System, which consisted of the Iosco County Pipeline and Reno Gas Processing Plant. The Company sold its interest during 1999.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
None.
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ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION AND NYSE LISTING
SEMCO Energy, Inc. Common Stock began trading on the New York Stock Exchange on January 6, 2000 under the trading symbol "SEN". Prior to this date the Company was traded on The Nasdaq Stock Market under the symbol "SMGS." The table below shows high and low quotations of the Company's common stock in the over-the-counter market (as reported in the Wall Street Journal) adjusted to reflect a 5% stock dividend in May 1998.
See the cover page for a recent stock price and the number of shares outstanding. The Company issued unregistered shares of its common stock in connection with certain acquisition transactions during the past three years (for additional information, refer to Notes 3 and 5 of the Notes to the Consolidated Financial Statements on page 49, 50, 52 and 53 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K). See Selected Financial Data in Item 6
Item 6 of this Form 10-K for the number of registered common shareholders at year end for the past five years. The Company had 9,214 registered common shareholders at February 29, 2000.
DIVIDENDS
For information regarding dividends, see Notes 5 and 16 of the Notes to the Consolidated Financial Statements on pages 52, 53 and 64 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K, and Selected Financial Data in item 6 of this Form 10-K.
ITEM 6. SELECTED FINANCIAL DATA
For the information required pursuant to this item, refer to the section titled "Selected Financial Data" in the Company's 1999 Annual Report to Shareholders, pages 66 and 67, which information is incorporated herein by reference from exhibit 13 to this Form 10-K.
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For the information required pursuant to this item, refer to the section titled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 1999 Annual Report to Shareholders, pages 24 through 39, which information is incorporated herein by reference from exhibit 13 to this Form 10-K.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For the information required pursuant to this item, refer to the section titled "Market Risk Information" on pages 37 and 38 of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For the information required pursuant to this item, refer to the following sections of the Company's 1999 Annual Report to Shareholders, which information is incorporated herein by reference from exhibit 13 to this Form 10-K:
Consolidated Statements of Income, page 40 Consolidated Statements of Cash Flows, page 41 Consolidated Statements of Financial Position, page 42 Consolidated Statements of Capitalization, page 43 Consolidated Statements of Changes in Shareholders' Investment, page 44 Notes to the Consolidated Financial Statements, pages 45 through 64 Report of Independent Public Accountants, page 65
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information appearing under the caption "Information About Directors" in the Company's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to the Company's April 18, 2000 Annual Meeting of Shareholders is incorporated by reference herein. Information about the executive officers of SEMCO Energy, Inc. follows: William L. Johnson (age 57) has been Chairman of the Board of Directors since December 1997 and Chief Executive Officer since May 1996. He was also President from May 1996 to September 1999. From 1994 to May 1996 he was Chief Executive Officer of Northern Pipeline Construction Company of Kansas City, Missouri, and from 1990 to 1994 he was President, Gas Service Division of Western Resources, Inc. of Topeka, Kansas.
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Carl W. Porter (age 50) has been President since September 1999 and Chief Operating Officer since July 1996. He was also a Senior Vice President from July 1996 to September 1999. Prior to joining SEMCO Energy, Inc., he was Vice President-Gas Utilities of Itron, Inc., Spokane, Washington, from August 1995 to July 1996. From 1992 to 1995 he was Senior Vice President of Operations of New Jersey Natural Gas, Wall, New Jersey, and from 1990 to 1992 he was Vice President of Operations of Western Resources, Inc., Topeka, Kansas. Sebastian Coppola (age 48) has been Senior Vice President and Chief Financial Officer since January 1999. Prior to joining SEMCO Energy, Inc., he was Senior Vice President of Finance, Treasurer and Investor Relations Officer of MCN Energy Group, Inc., Detroit, Michigan, from September 1994 to December 1998. While at MCN Energy Group, Inc., he was also Director of Accounting Services and Investor Relations from October 1988 to August 1994. Rudolfo D. Cifolelli (age 59) has been Senior Vice President and Chief Information Officer of SEMCO Energy, Inc. since November 1998. He was President and Owner of OACIS, Inc., Bloomfield, Michigan from June 1996 to October 1998. He was also employed by the GENIX Group, a subsidiary of MCN Energy Group, Inc., Detroit, Michigan, as President and Chief Executive Officer from 1994 to 1996 and President and Chief Operating Officer from 1990 to 1994. Barrett Hatches (age 44) became President of ENSTAR Natural Gas Co. (a division of SEMCO Energy, Inc.) in January 2000. He had been Senior Vice President of Human Resources and Public Affairs for SEMCO Energy, Inc. from February 1999 to December 1999, and Vice President of Human Resources and Public Affairs from February 1997 to February 1999. He was Vice President of V. Robinson & Company, Inc., Kansas City, Missouri, from 1996 to February 1997. He was Director of Logistics and Chief Operating Officer - H & N Railroad of North American Salt Company, Overland Park, Kansas, from 1995 to 1996. He worked at Missouri Gas Energy, Kansas City, Missouri, as Director of Field Services from May 1994 to January 1995 and Director of Customer Information from July 1992 to May 1994. John E. Schneider (age 51) has been Senior Vice President of Corporate Development for SEMCO Energy, Inc. since September 1999. He was Senior Vice President of SEMCO Energy Ventures, Inc. (a subsidiary of SEMCO Energy, Inc.) from May 1998 to September 1999. Prior to joining the Company, he was self-employed as a management and business consultant from 1994 to May 1998. From 1984 to 1994, Mr. Schneider was President and Chief Executive Officer of Westmark Mortgage Corporation and Westmark Insurance Company, Costa Mesa, California. Lila R. Bradley (age 55) has been Vice President of Human Resources and Public Affairs for SEMCO Energy, Inc. since January 2000. She was Director of Human Resources for SEMCO Energy Gas Company from March 1998 to January 2000. Prior to joining SEMCO Energy, Inc., she was Manager of Labor Relations for Burlington Northern Santa Fe Railway from 1988 to March 1998. Samuel B. Dallas (age 49) has been Vice President of Finance for SEMCO Energy, Inc. since May 1999. He was Director, Trust Investments at MCN Energy Group, Inc. from 1990 to 1999. Prior to 1990, he held other management positions at MCN Energy Group, Inc. and its affiliate companies including Director of Investor Relations and Director of Corporate Finance. Edric R. Mason, Jr. (age 54) has been Treasurer of SEMCO Energy, Inc. since September 1999 and Director of Investor Relations since October 1997. He was also Treasurer of SEMCO Energy Gas Company (a subsidiary of SEMCO Energy, Inc.) from October 1997 to September 1999. From 1987 to October 1997, he was Assistant Treasurer and Manager of Treasury Operations at Delmarva Power & Light Company in Wilmington, Delaware. Steven W. Warsinske (age 44) will become Vice President and Controller of SEMCO Energy, Inc. effective April 2000. He has been Vice President and Chief Accounting Officer of SEMCO Energy Gas Company since February 1998. Mr. Warsinske was Vice President of Accounting and Controller of SEMCO Energy Gas Company from 1996 to February 1998 and Secretary and Treasurer from 1988 to 1996. Prior to 1988, he held various positions with the Company.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information appearing under the captions "Compensation of Directors and Executive Officers" and "Compensation Committee Interlocks and Insider Participation" in the Company's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 18, 2000 Annual Meeting of Shareholders is incorporated by reference herein.
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ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information appearing under the caption "Stock Outstanding and Voting Rights" in the Company's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to the Company's April 18, 2000 Annual Meeting of Shareholders is incorporated by reference herein.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information appearing under the captions "Certain Business Relationships of Directors" and "Employment and Related Agreements" in the Company's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to the Company's April 18, 2000 Annual Meeting of Shareholders is incorporated by reference herein.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1 All Financial Statements. For a list of financial statements incorporated by reference, see the Part II, Item 8 of this 10-K.
(a) 2 Financial Statement Schedules. The following additional data and schedule should be read in conjunction with the Consolidated Financial Statements in Part II, item 8 of this 10-K. Schedules not included herein have been omitted because they are not applicable or the required information is shown in such financial statements or notes thereto.
Pages in 10-K -------------
Report of Independent Public Accountants. . . . . . 13
Schedule II - Consolidated Valuation and Qualifying Accounts for the years ended December 31, 1999, 1998 and 1997 . . . . . . . . . . . . . . . . . . . 14
(a) 3 Exhibits, including those incorporated by reference are on pages 15 and 16 of this 10-K.
(b) On November 12, 1999, the Company filed Form 8-K to disclose certain information regarding the acquisition of ENSTAR and to file the Regulatory Commission of Alaska order entitled "Order Approving Applications, Subject to Conditions; and Requiring Filings."
The Company filed Form 8-K on November 24, 1999, to file (1) the ENSTAR Financial Statements and Notes Thereto for the Years Ended December 31, 1998, 1997 and 1996 and (2) the Company's Pro Forma Financial Statements reflecting the acquisition of ENSTAR.
(c) The Exhibits, if any, filed herewith are identified in Item 14(a) 3 above.
(d) The financial statement schedules filed are identified under Item 14(a) 2 above.
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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To SEMCO Energy, Inc.:
We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of SEMCO Energy, Inc. included in this Form 10-K, and have issued our report thereon dated January 24, 2000. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in item 14 (a) 2 is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
Arthur Andersen LLP
Detroit, Michigan, January 24, 2000
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SCHEDULE II
SEMCO ENERGY, INC.
SCHEDULE II - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS (THOUSANDS OF DOLLARS)
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EXHIBITS, INCLUDING THOSE INCORPORATED BY REFERENCE
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SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SEMCO ENERGY, INC.
Date: March 20, 2000 By /s/William L. Johnson ------------------------------------ William L. Johnson Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
/s/William L. Johnson Chairman and March 20, 2000 - --------------------- William L. Johnson Chief Executive Officer (Director)
/s/Sebastian Coppola Senior Vice President and March 20, 2000 - -------------------- Sebastian Coppola Chief Financial Officer (Principal Financial and Accounting Officer)
/s/John M. Albertine* Director March 20, 2000 - -------------------- John M. Albertine
/s/Daniel A. Burkhardt* Director March 20, 2000 - ---------------------- Daniel A. Burkhardt
/s/Edward J. Curtis* Director March 20, 2000 - -------------------- Edward J. Curtis
/s/John T. Ferris* Director March 20, 2000 - ------------------ John T. Ferris
/s/Michael O. Frazer Director March 20, 2000 - -------------------- Michael O. Frazer
/s/Marcus Jackson* Director March 20, 2000 - ------------------ Marcus Jackson
/s/Harvey I. Klein* Director March 20, 2000 - ------------------- Harvey I. Klein
/s/Frederick S. Moore* Director March 20, 2000 - ---------------------- Frederick S. Moore
/s/Edith A. Stotler* Director March 20, 2000 - -------------------- Edith A. Stotler
/s/Donald W. Thomason* Director March 20, 2000 - ---------------------- Donald W. Thomason
*By /s/William L. Johnson March 20, 2000 ----------------------- William L. Johnson Attorney-in-fact
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885640_1999.txt | 885640_1999 | 1999 | 885640 | Item 1. Business
(A) General Development of Business
The Company was founded in 1932 as a single restaurant in Chattanooga, Tennessee by R. B. Davenport, Jr. and J. Glenn Sherrill. The Company expanded steadily in subsequent years, entering the Georgia market in 1936, and during the 1950's and 1960's, began relocating restaurants from urban to suburban locations and transforming its format from "cook-to-order" items to a more standardized quick-service menu.
The Company's centerpiece of growth was its namesake, the KRYSTAL, a small, square hamburger with steamed-in flavor served hot and fresh off the grill. As competition in the restaurant industry increased in the late 1980's, the Company firmly maintained its market niche by emphasizing the unique KRYSTAL. Krystal restaurants have continued to emphasize the KRYSTAL and have built their customer base around this and other items such as "Krystal Chili," "Chili Pups," "Corn Pups," the "Sunriser", a specialty breakfast sandwich, the "Krystal Chik", a specialty chicken sandwich and the "Country Breakfast."
On December 15, 1995, the Company filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code, solely for the purpose of completely and finally resolving various claims of former and current employees alleging violations of the Fair Labor Standards Act. On April 10, 1997 the Bankruptcy Court approved the Reorganization Plan including the settlement of the FLSA claims which became effective April 23, 1997. All allowed claims under the Reorganization Plan have been paid.
On September 26, 1997 (effective September 29, 1997 for accounting purposes), the Company was acquired by Port Royal Holdings, Inc. ("Port Royal") (the "Acquisition"). At the closing of the Acquisition, a wholly-owned subsidiary of Port Royal was merged with and into the Company (the "Merger") and the Company as the surviving corporation retained the name "Krystal." As a result of the Acquisition and Merger, Port Royal became the owner of 100% of the common stock of the Company.
(B) Financial Information about Industry Segments
See Part II, Item 7 Results of Operations.
(C) Narrative Description of Business
The Company develops, operates and franchises full-size KRYSTAL and smaller "double drive-thru" KRYSTAL KWIK quick-service restaurants. The Company has been in the fast food restaurant business since 1932, and believes it is among the first fast food restaurant chains in the country. The Company began to franchise KRYSTAL KWIK restaurants in 1990 and KRYSTAL restaurants in 1991. In 1995, the Company began to develop and franchise KRYSTAL restaurants located in non-traditional locations such as convenience stores. At January 3, 1999, the Company operated 241 units (234 KRYSTAL restaurants and 7 KRYSTAL KWIK restaurants) in eight states in the southeastern United States. Franchisees operated 110 units (40 KRYSTAL restaurants, 31 KRYSTAL KWIK restaurants and 39 KRYSTAL restaurants in non-traditional locations) as of January 3, 1999.
The Company also leases 23 restaurant sites in the Baltimore, Washington, D.C. and St. Louis metropolitan areas which it in turn subleases to Davco Restaurants, Inc. ("Davco"), a Wendy's International, Inc. franchisee and former affiliate of the Company.
Through a subsidiary company ("Krystal Aviation"), since 1977 the Company has operated a fixed base hangar and airplane fueling operation in Chattanooga, Tennessee.
Products --
KRYSTAL restaurants offer a substantially uniform menu consisting of the well known KRYSTAL hamburger, french fries, "Chili Pups", "Corn Pups", chili, "Krystal Chiks", milk shakes, soft drinks and hot beverages, pies and breakfast items including the "Sunriser" and the "Country Breakfast" during certain morning hours. Most KRYSTAL KWIK restaurants feature essentially the same menu as Krystal restaurants except breakfast offerings. From time to time the Company test markets new products.
The Company and its franchisees purchase their food, beverages and supplies from Company approved independent suppliers. All products must meet standards and specifications set by the Company. Management constantly monitors the quality of the food, beverages and supplies provided to the restaurants. The restaurants prepare, assemble and package these products using specially designed production techniques and equipment to obtain uniform standards of quality.
Sources of raw materials --
The Company and its franchisees purchase food, supplies, restaurant equipment, and signs from Company approved suppliers. The Company believes that alternate suppliers are available or can be made available.
Trademarks and patents --
The Company has registered "Krystal", "Krystal Kwik" and variations of each, as well as certain product names, with the United States Patent and Trademark office. The Company is not aware of any infringing uses that could materially affect its business or any prior claim to these service marks that would prevent the Company from using or licensing the use thereof for restaurants in any area of the United States. The Company's policy is to pursue registration of its marks whenever possible and oppose vigorously any infringement of its marks.
Seasonal operations --
The Company does not consider its operations to be seasonal to any material degree. Revenues during its first fiscal quarter, comprising the months of January, February and March, will, however, generally be lower than its other quarters due to consumer shopping habits and the climate in the location of a number of its restaurants.
Working capital practice --
See Part II, Item 7 Liquidity and Capital Resources.
Customers --
No material part of the business of the Company is dependent upon a single customer or a small number of customers.
Backlog --
Company-owned restaurants operate in a quick-service environment and have no backlog.
Government contracts --
No material portion of the business of the Company is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the U.S. Government.
Competition --
The quick-service restaurant industry is highly competitive and is dominated by major chains with substantially greater financial resources than the Company. The Company competes primarily on the basis of unique product offerings, food quality, price and speed of service. A significant change in pricing or other marketing strategies by one or more of these competitors could have an adverse impact on the Company's sales, earnings and growth. In addition, with respect to the sale of franchises, the Company competes with many franchisors of restaurants and other business concepts.
Research and development --
The Company operates a research and development laboratory in Chattanooga, Tennessee. While research and development activities are important to the business of the Company, expenditures for these operations are not material.
Environmental matters --
While the Company is not aware of any federal, state or local environmental regulations which will materially affect its operations or competitive position or result in material capital expenditures, it cannot predict the effect on its operations from possible future legislation or regulation. During 1998, other than normal equipment expenditures, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated.
Number of employees --
During 1998, the Company's average number of employees was approximately 8,150.
(D) Financial Information about Foreign and Domestic Operations and Export Sales
The Company leases 23 restaurant sites in the Baltimore, Washington, D.C. and St. Louis metropolitan areas which it in turn subleases to Davco Restaurants, Inc. Revenue from this operation is less than 10% of the Company's total revenue. All other operations of the Company are in the southeastern United States and the Company has no export sales.
Item 2.
Item 2. Properties
See Notes 4 and 9 of the Company's Consolidated Financial Statements.
Item 3.
Item 3. Legal Proceedings
The Company is a party to various legal proceedings incidental to its business. The ultimate disposition of these matters is not presently determinable but will not, in the opinion of management and the Company's legal counsel, have a material adverse effect on the Company's financial condition or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
In October 1998 the Company's sole shareholder, Port Royal Holdings, Inc. ("Port Royal"), elected the following directors by written consent: Philip H. Sanford, James F. Exum, Jr., W. A. Bryan Patten, Richard C. Patton, Benjamin R. Probasco and A. Alexander Taylor II.
PART II
Item 5.
Item 5. Market for the Company's Common Equity and Related Stockholder Matters
(a) Price Range of Common Stock. On September 26, 1997, the Company was acquired by Port Royal through the merger of a wholly-owned subsidiary of Port Royal with and into the Company. As a result of the merger, Port Royal is the owner of 100% of the common stock of the Company and no public trading market for the Company's stock exists. The Company's Common Stock formerly traded over-the-counter on the NASDAQ National Market System under the symbol KRYS. The following table sets forth the high and low closing sales prices per share of the Company's common stock as reported by the NASDAQ National Market System for the periods indicated for the nine months through September 26, 1997:
High Low ------ ----- First Quarter $ 7.50 $5.00 Second Quarter 5.75 4.875 Third Quarter 15.00 4.875 Fourth Quarter and thereafter N/A N/A
(b) Holders of common stock. As noted above, Port Royal is the owner of 100% of the common stock of the Company.
(c) Dividends. The Company has historically not declared dividends on its common stock and has no present intention to do so in the near future.
Item 6.
Item 6. Selected Financial Data
The following tables present (i) selected historical data of the Company prior to the Acquisition ("Pre-Merger Company") as of and for each of the years ended January 1, 1995, December 31, 1995, December 29, 1996, and the nine month period ended September 28, 1997, and (ii) selected historical data of the Company after the Acquisition ("Post-Merger Company") as of and for the three month period ended December 28, 1997 and the year ended January 3, 1999. The selected historical financial data as of and for each of the years ended January 1, 1995, December 31, 1995, December 29, 1996, and the nine month period ended September 28, 1997 have been derived from the audited financial statements of the Pre-Merger Company. The selected historical financial data as of and for the three month period ended December 28, 1997 and the year ended January 3, 1999 have been derived from the audited financial statements of the Post-Merger Company. The financial data set forth below should be read in conjunction with Item 7
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated audited financial statements of the Company (including the notes thereto) contained elsewhere in this report. On September 26, 1997 (effective September 29, 1997 for accounting purposes) the Company was acquired by, and merged with a wholly owned subsidiary of, Port Royal. The Acquisition and Merger were accounted for using the purchase method of accounting. To facilitate a meaningful comparison of the Company's fiscal years of 1996, 1997 (results of Pre-Merger Company for the nine months ended September 28, 1997 combined with the results of the Post-Merger Company for the three months ended December 28, 1997), and 1998, the following discussion of consolidated results of operations is presented on a traditional comparison basis of twelve month periods.
Cash operating profit --
Cash operating profit (net income or loss before interest, taxes, depreciation, amortization and other non-operating gains, losses or expenses) is one of the key standards used by the Company to measure operating performance. Cash operating profit is used to supplement operating income as an indicator of operating performance and cash flows from operating activities as a measure of liquidity, and not as an alternative to measures defined and required by generally accepted accounting principles.
Cash operating profit for the fiscal year ended January 3, 1999 was $24.7 million compared to $19.8 million for the combined twelve months ended December 28, 1997, an increase of 24.7%. This increase in cash operating profit was primarily attributable to reduced overall operating costs as a percentage of sales resulting from improvements in restaurant operations and reduced general and administrative expenses.
The following table reflects certain key operating statistics which impact the Company's financial results:
Consolidated Results of Operations --
General --
The Company's fiscal year ends on the Sunday nearest December 31. Consequently, the Company will occasionally have a 53 week fiscal year. The years ended December 29, 1996 and December 28, 1997 were 52 week fiscal years. The period December 29, 1997 through January 3, 1999 is a 53 week period.
The Company's revenues are derived primarily from sales by Company-owned restaurants. Total Company-owned restaurants decreased from 248 at the end of 1997 to 241 at the end of 1998. Royalties and franchise fees from franchisees have been a small, but growing, portion of the Company's revenues to date. The total number of franchised restaurants grew by 8.9% in 1998 from 101 at the end of 1997 to 110 at the end of 1998. The Company expects its franchisees to develop up to 25 new restaurants during fiscal 1999. The Company also operates through its wholly owned aviation subsidiary a fixed based aircraft hangar operation in Chattanooga, Tennessee. Revenues from this operation in each of the last three years were less than 3.0% of the Company's total revenues.
The Company expects to open up to 15 new Company-owned restaurants in fiscal 1999. Management estimates that approximately $10.0 million will be required to finance the Company's cost of constructing these restaurants. Funds required to finance the Company's restaurant expansion program are expected to be provided by cash flow from operations, available cash of approximately $9.0 million at January 3, 1999, an unused credit line of approximately $21.3 million at January 3, 1999 and sale leaseback financing through third party lenders.
Cost of restaurant sales relates to food and paper costs, labor and all other restaurant costs for Company-owned restaurants. Depreciation and amortization and general and administrative expenses relate primarily to Company-owned restaurants and to the Company's franchise sales and support functions. Other expenses relate primarily to Krystal Aviation.
Petition for relief under Chapter 11--
On December 15, 1995, Krystal filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code with the United States Bankruptcy Court for the Eastern District of Tennessee for the purpose of completely and finally resolving the various claims filed against the Company by current and former employees alleging violations of the Fair Labor Standards Act of 1938 ("FLSA").
In early 1997, Krystal and the majority of the FLSA plaintiffs reached a settlement providing for the payment of the FLSA claims and related legal costs. A plan of reorganization (the "Plan") was formally filed on February 24, 1997. On April 10, 1997, the Bankruptcy Court confirmed the Company's plan of reorganization and on April 23, 1997, the Plan became final resulting in the dismissal of the FLSA claims.
Results of Operations --
The following table sets forth the percentage relationship to total revenues, unless otherwise indicated, of certain items from the Company's statements of operations.
Comparison of the Fiscal Year Ended January 3, 1999 to the Combined Twelve Months Ended December 28, 1997
The following discussion compares a 53 week period of operations in 1998 to a 52 week combined period in 1997.
Total Krystal system (Company and Franchise combined) restaurant sales for the fiscal year ended January 3, 1999 ("fiscal 1998") were $328.6 million compared to $307.6 million for the combined twelve months ended December 28, 1997 ("fiscal 1997"), a 6.8% increase. Total Company revenues increased 3.6% to $257.4 million for fiscal 1998 compared to $248.4 million for fiscal 1997. Of this $9.0 million increase, restaurant sales accounted for $7.9 million (of which $5.0 million occurred during the fifty third week in fiscal 1998). The balance of the increase resulted from an increase in franchise fees and royalties of $699,000, and increased revenue from the Company's aviation subsidiary of $429,000. Company-owned average same restaurant sales per week for fiscal 1998 were $19,300 compared to $18,900 for fiscal 1997, an increase of 2.1%. The Company's management believes the fiscal 1998 per unit weekly sales increase can be attributed to several factors, including price increases, new promotional programs, reduced price discounting, introduction of new products, and continuing improvements in operations at the restaurant level. The Company had 241 restaurants open at the end of fiscal 1998 compared to 248 at the end of fiscal 1997.
The average customer check for Company-owned restaurants (both full size and Kwik) in fiscal 1998 was $3.96 as compared to $3.86 in fiscal 1997, an increase of 2.6%. The increase in average customer check was due primarily to product price increases of approximately 2.0% in fiscal 1998 over fiscal 1997, the introduction of the Krystal Chik and new menu combinations. Customer counts per restaurant day increased to 692 in fiscal 1998 compared to 685 in fiscal 1997, an increase of 1.2%. The customer count and check average was adjusted for fiscal 1997 for the installation of new cash registers installed throughout the system during fiscal 1997. The new registers record a customer with each sale registered rather than each time the cash drawer is opened. The conversion was completed during 1997.
Franchise fees were $333,000 in fiscal 1998 compared to $349,000 for fiscal 1997, a 4.6% decrease. Royalties increased 23.4% to $3.8 million in fiscal 1998 from $3.1 million in fiscal 1997. Expressed on a per week basis, in fiscal 1998 franchise fees and royalties increased 18.1% to $77,500 compared to $65,600 for fiscal 1997. The increase in royalties is primarily due to an 8.9% increase in franchise restaurants and a 3.2% increase in franchise same restaurant sales in fiscal 1998 compared to fiscal 1997. The franchise system had 110 restaurants open at the end of fiscal 1998 compared to 101 at the end of fiscal 1997.
Other revenue which is generated primarily from the Company's aviation subsidiary, was $5.2 million in fiscal 1998 compared to $4.8 million in fiscal 1997. Expressed on a per week basis, fiscal 1998 increased 7.0% to $97,900 compared to $91,500 for fiscal 1997.
Cost of restaurant sales was $204.6 million in fiscal 1998 compared to $199.0 million in fiscal 1997. Cost of restaurant sales as a percentage of restaurant sales decreased to 82.5% in fiscal 1998 from 82.8% in fiscal 1997. This decrease was primarily the result of negotiated decreases in food and paper costs but was partially offset by the increase in direct labor. Total food and paper costs were $76.6 million in fiscal 1998 as compared to $77.5 million in fiscal 1997. Food and paper costs as a percentage of restaurant sales decreased to 30.9% in fiscal 1998 compared to 32.3% in fiscal 1997. Direct labor cost was $58.5 million in fiscal 1998 versus $53.8 million in fiscal 1997. Direct labor cost as a percentage of restaurant sales was 23.6% for fiscal 1998 and 22.4% for fiscal 1997. This increase resulted primarily from a 5.4% increase in the minimum wage effective September 1, 1997. Other labor cost, which includes restaurant General Managers' and Assistant Managers' labor cost, was $17.2 million in fiscal 1998 compared to $18.8 million in fiscal 1997. Other labor as a percentage of restaurant sales was 6.9% in fiscal 1998 versus 7.8% in fiscal 1997.
Depreciation and amortization expenses were $12.9 million in fiscal 1998 as compared to $11.6 million in fiscal 1997. This increase in fiscal 1998 was due to the revaluation of Company assets on September 29, 1997 resulting from the acquisition of the Company by Port Royal.
General and administrative expenses decreased $1.4 million, approximately 5.3%, to $24.9 million in fiscal 1998 versus $26.3 million in fiscal 1997. The decrease in general and administrative expenses resulted primarily from overall reductions in expenditures related to corporate office activities. Advertising expense was approximately $9.9 million in fiscal 1998 compared to $10.1 million in fiscal 1997. Advertising expense as a percentage of restaurant sales was 4.0% in fiscal 1998 compared to 4.1% in fiscal 1997. Salaries were $7.0 million in fiscal 1998 compared to $7.9 million in fiscal 1997. Other areas of reduction included corporate office rent expense, supplies expense, and auto expense.
In accordance with Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, issued by the American Institute of Certified Public Accountants, the Company expensed Reorganization Items as incurred. The Company incurred no such professional fees and expenses during fiscal 1998, compared to $1.2 million in fiscal 1997.
During 1998, the Company agreed to settle its obligations under certain deferred compensation plans by making lump sum cash payments to two retired executives. The Company realized a gain of $925,000 from this transaction. The cash payments were funded with the proceeds from redeeming the cash surrender value of life insurance policies on the lives of the retired executives. Also during fiscal 1998 the Company realized a gain of $880,000 related to receipt of life insurance proceeds in excess of cash surrender value.
Interest expense, net of interest income, for fiscal 1998 increased $5.2 million to $10.5 million from $5.3 million in fiscal 1997. This increase was due to the acquisition related increase in long-term debt in the fourth quarter of fiscal 1997.
Provision for income taxes was $1.7 million for fiscal 1998 compared to $790,000 for fiscal 1997. The effective income tax rate of 56% for fiscal 1998 and 41% for fiscal 1997 was more than the statutory income tax rate primarily as a result of the non-deductible portion of amortization expense associated with acquisition-related goodwill.
The Company recorded a loss of $220,000, net of tax benefit, in 1997 related to the early extinguishment of debt.
Comparison of the Combined Twelve Months Ended December 28, 1997 to the Fiscal Year Ended December 29, 1996
Total Krystal system (Company and franchise combined) restaurant sales for the combined twelve months ended December 28, 1997 ("fiscal 1997") were $307.6 million compared to $297.6 million for the fiscal year ended December 29, 1996 ("fiscal 1996"), a 3.4% increase. Total Company revenues were $248.4 million for fiscal 1997 compared to $244.3 million for fiscal 1996, a 1.7% increase. Restaurant sales accounted for $3.8 million of this $4.1 million increase. Company-owned average same restaurant sales for fiscal 1997 were $969,200 compared to $944,600 for fiscal 1996, an increase of 2.6%. Fiscal 1997 sales increase can be attributed to several factors, including price increases, new advertising and promotional programs, continuing improvements in operations at the restaurant level and the mild weather in the southeast in the first quarter 1997 as compared to fiscal 1996. The Company had 248 restaurants open at the end of fiscal 1997 and 249 open at the end of fiscal 1996.
Franchise fees were $349,000 in both fiscal 1997 and fiscal 1996. Royalties increased 10.7% to $3.1 million in fiscal 1997 versus $2.8 million in fiscal 1996. This increase in royalties was attributable primarily to a 13.5% increase in franchise restaurants, offset by a 1.8% decrease in franchise same restaurant sales. The franchise system had 101 restaurants open at the end of fiscal 1997 compared to 89 open at the end of fiscal 1996.
Other revenue, which is generated from the Company's aviation subsidiary, was $4.8 million in fiscal 1997 compared to $4.7 million in fiscal 1996, a 2.1% increase.
The average customer check for Company-owned restaurants (both full size and double drive thru) in fiscal 1997 was $3.86 as compared to $3.66 in fiscal 1996, an increase of 5.5%. The increase in average customer check was due primarily to product price increases of approximately 3.1% in fiscal 1997 over fiscal 1996, and the introduction of promotional products and menu combinations. Customer counts per restaurant day decreased to 685 in fiscal 1997 compared to 702 in fiscal 1996, a decrease of 2.4%. The customer count and check average was adjusted for fiscal 1997 and fiscal 1996 for the installation of new cash registers installed throughout the system during fiscal 1997 and fiscal 1996. The new registers record a customer with each sale registered rather than each time the cash drawer is opened. The conversion was completed during 1997.
Cost of restaurant sales was $199.0 million in fiscal 1997 compared to $195.7 million in fiscal 1996. Cost of restaurant sales as a percentage of restaurant sales was 82.8% in fiscal 1997 and fiscal 1996. Total food and paper costs were $77.5 million in fiscal 1997 as compared to $76.2 million in fiscal 1996. Food and paper costs as a percentage of restaurant sales increased to 32.3% in fiscal 1997 from 32.2% in fiscal 1996. Direct labor cost was $53.8 million in fiscal 1997 versus $52.7 million in fiscal 1996. Direct labor cost as a percentage of restaurant sales was 22.4% for fiscal 1997 and 22.3% in fiscal 1996. Other labor cost, which include restaurant General Managers' and Assistant Managers' labor cost was $18.8 million in fiscal 1997 compared to $18.1 million in fiscal 1996. Other labor as a percentage of restaurant sales was 7.8% in fiscal 1997 versus 7.7% in fiscal 1997.
Depreciation and amortization expenses were $11.6 million in fiscal 1997 as compared to $11.4 million in fiscal 1996. Fiscal 1997 depreciation increase was due primarily to the revaluation of asset at the Acquisition on September 29, 1997.
General and administrative expenses were $26.3 million in fiscal 1997 versus $25.4 million in fiscal 1996. Advertising expense was approximately $10.1 million in fiscal 1997 compared to $9.9 million in fiscal 1996. Advertising expense as a percentage of restaurant sales was 4.2% in both fiscal 1997 and fiscal 1996. Salaries were $7.9 million in fiscal 1997 compared to $7.7 million in fiscal 1996.
In accordance with Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, issued by the American Institute of Certified Public Accountants, the Company expensed Reorganization Items as incurred. The total of such professional fees and expenses during fiscal 1997 was $1.2 million as compared to $3.8 million in fiscal 1996.
A reduction of $331,000 in interest related to certain pre-petition liabilities, resulted in net interest income of $96,000 during fiscal 1997 compared to expense of $791,000 in fiscal 1996. Contractual rate interest expense, net of interest income was $5.3 million in fiscal 1997 compared to $3.2 million in fiscal 1996. This increase was attributable mainly to the increase in long-term debt in connection with the Acquisition on September 29, 1997.
Provision for income taxes was $790,000 in fiscal 1997 as compared to an income tax benefit of $1.5 million for fiscal 1996. The effective tax rates of 41% in fiscal 1997, and 38% in fiscal 1996 approximate the combined statutory federal and state income rates.
An extraordinary charge of $334,000 (pre tax) was recorded in fiscal 1997 to write off unamortized financing costs related to debt extinguished during fiscal 1997.
Liquidity and Capital Resources --
The Company does not maintain significant inventory or accounts receivable since substantially all of its restaurants' sales are for cash. Like many restaurant businesses, the Company receives several weeks of trade credit in purchasing food and supplies. The Company's receivables from franchisees are closely monitored and collected weekly. The Company normally operates with working capital deficits (current liabilities exceeding current assets), and had a working capital deficit of $11.1 million at January 3, 1999, compared to a working capital deficit of $8.9 million at December 28, 1997. At December 28, 1997 the Company's balance sheet reflected an income tax receivable of approximately $4.6 million, which resulted primarily from tax loss carrybacks. The income tax receivable was collected during fiscal 1998.
Capital expenditures totaled approximately $10.9 million for the 12 months of 1998, compared to $7.1 million in 1997. Approximately $25.7 million is expected for capital expenditures in fiscal 1999. Expected capital expenditures include up to 15 new restaurants to open in fiscal 1999, acquiring land for restaurants to open in 2000, refurbishing of certain restaurants, on-going capital improvements and the conversion of all restaurant computer systems. The Company expects the cost associated with year 2000 compliance will approximate $7.0 million in fiscal 1999. The Company owns approximately 56.0% of its restaurant locations and leases the remainder.
In December 1998, the Company obtained a sales/lease back commitment with a firm for up to $6.0 million of properties which are to be developed and operated as Company-owned Krystal restaurants.
At January 3, 1999, the Company had existing cash balances of $9.0 million and an unused credit line of $21.3 million. The Company expects these funds, funds from operations and sale leaseback financing through third party lenders will be sufficient to meet its operating requirements and capital expenditures through 1999.
Impact of Inflation --
Although increases in labor, food and other operating costs could adversely affect the Company's operations, management does not believe that inflation has had a material effect on income during the past several years.
Seasonality --
The Company does not expect seasonality to affect its operations in a materially adverse manner. The Company's revenues during its first fiscal quarter, comprising the months of January, February and March, will, however, generally be lower than its other quarters due to consumer shopping habits and the climate in the location of a number of its restaurants.
Year 2000 --
Much of the computer software and, in certain cases, hardware in use today is not equipped to distinguish the year 2000 from the year 1900. Much of the software used today was designed with only two digits available for indicating the current year. This issue, at its fundamental level, threatens the integrity of date sensitive financial and other information that is produced by an organization's computer systems, and could undermine the organization's ability to accurately report financial and other date sensitive information.
The Company has established a Year 2000 strategic plan which adopts a series of initiatives necessary to upgrade the Company's computer systems and to minimize the impact of failures of other computer systems to process date- sensitive information after December 31, 1999. All mission critical systems are currently in the validation phase of the Year 2000 plan. The Company expects all critical systems to be Year 2000 compliant before December 31, l999.
A portion of the plan involves the replacement of the Company's hardware and software environment used to run application software, including the Company's centralized financial systems. During 1998, approximately $2.0 million was expended and capitalized by the Company in connection with this replacement. For each Company restaurant location, new restaurant reporting and management systems are scheduled for installation by October 1999, including upgrading of software and selected hardware and telecommunication systems to bring restaurant systems into Year 2000 compliance. This cost is estimated to be approximately $7.0 million, and is included in the Company's 1999 capital budget.
With respect to vendor and third party associations, the plan includes a survey of the systems and products provided by third parties, and includes contacting vendors or third-parties to gain knowledge of the status of their Year 2000 compliance. Currently all items in this area are in the validation process. Based on information received by the Company, these vendors and third parties are at various stages of completion of their Year 2000 compliance plans, and all major suppliers have reported that they expect to be in full compliance by the end of 1999 calendar year.
Management believes its approach to the Year 2000 issue to be comprehensive, and does not expect the Year 2000 issue to have a material adverse impact on its results of operations or financial condition. However, given the nature of the problem and the number of factors outside the Company's direct control, management is continuously evaluating the risks associated with the Year 2000 and cannot guarantee Year 2000 compliance. If for any reason critical suppliers are unable to resolve their Year 2000 issues in a timely manner, the Company's business could be adversely affected. Specifically, the lack of Year 2000 readiness by suppliers could affect the availability and expected cost of food products and other supplies used by the Company and, consequently, the Company's restaurant operations.
Forward looking statements --
Certain written and oral statements made by or on behalf of the Company may constitute "forward-looking" statements" as defined under the Private Securities Litigation Reform Act of 1995. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from the Company's historical experience and its present expectations or projections. These risks and uncertainties include, but are not limited to, unanticipated economic changes, interest rate movements, changes in governmental policies and the possible effects of the year 2000 problem on the Company, including such problems at the Company's vendors, counterparties and customers and the impact of competition. The Company cautions that such factors are not exclusive. Caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date of the making of such statements and are based on certain expectations and estimates of the Company which are subject to risks and changes in circumstances that are not within the Company's control.
Item 7a.
Item 7a. Quantitative and qualitative disclosures about market risks
Not applicable
Item 8.
Item 8. Financial Statements and Supplementary Data (commencing on the following page)
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To The Krystal Company:
We have audited the accompanying consolidated balance sheets of The Krystal Company (a Tennessee corporation) and subsidiary ("Post-Merger Company") as of January 3, 1999 and December 28, 1997 (see Note 1) and the related consolidated statements of operations, shareholder's equity and cash flows for the twelve and three months then ended. We have also audited the accompanying consolidated statements of operations, shareholder's equity and cash flows of The Krystal Company ( a Tennessee corporation) and subsidiary "Pre-Merger Company" for the nine months ended September 28, 1997 and the year ended December 29, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Post-Merger Company as of January 3, 1999 and December 28, 1997 and the results of its operations and its cash flows for the twelve months and the three months then ended and the Pre-Merger Company's results of operations and cash flows for the nine months ended September 28, 1997 and for the year ended December 29, 1996, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Chattanooga, Tennessee February 12, 1999
THE KRYSTAL COMPANY AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. MERGER WITH PORT ROYAL HOLDINGS INC.
On September 26, 1997, (effective September 29, 1997 for accounting purposes), pursuant to an Agreement and Plan of Merger by and among the Company, Port Royal Holdings, Inc. ("Port Royal") and TKC Acquisition Corp. dated July 3, 1997, Port Royal acquired the Company for an aggregate purchase price of $112,009,000 (the "Acquisition"). As a result of the merger, each share of the Company's issued and outstanding stock prior to the merger was converted into the right to receive $14.50 cash, and the Company became a wholly-owned subsidiary of Port Royal. The Company prior to the Acquisition is referred to herein as the "Pre-Merger Company." The Company after the Acquisition is referred to as the "Post-Merger Company."
The purchase price for the Acquisition was funded through (i) a $35 million equity contribution from Port Royal funded by a private equity placement, (ii) borrowings under a revolving credit facility of $25 million with a bank and (iii) the sale of the Company's 10.25% senior notes due 2007 in the aggregate principal amount of $100 million (the "Senior Notes").
The acquisition and merger were completed on September 26, 1997 (September 29, 1997 for accounting purposes) and were accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to assets acquired and liabilities assumed based on fair market values at the date of acquisition, with the remainder to goodwill. The historical shareholders' equity of Krystal was eliminated on the Post-Merger Company's consolidated balance sheet. The fair value adjustments to the historical consolidated balance sheet were as follows:
(In thousands) Net assets acquired on September 29, 1997 at historical cost $ 46,279 Revaluation of Krystal's property, buildings and equipment to estimated fair value 15,797 Adjustment to fair value of other assets acquired and liabilities assumed 3,075 Deferred income taxes associated with the revaluation of Krystal's assets and liabilities (3,052) Goodwill 49,910 --------- Total purchase price allocated $ 112,009 =========
2. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Business Activities --
Krystal (a Tennessee corporation) is engaged primarily in the development, operation and franchising of quick-service restaurants in the southeastern United States. Krystal's wholly-owned subsidiary, Krystal Aviation Co. ("Aviation") operates a fixed base airport hangar operation in Chattanooga, Tennessee. Aviation's revenues in each of the last three years were less than 3% of the Company's total revenues. As discussed in Note 3, on December 15, 1995, Krystal filed a petition for relief under Chapter 11 of the federal bankruptcy laws. Krystal emerged from Chapter 11 bankruptcy with the confirmation of Krystal's plan of reorganization by the U.S. Bankruptcy Court on April 10, 1997.
Basis of Presentation --
The consolidated financial statements for the nine months ended September 28, 1997 and for the year ended December 29, 1996 were prepared using the Pre-Merger Company's historical basis of accounting. The accompanying consolidated financial statements for the three months ended December 28, 1997 and for the year ended January 3, 1999 were prepared under a new basis of accounting that reflects the allocation of the fair value of assets acquired and liabilities assumed, the related financing and acquisition costs and all debt incurred in connection with the acquisition of Krystal by Port Royal. Accordingly, the consolidated financial statements for periods prior to September 29, 1997 are not comparable to consolidated financial statements on or subsequent to September 29, 1997. A black line on the accompanying consolidated financial statements distinguishes between the Pre-Merger and Post-Merger Company.
Principles of Consolidation --
The accompanying consolidated financial statements include the accounts of The Krystal Company and Aviation (herein after referred to collectively as The "Company"). All significant intercompany balances and transactions have been eliminated.
Fiscal Year End --
The Company's fiscal year ends on the Sunday nearest December 31. Consequently, the Company will periodically have a 53-week fiscal year. The fiscal year ended January 3, 1999 was a 53 week fiscal year. The years
ended December 28, 1997 (comprised of the nine months ended September 28, 1997 and the three months ended December 28, 1997) and December 29, 1996 were 52 week fiscal years.
Cash and Temporary Investments --
For purposes of the consolidated statements of cash flows, the Company considers repurchase agreements and other temporary cash investments with a maturity of three months or less to be temporary investments.
Inventories --
Inventories are stated at cost and consist primarily of food, paper products and other supplies. Prior to the acquisition of Krystal by Port Royal, the Company used the last-in, first-out (LIFO) method of accounting for a substantial portion of its inventories. Effective September 29, 1997, the Company changed to the first-in, first-out (FIFO) method. The change in accounting principle was made primarily to reflect inventory on the consolidated balance sheet at a value that more closely represents current cost at the date of the acquisition and merger. This accounting change was not material to the financial statements on an annual or quarterly basis, and accordingly, no retroactive restatement of prior years' financial statements was made.
Property, Buildings and Equipment --
Prior to September 29, 1997, property, buildings and equipment are stated at cost. Effective with the acquisition by Port Royal, property, buildings and equipment were adjusted to their estimated fair values. Properties acquired after September 29, 1997 are stated at cost.
Expenditures which materially increase useful lives are capitalized, whereas ordinary maintenance and repairs are expensed as incurred. Depreciation of fixed assets is computed using the straight-line method for financial reporting purposes and accelerated methods for tax purposes over the estimated useful lives of the related assets as follows:
Buildings and improvements 10 - 39 years Equipment 3 - 10 years Leaseholds Life of lease up to 20 years
Long-lived Assets --
The Company periodically evaluates the carrying value of its long-lived assets. The carrying value of specific long-lived assets are reviewed for potential impairment when the projected undiscounted future cash flow of such assets is less than its carrying value.
Intangibles --
The consolidated balance sheet of the Post-Merger Company includes the allocation of purchase accounting goodwill of $49,910,000 and deferred financing costs of $5,604,000. Intangibles are amortized on a straight-line basis over 10 to 25 years. Amortization expense for goodwill and deferred financing costs for the 3 months ended December 28, 1997 was $483,000 and $204,000, and $1,999,000 and $823,000 for the year ended January 3, 1999, respectively. Accumulated amortization of goodwill at January 3, 1999 and December 28, 1997 was $2,482,000 and $483,000, respectively. Accumulated amortization of deferred financing costs at January 3, 1999 and December 28, 1997 was $1,027,000 and $204,000, respectively.
Franchise and License Agreements --
Franchise or license agreements are available for single and multi-unit restaurants. The multi-unit agreement establishes the number of restaurants the franchisee or licensee is to construct and open in the franchised area during the term of the agreement. At January 3, 1999, there were 110 franchised or licensed restaurants of which 74 restaurants were operated under multi-unit agreements. At December 28, 1997, there were 101 franchised or licensed restaurants of which 68 restaurants were operated under multi-unit agreements.
Franchisees and licensees are required to pay the Company a franchise or license fee plus a weekly royalty and service fee of either 4.5% or 6.0% of the restaurants' gross receipts, depending on the duration of the franchise agreement. Unit franchise and license fees are recorded as income as related restaurants begin operations. Royalty and service fees, which are based on restaurant sales of franchisees and licensees, are accrued as earned. Franchise fees received prior to the opening of the restaurant are deferred and included in accrued liabilities on the consolidated balance sheets. At January 3, 1999 and December 28, 1997, total deferred franchise and license fees were approximately $396,000 and $682,000, respectively.
Fair market value of financial instruments --
Unless otherwise indicated elsewhere in the notes to the consolidated financial statements, the carrying values of the Company's financial instruments approximate their fair values.
Use of Estimates --
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Effects of Accounting Changes --
Statement of Financial Accounting Standards No. 132, "Employers' disclosures about Pensions and Other Postretirement Benefits" ("SFAS No. 132"), requires changes in the disclosures about pensions and other benefits provided by employers. This standard does not affect accounting measurements nor does it revise the disclosures made in the financial statements of the plans. The provisions of SFAS No. 132 are effective for fiscal years beginning after December 15, 1997. The Company adopted the provisions of SFAS No. 132 effective for fiscal 1998.
3. PETITION FOR RELIEF UNDER CHAPTER 11
On December 15, 1995, Krystal filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code with the United States Bankruptcy Court for the Eastern District of Tennessee for the purpose of completely and finally resolving the various claims filed against the Company by current and former employees alleging violations of the Fair Labor Standards Act of 1938
In early 1997, Krystal and the majority of the FLSA plaintiffs reached a settlement providing for the payment of the FLSA claims and related legal costs. A plan of reorganization (the "Plan") was formally filed on February 24, 1997. On April 10, 1997, the Bankruptcy Court confirmed the Company's plan of reorganization and on April 23, 1997, the Plan became final resulting in the dismissal of the FLSA claims.
4. PROPERTY, BUILDINGS AND EQUIPMENT
Property, buildings and equipment at January 3, 1999 and December 28, 1998, consisted of the following:
January 3, December 28, 1999 1997 ----------- ----------- (In thousands)
Land $ 40,254 $ 40,248 Buildings and improvements 32,026 27,315 Equipment 30,204 26,216 Leasehold improvements 9,654 8,701 Construction in progress 3,777 1,379 --------- --------- 115,915 103,859 Accumulated depreciation and amortization (16,221) (2,659) --------- --------- $ 99,694 $ 101,200 ========= =========
5. ACCRUED LIABILITIES
Accrued liabilities at January 3, 1999 and December 28, 1997, consisted of the following:
January 3, December 28, 1999 1997 ------------ ----------- (In thousands)
Salaries, wages and vacation pay $ 7,185 $ 4,018 Workers' compensation 3,258 4,590 State sales taxes 1,836 1,341 Accrued interest 2,676 2,823 Other 7,298 6,627 -------- -------- $ 22,253 $ 19,399 ======== ========
6. INDEBTEDNESS
Long-term debt at January 3, 1999 and December 28, 1997, consisted of the following:
January 3, December 28, 1999 1997 ----------- ----------- (In thousands)
Revolving credit facility, due August 26, 2000 $ -- $ 11,113 10.25% senior notes, due October 2007 100,000 100,000 Other 189 1,114 --------- -------- 100,189 112,227 Less-- Current maturities ( 53) ( 53) --------- -------- $100,136 $112,174 ========= ========
In September 1997, Port Royal issued $100,000,000 in unsecured 10.25% senior notes ("the Notes") which mature on October 1, 2007. Following the acquisition and merger, the Post-Merger Company became the obligor of the Notes. The Notes pay interest semi-annually on April 1 and October 1 of each year. The Notes are redeemable at the option of the Company at prices decreasing from 105 1/8% of the principal amount on April 1, 2002 to 100% of the principal amount on April 1, 2005. On or prior to April 1, 2000, the Company may redeem up to 35% of the original principal amount with the proceeds of one or more public equity offerings at a redemption price of 110 1/4%. Additionally, upon a change of control of the Company, the holders of the Notes will have the right to require the Company to purchase all or a portion of the Notes at a price equal to 101% of the original principal amount. The proceeds of the Notes were used to fund the acquisition by Port Royal.
In September 1997, the Company entered into a credit agreement with a bank for a $25 million credit facility (the "Credit Facility") which matures August 26, 2000. Borrowings under the Credit Facility bear interest rates, at the option of the Company, equal to either: (a) the greater of the prime rate, or the federal funds rate plus 0.5%, plus a margin of 0.5%; or (b) the rate offered in the Eurodollar market for amounts and periods comparable to the relevant loan, plus a margin that is determined by certain financial covenants. At January 3, 1999, the margin applicable to the Eurodollar interest rate was 2.5%.
The Credit Facility contains restrictive covenants including, but not limited to: (a) the Company's required maintenance of minimum levels of tangible net worth; (b) limitations regarding additional indebtedness; (c) the Company's required maintenance of a minimum amount of fixed charges coverage; and (d) limitations regarding liens on assets. Additionally, the Credit Facility contains a provision that, in the event of a defined change of control, the Credit Facility will be terminated. As of January 3, 1999, and for the year then ended, the Company was in compliance with all loan covenants.
The proceeds of the Credit Facility were used to pay a portion of the purchase price, certain fees and expenses related to the acquisition and merger, certain indebtedness and provide working capital for the Post-Merger Company.
Essentially all assets of the Company at January 3, 1999, are pledged as collateral on the Credit Facility. Additionally, the Credit Facility is guaranteed by Port Royal through a secured pledge of all the Company's common stock held by Port Royal and the common stock of each existing and future subsidiary of the Company.
Scheduled maturities of long-term debt at January 3, 1999, are as follows:
(In thousands):
1999 $ 53 2000 36 2001 5 2002 95 Thereafter 100,000
At January 3, 1999, the estimated fair value of the Credit Facility approximates the carrying amount of such debt because the interest rate changes with market interest rates. The estimated fair value of the Notes at January 3, 1999 exceeds their carrying value by approximately $2,000,000. The fair value was estimated based upon quoted market prices for the same or similar issues.
In April 1997, the Company obtained financing (the "Financing")from a financial lending institution to pay the settlement of the FLSA class suit, the payment of senior unsecured and secured debt and creditors' allowed claims in full including interest of 8.5%. The Financing provided for a $23,000,000 five year revolving credit facility, a $10,000,000 term loan due in equal quarterly installments over five years and a $20,000,000 term loan due in quarterly installments in the third through the fifth year following completion of the financing. The revolving credit facility and term loans were secured by substantially all of the Company's assets. In the first quarter of 1997, the Company recognized an extraordinary after-tax charge of $220,000 as a result of the early extinguishment of previously held senior unsecured debt and secured debt in conjunction with the Financing. In conjunction with the acquisition by Port Royal, the Financing was repaid in full.
7. BENEFIT PLANS
Retirement Plans --
Effective October 1, 1998, the Company amended and restated its defined benefit pension plan. The plan, as amended, is a defined benefit pension plan covering each employee who was participating in the plan on September 30, 1998 and each salaried employee or salaried benefits employee who is employed on or after October 1, 1998. The cost of the plan shall be borne by actuarially determined contributions made by the employer and by contributions made by the participants. The plan provides benefits of stated amounts based on years of service and the employee's compensation. This event was accounted for as a plan amendment. The Company's funding policy is consistent with the requirements of the Employee Retirement Income Security Act of 1974.
Effective March 31, 1998, the Company terminated its hourly benefit program to retired employees for all current and future participants. The Company's obligation for any future obligation under this plan was settled. This event was accounted for as a plan termination.
9. LEASES
The Company leases certain buildings and equipment and a number of restaurants (land and/or building) under noncancellable lease agreements, some of which are subleased to third parties. The restaurant lease terms are normally for a period of 15 to 20 years with options that permit renewals for additional periods. Certain leases provide for additional contingent rentals based on sales. Generally, the building portions of the restaurant leases have been recorded as capital leases, while the land portions have been recorded as operating leases.
The future minimum lease payments under capital and operating leases, together with the present value of such minimum lease payments as of January 3, 1999, are summarized as follows: Capital Operating Leases Leases ------- --------- Year (In thousands)
1999 $ 598 $ 4,227 2000 598 3,836 2001 598 3,280 2002 580 2,329 2003 548 1,500 Thereafter 1,374 3,906 ------ ------- Total minimum lease payments 4,296 $19,078 ======= Less amount representing interest 1,144 ------ Present value of minimum lease payments including current portion $3,152 ======
Rental expense under operating leases was $5,158,000, $1,324,000, $3,974,000, and $4,903,000 for periods ended January 3, 1999, December 28, 1997, September 28, 1997, and December 29, 1996, respectively.
Rental expense includes contingent rentals of $150,000, $31,000, $95,000 and $110,000 for periods ended January 3, 1999, December 28, 1997, September 28, 1997, and December 29, 1996, respectively.
Direct Financing and Operating Leases/Subleases with Third Parties --
The Company owns or leases from outside parties certain land and buildings which are leased/subleased to third parties. Generally, the building portions of the leases/subleases are treated as direct financing leases while the land portions of the leases/subleases are treated as operating leases.
The following summarizes the components of the net investment in direct financing leases and the minimum future rentals on operating leases/subleases as of January 3, 1999: Direct Financing Operating Leases Leases --------- --------- Year (In thousands)
1999 $ 56 $ 1,148 2000 7 1,164 2001 - 1,045 2002 - 535 2003 - 128 Thereafter - 97 ------ ------ Total minimum lease payments to be received 63 $ 4,117 ====== Less unearned income ( 5) ------ Net investment in direct financing leases including current portion $ 58 ======
Rental income under operating leases was $1,006,000, $185,000, $557,000, and $557,000 for periods ended January 3, 1999, December 28, 1997, September 28, 1997, and December 29, 1996, respectively.
10. CONTINGENCIES
The Company is party to various legal proceedings incidental to its business. The ultimate disposition of these matters is not presently determinable but will not, in the opinion of management, have a material adverse effect on the Company's financial condition or results of operations.
11. EMPLOYEE STOCK OPTIONS AND RESTRICTED STOCK PLANS
Employee stock options plan--
On July 30, 1998, the Board of Directors of Port Royal Holdings, Inc., authorized a nonqualified Incentive Stock Option Plan (the "Plan") for key employees of the Company and its subsidiary. The Plan is administered by the Compensation Committee (the "Committee") of the Board of Directors. Under the Plan, the Committee may grant options of up to 1,000,000 shares of Port Royal common stock. The Committee granted 700,000 options in 1998 of which 100,000 vest ratably over 5 years and the remaining 600,000 vest in 2007, or upon a change of control of the Company. These 700,000 options also contain a vesting acceleration provision if the Company achieves certain cash flow targets. No such options were vested under the acceleration provision in 1998.
The Company accounts for its stock-based compensation plans under APB No. 25, "Accounting for Stock Issued to Employees," under which no compensation expense has been recognized as all employee stock options have been granted with an exercise price equal to the estimated fair value of Port Royal common stock. SFAS No. 123, "Accounting for Stock-Based Compensation," established accounting and disclosure requirements using a fair-value based method of accounting for stock-based employee compensation plans. The Company has adopted the disclosure requirements as detailed below.
For SFAS No. 123 purposes, the fair value of each option grant has been estimated as of the date of the grant using the minimum value option pricing model because there is no established fair market value of the Company's stock as it is not available on the open market. The following weighted average assumptions were used for fiscal year 1998: expected dividend yield of 0%, a risk-free interest rate of 5.49% and expected life of 10 years. Using these assumptions, the fair value of the employee stock options granted in 1998 is $1,303,000, which would be amortized as compensation expense over the vesting period of the options. Had compensation cost been determined in accordance with SFAS No. 123, utilizing the assumptions detailed above, the Company's net income would have adjusted to the pro forma amounts indicated below:
------------ Net Income (in thousands): As reported $1,345 Pro forma 1,284
A summary of the Company's stock option activity is as follows (shares in thousands):
---------------------- Weighted Shares Average Under Exercise Option Price --------- ---------- Outstanding at beginning of year 0 $ 0 Granted 700 4.50 --------- ---------- Outstanding at end of year 700 $4.50 ========= ========== Exercisable at end of year 20 $4.50 Weighted average fair value of options granted $4.50 =========
Of the 700,000 shares subject to options outstanding at January 3, 1999, (i) options to purchase 100,000 shares have an exercise price of $4.50, with a remaining contractual life of 9.6 years, of which 20,000 shares are exercisable; and (ii) options to purchase 600,000 shares have an exercise price of $4.50, with a weighted average remaining contractual life of 9.5 years, of which none are exercisable.
Restricted stock plan --
The Company's 1990 Restricted Stock Plan ("Restricted Stock Plan") provided for the granting of shares of common stock to certain directors and key employees of the Company. The maximum number of shares that were issuable under the Restricted Stock Plan was 1,100,000 shares. The shares issued under the Restricted Stock Plan were restricted when issued and subject to forfeiture under certain circumstances. Due to the change in control and the merger with Port Royal, restrictions on the Restricted Stock Plan were terminated and restricted stockholders were entitled to receive $14.50 per share in cash and the Restricted Stock Plan was terminated.
A summary of the Company's restricted stock activity is as follows:
Restricted Stock Plan ---------- (Number of shares) Issued at December 31, 1995 984,400
Issued at an average market value of $4.63 per share 960 Forfeitures (36,000) ------- Issued at December 29, 1996 949,360
Issued at an average market value of $5.38 per share 720 Forfeitures (16,400) ------- Issued at September 28, 1997 933,680 Cancelled upon merger (933,680) ------- Issued at September 29,1997 -- =======
Deferred compensation related to the restricted stock awards was recorded based on the market value of the Company's common stock at the date of grant and such deferred compensation was amortized to expense over the period the restrictions lapsed. Compensation expense related to the restricted stock plans was $146,538 and $363,688 for the nine months ended September 28, 1997 and for fiscal year 1996.
12. QUARTERLY INFORMATION (unaudited)
(In thousands of dollars)
Fiscal 1998 Net Operating Income Revenues Income (Loss) -------- --------- ------ Quarter Ended: March 29 $ 59,625 $ 2,016 $ 228 June 28 61,546 2,593 ( 83) September 27 66,271 2,214 ( 287) January 3, 1999 70,006 4,981 1,487 -------- ------- -------- Total $257,448 $11,804 $ 1,345 ======== ======= ========
Fiscal 1997 Net Operating Income Revenues Income (Loss) -------- --------- ------ Quarter Ended: March 30 $ 59,163 $ 1,509 $ (263) June 29 63,325 2,669 1,107 September 28 62,247 1,847 601 -------- ------- ------- $184,735 $ 6,025 $ 1,445 ======== ======= =======
December 28 (1) $ 63,688 $ 2,264 $ (539) ======== ======= =======
(1) As described in Note 1, the Company was acquired and merged with and into a wholly-owned subsidiary of Port Royal Holdings, Inc. as of September 26, 1997 (September 29, 1997 for accounting purposes).
13. SUMMARIZED FINANCIAL INFORMATION - SUBSIDIARY GUARANTORS
The Senior Notes are guaranteed by each of the Company's subsidiaries. The guarantees are full, unconditional, joint and several obligations of each of the subsidiary guarantors. Summarized financial information for the subsidiary guarantors is set forth below. Separate financial statements for the subsidiary guarantors of the Company are not presented because the Company has determined that such financial statements would not be material to investors. The subsidiary guarantors comprise all of the direct and indirect subsidiaries of the Company. There are no restrictions on the ability of the subsidiary guarantors to declare dividends, or make loans or advances to the Company.
The following table presents summarized financial information for subsidiary guarantors in connection with the Company's Senior Notes:
January 3, December 28, 1999 1997 ---------- ----------- (in thousands) Balance Sheet Data: Current assets $ 872 $ 576 Noncurrent assets $ 954 $1,354 Current Liabilities $1,220 $1,659 Non Current Liabilities $ 79 $ 131
Post-Merger | Pre-Merger Company | Company ------------------------- | --------------------- Fiscal Year Three Months | Nine Months Fiscal Year Ended Ended | Ended Ended ------------ ----------- | ----------- --------- Jan.3, Dec. 28, | Sep. 28, Dec. 29, 1999 1997 | 1997 1996 ----------- ----------- | ----------- --------- (in thousands) Income Statement Data: | Net sales $5,188 $1,290 | $3,469 $4,671 Gross profit $1,647 $ 334 | $ 889 $ 815 Income before provision | for Federal and State | Income Taxes $1,222 $ 228 | $ 471 $ 210 Net Income $ 758 $ 140 | $ 293 $ 130
14. BUSINESS SEGMENTS
The Company and its subsidiary operate in two industry segments, quick-service restaurants and fixed base airport hangar operations ("FBO"). See Note 13, Summarized Financial Information-Subsidiary Guarantor, for summarized financial information for the FBO segment.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There were no disagreements with accountants on accounting and financial disclosure in 1998.
Item 10.
Item 10. Directors and Executive Officers of the Company
The directors of the Company are:
Philip H. Sanford 45 Chairman, Chief Executive Officer and Director James F. Exum, Jr. 42 President, Chief Operating Officer and Director W. A. Bryan Patten 58 Director Richard C. Patton 37 Director Benjamin R. Probasco 39 Director A. Alexander Taylor II 45 Director
Philip H. Sanford has been Chairman, Chief Executive Officer and a Director of the Company since September 1997. Prior to that time, Mr. Sanford was Senior Vice President, Finance and Administration, of Coca-Cola Enterprises Inc., from 1991 to 1997. Mr. Sanford was a senior executive with Johnston Coca-Cola Bottling Group until 1991.
James F. Exum, Jr. has been President, Chief Operating Officer and a Director of the Company since September 1997. From 1995 to September 1997, Mr. Exum served as President and Chief Executive Officer of Pennant Foods Corp., Knoxville, Tennessee. He was President and Chief Executive Officer of Southern California Food Services Corp. from 1991 to 1995.
W. A. Bryan Patten has been a Director of the Company since September 1997 and is the President of Patten & Patten Inc., a registered investment advisory firm in Chattanooga, Tennessee.
Richard C. Patton has been a Director of the Company since September 1997 and has been President of Investments at Ingram Industries Inc., a diversified holding company, since January of 1996. Prior to joining Ingram Industries Inc., Mr. Patton was self-employed as an investor. From June 1992 to June 1995, Mr. Patton was an equity analyst and portfolio manager with Fidelity Investments. From June 1984 to September 1990 Mr. Patton developed the San Antonio Taco Co. and Granite Falls restaurants.
Benjamin R. Probasco has been a Director of the Company since September 1997 and has been employed as Vice President, Real Estate, for Big River Breweries, Inc. since April 1998. Prior to joining Big River Breweries, Inc., Mr. Probasco was employed for two years at Probasco & Company, a real estate development company, six years at Leonard, Kinsey & Associates from 1991 to 1997 and from 1983 to 1988 was employed at Johnston Coca-Cola Bottling Group.
A. Alexander Taylor II has been a Director of the Company since April 22, 1998 and has been President and Chief Operating Officer of Chattem, Inc. since January 1998. Prior to joining Chattem, Inc. Mr. Taylor was a partner in the law firm of Miller & Martin and was affiliated with that firm from 1978 to 1998.
The Executive Officers of the Company, in addition to Messrs. Sanford and Exum, are:
Gordon L. Davenport, Jr. 39 Vice President, Marketing - Development Larry J. Reeher 51 Vice President, Human Resources Larry D. Bentley 42 Vice President and Chief Financial Officer Michael C. Bass 52 Vice President, Administration. Thomas C. Ragan 48 Vice President, Franchising
Gordon L. Davenport, Jr. has been Vice President Marketing - Development at Krystal since February 1997. From 1995 to 1997, Mr. Davenport served as Vice President of New Business and Strategic Planning and Vice President of Marketing and New Business. From 1986 to 1995, Mr. Davenport served in various marketing and sales management positions with Warner Lambert Company.
Larry J. Reeher has been Vice President Human Resources since August 1995. From 1988 to 1995, Mr. Reeher was Executive Vice President Human Resources for Gardner Merchant Food Services, Inc.
Larry D. Bentley was elected Vice President and Chief Financial Officer of the Company in December 1997. From 1991 to 1996, Mr. Bentley was Executive Vice President and Chief Financial Officer of U.S. Express Enterprises, Inc.
Michael C. Bass was appointed Vice President - Administration on April 22, 1998. He has served in various capacities with the Company since 1979, including Director of Purchasing, Director of Administration and Vice President of Administration. From 1969 to 1979 he held various management positions with Marriott Corporation.
Thomas C. Ragan was appointed Vice President of Franchising on May 14, 1998. From 1997 to 1998, Mr. Ragan served as Vice President of Franchising for Famous Dave's of America, Inc. From 1992 to 1997, he served as Vice President of Franchise Sales for Papa John's International, Inc. He served as Area Director of Operations for Rally's Hamburger, Inc. from 1986 to 1992.
Item 11.
Item 11. Executive Compensation
The following table summarizes the total compensation for the last three fiscal years of the following five highest compensated named executive officers of the Company during the last fiscal year.
(1) Represents stock options granted during fiscal 1998 under the Port Royal Holdings, Inc. Stock Incentive Plan for the Krystal Company. (2) Mr. Sanford was appointed Chairman and Chief Executive Officer of the Company on September 26, 1997. (3) This amount includes $153,290 paid to Mr. Sanford for moving expenses and $12,000 automobile expenses. (4) Mr. Exum was appointed President and Chief Operating Officer of the Company on September 26, 1997. (5) This amount includes $35,714 paid to Mr. Exum for moving expenses and $12,000 for automobile expenses. (6) Mr. Bentley was appointed Vice President and Chief Financial Officer on December 18, 1997. (7) Mr. Gordon L. Davenport, Jr. was appointed Vice President Marketing and Development on February 17, 1997. Bonus compensation includes $10,124 of bonus compensation earned in 1997, but paid in 1998. (8) Mr. Reeher was appointed Vice President Human Resources on August 14, 1995. Bonus compensation includes $8,269 of bonus compensation earned in 1997, but paid in 1998.
There are no employment agreements with any of these individuals. The Company has adopted performance-based incentive compensation plans for senior management of the Company, including a cash management bonus plan and a stock ownership plan, under which total awards may, in the aggregate, equal 10% of the outstanding common stock of the Company on a fully-diluted basis, assuming exercise of options. Non-employee directors receive a fee of $1,000 for each Board of Directors and committee meeting attended.
STOCK OPTIONS GRANTS IN LAST FISCAL YEAR
The following table contains information concerning the grant of stock options to acquire shares of Port Royal Stock to the named executive officers during the fiscal year ended January 3, 1999. All references to options refer to Port Royal Stock.
OPTION EXERCISES AND HOLDINGS
The option exercises by the Company's chief executive officer and the other named executive officers during the fiscal year ended January 3, 1999, as well as the number and total value of unexercised in-the-money options at January 3, 1999, are shown in the following table. All references to options and shares refer to Port Royal Stock.
Aggregate Option Exercises in Last Fiscal Year and Option Values at January 3, 1999
Name Number of Value Number of Value of Shares Realized Unexercised Unexercised Acquired Options at Options on Exercise Jan. 3. 1999 In-the-Money Exercisable/ Exercisable/ Unexercisable Unexercisable(1) - --------------------- -------- -------- ------------- ------------- Philip H. Sanford -- -- --/-- -/-
James F. Exum, Jr. -- -- 20,000/480,000 0/0
Larry D. Bentley -- -- --/100,000 -/0
Gordon L. Davenport, Jr. -- -- --/100,000 -/0
Larry J. Reeher -- -- --/-- -/-
(1) Since the shares of Port Royal Stock do not trade on any market, it is the assumed that the fair market value of the Port Royal Stock is equal to exercise price of the option.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
All of the outstanding capital stock of the Company is held by Port Royal. The following table sets forth certain information regarding beneficial ownership of the common stock of Port Royal by: (i) each person who holds more than 5% of the common stock of Port Royal, (ii) each Director of the Company, (iii) each of the Executive Officers of the Company and (iv) all Directors and Executive Officers as a group.
Name Amount of Percent of Beneficial Ownership Class (1) Directors Philip H. Sanford(2) 2,600,000 26.0 James F. Exum, Jr.(3) 20,000 0.2 W. A. Bryan Patten(4) 863,333(5) 8.6 Richard C. Patton(6) 1,233,333(7) 12.3 Benjamin R. Probasco(8) 863,333(9) 8.6 A. Alexander Taylor II 123,333 1.2
Executive Officers
Larry D. Bentley 0 0 Gordon L. Davenport, Jr.(13) 246,667 2.5 Larry J. Reeher 0 0 Michael C. Bass 0 0 Thomas C. Ragan 0 0
5% Shareholders Katherine J. Johnston Trust(10) 1,233,333 12.3 Woodmont Capital, LLC(11) 1,233,333 12.3 P&P Port Royal Investors, LP(12) 863,333 8.6 All Directors and Executive Officers as a group (9 persons) 5,949,999 59.5
(1) For purposes of computing percentage of outstanding shares owned by each beneficial owner, the shares issued pursuant to exercisable stock options held by such beneficial owner are deemed outstanding. Such shares are not deemed to be outstanding for the purpose of computing the percentage ownership of any other person. (2) The address for this beneficial owner is The Krystal Building, One Union Square, Chattanooga, Tennessee 37402. (3) Includes 20,000 shares subject to purchase within sixty days of March 12, 1999 under the company's Incentive Stock Plan. (4) The address for this beneficial owner is 520 Lookout Street, Chattanooga, Tennessee 37403. (5) Includes shares held by P&P Port Royal Investors, LP, an investment fund for which an affiliate of Patten & Patten, Inc. serves as general partner. Mr. Patten is a director, officer and shareholder of Patten & Patten, Inc. Mr. Patten disclaims ownership of all but 5,920 of these shares. (6) The address for this beneficial owner is 4400 Harding Road, Nashville, Tennessee 37205. (7) Includes shares held by Woodmont Capital, LLC, an investment fund for which Mr. Patton is the President. (8) The address for this beneficial owner is 100 East Tenth Street, Suite 600, Chattanooga, Tennessee 37402. (9) Includes shares held by various trusts of which Mr. Probasco is a beneficiary. (10) The address for this beneficial owner is Suite 600, The Krystal Building, Chattanooga, Tennessee 37402. (11) The address for this beneficial owner is 4400 Harding Road, Nashville, Tennessee 37205. (12) The address for this beneficial owner is 520 Lookout Street, Chattanooga, Tennessee 37403. (13) The address for this beneficial owner is One Union Square, Chattanooga, Tennessee 37402.
PART IV
Item 13.
Item 13. Certain Relationships and Related Transactions
None
Item 14.
Item 14. Exhibits , Financial Statement Schedules, and Reports on Form 8-K
(a) 1. Financial Statements
The financial statements are included herein by reference.
2. Financial statement schedules
All schedules are omitted because the information is either not required or is included in the financial statements or notes hereto.
3. Exhibits
Exhibit 10.2 --
PORT ROYAL HOLDINGS, INC. STOCK INCENTIVE PLAN FOR THE KRYSTAL COMPANY
A. Establishment and Purpose of the Plan. The purpose of this Plan is to provide a flexible means of compensation and motivation for outstanding performance by employees of The Krystal Company and its subsidiaries ("Krystal") and other certain persons to further the continued growth and profitability of Krystal through the grant of equity or equity-related interests in Port Royal Holdings, Inc. ("Port Royal"), which owns all of the issued and outstanding stock of Krystal.
B. Definitions. As used in the Plan, the following terms have the meanings indicated:
(a) Board of Directors. The Board of Directors of Port Royal.
(b) Committee. The Compensation Committee of the Board of Directors, which committee shall have at least three members, each of whom shall be a Non-Employee Director of Port Royal or Krystal within the meaning of Rule 16b-3 promulgated under the Securities Exchange Act of 1934, as amended.
(c) Common Stock. The common stock of Port Royal, no par value, or such other class or kind of shares of other securities as may be applicable under Section 11 of this Plan.
(d) Employee. A full-time key employee of the Krystal or its subsidiaries, including an officer who is such an employee.
(e) Fair Market Value. The fair market value of shares of Common Stock as of such date based upon (i) if publicly-traded, the closing price of the Common Stock as of the day in question (or, if such day is not a trading day, on the nearest preceding trading day) as reported with respect to the market in which such shares are traded, or (ii) if not publicly-traded, the determination of the Committee using any reasonable method in good faith.
(f) Incentive Stock Option. Any Option intended to meet the requirements of an incentive stock option as defined in Section 422.
(g) Non-Qualified Stock Option. Any Option not intended to be an Incentive Stock Option.
(h) Option. An option to purchase Common Stock granted under the Plan, including both an Incentive Stock Option and a Non-Qualified Stock Option.
(i) Other Plan Grants. Grants, other than those specified herein, that are valued in whole or part by reference to, or otherwise based upon, Common Stock, including without limitation performance shares, convertible or exchangeable debt or equity, and rights valued by reference to financial performance of Port Royal or Krystal or any of its subsidiaries.
(j) Plan. The Port Royal Holdings, Inc. Stock Incentive Plan for The Krystal Company herein set forth, as the same may from time to time be amended.
(k) Restricted Stock. Common Stock granted by the Committee subject to restrictions as to transferability and conditions of forfeiture in the hands of the grantee as determined by the Committee.
(l) Section 422. Section 422 of the Internal Revenue Code of 1986, as amended, or any successor statute.
(m) Stock Appreciation Right. A right to receive a payment equal to the excess of the (i) Fair Market Value of the shares of Common Stock covered by such right as of the date of exercise or termination over (ii) such amount as is determined by the Committee at the time the Stock Appreciation Right is granted.
(n) Time-Accelerated Options. An Option to purchase Common Stock granted under the Plan, which may be an Incentive Stock Option or a Non-Qualified Stock Option, with the right to exercise such Option vesting at specified times and subject to accelerated vesting upon the occurrence of certain events established by the Committee.
C. Eligibility. A grant under this Plan may be made to any Employee or any other person as to whom the Committee determines that making such grant is in the best interests of Krystal; provided, however, that (i) no person may participate in the decision to make a grant to himself, and (ii) no grant of an Incentive Stock Option may be made to a person other than an Employee.
D. Plan Administration. This Plan shall be administered by the Committee or, in the event the Committee is not for any reason constituted, by the Board of Directors (in which case all references to the Committee shall refer to the Board of Directors). The Committee shall have full power to interpret and administer this Plan and full authority to act in selecting the grantees and in determining type and amount of grants, the terms and conditions of grants, and the terms of agreements which will be entered into with grantees governing such grants. The Committee shall have the power to make rules and guidelines for carrying out the Plan and to make changes in such rules and guidelines as from time to time it deems proper. Any interpretation by the Committee of the terms and provisions of the Plan and the administration thereof and all action taken by the Committee shall be final.
E. Shares Subject to the Plan. Subject to adjustment as provided in Section 11, the total number of shares of Common Stock available for grant under this Plan shall be 1,000,000. Shares of Common Stock issued hereunder may consist, in whole or in part, of authorized and unissued shares, treasury shares, and shares acquired by private purchase. Any Common Stock which is purchased shall be purchased at prices no higher than the Fair Market Value of such Common Stock at the time of purchase. If for any reason any shares of Common Stock issued under any grant hereunder are forfeited or canceled, or a grant otherwise terminates or is terminated for any reason without the issuance of any shares, then all such shares, to the extent of any such forfeiture, cancellation or termination, shall again be available for grant under this Plan.
F. Types of Grants.
(a) The Committee may make such grants under this Plan as in its discretion it deems advisable to effectuate the purpose of the Plan, including without limitation grants of Restricted Stock, Incentive Stock Options, Non-Qualified Stock Options, Time-Accelerated Options, Stock Appreciation Rights, and Other Plan Grants. Such grants may be issued separately, in combination, or in tandem, and additional grants may be issued in combination or in tandem with grants previously issued under this Plan or otherwise. As used in this Plan, references to grants in tandem shall mean grants consisting of more than one type of grant where the exercise of one element of the grant effects the cancellation of one or more other elements of the grant.
(b) The exercise price of an Option or other grant shall be paid in cash or such other consideration as the Committee may determine consistent with applicable law, which may include without limitation (i) shares of Common Stock; and (ii) the withholding, from the shares of Common Stock receivable on exercise, of shares of Common Stock with a Fair Market Value as of the date of exercise equal to the exercise price.
G. Restricted Stock. Each grant of Restricted Stock shall specify the restrictions thereon and the terms and conditions governing the termination of such restrictions. Each certificate representing Restricted Stock shall at the Committee's discretion either bear a legend as to the restrictions thereon or be deposited by the grantee, together with a stock power endorsed in blank, with Port Royal. The grantee shall have the right to receive dividends from and to vote the shares of Restricted Stock owned by the grantee.
H. Options.
(a) The price at which Common Stock may be purchased upon exercise of an Option shall be determined by the Committee, but, for the grant of an Incentive Stock Option, shall not be less than 100 percent of the Fair Market Value of shares of Common Stock as of the date on which the Option is granted.
(b) Each Option shall have such terms and conditions as the Committee shall determine, except that no Incentive Stock Option shall have a term of more than ten years. A grantee shall have no rights of a shareholder with respect to any shares of Common Stock subject to an Option unless and until a certificate for such shares shall have been issued.
(c) All the provisions of Section 422 and the regulations thereunder as in effect from time to time are hereby incorporated by reference herein with respect to Incentive Stock Options to the extent that their inclusion in this Plan is necessary from time to time to preserve their status as incentive stock options for purposes of Section 422. Each provision of the Plan and each agreement relating to an Incentive Stock Option shall be construed so that it shall be an incentive stock option for purposes of Section 422, and any provisions thereof which cannot be so construed shall be disregarded.
I. Stock Appreciation Rights. Each grant of a Stock Appreciation Right shall be credited to the grantee's account on the books of the Plan. Payment may be made in whole or in part in cash, shares of Common Stock, or such other form as the Committee may determine.
J. Other Plan Grants. Other Plan Grants may be made by the Committee upon such terms and conditions as it may determine from time to time.
K. Adjustments Upon Changes in Capitalization. In the event of a reorganization, recapitalization, stock split, stock dividend, combination of shares, merger, consolidation or any other change in the corporate structure of Port Royal affecting Common Stock, or a sale by Port Royal of all or part of its assets, or any distribution to shareholders other than a normal cash dividend, or any assumption or conversion of outstanding grants as a result of an acquisition, the Board of Directors shall make appropriate adjustment in the number and kind of shares authorized by the Plan and any adjustments in outstanding grants as it deems appropriate.
L. Termination and Amendment. This Plan shall become effective upon its approval by the shareholders of Port Royal and shall terminate upon the tenth anniversary of such date. It shall remain in full force and effect during such period unless earlier terminated by the Board of Directors, which shall have the power to amend, suspend, terminate or reinstate this Plan at any time, provided that no amendment which increases the number of shares of Common Stock subject to the Plan or changes the exercise price of an Option shall be made without shareholder approval.
M. Non-Assignability. Grants are not transferable other than by will or the laws of descent and distribution, except that grants other than Incentive Stock Options may also be transferable to the grantee's spouse, children or a family limited partnership, trust or other similar entity solely for the benefit of the grantee or the grantee's spouse or children. A grant is exercisable during the grantee's lifetime only by the grantee or his or her guardian or legal representative.
N. Exercise by Estate. Any provision of this Plan to the contrary notwithstanding, unless otherwise determined by the Committee, the estate of any grantee shall have one year from the date of death to exercise any grant hereunder, or such longer period as the Committee may determine, except that this sentence shall in no event extend the term of any Incentive Stock Option beyond ten years.
O. General Provisions.
(a) Nothing contained in this Plan, or in any grant made pursuant to the Plan, shall confer upon any grantee any right with respect to terms, conditions or continuance of employment by Krystal or any subsidiary.
(b) Appropriate provision may be made by the Committee for all taxes required to be withheld in connection with any grant, the exercise thereof, and the transfer of shares of Common Stock, in respect of any federal, state, local or foreign withholding taxes. In the case of payment in the form of Common Stock, Port Royal shall have the right to retain the number of shares of Common Stock whose Fair Market Value equals the amount to be withheld.
(c) If any day on or before which such action the Plan must be taken falls on a Saturday, Sunday or legal holiday, such action may be taken on the next preceding day which is not a Saturday, Sunday or legal holiday.
(d) This Plan and all determinations made and actions taken pursuant thereto shall be governed by the laws of Tennessee without regard to principles of conflicts of laws.
(e) The Committee may amend any outstanding grants to the extent it deems appropriate, provided that the grantee's consent shall be required in the case of amendments adverse to the grantee.
See exhibit index
(b) Reports on Form 8-K -
The registrant did not file a Form 8-K during the fourth quarter of 1998.
Signatures --
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
The Krystal Company
Dated: March 18, 1999 By: /s/Larry D. Bentley ------------------------------ Larry D. Bentley, Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.
Signature Title Date /s/Philip H. Sanford - ---------------------- Philip H. Sanford Chairman of the Board of Directors and Chief Executive Officer and Director March 18, 1999 /s/James F. Exum, Jr. - ---------------------- James F. Exum, Jr. President, Chief Operating Officer and Director March 18, 1999
/s/W. A. Bryan Patten - ---------------------- W. A. Bryan Patten Director March 18, 1999
/s/Richard C. Patton - ---------------------- Richard C. Patton Director March 18, 1999
/s/Benjamin R. Probasco - ---------------------- Benjamin R. Probasco Director March 18, 1999
/s/A. Alexander Taylor II - ----------------------- A. Alexander Taylor II Director March 18, 1999
Supplemental information to be furnished with Reports filed pursuant to Section 15(d) of the Act by Registrants which have not registered securities pursuant to Section 12 of the Act --
The Company has not sent an annual report or proxy statement to its sole shareholder, Port Royal Holdings, Inc.
THE KRYSTAL COMPANY AND SUBSIDIARY EXHIBIT INDEX
Exhibit Number Description
2.1* Agreement and Plan of Merger dated July 3, 1997 by and among Port Royal Holdings, Inc., TKC Acquisition Corp. and The Krystal Company.
3.1** Charter of the Company.
3.2** By-laws of the Company.
4.1** Indenture, dated as of September 26, 1997 between TKC Acquisition Corp. and SunTrust Bank, Atlanta, N.A.
4.2** Supplemental Indenture No. 1 dated as of September 26, 1997, between The Krystal Company, Krystal Aviation Co., Krystal Aviation Management Co. and SunTrust Bank, Atlanta.
4.3** Form of Exchange Note (included in Exhibit 4.1).
4.4** Registration Rights Agreement, dated as of September 26, 1997, between TKC Acquisition Corp. and UBS Securities, LLC.
10.1** Credit Agreement dated as of September 26, 1997 among TKC Acquisition Corp., to be merged with and into the Krystal Company, SunTrust Bank, Atlanta, as agent, and Union Bank of Switzerland, New York Branch, as syndication agent.
10.2 Port Royal, Inc. Stock Incentive Plan for The Krystal Company, adopted July 30, 1998.
21.1** Subsidiaries of the Company.
27*** Financial Data Schedule.
* Incorporated by reference from the Definitive Proxy Statement of the Company filed on September 15, 1997.
** Incorporated by reference from the Company's Registration Statement on Form S-4 filed November 25, 1997.
*** Submitted only with the electronic filing of this document with the Commission pursuant to Regulation S-T under the Securities Act. | 14,447 | 91,886 |
758540_1999.txt | 758540_1999 | 1999 | 758540 | ITEM 1. BUSINESS - -------------------------------------------------------------------------------
GENERAL
Great Plains Software, Inc. provides fully integrated front office/back office business management software solutions for the midmarket. These include financial, distribution, enterprise reporting, project accounting, electronic business, human resources and payroll, manufacturing, service management, sales and marketing, and customer service and support applications. Our solutions are sold and implemented by a worldwide network of independent partner organizations that share our commitment to lasting customer relationships.
Great Plains' front office/back office business management products, eEnterprise (formally called Dynamics C/S+) and Dynamics, are designed to meet the broad spectrum of business application needs of the "midmarket," which generally consists of businesses with $1 million to $250 million in annual revenues. eEnterprise is our e-business and enterprise-wide solution which includes financial, distribution, enterprise reporting, project accounting, electronic business, human resources and payroll, manufacturing, service management, sales and marketing, and customer service and support solutions. Dynamics is our business management solution for smaller businesses in the midmarket and consists of financial, distribution, project accounting, electronic business, human resources and payroll, sales and marketing, and customer service and support applications. Great Plains also offers a DOS-based product, Great Plains Accounting.
To meet the needs of the midmarket, Great Plains designs, develops, markets, sells and supports business management solutions that are cost-effective, scalable, easy to implement, customize and use. Our solutions are optimized for Microsoft technologies, most notably Windows NT and SQL Server, the standard in the midmarket. Our solutions are also fully integrated across key application areas including front office. Moreover, by utilizing Internet and electronic commerce technologies, our e-business and enterprise-wide solutions allow midmarket businesses to effectively conduct business over the Internet.
Great Plains has made a significant investment in building an experienced, knowledgeable and highly motivated distribution network, which consists of value added resellers (VARs), systems integrators, independent software vendors (ISVs), global, national, regional and local accounting firms and specialized software consultants (together, the "partners"). Through our partner network, customers are served by trained and knowledgeable software professionals who are available locally to implement our systems as well as provide ongoing service. Partners customize Great Plains' systems to fit individual business needs, and more than 300 ISVs provide vertical and horizontal extensions to our eEnterprise and Dynamics solutions.
Great Plains believes that prompt and effective service and support are essential elements of a complete business management software solution and we dedicate significant resources to delivering timely, reliable and innovative service to our customers and partners. We have received numerous industry awards for our customer and partner service including our innovative online services, CustomerSource and PartnerSource. We earned a 1998 "Best Practices Award," sponsored by Arthur Andersen, in the category of "Exceeding Customer Expectations."
Great Plains has been recognized by numerous industry organizations and publications including being named as one of Business Week's "100 Hot Growth companies" on June 1, 1998; Forbes "200 Best Small Companies" on November 2, 1998; Forbes ASAP's "Dynamic 100" companies on April 5, 1999 and Start's "Hottest Companies of 1999" in July 1999. We earned two 1998 "Best Practices Awards," sponsored by Arthur Andersen, in the categories of "Exceeding Customer Expectations", as noted above, and "Motivating and Retaining Employees." In the January 11, 1999 issue of FORTUNE magazine, Great Plains was named as one of the "100 Best Companies to Work for in America" for the third time. Great Plains also received the Presidential "E" award from the President of the United States in July 1999 for outstanding contributions to export commerce.
Great Plains was founded in 1981 and was incorporated as a Minnesota corporation in 1983.
INDUSTRY BACKGROUND
The midmarket generally consists of businesses with $1 million to $250 million in annual revenues. In contrast, the "large enterprise" market consists of businesses with more than $250 million in annual revenues.
In the 1980s, the large enterprise market was the first to embrace client/server technologies and begin to implement large-scale, single-vendor enterprise solutions to replace aging mainframe-based applications. These large enterprise implementations were often multi-year projects with large budgets that extended across multiple departments and locations. At the same time, the midmarket continued to be highly fragmented with DOS, local area network and minicomputer technology implementations. These solutions were provided by hundreds of midmarket horizontal and vertical software vendors.
Beginning in the early to mid 1990s, the midmarket began embracing client/server technologies and specifically, Windows NT and Microsoft SQL Server technologies, and replace their aging systems with business management solutions optimized for the Microsoft platform. Their system needs were unique and different from those of the large enterprise businesses. The midmarket required systems that were far less costly to purchase, yet functionally rich, scalable and customizable. In addition, because midmarket businesses often have fewer information technology (IT) resources than large enterprise businesses, their systems had to be easier to customize, implement and use than large enterprise solutions.
MIDMARKET BUSINESS MANAGEMENT SYSTEM NEEDS
Today, the midmarket migration from aging systems to Microsoft-based business management systems continues. We believe that midmarket businesses require systems that are:
- - cost-effective, - - easy to customize, implement and use; and - - designed for Microsoft technologies.
Midmarket businesses generally have fewer IT resources and smaller IT budgets than large enterprise businesses. As a result, midmarket businesses require cost-effective software solutions from vendors that can provide a substantial amount of assistance during the software system selection and implementation process, as well as ongoing local support and service.
Many midmarket businesses experience rapid growth and have evolving business models. These businesses require solutions that can be customized quickly and cost-effectively to accommodate the constantly changing nature of their business systems and procedures. We believe that business management solutions must allow midmarket businesses to easily modify windows and reports, to integrate third-party solutions and to quickly write and seamlessly integrate custom applications. In addition, due to their limited IT resources and the often rapidly changing nature of their businesses, midmarket companies require systems than can be implemented in a short amount of time and are easy for their staff to use once implemented.
To ensure ongoing compatibility, supportability and ease of maintenance, midmarket businesses generally are standardizing on Microsoft technologies, most notably Windows NT and SQL Server, as well as other Microsoft BackOffice and Internet components. As a result, midmarket businesses are demanding business solutions that are native to Windows, optimized for Windows NT and SQL Server, and take advantage of Internet technologies.
Great Plains believes midmarket businesses also require systems that are:
- - e-commerce capable, - - fully integrated across key application areas, including front office, and - - seamlessly integrate with existing systems.
In business, the Internet is removing geographic boundaries and redefining the field of competition. We believe this technological, economic and business change has and will continue to impact midmarket businesses and require them to not only embrace Internet and electronic commerce technologies, but change the ways in which they interact with their customers, their suppliers and their employees. We believe that to remain competitive, midmarket businesses will need to implement Internet, intranet and e-commerce solutions that allow them to communicate electronically and conduct digital transactions.
Midmarket businesses are increasingly seeking a fully integrated platform of business management applications that fulfill their financial and operational software needs across the entire enterprise. Specifically, they are implementing the back office components of financials, distribution, human resources and payroll, manufacturing, and project accounting; and the front office components of sales, marketing, and customer service and support. In addition, they are complementing these solutions with knowledge management applications such as sophisticated reporting and intranet applications that deliver business-critical information to desktops across the enterprise. Moreover, midmarket businesses are beginning to implement e-commerce solutions. Further, midmarket business require these systems to integrate seamlessly with one another.
Midmarket businesses have a wide variety of existing software systems. When selecting a new business management software solution, midmarket businesses require a system that can be seamlessly integrated with their existing software applications. Because many companies in the midmarket have limited IT resources, midmarket businesses require their new business management software solutions to include integration tools that facilitate ease of integration with their existing software applications.
STRATEGY
Great Plains' strategy is to extend its position as a leading provider of front office/back office business management solutions for the midmarket. To meet the needs of businesses in the midmarket, we have deployed the following strategies:
ENABLE OUR CUSTOMERS TO IMPLEMENT E-COMMERCE. As the Internet changes almost every aspect of business, midmarket companies will need to implement comprehensive Internet and e-commerce solutions to remain competitive. Great Plains provides an enterprise-wide platform of front office/back office applications that fully integrate with our Internet and e-commerce solutions. These solutions allow our customers to take orders electronically from both established customers and at-large consumers with our business-to-business and consumer-to-business e-commerce solutions. Our e-business solutions also enable our customers to communicate and deliver services to their customers and employees with "customer-facing" and "employee-facing" applications, applications that allow their customers and employees to receive web-based services from their desktop.
DELIVER FULLY INTEGRATED FRONT OFFICE/BACK OFFICE SOLUTION. Businesses in the upper-tier of the midmarket are increasingly demanding a fully integrated enterprise-wide platform of front office and back office applications, including comprehensive Internet and electronic commerce solutions. Great Plains, through its own internal development efforts, acquisitions, and strategic partnerships, provides a fully integrated enterprise-wide platform of front office, back office and e-business applications. This enterprise-wide platform consists of financial, distribution, enterprise reporting, project accounting, electronic business, human resources and payroll, manufacturing, service management, sales and marketing, and customer service and support applications. In addition, independent software vendors offer more than 300 vertical and horizontal applications that further extend our software solutions.
EXTEND TECHNOLOGY LEADERSHIP. We have built a strong record of technical leadership and continue to invest in developing new technologies and products. Great Plains eEnterprise and Dynamics provide award-winning functionality including navigation, customization, information access, scalability and integration. During fiscal 1999 we delivered Release 5.0 to the market, with more than 100 new features and enhancements. Release 5.0 was followed by Release 5.1 in December 1999, which included enhanced multicurrency capabilities and support for the euro, the common currency being adopted by eleven European Monetary Union countries. Release 5.1, with it's euro functionality, has been certified by the Business and Accounting Software Developers Association (BASDA). Release 5.1 was the first midmarket solution to achieve that level of certification. Both eEnterprise and Dynamics are designed to take full advantage of Windows 2000, and we were among the first front office/back office solution providers in the midmarket to support Windows 98. In addition, we believe eEnterprise was one of the first front
office/back office solutions to fully integrate and leverage Microsoft Site Server, Commerce Edition, enabling midmarket businesses to integrate their web storefront with their back office applications. Our eEnterprise and Dynamics products have received more than 15 industry awards, including "Best Functionality" in the Microsoft BackOffice Challenge, an Editors' Choice Award from PC magazine and a Reviewers' Choice Award from Personal Computing Magazine in the United Kingdom. We believe that our product architecture is well suited for ongoing integration of new technologies. We maintain a research team dedicated to assessing new and emerging technologies. In addition, we intend to maintain our leadership in providing customization capabilities that are essential to businesses in the midmarket.
STRENGTHEN PARTNER NETWORK. We believe that our partner network has been effective in serving the midmarket by providing high-quality, cost-effective marketing, pre-sales, sales, local service and consulting. Through our channel development and recruiting efforts, as well as our training, certification and performance recognition programs, we continue to strengthen this network. We offer an innovative electronic implementation tool to assist our partners in delivering efficient, high-quality business management solutions to our customers. We also offer extensive programs that provide partners with training, service and support to help them develop and expand their businesses. In addition, we have programs that provide product and curricula offerings to colleges and universities designed to increase the number of graduates familiar with our products. We offer a number of technology conferences each year, including "Stampede," an annual partner conference in Fargo. In 1998, 1,365 participants attended Stampede.
CONTINUE AWARD-WINNING SERVICE AND SUPPORT. We believe that high-quality service and technical support are essential elements of a complete front office/back office business management solution and are vital to maintaining customer and partner satisfaction. We have received numerous industry awards for our customer and partner service and continue to invest in our support infrastructure. Our most recent honor was a prestigious Arthur Andersen "Best Practices Award" in the category of "Exceeding Customer Expectations." We believe that our initiatives will further increase the timeliness and effectiveness of our service and technical support.
EXPAND GLOBAL PRODUCT OFFERING AND INFRASTRUCTURE. We currently sell our products in the United States and through subsidiaries located in Canada, the United Kingdom, Scandinavia, South Africa, Singapore and Australia. In addition, we sell our products through international distribution partners in Germany, Poland, the Czech Republic, the Benelux countries, Portugal, Latin America and the Middle East. We intend to expand our global infrastructure by expanding our existing subsidiary and international partner operations, entering new markets, and extending the global functionality of our eEnterprise and Dynamics products. We also have development offices in Fargo, North Dakota; Minneapolis, Minnesota; Watertown, South Dakota; Seattle, Washington; Oslo, Norway; and Manila, Philippines.
REMAIN COMMITTED TO PARTNERS, CUSTOMERS AND TEAM MEMBERS. We are deeply committed to developing and sustaining long-term relationships with our partners, customers and team members. The Great Plains Mission Statement: "To improve the lives and business success of Partners and Customers," expresses this commitment. Great Plains has been recognized throughout the industry for its high levels of customer and partner service and its commitment to its team members. In addition, we have a low team member turnover rate. On January 11, 1999, Great Plains was named to the FORTUNE list of the "100 Best Companies to Work For in America." We also received two 1998 "Best Practices Awards" from Arthur Andersen in the categories of "Motivating and Retaining Employees" and "Exceeding Customer Expectations." These relationships allow us to achieve high customer, partner and team member satisfaction.
TECHNOLOGY
Great Plains' solutions leverage key Microsoft technologies and are based on the following design objectives:
INTERNET AND E-COMMERCE ENABLED. Great Plains was among the first midmarket business management solution providers to deliver Internet and e-commerce enabled business management solutions. We leverage Internet and e-commerce technologies, such as Microsoft Site Server, Commerce Edition, to deliver business-to-business and consumer-to-business e-commerce solutions as well as both "customer-facing" and "employee-facing" applications. Our business-to-business and consumer-to-business solutions allow our customers to complete digital transactions over the Internet, both with established customers and at-large consumers. Our customer-facing and employee-
facing applications allow customers to deliver web-based desktop services to their customers and employees.
NATIVE WINDOWS AND WINDOWS NT IMPLEMENTATION. Great Plains' front office/back office products are designed to take full advantage of Windows NT, Windows 98, and Windows 2000 capabilities, unlike "screen scraper" products that have a graphical interface grafted onto DOS-based or legacy software systems. We believe that our design philosophy has resulted in products that are easier to use and more intuitive because they adhere closely to the same interface standards as Windows desktop applications. Moreover, as native Windows applications, our products require less memory and enable more efficient multi-tasking than screen-scraper products.
STANDARDS-BASED C++ DEVELOPMENT ARCHITECTURE. The development architecture of Great Plains' business management solutions is standards-based C++. This powerful and flexible development environment has enabled us to build our products to leverage important technology advancements including 32-bit technologies, Windows NT, Microsoft SQL Server, Visual Basic for Applications, and Microsoft's standard for application interoperability, the Component Object Model (COM). The use of standards-based C++ as our development architecture will provide us flexibility in continuing to deliver solutions on the emerging technologies and platforms.
MICROSOFT SQL SERVER OPTIMIZATION. Great Plains eEnterprise is optimized for the latest releases of Microsoft SQL Server, including Microsoft SQL Server 7.0, and includes stored procedures to enhance distributed processing, overall performance and data integrity. Our implementation of Microsoft SQL Server and Windows NT also enhances data accessibility and system scalability.
COMPONENTIZED FUNCTIONALITY. The business rules, or financial logic, of Great Plains' products have been designed and developed into "logic components." This "componentization" of the product allows us to use software code multiple times within a product, and from product to product, increasing the speed with which new applications and product extensions can be developed. The componentized architecture of our products also allows our applications and third-party applications to share a common user interface, thereby creating a seamless and easy-to-use environment for customers. In addition, the components that make up the business logic are separate from the technical application layer, allowing eEnterprise to adopt new technologies like COM and VBA rapidly without affecting the quality or performance of the business logic. Moreover, we make certain components available to ISVs, which facilitates their ability to integrate companion products into our business management solutions.
PRODUCTS
Great Plains' upper-tier product, eEnterprise, is a fully integrated, enterprise-wide platform of front office, back office, knowledge management and e-business solutions, consisting of financial, distribution, enterprise reporting, project accounting, e-business, human resources and payroll, manufacturing, service management, sales and marketing management, and customer service and support applications. Our business management product for smaller midmarket businesses, Dynamics, is a front office/back office solution consisting of financial, distribution, project accounting, e-business, human resources and payroll, sales and marketing management, and customer service and support applications. Both business management products also include of a suite of reporting, customization and integration tools. We also offer a DOS-based product, Great Plains Accounting.
The eEnterprise typical system price is based on systems with six to 20 users and three to six modules. An eEnterprise system that includes our manufacturing solution or front office components typically costs more than $75,000. The Dynamics typical price range is based on systems with one to seven users and four to six modules. The system price is the price paid by the customer to a partner and does not represent sale proceeds to Great Plains or the cost of implementation. - --------------------------------------------------------------------------------
eENTERPRISE First released in July 1994, eEnterprise (formerly called Dynamics C/S+) is Great Plains' solution for midmarket businesses that have high volume processing requirements, complex enterprise-wide business management needs and formal IT departments. eEnterprise has received several industry awards, was one of the first enterprise-wide midmarket solutions to receive Microsoft BackOffice logo compliance, the first enterprise-wide solution to fully integrate with Microsoft Site Server, Commerce Edition, and the first to receive full accreditation for the euro by the Business and Accounting Software Developers Association (BASDA). eEnterprise also was awarded the 1998 Industry Solution Award in the "Best Mid Market/Financial Management Functionality" category in February 1999. The eEnterprise solution consists of the following:
FINANCIAL. The eEnterprise Financial Series consists of General Ledger, Accounts Receivable, Accounts Payable, Fixed Assets, Bank Reconciliation and Reporting and Analysis Tools. The Financial Series is designed to meet the needs of businesses in the upper-tier of the midmarket, including those businesses with multiple entity and multinational reporting requirements. The Financial Series fully integrates with all other components of the eEnterprise solution and is designed to meet the needs of businesses across all industries.
DISTRIBUTION. The eEnterprise Distribution Series consists of Inventory, Bill of Materials, Sales Order Processing, Purchase Order Processing, web-based purchase requisitions and electronic commerce solutions. The Distribution Series is designed to meet the distribution needs of wholesale distribution and manufacturing businesses in the midmarket and is integrated with eEnterprise Manufacturing, Sales and Marketing, Customer Service and Support and the Financial Series.
ENTERPRISE REPORTING. The Enterprise Reporting Series is designed for sophisticated group reporting and consolidation needs, and includes web-based reporting, advanced multi-dimensional consolidation and eliminations with complete multicurrency capabilities. Enterprise Reporting couples solid information
control with a high degree of flexibility to mold the reporting processes around evolving business practices.
PROJECT ACCOUNTING. The Project Series consists of project definition, tracking, purchasing, billing, plus time and expense entry for remote employees or employees who are otherwise not connected to the eEnterprise solution. The Project Series is designed to meet the needs of midmarket businesses that require an automated system to track internal projects, administer time and materials projects and manage accounting information. The Project Series integrates with the Financial, Distribution and Human Resources and Payroll Series for complete General Ledger, Accounts Payable, Accounts Receivable, Inventory and Payroll information control.
ELECTRONIC COMMERCE. Two eEnterprise e-business solutions, e.Commerce and e.Order, enable midmarket businesses to conduct commerce via the Internet, fully integrating with their distribution and financial applications. e.Commerce allows midmarket businesses to integrate their Microsoft Site Server-based web storefront with their eEnterprise Financial and Distribution Series. e.Order gives businesses an out-of-the-box solution to enable established customers and salespeople to enter and review their own orders over the Internet.
HUMAN RESOURCES AND PAYROLL. The eEnterprise Human Resources and Payroll solution consists of Payroll, Human Resources, Direct Deposit, integration to ADP Payroll, and web-based employee personal information management applications. The Human Resources and Payroll solutions are designed to meet the needs of midmarket businesses across all industries and are integrated with the eEnterprise Financial Series. In addition, for midmarket manufacturing businesses, the eEnterprise Human Resources and Payroll solutions integrate with eEnterprise Manufacturing, allowing more accurate cost accounting for discrete manufacturing firms.
MANUFACTURING. The eEnterprise Manufacturing Series consists of Sales Forecasting, Master Production Scheduling, Materials Requirements Planning, Capacity Requirements Planning, Routings, Work Center Definition, Work in Process, Inventory Management, Standard Costing, Bill of Materials, Engineering Change Management, Quality Assurance, Job Costing, and Sales Configuration. The Manufacturing Series is designed to meet the needs of discrete manufacturing businesses in the midmarket and is integrated with the eEnterprise Financial Series, Distribution Series, Customer Serivce and Support, and Human Resources and Payroll solutions.
SERVICE MANAGEMENT. The eEnterprise Service Management Series consists of Service Call Management, Depot Management, Contract Administration, Preventive Maintenance and Returns Management. In addition, the solution consists of an Internet self-service application, e.Service Center, which allows customers to schedule a service technician visit using the Internet. The Service Management Series is designed for service businesses in the midmarket that deliver fee, contract, or warranty based services on equipment, either at a customer's site or at a depot location. The Service Management Series is integrated with the eEnterprise Financial Series and Distribution Series. In addition, Manufacturing Series customers who also service the products they manufacture can utilize the Service Management Series.
SALES AND MARKETING MANAGEMENT. The Great Plains Siebel Front Office Series consists of Opportunity Management, Sales Pipeline Analysis, Account Management, Contact Management, Organizational Charting, Activity Management, Outlook Synchronization, Correspondence Fulfillment, Expense Reporting, Sales Reporting, and Mobile Synchronization. Additional modules include the Advanced Selling Pack for marketing libraries and product catalogs, quoting and forecasting; the Product Configurator for automating the ordering and buying processes; the Server Pack for territory management, lead routing, build data integration and remote software distribution; eSales to allow customers to browse product catalogs and create product configurations and quotes over the web; and eChannel for web-based lead routing and sales channel opportunity management. The Great Plains Siebel Front Office Series is designed to meet the needs of Midmarket businesses that want to automate sales, marketing, service and e-commerce processes, and is integrated with eEnterprise Financial and Distribution Series solutions for customer and order entry information control. The Great Plains Siebel Front Office Series was announced in July 1999 and the Sales and Marketing applications are scheduled to release in September 1999.
CUSTOMER SERVICE AND SUPPORT. In addition to Sales and Marketing Management, the Great Plains Siebel Front Office Series consists of applications for call center, e-business and tools. The Great Plains Siebel Front Office Customer Service and Support Series allows businesses to offer on-demand sales and service assistance to their customers. The Great Plains Siebel Front Office Series was announced in July 1999 and the Customer Service and Support applications are scheduled to release in December 1999.
In addition to the eEnterprise platform of front office, back office, knowledge management and e-business applications, numerous independent software developers provide vertical solutions on the same platform with the same architecture and interface as the eEnterprise solution, allowing eEnterprise customers and partners to deploy a fully integrated business solution.
DYNAMICS First released in February 1993, Dynamics is Great Plains' front office/back office business management solution for midmarket businesses that need a Windows solution that is flexible and cost-effective, but does not require IT personnel dedicated to database administration. Dynamics leverages leading Microsoft technologies, including Microsoft Windows 98, Windows NT and Visual Basic. Dynamics has received several industry awards, was one of the first business management applications to support Windows 98 and, along with Great Plains eEnterprise, the first to receive full accreditation for the euro by the Business and Accounting Software Developers Association (BASDA). The Dynamics solution consists of the following:
FINANCIAL. The Dynamics Financial Series consists of General Ledger, Accounts Receivable, Accounts Payable and Bank Reconciliation. The Dynamics Financial Series is designed to meet the needs of smaller businesses in the midmarket and is fully integrated with all other components of the Dynamics solution.
DISTRIBUTION. The Distribution Series consists of Inventory, Sales Order Processing, Purchase Order Processing and Bill of Materials. The Distribution Series is designed to meet the distribution needs of wholesale distribution and light manufacturing businesses in the midmarket, and is integrated with the Dynamics Financial Series.
PROJECT ACCOUNTING. The Dynamics Project Series consists of Project Definition, Tracking, Purchasing, Billing, plus Time and Expense Entry for remote employees or employees who are otherwise not connected to the Dynamics solution. The Project Series is designed to meet the needs of midmarket businesses that require an automated system to track internal projects, administer time and materials projects, and manage accounting information. The Project Series integrates with Dynamics Financial, Distribution and Human Resources and Payroll solutions for complete General Ledger, Accounts Payable, Accounts Receivable, Inventory and Payroll information control.
E-BUSINESS. The Dynamics E-business Series consists of e.View. This solution allows customers to use the potential of the Internet to build corporate knowledge.
HUMAN RESOURCES AND PAYROLL. The Dynamics Human Resources and Payroll solution consists of Payroll, Human Resources and Direct Deposit applications. The Dynamics Human Resources and Payroll solution is designed to meet the needs of smaller midmarket businesses across all industries, and is integrated with the Dynamics Financial Series.
SALES AND MARKETING MANAGEMENT. The Great Plains Siebel Front Office Series consists of Opportunity Management, Sales Pipeline Analysis, Account Management, Contact Management, Organizational Charting, Activity Management, Outlook Synchronization, Correspondence Fulfillment, Expense Reporting, Sales Reporting, and Mobile Synchronization. The Great Plains Siebel Front Office Series is designed to meet the needs of midmarket businesses that want to automate sales, marketing and service, and is integrated with Dynamics Financial and Distribution Series solutions for customer and order entry information control. The Great Plains Siebel Front Office Series was announced in July 1999 and the Sales and Marketing applications are scheduled to release in September 1999.
CUSTOMER SERVICE AND SUPPORT. In addition to Sales and Marketing Management, the Great Plains Siebel Front Office Series consists of applications for call center, e-business and tools. The Great Plains Siebel Front Office Customer Service and Support Series allows businesses to offer on-demand sales and service assistance to their customers. The Great Plains Siebel Front Office Series was announced in July 1999 and the Customer Service and Support applications are scheduled to release in December 1999.
In addition to the Dynamics platform of applications, numerous independent software developers provide vertical solutions on the same platform with the same architecture and interface as the Dynamics solution, allowing Dynamics customers and partners to deploy a fully integrated business solution.
REPORTING, CUSTOMIZATION AND INTEGRATION Great Plains' suite of business management reporting tools consists of the Dynamics Report Writer, FRx Advanced Report Writer, Seagate Crystal Reports, and e.View. The Dynamics Report Writer, FRx Advanced Report Writer and Seagate Crystal Reports enable our customers and partners to create custom financial and business management reports. e.View, an Intranet-based application, allows employees across a customer's enterprise secure access to business information via a web browser. In addition, for eEnterprise customers, we offer Enterprise Reporting for handling multi-entity consolidations and reporting, and an eEnterprise edition of Cognos PowerPlay, which includes specialized reporting templates for sophisticated reporting and analysis.
Great Plains' suite of business management customization and integration tools, our Customization and Integration Series, allows our customers and partners to customize and extend the functionality of eEnterprise and Dynamics. Key tools in the Customization and Integration Series are Integration Manager, Modifier with Visual Basic for Applications, the Continuum line of application integration solutions, and Dexterity. Integration Manager enables customers to integrate data from external databases, e-commerce solutions and desktop applications with Dynamics and eEnterprise. Modifier with Visual Basic for Applications can be used to customize any eEnterprise and Dynamics window, report, control or component of business logic. The Continuum line of application integration solutions, including Continuum for Visual Basic, Continuum for Excel, and Continuum for Delphi, facilitate integration between our business management products and applications written in Visual Basic, Excel, Delphi or other Microsoft Component Object Model (COM) compliant development tools through the use of wizards (online instruction guides) and point-and-click operations. Dexterity enables customers and third party developers to create applications that seamlessly integrate with, and have the same look and feel as our business management applications.
GREAT PLAINS ACCOUNTING Great Plains' product for DOS operating systems, Great Plains Accounting, is available for systems in single user and local area network environments. Great Plains Accounting includes a suite of financial and distribution applications that provide customers with a broad range of features and functions. We are actively promoting the migration of our Great Plains Accounting customers to eEnterprise and Dynamics. Great Plains' revenues from our Great Plains Accounting product have been declining, and we expect that these revenues will continue to decline in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Revenues."
SALES AND MARKETING SALES. Great Plains sells, implements and supports its products exclusively through its partner network consisting of:
- - value added resellers (VARs) - professionals who sell and install business hardware and software - - systems integrators - professionals who combine technological products from various vendors to produce enhanced solutions - - independent software vendors (ISVs) - professionals who develop and market complementary software products - - global, national, regional and local accounting firms - - specialized software consultants.
Our partners are independent organizations that perform some or all of the following functions: sales and marketing; systems implementation and integration; software development and customization; and ongoing consulting, training, service and technical support. In many instances, a partner's primary source of income is derived from selling, implementing and supporting our products.
We believe that our partners have a significant influence over product choices by customers, and that our relationships with our partners are an essential element in our marketing, sales and implementation efforts. Through our partner network, customers are served by trained and knowledgeable software professionals who are available locally to implement our systems as well as provide ongoing service and support. Many of our partners customize our systems to fit individual business needs and develop industry-specific software applications that integrate with and extend the functionality of our products.
Great Plains actively recruits partners through channel development groups. More importantly, we continue to assist our partners in growing their businesses through:
- - Management strategy consulting - - Employee recruitment and placement - - Comprehensive training and support - - Cooperative marketing programs - - Annual professional conferences
We also have specialized strategies aimed at recruiting and supporting ISVs and accounting firms. Partners are required to undergo training and certification procedures before being authorized to sell and implement our products, and must maintain certain standards and sales volumes to retain such authorization.
Great Plains has subsidiary offices and distribution relationships worldwide. Internationally, we operate via subsidiaries in Canada, the United Kingdom, Scandinavia, South Africa, Singapore, and Australia. In addition, we have established distribution relationships with international partners in Western and Eastern Europe, the Middle East, and Latin America to further the international distribution of our products. These distribution partners typically localize and translate our products, locate and train qualified VARs, market our products, and provide ongoing customer service and technical support. International partners typically pay localization and translation costs for our software in exchange for exclusive distribution rights, while Great Plains retains ownership of the localized version of the software. Great Plains and its international distributors have developed localized language versions of our business management solutions including Arabic, Polish, German, Portuguese and Spanish. In addition, we have developed localized versions for the United Kingdom, Australia, New Zealand, South Africa and French-speaking Canada. Our product architecture is designed to facilitate the translation, localization and maintenance of multilingual, multinational versions.
Great Plains' international business may be affected by such factors as local economic and market conditions, political and economic instability, greater difficulty in administering operations, difficulties in enforcing intellectual property and contractual rights, difficulties in tailoring our software products to fit local accounting principles, rules, regulations, language, tax codes and customs, fluctuations in currency exchange rates and the need for compliance with a wide variety of foreign and United States export regulations.
MARKETING. Great Plains is focused on building market awareness and acceptance of the company and our products as well as on generating qualified customer leads. Partners pursue customer leads with assistance from our sales personnel.
Great Plains has a comprehensive marketing strategy with several key components: global corporate and product image and awareness building, direct marketing to both prospective and existing customers, a strong web presence, and local marketing with partners. Our corporate image strategy includes global advertising in key financial, business and technology publications as well as web-based advertising. Our direct marketing includes direct mail, online and regional seminars, tradeshows, and outbound telemarketing to existing and prospective customers. For prospective customers, we also offer seminars and self-qualifying tools to assist them in selecting business management solutions. Seminars are offered in conjunction with partners in their local or industry-specific markets. Our web-based marketing is designed to generate new leads for Great Plains. Our marketing strategy is designed to take advantage of our partner network by including cooperative marketing programs designed for partners' local markets. Finally, we have developed a new brand mark to more accurately align our image with our core strategies and position us for global expansion.
SEASONALITY Great Plains' business has experienced and may continue to experience seasonality. In recent years, we have recognized a greater percentage of our revenue and operating income in the fourth fiscal quarter than in any of the first three fiscal quarters due to a number of factors, including the timing of product releases and our sales incentive programs. Moreover, due to generally diminished business activity in the summer quarter, and to Great Plains' fiscal year-end sales incentive programs, we have historically recognized less revenue and operating income in our first fiscal quarter than in other quarters.
CUSTOMERS Great Plains' products offer functionality and scalability to suit a wide range of midmarket businesses, from fast-growing entrepreneurial businesses to divisions of large enterprises. In addition, our front office/back office solution, implemented as a integrated e-business and enterprise-wide solution or with an industry-specific third party application, have been purchased by companies in a wide variety of industries, such as:
Advertising Healthcare Non-Profit Broadcasting Hospitality Professional Sports Computer Software Information Services Publishing Construction Insurance and Financial Services Retail Distribution Internet Software and Services Telecommunications Education Manufacturing Transportation
Great Plains provides an annual learning and information sharing opportunity for our customers through our annual customer conference, Convergence. Convergence is designed specifically to bring together customers, business partners and industry experts. More than 1,000 customers, business partners and industry experts attended Convergence 1999. Convergence is held each spring in Orlando, Florida, and is aimed at our front office/back office customers.
CUSTOMER AND PARTNER SERVICE Great Plains believes that prompt and effective service and technical support is an important component of a complete e-business and enterprise-wide solution and is critical to the long-term satisfaction of our customers and partners. We have received numerous awards for our partner and customer service, including the 1998 "Best Practices Award" in the category of "Exceeding Customer Expectations," sponsored by Arthur Andersen.
Great Plains was one of the first personal computer software providers to introduce fee-based support plans and guaranteed telephone response times. We also maintain profiles and detailed call histories on each of our customers and partners. These profiles enable our support personnel to respond more effectively to service inquiries, allow us to better forecast which customers are likely to purchase new products or upgraded versions of existing products and assist us in developing new applications and features that accurately address the needs of the market.
Great Plains provides service and technical support through a service organization consisting of 312 (FTE) employees as of May 31, 1999. We provide a variety of training, technical support and service programs for
customers that supplement the primary support provided by partners. We offer video, teleconference and classroom training as well as technical support through a toll-free number and our website. Telephone support calls are handled by professional support personnel and have various guaranteed response times, depending on the type of support plan purchased. Response times as short as 30 minutes are offered. In addition to our technical support programs, customers are offered software maintenance programs for an annual fee. These programs provide customers with product upgrades and online information and assistance through our CustomerSource web site. We also offer comprehensive training and product support to our partners, including an award-winning web site, PartnerSource, to ensure that they provide the necessary levels of technical support and assistance to customers. We offer our partners a variety of consulting resources for resale to customers, including strategic implementation planning, project management and product customization.
RESEARCH AND DEVELOPMENT Since our inception, Great Plains has made substantial investments in research and development. During the fiscal years 1999, 1998 and 1997, software development expenses were $20.4 million, $12.6 million, and $9.7 million, respectively. As of May 31, 1999, we had 290 employees engaged in research and development.
Great Plains' research and development efforts employ a standard development process to guide software development through stages of product concept, market requirements analysis, product definition, design specification, coding, testing and release. These efforts are also focused on identifying, developing and integrating leading technologies into our products to better meet customer needs.
Great Plains' software products are designed for Microsoft technologies, including Windows NT, Windows 98, Windows 2000 and SQL Server. In addition, our products utilize other Microsoft technologies, including Site Server, Internet Information Server, Visual Basic, Visual Basic for Applications and BizTalk. Accordingly, our strategy will require that our products and technology are compatible with new developments in Microsoft's technology.
PRODUCTION The principal physical components of Great Plains' software products are computer media and manuals. We prepare master software CDs, manuals and packaging materials that are then duplicated by Great Plains and third party vendors. To date, we have not experienced any material difficulties or delays in the manufacture and assembly of our products or material returns due to product defects.
INTELLECTUAL PROPERTY RIGHTS AND LICENSES Great Plains regards certain features of our internal operations, software and documentation as intellectual property. We rely on a combination of contract, copyright, trademark and trade secret laws, a mandatory software registration mechanism and other measures to protect our intellectual property. We have no patents. We believe that, because of the rapid pace of technological change in the computer software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our team members, frequent product enhancements and the timeliness and quality of support services. It is our policy to file for protection of our basic trademarks and service marks in countries in which we sell our products either directly or through our international partners and in countries in which protection is advisable. Despite these measures there can be no assurance that we will be able to fully protect our intellectual property.
Great Plains provides our products to customers on a "right-to-use" basis, under non-exclusive licenses, which generally are nontransferable and have a perpetual term. We typically license our products solely for the customer's internal operations.
COMPETITION The market for Great Plains' products is highly competitive and rapidly changing. Our primary market consists of businesses in the midmarket. Our current and prospective competitors offer a variety of solutions for this market. We experience significant competition and expect substantial additional competition from established and emerging software companies that offer products similar to our products and target the same customers as we do. We believe we compete on each of the following factors:
- - product features, functionality, performance and price - - the capacity and capabilities of distribution partners
- - the quality of customer and partner service and technical support - - sales and marketing efforts - - new product and technology introductions, including e-commerce - - company image and stability.
In North America, Great Plains faces a number of competitors in the midmarket. Outside North America, we also face competition from a number of competitors, several of which have significant shares in their home markets. In addition, we compete for midmarket business with companies primarily targeting the large enterprise market. We believe that the products from these competitors are neither designed nor priced to meet the needs of the midmarket, and that we compete effectively against them in the midmarket. Our products also face competition from providers of industry-specific applications as well as indirect competition from in-house, custom-developed business management applications.
Certain of Great Plains' competitors have substantially greater financial, marketing or technical resources than Great Plains. There can be no assurance that other companies have not developed or marketed or will not develop or market products that are superior to our products, that are offered at substantially lower prices than ours, or that have or will achieve greater market acceptance than those of our products. In addition, there can be no assurance that alternative methods of delivering business management applications will not provide increased competition.
TEAM MEMBERS As of May 31, 1999, Great Plains (including subsidiaries) had a total of 1,065 full time equivalent employees ("FTEs"), including 655 FTEs in sales, marketing, technical support and consulting services, 290 FTEs in research and development, and 120 FTEs in administration. None of our employees are represented by a labor union. Management believes that its relations with its employees are good. We earned a 1998 "Best Practices Award" sponsored by Arthur Andersen, in the category of "Motivating and Retaining Employees." We also received recognition for the third time as one of the "100 Best Companies to Work for in America," as reported in FORTUNE magazine, January 11, 1999.
Great Plains believes that our continued success will depend in large part upon our ability to attract and retain highly-skilled technical, managerial, sales and marketing personnel. The loss of services of one or more of our key employees could have a materially adverse effect on our business, operating results and financial condition. We intend to hire a significant number of additional service and technical personnel in fiscal 2000. Competition for the hiring of such personnel in the software industry is intense, and from time to time we experience difficulty in locating candidates with appropriate qualifications, particularly within the desired geographic location. It is widely believed that the technology sector is at or over a state of full employment. There can be no assurance that we will be successful in attracting and retaining the personnel required to develop, market and support new or existing software. The growth in our customer base and expansion of our product lines and supported platforms have placed, and are expected to continue to place, a significant strain on our management and operations, including our service and development organizations.
FORWARD-LOOKING STATEMENTS The above Business section and other parts of the Form 10-K Report contain forward-looking statements that involve risk and uncertainties. Great Plains' actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those contained above in this Item 1, the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 and Exhibit 99.1 to the Form 10K Report.
EXECUTIVE OFFICERS
Great Plains' executive officers as of August 1, 1999, their ages and positions and a brief biography of each individual are as follows:
DOUGLAS J. BURGUM has served as President of Great Plains since March 1984, Chief Executive Officer since September 1991 and Chairman of the Board since January 1996. Mr. Burgum was an early investor in Great Plains, and he initially served as Vice President and a director from March 1983 to March 1984. Before joining Great Plains, Mr. Burgum was a management consultant in the Chicago office of McKinsey & Company, Inc. Mr. Burgum holds a B.U.S. from North Dakota State University and an M.B.A. from the Stanford University Graduate School of Business.
TAMI L. RELLER has served as Chief Financial Officer since July 1999. Ms. Reller is a 15 year veteran with Great Plains and has served as Vice President of Finance and Investor Relations since January 1998, and Director of Finance and Investor Relations since December 1996. She has also held accounting, marketing management and sales positions during her career with Great Plains. She holds a B.S. degree from Moorhead State University and a M.B.A. from St. Mary's College in Moraga, CA.
STEVEN K. SYDNESS has served as Executive Vice President, Worldwide Sales and Marketing, since January 1999. Mr. Sydness was Vice President, International Operations from June 1997 to January 1999, Vice President, Dynamics July 1996 to June 1997, Vice President, Business Development from June 1995 to June 1996, Vice President of Sales from June 1994 to June 1995 and Vice President of Strategic Planning June 1993 to June 1994. Prior to joining Great Plains in January 1987, he was employed by Dr. Henry Kissinger Associates and the management consulting firm McKinsey & Company, Inc. in their New York and Tokyo offices. Mr. Sydness holds a B.A. from Principia College and an M.B.A. from Harvard Business School.
JODI A. UECKER-RUST has served as Executive Vice President, Organizational Development, since November 1998. Ms. Uecker-Rust served as Vice President, Center for Organizational Excellence (CORE) and Heritage Business of Great Plains from June 1996 through November 1998. Ms. Uecker-Rust served as Vice President, Employee Services for Great Plains from August 1994 through May 1996 and as Vice President of Operations and Customer Service from June 1993 through August 1994. Ms. Uecker-Rust has been with Great Plains for more than 14 years. Prior to 1984 she was with Honeywell, Inc. She is a 1983 graduate of North Dakota State University in Fargo, North Dakota where she earned a B.S. in Industrial Engineering.
DARREN C. LAYBOURN has served as Vice President, Research and Development since July 1998. From June 1997 to July 1998, Mr. Laybourn served as General Manager, Global Development, and from June 1994 to June 1997 he was General Manager, DynamicTools. Mr. Laybourn joined Great Plains in 1994 and prior to that time was employed by the Boeing Company in Seattle, where he lead development efforts supporting manufacturing and corporate computing infrastructure. He holds a B.S. in Computer Science and Mathematics from the University of Washington.
ITEM 2.
ITEM 2. PROPERTIES - --------------------------------------------------------------------------------
Great Plains' principal administrative, marketing, production and product development facilities consist of an aggregate of approximately 86,000 square feet at three locations in Fargo, North Dakota. We also lease space for our subsidiary operations in Canada, the United Kingdom, Scandinavia, South Africa, Singapore and Australia. In addition, we have research and development offices in Seattle, Washington, Minneapolis, Minnesota, Watertown, South Dakota; Oslo, Norway; and Manila, Philippines. We occupy the Fargo sites under lease agreements that expire at various times through 2004. Total rent expense during fiscal 1999, 1998, and 1997 was $1,593,000, $1,054,000, and $866,000, respectively. We are currently planning to move into an expanded leased facility in Fargo, North Dakota, that is expected to be occupied during the month of September and is under a lease agreement that expires in 2013. We expect that the new facility will result in a substantial increase in rent expense.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS - --------------------------------------------------------------------------------
From time to time, Great Plains and our subsidiaries are involved in litigation arising out of operations in the normal course of business. In the opinion of management, we currently are not a party to any legal proceedings the adverse outcome of which, individually or in the aggregate, could reasonably be expected to have a material adverse effect on our results of operations or financial position.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - --------------------------------------------------------------------------------
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended May 31, 1999.
PART II
ITEM 5.
ITEM 5. MARKET PRICE - -------------------------------------------------------------------------------- Great Plains' Common Stock began trading on the Nasdaq National Market under the symbol "GPSI" on June 20, 1997. Prior to such date, there was no established public trading market for our Common Stock.
The following table sets forth, for the period indicated, the high and low closing sales prices of Great Plains' Common Stock, as quoted on the Nasdaq National Market.
On July 26, 1999, the closing sales price per share of Great Plains' Common Stock as quoted on the Nasdaq National Market was $44.313. On July 26, 1999, there were approximately 284 holders of record of our Common Stock, representing approximately 3,000 shareholder accounts.
The trading price of Great Plains' Common Stock may be subject to wide fluctuations in response to quarterly variations in operating results, announcements of technological innovations or new software products by us or our competitors, as well as other events or factors. In addition, the stock market has from time to time experienced extreme price and volume fluctuations, which have particularly affected the market prices of many high technology companies and which often have been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of Great Plains' Common Stock.
Great Plains has never declared or paid cash dividends on its capital stock. We currently intend to retain future earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA - -------------------------------------------------------------------------------- The selected consolidated financial data below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF GREAT PLAINS SHOULD BE READ IN CONJUNCTION WITH GREAT PLAINS' CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO, AND THE OTHER FINANCIAL INFORMATION INCLUDED ELSEWHERE IN THIS FORM 10-K REPORT. THIS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS DESCRIPTIONS OF GREAT PLAINS' EXPECTATIONS REGARDING FUTURE TRENDS AFFECTING OUR BUSINESS. THESE FORWARD-LOOKING STATEMENTS AND OTHER FORWARD-LOOKING STATEMENTS MADE ELSEWHERE IN THIS DOCUMENT ARE MADE IN RELIANCE UPON SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. THE FOLLOWING DISCUSSION AS WELL AS EXHIBIT 99.1 TO THIS FORM 10-K SET FORTH CERTAIN FACTORS GREAT PLAINS BELIEVES COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE CONTEMPLATED BY THE FORWARD-LOOKING STATEMENTS. GREAT PLAINS UNDERTAKES NO OBLIGATION TO UPDATE THE FORWARD-LOOKING INFORMATION CONTAINED IN THIS ITEM 7.
OVERVIEW - -------------------------------------------------------------------------------- Great Plains Software, Inc. (Nasdaq: GPSI) provides fully integrated front office/back office business management solutions for the midmarket. These include financial, distribution, enterprise reporting, project accounting, electronic business, human resources and payroll, manufacturing, service management, sales and marketing, and customer service and support applications. Our solutions are sold and implemented by a worldwide network of independent partner organizations that share the company's commitment to lasting customer relationships.
Great Plains has been a leading provider of business software solutions since 1982 when it began selling Great Plains Accounting (the "heritage product"). In the late 1980s, we anticipated the market shift toward Windows and client/server technologies and in February 1993, released Dynamics. Dynamics is our business management solution for small businesses in the midmarket. In July 1994, we released eEnterprise (formally Dynamics C/S+). eEnterprise is our e-business and enterprise-wide business management solution for the upper tier of the midmarket, and is optimized for Windows NT and Microsoft SQL Server.
During fiscal 1999, Great Plains launched several new applications on our fully integrated platform. We added a human resources application, a manufacturing solution and a sophisticated enterprise reporting solution, which enhance our front office/back office business management solutions. The acquisition of Match Data Systems in April 1999 further expanded our offering with the addition of a project accounting solution developed specifically for the Great Plains platform. Through this acquisition, we also acquired a development center in Manila, Philippines with a 45-member development team. In addition, in July 1999 we announced a partnership with Siebel Systems to offer Great Plains Siebel Front Office, providing midmarket customers the only fully integrated back office, front office, and electronic business solution from a single source.
In addition to the new Manila development office established through the Match Data Systems acquisition, our global organization now includes subsidiaries in Canada, the United Kingdom, Scandinavia, South Africa, Singapore and Australia. Our activities in additional countries through international distribution partners include an intensified focus on Germany, as well as ongoing efforts in Poland, the Czech Republic, the Benelux countries, Portugal, Latin America, and the Middle East. Our solutions are available in nine languages and have been sold in approximately 95 countries.
Great Plains made significant investments in research and development in the early 1990s to launch Dynamics and eEnterprise. In addition, we have made a significant investment in building an experienced and knowledgeable network of independent channel partners to market, implement and support our Dynamics and eEnterprise products (together, the "Great Plains platform products"). Since the release of the Great Plains platform products, our principal source of revenues has shifted from the heritage product to Great Plains platform products. Great Plains platform products accounted for 93.7%, 87.3% and 77.4% of our total revenue for fiscal 1999, 1998 and 1997, respectively.
Great Plains' revenues are derived from two principal sources: software license fees and fees for maintenance, technical support, training and consulting services. As required, Great Plains recognizes revenue in accordance with Statement of Position 97-2, Software Revenue Recognition, which we adopted beginning June 1, 1998. Statement of Position 97-2 generally requires revenue earned on software products, upgrades or enhancements, rights to exchange or return software, post contract customer support, or services, including elements deliverable only on a when-and-
if-available basis, to be allocated to the various elements of such sale based on vendor specific objective evidence of fair market values. If this evidence does not exist, revenue from the sale would be deferred until sufficient evidence exists, or until all elements have satisfied the requirements for revenue recognition. Prior to adoption of Statement of Position 97-2, Great Plains recognized revenue in accordance with Statement of Position 91-1, Software Revenue Recognition. This adoption did not have a material effect on the timing of Great Plains' revenue recognition or cause changes to our revenue recognition policies. See Note 1 of Notes to Consolidated Financial Statements.
License fee revenues are generally recognized upon shipment of the related software product and associated registration keys. Fees for Great Plains' maintenance and support plans are recorded as deferred revenue when billed to the customer and recognized ratably over the term of the maintenance and support agreement, which is typically one year. Fees for Great Plains' training and consulting services are recognized at the time the services are performed.
Great Plains' eEnterprise and Dynamics customers are required to purchase a one-year maintenance plan at the time the product is acquired. A majority of these customers renew the maintenance plan after the initial term. Under the maintenance plan, Great Plains provides these customers with product upgrades in addition to on-line assistance and information. The maintenance program for Great Plains' heritage product provides customers with product "updates," which are less significant releases of the heritage product; however, heritage product upgrades are not included in the heritage maintenance program. Heritage customers can purchase product upgrades as they are released.
For further discussion of recently issued accounting standards that may impact Great Plains' future financial results, see Note 1 of the Consolidated Financial Statements.
RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- The following table sets forth for the periods indicated the percentage of total revenues represented by certain items reflected in Great Plains' consolidated statement of income.
REVENUES
REVENUES. Revenues increased to $134.9 million for fiscal 1999 from $85.7 million in fiscal 1998 and $57.1 million in fiscal 1997, representing increases of 57.5% and 50.0%, respectively. These increases in revenues were primarily due to increased demand for Great Plains platform products and related services. The following table sets forth for the periods indicated Great Plains platform and heritage product revenues, each as a percentage of total revenues:
Great Plains platform product revenues, including license and service fees, increased to $126.4 million for fiscal 1999 from $74.8 million in fiscal 1998 and $44.2 million in fiscal 1997, representing increases of 69.1% and 69.1%, respectively.
The increase in Great Plains platform product revenues was offset, in part, by a decrease in revenues from Great Plains' heritage product. Heritage product revenues decreased to $8.5 million in fiscal 1999 from $10.9 million in fiscal 1998 and $12.9 million in fiscal 1997 representing decreases of 22.1% and 15.6%, respectively. The decrease in heritage product revenues was primarily due to a decrease in demand for DOS and Macintosh solutions, which reflects the broader market trend toward Windows and Windows NT solutions. Also, the decrease in heritage product revenue can be attributed to the expected decline in the number of customers purchasing Great Plains Accounting Version 9 heritage upgrade, which was initially released in February 1997. Great Plains anticipates that heritage product revenues will continue to decrease in future periods.
Great Plains' international revenues increased to $22.8 million in fiscal 1999 from $13.4 million in fiscal 1998 and $8.6 million in fiscal 1997, representing 16.9%, 15.6%, and 15.0% of total revenues for fiscal 1999, 1998 and 1997, respectively. These increases were the result of growth in existing markets as well as the addition of distribution in new markets through new subsidiaries and new international distribution partners. In fiscal 1999, the revenue growth was largely a result of growth in markets served by our existing subsidiary operations and the fact that all of our subsidiaries were in operation for the entire year. In fiscal 1998, the growth was primarily a result of growth in our international subsidiary operations in the United Kingdom and Australia, as well as from the addition of new subsidiary operations in Singapore, South Africa and Scandinavia.
LICENSE. Total license fee revenues increased to $79.7 million in fiscal 1999 from $53.0 million in fiscal 1998 and $35.9 million in fiscal 1997, representing increases of 50.5% and 47.4%, respectively. These increases in total license fee revenues are largely attributable to increased market demand for our Great Plains platform products. In addition, we broadened our Great Plains platform solutions in fiscal 1999 with the addition of human resources, manufacturing and enterprise reporting solutions. The release of these new solutions contributed to the increase in license fee revenue for fiscal 1999.
The increase in Great Plains platform product license fee revenues was offset, in part, by a decrease in heritage product license fee revenues. The decrease in heritage product license fees is primarily a result of decreased sales of upgrades to existing heritage customers. The most recent significant upgrade of the heritage product, Great Plains Accounting Version 9, was released in February 1997 which was marketed principally to our installed base of heritage product customers. Therefore, the decline in revenue from the heritage products of 22.1% and 15.6% in 1999 and 1998 respectively, was expected as we generally experience the majority of upgrade sales in the quarters following a new release. Great Plains continues to expect that overall heritage product license fee revenues will continue to decline.
SERVICE. Service revenues increased to $55.2 million in fiscal 1999, from $32.7 million in fiscal 1998 and $21.2 million in fiscal 1997, representing increases of 68.8% and 54.3%, respectively. Service revenues as a percentage of total revenues were 40.9%, 38.2%, and 37.1% for fiscal 1999, 1998 and 1997, respectively. The increase in service revenues is due largely to the increased number of licenses for Great Plains platform products and renewals of existing maintenance and support contracts from the increased installed base of Great Plains platform customers.
COSTS AND EXPENSES
COST OF LICENSE FEES. Cost of license fees consists primarily of the costs of product manuals, media, shipping and royalties paid to third-parties. Cost of license fees increased to $19.4 million in fiscal 1999 from $11.2 million in fiscal 1998 and $6.4 million in fiscal 1997, representing 24.3%, 21.2% and 17.7% of total license fee revenues in fiscal 1999, 1998 and 1997, respectively. The increases in cost of license fees for fiscal 1999 and fiscal 1998 are primarily attributable to an overall growth in license fee revenues and an increase in the sale of products for which Great Plains is obligated to pay royalties to third-party vendors. The increase in cost of license fees as a percentage of license revenue increased in fiscal 1999 and fiscal 1998 due to a higher mix of revenue from sales of third-party products for which we have a royalty obligation. The cost of license fees as a percentage of license fee revenues may continue to increase if Great Plains enters into additional royalty arrangements or if the sale of products which include a royalty obligation increase as a percentage of total license fee revenues.
COST OF SERVICES. Cost of services consists of the costs of providing telephone support, training and consulting services to customers and partners. Cost of services increased to $18.3 million for fiscal 1999 from $11.1 million in fiscal 1998 and $8.3 million in fiscal 1997. The increase in cost of services is primarily due to the expansion of Great Plains' service resources. Cost of services as a percentage of service revenues decreased to 33.2% for fiscal 1999 from 34.0% in fiscal 1998 and 39.0% for fiscal 1997. These decreases are due, in part, to improved efficiency in operations and continued strong customer enrollment in maintenance plans and support contracts. We anticipate that cost of services will increase in dollar amount as service revenues increase and may increase as a percentage of service revenue if additional resources are added to support new initiatives.
SALES AND MARKETING. Sales and marketing expenses consist primarily of salaries, commissions, travel and promotional expenses. Sales and marketing expenses increased to $48.0 million for fiscal 1999 from $31.6 million in fiscal 1998 and $21.9 million in fiscal 1997, representing 35.6%, 36.9%, and 38.4% of total revenues for fiscal 1999, 1998 and 1997, respectively. The decrease in sales and marketing expenses as a percentage of total revenues in fiscal 1999 reflects an increase in sales and marketing productivity and a corresponding increase in revenues derived from our Great Plains platform products. The dollar increase in sales and marketing expenses for fiscal 1999 and fiscal 1998 is attributable to the hiring of additional sales and marketing personnel, continued investments in expanding the capacity and capability of the channel for our platform products, increased marketing expenses for our Great Plains platform products including, a global advertising and brand awareness campaign, and increased commission expenses associated with higher revenues. In addition, Great Plains increased sales and marketing expenses related to the operation of our international subsidiaries in Canada, the United Kingdom, Scandinavia, South Africa, Singapore and Australia. Great Plains anticipates that sales and marketing expenses will increase in dollar amount as total revenues increase; however, Great Plains does not anticipate significant changes in sales and marketing expenses as a percentage of total revenues.
RESEARCH AND DEVELOPMENT. Research and development expenses consist primarily of compensation of development personnel and depreciation of equipment. Research and development expenses increased to $20.4 million in fiscal 1999 from $12.6 million in fiscal 1998 and $9.7 million in fiscal 1997, representing 15.2%, 14.7% and 16.9% of total revenues for fiscal 1999, 1998 and 1997, respectively. In fiscal 1999, the increase in research and development both in dollars and as a percentage of total revenues was, in part, due to additional resources added to further develop the new solution areas of e-business, human resources, manufacturing and enterprise reporting, as well as from resources added as a result of the fourth quarter 1999 acquisition of Match Data Systems, which included an established development center in Manila, Philippines. In fiscal 1998, the dollar increase for research and development was from development efforts primarily focused on the delivery of substantial new versions of Great Plains platform products and the release of an electronic commerce solution. Research and development expenses decreased as a percentage of total revenues in fiscal 1998 due to efficiencies gained through greater experience
levels among development personnel, greater automation in our development testing process and an increased focus on Microsoft technologies. We anticipate that we will continue to devote substantial resources to our research and development effort and that research and development expenses will increase in dollar amount in future periods and may increase as a percentage of revenues.
GENERAL AND ADMINISTRATIVE. General and administrative expenses consist primarily of salaries of executive, financial, human resources and information services personnel, as well as outside professional fees. General and administrative expenses increased to $11.1 million for fiscal 1999 from $7.6 million in fiscal 1998 and $5.6 million in fiscal 1997, representing 8.2%, 8.9% and 9.8% of total revenues for fiscal 1999, 1998 and 1997, respectively. These increases in dollar amount were primarily due to increased staffing and related expenses necessary to manage and support the expansion of our operations. In addition, dollar increases in fiscal 1998 were due, in part, to expenses related to being a publicly held company. We believe that our general and administrative expenses will increase in dollar amount in the future to support the expansion of our operations.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT. Great Plains completed two acquisitions in the fourth quarter of fiscal 1998, both of which were accounted for using the purchase method of accounting. The first acquisition provided a human resources application and manufacturing solution, while the second acquisition provided a multinational enterprise reporting solution. The purchase price for these acquisitions was $7.5 million for the manufacturing and human resource applications and $4.4 million for the enterprise reporting solution.
Valuation of the intangible assets acquired were determined by an independent third party appraisal company and consisted of in-process research and development, current technology, assembled workforce, and goodwill. The amounts related to in-process research and development, as determined by the independent third party appraisal company that was charged against income in fiscal 1998, as the underlying research and development projects had not yet reached technological feasibility and had no alternative future uses included $3.2 million for manufacturing, $2.2 million for human resources, and $1.7 million for enterprise reporting.
Great Plains has used the acquired in-process research and development to complete new products in the areas of human resources, manufacturing, and enterprise reporting, which will become part of our product lines over the next several years. We released the initial products developed from the acquired in-process research and development in fiscal 1999. We expect additional significant releases will continue through fiscal 2003.
The nature of the efforts required to complete development of the acquired in-process research and development into commercially viable products principally related to the completion of all designing, prototyping, verification and testing activities necessary to establish that the products can be produced to meet design specifications, including functions, features, and technical performance requirements. The estimated costs at the time of acquisition to be incurred to develop the purchased in-process technology into commercially viable products were $8.6 million for the manufacturing solution, $3.4 million for human resources, and $2.7 million for enterprise reporting.
The value assigned to purchased in-process research and development was determined by an independent third party appraiser, which projected cash flows related to future products expected to be derived once technological feasibility was achieved, including costs to complete the development of technology and the future revenues and costs which are expected to result from commercialization of the products. Cash flows recognized the contribution of core technology and other supporting assets and were discounted back to their present value at a rate of 35%. The resulting net cash flows from such projects were based on estimates made by Great Plains management of revenues, cost of sales, research and development costs, selling, general and administrative costs, and income taxes resulting from such projects. These management estimates were based on expected trends in technology and the nature and expected timing of completion of acquired in-process research and development. Nothing has come to management's attention that would lead management to believe substantial changes need to be made to the underlying assumptions.
Great Plains did not have any write-off of acquired in-process research and development in fiscal 1999 or fiscal 1997. See Note 2 of Notes to Consolidated Financial Statements.
OTHER INCOME, NET. Other income, net, consists primarily of earnings from investments and gains or losses from disposal of fixed assets, net of any interest expense. Other income, net increased to $3.6 million for fiscal 1999 from $3.3 million in fiscal 1998 and $0.6 million in fiscal 1997. The increase in other income, net in fiscal 1999 was
primarily a result of increased investment earnings due to increased investments as a result of the more than $47 million received from Great Plains' public offering of common stock in March 1999, as well as additional cash resulting from our increased operating income.
The increase in other income, net in fiscal 1998 was primarily a result of increased investment earnings due to increased investments as a result of the more than $50 million received from Great Plains' initial public offering of common stock in June 1997, as well as additional cash resulting from our increased operating income.
PROVISION FOR INCOME TAXES. Provision for income taxes was $8.5 million, $3.2 million and $2.2 million for fiscal 1999, 1998 and 1997, respectively. In fiscal 1999 and 1998, the provision for income taxes was 40% and 42%, respectively, of income before income taxes, which represents an increase from the fiscal 1997 annual effective income tax rate of 38%. See Note 10 of Notes to Consolidated Financial Statements.
SELECTED QUARTERLY OPERATING RESULTS
The following table sets forth certain unaudited consolidated financial information for each of the four quarters in Great Plains' fiscal years ended May 31, 1999, and May 31, 1998. In management's opinion, this unaudited quarterly information has been prepared on the same basis as the audited consolidated financial statements and includes all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information for the quarters presented when read in conjunction with the audited consolidated financial statements and notes thereto included elsewhere in this document. Great Plains believes that quarter-to-quarter comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of future performance.
Great Plains' quarterly revenues and operating results have varied significantly in the past and are likely to vary substantially from quarter to quarter in the future. Such fluctuations may result in volatility in the price of Great Plains' common stock. Great Plains establishes its expenditure levels based on its expectations as to future revenue, and, if revenue levels are below expectations, expenses can be disproportionately high. As a result, a drop in near-term demand for Great Plains' products could significantly affect both revenues and profits in any quarter. In the
future, Great Plains' operating results may fluctuate for this reason or as a result of a number of other factors, including increased expenses, timing of product releases, increased competition, variations in the mix of sales, announcements of new products by Great Plains or our competitors, and capital spending patterns of Great Plains' customers.
Great Plains' business has experienced and may continue to experience seasonality. In recent years, due to a number of factors, including the timing of product releases and sales incentive programs, Great Plains has recognized a greater percentage of our revenue and operating income in our fourth fiscal quarter than in any of the first three quarters. Moreover, due to fiscal year-end sales incentive programs, Great Plains has historically recognized less revenue and operating income in our first fiscal quarter than in the other quarters.
As a result of these factors, there can be no assurance that Great Plains will be able to maintain profitability on a quarterly basis.
LIQUIDITY AND CAPITAL RESOURCES
Great Plains has historically funded operations primarily through cash provided by operations and the sale of equity securities. Currently, Great Plains meets its working capital needs and capital equipment needs with cash provided by operations.
Cash provided by operating activities was $24.6 million, $17.6 million, and $10.3 million for fiscal 1999, 1998 and 1997, respectively. The increase in cash provided by operations in fiscal 1999 was primarily due to revenue growth and increased profits from Great Plains' operations as well as increases in deferred revenues of $8.8 million, increase in accounts payable and accrued expenses of $8.9 million offset by a $3.3 million reduction in income taxes payable and a $3.8 million increase in accounts receivable. The increase in cash provided by operations for fiscal 1998 was due primarily to cash provided by the following: improved profitability of Great Plains' operations, the $7.1 million non-cash charge for acquired in-process research and development, an increase in accounts payable and accrued expenses of $4.4 million, an increase in deferred revenues of $3.9 million and an increase in income taxes payable of $3.8 million. Cash generated from operations was offset primarily by a $5.2 million increase in deferred tax assets and a $2.6 million increase in accounts receivable.
Great Plains' investing activities used cash of $65.8 million, $63.8 million, and $7.1 million for fiscal 1999, 1998, and 1997, respectively. The principal use of cash in investing activities for fiscal 1999 and 1998 was approximately $47 million and approximately $50 million for the purchase of investments following Great Plains' second public offering and initial public offering of common stock, respectively. Investing activities in fiscal 1999 also included cash used of approximately $14.7 million for the purchase of property and equipment to support our growth as well as the need to furnish the new building that we will be moving into late in the first quarter of fiscal 2000. Investing activities in fiscal 1998 also included cash used of approximately $11.9 million for two acquisitions completed in the fourth quarter of fiscal 1998. In addition, investing activities for fiscal 1998 included increased capital expenditures related to the acquisition of computer equipment and furniture required to support expansion of our operations. Investing activities in fiscal 1997 primarily consisted of increased capital expenditures related to the acquisition of computer equipment and furniture required to support expansion of our operations as well as the purchase of investments.
Great Plains' financing activities provided cash of $50.0 million, $52.2 million, and $0.7 million during fiscal 1999, 1998 and 1997, respectively. For fiscal 1999, cash of $50.0 million was provided from financing activities primarily from $47.2 million from the sale of Great Plains common stock in a public offering in March 1999 and proceeds received from stock options that were exercised during the year. For fiscal 1998, cash of $52.2 million was provided from financing activities primarily from $50.2 million from the sale of Great Plains common stock in an initial public offering and proceeds received from the exercise of stock options. For fiscal 1997, cash of $0.7 million was provided from financing activities which consisted primarily of proceeds received from the exercise of stock options offset in part by payments on capital lease obligations and notes payable.
Great Plains' sources of liquidity at May 31, 1999, consisted principally of cash, cash equivalents and investments of $123.7 million. Great Plains also has a $10.0 million revolving line of credit facility with a bank. The line of credit
expires November 1999, and borrowings made thereunder are subject to certain covenants. No amounts were outstanding under the line of credit at May 31, 1999. See Note 8 of Notes to Consolidated Financial Statements. Great Plains believes that its existing cash, cash equivalents and investments, cash generated from operations and the amounts available under the line of credit will be sufficient to fund its operations for the foreseeable future.
YEAR 2000
Many currently installed computer systems and software are coded to accept only two-digit entries in the date code fields. These date code fields will need to accept four-digit entries to distinguish 21st century dates from 20th century dates. This problem could result in system failures or miscalculations causing disruptions of business operations (including, among other things, a temporary inability to process transactions, send invoices or engage in other similar business activities). As a result, many companies' computer systems and software will need to be upgraded or replaced to comply with Year 2000 requirements. The potential global impact of the Year 2000 problem is not known. If Year 2000 problems are not corrected in a timely manner, they could affect Great Plains, and the U.S. and world economy generally.
All of Great Plains' current products are Year 2000 compliant. Great Plains platform products have been Year 2000 compliant since their initial introduction, as are Versions 8 and 9 of the heritage product. Great Plains is currently offering our heritage product customers a free Year 2000 compliant upgrade for prior versions of the heritage product. Even though Great Plains' current products are Year 2000 compliant, there can be no assurance that midmarket businesses will have sufficient resources available for the acquisition of new systems from us because they may be diverting resources to fix internal systems that are not Year 2000 compliant.
Great Plains has formed a project team (consisting of representatives from our information technology, finance, manufacturing, product development, sales, marketing and legal departments) to address other internal and external Year 2000 issues. Our internal financial, manufacturing and other computer systems are being reviewed to assess and remediate Year 2000 problems. Our assessment of internal systems includes our information technology as well as other systems that contain embedded technology in manufacturing or process control equipment containing microprocessors or other similar circuitry. Our Year 2000 compliance program includes the following phases:
- - identifying systems that need to be modified or replaced; - - carrying out remediation work to modify existing systems or convert to new systems; and - - conducting validation testing of systems and applications to ensure compliance. Great Plains is currently completing the second phase of this program.
The amount of remediation work required to address Year 2000 problems is not expected to be extensive. We have replaced certain financial and operational systems in the last several years, and management believes that the new equipment and software substantially addresses Year 2000 issues. However, we will be required to modify some of our existing hardware and software for our computer systems to function properly in the Year 2000 and thereafter. We have substantially completed our Year 2000 compliance program for all of our significant internal systems as of May 31, 1999.
In addition, Great Plains has received assurances from our major suppliers that they are addressing the Year 2000 issue, and that products purchased by us from such suppliers will function properly in the Year 2000. However, it is impossible to fully assess the potential consequences in the event service interruptions from suppliers occur or in the event that there are disruptions in such infrastructure areas as utilities, communications, transportation, banking and government.
The total estimated cost for resolving Great Plains' Year 2000 issues is approximately $100,000, of which approximately $75,000 has been spent through May 31, 1999. The total cost estimate includes the cost of replacing non-compliant systems as a remediation cost in cases where we have accelerated plans to replace such systems. Estimates of Year 2000 costs are based on numerous assumptions, and there can be no assurance that the estimates are correct or that actual costs will not be materially greater than anticipated.
Based on assessments to date, Great Plains believes it will not experience any material disruption as a result of Year 2000 problems in internal manufacturing processes, information processing or interface with major customers, or with processing orders and billing. However, if certain critical third-party providers, such as those providers supplying electricity, water or telephone service, experience difficulties resulting in disruption of service to Great Plains, a shutdown of Great Plains' operations at individual facilities could occur for the duration of the disruption. Great Plains has developed a contingency plan to provide for continuity of processing in the event of various problem scenarios. Assuming no major disruption in service from utility companies or other critical third-party providers, we believe that we will be able to manage our total Year 2000 transition without any material effect on our results of operations or financial condition.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." See Note 1 of Notes to Consolidated Financial Statements included in "Item 8 -- Consolidated Financial Statements and Supplementary Data."
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - --------------------------------------------------------------------------------
Great Plains does not have operations subject to risks of material foreign currency fluctuations, nor does it use derivative financial instruments in our operations or investment portfolio. Great Plains places our investments in instruments that meet high credit quality standards, as specified in our investment policy guidelines. We do not expect any material loss with respect to our investment portfolio or exposure to market risks associated with interest rates.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - --------------------------------------------------------------------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Great Plains Software, Inc.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Great Plains Software, Inc. and its subsidiaries at May 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended May 31, 1999, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP Minneapolis, Minnesota June 25, 1999
GREAT PLAINS SOFTWARE, INC.
CONSOLIDATED BALANCE SHEET (DOLLARS IN THOUSANDS)
See accompanying notes to the consolidated financial statements.
GREAT PLAINS SOFTWARE, INC.
CONSOLIDATED STATEMENT OF INCOME (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
See accompanying notes to the consolidated financial statements.
GREAT PLAINS SOFTWARE, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
See accompanying notes to the consolidated financial statements.
GREAT PLAINS SOFTWARE, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN THOUSANDS)
See accompanying notes to the consolidated financial statements.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS INFORMATION AND SIGNIFICANT ACCOUNTING POLICIES
BUSINESS INFORMATION Great Plains Software, Inc. (NASDAQ: GPSI) provides fully integrated front office/back office business management solutions for the midmarket. These include financial, distribution, enterprise reporting, project accounting, electronic business, human resources and payroll, manufacturing, service management, sales and marketing, and customer service and support applications. Our solutions are sold and implemented by a unique worldwide network of independent partner organizations that share the Company's commitment to lasting customer relationships.
SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION POLICY AND FOREIGN CURRENCY TRANSLATIONS
The consolidated financial statements include the accounts of the Company and its subsidiaries in Canada, the United Kingdom, Scandinavia, South Africa, Singapore, Australia and the Philippines. All significant intercompany accounts and transactions have been eliminated in consolidation. Essentially all assets and liabilities are translated to U.S. dollars at year-end exchange rates, while elements of the income statement are translated at average exchange rates in effect during the year. The functional currency of the subsidiaries is the local currency. Therefore, all translation gains and losses resulting from fluctuations in currency exchange rates of these subsidiaries are recorded as a component of accumulated other comprehensive loss in equity.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist of cash, investments, short-term receivables and payables for which their current carrying amounts approximate fair market value.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to credit risk consist primarily of cash, cash equivalents, investments and accounts receivable. The Company grants credit to customers in the ordinary course of business. No single customer or region represents a significant concentration of credit risk. The Company invests its cash with high quality financial institutions.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash and highly liquid investments with original maturities of three months or less and which are readily convertible to cash.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS INFORMATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INVESTMENTS
Investments in debt securities that are not cash equivalents have been designated as available for sale. Those securities, which consist of various high rated governmental securities and corporate commercial paper, are reported at fair value, with net unrealized gains and losses included in stockholders' equity. The unrealized loss, net of income tax, was $81,000 at May 31, 1999. The maturities of the of the debt securities range from 1999 to 2000.
INVENTORIES
Inventories consisting of media, training materials and packaging supplies are stated at lower of cost or market, with cost determined on a first-in, first-out ("FIFO") basis.
INCOME TAXES
Income taxes are accounted for under the liability method in accordance with Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), "Accounting for Income Taxes." Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Major improvements are capitalized while maintenance and repairs are expensed currently. Depreciation is computed using the straight-line method based on estimated useful lives of three to five years for computer equipment and five to ten years for furniture, fixtures and equipment. Leasehold improvements are amortized over the lesser of the terms of the related leases or estimated useful life. Purchased computer software, which is used internally, is amortized over a period of three to five years using the straight-line method. Amortization expense is included with depreciation expense in the consolidated statement of cash flows.
INTANGIBLE ASSETS AND GOODWILL
Amortization of intangible assets and goodwill is recorded on a straight line basis over their estimated useful lives ranging from four to seven years. The recoverability of unamortized intangible assets and goodwill is assessed on an ongoing basis by comparing anticipated undiscounted cash flows to net book value.
REVENUE RECOGNITION AND DEFERRED REVENUE
Software license revenues are recognized upon shipment less a reserve for estimated future returns. Revenues from support and maintenance service contracts are recorded as deferred revenues when billed and recognized ratably over the contract period. Other service revenues such as training and consulting services are recognized as the services are performed. The Company, in its discretion, may allow customers to return products for a short period of time following the sale. The Company provides an allowance for these anticipated returns based upon its historical experience of returns for similar products. These amounts are recorded as an offset to license revenues. Statement of Position 97-2 ("SOP 97-2"), "Software Revenue Recognition," is effective in fiscal 1999 and was adopted by the Company on June 1, 1998. The adoption of SOP 97-2 did not have a material effect on the timing of the Company's revenue recognition or cause changes to its revenue recognition policies.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS INFORMATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING
The Company accrues, at the time of sale, an estimated liability for qualified advertising expenses incurred by partner organizations for which the Company has agreed to reimburse such parties as part of a cooperative advertising program. Other advertising costs are expensed as incurred. Advertising expense was approximately $7,638,000, $3,731,000, and $1,990,000 for the years ended May 31, 1999, 1998 and 1997, respectively.
RESEARCH AND DEVELOPMENT
Expenditures for software development costs and research are expensed as incurred. Such costs are required to be expensed until the point that technological feasibility is established. The period between achieving technological feasibility and the general availability of such software has been short. Consequently, costs otherwise capitalizable after technological feasibility is achieved are generally expensed because they are insignificant.
EARNINGS PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"), "Earnings Per Share." SFAS No. 128 requires dual presentation of basic and diluted earnings per share for entities with complex capital structures. Basic earnings per share includes no dilution and is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of an entity. All earnings per share amounts for all periods have been presented, and where necessary, restated to conform with the provisions of SFAS No. 128.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS INFORMATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following table sets forth the computation of basic and diluted net income per share (dollars in thousands, except share and per share amounts):
COMPREHENSIVE INCOME
On June 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130 ("SFAS No. 130"), "Reporting of Comprehensive Income." Comprehensive income for the Company includes net income, the effects of currency translation which are charged or credited to the cumulative translation adjustment account within stockholder's equity, and the unrealized gain/loss on investments available for sale which is recorded within stockholders' equity. Comprehensive income for all periods presented is included in the Consolidated Statement of Stockholders' Equity.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued Statement No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging Activities." This standard establishes accounting and reporting standards for derivative instruments and hedging activities. The Company must adopt this standard no later than June 1, 2001. Management believes the adoption of SFAS No. 133 will not have a material effect on the Company's financial statements.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. BUSINESS COMBINATIONS
On April 30, 1999, the Company received all of the outstanding capital stock of Match Data Systems, Inc., a software provider of project accounting solutions, in a transaction that was accounted for as a pooling of interests. To affect the business combination, the Company issued a combination of 159,618 shares and options of the Company's common stock. Financial data for the periods prior to the closing of this transaction has not been restated because neither the net assets nor operating results were material to the Company's consolidated financial statements. The Company's consolidated financial statements include the results of Match Data Systems, Inc. since May 1, 1999.
On April 20, 1998, the Company acquired certain assets and assumed certain liabilities of ICONtrol, Inc., a software provider of manufacturing and human resource solutions. The purchase price was paid in cash and totaled $7,536,000.
The acquisition was accounted for as a purchase and accordingly, the net assets acquired were recorded at their estimated fair values at the effective date of the acquisition. The allocation included $5,456,000 to in-process research and development, $1,935,000 to intangible assets and $145,000 to the fair value of net tangible assets.
The $5,456,000 related to acquired in-process research and development, as determined by an independent third party appraisal, was charged against income in fiscal 1998 as the underlying research and development projects had not yet reached technological feasibility. The Company's consolidated financial statements include the results of ICONtrol since date of acquisition.
The following table presents the consolidated results of operations on an unaudited pro forma basis as if the acquisition of ICONtrol had taken place at the beginning of each year (dollars in thousands):
The one time charge for acquired in-process research and development is not reflected in the pro forma results presented above. The unaudited pro forma results of operations are for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisition occurred at the beginning of the periods presented or the results which may occur in the future.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. BUSINESS COMBINATIONS (CONTINUED)
On May 1, 1998, the Company acquired certain assets and assumed certain liabilities of Telenor Financial Systems, a software provider of sophisticated multinational consolidations and budgeting solutions. The purchase price was paid in cash and totaled $4,406,000. The acquisition was accounted for as a purchase and accordingly, the net assets acquired were recorded at their estimated fair values at the effective date of the acquisition. The allocation included $1,680,000 to in-process research and development, $990,000 to intangible assets, $1,681,000 to goodwill and $55,000 to the fair value of net tangible assets.
The $1,680,000 related to acquired in-process research and development, as determined by an independent third party appraisal, was charged against income in fiscal 1998 as the underlying research and development projects had not yet reached technological feasibility. The Company's consolidated financial statements include the results of Telenor Financial Systems from May 1, 1998. The results of operations prior to May 1, 1998, were not material to the consolidated financial statements; accordingly, pro forma financial disclosures are not presented.
The application of purchase accounting to the acquisitions described above was based on independent third-party appraisals using valuation techniques commonly applied to attribute fair value to acquired assets. The appraisals incorporated management's best estimates for future revenue and profitability from products in the process of development at the time of acquisition. As is the case with all projections of future events, actual results could differ. Additionally, the SEC has challenged valuations incorporating in-process research and development. If the assumptions or valuation methods used were changed, the Company's financial statements would be affected because allocations to in-process research and development, which have been expensed, would be reallocated to intangible assets which require amortization against income in future periods.
In September 1997, the Company received all of the outstanding capital stock of its Singapore distributor in a transaction that was accounted for as a pooling of interests. To effect the business combination, the Company issued 56,250 shares of the Company's common stock. Financial data for the periods prior to the closing of this transaction have not been restated because neither the net assets nor operating results were material to the Company's consolidated financial statements. The Company's consolidated financial statements include the results of the Singapore distributor since September 1, 1997.
3. ACCOUNTS RECEIVABLE
Accounts receivable, net of allowances, consist of the following (dollars in thousands):
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (dollars in thousands):
Depreciation expense for the years ended May 31, 1999, 1998, 1997, was $4,069,000, $2,676,000, and $2,038,000, respectively.
5. GOODWILL AND OTHER INTANGIBLES
Goodwill and other intangibles consist of the following (dollars in thousands):
Amortization expense for the years ended May 31, 1999, 1998 and 1997 was $1,078,000, $187,000, and $117,000, respectively.
6. ACCRUED EXPENSES
Accrued expenses consist of the following (dollars in thousands):
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. OTHER INCOME, NET
Other income, net consists of the following (dollars in thousands):
8. LINE OF CREDIT
The Company has a $10,000,000 revolving line of credit facility with a bank that provides for interest at prime. Substantially all of the Company's assets are pledged as collateral on the line of credit, which expires in November 1999, and is subject to certain covenants, all of which had been complied with at May 31, 1999. There were no amounts outstanding at May 31, 1999 or 1998.
9. COMMITMENTS AND CONTINGENCIES
LEASE OBLIGATIONS
Rental expense incurred for operating leases of office facilities and office equipment was approximately $1,706,000 in 1999, $1,054,000 in 1998 and $866,000 in 1997. Future minimum rental payments as of May 31, 1999, for noncancelable operating leases with initial or remaining terms in excess of one year are payable as follows: fiscal 2000 - $3,413,000, fiscal 2001 - $3,154,000, fiscal 2002 - $2,889,000 and fiscal 2003 - $2,454,000 and fiscal 2004 - $2,303,000.
LITIGATION
The Company is, from time to time, a party to litigation arising in the normal course of business. Management believes that none of this litigation will have a material adverse effect on the financial position or results of operations or cash flows of the Company.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. INCOME TAXES
Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
Significant components of the Company's deferred tax liabilities and assets are as follows (dollars in thousands):
The provision for income taxes is summarized as follows (dollars in thousands):
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. INCOME TAXES (CONTINUED)
The differences between the expected tax provision based on the federal income tax statutory rate and the actual provision for the years presented are summarized as follows (dollars in thousands):
11. INCENTIVE STOCK OPTION PLAN
On May 31, 1999, 1,709,727 shares of common stock had been reserved for issuance or grant under the Company's stock option plans. The options are granted to employees at 100% of the fair market value on the date of grant. The fair market value, rate of exercisability and expiration dates of the options granted are determined by the Board of Directors at the time of grant. Options generally vest ratably over five years from date of grant and expire ten years after grant. Options issued prior to fiscal 1998 vest ratably over five years from date of grant and expire six years after grant.
The following summary of outstanding options and shares reserved under the Plan is as follows:
As of May 31, 1999 there were currently exercisable options outstanding covering 352,478 shares, exercisable at prices ranging from $3.41 to $41.94 per share.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. INCENTIVE STOCK OPTION PLAN (CONTINUED)
In fiscal 1997, the Company adopted Statement of Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation." As permitted by SFAS No. 123, the Company has elected to continue following the guidance of APB 25 for measurement and recognition of stock-based transactions with employees and adopt the disclosure only provisions of SFAS No. 123. As a result, no compensation expense has been recognized for the awards made in the form of stock options. If the Company had elected to recognize compensation costs for stock-based compensation plans based on the fair value at the grant dates for awards under those plans consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts shown as follows (dollars in thousands, except per share amounts):
The fair value of the stock options used to compute pro forma net income and earnings per share disclosures is the present value at grant date using the Black-Scholes option pricing model with the following weighted average assumptions:
The following table summarizes the status of the Company's stock options outstanding as of May 31, 1999:
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. EMPLOYEE BENEFIT PLAN
The Company maintains a defined contribution 401(k) Profit Sharing Plan covering substantially all employees. The Company currently matches 25% of each participant's contribution up to 8% of their annual salary, and can make discretionary profit sharing contributions to the plan. The Company's contribution to this plan for the years ended May 31, 1999, 1998, and 1997, was approximately $578,000, $389,000, and $310,000, respectively.
13. STOCKHOLDERS' EQUITY
The Board of Directors met on February 20, 1997, and took the following actions in connection with the initial public offering of shares of the Company's common stock: (a) authorized a four-for-three stock split of the issued and outstanding common stock of the Company, the form of a stock dividend, to be effective immediately prior to the public offering (all references to common stock amounts, shares, per share data and preferred stock conversion rights included in the financial statements and these notes have been adjusted to give retroactive effect to the stock split); (b) authorized an increase in capital stock to 100,000,000 shares of $0.01 par value common stock and 30,000,000 shares of $0.01 par value preferred stock to be both contingent and effective upon stockholder approval and the first closing of the initial public offering of common stock; (c) waived, subject to the closing of an initial public offering, the Company's contractual rights to repurchase shares of common stock from employees of the Company; and (d) authorized certain incentive stock plans contingent and effective upon stockholder approval and consummation of the initial public offering. These incentive plans include (i) the 1997 Employee Stock Purchase Plan providing for the purchase of common stock at a discounted price, (ii) the 1997 Stock Incentive Plan providing for the grant of stock-based compensation to eligible persons and (iii) the Outside Directors' Stock Option Plan providing for the grant of nonqualified stock options to nonemployee directors of the Company.
SERIES A CONVERTIBLE PREFERRED STOCK
In June 1994, the Company sold 225,000 shares of $.01 par value Series A Convertible Preferred Stock (the "Series A Preferred Stock") at $1.00 per share to an officer/director who may convert these shares into 54,000 shares of common stock at any time after June 15, 1997, at a rate of .24 shares of common stock for each share of Series A Preferred Stock. The Series A Preferred Stock were converted to shares of common stock upon completion of the Initial Public Offering on June 19, 1997.
SERIES B MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
Also in June 1994, the Company entered into an agreement for the sale of Series B Mandatorily Redeemable Convertible Preferred Stock (the "Series B Preferred Stock") and issued a total of 1,345,220 shares at an average price of $6.17.
Holders of the Series B Preferred Stock converted their shares into 1,793,627 shares of common stock upon completion of the Initial Public Offering on June 19, 1997. Prior to the conversion to common stock, the Company carried this Series B Preferred Stock at fair value which management considered to equal $21.33 per share at May 31, 1997. The increase in carrying value of Series B Preferred Stock is reflected as a reduction to Additional Paid-in Capital.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. SEGMENT INFORMATION AND GEOGRAPHIC AREAS
Effective June 1, 1998, the Company adopted the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 131 ("SFAS No. 131"), "Disclosures About Segments of an Enterprise and Related Information." SFAS No. 131 superseded FASB Statement No. 14, "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 establishes standards for disclosures about operating segments, products and services, geographic areas and major customers. Management has determined that the Company operates in one industry segment, providing business management software solutions to midmarket businesses. Substantially all of the Company's revenues are derived from the licensing of software products and providing related consulting, support and training services. The following table presents a revenue and long-lived asset summary by geographic region (dollars in thousands):
Sales between geographic regions are made at prices which would approximate transfers to unaffiliated distributors. Revenues are allocated to geographic regions based on the location in which the sale originated. No single customer represents over 10% of the Company's consolidated sales.
GREAT PLAINS SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
15. QUARTERLY FINANCIAL DATA (UNAUDITED, DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Quarterly and annual earnings per share are calculated independently based on the weighted-average number of shares outstanding during the period.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - --------------------------------------------------------------------------------
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - --------------------------------------------------------------------------------
The section under the heading "Election of Directors" on pages 3 through 5 and the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" on page 12 of the Company's Proxy Statement dated August 9, 1999 ("1999 Proxy Statement") are incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION - --------------------------------------------------------------------------------
The section under the heading "Election of Directors" entitled "Compensation of Directors" on pages 5 and 6 and the section entitled "Executive Compensation" on pages 8 through 13 of the 1999 Proxy Statement are incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - --------------------------------------------------------------------------------
The section entitled "Security Ownership of Certain Beneficial Owners and Management" on pages 2 and 3 of the 1999 Proxy Statement is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - --------------------------------------------------------------------------------
None.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - --------------------------------------------------------------------------------
DOCUMENTS FILED AS PART OF THIS REPORT (a) (1) Financial Statements. The following financial statements of the Company are included in Part II, Item 8, of this Annual Report on Form 10-K.
Report of Independent Accountants Consolidated Balance Sheet as of May 31, 1999 and 1998 Consolidated Statement of Income for the three years in the period ended May 31, 1999 Consolidated Statement of Stockholder's Equity for the three years in the period ended May 31, 1999 Consolidated Statement of Cash Flows for the three years in the period ended May 31, 1999 Notes to Consolidated Financial Statements
(2) Financial Statement Schedules. The following schedule follows the signature page of this Annual Report on Form 10-K
Schedule II. Valuation and Qualifying Accounts
All other schedules have been omitted because they are not applicable or not required or because the required information is included in financial statements or notes thereto.
(3) Exhibits
3.1 Amended and Restated Articles of Incorporation, as amended (incorporated herein by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833))
3.2 Amended Bylaws (incorporated herein by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q filed January 4, 1999)
10.1 Lease Agreement, dated October 1, 1983, as amended, between the Company and West Acres Office Park (incorporated herein by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833))
10.2 Amendments 5 & 6 to Lease Agreement dated October 1, 1983, between the Company and West Acres Office Park
10.3 Lease Agreement, dated October 23, 1997, between the Company and Investor's Real Estate Trust
10.4 1983 Incentive Stock Option Plan, as amended (incorporated here herein by reference to Exhibit 10.4 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833))
10.5 1997 Stock Incentive Plan, including form of option agreement (incorporated here herein by reference to Exhibit 10.5 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833)) *
10.6 Outside Directors Stock Option Plan, as amended
* Management contract or compensatory plan or arrangement required to be filed as an exhibit to Form 10-K to Item 14(c) of the Form 10-K Report.
10.7 1997 Employee Stock Purchase Plan, as amended
10.8 Registration Rights Agreement, dated as of June 24, 1994, between the Company and the holders of registerable securities named therein (incorporated here herein by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833))
10.9 Limited Liability Company Agreement for Great Plains Software U.K., LLC, dated as of February 20, 1996, between the Company and Douglas J. Burgum therein (incorporated here herein by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833))
10.10 Agreement between the Company and Terri F. Zimmerman (incorporated here herein by reference to Exhibit 10.10 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833)) *
10.11 Form of Nonemployee Director Stock Option Agreement (incorporated here herein by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-1 filed March 5, 1997 (SEC File No. 333-22833)) *
21.1 Subsidiaries of the Company
23.1 Consent of PricewaterhouseCoopers LLP
24.1 Powers of Attorney
27.1 Financial Data Schedule
99.1 Cautionary Statement for Purposes of the "Safe Habor" Provisions of the Private Securities Litigation Reform Act of 1995
(b) Reports on Form 8-K
Great Plains filed no reports on Form 8-K during the quarter ended May 31, 1999
* Management contract or compensatory plan or arrangement required to be filed as an exhibit to Form 10-K to Item 14(c) of the Form 10-K Report.
SIGNATURES
Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: August 9, 1999 GREAT PLAINS SOFTWARE, INC.
By /s/ Douglas J. Burgum ------------------------------- Douglas J. Burgum Chief Executive Officer, Chairman of the Board and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
* By /s/ Douglas J. Burgum ---------------------------- Douglas J. Burgum Attorney-in-Fact
GREAT PLAINS SOFTWARE, INC. SCHEDULE II--SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS RECEIVABLE AND RESERVES | 18,628 | 129,902 |
818764_1999.txt | 818764_1999 | 1999 | 818764 | ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF BUSINESS
Centex is incorporated in the State of Nevada. The Company's common stock, par value $.25 per share ("Centex Common Stock"), began trading publicly in 1969. As of June 1, 1999, 59,441,124 shares of Centex Common Stock, which are traded on the New York Stock Exchange ("NYSE") and The London Stock Exchange Limited, were outstanding.
Since its founding in 1950 as a Dallas, Texas-based residential and commercial construction company, Centex has evolved into a multi-industry company. Centex currently operates in five principal business segments: Home Building, Investment Real Estate, Financial Services, Construction Products and Contracting and Construction Services. A brief overview of each segment is provided below and a more detailed discussion of each segment is provided later in this section.
Centex's Home Building business has expanded to include both Conventional Homes and Manufactured Homes. Centex is one of the nation's largest home builders. Centex's Conventional Homes operations currently involve the construction and sale of single-family homes, town homes and low-rise condominiums and also include the purchase and development of land. Centex has participated in the conventional home building business since 1950. Centex entered the Manufactured Homes business during March 1997 when Centex Real Estate Corporation ("Real Estate") acquired approximately 80% of Cavco Industries, LLC. As used herein, "Cavco" refers to the manufactured housing group of the Company, which includes the manufacture of quality residential and park model homes and their sale through company-owned retail outlets and through a network of independent dealers.
Centex's Investment Real Estate operations involve the acquisition, development and sale of land, the development of industrial, office, retail and other commercial projects and apartment complexes.
Centex's Financial Services operations include mortgage origination and other related services on homes sold by Centex subsidiaries and by third parties, including home equity and sub-prime lending. Centex has been in the mortgage banking business since 1973.
Centex's involvement in the Construction Products business started in 1963 when it began construction of its first cement plant. Since that time, this segment has expanded to include additional cement production and distribution facilities and the production, distribution and sale of gypsum wallboard, readymix concrete and aggregates. During the quarter ended June 30, 1994, Centex Construction Products, Inc. ("Construction Products") completed an initial public offering of 51% of its stock and began trading on the NYSE under the symbol "CXP." Primarily as a result of Construction Products's repurchase of its own stock during the quarter ended June 30, 1996, Centex's ownership interest increased to more than 50%. Due to additional stock repurchases by Construction Products, Centex's ownership interest increased to 60.6% as of March 31, 1999. Accordingly, Construction Products's fiscal 1999, 1998 and 1997 financial results have been consolidated with those of Centex.
Centex entered the Contracting and Construction Services business in 1966 with the acquisition of a Dallas-based contractor that had been in business since 1936. Additional significant acquisitions of construction companies were made in 1978, 1982, 1987 and 1990. Centex currently ranks among the nation's largest general building contractors. The contracting and construction activities of the Company involve the construction of buildings for both private and government interests, including office, commercial and industrial buildings, hospitals, hotels, museums, libraries, airport facilities and educational institutions.
In fiscal 1988, Centex established Centex Development Company. Please refer to PART B of this Report for a discussion of the business of the Partnership.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
Note (I) of the Notes to Consolidated Financial Statements of Centex on pages 60-64 of this Report contain additional information about the Company's business segments for the years ended March 31, 1999, 1998 and 1997.
NARRATIVE DESCRIPTION OF BUSINESS
HOME BUILDING
CONVENTIONAL HOMES
Centex Homes, Centex's conventional home building operation, is primarily involved in the purchase and development of land or lots and the construction and sale of single-family homes, town homes and low-rise condominiums. Centex Homes operations are currently involved in 299 neighborhoods in 64 different markets. Centex Homes is one of the leading U.S. builders of single-family detached homes, as measured by the number of units produced in a calendar year. Centex Homes is also the only company to rank among the nation's top 10 home builders for each of the past 30 years according to Professional Builder magazine. Centex Homes sells to both first-time and move-up buyers. Approximately 91% of the houses Centex Homes sells are single-family detached homes and the remainder are town homes and low-rise condominiums.
Markets
Centex Homes follows a strategy of reducing exposure to local market volatility by spreading operations across geographically and economically diverse markets. Centex Homes currently builds in 64 market areas in 19 states and in Washington, D. C. The markets are listed below by geographic areas.
In fiscal 1999, Centex Homes closed 14,792 houses, including first-time, move-up and, in some markets, custom homes, ranging in price from approximately $54,000 to about $1.1 million with the average sale price being approximately $185,700.
Centex Homes's policy has been to acquire land with the intent to complete the sale of housing units within approximately 24 to 36 months from the date of acquisition. Generally this involves acquiring land that is properly zoned and is either ready for development or, to some degree, already developed.
Centex Homes has acquired a substantial amount of its finished and partially improved lots and land under option agreements that are exercised over specified time periods, or in certain cases, as the lots are needed. The purchase of finished lots generally allows Centex Homes to shorten the lead time to commence construction and reduces the risks of unforeseen improvement costs and volatile market conditions.
Summarized below by geographic area are Centex Homes's home closings, sales (orders) backlog and sales (orders) for the five fiscal years ended March 31, 1999.
Competition and Other Factors
The conventional housing industry is essentially a "local" business and is highly competitive. Centex Homes competes in each of its market areas with numerous other homebuilders. Centex Homes's operations account for approximately 1% of the total housing starts in the United States. The main competitive factors affecting Centex Homes operations are location, price, cost of providing mortgage financing for customers, construction costs, design and quality of homes, marketing expertise, availability of land and reputation. Management believes that Centex Homes competes effectively by maintaining geographic diversity, being responsive to the specific demands of each market and managing the operations at a local level.
The home building industry is cyclical and is particularly affected by changes in local economic conditions and in long-term and short-term interest rates and, to a lesser extent, changes in property taxes and energy costs, federal income tax laws, federal mortgage financing programs and various demographic factors. The political and economic environment affects both the demand for housing constructed by Centex Homes and Centex Homes's cost of financing. Unexpected climatic conditions, such as unusually heavy or prolonged rain or snow, may affect operations in certain areas.
The housing industry is subject to extensive and complex regulations. Centex Homes and its subcontractors must comply with various federal, state and local laws and regulations including worker health and safety, zoning, building, advertising, consumer credit rules and regulations and the extensive and changing federal, state and local laws, regulations and ordinances governing the protection of the environment ("Environmental Laws"), including the protection of endangered species. Centex Homes is also subject to other rules and regulations in connection with its manufacturing and sales activities, including requirements as to building materials to be used and building designs. Centex Homes's houses are inspected by local authorities. All of the foregoing regulatory requirements are applicable to all home building companies, and to date, compliance with the foregoing requirements has not had a material impact on Centex Homes. Centex Homes believes that it is in material compliance with these requirements.
Centex purchases materials, services and land from numerous sources and believes that it can deal effectively with any problems it may experience relating to the supply or availability of materials and services as well as land.
MANUFACTURED HOMES
Cavco operations include the manufacture of quality residential and park model homes and the sale thereof through company-owned retail outlets and a network of independent dealers. The Company entered the manufactured homes industry in March 1997, when Real Estate acquired approximately 80% of the predecessor of Cavco Industries, LLC for a total of $74.3 million. During February 1998, Cavco
purchased substantially all of the assets of AAA Homes, Inc., Arizona's largest manufactured homes retailer, marking Cavco's entry into the retailing of manufactured homes.
Markets
Cavco is the largest producer of manufactured homes in Arizona and New Mexico as well as the nation's largest producer of park model homes, having built 6,275 manufactured housing units during the fiscal year ended March 31, 1999. Cavco currently operates three manufactured housing plants in the Phoenix area, a plant in Belen, New Mexico that opened August 1997, and a plant in central Texas, that opened in January 1999.
Cavco sells its manufactured homes through company-owned retail outlets and a network of independent dealers. As of March 31, 1999, Cavco had its products in approximately 364 outlets in 11 states, Canada and Japan, of which there were approximately 155 in Arizona, 58 in New Mexico, 50 in Texas, 34 in Colorado, 26 in California, 25 in Utah, 4 in Nevada, 4 in Washington, 2 each in Wyoming, Idaho, and Oregon, 1 in Canada and 1 in Japan. Twenty-two of these outlets are company-owned, 13 of which sell Cavco's product exclusively: 11 in Arizona, 7 in Texas, 3 in New Mexico and 1 in Colorado. In addition, Cavco is selling its products exclusively at its first manufactured home community development in New Mexico. Many of Cavco's independent dealers operate more than one retail outlet. Most of Cavco's independent dealers sell competing products, although from time to time Cavco also may enter into exclusive agreements with certain dealers. The independent dealers set their own retail prices of Cavco's manufactured homes.
Cavco's dealers finance their purchase of manufactured homes through floor plan financing arrangements with third-party lenders. Generally, Cavco receives a commitment from the dealer's lender for each order, which is earmarked for the home ordered, identified by its serial number. Cavco then manufactures the home and ships it at the dealer's expense. Payment is due from the third-party floor plan lender upon the dealer's notice of delivery and acceptance of the product. The length of time it takes to manufacture and ship a home after an order is placed varies according to Cavco's backlog.
Cavco is contingently liable under terms of repurchase agreements with the third-party lenders that provide dealer floor plan financing arrangements. These arrangements, which are customary in the industry, provide for the repurchase of the manufacturer's products in the event that the dealer defaults on payments. The risk of loss is spread over numerous dealers and financing institutions and is further offset by the resale value of repurchased units. Cavco has not incurred any significant losses from these arrangements since its inception.
Cavco extends a limited warranty to original retail purchasers of its manufactured homes. Cavco warrants structural components for 12 months and nonstructural components for 90 days. Its warranty does not extend to installation, setup or appliances. Appliances are warranted by their original manufacturer.
Cavco's backlog of firm orders for manufactured homes as of March 31, 1999 was approximately $13.4 million (526 units) and $6.4 million (300 units) as of March 31, 1998. Cavco currently requires six to eight weeks, on average, to fill an order. Cavco anticipates that the entire backlog at March 31, 1999 will be filled during the next fiscal year.
Competition and Other Factors
Cavco estimates that there are seven other manufacturers competing for a significant share of the Arizona and New Mexico markets. Cavco believes that its business (based on total sales) represents an approximate 31% share of the Arizona market, 17% share of the New Mexico market and smaller shares of the market in other states in which it does business. Cavco believes the principal factors affecting competition in the manufactured housing market are price, design, product quality and reliability, distribution network, retail financing and brand recognition.
Cavco has not experienced any material difficulty in purchasing its raw materials or component parts. Cavco buys wood, wood products, aluminum, steel, tires, hardware, windows and doors from manufacturers and distributors located primarily in California and Arizona. Approximately 39% of the unit cost of Cavco's manufactured homes is attributable to raw wood products. The majority of the other component parts of its homes are purchased manufactured components.
The Company believes that compliance with federal, state and local environmental protection regulations will not have a material adverse effect on its capital expenditures, earnings or competitive position.
INVESTMENT REAL ESTATE
In September 1995, the Company acquired certain equity interests in Vista Properties, Inc. ("Vista") for a net investment of approximately $85 million in cash. At the time of the acquisition, Vista owned a real estate portfolio of properties located in seven states in which the Company has significant operations. Vista's real property portfolio generally consisted of land zoned, planned or developed for single- and multi-family residential, office, retail, industrial and other commercial uses. During the quarter ended June 30, 1996, Real Estate completed a business combination transaction and reorganization with Vista where Vista acquired Real Estate's assets and operations in return for 12.4 million shares of Vista. Immediately following the closing of the acquisition, Vista changed its name to Centex Real Estate Corporation. As a result of the combination, the value of assets received exceeded their costs to Real Estate; accordingly, Centex's Investment Real Estate portfolio and related assets, valued in excess of $125 million, were reduced to a nominal "book basis." Accordingly, as these properties are developed or sold, the net sales proceeds are reflected as operating margin. "Negative Goodwill" recorded as a result of the business combination is being amortized to earnings over approximately seven years.
As of March 31, 1999, the Investment Real Estate Group's property portfolio consisted of land located in nine states: Texas, New Jersey, Florida, North Carolina, California, Tennessee, Virginia, Massachusetts and Colorado. The Company has major Conventional Homes operations in each of the markets where Vista owns substantial property.
The land held, by state, at March 31, 1999 is set forth in the following table:
At March 31, 1999, the Investment Real Estate Group also owned either directly, through interests in joint ventures, or through its ownership of a limited partner interest in Centex Development Company, L.P., two multi-family communities totaling 476 units located in The Colony and College Station, Texas, as well as a 38,000 square foot industrial building in Charlotte, North Carolina. During fiscal 1999, Centex Development Company, L.P. began construction on a 400-unit apartment complex in Grand Prairie, TX and 633,000 square feet of industrial and office space located in Florida, California, and North Carolina. All of the projects under construction at March 31, 1999 are scheduled for completion during fiscal 2000. Many of the areas targeted for development include land owned by the Company or its affiliates.
The Investment Real Estate Group is involved in the acquisition, development and sale of land, the development of industrial, retail, office and other commercial projects, and apartment complexes.
FINANCIAL SERVICES
Financial Services operations involve the financing of conventional and manufactured homes, home equity and sub-prime lending and the sale of title and various insurance coverages. These activities include mortgage origination and other related services for homes sold by Centex subsidiaries and by others.
Conforming Mortgage Banking
CTX Mortgage Company ("CTX Mortgage") was established in 1973 to provide mortgage financing for homes built by Centex Homes. The opening of CTX Mortgage offices in substantially all of Centex Homes's housing markets has enabled it to consistently provide mortgage financing for an average of 73.4% of the homes built by Centex Homes ("Builder Loans") over the past five years. In 1985, CTX Mortgage expanded its operations to include third-party loans ("Retail Loans") that are not associated with the sale of homes built by Centex. At March 31, 1999, CTX Mortgage had 251 offices located in 38 states. The offices vary in size depending on loan volume in each locality.
The unit breakdown of Builder and Retail Loans for CTX Mortgage for the five years ended March 31, 1999 are set forth in the following table:
CTX Mortgage provides mortgage origination and other mortgage related services for Federal Housing Administration ("FHA"), Department of Veterans' Affairs ("VA") and conventional loans on homes built and sold by the Company or by others, as well as resale homes. CTX Mortgage's loans are generally first-lien mortgages secured by one- to four-family residences. A majority of the conventional loans qualify for inclusion in guaranteed programs sponsored by Fannie Mae or the Federal Home Loan Mortgage Corporation ("Freddie Mac"). Such loans are known in the industry as "conforming" loans. The remainder of the loans are either pre-approved and individually underwritten by CTX Mortgage or private investors who subsequently purchase the loans on a whole loan basis or are funded by private investors who pay a broker fee to CTX Mortgage for referring a loan.
CTX Mortgage's principal sources of income are from loan origination fees, revenues from sale of servicing rights, positive carry (discussed below) and marketing gains and losses. Generally, CTX Mortgage sells its right to service the mortgage loans to various loan servicing companies, and therefore retains no mortgage servicing rights. CTX Mortgage enters into various financial agreements, in the normal course of business, in order to manage the exposure to changing interest rates as a result of having issued loan commitments to its customers at a specified price and period. By selling the mortgages for future delivery at a specified price, the interest rate risk is mitigated.
CTX Mortgage borrows money at short-term rates to fund its mortgage loans. During the 30- to 60-day period between the closing of a loan and delivery of the loan to the purchaser, CTX Mortgage earns the interest accrued on the mortgage, which is normally a higher interest rate than the rate paid on the short-term loans used to fund the mortgage during this 30- to 60-day holding period. This positive spread between the long-term interest rate earned and the short-term interest rate paid is referred to as "positive carry," and generally represents an important source of income.
CTX Mortgage also participates in joint-venture agreements with third-party home builders to provide mortgage originations for homes built by the home builders. At March 31, 1999, CTX Mortgage has 21 of these agreements, operating in 59 offices in eleven states.
Home Equity and Sub-Prime Lending
Centex Credit Corporation, a Nevada corporation doing business as Centex Home Equity Corporation ("Home Equity"), is a Fannie Mae approved sub-prime mortgage lender formed in fiscal 1995 and engages in the origination of primarily non-conforming home equity loans. The sub-prime lending market is comprised of borrowers whose financing needs are not being met by traditional mortgage lenders for a variety of reasons, including credit histories that may limit such borrower's
access to credit or the borrower's need for specialized loan products. In the first calendar quarter of 1997, Home Equity operations underwent a reorganization and hired a new management team. Since its inception, Home Equity has focused on lending to individuals who have substantial equity in their homes but have impaired or limited credit histories. Home Equity's mortgage loans to these borrowers are made for such purposes as debt consolidation, refinancing, home improvement or educational expenses. Substantially all of Home Equity's mortgage loans are secured by first or second mortgage liens on one- to four-family residences, and have amortization schedules ranging from five years to 30 years.
At March 31, 1999, Home Equity had 124 offices doing business in 48 states. Home Equity originates home equity loans through four major origination sources: 1) retail branch network, 2) broker referral network, 3) referrals from its affiliated conforming mortgage company, CTX Mortgage, and 4) Home Equity's direct sales unit, which sources loans through telemarketing and direct mail efforts.
The following table summarizes origination statistics for the five years ended March 31, 1999.
Home Equity has been servicing loans since March 1997. The servicing fees paid for sub-prime loans are significantly higher than for conforming loans. Servicing encompasses, among other activities, the following processes: billing and collection of payments when due, movement of cash to the payment clearing bank accounts, investor reporting, customer help, reconveyance, recovery of delinquent installments, instituting foreclosure, and liquidation of the underlying collateral. As of March 31, 1999, Home Equity was servicing a portfolio of approximately $1.2 billion.
Commencing in October 1997, a majority of Home Equity volume has been accumulated by Home Equity for securitization through Real Estate Mortgage Investment Conduit ("REMIC") Trusts for which Home Equity has retained the residual interest as well as the servicing rights to the securitized loans. The remainder of the loans are sold to investors on a whole-loan sale basis. In February 1998, Home Equity completed its first securitization of $175 million of sub-prime home equity mortgage loans. During fiscal year 1999, Home Equity completed additional securitizations totaling $890 million.
Home Equity's principal sources of income are from gains on securitizations and whole loan sales, loan origination fees, revenues from the sale of servicing rights, positive carry, and servicing fees.
Other Financial Services Operations
Centex's Title operations operate principally in Texas, Florida, Virginia and Maryland. Through Westwood Insurance (a homeowner's insurance broker that specializes in writing insurance for the homebuilding industry), which was acquired during fiscal 1999, homeowners and hazard insurance is sold to Centex's and other homebuilding customers in 31 states. In addition to Centex and commercial loan customers, Westwood serves approximately 120 other builders.
Centex Financial Services, Inc., the parent of CTX Mortgage, acquired substantially all of the assets of Advanced Financial Technology, Inc. ("Adfitech") and Loan Processing Technologies, Inc. ("Loan Processing") in April 1996 and Adfinet, Inc. ("Adfinet") in July 1997, all of which are headquartered in Oklahoma City, Oklahoma. Adfitech is a provider of mortgage quality control services. Loan Processing owns and operates an automated mortgage processing system and Adfinet provides the mortgage industry with regulations and guidelines in an electronic format. These acquisitions expanded the products and services that Financial Services offers to the mortgage industry.
Competition and Other Factors
The mortgage banking industry in the United States is highly competitive. CTX Mortgage competes with other mortgage banking companies as well as financial institutions to supply mortgage financing at attractive rates to purchasers of Centex homes as well as to the general public. Home Equity competes with other sub-prime lenders as well as financial institutions to supply sub-prime financing at attractive rates. The Title and Insurance operations compete with numerous other providers of title and insurance products to purchasers of Centex homes and as well as to the general public. During fiscal 1999, Financial Services continued to operate in a very competitive environment.
Other Legal Considerations
The Financial Services operations are subject to extensive state and federal regulations as well as the rules and regulations of, and examinations by, Fannie Mae, Freddie Mac, FHA, VA, Department of Housing and Urban Development ("HUD"), Government National Mortgage Association ("GNMA") and state regulatory authorities with respect to originating, processing, underwriting, making, selling, securitizing and servicing loans. In addition, there are other federal and state statutes and regulations affecting such activities. These rules and regulations, among other things, impose licensing obligations on Financial Services, specify standards for origination procedures, establish eligibility criteria for mortgage loans, provide for inspection and appraisals of properties, regulate payment features and, in some cases, fix maximum interest rates, fees and loan amounts. The Financial Services operations are required to maintain specified net worth levels by, and submit annual audited financial statements to HUD, VA, FNMA, FHLMC and GNMA and certain state regulators. As an approved FHA mortgagee, CTX Mortgage is subject to examination by the Federal Housing Commissioner at all times to ensure compliance with FHA regulations, policies and procedures. Among other federal and state consumer credit laws, mortgage origination and servicing activities are subject to the Equal Credit Opportunity Act, the Fair Housing Act, the Fair Credit Reporting Act, the Federal Truth-In-Lending Act, the Real Estate Settlement Procedures Act, the Riegle Community Development and Regulatory Improvement Act, the Home Ownership and Equity Protection Act, and the regulations promulgated under such statutes. These statutes prohibit discrimination and unlawful kickbacks and referral fees and require the disclosure of certain information to borrowers concerning credit and settlement costs. Many of these regulatory requirements are designed to protect the interest of consumers, while others protect the owners or insurers of mortgage loans. Failure to comply with these requirements can lead to loss of approved status, demands for indemnification or loan repurchases from investors, class action lawsuits by borrowers, administrative enforcement actions and, in some cases, rescission or voiding of the loan by the consumer.
CONSTRUCTION PRODUCTS
Construction Products's operations include the manufacture, production, distribution and sale of cement (a basic construction material which is the essential binding ingredient in concrete), gypsum wallboard, readymix concrete and aggregates (sand and gravel).
During the quarter ended June 30, 1994, Construction Products completed an initial public offering of 51% of its stock and began trading on the NYSE under the symbol "CXP". Primarily as a result of Construction Products's repurchase of its own stock during fiscal years 1999, 1998 and 1997, Centex's ownership has increased to 60.6% as of March 31, 1999. Accordingly, Construction Products's financial statements for the years ended March 31, 1999, 1998 and 1997 have been consolidated with those of Centex. References to Construction Products include its subsidiaries unless the context requires otherwise.
CEMENT
Construction Products operates cement plants in or near Buda, Texas; LaSalle, Illinois; Fernley, Nevada and Laramie, Wyoming. The plants in Buda and LaSalle are owned by separate joint ventures in which Construction Products has a 50% interest. The kiln start-up dates of the cement plants were as follows: Buda, Texas, 1978 (expanded 1983); LaSalle, Illinois, 1974; Fernley, Nevada (2 kilns), 1964 and 1969 and Laramie, Wyoming (2 kilns), 1988 and 1996. All four of the cement plants are fuel-efficient dry process plants.
Construction Products's net cement production, excluding the joint venture partners' 50% interest in the Buda and LaSalle plants, totaled approximately 2.0 million tons in both fiscal 1999 and 1998. Total net cement sales were approximately 2.2 million tons both in fiscal 1999 and 1998, as all four cement plants sold the entire product they produced. During the past two years, Construction Products purchased and resold minimal amounts of cement.
Raw Materials and Fuel Supplies
The principal raw material used in the production of portland cement is calcium carbonate in the form of limestone. Limestone is obtained principally through the mining and extraction operations conducted at quarries owned or leased by Construction Products or the joint ventures and located in close proximity to the plants. Other raw materials used in substantially smaller quantities than limestone are sand, clay, iron ore and gypsum, which are either obtained from reserves owned or leased by Construction Products or the joint ventures or are purchased from outside suppliers and are readily available. Construction Products's management believes that the estimated recoverable limestone reserves owned or leased by it or its joint ventures will permit each of its plants to operate at its present production capacity for at least 30 years or, in the case of the Fernley plant, at least 17 years. Construction Products's management expects that additional limestone reserves for its Fernley plant will be available when needed on an economically feasible basis, although they may be more distant and more expensive to transport than existing reserves.
The cement plants use coal and coke as their primary fuel, but are equipped to burn natural gas as an alternative. Hazardous waste-derived fuels have not been used in the plants. The Buda and LaSalle plants have been permitted to burn scrap tires as a partial fuel alternative. Electric power is also a major cost component in the manufacture of cement. Construction Products has sought to diminish overall power costs by adopting interruptible power supply agreements which may expose the plants to some production interruptions during periods of power curtailment.
Sales and Distribution
The principal geographic markets for Construction Products's cement are Texas and western Louisiana (serviced by the Buda, Texas plant); Illinois and southern Wisconsin (serviced by the LaSalle, Illinois plant); Nevada (except Las Vegas) and northern California (serviced by the Fernley, Nevada plant); and Wyoming, Utah, northern Colorado, western Nebraska and eastern Nevada (serviced by the Laramie, Wyoming plant).
Distribution of cement is generally made by common carriers, customer pickup and, to a lesser extent, by trucks owned and operated by Construction Products. In addition, cement is transported principally by rail to storage and distribution terminals located in Roanoke (in the Dallas-Ft.Worth area), Waco, Corpus Christi, Houston and Orange, Texas; Hartland, Wisconsin; Sacramento, California; Denver, Colorado; Salt Lake City, Utah; Rock Springs, Wyoming and North Platte, Nebraska, from which further distribution occurs.
Cement produced by the cement plants is sold primarily to readymix concrete producers and paving contractors. No single customer accounted for as much as 10% of total cement sales during fiscal 1999.
Competition and Other Factors
The cement business is extremely competitive. In every geographic area in which Construction Products sells cement, one or more other domestic producers compete for the available business. In addition, foreign companies compete in most sales areas by importing cement into the United States. The number of principal competitors of the Buda, LaSalle, Fernley and Laramie plants are six, six, five and five, respectively, operating in these geographic areas. Construction Products competes by operating efficient cement plants, merchandising a high quality product and providing good service and competitive pricing. Cement is also sold from terminals to expand each cement plant's selling area.
GYPSUM WALLBOARD
Construction Products owns and operates three gypsum wallboard manufacturing facilities, two located in Albuquerque and nearby Bernalillo, New Mexico and one located in Gypsum, Colorado (near Vail). The Albuquerque plant was acquired in 1985 and was operated until early 1991. Following the start-up of the Bernalillo plant in the spring of 1990, Construction Products elected to suspend operations at the Albuquerque plant due to weak market conditions. Operations at the Albuquerque plant were recommenced in May 1993 due to improvements in wallboard demand and pricing. In February 1997, Construction Products purchased a company that owned the gypsum wallboard plant and accompanying electric power cogeneration facility in Gypsum, Colorado. The plant originally commenced production in early 1990 and had been operated by an independent producer until its acquisition by Construction Products.
Construction Products mines and extracts gypsum and then manufactures gypsum wallboard by first pulverizing quarried gypsum, then placing it in a calciner for conversion into plaster. The plaster is mixed with various chemicals and water to produce a mixture known as slurry, which is inserted between two continuous sheets of recycled paperboard on a high-speed production line and allowed to harden. The resulting sheets of gypsum wallboard are then cut to appropriate lengths, dried and bundled for sale.
Raw Materials and Fuel Supplies
Construction Products mines and extracts gypsum rock, the principal raw material used in the manufacture of wallboard, from mines and quarries owned, leased or subject to claims owned by Construction Products and located near its plants. The New Mexico and Colorado mines and quarries are estimated to contain approximately 50 million tons and 21 million tons of proven and probable gypsum reserves, respectively. Based on its current production capacity, Construction Products's management estimates that the life of its existing gypsum rock reserves is approximately 80 years in New Mexico and 35 years in Colorado.
Paper used in manufacturing gypsum wallboard is purchased by Construction Products from third-party suppliers. Approximately 65% of Construction Products's paper requirements are under two evergreen paper contracts, with one contract having a six-month notice provision for termination and the other a twelve-month notice provision for termination. The remainder of Construction Products's paper requirements is purchased on the open market from various suppliers. Centex does not believe that the loss of a supplier would have a material adverse effect on its business.
Construction Products's wallboard plants use large quantities of natural gas and electrical power. Power for the Gypsum, Colorado plant is supplied by the cogeneration power facility that was acquired along with the gypsum wallboard plant.
Sales and Distribution
The principal sources of demand for gypsum wallboard are residential construction, repair and remodeling and non-residential construction. While the gypsum wallboard industry remains highly cyclical, recent growth in the repair and remodeling segment, together with certain trends in new residential and commercial construction activity, have partially mitigated the impact of fluctuations in overall levels of new construction.
Construction Products sells wallboard to numerous building materials dealers, wallboard specialty distributors, home center chains and other customers located throughout the United States. One customer with multiple shipping locations accounted for approximately 16% of Construction Products's total gypsum wallboard sales during fiscal 1999. However, Centex does not believe that the loss of that customer would have a material adverse effect on Construction Products and its subsidiaries taken as a whole.
Although wallboard is distributed principally in regional areas, Construction Products and certain other producers have the ability to ship wallboard by rail outside their usual regional distribution area to take advantage of other regional increases in demand. Construction Products's rail distribution capabilities permit it to reach customers in all states west of the Mississippi River and many eastern states. In addition, in order to facilitate distribution in certain strategic areas, Construction Products maintains a distribution center in Albuquerque, New Mexico and four reload yards in Florida, Alabama and Illinois.
Competition and Other Factors
There are eleven principal manufacturers of wallboard operating a total of 73 plants. Centex estimates that the three largest producers, none of which is Construction Products, account for approximately 80% of wallboard sales in the United States. Competition among wallboard producers is primarily on a regional basis, with local producers benefiting from lower transportation costs and, to a lesser extent, on a national basis. Because of the commodity nature of the product, competition is based principally on price and, to a lesser extent, on product quality and customer service.
READYMIX CONCRETE AND AGGREGATES
Construction Products's readymix concrete and aggregates operations are located in and around Austin, Texas and northern California. The 10,000-acre aggregates deposit in northern California contains an estimated two billion tons of reserves. Construction Products is engaged in negotiations with state and federal government agencies over issues of title to a portion of its principal aggregate deposit in northern California. Even if the negotiations are unsuccessful in resolving adverse claims, the undisputed portion of Construction Products's California aggregate deposit contains sufficient reserves to serve Construction Products's needs. Construction Products sells aggregates from this deposit in the Sacramento, California area and in nearby counties. No single customer accounted for as much as 10% of Construction Products's concrete and aggregates sales during fiscal 1999. Competition among concrete producers within Construction Products's northern California and Austin markets is strong. Construction Products's competitors include five small and four large concrete producers in the northern California area and five large and four small concrete producers in the Austin area.
ENVIRONMENTAL MATTERS
The construction products industry, including the operations of Construction Products, is regulated by federal, state and local laws and regulations pertaining to several areas including human health and safety and environmental compliance (collectively, "Environmental Laws"). The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA"), as amended by the Superfund Amendments and Reauthorization Act of 1986, as well as analogous laws in certain states, create joint and several liability for the cost of cleaning up or correcting releases to the environment of designated hazardous substances. Among those who may be held jointly and severally liable are those who generated the waste, those who arranged for disposal, those who owned or operated the disposal site or facility at the time of disposal, and current owners. In general, this liability is imposed in a series of governmental proceedings initiated by the identification of a site for initial listing as a "Superfund site" on the National Priorities List or a similar state list and the identification of potentially responsible parties who may be liable for cleanup costs. None of Construction Products's sites are listed as a "Superfund site."
Construction Products's operations are also potentially affected by the Resource Conservation and Recovery Act ("RCRA"), which is the primary federal statute governing the management of solid waste and which includes stringent regulation of solid waste that is considered hazardous waste. Such operations generate non-hazardous solid waste, which may include cement kiln dust ("CKD"). Because of a RCRA exemption, known as the Bevill Amendment, CKD generated in Construction Products's operations is currently not considered a hazardous waste under RCRA, pending completion of a study and recommendations to Congress by the U.S. Environmental Protection Agency ("U.S. EPA"). Nevertheless, CKD is still considered a solid waste and is regulated primarily under state environmental laws and regulations. The U.S. EPA completed its review of CKD and has decided to promulgate
regulations to govern the handling and disposal of CKD, which will supersede the Bevill Amendment. The Bevill Amendment will remain in effect until those regulations are in place.
In the past, Construction Products collected and stored CKD on-site at its cement plants. Construction Products continues to store such CKD at its Illinois, Nevada and Wyoming cement plants and at a former plant site in Corpus Christi, Texas, which is no longer in operation. Currently, substantially all CKD related to present operations at all cement facilities is recycled. When the U.S. EPA removes the CKD exemption and develops particular CKD management standards in the future, Construction Products might be required to incur significant costs in connection with its CKD. CKD that comes in contact with water might produce a leachate with an alkalinity high enough to be classified as hazardous and might also leach certain hazardous trace metals therein.
Construction Products's cement kilns utilize coal, natural gas, minimal amounts of self-generated waste oil, and scrap tires in the Illinois and Texas plants, as fuel.
Another issue of potential significance is global warming and the international accord on carbon dioxide stabilization/reduction. Carbon dioxide is a greenhouse gas many scientists and others believe contributes to a warming of the Earth's atmosphere. In December 1997, the United Nations held an international convention in Kyoto, Japan to take further international action to ensure greenhouse gas stabilization and/or reduction after the turn of the century. The conference agreed to a protocol to the United Nations Framework Convention on Climate Change originally adopted in May 1992. The protocol establishes quantified emission reduction commitments for certain developed countries, including the United States, and certain countries that are undergoing the process of transition to a market economy. These reductions are to be obtained by 2008-2012. This protocol was made available for signature by member countries starting in the spring of 1998. The protocol will require Senate ratification and enactment of implementing legislation before it becomes effective in the United States.
The consequences of greenhouse gas reduction measures for cement producers are potentially significant because carbon dioxide is generated from combustion of fuels such as coal and coke in order to generate the high temperatures necessary to manufacture cement clinker (which is then ground with gypsum to make cement). In addition, carbon dioxide is generated in the calcining of limestone to make cement clinker. Any imposition of raw material or production limitations or fuel-use or carbon taxes could have a significant impact on the cement manufacturing industry. It will not be possible to determine the impact on Construction Products until governmental requirements are defined and/or it is determined whether emission offsets and/or credits are obtainable, and whether alternative cementitious products or alternative fuel can be substituted.
Another RCRA concern in the cement industry involves the historical disposal of refractory brick containing chromium. Such refractory brick was formerly widely used in the cement industry to line cement kilns. Construction Products currently crushes spent refractory brick and uses it as raw feed, but such brick does not contain chromium.
The Clean Air Act Amendments of 1990 (the "Amendments") provided comprehensive federal regulation of all sources of air pollution and established a new federal operating permit and fee program for virtually all manufacturing operations. The Amendments will likely result in increased capital and operational expenses for Construction Products in the future, the amounts of which are not presently determinable. Construction Products has submitted detailed permit applications and will pay increased recurring permit fees. In addition, the U.S. EPA is developing regulations for toxic air pollutants under these Amendments for a broad spectrum of industrial sectors, including portland cement manufacturing. The U.S. EPA has indicated that the new maximum available control technology standards could require
significant reduction of air pollutants below existing levels prevalent in the industry. Management has no reason to believe, however, that these new standards would place Construction Products at a competitive disadvantage.
Management believes that Construction Products's current procedures and practices in its operations, including those for handling and managing materials, are consistent with industry standards. Nevertheless, because of the complexity of operations and compliance with Environmental Laws, there can be no assurance that past or future operations will not result in operational errors, violations, remediation or other liabilities or claims. Moreover, Construction Products cannot predict what Environmental Laws will be enacted, adopted or amended in the future or how such future Environmental Laws will be administered or interpreted. Compliance with more stringent Environmental Laws, as well as potentially more vigorous enforcement policies of regulatory agencies or stricter interpretation of existing Environmental Laws, could necessitate significant capital outlays.
With respect to some of Construction Products's quarries used for the extraction of raw materials for its cement and gypsum operations and for the mining of aggregates for its aggregates operations, Construction Products is obligated under certain of its permits and certain regulations to engage in reclamation of land within the quarries upon completion of extraction and mining. Construction Products generally accrues the reclamation costs for a specific quarry over the life of the quarry.
CONTRACTING AND CONSTRUCTION SERVICES
Centex's contracting and construction services work is performed through its construction group nationwide. Centex Construction Group's subsidiaries rank together as one of the largest building contractors in the country as well as one of the largest U.S.-owned construction groups. The Construction Group is made up of five firms with various geographic locations and project niches. Healthcare facility construction has represented nearly one-fourth of the Group's business mix during recent years. New contracts for the group for fiscal 1999 totaled $1.128 billion versus $999 million for fiscal 1998. The backlog of uncompleted contracts at March 31, 1999 was $937 million, compared to $1.16 billion at March 31, 1998. The Group's principal subsidiaries are as follows:
CENTEX CONSTRUCTION COMPANY, INC. - This entity, which emerged from the combination of Centex Bateson Construction Company, Inc. and Centex-Simpson Construction Company, Inc., has operational offices in Dallas, Texas and in Fairfax, Virginia. This company pursues negotiated work in its regional market areas in addition to competitively-bid projects nationwide.
CENTEX-RODGERS CONSTRUCTION COMPANY - This nationwide healthcare construction specialist is headquartered in Nashville, Tennessee with operational offices in Pasadena and Sacramento, California; Detroit, Michigan and West Palm Beach, Florida.
CENTEX-ROONEY CONSTRUCTION CO., INC. - This Ft. Lauderdale-based subsidiary performs all types of work, principally within the state of Florida having operational offices in Miami, Orlando, Tampa, Tallahassee, Jacksonville and Ft. Myers.
CENTEX-LANDIS CONSTRUCTION CO., INC. - This wholly-owned subsidiary of Centex-Rooney Construction Co., Inc. is headquartered in New Orleans, Louisiana. This company pursues competitively-bid projects and negotiated work in its regional market area.
CENTEX FORCUM LANNOM, INC. - This company, which focuses on industrial client construction projects, is located in Dyersburg, Tennessee and operates in Tennessee and surrounding states with additional marketing offices in Memphis, Tennessee and Lexington, Kentucky.
As a general contractor or construction manager, the Construction Group provides supervisory personnel for the construction of a building or facility. In addition, the Construction Group may perform varying amounts of the actual construction work on a project, but will generally hire subcontractors to perform the majority of the work.
Construction contracts are primarily entered into under two formats: competitively-bid and negotiated jobs. In a competitively-bid format, the Construction Group will bid a fixed amount for which it will agree to construct the project based on an evaluation of detailed plans and specifications. In a negotiated job, the contractor bids a fee (fixed or percentage) over the cost of the project and, in many instances, agrees that the final cost will not exceed a designated amount. Such contracts may include a provision whereby the owner will pay a part of any savings from the guaranteed amount to the contractor. Historically, the majority of the Construction Group's projects have been in the higher risk competitively bid jobs. Recent years have seen a shift to higher-margin private negotiated projects from the competitively-bid public projects. At March 31, 1999, approximately 90% of the outstanding projects were negotiated projects with private owners. The Construction Group's projects include hospitals, hotels, office buildings, correctional facilities, apartments, shopping centers, airports, parking garages, sport stadiums, military facilities, post offices and convention and performing arts centers.
Competition and Other Factors
The construction industry is very competitive, and the Construction Group competes with numerous other companies. With respect to competitively-bid projects and negotiated healthcare work, the Construction Group generally competes throughout the United States and with local, regional and national contractors, depending upon the nature of the project. For negotiated projects other than healthcare, the Construction Group competes primarily in the general geographical area where the entity is located and with other local, regional and national contractors. The Construction Group solicits new projects by attending project bid meetings, by and meeting with builders and owners and through existing customers. The Construction Group competes successfully on the basis of its reputation, financial strength, knowledge and understanding of its clients' needs.
The Construction Group's operations are affected by federal, state and local laws and regulations relating to worker health and workplace safety as well as Environmental Laws. With respect to health and safety matters, the Company believes that the Construction Group has taken appropriate precautions to protect employees and others from workplace hazards. Current Environmental Laws may require the Construction Group's operating subsidiaries to work in concert with project owners to acquire the necessary permits or other authorizations for certain activities, including the construction of projects located in or near wetland areas. The Construction Group's operations are also affected by Environmental Laws regulating the use and disposal of hazardous materials encountered during demolition operations.
The Company believes that the Contracting and Construction Services Group's current procedures and practices are consistent with industry standards and that compliance by the Construction Group with the health and safety laws and Environmental Laws does not constitute a material burden or expense for the Company.
The Company's Contracting and Construction Services operations obtain materials and services from numerous sources. The Company believes that its construction companies can deal effectively with any problems they may experience in the supply of materials and services.
EMPLOYEES
The following table presents the breakdown of employees in each line of business as of March 31, 1999:
Except for the 97 Corporate employees who are employees of Centex Corporation, all others are employees of different subsidiaries of Centex Corporation.
ITEM 2.
ITEM 2. PROPERTIES
(a) Holding
Due to the nature of its business, Holding does not own or hold for investment any real or personal properties other than cash, receivables and other similar assets, and the securities relating to its subsidiary, Development.
In fiscal 1998, through wholly-owned subsidiaries, Development acquired the general partnership interests in entities formed for both multi-family and commercial development activities. In each instance, the Partnership, for whom Development serves as general partner, is the 99% limited partner.
(b) The Partnership
The remaining Original Properties and the Additional Properties consist of properties located in Texas, North Carolina, New Jersey, Florida and California. The remaining Original Properties predominantly consist of undeveloped sites zoned for light industrial, agricultural, general retail, office industrial, business park, research and development and single-family and multi-family residential property purposes. The Additional Properties generally consist of land acquired or contributed by Centex Homes for near-term multi-family and commercial development purposes.
At March 31, 1999, there were three remaining Original Properties and thirteen Additional Properties owned by the Partnership. Set forth below is a brief description of these properties, including present zoning.
ORIGINAL PROPERTIES
Colony South Planning Unit. Colony South Planning Unit is located in suburban Dallas, Texas in the cities of The Colony (approximately 132 acres) and Lewisville (approximately 116 acres). The Colony acreage is zoned office, general retail and business park. The Lewisville acreage is zoned light industrial. During fiscal 1999, the Partnership completed a 304-unit apartment community on 21 acres located in The Colony.
East Windsor. East Windsor is a development which was originally comprised of approximately 600 acres with residential tracts, farm parcels and 100 acres of office industrial zoned property in East Windsor, New Jersey, a township located in the vicinity of Princeton. At March 31, 1999 there were 456 remaining acres owned by the Partnership. Through its homebuilding operations, the Partnership plans to build out the remaining single-family land in East Windsor.
Bryan Place. Bryan Place is located in Dallas, Texas just east of downtown and Central Expressway. It is comprised of one parcel, zoned commercial, totaling approximately 71,000 square feet.
ADDITIONAL PROPERTIES
The Arbors of Wolf Penn Creek. The Arbors of Wolf Penn Creek is a 172-unit apartment complex located in College Station, Texas. The complex is situated on eight acres and was completed in the fall of 1996. The Arbors of Wolf Penn Creek was developed through a joint venture with a third party. The complex is currently being marketed for sale.
Heritage Park. Heritage Park is located in a suburb of Dallas, Texas in the city of Allen and consists of approximately 91 acres. The Heritage Park property is zoned single-family residential and commercial.
Goodlett-Frank. Goodlett-Frank is located in Naples, Florida and consists of approximately 67 acres developed into 216 lots. Seventy-five lots were sold to Centex Homes during fiscal 1999.
Park West at Gateway Centre. Park West at Gateway Centre is a 24-acre industrial tract situated in a mixed-use development located in St. Petersburg, Florida. During fiscal 1998, a 49.5% interest in a limited partnership, whose only asset is the 24 acres, was acquired by the Partnership from Centex Homes in exchange for Class C Units. During fiscal 1999, the Partnership began construction on a 74,000 square foot industrial facility. As of March 31, 1999, the Partnership had signed two leases totaling 13,800 square feet. The building is scheduled for completion in the first quarter of fiscal 2000.
Southpointe. The Southpointe property, located in Plantation, Florida, 13 miles west of the Ft. Lauderdale Airport, is comprised of 11 acres zoned for office use. During fiscal 1999, the Partnership began construction of a 141,000 square foot office building pre-leased by the General Services Administration for use by the Internal Revenue Service. Centex-Rooney Construction Company, Inc., a wholly-owned subsidiary of Centex, is the general contractor for the facility. Construction is scheduled for completion in early fiscal 2000. During fiscal 1998, a 49.5% interest in a limited partnership, whose only asset is the 11 acres, was acquired by the Partnership from Centex Homes in exchange for Class C Units.
Westlake. The Westlake property consists of a 38,000 square foot industrial building situated on six acres located in a business park in Charlotte, North Carolina. The facility was pre-leased prior to the start of construction. Construction was completed in December 1997. The six-acre parcel was acquired by the Partnership from Centex Homes in exchange for Class C Units. During fiscal 1999, an additional fifteen acres in the Westlake project was acquired by the Partnership from Centex Homes in exchange for Class C Units. The Partnership has completed construction of a 105,000 square foot pre-leased industrial building on eight of the fifteen acres.
Northfield. Northfield is located in Ventura County, California approximately 60 miles west of downtown Los Angeles and is comprised of 23 acres. Northfield is zoned light industrial and is situated in an industrial business park. Of the 23 acres owned by the Partnership, 18 acres were acquired by the Partnership from Centex Homes in exchange for Class C Units, while five acres of adjacent land were purchased by the Partnership during fiscal 1998. During fiscal 1999, the Partnership entered into a joint-venture agreement with a third party to develop approximately 182,000 square feet of industrial inventory buildings on 10 acres in the Northfield Business Park. Shell completion of the buildings is scheduled for early fiscal 2000.
Sheffield. Sheffield is an 18-acre multi-family tract located in Grand Prairie, Texas. Sheffield was acquired by the Partnership from Centex Homes in exchange for Class C Units in fiscal 1998. During fiscal 1999, the Partnership began construction of a 400-unit complex. The Partnership is actively marketing this project for sale upon completion of construction.
Vista Ridge. Vista Ridge is a 1,000-acre master planned community located twenty-five miles north of the Dallas central business district in Dallas and Denton counties, Texas in the cities of Lewisville and Coppell. The Partnership currently owns fifty-five acres zoned for multi-family and retail development. During fiscal 1999 and 1998, forty-three acres of multi-family zoned land were acquired by the Partnership from Centex Homes in exchange for Class C Units. The other twelve acres had previously been acquired through a third-party joint venture. In fiscal 1998, the Partnership acquired the joint venture partner's interest in the joint venture.
Camarillo Ranch. Camarillo Ranch is located in Ventura County, California, west of Los Angeles directly off the Ventura Freeway. Camarillo Ranch is zoned light industrial and totals fifty-five net acres. The Partnership began construction on a 132,500 square foot pre-leased facility in Camarillo Ranch during fiscal 1999, on which construction has since been completed. The Partnership also began improvements to provide on-site utilities to the entire tract.
Brighton Bay. Brighton Bay is located in Pinellas County, Florida in the city of St. Petersburg. During fiscal 1999, the Partnership acquired a sixty-two acre site in exchange for Class C Units. The two parcels acquired are zoned for multi-family development. The master plan's infrastructure and interior lakes are currently under development. The Partnership has plans to develop this property in two phases to total 776 apartment units with phase one anticipated to begin in fiscal 2000.
Deerfield. Deerfield is a sixteen-acre tract of land zoned for single-family development located in Plano, Texas. The Partnership acquired the land from Centex Homes in exchange for Class C Units. During fiscal 1999, the Partnership developed the sixteen acres into fifty-five lots, which are under contract for sale to third party homebuilders on a lot take-down program. As of March 31, 1999, 15 lots have closed and 40 lots on approximately 12 acres remain to be taken down.
Waterford Chase. Waterford Chase is located in Orange County, Florida and consists of 329 single-family lots. During fiscal 1999, 146 lots were sold to Centex Homes. As of March 31, 1999, 183 lots on approximately fifty-seven acres remained.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Holding is not a party to, and its assets are not the subject of, any material pending legal proceedings. The Partnership may be involved from time to time in litigation matters incident to its day-to-day business; however, management of Development believes that such litigation, if determined unfavorably to the Partnership, would not have a material adverse effect on the financial condition or operations of the Partnership.
ITEM 4.
Item 4.
SERVICES AGREEMENT
Holding has no full-time employees. The directors and executive officers of Holding, who hold the same directorships and offices in Development, perform all executive management functions. See "Item 11. Executive Compensation". All tax, accounting, bookkeeping, clerical and similar services that are necessary to operate the business of Holding are provided pursuant to a services agreement (the "Services Agreement") entered into between Holding and Centex Service Company. See "Item 13. Certain Relationships and Related Transactions". The term of the Services Agreement is subject to automatic renewal for successive one-year terms unless either party elects to terminate the Services Agreement upon at least 30 days written notice prior to December 31 of any year. However, the Services Agreement may not be terminated by Holding (other than in the event of a breach by Centex Service Company constituting gross negligence or willful or wanton misconduct) prior to the full and complete detachment of the Stockholder Warrants from Centex Common Stock or the occurrence of Payout. Service fees of $360,000 were paid pursuant to the Services Agreement during fiscal 1999.
(b) The Partnership
GENERAL PARTNER AND MANAGEMENT
The Partnership has no directors, officers or employees and, instead, is managed by Development, its sole general partner. Development, in turn, is controlled by its sole stockholder, Holding. Directors and officers of Development perform all executive management functions required for the Partnership. Except as provided in the Plan with respect to the Original Properties, the limited partners of the Partnership have no power to direct or participate in the control of the Partnership or to remove the general partner, and Development and the independent board of directors of Holding manage how the Partnership conducts its activities including the sales development, maintenance and zoning of properties belonging to the Partnership and all other decisions regarding the Partnership's business or operations. See "Item 1. Business". The Partnership has entered into a management agreement pursuant to which Holding will sell, develop, maintain and zone the properties of the Partnership for and on behalf of the Partnership. Holding is managed by a three-person board of directors elected by the stockholders of Centex. Two of the board members are independent outside directors who are not directors of Centex. See "Management Agreement" below in this Item 10. Except for the allocations of profit and loss and distributions of cash and other property to which Development is entitled under the Partnership Agreement, and except for the right to be reimbursed for certain expenses, Development
does not receive any compensation from the Partnership in respect of its duties and obligations as general partner of the Partnership. See "Item 11. Executive Compensation".
DIRECTORS AND EXECUTIVE OFFICERS OF DEVELOPMENT
Information concerning the present directors and executive officers of Development is set forth below. All of such persons have served in their capacities since the organization of Development, except as indicated.
* Member of the audit committee of the Board of Directors.
(1) Mr. Decker is an employee of a subsidiary of Centex and has been Chairman, President and Chief Executive Officer of both Holding and Development, the general partner of the Partnership, since April 1, 1998. Mr. Decker was elected Director of both Holding and Development effective June 10, 1998. Mr. Decker has also been a director and officer of various Centex subsidiaries engaged in real estate development since July 1996. Prior thereto, Mr. Decker was a partner with Dallas-based Trammell Crow Company, a commercial real estate development firm, for 15 years, and served as Principal from 1990 until 1995. From 1995 until July 1996, Mr. Decker operated Decker & Company, a Phoenix, Arizona-based real estate development company.
(2) Mr. Bilheimer is an employee of a subsidiary of Centex. Mr. Bilheimer was appointed to the position of Vice Chairman for Holding effective April 1, 1998. Prior thereto, Mr. Bilheimer served as President of Holding and Development from 1987 to 1998. Mr. Bilheimer was a director of Holding and Development from its date of incorporation until his resignation as of June 1, 1987. Mr. Bilheimer was re-elected to the Board of Directors on May 24, 1989. Mr. Bilheimer also served as Executive Vice President of Centex Real Estate Corporation from April 1987 until March 31, 1988 and served as a director until July 23, 1998 at which time he declined to stand for re-election.
(3) Mr. Low serves as Senior Vice President of Donaldson, Lufkin & Jenrette Securities Corporation since February 1988. Mr. Low is also a director of Holding. Mr. Low was elected as a director of Development as of June 1, 1987.
(4) Mr. Sherer has been President of David M. Sherer Associates, Inc., a commercial real estate, investment and brokerage firm, for 20 years. Mr. Sherer is also a director of Holding. Mr. Sherer was elected as a director of Development as of June 1, 1987.
(5) Ms. Pinson is an employee of a subsidiary of Centex and serves as Vice President, Treasurer, Controller and Assistant Secretary of Holding, Development, and various Centex subsidiaries engaged in real estate development. Ms. Pinson joined Vista Properties, Inc. (now Centex Real Estate Corporation) in March 1993 and was elected to her present positions with Holding and Development as of July 23, 1996.
All directors are elected annually by the stockholders to serve until the next annual meeting of stockholders and until their successors have been elected and qualified, subject to removal by a vote of the holders of not less than two-thirds of the outstanding shares of the common stock, par value $1.00 per share, of Development. All executive officers of Development are elected annually by the Board of Directors to serve until the next annual meeting of the Board of Directors or until their successors have been duly elected and qualified. There are no family relationships among or between Development's directors or executive officers.
The current executive officers of Development are employees of one of the subsidiaries of Centex, and it is presently anticipated that this arrangement will continue. See "Item 11. Executive Compensation".
MANAGEMENT AGREEMENT
All services (other than executive management decision-making) necessary to operate the Partnership's business are provided to the Partnership pursuant to a management agreement (the "Management Agreement") entered into with Holding. Under the Management Agreement, Holding keeps all necessary books and records, and provides all additional accounting and clerical services that Development may deem necessary. Holding's responsibilities related to real estate management also include ensuring that the Partnership's properties are operated, managed and maintained in full compliance with all relevant laws and regulations, that all real property and any improvements thereon are maintained and repaired, that all income produced by the Partnership's properties is collected and that any development on any property is done in an efficient manner. Because Holding currently does not have any employees, it contracts with Centex subsidiaries to provide such services to the Partnership.
Holding is entitled to reimbursement from the Partnership for all reasonable costs and expenses incurred and paid by Holding in connection with the performance of its duties and obligations under the Management Agreement, plus a $25,000 quarterly managerial fee. During fiscal 1999, Holding received $713,000 from the Partnership for its services.
The Management Agreement also provides that Holding will provide, consistent with the Plan, pre-development and development services on behalf of the Partnership, and the Management Agreement specifically provides that Holding is delegated full authority to carry out and perform on behalf of the Partnership all aspects of the Plan.
The term of the Management Agreement is subject to automatic renewal for successive one-year terms unless either party elects to terminate the Management Agreement upon at least 30 days written notice prior to December 31 of any year. However, it may not be terminated by the Partnership (other than in the event of a breach by Holding constituting gross negligence or willful or wanton misconduct) prior to the latest of the complete detachment of the Stockholder Warrants from Centex Common Stock, Payout or the payment in full of the Holding Note.
From time to time, Holding delegates the performance of certain of its responsibilities to Centex Service Company and other Centex subsidiaries, upon terms and conditions to be determined. These responsibilities may include enhancement of properties owned or controlled by the Partnership, for which reasonable additional compensation may be paid by the Partnership to Holding pursuant to terms to be negotiated between them. In turn, some or all of such additional compensation may be paid by Holding to Centex Service Company or other Centex subsidiaries.
ITEM 11. EXECUTIVE COMPENSATION
Holding and the Partnership
The information called for by this Item 11 with respect to Holding and the Partnership is incorporated herein by reference to the information included and referenced under the caption "Executive Compensation" in the 1999 Holding Proxy Statement.
The Partnership does not have any directors, officers or employees, and is managed by its sole general partner, Development. Except for the allocations of profit and loss and distributions of cash and other property to which Development is entitled under the Partnership Agreement, and except for the right to be reimbursed for certain expenses, Development does not receive any compensation from the Partnership with respect to its duties and obligations as general partner for the Partnership. As general partner, Development is entitled to be allocated certain items of income and loss of the Partnership and to receive certain distributions of cash from the Partnership depending upon the level of income and cash available for distribution and whether Payout has occurred. The terms and conditions upon which Development will be allocated items of income and loss and will receive distributions are set forth in the Partnership Agreement. For a summary of these rights and benefits, see Note (H) of the Notes to the Holding/Partnership Combining Financial Statements included on pages 96-97 of this Report.
The directors and executive officers of Development perform all executive management functions for the Partnership. See "Item 10. Directors and Executive Officers of the Registrant". Services required by the Partnership in its operations are also provided pursuant to a Management Agreement with Holding pursuant to which Holding operates, manages and develops the properties of the Partnership for and on behalf of the Partnership. See "Item 10. Directors and Executive Officers of the Registrant--Management Agreement". The executive officers of Development did not receive any remuneration from Development or the Partnership for the year ended March 31, 1999. Directors of Development who are neither officers nor employees of Development, Centex or Centex's subsidiaries received compensation from Development in the form of directors' and committee members' fees. During the 1999 fiscal year, each executive officer of Development received remuneration from Centex or one of its subsidiaries in his capacity as a director, officer or employee thereof. None of the directors or executive officers of Development received any additional compensation from Centex or any of its subsidiaries for services rendered on behalf of Development or the Partnership during the 1999 fiscal year.
During fiscal 1999, Richard C. Decker, Chairman, President and Director and Kimberly A. Pinson, Vice President, Treasurer, Controller and Assistant Secretary of Development, both of whom are employees of subsidiaries of Centex, have devoted a majority of their time and attention to the management of Development and Holding. Mr. Decker and Ms. Pinson provided such services to Development on behalf of and in their capacities as officers of Holding pursuant to the Management Agreement. Each current executive officer of Development continues to receive remuneration from Centex or one of its subsidiaries in his capacity as an officer or employee thereof and is not compensated by Development or the Partnership.
The directors of Development, who also hold the same directorships in Holding and are neither officers nor employees of Development, Centex or Centex's subsidiaries, each receive directors' fees annually in their capacities as directors of Development ($10,000) and Holding ($10,000). Each director who is neither an officer nor an employee of Development, Centex or a subsidiary of Centex, also receives $1,500 per meeting for each board meeting attended of Development and Holding. During fiscal 1999, board meeting fees of $4,500 for Development and $4,500 for Holding were paid to each
director eligible for payment. In addition, Development reimburses these directors for the reasonable expenses incurred in attending directors' and committee meetings.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
(a) Holding
The information called for by this Item 12 with respect to Holding is incorporated herein by reference to the information included and referenced under the caption "Security Ownership of Management and Certain Beneficial Owners" in the 1999 Holding Proxy Statement.
(b) The Partnership
The following table sets forth certain information with respect to the ownership of the equity securities of the Partnership as of May 3, 1999 by Development, the directors of Development, individually itemized, all directors and executive officers of Development as a group, and any person known to the Partnership to be the beneficial owner of more than 5% of any class of the Partnership's equity securities. Except as otherwise indicated, all securities are owned directly, and the beneficial owner of such securities has the sole voting and investment power with respect thereto.
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* Under the terms of the Partnership Agreement, the Partnership is managed by a sole corporate general partner and none of the present classes of the Partnership's securities are "voting securities" within the meaning of the rules and regulations of the Commission promulgated pursuant to the Exchange Act. Nonetheless, information with respect to each class of the Partnership's equity securities has been set forth in accordance with such rules and regulations.
** The address of any person who is the beneficial owner of more than five percent of a class of the Partnership's securities is also included.
*** Less than 1%.
(1) In connection with the formation of the Partnership, Development made a capital contribution to the Partnership of $767,182, in exchange for Development's general partner interest in the Partnership. As general partner, Development is entitled to receive allocations of income and loss and distributions of property from the Partnership.
(2) The Class A Units were issued to the Original Limited Partners in exchange for the acquisition of the Original Properties by the Partnership. Record title to the Class A Units presently is held by Centex Homes. See "Item 1. Business--General Development of Business". As of the date or dates when the Stockholder Warrants are deemed to have been exercised, the Class A Units and Class C Units will be automatically converted collectively into (i) a number of Class B Units equal to 20% of the total number of Class B Units that would be outstanding after conversion based on the actual exercise of the Stockholder Warrants and the assumed exercise of all the then exercisable Centex Class B Unit Warrants (see footnote (3)) and (ii) a like number of Class A Units and Class C Units. The Class A Units and Class C Units will be automatically canceled upon Payout and the exercise and/or expiration of all of the Stockholder Warrants and the Centex Class B Unit Warrants.
(3) The Nominee holds record title to the Stockholder Warrants, which are exercisable for Class B Units, for the benefit of Centex Stockholders pursuant to the Nominee Agreement. See "Item 5.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) Holding
The information called for in Item 13 with respect to Holding is incorporated herein by reference to the information included under the caption "Certain Transactions" in the 1999 Holding Proxy Statement.
(b) The Partnership
Holding entered into a services agreement in May 1987 with Centex Service Company, whereby Centex Service Company provides certain tax, accounting and other services for Holding at a fee of $2,500 per month. In April 1998, the services agreement was amended to also include certain real estate development and management services and the related fee increased to $30,000 per month. Service fees of $360,000 were paid pursuant to this agreement for fiscal 1999.
The Partnership has entered into an agreement with Holding to provide management services to the Partnership in connection with the development, operation and maintenance of the Partnership property and other administrative services. Management fees and reimbursable costs totaling $713,000 were incurred under this agreement during fiscal 1999.
In connection with Holding's acquisition of additional shares of common stock of Development in 1987, Holding borrowed $7,700,000 from Centex pursuant to a secured promissory note (the "Holding Note"). The Holding Note, which had a fluctuating balance, bore interest, payable quarterly, at the prime rate of interest of NationsBank, N.A. ("NationsBank") plus 1%. On May 29, 1998, the outstanding principal balance of the Holding Note was repaid. The Holding Note was secured by a pledge of all the issued and outstanding shares of Development, and such pledge has been terminated. There was interest expense of $62,000 related to the Holding Note for the year ended March 31, 1999.
In 1987, Development advanced $7,700,000 to a wholly-owned subsidiary of Centex pursuant to an unsecured note and related loan agreement. The note bore interest, payable quarterly, at the prime rate of interest of NationsBank plus 7/8%. On May 29, 1998, the outstanding principal balance on the note was repaid. Fiscal year 1999 interest income on the note totaled $116,000.
In fiscal 1999, the Partnership sold to Centex Homes certain tracts of land for $3,364,000. Centex Homes has agreements to purchase an additional 659 lots from the Partnership.
Centex Homes had guaranteed a $5,000,000 bank line of credit for the Partnership to utilize in conjunction with development of lots to be sold to Centex Homes. This line of credit was repaid and canceled on April 15, 1998.
During fiscal 1998, the Partnership Agreement governing the Partnership was amended to allow for the issuance of Class C Units, to be issued in exchange for assets acquired from a limited partner or from an entity who is to be admitted as a limited partner. During fiscal 1999, the Partnership acquired assets valued at $19,445,000 in exchange for 19,445 Class C Units.
In April 1998, a 49% owned subsidiary of the Partnership purchased for $3.1 million the real estate development properties of an indirect subsidiary of Centex Real Estate Corporation. In connection with the transaction, the Partnership's subsidiary may borrow up to $500,000 on a revolving basis from Centex Corporation.
During fiscal 1999, the Partnership, through its operating subsidiaries, had contracts with certain of Centex's construction subsidiaries totaling $43.2 million for the construction of multi-family apartments and an office building. During fiscal 1999, $19.3 million was paid to Centex's construction subsidiaries pursuant to the contracts.
Fairclough Acquisition
In connection with the Fairclough acquisition certain obligations of the purchaser, a wholly-owned subsidiary of the Partnership, were guaranteed by the Partnership, including payment under two notes for a major portion of the $225 million purchase price, and payment of the dividends due to the seller from April 1, 1999 through March 31, 2001. Centex Homes, the sole limited partner of the Partnership, has agreed that if the Partnership does not have sufficient funds to satisfy its obligations (excluding any payment under the negotiable note), Centex Homes will make such capital contributions to the Partnership as are necessary to enable the Partnership to satisfy such obligations (again excluding any payment under the negotiable note).
In addition, Centex agreed that if Centex Homes does not perform its obligations, Centex will take appropriate action to cause the performance of those obligations.
Payment of the negotiable note is primarily secured by a letter of credit issued by a United Kingdom bank. In order to obtain the letter of credit, the Partnership guaranteed payment of the principal amount when due to the bank. Centex also provided an assurance to the bank that if the Partnership does not meet its obligations, Centex will cause the Partnership to have sufficient funds to perform its obligations, primarily through Centex's purchase of limited partnership units in the Partnership.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Report:
(1) EXHIBITS
(A) Holding
The information on exhibits required by this Item 14 is set forth in the Holding Index to Exhibits appearing on pages 117-118 of this Report.
(B) The Partnership
The information on exhibits required by this Item 14 is set forth in the Partnership Index to Exhibits appearing on pages 119-122 of this Report.
(b) Reports on Form 8-K:
Neither Holding nor the Partnership filed any reports on Form 8-K during the quarter ended March 31, 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
3333 HOLDING CORPORATION ------------------------------------------------ Registrant
June 22, 1999 By: /s/ RICHARD C. DECKER ------------------------------------------------ Richard C. Decker, Director, Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
June 22, 1999 /s/ RICHARD C. DECKER ------------------------------------------------ Richard C. Decker, Director, Chairman, President and Chief Executive Officer (principal executive officer)
June 22, 1999 /s/ KIMBERLY A. PINSON ------------------------------------------------ Kimberly A. Pinson, Vice President, Treasurer, Controller and Assistant Secretary (principal financial officer and principal accounting officer)
Directors: Richard C. Decker, Josiah O. Low, III and David M. Sherer
June 22, 1999 By: /s/ RICHARD C. DECKER ------------------------------------------------ Richard C. Decker, Individually and as Attorney-in-Fact*
- ---------------
*Pursuant to authority granted by powers of attorney, copies of which are filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, 3333 Development Corporation, as general partner of, and on behalf of, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CENTEX DEVELOPMENT COMPANY, L.P. ------------------------------------------------ Registrant
By: 3333 Development Corporation, General Partner
June 22, 1999 By: /s/ RICHARD C. DECKER ------------------------------------------------ Richard C. Decker, Director, Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of 3333 Development Corporation, as general partner of, and on behalf of, the registrant in the capacities and on the dates indicated.
June 22, 1999 /s/ RICHARD C. DECKER ------------------------------------------------ Richard C. Decker, Director, Chairman, President and Chief Executive Officer (principal executive officer)
June 22, 1999 /s/ KIMBERLY A. PINSON ------------------------------------------------ Kimberly A. Pinson, Vice President, Treasurer, Controller and Assistant Secretary (principal financial officer and principal accounting officer)
Directors: Richard C. Decker, Josiah O. Low, III and David M. Sherer
June 22, 1999 By: /s/ RICHARD C. DECKER ------------------------------------------------ Richard C. Decker, Individually and as Attorney-in-Fact* - ------------ *Pursuant to authority granted by powers of attorney, copies of which are filed herewith.
INDEX TO EXHIBITS
CENTEX CORPORATION AND SUBSIDIARIES
INDEX TO EXHIBITS
CENTEX CORPORATION AND SUBSIDIARIES--CONTINUED
INDEX TO EXHIBITS
CENTEX CORPORATION AND SUBSIDIARIES--CONTINUED
- ------------ * Management contract or compensatory plan or arrangement
INDEX TO EXHIBITS
3333 HOLDING CORPORATION AND SUBSIDIARY
INDEX TO EXHIBITS
3333 HOLDING CORPORATION AND SUBSIDIARY--CONTINUED
- -----------
INDEX TO EXHIBITS
CENTEX DEVELOPMENT COMPANY, L.P. AND SUBSIDIARIES
INDEX TO EXHIBITS
CENTEX DEVELOPMENT COMPANY, L.P. AND SUBSIDIARIES --CONTINUED
INDEX TO EXHIBITS
CENTEX DEVELOPMENT COMPANY, L.P. AND SUBSIDIARIES --CONTINUED
INDEX TO EXHIBITS
CENTEX DEVELOPMENT COMPANY, L.P. AND SUBSIDIARIES--CONTINUED
- ---------- | 13,205 | 88,933 |
1059498_1999.txt | 1059498_1999 | 1999 | 1059498 | ITEM 1. BUSINESS
UNLESS THE CONTEXT OTHERWISE REQUIRES: (I) THE "COMPANY" REFERS TO AMERICAN LAWYER MEDIA, INC. AND ITS SUBSIDIARIES; AND (II) "HOLDINGS" REFERS TO AMERICAN LAWYER MEDIA HOLDINGS, INC., WHICH IS THE PARENT COMPANY OF THE COMPANY, AND TO HOLDINGS' PREDECESSOR, CRANBERRY PARTNERS, LLC. REFERENCES HEREIN TO THE COMPANY'S ESTIMATED CIRCULATION INCLUDE TOTAL PAID AND FREE CIRCULATION FOR ALL OF THE COMPANY'S PERIODICALS. REFERENCES HEREIN TO READERSHIP INCLUDE ESTIMATED CIRCULATION PLUS COMBINED PASS-ALONG READERSHIP UNADJUSTED FOR ANY OVERLAP THAT EXISTS AMONG READERS OF THE COMPANY'S VARIOUS PUBLICATIONS.
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS ARE BASED UPON THE BELIEFS AND ASSUMPTIONS OF, AND ON INFORMATION AVAILABLE TO, THE MANAGEMENT OF THE COMPANY AT THE TIME SUCH STATEMENTS ARE MADE. THE FOLLOWING ARE OR MAY CONSTITUTE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: (I) STATEMENTS PRECEDED BY OR FOLLOWED BY OR THAT INCLUDE THE WORDS "MAY," "WILL," "COULD," "SHOULD," "BELIEVE," "EXPECT," "FUTURE," "POTENTIAL," "ANTICIPATE," "INTEND," "PLAN," "ESTIMATE" OR "CONTINUE" OR THE NEGATIVE OR OTHER VARIATIONS THEREOF AND (II) STATEMENTS REGARDING MATTERS THAT ARE NOT HISTORICAL FACTS. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES, INCLUDING WITHOUT LIMITATION, (I) GENERAL ECONOMIC CONDITIONS AND DEVELOPMENTS IN THE LEGAL SERVICES INDUSTRY OR THE PUBLISHING INDUSTRY, (II) PRODUCT DEMAND AND PRICING, (III) THE SUCCESS OF NEW INITIATIVES, (IV) INCREASED COMPETITION WITH RESPECT TO SERVICES IT PROVIDES AND FOR ADVERTISING AND SUBSCRIPTION REVENUE, AND (V) SUFFICIENCY OF CASH FLOW TO FUND ITS OPERATIONS.
COMPANY OVERVIEW
The Company publishes 22 periodicals serving legal and business professionals, including several leading national periodicals and regional publications serving four of the five largest state legal markets. The Company's nationally-recognized periodicals include THE AMERICAN LAWYER, a monthly magazine containing articles and features targeted to attorneys practicing in large law firms, and THE NATIONAL LAW JOURNAL, the nation's largest selling legal newspaper, which covers the law, lawyers and the business of the legal profession. The Company's regional publications are led by the NEW YORK LAW JOURNAL, which has the largest paid circulation of any regional legal newspaper in the United States. In addition to the NEW YORK LAW JOURNAL, the Company publishes seven other daily newspapers serving Atlanta, Philadelphia, Northern California, Miami, Fort Lauderdale and Palm Beach, as well as eight weekly newspapers serving New Jersey, Delaware, Texas, Washington, D.C., Connecticut, California, Georgia and Pennsylvania. In September 1999, the Company launched THE DAILY DEAL, a daily publication and Web site that focuses on international deals and the deal-making community of bankers, accountants, lawyers, venture capitalists and business professionals, which the Company sold in March 2000. See RECENT DEVELOPMENTS.
In addition to the periodicals referred to above, the Company publishes CORPORATE COUNSEL, a leading magazine for corporate in-house attorneys, LAW TECHNOLOGY NEWS and AMLAW TECH, two leading legal technology magazines, as well as IP WORLDWIDE, a leading specialty magazine focusing on intellectual property.
The Company also creates and packages information for attorneys and business professionals through its Professional Information division. This business includes a portfolio of publications covering a variety of specialized legal interests and practice areas, including 37 newsletters and 111 books on topics of national and regional interest. The Company also publishes various directories used by legal professionals.
The Company, under its LegalTech trademark, is a leading producer of trade shows and conferences relating to law practice technology. In addition, the Company organizes and sponsors numerous professional seminars and conferences that cover issues of current legal interest.
The Company derives its revenues principally from advertising and subscriptions, with additional revenues generated by its Professional Information division and its LegalTech and seminars divisions. For
the twelve months ended December 31, 1999, approximately 57% of the Company's revenues were from advertising, 18% were from subscriptions, 24% were from ancillary products and services and 1% were from Internet services.
At the beginning of 1999, the Company's Internet business consisted of various web sites that offered a myriad of legal resources to serve lawyers, legal professionals, law students, business people and consumers. Its Law News Network site (www.lawnewsnetwork.com), launched in December 1998, provided updated legal news and information from the Company's publications as well as original content, online advertising and specialized legal subscription services. The Company's Internet business also included Law Journal Information Systems, a division which included MA/3000, a case tracking and docketing software package that allows litigators to track court activity published in the NEW YORK LAW JOURNAL, and QDS, which offers subscribers faxed copies on request of both published and unpublished state and federal court opinions for New York.
In May 1999, the Company reorganized its Internet business under a wholly-owned subsidiary, Professional On-Line, Inc. In July 1999, the Company completed the sale of its Internet business to Law.com, Inc. ("Law.com"), the holding company for a leading Internet destination for legal information, e-commerce and e-services, for $1.0 million in cash and the Company retained a preferred stock interest with a face amount of $3.75 million. The sale consisted of various national and regional web sites of Law News Network, the uniform resource locators for these web sites and substantially all of the Law Journal Information Systems division. In December 1999, Law.com redeemed all of the preferred stock for $3.75 million plus accrued dividends.
As part of the sale, the Company entered into a license agreement with Law.com, which provides for an exclusive license to Law.com of digital and electronic distribution rights to all of the Company's content through 2004.
PRODUCT LINES
PERIODICALS. The Company's newspaper and magazine business publishes 22 national, regional and local periodicals that serve legal and business professionals. The Company's periodicals have a combined circulation of approximately 300,000. The subscription renewal rate for the Company's periodicals has historically averaged approximately 80%.
NEWSPAPERS. The Company's newspapers provide news, features, analysis and commentary about the world of law and advocacy. Feature articles and stories covering the local, state and federal courts and law firms are supplemented by reports and analyses of cutting-edge legal issues. The Company is committed to providing high quality and balanced coverage of its local markets. Most of the Company's newspapers serve as the newspaper of record for their respective legal markets. Lawyers look to the newspapers for reports on local court rulings and opinions, as well as information regarding local court dockets.
As of December 31, 1999, the Company published sixteen daily and weekly newspapers including THE NATIONAL LAW JOURNAL, the leading national legal newspaper in the United States, and the NEW YORK LAW JOURNAL, which has the largest circulation of any regional legal newspaper. In the aggregate, the Company's newspapers serve nine state markets, including New York, New Jersey, Pennsylvania, Georgia, Florida, Texas, California, Connecticut and Delaware, and the District of Columbia, which cover approximately 45% of all active attorneys in the United States. Each of the Company's regional newspapers has a significant presence in its respective market.
The following table sets forth information regarding the Company's newspapers:
NEWSPAPERS
- ------------------------
(1) References in the table above to the Company's total circulation include total paid and free circulation.
(2) References in the table above to the Company's estimated total readership include total circulation plus combined pass-along readership unadjusted for any overlap that exists among readers of the Company's various publications.
(3) CALIFORNIA LAW WEEK ceased publishing in December 1999.
(4) For these recently launched publications, insufficient information is currently available.
(5) In March 2000, the Company sold THE DAILY DEAL. See RECENT DEVELOPMENTS.
MAGAZINES. THE AMERICAN LAWYER anchors the Company's magazine portfolio. Founded in 1979, THE AMERICAN LAWYER is a glossy magazine that features stories on the strategies, successes, failures and personalities of the most important figures in the legal world. The target audience for the publication is attorneys practicing in large law firms and corporate legal departments across the United States. THE AMERICAN LAWYER has been the winner of National Magazine awards granted by the American Society of Magazine Editors four times, and has been nominated for 22 such awards since its founding.
The Company's other magazines focus on specific practice areas or segments within the legal profession and certain topics applicable to the business of law. The Company's specialty legal magazines include CORPORATE COUNSEL, one of the nation's largest magazines focused on issues of importance to in-house lawyers at large and mid-size corporations, and IP WORLDWIDE, which covers developments in intellectual property law. The Company also publishes two leading technology magazines targeted to the legal community, AMLAW TECH and LAW TECHNOLOGY NEWS, which focus on information technology and its applications to the practice of law. AMLAW TECH is targeted toward persons at law firms with purchase-
making authority and is distributed to all readers of THE AMERICAN LAWYER, while LAW TECHNOLOGY NEWS is targeted toward attorneys and information services departments in law offices. At the end of 1999, the Company introduced L magazine, a law and lifestyle quarterly publication for law students.
The Company publishes the following six magazines:
MAGAZINES
- ------------------------
(1) References in the table above to the Company's total circulation include total paid and free circulation.
(2) References in the table above to the Company's estimated total readership include total circulation plus combined pass-along readership unadjusted for any overlap that exists among readers of the Company's various publications.
(3) AMLAW TECH is distributed for free to subscribers of THE AMERICAN LAWYER.
(4) These magazines are distributed primarily free of charge. For these publications, the Company assumes only two readers per copy.
(5) L was only distributed once in 1999, as it was founded in December.
NEWSLETTERS. The Company's newsletter division publishes 37 newsletters that cover specialized legal practice areas. Circulation for the Company's newsletters ranges from approximately 250 to 2,000, with an average circulation of over 700. The total number of paid subscribers for all newsletters was approximately 18,200 as of December 31, 1999. In February 2000, the Company discontinued publication of four of its weekly newsletters. See RECENT DEVELOPMENTS. The following table sets forth a list of the Company's newsletters as of December 31, 1999:
NEWSLETTERS
Accounting for Law Firms
The Bankruptcy Strategist
Broadcast Law Report
Business Crimes Bulletin
Commercial Leasing Law & Strategy
Corporate Control Alert
Corporate Law Weekly
The Corporate Counsellor
Criminal Justice Weekly
Employment Law Strategist
Employment Law Weekly
Entertainment Law & Finance
Environmental Compliance and Litigation Strategy
Equipment Leasing
E-Commerce Law Weekly
E-Commerce Law & Strategy
e Securities
Fen Phen Litigation Strategist
Healthcare Fraud and Abuse
The Intellectual Property Law Strategist
The Internet Newsletter: Legal & Business Aspects
IP Law Weekly
Law Firm Partnership & Benefits Report
Leader's Franchising Business & Law Alert
Legal Tech
Managed Care Law Strategist
Marketing for Lawyers
The Matrimonial Strategist
Medical Malpractice Law & Strategy
Medical/Legal Aspects of Breast Implants
New York Employment Law & Practice
New York Family Law Monthly
New York Real Estate Law Reporter
Personal Injury Reporter
Product Liability Law & Strategy
Securities Law Weekly
Shopping Center Law Report
BOOKS. The Company currently publishes 111 books on a broad array of legal topics. These books generally focus on practical legal subjects that arise in the daily professional lives of lawyers. Most of the Company's books are updated once or twice per year with inserts to keep the material current. The Company focuses on publishing books that cover particularly dynamic areas of law that lend themselves to frequent supplementation.
The Company most often develops the concept for a new book and then solicits an author to write the text. However, in certain cases, the Company has received unsolicited manuscripts which it has ultimately published. Authors who have written books for the Company include prominent attorneys and judges such as Martin Lipton, Judge Jed Rakoff, James Freund and James Goodale. The following tables set forth the Company's current offering of books:
BOOKS
STATE AND LOCAL SUBJECTS
Encyclopedia of New Jersey Causes of Action Georgia Bench Book 1999 Harris County Bench Book Supplement (Texas) Texas Auto Insurance Policy Annotated Marketing and Maintaining a Family Law Mediation Practice Mediation: A Texas Practice Guide New Jersey Brownfields Law New Jersey Employment Law New Jersey Federal Civil Procedure New Jersey Insurance Law New Jersey Product Liability Law New York County Bench Book 2000 Pennsylvania Tax Handbook Pennsylvania District and County Reports Pennsylvania Court Rules Pennsylvania: The Legal Directory Pleadings and Pretrial Practice (Connecticut) Representing Clients in Mediation 1999 Tarrant County Bench Book (Texas) 1999-2000 Texas Criminal Codes and Rules, Annotated 2000 Assigned Judges Bench Book
NATIONAL SUBJECTS
A Practical Guide to Equal Employment Opportunity A Practical Guide to the Occupational Safety and Health Act Acquisitions Under the Hart-Scott-Rodino Antitrust Improvements Act All About Cable Alternative Dispute Resolution in the Work Place Anatomy of a Merger: Strategies and Techniques for Negotiating Corporate Acquisitions Antitrust Basics Antitrust: An Economic Approach Changing the Situs of a Trust Class Actions: The Law of 50 States Communications Law and Practice Computer Law: Drafting and Negotiating Forms and Agreements Corporate Internal Investigations
Corporate Privileges and Confidential Information Corporate Sentencing Guidelines: Compliance and Mitigation Divorce, Separation and the Distribution of Property Doing Business on the Internet: Forms and Analysis Due Diligence in Business Transactions Employee Benefits Law: ERISA and Beyond Encyclopedia of Matrimonial Clauses Environmental Enforcement: Civil and Criminal Environmental Law Lexicon Environmental Regulation of Real Property Estate Planning Executive Compensation Executive Stock Options and Stock Appreciation Rights Federal Bank Holding Company Law Federal Rules of Civil Procedure Federal Taxation of Intellectual Property Transfers Federal Taxation of Real Estate Federal Taxation of S Corporations Federal Trade Commission: Law, Practice and Procedure Ferrara on Insider Trading and The Wall Franchising: Realities and Remedies Franchising: Realities and Remedies Forms Volume Going Private Grand Jury Practice Ground Leases and Land Acquisition Contracts Health Care Fraud: Enforcement and Compliance Hospital Liability "I'd Rather Do It Myself": How to Set Up Your Own Law Firm Insurance Coverage Disputes Intellectual Property Law: Commercial, Creative and Industrial Property Intellectual Property Licensing Forms and Analysis Internet and Online Law Law Firm Accounting and Financial Management Law Firm Partnership Agreements Lawyering: A Realistic Approach to Legal Practice Legal Research and Law Library Management Lender Liability and Banking Litigation Licensing of Intellectual Property Limited Liability Companies and Limited Liability Partnerships Marketing the Law Firm: Business Development Techniques Maximizing Law Firm Profitability: Hiring, Training and Developing Productive Lawyers Merit Systems Protection Board: Rights and Remedies Model Terms of Engagement Modern Visual Evidence Multimedia Law: Forms and Analysis Negotiated Acquisitions of Companies, Subsidiaries and Divisions Negotiating and Drafting Office Leases Negotiation: Strategies for Law and Business Partnership and Joint Venture Agreements Private Equity Funds: Business Structure & Operations Private Real Estate Syndications
Product Liability Product Liability: Winning Strategies and Techniques Products Liability: Recreation and Sports Equipment Real Estate, A Guide for the Profession Real Estate Financing Reorganizations under Chapter 11 of the Bankruptcy Code Representing High-Tech Companies RICO: Civil and Criminal, Law and Strategy Savings Institutions: Mergers, Acquisitions and Conversions Securities Practice and Electronic Technology Securities Regulation: Liabilities and Remedies Sex Discrimination and Sexual Harassment in the Workplace Shareholder Derivative Litigation: Besieging the Board Shopping Center and Store Leases Start-Up and Emerging Companies: Planning, Financing and Operating the Successful Business State Antitrust Law Structured Settlements and Periodic Payment Judgments Takeovers and Freezeouts Tax Aspects of Divorce and Separation The Law and Practice of Secured Transactions: Working with Article 9 The Preparation and Trial of Medical Malpractice Cases Trade Secrets Travel Law Use of Statistics in Equal Employment Opportunity Litigation White Collar Crime: Business and Regulatory Offenses Winning Attorney's Fees from the U.S. Government
CONFERENCES AND SEMINARS. Under its LegalTech tradename, the Company produces conferences and exhibitions relating to law practice technology in New York, Los Angeles, Chicago, Miami, Atlanta and Houston. In 2000, the Company plans to produce Legal Tech shows in New York, Los Angeles, Chicago, Miami, Atlanta, Dallas, Toronto, Canada and London, England. The conferences are generally three-day events that include vendor exhibits, a seminar program and a variety of workshops and focus sessions. Attendees typically include attorneys in private practice, corporate counsel, law firm administrators and information technology personnel, while exhibitors include a variety of software, hardware, publishing and other technology product related companies. The Company conducts a number of seminars for lawyers and other professionals in related fields. The Company's seminars complement its other products and services both by serving as powerful marketing vehicles for the Company's existing books and newsletters and by generating ideas for new seminars, books and newsletters. Seminars also introduce the Company to lawyers who may subsequently write articles or books for the Company. The following table sets forth the seminars and conferences held in 1999:
SEMINARS
Civil Litigation Practice Year 2000 Litigation Acquisitions Of Subsidiaries, Divisions and Private Companies Distribution and Dealer Termination Failure to Diagnose Breast Cancer Computer Law General Counsel Conference Negotiating Joint Ventures and Strategic Alliances Failure to Diagnose Fetal Distress
Counseling Start-up and Emerging Companies Negotiating the Modern Lease Law Firm Marketing Beyond the New Millennium Negotiating Contracts in the Entertainment Industry Trial of Obstetrical Malpractice Case Negotiating Corporate Acquisitions Internet Security Summit International Money Laundering China Update Avoiding Ethical Pitfalls Facing Experienced Practitioners Ethics in the 21(st) Century Ethics for Corporate Lawyers and Business Litigators Internet and Electronic Commerce
CONFERENCES
LegalTech New York (January) LegalTech Miami LegalTech Los Angeles LegalTech New York (September) LegalTech Chicago LegalTech Houston LegalTech Atlanta
PRINTING AND DISTRIBUTION
Layouts for the Company's publications are prepared in-house, while the large majority of the Company's printing activities, and all of its distribution activities, are outsourced.
COMPETITION
The Company competes for advertising and subscription revenues with publishers of special-interest legal newspapers and magazines with similar editorial content. However, in most of the Company's markets, its newspaper is the only newspaper focused on serving the legal community. The Company also competes for advertising revenues with other national legal publications, as well as general-interest magazines and other forms of media, including broadcast and cable television, radio, direct marketing and electronic media. Factors that may affect competition for advertisers include effective costs of such advertising compared to other forms of media, and the size and characteristics of the readership of the Company's publications. The Company also faces significant competition from other legal publishers and legal service providers in all media.
INTELLECTUAL PROPERTY
The Company owns a number of registered and unregistered trademarks for use in connection with its business, including trademarks in the titles of its major periodicals such as THE AMERICAN LAWYER, CORPORATE COUNSEL, THE NATIONAL LAW JOURNAL and NEW YORK LAW JOURNAL. Provided that trademarks remain in continuous use in connection with similar goods or services, their term can be perpetual, subject, with respect to registered trademarks, to the timely renewal of such registrations in the United States Patent and Trademark Office.
The Company approaches copyright ownership with respect to its publications in the same manner as is generally customary within the publishing industry. Consequently, the Company owns the copyright in all
of its newspapers, magazines and newsletters, as compilations, and also owns the copyright in most of its books. With respect to the specific articles in its publications, the Company generally obtains the assignment of all right, title and interest in original materials created by the Company's full-time journalists and editors as well as by paid contributors. For articles authored by outside contributors, the Company generally obtains only the exclusive "first-time publication" and non-exclusive republication rights. Judicial opinions, court schedules and docketing information are provided to the Company directly by the courts, on a non-exclusive basis, and are public information. In connection with the sale of the Company's Internet business to Law.com, the Company entered into an exclusive content license with Law.com which grants Law.com the right to publish all Company content in electronic or digital format. The license runs through 2004.
The Company licenses the content of certain of its publications and forms to third parties, including West Publishing Company and LEXIS/NEXIS, on a non-exclusive basis, for republication and dissemination on electronic databases marketed by the licensees. After the expiration of their initial terms (the latest of which is September 2002 and May 2002, respectively), the licenses automatically renew, subject to either parties' right to terminate at the end of each subsequent term.
Some of the Company's products, such as the DAILY DECISION SERVICE and PICS, which offers subscribers faxed copies on request of both published and unpublished state and federal court opinions for New Jersey and Pennsylvania, respectively, utilize the extensive databases of court decisions compiled by the Company. The Company also has extensive subscriber and other customer databases which it believes would be extremely difficult to replicate. The Company attempts to protect these databases and lists as trade secrets by restricting access thereto and/or by the use of non-disclosure agreements. There can be no assurance, however, that the means taken to protect the confidentiality of these items will be sufficient, or that others will not independently develop similar databases and customer lists.
EMPLOYEES AND LABOR RELATIONS
As of December 31, 1999, the Company employed approximately 960 full-time employees, 21 of whom are subject to a single collective bargaining agreement. The Company believes that its relations with its employees are satisfactory.
SIGNIFICANT TRANSACTIONS
SALE OF INTERNET ASSETS TO LAW.COM. In July 1999, the Company sold the common stock of its wholly-owned subsidiary, Professional On-Line, Inc., which held the Company's Internet business, to Law.com for $1.0 million in cash and the Company retained a preferred stock interest with a face amount of $3.75 million. In December 1999, Law.com redeemed the preferred stock for $3.75 million plus accrued dividends of $187,500. The Company and Law.com entered into an exclusive content license which grants Law.Com the right to publish all Company content in electronic or digital format through 2004 as part of the transaction. Law.com is the holding company for a leading Internet destination for legal information, e-commerce and e-services whose stockholders include substantially all of the stockholders of Holdings.
RECENT DEVELOPMENTS
RESTRUCTURING OF WEEKLY NEWSLETTER DIVISION. In February 2000, the Company restructured its weekly newsletter division by discontinuing publication of four of its weekly newsletters. The Company will continue to publish IP LAW WEEKLY and E-COMMERCE LAW WEEKLY which serve reader demand for information in these two growing practice areas.
SALE OF THE BUSINESS OF THE DAILY DEAL AND CORPORATE CONTROL ALERT. On March 28, 2000, the Company sold the business of the Company and certain of the Company's wholly-owned subsidiaries constituting THE DAILY DEAL and CORPORATE CONTROL ALERT (the "Business") to TDD, L.L.C., a newly formed limited liability company (the "Purchaser"), owned by substantially all of the same stockholders as Holdings. The
consideration for the sale was $7.5 million in cash and a $2.5 million face amount of a membership interest in the Purchaser with a preferred return (the "Preferred Membership Interest"). In addition, the Purchaser will pay the Company the aggregate amount of operating losses incurred by the Company in connection with the operation of the Business for the month of March 2000. The Preferred Membership Interest accretes at 12.25% compounded annually, is convertible into 3.0% of the common equity of the Purchaser, has anti-dilution protection for dividends in the form of additional equity interests, combinations, splits and reclassifications and has anti-dilution protection up to the first $25.0 million of equity capital including the Preferred Membership Interest issued by the Purchaser.
STOCK SPLIT. On March 7, 2000, The Board of Directors of Holdings approved a 10-for-1 split of its common stock, par value $0.01 per share. Prior to the stock split, Holdings had 200,000 shares of common stock authorized and 120,000 shares of common stock outstanding. After giving effect to the stock split, Holdings has 2,000,000 shares of common stock authorized and 1,200,000 shares of common stock outstanding.
ITEM 2.
ITEM 2. PROPERTIES
The Company operates from various locations throughout the United States. Its corporate headquarters are based in New York. Information relating to the Company's corporate headquarters and other significant regional offices which are owned or leased is set forth in the following table:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to various litigation matters incidental to the conduct of its business. The Company does not believe that the outcome of any of the matters in which it is currently involved will have a material adverse effect on its financial condition or on the results of its operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MARKETS
The Company is a wholly-owned subsidiary of American Lawyer Media Holdings, Inc. There is no public trading market for the Company's common stock.
The Company has never paid any cash dividends on its common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
In August 1997, U.S. Equity Partners, L.P. and its affiliates and certain other investors controlled by or managed by WP Management Partners, LLC., the merchant banking arm of Wasserstein Perella Group, Inc. (the "Investors"), through Holdings, acquired substantially all of the assets and assumed certain of the liabilities related to American Lawyer Media, L.P. (the "ALM Acquisition"), and in December 1997, Holdings acquired all of the issued and outstanding capital stock of National Law Publishing Company, Inc. (the "NLP Acquisition"). The two acquisitions (the "Acquisitions") have been accounted for using the purchase method of accounting. The results of operations of American Lawyer Media, L.P. have been included in the financial statements of the Company since August 1, 1997, the effective date of the ALM Acquisition, and the results of operations of National Law Publishing Company have been included in the financial statements of the Company since December 22, 1997, the closing date of the NLP Acquisition. As a result, the Acquisitions affect the Company's results of operations in certain significant respects. In connection with the ALM Acquisition, the purchase price was $63.0 million and the excess of the purchase price over the book value of net tangible assets acquired was $67.7 million. The aggregate purchase price for the NLP Acquisition was $203.2 million, and the excess of the purchase price over the book value of net tangible assets acquired was $257.6 million. The excess purchase price of both Acquisitions has been allocated to the tangible and intangible assets acquired by the Company based upon their respective fair values as of the acquisition date.
The following tables present selected historical financial information (i) for American Lawyer Media, L.P. and its subsidiaries ("Old ALM"), as of and for the years ended December 31, 1995 and 1996, (ii) for National Law Publishing Company, Inc. and its subsidiaries ("NLP"), as of and for the years ended December 31, 1995 and 1996, (iii) for Old ALM, as of and for the seven months ended July 31, 1997, (iv) for the Company, as of and for the five months ended December 31, 1997 and the years ended December 31, 1998 and 1999, and (v) for NLP, as of and for the period from January 1, 1997 through December 21, 1997. The financial data for the Company, as of and for the five months ended December 31, 1997 and the years ended December 31, 1998 and 1999, and the financial data for Old ALM for the years ended December 31, 1995 and 1996 and the seven months ended July 31, 1997 were derived from financial statements audited by Arthur Andersen LLP. The financial data for NLP as of and for the period from January 1, 1997 through December 21, 1997 were derived from financial statements audited by Arthur Andersen LLP and financial data for NLP for the years ended December 31, 1995 and 1996 were derived from financial statements audited by Leslie Sufrin and Company, P.C. Results of operations for the interim periods presented are not necessarily indicative of the results of operations for the full year. The selected financial information should be read in conjunction with MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS and the historical financial statements and notes thereto included elsewhere in this Report. See INDEX TO FINANCIAL STATEMENTS.
AMERICAN LAWYER MEDIA, L.P.
AND AMERICAN LAWYER MEDIA, INC.
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
(IN THOUSANDS)
- ------------------------------ (1) "EBITDA" is defined as income before interest, income taxes, depreciation and amortization and gain on sale of assets. EBITDA is not a measure of performance under generally accepted accounting principles ("GAAP"). Items excluded from income in calculating EBITDA are significant components in understanding and evaluating Old ALM's and ALM's financial performance. While EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operating activities and other income or cash flow statement data prepared in accordance with GAAP or as a measure of profitability or liquidity, management understands that EBITDA is customarily used in evaluating publishing companies. The EBITDA measures presented herein may not be comparable to similarly titled measures of other companies.
NATIONAL LAW PUBLISHING COMPANY, INC.
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
(IN THOUSANDS)
- ------------------------------
(1) EBITDA is not a measure of performance under GAAP. Items excluded from income in calculating EBITDA are significant components in understanding and evaluating NLP's financial performance. While EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operating activities and other income or cash flow statement data prepared in accordance with GAAP or as a measure of profitability or liquidity, management understands that EBITDA is customarily used in evaluating publishing companies. The EBITDA measures presented herein may not be comparable to similarly titled measures of other companies.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion should be read in conjunction with the SELECTED FINANCIAL DATA and the historical consolidated financial statements of the Company, including the notes thereto, included elsewhere in this Form 10-K.
OVERVIEW
In August and December 1997, the Investors consummated the ALM Acquisition and the NLP Acquisition, respectively. The Acquisitions have been accounted for using the purchase method of accounting. The results of operations of Old ALM have been included in the financial statements of the Company since August 1, 1997, the effective date of the ALM Acquisition, and the results of operations of NLP have been included in the financial statements of the Company since December 22, 1997, the closing date of the NLP Acquisition. As a result, the Acquisitions affect the Company's results of operations in certain significant respects. In connection with the ALM Acquisition, the purchase price was $63.0 million and the excess of the purchase price over the book value of net tangible assets acquired was $67.7 million. The aggregate purchase price for the NLP Acquisition was $203.2 million, and the excess of the purchase price over the book value of net tangible assets acquired was $257.6 million. The excess purchase price of both Acquisitions has been allocated to the tangible and intangible assets acquired by the Company based upon their respective fair values as of the acquisition date.
In March 1998, the Company acquired all the assets and certain liabilities of Corporate Presentations, Inc., an operator of legal technology trade shows ("LegalTech"), for approximately $10.8 million. The excess purchase price over the net liabilities acquired was $11.3 million. In April 1998, the Company acquired the legal publishing-related assets and certain liabilities of Legal Communications, Ltd. ("LCL") for approximately $20.1 million. The excess purchase price over the net assets acquired was allocated $14.3 million and $6.3 million to identified intangibles and goodwill, respectively. The allocation was based on the assets' respective fair values at acquisition date. The results of operations of these acquisitions have been included in the Company's results of operations since their respective acquisition dates.
The following table presents the results of operations (in thousands) for the years ended December 31, 1999 and 1998 and the pro forma calculation for the combined period ended December 31, 1997:
The total combined information for the period ended December 31, 1997 is derived from the financial information for Old ALM for the seven months ended July 31, 1997 and for ALM for the five months ended December 31, 1997, including adjustments for the ALM Acquisition and financial information for NLP for the period from January 1, 1997 through December 31, 1997. As a result, the financial information for the combined year ended December 31, 1997 has not been prepared on a basis in conformity with GAAP.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
For the year ended December 31, 1998, the financial results include the acquisitions of LegalTech in March 1998 and LCL in April 1998 as well as the acquisition of a regional publication entitled DELAWARE LAW MONTHLY (the "Delaware Acquisition") in October 1998, since their respective acquisition dates.
OVERVIEW. Revenues increased by $11.0 million, or 9.0%, from $121.5 million for the year ended December 31, 1998 to $132.5 million for the year ended December 31, 1999. Total operating costs and expenses increased $21.4 million, or 17.6%, from $121.8 million for the year ended December 31, 1998 to $143.2 million for the year ended December 31, 1999 due primarily to new initiatives launched by the
Company during 1999. These initiatives included the launch of a new daily publication entitled THE DAILY DEAL, a daily publication and Web site that focuses on international deals and the deal-making community of bankers, accountants, lawyers, venture capitalists and business professionals, which was sold in March 2000, and a new high-end newsletter division, which published six weekly newsletters focusing on various legal topics during 1999. As a result, the operating loss increased $10.5 million from a loss of $0.2 million for the year ended December 31, 1998 to a loss of $10.7 million for the year ended December 31, 1999 and EBITDA decreased $9.5 million, or 36.4%, from $26.1 million for the year ended December 31, 1998 to $16.6 million for the year ended December 31, 1999. Internet services revenues decreased $1.4 million, or 52.9%, from $2.6 million for the year ended December 31, 1998 to $1.2 million for the year ended December 31, 1999. Internet services expenses decreased $1.4 million, or 29.0%, from $4.7 million for the year ended December 31, 1998 to $3.3 million for the year ended December 31, 1999. The reduction in Internet services revenues and expenses in 1999 was due to the sale of the common stock of the entity holding the Company's Internet business to Law.com during the third quarter of 1999. Excluding the Internet services business and new initiatives, revenues increased $11.6 million, or 9.8%, from $118.9 million for the year ended December 31, 1998 to $130.5 million for the year ended December 31, 1999. In addition, excluding the Internet services business and new initiatives, EBITDA also increased $1.0 million, or 3.6%, from $28.1 million in 1998 to $29.1 million in 1999.
REVENUES. Advertising revenues increased $8.4 million, or 12.4%, from $67.5 million for the year ended December 31, 1998 to $75. 9 million for the year ended December 31, 1999. The acquisition of LCL accounted for $2.0 million of this increase recorded during the first quarter of this year with no revenue for LCL recorded during the first quarter of 1998. Excluding the revenues from LCL, advertising revenues increased $6.4 million, or 9.5% during 1999. This increase in advertising revenues was due to a growth in classified, law firm and legal advertising, but was partially offset by a decline in display advertising. Advertising growth was also due to an increase in advertising rates along with an increase in advertising pages.
Subscription revenue increased $0.4 million, or 1.7%, from $23.2 million for the year ended December 31, 1998 to $23.6 million for the year ended December 31, 1999. Growth in subscription revenue in 1999 resulted primarily from the acquisition of LCL at the end of the first quarter of 1998.
Revenue from ancillary products and services increased $3.6 million, or 12.7%, from $28.2 million for the year ended December 31, 1998 to $31.8 million for the year ended December 31, 1999. The acquisition of LegalTech and LCL during early 1998 accounted for approximately $2.5 million, or 69% of the growth, with no LegalTech and LCL revenues recorded during the first three months of 1998. The remaining increase was due to higher licensing and royalty fees received by the Company and to increased book and newsletter revenue. However, the increase in revenue was partially offset by lower printing revenue. In addition, lower information service income was recorded in 1999 as a result of the sale of the Company's Internet business to Law.com during the third quarter of 1999.
Revenue from Internet services decreased $1.4 million, or 52.9%, from $2.6 million for the year ended December 31, 1998 to $1.2 million for the year ended December 31, 1999. The decrease is attributable to the sale of the Company's Internet business to Law.com during the third quarter of 1999.
OPERATING COSTS AND EXPENSES. Total operating costs and expenses increased $21.4 million, or 17.6%, from $121.8 million for the year ended December 31, 1998 to $143.2 million for the year ended December 31, 1999. Included in operating costs and expenses for 1999 was $3.3 million recorded during the first quarter of 1999 for LCL and LegalTech with no expenses recorded during the same period of 1998. In addition, start-up and operating costs and expenses for the Company's new initiatives during 1999 totaled $11.2 million with no similar costs or expenses during 1998. Excluding the above-mentioned items, total operating costs and expenses increased $6.9 million, or 5.6%. The remaining increase in operating costs and expenses resulted primarily from higher costs in all categories due to the overall growth in revenues.
Editorial expenses increased $7.4 million, or 47.8%, from $15.5 million for the year ended December 31, 1998 to $22.9 million for the year ended December 31, 1999. The acquisition of LCL and start-up costs for the new initiatives accounted for $3.6 million of the increase and general salary increases and the hiring for a number of key vacant positions accounted for the remaining increase.
Production and distribution expenses increased $3.6 million, or 13.5%, from $26.3 million for the year ended December 31, 1998 to $29.8 million for the year ended December 31, 1999. The acquisition of LCL and LegalTech increased expenses by $1.3 million and the new initiatives launched during 1999 accounted for $1.4 million of the increase. Excluding the acquisitions of LCL and LegalTech and new initiatives, production and distribution expenses increased $0.9 million, or 3.3% over prior year costs. This increase primarily resulted from the introduction of a new weekly publication in California (CALIFORNIA LAW WEEK), which has since been discontinued, along with higher materials costs and increased runs in an effort to increase coverage in some markets.
Selling expenses increased $8.8 million, or 46.3%, from $19.0 million for the year ended December 31, 1998 to $27.8 million for the year ended December 31, 1999. LCL and LegalTech accounted for $1.0 million of the increase and costs incurred for the new initiatives accounted for $4.1 million of the increase. Excluding these items mentioned above, selling expenses increased $3.7 million, or 19.4%. This increase resulted primarily from higher commission costs related to an increase in revenues, increased headcount and increased direct mailing efforts and other marketing related costs.
General and administrative expenses increased $2.0 million, or 6.7%, from $30.0 million for the year ended December 31, 1998 to $32.0 million for the year ended December 31, 1999. This increase reflects $0.7 million of costs associated with the acquisitions of LCL and LegalTech. The remaining expense increase relates primarily to the launching of the new initiatives during 1999, which included increased total occupancy and other related general overhead costs.
Internet services expenses decreased $1.4 million, or 29.0%, from $4.7 million for the year ended December 31, 1998 to $3.3 million for the year ended December 31, 1999. This decrease is attributable to the sale of the Company's Internet business to Law.com during the third quarter of 1999.
Depreciation and amortization expenses increased $1.0 million, or 3.8%, from $26.3 million for the year ended December 31, 1998 to $27.3 million for the year ended December 31, 1999. An increase in amortization of goodwill during 1999 was due to the acquisitions of LCL and LegalTech during early 1998. The increase in depreciation during 1999 was due to increased capital expenditures in 1999 for new and upgraded systems in order to ensure Year 2000 compliance and to replace outdated systems with new systems and facilities to support the new initiatives and the Company's core growth.
OPERATING LOSS. As a result of the above factors, the operating loss increased $10.5 million from a $0.2 million loss for the year ended December 31, 1998 to a $10.7 million loss for the year ended December 31, 1999. EBITDA decreased $9.5 million, or 36.4%, from $26.1 million for the year ended December 31, 1998 to $16.6 million for the year ended December 31, 1999. Excluding the Internet services business and new initiatives, EBITDA increased $1.0 million, or 3.6% from $28.1 million at December 31, 1998 to $29.1 million at December 31, 1999.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
The following discussion includes the year ended December 31, 1997 which is derived from the financial information for Old ALM for the seven months ended July 31, 1997 and for ALM for the five months ended December 31, 1997, including adjustments for the ALM Acquisition, and financial information for NLP for the periods from January 1, 1997 through December 21, 1997, presented above. As a result, the financial information for the combined year ended December 31, 1997 has not been prepared on a basis in conformity with GAAP.
For the year ended December 31, 1998, the financial results include the acquisitions of LegalTech, LCL and the Delaware Acquisition, since their respective acquisition dates.
OVERVIEW. Revenues increased by $15.1 million, or 14.2%, from $106.5 million for the year ended December 31, 1997 to $121.5 million for the year ended December 31, 1998. Total operating costs and expenses increased $10.9 million, or 9.9%, from $110.8 million for the year ended December 31, 1997 to $121.8 million for the year ended December 31, 1998, due primarily to a $14.2 million increase in depreciation and amortization resulting from the ALM and NLP Acquisitions. As a result, the operating loss decreased $4.1 million, or 94.4%, from a loss of $4.4 million for the year ended December 31, 1997 to a loss of $0.2 million for the year ended December 31, 1998, while EBITDA increased $18.3 million, or 234.9%, from $7.8 million for the year ended December 31, 1997 to $26.1 million for the year ended December 31, 1998. Internet services revenues decreased $1.8 million, or 40.3%, from $4.4 million for the year ended December 31, 1997 to $2.6 million for the year ended December 31, 1998. Internet services expenses decreased $6.4 million, or 58.0%, from $11.1 million for the year ended December 31, 1997 to $4.7 million for the year ended December 31, 1998. Also included in the operating costs and expenses for 1997 was a special compensation charge of $6.9 million reflecting stock option and bonus payments related to the sale of NLP. Accordingly, excluding the net operating loss from Internet services, the shutdown charge, and the one time special compensation charge, operating income decreased $10.5 million, or 85.4%, from $12.2 million for the year ended December 31, 1997 to $1.8 million for the year ended December 31, 1998, while EBITDA increased $3.7 million, or 15.1%, from $24.4 million to $28.1 million over the same periods.
REVENUES. Advertising revenues increased $9.6 million, or 16.5%, from $58.0 million for the year ended December 31, 1997 to $67.5 million for the year ended December 31, 1998. The acquisition of LCL accounted for $3.9 million of this increase. Without LCL, revenues increased $5.7 million, or 9.8%, due principally to an increase in advertising rates as well as an overall increase in advertising pages.
Subscription revenues increased $1.7 million, or 7.9%, from $21.5 million for the year ended December 31, 1997 to $23.2 million for the year ended December 31, 1998. This increase was primarily due to the acquisition of LCL.
Revenues from ancillary products and services increased $5.6 million, or 24.8%, from $22.6 million for the year ended December 31, 1997 to $28.2 million for the year ended December 31, 1998. The additions of LCL and LegalTech accounted for $3.1 million of the increase. The $2.5 million balance of this increase was due to an increase in the number of book updates released along with increased royalty income. In addition, a portion of book sales historically recorded in the fourth quarter were shipped and included in the first quarter results of 1998.
Revenues from Internet services decreased $1.8 million, or 40.3%, from $4.4 million for the year ended December 31, 1997 to $2.6 million for the year ended December 31, 1998. This decrease is attributable primarily to the shutdown of Counsel Connect, Old ALM's Internet service.
OPERATING COSTS AND EXPENSES. Total operating costs and expenses increased $10.9 million, or 9.9%, from $110.8 million for the year ended December 31, 1997 to $121.8 million for the year ended December 31, 1998. This increase is due to a $14.2 million increase in depreciation and amortization resulting from the ALM and NLP Acquisitions. The inclusion of $7.1 million in costs and expenses of LCL and LegalTech as well as other normal operating costs and expense increases were offset by the reduction in Internet services expenses.
Editorial expenses increased by $2.3 million, or 17.8%, from $13.2 million for the year ended December 31, 1997 to $15.5 million for the year ended December 31, 1998 as a number of key vacant positions were filled. The addition of LCL accounted for $0.7 million of the increase.
Production and distribution expenses increased $3.7 million, or 16.4%, from $22.6 million for the year ended December 31, 1997 to $26.3 million for the year ended December 31, 1998. The addition of LCL and LegalTech accounted for $2.0 million of the increase. The remainder of this increase is primarily the result of the increased book sales as well as higher paper usage at ALM's printing facilities.
Selling expenses increased $2.5 million, or 15.1%, from $16.5 million for the year ended December 31, 1997 to $19.0 million for the year ended December 31, 1998. This increase is primarily the result of the additions of LCL and LegalTech.
General and administrative expenses increased $4.6 million, or 18.2%, from $25.4 million for the year ended December 31, 1997 to $30.0 million for the year ended December 31, 1998. This increase reflects $2.0 million of costs associated with the addition of LCL and LegalTech. The balance of the increase is primarily the result of transition costs associated with the Company's new corporate structure and salary increases.
Internet services expenses decreased $6.4 million, or 58.0%, from $11.1 million for the year ended December 31, 1997 to $4.7 million for the year ended December 31, 1998. This decrease is the direct result of the shutdown of Counsel Connect.
Depreciation and amortization expenses increased $14.2 million, or 116.5%, from $12.1 million for the year ended December 31, 1997 to $26.3 million for the year ended December 31, 1998. These expenses are not comparable for the two periods due to purchase accounting adjustments related to the ALM and NLP Acquisitions.
OPERATING LOSS. As a result of the above factors, the operating loss decreased $4.1 million, or 94.4%, from $4.4 million for the year ended December 31, 1997 to $0.2 million for the year ended December 31, 1998. EBITDA increased $18.3 million, or 234.9%, from $7.8 million for the year ended December 31, 1997 to $26.1 million for the year ended December 31, 1998. Excluding the one-time charges in 1997 related to the shutdown of Counsel Connect and special compensation charge, EBITDA increased $8.4 million, or 47.2%, from $17.7 million for the year ended December 31, 1997 to $26.1 million for the year ended December 31, 1998. Excluding all Internet services and the special compensation charge, EBITDA increased $3.7 million, or 15.1%, from $24.4 million for the year ended December 31, 1997 to $28.1 million for the year ended December 31, 1998.
LIQUIDITY AND CAPITAL RESOURCES
CAPITAL EXPENDITURES. Capital expenditures were $11.8 million for the year ended December 31, 1999. The amount of capital expenditures in 1999 was higher than historical and expected future spending due to an investment in new editorial and advertising systems to replace outdated systems and ensure Year 2000 compliance and due to the implementation of new systems and facilities needed for the new initiatives and to support the Company's core growth.
NET CASH USED IN OPERATING ACTIVITIES. Net cash used in operating activities was $0.7 million for the year ended December 31, 1999, which primarily reflects depreciation and amortization of $27.3 million, an increase in accounts payable of $4.3 million and non-cash interest recorded during 1999 of $0.8 million, offset by a net loss of $26.4 million, an increase in accounts receivable of $3.3 million, a decrease in other non-current liabilities of $2.4 million and an increase in other assets of $1.5 million. The use of funds during 1999 primarily resulted from the Company's net loss, of which $10.6 million resulted from new initiatives started during 1999. Excluding these new initiatives would have resulted in net cash provided by operating activities of $9.9 million.
NET CASH USED IN INVESTING ACTIVITIES. Net cash used in investing activities was $8.0 million for the year ended December 31, 1999, which primarily resulted from capital expenditures of $11.8 million offset by the proceeds related to the sale of the Company's Internet business to Law.com during the third quarter of 1999.
NET CASH PROVIDED BY FINANCING ACTIVITIES. Net cash provided by financing activities totaled $9.8 million for the year ended December 31, 1999, which reflects a drawdown of $9.8 million under the Revolving Credit Facility (described below).
WORKING CAPITAL. The Company traditionally has had favorable cash flow characteristics resulting from its high level of advance payments by subscribers, low working capital investment, minimal capital expenditure needs, predictable cost structure and high margins. Because cash receipts associated with subscriptions are received toward the beginning of a subscription cycle, the Company's periodicals business requires minimal investment in working capital. During 1999, the Company incurred startup costs for the new initiatives resulting in EBITDA losses totaling approximately $10.3 million. Additionally, the Company invested $11.8 million in capital expenditures as described above. These two factors, both unusual, combined to produce an unfavorable cash flow for 1999.
LIQUIDITY. The Company's principal sources of funds are anticipated to be cash flows from operating activities, which may be supplemented by borrowings under the Revolving Credit Facility (described below). The Company believes that these funds will be sufficient to meet its current and future financial obligations, including the payment of interest on the $175,000,000 of 9.75% senior notes and the outstanding balance under the Company's Revolving Credit Facility, working capital, capital expenditures and other obligations. No assurance can be given, however, that this will be the case. The Company's future operating performance and ability to service or refinance the Notes and to repay, extend or refinance any credit agreements to which it is a party will be subject to future economic conditions and to financial, business and other factors, many of which are beyond the Company's control.
MATERIAL FINANCINGS
The Company has borrowed funds to finance its operations through the transactions described below.
REVOLVING CREDIT FACILITY. On March 25, 1998, the Company entered into a $40 million, five-year senior secured revolving credit facility (the "Revolving Credit Facility") with a group of banks to be available for working capital and general corporate purposes, including acquisitions and capital expenditures.
The Revolving Credit Facility is guaranteed by Holdings and by all existing and future subsidiaries of the Company. In addition, the Revolving Credit Facility is secured by a first priority security interest in substantially all of the properties and assets of the Company and its existing and future domestic subsidiaries, including a pledge of all of the stock of such subsidiaries, and a pledge by Holdings of all of the stock of the Company. The Revolving Credit Facility contains customary covenants commensurate with the size of the Revolving Credit Facility that, among other things, restrict the ability of the Company and its subsidiaries to take certain actions.
On April 14, 1998, Holdings contributed an aggregate of $15 million to the equity capital of the Company. The proceeds of the equity contribution were used to fund acquisitions and to provide capital for aggressive internal growth. On April 26, 1999, Holdings and the Company amended the Revolving Credit Facility, effective as of March 29, 1999. This amendment (INTER ALIA) limits the Company's ability to borrow in excess of $20 million under the Revolving Credit Facility until certain ratios are achieved, modifies certain of the covenants and modifies the interest calculation mechanism. Effective July 20, 1999, the Revolving Credit Facility was further amended to provide for the sale of the Company's Internet business to Law.com and to modify certain debt covenants. On March 8, 2000 (effective March 28, 2000), the Revolving Credit Facility was further amended to modify certain of the covenants, to permit the transaction described below under RECENT DEVELOPMENTS--SALE OF THE BUSINESS OF THE DAILY DEAL AND CORPORATE CONTROL ALERT and to increase the borrowing limit described above from $20 million to $22.5 million.
SENIOR NOTES FINANCING. In December 1997, the Company issued $175,000,000 aggregate principal amount of 9.75% Senior Notes due 2007 (the "Notes"). The Notes are unsecured general obligations of the Company and are fully and unconditionally guaranteed on a joint and several and senior unsecured basis, by each of the Company's existing and future subsidiaries. The subsidiary guarantors comprise all of the direct and indirect subsidiaries of the Company and each of the subsidiary guarantors is a wholly-owned subsidiary of the Company. Separate financial statements of, and other disclosures concerning the subsidiary guarantors are not included herein because of the subsidiary guarantors' full and unconditional guarantee of the Notes and management has determined that separate financial statements and other disclosures concerning the subsidiary guarantors are not material and would not provide any additional meaningful disclosure. There are currently no contractual or regulatory restrictions limiting the ability of the subsidiary guarantors to make distributions to the Company. The Notes may be redeemed at any time by the Company, in whole or in part, at various redemption prices that include accrued and unpaid interest. The Notes contain certain covenants that, among other things, limit the incurrence of additional indebtedness by the Company and its subsidiaries, the payment of dividends and other restricted payments by the Company and its subsidiaries, asset sales, transactions with affiliates, the incurrence of liens, and mergers and consolidations. Assuming there is no redemption of the Notes prior to maturity, the entire principal will be payable on December 15, 2007.
YEAR 2000 COMPLIANCE.
The Company did not experience any significant malfunctions or errors in its operating or business systems related to the "Year 2000" issue. Based on operations since January 1, 2000, the Company does not expect any significant impact to its ongoing business as a result of the "Year 2000" issue. However, it is possible that the full impact of the date change, which was of concern due to computer programs that use two digits instead of four digits to define years, has not been fully recognized. For example, it is possible that Year 2000 or similar issues such as leap year-related problems may occur with billing, payroll or financial closings at month, quarterly or year-end. The Company believes that any such problems are likely to be minor and correctable. In addition, the Company could still be negatively impacted if customers or suppliers are adversely affected by the Year 2000 or similar issues. The Company is not aware of any significant Year 2000 or similar problems that have arisen for its customers and suppliers.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
On March 25, 1998, the Company and ALM entered into the Revolving Credit Facility. Each revolving loan shall bear interest on the outstanding principal amount from the borrowing date until it becomes due at a rate per annum equal to the "Base Rate" or the Eurodollar rate plus the "Applicable Margin" of 1.5% for base rate loans and 2.5% for Eurodollar rate loans. The Base Rate is the higher of the Bank of America publicly announced "Reference Rate" or the Federal Funds Rate plus 0.5%. The amount outstanding under the Revolving Credit Facility was $18.3 million at December 31, 1999. The interest rate at December 31, 1999 was 9.15%. A 10% increase in the average rate, during 1999, would have increased the Company's net loss to approximately $26.5 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Index to Financial Statements and Exhibits, which appears on Page hereof.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES OF THE REGISTRANT
The following table sets forth certain information regarding each of the executive officers, directors and certain other key employees of the Company and Holdings, as of March 15, 2000.
Each Director is elected annually and serves until the next annual meeting of stockholders or until his or her successor is duly elected and qualified. The Independent Directors are each compensated $20,000 per year for their service as Directors and receive reimbursement of expenses incurred from their attendance at Board of Directors meetings. Directors will also be eligible to participate in an equity participation plan to be established.
The Board has established an executive committee (the "Executive Committee") consisting of three members, currently Bruce Wasserstein, Bruce Barnes and Anup Bagaria. The Executive Committee has been delegated the authority to approve (i) the acquisition and divestiture by the Company or an affiliate of the Company of all or a portion of one or more business entities for a price of up to $25 million, (ii) the appointment of senior officers of the Company or its affiliates and termination of such employment, (iii) the preparation and approval of short-term and long-term budgets, and (iv) other material policy-level decisions to the extent permitted by the Delaware General Corporation Law.
EXECUTIVE OFFICERS, DIRECTORS AND KEY EMPLOYEES OF THE COMPANY AND HOLDINGS
Bruce Wasserstein is Chairman of the Board of Directors of the Company and Holdings since December 1997. He is Chairman, Chief Executive Officer and founder of Wasserstein Perella Group, Inc. ("WPG"). Previously, Mr. Wasserstein served as a Director and the Chairman of Maybelline, Inc. and as a Director of Collins & Aikman Corp. Before establishing WPG, Mr. Wasserstein was Co-Head of Investment Banking at The First Boston Corporation, and a Managing Director and Member of its Management
Committee. Prior to joining First Boston in 1977, Mr. Wasserstein was an attorney at Cravath, Swaine & Moore in New York City. Mr. Wasserstein graduated with honors from the University of Michigan in 1967. In 1971 he graduated from Harvard Business School as a Baker Scholar with high distinction, and earned a J.D., CUM LAUDE, from Harvard Law School. In 1972 he was a Knox Traveling Fellow at Cambridge University. Mr. Wasserstein is a member of the Council on Foreign Relations. He has served as a member of the SEC's Advisory Committee on Tender Offers and as a member of the Visiting Committees of Harvard Law School, the University of Michigan and Columbia Journalism School. Mr. Wasserstein is also on the board of numerous private companies.
William L. Pollak has served as President, Chief Executive Officer and Director of the Company and Holdings since March 1998. Before joining the Company, Mr. Pollak spent 16 years at the New York Times, where he held a variety of positions, most recently as Executive Vice President, Circulation.
Anup Bagaria has served as a Vice President and Director of the Company and Holdings since their founding since November 1998. He is a Managing Director of Wasserstein Perella & Co., Inc. He graduated from the Massachusetts Institute of Technology. Mr. Bagaria also serves on the board of various private companies.
Bruce R. Barnes has served as a director of the Company and Holdings since November 1998. Dr. Barnes has been Managing Director of Wasserstein Perella & Co., Inc. since February 1997 and has been a senior member of its Merchant Banking Group since September 1998. He was Executive Vice President of Ziff Brothers Investments, L.L.C., a private investment company, from January 1995 to June 1996. Prior to that, at Ziff Communications Company, a privately-held publishing and media company, Dr. Barnes was Senior Vice President and Chief Financial Officer from September 1993 to December 1994 and was Vice President and Special Assistant to the Chairman from November 1992 to September 1993. Dr. Barnes received a B.A. in Economics MAGNA CUM LAUDE and a Ph.D. in Economics from the University of Pennsylvania. Dr. Barnes is also a director of Collins & Aikman Corporation and various private companies.
Michael J. Biondi has served as a Director of the Company and Holdings since March 1998. He is Chairman and Chief Executive Officer of Wasserstein Perella & Co., Inc. Mr. Biondi holds M.B.A. and J.D. degrees from the Wharton School and the University of Pennsylvania Law School, respectively. Prior to joining Wasserstein Perella, Mr. Biondi was a member of the First Boston Mergers & Acquisitions Group, and practiced law at Skadden, Arps, Slate, Meagher & Flom LLP.
Robert C. Clark has served as a Director of the Company and Holdings since their founding. He has been Dean of the Harvard Law School since 1989 and is the Royall Professor of Law. Mr. Clark is a trustee of Teachers' Insurance Annuity Association (TIAA). He is currently a Director of Collins & Aikman Corp. and of Household International, Inc.
Donald G. Drapkin has served as a Director of the Company and Holdings since their founding. He has been a Director and Vice Chairman and Director of MacAndrews & Forbes Holdings Inc. and various of its affiliates since 1987. Mr. Drapkin also is a Director of the following corporations which file reports pursuant to the Exchange Act: Algos Pharmaceutical Corporation, Anthracite Capital, Inc., BlackRock Asset Investors, Cardio Technologies, Inc., The Molson Companies Limited, Revlon Consumer Products Corporation, Revlon, Inc., Playboy Enterprises, Inc., Weider Nutrition International, Inc., and VIMRX Pharmaceuticals Inc. On December 27, 1996, Marvel, Marvel Holdings, Marvel Parent and Marvel III of which Mr. Drapkin was a Director on such date, and several subsidiaries of Marvel filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code.
James A. Finkelstein has served as a Director of the Company and Holdings since March 1998. He has been President and Chief Executive Officer of JAF Communications, LLC since July 1998. Prior to that, Mr. Finkelstein served as President and Chief Executive Officer of NLP and its predecessor companies beginning in 1974. He joined the New York Law Publishing Company in 1970. He was the former publisher
of the NEW YORK LAW JOURNAL and the founder and publisher of THE NATIONAL LAW JOURNAL. He currently serves on the Faculty of Arts and Sciences Board of Overseers at New York University.
Andrew G. T. Moore, II has served as a Director of the Company and Holdings since their founding. He is a Managing Director of Wasserstein Perella and is a former Justice of the Delaware Supreme Court. Justice Moore served on the Delaware Supreme Court for 12 years until 1994. Justice Moore has served as the Lehmann Distinguished Visiting Professor of Law at Washington University in St. Louis. He has also served as an adjunct professor of law at the Georgetown University Law Center, University of Iowa College of Law and Widener University School of Law, where he taught seminars in advanced corporation law. He also teaches comparative principles of international corporation law at the Tulane University Institute of European Legal Studies in Paris, and has been a guest lecturer at various law schools and national corporate law programs in the United States, Canada and Europe.
Jack Berkowitz has served as Vice President, Strategic Planning of the Company since January 1999. Prior to joining the Company, Mr. Berkowitz served as a consultant to the Company during 1998. Mr. Berkowitz is a 25 year veteran of the publishing industry. As a consultant, in addition to the Company, his client roster has included Cowles Business Media, Hearst Magazines, Time Inc., Felker Media, Associated Newspapers and Adweek. Mr. Berkowitz had previously served as Executive Vice President of the Village Voice and President of The Nation.
Michael Cronan has served as Vice President, Marketing of the Company since September 1999 and served as the Company's Director of Circulation for National Publications from April 1999 until September 1999. Prior to joining the Company, Mr. Cronan served in various positions with McGraw Hill Cos. From February 1995 until April 1999 and most recently served as the director of sales and marketing with its Construction Information Group On-line. In this capacity, Mr. Cronan developed design, branding and content and implemented successful e-commerce subscription systems for CIG On-Line's Web sites.
Sally Feldman has served as Vice President, Professional Information Division of the Company since October 1999. Prior to joining the Company, Ms. Feldman served as Director of Marketing and Communications at Skadden, Arps, Slate, Meagher & Flom LLP where she was responsible for all aspects of global marketing and public relations.
Stephen C. Jacobs has served as Vice President, General Counsel and Secretary of the Company since May 1998. Prior to joining the Company, Mr. Jacobs was Assistant General Counsel, Global Transactions for American International Group, Inc.
Leslye G. Katz has served as Vice President and Chief Financial Officer of the Company since September 1998. Prior to joining the Company, Ms. Katz served as Vice President and Treasurer of IMS Health, Inc. Previously, she held senior financial management positions for 18 years in the publishing industry, most recently as Senior Vice President and Chief Financial Officer of Reuben H. Donnelley.
Kevin Vermeulen has been Vice President, National Advertising of the Company since 1998. Prior to that he was a Vice President of Sales for NLP, which he joined in October 1992.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following Summary Compensation Table includes individual compensation information for the Chief Executive Officer and certain other executive officers of the Company for the year ended December 31, 1999 (collectively, the "Named Executive Officers") for services rendered in all capacities to the Company during the year ended December 31, 1999. All numbers relating to option grants relate to options to purchase shares in Holdings and include the effect of a 10-for-1 stock split in March 2000. See BUSINESS--RECENT DEVELOPMENTS--STOCK SPLIT.
SUMMARY COMPENSATION TABLE
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(1) Represents payments made by the Company to Mr. Pollak pursuant to the terms of his employment agreement with the Company to reimburse him for the value of options forfeited upon his resignation from his former employer.
(2) Mr. Pollak's employment with the Company pursuant to his employment agreement commenced as of March 9, 1998.
(3) Mr. Berkowitz's employment with the Company pursuant to his employment agreement commenced as of January 1, 1999.
(4) Mr. Jacobs' employment with the Company pursuant to his employment agreement commenced as of May 4, 1998.
(5) Represents payments made by the Company to Ms. Katz pursuant to the terms of her employment agreement with the Company to reimburse her for the value of options forfeited upon her resignation from her previous employer.
(6) Ms. Katz's employment with the Company pursuant to her employment agreement commenced as of September 1, 1998.
(7) Represents commissions earned by Mr. Vermeulen pursuant to the terms of his employment agreement.
(8) The 1997 compensation information for Mr. Vermeulen includes salary, bonus and commission in the aggregate. A breakdown of this amount was not easily ascertainable.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
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* As of December 31, 1999, each of the outstanding options was out-of-the-money and therefore the potential realizable value was less than zero.
+ Each of the options is exercisable for a share of Holdings common stock.
EMPLOYMENT AGREEMENTS
Each of William Pollak, President and Chief Executive Officer, and Leslye Katz, Vice President and Chief Financial Officer, has entered into an employment agreement with the Company for a five year term effective March 9, 1998 and September 1, 1998, respectively. The employment agreements provide for an annual salary of $400,000, in the case of Mr. Pollak, and $300,000, in the case of Ms. Katz, subject to increases of 5% annually during the term. In addition, the employment agreements provide for bonuses of (i) $400,000 after the first year of the term and between 50% and 150% of the base salary, as determined by the Board of Directors, in each of the remaining years of the term, for Mr. Pollak, and (ii) $150,000 after the first year of the term and between 25% and 75% of the base salary, as determined by the Board of Directors, in each of the remaining years of the term, for Ms. Katz. Under the employment agreements, if the executives' employment is terminated by the Company without cause or by the executive with good reason, the executive will be entitled to severance equal to the amount of the executive's salary and bonus accrued but unpaid through the termination date and one year's salary in the cases of Mr. Pollak and Ms. Katz, commencing on the termination date, together with any accrued but unpaid bonus. Each of Mr. Pollak and Ms. Katz is also entitled to payments for options granted to them and forfeited upon their resignations from their prior employers.
The Company has also entered into employment agreements with each of its executive officers providing for varying bonuses, severance provisions and termination rights.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
All of the outstanding shares of the Company are beneficially owned by Holdings. The following table sets forth certain information regarding beneficial ownership of Holdings as of December 31, 1999 by (i) each person (or group of affiliate persons) known by the Company to be the beneficial owner of more than 5% of the outstanding Common Stock of Holdings, (ii) each Director, Director nominee, and the Chief Executive Officer and Vice President of the Company, and (iii) all directors and executive officers of
the Company as a group. The share numbers below include the effect of a 10-for-1 stock split in March 2000. See BUSINESS--RECENT DEVELOPMENTS--STOCK SPLIT.
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(1) Includes approximately 2.9% of the issued and outstanding common stock of Holdings held by a co-investor of U.S. Equity Partners, L.P. ("USEP") which has granted WP Management Partners, LLC ("WPMP"), the general partner of USEP, an irrevocable proxy to vote such shares of common stock. Wasserstein & Co., Inc. shares voting and dispositive power with respect to the shares held by USEP. See footnote (4).
(2) Wasserstein & Co., Inc. shares voting and dispositive power with respect to the shares held by U.S. Equity Partners (Offshore), L.P. See footnote (4).
(3) ALM Employee Partners, L.L.C. is managed by WP Plan Management Partners, Inc., a wholly-owned subsidiary of Wasserstein & Co., Inc. Wasserstein & Co., Inc. shares voting and dispositive power with respect to the shares held by ALM Employee Partners, L.L.C. See footnote (4).
(4) Does not include: 569,960 shares as to which Wasserstein & Co. shares voting and dispositive power with USEP; 144,110 shares as to which Wasserstein & Co. shares voting and dispositive power with U.S. Equity Partners (Offshore), L.P.; and 80,000 shares as to which Wasserstein & Co. shares voting and dispositive power with ALM Employee Partners, L.L.C.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company is a wholly-owned subsidiary of Holdings. A majority of Holdings' equity securities are held by USEP and its affiliates. USEP is a Delaware limited partnership investment fund of which WPMP is the general partner. WPMP is controlled by Wasserstein Perella & Co., Inc. WPMP is entitled to receive a monitoring fee in an amount not to exceed $1.0 million in respect of any year.
The Company may engage in transactions with its affiliates, including entities owned or controlled by certain of its principal shareholders. The Company believes that such transactions will be no more favorable to the Company than similar transactions with non-affiliates.
In July 1999, the Company sold the common stock of its wholly-owned subsidiary, Professional On-Line, Inc., which held the Company's Internet business, to Law.com for $1.0 million in cash and the Company retained a preferred stock interest with a face amount of $3.75 million. On March 28, 2000, the Company sold its business constituting THE DAILY DEAL and CORPORATE CONTROL ALERT to TDD, L.L.C. The stockholders of Law.com and TDD, L.L.C. include substantially all of the stockholders of Holdings. See SIGNIFICANT TRANSACTIONS and RECENT DEVELOPMENTS.
In connection with the sale of the Company's Internet business to Law.com, the Company entered into an exclusive five-year license agreement with Law.com granting Law.com the right to publish all Company content in electronic or digital format. See SIGNIFICANT TRANSACTIONS. The Company believes that the transactions referred to in the preceding paragraph were effected on arms-length terms and conditions.
In 1999, $260,000 in fees, related to the sale of the Company Internet business to Law.Com, were paid to Wasserstein & Co., Inc.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) FINANCIAL STATEMENTS
See Index to Financial Statements that appears on page hereof. No Schedules are provided as the Schedules are either not applicable, or the information has been otherwise provided in the Financial Statements.
(B) REPORTS ON FORM 8-K
The Company has filed a report on Form 8-K, dated July 27, 1999, and filed August 24, 1999, relating to the sale of the Company's Internet business to Law.com.
(C) EXHIBITS
The exhibits listed on the Exhibit Index following the signature page hereof are filed herewith in response to this Item.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To American Lawyer Media, Inc.:
We have audited the accompanying consolidated balance sheets of American Lawyer Media, Inc. (a Delaware corporation) as of December 31, 1999 and 1998 and the related consolidated statements of operations, changes in stockholder's equity and cash flows for the years ended December 31, 1999 and 1998 and the five months ended December 31, 1997. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of American Lawyer Media, Inc. as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the years ended December 31, 1999 and 1998 and the five months ended December 31, 1997 in conformity with accounting principles generally accepted in the United States.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule appearing on SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS of this Form 10-K is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
New York, New York March 28, 2000
AMERICAN LAWYER MEDIA, INC.
CONSOLIDATED BALANCE SHEETS
FOR THE YEARS ENDED DECEMBER 31, 1999 AND 1998
(IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes to consolidated financial statements are an integral part of these balance sheets.
AMERICAN LAWYER MEDIA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS)
The accompanying notes to consolidated financial statements are an integral part of these statements.
AMERICAN LAWYER MEDIA, INC.
STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1999 AND 1998
AND FOR THE FIVE MONTHS ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes to consolidated financial statements are an integral part of these statements.
AMERICAN LAWYER MEDIA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
The accompanying notes to consolidated financial statements are an integral part of these statements.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1999, 1998 AND 1997
1. ORGANIZATION AND OPERATIONS
American Lawyer Media, Inc. (the "Company") is a wholly-owned subsidiary of American Lawyer Media Holdings, Inc. (formerly Cranberry Partners, LLC ("Cranberry")).
Cranberry, a Delaware limited liability company, was formed on August 1, 1997. On August 27, 1997 (the "ALM Acquisition Closing"), Cranberry acquired substantially all of the assets and liabilities of American Lawyer Media, L.P. ("Old ALM") for $63,000,000 ("ALM Acquisition"). The acquisition was effective retroactive to July 31, 1997. As of the ALM Acquisition Closing, all of the membership interests of Cranberry were held by W.P. Management Partners, LLC on behalf of U.S. Equity Partners, L.P. and certain of its affiliates. Old ALM was a publisher of legal publications, which included primarily THE AMERICAN LAWYER, CORPORATE COUNSEL MAGAZINE, AMLAW TECH, THE CONNECTICUT LAW TRIBUNE, LEGAL TIMES, NEW JERSEY LAW JOURNAL, THE RECORDER, TEXAS LAWYER, FULTON COUNTY DAILY REPORT, and MIAMI DAILY BUSINESS REVIEW. In addition, Old ALM operated Counsel Connect, a membership-based online service exclusively for lawyers and legal professionals.
Prior to the ALM Acquisition Closing, Cranberry formed ALM Holdings, LLC, a Delaware limited liability company, and ALM Holdings, LLC formed two wholly-owned subsidiaries, ALM, LLC (a New York limited liability company) and Counsel Connect, LLC (a Delaware limited liability company) and one 99% owned subsidiary (the remaining 1% of which was, as of the ALM Acquisition Closing, held by W.P. Management Partners, LLC on behalf of U.S. Equity Partners, L.P. and certain of its affiliates), ALM IP, LLC (a Delaware limited liability company). On the ALM Acquisition Closing, Cranberry transferred all of the non-intellectual property publishing assets and liabilities acquired from Old ALM to ALM, LLC, all the non-intellectual property Counsel Connect assets and liabilities acquired from Old ALM to Counsel Connect, LLC, and all of the intellectual property assets acquired from Old ALM to ALM IP, LLC.
On November 26, 1997, Cranberry was merged with and into ALM Capital Corp. (a Delaware corporation), and ALM Capital Corp. was simultaneously renamed American Lawyer Media Holdings, Inc. ("Holdings"). Also on November 26, 1997, ALM Holdings, LLC was merged with and into ALM Capital Corp. II (a Delaware corporation), and ALM Capital Corp. II was simultaneously renamed American Lawyer Media, Inc. The Company's operations are based in New York with regional offices in nine states and the District of Columbia.
In December 1997, Holdings received capital contributions from its stockholders, Wasserstein & Co., Inc., U.S. Equity Partners L.P. and U.S. Equity Partners (Offshore) L.P., totaling $75 million. On December 22, 1997, Holdings issued $35 million of 12.25% Senior Discount Notes in an offering under Rule 144A promulgated under the Securities Act of 1933, as amended (the "Act"). Simultaneously, Holdings contributed capital of $108.8 million to the Company. Also on December 22, 1997, the Company issued $175 million of 9.75% Senior Notes in an offering under Rule 144A promulgated under the Act. The Company used a portion of the capital and the proceeds from the Company's 144A offering to acquire all of the outstanding capital stock of National Law Publishing Company, Inc. (a Delaware corporation) ("Old NLP") for approximately $203 million (the "NLP Acquisition") through a wholly-owned subsidiary, NLP Acquisition Co., Inc., (a New York corporation) ("Acquisition"). Old NLP was then, on December 22, 1997, merged with and into Acquisition with Acquisition surviving. Subsequent to the merger, Acquisition was renamed National Law Publishing Company, Inc. ("NLP"). At the closing of the NLP Acquisition, all intellectual property of NLP and its subsidiaries was transferred to NLP IP Company, a wholly-owned subsidiary of NLP. Old NLP was a publisher of legal publications, which include NEW YORK LAW JOURNAL, THE NATIONAL LAW JOURNAL and LAW TECHNOLOGY NEWS. In addition, Old NLP operated Law Journal EXTRA!, a
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
1. ORGANIZATION AND OPERATIONS (CONTINUED) membership-based Internet service for lawyers and legal professionals, publishes legal text and provides seminars targeted at the U.S. legal community.
On April 2, 1998, the Board of Directors authorized Holdings to issue shares of Holdings' $.01 par value per share common stock to U.S. Equity Partners, L.P., in consideration of payment by U.S. Equity Partners, L.P. of $15,000,000.
On December 29, 1998, the Company enacted an internal plan of reorganization (the "Plan") approved by a subcommittee of Holdings' Board of Directors appointed by the Board of Directors at its quarterly meeting on November 9, 1998. Pursuant to the Plan, Holdings and its subsidiaries entered into the following transactions: (i) ALM, LLC merged with and into The New York Law Publishing Company, a New York corporation, and a wholly-owned indirect subsidiary of Holdings ("NYLP"), with NYLP surviving; (ii) ALM IP, LLC merged with and into NLP IP Company, with NLP IP Company surviving; (iii) ALM Counsel Connect, Inc. merged with and into Counsel Connect, LLC, with Counsel Connect LLC surviving; (iv) ALM formed a new, wholly-owned subsidiary, Professional On-Line, Inc., a Delaware corporation ("POL"); (v) Counsel Connect LLC merged with and into POL with POL surviving; (vi) Law Journal Extra, Inc., a New York corporation, and a wholly-owned indirect subsidiary of Holdings, merged with and into POL with POL surviving; and (vii) LegalTech, LLC, a Delaware limited liability company, and a wholly-owned indirect subsidiary of Holdings, merged with and into NYLP with NYLP surviving.
Effective March 5, 1999, ALM Intermediate Offshore Holdings, Inc. ("ALM Intermediate") was merged with and into the Company with the Company surviving (the "Reorganization Merger"). Immediately prior to the effectiveness of the Reorganization Merger, (i) ALM Intermediate owned of record 14,411 shares of Common Stock, par value $.01 per share, of the Company (the "ALM Intermediate Shares") and (ii) all of the issued and outstanding capital stock of ALM Intermediate was owned of record by U.S. Equity Partners (Offshore), L.P. ("Offshore"). In connection with the Reorganization Merger, the ALM Intermediate Shares became treasury shares of the Company and were simultaneously reissued directly to Offshore. The beneficial ownership of the capital stock of the Company has not changed as a result of the Reorganization Merger.
On July 21, 1999, the Company transferred all of its and its subsidiaries' Internet and electronic commerce business to Professional On-Line, Inc. ("POL"). On July 24, 1999, POL was recapitalized by creating a class of 12.25% preferred stock, par value $0.01 (the "POL Preferred Stock"), in addition to the class of Common Stock, par value $0.01 per share, previously authorized (the "POL Common Stock"). On July 27, 1999, the Company sold all of the issued and outstanding POL Common Stock to Law.com, Inc. (f/ k/a Law.com Acquisition Corp.) ("Law.com") for $1.0 million in cash and the Company retained all of the issued and outstanding POL Preferred Stock. In December 1999, Law.com redeemed all of the 12.25% preferred stock for $3.75 million plus accrued dividends. Law.com is a web destination for legal information, e-commerce and e-services. Under a cross-licensing agreement, the Company will continue to provide content and editorial direction for Law.com. Law.com is owned by substantially the same investors that own the Company, including Wasserstein & Co., Inc., U.S. Equity Partners, L.P., and U.S. Equity Partners (Offshore) L.P.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
2. ACQUISITIONS
Pursuant to an Asset Purchase Agreement dated as of March 3, 1998, among Corporate Presentations, Inc., its sole stockholder and LegalTech, LLC, a wholly-owned indirect subsidiary of American Lawyer Media, Inc., LegalTech, LLC agreed to purchase substantially all of the assets and assume certain of the liabilities of Corporate Presentations, Inc., for approximately $10.8 million (the "LegalTech Acquisition"). Approximately $11.3 million was recorded as goodwill for the excess purchase price over the net liabilities acquired. Corporate Presentations, Inc. is a producer of trade shows and conferences for the legal community. For advisory services rendered to the Company (as defined below) in connection with the LegalTech Acquisition, the Company paid WP Management Partners, LLC ("WPMP"), an affiliate of Holdings, a fee of 1% of the purchase price of the LegalTech Acquisition.
On April 22, 1998, effective as of April 1, 1998, the Company consummated the acquisition of substantially all of the legal publishing-related assets and assumed certain liabilities of Legal Communications, Ltd ("LCL") for an aggregate purchase price of approximately $20.1 million (the "LCL Acquisition"). The excess purchase price over the net liabilities acquired was allocated $6.3 million to goodwill and $14.3 million to identified intangibles based upon the appraisal done. LCL is a publisher of regional legal publications. For advisory services rendered to the Company in connection with the LCL Acquisition, the Company paid WPMP a fee of 1% of the purchase price of the LCL Acquisition.
The following unaudited pro forma information presents a summary of consolidated results of operations of the Company as if the LegalTech Acquisition and the LCL Acquisition had occurred on January 1, 1998 (in thousands):
These unaudited pro forma results have been prepared for comparative purposes only and include certain adjustments, such as additional amortization expense as a result of goodwill. They do not purport to be indicative of the results of operations which actually would have resulted had the combination been in effect on January 1, 1998, or of future results of operations of the consolidated entities.
On October 28, 1998, the Company consummated the acquisition of all of the assets, properties and rights of the Delaware Law Monthly for an aggregate purchase price of $280,000 (the "DLM Acquisition"). DLM is a publisher of a monthly magazine.
On November 22, 1999, effective December 1, 1999, the Company consummated the acquisition of all of the assets, properties and rights of Houston Trial Reports, Inc. and Blue Sheet Publications, Inc. (collectively, "Blue Sheet") for an aggregate purchase price of $750,000 (the "Blue Sheet Acquisition"). Blue Sheet publishes regional and statewide publications which serve the legal community and provides legal research through in-house and on-line facilities.
The LegalTech Acquisition, the LCL Acquisition, the DLM Acquisition and the Blue Sheet Acquisition have been accounted for under the purchase method of accounting and the results of operations of the acquired businesses have been included in the financial statements since the effective dates of the respective acquisitions. The excess of the purchase price over net assets acquired was allocated to goodwill.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
2. ACQUISITIONS (CONTINUED) In the accompanying consolidated statements of operations, the excess of purchase price over net assets acquired is being amortized over fifteen years.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of American Lawyer Media, Inc. and its wholly-owned subsidiaries which, unless the context otherwise requires, are collectively referred to herein as the "Company." Intercompany transactions and balances have been eliminated in consolidation.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
CONCENTRATIONS OF CREDIT RISK
The Company's financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. The Company believes it is not exposed to any significant credit risk related to cash and cash equivalents. Concentrations of credit risk with respect to trade accounts receivable are, except for amounts due from legal advertising agents ("Legal Ad Agents"), generally limited due to the large number of customers comprising the Company's customer base. Such Legal Ad Agents do not have significant liquid net worth and, as a result, the Company is exposed to a certain level of credit concentration risk in this area, which the Company believes it has adequately provided for.
REVENUE RECOGNITION
Periodical advertising revenues are generated from the placement of display and classified advertisements, as well as legal notices, in the Company's publications. Advertising revenue is recognized upon release of the related publications.
Periodical subscription revenues are recognized on a pro rata basis as issues of a subscription are served.
Ancillary products and services revenues consist principally of third-party printing revenues, newsletter subscriptions, sales of professional books, seminar and conference income, income from a daily fax service of court decisions and income from electronic products. Printing revenue is recorded upon shipment. Book revenues are recognized upon shipment and are reflected net of estimated returns. Newsletter revenues are recognized on the same basis as subscription revenues. Seminar and conference revenues are recognized when the seminar or conference is held. Daily fax service revenue is recognized upon fulfillment of orders. Income from electronic products is recognized monthly as the service is provided.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Internet services revenues consist primarily of revenues from subscriptions and advertising. Internet subscription income is recognized on a pro-rata basis over the life of a subscription, generally one year. Internet advertising revenues are recognized upon the release of an advertisement on the website.
DEFERRED SUBSCRIPTION INCOME
Deferred subscription income results from advance payments or orders for subscriptions received from subscribers and is amortized on a straight-line basis over the life of the subscription as issues are served. Subscription receivables of $3,128,600 and $2,602,000 at December 31, 1999 and 1998, respectively, are included in accounts receivable in the accompanying consolidated balance sheet.
ADVERTISING AND PROMOTION COSTS
Advertising and promotion expenditures totaled approximately $11.0 million and $6.2 million for the years ended December 31, 1999 and 1998, respectively. These are expensed as the related advertisement or campaign is released.
CASH AND CASH EQUIVALENTS
The Company considers time deposits and certificates of deposit with original maturities of three months or less to be cash equivalents.
INVENTORIES
Inventories consist principally of paper and related binding materials utilized by the Company and its outside printers and professional books published and sold by the Company. Inventories are stated at the lower of cost, as determined by the average cost method, or market.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment is stated at cost, with the exception of fixed assets acquired as part of the Acquisitions, which are stated at approximate fair market value as of the date of the acquisitions. Significant improvements are capitalized, while expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is calculated using the straight-line method over the estimated remaining useful lives of the assets acquired as part of the Acquisitions. Assets purchased after the Acquisitions are depreciated using the straight-line method over the following estimated useful lives:
Leasehold improvements are amortized over the shorter of the remaining lease term or the estimated useful life.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) GOODWILL
Goodwill represents the excess of purchase price over the fair value of net assets acquired. It is stated at cost less accumulated amortization and is amortized on a straight-line basis over a fifteen-year useful life. The Company periodically assesses the recoverability of goodwill by determining whether the amortization of goodwill over its estimated remaining life can be recovered through projected undiscounted future consolidated operating cash flows.
INTANGIBLE ASSETS
Intangible assets represent advertiser commitments, trademarks, customer and subscriber lists and non-compete agreements. They are stated at cost less accumulated amortization and are amortized on a straight-line basis over a weighted average life of fifteen years.
SALES OF SUBSIDIARY STOCK
The Company has elected to treat gains and losses on the sales of subsidiary stock as equity transactions. Therefore, the sale of Law.com has been reflected this way in the accompanying financial statements.
RECLASSIFICATIONS
Certain amounts have been reclassified to conform with the current year presentation.
NEW ACCOUNTING PRONOUNCEMENTS
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS No. 133") Accounting for Derivative Instruments and Hedging Activities." The Statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or a liability measured at its fair value. The Statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement and requires that a company must formally document, designate and assess the effectiveness of transactions that require hedge accounting.
In June 1999, the Financial Accounting Standards Board delayed the required adoption of SFAS No. 133 to be effective for fiscal years beginning after June 15, 2000. The Company is currently evaluating the impact that SFAS No. 133 will have on the Company's consolidated financial position and results of operations.
4. SHUTDOWN OF COUNSEL CONNECT
The Company had operated Counsel Connect, a major legal Internet site, since 1993. Counsel Connect operated as a subscription based service offering users the opportunity to exchange legal information such as court opinions, insights about judges and legal opinions and special written work. The
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
4. SHUTDOWN OF COUNSEL CONNECT (CONTINUED) Company, through Counsel Connect, provided general Internet access (as an "Internet service provider") to its subscribers.
During 1998, the Company essentially completed its shutdown of Counsel Connect and migrated its customers to Law News Network. The 1997 accompanying statement of operations includes a provision of $3,000,000 related to the shutdown of Counsel Connect to cover severance costs, uncollectible receivables, writedown of computer and network equipment and termination of contracts related to network services which provided Internet access. Through December 31, 1999, approximately $3.0 million was charged against the reserve established in 1997 for the costs listed above.
5. INCOME TAXES
Deferred income taxes are provided for the temporary differences between the financial reporting and the tax basis of the Company's assets and liabilities and principally consist of identified intangibles relating to NLP, accelerated depreciation, allowance for doubtful accounts, certain accrued liabilities not currently deductible for tax purposes and net operating loss carryforwards.
The reconciliation between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to loss before income taxes is as follows (in thousands):
The Company had a deferred tax liability of $38,182 and $43,834 at December 31, 1999 and 1998, respectively. These deferred income tax liabilities primarily relate to the identified intangibles from the NLP Acquisition which were recorded at the acquisition date as an increase in goodwill. The liability was calculated on the identified intangibles from the NLP Acquisition using the effective tax rate of the Company.
The Company has recorded a 100% valuation allowance against its net deferred tax assets consisting primarily of net operating losses. The valuation allowance was provided as management cannot be sure of when or if they will be able to utilize these net operating losses.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following at December 31 (in thousands):
7. INTANGIBLE ASSETS
Intangible assets consisted of the following at December 31 (in thousands):
8. OTHER CURRENT ASSETS
Other current assets consisted of the following at December 31 (in thousands):
9. RELATED PARTY TRANSACTIONS
In July 1999, the Company sold the common stock of its wholly-owned subsidiary, Professional On-Line, Inc., which held the Company's Internet business, to Law.com for $1 million in cash and the Company retained a preferred stock, with a face amount of $3.75 million. The preferred stock was redeemed prior to December 31, 1999 for $3.75 million plus preferred dividends. On March 28, 2000, the Company sold its business constituting THE DAILY DEAL and CORPORATE CONTROL ALERT to TDD, L.L.C. The stockholders of Law.com and TDD, L.L.C. include substantially all of the stockholders of Holdings. See Note 14--Subsequent Events.
In connection with the sale of the Company's Internet business to Law.com, the Company entered into an exclusive five-year license with Law.com granting Law.com the right to publish all Company content in electronic or digital format. See Note 1--Organization and Operations.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
9. RELATED PARTY TRANSACTIONS (CONTINUED)
The Company believes that the transactions referred to in the preceding paragraphs were effected on arms-length terms and conditions.
The Company and CourtRoom Television Network ("CourtTV"), an affiliate of Old ALM's general partner, shared certain administrative resources and employees in 1997 only. In addition, the Company had advertising revenue from Court TV under an agreement made by the former owner of Old ALM. This agreement was terminated in October 1997. The cost associated with Court TV employees who devoted a portion of their time to the Company's activities was charged to the Company based on an estimate of the time spent on such activities. These charges amounted to $99,191, while the revenue was $44,730 for the five months ended December 31, 1997. In addition, the Company had a receivable from CourtTV of $0 and $118,500 at December 31, 1999 and 1998 respectively, reflected in accounts receivable on the accompanying balance sheets.
Approximately $5,250,000 of financing costs related to the Senior Notes, as defined in Note 12, were paid to Wasserstein Perella, an affiliate of the Company. In addition, approximately $4,150,000 of acquisition related fees and expenses were paid to Wasserstein Perella. In 1999, $260,000 in fees relating to the sale of the Company's Internet business to Law.com were paid to Wasserstein & Co., Inc.
Included in other current assets on the accompanying balance sheets is a net receivable due from Holdings of $555,300 and $447,800 at December 31, 1999 and 1998, respectively, resulting from various intercompany transactions.
10. COMMITMENTS AND CONTINGENCIES
Rent expense, including payments of real estate taxes, insurance and other expenses required under certain leases, amounted to approximately $3,685,000, $3,580,000 and $783,000 for the years ended December 31, 1999 and 1998 and the five months ended December 31, 1997. This amount includes the monthly rent payments for corporate headquarters discussed below.
At December 31, 1999, minimum rental commitments under noncancellable leases were as follows (in thousands):
Certain of the leases provide for free rent periods as well as rent escalations. The rental commitments above represent actual rental payments to be made. The financial statements reflect rent expense and rental income on a straight-line basis over the terms of the leases. Approximately $2,665,000 and $1,924,000, representing accrued pro rata future payments, net of receipts, is included in other noncurrent liabilities in the accompanying balance sheets as of December 31, 1999 and 1998, respectively.
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
10. COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company is involved in a number of legal proceedings, some of which are significant, which arose in the ordinary course of business. In the opinion of management, the ultimate outcome of these contingencies is not expected to have a material adverse effect on the Company's financial position or results of operations.
The Company has letters of credit outstanding totaling approximately $1,121,000 and $983,000 for security deposits on its corporate office space as of December 31, 1999 and 1998, respectively.
11. EMPLOYEE BENEFITS
NLP has a 401(k) profit sharing plan (the "NLP Plan") for all eligible employees who have completed one year of service. Under the NLP Plan, NLP has the option of making a matching contribution of up to 3% of a participant's compensation. NLP may also annually contribute additional discretionary amounts to participants. For the years ended December 31, 1999 and 1998 and the five months ended December 31, 1997, NLP did not make any matching discretionary contributions to the NLP Plan. In addition, approximately twenty NLP employees are covered by certain defined contribution retirement plans sponsored by the Typographical Union. NLP made contributions to these retirement plans of $0, $11,719 and $0 for the years ended December 31, 1999, 1998 and the five months ended December 31, 1997, respectively.
ALM, LLC sponsored a 401(k) salary deferral plan (the "ALM Plan") which was transferred to the Company upon the Acquisitions. Participation in the ALM Plan is available for substantially all Company employees. The ALM Plan provides for employer matching of employees' contributions, as defined. The cost of the ALM Plan for the years ended December 31, 1999 and 1998 and the five months ended December 31, 1997 was $606,979, $276,400 and $137,400, respectively.
ALM, LLC also sponsored a defined benefit plan covering substantially all ALM, LLC and Counsel Connect, LLC employees. This plan was frozen effective December 31, 1997, resulting in an insignificant curtailment gain.
Pension benefits for 1999, 1998 and 1997 for the ALM Plan consist of the following (in thousands):
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
11. EMPLOYEE BENEFITS (CONTINUED)
In determining the actuarial present value of the projected benefit obligation as of December 31, 1999, 1998 and 1997, the discount rate was 6.75%, and the expected long-term rate of return on assets was 9.00% as of December 31, 1999, 1998 and 1997.
ALM, LLC also sponsored an Excess Benefit Pension Plan providing a benefit to highly compensated employees in excess of the benefits provided by the tax qualified defined benefit plan. The plan is an unfunded, non-qualified deferred compensation plan. This plan was also frozen as of December 31, 1997.
The Company sponsors a comprehensive medical and dental insurance plan, which is available to substantially all employees.
12. LONG-TERM DEBT
On December 22, 1997, the Company issued $175,000,000 of 9.75% senior notes ("Senior Notes") due December 15, 2007. The Senior Notes accrue interest at 9.75% which is payable in cash semi-annually on June 15 and December 15 (beginning June 15, 1998) of each year. The Senior Notes are unsecured general obligations of the Company and are fully and unconditionally guaranteed, on a joint and several and senior unsecured basis, by each of the Company's existing and future subsidiaries. Separate financial statements of, and other disclosures concerning, the Guarantors are not included herein because of the Guarantors' full and unconditional guarantee of the Senior Notes and management's determination that separate financial statements and other disclosures concerning the Guarantors are not material and would not
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
12. LONG-TERM DEBT (CONTINUED) provide any additional meaningful disclosure. The Senior Notes may be redeemed at any time by the Company, in whole or in part, at various redemption prices that include accrued and unpaid interest as well as any existing liquidating damages. The Senior Notes contain certain covenants that, among other things, limit the incurrence of additional indebtedness by the Company and its Subsidiaries, the payment of dividends and other restricted payments by the Company and its Subsidiaries, asset sales, transactions with affiliates, the incurrence of liens, and mergers and consolidations. Financing costs, totaling $7,236,000, have been capitalized in 1998 and are being amortized over the term of the Senior Notes. Amortization of deferred financing costs is recorded as interest expense. Assuming there is no redemption of the Senior Notes prior to maturity, the entire principal will be payable on December 15, 2007.
On March 25, 1998, Holdings and the Company entered into a Credit Agreement with various banks that has a combined revolving commitment in the initial principal amount of $40,000,000 (the "Revolving Credit Facility"). Financial costs associated with the Revolving Facility have been capitalized and are being amortized over the term of the agreement. The Revolving Credit Facility is guaranteed by Holdings and by all subsidiaries of the Company. In addition, the Revolving Credit Facility is secured by a first priority security interest in substantially all of the properties and assets of the Company and its domestic subsidiaries, including a pledge of all of the stock of such subsidiaries, and a pledge by Holdings of all of the stock of the Company. The Revolving Credit Facility bears interest at a fluctuating rate determined by reference to (i) the Base Rate plus a margin ranging from .25% to 1.5%, or (ii) the Eurodollar Rate plus a margin ranging from 1.25% to 2.5% as the case may be. The applicable margin is based on the Company's total consolidated leverage ratio. The Base Rate equals the higher of (a) the rate of interest publicly announced from time to time by Bank of America as its reference rate, or (b) the Federal funds rate plus .5%. The Eurodollar Rate is based on (i) the interest rate per annum at which deposits in U.S. Dollars are offered by Bank of America's applicable lending office to major banks in the offshore market account in an aggregate principal amount approximately equal to the amount of the loan made to the Company and (ii) the maximum reserve percentage in effect under regulations issued from time to time by the Federal Reserve Board. The Company is also required to pay customary fees with respect to the Revolving Credit Facility, including an up-front arrangement fee, annual administrative agency fees and commitment fees on the unused portion of the Revolving Credit Facility. The Revolving Credit Facility includes both affirmative and negative covenants that include meeting certain financial ratios.
On April 26, 1999, Holdings and the Company amended the Revolving Credit Facility, effective as of March 29, 1999. This amendment limits the Company's ability to borrow in excess of $20,000,000 under the Revolving Credit Facility until certain ratios are achieved. This amendment also adjusted certain covenants contained in the original Revolving Credit Facility.
Effective July 20, 1999, the Revolving Credit Facility was further amended to provide for the sale of the Company's Internet business to Law.com (described below) and to modify certain debt covenants. On March 8, 2000 (effective March 28, 1999), the Revolving Credit Facility was further amended to modify certain of the covenants, permit the proposed transaction described below under Note 14--Subsequent Events and to increase the borrowing limit described above from $20 million to $22.5 million.
At December 31, 1999, the unused commitment was approximately $21,700,000, of which 1,700,000 is available in accordance with the April 26, 1999 Revolving Credit Facility amendment. The available balance under the unused commitment is further reduced by any letters of credit outstanding of which
AMERICAN LAWYER MEDIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1999, 1998 AND 1997
12. LONG-TERM DEBT (CONTINUED) totaled $1,121,000 at December 31, 1999. A 10% increase in the average rate in the Revolving Credit Facility during 1999 would have increased the Company's net loss to approximately $26,506,000.
13. FASB 107--FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and notes payable. The Company believes that the carrying amount for these accounts approximates fair value.
14. SUBSEQUENT EVENTS
On March 28, 2000, the Company sold the business of the Company and certain of the Company's wholly-owned subsidiaries constituting THE DAILY DEAL and CORPORATE CONTROL ALERT (the "Business") to TDD, L.L.C., a newly formed limited liability company (the "Purchaser") owned by substantially all of the same stockholders as Holdings. The consideration for the sale was $7.5 million in cash and $2.5 million face amount of a membership interest in the Purchaser with a preferred return (the "Preferred Membership Interest"). In addition, the Purchaser will pay the Company the aggregate amount of operating losses incurred by the Company in connection with the operation of the Business for the month of March 2000. The Preferred Membership Interest accretes at 12.25% compounded annually, is convertible into 3.0% of the common equity of the Purchaser, has anti-dilution protection for dividends in the form of additional equity interests, combinations, splits and reclassifications and has anti-dilution protection up to the first $25.0 million of equity capital including the Preferred Membership Interest issued by the Purchaser.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To American Lawyer Media, L.P.:
We have audited the accompanying balance sheet of American Lawyer Media, L.P. as of July 31, 1997 and the related statements of operations, changes in partners' capital and accumulated deficit and cash flows for the seven months then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of American Lawyer Media, L.P. as of July 31, 1997, and the results of its operations and its cash flows for the seven months then ended in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
New York, New York November 20, 1997
AMERICAN LAWYER MEDIA, L.P.
BALANCE SHEET
JULY 31, 1997
(IN THOUSANDS)
The accompanying notes to financial statements are an integral part of this balance sheet.
AMERICAN LAWYER MEDIA, L.P.
STATEMENT OF OPERATIONS (NOTE 3)
FOR THE SEVEN MONTHS ENDED JULY 31, 1997
(IN THOUSANDS)
The accompanying notes to financial statements are an integral part of this statement.
AMERICAN LAWYER MEDIA, L.P.
STATEMENT OF CHANGES IN PARTNERS' CAPITAL AND ACCUMULATED DEFICIT
FOR THE SEVEN MONTHS ENDED JULY 31, 1997
(IN THOUSANDS)
The accompanying notes to financial statements are an integral part of this statement.
AMERICAN LAWYER MEDIA, L.P.
STATEMENT OF CASH FLOWS
FOR THE SEVEN MONTHS ENDED JULY 31, 1997
(IN THOUSANDS)
The accompanying notes to financial statements are an integral part of this statement.
AMERICAN LAWYER MEDIA, L.P.
NOTES TO FINANCIAL STATEMENTS
JULY 31, 1997
1. ORGANIZATION
American Lawyer Media, L.P. (the "Company") is a limited partnership of Time Warner and Associated Newspapers. The sole general partner of American Lawyer Media, L.P. is Time Warner. The Company is based in New York and has operations in seven states and the District of Columbia. The Company publishes THE AMERICAN LAWYER, CORPORATE COUNSEL MAGAZINE, AMLAW TECH, THE CONNECTICUT LAW TRIBUNE, LEGAL TIMES, NEW JERSEY LAW JOURNAL, THE RECORDER, TEXAS LAWYER, FULTON COUNTY DAILY REPORT, and the DAILY BUSINESS REVIEWS, all of which are divisions of the Company. In addition, the Company consolidates its interest in COUNSEL CONNECT, a New York general partnership. The partnership, which runs a membership-based Internet service exclusively for lawyers and legal professionals, was formed in February 1994 by Mead Data Central and the Company. In February 1996, Mead Data Central assigned its interest in the partnership to the Company and also contributed the balance in its capital account of approximately $1,647,000, to the Company.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION
Advertising revenues are generated from the placement of display and classified advertisements, as well as legal notices, in the Company's publications. Advertising revenue is recognized upon release of the related publications to subscribers. Allowances for estimated doubtful accounts are provided based upon historical experience.
Subscription revenues are recognized on a pro rata basis as issues of a subscription are served.
Ancillary revenues consist principally of third-party printing services, newsletter subscriptions, sales of professional books and directories, Lexis/Nexis royalty income, seminar income, and a daily fax service of court decisions.
Internet services revenues consist of income earned from COUNSEL CONNECT subscriptions and usage fees.
DEFERRED SUBSCRIPTION INCOME
Deferred subscription income results from advance payments or orders for magazine subscriptions received from subscribers.
CIRCULATION PROMOTION (SUBSCRIPTION DIRECT MAIL) COSTS
Circulation promotion costs are charged to expense upon the release of the campaign.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
AMERICAN LAWYER MEDIA, L.P.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
JULY 31, 1997
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CASH AND CASH EQUIVALENTS
The Company considers time deposits and certificates of deposit with original maturities of three months or less to be cash equivalents.
INVENTORIES
Inventories consist principally of paper utilized by the Company and its outside printers and professional books published and sold by the Company. Inventories are stated at the lower of cost or market.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment is stated at cost. Significant improvements are capitalized, while expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets as follows:
Leasehold improvements are amortized over the shorter of the remaining lease term or the estimated useful life. The cost and accumulated depreciation of property sold or retired are removed from the accounts upon disposition.
INTANGIBLES AND GOODWILL
Intangible assets, consisting primarily of noncompete agreements and subscription lists, are valued at the appraised market value of the assets at the date of acquisition, net of accumulated amortization. Intangibles are amortized over the expected useful lives of the respective assets, ranging from two to thirteen years. Goodwill represents the excess of purchase price over the fair value of net assets acquired, less accumulated amortization. Goodwill is being amortized on a straight-line basis over 40 years.
ACCOUNTS PAYABLE
Included in accounts payable are $425,000 of bank overdrafts as of July 31, 1997.
3. INCOME TAXES
No provision has been made in the accompanying statement of operations for income taxes since, pursuant to provisions of the Internal Revenue Code, the net loss appearing on the accompanying statement of operations is reportable by each of the partners on their individual tax returns.
AMERICAN LAWYER MEDIA, L.P.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
JULY 31, 1997
4. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following at July 31, 1997 (in thousands):
5. RELATED PARTY TRANSACTIONS
The Company has a business relationship with Courtroom Television Network ("Court TV"), an affiliate of the Company's general partner. Revenues are generated through licensing fees charged to Court TV for editorial content and sales of advertisements. The licensing fees for American Lawyer publications totaled approximately $149,000 for the seven months ended July 31, 1997. Advertising revenues from Court TV totaled approximately $122,000 for the seven months ended July 31, 1997. In addition, the Company and Court TV share certain editorial and administrative resources and employees, as well as office facilities. The cost associated with employees who devote all or a portion of their time to Court TV activities is charged to Court TV based on an estimate of their time spent on such activities. These charges, which include an allocation for the chairman of the Company, amounted to $321,000 for the seven months ended July 31, 1997. Court TV is also charged a flat annual fee of $195,000 for use of the Company's reporters for on-camera appearances and background reports. Finally, an allocation is made to Court TV to cover general overhead costs (e.g., rent, utilities, etc.) which amounted to approximately $53,000 for the seven months ended July 31, 1997. Amounts due from Court TV are reflected as due from affiliate on the accompanying balance sheet.
The Company's general partner provides certain legal, administrative, accounting, and tax services for the Company. Charges for such services amounted to approximately $47,000 for the seven months ended July 31, 1997.
6. DUE TO GENERAL PARTNER
Due to General Partner consists of borrowings from WCI/AMLAW Inc. and interest accrued thereon. The borrowings bear interest at 1% under prime and do not have a stated maturity date. This amount has been included in long-term liabilities in the accompanying balance sheet since the amount is not intended to be repaid within the next year.
7. COMMITMENTS AND CONTINGENCIES
Rent expense, including payments of real estate taxes, insurance and other expenses required under certain leases, amounted to approximately $1,046,500 for the seven months ended July 31, 1997, including rent accruals in excess of payments of $6,600.
AMERICAN LAWYER MEDIA, L.P.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
JULY 31, 1997
7. COMMITMENTS AND CONTINGENCIES (CONTINUED) Minimum rental commitments under noncancellable leases as of July 31, 1997 were as follows (in thousands):
Certain of the leases provide for free rent periods as well as rent escalations. The rental commitments above represent actual rental payments to be made. The financial statements reflect rent expense and rental income on a straight-line basis over the terms of the leases. An obligation of $6,600, representing accrued pro rata future payments, net of receipts, is included in the accompanying balance sheet.
The Company subleases a portion of its office facilities to Court TV. The sublease charges summarized above are based on an oral agreement between the Company and Court TV.
The lease for the Company's headquarters contains a provision whereby the Company could elect not to renew the lease for the years 1999 through 2008 upon payment of a $2,200,000 termination penalty.
The Company is involved in a number of legal proceedings, some of which are significant, which arose in the ordinary course of business. In the opinion of management, the ultimate outcome of these contingencies is not expected to have a material adverse effect on the Company's financial position or results of operations.
8. EMPLOYEE BENEFITS
The Company sponsors a retirement savings plan. Participation in this plan is available for substantially all employees. The plan provides for employer matching of employees' contributions, as defined. The cost of the plan was $177,000 for the seven months ended July 31, 1997.
The Company has a defined benefit plan covering substantially all employees. The Company's general funding policy is to contribute annual amounts that satisfy the Internal Revenue Code funding requirements. The components of net periodic pension cost for the year ended December 31, 1996 were as follows (in thousands):
AMERICAN LAWYER MEDIA, L.P.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
JULY 31, 1997
8. EMPLOYEE BENEFITS (CONTINUED) The following table sets forth the funded status of the Company's defined benefit plan and amounts recognized in the balance sheet as of December 31, 1996 (in thousands):
In determining the actuarial present value of the projected benefit obligation as of December 31, 1996, the discount rate was 7.5%, the rate of increase in future compensation levels was 6%, and the expected long-term rate of return on assets was 9%.
The Company sponsors an Excess Benefit Pension Plan providing a benefit to highly compensated employees in excess of the benefits provided by the tax qualified defined benefit plan. The plan is an unfunded, non-qualified deferred compensation plan.
The Company also sponsors a comprehensive medical and dental insurance plan which is available to substantially all employees. The Company is self insured for claims submitted under this plan up to predetermined amounts, above which third party insurance applies.
9. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 107-FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and due to general partner. The carrying amount of these accounts approximates fair value.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the National Law Publishing Company, Inc.:
We have audited the accompanying consolidated balance sheet of National Law Publishing Company, Inc. (a New York corporation) and subsidiaries as of December 21, 1997 and the related consolidated statement of operations, stockholders' equity and cash flows for the period from January 1, 1997 through December 21, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of National Law Publishing Company, Inc. and subsidiaries as of December 21, 1997, and the results of their operations and their cash flows for the period from January 1, 1997 through December 21, 1997 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
New York, New York April 3, 1998
NATIONAL LAW PUBLISHING COMPANY, INC.
CONSOLIDATED BALANCE SHEET
AS OF DECEMBER 21, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of this balance sheet
NATIONAL LAW PUBLISHING COMPANY, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE PERIOD FROM JANUARY 1, 1997 THROUGH DECEMBER 21, 1997
(IN THOUSANDS)
The accompanying notes are an integral part of this statement
NATIONAL LAW PUBLISHING COMPANY, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE PERIOD FROM JANUARY 1, 1997 THROUGH DECEMBER 21, 1997
(IN THOUSANDS)
The accompanying notes are an integral part of this statement
NATIONAL LAW PUBLISHING COMPANY, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE PERIOD FROM JANUARY 1, 1997 THROUGH DECEMBER 21, 1997
(IN THOUSANDS)
The accompanying notes are an integral part of this statement
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 21, 1997
1. ORGANIZATION
The National Law Publishing Company, Inc. ("National") through its wholly owned operating subsidiary, New York Law Publishing Company, Inc. ("NYLP" or the "Company") is considered a leading publisher of periodicals, books and newsletters as well as a provider of seminars and electronic information services targeted to the U.S. legal community. NYLP's principal periodical publications are the New York Law Journal (a daily newspaper), The National Law Journal (a weekly publication) and Law Technology Product News (published approximately fifteen times per year). NYLP also wholly owns Law Journal EXTRA!, Inc. ("LJX"). LJX is an on-line service available on the World Wide Web providing access to various legal information and related services including electronic versions of NYLP's principal periodicals.
On December 1, 1995, Boston Ventures Limited Partnership IV and Boston Ventures Limited Partnership IVA (collectively "Boston Ventures"), through a wholly-owned subsidiary, NLPC Acquisition, Inc. ("NAI"), acquired approximately 71,308 shares of National's common stock from Apollo Publishing Partners, L.P. ("Apollo") and James A. Finkelstein ("Finkelstein"), the chief executive of the Company, and initiated a series of related transactions which resulted in Boston Ventures acquiring approximately 94.3% of National for $141,958,454 in cash plus acquisition related costs of $757,000.
In addition, on December 1, 1995, NAI was merged into National, with National as the surviving corporation. In connection with the merger, Boston Ventures received 60,916.5954 shares of National's common stock (approximately 94.3% of National's outstanding stock) in exchange for its shares of NAI. Finkelstein retained 3,691.9149 shares of National, approximately 5.7% of its outstanding stock. In addition, under a related stock option agreement, Finkelstein was granted options to acquire up to an additional 6,461 shares of National which vest, subject to certain employment and operating performance criteria, over a five year period (Note 7).
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
CONCENTRATIONS OF CREDIT RISK
The Company's financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. The Company believes it is not exposed to any significant credit risk related to cash and cash equivalents. Concentrations of credit risk with respect to trade accounts receivable are, except for amounts due from legal advertising ad agents ("Legal Ad Agents"), generally limited due to the large number of customers comprising the Company's customer base. Such Legal Ad Agents do not have significant liquid net worth and, as a result, the Company is exposed to a certain level of credit concentration risk in this area, which the Company believes it has adequately provided for.
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) REVENUE RECOGNITION
Advertising revenues are generated from the placement of display and classified advertisements, as well as legal notices, in the Company's publications. Advertising revenue is recognized upon release of the related publications to subscribers.
Subscription revenues are recognized on a pro rata basis as issues of a subscription are served.
Ancillary revenues consist principally of newsletter subscriptions, sales of professional books, software, royalty income and seminar income.
Internet services revenues are recognized upon the release of an advertisement on the website.
DEFERRED SUBSCRIPTION INCOME
Deferred subscription income results from advance payments or orders for subscriptions received from subscribers and is amortized on a straight-line basis over the life of the subscription as issues are served. Subscription receivables of $734,000 are included in accounts receivable in the accompanying consolidated balance sheet.
EXPENSE RECOGNITION
ADVERTISING AND PROMOTION COSTS--Advertising expenditures are expensed when the particular advertisement is released. The Company capitalizes direct response promotional costs. At December 21, 1997 approximately $1,152,000 of direct response promotional costs was recorded in other assets on the accompanying consolidated balance sheet. Advertising expense was approximately $3,018,000 for the period ended December 21, 1997. The amortization of direct response promotion expenditures is included in selling expense in the accompanying consolidated statements of operations.
EDITORIAL COSTS--All editorial costs are expensed as incurred.
CASH AND CASH EQUIVALENTS
The Company considers time deposits and certificates of deposit with original maturities of three months or less to be cash equivalents.
INVENTORIES
Inventories consist principally of professional books published and sold by the Company and related binding materials utilized. Inventories are stated at the lower of cost, as determined by the average cost method, or market.
PROPERTY, PLANT AND EQUIPMENT
Furniture, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Furniture, equipment and purchased software are depreciated on a straight-line basis over their respective estimated useful lives. Repairs and maintenance are charged to expense as incurred. Leasehold improvements are amortized over the lives of the improvements or the term of the related lease, whichever is shorter.
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INTANGIBLE ASSETS
Intangible assets include deferred financing costs with the amortization and/or write-off of such costs classified as part of amortization expense. Goodwill represents the excess of purchase price over the fair value of net assets acquired.
3. PROPERTY, PLANT AND EQUIPMENT, NET
The following is a summary of property, plant and equipment at December 21, 1997:
4. INTANGIBLE ASSETS, NET
The following is a summary of intangible assets at December 21, 1997:
Total amortization expense of intangibles was approximately $6,709,000 for the period ended December 21, 1997.
5. LONG-TERM DEBT
Long-term debt was comprised of the following at December 21, 1997:
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
5. LONG-TERM DEBT (CONTINUED) REVOLVING CREDIT FACILITIES
On December 1, 1995, the Company entered into a revolving credit facility agreement (the "Credit Agreement") with The First National Bank of Boston (the "Bank"), as a lender and as agent for other lenders, under which NAI borrowed $15,674,061 and NYLP borrowed $55,225,939 (aggregating $70,900,000) in connection with Boston Ventures' acquisition of the Company. Upon NAI's merger into National, NYLP assumed the $15,674,061 of Bank debt, in the form of a dividend from NYLP to National. The Company's borrowing capacity under the Revolving Credit Facility, including cash loans and standby letters of credit of up to $6 million, was $70.5 million through December 21, 1997, and decreases semi-annually until final maturity on December 31, 2002 as follows:
Available borrowings under this facility are further limited by the sum of (a) the Company's letter of credit exposure and (b) certain stipulated percentages of excess cash flow based on the ratio of the Company's consolidated funded debt to consolidated operating cash flow, as defined. Outstanding borrowings under the facility bear interest at a fluctuating rate, subject to the Company's elected pricing option, at either the Base Rate, Eurodollar Rate, and/or CD Rate, plus a variable margin based on the Company's ratio of consolidated funded debt to consolidated operating cash flow, as defined. The interest rate under this Revolving Credit Facility approximated 8.0% for the period ended December 21, 1997. Commitment fees are charged and payable quarterly at either a .375% or .500% annual rate, depending on the Company's ratio of consolidated funded debt to consolidated operating cash flow for the immediately preceding quarter (the "Quarterly Funded Debt Ratio") and on the average daily unused portion of the Revolving Credit Facility. In addition, letter of credit usage fees are payable at rates which range between 1.25% and 2.5% depending on the Quarterly Funded Debt Ratio and on the daily letter of credit exposure during the three month period or portion thereof ending on such payment date. The Revolving Credit Facility is secured by the assets of National and NYLP and the stock of NYLP and its subsidiaries.
The Credit Agreement requires, among other things, that the Company maintain certain minimum levels of consolidated operating cash flow and certain prescribed ratios of consolidated funded debt to consolidated operating cash flows, consolidated operating cash flow to interest expense and consolidated adjusted operating cash flow to consolidated fixed charges, as defined. The Credit Agreement contains
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
5. LONG-TERM DEBT (CONTINUED) other restrictive covenants, including limitations on indebtedness, investments and acquisitions, the disposition of assets, transactions with affiliates and distributions to stockholders.
The Agreement provides that within 10 days after the Eurodollar Basic Rate for three month Eurodollar Pricing Options first exceeds 5.875% per annum, the Company will obtain and thereafter keep in effect one or more interest rate protection agreements covering a notional amount of at least 50% of the outstanding borrowings under the Revolving Credit Facility for an aggregate period of not less than two years.
6. INCOME TAXES
National and its subsidiaries file a consolidated Federal and combined New York State and New York City income tax returns. NYLP also files income tax returns in California and the District of Columbia. At December 21, 1997, National had a net operating loss carryforwards available to offset future taxable income for Federal income tax purposes of approximately $2.0 million. These carryforwards expire in the years 2004 through 2010 and, as a result of the change in ownership described in Note 1, are subject to the limitations of Internal Revenue Code Section 382. At December 21, 1997, National had approximately $75,000 of operating loss carryforwards for New York State and New York City income tax purposes.
The provision for income taxes is comprised of the following for the period from January 1, 1997 to December 21, 1997:
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
6. INCOME TAXES (CONTINUED) The reconciliation between the provision for income taxes and the amount computed by applying the statutory Federal income tax rate to loss before income taxes is as follows for the period from January 1, 1997 to December 21, 1997:
7. STOCKHOLDERS' EQUITY
STOCK OPTIONS
In connection with and as a condition of Boston Ventures' acquisition, the Company entered into a stock option agreement (the "Agreement") with Finkelstein which, subject to certain terms and conditions of the Agreement, granted Finkelstein an option to purchase an aggregate of approximately 6,461 shares of National's common stock. One-third of the shares covered by the option vest and become exercisable in 60 equal installments of approximately 36 shares on the last day of each month commencing on January 31, 1996 and continuing until December 31, 2000. The remaining shares vest and become exercisable, subject to the Company's attainment of two separate annual operating cash flow targets, as defined, in equal annual installments of approximately 431 shares or approximately 862 shares, respectively (if such respective operating cash flow targets are reached), on December 31, 1996 through 2000 or upon sale, subject to achieving certain performance targets. The vesting of all shares is generally subject to Finkelstein being employed by the Company on such dates. The shares are exercisable at a price of approximately $1,083 per share and expire on the tenth anniversary date of the Agreement.
STOCKHOLDERS' AGREEMENT
On December 1, 1995, Boston Ventures, National and Finkelstein entered into a stockholders' agreement which, among other things, allows Finkelstein, upon the nonrenewal of his employment, as defined in his employment agreement to require the Company to purchase all of his shares and liquidate and cash out his vested option shares for fair value. The Company's obligation to acquire Finkelstein's shares is subject to it being permitted by the Credit Agreement and applicable law to do so. In addition, the stockholders' agreement gives the Company, along with Boston Ventures, the right of first refusal with respect to Finkelstein's shares.
8. RETIREMENT PLANS
The Company has a 401(k) profit sharing plan (the "Plan") for all eligible employees who have completed one year of service. Under the Plan, the Company has the option of making a matching contribution of up to 3% of a participant's compensation. The Company may also annually contribute
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
8. RETIREMENT PLANS (CONTINUED) additional discretionary amounts to participants. For the period ended December 21, 1997, the Company did not make any matching discretionary contributions to the Plan.
In addition, approximately twenty Company employees are covered by certain defined contribution retirement plans sponsored by the Typographical Union. Company contributions to these retirement plans for the period ended December 21, 1997 were approximately $474,000.
9. COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
The Company leases office space under non-cancelable operating leases which expire at various dates through October 2008. At December 21, 1997, the future minimum payments due under these leases, net of sublease income are as follows:
Rent expense, net of sublease income, was approximately $1,153,000 for the period ended December 21, 1997.
At December 21, 1997, the Company had a letter of credit outstanding of approximately $533,000 for the security deposit on its corporate office space.
EMPLOYMENT AGREEMENT
In connection with Boston Ventures' December 1, 1995 acquisition of the Company, Finkelstein entered into a long-term employment agreement (the "Employment Agreement") with the Company. The initial term of the Employment Agreement is through December 31, 2000 and provides for, among other things, an annual base salary which, beginning on June 30, 1996, and annually thereafter, is to be increased by the greater of (i) 5% or (ii) the annual increase in the consumer price index for all urban consumers not in excess of 8%.
LEGAL MATTERS
The Company is subject to certain legal actions and complaints that arise in the ordinary course of its business. In the opinion of management, the amount of the ultimate liability, if any, which may result from these legal actions and complaints will not materially affect the consolidated financial statements of the Company.
NATIONAL LAW PUBLISHING COMPANY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 21, 1997
10. FAIR VALUES OF FINANCIAL INSTRUMENTS
The Company has a number of financial instruments, none of which are held for trading purposes. These financial instruments consist of cash and cash equivalents, long-term debt and interest rate protection agreements. The Company estimates that the fair value of all financial instruments at December 21, 1997 does not differ materially from the aggregate carrying values of its financial instruments recorded in the accompanying consolidated balance sheet.
11. SUBSEQUENT EVENT
On December 22, 1997, Boston Ventures and Mr. James A. Finkelstein completed a Stock Purchase Agreement with American Lawyer Media, LLC for the sale of NLP. The purchase price for the NLP acquisition was approximately $203,200,000 in cash. In connection with the sale of the Company, Boston Ventures cashed out options held by certain management employees with a portion of the proceeds of the sale. The payment totaled approximately $6,926,000 which is included as a special compensation charge in the accompanying consolidated statement of operations (See Note 7).
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
POWER OF ATTORNEY
Each person whose signature appears below constitutes and appoints William L. Pollak and Anup Bagaria and each of them, his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any or all amendments (including post-effective amendments) to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their, his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
* * * * *
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the date indicated.
EXHIBIT INDEX
- ------------------------
* Exhibits are incorporated by reference from the Company's Registration Statement on Form S-4 (File No. 333-50117).
+ Confidential treatment has been requested for certain portions of this document.
(B) FINANCIAL STATEMENT SCHEDULES
AMERICAN LAWYER MEDIA, INC.
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
For the Twelve Months Ended December 31, 1999 and the Twelve Months Ended December 31, 1998 (dollars in thousands):
- ------------------------
(1) Represents reversals of the allowance account and write-offs of accounts receivable, net of recoveries. | 23,351 | 154,209 |
884940_1999.txt | 884940_1999 | 1999 | 884940 | ITEM 1. BUSINESS
At January 2, 1999, Stein Mart, Inc., (the "Company" or "Stein Mart") was a 182-store retail chain offering fashionable, current-season, primarily branded merchandise comparable in quality and presentation to that of traditional department and fine specialty stores at prices typically 25% to 60% below those regularly charged by such stores. The Company's focused assortment of merchandise features moderate to designer brand-name apparel for women, men and children, as well as accessories, gifts, linens, shoes and fragrances. Stein Mart operated a single store in Greenville, Mississippi from the early 1900's until 1977, when it began its expansion program. During the last five years, the Company has more than doubled the number of Stein Mart stores from 66 in 16 states at year-end 1993 to 182 in 29 states at January 2, 1999. The Company's stores, which average approximately 38,000 gross square feet, are located primarily in neighborhood shopping centers in metropolitan areas.
Business Strategy
The Company's business strategy is to (i) maintain the quality of merchandise, store appearance, merchandise presentation and customer service levels typical of traditional department and fine specialty stores and (ii) offer value pricing to its customers through its vendor relationships, tight control over corporate and store expenses and efficient management of inventory. The principal elements of the Company's business strategy are as follows:
Timely, Consistent, Upscale Merchandise. The Company purchases upscale, branded merchandise primarily through preplanned buying programs similar to those used by traditional department and fine specialty stores. These preplanned buying programs enable the Company to offer fashionable, current-season assortments on a consistent basis.
Appealing Store Appearance and Merchandise Presentation. The Company creates an ambiance in its stores similar to that of upscale retailers through attractive in-store layout and signage. Merchandise is displayed in lifestyle groupings to encourage multiple purchases.
Emphasis on Customer Service. Customer service is fundamental to Stein Mart's objective of building customer loyalty. Management believes that the Company offers customer service superior to off-price retailers and more comparable to traditional department and fine specialty stores.
Value Pricing through Vendor Relationships. In negotiating with Stein Mart, vendors do not build into their pricing structure anticipated returns or markdown and advertising allowances which are typical in the department store industry. Stein Mart passes these savings on to its customers through prices which are
typically 25% to 60% below those regularly charged by traditional department and fine specialty stores.
Efficient Inventory Handling. Stein Mart does not rely on a large distribution center or warehousing facility. Rather, it primarily utilizes drop shipments from its vendors directly to its stores. This system enables the Company to receive merchandise at each store on a timely basis and to save the time and expense of handling merchandise twice, which is typical of a traditional distribution center structure.
Operating Efficiencies. Management believes that there will be opportunities to create additional operating efficiencies as the Company continues to add stores in new and existing markets.
Expansion Strategy
The Company's expansion strategy is to add stores in new markets, including those markets with the potential for multiple stores, and existing markets to capture advertising and management efficiencies. The Company plans to open approximately 33 stores in 1999.
The Company targets metropolitan statistical areas with populations of 125,000 or more for new store expansion. In determining where to locate new stores, the Company evaluates detailed demographic information, including, among other factors, data relating to income, education levels, age, occupation, the availability of prime real estate locations, existing and potential competitors, and the number of Stein Mart stores that a market can support. As a result of processing less than 10% of its merchandise through its distribution center, the Company is not constrained geographically or by the capacity limits of a central facility. This allows management to concentrate on the best real estate opportunities in targeted markets.
The Company refurbishes existing retail locations or occupies newly constructed stores, which typically are anchor stores in new or existing shopping centers situated near upscale residential areas, ideally with co-tenants that cater to a similar customer base. The Company's ability to negotiate favorable leases and to construct attractive stores with a relatively low investment provides a significant cost advantage over traditional department and fine specialty stores. The cost of opening a typical new store includes approximately $450,000 to $650,000 for fixtures, equipment, leasehold improvements and pre-opening expenses (primarily advertising, stocking and training). Pre-opening costs are expensed when incurred. Initial inventory investment for a new store is approximately $1 million (a portion of which is financed through vendor credit).
Merchandising
Stein Mart's focused assortment of merchandise features moderate to designer brand-name apparel for women, men and children, as well as accessories, gifts, linens, shoes and fragrances. Branded merchandise is complemented by a limited private label program that enhances the Company's assortments of current fashion trends and provides key upper-end classifications in complete size ranges.
Management believes that Stein Mart differentiates itself from typical off-price retailers by offering: (i) a higher percentage of current-season merchandise carried by traditional department and fine specialty stores at moderate to better price levels, (ii) a stronger merchandising "statement," consistently offering more depth of color and size in individual stockkeeping units, and (iii) a merchandise presentation more comparable to traditional department and fine specialty stores.
The Company identifies and responds to the latest fashion trends. Within each major merchandise category, the Company offers a focused assortment of the best-selling department and fine specialty store items. Stein Mart's merchandise selection is driven primarily by its own merchandising plans which are based on management's assessment of fashion trends, color, and market conditions. This strategy distinguishes Stein Mart from traditional off-price retailers who achieve cost savings by responding to unplanned buying opportunities. The Company's merchandise is typically priced at levels 25% to 60% below prices regularly charged by traditional department and fine specialty stores, therefore offering distinct value to the Stein Mart customer.
The following reflects the percentage of the Company's revenues by major merchandise category for the periods indicated:
Fiscal Year Ended -------------------------------------------- December 28, January 3, January 2, 1996 1998 1999 ------------ ---------- ---------- Ladies' and Boutique apparel 36% 38% 38% Ladies' accessories 11 11 11 Men's and young men's 20 19 19 Gifts and linens 18 17 18 Shoes (leased department) 8 8 7 Children's 6 6 6 Other 1 1 1 ---- ---- ---- 100% 100% 100% ==== ==== ====
Ladies' apparel, the Company's largest contributor of revenues, consists of distinctive presentations of dresses, sportswear, petites, juniors and women's sizes at moderate to upper-moderate prices. Stein Mart's distinctive Boutique is a key element of the Company's merchandising strategy to attract the more fashion-conscious customers. The Boutique, a store-within-a-store department, carries better to designer ladies' apparel and offers the presentation and service levels of a fine specialty boutique. Each Stein Mart store has its own Boutique, staffed generally by women employed on a part-time basis who are civically and socially prominent in the community. The Boutique highlights the Company's strategy of offering upscale merchandise, presentation and service levels at value prices.
The Company's typical store layout emphasizes ladies' accessories as the fashion focus at the front of each store. The key merchandise in this department is fashion-oriented, brand-name, designer and private label jewelry, as well as scarves, hosiery, leather goods, bath products and fragrances.
Men's and young men's areas together provide the second largest contribution to revenues. Menswear consists of sportswear, suits, sportcoats, slacks, dress furnishings and a Big and Tall assortment. The Company believes that its merchandise presentation is particularly strong in men's better sportswear.
Stein Mart's gifts and linens departments consist primarily of a broad assortment of fashion-oriented gifts (rather than basic items) for the home and a wide range of table, bath and bed linens and, in some stores, decorative fabrics. The presentation in this distinctive department emphasizes fashion, lifestyle and seasonal themes and includes the full range of merchandise available in a typical department store. The strength of this category has been the consistent presentation with a higher percentage mix of better goods.
Stein Mart's children's department offers a range of apparel for infants and children and features an infants' gift boutique.
The Company's shoe department is a leased department operated in individual stores by one of two shoe retailers. The merchandise in this department is presented in a manner consistent with the Company's overall presentation in other departments, stressing fashionable, current-season footwear at value prices. This department offers a variety of men's and women's casual and dress shoes, which complement the range of apparel available in other departments. Shoe department leases provide for the Company to be paid the greater of an annual base rent or a percentage of sales. Almost all of the leases currently pay on the percentage of sales basis.
In 1995, the Company began leasing its fragrance department to a third-party operator. The operating agreement requires the third-party operator to pay the Company the greater of an annual base amount or a percentage of sales.
Store Appearance
Stein Mart's stores are designed to reflect the upscale ambiance and appearance of traditional department and fine specialty stores through attractive layout, displays and in-store signage. The typical store is approximately 38,000 gross square feet with convenient check-out and customer service areas and attractive, individual dressing rooms. The Company seeks to create excitement in its stores through the continual flow of brand-name merchandise, sales promotions, store layout, merchandise presentation, and the quality, value and depth of its merchandise assortment.
The Company displays merchandise in lifestyle groupings of apparel and accessories. Management believes that the lifestyle grouping concept strengthens the fashion image of its merchandise and enables the customer to locate desired merchandise in a manner that encourages multiple purchases.
Customer Service
Customer service is fundamental to Stein Mart's objective of building customer loyalty. The Company's stores offer most of the same services typically found in traditional department and fine specialty stores such as alterations and a liberal merchandise return policy. Each store is staffed to provide a number of sales associates to properly attend to customer needs.
The Company's training programs for sales associates and cashiers emphasize attentiveness, courtesy and the effective use of selling techniques. The Company reinforces its training programs by employing independent shopping services to monitor associates' success in implementing the principles taught in sales training. Associates who are highly rated by the shopping service receive both formal recognition and cash awards. Management believes this program emphasizes the importance of customer service necessary to create customer loyalty.
Vendor Relationships and Buying
Stein Mart buys from over 2,900 vendors. Many of these are considered key vendors, with whom the Company enjoys longstanding working relationships that create a continuity of preplanned buying opportunities for upscale, current-season merchandise. Most of the Company's vendors are based in the United States, which generally reduces the time necessary to purchase and obtain shipments and allows the Company to react to merchandise trends in a timely fashion. The Company does not have long-term or exclusive contracts with any particular vendor. In 1998, less than 2% of Stein Mart's purchases were from any single vendor.
The Company employs several purchasing strategies to provide its customers with a consistent selection of quality, fashionable merchandise at value prices: (i) Stein Mart commits to its purchases from vendors well in advance of the selling season, in the same manner as department stores, unlike typical off-price retailers who rely heavily on buys of close-out merchandise or overruns; (ii) the Company's information systems enable it to acquire merchandise and track sales information on a store-by-store basis, allowing its buying staff to respond quickly to customer buying trends; and (iii) an in-house merchandise development department works with buyers and brand-name vendors to
ensure that the merchandise assortments offered are unique, fashionable, color-forward and of high quality.
Stein Mart negotiates favorable prices from its vendors by not requiring advertising and markdown allowances or return privileges that are typical in the department store industry, resulting in savings that the Company passes along to its customers in the form of prices that are typically 25% to 60% below those regularly charged by traditional department and fine specialty stores.
The Company's buying staff is headed by the Executive Vice President, Merchandising, who is supported by four Vice Presidents - General Merchandising Managers, nine Divisional Merchandising Managers and 34 buyers. In addition to base salary, the merchandising staff receives incentive compensation for achieving certain sales goals within their areas of responsibility. Historically, the Company has had very low turnover within its buying staff, enabling it to capitalize on an experienced, respected group of buyers capable of maintaining and enhancing the Company's vendor relationships.
Information Systems
The Company's information systems provide daily financial and merchandising information that is used by management to make timely and effective purchasing and pricing decisions and for inventory control.
The Company's inventory control system enables it to achieve economies of scale from bulk purchases while at the same time ordering and tracking separate drop shipments by store. Store inventory levels are regularly monitored and adjusted as sales trends dictate. The inventory control system provides information that enhances management's ability to make informed buying decisions and accommodate unexpected increases or decreases in demand for a particular item. The Company uses bar codes and bar code scanners as part of an integrated inventory management and check-out system in its stores.
The Company's merchandise planning and allocation system enables the merchandise buyers to customize their merchandise assortments at the individual store and department level, based on selected criteria, such as a store's selling patterns, geography and merchandise color preferences. The ability to customize individual store assortments enables the Company to more effectively manage inventory, capitalize on sales trends and reduce markdowns.
A computerized time management system assists management in scheduling store associates' hours based on individual store's own customer traffic patterns and necessary tasks. This system helps to maximize customer service levels and enhance efficiency.
Store Operations
The Company has five Vice Presidents - Regional Directors of Stores who report to the Executive Vice President, Stores. Two of the Vice Presidents each directly oversee 12 to 13 stores and three of the Vice Presidents have District Directors of Stores reporting to them, who are each responsible for overseeing 8 to 13 stores. Each Vice President's and District Director's compensation includes an incentive component based on overall performance. Each Stein Mart store is managed by a general manager who reports directly to a Vice President or a District Director. Store general managers are responsible for individual store operations, including hiring, motivating and supervising sales associates; receiving and effectively presenting merchandise; and implementing price change determinations made by the Company's buying staff. Store general managers receive incentive compensation based upon operating results in several key areas, including increases in store sales. In addition to the store general manager and two assistant store managers, each Stein Mart store employs an average of 55 persons as department managers, sales associates, cashiers and in other positions.
Stein Mart stores are generally open 11 hours per day, 6 days a week, and on Sunday afternoons. The store hours are extended during the Christmas selling season.
Advertising and Sales Promotion
The Company's advertising strategy stresses the offering of upscale, branded merchandise at significant savings. The Company generally allocates the majority of its advertising budget to newspaper advertising, employing a combination of image, price-and-item and sales event approaches. While newspaper and color inserts will continue to be an integral part of the media mix, radio, television and direct mail will be utilized in selected markets. Stein Mart's per-store advertising expense is reduced by spreading its advertising over multiple stores in a single market. Management believes the Company also enjoys substantial word-of-mouth advertising benefits from its customer base.
Competition
Management believes that the Company occupies a market niche closer to traditional department stores than typical off-price retail chains. The Company faces competition for customers and for access to quality merchandise from traditional department stores, fine specialty stores and, to a lesser degree, from off-price retail chains. Many of these competitors are units of large national or regional chains that have substantially greater resources than the Company. The retail apparel industry is highly fragmented and competitive, and the off-price retail business may become even more competitive in the future.
The principal competitive factors in the retail apparel industry are assortment, presentation, quality of merchandise, price, customer service, vendor relations and store location. Management believes that the Company is well-positioned to compete on the basis of each of these factors.
Employees
At January 2, 1999, the Company's work force consisted of approximately 10,500 employees (6,700 40-hour equivalent employees). The number of employees fluctuates based on the particular selling season.
Trademarks
The Company owns the federally registered trademark Stein Mart(R), together with a number of other marks used in conjunction with its private label merchandise program. Stein Mart primarily sells branded merchandise. However, in certain classifications of merchandise, the Company uses several private label programs to provide additional availability of items. Management believes that its trademarks are important but, with the exception of Stein Mart(R), not critical to the Company's merchandising strategy.
ITEM 2.
ITEM 2. PROPERTIES
At January 2, 1999, the Company operated stores in the following states:
State Number of Stores ----- ---------------- Alabama 5 Arizona 6 Arkansas 5 California 2 Colorado 3 Florida 24 Georgia 13 Illinois 4 Indiana 5 Iowa 2 Kansas 2 Kentucky 3 Louisiana 8 Mississippi 4 Missouri 2 Nebraska 1 Nevada 2 New Mexico 2 New York 2 North Carolina 12 Ohio 10 Oklahoma 4 Pennsylvania 1 South Carolina 4 South Dakota 1 Tennessee 10 Texas 34 Virginia 6 Wisconsin 5 ---- ====
The Company leases all of its store locations and therefore has been able to grow without incurring indebtedness to acquire real estate. Management believes that the Company has earned a reputation as an "anchor tenant," which, along with its established operating history, has enabled it to negotiate favorable lease terms. Most of the leases provide for minimum rents, as well as percentage rents that are based on sales in excess of predetermined levels.
The table below reflects (i) the number of the Company's leases (as of January 2, 1999) that will expire each year if the Company does not exercise any of its renewal options, and (ii) the number of the Company's leases that will expire each year if the Company exercises all of its renewal options (assuming the lease is not otherwise terminated by either party pursuant to any other provision).
Number of Leases Number of Leases Expiring Each Year Expiring Each Year if no Renewals if all Renewals Exercised Exercised ------------------ ------------------ 1999 1 0 2000 8 0 2001 7 0 2002 7 0 2003 14 0 2004-2008 105 6 2009-2013 39 22 2014-2045 1 154
The Company has made consistent capital commitments to maintain and improve existing store facilities. During 1998, approximately $4.2 million was spent to upgrade computer equipment, fixtures, equipment and leasehold improvements in stores opened prior to 1998.
The Company leases approximately 54,000 gross square feet of office space for its corporate headquarters in Jacksonville, Florida. The Company also leases a 92,000 square foot distribution center in Jacksonville for the purpose of processing a limited amount of merchandise (less than 10%).
The Company continually evaluates underperforming stores and may choose to close selected underperforming stores. In accordance with this policy, the Company closed its Denver, Colorado store in May 1992, its Plantation, Florida store in February 1996 and its Milpitas, California store in December 1998. A new store at a different location was opened in Denver in March 1996 and a new store will be opening in Plantation, Florida in Fall 1999.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in various routine legal proceedings incidental to the conduct of its business. Management does not believe that any of these legal proceedings will have a material adverse effect on the financial condition or results of operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference and is shown in Exhibit 13.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information required by this item is incorporated by reference and is shown in Exhibit 13.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item is incorporated by reference and is shown in Exhibit 13.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements with PricewaterhouseCoopers LLP report dated February 19, 1999, are incorporated by reference in the Form 10-K Annual Report and are shown in Exhibit 13.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item appears under the caption "Election of Directors" in the Company's Proxy Statement for its 1999 Annual Meeting of Stockholders and is incorporated by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item appears under the caption "Executive Compensation" in the Company's Proxy Statement for its 1999 Annual Meeting of Stockholders and is incorporated by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item appears under the caption "Voting Securities" in the Company's Proxy Statement for its 1999 Annual Meeting of Stockholders and is incorporated by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item appears under the caption "Certain Transactions; Compensation Committee Interlocks and Insider Participation" in the Company's Proxy Statement for its 1999 Annual Meeting of Stockholders and is incorporated by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
Financial Statements
The financial statements shown in Exhibit 13 are hereby incorporated by reference.
Financial Statement Schedules
All schedules are omitted because they are not applicable or the required information is presented in the financial statements or notes thereto.
Reports on Form 8-K
The Company did not file a report on Form 8-K during the quarter ended January 2, 1999.
Exhibits
* 3A - Articles of Incorporation of the registrant
* 3B - Bylaws of the registrant
4A - See Exhibits 3A and 3B for provisions of the Articles of Incorporation and Bylaws of the Registrant defining rights of holders of Common Stock of the registrant
* 4B - Form of stock certificate for Common Stock
~*10E - Form of Director's and Officer's Indemnification Agreement
10F - Loan Agreement and related promissory notes between the registrant and NationsBank, N.A. and SunTrust Bank, North Florida, N.A (previously filed as Exhibit 10 to Registrant's 10-Q for the quarter ended October 3, 1998 and incorporated herein by reference)
~*10G - Employee Stock Plan
~*10H - Form of Non-Qualified Stock Option Agreement
~*10I - Form of Incentive Stock Option Agreement
*10J - Profit Sharing Plan
~*10K - Executive Health Plan
~*10L - Director Stock Option Plan
13 - Portions of 1998 Annual Report incorporated by reference into 1998 Annual Report on Form 10K.
23 - Consent of PricewaterhouseCoopers LLP
27 - Financial Data Schedule
* Previously filed as Exhibit to Form S-1 Registration Statement 33-46322 and incorporated herein by reference. ~ Management Contracts or Compensatory Plan or Arrangements filed pursuant to S-K 601 (10)(iii)(A).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
STEIN MART, INC.
Date: April 1, 1999 By: /s/ Jay Stein -------------------------------- Jay Stein, Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated on the 1st day of April, 1999.
/s/ Jay Stein /s/ Alvin R. Carpenter - ---------------------------- ---------------------- Jay Stein Alvin R. Carpenter Chairman of the Board and Director Chief Executive Officer
/s/ John H. Williams, Jr. /s/ Albert Ernest, Jr. - ---------------------------- ---------------------- John H. Williams, Jr. Albert Ernest, Jr. President, Chief Operating Director Officer and Director
/s/ James G. Delfs /s/ Mitchell W. Legler - ---------------------------- ---------------------- James G. Delfs Mitchell W. Legler Senior Vice President, Director Chief Financial Officer
/s/ Clayton E. Roberson, Jr. /s/ Michael D. Rose - ---------------------------- ---------------------- Clayton E. Roberson, Jr. Michael D. Rose Vice President, Controller Director
/s/ James H. Winston ---------------------- James H. Winston Director | 4,130 | 27,997 |
1087420_1999.txt | 1087420_1999 | 1999 | 1087420 | ITEM 1. BUSINESS
Salton Sea Funding Corporation ("Funding Corporation") is a special purpose Delaware corporation, an indirect wholly-owned subsidiary of CE Generation, LLC ("CE Generation") and formed for the sole purpose of issuing securities in its individual capacity as principal and as agent acting on behalf of the Guarantors (as defined below). The principal executive office of the Funding Corporation is located at 302 South 36th Street, Suite 400-A, Omaha, Nebraska 68131 and its telephone number is (402) 341-4500.
CE Generation owns all of the capital stock of Magma Power Company ("Magma") which in turn owns all of the outstanding capital stock of Funding Corporation. Through its subsidiaries, CE Generation is primarily engaged in the development, ownership and operation of environmentally responsible independent power production facilities in the United States utilizing geothermal and natural gas resources. CE Generation has an aggregate net ownership interest of 756 MW of electrical generating capacity in power plants in operation or under construction in the United States, which have an aggregate net capacity of 816 MW (including its interests in the Salton Sea Projects and the Partnership Projects as defined below).
All of the outstanding stock of Magma was contributed by MidAmerican Energy Holdings Company, the successor of CalEnergy Company, Inc. ("MidAmerican"), to CE Generation in February 1999. In March 1999, MidAmerican sold a 50% interest in CE Generation to El Paso Holding Company, an affiliate of El Paso Energy Corporation ("El Paso").
Magma directly or indirectly owns all of the capital stock of or partnership interests in the Funding Corporation and the Guarantors, except for CalEnergy Minerals LLC ("Minerals LLC") and Salton Sea Minerals Corp. The Guarantors are comprised of the Salton Sea Guarantors, the Partnership Guarantors and the Royalty Guarantor.
The Salton Sea Guarantors include Salton Sea Brine Processing L.P. ("SSBP"), Salton Sea Power Generation L.P. ("SSPG") and Fish Lake Power LLC ("Fish Lake") (collectively, the "Initial Salton Sea Guarantors"), which own four operating geothermal power plants located in Imperial Valley, California known as Salton Sea I, Salton Sea II, Salton Sea III and Salton Sea IV, and Salton Sea Power L.L.C. ("Power LLC" together with the Initial Salton Sea Guarantors, the "Salton Sea Guarantors"), which is constructing a geothermal power plant in Imperial Valley, California known as Salton Sea V (such project together with Salton Sea I, II, III and IV, the "Salton Sea Projects").
The Partnership Guarantors include the Vulcan/BN Geothermal Power Company ("Vulcan"), Elmore, L.P. ("Elmore"), Leathers, L.P. ("Leathers") and Del Ranch, L.P. ("Del Ranch"), each of which owns an operating geothermal power plant located in Imperial Valley, California known as the Vulcan Project, the Elmore Project, the Leathers Project and the Del Ranch Project, respectively (together with the CE Turbo Project and the Zinc Recovery Project, the "Partnership Projects"). The Partnership Guarantors also include CE Turbo LLC ("Turbo LLC"), which is constructing a geothermal power plant in the Imperial Valley, California and CalEnergy Minerals LLC ("Minerals LLC"), which is constructing a zinc recovery project in the Imperial Valley, California. Finally, the Partnership Guarantors include CalEnergy Operating Corporation ("CEOC"), Vulcan Power Company ("VPC"), San Felipe Energy Company ("San Felipe"), Conejo Energy Company ("Conejo"), Niguel Energy Company ("Niguel"), VPC Geothermal LLC (formerly, BN Geothermal Inc.) ("VPCG"), Salton Sea Minerals Corp. and CE Salton Sea Inc. Vulcan Power Company ("VPC") and VPCG, collectively own 100% of the partnership interests in Vulcan. CEOC and Niguel, San Felipe and Conejo, collectively own 90% partnership interests in each of Elmore, Leathers and Del Ranch, respectively.
Magma owns all of the remaining 10% interests in each of Elmore, Leathers and Del Ranch. CEOC is entitled to receive from Magma, as payment for certain data and services provided by CEOC, all of the partnership distributions Magma receives with respect to its 10% ownership interests in each of the Elmore, Leathers and Del Ranch Projects and Magma's special distributions equal to 4.5% of total energy revenues from the Leathers Project.
Salton Sea Royalty LLC, ("SSRC" or the "Royalty Guarantor") is the Royalty Guarantor. SSRC received an assignment of certain fees and royalties ("Royalties") paid by three Partnership Projects, Elmore, Leathers and Del Ranch.
CEOC currently operates each of the Salton Sea Projects and the Partnership Projects. Affiliates of Magma control, through a variety of fee, leasehold, and royalty interests, rights to geothermal resources for power production in the Salton Sea Known Geothermal Resource Area ("SSKGRA"). The Funding Corporation believes that such resources will be sufficient to operate the Salton Sea Projects and the Partnership Projects at contract capacity under their respective power purchase agreements through the final maturity date of the Securities.
The principal executive offices of the Salton Sea Guarantors are located at 302 South 36th Street, Suites 400-B, 400-D, 400-E, 400-K and 400-N, Omaha, Nebraska 68131. The principal executive offices of the Partnership Guarantors is 302 South 36th Street, Suite 400-F, 400-G, 400-I, 400-J, 400-L, 400-M, 400-N, 400-O, 400-P, 400-Q, 400-R, 400-S, 400-T, and 400-U, Omaha, Nebraska 68131. The principal executive office of the Royalty Guarantor is 302 South 36th Street, Suite 400-H, Omaha, Nebraska 68131. The Salton Sea Guarantors, Partnership Guarantors and the Royalty Guarantor are sometimes referred to collectively herein as the "Guarantors".
THE PROJECTS
Set forth below is a table describing certain characteristics of the Salton Sea Projects and the Partnership Projects, and the Guarantors' collective interests therein. All the projects are located in the Imperial Valley, California. The Salton Sea I-IV, Elmore, Leathers, Del Ranch and Vulcan projects (the "Existing Projects") each sell power to Southern California Edison Company ("Edison").
DATE OF
PROJECT FACILITY COMMERICAL CONTRACT CONTRACT POWER CAPACITY(1)(2)OPERATION EXPIRATION TYPE PURCHASERS (3)
SALTON SEA PROJECTS
Salton Sea I 10.0 7/1987 6/2017 Negotiated Edison Salton Sea II 20.0 4/1990 4/2020 SO4 Edison Salton Sea III 49.8 2/1989 2/29/19 SO4 Edison Salton Sea IV 39.6 6/1996 5/2026 Negotiated Edison SALTON SEA V 49.0 Mid-2000 N/A N/A PX/Zinc Recovery ------ Project SUBTOTAL 168.4
PARTNERSHIP PROJECTS
Vulcan 34.0 2/1986 2/2016 SO4 Edison Elmore 38.0 1/1989 12/2018 SO4 Edison Leathers 38.0 1/1990 12/2019 SO4 Edison Del Ranch 38.0 1/1989 12/2018 SO4 Edison CE TURBO 10.0 Mid-2000 N/A N/A PX/Zinc Recovery ----- Project SUBTOTAL 158.0
TOTAL POWER PROJECTS 326.4
ZINC RECOVERY
PROJECT 30,000 Mid-2000 N/A N/A N/A ======
(1) Power capacity varies with operating and reservoir conditions.
(2) Facility capacities are measured in MW; zinc recovery project capacity is measured in estimated tons per year production. (3) Edison is Southern California Edison Company and PX is the California Power Exchange.
SALTON SEA PROJECTS
The Salton Sea Guarantors collectively own the four operating Salton Sea Projects and the Salton Sea V project under construction with an aggregate net generating capacity of approximately 168.4 MW. Each of the four operating Salton Sea Projects has an executed long term power purchase agreement, providing for the sale of capacity and energy to Edison.
The Salton Sea II and Salton Sea III power contracts provide for fixed price capacity payments for the life of the contract, and fixed price energy payments for the first 10 years. Thereafter, the energy payments paid by Edison will be based on Edison's then-current, published short-run avoided cost of energy. The fixed price energy period expired on February 13, 1999 for Salton Sea III and expires on April 4, 2000 for Salton Sea II.
Salton Sea I and Salton Sea IV have negotiated contracts with Edison. The Salton Sea I contract provides for a capacity payment and energy payment for the life of the contract. Both payments are based upon an initial value that is subject to quarterly adjustment by reference to various inflation-related indices. The Salton Sea IV contract also provides for fixed price capacity payments for the life of the contract. Approximately 56% of the kWhs are sold under the Salton Sea IV PPA at a fixed energy price, which is subject to quarterly adjustment by reference to various inflation-related indices, through June 20, 2017 (and at Edison's avoided cost of energy thereafter), while the remaining 44% of the Salton Sea IV kWhs are sold according to a 10-year fixed price schedule followed by payments based on a modified avoided cost of energy for the succeeding 5 years and at Edison's avoided cost of energy thereafter.
Salton Sea V is being constructed as a 49 MW geothermal power plant which will extract unutilized geothermal energy from geothermal brine that has previously passed through the other Salton Sea Projects. Salton Sea V has a negotiated power sale contract to sell a portion of its output to the Zinc Recovery Project and will sell the remainder into the California Power Exchange ("PX") or such other markets as may develop. Salton Sea V is being constructed pursuant to a date certain, fixed price, turn key engineering, procurement and construction contract (the "Salton Sea V EPC Contract") by Stone & Webster Engineering Corporation ("SWEC"). SWEC's obligations under the Salton Sea V EPC Contract, including provisions for liquidated damages of up to 20% of the contract price for certain delays or failures to meet performance guarantees, are guaranteed by SWEC's parent, Stone & Webster, Incorporated. Salton Sea V is scheduled to commence Commercial Operation in mid-2000.
Salton Sea I through IV Projects operated at a combined facility capacity factor of 95.6% in 1997, 94.2% in 1998 and 91.9% in 1999.
PARTNERSHIP PROJECTS
All of the Partnership Projects except the CE Turbo Project and the Zinc Recovery Project have executed Standard Agreements (called "SO4 Agreements") for the sale of capacity and energy to Edison which contracts provide for fixed price capacity payments for the life of the contract and fixed price energy payments for the first 10 years. Thereafter, the energy payments paid by Edison will be based on Edison's avoided cost of energy. The fixed price energy period for the Vulcan Project, the Del Ranch Project, the Elmore Project and the Leather Project expired on February 9, 1996, December 31, 1998, December 31, 1998 and December 31, 1999, respectively.
Turbo LLC, one of the Partnership Guarantors, is constructing the CE Turbo Project (the "CE Turbo Project"), which will have a capacity of 10 net MW. The net output of the CE Turbo Project will be sold to the Zinc Recovery Project (if Salton Sea V is not delivering power) or sold through the PX or in open market transactions.
The Partnership Guarantors are upgrading the geothermal brine processing facilities at the Vulcan and Del Ranch Projects (the "Region 2 Brine Facilities Construction"). In addition to incorporating the pH modification process, which has reduced operating costs at the Salton Sea Projects, the new facilities will achieve economies of scale through improved brine processing systems and the utilization of more modern equipment.
The CE Turbo Project and the Region 2 Brine Facilities Construction are being constructed by SWEC pursuant to a date certain, fixed-price, turnkey engineering, procurement and construction contract (the "Region 2 Upgrade EPC Contract"). The obligations of SWEC are guaranteed by Stone & Webster, Incorporated. The CE Turbo Project and the Region 2 Brine Facilities Construction are scheduled to be completed in mid-2000.
The existing Partnership Projects operated at a combined facility capacity factor of 102.2% in 1997, 101.3% in 1998, and 103.4% in 1999.
ZINC RECOVERY PROJECT
CalEnergy Minerals LLC ("Minerals LLC"), one of the Partnership Guarantors, is constructing the Zinc Recovery Project which will recover zinc from the geothermal brine (the "Zinc Recovery Project"). Facilities will be installed near the Existing Project sites to extract a zinc chloride solution from the geothermal brine through an ion exchange process. This solution will be transported to a central processing plant where zinc ingots will be produced through solvent extraction, electrowinning and casting processes. The Zinc Recovery Project is designed to have a capacity of approximately 30,000 tons per year and is scheduled to commence commercial operation in mid-2000. In September 1999, Minerals LLC entered into a sales agreement whereby all zinc produced by the Zinc Recovery Project will be sold to Cominco, Ltd. The initial term of the agreement expires in December 2005.
The Zinc Recovery Project is being constructed by Kvaerner U.S. Inc. ("Kvaerner") pursuant to a date certain, fixed-price, turnkey engineering, procurement and construction contract (the "Zinc Recovery Project EPC Contract"). Kvaerner is a wholly-owned indirect subsidiary of Kvaerner ASA, an internationally recognized engineering and construction firm experienced in the metals, mining and processing industries. The payment obligations of Kvaerner, including payment of liquidated damages of up to 20% of the contract price for certain delays or failures to meet performance guarantees, are secured by a letter of credit issued by Union Europeenne de CIC (or another financial institution rated "A" or better by S&P or "A2" or better by Moody's and otherwise acceptable to Minerals LLC) in an initial aggregate amount equal to $29.6 million.
ROYALTY PROJECTS
The Royalty Guarantor has received an assignment from Magma of certain payments ("Royalties") received from the Leathers, Del Ranch and Elmore Projects in exchange for the provision to those projects of the rights to use certain geothermal resources. Substantially all of the assigned Royalties are based on a percentage of energy and capacity revenues of the respective projects. Pursuant to the assignment, the Royalty Guarantor is entitled to receive the aggregate percentages of such project's energy and capacity revenues as illustrated in the chart below. The Partnership Guarantors are also entitled to receive Royalties from the Partnership Projects as illustrated in the chart below. Royalties are subject to netting and reduction from time to time to reflect various operating costs, as reflected in the financial statements herein. All such Royalties (other than the various operating costs, as reflected in the financial statements) are payable from revenues which will constitute Partnership Guarantors collateral.
ROYALTIES TO BE PAID TO ROYALTIES TO BE PAID TO ROYALTY GUARANTOR PARTNERSHIP GUARANTORS
PROJECT FACILITY % ENERGY % CAPACITY % ENERGY % CAPACITY CAPACITY REVENUES REVENUES REVENUES REVENUES
(MW)
Del Ranch 38 23.33 1.00 5.67 3.00 Elmore 38 23.33 1.00 5.67 3.00 Leathers 38 21.50 0.00 7.50 3.00 VULCAN 34 0.00 0.00 4.17 0.00 ----
TOTAL 148
TERMS OF THE SECURITIES
THE SECURITIES
The Funding Corporation is a special purpose Delaware corporation formed for the sole purpose of issuing securities in our individual capacity as principal and as agent acting on behalf of our affiliates which guarantee the Securities.
The Funding Corporation has completed the following issuances and exchanges of securities (together, the "Securities"):
* On July 21, 1995, the Funding Corporation issued (1) $232,750,000 of 6.69% Senior Secured Series A Notes due 2000 (the "Series A Securities"), (2) $133,000,000 of 7.37% Senior Secured Series B Bonds Due 2005 (the "Series B Securities") and (3) $109,250,000 of 7.84% Senior Secured Series C Bonds Due 2010 (the "Series C Securities");
* On February 13, 1996, the Funding Corporation consummated an exchange offer where the Funding Corporation issued substantially identical securities which had been registered under the Securities Act in exchange for the unregistered Series A through C Securities;
* On June 20, 1996, the Funding Corporation issued (1) $70,000,000 of our 7.02% Senior Secured Series D Bonds Due 2000 (the "Series D Securities") and (2) $65,000,000 of our 8.30% Senior Secured Series E Bonds Due 2011 (the "Series E Securities");
* On July 29, 1996, the Funding Corporation consummated an exchange offer where the Funding Corporation issued substantially identical Supplemental Securities which had been registered under the Securities Act in exchange for the unregistered Series D and E Securities; and
* On October 13, 1998, the Funding Corporation issued $285,000,000 of our 7.475% Senior Secured Series F Bonds Due 2018 (the "Series F Securities").
* On August 3, 1999, the Funding Corporation consummated an exchange offer where the Funding Corporation issued substantially identical Series F Securities which have been registered under the Securities Act in exchange for the unregistered Series F Securities.
The Securities have received ratings of "Baa2" by Moody's Investors Serivce, Inc. ("Moody's") and "BBB" by Standard & Poor's Ratings Group ("S&P"). The Securities will be equivalent in right of payment and in the right to share in the collateral. On December 31, 1999, the aggregate principal amount of all Securities outstanding was $569 million.
The Funding Corporation received no proceeds from the exchange pursuant to the exchange offers. The net proceeds received by the Funding Corporation from the issuance of the Securities to the Initial Purchasers in the three separate offerings (after deduction of certain transaction costs) were approximately $884 million and were loaned to the Guarantors in return for the issuance of certain notes (the "Project Notes"), and were used for the following purposes: (a) approximately $253 million to repay certain non-recourse indebtedness of MidAmerican incurred in connection with the Magma Acquisition; (b) approximately $102 million to refinance existing indebtedness of the Salton Sea Projects; (c) approximately $115 million to finance the Salton Sea IV Expansion, (d) approximately $96 million to refinance all of the existing project-level indebtedness under credit agreements of the Partnership Project Companies; (e) approximately $15 million to fund the Capital Expenditure Fund to be used for certain capital improvements to the Partnership Projects and the Salton Sea Projects, (f) approximately $23 million to fund a portion of the purchase price payable by the Initial Partnership Guarantors for the Acquired Partnership Companies, and (g) approximately $280 million to fund in part construction of the Zinc Recovery Project, CE Turbo Project and Salton Sea V Project, as well as associated capital improvements and finance costs .
There is no existing trading market for the New Securities and there can be no assurance regarding the future development of such a market for the New Securities or the ability of holders of the New Securities to sell their Securities or the price at which such holders may be able to sell their New Securities. If such a market were to develop, future trading prices will depend on many factors, including, among other things, prevailing interest rates, the operating results of the Funding Corporation and the Guarantors, and the market for similar securities. The Funding Corporation does not intend to apply for listing or quotation of the Securities on any securities exchange or stock market.
STRUCTURE OF AND COLLATERAL FOR THE SECURITIES
The Funding Corporation will make payments on the Securities with the principal of and interest paid on promissory notes issued by the Guarantors to the Funding Corporation (the "Project Notes"). The Securities are secured by a pledge of our capital stock and are guaranteed by the Guarantors. These guarantees are secured by:
* in the case of the guarantee issued by the Salton Sea Guarantors, by a lien on substantially all of the assets of the Salton Sea Guarantors and a pledge of the equity interests in the Salton Sea Guarantors;
* in the case of the guarantee issued by the Partnership Guarantors, by a lien on substantially all of the assets of the Partnership Project Companies, a lien on the equity cash flows and royalties of the Initial Partnership Guarantors and a pledge of the stock of and other equity interests in the Partnership Guarantors; and
* in the case of the guarantee issued by the Royalty Guarantor, by a lien on all royalties paid to the Royalty Guarantor and a pledge of the capital stock of the Royalty Guarantor.
The guarantees issued by the Salton Sea Guarantors are unlimited. However, the guarantees issued by the Partnership Guarantors and the Royalty Guarantor are limited to the following amounts:
* for any Initial Partnership Guarantor or the Royalty Guarantor, the total equity cash flows and royalties received by the Guarantor, minus, without duplication, (1) any royalties paid, (2) all operating and maintenance costs, (3) all capital expenditures and (4) debt service;
* for any Additional Partnership Guarantor, the total revenues received by the Guarantor, minus, without duplication (1) any royalties paid, (2) all operating and maintenance costs, (3) all capital expenditures and (4) debt service.
The structure has been designed to cross-collateralize cash flows from each Guarantor without cross-collateralizing all of the Guarantors' assets. Therefore, if a Guarantor defaults under its guarantee or its promissory note issued to the Funding Corporation, without causing a payment default on the Securities, then the trustee may direct the collateral agent to exercise remedies only with respect to the collateral securing that Guarantor's obligations. If, however, the default causes a payment default on the Securities, then the trustee may accelerate the Securities and direct the collateral agent to exercise remedies against all of the collateral and, if different, the collateral pledged by the Salton Sea Guarantors.
The Funding Corporation is a special purpose finance subsidiary of Magma. Its ability to make payments on the Securities will be entirely dependent on the Guarantors' performance of their obligations under the Project Notes and the Guarantees. As is common in non-recourse, project finance structures, the assets and cash flows of the Guarantors are the sole source of repayment of the Project Notes and the Guarantees. The Salton Sea Guarantors conduct no other business and own no other significant assets except those related to the ownership or operation of the Salton Sea Projects. The Partnership Guarantors conduct no business other than owning their respective ownership interests in the Partnership Projects and providing operation, maintenance, administrative and technical services for Magma, the Salton Sea Projects and the Partnership Projects. The Royalty Guarantor has been organized solely to receive royalty payments owed by the Partnership Projects and conducts no other business and owns no other assets. In the event of a default by any Guarantor under a Project Note, Credit Agreement or Guarantee, there is no assurance that the exercise of remedies under such Project Note, Credit Agreement or Guarantee, including foreclosure on the assets of such Guarantor, would provide sufficient funds to pay such Guarantor's obligation under the Project Notes and the Guarantees. Moreover, unless such default causes a payment default under the Indenture (in which case remedies may be exercised against the defaulting Guarantor's and the Salton Sea Guarantors' assets), remedies may be exercised only against the assets of the defaulting Guarantors. No shareholders, partners or affiliates of the Funding Corporation (other than the Guarantors) and no directors, officers or employees of the Funding Corporation or the Guarantors will guarantee or be in any way liable for the payment of the Securities, the Project Notes or the Guarantees except the guarantee by MidAmerican for the direct and indirect owners of the Zinc Recovery Project of a specified portion of the scheduled debt service on the Series F Securities including the current principal amount of $140.52 million and associated interest. In addition, the obligations of the Partnership Guarantors and the Royalty Guarantor under the Guarantees are limited to the available cash flows of such Guarantors. As a result, payment of amounts owed pursuant to the Project Notes, the Guarantees and the Securities is dependent upon the availability of sufficient revenues and royalty payments from the Guarantors' businesses or holdings, after the payment of operating expenses and the satisfaction of certain other obligations.
PAYMENT OF INTEREST AND PRINCIPAL
The interest payment dates for the Securities are May 30 and November 30.
The $232,750,000 initial principal amount of the 6.69% Series A Securities due May 30, 2000 is payable in semiannual installments, which commenced November 30, 1995, as follows:
PAYMENT DATE PERCENTAGE OF PRINCIPAL AMOUNT
PAYABLE
November 30, 1995 9.8440386681% May 30, 1996 10.3342642320% November 30, 1996 10.3342642320% May 30, 1997 13.8298603652% November 30, 1997 13.8298603652% May 30, 1998 10.5087003222% November 30, 1998 10.5087003222% May 30, 1999 6.4240601504% November 30, 1999 6.4240601504% May 30, 2000 7.9621911923%
The $133,000,000 initial principal amount of the 7.37% Series B Securities due May 30, 2005 is payable in semiannual installments, commencing May 30, 1998, as follows:
PAYMENT DATE PERCENTAGE OF PRINCIPAL AMOUNT
PAYABLE
May 30, 1998 9.7819548872% November 30, 1998 9.7819548872% May 30, 1999 1.9563909774% November 30, 1999 1.9563909774% May 30, 2000 0.3909774436% November 30, 2000 0.3909774436% May 30, 2001 8.0360902256% November 30, 2001 8.0360902256% May 30, 2002 8.5330827068% November 30, 2002 8.5330827068% May 30, 2003 5.6390977444% November 30, 2003 5.6390977444% May 30, 2004 7.5781954887% November 30, 2004 7.5781954887% May 30, 2005 16.1684210526%
The $109,250,000 initial principal amount of the 7.84% Series C Securities due May 30, 2010 is payable in semiannual installments, commencing May 30, 2003, as follows:
PAYMENT DATE PERCENTAGE OF PRINCIPAL AMOUNT
PAYABLE
May 30, 2003 3.3116704805% November 30, 2003 3.3116704805% May 30, 2004 1.6558352403% November 30, 2004 1.6558352403% May 30, 2005 0.8283752860% November 30, 2005 0.8283752860% May 30, 2006 9.8572082380% November 30, 2006 9.8572082380% May 30, 2007 9.8425629291% November 30, 2007 9.8425629291% May 30, 2008 10.0851258581% November 30, 2008 10.0851258581% May 30, 2009 10.0118993135% November 30, 2009 10.0118993135% May 30, 2010 8.8146453090%
The $70,000,000 initial principal amount of the 7.02% Series D Securities due May 30, 2000 is payable in semiannual installments, commencing May 30, 1997, as follows:
PAYMENT DATE PERCENTAGE OF PRINCIPAL AMOUNT
PAYABLE
May 30, 1997 18.4642857143% November 30, 1997 18.4642857143% May 30, 1998 22.8571428571% November 30, 1998 22.8571428571% May 30, 1999 7.6071428571% November 30, 1999 7.6071428571% May 30, 2000 2.1428571430%
The $65,000,000 initial principal amount of the 8.30% Series E Securities due May 30, 2011 is payable in semiannual installments, commencing May 30, 1999, as follows:
PAYMENT DATE PERCENTAGE OF PRINCIPAL AMOUNT
PAYABLE
May 30, 1999 9.2907692308% November 30, 1999 9.2907692308% May 30, 2000 3.0769230769% November 30, 2000 3.0769230769% May 30, 2001 0.7692307692% November 30, 2001 0.7692307692% May 30, 2002 1.2307692308% November 30, 2002 1.2307692308% May 30, 2003 2.3076923077% November 30, 2003 2.3076923077% May 30, 2004 2.5000000000% November 30, 2004 2.5000000000% May 30, 2005 2.6923076923% November 30, 2005 2.6923076923% May 30, 2006 1.9230769231% November 30, 2006 1.9230769231% May 30, 2007 1.9230769231% November 30, 2007 1.9230769231% May 30, 2008 2.6923076923% November 30, 2008 2.6923076923% May 30, 2009 2.5000000000% November 30, 2009 2.5000000000% May 30, 2010 10.3846153846% November 30, 2010 10.3846153846% May 30, 2011 17.4184615384%
The $285,000,000 initial principal amount of the 7.475% Series F Securities due November 30, 2018 is payable in semiannual installments, commencing May 30, 2001 as follows:
PAYMENT DATE PERCENTAGE OF PRINCIPAL AMOUNT
PAYABLE
May 30, 2001 0.225% November 30, 2001 0.225% May 30, 2002 0.750% November 30, 2002 0.750% May 30, 2003 0.500% November 30, 2003 0.500% May 30, 2004 0.625% November 30, 2004 0.625% May 30, 2005 0.625% November 30, 2005 0.625% May 30, 2006 0.650% November 30, 2006 0.650% May 30, 2007 0.375%
November 30, 2007 0.375% May 30, 2008 0.875% November 30, 2008 0.875% May 30, 2009 0.375% November 30, 2009 0.375% May 30, 2010 1.250% November 30, 2010 1.250% May 30, 2011 3.000% November 30, 2011 3.000% May 30, 2012 5.750% November 30, 2012 5.750% May 30, 2013 5.075% November 30, 2013 5.075% May 30, 2014 6.000% November 30, 2014 6.000% May 30, 2015 6.550% November 30, 2015 6.550% May 30, 2016 7.050% November 30, 2016 7.050% May 30, 2017 6.875% November 30, 2017 6.875% May 30, 2018 3.450% November 30, 2018 3.450%
PRIORITY OF PAYMENTS
All revenues received by the Salton Sea Guarantors from the Salton Sea Projects, all revenues received by the Partnership Guarantors and all Royalties received by the Royalty Guarantor shall be paid into a Revenue Fund maintained by the depository agent. Amounts paid into the Revenue Fund shall be distributed in the following order of priority: (a) to pay operating and maintenance costs of the Guarantors; (b) to pay certain administrative costs of the agents for the secured parties under the Financing Documents; (c) to pay principal of, premium (if any) and interest on the Securities and the debt service reserve bonds, if any, and interest and certain fees payable to the debt service reserve letter of credit provider; (d) to pay principal of debt service reserve letter of credit loans and certain related fees and charges; (e) to replenish any shortfall in the Debt Service Reserve Fund; (f) to pay certain breakage costs in respect of debt service reserve letter of credit loans, and indemnification and other expenses to the secured parties, and (g) to the Distribution Fund or Distribution Suspense Fund, as applicable.
DEBT SERVICE RESERVE FUND
The Funding Corporation is obligated at all times to maintain a Debt Service Reserve Fund and/or an acceptable letter of credit, the Debt Service Reserve Fund is funded from available funds in accordance with the priority of payments until the aggregate amount of the fund and letter of credit are equal to:
* through December 31, 1999, the maximum semiannual principal and interest payments on the Securities for the remaining term of the Securities;
* after December 31, 1999 through payment in full of the Initial Securities and the Supplemental Securities, the maximum annual principal and interest payments on the Securities for the remaining term of the Securities; and
* after payment in full of the Initial Securities and the Supplemental Securities, (a) the maximum annual principal and interest payments on the Series F Securities for the remaining term or (b) if we obtain a confirmation of the current ratings of the Securities, the maximum semiannual principal and interest payments on the Series F Securities.
The Debt Service Reserve Letter of Credit, which is being provided by Credit Suisse First Boston, must be issued by a financial institution rated at least "A" by S&P and "A2" by Moody's. Drawings on the Debt Service Reserve Letter of Credit will be available to pay principal of and interest on the Securities and interest on loans resulting from drawings on such Debt Service Reserve Letter of Credit.
OPTIONAL REDEMPTION
The Series B Securities, Series C Securities, Series E Securities and Series F Securities are subject to optional redemption, in whole or in part, pro rata at par plus accrued interest to the redemption date plus a premium calculated to "make whole" to comparable U.S. Treasury securities plus 50 basis points. The Series A Securities and Series D Securities are not subject to optional redemption.
MANDATORY REDEMPTION
The Securities are subject to mandatory redemption, pro rata within each maturity, at par plus accrued interest to the redemption date, (a) if a permitted power contract buy-out occurs unless the rating agencies confirm the then current rating of the Securities; (b) upon the acceleration of a Project Note in an amount equal to the principal amount of such note plus accrued interest; (c) upon the occurrence of certain events of loss, condemnation, title defects or similar events related to the Salton Sea Projects or the Partnership Projects; or (d) in certain circumstances if any New Project fails to achieve substantial completion by the applicable guaranteed substantial completion date or receives certain net performance liquidated damages under the construction contract for such Project or (e) upon the foreclosure by the Collateral Agent of collateral securing the Guarantor's obligations under the Salton Sea Guarantee, the Partnership Guarantee or Royalty Guarantee.
DISTRIBUTIONS
Distributions may be made only from and to the extent of monies on deposit in the Distribution Fund. Such distributions are subject to the prior satisfaction of the following conditions:
(a) the amounts contained in the Principal Fund and the Interest Fund shall be equal to or greater than the aggregate scheduled principal and interest payments next due on the Securities;
(b) no default or event of default under the Indenture shall have occurred and be continuing;
(c) the debt service coverage ratio for the preceding four fiscal quarters, measured as one annual period, is equal to or greater than 1.4 to 1, if such distribution date occurs prior to the year 2000, and, if in or subsequent to the year 2000, is equal to or greater than 1.5 to 1, as certified by an officer of the Funding Corporation;
(d) the projected debt service coverage ratio of the Securities for the succeeding four fiscal quarters measured as one annual period is equal to or greater than 1.4 to 1, if such distribution date occurs prior to the year 2000, and, if such distribution date occurs in or subsequent to the year 2000, is equal to or greater than 1.5 to 1, as certified by an officer of the Funding Corporation;
(e) the debt service reserve fund shall have a balance equal to or greater than the debt service reserve fund required balance or one or more Debt Service Reserve Letter (or Letters) of Credit at least equal to (collectively with the balance, if any, in the Debt Service Reserve Fund) the debt service reserve fund required balance;
(f) an officer of the Funding Corporation provides a certificate (based on customary assumptions) that there are sufficient geothermal resources to operate the Salton Sea Projects and the Partnership Projects at contract capacity through the final maturity date of the Securities; and
(g) substantial completion of each New Project shall have occurred on or prior to such New Project's guaranteed substantial completion date unless the required amount of Securities shall have been redeemed as described above under "Mandatory Redemption" or (ii) the rating agencies shall have confirmed that no rating downgrade would result from such delay; provided that such condition will apply to a New Project only (x) after such New Project's guaranteed substantial completion date or (y) if such New Project has been abandoned.
INCURRENCE OF ADDITIONAL DEBT
The Funding Corporation shall not incur any debt other than "Permitted Debt". "Permitted Debt" means:
(a) The Securities;
(b) Debt incurred to acquire the East Mesa Project in whole or in part; provided that no such Debt may be incurred unless at the time of such incurrence (i) no default or event of default has occurred and is continuing and (ii) the rating agencies confirm that the incurrence of such debt will not result in a rating downgrade; (c) Debt incurred to develop, construct, own, operate or acquire additional permitted facilities in the Imperial Valley ("Additional Projects"); provided that no such debt may be incurred unless at the time of such incurrence (i) no default or event of default has occurred and is continuing and (ii) the rating agencies confirm that the Securities will maintain an investment grade rating after giving effect to such debt; (d) Debt incurred to finance the making of capital improvements to the Salton Sea Projects, the Partnership Projects or Additional Projects required to maintain compliance with applicable law or anticipated changes therein; provided that no such debt may be incurred unless at the time of such incurrence the independent engineer confirms as reasonable (i) a certification by the Funding Corporation (containing customary qualifications) that the proposed capital improvements are reasonably expected to enable such Project to comply with applicable or anticipated legal requirements and (ii) the calculations of the Funding Corporation that demonstrate, after giving effect to the incurrence of such debt, the minimum projected debt service coverage ratio (x) for the next four consecutive fiscal quarters, commencing with the quarter in which such debt is incurred, taken as one annual period, and (y) for each subsequent fiscal year through the final maturity date, will not be less than 1.2 to 1; (e) Debt incurred to finance the making of capital improvements to the Salton Sea Projects, the Partnership Projects or Additional Projects not required by applicable law so long as after giving effect to the incurrence of such debt (i) no default or event of default has occurred and is continuing, and (ii) (A) the independent engineer confirms as reasonable (x) the calculations of the Funding Corporation that demonstrate that the minimum projected debt service coverage ratio for the next four consecutive quarters, taken as one annual period, and each subsequent fiscal year, will not be less than 1.4 to 1, and (y) the calculations of the Funding Corporation that demonstrate the average projected debt service coverage ratio for all succeeding fiscal years until the final maturity date will not be less than 1.7 to 1 or (B) the Rating Agencies confirm that the incurrence of such debt will not result in a rating downgrade; (f) Working capital debt in an aggregate amount not to exceed $15,000,000; (g) Debt incurred under the Debt Service Reserve LOC Reimbursement Agreement; (h) Debt incurred in connection with certain permitted interest rate swap arrangements; (i) Debt incurred by the Funding Corporation in an aggregate amount not to exceed $30,000,000, in connection with the development, construction, ownership, operation, maintenance or acquisition of Permitted Facilities; and (j) Subordinated debt from affiliates in an aggregate amount not to exceed $200,000,000 which shall be used to finance capital, operating or other costs with respect to the Projects or Additional Projects.
All Permitted Debt incurred by the Funding Corporation shall be loaned to the Guarantors and guaranteed by the Guarantors.
PRINCIPAL INDENTURE COVENANTS
Principal covenants under the Indenture require the Funding Corporation to agree, except as permitted under the Indenture, (a) not to exercise any remedies or waive any defaults under the Credit Agreements and the Project Notes, except as otherwise permitted under the Indenture; (b) not to incur (i) any Debt except Permitted Debt or (ii) any Lien upon any of its properties except Permitted Liens and (c) not to enter into any transaction of merger or consolidation or change its form of organization or its business.
EQUITY COMMITMENT
Pursuant to the Equity Commitment Agreement executed by MidAmerican in favor of the Guarantors and the Collateral Agent, MidAmerican agreed to contribute cash equity to the Guarantors in an amount of up to $122,513,000 to fund a portion of the budgeted costs for construction of the New Projects and Additional Capital Improvements.
THE PROJECT NOTES
The Salton Sea Guarantors jointly and severally issued a Project Note in an initial principal amount of $325,000,000 and an additional Project Note in the amount of $83,272,000; the Partnership Guarantors jointly and severally issued a Project Note in an initial principal amount of $75,000,000, and additional Project Notes in amounts of $135,000,000 and $201,728,000, respectively, and the Royalty Guarantor issued a Project Note in an initial principal amount of $75,000,000.
PRINCIPAL CREDIT AGREEMENT COVENANTS
Principal covenants under the Credit Agreements require each Guarantor to agree, subject to certain exceptions and qualifications, (a) not to enter into any transaction of merger or consolidation, change its form of organization, liquidate, wind-up or dissolve itself; (b) not to enter into non-arm's length transactions or agreements with Affiliates; (c) not to incur (i) any debt except Permitted Guarantor Debt and (ii) any liens except for permitted liens; (d) not to engage in any business other than as contemplated by the respective Credit Agreement; and (e) not to amend, terminate or otherwise modify the Project Documents to which they are a party except as permitted under the respective Credit Agreements. In addition to these principal covenants, in the Salton Sea Credit Agreement and the Partnership Credit Agreement, the Salton Sea Guarantors and the Partnership Guarantors have agreed (a) not to sell, lease or transfer any property or assets material to the Salton Sea Projects or the Partnership Projects, as applicable, except in the ordinary course of business; and (b) to maintain insurance as is generally carried by companies engaged in similar businesses and owning similar properties.
CONSIDERATIONS REGARDING LIMITATION ON REMEDIES
A significant portion of the proceeds of the Initial Offering were distributed to MidAmerican to repay certain non-recourse indebtedness incurred by MidAmerican in connection with the acquisition of Magma (including the Guarantors). The Royalty Guarantor has purchased an assignment of the royalties from Magma pursuant to the Magma Assignment Agreement. Magma has also agreed to make certain payments to CEOC pursuant to the Magma Services Agreement and to secure such payment obligation with a collateral assignment of certain cash flows. The Guarantors have executed Guarantees with respect to the entire amount of Securities. Under certain circumstances (including a proceeding under Title 11 of the United States Code or any similar proceeding), it is possible that a creditor of a Guarantor or Magma could make a claim, under federal or state fraudulent conveyance laws, that the Funding Corporation's claims under the Credit Agreements, the Security Holders' claims under the Guarantees, the Royalty Guarantor's interest pursuant to the Magma Assignment Agreement or CEOC's rights under the Magma Services Agreement should be subordinated or not enforced in accordance with such instruments' terms or that payments thereunder (including payments to the Holders of the Securities) should be recovered. In order to prevail on such a claim, a claimant would have to demonstrate that the obligations incurred under any Guarantor's Credit Agreement or Guarantee or the transfers made under the Magma Assignment Agreement or the Magma Services Agreement were not incurred in good faith or that any Guarantor or Magma did not receive fair consideration in connection with such obligations and transfers, and that any Guarantor or Magma is and was insolvent at the time of entering into the Credit Agreement, Guarantee, the Magma Assignment Agreement and/or the Magma Services Agreement or that it did not have and will not have sufficient capital for carrying on its business or was not and will not be able to pay its debts as they mature.
RELIANCE ON SINGLE UTILITY CUSTOMER
Each of the Existing Projects relies on an agreement with Edison to generate 100% of its operating revenues. The payments under these agreements have constituted 100% of the operating revenues of each Existing Project since its inception, and may do so for the life of the Securities. Any material failure of Edison to fulfill its contractual obligations under the Power Purchase Agreements could have a material adverse effect on the ability of the Funding Corporation to pay principal of and interest on the Securities.
POWER PRICE AND SALES UNCERTAINTY
The Power Purchase Agreements pursuant to which all of the Existing Projects (other than Salton Sea I and Salton Sea IV) sell electricity to SCE are SO4 Agreements. These agreements provide for both capacity payments and energy payments for a term of 30 years. While the basis for the capacity payment is fixed for the entire 30-year term, the price of energy payments is fixed only for the first ten years of the term. Thereafter, the required energy payment converts to Edison's avoided cost of energy, as determined by a methodology approved by, and subject to change by, the California Public Utility Commission. The fixed price period expired in February 1996 for Vulcan, in December 1998 for Del Ranch and Elmore; in February 1999 for Salton Sea III and in December 1999 for Leathers and will expire in April 2000 for Salton Sea II.
For the year ended December 1999 and 1998, Edison's average avoided cost of energy was 3.1 cents and 3.0 cents per kWh, respectively, which is substantially below the contract energy prices earned for the year ended December 31, 1999. Estimates of Edison's future avoided cost of energy vary substantially from year to year. The Funding Corporation and the Guarantors cannot predict the likely level of avoided cost of energy prices under these agreements at the expiration of the fixed price periods. The revenues generated by each of these Projects has or will likely decline significantly after the expiration of the relevant fixed price periods.
Although approximately one-third of the net electrical output of Salton Sea V is expected to be sold for use by the Zinc Recovery Project, neither Salton Sea V nor the CE Turbo Project currently has any power sales agreements for any significant portion of the capacity of such Projects. The strategy for Salton Sea V and the CE Turbo Project is to sell output not needed by the Zinc Recovery Project in short term transactions through the PX or in such other transactions from time to time as may be found to be more advantageous than those conducted through the PX. The PX was recently created to establish markets for the sale of power on a daily and an hourly basis. Thus, PX prices are expected to have the characteristics of short term spot prices and to fluctuate from time to time in a manner that cannot be predicted with accuracy and is not within the control of the Funding Corporation, the Guarantors or any other person.
ZINC PRICE AND SALES UNCERTAINTY
In September 1999, Minerals LLC entered into a sales agreement whereby all zinc produced by the Zinc Recovery Project will be sold to Cominco, Ltd. The
initial term of the agreement expires in December 2005.
Because most of the Zinc Recovery Project's revenues will be derived from the sale of zinc, earnings will be directly related to the price of zinc in the domestic and world markets. However, zinc prices fluctuate and are affected by numerous factors, including expectations of inflation, speculative activities, currency exchange rates, interest rates, global and regional demand and production, political and economic conditions, discovery of new deposits, and production costs in major producing regions. The aggregate effect of these factors, all of which are beyond the control of the Funding Corporation or the Guarantors, is impossible for the Funding Corporation to predict.
CONSTRUCTION UNCERTAINTY
Although the eight Existing Projects have been operating for a number of years, the three New Projects have commenced construction pursuant to fixed price, date certain turnkey engineering, procurement and construction contracts and are subject to customary risks associated with the construction of power and metals processing plants including risks of delays in completion, cost overruns and failures to perform in accordance with contract terms. In addition, while each of the individual process steps to be utilized in the Zinc Recovery Project (including ion exchange, solvent extraction and electrowinning) has been in operation for more than twenty years and the demonstration plant at the SSKGRA has successfully recovered zinc through this integrated process, the integrated process for the production of zinc from geothermal brine has not been attempted in a large scale commercial facility. Any material unremedied delay in or unsatisfactory completion of the New Projects could have an adverse effect on the applicable Guarantors' results of operations.
UNCERTAINTIES RELATING TO EXPLORATION AND DEVELOPMENT OF GEOTHERMAL ENERGY RESOURCES
Geothermal exploration, development and operations are subject to uncertainties which vary among different geothermal reservoirs and are similar to those typically associated with oil and gas exploration and development, including dry holes and uncontrolled releases. Because of the geological complexities of geothermal reservoirs, the geographic area and sustainable output of geothermal reservoirs can only be estimated and cannot be definitively established. There is, accordingly, a risk of an unexpected decline in the capacity of geothermal wells and a risk of geothermal reservoirs not being sufficient for sustained generation of the electrical power capacity desired.
In addition, both the cost of operations and the operating performance of geothermal power plants may be adversely affected by a variety of operating factors. Production and injection wells can require frequent maintenance or replacement. Corrosion caused by high-temperature and high-salinity geothermal fluids may require the replacement or repair of certain equipment, vessels or pipelines. New production and injection wells may be required for the maintenance of current operating levels, thereby requiring substantial capital expenditures.
INSURANCE
The Salton Sea Projects and the Partnership Projects currently possess property, business interruption, catastrophic and general liability insurance. Proceeds of insurance received in connection with the Salton Sea Projects will be payable to the Depositary for the account of the Salton Sea Guarantors and will be applied as required under the financing documents. There can be no assurance that such comprehensive insurance coverage will be available in the future at commercially reasonable costs or terms or that the amounts for which the Salton Sea Guarantors and the Partnership Guarantors are or will be insured will cover all potential losses.
Because geothermally active areas such as the area in which the Projects are located are subject to frequent low-level seismic disturbances, and serious seismic disturbances are possible, the power generating plants and other facilities at the Projects are designed and built to withstand relatively significant levels of seismic disturbance. However, there is no assurance that seismic disturbances of a nature and magnitude so as to cause material damage to the Projects or gathering systems or a material change in the nature of the geothermal resource will not occur, that insurance with respect to seismic disturbances will be maintained by or on behalf of all of the Projects, that insurance proceeds will be adequate to cover all potential losses sustained, or that insurance will continue to be available in the future in amounts adequate to insure against such seismic disturbances.
REGULATORY AND ENVIRONMENTAL MATTERS
The Guarantors are subject to a number of environmental laws and regulations affecting many aspects of their present and future operations, including the disposal of various forms of materials resulting from geothermal reservoir production and the drilling and operation of new wells. Such laws and regulations generally require the Guarantors to obtain and comply with a wide variety of licenses, permits and other approvals. In addition, regulatory compliance for the construction of new facilities is a costly and time-consuming process, and intricate and rapidly changing environmental regulations may require major expenditures for permitting and create the risk of expensive delays or material impairment of project value if projects cannot function as planned due to changing regulatory requirements or local opposition. The Guarantors and the Projects also remain subject to a varied and complex body of environmental and energy regulations that both public officials and private individuals may seek to enforce. There can be no assurance that existing regulations will not be revised or that new regulations will not be adopted or become applicable to the Guarantors and the Projects which could have an adverse impact on their operations. In particular, the independent power market in the United States is dependent on the existing energy regulatory structure, including the Public Utility Regulatory Policies Act and its implementation by utility commissions in the various states. The structure of such federal and state energy regulations has in the past, and may in the future, be the subject of various challenges and restructuring proposals by utilities and other industry participants. The implementation of regulatory changes in response to such challenges or restructuring proposals, or otherwise imposing more comprehensive or stringent requirements on the Guarantors and Projects, which would result in increased compliance costs could have a material adverse effect on the Guarantors' and the Projects' results of operations.
EMPLOYEES
Employees necessary for the operation of the Salton Sea Projects and the Partnership Projects are provided by CEOC, under the operation and maintenance agreements described below. As of December 31, 1999, CEOC employed 197 people at the Salton Sea Projects and the Partnership Projects, collectively. CEOC employees are not covered by any collective bargaining agreement. The Funding Corporation believes that CEOC's employee relations are good.
CEOC maintains a qualified technical staff covering a broad range of disciplines including geology, geophysics, geochemistry, hydrology, volcanology, drilling technology, reservoir engineering, plant engineering, construction management, maintenance services, production management and electric power operation.
Administrative services for the Guarantors are provided pursuant to the administrative services agreements described below. MidAmerican employees provide corporate level managerial, financial, accounting, technical and other administrative services and CEOC employees provide certain accounting, purchasing and payroll services.
ITEM 2.
ITEM 2. PROPERTIES
The Funding Corporation does not separately own or lease office space but has arranged for a separate suite at MidAmerican's offices in Omaha, Nebraska. (See page 4 for a schedule of the Guarantors facilities.)
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Funding Corporation is not a party to any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER'S MATTERS
Not applicable.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands)
SALTON SEA FUNDING CORPORATION
The following tables set forth selected historical financial and operating data of the Funding Corporation. The data should be read in conjunction with the financial statements and related notes and other financial information appearing elsewhere in this Form 10-K.
(1) On October 13, 1998 Funding Corporation issued additional securities of $285,000 of Salton Sea Notes and Bonds Series F.
(2) On June 20, 1996 Funding Corporation issued additional securities of $135,000 of Salton Sea Notes and Bonds Series D and E.
(3) Funding Corporation was formed on June 20, 1995 for the sole purpose of acting as issuer of senior notes and bonds and issued $475,000 of senior secured notes and bonds.
SALTON SEA GUARANTORS
The following tables set forth selected historical combined financial and operating data of the Salton Sea Guarantors. The data should be read in conjunction with the financial statements and related notes and other financial information appearing elsewhere in this Form 10-K.
(1) The decrease is due to Salton Sea III reaching the end of its fixed price period in February 1999.
(2) In June 1996, Salton Sea IV commenced operations.
(3) Information as of December 31, 1995 and for the year then ended reflects adjustments which have been made to the net assets of the Salton Sea Guarantors to reflect the effect of the acquisition of Magma accounted for as a purchase business combination pushed down to the Salton Sea Guarantors.
PARTNERSHIP GUARANTORS
The following tables set forth selected historical combined financial and operating data of the Partnership Guarantors. The data should be read in conjunction with the financial statements and related notes, and other financial information appearing elsewhere in this Form 10-K.
(1) The decrease is due to the end of the fixed price period at Del Ranch and Elmore.
(2) On April 17, 1996 the remaining 50% interest of the Partnership Projects was acquired from Edison Mission Energy.
(3) Information as of December 31, 1995 and for the year then ended reflects adjustments which have been made to the net assets of the Partnership Guarantors to reflect the effect of the acquisition of Magma accounted for as a purchase business combination pushed down to the Partnership Guarantors.
ROYALTY GUARANTOR
The following tables set forth selected historical financial and operating data of the Royalty Guarantor. The data should be read in conjunction with the financial statements and related notes and other financial information appearing elsewhere in this Form 10-K.
(1) In 1998, the Royalty Guarantor received $25,000 in a settlement related to the GEO East Mesa payments.
(2) Information as of December 31, 1995 and for the year then ended reflects adjustments which have been made to the net assets of the Royalty Guarantor to reflect the effect of the acquisition of Magma accounted for as a purchase business combination pushed down to the Royalty Guarantor.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FACTORS AFFECTING RESULTS OF OPERATIONS
Funding Corporation was organized for the sole purpose of acting as issuer of senior secured notes and bonds. On October 13, 1998, June 20, 1996 and July 21, 1995, the Funding Corporation issued $285 million, $135 million and $475 million, respectively, of senior secured notes and bonds (the "Securities"). The Securities are payable from payments made of principal and interest on the Project Notes by the Guarantors, to the Funding Corporation. The Securities are guaranteed on a joint and several basis by the Guarantors. The guarantees of the Partnership Guarantors and Royalty Guarantor are limited to available cash flow. The Funding Corporation does not conduct any operations apart from issuing the Securities.
The periodic results of operations for the Guarantors are influenced to varying degrees by a number of factors, principally the level of revenues received under the power purchase agreements, project capacity utilization, the level of operating expenses and capital expenditures.
POWER PURCHASE AGREEMENTS
The Imperial Valley Project consists of the Partnership Project and the Salton Sea Project located in the Imperial Valley in California. The operating Partnership Project consists of the Vulcan, Hoch (Del Ranch), Elmore, and Leathers Partnerships. The operating Salton Sea Project consists of Salton Sea I, Salton Sea II, Salton Sea III and Salton Sea IV.
Each of the Projects sells electricity to Edison pursuant to a separate SO4 Agreement or a negotiated power purchase agreement. Each power purchase agreement is independent of the others, and performance requirements specified within one such agreement apply only to the Project which is subject to that agreement. The power purchase agreements provide for energy payments, capacity payments and capacity bonus payments. Edison makes fixed annual capacity payments and capacity bonus payments to the projects to the extent that capacity factors exceed certain benchmarks. The price for capacity is fixed for the life of the SO4 Agreements and are significantly higher in the months of June through September. Energy payments are at increasing fixed rates for the first ten years after firm operation and thereafter at Edison's Avoided Cost of Energy.
The scheduled energy price periods of the Partnership Projects' SO4 Agreements extended until February 1996 for the Vulcan Partnership, December 1998 for the Del Ranch and Elmore Partnerships and December 1999 for the Leathers Partnerships.
Salton Sea I sells electricity to Edison pursuant to a 30-year negotiated power purchase agreement, as amended (the "Salton Sea I PPA"), which provides for capacity and energy payments. The energy payment is calculated using a Base Price which is subject to quarterly adjustments based on a basket of indices. The time period weighted average energy payment for Salton Sea I was 5.3 cents per kWh during 1999. As the Salton Sea I PPA is not an SO4 Agreement, the energy payments do not revert to Edison's Avoided Cost of Energy. The capacity payment is approximately $1.1 million per annum.
Salton Sea II and Salton Sea III sell electricity to Edison pursuant to 30-year modified SO4 Agreements that provide for capacity payments, capacity bonus payments and energy payments. The price for contract capacity and contract capacity bonus payments is fixed for the life of the modified SO4 Agreements. The energy payments for the first ten year period, which period expires in April 2000 for Salton Sea II and expired in February 1999 for Salton Sea III are levelized at a time period weighted average of 10.6 cents per kWh and 9.8 cents per kWh for Salton Sea II and Salton Sea III, respectively. Thereafter, the monthly energy payments will be at Edison's Avoided Cost of Energy. For Salton Sea II only, Edison is entitled to receive, at no cost, 5% of all energy delivered in excess of 80% of contract capacity through September 30, 2004. The annual capacity and bonus payments for Salton Sea II and Salton Sea III are approximately $3.3 million and $9.7 million, respectively.
Salton Sea IV sells electricity to Edison pursuant to a modified SO4 agreement which provides for contract capacity payments on 34 MW of capacity at two different rates based on the respective contract capacities deemed attributable to the original Salton Sea PPA option (20 MW) and to the original Fish Lake PPA (14 MW). The capacity payment price for the 20 MW portion adjusts quarterly based upon specified indices and the capacity payment price for the 14 MW portion is a fixed levelized rate. The energy payment (for deliveries up to a rate of 39.6 MW) is at a fixed price for 55.6% of the total energy delivered by Salton Sea IV and is based on an energy payment schedule for 44.4% of the total energy delivered by Salton Sea IV. The contract has a 30 year term but Edison is not required to purchase the 20 MW of capacity and energy originally attributable to the Salton Sea I PPA option after September 30, 2017, the original termination date of the Salton Sea I PPA.
For the year ended December 31, 1999 and 1998, Edison's average Avoided Cost of Energy was 3.1 cents and 3.0 cents per kWh, respectively, which is substantially below the contract energy prices earned for the year ended December 31, 1999. Estimates of Edison's future Avoided Cost of Energy vary substantially from year to year. The Company cannot predict the likely level of Avoided Cost of Energy prices under the SO4 Agreements and the modified SO4 Agreements at the expiration of the scheduled payment periods. The revenues generated by each of the projects operating under SO4 Agreements will likely decline significantly after the expiration of the respective scheduled payment periods.
CAPACITY UTILIZATIONS
For purposes of consistency in financial presentation, plant capacity factors for Vulcan, Hoch (Del Ranch), Elmore and Leathers plants are based on capacity amounts of 34, 38, 38, and 38 net MW respectively, and for Salton Sea I, Salton Sea II, Salton Sea III and Salton Sea IV plants, are based on nominal capacity amounts of 10, 20, 49.8 and 39.6 net MW, respectively. Each plant possesses an operating margin which allows for production in excess of the amount listed above. Utilization of this operating margin is based upon a variety of factors and can be expected to vary throughout the year under normal operating conditions.
The following operating data represents the aggregate capacity and electricity production of Salton Sea I and II, Salton Sea III and Salton Sea IV:
Years Ended December 31, 1999 1998 1997
Overall capacity factor 91.9% 94.2% 95.6% Capacity NMW (average) 119.4 119.4 119.4 Kwh produced (in thousands) 960,800 985,500 999,400
The following operating data represents the aggregate capacity and electricity production of Vulcan, Del Ranch, Elmore and Leathers:
Years Ended December 31, 1999 1998 1997 Operating capacity factor 103.4% 101.3% 102.2% Capacity NMW (average) 148.0 148.0 148.0 Kwh produced (in thousands) 1,339,900 1,313,900 1,324,400
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
REVENUES
The Salton Sea Guarantors' sales of electricity decreased to $81.9 million for the year ended December 31, 1999 from $106.3 million for the same period in 1998. The decrease is due to Salton Sea III reaching the end of its fixed price period in February, 1999. The Salton Sea Guarantors' sales of electricity was $106.3 million for the year ended December 31, 1998 compared to $106.3 million for the same period in 1997.
The Partnership Guarantors' sales of electricity decreased to $105.9 million for the year ended December 31, 1999 from $165.8 million for the same period in 1998, a 36.1% decrease. The decrease is due to the end of the fixed price period at Del Ranch and Elmore in December 1998. The Partnership Guarantors' sales of electricity increased to $165.8 million for the year ended December 31, 1998 from $158.1 million for the same period in 1997, a 4.8% increase. This increase was due primarily to scheduled price increases.
Interest and other income for the Partnership Guarantors increased to $9.1 million for the year ended December 31, 1999 from $6.8 million for the same period in 1998. Interest and other income for the Partnership Guarantors increased to $6.8 million for the year ended December 31, 1998 from $4.2 million for the same period in 1997. The increases were due to interest income on the higher restricted cash balances.
The Royalty Guarantor revenue decreased to $26.3 million for the year ended December 31, 1999 from $51.7 million for the same period in 1998 and $32.2 million for the same period in 1997. The decreases in royalty revenue were primarily due to a decrease in East Mesa payments related to a settlement agreement in 1998 for prior years and the result of the lower energy sales at the Partnership Projects resulting in lower royalties.
OPERATING EXPENSES
The Salton Sea Guarantors' operating expenses, which include royalty, operating, and general and administrative expenses, decreased to $28.8 million, or 2.99 cents per kWh, for the year ended December 31, 1999, from $30.3 million or 3.08 cents per kWh for the same period in 1998 and $30.9 million or 3.09 cents per kWh for the same period in 1997. The decrease in expenses from 1998 to 1999 was due primarily to lower royalty expense and management fees associated with the lower revenue.
The Partnership Guarantors' operating expenses, which include royalty, operating, and general and administrative expenses, decreased to $48.0 million, or 3.88 cents per kWh, for the year ended December 31, 1999, from $63.7 million or 5.26 cents per kWh for the same period in 1998 and $64.1 million or 5.25 cents per kWh for the same period in 1997. The decrease in costs from 1998 to 1999 was due primarily to the decreases in royalty expense due to lower revenue.
The Royalty Guarantor's operating expenses decreased to $4.6 million for the year ended December 31, 1999 from $8.1 million for the same period of 1998 and $7.8 million for the same period of 1997. The decrease was due to scheduled decreases in third party lessor royalties related to the decreases in the Partnership Projects' sales of electricity.
DEPRECIATION AND AMORTIZATION
The Salton Sea Guarantors' depreciation and amortization increased to $16.9 million for the year ended December 31, 1999 from $14.9 million for the year ended December 31, 1998 and $14.7 million for the year ended December 31, 1997. The increase was due to an adjustment in the step up depreciation charges.
The Partnership Guarantors' depreciation and amortization decreased to $22.6 million for the year ended December 31, 1999 from $48.6 million for the same period in 1998 and $38.8 million for the same period in 1997. The decrease from 1998 to 1999 was primarily due to reduced step up depreciation after the end of the fixed price periods for the Del Ranch and Elmore projects as a result of greater value being assigned to the scheduled price periods for the contracts relating to these projects at the time of acquisition. The scheduled price periods for the contracts relating to Del Ranch and Elmore expired in December 1998. The increase from 1997 to 1998 was due primarily to a modification of the amortization method used to amortize the fair value adjustments associated with the scheduled price periods of the four plants acquired in the Imperial Valley. The amortization method was modified from the weighted average of the scheduled price periods of the four plants to the scheduled price periods of each individual plant. The impact of this modification was to increase amortization expense by $7.5 million in 1998 compared with 1997.
The Royalty Guarantor's amortization decreased to $7.1 million for the year ended December 31, 1999 from $9.8 million for the same period in 1998 and 1997. The decrease in 1999 is consistent with the Company's scheduled amortization of the royalty stream and the excess of cost over fair value related to the Magma acquisition.
INTEREST EXPENSE
The Salton Sea Guarantors' interest expense, net of capitalized amounts, decreased to $15.0 million for the year ended December 31, 1999 from $16.0 million for the same period in 1998. The decrease was due primarily to higher capitalized interest charges on the Salton Sea V construction costs and repayment of debt. The Salton Sea Guarantors' interest expense, net of capitalized amounts, decreased to $16.0 million for the year ended December 31, 1998 from $18.1 million for the same period in 1997. The decrease was due primarily to the repayment of debt.
The Partnership Guarantors' interest expense, net of capitalized amounts, increased to $6.4 million for the year ended December 31, 1999 from $3.6 million for the same period in 1998 and $4.4 million for the same period in 1997. The changes are a result of the issuance of $201.8 million of senior secured project notes in October 1998 partially offset by repayment of debt and capitalization of interest on the mineral extraction project.
The Royalty Guarantors' interest expense decreased to $1.7 million for the year ended December 31, 1999 from $2.8 million for the same period in 1998 and $4.2 million for the same period in 1997. These decreases are due to the repayment of debt.
INCOME TAX PROVISION
The Salton Sea Guarantors are substantially comprised of partnerships. Income taxes are the responsibility of the partners and Salton Sea Guarantors have no obligation to provide funds to the partners for payment of any tax liabilities. Accordingly, the Salton Sea Guarantors have no tax obligations.
The Partnership Guarantors' income tax provision decreased to $12.5 million for the year ended December 31, 1999 from $19.5 million for the same period in 1998 and $21.4 million for the same period in 1997. Income taxes will be paid by the parent of the Guarantors from distributions to the parent company by the Guarantors which occur after payment of operating expenses and debt service.
The Royalty Guarantor's income tax provision decreased to a benefit of $6.3 million for the year ended December 31, 1999 from an expense of $11.5 million for the same period in 1998. The decrease in the provision is due to the change in the Royalty Guarantor from a corporation to a limited liability company which is not taxed. The Royalty Guarantor's income tax provision increased to $11.5 million for the year ended December 31, 1998 from $1.8 million for the same period in 1997. The increase in the provision can be attributed to higher royalty stream income.
NET INCOME
The Funding Corporation's net income was $1.1 million for the year ended December 31, 1999 compared to $1.8 million for the year ended December 31, 1998 and $1.5 million for the period ended December 31, 1997, which represented interest income and expense, net of applicable tax, and the Funding Corporation's 1% equity in earnings of the Guarantors.
The Salton Sea Guarantors' net income decreased to $23.0 million for the year ended December 31, 1999, compared to $45.9 million for the year ended December 31, 1998 and $42.8 million for the year ended December 31, 1997.
The Partnership Guarantors' net income decreased to $25.5 million for the year ended December 31, 1999, compared to $37.1 million for the year ended December 31, 1998 and $33.6 million for the year ended December 31, 1997.
The Royalty Guarantor's net income decreased to $19.2 million for the year ended December 31, 1999, compared to $19.5 million for the year ended December 31, 1998 and $8.7 million for the year ended December 31, 1997.
CAPITAL RESOURCES AND LIQUIDITY
CalEnergy Minerals LLC, a Partnership Guarantor ("Minerals LLC"), developed and owns the rights to proprietary processes for the extraction of zinc from elements in solution in the geothermal brine and fluids utilized at the Company's Imperial Valley plants (the "Zinc Recovery Project") A pilot plant has successfully produced commercial quality zinc at the company's Imperial Valley Project. The Company's affilates intend to sequentially develop facilities for the extraction of manganese, silver, gold, lead, boron, lithium and other products as it further develops the extraction technology. The Company's affiliates are also investigating producing silica as an extraction project. Silica is used as a filler for such products as paint, plastics and high temperature cement.
Minerals LLC is constructing the Zinc Recovery Project which will recover zinc from the geothermal brine (the "Zinc Recovery Project"). Facilities will be installed near the Imperial Valley Project sites to extract a zinc chloride solution from the geothermal brine through an ion exchange process. This solution will be transported to a central processing plant where zinc ingots will be produced through solvent extraction, electrowinning and casting processes. The Zinc Recovery Project is designed to have a capacity of approximately 30,000 metric tonnes per year and is scheduled to commence commercial operation in mid-2000. In September 1999, Minerals LLC entered into a sales agreement whereby all zinc produced by the Zinc Recovery Project will be sold to Cominco, Ltd. The initial term of the agreement expires in December 2005.
The Zinc Recovery Project is being constructed by Kvaerner U.S. Inc. ("Kvaerner") pursuant to a date certain, fixed-price, turnkey engineering, procurement and construction contract (the "Zinc Recovery Project EPC Contract"). Kvaerner is a wholly-owned indirect subsidiary of Kvaerner ASA, an internationally recognized engineering and construction firm experienced in the metals, mining and processing industries. Total project costs of the Zinc Recovery Project are expected to be approximately $200.9 million. The Company has incurred $92.8 million of such costs through December 31, 1999.
Salton Sea Power LLC, a Salton Sea Guarantor, is constructing Salton Sea V. Salton Sea V will be a 49 net MW geothermal power plant which will sell approximately one-third of its net output to the Zinc Recovery Project. The remainder will be sold through the California Power Exchange ("PX") or in other market transactions.
Salton Sea V is being constructed pursuant to a date certain, fixed price, turn-key engineering, procurement and construction contract (the "Salton Sea V EPC Contract") by Stone & Webster Engineering Corporation ("SWEC"). Salton Sea V is scheduled to commence commercial operation in mid-2000. Total project costs of Salton Sea V are expected to be approximately $119.1 million. Salton Sea Power LLC has incurred approximately $85.6 million of such costs through December 31, 1999.
CE Turbo LLC, a Partnership Guarantor, is constructing the CE Turbo Project. The CE Turbo Project will have a capacity of 10 net MW. The net output of the CE Turbo Project will be sold to the Zinc Recovery Project or sold through the PX or in other market transactions.
The Partnership Projects are upgrading the geothermal brine processing facilities at the Vulcan and Del Ranch Projects with the Region 2 Brine Facilities Construction. In addition to incorporating the pH modification process, which has reduced operating costs at the Salton Sea Projects, the new, more efficient facilities will achieve economies through improved brine processing systems and the utilization of more modern equipment. The Partnership Projects expect these improvements to reduce brine-handling operating costs at the Vulcan Project and the Del Ranch Project.
The CE Turbo Project and the Region 2 Brine Facilities Construction are being constructed by SWEC pursuant to a date certain, fixed price, turnkey engineering, procurement and construction contract (the "Region 2 Upgrade EPC Contract"). The obligations of SWEC are guaranteed by Stone & Webster, Incorporated. The CE Turbo Project is scheduled to commence initial operations in early 2000 and the Region 2 Brine Facilities Construction is scheduled to be completed in mid-2000. Total project costs for both the CE Turbo Project and the Region 2 Brine Facilities Construction are expected to be approximately $63.7 million. The Company has incurred approximately $40.8 million of such costs through December 31, 1999.
The operating Salton Sea Guarantors' only source of revenue is payments received pursuant to long term power sales agreements with Edison, other than interest earned on funds on deposit. The operating Partnership Guarantors' primary source of revenue is payments received pursuant to long term power sales agreements with Edison. The Royalty Guarantor's only source of revenue is payments received pursuant to resource lease agreements with the Partnership Projects and agreements with the East Mesa Project. These payments, for each of the Guarantors, are expected to be sufficient to fund operating and maintenance expenses, payments of interest and principal on the Securities, projected capital expenditures and debt service reserve fund requirements.
Inflation has not had a significant impact on the Guarantors' operating revenue and costs; energy payments for the Guarantors (excluding those projects receiving avoided cost rates) will continue to be based on fixed rates and are not adjusted for inflation through the initial ten-year period of each power purchase agreement.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion of the Company's exposure to various market risks contains "forward-looking statements" that involve risks and uncertainties. These projected results have been prepared utilizing certain assumptions considered reasonable in the circumstances and in light of information currently available to the Company. Actual results could differ materially from those projected in the forward-looking information.
INTEREST RATE RISK
At December 31, 1999, the Funding Corporation had fixed-rate long-term debt of $569.0 million in principal amount and having a fair value of $540.7 million. These instruments are fixed-rate and therefore do not expose the Company to the risk of earnings loss due to changes in market interest rates. However, the fair value of these instruments would decrease by approximately $32.2 million if interest rates were to increase by 10% from their levels at December 31, 1999. In general, such a decrease in fair value would impact earnings and cash flows only if the Company were to reacquire all or a portion of these instruments prior to their maturity.
Certain information included in this report contains forward-looking statements made pursuant to the Private Securities Litigation Reform Act of 1995 ("Reform Act"). Such statements are based on current expectations and involve a number of known and unknown risks and uncertainties that could cause the actual results and performance of the Company to differ materially from any expected future results or performance, expressed or implied, by the forward-looking statements. In connection with the safe harbor provisions of the Reform Act, the Company has identified important factors that could cause actual results to differ materially from such expectations, including development uncertainty, operating uncertainty, acquisition uncertainty, uncertainties relating to doing business outside of the United States, uncertainties relating to geothermal resources, uncertainties relating to domestic and international economic and political conditions and uncertainties regarding the impact of regulations, changes in government policy, industry deregulation and competition. Reference is made to all of the Company's SEC filings incorporated herein by reference. The Company assumes no responsibility to update forward-looking information contained herein.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
SALTON SEA FUNDING CORPORATION
SALTON SEA FUNDING CORPORATION
Independent auditors' report--Deloitte & Touche LLP...........................31
Balance sheets as of December 31, 1999 and 1998 ..............................32
Statements of operations for the three years ended December 31, 1999 .........33
Statements of stockholder's equity for the three years ended December 31, 1999...........................................................34
Statements of cash flows for the three years ended December 31, 1999 .........35
Notes to financial statements.................................................36
SALTON SEA GUARANTORS
Independent auditors' report--Deloitte & Touche LLP...........................38
Combined balance sheets as of December 31, 1999 and 1998.....................39
Combined statements of operations for the three years ended December 31, 1999...........................................................40
Combined statements of Guarantors' equity for the three years ended December 31, 1999...........................................................41
Combined statements of cash flows for the three years ended December 31, 1999.42
Notes to combined financial statements........................................43
PARTNERSHIP GUARANTORS
Independent auditors' report--Deloitte & Touche LLP...........................48
Combined balance sheets as of December 31, 1999 and 1998......................49
Combined statements of operations for the three years ended December 31, 1999.50
Combined statements of Guarantors' equity for the three years ended December 31, 1999...........................................................51
Combined statements of cash flows for the three years ended December 31, 1999.52
Notes to combined financial statements........................................53
SALTON SEA ROYALTY LLC
Independent auditors' report--Deloitte & Touche LLP...........................65
Balance sheets as of December 31, 1999 and 1998...............................66
Statements of operations for the three years ended December 31, 1999..........67
Statements of equity for the three years ended December 31, 1999 .............68
Statements of cash flows for the three years ended December 31, 1999 .........69
Notes to financial statements.................................................70
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholder Salton Sea Funding Corporation Omaha, Nebraska
We have audited the accompanying balance sheets of Salton Sea Funding Corporation as of December 31, 1999 and 1998 and the related statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of Salton Sea Funding Corporation as of December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Omaha, Nebraska January 25, 2000
SALTON SEA FUNDING CORPORATION BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) December 31, 1999 1998 ASSETS
Cash $ 2,086 $ 17,629 Prepaid expenses and other assets 3,617 6,768 Due from affiliates 2,118 --- Current portion secured project notes from guarantors 25,072 57,836 ------ ------ Total current assets 32,893 82,233
Secured project notes from Guarantors 543,908 568,980 Investment in 1% of net assets of Guarantors 8,847 8,124 $ 585,648 $ 659,337 ======= =======
LIABILITIES AND STOCKHOLDER'S EQUITY Liabilities:
Accrued liabilities $ 3,607 $ 3,971 Due to affiliates --- 16,612 Current portion long term debt 25,072 57,836 ------ ------ Total current liabilities 28,679 78,419
Senior secured notes and bonds 543,908 568,980 --------- --------- Total liabilities 572,587 647,399 Commitments and contingencies (Note 3)
Stockholder's equity: Common stock--authorized 1,000 shares, par value $.01 per share; issued and outstanding 100 shares - - Additional paid-in capital 5,366 5,366 Retained earnings 7,695 6,572 --------- --------- Total stockholder's equity 13,061 11,938 --------- --------- $ 585,648 $ 659,337 ======= =======
The accompanying notes are an integral part of the financial statements.
SALTON SEA FUNDING CORPORATION STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
For the Year Ended December 31, 1999 1998 1997 Revenues:
Interest income $47,815 $38,349 $39,823 Equity in earnings of Guarantors 723 980 851 ------- ------- ------- 48,538 39,329 40,674 Expenses:
General and administrative expenses 775 804 748 Interest expense 45,859 35,495 37,443 ------ ------- ------ Total expenses 46,634 36,299 38,191 Income before income taxes 1,904 3,030 2,483 Provision for income taxes 781 1,247 1,022 --------- ---------- ---------- Net income $ 1,123 $ 1,783 $ 1,461 ====== ====== ======
The accompanying notes are an integral part of the financial statements.
SALTON SEA FUNDING CORPORATION STATEMENTS OF STOCKHOLDER'S EQUITY FOR THE THREE YEARS ENDED DECEMBER 31, 1999 (DOLLARS IN THOUSANDS)
Additional Common Stock Paid-in Retained Total Shares Amount Capital Earnings Equity
Balance, January 1, 1997 100 $ - $ 5,366 $ 3,328 $ 8,694
Net income - - - 1,461 1,461 ------ -------- -------- -------- -------- Balance, December 31, 1997 100 - 5,366 4,789 10,155
Net income - - - 1,783 1,783 ------ -------- -------- -------- -------- Balance, December 31, 1998 100 - 5,366 6,572 11,938
Net income - - - 1,123 1,123 ------ -------- -------- -------- -------- Balance, December 31, 1999 100 $ - $ 5,366 $ 7,695 $ 13,061 ===== ===== ===== ===== =====
The accompanying notes are an integral part of the financial statements.
SALTON SEA FUNDING CORPORATION STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
For the Years Ended December 31, 1999 1998 1997 Cash flows from operating activities:
Net income $ 1,123 $ 1,783 $ 1,461 Adjustments to reconcile net income to net cash flows from operating activities:
Equity in earnings of guarantors (723) (980) (851) Changes in assets and liabilities: Prepaid expenses and other assets 3,151 (3,945) 629 Accrued liabilities (364) 1,189 (509) -------- --------- -------- Net cash flows from operating activities 3,187 (1,953) 730 -------- --------- -------- Cash flows from investing activities:
Decrease in restricted cash --- --- 14,044 Secured project notes from Guarantors --- (285,000) --- Principal repayments of secured project notes from Guarantors 57,836 106,938 90,228 -------- --------- -------- Net cash flows from investing activities 57,836 (178,062) 104,272 -------- --------- -------- Cash flows from financing activities: Proceeds from offering of senior secured
notes and bonds --- 285,000 --- Repayment of senior secured notes and bonds (57,836) (106,938) (90,228) Due to affiliates (18,730) 4,014 (12,424) -------- --------- -------- Net cash flows from financing activities (76,566) 182,076 (102,652) -------- --------- -------- Net change in cash (15,543) 2,061 2,350 Cash at the beginning of period 17,629 15,568 13,218 -------- --------- -------- Cash at the end of period $ 2,086 $ 17,629 $ 15,568 ======== ======= ======= Supplemental disclosure Interest paid $ 46,210 $ 34,326 $ 37,974 ======== ======= ======= Income taxes paid $ 781 $ 1,247 $ 1,022 ======== ======= =======
The accompanying notes are an integral part of the financial statements.
SALTON SEA FUNDING CORPORATION NOTES TO FINANCIAL STATEMENTS
1. THE PURPOSE AND BUSINESS OF SALTON SEA FUNDING CORPORATION
Salton Sea Funding Corporation (the "Funding Corporation"), which was formed on June 20, 1995, is a special purpose Delaware corporation and was organized for the sole purpose of acting as issuer of senior secured notes and bonds. On July 21, 1995, June 20, 1996 and October 31, 1998, the Funding Corporation issued $475.0 million and $135.0 million and $285.0 million, respectively, of Senior Secured Notes and Bonds (collectively, the "Securities").
The Funding Corporation is a wholly-owned subsidiary of Magma Power Company, which in turn was wholly-owned by MidAmerican Energy Holdings Company ("MidAmerican"). On February 8, 1999, MidAmerican created a new subsidiary, CE Generation and subsequently transferred its interest in the Company and its power generation assets in the Imperial Valley to CE Generation, with certain assets being retained by MidAmerican. On March 3, 1999, MidAmerican closed the sale of 50% of its ownership interests in CE Generation to El Paso Holding Company, an affiliate of El Paso Energy Corporation.
The Securities are payable from the proceeds of payments made of principal and interest on the Secured Project Notes from the Guarantors to the Funding Corporation. The Securities are also guaranteed on a joint and several basis by the Salton Sea Guarantors, the Partnership Guarantors and Salton Sea Royalty LLC (collectively the "Guarantors"). The guarantees of the Partnership Guarantors and Salton Sea Royalty LLC are limited to available cash flow. The Funding Corporation does not conduct any operations apart from issuing the Securities.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
INVESTMENT IN GUARANTORS
Since the Funding Corporation has the ability to assert significant influence over the operations of the Guarantors, it accounts for its one percent investment in the Guarantors using the equity method of accounting.
INCOME TAXES
The Funding Corporation is included in the consolidated income tax returns with its parent and affiliates. Income taxes are provided on a separate return basis; however, tax obligations of the Funding Corporation will be remitted to the parent only to the extent of cash flows available after operating expenses and debt service.
FAIR VALUES OF FINANCIAL INSTRUMENTS
Fair values have been estimated based on quoted market prices for debt issues listed on exchanges. Fair values of financial instruments that are not actively traded are based on market prices of similar instruments and/or valuation techniques using market assumptions. Unless otherwise noted, the estimated fair value amounts do not differ significantly from recorded values.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which established accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company has not yet determined the impact of this accounting pronouncement.
3. SENIOR SECURED NOTES AND BONDS
The Funding Corporation's debt securities (the "Notes and Bonds") are as follows (in thousands):
SENIOR FINAL MATURITY DECEMBER 31, DECEMBER 31, SECURED SERIES DATE RATE 1999 1998
July 21, 1995 A Notes May 30, 2000 6.69% $18,532 $48,436 July 21, 1995 B Bonds May 30, 2005 7.37% 101,776 106,980 July 21, 1995 C Bonds May 30, 2010 7.84% 109,250 109,250 June 20, 1996 D Notes May 30, 2000 7.02% 1,500 12,150 JUNE 20, 1996 E BONDS MAY 30, 2011 8.30% 52,922 65,000 OCTOBER 13, 1998 F BONDS NOVEMBER 30, 2018 7.475% 285,000 285,000 --------- -------- $568,980 $626,816
Principal and interest payments are made in semi-annual installments. Principal maturities of the Senior Secured Notes and Bonds are as follows (in thousands):
2000 $ 25,072 2001 23,658 2002 28,572 2003 28,086 2004 30,588 Thereafter 433,004 ----------- $568,980 =======
On October 13, 1998, the Funding Corporation completed a sale to institutional investors of $285.0 million aggregate amount of 7.475% Senior Secured Series F Bonds due November 30, 2018. The proceeds from the offering will be used to fund construction of two new geothermal power projects, a related zinc recovery project, certain upgrades for brine processing facilities and other capital improvements and financing costs.
Pursuant to a depository agreement, Funding Corporation established a debt service reserve fund in the form of a letter of credit in the amount of $42.5 million from which scheduled interest and principal payments can be made.
The estimated fair values of the Senior Secured Notes and Bonds at December 31, 1999 and 1998 were $540.7 million and $646.4 million, respectively.
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholder Magma Power Company Omaha, Nebraska
We have audited the accompanying combined balance sheets of the Salton Sea Guarantors as of December 31, 1999 and 1998, and the related combined statements of operations, Guarantors' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Salton Sea Guarantors' management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such combined financial statements present fairly, in all material respects, the financial position of the Salton Sea Guarantors as of December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Omaha, Nebraska January 25, 2000
SALTON SEA GUARANTORS COMBINED BALANCE SHEETS (DOLLARS IN THOUSANDS) December 31, 1999 1998 Accounts receivable $ 11,537 $ 15,957 Prepaid expenses and other assets 11,695 12,410 ------ ------ Total current assets 23,232 28,367
Restricted cash 10,001 71,673 Property, plant, contracts and equipment, net 552,903 480,293 Excess of cost over fair value of net assets acquired, net 46,878 48,182 ---------- ---------- $633,014 $628,515 ======= =======
LIABILITIES AND GUARANTORS' EQUITY Liabilities:
Accounts payable $ 33 $ 504 Accrued liabilities 7,862 7,166 Current portion of long term debt 9,737 16,076 ----- ------ Total current liabilities 17,632 23,746
Due to affiliates 27,993 30,688 Senior secured project note 284,217 293,954 ---------- ---------- Total liabilities 329,842 348,388
Commitments and contingencies (Notes 5 and 6)
Total Guarantors' equity 303,172 280,127 ---------- ---------- $633,014 $628,515 ======= =======
The accompanying notes are an integral part of the combined financial statements
SALTON SEA GUARANTORS COMBINED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
Year Ended December
31,
1999 1998 1997 Revenues:
Sales of electricity $ 81,850 $106,274 $106,252 Interest and other income 1,868 817 173 ---------- ---------- ---------- Total Revenues 83,718 107,091 106,425 ---------- ---------- ---------- Expenses: Operating, general and
administrative expenses 28,772 30,306 30,865 Depreciation and amortization 16,891 14,857 14,689 Interest expense 24,251 21,730 23,004 Less capitalized interest (9,241) (5,741) (4,949) ---------- ----------- ---------- Total expenses 60,673 61,152 63,609 ---------- ----------- ---------- Net income $23,045 $45,939 $42,816 ========== ========== ==========
The accompanying notes are an integral part of the combined financial statements
SALTON SEA GUARANTORS COMBINED STATEMENTS OF GUARANTORS' EQUITY FOR THE THREE YEARS ENDED DECEMBER 31, 1999 (DOLLARS IN THOUSANDS)
Balance, January 1, 1997 $ 191,372
Net income 42,816
------------ Balance, December 31, 1997 234,188
Net income 45,939
------------ Balance, December 31, 1998 280,127
Net income 23,045
------------ Balance, December 31, 1999 $ 303,172 ============
The accompanying notes are an integral part of the combined financial statements
SALTON SEA GUARANTORS COMBINED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
Years Ended December 31, 1999 1998 1997
Cash flows from operating activities:
Net income $ 23,045 $ 45,939 $ 42,816 Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 16,891 14,857 14,689 Changes in assets and liabilities: Accounts receivable 4,420 (134) (869) Prepaid expenses and other assets 715 633 2,965 Accounts payable and accrued liabilities 225 (546) (2,415) --------- --------- --------- Net cash flows from operating activities 45,296 60,749 57,186 --------- --------- --------- Cash flows from investing activities:
Capital expenditures (88,197) (15,845) (7,204) Decrease (Increase) in restricted cash 61,672 (71,673) --- --------- --------- --------- Net cash flows from investing activities (26,525) (87,518) (7,204) --------- --------- --------- Cash flows from financing activities:
Repayments of senior secured project note (16,076) (39,450) (33,632) Proceeds from offering of senior secured project note --- 83,272 --- Due to affiliates (2,695) (17,053) (16,350) ---------- --------- --------- Net cash flows from financing activities (18,771) 26,769 (49,982) ---------- --------- -------- Net change in cash --- --- --- Cash at beginning of period --- --- --- ---------- -------- -------- Cash at end of period $ $ --- $ --- ======= ======== ======= Supplemental disclosure: Cash paid for interest $ 24,394 $ 21,434 $ 21,591 ======= ======== =======
The accompanying notes are an integral part of the combined financial statements.
SALTON SEA GUARANTORS NOTES TO COMBINED FINANCIAL STATEMENTS
1. ORGANIZATION AND OPERATIONS
Salton Sea Guarantors (the "Guarantors") (not a legal entity) own 100% interests in four operating geothermal electric power generating plants (Salton Sea I, II, III and IV) and a fifth plant (Salton Sea V or the Salton Sea Expansion) which is currently under construction (collectively, the "Salton Sea Projects"). All five plants are located in the Imperial Valley of California. The Salton Sea Guarantors guarantee loans from Salton Sea Funding Corporation ("Funding Corporation"), an indirect wholly-owned subsidiary of Magma Power Company ("Magma") which in turn was wholly-owned by MidAmerican Energy Holdings Company ("MidAmerican").
On February 8, 1999, MidAmerican created a new subsidiary, CE Generation LLC ("CE Generation") and subsequently transferred its interest in the Company and its power generation assets in the Imperial Valley to CE Generation, with certain assets being retained by MidAmerican. On March 3, 1999, MidAmerican closed the sale of 50% of its ownership interests in CE Generation to El Paso Holding Company, an affiliate of El Paso Energy Corporation.
The financial statements consist of the combination of (1) Salton Sea Brine Processing, L.P., a California limited partnership between Magma as a 99% limited partner and Salton Sea Power Company ("SSPC"), a wholly-owned subsidiary of Magma, as a 1% general partner, (2) Salton Sea Power Generation, L.P., a California limited partnership between Salton Sea Brine Processing, L.P., as a 99% limited partner, and Salton Sea Power Company, as a 1% general partner, (3) assets and liabilities attributable to Salton Sea IV which are held 99% by Salton Sea Power Generation, L.P. and 1% by Fish Lake Power LLC ("FLPC") and (4) Salton Sea Power L.L.C., a Delaware limited liability company. Effective in June of 1995, 1% interests in SSPC and FLPC were transferred to Funding Corporation. All of the entities in the combination are affiliates of Magma and indirect subsidiaries of CE Generation.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying financial statements present the combined accounts of the Salton Sea Projects described above. All significant intercompany transactions and accounts have been eliminated.
The financial statements reflect the acquisition of Magma and the resulting push down to the Guarantors of the accounting as a purchase business combination.
REVENUE RECOGNITION
The Guarantors recognize revenues and related accounts receivable with respect to their four operating facilities from sales of electricity to Southern California Edison Company ("Edison") on an accrual basis. Edison is the sole customer of the Guarantors. The Guarantors earn energy payments based on kilowatt hours ("kWhs") of energy provided to Edison. During the first 10 years for Salton Sea II and III, the Guarantors earn payments for energy as scheduled in their SO4 Agreements. After the 10-year scheduled payment period has expired (in 1999 for Salton Sea III and 2000 for Salton Sea II), the energy payment per kWh throughout the remainder of the contract period will be at Edison's Avoided Cost of Energy.
Salton Sea I sells electricity to Edison pursuant to a 30-year negotiated power purchase agreement, as amended (the "Salton Sea I PPA"), which provides for capacity and energy payments. The energy payment is calculated using a Base Price which is subject to quarterly adjustments based on a basket of indices. The time period weighted average energy payment for Salton Sea I was 5.3 cents per kWh during 1999. As the Salton Sea I PPA is not an SO4 Agreement, the energy payments do not revert to Edison's Avoided Cost of Energy. The capacity payment is approximately $1.1 million per annum.
Salton Sea II and Salton Sea III sell electricity to Edison pursuant to 30-year modified SO4 Agreements that provide for capacity payments, capacity bonus payments and energy payments. The price for contract capacity and contract capacity bonus payments is fixed for the life of the modified SO4 Agreements. The energy payments for the first ten year period, which period expire in April 2000 for Salton Sea II and expired in February 1999 for Salton Sea III are levelized at a time period weighted average of 10.6 cents per kWh and 9.8 cents per kWh for Salton Sea II and Salton Sea III, respectively. Thereafter, the monthly energy payments will be Edison's Avoided Cost of Energy. For Salton Sea II only, Edison is entitled to receive, at no cost, 5% of all energy delivered in excess of 80% of contract capacity through September 30, 2004. The annual capacity and bonus payments for Salton Sea II and Salton Sea III are approximately $3.3 million and $9.7 million, respectively.
Salton Sea IV sells electricity to Edison pursuant to a modified SO4 agreement which provides for contract capacity payments on 34 MW of capacity at two different rates based on the respective contract capacities deemed attributable to the original Salton Sea PPA option (20 MW) and to the original Fish Lake PPA (14 MW). The capacity payment price for the 20 MW portion adjusts quarterly based upon specified indices and the capacity payment price for the 14 MW portion is a fixed levelized rate. The energy payment (for deliveries up to a rate of 39.6 MW) is at a fixed price for 55.6% of the total energy delivered by Salton Sea IV and is based on an energy payment schedule for 44.4% of the total energy delivered by Salton Sea IV. The contract has a 30-year term but Edison is not required to purchase the 20 MW of capacity and energy originally attributable to the Salton Sea I PPA option after September 30, 2017, the original termination date of the Salton Sea I PPA.
For the year ended December 31, 1999 and 1998, Edison's average Avoided Cost of Energy was 3.1 cents and 3.0 cents per kWh, respectively, which is substantially below the contract energy prices earned in 1999. Estimates of Edison's future Avoided Cost of Energy vary substantially from year to year. The Guarantors cannot predict the likely level of Avoided Cost of Energy prices under the SO4 Agreements at the expiration of the scheduled payment periods. The revenues generated by each of the units operating under SO4 Agreements will likely decline significantly after the expiration of the relevant scheduled payment periods.
If Edison was unable to perform, the Guarantors could incur an accounting loss equal to the entire accounts receivable balance.
RESTRICTED CASH
The restricted cash balance primarily included commercial paper, money market securities and mortgage backed securities and was composed of amounts deposited in restricted accounts which the Guarantors will use to fund capital expenditures.
PROPERTY, PLANT, CONTRACTS AND EQUIPMENT
Property, plant, contracts and equipment are carried at cost less accumulated depreciation. The Guarantors provide depreciation and amortization of property, plants, contracts and equipment upon the commencement of revenue production over the estimated useful life of the assets.
Depreciation of the operating power plant costs, net of salvage value, is computed on the straight line method over the estimated useful lives, between 10 and 30 years. Depreciation of furniture, fixtures and equipment is computed on the straight line method over the estimated useful lives of the related assets, which range from three to ten years.
Power sale agreements have been assigned values separately for each of (1) the remaining portion of the fixed price periods of the power sales agreements and (2) the 20 year avoided cost periods of the power sales agreements and are being amortized separately over such periods using the straight line method.
The Salton Sea reservoir contains commercial quantities of extractable minerals. The carrying value of the mineral reserves will be amortized upon commencement of commercial production.
EXCESS OF COST OVER FAIR VALUE
Total acquisition costs in excess of the fair values assigned to the net assets acquired are amortized over a 40 year period using the straight line method. At December 31, 1999 and 1998, accumulated amortization of the excess of cost over fair value was $6.4 million and $5.1 million, respectively.
CAPITALIZATION OF INTEREST AND DEFERRED FINANCING COSTS
Prior to the commencement of operations, interest is capitalized on the costs of the plants and geothermal resource development to the extent incurred. Capitalized interest and other deferred charges are amortized over the lives of the related assets.
Deferred financing costs are amortized over the term of the related financing using the effective interest method.
INCOME TAXES
The Guarantors are comprised substantially of partnership interests. The income or loss of each partnership for income tax purposes, along with any associated tax credits, is the responsibility of the individual partners. Accordingly, no recognition has been given to federal or state income taxes in the accompanying combined financial statements.
STATEMENTS OF CASH FLOWS
For purposes of the statements of cash flows, the Guarantors consider only demand deposits at banks to be cash.
FAIR VALUES OF FINANCIAL INSTRUMENTS
Fair values of financial instruments that are not actively traded are based on market prices of similar instruments and/or valuation techniques using market assumptions. Unless otherwise noted, the estimated fair value amounts do not differ significantly from recorded values.
IMPAIRMENT OF LONG-LIVED ASSETS
The Guarantors review long-lived assets and certain identifiable intangibles for impairments whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss would be recognized, based on discounted cash flows or various models, whenever evidence exists that the carrying value is not recoverable.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which established accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Guarantors have not yet determined the impact of this accounting pronouncement.
3. PROPERTY, PLANT, CONTRACTS AND EQUIPMENT
Property, plant, contracts and equipment consisted of the following:
December 31, 1999 1998 ------------- ------------- Plant and equipment $333,109 $331,230 Power sale agreements 64,609 64,609 Mineral reserves 86,762 77,521 Wells and resource development 43,584 43,549 -------- ------------ 528,064 516,909 Less accumulated depreciation and amortization (60,786) (45,874) -------- ------------ 467,278 471,035 Construction in progress: Salton Sea V 85,625 9,258 -------- ------------ $552,903 $480,293 ======= =======
4. SENIOR SECURED PROJECT NOTE
The Guarantors have a project note payable to Salton Sea Funding Corporation with interest rates ranging from 6.69% to 7.84%. They have also guaranteed, along with other guarantors, the debt of Salton Sea Funding Corporation, which amounted to $569.0 million at December 31, 1999. The guarantee issued is collateralized by a lien on substantially all the assets of and a pledge of the equity interests in the Guarantors. The structure has been designed to cross collateralize cash flows from each guarantor without cross collateralizing all of the guarantors' assets.
On October 13, 1998, the Salton Sea Funding Corporation issued an additional investment grade offering for $285.0 million. In connection with this offering the Guarantors issued an additional project note in the amount of $83.3 million with an interest rate of 7.475% with a final maturity of November 30, 2018.
Principal maturities of the senior secured project note are as follows (in thousands):
2000 $ 9,737 2001 17,319 2002 20,487 2003 22,765 2004 24,409 Thereafter 199,237 ------------ $293,954 =======
The estimated fair values of the senior secured projects notes at December 31, 1999 and 1998 were $282.4 million and $323.1 million, respectively.
5. RELATED PARTY TRANSACTIONS
The Guarantors have entered into the following agreements:
o Amended and Restated Easement Grant Deed and Agreement Regarding Rights for Geothermal Development dated February 23, 1994, as amended, whereby the Guarantors acquired from Magma Land I, a wholly-owned subsidiary of Magma, rights to extract geothermal brine from the geothermal lease rights property which is necessary to operate the Salton Sea Power Generation, L.P. facilities in return for 5% of all electricity revenues received by the Guarantors. The amount expensed for the years ended December 31, 1999, 1998 and 1997 was $3.7 million, $4.9 million and $4.9 million, respectively.
o Administrative Services Agreement dated April 1, 1993 with Magma, whereby Magma will provide to the Guarantors, excluding Salton Sea IV, administrative and management services. Fees payable to Magma amount to 3% of total electricity revenues. The amount expensed for the years ended December 31, 1999, 1998 and 1997 was $1.5 million, $2.3 million and $2.3 million, respectively.
o Operating and Maintenance Agreement dated April 1, 1993 with CalEnergy Operating Corporation ("CEOC"), whereby the Guarantors retain CEOC to operate the Salton Sea facilities for a period of 32 years. Payment is made to CEOC in the form of reimbursements of expenses incurred. During 1999, 1998 and 1997, the Guarantors reimbursed CEOC for expenses of $6.7 million, $6.3 million and $7.5 million, respectively.
6. COMMITMENTS AND CONTINGENCIES
Salton Sea Power LLC, a Salton Sea Guarantor, is constructing Salton Sea V. Salton Sea V will be a 49 net MW geothermal power plant which will sell approximately one-third of its net output to the Zinc Recovery Project. The remainder will be sold through the California Power Exchange ("PX") or in other market transactions.
Salton Sea V is being constructed pursuant to a date certain, fixed price, turn-key engineering, procurement and construction contract (the "Salton Sea V EPC Contract") by Stone & Webster Engineering Corporation ("SWEC"). Salton Sea V is scheduled to commence commercial operation in mid-2000. Total project costs of Salton Sea V are expected to be approximately $119.1 million. Salton Sea Power LLC has incurred approximately $85.6 million of such costs through December 31, 1999.
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholder Magma Power Company Omaha, Nebraska
We have audited the accompanying combined balance sheets of the Partnership Guarantors as of December 31, 1999 and 1998, and the related combined statements of operations, Guarantors' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Partnership Guarantors' management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such combined financial statements present fairly, in all material respects, the financial position of the Partnership Guarantors as of December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Omaha, Nebraska January 25, 2000
PARTNERSHIP GUARANTORS COMBINED BALANCE SHEETS (DOLLARS IN THOUSANDS)
December 31,
1999 1998 ASSETS
Accounts receivable $ 16,295 $ 33,404 Prepaid expenses and other assets 18,959 23,088 -------- -------- Total current assets 35,254 56,492 -------- -------- Restricted cash 60,454 164,983 Property, plant, contracts and equipment, net 531,427 399,817 Management fee, net 71,489 71,596 Due from affiliates 75,274 83,373 Excess of fair value over net assets acquired, net 127,994 131,558 ---------- ----------- $901,892 $907,819 ======= ======= LIABILITIES AND GUARANTORS' EQUITY Liabilities:
Accounts payable $ 3,925 $ 1,879 Accrued liabilities 13,534 15,890 CURRENT PORTION OF LONG TERM DEBT 10,562 32,364 ------ ------ Total current liabilities 28,021 50,133
Senior secured project note 250,650 261,212 Deferred income taxes 98,907 97,641 ----------- ---------- Total liabilities 377,578 408,986
Commitments and contingencies (Notes 4, 5 and 8)
Guarantors' equity: Common stock 3 3 Additional paid-in capital 387,663 387,663 Retained earnings 136,648 111,167 ----------- ---------- Total Guarantors' equity 524,314 498,833 ---------- ----------- $901,892 $907,819 ======= =======
The accompanying notes are an integral part of the combined financial statements
PARTNERSHIP GUARANTORS COMBINED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
Years Ended December 31,
1999 1998 1997 Revenues:
Sales of electricity $105,921 $165,779 $158,125 Interest and other income 9,067 6,786 4,190 --------- -------- -------- Total revenues 114,988 172,565 162,315
Costs and expenses:
Operating, general and administrative costs 47,967 63,717 64,103 Depreciation and amortization 22,566 48,615 38,771 Interest expense 22,200 13,836 13,753 Less capitalized interest (15,773) (10,266) (9,323) ----------- -------- ----------- Total expenses 76,960 115,902 107,304 --------- -------- -------- Income before income taxes 38,028 56,663 55,011 Provision for income taxes 12,547 19,529 21,374 --------- -------- -------- Net income $ 25,481 $ 37,134 $ 33,637 ======= ====== ======
The accompanying notes are an integral part of the combined financial statements
PARTNERSHIP GUARANTORS COMBINED STATEMENTS OF GUARANTORS' EQUITY FOR THE THREE YEARS ENDED DECEMBER 31, 1999 (DOLLARS IN THOUSANDS)
Additional Common Stock Paid-in Retained Total Shares Amount Capital Earnings Equity -------- --------- --------- ---------- ----------- Balance, January 1, 1997 3 $ 3 $387,663 $ 40,396 $428,062
Net income - - - 33,637 33,637 ----- -------- -------- -------- --------- Balance, December 31, 1997 3 3 387,663 74,033 461,699
Net income - - - 37,134 37,134 ----- -------- -------- -------- --------- Balance, December 31, 1998 3 3 387,663 111,167 498,833
Net income - - - 25,481 25,481 ----- -------- -------- -------- --------- Balance, December 31, 1999 3 $ 3 $387,663 $136,648 $524,314 ===== ====== ======= ====== =======
The accompanying notes are an integral part of the combined financial statements
PARTNERSHIP GUARANTORS COMBINED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
Years Ended December 31,
1999 1998 1997
Cash flows from operating activities: Net income $25,481 $37,134 $ 33,637 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 22,566 48,615 38,771 Deferred income taxes 1,266 (9,210) (1,426) Changes in assets and liabilities: Accounts receivable 17,109 (9,923) (715) Prepaid expenses and other assets 4,129 (9,967) 5,962 Accounts payable and accrued liabilities (310) 30,903 983
---------- --------- ---------- Net cash flows from operating activities 70,241 87,552 77,212
---------- --------- ---------- Cash flows from investing activities:
Capital expenditures (147,801) (74,202) (39,556) Decrease (increase) in restricted cash 104,529 (164,983) - Management fee (2,704) (1,514) (4,029)
---------- --------- ---------- Net cash flows from investing activities (45,976) (240,699) (43,585) ---------- --------- ---------- Cash flows from financing activities:
Repayments of senior secured project notes (32,364) (51,762) (38,594) Proceeds of offering from senior secured project notes --- 201,728 ---
Decrease in amounts due from affiliates 8,099 3,181 4,967 ---------- --------- ------- Net cash flows from financing activities (24,265) 153,147 (33,627) --------- --------- ------- Net change in cash --- --- --- Cash at beginning of period --- --- ---
--------- --------- ------- Cash at the end of period $ --- $ --- $ --- ======== ========= ======= Supplemental disclosure: Cash paid for interest $ 21,715 $ 13,361 $ 13,165 ======== ======== ======= Income taxes paid $ 11,281 $ 28,739 $ 22,800 ======== ======== =======
The accompanying notes are an integral part of these combined financial statements.
PARTNERSHIP GUARANTORS NOTES TO COMBINED FINANCIAL STATEMENTS
1. ORGANIZATION AND OPERATIONS
Partnership Guarantors (the "Guarantors") (not a legal entity) consists of the combination of Vulcan Power Company ("VPC"), CalEnergy Operating Corporation ("CEOC"), both 99% owned by Magma Power Company ("Magma") and 1% owned by Salton Sea Funding Corporation (the "Funding Corporation"); CE Turbo LLC, indirectly wholly-owned by Magma; and CalEnergy Minerals LLC, a Delaware limited liability company ("Minerals LLC"), formerly indirectly owned by Magma and currently owned indirectly by MidAmerican Energy Holdings Company ("MidAmerican"). VPC's and CEOC's principal assets are interests in certain partnerships which are engaged in the operation of geothermal power plants in the Imperial Valley of California. The Guarantors have guaranteed the loans to such partnerships from Funding Corporation, an indirect wholly-owned subsidiary of Magma, which in turn was wholly-owned by MidAmerican.
On February 8, 1999, MidAmerican created a new subsidiary, CE Generation LLC ("CE Generation") and subsequently transferred its interest in the Company and its power generation assets in the Imperial Valley to CE Generation, with Minerals, LLC and other assets being retained by MidAmerican. On March 3, 1999, MidAmerican closed the sale of 50% of its ownership interests in CE Generation to El Paso Holding Company, an affiliate of El Paso Energy Corporation.
VPC and its subsidiary hold a 100% interest in Vulcan/BN Geothermal Power Company, a Nevada general partnership, and CEOC and its subsidiaries hold a 90% general partner interest in Leathers, L.P., a California limited partnership, Del Ranch, L.P., a California limited partnership and Elmore, L.P. a California limited partnership (collectively, the "Partnerships"). Magma owns a 10% limited partnership interest in each of Leathers L.P., Elmore L.P. and Del Ranch L.P. and has entered into an agreement to pay to the Guarantors the distributions it receives related to such 10% interests, in addition to a special distribution equal to 4.5% of total energy sales from the Leathers Project.
Turbo LLC is constructing the CE Turbo Project. The CE Turbo Project will have a capacity of 10 net MW. The net output of the CE Turbo Project will be sold to the Zinc Recovery Project or sold through the California Power Exchange.
Minerals LLC is constructing the Zinc Recovery Project which will recover zinc from the geothermal brine (the "Zinc Recovery Project"). Facilities will be installed near Imperial Valley Project sites to extract a zinc chloride solution from the geothermal brine through an ion exchange process. This solution will be transported to a central processing plant where zinc ingots will be produced through solvent extraction, electrowinning and casting processes. The Zinc Recovery Project is designed to have a capacity of approximately 30,000 metric tonnes per year and is scheduled to commence commercial operation in mid-2000. In September 1999, Minerals LLC entered into a sales agreement whereby all zinc produced by the Zinc Recovery Project will be sold to Cominco, Ltd. The initial term of the agreement expires in December 2005.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying financial statements of the Guarantors present the accounts of CEOC, VPC, CE Turbo LLC and Minerals LLC and their proportionate share of the Partnerships in which they have an undivided interest in the assets and are proportionately liable for their share of the liabilities. All significant intercompany balances and transactions have been eliminated.
The financial statements reflect the acquisition of Magma and the resulting push down to the Guarantors of the accounting as a purchase business combination.
REVENUE RECOGNITION
The Guarantors recognize revenues and related accounts receivable from sales of electricity on an accrual basis using stated contract prices. All of the Guarantors sales of electricity are to Southern California Edison Company ("Edison") and are under long-term power purchase contracts.
The Partnership Projects sell all electricity generated by the respective plants pursuant to four long-term power purchase agreements ("SO4 Agreements") between the projects and Edison. These SO4 Agreements provide for capacity payments, capacity bonus payments and energy payments. Edison makes fixed annual capacity payments to the projects, and to the extent that capacity factors exceed certain benchmarks is required to make capacity bonus payments. The price for capacity and capacity bonus payments is fixed for the life of the SO4 Agreements. Energy is sold at increasing fixed rates for the first ten years of each contract and thereafter at Edison's Avoided Cost of Energy.
The fixed energy price periods of the Partnership Project SO4 Agreements extended until February 1996 for Vulcan, December 1998 for Hoch (Del Ranch) and Elmore, and December 1999 for the Leathers Partnership. For 1999, Vulcan, Hoch and Elmore are receiving Edison's Avoided Cost of Energy pursuant to their respective SO4 Agreements. The weighted average energy rate for the Partnership Project was 6.49 cents per kWh in 1999.
For the year ended December 31, 1999 and 1998, Edison's average Avoided Cost of Energy was 3.1 cents and 3.0 cents per kWh, respectively, which is substantially below the contract energy prices earned in 1999. Estimates of Edison's future Avoided Cost of Energy vary substantially from year to year. The Guarantors cannot predict the likely level of Avoided Cost of Energy prices under the SO4 Agreements at the expiration of the scheduled payment periods. The revenues generated by each of the projects operating under SO4 Agreements will likely decline significantly after the expiration of the relevant scheduled payment periods.
If Edison was unable to perform, the Guarantors could incur an accounting loss equal to the entire accounts receivable balance.
RESTRICTED CASH
The restricted cash balance primarily included commercial paper, money market securities and mortgage backed securities and was composed of amounts deposited in restricted accounts which the Guarantors will use to fund capital expenditures.
PROPERTY, PLANT, CONTRACTS AND EQUIPMENT
Property, plant, contracts and equipment are carried at cost less accumulated depreciation. The Guarantors provide depreciation and amortization of property, plants, contracts and equipment upon the commencement of revenue production over the estimated useful life of the assets.
Depreciation of the operating power plant costs, net of salvage value, is computed on the straight line method over the estimated useful lives, between 10 and 30 years. Depreciation of furniture, fixtures and equipment is computed on the straight line method over the estimated useful lives of the related assets, which range from three to ten years.
Power sale agreements have been assigned values separately for each of (1) the remaining portion of the fixed price periods of the power sales agreements and (2) the 20 year avoided cost periods of the power sales agreements and are amortized separately over such periods using the straight line method.
The Salton Sea reservoir contains commercial quantities of extractable minerals. The carrying value of the mineral reserves will be amortized upon commencement of commercial production.
The process license represents the economic benefits expected to be realized from the installation of the license and related technology at the Imperial Valley. The carrying value of the process license is amortized using the straight line method over the remaining estimated useful life of the license.
EXCESS OF COST OVER FAIR VALUE
Total acquisition costs in excess of the fair values assigned to the net assets acquired are amortized over a 40 year period using the straight line method. At December 31, 1999 and 1998 accumulated amortization of the excess of cost over fair value of net assets acquired was $17.5 million and $13.9 million, respectively.
CAPITALIZATION OF INTEREST AND DEFERRED FINANCING COSTS
Prior to the commencement of operations, interest is capitalized on the costs of the plants and geothermal resource development to the extent incurred. Capitalized interest and other deferred charges are amortized over the lives of the related assets.
Deferred financing costs are amortized over the term of the related financing using the effective interest method.
INCOME TAXES
The entities comprising the Guarantors are included in consolidated income tax returns with their parent and affiliates; however, income taxes are provided on a separate return basis. Tax obligations of the Guarantors will be remitted to the parent only to the extent of cash flows available after operating expenses and debt service.
MANAGEMENT FEE
Pursuant to the Magma Services Agreement, Magma has agreed to pay CEOC all equity cash flows and certain royalties payable by the Guarantors in exchange for providing data and services to Magma. As security for the obligations of Magma under the Magma Services Agreement, Magma has collaterally assigned to CEOC its rights to such equity cash flows and certain royalties.
STATEMENTS OF CASH FLOWS
For purposes of the statement of cash flows, the Guarantors consider only demand deposits at banks to be cash.
FAIR VALUES OF FINANCIAL INSTRUMENTS
Fair values of financial instruments that are not actively traded are based on market prices of similar instruments and/or valuation techniques using market assumptions. Unless otherwise noted, the estimated fair value amounts do not differ significantly from recorded values.
IMPAIRMENT OF LONG-LIVED ASSETS
The Guarantors review long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss would be recognized, based on discounted cash flows or various models, whenever evidence exists that the carrying value is not recoverable.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which established accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Guarantors has not yet determined the impact of this accounting pronouncement.
3. PROPERTY, PLANT, CONTRACTS AND EQUIPMENT
Property, plant, contracts and equipment consisted of the following (in thousands):
December 31,
1999 1998
Plant and equipment $ 116,316 $ 92,920 Power sale agreements 123,588 123,588 Process license 46,290 46,290 Mineral reserves 156,563 140,790 Wells and resource development 95,329 91,990 --------- ----------- 538,086 495,578 Less accumulated depreciation and amortization (140,224) (121,980) --------- ----------- 397,862 373,598 Construction in progress: Zinc recovery project 92,794 23,507 TURBO AND REGION 2 BRINE FACILITIES UPGRADE 40,771 2,712 --------- ----------- $531,427 $399,817 ======= =======
4. SENIOR SECURED PROJECT NOTE
The Guarantors have a project note payable to Salton Sea Funding Corporation with interest rates ranging from 6.69% to 8.30%. They have also guaranteed, along with other guarantors, the debt of Salton Sea Funding Corporation, which amounted to $569.0 million at December 31, 1999. The guarantee is collateralized by a lien on the available cash flow of and a pledge of stock in the Guarantors. The structure has been designed to cross collateralize cash flows from each guarantor without cross collateralizing all of the guarantors' assets.
On October 13, 1998 the Salton Sea Funding Corporation issued an additional investment grade offering for $285.0 million. In connection with this offering, the Guarantors issued an additional project note in the amount of $201.7 million with an interest rate of 7.475% with a final maturity on November 30, 2018.
Principal maturities of the senior secured project note are as follows (in thousands):
2000 $ 10,562 2001 1,907 2002 4,625 2003 5,017 2004 5,771 Thereafter 233,330 -------- $261,212 =======
The estimated fair values of the senior secured project note at December 31, 1999 and 1998 were $244.7 million and $299.7 million, respectively.
5. RELATED PARTY TRANSACTIONS
The Guarantors are party to a 30-year brine supply agreement through the Vulcan/BN Geothermal Power Company partnership and a technology license agreement for the rights to use the technology necessary for the construction and operation of the Vulcan Plant. Under the brine supply agreement, the Guarantors will pay VPC 4.167% of the contract energy component of the price of electricity provided by the Vulcan Plant. In addition, VPC has been designated as operator of the Vulcan Plant and receives agreed-upon compensation for such services.
Charges to the Guarantors related to the brine supply agreement and operator's fees on a pro rata basis amounted to $423,000 and $472,000, respectively, for the year ended December 31, 1999, $363,000 and $416,000, respectively, for the year ended December 31, 1998, $403,000 and $456,000, respectively, for the year ended December 31, 1997, respectively.
In addition, the Guarantors entered into the following agreements:
o Easement Grant Deed and Agreement Regarding Rights for Geothermal Development, whereby the Guarantors acquired from Magma rights to extract geothermal brine from the geothermal lease rights property which is necessary to operate the Leathers, Del Ranch and Elmore Plants in return for 17.333%, on a pro rata basis, of all energy revenues received by each plant. The Guarantors' share of amounts expensed under this agreement for 1999, 1998 and 1997 were $11.9 million, $22.6 million and $21.1 million, respectively.
o Ground Leases dated March 15 and August 15, 1988 with Magma whereby the Guarantors lease from Magma for 32 years the surface of the land as described in the Imperial County Assessor's official records. Amounts expensed under the ground leases for 1999, 1998 and 1997 were $70,000 per year.
o Administrative Services Agreements whereby CEOC will provide to the Partnerships administrative and management services for a period of 32 years through 2020. Fees payable to CEOC amount to the greater of 3% of total electricity revenues or $60,000 per month. The minimum monthly payments for years subsequent to 1989 are increased based on the consumer price index of the Bureau of Labor and Statistics. Amounts expensed related to these agreements for 1999, 1998 and 1997 amounted to $2.7 million, $4.5 million and $4.3 million, respectively.
o Operating and Maintenance Agreements whereby the Guarantors retain CEOC to operate the plants for a period of 32 years through 2020. Payment is made to CEOC in the form of reimbursements of expenses incurred and a guaranteed capacity payment ranging from 10% to 25% of energy revenues over stated amounts. The Guarantors in 1999, 1998 and 1997 reimbursed CEOC for expenses of $7.5 million, $8.9 million and $9.0 million, respectively, and accrued a guaranteed capacity payment of $3.3 million, $4.7 million and $4.5 million at December 31, 1999, 1998 and 1997, respectively.
6. CONDENSED FINANCIAL INFORMATION
Condensed balance sheet information of the Guarantors' pro rata interest in the respective entities as of December 31, 1999 and 1998 is as follows (in thousands):
6. CONDENSED FINANCIAL INFORMATION
Condensed balance sheet information of the Guarantors' pro rata interest in the respective entities as of December 31, 1999 and 1998 is as follows (in thousands):
6. CONDENSED FINANCIAL INFORMATION (CONTINUED)
6. CONDENSED FINANCIAL INFORMATION (CONTINUED)
6. CONDENSED FINANCIAL INFORMATION (CONTINUED)
Condensed combining statements of operations including information of the Guarantors' pro rata interest in the respective entities for the years ended December 31, 1999, 1998 and 1997 is as follows:
6. CONDENSED FINANCIAL INFORMATION (CONTINUED)
Condensed combining statements of operations including information of the Guarantors' pro rata interest in the respective entities for the years ended December 31, 1999, 1998 and 1997 is as follows:
Vulcan Adjustments/ Combined BNG Eliminations Total
------------------------ ------------ December 31, 1999
Revenues $15,756 $1,902 $114,988 Expenses 9,663 13,361 89,507 ---------- ------------ ----------- Net income $ 6,093 $(11,459) $25,481 ====== ======= ====== December 31, 1998
Revenues $14,608 $(41,713) $172,565 Expenses 9,458 10,843 135,431 ---------- ------------ ----------- Net income $ 5,150 $(52,556) $37,134 ====== ======= ====== December 31, 1997
Revenues $15,208 $(42,366) $162,315 Expenses 8,903 12,507 128,678 ---------- ------------ ----------- Net income $ 6,305 $(54,873) $33,637 ====== ======= ======
7. INCOME TAXES
The provision for income taxes for the years ended December 31, 1999, 1998 and 1997 consisted of the following (in thousands):
1999 Current Deferred Total - ------------ --------- ---------- ---------- Federal $ 8,527 $ 991 $ 9,518 State 2,754 275 3,029 --------- --------- ---------- Total $11,281 $1,266 $12,547 ===== ===== ======
- ------------ Federal $22,021 $(7,212) $14,809 State 6,718 (1,998) 4,720 --------- --------- ---------- Total $28,739 $(9,210) $19,529 ===== ===== ======
- ------------ Federal $17,563 $(1,222) $16,341 State 5,237 (204) 5,033 --------- --------- ---------- Total $22,800 $(1,426) $21,374 ===== ===== ======
Deferred tax liabilities at December 31, 1999 and 1998 consisted of differences between book and tax methods relating to depreciation and amortization.
The effective tax rate differs from the federal statutory tax rate due primarily to percentage depletion in excess of cost depletion and goodwill amortization.
8. COMMITMENTS AND CONTINGENCIES
CalEnergy Minerals LLC, a Partnership Guarantor ("Minerals LLC"), developed and owns the rights to proprietary processes for the extraction of zinc from elements in solution in the geothermal brine and fluids utilized at the Company's Imperial Valley plants (the "Zinc Recovery Project") as well as the production of power to be used in the extraction process. A pilot plant has successfully produced commercial quality zinc at the company's Imperial Valley Project. The Company's affilates intend to sequentially develop facilities for the extraction of manganese, silver, gold, lead, boron, lithium and other products as it further develops the extraction technology. The Company's affiliates are also investigating producing silica as an extraction project. Silica is used as a filler for such products as paint, plastics and high temperature cement.
Minerals LLC is constructing the Zinc Recovery Project which will recover zinc from the geothermal brine (the "Zinc Recovery Project"). Facilities will be installed near the Imperial Valley Project sites to extract a zinc chloride solution from the geothermal brine through an ion exchange process. This solution will be transported to a central processing plant where zinc ingots will be produced through solvent extraction, electrowinning and casting processes. The Zinc Recovery Project is designed to have a capacity of approximately 30,000 metric tonnes per year and is scheduled to commence commercial operation in mid-2000. In September 1999, Minerals LLC entered into a sales agreement whereby all zinc produced by the Zinc Recovery Project will be sold to Cominco, Ltd. The initial term of the agreement expires in December 2005.
The Zinc Recovery Project is being constructed by Kvaerner U.S. Inc. ("Kvaerner") pursuant to a date certain, fixed-price, turnkey engineering, procurement and construction contract (the "Zinc Recovery Project EPC Contract"). Kvaerner is a wholly-owned indirect subsidiary of Kvaerner ASA, an internationally recognized engineering and construction firm experienced in the metals, mining and processing industries. Total project costs of the Zinc Recovery Project are expected to be approximately $200.9 million.
The Company has incurred $92.8 million of such costs through December 31, 1999.
CE Turbo LLC, a Partnership Guarantor, is constructing the CE Turbo Project. The CE Turbo Project will have a capacity of 10 net MW. The net output of the CE Turbo Project will be sold to the Zinc Recovery Project or sold through the California Power Exchange ("PX") or in other market transactions.
The Partnership Projects are upgrading the geothermal brine processing facilities at the Vulcan and Del Ranch Projects with the Region 2 Brine Facilities Construction. In addition to incorporating the pH modification process, which has reduced operating costs at the Salton Sea Projects, the new, more efficient facilities will achieve economies through improved brine processing systems and the utilization of more modern equipment. The Partnership Projects expect these improvements to reduce brine-handling operating costs at the Vulcan Project and the Del Ranch Project.
The CE Turbo Project and the Region 2 Brine Facilities Construction are being constructed by Stone & Webster Engineering Corporation ("SWEC") pursuant to a date certain, fixed price, turnkey engineering, procurement and construction contract (the "Region 2 Upgrade EPC Contract"). The obligations of SWEC are guaranteed by Stone & Webster, Incorporated. The CE Turbo Project is scheduled to commence initial operations in early 2000 and the Region 2 Brine Facilities Construction is scheduled to be completed in early-2000. Total project costs for both the CE Turbo Project and the Region 2 Brine Facilities Construction are expected to be approximately $63.7 million. The Company has incurred approximately $40.8 million of such costs through December 31, 1999.
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholder Magma Power Company Omaha, Nebraska
We have audited the accompanying balance sheets of the Salton Sea Royalty LLC as of December 31, 1999 and 1998 and the related statements of operations, equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of the Salton Sea Royalty LLC as of December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP
Omaha, Nebraska January 25, 2000
SALTON SEA ROYALTY LLC BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
December 31, 1999 1998 ASSETS
Prepaid expenses and other assets $ 235 $ 513 -------- --------- Total current assets 235 513
Royalty stream, net 16,776 22,932 Excess of cost over fair value of net assets acquired, net 32,280 33,188 Due from affiliates 21,825 20,799 -------- -------- $71,116 $77,432 ======= =======
LIABILITIES AND EQUITY Liabilities:
Accrued liabilities 82 $ 9,455 CURRENT PORTION OF LONG TERM DEBT 4,773 9,396 ------- --------- Total current liabilities 4,855 18,851
Senior secured project note 9,041 13,814 Deferred income taxes --- 6,769 -------- ---------- Total liabilities 13,896 39,434
Commitments and contingencies (Note 3)
Equity:
Common stock, par value $.01 per share; 100 shares
authorized, issued and outstanding - - Additional paid-in capital 1,561 1,561 Retained earnings 55,659 36,437 -------- ---------- Total equity 57,220 37,998 -------- ---------- $ 71,116 $ 77,432 ======= =======
The accompanying notes are an integral part of the financial statements.
SALTON SEA ROYALTY LLC STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
1999 1998 1997 Revenues: Royalty income $26,274 $51,703 $32,231
Expenses: Operating, general and administrative expenses 4,610 8,120 7,769 Amortization of royalty stream and goodwill 7,064 9,794 9,794 Interest expense 1,682 2,784 4,179 --------- --------- --------- Total expenses 13,356 20,698 21,742 --------- --------- --------- Income before income taxes 12,918 31,005 10,489 Provision (benefit) for income taxes (6,304) 11,508 1,828 --------- --------- --------- Net income $ 19,222 $19,497 $ 8,661 ======= ======= =======
The accompanying notes are an integral part of the financial statements.
SALTON SEA ROYALTY LLC STATEMENTS OF EQUITY FOR THE THREE YEARS ENDED DECEMBER 31, 1999 (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of the financial statements.
SALTON SEA ROYALTY LLC STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of the financial statements.
SALTON SEA ROYALTY LLC NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION
Salton Sea Royalty LLC (the "Royalty Company") is a special-purpose entity, 99% owned by Magma Power Company ("Magma") and 1% owned by Salton Sea Funding Corporation (the "Funding Corporation"). Magma was a wholly-owned subsidiary of MidAmerican Energy Holdings Company ("MidAmerican").
On February 8, 1999, MidAmerican created a new subsidiary, CE Generation LLC ("CE Generation") and subsequently transferred its interest in the Company and its power generation assets in the Imperial Valley to CE Generation, with certain assets being retained by MidAmerican. On March 3, 1999, MidAmerican closed the sale of 50% of its ownership interests in CE Generation to El Paso Power Holding Company, an affiliate of El Paso Energy Corporation.
In June 1995, the Royalty Company received an assignment of royalties and certain fees paid by three partnership projects, Del Ranch, Elmore and Leathers (collectively, the "Partnership Projects"). On April 17, 1996, MidAmerican acquired the remaining 50% interest in the Partnership Projects. Prior to this transaction, Magma and its affiliates had a 50% interest in the Partnership Projects. In addition, the Royalty Company has received an assignment of certain resource-related and contract assignment payments payable by the geothermal power plant located in Imperial Valley, California which is owned by an unaffiliated third party (East Mesa, together with the Partnership Projects, the "Projects"). All of the Projects are engaged in the operation of geothermal power plants in the Imperial Valley in Southern California. Substantially all of the assigned royalties are based on a percentage of energy and capacity revenues of the Projects. Included in royalty income are payments from East Mesa related to a settlement agreement in 1998 for prior years.
All of the Projects have executed long-term power purchase agreements ("SO4 Agreements") providing for capacity and energy sales to Southern California Edison Company ("Edison"). Each of these agreements provides for fixed price capacity payments for the life of the contract. In 1998, the East Mesa Project entered into a Termination Agreement, to which Magma consented, which terminated its SO4 Agreement upon CPUC approval becoming final in 1999.
The Partnership Projects earn energy payments based on kilowatt hours (kWhs) of energy provided to Edison. During the first 10 years of the agreement, the Projects earn payments for energy as scheduled in the SO4 Agreements. After the 10-year scheduled payment period has expired (1998 for Del Ranch and Elmore; 1999 for Leathers), the energy payment per kWh throughout the remainder of the contract period will be at Edison's Avoided Cost of Energy.
For the year ended December 31, 1999 and 1998, Edison's average Avoided Cost of Energy was 3.1 cents and 3.0 cents per kWh, respectively, which is substantially below the contract energy prices earned in 1999. Estimates of Edison's future Avoided Cost of Energy vary substantially from year to year. The Royalty Company cannot predict the likely level of Avoided Cost of Energy prices under the SO4 Agreements at the expiration of the scheduled payment periods. The revenues generated by each of the units operating under SO4 Agreements will likely decline significantly after the expiration of the relevant scheduled payment period which would have a direct effect on the related royalty streams.
As discussed above, all revenues except those derived from East Mesa are from, and all operating expenses are paid by, related parties.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying statement of operations presents revenues and expenses which have been assigned to the Royalty Company under the arrangements described above on the accrual method of accounting. This presentation is a "carve out" of information from Magma and certain of its affiliates. Such revenues, net of related expenses, guarantee loans from the Funding Corporation, a wholly-owned subsidiary of Magma.
The financial statements reflect the acquisition of Magma and the resulting push down to the Royalty Company of the accounting as a purchase business combination.
ROYALTY STREAM
The Royalty Company's policy is to provide amortization expense beginning upon the commencement of revenue production over the estimated remaining useful life of the identifiable assets.
The royalty streams have been assigned values separately for each of (1) the remaining portion of the fixed price periods of the Projects' power sales agreements and (2) the 20 year avoided cost periods of the Projects' power sales agreements and are amortized separately over such periods using the straight line method. At December 31, 1999 and 1998, accumulated amortization was $43.7 million and $37.6 million, respectively.
EXCESS OF COST OVER FAIR VALUE
Total acquisition costs in excess of the fair values assigned to the net assets acquired are amortized over a 40 year period using the straight line method. At December 31, 1999 and 1998, accumulated amortization of the excess of cost over fair value was $4.5 million and $3.6 million, respectively.
INCOME TAXES
The Royalty Company is included in consolidated income tax returns with its parent and affiliates. Income taxes are provided on a separate return basis, however, tax obligations of the Royalty Company will be remitted to the parent only to the extent of cash flows available after operating expenses and debt service. On February 19, 1999, the Royalty Company was converted to a limited liability company which is not taxed. Therefore, since that date, no recognition has been given to federal or state income taxes as that is the responsibility of the individual members of the LLC.
FAIR VALUES OF FINANCIAL INSTRUMENTS
Fair values of financial instruments that are not actively traded are based on market prices of similar instruments and/or valuation techniques using market assumptions. Unless otherwise noted, the estimated fair value amounts do not differ significantly from recorded values.
IMPAIRMENT OF LONG-LIVED ASSETS
The Royalty Company reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss would be recognized, based on discounted cash flows or various models, whenever evidence exists that the carrying value is not recoverable.
ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which established accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company has not yet determined the impact of this accounting pronouncement.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
3. SENIOR SECURED PROJECT NOTE
The Royalty Company has a project note payable to Salton Sea Funding Corporation at interest rates ranging from 6.69% to 7.37%. They have also guaranteed, along with other guarantors, the debt of Salton Sea Funding Corporation, which amounted to $569.0 million at December 31, 1999. The guarantee issued is collateralized by a lien on substantially all the assets of and a pledge of stock in the Guarantor. The structure has been designed to cross collateralize cash flows from each guarantor without cross collateralizing all of the guarantors' assets.
Principal maturities of the senior secured project note are as follows (in thousands):
2000 $ 4,773 2001 4,434 2002 3,460 2003 304 2004 408 Thereafter 435 ---------- $13,814 ======
The estimated fair values of the senior secured project note at December 31, 1999 and 1998 were $13.5 million and $23.5 million, respectively.
4. INCOME TAXES
The provision for income taxes for the year ended December 31, 1999, 1998 and 1997, consisted of the following:
Current Deferred Total --------- ----------- --------
Federal $ 363 $(5,921) $(5,558) State 102 (848) (746) --------- ----------- -------- Total $ 465 $(6,769) $(6,304) ===== ====== =====
Federal $ 9,267 $ (294) $ 8,973 State 2,740 (205) 2,535 --------- ----------- -------- Total $12,007 $ (499) $11,508 ===== ====== =====
Federal $5,292 $(4,159) $1,133 State 1,495 (800) 695 --------- ----------- -------- Total $6,787 $(4,959) $1,828 ===== ====== =====
The Royalty Company's effective tax rate differs from the statutory federal income tax rate due primarily to percentage depletion in excess of cost depletion and goodwill amortization.
Deferred tax liabilities (assets) at December 31, 1999 and 1998 consisted of the following:
1999 1998 ----------- ---------- Deferred liabilities:
Depreciation and amortization $ --- $9,368 Deferred assets: Deferred income --- (2,599) ----------- ----------- Net deferred tax liability $ --- $6,769 ====== ======
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below are the current executive officers of the Funding Corporation and the Guarantors and their positions with the Funding Corporation and each of the Guarantors (or general partner thereof):
EXECUTIVE OFFICER POSITION
Gregory E. Abel* Director Robert S. Silberman* President and Chief Operating Officer Brian K. Hankel Vice President and Treasurer Joseph M. Lillo Vice President and Controller Douglas L. Anderson Director, Vice President, and General Counsel Patrick J. Goodman Director Larry Kellerman* Director John L. Harrison* Director
* Gregory E. Abel is Director of CalEnergy Minerals LLC and Salton Sea Minerals Corp. only. * Robert S. Silberman, in addition to President and Chief Operating Officer, is Director of CalEnergy Minerals LLC and Salton Sea Minerals Corp. * Larry Kellerman is Director for all entities except CalEnergy Minerals LLC and Salton Sea Minerals Corp. * John L. Harrison is Director for all entities except CalEnergy Minerals LLC and Salton Sea Minerals Corp.
GREGORY E. ABEL, 37, Director for CalEnergy Minerals LLC and Salton Sea Minerals Corp. only. Mr. Abel joined MidAmerican in 1992. Mr. Abel is a Chartered Accountant and from 1984 to 1992 he was employed by Price Waterhouse. As a Manager in the San Francisco office of Price Waterhouse, he was responsible for clients in the energy industry.
ROBERT S. SILBERMAN, 42, President and Chief Operating Officer of each Guarantor subsidiary except CalEnergy Minerals LLC and Salton Sea Minerals Corp. where he is also Director. Mr. Silberman joined MidAmerican in 1995. Prior to that, Mr. Silberman served as Executive Assistant to the Chairman and Chief Executive Officer of International Paper Company from 1993 to 1995, as Director of Project Finance and Implementation for the Ogden Corporation from 1986 to 1989 and as Project Manager in Business Development for Allied-Signal, Inc. from 1984 to 1985. He has also served as the Assistant Secretary of the Army for the United States Department of Defense.
BRIAN K. HANKEL, 37, Vice President and Treasurer of each Guarantor subsidiary. Mr. Hankel joined MidAmerican in February 1992 as Treasury Analyst and served in that position to December 1995. Mr. Hankel was appointed Assistant Treasurer in January 1996 and was appointed Treasurer in January 1997. Prior to that, Mr. Hankel was a Money Position Analyst at FirsTier Bank of Lincoln from 1988 to 1992 and Senior Credit Analyst at FirsTier from 1987 to 1988.
JOSEPH M. LILLO, 30, Vice President and Controller. Mr. Lillo joined MidAmerican in November 1996, and served as Manager of Financial Reporting and was promoted to Controller/IPP in March 1998. Mr Lillo was promoted to Controller in July 1999. Prior to joining the Company, Mr. Lillo was a senior associate with Coopers & Lybrand LLP.
DOUGLAS L. ANDERSON, 42, Director, Vice President and General Counsel of each Guarantor subsidiary. Mr. Anderson joined MidAmerican in February 1993. From 1990 to 1993, Mr. Anderson was a business attorney with Fraser, Stryker, Vaughn, Meusey, Olson, Boyer & Cloch, P.C. in Omaha. Prior to that Mr. Anderson was a principal in the firm Anderson & Anderson.
PATRICK J. GOODMAN, 33, Director. Mr. Goodman joined MidAmerican in June 1995, and served as Manager of Consolidation Accounting until September 1996 when he was promoted to Controller. Prior to joining MidAmerican, Mr. Goodman was a financial manager for National Indemnity Company and a senior associate at Coopers & Lybrand.
LARRY KELLERMAN, 44, President of El Paso Power Services Company and a Director of each Guarantor subsidiary except CalEnergy Minerals LLC and Salton Sea Minerals Corp. Mr. Kellerman joined El Paso Energy in February 1998. Prior to joining El Paso Energy, he was President of Citizens Power, where he initiated Citizens' activities in the power marketing field in 1988, when Citizens was the initial power marketer granted FERC authorization. From 1982 through 1988, Mr. Kellerman was General Manager of Power Marketing and Power Supply for Portland General Electric. From 1979 through 1982, Mr. Kellerman was Financial Analyst and Power Contract Negotiator with Southern California Edison, where he negotiated some of the first Public Utility Regulatory Policies Act qualifying facility contracts in the nation.
JOHN L. HARRISON, 41, Senior Managing Director and Chief Financial Officer of El Paso Merchant Energy and a Director of each Guarantor subsidiary except CalEnergy Minerals LLC and Salton Sea Minerals Corp. Mr. Harrison joined El Paso Energy in June 1996. Prior to joining El Paso Energy, Mr. Harrison was a partner with Coopers & Lybrand LLP for five years.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Funding Corporation's and the Guarantors' directors and executive officers receive no remuneration for serving in such capacities.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
DESCRIPTION OF CAPITAL STOCK
As of December 31, 1999, the authorized capital stock of the Funding Corporation consisted of 1,000 shares of common stock, par value $.01 per share (the "Common Stock"), of which 100 shares were outstanding. There is no public trading market for the Common Stock. As of December 31, 1999, there was one holder of record of the Common Stock. Holders of Common Stock are entitled to one vote per share on any matter coming before the stockholders for a vote.
The Funding Corporation does not expect in the foreseeable future to pay any dividends on the Common Stock. The Indenture contains certain restrictions on the payment of dividends with respect to the Common Stock.
PRINCIPAL HOLDERS
Since the formation of the Funding Corporation in June 1995, all of the outstanding shares of Common Stock have been owned by Magma. Magma directly or indirectly owns all of the capital stock of or partnership interests in the Funding Corporation and the Guarantors.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
OTHER RELATIONSHIPS AND RELATED TRANSACTIONS
The Salton Sea Projects' and the Partnership Projects' geothermal power plants are owned, administered and operated by Magma or subsidiaries of Magma. Geothermal fluid supplying these facilities is provided from Magma's (or a subsidiary's) geothermal resource holdings in the SSKGRA.
In providing rights to geothermal resources and/or geothermal fluids, administering and operating the geothermal power plants, and disposing of solids from these facilities, Magma (directly and through subsidiaries) receives certain royalties, cost reimbursements and fees for its services and the rights it provides. See the financial statements attached hereto.
The Funding Corporation believes that the transactions with related parties described above, taking into consideration all of the respective terms and conditions of each of the relevant contracts and agreements, are at least as favorable to the Guarantors as those which could have been obtained from unrelated parties in arms' length negotiations.
RELATIONSHIP OF THE FUNDING CORPORATION AND THE GUARANTORS TO MAGMA AND MIDAMERICAN
The Funding Corporation is a wholly owned direct subsidiary of Magma organized for the sole purpose of acting as issuer of the Securities. The Funding Corporation is restricted, pursuant to the terms of the Indenture, to acting as issuer of the Securities and other indebtedness as permitted under the Indenture, making loans to the Guarantors pursuant to the Credit Agreements, and transactions related thereto. The Funding Corporation and each of the Guarantors (and, in the case of SSBP, SSPG, Elmore, Leathers, Del Ranch and Vulcan, the general partners thereof) have been organized and are operated as legal entities separate and apart from MidAmerican, El Paso, CE Generation, Magma and any other Affiliates of MidAmerican, El Paso, CE Generation or Magma, and, accordingly, the assets of the Funding Corporation and the Guarantors (and, in the case of SSBP, SSPG, Elmore, Leathers, Del Ranch and Vulcan, the general partners thereof) will not be generally available to satisfy the obligations of MidAmerican, El Paso, CE Generation, Magma or any other Affiliates of MidAmerican, El Paso, CE Generation or Magma; provided, however, that unrestricted cash of the Funding Corporation and the Guarantors or other assets which are available for distribution may, subject to applicable law and the terms of financing arrangements of such parties, be advanced, loaned, paid as dividends or otherwise distributed or contributed to MidAmerican, El Paso, CE Generation, Magma or Affiliates thereof.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULE AND REPORTS ON FORM 8-K
(a) Financial Statements and Schedules
(i) Financial Statements
Financial Statements are included in Part II of this Form 10-K
(ii) Financial Statement Schedules
Financial Statement Schedules are not included because they are not required or the information required is included in Part II of this Form 10-K.
(b) Reports on Form 8-K
Not applicable.
(c) Exhibits
The exhibits listed on the accompanying Exhibit Index are filed as part of this Annual Report.
For the purposes of complying with the amendments to the rules governing Form S-4 effective July 13, 1990 under the Securities Act of 1933, the undersigned hereby undertakes as follows, which undertaking shall be incorporated by reference into the Funding Corporation's currently effective Registration Statements on Form S-4.
Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant, the registrant has been advised that in the opinion the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question of whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue.
(d) Financial statements required by Regulations S-X, which are excluded from the Annual Report by Rule 14a-3(b).
Not Applicable
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
SALTON SEA FUNDING CORPORATION BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
SALTON SEA BRINE PROCESSING, L.P. a California limited partnership
By: Salton Sea Power Company, a California corporation, its general partner
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
SALTON SEA POWER GENERATION, L.P., a California limited partnership
By: Salton Sea Power Company, a California corporation, its general partner
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
FISH LAKE POWER LLC
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
VULCAN POWER COMPANY
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
CALENERGY OPERATING CORPORATION
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
SALTON SEA ROYALTY LLC
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000
LEATHERS, L.P., a California limited partnership By: CalEnergy Operating Corporation, a Delaware corporation, its general partner
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
ELMORE L.P., a California limited partnership
By: CalEnergy Operating Corporation, a Delaware corporation, its general partner
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
DEL RANCH L.P., a California limited partnership
By: CalEnergy Operating Corporation, a Delaware corporation, its general partner
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
VPC GEOTHERMAL LLC., a Delaware corporation
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
NIGUEL ENERGY COMPANY, a California corporation
BY:/S/ ROBERT S. SILBERMAN*
Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
CONEJO ENERGY COMPANY, a California corporation
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
SAN FELIPE ENERGY COMPANY, a California corporation
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
VULCAN/BN GEOTHERMAL POWER COMPANY, a Nevada general partnership By: VULCAN POWER COMPANY, a Nevada corporation, Partner
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
SALTON SEA POWER L.L.C., a Delaware Limited Liability Company
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
CE TURBO LLC, a Delaware Limited Liability Company
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
CE SALTON SEA INC., a Delaware Corporation
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ LARRY KELLERMAN * March 29, 2000 Larry Kellerman Director
/S/ JOHN L. HARRISON * March 29, 2000 John L. Harrison Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
CALENERGY MINERALS LLC, a Delaware Limited Liability Company
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman Director, President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman Director, President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ GREGORY E. ABEL * March 29, 2000 Gregory E. Abel Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Omaha, State of Nebraska, on March 29, 2000.
SALTON SEA MINERALS CORP., a Delaware Corporation
BY:/S/ ROBERT S. SILBERMAN* Robert S. Silberman Director, President and Chief Operating Officer
Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this report to be signed on its behalf by the undersigned, each thereunto duly authorized in the City of Omaha, State of Nebraska, on the dates indicated.
SIGNATURE DATE
/S/ ROBERT S. SILBERMAN* March 29, 2000 Robert S. Silberman Director, President and Chief Operating Officer (Principal Executive Officer)
/S/ JOSEPH M. LILLO * March 29, 2000 Joseph M. Lillo Vice President and Controller (Principal Accounting Officer)
/S/ DOUGLAS L. ANDERSON March 29, 2000 Douglas L. Anderson Director
/S/ PATRICK J. GOODMAN* March 29, 2000 Patrick J. Goodman Director
/S/ GREGORY E. ABEL * March 29, 2000 Gregory E. Abel Director
* BY: /S/ DOUGLAS L. ANDERSON Douglas L. Anderson Attorney-in-fact
INDEX TO EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT
3.1 Articles of Incorporation of the Funding Corporation (incorporated by reference to Exhibit 3.1 to the Funding Corporation Registration Statement on Form S-4 dated August 9, 1995, 33-95538 ("Form S-4")).
3.2 By-laws of the Funding Corporation (incorporated by reference to Exhibit 3.2 to the Funding Corporation Form S-4).
3.3 Limited Partnership Agreement of SSBP (incorporated by reference to Exhibit 3.3 to the Funding Corporation Form S-4).
3.4 Limited Partnership Agreement of SSPG (incorporated by reference to Exhibit 3.4 to the Funding Corporation Form S-4).
3.5 Articles of Incorporation of Fish Lake (incorporated by reference to Exhibit 3.5 to the Funding Corporation Form S-4).
3.6 By-laws of Fish Lake (incorporated by reference to Exhibit 3.6 to the Funding Corporation Form S-4).
3.7 Articles of Incorporation of VPC (incorporated by reference to Exhibit 3.7 to the Funding Corporation Form S-4).
3.8 By-laws of VPC (incorporated by reference to Exhibit 3.8 to the Funding Corporation Form S-4).
3.9 Articles of Incorporation of CEOC (incorporated by reference to Exhibit 3.9 to the Funding Corporation Form S-4).
3.10 By-laws of CEOC (incorporated by reference to Exhibit 3.10 to the Funding Corporation Form S-4).
3.11 Articles of Incorporation of the Royalty Guarantor (incorporated by reference to Exhibit 3.11 to the Funding Corporation Form S-4).
3.12 By-laws of the Royalty Guarantor (incorporated by reference to Exhibit 3.12 to the Funding Corporation Form S-4).
3.13 Certificate of Amendment of Certificate of Incorporation dated as of March 26, 1996 (incorporated by reference to Exhibit 3.13 to the Funding Corporation Form 10-K for the year ending December 31, 1996).
3.14 Articles of Incorporation of BNG (incorporated by reference to Exhibit 3.13 to the Funding Corporation Registration Statement on Form S-4 dated July 2, 1996, 333-07527 ("Funding Corporation II Form S-4")).
3.15 By-laws of BNG (incorporated by reference to Exhibit 3.14 to the Funding Corporation II Form S-4).
3.16 Articles of Incorporation of San Felipe (incorporated by reference to Exhibit 3.15 to the Funding Corporation II Form S-4).
3.17 By-laws of San Felipe (incorporated by reference to Exhibit 3.16 to the Funding Corporation II Form S-4).
3.18 Articles of Incorporation of Conejo (incorporated by reference to Exhibit 3.17 to the Funding Corporation II Form S-4).
3.19 By-laws of Conejo (incorporated by reference to Exhibit 3.18 to the Funding Corporation II Form S-4).
3.20 Articles of Incorporation of Niguel (incorporated by reference to Exhibit 3.19 to the Funding Corporation II Form S-4).
3.21 By-laws of Niguel (incorporated by reference to Exhibit 3.20 to the Funding Corporation II Form S-4).
3.22 General Partnership Agreement of Vulcan (incorporated by reference to Exhibit 3.21 to the Funding Corporation II Form S-4).
3.23 Limited Partnership Agreement of Leathers (incorporated by reference to Exhibit 3.22 to the Funding Corporation II Form S-4).
3.24 Amended and Restated Limited Partnership Agreement of Del Ranch (incorporated by reference to Exhibit 3.23 to the Funding Corporation II Form S-4).
3.25 Amended and Restated Limited Partnership Agreement of Elmore (incorporated by reference to Exhibit 3.24 to the Funding Corporation II Form S-4).
4.1(a) Indenture, dated as of July 21, 1995, between Chemical Trust Company of California and the Funding Corporation (incorporated by reference to Exhibit 4.1(a) to the Funding Corporation Form S-4).
4.1(b) First Supplemental Indenture, dated as of October 18, 1995, between Chemical Trust Company of California and the Funding Corporation (incorporated by reference to Exhibit 4.1(b) to the Funding Corporation Form S-4).
4.1(c) Second Supplemental Indenture, dated as of June 20, 1996, between Chemical Trust Company of California and the Funding Corporation (incorporated by reference to Exhibit 4.1(c) to the Funding Corporation II Form S-4).
4.1(d) Third Supplemental Indenture between Chemical Trust Company of California and the Funding Corporation (incorporated by reference to Exhibit 4.1(d) to the Funding Corporation II Form S-4).
4.1(e) Fourth Supplemental Indenture between Chemical Trust Company of California and the Funding Corporation (incorporated by reference to Exhibit 4.1(e) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.2 Salton Sea Secured Guarantee, dated as of July 21, 1995, by SSBP, SSPG and Fish Lake in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.2 to the Funding Corporation Form S-4).
4.3(a) Partnership Guarantors Secured Limited Guarantee, dated as of July 21, 1995, by CEOC and VPC in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.3 to the Funding Corporation Form S-4).
4.3(b) Amended and Restated Partnership Guarantors Secured Limited Guarantee, dated as of June 20, 1996 by CEOC, and VPC, Conejo, Niguel, Sal Felipe, BNG, Del Ranch, Elmore, Leathers and Vulcan in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.3 to the Funding Corporation II Form S-4).
4.3(c) Second Amended and Restated Partnership Secured Limited Guarantee, dated as of October 13, 1998 by by CEOC, and VPC, Conejo, Niguel, Sal Felipe, BNG, Del Ranch, Elmore, Leathers and Vulcan in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.3(c) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.4 Royalty Guarantor Secured Limited Guarantee, dated as of July 21, 1995, by the Royalty Guarantor in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.4 to the Funding Corporation Form S-4).
4.5(a) Exchange and Registration Rights Agreement, dated July 21, 1995, by and among CS First Boston Corporation, Lehman Brothers Inc. and the Funding Corporation (incorporated by reference to Exhibit 4.5 to the Funding Corporation Form S-4).
4.5(b) Exchange and Registration Rights Agreement, dated June 20, 1996, by and between CS First Boston Corporation and the Funding Corporation (incorporated by reference to Exhibit 4.5 to the Funding Corporation II Form S-4).
4.6(a) Collateral Agency and Intercreditor Agreement, dated as of July 21, 1995, by and among Credit Suisse, Chemical Trust Company of California, the Funding Corporation and the Guarantors (incorporated by reference to Exhibit 4.6 to the Funding Corporation Form S-4).
4.6(b) First Amendment to the Collateral Agency and Intercreditor Agreement, dated asm of June 20, 1996, by and among Credit Suisse, Chemical Trust Company of California, the Funding Corporation and the Guarantors (incorporated by reference to Exhibit 4.6(b) to the Funding Corporation II Form S-4).
4.6(c) Second Amendment to the Collateral Agency and Intercreditor Agreement, dated as of October 13, 1998, by and among Credit Suisse, Chemical Trust Company of California, the Funding Corporation and the Guarantors (incorporated by reference to Exhibit 4.6(c) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.7 Stock Pledge Agreement, dated as of July 21, 1995, by Magma Power Company in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.7 to the Funding Corporation Form S-4).
4.8(a) Purchase Agreement, dated July 18, 1995, by and among CS First Boston Corporation, Lehman Brothers Inc., the Guarantors and the Funding Corporation (incorporated by reference to Exhibit 4.8 to the Funding Corporation Form S-4).
4.8(b) Purchase Agreement, dated June 17, 1996, by and among CS First Boston Corporation, the Guarantors and the Funding Corporation (incorporated by reference to Exhibit 4.8 to the Funding Corporation II Form S-4).
4.8(c) Purchase Agreement, dated October 13, 1998 by and among CS First Boston Corporation, the Guarantors and the Funding Corporation (incorporated by reference to Exhibit 4.8(c) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.9 Support Letter, dated as of July 21, 1995, by and among Magma Power Company, the Funding Corporation and the Guarantors (incorporated by reference to Exhibit 4.9 to the Funding Corporation Form S-4).
4.37 Debt Service Reserve Letter of Credit and Reimbursement Agreement, dated as of July 21, 1995, by and among the Funding Corporation, certain banks and Credit Suisse, as agent (incorporated by reference to Exhibit 4.10 to the Funding Corporation Form S-4).
4.10(a) Amendment to Notes and to Amended Debt Service Reserve Letter of Credit and Reimbursement Agreement, dated October 13, 1998, by and among the Funding Corporation, certain banks and Credit Suisse, as agent (incorporated by reference to Exhibit 4.10(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.11 Revolving Credit Agreement, dated as of July 21, 1995, by and among Credit Suisse and the Funding Corporation (incorporated by reference to Exhibit 4.11 to the Funding Corporation Form S-4).
4.12 Salton Sea Credit Agreement, dated July 21, 1995, by and among SSBP, SSPG and Fish Lake (incorporated by reference to Exhibit 4.12 to the Funding Corporation Form S-4).
4.13 Salton Sea Project Note, dated July 21, 1995, by SSBP, SSPG and Fish Lake in favor of the Funding Corporation (incorporated by reference to Exhibit 4.13 to the Funding Corporation Form S-4).
4.13(a) Salton Sea Project Note (SSI), dated October 13, 1998, by SSBP, SSPG and Fish Lake in favor of the Funding Corporation (incorporated by reference to Exhibit 4.13(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.13(b) Salton Sea Project Note (SSIII), dated October 13, 1998, by SSBP, SSPG and Fish Lake in favor of the Funding (incorporated by reference to Exhibit 4.13(b) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.14(a) Deposit and Disbursement Agreement, dated as of July 21, 1995, by and among the Funding Corporation, Chemical Trust Company of California and the Guarantors (incorporated by reference to Exhibit 4.14 to the Funding Corporation Form S-4).
4.14(b) Amendment No. 1 to Deposit and Disbursement Agreement, dated as of June 20, 1996, by and among the Funding Corporation, Chemical Trust Company of California and the Guarantors (incorporated by reference to Exhibit 4.14(b) to the Funding Corporation II Form S-4).
4.14(c) Amended and Restated Deposit and Disbursement Agreement, dated as of October 13, 1998, by and among the Funding Corporation, Chemical Trust Company of California and the Guarantors. *
4.15 Partnership Interest Pledge Agreement, dated as of July 21, 1995, by Magma Power Company and Salton Sea Power Company in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.15 to the Funding Corporation Form S-4).
4.16 Partnership Interest Pledge Agreement, dated as of July 21, 1995, by SSBP and Salton Sea Power Company in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.16 to the Funding Corporation Form S-4).
4.17 Stock Pledge Agreement (Pledge of Stock of Fish Lake by Magma Power Company and the Funding Corporation), dated as of July 21, 1995, by Magma Power Company and the Funding Corporation in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.17 to the Funding Corporation Form S-4).
4.18 Cost Overrun Commitment, dated as of July 21, 1995, between MidAmerican, SSPG, SSBP and Fish Lake (incorporated by reference to Exhibit 4.18 to the Funding Corporation Form S-4).
4.19(a) Partnership Guarantors Credit Agreement, dated July 21, 1995, by and among CEOC, VPC and the Funding Corporation (incorporated by reference to Exhibit 4.19 to the Funding Corporation Form S-4).
4.19(b) Amended and Restated Partnership Guarantors Credit Agreement, dated June 20, 1996, by and among the Partnership Guarantors and the Funding Corporation (incorporated by reference to Exhibit 4.19 to the Funding Corporation II Form S-4).
4.19(c) Second Amended and Restated Partnership Guarantors Credit Agreement, dated October 13, 1998, by and among the Partnership Guarantors and the Funding Corporation (incorporated by reference to Exhibit 4.19(c) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.20 Partnership Guarantors Security Agreement and Assignment of Rights, dated as of July 21, 1995, by CEOC and VPC in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.20 to the Funding Corporation Form S-4).
4.21 Stock Pledge Agreement (Pledge of Stock of CEOC by Magma Power Company and the Funding Corporation), dated as of July 21, 1995, by Magma Power Company and Funding Corporation in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.21 to the Funding Corporation Form S-4).
4.22 Stock Pledge Agreement (Pledge of Stock of VPC by Magma Power Company and the Funding Corporation), dated as of July 21, 1995, by Magma Power Company and the Funding Corporation in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.22 to the Funding Corporation Form S-4).
4.23 Royalty Guarantor Credit Agreement, among the Royalty Guarantor and the Funding Corporation, dated as of July 21, 1995 (incorporated by reference to Exhibit 4.23 to the Funding Corporation Form S-4).
4.24 Royalty Project Note, dated as of July 21, 1995, by the Royalty Guarantor in favor of the Funding Corporation (incorporated by reference to Exhibit 4.24 to the Funding Corporation Form S-4).
4.25 Royalty Security Agreement and Assignment of Revenues, dated as of July 21, 1995, by the Royalty Guarantor in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.25 to the Funding Corporation Form S-4).
4.26 Royalty Deed of Trust, dated as of July 21, 1995, by the Royalty Guarantor to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.26 to the Funding Corporation Form S-4).
4.27 Stock Pledge Agreement (Pledge of Stock of Royalty Guarantor by Magma Power Company and the Funding Corporation), dated as of July 21, 1995, by Magma Power Company and the Funding Corporation in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.27 to the Funding Corporation Form S-4).
4.28 Collateral Assignment of the Imperial Irrigation District Agreements, dated as of July 21, 1995, by SSBP, SSPG and Fish Lake in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.28 to the Funding Corporation Form S-4).
4.29 Collateral Assignments of Certain Salton Sea Agreements, dated as of July 21, 1995, by SSBP, SSPG and Fish Lake in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.29 to the Funding Corporation Form S-4).
4.30 Debt Service Reserve Letter of Credit by Credit Suisse in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.30 to the Funding Corporation Form S-4).
4.31 Partnership Project Note, dated July 21, 1995, by VPC and CEOC in favor of the Funding Corporation.
4.31(a) Partnership Project Note (SSI), dated October 13, 1998, by VPC and CEOC in favor of the Funding Corporation (incorporated by reference to Exhibit 4.31(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.31(b) Partnership Project Note (SSII), dated October 13, 1998, by VPC and CEOC in favor of the Funding Corporation (incorporated by reference to Exhibit 4.31(b) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.31(c) Partnership Project Note (SSIII), dated October 13, 1998, by VPC and CEOC in favor of the Funding Corporation (incorporated by reference to Exhibit 4.31(c) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.32 Collateral Assignment of the Imperial Irrigation District Agreements, dated as of June 20, 1996, by Vulcan, Elmore, Leathers, VPC and Del Ranch in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.29 to the Funding Corporation II Form S-4).
4.33 Collateral Assignments of Certain Partnership Agreements, dated as of June 20, 1996, by Vulcan Elmore, Leathers and Del Ranch in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.31 to the Funding Corporation II Form S-4).
4.34 Debt Service Reserve Letter of Credit by Credit Suisse in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 4.32 to the Funding Corporation II Form S-4).
4.35 Partnership Project Note, dated June 20, 1996, by the Partnership Guarantors in favor of the Funding Corporation in the principal amount of $54,956,000 (incorporated by reference to Exhibit 4.33 to the Funding Corporation II Form S-4).
4.36 Partnership Project Note, dated June 20, 1996, by the Partnership Guarantors in favor of the Funding Corporation in the principal amount of $135,000,000 (incorporated by reference to Exhibit 4.34 to the Funding Corporation II Form S-4).
4.37 Deed of Trust, dated as of June 20, 1996, by Vulcan to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.35 to the Funding Corporation II Form S-4).
4.37(a) First Amendment to Deed of Trust, dated October 13, 1998 by Vulcan to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.37(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.38 Deed of Trust, dated as of June 20, 1996, by Elmore to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.36 to the Funding Corporation II Form S-4).
4.38(a) First Amendment to Deed of Trust, dated October 13, 1998, by Elmore to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.38(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.39 Deed of Trust, dated as of June 20, 1996, by Leathers to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.37 to the Funding Corporation II Form S-4).
4.39(a) First Amendment to Deed of Trust, dated October 13, 1998, by Leathers to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.39(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.40 Deed of Trust, dated as of June 20, 1996, by Del Ranch to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.38 to the Funding Corporation II Form S-4).
4.40(a) First Amendment to Deed of Trust, dated October 13, 1998, by Del Ranch to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 4.40(a) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
4.41 Stock Pledge Agreement, Dated as of June 20, 1996, by CEOC, pledging the stock of Conejo, Niguel and San Felipe in favor of Chemical Trust Company of California for the benefit of the Secured Parties and the Funding Corporation (incorporated by reference to Exhibit 4.39 to the Funding Corporation II Form S-4).
4.42 Stock Pledge Agreement, dated as of June 20, 1996, by VPC, pledging the stock of BNG in favor of Chemical Trust Company of California for the benefit of the Secured Parties and the Funding Corporation (incorporated by reference to Exhibit 4.40 to the Funding Corporation II Form S-4).
4.43 Partnership Interest Pledge Agreement, dated as of June 20, 1996, by VPC and BNG, pledging the partnership interests in Vulcan in favor of Chemical Trust Company of California for the benefit of the Secured Parties and the Funding Corporation (incorporated by reference to Exhibit 4.41 to the Funding Corporation II Form S-4).
4.44 Partnership Interest Pledge Agreement, dated as of June 20, 1996, by Magma, CEOC and each of Conejo, Niguel, San Felipe, respectively, pledging the partnership interests in Del Ranch, Elmore and Leathers, respectively, in favor of Chemical Trust Company of California for the benefit of the Secured Parties and the Funding Corporation (incorporated by reference to Exhibit 4.42 to the Funding Corporation II Form S-4).
4.45 Agreement regarding Security Documents, dated as of June 20, 1996, by and among the Initial Guarantors, Magma, SSPC, the Funding Corporation and Chemical Trust Company of California (incorporated by reference to Exhibit 4.43 to the Funding Corporation II Form S-4).
10.1(a) Salton Sea Deed of Trust, Assignment of Rents, Security Agreement and Fixture Filing, dated as of July 21, 1995, by SSBP, SSPG and Fish Lake to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 10.1 to the Funding Corporation Form S-4) .
10.1(b) First Amendment to Salton Sea Deed of Trust, Assignment of Rents, Security Agreement and Fixed Filing, dated as of June 20, 1996, by SSBP, SSPG and Fish Lake to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 10.2 to the Funding Corporation II Form S-4).
10.1(c) Second Amendment to Salton Sea Deed of Trust, Assignment of Rents, Security Agreement and Fixed Filing, dated as of October 13, 1998, by SSBP, SSPG and Fish Lake to Chicago Title Company for the use and benefit of Chemical Trust Company of California (incorporated by reference to Exhibit 10.1(c) to the Funding Corporation Form 10-K/A for the year ending December 31, 1998).
10.2 Collateral Assignment of Southern California Edison Company Agreements, dated as of July 21, 1995, by SSPG and Fish Lake in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 10.2 to the Funding Corporation Form S-4).
10.3 Contract for the Purchase and Sale of Electric Power from the Salton Sea Geothermal Facility, dated May 9, 1987 (the "Unit 1 Power Purchase Agreement"), between Southern California Edison Company and Earth Energy, Inc. (incorporated by reference to Exhibit 10.3 to the Funding Corporation Form S-4).
10.4 Amendment No. 1 to the Unit 1 Power Purchase Agreement, dated as of March 30, 1993, between Southern California Edison Company and Earth Energy, Inc. (incorporated by reference to Exhibit 10.4 to the Funding Corporation Form S-4).
10.5 Amendment No. 2 to Unit 1 Power Purchase Agreement, dated November 29, 1994, between Southern California Edison Company and SSPG (incorporated by reference to Exhibit 10.5 to the Funding Corporation Form S-4).
10.6 Contract for the Purchase and Sale of Electric Power, dated April 16, 1985 (the "Unit 2 Power Purchase Agreement"), between Southern California Edison Company and Westmoreland Geothermal Associates (incorporated by reference to Exhibit 10.6 to the Funding Corporation Form S-4).
10.7 Amendment No. 1 to Unit 2 Power Purchase Agreement, dated as of December 18, 1987, between Southern California Edison Company and Earth Energy, Inc. (incorporated by reference to Exhibit 10.7 to the Funding Corporation Form S-4).
10.8 Power Purchase Contract, dated April 16, 1985 (the "Unit 3 Power Purchase Agreement"), between Southern California Edison Company and Union Oil Company of California (incorporated by reference to Exhibit 10.8 to the Funding Corporation Form S-4).
10.9 Power Purchase Contract (the "Unit 4 Power Purchase Agreement"), dated November 29, 1994, between Southern California Edison Company, SSPG and Fish Lake (incorporated by reference to Exhibit 10.9 to the Funding Corporation Form S-4).
10.10Plant Connection Agreement (Unit 2), dated October 3, 1989, between the Imperial Irrigation District and Earth Energy, Inc. (incorporated by reference to Exhibit 10.10 to the Funding Corporation Form S-4).
10.11Plant Connection Agreement, dated August 2, 1988 (Unit 3), between the Imperial Irrigation District and Desert Power Company (incorporated by reference to Exhibit 10.11 to the Funding Corporation Form S-4).
10.12Imperial Irrigation District Funding and Construction Agreements as amended (Units 2 and 3), dated as of June 29, 1987, among the Imperial Irrigation District, Earth Energy, Inc., Chevron Geothermal Company of California, Geo East Mesa No. 3, Inc., Magma Power Company, Desert Power Company, Geo East Mesa No. 2, Inc., Heber Geothermal Company, Ormesa Geothermal, Ormesa Geothermal II, Vulcan/BN Geothermal Power Company, Union Oil Company of California, Del Ranch L.P., Elmore L.P., Leathers L.P., Geo East Mesa Limited Partnership and Imperial Resource Recovery Associates, L.P. (incorporated by reference to Exhibit 10.12 to the Funding Corporation Form S-4).
10.13Transmission Service Agreement, dated as of October 3, 1989 (Unit 2), between the Imperial Irrigation District and Earth Energy, Inc. (incorporated by reference to Exhibit 10.13 to the Funding Corporation Form S-4).
10.14Transmission Service Agreement, dated as of August 2, 1988 (Unit 3), between the Imperial Irrigation District and Desert Power Company (incorporated by reference to Exhibit 10.14 to the Funding Corporation Form S-4).
10.15Plant Connection Agreement (Unit 4), dated as of July 14, 1995, by and between the Imperial Irrigation District, SSPG and Fish Lake (incorporated by reference to Exhibit 10.15 to the Funding Corporation Form S-4).
10.16Letter Agreement, dated February 2, 1995, between Magma Power Company and the Imperial Irrigation District (incorporated by reference to Exhibit 10.16 to the Funding Corporation Form S-4).
10.17Transmission Service Agreement (Unit 4), dated as of July 14, 1995, by and between the Imperial Irrigation District, SSPG and Fish Lake (incorporated by reference to Exhibit 10.17 to the Funding Corporation Form S-4).
10.18Transmission Line Construction Agreement (Unit 4), dated July 14, 1995, between the Imperial Irrigation District, SSPG and Fish Lake (incorporated by reference to Exhibit 10.18 to the Funding Corporation Form S-4).
10.19Funding Agreement, dated June 15, 1988 (Unit 2), between Southern California Edison Company and Earth Energy, Inc. (incorporated by reference to Exhibit 10.19 to the Funding Corporation Form S-4).
10.20Second Amended and Restated Administrative Services Agreement, by and among CEOC, SSBP, SSPG and Fish Lake, dated as of July 15, 1995 (incorporated by reference to Exhibit 10.20 to the Funding Corporation Form S-4).
10.21Second Amended and Restated Operating and Maintenance Agreement, dated as of July 15, 1995, by and among Magma Power Company, SSBP, SSPG and Fish Lake (incorporated by reference to Exhibit 10.21 to the Funding Corporation Form S-4).
10.22 Intentionally Omitted.
10.23Collateral Assignment of Southern California Edison Company Agreements, dated as of June 20, 1996, by Vulcan, Elmore, Leathers and Del Ranch in favor of Chemical Trust Company of California (incorporated by reference to Exhibit 10.23 to the Funding Corporation II Form S-4).
10.24Administrative Services Agreement, dated as of June 17, 1996, between CEOC and Vulcan (incorporated by reference to Exhibit 10.24 to the Funding Corporation II Form S-4).
10.25Amended and Restated Construction, Operating and Accounting Agreement, dated as of June 17, 1996, between VPC and Vulcan (incorporated by reference to Exhibit 10.25 to the Funding Corporation II Form S-4).
10.26Long Term Power Purchase Contract, dated March 1, 1984, as amended, between SCE and Vulcan, as successor to Magma Electric Company (incorporated by reference to Exhibit 10.26 to the Funding Corporation II Form S-4).
10.27Transmission Service Agreement, dated December 1, 1988, between VPC and IID (incorporated by reference to Exhibit 10.27 to the Funding Corporation II Form S-4).
10.28Plant Connection Agreement, dated as of December 1, 1988, between VPC and IID (incorporated by reference to Exhibit 10.28 to the Funding Corporation II Form S-4).
10.29Amended and Restated Administrative Services Agreement, dated as of June 17, 1996 between CEOC and Elmore (incorporated by reference to Exhibit 10.29 to the Funding Corporation II Form S-4).
10.29Amended and Restated Operating and Maintenance Agreement, dated as of June 17, 1996, between CEOC and Elmore (incorporated by reference to Exhibit 10.30 to the Funding Corporation II Form S-4).
10.31Long Term Power Purchase Contract, dated June 15, 1984, as amended, between SCE and Elmore, as successor to Magma Electric Company (incorporated by reference to Exhibit 10.31 to the Funding Corporation II Form S-4).
10.32Transmission Service Agreement, dated as of August 2, 1988, as amended, between Elmore and IID (incorporated by reference to Exhibit 10.32 to the Funding Corporation II Form S-4).
10.33Plant Connection Agreement, dated as of August 2, 1988, between Elmore and IID (incorporated by reference to Exhibit 10.33 to the Funding Corporation II Form S-4).
10.34Amended and Restated Administrative Services Agreement, dated as of June 17, 1996, between CEOC and Leathers (incorporated by reference to Exhibit 10.34 to the Funding Corporation II Form S-4).
10.35Amended and Restated Operating and Maintenance Agreement, dated as of June 17, 1996, between CEOC and Leathers (incorporated by reference to Exhibit 10.35 to the Funding Corporation II Form S-4).
10.36Long Term Power Purchase Contract, dated August 16, 1985, as amended, between SCE and Leathers, as successor to Imperial Energy Corporation (incorporated by reference to Exhibit 10.36 to the Funding Corporation II Form S-4).
10.37Transmission Service Agreement, dated as of October 3, 1989, as amended, between Leathers and IID (incorporated by reference to Exhibit 10.37 to the Funding Corporation II Form S-4).
10.38Plant Connection Agreement, dated as of October 3, 1989, between Leathers and IID (incorporated by reference to Exhibit 10.38 to the Funding Corporation II Form S-4).
10.39Amended and Restated Administrative Services Agreement, dated as of June 17, 1996, between CEOC and Del Ranch (incorporated by reference to Exhibit 10.39 to the Funding Corporation II Form S-4).
10.40Amended and Restated Operating and Maintenance Agreement, dated as of June 17, 1996, between CEOC and Del Ranch (incorporated by reference to Exhibit 10.40 to the Funding Corporation II Form S-4).
10.41Long Term Power Purchase Contract, dated February 22, 1984, as amended, between SCE and Del Ranch, as successor to Magma (incorporated by reference to Exhibit 10.41 to the Funding Corporation II Form S-4).
10.42Transmission Service Agreement, dated as of August 2, 1988, as amended, between Del Ranch and IID (incorporated by reference to Exhibit 10.42 to the Funding Corporation II Form S-4).
10.43Plant Connection Agreement, dated as of August 2, 1988, between Del Ranch and IID (incorporated by reference to Exhibit 10.43 to the Funding Corporation II Form S-4).
10.44Funding Agreement, dated May 18, 1990, between SCE and Del Ranch (incorporated by reference to Exhibit 10.44 to the Funding Corporation II Form S-4).
10.45Funding Agreement, dated May 18, 1990, between SCE and Elmore (incorporated by reference to Exhibit 10.45 to the Funding Corporation II Form S-4).
10.46Funding Agreement, dated June 15, 1990, between SCE and Leathers (incorporated by reference to Exhibit 10.46 to the Funding Corporation II Form S-4).
10.47Funding Agreement, dated May 18, 1990, between SCE and Leathers (incorporated by reference to Exhibit 10.47 to the Funding Corporation II Form S-4).
10.48Funding Agreement, dated May 18, 1990, between SCE and Vulcan (incorporated by reference to Exhibit 10.48 to the Funding Corporation II Form S-4).
24. Power of Attorney
27. Financial Data Schedule. | 34,887 | 226,938 |
1054102_1999.txt | 1054102_1999 | 1999 | 1054102 | ITEM 1. BUSINESS
Description of Business
We are a leading and rapidly growing contract sales organization, providing customized product detailing programs and other marketing and promotional services to the United States pharmaceutical industry. We have achieved our leadership position in the CSO industry based on 12 years of designing and executing customized product detailing programs for many of the pharmaceutical industry's largest companies, including Abbott, Allergan, Astra-Zeneca, Glaxo Wellcome, Novartis, Pfizer, Procter & Gamble, Rhone-Poulenc Rorer (now known as Aventis Pharma), Hofmann LaRoche and Solvay. We have designed programs that promote more than 90 different products, including such leading prescription medications as Imitrex(Registered), Flonase(Registered), Prilosec(Registered), Wellbutrin(Registered) and Cardura(Registered), as well as a number of leading OTC products such as Bayer(Registered) Aspirin, Pepcid AC(Registered) and Monistat 5(Registered), to hospitals, pharmacies and physicians in more than 20 different specialties.
We are engaged by our clients on a contractual basis to design and implement product detailing programs for both prescription and OTC pharmaceutical products. Such programs typically include three phases: design, execution and assessment. In the program design phase, we work with the client to understand needs, define objectives, select targets and determine appropriate staffing. Program execution involves recruiting, hiring, training and managing a sales force, which performs detail calls promoting the particular client's pharmaceutical products. Assessment, the last phase of the program, involves measurement of sales force performance and program success relative to the goals and objectives outlined in the program design phase.
We have generated strong internal growth by renewing and expanding programs with existing clients and by securing new business from leading pharmaceutical companies. Recent acquisitions have also contributed to our growth. We believe that we are one of the largest CSOs operating in the United States measured both by revenue and total number of sales representatives used in detailing programs. The number of sales representatives employed by us has grown from 134 as of January 1, 1995 to 2,101 as of December 31, 1999, consisting of 1,668 full-time sales representatives and 433 part-time sales representatives. Whereas none of our sales representatives at January 1, 1995 were full-time employees, 79% of our current sales representatives are full-time employees.
We believe that because of the benefits of outsourcing, pharmaceutical companies have made a strategic decision to continue to outsource a significant portion of their sales and marketing activities. We further believe that the trend toward the increased use of CSOs by pharmaceutical companies will continue due to the following industry dynamics: (i) pharmaceutical companies will continue to expand their product portfolios and as a result will need to add sales force capacity, (ii) pharmaceutical companies will continue to face margin pressures and will seek to maintain flexibility by converting fixed costs to variable costs, and (iii) the availability of qualified CSOs will provide an incentive to pharmaceutical companies to continue to outsource this function.
We believe that we are well positioned to benefit from these growth opportunities. Through our 12 years of providing service to the United States pharmaceutical industry, we have demonstrated that we are a high-quality, results-oriented provider of detailing services. In addition, we maintain a highly qualified sales force as a result of a rigorous recruiting process and training programs that are comparable to those of the pharmaceutical companies. We also believe that one of our biggest competitive advantages is our ability to provide customized solutions to our clients. Finally, as one of the largest CSOs, we have achieved the size and demonstrated the ability to perform large detailing programs and execute several programs simultaneously.
In order to leverage our competitive advantages, our growth strategy emphasizes: (i) enhancing our leadership position in the growing CSO market by maintaining our historic focus on high-quality contract sales services and by continuing to build and invest in our core competencies and operations; (ii) expanding both our relationship with existing clients and our selling efforts to capture new clients; (iii) offering additional promotional, marketing and educational services and further developing our existing detailing services; (iv) entering new geographic markets; and (v) investigating and pursuing appropriate acquisitions of detailing or detailing-related companies.
Recent Developments
In May 1999 we acquired 100% of the capital stock of TVG, Inc. in a merger transaction. TVG provides brand marketing strategy, product profiling, positioning, message development services, and a broad spectrum of promotional and educational communications programs, including dinner meetings, symposia, teleconferences and on-site hospital programs for the pharmaceutical industry.
In August 1999 we acquired substantially all of the operating assets of ProtoCall, LLC, a leading provider of syndicated contract sales services to the pharmaceutical industry. In a syndicated product detailing program, a single sales representative details non-competing products of multiple manufacturers during a meeting with a targeted prescriber. The acquisition of the ProtoCall business adds a syndicated sales force option to our product detailing offerings, expanding the scope and flexibility of the high-quality services that we can provide to our clients.
Services Offered
We currently provide three principal services to the pharmaceutical industry:
o customized product detailing programs using dedicated or syndicated sales forces; o professional communication and education services; and o marketing research and consulting services.
Product Detailing Programs
Our primary business is designing and executing customized product detailing programs using dedicated or syndicated sales forces.
Dedicated detailing programs. A dedicated detailing program typically involves designing and deploying a fully integrated sales force customized to the client's particular needs. A dedicated sales force promotes one to three products of a single client. The amount of time devoted to each product detailed during a call depends upon that product's detail position, i.e., the slot, within the call. Repeat interactions between the sales representative and the targeted prescriber are intended to establish trust between the sales representative and the targeted prescriber, influence the prescribing pattern of the targeted prescriber, obtain market share for new products, maintain market share for existing products and build barriers to entry against competing products.
While each detailing program relies on our basic core competencies, we custom design each program to provide significant strategic advantages to the client. Our product detailing programs can be divided into three distinct phases: design, execution and assessment. In the design phase, we undertake to understand the client's needs and objectives, identify, define and rank the proposed target audience and determine appropriate staffing. In the execution phase, we recruit, hire, train and manage the sales force. Finally, in the assessment phase, we measure the performance of the sales force and the success of the program relative to the goals and objectives of the program.
Syndicated detailing programs. Through ProtoCall, we provide syndicated product detailing programs. ProtoCall is the leading provider of syndicated detailing programs to the United States pharmaceutical industry. A syndicated sales program utilizes a team of highly qualified sales representatives to promote non-competing products of multiple manufacturers. Because the costs associated with a syndicated sales force are shared among the various manufacturers, these programs are less expensive than programs involving a dedicated sales force. In addition, since the sales force is already deployed, the detailing program can be launched even more quickly than a program using a dedicated sales force. Accordingly, a syndicated sales force is typically used for seasonal products or products with short-term promotional needs. Examples of seasonal brands include flu medicines that are promoted during the winter cold and flu season. Brands with short-term promotional needs may include brands that are currently being promoted but require supplemental promotion.
Professional communication and education services
Through TVG's education/communication division, we are a leading provider of customized professional communication and education programs to the pharmaceutical industry. These programs are designed to optimize sales of pharmaceutical products. These programs fall into three basic categories:
o peer-to-peer promotional events such as dinner meetings and teleconferences; o developing and organizing advisory boards, speaker bureaus and symposia; and o customized continuing medical education programs for physicians.
Marketing research and consulting services
Through TVG's MR&C division, we are a leading provider of custom marketing research and consulting services to the pharmaceutical industry. The MR&C division provides a broad range of services across the entire life cycle of a pharmaceutical product. TVG has developed a proprietary marketing model and tools that utilize both qualitative and quantitative methodologies. This model and the related tools are intended to identify the work that must be done in order to achieve the client's marketing goals. The model uses a six-step analysis:
o market assessment involves identifying current knowledge, attitudes and practices of the relevant target audience;
o product profiling attempts to identify how an existing product is viewed or how a new product will be viewed by the targeted audience, particularly in relation to competing products and treatment alternatives;
o product positioning helps the client develop the appropriate marketing strategy for the product;
o message awareness evaluates the efficacy of a client's existing marketing program;
o execution involves translating the message to effective promotional materials; and
o implementation involves designing a program to actually deliver the marketing material to the targeted audience.
In addition, the MR&C division also conducts a series of marketing seminars for both new and experienced pharmaceutical marketing researchers and product managers. These seminars generally focus on the techniques of pharmaceutical marketing research and the key marketing principles for successfully promoting pharmaceutical products. Finally, the MR&C division has also created a team dedicated to addressing the effect of managed care on marketing issues relating to a client's product.
Company's Competitive Advantages
We believe that a significant market opportunity exists for CSOs that can provide high-quality sales solutions across a variety of sales, marketing and therapeutic applications and that have demonstrated a willingness and ability to respond to the particular needs of clients. We believe that our principal competitive strengths are as follows:
Established reputation for quality. We believe that the strength of our client relationships is evidence of our overall commitment to quality. Virtually every program that we have designed has met or exceeded the goals established with the client at the beginning of the program. We believe that, as a result, we have earned a reputation in the CSO industry as a high-quality, results-oriented provider of product detailing services. This belief is based on our long-standing relationships with "blue chip" pharmaceutical companies like Astra-Zeneca, Glaxo Wellcome, Pfizer, Procter & Gamble, and Rhone-Poulenc Rorer (now known as Aventis Pharma), who not only have renewed but have also expanded their relationships with us, and our ability to attract new clients.
Ability to quickly and efficiently deploy a high-quality, highly-motivated sales force. As a result of our national field-based recruiting and hiring process, we can quickly field a high quality, highly motivated sales force. As an example, we recently built a new 300-person sales force in four weeks. The quality of our sales force is assured by a recruiting and hiring process that is one of the most comprehensive, challenging, rigorous, selective and professional processes in the industry. Our training programs are comparable to those designed by pharmaceutical companies to train their internal sales forces. In addition, we offer our sales representatives a compensation package that we believe is competitive with compensation packages offered by the major pharmaceutical companies. Our highly motivated sales force is evidenced by our low turnover rate.
Success in designing customized detailing programs. We successfully innovate and create custom-designed product detailing programs that meet the specific needs of our clients as they relate to the product or products being promoted. The two principal areas of customization are the geographic deployment of the sales representatives to be used in the program and the profile of the sales force (i.e., part-time versus full-time). We believe that our ability to provide full-time, part-time or a combination of full-time and part-time sales representatives, constitutes a competitive advantage. Other areas of customization include the experience of the sales representatives, type of sales force to be used (i.e., a dedicated, vertically integrated sales force or a syndicated sales force), and call frequency, compensation, and field and database management support, such as in-house territory mapping, physician satisfaction surveys, call reporting services and regulatory compliance services. In addition, we are exploring the possibility of entering into contracts under which we would share the costs of a detailing program with the client in exchange for a contingent fee based on future sales of the product being promoted or some other performance based criteria. Our acquisition of TVG enhances our ability to properly address the market potential of various pharmaceutical products and to properly structure these arrangements.
Ability to manage multiple large complex programs. We have demonstrated an ability to manage multiple large and complex programs simultaneously. This ability is due, in part, to our experienced and highly qualified management team, an organizational structure that enables us to respond to client demands promptly and our management, database and information technology support systems.
Clients and Contracts
Clients
We believe that our relationships with our clients, which include many of the largest pharmaceutical companies in the United States, are among our most important strategic assets and competitive advantages. We have enjoyed long-standing relationships with many of these clients, and a high percentage of our clients either renew their programs or enter into new contracts with us for new programs. We believe that the quality and stability of our client base promotes the consistency of our core business and that the scope and complexity of our clients' marketing needs present opportunities for expansion into new areas. There can be no assurance, however, that our clients will continue to renew or expand their relationship with us.
Contracts
Given the customized nature of our business, we utilize a variety of contract structures with our clients. Generally, contracts provide for a fee to be paid based on us delivering a specified package of services. Contracts typically include performance benchmarks, such as a minimum number of sales representatives or a minimum number of calls. We typically receive a portion of our fee upon commencement of the program to offset the costs of initiating such program. In addition, contracts typically provide that we are entitled to a fee for each sales representative hired by the client during or at the conclusion of a program. In certain instances, we may be entitled to additional compensation based upon the success of the program and/or subject to penalties for failing to meet stated performance benchmarks.
Our contracts generally are for terms of one year and are subject to renewal upon expiration. However, our contracts are terminable by the client for any reason upon 30 to 90 days notice. Our contracts typically provide for termination payments by the client upon a termination without cause. While the cancellation of certain contracts by a client without cause may result in the imposition of penalties on such client, such penalties may not act as an adequate deterrent to the termination of any such contracts. In addition, there can be no assurance that such penalties will offset the revenue which could have been earned under such contract or the costs which we may incur as a result of such termination. The loss or termination of a large contract or the loss of multiple contracts could adversely affect our future revenue and profitability. Contracts may also be terminated for cause if we fail to meet stated performance benchmarks. To date, no programs have been terminated for cause.
Our contracts typically contain cross-indemnification provisions between us and our client. The client will usually indemnify us against product liability and related claims arising from the sale of the product and we indemnify the clients with respect to the errors and omissions of our sales representatives in the course of their detailing activities. To date, we have not asserted, nor has there been asserted against us, any claim for indemnification pursuant to a contract.
Marketing and Business Development
Most of our revenue is derived from renewals and extensions of existing programs, new programs with existing clients and new programs from new clients. Most of our new business, from both existing clients and new clients, is derived from responses to "requests for proposals" from pharmaceutical companies. However, we are also engaged in proactive efforts to generate more business from new and prospective clients. Recently, we hired a business development team, led by our vice president-new business development. We have also implemented a sales process that is designed to leverage our results-oriented image through case studies, references and comprehensive proposals. This new business development process relies on the use of a dedicated sales and marketing team as well as our experienced senior management team.
Competition
Traditionally, our competition has included in-house sales and marketing departments of pharmaceutical companies and other CSOs, the largest of which are Innovex (a subsidiary of Quintiles Transnational) the various sales and marketing affiliates of Ventiv Health (formerly, Snyder Communications) and Nelson Professional Sales (a division of Nelson Communications, Inc.). However, there are relatively few barriers to entry into the CSO industry and, as the CSO industry continues to evolve, new competitors are likely to emerge. For example, recently, two major wholesale drug distributors have begun to provide product detailing services. Many of our current and potential competitors are larger than we are and have greater financial, personnel and other resources than we do. Increased competition may lead to price and other forms of competition that may have a material adverse effect on our business and results of operations.
As a result of competitive pressures, pharmaceutical companies, as well as various organizations providing services to the pharmaceutical industry are consolidating and are becoming targets of global organizations. This trend is likely to produce increased competition for clients and increased competitive pressures on smaller providers. If the trend in the pharmaceutical industry towards consolidation continues, pharmaceutical companies may have excess in-house sales force capacity and may, as a result, reduce or eliminate their use of CSOs. Alternatively they may choose to award their product detailing and other marketing and promotion contracts to organizations that can provide a broader range of services. Although we intend to monitor industry trends and respond appropriately, we cannot be certain that we will be able to anticipate and successfully respond to such trends.
We believe that the primary competitive factors affecting contract sales services is the ability to quickly hire, train, deploy and manage qualified sales representatives to implement simultaneously several large product detailing programs. We also compete on the basis of such factors as reputation, quality of services, experience of management, performance record, customer satisfaction, ability to respond to specific client needs, integration skills and price. We believe we compete favorably with respect to each of these factors.
Government and Industry Regulation
The healthcare industry is subject to extensive government and industry regulation. Various laws, regulations and guidelines promulgated by government, industry and professional bodies affect, among other matters, the provision, licensing, labeling, marketing, promotion, sale and reimbursement of healthcare services and products, including pharmaceutical products. It is also possible that additional or amended laws, regulations or guidelines could be adopted in the future.
The pharmaceutical industry is subject to extensive federal regulation and oversight by the United States Food and Drug Administration, the FDA. The Food, Drug and Cosmetic Act, as supplemented by various other statutes, regulates, among other matters, the approval, labeling, advertising, promotion, sale and distribution of drugs, including the practice of providing product samples to physicians. Under this statute, the FDA asserts its authority to regulate all promotional activities involving prescription drugs. In addition, the sale or distribution of pharmaceuticals may also be subject to the Federal Trade Commission Act. Finally, the Prescription Drug Marketing Act, the PDMA, regulates the ability of pharmaceutical companies to provide physicians with free samples of their products. Essentially, the PDMA requires extensive record keeping and labeling of such samples for tracing purposes.
In addition, some of the services that we currently perform or that we may provide in the future are affected by various guidelines promulgated by industry and professional organizations. For example, ethical guidelines
promulgated by the American Medical Association govern, among other matters, the receipt by physicians of gifts from health-related entities. These guidelines govern the honoraria, and other items of pecuniary value, which AMA member physicians may receive, directly or indirectly, from pharmaceutical companies. Similar guidelines and policies have been adopted by other professional and industry organizations, such as Pharmaceutical Research and Manufacturers of America.
The healthcare industry is subject to federal and state laws pertaining to healthcare fraud and abuse. In particular, certain federal and state laws prohibit manufacturers, suppliers and providers from offering or giving or receiving kickbacks or other remuneration in connection with ordering or recommending purchase or rental of healthcare items and services. The federal anti-kickback statute imposes both civil and criminal penalties for, among other things, offering or paying any remuneration to induce someone to refer patients to, or to purchase, lease, or order (or arrange for or recommend the purchase, lease, or order of), any item or service for which payment may be made by Medicare or certain federally-funded state healthcare programs (e.g., Medicaid). This statute also prohibits soliciting or receiving any remuneration in exchange for engaging in any of these activities. The prohibition applies whether the remuneration is provided directly or indirectly, overtly or covertly, in cash or in kind. Violations of the law can result in numerous sanctions, including criminal fines, imprisonment, and exclusion from participation in the Medicare and Medicaid programs.
Several states also have referral, fee splitting and other similar laws that may restrict the payment or receipt of remuneration in connection with the purchase or rental of medical equipment and supplies. State laws vary in scope and have been infrequently interpreted by courts and regulatory agencies, but may apply to all healthcare items or services, regardless of whether Medicare or Medicaid funds are involved.
Finally, we are subject to the rules and regulations promulgated by the Equal Employment Opportunity Commission and similar state entities which govern our recruiting and hiring practices and our relationship with our employees.
Our failure, or the failure of our clients to comply with, or any change in, the applicable regulatory requirements or professional organization or industry guidelines could, among other things, limit or prohibit us or our clients from conducting certain business activities, subject us or our clients to adverse publicity, increase the costs of regulatory compliance or subject us or our clients to monetary fines or other penalties. Any such actions could have a material adverse affect on us.
Insurance
General liability insurance. As a provider of product detailing services to the pharmaceutical industry, we may become involved in litigation regarding the products promoted by our employees, with the associated risks of significant legal costs, substantial damage awards and adverse publicity. Even if these claims ultimately prove to be without merit, defending against them can result in adverse publicity, diversion of management's time and attention and substantial expenses, which could have a material adverse effect on our operations and financial condition. In addition, we are often required to indemnify our clients for the negligence of our employees.
We protect ourselves against potential liability by maintaining general liability and professional liability insurance, which we believe to be adequate in amount and coverage for the current size and scope of our operations, and by contractual indemnification provisions with our clients. We may seek to increase our existing policy limits or obtain additional insurance coverage in the future as our business grows. Although we have not experienced difficulty obtaining insurance coverage in the past, we cannot be certain that we can increase our existing policy limits or obtain additional insurance coverage on acceptable terms or at all. In addition, although our clients may indemnify us for their negligent conduct, that may not be adequate protection for us.
Employment practice liability insurance. The success of our business depends on our ability to deploy a high-quality sales force quickly. As part of our recruiting and hiring process, we conduct a thorough screening process, drug testing and rigorous interviews. In addition, we must continually evaluate our personnel and, when necessary, terminate some of our employees with or without cause. Accordingly, we may be subject to lawsuits relating to wrongful termination, discrimination and harassment. We have obtained employment practice liability insurance, which insures us against claims made by employees or former employees relating to their employment, i.e., wrongful termination, sexual harassment, etc. To date, we have not made any claims under this policy. We cannot be sure that the coverage we maintain will be sufficient to cover any future claims or will continue to be available in adequate
amounts or at a reasonable cost. We could be materially and adversely affected if we were required to pay damages or incur defense costs in connection with a claim by an employee that is outside the scope of coverage or exceeds the limits of our policy.
CERTAIN FACTORS THAT MAY AFFECT FUTURE GROWTH
The following factors may affect our future growth and should be considered by any prospective purchaser of our securities:
If the pharmaceutical industry does not continue to use, or fails to increase its use of, third party service organizations to market and promote its products, our business would be seriously harmed.
We generate substantially all of our revenue from providing product detailing services to pharmaceutical companies. We have benefited from the growing trend of pharmaceutical companies to outsource marketing and promotional programs. We cannot be certain that this trend will continue. For example, the growth in outsourcing is driven, in part, by the growth in the number of pharmaceutical products developed over the last few years. However, recently there has been a decrease in the number of new ethical compounds coming to market. If this trend continues, pharmaceutical companies may reduce their outsourcing programs. Furthermore, the trend in the pharmaceutical industry toward consolidation, by merger or otherwise, may result in a reduction in the use of CSOs. A significant change in the direction of the outsourcing trend generally, or a trend in the pharmaceutical industry not to use, or to reduce the use of, outsourced marketing services, such as those we provide, would have a material adverse effect on our business.
A decrease in marketing or promotional expenditures by the pharmaceutical industry as a result of private initiatives, government reform or otherwise, could have an adverse affect on our business.
Our business, financial condition and results of operations depend on marketing and promotional expenditures by pharmaceutical companies for their products. Because we generate substantially all of our revenue from product detailing programs, unfavorable developments in the pharmaceutical industry could adversely affect our business. These developments could include reductions in expenditures for marketing and promotional activities or a shift in marketing focus away from product detailing. Promotional, marketing and sales expenditures by pharmaceutical companies could also be negatively impacted by government reform or private market initiatives intended to reduce the cost of pharmaceutical products or by government, medical association or pharmaceutical industry initiatives designed to regulate the manner in which pharmaceutical companies promote their products.
Most of our revenue is derived from a limited number of clients, the loss of any one of which could adversely affect our business.
Our revenue and profitability are highly dependent on our relationships with a limited number of large pharmaceutical companies. In 1999, our four largest clients accounted for approximately 30%, 22%, 19% and 6%, respectively, or a total of 77% of our revenue. We are likely to continue to experience a high degree of client concentration, particularly if there is further consolidation within the pharmaceutical industry. The loss or a significant reduction of business from any of our major clients could have a material adverse effect on our business and results of operations.
Our contracts are short-term agreements and are subject to cancellation at any time, which may result in lost revenue and additional costs and expenses.
Our contracts are generally for a term of one year and may be terminated by the client at any time for any reason. The termination of a contract by one of our major clients would not only result in lost revenue, but may cause us to incur additional costs and expenses. For example, all of our sales representatives are employees rather than independent contractors. Accordingly, upon termination of a contract, unless we can immediately transfer the related sales force to a new program, we either must continue to compensate those employees, without realizing any related revenue, or terminate their employment. If we terminate their employment, we may incur significant expenses relating to their termination.
We may lose money on fixed-fee contracts and performance-based contracts.
Substantially all of our contracts are fixed fee arrangements. We also enter into some contracts in which a portion of our fees are contingent on meeting performance objectives. Finally, we are exploring the possibility of entering into contracts under which we may share the costs of a detailing program with the client in exchange for a contingent fee based on the future sales of the product being promoted or some other performance based criteria. Accordingly, if we underestimate the costs associated with the services to be provided under a particular contract, or if there are unanticipated increases in our operating or administrative expenses, or if we fail to meet certain performance objectives, or if we incorrectly assess the market potential of a particular product, the margins on that contract and our overall profitability may be adversely affected.
Management of Growth
We have recently experienced rapid growth in the number of employees, the size of our programs and the scope of our operations. Our ability to manage such growth effectively will depend upon our ability to enhance our management team and our ability to attract and retain skilled employees. Our success will also depend on the ability of our officers and key employees to continue to implement and improve our operational, management information and financial control systems, and to expand, train and manage our workforce. Failure to manage growth effectively could have a material adverse effect on our business and results of operations.
Government or private initiatives to reduce healthcare costs could have a material adverse effect on the pharmaceutical industry and on us.
The primary trend in the United States healthcare industry is toward cost containment. Comprehensive government healthcare reform intended to reduce healthcare costs, the growth of total healthcare expenditures and expand healthcare coverage for the uninsured have been proposed in the past and may be considered again in the near future. Implementation of government healthcare reform may adversely affect promotional and marketing expenditures by pharmaceutical companies, which could decrease the business opportunities available to us. In addition, the increasing use of managed care, centralized purchasing decisions, consolidations among and integration of healthcare providers are continuing to affect purchasing and usage patterns in the healthcare system. Decisions regarding the use of pharmaceutical products are increasingly being consolidated into group purchasing organizations, regional integrated delivery systems and similar organizations and are becoming more economically focused, with decision makers taking into account the cost of the product and whether a product reduces the cost of treatment. Significant cost containment initiatives adopted by government or private entities could have a material adverse effect on our business.
Our failure, or that of our clients, to comply with applicable healthcare regulations could limit, prohibit or otherwise adversely impact our business activities.
Various laws, regulations and guidelines promulgated by government, industry and professional bodies affect, among other matters, the provision, licensing, labeling, marketing, promotion, sale and distribution of healthcare services and products, including pharmaceutical products. In particular, the healthcare industry is subject to various Federal and state laws pertaining to healthcare fraud and abuse, including prohibitions on the payment or acceptance of kickbacks or other remuneration in return for the purchase or lease of products that are paid for by Medicare or Medicaid. Sanctions for violating these laws include civil and criminal fines and penalties and possible exclusion from Medicare, Medicaid and other Federal healthcare programs. Although we believe our current business arrangements do not violate these Federal and state fraud and abuse laws, we cannot be certain that our business practices will not be challenged under these laws in the future or that a challenge would not have a material adverse effect on our business, financial condition and results of operations. Our failure, or the failure of our clients, to comply with these laws, regulations and guidelines, or any change in these laws, regulations and guidelines may, among other things, limit or prohibit our business activities or those of our clients, subject us or our clients to adverse publicity, increase the cost of regulatory compliance or subject us or our clients to monetary fines or other penalties.
Our industry is highly competitive and our failure to address competitive developments promptly will limit our ability to retain and increase our market share.
Traditionally, our primary competitors were the in-house sales and marketing departments of pharmaceutical companies and other CSOs, such as Innovex (a subsidiary of Quintiles Transnational) the various sales and marketing affiliates of Ventiv Health (formerly, Snyder Communications) and Nelson Professional Sales (a division of Nelson Communications, Inc.). However, there are relatively few barriers to entry in the CSO industry and, as the CSO industry continues to evolve, new competitors are likely to emerge. For example, recently, two major wholesale drug distributors have begun to provide product detailing services. Many of our current and potential competitors are larger than we are and have substantially greater capital, personnel and other resources than we have. Increased competition may lead to price and other forms of competition that could have a material adverse effect on our market share, business and results of operations.
As a result of competitive pressures, various organizations providing services to the pharmaceutical industry are consolidating and are becoming targets of global organizations. This trend is likely to produce increased competition for clients. In addition, if the trend in the pharmaceutical industry towards consolidation continues, pharmaceutical companies may have excess in-house sales force capacity and they may, as a result, reduce or eliminate their use of CSOs or choose to award their product detailing and other marketing and promotional programs to organizations that can provide a broader range of services. Although we intend to monitor industry trends and respond appropriately, we may not be able to anticipate and successfully respond to such trends.
Our business will suffer if we fail to attract and retain experienced sales representatives.
The success and growth of our business depends on our ability to attract and retain qualified and experienced pharmaceutical sales representatives. There is intense competition for experienced pharmaceutical sales representatives from competing CSOs and pharmaceutical companies. On occasion our clients have hired the sales representatives that we trained to detail its products. We cannot be certain that we can continue to attract and retain qualified personnel. If we cannot attract, retain and motivate qualified sales personnel, we will not be able to expand our business and our ability to perform under our existing contracts will be impaired.
Our business will suffer if we lose certain key management personnel.
The success of our business also depends on our ability to attract, retain and motivate qualified senior management, financial and administrative personnel who are in high demand and who often have multiple employment options. Currently, we depend on a number of our senior executives, including Charles T. Saldarini, our president and chief executive officer; Steven K. Budd, our chief operating officer; and Bernard C. Boyle, our chief financial officer. The loss of the services of any one or more of these executives could have a material adverse effect on our business, financial condition and results of operations. Except for a $5 million key-man life insurance policy on the life of Mr. Saldarini and a $3 million policy on the life of Mr. Budd, we do not maintain and do not contemplate obtaining insurance policies on any of our employees.
The costs and difficulties of acquiring and integrating new businesses could impede our future growth and adversely affect our competitiveness.
As part of our growth strategy, we constantly evaluate new acquisition opportunities. Acquisitions involve numerous risks and uncertainties, including:
o the difficulty of identifying appropriate acquisition candidates;
o the difficulty integrating the operations and products and services of the acquired companies;
o the expenses incurred in connection with the acquisition and subsequent integration of operations and products and services;
o the impairment of relationships with employees, customers or vendors as a result of changes in management and ownership;
o the diversion of management's attention from other business concerns; and
o the potential loss of key employees or customers of the acquired company.
Acquisitions of companies outside the United States also may involve the following additional risks:
o assimilating differences in international business practices;
o overcoming language differences;
o exposure to currency fluctuations;
o difficulties in complying with a variety of foreign laws;
o unexpected changes in regulatory requirements;
o difficulties in staffing and managing foreign operations; and
o potentially adverse tax consequences.
We may be unable to successfully identify, complete or integrate any future acquisitions, and acquisitions that we complete may not contribute favorably to our operations and future financial condition. We may also face increased competition for acquisition opportunities, which may inhibit our ability to consummate suitable acquisitions on favorable terms.
Our quarterly revenues and operating results may vary which may cause the price of our common stock to fluctuate.
Our quarterly operating results may vary as a result of a number of factors, including:
o the commencement, delay, cancellation or completion of programs;
o the mix of services provided;
o the timing and amount of expenses for implementing new programs and services;
o the accuracy of estimates of resources required for ongoing programs;
o uncertainty related to compensation based on achieving performance benchmarks;
o the timing and integration of acquisitions;
o changes in regulations related to pharmaceutical companies; and
o general economic conditions.
In addition, generally, we recognize revenue as services are performed, while program costs, other than training costs, are expensed as incurred. As a result, during the first two to three months of a new contract, we may incur substantial expenses associated with staffing that new program without recognizing any revenue under that contract. This could have an adverse impact on our operating results and the price of our common stock for the quarters in which these expenses are incurred.
We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. Fluctuations in quarterly results could adversely affect the market price of our common stock in a manner unrelated to our long term operating performance.
ITEM 2.
ITEM 2. PROPERTIES
Facilities and Employees
Our corporate headquarters are located in Upper Saddle River, New Jersey, in approximately 38,500 square feet of space occupied under a lease that expires in the fourth quarter of 2004 with an option to extend for an additional five years. We also rent a 1,000 square foot sales office in Raleigh-Durham, North Carolina. TVG operates out of a 48,000 square foot facility in Fort Washington, Pennsylvania, with a lease that expires on August 31, 2000.
As of December 31, 1999, we had 2,591 employees, including 2,101 sales representatives. Approximately 110 employees work at our headquarters in Upper Saddle River, New Jersey, 144 employees work out of TVG's headquarters in Fort Washington, Pennsylvania, and 37 employees work out of ProtoCall's headquarters in Cincinnati, Ohio. In addition, we have 199 field based sales managers. We are not party to a collective bargaining agreement with a labor union and our relations with our employees are good.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are not currently a party to any material pending litigation and we are not aware of any material threatened litigation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR OUR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is quoted on the Nasdaq Stock Market under the symbol "PDII." The following table sets forth, for each of the periods indicated, the high and low closing sale prices per share as reported on the Nasdaq National Market since trading commenced on May 19, 1998.
High Low ------- ------- Second quarter ............................. $27.875 $19.250 Third quarter .............................. 28.000 17.000 Fourth quarter ............................. 28.250 20.750
First quarter .............................. 36.000 23.375 Second quarter ............................. 32.000 22.750 Third quarter .............................. 33.875 24.750 Fourth quarter ............................. 31.625 24.875
We believe that, as of February 25, 2000, we have approximately 4,103 beneficial stockholders.
Dividend Policy
We have not paid any dividends and do not intend to pay any dividends in the foreseeable future. Future earnings, if any, will be used to finance the future growth of our business. Future dividends will be determined by our board of directors.
Changes in Securities and Use of Proceeds
In May 1998, we completed our initial public offering (the "IPO") of 3,220,000 shares of Common Stock (including 420,000 shares in connection with the exercise of the underwriters' over-allotment option) at a price per share of $16.00. Net proceeds to us after expenses of the IPO were approximately $46.4 million.
(1) Effective date of Registration Statement: May 19, 1998 (File No. 333-46321).
(2) The Offering commenced on May 19, 1998 and was consummated on May 22, 1998.
(4)(i) All securities registered in the Offering were sold.
(4)(ii) The managing underwriters of the Offering were Morgan Stanley Dean Witter, William Blair & Company and Hambrecht & Quist.
(4)(iii) Common Stock, $.01 par value
(4)(iv) Amount registered and sold: 3,220,000 shares Aggregate purchase price: $51,520,000 All shares were sold for the account of the Issuer.
(4)(v) $3,606,400 in underwriting discounts and commissions were paid to the underwriters. $1,490,758 of other expenses were incurred, including estimated expenses.
(4)(vi) $46,422,842 of net Offering proceeds to the Issuer.
(4)(vii) Use of Proceeds: $46,422,842 of temporary investments with maturities of up to 3 months as of December 31, 1999.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below as of and for the years ended December 31, 1995, 1996, 1997, 1998 and 1999 are derived from our audited consolidated financial statements and the accompanying notes. Our consolidated financial statements for each of the periods presented reflects our acquisition of TVG in May 1999, which was accounted for as a pooling of interests. Consolidated balance sheets at December 31, 1998 and 1999 and consolidated statements of operations, stockholders' equity and cash flows for the three years ended December 31, 1997, 1998 and 1999 and the accompanying notes are included in this report and have been audited by PricewaterhouseCoopers LLP, independent accountants, in reliance of the audit reports issued to TVG by Grant Thornton LLP for 1997 and 1998 and by Arthur Andersen LLP for 1996. Our audited consolidated balance sheets at December 31, 1995, 1996 and 1997 and our consolidated statements of operations, stockholder's equity and cash flows for the years ended December 31, 1995 and 1996 are not included in this report but have been audited by PricewaterhouseCoopers LLP in reliance on audit reports issued to TVG by Arthur Andersen LLP. The selected financial data set forth below should be read in conjunction with, and are qualified by reference to, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our audited Financial Statements and related notes appearing elsewhere in this report on Form 10-K.
Statement of Operations Data:
Other Operating Data:
Balance Sheet Data:
- ---------- (1) Prior to the IPO, we were treated as an S Corporation under subchapter S of the Internal Revenue Code and under the corresponding provisions of the tax laws of the State of New Jersey. Historically, as an S Corporation, we made annual bonus payments to our majority stockholder based on our estimated profitability and working capital requirements. We do not expect to pay bonuses to our majority stockholder in future periods.
(2) There were no bonus to majority stockholder and stock grant expense charges in 1998 and 1999 and we do not expect to incur such charges in future periods. Exclusive of these non-recurring charges, our operating income (loss) for the years ended December 31, 1995, 1996 and 1997 would have been ($101), $1,324 and $2,619 respectively. See footnote 1 above.
(3) On January 1, 1997, we issued shares of our common stock to Charles T. Saldarini, our current President and Chief Executive Officer. For financial accounting purposes, a non-recurring, non-cash compensation expense was recorded in the quarter ended March 31, 1997. See note 16 to our audited Financial Statements.
(4) Prior to the IPO, we were an S Corporation and had not been subject to Federal or New Jersey corporate income taxes, other than a New Jersey state corporate income tax of approximately 2%. In addition, TVG, a 1999 acquisition accounted for as a pooling of interest, was also taxed as an S corporation from January 1997 to May 1999. Pro forma provision for (benefit from) income taxes, pro forma net income (loss) and basic and diluted net income (loss) per share for all periods presented reflect a provision for or (benefit from) income taxes as if PDI and TVG had been taxed as a C Corporation for all periods. The pro forma effective tax rate for the period ended December 31, 1998 is 40%. We expect our effective tax rate to approximate 40% in future periods. See note 18 to our audited Financial Statements.
(5) See note 4 to our audited Financial Statements included in this Report on Form 10-K for a description of the computation of pro forma basic and diluted net income (loss) per share and basic and diluted weighted average number of shares outstanding.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Statement Identifying Important Factors That Could Cause the Company's Actual Results to Differ From Those Projected in Forward Looking Statements.
Pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, readers of this report are advised that this document contains both statements of historical facts and forward looking statements. Forward looking statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those indicated by the forward looking statements. Examples of forward looking statements include, but are not limited to (i) projections of revenues, income or loss, earnings per share, capital expenditures, dividends, capital structure and other financial items, (ii) statements of the plans and objectives of the Company or its management or Board of Directors, including product enhancements, or estimates or predictions of actions by customers, suppliers, competitors or regulatory authorities, (iii) statements of future economic performance, and (iv) statements of assumptions underlying other statements and statements about the Company and its business.
This report also identifies important factors which could cause actual results to differ materially from those indicated by the forward looking statements. These risks and uncertainties include the factors discussed under the heading "Certain Factors That May Affect Future Growth" beginning at page 10 of this report.
The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company's Financial Statements and the notes thereto appearing elsewhere in this report.
Overview
We are a leading and rapidly growing contract sales organization, providing product detailing programs and other marketing and promotional services to the United States pharmaceutical industry. Most of our business involves designing and executing customized product detailing programs for both prescription and OTC products. We utilize a variety of contract structures with our clients for these programs. The terms of our product detailing contracts range
from 12 to 36 months. Generally, all of our contracts provide for a fee to be paid to us based on our ability to deliver a specified package of services. We may be entitled to additional fees based upon the achievement of certain performance benchmarks. We may also be subject to penalties for failing to meet the stated minimum benchmarks, such as number of sales representatives or number of sales calls.
Most contracts can be terminated by the client for any reason on 30 to 90 days notice and may also be terminated for cause if we fail to meet the stated performance benchmarks. Many of our contracts provide for the client to pay us a termination fee if a contract is terminated without cause. These penalties may not act as an adequate deterrent to the termination of any contract. Further they may not offset the revenue that we could have earned under the contract had it not been terminated or reimburse us for the costs that we may incur as a result of its termination. The loss or termination of a large contract or of multiple contracts could adversely affect our future revenue and profitability. To date, no programs have been terminated for cause.
Revenue and Program Expenses
Historically, we have derived a significant portion of our revenue from a limited number of major clients. In 1997, 1998 and 1999, our four largest clients accounted for approximately 65%, 80% and 77%, respectively, of our revenue. This client concentration reflects our continued expanding relationships with our largest clients. Concentration of business in the CSO industry is common and we believe that pharmaceutical companies will continue to outsource larger projects as the CSO industry grows and continues to demonstrate an ability to successfully implement large programs. Accordingly, we are likely to continue to experience significant client concentration in future periods.
Revenue is earned primarily by performing product detailing programs and other marketing and promotional services under contracts. Product detailing programs represent the largest and fastest growing portion of our total revenue but have had lower gross profit margins than our other service offerings. Revenue is recognized as the services are performed and the right to receive payment for the services is assured. In the case of contracts relating to product detailing programs, revenue is recognized net of any potential penalties until the performance criteria eliminating the penalties have been achieved. Bonus and other performance incentives as well as termination payments are recognized as revenue in the period earned and when payment of the bonus, incentive or other payment is assured.
Program expenses consist primarily of the costs associated with executing a product detailing program or the other services identified in the contract. Program expenses include personnel costs and other costs, including facility rental fees, honoraria and travel expenses, associated with executing a product detailing or other marketing or promotional program, as well as the initial direct costs associated with staffing a product detailing program. Personnel costs, which constitute the largest portion of program expenses, include all labor related costs, such as salaries, bonuses, fringe benefits and payroll taxes for the sales representatives and sales managers and professional staff who are directly responsible for executing a particular program. Initial direct program costs are those costs associated with initiating a product detailing program, such as recruiting, hiring and training the sales representatives who staff a particular product detailing program. All personnel costs and initial direct program costs, other than training costs, are expensed as incurred. Training costs include the costs of training the sales representatives and managers on a particular product detailing program so that they are qualified to properly perform the services specified in the related contract. Training costs are deferred and amortized on a straight-line basis over the shorter of the life of the contract to which they relate or 12 months.
As a result of the revenue recognition and program expense policies described above, we may incur significant initial direct program costs prior to recognizing revenue under a particular product detailing contract. We typically receive an initial payment upon commencement of a product detailing program and, wherever possible, characterize that payment as compensation for recruiting, hiring and training services associated with staffing that program. This permits us to record the initial payment as revenue in the same period in which the costs of the services are expensed. Our inability to specifically provide in our product detailing contracts that we are being compensated for recruiting, hiring or training services could adversely impact our operating results for periods in which the costs associated with the product detailing services are incurred.
As a result of our interpretation of accounting guidance from the Securities and Exchange Commission, including recently issued Staff Accounting Bulletin No. 101, we determined to make accounting presentation changes to certain of our revenues and program expenses for the year ended December 31, 1999. These reclassifications reflect costs incurred by us for which we received direct reimbursement from our clients and represented
approximately 4.8% of our revenue in this period. Because the amounts excluded from revenue and program expenses were identical, gross profit, operating income, net income and net income per share did not change.
Corporate Overhead and Taxes
General, selling and administrative expenses include compensation expense, bonus to majority stockholder, stock grant expense and general corporate overhead. Compensation expense consists primarily of salaries and related fringe benefits for senior management and other administrative, marketing, finance, information technology and human resources personnel who are not directly involved with executing a particular program. Bonus to majority stockholder for 1996 and 1997 reflects the discretionary cash bonus paid to our majority stockholder and chairman of the board, John P. Dugan. No bonuses have been or will be paid to Mr. Dugan for any period subsequent to 1997. Stock grant expense for 1997 reflects the non-cash, non-recurring charges related to the grant of 1,119,684 shares to our president and chief executive officer, Charles T. Saldarini. Other general, selling and administrative expenses include corporate overhead such as facilities costs, depreciation and amortization expenses and professional services fees.
General, selling and administrative expenses (excluding bonus to majority stockholder and stock grant expense) as a percentage of revenue have generally declined as we have spread our overhead expenses across our growing revenue base. We anticipate that general, selling and administrative expenses will continue to decline as a percentage of revenue as our business grows, although such expenses are expected to increase on an absolute basis.
From January 1, 1995 through May 1998, we were an S corporation for Federal and New Jersey state corporate income tax purposes. In addition, TVG was an S corporation from January 1, 1997 through May 1999. Accordingly, during those respective periods neither PDI nor TVG were subject to Federal corporate income taxes or state corporate income taxes at the regular corporate income tax rates. Our consolidated statement of operations data in the "Summary Financial Data" and "Selected Financial Data" tables reflect a provision for income taxes on a pro forma basis as if we were required to pay Federal and state corporate income taxes during all periods.
Recent Developments
In May 1999 we acquired 100% of the capital stock of TVG in a merger transaction. In connection with this transaction, we issued 1,256,882 shares of common stock in exchange for the outstanding shares of TVG. The acquisition was accounted for as a pooling of interests and, as a result, the financial information for all prior periods presented in this report has been restated to include the accounts and operations of TVG.
In August 1999, through our wholly-owned subsidiary, ProtoCall, we acquired substantially all of the operating assets of ProtoCall, LLC a leading provider of syndicated contract sales services to the United States pharmaceutical industry. The purchase price was $4.5 million, of which $4.1 million was paid at closing and the balance was paid in the fourth quarter of 1999. In addition, up to $3.0 million in contingent payments may be payable in 2000 if ProtoCall achieves defined performance benchmarks. ProtoCall, LLC recorded revenue in excess of $8 million during 1998. The transaction has been accounted for under the purchase method of accounting and we recorded $4.3 million in goodwill, which will be amortized over a period of 10 years. The amount recorded as goodwill will increase if the contingent payments are required.
On January 26, 2000, we completed a public offering of 2,800,000 shares of common stock at a public offering price per share of $28.00, yielding net proceeds per share after deducting underwriting discounts of $26.35 (before deducting expenses of the offering). Of the shares offered, 1,399,312 shares were sold by us and 1,400,688 shares were sold by certain selling shareholders. In addition, in connection with the exercise of the underwriters' over-allotment option, an additional 420,000 shares were sold to the underwriters on February 1, 2000 on the same terms and conditions (210,000 shares were sold by us and 210,000 shares were sold by a selling shareholder). Net proceeds to us after expenses of the offering were approximately $41.0 million.
In February 2000, we signed a three year agreement with iPhysicianNet Inc. ("iPhysicianNet"). In connection with this agreement, we made an investment of $2.5 million in preferred stock of iPhysicianNet. Under this agreement we were appointed as the exclusive CSO in the United States to be affiliated with the iPhysicianNet network, allowing us to offer e-detailing capabilities to iPhysicianNet's and our existing and potential clients.
Results of Operations
The following table sets forth, for the periods indicated, selected statement of operations data as a percentage of revenue. The trends illustrated in this table may not be indicative of future operating results.
Years Ended December 31, 1999 and 1998
Revenue, net. Revenue for 1999 was $174.9 million, an increase of 46.5% over revenue of $119.4 million for 1998. This increase in revenue for 1999 was generated primarily from the continued renewal and expansion of product detailing programs from existing clients and the expansion of our client base, as well as the increase in marketing research services provided by TVG. Net revenue excludes $8.9 million of costs (approximately 4.8% of gross revenue) incurred by us for which we received direct reimbursement from our clients.
Program expenses. Program expenses for 1999 were $130.1 million, an increase of 48.1% over program expenses of $87.8 million for 1998. As a percentage of revenue, program expenses increased to 74.4% for 1999 from 73.6% for 1998. This increase is due to our fastest growing segment, product detailing, having lower gross profit margins, in general, than our other business segments. Program expenses exclude $8.9 million of costs incurred by us for which we received direct reimbursement from our clients.
Compensation expense. Compensation expense for 1999 was $19.6 million compared to $15.8 million for 1998. As a percentage of revenue, compensation expense decreased to 11.2% for 1999 from 13.2% for 1998. This percentage decrease reflects the continued general, selling and administrative expense leverage that we have realized through our expansion. We expect to continue to invest in the staffing and related resources needed to manage future growth.
Other general, selling and administrative expenses. Other general, selling and administrative expenses were $9.4 million for 1999, an increase of 44.3% from other general, selling and administrative expenses of $6.5 million for 1998. As a percentage of revenue, other general, selling and administrative expenses decreased slightly to 5.4% for 1999 from 5.5% for 1998.
Acquisition and related expenses. In 1999, we incurred $1.2 million of non-recurring acquisition and related expenses in connection with the acquisition of TVG which was accounted for as a pooling of interest. No such expenses were incurred in 1998. As a percentage of revenue, acquisition and related expenses were 0.7% in 1999.
Operating income. Operating income for 1999 was $14.5 million, an increase of 56.4% from operating income of $9.3 million for 1998. As a percentage of revenue, operating income increased to 8.3% in 1999 from 7.7% in 1998.
Other income, net. Other income, primarily net interest income, for 1999 was $3.5 million, compared to other income of $2.3 million for 1998. The increase was primarily due to the full year impact of the investment of the net proceeds of the IPO in May 1998, and the increase in net cash provided by operations for 1999.
Pro forma net income. Pro forma net income for 1999 was $10.3 million, an increase of 48.5% from pro forma net income of $6.9 million for 1998. Pro forma net income for both periods assumes that we were taxed for Federal and state income tax purposes as a C corporation during both periods. The pro forma effective tax rate for 1999 was 42.8%, primarily as a result of the impact of $1.2 million of non-deductible acquisition and related expenses, compared to a pro forma effective tax rate for 1998 of 40.0%.
Years Ended December 31, 1998 and 1997
Revenue. Revenue for 1998 was $119.4 million, an increase of 58.7% over revenue of $75.2 million for 1997. Revenue from product detailing programs for 1998 was $101.1 million, or 84.6% of total revenue. Revenue from product detailing programs for 1997 was $54.7 million, or 72.7% of total revenue.
Program expenses. Program expenses for 1998 were $87.8 million, an increase of 57.3% over program expenses of $55.9 million for 1997. As a percentage of revenue, program expenses decreased to 73.6% for 1998 from 74.2% for 1997. Gross profit margins for both our product detailing programs and our marketing and promotion programs increased slightly in 1998 as compared to 1997.
Compensation expense. Compensation expense for 1998 was $15.8 million compared to $12.0 million for 1997. As a percentage of revenue, compensation expense decreased to 13.2% for 1998 from 16.0% for 1997.
Bonus to majority stockholder. In 1997, we paid a bonus of $2.2 million to our majority stockholder. No such bonus was paid in 1998.
Stock grant expense. There were no compensatory stock grants in 1998. In 1997 we incurred a non-recurring, non-cash charge of $4.5 million relating to stock granted to Charles T. Saldarini, our president and chief executive officer.
Other general, selling and administrative expenses. Other general, selling and administrative expenses were $6.5 million for 1998, an increase of 37.8% from other general, selling and administrative expenses of $4.7 million for 1997. As a percentage of revenue, other general, selling and administrative expenses decreased to 5.5% for 1998 from 6.3% for 1997. This reduction is due, in part, to the fact that various services for which we had previously used outside consultants were performed by employees.
Operating income/loss. Operating income for 1998 was $9.3 million, or 7.8% of revenues, compared to an operating loss for 1997 of $4.1 million. Before bonus to majority stockholder and stock grant expense, both of which were non-recurring expenses, operating income for 1997 was $2.6 million. Approximately $1.8 million of 1997's operating loss was attributable to costs associated with product detailing programs begun in 1997 that were expensed as incurred in the fourth quarter of 1997 while the revenue from those programs could not be recognized under our revenue recognition policies until the first quarter of 1998.
Other income, net. Other income, primarily net interest income, for 1998 was $2.3 million, compared to other income of $0.4 million for 1997. The increase was primarily due to investment of the net proceeds of our initial public offering.
Pro forma net income/loss. Pro forma net income for 1998 was $6.9 million compared to a pro forma net loss of $3.7 million for 1997. Pro forma net income/loss for both periods assumes that we were taxed for Federal and state
income tax purposes as a C corporation with no tax benefit assumed for net operating loss carryforwards. The pro forma effective tax rate for 1998 is 40%.
Years Ended December 31, 1997 and 1996
Revenue. Revenue for 1997 was $75.2 million, an increase of 53.3% over 1996 revenue of $49.1 million. Revenue from product detailing programs in 1997 was $54.7 million, or 72.7% of total revenue. Revenue from product detailing programs in 1996 was $33.0 million, or 67.3% of total revenue.
Program expenses. Program expenses for 1997 were $55.9 million, an increase of 56.3% over program expenses of $35.7 million for 1996. As a percentage of revenue, program expenses increased to 74.2% for 1997 from 72.8% for 1996. This increase occurred because approximately $1.8 million of costs associated with product detailing programs begun in the first quarter of 1998 were expensed as incurred in the fourth quarter of 1997.
Compensation expense. Compensation expense for 1997 was $12.0 million compared to $8.5 million for 1996. This increase was due to an increase in the number of management and administrative personnel in 1997 over the 1996 number necessitated by the expansion of our business. As a percentage of revenue, compensation expense was 16.0% for 1997 compared to 17.4% for 1996.
Bonus to majority stockholder. Bonus to majority stockholder for 1997 was $2.2 million compared to $1.5 million for 1996.
Stock grant expense. In the first quarter of 1997, the Company incurred a non-recurring, non-cash charge of $4.5 million related to stock issued to Charles T. Saldarini, our president and chief executive officer.
Other general, selling and administrative expenses. Other general, selling and administrative expenses were $4.7 million for 1997, an increase of 35.3% over other general, selling and administrative expenses of $3.5 million for 1996. As a percentage of revenue, other general, selling and administrative expenses decreased to 6.3% for 1997 from 7.1% for 1996.
Operating loss. Loss from operations for 1997 was $4.1 million compared to $0.2 million for 1996. Before bonus to majority stockholder and stock grant expense, operating income for 1997 was $2.6 million or 3.5% of revenue, compared to $1.3 million, or 2.7% of revenue, for 1996. Operating losses for 1997 were principally attributable to bonus to majority stockholder, stock grant expense and approximately $1.8 million of costs associated with programs begun in 1997 that were expensed as incurred in the fourth quarter of 1997 while the revenue from those programs could not be recognized under our revenue recognition policies until the first quarter of 1998.
Other income, net. Other income, primarily net interest income, for 1997 was $0.4 million compared to other income of $0.3 million for 1996, due to the greater availability of funds for investment.
Pro forma net income/loss. Pro forma net loss for 1997 was $3.7 million compared to pro forma net income of $0.1 million for 1996. Pro forma net income/loss for both periods assumes that we were taxed for Federal and state income tax purposes as a C corporation, with no tax benefits assumed for the net operating losses incurred in 1997 and 1996.
Liquidity and Capital Resources
As of December 31, 1999 we had cash and cash equivalents of approximately $57.8 million and working capital of $53.1 million compared to cash and cash equivalents of approximately $57.0 million and working capital of $47.0 million at December 31, 1998.
In May 1998, we completed our initial public offering. Net proceeds, after expenses, were approximately $46.4 million. Prior to the initial public offering our principal source of funds had been cash flow from operations. Immediately prior to our initial public offering, we declared a final distribution to our then existing stockholders of $5.8 million. The amount of the distribution reflected stockholders' equity at March 31, 1998 of $3.9 million and our earnings from April 1, 1998 to May 18, 1998. In addition, TVG distributed $0.3 million to its stockholders in 1998.
For the year ended December 31, 1999, net cash provided from operating activities was $5.6 million, a decrease of $9.5 million from cash provided from operating activities of $15.1 million for the year ended December 31, 1998.
Net cash provided from operating activities has fluctuated and, we believe, will continue to fluctuate depending on a number of factors, including the number and size of programs and contract terms. These fluctuations may vary in size and direction each reporting period. The main components of cash provided from operating activities for the year ended December 31, 1999 were net income from operations of $10.4 million offset by net decreases of $6.6 million in "Other changes in assets and liabilities." The large increase in contract payments receivable of $19.1 million, and to a lesser extent, unearned contract revenue of $7.4 million, resulted from December billings to several clients for which we were initiating contract sales programs. For the year ended December 31, 1998, we generated approximately $15.0 million of net cash from operating activities compared to $3.6 million for 1997. The increase in cash provided from operating activities mainly results from $9.8 million in net income from operations. The remaining $5.2 million resulted from fluctuations in "Other changes in assets and liabilities," particularly the increase in accrued liabilities of $4.8 million, of which $3.8 million related to performance incentives.
For the year ended December 31, 1999, net cash used in investing activities was $4.7 million, an increase of $1.4 million over net cash used in investing activities of $3.3 million for the same period in 1998. Net cash used in investing activities for the year ended December 31, 1999 consisted of $4.1 million paid in connection with the purchase of the ProtoCall business and $1.4 million in purchases of property and equipment, offset by the sale of $0.8 million in short-term investments. For the years ended December 31, 1998 and 1997, net cash used in investing activities was $3.4 million and $0.8 million, respectively. The primary use of such cash in the 1998 period was investments of $2.2 million in computer and networking equipment and in furniture and fixtures for our corporate headquarters. We also purchased $1.2 million in short-term investments.
For the year ended December 31, 1999, net cash used in financing activities was $0.1 million, reflecting $0.7 million of distributions to the TVG S corporation stockholders, offset by $0.5 million in proceeds from the exercise of common stock options and $0.1 million in tax benefits relating to employee compensation programs. Net cash provided by financing activities for the year ended December 31, 1998 was $37.5 million. Net proceeds from our initial offering of $46.4 million, after expenses, were partially offset by a $5.8 million final distribution to our existing stockholders immediately prior to our initial public offering. For 1997, net cash provided by financing activities was $1.3 million as a result of a $1.3 million loan from the TVG stockholders. This loan was repaid in 1998.
Capital expenditures during the period ended December 31, 1999 were $1.4 million and were funded out of cash generated from operations. Capital expenditures for 1998 were approximately $2.2 million, and were funded entirely through cash generated from operations. During 1997, our capital expenditures were $0.7 million.
When we bill clients for services before they have been completed, billed amounts are recorded as unearned contract revenue, and are recorded as income when earned. When services are performed in advance of billing, the value of such services is recorded as unbilled costs and accrued profits. As of December 31, 1999 and 1998, we had $17.7 million and $9.6 million, respectively, of unearned contract revenue and $2.3 million and $3.6 million, respectively, of unbilled costs and accrued profits. Substantially all deferred and unbilled costs and accrued profits are earned or billed, as the case may be, within 12 months of the end of the respective period.
We believe that our cash flows from operations and existing cash balances will be sufficient to meet our working capital and capital expenditure requirements for the next twelve months.
Quarterly Results
Our results of operations have varied, and are expected to continue to vary, from quarter-to-quarter. These fluctuations result from a number of factors including, among other things, the timing of commencement, completion or cancellation of major programs. Revenue, generally, is recognized as services are performed while program costs, other than training costs, are expensed as incurred. As a result, we may incur substantial expenses associated with staffing a new program during the first two to three months of a contract without recognizing any revenue under that contract. This could have an adverse impact on our operating results for the quarters in which those expenses are incurred. In the future, our revenue may also fluctuate as a result of a number of additional factors, including delays or costs associated with acquisitions, government regulatory initiatives and conditions in the healthcare industry generally. We believe that because of these fluctuations, quarterly comparisons of our financial results cannot be relied upon as an indication of future performance.
The following table sets forth quarterly operating results for the eight quarters ended December 31, 1999.
Effect of New Accounting Pronouncements
The Financial Accounting Standards Board released in June 1998, Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999. This statement addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts and for hedging activities. Since we have not entered into transactions involving derivative instruments, we do not believe that the adoption of this new statement will have a material effect on our financial statements.
Year 2000 Compliance
During 1999, we undertook a project addressing the Y2K issue of computer systems and other equipment with embedded chips or processors not being able to properly recognize and process date-sensitive information after December 31, 1999. Our project was divided into two sections; one section addressed our internal business systems; the other section addressed the business systems of our key business partners. Key business partners are those clients and vendors that have a material impact on our operations.
The portion of the project that dealt with our internal business systems had six major phases:
o inventorying all Y2K items;
o prioritizing all Y2K items;
o assessing all Y2K items;
o repairing or replacing all systems or hardware that are not Y2K compliant;
o testing repaired or replaced Y2K items; and
o designing and implementing contingency plans for those systems that cannot be repaired or replaced by January 1, 2000.
The portion of the project that dealt with the business systems of key business partners had three major phases:
o identifying all key business partners;
o evaluating the status of their Y2K compliance efforts; and
o determining alternatives and contingency plan requirements.
All phases of both sections of our Y2K project were completed by November 30, 1999. Through March 1, 2000, all of our internal operations have functioned normally. There have been no disruptions in business activities and therefore we have not had to implement any contingency plans. Additionally, our key business partners appear to be operating normally. We have not been made aware of any Y2K contingency planning being implemented by our key business partners. However, we are continually monitoring our operations and that of our key business partners to ensure Y2K compliance.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements and required financial statement schedules are included herein beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
Directors and Executive Officers
The following table sets forth the names, ages and positions of our directors, executive officers and key employees:
Name Age Position - ---- --- --------
John P. Dugan.............. 64 Chairman of the board of directors and director of strategic planning Charles T. Saldarini....... 36 President, chief executive officer and director Bernard C. Boyle........... 55 Chief financial officer, executive vice president, secretary and treasurer Steven K. Budd............. 43 Chief operating officer and executive vice president Robert R. Higgins.......... 57 Executive vice president--client programs John M. Pietruski(1)....... 66 Director Jan Martens Vecsi(1)....... 56 Director Gerald J. Mossinghoff(1)... 64 Director
(1) Member of audit and compensation committees
John P. Dugan is our founder, chairman of the board of directors and director of strategic planning. He served as our president from inception until January 1995 and as our chief executive officer from inception until November 1997. In 1972, Mr. Dugan founded Dugan Communications, a medical advertising agency that later became known as Dugan Farley Communications Associates Inc. and served as its president until 1990. We were a wholly-owned subsidiary of Dugan Farley in 1990 when Mr. Dugan became our sole stockholder. Mr. Dugan was a founder and served as the president of the Medical Advertising Agency Association from 1983 to 1984. Mr. Dugan also served on the board of directors of the Pharmaceutical Advertising Council (now known as the Healthcare Marketing Communications Council, Inc.) and was its president from 1985 to 1986. Mr. Dugan received an M.B.A. from Boston University in 1964.
Charles T. Saldarini is our president and chief executive officer and a director. Mr. Saldarini became president in January 1995 and chief executive officer in November 1997. Prior to January 1995 Mr. Saldarini was our chief operating officer. Mr. Saldarini joined us in 1987 as a sales manager. Mr. Saldarini received an A.B. in political science from Syracuse University in 1985.
Bernard C. Boyle has served as our chief financial officer and executive vice president since March 1997. In 1990, Mr. Boyle founded BCB Awareness, Inc., a firm that provided management advisory services, and served as its president until March 1997. During that period he was also a partner in Boyle & Palazzolo, Partners, an accounting firm. From 1982 through 1990 he served as controller and then chief financial officer and treasurer of William Douglas McAdams, Inc., an advertising agency. From 1966 through 1971, Mr. Boyle was employed by the national accounting firm of Coopers & Lybrand L.L.P. as supervisor/senior audit staff. Mr. Boyle received a B.B.A. in Accounting from Manhattan College in 1965 and an M.B.A. in corporate finance from New York University in 1972.
Steven K. Budd joined us in April 1996 as vice president, account group sales. He became executive vice president in July 1997 and chief operating officer in January 1998. From April, 1995 through April 1996, Mr. Budd was an independent consultant. From January 1994 through April 1995, Mr. Budd was employed by Innovex, Inc., a competing CSO, as a director of new business development. From 1989 through December 1993, Mr. Budd was employed by Professional Detailing Network (now known as Nelson Professional Sales, a division of Nelson Communications, Inc.), a competing CSO, as a vice president with responsibility for building sales teams and developing marketing strategies. Mr. Budd received a B.A. in history and education from Susquehanna University in 1978.
Robert R. Higgins became our executive vice president-client programs in October 1998. He joined us as a district sales manager in August 1996. From 1965 to 1995, Mr. Higgins was employed by Burroughs Wellcome Co., where he was responsible for building and managing sales teams and developing and implementing marketing strategies. After he left Burroughs Wellcome and before he joined us, Mr. Higgins was self-employed. Mr. Higgins received a B.S. in biology from Kansas State University in 1964, and an MBA from North Texas State University in 1971.
Gerald J. Mossinghoff became a director in May 1998. Mr. Mossinghoff is a former Assistant Secretary of Commerce and Commissioner of Patents and Trademarks of the Department of Commerce (1981 to 1985) and served as President of Pharmaceutical Research and Manufacturers of America from 1985 to 1996. Since 1997 he has been senior counsel to the law firm of Oblon, Spivak, McClelland, Maier and Newstadt of Arlington, Virginia. Mr. Mossinghoff has been a visiting professor of Intellectual Property Law at the George Washington University Law School since 1997 and Adjunct Professor of Law at George Mason University School of Law since 1997. Mr. Mossinghoff served as United States Ambassador to the Diplomatic Conference on the Revision of the Paris Convention from 1982 to 1985 and as Chairman of the General Assembly of the United Nations World Intellectual Property Organization from 1983 to 1985. He is also a former Deputy General Counsel of the National Aeronautics and Space Administration (1976 to 1981). Mr. Mossinghoff received an electrical engineering degree from St. Louis University in 1957 and a juris doctor degree with honors from the George Washington University Law School in 1961. He is a member of the Order of the Coif and is a Fellow in the National Academy of Public Administration. He is the recipient of many honors, including NASA's Distinguished Service Medal and the Secretary of Commerce Award for Distinguished Public Service.
John M. Pietruski became a director in May 1998. Since 1990 Mr. Pietruski has been the chairman of the board of Texas Biotechnology Corp., a pharmaceutical research and development company. He is a retired chairman of the board and chief executive officer of Sterling Drug Inc. where he was employed from 1977 until his retirement in 1988. Mr. Pietruski is a member of the boards of directors of Hershey Foods Corporation, GPU, Inc., and Lincoln National Corporation. Mr. Pietruski graduated Phi Beta Kappa with a B.S. in business administration with honors from Rutgers University in 1954 and currently serves as a regent of Concordia College.
Jan Martens Vecsi became a director in May 1998. Ms. Vecsi is the sister-in-law of John P. Dugan, our chairman. Ms. Vecsi was employed by Citibank, N.A. from 1967 through 1996 when she retired. Starting in 1984 she served as the senior human resources officer and vice president of the Citibank Private Bank. Ms. Vecsi received a B.A. in psychology and elementary education from Immaculata College in 1965.
Our board of directors is divided into three classes. Each year the stockholders elect the members of one of the three classes to a three-year term of office. Messrs. Saldarini and Pietruski serve in the class whose term expires in 2000; Messrs. Dugan and Mossinghoff serve in the class whose term expires in 2001; and Ms. Vecsi serves in the class whose term expires in 2002.
Our board of directors has an audit committee and a compensation committee. The audit committee reviews the scope and results of the audit and other services provided by our independent accountants and our internal controls.
The compensation committee is responsible for the approval of compensation arrangements for our officers and the review of our compensation plans and policies.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires our officers and directors, and persons who own more than ten percent of a registered class of our equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission ("SEC"). Officers, directors and greater than ten-percent stockholders are required by SEC regulation to furnish us with copies of all Section 16(a) forms they file. Based solely on review of the copies of such forms furnished to us, or written representations that no Forms 5 were required, we believe that all Section 16(a) filing requirements applicable to our officers and directors were complied with.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation. The following table sets forth certain information concerning compensation paid for services in all capacities awarded to, earned by or paid to our chief executive officer and the other four most highly compensated executive officers during 1999 and 1998 whose aggregate compensation exceeded $100,000.
Option Grants. The following table sets forth certain information regarding options granted by us in 1999 to each of the executives named in the Summary Compensation Table.
- ---------- (1) The options vest with respect to one-third of the shares of common stock covered by the options on each of October 28, 2000, 2001 and 2002.
(2) Potential realizable values are net of exercise price but before taxes, and are based on the assumption that our common stock appreciates at the annual rate shown (compounded annually) from the date of grant until the expiration date of the options. These numbers are calculated based on Securities and Exchange Commission requirements and do not reflect our projection or estimate of future stock price growth. Actual gains, if any, on stock option exercises are dependent on our future financial performance, overall market conditions and the option holder's continued employment through the vesting period. This table does not take into account any appreciation in the price of the common stock from the date of grant to the date of this Form 10-K.
Option Exercises and Year-End Option Values. The following table provides information with respect to options exercised by the Named Executive Officers during 1999 and the number and value of unexercised options held by the Named Executive Officers as of December 31, 1999.
Aggregated Option Exercise in Last Fiscal Year and Year-End Option Values
- ---------- (1) For the purposes of this calculation, value is based upon the difference between the weighted average exercise price of the exercisable and unexercisable options and the stock price at December 31, 1999 of $29.9375 per share.
Employment Contracts
In January 1998, we entered into an agreement with John P. Dugan providing for his appointment as chairman of the board and director of strategic planning. The agreement provides for an annual salary of $125,000, no cash bonuses and for participation in all executive benefit plans.
As of April, 1998, we entered into an employment agreement with Charles T. Saldarini providing for his employment, as president and chief executive officer for a term expiring on February 28, 2003 subject to automatic one-year renewals unless either party gives written notice 180 days prior to the end of the then current term of the agreement. The agreement provides for an annual base salary of $275,000 and for participation in all executive benefit plans. The agreement also provides that Mr. Saldarini will be entitled to bonus and incentive compensation awards as determined by the compensation committee. Further, the agreement provides, among other things, that, if his employment is terminated without cause (as defined) or if Mr. Saldarini terminates his employment for good reason (as defined), we will pay him an amount equal to the salary which would have been payable over the unexpired term of his employment agreement.
In March, 1998, we also entered into employment agreements with each of Messrs. Boyle and Budd, providing for Mr. Boyle's employment as chief financial officer and Mr. Budd's employment as chief operating officer. Mr. Boyle's agreement terminates on December 31, 2000 and Mr. Budd's agreement terminates on March 31, 2001. Each agreement is subject to automatic one-year renewals unless either party gives written notice 180 days prior to the end of the then current term of the agreement. The agreements provide for an annual base salary of $165,000 for Mr. Boyle and $178,605 for Mr. Budd and for their participation in all executive benefit plans. The agreements also provide that Messrs. Boyle and Budd are entitled to bonus and incentive compensation awards as determined by the compensation committee. Each agreement also provides, among other things, that, if we terminate the employee's employment without cause (as defined) or the employee terminates his employment for good reason (as defined), we will pay the employee an amount equal to the salary which would have been payable over the unexpired term of the employment agreement.
Compensation Committee Interlocks and Insider Participation in Compensation Decisions
None of the directors serving on the compensation committee of the board of directors is employed by us. In addition, none of our directors or executive officers is a director or executive officer of any other corporation that has a director or executive officer who is also a member of our board of directors.
1998 Stock Option Plan
In order to attract and retain persons necessary for our success, in March 1998, our board of directors adopted our 1998 stock option plan reserving for issuance up to 750,000 shares. Officers, directors, key employees and consultants are eligible to receive incentive and/or non-qualified stock options under this plan. The plan, which has a term of ten years from the date of its adoption, is administered by the compensation committee. The selection of participants, allotment of shares, determination of price and other conditions relating to the purchase of options is determined by the compensation committee in its sole discretion. Incentive stock options granted under the plan are exercisable for a period of up to 10 years from the date of grant at an exercise price which is not less than the fair market value of the common stock on the date of the grant, except that the term of an incentive stock option granted under the plan to a stockholder owning more than 10% of the outstanding common stock may not exceed five years and its exercise price may not be less than 110% of the fair market value of the common stock on the date of the grant.
At December 31, 1999, options for an aggregate of 632,834 shares were outstanding under the plan, including 64,189 granted to Steven Budd, our chief operating officer, 42,992 granted to Bernard Boyle, our chief financial officer, 22,500 granted to Robert Higgins, our executive vice president of client programs, and 11,250 granted to each of Gerald J. Mossinghoff, John M. Pietruski and Jan Martens Vecsi, our outside directors. In addition, as of December 31, 1999, options to purchase 33,653 shares of common stock had been exercised.
Compensation of Directors
Each non-employee director receives an annual director's fee of $8,000, payable quarterly in arrears, plus $1,000 for each meeting attended in person and $150 for each meeting attended telephonically and reimbursement for travel costs and other out-of-pocket expenses incurred in attending each directors' meeting. In addition, committee members receive $200 for each committee meeting attended in person and $100 for each committee meeting attended telephonically. Under our stock option plan, each non-employee director is granted options to purchase 7,500 shares upon first being elected to our board of directors and options to purchase an additional 3,750 shares on the date of our annual meeting. All options have an exercise price equal to the fair market value of the common stock on the date of grant and vest one-third on the date of grant and one-third at the end of each subsequent year of service on the board.
401(k) Plan
We maintain two 401(k) retirement plans intended to qualify under sections 401(a) and 401(k) of the Internal Revenue Code. These 401(k) plans are defined contribution plans. Under one plan, we committed to make mandatory contributions to the 401(k) plan to match employee contributions up to a maximum of 2% of each participating employee's annual wages. Under the other 401(k) plan, we committed to match 100% of the first $1,250 contributed
by each employee, 75% of the next $1,250, 50% of the next $1,250 and 25% of the next $1,250 contributed. In addition we can make discretionary contributions to this plan. Our contribution to the 401(k) plan for 1999 was approximately $879,000.
Limitation of Directors' Liability and Indemnification
The Delaware General Corporation Law authorizes corporations to limit or eliminate the personal liability of directors of corporations and their stockholders for monetary damages for breach of directors' fiduciary duty of care. Our certificate of incorporation limits the liability of our directors to the fullest extent permitted by Delaware law.
Our certificate of incorporation provides mandatory indemnification rights to any officer or director who, by reason of the fact that he or she is an officer or director, is involved in a legal proceeding of any nature. These indemnification rights include reimbursement for expenses incurred by an officer or director in advance of the final disposition of a legal proceeding in accordance with the applicable provisions of the DGCL. We have been informed that, in the opinion of the Securities and Exchange Commission, indemnification for liabilities under the Securities Act is against public policy as expressed in the Securities Act and is, therefore, unenforceable.
There is no pending litigation or proceeding involving any of our directors, officers, employees or agents in which indemnification by us is required or permitted. We are not aware of any threatened litigation or proceeding that may result in a claim for indemnification.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information regarding the beneficial ownership of our common stock as of March 7, 2000 by:
o each person known to us to be the beneficial owner of more than 5% of our outstanding shares; o each of our directors; o each executive officer named in the Summary Compensation Table above; o all of our directors and executive officers as a group.
Except as otherwise indicated, the persons listed below have sole voting and investment power with respect to all shares of common stock owned by them. All information with respect to beneficial ownership has been furnished to us by the respective stockholder. The address for each of Messrs. Dugan and Saldarini is c/o Professional Detailing, Inc., 10 Mountainview Road, Upper Saddle River, New Jersey 07458.
---------- * Less than 1%.
(1) Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of common stock subject to options and warrants held by that person that are currently exercisable or exercisable within 60 days of March 7, 2000 are deemed outstanding. Such shares, however, are not deemed outstanding for the purpose of computing the percentage ownership of any other person.
(2) Includes 39,189 shares issuable pursuant to options exercisable within 60 days of the date of this report.
(3) Includes 22,992 shares issuable pursuant to options exercisable within 60 days of the date of this report.
(4) Includes 2,500 shares issuable pursuant to options exercisable within 60 days of the date of this report.
(5) Includes 6,250 shares issuable pursuant to options exercisable within 60 days of the date of this report.
(6) Represents shares issuable pursuant to options exercisable within 60 days of the date of this report.
(7) Includes 83,431 shares issuable pursuant to options exercisable within 60 days of the date of this report.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In connection with our efforts to recruit sales representatives, we place advertisements in various print publications. These ads are placed on our behalf through Boomer & Son, Inc., which receives commissions from the publications. Prior to 1998, B&S was wholly-owned by John P. Dugan, our chairman of the board. At the end of 1997 Mr. Dugan transferred his interest in B&S to his son, Thomas Dugan, and daughter-in-law, Kathleen Dugan.
John P. Dugan is not actively involved in B&S; however, his son, Thomas Dugan, is active in B&S. For the year ended December 31, 1999 we purchased $2.0 million of advertising through B&S and B&S received commissions of approximately $316,000. All ads were placed at the stated rates set by the publications in which they appeared. In addition, we believe that the amounts paid to B&S were no less favorable than would be available in an arms-length negotiated transaction with an unaffiliated entity.
Peter Dugan, the son of John P. Dugan, our chairman of the board, is employed by us as executive director of marketing. In 1999, compensation paid or accrued to Peter Dugan was $129,742.
In May 1998, immediately prior to our initial public offering, we made a final cash distribution of $5.8 million to our then existing stockholders. This distribution reflected stockholders' equity as of March 31, 1998 plus our earnings from April 1, 1998 to May 18, 1998. No similar distributions have been made since and it is not anticipated that any will be made in the future.
In April 1998, we loaned $1.4 million to our president and chief executive officer, Charles T. Saldarini. The proceeds of this loan were used by Mr. Saldarini to pay income taxes relating to his receipt of shares of common stock in January 1997. This loan is for a term of three years, bears interest at a rate equal to 5.4% per annum payable quarterly in arrears and is secured by a pledge of the shares held by Mr. Saldarini. In February 2000, Mr. Saldarini repaid this loan in full.
In November 1998, we agreed to loan $250,000 to Steven Budd, our executive vice president and chief operating officer, in connection with his relocation and purchase of a primary residence. This loan is for a term of ten years, subject to acceleration upon termination of employment, bears interest at the rate of 5.5% per annum payable quarterly in arrears and is secured by a pledge of Mr. Budd's rights under his stock option agreement and any shares issuable thereunder. We funded $100,000 of this loan in November 1998 and the remainder in February 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Exhibits: --------
Exhibit No. Description --- -----------
3.1. Certificate of Incorporation of Professional Detailing, Inc.(1) 3.2. By-Laws of Professional Detailing, Inc.(1) 4.1. Specimen Certificate Representing the Common Stock(1) 10.1. Form of 1998 Stock Option Plan(1) 10.2. Office Lease between IB Brell, L.P. (Landlord) and Professional Detailing, Inc. (Tenant) and amendment thereto(1) 10.3. Form of Employment Agreement between the Company and Charles T. Saldarini(1) 10.4. Agreement between the Company and John P. Dugan(1) 10.5. Form of Employment Agreement between the Company and Steven K. Budd(1) 10.6. Form of Employment Agreement between the Company and Bernard C. Boyle(1) 10.7. Form of Loan Agreements between the Company and Charles Saldarini (2) 10.8. Form of Loan Agreements between the Company and Steven Budd (2) 21.1. Subsidiaries of the Registrant 23.1. Consent of PricewaterhouseCoopers LLP 27. Financial Data Schedule
---------- (1) Filed as an exhibit to our Registration Statement on Form S-1 (File No 333-46321), and incorporated herein by reference.
(2) Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1999, and incorporated herein by reference.
Reports on Form 8-K:
We did not file any reports on Form 8-K during the Quarter ended December 31, 1999.
Financial Statement Schedules:
None
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, as amended, the Registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized in the City of Upper Saddle River, State of New Jersey, on the 13th day of March, 2000.
PROFESSIONAL DETAILING, INC.
/s/ Charles T. Saldarini ----------------------------- Charles T. Saldarini, President and Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1934, as amended, this Form 10-K has been signed by the following persons in the capacities indicated and on the 13th day of March, 2000.
Signature Title --------- -----
/s/ John P. Dugan Chairman of the Board of Directors - -------------------------------- John P. Dugan
/s/ Charles T. Saldarini President, Chief Executive Officer and - -------------------------------- Director Charles T. Saldarini
/s/ Bernard C. Boyle Chief Financial Officer (principal - -------------------------------- accounting and financial officer) Bernard C. Boyle
/s/ Gerald J. Mossinghoff Director - -------------------------------- Gerald J. Mossinghoff
/s/ John M. Pietruski Director - -------------------------------- John M. Pietruski
/s/ Jan Martens Vecsi Director - -------------------------------- Jan Martens Vecsi
Page ---- PROFESSIONAL DETAILING, INC.
Reports of Independent Accountants
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Cash Flows
Consolidated Statements of Stockholders' Equity
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Professional Detailing, Inc.
In our opinion, based upon our audits and the reports of other auditors, the accompanying consolidated balance sheets and the related consolidated statements of operations and stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Professional Detailing, Inc. and its subsidiaries at December 31, 1999 and 1998 and the results of their operations and their cash flows for the three years ended December 31, 1999, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of TVG, Inc. a wholly-owned subsidiary, which statements reflect total assets of $7,450,369 at December 31, 1998 and total revenues of $18,340,216 and $20,569,036 for the years ended December 31, 1998 and 1997, respectively. Those statements were audited by other auditors whose reports thereon have been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for TVG, Inc. is based solely on the reports of the other auditors. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for the opinion expressed above.
/s/: PricewaterhouseCoopers
January 26, 2000
Report of Independent Certified Public Accountants
Shareholders and Board of Directors TVG, Inc.
We have audited the accompanying balance sheets of TVG, Inc. (a Delaware corporation), as of December 31, 1998 and 1997, and the related statements of income and comprehensive income, changes in shareholders' equity, and cash flows for the years then ended. These financial statements (not presented separately herein) are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above (not presented separately herein) present fairly, in all material respects, the financial position of TVG, Inc. as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles.
Grant Thornton LLP Philadelphia, Pennsylvania February 3, 1999
PROFESSIONAL DETAILING, INC. CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements
PROFESSIONAL DETAILING, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements
PROFESSIONAL DETAILING, INC. STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements
PROFESSIONAL DETAILING, INC. STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Business and Significant Accounting Policies
Nature of Business
Professional Detailing, Inc. ("PDI" and, together with its wholly owned subsidiaries, the "Company") is a leading and rapidly growing contract sales organization, providing customized product detailing programs and other marketing and promotion services to the United States pharmaceutical industry.
Principles of Consolidation
The consolidated financial statements include accounts of PDI and its wholly owned subsidiaries, TVG, Inc. ("TVG") and ProtoCall, Inc. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates. Significant estimates include accrued incentives payable to employees.
Revenue Recognition
The Company uses a variety of contract structures with its clients. Product detailing contracts generally are for a term of one year, although some contracts have a two-year term. Generally, contracts provide for a fee to be paid to the Company based on its ability to deliver a specified package of services. In the case of product detailing programs, PDI may also be entitled to additional fees based upon the success of the program and/or subject to penalties for failing to meet stated performance benchmarks. Performance benchmarks usually are a minimum number of sales representatives or minimum number of calls. PDI's contracts also usually provide that it is entitled to a fee for each sales representative hired by the client during or at the conclusion of a program.
Most contracts may be terminated by the client for any reason on 30 to 90 days notice. Many of PDI's contracts provide for the client to pay PDI a termination fee if a contract is terminated without cause. These penalties may not act as an adequate deterrent to the termination of any contract and may not offset the revenue which PDI could have earned under the contract had it not been terminated and it may not be sufficient to reimburse PDI for the costs which it may incur as a result of its termination. Contracts may also be terminated for cause if PDI fails to meet stated performance benchmarks. The loss or termination of a large contract or of multiple contracts could adversely affect PDI's future revenue and profitability. To date, no programs have been terminated for cause.
Revenue is earned primarily by performing services under contracts and is recognized as the services are performed and the right to receive payment for such services is assured. In the case of contracts relating to product detailing programs, revenue is recognized net of any potential penalties until the performance criteria eliminating the penalties have been achieved. Bonus and other performance incentives as well as termination payments are recognized as revenue in the period earned and when payment of the bonus, incentive or other payment is assured.
Program expenses consist primarily of the costs associated with the execution of product detailing programs or other marketing and promotional services identified in the contract. Program expenses include all personnel costs and other costs, including facility rental fees, honoraria and travel expenses, associated with executing a product detailing or other marketing or promotional program, as well as the initial direct costs associated with staffing a product detailing program. Personnel costs, which constitute the largest portion of program expenses, include all labor related costs, such as salaries, bonuses, fringe benefits and payroll taxes for the sales representatives, managers and professional staff who are directly responsible for the rendering of services in connection with a particular program. Initial direct program costs are the costs associated with initiating a product detailing program, such as recruiting, hiring and training the sales representatives who staff a particular product detailing program. All
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
1. Nature of Business and Significant Accounting Policies - (Continued)
personnel costs and initial direct program costs, other than training costs, are expensed as incurred. Training costs include the costs of training the sales representatives and managers on a particular product detailing program so that they are qualified to properly render the services specified in the related contract. Training costs are deferred and amortized on a straight-line basis over the shorter of (i) the life of the contract to which they relate or (ii) 12 months. Expenses that are directly reimbursable are netted for income statement purposes.
Fair Value of Financial Instruments
The book values of cash and cash equivalents, contract payments receivable, accounts payable and other financial instruments approximate their fair values principally because of the short-term maturities of these instruments.
Unbilled Costs and Accrued Profits and Unearned Contract Revenue
In general, contractual provisions, including predetermined payment schedules or submission of appropriate billing detail, establish the prerequisites for billings. Unbilled costs and accrued profits arise when services have been rendered and payment is assured but clients have not been billed. These amounts are classified as a current asset. Normally, in the case of product detailing contracts, the clients agree to pay PDI a portion of the fee due under a contract in advance of performance of services because of large recruiting and employee development costs associated with the beginning of a contract. The excess of amounts billed over revenue recognized represents unearned contract revenue, which is classified as a current liability.
Cash and Cash Equivalents
Cash and cash equivalents consist of unrestricted cash accounts, highly liquid investment instruments and certificates of deposit with a maturity of three months or less at the date of purchase.
Available-for-Sale Securities
Available-for-sale securities are valued at fair market value and are classified as short-term. For the purposes of determining gross realized gains and losses the cost of securities sold is based upon specific identification. Any unrealized holding gains or losses are recorded as a separate component of stockholders' equity as accumulated other comprehensive income.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. The estimated useful lives of asset classifications are five to ten years for furniture and fixtures and three to seven years for office equipment and computer equipment. Depreciation is computed using the straight-line method, and the cost of leasehold improvements is amortized over the shorter of the estimated service lives or the terms of the related leases. Repairs and maintenance are charged to expense as incurred. Upon disposition, the asset and related accumulated depreciation are removed from the related accounts and any gains or losses are reflected in operations.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
1. Nature of Business and Significant Accounting Policies - (Continued)
Stock-Based Compensation
Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" allows companies a choice of measuring employee stock-based compensation expense based on either the fair value method of accounting or the intrinsic value approach under APB Opinion No. 25. The Company has elected to measure compensation expense based upon the intrinsic value approach under APB Opinion No. 25.
Advertising
The Company recognizes advertising costs as incurred. The total amounts charged to advertising expense were $266,548, $239,996 and $317,514 for the years ended December 31, 1999, 1998 and 1997, respectively.
2. Initial Public Offering of Common Stock
In May 1998, the Company completed its initial public offering (the "IPO") of 3,220,000 shares of common stock (including 420,000 shares in connection with the exercise of the underwriters' over-allotment option) at a price per share of $16.00. Net proceeds to the Company after expenses of the IPO were approximately $46.4 million. The Company made a distribution of $5.8 million to the S corporation stockholders, representing stockholders' equity of the Company as of March 31, 1998, plus the earnings of the Company from April 1, 1998 to May 18, 1998.
In connection with the IPO, the Company has reincorporated in Delaware. To effect such reincorporation, on May 15, 1998, Professional Detailing, Inc., a New Jersey corporation (the "New Jersey Entity") merged with and into Professional Detailing, Inc., a Delaware corporation (the "Delaware Entity"). As a result of the merger, the former stockholders of the New Jersey Entity owned 7,464,562 shares of the Delaware Entity's common stock which shares constituted all of the issued and outstanding shares of common stock of the Delaware Entity prior to the IPO. In addition, outstanding options to purchase common stock of the New Jersey Entity converted into 67,181 options to purchase shares of common stock of the Delaware Entity at $1.61 per share. The conversion of shares and options related to the merger has been retroactively reflected in the Company's consolidated financial statements.
3. Acquisitions
On May 12, 1999, PDI and TVG signed a definitive agreement pursuant to which PDI acquired 100% of the capital stock of TVG in a merger transaction. In connection with the transaction, PDI issued 1,256,882 shares of common stock in exchange for the outstanding shares of TVG. The acquisition has been accounted for as a pooling of interest and, accordingly, all periods presented in the accompanying consolidated financial statements have been restated to include the accounts and operations of TVG.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
3. Acquisitions - (Continued)
The results of operations previously reported by separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized below.
Three Months Years Ended December 31, Ended ------------------------------- March 31, 1999 1998 1997 ------------ ------------ ------------ Revenue: PDI ................. $ 36,013,617 $101,081,137 $ 54,673,986 TVG ................. 5,730,771 18,340,216 20,569,036 ------------ ------------ ------------ Combined ............ $ 41,744,388 $119,421,353 $ 75,243,022 ============ ============ ============
Net income (loss): PDI ................. $ 2,696,097 $ 9,491,928 $ (4,151,883) TVG ................. 625,482 346,298 308,163 ------------ ------------ ------------ Combined ............ $ 3,321,579 $ 9,838,226 $ (3,843,720) ============ ============ ============
In August 1999, the Company, through its wholly-owned subsidiary, ProtoCall, Inc. ("ProtoCall"), acquired substantially all of the operating assets of ProtoCall, LLC, a leading provider of syndicated contract sales services to the United States pharmaceutical industry. The purchase price was $4.5 million (of which $4.1 million was paid at closing) plus up to an additional $3.0 million in contingent payments payable during 2000 if ProtoCall achieves defined performance benchmarks. This acquisition was accounted for as a purchase. In connection with this transaction, the Company recorded $4.3 million in goodwill (included in other long-term assets) which is being amortized over a period of 10 years.
4. Historical and Pro Forma Basic and Diluted Net Income/Loss Per Share
Historical and pro forma basic and diluted net income/loss per share is calculated based on the requirements of SFAS No. 128, "Earnings Per Share."
A reconciliation of the number of shares used in the calculation of basic and diluted earnings per share for the year ended December 31, 1999 and 1998 is as follows:
At December 31, 1999, outstanding options to purchase 34,562 shares of common stock with an exercise price of $29.88 per share have not been included in the 1999 computation of historical and pro forma diluted net income per share because to do so would have been antidilutive.
At December 31, 1997, outstanding options to purchase 67,181 shares of common stock with an exercise price of $1.61 per share have not been included in the 1997 computation of historical and pro forma diluted net loss per share because to do so would have been antidilutive.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
5. Short-Term Investments
Short-term investments of $1,677,317 at December 31, 1999 consisted of investments classified as available for sale securities. At December 31, 1998, short-term investments of $2,422,111 included $1,422,111 of investments classified as available for sale securities. The unrealized after-tax gain/(loss) on the available for sale securities is included as a separate component of stockholders' equity as accumulated other comprehensive income.
6. Property, Plant and Equipment
Property, plant and equipment consists of the following:
December 31, -------------------------- 1999 1998 ---------- ---------- Furniture and fixtures $1,338,773 $1,191,264 Office equipment 1,962,306 2,007,070 Computer equipment 3,945,104 2,536,623 Leasehold improvements 891,915 519,887 ---------- ---------- Total property, plant and equipment 8,138,098 6,254,844
Less accumulated depreciation and amortization 4,430,741 3,184,447 ---------- ----------
Property, plant and equipment, net $3,707,357 $3,070,397 ========== ==========
7. Operating Leases
The Company leases facilities, automobiles and certain equipment under agreements classified as operating leases which expire at various dates through 2004. Lease expense under these agreements for the twelve months ended December 31, 1999 was $6,465,328, of which $5,118,659 related to automobiles leased for employees for a term of one year from the date of delivery. In the fourth quarter of 1998, the Company instituted a leasing program providing most field representatives with an automobile.
Lease expense under facilities and equipment agreements for the twelve months ended 1998 and 1997 were $1,260,509 and $780,410, respectively. The Company entered into a new facilities lease in May 1998 for a term that expires in the fourth quarter of 2004, with an option to extend for an additional five years, for the premises which house its corporate headquarters. TVG's office lease is for seven years and commenced in August 1993. The Company records lease expense on a straight line basis over the lease term.
As of December 31, 1999, the aggregate minimum future rental payments required by operating leases with initial or remaining lease terms exceeding one year are as follows:
2000............................................................ $1,499,333 2001............................................................ 972,949 2002............................................................ 909,263 2003............................................................ 797,632 2004............................................................ 726,724 ----------
Total........................................................... $4,905,901 ==========
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
8. Significant Customers
During 1999, 1998 and 1997, the Company had several significant customers for which it provided services under specific contractual arrangements. The following sets forth the revenue generated by customers who accounted for more than 10% of the Company's revenue during each of the periods presented.
Years Ended December 31, ------------------------------------------ Customers 1999 1998 1997 --------- ----------- ----------- -----------
A........................ $52,359,391 $25,272,009 $12,138,999 B........................ 38,100,930 31,576,256 14,831,507 C........................ 33,780,905 32,007,807 14,998,321
At December 31, 1999 and 1998, these customers represented 63.4% and 70.8%, respectively, of the aggregate of outstanding receivables and unbilled services. The loss of any one of the foregoing customers could have a material adverse effect on the Company's financial position, results of operations or cash flows.
9. Borrowings
As of December 31, 1998, the Company had a $500,000 line of credit from a bank under which interest was payable monthly on the outstanding balance at a floating rate equal to 1% above the prime rate. The line of credit was collateralized by a lien on all of the assets of the Company. In addition, if the Company were to draw on such line, it would have been subject to certain restrictive financial covenants and other customary provisions found in commercial loan documentation. The commitment fee associated with the line was immaterial. This line of credit terminated in February 1999.
The Company also had a $1,000,000 revolving credit facility that expired on May 31, 1999. The facility provided for available stand by letters of credit up to $1,000,000. Interest was at a rate approximating the prime rate and the facility required a commitment fee of 1/4% or required the Company to maintain a compensating balance of $75,000. The agreement also required the Company to maintain certain financial covenants customarily found in commercial loan documentation.
10. Related Party Transactions
The Company purchased certain print advertising for initial recruitment of representatives through a company that is wholly-owned by family members of the Company's majority stockholder. The net amounts charged to the Company for these purchases amounted to $2,023,700, $1,753,018 and $1,564,606 for the years ended December 31, 1999, 1998 and 1997. As of December 31, 1998, the Company had amounts payable to the affiliate of $56,236. Additionally, the Company also provided administrative services to this affiliate during the first six months of 1998.
11. Income Taxes
PDI was treated as an S corporation for Federal and state income tax purposes until its initial public offering in May 1998. TVG was treated as an S corporation in 1997, 1998 and through the time of merger with PDI in May 1999. Consequently, during the periods in which TVG and PDI were treated as S corporations, they were not subject to Federal income taxes. In addition, they were not subject to state income tax at the regular corporate rates.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
11. Income Taxes - (Continued)
The provisions for income taxes for the years ended December 31, 1999, 1998 and 1997 are summarized as follows:
1999 1998 1997 ----------- ----------- ----------- Current: Federal ...................... $ 6,027,282 $ 1,630,919 $ -- State ........................ 870,343 396,662 -- ----------- ----------- ----------- Total current .................. 6,897,625 2,027,581 -- Deferred ....................... 641,910 (336,400) 125,973 ----------- ----------- ----------- Provision for income taxes ..... $ 7,539,535 $ 1,691,181 $ 125,973 =========== =========== ===========
Effective January 1, 1997, TVG changed its tax status from a C corporation to an S corporation. Accordingly, a deferred tax asset as of December 31, 1996 of $125,973 was eliminated in 1997 through the deferred tax provision.
A reconciliation of the difference between the Federal statutory tax rates and the Company's effective tax rate is as follows:
12. Preferred Stock
The Company's board of directors is authorized to issue, from time to time, up to 5,000,000 shares of preferred stock in one or more series. The board is authorized to fix the rights and designation of each series, including dividend rights and rates, conversion rights, voting rights, redemption terms and prices, liquidation preferences and the number of shares of each series. As of each of December 31, 1999 and 1998, there were no issued and outstanding shares of preferred stock.
13. Loans to Stockholders/Officers
The Company loaned $1.4 million to its President and Chief Executive Officer, Charles T. Saldarini in April 1998. The proceeds of this loan were used by Mr. Saldarini to pay income taxes relating to his receipt of shares of common stock. Such loan is for a term of three years, bears interest at a rate equal to 5.4% per annum payable quarterly in arrears and is secured by a pledge of the shares of common stock held by Mr. Saldarini. This loan was repaid by Mr. Saldarini in February 2000.
In November 1998, the Company agreed to lend $250,000 to an executive officer of which $100,000 was funded in November 1998, and the remaining $150,000 was funded in February 1999. This amount was recorded in other long-term assets. Such loan is payable on December 31, 2008, bears interest at a rate of 5.5% per annum, payable quarterly in arrears.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
14. Retirement Plans
In 1999, 1998 and 1997, the Company provided its employees with two qualified profit sharing plans with 401(k) features. Under one plan, the Company expensed contributions of $533,098, $310,248 and $172,310 for the years ended December 31, 1999, 1998 and 1997, respectively. Effective January 1, 1997, the Company committed to make mandatory contributions to this 401(k) plan. This commitment requires contributions from the Company each year equal to 100% of the amount contributed by each employee up to 2% of the employee's wages. Any additional contribution to this plan is at the discretion of the Company.
Under the other 401(k) plan, the Company expensed contributions of $345,669, $346,419 and $410,351 for the years ended December 31, 1999, 1998 and 1997, respectively. Effective January 1, 1998, the Company matched 100% of the first $1,250 contributed by each employee, 75% of the next $1,250, 50% of the next $1,250 and 25% of the next $1,250 contributed. In addition the Company can make discretionary contributions.
In 1995, TVG established a deferred compensation plan (the "Plan") covering full-time employees who meet certain eligibility criteria as defined in the Plan. Participants become eligible to receive distributions from the Plan equal to 25% of their net balance after receiving three annual contribution pledges. Upon retirement from the Company or death, the participant or their beneficiaries receive the remaining balance in four equal annual installments. All forfeitures and interest are credited to the Company. Compensation expense recognized in 1999, 1998 and 1997 related to the Plan was $79,113, $260,009 and $195,996, respectively. This plan was terminated upon the acquisition of TVG on May 12, 1999.
15. Commitments and Contingencies
PDI is engaged in the business of detailing pharmaceutical products. Such activities could expose the Company to risk of liability for personal injury or death to persons using such products, although the Company does not commercially market or sell the products to end users. While the Company has not been subject to any claims or incurred any liabilities due to such claims, there can be no assurance that substantial claims or liabilities will not arise in the future. The Company seeks to reduce its potential liability through measures such as contractual indemnification provisions with clients (the scope of which may vary from client to client, and the performances of which are not secured) and insurance. The Company could, however, also be held liable for errors and omissions of its employees in connection with the services it performs that are outside the scope of any indemnity or insurance policy. The Company could be materially adversely affected if it were required to pay damages or incur defense costs in connection with a claim that is outside the scope of the indemnification agreements; if the indemnity, although applicable, is not performed in accordance with its terms; or if the Company's liability exceeds the amount of applicable insurance or indemnity.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
15. Commitments and Contingencies - (Continued)
From time to time the Company is involved in litigation incidental to its business. The Company is not currently a party to any pending litigation which, if decided adversely to the Company, would have a material adverse effect on the business, financial condition, results of operations or cash flows of the Company.
16. Stock Grant
In January 1997, the Company issued 1,119,684 shares of its common stock to its President and Chief Executive Officer. As a result, Mr. Saldarini owned 15.0% of the Company's outstanding shares of common stock at that time. The Company has treated these shares as outstanding for all periods.
This grant of stock was in consideration of services performed on behalf of the Company. The value of the shares, as determined by Hempstead & Co. Incorporated, independent valuation experts, was $4,050,000. Such valuation was prepared utilizing standard valuation techniques used to value businesses including discounted cash flow and comparable transactions. The Company recognized $4,470,000 in compensation and related expenses in the first quarter of 1997. Such expenses include a reserve for taxes related to such grant.
17. Stock Option Plan
In March 1998, the Board of Directors of the Company adopted its 1998 Stock Option Plan (the "1998 Plan") which reserves for issuance up to 750,000 shares of its common stock, pursuant to which officers, directors and key employees of the Company and consultants to the Company are eligible to receive incentive and/or non-qualified stock options. The 1998 Plan, which has a term of ten years from the date of its adoption, is administered by a committee designated by the Board of Directors. The selection of participants, allotment of shares, determination of price and other conditions relating to the purchase of options is determined by the committee, in its sole discretion. Incentive stock options granted under the 1998 Plan are exercisable for a period of up to 10 years from the date of grant at an exercise price which is not less than the fair market value of the common stock on the date of the grant, except that the term of an incentive stock option granted under the 1998 Plan to a shareholder owning more than 10% of the outstanding common stock may not exceed five years and its exercise price may not be less than 110% of the fair market value of the common stock on the date of the grant. Options are exercisable either at the date of grant or in ratable installments over a period from one to three years. In January 1997, the Company adopted its 1997 Stock Option Plan (the "1997 Plan"). In March 1998, the 1997 Plan was incorporated into the 1998 Plan.
The activity for the 1998 Plan during the years ended December 31, 1997, 1998 and 1999 is set forth in the table below:
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
17. Stock Option Plan - (Continued)
During 1997, there were two grants of stock options to officers of the Company, one in January for 39,189 shares at an exercise price of $1.61 and one in March for 27,992 shares at an exercise price of $1.61. In connection with the grant of such options, the Company will amortize $143,852 of compensation expense over the expected vesting period. The options vest as follows: one-third became exercisable on the date of the IPO (the "Initial Exercise Date"), another third shall become exercisable on the first anniversary of the Initial Exercise Date and the final third become exercisable on the second anniversary of the Initial Exercise Date. Compensation expense of $45,264, $45,265 and $42,030 was recognized for the years ended December 31, 1999, 1998 and 1997, respectively. All other grants of stock options were at a price not less than the fair market value on the date of grant, and, therefore the Company will not recognize any compensation expense related to those options.
The following table summarizes information about stock options outstanding at December 31, 1999:
Options Outstanding Options Exercisable ------------------------------------------ ---------------------- Exercise Number Remaining Number price of options contractual of options Exercise per share outstanding life (years) exercisable price --------- ----------- ------------ ----------- -------- $ 1.61 62,181 6.0 39,787 $ 1.61 16.00 320,741 8.4 97,212 16.00 27.00 11,250 9.4 3,750 27.00 27.19 204,100 9.8 -- 27.19 29.88 34,562 9.6 -- 29.88 ------------------------------------------ ---------------------- $1.61-29.88 632,834 8.7 140,749 $12.23 ========================================== ======================
Had compensation cost for the Company's stock option grants been determined for awards consistent with the fair value approach of SFAS No. 123, "Accounting for Stock Based Compensation," which requires recognition of compensation cost ratably over the vesting period of the underlying instruments, the Company's pro forma net income (loss) and pro forma basic and diluted net income (loss) per share would have been adjusted to the amounts indicated below:
Compensation cost for the determination of Pro forma net income (loss) - as adjusted and related per share amounts were estimated using the Black Scholes option pricing model, and the following assumptions: (i) risk free interest rate of 6.21%, 5.62% and 6.27% at December 31, 1999, 1998 and 1997, respectively; (ii) expected life of 5 years for 1999, 1998 and 1997; (iii) expected dividends - - $0 for the years ended December 31, 1999, 1998 and 1997; and (iv) volatility - 60% for 1999 and 1998 and 0% for 1997. The weighted average fair value of options granted during 1999, 1998 and 1997 was $15.78, $9.63 and $2.56, respectively.
18. Pro Forma Information (unaudited) Pro Forma Provision for (Benefit From) Income Tax
The accompanying financial statements reflect a provision for income taxes on a pro forma basis as if the Company were subject to Federal and state income taxes throughout the years presented. The pro forma income tax rate of 40% is based upon the statutory rates in effect for C corporations for the periods presented, with no tax benefits assumed for the net operating losses in 1997. The pro forma adjustment for income taxes for the year ended December 31, 1999 also reflects the non-deductibility of certain acquisition related costs.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
19. New Accounting Pronouncements
The Financial Accounting Standards Board released in June 1998, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. This statement addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts and for hedging activities. As the Company has not entered into transactions involving derivative instruments, the Company does not believe that the adoption of this new statement will have a material effect on the Company's financial statements.
20. Segment Information
The Company is organized primarily on the basis of its three principal service offerings, including customized contract sales services, marketing research and consulting services and professional education and communication services. Marketing research and consulting services and professional education and communication services have been combined to form the "All other" category. The accounting policies of the segments are the same as those described in the "Nature of Business and Significant Accounting Policies" footnote. Segment data includes a charge allocating all corporate headquarters costs to each of the operating segments. The Company evaluates the performance of its segments and allocates resources to them based on earnings before interest and taxes (EBIT). The Company does not utilize information about assets for its operating segments and, accordingly, no asset information is presented in the table below.
PROFESSIONAL DETAILING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)
Note 21. Subsequent Events
On January 26, 2000, the Company completed a public offering of 2,800,000 shares of common stock at a public offering price per share of $28.00, yielding net proceeds per share after deducting underwriting discounts of $26.35 (before deducting expenses of the offering). Of the shares offered, 1,399,312 shares were sold by the Company and 1,400,688 shares were sold by certain selling shareholders. In addition, in connection with the exercise of the underwriters' over-allotment option, an additional 420,000 shares were sold to the underwriters on February 1, 2000 on the same terms and conditions (210,000 shares were sold by the Company and 210,000 shares were sold by a selling shareholder). Net proceeds to the Company after expenses of the offering were approximately $41.7 million.
In February 2000, the Company signed a three year agreement with iPhysicianNet Inc. ("iPhysicianNet"). In connection with this agreement, the Company has made an investment of $2.5 million in preferred stock of iPhysicianNet. Under this agreement PDI was appointed as the exclusive CSO in the United States to be affiliated with the iPhysicianNet network, allowing PDI to offer e-detailing capabilities to its existing and potential clients. | 22,151 | 145,956 |
855581_1999.txt | 855581_1999 | 1999 | 855581 | Item 1. Business
The Company was incorporated in 1986 and completed an initial public offering of its Common Stock in 1989. From the time of its incorporation until early 1993 it was a developer and marketer of integrated optical disk-based imaging systems and large network document management systems, which it marketed primarily to the pharmaceutical industry in the United States and Europe and to users of litigation support applications.
In 1993 the Company commenced an orderly winding up and liquidation of its assets, which it completed substantially in 1994. It has been inactive since that date, and has recently commenced searching for a merger with an operating entity.
Employees
The Company's four officers are its only employees. Each of them has other employment and devotes only such time to the Company's business as is necessary for its limited operations.
Item 2.
Item 2. Properties
The Company maintains its principal executive offices at 1395 New York Avenue, Huntington Station, NY, on a rent free basis pursuant to a verbal agreement with Carl Lanzisera, its Chairman and principal shareholder.
Item 3.
Item 3. Legal Proceedings
None
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the last quarter of the period covered by this report.
Part II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Company's Common Stock is traded in the over-the-counter market. The range of high and low bid quotations, as reported by the National Quotation Bureau Incorporated, for the Company's securities through the three months ended January 31, 1999, is as follows:
Common Stock Bid High Low - ---------------- ----- ---
Three months ended
April 30, 1997 $.02 $.02
July 31, 1997 $.02 $.02
October 31, 1997 $.02 $.02
January 31, 1998 $.02 $.01
April 30, 1998 $.02 $.01
July 31, 1998 $.01 $.01
October 31, 1998 $.01 $.01
January 31, 1999 $.01 $.001
The market for the Company's Common Stock is extremely thin, with actual transactions occurring only sporadically. As of January 31, 1999, the approximate number of holders of record of the Company's Common Stock was 747.
The Company has never paid cash dividends on its Common Stock. Payment of dividends is within the sole discretion of the Company's Board of Directors and depends, among other factors, on earnings, capital requirements and the operating and financial condition of the Company.
Item 6.
Item 6. Selected Financial Data
The following selected financial data should be read in connection with the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this report. Such data have been derived from the financial statements audited by Tamas B. Revae, Certified Public Accountant.
Fiscal Year Ended January 31 1995(1) 1996(1) 1997 1998 1999 ------- ------- ---- ---- ---- Operating revenues -- -- --
Income (loss) from continuing operations 1,839 (529) (2,218)
Income (loss) from continuing operations per common share -- -- --
Total assets 13,245 13,656 10,498
Long-term obligations and redeemable preferred stock -- -- -- -- --
Cash dividends declared per common share -- -- -- -- --
(1) Financial statements were not prepared for the fiscal years ended January 31, 1995 and 1996 because the Company had no operations during those years. See Notes to Financial Statements included elsewhere in this Report.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations
The Company has no sources of revenue. Expenses reflect only the minimum cost of maintaining the Company's operations and miscellaneous expenses associated with seeking a merger partner. In view of these limited operations, management does not believe that a comparison of specific line items from period to period it would be meaningful.
Liquidity and Capital Resources
The Company's financial statements have been prepared assuming that it will continue as a going concern. As shown in the consolidated financial statements, at January 31, 1999 the Company had total assets of $10,498 and an accumulated deficit of $7,398,412. The Company obtains its entire financial support from loans from the Company's majority shareholder, and it is likely that additional loans from that shareholder will be necessary if the Company is to pursue its plans to merge with an operating enterprise. These factors, among other things, raise substantial doubt about its ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts or classification of liabilities that might be necessary should the Company be unable to continue in operation.
Item 7A.
Item 7A. Qutative and Qualitative Disclosures About Market Risk
Not applicable
Item 8.
Item 8. Financial Statements and Supplementary Data.
INDEPENDENT AUDITOR'S REPORT
TAMAS B. REVAI
CERTIFIED PUBLIC ACCOUNTANT
CERTIFIED VALUATION ANALYST
68124 HAMILTON PARKWAY, BROOKLYN, NY 11219
(718) 833-0982 Fax: (718) 833-3658
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors
and Stockholder of
Laser Recording Systems, Inc.
We have audited the accompanying balance sheet's of Laser Recording Systems, Inc. as of January 31, 1999, January 31, 1998, January 31, 1997 and the related statements of income, retained earnings and cash flows for the years then ended. These financial statements are responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Laser Recording Systems, Inc. as of January 31, 1999, 1998, 1997 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
As we discussed in Note 2 to the financial statements, the Company discontinued operation in 1993 and liquidated most of its assets. As a result, all revenues and expenses were classified as non-operating items for the years of February 1, 1994 to January 31, 1999.
/s/ Tamas B. Revai
Certified Public Accountant
Brooklyn, NY
August 5, 1999
LASER RECORDING SYSTEMS, INC. BALANCE SHEET January 31,
ASSETS 1999 1998 CURRENT ASSETS: Cash and Cash Equivalents $ 10,498 $ 13,656 ----------- ----------- Total Current Assets $ 10,498 $ 13,656 ----------- ----------- Total Assets $ 10,498 $ 13,656 =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES: Accrued Expenses $ -- $ 44,846 Total Current Liabilities $ -- $ 44,846 Loan Payable-- Stockholder $ -- $ 190,000 Total Liabilities $ -- $ 234,846 ----------- -----------
Stockholders' Equity Preferred Stocks -- 2,200,729 Preferred Shares; 225,321 Class B Cumulative Preferred Shares; 1,080,000 Class C Cumulative Convertible Preferred Shares issued and outstanding on January 31, 1998 and 1997 $ 2,507,364
Common Stocks -- 10,000,000 shares authorized, 7,800,000 shares issued and outstanding on January 31, 1999; 4,798,815 issued and outstanding on January 31, 1998 $ 7,408,910 4,574,865 Paid in Capital 92,775 Retained Earnings (7,398,412) (7,396,194) ----------- ----------- Total Stockholders' Equity 10,498 (221,190) ----------- ----------- Total Liabilities and Stockholders' Equity $ 10,498 $ 13,656 =========== ===========
The accompanying notes are an integral part of the financial statements.
LASER RECORDING SYSTEMS, INC. STATEMENT OF REVENUES, EXPENSES AND RETAINED EARNINGS For the Year Ended January 31, 1999
1999 1998 ---- ---- Revenue:
Interest Income $ 123 $ 120 Recovery of Bad Debts -- -- ----------- ----------- Total Revenues $ 123 $ 120 ----------- -----------
Expenses:
Document Storage $ -- $ -- Administrative Expenses 2341 649 ----------- ----------- Total Expenses 2341 649 ----------- ----------- Net Income $ (2,218) $ (529) Retained Earnings at Beginning of Year (7,396,194) (7,395,665) ----------- ----------- Retained Earnings at End of Year $(7,398,412) $(7,396,194) =========== ===========
The accompanying notes are an integral part of the financial statements.
LASER RECORDING SYSTEMS, INC. ANALYSIS OF STOCKHOLDERS' EQUITY JANUARY 31,
The accompanying notes are an integral part of the financial statements.
LASER RECORDING SYSTEMS, INC. STATEMENT OF CASH FLOWS For the Year Ended January 31,
1999 1998 ---- ----
Cash flows from operating activities: Net Income $ -- $ -- -------- --------
Cash flows from financing activities: Maintaining of the Corporate Entity $ (3,158) $ 411 -------- --------
Net cash provided by (used in) financing activities $ (3,158) $ 411 -------- -------- Increase (Decrease) in Cash $ (3,158) $ 411 Cash -- Beginning of year 13,656 13,245 -------- -------- Cash -- End of Year $ 10,498 $ 13,656 ======== ========
The accompanying notes are an integral part of the financial statements.
LASER RECORDING SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS JANUARY 31, 1999
Laser Recording Systems, Inc. (the Company) was organized in 1985 as the successor to several other businesses by the original founder. In 1988, Poly Ventures, Limited Partnership held approximately 70% of the outstanding voting shares and maintained a controlling interest in the Company until 1998. In 1998 several investors acquired the remaining interest from Poly Ventures.
As reported in form 10- Q, on October 31st 1993, the Company ceased operations and laid off all its employees on August 16 1993 . The Company handed over projects to their customers on that date. Since October 31st 1993, the Company did not file any reports with the Securities and Exchange Commission.
Note 1.
In 1998 several investors purchased from Poly Ventures 1,975,408 Common Shares, 2,200,729 Preferred Shares, 225,321 Class B Cumulative Preferred Shares and 1,080,000 Class C Cumulative Preferred Shares. Included in the purchased were two notes for the total of $190,000.
In 1999 all classes of the preferred shares, accrued dividends and interest, paid-in capital and loans payable were converted to capital stock. As a result the Company's board of Directors authorized issuing 3,001,185 Common Shares on January 15, 1999.
Note 2
The Company discontinued operation on August 16, 1993, however the Company maintain certain functions to continue the existence of the Corporation. Stockholders services and maintaining of records were handled on an ongoing basis. In 1999, the Company filed all necessary tax returns for the years of February 1, 1993 to January 31, 1999. For financial statement purposes all revenues and expenses are considered non-operating transactions from February 1, 1994 to the present.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Not applicable
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The directors and executive officers of the Company are as follows:
Name Age Position - ---- --- --------
Carl Lanzisera 60 Chairman of the Board, Treasurer and Director
Walter J. Hinchcliffe 67 President and Director
Carrie Niemiera 37 Secretary and Director
Harvey Kash 65 Director
Carl Lanzisera has for the last year been the President of Federated Securities, Inc., a registered broker-dealer. From 1997 to 1998 he was branch manager of an independent office of First Securities, Inc. Prior to that he was branch manager of an independent office of Myers Pollack & Robbins Securities. He has been registered with the NASD for more than 35 years and has been a registered securities principle for 25 years. He holds a M.S degree in business from Adelphi University.
Walter J. Hinchcliffe is and has been since 1976 a principal in the management consulting firm Reed Wilson & Company. He holds a B.B.A. degree in marketing and retailing.
Carrie Niemiera has been a building manager of a commercial office building in Melville, NY since 1989.
Harvey Kash was the President and founder of a Mineola NY consumer advisory service from 1992 until he joined the Company. From 1984 to 1991 he was the President and they co-founder of DKS Sales, Inc. a full-service manufacturer's representative in the areas of housework, hardware, lawn and garden furniture. He holds a BBA from the Baruch School of Business of the City University of New York.
The above officers and directors serve for a term of one year or until their successors have been elected.
Each of the Company's officers and directors holds other employment and is devoting only such time to the operation of the Company's business as its limited operations require.
Item 11.
Item 11. Executive Compensation
In November, 1997 the Board of Directors authorized the issuance of 500,000 shares of the Company's Common Stock to Mr. Hinchcliffe and 300,000 shares of such Common Stock to each of Messrs. Lanzisera and Kash and Ms. Niemiera upon activation of the Company. For the year ended January 31, 1999 no executive officers or directors of the Company were paid or
accrued any additional remuneration. However, the Board of Directors has authorized the issuance of warrants to each of Messrs. Lanzisera and Hinchcliffe, Ms. Neimiera and Mr. Kash to purchase 300,000 shares, also upon activation of the Company.
No compensation has been or will be paid on account of services rendered by a director in such a capacity other than for the reasonable expenses incurred in connection with the Company's business.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth as of January 31, 1999, certain information with respect to the beneficial ownership of shares of Common Stock of (i) all shareholders known by the Company to be the beneficial owners of more than 5% of its outstanding Common Stock, and (ii) each director of the Company and each executive officer of the Company and (iii) all directors and executive officers of the Company has a group. The beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and includes voting and investment power with respect to shares.
Name and Address of Beneficial Owner (1) Shares Beneficially Owned - ---------------------------------------- -------------------------
Number Percent ------ -------
Carl Lanzisera (2) 3,601,185 66.4%
Walter J. Hinchcliffe (3) 800,000 9.3%
Carrie Neiviera (4) 600,000 7.1%
Harvey Kash (5) 600,000 7.1%
All current directors and executive officers as a group (4 persons) 5,602,185 72.9%
(1) Except as otherwise indicated, (i) the shareholders named in the table have sole voting and investment power with respect to all shares beneficially owned by them and (ii) the address of all shareholders listed in the table is c/o Laser Recording Systems, Inc., PO Box 214, Huntington Station, NY 11746
(2) Includes 3,001,185 shares held by Mr. Lanzisera, 300,000 shares issuable within 60 days and a warrant to purchase an additional 300,000 shares exercisable within 60 days.
(3) Includes 500,000 shares issuable within 60 days and a warrant to purchase an additional 300,000 shares exercisable within 60 days.
(4) Includes 300,000 shares issuable within 60 days and a warrant to purchase an additional 300,000 shares exercisable within 60 days.
(5) Includes 300,000 shares issuable within 60 days and a warrant to purchase an additional 300,000 shares exercisable within 60 days.
Item 13.
Item 13. Certain Relationships and Related Transactions
The Company occupies its principal executive offices on a month to month basis, free of charge, from its Chairman.
Part IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8K
The Company has not filed any reports on Form 8-K during the last quarter of the period covered by this report.
All other schedules required by Regulation S-K are omitted because they are not applicable or the required information is included in the financial statements or the notes thereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
LASER RECORDING SYSTEMS, INC. (Registrant)
By: /s/ Walter Hinchcliffe ---------------------------------- Walter Hinchcliffe, President
Dated December 28, 1999
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ----
/s/ Carl Lanzisera Chairman of the Board, Treasurer - ------------------------ and Director December 28, 1999 Carl Lanzisera
/s/ Walter Hinchcliffe - ------------------------ Walter Hinchcliffe President and Director December 28, 1999
/s/ Harvey Kash - ------------------------ Harvey Kash Director December 28, 1999
/s Carrie Niemiera - ------------------------ Carrie Niemiera Secretary and Director December 28, 1999 | 2,757 | 17,793 |
884064_1999.txt | 884064_1999 | 1999 | 884064 | ITEM 1. BUSINESS
INTRODUCTION
Option Care, Inc. (together with its subsidiaries, collectively "the Company") is a provider of specialty pharmaceutical products and services for intravenous delivery. The Company contracts with managed care organizations and other third party payors to provide pharmaceutical products and complex compounded solutions through its national network of 140 offices for administration to patients in alternative site settings. In addition, the Company markets specialty drugs and pharmacy consulting services directly to physicians and patients. The Company also supplies state-of-the-art data management products and services to the home healthcare industry. The Company was incorporated in Delaware on July 9, 1991. The Company's predecessor was incorporated in California in January 1984.
The Company has an established nationwide presence with a strong brand identity and broad accessibility for managed care payors and customers. As of December 31, 1999, 140 Option Care offices were operating in 34 states, with 117 offices owned and operated by franchise owners and 23 offices owned and operated by the Company. Certain of the Company-owned offices also operate other ancillary healthcare businesses, which provide nursing, respiratory therapy and durable medical equipment. Revenue generated from patient care services from all 140 Option Care offices grew by $14 million to $285 million in 1999 from $271 million realized in 1998.
The Company and its franchises have formed networks to provide managed care companies and payors with infusion therapy, respiratory services, nursing services and durable medical equipment. Many referral sources, such as hospitals, physicians, third-party payors and case management companies, may prefer making patient referrals to multi-office companies or systems, such as the Option Care system. Under the Company's Optionet-Registered Trademark- program, the Company has contracted with certain regional and national third-party payors and case management companies to refer patients to Company and franchise offices.
The Company is committed to the providing of superior quality care and believes that an important measure of quality in the healthcare industry is accreditation by the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO") or similar organizations. As of December 31, 1999, over 90% of the franchise and Company owned offices were accredited and a total of 24 or 17% received commendations. Since 1990, all new franchises have been required by the Company to apply for accreditation within their first year of operation. The Company's goal is for all Option Care offices to become accredited.
The Company's business consists of the following components:
- - HEALTHCARE SERVICES
The Company is a direct provider of alternate site infusion therapy, specialty pharmacy and drug distribution and other healthcare services. Option Care offices compound, dispense and administer pharmaceuticals, sell medical supplies, sell or rent associated durable medical equipment, provide skilled nursing services, train patients and their caregivers, consult with attending physicians, and process reimbursement claims. The decision to proceed with alternate site therapies is generally made jointly by the patient, the attending physician and a representative of the Option Care office involved. The decision involves obtaining and evaluating information about the patient's medical history, care environment and insurance coverage, as well as discussing the patient's or caregiver's willingness and ability to participate in the management of care in an alternate site setting.
Through its owned offices in Florida and Michigan, the Company contracts with managed care organizations and physician groups to provide biotech injectable drugs for administration to patients in physicians' offices and other alternative sites. The Company also markets injectable drugs and provides pharmacy consulting services directly to physicians and patients. In January 2000, the
Company repositioned the specialty pharmacy and drug distribution business into a separate division doing business as OptionMed-TM-.
The Company's nursing services include providing support for infusion therapies, providing traditional home health nursing services, skilled nursing services and private duty services. These nursing services include patient assessment, training, monitoring, documentation and physician communication.
- - FRANCHISING PROGRAM
As of December 31, 1999, the Company had 117 franchise offices that also are providers of in-home or alternative site infusion therapy and other healthcare services. Effective January 1, 1999 any new franchise granted by the Company provides the franchise owner the authority to own and operate an Option Care office within a granted territory for up to a 10-year term. The initial franchise fee for start-up franchises is payable by the franchise owner upon execution of the franchise agreement. The exact amount of the initial franchise fee is determined by the Company based on the population in the territory granted to the franchise owner. The Company's franchise agreements generally provide for royalties on a sliding scale ranging from a high of 9% to a low of 2% of annual gross cash receipts.
Each franchise office is required to maintain a licensed pharmacy equipped to compound sterile patient medications and parenteral solutions as prescribed by the patient's physician. Each location operates under a confidential, proprietary system developed by the Company, which includes procedures for quality assurance, patient care, consistency and uniformity of pharmaceuticals and offered services, initial training and ongoing assistance.
Key employees of each franchise office, including the director of pharmacy, director of nursing, and general manager, must complete initial training programs provided by the Company. In addition to required initial training, the Company may offer additional programs on selected topics to franchise owners and their employees. The Company's initial training stresses the importance of responsive service. In addition, the Company may make available to franchisees additional programs for marketing and operating support services.
The Company's franchise agreements require, among other things, that franchise owners meet the Company's policies on quality assurance, clinical services and local marketing and to obtain specified liability insurance protecting the franchise owner against claims arising from the operation of the franchised business.
The Company conducts an annual meeting for franchise owners and their key employees to offer information on new and existing Option Care programs and procedures. The Company works with a National Advisory Council to discuss and communicate recommendations concerning the franchise system.
The following table indicates the number of Option Care franchise offices at the beginning of the year, the number of new franchises sold, the number of franchises terminated, consolidated or purchased and the number of franchises at the end of each year for the three-year period ended December 31, 1999:
- - DATA MANAGEMENT SYSTEMS
Management by Information, Inc. (MBI) supplies state-of-the-art data management products and services to the healthcare industry through such products as MBI HomeCare V5.0, which was introduced in 1999. MBI specializes in home infusion and home medical equipment software products which are designed with the ability to integrate with other key information systems to provide a seamless business solution to healthcare companies.
The Company plans to continue to investigate expanding, growing and developing its business through (i) selective entry into new geographic markets through alliances, acquisition or start-ups, (ii) expanding the specialty pharmacy and distribution division, OptionMed-TM-, into additional geographic markets, and (iii) increasing the volume of current therapies and expanding coverage of new therapies and services. To meet the Company's objectives, additional financing sources may be required, for which the Company can give no guarantees that such financing will be available or available at an acceptable cost.
REIMBURSEMENT FOR SERVICES
Most patient care service revenue of Company-owned offices are derived from third-party payors, such as insurance companies, health maintenance organizations, self-insured employers, Medicare and state Medicaid programs. Where permitted by law or contract, patients are billed for amounts not reimbursed by third-party payors. Reimbursement from Medicare and Medicaid programs is subject to statutory and regulatory requirements, administrative rulings, interpretations of policy, implementation of reimbursement procedures, retroactive payment adjustments and governmental funding restrictions, all of which may materially affect payments to home healthcare providers.
The following table sets forth the approximate percentages of revenue attributable to private and government reimbursement sources for Company-owned offices for the three year period as indicated:
SALES AND MARKETING
Generating patient referrals is vital to the success of any alternative site healthcare business. Option Care offices are required to employ sales personnel whose primary responsibility is to market Option Care services to potential referral sources. Marketing efforts focus on area hospitals, physicians, managed-care and other payors and case management companies. The active role which general managers and franchise owners typically play in the operation of the business also helps create a focused effort on developing the market for each location.
The Company has established a program called Optionet-Registered Trademark-, through which the Company contracts with certain regional and national third-party payors (e.g., insurance companies, health maintenance organizations and large self-insured employers) to receive referrals of their covered members to participating Option Care offices. Based on payor preference or requirements, Option Care offices bill the payor directly for services rendered, or Optionet-Registered Trademark- arranges for a third-party billing service to bill the payor for a billing fee.
SUPPLIERS
Option Care offices purchase pharmaceuticals and supplies relating to their Option Care business from suppliers specified by the Company. The Company may derive revenue through administrative fees received from contracted manufacturers.
Neither the Company nor its franchises have experienced significant difficulty in purchasing pharmaceuticals, supplies or equipment. In the event that current suppliers cease or are unable to sell pharmaceuticals and supplies to the Company or its franchises, the Company believes that alternate sources can be located which would adequately meet their needs without undue burden.
GOVERNMENT REGULATION
HEALTH CARE REGULATION
Healthcare is subject to regulation by the various states in which the Company and its franchise owners conduct their businesses, as well as by the federal government. Option Care offices are subject to federal, state and local laws (including licensing laws) governing pharmacies, home health agencies, nursing services, health planning and professional conduct. Each Option Care office must be appropriately registered with the United States Food and Drug Administration and Drug Enforcement Administration and comply with record keeping and inventory requirements for the dispensing of controlled substances. Although the Company provides its franchise offices guidance in compliance with regulatory requirements, it is not responsible for such compliance. The failure of an Option Care office to obtain, renew or maintain any required regulatory approvals or licenses could adversely affect that location and could prevent such location from offering services to patients.
To the extent an Option Care office provides service under the Medicare, Medicaid and other governmental programs, it is subject to a broad body of laws regulating those programs, including federal "fraud and abuse" laws. Among other things, these laws prohibit any bribe, kickback or rebate in return for the referral of Medicare or Medicaid patients. In addition, many of the states in which Option Care offices operate have laws that prohibit certain direct or indirect payments or fee-splitting arrangements between health care providers that are designed to induce or encourage the referral of patients to, or the recommendation of, a particular provider for medical products and services. Several states restrict or prohibit referrals where a physician has a financial relationship with the provider. In addition, some states restrict certain business relationships between physicians and pharmacies. State laws vary from state to state. The Company exercises care in structuring its arrangements with health care providers and referral sources to comply with the relevant statutes, but there can be no assurance that such laws will ultimately be interpreted in a manner consistent with the practices of the Company or the franchise owners.
Other state and federal laws and regulations could also adversely affect existing or future financial relationships between physicians and health care businesses, including franchised businesses. The Omnibus Reconciliation Act of 1993 ("Act") prohibits physicians, subject to certain exceptions, who have a "financial relationship" with an entity from referring patients to that entity for the provision of "designated health services" which may be reimbursed by Medicare or Medicaid. The "designated health services" include parenteral and enteral nutrients; equipment and supplies; outpatient prescription drugs; and durable medical equipment. With certain exceptions, this Act also requires entities seeking payment from the Medicare and Medicaid programs to report any ownership and compensation arrangements with physicians. This federal law bars, with limited exceptions, physician ownership of an Option Care franchise office.
The United States Department of Health and Human Services, Office of the Inspector General ("OIG"), has been utilizing a civil statute, the False Claims Act, in challenging Medicare billing practices. In particular, the False Claims Act provides that any person who knowingly presents, or causes to be presented, to an officer or employee of the United States Government or a member of the Armed Forces
of the United States a false or fraudulent claim for payment or approval may be subject to a civil penalty of $10,000, plus treble damages for each fraudulent claim. It is the Company's understanding that the OIG considers each claim that is submitted for reimbursement to the Medicare program to be a claim for purposes of the False Claims Act.
New healthcare legislation is promulgated on an ongoing basis and could impact providers of Option Care services, although it is not possible at this time to predict the nature or extent of any impact upon Option Care offices.
The Company is unable to predict whether any new legislation or regulations may be enacted in the future which may affect the business of the Company, Option Care offices or the health care industry, including third-party reimbursement. Accordingly, the Company cannot predict whether any such new legislation or regulations would have a material adverse impact on the Company.
FRANCHISE REGULATION
The Company's franchising operations are subject to Federal Trade Commission ("FTC") regulation and state laws which regulate the offer and sale of franchises. The Company is also subject to a number of state laws which regulate substantive aspects of the relationship between franchisors and franchise owners.
The FTC's Trade Regulation Rule on Franchising (the "FTC Rule") requires the Company to furnish prospective franchise owners with a uniform franchise offering circular containing information prescribed by the FTC Rule. At least 12 states presently regulate the offer and sale of franchises and, in almost all cases, require registration of the franchise offering with state authorities.
State laws which regulate the relationship between franchisors and franchise owners presently exist in a substantial number of states. Such laws regulate the franchise relationship by, for example, requiring the franchisor to deal with its franchise owners in good faith, prohibiting interference with the right of free association among franchise owners, and limiting the imposition of standard charges, royalties or fees. These laws have not precluded the Company from seeking franchise owners in any given area and have not had a significant effect on the Company's operations.
The Company is not aware of any pending franchise legislation which in its view is likely to significantly affect the operations of the Company. The Company believes that its operations comply substantially with the FTC Rule and applicable state franchise laws.
SERVICE MARKS
The Company has registered with the federal government OPTION CARE-Registered Trademark-, among others, as a service mark. The Company believes that this service mark is becoming increasingly recognized by many referral sources as representing a reliable, cost-effective source of home healthcare services. The Company believes that its use of this service mark does not violate or otherwise infringe on the rights of others.
EMPLOYEES
As of December 31, 1999, the Company employed 613 persons on a full-time basis and 405 persons on a part-time basis. Of the Company's full-time employees, 62 were corporate management and administrative personnel and the remaining 551 were employees of Company owned offices, primarily in clinical, management and administrative positions.
The Company considers its employee relations to be good. None of the Company's employees are covered by a collective bargaining agreement.
INSURANCE
The Company currently maintains insurance for general and professional liability claims in an aggregate amount which it believes to be sufficient given the nature of its business. In addition, the Company maintains insurance for vicarious liability of the Company, if any, for the acts and omissions of its franchises, and the Company requires each franchise to maintain general liability insurance and professional liability insurance on each of its professionals, in each case covering both the franchise and the Company, with coverage at levels which the Company believes to be sufficient. These policies generally provide coverage on a claims-made or occurrence basis and have certain exclusions from coverage. These insurance policies must generally be renewed annually. There can be no assurance that insurance coverage will be adequate to cover liability claims that may be asserted against the Company or that adequate insurance will be available in the future at acceptable cost. To the extent that liability insurance is not adequate to cover liability claims against the Company, the Company will be responsible for the excess.
ITEM 2.
ITEM 2. PROPERTIES
The Company maintains executive offices at 100 Corporate North, Suite 212, Bannockburn, IL, consisting of approximately 18,845 square feet of leased space.
At December 31, 1999, the Company had operations located in Little Rock, AR, Bullhead City, AZ, Chico, Victorville and Vista, CA, Grand Junction and Denver, CO, Brandon and Miami, FL, Ann Arbor and Grand Haven, MI, Columbia and Jefferson City, MO, Grand Island, Lincoln and Omaha, NE, Milford, OH, Oklahoma City, OK, Bethlehem and Horsham, PA, Houston, TX, Bellingham, Everett and Kennewick, WA. These locations consist of approximately 148,294 square feet in total.
At December 31, 1999, all Company owned offices have ongoing leases for office space with remaining terms ranging from six months to five years. The Company owned offices are in good condition, well maintained, and are adequate to fulfill the operational needs for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is party to certain legal proceedings incidental to its business. The Company does not believe that the outcome of such legal proceedings will have a material adverse impact on the Company's financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders through the solicitation of proxies, or otherwise during the fourth quarter of the fiscal year ended December 31, 1999.
ITEM 4(A). EXECUTIVE OFFICERS
The names, ages and positions of the executive officers of the Company are set forth below. Executive officers of the Company serve at the discretion of the Board of Directors.
All executive officers are elected annually and serve for a one-year term. There are no family relationships between any of the Company's executive officers and Directors and there are no arrangements or understandings between any of the executive officers and any other person pursuant to which the executive officer was selected as an officer.
John N. Kapoor, Ph.D., is currently the Company's Chairman of the Board. He has been Chairman of the Board of Directors since October 1990. He served as the Company's Chief Executive Officer from August 1993 to April 1996 and served as President from August 1993 through October 1993 and from January 1995 through February 1996. Dr. Kapoor also served as Chief Executive Officer and President from March 1991 to May 1991. In addition, Dr. Kapoor is President of E. J. Financial Enterprises, Inc., a position he has held since April 1990. From June 1982 to April 1990, Dr. Kapoor held several positions with Lyphomed, Inc., including Chairman, Chief Executive Officer and President. Dr. Kapoor is also a Director of Integrated Surgical Systems, Inc. and the Chairman of the Board and Director for each of Akorn, Inc., and NeoPharm, Inc. Dr. Kapoor received his Ph.D. in medicinal chemistry from the State University of New York and a B.S. in pharmacy from Bombay University.
Mr. Michael A. Rusnak has been the Company's President and Chief Executive Officer since October 1998 and a member of the Board of Directors since November 1998. From June 1998 to October 1998, Mr. Rusnak was Executive Vice President and Chief Operating Officer. Prior to such time he was Senior Vice President of Option Care, Inc. and President of Option Care Enterprises, Inc. from May 1998 to June 1998. Mr. Rusnak was also the Company's Vice President-Franchise Services from November 1997 to May 1998. Prior to joining the Company, he was employed by Columbia Home Care Group, a division of Columbia HCA, from October 1996 to October 1997 as the Senior Vice President of Operations. From 1992 to 1997 he was the Vice President of Operations for Staff Builders Services, Inc. From 1982 to 1992 he was the Operations Manager for Interim Systems Corporation. He has a B.S. degree from St. Francis University and a Nursing and Respiratory degree from Northwestern University/Wesley Passavant School of Nursing.
Ms. Cathy Bellehumeur has been Secretary and General Counsel since February 1994, a Vice President since March 1994, Corporate Compliance Officer since May, 1995 and Senior Vice President since January 1997. Prior to joining the Company, Ms. Bellehumeur was an attorney in private practice with Godfrey & Cahn, S.C., Milwaukee WI from May 1987 to August 1991 and with Ross & Hardies, Chicago, Illinois from August 1991 to January 1994. Ms. Bellehumeur graduated Magna Cum Laude from Marquette University Law School and also has a Masters Degree in Education.
Mr. Rai has been Chief Operating Officer since August 1999. He had previously been Executive Vice President of Option Care Enterprises, Inc. since October 1998. Mr. Rai has been with the Company since August 1992, and has served in many positions ranging from Senior Vice President to General Manager and has held a variety of finance positions. Prior to joining the Company, he received his MBA in Finance from Wayne State University and also has a B.S. degree from Mechanical Engineering College in Warangal, India.
Mr. Michael A. Siri has been Vice President and Chief Financial Officer since October 1998. Prior to such time, Mr. Siri was the Company's Vice President-Finance from July 1998 to October 1998. From November 1986 to January 1998, Mr. Siri was employed by Culligan Water Technologies, Inc., where he was their Executive Director Finance and Treasurer. Mr. Siri has a B.S. in Accounting from Indiana University and a M.B.A. in Finance from the University of Chicago.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "OPTN". The following table sets forth, for the periods indicated the high and low sales prices for the Company's Common Stock.
As of March 17, 2000, there were approximately 283 holders of record of the Company's Common Stock. The closing price of the Company's Common Stock on March 17, 2000 was $6.50 per share, as reported by the Nasdaq National Market.
The Company did not pay cash dividends in 1999 or 1998. The payment of dividends by the Company is restricted under the Company's revolving credit facility. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 4 to the Company's Consolidated Financial Statements.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected consolidated financial data for the Company for each of the five years in the period ended December 31, 1999. The selected consolidated financial data reflects the Company's acquisitions, all of which were accounted for using the purchase method of accounting, except for the acquisition of Addison Home Care, Inc. on September 19, 1996, which was treated as a pooling of interests. This summary should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto, contained elsewhere in this Annual Report on Form 10-K.
CONSOLIDATED STATEMENTS OF OPERATIONS DATA
CONSOLIDATED BALANCE SHEET DATA:
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Option Care, Inc. (together with its subsidiaries, collectively "the Company") is a provider of specialty pharmaceutical products and services for intravenous delivery. The Company contracts with managed care organizations and other third party payors to provide pharmaceutical products and complex compounded solutions through its national network of more than 140 offices for administration to patients in alternative site settings. In addition, the Company markets specialty drugs and pharmacy consulting services directly to physicians and patients. The Company also supplies state-of-the-art data management products and services to the home health industry.
RESULTS OF OPERATIONS
The Company's revenues are derived primarily from three sources: (i) patient care services from Company-owned offices; (ii) product sales and network management services; and (iii) royalty fees from franchise offices. The following table sets forth the percentage relationships that certain items from the Company's Consolidated Statements of Operations bear to total revenue for the years ended December 31, 1999, 1998, and 1997, and should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto contained elsewhere in this Annual Report on Form 10-K:
1999 COMPARED TO 1998
REVENUE--
Revenue for the year ended December 31, 1999 was $120.4 million, an increase of $5.5 million, or 4.8%, over 1998. Revenue from patient care services for 1999 was $108.6 million, an increase of $12.5 million over 1998. The increase was due primarily to same-store growth of 12.5% realized at the Company-owned offices for 1999. Product sales and network management revenue for 1999 declined by $7.0 million, due primarily to the Company's decisions, made in the second and third quarters of 1998, to terminate its participation under contracts to perform network management services. The current year revenue amount of $3.1 million consists mainly of sales of software made through the Company's wholly-owned subsidiary, MBI. Excluding the revenue recognized during 1998 under the terminated contracts, product sale revenue in 1999 increased by $0.6 million as MBI successfully rolled out its MBI Home IV Manager V5.0 software during 1999. Royalty fees and other revenue of $8.7 million for 1999 equaled the $8.7 million reported for 1998.
GROSS PROFIT--
Gross profit of $49.7 million for 1999 represented an increase of $3.9 million, or 8.4%, from the $45.8 million realized in 1998. Gross profit margin for 1999 increased to 41.3% compared to 1998's gross margin of 39.9% due in part to the 13.0% increase in patient care services revenue. In addition, the 1999 gross margin did not include any impact from the terminated network management service contracts, which in 1998 provided little or no gross margin on over $6 million of network management revenue. Also, the revenue mix realized in 1999, compared to 1998, consisted of significantly increased specialty pharmacy and drug distribution revenue, which realizes a lower gross margin than the Company's core infusion therapies. This revenue increased by 46.1% or $9.5 million from $20.6 million in 1998 to $30.1 million in 1999.
During the first quarter of 1999, the Company changed its methodology for reporting gross profit. Costs deemed to be directly related to the production of revenues, such as pharmacy and nursing, remained in the cost of service, while all other costs, previously reported as patient care services operations were reclassified into selling, general and administrative. The Company determined that the new method of reporting was more appropriate and provided a better indication of the actual gross profit provided by the revenue. Certain amounts from prior years have been reclassified to conform to the 1999 presentation.
OPERATING EXPENSES--
Operating expenses for 1999 declined by $2.9 million, or 6.7%, to $40.4 million from $43.3 million in 1998. Operating expenses as a percentage of revenue declined from 37.7% in 1998 to 33.6% in 1999. Selling, general and administrative expenses decreased by $1.0 million or 2.5%, primarily due to better productivity. The provision for doubtful accounts declined by $2.0 million, or 39.8%, due to the strong cash collections realized in 1999 of outstanding accounts receivable. Amortization of goodwill for 1999 was consistent with 1998 amortization.
INTEREST EXPENSE--
Interest expense declined by $1.4 million or 58% as overall debt was reduced from $22.4 million at December 31, 1998 to $8.6 million at December 31, 1999. The decline came in part from the Company's use of cash on hand to reduce debt upon signing its new debt facility in the first quarter of 1999. In the third quarter of 1998, the Company discontinued its policy of using excess cash flow to pay down on its revolver debt. Once the new debt facility was in place, the Company re-instituted its policy and used cash-on-hand to retire debt. In addition, in 1999 the Company used its operating cash flow of $7.7 million, generated by strong cash collections of outstanding accounts receivable and proper management of accounts payable, to minimize outstanding amounts under its revolver facility.
INCOME TAXES--
Income taxes were provided for at a 40.3% rate reflecting the Company's profitability during 1999. Comparisons to prior year are not meaningful because the Company in 1998 settled outstanding audits and recognized additional tax expense.
EARNINGS PER SHARE--
As a result of the forgoing, the Company for the full year of 1999 recorded net income of $4.6 million or 3.8% of revenue, an increase of $5.3 million over the net loss of ($0.7) million recorded in 1998. Earnings per diluted share increased for the year from a loss of $(0.06) in 1998 to $0.39 for 1999, due to the increase in net income, offset by an 855,000 increase, or 7.7%, of diluted shares outstanding. The increase in the diluted shares is due to the 81.5% increase in the market price of the Company's stock at December 31, 1999 compared to December 31, 1998 and to issuance of shares under certain of the Company's 1996 and 1997 acquisition agreements.
1998 COMPARED TO 1997
REVENUE--
Revenue for the year ended December 31, 1998 was $114.9 million, an increase of $14.4 million or 14.4 percent over 1997. The $14.4 million increase in revenue is due to: $9.6 million of internal growth from the Company's owned operations; $8.6 million from a full year of results from the Company's 1997 acquisitions; $6.0 million of network management revenue from the Company's administration of the Health Net contract at the Company's West Coast Coordinated Care Center; offset by a net $9.8 million decline in other revenues. Other revenues declined primarily due to reductions in product sales as a result of management's decision during the second quarter of 1998 to end its program of product distribution to the franchise network. Revenues from patient care services for 1998 were $96.1 million, representing an increase of 18.5% over 1997. Product sales and network management revenue of $10.1 million increased 7.4% due to the Company's administration of the Health Net contract in 1998, which more than offset the decline in products sales. Royalty fees and other revenue of $8.7 million in 1998 declined 12.7% from the 1997 period due to replacement of royalty fees with patient care services revenue due to the acquisition by the Company of several large franchises during 1997.
GROSS PROFIT--
Gross profit of $45.8 million for 1998 increased by $2.8 million, or 6.6%, over the $43.0 million realized in 1997 due mostly to the $15.0 million or 18.5% increase in patient care services revenue. Gross profit margin for 1998 of 39.9% declined from 1997's margin of 42.8% due mainly to the effects of the administration of the Healthnet contract in 1998 which provided a negative gross margin of $(0.3) million on a revenue base of $6.5 million, excluding the Healthnet contract, gross margin percentage for 1998 was 42.5%.
OPERATING EXPENSES--
Operating expenses declined by $1.4 million to $43.3 million for 1998 due in part to the inclusion of a $3.9 million asset write-off and other charges taken by the Company in 1997. Excluding such charge, the Company's operating expenses increased by $2.5 million, largely due to increased administrative costs of $3.2 million due to the cost of integrating the newly acquired offices made in 1996 and 1997. This increase was offset by a decline in the provision for doubtful accounts of $0.8 million. In addition, during the fourth quarter of 1998, the Company ended its participation under the HealthNet contract and accrued $0.4 million of expenses for the run-off costs associated with such close-out.
INTEREST EXPENSE--
Interest expense for 1998 increased by 39.8% or $0.7 million over the 1997 period as a result of higher interest rates incurred by the Company during the third and fourth quarters of 1998 due to the Company's default under certain interest coverage covenant in the revolving credit facility.
INCOME TAXES--
Income tax expense recognized in fiscal 1998 includes the recognition of $0.7 million of expense due to tax adjustments and changes in reserves related to the settlement of an IRS audit of prior years tax returns for the 1992 through 1995 periods.
As a result of the forgoing, the Company recorded a net loss of $0.7 million in 1998 compared to a net loss of $2.1 million in 1997.
LIQUIDITY AND CAPITAL RESOURCES
CASH AND CASH EQUIVALENTS--
As of December 31, 1999, the Company had no cash and cash equivalents, compared to $3.7 million of cash and cash equivalents at December 31, 1998. At year-end 1998, the Company was engaged in negotiations with its bank group and concurrently negotiated the terms of a replacement facility and had temporarily discontinued its policy of reducing its outstanding debt with its excess cash flow from operations. This generated a large net cash balance of $3.7 million at December 31, 1998 in relation to historical practices. In 1999, after the signing of the new facility, the Company continued its prior practice of using its excess cash flow from operation to retire amounts outstanding under its revolver facility.
NET CASH FLOWS--
Net cash flow provided by operations for 1999 was $7.7 million, a decrease of $5.2 million from 1998 due to the reduction in the improvement in accounts receivable and an increase in inventory balances. The reduced improvement from account receivable is due in part to the 12.5% increase in same store sales realized in 1999 and the impact of the significant reduction of accounts receivables that occurred in 1998. The inventory balance increased in 1999 due to the purchase at year-end of selected high cost pharmaceuticals due to Year 2000 planning and the ability to obtain favorable price reductions based on volume purchases.
Net cash flow used in investing activities for 1999 of $1.8 million represented a $1.6 million decrease from the $3.4 million used in 1998 as purchases of equipment declined by $1.4 million. Net cash flow used by financing activities in 1999 of $9.6 million, increased by $3.7 million over the 1998 usage of $5.9 million mainly due to increased payments made under the Company's revolving agreement.
REVOLVING DEBT FACILITY--
During 1998, the Company was a party to a $35 million revolving credit facility, which contained certain financial covenants. As of June 30, 1998, the Company was out of compliance with the interest coverage covenant. As a result, the Company was not able to make draw downs on its facility for working capital purposes. The Company was in negotiations with its lenders to secure forbearance with respect to such covenant as of December 31, 1998. The forbearance was secured on January 15, 1999.
On February 5, 1999, the Company entered into a $25 million Loan and Security Agreement ("Agreement") with Banc of America Commercial Finance that replaced the former facility. All amounts outstanding under the former facility were repaid using cash on hand and proceeds from the Agreement. The Agreement provides for borrowings up to $25 million and requires the Company to meet certain financial covenants including, but not limited to: fixed charge coverage ratio; debt ratio; and limitation on annual capital expenditures. The Agreement provides for, among other things, the ability to meet working capital needs and to retire in its entirety the Company's former facility. The Company is subject to an early termination fee if the loan is terminated prior to its natural expiration of February 2002. The Company paid a facility fee of $0.2 million at the time of signing the Agreement. The Agreement prohibits the Company from declaring any cash dividends on its common stock. The Company may elect interest rates ranging from various LIBOR periods plus a 2.125% margin, to the bank's reference rate. During 1999, the Company paid an average interest rate of 7.7% on its outstanding amounts under the Agreement.
Availability under the facility is related to a percentage of the Company's net outstanding accounts receivable and inventory balances, less certain ineligible amounts, as defined in the Agreement. The facility is secured by all of the issued and outstanding Common Stock of each of the Company's subsidiaries. Overall borrowings allowable under the Agreement are limited to the lessor of $25 million or, the total allowable collateral base.
Management believes that cash flow from operations and amounts available under the Agreement will be sufficient to meet the cash needs of the business for the immediate future. In the event that additional capital is required, management cannot assure that such capital can be obtained on terms acceptable to the Company.
There are currently various proposals under development to enact healthcare reform on a national, state and local level. It is not possible at this time to predict the cash flow impact, if any, which any such changes may have on providers of home healthcare services and on the Option Care offices.
GOODWILL AND OTHER INTANGIBLE ASSETS--
Goodwill and other intangible assets, net, at December 31, 1999 of $22.1 million, rose by $2.0 million or 10% over the $20.1 million at December 31, 1998. The increase was due to payments made under certain of the Company's purchase agreements for acquisitions made in 1997 and 1996. These agreements obligate the Company, upon the acquired businesses meeting of determined milestones, the attainment of certain financial results or contractually, to pay additional consideration to former owners representing additional purchase price for these acquisitions. Total net goodwill and other intangible assets increased as a percentage of total assets from 33.8% at December 31, 1998 to 38.3% at December 31, 1999, due mainly to the additional payments made and a $2.4 million reduction in current assets in 1999 from 1998 levels. Total net goodwill and other intangible assets reduced as a percentage of stockholders' equity from 84.5% at December 31, 1998 to 75.3% at December 31, 1999, due mainly to the $5.6 million increase in stockholders' equity due to the net income realized in 1999 and from increases due to shares issued by the Company, offset by the aforementioned increase in net goodwill.
YEAR 2000 ISSUE
The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Computer equipment, software and devices with imbedded technology that are time sensitive may treat years as occurring between 1900 and the end of 1999 and may not self-convert to reflect the upcoming change in the century. If not corrected, this problem could result in system failures or miscalculations and erroneous results by, or at, Year 2000.
The Company has completed its program to make its systems Year 2000 compliant. This program encompassed the Company's operating information and facilities systems, and the readiness of customers, third-party payers, vendors and other third parties with which the Company does business. The program included the following phases: awareness and inventory, detailed assessment and resolution, testing, deployment and contingency plan development for all areas.
Prior to the end of 1999, the Company completed an internal review of its computer equipment and software systems and other equipment with imbedded technology. Other phases of its program, included the implementation of remediation measures for certain identified systems, ordinary course replacement of equipment and software with replacements which are Year 2000 complaint, and a comprehensive review of customers, vendors and other third parties to determine the extent to which interfaces with such entities are vulnerable to Year 2000 issues.
The total cost of the Year 2000 project to date has not been material. Based on the program to date, the Company does not expect that future costs of modifications, if any, will have a material adverse effect on the Company's financial position or results of operations and that currently anticipated costs to be incurred by the Company with respect to Year 2000 issues will be funded from operating cash flows. However, if all Year 2000 issues have not been properly identified, there can be no assurance that the Year 2000 issue will not materially adversely impact the Company's results of operations or adversely affect the Company's relationships with customers, vendors, or others. Additionally, there can be no assurance that the Year 2000 issues of other entities will not have a material adverse impact on the Company's systems or results of operations.
Because the Company's internal systems have become Year 2000 compliant in a timely manner, the Company believes that the most likely worst case scenario would result from vendors or other third parties failing to achieve Year 2000 compliance. Depending upon the number of third parties, their identity and the nature of the noncompliance, the Year 2000 issue could have a material adverse effect on the Company's financial position or results of operations.
QUARTERLY INFORMATION
Below is a summary of unaudited consolidated quarterly financial information for the years ended December 31, 1999 and 1998 (in thousands, except per share data). Certain amounts have been restated from previously published amounts.
QUARTER
ITEM 7(A). QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of the Company and its subsidiaries and the Independent Auditors' Reports thereon are included at Item 14(a) (1) & (2).
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
As of December 1, 1998, the Board of Directors of Option Care, Inc. (the "Registrant"), upon recommendation of its Audit Committee, engaged Ernst & Young LLP ("E&Y") as the Registrant's independent auditors for the year ending December 31, 1998. The Board of Directors of the Registrant retained E&Y based upon the Board's determination that the Registrant would benefit from E&Y's competitive fee structure. The engagement of E&Y arose from the Registrant's decision to request proposals for audit services from multiple firms, including KPMG Peat Marwick LLP ("KPMG").
The KPMG audit reports on the consolidated financial statements of the Registrant as of and for the two years ended December 31, 1997 did not contain an adverse opinion or disclaimer of opinion, and were
not qualified or modified as to uncertainty, audit scope or accounting principles. During the two year period ended December 31, 1997 and through the period ended December 1, 1998, there were no disagreements between the Registrant and KPMG on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which disagreements if not resolved to the satisfaction of KPMG, would have caused it to make references to the subject matter of such disagreements in connection with its report.
In its management letter to the audit committee of the Registrant, dated May 13, 1998, KPMG identified two reportable conditions: (1) excessive turnover in the Registrant's Chief Financial Officer position and (2) a lack of segregation of duties between the treasury and the controller functions of the Registrant. The Registrant believes it has implemented steps to correct the deficiencies noted, including (1) the hiring of Michael A. Siri as Chief Financial Officer, who has 22 years experience in accounting and finance and (2) the Registrant's implementation of alternative internal controls to mitigate the risk of asset misappropriation.
The Registrant has authorized KPMG to respond to any inquiries of E&Y concerning its audit. During the two years ended December 31, 1997 and through the dated appointment, E&Y did not provide any consultations to the Registrant regarding the application of accounting principles to specific transactions or the type of opinion that they may have rendered on the financial statements.
PART III
ITEMS 10. THROUGH 13.
Information regarding executive officers is contained in Item 4(A) of Part I of this Report and is incorporated herein by reference. Information on Directors of the Registrant, executive compensation, security ownership of certain beneficial owners and management and certain relationships and related transactions is set forth under the Election of Directors, Security Ownership of Certain Beneficial Owners and Management, Executive Compensation and Certain Transactions with Management and Directors captions of the Registrant's definitive proxy statement dated April 7, 2000 for its May 12, 2000 Annual Shareholders' Meeting, to be filed with the Securities and Exchange Commission in April 2000, and such information is incorporated herein by reference; provided, however the report of the compensation committee on executive compensation and the stock performance graph shall not be deemed to be so incorporated by reference. The information under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" of the 2000 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
(a)(1) & (2) The Consolidated Financial Statements and Schedule of the Company and its subsidiaries and independent auditors' reports thereon are included on pages 21 through 40 of this Annual Report on Form 10-K:
All other Schedules are omitted because the required information is not applicable or information is presented in the Consolidated Financial Statements or related notes.
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Option Care, Inc.
We have audited the accompanying consolidated balance sheets of Option Care, Inc. and subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Option Care, Inc. and subsidiaries at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information set forth therein.
ERNST & YOUNG LLP
Chicago, Illinois March 10, 2000
INDEPENDENT AUDITORS' REPORT
The Board of Directors Option Care, Inc.
We have audited the accompanying consolidated statements of operations, stockholders' equity and cash flows of Option Care, Inc. and subsidiaries for the year ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Option Care, Inc. and subsidiaries for the year ended December 31, 1997 in conformity with generally accepted accounting principles.
KPMG LLP
Chicago, Illinois March 26, 1998
OPTION CARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AT DECEMBER 31 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The accompanying notes are an integral part of these consolidated financial statements.
OPTION CARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The accompanying notes are an integral part of these consolidated financial statements.
OPTION CARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31 (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
OPTION CARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31
(IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) DESCRIPTION OF BUSINESS
Option Care, Inc. (together with its subsidiaries, collectively "the Company") is a provider of specialty pharmaceutical products and services for intravenous delivery. The Company contracts with managed care organizations and other third party payors to provide pharmaceutical products and complex compounded solutions through its national network of more than 140 offices for administration to patients in alternative site settings. In addition, the Company markets specialty drugs and pharmacy consulting services directly to physicians and patients. The Company also supplies state-of-the-art data management products and services to the home health industry.
The Company was incorporated in Delaware on July 9, 1991. The Company's predecessor was incorporated in California in January 1984. As of December 31, 1999, 140 Option Care offices, including satellite offices, were operating in assigned territories in 34 states. Existing offices include 117 offices owned and operated by franchise owners and 23 offices owned and operated by the Company.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the Company and its 50 percent or more owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.
(c) USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates.
(d) CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.
(e) FINANCIAL INSTRUMENTS
The fair value of the Company's financial instruments approximates their carrying value.
(f) INVENTORY
Inventory, which consists primarily of finished goods, mainly pharmaceuticals, are stated at their cost, which approximates market, and are accounted on the first-in, first-out (FIFO) basis.
(g) LONG-LIVED ASSETS
Equipment and other fixed assets are stated at cost. Equipment purchased under capital leases is stated at the lower of the present value of minimum lease payments at the beginning of the lease term or fair value at the inception of the lease. Depreciation on equipment is calculated on the straight-line method over the estimated useful lives of the assets. Leasehold improvements and equipment purchased
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) under capital leases are amortized on the straight-line method over the shorter of the lease term or estimated useful life of the asset.
Goodwill, which represents the excess of fair market value over the cost of net assets acquired, is amortized on a straight-line basis over 40 years. Accumulated amortization was $2,036 and $1,483 at December 31, 1999 and 1998, respectively.
Intangible assets, arising from certain of the Company's 1996 and 1997 acquisitions, are being amortized on a straight-line basis over the estimated useful life of each asset, ranging from 3 to 15 years. Accumulated amortization was $1,094 and $1,382 at December 31, 1999 and 1998, respectively. Certain fully amortized intangible assets were removed from the balance sheet in 1999.
Long-lived assets and certain identifiable intangibles are reviewed for impairment in value based upon non-discounted future cash flows, and appropriate losses are recognized, whenever the carrying amount of an asset may not be recovered.
(h) INCOME TAXES
The Company files a consolidated federal income tax return with all of its 80 percent or more owned subsidiaries. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the consolidated financial statements in the period that includes the enactment date.
(i) COMMON STOCK TO BE ISSUED
The Company has recorded the approximate number of shares to be issued due to certain of the Company's purchase agreements for acquisitions made in 1997 and 1996. These agreements obligate the Company to pay additional consideration to former owners representing additional purchase price for these acquisitions. Certain amounts to be paid out under these agreements will be paid out in Common Stock of the Company and are recorded as part of the equity section until the shares are issued. In addition, the amount withheld from the Company's employees for the purchase of shares under the Employee Stock Purchase Plan are also recorded in this account until the shares are issued.
(j) REVENUE RECOGNITION
(i) Patient care service revenue is reported at the estimated realized amounts from patients, third-party payors and others for services rendered. Revenue under certain third-party payor agreements is subject to audit and retroactive adjustments. Provisions for estimated third-party payor settlements and adjustments are estimated in the period the related services are rendered and are adjusted in future periods as final settlements are determined.
During 1999 and 1998, approximately 18% and 25%, respectively, of patient care service revenue and patient account receivables was from governmental programs. Governmental programs pay for services
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) based on fee schedules and rates which are determined by the related governmental agency. The Company's concentration of credit risk relating to trade account receivables is limited due to the diversity of patients and payors.
Laws and regulations governing government programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the government programs.
(ii) Royalty fees are recognized when cash is reported as received by the franchises. Franchise agreements provide for royalties on either 9% of gross cash receipts (subject to certain minimums and discounts), or on a sliding scale ranging from 9% to 2% depending on the levels of such receipts and other certain factors. Initial franchise fees are recognized when franchise training and substantially all other services have been provided.
(k) COST OF REVENUE
The Company has revised reporting for cost of revenue on the statements of operations. Costs directly related to the production of revenues, such as pharmacy and nursing, are classified as cost of services provided, while all other costs, previously reported as patient care services operations were reclassified into operating expenses as selling, general and administrative expense. The Company determined that the new method of reporting was more appropriate and provided a better indication of the actual gross profit provided by the revenue. Prior years amounts in the consolidated financial statements have been reclassified to conform to the current year presentation.
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (l) NET INCOME (LOSS) PER COMMON SHARE
The reconciliation of net income (loss) per common share for the years ended December 31, 1999, 1998 and 1997 is as follows: (in thousands, except for per share amounts)
The effect of dilutive securities is primarily from stock options. Such securities were not included in the calculation of diluted loss per share in 1998 and 1997 as the impact would have been anti-dilutive.
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (m) COMPREHENSIVE INCOME
The Company has no significant components of comprehensive income.
(n) RECLASSIFICATIONS
Certain prior year amounts in the consolidated financial statements have been reclassified to conform to the current year presentation.
(2) BUSINESS COMBINATIONS
At various dates during 1997, the Company purchased the assets of franchises located in Vista and Victorville, CA, Miami, FL, Ann Arbor and Grand Haven, MI and Lincoln and Grand Island, NE. The Company also purchased the assets of other healthcare related businesses in Victorville, CA and Miami, FL. The aggregate purchase price for these transactions was $10,689, of which $9,129 was paid in cash, $1,260 in short-term obligations and $300 in forgiveness of accounts receivable. The purchase method of accounting was used and $9,026 of goodwill was recorded. The accompanying consolidated financial statements include the results of operations of all acquired businesses from the date of acquisition.
The Company recorded an additional $2,923 and $1,257 of goodwill, in 1999 and 1998, respectively, from payments made under certain of the Company's purchase agreements due to the meeting of certain financial milestones. The obligations due to contractual commitments that will be paid in shares of the Company's Common Stock has been recorded as common stock to be issued in the equity section of the consolidated financial statements.
The unaudited pro-forma results of operations, affected by the acquisitions accounted for as purchases as if they had occurred as of January 1, 1997, were as follows:
(3) EQUIPMENT AND OTHER FIXED ASSETS
Equipment and other fixed assets consists of:
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(3) EQUIPMENT AND OTHER FIXED ASSETS (CONTINUED) Capitalized computer software is being amortized over a three year period, the estimated life of the product. Amortization expense for capitalized software was $204 and $0 in 1999 and 1998, respectively.
(4) LONG-TERM DEBT
Long-term debt consists of:
Maturities of long-term debt and capital lease obligations are:
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(4) LONG-TERM DEBT (CONTINUED)
On February 5, 1999, the Company entered into a $25,000 Loan and Security Agreement ("Agreement") with Banc of America Commercial Finance that replaced the former facility. The Agreement provides for borrowings up to $25,000 and requires the Company to meet certain financial covenants including, but not limited to: fixed charge coverage ratio; debt ratio; and limitation on annual capital expenditures. The Agreement provides for, among other things, the ability to meet working capital needs and to retire in its entirety the Company's existing facility. The Company is subject to an early termination fee if the loan is terminated prior to its natural expiration of February 2002. The Company paid a facility fee of $185 at time of signing the Agreement. The Agreement prohibits the Company from declaring any cash dividends on its common stock. The Company may elect interest rates ranging from various LIBOR periods plus a 2.125% margin, to the bank's reference rate. The average interest rate paid under the Agreement for 1999 averaged 7.7%.
Availability under the facility is related to a percentage of the Company's net outstanding accounts receivable and inventory balances, as defined, less certain ineligible amounts, as defined in the Agreement. Overall borrowings under the Agreement are limited to the lessor of the total allowable collateral base or $25,000.
The facility is secured by the assets of the Company. Prior to November 1, 1999, the John N. Kapoor Trust, dated September 20, 1989, ("the Trust"), had pledged an irrevocable letter of credit ("the LOC") totaling $7,000 in favor of Bank America Business Credit to support additional borrowings that exceeded the allowable collateral base as defined in the Agreement. The LOC was issued on February 5, 1999, was reduced by $2,500 twice in the subsequent four months and eliminated in total effective November 1, 1999. In exchange for the LOC, the Company paid administrative fees to the Trust of $94 prior to its elimination.
The effective borrowing rate of interest under the prior facility as of December 31, 1998 averaged 9.6%, as a result of non-compliance with the interest coverage covenant. The interest rate paid by the Company on its outstanding liability was 2% above the bank's reference rate plus an additional 0.25%. The Company retired its existing amount due in its entirety and terminated this facility on February 5, 1999. As part of the termination of this facility, the Company wrote off the $185 of remaining deferred financing costs.
The Company leases certain medical equipment under long-term lease agreements. Most of these agreements have a term of 36 months and are classified as capital leases. The net book value of the medical equipment under capital leases were $172 and $298 for 1999 and 1998, respectively.
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(5) PROVISION FOR INCOME TAXES
The income tax provision (benefit) consisted of the following:
A reconciliation between the income tax expense (benefit) recognized in the Company's Consolidated Statement of Operations and the income tax expense (benefit) computed by applying the U.S. Federal corporate income tax rate of 35%, 34% and 35% for 1999, 1998 and 1997, respectively, to earnings (loss) before income taxes follows:
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(5) PROVISION FOR INCOME TAXES (CONTINUED) Deferred income tax assets and (liabilities) at December 31, 1999 and 1998 include:
The Company has a capital loss carry-forward of $1,475, which expires in 2001.The Company has a valuation allowance of $575 for 1999 and 1998, related to the capital loss carry-forward. In 1998, the Company incurred additional expenses for taxes due to the settlement of an IRS audit for prior years and the corresponding adjustment to deferred taxes.
The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the net deferred tax asset.
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(6) STOCK INCENTIVE PLAN
The Company's Amended and Restated Incentive Plan (1997) was originally adopted by the Board and approved by the shareholders on September 11, 1991 and amended on February 21, 1997 (the "Incentive Plan"). The Incentive Plan provides for the award of cash, stock, and stock unit bonuses, and the grant of stock options and stock appreciation rights ("SARs"), to officers and employees of the Company and its subsidiaries and other persons who provide services to the Company on a regular basis. On February 21, 1997, the Company's Board approved an increase in the amount of shares reserved for the Incentive Plan to 2,000,000 shares of Common Stock. All options under the Incentive Plan must be exercised within ten years after the grant date. As of December 31, 1999, no cash, stock, stock unit bonuses or SARs have been granted pursuant to the Incentive Plan.
The following schedule details the changes in options granted under the Incentive Plan for the three years ending December 31, 1999:
- ------------------------
(1) Includes an aggregate of 262,500 shares of options re-priced in October 1998 from exercise prices ranging from $3.375 to $6.00, to an exercise price of $0.75.
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The following table summarizes information about the Incentive Plan and options outstanding at December 31, 1999:
The Company applies Accounting Principles Board (APB) Opinion 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans.
Had compensation cost for the Company's stock-based compensations plans been determined based on FASB Statement No. 123, the Company's net income (loss) and income (loss) per common share in 1999, 1998 and 1997 on a pro-forma basis would have been:
The fair value of options granted under the Company's stock option plan during 1999, 1998 and 1997 was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield, expected volatility of 74% for 1999, 65% for 1998 and 45% for 1997, risk free interest rate of 5.00% for 1999, 4.65% for 1998 and 5.75% for 1997, and expected lives of 5 years for each year.
(7) EMPLOYEE BENEFIT PROGRAMS
(a) 401(K) PLAN
The Company has a defined contribution plan under which the Company may make matching contributions based on employee contributions. The match, if any, is determined at discretion by the Board of Directors of the Company. The plan is intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code of 1986. Contributions are invested at the direction of the employee into one or more funds. All employees who have attained the age of 20 1/2 with one year's service
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(7) EMPLOYEE BENEFIT PROGRAMS (CONTINUED) are eligible for participation in the plan. The amount of expense recognized in 1999, 1998, and 1997 related to this plan totaled $322, $304 and $176, respectively.
(b) EMPLOYEE STOCK PURCHASE PLAN
The 1996 Employee Stock Purchase Plan, (ESPP) which has an expiration date of December 31, 2000, permits eligible employees, per the ESPP, the ability to acquire shares of the Company's stock through payroll deductions, up to a maximum of 15% of eligible wages. Employees can elect to enter the ESPP once a year, in December of the prior year for participation in the next year. Employees can stop their participation at any time during the year, but cannot re-enroll until the next year. In addition, enrolled employees can increase or decrease their participation percentage in May, effective July 1 of that year.
The price paid for the shares issued under the ESPP is at a 15% discount from the lower of the average of the asks and bids prices, as listed on the NASDAQ, for the Company's shares on the first and the last business day of each year. The shares are issued in January of the following year from un-issued shares. For the 1999 plan year, 123,925 shares were issued in January of 2000. 108,580 shares were issued in January of 1999 for the 1998 plan year.
8) ASSET WRITE-OFFS AND OTHER CHARGES
In the fourth quarter of 1997, the Company performed an evaluation of its operations, instituted a cost reduction program and disposed of certain under-performing assets. In conjunction with these steps, the Company recorded $3,902 in asset write-offs and other charges. The charge consists of $1,395 of cash charges, of which payments of $759 were made in 1997 and $636 were made in 1998.
(9) COMMITMENTS AND CONTINGENCIES
The Company may be required, upon death or termination of employment, to purchase stock of certain minority shareholders of subsidiaries.
Certain of the Company's purchase agreements for acquisitions made in 1997 and 1996, obligate the Company, upon the acquired businesses meeting of determined milestones, the attainment of certain financial results or contractually, to pay additional consideration to former owners representing additional purchase price for these acquisitions. The contingency period for these payments is through December 31, 2001. Amounts to be paid out under these agreements, of which certain amounts will be paid out in Common Stock of the Company, will be recorded as additional goodwill in the year that the amounts become certain. 204,563 shares and 183,568 shares of the Company's Common Stock were issued under these agreements in 1999 and 1998, respectively.
Certain management employees of the Company have employment agreements that provide for the payment of salary and benefits through a specific time frame. The agreements can only be terminated early for cause, as defined in the agreements. These agreements are not renewable and the Company currently has no plans in extending the agreements currently in place.
The Company is subject to claims and legal actions that may arise in the ordinary course of business. However, the Company maintains insurance to protect against such claims or legal actions. The Company is not aware of any litigation either pending or filed that might have a potential impact on the Company's
OPTION CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(9) COMMITMENTS AND CONTINGENCIES (CONTINUED) financial position and statement of operations. The Company leases office space under leases that are classified as operating leases. Operating lease expense for 1999, 1998 and 1997 was $2,280, $2,980, and $3,286, respectively. The future minimum lease payments for these leases are as follows:
(10) SUPPLEMENTAL CASH FLOW INFORMATION
OPTION CARE, INC. AND SUBSIDIARIES
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999
(IN THOUSANDS)
ALLOWANCE FOR DOUBTFUL ACCOUNTS:
ALLOWANCE FOR UNCOLLECTIBLE NOTES RECEIVABLE--CURRENT AND LONG TERM:
- ------------------------
(A) Represents balances related to companies acquired during the year.
(B) Represents accounts written off.
(a)(3)Exhibits:
- ------------------------
* Management contracts and compensatory plans and arrangements.
(d) Reports on Form 8-K.
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, and in the capacities and on the dates indicated. | 11,759 | 77,144 |
885475_1999.txt | 885475_1999 | 1999 | 885475 | ITEM 1. BUSINESS.
CORPORATE SUMMARY
HeavenlyDoor.com, Inc. together with its subsidiaries (collectively "HeavenlyDoor.com" or the "Company"), currently provides business to business and business to consumer products and services for the funeral service industry over the Internet. The Company plans to enhance and expand its web site to provide a broader range of products and services for senior citizens, including life insurance, assisted living, estate management and more. As such, the Company is positioning itself strategically as a senior life care portal. From its inception in 1985 to 1999, HeavenlyDoor.com operated as a biopharmaceutical company named Procept, Inc. ("Procept") that was engaged in the development and commercialization of novel drugs with a focus on infectious diseases and oncology. On March 17, 1999, Procept merged with Pacific Pharmaceuticals, Inc. ("Pacific"), and Pacific became a wholly owned subsidiary of Procept. On November 8, 1999 the Company announced a major strategic change in its business with the signing of an Agreement and Plan of Merger to acquire Heaven's Door Corporation. The merger with Heaven's Door Corporation was completed on January 28, 2000, and Procept's name was changed to HeavenlyDoor.com, Inc. The name of the Company's subsidiary, Pacific, was changed to Procept. After stockholder approval at the 2000 Annual Meeting, Procept will hold all of the biotechnology assets. The Company will now focus on growing the Internet business, while maximizing the value of the biotechnology assets.
Heaven's Door Corporation
The U.S. funeral industry is large and fragmented with approximately $15 billion in revenues in 1999 and over 30,000 funeral homes and cemeteries. The worldwide market is substantially larger with an estimated $50 billion in revenues. In addition, the pre-planning of funerals has grown significantly. More Americans are making their final resting plans ahead of time to spare family members the burden and are entering into pre-need agreements to purchase funeral and burial goods and services prior to death. Currently, funds in pre-need agreement exceed $25 billion according to the Committee on Aging Statistics GAO on Pre-Need. Industry analysts estimate the potential U.S. pre-need market at $85 billion.
HeavenlyDoor.com hopes to become the primary link between these pre-need customers and funeral homes. The pre-need customer can find substantial information on this difficult and sensitive topic from the privacy of his/her own home, and funeral homes can have a customized web site designed to reach these customers with computer set-up in their funeral homes, as well as national advertising support. Potential benefits for funeral homes are: natural access to additional customers, a web presence that most of them do not now have, and valuable business to business connectivity within their industry.
Visitors to the HeavenlyDoor.com web site will find a comprehensive funeral home search capability, interactive online obituaries and tributes, links to major
newspaper obituaries, various e-commerce features including sympathy gifts, flowers, cards, and detailed information concerning funerals and related topics. HeavenlyDoor.com plans to offer additional features including a bereavement chat room, grief and religious counseling, memorials for veterans, firefighters and police, a bulletin board, and a resource center for all funeral-related topics. Various business to business services are also being planned for the benefit of the funeral home. The HeavenlyDoor.com revenue model is multi-faceted and includes subscription fees from funeral homes, online obituaries, transaction fees from many types of e-commerce applications, and advertising fees.
Finally HeavenlyDoor.com is actively pursuing significant growth opportunities internationally and outside of the funeral industry as well. HeavenlyDoor.com is currently exploring expansion into the European funeral market and may develop plans for a related web site focused on religion. As HeavenlyDoor.com grows, it plans to expand its offerings to other products and services for the elderly and aging baby boomer population, including, but not limited to, the life care/assisted living industry and financial/estate planning.
Procept, Inc.'s Biotechnology Assets
Until the search for potential partners and acquirers of the biotechnology assets is complete, Procept intends to continue the clinical development of its two lead compounds, both of which have substantial government support.
PRO 2000 Gel. PRO 2000 Gel is being developed as a vaginal, topical microbicide designed to provide protection against human immunodeficiency virus ("HIV") infection, as well as herpes, chlamydial and gonorrhea infection. Two Phase I clinical trials showed that PRO 2000 Gel is safe and well tolerated in healthy, sexually abstinent women. A larger safety study in sexually active women and HIV-infected women is ongoing in the United States and South Africa, with support from the National Institute of Allergy and Infectious Diseases ("NIAID"), a unit of the National Institutes of Health ("NIH"). Procept envisions that the current clinical trial will be followed by a pivotal Phase II/III trial to demonstrate safety and protective efficacy in a population of women at high risk for HIV infection. Recent independent surveys have shown that the potential worldwide market for topical microbicides may exceed $1 billion annually.
O6-Benzylguanine ("BG"). BG is a chemosensitizer that is designed to overcome resistance to a significant class of commonly used chemotherapeutic agents known as O6-alkylating agents. In preclinical animal studies, treatment with BG increased the anti-tumor activity of these agents in brain, colon, and prostate cancers, as well as in melanoma. A Phase II development program has recently begun and will be conducted in accordance with a Cooperative Research and Development Agreement ("CRADA") executed with the National Cancer Institute ("NCI"). In addition to multiple myeloma, brain cancer, and melanoma, Procept hopes that BG may provide increased efficacy for O6-alkylating agents in other cancers, such as colon and breast, for which these agents are not commonly used.
INTERNET BUSINESS
HeavenlyDoor.com seeks to be a leader in offering products and services to the elderly and the aging baby boomer population through its web site. Currently, our web site offers consumers information about funeral products and services and Internet linking to funeral service providers, including funeral homes, cemeteries and monument dealers. The Company believes that the sale of pre-need and at-need products and services over the web offers attractive benefits to consumers including, without limitation, enhanced selection, convenience, ease-of-use, depth of content and information.
In addition, the site provides Internet linking to third party vendors of death-care products, such as books, flowers, and bereavement counseling. The key services of the web site include browsing, searching, and at-home easy one-stop guidance on the subject of death care. Over time, the Company anticipates expanding its products and services to senior citizens in other areas such as religion, life care/assisted living, and financial services. We also believe that financial/estate planning will provide opportunities for growth as well.
HeavenlyDoor.com offers to businesses participating in the funeral industry customized web page development services as well as linkage to the HeavenlyDoor.com site. The Company believes that its web site will offer funeral industry participants a compelling method of increasing their visibility and utilization. For the most part, the death-care industry has been subject to limited advertising options. During the past one hundred years, death-care providers have generally utilized regional trade magazines, yellow-page telephone directories and community newspaper publications as advertising outlets. We believe the HeavenlyDoor.com web site promises to enable death-care providers to enjoy the most aggressive marketing opportunity ever presented to the industry.
To date, our revenues have been derived from sales of our online products, advertising sales and funeral industry participants' subscriptions. We will seek to obtain revenue from our web site through:
o transaction fees on business to business applications;
o the sale of online products and services;
o commissions from third party e-commerce transactions; and
o sale of advertising space.
The Web Site
Overview. The Company's web site provides a simple, easy-to-use, online experience. Visitors to the web site find substantial information on the products and services from particular funeral industry providers, as well as general information on the funeral industry. Our subscribing funeral homes have customized web sites. We also provide lists of other funeral service providers who are not currently subscribers.
Visitors to the HeavenlyDoor.com web site will find features that include a comprehensive funeral home search capability, interactive online obituaries and tributes, as well as detailed information concerning funerals and related topics. We are developing additional features including a bereavement chat room, grief and religious counseling, memorials for veterans, firefighters and police, a bulletin board, and a resource center for all funeral-related topics. The key capabilities of the HeavenlyDoor.com web site are:
o Browsing. The web site offers visitors a variety of highlighted subject areas and special features arranged in a simple, easy-to-use fashion intended to improve funeral home, cemetery, or other product search, selection and discovery. In addition, the home page offers a menu of buttons linking to information of topical interest.
o Searching. A leading feature of the web site is its searchable database of more than 31,000 funeral homes, cemeteries, and monument dealers. In addition, visitors may search the online obituaries, or various businesses to business services.
o Reviews and Content. The web site offers multiple forms of materials to provide support, assistance, and information, to visitors. The content includes featured news columns, newspaper articles, online obituaries of various newspapers, and links to other sources.
Current Content. In addition to content resulting from the sale of our online products and our funeral industry listings and Internet links, HeavenlyDoor.com has sought to develop a broad array of content to attract visitors to the web page. These proprietary content offerings include:
o Lists of Related Web Sites. We provide a list of web page addresses for bereavement chat rooms, charities, hospices and other related web sites.
o Lists of Bereavement Related Books. We provide a list of books available through Amazon.com and a web page link to purchase books.
o Newspaper Obituaries. We provide web page links to obituaries published by major newspapers.
o Funeral Guide. We publish an Internet guide to the process of planning for, purchasing and conducting funerals and related products and services.
Online Products. While all content on our web page is accessible without a fee, we offer consumers the following online products at a fee. We have made arrangements with credit card merchant accounts to process our e-commerce transactions:
o Online Obituary. Consumers may purchase Online Obituaries, which are each a one hundred-word message and photograph posted on our web page. These obituaries are searchable and may be visited by interested users. While we have adopted the concept of the newspaper obituary, the placement of an obituary online allows friends and family members throughout the world to access the obituary year after year. We price the online obituary at a fraction of the cost of a one-time newspaper obituary. Viewers of online obituaries may post a message on a bulletin board dedicated to that obituary.
o Online Testimonial Announcements. Similarly, consumers can purchase special testimonial messages to celebrate the life of deceased loved ones or to commemorate anniversaries and special holidays. Testimonials can be purchased for one month at a time or for postings on certain holidays.
In addition to these individual product offerings, the web site also offers a wide selection of special package options to accommodate family needs.
Content Under Development. We are constantly investing in our web site content in order to expand the types of content and to maintain current content to attract return viewers. Our current development projects include:
o Bereavement Chat Room. We are developing an online chat room to provide a support group service. The chat room will be moderated by professional bereavement therapists, allowing participants from around the world to interact with the bereavement therapists "live" via the Internet.
o Online Obituary Pages of Honor. Our Online Obituary presents various marketing opportunities, particularly with regard to the concept of Honor Pages. We are developing
pages of Honor that memorialize Firefighters, Veterans from all wars and Law Enforcement officers. The Veterans page of Honor is currently being designed and organized under the direction of Major General Harry W. Brooks, a retired three star army general. The Firefighter and Police Honor pages are being developed under the direction of expert consultants still active in their respective service. The Online Obituary Honor pages will present an extended advertising opportunity for a variety of product manufacturers and service providers to target advertising campaigns directly to the 55 and over demographic markets. We believe that our Honor page feature will attract vast numbers of Americans and people from around the world, all of which are potential shoppers, to visit the web site in support of those fallen heroes.
E-Commerce. In addition to our direct online product offerings, our web site offers links to third party e-commerce web sites offering various products and services. These products include religious jewelry, flowers, catering, chocolates, books, sympathy cards, gift items, legal services, etc. We intend to expand our e-commerce vendor offerings to offer specialized products and services (which do not compete which the subscribing participants' offerings), such as estate planning, insurance policies, specialty books, legal services, etc. These additional offerings may be through linked web pages or direct custom e-commerce offerings by HeavenlyDoor.com.
Business to Business Services
The Company currently provides web site development services to funeral industry participants. In addition, we plan to implement a subscription program for funeral industry participants, under which, in exchange for web site linking and involvement in regional and national marketing activities, they will pay a monthly subscription fee.
The Company is currently developing a comprehensive business to business feature for its web site. This will enable industry vendors and death-care service providers to market products and services to each other while utilizing password protection to prevent consumers from accessing the business to business feature of the web site. We plan to charge transaction fees, thereby participating at multiple stages of the value-added chain on these business to business sales.
Sales and Marketing
While the HeavenlyDoor.com web site promises to enable death-care providers to enjoy the most aggressive marketing opportunity ever presented to the industry, promotion and advertising of the site itself may be the key to the overall success of the programs. The Company's sales and marketing strategy is designed to strengthen the HeavenlyDoor.com brand name, increase customer traffic to the web site, build a strong customer database, maximize repeat purchases and to develop incremental revenue opportunities. The Company seeks to build customer loyalty by creatively applying technology to deliver personalized web presence, as well as creative and flexible merchandising. The Company employs a variety of media, business development and promotional methods to achieve these goals, including online and traditional advertising and public relations activities.
Conventions and Trade Shows. Our web site has been well received with thousands of potential subscribers having visited the Company's show booth at the New Jersey State Trade Show, the National Funeral Directors Convention and Trade Show, and International Expo Trade Show. These trade shows are major industry events and have marked the launch of a full-scale sales effort by the Company to sign subscribers. The Company has received a significant number of inquiries from death-care service providers about HeavenlyDoor.com business to business and business to consumer capability. The Company has exhibited or plans to exhibit at nine convention/trade shows throughout the United States during the upcoming year.
Public Awareness National Seminar Program. We intend to implement a national seminar program in the second quarter of 2000. HeavenlyDoor.com's sales teams plan to visit key cities throughout the United States conducting public awareness seminars at senior centers in adult communities to the 55 and over demographic age groups. The Company believes that these seminars will enlighten the public in the use and benefits of the HeavenlyDoor.com web site. Subscribers will have the opportunity to be involved in organizing senior citizen groups to attend the seminars. The Company believes that this program will capture the interest of those so inclined to pre-plan as well as to enlighten other potential pre-planners to consider the benefits, the ease and stress-free method of reviewing their pre-need options while visiting the HeavenlyDoor.com web site.
Advertising. The Company believes a national advertising campaign is the best way to encourage visitors to use the web site and support the overall concept. Our advertising campaign planned for 2000 will feature television commercials, billboard and magazine ads. The campaign will focus on public awareness of the HeavenlyDoor.com web site and enlighten the public that pre-planning is easy, stress free, cost effective and a natural alternative method. This will involve a national spokesperson.
Funeral Industry Association Offerings. The funeral industry is characterized by several significant funeral industry associations. We believe that a key to accelerating subscriptions to our web site is through developing and maintaining relationships with these associations. For example, HeavenlyDoor.com is working with funeral industry associations to install quick-links on the association's member database to each HeavenlyDoor.com subscriber's web site, thereby allowing the association to maintain a direct relationship with members by building a mini-database with hyperlinks to each member. We currently do not charge any fee for this linking service, offering the funeral industry association enhanced communication, technology, and distribution services to the association and its members.
Customer Service
The Company believes its ability to build long-term relationships with its customers depends on offering an efficient service-oriented support team to respond to new and repeat customers. The Company seeks to maintain communication and respond to its customers while continually improving the web site. The Company offers e-mail addresses and telephone contact numbers to enable customers to request information and to receive feedback and suggestions. The Company intends to actively pursue enhancements to its customer support and service systems and operations.
Technology
The Company has implemented a range of site management, search, customer interaction, transaction-processing and fulfillment services and systems using commercially available, licensed technologies. The Company's current strategy is to focus its development efforts on licensing commercially developed technology for applications where available and appropriate.
The Company uses various software programs for building a web presence and processing customer orders with suppliers. The Company's transaction-processing systems are capable of searching through databases, identifying the selected products, and processing multiple orders. The software also allows access to e-commerce transactions that process customer debit and credit cards. In addition, the web site incorporates a variety of tools that allow the user to search databases, and link to other sites.
The Company's technology team will monitor and operate the web site, network operations and transaction-processing systems. The continued uninterrupted operation of the Company's web site and transaction-processing systems is essential to its business, and it is the job of the site technology team to ensure their reliability. The Company uses the services of Interland, the Company's current Internet service provider, to obtain connectivity to the Internet over multiple dedicated lines.
Proprietary Rights
HeavenlyDoor.com regards its copyrights, trademarks, trade dress, trade secrets, and similar intellectual property as critical to its success. HeavenlyDoor.com relies upon trademark and copyright law, trade secret protection and confidentiality or license agreements with its employees, customers, partners and others to protect its proprietary rights. HeavenlyDoor.com has obtained the registration for certain of its trademarks, including "HeavenlyDoor." Effective trademark, copyright, and trade secret protection may not be available in every country in which its products and media properties are distributed or made available through the Internet. HeavenlyDoor.com may license in the future elements of its distinctive trademarks, trade dress, and similar proprietary rights to third parties. While HeavenlyDoor.com attempts to ensure that the quality of its brand is maintained by its licensees, its licensees may take actions that could materially and adversely affect the value of its proprietary rights or the reputation of its products and media properties. The distinctive elements of HeavenlyDoor.com may not be subject to protection under copyright law. HeavenlyDoor.com cannot guarantee that the steps the Company has taken to protect its proprietary rights will be adequate. Many parties are actively developing death-care specific web sites. HeavenlyDoor.com believes that such parties will continue to take steps to protect these technologies, including seeking patent protection. As a result, HeavenlyDoor.com believes that disputes regarding the ownership of such technologies are likely to arise in the future. In addition, more general Internet use proprietary rights may be asserted. For example, HeavenlyDoor.com is aware that a number of patents have been issued in the areas of electronic commerce, online auctions, web-based information indexing and retrieval, online direct marketing, fantasy sports, common web graphics formats and mapping technologies. HeavenlyDoor.com anticipates that additional third-party patents will be issued in the future. To the extent that HeavenlyDoor.com determines that licensing such patents is appropriate, HeavenlyDoor.com cannot guarantee that it would be able to license such patents on reasonable terms. HeavenlyDoor.com may incur substantial expenses in defending against third-party patent claims regardless of the merit of such claims. In the event that there is a determination that HeavenlyDoor.com has infringed such third-party patent rights, HeavenlyDoor.com could incur substantial monetary liability and be prevented from using the rights in the future. In addition to patent claims, third parties may assert claims against HeavenlyDoor.com alleging infringement of copyrights, trademark rights, trade secret rights or other proprietary rights or alleging unfair competition.
There are no substantial barriers to entry in these markets, and HeavenlyDoor.com expects that competition will continue to intensify.
In the area of advertising revenue, HeavenlyDoor.com competes with online services, other web site operators and advertising networks, as well as traditional offline media such as television, radio and print for a share of advertisers' total advertising budgets. HeavenlyDoor.com believes
that the number of companies selling web-based advertising and the available inventory of advertising space has recently increased substantially. Accordingly, HeavenlyDoor.com may face increased pricing pressure for the sale of advertisements, which could reduce its advertising revenues. In addition, its sales may be adversely affected to the extent that its competitors offer superior advertising services that better target users or provide better reporting of advertising results.
PROCEPT SUBSIDIARY: BIOTECHNOLOGY DRUG DEVELOPMENT PROGRAMS
PRO 2000 Gel: A Microbicide to Prevent Human Immunodeficiency Virus ("HIV") and Sexually Transmitted Disease ("STD") Infection
PRO 2000 Gel is a topical microbicide designed to prevent the sexual transmission of HIV and other STD pathogens.
HIV infection usually leads to AIDS, a severe, life threatening impairment of the immune system. In 1999, the HIV epidemic continued with an estimated 5.8 million new infections worldwide. In addition, The Centers for Disease Control estimates that there are 330 million new cases of other STDs each year worldwide. "Topical microbicides," which are designed to provide a chemical barrier to infection, are an attractive alternative to male condoms; they are likely to be more acceptable than condoms and offer women a method they can use to protect themselves. Development of topical microbicides is a high priority for both the United States government and international agencies.
Procept believes that its proprietary antiviral compound PRO 2000 Gel is ideally suited for use as a topical microbicide. PRO 2000 was shown in laboratory studies to be effective at preventing HIV infection of cultured T cells, macrophages, and dendritic cells (dendritic cells are believed to be the first cells infected during sexual transmission). PRO 2000 showed high activity against HIV strains from both the developed and developing world; the virus did not develop resistance to the compound even after prolonged exposure. Preclinical studies also demonstrate that PRO 2000 is active against other STD agents including genital herpes simplex virus type 2 and Chlamydia trachomatis. In addition to its broad antiviral activity, the compound is straightforward to manufacture, highly stable, odorless and virtually colorless. PRO 2000 Gel has also been formulated for intravaginal use. In preclinical irritation studies, PRO 2000 Gel was shown to be much safer than the marketed vaginal spermicide containing nonoxynol-9. In other preclinical studies, PRO 2000 Gel was shown to be non-mutagenic, non-sensitizing and compatible with latex condoms.
Collaborators at the Children's Hospital Medical Center, Cincinnati, showed that vaginally applied PRO 2000 Gel can protect mice completely from vaginal infection from HIV infection. Moreover, unlike many other agents, PRO 2000 Gel provided significant protection even when applied up to an hour before exposure to the virus. These results, which were presented at the XII World AIDS Conference in Geneva in July 1998, provide greater confidence that PRO 2000 Gel will prevent STDs in humans. Genital herpes lesions are a significant public health problem and are believed to promote HIV infection; therefore, preventing the transmission of herpes may assist in the reduction of HIV infection.
The completed monkey study extends these results by showing that PRO 2000 Gel can also protect animals from infection by a HIV-like virus. The hybrid simian/HIV used in the study contains a HIV envelope and a simian immunodeficiency virus core, which allows it to infect monkeys. Because it contains HIV elements, the use of HIV rather than simian immunodeficiency may provide a better indication of PRO 2000 Gel's potential effectiveness against the human virus.
These promising results support accelerated human clinical evaluation of PRO 2000 Gel. Two Phase I clinical trials, completed in 1997, showed that daily intravaginal doses of 4% PRO 2000 Gel were safe and well tolerated in healthy, sexually abstinent women. One of these studies was supported by the British Medical Research Center ("MRC"). In July 1999, a Phase I/II clinical trial of PRO 2000 Gel was initiated by the National Institute of Allergy and Infectious Diseases ("NIAID"), a component of the National Institutes of Health ("NIH"), at sites in the United States and South Africa. The trial is designed to evaluate the safety, tolerance and acceptability of PRO 2000 Gel in healthy, sexually active women and in sexually abstinent HIV-infected women. HIV-infected women were included because the product is designed to inhibit both male-to-female and female-to-male transmission. A total of approximately 60 volunteers in 4 urban areas will be asked to apply the product up to twice a day for 2 weeks. Effects on the genital mucosa will be carefully assessed, and perceptions about the product will be ascertained through volunteer interviews and focus group discussions. This information is expected to extend the findings of previous Phase I clinical trials, and to aid in the selection of an appropriate dose for testing in a pivotal efficacy trial involving women at high risk for HIV infection. Phase II safety studies are also under discussion with the MRC. Procept believes that safety data from these trials, coupled with the promising animal protection results, will make PRO 2000 Gel an attractive candidate for testing in a large, government-funded Phase III clinical trial designed to demonstrate safety and protective efficacy.
The Company holds two issued patents on the use of PRO 2000 Gel to prevent HIV infection. Procept announced that it had received two Notices of Allowance from the United States Patent and Trademark Office relating to PRO 2000, the Company's lead anti-infective drug candidate. One patent contains composition-of-matter claims covering PRO 2000 and similar compounds, while the other covers the use of a PRO 2000-based vaginal gel formulation for the prevention of pregnancy. A similar contraception patent was independently allowed in South Africa. Additional international patent applications have been filed.
O6-benzylguanine ("BG"): A Chemosensitizer to Enhance Chemotherapy
Procept's wholly owned subsidiary, BG Development Corp. ("BGDC"), holds an exclusive worldwide license from Pennsylvania State University ("Penn State") and others for BG, a series of related compounds and a gene therapy that Procept believes will enhance the effectiveness of a class of currently used chemotherapeutic agents known as O6-alkylators agents.
BG and related compounds are small molecules for intravenous administration in the treatment of cancer. Procept believes BG to be capable of destroying the resistance of cancer cells to a class of chemotherapeutic agents, O6-alkylating agents. Procept believes that the effectiveness of alkylating chemotherapeutic agents against various tumors such as brain, prostate, colon cancers, melanoma and lymphoma is limited due to the ability of tumor cells to repair the DNA damage caused by the O6-alkylating agents, because the DNA repair protein, O6-alkylguanine-DNA alkyltransferase ("AGT"), protects tumor cells by repairing the tumor cell DNA. Procept believes that BG inactivates the AGT protein in a variety of cancers thereby overcoming resistance to the O6-alkylating agents.
The treatments for most cancers include surgery, radiation therapy and/or chemotherapy. O6-alkylators are chemotherapeutic agents that are primarily used to treat brain cancer, melanoma, lymphoma and certain gastrointestinal cancers. They include carmustine ("BCNU"), lomustine ("CCNU"), dacarbazine ("DTIC"), procarbazine, fomustine, and temozolomide. CCNU, fomustine and DTIC remain important in the chemotherapeutic treatment of brain cancer and advanced melanoma. Procarbazine has become an important agent in the treatment of Hodgkin's disease and brain tumors. Temozolomide has shown potential for the treatment of lymphomas, melanoma and brain tumors. In general, although there is a small percentage of patients who have achieved long-term remission, the O6-alkylators are generally not considered curative. The critical
factor contributing to the poor prognosis is the resistance of cancers to the chemotherapeutic agents.
Tumor cells display a variety of mechanisms of resistance to many drugs. Alkylating agents act by causing damage to the DNA by binding to the O6-position of guanine on the DNA strand. AGT is believed to play a significant role in cancer resistance to the O6-alkylators by removing this chemical bond. A published study in 226 patients with brain cancer (high-grade astrocytoma) receiving BCNU therapy showed that the patients with low levels of AGT responded better to treatment and had increased survival relative to patients with high levels of AGT. Conversely, the patients with high levels of tumor AGT protein had poor disease prognosis. Since it appears that BG temporarily destroys AGT, Procept believes that BG may reduce the resistance that is commonly observed in cancer cells following treatment with O6-alkylating agents.
O6-alkylating agents such as BCNU and CCNU are believed to cause a number of different damages to the tumor DNA, including an interstrand cross-link between guanine and cytosine (building blocks of DNA) on the opposite strand. Procept believes that there is a strong correlation between the number of strand cross-links and tumor cells killed. AGT protein protects tumor cells from damage by removing the damage from the O6-position of guanine. Procept believes that there are no other proteins involved in the repair process, and that the AGT protein is inactivated in the repair process. Procept believes that BG binds to the AGT protein, thereby blocking the tumor DNA repair and believes that inactivation of the AGT protein in a variety of human tumors by non-toxic doses of BG could render these tumors more sensitive to the cytotoxic effects of O6-alkylating agents.
Results of in vitro testing have led to an evaluation of O6-alkylating agents in animal tumor models. Upon administration of BG to mice carrying two different human brain tumors prior to the administration of BCNU, 80% and 100% tumor regression was observed compared to 0% and 10% suppression in animals treated with BCNU alone. Combinations of BG and BCNU were also found to be effective in mice bearing human colon cancers, showing 96% tumor regression compared to 35% tumor regression with BCNU alone. Growth inhibition was also observed in a rat prostate model after treatment with BG and BCNU, but was not observed in animals treated with BCNU alone.
A Phase I clinical trial of BG has been completed at Duke University ("Duke"). Procept believes that the study has shown that BG, injected intravenously, crosses the blood-brain barrier and effectively blocks the activity of human brain tumor AGT protein. Procept also believes that the study at Duke has demonstrated BG to be nontoxic when administered alone, and to be effective in inhibiting over 90% of AGT activity in brain cancer specimens surgically removed from patients 18 hours after the intravenous administration of BG. Three other Phase I clinical studies at the University of Chicago, Case Western Reserve University ("CWRU") and Duke University Medical Center have examined the use of BG in combination with BCNU in brain, colon and renal cancer. In these studies, BG was administered over a one-hour period by intravenous infusion, followed by an infusion of BCNU one hour after completion of the BG infusion. The National Cancer Institute ("NCI") of the National Institutes of Health ("NIH") is sponsoring the trials under a Cooperative Research and Development Agreement ("CRADA") executed between the NCI and Pacific. From these studies, which involved patients who had failed other cancer therapies, a BG/BCNU dose of 120/40 mg/m2 was chosen as the initial Phase II dose. Preliminary clinical response data for the Phase I trial conducted at CWRU was presented by Dr. Timothy P. Spiro at the 1999 Annual Meeting of the American Society of Clinical Oncology. One metastatic colon carcinoma patient achieved a sustained partial response for 13 months after failing other therapies. A second patient with carcinoma of unknown primary had sustained stable disease for 20 months. The Phase I trials have successfully demonstrated the safety of BG, and the Company is eager to obtain efficacy data in Phase II. Procept plans to test BG in several cancer indications, and with other chemotherapeutic agents such as the Gliadel
Wafer and temozolomide. The NCI and many investigators continue to support the clinical development of BG for a variety of cancer indications. In addition to multiple myeloma, brain cancer and melanoma, Procept hopes that BG may provide increased efficacy for O6-alkylating agents in other cancers, such as colon and breast, for which O6-alkylating agents are not commonly used.
Standard therapy with O6-alkylating chemotherapeutic agents commonly results in bone marrow suppression. Through the BG license, Procept has also acquired a proprietary gene therapy that may result in the production of an altered AGT protein in bone marrow cells. A gene for an altered AGT protein is introduced to the bone marrow hematopoietic stem cells in vitro, followed by the introduction of the modified stem cells to the host. Procept believes that the concomitant use of an O6-alkylating agent plus BG in the presence of the altered AGT protein may result in reduced resistance of the cancer cells with less toxicity to the bone marrow.
In addition to BG, Procept has tested a considerable number of additional compounds for AGT protein inactivation. Procept believes that a number of next generation compounds are effective in inhibiting the activity of tumor AGT protein. Procept also believes that it has a proprietary interest in these compounds. Procept believes that it is possible that these compounds will offer complementary properties to that of BG in further abrogation of cancer resistance to O6-alkylating agents.
Four patents including the composition of matter and use for BG and related compounds have been issued to Penn State and licensed to BG. Four additional applications provide protection for the next generation compounds. A patent application currently under prosecution is intended to provide protection for the use of gene therapy to introduce AGT mutant into the stem cells.
In September 1998, Procept paid to Penn State $150,000 as an up-front licensing fee. Penn State will also be due a (i) royalty on sales of licensed products, (ii) certain performance-based milestones, and (iii) a non-refundable, minimum annual royalty (the "Minimum Annual Royalty") equal to $75,000 per year creditable against future milestone payments and third party payments, subject to certain deferrals. The licensing agreement gave Procept the option to fulfill up to 75% of its obligations, to pay minimum annual royalties or performance milestones through the issuance of a number of shares of Procept's common stock equal to the cash value of such payments. Procept is obligated to reimburse the Licensor approximately $200,000 for prior patent costs. Procept may issue shares of its common stock in lieu of these payments.
In 1998, the NIH entered into a CRADA with Pacific. Under the terms of the agreement, the NIH will conduct research involving BG and will make available to the Company (i) NIH clinical data relating to any potential products incorporating BG developed or generated by NIH prior to the date of the CRADA and (ii) all subsequent data developed under the CRADA. The Company is required to pay the NIH $125,000 per year for five years, payable in quarterly installments.
Periodontal Tissue Monitor ("PTM")
Procept holds the rights to a proprietary diagnostic test of periodontitis, known as PTM. PTM is an eye-readable, chairside disposable test designed for use within the dental office to assist practitioners (dentists and periodontists) in the diagnosis of periodontitis and in the monitoring of the effectiveness of their efforts to treat the disease. The PTM works by identifying the enzyme AST which is found in crevicular fluid when cells die.
In June 1997, Pacific received approval from the United States Food and Drug Administration ("FDA") to begin commercial sales and distribution in the United States of the PTM product. Pacific also had two distribution agreements with Steri-Oss, Inc. for the exclusive distribution of PTM worldwide, except in Japan. To date, there have been no significant sales under the distribution agreements. In addition in 1998, Nobel Biocare AB acquired Steri-Oss, Inc. and decided to terminate the agreement.
Shofu, Inc. of Japan is currently completing clinical trials of PTM in Japan under a Material Transfer Agreement with Procept and may decide to market PTM in Japan if the product is ultimately approved by Japanese regulators.
Patents and Proprietary Technology
Procept's policy is to protect its technology by, among other things, filing or causing to be filed on its behalf, patent applications for technology relating to the development of its business. Currently, the Company is awaiting action on various patent applications relating to technology or the uses or products thereof that it owns or that it has licensed.
The Company believes its copyrights, service marks, trademarks, trade dress, trade secrets, proprietary technology and similar intellectual property is critical to its success. The Company relies on trademark, copyright and trade secret protection in conjunction with confidentiality and/or license agreements with its employees, consultants, partners and others to protect its proprietary rights. The Company pursues the registration of its trademarks and service marks in the U.S. and internationally, and has applied for the registration of certain of its trademarks and service marks. As the Company expands into overseas markets, the Company will seek a best efforts approach for effective trademark, service mark, copyright, and trade secret protection in countries in which the Company's products and services are made available online.
To protect its right to and to maintain the confidentiality of trade secrets and proprietary information, the Company requires employees, Scientific Advisory Board members, consultants and collaborators to execute confidentiality and invention assignment agreements upon commencement of a relationship with the Company. These agreements prohibit the disclosure of confidential information to anyone outside the Company and require disclosure and assignment to the Company of ideas, developments, discoveries and inventions made by employees, consultants, advisors and collaborators.
The Company's ability to compete effectively with other companies will depend, in part, on the ability of the Company to maintain the proprietary nature of its technology. Although the Company has been granted, has filed applications for and has licensed a number of patents in the United States and foreign countries, there can be no assurance as to the degree of protection offered by these patents, as to the likelihood that pending patents will be issued or as to the validity or enforceability of any issued patents.
Competitors in both the United States and foreign countries, many of which have substantially greater resources and have made substantial investments in competing technologies, may have applied for or obtained, or may in the future apply for and obtain, patents that will prevent, limit or interfere with the Company's ability to make and sell its products. There can be no assurance that other third parties will not assert infringement claims against the Company or that such claims will not be successful. There can also be no assurance that competitors will not infringe the Company's patents. Further, with respect to licensed patents, which, in the case of the Company, represent a significant portion of the Company's proprietary technology, the defense and prosecution of patent suits may not be in the Company's control.
The Company also relies on unpatented proprietary technology that is significant to the development of the Company's technology, and there can be no assurance that others may not independently develop the same or similar technology or otherwise obtain access to HeavenlyDoor.com's unpatented technology. If the Company is unable to maintain the proprietary nature of its technology, the Company could be adversely affected.
Government Regulations
Regulations imposed by United States, federal, state and local authorities, as well as their counterparts in other countries, are a significant factor in the conduct of the research, development, manufacturing and marketing activities for the Company's proposed pharmaceutical products.
Before testing of any compounds with potential therapeutic value in human test subjects may begin, stringent government requirements for preclinical data must be satisfied. These data, obtained both from in vivo studies and in vitro studies, are submitted in an Investigational New Drug ("IND") Application or its equivalent in countries outside the United States where clinical studies are to be conducted.
All data obtained from a comprehensive development program are submitted in New Drug Application ("NDA") or Product License Application ("PLA") to the FDA and the corresponding agencies in other countries for review and approval.
In addition to the regulations relating specifically to product approval, the activities of the Company, its partners and licensees are subject to laws and regulations regarding laboratory and manufacturing working conditions, handling and disposition of potentially hazardous material, and use of laboratory animals. In many markets, effective commercialization also requires inclusion of the product in national, state, provincial or institutional formularies or cost reimbursement systems.
Completing the multitude of steps necessary before marketing can begin requires the expenditure of considerable resources and can consume a long period of time. Delay or failure in obtaining the required approvals, clearances, permits or inclusions by the Company, its collaborators or its licensees would have an adverse effect on the ability of the Company to generate sales or royalty revenue. In addition, the impact of new or changed laws or regulations cannot be predicted.
COMPETITION
Internet
The world wide web currently has new start-up web sites evolving every day generating competition in all areas including the funeral industry. The e-commerce market via web sites is growing and intensely competitive. There are no substantial barriers to entry in these markets, and HeavenlyDoor.com expects that competition will continue to intensify. The Company's current or potential competitors include (1) online web sites offering similar services, (2) indirectly by corporate conglomerates, associations, or other groups of funeral homes implementing similar services, (3) distributors and retail vendors of funeral supplies with significant brand awareness, sales volume and customer bases. The Company believes the principal competitive factors in its market are brand recognition, quality selection, personalized services, convenience, price, accessibility, customer service, quality of search tools, quality of site content, and reliability. Some of the Company's competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than the Company. Certain of the Company's competitors may be able to offer similar or additional services with more favorable terms, devote larger resources to marketing and promotional campaigns, adopt more aggressive pricing or inventory availability policies and devote
substantially more resources to web site, web presence, and system development than the Company. Increased competition may affect the Company's business plan in areas of operating margins and market share. In the area of advertising revenue, HeavenlyDoor.com competes with online services, other web site operators and advertising networks, as well as traditional offline media such as television, radio and print for a share of advertisers' total advertising budgets. HeavenlyDoor.com believes that the number of companies selling web-based advertising and the available inventory of advertising space has recently increased substantially. Accordingly, HeavenlyDoor.com may face increased pricing pressure for the sale of advertisements, which would reduce its advertising revenues. In addition, its sales may be adversely affected to the extent that is competitors offer superior advertising services that better target users or provide better reporting of advertising results.
Biotechnology
The biotechnology and pharmaceutical industries are subject to rapid and significant technological change. Competitors of the Company in the United States and abroad are numerous and include, among others, major pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions. Competition may increase further as a result of potential advances in the commercial application of biotechnology and greater availability of capital for investment in these fields. Acquisitions of competing companies and potential competitors by large pharmaceutical companies or others could enhance financial, marketing and other resources available to such competitors. As a result of academic and government institutions becoming increasingly aware of the commercial value of their research findings, such institutions are more likely to enter into exclusive licensing agreements with commercial enterprises, including competitors of the Company, to market commercial products. There can be no assurance that the Company's competitors will not succeed in developing technologies and products that are more effective than any which are being developed by the Company or which would render the Company's technology obsolete and noncompetitive, or that such competitors will not succeed in obtaining FDA or other regulatory approvals for products more rapidly than the Company.
EMPLOYEES
As of March 18, 2000, the Company employed 20 full-time and 3 part-time employees. The Company also utilizes independent contractors to perform various functions for the Company. Currently, the Company's employees are not represented by a labor union, and the Company regards its employee relations to be in good standing. Due to the intense competition for qualified personnel in the Company's industry, particularly for software development and other technology personnel, the Company believes its future success depends in part on the continued ability to hire and retain qualified personnel.
ITEM 2.
ITEM 2. PROPERTIES.
HeavenlyDoor.com's headquarters and research and development facilities are located in Cambridge, Massachusetts. At its 840 Memorial Drive location, HeavenlyDoor.com leases a total of approximately 41,200 square feet of space, which includes approximately 34,800 square feet of research laboratories. HeavenlyDoor.com currently subleases substantially all of the laboratory space at its headquarters to start-up pharmaceutical or biotechnology companies. HeavenlyDoor.com also leases approximately 3,400 square feet of space at 84 Hamilton Street, which includes approximately 1,100 square feet of research laboratories. HeavenlyDoor.com believes such laboratory space will be adequate for its existing research and drug development activities.
Heaven's Door Corporation leases approximately 3,000 square feet of office space at 3300 N. University Drive, Coral Springs, Florida.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
On October 23, 1997, Commonwealth Associates ("Commonwealth") filed a Complaint with the United States District Court for the Southern District of New York naming the Company as a defendant (the "Complaint"). The Complaint alleges that the Company breached obligations to Commonwealth under the Underwriting Agreement between Commonwealth and the Company dated February 8, 1996, giving Commonwealth a right of first refusal to act as co-lead underwriter or co-managing agent of a public offering or private placement of the Company's securities during the period ended August 8, 1997. In the Complaint, Commonwealth seeks aggregate compensatory damages in the amount of $375,000, incidental and consequential damages in an amount to be proven at trial, costs, disbursements and accrued interest and such other and further relief as the court deems proper. The Company served an answer on or about March 16, 1998 denying Commonwealth's allegations and has engaged in substantial discovery. At a court-sponsored mediation held on February 9, 1999, the Company and Commonwealth reached an agreement in principle to settle this matter whereby Commonwealth agreed to dismiss the suit in return for payment of $45,000 in cash and 36,785 shares of the Company's common stock. In early 1999, the Company made these payments.
On February 22, 1999, Christopher R. Richied ("Richied") filed a Complaint with the United States District Court for the Southern District of New York naming Pacific Pharmaceuticals, Inc. ("Pacific") and Binary Therapeutics Inc. ("Binary"), both subsidiaries of the Company, as defendants (the "Complaint"). The Complaint alleges that Pacific and Binary breached obligations to Richied under certain consulting agreements. In the Complaint, Richied seeks approximately $40,000 in cash and an indeterminate amount based upon the value of certain equity components of the consulting agreements. The Company's answer to the Complaint was filed on August 9, 1999. Based on facts alleged in the Complaint, the Company does not believe this action will have a material adverse effect on the Company's business, even in the event of a decision by the court in the plaintiff's favor or other conclusion of the litigation in a manner adverse to Pacific and Binary.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.
No matters were submitted to a vote of securityholders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
From February 17, 1994, the date of the Company's initial public offering, until March 26, 1998, the Company's common stock was quoted on the Nasdaq National Market under the symbol "PRCT". From March 27, 1998 through January 27, 2000, the Company's common stock has been quoted on the Nasdaq SmallCap Market under the symbol "PRCT". Beginning January 28, 2000, effective with the merger with Heaven's Door Corporation, the Company's shares are quoted on the Nasdaq SmallCap market under the trading symbol "HVDC." The following table sets forth the range of high and low closing sale prices for HeavenlyDoor.com's common stock as reported by the Nasdaq National Market and the Nasdaq SmallCap Market for the periods indicated below. The dollar values in this table have been adjusted to reflect the one-for-ten reverse split of HeavenlyDoor.com's common stock effected on June 1, 1998 and the one-for-seven reverse split of HeavenlyDoor.com's common stock effected on October 14, 1997.
High Low ---- --- Fourth Quarter $3.68 $1.38 Third Quarter $2.28 $1.13 Second Quarter $2.50 $1.38 First Quarter $4.50 $2.00
Fourth Quarter $3.50 $0.31 Third Quarter $4.06 $0.94 Second Quarter $13.13 $3.63 First Quarter $11.86 $6.25
As of March 22, 2000 there were 1,656 holders of record. On March 22, 2000 the closing price reported on the Nasdaq SmallCap Market for HeavenlyDoor.com Common Stock was $3.75.
Dividend Policy
The Company has never paid cash dividends on its common stock and does not anticipate paying such dividends in the foreseeable future. HeavenlyDoor.com intends to retain any future earnings for use in its business. See "Management Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The selected financial data set forth below as of December 31, 1999 and 1998 and for each of the three years in the period ended December 31, 1999 are derived from the Company's financial statements included elsewhere in this Report, which have been audited by PricewaterhouseCoopers LLP, independent accountants. The selected financial data set forth below as of December 31, 1997, 1996 and 1995 and for the years ended December 31, 1996 and 1995 are derived from audited financial statements not included in this Report. This data should be read in conjunction with the Company's financial statements and related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
OVERVIEW
From its inception in 1985 through 1999, HeavenlyDoor.com, Inc. (formerly "Procept, Inc." or the "Company") operated as a biopharmaceutical company engaged in the development and commercialization of novel drugs with a product portfolio focused on infectious diseases and oncology. On March 17, 1999, Procept completed its merger with Pacific Pharmaceuticals, Inc. ("Pacific"), in which Pacific became a subsidiary of the Company. On November 8, 1999, the Company announced a major strategic change in its business with the signing of an Agreement and Plan of Merger to acquire Heaven's Door Corporation, a company that provides business to business and business to consumer products and services for the funeral service industry over the Internet. The merger with Heaven's Door Corporation closed on January 28, 2000. Effective with the merger with Heaven's Door Corporation, the Company's name was changed from Procept, Inc. to HeavenlyDoor.com, Inc. The Company will focus on growing the Internet business, while maximizing the value of the biotechnology assets through outlicense or disposition.
RESULTS OF OPERATIONS
From inception through December 31, 1999, the Company has generated no revenues from product sales, has not been profitable since inception, and has an accumulated deficit of $76.8 million. During that period, the Company was dependent upon corporate collaborations, equity
financing and interest on invested funds to provide the working capital necessary for the research and development activities. Losses have resulted principally from costs incurred in research and development activities related to the Company's efforts to develop drug candidates and from the associated administrative costs required to support these efforts. The Company expects to incur significant additional operating losses over the next several years due to its ongoing efforts to develop the new Internet business and its acceptance in the funeral services industry.
Years ended December 31, 1999 compared to the year ended December 31, 1998
The Company's total revenues decreased 15.2% to $0.28 million for the year ended December 31, 1999 from $0.33 million during the comparable period of 1998. The $50,000 decrease resulted primarily from the expiration of the Sponsored Research Agreement with VacTex, Inc. offset by an increase in interest income. Interest income increased 27.3% to $0.28 million for the year ended December 31, 1999 from $0.22 million for the comparable period of 1998. The $60,000 increase in interest income resulted from additional cash balances available for investment during the year ended December 31, 1999.
The Company's total operating expenses increased 305.6% to $14.6 million for the year ended December 31, 1999 from $3.6 million for the comparable period in 1998. The $11.0 million increase primarily resulted from a $9.4 million in-process research and development charge associated with the acquisition of Pacific, and a $2.5 million compensation charge associated with the revaluation of variable stock options. Without these charges, total operating expenses decreased $25.0% to $2.7 million for the year ended December 31, 1999 from $3.6 million for the comparable period of 1998. Research and development decreased 45.0% to $1.1 million for the year ended December 31, 1999 from $2.0 million for the comparable period of 1998. The $0.9 million decrease primarily resulted in a decline in personnel in the Company's biotech research and development organization and their related costs. In January 1998, the Company terminated work on all research programs other than PRO 2000 and underwent a significant downsizing, reducing its staff to ten people. General and administrative expenses decreased $35,000, or 2.2% to $1.6 million for the year ended December 31, 1999. The decrease primarily resulted from lower professional services expenditures. Other income of $34,000 recorded during the year ended December 31, 1999 resulted primarily from the gain on sale of pharmaceutical research and development equipment and supplies. Based on the Company's strategy, the Company has sold or plans to continue to sell its research and development equipment.
In June of 1999, the Company incurred a $0.5 million non-cash charge associated with the purchase of the minority interest of its majority owned subsidiary, BG Development Corp. ("BGDC").
Years ended December 31, 1998 and 1997
The Company's 1998 total revenues decreased to $0.3 million from $0.8 million in 1997. In 1998, revenues consisted of $0.1 million earned under the Sponsored Research Agreement with VacTex and $0.2 million in interest earned on invested funds. In 1997, revenues consisted of $0.5 million earned under the VacTex Agreement, $0.1 million under a grant from the National Cooperative Drug Discovery Group and $0.1 million in interest earned on invested funds. The decrease in revenue from VacTex is the result of the Company not renewing the Sponsored Research Agreement in order to apply available resources to the PRO 2000 Gel development program.
The Company's 1998 total operating expenses decreased to $3.6 million from $9.8 million in 1997. Research and development expenses decreased 70% to $2.0 million in 1998 from $6.6 million in 1997, due primarily to a decrease in personnel in the Company's research and development organization and their related research costs. In order to focus its limited resources
on PRO 2000 Gel, in January 1998 the Company terminated work on all other research programs, except preclinical support for its intracellular T-cell enzyme (DHODH) program, and underwent a significant downsizing, reducing its staff to 10 people. The amount of termination benefits accrued and charged to restructuring costs in the statement of operations for the year ended December 31, 1998 was $0.2 million. Also in 1997, the Company accrued $0.5 million in restructuring costs. The amount of termination benefits paid and charged against the 1998 and 1997 liability for the year ended December 31, 1998 was $0.4 million. The remaining liability of $0.1 million was utilized by March 31, 1999.
General and administrative expenses for 1998 decreased 41% to $1.6 million from $2.7 million in 1997, reflecting a decrease in administrative personnel and continued cost control measures including subleasing of its facility. Interest expense, included in other expenses, decreased to $5,000 in 1998 from $40,000 for 1997 as a result of the scheduled completion of the Company's equipment lease financing arrangements. Also included in other expenses in 1998 is a gain of $0.2 million from the sale of research and development equipment. Based on the Company's current strategy, Company has sold and plans to continue to sell most of its research and development equipment.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception through December 31, 1999, the Company has financed its operations from the issuance of $68.0 million of its securities, the receipt of $29.4 under collaborative research agreements and $3.2 million in interest income.
For the year ended December 31, 1999, the Company incurred a net loss of approximately $14.3 million. The net loss included non-cash charges of approximately $9.4 million for purchased in-process research and development and an approximate $2.5 million charge associated with variable stock options. During 1999, the Company used approximately $3.5 to fund operating activities.
The acquisition of Pacific resulted in a cash infusion of approximately $2.8 million. In addition, during 1999 the Company received approximately $2.0 million from the maturity of marketable securities. For the period, investing activities provided the Company with approximately $4.6 million of cash.
During the year ended December 31, 1999, the Company paid off a short-term note payable of $85,000. The Company received approximately $0.2 million from the exercise of common stock warrants. Net cash provided by financing activities amounted to approximately $0.1 million.
At December 31, 1999, the Company's aggregate cash, cash equivalents and marketable securities were $4.1 million, representing a $0.8 million decrease from December 31, 1998. Included in cash is $41,000 from the sale of pharmaceutical research and development equipment. Based on the Company's current strategy, the Company plans to continue to sell most of its research equipment.
On March 17, 1999, the Company completed the acquisition of Pacific, a publicly held research and development company engaged in the development of cancer therapies. Each of Pacific's shares of common stock (including preferred stock on an as converted basis into common stock) converted into approximately 0.11 shares of the Company's common stock or a total of 2,753,205 shares. An additional 414,584 shares of the Company common stock were issued in the merger to the holders of Pacific's preferred stock as a result of certain contractual rights identical to contractual rights held by purchasers of the Company's 1998 Offering. In addition, the Company agreed to exchange all of Pacific's outstanding warrants, unit purchase option and stock option obligations into like instruments of the Company. The Company also assumed an
approximately $6.5 million net obligation (payable in cash or common stock of the Company at the option of the Company) of Pacific's subsidiary, BG Development Corp ("BGDC"). On June 30, 1999, the Company issued 2,773,575 common shares and 924,525 Class D Warrants in exchange for outstanding preferred stock of its subsidiary, BGDC. The shares have contractual rights identical to those held by purchasers in the Company's 1998 Offering. The Class D Warrants are exercisable for an aggregate of 924,525 shares of the Company's common stock at $2.11 per share and expire on June 30, 2004.
On March 28, 2000, the Company received proceeds of approximately $3.1 million from the exercise of approximately 1.3 million warrants by The Aries Trust and The Aries Domestic Fund, L.P. These warrants were exercised at a discount to the contractual strike price. Accordingly, a charge of approximately $1.1 million will be recorded in the first quarter of 2000. The Company expects that its current funds, along with the proceeds generated through the exercise of these warrants and interest income will be sufficient to fund the Company's operations into the second quarter of 2001. Although management continues to pursue additional funding arrangements, no assurance can be given that such financing will be available to the Company. If the Company is unable to produce revenue or secure additional financing, the Company's financial condition will be adversely affected. If additional funds are raised by issuing equity securities, further dilution to existing shareholders will result and future investors may be granted rights superior to those of existing shareholders.
The Company's expectations regarding its rate of spending and the sufficiency of its cash resources over future periods are forward-looking statements. The rate of spending and sufficiency of its cash resources will be affected by numerous factors including the rate of planned and unplanned expenditures by the Company, the success of the Internet business, the execution of new partnership agreements, or the sale or license of the Company's biotechnology programs.
RECENTLY ISSUED FINANCIAL AND ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement was originally effective for all fiscal year ends beginning after June 15, 1999. In June 1999, the FASB issued Statement 137, which delayed the effective date of Statement 133 by one year. Statement 133 is currently effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designed as part of a hedge transaction and, if it is, the type of hedge transaction. The Company does not believe that the adoption of SFAS 133 will have a significant effect on the Company's results of operations or its financial position.
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," ("SAB 101") which is effective no later than the quarter ending March 31, 2000. SAB 101 clarifies the Securities and Exchange Commission's views regarding recognition of revenue. In March 2000, the Securities Exchange Commission issued Staff Accounting Bulletin No. 101A, "Amendment: Revenue Recognition in Financial Statements" ("SAB 101A"). SAB 101A delays the implementation date of SAB 101 by one quarter to the quarter ending June 30, 2000 for registrants with the fiscal years that begin between December 16, 1999 and March 15, 2000. The Company does not believe that the adoption of SAB 101 will have a significant effect on the Company's results of operation or its financial position.
YEAR 2000
During 1998, the Company completed its assessment of the potential impact of the year 2000 on its information technology and non-information technology systems. The year 2000 problem as defined is the result of computer programs being written using two digits (rather than four) to define the applicable year. Any of the Company's programs or systems that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000, which could result in a miscalculation or system failures. Based on the Company's assessment, there is no year 2000 impact on the Company's information technology systems. Operating systems and applications used by the Company are year 2000 compliant. At this time, the Company is not aware of any year 2000 issues relating to its third party vendors. The Company replaced several non-information technology systems. The cost of year 2000 compliant non-technology information systems was approximately $8,000. The Company's most critical uncertainty relates to its third parties' information technology systems not being year 2000 compliant. This may result in inaccurate information from banks, government agencies, contracted research organization, vendors, etc. As of March 2000, the Company had not experienced any adverse effects as a result of the year 2000 problem.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
In January 1997, the Securities and Exchange Commission issued Financial Reporting Release 48 ("FRR 48"), "Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments." FRR 48 required disclosure of qualitative and quantitative information about market risk inherent in derivative financial instruments, other financial instruments, and derivative commodity instruments beyond those already required under generally accepted accounting principles. The Company is not a party to any of the instruments discussed in FRR 48 and considers its market risk to be minimal.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Page(s) ------
Report of Independent Accountants 25
Consolidated Balance Sheets as of December 31, 1999 and 1998 26
Consolidated Statements of Operations for the years ended December 31, 1999, 1998, and 1997 27
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 1999, 1998, and 1997 27
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1999, 1998, and 1997 28-29
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998, and 1997 30-31
Notes to Financial Statements 32-53
Financial statement schedules have been omitted since they are not required or are inappropriate.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of HeavenlyDoor.com, Inc. (formerly Procept, Inc.):
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income (loss), shareholders' equity and cash flows present fairly, in all material respects, the financial position of HeavenlyDoor.com, Inc. and its subsidiaries (formerly Procept, Inc.) at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
Boston, Massachusetts March 29, 2000
HEAVENLYDOOR.COM, INC. (FORMERLY PROCEPT, INC.) CONSOLIDATED BALANCE SHEETS ----------------
The accompanying notes are an integral part of the financial statements.
HEAVENLYDOOR.COM, INC. (FORMERLY PROCEPT, INC.) CONSOLIDATED STATEMENTS OF OPERATIONS --------------
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
--------------
The accompanying notes are an integral part of the financial statements.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Consolidated Statements of Shareholders' Equity For the Years Ended December 31, 1999, 1998, and 1997
The accompanying notes are an integral part of the financial statements.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Consolidated Statements of Shareholders' Equity For the Years Ended December 31, 1999, 1998, and 1997 (continued)
The accompanying notes are an integral part of the financial statements.
HEAVENLYDOOR.COM, INC. (FORMERLY PROCEPT, INC.) CONSOLIDATED STATEMENTS OF CASH FLOWS -------------
The accompanying notes are an integral part of the financial statements.
HEAVENLYDOOR.COM, INC. (FORMERLY PROCEPT, INC.) CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) -------------
The accompanying notes are an integral part of the financial statements.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
A. Nature of Business
From its inception in 1985 through 1999, HeavenlyDoor.com, Inc. (formerly "Procept, Inc." or the "Company") operated as a biopharmaceutical company engaged in the development and commercialization of novel drugs with a product portfolio focused on infectious diseases and oncology. On March 17, 1999, Procept completed its merger with Pacific Pharmaceuticals, Inc. ("Pacific"), in which Pacific became a subsidiary of the Company. On November 8, 1999, the Company announced a major strategic change in its business with the signing of an Agreement and Plan of Merger to acquire Heaven's Door Corporation, a company that provides business to business and business to consumer products and services for the funeral service industry over the Internet. The merger with Heaven's Door Corporation closed on January 28, 2000. Effective with the merger with Heaven's Door Corporation, the Company's name was changed from Procept, Inc. to HeavenlyDoor.com, Inc. The Company will focus on growing the Internet business, while maximizing the value of the biotechnology assets through outlicense or disposition.
The Company is subject to risks common to companies in the Internet and biotechnology industries including but not limited to development by the Company or its competitors of new technological innovations, dependence on key personnel, protection of proprietary technology, compliance with United States Food and Drug Administration ("FDA") government regulations and the ability to obtain financing.
Plan of Operations
Since its inception in 1985 through 1999, the Company devoted its principal efforts to drug discovery and research. Since 1998, the Company has devoted its principal efforts to drug development, human clinical trials and partnership commercialization focusing on PRO 2000 Gel and O6-Benzylguanine ("BG").
Effective with the merger with Heaven's Door Corporation, the Company, through its web site www.HeavenlyDoor.com will provide a range of products and services specifically related to the funeral service industry. The Company's current web site provides consumers access to information concerning the arrangement and handling of funeral related services from the privacy of their own homes. In addition, the web site offers funeral homes and other service providers the ability to have an Internet presence through a customized, linked web site designed by Heaven's Door Corporation for the funeral home or other provider.
From inception through December 31, 1999, the Company generated no revenue from product sales, has not been profitable since inception, and has incurred an accumulated deficit of $76.8 million. Losses have resulted primarily from costs incurred in research and development activities related to the Company's efforts to develop drug candidates and from the associated administrative costs. The Company expects to incur additional operation losses over the next several years as it focuses on growing the new Internet business, while maximizing the value of the biotechnology assets.
On March 28, 2000, the Company received proceeds of approximately $3.1 million from the exercise of approximately 1.3 million warrants for common stock (see Note M). These warrants were exercised at a discount to the contractual exercise price. Accordingly, a charge of approximately $1.1 million will be recorded in the first quarter of 2000. The Company expects that its current funds along with the proceeds generated through the exercise of these warrants and interest income will be sufficient to fund the Company's operations into the second quarter of 2001.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
Restructuring
In 1997, the Company reduced staffing in its research organization through the elimination of six senior research positions and the departure of one executive. The amount of termination benefits accrued and charged to restructuring costs in the consolidated statement of operations for the year ended December 31, 1997 was $0.5 million. The amount of termination benefits paid and charged against the liability for the year ended December 31, 1997 was $0.2 million.
In order to focus its limited resources on PRO 2000 Gel, in January 1998 the Company terminated work on all other research programs and underwent a significant downsizing, reducing its staff to 13 people. The amount of termination benefits accrued and charged to restructuring costs in the consolidated statement of operations for the year ended December 31, 1998 was $0.2 million. Due to the restructuring, and the focus on the new Internet business, the Company has sold and plans to continue to sell most of its research and development equipment. For the years ended December 31, 1999 and 1998, the Company received approximately $41,000 and $0.7 million, respectively, from the sale of equipment and has recorded gains of approximately $36,000 and $0.2 million, respectively, which are included in other (income) expenses on the accompanying consolidated statements of operations.
B. Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and all of its subsidiaries. All intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.
Cash Equivalents and Marketable Securities
The Company considers all short-term investments purchased with an original maturity of three months or less at the date of acquisition to be cash equivalents, all short-term investments with a scheduled maturity date of less than 12 months at the balance sheet date are considered to be current marketable securities, and all investments purchased with a scheduled maturity date greater than 12 months at the balance sheet date are noncurrent marketable securities.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
Property and Equipment
Property and equipment is recorded at cost and depreciated on a straight-line basis over the following estimated useful lives:
Laboratory equipment 5 years Furniture and fixtures 5 years Office equipment 5 years Equipment and furniture under capital lease Estimated useful life or term of lease, if shorter Leasehold improvements Estimated useful life or term of lease, if shorter
Major additions and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon retirement or other disposition, the cost and related accumulated depreciation are removed from the accounts and the resulting gain or loss is included in the determination of net loss.
Research and Development
Research and development costs are expensed as incurred.
Income Taxes
The Company provides for income taxes under the liability method which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is provided for net deferred tax assets if, based on the weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
Revenue Recognition
Revenue is recognized under collaborative research and development agreements and research grants as earned based upon the performance requirements of each agreement. Payments received in advance under these agreements are recorded as deferred revenue until earned. Amounts received under research and development agreements and research grants are non-refundable and are not contingent on the outcome of research efforts.
Financial Instruments
Cash, cash equivalents and marketable securities are financial instruments which potentially subject the Company to concentrations of credit risk. The Company invests its excess cash in United States Government securities and money market instruments.
Basic and Diluted Net (Loss) Per Common Share
Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS is based upon the weighted average number of common shares outstanding during the period plus the additional weighted average common equivalent shares during the period. Common equivalent shares are not included in the per share calculations where the effect of their inclusion would be anti-dilutive. Common equivalent
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
shares result from the assumed exercises of outstanding stock options and warrants, the proceeds of which are then assumed to have been used to repurchase outstanding stock options using the treasury stock method.
For the years ended December 31, 1999 and 1998, the Company had stock options and stock warrants outstanding that were anti-dilutive. For the year ended December 31, 1997, the Company had convertible preferred stock, stock options and stock warrants outstanding that were anti-dilutive. These securities could potentially dilute basic EPS in the future and were not included in the computation of diluted EPS because to do so would have been anti-dilutive for the periods presented. Consequently, there were no differences between basic and diluted EPS for these periods.
Comprehensive (Loss) Income
The Company accounts for comprehensive income under the Financial Accounting Standards Board ("FSAB") SFAS 130, "Reporting Comprehensive Income". SFAS 130 established standards for reporting and displaying comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. The statement required that all components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements.
Business Segments
The Company follows FASB SFAS 131, "Disclosures about Segments of an Enterprise and Related Information" with respect to business segments. SFAS 131 established standards for the way public business enterprises report information about operating segments in annual financial statements and required those enterprises to report selected information about operating segments in interim financial statements. It also required disclosures about products and services, geographic areas and major customers.
From its inception in 1985 through 1999, the Company was in the business of developing and commercializing novel drugs based on biotechnological research. The Company evaluated its business activities that are regularly reviewed by the executive management team and the Board of Directors for which discrete financial information is available. As a result of this evaluation, the Company determined that it has one operating segment through 1999 and, accordingly, one reportable segment.
New Accounting Standards
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement was originally effective for all fiscal year ends beginning after June 15, 1999. In June 1999, the FASB issued SFAS 137, which delayed the effective date of SFAS 133 by one year. SFAS 133 is currently effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designed as part of a hedge transaction and, if it is, the type of hedge transaction. The Company does not believe that the adoption of SFAS 133 will have a significant effect on the Company's results of operations or its financial position.
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," ("SAB 101") which is
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
effective no later than the quarter ending March 31, 2000. SAB 101 clarifies the Securities and Exchange Commission's views regarding recognition of revenue. In March 2000, the Securities Exchange Commission issued Staff Accounting Bulletin No. 101A, "Amendment: Revenue Recognition in Financial Statements" ("SAB 101A"). SAB 101A delays the implementation date of SAB 101 by one quarter to the quarter ending June 30, 2000 for registrants with the fiscal years that begin between December 16, 1999 and March 15, 2000. The Company does not believe that the adoption of SAB 101 will have a significant effect on the Company's results of operation or its financial position.
Reclassifications
Certain reclassifications may have been made to the prior years' financial statements to conform with current year presentation. These reclassifications had no effect on net income of stockholders equity.
C. Acquisition of Pacific Pharmaceuticals, Inc.
On December 10, 1998, the Company entered into a definitive Agreement and Plan of Merger (the "Merger Agreement") to acquire Pacific Pharmaceuticals, Inc. ("Pacific"), a Delaware corporation engaged in the development of cancer therapies, based in San Diego, California, through a merger of a wholly owned subsidiary of the Company with and into Pacific. The acquisition of Pacific closed on March 17, 1999 and Pacific became a wholly owned subsidiary of the Company.
The acquisition of Pacific was accounted for under the purchase accounting method. The aggregate purchase price of $3.8 million, plus estimated acquisition costs of $1.7 million, assumed liabilities (including a $200,000 note payable to a significant shareholder of the Company) of $5.7 million and $1.0 million for the value of the stock options and warrants being issued to the Pacific shareholders were allocated to the acquired tangible and intangible assets based on their estimated respective fair values. Approximately $9.4 million of the purchase price has been allocated to in-process research and development and expensed in the quarter ended March 31, 1999. The charge for in-process research and development represents the value assigned to Pacific's programs that are still in the development stage for which there is no alternative future use. The value assigned to these programs has been developed by determining the fair value of these programs, as provided by an independent valuation of the Pacific business. The valuation methodology was based on estimated discounted cash flows. The Company had recorded acquisition costs of $176,025 associated with the Pacific merger as deferred charges on the December 31, 1998 balance sheet.
Pursuant to the Merger Agreement, each share of Pacific common stock (including preferred stock on an as converted basis into common stock) converted into approximately 0.11 shares of the Company's common stock or a total of 3,167,789 of the Company's shares (of which 1,558,587 shares of the Company's common stock issued in the merger to holders of Pacific preferred stock were accompanied by certain contractual rights identical to contractual rights held by purchasers in the Company's 1998 Offering). In
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
addition, all of Pacific's outstanding warrants, unit purchase options and stock option obligations were exchanged into approximately 1,916,730 like instruments of the Company. The Company also assumed an approximately $6.5 million net obligation (payable in cash or common stock of the Company, at the sole discretion of the Company) of Pacific's subsidiary, BG Development Corp. ("BGDC"). On June 30, 1999, the Company issued 2,773,575 shares of its common stock and 924,525 Class D Warrants in exchange for all of the BGDC outstanding preferred stock holdings. The Class D Warrants are exercisable for an aggregate of 924,525 shares of the Company's common stock at $2.11 per share and expire on June 30, 2004 (see Note F).
Pro Forma Results of Operations
The following unaudited pro forma results of operations for the years ended December 31, 1999 and 1998 give effect to the Company's acquisition of Pacific as if the transaction had occurred at the beginning of each period. The pro forma results of operation exclude the charge for in-process research and development of $9.4 million that was recorded with the acquisition in 1999, and does not purport to reflect what the Company's results of operations actually would have been if the acquisition had occurred as of the beginning of the periods, or what such results would be for any future period. The financial data is based upon financial assumptions that the Company believes are reasonable and should be read in conjunction with the consolidated financial statements and accompanying notes thereto included elsewhere in this report.
Pro Forma Results for the Year Ended December 31, ------------------------- 1999 1998 ------------ ----------- Revenues $317,558 $539,847 Net Loss $(5,696,867) $(7,300,848) Basic and diluted net loss per common share $(0.53) $(2.23)
D. Marketable Securities
The marketable securities of the Company, consisting of United States Government Agencies have been classified as available for sale. Realized gains and losses on disposition of securities are determined on the specific identification method and are reflected in the consolidated statement of operations. Net unrealized gains and losses are recorded directly in a separate shareholders' equity account, except those losses that are deemed to be other than temporary, which losses, if any, are reflected in the consolidated statement of operations.
Fair values are estimated based on quoted market prices. Interest is recognized when earned. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization and interest are included in interest income.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
The following is a summary of marketable securities as of December 31, 1998:
Fair Unrealized Amortized Value Gains Cost ----- ----- ----
Marketable securities, current:
United States Government Securities $2,003,755 $3,600 $2,000,155 ========== ====== ==========
The average maturity of the Company's marketable securities as of December 31, 1998 was four months.
In 1999, all outstanding marketable securities matured, and the Company received proceeds of approximately $2.0 million. As of December 31, 1999, the Company had no outstanding marketable securities.
E. Property and Equipment
Property and equipment consisted of the following:
December 31, ------------ 1999 1998 ---- ----
Laboratory equipment $ 610,182 $ 745,319 Furniture and fixtures 86,844 86,844 Office equipment 220,305 264,862 Leasehold improvements 1,035,019 1,040,027 ----------- ----------- 1,952,350 2,137,052
Less: accumulated depreciation & amortization (1,901,797) (1,956,600) ----------- -----------
Property and equipment, net $ 50,553 $ 180,452 =========== ===========
In 1999 and 1998, the Company sold equipment with a net book value of $5,000 and $0.5 million respectively, for proceeds of $41,000 and $0.7 million, respectively, resulting in a $36,000 and $0.2 million respectively, gain which is included in other (income) expense in the accompanying consolidated statement of operations.
Included above in property and equipment are the following assets that were acquired pursuant to capital lease arrangements:
December 31, ------------ 1999 1998 ---- ----
Laboratory equipment $ 353,466 $ 462,174 Furniture and fixtures 12,203 12,203 Office equipment 114,109 151,803 Leasehold improvements 459,410 459,410 ----------- ----------- 939,188 1,085,590
Less: accumulated amortization (939,188) (1,060,218) ----------- -----------
$ -- $ 25,372 =========== ===========
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
F. Shareholders' Equity
Common and Preferred Stock
On May 18, 1998, the Company's shareholders approved a one-for-ten reverse split of the Company's Common Stock (the "May 18, 1998 Reverse Stock Split"). The May 18, 1998 Reverse Stock Split was effected on June 1, 1998. Shareholders' equity has been restated to give retroactive application to the May 18, 1998 Reverse Stock Split in prior periods by reclassifying from Common Stock to additional paid-in capital the par value of the eliminated shares arising from the May 18, 1998 Reverse Stock Split. In addition, all references in the financial statements to the number of shares, per share amounts and stock option and warrant data of the Company's Common Stock have been restated.
On September 29, 1997, the Company's shareholders approved a one-for-seven reverse split of the Company's Common Stock (the "September 29, 1997 Reverse Stock Split"). The September 29, 1997 Reverse Stock Split was effected on October 14, 1997. Shareholders' equity has been restated to give retroactive application to the September 29, 1997 Reverse Stock Split in prior periods by reclassifying from Common Stock to additional paid-in capital the par value of the eliminated shares arising from the September 29, 1997 Reverse Stock Split. In addition, all references in the financial statements to number of shares, per share amounts, and stock option and warrant data of the Company's Common Stock have been restated.
On June 30, 1997, The Aries Fund and the Aries Domestic Fund, L.P. (collectively the Aries Funds) made a direct investment of $3.0 million into the Company. The Company received proceeds of $2.8 million for the issuance of 85,334 shares of Common Stock (the Common Shares). The Common Shares contained certain contractual obligations including, but not limited to, the right to convert the Common Shares into preferred stock (the Preferred Stock) upon the Company's shareholder approval of such Preferred Stock. The Company also received from the Aries Funds an additional $0.2 million for the issuance of two convertible promissory notes. The notes accrued interest at a rate of 12% per year and were due on or before September 30, 1997. In addition to the Common Shares and the notes, the Aries Funds received (i) Class A Warrants exercisable for an aggregate of 39,182 shares of the Company's Common Stock at an initial exercise price of $0.70 and (ii) Class B Warrants exercisable for an aggregate of 108,603 shares of the Company's Common Stock at an initial exercise price of $41.00. The Company did not separately value the Class A and Class B Warrants from the Preferred Stock since the resulting accounting treatment for both securities is to record their value in additional paid-in capital within the equity section of the balance sheet. Additionally, since the Preferred Stock and the Class A and Class B Warrants were not redeemable, no accretion was required. All of the Class A Warrants and the Class B Warrants contemplated that such warrants would be converted on September 30, 1997 into "New Warrants" having the same aggregate exercise price as the Class A and Class B Warrants converted, but with a per share exercise price equal to the lesser of (i) $20.30 or (ii) 50% of the trading price (determined per a formula) at September 30, 1997. The Class A and Class B Warrants further provided that the exercise price of the New Warrants would be adjusted at the time of the Company's next equity financing to ensure that the exercise price of the New Warrants was at least 50% of the pricing in such future equity financing. On September 30, 1997, the Class A and Class B Warrants were converted to New Warrants for 328,314 shares of the Company's Common Stock having a per share exercise price of $10.90 pursuant to a formula set forth in the Class A and B Warrant. In a negotiated transaction with the Aries Funds, the New Warrants were exchanged in April 1998 for Class C Warrants for an aggregate of 841,680 shares of the Company's Common Stock having an exercise price of $5.00, which exercise price was reduced to $3.67 in March 1999 as a result of anti-dilution provisions.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
At an adjourned session of the Company's 1997 annual meeting held on July 15, 1997, its shareholders approved an amendment and restatement of the Company's Restated Certificate of Incorporation which authorized 1,000,000 shares of preferred stock. On August 1, 1997, the Board of Directors established a series of 30,061 shares of Series A Convertible Preferred Stock (the Series A Preferred Stock). Upon the establishment of this Series A Preferred Stock, the purchasers of the securities issued in the June 1997 direct investment exercised the right to convert their Common Shares to shares of Series A Preferred. On August 22, 1997, the Aries Funds converted the 85,334 Common Shares into 28,000 shares of Series A Preferred Stock. On September 30, 1997, the Aries Funds converted the convertible promissory notes and the corresponding accrued interest into 2,060 shares of Series A Preferred Stock.
The Series A Preferred Stock was initially convertible into Common Stock at a conversion price equal to $32.80. The terms of the Series A Preferred Stock provided that the conversion price would adjust on September 30, 1997 (or earlier, if certain events occurred) to a new conversion price equal to the lesser of (i) $20.30 or (ii) 50% of the trading price (determined per a formula) at September 30, 1997. On September 30, 1997, the conversion price of the Series A Preferred Stock adjusted to $10.90. In connection with this adjustment, the Company recorded a preferred stock dividend in the amount of $4,217,388 which reflects the intrinsic value of the beneficial conversion feature based upon the difference between the $26.25 per share fair market value of the Company's Common Stock on the date of issuance and the $10.90 per share adjusted conversion price of the Series A Preferred Stock. Additionally, since the Series A Preferred Stock is not redeemable, no accretion is required. As of December 31, 1997, the conversion price of the Series A Preferred Stock was $10.90, but remains subject to further conversion rate adjustments based on future events. At December 31, 1997, the Series A Preferred Stock was convertible into 274,748 shares of Common Stock. After the September 30, 1997 conversion price adjustment, the terms of the Series A Preferred Stock provided for further reduction of the conversion price of the Series A Preferred Stock (i) on June 30, 1998 to ensure that the market price at that time was at least 140% of the conversion price, (ii) if equity securities were issued in the future with a pricing reset feature, on the reset date of such future equity securities (if such a reset date occurred on or prior to June 30, 1999), so that the conversion price of the Series A Preferred Stock was reduced proportionately to the price reduction in the future equity securities, (iii) if no reset date for future equity securities occurred by June 30, 1999, to ensure that the market price at that time was at least 200% of the conversion price, and (iv) on future issuances of equity securities at a price below the then effective conversion price or the then market price, to a price determined by a weighted average formula reflecting such dilutive issuance. Other significant features of the Series A Preferred Stock include (i) a per share cumulative annual dividend, payable in cash or in kind, of 10% of the sum of $140 per share plus accrued but unpaid dividends, (ii) the right to participate in most subsequent dividend distributions to Common Stock, (iii) the right to vote the Series A Preferred Stock on an as converted to Common Stock basis reflecting the then effective conversion price, and (iv) the right to a liquidation preference of $140 per share plus accrued but unpaid dividends.
Furthermore, on September 30, 1997 in accordance with the original terms of the Class A and Class B Warrants issued in the June 1997 private placement, such warrants were exchanged for 328,314 "New Warrants" at an exercise price of $10.90 per share. The $10.90 exercise price of the New Warrants was determined based on a formula set forth in the Class A Warrants and Class B Warrants. The formula provided that the exercise price of the New Warrants would equal the lesser of (i) $20.30 or (ii) 50% of the trading price (determined per a formula) at September 30, 1997. The formula trading price at September 30, 1997 was $21.80, and the exercise price was fixed at $10.90. The Company incurred costs in the amount of $0.1 million related to the June 1997 private placement and the subsequent conversion events which were charged to additional paid-in capital.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
In April 1998, all outstanding Series A Preferred Stock converted into shares of common stock having certain contractual rights, and in March 1999, the Company eliminated the authorization of the Series A Preferred Stock by a filing with the Secretary of the State of Delaware. Also, in April 1998, all New Warrants were converted to Class C Warrants, as discussed above.
As a part of a unit offering, the Company sold an aggregate of 1,960,500 shares of Common Stock in January, February, and April of 1998 together with five-year Class C Warrants to purchase 1,960,500 shares of Common Stock at an exercise price of $5.00 per share (the 1998 Offering). The $5.00 per share exercise price of the Class C Warrants was determined as part of the terms of the 1998 Offering in a negotiation between the Company and the placement agent for the 1998 Offering. The Company did not separately value the Class C Warrants from the Common Stock issued in the 1998 Offering since the resulting accounting treatment for both securities is to record their value in additional paid-in capital within the equity section of the balance sheet. These securities were sold for gross proceeds of $9.8 million. The Company received net proceeds of $8.1 million, after offering costs of $1.7 million. The purchasers in the 1998 Offering held certain contractual rights (the "Contractual Rights")requiring contingent additional issuances of Common Stock to the purchasers, (x) based on the market price on April 9, 1999 (the "Contractual Reset Rights") (y) in the event of future dilutive sales of securities (the "Contractural Anti-dilution Rights") and (z) as a dividend substitute beginning October 1999 and each six months thereafter (the "Contractual Dividend Rights). Additionally the Class C Warrants have contractual rights to reduce the exercise price in the event of future dilutive sales of securities (the "Class C Warrant Contractual Rights"). In the event of (i) a liquidation, dissolution or winding up of the Company, (ii) the sale or other disposition of all or substantially all of the assets of the Company, or (iii) any consolidation, merger, combination, reorganization or other transaction in which the Company is not the surviving entity, the purchasers are entitled to receive an amount equal to 140% of such purchaser's investment as a liquidation "preference." Except in the case of a liquidation, dissolution or winding up, such payment will be in the form that equity holders will receive such as in cash, property or securities of the entity surviving the acquisition transaction. In the event of a liquidation, dissolution or winding up, such payment is contingent upon the Company having available resources to make such payment (see Note M).
In March 1999, the Company issued 36,785 shares of its common stock to Commonwealth Associates in connection with the settlement of the litigation described in Note K. On the same date, the Company issued 2,764 shares of its common stock to The Harvard School of Dental Medicine as satisfaction of certain contractual obligations of Pacific.
In March 1999, Pacific was merged with and became a wholly owned subsidiary of the Company. In connection with the merger, a total of 3,167,789 shares were issued to former Pacific stockholders; of these shares, 1,558,587 shares had the Contractual Rights identical to those held by purchasers in the Company's 1998 Offering. On March 17, 1999 and November 10, 1999, the Company issued 88,374 and 109,778, along with $50,000 in cash for the cancellation of certain indebtedness of Pacific. In addition, the Company issued 160,160 shares of its common stock and $50,000 in cash to Paramount Capital, Inc. or its designees as compensation for services performed in conjunction with the merger with Pacific.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
The issuance of common stock in connection with the Pacific merger was a dilutive issuance under the terms of the 1998 Offering. As a result, as of March 17, 1999 pursuant to the Contractual Anti-dilution rights contained in the 1998 Offering the Company issued a total of 1,017,742 shares of its common stock to certain stockholders. In addition, the Company issued an additional 1,015,504 Class C Warrants at an exercise price of $3.67, and reduced the exercise price of the existing Class C Warrants from $5.00 to $3.67 as a result of the dilutive issuance under the Class C Warrant Contractual Rights.
In April 1999, pursuant to the Contractual Reset Rights contained in the 1998 offering, the Company issued a total of 3,970,734 shares of its common stock to certain stockholders.
On May 18, 1999, the Company issued 51,087 shares of its common stock in connection with the exercise of Class C Warrants for proceeds of $187,500.
On June 22, 1999 and July 15, 1999, the Company issued 5,000 and 10,000 shares, respectively, of its common stock as bonuses to certain employees. In addition, on June 22, 1999, the Company issued 11,765 of its common stock as payment for services rendered in connection with the acquisition of Pacific.
On June 30, 1999, the Company issued 2,773,575 shares of its common stock and 924,525 Class D Warrants to purchase common stock in exchange for outstanding preferred stock in its majority owned subsidiary BG Development Corp. ("BGDC"), thereby eliminating a $6.5 million obligation held by holders of this preferred stock while obtaining 100% ownership of BGDC. The 2,773,575 common shares issued in the conversion had a fair value of $2.11 per share. The shares have the Contractual Rights identical to those held by purchasers in the Company's 1998 Offering. The Class D Warrants are exercisable for an aggregate of 924,525 shares of the Company's common stock at $2.11 per share and expire June 30, 2004. The total value of the shares plus the warrants (utilizing the Black-Scholes valuation method), less the book value in the minority interest in BGDC resulted in a charge to net loss of $501,000 during the period. This issuance was also a dilutive event under the terms of the Class C Warrant Contractual Rights. Accordingly, the Company issued an additional 447,858 Class C Warrants at an exercise price of $3.28 and reduced the exercise price on the existing Class C Warrants from $3.67 to $3.28.
On October 9, 1999 pursuant to the Contractual Dividend rights contained in 1998 offering, the Company issued 562,951 shares of its common stock to certain stockholders.
1998 Equity Incentive Plan
Under the Company's 1998 Equity Incentive Plan, which amended and restated the 1989 Stock Plan (the "Plan"), the Company is permitted to sell or award common stock or to grant stock options for the purchase of common stock to employees, officers and consultants up to a maximum of 4,800,000 shares. In February 2000, the Board of Directors approved an amendment to the Plan to increase the number of shares covered by the Plan by 6,000,000, which amendment is subject to approval by the shareholders at the
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
2000 Annual Meeting of Shareholders. At December 31, 1999, there were 1,103,298 shares available for future grants under the 1998 Plan.
The 1998 Plan provides for the granting of incentive stock options ("ISOs") and nonstatutory stock options. In the case of ISOs, the exercise price shall not be less than 100% of the fair market value per share of the common stock, on the date of grant. In the case of nonstatutory options, the exercise price shall be determined by a committee appointed by the Board of Directors ("Compensation Committee"). All stock options under the 1998 Plan have been granted at exercise prices at least equal to the fair market value of the common stock on the date of grant.
The options either are exercisable immediately on the date of grant or become exercisable in such installments as the Compensation Committee may specify, generally over a four year period. Each option expires on the date specified by the Compensation Committee, but not more than ten years from the date of grant in the case of ISOs (five years in certain cases).
Director Stock Option Plan
In June 1994, the shareholders of the Company adopted the 1994 Director Stock Option Plan (the "Director Plan"). The Director Plan was established to attract and retain highly qualified, non-employee directors. The price per share for each option granted under this plan shall be the current fair market value at date of grant. The options vest over a period of three years and have a term of ten years. As originally adopted, the aggregate number of shares of the Company's common stock which may be optioned under this plan is 2,143 shares. In March 1997, the Board of Directors approved an amendment to the Director Plan to increase the number of shares covered by the Director Plan by 2,143 shares, which amendment was approved by the shareholders at the 1997 Annual Meeting of Shareholders. In April 1998, the Board of Directors approved an amendment to the Director Plan to increase the number of shares covered by the Director Plan to 500,000, which amendment was approved at the 1998 Annual Meeting of Shareholders. In June 1998, the Board of Directors terminated the Director Plan.
Supplemental Disclosures for Stock-Based Compensation
The Company applies APB Opinion No. 25 and related Interpretations in accounting for its stock option plans. Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), issued in 1995, defined a fair value method of accounting for stock options and other equity instruments. Under the fair value method, compensation cost is measured at grant date based on the fair value of the award and is recognized over the service period, which is usually the vesting period. The Company elected to continue to apply the accounting provisions of APB Opinion No. 25 for stock options. The required disclosures under SFAS 123 as if the Company had applied the new method of accounting are made below.
During 1998 and 1999, the Company granted stock options (the "Variable Options") to certain employees, directors and consultants with Contractual Reset Rights, Contractual Anti-Dilution Rights, and Class C Warrant Contractual Rights contained in the 1998 Offering. The Variable Options had an initial exercise price of $5.00 per share. Since the number of options and the associated exercise price were subject to adjustment and not fixed at the grant date, these stock options are accounted for under variable stock option accounting. Accordingly, the Variable Options were re-valued on a quarterly basis by measuring the difference between the current exercise price and the fair market value of the Company's common stock on that balance sheet date. As a result, the Company recorded a $2.5 million charge in the fourth quarter
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
of 1999 representing the earned portion of the $4.6 million total compensation charge. There were no charges in 1998 or in the first three quarters of 1999, since the fair market value of the Company's common stock was less then the current exercise price with respect to the Variable Options.
During 1999, the number and the exercise price of the Variable Options were adjusted according to the Contractual Anti-dilution Rights, the Contractual Reset Rights, and the Class C Warrant Contractual Rights contained in the 1998 Offering. As a result, the Company granted 819,064 (586,218 incentive stock options and 232,846 nonqualified stock options) additional options and the associated exercise price of the Variable Options were reduced from $5.00 per share to $2.11 per share (see Note M).
Activity under all stock plans related to all the incentive stock options and nonqualified stock options for the three years ended December 31, 1999 is listed below.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
Summarized information about stock options outstanding at December 31, 1999 is as follows:
Options for the purchase of 1,275,466 shares, 63,599 shares and 23,538 shares are exercisable at December 31, 1999, 1998 and 1997, respectively.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:
1999 1998 1997 ---- ---- ---- Dividend yield None None None Expected volatility 100% 104% 75% Risk free interest rate 5.75% 5.25% 6.00% Expected life of option 5.0 5.0 5.0
All options granted in 1999, 1998 and 1997 were granted at fair value or at amounts greater than fair value. Options to consultants are recorded at fair value and recognized as expense over the vesting period. The weighted average fair value of options granted was $1.56 $1.62, and $15.90 for 1999, 1998 and 1997, respectively.
Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards made in 1999, 1998 and 1997 consistent with the provisions of SFAS 123, the Company's net loss and loss per share would have been increased to the pro forma amounts shown below:
The effects of applying SFAS 123 in the pro forma disclosure are not indicative of future amounts.
1994 Employee Stock Purchase Plan
In April 1994, the Board of Directors adopted the 1994 Employee Stock Purchase Plan (the "1994 Plan"). Under the 1994 Plan, eligible employees of the Company may purchase shares of Common Stock, through payroll deductions, at the lower of 85% of fair market value of the stock at the time of grant or 85% of fair market value at the time of exercise. As amended, a total of 200,000 shares were reserved for issuance under the 1994 Plan. The Company is not currently offering shares under the 1994 Plan. The Company issued 763 shares under the 1994 Plan in 1997. The weighted average fair values of grants at fair
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
value under the 1994 Plan during 1997 was $14.10. No shares were issued during 1998 or 1999 under the 1994 Plan.
Common Stock Warrants
On February 10, 1994, in connection with the closing of the initial public offering the Company's underwriter purchased for $210.00 warrants to purchase 3,000 shares of the Company's common stock at an exercise price of $833.00 per share. The warrants expired on February 10, 1999.
On April 1, 1994, in connection with the Company's $2 million master lease agreement, the Company issued common stock warrants for a purchase price of $350.00 to purchase 500 shares of common stock at a price of $595.00. These warrants expired on April 1, 1999.
On September 11, 1995, the Company issued common stock warrants for a purchase price of $300.00 to purchase 429 shares of the Company's common stock at an exercise price of $490.00 per share, in connection with investment banking services to the Company. These warrants expire September 10, 2000.
On February 14, 1996, the Company issued common stock warrants for a purchase price of $220.00 to purchase up to 3,142 shares of the Company's common stock to Commonwealth Associates at an exercise price of $219.10 per share in connection with a public financing. These warrants expire on February 14, 2001.
On May 17, 1996, the Company issued a common stock warrant to purchase 11,283 shares of the Company's common stock at an exercise price of $175.00 per share in connection with financial advisory services to the Company. This warrant expires on May 16, 2001.
On May 17, 1996, the Company issued to a number of investors warrants to purchase an aggregate of 67,690 shares of common stock at $175.00. The Warrants are subject to redemption by the Company upon 30 days prior notice to the holders of the Warrants at a price of $0.10 per Warrant Share in the event that the average closing price of the Company's Common Stock for any 20 consecutive trading day period exceeds $262.50. The warrants expire on May 17, 2001.
On January 6, 1997, the Company issued a common stock warrant to purchase 1,071 shares of the Company's common stock at an exercise price of $105.00 per share in connection with financial advisory services to the Company. This warrant expires on January 6, 2002.
In August 1991 and September 1992, the Company issued warrants to purchase up to 432 and 286 shares, respectively, of the Company's Class D Preferred Stock (the "Class D Warrants") at a minimum exercise price of $175.00 per share, in connection with leasing arrangements. The Class D Warrants were automatically converted into warrants to purchase 268 shares of common stock at an exercise price of $468.30 per share upon the closing of the Company's initial public offering on February 17, 1994. The warrants expired on February 10, 1999.
As described earlier, the Company issued Class C Warrants which were originally issued at an exercise price of $5.00 per share and were subsequently reduced to an exercise price of $3.28 per share.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
As part of the final closing of the unit offering, The Aries Fund and the Aries Domestic Fund, L.P. exchanged an aggregate of 30,060 shares of Series A Convertible Preferred Stock, $0.01 par value per share, and Class B Warrants to purchase an aggregate of 328,314 shares of the Company's common stock for an aggregate of 42.084 Units (841,680 shares of the Company's common stock and Class C Warrants to purchase 841,680 shares of the Company's common stock at an exercise price of $5.00 per share, which exercise price was reduced to $3.28 in June 1999 as a result of the Class C Warrant Contractual Rights contained in the 1998 Offering).
In connection with the final closing of the Company's 1998 private placement on April 9, 1998 and certain advisory services, the Company sold to Paramount Capital, Inc., the Company's placement agent in the 1998 private placement, unit purchase options, options to purchase an aggregate of 481,381 shares of common stock and Class C Warrants to purchase 481,381 shares of common stock at an exercise price of $5.00 per share. Pursuant to the Contractual Rights contained in the 1998 Offering, the Company increased the number of shares underlying the 1998 UPO's by 716,366. The Company also issued an additional 252,431 Class C Warrants at an exercise price of $3.28 per share and reduced the exercise price on the existing Class C Warrants from $5.00 to $3.28 as a result of the Class C Warrant Contractual Rights. The unit purchase options are exercisable at $5.50 per unit for 2.37 shares of common stock and a Class C Warrant exercisable for 1.52 shares.
In conjunction with the Pacific merger, the Company converted approximately 7,961,713 Pacific Class A Warrants into 864,870 of the Company's Class A Warrants. Each Class A Warrant is convertible into one share of the Company's common stock at an exercise price of $9.20 per warrant. The Class A Warrants expire in November 2005 and March 2007. In addition, the Company converted approximately 309,734 Pacific Class B Warrants into 33,653 the Company's Class B Warrants. Each Class B Warrant is convertible into one share of the Company's common stock at an exercise price of $202.49 per warrant. The Class B Warrants expire in August 2001. In addition, in conjunction with the Pacific Merger, the Company converted Unit Purchase Options consisting of options to purchase 3,984,625 shares of common stock and 1,683,663 Class A Warrants to purchase common stock, into Unit Purchase Options consisting of options to purchase 432,943 shares of common stock and 183,147 Class A warrants to purchase common stock. Pursuant to the Contractual Rights contained in the 1998 Offering, the Company increased the number of shares underlying these Unit Purchase options by 587,935. The Unit Purchase Options expire on various dates beginning in November 2005 through September 2007.
As previously described, on June 30, 1999, the Company issued 924,525 Class D Warrants to purchase common stock to the former holders of preferred stock in its majority owned subsidiary BG Development Corp. ("BGDC"), thereby eliminating a $6.5 million obligation while obtaining 100% ownership in BGDC. The Class D Warrants are exercisable at $2.11 per share and expire on June 30, 2004. The total value of the shares plus the warrants (utilizing the Black-Scholes valuation method), minus the book value of the minority interest in BGDC resulted in an incremental charge against earnings of $501,000 during the period.
On June 30, 1999, the Company issued 11,500 Warrants to purchase common stock in exchange for certain contractual obligations. The Warrants are exercisable for one share of common stock at $2.11 per share and expire on June 30, 2004.
At December 31, 1999 there were 9,284,980 warrants and unit purchase options outstanding, all of which are exercisable. The warrants and unit purchase options have exercise prices ranging from $2.11 to $490.00 and expiration dates ranging from 2000 to 2007.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
G. Comprehensive Income (Loss)
The Company accounts for comprehensive income under SFAS 130, "Reporting Comprehensive Income." This statement required changes in comprehensive income to be shown in a financial statement that is displayed with the same prominence as other financial statements. Accumulated other comprehensive income (loss) currently consists of unrealized gain (loss) on investments as follows:
H. Collaborative Research and Development Agreements
In January 1996, the Company entered into a Sponsored Research Agreement with VacTex, Inc. (VacTex), to provide research services relating to the development of novel vaccines based on discoveries licensed from the Brigham and Women's Hospital and Harvard Medical School. These discoveries shed light on a previously unknown aspect of immunology, the CD1 system of lipid antigen presentation.
Under the Sponsored Research Agreement, the Company conducted specified research tasks on behalf of VacTex for which the Company received a combination of cash and equity in VacTex based on the number of full-time equivalent employees of the Company engaged in the research, but subject to maximum cash and stock limits. The Sponsored Research Agreement also includes a provision requiring the Company to issue to VacTex or its shareholders warrants to purchase an aggregate of 1,429 shares of the Company's Common Stock at an exercise price of $245.00 per share.
In the year ended December 31, 1998, the Company recorded revenue of $0.1 million which was paid in cash. In the year ended December 31, 1997, the Company recorded revenue of $0.5 million which consisted of $0.4 million in cash and 150,000 shares of VacTex common stock.
The Sponsored Research Agreement with VacTex expired on January 8, 1998.
On April 13, 1998, VacTex was acquired by Aquila Biopharmaceuticals, Inc. ("Aquila"). The Company's investment in VacTex of 300,000 shares of common stock was converted to 113,674 shares of Aquila common stock and $128,501 of 7% debentures. As a result, the Company is accounting for its investment in Aquila under Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" as an available for sale security and marked it to market by recording a cumulative unrealized gain of $0.1 million and $0.3 million on December 31, 1999 and 1998, respectively, as part of Shareholders' Equity, based on Aquila's common stock
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
closing price. The Company's investment in VacTex was originally accounted for under the cost method since it was a restricted security, it did not have a readily determinable fair value and the Company owned less than 20% of VacTex. On July 15, 1999, the Company redeemed the Aquila 7% debentures for the total proceeds of $139,758 which represented the principal and accrued interest due at the time of redemption. Subsequent to December 31, 1999, the Company liquidated all security interests in Aquila for a total proceeds of approximately $406,000.
I. Income Taxes
No federal or state income taxes have been provided for as the Company has incurred losses since its inception. At December 31, 1999, the Company had federal and state tax net operating loss ("NOL") carryforwards of approximately $100.0 million and $51.0 million, which will expire beginning in the year 2000 through 2019 for federal and beginning in the year 2001 through 2006 for state, respectively. Additionally, the Company had federal and state research and experimentation credit carryforwards of approximately $2.0 million and $1.0 million, respectively, which will expire through 2019. Internal Revenue Code of 1986 (the "Code") contains provisions which limit the net operating loss carryforwards and tax credits available to be used in any given year upon the occurrence of certain events, including significant change in ownership interests. In conjunction with the initial public offering and the acquisition of Pacific Pharmaceuticals, Inc., such changes in ownership as defined in the Code occurred. Accordingly, certain available NOL carryforwards and tax credits are subject to these limitations.
The components of the Company's net deferred tax assets were as follows at December 31:
As required by Financial Accounting Statement No. 109, management of the Company has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets which are comprised principally of net operating loss and tax credit carryforwards. Management has considered the Company's history of losses and concluded, in accordance with the applicable accounting standards, that it is more likely than not that the Company will not recognize the benefit of the net deferred tax assets. Accordingly, the deferred tax assets have been fully reserved. Management re-evaluates the positive and negative evidence on an annual basis.
J. Savings and Retirement Plan
On July 1, 1990, the Company established the Procept, Inc. Savings and Retirement Plan (the "401(k) Plan"), a profit-sharing plan under Section 401 of the Code. Employees are eligible to participate in the 401(k) Plan by meeting certain requirements, including length of service and minimum age. The Company may contribute to the 401(k) Plan, without regard to current or accumulated net profits, in an amount not to exceed the maximum allowable under applicable provisions of the Code. The amount is to be allocated to active
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
participants based on their annual pay as a percentage of the total annual pay of all such participants. Participants may also contribute to the 401(k) Plan, but no more than the maximum permissible amount allowed by regulatory definitions. For the year ended December 31, 1998 and 1997, the Company did not contribute to the 401(k) Plan. For the plan year 1999, the Company contributed 512 shares of its common stock to the 401(k) Plan with a value of $740.
K. Commitments and Contingencies
Operating Leases
On February 28, 1989, the Company entered into an operating lease arrangement for its facility. The Company has made several amendments to its operating lease arrangement for its facility to include additional leased space and extension of the lease terms. The commitment under the operating lease requires the Company to pay monthly base rent and an allocable percentage of operating costs and property taxes.
The monthly base rent is subject to increases during the course of the lease term which are unrelated to increases in utilized space. Accordingly, the Company is providing for rent expense based on an amortization of the lease payments on a straight-line basis over the life of the lease arrangement.
Pursuant to the aforementioned leasing arrangements, at December 31, 1999 and 1998, the Company has recorded liabilities of approximately $67,000 and $0.2 million, respectively, for rent expense in excess of cash expenditures for leased facilities.
Gross rent expense for leased facilities and equipment amounted to approximately $1.4 million, $1.4 million and $1.8 million for the years ended December 31, 1999, 1998 and 1997, respectively. The approximate gross future minimum annual rental payments for leased facilities for the next year under the lease arrangements consist of the following at December 31, 1999:
2000 $706,000
The Company's facility lease expires June 30, 2000. The Company does not intend to renew this lease.
The Company has entered into sublease agreements which offset the future minimum lease payments by $1.0 million in 2000. The sublease agreements require that the Company provide certain services including utilities. The Company expects sublease income to continue to approximate its related costs.
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
Capital Leases
On March 17, 1999, as part of the acquisition of Pacific, the Company assumed a capital lease obligation for office equipment. The future minimum lease payments under this capital lease are as follows:
December 31, 1999 -----------------
2000 $6,519 2001 6,519 2002 6,519 2003 3,259 ------- Total future minimum lease payments: 22,816 Less amounts representing interest: 3,600 ------- Present value of future minimum lease payments: 19,216 Less current portion: 4,832 ------- $14,384 =======
Legal Proceedings
On October 23, 1997, Commonwealth Associates ("Commonwealth") filed a Complaint with the United States District Court for the Southern District of New York naming the Company as a defendant (the "Complaint"). The Complaint alleges that the Company breached obligations to Commonwealth under the Underwriting Agreement between Commonwealth and the Company dated February 8, 1996, giving Commonwealth a right of first refusal to act as co-lead underwriter or co-managing agent of a public offering or private placement of the Company's securities during the period ended August 8, 1997. In the Complaint, Commonwealth seeks aggregate compensatory damages in the amount of $375,000, incidental and consequential damages in an amount to be proven at trial, costs, disbursements and accrued interest and such other and further relief as the court deems proper. The Company served an answer on or about March 16, 1998 denying Commonwealth's allegations and has engaged in substantial discovery. At a court-sponsored mediation held on February 9, 1999, the Company and Commonwealth reached an agreement in principle to settle this matter whereby Commonwealth agreed to dismiss the suit in return for payment of $45,000 in cash and 36,785 shares of the Company's common stock. In early 1999, the Company made these payments.
On February 22, 1999, Christopher R. Richied ("Richied") filed a Complaint with the United States District Court for the Southern District of New York naming Pacific Pharmaceuticals, Inc. ("Pacific") and Binary Therapeutics Inc. ("Binary"), both subsidiaries of the Company, as defendants (the "Complaint"). The Complaint alleges that Pacific and Binary breached obligations to Richied under certain consulting agreements. In the Complaint, Richied seeks approximately $40,000 in cash and an indeterminate amount based upon the value of certain equity components of the consulting agreement. The Company's answer to the Complaint was filed on August 9, 1999. Based on facts alleged in the Complaint, the Company does not believe this action will have a material adverse effect on the Company's business, even in the event of a decision by the court in the plaintiff's favor or other conclusion of the litigation in a manner adverse to Pacific and Binary.
L. Related Parties
Certain members of the Company's Board of Directors are also retained as consultants by the Company. Management believes the consulting agreements have been negotiated at an "arm-length" basis and are immaterial.
On December 31, 1997, in connection with the severance agreement with an officer and shareholder, three notes and the associated accrued interest, in the amount of $124,646, were cancelled in exchange for the surrender to the Company of 1,186 outstanding shares of Common Stock resulting in treasury stock of $11,857 recorded at cost and $112,789 of compensation expense which is included in general and administrative expenses for 1997.
As of March 28, 2000 the Aries Trust, the Aries Domestic Fund, L.P., the Aries Master Fund, the Aries Domestic Fund II, L.P., Paramount Capital Investments, LLC, Paramount Capital, Inc. and Dr. Lindsay Rosenwald, who are referred to collectively as the Aries Purchasers, are the holders of an aggregate of approximately 10,678,698 shares of common stock, representing approximately 33% of the outstanding shares of the Company's common stock. In addition, the Aries purchasers hold approximately 4,340,413 warrants and options to purchase common stock. Mark C. Rogers is a member of the Company's Board of Directors and is the President of Paramount Capital, Inc.
On April 9, 1998, the Company entered into a Financial Advisory Agreement with Paramount Capital, Inc. pursuant to which Paramount is entitled to receive a monthly retainer of $3,000 for a minimum of 24 months, out-of-pocket expenses and certain cash and equity success fees in the event Paramount assists the Company with certain financing and strategic transactions. During the year ended December 31, 1999, the Company paid Paramount Capital, Inc. approximately $44,000 under this Agreement.
In connection with the acquisition of Pacific, the Company issued an aggregate of approximately 1,102,504 shares of common stock to the Aries Purchasers in exchange for their shares of Pacific common stock and pursuant to the Contractual Anit-dilution and Contractual Reset Rights contained in the 1998 Offering (see Note M). The Company also issued to the Aries Purchasers (i) an aggregate of 160,160 shares of common stock as payment for brokerage services in connection with the Pacific merger and (ii) an aggregate of 320,126 shares of common stock in cancellation of certain indebtedness incurred by Pacific to the Aries Purchasers through Pacific's merger with Binary Therapeutics, Inc., and pursuant to the Contractual Anti-dilution and Contractual Reset Rights contained in the 1998 Offering (see Note M).
As described below in Footnote C, the Company also assumed an approximately $6.5 million, net obligation of Pacific's subsidiary, BG Development Corp. ("BGDC") in connection with the Company's merger with Pacific. As payment of this obligation, the Company issued approximately 2,773,575 shares of its common stock and Class D Warrants to purchase an aggregate of 924,525 shares of common stock in exchange for all of the outstanding shares of BGDC Series A Convertible Preferred Stock. On June 30, 1999, the Aries Purchasers exchanged their BGDC Series A Convertible Preferred Stock
HeavenlyDoor.com, Inc. (Formerly Procept, Inc.) Notes to Financial Statements
for an aggregate of 1,890,000 shares of common stock and Class D Warrant to purchase an aggregate of 630,000 shares of common stock.
On April 9, 1999, the Company issued 3,970,734 shares of its common stock pursuant to the Contractual Reset Rights contained in the 1998 Offering (see Note M) held by certain holders of the Company's Common Stock, including those who purchased their shares in the 1998 private placement. An aggregate of 1,842,813 shares were issued to the Aries Purchasers pursuant to the Contractual Reset Rights.
On October 9, 1999, the Company issued 562,961 shares of its common stock pursuant to Contractual Dividend Rights held by certain holders of the Company's Common Stock, including those who purchased their shares in the 1998 Offering. An aggregate of 311,267 shares were issued to the Aries Purchasers pursuant to this Contractual Dividend Right.
M. Subsequent Events (Unaudited)
Merger
On November 8, 1999, the Company entered into the merger between Procept, Inc. and Heaven's Door Corporation to acquire Heaven's Door Corporation (the "Merger Agreement"), a Delaware corporation engaged in providing a range of funeral-related products and services through its web site, www.HeavenlyDoor.com.
The acquisition of Heaven's Door Corporation will be accounted for utilizing the purchase accounting method. The aggregate purchase price of $19.2 million plus estimated acquisition costs of $2.0 million and assumed liabilities of $260,000 were allocated to the acquired tangible and intangible assets. As a result of this acquisition, the Company has recorded goodwill and other intangibles of approximately $21.4 million, which represents the excess cost of net assets acquired and which will be amortized over their respective lives. Pursuant to the Merger Agreement, each share of Heaven's Door Corporation was converted into approximately .81 shares of the Company's common stock, or a total of 10,920,000 shares. The Company has recorded deferred charges of $321,544 as of December 31, 1999 associated with acquisition costs related to the Heaven's Door Corporation merger.
In accordance with the Merger Agreement, the Company will also issue 3,876,887 shares to holders of common stock purchased in the 1998 Offering in exchange for the elimination of the Contractual Rights contained in the 1998 Offering. This transaction will be accounted for as an induced conversion and accordingly the Company will record a charge of approximately $23.0 million during the first quarter of 2000.
On January 28, 2000, concurrent with the merger with Heaven's Door Corporation, all Variable Options were adjusted by issuing an additional 1,004,224 options at an exercise price of $1.56 per share, the exercise price on the existing Variable Options was reduced from $2.11 per share to $1.56 per share, and the Board of Directors accelerated the vesting of the Variable Options. Following the termination of the Contractual Rights including those associated with the Variable Options, the number and the associated exercise price of the Variable Options became fixed and accounted for accordingly. Therefore, a compensation charge of approximately $14.7 million will be recorded in the first quarter of 2000, resulting from the revaluation under variable plan accounting and the acceleration of the vesting of the Variable Options.
Exercise of Warrants
On March 28, 2000, the Company received proceeds of approximately $3.1 million by the Aries Trust and the Aires Domestic Fund L.P. from the exercise of approximately 1.3 million common stock warrants. These warrants were exercised at a discount to the contractual exercise price. Accordingly, a charge of approximately $1.1 million will be recorded in the first quarter of 2000.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information concerning disclosure pursuant to Item 405 of Regulation S-K is included under the caption "Compliance with Section 16(a) of the Securities Exchange Act" in the Proxy Statement and is incorporated herein by reference.
The current Executive Officers, Key Employees and Directors of the Company are as follows:
GLENN L. COOPER, M.D. has been a director of the Company since June 1999. Dr. Cooper has served as President, Chief Executive Officer and a director of Interneuron Pharmaceuticals, a public biotechnology company, since May 1993 and was named Chairman of the Board in January 2000. He is also a director of Genta, Inc., a public biotechnology company located in Lexington, Massachusetts. Dr. Cooper received his M.D. from Tufts University School of Medicine, and his B.S. from Harvard University. He performed his postdoctoral training at Massachusetts General Hospital and New England Deaconess Hospital.
JOHN F. DEE has served as Vice Chairman of the Board of Directors since February 2000. Previously, Mr. Dee was President, Chief Executive Officer and a member of the Board of Directors of Procept, Inc. since joining the Company in February 1998. From April 1997 to October 1997, Mr. Dee was Interim Chief Executive Officer of Genta Incorporated. From 1994 to 1997 and 1988 to 1992, Mr. Dee was a Senior Management Consultant with McKinsey & Company, Inc. and from 1992 to 1994 served as Chief Operating Officer, Chief Financial Officer, and Director of Walden Laboratories, Inc. (now AVAX Technologies, Inc.). Mr. Dee holds an M.S. in Engineering from Stanford University and an M.B.A. from Harvard University.
MICHAEL E. FITZGERALD has been Vice President, Finance and Chief Financial Officer of the Company since March 1999. Mr. Fitzgerald was previously Vice President and Chief Financial Officer of CytoMed, Inc. since March 1993 and Treasurer since February 1992. From June 1991 to January 1992 he served as Corporate Controller and Chief Accounting Officer of TSI Corporation, a life sciences company. Mr. Fitzgerald served as Corporate Controller and Chief Accounting Officer of BioTechnica International, Inc., an agricultural biotechnology firm, from September 1986 to May 1991. From January 1975 to August 1986, he was employed by the Amicon Division of W.R. Grace, a life sciences company, most recently as Manager, Corporate Accounting. Mr. Fitzgerald holds a B.S. in Economics and Finance and an M.B.A. in Finance from Bentley College.
ZOLA P. HOROVITZ, Ph.D. has been a director of the Company since 1992. Dr. Horovitz, currently a consultant to pharmaceutical companies, served as Vice President - Business Development and Planning at Bristol-Myers Squibb Pharmaceutical Group, from August 1991 to April 1994, and as Vice President - Licensing, from 1989 to August 1991. Prior to 1989, Dr. Horovitz spent 30 years as a member of the Squibb Institute for Medical Research, most recently as Vice President - Research Planning. He is also a director of seven other biotechnology and pharmaceutical companies: Avigen, Inc., BioCryst, Inc., Clinicor, Inc., Diacrin, Inc., Magainin Pharmaceuticals, Inc., Roberts Pharmaceutical Corporation and Synaptic Pharmaceuticals, Inc. Dr. Horovitz received his Ph.D. from the University of Pittsburgh.
LLOYD J. KAGIN has served as President, Chief Executive Office and a member of the Board of Directors since joining the Company in February 2000. From 1995 to January 2000, Mr. Kagin was a Senior Managing Director and Director of Consumer Markets Division of Josephthal & Co., Inc. From 1994 to 1995, Mr. Kagin was a consultant with GKN Securities Corporation. From 1991 to 1994, he was employed by Reich & Co., Inc., most recently as Senior Vice President. From 1990 to 1991, Mr. Kagin served as a Vice President and Branch Manager for First Albany Corporation. From 1983 to 1989, Mr. Kagin was employed by Paine Webber Inc., most recently as Vice President. Mr. Kagin holds a B.A. in Neurophysiology from New York University.
RICHARD J. KURTZ, has been a director of HVDC since we acquired Heaven's Door Corporation in January 2000. Mr. Kurtz has been the Chairman of the Board of Directors of Urecoats Industries, Inc., a publicly-traded corporation in the sealant and coating business, since February 1999. He has been the President and Chief Executive Officer of the Kamson Corporation, a privately-held corporation, for over twenty years. Kamson Corporation owns and operates real estate investment properties in the northeastern United States. Mr. Kurtz received his B.A. from the University of Miami in 1962.
PHILIP C. PAUZE has been a director of HVDC since we acquired Heaven's Door Corporation in January 2000. Since 1993, Mr. Pauze has been the President of Pauze Swanson Capital Management Co.(TM), which provides investment advice and management services. Mr. Pauze also has been President and Trustee since 1993 of the Pauze Funds(TM), a mutual fund company registered under the Investment Company Act of 1940. Since 1999, Mr. Pauze has been President of Champion Fund Services(TM), an accounting, administration, and transfer agency firm serving the mutual fund industry. In 2000, Mr. Pauze formed and is President of Senior Family Care, Inc.(TM), a firm providing pre-need funeral services via the Internet. Mr. Pauze received his B.A. from Auburn University in 1963.
ALBERT T. PROFY, Ph.D. has been Vice President, Research and Development since March 1999. From 1996 to 1999, Dr. Profy was Vice President, Protein Biochemistry and Preclinical Development and from 1994 to 1996, Dr. Profy was Director, Protein Biochemistry. Prior to joining HeavenlyDoor.com, Dr. Profy was Director of Peptide and Protein Biochemistry at Repligen Inc., from 1986 to 1994, where he managed that company's HIV research program. From 1984 to 1986, Dr. Profy was a Postdoctoral Research Associate at the Massachusetts Institute of Technology. Dr. Profy received his Ph.D. and M.S. in Bio-Organic Chemistry from Cornell University in 1984 and 1981 respectively, and a B.S. in Chemistry From Bates College in 1978.
MARK C. ROGERS, M.D. has been a director of the Company since 1997. Dr. Rogers is presently the President of Paramount Capital, Inc. From 1996 until 1998, Dr. Rogers was Senior Vice President, Corporate Development and Chief Technology Officer at The Perkin-Elmer Corporation. From 1992 to 1996, Dr. Rogers was the Vice Chancellor for Health Affairs at Duke University, and Executive Director and Chief Executive Officer of Duke University Hospital and Health Network. Prior to his employment at Duke, Dr. Rogers was on the faculty of Johns
Hopkins University for 15 years where he served as a Distinguished Faculty Professor and Chairman of the Department of Anesthesiology and Critical Care Medicine, Associate Dean for Clinical Affairs, Director of the Pediatric Intensive Care Unit and Professor of Pediatrics. Dr. Rogers currently serves on the board of directors of three publicly traded companies: Discovery Laboratories, Inc., Galileo Corporation and HCIA, Inc. Dr. Rogers received his M.D. from Upstate Medical Center, State University of New York and has his M.B.A. from The Wharton School of Business. He received his B.A. from Columbia University and held a Fulbright Scholarship.
ELLIOTT H. VERNON has been a director of the Company since December 1997. Mr. Vernon has been the Chairman of the Board, President and Chief Executive Officer of Healthcare Imaging Services, Inc., a publicly held operator of fixed-site magnetic resonance imaging centers in the northeast, since its inception in 1991. For the past ten years, Mr. Vernon has also been the managing partner of MR General Associates, a New Jersey general partnership which is the general partner of DMR Associates, L.P., a Delaware limited partnership. Mr. Vernon was also one of the founders of Transworld Nurses, Inc., the predecessor of Transworld HealthCare, Inc., a publicly held regional supplier of a broad range of alternate site healthcare services and products. Mr. Vernon is also a principal of Healthcare Financial Corp., LLC, a healthcare financial consulting company engaged primarily in FDA matters. From January 1990 to December 1994, Mr. Vernon was a director, Executive Vice President and General Counsel of Aegis Holdings Corporation, an international provider of financial services through its investment management and capital markets consulting subsidiaries.
HOWARD WEISER has been a director of HVDC since we acquired Heaven's Door Corporation in January 2000. Prior to becoming a director of HVDC, Mr. Weiser was a director of Heaven's Door Corporation from its inception in May 1999 until its acquisition by HVDC in January 2000. From 1994 to 1999, Mr. Weiser was Chairman, President, Chief Executive Officer, and Secretary of Urecoats Industries Inc., a publicly traded sealant and coating business, and its predecessors.
MICHAEL S. WEISS has been a director of the Company and Chairman of the Board since July 8, 1997. He is the President of CancerEducation.com. Mr. Weiss was formerly a Senior Managing Director of Paramount Capital, Inc. Prior to joining Paramount, Mr. Weiss was an attorney with Cravath, Swaine & Moore. Mr. Weiss is currently Vice-Chairman of the Board of Directors of Genta Incorporated, a director of AVAX Technologies, Inc. and Palatin Technologies, Inc., each of which is a publicly traded biopharmaceutical company. Additionally, Mr. Weiss is currently a member of the boards of directors of several privately held biopharmaceutical companies. Mr. Weiss received his J.D. from Columbia University School of Law and a B.S. in Finance from the State University of New York at Albany. Mr. Weiss devotes only a portion of his time to the business of the Company.
The term of office of each officer extends until the meeting of the Board of Directors following the next annual meeting of Shareholders and until his successor is elected and qualified or until his earlier resignation or removal.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
SUMMARY COMPENSATION TABLE. The table below sets forth certain compensation information for the following executive officers of HVDC: Mr. Lloyd J. Kagin, current President and Chief Executive Officer, Mr. John F. Dee, President and Chief Executive Officer during fiscal year 1999, Nigel Rulewski, Chief Medical Officer, and Michael Fitzgerald, Chief Financial Officer. Mr. Dee resigned as an executive officer of HVDC as of February 25, 2000 and Mr. Kagin was hired to fill his position. Mr. Fitzgerald became an executive officer of HVDC in March of 1999. Dr. Rulewski resigned as Chief Medical Officer effective February 29, 2000.
SUMMARY COMPENSATION TABLE
- ----------------
(1) Mr. Kagin joined HVDC as President and Chief Executive Officer effective as of February 25, 2000. His compensation arrangements are discussed under "Executive Employment Contracts and Termination Agreements" below.
(2) Mr. Dee joined HVDC as President and Chief Executive Officer in February 1998 and resigned his office effective February 25, 2000. Mr. Dee is currently serving as HVDC's Vice Chairman.
(3) In lieu of the annual cash bonus Mr. Dee is entitled to under his employment agreement, he received an option to purchase 106,667 shares of HVDC common stock for his services in 1998.
(4) This option was granted in January 1999, but was approved in principle in 1998 in connection with Mr. Dee's offer of employment. This option was initially exercisable for 415,000 shares at $5.00 per share, but the number of shares and the exercise price have been adjusted in accordance with provisions that paralleled antidilution and reset rights held by investors in HVDC's 1998 private placement, thereby keeping the executive's interests in line with those of the investors.
(5) Mr. Fitzgerald joined HVDC as Vice President and Chief Financial Officer in March of 1999.
(6) In lieu of a cash bonus, Mr. Fitzgerald received 5,000 shares of HVDC common stock.
(7) This option was initially exercisable for 110,000 shares at $5.00 per share, but the number of shares and the exercise price have been adjusted in accordance with provisions that paralleled antidilution and reset rights held by investors in HVDC's 1998 private placement, thereby keeping the executive's interests in line with those of the investors.
(8) Dr. Rulewski joined HVDC as Chief Medical Officer in December 1998 and resigned from this office effective February 29, 2000.
(9) In lieu of a cash bonus, Dr. Rulewski received 10,000 shares of HVDC's common stock.
(10) This option initially was exercisable for 300,000 shares at $5.00 per share, but the number of shares and the exercise price have been adjusted in accordance with provisions that paralleled antidilution and reset rights held by investors in HVDC's 1998 private placement, thereby keeping the executive's interests in line with those of the investors.
OPTION GRANT TABLE. The following table provides information concerning the grant of stock options under HVDC's 1998 Equity Incentive Plan to the named executive officers during the last fiscal year. In addition, the table shows hypothetical gains that could be achieved for the respective options if exercised at the end of the option term. These gains are based on assumed rates of stock price appreciation of 5% and 10%, compounded annually, from the date the options were granted to their expiration date. This table does not take into account any change in the price of HVDC common stock to date, nor does HVDC make any representation regarding the rate of its appreciation.
OPTION GRANTS IN LAST FISCAL YEAR
- -----------------
(1) The dollar amounts under these columns include the results at the 5% and 10% rates set by the Securities and Exchange Commission and, therefore, are not intended to forecast possible future appreciation, if any, in the price of the underlying common stock. No gain to the optionees is possible without an increase in price of the common stock, which will benefit all stockholders proportionately.
(2) Based on a total of 568,771 shares subject to options granted during 1999, as adjusted through January 28, 2000. This total does not include an option issued to John Dee in January 1999 to purchase an adjusted total of 1,330,128 shares, because this option was approved in principle in 1998 in connection with Mr. Dee's employment agreement.
(3) The exercise price and number of shares subject to this option reflect adjustments pursuant to the original terms thereof through January 28, 2000 when the terms became fixed. The adjustment provisions were designed to keep Mr. Dee's interests in line with the interests of investors.
(4) The exercise price and number of shares subject to this option reflect adjustments pursuant to the original terms thereof through January 28, 2000 when the terms became fixed. The adjustment provisions were designed to keep Mr. Fitzgerald's interests in line with the interests of investors.
FISCAL YEAR-END OPTION VALUES. The following table provides information regarding exerciseable and unexerciseable stock options held by the named executive officers as of December 31, 1999:
FISCAL YEAR-END OPTION VALUES
- -----------------
(1) These numbers reflect acceleration of vesting and adjustment of option terms that occurred on January 28, 2000.
(2) Based on the difference between the option exercise price and the closing price of the underlying common stock on December 31, 1999, which closing price was $3.6875.
EXECUTIVE EMPLOYMENT CONTRACTS AND TERMINATION AGREEMENTS
Provided below is information concerning the employment and termination arrangements that the company has entered into with its executive officers named in the compensation table above. Mr. Fitzgerald has not entered into an employment agreement with the company regarding his service as Chief Financial Officer.
LLOYD J. KAGIN. On February 25, 2000, HVDC and Mr. Kagin entered into an employment agreement providing for Mr. Kagin to serve as president and chief executive officer on the company until March 25, 2004. Mr. Kagin's employment agreement entitles him to a minimum annual base salary of $250,000 and an annual bonus of between $25,000 and $100,000. The amount of Mr. Kagin's bonus is determined annually by the compensation committee in light of his and the company's performance over the prior year. Mr. Kagin received a signing bonus of $75,000 and options to purchase an aggregate of 2.4 million shares of the company's common stock at a price of $4.438 per share Half of these options become exercisable in quarterly installments over a four-year period, and the other half all become exercisable at the end of the four-year period, subject to acceleration if certain performance goals are met. If the company terminates Mr. Kagin's employment without cause, or if Mr. Kagin terminates his employment because the company has breached its obligations to him or there has been a change of control of the company, then Mr. Kagin is entitled to receive (i) severance payments in a lump sum equal to his cash compensation from HVDC for the twelve month period preceding the termination date and (ii) immediate acceleration of the exercisability of any unvested options then held by Mr. Kagin, except that the exercisability of his options to purchase 1.2 million shares will not accelerate unless the company has attained a certain market capitalization.
JOHN F. DEE. HVDC and Mr. Dee entered into an employment agreement effective in February of 1998 providing for Mr. Dee to serve as the company's President and Chief Executive Officer until such time as his employment is terminated. Mr. Dee's employment agreement entitles him to a minimum annual base salary of $200,000 and an annual bonus of a minimum of $25,000 and a maximum $200,000. The amount of Mr. Dee's bonus is determined annually by the compensation committee in light of his and the company's performance over the prior year. As of the date of this proxy, the compensation committee had not yet considered whether Mr. Dee will receive more than the minimum bonus for 1999. Mr. Dee was also granted an option to purchase shares of the company's common stock under the employment agreement. As adjusted through January 28, 2000, this option entitles Mr. Dee to purchase 1,330,128 shares of common stock at $1.56 per share. This option became exercisable
in full in connection with the adjustment on January 28, 2000. Mr. Dee's employment may be terminated by mutual agreement of the parties, by Mr. Dee if the company breaches it's obligations to him, or by HVDC if Mr. Dee breaches his obligations to the company. Although Mr. Dee ceased to serve as President and Chief Executive Officer of HVDC in February 2000, he has continued to serve HVDC through the date of this proxy statement as Vice Chairman of the Board of Directors, and his annual compensation remains the same as before.
NIGEL J. RULEWSKI. On September 3, 1998, HVDC and Dr. Rulewski entered into an employment agreement whereby Dr. Rulewski agreed to serve as the company's Chief Medical Officer. Dr. Rulewski's employment agreement entitled him to a minimum annual base salary of $200,000 and a performance bonus of up to $225,000 each year. The amount of Dr. Rulewski's bonus is determined by the compensation committee based upon the recommendation of the company's President and is subject to his achievement of agreed upon milestones set at the beginning of each year. As of the date of this proxy, the compensation committee had not yet considered Dr. Rulewski's bonus award for 1999. Dr. Rulewski was also granted an option to purchase 961,538 shares of the company's common stock at a price of 1.56 per share, as adjusted through January 28, 2000. Dr. Rulewski resigned as Chief Medical Officer effective February 29, 2000.
COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
During 1999, the Compensation Committee of the Board of Directors consisted of Dr. Zola P. Horovitz, Dr. Max Link, and Michael S. Weiss from January until June, at which time Dr. Mark C. Rogers replaced Dr. Max Link on the Committee. The Committee's responsibilities include: (i) reviewing the performance of the Chief Executive Officer and the other executive officers of HVDC and making determinations as to their cash and equity-based compensation and benefits, and (ii) administration of employee stock option grants and stock awards. The Committee met three times during 1999. The Committee submits this report on compensation policies and actions during 1999 with respect to Mr. Dee, in his capacity as President and Chief Executive Officer of the company, and Dr. Nigel Rulewski and Michael Fitzgerald, the only other HVDC executive officers whose combined salary and bonus for 1999 exceeded $100,000. Lloyd J. Kagin, who is also named in the compensation tables, joined HVDC in February 2000. These four executive officers are named in the compensation tables contained in this proxy statement.
COMPENSATION PHILOSOPHY.
HVDC's executive compensation policy is comprised of three principal elements: base salary, cash or stock bonuses based on performance and stock option grants, and is designed to attract, retain and reward executive officers who contribute to the long term success of HVDC. Through its compensation policy, HVDC strives to provide total compensation that is competitive with other companies in comparable lines of business. The compensation program includes both motivational and retention-related compensation components. Individual performance that meets and exceeds the company's plans and objectives is encouraged through bonus awards, and stock options are granted to connect the performance of the company's stock with the compensation of its executives.
HVDC endeavors to reward each executive's achievement of goals related to the company's annual and long-term performances and individual fulfillment of responsibilities. While compensation survey data provide useful guides for comparative purposes, the Committee believes that an effective compensation program also requires the application of judgment and subjective determinations of individual performance. Accordingly, the Committee members apply their judgment to reconcile the program's objectives with the realities of retaining valued employees.
CHIEF EXECUTIVE OFFICER COMPENSATION
John Dee served as the Chief Executive Officer from February 1998 through February 2000. Pursuant to his employment agreement, Mr. Dee's base salary for his first year of service was fixed at $200,000 and is subject to upward adjustment in the discretion of the committee for each consecutive year of employment. Mr. Dee is also entitled to a performance bonus of up to $200,000, subject to the achievement of agreed upon milestones, with a
minimum bonus of $25,000. As of the date of this proxy statement, the Compensation Committee has not yet considered whether Mr. Dee will receive more than the minimum base salary and bonus for 1999.
The Committee approved an option grant to Mr. Dee as part of his offer of employment, which option was initially exercisable for 415,000 shares at $5.00. The exercise price of Mr. Dee's option was set at the price per share paid by the investors in HVDC's 1998 private placement, which price exceeded the fair market value of the common stock on the date of grant. Mr. Dee's option grant included provisions to adjust the number of shares and the exercise price which paralleled antidilution and reset rights held by investors in HVDC's 1998 private placement, thereby keeping Mr. Dee's interests parallel with those of the investors. As of January 28, 2000, Mr. Dee's option was adjusted to cover 1,330,128 shares at an exercise price of $1.56 per share, at which time its terms became fixed. At that same time, the exercisability schedule of the option was accelerated, and it became exercisable in full. In addition, Mr. Dee was granted an option in 1999 that entitles him to purchase 106,667 shares of common stock at $1.125 per share, after giving effect to adjustments through January 28, 2000. This option also has been accelerated and is exercisable in full.
Mr. Dee has resigned, effective as of February 25, 2000, as the company's President and Chief Executive Officer and has been replaced by Mr. Kagin. Mr. Dee continues to serve the company as Vice Chairman.
COMPENSATION OF OTHER EXECUTIVE OFFICERS
BASE SALARY. Dr. Rulewski had an employment agreement with HVDC that set his minimum annual base salary. (see "Executive Employment Contracts and Termination Agreements"). The compensation committee set Mr. Fitzgerald's annual base salary at $150,000 when HVDC hired him in 1999. HVDC sets the annual base salary for its executives based on each executive's salary history, the salaries of other HVDC executives, and the compensation of executives at comparable companies. The Compensation Committee periodically reviews the base salaries paid to executive officers. In addition, executive officers may receive bonuses in the discretion of the compensation committee. No bonuses have been awarded with regard to services performed during 1999.
STOCK OPTIONS. Executive officer compensation also includes long-term incentives afforded by options to purchase shares of common stock. Information pertaining to option grants to executive officers in 1999 is provided in the table entitled "Option Grants in Last Fiscal Year."
STOCK OPTIONS
Stock options generally are granted to HVDC's executive officers at the time of their hire and at such other times as the Committee may deem appropriate, such as a promotion and upon nearing full vesting of prior options. In determining option grants, the Committee considers the same industry survey data as used in its analysis of base salaries and bonuses, and strives to make awards that are in line with its competitors. In general, the number of shares of common stock underlying the stock options granted to each executive reflects the significance of that executive's current and anticipated contributions to HVDC.
In addition, the stock option grants made by the Committee are designed to align the interest of management with those of the shareholders. In order to maintain the incentive and retention aspects of these grants, the Committee has determined that a significant percentage of any officer's stock options should be unvested option shares.
The value that may be realized from exercisable options depends on whether the price of the company's common stock at any particular point in time accurately reflects the company's performance. However, each individual optionholder, and not the Committee, makes the determination as to whether to exercise options that have vested in any particular year.
COMPLIANCE WITH INTERNAL REVENUE CODE SECTION 162(m)
Section 162(m) of the Internal Revenue Code generally disallows a tax deduction to a public company for compensation over $1 million paid to its Chief Executive Officer and its four other most highly compensated
executive officers. However, if certain performance-based requirements are met, qualifying compensation will not be subject to this deduction limit.
By the Compensation Committee,
Zola P. Horovitz, Ph.D.
Mark C. Rogers, M.D.
Michael S. Weiss
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table and footnotes set forth certain information regarding the beneficial ownership of HVDC's common stock as of April 1, 2000 by (i) the only persons known by HVDC to be beneficial owners of more than 5% of the common stock, (ii) the executive officers named in the Summary Compensation Table, (iii) each director and nominee for election as a director, and (iv) all current executive officers and directors as a group:
- -------------- * Indicates less than 1%
(1) Unless otherwise indicated in these footnotes, each stockholder has sole voting and investment power with respect to the shares of common stock shown as beneficially owned by such stockholder, subject to community property laws where applicable. Shares of common stock issuable upon the exercise of options or warrants currently exercisable or exercisable within 60 days of April 1, 2000 are treated as outstanding solely for the purpose of calculating the amount and percentage of shares beneficially owned by the holder of such options or warrants.
(2) Reported ownership consists of:
(A) the following holdings of The Aries Domestic Fund L.P.: (1) 3,404,259 outstanding shares of common stock, (2) 258,136 shares issuable on exercise of Class C Warrants, (3) 55,443 shares issuable upon exercise of 1998 Unit Purchase Options, (4) 25,153 shares issuable upon exercise of Class C Warrants issuable on exercise of 1998 Unit Purchase Options, (5) 45,654 shares issuable upon exercise of 1997 Unit Purchase Options originally issued by Pacific Pharmaceuticals, Inc., (6) 4,671 shares issuable upon exercise of Class A Warrants issuable on exercise of 1997 Unit Purchase Options originally issued by Pacific, (7) 2,716 shares issuable upon exercise of 1995 Unit Purchase Options originally issued by Pacific, (8) 3,395 shares issuable upon exercise of Class A Warrants issuable on exercise of 1995 Unit Purchase Options originally issued by Pacific, (9) 73,871 shares issuable upon exercise of Class A Warrants originally issued by Pacific, (10) 189,000 shares issuable upon exercise of Class D Warrants, (11) 4,889 shares issuable upon exercise of common stock Warrants originally issued by Pacific, and (12) 1,754 shares issuable upon exercise of common stock Warrants originally issued by HVDC;
(B) the following holdings of the Aries Trust: (1) 6,731,810 shares of common stock, (2) 495,442 shares issuable on exercise of Class C Warrants, (3) 112,564 shares issuable upon exercise of 1998 Unit Purchase Options, (4) 51,067 shares issuable upon exercise of Class C Warrants issuable on exercise of 1998 Unit Purchase Options, (5) 88,568 shares issuable upon exercise of 1997 Unit Purchase Options originally issued by Pacific Pharmaceuticals, Inc., (6) 9,061 shares issuable upon exercise of Class A Warrants issuable on exercise of 1997 Unit Purchase Options originally issued by Pacific, (7) 2,716 shares issuable upon exercise of 1995 Unit Purchase Options originally issued by Pacific, (8) 3,395 shares issuable upon exercise of Class A Warrants issuable on exercise of 1995 Unit Purchase Options originally issued by Pacific, (9) 117,757 shares issuable upon exercise of Class A Warrants originally issued by Pacific, (10) 441,000 shares issuable upon exercise of Class D Warrants, (11) 11,408 shares issuable upon exercise of Common stock Warrants originally issued by Pacific, and (12) 4,092 shares issuable upon exercise of Common stock Warrants originally issued by HVDC;
(C) the following holding of Aries Master Fund: 26,962 shares of common stock;
(D) the following holding of Aries Domestic Fund II, L.P.: 634 shares of common stock;
(E) the following holdings of Dr. Lindsay A. Rosenwald: (1) 276,258 shares of common stock, (2) 936,954 shares issuable upon exercise of 1998 Unit Purchase Options, (3) 425,069 shares issuable upon exercise of Class C Warrants issuable on exercise of 1998 Unit Purchase Options, (4) 843,445 shares issuable upon exercise of 1997 Unit Purchase Options originally issued by Pacific, (5) 86,292 shares issuable upon exercise of Class A Warrants issuable on exercise of 1997 Unit Purchase Options originally issued by Pacific, (6) 20,879 shares issuable upon exercise of 1995 Unit Purchase Options originally issued by Pacific, and (7) 26,099 shares issuable upon exercise of Class A Warrants issuable on exercise of 1995 Unit Purchase Options originally issued by Pacific;
(F) 10,865 shares of common stock held by Paramount Capital Investments LLC; and
(G) 216,288 shares of common stock held by Paramount Capital, Inc.
(3) Includes 1,436,795 shares issuable to Mr. Dee upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(4) Includes 352,564 shares issuable to Mr. Fitzgerald upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(5) Consists of (1) 17,893 outstanding shares of common stock; (2) 168,019 shares issuable to Mr. Weiss upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000; (3) 45,022 shares issuable upon exercise of 1998 Unit Purchase Options, (4) 20,426 shares issuable upon exercise of Class C Warrants issuable on exercise of 1998 Unit Purchase Options, (5) 181,725 shares issuable upon exercise of 1997 Unit Purchase Options originally issued by Pacific Pharmaceuticals, Inc., (6) 18,592 shares issuable upon exercise of Class A Warrants issuable on exercise of 1997 Unit Purchase Options originally issued by Pacific, (7) 2,230 shares issuable upon exercise of 1995 Unit Purchase Options originally issued by Pacific, (8) 2,787 shares issuable upon exercise of Class A Warrants issuable on exercise of 1995 Unit Purchase Options originally issued by Pacific and (9) options held by Hawkins Group, LLC to purchase units consisting of an aggregate of 215,637 shares of common stock, plus Class C Warrants to purchase 97,828
shares of common stock. Mr. Weiss is a managing member of the Hawkins Group, LLC and disclaims beneficial ownership of its shares except to the extent of his pecuniary interest therein, if any.
(6) Consists solely of shares issuable to Dr. Horovitz upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(7) Consists of (A) 10,390,818 shares and 2,001,752 shares issuable upon exercise of options and warrants held by The Aries Trust, Aries Domestic Fund, L.P., Aries Master Fund, Aries Domestic Fund II, L.P., Paramount Capital Investments LLC and Paramount Capital Asset Management Inc. (the "Paramount" Entities") and (B) 150,513 shares issuable to Dr. Rogers upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000. Dr. Rogers is the President of Paramount Capital, Inc., an affiliate of the Paramount Entities. Dr. Rogers disclaims beneficial ownership of the shares held by the Paramount Entities except to the extent of his pecuniary interest therein, if any.
(8) Consists of shares issuable to Mr. Rulewski upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(9) Includes 162,325 shares issuable to Mr. Vernon upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(10) Consists of shares issuable to Dr. Cooper upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(11) Includes 33,334 shares issuable to Mr. Pauze upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
(12) Mr. Weiser's ownership is calculated on the basis of his Form 3 filed with the SEC in February 2000. Includes 1,250,000 shares held by J.E. Holdings, Inc., a corporation of which Mr. Weiser's wife is an affiliate. Also includes 1,050,000 shares held by Weistanta Investment Co., as to which Mr. Weiser [disclaims?] beneficial ownership.
(13) Includes 3,650,975 shares issuable to directors and executive officers upon the exercise of options currently exercisable or exercisable within 60 days of April 1, 2000.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
PARAMOUNT AFFILIATES. Various entities affiliated with Paramount Capital Asset Management, Inc. (named in the table headed "Security Ownership of Management and Five Percent Owners" set forth above) are significant stockholders of HVDC. During 1999, HVDC had certain relationships and transactions with these stockholders and their affiliates, known as "Paramount Affiliates."
- - During 1999, two members of the HVDC Board of Directors had relationships with the Paramount Affiliates. During part of 1999, Mr. Weiss was a Senior Managing Director of Paramount Capital, Inc., a Paramount Affiliate. In addition, Dr. Rogers was the President of Paramount Capital, Inc. during all of 1999 to date.
- - Certain Paramount Affiliates have a contractual right to designate a majority of the members of HVDC's Board of Directors, as long as these Paramount Affiliates hold at least 5% of the voting stock of HVDC. In addition, during that period, HVDC must obtain the consent of these Paramount Affiliates prior to (1) making any payments in excess of $50,000, (2) incurring any indebtedness, (3) engaging in transactions with other affiliates or (4) increasing executive compensation or bonuses, except for bonuses guaranteed in an employment contract.
- - During 1999, HVDC paid Paramount Affiliates (1) an aggregate of $44,000 in monthly advisory fees for financial advisory services, (2) $50,000 in cash and 160,160 shares of HVDC Common Stock as payment for a 6% brokerage fee incurred by Pacific in connection with the merger, (3) 546,000 shares of HVDC common stock as a fee for services that Paramount provided in structuring and negotiating the merger, (5) 27,615 shares of Common Stock in exchange for the cancellation of indebtedness originally incurred by Pacific.
- - In addition, HVDC is obligated to pay Paramount a commission of 5% upon the exercise of any Class C Warrants.
PACIFIC PHARMACEUTICALS. Mr. Weiss and Dr. Vernon, HVDC Board members, were serving on the Board of Directors of Pacific Pharmaceuticals, Inc. during the negotiation, execution and consummation of HVDC's acquisition of Pacific. The HVDC Board of Directors formed a Special Committee to consider and approve any terms of the transaction with Pacific. Mr. Weiss and Dr. Vernon were not members of the HVDC Special Committee.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) 1. FINANCIAL STATEMENTS.
The financial statements are listed under Part II, Item 8 of this Report.
2. FINANCIAL STATEMENT SCHEDULES.
None.
3. EXHIBITS.
The exhibits filed as part of this Form 10-K are listed on an Exhibit Index preceeding such exhibits.
(b) REPORTS ON FORM 8-K.
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, on this 30th day of March, 1999.
HEAVENLYDOOR.COM, INC. (Registrant)
/s/ Lloyd J. Kagin ----------------------------------------------- Lloyd J. Kagin, President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on this 30th day of March, 1999:
Capacity
/s/ Glenn L. Cooper, M.D. Director - ------------------------------------ Glenn L. Cooper, M.D.
/s/ John F. Dee Vice Chairman - ------------------------------------ John F. Dee
/s/ Michael E. Fitzgerald Vice President, Finance and - ------------------------------------ Chief Financial Officer Michael E. Fitzgerald (Principal Financial Officer and Principal Accounting Officer)
/s/ Zola P. Horovitz, Ph.D. Director - ------------------------------------ Zola P. Horovitz, Ph.D.
/s/ Lloyd J. Kagin President, Chief Executive - ------------------------------------ Officer and Director Lloyd J. Kagin (Principal Executive Officer)
/s/ Richard J. Kurtz Director - ------------------------------------ Richard J. Kurtz
/s/ Philip C. Pauze Director - ------------------------------------ Philip C. Pauze
/s/ Mark C. Rogers, M.D. Director - ------------------------------------ Mark C. Rogers, M.D.
/s/ Elliott H. Vernon Director - ------------------------------------ Elliott H. Vernon
/s/ Howard Weiser Director - ------------------------------------ Howard Weiser
/s/ Michael S. Weiss Chairman - ------------------------------------ Michael S. Weiss
EXHIBIT INDEX
Exhibit No. Description
3.1 Restated Certificate of Incorporation of HeavenlyDoor.com, Inc. Filed as Exhibit 3.1 to HeavenlyDoor.com's Form 10-Q for the quarter ended June 30, 1997, Commission File No. 0-21134, and incorporated herein by reference.
3.2 Certificate of Amendment of the Restated Certificate of Incorporation of HeavenlyDoor.com, filed with the Secretary of State of Delaware on October 7, 1997, to be effective as of October 14, 1997. Filed as Exhibit 3.1 to HeavenlyDoor.com's Form 10-Q for the quarter ended September 31, 1997, Commission File No. 0-21134, and incorporated herein by reference.
3.3 Certificate of Amendment of the Restated Certificate of Incorporation, as amended, filed with the Secretary of State of Delaware on May 19, 1998, effective as of June 1, 1998. Filed as Exhibit 4.4 to HeavenlyDoor.com's Registration Statement on Form S-8, Commission File No. 333-66885, and incorporated herein by reference.
3.4 Certificate of Amendment of the Restated Certificate of Incorporation, as amended, filed with the Secretary of State of Delaware on January 26, 2000. Filed herewith.
4.4 Unit Purchase Warrant Agreement dated May 17, 1996, issued to David Blech. Filed as Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1997, Commission File No. 0-21134, and incorporated herein by reference.
4.5 Form of Class C Warrant to Purchase Common Stock dated April 9, 1998, including Schedule of Holders. Filed as Exhibit 4.18 to HeavenlyDoor.com's Registration Statement on Form S-3, Commission File No. 333-51245, and incorporated herein by reference.
4.10 Warrant to Purchase Common Stock dated as of September 11, 1995, issued to Oppenheimer & Co., Inc. Filed as Exhibit 4.10 to the Company's Registration Statement on Form S-1, Commission File No. 33-96798, and incorporated herein by reference.
4.11 Form of Warrant Agreement between the Company and Commonwealth Associates. Filed as Exhibit 4.11 to the Company's Registration Statement on Form S-1, Commission File No. 33-96798, and incorporated herein by reference.
4.12 Form of Warrant to Purchase Common Stock dated May 17, 1996 and schedule of holders. Filed as Exhibit 4.12 to the Company's
Form 10-K for the year ended December 31, 1996, Commission File No. 0-21134, and incorporated herein by reference.
4.13 Warrant to Purchase Common Stock issued to Furman Selz LLC dated January 6, 1997. Filed as Exhibit 4.13 to the Company's Form 10-K for the year ended December 31, 1996, Commission File No. 0-21134, and incorporated herein by reference. 4.14 Class A Warrants (originally issued by Pacific Pharmaceuticals, Inc.) held by a Schedule of Holders. Filed as Exhibit 4.3 to HeavenlyDoor.com, Inc.'s Form 8-K filed on March 31, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.15 Class B Warrants (originally issued by Pacific Pharmaceuticals, Inc.) held by a Schedule of Holders. Filed as Exhibit 4.4 to HeavenlyDoor.com, Inc.'s Form 8-K filed on March 31, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.16 Aries Warrants (originally issued by Pacific Pharmaceuticals, Inc.) held by the Aries Trust and Aries Domestic Fund, L.P. Filed as Exhibit 4.5 to HeavenlyDoor.com, Inc.'s Form 8-K, filed on March 31, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.17 1995 Unit Purchase Options (originally issued by Pacific Pharmaceuticals, Inc.) held by a Schedule of Holders. Filed as Exhibit 4.1 to HeavenlyDoor.com, Inc.'s Form 8-K filed on March 31, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.18 1997 Unit Purchase Options (originally issued by Pacific Pharmaceuticals, Inc.) held by a Schedule of Holders. Filed as Exhibit 4.2 to HeavenlyDoor.com, Inc.'s Form 8-K filed on March 31, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.19 Common Stock Purchase Warrant issued in June 1999 to Wound Healing of Oklahoma. Filed as Exhibit 4.1 to HeavenlyDoor.com, Inc.'s Form 10-Q for the quarter ended June 30, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.20 Class D Warrants issued in June 1999 to a Schedule of Holders. Filed as Exhibit 4.2 to HeavenlyDoor.com, Inc.'s Form 10-Q for the quarter ended June 30, 1999, Commission File No. 0-21134, and incorporated herein by reference.
4.21 Form of Unit Purchase Option, including Schedule of Holders. Filed as Exhibit 4.2 to HeavenlyDoor.com's Form 10-Q for the quarter ended June 30, 1998, Commission File No. 0-21134, and incorporated herein by reference.
10.1 The 1998 Equity Incentive Plan, as amended through June 30, 1999. Filed as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended June 30, 999, Commission File No. 0-21134, and incorporated herein by reference.
10.2 The 1994 Employee Stock Purchase Plan, as amended. Filed as Exhibit 10.2 to the Company's Form 10-Q for the quarter ended June 30, 1997, Commission File No. 0-21134, and incorporated herein by reference.
10.3 Lease for 840 Memorial Drive dated February 28, 1989 between the Company and Robert Epstein et al., Trustee of the 840 Memorial Drive Trust, as amended February 28, 1989 and April 4, 1989. Filed as Exhibit 10.7 to the Company's Registration Statement on Form S-1, Commission File No. 33-57188, and incorporated herein by reference.
10.4 Lease for 840 Memorial Drive dated August 21, 1990 between the Company and Robert Epstein et al., Trustee of 840 Memorial Drive Trust. Filed as Exhibit 10.8 to the Company's Registration Statement on Form S-1, Commission File No. 33-57188, and incorporated herein by reference.
10.5 Lease for 840 Memorial Drive dated February 10, 1992 between the Company and Robert Epstein et al., Trustee of the 840 Memorial Drive Trust. Filed as Exhibit 10.9 to the Company's Registration Statement on Form S-1, Commission File No. 33-57188, and incorporated herein by reference.
10.6 Lease for 840 Memorial Drive dated September 8, 1992 between the Company and Robert Epstein et al., Trustee of the 840 Memorial Drive Trust. Filed as Exhibit 10.10 to the Company's Registration Statement on Form S-1, Commission File No. 33-57188, and incorporated herein by reference.
10.7 Lease for 840 Memorial Drive dated April 27, 1994 between the Company and Robert Epstein et al., Trustee of the 840 Memorial Drive Trust. Filed as Exhibit 10 to the Company's Form 10-Q for the quarter ended March 31, 1994, Commission File No. 0-21134, and incorporated herein by reference.
10.8 Consulting and Confidentiality Agreement dated January 1, 1998 between HeavenlyDoor.com, Inc. and Mark C. Rogers, M.D. Filed as Exhibit 10.11 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.9 Consulting and Confidentiality Agreement dated January 1, 1998 between HeavenlyDoor.com, Inc. and Elliott H. Vernon. Filed as Exhibit 10.12 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.10 Consulting and Confidentiality Agreement dated January 1, 1998 between HeavenlyDoor.com, Inc. and Michael S. Weiss. Filed as Exhibit 10.13 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.11 Consulting and Confidentiality Agreement dated as of May 1, 1994 between the Company and Zola P. Horovitz, Ph.D. Filed as Exhibit 10 to the Company's Form 10-Q for the quarter ended June 30, 1994, Commission File No. 0-21134, and incorporated herein by reference.
10.12 Registration Rights Agreement dated January 6, 1997 between the Company and Furman Selz LLC. Filed as Exhibit 10.36 to the Company's Form 10-K for the year ended December 31, 1996, Commission File No. 0-21134, and incorporated herein by reference.
10.13 Form of Indemnification Agreement between HeavenlyDoor.com, Inc. and its Directors. Filed as Exhibit 10.15 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.14 Placement Agency Agreement between the Company and Paramount Capital, Inc. dated as of October 26, 1997. Filed as Exhibit 10.40 to the Company's Form 10-K for the year ended December 31, 1997, Commission File No. 0-21134, and incorporated herein by reference.
10.15 Extension to the Consulting and Confidentiality Agreement dated December 3, 1998 between HeavenlyDoor.com, Inc. and Mark C. Rogers, M.D. Filed as Exhibit 10.25 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.16 Extension to the Consulting and Confidentiality Agreement dated December 3, 1998 between HeavenlyDoor.com, Inc. and Elliott H. Vernon. Filed as Exhibit 10.26 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.17 Extension to the Consulting and Confidentiality Agreement dated December 3, 1998 between HeavenlyDoor.com, Inc. and Michael S. Weiss. Filed as Exhibit 10.27 to the Company's Registration Statement on Form S-4, Commission File No. 33-369821, and incorporated herein by reference.
10.18 Executive Employment Agreement dated as of February 4, 1998 between HeavenlyDoor.com, Inc. and John F. Dee. Filed as Exhibit 10.3 to HeavenlyDoor.com, Inc.'s Form 10-Q for the quarter ended June 30, 1999, Commission File No. 0-21134, and incorporated herein by reference.
10.19 Consulting and Confidentiality Agreement dated January 24, 2000 between HeavenlyDoor.com, Inc. and Philip Pauze. Filed herewith.
10.20 Executive Employment Agreement dated as of February 25, 2000 between HeavenlyDoor.com, Inc. and Lloyd Kagin. Filed herewith.
23.1 Consent of PricewaterhouseCoopers LLP, independent accountants to the Company. Filed herewith.
27.1 Financial Data Schedule. Filed herewith.
99.1 Important factors regarding forward-looking statements. Filed herewith.
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Exhibits 10.1, 10.2, 10.8 through 10.10, and 10.15 through 10.20 are management contracts or compensatory plans, contracts or arrangements in which executive officers or directors of the Company participate. | 29,865 | 195,455 |
67686_1999.txt | 67686_1999 | 1999 | 67686 | ITEM 1. BUSINESS.
Monsanto Company is a life sciences company, committed to finding solutions to the growing global needs for food and health by applying common forms of science and technology among agriculture, nutrition and health. Monsanto makes, researches and markets high-value agricultural products, pharmaceuticals and nutrition-based health products. Monsanto Company was incorporated in 1933 under Delaware law and is the successor to a Missouri corporation, Monsanto Chemical Works, organized in 1901. "Monsanto" and the "Company" are used interchangeably to refer to Monsanto Company or to Monsanto Company and its subsidiaries, as appropriate to the context.
For 1999, Monsanto reported its business under three segments: Agricultural Products, Pharmaceuticals, and Corporate and Other. In 1999, Monsanto announced its intention to sell the artificial sweetener and biogum businesses. The results of operations, financial position, and cash flows of these businesses, and of the alginates and Ortho(R) lawn-and-garden products businesses, the dispositions of which were approved by Monsanto's Board of Directors in 1998, have been reclassified as discontinued operations; and, for all periods presented, the consolidated financial statements and notes have been reclassified to conform to this presentation. In addition, Monsanto transferred the Roundup(R) lawn-and-garden and nutrition research operations of the former Nutrition and Consumer Products segment to the Agricultural Products and Corporate and Other segments, respectively.
The first and last paragraphs appearing under "Definitions" on page 3, the information regarding sales of certain herbicides in 1999, 1998 and 1997 appearing under "Agricultural Products" on pages 11 and 12, the information regarding sales of certain arthritis treatments in 1999, 1998 and 1997 appearing under "Pharmaceuticals" on pages 14 and 15, and the tabular and narrative information appearing in "Note 3: Geographic Data" on page 32 and in "Note 23: Segment Information" on pages 52 and 53, all appearing in Exhibit 99.1 of this Report, are incorporated herein by reference.
PRINCIPAL PRODUCTS
Monsanto's principal products for 1999, categorized by segments reclassified as described above, include the following:
Products may be sold under different brand names outside the United States.
Monsanto's products are sold and/or licensed directly to customers in various industries, to wholesalers and other distributors, to retailers and to the ultimate user or consumer, principally by its own sales force, or, in some cases, through third parties. With respect to pharmaceuticals, such sales force concentrates on detailing to physicians and managed health care providers. The Pharmaceuticals segment's anti-arthritis product Celebrex(R) will be co-promoted with Yamanouchi Pharmaceutical Co. Ltd. in Japan and with Pfizer Inc. in most other countries of the world.
PRINCIPAL EQUITY AFFILIATES
Monsanto participates in a number of joint ventures in which it shares management control with other companies. For example, Monsanto has a 60% ownership interest in a joint venture with Solutia Inc., from which it purchases elemental phosphorus. In addition, Monsanto and Cargill Incorporated have established Renessen LLC, a worldwide joint
venture in which Monsanto has a 50% interest, to create and market new products enhanced through biotechnology for the crop processing and animal feed markets.
SALE OF PRODUCTS
Monsanto's net income has been historically higher during the first half of the year, primarily because of the concentration of generally more profitable sales of the Agricultural Products segment during that part of the year. Monsanto's marketing and distribution practices do not result in unusual working capital requirements on a consolidated basis, although the seasonality of sales of the Agricultural Products segment results in short- term borrowings to finance customer accounts receivable and inventories. Inventories of finished goods, goods in process and raw materials are maintained to meet customer requirements and Monsanto's scheduled production. In general, Monsanto does not manufacture its products against a backlog of firm orders; production is geared primarily to the level of incoming orders and to projections of future demand.
Monsanto generally is not dependent upon one or a group of customers and Monsanto has no material contracts with the government of the United States or any state, local or foreign government. However, pursuant to contracts executed under U.S. federal and state laws, the Pharmaceuticals segment pays rebates to state governments for pharmaceuticals sold under state Medicaid programs and under state-funded programs for the indigent. The Pharmaceuticals segment also grants discounts to certain managed health care providers. Sales through managed health care providers constitute an increasing percentage of that segment's sales.
Introduction of new products by the Agricultural Products and Pharmaceuticals segments typically is, and introduction of new products by other segments may be, subject to prior review and approval by the FDA, the U.S. Environmental Protection Agency and/or the U.S. Department of Agriculture (or comparable agencies of governments outside the United States) before they can be sold. Such reviews are often time-consuming and costly. These agencies also have continuing jurisdiction over many existing products of these segments. Governmental actions may also affect or determine the pricing of certain products, particularly in the Pharmaceuticals segment.
RAW MATERIALS AND ENERGY RESOURCES
Monsanto is both a producer and significant purchaser of a wide spectrum of its basic and intermediate raw material requirements. Major requirements for key raw materials and fuels are typically purchased pursuant to long-term contracts. Monsanto is not dependent on any one supplier for a material amount of its raw materials or fuel requirements, but certain important raw materials are obtained from a few major suppliers. Monsanto purchases its North American supply, and has the option to purchase its ex-North American supplies, of elemental phosphorus, a key raw material for the production of Roundup(R) brand herbicides, from P4 Production, L.L.C., a joint venture between the Company and Solutia Inc. In general, where Monsanto has limited sources of raw materials, it has developed contingency plans to minimize the effect of any interruption or reduction in supply.
While temporary shortages of raw materials and fuels may occasionally occur, these items are generally sufficiently available to cover current and projected requirements. However, their continuing availability and price are subject to unscheduled plant interruptions occurring during periods of high demand, or due to domestic and world market and political conditions, as well as to the direct or indirect effect of U.S. and other countries' government regulations. The impact of any future raw material and energy shortages on Monsanto's business as a whole or in specific world areas cannot be accurately predicted. Operations and products may, at times, be adversely affected by legislation, shortages or international or domestic events.
PATENTS, TRADEMARKS, LICENSES, FRANCHISES AND CONCESSIONS
Monsanto owns a large number of patents which relate to a wide variety of products and processes and has pending a substantial number of patent applications. United States Plant Variety Protection Act Certificates and foreign plant registrations are also significant to the Agricultural Products segment. In addition, Monsanto holds a number of licenses granted by other parties, some of which may be significant. Monsanto also owns a considerable number of established trademarks in many countries under which it markets its products. Monsanto's patents and trademarks in the aggregate are of material importance to the Agricultural Products and Pharmaceuticals segments. Certain proprietary products are covered by patents. Certain of Monsanto's patents and licenses are currently the subject of litigation; see "Legal Proceedings" below.
Although patents protecting Roundup(R) herbicide have expired in most countries, compound per se patent protection for the active ingredient in Roundup(R) herbicide continues in the United States until September 20, 2000. Monsanto's insect-resistant seed traits (including NewLeaf(R) traits in potato, YieldGard(R) trait in corn and Bollgard(R) trait in cotton) are protected by patents which extend until at least 2013. Monsanto's herbicide-resistant seed traits (Roundup Ready(R) traits in cotton, corn, canola and soybeans) are protected by patents which extend until at least 2014. Posilac(R) bovine somatotropin is protected by a United States patent that expires in 2008, and by corresponding patents in other countries, most of which expire in 2005. Other patents protect various aspects of bovine somatotropin manufacture in the United States and expire as late as 2012; corresponding patents in other countries have varying terms.
Calan(R) SR, an antihypertensive pharmaceutical, is licensed through the year 2004 to Searle by a third party, which has retained co-marketing rights. The product no longer has patent protection nor non-patent regulatory exclusivity conferred by the Waxman-Hatch amendments to the U.S. Food, Drug and Cosmetics Act. Cytotec(R) ulcer preventive drug is protected by a U.S. composition patent until July 29, 2000. Ambien(R) short-term treatment for insomnia is licensed to a joint venture of which Searle is a general partner for the duration of the venture. Pursuant to the joint venture agreement, the other partner has agreed to purchase Searle's interest and thereby terminate the venture in April 2002. Ambien(R) is protected by a U.S. patent until October 21, 2006. Daypro(R) once-a-day arthritis treatment is licensed to Searle until January 5, 2003 in the U.S. and varying dates in other countries. This product is protected by a U.S. process patent that expires on February 26, 2002 and by non-patent regulatory exclusivity extending to April 29, 2000. Arthrotec(R)
arthritis treatment is protected by a U.S. patent until February 11, 2014. Celebrex(R), a COX-2 inhibitor for the treatment of osteoarthritis and rheumatoid arthritis is protected by a U.S. patent to November 30, 2013 and by regulatory exclusivity under the Waxman-Hatch Act to December 31, 2003.
COMPETITION
Monsanto encounters substantial competition in each of its industry segments. This competition, from other manufacturers of the same products and from manufacturers of different products designed for the same uses, is expected to continue in both U.S. and ex-U.S. markets. Depending on the product involved, various types of competition are encountered, including price, delivery, service, performance, product innovation, product recognition and quality.
The number of Monsanto's principal competitors varies from product to product. It is not practical to discuss Monsanto's numerous competitors because of the large variety of Monsanto's products, the markets served and the worldwide business interests of Monsanto. Overall, however, Monsanto regards its principal product groups to be competitive with many other products of other producers and believes that it is an important producer of many of such product groups.
RESEARCH AND DEVELOPMENT
Research and development constitute an important part of Monsanto's activities. See "Development and Commercialization of New Products Continue to be Priorities," and "Note 21: Supplemental Data", on pages 8 and 51, respectively, appearing in Exhibit 99.1 of this Report and incorporated herein by reference.
ENVIRONMENTAL MATTERS
Monsanto remains strongly committed to complying with various laws and government regulations concerning environmental matters and employee safety and health in the United States and other countries. Monsanto is dedicated to long-term environmental protection and compliance programs that reduce and monitor emissions of hazardous materials into the environment, as well as to the remediation of identified existing environmental concerns. While the costs of compliance with environmental laws and regulations cannot be predicted with certainty, Monsanto does not expect such costs to have a material adverse effect upon its capital expenditures, earnings, or competitive position. See information regarding remediation of waste disposal sites appearing in "Note 20: Commitments and Contingencies" on page 50 appearing in Exhibit 99.1 of this Report and incorporated herein by reference.
On November 22, 1999, Monsanto, Solutia Inc. and P4 Production, L.L.C. ("P4 Production") received notice that the Department of Justice ("DOJ") was preparing a federal court enforcement action against the companies on behalf of the Environmental Protection Agency (EPA). P4 Production is a joint venture formed by Monsanto and Solutia Inc. ("Solutia"), and operated by Solutia under an operating agreement with P4 Production. The potential action concerned alleged violations of Wyoming's environmental laws and
regulations, and an air permit issued in 1994 by the Wyoming Department of Environmental Quality to Sweetwater Resources, Inc., a former subsidiary of Monsanto's. The permit was issued for a coal coking facility in Rock Springs, Wyoming that is currently owned by P4 Production. The DOJ recommended a proposed settlement of $2.5 million. After discussions with the DOJ, Monsanto, Solutia and P4 Production filed a lawsuit in the United States District Court for the District of Wyoming on January 18, 2000 against the EPA seeking a declaratory judgment that the threatened enforcement action is precluded by the doctrine of res judicata on the grounds that the companies had already fully resolved the underlying allegations in a consent decree entered in the First Judicial District Court in Laramie County, Wyoming on June 25, 1999.
EMPLOYEE RELATIONS
As of December 31, 1998, Monsanto had approximately 29,900 employees worldwide, 1,700 of whom were associated with businesses classified as discontinued operations. Satisfactory relations have prevailed between Monsanto and its employees.
INTERNATIONAL OPERATIONS
Monsanto and affiliated companies are engaged in manufacturing, sales and/or research and development in the United States, Europe, Canada, Latin America, Australia, Asia and Africa. A number of products are manufactured abroad. Ex-U.S. operations are potentially subject to a number of unique risks and limitations, including: fluctuations in currency values; exchange control regulations; import and trade restrictions, including embargoes; governmental instability; economic conditions in other countries; and other potentially detrimental domestic and foreign governmental practices or policies affecting U.S. companies doing business abroad. See "Note 3: Geographic Data" on page 32 appearing in Exhibit 99.1 of this Report and incorporated herein by reference.
LEGAL PROCEEDINGS
Because of the size and nature of its business, Monsanto is a party to numerous legal proceedings. Most of these proceedings have arisen in the ordinary course of business and involve claims for money damages or seek to restrict Monsanto's business activities. While the results of litigation cannot be predicted with certainty, Monsanto does not believe these matters or their ultimate disposition will have a material adverse effect on Monsanto's financial position, profitability or liquidity in any one year, as applicable.
In 1974, Searle introduced in the United States an intrauterine contraceptive product, commonly referred to as an intrauterine device ("IUD"), under the name Cu-7(R). Following extensive testing by Searle and review by the FDA, the Cu-7(R) was approved for sale as a prescription drug in the United States. It was marketed internationally as the Gravigard(R). Searle has been named as a defendant in a number of product liability lawsuits alleging that this IUD caused personal injury resulting from pelvic inflammatory disease, perforation, pregnancy or ectopic pregnancy. As of March 1, 2000, there remains 1 case pending in the United States, and approximately 270 cases filed outside the United States (the vast majority in Australia). On February 22, 1999, Searle received a defense verdict after a trial of the nine lead Australian plaintiffs. Though not technically a class
action, these nine individuals are considered representative of the entire group of Australian plaintiffs. Plaintiffs' are appealing that verdict. The lawsuits seek damages in varying amounts, including compensatory and punitive damages, with most suits seeking at least $50,000 in damages. Searle believes it has meritorious defenses and is vigorously defending each of these lawsuits. On January 31, 1986, Searle voluntarily discontinued the sale of the Cu-7(R) in the United States, citing the cost of defending such litigation. Ex-U.S. sales were discontinued in 1990.
Searle has been named, together with numerous other prescription pharmaceutical manufacturers and in some cases wholesalers or distributors, as a defendant in a large number of related actions brought in federal and/or state court, based on the practice of providing discounts or rebates to managed care organizations and certain other large purchasers. The federal cases have been consolidated for pre-trial proceedings in the Northern District of Illinois. The federal suits include a certified class action on behalf of retail pharmacies representing the majority of retail pharmacy sales in the United States. The class plaintiffs alleged an industry-wide agreement in violation of the Sherman Act to deny favorable pricing on sales of brand-name prescription pharmaceuticals to certain retail pharmacies in the United States. The other federal suits, brought as individual claims by several thousand pharmacies, allege price discrimination in violation of the Robinson-Patman Act as well as Sherman Act claims. Several defendants, not including Searle, settled the federal class action case. On November 30, 1998, Searle and its co-defendants in the Federal class action case received a verdict for the defense and all claims were dismissed. On July 13, 1999, the U. S. Court of Appeals for the Seventh Circuit upheld most of the lower court's decision to throw out price fixing charges against the manufacturers as well as the wholesalers, but reversed the trial judge on one discrete issue involving the Consumer Price Index. Petitions for a rehearing on that issue have been denied. Cases relating to the chain pharmacies that had opted out of the class are in the final stages of discovery. In addition, consumers and a number of retail pharmacies have filed suit in various state courts throughout the country alleging violations of state antitrust and pricing laws. While many of these suits have been settled, suits remain pending in a number of states including California, Alabama, New Mexico and West Virginia.
On December 14, 1999, suit was filed against Monsanto in the United States District Court for the District of Columbia (Cause No. 1:99CV03337) by six farmers as representative of a putative class action alleging that purchasers of genetically modified soybean and corn seed may assert antitrust and other claims against Monsanto. The suit alleges that Monsanto has violated various antitrust laws and unspecified international laws through its patent license agreements and has breached an implied warranty of merchantability by offering for sale genetically modified seed. Nine other companies are accused in the lawsuit of participating in an international cartel to violate the antitrust laws but Monsanto is the only named defendant. The suit claims anti-competitive behavior and monopolistic practices by artificially inflating the prices of genetically modified seed and imposing excessive technology fees, prohibiting the reuse of modified seed, or requiring the use of specified herbicides with the seed. The suit claims that despite governmental approval for the sale of the genetically modified products there are uncertain risks posed by the technology which subjects Monsanto to liability regardless of the actual safety of the products. Plaintiffs seek declaratory and injunctive relief in addition to antitrust, treble,
compensatory and punitive damages and attorneys' fees. On November 8, 1999, a similar lawsuit was filed by a single plaintiff in United States District Court for the Northern District of Mississippi (Cause No. 2:99CV218-P-B) alleging to represent a putative class of soybean farmers who have purchased genetically-modified soybeans which contain Monsanto's patented technology. The complaint asserts claims under the Racketeer Influenced and Corrupt Organizations Act (RICO) and various antitrust acts and also asserts claims for breach of contract. The suit seeks an award of antitrust damages, treble damages and compensatory damages and attorneys' fees. On February 14, 2000, a similar lawsuit was filed in United States District Court for the Southern District of Illinois (Cause No. 00-403JLF), on behalf of five farmers purporting to represent various classes of farmers and alleging claims virtually identical to those in the District of Colombia and Mississippi cases. Monsanto has filed motions to dismiss the District of Columbia and Mississippi cases with prejudice. Subsequently, plaintiffs filed motions to dismiss these cases without prejudice, and have expressed their intention to refile in connection with the Illinois case. Monsanto is vigorously defending these lawsuits and has meritorious defenses to all claims in the lawsuits, including: failure to state any claim under existing law, no breach of any legal duty, lack of damage, legal authorization to extend technology licenses under the patent laws and other defenses. Monsanto will maintain in the litigation that its products are safe, approved for sale by regulatory authorities and that its actions have been pro-competitive under the antitrust laws and protected under the patent laws.
In 1996 Monsanto was the first to commercially introduce cotton containing a gene encoding for Bacillus thuringiensis ("Bt") endotoxin. Monsanto is a leader in this scientific field and has engaged in Bt research and biotechnology development over many years and owns a number of present and pending patents which relate to this technology. On October 22, 1996, Mycogen Corporation ("Mycogen") filed suit in U.S. District Court in Delaware seeking damages and injunctive relief against Monsanto, DEKALB Genetics Corporation ("DEKALB") (subsequently acquired by Monsanto) and Delta & Pine Land Company alleging infringement of Bt related U.S. Patent Nos. 5,567,600 and 5,567,862 issued to Mycogen on that date. Jury trial in this matter concluded on February 3, 1998 with a verdict in favor of all defendants. The patents of Mycogen were found invalid on the basis that Monsanto was a prior inventor. On September 8, 1999, the District Court issued a revised order which upheld the jury verdict and also ruled that Mycogen's patents were invalid due to their lack of enablement. Mycogen's appeal was filed in the Court of Appeals for the Federal Circuit on December 6, 1999, as appeal number 00-1001-1051. Monsanto has meritorious legal positions and will continue to vigorously oppose Mycogen's claims in the appeal.
On May 19, 1995, Mycogen Plant Science Inc. initiated suit in U.S. District Court in California against Monsanto alleging infringement of U.S. Patent No. 5,380,831 involving synthetic Bt genes and seeking damages and injunctive relief. On November 10, 1999, the District Court granted summary judgment in Monsanto's favor dismissing all of Mycogen's patent claims and finding the patent invalid on the basis of prior invention by Monsanto. Previously, the District Court had also held that products containing Bt genes made prior to January 1995 did not infringe the patent. Mycogen has filed an appeal with the Court of Appeals for the Federal Circuit (Appeal Number 00-1127) seeking to overturn the dismissal. Monsanto has various meritorious defenses against all claims of Mycogen
including non-infringement, lack of validity, prior invention and collateral estoppel as a result of the outcome in the jury trial in which Mycogen's related patents were found invalid. Monsanto will continue to vigorously oppose the claims of Mycogen in the litigation. Monsanto is also a party in interference proceedings against Mycogen in the U.S. Patent and Trademark Office to determine the first party to invent certain inventions related to Bt technology and has requested a stay of the interference pending determination of the appeals. In all of the foregoing actions Monsanto has meritorious legal positions which it is vigorously litigating to establish that the final judgment in the Delaware litigation is dispositive of Mycogen's claims and that all Mycogen Bt patents are invalid as a result of prior judicial determinations.
On December 22, 1999, Mycogen Plant Science, Inc. ("MPS"), filed a patent suit in the Federal Court of Australia, Victoria District Registry as Cause No. V746 of 1999, against Monsanto Australia Limited and DeltaPine Australia Limited. The suit alleges that the respondents have infringed certain claims of two Australian patents (574101 and 623429) associated with Bt technology. These patents are Australian counterparts to patents and inventions found invalid in other jurisdictions. Monsanto has meritorious defenses against the lawsuit, including patent invalidity due to lack of enablement, prior art and obviousness. Monsanto will vigorously defend against MPS's claims in the action.
Monsanto and/or DEKALB are involved in various legal actions involving herbicide-resistant and/or insect-resistant fertile, transgenic corn. The DEKALB patents involved in the most significant DEKALB-initiated transactions are: U.S. Patent No. 5,484,956 covering fertile, transgenic corn plants expressing genes encoding Bacillus thuringiensis (Bt) insecticidal proteins; U.S. Patent No. 5,489,520 covering the microprojectile method for producing fertile, transgenic corn plants covering a bar or pat gene, as well as the production and breeding of progeny of such plants; U.S. Patent Nos. 5,538,880 and 5,538,877 directed to methods of producing either herbicide-resistant or insect-resistant transgenic corn; and U.S. Patent No. 5,550,318 directed to transgenic corn plants containing a bar or pat gene (all lawsuits related to this patent have been stayed pending resolution of an interference proceeding at the U.S. Patent and Trademark Office). (a) DEKALB has filed infringement actions in U.S. District Court for the Northern District of Illinois (the "Rockford Litigation"). These include actions initially filed on April 30, 1996, against Pioneer Hi-Bred International, Inc. ("Pioneer") and Mycogen Corporation and two of its subsidiaries; and on August 27, 1996, against several Hoechst Schering AgrEvo GmbH entities. In each case DEKALB has asked the court to determine that infringement has occurred, to enjoin further infringement and to award unspecified compensatory and exemplary damages. By order dated June 30, 1999, a special master appointed in the Rockford Litigation construed the patent claims in a manner largely in accord with the position of DEKALB. The judge has adopted the findings of the special master and appointed a settlement mediator to conduct discussions among the parties. (b) On July 2, 1999, DEKALB sued Pioneer in United States District Court for the Northern District of Illinois in a patent interference action to declare that DEKALB was the first inventor of the microprojectile method of producing fertile transgenic corn. Pioneer's motion to dismiss that litigation has been denied. On July 30, 1999, DEKALB moved to consolidate this suit with the remainder of the Rockford Litigation for purposes of trial but the consolidation request has been provisionally denied. (c) On November 23, 1999, Pioneer sued Monsanto, DEKALB and Novartis Seeds Inc. in United States District Court for the
Eastern District of Iowa (Cause No 4-99-CV90666) for alleged infringement of its new patent (United States Patent No. 5,990,387) pertaining to microprojectile transformation of corn. Suit was also filed by DEKALB (CA 99-C-50385) on the same date in the federal court responsible for the Rockford Litigation seeking an interference action to declare that DEKALB was the first inventor of the microprojectile method of producing fertile transgenic corn.
On March 19, 1996, Monsanto was issued U.S. Patent No. 5,500,365 pertaining to synthetic Bt genes and filed suit in U.S. District Court in Delaware seeking damages and injunctive relief against Mycogen Plant Science, Inc., Agrigenetics, Inc. and Ciba-Geigy Corporation (Seed Division) (now Novartis Seeds, Inc.) for infringement of that patent. Trial of this matter ended June 30, 1998, with a jury verdict that while the patent was literally infringed by defendants, the patent was not enforceable due to a finding of prior invention (now owned by Monsanto) by another party, and not infringed due to the defense of the reverse doctrine of equivalents. On September 8, 1999 the District Court affirmed in part the jury's verdict on the issue of prior invention but overturned the finding of non-infringement on the reverse doctrine of equivalents. The matter remains pending on appeal and Monsanto is continuing to litigate vigorously its position on appeal.
On March 27, 1997, Pioneer Hi-Bred International Inc. ("Pioneer") filed an action against Monsanto which is now pending in U.S. District Court for the Eastern District of Missouri (4:97CV01609-ERW). In the lawsuit, Pioneer alleged that it was entitled to obtain via Monsanto a license to the corn transformation patents of DEKALB which were being enforced against Pioneer in the Rockford Litigation. Pioneer's license claims all have been denied by the District Court and Pioneer's claims have been dismissed. The litigation remains pending only to consider Monsanto's counterclaim to terminate the 1993 license to Pioneer pertaining to Bt corn technology, including the Yieldgard(R) corn product which is currently sold by Pioneer. Monsanto's counterclaims allege that Pioneer's actions breached the contract. All of Pioneer's summary judgment motions have been denied. Compensatory damages and equitable relief to terminate Pioneer's existing rights under the 1993 license for Yieldgard(R) Bt corn product and technology are sought by Monsanto in the litigation. The case is set for jury trial commencing in August 2000.
On November 30, 1999, Monsanto filed suit against Pioneer Hi-Bred International Inc. (4:99CV0917-LOD) ("Pioneer") in U.S. District Court for the Eastern District of Missouri to terminate a technology license for glyphosate tolerant soybeans and canola which had been previously extended to Pioneer and was assigned by Pioneer in connection with its merger with E.I. DuPont De Nemours and Company. The lawsuit alleges that the assignment resulted in unauthorized sales of herbicide tolerant soybeans and canola and thereby infringed Monsanto patents and violated certain of its trademark rights. Monsanto seeks injunctive relief and is vigorously pursuing its claims against Pioneer in the lawsuit.
In 1997 Monsanto commercially introduced corn containing a gene providing glyphosate resistance. On November 20, 1997, Aventis CropScience S.A. (formerly Rhone Poulenc Agrochimie S. A.) ("Aventis") filed suit in U.S. District Court in North Carolina (Charlotte) against Monsanto and DEKALB (now a subsidiary of Monsanto) alleging that a 1994 license agreement (the "1994 Agreement") between DEKALB and Aventis was
induced by fraud stemming from DEKALB's nondisclosure of a research report involving testing of plants to determine glyphosate tolerance. Aventis also alleged that DEKALB did not have a right to license, make or sell products using Aventis technology for glyphosate resistance under the terms of the 1994 Agreement. The subject of the 1994 Agreement and of the lawsuit is certain technology incorporated in herbicide-resistant corn known as "GA21 corn". On April 5, 1999, the trial court rejected Aventis's claim that the contract language did not convey a license but found that a disputed issue of fact existed as to whether the contract was obtained by fraud. Jury trial of the fraud claims ended April 22, 1999, with a verdict for Aventis and against DEKALB, under which the jury awarded $15 million in actual damages for "unjust enrichment" and $50 million in punitive damages. The trial was bifurcated to allow claims for patent infringement and misappropriation of trade secrets to be tried before a different jury. Jury trial of the patent infringement and misappropriation claims ended June 3, 1999, with a verdict for Aventis and against DEKALB. On or about February 8, 2000, the District Court issued its order affirming both the fraud and infringement/misappropriation jury verdicts against DEKALB and enjoining DEKALB from future sales of GA21 corn (other than materials held in DEKALB's inventory on June 2, 1999). The District Court suspended entry of the injunction for 30 days to allow DEKALB to file an appeal and request a stay of the injunction. Notice of Appeal has been filed by DEKALB and the matter is now on appeal to the U. S. Court of Appeals for the Federal Circuit, which has extended the stay and is considering whether the stay should be extended for the duration of the appeal. DEKALB will vigorously appeal the injunction and verdicts and will assert its meritorious defenses to all remaining claims in the litigation. DEKALB is continuing to defend the litigation and maintains that it also remains licensed to use any Aventis technology incorporated in GA21 corn notwithstanding the verdict or any subsequent action that may occur to rescind the 1994 license between Aventis and DEKALB. In addition to the claim of license, DEKALB believes that it has other meritorious defenses to the patent and trade secret allegations, including patent invalidity and absence of trade secret status due to Aventis's own public disclosure of the alleged trade secret. The District Court had dismissed Monsanto from both phases of the trial prior to verdict on the legal basis that it was a bona fide licensee of the GA21 corn technology. Monsanto, its licensees and DEKALB (to the extent permitted under the District Court's order and an agreement with Aventis) continue to sell GA21 corn pursuant to a royalty-bearing agreement with Aventis, entered into prior to the June 3, 1999 jury verdict. Previously, Monsanto and DEKALB had announced their intention to replace GA21 corn, commencing in 2001, with new technology that is not associated with the claims asserted by Aventis in the litigation.
In June 1996, Mycogen Corporation ("Mycogen"), Agrigenetics Inc. and Mycogen Plant Sciences, Inc. ("MPS") filed suit against Monsanto in California State Superior Court in San Diego, alleging damage by an alleged failure of Monsanto to license, under an option agreement, technology relating to Bt corn and to glyphosate resistant corn, cotton and canola. On September 9, 1996, Monsanto successfully demurred to all claims but plaintiffs were permitted to amend to file a damage claim seeking recovery under a theory of continuing breach. On October 20, 1997, the court construed the contract as involving only a license to receive genes rather than a license to receive germplasm. Jury trial of the remaining damage claim for lost future profits from the alleged delay in performance ended March 20, 1998, with a verdict against Monsanto awarding damages totaling $174.9 million. The case is now on appeal as Appeal No. D031336 before the California Court of
Appeal for the Fourth Appellate District. Mycogen, Agrigenetics Inc. and MPS have filed a cross appeal seeking to reinstate claims for damages that were dismissed prior to trial. This cross appeal has been consolidated for all purposes on appeal. Monsanto has numerous meritorious defenses and grounds to overturn the award, including the speculative nature of the damages for lost future profits, improper splitting of the causes of action, lack of continuing breach, and trial error in directing a verdict against Monsanto on the issue of liability. Mycogen and MPS are also seeking to overturn an award of monetary sanctions against them in connection with this litigation and to obtain a determination that the contract entitles Mycogen and MPS to a license to germplasm from Monsanto. Monsanto will continue to vigorously litigate its position on appeal.
On October 28, 1998, two related lawsuits were filed in U.S. District Court in Iowa: one against Asgrow Seed Company, L.L.C. ("Asgrow"), a subsidiary of Monsanto (No. 4-98-CV-70577); and the other against DEKALB (since acquired by Monsanto) (No. 4-98-CV-90578). The lawsuits allege that defendants misappropriated trade secrets of Pioneer in their corn breeding programs. On October 8, 1999, Pioneer added the prior owners of Asgrow and DEKALB (The Upjohn Company and Pfizer Inc.) and Monsanto as defendants in the litigation. In addition to claims under Iowa state law for trade secret misappropriation, Pioneer alleges violations of the Lanham Act and the patent law. Actual and exemplary damages and injunctive relief are sought. Pioneer also asserts that defendants have violated an unspecified contractual obligation not to breed with Pioneer germplasm. On July 17, 1999, the court denied without prejudice defendants' motions to dismiss the initial trade secret claims. On January 4, 2000, the District Court allowed Pioneer to amend its claims in the litigation to assert claims that the defendants infringed numerous patents. As a consequence of the new claims the prior trial date has been vacated and no trial date has been assigned. The defendants have meritorious defenses including non- infringement of patents, lack of validity of the patents on numerous grounds, preemption, laches, statute of limitations, lack of trade secrets, ownership of the germplasm, bona fide purchaser status and other defenses. The defendants will vigorously defend against Pioneer's claims in the litigation.
Monsanto is engaged in litigation relating to the failed merger with Delta and Pine Land Company ("D&PL"). On December 20, 1999, Monsanto announced that it had withdrawn its filing for U.S. antitrust clearance of the proposed merger. The filing was withdrawn in light of the U.S. Department of Justice's unwillingness to approve the transaction on commercially reasonable terms. (a) Following the announcement on May 11, 1998, of the merger agreement between Monsanto and D&PL, five alleged holders of D&PL common stock filed suits, now consolidated (the "D&PL Shareholder Suit"), in the Delaware Court of Chancery in and for New Castle County against Monsanto, D&PL, and members of the D&PL Board of Directors (the "D&PL Board"). Seeking to represent a purported class of D&PL shareowners, plaintiffs in the D&PL Shareholder Suit alleged that the consideration that was to be received by holders of D&PL common stock in the merger was unfair and inadequate, that the members of the D&PL Board breached their fiduciary duties by approving the transaction and that Monsanto aided and abetted such breaches. Plaintiffs in the D&PL Shareholder Suit sought judgment declaring that each Delaware action is maintainable as a class action, preliminarily and permanently enjoining consummation of the merger or rescinding the transaction in the event that it was consummated, awarding unspecified compensatory damages against defendants, and
awarding plaintiffs their attorneys' fees and expenses. On or about November 18, 1998, the parties in the D&PL Shareholder Suit entered into a Memorandum of Understanding to settle the litigation. That Memorandum of Understanding, however, appears to be null and void because of the failure of completion of the merger. (b) On December 30, 1999, a derivative and class action lawsuit was filed (Civil Action 17707) (the "Delaware Suit"), by two alleged holders of D&PL common stock, in the Delaware Court of Chancery. Defendants include Monsanto, D&PL and members of the D&PL Board. The Delaware Suit relates to Monsanto's withdrawal of its filing for U.S. antitrust clearance of the proposed merger, and alleges that D&PL has been harmed by the termination of the effort to complete the transaction and that the individual defendants have a continuing duty to seek a value-maximizing transaction for the shareholders. The suit seeks a declaration that the individual defendants have violated their fiduciary duties and a direction that the individual defendants take certain actions to maximize shareholder value. The suit also requests compensatory damages, costs, disbursements and fees. (c) On January 18, 2000, suit was reinstituted against Monsanto by D&PL (Cause No. 2000-2) in Circuit Court of the First Judicial District of Bolivar County, Mississippi, seeking compensatory and punitive damages allegedly as a result of the failure to complete the merger pursuant to the exercise of reasonable efforts. Monsanto did exercise commercially reasonable efforts to complete the transaction and believes it has meritorious defenses to the claims in the lawsuits and will vigorously defend the actions. Monsanto has requested a stay of the Bolivar County suit during the pendency of the previously-filed Delaware Suit.
On April 15, 1996, one hundred ten (110) current and former employees of Fisher Controls International, Inc. ("Fisher"), a former subsidiary of Monsanto, filed suit against Monsanto in the District Court of Brazoria County, Texas, 149th Judicial District (Cause No. 96M0975), alleging breach of contract, breach of a duty of good faith and fair dealing, and fraud. Plaintiffs challenged Monsanto's decision, pursuant to the terms of the stock option plans in effect, to curtail the duration of plaintiffs' options to purchase common stock of Monsanto following the divestiture of Fisher from the Monsanto corporate family in 1992. On June 24, 1997, the trial court granted Monsanto's motion for summary judgment and dismissed the case with prejudice. Plaintiffs appealed the judgment to the Court of Appeals for the First District of Texas (No. 01-97-01142-CV). On September 7, 1999, the Court of Appeals issued an opinion reversing the summary judgment and remanding the case to the trial court for further proceedings. Monsanto's motion for rehearing or, in the alternative, for rehearing en banc, was denied. Monsanto believes that the decision of the trial court was correct and that its actions regarding the Fisher employees were in accordance with the terms of the stock option plans and entitled to substantial deference under Delaware law. Monsanto intends to pursue its efforts to overturn the decision of the Court of Appeals and will continue to vigorously defend against all claims of plaintiffs.
On December 2, 1999, a complaint was filed in United States District Court for the Eastern District of Pennsylvania as a putative class action purporting to represent the claims of over 9,000 Korean and 1,000 U.S. service persons allegedly exposed to the herbicide Agent Orange and other defoliants, including Agent Blue and Monuran, sprayed during 1967-1970 in or near the demilitarized zone separating North Korea from South Korea. The complaint names Monsanto and five other manufacturers of the defoliants which were made and sold to the U.S. government for use in Vietnam. The complaint does
not assert any specific causes of action or demand a specified amount in damages. The Judicial Panel on Multidistrict Litigation has granted provisional transfer of the case to the United States District Court for the Eastern District of New York for coordinated pretrial proceedings as part of In re "Agent Orange" Product Liability Litigation, MDL 381 (which is the multidistrict litigation proceeding established in 1977 to coordinate Agent Orange related litigation in the United States). Various other claims by veterans or civilians alleging personal injury from exposure to herbicides used in Vietnam have been filed since a 1984 settlement in the MDL proceeding concluded all class action litigation filed on behalf of U.S. and certain other groups of plaintiffs. In a suit filed against Dow Chemical Company and Monsanto in Seoul Korea during October 1999, approximately 13,760 Korean veterans of the Vietnam war alleged they were exposed to herbicides and suffered injuries as a result. The suit involves three separate complaints which were filed and are being handled collectively as Case No. 99 Kahap 84147 (84123; 84130), 13th Civil Division, Seoul District Court. The complaints fail to assert any specific causes of action but seek damages of 300 million won (approximately $250,000) per plaintiff. Other ancillary actions are also pending in Korea, including a request for provisional relief pending resolution of the main action. In all of the above referenced matters Monsanto has numerous meritorious defenses including: lack of jurisdiction; absence of injury; lack of causation; lack of negligence or legal liability; acting under the supervision and direction of the U.S. government; and statutes of limitations. In all of the actions Monsanto is vigorously defending the actions.
RISK MANAGEMENT
Monsanto continually evaluates risk retention and insurance levels for product liability, property damage and other potential areas of risk. Monsanto devotes significant effort to maintaining and improving safety and internal control programs, which reduce its exposure to certain risks. Management decides the amount of insurance coverage to purchase from unaffiliated companies and the appropriate amount of risk to retain, based on the cost and availability of insurance and the likelihood of a loss. Since 1986, Monsanto's liability insurance has been on the "claims made" policy form. Management believes that the current levels of risk retention are consistent with those of other companies in the various industries in which Monsanto operates and are reasonable for Monsanto. There can be no assurance that Monsanto will not incur losses beyond the limits of, or outside the coverage of, its insurance. Monsanto's liquidity, financial position and profitability are not expected to be affected materially by the levels of risk retention that the Company accepts.
CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING INFORMATION
Information regarding forward-looking statements, and factors that could cause actual performance or results to differ materially from those described in this Report, are set forth under the heading "Cautionary Statements Regarding Forward-Looking Information" described on pages 21 through 23 of Exhibit 99.1, accompanying this Report and incorporated herein by reference.
ITEM 2.
ITEM 2. PROPERTIES.
The General Offices of the Company are located on a 245-acre tract of land in St. Louis County, Missouri. The Company also owns a 210-acre tract in St. Louis County on which additional research facilities are located. These two office and research facilities serve the Agricultural Products, Pharmaceuticals and Corporate and Other segments. In addition, Monsanto and its subsidiaries own or lease manufacturing facilities, laboratories, agricultural facilities, office space, warehouses, and other land parcels in North America, South America, Europe, Asia, Australia and Africa.
In addition to the facilities in St. Louis County, Missouri, Monsanto's principal properties include the following locations, serving the segments noted: Alvin, Texas (Agricultural Products); Antwerp, Belgium (Agricultural Products); Augusta, Georgia (Agricultural Products, Pharmaceuticals); Barceloneta, Puerto Rico (Pharmaceuticals); Caguas, Puerto Rico (Pharmaceuticals); Fayetteville, North Carolina (Agricultural Products); Feucht, Germany (Pharmaceuticals); Luling, Louisiana (Agricultural Products); Morpeth, United Kingdom (Pharmaceuticals); Muscatine, Iowa (Agricultural Products); Sao Jose dos Campos, Brazil (Agricultural Products); Skokie (Old Orchard), Illinois (Pharmaceuticals); Skokie (Searle Parkway), Illinois (Pharmaceuticals); and Zarate, Argentina (Agricultural Products). All of these properties are manufacturing facilities, except for the research building in Skokie (Searle Parkway), Illinois, and the office building in Skokie (Old Orchard), Illinois. The Company is also constructing a new Agricultural Products manufacturing facility at Camacari, Brazil.
Monsanto's principal properties are suitable and adequate for their use. Utilization of these facilities may vary with seasonal, economic and other business conditions, but none of the principal properties is substantially idle. The facilities generally have sufficient capacity for existing needs and expected near-term growth, and expansion projects are undertaken as necessary to meet future needs. Most of these properties are owned in fee. However, the Company leases the land underlying facilities that it owns at Alvin, Texas. In certain instances, Monsanto has granted leases on portions of plant sites not required for current operations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
For information concerning certain legal proceedings involving Monsanto, see "Business--Environmental Matters", "Business--Legal Proceedings" and "Business--Cautionary Statements Regarding Forward- Looking Information" in Item 1 of this Report.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to the security holders during the fourth quarter of 1999.
EXECUTIVE OFFICERS OF THE REGISTRANT.
Information regarding executive officers is contained in Item 10 of Part III of this Report (General Instruction G) and is incorporated herein by reference.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
SHAREOWNER MATTERS
The narrative information appearing under "Shareowner Matters" on page 18, and the tabular information regarding Dividends Per Share and Common Stock Price (for the years 1999 and 1998) appearing in "Note 25: Quarterly Data" on pages 54 and 55, all appearing in Exhibit 99.1 of this Report, are incorporated herein by reference.
SALE OF UNREGISTERED SECURITIES
On December 19, 1999, Monsanto and Pharmacia & Upjohn, Inc. ("Pharmacia & Upjohn") entered into a Stock Option Agreement (the "Stock Option Agreement"), dated as of December 19, 1999, pursuant to which Monsanto granted an option (the "Option") to Pharmacia & Upjohn to purchase up to 94,774,810 shares (the "Option Shares") of the Company's common stock at a price of $41.75 per share. The Option was granted by the Company as an inducement to Pharmacia & Upjohn (1) to enter into the Agreement and Plan of Merger (the "Merger Agreement"), dated as of December 19, 1999 (and subsequently amended as of February 18, 2000), among the Company, a wholly owned subsidiary of the Company and Pharmacia & Upjohn, pursuant to which such wholly owned subsidiary of the Company will merger with and into Pharmacia & Upjohn (the "Merger") and (2) to grant to Monsanto a substantially similar option to purchase up to 77,388,932 shares of Pharmacia & Upjohn's common stock, par value $0.01 per share, at an exercise price of $50.25.
The number of Option Shares is subject to adjustment in certain circumstances, provided that the aggregate number of Option Shares may not exceed 14.9% of the total outstanding shares of the Company's common stock immediately prior to the time of exercise. The option will, subject to certain limitations, become exercisable upon the occurrence of an event the result of which is that the total fee or fees required to be paid by the Company to Pharmacia & Upjohn pursuant to the Merger Agreement equals $575 million (a "Purchase Event"). The Stock Option Agreement provides that Monsanto may, after the occurrence of a Purchase Event, repurchase all or a portion of the Option for a specified price in cash. In no event may the "Total Profit" (as defined in the Stock Option Agreement) of Pharmacia & Upjohn under the Stock Option Agreement and the Merger Agreement exceed $635 million. No Purchase Event has occurred at the time of this filing. The Option will terminate upon the occurrence of certain events, including the consummation of the Merger.
The granting of the Option was deemed to be exempt from registration under the Securities Act or 1933, as amended (the "Securities Act"), in reliance on Section 4(2) of the Securities Act, as a transaction by an issuer not involving a public offering.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following information, appearing on the pages indicated of Exhibit 99.1 of this Report, is incorporated herein by reference: (a) the second sentence of the first paragraph under "Definitions" on page 3; and (b) the tabular information regarding Net Sales, Income (Loss) From Continuing Operations, Income (Loss) From Continuing Operations (per share), Total Assets, Long-Term Debt, and Dividends (per share), appearing under "Financial Summary" on page 2.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
The following information, appearing on the pages indicated of Exhibit 99.1 of this Report, is incorporated herein by reference: (a) the four paragraphs under "Definitions" on page 3; and (b) the tabular and narrative information appearing under "Management's Discussion and Analysis of Financial Condition and Results of Operation" on pages 4 through 23.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.
The tabular and narrative information appearing under "Market Risk Management" on pages 19 and 20 of Exhibit 99.1 of this Report is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following information, appearing on the pages indicated of Exhibit 99.1 of this Report, is incorporated herein by reference: (a) the first and last paragraphs under "Definitions" on page 3; (b) the consolidated financial statements of Monsanto appearing on pages 24 through 55 (excluding "Key Financial Measures" on page 28); and (c) the Independent Auditors' Report appearing on page 56.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
DIRECTORS: The following information is as of March 1, 2000.
The following Directors have been elected to terms expiring at the annual meeting of shareowners to be held in 2000:
EXECUTIVE OFFICERS
The following information with respect to the Executive Officers of the Company on March 1, 2000, is included pursuant to Instruction 3 of Item 401(b) of Regulation S-K:
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 (the "Exchange Act") requires all Company executive officers, directors, and persons owning more than 10% of any registered class of Company stock to file reports of ownership and changes in ownership with the Securities and Exchange Commission. During 1999, Mr. Nick E. Rosa was inadvertently late in filing his initial report on Form 3.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
DIRECTORS' FEES AND OTHER ARRANGEMENTS
Non-employee directors receive annual compensation having an anticipated total annual value of $90,000 ($100,000 for directors who serve as Chair of a Board Committee). One-half of this amount is in the form of stock options to purchase shares of the Company's common stock. Each director may elect the form of the other half of compensation, choosing any combination of additional options, cash paid currently, deferred cash, common stock that is subject to forfeiture if the director does not complete his or her term, or common stock the delivery of which is deferred. Each director makes this election at the beginning of each term for which he or she is elected.
The number of options granted as compensation to each director is determined in accordance with the Black-Scholes option valuation method used for employee option grants, with an exercise price equal to the value of a share of the Company's common stock on the date of grant. Options granted for a term will vest in pro rata installments on the day before each Annual Meeting of Shareowners during that term. After vesting, options will generally be exercisable until the tenth anniversary of the date of grant. When a director's service as a director of the Company ends, any unvested options will be forfeited automatically.
The portion of his or her compensation, if any, which a director elects to receive in cash is paid on a pro rata basis throughout the director's term. Deferred cash will accrue interest at an interest rate equal to the average Moody's Baa Bond Index Rate for the prior calendar year until it is paid either in a lump sum or in installments after the director's service as a director terminates.
A director who elects to receive a portion of Board compensation in restricted stock will be issued the number of shares of the Company's common stock having a value, as of the first day of the term to which the compensation relates, equal to such portion. Restricted stock will be forfeitable and nontransferable until it vests in pro rata installments on the day before each Annual Meeting of Shareowners during the term. The portion, if any, of director compensation that a director elects to receive in deferred stock will be provided by crediting a stock unit account maintained by the Company for the director with a number of stock units representing hypothetical shares of the Company's common stock having a value, as of the first day of the term to which the compensation relates, equal to such portion. Stock units are paid in shares of the Company's common stock either in a lump sum or in installments after the director's service as a director terminates. Whenever the Company declares a dividend or other distribution with respect to its common stock, deferred stock accounts will be credited with additional stock units equal to the number of shares of the Company's common stock having a value equal to the dividend or other distribution that the director would have received had the stock units on the record date of such dividend or other distribution been shares of the Company's common stock.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
None of the members of the People Committee of the Board of Directors is or has been an
officer or employee of Company. However, until his consulting agreement with the Company expired in January 2000, Dr. Leder, who is a member of the Committee, provided consulting services and the benefit of his considerable professional skills, knowledge, experience, and judgment in areas of interest to the Company, particularly in the field of biological sciences. In 1999, Dr. Leder received $143,400 under the consulting agreement.
LONG-TERM INCENTIVE PLANS--AWARDS IN 1999
There were no long-term incentive awards to the named executive officers in 1999.
PENSION PLAN
The named executive officers (as well as other employees of the Company) are eligible for retirement benefits payable under the Company's tax- qualified and non-qualified defined benefit pension plans. Effective January 1, 1997, the U.S. defined benefit pension plans for the Company, Searle and The NutraSweet Company, a wholly owned subsidiary of the Company ("NutraSweet"), were amended and unconsolidated. The amended defined benefit pension plan consists of two accounts: a "Prior Plan Account" and a "Cash Balance Account."
The opening balance of the Prior Plan Account was the lump sum value of the executive's December 31, 1996 monthly retirement benefit earned prior to January 1, 1997 under the old defined benefit pension plans described below, calculated using the assumption that the monthly benefit would be payable at age 55 with no reduction for early payment. The formula used to calculate the opening balance for employment with the Company was the
greater of 1.4% (1.2% for employees hired by the Company on or after April 1, 1986) of average final compensation multiplied by years of service, without reduction for Social Security or other offset amounts, or 1.5% of average final compensation multiplied by years of service, less a 50% Social Security offset. Average final compensation for purposes of determining the opening balance was the greater of (1) average compensation received during the 36 months of employment prior to 1997 or (2) average compensation received during the highest three of the five calendar years of employment prior to 1997. The annual normal retirement benefits under the Searle and NutraSweet pension plans used to determine the opening balance for employment with Searle or NutraSweet was (1) 1.8% of average compensation (the average compensation for the highest consecutive 60 of the last 120 months of employment preceding 1997) multiplied by years of service (up to a maximum of 30 years) less (2) 1.67% of estimated annual Social Security benefits at age 65 multiplied by years of service (up to a maximum of 30 years).
For each year of the executive's continued employment with the Company, the executive's Prior Plan Account will be increased by 4% to recognize that prior plan benefits would have grown as a result of pay increases.
For each year that the executive is employed by the Company after 1996, 3% of annual eligible compensation in excess of the Social Security wage base and a percentage (based on age) of annual compensation (salary and annual bonus) will be credited to the Cash Balance Account. The applicable percentages and age ranges are: 3% before age 30, 4% for ages 30 to 39, 5% for ages 40 to 44, 6% for ages 45 to 49, and 7% for age 50 and over. In addition, the Cash Balance Account of executives who earned benefits under the Company's old defined benefit pension plan will be credited each year (for up to 10 years based on prior years of service with the Company), during which the executive is employed after 1996, with an amount equal to a percentage (based on age) of annual compensation. The applicable percentages and age ranges are: 2% before age 30, 3% for ages 30 to 39, 4% for ages 40 to 44, 5% for ages 45 to 49, and 6% for age 50 and over.
The estimated annual benefits payable as a single life annuity beginning at age 65 (assuming that each executive officer remains employed by the Company until age 65 and receives 4% annual compensation increases) are as follows: Mr. Shapiro, $751,290; Mr. Crittenden, $660,375; Mr. De Schutter, $828,269; Mr. Needleman, $280,810; and Mr. Verfaillie, $785,296.
Mr. Shapiro will be provided supplemental retirement benefits to recognize his experience prior to employment by the Company. The Company will provide Mr. Shapiro with supplemental retirement benefits equal to 12% of average final compensation. The supplemental retirement benefits become non- revocable immediately in the event of a change of control of the Company. The estimated annual supplemental benefits payable to Mr. Shapiro upon retirement at age 65 are $222,837. Mr. Shapiro will also receive the same Company contribution to the retiree medical plan as an eligible retiree with 30 years of service. The value of his benefits will be determined at retirement based on age, the premium paid for medical coverage, and projected premium cost increases.
If the total of the benefits payable to Mr. De Schutter under the Company's defined benefit pension plans described above do not equal the benefit Mr. De Schutter would have
received if all his service had been with the Company, he will be provided supplemental retirement benefits in an amount equal to the benefits he would have received under the Company's plans had all his years of service been with the Company, less the benefits provided by the Searle plans. It is estimated that there will be no annual supplemental benefit payable to Mr. De Schutter if he retires at age 65.
Mr. Needleman will be provided supplemental retirement benefits equal to 14% of his annual compensation to recognize his experience prior to employment by the Company. The supplemental retirement benefits become non-revocable immediately in the event of a change of control of the Company. The estimated annual supplemental benefits payable to Mr. Needleman upon retirement at age 65 are $196,952.
In addition to the retirement benefits for Mr. Verfaillie based on his years of service as a Company employee in the U.S., Mr. Verfaillie is also eligible for regular retirement benefits based on his years of service as an employee outside the U.S. In addition, he participates in the Company's regular, non-qualified pension plan designed to protect retirement benefits for employees serving in more than one country. However, his total retirement benefits from the combined plans when considering his total service are expected to be generally comparable to the benefits described in this section.
CERTAIN AGREEMENTS
The Company has entered into Change of Control Employment Agreements with each of the executive officers who are named in the Summary Compensation Table and certain other key executives. Each such Change of Control Employment Agreement becomes effective upon a "change of control" of the Company (as defined in the Change of Control Employment Agreement). Each Change of Control Employment Agreement provides for the continuing employment of the executive after the change of control on terms and conditions no less favorable than those in effect before the change of control. If the executive's employment is terminated by the Company without "cause" or if the executive terminates his or her own employment for "good reason" (each as defined in the Change of Control Employment Agreement), the executive is entitled to severance benefits equal to a "multiple" of his or her annual compensation (including bonus) and continuation of certain benefits for a number of years equal to the multiple. For two executives, including Mr. Crittenden, the severance benefits calculation also includes such executive's long-term incentive opportunity. The multiple is three for the executive officers who are named in the Summary Compensation Table and two or three for the other executives (or, in either case, the shorter number of years until the executive's normal retirement date). In addition, each of the executive officers who are named in the Summary Compensation Table and the other executives who are entitled to a severance multiple of three is entitled to receive the severance benefits if he or she voluntarily terminates his or her own employment during the 30-day period beginning on the first anniversary of the occurrence of certain changes of control. Finally, the executives are entitled to an additional payment, if necessary, to make them whole as a result of any excise tax imposed by the Code on certain change of control payments (unless the safe harbor below which the excise tax is imposed is not exceeded by more than 10%, in which event the payments will be reduced to avoid the excise tax). A cash medical allowance of $15,000 for payment of medical insurance premiums will also be provided to Mr. Verfaillie if he does not qualify for retiree
medical coverage.
In addition to any payments that may be due to him pursuant to his Change of Control Employment Agreement, under a supplemental agreement Mr. De Schutter will be entitled to receive a payment from the Company in the event his employment is terminated for any reason other than cause. This supplemental agreement was entered into to retain Mr. De Schutter's employment with the Company. If triggered, the payment will be equal to one year of base salary and annual incentive at one-half of Mr. De Schutter's opportunity at an outstanding level of performance if such termination occurs prior to December 31, 2000 and two years of base salary and annual incentive at one-half his opportunity at an outstanding level of performance if such termination occurs after December 31, 2000. The estimated amounts that would be payable to Mr. De Schutter pursuant to this agreement prior to and after December 31, 2000, are $1,820,000 and $3,640,000, respectively.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information is set forth below regarding beneficial ownership of common stock of the Company by (i) each person who is a director or nominee; (ii) each executive officer named in the Summary Compensation Table on page 24; and (iii) all directors and executive officers as a group. Except as otherwise noted, each person has sole voting and investment power as to his or her shares. All information is as of December 31, 1999.
The percentage of shares of outstanding common stock of the Company, including options exercisable within 60 days of December 31, 1999, beneficially owned by all directors and executive officers as a group is approximately 1.7%. The percentage of such shares beneficially owned by any director or nominee does not exceed 1%.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
TRANSACTIONS AND RELATIONSHIPS
Mr. Michael Kantor is a partner at the law firm of Mayer, Brown & Platt, which provided services to the Company in 1999 and is providing services to the Company in 2000.
Mr. John E. Robson is Senior Advisor of BancBoston Robertson Stephens, which provided services to the Company in 1999 and is expected to provide services to the Company in 2000.
INDEBTEDNESS
In May 1996, the Company's shareowners approved a plan whereby each of the Company's executive officers received full-recourse, interest bearing loans for the purchase price of Company common stock purchased pursuant to the Monsanto Executive Stock Purchase Incentive Plan ("Executive Plan"). The loans have an eight-year term and accrue interest at the applicable federal rate (as determined pursuant to Section 1274(d) of the Code) on the purchase date for loans of such maturity, compounded annually. Interest is payable prior to maturity to the extent of dividends paid on the purchased shares, with the balance due at the maturity of the loan. The proceeds of the deferred cash incentives awarded during the performance cycle under the Executive Plan must also be applied to prepay the loans. Following such prepayment, the balance of the loans at the end of the performance cycle, together with accrued and unpaid interest thereon, will generally be payable in three equal installments (plus interest) on the first three anniversaries after the end of the performance cycle. The payment of the loan will be accelerated if the executive officer's service is terminated during the performance cycle for any reason other than retirement or following a change of control. In the event of retirement, there is no loan acceleration. In the event of a change of control, the loan must be repaid over a three-year period following such event. The loan may also be prepaid at any time at the executive officer's option.
In addition to the Executive Plan, executive officers may also participate in the Company's Employee Stock Purchase Plan ("Employee Plan"). The Employee Plan is open to all regular U.S., Canada, and Singapore full-time and regular part-time employees of the Company for shares of stock they contracted to purchase over a period of months by means of payroll deductions. No interest is charged on loans granted under the Employee Plan.
The following table describes the indebtedness of the executive officers under the Executive Plan, except where otherwise indicated:
/s/ Sonya M. Davis -------------------------- Sonya M. Davis Attorney-in-Fact
EXHIBIT INDEX
These Exhibits are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K.
EXHIBIT NO. DESCRIPTION - ----------- -----------
2 1. Agreement and Plan of Merger, dated as of December 19, 1999, as amended by Amendment No. 1 dated as of February 18, 2000, among Monsanto Company, MP Sub, Incorporated and Pharmacia & Upjohn, Inc. (incorporated herein by reference to Exhibit 2.1 of the Company's Form S-4 filed on February 22, 2000, File No. 333-30824)
2. Stock Option Agreement, dated as of December 19, 1999, by and between Monsanto Company, as Issuer, and Pharmacia & Upjohn, Inc., as Grantee (incorporated herein by reference to Exhibit 2.2 of the Company's Form S-4 filed on February 22, 2000, File No. 333-30824)
3. Stock Option Agreement, dated as of December 19, 1999, by and between Pharmacia & Upjohn, Inc. and Monsanto Company, as Grantee (incorporated herein by reference to Exhibit 2.3 of the Company's Form S-4 filed on February 22, 2000, File No. 333-30824)
3 1. Restated Certificate of Incorporation of the Company as of October 28, 1997 (incorporated herein by reference to Exhibit 3(i) of the Company's Form 10-Q for the quarter ended September 30, 1997)
2. By-Laws of the Company, as amended effective February 10, 2000
4 1. Form of Rights Agreement, dated as of December 19, 1999 between the Company and EquiServe Trust Company N.A., First Chicago Trust Company as successor to The First National Bank of Boston (incorporated herein by reference to Form 8-A filed on December 30, 1999)
2. Master Unit Agreement, dated as of November 30, 1998, by and between the Company and The First National Bank of Chicago, as Unit Agent (incorporated herein by reference to Exhibit 4.2 of the Company's Form 8-K filed on December 14, 1998)
3. Call Option Agreement, dated as of November 30, 1998, by and between Goldman, Sachs & Co., as Call Option Holder, and The First National Bank of Chicago, as Unit Agent and as Attorney-In- Fact (incorporated herein by reference to Exhibit 4.3 of the Company's Form 8-K filed on December 14, 1998)
4. Pledge Agreement, dated as of November 30, 1998, by and among the Company, Goldman, Sachs & Co., as Call Option Holder, First Union National Bank, as Collateral Agent and Securities Intermediary, and The First National Bank of Chicago, as Unit Agent and as Attorney-In-Fact (incorporated herein by reference to Exhibit 4.4 of the Company's Form 8-K filed on December 14, 1998)
5. Registrant agrees to furnish to the Securities and Exchange Commission upon request copies of instruments defining the rights of holders of certain long-term debt not being registered of the registrant and all subsidiaries for which consolidated or unconsolidated financial statements are required to be filed.
9 Omitted--Inapplicable
10 1. Distribution Agreement by and between Monsanto Company and Solutia Inc., as of September 1, 1997, plus identification of contents of omitted schedules and exhibits and agreement to furnish supplementally a copy of any omitted schedule or exhibit to the Securities and Exchange Commission upon request (incorporated herein by reference to Exhibit 2.1 of the Company's Form 8-K filed September 16, 1997)
2. Employee Benefits and Compensation Allocation Agreement between Monsanto Company and Solutia Inc., dated as of September 1, 1997 (incorporated herein by reference to Exhibit 99.1 of the Company's Form 8-K filed September 16, 1997)
3. Tax Sharing and Indemnification Agreement dated as of September 1, 1997, by and between Monsanto Company and Solutia Inc. (incorporated herein by reference to Exhibit 99.2 of the Company's Form 8-K filed September 16, 1997)
4. Monsanto Company Non-Employee Director Deferred Compensation Plan, as amended February 25, 2000
5. Monsanto Company Non-Employee Director Equity Incentive Compensation Plan (incorporated herein by reference to Exhibit 10.4 of the Company's Form 10-Q for the quarter ended September 30, 1997)
6. Non-Employee Directors Stock Plan, as amended in 1991 (incorporated herein by reference to Exhibit 19(ii)1 of the Company's Form 10-Q for the quarter ended June 30, 1991)
7. Amendment to Non-Employee Directors Stock Plan (incorporated herein by reference to Exhibit 10.8 of the Company's Form 10-Q for the quarter ended June 30, 1997)
8. Charitable Contribution Program effective April 1, 1992 (incorporated herein by reference to Exhibit 19(i)1 of the Company's Form 10-K for the year ended December 31, 1991)
9. Deferred Compensation Plan for Non-Employee Directors, as amended in 1983 and 1991 (incorporated herein by reference to Exhibit 19(ii)1 of the Company's Form 10-K for the year ended December 31, 1991)
10. Excerpt of Resolutions of Monsanto Company Board of Directors Regarding Directors' Compensation, adopted by Unanimous Consent effective August 4, 1997 (incorporated herein by reference to Exhibit 10.5 of the Company's Form 10-Q for the quarter ended September 30, 1997)
11. Monsanto Management Incentive Plan of 1988/I, as amended in 1988, 1989, 1991, 1992, April 1997, July 1997, and 1999 (incorporated herein by reference to Exhibit 10.2 of the Company's Form 10-Q for the quarter ended September 30, 1999)
12. Monsanto Management Incentive Plan of 1988/II, as amended in 1989, 1991, 1992, April 1997, July 1997, and 1999 (incorporated herein by reference to Exhibit 10.3 of the Company's Form 10-Q for the quarter ended September 30, 1999)
13. Monsanto Management Incentive Plan of 1994, as amended in April 1997, July 1997, and 1999 (incorporated herein by reference to Exhibit 10.4 of the Company's Form 10-Q for the quarter ended September 30, 1999)
14. Monsanto Management Incentive Plan of 1996 as amended April 25, 1997, July 25, 1997, August 18, 1997, February 26, 1998, September 25, 1998, April 23, 1999, and October 22, 1999, and as Adjusted to Reflect Stock Split as of May 15, 1996 and Spinoff as of September 1, 1997 (incorporated herein by reference to Exhibit 10.1 of the Company's Form 10-Q for the quarter ended September 30, 1999)
15. Monsanto Executive Stock Purchase Incentive Plan (incorporated herein by reference to Appendix B of the Monsanto Company Notice of Annual Meeting and Proxy Statement dated March 14, 1996)
16. Form of Non-Qualified Purchased and Year 2000 Premium Stock Option Certificate (incorporated herein by reference to Exhibit 10 of the Company's Form 10-Q for the quarter ended March 31, 1999)
17. Form of Non-Qualified Premium Stock Option Certificate (incorporated herein by reference to Exhibit 10.2 of the Company's Form 10-Q for the quarter ended June 30, 1998)
18. Form of Monsanto Company 1999 Non-Qualified Premium Stock Option Certificate (incorporated herein by reference to Exhibit 10.5 of the Company's Form 10-Q for the quarter ended September 30, 1999)
19. Annual Incentive Program for Executive Officers (incorporated herein by reference to the description on pages 25-26 of the Monsanto Company Notice of Annual Meeting and Proxy Statement dated March 15, 1999)
20. Split-dollar Life Insurance Plan (incorporated herein by reference to Exhibit 10(iii)19 of the Company's Form 10-K for the year ended December 31, 1987)
21. Form of Employment Agreement for Executive Officers (incorporated herein by reference to Exhibit 10.7 of the Company's Form 10-Q for the quarter ended September 30, 1997)
22. 1999 Form of Employment Agreement for Executive Officers (incorporated herein by reference to Exhibit 10.24 of the Company's Form 10-K/A filed January 21, 2000)
23. Letter Agreement between the Company and Robert B. Shapiro entered into as of July 23, 1990 (incorporated herein by reference to Exhibit 19(i)3 of the Company's Form 10-Q for the quarter ended September 30, 1990)
24. Amendment to Letter Agreement between the Company and Robert B. Shapiro entered into as of July 23, 1990 (incorporated herein by reference to Exhibit 10.23 of the Company's Form 10-K for the year ended December 31, 1996)
25. Agreement between Monsanto Company and Robert B. Shapiro dated as of December 19, 1999 (incorporated herein by reference to Exhibit 10.1 of the Company's Form S-4 filed February 22, 2000, File No. 333-30824)
26. Letter Agreement between the Company and Hendrik A. Verfaillie entered into as of June 27, 1988 (incorporated herein by reference to Exhibit 10.20 of the Company's Form 10-K for the year ended December 31, 1996)
27. Supplemental Retirement Plan regarding Richard U. De Schutter (incorporated herein by reference to Exhibit 10.26 of the Company's Form 10-K for the year ended December 31, 1996)
28. Letter Agreement between the Company and Richard U. De Schutter, dated February 7, 1997 (incorporated herein by reference to Exhibit 10.2 of the Company's Form 10-Q for the quarter ended June 30, 1999)
29. Supplemental Retirement Plan and Amendment to Supplemental Retirement Plan for Philip Needleman
30. G. D. Searle & Co. Split Dollar Life Insurance Plan, as amended in 1989 (incorporated herein by reference to Exhibit 19(ii)3 of the Company's Form 10-Q for the quarter ended June 30, 1989)
11 Omitted--Inapplicable; see "Note 18: Earnings per Share" on page 49 of Exhibit 99.1 to this Report
12 Statement re Computation of the Ratio of Earnings to Fixed Charges - See Exhibit 99.2 below
13 Omitted - Inapplicable
18 Omitted--Inapplicable
21 Subsidiaries of the registrant
22 Omitted--Inapplicable
23 Consent of Independent Auditors
24 1. Powers of attorney submitted by Richard U. De Schutter, Michael Kantor, Gwendolyn S. King, Philip Leder, Jacobus F.M. Peters, John S. Reed, John E. Robson, William D. Ruckelshaus, Robert B. Shapiro Hendrik A. Verfaillie, Gary L. Crittenden and Richard B. Clark
2. Certified copy of Board resolution authorizing Form 10-K filing utilizing powers of attorney
27 Financial Data Schedule (part of electronic submission only)
99 1. Financial Information for Fiscal Year Ended December 31, 1999
2. Computation of the Ratio of Earnings to Fixed Charges for Monsanto Company and Subsidiaries
[FN] - -------------
Only Exhibits Nos. 21, 23, 99.1 and 99.2 have been included in the printed copy of this Report.
APPENDIX
1. Throughout the electronic submission, trademarks are designated on each page by the letter "R" in parentheses or the letters "TM" in parentheses. In the printed copy of the Form 10-K, trademarks are indicated by the "R" registered symbol or the "TM" symbol. | 12,696 | 82,495 |
64463_1999.txt | 64463_1999 | 1999 | 64463 | ITEM 1: BUSINESS
MTI manufactures and sells precision diagnostic and measurement instruments and incubates alternative energy technology. Given MTI's recent success with Plug Power, Inc. and its early development efforts with Proton Exchange Membrane ("PEM") fuel cells, gas and steam powered turbines and the Sterling Engines, MTI is in a unique position to be a leader in the evolution of alternative energy technology. MTI's alternate energy strategy includes: acquisition of companies that have synergies with MTI's core competencies; acquisition of majority stock positions in established alternative energy companies; and internal development and growth of alternative energy businesses.
Over the last several years MTI sold off non-core businesses and restructured its balance sheet. Today MTI is a very different company, substantially streamlined in focus, but with challenges remaining. MTI is a manufacturer of advanced diagnostic, test and measurement products that combine precision sensing capabilities with proprietary software and systems to serve a variety of applications for commercial and military customers. The Company has two principal business units: the Advanced Products Division ("Advanced Products"), which produces diagnostic and sensing instruments and computer-based balancing systems; and Ling Electronics, Inc. ("Ling"), a developer and manufacturer of vibration test systems and power conversion products, which was sold on October 21, 1999, as part of a strategic alliance with SatCon Technology Corporation.
In the coming year, Advanced Products will focus on improving existing products and developing additional products for diagnostic and testing equipment. The non-contact sensing instrumentation products utilize fiber optic, laser and capacitance technology to perform high precision position measurements for product design and quality control inspection requirements, primarily in the semiconductor and computer disk drive industries. Advanced Products' computer-based aircraft engine balancing systems include an on-wing jet engine balancing system used by both commercial and military aircraft fleet maintenance personnel. This product provides trim balancing and vibration analysis in the field or in test cells.
MTI is uniquely positioned to be the moving force behind the evolution of alternative energy technology. As a pioneer in the alternative energy field, MTI has demonstrated its ability, first in the research and development of gas and steam turbines; then through its development efforts in connection with the Sterling Engines; and most recently in its research and development of PEM fuel cell technology. MTI has successfully turned its PEM fuel cell research into a public company dedicated to bringing a safe, reliable and cost-effective fuel cell to market. Plug Power, Inc., which was initially a joint venture of MTI and Detroit Edison, believes that it will soon have residential fuel cells in the market place. MTI helped develop the strategic partnerships, capital investment, and growth strategy of Plug Power, Inc. It is MTI's forward strategy to use its resources and experiences to repeat this success with other alternative energy companies.
Mechanical Technology Incorporated was incorporated in New York in 1961. Unless the context otherwise requires, the "registrant", "Company", "Mechanical Technology" and "MTI" refers to Mechanical Technology Incorporated and its subsidiaries. The Company's principal executive offices are located at 325 Washington Avenue Extension, Albany, New York 12205 and its telephone number is (518) 218-2500.
Significant Developments in the Business
On June 27, 1997, the Company and Edison Development Corp. ("EDC"), a subsidiary of DTE Energy Co. formed a joint venture, Plug Power, L.L.C. ("Plug Power"), to further develop the Company's Proton Exchange Membrane ("PEM") Fuel Cell technology. In exchange for its contribution of contracts and intellectual property and certain other net assets that had comprised the fuel cell research and development business activity of the Technology segment (which assets had a net book value of $357 thousand), the Company received a 50% interest in Plug Power. EDC made an initial cash contribution of $4.75 million in exchange for the remaining 50% interest in Plug Power. The Company's investment in Plug Power is included in the balance sheet caption "Investment in Plug Power"; the assets contributed by the Company to Plug Power had previously been included in the assets of the Company's Technology segment. See the supplemental disclosure regarding Contribution of Net Assets to Plug Power in the Consolidated Statements of Cash Flows for additional information regarding the assets contributed by the Company to Plug Power.
Plug Power has focused exclusively on the research, development and manufacture of an economically viable PEM fuel cell. During 1999, the Company invested $6 million cash in Plug Power and sold the MTI campus to Plug Power in exchange for shares of Plug Power and Plug Power's assumption of $6 million of debt.
On October 29, 1999 Plug Power Inc. made an initial public offering ("IPO") of its common stock on the NASDAQ National Market under the symbol "PLUG." The initial public offering price for the 6 million shares issued was $15 per share. Additionally, the underwriters of the IPO exercised their 900,000 share over allotment at the IPO price.
Since Plug Power was formed in 1997 the Company, EDC and other investors have contributed substantial amounts of cash and other assets to Plug Power. Contributions to Plug Power by the Company totaled $20.7 million as of September 30, 1999. Immediately prior to the Plug Power IPO, the Company purchased an additional 2,733,333 shares of Plug Power at $7.50 per share for a total purchase price of $20.5 million. Immediately after Plug Power's IPO, the Company owned 13,704,315 shares of Plug Power or approximately 31.9 percent of outstanding Plug Power stock. The Company's contribution to Plug Power increased to $41.2 million as of Plug Power's IPO date.
On October 21, 1999, the Company created a strategic alliance with SatCon Technology Corporation (SatCon), an innovator of alternative energy technologies. SatCon acquired Ling Electronics, Inc. and Ling Electronics, Ltd. from the Company and the Company committed to invest approximately $7 million in SatCon. In consideration for the acquisition of Ling Electronics and the Company's investment, the Company will receive 1,800,000 shares of SatCon's common stock and
warrants to purchase an additional 100,000 shares of SatCon's common stock. The Company funded $2.57 million of its investment in SatCon and will make the remaining investment by the end of January 2000. SatCon will also receive warrants to purchase 100,000 shares of the Company's common stock.
On July 12, 1999, the Company completed the sale of 801,223 shares of common stock to current shareholders through a rights offering. The offering raised approximately $12.8 million before offering costs of approximately $158 thousand for net proceeds of approximately $12.7 million. The Company will use some or all of the proceeds of the offering for investment into Plug Power. In addition, some proceeds may be used for acquisitions, efforts to increase market share, working capital, general corporate purposes and other capital expenditures.
On September 30, 1998, the Company completed the sale of 1,196,399 shares of common stock to current shareholders through a rights offering. The offering raised approximately $7.2 million before offering costs of approximately $186 thousand for net proceeds of approximately $7 million. The Company used substantially all of the proceeds of the offering for investment in Plug Power. The remaining proceeds were used for efforts to increase market share, working capital, general corporate purposes and other capital expenditures.
The sale of the Company's Technology Division, the sole component of the Technology segment, to NYFM, Incorporated (a wholly owned subsidiary of Foster-Miller, Inc., a Waltham, Massachusetts-based technology company) on March 31, 1998, completed management's planned sale of non-core businesses. Accordingly, the Company no longer includes Technology among its reportable business segments. The Technology Division is reported as a discontinued operation as of December 26, 1997, and the consolidated financial statements have been restated to report separately the net assets and operating results of the business. The Company's prior year financial statements have been restated to conform to this treatment. See Note 16 to the accompanying Consolidated Financial Statements.
On September 30, 1997, the Company sold all of the assets of its L.A.B. division to Noonan Machine Company of Franklin Park, IL. The Company received $2.6 million in cash and two notes, totaling $650 thousand, from Noonan Machine Company. The purchaser has requested that the principal amount of the note be reduced to reflect the resale value of certain assets of L.A.B. The Company is enforcing its rights with respect to the note. The net proceeds from the sale were used to pay down all outstanding debt and build working capital. The sale of L.A.B. resulted in a $2.0 million gain, which was recorded in the fourth quarter of fiscal year 1997.
On December 27, 1996, the Company and First Albany Companies Inc. ("FAC") entered into a Settlement Agreement and Release whereby the Company issued FAC 1.0 million shares of Common Stock in full satisfaction of its obligations pursuant to the Claim Participation Agreement dated December 21, 1993 and amended December 14, 1994, among United Telecontrol Electronics, Inc. ("UTE"), the Company and First Commercial Credit
Corporation, in the principal amount of $3.0 million plus accrued interest of $1.2 million. As a result, the Company in the first quarter of fiscal 1997 realized a gain on the extinguishment of debt totaling $2.5 million, net of approximately $100 thousand of transaction related expenses and net of taxes of $106 thousand.
Business Segments
The Company currently conducts business in two business segments: Alternative Energy Technology and Test and Measurement.
Alternative Energy Technology
The Alternative Energy Technology segment incubates companies that research, develop, manufacture and distribute alternative energy technology solutions. Investments at September 30, 1999 consist of a 40.65 percent equity interest in Plug Power L.L.C. Plug Power is a leading designer and developer of on-site, electricity generation systems utilizing proton exchange membrane ("PEM") fuel cells for residential applications. GE Fuel Cell Systems, LLC, a joint venture that is owned by General Electric's GE Power Systems business (75%) and Plug Power (25%) will market, sell, service, and install Plug Power's products once they are developed.
On October 29, 1999 Plug Power Inc. made an initial public offering ("IPO") of its common stock on the NASDAQ National Market under the symbol "PLUG." The initial public offering price for the 6 million shares issued was $15 per share.
Immediately prior to the Plug Power IPO, the Company purchased an additional 2,733,333 shares of Plug Power at $7.50 per share for a total purchase price of $20.5 million. The Company financed the acquisition of these shares through a $22.5 million loan from KeyBank N.A. Immediately after Plug Power's IPO, the Company owned 13,704,315 shares of Plug Power or approximately 31.9 percent of outstanding Plug Power stock.
Plug Power is developing a PEM fuel cell for residential and automotive applications. As of December 1999, Plug Power has reported achieving the following milestones:
June 1998 Powered a three-bedroom home ("Demonstration Home") with a hydrogen-fueled residential fuel cell system
November 1998 Demonstrated a methanol-fueled residential fuel cell system
December 1998 Selected to design and manufacture 80 test and evaluation residential fuel cell systems for the State of New York for installation at various test sites over the next two years
December 1998 Demonstrated a natural gas-fueled residential fuel cell system
February 1999 Entered into agreement with GE On-Site Power to distribute and service Plug Power residential fuel cell systems
June 1999 Began construction of a state-of-the-art, 51,000 square foot manufacturing facility in Latham, New York
August 1999 Powered the Demonstration Home with a residential fuel cell system connected to its existing natural gas pipeline
September 1999 Filed their 50th patent application relating to fuel cell technology, system designs and manufacturing processes
December 1999 Announced successful completion of a four-month test of a natural gas powered fuel cell system in the Demonstration Home
In October, 1999, MTI sold Ling to SatCon in exchange for common stock and purchased or made commitments to purchase SatCon common stock and warrants. Assuming all funding commitments are made and warrants exercised, MTI will own approximately 16% of SatCon's issued and outstanding common stock.
SatCon manufactures and sells power and energy management products for telecommunications, silicon wafer manufacturing, factory automation, aircraft, satellites and automotive applications. SatCon has four operating divisions: Film Microelectronics, Inc. designs and manufactures microelectronic circuits and interconnect products; Magmotor manufactures motors and magnetic suspension systems; Beacon Power manufactures flywheel energy storage devices; and the Technology Center is responsible for new technology and product development.
Test and Measurement
Test and Measurement offers a wide range of technology-based equipment and systems for improved manufacturing, product testing, and inspection for industry. Business units in this segment include the Advanced Products Division, Ling Electronics, Inc. (sold on October 21, 1999) and the L.A.B. Division (sold on September 30, 1997).
Advanced Products designs, manufactures and markets high-performance test and measurement instruments and systems. These products are categorized in two general product families: non-contact sensing instrumentation and computer-based balancing systems. The Division's largest customers include industry leaders in the computer, electronic, semiconductor, automotive, aerospace, aircraft and bioengineering fields.
The non-contact sensing instrumentation products utilize fiber optic, laser and capacitance technology to perform high precision position measurements for product design and quality control inspection requirements, primarily in the semiconductor and computer disk drive industries. Product trademarks such as the Fotonic Sensor and Accumeasure are recognized worldwide.
The Division's computer-based aircraft engine balancing systems include an on-wing jet engine balancing system used by both commercial and military aircraft fleet maintenance personnel. This product provides trim balancing and vibration analysis in the field or in test cells.
Ling, of Anaheim, California, designs, manufactures, and markets electro-dynamic vibration test systems, high-intensity-sound transducers, power conversion equipment and power amplifiers used to perform reliability testing and stress screening during product development and quality control. This mode of testing is used by industry and the military to reveal design and manufacturing flaws in a broad range of precision products, from satellite parts to computer components. Recent Ling products for power and frequency conversion and "clean power" applications include systems capable of output up to 432 kVA. Ling was sold on October 21, 1999 to SatCon in exchange for 770,000 shares of SatCon common stock (with a market value of $6.738 million on the transaction date).
The L.A.B. Division, which was sold on September 30, 1997, designed, manufactured and marketed mechanically driven and hydraulically driven test systems for package and product reliability testing. Among other uses, this equipment simulates the conditions a product will encounter during transportation and distribution including shock, compression, vibration and impact. This type of testing is widely conducted by businesses involved in product design, packaging and distribution.
The Company believes that the test and measurement industry will undergo substantial consolidation in the near future. The challenges facing MTI today are similar to those facing other smaller companies in industries where consolidation is a part of the landscape. The Company believes that consolidation may become a competitive necessity and that Advanced Products is well-positioned to combine with complementary, synergistic businesses to enhance and expand product offerings and increase profitability and market position. Accordingly, the Company is actively exploring strategic acquisitions and alliances for its businesses.
The business units in the Test and Measurement segment have numerous customers and are not dependent upon a single or a few customers.
Backlog
The backlog of orders believed to be firm as of September 30, is $2.1 million for 1999 and 1998 (of which $997 thousand and $487 thousand, respectively, relates to the Company's Advanced Products Division). The backlog relates to contracts awarded by commercial customers or government agencies.
Marketing and Sales
The Company sells its products and services through a combination of a direct sales force, manufacturer's representatives, distributors and commission salespeople. Each business unit is responsible for its own sales organization. Typically, the Company's product businesses employ regional manufacturer's representatives on an exclusive geographic basis to form a nationwide or worldwide distribution organization; the business unit is responsible for marketing and sales management and provides the representatives with sales and technical expertise on an "as-required" basis. To a great extent, the marketing and sales of the Company's larger products and systems consist of a joint effort by the business unit's senior management, its direct sales force and manufacturer's representatives to sophisticated customers. The manufacturer's representatives are compensated on a commission basis.
Research and Development
The Company conducts considerable research and development to support existing products and develop new products. (See the accompanying Consolidated Statements of Operations). The Company holds patents and rights in various fields of technology. The technology of the Company is generally an advancement of the "state of the art", and the Company expects to maintain a competitive position by continuing such advances rather than relying on patents. Licenses to other companies to use Company-developed technology have been granted and are expected to be of benefit to the Company, though royalty income received in recent years has not been material in amount and is not expected to be material in the foreseeable future.
Competition
The Company and each of its business units are subject to intense competition. The Company faces competition from at least several companies, many of which are larger than MTI and have greater financial resources. While the business units in the Company's Test and Measurement segment each have a major share of their respective markets, the Company does not consider any of them to be dominant within its industry.
The primary competitive considerations in the test and measurement segment are product quality and performance, price and timely delivery. The Company believes that its product development skills and reputation are competitive advantages.
Employees
The total number of employees of the Company and its subsidiaries was 104 as of September 30, 1999, compared to 123 as of the beginning of the fiscal year.
Executive Officers
The executive officers of the registrant (all of whom serve at the pleasure of the Board of Directors), their ages, and the position or office held by each, are as follows:
Position or Office Name Age
Chief Executive Officer, George C. McNamee 53 and a Director
Vice President and Chief Cynthia A. Scheuer 38 Financial Officer
Vice President and General Manager, Denis P. Chaves 59 Advanced Products
President and Chief Executive Officer James R. Clemens 50 Ling Electronics, Inc.
Mr. McNamee has been Chief Executive Officer of the Company since April 1998 and a director since 1996.
Ms. Scheuer was appointed Vice President and Chief Financial Officer of the Company in November 1997. Prior to joining the Company, she was a senior business assurance manager at Coopers & Lybrand L.L.P. where she was employed since 1983.
Mr. Chaves has been Vice President and General Manager of the Company's Advanced Products Division since 1987 and was Vice President and General Manager of the Company's L.A.B. Division from January 1994 until it was sold in September, 1997. Previously, he served as Manager of Corporate Marketing for the Company from 1981 to 1987.
Mr. Clemens has been President and Chief Executive Officer of Ling Electronics, Inc., a wholly owned subsidiary of the Company, since April 1998. Mr. Clemens was previously Vice President and General Manager of Ling from April 1997 to April 1998. Mr. Clemens resigned as an officer of the Company on October 21, 1999, to join SatCon Technology Corporation. From December 1994 to March 1997, he was a site manager for Teleflex Control. From September 1992 to November 1994, he was President and Chief Operating Officer of MTI's former subsidiary United Telecontrol Electronics, Inc.
ITEM 2:
ITEM 2: PROPERTIES
The Company leases property in New York and, prior to the sale of Ling, leased space in California. In management's opinion, the facilities are generally well-maintained and adequate to meet the Company's current and future needs.
The Company's corporate headquarters were located in a building in Latham, New York which was sold to Plug Power during 1999 and a portion of which was leased back to the Company until November 1999. The building contained a total of approximately 31,000 square feet. In November 1999, the Company
completed its relocation to Albany, New York, where it leases a facility for Advanced Products and corporate headquarters. The facility has approximately 20,700 square feet of office and manufacturing space. The lease expires on November 30, 2009.
Ling Electronics, Inc. (Ling) leases approximately 85,000 square feet of office and manufacturing space in Anaheim, California. The lease will expire in June of 2003. Ling was sold, and the lease assigned, to SatCon Technology Corporation on October 21, 1999.
ITEM 3:
ITEM 3: LEGAL PROCEEDINGS
At any point in time, the Company and its subsidiaries may be involved in various lawsuits or other legal proceedings; these could arise from the sale of products or services or from other matters relating to its regular business activities, may relate to compliance with various governmental regulations and requirements, or may be based on other transactions or circumstances. The Company does not believe there are any such proceedings presently pending that could have a material adverse effect on the Company's financial condition except for the matters described in Note 14 to the accompanying Consolidated Financial Statements (which description is incorporated herein by reference).
On September 9, 1998, Barbara Lawrence, the Lawrence Group, Inc. ("Lawrence"), and certain other Lawrence-related entities ("Plaintiffs") filed suit in the United States Bankruptcy Court for the Northern District of New York against First Albany Corporation ("FAC"), Dale Church, Edward Dohring, Alan Goldberg, George McNamee, Beno Sternlicht, Marty Mastroianni (former President and Chief Operating Officer of MTI) and 33 other individuals ("Defendants") who purchased a total of 820,909 shares of MTI stock from the Plaintiffs. The complaint alleged that Defendants purchased MTI stock from the Plaintiffs in violation of sections 10b, 20, 20A and rule 10b-5 of the Securities Exchange Act of 1934. In December 1998, the complaint was amended to add MTI as a defendant and assert a claim for common law fraud against all the Defendants including MTI. The case concerns the Defendants' 1998 purchase of MTI shares from the Plaintiffs at the price of $2.25 per share. Ownership of the shares was disputed and several of the Plaintiffs were in bankruptcy at the time of the sale. FAC acted as Placement Agent for the Defendants in the negotiation and sale of the shares and in proceedings before the Bankruptcy Court for the Northern District of New York, which approved the sale in September 1997. Plaintiffs claim that the Defendants failed to disclose material inside information concerning Plug Power, LLC to the Plaintiffs and therefore the $2.25 per share purchase price was unfair. Plaintiffs are seeking damages of $5 million plus punitive damages and costs. In April 1999, Defendants filed a motion to dismiss the amended compliant, which was denied. In June 1999, the parties agreed to stay discovery and amend Defendants time to answer the amended complaint until September 17, 1999. In October 1999, Defendants answered the amended Complaint.
ITEM 4:
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the registrant's security holders during the fourth quarter of fiscal 1999.
PART II
ITEM 5:
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Price Range of Common Stock
On April 16, 1999, the stock began trading on the NASDAQ National Market System under the same symbol, MKTY. From August 1994 through April 15, 1999, the Company's Common Stock traded on the over-the-counter market under the symbol MKTY on the OTC Bulletin Board. Set forth below are the highest and lowest prices at which shares of the Company's Common Stock have been traded during each of the Company's last two fiscal years.
Prices as Adjusted to Effect for April 30,1999 Prices as Reported Three for Two Stock Split High Low High Low
Fiscal Year 1999 First Quarter 8-5/8 6-3/4 5-3/4 4-1/2 Second Quarter 21 8 14 5-1/3 Third Quarter 30 11-11/12 30 7-15/16 Fourth Quarter 35-9/16 23-6/16 35-9/16 23-6/16
Fiscal Year 1998 First Quarter 6-3/4 3-3/4 4-1/2 2-1/2 Second Quarter 8-1/8 3-1/2 5-5/12 2-1/3 Third Quarter 8-1/8 5-11/16 5-5/12 3-3/4 Fourth Quarter 9-3/8 6 6-1/4 4
Number of Equity Security Holders
As of December 20, 1999, the Company had approximately 479 holders of its $1.00 par value Common Stock. In addition, there are approximately 4,154 beneficial owners holding stock in "street" name.
Dividends
The payment of dividends is within the discretion of the Company's Board of Directors and will depend, among other factors, on earnings, capital requirements, and the operating and financial condition of the Company. The Company has never paid and does not anticipate paying dividends in the foreseeable future.
ITEM 6:
ITEM 6: SELECTED FINANCIAL DATA
The following table sets forth summary financial information regarding Mechanical Technology Incorporated for the years ended September 30, as indicated:
Prior years have been restated to reflect the Technology and Defense/Aerospace segments as discontinued operations. (See Note 16 to the accompanying Consolidated Financial Statements).
There were no cash dividends on common stock declared for any of the periods presented.
ITEM 7:
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations: 1999 in Comparison with 1998
The following three paragraphs summarize significant organizational changes, which impact the comparison of 1999 and 1998 results of operations.
On June 27, 1997, the Company and Edison Development Corp. ("EDC"), a subsidiary of DTE Energy Co. formed a joint venture, Plug Power L.L.C. ("Plug Power") to further develop the Company's Proton Exchange Membrane ("PEM") Fuel Cell technology. In exchange for its contribution of employees, contracts, intellectual property and certain other assets that had comprised the fuel cell research and development business activity of the Technology segment (which assets had a net book value of $357 thousand), the Company received a 50% interest in Plug Power. EDC made an initial cash contribution of $4.75 million in exchange for the remaining 50% interest in Plug Power. The Company's investment in Plug Power is included in the balance sheet caption "Investment in Plug Power"; the assets contributed by the Company to Plug Power had previously been included in the assets of the Company's Technology segment. See the supplemental disclosure regarding Contribution of Net Assets to Plug Power in the Consolidated Statements of Cash Flows for additional information regarding the assets contributed by the Company to Plug Power.
Since Plug Power was formed in 1997 the Company, EDC and other investors have contributed substantial amounts of cash and other assets to Plug Power. Contributions to Plug Power by the Company totaled $20.7 million as of September 30, 1999 and increased to $41.2 million as of Plug Power's IPO date. After Plug Power' s IPO, the Company owned 13,704,315 shares or 31.9% of outstanding Plug Power stock.
The sale of the Company's Technology Division, the sole component of the Technology segment, to NYFM, Incorporated (a wholly owned subsidiary of Foster-Miller, Inc., a Waltham, Massachusetts-based technology company) on March 31, 1998 completed management's planned sale of non-core businesses. Accordingly, the Company no longer includes Technology among its reportable business segments. The Technology Division is reported as a discontinued operation as of December 26, 1997, and the consolidated financial statements have been restated to report separately the net assets and operating results of the business.
The following is management's discussion and analysis of certain significant factors, which have affected the Company's results of operations for 1999 compared to 1998. This discussion relates only to the Company's continuing operations before the sale of Ling, which occurred in
October 1999.
Sales for fiscal 1999 totaled $12.9 million compared to $21.0 million for the prior year, a decrease of $8.1 million or 38.7%. This decrease is the result of continuing weak market conditions. Advanced Products and Ling reported sales decreases of 48.7% and 31.6%, respectively in the year ended September 30, 1999.
Selling, general and administrative expenses for fiscal 1999 were 38.4% of sales, as compared to 27.6% in 1998. Higher levels of general/administrative expenses as a percentage of sales for fiscal 1999 resulted primarily from the 38.7% decrease in sales. Actual selling, general and administrative expenses decreased $.863 million from 1998 to 1999.
Product development and research costs during fiscal 1999 were 8.6% of sales, compared to 4% for 1998. Development costs increased $.274 million from 1998 to 1999 reflecting the Advanced Products Division's commitment to developing diagnostic and other new products.
The operating loss of $1.4 million for the year ended September 30, 1999 represents a $3.4 million or 170.4% decrease from the $2 million operating income reported during the same period last year. The decrease is the result of decreased sales levels and corresponding decreases in gross profits due to fixed cost absorption at lower sales levels. Gross profit decreased to 36% of sales in fiscal 1999 from 41% of sales in fiscal 1998.
In addition to the matters noted above, the Company recorded a $9.4 million loss from the recognition of the Company's proportionate share of losses of Plug Power compared to a $3.8 million loss in 1998.
Results during fiscal 1999 were adversely effected by the sales decrease. Further, as a result of ownership changes in 1996, the availability of net operating loss carryforwards to offset future taxable income will be significantly limited pursuant to the Internal Revenue Code.
Results of Operations: 1998 in Comparison with 1997
The following two paragraphs summarize significant organizational changes, which impact the comparison of 1998 and 1997 results of operations.
Net assets of the discontinued technology operation were $8 thousand and $3,186 thousand at September 30, 1998 and 1997, respectively, and the loss on discontinued operations included a loss from operations of $516 thousand and a loss on disposal of $1,769 thousand at September 30, 1998. The loss on disposal includes a provision for estimated operating results prior to disposal. The Company's prior year financial statements have been restated to conform to this treatment.
On September 30, 1997, the Company sold all of the assets of its L.A.B. Division to Noonan Machine Company of Franklin Park, IL. The Company received $2.6 million in cash and two notes, totaling $650 thousand, from Noonan Machine Company. The purchaser has requested that the principal amount of the note be reduced to reflect the resale value of certain assets of L.A.B. The Company is enforcing its rights with respect to the
note. The net proceeds from the sale were used to pay down outstanding debt and build working capital. The sale of L.A.B. resulted in a $2.0 million gain, which was recorded in the fourth quarter of fiscal year 1997. In addition, $250 thousand of the proceeds associated with one of the notes was recorded as deferred revenue due to the possible reduction of the $250 thousand note receivable, in the event of a sale of certain fixed assets, in accordance with the terms of the note.
The following is management's discussion and analysis of certain significant factors, which have affected the Company's results of operations for 1998 compared to 1997. This discussion relates only to the Company's continuing operations.
Sales for fiscal 1998 totaled $21.0 million compared to $24.1 million for the prior year, a decrease of $3.1 million or 12.8%. This decrease is attributable to the reduction of sales resulting from the sale of the L.A.B. Division on September 30, 1997, which reported sales of $3.3 million and operating income of $500 thousand at September 30, 1997. Advanced Products reported a sales increase of 26.2% and Ling reported a sales decrease of 11.3% in the year ended September 30, 1998.
Selling, general and administrative expenses for fiscal 1998 were 27.6% of sales, as compared to 29.1% in 1997. Product development and research costs during fiscal 1998 were 4% of sales, compared to 4.2% for 1997. Lower levels of selling, general and administrative expenses for fiscal 1998 resulted primarily from cost reduction efforts during fiscal 1998 as well as the elimination of costs for L.A.B. of $600 thousand.
Operating income of $2 million at September 30, 1998 represented a $400 thousand or 25.5% increase from the $1.6 million operating income recorded during the same period last year. The increase is the result of increased sales levels for Advanced Products and improved margins as a result of cost control measures. Excluding the L.A.B. division results in 1997, operating income increased $900 thousand.
In addition to the matters noted above, during the fourth quarter of fiscal 1998, the Company recorded a $3.8 million loss from the recognition of the Company's proportionate share of losses in Plug Power compared to a $330 thousand loss in 1997. During the fourth quarter of fiscal 1997, the Company recorded a $2.0 million gain on the sale of the L.A.B. Division. Further, the Company recorded a $2.5 million extraordinary gain, net of taxes, on the extinguishment of debt during the first quarter of fiscal 1997.
Results during fiscal 1998 were enhanced by lower interest expense, principally resulting from reduced indebtedness. Moreover, the Company benefited from reduced income tax expense due to the loss generated by discontinued operations and the use of net operating loss carryforwards. However, as a result of recent ownership changes, the availability of further net operating loss carryforwards to offset future taxable income will be significantly limited pursuant to the Internal Revenue Code.
Liquidity and Capital Resources
At September 30, 1999, the Company's order backlog was $2.1 million, representing no change from the prior year-end.
Inventories in 1999 remained stable at $3.75 million to support expected sales increases during the first quarter of 2000. Additionally, accounts receivable decreased by $1.1 million in 1999 due to the reduced sales during fiscal 1999.
Cash flow used by continuing operations was $2.3 million in 1999 compared with $.5 million provided in 1998 and $1.1 million provided in 1997. Cash flow from operating activities was impacted in 1999 by operating losses and 1998 and 1997 were impacted by positive operating income and fluctuations in working capital components.
Working capital was $18.7 million at September 30, 1999, a $12.9 million increase from $5.8 million at fiscal year-end 1998. Capital increased $12.7 million in 1999 which reflects the proceeds received from the sale of common shares to existing shareholders through a rights offering.
Capital expenditures were $2.7 million for 1999, $3.2 million for 1998 and $.4 million for 1997. The capital expenditures in 1999 were in accordance with the higher level of planned expenditures including the construction of a new facility for Advanced Products and corporate headquarters and renovations to an existing building, which were subsequently sold to Plug Power in July 1999. Capital expenditures in 2000 are expected to approximate $.4 million, which consists of expenditures for facility fit- up and computer and manufacturing equipment. The Company expects to finance these expenditures with cash from operations and existing credit facilities.
Cash and cash equivalents were $5.9 million at September 30, 1999 compared to $5.6 million at September 30, 1998. Investments in marketable securities were $7.9 million at September 30, 1999. These increases are primarily attributable to $12.7 million of net cash proceeds from the sale of common shares to existing shareholders through a rights offering, which closed on July 12, 1999 net of payments associated with the Company's construction project. During 1999, the Company also funded $4 million of previously accrued capital contributions to Plug Power.
At September 30, 1999 and 1998, there were no borrowings outstanding on the lines of credit. The Company has a working capital line of credit available in the amount of $4 million and a $1 million equipment line of credit. These lines of credit expire on January 31, 2000. The Company is currently negotiating an extension of these lines of credit.
The reduction in net assets of discontinued operations to a net liability of $.5 million reflects the collection of receivables and settlement of liabilities. The sale of the Technology Division was completed as of March 31, 1998.
KeyBank issued a letter of credit for approximately $6 million in connection with the issuance of $6 million of Industrial Development Revenue Bonds ("IDR Bonds"). The KeyBank credit agreements required the Company to meet certain covenants, including a fixed charge coverage and leverage ratio. Further, if certain performance standards were achieved,
the interest rates on the debt may be reduced. The IDR Bond Obligation, letter of credit and unexpended bond proceeds were transferred to Plug Power in connection with the sale of the MTI facility and adjacent residence effective July 1, 1999.
The Industrial Development Agency for the Town of Colonie issued $6 million in IDR Bonds on behalf of the Company to assist in the construction of a new building for Advanced Products and the Company's corporate staff and renovation of existing buildings leased to Plug Power. The bond closing was completed December 17, 1998 and proceeds of the IDR Bonds were deposited with a trustee for the bondholders. The Company has drawn bond proceeds to cover qualified project costs.
On November 1, 1999, the Company entered into a $22.5 million Credit Agreement with KeyBank, N.A. ("the $22.5 million Credit Agreement"). The proceeds of this loan were used to fund the Company's remaining $20.5 million balance of its Mandatory Capital Commitment to contribute $22.5 million to Plug Power. Pursuant to the Mandatory Capital Commitment, the Company purchased 266,667 shares of Plug Power for $2 million on September 30, 1999 and 2,733,333 shares of Plug Power for $20.5 million in November 1999. The Company may sell shares of Plug Power Common Stock to pay monthly interest and or quarterly principal payments (beginning May 2001) on the Loan. Plug Power's stock is currently traded on the NASDAQ, therefore the stock is subject to stock market conditions. Due to the Company's significant ownership position, sales of Plug Power stock will be subject to SEC Rule 144 limitations including a limit of one (1) percent of total outstanding shares per quarter.
The $22.5 million Credit Agreement requires the Company to meet certain covenants, including maintenance of a collateral account which at all times has a minimum market value of $600 thousand and a balance on November 1, 1999 of $2.65 million, and maintenance of a collateral coverage ratio. The existing covenants under the original letter of credit were eliminated pursuant to the $22.5 million Credit Agreement. The $22.5 million Credit Agreement is collateralized by 100% of the Company's equity interest in Plug Power.
On October 21, 1999, the Company created a strategic alliance with SatCon Technology Corporation (SatCon). SatCon acquired Ling Electronics, Inc. and Ling Electronics, Ltd. from the Company and the Company committed to invest approximately $7 million in SatCon. In consideration for the acquisition of Ling Electronics and the Company's investment, the Company will receive 1,800,000 shares of SatCon's common stock and warrants to purchase an additional 100,000 shares of SatCon's common stock. The Company funded $2.57 million of its investment in SatCon and will make the remaining investment by the end of January 2000. SatCon will also receive warrants to purchase 100,000 shares of the Company's common stock.
The Company anticipates that it will be able to meet the liquidity needs of its continuing operations and its investment commitment to SatCon from current cash resources, cash flow generated by operations and borrowing under its existing lines of credit.
Market Risk
Market risk represents the risk of changes in value of a financial instrument, caused by fluctuations in interest rates and equity prices.
Because the Company's cash and investment position exceeds both short and long term obligations, the Company's exposure to interest rate risk relates primarily to its investment in marketable debt securities. The investments are at variable rates, which generally reflect market conditions. The Company manages its investments to increase return on investment and only invests in instruments with high credit quality.
The Company has performed a sensitivity analysis on its marketable debt securities and its investment in Plug Power common stock. The sensitivity analysis presents the hypothetical change in fair value of those financial instruments held by the Company at September 30, 1999 which are sensitive to changes in interest rates. Market risk is estimated as the potential change in fair value resulting from an immediate hypothetical one-percentage point parallel shift in the yield curve. The fair values of the Company's investments in marketable securities have been based on quoted market prices. As the carrying amounts on short-term investments maturing in less than 180 days approximate the fair value, these are not included in the sensitivity analysis. The fair value of marketable securities over 180 days is $3.0 million. A one-percentage point change in the interest rates would change the fair value of investments over 180 days by $85 thousand.
The Company also has an investment in Plug Power, which is accounted for on the equity method. The fair market value of the investment is $164.6 million based on the October 28, 1999 $15 per share initial public offering price. If the market price on the Plug Power stock would decrease by ten percent the fair value of the stock would decrease by $16.5 million.
Year 2000
The Company's Year 2000 plan is complete. The plan addresses the issue of computer programs and embedded computer chips being unable to distinguish between the year 1900 and the year 2000 as well as the ability to recognize the leap year date of February 29, 2000. The plan has been divided into six areas: (1)Systems evaluation, (2) Software evaluation, (3) Third-party suppliers, (4) Facility systems, (5) Products and (6)Contingency plans. The general phases common to all segments are: (1) Inventorying Year 2000 items, (2) Assigning priorities to identified items, (3) Assessing the Year 2000 compliance of items determined to be material to the Company, (4) Repairing or replacing material items that are determined not to be Year 2000 compliant, (5) Testing material items and (6) Designing and implementing contingency and business continuation plans for each organization and company location.
Systems Evaluation
All internal systems have been identified, inventoried, prioritized and assessed for Year 2000 compliance. Systems found to be non-compliant
were replaced and compliant systems were assessed to determine what if any maintenance is required to keep them compliant. Plans have been developed to ensure that staff is available to oversee restarting certain machines and manually adjusting their dates.
Software Evaluation
All software material to the Company has been identified, evaluated, and is now in compliance and certified as such by vendors or new software has been purchased.
Third-Party Suppliers
Third-party suppliers have been identified and reviewed to determine whether their products and supplies are Year 2000 compliant. Any provider identified as non-compliant has been or will be replaced with an alternative provider if they cannot serve our needs.
Facility Systems
All facility systems are believed to be Year 2000 compliant including telephone, fire alarm, security and network components.
Products
The Company has evaluated both current product offerings and products in the field to determine their ability to comply with Year 2000 issues. The products were found to fall into three categories, non-compliant, compliant if modifications are made and fully compliant or not impacted (that is, the product does not have a computer or contains an embedded computer but does not use a date function). All products currently sold by the Company are fully Year 2000 compliant. The Company has produced and made available for sale, upgrades to products requiring modifications to be Year 2000 compliant. Those products identified as non-compliant are products that have been in the field for a number of years and must be replaced by the customer.
Contingency Plans
In the event the Company's Year 2000 plan is ineffective or unanticipated problems arise, the Company has developed contingency plans which are now in place. The plans include use of hard copy data and alternate suppliers.
Costs
The total cost associated with required modifications to become Year 2000 compliant is not expected to be material to the Company's financial position. The estimated total cost of the Year 2000 project was approximately $120 thousand, which included software, hardware and cabling upgrade and replacement costs. This estimate does not include the Company's potential share of Year 2000 costs that may be incurred by joint ventures, in which the company participates but is not the operator. The total amount expended on the Plan through September 30, 1999 was $124 thousand for the upgrade and replacement of hardware.
Risks
The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-party suppliers and customers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's results of operations, liquidity or financial condition. The Year 2000 Plan is expected to significantly reduce the Company's level of uncertainty about the Year 2000 problem and, in particular, about the Year 2000 compliance and readiness of its material customers. The Company believes that, with its Year 2000 Plan, the possibility of significant interruptions of normal operations should be reduced.
Forward Looking Statements
Statements in this Form 10-K or in documents incorporated herein by reference that are not historical facts or information constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including, but not limited to, the information set forth herein. Such forward looking statements involve known and unknown risks, uncertainties or other factors which may cause the actual results, levels of activity, performance or achievement of Company or industry results to be materially different from any future results, levels of activity, performance or achievement expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions; the ability of the Company to implement its business strategy; the Company's access to financing; the Company's ability to successfully identify new business opportunities; the Company's ability to attract and retain employees; changes in the industry; competition; the effect of regulatory and legal proceedings and other factors discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations". As a result of the foregoing and other factors, no assurance can be given as to the future results and achievements of the Company. Neither the Company nor any other person assumes responsibility for the accuracy and completeness of these statements.
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS
The financial statements filed herewith are set forth on the Index to Consolidated Financial Statements on Page of the separate financial section which follows page 29 of this report and are incorporated herein by reference.
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10:
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the caption "Executive Officers" in Item 1 of this Form 10-K Report, and the information which will be set forth in the section entitled "Election of Directors", and under the captions "Security Ownership of Certain Beneficial Owners" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the section entitled "Additional Information", in the definitive Proxy Statement to be filed by the registrant, pursuant to Regulation 14A, for its Annual Meeting of Shareholders to be held on March 16, 2000 (the "2000 Proxy Statement"), is incorporated herein by reference.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION
The information which will be set forth under the captions "Executive Compensation", "Compensation Committee Report", "Compensation Committee Interlocks and Insider Participation", "Employment Agreements", and "Directors Compensation", in the section entitled "Additional Information" in the registrant's 2000 Proxy Statement, is incorporated herein by reference.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information which will be set forth under the captions "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" in the section entitled "Additional Information" in the registrant's 2000 Proxy Statement, is incorporated herein by reference.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information which will be set forth under the caption "Certain Information Regarding Nominees" in the section entitled "Election of Directors", and under the captions "Directors Compensation", "Security Ownership of Certain Beneficial Owners", and "Certain Relationships and Related Transactions", in the section entitled "Additional Information", in the registrant's 2000 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
(a) (1) The financial statements filed herewith are set forth on the Index to Consolidated Financial Statements on page of the separate financial section which accompanies this Report, which is incorporated herein by reference.
The following exhibits are filed as part of this Report:
Exhibit Number Description
3.1 Certificate of Incorporation of the registrant, as amended and restated. (6)
3.2 By-Laws of the registrant, as restated. (6)
4.93 Credit Agreement dated as of September 22, 1998 among Mechanical Technology Incorporated and KeyBank National Association ("KeyBank"). (8)
4.94 Security Agreement, dated as of September 22, 1998, executed by the registrant in favor of KeyBank and securing the registrant's obligations to KeyBank. (8)
4.95 Security Agreement, dated as of September 22, 1998, executed by Ling Electronics, Inc. (a wholly owned subsidiary of the registrant) in favor of KeyBank and securing the registrant's obligations to KeyBank. (8)
4.96 Guaranty of Payment and Performance, dated as of September 22, 1998, executed by Ling Electronics, Inc. (a wholly-owned subsidiary of the registrant) in favor of KeyBank and guaranteeing payment of the registrant's obligations to KeyBank. (8)
4.103 Assignment and Assumption Agreement, dated as of July 1, 1999, by and among Town of Colonie Industrial Development Agency, the registrant, Plug Power, LLC, KeyBank National Association and First Albany Corporation in connection with the sale of the MTI facility to Plug Power and the assignment and assumption of rights and obligations in connection with the Industrial Development Revenue Bonds (Letter of Credit Secured) Series 1998 A in the original aggregate amount of $6,000,000. (10)
4.104 Credit Agreement, dated as of November 1, 1999, between the registrant and KeyBank National Association for a $22.5 million term loan to finance a capital contribution to Plug Power, LLC. (11)
4.105 Stock Pledge Agreement, dated as of November 1, 1999, by the registrant with KeyBank National Association pledging 13,704,315 shares of Plug Power stock in support of the $22.5 million credit agreement. (11)
10.1 Mechanical Technology Incorporated Restricted Stock Incentive Plan. Filed as Exhibit 28.1 to the registrant's Form S-8 Registration Statement No. 33-26326 and incorporated herein by reference. (1)
10.14 Mechanical Technology Incorporated Stock Incentive Plan - included as Appendix A to the registrant's Proxy Statement, filed pursuant to Regulation 14A, for its December 20, 1996 Special Meeting of Shareholders and incorporated herein by reference. (2)
10.17 Agreement, dated March 14, 1998, between the Registrant and Mr. James Clemens, Vice President and General Manager of Ling Electronic, Inc., regarding his employment. (3)
10.18 Limited Liability Company Agreement of Plug Power, L.L.C., dated June 27, 1998, between Edison Development Corporation and Mechanical Technology, Incorporated. (4)(5)
10.19 Contribution Agreement, dated June 27, 1998, between Mechanical Technology, Incorporated and Plug Power, L.L.C. (4)(5)
10.20 Asset Purchase Agreement, dated as of September 22, 1998, between Mechanical Technology, Incorporated and Noonan Machine Company. (4)
10.21 Asset Purchase Agreement between MTI and NYFM, Incorporated, dated as of March 31, 1998. (7)
10.24 Contribution Agreement between Edison Development Corporation and MTI, dated as of June 10, 1998. (7)
10.30 Mechanical Technology Incorporated 1999 Employee Stock Incentive Plan. (9)
10.31 Agreement of Sale, dated June 23, 1999, by and between the registrant and Plug Power, LLC for the sale of the MTI campus and adjacent residence. (10)
10.32 Stock Purchase Agreement, dated October 21, 1999, between the registrant, Ling Electronics, Inc., Ling Electronics, Ltd. and SatCon Technology Corporation.
10.33 Securities Purchase Agreement, dated October 21, 1999, between the registrant and SatCon Technology Corporation.
10.34 Mechanical Technology Incorporated Registration Rights Agreement, dated October 21, 1999, between the registrant and SatCon Technology Corporation.
10.35 SatCon Technology Corporation Registration Rights Agreement, dated October 21, 1999, between SatCon Technology Corporation and the registrant.
10.36 Mechanical Technology Incorporated Stock Purchase Warrant dated October 21, 1999.
10.37 SatCon Technology Corporation Stock Purchase Warrant dated October 21, 1999.
10.38 Lease dated August 10, 1999 between Carl E. Touhey and Mechanical Technology, Inc.
10.39 Registration Rights Agreement, dated November 1, 1999 by and among Plug Power Inc. and the registrant.
10.40 Plug Power Inc. Lock-Up Agreement, dated November 1, 1999.
21 Subsidiaries of the registrant.
27 Financial Data Schedule
______________________ Certain exhibits were previously filed (as indicated below) and are incorporated herein by reference. All other exhibits for which no other filing information is given are filed herewith:
(1) Filed as Exhibit 28.1 to the registrant's Form S-8 Registration Statement No. 33-26326, filed December 29, 1988, and incorporated herein by reference.
(2) Filed as an Exhibit (bearing the same exhibit number) to the registrant's Form 10-K Report for its fiscal year ended September 30, 1996.
(3) Filed as an Exhibit (bearing the same exhibit number) to the registrant's Form 8-K Report dated May 12, 1997.
(4) Filed as an Exhibit (bearing the same exhibit number) to the registrant's Form 10-K Report for the fiscal year ended September 30,1997.
(5) Refiled herewith after confidential treatment request with respect to certain schedules and exhibits were denied by the Commission. Confidential treatment with respect to certain schedules and exhibits was granted.
(6) Filed as an Exhibit to the Proxy Statement, Schedule 14A, dated March 9, 1998.
(7) Filed as an Exhibit (bearing the same exhibit number) to the registrant's Form S-2 dated August 18, 1998.
(8) Filed as an Exhibit (bearing the same exhibit number) to the registrant's Form 10-K Report for the fiscal year ended September 30, 1998.
(9) Filed as an Exhibit to the registrant's Proxy Statement, Schedule 14A, dated February 12, 1999.
(10) Filed as an Exhibit (bearing the same exhibit number) to the registrant's Form 10-Q Report for its fiscal quarter ended June 25, 1999.
(11) Filed as an Exhibit to the registrant's 13D Report dated November 4, 1999.
(a) (2) Schedule. The following consolidated financial statement schedule for each of the three years in the period ended September 30, 1999 is included pursuant to Item 14(d):
Report of Independent Accountants on Financial Statements Schedule
Schedule II--Valuation and Qualifying Accounts
(b) Two reports on Form 8-K were filed during the quarter ended September 30, 1999 and three reports were filed subsequent to the quarter ended September 30, 1999.
The Company filed a Form 8-K Report, dated July 2, 1999, reporting under item 5 thereof its intention to release 125,000 shares for the Rights Offering over-subscription and pre-releasing preliminary third quarter 1999 results.
The Company filed a Form 8-K Report, dated August 30, 1999, reporting under item 5 thereof that the Company's fuel cell affiliate, Plug Power, filed a registration statement with the Securities and Exchange Commission, in connection with the initial public offering of its common stock. If the public offering price is greater than $7.50 per share, the Company has agreed to purchase 3 million shares of Plug Power stock at the fixed price of $7.50 per share, pursuant to the Mandatory Capital Contribution Agreement dated as of January 26, 1999.
The Company filed a Form 8-K Report, dated October 4, 1999, reporting under item 5 thereof that Plug Power filed an amendment to its registration statement with the Securities and Exchange Commission stating that shares of Plug Power would be offered at an estimated price range of $13 to $15 per share. On September 30, 1999, the Company purchased 266,667 shares of Plug Power at $7.50 per share thereby reducing the Company's commitment to purchase shares at the public offering from 3 million to 2,733,333 shares.
The Company filed a Form 8-K Report, dated October 22, 1999, reporting under item 5 thereof the creation of a strategic alliance with SatCon Technology Corporation. SatCon acquired Ling Electronics, Inc. and Ling Electronics, Ltd. from the Company and the Company will invest approximately $7,000,000 in SatCon. In consideration for the acquisition of Ling Electronics and the Company's investment, the Company will receive 1,800,000 shares of SatCon's common stock and warrants to purchase an additional 100,000 shares of SatCon's common stock. The Company immediately funded $2,570,000 of its investment in SatCon and will make the remaining investment by the end of January 2000. SatCon will also receive warrants to purchase 100,000 shares of the Company's common stock.
The Company filed a Form 8-K Report, dated November 16, 1999, reporting under item 5 thereof that on November 8, 1999 Plug Power received correspondence from counsel to DCT, Inc., alleging , among other things, that the Company misappropriated from DCT, Inc. business and technical trade secrets, ideas, know-how and strategies relating to fuel cell systems, and that certain contractual obligations owed to DCT, Inc. were breached.
(d) Separate financial statements for Plug Power, Inc., a less than fifty percent owned entity, will be filed as an amendment to this Form 10-K as soon as they become available. Plug Power's fiscal year ends December 31, 1999 and their financial statements should be available by March 30, 1999, the SEC filing deadline for their Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MECHANICAL TECHNOLOGY INCORPORATED
Date: December 28,1999 By: /s/ G.C. McNamee George C. McNamee Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
/s/ George C. McNamee Chief Executive Officer and George C. McNamee Chairman of the Board of Directors December 28, 1999
/s/ Cynthia A. Scheuer Chief Financial Officer Cynthia A. Scheuer (Principal Financial and Accounting Officer) "
/s/ Dale W. Church Director " Dale W. Church
/s/ Edward A. Dohring Director " Edward A. Dohring
/s/ Alan P. Goldberg Director " Alan P. Goldberg
/s/ E. Dennis O'Connor Director " E. Dennis O'Connor
/s/ Walter L. Robb Director " Dr. Walter L. Robb
/s/ Beno Sternlicht Director " Dr. Beno Sternlicht
REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Shareholders of Mechanical Technology Incorporated
Our audits of the consolidated financial statements referred to in our report dated November 12, 1999 appearing on page of this Form 10-K of Mechanical Technology Incorporated also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers L.L.P.
Albany, New York November 12, 1999
SCHEDULE II
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (DOLLARS IN THOUSANDS)
Additions Balance at Charged to Charged Balance beginning costs and to other at end of Description of period expenses accounts Deductions period
Allowance for doubtful accounts
Year ended September 30:
1999 $ 99 $ 76 $ - $ 62 $ 113 1998 94 95 - 90 99 1997 73 49 - 28 94
Includes accounts written off as uncollectible, recoveries and the effect of currency exchange rates.
Valuation allowance for deferred tax assets
Year ended September 30:
1999 $ 4,089 $ 5,092 $ - $ 5,431 $ 3,750 1998 2,754 1,335 - - 4,089 1997 4,264 - - 1,510 2,754
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Accountants. . . . . . . . . . .
Consolidated Financial Statements:
Balance Sheets as of September 30, 1999 and 1998 . . &
Statements of Operations for the Years Ended September 30, 1999, 1998 and 1997 . . . . . . . .
Statements of Shareholders' Equity for the Years Ended September 30, 1999, 1998 and 1997 . . . . . . . .
Statements of Cash Flows for the Years Ended September 30, 1999, 1998 and 1997 . . . . . . . . -
Notes to Consolidated Financial Statements . . . . . -
Separate financial statements of the registrant alone are omitted because the registrant is primarily an operating company and all subsidiaries included in the consolidated financial statements being filed, in the aggregate, do not have minority equity interest and/or indebtedness to any person other than the registrant or its consolidated subsidiaries in amounts which together exceed 5% of the total assets as shown by the most recent year-end consolidated balance sheet.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of Mechanical Technology Incorporated
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and retained earnings and of cash flows present fairly, in all material respects, the financial position of Mechanical Technology Incorporated and Subsidiaries at September 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1999, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/PricewaterhouseCoopers L.L.P.
Albany, New York November 12, 1999
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS September 30, 1999 and 1998
(Dollars in thousands) 1999 1998 ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 5,870 $ 5,567 Investments in marketable securities 7,876 - Accounts receivable, less allowance of $113 (1999) and $99 (1998) 3,852 4,959
Other receivables - related parties 105 87
Inventories 3,752 3,748 Taxes receivable 10 8 Note receivable - current 329 327 Prepaid expenses and other current assets 265 472 Net assets of a discontinued operation - 8 ______ ______ Total Current Assets 22,059 15,176
Property, Plant and Equipment, net 827 4,467
Note receivable - noncurrent 184 264
Investment in Plug Power 8,710 1,221 _______ ________ Total Assets $ 31,780 $ 21,128 ======= ========
The accompanying notes are an integral part of the consolidated financial statements.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Continued) September 30, 1999 and 1998
(Dollars in thousands) 1999 1998 LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES Income taxes payable $ - $ 5 Accounts payable 614 2,064 Accrued liabilities 2,243 3,328 Contribution payable-Plug Power - 4,000 Net liabilities of discontinued operations 540 - _______ _______ Total Current Liabilities 3,397 9,397
LONG-TERM LIABILITIES Deferred income taxes and other credits 597 607 _______ _______ Total Liabilities $ 3,994 $ 10,004 _______ _______ COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY Common stock, par value $1 per share, authorized 15,000,000; issued 11,649,959 (1999) and 10,773,968(1998) 11,649 10,775 Paid-in capital 42,755 16,274 Deficit (26,573) (15,885) _______ _______ 27,831 11,164 Accumulated Other Comprehensive Loss: Unrealized loss on available for sale securities, net (5) - Foreign currency translation adjustment (11) (11) _______ _______ Accumulated Other Comprehensive Loss (16) (11)
Common stock in treasury, at cost, 6,750 shares (1999) and 4,500 shares (1998) (29) (29) _______ _______ Total Shareholders' Equity 27,786 11,124
Total Liabilities and Shareholder's Equity $ 31,780 $ 21,128 ======= =======
The accompanying notes are an integral part of the consolidated financial statements.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended September 30, 1999, 1998 and 1997 (Dollars in thousands, except per share) Restated 1999 1998 1997
Net sales $ 12,885 $ 21,028 $ 24,102 Cost of sales 8,239 12,386 14,474 _______ _______ _______ Gross profit 4,646 8,642 9,628 Selling, general and administrative expenses 4,949 5,812 7,015 Product development and research costs 1,105 831 1,020 _______ _______ _______ Operating (loss) income (1,408) 1,999 1,593
Interest expense (106) (102) (323) Gain on sale of division/subsidiary - - 2,012 Equity in losses of Plug Power (9,363) (3,806) (330) Other income(expense), net 185 (97) (251) _______ _______ _______ (Loss)income from continuing operations before extraordinary item and income taxes (10,692) (2,006) 2,701 Income tax expense 37 25 143 _______ _______ _______ (Loss)income from continuing operations before extraordinary item (10,729) (2,031) 2,558 Extraordinary item- gain on extinguishment of debt, net of taxes ($106) - - 2,507 _______ _______ _______ (Loss)income from continuing operations (10,729) (2,031) 5,065 Income(loss)from discontinued operations 41 (2,285) (545) _______ _______ _______ Net(loss)income $(10,688) $ (4,316) $ 4,520 ======= ======= =======
Earnings (loss) per share (Basic and Diluted):
(Loss)income before extraordinary item $ (.94) $ (.21) $ .28 Extraordinary item - - .27 (Loss)from discontinued operations - (.24) (.06) _______ _______ _______ Net(loss)income $ (.94) $ (.45) $ .49 ======= ======= =======
The accompanying notes are an integral part of the consolidated financial statements.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the Years Ended September 30, 1999, 1998 and 1997 (Dollars in thousands) Restated 1999 1998 1997 COMMON STOCK Balance, October 1 (1997 balance as previously reported) $ 10,775 $ 8,864 $ 4,902 Three-for-two common stock split effected in the form of a 50% stock dividend effective April 30, 1999 - - 2,451 Issuance of shares - options 56 117 - Issuance of shares 818 1,794 1,511 _______ _______ _______ Balance, September 30 $ 11,649 $ 10,775 $ 8,864 ======= ======= ======= PAID-IN-CAPITAL Balance, October 1 (1997 balance as previously reported) $ 16,274 $ 10,968 $ 13,423 Three-for-two common stock split effected in the form of a 50% stock dividend effective April 30, 1999 - - (2,451) Issuance of shares - options 168 108 - Issuance of shares 11,826 5,198 (4) Plug Power investment 14,487 - - _______ _______ _______ Balance, September 30 $ 42,755 $ 16,274 $ 10,968 ======= ======= ======= DEFICIT Balance, October 1 $(15,885) $(11,569) $(16,089) Net(loss)income (10,688) (4,316) 4,520 _______ _______ _______ Balance, September 30 $(26,573) $(15,885) $(11,569) ======= ======= ======= UNREALIZED LOSS ON AVAILABLE FOR SALE SECURITIES, NET Balance, October 1 $ - $ - $ - Unrealized loss on available for for sale securities, net (5) - - _______ _______ _______ Balance, September 30 $ (5) $ - $ - ======= ======= ======= FOREIGN CURRENCY TRANSLATION ADJUSTMENT Balance, October 1 $ (11) $ (19) $ (19) Adjustments - 8 - _______ _______ _______ Balance, September 30 $ (11) $ (11) $ (19)
======= ======= =======
TREASURY STOCK Balance, October 1 $ (29) $ (29) $ (29) Restricted stock grants - - - _______ _______ _______ Balance, September 30 $ (29) $ (29) $ (29) ======= ======= ======= RESTRICTED STOCK GRANTS Balance, October 1 $ - $ (2) $ (24) Grants issued/vested, net - 2 22 _______ _______ _______ Balance, September 30 $ - $ - $ (2) ======= ======= ======= SHAREHOLDERS' EQUITY September 30 $ 27,786 $ 11,124 $ 8,213 ======= ======= =======
The accompanying notes are an integral part of the consolidated financial statements.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) For The Years Ended September 30, 1999, 1998 and 1997 (Dollars in thousands) Restated 1999 1998 1997 Supplemental Disclosures
NONCASH INVESTING ACTIVITIES
Contribution of net assets to Plug Power: Accounts receivable $ - $ 500 $ - Note receivable - 500 - Inventories - - 1 Property, plant and equipment, net - - 452 Accounts payable - - (46) Accrued liabilities - - (50) Contribution payable - Plug Power - 4,000 - ______ ______ ________
$ - $ 5,000 $ 357 ______ ______ ________ Proceeds from sale of subsidiary Notes receivable $ - $ - $ 650 ______ ______ ________
Net noncash provided by investing activities $ - $ 5,000 $ 1,007 ______ ______ ________
NONCASH FINANCING ACTIVITIES
Conversion of Note Payable to Common Stock: Note Payable extinguishment $ - $ - $ (3,000) Common stock issued - - 1,500 Accrued interest - Note Payable - - (1,213) Additional paid-in capital - Other Investors 14,487 - - Campus contribution to Plug Power: Debt (6,000) - - Fixed assets 5,861 - - Prepaid expenses 364 - - Restricted cash 142 - - ______ ______ ________ Net noncash provided (used) by financing activities $14,854 $ - $ (2,713) ______ ______ ________ Net noncash provided (used) by investing and financing activities $14,854 $ 5,000 $ (1,706)
====== ====== ========
The accompanying notes are an integral part of the consolidated financial statements.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and accounts have been eliminated. The Company has a 40.65% interest in Plug Power, L.L.C. ("Plug Power"). The consolidated financial statements include the Company's investments in Plug Power (including obligations to invest), plus its share of losses. The investment is included in the financial line "Investment in Plug Power".
Use of Estimates
The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Financial Instruments
The fair value of the Company's financial instruments including cash and cash equivalents, investments, line-of-credit, note payable and long-term debt, approximates carrying value. Fair values were estimated based on quoted market prices, where available, or on current rates offered to the Company for debt with similar terms and maturities.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market.
Property, Plant, and Equipment
Property, plant and equipment are stated at cost and depreciated using primarily the straight-line method over their estimated useful lives:
Buildings and improvements 20 to 40 years Leasehold improvements 10 years Machinery and equipment 2 to 10 years Office furniture and fixtures 3 to 10 years
Significant additions or improvements extending assets' useful lives are capitalized; normal maintenance and repair costs are expensed as incurred. The costs of fully depreciated assets remaining in use are included in the respective asset and accumulated depreciation accounts.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Accounting Policies (continued)
When items are sold or retired, related gains or losses are included in net income.
Income Taxes
The Company accounts for taxes in accordance with Financial Accounting Standard No. 109, "Accounting for Income Taxes," which requires the use of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable for future years to differences between financial statement and tax bases of existing assets and liabilities. Under FAS No. 109, the effect of tax rate changes on deferred taxes is recognized in the income tax provision in the period that includes the enactment date. The provision for taxes is reduced by investment and other tax credits in the years such credits become available.
Revenue Recognition
Sales of products are recognized when products are shipped to customers. Sales of products under long-term contracts are recognized under the percentage-of-completion method. Percentage-of-completion is based on the ratio of incurred costs to current estimated total costs at completion. Total contract losses are charged to operations during the period such losses are estimable.
Foreign Currency Translation
Assets and liabilities of the foreign subsidiary are translated at year- end rates of exchange, and revenues and expenses are translated at the average rates of exchange for the year. Gains or losses resulting from the translation of the foreign subsidiary's balance sheet are accumulated in a separate component of shareholders' equity.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash and highly liquid short-term investments with maturities of less than three months.
Investments in Marketable Securities Management determines the appropriate classification of its investments in marketable securities at the time of purchase and reevaluates such determinations at each balance sheet date. Marketable securities for which the Company does not have the intent or ability to hold to maturity are classified as available for sale along with any
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Accounting Policies (continued)
investments in mutual funds. Securities available for sale are carried at fair value, with the unrealized gains and losses, net of income taxes, reported as a separate component of Shareholders' Equity. The Company has had no investments that qualify as trading or held to maturity.
The amortized cost of debt securities is adjusted for accretion of discounts to maturity. Such accretion as well as interest are included in interest income. Realized gains and losses are included in Other income (expense), net in the Consolidated Statements of Operations. The cost of securities sold is based on the specific identification method.
The Company's investments in marketable securities are diversified among high-credit quality securities in accordance with the Company's investment policy.
Earnings (Loss) Per Share
Effective October 1, 1997, the Company adopted Financial Accounting Standard No. 128, "Earnings per Share." In accordance with this Standard, net income(loss) per share is computed using the weighted average number of common shares outstanding during each year. Diluted net income(loss) per share includes the effects of all potentially dilutive securities. Earnings per share amounts for all periods presented have been computed in accordance with this Standard.
Advertising
The costs of advertising are expensed as incurred. Advertising expense was approximately $102, $83 and $92 thousand in 1999, 1998, and 1997, respectively.
Asset Impairment
The Company adopted SFAS No. 121, "Accounting For The Impairment of Long- Lived Assets and for Long-Lived Assets To Be Disposed Of." This statement requires companies to record impairments to long-lived assets, certain identifiable intangibles, and related goodwill when events or changing circumstances indicate a probability that the carrying amount of an asset may not be fully recovered. Impairment losses are recognized when expected future cash flows are less than the asset's carrying value.
Reclassification and Restatement
Certain 1998 and 1997 amounts have been reclassified to conform to the 1999 presentation. The financial statements for 1997 have also been restated to reflect the discontinuance of the Company's Technology Division (See Note 16).
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(2) Investments in Marketable Securities
The following is a summary of the investments in marketable securities classified as current assets:
(Dollars in thousands) 1999 1998
Available for sale securities: Corporate debt securities Fair Value $ 7,876 $ - ====== =====
Amortized Cost $ 7,881 $ - ====== =====
Unrealized Loss $ (5) $ - ====== =====
The difference between the amortized cost of available for sale securities and their fair market value results in unrealized gains and losses, which are recorded as a separate component of stockholders' equity. Gross realized gains and losses on sales of available for sale securities were immaterial in 1999, 1998 and 1997.
The estimated fair value of available for sale securities by contractual maturity is as follows:
(Dollars in thousands) 1999
Due in one year or less $ 4,916 Due after one year through three years - Due after three years 2,960 ______ $ 7,876 ======
Expected maturities may differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.
(3) Inventories Inventories consist of the following:
(Dollars in thousands) 1999 1998
Finished goods $ 73 $ 112 Work in process 916 791 Raw materials, components and Assemblies 2,763 2,845 ______ ______ $ 3,752 $ 3,748 ====== ======
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(4) Property, Plant and Equipment Property, plant and equipment consists of the following:
(Dollars in thousands) 1999 1998
Land and improvements $ - $ 125 Buildings and improvements 26 6,111 Leasehold improvements 470 517 Machinery and equipment 3,686 4,285 Office furniture and fixtures 621 866 _____ ______ 4,803 11,904 Less accumulated depreciation 3,976 7,437 _____ ______ $ 827 $ 4,467 ===== ======
At the beginning of 1998, assets with a net book value of $878 thousand consisting primarily of land, building and management information systems were transferred from discontinued operations to continuing operations.
Construction in progress, included in buildings and improvements, was approximately $1,371 thousand in 1998.
At the end of 1999, the Company was committed to approximately $387 thousand of future expenditures for new furniture, equipment and fixtures.
Depreciation expense was $489, $317 and $216 thousand for 1999, 1998 and 1997, respectively. Repairs and maintenance expense was $166, $177 and $175 thousand for 1999, 1998 and 1997, respectively.
Prior to the sale of all land and buildings to Plug Power in 1999, the cost and accumulated depreciation of buildings and improvements leased to Plug Power was:
(Dollars in thousands) 1998 1997
Cost $ 1,547 $ 21 Accumulated depreciation (660) (17) ______ _____ $ 887 $ 4 ====== =====
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(5) Notes Receivable
Notes receivable consists of the following:
(Dollars in thousands) 1999 1998 Notes receivable with an interest rate of 10%, interest and principal due September 30, 1998 (A) $ 250 $ 250
Notes receivable with an interest rate 10%, due in monthly installments through September 30, 2002 263 341 ______ _____ 513 591 Less: Current portion (329) (327) ______ _____ $ 184 $ 264 ====== ===== (A) The principal amount of this note may be reduced in accordance with the terms of the note in the event of a sale of the fixed assets. The purchaser has requested that the principal amount of the note be reduced to reflect the resale value of certain assets of L.A.B. The Company is enforcing its rights with respect to the note and is currently litigating for the collection of this note.
(6) Investment in Plug Power, L.L.C.
On June 27, 1997, the Company and Edison Development Corp. ("EDC"), a subsidiary of DTE Energy Co. formed a joint venture, Plug Power, L.L.C. ("Plug Power"), to further develop the Company's Proton Exchange Membrane ("PEM") Fuel Cell technology. In exchange for its contribution of contracts and intellectual property and certain other net assets that had comprised the fuel cell research and development business activity of the Technology segment (which assets had a net book value of $357 thousand), the Company received a 50% interest in Plug Power. EDC made an initial cash contribution of $4.75 million in exchange for the remaining 50% interest in Plug Power. The Company's investment in Plug Power is included in the balance sheet caption "Investment in Plug Power"; the assets contributed by the Company to Plug Power in fiscal 1997 had previously been included in the assets of the Company's Technology segment. See the supplemental disclosure regarding Contribution of Net Assets to Plug Power in the Consolidated Statements of Cash Flows for additional information regarding the assets contributed by the Company to Plug Power. The Company recorded the carrying value of the net assets contributed as its initial investment in Plug Power in recognition of the nature of the venture's undertaking.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(6) Investment in Plug Power, L.L.C. (continued)
On April 15, 1998, EDC contributed $2.25 million in cash to Plug Power. The Company contributed a below-market lease for office and manufacturing facilities in Latham, New York valued at $2 million and purchased a one- year option to match the remaining $250 thousand of EDC's contribution. In May 1998, EDC contributed an additional $2 million to Plug Power and the Company purchased another one-year option to match the contribution. The Company paid approximately $191 thousand for the options, which were scheduled to mature April 24, 1999 ($250 thousand) and June 15, 1999 ($2 million).
As of March 25, 1999, the Company and Plug Power exchanged the foregoing options and certain "research credits" (described below) for 2.25 million Plug Power membership interests. The Company earned the research credits by assisting Plug Power in securing the award of certain government grants and research contracts during the period June 1997 through April 1999.
In August, 1998, the Company committed to contribute an additional $5 million dollars (in cash, accounts receivable and research credits) to Plug Power between August 5, 1998 and March 31, 1999 and recorded a liability representing this obligation. During the period from September 1998 to February 1999, the Company fully funded this commitment by contributing $4 million cash and converting $.5 million of accounts receivable and $.5 million of notes receivable.
During April 1999, the Company and EDC amended and restated the Plug Power Mandatory Capital Contribution Agreement. The agreement, which was effective as of January 26, 1999, stated that, in the event Plug Power determined that it required funds at any time through December 31, 2000, Plug Power had the right to call upon the Company and EDC to each make capital contributions as follows:
* The Company and EDC would each fund capital calls of up to $7.5 million in 1999 and $15 million in 2000 ("Capital Commitment"). * In exchange for such capital contributions to Plug Power, the Company and EDC would receive class A membership interests ("Shares") from Plug Power at $7.50 per share. * The Company and EDC would share the Capital Commitment equally. * Plug Power's Board of Managers would determine when there is need for such capital contributions. * The Company and EDC would have sixty (60) days from the date of such authorization to tender their payment to Plug Power.
The agreement was scheduled to terminate on December 31, 2000 or the date of an initial public offering of shares by Plug Power at a per
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(6) Investment in Plug Power, L.L.C. (continued)
share price of greater than $7.50 per share ("Termination Date"). In exchange for the Capital Commitment, Plug Power agreed to permit the Company and EDC to make capital contributions to the extent of their Capital Commitment on the Termination Date, whether or not such funds have been called, in exchange for shares at the fixed price of $7.50 per share.
In June 1999, the Company and Plug Power entered into an agreement for the sale of the MTI campus and adjacent residence, including all land and buildings, to Plug Power in exchange for 704,315 Class A membership interests and the assumption of approximately $6 million in debt by Plug Power. The sale of the MTI facility and the transfer of the $6 million IDR bonds to Plug Power were effective as of July 1, 1999 with no gain or loss recognized.
In August 1999, the Company committed to purchase 3 million shares of Plug Power if the public offering price of Plug Power's stock was greater than $7.50 per share. The Mandatory Capital Contribution Agreement between the Company and Plug Power, dated as of January 26, 1999 was amended and restated to reflect this commitment.
On September 30, 1999, the Company purchased 266,667 shares of Plug Power at $7.50 per share. This purchase reduced the Company's commitment to purchase Plug Power shares at the time of its public offering from 3,000,000 shares to 2,733,333 shares at a price of $7.50 per share.
The Company's total contributions to Plug Power (including contributions of cash, assets, research credits, below market lease and real estate) for the period commencing on June 27, 1997, and ending September 30, 1999 total $20.7 million.
During calendar 1999, Plug Power's equity increased approximately $50.628 million primarily due to investments by investors. Of this amount, $30.368 million was received in cash, $9.010 million in property and services and $11.250 million represents membership interests issued in connection with the formation of GE Fuel Cell Systems LLC. As a result, the Company recorded its proportionate share of the increase in Plug Power's equity ($14.854 million) as investment in Plug Power and additional paid-in capital.
The Company has recorded its proportionate share of Plug Power's losses to the extent of its recorded investment in Plug Power. The carrying value of the Company's investment is $8.71 million as of September 30, 1999 for a 40.65% interest in Plug Power.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(6) Investment in Plug Power, L.L.C. (continued)
The Company will recognize its proportionate shares of losses in the future to the extent of its carrying value and additional future investments.
On November 1, 1999, the Company purchased 2,733,333 shares of Plug Power at $7.50 per share. This purchase completed the Company's commitment to purchase Plug Power shares at the time of its public offering. Plug Power's public offering was completed at $15 per share. The Company's total contributions to Plug Power as of November 1, 1999 total $41.2 million. Immediately after the Plug Power IPO, the Company owned 13,704,315 shares or 31.9% of Plug Power.
At September 30, 1999 and 1998, the difference between the carrying value of the Company's investment in Plug Power and its interest in the underlying equity consists of the following:
(Dollars in thousands) 1999 1998
Calculated ownership (40.65% in 1999 and 50% in 1998) $12,704 $ 2,431 Unrecognized negative goodwill (3,994) (2,085) Value of below market lease contribution - (2,000) Calculated 50% of equity value under option - (1,125) Contribution liability - 4,000 ______ ______ Carrying value of Investment in Plug Power $ 8,710 $ 1,221 ====== ======
Summarized below is financial information for Plug Power. Plug Power's fiscal year ends December 31. 9 Months Ended Year Ended Sept 30, Dec 31, Dec 31, (Dollars in thousands) 1999 1998 1997
Current assets $12,024 $ 5,293 $3,917 Noncurrent assets 31,522 2,800 929 Current liabilities 6,291 2,601 1,250 Noncurrent liabilities 6,002 - - Stockholders' equity 31,253 5,493 3,597
Gross revenue 6,702 6,541 1,194 Gross profit (3,148) (2,323) (33) Net loss (24,867) (9,616) (5,903)
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(7) Income Taxes
Deferred tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates.
Income tax expense (benefit) for the years ended September 30, consists of the following:
(Dollars in thousands) 1999 1998 1997 Continuing operations Federal $ 1 $ 15 $ 62 State 36 10 81 Deferred - - - _______ _______ _______ 37 25 143 _______ _______ _______ Discontinued operations Federal - - (17) State - - (12) Deferred - - - _______ _______ _______ - - (29) _______ _______ _______ Extraordinary Item Federal - - 28 State - - 78 Deferred - - - _______ _______ _______ - - 106 _______ _______ _______ $ 37 $ 25 $ 220 ======= ======= =======
The significant components of deferred income tax expense (benefit) for the years ended September 30, are as follows:
(Dollars in thousands) 1999 1998 1997
Continuing operations Deferred tax (benefit) expense $ (1,833) $ (667) $ (356) Net operating loss carryforward (3,259) 105 1,223 Valuation allowance 5,092 562 (867) _______ ________ _______ - - - _______ ________ _______ Discontinued operations Deferred tax expense(benefit) 114 (508) 60 Net operating loss carryforward (97) (265) (251) Valuation allowance (17) 773 191 _______ ________ _______ - - - _______ ________ _______ $ - $ - $ - ======= ======== =======
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(7) Income Taxes (continued) 1999 1998 1997 Extraordinary item Deferred tax (benefit) expense - - (28) Net operating loss carryforward - - 862 Valuation allowance - - (834) _______ _______ _______ - - - _______ _______ _______ $ - $ - $ - ======= ======= =======
The Company's effective income tax rate from continuing operations differed from the Federal statutory rate as follows:
1999 1998 1997
Federal statutory tax rate (34%) (34%) 34% State taxes, net of federal tax effect - - 2% Change in valuation allowances 34% 28% (32%) Alternative minimum tax - - 2% Other, net - 7% (1%) _______ _______ _______ -% 1% 5% ======= ======= =======
The deferred tax assets and liabilities as of September 30, consist of the following tax effects relating to temporary differences and carryforwards:
(Dollars in thousands) 1999 1998 Current deferred tax assets: Loss provisions for discontinued operations $ 300 $ 337 Bad debt reserve 112 96 Inventory valuation 173 161 Inventory capitalization 39 20 Vacation pay 63 66 Warranty and other sale obligations 86 25 Other reserves and accruals 116 151 _______ _______ 889 856 Valuation allowance (889) (856) _______ _______ Net current deferred tax assets $ - $ - ======= =======
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(7) Income Taxes (continued) 1999 1998 Noncurrent deferred tax assets (liabilities): Net operating loss $ 5,687 $ 1,951 Property, plant and equipment 122 (9) Investment in Plug Power (3,322) 954 Other 224 187 Alternative minimum tax credit 150 150 _______ _______ 2,861 3,233 Valuation allowance (2,861) (3,233) Other credits (597) (607) _______ _______ Noncurrent net deferred tax liabilities and other credits $ (597) $ (607) ======= =======
The valuation allowance at year ended September 30, 1999 is $3.750 million and at September 30, 1998 was $4.089 million. During the year ended September 30, 1999, the valuation allowance decreased by $339 thousand.
At September 30, 1999, the Company has unused Federal net operating loss carryforwards of approximately $14.219 million. The Federal net operating loss carryforwards if unused will begin to expire during the year ended September 30, 2009. The use of $5.339 million of these carryforwards is limited on an annual basis, pursuant to the Internal Revenue Code, due to certain changes in ownership and equity transactions. For the year ended September 30, 1999, the Company has available alternative minimum tax credit carryforward of approximately $150 thousand.
The Company made cash payments, net of refunds, for income taxes of $15, $42 and $361 thousand for 1999, 1998 and 1997, respectively.
(8) Accrued Liabilities
Accrued liabilities consist of the following: (Dollars in thousands) 1999 1998
Salaries, wages and related expenses $ 553 $ 999 Acquisition and disposition costs 431 410 Legal and professional fees 169 305 Warranty and other sale obligations 398 607 Accrued severance - 143 Deferred income 264 267 Commissions 182 213 Interest expense 7 8 Other 239 376 ______ ______ $ 2,243 $ 3,328 ====== ======
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(9) Debt
The Company has a working capital line of credit available in the amount of $4 million with interest payable monthly at a rate of prime (8.25% and 8.5% at September 30, 1999 and 1998, respectively) or LIBOR plus 2.5% (7.9% and 7.875% at September 30, 1999 and 1998, respectively). This obligation is collateralized by the assets of the Company, exclusive of its investment in Plug Power. The Company also has a $1 million equipment loan/lease line of credit at an interest rate of LIBOR plus 2.75% (8.15% and 8.125% at September 30, 1999 and 1998, respectively). This obligation is collateralized by the equipment purchased under the line of credit. The lines of credit expire on January 31, 2000. No amounts were outstanding under these lines at September 30, 1999 and 1998.
On December 17, 1998, the Industrial Development Agency for the Town of Colonie issued $6 million in Industrial Development Revenue ("IDR") Bonds on behalf of the Company to assist in the construction of a new building for Advanced Products and the Company's corporate staff and renovation of existing buildings leased to Plug Power. The IDR Bond proceeds were deposited with a trustee for the bondholders and the Company drew bond proceeds to cover qualified project costs. First Albany Companies Inc. ("FAC"), which owns 34% of the Company's stock, underwrote the sale of the IDR Bonds. FAC received no fees for underwriting the IDR Bonds but will be reimbursed for its out-of-pocket costs.
KeyBank issued a letter of credit (the credit agreement) for approximately $6 million in connection with the $6 million IDR Bonds. The KeyBank credit agreements require the Company to meet certain covenants, including a fixed charge coverage and leverage ratio. Further, if certain performance standards are achieved, the interest rates on the debt may be reduced.
The credit agreement also requires the Company to grant a first lien on all consolidated assets of the Company, exclusive of its investment in Plug Power, a first mortgage on all land and buildings owned by the Company and a first lien on any equipment purchased by the Company.
The IDR Bond Obligation, letter of credit and unexpended bond proceeds were transferred to Plug Power in connection with the sale of the MTI facility and adjacent residence effective July 1, 1999.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(9) Debt (continued)
On November 1, 1999, the Company entered into a $22.5 million Credit Agreement with KeyBank, N.A. ("the $22.5 million Credit Agreement"), the Company has pledged 13,704,315 shares of Plug Power Common Stock as collateral for its $22.5 million loan from KeyBank, N.A. ("Loan"). The proceeds of this loan were used to fund the Company's remaining $20.5 million balance of its Mandatory Capital Commitment to contribute $22.5 million to Plug Power. Although the Credit Agreement does not require the Company to sell shares of Plug Power Common Stock, the Company may sell shares of Plug Power Common Stock to pay interest or principal on the Loan. Pursuant to the $22.5 million Credit Agreement, the Company is obligated to make interest only payments for the first 18 months following the closing of the Loan, and to repay the principal in 6 equal quarterly installments of $3.750 million each, commencing on June 30, 2001. In addition, a one time commitment fee totaling $247,500 is payable for the Loan, $75,000 of which was paid as of September 30, 1999. Interest is payable monthly at a rate of Prime (8.25% on November 1, 1999) or if certain performance standards are achieved, the interest rates on the $22.5 million Credit Agreement may be reduced.
The $22.5 million Credit Agreement requires the Company to meet certain covenants, including maintenance of a collateral account which at all times has a minimum market value of $600 thousand and a balance on November 1, 1999 of $2.65 million, and maintenance of a collateral coverage ratio. The existing covenants under the original letter of credit were eliminated pursuant to the $22.5 million Credit Agreement.
The weighted average interest rate for the Note Payable, IDR Bonds and Line of Credit during 1999 was 5.11%, 9.02% during 1998 and 10.75% during 1997.
Cash payments for interest were $164, $97 and $201 thousand for 1999, 1998 and 1997, respectively.
(10) Shareholders' Equity
On July 12, 1999, the Company completed the sale of 801,223 shares of common stock to current shareholders through a rights offering. The offering raised approximately $12.820 million before offering costs of approximately $158 thousand for net proceeds of approximately $12.671 million. The Company will use some or all of the proceeds of the offering for investment into Plug Power. In addition, some proceeds may be used for acquisitions for the Company's core businesses, efforts to increase market share, working capital, general corporate purposes and other capital expenditures.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(10) Shareholders' Equity (continued)
On April 23, 1999, the Company declared a 3 for 2 stock split in the form of a stock dividend. Holders of the Company's $1.00 par value common stock received one additional share of $1.00 par value common stock for every two shares of common stock owned as of April 30, 1999. The financial statements for all prior periods have been retroactively adjusted to reflect this stock split for both common stock issued and options outstanding.
On September 30, 1998, the Company completed the sale of 1,196,399 shares of common stock to current shareholders through a rights offering. The offering raised approximately $7.178 million before offering costs of approximately $186 thousand for net proceeds of approximately $6.992 million. The Company has used some or all of the proceeds of the offering for investment in Plug Power. In addition, some proceeds may be used for acquisitions for the Company's core businesses, efforts to increase market share, working capital, general corporate purposes and other capital expenditures.
Changes in common shares for 1999, 1998 and 1997 are as follows:
Common Shares 1999 1998 1997 Balance, October 1 (1997 balance as previously reported) 10,773,968 8,862,992 4,902,201 Three-for-two common stock split effected in the form of a 50% stock dividend effective April 30, 1999 - - 2,451,101 Issuance of shares for stock option exercises 74,768 116,377 - Issuance of shares for stock sale 801,223 1,794,599 1,500,000 Issuance of shares - consultant - - 9,690 __________ __________ _________ Balance, September 30 11,649,959 10,773,968 8,862,992 ========== ========== ========= Treasury Shares Balance, October 1 4,500 4,500 4,500 Acquisition of shares 2,250 - - __________ __________ _________ Balance, September 30 6,750 4,500 4,500 ========== ========== =========
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(11) Earnings per Share
The amounts used in computing earnings per share and the effect on income and the weighted average number of shares of potentially dilutive securities are as follows:
(Dollars in Thousands) 1999 1998 1997
(Loss) income before extraordinary item and available to common stockholders $ (10,729) $ (2,031) $ 2,558
Weighted average number of shares: Weighted average number of shares used in net (loss)/income per share, including the bonus element effects for the rights offering 11,330,530 9,576,672 9,134,308 Effect of dilutive securities: Stock options - - 14,868 ___________________________________________________________________________ Weighted average number of shares used in diluted net (loss)/income per share 11,330,530 9,576,672 9,149,176 ___________________________________________________________________________
During fiscal 1999, options to purchase 741,613 shares of common stock at prices ranging between $1.63 and $22.50 per share were outstanding but were not included in the computation of Earnings per Share-assuming dilution because the Company incurred a loss from continuing operations and inclusion would be anti-dilutive. The options expire between December 20, 2006 and June 16, 2009.
During fiscal 1998, options to purchase 607,372 shares of common stock at prices ranging from $1.63 to $4 per share were outstanding but were not included in the computation of Earnings per Share-assuming dilution because the Company incurred a loss from continuing operations and inclusion would be anti-dilutive. The options expire between December 20, 2006 and August 31, 2008.
(12) Stock Option Plan
During March 1999, the shareholders approved the 1999 Employee Stock Incentive Plan ("1999 Plan"). The 1999 Plan provides that an initial aggregate number of 1 million shares of common stock may be awarded or issued. The number of shares available under the 1999 Plan may be adjusted for stock splits and during 1999 the number of shares available under the plan increased to 1,500,000 shares. Under the 1999 Plan, the Board of Directors is authorized to award stock options to officers, employees and others.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(12) Stock Option Plan (continued)
During December 1996, the shareholders approved a stock incentive plan ("1996 Plan"). The 1996 Plan provides that an initial aggregate number of 500,000 shares of common stock may be awarded or issued. The number of shares available under the 1996 Plan may be increased by 10% of any increase in the number of outstanding shares of common stock for reasons other than shares issued under this 1996 Plan. During 1999 and 1998, the number of shares available under the 1996 Plan increased to 1,159,582 and 719,640 shares respectively. Under the 1996 Plan, the Board of Directors is authorized to award stock options, stock appreciation rights, restricted stock, and other stock-based incentives to officers, employees and others.
Options are generally exercisable in from one to five cumulative annual amounts beginning 12 months after the date of grant. Certain options granted may be exercisable immediately. Option exercise prices are not less than the market value of the shares on the date of grant. Unexercised options generally terminate ten years after grant.
During 1999, the Company awarded 15,000 options to a consultant. The fair value of these options ($55 thousand) was charged to expense.
For the purpose of applying Financial Accounting Standard No. 123 ("FAS 123"), "Accounting for Stock-Based Compensation", the fair value of each option granted is estimated on the grant date using the Black-Scholes Single Option model. The dividend yield was 0% for 1999, 1998, and 1997, respectively. The expected volatility was 78% in 1999, 102% in 1998 and 78% in 1997. The expected life of the options is 5 years. The risk free interest rate ranges from 4.37% to 5.81% in 1999, 5.52% to 5.85% in 1998 and 6.12% to 6.67% in 1997. The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," in accounting for stock options. Accordingly, no compensation cost has been recognized in 1999, 1998 or 1997. Had compensation cost and fair value been determined pursuant to FAS 123, net loss would increase from $(10,688) to $(11,988) thousand in 1999 and from $(4,316) to $(4,773) thousand in 1998 and net income would decrease from $4,520 to $4,351 thousand in 1997. Basic and diluted loss per share would increase from $(0.94) to $(1.06) in 1999 and from $(0.45) to $(0.50) in 1998 and basic and diluted earnings per share would decrease from $0.49 to $0.48 in 1997. The weighted average fair value of options granted during 1999, 1998 and 1997 for purposes of FAS 123, is $5.80, $4.70 and $1.96 per share, respectively.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(12) Stock Option Plan (continued)
Activity with respect to the 1996 Plan is as follows:
1999 1998 1997 Shares under option at October 1 607,372 623,400 - Options granted 232,550 297,750 634,650 Options exercised (78,949) (116,378) - Options canceled (19,360) (197,400) (11,250) ________ _________ ________ Shares under option at September 30 741,613 607,372 623,400 ======== ========= ======== Options exercisable at September 30 419,438 271,373 115,200 Shares available for granting of options 222,642 355,710 276,600
The weighted average exercise price is as follows: 1999 1998 1997 Shares under option at October 1 $ 2.89 $ 1.94 $ - Options granted 8.62 3.83 1.94 Options exercised 2.26 1.91 - Options canceled 3.36 1.74 1.63 Shares under option at September 30 4.89 2.89 1.94 Options exercisable at September 30 5.59 2.64 1.95
The following is a summary of the status of options outstanding at September 30, 1999:
Outstanding Options Exercisable Options ___________________________________ ________________________________ Weighted Average Weighted Weighted Exercise Remaining Average Average Price Contractual Exercise Exercise Range Number Life Price Number Price
$1.63-$2.29 257,438 7.7 $2.12 151,313 $2.09 $3.17-$4.67 244,875 8.7 $3.98 113,625 $3.98 $5.00-$5.33 129,300 9.2 $5.28 49,500 $5.30 $12.50 105,000 9.5 $12.50 105,000 $12.50 $22.50 5,000 9.7 $22.50 - _______ _______ 741,613 419,438 ======= =======
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(13) Retirement Plan
The Company maintains a voluntary savings and retirement plan (Internal Revenue Code Section 401(k) Plan) covering substantially all employees. The Company plan allows eligible employees to contribute a percentage of their compensation; the Company makes additional contributions in amounts as determined by management and the Board of Directors. The investment of employee contributions to the plan is self-directed. The cost of the plan was $168, $152 and $179 thousand for 1999, 1998 and 1997, respectively.
(14) Commitments and Contingencies
On September 9, 1998, Barbara Lawrence, the Lawrence Group, Inc. ("Lawrence"), and certain other Lawrence-related entities ("Plaintiffs") filed suit in the United States Bankruptcy Court for the Northern District of New York against First Albany Corporation, a wholly owned subsidiary of First Albany Companies Inc., Dale Church, Edward Dohring, Alan Goldberg, George McNamee, Beno Sternlicht, Marty Mastroianni (former President and Chief Operating Officer of the Company) and 33 other individuals ("Defendants") who purchased a total of 820,909 shares of MTI stock from the Plaintiffs. The complaint alleged that Defendants purchased MTI stock from the Plaintiffs in violation of sections 10b, 20, 20A and rule 10b-5 of the Securities Exchange Act of 1934. In December 1998, the complaint was amended to add MTI as a defendant and assert a Claim for common law fraud against all the Defendants including the Company. The case concerns the Defendants' 1998 purchase of MTI shares from the Plaintiffs at the price of $2.25 per share. Ownership of the shares was disputed and several of the Plaintiffs were in bankruptcy at the time of the sale. First Albany Corporation acted as Placement Agent for the Defendants in the negotiation and sale of the shares and in proceedings before the Bankruptcy Court for the Northern District of New York, which approved the sale in September 1997. Plaintiffs claim that the Defendants failed to disclose material inside information concerning Plug Power, LLC to the Plaintiffs and therefore the $2.25 per share purchase price was unfair. Plaintiffs are seeking damages of $5 million plus punitive damages and costs. In April 1999, Defendants filed a motion to dismiss the amended complaint, which was denied. In June 1999, the parties agreed to stay discovery and amend Defendants time to answer the amended complaint until September 17, 1999. In October 1999, Defendants answered the amended Complaint.
During October 1998, a legal action brought by a group of investors against the Company related to a stock purchase agreement and side letter agreements for the sale of the stock of the Company's wholly owned subsidiary, Ling Electronics, Inc. ("Ling"), was determined in favor of the Company.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(14) Commitments and Contingencies (continued)
In February 1995, Ling made a voluntary disclosure to the United States Department of Commerce regarding unlicensed exports of certain products shipped in the first four months of fiscal 1995. Ling has fully cooperated with the Office of Export Enforcement, which has not taken any action to date. Possible administrative sanctions include: no action; a warning letter; denial of export privileges; and/or imposition of civil penalties. Foreign sales represent a significant portion of Ling's total revenue. The final outcome of this matter is not presently determinable and, therefore no provision for any liability that may result has been recorded in the Company's financial statements.
The Company and its subsidiaries lease certain manufacturing, warehouse and office facilities. The leases generally provide for the Company to pay increases over a base year level for taxes, maintenance, insurance and other costs of the leased properties. The leases contain renewal provisions.
Future minimum rental payments required under noncancelable operating leases are (dollars in thousands): $269 in 2000; $305 in 2001; $304 in 2002; $300 in 2003; and $300 in 2004. Rent expense under all leases was $482, $403 and $446 thousand for 1999, 1998 and 1997, respectively.
Rental income under all sub-leases was $164, $66 and $19 thousand in 1999, 1998 and 1997, respectively.
(15) Related Party Transactions
At September 30, 1999 First Albany Companies Inc. ("FAC") owned approximately 34% of the Company's Common Stock (See Note 19).
During fiscal 1999, 1998 and 1997, First Albany Corporation, a wholly owned subsidiary of FAC, provided financial advisory services in connection with the sale of the Technology Division in 1999 and 1998 and the L.A.B. Division in 1997, for which First Albany Corporation was paid fees of $15, $10 and $75 thousand, respectively.
Amounts receivable from an officer totaled approximately $38 thousand and is included in the balance sheet caption "Other receivables-related parties" at September 30, 1999.
On June 27, 1997, the Company entered into a management services agreement with Plug Power to provide certain services and facilities for a period of one year. This agreement expired on June 27, 1998. The Company continued to provide services, which were billed on a cost reimbursement basis. During 1998, the Company entered into leases for manufacturing, laboratory and office space which expired on July 1, 1999 pursuant to the sale of the MTI facility to Plug Power in exchange for 704,315 Plug Power Class A membership interests and the assumption of $6 million in debt by Plug Power.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(15) Related Party Transactions (continued)
Billings under these agreements amounted to $448, $661 and $65 thousand for 1999, 1998 and 1997, respectively. Amounts receivable from Plug Power under these agreements is included in the balance sheet caption "Other receivables-related parties".
On September 30, 1999, the Company made an additional cash contribution of approximately $2 million to Plug Power in exchange for 266,667 Plug Power Class A membership interests.
On July 1, 1999, the Company contributed the MTI campus to Plug Power in exchange for 704,315 Plug Power Class A membership interests. During the remainder of 1999, the Company paid $59 thousand to Plug Power in connection with a lease of office and manufacturing space. This lease will terminate on November 24, 1999.
On August 5, 1998, the Company made a short-term loan to Plug Power of $500 thousand, which was subsequently contributed to capital on September 23, 1998. The Company also converted $500 thousand of its accounts receivable from Plug Power to capital on September 23, 1998. At September 30, 1998, the remaining obligation to provide additional funds to Plug Power was $4 million. During fiscal 1999, the Company fully funded this commitment by contributing $4 million cash.
(16) Discontinued Operations
The sale of the Company's Technology Division, the sole component of the Technology segment, to NYFM, Incorporated (a wholly owned subsidiary of Foster-Miller, Inc., a Waltham, Massachusetts-based technology company) on March 31, 1998 completed management's planned sale of non-core businesses. Accordingly, the Company no longer includes Technology among its reportable business segments and now operates in only one segment, Test & Measurement. The Technology Division is reported as a discontinued operation as of December 26, 1998, and the consolidated financial statements have been restated to report separately the net assets and operating results of the business. In exchange for the Technology Division's assets, NYFM, Incorporated (a) agreed to pay the Company a percentage of gross sales in excess of $2.5 million for a period of five years; (b) assumed approximately $40 thousand of liabilities; and (c) established a credit for warranty work of approximately $35 thousand.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(16) Discontinued Operations (continued)
Discontinued operations consist of the following:
(Dollars in thousands) 1999 1998 1997
Sales $ - $ 532 $ 7,878 ======= ====== ====== Income(loss)from discontinued operations before income tax 41 (516) (574) Income tax (benefit) - - (29) _______ ______ ______ Net income(loss)from discontinued operations $ 41 $ (516) $ (545) ======= ====== ======
Loss on disposal of Division $ - $(1,769) $ - Income tax (benefit) - - - _______ ______ ______ Loss on disposal of Division $ - $(1,769) $ - ======= ====== ======
The assets and liabilities of the Company's discontinued operations are as follows at September 30:
(Dollars in thousands) 1999 1998
Assets (primarily accounts receivable) $ 220 $ 1,136 Liabilities (primarily accrued expenses) 760 1,128 _______ ______ Net (Liabilities)Assets $ (540) $ 8 ======= ======
Assets with a net book value of $878 thousand consisting primarily of land, building and management information systems were transferred to continuing operations on October 1, 1997.
(17) Sale of Division/Subsidiary
L.A.B. Division
On September 30, 1997, the Company sold all of the assets of its L.A.B. Division to Noonan Machine Company of Franklin Park, IL. The Company received $2.60 million in cash and two notes, totaling $650 thousand, from Noonan Machine Company. The purchaser has requested that the principal amount of the note be reduced to reflect the resale value of certain assets of L.A.B. The Company is enforcing its rights with respect to the note. The net proceeds from the sale were used to pay down all outstanding debt and build working capital.
The sale resulted in a $2.0 million gain, which was recorded in the fourth quarter of fiscal year 1997. In addition, $250 thousand of the proceeds associated with one of the notes was recorded as deferred revenue due to contingencies associated with the realization of this note. This note is still outstanding as of September 30, 1999.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(18) Geographic and Segment Information
The Company sells its products on a worldwide basis with its principal markets listed in the table below where information on export sales is summarized by geographic area for the Company as a whole:
(Dollars in thousands)
Geographic Area 1999 1998 1997
United States $ 9,576 $ 17,022 $ 17,290 Europe 1,180 1,072 1,223 Japan 787 1,534 1,243 Pacific Rim 760 834 1,901 China 278 302 1,900 Canada 153 228 178 Rest of World 151 36 367 ______ _______ _______ Total Sales $12,885 $ 21,028 $ 24,102 ====== ======= =======
In 1999, no customers accounted for more than 10% of sales and in 1998, one customer accounted for 11.5% of sales.
The Company operates in two business segments, Alternative Energy Technology and Test and Measurement. The Alternative Energy Technology segment incubates alternative energy technology. The Test and Measurement segment develops, manufactures, markets and services sensing instruments, computer-based balancing systems for aircraft engines, vibration test systems and power conversion products.
The accounting policies of the Alternative Energy Technology and Test and Measurement segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before income taxes, accounting changes, non-recurring items and interest income and expense. Inter- segment sales are not significant.
Summarized financial information concerning the Company's reportable segments is shown in the following table. The "Other" column includes corporate related items and items like income taxes or unusual items, which are not allocated to reportable segments. In addition, segments noncash items include any depreciation and amortization in reported profit or loss. For the Alternative Energy Technology segment, the information is based on an annual period from October 1 to September 30 derived from Plug Power's unaudited financial statements.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(18) Geographic and Segment Information (continued)
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(18) Geographic and Segment Information (continued)
The following table presents the details of "Other" segment profit (loss).
(Dollars in thousands) 1999 1998 1997
Corporate and Other Expenses/(Income): Depreciation and amortization $ 379 $ 118 $ 37 Interest expense 106 102 323 Interest income (335) (65) - Income tax expense 37 25 143 Other (income)expense, net (225) 200 1,032 (Income)loss from discontinued operations (41) 2,285 545 Gain on sale of division - - (2,012) Gain on extinguishment of debt, net of tax - - (2,507)
_____ _______ _______ Total (income) expense $ (79) $ 2,665 $ (2,439)
The reconciling items are the amounts of revenues earned and expenses incurred for corporate operations, which is not included in the segment information.
(19) Extraordinary Item - Extinguishment of Debt
During fiscal 1996, FAC purchased 909,091 shares of the Company's Common Stock from the New York State Superintendent of Insurance as the court- ordered liquidator of United Community Insurance Company ("UCIC"). In connection with this purchase, FAC also acquired certain rights to an obligation ("Term Loan") due from the same finance company ("FCCC") to whom the Company was obligated under a Note Payable, due December 31, 1996.
FCCC was in default of its Term Loan to UCIC. FAC, as the owner of the rights to the Term Loan, filed suit-seeking payment. Collateral for the FCCC Term Loan included the Company's Note Payable to FCCC. FAC exercised its rights to the collateral securing the Term Loan, including the right to obtain payment on the Note Payable directly from the Company. The Company and FAC entered into an agreement dated as of December 27, 1996 under which the Company issued to FAC 1.0 million shares of Common Stock in full satisfaction of the Note Payable and accrued interest.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(19) Extraordinary Item - Extinguishment of Debt (continued)
If FCCC were to seek collection of the Note Payable plus accrued interest from the Company, the Company, based on the opinion of counsel, believes that the outcome of any such action pursued by FCCC against the Company would not have a material adverse impact on the Company's financial position or results of operation.
(20) Comprehensive (Loss) Income
Total comprehensive (loss) income for the years ended September 30 consists of:
(Dollars in Thousands) 1999 1998 1997
Net (loss)income $(10,688) $ (4,316) $ 4,520 Other comprehensive income(loss), before tax: Foreign currency translation adjustments - 8 - Unrealized loss on available for sale securities (5) - - Income tax related to items of other comprehensive income(loss) - - - _______ _______ ______
Total comprehensive (loss)income $(10,693) $ (4,308) $ 4,520 ======= ======= ======
(21) Subsequent Events
On October 21, 1999, the Company created a strategic alliance with SatCon Technology Corporation (SatCon). SatCon acquired Ling Electronics, Inc. and Ling Electronics, Ltd. from the Company and the Company will invest approximately $7 million in SatCon. In consideration for the acquisition of Ling Electronics and the Company's investment, the Company will receive 1,800,000 shares of SatCon's common stock and warrants to purchase an additional 100,000 shares of SatCon's common stock. The Company immediately funded $2.57 million of its investment in SatCon and will make the remaining investment by the end of January 2000. SatCon will also receive warrants to purchase 100,000 shares of the Company's common stock.
The Company immediately issued SatCon 36,000 stock purchase warrants. The warrants are immediately exercisable at $37.66 per share and expire on October 21, 2003. The estimated fair value of these warrants at the date issued was $14.81 per share using a Black Scholes option pricing model and assumptions similar to those used for valuing the Company's stock options.
The Company immediately received 36,000 stock purchase warrants from SatCon. The warrants are immediately exercisable at $8.83 per share and expire on October 21, 2003.
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(21) Subsequent Events (continued)
In addition, David Eisenhaure, President and Chief Executive Officer of SatCon Technology Corporation, will become a member of the Board of Directors of the Company and Alan Goldberg, a director of the Company and co-Chief Executive Officer of First Albany Companies Inc. will become a member of SatCon Technology Corporation's Board of Directors. SatCon Technology Corporation has also agreed to appoint an additional member to its Board of Directors based on recommendations by the Company.
SatCon Technology Corporation manufactures and sells power and energy management products for telecommunications, silicon wafer manufacturing, factory automation, aircraft, satellites and automotive applications. SatCon has four operating divisions: Film Microelectronics, Inc. designs and manufactures microelectronic circuits and interconnect products. Magmotor manufactures motors and magnetic suspension systems. Beacon Power manufactures flywheel energy storage devices and the Technology Center is responsible for new technology and product development. | 19,839 | 129,835 |
27879_1999.txt | 27879_1999 | 1999 | 27879 | ITEM 1. BUSINESS
Overview
Delmarva Power & Light Company (DPL) is a regulated public electric and gas utility and a subsidiary of Conectiv, which is a Delaware corporation and a registered holding company under the Public Utility Holding Company Act of 1935 (PUHCA). DPL was incorporated in Delaware in 1909 and in Virginia in 1979. Effective March 1, 1998, DPL and Atlantic Energy, Inc. (Atlantic) con- summated a series of merger transactions (the Merger) by which DPL and Atlan- tic City Electric (ACE) became wholly-owned subsidiaries of Conectiv. Effec- tive with the Merger, DPL's former nonutility subsidiaries were transferred to Conectiv. For additional information about the Merger, refer to Note 4 to the Consolidated Financial Statements included in Item 8 of Part II.
At December 31, 1999, DPL had 1,244 employees, including 1,008 employees represented by labor organizations.
The sources of DPL's 1999 consolidated revenues were as follows: regulated (subject to price regulation) electricity sales-49.2%; non-regulated (not sub- ject to price regulation) electricity sales-13.0%; regulated gas sales-5.2%; non-regulated gas sales-31.1%; and other services-1.5%. In 1999, the regulated retail electricity and supply businesses provided most of DPL's earnings. In 1999, DPL's consolidated regulated electric retail revenues were earned from the following customer classes: residential-44.7%; commercial-36.2%; industri- al-18.2%; and other-0.9%.
Certain aspects of DPL's electric utility business are subject to regulation by the Delaware and Maryland Public Service Commissions (DPSC and MPSC, re- spectively), the Virginia State Corporation Commission (VSCC), and the Federal Energy Regulatory Commission (FERC). Retail gas sales are subject to regula- tion by the DPSC. Excluding off-system sales not subject to price regulation, the percentage of electric and gas utility operating revenues regulated by each regulatory commission for the year ended December 31, 1999, was as fol- lows: DPSC, 67.6%; MPSC, 24.6%; VSCC, 2.4%; and FERC, 5.4%.
PUHCA imposes certain restrictions on the operations of registered holding companies and their subsidiaries. Pursuant to PUHCA regulations, Conectiv formed a subsidiary service company, Conectiv Resource Partners, Inc. (CRP), in 1998. CRP provides a variety of support services to Conectiv subsidiaries, and its employees are primarily former DPL and ACE employees. The costs of CRP are directly assigned and allocated to the Conectiv subsidiaries using CRP's services, including DPL and ACE.
As a public utility, DPL supplies and delivers electricity and natural gas to its customers. These businesses, which are discussed below, are weather sensitive and seasonal because sales of electricity are usually higher during the summer months due to air conditioning and natural gas sales are usually higher in the winter when gas is used for space-heating. For other information concerning DPL's business segments, see Note 22 to DPL's 1999 Consolidated Fi- nancial Statements included in Item 8 of Part II.
Electricity and Gas Delivery
DPL delivers electricity to approximately 462,600 regulated customers through its transmission and distribution systems and also supplies electric- ity to most of its electricity delivery customers. Rates charged to DPL's cus- tomers for delivery services are subject to regulation primarily by the DPSC, MPSC, and VSCC. DPL's regulated electric service area has a population of ap- proximately 1.2 million and covers an area of about 6,000 square miles on the Delmarva Peninsula (Delaware and portions of Maryland and Virginia).
DPL delivers natural gas through its gas transmission and distribution sys- tems to approximately 107,300 customers in a service territory that covers about 275 square miles in Northern Delaware and has a population of approxi- mately 0.5 million.
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As discussed below, DPL's electric utility business was restructured in 1999 pursuant to legislation enacted in Delaware and Maryland and orders issued to DPL by the DPSC and MPSC. Some of DPL's customers could choose an alternative electricity supplier effective October 1, 1999, and by October 1, 2000, about 96% of DPL's customers will be able to choose an alternative electricity sup- plier. Some of DPL's natural gas customers can currently choose an alternative supplier. The electricity and natural gas delivered by DPL may be supplied to customers by alternative suppliers or DPL. Delivery services are structured into various forms of price regulated offers, some including energy supply, so that customers may choose the combination that provides the best value. As the electric utility industry evolves and restructuring of electricity supply is implemented, there will be opportunities to serve new customers such as inter- mediate marketers, wholesalers, bundled services providers, and energy service companies.
Electricity and Gas Supply
DPL supplies electricity to customers in its service area with power pur- chased from other suppliers and electricity generated by its power plants. DPL also supplies natural gas to its customers in northern Delaware under regu- lated tariffs. The transition to market pricing and terms of service for sup- plying electricity to customers in the regulated Delaware and Maryland service areas of DPL began in the latter half of 1999, when the DPSC and MPSC issued orders to DPL which restructured the electricity supply business. On October 1, 1999, Delaware customers with peak monthly loads of 1,000 kilowatts or more could choose an alternative electricity supplier. By October 1, 2000, all of DPL's Delaware and Maryland customers (approximately 96% of DPL's customers) will be able to choose an alternative electricity supplier. Among other things, the restructuring orders also provided for decreases in customer elec- tric rates, partial recovery of stranded costs, and no change in DPL's cus- tomer rates for the divestiture of its electric power plants. For information about restructuring the electricity supply business of DPL, see Notes 1, 6, 8, and 13 to the Consolidated Financial Statements, included in Item 8 of Part II, and "Electric Utility Industry Restructuring" within Management's Discus- sion and Analysis of Financial Condition and Results of Operations (MD&A), in- cluded in Item 7 of Part II.
DPL currently trades electricity and gas, and sells electricity and gas in bulk in markets which are not subject to price regulation. DPL also sells electricity and gas in competitive retail markets (including Delaware, Mary- land, and New Jersey) where customers may choose an electric supplier other than the local utility responsible for delivery.
As discussed under "Deregulated Generation and Power Plant Divestiture" within the MD&A, included in Item 7 of Part II, Conectiv is realigning the mix of electric generating plants owned by its subsidiaries. Conectiv expects that, in the future, the electric generating plants owned by its subsidiaries will be primarily "mid-merit" units. The kilowatt-hour (kWh) output of mid- merit units can be increased or decreased quickly on an economic basis. Mid- merit plants also typically have relatively low fixed operating and mainte- nance costs, can use different fuel types, and are generally operated when de- mand rises and electricity prices are higher.
In conjunction with Conectiv's mid-merit strategy, DPL has entered into agreements to sell its nuclear and non-strategic baseload fossil electric gen- erating plants (1,412 megawatts of capacity), as discussed under "Installed Electric Capacity" in Part I, in Note 11 to the Consolidated Financial State- ments included in Item 8 of Part II, and under "Deregulated Generation and Power Plant Divestiture" in the MD&A included in Item 7 of Part II.
In December 1999, DPL filed an application with the FERC for approval of the transfer to other Conectiv subsidiaries of the electric generating plants which are not being sold. Through the planned sales and transfers (divesti- ture) of DPL's electric generating plants, the principal businesses of DPL will be the transmission and distribution of energy, as envisioned by legisla- tion enacted during 1999 which restructured the electric utility industry in Delaware and Maryland. The production of electricity will be conducted by the Conectiv subsidiaries receiving the transferred electric generating units, which are also expected to assume the non-regulated electricity and gas trad- ing activities currently conducted by DPL. DPL's exit from the businesses of electricity production
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and non-regulated electricity and gas trading is expected to cause a decrease in DPL's earnings capacity. For information concerning non-regulated electric- ity and gas trading activities, see Note 9 to the Consolidated Financial Statements. For pro forma information concerning the divestiture of DPL's electric generating plants, see Exhibit 99 to this Report on Form 10-K.
Installed Electric Capacity
Capacity is the capability to produce electric power, typically from owned generation or third-party purchase contracts, and differs from the electric energy markets, which trade the actual energy being generated. The megawatts (MW) of net installed summer electric generating capacity available to DPL to serve its peak load as of December 31, 1999, is presented below. The net gen- erating capacity available for operations at any time may be less than the to- tal net installed generating capacity due to generating units being out of service for inspection, maintenance, repairs, or unforeseen circumstances. See Item 2, Properties, for additional information concerning electric generating units.
As a member of the Pennsylvania-New Jersey-Maryland Interconnection Associa- tion (PJM), DPL is obligated to maintain capacity levels based on its allo- cated share of estimated aggregate PJM capacity requirements. (The PJM is dis- cussed below.) DPL periodically updates its forecast of peak demand and re- evaluate resources available to supply projected growth. DPL's regulated peak load in 1999 was 3,255 MW on July 5, a 5.5% increase from DPL's previous his- torical peak demand of 3,085 MW which occurred on July 23, 1998. DPL met its 20% reserve margin obligation to the PJM in 1999. After DPL's divestiture of its power plants, DPL will satisfy its PJM reserve margin obligation with ca- pacity purchased from sources that may include other Conectiv subsidiaries, other utilities, and the PJM.
Pennsylvania-New Jersey-Maryland Interconnection Association
As members of the PJM, DPL's generation and transmission facilities are op- erated on an integrated basis with other electricity suppliers in Pennsylva- nia, New Jersey, Maryland, and the District of Columbia, and are
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interconnected with other major utilities in the United States. This power pool improves the reliability and operating economies of the systems in the group and provides capital economies by permitting shared reserve require- ments. The PJM's installed capacity as of December 31, 1999, was 57,588 MW. The PJM's peak demand during 1999 was 51,600 MW on July 6, which resulted in a summer reserve margin of 10.4% (based on installed capacity of 56,944 MW on that date).
The PJM operates a centralized capacity credit market, enabling participants to procure or sell surplus capacity to meet reliability obligations within the PJM region.
The PJM operating agreement allows bids to sell electricity (energy) re- ceived from generation located within the PJM control area. Transactions that are bid into the PJM pool are capped at $1,000 per megawatt hour. All power providers are paid the locational marginal price (LMP) set through power prov- iders' bids. The LMP will be higher in congested areas reflecting the price bids of those higher cost generating units that are dispatched to supply de- mand and alleviate the transmission constraint. Furthermore, in the event that all available generation within the PJM control area is insufficient to sat- isfy demand, the PJM may institute emergency purchases from adjoining regions. The cost of such emergency purchases is not subject to any PJM price cap.
Purchased Power
In Delaware and Maryland, DPL is the electricity supplier for customers who do not choose an alternative electricity supplier, or the "default service" provider. Upon completion of the divestiture of DPL's electric generating plants, DPL will supply default service customers entirely with purchased pow- er. As discussed in Note 11 to the Consolidated Financial Statements included in Item 8 of Part II, the terms of DPL's power plant sale agreement with NRG Energy, Inc. provide for DPL to purchase from NRG Energy, Inc. 500 megawatt- hours of firm electricity per hour from completion of the sale through Decem- ber 31, 2005. DPL currently purchases from PECO Energy Company (PECO) 243 MW of capacity and energy, which increases to 279 MW by 2006 when the contract expires. Recently, DPL entered into another agreement with PECO to purchase 350 MW of capacity and energy from March 2000 to February 2003. Subsequent to the divestiture of DPL's electric generating plants, management expects that these contracts with NRG Energy, Inc. and PECO will satisfy approximately 80% of DPL's forecasted average energy requirements. DPL also contracts with other electric suppliers on an as needed basis for capacity and energy.
Nuclear Power Plants
DPL has entered into agreements for the sale of its ownership interests in nuclear power plants to PSEG Power LLC (a subsidiary of Public Service Enter- prise Group) and PECO. Upon completion of the sales, DPL will transfer its re- spective nuclear decommissioning trust funds to the purchasers, who will as- sume full responsibility for the decommissioning of Peach Bottom Atomic Power Station (Peach Bottom) and Salem Nuclear Generating Station (Salem). The sales are subject to various federal and state regulatory approvals and are expected to be completed by the third quarter of 2000. For additional information, see Note 11 to the Consolidated Financial Statements included in Item 8 of Part II.
DPL's nuclear capacity is provided by Peach Bottom Units 2 and 3 and by Sa- lem Units 1 and 2. Peach Bottom is located in York County, Pennsylvania, is operated by PECO, and has a summer capacity of 2,186 MW. DPL has a 7.51%, or 164 MW, ownership interest in Peach Bottom. Public Service Electric and Gas (PSE&G) operates Salem, which is located in Salem County, New Jersey, and has a summer capacity of 2,212 MW. DPL's ownership interest in Salem is 7.41%, or 167 MW including 3 MW for an on-site combustion turbine.
DPL's ownership interests in nuclear power plants provided approximately 10% of its total installed capacity as of December 31, 1999. See Note 10 to DPL's 1999 Consolidated Financial Statements, included in Item 8 of Part II, for in- formation about DPL's investment in jointly-owned generating stations.
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The operation of nuclear generating units is regulated by the Nuclear Regu- latory Commission (NRC). Such regulation requires that all aspects of plant operations be conducted in accordance with NRC safety and environmental re- quirements and that continuous demonstrations be made to the NRC that plant operations meet applicable requirements. The NRC has the ultimate authority to determine whether any nuclear generating unit may operate.
As a by-product of nuclear operations, nuclear generating units produce low- level radioactive waste (LLRW). LLRW is accumulated on-site until shipped to a federally licensed permanent disposal facility. Salem and Peach Bottom have on-site interim storage facilities with five-year storage capacities. For a discussion about the disposal of nuclear fuel, see "Nuclear," under "Fuel Sup- ply for Electric Generation."
For information concerning funding DPL's estimated future cost of decommissioning the Salem and Peach Bottom nuclear reactors, see Note 12 to the Consolidated Financial Statements included in Item 8 of Part II.
For information about DPL's lawsuit seeking to recover damages for the costs of replacing the steam generators at Salem, see Item 3, Legal Proceedings.
Fuel Supply for Electric Generation
DPL's electric generating capacity by fuel type is shown under "Installed Electric Capacity." To facilitate the purchase of adequate amounts of fuel, DPL contracts with various suppliers of coal, oil, and natural gas on both a long- and short-term basis. DPL's long-term coal contracts generally contain provisions for periodic and limited price adjustments, which are based on cur- rent market prices. Oil and natural gas contracts generally are of shorter term with prices determined by market-based indices.
DPL's obligations for coal, oil, and gas supply contracts related to the fossil fuel-fired electric generating units to be sold are expected to be as- sumed by NRG Energy, Inc., the party which has agreed to purchase the fossil fuel-fired plants. Under the sales agreements for DPL's interests in nuclear generating units, DPL will receive proceeds for the book value of the nuclear fuel inventories, which are expected to be used to liquidate DPL's obligations for the lease of the nuclear fuel inventories.
Coal
Edge Moor Units 3 and 4, and the Indian River, Keystone and Conemaugh Gener- ating Stations are coal-fired. During 1999, 30% of DPL's coal supply was pur- chased under contracts of less than three years in duration, 51% under long- term contracts (up to ten years), and the balance on the spot market. Approxi- mately 41% of DPL's projected coal requirements are expected to be provided under supply contracts. DPL does not anticipate any difficulty in obtaining adequate amounts of coal.
Oil
Currently, 100% of the residual oil used in Edge Moor Unit 5 is purchased on a spot basis. Natural gas is used when economically feasible. A two-year re- sidual oil supply contract that expires in 2001 provides 90% to 100% of the fuel supply requirements for the Vienna Generating Station (Vienna). Any amount over 90% of Vienna's requirements may be purchased in the spot market.
Gas
Natural gas is the primary fuel for the three combustion turbines at DPL's Hay Road site and a secondary fuel for Edge Moor Units 3, 4, and 5. Natural gas for these generating units is purchased on a firm or interruptible basis from suppliers such as marketers, producers, and utilities. The gas is deliv- ered to DPL through the interstate pipeline system under contracts that are a mix of long-term firm, short-term firm, and interruptible contracts. The sec- ondary fuel for the Hay Road combustion turbines is low-sulfur diesel fuel, which is purchased in the spot market.
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Nuclear
PSE&G has informed DPL that it has several long-term contracts with uranium ore operators, converters, enrichers and fabricators to meet the currently projected fuel requirements for Salem. DPL has also been advised by PECO that it has contracts similar to PSE&G's contracts to satisfy the fuel requirements of Peach Bottom. Currently, there is an adequate supply of nuclear fuel for Salem and Peach Bottom.
After spent fuel is removed from a nuclear reactor, it is placed in tempo- rary storage for cooling in a spent fuel pool at the nuclear station site. Un- der the Nuclear Waste Policy Act of 1982 (NWPA), the federal government en- tered into contracts with utilities operating nuclear power plants for trans- portation and ultimate disposal of spent nuclear fuel and high level radioac- tive waste. However, no permanent government-owned and operated repositories are in service or under construction. The United States Department of Energy (DOE) has stated that it would not be able to open a permanent, high level nu- clear waste storage facility until 2010, at the earliest.
Pursuant to NRC rules, spent nuclear fuel generated in any reactor can be stored in reactor facility storage pools or in independent spent nuclear fuel storage installations located at or away from reactor sites for at least 30 years beyond the licensed life for operation (which may include the term of a revised or renewed license). PSE&G has advised DPL that, as a result of reracking the two spent fuel storage pools at Salem, the availability of spent fuel storage capacity is estimated to be adequate through 2012 for Unit 1 and 2016 for Unit 2. PECO has advised DPL that spent fuel racks at Peach Bottom have storage capacity until 2000 for Unit 2 and until 2001 for Unit 3. PECO has also advised DPL that it is constructing an on-site dry storage facility, which is expected to be operational in 2000, to provide additional storage ca- pacity.
Energy Adjustment Clauses
As a result of electric utility industry restructuring, energy adjustments in DPL's Delaware regulated retail electric tariffs were eliminated effective October 1, 1999, and energy adjustments in DPL's Maryland regulated retail electric tariffs are to be eliminated effective June 30, 2000. The energy ad- justment clauses provided for collection from customers of fuel costs and pur- chased energy costs. In Virginia, DPL proposed to the VSCC that the energy ad- justment clause be discontinued in 2000. Earnings volatility may increase due to elimination of DPL's energy adjustment clauses.
A gas cost rate clause provides for the recovery of gas costs through regu- lated tariffs from DPL's regulated gas customers. Gas costs for regulated, on- system customers are charged to operations based on costs billed to customers under the gas cost rate clause. Any under-collection or over-collection of gas costs in a current period is generally deferred. Customer rates are adjusted periodically to reflect amounts actually paid by DPL for purchased gas.
Retail Electric and Gas Rates
Changes in DPL's customer rates other than those related to the energy ad- justment clauses are discussed below. Changes in customer rates due to the electric and gas energy adjustment clauses generally do not affect earnings.
Effective October 1, 1999, DPL's Delaware residential electric rates were reduced 7.5%, in connection with restructuring the electric utility industry within Delaware. Also, electric rates in effect on October 1, 1999 are to re- main unchanged for four years for Delaware residential customers and three years for Delaware non-residential customers. Management estimates that the initial 7.5% Delaware residential rate reduction will reduce revenues by ap- proximately $17.5 million (on an annualized basis, assuming fiscal year 1998 sales and revenues).
A 7.5% reduction in DPL's Maryland residential electric rates is scheduled for July 1, 2000, in connection with restructuring the electric utility indus- try within Maryland. Also, the electric rates which become effective on July 1, 2000 are to remain unchanged for four years for Maryland residential cus- tomers and three years for Maryland non-residential customers. Management es- timates that the initial 7.5% Maryland residential rate
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reduction will reduce revenues by approximately $12.5 million (on an annualized basis, assuming fiscal year 1998 sales and revenues).
DPL has proposed a 2.6% (approximately $0.7 million on an annual basis) rev- enue decrease for Virginia electric retail customers by the completion of the divestiture of DPL's electric generating plants.
In accordance with the terms included in regulatory commissions orders' which approved the Merger, DPL phased in a $13.0 million reduction in electric and gas retail customer rates as follows: (1) $11.5 million effective March 1, 1998, (2) $1.1 million effective March 1, 1999, and (3) $0.4 million effective October 1, 1999.
For additional information concerning the impact of electric utility indus- try restructuring on customer rates, see Note 8 to the Consolidated Financial Statements included in Item 8 of Part II.
Customer Billing
In December 1999, a new customer billing system was installed, among other reasons, to accommodate the unbundled utility bills required by electric util- ity industry restructuring. As is the case with any complex billing system changeover, errors have occurred, which Conectiv is in the process of resolv- ing. On March 14, 2000, the DPSC initiated a proceeding in which billing sys- tem and related customer service issues are to be reviewed. Although billing system implementation problems may potentially affect future revenues and cash flows, management currently does not expect such problems to materially affect DPL's results of operations or financial position.
Electric System Outages
After customers experienced electric service outages in early July 1999 dur- ing an extended period of hot and humid weather and high demand for electrici- ty, (i) the DPSC initiated an investigation of outages occurring in DPL's Del- aware service territory (as well as an examination of post-Merger DPL customer service levels); and (ii) the MPSC initiated an investigation of outages oc- curring in the service territories of DPL and other Maryland electric utili- ties. DPL has responded to, and expects to continue to respond to, information requests during the pendency of these investigations.
On October 13, 1999, the DPSC initiated a formal proceeding to investigate the adequacy of DPL's facilities and services, including the remedies and in- centives (if any) to be imposed or offered, respectively, to ensure the con- tinued adequacy of DPL's facilities and services. That proceeding also will consider the effects (if any) of electric industry restructuring in Delaware on the reliability of electric service. DPL is actively involved in defending actions taken (including rotating load-shedding) during early-July 1999 and explaining its view that electric industry restructuring is unlikely to affect DPL's electric system reliability. This DPSC proceeding is scheduled to con- clude by May 2000.
On November 4-5, 1999, the MPSC held hearings on outages occurring during 1999 in the service territories of DPL and other Maryland utilities.
Cost Accounting Manual/Code of Conduct
DPL has cost allocation and direct charging mechanisms in place to ensure that there is no cross-subsidization of competitive activities by regulated utility activities. DPL is also subject to various Codes of Conduct that af- fect the relationship between DPL's regulated activities and Conectiv's unreg- ulated activities. In general, these Codes of Conduct limit information ob- tained through utility activities from being disseminated to employees engaged in non-regulated activities, and restrict or prohibit sales leads, joint sales calls, joint promotions, and the use of the same telephone numbers for regu- lated and unregulated activities. There are ongoing
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regulatory proceedings affecting DPL that could result in modifications to the existing Codes of Conduct, which modifications could adversely impact the way Conectiv's subsidiaries are organized and the ability of DPL and Conectiv to capture economies of common management and to deploy resources efficiently.
Virginia Affiliates Act
Certain types of transactions between DPL and its affiliates may require the prior approval of the VSCC under the Virginia Affiliates Act. Past applica- tions have generally been approved by the VSCC.
Federal Decontamination & Decommissioning Fund
The Energy Policy Act of 1992 provided for creation of a Decontamination & Decommissioning (D&D) Fund to pay for the future clean-up of DOE gaseous dif- fusion enrichment facilities. Domestic utilities and the federal government are required to make payments to the D&D Fund until 2008 or $2.25 billion, ad- justed annually for inflation, is collected. The liability accrued for DPL's share of the D&D Fund was $4.6 million as of December 31, 1999. The terms of DPL's agreements for the sales of its interests in the nuclear power plants provide for the buyers of the plants to assume the amount of this liability which exists at the time the sales are completed.
Regulated Gas Delivery and Supply
DPL's large and medium volume commercial and industrial customers may pur- chase gas from DPL, or directly from other suppliers and make arrangements for transporting gas purchased from these suppliers to the customers' facilities. DPL's transportation customers pay a fee, which may be either fixed or negoti- ated, for the use of DPL's gas transmission and distribution facilities.
On November 1, 1999, DPL instituted a pilot program to provide transporta- tion service and a choice of gas suppliers to a group of retail customers. The program was open to 15% of residential and 15% of small commercial customers. Approximately 40% of residential and 80% of small commercial customers who were eligible for the program actually enrolled. The pilot program will be in effect until October 30, 2001.
DPL purchases gas supplies from marketers and producers under spot market, short-term, and long-term agreements. As shown in the table below, DPL's maxi- mum 24-hour system capability, including natural gas purchases, storage deliv- eries, and the emergency sendout capability of its peak shaving plant, is 190,416 Mcf (thousand cubic feet).
DPL experienced an all-time daily peak in combined firm sales and transpor- tation sendout of 158,810 Mcf on January 17, 1997. DPL's peak shaving plant liquefies, stores, and re-gasifies natural gas in order to provide supplemen- tal gas in the event of pipeline supply shortfalls or system emergencies.
In 1998, DPL implemented a DPSC-approved gas price hedging/risk management program with respect to gas supply for regulated customers. The program seeks to limit exposure to commodity price uncertainty. Costs and benefits of the program are included in the gas cost rate clause, resulting in no effect on DPL's earnings.
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Capital Spending and Financing Program
For financial information concerning DPL's capital spending and financing program, refer to "Liquidity and Capital Resources" in the MD&A, included in Item 7 of Part II and Notes 15 and 16 to the Consolidated Financial State- ments, included in Item 8 of Part II.
DPL's ratios of earnings to fixed charges and earnings to fixed charges and preferred stock dividends under the Securities and Exchange Commission (SEC) Methods for 1995-1999 are shown below.
For purposes of computing the above ratios, earnings, including Allowance For Funds During Construction, are income before extraordinary item plus in- come taxes and fixed charges, less capitalized interest. Fixed charges include gross interest expense, the estimated interest component of rentals, and divi- dends on preferred securities of a subsidiary trust. For the ratio of earnings to fixed charges and preferred dividends, preferred stock dividends represent preferred stock dividend requirements multiplied by the ratio that pre-tax in- come bears to net income.
Environmental Matters
DPL is subject to various federal, regional, state, and local environmental regulations, including air and water quality control, oil pollution control, solid and hazardous waste disposal, and limitation on land use. Permits are required for DPL's construction projects and the operation of existing facili- ties. DPL has incurred, and expects to continue to incur, capital expenditures and operating costs because of environmental considerations and requirements. DPL has a continuing program to assure compliance with the environmental stan- dards adopted by various regulatory authorities.
Included in DPL's forecasted capital requirements are construction expendi- tures for compliance with environmental regulations, which are estimated to be $11 million in 2000.
Air Quality Regulations
The federal Clean Air Act requires utilities and other industries to signif- icantly reduce emissions of air pollutants such as sulfur dioxide (SO\\2\\) and oxides of nitrogen (NOx). Title IV of the Clean Air Act, the acid rain provisions, established a two-phase program which mandated reductions of SO\\2\\ and NOx emissions from certain utility units by 1995 (Phase I) and re- quired other utility units to begin reducing SO\\2\\ and NOx emissions in the year 2000 (Phase II). Phase I emission reductions requirements applicable to the jointly-owned Conemaugh Power Plant have been achieved. The remainder of DPL's wholly- and jointly-owned fossil fuel-fired units are expected to meet Phase II emission limits through a combination of fuel switching and SO\\2\\ allowance trading.
DPL's facilities also must comply with Title I of the Clean Air Act, the ozone nonattainment provisions, which require states to promulgate Reasonably Available Control Technology (RACT) regulations for existing sources located within ozone nonattainment areas or within the Northeast Ozone Transport Re- gion (NOTR). DPL's facilities in Delaware and Maryland are in the NOTR. To comply with RACT regulations, DPL has installed low NOx burner technology on six of its generating units. DPL filed its RACT compliance program in accor- dance with regulatory requirements, but the program has not yet received final regulatory approvals from Delaware and Maryland.
Additional "post-RACT" NOx emission regulations are being pursued by states in the NOTR. Delaware implemented post-RACT NOx control regulations requiring attainment of summer seasonal emission reductions
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of up to 65% below 1990 levels by May 1999 through reduced emissions or the procurement of NOx emission allowances. In 1999, DPL complied with these post- RACT requirements. DPL's post-RACT compliance plan for its Delaware generating units includes capital expenditures of approximately $12 million.
In addition to the above requirements, the United States Environmental Pro- tection Agency (USEPA) has proposed summer seasonal NOx controls commensurate with reductions of up to 85% below baseline years by the year 2003 for a 22 state region, including Delaware. Because Delaware has not yet promulgated regulations to implement the reductions that the USEPA has mandated by 2003, DPL currently cannot determine the additional operating and capital costs that will be incurred to comply with these initiatives.
In July 1997, the USEPA adopted new federal air quality standards for par- ticulate matter and ozone. The new particulate matter standard addressed fine particulate matter. Attainment of the fine particulate matter standard may re- quire reductions in NOx and SO\\2\\. However, under the time schedule an- nounced by the USEPA, particulate matter non-attainment areas will not be des- ignated until 2002 and control measures to meet this standard will not be identified until 2005.
Water Quality Regulations
The Federal Water Pollution Control Act, as amended (the Clean Water Act) provides for the imposition of effluent limitations to regulate the discharge of pollutants, including heat, into the waters of the United States. National Pollution Discharge Elimination System (NPDES) permits issued by state envi- ronmental regulatory agencies specify effluent limitations, monitoring re- quirements, and special conditions with which facilities discharging wastewaters must comply. To ensure that water quality is maintained, permits are issued for a term of five years and are modified as necessary to reflect requirements of new or revised regulations or changes in facility operations.
The Clean Water Act also requires that cooling water intake structures be designed to minimize adverse environmental impact. The USEPA is required by a consent order to adopt regulations in determining whether cooling water intake structures represent the best technology available for minimizing adverse en- vironmental impacts. As part of its efforts to develop regulations, the EPA has requested information from DPL regarding current intake structure design. Final action on the proposed regulations is required in 2001.
In reviewing DPL's applications to renew NPDES permits, DNREC has required DPL to update earlier studies to determine if Indian River and Edge Moor power plants are still in compliance with Clean Water Act requirements. Studies as- sessing thermal water quality standards compliance were completed in 1999 and studies assessing impacts of the cooling water intake structures will be com- pleted in 2000. A report of the results of the thermal impact studies will be completed in May 2000. If the studies indicate an adverse environmental im- pact, then upgrades to the intake structures and/or environmental enhancement projects to offset adverse impacts may be required. Impact studies would cost up to $2 million per plant. Costs for intake structure upgrades and enhance- ment projects would range from approximately $1 million if little adverse im- pact is found, to $45 million if cooling towers are required, which DPL con- siders to be an unlikely potential outcome.
Hazardous Substances
The nature of the electric and gas utility businesses results in the produc- tion or handling of various by-products and substances which may contain sub- stances defined as hazardous under federal or state statutes. The disposal of hazardous substances can result in costs to clean up facilities found to be contaminated due to past disposal practices. Federal and state statutes autho- rize governmental agencies to compel responsible parties to clean up certain abandoned or uncontrolled hazardous waste sites. DPL's exposure is minimized by adherence to environmental standards for DPL-owned facilities and through a waste disposal contractor screening and audit process.
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In December 1999, DPL discovered an oil leak at the Indian River power plant. DPL took action to determine the source of the leak and cap it, contain the oil to minimize impact to a nearby waterway and began recovering oil from the soil. DPL is in the process of determining the extent of the leak, design- ing an oil recovery/remediation system, and estimating the costs to remediate the site. DPL is working together with regulatory agencies and may be subject to monetary penalties. Management cannot predict the outcome of this matter.
As of December 31, 1999, DPL's other accrued liabilities included $2 million for clean-up and other potential costs related to federal and state superfund sites. DPL does not expect such future costs to have a material effect on DPL's financial position or results of operations. For additional information, see Note 21 to the Consolidated Financial Statements included in Item 8 of Part II.
Executive Officers
The names, ages, and positions of all of the executive officers of DPL as of December 31, 1999, are listed below, along with their business experiences during the past five years. Officers are elected annually by Conectiv's Board of Directors. There are no family relationships among these officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected.
Executive Officers of DPL (As of December 31, 1999)
(continued on following page)
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Executive Officers of DPL (continued)
ITEM 2.
ITEM 2. PROPERTIES
Substantially all utility plants and properties of DPL are subject to the lien of the Mortgage under which DPL's First Mortgage Bonds are issued.
The electric properties of DPL are located in Delaware, Maryland, Virginia, Pennsylvania, and New Jersey. The following table sets forth the net installed summer electric generating capacity available to DPL to serve its peak load as of December 31, 1999.
(continued on following page)
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- -------- (A) DPL portion of jointly-owned plants. (B) Represents capacity owned by a refinery customer which is available to DPL to serve its peak load.
The electric transmission and distribution systems of DPL includes 1,391 transmission poleline miles of overhead lines, 5 transmission cable miles of underground cables, 6,931 distribution poleline miles of overhead lines, and 5,540 distribution cable miles of underground cables.
DPL has a liquefied natural gas plant located in Wilmington, Delaware, with a storage capacity of 3.045 million gallons and an emergency sendout capabil- ity of 45,000 Mcf per day. DPL also owns five natural gas city gate stations at various locations in its gas service territory. These stations have a total sendout capacity of 200,000 Mcf per day.
The following table sets forth DPL's gas pipeline miles:
- -------- * Includes 11 miles of joint-use gas pipeline that is used 10% for gas opera- tions and 90% for electric operations.
DPL owns and occupies office buildings in Wilmington and Christiana, Dela- ware and Salisbury, Maryland, and also owns other properties located within its service area that are used for office, service, and other purposes.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
As previously reported, on February 27, 1996, the co-owners of Salem, in- cluding DPL, filed a complaint in the United States District Court for New Jersey against Westinghouse Electric Corporation (Westinghouse), the designer and manufacturer of the Salem steam generators. The complaint, which sought to recover from Westinghouse the costs associated with and resulting from the cracks discovered in Salem's steam generators and
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with replacing such steam generators, alleged violations of federal and New Jersey Racketeer Influenced and Corrupt Organizations Acts, fraud, negligent misrepresentation and breach of contract. On November 4, 1998, the Court granted Westinghouse's motion for summary judgment with regard to the federal Racketeer Influenced and Corrupt Organizations Act claim, and dismissed the remaining state law claims against Westinghouse in the Superior Court of New Jersey. The co-owners also filed an appeal of the District Court's dismissal with the United States Court of Appeals for the Third Circuit. Following oral argument before the Court of Appeals for the Third Circuit, Westinghouse and Public Service Electric and Gas, on behalf of the co-owners, negotiated a set- tlement of the litigation. The federal and state cases have been dismissed with prejudice.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise.
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DELMARVA POWER & LIGHT COMPANY
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
All shares of DPL's common stock are owned by Conectiv, its parent company.
DPL's certificate of incorporation requires payment of all preferred divi- dends in arrears (if any) prior to payment of common dividends to Conectiv, and has certain other limitations on the payment of common dividends.
As a subsidiary of a registered holding company under PUHCA, DPL can pay div- idends only to the extent of its retained earnings unless SEC approval is ob- tained.
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DELMARVA POWER & LIGHT COMPANY
ITEM. 6 SELECTED FINANCIAL DATA
- ------- (1) As discussed in Note 4 to the Consolidated Financial Statements, Delmarva Power & Light (DPL) and Atlantic City Electric Company (ACE) became whol- ly-owned subsidiaries of Conectiv (the Merger) on March 1, 1998. In con- junction with the Merger, DPL transferred its nonutility subsidiaries to Conectiv. The 1998 Consolidated Statement of Income includes two months of operating results of DPL's former nonutility subsidiaries. (2) In 1999, special charges primarily for employee separations and certain other non-recurring items decreased operating income by $10.5 million and income before extraordinary item, net income, and earnings applicable to common stock by $6.4 million. (3) As discussed in Note 6 to the Consolidated Financial Statements, the ex- traordinary item in 1999 resulted from the restructuring of the electric utility industry. (4) In 1998, special charges for employee separation costs and other Merger- related costs decreased operating income by $27.4 million and income be- fore extraordinary item, net income, and earnings applicable to common stock by $16.6 million. (5) In 1997, the after-tax gain on the sale of a landfill and waste-hauling company increased income before extraordinary item, net income, and earn- ings applicable to common stock by $13.7 million. (6) Excludes interchange deliveries. (7) Although Variable Rate Demand Bonds are classified as current liabilities, DPL intends to use the bonds as a source of long-term financing as dis- cussed in Note 16 to the Consolidated Financial Statements. (8) Amounts shown in total, rather than on a per-share basis, since DPL is a wholly-owned subsidiary of Conectiv. Excludes non-cash dividend of $123.4 million for the transfer of nonutility subsidiaries to Conectiv on March 1, 1998, due to the Merger.
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DELMARVA POWER & LIGHT COMPANY
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 (Litigation Reform Act) provides a "safe harbor" for forward-looking statements to encourage such dis- closures without the threat of litigation, provided those statements are iden- tified as forward-looking and are accompanied by meaningful, cautionary state- ments identifying important factors that could cause the actual results to differ materially from those projected in the statement. Forward-looking statements have been made in this report. Such statements are based on manage- ment's beliefs as well as assumptions made by and information currently avail- able to management. When used herein, the words "will," "anticipate," "esti- mate," "expect," "believe," and similar expressions are intended to identify forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with such forward-looking statements, factors that could cause actual results to differ materially from those con- templated in any forward-looking statements include, among others, the follow- ing: the effects of deregulation of energy supply and the unbundling of deliv- ery services; an increasingly competitive marketplace; results of any asset dispositions; sales retention and growth; federal and state regulatory ac- tions; future litigation results; costs of construction; operating restric- tions; increased costs and construction delays attributable to environmental regulations; nuclear decommissioning and the availability of reprocessing and storage facilities for spent nuclear fuel; and credit market concerns. DPL un- dertakes no obligation to publicly update or revise any forward-looking state- ments, whether as a result of new information, future events or otherwise. The foregoing list of factors pursuant to the Litigation Reform Act should not be construed as exhaustive or as any admission regarding the adequacy of disclo- sures made by DPL prior to the effective date of the Litigation Reform Act.
OVERVIEW
DPL is a public utility located on the Delmarva Peninsula (Delaware and por- tions of Maryland and Virginia) which supplies and delivers electricity and natural gas to its customers. DPL supplies electricity to customers with power purchased from other suppliers and electricity generated by its power plants. The transition to market pricing and terms of service for supplying electric- ity in DPL's regulated service area began in 1999. DPL also supplies electric- ity in markets which are not subject to price regulation.
DPL provides regulated gas service (supply and/or delivery) to its Delaware customers and also sells gas off-system and in markets which are not subject to price regulation.
On March 1, 1998, Conectiv was formed (the Merger) through an exchange of common stock with Delmarva Power & Light Company (DPL) and Atlantic Energy, Inc. (Atlantic). Conectiv is a registered holding company under the Public Utility Holding Company Act of 1935 (PUHCA). In conjunction with the Merger, DPL became a Conectiv subsidiary and transferred its ownership in nonutility subsidiaries to Conectiv. As a result of the transfer of the nonutility sub- sidiaries, DPL's 1998 Consolidated Statement of Income includes the January and February 1998 operating results of DPL's former nonutility subsidiaries and the 1997 Consolidated Statement of Income includes a full year of operat- ing results for DPL's former nonutility subsidiaries. The Consolidated State- ments of Income include revenues of $19.5 million and $113.0 million for 1998 and 1997, respectively, and a net loss of $3.5 million and net income of $9.8 million for 1998 and 1997, respectively, from the operations of these nonutil- ity subsidiaries.
EARNINGS RESULTS SUMMARY
In 1999, DPL reported a net loss applicable to common stock of $115.9 mil- lion. The net loss resulted from (i) a $253.6 million extraordinary charge, after income taxes of $147.8 million, applicable to common stock for discon- tinuing the application of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for
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the Effects of Certain Types of Regulation," (SFAS No. 71) to DPL's electric- ity supply businesses because of deregulation, and (ii) $6.4 million of spe- cial charges, net of taxes, primarily for accrued employee separation costs and certain other nonrecurring items. For additional information concerning deregulation and the extraordinary charge to earnings, see Notes 1, 6, 8, and 13 to the Consolidated Financial Statements and the "Electric Utility Industry Restructuring" section within Management's Discussion and Analysis of Finan- cial Condition and Results of Operations (MD&A).
In 1998, DPL's earnings applicable to common stock were $108.1 million, af- ter (i) special charges of $16.6 million, net of taxes, for the cost of em- ployee separations associated with Merger-related workforce reductions and other Merger-related costs, and (ii) a $3.5 million net loss for the two months of nonutility subsidiary operations.
Excluding extraordinary and special charges to earnings and the net loss of the nonutility subsidiaries in 1998, earnings applicable to common stock were $144.1 million in 1999 compared to $128.2 million in 1998. This $15.9 million earnings increase was mainly due to higher retail electric and gas sales, which benefited from the effects of weather, partly offset by electric rate decreases and higher operating expenses.
Excluding operating results of nonutility subsidiaries in 1998 and 1997 and the special charges in 1998, earnings increased $36.8 million in 1998. This increase was primarily due to a 2.5% retail electric kilowatt-hour (kWh) sales increase and lower operation and maintenance expenses. The earnings increase was constrained by milder winter weather's unfavorable effect on electric and gas sales. Nonutility subsidiaries earned $9.8 million in 1997, mainly due to a $13.7 million after-tax gain on the sale of a landfill and waste-hauling company, partly offset by net operating losses.
ELECTRIC UTILITY INDUSTRY RESTRUCTURING
During the latter half of 1999, as discussed in Notes 1, 6 ,8 and 13 to the Consolidated Financial Statements, the Delaware Public Service Commission (DPSC) and Maryland Public Service Commission (MPSC) issued orders to DPL, concerning restructuring the electricity supply businesses of DPL. Based on these orders, DPL determined that the requirements of SFAS No. 71 no longer applied to its electricity supply businesses as of September 30, 1999. As a result, DPL discontinued applying SFAS No. 71 and applied the requirements of SFAS No. 101, "Regulated Enterprises--Accounting for the Discontinuation of Application of FASB Statement No. 71" (SFAS No. 101) and Emerging Issues Task Force (EITF) Issue No. 97-4, "Deregulation of the Pricing of Electricity--Is- sues Related to the Application of FASB Statements No. 71 and No. 101" (EITF 97-4), which among other things, resulted in an extraordinary charge to earn- ings of $253.6 million, net of income taxes of $147.8 million. The provisions of the restructuring orders issued by the DPSC and MPSC are summarized below.
Implementation Dates
The table below shows when DPL's Delaware and Maryland retail electric cus- tomers may choose an alternative supplier. The Virginia Electric Utility Re- structuring Act, signed into law on March 29, 1999, phases in retail electric competition beginning January 1, 2002.
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Revenue Reductions
Pursuant to the electric utility restructuring orders issued by the DPSC and MPSC, electric rate decreases became effective, or are scheduled to become ef- fective, as shown in the table below.
- -------- (1) Estimated based on 1998 fiscal year sales and revenues. (2) Represents a 7.5% reduction for residential rates, which are held constant for four years. Non-residential rates are held constant for three years.
Regulatory Implications on Sales of Electric Generating Plants
As discussed under "Deregulated Generation and Power Plant Divestiture," DPL has reached agreements for the sale of certain of its electric generating units. Under the DPSC's and MPSC's electric restructuring orders, customer rates will not be changed for any gain or loss on the sale of DPL's electric generating plants. Based on the existing agreements for the sale of electric generating plants of DPL with 1,411.8 megawatts (MW) of capacity, management expects to recognize a net gain for such sales. There can be no assurances, however, that the sales of DPL's electric generating plants will be completed pursuant to the agreements, or that any gain will be realized from such sales of electric generating plants.
Stranded Cost Recovery
Based on the $24 million of after-tax stranded cost recovery that the DPSC and MPSC restructuring orders provided for, DPL recorded recoverable stranded costs on a pre-tax basis of $44.3 million in the third quarter of 1999 ($41.8 million as of December 31,1999). Although only partial stranded cost recovery was provided for by the DPSC's and MPSC's restructuring orders, customer rates will not be reduced for any gain realized on the sale of the electric generat- ing plants.
Default Service
DPL is obligated to supply electricity to customers who do not choose an al- ternative electricity supplier after October 1, 1999 in Delaware and July 1, 2000 in Maryland. After October 1, 1999 in Delaware and July 1, 2000 in Mary- land, DPL's earnings will be affected to the extent that DPL's actual energy costs vary from the amounts included in its customer rates.
Shopping Credits
Customers who choose an alternative electricity supplier receive a credit to their bill, or a shopping credit, which generally represents the cost of elec- tricity supply and transmission service. System-average shopping credits for the first three to four years (depending on the state and/or customer group) after customer choice begins, have been initially estimated. The estimates range from 4.736 to 4.740 cents per kWh for DPL's Delaware customers, and from 5.302 to 5.307 cents per kWh for DPL's Maryland customers.
Deregulated Generation and Power Plant Divestiture
Conectiv's management is changing the mix of the types of electric generat- ing plants owned by its subsidiaries, including DPL, in conjunction with im- plementing its asset-backed, "merchant" strategy focusing on "mid-merit" elec- tric generating plants. Mid-merit electric generating plants can quickly in- crease or decrease their kWh output level on an economic basis. Mid-merit plants typically have relatively low fixed operating and maintenance costs and also can use different types of fuel. These plants are generally operated dur- ing times when
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demand for electricity rises and prices are higher. As discussed below, DPL has entered into agreements to sell its nuclear and non-strategic baseload fossil electric generating plants. Baseload electric generating plants run al- most continuously to supply the base level of demand for electricity, or the minimum demand level, which generally always exists on an electrical system. In a deregulated electricity supply market, management expects that mid-merit electric generating plants will be more profitable and provide higher returns on invested capital than baseload electric generating plants.
Effective October 1, 1999, the Delaware portion (approximately 59%) of DPL's electric generating plants was deregulated and the plants' kWh output may, at DPL's option, be sold in deregulated markets or used to supply default service customers in Delaware. Similarly, effective July 1, 2000, the Maryland portion (approximately 30%) of DPL's electric generating plants is deregulated and the plants' kWh output may, at DPL's option, be sold in deregulated markets or used to supply default service customers in Maryland.
The electric generating plants of DPL which are not sold (approximately 1,380 MW of capacity) are expected to be transferred to a nonutility electric generation subsidiary of Conectiv. As result of the sales and transfers (di- vestiture) of DPL's electric generating plants, the principal businesses of DPL would be the transmission and distribution of energy, as envisioned by legislation enacted in Delaware and Maryland during 1999 which restructured the electric utility industry in those states. The production of electricity will be conducted by other Conectiv subsidiaries, which are also expected to assume the non-regulated electricity and gas trading activities currently con- ducted by DPL. DPL's exit from the businesses of electricity production and non-regulated electricity and gas trading is expected to cause a decrease in DPL's earnings capacity. For information concerning non-regulated electricity and gas trading activities see Note 9 to the Consolidated Financial State- ments. For pro forma information concerning the divestiture of DPL's electric generating plants, see Exhibit 99 to this Report on Form 10-K.
Due to the expected divestiture of the electric generating plants, more electric capacity and energy is expected to be purchased in the future. Howev- er, upon the sale of the electric generating plants, DPL's depreciation, fuel, operating, and maintenance expenses for these plants will end. Also, to the extent the sales proceeds are used to pay off securities that had financed the plants, financing costs will also decrease.
On September 30, 1999, Conectiv announced that DPL reached agreements to sell its ownership interests in nuclear plants, representing 331 MW of capaci- ty, to PSEG Power LLC and PECO Energy Company (PECO). The aggregate sales price of $9 million, less selling costs, was used as the fair value of the nu- clear plants in determining the amount of impairment that resulted from dereg- ulation and the amount of the write-down of DPL's investments in nuclear plants that was recorded in 1999. Upon completion of the sales, DPL will transfer its respective nuclear decommissioning trust funds to the purchasers, and PSEG Power LLC and PECO will assume full responsibility for the decommissioning of Peach Bottom and Salem. The sales are subject to various federal and state regulatory approvals and are expected to close by the third quarter of 2000.
On January 19, 2000, Conectiv announced that DPL reached agreements to sell wholly- and jointly owned fossil fuel-fired units. The units have a total ca- pacity of 1,080.8 MW and a net book value of $309.1 million as of December 31, 1999. The units will be sold to NRG Energy, Inc., a subsidiary of Northern States Power Company for approximately $622 million. The sales are subject to various federal and state regulatory approvals and are expected to be com- pleted during the third quarter of 2000.
Conectiv's management expects that the proceeds from the sale of the elec- tric generating plants will be used for debt repayment, repurchases of Conectiv common stock, and new investments that fit with Conectiv's strate- gies, including expansion of Conectiv's mid-merit generation business. Some or all of DPL's proceeds from the sale of the electric generating plants could be paid as a dividend to Conectiv, or loaned to Conectiv's pool of funds that Conectiv subsidiaries borrow from or invest in depending on their cash posi- tion.
Upon completion of the divestiture of DPL's electric generating plants, DPL will supply default service customers entirely with purchased power. The terms of DPL's power plant sale agreement with NRG Energy,
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Inc. provide for DPL to purchase from NRG Energy, Inc. 500 megawatt-hours of firm electricity per hour from completion of the sale through December 31, 2005. DPL currently purchases from PECO 243 MW of capacity and energy, which increases to 279 MW by 2006 when the contract expires. Recently, DPL entered into another agreement with PECO to purchase 350 MW of capacity and energy from March 2000 to February 2003. Subsequent to the divestiture of DPL's elec- tric generating plants, management expects that these contracts with NRG Ener- gy, Inc. and PECO will satisfy approximately 80% of DPL's forecasted average energy requirements. DPL also contracts with other electric suppliers on an as needed basis for capacity and energy.
DPL's mortgage requires that the electric generating plants being divested be released from the lien of the mortgage. These assets may be released with a combination of cash, bondable property additions and credits representing pre- viously issued and retired first mortgage bonds. DPL expects to have suffi- cient bondable property additions and retired first mortgage bonds to release such assets at fair values.
OPERATING REVENUES
Electric Revenues
The table below shows the amounts of electric revenues earned which are sub- ject to price regulation (Regulated) and which are not subject to price regu- lation (Non-regulated). "Regulated electric revenues" include revenues for de- livery (transmission and distribution) service and electricity supply service within DPL's service area. DPL's default service is subject to price regula- tion during the transition to retail competition.
"Non-regulated electric revenues" result primarily from electricity trading activities, bulk sales of electricity including sales of output from deregu- lated electric generating plants, and competitive retail sales. DPL actively participates in the wholesale energy markets to support wholesale utility and competitive retail marketing activities. Energy market participation results in exposure to commodity market risk when, at times, net open energy commodity positions are created or allowed to continue. To the extent that DPL has net open positions, controls are in place that are intended to keep risk exposures within certain management approved risk tolerance levels.
For 1999 compared to 1998, "Regulated electric revenues" increased $46.9 million, from $1,054.6 million for 1998 to $1,101.5 million for 1999. The $46.9 million increase was due to the following: (a) a $34.9 million revenue increase from a 2.9% increase in retail kWh sold, due to the effects of weather and a 1.6% increase in the number of customers; (b) a $6.4 million de- crease due to retail rate decreases for electric utility industry restructur- ing and the Merger; and (c) an $18.4 million increase in interchange/resale revenues primarily from revenues for transmission network usage and system congestion. The effect on consolidated electric revenues of customers choosing an alternative electricity supplier due to implementation of electric utility industry restructuring did not have a material effect on total electric reve- nues in 1999.
"Non-regulated electric revenues" increased by $15.1 million in 1999, from $274.8 million for 1998 to $289.9 million for 1999. The $15.1 million increase was mainly due to higher bulk sales of electricity, including sales to compet- itive retail aggregators, partially offset by lower electricity trading vol- umes. Higher competitive retail electricity sales in Pennsylvania also con- tributed to the increase.
For 1998 compared to 1997, "Regulated electric revenues" increased by $65.1 million, from $989.5 million for 1997 to $1,054.6 million for 1998. The $65.1 million increase was primarily due to higher interchange delivery revenues, which did not significantly impact operating income due to low gross margins. Additional "Regulated electric revenues" due to a 2.5% kWh sales increase were offset by the impact of the Merger-related
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customer rate decrease ($10.7 million) and lower average rates for the energy- portion of revenues ($15.3 million). Prior to electric utility industry re- structuring, the energy portion of revenues generally did not affect operating income, as discussed under "Energy Supply Costs" in Note 1 to the Consolidated Financial Statements. The 2.5% kWh sales increase was primarily due to favora- ble economic conditions and 1.6% customer growth.
"Non-regulated electric revenues" increased from $102.6 million for 1997 to $274.8 million for 1998 mainly due to higher electricity trading volumes. The gross margin earned from non-regulated trading electricity revenues is gener- ally much lower than the gross margin earned from "Regulated electric reve- nues," which include amounts for recovery of the costs of utility plant and services provided.
In December 1999, a new customer billing system was installed to accommodate the unbundled utility bills required by electric utility industry restructur- ing. As is the case with any complex billing system changeover, errors have occurred, which Conectiv's service subsidiary is in the process of resolving. On March 14, 2000, the DPSC initiated a proceeding in which billing system and related customer service issues are to be reviewed. Although billing system implementation problems may potentially affect future revenues and cash flows, management currently does not expect such problems to materially affect DPL's results of operations or financial position.
Gas Revenues
DPL earns gas revenues from on-system sales which generally are subject to price regulation, off-system trading and sales of natural gas which are not subject to price regulation, and from the transportation of gas for customers. The table below shows the amounts of gas revenues earned which are subject to price regulation (Regulated) and which are not subject to price regulation (Non-regulated).
The primary factor affecting fluctuations in "Regulated gas revenues" is winter weather's impact on residential customers gas usage levels in heating their homes. Mild winter weather in early 1998 resulted in less cubic feet of gas sold to residential customers and lower revenues than in 1999 or in 1997.
As a percent of gross revenues, the gross margin earned from "Non-regulated gas revenues" in excess of related purchased gas costs is much lower than the margin earned from "Regulated gas revenues," since rates charged to regulated gas customers include amounts for recovery of the cost of gas delivery systems and services. "Non-regulated gas revenues increased by $266.9 million in 1999 and by $339.5 million in 1998 primarily due to higher volumes of natural gas traded.
Other Services Revenues
Other services revenues decreased by $9.7 million in 1999 mainly due to the two months of revenues from the nonutility subsidiaries included in operating results for 1998, partly offset by higher revenue for administrative facili- ties of DPL used by Conectiv's service company pursuant to regulations of the 1935 Public Utility Holding Company Act. Other services revenues decreased $75.9 million in 1998, primarily due to the transfer of DPL's nonutility sub- sidiaries to Conectiv on March 1, 1998.
OPERATING EXPENSES
Electric Fuel and Purchased Power
Electric fuel and purchased power increased $24.6 million in 1999 primarily due to higher average energy costs per kWh, reflecting additional costs for the prolonged periods of high peak demands during the summer of
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1999. Lower energy expenses recorded pursuant to regulated energy adjustment clauses (discussed under "Energy Supply Costs" in Note 1 to the Consolidated Financial Statements) mitigated the increase.
In 1998, electric fuel and purchased power increased $204.4 million from 1997 primarily due to more energy supplied for greater volumes of electricity sold off-system and within DPL's service territory.
Gas Purchased
Primarily due to larger volumes of gas purchased for resale off-system, gas purchased increased $268.6 million in 1999 and $333.4 million in 1998.
Other Services' Cost of Sales
Other services' cost of sales decreased by $6.6 million in 1999 and $53.8 million in 1998 mainly due to the effect of the transfer of DPL's nonutility subsidiaries to Conectiv on March 1, 1998, partly offset by the costs of ad- ministrative facilities of DPL which are used by Conectiv's service subsidi- ary.
Purchased Electric Capacity
Purchased electric capacity increased $4.0 million in 1999 and $10.3 million in 1998 primarily due to higher capacity requirements associated with energy supplied within and outside of DPL's regulated service areas.
Special Charges
As discussed in Note 5 to the Consolidated Financial Statements, special charges of $10.5 million before taxes ($6.4 million after taxes) were recorded in the third quarter of 1999 primarily for costs of employee separations and certain other non-recurring items. Including the cost of employees allocated to DPL from Conectiv's service subsidiary, 95 employee separations were ac- crued for, 48 of which had occurred by December 31, 1999.
In 1998, DPL recorded special charges of $27.4 million before taxes ($16.6 million after taxes) for the cost of DPL employee separations associated with the Merger-related workforce reduction and other Merger-related costs. The $27.4 million pre-tax charge includes a net $45.5 million gain from curtail- ments and settlements of pension and other postretirement benefits.
Operation and Maintenance Expenses
In 1999, operation and maintenance expenses increased by $6.6 million to $271.7 million. The increase was primarily due to higher expenses for customer care and electric generating plant operations, partly offset by a decrease due to the transfer of the nonutility subsidiaries to Conectiv on March 1, 1998.
In 1998, operation and maintenance expenses decreased by $66.7 million to $265.1 million. The decrease was primarily due to fewer employees, the trans- fer of the nonutility subsidiaries to Conectiv on March 1, 1998, and the ab- sence of the 1997 start-up activities at the Salem nuclear power plant.
Depreciation and Amortization
Depreciation and amortization expense decreased $3.0 million in 1999 mainly due to the reduction in book values of regulatory assets and electric power plants which resulted from discontinuing the application of SFAS No. 71 to the electricity supply business. In 1998, depreciation and amortization expense decreased $4.4 million primarily due to the transfer of nonutility subsidiar- ies to Conectiv on March 1, 1998.
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Taxes Other Than Income Taxes
The $3.6 million increase in taxes other than income taxes for 1999 was principally due to higher revenues.
OTHER INCOME
In 1997, the nonutility subsidiaries which were transferred to Conectiv ef- fective with the Merger provided $33.3 million of other income, which was principally attributed to a $22.9 million pre-tax gain ($13.7 million after- taxes) on the sale of a landfill and related waste-hauling operation.
INTEREST EXPENSE
Interest charges before capitalized amounts decreased $3.8 million in 1999 primarily due to lower average debt balances.
INCOME TAXES
Income taxes increased in 1999 primarily due to higher income before income taxes and extraordinary item.
YEAR 2000
DPL experienced no material operational problems, loss of revenues or impact on customers in any of its businesses and is not aware of any material claims made or to be made by or against DPL as a result of the Year 2000 issue around either the rollover from 1999 to 2000 or the Year 2000 Leap Year issue on Feb- ruary 29, 2000.
The Year 2000 issue was the result of computer programs and embedded systems using a two-digit format, as opposed to four digits, to indicate the year. Computer and embedded systems with this characteristic may have been unable to interpret dates during and beyond the year 1999, which could have caused a system failure or other computer errors, leading to disruption of operations. A project team, originally started in 1996 by ACE, managed Conectiv's response to this situation. A Conectiv corporate officer, reporting directly to the Chief Executive Officer, coordinated all Year 2000 activities. Conectiv met substantial challenges in identifying and correcting the computer and embedded systems critical to generating and delivering power, delivering natural gas and providing other services to customers.
The project team used a phased approach to managing its activities. The first phase was inventory and assessment of all systems, equipment, and processes. Each identified item was given a criticality rating of high, medium or low. Those items rated as high or medium were then subject to the second phase of the project. The second phase--determining and implementing correc- tive action for the identified systems, equipment and processes--concluded with a test of the unit being remediated. The third phase involved system testing and compliance certification.
Overall, Conectiv's Year 2000 Project covered approximately 140 different systems (some with numerous components) that had been originally identified as high or medium in criticality. However, only 21 of those 140 systems were es- sential for continued operations and customer response across Conectiv's sev- eral businesses; these were regarded as "mission critical." The Year 2000 Project team focused on these 21 systems, with work on the other systems con- tinuing based on their relative importance to Conectiv's businesses.
At the time of the change from 1999 to 2000, 100% of all inventory and as- sessment, corrective action/unit testing and system testing/compliance work was complete on the mission critical systems. For the balance of the high and medium criticality systems, 99% of this work was complete.
Additionally, DPL developed and tested contingency plans in the event that Year 2000 outages occurred, which they did not. Contingency plans were in place for all mission critical systems and were coordinated into a detailed overall Year 2000 restoration plan under the direction of a senior-level engi- neering and operations
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manager. Contingency plans were also developed for non-mission critical sys- tems. The Year 2000 plans built on DPL's existing expertise in service resto- rations. DPL also coordinated these efforts with state and local emergency management agencies. DPL followed this approach for both the change from 1999 to 2000 and for the Leap Year issue.
Further, DPL participated in two industry-wide drills sponsored by the North American Electric Reliability Council ("NERC") and conducted its own internal drills. All of these drills were exercises only and did not result in service interruptions.
Distribution of electricity is dependent on the overall reliability of the electric grid. DPL cooperated with NERC and the PJM in Year 2000 remediation, contingency planning and restoration planning efforts. As requested by NERC, DPL filed its Year 2000 Readiness Statement with NERC stating that as of June 30, 1999, 96% of work on mission critical systems had been completed. The re- maining 4% of work constituted three exceptions to full readiness status and were reported to NERC in the regular monthly filing made on June 30, 1999. On the basis of Conectiv's filings, NERC designated Conectiv as "Ready with Lim- ited Exceptions." NERC regarded exceptions as "limited" only if they did "not pose a measurable risk to reliable electric operations into the Year 2000." All three exceptions were completed prior to the change from 1999 to 2000.
Conectiv also contacted vendors and service providers to review their Year 2000 efforts. Many aspects of Conectiv's businesses are dependent on third parties. For example, fuel suppliers must be able to provide coal or gas for DPL to generate electricity.
Conectiv incurred approximately $16 million in costs for the Year 2000 Proj- ect through year-end 1999. Management anticipates approximately $1 million to $2 million in 2000 expenses, including those already incurred for the period around the change from 1999 to 2000. Project costs do not include significant expenditures covering new systems, such as Conectiv's SAP business, financial and human resources management systems, an energy control system, and a cus- tomer information system. While these new systems effectively remediated Year 2000 problems in the systems they replaced, Conectiv is not reporting the ex- penditures on these systems in its costs for the Year 2000 Project, because the new systems were installed principally for other reasons. The total cost of these other projects over several years exceeds $87 million.
During July 1999, President Clinton signed the Year 2000 litigation reform bill, known as the "Y2K Act." The Y2K Act provides some new partial liability and damages protections to defendants in Year 2000 failure-related cases. It also establishes new litigation procedures that plaintiffs and defendants must follow. In general, the Y2K Act provides a pre-litigation notice period, pro- portionate liability among defendants in Year 2000 cases, a requirement that plaintiffs mitigate damages from Year 2000-related failures, and federal court jurisdiction for Year 2000 claims. The law covers many types of civil actions that allege harm or injury related to an actual or potential Year 2000-related failure, or a claim or defense arising or related to such a failure. The Y2K Act does not, however, cover civil actions for personal injury or wrongful death or most actions brought by a government entity acting in a regulatory, supervisory or enforcement capacity. The law governs actions brought after January 1, 1999 for a Year 2000-related failure occurring before January 1, 2003. Although the Y2K Act will not afford DPL complete protection from Year 2000-related claims, it should help limit any liability related to any Year 2000-related failures. DPL cannot predict the extent to which such liability will be limited by the Y2K Act.
Even though the critical dates occurred with no material operational prob- lems, loss of revenues or impact on customers in any of its businesses, DPL will not with certainty be able to determine whether there may be Year 2000- related claims against DPL for some time. DPL does not believe at this time that there are any material Year 2000-related claims that it will make against vendors or suppliers but this evaluation is on-going.
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LIQUIDITY AND CAPITAL RESOURCES
General
DPL's primary ongoing sources of capital are internally generated funds (net cash provided by operating activities less common and preferred dividends) and external financings. Additionally, restructuring the electric utility industry has created new opportunities for raising capital. As discussed under "Deregu- lated Generation and Power Plant Divestiture," DPL plans to sell in 2000 elec- tric generating units with 1,411.8 MW of capacity for approximately $631 mil- lion, before certain adjustments and selling expenses. Capital requirements generally include construction expenditures for the electric and gas delivery businesses and the electric generating units, and repayment of debt, preferred securities and capital lease obligations.
Cash Flows From Operating Activities
Net cash inflows from operating activities were $246.8 million in 1999 com- pared to $246.2 million in 1998, and $221.3 million in 1997. In 1998, cash flows from operations increased $24.9 million primarily to lower operations and maintenance expenses and higher electric revenues, net of amounts paid for electric fuel and purchased energy.
There were increases in accounts receivable and accounts payable as of De- cember 31, 1999 in comparison to December 31, 1998 mainly due to higher levels of sales and purchases of non-regulated electricity and gas.
Taxes accrued as of December 31, 1999 increased from December 31, 1998, mainly due to higher taxable income; the items included in the 1999 extraordi- nary charge to earnings generally are not currently deductible for income tax purposes, but instead result in a deferred tax benefit.
The liabilities accrued for "Above-market purchased energy contracts and other electric restructuring liabilities" resulted from the extraordinary charge to earnings discussed in Note 6 to the Consolidated Financial State- ments and did not affect cash flows in 1999.
Cash Flows From Investing Activities
Capital expenditures decreased by $26.8 million in 1999 to $87.9 million. This decrease was primarily due to a shift in the funding of expenditures for certain assets such as software, computer systems, and administrative facili- ties to Conectiv's service subsidiary. After mid-1998, new assets which are to be shared by more than one Conectiv subsidiary have been purchased or con- structed by Conectiv's service subsidiary. In 1998, capital expenditures de- creased $42.1 million mainly due to the transfer of the nonutility subsidiar- ies to Conectiv on March 1, 1998, and lower utility construction expenditures.
The $13.5 million use of cash in 1999 for "Intercompany loan receivable" represents DPL's loan to Conectiv's pool of funds that Conectiv subsidiaries borrow from or invest in, depending on their cash position.
Cash expenditures for business acquisitions of $9.0 million in 1998 and $32.0 million in 1997 were primarily attributed to direct Merger costs and DPL's former nonutility subsidiaries' expenditures for HVAC businesses.
Cash Flows From Financing Activities
Common dividends paid were $76.4 million in 1999, $94.7 million in 1998, and $93.8 million in 1997. Common dividends in 1997 and the first quarter of 1998 were paid to the former holders of DPL common stock. Subsequent to the Merger, DPL began paying a common dividend each quarter to Conectiv. In 1999, common dividends paid decreased $18.3 million due to lower common dividends paid to Conectiv.
Dividends payable as of December 31, 1999 were lower in comparison to Decem- ber 31, 1998 primarily due to a lower common dividend payable to Conectiv.
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As a subsidiary of a registered holding company under PUHCA, DPL can pay dividends only to the extent of its retained earnings unless SEC approval is obtained.
During 1999, 1998, and 1997, DPL's external financing activities primarily involved debt. Cash flows from debt financing activity during 1999, 1998, and 1997 are summarized below.
Long-term debt issued during 1997 to 1999 included $33.0 million of 6.81% Medium Term Notes (MTN) in 1998 and $166.2 million of 6.6% to 7.72% MTN in 1997. In 1999, $33.3 million of Variable Rate Demand Bonds (VRDB) were issued.
Purchases and redemptions of long-term debt and VRDB during 1997 to 1999 in- cluded $34.5 million of 6.85% to 7.5% First Mortgage Bonds (FMB) in 1999, $30.0 million of 7.8% MTN in 1999, $25.0 million of $5.69% MTN in 1998, $25.0 million of 6 3/8% FMB in 1997, and $12.5 million of other purchases and re- demptions.
As shown above, there was a net $151.4 million decrease in short-term debt during 1997 to 1999, which was primarily due to refinancing short-term debt in 1997 with MTN.
DPL's capital structure as of December 31, 1999 and 1998, expressed as a percentage of total capitalization is shown below.
The decrease in common stockholder's equity and increase in long-term debt as a percent of total capitalization were primarily due to the special and ex- traordinary charges recorded in the third quarter of 1999, partly offset by a reduction in long-term debt outstanding.
The balances for long-term debt due within one year and for long-term debt as of December 31, 1999 decreased by $29.7 million and $34.7 million, respec- tively, from the balances as of December 31, 1998 primarily due to repayments of debt, as discussed in Note 16 to the Consolidated Financial Statements.
Forecasted Capital Requirements
DPL's expected capital expenditures are estimated to be approximately $110 million to $120 million in 2000, primarily for DPL's electric and gas delivery businesses. After the planned divestiture of the electric generating units by the third quarter of 2000, DPL will no longer have any capital requirements for electric generating units. After 2000, capital expenditures for DPL's electric and gas delivery businesses are expected to range from $80 million to $100 million per year.
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Scheduled maturities of long-term debt over the next five years are as fol- lows: 2000--$1.5 million; 2001--$2.3 million; 2002--$48.1 million; 2003--$92.3 million, 2004--$37.7 million.
Future capital requirements are expected to be funded through internally generated funds and external financings.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The following discussion contains "forward looking statements." These pro- jected results have been prepared based upon certain assumptions considered reasonable given the information currently available to DPL. Nevertheless, be- cause of the inherent unpredictability of interest rates, equity market pric- es, and energy commodity prices as well as other factors, actual results could differ materially from those projected in such forward-looking information. For a description of DPL's significant accounting policies associated with these activities see Notes 1 and 9 to the Consolidated Financial Statements.
Interest Rate Risk
DPL is subject to the risk of fluctuating interest rates in the normal course of business. DPL manages interest rates through the use of fixed and, to a lesser extent, variable rate debt. As of December 31, 1999, a hypotheti- cal 10% change in interest rates would result in a $0.4 million change in in- terest costs and earnings before taxes related to variable rate debt.
Equity Price Risk
DPL maintains trust funds, as required by the Nuclear Regulatory Commission, to fund certain costs of nuclear decommissioning (See Note 12 to the Consoli- dated Financial Statements). The trust funds are invested primarily in domes- tic and international equity securities, fixed-rate, fixed income securities, and cash and cash equivalents. By maintaining a portfolio that includes long- term equity investments, DPL is maximizing the returns to be utilized to fund nuclear decommissioning costs. However, the equity securities included in DPL's portfolio are exposed to price fluctuations in equity markets, and the fixed-rate, fixed income securities are exposed to changes in interest rates. DPL actively monitors its portfolio by benchmarking the performance of its in- vestments against certain indexes and by maintaining, and periodically review- ing, established target asset allocation percentages of the assets in its trust funds. Because the accounting for nuclear decommissioning recognizes that costs are recovered through electric rates, fluctuations in equity prices and interest rates do not affect the earnings of DPL.
Commodity Price Risk
DPL is exposed to the impact of market fluctuations in the price and trans- portation costs of natural gas, electricity, and petroleum products. DPL en- gages in commodity hedging activities to minimize the risk of market fluctua- tions associated with the purchase and sale of energy commodities (natural gas, petroleum and electricity). Some hedging activities are conducted using energy derivatives (futures, options, and swaps). The remainder of DPL's hedg- ing activity is conducted by backing physical transactions with offsetting physical positions. The hedging objectives include the assurance of stable and known minimum cash flows and the fixing of favorable prices and margins when they become available. DPL also engages in energy commodity trading and arbi- trage activities, which expose DPL to commodity market risk when, at times, DPL creates net open energy commodity positions or allows net open positions to continue. To the extent that DPL has net open positions, controls are in place that are intended to keep risk exposures within management-approved risk tolerance levels.
DPL uses a value-at-risk model to assess the market risk of its electricity, gas, and petroleum commodity activities. The model includes fixed price sales commitments, physical forward contracts, and commodity derivative instruments. Value at risk represents the potential gain or loss on instruments or portfo- lios due to changes
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in market factors, for a specified time period and confidence level. DPL esti- mates value-at-risk for its power and gas, commodity businesses using a delta- normal variance/covariance model with a 95 percent confidence level and assum- ing a five-day holding period. At December 31, 1999, DPL's calculated value at risk with respect to its commodity price exposure was approximately $5.3 mil- lion including generation activities and $0.7 million exclusive of generation. At December 31, 1998, DPL's calculated value at risk with respect to its com- modity price exposure was approximately $0.6 million exclusive of generation.
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DELMARVA POWER & LIGHT COMPANY
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF MANAGEMENT
Management is responsible for the information and representations contained in the consolidated financial statements of Delmarva Power & Light Company (DPL). Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States based upon currently available facts and circumstances and management's best estimates and judgments of the expected effects of events and transactions.
DPL maintains a system of internal controls designed to provide reasonable, but not absolute, assurance of the reliability of the financial records and the protection of assets. The internal control system is supported by written administrative policies, a program of internal audits, and procedures to as- sure the selection and training of qualified personnel.
PricewaterhouseCoopers LLP, independent accountants, are engaged to audit the financial statements and express their opinion thereon. Their audits are conducted in accordance with auditing standards generally accepted in the United States which include a review of selected internal controls to deter- mine the nature, timing, and extent of audit tests to be applied.
The Audit Committee of Conectiv's Board of Directors, composed of outside directors only, meets with management, internal auditors, and independent ac- countants to review accounting, auditing, and financial reporting matters. The independent accountants are appointed by the Board on recommendation of the Audit Committee, subject to approval by Conectiv's common stockholders.
/s/ Howard E. Cosgrove /s/ John C. van Roden Howard E. Cosgrove John C. van Roden Chairman of the Board, President Senior Vice President and Chief Executive Officer and Chief Financial Officer
February 7, 2000
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REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors Delmarva Power & Light Company Wilmington, Delaware
In our opinion, the accompanying consolidated financial statements listed in the accompanying index appearing under Item 14(a)(1) on page IV-1 present fairly, in all material respects, the financial position of Delmarva Power & Light Company and subsidiary companies ("DPL") at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. In addition, in our opin- ion, the financial statement schedule listed in the accompanying index appear- ing under Item 14(a)(2) on page IV-1 presents fairly, in all material re- spects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and fi- nancial statement schedule are the responsibility of DPL's management; our re- sponsibility is to express an opinion on these financial statements and finan- cial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain rea- sonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence support- ing the amounts and disclosures in the financial statements, assessing the ac- counting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Philadelphia, Pennsylvania
February 7, 2000
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DELMARVA POWER & LIGHT COMPANY
CONSOLIDATED STATEMENTS OF INCOME
See accompanying Notes to Consolidated Financial Statements.
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DELMARVA POWER & LIGHT COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
- -------- (1) Other than debt and deferred income taxes classified as current.
See accompanying Notes to Consolidated Financial Statements.
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DELMARVA POWER & LIGHT COMPANY
CONSOLIDATED BALANCE SHEETS
See accompanying Notes to Consolidated Financial Statements
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DELMARVA POWER & LIGHT COMPANY
CONSOLIDATED BALANCE SHEETS
See accompanying Notes to Consolidated Financial Statements
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DELMARVA POWER & LIGHT COMPANY
CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCKHOLDER'S EQUITY
- -------- (1) Dividend Reinvestment and Common Share Purchase Plan (DRIP)--As part of the Merger, DPL's (DRIP) was transferred to Conectiv. (2) Long-term incentive plan (LTIP). (3) As part of the Merger, all of DPL's outstanding shares of stock were ex- changed for Conectiv shares of stock on a one for one basis. Effective March 1, 1998, DPL had 1,000 shares of stock outstanding, $2.25 par value, held by Conectiv. (4) In conjunction with the Merger, DPL's nonutility subsidiaries, treasury shares and unearned compensation were transferred to Conectiv on March 1, 1998.
See accompanying Notes to Consolidated Financial Statements.
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DELMARVA POWER & LIGHT COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
As discussed in Note 4 to the Consolidated Financial Statements, effective March 1, 1998, Delmarva Power & Light Company (DPL) and Atlantic Energy, Inc. (Atlantic) consummated a series of merger transactions (the Merger) by which DPL and Atlantic City Electric Company (ACE) became wholly-owned subsidiaries of Conectiv. Conectiv is a registered holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Effective with the Merger, DPL's former nonutility subsidiaries were transferred to Conectiv.
DPL is a public utility, which supplies and delivers electricity and natural gas to its customers. DPL supplies electricity to customers with power pur- chased from other suppliers and electricity generated by its power plants. The transition to market pricing and terms of service for supplying electricity in DPL's regulated service area began on October 1, 1999. DPL also supplies elec- tricity in markets which are not subject to price regulation. DPL delivers electricity to approximately 462,600 regulated customers through its transmis- sion and distribution systems and also supplies electricity to most of its electricity delivery customers. DPL's regulated electric service territory is located on the Delmarva Peninsula (Delaware and portions of Maryland and Vir- ginia). DPL's electric service area encompasses about 6,000 square miles and has a population of approximately 1.2 million.
DPL provides regulated gas service (supply and/or delivery) to approximately 107,300 customers located in a service territory that covers about 275 square miles with a population of approximately 0.5 million in northern Delaware. DPL also sells gas off-system and in markets which are not subject to price regu- lation.
As discussed in Note 11 to the Consolidated Financial Statements, DPL plans to sell certain of its electric generating units. In December 1999, DPL filed an application with the Federal Energy Regulatory Commission (FERC) for ap- proval of the transfer to other Conectiv subsidiaries of the electric generat- ing plants which are not sold. Through this planned divestiture, the principal businesses of DPL would be the transmission and distribution of energy, as en- visioned by legislation enacted in Delaware and Maryland during 1999 which re- structured the electric utility industry in those states. The production of electricity will be conducted by the Conectiv subsidiaries receiving the transferred electric generating units. See Note 8 to the Consolidated Finan- cial Statements for information concerning restructuring of the electric util- ity industry.
Through March 1, 1998, revenues from "Other services" which are not subject to price regulation, were primarily from the former nonutility subsidiaries of DPL which were transferred to Conectiv effective with the Merger. Other serv- ices revenues also includes amounts for certain non-regulated services pro- vided by DPL to its customers and amounts for administrative facilities owned by DPL which are used by Conectiv's service company. Revenues from marketing non-regulated electricity and gas are included in "Electric" revenues and "Gas" revenues, respectively.
Regulation of Utility Operations
Certain aspects of DPL's utility businesses are subject to regulation by the Delaware and Maryland Public Service Commissions (DPSC and MPSC, respective- ly), the Virginia State Corporation Commission (VSCC), and the FERC. Retail gas sales are subject to regulation by the DPSC. Excluding off-system sales not subject to price regulation, the percentage of electric and gas utility operating revenues regulated by each regulatory commission for the year ended December 31, 1999, was as follows: DPSC, 67.6%; MPSC, 24.6%; VSCC, 2.4%; and FERC, 5.4%.
DPL's electric delivery business and retail gas business are subject to the requirements of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation"
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(SFAS No. 71). As discussed below, DPL's electricity supply business was sub- ject to the requirements of SFAS No. 71 prior to the third quarter of 1999. Regulatory commissions occasionally provide for future recovery from customers of current period expenses. When this happens, the expenses are deferred as regulatory assets and subsequently recognized in the Consolidated Statements of Income during the periods the expenses are recovered from customers. Simi- larly, regulatory liabilities may also be created due to the economic impact of regulatory commissions' actions.
In 1999, as discussed in Note 8 to the Consolidated Financial Statements, the DPSC and MPSC issued orders to DPL, concerning restructuring the electric- ity supply businesses of DPL. These orders were issued pursuant to the Dela- ware and Maryland electric restructuring legislation enacted earlier in 1999. Based on these orders, DPL determined that the requirements of SFAS No. 71 no longer applied to its electricity supply businesses as of September 30, 1999. As a result, DPL discontinued applying SFAS No. 71 to its electricity supply business and applied the requirements of SFAS No. 101, "Regulated Enter- prises--Accounting for the Discontinuation of Application of FASB Statement No. 71" (SFAS No. 101) and Emerging Issues Task Force (EITF) Issue No. 97-4, "Deregulation of the Pricing of Electricity--Issues Related to the Application of FASB Statements No. 71 and No. 101" (EITF 97-4). For information concerning the extraordinary charge to earnings that resulted from applying the require- ments of SFAS No. 101 and EITF 97-4, refer to Note 6 to the Consolidated Fi- nancial Statements.
Refer to Note 13 to the Consolidated Financial Statements for information about regulatory assets and liabilities arising from the financial effects of rate regulation.
Financial Statement Presentation
Due to the Merger-related restructuring discussed above, Delmarva Power Fi- nancing I (a financing subsidiary) became the sole remaining wholly-owned sub- sidiary of DPL as of March 1, 1998. Thus, the 1998 Consolidated Statement of Income includes the January and February 1998 operating results of DPL's for- mer nonutility subsidiaries and the 1997 Consolidated Statement of Income in- cludes a full year of operating results for DPL's former nonutility subsidiar- ies.
The consolidated financial statements include the accounts of DPL's wholly- owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation.
Ownership interests of 20% or more in other entities not controlled by DPL are accounted for on the equity method of accounting. Investments in entities accounted for under the equity method are included in "Other investments" on the Consolidated Balance Sheets. Earnings from equity method investees are in- cluded in "Other income" in the Consolidated Statements of Income. Ownership interests of less than 20% in other entities are accounted for on the cost method of accounting.
Certain reclassifications of prior period data have been made to conform with the current presentation.
Use of Estimates
The preparation of financial statements in conformity with accounting prin- ciples generally accepted in the United States requires management to make certain estimates and assumptions. These assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and lia- bilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions.
Revenue Recognition
DPL accrues revenues for electric and gas service rendered from the last me- ter reading to the month-end which has not yet been billed to customers. Simi- larly, revenues from "Other services" are recognized when services are per- formed or products are delivered.
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Energy Supply Costs
Under "energy adjustment clauses" prior to deregulation of electricity sup- ply, regulated electric customer rates were subject to adjustment for differ- ences between energy costs incurred in supplying regulated customers and amounts billed to customers for recovery of such costs. As a result, the amount recognized in the Consolidated Statements of Income for energy costs incurred in supplying electricity to regulated customers was adjusted to match the amounts billed to DPL's regulated customers. An asset was recorded for un- der-collections from customers and a liability was recorded for over-collec- tions from customers.
The DPSC and MPSC electric restructuring orders discussed in Note 8 to the Consolidated Financial Statements did not provide a rate adjustment mechanism for any under-recovery or over-recovery of energy costs after the start of customer choice (October 1, 1999 in Delaware and July 1, 2000 in Maryland). Thus, effective October 1, 1999 for DPL's Delaware electricity supply business (July 1, 2000 for DPL's Maryland electricity supply business), the practice of deferring the difference between the amount collected in revenues for energy costs and the amount of actual energy costs incurred was ended. As a result, differences between DPL's energy revenues and expenses will affect earnings and earnings volatility may increase.
The amount recognized in the Consolidated Statements of Income for the cost of gas purchased to supply DPL's regulated gas customers is adjusted to cus- tomer billings for such costs since customer rates are periodically adjusted to reflect amounts actually paid by DPL for purchased gas.
Nuclear Fuel
The ownership interests of DPL in nuclear fuel at the Peach Bottom Atomic Power Station (Peach Bottom) and the Salem Nuclear Generating Station (Salem) is financed through contracts accounted for as capital leases. Nuclear fuel costs, including a provision for the future disposal of spent nuclear fuel, are charged to fuel expense on a unit-of-production basis.
Energy Trading and Risk Management Activities
In June 1999, the Financial Accounting Standards Board (FASB) issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Defer- ral of the Effective Date of FASB Statement No. 133," which delays the re- quired implementation date for SFAS No. 133, "Accounting for Derivative In- struments and Hedging Activities," until all fiscal quarters of all years be- ginning after June 15, 2000. Reporting entities may elect to adopt SFAS No. 133 prior to the required implementation date. SFAS No. 133 establishes ac- counting and reporting standards for derivative instruments and hedging activ- ities. DPL has not yet adopted SFAS No. 133 and currently cannot determine the effect that SFAS No. 133 will have on its financial statements.
On January 1, 1999, DPL adopted the EITF consensus EITF 98-10, "Accounting for Contracts Involved in Energy Trading and Risk Management Activities" under which contracts (including derivative financial instruments) entered into in connection with energy trading activities are marked to market, with gains and losses (unrealized and realized) included in earnings. Implementation of EITF 98-10 did not have a material impact on net income. In 1997 and 1998 (prior to implementation of EITF 98-10), certain energy trading transactions were ac- counted for with "hedge accounting," as discussed below.
DPL uses futures, options and swap agreements to hedge firm commitments or anticipated transactions of energy commodities and also creates net open en- ergy commodity positions. Under hedge accounting, a derivative, at its incep- tion and on an ongoing basis, is expected to substantially offset adverse price movements in the firm commitment or anticipated transaction that it is hedging. Gains and losses related to qualifying hedges are deferred and are recognized in operating results when the underlying transaction occurs. If, subsequent to being hedged, underlying transactions are no longer likely to occur or the hedge is no longer effective, the gains or losses on the related derivatives are recognized currently in operating results. Gains and losses from hedges of the cost of energy sold are reflected within the Consolidated Statements of Income as "Electric fuel and
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purchased power" or "Gas purchased," as appropriate for the hedged transac- tion. Gains and losses on hedges of the selling price of generated electricity are recognized in revenues.
Premiums paid for options are included as current assets in the Consolidated Balance Sheet until they are exercised or expire. Margin requirements for futures contracts are also recorded as current assets. Under hedge accounting, unrealized gains and losses on all futures contracts are deferred on the Con- solidated Balance Sheet as either current assets or deferred credits.
The cash flows from derivatives are included in the cash flows from opera- tions section of the cash flow statement.
Depreciation Expense
The annual provision for depreciation on utility property is computed on the straight-line basis using composite rates by classes of depreciable property. Accumulated depreciation includes the cost of depreciable property retired, including removal costs less salvage and other recoveries. The relationship of the annual provision for depreciation for financial accounting purposes to av- erage depreciable property was 3.5% for 1999, 3.6% for 1998, and 3.7% for 1997. Depreciation expense includes a provision for DPL's share of the esti- mated cost of decommissioning nuclear power plant reactors based on amounts billed to customers for such costs. Refer to Note 12 to the Consolidated Fi- nancial Statements for additional information on nuclear decommissioning.
Nonutility property is generally depreciated on a straight-line basis over the useful lives of the assets.
Income Taxes
The consolidated financial statements include two categories of income tax- es--current and deferred. Current income taxes represent the amounts of tax expected to be reported on DPL's federal and state income tax returns. De- ferred income taxes are discussed below.
Deferred income tax assets and liabilities represent the tax effects of tem- porary differences between the financial statement and tax bases of existing assets and liabilities and are measured using presently enacted tax rates. The portion of DPL's deferred tax liability applicable to its utility operations that has not been recovered from utility customers represents income taxes re- coverable in the future and is shown on the Consolidated Balance Sheets as "Deferred recoverable income taxes." Deferred recoverable income taxes de- creased to $72.0 million as of December 31, 1999, from $82.2 million as of De- cember 31, 1998, primarily due to deregulation of the electricity supply busi- nesses of DPL in 1999.
Deferred income tax expense generally represents the net change during the reporting period in the net deferred tax liability and deferred recoverable income taxes.
Investment tax credits from utility plant purchased in prior years are re- ported on the Consolidated Balance Sheets as "Deferred investment tax cred- its." These investment tax credits are being amortized to income over the use- ful lives of the related utility plant.
Deferred Debt Refinancing Costs
Prior to the third quarter of 1999, the costs of refinancing debt of the utility businesses of DPL were deferred and amortized over the period during which the costs are recovered in rates, which is generally the life of the new debt. In the third quarter of 1999, the deferred costs associated with previ- ously refinanced debt attributed to DPL's electric generation businesses were written-off and charged to earnings, net of anticipated rate recovery. Any costs incurred in the future for refinancing debt attributed to the electric generation business for which rate recovery is not provided will be accounted for in accordance with SFAS No. 4, "Reporting Gains and Losses from Extin- guishment of Debt," which requires such costs to be expensed.
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Interest Expense
The amortization of debt discount, premium, and expense, including deferred refinancing expenses associated with the regulated electric and gas transmis- sion and distribution businesses, is included in interest expense.
Utility Plant
As discussed in Note 6 to the Consolidated Financial Statements, utility plant which became impaired as a result of deregulation of the electric util- ity industry is stated at fair value. The estimated fair values were based on amounts included in agreements for the sale of certain electric generating plants of DPL. Utility plant which is not impaired is stated at original cost.
Utility plant is generally subject to a first mortgage lien.
Allowance for Funds Used During Construction
Allowance for Funds Used During Construction (AFUDC) is included in the cost of regulated transmission and distribution utility plant and represents the cost of borrowed and equity funds used to finance construction. In the Consol- idated Statements of Income, the borrowed funds component of AFUDC is reported as a reduction of interest expense and the equity funds component of AFUDC is reported as other income. AFUDC was capitalized on utility plant construction at the rates of 8.8% in 1999, 8.9% in 1998, and 7.5% in 1997.
Effective in the third quarter of 1999, the cost of financing the construc- tion of electric generation plant is capitalized in accordance with SFAS No. 34, "Capitalization of Interest Cost."
Cash Equivalents
In the consolidated financial statements, DPL considers highly liquid mar- ketable securities and debt instruments purchased with a maturity of three months or less to be cash equivalents.
Goodwill
DPL amortizes goodwill arising from business acquisitions over the shorter of the estimated useful life or 40 years.
Funds Held By Trustee
Funds held by trustee are stated at fair market value and primarily include deposits in DPL's external nuclear decommissioning trusts. Changes in the fair market value of the trust funds are also reflected in the accrued liability for nuclear decommissioning which is included in accumulated depreciation.
NOTE 2. SUPPLEMENTAL CASH FLOW INFORMATION
Cash Paid During the Year
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NOTE 3. INCOME TAXES
DPL, as a subsidiary of Conectiv, is included in the consolidated federal income tax return of Conectiv. Income taxes are allocated to DPL based upon the taxable income or loss, determined on a separate return basis.
Components of Consolidated Income Tax Expense
Reconciliation of Effective Income Tax Rate
The amount computed by multiplying "Income before income taxes and extraor- dinary item" by the federal statutory rate is reconciled below to income tax expense on operations (which excludes amounts applicable to the extraordinary item).
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Components of Deferred Income Taxes
The tax effects of temporary differences that give rise to DPL's net de- ferred tax liability are shown below.
Valuation allowances for deferred tax assets were not material as of Decem- ber 31, 1999 and 1998.
NOTE 4. MERGER
On March 1, 1998, DPL and ACE became wholly-owned subsidiaries of Conectiv. Before the Merger, Atlantic owned ACE, an electric utility serving the south- ern one-third of New Jersey, and nonutility subsidiaries. As a result of the Merger, Atlantic ceased to exist, and Conectiv owns (directly or indirectly) DPL, ACE, and the nonutility subsidiaries that were formerly held separately by DPL and Atlantic. Conectiv is a registered holding company under the Public Utility Holding Company Act of 1935 (PUHCA).
In connection with the Merger, each outstanding share of DPL's common stock, par value $2.25 per share, was exchanged for one share of Conectiv's common stock, par value $0.01 per share. Also, DPL's Board of Directors declared that DPL's nonutility subsidiaries be transferred to Conectiv. These nonutility subsidiaries had common stockholder's equity of $123.4 million as of February 28, 1998 and net losses of $3.5 million for January 1 to February 28, 1998.
NOTE 5. SPECIAL CHARGES
DPL's operating results for 1999 include "Special charges" of $10.5 million before taxes ($6.4 million after taxes) primarily for costs of employee sepa- rations and certain other non-recurring items. Including the cost of employees allocated to DPL from Conectiv's service subsidiary, 95 employee separations were accrued for, 48 of which had occurred by December 31, 1999.
DPL's operating results for 1998 include "Special charges" of $27.4 million before taxes ($16.6 million after taxes) for the cost of DPL employee separa- tions associated with the Merger-related workforce reduction and other Merger- related costs. The $27.4 million pre-tax charge includes a net $45.5 million gain from curtailments and settlements of pension and other postretirement benefits.
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NOTE 6. EXTRAORDINARY ITEM
As discussed in Note 1 to the Consolidated Financial Statements, as of a re- sult of electric utility industry restructuring orders received in 1999, DPL discontinued applying SFAS No. 71 to its electricity supply businesses and ap- plied the requirements of SFAS No. 101 and EITF 97-4. Pursuant to the require- ments of SFAS No. 101 and EITF 97-4, DPL recorded an extraordinary charge which reduced earnings by $253.6 million, net of income taxes. The portion of the extraordinary charge related to impaired assets was determined in accor- dance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of" (SFAS No. 121). The extraordinary charge primarily resulted from impaired nuclear electric generating plants and certain other assets, uneconomic energy contracts, and other effects of dereg- ulation requiring loss recognition. The impairment amount for nuclear electric generating plants was determined based on expected proceeds under agreements for the sale of the nuclear electric generating plants, which is discussed in Note 11 to the Consolidated Financial Statements. The extraordinary charge was decreased by the regulatory asset established for the amount of stranded costs expected to be recovered through regulated electricity delivery rates.
The details of the extraordinary charge are shown in the following table.
NOTE 7. SALE OF PINE GROVE LANDFILL AND WASTE HAULING COMPANY
In the fourth quarter 1997, a subsidiary of DPL sold the Pine Grove Landfill and a related waste-hauling company. Pre-tax proceeds received from the sale were $34.2 million ($33.4 million net of cash sold), resulting in a pre-tax gain of $22.9 million ($13.7 million after income taxes).
NOTE 8. RATE MATTERS
Delaware Electric Utility Industry Restructuring
On March 31, 1999, Delaware enacted the Electric Utility Restructuring Act of 1999 (the Delaware Act), which provided for a phase-in of retail customer choice of electricity suppliers from October 1999 to October 2000, customer rate decreases, and other matters concerning restructuring the electric util- ity industry in Delaware. On April 15, 1999, DPL submitted to the DPSC a com- pliance plan for implementing the provisions of the Delaware Act in DPL's Del- aware service area. On August 31, 1999, the DPSC issued an order on DPL's com- pliance plan. The DPSC's order is discussed below.
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Implementation Dates
The DPSC approved implementation dates for retail customer choice of elec- tric suppliers of October 1, 1999 for customers with a peak monthly load of 1,000 kilowatts (kW) or more; January 15, 2000 for customers with a peak monthly load of 300 kW or more; and October 1, 2000 for all other customers.
Rate Decrease
The DPSC approved DPL's proposed rate structure, which provides for a 7.5% decrease in DPL's Delaware residential electric rates, effective October 1, 1999, with those rates held constant from October 1, 1999 to September 30, 2003. Also, non-residential rates are to be held constant from October 1, 1999 to September 30, 2002. Management estimates that the initial 7.5% residential rate reduction effective October 1, 1999, will reduce revenues by approxi- mately $17.5 million (on an annualized basis, assuming fiscal year 1998 sales and revenues).
Sale of Electric Generating Plants
The Delaware Act permits DPL to sell, transfer, or otherwise divest its electric generating plants without DPSC approval after October 1, 1999. The DPSC's order effectively provides that electric rates will remain unchanged as a result of such divestiture. See Note 11 to the Consolidated Financial State- ments for related information concerning the expected sales of electric gener- ating plants.
Stranded Cost Recovery
The rate structure approved by the DPSC also provides for DPL's recovery of stranded costs, $16 million net of taxes, or $31 million before taxes, through a Competitive Transition Charge billed to non-residential customers from Octo- ber 1, 1999 to September 30, 2002.
Shopping Credits
The system-average customer shopping credits, which include the costs of electricity supply, transmission, and ancillary services, are 4.736 cents per kWh for the year beginning October 1, 1999, 4.738 cents per kWh for the year beginning October 1, 2000, and 4.740 cents per kWh for the year beginning Oc- tober 1, 2001.
Default Service for Electricity Supply
The Delaware Act makes DPL the provider of default service to customers who do not choose an alternative electricity supplier for periods of 3 and 4 years (transition periods) for non-residential and residential customers, respec- tively. Thereafter, the DPSC may conduct a bidding process to select the de- fault supplier for such customers. During the transition period, the energy component of customers' rates for default service will be set at DPL's average energy cost per kWh for the twelve months ended September 30, 1999.
The DPSC order permits customers with demand below 300 kW to choose an al- ternative electric supplier and to switch back to DPL's default service with- out any time restrictions or price differential. Customers with demand above 300 kW who choose an alternative supplier and switch back to DPL's default service must either, at the customer's option, return to DPL's default service for a minimum of 12 months or pay market prices.
Code of Conduct
The DPSC ruled that the existing Code of Conduct will remain in place, con- ditioned upon the requirement that a revised code be proposed and, if neces- sary, litigated. As requested by the DPSC, DPL filed a new Cost Accounting Manual and Code of Conduct in November 1999.
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Maryland Electric Utility Industry Restructuring
On April 8, 1999, Maryland enacted the Electric Customer Choice and Competi- tion Act of 1999 (the Maryland Act), which provided for customer choice of electricity suppliers, customer rate decreases, and other matters concerning restructuring the electric utility industry in Maryland. On May 5, 1999, DPL submitted to the MPSC a proposed settlement agreement (subsequently supple- mented) for implementing the provisions of the Maryland Act in DPL's Maryland service area. On October 8, 1999, the MPSC issued an order to DPL which ap- proved the settlement agreement. The key elements of the approved settlement agreement are discussed below.
Implementation Date
Effective July 1, 2000, all of DPL's Maryland-retail customers will be eli- gible to select an alternative electricity supplier.
Rate Decrease
The MPSC approved a 7.5% decrease in DPL's Maryland residential electric rates, effective July 1, 2000, with those rates held constant from July 1, 2000 to June 30, 2004. Also, non-residential rates are to be held constant from July 1, 2000 to June 30, 2003. Management estimates that the initial 7.5% residential rate reduction effective July 1, 2000, will reduce revenues by ap- proximately $12.5 million (on an annualized basis, assuming fiscal year 1998 sales and revenues).
Sale of Electric Generating Plants
The Maryland Act in conjunction with the approved settlement effectively provide that electric rates will not be changed in the event DPL sells or transfers generating assets. See Note 11 to the Consolidated Financial State- ments for related information concerning the expected sales of electric gener- ating plants.
Stranded Cost Recovery
The MPSC approved DPL's recovery of stranded costs, $8 million net of taxes, or $14 million before taxes, through a Competitive Transition Charge billed to non-residential customers from July 1, 2000 to June 30, 2003.
Shopping Credits
The system-average customer shopping credits include the costs of electric- ity supply, transmission, and ancillary services. They are estimated to be ap- proximately 5.302 cents per kWh for the year beginning July 1, 2000, 5.305 cents per kWh for the year beginning July 1, 2001, and 5.307 cents per kWh for the year beginning July 1, 2002. These estimated shopping credits will be re- set so that the energy component is DPL's average energy cost per kWh for the twelve months ended April 30, 2000.
Default Service for Electricity Supply
DPL is to provide default service to customers who do not choose an alterna- tive electricity supplier during July 1, 2000 to July 1, 2004 for residential customers and during July 1, 2000 to July 1, 2003 for non-residential custom- ers. Subsequent to these default service periods, the MPSC is to determine the default service supplier. During the initial periods when DPL provides default service, the energy component of customers rates will be set at DPL's average energy cost per kWh for the twelve months ended April 30, 2000.
Code of Conduct
On July 26, 1999, the MPSC initiated a new review of the generic affiliate transaction provisions of the Maryland Act. Subsequently, the MPSC conducted hearings and is expected to issue an order within several months.
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Virginia Electric Utility Industry Restructuring
On March 29, 1999, the Governor of Virginia signed the Virginia Electric Utility Restructuring Act (the Virginia Act). In 1999, revenues from DPL's Virginia customers comprised about 2.6% of consolidated DPL electric revenues earned from regulated electricity sales and deliveries. Significant provisions of the Virginia Act are as follows:
(a) A phase-in of retail electric competition is to start on January 1, 2002.
(b) The rates in effect on January 1, 2001 are to become "capped rates," which continue in effect through July 1, 2007, except for adjustments for changes in fuel costs and state tax rates.
(c) A customer who chooses an alternative electricity supplier would pay the incumbent utility the capped transmission and distribution rates and a "wires" charge, representing the difference between the capped generation rate and projected market prices for electricity.
(d) Just and reasonable net stranded costs are to be recovered through capped rates and wires charges during the period January 1, 2001 through July 1, 2007.
Pursuant to the requirements of the Virginia Act, DPL filed in January 2000 an application for approval of a plan for functional separation of electric generation from transmission and distribution by divestiture. The plan in- volves complete divestiture by the third quarter of 2000 of DPL's generation facilities, some of which would be sold to unaffiliated parties and the re- mainder of which are proposed to be transferred to a Conectiv subsidiary. By the completion of the divestiture, DPL proposes an overall revenue decrease of 2.6% (approximately $0.7 million on an annual basis). DPL also indicated in its application that it expects to propose starting retail choice on or after January 1, 2002 for all of its Virginia retail customers, instead of a phase- in of retail choice.
Merger Rate Decrease
In accordance with the terms included in regulatory commissions orders which approved the Merger, DPL phased-in a $13.0 million reduction in electric and gas retail customer base rates as follows: (1) $11.5 million effective March 1, 1998, (2) $1.1 million effective March 1, 1999, and (3) $0.4 million effec- tive October 1, 1999.
NOTE 9. ENERGY HEDGING AND TRADING ACTIVITIES
DPL actively participates in the wholesale energy markets to support its wholesale utility and competitive retail marketing activities. DPL engages in commodity hedging activities to minimize the risk of market fluctuations asso- ciated with the purchase and sale of electricity and natural gas. Some hedging activities are conducted using energy derivatives. The remainder of DPL's hedging activity is conducted by backing physical transactions with offsetting physical positions. The hedging objectives include the assurance of stable and known minimum cash flows and the fixing of favorable prices and margins when they become available. DPL also engages in energy commodity trading and arbi- trage activities, which expose DPL to commodity market risk when, at times, DPL creates net open energy commodity positions or allows net open positions to continue. To the extent that DPL has net open positions, controls are in place that are intended to keep risk exposures within management-approved risk tolerance levels.
DPL utilizes futures, options and swap agreements to manage risk. Futures help manage commodity price risk by fixing purchase or sales prices. Options provide a floor or ceiling on future purchases or sales prices while allowing DPL to benefit from favorable price movements. Swaps are structured to provide the same risk protection as futures and options. Basis swaps are used to man- age risk by fixing the basis differential that exists between a delivery loca- tion index and the commodity futures price.
Exposed commodity positions may be "long" or "short." A long position indi- cates that DPL has an excess of the commodity available for sale. A short po- sition means DPL will have to obtain additional commodity to fulfill its sales requirements. A "delta" position is the conversion of an option into futures contract equivalents. The option delta is dependent upon the strike price, volatility, current market price and time-value of the option.
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Counterparties to its various hedging and trading contracts expose DPL to credit losses in the event of nonperformance. Management has evaluated such risk and implemented credit checks and has established reserves for credit losses. A large portion of the hedging and trading activities are conducted on national exchanges backed by exchange clearinghouses. Management believes that the overall business risk is minimized as a result of these procedures.
Natural Gas Activities
At December 31, 1999, DPL's open futures contracts represented a net long position with a notional quantity of 8.5 billion cubic feet (Bcf), through March 2002. DPL also had a net long commodity swap position at December 31, 1999 equivalent to 1.2 Bcf and a net short basis swaps position equivalent to 0.2 Bcf. At December 31, 1998, DPL's open futures contracts represented a net long position with a notional quantity of 13.1 Bcf, through February 2001. DPL also had a net long commodity swap position at December 31, 1998 equivalent to 4.6 Bcf and a net long basis swaps position equivalent to 5.3 Bcf.
During 1999, a gain of $5.0 million, including a $3.0 million unrealized gain, was recognized for gas trading positions (physical and financial com- bined). In 1999, the annual average unrealized gain on trading activities was $2.1 million. During 1998, recognized and unrealized gains from gas trading positions were not material to DPL's results of operations or financial posi- tion.
Unrealized hedging losses of $7.6 million and $8.6 million as of December 31, 1999 and 1998, respectively, from natural gas futures, swaps and options contracts used to hedge gas marketing activities are deferred in the Consoli- dated Balance Sheets. These losses are offset by gains on the physical commod- ity transactions being hedged.
Electricity Marketing and Trading Activities
At December 31, 1999, DPL had a net long exposure of 219,900 megawatt-hours (MWH) through December 2000 primarily from forward contracts. At December 31, 1998, DPL had a net short exposure of 102,400 MWH through December 1999 pri- marily from forward contracts.
During 1999, a gain of $6.0 million, including a $1.3 million unrealized gain, was recognized for electricity trading activities (physical and finan- cial combined). During 1998, a gain of $11.4 million, including a $1.2 million unrealized gain, was recognized for electricity trading activities (physical and financial combined). The annual average unrealized gain on electricity trading activities was $0.1 million in 1999 and $1.3 million in 1998.
The deferred gains and losses from hedges of electricity marketing activi- ties were not material to DPL's financial position as of December 31, 1999 and December 31, 1998.
Electricity Generation Activities
Effective October 1, 1999, the Delaware portion (approximately 59%) of DPL's electric generating plants was deregulated and the plants' output may, at DPL's option, be sold in deregulated markets or used to supply default service customers in Delaware. Similarly, effective July 1, 2000, the Maryland portion (approximately 30%) of DPL's electric generating plants is deregulated and the plants' output may, at DPL's option, be sold in deregulated markets or used to supply default service customers in Maryland.
DPL hedges the newly deregulated portion of its electric generating units using derivative financial instruments and forward contracts. DPL hedges por- tions of the fuel purchased and the electricity output of the generating plants to stabilize fuel costs and to lock-in prices for electricity generat- ed. As of December 31, 1999, DPL hedged 3,353,500 MWH of forward generation output, through the sale of forward contracts, which resulted in a $10.3 mil- lion unrealized and unrecognized gain as of December 31, 1999. A net unrealized loss of $4.1
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million which resulted from hedging the cost of gas burned by electric gener- ating units was deferred in the Consolidated Balance Sheet as of December 31, 1999. This hedge consisted of a long position of natural gas futures, forwards and swaps with a combined notional amount of 12.9 Bcf.
NOTE 10. JOINTLY OWNED PLANT
DPL's Consolidated Balance Sheets include its proportionate share of assets and liabilities related to jointly owned plant. DPL has ownership interests in electric power plants, transmission facilities, and other facilities in which various parties have ownership interests. DPL's proportionate shares of oper- ating and maintenance expenses of the jointly owned plant is included in the corresponding expenses in DPL's Consolidated Statements of Income. DPL is re- sponsible for providing its share of financing for the jointly owned facili- ties.
DPL owns 7.41% of Salem. Salem Units 1 and 2 were removed from operation by Public Service Electric & Gas Company (PSE&G), the Salem operator, in the sec- ond quarter of 1995 due to operational problems and safety concerns. PSE&G re- turned Unit 2 to service in August 1997, and Unit 1 to service in April 1998. The net increase in expenses due to unrecovered replacement power and other costs, net of the benefit of lawsuit settlement proceeds received in 1997, was $2.4 million in 1998 and $7.1 million in 1997.
Information is shown below with respect to DPL's share of jointly owned plants as of December 31, 1999, including megawatts (MW) of generating capaci- ty. The amounts for the nuclear plants reflect the write-downs which resulted from discontinuing application of SFAS No. 71 as discussed in Note 6 to the Consolidated Financial Statements.
As discussed in Note 11 to the Consolidated Financial Statements, agreements have been reached to sell to third parties the jointly-owned nuclear and coal- fired plants listed below
- -------- (a) Excludes nuclear decommissioning reserve. (b) Includes 3 megawatts for on-site combustion turbine.
NOTE 11. SUBSEQUENT EVENT--EXPECTED DIVESTITURE OF ELECTRIC GENERATING PLANTS
In 1999, DPL distributed offering memoranda for the proposed sale of certain of its nuclear and non-strategic baseload fossil electric generating plants. The plants are being sold pursuant to Conectiv's "mid-merit" strategy which is discussed in the "Deregulated Generation and Power Plant Divestiture" section of Management's Discussion and Analysis of Financial Condition and Results of Operations. The electric generating plants of DPL which are not sold are ex- pected to be transferred to other Conectiv subsidiaries, which will produce and sell electricity and assume the non-regulated electricity and gas trading activities currently conducted by DPL. DPL's exit from the businesses of elec- tricity production and non-regulated electricity and gas trading is expected
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to cause a decrease in DPL's earnings capacity. For information concerning non-regulated electricity and gas trading activities see Note 9 to the Consol- idated Financial Statements. For pro forma information concerning the divesti- ture of DPL's electric generating plants, see Exhibit 99 to this Report on Form 10-K.
A summary of the electric generating plants that have been offered for sale by DPL is shown in the following table.
- -------- (a) The net book values shown above are as of December 31, 1999, are stated in millions of dollars, and reflect the write-downs discussed in Note 6 to the Consolidated Financial Statements.
In the third quarter of 1999, DPL reached agreements to sell its ownership interests in various nuclear plants to PSEG Power LLC (a subsidiary of Public Service Enterprise Group Incorporated) and PECO Energy Company (PECO) for ap- proximately $9 million, plus the net book value of DPL's interest in nuclear fuel on-hand as of the closing date. DPL's interest in the nuclear units which are being sold include a 7.51% (164 MW) interest in the Peach Bottom Atomic Power Station (Peach Bottom), and a 7.41% interest (167 MW) in the Salem Nu- clear Generating Station (Salem). Upon completion of the sale, DPL will trans- fer its nuclear decommissioning trust funds to the purchasers and PSEG Power LLC and PECO will assume full responsibility for the decommissioning of Peach Bottom and Salem. The sales are subject to various federal and state regula- tory approvals and are expected to close by the third quarter of 2000.
On January 19, 2000, Conectiv announced that DPL reached an agreement to sell the wholly- and jointly-owned fossil fuel-fired units listed in the above table. The units have a total capacity of 1,080.8 MW and a net book value of $309.1 million as of December 31, 1999. NRG Energy, Inc., a subsidiary of Northern States Power Company, agreed to purchase the units for approximately $622 million. The sale is subject to various federal and state regulatory ap- provals and is expected to be completed during the third quarter of 2000.
Conectiv's management expects that the proceeds from the sale of the elec- tric generating plants will be used for debt repayment, repurchases of Conectiv common stock, and new investments that fit with Conectiv's strate- gies, including expansion of the mid-merit generation business. Some or all of DPL's proceeds from the sale of the electric generating plants could be paid as a dividend to Conectiv, or loaned to Conectiv's pool of funds that Conectiv subsidiaries borrow from or invest in, depending on their cash position.
The terms of DPL's agreement with NRG Energy, Inc. provide for DPL to pur- chase from NRG Energy, Inc. 500 megawatt-hours of firm electricity per hour from completion of the sale through December 31, 2005. DPL expects to use electricity purchased under this agreement and other purchased power agree- ments to fulfill its obligations in Delaware and Maryland as a default service provider.
Under the restructuring orders issued by the DPSC and MPSC, as discussed in Note 8 to the Consolidated Financial Statements, DPL's Delaware and Maryland retail electric rates will not be changed in the event DPL sells or transfers generating assets. Management expects to recognize a net gain when DPL sells its electric generating plants which were not impaired from deregulation.
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NOTE 12. NUCLEAR DECOMMISSIONING
DPL records a liability for its share of the estimated cost of decommissioning the Peach Bottom and Salem reactors over the remaining lives of the plants based on amounts collected in rates charged to electric custom- ers. DPL estimates its share of future nuclear decommissioning costs ($98 mil- lion) based on Nuclear Regulatory Commission (NRC) regulations concerning the minimum financial assurance amount for nuclear decommissioning. The ultimate cost of nuclear decommissioning for Peach Bottom and Salem may exceed the cur- rent estimates, which are updated periodically.
DPL's accrued nuclear decommissioning liability, which is reflected in the accumulated reserve for depreciation, was $78.5 million as of December 31, 1999 and $69.5 million as of December 31, 1998. The provision reflected in de- preciation expense for nuclear decommissioning was $3.0 million in 1999, $4.2 million in 1998, and $4.2 million in 1997. External trust funds established by DPL for the purpose of funding nuclear decommissioning costs had an aggregate book balance (stated at fair market value) of $66.4 million as of December 31, 1999 and $57.7 million as of December 31, 1998. Earnings on the trust funds are recorded as an increase to the accrued nuclear decommissioning liability, which, in effect, reduces the expense recorded for nuclear decommissioning. As discussed in Note 11 to the Consolidated Financial Statements, upon completion of the expected sale of the nuclear plants, DPL will transfer its respective nuclear decommissioning trust funds to the purchasers who will then assume full responsibility for the decommissioning of the nuclear plants.
The staff of the Securities and Exchange Commission has questioned certain of the current accounting practices of the electric utility industry, includ- ing DPL, regarding the recognition, measurement and classification of decommissioning costs for nuclear generating stations in the financial state- ments of electric utilities. Recently, the FASB issued an exposure draft of a new accounting pronouncement which addresses the accounting for obligations associated with the retirement of long-lived assets, such as decommissioning costs of nuclear generating stations. Under this proposed pronouncement, the present value of the decommissioning obligation would be capitalized as part of the cost of the nuclear generating station and recorded as a liability. The cost capitalized would be depreciated over the life of the nuclear generating station. Changes in the liability due to the passage of time would be recorded as interest expense. Changes in the liability resulting from revisions in the timing or amount of cash flows would increase or decrease the liability and the carrying amount of the nuclear generating station. Trust fund income from the external decommissioning trusts would be reported as investment income un- der the proposed pronouncement rather than as a reduction of decommissioning expense.
NOTE 13. REGULATORY ASSETS AND LIABILITIES
In conformity with SFAS No. 71, DPL's accounting policies reflect the finan- cial effects of rate regulation and decisions by regulatory commissions having jurisdiction over the regulated utility businesses of DPL. Regulatory commis- sions occasionally provide for future recovery from customers of current pe- riod expenses. When this happens, the expenses are deferred as regulatory as- sets and subsequently recognized in the Consolidated Statement of Income dur- ing the period the expenses are recovered from customers. Similarly, regula- tory liabilities may also be created due to the economic impact of an action taken by a regulatory commission.
As discussed in Notes 1, 6, and 8 to the Consolidated Financial Statements, in the third quarter of 1999, the electricity supply businesses of DPL no longer met the requirements of SFAS No. 71. Accordingly, regulatory assets and liabilities related to the electricity supply business were written off, ex- cept to the extent that future cost recovery was provided for through the reg- ulated electricity delivery business. A new regulatory asset, "Recoverable stranded costs," was established to recognize amounts to be collected from regulated delivery customers for stranded costs which resulted from deregula- tion of the electricity supply business.
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The table below displays the regulatory assets and liabilities as of Decem- ber 31, 1999 and December 31, 1998.
Recoverable Stranded Costs: Represents amounts to be collected from regu- lated delivery customers (net of amounts which have been amortized to expense) for stranded costs which resulted from deregulation of the electricity supply business.
Deferred Recoverable Income Taxes: Represents the portion of deferred income tax liabilities applicable to DPL's utility operations that has not been re- flected in current customer rates for which future recovery is probable. As temporary differences between the financial statement and tax bases of assets reverse, deferred recoverable income taxes are amortized. Due to discontinuing the application of SFAS No. 71 to the electricity supply business, the portion of deferred recoverable income taxes attributable to the electricity supply business of DPL was written off in 1999.
Deferred Debt Refinancing Costs: See "Deferred Debt Refinancing Costs" in Note 1 to the Consolidated Financial Statements.
Deferred Energy Supply Costs: See "Energy Supply Costs" in Note 1 to the Consolidated Financial Statements.
Deferred Costs for Nuclear Decommissioning/Decontamination: This regulatory asset was written off in 1999 due to discontinuing the application of SFAS No. 71 to DPL's electricity supply business.
Deferred Demand-Side Management Costs: Represents deferred costs of programs that allow DPL to reduce the peak demand for power. These costs are being re- covered over 4 years.
NOTE 14. COMMON STOCKHOLDER'S EQUITY
The public holders of DPL's common stock prior to the Merger exchanged each share of DPL's common stock for one share of Conectiv common stock. Effective with the Merger, Conectiv owns all 1,000 outstanding shares of DPL's common stock ($2.25 par value per share). See Note 4 to the Consolidated Financial Statements for additional information concerning the Merger. Also see the Statement of Changes in Common Stockholder's Equity for information about changes in common stock during 1999, 1998, and 1997.
DPL's certificate of incorporation requires payment of all preferred divi- dends in arrears (if any) prior to payment of common dividends to Conectiv, and has certain other limitations on the payment of common dividends.
As a subsidiary of a registered holding company under PUHCA, DPL can pay dividends only to the extent of its retained earnings unless SEC approval is obtained.
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NOTE 15. PREFERRED STOCK AND PREFERRED SECURITIES OF A SUBSIDIARY TRUST
DPL has $1, $25, and $100 par value per share preferred stock for which 10,000,000, 3,000,000, and 1,800,000 shares are authorized, respectively. Div- idends on DPL preferred stock are cumulative. No shares of the $1 par value per share preferred stock are outstanding. Shares outstanding for each series of the $25 and $100 par value per share preferred stock are listed below under "Preferred Stock Not Subject to Mandatory Redemption."
Preferred Stock Not Subject to Mandatory Redemption
- -------- (1) Redeemable beginning September 30, 2002, at $25 per share. (2) Redeemable beginning November 1, 2003, at $100 per share. (3) Average dividend rates were 5.5 % during 1999 and 1998. (4) Average dividend rates were 4.3 % during 1999 and 4.2% during 1998.
Preferred Securities of Subsidiary Trust Subject to Mandatory Redemption
DPL has established a wholly-owned subsidiary trust for the purposes of is- suing common and preferred trust securities and holding Junior Subordinated Debentures (the Debentures) issued by DPL. The trust's only assets are the De- bentures it holds. The trust uses interest payments received on the Debentures it holds to make cash distributions on the trust securities. As of December 31, 1999 and 1998, the trust had $70 million of 8.125% Cumulative Trust Pre- ferred Capital Securities outstanding, representing 2,800,000 trust preferred securities with a stated liquidation value of $25 per security.
DPL's obligations pursuant to the Debentures and guarantees of distributions with respect to the trust's preferred securities, to the extent the trust has funds available therefor, constitute full and unconditional guarantees of the obligations of the trust under the trust preferred securities the trust has issued. DPL owns all of the common securities of the trust, which constitute approximately 3% of the liquidation amount of the securities issued by the trust.
For consolidated financial reporting purposes, the Debentures are eliminated in consolidation against the trust's investment in the Debentures. The trust preferred securities are subject to mandatory redemption upon payment of the Debentures at maturity or upon redemption. The Debentures mature in 2036. The Debentures are subject to redemption, in whole or in part, at the option of DPL, at 100% of their principal amount plus accrued interest, after an initial period during which they may not be redeemed and at any time upon the occur- rence of certain events.
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NOTE 16. DEBT
Substantially all utility property of DPL is subject to the liens of the Mortgages collateralizing DPL's First Mortgage Bonds.
Maturities of long-term debt and sinking fund requirements during the next five years are as follows: 2000--$1.5 million; 2001--$2.3 million; 2002--$48.1 million; 2003--$92.3 million; 2004 $37.7 million.
In May 1999, DPL repaid at maturity $30 million of 7.50% Medium Term Notes. In July 1999, the Delaware Economic Development Authority issued, on behalf of DPL, $33.33 million of Variable Rate Demand Bonds (VRDB) due on demand or at maturity in July 2024. The proceeds from the VRDB were used to refinance $22.33 million of 7.3% long-term debt in September 1999 and $11.0 million of 7.5% long-term debt in October 1999.
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Long-term debt outstanding as of December 31, 1999 and 1998 is presented be- low.
- -------- (1) The debt obligations of DPL included Variable Rate Demand Bonds (VRDB) in the amounts of $104.8 million and $71.5 million as of December 31, 1999 and 1998, respectively. The VRDB are classified as current liabilities be- cause the VRDB are due on demand by the bondholder. However, bonds submit- ted to DPL for purchase are remarketed by a remarketing agent on a best efforts basis. Management expects that bonds submitted for purchase will continue to be remarketed successfully due to the credit worthiness of DPL and the bonds' interest rates being set at market. DPL also may utilize one of the fixed rate/fixed term conversion options of the bonds. Thus, management considers the VRDB to be a source of long-term financing. The $104.8 million balance of VRDB outstanding as of December 31, 1999, ma- tures in 2017 ($26.0 million), 2024 ($33.33 million); 2028 ($15.5 million) and 2029 ($30.0 million). Average annual interest rates on the VRDB were 3.5% in 1999 and 3.5% in 1998.
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NOTE 17. FAIR VALUE OF FINANCIAL INSTRUMENTS
The year-end fair values of certain financial instruments are listed below. The fair values were based on quoted market prices of DPL's securities or se- curities with similar characteristics.
NOTE 18. LONG-TERM PURCHASED POWER CONTRACTS
As of December 31, 1999, DPL's commitments under long-term purchased power contracts included 243 MW of capacity; and 100 MWH of firm electricity per hour. Historical information for power purchased under long-term contracts is presented below.
Based on existing contracts as of December 31, 1999, DPL's future commit- ments for capacity and energy under long-term purchased power contracts are estimated to be $81.5 million in 2000; $84.4 million in 2001; $87.2 million in 2002; $90.1 million in 2003; and $93.2 million in 2004.
The terms of DPL's power plant sale agreement discussed in Note 11 to the Consolidated Financial Statements provides for DPL to purchase from NRG Ener- gy, Inc. 500 megawatt-hours of firm electricity per hour from completion of the sale through December 31, 2005. DPL expects to use electricity purchased under this agreement and other purchased power agreements to fulfill its obli- gations in Delaware and Maryland as a default service provider. Recently, DPL entered into an agreement to purchase 350 MW of capacity and energy from PECO from March 2000 to February 2003. These planned power purchases are excluded from the commitments discussed above.
NOTE 19. LEASES
Nuclear Fuel
The ownership interests of DPL in nuclear fuel at Peach Bottom and Salem are financed through nuclear fuel energy contracts, which are accounted for as capital leases. Payments under the contracts are based on the quantity of nu- clear fuel burned by the plants. The obligation of DPL under the contracts is generally the net book value of the nuclear fuel financed, which was $25.6 million, in total, as of December 31, 1999. As discussed in Note 11 to the Consolidated Financial Statements, under sales agreements for the nuclear power plants which are pending completion, the nuclear fuel is to be sold at its net book value, in conjunction with the sale of the plants.
Lease Commitments
DPL leases an 11.9% interest in the Merrill Creek Reservoir. The lease is an operating lease and payments over the remaining lease term, which ends in 2032, are $167.6 million in aggregate. As discussed in Note 6 to
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the Consolidated Financial Statements, the net present value of water-supply capacity from the Merrill Creek Reservoir in excess of the requirements of DPL's electric generating plants was included in the extraordinary item in the third quarter of 1999. DPL also has long-term leases for certain other facili- ties and equipment. Minimum commitments as of December 31, 1999, under the Merrill Creek Reservoir lease and other lease agreements (excluding payments under the nuclear fuel energy contracts, which cannot be reasonably estimated) are as follows: 2000--$11.5 million; 2001--$11.5 million; 2002--$11.5 million; 2003--$13.6 million; 2004--$11.0 million; beyond 2004--$154.6 million; total-- $213.7 million. Approximately 78% of the minimum lease commitments shown above are payments due under the Merrill Creek Reservoir lease.
Rentals Charged To Operating Expenses
The following amounts were charged to operating expenses for rental payments under both capital and operating leases.
NOTE 20. PENSION AND OTHER POSTRETIREMENT BENEFITS
The employees of DPL and other Conectiv subsidiaries are provided pension benefits and other postretirement benefits under Conectiv benefit plans. The amounts shown below are for the benefit plans of Conectiv and include amounts for all covered employees of the Conectiv subsidiaries which elect to partici- pate in the benefit plans.
Assumptions
The health-care cost trend rate, or the expected rate of increase in health- care costs, is assumed to gradually decrease to 5.0% by 2002. Increasing the health-care cost trend rates of future years by one percentage point would in- crease Conectiv's total accumulated postretirement benefit obligation by $15.9 million and would increase Conectiv's total annual aggregate service and in- terest costs by $1.8 million. Decreasing the health-care cost trend rates of future years by one percentage point would decrease Conectiv's total accumu- lated postretirement benefit obligation by $14.0 million and would decrease Conectiv's total annual aggregate service and interest costs by $1.6 million.
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The following schedules reconcile the beginning and ending balances of the pension and other postretirement benefit obligations and related plan assets for Conectiv. Other postretirement benefits include medical benefits for re- tirees and their spouses and retiree life insurance.
Change in Conectiv's Benefit Obligation
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Based on fair values as of December 31, 1999, Conectiv's pension plan assets were comprised of publicly traded equity securities ($723.5 million or 71.1%) and fixed income obligations ($294.3 million or 28.9%). Based on fair values as of December 31, 1999, Conectiv's other postretirement benefit plan assets included equity securities ($74.8 million or 62.3%) and fixed income obliga- tions ($45.3 million or 37.3%).
Components of Conectiv's Net Periodic Benefit Cost
The special termination benefits and curtailment and settlement gains and losses shown above for 1998 resulted from Merger-related employee separation programs primarily for DPL and ACE employees. The costs of pension benefits and other postretirement benefits included in DPL's 1998 results of operations include a $4.2 million credit and a $7.9 million charge, respectively, for the net effects of the special termination benefits and curtailment and settlement gains and losses attributed to DPL's employees.
Conectiv also maintains 401(k) savings plans for covered employees. Conectiv contributes to the plan, in the form of Conectiv stock, at varying levels up to $0.50 for each dollar contributed by employees, up to 6% of employee base pay. The amount expensed for DPL's share of the 401(k) savings plan was $1.4 million in 1999, $2.7 million in 1998, and $3.0 million in 1997.
NOTE 21. COMMITMENTS AND CONTINGENCIES
Commitments
DPL's expected capital expenditures are estimated to be approximately $110 million to $120 million in 2000.
See Note 18 to the Consolidated Financial Statements for commitments related to long-term purchased power contracts and Note 19 to the Consolidated Finan- cial Statements for commitments related to leases.
Environmental Matters
DPL is subject to regulation with respect to the environmental effect of its operations, including air and water quality control, solid and hazardous waste disposal, and limitation on land use by various federal, regional,
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state, and local authorities. Costs may be incurred to clean up facilities found to be contaminated due to past disposal practices. Federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or uncontrolled hazardous waste sites. DPL is cur- rently a potentially responsible party at three federal superfund sites. At one of these sites, DPL has resolved its liability for clean up costs through a de minimis settlement with the government. At this site, DPL may be liable for a claim by the state or federal government for natural resource damages. DPL also is alleged to be a third-party contributor at three other federal superfund sites. DPL also has two former coal gasification sites in Delaware and one former coal gasification site in Maryland, each of which is a state superfund site. Also, the Delaware Department of Natural Resources and Envi- ronmental Control notified DPL in 1998 that it is a potentially responsible party liable for clean-up of the Wilmington Public Works Yard as a former owner of the property.
In December 1999, DPL discovered an oil leak at the Indian River power plant. DPL took action to determine the source of the leak and cap it, contain the oil to minimize impact to a nearby waterway and began recovering oil from the soil. DPL is in the process of determining the extent of the leak, design- ing an oil recovery/remediation system, and estimating the costs to remediate the site. DPL is working together with regulatory agencies and may be subject to monetary penalties. Management cannot predict the outcome of this matter.
There is $2 million included in DPL's current liabilities as of December 31, 1999, and December 31, 1998, for clean-up and other potential costs related to these sites. DPL does not expect such future costs to have a material effect on DPL's financial position or results of operations.
Nuclear Insurance
In conjunction with DPL's ownership interests in Peach Bottom and Salem, DPL could be assessed for a portion of any third-party claims associated with an incident at any commercial nuclear power plant in the United States. Under the provisions of the Price Anderson Act, if third-party claims relating to such an incident exceed $200 million (the amount of primary insurance), they could be assessed up to $26.3 million on an aggregate basis for such third-party claims. In addition, Congress could impose a revenue-raising measure on the nuclear industry to pay such claims.
The co-owners of Peach Bottom and Salem maintain property insurance coverage of approximately $2.8 billion for each unit for loss or damage to the units, including coverage for decontamination expense and premature decommissioning. In addition, DPL is a member of an industry mutual insurance company, which provides replacement power cost coverage in the event of a major accidental outage at a nuclear power plant. Under these coverages, DPL is subject to po- tential retrospective loss experience assessments of up to $3.4 million on an aggregate basis.
NOTE 22. BUSINESS SEGMENTS
Conectiv's organizational structure and management reporting information is aligned with Conectiv's business segments, irrespective of which subsidiary, or subsidiaries, a business is conducted through. Businesses are managed based on lines of business, not based on legal entity. Business segment information is not produced, or reported, on a subsidiary by subsidiary basis. Thus, as a Conectiv subsidiary, no business segment information (as defined by SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information") is available for DPL on a stand-alone basis.
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NOTE 23. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
The quarterly data presented below reflect all adjustments necessary in the opinion of management for a fair presentation of the interim results. Quar- terly data normally vary seasonally because of temperature variations, differ- ences between summer and winter rates, the timing of rate orders, and the scheduled downtime and maintenance of electric generating units.
As discussed in Note 5 to the Consolidated Financial Statements, special charges for the cost of DPL employee separations associated with the Merger- related workforce reduction and other Merger-related costs were recorded in 1998. These special charges caused (1) operating income and net income to de- crease by $40.3 million and $24.4 million, respectively, in the first quarter of 1998, and (2) operating income and net income to increase by $14.3 million and $8.6 million, respectively, in the second quarter of 1998.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
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PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Executives
Information about DPL's executive officers is included under Item 1.
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ITEM. 11 EXECUTIVE COMPENSATION
As previously noted, DPL is a wholly owned electric utility subsidiary of Conectiv. The Chief Executive Officer and the four most highly compensated ex- ecutive officers of Conectiv maintain the same position at both DPL and ACE. In 1999, the salaries and other compensation awarded to the Chief Executive Officer and the four most highly compensated executive officers of DPL were paid by Conectiv for their service as executive officers of Conectiv, DPL and ACE. The following tables show information concerning the total compensation paid or awarded to DPL's Chief Executive Officer and each of the four most highly compensated executive officers for the fiscal year ended December 31, 1999.
Personnel & Compensation Committee Interlocks and Insider Participation
The Personnel & Compensation Committee is comprised solely of non-employee Directors. Logical Business Solutions, which is owned by Mr. Emery's son-in- law, Paul Kleiman, had contracts with Conectiv Resource Partners, Inc., a subsidiary of Conectiv, with a gross value of $239,000 during 1999, for information technology consulting services. There are no other Personnel & Compensation Committee interlocks.
Executive Compensation Table 1--Summary Compensation Table
- -------- (1) The 1998 merger involving Atlantic Energy, Inc. and Delmarva Power & Light Company was effective as of March 1, 1998. Accordingly, except for Mr. van Roden, 1998 salary is shown as an annualized amount. Mr. van Roden joined Conectiv on November 30, 1998 and the 1998 salary shown is his actual sal- ary. Other 1998 items of compensation reflect full calendar 1998 compensa- tion received from Conectiv or Delmarva Power & Light Company. (2) The 1999 bonus, which is an annual variable award, has not yet been deter- mined. The 1999 target award is 50% of salary for Mr. Cosgrove, 45% for Messrs. Elson and Shaw, 40% for Mr. van Roden and Mrs. Graham. For 1998, the dollar value of the bonus reported above has been reduced by the por- tion of the bonus deferred and reported above as a 1999 Restricted Stock Award as follows: H. E. Cosgrove ($300,000 bonus with $150,000 purchasing Restricted Stock Units ("RSU's"); T.S. Shaw ($156,000 bonus with $78,000 purchasing RSU's); B. R. Elson ($130,000 bonus with $52,000 purchasing RSU's); B. S. Graham ($100,400 bonus with $50,200 purchasing RSU's).
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(3) A mandatory 20% of the bonus (reported in this Table as "Variable Compen- sation") and any additional portion of the bonus that an executive elects to defer (up to an additional 30%) is deferred for at least three years under the Management Stock Purchase Program ("MSPP") and used to purchase RSU's at a 20% discount. The dollar value of RSU's deferred under MSPP in 1999 (inclusive of the discounted portion), based on the fair market value at the award date, was: H. E. Cosgrove ($187,500, of which $37,500 is the discount); T.S. Shaw ($97,500, of which $19,500 is the discount); B. R. Elson ($65,000, of which $13,000 is the discount); B. S. Graham ($62,750, of which $12,550 is the discount). In addition, Messrs. Shaw and Elson each received in 1999 an 8,000 share award of Restricted Stock valued at $194,000, based on a fair market value of $24.25 per share of Common Stock on the award date. One-half of the awards to Messrs. Shaw and Elson vest after three years, the balance after four years. Dividends accrue and are paid as the awards vest. The RSU awards do not vest in under three years but do accrue dividends. At the end of 1999, the number and value of the aggregate restricted stock holdings (including RSUs, PARs and special grants) of the individuals identified in the Summary Compensation Table was as follows: for Mr. Cosgrove, 28,298 restricted stock holdings valued at $475,757; for Mr. Shaw, 21,149 restricted stock holdings valued at $445,067; for Mr. Elson, 19,397 restricted stock holdings valued at $385,605; for Mr. van Roden, 3,000 restricted stock holdings valued at $50,438; and, for Mrs. Graham 9,779 restricted stock holdings valued at $164,410. (4) During 1998 all restrictions lapsed on the performance-based restricted stock granted in 1995 and 1996 under the Delmarva LTIP due to the merger involving Delmarva and Atlantic Energy. Under the "change in control" provisions, the awards fully vested resulting in a payout to Mr. Cosgrove of 21,160 shares (11,570 for 1995 and 9,590 for 1996) valued at $454,940; to Mr. Shaw of 5,450 shares (2,870 for 1995 and 2,580 for 1996) valued at $117,175; and to Mrs. Graham of 5,540 shares (2,870 for 1995 and 2,580 for 1996) valued at $117,175. Shares were valued at $21.50 at the time of payout. Dividends on shares of restricted stock and dividend equivalents are accrued at the same rate as that paid to all holders of Common Stock. As of December 31, 1998, Mr. Cosgrove held 45,520 shares of restricted stock (35,520 for 1997 and 10,000 for 1998) and 30,000 Dividend Equivalent Units ("DEU's); Mr. Elson held 4,000 shares of restricted stock for 1998 and 10,000 DEU's; Mr. Shaw held 12,010 shares of restricted stock (8,010 for 1997 and 4,000 for 1998) and 10,000 DEU's; Mrs. Graham held 12,010 shares of restricted stock (8,010 for 1997 and 4,000 for 1998) and 10,000 DEU's. Holders of restricted stock are entitled to receive dividends as declared. (5) "All Other Compensation" includes the following for fiscal year 1999: For Mr. Cosgrove, $3,000 in Company matching contributions to the Savings and Investment Plan, $15,000 in Company matching contributions to the Deferred Compensation Plan and $204 in term life insurance premiums paid by Conectiv. For Mr. Shaw, $3,104 in Company matching contributions to the Savings and Investment Plan, $4,950 in Company matching contribution to the Deferred Compensation Plan and $204 in term life insurance premiums paid by Conectiv. For Mrs. Graham, $4,800 in Company matching contributions to the Savings and Investment Plan, $2,500 in Company matching contributions to the Deferred Compensation Plan and $204 in term life insurance premiums paid by Conectiv. For Mr. Elson, $4,800 in Company matching contributions to the Savings and Investment Plan and $1,316 in term life insurance premiums paid by Conectiv. For Mr. van Roden, $4,800 in Company matching contributions to the Savings and Investment Plan, $2,814 in Company matching contributions to the Deferred Compensation Plan and $728 in term life insurance premiums paid by Conectiv. (6) Mr. van Roden was elected Senior Vice President and Chief Financial Offi- cer as of January 4, 1999.
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Table 2--Option Grants in Last Fiscal Year (1)
- -------- (1) Currently, Conectiv does not grant stock appreciation rights. (2) Denotes Nonqualified Stock Options ("NQSO's"). One-half vest and are exer- cisable at end of second year from date of grant. Second one-half vest and are exercisable at end of third year from date of grant. (3) Denotes Performance Accelerated Stock Options ("PASO's") granted on a one- time basis. PASO's have a ten-year term and vest and are first exercisable nine and 1/2 years from date of grant without regard to stock price per- formance. Exercise date will accelerate for favorable stock price perfor- mance (i.e. first 1/3, second 1/3 and third 1/3 of PASO's vest after stock trades at $26, $28 or $30 per share, respectively, for ten consecutive trading days). PASO's must be held for three years from date of grant be- fore they can be exercised. (4) Determined using the Black-Scholes model, incorporating the following ma- terial assumptions and adjustments: (a) exercise price of $24.25, equal to the Fair Market Value ("FMV") as of date of grant; (b) an option term of ten years; (c) risk-free rate of return of 5.6%; (d) volatility of 16.0% and (e) dividend yield of 6.4%. For valuation purposes, PASO's are valued as a premium-priced stock option as of the date of grant with an exercise price of $30 on a FMV of $24.25.
Table 3--Aggregated Option Exercises in Last Fiscal Year and FY-End Option Values
- -------- (1) The closing price for Conectiv Common Stock on the New York Stock Exchange on December 31, 1999 was $16.8125. Option value would be based on the dif- ference between grant price (i.e., closing price shown above) and exercise price, multiplied by the number of options exercised. (2) 14,400 stock options of Mr. Cosgrove are currently exercisable. None of the remaining options may be exercised earlier than two years from date of grant for NQSO and nine and 1/2 years from date of grant for PASO's (sub- ject to accelerated vesting for certain levels of stock price perfor- mance).
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Table 4--Long-Term Incentive Plans--Awards in Last Fiscal Year
- -------- (1) In addition, Mr. Cosgrove held 35,520 performance shares (valued at $597,180) and Mr. Shaw and Mrs. Graham each held 8,010 performance shares (valued at $134,668) from a 1997 award with a four-year performance cycle under the former Delmarva Power Long Term Incentive Plan. These are pre- existing awards reported in the 1999 Proxy Statement and valued in this Proxy Statement at the share price of Common Stock on December 31, 1999. (2) Awards of Restricted Shares (Performance Accelerated Restricted Stock or "PARS") and Dividend Equivalent Units ("DEU's") were made to the five named executive officers on January 4, 1999. The payout of PARS may poten- tially be "performance accelerated". Restrictions may lapse and vesting may accelerate any time after 3 years (i.e., after January 4, 2002) upon achievement of pre-determined levels of total return to shareholders. Oth- erwise, restrictions lapse after 7 years (i.e., January 4, 2006), provided that at least a defined level of average, total return to shareholders is achieved. As of December 31, 1999, Mr. Cosgrove's 8,500 PARS were valued at $142,906, Messrs. Elson and Shaw's 4,000 PARS were valued at $67,250, Mr. van Roden's 3,000 PARS were valued at $50,438 and Mrs. Graham's 2,500 PARS were valued at $42,032. These values for PARS are based on the Decem- ber 31, 1999 closing price of $16.8125 per share of Common Stock. One DEU equals the regular quarterly dividend paid on one share of Conectiv Common Stock. The DEU's shown are payable in cash for eight quarters over a two year period ending with the DEU payable January 31, 2001. At that point, the 1999 DEU award lapses.
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PENSION PLAN
The Conectiv Retirement Plan includes the Cash Balance Pension Plan and grandfathered provisions relating to the Delmarva Retirement Plan and the At- lantic Retirement Plan that apply to employees who had either 20 years of service or were age 50 on the effective date of the Cash Balance Pension Plan (January 1, 1999). Certain executives whose benefits from the Conectiv Retire- ment Plan are limited by the application of federal tax laws also receive ben- efits from the Supplemental Executive Retirement Plan.
Cash Balance Pension Plan
The named executive officers participate in the Conectiv Retirement Plan and earn benefits that generally become vested after five years of service. Annu- ally, a recordkeeping account in a participant's name is credited with an amount equal to a percentage of the participant's total pay, including base pay, over-time and bonuses, depending on the participant's age at the end of the plan year, as follows:
These accounts also receive interest credits based on average U.S. Treasury Bill rates for the year. In addition, certain annuity benefits earned by par- ticipants under the former Delmarva and Atlantic Retirement Plans are fully protected as of December 31, 1998, and were converted to an equivalent cash amount and included in each participant's initial cash balance account. When a participant terminates employment, the amount credited to his or her account is converted into an annuity or paid in a lump sum.
Supplemental Retirement Benefits
Supplemental retirement benefits are provided to certain employees, includ- ing each executive officer, whose benefits under the Conectiv Retirement Plan are limited by type of compensation or amount under federal tax laws and regu- lations.
Estimated Retirement Benefits Payable to Named Executive Officers
The following table shows the estimated retirement benefits, including sup- plemental retirement benefits under the plans applicable to the named execu- tive officers, which would be payable if he or she were to retire at normal retirement age (65), expressed in the form of a lump sum payment. Years of service credited to each named executive officer as of his or her normal re- tirement date are as follows: Mr. Cosgrove, 42; Ms. Graham, 30; Mr. Shaw, 40; Mr. Elson, 16 (8 of which are additional years of service for purposes of the supplemental retirement benefits), and Mr. van Roden, 15.
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- -------- (1) Amounts include (i) interest credits for cash balances projected to be 6.26% per annum on annual salary credits and prior service balances, if any, and (ii) accrued benefits as of December 31, 1999 under retirement plans then applicable to the named executive officer. Benefits are not subject to any offset for Social Security payments or other offset amounts and assume no future increases in base pay or total pay.
Under the Conectiv Retirement Plan's grandfather provisions, employees who participated in the Delmarva or Atlantic Retirement Plans and who met certain age and service requirements as of December 31, 1998, will have retirement benefits for all years of service up to retirement calculated according to their original benefit formula. This benefit will be compared to the cash bal- ance account and the employee will receive whichever is greater. Estimated benefits are based on the Delmarva Retirement Plan for Messrs. Cosgrove, Shaw and Elson and the Cash Balance Pension Plan for Mrs. Graham (whose benefits under the Cash Balance Pension Plan exceed the benefits under the Delmarva Re- tirement Plan) and Mr. van Roden (who was not grandfathered into the Delmarva Retirement Plan). The amount of benefit under such grandfathering is illus- trated in the following table:
Delmarva Retirement Plan PENSION PLAN TABLE Annual Retirement Benefits in Specified Remuneration and Years of Service Classifications
- -------- (1) Effective January 1, 1999, annual compensation recognized may not exceed $160,000. (2) For 1999, the annual limit on annual benefits is $130,000.
Benefits are payable in the form of a 50% joint and surviving spouse annuity or lump sum. Earnings include base salary, overtime and bonus.
Change in Control Severance Agreements And Other Provisions Relating to Possible Change in Control
Conectiv has entered into change in control severance agreements with Messrs. Cosgrove, Elson, Shaw, and van Roden and Mrs. Graham and one other se- nior executive. The agreements are intended to encourage the continued dedica- tion of Conectiv's senior management team. The agreements provide potential benefits for these executives upon actual or constructive termination of em- ployment (other than for cause) following a change in control of Conectiv, as defined in the agreements. Each affected executive would receive a severance payment equal to three times base salary and bonus, medical, dental, vision, group life and disability benefits paid by Conectiv for three years after ter- mination of employment, and a cash payment equal to the actuarial equivalent of accrued pension credits equal to 36 months of additional service.
In the event of a change in control, the Variable Compensation Plan provides that outstanding options become exercisable in full immediately, all condi- tions to the vesting of PARS are deemed satisfied and shares will be fully vested and nonforfeitable, DEU's will become fully vested and be immediately payable, variable compensation deferred under the Management Stock Purchase Program will be immediately distributed, and payment of variable compensation, if any, for the current year will be decided by the Personnel & Compensation
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Committee. For the Deferred Compensation Plan, this Committee may decide, in the event of a change in control, to distribute all deferrals in cash immedi- ately or continue the deferral elections of participants, in which case Conectiv will fully fund a "springing rabbi trust" to satisfy the obligations. An independent institutional trustee will maintain any trust established by reason of this provision.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
All shares of DPL's common stock are owned by Conectiv, DPL's parent company.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
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PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents are filed as part of this report:
1. Financial Statements
The following financial statements are contained in Item 8 of Part II.
2. Financial Statement Schedules
Schedule II, Valuation and Qualifying Accounts, is presented below for each of the three years in the period ended December 31, 1999. No other financial statement schedules have been filed since the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the respective financial statements or the notes thereto.
Schedule II--Valuation and Qualifying Accounts Years Ended December 31, 1999, 1998, 1997 (Dollars in thousands)
- -------- (a) Accounts receivable written off.
3. Exhibits
Exhibit Number - ------
2 Amended and Restated Agreement and Plan of Merger, dated as of Decem- ber 26, 1996, between DPL, Atlantic Energy, Inc., Conectiv, Inc. and DS Sub, Inc. (Filed with Registration Statement No. 333-18843.)
3-A Copy of the Restated Certificate and Articles of Incorporation effec- tive as of April 12, 1990. (Filed with Registration Statement No. 33- 50453.)
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3-B Copy of DPL's Certificate of Designation and Articles of Amendment es- tablishing the 7 3/4% Preferred Stock--$25 Par. (Filed with Registra- tion Statement No. 33-50453.)
3-C Copy of DPL's Certificate of Designation and Articles of Amendment es- tablishing the 6 3/4% Preferred Stock. (Filed with Registration State- ment No. 33-53855.)
3-D A copy of DPL's Certificate of Amendment of Restated Certificate and Articles of Incorporation, filed with the Delaware Secretary of State, effective as of June 7, 1996. (Filed with Registration No. 333-07281.)
3-E A copy of DPL's Articles of Amendment of Restated Certificate and Ar- ticles of Incorporation, filed with the Virginia State Corporation Commission, effective as of June 7, 1996. (Filed with Registration No. 333-07281.)
3-F A copy of DPL's Certificate and Articles of Amendment of Restated Cer- tificate and Articles of Incorporation, filed with the Delaware Secre- tary of State, effective as of March 2, 1998 (filed with DPL's Current Report on Form 8-K dated March 4, 1998; File No. 1-1405).
3-G A copy of DPL's Articles of Amendment of Restated Certificate and Ar- ticles of Incorporation, filed with the Virginia State Corporation Commission, effective as of March 2, 1998 (filed with DPL's Current Report on Form 8-K dated March 4, 1998; File No. 1-1405).
3-H Certificate of Merger of DS Sub, Inc., a Delaware Corporation with and into DPL, filed with the Delaware Secretary of State, effective as of March 1, 1998 (filed with DPL's Current Report on Form 8-K dated March 4, 1998; File No. 1-1405).
3-I Certificate of Merger of DS Sub, Inc., a Delaware Corporation with and into DPL, filed with the Virginia State Corporation Commission, effec- tive as of March 1, 1998 (filed with DPL's Current Report on Form 8-K dated March 4, 1998; File No. 1-1405).
3-J Copy of DPL's By-Laws as amended March 2, 1998 ( filed with DPL's Cur- rent Report on Form 8-K dated March 4, 1998; File No. 1-1405).
4-A Copy of the Mortgage and Deed of Trust of Delaware Power & Light Com- pany to the New York Trust Company, Trustee, (the Chase Manhattan Bank, successor Trustee) dated as of October 1, 1943 and copies of the First through Sixty-Eighth Supplemental Indentures thereto. (Filed with Registration Statement No. 33-1763.)
4-B Copy of the Sixty-Ninth Supplemental Indenture. (Filed with Registra- tion Statement No. 33-39756.)
4-C Copies of the Seventieth through Seventy-Fourth Supplemental Inden- tures. (Filed with Registration Statement No. 33-24955.)
4-D Copies of the Seventy-Fifth through the Seventy-Seventh Supplemental Indentures. (Filed with Registration Statement No. 33-39756.)
4-E Copies of the Seventy-Eighth and Seventy-Ninth Supplemental Inden- tures. (Filed with Registration Statement No. 33-46892.)
4-F Copy of the Eightieth Supplemental Indenture. (Filed with Registration Statement No. 33-49750.)
4-G Copy of the Eighty-First Supplemental Indenture. (Filed with Registra- tion Statement No. 33-57652.)
4-H Copy of the Eighty-Second Supplemental Indenture. (Filed with Regis- tration Statement No. 33-63582.)
IV-2
4-I Copy of the Eighty-Third Supplemental Indenture. (Filed with Registra- tion Statement No. 33-50453.)
4-J Copies of the Eighty-Fourth through Eighty-Eighth Supplemental Inden- tures. (Filed with Registration Statement No. 33-53855.)
4-K Copies of the Eighty-Ninth and Ninetieth Supplemental Indentures. (Filed with Registration Statement No. 333-00505.)
4-L A copy of the Indenture between DPL and The Chase Manhattan Bank (ul- timate successor to Manufacturers Hanover Trust Company), as Trustee, dated as of November 1, 1988. (Filed with Registration Statement No. 33-46892.)
4-M A copy of the Indenture (for Unsecured Subordinated Debt Securities relating to Trust Securities) between DPL and Wilmington Trust Compa- ny, as Trustee, dated as of October 1, 1996. (Filed with Registration Statement No. 333-20715.)
4-N A copy of the Officer's Certificate dated October 3, 1996, establish- ing the 8.125% Junior Subordinated Debentures, Series I, Due 2036. (Filed with Registration Statement No. 333-20715.)
4-O A copy of the Guarantee Agreement between DPL, as Guarantor, and Wil- mington Trust Company, as Trustee, dated as of October 1, 1996. (Filed with Registration Statement No. 333-20715.)
4-P A copy of the Amended and Restated Trust Agreement between DPL, as De- positor, and Wilmington Trust Company, Barbara S. Graham, Edric R. Ma- son and Donald P. Connelly, as Trustees, dated as of October 1, 1996. (Filed with Registration Statement No. 333-20715.)
4-Q A copy of the Agreement as to Expenses and Liabilities dated as of Oc- tober 1, 1996, between DPL and Delmarva Power Financing I. (Filed with Registration Statement No. 333-20715.)
10-A Copy of the Supplemental Executive Retirement Plan, revised as of Oc- tober 29, 1991. (Filed with Form 10-K for the year ended December 31, 1992, File No. 1-1405.)
10-B Copies of amendments to the Supplemental Executive Retirement Plan, effective June 15, 1994, and November 1, 1994. (Filed with Form 10-K for the year ended December 31, 1994, File No. 1-1405.)
10-C Copy of the Long Term Incentive Plan amended and restated as of Janu- ary 1, 1996. (Filed with Form 10-K for the year ended December 31, 1996, File No. 1-1405.)
10-D Copies of amendments to the Long Term Incentive Plan, effective Janu- ary 1, 1997, and January 30, 1997. (Filed with Form 10-K for the year ended December 31, 1996, File No. 1-1405.)
10-E Copy of the severance agreement with members of management. (Filed with Form 10-K for the year ended December 31, 1994, File No. 1-1405.)
10-F Copy of the current listing of members of management who have signed the severance agreement. (Filed with Form 10-K for the year ended De- cember 31, 1996, File No. 1-1405.)
10-G Copy of the Management Life Insurance Plan amended and restated as of January 1, 1992. (Filed with Form 10-K for the year ended December 31, 1996, File No. 1-1405.)
10-H Copy of the Deferred Compensation Plan, effective as of January 1, 1996. (Filed with the Form 10-K for the year ended December 31, 1995, File No. 1-1405.)
12-A Ratio of earnings to fixed charges (filed herewith)
IV-3
12-B Ratio of earnings to fixed charges and preferred dividends (filed herewith)
23 Consent of Independent Accountants (filed herewith)
27 Financial Data Schedule (filed herewith)
99 Pro Forma Financial Statements--Generation Asset Sale and Transfer
(b) Reports on Form 8-K
The following Reports on Form 8-K were filed in the fourth quarter of 1999.
On October 7, 1999, DPL filed a Report on Form 8-K dated September 30, 1999 reporting on Item 5, Other Events, and Item 7 (c), Exhibits.
On October 26, 1999, DPL filed a Report on Form 8-K dated October 26, 1999 reporting on Item 5, Other Events.
IV-4
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Ex- change Act of 1934 the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 29, 2000.
Delmarva Power & Light Company (Registrant)
/s/ John C. van Roden By: _________________________________ (John C. van Roden, Senior Vice President and Chief Financial Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Regis- trant and in the capacities indicated, on March 29, 2000 .
Signature Title
/s/ Howard E. Cosgrove Chairman of the Board, _____________________________________ President and Chief Executive (Howard E. Cosgrove) Officer
/s/ John C. van Roden Senior Vice President and _____________________________________ Chief Financial Officer (John C. van Roden)
/s/ James P. Lavin Controller and Chief _____________________________________ Accounting Officer (James P. Lavin)
/s/ Thomas S. Shaw Director _____________________________________ (Thomas S. Shaw)
/s/ Barry R. Elson Director _____________________________________ (Barry R. Elson)
/s/ Barbara S. Graham Director _____________________________________ (Barbara S. Graham)
IV-5
Exhibit Index
Exhibit Number Description - ---------------- ---------------
12-A Ratio of Earnings to Fixed Charges
12-B Ratio of Earnings to Fixed Charges and Preferred Dividends
23 Consent of Independent Accountants
27 Financial Data Schedule
99 Pro Forma Financial Statements - Generation Asset Sale and Transfer | 28,995 | 188,008 |
790067_1999.txt | 790067_1999 | 1999 | 790067 | ITEM 1: BUSINESS - -----------------
The Registrant, Realmark Property Investors Limited Partnership-V (the "Partnership"), is a Delaware limited partnership organized in 1986, pursuant to an Agreement and Certificate of Limited Partnership (the "Partnership Agreement"), under the Revised Delaware Uniform Limited Partnership Act. The Partnership's general partners are Realmark Properties, Inc. (the "Corporate General Partner"), a Delaware corporation, and Joseph M. Jayson (the "Individual General Partner").
The Registrant commenced the public offering of its limited partnership units, registered with the Securities and Exchange Commission under the Securities Act of 1933, as amended, on July 14, 1986, and concluded the offering on October 31, 1987, having raised a total of $20,999,800 before deducting sales commissions and expenses of the offering.
The Partnership's primary business and its only industry segment is to own and operate income-producing real property for the benefit of its partners. As of December 31, 1999, the Partnership owned one (1) 205 unit apartment complex in Louisville, KY, one (1) 65,334 square foot office/warehouse building in Nashville, Tennessee, one (1) 115,021 square foot office complex in Durham, North Carolina, and two (2) office/warehouse complexes in Amherst, New York, totaling 196,500 square feet.
The business of the Partnership is not seasonal. As of December 31, 1999, the Partnership did not directly employ any persons in a full-time position. All persons who regularly rendered services on behalf of the Partnership through December 31, 1999 were employees of the Corporate General Partner or its affiliates.
The occupancy for each complex as of December 31, 1999, 1998 and 1997 was as follows:
The percentage of total Partnership revenue generated from each complex as of December 31, 1999, 1998 and 1997 was as follows:
This annual report contains certain forward-looking statements concerning the Partnership's current expectations as to future results. Such forward-looking statements are contained in Item 7: Management's Discussion and Analysis of Financial Conditions and Results of Operations. Words such as "believes", "forecasts", "intends", "possible", "expects", "estimates", "anticipates" or "plans" and similar expressions are intended to identify forward-looking statements.
ITEM 2:
ITEM 2: PROPERTIES - -------------------
The following is a list of properties owned by the Partnership at December 31, 1999:
ITEM 3:
ITEM 3: LEGAL PROCEEDINGS - --------------------------
The Partnership is not a party to, nor is any of the Partnership's property the subject of, any material pending legal proceedings; however, for a discussion of litigation which is pending against the General Partners and certain other associates, please see Item 7.
ITEM 4:
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. - -------------------------------------------------------------
None.
PART II -------
ITEM 5:
ITEM 5: MARKET FOR REGISTRANT'S UNITS OF LIMITED PARTNERSHIP INTEREST. - ------- --------------------------------------------------------------
There is currently no established trading market for the units of Limited Partnership Interest of the Partnership and it is not anticipated that any will develop in the future.
There were no Partnership distributions for the years ended December 31, 1999 or 1997. Distributions of approximately $3,580,000 were made to the partners in the year ended December 31, 1998.
As of December 31, 1999, there were 2,180 record holders of units of Limited Partnership Interest.
ITEM 7:
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF - ------- --------------------------------------- FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ----------------------------------------------
Liquidity and Capital Resources: - --------------------------------
The Partnership successfully refinanced the mortgages on The Paddock, Inducon East and Inducon East Phase III during the year ended December 31, 1998. A bridge loan which originated in 1998 on Commercial Park West was replaced by permanent mortgage financing during the year ended December 31, 1999. Upon obtaining the new financing, the previous mortgages were paid in full with no gain or loss resulting. The result of the refinancing was additional cash provided by the new mortgages and lower interest rates. Escrow accounts were set up as part of the new mortgages on The Paddock and Inducon East; these accounts are to be used to cover the costs of the necessary improvements and future tenant improvements at these commercial buildings.
During November of 1997, the Partnership acquired 100% interest in Inducon East and Inducon East Phase III. Prior to this time, the Partnership had a 50% interest in each of these commercial properties. These properties began to be consolidated in the Partnership's financial statements in November 1997.
On November 4, 1997, a consent solicitation statement was sent to all Limited Partners of this Partnership. The offering was for the purchase of five of the residential complexes in the Partnership: Williamsburg North Apartments, The Fountains Apartments, O'Hara Apartments, Wayne Estates Apartments, and Jackson Park Apartments. The price offered in the document for the properties, including the proceeds from the sale and distributions from other sources, was $16,107,000 or approximately $171 per Limited Partnership unit. The purchaser is an affiliate by common ownership of the General Partners. Consent under the offering was received and the sale was finalized on December 5, 1997. The sale resulted in a gain of $5,009,787. A distribution of a portion of the proceeds from the sale of approximately $3,580,000 was made during the first quarter of 1998. The Partnership made no distributions in the years ended December 31, 1999 or 1997. It is uncertain as to when the Partnership will be in a position to make future distributions, although management is hopeful that distributions will be made again in the future once the capital improvement work scheduled at the properties is either completed or the full costs may be measured.
Numerous capital projects were undertaken in 1999. At Camelot East a total of $77,000 was spent on capital projects. These projects included the replacement of sidewalks, replacement of exterior siding, hallway painting, boiler replacement and chiller repairs, appliances, carpeting and flooring. At the Paddock a total of $99,000 was spent on projects such as asphalt repairs, curb repairs, exterior wall repairs, replacing flashing on the exterior of buildings, painting the exterior of buildings, replacement of exterior doors, repairing electrical distribution boxes, installing handicap parking areas and installing ramps. At Inducon East (Phase I, II & III) a total of $31,000 was spent on capital projects. These projects included roof repair and window lentil and accent painting. At Commercial Park West a total of $25,000 was spent on capital projects. These projects included the painting of halls, design of an additional parking lot and window and door frame painting.
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF - ------- --------------------------------------- FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Con't.) ------------------------------------------------------
Liquidity and Capital Resources: - --------------------------------
The Partnership conducted a review of its computer systems to identify the systems that could have been affected by the "year 2000 issue" and implemented a plan to resolve such issues. The year 2000 issue is the result of computer programs being written using two digits rather than four digits to define the applicable year. Computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could have resulted in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. Management contracted with outside independent computer consultants to resolve this issue. The majority of the software in use is "2000 compliant" or was added at no significant cost. Management also engaged a computer firm to re-write its tax software making it Year 2000 compliant. Management did not experience any significant problems with its computers as a result of the year 2000 issue and does not anticipate any such problems in the future.
The Partnership, as a nominal defendant, the General Partners of the Partnership and the three individuals constituting the officers and directors of the Corporate General Partner, as defendants, were served with a Summons and Complaint on April 19, 2000 in a class and derivative action instituted by Ira Gaines and on August 21, 2000 in a class and derivative action instituted by Sean O'Reilly and Louise Homburger, each in Supreme Court, County of Erie, State of New York. The actions allege breaches of contract and breaches of fiduciary duty and seek, among other things, an accounting, the removal of the General Partners, the liquidation of the Partnership and the appointment of a receiver to supervise the liquidation, and damages. The General Partners and the officers and directors of the Corporate General Partner have filed a motion to dismiss the first complaint and are presently reviewing the second complaint and intend to vigorously pursue their defense.
Results of Operations: - ----------------------
For the year ended December 31, 1999, the Partnership incurred a loss of $589,338 or $27.22 per limited partnership unit. For the year ended December 31, 1998, the Partnership reported net loss of $1,257,843 or $58.09 per limited partnership unit. For the year ended December 31, 1997, the Partnership reported net income of $2,301,229 or $99.31 per limited partnership unit. The income was the result of a gain from the sale of five residential apartment complexes amounting to approximately $5,000,000.
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF - ------- --------------------------------------- FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Con't.) ------------------------------------------------------
Results of Operations (Con't.): - -------------------------------
Partnership revenue for the year ended December 31, 1999 totaled $5,129,937 consisting of rental revenue of $4,443,569 and other income, which includes interest, laundry income, common area maintenance and other miscellaneous sources of income of $686,368. For the year ended December 31, 1998, Partnership revenue totaled $4,751,433, consisting of rental revenue of $4,656,844 and other income, which includes interest, laundry income and other miscellaneous sources of income, of $94,589. For the same time period in 1997, total revenue reported was $7,068,782, consisting of rental income of $6,739,210 and other income of $329,572. The primary reason for the decrease in total revenue when comparing the year ended December 31, 1999 to both 1998 and 1997 is that the Partnership owned five more residential apartment complexes which were reporting income for most of 1997 (i.e., in 1997 these complexes reported rental income of approximately $3,433,000 and other income of approximately $264,000; total income for 1999 increased by $378,504 over 1998 total income). Contributing to the increase was the increased occupancy of Inducon East. Occupancy at Commercial Park West remained at 100%. The Paddock/warehouse building in Nashville, Tennessee remained at 71% occupancy. Management is anticipating that a new tenant will take 5,000 square feet in June 2000, this will bring occupancy up to 78%.
Partnership expenses for year ended December 31, 1999 totaled $5,719,275 a decrease over the expenses for the year ended December 31, 1998. A considerable decrease over the expenses of the year ended December 1997. The major decrease over 1997 can be attributed to there being fewer properties reporting expenses in the Partnership. The biggest decrease over 1999 and 1998 is the reduction in interest expense of $480,433. This was due to the loan refinancing which occurred in 1998 and 1999. The expenses for property operations for 1999 increased $341,485 over those of 1998. The increased expenses are attributable to significant non-capitalizable repairs and maintenance work being done at the properties. At Camelot Apartments, appliances, pool repair, carpets, heating and cooling were major expenses totaling $200,000. Common area repairs were made at The Paddock and Commercial Park West that totaled $90,000.
For the year ended December 31, 1999, the tax basis loss was $53,411 or $2.47 per limited partnership unit compared to a tax loss of $510,373 or $23.57 per unit for the year ended December 31, 1998 and tax income of $1,461,448 or $67.50 per limited partnership unit for the year ended December 31, 1997.
ITEM 7A:
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - ------- ----------------------------------------------------------
The Partnership does not have investments in instruments which are subject to market risk (e.g., derivatives, options or other interest sensitive instruments).
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------- --------------------------------------------
Listed under Item 14 of the report.
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS - ------- --------------------------------------------- ON ACCOUNTING AND FINANCIAL DISCLOSURE. ---------------------------------------
As reported on Form 8-K/A, filed with the Securities and Exchange Commission on April 17, 2000, and incorporated herein by reference in its entirety: (i) Deloitte & Touche, LLP notified the Company on January 11, 2000 that its relationship as the principal accountants to audit the Company's financial statements had ceased; (ii) effective January 28, 2000, the company engaged Toski, Schaefer & Co., P.C. as its independent accountants.
PART III
ITEM 10:
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - ------------------------------------------------------------
The Partnership, as an entity, does not have any directors or officers. The Individual General Partner of the Partnership is Joseph M. Jayson. The directors and executive officers of Realmark Properties, Inc., the Partnership's Corporate General Partner, as of December 31, 1999, are listed below. Each director is subject to election on an annual basis.
Joseph M. Jayson, President and Director of Realmark Properties, Inc. and Judith P. Jayson, Vice President and Director of Realmark Properties, Inc., are married to each other.
The Directors and Executive Officers of the Corporate General Partner and their principal occupations and affiliations during the last five years or more are as follows:
Joseph M. Jayson, age 61, is President and Director and sole stockholder of J.M. Jayson & Company, Inc. and certain of its affiliated companies: U.S. Apartments LLC, Westmoreland Capital Corporation, Oilmark Corporation and U.S. Energy Development Corporation. In addition, Mr. Jayson is President and Director of Realmark Corporation and Realmark Properties, Inc., wholly owned subsidiaries of J.M. Jayson & Company, Inc. and co-general partner of Realmark Property Investors Limited Partnership, Realmark Property Investors Limited Partnership-II, Realmark Property Investors Limited Partnership-III, Realmark Property Investors Limited Partnership-IV, Realmark Property Investors Limited Partnership-V, Realmark Property Investors Limited Partnership-VI A and Realmark Property Investors Limited Partnership-VI B. Mr. Jayson has been engaged in real estate business for the last 37 years and is a Certified Property Manager as designated by the Institute of Real Estate Management ("I.R.E.M."). Mr. Jayson received a B.S. Degree in Education in 1961 from Indiana University, a Masters Degree from the University of Buffalo in 1963, and has served on the Educational Faculty of the Institute of Real Estate Management. Mr. Jayson has for the last 37 years been engaged in various aspects of real estate brokerage and investment. He brokered residential properties from 1962 to 1964, commercial and investment properties from 1964 to 1967, and in 1967, left commercial real estate to form his own investment firm. Since that time, Mr. Jayson and J.M. Jayson & Company, Inc. have formed, or participated in various ways, in forming over 30 real estate related limited partnerships. For the past eighteen years, Mr. Jayson and J.M. Jayson & Company, Inc. and an affiliate have also engaged in developmental drilling for gas and oil.
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. (Con't) - --------------------------------------------------------------------
Judith P. Jayson, age 59, is currently Vice-President and a Director of Realmark Properties, Inc. She is also a Director of the property management affiliate, Realmark Corporation. Mrs. Jayson has been involved in property management for the last 28 years and has extensive experience in the hiring and training of property management personnel and in directing, developing and implementing property management systems and programs. Mrs. Jayson, prior to joining the firm in 1973, taught business in the Buffalo, New York high school system. Mrs. Jayson graduated from St. Mary of the Woods College in Terre Haute, Indiana, with a degree in Business Administration. Mrs. Jayson is the wife of Joseph M. Jayson, the Individual General Partner.
Michael J. Colmerauer, 42, is Secretary and in-house legal counsel for J.M. Jayson & Company, Inc., Realmark Corporation, Realmark Properties, Inc. and other companies affiliated with the General Partners. He received a Bachelor's Degree (BA) from Canisius College in 1980 and a Juris Doctors (J.D.) from the University of Tulsa in 1983. Mr. Colmerauer is a member of the American and Erie County Bar Association and has been employed by the Jayson group of companies for the last 16 years.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION. - --------------------------------
No direct remuneration was paid or payable by the Partnership to directors and officers (since it has no directors or officers) for its fiscal years ended December 31, 1999, 1998 or 1997; nor was any direct remuneration paid or payable by the Partnership to directors or officers of Realmark Properties, Inc., the Corporate General Partner and sponsor, for the years ended December 31, 1999, 1998 or 1997.
The following table sets forth for the years ended December 31, 1999, 1998 and 1997 the compensation paid by the Partnership, directly or indirectly, to affiliates of the General Partners:
ITEM 11: EXECUTIVE COMPENSATION (Con't.). - ------------------------------------------
The Corporate General Partner is entitled to a continuing Partnership Management Fee equal to 7% of net cash flow as defined in the Partnership Agreement. No such fee was paid in the year ended December 31, 1999. This fee totaled $30,600 for the year ended December 31, 1997. The General Partners are also entitled to 3% of Distributable Cash, as defined in the Partnership Agreement (no such amounts were distributed for the years ended December 31, 1999, 1998 and 1997) and to certain expense reimbursements with respect to Partnership operations.
The General Partners are also allowed to collect a property disposition fee upon sale of acquired properties. This fee is not to exceed the lesser of 50% of amounts customarily charged in arm's-length transactions by others rendering similar services for comparable properties or 2.75% of the sales price. The property disposition fee is subordinate to payments to the Limited Partners of a cumulative annual return (not compounded) equal to 7% of their average adjusted capital balances and to repayment to the Limited Partners of an amount equal to their original capital contributions.
Since the conditions described above have not been met, no disposition fee was paid or accrued on the March 1990 sale of Pelham East or on the five properties sold in 1997 as described in Item 7.
The General Partners may also be entitled to 13% of any remaining sale or refinancing proceeds after payments to the Limited Partners pursuant to the terms outlined in the Partnership Agreement
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - ------------------------------------------------------------------------
No person is known to the Partnership to own of record or beneficially more than five percent (5%) of the units of Limited Partnership Interest of the Partnership. The General Partners, as of December 31, 1999, owned three (3) units of Limited Partnership Interest.
Affiliates of the General Partners own of record or beneficially 598.2 units of Limited Partnership Interest constituting 2.85% of the Partnership Interest.
Based upon a review of Forms 3, 4 and 5 and amendments thereto furnished to the registrant, all reports were filed, however one report was filed subsequent to its required due date. This report contained a total of two transactions totaling 48.5 limited partnership units.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: - --------------------------------------------------------
During 1999, no transactions occurred between the Partnership and the officers and directors of Realmark Properties, Inc. All transactions between the Partnership and Realmark Properties, Inc. (the Corporate General Partner) and any other affiliated organization are described in Item 11 of this report and in Note 8 to the financial statements.
As discussed in Item 7, the Partnership sold five residential properties to U.S. Apartments LLC, a wholly-owned affiliate of the General Partners, in December 1997.
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K. - ---------------------------------------------------------------------------
SIGNATURES ----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V
By: /s/ Joseph M. Jayson 09/19/00 -------------------------- ---------- JOSEPH M. JAYSON, Date Individual General Partner
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
By: REALMARK PROPERTIES, INC. Corporate General Partner
/s/ Joseph M. Jayson 09/19/00 -------------------------- ---------- JOSEPH M. JAYSON, Date President and Director
/s/ Judith P. Jayson 09/19/00 -------------------------- ---------- JUDITH P. JAYSON, Date Director
/s/ Michael J. Colmerauer 09/19/00 -------------------------- ---------- MICHAEL J. COLMERAUER Date Secretary
INDEPENDENT AUDITOR'S REPORT ----------------------------
The Partners Realmark Property Investors Limited Partnership - V
We have audited the accompanying balance sheet of Realmark Property Investors Limited Partnership - V as of December 31, 1999, and the related statements of operations, partners' equity, and cash flows for the year ended December 31, 1999. Our audit also included the financial statement schedule listed in the index at Item 14. These financial statements and the financial statement schedule are the responsibility of the General Partners. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audit. The financial statements of Realmark Property Investors Limited Partnership - V for the years ended December 31, 1998 and 1997 were audited by other auditors whose report dated April 27, 1999 expressed an unqualified opinion on those statements.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to in the first paragraph present fairly, in all material respects, the financial position of Realmark Property Investors Limited Partnership - V as of December 31, 1999, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ TOSKI, SCHAEFER & CO., P.C. Williamsville, New York ----------------------------------- April 12, 2000 TOSKI, SCHAEFER & CO., P.C. (August 21, 2000 as to note 11)
INDEPENDENT AUDITORS' REPORT
The Partners Realmark Property Investors Limited Partnership - V We have audited the accompanying balance sheets of Realmark Property Investors Limited Partnership - V as of December 31, 1998 and 1997, and the related statements of operations, partners' capital (deficit), and cash flows for each of the two years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the index at Item 14.
These financial statements and financial statement schedule are the responsibility of the General Partners. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of Realmark Property Investors Limited Partnership - V at December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ DELOITTE & TOUCHE LLP - ------------------------- DELOITTE & TOUCHE LLP
Buffalo, New York April 27, 1999
See accompanying notes to financial statements.
See accompanying notes to financial statements.
See accompanying notes to financial statements.
See accompanying notes to financial statements.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements December 31, 1999, 1998 and 1997
(1) Formation and Operation of Partnership - -------------------------------------------
Realmark Property Investors Limited Partnership - V (the Partnership), a Delaware limited partnership, was formed on February 28, 1986, to invest in a diversified portfolio of income-producing real estate investments, its only industry segment.
In July 1986, the Partnership commenced the public offering of units of limited partnership interest. Other than matters relating to organization, it had no business activities and, accordingly, had not incurred any expenses or earned any income until the first interim closing (minimum closing) of the offering, which occurred on December 5, 1986. All items of income and expense arose subsequent to this date. As of December 31, 1987, 20,999.8 units of limited partnership interest were sold and outstanding, excluding 3 units held by an affiliate of the general partners. The offering terminated on October 31, 1987 with gross offering proceeds of $20,999,800. The general partners are Realmark Properties, Inc. (the corporate general partner) and Mr. Joseph M. Jayson (the individual general partner). Mr. Joseph M. Jayson is the sole shareholder of J.M. Jayson & Company, Inc. Realmark Properties, Inc. is a wholly-owned subsidiary of J.M. Jayson & Company, Inc. Under the partnership agreement, the general partners and their affiliates can receive compensation for services rendered and reimbursement for expenses incurred on behalf of the Partnership (note 8).
The partnership agreement provides that distribution of funds, revenues, costs and expenses arising from partnership activities, exclusive of any sale or refinancing activities, are to be allocated 97% to the limited partners and 3% to the general partners.
Net income or loss and proceeds arising from a sale or refinancing shall be distributed first to the limited partners in amounts equivalent to a 7% return on the average of their adjusted capital contributions; second, an amount equal to their capital contributions; third, an amount equal to an additional 5% of the average of their adjusted capital contributions after the corporate general partner receives a 2.75% property disposition fee; fourth, to all partners in an amount equal to their respective positive capital balances; and finally, in the ratio of 87% to the limited partners and 13% to the general partners.
(2) Summary of Significant Accounting Policies - -----------------------------------------------
(a) Basis of Accounting -----------------------
The accompanying financial statements have been prepared on the accrual basis of accounting.
(b) Estimates -------------
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(2) Summary of Significant Accounting Policies, Continued - ----------------------------------------------------------
(c) Property and Equipment --------------------------
Property and equipment are recorded at cost. Depreciation is provided for in amounts sufficient to relate the cost of depreciable assets to operations over their estimated service lives using the straight-line method. The estimated lives of the Partnership's assets range from 5 to 25 years. Depreciation expense totaled $1,103,734, $1,212,114 and $1,094,232 for the years ended December 31, 1999, 1998 and 1997, respectively. Improvements are capitalized, while expenditures for maintenance and repairs are charged to expense as incurred. Upon disposal of depreciable property, the appropriate property accounts are reduced by the related costs and accumulated depreciation. The resulting gains and losses are reflected in the statements of operations. The accelerated cost recovery system and modified accelerated cost recovery system are used to calculate depreciation expense for tax purposes.
(d) Cash --------
For purposes of reporting cash flows, cash includes money market accounts and any highly liquid debt instruments purchased with a maturity of three months or less.
(e) Accrued Residential Rent Receivable ---------------------------------------
Due to the nature of accrued rent receivable, all such receivables are fully reserved at December 31, 1999 and 1998.
(f) Escrow Deposits -------------------
Escrow deposits represent cash which is restricted for the payment of property taxes and insurance in accordance with the mortgage agreement.
(g) Mortgage Costs ------------------
Mortgage costs incurred in obtaining the property mortgage financing are recorded at cost less applicable amortization. Amortization is being computed using the straight-line method over the life of the respective mortgages.
(h) Rental Income -----------------
Leases for residential properties have terms of one year or less. Commercial leases generally have terms of one to five years. Rental income is recognized on the straight line method over the term of the lease.
(i) Income (Loss) Per Limited Partnership Unit ----------------------------------------------
The income (loss) per limited partnership unit is based on the weighted average number of limited partnership units outstanding for the year.
(j) Income Taxes ----------------
No income tax provision has been included in the financial statements since profit or loss of the Partnership is required to be reported by the respective partners on their income tax returns.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(2) Summary of Significant Accounting Policies, Continued - ----------------------------------------------------------
(k) Comprehensive Income ------------------------
The Partnership has adopted Statement of Financial Accounting Standards (SFAS) No. 130 - "Reporting Comprehensive Income." SFAS 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income is defined as "the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources." Other than net income (loss), the Partnership has no other sources of comprehensive income.
(l) Segment Information -----------------------
SFAS No. 131 - "Disclosures about Segments of an Enterprise and Related Information" establishes standards for the way public business enterprises report information about operating segments and annual financial statements. The Partnership's only operating segment is the ownership and operation of income-producing real property for the benefit of its partners.
(m) Accounting Changes and Developments ---------------------------------------
In June 1998, the Financial Accounting Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133 - "Accounting for Derivative Instruments and Hedging Activities" which establishes revised accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity measure all derivative instruments at fair value and recognize such instruments as either assets or liabilities in the balance sheets. The accounting for changes in the fair value of a derivative instrument will depend on the intended use of the derivative as either a fair value hedge, a cash flow hedge or a foreign currency hedge. The effect of the changes in fair value of the derivatives and, in certain cases, the hedged items are to be reflected in either the statements of operations or as a component of other comprehensive income based upon the resulting designation. As issued, SFAS No. 133 was effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued SFAS No. 137 - "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133." SFAS No. 137 defers the effective date of SFAS No. 133 for one year to fiscal years beginning after June 15, 2000. Since the Partnership does not currently have any derivative instruments or hedging activities, management does not believe that SFAS No. 133 will have a material effect on the partnership financial statements, taken as a whole.
(n) Reclassifications ---------------------
Reclassifications have been made to certain 1998 and 1997 balances in order to conform them to the 1999 presentation. Additionally, a reclassification has been recorded on the balance sheet as of December 31, 1998, increasing accounts receivable and accounts payable - affiliates by $152,979. This reclassification was recorded in connection with the December 1998 refinancing of bonds payable with regard to Inducon East Phase III. The net proceeds of this refinancing, amounting to $152,979, were received on January 5, 1999.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(3) Acquisition and Dispositions of Rental Property - ----------------------------------------------------
In April 1987, the Partnership acquired a 50% interest in Inducon - East Joint Venture, a 150,000 square foot office/warehouse located in Amherst, New York. The Partnership contributed $2,414,592 of capital to the joint venture.
In May 1987, the Partnership acquired a 65,334 square foot office building (The Paddock Building) located in Nashville, Tennessee, for a purchase price of $3,163,324, which included $148,683 in acquisition fees.
In December 1987, the Partnership acquired a 192 unit apartment complex (Williamsburg North) located in Columbus, Indiana for a purchase price of $3,525,692, which included $285,369 in acquisition fees.
In February 1988, the Partnership acquired a 215 unit apartment complex (The Fountains) located in Westchester, Ohio for a purchase price of $5,293,068, which included $330,155 in acquisition fees.
In May 1988, the Partnership acquired a 100 unit apartment complex (Pelham East) located in Greenville, South Carolina, for a purchase price of $2,011,927, which included $90,216 in acquisition fees. In March 1990, the Partnership sold the 100 unit apartment complex for a sale price of $2,435,000 which generated a net gain for financial statement purposes of $572,562.
In May 1988, the Partnership acquired a 205 unit apartment complex (Camelot East) located in Louisville, Kentucky for a purchase price of $6,328,363, which included $362,540 in acquisition fees.
In June 1988, the Partnership acquired a 100 unit apartment complex (O'Hara) located in Greenville, South Carolina, for a purchase price of $2,529,390, which included $498,728 in acquisition fees.
In July 1988, the Partnership acquired a 158 unit apartment complex (Wayne Estates) located in Huber Heights, Ohio, for a purchase price of $4,250,013, which included $793,507 in acquisition fees.
In April 1989, the Partnership acquired a 102 unit apartment complex (Jackson Park) located in Seymour, Indiana for a purchase price of $1,911,585, which included $111,585 in acquisition fees.
In June 1991, the Partnership acquired a 115,021 square foot office complex (Commercial Park West) located in Durham, North Carolina, for a purchase price of $5,773,633, which included $273,663 in acquisition fees.
In September 1992, Inducon East Phase III Joint Venture (the "Phase III Venture") was formed pursuant to an agreement between the Partnership and Inducon Corporation. Each held a 50% interest in the Phase III Venture. The Phase III Venture developed two buildings totaling approximately 46,500 square feet on 4.2 acres of land in Amherst, New York.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(3) Acquisition and Dispositions of Rental Property, Continued - ---------------------------------------------------------------
In June 1997, the Partnership entered into a plan to dispose of the property, plant and equipment of Camelot East with a carrying amount of $3,825,407 at December 31, 1997. Management had determined that a sale of the property was in the best interests of the limited partners. An agreement was signed with a potential buyer for the purchase of the property. The agreement expired in October 1997, and management discontinued its plan to dispose of the property.
In November 1997, the Partnership acquired an additional 50% interest in Inducon East and Inducon East Phase III through a buyout of the other joint venturers. The Partnership owns 100% of the properties.
In December 1997, the Partnership sold Williamsburg North, the Fountains, O'Hara, Wayne Estates and Jackson Park for a total purchase price of $16,107,000, which generated a net gain for financial statement purposes of $5,009,787. The properties were sold to U.S. Apartments LLC, a wholly-owned affiliate of Joseph M. Jayson, the individual general partner.
Statement of Financial Accounting Standards No. 121 - "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed Of " (the Statement) requires that assets to be disposed of be recorded at the lower of carrying value or fair value, less costs to sell. The Statement also requires that such assets not be depreciated during the disposal period, as the assets will be recovered through sale rather than through operations. In accordance with this Statement, the long-lived assets of Camelot East, classified as held for sale on the balance sheet at December 31, 1997, were recorded at the carrying amount which is the lower of carrying value or fair value less costs to sell, and were not depreciated during the disposal period. Fair value is determined based on estimated future cash flows. Depreciation expense, not recorded during the disposal period, for the year ended December 31, 1997 totaled approximately $55,000 for Camelot East Apartments. Depreciation expense not recorded during the same period for the five properties sold to U.S. Apartments LLC totaled approximately $281,000.
(4) Investment in Land - -----------------------
The Partnership owns approximately 96 acres of vacant land in Amherst, New York. The investment totaled $417,473 as of December 31, 1999 and 1998. The balance approximates the fair value of the investment.
(5) Mortgages Payable - ----------------------
The Partnership has the following mortgages payable as of December 31, 1999 and 1998:
(a) The Paddock Building ------------------------
The mortgage outstanding at December 31, 1999 and 1998 of $1,678,683 and $1,700,000, respectively, provides for monthly principal and interest payments of $12,785 including interest at 7.70%. The mortgage matures January 2009 with a balloon payment of approximately $1,375,000.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(5) Mortgages Payable, Continued - ---------------------------------
(b) Camelot East Apartments ---------------------------
Camelot East Apartments' mortgage had an outstanding balance of $4,810,739 and $4,855,113 at December 31, 1999 and 1998, respectively, providing for annual principal and interest payments of approximately $407,000 including interest at 7.4%. The mortgage matures November 2027.
(c) Commercial Park West ------------------------
The property's mortgage of $4,826,425 at December 31, 1997 was refinanced in 1998. The mortgage outstanding (bridge loan) at December 31, 1998 of $5,400,000 provided for monthly interest payments at 3.50% above the Euro Libor rate (9.0625% at December 31, 1998). The mortgage outstanding at December 31, 1999 of $5,989,366, provides for monthly principal and interest payments of $44,319 including interest at 8.07%. The mortgage matures October 2029.
(d) Inducon East ----------------
The bonds payable totaling $6,465,646 at December 31, 1997 were refinanced into a mortgage payable in 1998. The mortgage outstanding at December 31, 1999 and 1998 of $6,127,682 and $6,205,000, respectively, provides for monthly principal and interest payments of $46,827 including interest at 7.74%. The mortgage matures January 2009.
(e) Inducon East Phase III --------------------------
The loans outstanding of $523,433 at December 31, 1997 were refinanced in 1998. The mortgage outstanding at December 31, 1999 and 1998 of $1,851,636 and $1,875,000, respectively, provides for monthly principal and interest payments of $14,150 including interest at 7.74%. The mortgage matures January 2009.
The mortgage notes are secured by the individual complexes to which they relate and are of a non-recourse nature.
The aggregate maturities of mortgages for each of the next five years and thereafter, assuming principal payments are not accelerated, are as follows:
(6) Fair Value of Financial Instruments - ----------------------------------------
Statement of Financial Accounting Standards No. 107 requires disclosure about fair value of certain financial instruments. The fair values of cash, accounts receivable, accounts receivable - affiliates, accounts payable, accrued interest payable and deposit liabilities approximate the carrying value due to the short-term nature of these instruments.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(6) Fair Value of Financial Instruments, Continued - ---------------------------------------------------
Management has estimated based on current interest rates for similar mortgages, that the fair value of the mortgages payable at December 31, 1999 are as follows:
The Paddock $ 1,632,000 Inducon East 6,064,000 Camelot East Apartments 4,550,000 Commercial Park West 5,994,000 Inducon East Phase III 1,832,000 =========
The terms of the mortgages are described in note 5.
(7) Investments in Joint Ventures - ----------------------------------
Inducon East Joint Venture (the Venture) was formed pursuant to an agreement dated April 22, 1987 between the Partnership and Curtlaw Corporation, a New York corporation (the Corporation). The primary purpose of the Venture was to acquire land and construct office/warehouse buildings as income-producing property. The development consists of two parcels of land being approximately 8.4 acres for Phase I and 6.3 acres for Phase II. Phase I consists of two (2) buildings of approximately 38,000 and 52,000 square feet, while Phase II consists of four (4) buildings totaling approximately 75,000 square feet, with each building being approximately 19,000 square feet.
The Partnership had contributed capital of $2,744,901 to the Venture. The remaining funds needed to complete Phase I came from $3,950,000 taxable industrial revenue bonds which the Venture received in 1989. The Venture completed the financing of the Phase II project with an additional $3,200,000 taxable industrial revenue bond.
The total cost of Phase I and Phase II were approximately $4,425,000 and $4,600,000, respectively.
The Joint Venture agreement provided that income and losses be allocated 95% to the Partnership and 5% to the Corporation. Net cash flow from the joint venture was to be distributed to the Partnership and Corporation in accordance with the terms of the joint venture agreement.
In November 1997, the Partnership acquired the interest of Curtlaw Corporation for $40,000. The Partnership now owns 100% of the Inducon East property. The results of the property's operations for the period from January 1, 1997 through October 31, 1997 were allocated in accordance with the Joint Venture Agreement. The property began to be consolidated in the Partnership's financial statements beginning November 1, 1997.
Inducon East Phase III Joint Venture (the Phase III Venture) was formed pursuant to an agreement dated September 8, 1992 between the Partnership and Inducon Corporation (Inducon). The primary purpose of the Phase III Venture was to acquire land and construct office/warehouse buildings as income-producing property. The development consists of 4.2 acres of land and two buildings with approximately 25,200 and 21,300 square feet, respectively.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(7) Investments in Joint Ventures, Continued - ---------------------------------------------
The Partnership contributed $1,582,316 to the Phase III Venture. The remaining funds needed to complete construction came from a $750,000 construction loan described in note 5.
The total cost of the Phase III venture was approximately $2,450,000.
The Joint Venture agreement provided that income and losses be allocated 95% to the Partnership and 5% to Inducon. Net cash flow from the joint venture was to be distributed to the Partnership and Inducon in accordance with the terms of the joint venture agreement.
In November 1997, the Partnership acquired the interest of Inducon for $40,000. The Partnership now owns 100% of the Phase III property. The results of the property's operations for the period from January 1, 1997 through October 31, 1997 were allocated in accordance with the joint venture agreement. The property began to be consolidated in the Partnership's financial statements beginning November 1, 1997.
(8) Related Party Transactions - -------------------------------
The corporate general partner and its affiliates earned the following fees and commissions as provided for in the partnership agreement for the years ended December 31, 1999, 1998 and 1997:
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(8) Related Party Transactions, Continued - ------------------------------------------
Accounts payable - affiliates totaled $107,861 and $338,251 at December 31, 1999 and 1998, respectively.
Partnership accounting and portfolio management fees, investor services fees and brokerage fees are allocated based on total assets, the number of partners, and number of units, respectively. In addition to the above, other property specific expenses, such as payroll, benefits, etc. are charged to property operations on the statement of operations.
The general partners are also allowed to collect a property disposition fee upon sale of acquired properties. This fee is not to exceed the lesser of 50% of amounts customarily charged in arm's-length transactions by others rendering similar services for comparable properties or 2.75% of the sales price. The property disposition fee is subordinate to payments to the limited partners of a cumulative annual return (not compounded) equal to 7% of their average adjusted capital balances and to repayment to the limited partners of an amount equal to their original capital contributions. Since these conditions described above have not been met, no disposition fees were paid or accrued on the March 1990 sale of Pelham East or on the five properties sold in 1997 as described in note 3.
(9) Leases - -----------
In connection with the commercial properties owned, the Partnership has entered into lease agreements with terms of one to five years. Minimum future rentals to be received for each of the next five years, under noncancelable operating leases are as follows:
2000 $ 2,619,198 2001 1,706,381 2002 1,102,924 2003 349,641 2004 33,714 ===========
(10) Income Taxes - ------------------
The tax returns of the Partnership are subject to examination by the Federal and state taxing authorities. Under federal and state income tax laws, regulations and rulings, certain types of transactions may be accorded varying interpretations and, accordingly, reported Partnership amounts could be changed as a result of any such examination.
REALMARK PROPERTY INVESTORS LIMITED PARTNERSHIP - V Notes to Financial Statements, Continued
(10) Income Taxes, Continued - -----------------------------
The reconciliation of partners' capital as of December 31, 1999, 1998 and 1997, as reported in the balance sheets, and as reported for tax return purposes, is as follows:
The reconciliation of net (loss) income for the years ended December 31, 1999, 1998 and 1997 and as reported in the statements of operations, and as reported for tax return purposes, is as follows:
(11) Subsequent Event - Contingency - ------------------------------------
The Partnership, as a nominal defendant, the General Partners of the Partnership and the three individuals constituting the officers and directors of the Corporate General Partner, as defendants, were served with a Summons and Complaint on April 19, 2000 in a class and derivative action instituted by Ira Gaines and on August 21, 2000 in a class and derivative action instituted by Sean O'Reilly and Louise Homburger, each in Supreme Court, County of Erie, State of New York. The actions allege breaches of contract and breaches of fiduciary duty and seek, among other things, an accounting, the removal of the General Partners, the liquidation of the Partnership and the appointment of a receiver to supervise the liquidation, and damages. The General Partners and the officers and directors of the Corporate General Partner have filed a motion to dismiss the first complaint and are presently reviewing the second complaint and intend to vigorously pursue their defense. | 7,780 | 52,955 |
1038373_1999.txt | 1038373_1999 | 1999 | 1038373 | ITEM 1. BUSINESS
Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
ITEM 2.
ITEM 2. PROPERTIES
Reference is made to the Annual Compliance Certificate attached hereto as Exhibit 20.
Reference is made to the Annual Statement attached hereto as Exhibit 13.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ---------------------------------------------------
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ---------------------------------------------------------------------
There is no established trading market for Registrant's securities subject to this filing.
Number of holders of the NOTES as of March 15, 2000: 20 --
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ------------------------------------------------------------------------
Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not Applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the Annual Compliance certificate attached as Exhibit 20.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ------------------------------------------------------------------------
Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
None.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT --------------------------------------------------------------
The following information is furnished as of March 15, 2000 as to each holder of record of more than 5% of a class of the Trust's securities:
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(A) None
(B)-(D) Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
PART IV
Item 14.
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K ---------------------------------------------------------------- (a)
1. Ambac Assurance Corporation and subsidiaries audited consolidated financial statements as of December 31, 1999 and 1998 and for each of the years in the three year period ended December 31, 1999 included in the Annual Report on Form 10-K of Ambac Financial Group, Inc., which was filed with the Securities and Exchange Commission on March 30, 2000, are hereby incorporated by reference.
2. Not applicable
3. Exhibits
13. Annual Statement
20. Annual Compliance Certificate
23. Independent Auditors' Consent
(B)-(D) Omitted pursuant to the "Request for no-action letter forwarded to the Office of Chief Counsel Division of Corporation Finance" dated February 12, 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as Representative on behalf of the trust on the 7th day of April, 2000.
CLASSNOTES, INC.
By: /s/ Arthur Q. Lyon --------------------- Name: Arthur Q. Lyon Title: Chief Financial Officer
EXHIBIT INDEX
DESCRIPTION PAGE NUMBER
ANNUAL STATEMENT 7
ANNUAL COMPLIANCE CERTIFICATE 18
INDEPENDENT AUDITORS' CONSENT 19 | 582 | 4,076 |
1088914_1999.txt | 1088914_1999 | 1999 | 1088914 | ITEM 1. BUSINESS
GENERAL
Sleepmaster L.L.C. (the "Company" or "Sleepmaster") is a leading manufacturer and distributor of a full line of conventional bedding, including mattresses and box springs, marketed under the well-known brand names of Serta, Serta Perfect Sleeper, Sertapedic and Masterpiece. Sleepmaster is the second largest Serta licensee in North America with approximately a 23% market share in its domestic licensed territories as of December 31, 1999. Serta, Inc. ("Serta"), through its licensees, is the second largest manufacturer of conventional bedding products in the United States.
Serta, Inc. is a national organization that is owned by and operated for the benefit of its licensees. The organization consists of 10 domestic licensed mattress manufacturers, covering 34 licensing territories and operating out of 27 domestic manufacturing facilities. Serta also has 27 international licensees in Canada, Europe, Asia, the Middle East, South America and the Caribbean.
Sleepmaster is one of Serta's 10 domestic licensed mattress manufacturers, covering licensing territories in all or a portion of New York, Connecticut, New Jersey, Pennsylvania, Delaware, Maryland, Ohio, Indiana, West Virginia, Commonwealth of Kentucky, Florida and Ontario, Canada.
The Company distributes its products through a variety of channels, including bedding chains, furniture retailers, department stores, wholesale buying clubs and contract customers. The Company operates manufacturing facilities located in Linden, New Jersey, Lancaster, Pennsylvania, Riviera Beach, Florida, Cincinnati, Ohio and Concord, Ontario, Canada.
HISTORY OF THE COMPANY
The Company was formed as a limited liability company in January 1995, for the purpose of acquiring substantially all of the assets of Sleepmaster Products Company, L.P., a Delaware limited partnership. At its formation, 98% of the Company was owned by Sleepmaster Holdings L.L.C. ("Holdings") and 2% was owned by Brown/Schweitzer Holdings Inc. ("B/S Holdings"), an investor group. Holdings, in turn, was owned by management of Sleepmaster and outside investors. On November 14, 1996, Sleepmaster entered into a recapitalization agreement with a new group of investors led by Citicorp Venture Capital and PMI Mezzanine Fund L.L.P., pursuant to which the new investor group and Sleep Investor L.L.C., a Delaware limited liability company ("Sleep Investor"), paid cash and issued promissory notes to effect a leveraged recapitalization of Sleepmaster (the "Recapitalization"). As a result of the Recapitalization, Sleep Investor acquired a 72.0% interest and management of Sleepmaster acquired a 28.0% interest in Holdings. Holdings ownership of Sleepmaster increased to over 99.9%.
Since the Recapitalization, Sleepmaster acquired the stock of Palm Beach Bedding Company ("Palm Beach") on March 3, 1998, the stock of Herr Manufacturing Company ("Herr") on February 26, 1999, substantially all of the assets of Star Bedding Products (1986) Limited ("Star") on May 18, 1999 and substantially all of the assets of Adam Wuest, Inc. ("Adam Wuest") on November 5, 1999.
THE SERTA NATIONAL ORGANIZATION
Serta owns the rights to the Serta trademark and licenses companies to manufacture and sell mattresses under the Serta brand name. The licensing agreements prohibit each licensee from manufacturing outside of its licensing territories. The Serta organization generated total domestic licensing revenues of $720 million in the year ended December 31, 1999.
The Serta organization is headed by Serta's president, who reports to a board of directors which consists of representatives of six licensees, two outside directors and the president of Serta. Charles Schweitzer, Chief Executive Officer of Sleepmaster, has been a member of the board of directors of Serta since 1995 and is currently a Vice Chairman of the board of directors. Serta cannot own its licenses and does not have a "right-of-first-refusal" if any are to be sold. Strategic decisions for Serta are made by the board of directors and
passed through to the Serta licensees. Although all Serta national advertising budgets are voted on and approved by the Serta board of directors, Serta licensees control their own marketing, merchandising, manufacturing and administrative functions and thus have the ability to tailor their businesses to the needs of local customers. Serta focuses on the following programs and services for the licensing group: conducting national advertising campaigns; issuing guidelines for Serta products; supervising quality control programs; handling sales programs for national accounts; protecting Serta trademarks; and conducting product research and development. The Company paid approximately 3.0% of its 1999 gross sales as a royalty to the Serta organization.
PRODUCTS
The Company's product line consists of conventional bedding sold primarily under the Serta brand which varies in price, design, material and size. Retail prices for Serta brand products range from under $200 for a twin size promotional bedding set to approximately $2,400 for a king size luxury set. Introduced in 1999, the Masterpiece line represents an upscale collection of mattresses and boxsprings. Retail prices of the Masterpiece line range from approximately $700 for twin size to $5,000 for king size. Serta Perfect Sleeper brand mattress is the second largest selling mattress brand in North America. The Company offers retailers a full line of products, allowing retailers to develop their own product assortment to facilitate step-up sales and to meet various consumer comfort and support preferences.
CUSTOMERS
The Company manufactures and supplies products to over 2,780 retail outlets, representing more than 1,150 customers, which include furniture stores, department stores, specialty sleep shops, contract customers and other stores. The Company's ten largest customers accounted for approximately 48% of net sales in 1999. One account represented 11% of net sales in 1999.
In 1999, the Company experienced a substantial decline in sales to one of its customers. Management anticipates that its relationship with this customer will improve in 2000.
SALES, MARKETING AND ADVERTISING
The Company's marketing and advertising focus on local markets as well as the national market. The Company employs a sales organization of approximately 60 people to target local retailers and to sell its products to authorized retailers in local markets. The sales force is provided with ongoing, extensive training in advertising, merchandising and salesmanship so that they can successfully target retailers and work closely with retailers to assist them in implementing and improving their sales techniques. In addition, Serta has formed an organization to sell Serta products on a national level and to administer programs for national accounts such as Sears and Sam's Club. The combination of the Company's local sales efforts and Serta's national marketing efforts allows the Company to better analyze the needs of its retailers and to customize its sales and marketing efforts to specific competitive environments.
The Company's marketing strategy focuses on two areas: (1) total retailer support programs -- including cooperative advertising programs designed to meet individual retailer needs and to complement individual retailers' marketing programs and (2) a continuation of the substantial investment in national advertising that has established and will continue to build brand awareness. The retailer support program assists retailers in increasing sales by providing them with advertising and retail incentive packages tailored to their needs, point of sale materials that enable retail sales people to demonstrate the unique features of the Company's products and explain step-up features to increase average unit selling prices, retail sales education programs conducted at retail sites and at the Company's factory showrooms, and merchandised product assortments to meet the needs of retailers and help achieve step-up sales. Management believes this program differentiates the Company from most of its competitors.
Serta invests in building the Serta brand name through national advertising, and has been recognized as one of the leading brands in the home furnishing industry. Serta advertises throughout the year on prime network and cable programs, as well as on selected daytime and syndicated programs. Serta also advertises in various magazine publications and sponsors highly successful radio programs.
INDUSTRY AND COMPETITION
Overall, the U.S. conventional bedding industry is mature and stable. Over the past 20 years, the industry experienced increases in revenues at a compounded annual growth rate of 6.7%. Sales in the bedding industry declined only once during this period, 1.9 % in 1982. According to International Sleep Products Association, the domestic bedding industry consists of over 800 manufacturers, generating wholesale revenues of $4.1 billion during 1999. Conventional bedding is primarily sold to furniture stores and specialty sleep shops. Management estimates that U.S. consumers replace mattresses, on average, every 7 to 8 years resulting in approximately seventy percent of new mattresses being purchased as replacements.
Serta is the second largest conventional bedding manufacturer in the United States, with well-known brand names such as Serta, Serta Perfect Sleeper, Sertapedic and Masterpiece, and primarily competes with two national companies, Sealy and Simmons. In 1998, these top three bedding manufacturers accounted for approximately 54% of domestic wholesale mattress and box spring shipments. Of the top three bedding manufacturers, Serta is the only one comprised solely of licensees. The license structure gives Serta and its licensees the advantage of having a strong national organization combined with localized marketing and sales efforts to maximize opportunities in local markets.
MANUFACTURING FACILITIES AND DISTRIBUTION
The Company operates four bedding manufacturing facilities in the United States and one manufacturing facility in Concord, Ontario, Canada. Of the five facilities, one operates a single shift and the others operate two shifts daily.
The Company's facilities are strategically located to service one or more major metropolitan areas. The Company has instituted just-in-time inventory techniques to enable it to supply products in an efficient manner and minimize its inventory carrying costs. The Company adjusts production levels to meet demand and as a result has no material backlog of orders.
The Company has entered into various distribution arrangements at each facility based upon its needs and the circumstances at each location. In some locations, the Company has contracted with independent third parties to distribute all or a portion of its products and in other locations the Company owns or leases trailers and either distributes the products themselves or outsources the distribution function. Management believes that the flexibility of this distribution program allows the Company to distribute products using the most cost effective method.
In August 1999, the Company terminated its agreement with an exclusive distributor for its Linden facility due to the distributor's poor performance. In October 1999, the Company executed a five-year logistics contract with a new distributor with a national presence to replace its existing distributor. As a result of the new arrangement, distribution costs at the Linden facility increased by approximately 8%. Subsequent to December 1999, the Company terminated the logistics agreement with its new distributor and entered into a five-year leasing arrangement with the same distributor to lease tractors and trailers. The Company plans to manage its own distribution with these leased tractors and trailers. No additional costs were incurred as a result of terminating the logistics agreement and entering into the new leasing arrangement.
SUPPLIERS
The Company purchases raw materials, including innersprings, box spring modules, lumber, foam and ticking from a variety of suppliers. The Company takes advantage of all trade discounts and does not enter into written supply contracts with any of its suppliers. The Company purchased approximately 70% of its raw materials from 10 suppliers, including approximately 37% of the Company's total raw materials from
Leggett & Platt in 1999. The Company maintains several alternative-source suppliers for most of its raw materials. However, the Perfect Sleeper innerspring units can only be purchased from Leggett & Platt. The Company has never suffered a significant production loss from insufficient raw material supplies.
WARRANTIES
The Company's conventional bedding products generally offer limited warranties of ten years against manufacturing defects, with promotional products carrying warranties of one year. Historically, the Company's costs of honoring warranty claims have been immaterial.
ENVIRONMENTAL, HEALTH AND SAFETY MATTERS
The Company's principal wastes are nonhazardous materials such as wood, cardboard, scrap foam and packaging materials, which are primarily sold to recyclers. The Company also disposes of small amounts of used oil, primarily by recycling. As is the case with manufacturers in general, if a release of hazardous substances occurs on or from the Company's properties or any associated off-site disposal location, or if contamination from prior activities is discovered at any of its properties, the Company may be held liable and the amount of the liability could be material.
The Company is subject to federal, state, and local laws and regulations relating to pollution, environmental protection and occupational health and safety. In addition, its conventional bedding and other product lines are subject to various federal and state laws and regulations relating to flammability, sanitation and consumer protection standards. The Company believes that it is in material compliance with such laws and regulations.
The Company is not aware of any pending federal environmental legislation which would have a material impact on the Company's operations. The Company does not expect to make any material capital expenditures for environmental controls during the next two fiscal years.
EMPLOYEES
As of December 31, 1999, the Company employed approximately 1,024 full-time employees, of whom approximately 500 were represented by various labor unions with separate collective bargaining agreements. The Company is periodically in negotiations with certain of the unions representing its employees. The Company is not a party to any master labor agreement covering production employees at more than a single manufacturing facility. The Company has not experienced any work stoppages or slowdowns as a result of labor difficulties during the last ten years and believes that its relationships with its employees are good.
SEASONALITY
Sleepmaster's net sales and net income are generally consistent throughout the fiscal year, except for slight increases in the third quarter. However, seasonal variations in net sales and net income affect each of Sleepmaster's five facilities. Palm Beach's net sales and net income are typically higher during the first and fourth quarters of the fiscal year. In contrast, net sales and net income are typically higher during the third quarter of the fiscal year at the Linden, New Jersey, Lancaster, Pennsylvania, Cincinnati, Ohio, and Concord, Ontario, Canada facilities. Since Palm Beach's sales cycle does not coincide with the sales cycles at the other facilities, seasonal variations of Sleepmaster are reduced.
ITEM 2.
ITEM 2. PROPERTIES
The Company's principal executive offices are located at 2001 Lower Road, Linden, New Jersey, 07036-6520.
The following table sets forth certain information regarding the manufacturing facilities operated by the Company at December 31, 1999:
The Linden, New Jersey, facility is held pursuant to a lease which terminates on February 1, 2004 but contains two five-year options to extend the lease. The Star facility in Concord, Ontario, Canada is held pursuant to a lease which terminates on December 31, 2000 but contains a five year option to renew. It is management's intention to exercise its right to extend the leases beyond the initial expiration dates for both the Linden and Star facilities.
The Company considers its present facilities to be generally well maintained, in sound operating condition and adequate for its present needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company is involved in various legal proceedings arising in the ordinary course of business. Management does not expect that these matters, individually or in the aggregate, will have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company. The Company is not currently involved in any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There is no established public trading market for the common membership interests of the Company. As of March 15, 2000, Sleepmaster Holdings L.L.C. owned 7,999 units of the Company's Class A common membership interests and Sleep Investor L.L.C. owned one unit of the Company's Class A common membership interests.
The Company has not paid any cash distributions on its common membership interests during the fiscal years ended December 31, 1999, 1998 or 1997. The Company has not sold any securities during the past three years in transactions not registered under the Securities Act.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected consolidated financial and other data of the Company. The selected consolidated financial and other data for the fiscal years ended December 31, 1999, 1998, 1997 and 1996 have been derived from, and should be read in conjunction with, the Company's audited consolidated financial statements. The financial and other data as of and for the fiscal year ended December 31, 1995 has been derived from the Company's internal financial records and is unaudited but, in the opinion of management, includes all adjustments considered necessary for the fair presentation of the financial condition and results of operations for the period and as of that date.
The selected consolidated financial and other data provided below should be read in conjunction with the accompanying consolidated financial statements and notes thereto as well as Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein.
- --------------- (a) Interest expense, net includes the amortization of deferred debt issuance costs of $60, $391, $170, $281 and $454 for the years ended December 31, 1995, 1996, 1997, 1998 and 1999, respectively.
(b) Represents total current assets, excluding cash and cash equivalents, less total current liabilities, excluding current portion of long-term debt.
(c) Adjusted EBITDA represents, for any period, net income before interest expense, income taxes, depreciation and amortization and other non-operating income/expense. Adjusted EBITDA is presented because it is a widely accepted financial indicator of a company's ability to service and/or incur indebtedness. The Company believes that presentation of Adjusted EBITDA may be helpful to investors. However, Adjusted EBITDA should not be considered an alternative to net income as a measure of Sleepmaster's operating results or to cash flows as a measure of liquidity. In addition, although the Adjusted EBITDA measure of performance is not recognized under generally accepted accounting principles, it is widely used by industrial companies as a general measure of a company's operating performance because it assists in comparing performance on a relatively consistent basis across companies without regard to depreciation and amortization, which can vary significantly depending on accounting methods, particularly where acquisitions are involved, or non-operating factors such as historical cost bases. Because Adjusted EBITDA is not calculated identically by all companies, the presentation in this prospectus may not be comparable to other similarly titled measures of other companies.
(d) In calculating the ratio of earnings to fixed charges, earnings consist of income before income taxes and extraordinary items plus fixed charges. Fixed charges consist of interest expense, net, including amortization of issuance costs, whether capitalized or expensed, plus one-third of rental expense under operating leases, the portion that has been deemed by management to be representative of an interest factor.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the "Selected Financial Data", set forth in Item 6 hereof, and the Financial Statements of the Company and the notes thereto included elsewhere herein.
GENERAL
Sleepmaster acquired the stock of Palm Beach on March 3, 1998, the stock of Herr on February 26, 1999, substantially all of the assets of Star on May 18, 1999 and substantially all of the assets of Adam Wuest on November 5, 1999. Each of these acquisitions has been accounted for using the purchase method of accounting. The Company's historical results of operations reflect the results of the acquired businesses. Therefore, the historical operating results of the Company for the periods presented are not necessarily comparable.
RESULTS OF OPERATIONS
The following table sets forth operating data of Sleepmaster as a percentage of net sales for the fiscal years ended December 31, 1997, 1998 and 1999.
FISCAL 1999 COMPARED WITH FISCAL 1998
Net Sales. Net sales increased 55.4%, or $61.0 million, to $171.3 million in 1999 from $110.3 million in 1998. A significant portion of the increase was due to the contribution of net sales from Herr, acquired on February 26, 1999, Star, acquired on May 18, 1999 and, to a less significant extent, Adam Wuest, acquired on November 5, 1999. Net sales contributed by Herr, Star and Adam Wuest were $20.5 million, $11.5 million and $6.4 million in 1999, respectively. Excluding the acquisitions of Herr, Star, and Adam Wuest and considering the annualized 1998 results of Palm Beach, net sales increased by 13.4%, or $15.7 million, in 1999. Better sales penetration with existing customers, the addition of new customers and the introduction of the new Masterpiece line of bedding products during the year were significant factors contributing to the strong sales growth. In addition, generally higher unit sales volumes and higher average unit selling prices resulting from shifts in product sales mix toward higher priced products contributed to this increase.
Cost of Sales. Cost of sales increased 52.0%, or $35.9 million, to $104.9 million in 1999 from $69.0 million in 1998. Cost of sales as a percentage of net sales decreased to 61.2% in 1999 from 62.6% in 1998. The reduction of cost of sales as a percentage of net sales in 1999 was primarily due to the impact of higher margin business generated by Palm Beach, Herr and Star, as well as higher margins realized on sales of the Masterpiece line of bedding products introduced in 1999. Margins were also favorably impacted by Sleepmaster successfully obtaining volume-related cost savings on raw material purchases as a result of the acquisitions of Palm Beach, Herr, Star and Adam Wuest, which serve to reduce purchase costs and hence reduce the ratio of cost of sales to net sales. Partially offsetting these higher margins were higher manufacturing costs for Sleepmaster resulting from (1) the development and launch of the Masterpiece line of bedding products during 1999 and (2) a realignment of direct and indirect labor resources to extend production capabilities, together with associated costs.
Selling, General and Administrative Expenses. Selling, general and administrative expenses ("SG&A") increased 67.8%, or $17.5 million, to $43.3 million in 1999 from $25.8 million in 1998. SG&A as a percentage of net sales increased to 25.3% in 1999 from 23.4% in 1998. Several factors contributed to the increase in SG&A as a percentage of net sales: (1) Palm Beach and Herr have higher fixed cost bases than Sleepmaster and the second, third and fourth quarters of 1999 include the full impact of Herr's fixed cost base on the consolidated results; (2) Palm Beach and Herr have higher delivery expenses as a percentage of net sales due to the large geographical territories they service compared with that of Sleepmaster; (3) Palm Beach has certain contractual employment arrangements which expire in March 2000 that contributed to the increase in SG&A as a percentage of net sales; and (4) promotional costs increased in 1999 as a result of the market introduction of the Masterpiece range of bedding products.
Amortization of Intangibles. Amortization of intangibles increased $1.3 million to $2.5 million in 1999 from $1.2 million in 1998. This increase was due to the acquisitions of Palm Beach in March 1998, Herr in February 1999, Star in May 1999 and Adam Wuest in November 1999.
Operating Income. Operating income increased 45.1%, or $6.4 million, to $20.6 million in 1999 from $14.2 million in 1998. As a result of the above factors, operating income as a percentage of net sales decreased to 12.1% in 1999 from 12.9% in 1998.
Interest Expense, Net. Interest expense increased 76.1%, or $5.4 million, to $12.5 million in 1999 from $7.1 million in 1998. This increase was due to the cost of additional debt financing incurred for the acquisitions of Palm Beach, Herr and Adam Wuest and the issuance of senior subordinated notes on May 18, 1999. See "Liquidity and Capital Resources".
Provision for Income Taxes. The provision for income taxes increased by $0.2 million, to $3.2 million, in 1999 from $3.0 million in 1998. The provision for income taxes resulted in an effective tax rate of 39.4% in 1999 compared with 42.1% in 1998. The effective tax rate decreased due to the expansion of the business toward lower tax jurisdictions as a result of the aforementioned acquisitions, as well as the effect of additional debt financing being incurred by Sleepmaster for such acquisitions.
Extraordinary Items. The extraordinary items recorded in 1999 consisted of the payment of $3.6 million in premiums on the redemption of $20 million in aggregate principal amount of Series A and Series B 12% Subordinated Notes and repayment of $69.2 million of borrowings under the Company's former credit facility, together with the write-off of $1.9 million of unamortized debt issuance costs relating to such redemption and repayment on May 18, 1999. See "Liquidity and Capital Resources". There were no extraordinary items incurred during 1998.
Net Income. As a result of the above factors, net income decreased by $2.3 million, to $1.8 million in 1999 from $4.1 million in 1998.
FISCAL 1998 COMPARED WITH FISCAL 1997
Net Sales. Net sales increased by 63.4%, or $42.8 million, to $110.3 million in 1998 from $67.5 million in 1997. This increase was primarily due to the acquisition of Palm Beach which contributed ten months of sales totaling $37.1 million. Excluding the acquisition of Palm Beach, net sales increased by 8.4%, or $5.7 million, to $73.2 million in 1998 from $67.5 million in 1997. This increase was primarily attributable to higher unit volumes in 1998. There was also an increase in average unit selling prices due to a change in product sales mix to higher priced products.
Cost of Sales. Cost of sales increased by 62.7%, or $26.6 million, to $69.0 million in 1998 from $42.4 million in 1997. Cost of sales as a percentage of net sales decreased to 62.6% in 1998 from 62.9% in 1997. This improvement was primarily due to higher margin business generated by Palm Beach. These higher margins, which serve to reduce cost of sales as a percentage of net sales, were partially offset by an increase in Sleepmaster's manufacturing costs in 1998. As a result of the Palm Beach acquisition, Sleepmaster was also able to realize cost savings on raw material purchases as a result of obtaining additional volume-related purchase discounts from vendors.
Selling, General and Administrative Expenses. Selling, general and administrative expenses ("SG&A") increased by 72.0%, or $10.8 million, to $25.8 million in 1998 from $15.0 million in 1997. SG&A as a percentage of net sales increased to 23.4% in 1998 from 22.3% in 1997. Several factors contributed to this increase. First, Palm Beach has a higher fixed cost base as a percentage of net sales than Sleepmaster's base business and has a greater number of smaller customers than Sleepmaster. Second, Palm Beach has higher delivery expenses as a percentage of net sales due to its large geographical licensed territory. Such expenses were offset by increases in average unit selling prices and generally fixed delivery costs per unit at our Linden, New Jersey, facility. Finally, Palm Beach has certain contractual employment arrangements, which expire in March 2000, which contributed to the increase in SG&A as a percentage of net sales.
Amortization of Intangibles. Amortization of intangibles increased by $0.6 million, to $1.2 million in 1998 from $0.6 million in 1997. This increase was due to the acquisition of Palm Beach in March 1998.
Operating Income. Operating income increased by 52.6%, or $4.9 million, to $14.2 million in 1998 from $9.3 million in 1997. As a result of the above factors, operating income as a percentage of net sales decreased to 12.9% in 1998 from 13.8% in 1997.
Interest Expense, Net. Interest expense increased by 52.2%, or $2.4 million, to $7.1 million in 1998 from $4.7 million in 1997. This increase was due to the cost of additional debt financing on debt incurred and assumed resulting from the acquisition of Palm Beach. See "Liquidity and Capital Resources."
Provision for Income Taxes. The provision for income taxes increased by 50%, or $1.0 million, to $3.0 million in 1998 from $2.0 million in 1997. The provision for income taxes resulted in an effective rate of 42.1% in 1998 and 42.2% in 1997.
Net Income. As a result of the above factors, net income for 1998 was $4.1 million compared to $2.8 million in 1997.
RECENT ACCOUNTING PRONOUNCEMENTS
In February 1998, the American Institute of Certified Public Accountants' Accounting Standards Executive Committee issued Statement of Position ("SOP") No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use", which requires certain costs incurred in connection with developing or obtaining internal use software to be capitalized and other costs to be expensed. The Company adopted SOP 98-1 effective January 1, 1999. The impact of adopting this standard was to increase pre-tax income for 1999 by $1.9 million.
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal source of cash to fund its liquidity needs is net cash provided by operating activities and availability under its amended and restated credit facility. Net cash provided by operating activities was $13.9 million in 1999 compared to $8.9 million in 1998 and $6.0 million in 1997. The increase in cash flows in 1999 was primarily due to increased net income from operations, before extraordinary items, and the acquisitions of Herr, Star and Adam Wuest. The Company's principal uses of funds provided by operating activities consist of payments of principal and interest on the Company's indebtedness and capital expenditures.
Capital expenditures totaled $4.2 million, $1.1 million and $0.6 million in 1999, 1998 and 1997, respectively. The increase in expenditures in 1999 was primarily attributable to the Company upgrading and expanding its information systems' capabilities. The balance of the increase in capital expenditures was for machinery and equipment at all facilities. Management expects that capital expenditures at all its facilities will be approximately $4.5 million in 2000. Additionally, management believes that annual capital expenditure limitations under the amended and restated credit facility will not significantly inhibit Sleepmaster from meeting its capital needs.
Sleepmaster generated $92.1 million of cash inflows from financing activities in 1999, principally arising from net proceeds from the issuance on May 18, 1999 of $115.0 million of 11% senior subordinated
notes due 2009 and borrowings under an increased credit facility to acquire Herr and Adam Wuest, compared with cash inflows of $24.5 million in 1998 and cash outflows of $5.0 million in 1997. Financing cash inflows in 1998 arose primarily from borrowings under an increased credit facility to acquire Palm Beach and financing cash outflows in 1997 arose principally from repayments of borrowings under the revolving credit facility.
On February 26, 1999, Sleepmaster purchased all of the capital stock of Herr. In connection with the acquisition, Sleepmaster amended and restated its credit facility to provide for an aggregate amount of borrowings of up to $86.0 million, a portion of which was used to finance the acquisition of Herr.
On May 18, 1999, Sleepmaster purchased substantially all the assets of Star, the Serta licensee located in Concord, Ontario, Canada. The acquisition was primarily funded with the net proceeds of the issuance of $115.0 million of 11% senior subordinated notes due 2009.
On November 5, 1999, Sleepmaster purchased substantially all the assets of Adam Wuest. This acquisition was funded primarily through the expansion of its existing credit facility and additional equity contributed by Holdings.
Debt
On November 5, 1999, Sleepmaster amended and restated its credit facility to provide for borrowings of up to $70.0 million, consisting of a $33.0 million six-year revolving credit facility and a $37.0 million amortizing term loan facility. Borrowings under the amended and restated credit facility are collateralized by substantially all of Sleepmaster's domestic assets and are guaranteed by all of its domestic restricted subsidiaries and Sleepmaster Holdings L.L.C. Similar to the prior credit facility, the revolving credit facility includes a sublimit for letters of credit. At December 31, 1999, the Company had approximately $17.1 million available under its revolving credit facility. As of December 31, 1999, letters of credit issued under this sublimit, which was increased to $15.0 million, consist of:
(a) $6.6 million to collateralize the Palm Beach industrial revenue bonds currently outstanding,
(b) $2.3 million to collateralize the Adam Wuest economic development bonds currently outstanding,
(c) $0.72 million for a security deposit on the Linden, New Jersey, facility, and
(d) $0.06 million for a parcel of land purchased by Herr.
Borrowings under the amended and restated credit facility bear interest at floating rates that are based on LIBOR or on the applicable alternate base rate and, accordingly, Sleepmaster's financial condition and performance will be affected by changes in interest rates. The amended and restated credit facility also imposes certain restrictions on Sleepmaster and requires Sleepmaster to comply with certain financial ratios and tests.
On November 5, 1999 Sleepmaster Holdings L.L.C. entered into a subordinated credit agreement with Citicorp Mezzanine Partners, L.P. with availability of $10.0 million. In connection with the acquisition of Adam Wuest, Sleepmaster Holdings L.L.C. borrowed $10.0 million under the subordinated credit agreement and made an equity contribution of $10.0 million to Sleepmaster. Sleepmaster used the $10.0 million equity contribution to assist in financing its acquisition of Adam Wuest.
On May 18, 1999, Sleepmaster and Sleepmaster Finance Corporation issued $115.0 million of 11% senior subordinated notes due 2009. Sleepmaster used a portion of the proceeds of the senior subordinated note offering to prepay the old credit facility, redeem the series A and series B senior subordinated notes due 2007 and acquire substantially all of the assets of Star. Also on May 18, 1999, Sleepmaster entered into a credit facility with First Union National Bank. The credit facility provided revolving credit facilities with aggregate availability of $25.0 million. The revolving credit facility was scheduled to mature six years after closing and included a sublimit of $8.0 million for letters of credit.
In conjunction with the purchase of substantially all the assets of Star on May 18, 1999, Sleepmaster Holdings L.L.C. issued a junior subordinated note to the seller in the initial aggregate principal amount of $0.68 million as a portion of the purchase price. The junior subordinated note bears interest at a fixed rate of 6.0% per annum, which interest shall be paid in kind, and will mature on the third anniversary of the closing.
Sleepmaster, through its subsidiary Palm Beach, is obligated to the County of Palm Beach, Florida, pursuant to revenue bonds issued on behalf of Palm Beach. On April 1, 1996, the County of Palm Beach Florida issued Variable Rate Demand Industrial Development Revenue Bonds, Palm Beach Bedding Company Project, Series 1996 in the aggregate principal amount of $7.7 million to finance the construction of a 235,000 square foot manufacturing facility for Palm Beach. As of December 31, 1999, $6.3 million of the bonds were outstanding. The bonds mature in April 2016 and bear interest at a variable rate that was 5.15% at December 31, 1999.
Sleepmaster, through its subsidiary Adam Wuest, is obligated to the County of Hamilton, Ohio, pursuant to economic revenue bonds issued on behalf of Adam Wuest. On February 1, 1994, the County of Hamilton, Ohio, issued Fixed Rate Economic Development Revenue Funding Bonds, Series 1994 in the aggregate principal amount of $3.0 million to finance the Adam Wuest, Inc. Project. As of December 31, 1999, $2.0 million of the bonds were outstanding. The bonds mature in September 2010 and bear interest at fixed rates ranging from 4.5% to 5.6% depending on the maturity date of the bond series.
In connection with the recapitalization of Sleepmaster Holdings L.L.C. on November 14, 1996, Sleepmaster issued $15.0 million of series A 12% senior subordinated notes due 2006 to PMI. In connection with the acquisition of Palm Beach on March 3, 1998, Sleepmaster issued $5.0 million of series B 12% senior subordinated notes due 2007 to PMI and amended the terms of the series A senior subordinated notes to extend the maturity date to 2007. On May 18, 1999, Sleepmaster used a portion of the net proceeds from the $115.0 million senior subordinated note offering to prepay the Series A and Series B senior subordinated notes due 2007.
Also in connection with the recapitalization of Sleepmaster Holdings L.L.C. on November 14, 1996, Sleep Investor issued $7.0 million of 7.02% junior subordinated promissory notes, due November 14, 2007, and paid cash to the then existing members of Sleepmaster Holdings L.L.C., including current members of the Company's management. In exchange for the notes, the then-existing members of Sleepmaster Holdings L.L.C. delivered common and preferred interests of Sleepmaster Holdings L.L.C., as well as notes issued by Sleepmaster Holdings L.L.C., to Sleep Investor. Interest payments received by Sleep Investor on the notes issued by Sleepmaster Holdings L.L.C. correspond to Sleep Investor's obligation to make interest payments on the promissory notes. The interest on the promissory notes is pay-in-kind except that an amount equal to the current tax liability for interest payments received on the promissory notes is paid in cash. The maturity date of the promissory notes was extended in connection with the acquisition of Palm Beach from November 14, 2007 to November 14, 2008. In connection with the completion of the $115.0 million senior subordinated note offering, and the prepayment of the Series A and Series B senior subordinated notes due 2007, the promissory notes were further amended to retroactively bear interest at a fixed rate of 12.0% per annum and to mature on November 14, 2007.
Sleepmaster has no obligations or commitments to Sleepmaster Holdings L.L.C. or Sleep Investor either under the promissory notes or the junior subordinated note. The amended and restated credit facility will allow Sleepmaster to fund interest payments on the promissory notes and the junior subordinated note. Distributions, dividends and loans from Sleepmaster to Sleepmaster Holdings L.L.C. are restricted by the terms of the indenture governing the notes.
Management believes that cash flows from operations, together with borrowings under the senior credit facility, will be adequate to fund Sleepmaster's currently anticipated working capital, capital spending and debt service requirements for the forseeable future.
SEASONALITY OF BUSINESS
Sleepmaster's net sales and net income are generally consistent throughout the fiscal year, except for slight increases in the third quarter. However, seasonal variations in net sales and net income affect each of Sleepmaster's five facilities. Palm Beach's net sales and net income are typically higher during the first and fourth quarters of the fiscal year. In contrast, net sales and net income are typically higher during the third quarter of the fiscal year at the Linden, New Jersey, Lancaster, Pennsylvania, Cincinnati, Ohio, and Concord, Ontario, Canada facilities. Since Palm Beach's sales cycle does not coincide with the sales cycles at the other facilities, seasonal variations of Sleepmaster are reduced.
YEAR 2000
In order to minimize or eliminate the effect of the Year 2000 risk on the Company's business systems and applications, the Company identified, evaluated, implemented and tested changes to its computer systems, applications and software necessary to achieve Year 2000 compliance. The computer systems and equipment successfully transitioned to the Year 2000 with no significant issues. The Company continues to keep its Year 2000 project management in place to monitor latent problems that could surface at key dates or events in the future. Management does not anticipate any significant problems related to these events. The total cost of the Year 2000 compliance plan was approximately $650,000 and was incurred principally during the first two quarters of 1999. The Company expensed and capitalized the costs to complete its compliance plan in accordance with appropriate accounting policies.
FORWARD LOOKING STATEMENTS AND RISK FACTORS
This document contains forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although the Company believes its plans are based upon reasonable assumptions as of the current date, it can give no assurance that such expectations can be attained. Factors that could cause actual results to differ materially from the Company's expectations include: general business and economic conditions; competitive factors; raw materials availability and pricing; fluctuations in demand; and retention and availability of qualified employees.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk from fluctuations in interest rates, which could impact its consolidated financial position, results of operations and cash flows. The Company manages its exposure to market risk through its regular operating and financing activities. The Company does not use derivative financial instruments for speculative or trading purposes and does not maintain such instruments that may expose the Company to significant market risk.
The Company's earnings are sensitive to changes in short-term interest rates as a result of its borrowings under the senior credit facility. If interest rates increase by 10 percent during the year ended December 31, 2000, the Company's interest expense would increase, and income before income taxes would decrease, by approximately $0.5 million. This analysis does not consider the effects of the reduced level of overall economic activity, or other factors, that could exist in such an environment. Further, in the event of a change of such magnitude, management could take actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in the Company's financial structure.
The Company also manages its portfolio of fixed-rate debt to reduce its exposure to interest rate changes. The fair value of the Company's fixed-rate long-term debt is sensitive to interest rate changes. Interest rate changes would result in gains or losses in the fair value of this debt due to differences between market interest rates and rates at the inception of the obligation. Based on a hypothetical 10 percent increase in interest rates at December 31, 1999, the fair value of the Company's fixed-rate long-term debt would decrease by approximately $3.7 million.
See Note 11 to the consolidated financial statements for a discussion of the Company's debt.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Financial Statements and accompanying notes as listed in the Index to Financial Statements commencing on page herein.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. ADVISORS AND EXECUTIVE OFFICERS OF THE COMPANY
The following sets forth certain information as of December 31, 1999, with respect to the persons who are members of the Board of Advisors and key executive officers of the Company.
Charles Schweitzer has served as President and Chief Executive Officer of Sleepmaster since April 1993, after joining Sleepmaster as Senior Vice President in April 1986. Prior to joining Sleepmaster, he served as Senior Vice President, Sales and Marketing for Classic Corporation, one of the world's largest waterbed manufacturers. Before his tenure at Classic Corporation, Mr. Schweitzer served as Vice President, Marketing for Sealy Mattress Company of Connecticut/New York. Mr. Schweitzer has a B.A. in Economics and an MBA in Marketing from City College of New York.
James Koscica has served as Executive Vice President and Chief Financial Officer of Sleepmaster since January 1995 and served as Vice President of Finance and Administration since April 1993, after joining Sleepmaster as controller in November 1989. Before he joined Sleepmaster, he served as controller for a Budget Rent-A-Car Corporation franchise. Prior to his work at Budget, Mr. Koscica served in management in systems development at AT&T. Mr. Koscica has a B.A. in Accounting from Rutgers University and is a licensed CPA in New Jersey.
Michael Reilly has served as Senior Vice President of Sales and Marketing since January 1995 and Vice President of Sales from April 1993, after joining Sleepmaster as Key Account Executive in February 1978. Before joining Sleepmaster, Mr. Reilly served as Marketing Representative for Simmons Company. Mr. Reilly has a B.A. in Business Administration from Catholic University.
Timothy DuPont has served as Vice President of Manufacturing since April 1993, after joining Sleepmaster as Manufacturing Manager in January 1985. Before joining Sleepmaster, he served as General Manager for Guilden Development Company. Mr. DuPont has a B.A. in Business Administration from Chapman College.
Michael Bubis is an advisor of Sleepmaster. Mr. Bubis has worked at Palm Beach since 1969 and has been President of Palm Beach since 1991. Mr. Bubis served as a member of the board of directors of Serta from 1995 through 1998.
David Thomas is an advisor of Sleepmaster. Mr. Thomas has been a Managing Director of Citicorp Venture Capital, Ltd. for over five years. Mr. Thomas is a director of Lifestyle Furnishings International Ltd., Galey & Lord, Inc., Anvil Knitwear, Inc., Plainwell, Inc., Stage Stores, Inc. and American Commercial Lines LLC.
John Weber is an advisor of Sleepmaster. Mr. Weber has been a Vice President at Citicorp Venture Capital, Ltd. since 1994. Previously, Mr. Weber worked at Putnam Investments from 1992 through 1994.
Mr. Weber is a director of Anvil Knitwear, Inc., Electrocal Designs, Inc., FFC Holding, Inc., Graphic Design Technologies, Marine Optical, Inc., Gerber Childrenswear, Inc., Plainwell, Inc. and Smith Alarm.
Michael Bradley is an advisor of Sleepmaster. Mr. Bradley joined Citicorp Venture Capital, Ltd. in 1996. Prior to joining Citicorp Venture Capital, Ltd., Mr. Bradley worked at Merrill Lynch and Selected Equity Research. Mr. Bradley received his B.A. from the University of Virginia, his J.D. from the University of Virginia and his MBA from Columbia Business School. Mr. Bradley serves on the board of directors of Hayden Corporation, MinCorp, Galey & Lord, Inc. and HL Holdings.
Robert Bartholomew is an advisor of Sleepmaster. Mr. Bartholomew co-founded Pacific Mezzanine Investors in 1990. Previously, Mr. Bartholomew worked at Pacific Mutual from 1986 through 1989. Mr. Bartholomew received his B.A. in Economics and an MBA in Finance from Rutgers University.
CHANGES IN MANAGEMENT
On March 2, 2000, Timothy Dupont resigned as the Vice President of Manufacturing. Effective immediately, Timothy Gann, Director of Manufacturing, assumed substantially all of the responsibilities of Mr. Dupont. Mr. Gann has served as the Director of Manufacturing from July 1999 through the present time.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information concerning the annual and long-term compensation for services in all capacities to the Company for the fiscal year ended December 31, 1999, of those persons who served as (i) the chief executive officer during fiscal year 1999, and (ii) the other four most highly compensated executive officers of the Company for fiscal year 1999 (collectively, the "Named Executive Officers"):
SUMMARY COMPENSATION TABLE
- ---------------
(a) Includes amounts paid as discretionary awards for fiscal 1999.
(b) Represents amounts paid on behalf of each of the Named Executive Officers for (i) premiums for health, life and accidental death and dismemberment insurance and for long-term disability benefits; (ii) contributions to Sleepmaster's defined contribution plans; and (iii) automobile allowances.
No stock options were exercised by any of the Named Executive Officers during fiscal 1999. The following table sets forth the number of securities underlying unexercised options held by each of the Named Executive Officers and the value of the options as of December 31, 1999:
FISCAL YEAR END OPTION VALUES
- --------------- (a) Value of unexercised options at fiscal year-end represents the difference between the exercise price of any outstanding-in-the-money options and the fair market value of Sleepmaster Holdings L.L.C.'s class A common membership interests on December 31, 1999.
EXECUTIVE EMPLOYMENT AGREEMENTS
In 1996, Sleepmaster Holdings L.L.C., Sleepmaster and Sleep Investor entered into employment and option agreements with Charles Schweitzer, James Koscica, Michael Reilly and Timothy DuPont dated as of November 14, 1996. These agreements provide for, among other things, terms of employment until November 1, 2001 and base salaries of $305,000 (Mr. Schweitzer), $210,000 (Mr. Koscica), $171,000 (Mr. Reilly) and $111,000 (Mr. DuPont) subject to annual increases by the Board of Advisors. Annual bonuses are to be calculated based upon EBITDA performance of Sleepmaster. The agreements also provide an option vesting schedule for employees to acquire membership interests in Sleepmaster Holdings L.L.C., which Sleepmaster Holdings L.L.C. or Sleepmaster, if Sleepmaster Holdings L.L.C. does not elect to purchase all such interests, may repurchase if the employee is terminated for any reason. Timothy DuPont resigned on March 3, 2000 and Sleepmaster Holdings L.L.C. is in the process of repurchasing the Class A common interests held by Mr. DuPont which are subject to the repurchase option.
On March 3, 1998, Palm Beach (joined by Sleepmaster Holdings L.L.C. and Sleepmaster) entered into an employment agreement with Michael Bubis. The agreement has terms which are substantially similar to the terms of the agreements described above and provide for, among other things, terms of employment until March 3, 2001 and a base salary of $267,904, subject to annual increases by the Board of Advisors. Additionally, Michael Bubis was elected to the Board of Advisors of Sleepmaster and Sleepmaster Holdings L.L.C. during his term of employment.
STOCK OPTION PLANS
On November 14, 1996, the Company entered into stock option agreements with Charles Schweitzer, James Koscica, Michael Reilly and Timothy DuPont. These nonqualified options entitle the executives to purchase an aggregate amount of 530 units of class A common interests of Sleepmaster Holdings L.L.C. at an exercise price of $100 per unit. Options granted under these agreements vest 50% on December 31, 1999 and 50% on December 31, 2001, subject to Sleepmaster's achievement of EBITDA targets as long as the executive remains employed by Sleepmaster. As of December 31, 1999, Sleepmaster did not achieve the EBITDA targets specified in the agreements. Additionally, applicable portions of the options shall vest upon a sale of Sleepmaster if (i) the sale occurs prior to December 31, 1999 and (ii) the aggregate cash consideration received by the holders of Sleepmaster's common interests equals or exceeds either the target for December 31, 1999 or for December 31, 2001. Fifty percent of the options shall vest upon a sale of Sleepmaster if (i) the sale occurs after December 31, 1999 but before December 31, 2001 and (ii) the aggregate cash consideration received by holders of Sleepmaster's common interests equals or exceeds the target for December 31, 2001. If as of December 31, 2001 any portion of the options have not vested, Sleepmaster may
automatically transfer any portion of the unvested options and re-grant the unvested options without payment of any consideration to the executives. The option agreements may be amended by Sleepmaster Holdings L.L.C.'s board of advisors. Timothy DuPont's stock option agreement terminated upon his resignation on March 3, 2000, and none of the options granted to Mr. DuPont had vested as of such date.
COMPENSATION OF ADVISORS
The advisors to the Company are not compensated for the services they render on the board of advisors, and they are not reimbursed for expenses incurred as a result of board membership.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Board of Advisors authorized and formed a Compensation Committee on September 30, 1999. The Board of Advisors designated John Weber, a member of the Company's Board of Advisors, Charles Schweitzer, President and Chief Executive Officer and a member of the Company's Board of Advisors and Guy Boyle, a member of Sleep Investor L.L.C.'s Board of Advisors to serve as members of the Compensation Committee.
The Named Executive Officers are compensated according to their individual employment agreements described under the Section entitled "Executive Employment Agreements" above.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth ownership information with respect to the common equity interests of Sleepmaster Holdings L.L.C. Sleepmaster Holdings L.L.C. owns over 99.9% of the common equity interests of Sleepmaster.
- --------------- (a) Interests are held indirectly through Sleep Investor L.L.C.
(b) Consists of 1,000 class A common membership interests and warrants currently exercisable for 2,403 common membership interests.
(c) Includes 4,529.76 common membership interests held by Citicorp Venture Capital and CCT Partners IV. Messrs. Thomas and Weber each disclaim beneficial ownership of these common membership interests.
(d) Includes 3,852.3 common membership interests held by Citicorp Venture Capital. Mr. Bradley disclaims beneficial ownership of these common membership interests.
(e) Includes 1,000 common membership interests held by PMI and warrants held by PMI currently exercisable for 2,403 common membership interests. Mr. Bartholomew disclaims beneficial ownership of these common membership interests and warrants.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Each of the following descriptions is a summary of the documents listed below and thus, each summary does not restate the document described in its entirety.
SLEEPMASTER HOLDINGS L.L.C. LIMITED LIABILITY COMPANY OPERATING AGREEMENT
In 1996, Sleep Investor, Charles Schweitzer, James Koscica, Timothy DuPont and Michael Reilly entered into the Sleepmaster Holdings L.L.C. second amended and restated limited liability company operating agreement. Sleepmaster Holdings L.L.C. was formed under the New Jersey Limited Liability Company Act. The business and affairs of Sleepmaster Holdings L.L.C. are managed by the managing member, Charles Schweitzer, subject to the direction of a board of advisors having duties comparable to a corporate board of directors. Currently, the board of advisors is composed of seven advisors. The number of advisors can be increased by a vote of at least 80% of the advisors. The Sleepmaster Holdings L.L.C. limited liability company agreement calls for the existence of four senior officers as follows:
(1) Chief Executive Officer and President,
(2) Executive Vice President and Chief Financial Officer,
(3) Vice President of Sales and
(4) Vice President of Production.
Membership Interests
The board of advisors is authorized to issue or sell any of the following: (1) additional membership interests or other interests in Sleepmaster Holdings L.L.C., (2) obligations, evidences of indebtedness or other securities or interests convertible into or exchangeable for membership interests or other interests in
Sleepmaster Holdings L.L.C. and (3) warrants, options, or other rights to purchase or otherwise acquire membership interests or other interests in Sleepmaster Holdings L.L.C.
The class A members are entitled to one vote per class A common unit. Except as specifically required by law, the class B members and the preferred members have no right to vote on any matters to be voted on by the members of Sleepmaster Holdings L.L.C., except in the case of mergers, consolidations, recapitalizations, or reorganizations. Each class B member is entitled at any time to convert any or all of the class B common units held by the class B member into the same number of class A common units and members holding a majority of the class B common units can cause a conversion of 100% of the class B common units into the same number of class A common units.
Distributions
The board of advisors has sole discretion regarding the amounts and timing of distributions to members of Sleepmaster Holdings L.L.C., subject to the retention and establishment of reserves of, or payments to third parties of, the funds as it deems necessary with respect to the reasonable business needs of Sleepmaster Holdings L.L.C. Distributions are to be made in the following order and priority:
(1) first, to the members in proportion to and to the extent of their unpaid preferred return (as defined in the Sleepmaster Holdings L.L.C. limited liability company agreement),
(2) second, to the members in proportion to and to the extent of their unreturned preferred capital (as defined in the Sleepmaster Holdings L.L.C. limited liability company agreement), and
(3) third, to the members in proportion to their common units.
Redemption
Except as extensions are provided for, Sleepmaster Holdings L.L.C. shall make a distribution to each preferred member on November 14, 2008 in an amount equal to the full amount of the preferred member's unpaid preferred return and unreturned preferred capital as of the scheduled redemption date. In connection with the closing of the old note offering on May 18, 1999, the parties to the Sleepmaster Holdings L.L.C. limited liability company agreement amended the agreement to extend the redemption date of the preferred membership interests to November 14, 2009.
SLEEPMASTER LIMITED LIABILITY COMPANY OPERATING AGREEMENT
Sleep Investor and Sleepmaster Holdings L.L.C. entered into the Sleepmaster amended and restated limited liability company operating agreement. Sleepmaster was formed under the New Jersey Limited Liability Company Act. The business and affairs of Sleepmaster are managed by the managing member, Charles Schweitzer, subject to the direction of a board of advisors having duties comparable to a corporate board of directors. Currently, the Sleepmaster board of advisors is composed of seven advisors. The number of advisors can be increased by a vote of at least 80% of the advisors. The Sleepmaster limited liability company agreement calls for the existence of four senior officers as follows:
(1) Chief Executive Officer and President,
(2) Executive Vice President and Chief Financial Officer,
(3) Vice President of Sales and
(4) Vice President of Production.
Membership Interests
Sleepmaster's board of advisors is authorized to issue or sell any of the following: (1) additional membership interests or other interests in Sleepmaster, (2) obligations, evidences of indebtedness or other securities or interests convertible into or exchangeable for membership interests or other interests in
Sleepmaster, and (3) warrants, options, or other rights to purchase or otherwise acquire membership interests or other interests in Sleepmaster.
The class A members are entitled to one vote per class A common unit. Except as specifically provided or required by law, the class B members and the preferred members have no right to vote on any matters to be voted on by the members of Sleepmaster, except in the case of mergers, consolidations, recapitalizations, or reorganizations. Each class B member is entitled at any time to convert any or all of the class B common units held by the class B member into the same number of class A common units and members holding a majority of the class B common units can cause a conversion of 100% of the class B common units into the same number of class A common units. Currently, 7,999 class A membership interests are held by Sleepmaster Holdings L.L.C. and one is held by Sleep Investor. Sleepmaster Holdings L.L.C. also holds 9,999.96 preferred membership interests.
Distributions
Sleepmaster's board of advisors has sole discretion regarding the amounts and timing of distributions to members of Sleepmaster, subject to the retention and establishment of reserves of, or payments to third parties of, the funds as it deems necessary with respect to the reasonable business needs of Sleepmaster. Distributions are to be made in the following order and priority:
(1) first, to the members in proportion to and to the extent of their Unpaid Preferred Return, as defined in the Sleepmaster limited liability company agreement,
(2) second, to the members in proportion to and to the extent of their Unreturned Preferred Capital, as defined in the Sleepmaster limited liability company agreement, and
(3) third, to the members in proportion to their common units.
Redemption
Except as extensions are provided for, Sleepmaster shall make a distribution to each preferred member on November 14, 2008 in an amount equal to the full amount of such preferred member's unpaid preferred return and unreturned preferred capital as of the scheduled redemption date. In connection with the closing of the old note offering, the parties to the Sleepmaster LLC agreement amended the agreement to extend the redemption date of the preferred membership interests to November 14, 2009.
SLEEPMASTER HOLDINGS L.L.C. SECURITYHOLDERS AGREEMENT
In 1998, Sleepmaster Holdings L.L.C., Sleep Investor, PMI, Charles Schweitzer, James Koscica, Michael Reilly, Timothy DuPont, Michael Bubis, Richard Tauber and Douglas Phillips entered into an amended and restated securityholders agreement dated as of March 3, 1998. On February 26, 1999, John Herr and Stuart Herr executed a joinder to the amended and restated securityholders agreement. On November 5, 1999, David Deye, Stephen Lund and Citicorp Mezzanine Partners executed a joinder to the amended and restated securityholders agreement. The amended and restated securityholders agreement requires that Sleepmaster Holdings L.L.C., Sleep Investor, PMI and those executives of Sleepmaster Holdings L.L.C. vote their membership interests and take all other actions within their control so that the board of advisors of Sleepmaster Holdings L.L.C. will be comprised of four advisors designated by Sleep Investor and three advisors representative of management, Schweitzer, Koscica and Bubis. The board of advisors, or similar governing bodies of Sleepmaster Holdings L.L.C.'s subsidiaries must have the same composition.
In addition, the securityholders agreement:
(1) restricts the transfer of membership interests of Sleepmaster Holdings L.L.C.;
(2) grants tag-along rights on transfers of membership interests of Sleepmaster Holdings L.L.C.;
(3) grants first offer rights on transfers of membership interests of Sleepmaster Holdings L.L.C.;
(4) requires each securityholder to consent to a sale of Sleepmaster Holdings L.L.C. if the sale is approved by the board of advisors of Sleepmaster Holdings L.L.C. and the holders of a majority of the membership interests issued to Sleep Investor and its affiliates; and
(5) grants limited preemptive rights on issuances of membership interests of Holdings.
The tag-along and first offer rights with respect to each securityholder's interests will terminate upon the consummation of a sale of the interests to the public pursuant to an offering registered under the Securities Act of 1933 or to the public effected through a broker-dealer or market-maker pursuant to Rule 144.
SLEEPMASTER HOLDINGS L.L.C. REGISTRATION RIGHTS AGREEMENT
In 1998, Sleepmaster Holdings L.L.C., Sleep Investor, PMI, Charles Schweitzer, James Koscica, Michael Reilly, Timothy DuPont, Michael Bubis, Richard Tauber and Douglas Phillips entered into an amended and restated registration rights agreement dated as of March 3, 1998. On February 26, 1999, John Herr and Stuart Herr executed a joinder to the amended and restated registration rights agreement. On November 5, 1999, David Deye, Stephen Lund and Citicorp Mezzanine Partners executed a joinder to the amended and restated registration rights agreement. Under the amended and restated registration rights agreement, the holders of a majority of the membership interests issued to Sleep Investor or its affiliates have the right, subject to certain conditions, to require Sleepmaster Holdings L.L.C. to consummate a registered offering of equity securities of Sleepmaster Holdings L.L.C. or a successor corporate entity.
In addition, all holders of registrable securities are entitled to request the inclusion, subject to the terms and conditions of the registration rights agreement, of any of their common interests in any registration statement, other than registration statements on forms S-8 or S-4 or any similar form in connection with a registration to primarily register debt securities, at Sleepmaster Holdings L.L.C.'s expense whenever Sleepmaster Holdings L.L.C. proposes to register any of its common interests under the Securities Act of 1933. In connection with all the registrations, Sleepmaster Holdings L.L.C. has agreed to indemnify all holders of registrable securities against liabilities, including liabilities under the Securities Act of 1933.
THE RECAPITALIZATION AND OTHER TRANSACTIONS
Recapitalization Agreement
In November 1996, Sleepmaster Holdings L.L.C., Sleepmaster, Sleep Investor, Brown/Schweitzer Holdings Inc. and each of the then existing members of Sleepmaster Holdings L.L.C. entered into a recapitalization agreement. Pursuant to the recapitalization agreement, Sleepmaster Holdings L.L.C. redeemed all of the membership interests of its members, except for four members who are current members of management, and then sold the membership interests to Sleep Investor. In addition, Sleep Investor purchased 8,714 units of redeemable preferred interests and 6,099 units of common interests of Sleepmaster Holdings L.L.C. for approximately $12.9 million plus issuance of notes to the then existing members of Sleepmaster Holdings L.L.C. totaling $7.0 million. The remaining preferred and common interests of Sleepmaster Holdings L.L.C. were allocated to the four members of Sleepmaster Holdings L.L.C. who are currently members of our management. As a result of the recapitalization, Sleep Investor acquired 72% of the outstanding interests of Sleepmaster Holdings L.L.C. and Sleepmaster Holdings L.L.C. management retained 28%.
Sleep Investor Promissory Notes
In conjunction with the recapitalization of Sleepmaster Holdings L.L.C. in 1996, Sleep Investor issued $7.0 million of junior subordinated notes and paid cash to the then-existing members of Sleepmaster Holdings L.L.C., including current members of our management. In exchange for the notes, the then-existing members of Sleepmaster Holdings L.L.C. delivered common and preferred interests of Sleepmaster Holdings L.L.C., as well as notes issued by Sleepmaster Holdings L.L.C., to Sleep Investor. As of December 31, 1999, the amount outstanding of the promissory notes, including interest, totaled $8.7 million. In connection with the old note
offering and the redemption of the senior subordinated notes, the promissory notes were amended to provide for a 12.0% interest rate and a maturity date of November 14, 2007.
Senior Subordinated Notes
In November 1996 Sleepmaster, Sleepmaster Holdings L.L.C. and PMI entered into a securities purchase agreement. Pursuant to this agreement, Sleepmaster sold $15.0 million series A senior subordinated notes due 2007 to PMI. These senior subordinated notes held by PMI were redeemed with a portion of the net proceeds of the old note offering. In addition, in March 1998, Sleepmaster, Sleepmaster Holdings L.L.C. and PMI entered into a securities purchase agreement. Pursuant to this agreement, Sleepmaster sold $5.0 million series B senior subordinated notes due 2007 to PMI. These senior subordinated notes held by PMI were redeemed with a portion of the proceeds of the old note offering.
Warrants
In connection with the sale of senior subordinated notes by Sleepmaster to PMI in 1996 and 1998, Sleepmaster Holdings L.L.C. issued to PMI 2000 warrants and 403 warrants, respectively, to purchase class A common units of Sleepmaster Holdings L.L.C. The warrants are currently exercisable at any time until March 3, 2010 at an exercise price of $0.01 per unit, subject to adjustment. The holders of a majority of the outstanding warrants, during a specified window period each year from November 14, 2003 to November 14, 2009, have the right to require Sleepmaster Holdings L.L.C. to purchase all of the warrants or common units into which the warrants are exercisable. If this right is exercised, the purchase price on a per unit basis would be an amount equal to the value of Sleepmaster Holdings L.L.C. divided by the number of outstanding units of common interests. The value of Sleepmaster Holdings L.L.C. would be the greater of a multiple of EBITDA and the aggregate current market price of the units of common interests on a fully diluted basis. The put option is subject to the availability of financing. The put option shall terminate upon 1) an approved sale, or (2) the consummation of an underwritten public offering of units of common interests.
In connection with the issuance of a subordinated note to assist in the purchase of substantially all of the assets of Adam Wuest by Sleepmaster on November 5, 1999, Sleepmaster Holdings L.L.C. issued to Citicorp Mezzanine Partners, L.P. warrants to purchase Class B common membership interests of Sleepmaster Holdings L.L.C. The warrants are exercisable at any time after June 30, 2007 and before June 30, 2009 at an exercise price of $0.01 per unit, subject to certain anti-dilution adjustments. If Sleepmaster Holdings L.L.C. prepays in full the subordinated note on or prior to June 30, 2007, the warrants will not be exercisable and will be terminated.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Consolidated Financial Statements
See Financial Statements and accompanying notes as listed in the Index to Financial Statements commencing on page herein.
(2) Financial Statement Schedules
All schedules called for by Regulation S-X are not submitted because either they are not applicable or not required or because the required information is included in the consolidated financial statements or notes thereto.
(3) Exhibits
The Exhibits listed in (c) below are filed herewith.
(b) Reports on Form 8-K
The Company filed no reports on Form 8-K during the year ended December 31, 1999.
(c) Exhibits
- --------------- ** Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Sleepmaster L.L.C. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the City of Linden, State of New Jersey.
SLEEPMASTER L.L.C.
By: /s/ CHARLES SCHWEITZER ------------------------------------ President and Chief Executive Officer
Dated: March 30, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Advisors and Members of Sleepmaster L.L.C.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, members' deficit and of cash flows present fairly, in all material respects, the consolidated financial position of Sleepmaster L.L.C. (the "Company") and its subsidiaries at December 31, 1999, 1998 and 1997 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
New York, New York March 24, 2000
SLEEPMASTER L.L.C.
CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND 1998
The accompanying notes are an integral part of these consolidated financial statements.
SLEEPMASTER L.L.C.
CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
The accompanying notes are an integral part of these consolidated financial statements.
SLEEPMASTER L.L.C.
CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS' EQUITY (DEFICIT)
The accompanying notes are an integral part of these consolidated financial statements.
SLEEPMASTER L.L.C.
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
The accompanying notes are an integral part of these consolidated financial statements.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BUSINESS
Sleepmaster L.L.C. ("Sleepmaster" or the "Company"), is a leading manufacturer and distributor of Serta brand mattresses and box springs and owns the exclusive Serta manufacturing rights in all or a portion of ten states (New York, Connecticut, Pennsylvania, New Jersey, Delaware, Maryland, Florida, Ohio, Indiana, West Virginia), the Commonwealth of Kentucky and Ontario, Canada. The Company was formed on January 2, 1995 by acquiring substantially all of the assets and liabilities of Sleepmaster Products Company, L.P., a Delaware limited partnership. The business and affairs of the Company are governed by the Limited Liability Company Operating Agreement of Sleepmaster L.L.C. (the "Sleepmaster L.L.C. Agreement"), which established a board of advisors having duties comparable to a corporate board of directors.
Prior to November 1996, 98% of the Company was owned by Sleepmaster Holdings L.L.C. ("Holdings") and 2% was owned by Brown/Schweitzer Holdings Inc. ("B/S Holdings"). Holdings was owned by management of Sleepmaster and outside investors. On November 14, 1996, the Company entered into a recapitalization agreement (the "Recapitalization"). Under the Recapitalization, the members of Holdings sold their respective interests in part to Holdings, followed by the sale of a portion of the membership interest to new investors. As a result of the Recapitalization, Holdings' ownership of Sleepmaster was increased to almost 100% and B/S Holdings was replaced by Sleep Investor L.L.C. ("Sleep Investor"), a group of investors led by Citicorp Venture Capital and PMI Mezzanine Fund L.L.P. Because of the ownership change of Holdings as a result of the Recapitalization, management of Sleepmaster owns 28% of Holdings. The Sleepmaster L.L.C. Agreement was amended following the completion of this transaction (the "Amended Sleepmaster L.L.C. Agreement"). See Note 4 for further details of the transaction and impact on members of the Company.
On March 3, 1998, the Company acquired the capital stock of Palm Beach Bedding Company ("Palm Beach") for cash and the assumption of Palm Beach County, Florida, variable rate industrial development revenue bonds.
On February 26, 1999, the Company acquired substantially all of the capital stock of Herr Manufacturing Company ("Herr") for cash.
On May 18, 1999, the Company acquired substantially all of the assets of Star Bedding Products (1986) Limited, including its subsidiary, Burrell Bedding Limited (collectively, "Star") for cash and a promissory note issued by Holdings.
On November 5, 1999, the Company acquired substantially all of the assets of Adam Wuest Inc. and Adam Wuest Realty (collectively "Adam Wuest") for cash and the assumption of Hamilton County, Ohio, fixed rate economic development revenue funding bonds.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Palm Beach, Herr, Star and Adam Wuest for the year ended December 31, 1999. All significant intercompany balances and transactions have been eliminated. Sleepmaster Finance Corporation is a wholly-owned subsidiary of the Company, formed solely for the purpose of acting as co-issuer of the 11% senior subordinated notes, issued on May 18, 1999, and has no assets or operations. See Note 11 for further discussion regarding the issuance of these senior subordinated notes.
For the year ended December 31, 1998, the consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Palm Beach. For the year ended December 31, 1997, the consolidated financial statements include the accounts of the Company only.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Use of Estimates in Preparation of the Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates and assumptions relate to the determination of the allowance for doubtful accounts, accruals for sales allowances and advertising expenses and the recoverability of long-lived assets. Actual results could differ from those estimates.
Revenue Recognition
The Company recognizes revenue at the time of shipment. Appropriate accruals for returns, discounts, rebates and other allowances are recorded as reductions in sales. The Company's bedding products offer limited warranties of up to 10 years against manufacturing defects. The Company's cost of honoring warranty claims is immaterial.
Cash and Cash Equivalents
Cash and cash equivalents include all highly liquid investments with original maturities of three months or less. Cash equivalents are stated at cost, plus accrued interest, which approximates fair value.
Inventories
Inventories are stated at the lower of cost or market and include the cost of materials, labor and manufacturing overhead. Cost is determined using the first-in, first-out (FIFO) method. Inventories are primarily produced on a made-to-order basis.
Property, Plant and Equipment
Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the following estimated useful lives of the assets:
Leasehold improvements are amortized over the shorter of the terms of the leases or lives of the assets. Expenditures for maintenance and routine repairs are expensed as incurred. Upon the disposition of property, plant and equipment, the accumulated depreciation is deducted from the original cost and any gain or loss is reflected in current income.
Intangible Assets
Intangible assets include goodwill, which represents the excess of the purchase price over the fair value of net assets acquired, and licenses, which are amortized using the straight-line basis over forty years. In 1998, intangible assets also included a non-compete agreement, which was fully amortized by December 31, 1999.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Long-Lived Assets
The Company reviews its long-lived assets and certain intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. The measurement of impairment losses to be recognized is based on the difference between the fair values and the carrying amounts of the assets. Impairment would be recognized in operating results if a diminution in value occurred. At December 31, 1999, the Company does not believe that any such changes have occurred.
Deferred Financing Costs
The costs incurred for obtaining financing, including all related legal fees, which were approximately $6,873,000 at December 31, 1999, net of accumulated amortization of $454,000, are included in other assets in the accompanying consolidated balance sheets and are amortized to interest expense over the lives of the related financing.
Advertising Costs
The Company expenses advertising costs, consisting primarily of cooperative advertising with dealers and retailers, when the revenue from sales to customers is recorded. Advertising costs for the years ended December 31, 1999, 1998 and 1997 amounted to approximately $13,638,000, $8,154,000 and $5,779,000 respectively.
Recent Accounting Pronouncements
In February 1998, the American Institute of Certified Public Accountants' Accounting Standards Executive Committee issued Statement of Position ("SOP") No. 98-1, "Accounting for the Costs of Computer Software Developed or obtained for Internal Use", which requires certain costs incurred in connection with developing or obtaining internal use software to be capitalized and other costs to be expensed. The Company adopted SOP 98-1 effective January 1, 1999. The impact of adopting this standard was to increase pre-tax income for 1999 by $1.9 million.
Income Taxes
Income taxes are accounted for by the asset and liability method, which recognizes deferred tax assets and liabilities by applying statutory tax rates in effect at the balance sheet date to differences between the book and tax basis of existing assets and liabilities. The Company files various state income tax returns and a consolidated Federal income tax return with its Parent, Holdings. The current and deferred income tax provisions and related current and deferred income tax assets and liabilities for the Company were determined on a separate company basis. Currently, the Company does not maintain a tax sharing agreement with its Parent.
Reclassifications
Certain reclassifications were made to prior years' consolidated financial statements to conform with the current year's presentation.
3. ACQUISITIONS
On February 26, 1999, the Company acquired all the capital stock of Herr Manufacturing Company ("Herr") for approximately $25,600,000 in cash. In order to finance the acquisition of Herr, the Company increased its existing Senior Credit Facility by $25,300,000.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On May 18, 1999, the Company acquired substantially all the assets of Star Bedding Products (1986) Limited, including its subsidiary, Burrell Bedding Limited (collectively, "Star"), for approximately $16,700,000 in cash and a promissory note issued by Holdings (the Company's Parent) in the amount of approximately $680,000. The acquisition was primarily funded with the net proceeds of the note offering as discussed in Note 11.
On November 5, 1999, the Company acquired substantially all the assets of Adam Wuest for approximately $57,038,000 in cash. This acquisition was funded primarily through the expansion of its existing credit facility and additional equity provided by Holdings which, in turn, was raised by a subordinated credit facility.
These acquisitions were accounted for under the purchase method and, accordingly, their results are included in the consolidated financial statements since their respective dates of acquisition. The assets acquired and liabilities assumed have been recorded at their estimated fair values at the dates of acquisition. The excess of the purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill and is being amortized over 40 years.
A summary of the purchase price allocations (in thousands) is as follows:
The following summarized unaudited pro forma financial information (in thousands) assumes that the acquisitions of Palm Beach, Herr, Star, and Adam Wuest were consummated on January 1, 1999 and 1998. The following also gives effect to the issuance of the senior subordinated notes and the application of the proceeds therefrom as of such dates. This information is not necessarily indicative of the results that the Company would have achieved had these events actually occurred on such dates or of the Company's actual or future results.
4. RECAPITALIZATION
On November 16, 1996, the Company's Parent, Holdings, entered into a recapitalization agreement (the "Recapitalization Agreement") with the Company, B/S Holdings and Sleep Investor. As part of the Recapitalization, all outstanding membership interests were converted to redeemable cumulative preferred interests and common interests pursuant to the terms of the Amended Sleepmaster L.L.C. Agreement (See Note 1).
Pursuant to the Recapitalization Agreement, Holdings redeemed all of the membership interests of its members, except for four members who are members of management of the Company ("Retained
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Members"), for an aggregate amount of cash equal to approximately $34,700,000 and then sold such membership interests to Sleep Investor. In addition, Sleep Investor purchased 8,714 units of redeemable cumulative preferred interests and 6,099 units of common interests of Holdings for approximately $12,900,000 plus issuance of a $7,000,000 pay-in-kind note payable to all former members of Holdings, including the Retained Members. The remaining redeemable cumulative preferred and common interests of Holdings were allocated to the Retained Members. As a result of the Recapitalization, Sleep Investor owns 72% of the outstanding units of Holdings and the Retained Members own the remaining 28%.
Financing for the Recapitalization, including the refinancing of existing indebtedness and fees and expenses incurred, was provided by (1) the Company's borrowings under a new $29,700,000 Senior Secured Credit Facility, (2) the Company's borrowing under $15,000,000 Senior Subordinated Notes and (3) the $12,900,000 of capital provided by Sleep Investor.
The Company has accounted for the Recapitalization as a leveraged recapitalization, whereby the historical bases of the assets and liabilities of the Company have been maintained for financial reporting purposes.
5. INVENTORIES
Inventories consist of the following (in thousands):
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following (in thousands):
Depreciation and amortization expense was approximately $1,539,000, $866,000 and $449,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. INTANGIBLE ASSETS
Intangible assets consist of the following (in thousands):
8. CONCENTRATION OF CREDIT RISK
A substantial portion of the consolidated net sales of the Company is made to a limited number of customers. In 1999, one customer accounted for approximately 11% of consolidated net sales. In 1998, two customers accounted for approximately 13% and 11%, respectively, of consolidated net sales. In 1997, three customers accounted for approximately 17%, 14% and 12%, respectively, of net sales.
Amounts receivable from these customers represented approximately 14% and 30% of the trade accounts receivable balance at December 31, 1999 and 1998, respectively.
Purchases of raw materials from one vendor represented approximately 37%, 43% and 34% of total raw material purchases for 1999, 1998 and 1997, respectively.
9. LICENSE AGREEMENT
Serta, Inc. ("Serta") is a national non-profit organization consisting of 10 domestic licensed operating mattress manufacturing companies. The organization aids the manufacturers in marketing, merchandising, manufacturing specifications, trademarks and related activities through license fees paid by the licensees. Serta owns the rights to the Serta trademark and licenses companies to manufacture and sell mattresses under the Serta brand name. The Company's license with Serta is effective until terminated by mutual written agreement by both parties or if the Company does not comply with the provisions of the license agreement. In 1999, 1998 and 1997, the Company paid approximately $5,590,000, $3,400,000 and $2,400,000, respectively, in license fees to Serta.
The Company is obligated to contribute to a Serta deferred compensation arrangement based upon the achievement of certain earnings targets by the Serta licensee group. The Company recorded an expense of approximately $320,000 for 1999 and $75,000 for 1998 under this arrangement. No expense was recorded in 1997 since the earnings targets were not achieved.
10. EMPLOYEE BENEFIT PLANS
In 1999, the Company maintained a contributory profit sharing plan ("401(k)/Profit Sharing Plan") covering substantially all non-union employees of the Company and of Herr, one of its wholly owned subsidiaries, who met certain eligibility requirements. Prior to the acquisition of Herr, this plan covered substantially all of the non-union employees of the Company only. Employees may elect to make contributions of up to 15% of their salary. The plan also provides for an employer match contribution. The Company currently contributes an amount equal to 100% of the first 3% of salary contributed plus 50% of the next 2% of salary contributed. Prior to 1999, the Company contributed an amount equal to 50% up to the first 4% of employee contributions. In addition, the Company may elect to contribute a discretionary amount, which is
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
determined annually by management, to all eligible employees. The Company reserves the right to terminate or amend the 401(k)/Profit Sharing Plan at any time. The Company contributed approximately $553,000 for 1999, $286,000 for 1998 and $259,000 for 1997.
Union employees, pursuant to a collective bargaining agreement, are covered under a salary reduction plan ("Retirement 401(k) Plan") established by the Company. Employees, who have met certain eligibility requirements, may elect to make contributions of up to 15% of their salary. In addition, the Company may elect to contribute a discretionary amount to all eligible employees. All eligible employees receive an equal contribution amount per year. Contribution expense for this plan was approximately $59,000 for 1999, $35,000 for 1998 and $24,000 for 1997.
In 1999 and 1998, Palm Beach maintained its own contributory profit sharing plan ("401(k)/Profit Sharing Plan and Trust"), covering substantially all employees. Palm Beach contributed an amount equal to 50% of the first 6% of salary contributed. An additional discretionary amount was determined by management and contributed to each eligible employee. Palm Beach elected to contribute approximately $200,000 for each of the fiscal years ended 1999 and 1998. Effective January 1, 2000, substantially all of the employees of Palm Beach will be covered under the Company's 401(k)/Profit Sharing Plan.
In 1999, Adam Wuest maintained its own contributory profit sharing plan, covering salaried employees who met certain eligibility requirements. In addition, union employees of Adam Wuest were covered by a union sponsored multi-employer pension plan. The contribution expense for these plans for the period since acquisition is immaterial to the consolidated financial statements.
11. DEBT
The following is a summary of the Company's long-term debt (in thousands):
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
During the first quarter of 1999, the Company amended and restated its credit facility to provide for an aggregate amount of borrowings of up to $86,000,000 and used a portion of this increased facility to finance its acquisition of Herr on February 26, 1999. The terms of the amended facility were substantially equivalent to those of the prior credit facility.
On May 18, 1999, the Company issued $115,000,000 of 11% senior subordinated notes due 2009 (the "Notes"). A portion of the proceeds of the note offering was used to prepay the existing credit facility, redeem the Company's Series A and Series B Senior Subordinated Notes due 2007 and complete the acquisition of Star. In connection with the repayment of the existing credit facility and Series A and Series B Senior Subordinated Notes, the Company wrote-off unamortized debt issuance costs and incurred prepayment penalties. These transactions resulted in an extraordinary loss of $3,167,000 net of the associated income tax benefit of $2,293,000. Also on May 18, 1999, the Company entered into a six-year $25,000,000 revolving credit facility which replaced the prior credit facility. The new credit facility included a letter of credit sublimit of $8,000,000. Borrowings under this credit facility bore interest at floating rates based on LIBOR or applicable alternative base rates. The credit facility imposed certain restrictions on the Company and required compliance with certain financial ratios and other requirements customary to credit facilities of this nature.
On November 5, 1999, the Company expanded and restated the credit facility entered into on May 18, 1999 to $70,000,000, comprising a $33,000,000 six-year revolving credit facility ("Revolving Credit Facility") and a $37,000,000 amortizing term loan facility ("Term Loan Facility" and, together with the Revolving Credit Facility, the "Credit Facility"), under substantially the same terms as the prior credit facility except that the letter of credit sublimit was increased to $15,000,000. At December 31, 1999, the Company had approximately $17,100,000 available under its Revolving Credit Facility with letters of credit issued totaling approximately $9,600,000. Borrowings under the Term Loan Facility were used to finance the acquisition of Adam Wuest. Indebtedness under the Credit Facility is guaranteed jointly and severally by the Company, its Parent and each of its domestic subsidiaries.
The Company, through its subsidiary Palm Beach, is obligated to the County of Palm Beach, Florida, pursuant to revenue bonds issued on behalf of Palm Beach. On April 1, 1996, the County of Palm Beach issued Variable Rate Demand Industrial Development Revenue Bonds, Palm Beach Bedding Company Project, Series 1996 in the aggregate principal amount of $7,700,000 to finance the construction of a 235,000 square foot manufacturing facility for Palm Beach. The bonds are collateralized by a letter of credit issued by Fifth Third Bank and further collateralized by First Union National Bank for the benefit of the trustee under the indenture relating to the bonds on the Palm Beach manufacturing facilities and a pledge of Palm Beach's interest in the bonds.
The Company, through its subsidiary Adam Wuest, is obligated to the County of Hamilton, Ohio, pursuant to economic revenue bonds issued on behalf of Adam Wuest. On February 1, 1994, the County of Hamilton, Ohio issued Fixed Rate Economic Development Revenue Funding Bonds, Series 1994 in the aggregate principal amount of $3,000,000 to finance the Adam Wuest, Inc. Project. The bonds are
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
collateralized by a letter of credit issued by Fifth Third Bank and further collateralized by First Union National Bank for the benefit of the trustee under the indenture relating to the bonds on the Adam Wuest manufacturing faculties and a pledge of Adam Wuest's interest in the bonds.
Additionally, the Company has a letter of credit with a bank in the amount of $720,462 as a rental security deposit on its Linden, New Jersey, facility. The Company pays a commitment fee of 3% per year of the face amount.
The Company pays commitment fees of 1/2% per annum on the unused amount of the credit facilities.
Under the terms of the agreements of the Credit Facility and Senior Subordinated Notes, the Company is required to maintain certain financial ratios and other financial conditions. The agreements of the Credit Facility and Senior Subordinated Notes also prohibit the Company from incurring certain additional indebtedness and limit certain investments, capital expenditures and cash dividends. At December 31, 1999, the Company was in compliance with these financial ratios and conditions.
Long term debt at December 31, 1999 is scheduled to mature as follows (in thousands):
In conjunction with the purchase, by Sleepmaster, of substantially all the assets of Star on May 18, 1999, Holdings issued a junior subordinated note to the seller in the initial aggregate principal amount of approximately $685,000, included in other liabilities at December 31, 1999. The junior subordinated note bears interest at a fixed rate of 6.0% per annum, which interest shall be paid in kind, and will mature on the third anniversary of the closing of the purchase of Star. Sleepmaster has no obligations or commitments to Holdings for the junior subordinated note; however, the Credit Facility will allow Sleepmaster to fund interest payments on the junior subordinated note. Distributions, dividends and loans from Sleepmaster to Holdings are restricted by the terms of the indenture governing the notes.
12. MEMBERS' EQUITY
In accordance with the Amended Sleepmaster L.L.C. Agreement, the Company's board of advisors may issue three classes of membership interests: Class A common interests, Class B common interests and preferred interests. Class A common interests entitle the holder to one vote per Class A common unit. The holders of Class B common interests and preferred interests have no voting or participating rights except in the case of mergers, consolidations, recapitalizations or reorganizations. The Company had outstanding Class A common units of 8,000 as of December 31, 1999 and 1998. No Class B common units have been issued by the Company as of December 31, 1999. See Note 13 for further details of the preferred interests issued as of December 31, 1999.
In connection with the purchase of Adam Wuest on November 5, 1999 as discussed in Note 3, the Company received $9,800,000 in common interest contributions, net of issuance costs of $200,000, from Holdings and approximately $800,000 in common interest contributions from certain owners of Adam Wuest. Holdings financed its contribution by issuing a 14% subordinated note in an aggregate principal amount of $10,000,000, due June 30, 2007, ("Subordinated Note") to Citicorp Mezzanine Partners, L.P. Since the Subordinated Note will not be assumed by the Company, none of the Company's assets or membership
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
interests are pledged as collateral for the Subordinated Note and the Company is not required to but may utilize its cash flows to assist Holdings in meeting its debt service obligations under the Subordinated Note, management does not believe there is or will be any impact on the Company's results of operations, financial position or cash flows as a result of Holdings issuing the Subordinated Note.
13. REDEEMABLE CUMULATIVE PREFERRED INTERESTS
The Company had outstanding 9,999.96 units of cumulative redeemable preferred units as of December 31, 1999 and 1998. The preferred units are not convertible into any other security of the Company and the holders have no voting rights except in the case of mergers, consolidations, recapitalizations or reorganizations. The preferred units accrue dividends at a compounded rate of 12% per annum. The preferred units are redeemable on November 14, 2009, together with the accrued and unpaid dividends unless the maturity date of the Senior Subordinated Notes is extended, at which point the redemption date will be the earlier of (i) the twelve month anniversary of the extended maturity date of the Senior Subordinated Notes and (ii) November 14, 2011; provided further that the redemption date shall only be extended one time.
14. WARRANTS
In connection with the sale of senior subordinated notes by Sleepmaster to PMI in 1996 and 1998, Holdings issued to PMI 2,000 warrants and 403 warrants, respectively, to purchase class A common interests of Holdings (the "Class A Warrants"). The Class A Warrants are exercisable at any time until March 3, 2010 at an exercise price of $0.01 per unit, subject to adjustment, and represent 2,403 Class A common units of Holdings (approximately 22% of the total common interests).
In connection with the issuance of the Subordinated Note by Holdings, as discussed in Note 12, Holdings issued to Citicorp Mezzanine Partners, L.P. ("CMP") warrants to purchase Class B common interests of Holdings (the "Class B Warrants") at an exercise price of $0.01 per unit, subject to certain conditions. The Class B Warrants are exercisable at any time after June 30, 2007 and before June 30, 2009 and represent 1,298.14 Class B common units of Holdings (approximately 12% of the total common interests).
Since both the Class A Warrants and Class B Warrants were issued by Holdings and the only operation of Holdings is its investment in Sleepmaster, the Company would record an adjustment to reduce the carrying amount of debt issued, with an offsetting charge to accumulated deficit to the extent of the fair value of the warrants issued, if material. No adjustments were recorded when the warrants were issued, since management considered the fair value of the warrants to be immaterial.
15. STOCK OPTIONS
In 1998 and 1996, pursuant to the employment agreements of certain employees, Holdings issued options to purchase 100 shares and 530 shares, respectively, of Class A common units of Holdings at an exercise price of $100 (the "Options"). The Options vest 50% on December 31, 1999 and 50% on December 31, 2001 subject to the achievement of certain earnings targets by Sleepmaster. Any unexercised options terminate on the tenth anniversary of the date of grant or earlier, in connection with the termination of employment.
Since this is a variable stock compensation plan of Holdings and the only operation of Holdings is its investment in Sleepmaster, the Company will record compensation expense based on the difference between the exercise price and the fair value of the Options at the balance sheet date, when it believes it probable that the Company will meet the earning targets. No compensation cost related to the Options has been recorded in 1999, 1998 or 1997 since, based on the Company's current trend of earnings, management considers it unlikely that they will achieve the earnings targets set forth in the option agreements.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
16. INCOME TAXES
The provision for income taxes consists of the following (in thousands):
The Company's effective tax rate differs from the Federal statutory rate as indicated in the following reconciliation for the years ended December 31:
Deferred income taxes reflect the net tax differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax reporting purposes. The significant component of the Company's net deferred tax assets represents the tax effect of goodwill attributable to the step-up in the tax bases of the Company's assets and liabilities as a result of the leveraged recapitalization on November 14, 1996 (see Note 4). The Company recognized a net deferred tax asset of approximately $16,500,000 in connection with this recapitalization. At December 31, 1999 and 1998, no valuation allowance has been recorded against this deferred tax asset since management considers it more likely than not that such deferred tax asset will be realized. At December 31, 1999, the Company had a Federal net operating loss carryforward of approximately $3,407,000, which expires in 2019, and a state net operating loss carryforward of approximately $12,508,000, which expires between 2007 and 2015. These net operating loss carryforwards represent a deferred tax benefit of approximately $1,305,000.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The components of net deferred tax assets as of December 31, 1999 and 1998 are as follows (in thousands):
17. COMMITMENTS AND CONTINGENCIES
Operating Leases
On January 12, 1995, the Company assumed the balance of a 10-year, noncancelable operating lease agreement entered into by the former owner of the Company for facilities in Linden, New Jersey. The lease expires on January 31, 2004, with renewal options. The Company also leases its facilities in Canada. Additionally, the Company leases office furniture and equipment, manufacturing equipment and distribution trucks under noncancelable operating leases with various expiration dates through August 31, 2004. Rent expense under operating leases was approximately $1,658,000, $1,221,000 and $780,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
Future minimum lease payments under noncancelable operating leases as of December 31, 1999 are as follows:
Litigation
The Company and its subsidiaries are, from time to time, parties to litigation arising in the normal course of business, most of which involves claims for personal injury and property damage incurred in connection with its operations. Management believes that none of these actions will have a material adverse effect on the financial position, results of operations or cash flows of the Company and its subsidiaries.
Employment Contracts
The Company has employment agreements with its executive officers, the terms of which expire at various dates through November 1, 2001. Such agreements provide for minimum salaries as well as incentive bonuses that are payable if specified management goals are attained. The employment agreements also provide for benefits, including medical, life insurance and disability benefits. In addition, executive securities will automatically vest in connection with a sale of the Company. The Company's potential minimum obligation to its executive officers, excluding bonuses, was approximately $2,400,000 million at December 31, 1999.
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
18. FAIR VALUE OF FINANCIAL INSTRUMENTS
Due to the short maturities of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, the carrying value of these financial instruments approximates fair value. The carrying amount of borrowings under the Revolving Credit Facility and Term Loan Facility approximates fair value because the interest rates adjust to market interest rates. At December 31, 1999, the carrying value of the 11.0% Senior Subordinated Notes approximated fair value, based on their quoted market prices.
19. SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for interest and income taxes for the years ended December 31, 1999, 1998 and 1997 was as follows (in thousands):
In connection with the issuance of redeemable cumulative preferred interests upon the leveraged recapitalization of the Company in 1996 (see Note 4), the Company recorded a charge to retained earnings (deficit) of $2,156,000, $1,979,000 and $1,707,000 for the years ended December 31, 1999, 1998 and 1997, respectively, representing the accretion of redeemable cumulative preferred interests at a compounded annual rate of 12.0%.
20. SUBSEQUENT EVENTS
On January 25, 2000, the Company signed a letter of intent to acquire all the capital stock of a Serta licensee for approximately $40,000,000 in cash. The Company anticipates financing the acquisition through an expansion of its existing credit facility.
21. GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
As of May 18, 1999, Sleepmaster and each of the domestic wholly owned subsidiaries ("Guarantor Subsidiaries") fully and unconditionally guaranteed, on a joint and several basis, the obligation to pay principal and interest with respect to the Notes. The Company generates funds necessary to satisfy its debt service obligations from either its own operations or by distributions or advances from its subsidiaries. There are no contractual or legal restrictions that could limit the Company's ability to obtain cash from its subsidiaries for the purpose of meeting its debt service obligations, including the payment of principal and
SLEEPMASTER L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
interest on the Notes. Although holders of the Notes will be direct creditors of Sleepmaster's principal direct subsidiaries by virtue of the guarantees, Sleepmaster has a foreign subsidiary ("Non-Guarantor Subsidiary") that is not included among the Guarantor Subsidiaries and such subsidiary will not be obligated with respect to the Notes. As a consequence, the claims of creditors of the Non-Guarantor Subsidiary will effectively have priority with respect to the assets and earnings of such companies over the claims of creditors of Sleepmaster, including the holders of the Notes. No supplemental consolidating condensed financial statements have been presented for the year ended December 31, 1997, since the financial statements included the accounts of Sleepmaster only.
The following supplemental consolidating condensed financial statements present:
1. Consolidating condensed balance sheets as of December 31, 1999 and 1998; consolidating condensed statements of operations and cash flows for the years ended December 31, 1999 and 1998.
2. Sleepmaster, combined Guarantor Subsidiaries and Non-Guarantor Subsidiary with their investments in subsidiaries accounted for using the equity method.
3. Elimination entries necessary to consolidate Sleepmaster and all of its subsidiaries.
SLEEPMASTER L.L.C. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATING CONDENSED BALANCE SHEET DECEMBER 31, 1999
SLEEPMASTER L.L.C. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATING CONDENSED BALANCE SHEET DECEMBER 31, 1998
SLEEPMASTER L.L.C. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATING CONDENSED STATEMENT OF OPERATIONS YEAR ENDED DECEMBER 31, 1999
SLEEPMASTER L.L.C. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATING CONDENSED STATEMENT OF OPERATIONS YEAR ENDED DECEMBER 31, 1998
SLEEPMASTER L.L.C. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATING CONDENSED STATEMENT OF CASH FLOWS YEAR ENDED DECEMBER 31, 1998
SLEEPMASTER L.L.C. AND SUBSIDIARIES
SUPPLEMENTAL CONSOLIDATING CONDENSED STATEMENT OF CASH FLOWS YEAR ENDED DECEMBER 31, 1999 | 17,189 | 113,633 |
39547_1999.txt | 39547_1999 | 1999 | 39547 | ITEM 1. BUSINESS
OVERVIEW
Metromedia International Group, Inc. ("MMG" or the "Company") is a global communications company engaged in the development and operation of a variety of communications businesses in Eastern Europe, the republics of the former Soviet Union and other selected emerging markets, through its subsidiaries Metromedia International Telecommunications, Inc. ("MITI"), Metromedia China Corporation and as of September 30, 1999, PLD Telekom Inc., collectively referred to as the "Communications Group."
On September 30, 1999, the Company consummated the acquisition of PLD Telekom Inc., which held interests in fixed and wireless telephony operations in Russia, Kazakhstan and Belarus. Following the consummation of the acquisition, PLD Telekom became a part of the Communications Group.
The Communications Group's principal areas of operation currently include:
- wireless telecommunications, including GSM operators in Georgia and Latvia and an AMPS operator in Kazakhstan
- fixed telephony, including PeterStar in St. Petersburg and Teleport-TP based in Moscow
- cable television and broadband networks, including systems in Moscow, Romania, Kazakhstan and Latvia
- radio broadcasting, including the established brands Radio 7 in Moscow, Radio Juventus in Hungary and Country Radio in the Czech Republic
Until recently, the Company also held interests in several telecommunications joint ventures in China. Those ventures were terminated in late 1999 and the Company reached agreement with China Unicom, its Chinese partner in the ventures, for the distribution of approximately $90.1 million (based on the December 31, 1999 exchange rate) in settlement of all claims under the joint venture agreements, of which $29.3 million has been received.
The Company also owns Snapper, Inc., which is a wholly-owned subsidiary. Snapper manufactures Snapper-Registered Trademark- brand premium-priced power lawnmowers, lawn tractors, garden tillers, snowthrowers and related parts and accessories. The Company owned Snapper prior to the November 1, 1995 merger described below under "Corporate History" and the subsequent shift in the Company's business focus to a global communications company. Accordingly, the Company views Snapper as a non-core asset and is managing Snapper in order to maximize stockholder value.
COMPANY STRATEGY
The Company's strategy is to focus and develop its position as a leading provider of communications services in the republics of the former Soviet Union, Eastern Europe and other emerging markets, by pursuing the following principal objectives:
- Pursue a convergence strategy to develop delivery for voice and data services over its existing cable and telephony infrastructure
- Geographically focus the Communications Group's efforts on several key countries where the Communications Group already has a significant presence, including Russia, Georgia, Romania, Latvia and Kazakhstan
ITEM 1. BUSINESS (CONTINUED) - Work towards obtaining consolidatable positions in certain of the Communications Group's principal assets
- Develop Internet capability in the Communications Group's existing businesses and explore expansion of Internet-related businesses in Central and Eastern Europe
- Develop e-commerce business opportunities in China
- Leverage the Communications Group's existing radio brands in their markets, with a view to using them in developing its other businesses, including the development of Internet-based businesses
- Continue to focus on cost control and reduction in corporate overhead costs
Set forth below is a chart of the Company's operational structure and business segments:
[FLOW CHART]
SUMMARY OF 1999 BUSINESS PERFORMANCE
RESULTS OF OPERATIONS. In 1999, the Company reported revenue of $48.7 million from the Communications Group's operations in Eastern Europe and the republics of the former Soviet Union and $216.1 million from Snapper. Its Communications Group's consolidated revenues will increase with the acquisition of PLD Telekom and should increase further as the Communications Group's joint ventures grow their businesses, thereby generating a greater share of the Company's total consolidated revenues.
CONSOLIDATION OF OPERATIONS AND REDUCTION IN OVERHEAD. Following the acquisition of PLD Telekom in September 1999, the Communications Group undertook a review of the overhead expenses of the combined entity. Following this review, the Communications Group determined to make significant reductions in its projected overhead costs for 2000 by closing its offices in Stamford, Connecticut and London, England, consolidating its executive offices in New York, New York, consolidating its operational headquarters in Vienna, Austria and by consolidating its two Moscow offices into one. In
ITEM 1. BUSINESS (CONTINUED) connection with this, the Communications Group reduced the headcount among its U.S. domestic and expatriate employees by approximately 60 individuals. In connection with these moves, the Company recorded a restructuring charge of $8.4 million for the year ended December 31, 1999.
SUBSCRIBER GROWTH. During 1999, the Company's Communications Group continued to experience significant subscriber growth. Aggregate subscribers to the Communications Group's joint ventures' various services as of the 1999 fiscal year end was 874,133, an increase of approximately 71% over the 1998 fiscal year end total of 511,459 subscribers. The 1999 subscriber numbers include the subscriber numbers of the PLD Telekom businesses as of December 31, 1999. As described below with respect to the financial results, the year-end subscriber numbers of almost all of the Communications Group's businesses other than the businesses of PLD Telekom are reported on a three-month lag, so that the subscriber numbers for such businesses are as of September 30 of each year.
MARKET AND POLITICAL ENVIRONMENT. 1999 was another year of significant change and challenges in the business environment in which the Company operates, involving significant competitive, political and economic challenges.
The Company continuously monitors and reviews the performance of its operations to maximize value to its shareholders. During 1999, the Company continued to focus its growth on opportunities in communications businesses, an important aspect of which was the September 30 acquisition of PLD Telekom. The increasing convergence of cable television and telephony and the relationship of each business to Internet access has provided the Company with new opportunities. However, the quick pace of technological, regulatory and political change has limited the opportunities for the Company in some of the businesses in which it operates.
During 1998 and continuing into 1999, a number of the countries in which the Communications Group operates experienced economic and financial difficulties. For example, adverse economic conditions in Russia in 1998 resulted in a national liquidity crisis, devaluation of the rouble, higher interest rates and reduced opportunities for refinancing or refunding of maturing debts. Although the Russian government announced policies intended to address structural weaknesses in the Russian economy and financial sector, it is unclear if such policies will improve the economic situation. The financial difficulties in Russia also had adverse impacts on certain of the other markets in which the Communications Group operates.
If the economic and financial situation in Russia and other emerging markets does not improve, the reduced level of economic activity and the opportunity to obtain financing for investments in these markets could have a material adverse effect on the Communications Group's telephony, cable television and radio broadcasting businesses in Russia, Kazakhstan, Belarus and other emerging countries. The Company cannot yet predict the impact that such factors may have on its future financial condition or results of operations.
CORPORATE HISTORY
The Company was organized in 1929 under Pennsylvania law and reincorporated in 1968 under Delaware law. On November 1, 1995, as a result of the merger of Orion Pictures Corporation and Metromedia International Telecommunications with and into wholly-owned subsidiaries of the Company and the merger of MCEG Sterling Incorporated with and into the Company, the Company changed its name from "The Actava Group Inc." to "Metromedia International Group, Inc.", and changed its strategic focus to a global media, communications and entertainment company. On July 10, 1997, the Company narrowed its strategic focus to a global communications company when it consummated the sale of substantially all of its entertainment assets, consisting of Orion Pictures Corporation, Samuel
ITEM 1. BUSINESS (CONTINUED) Goldwyn Company and Motion Picture Corporation of America (and their respective subsidiaries), including its feature film and television library of over 2,200 titles, to P&F Acquisition Corp., the parent company of Metro-Goldwyn-Mayer, Inc., for a gross consideration of $573.0 million. Following on from this, on April 16, 1998, the Company sold to Silver Cinemas, Inc. its remaining entertainment assets consisting of all of the assets of the Landmark Theater Group, except cash, for an aggregate cash purchase price of approximately $62.5 million and the assumption of certain Landmark liabilities. These transactions provided significant funds for the Company's expansion in its communications businesses.
With the sale of these assets the Company is focusing on its core business of providing modern digital voice, data and multimedia communications capabilities.
The Company owns approximately 39% of the outstanding common stock of RDM Sports Group, Inc. In August 1997, RDM and certain of its affiliates filed a voluntary bankruptcy petition under chapter 11 of the Bankruptcy Code. The chapter 11 trustee for RDM is in the process of selling all of RDM's assets to satisfy its obligations to its creditors and the Company believes that its equity interest will not be entitled to receive any distributions. The Company also holds additional claims against RDM in the RDM proceeding. There can be no assurance that the Company will receive any distribution with respect to such claims.
PRINCIPAL SHAREHOLDERS
Metromedia Company, a Delaware general partnership, and related entities hold 16,401,228 shares of the Company's common stock, representing approximately 17.6% of the Company's outstanding common stock at December 31, 1999. John W. Kluge, the Company's Chairman of the Board, and Stuart Subotnick, its Vice Chairman, President and Chief Executive Officer, are Metromedia Company's partners. News PLD LLC, a subsidiary of The News Corporation, holds 9,136,744 shares of the Company's common stock, representing approximately 9.8% of the Company's outstanding common stock.
* * * * *
The Company's principal executive offices are located at One Meadowlands Plaza, East Rutherford, New Jersey 07073-2137, telephone: (201) 531-8000.
CERTAIN STATEMENTS SET FORTH BELOW IN THIS FORM 10-K CONSTITUTE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. SEE "SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS" ON PAGE 95.
DESCRIPTION OF BUSINESS GROUPS
COMMUNICATIONS GROUP
The Communications Group invests in communications businesses principally in Eastern Europe and the republics of the former Soviet Union. Until the end of 1999, the Communications Group also held interests in several telecommunications joint ventures in China. The percentage of consolidated revenues from operations in Eastern Europe and the republics of the former Soviet Union for 1999, 1998 and 1997 were 18%, 13%, and 10%, respectively.
At December 31, 1999, the Communications Group owned interests in and participated with partners in the management of joint ventures that had 55 operational systems, consisting of 12 cable television systems, 3 GSM wireless telephone systems (the Communications Group's interest in one of which is in the process of being sold), 2 analog wireless telephone systems, 7 fixed and other telephony networks (which include local, international and long distance telephony providers and satellite-based telephony and wireless local loop operators), 17 radio broadcasting stations, 12 paging systems and 2 other telephony-related businesses.
ITEM 1. BUSINESS (CONTINUED)
The Company's Communications Group's joint ventures experienced significant growth in 1999. Aggregate subscribers to the Communications Group's joint ventures' various services as of the 1999 fiscal year end was 874,133, an increase of approximately 71% over the 1998 fiscal year end total of 511,459 subscribers. The 1999 subscriber numbers include the subscriber numbers of the PLD Telekom businesses as of December 31, 1999. As described below with respect to the financial results, the year-end subscriber numbers of almost all of the Communications Group's businesses other than the businesses of PLD Telekom are reported on a three-month lag, so that the subscriber numbers for such businesses are as of September 30 of each year. Total combined revenues reported by the Communications Group's consolidated and unconsolidated joint ventures for the years ended December 31, 1999, 1998, and 1997 were $163.8 million, $128.9 million and $91.7 million, respectively, including the results of PLD Telekom's operating businesses for the three months ended December 31, 1999.
Almost all of the Communications Group's joint ventures other than the businesses of PLD Telekom report their financial results on a three-month lag. Therefore, the Communications Group's financial results for December 31 include the financial results for those joint ventures for the 12 months ending September 30. The Company is currently evaluating the financial reporting of these ventures and the possibility of reducing or eliminating the three-month reporting lag for certain of its principal businesses during 2000.
JOINT VENTURE OWNERSHIP STRUCTURES
The following table summarizes the Communications Group's joint ventures and subsidiaries at December 31, 1999 and the Communications Group's ownership in each company:
ITEM 1. BUSINESS (CONTINUED)
ITEM 1. BUSINESS (CONTINUED)
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(1) Each parenthetical notes the area of operations for each operational joint venture or the area for which each pre-operational joint venture is licensed.
(2) Results of operations are consolidated with the Company's financial statements.
(3) Pre-operational system as of December 31, 1999.
(4) The Communications Group is selling its 25% interest to one of the other partners in the venture and the sale is expected to close in the first half of 2000.
(5) Ningbo Ya Mei Telecommunications supported development by China Unicom, a Chinese telecommunications operator, of a GSM mobile telephone system in Ningbo City, China. Ningbo Ya Lian Telecommunications similarly supported development by China Unicom of expansion of GSM services throughout Ningbo Municipality, China. Both joint ventures provided financing, technical assistance and consulting services to the Chinese operator. The operations of these joint ventures have been terminated at the direction of the Chinese government and settlement payments have been received from China Unicom in consideration of this termination. The joint ventures are currently being dissolved and the Company anticipates full recovery of its investments in and advances to the joint ventures. See "--Telecommunications Joint Ventures in China" and "Management's Discussion and Analysis of Financial Condition and Results of Operations".
(6) The Company's interests in Teleport-TP and MTR-Sviaz are held through its wholly owned subsidiary Technocom Limited.
(7) In August 1998, the Communications Group acquired a 76% interest in Omni-Metromedia Caspian, Ltd., a company that owns 50% of a joint venture in Azerbaijan, Caspian American. Caspian American has been licensed by the Ministry of Communications of Azerbaijan to provide high speed wireless local loop services and digital switching throughout Azerbaijan. Omni-Metromedia has committed to provide up to $40.5 million in loans to Caspian American for the funding of equipment acquisition and operational expenses subject to its concurrence with Caspian American's business plans. Caspian American Telecommunications launched commercial operations in April 1999. In May 1999, the Communications Group sold 2.2% of Omni-Metromedia thereby reducing its ownership interest in Caspian American Telecommunications to 37%.
During the fourth quarter of 1999, the Company determined that there was a decline in value of its investment in Caspian American that was other than temporary and has recorded the decline of $9.9 million as an impairment charge.
(8) CPY Yellow Pages is the publisher of a yellow pages directory in St. Petersburg.
(9) Cardlink ZAO is utilizing proprietary wireless technology for the processing and management of wireless electronic transactions, initially in Moscow.
(10) In July 1998 the Communications Group sold its share of Protocall Ventures Limited. As part of the transaction, Protocall Ventures Limited repaid its outstanding debt to the Communications Group. The Communications Group retained Protocall Ventures Limited's interest in Spectrum. The Company recorded a gain of approximately $7.1 million on the sale. The Company's interest in Spectrum of $1.6 million was written down and offset against the gain on the sale of Protocall Ventures.
ITEM 1. BUSINESS (CONTINUED) (11) Sichuan Tai Li Feng Telecommunications supported development by China Unicom, a Chinese telecommunications operator, of a fixed line public switched telephone network in Sichuan Province, China. Chongqing Tai Le Feng Telecommunications supported development by China Unicom of a fixed line telephone network in Chongqing City, China. Both joint ventures provided financing, technical assistance and consulting services to the Chinese operator. The operations of these joint ventures have been terminated at the direction of the Chinese government and settlement payments have been received from China Unicom in consideration of this termination. The joint ventures are currently being dissolved and the Company anticipates full recovery of investments in and advances to the joint ventures. See "--Telecommunications Joint Ventures in China" and "Management's Discussion and Analysis of Financial Condition and Results of Operations."
(12) The Communications Group owns 49% of a pre-operational joint venture in China licensed to provide e-commerce trading support systems to the Chinese partner in the joint venture. The partner is a domestic trading company pursuing internet-based commerce among Chinese state-owned enterprises.
(13) Launched service in June 1999.
(14) Radio Katusha includes two radio stations operating in St. Petersburg, Russia and AS Trio LSL includes five radio stations operating in various cities throughout Estonia. Radio Georgia includes two radio stations operating in Georgia.
(15) Kazpage is comprised of a service entity and 10 paging joint ventures that provide services in Kazakhstan. The Company's interest in the joint ventures ranges from 26% to 41% and its interest in the service entity is 51%.
(16) The Company's purchase of Mobile Telecom closed during June 1998. The Company purchased its 50% interest in Mobile Telecom for $7.0 million plus two additional earnout payments to be made in 2000 and 2001. Each of the two earnout payments is to be equal to $2.5 million, adjusted up or down based upon performance in 1999 and 2000, respectively, as compared to certain financial targets. The Company does not believe that any payment will be due with respect to 1999. Simultaneously with the purchase of Mobile Telecom, the Company purchased 50% of a related pager distribution company for $500,000.
COMMUNICATIONS GROUP STRATEGY
OVERVIEW
The Communications Group's objective is to develop its core business of providing high-quality modern digital voice, data, multimedia and Internet-based communications capabilities at the lowest possible capital cost in order to generate the highest possible return on investment.
In 1999, the Communications Group greatly enhanced its telecommunications portfolio with the acquisition of PLD Telekom, which had a number of telecommunications businesses in Russia, Kazakhstan and Belarus. Following this merger, the Communications Group has continued to explore the opportunities for convergence between the infrastructure already in place within its cable television businesses and its expanded telecommunications portfolio.
The Communications Group has also expanded its strategy to include development of services based on the use of the Internet, in connection with its existing businesses, possible expansion into new markets in Central and Eastern Europe and with the development of an e-commerce business in China. Such services represent a new form of communications and provide a basis for various forms of electronic
ITEM 1. BUSINESS (CONTINUED) commerce among enterprises and with the consuming public. The Internet provides an extremely economical means for multi-media communications and e-commerce.
MARKET BACKGROUND
The Communications Group's markets generally have large populations, but lack reliable and efficient communications service. The Communications Group believes that many of these markets have a growing number of persons who desire and can afford high quality communications services. The Communications Group has assembled a management team consisting of executives who have significant experience in the communications services industry and in operating businesses in developing markets. This management team believes that the Communications Group's systems can be constructed with relatively low capital investments and focuses on markets where the Company can provide multiple communications services. The Company believes that the establishment of a far-reaching communications infrastructure is crucial to the development of the economies of these countries, and such development will, in turn, supplement the growth of the Communications Group.
The Communications Group believes that the performance of its joint ventures has demonstrated that there is significant demand for its services in its license areas. While the Communications Group's operating systems have experienced rapid growth to date, many of the systems are still in early stages of rolling out their services, and therefore, the Communications Group believes it will significantly increase its subscriber and customer bases as these systems mature. In addition, as an early entrant in many markets, the Communications Group believes that it has developed a reputation for providing quality service and has formed important relationships with local entities. As a result, the Company believes it will be able to capitalize on opportunities to provide additional communications services in its markets.
The Communications Group continually explores new investment opportunities for communications systems in Eastern Europe, republics of the former Soviet Union, China and other emerging markets. In China, the Communications Group's recently formed e-commerce joint venture is developing Internet trading software usable for a wide variety of commercial trade applications, while the Communications Group is developing services based on the Internet in connection with its existing businesses and possible new markets in Central and Eastern Europe. The range and depth of the Communications Group's capabilities in advanced communications technology and business development makes the Communications Group a uniquely attractive joint venture partner for parties seeking to exploit the substantial growth opportunities present in the emerging communications markets. The Communications Group believes that it is well positioned to convert these capabilities into a continuing stream of new investment projects.
SPECIFIC OBJECTIVES
The Communications Group intends to achieve its objectives and expand its subscriber and customer bases, as well as its revenues and cash flow, by pursuing the following strategies to build on the developments of 1999:
PURSUE A CONVERGENCE STRATEGY TO DEVELOP DELIVERY FOR VOICE AND DATA SERVICES OVER ITS EXISTING CABLE AND TELEPHONY INFRASTRUCTURE. The Communications Group is pursuing a convergence strategy to develop multi-services delivery capability for voice and data services over its existing infrastructures of cable television, wireless telecommunications and fixed telephony networks using the inherent attributes of the Internet Protocol ("IP"). This will allow the use of the networks currently dedicated to the delivery of specific services to become multi-purpose delivery mechanisms capable of carrying a range of services. This would maximize the use of the Group's existing infrastructure and provide additional revenue streams through new product developments not previously possible.
ITEM 1. BUSINESS (CONTINUED) GEOGRAPHICALLY FOCUS THE COMMUNICATIONS GROUP'S ACTIVITIES. Following the acquisition of PLD Telekom, the Company has been working to identify those countries and geographic regions in which the combined communications portfolio has a significant presence. It has concluded that these include Russia, Georgia, Romania, Latvia and Kazakhstan. The Company intends to focus its efforts on developing its businesses in those countries by aggressively growing the customer and advertiser bases, and by cross-selling services in conjunction with the convergence strategy described above. This strategy enables the Communications Group to (i) leverage its existing infrastructure and brand loyalty, (ii) capitalize on marketing opportunities afforded by bundling its services, and (iii) build brand loyalty and awareness.
OBTAIN CONSOLIDATABLE POSITIONS IN THE GROUP'S PRINCIPAL ASSETS. Currently, the Communications Group accounts for a number of its principal assets (including the GSM operators in Latvia and Georgia) on the equity method due to the size of its shareholding in those ventures. The Communications Group is exploring the possibility of obtaining control of certain of its principal ventures in order to consolidate their financial results with those of the Company.
DEVELOP INTERNET CAPABILITY IN ITS EXISTING BUSINESSES AND EXPANSION INTO NEW AREAS. The Communications Group is actively developing Internet capabilities in a number of its key businesses. These developments are designed to maximize the Group's existing telephony and cable infrastructure to provide a range of Internet-related services including Internet Service Provider ("ISP") gateway services to Internet exchange complexes and the development of portals and other services for its existing customer base. In addition to working with its existing businesses and markets, the Communications Group is also working to identify other Internet-related market opportunities in Central and Eastern Europe.
DEVELOP E-COMMERCE BUSINESS OPPORTUNITIES IN CHINA. The Communications Group has begun investment in Chinese enterprises engaged in development of Internet-based e-commerce services. In its first such venture, the Company owns 49% of Huaxia Metromedia Information Technology Co., Ltd., a sino-foreign joint venture formed with a domestic trading company. The joint venture develops and operates the Internet-based information systems that the Chinese partner uses in its electronic trading activities. The Company is actively in negotiation for formation of several similar ventures operating in other regions and commercial sectors of China.
LEVERAGE THE GROUP'S EXISTING BRAND NAMES IN RADIO BROADCASTING. Several of the Communications Group's radio businesses have established strong brand names in their markets, including in Moscow, Hungary and the Czech Republic. The Communications Group is seeking to leverage those brands in connection with its Internet strategy, including the possible branding of Internet providers using those brand names and using the radio stations as an advertising medium for those new businesses.
CONTINUE TO FOCUS ON COST CONTROL AND REDUCTION IN CORPORATE OVERHEAD COSTS. Following the acquisition of PLD Telekom, the Communications Group consolidated its operations and reviewed the overhead costs of the combined businesses. The Communications Group made significant reductions in these costs following the merger but intends to continually review its cost structure in light of the Group's operations and business focus.
TELEPHONY
The Communication Group's telephony lines of business consist of wireless telecommunications operators and fixed and other telephony networks (including local, international and long distance telephony providers and satellite-based telephony and wireless local loop operators).
ITEM 1. BUSINESS (CONTINUED)
WIRELESS TELECOMMUNICATIONS
The Communications Group has interests in joint ventures and other investments in wireless operators in Georgia and Latvia (both using the digital GSM standard) and in Kazakhstan, Belarus and Tyumen, Russia (using analog standards). As of December 31, 1999, these businesses had a total of 152,891 active subscribers, a 208% increase over the 49,607 active subscribers as of December 31, 1998. The 1999 subscriber numbers include the subscriber numbers of the PLD Telekom wireless telephony businesses as of December 31, 1999, as well as Baltcom GSM, and the other non-PLD Telekom wireless telephony businesses as of September 30, 1999. The Communications Group also has an interest in a GSM operator in the Republic of Sakha which is in the process of being sold.
GSM VENTURES--GEORGIA, LATVIA AND SAKHA
BALTCOM GSM/LATVIA. The Communications Group owns 50% of Latcom, a joint venture with Western Wireless, which owns 44% of Baltcom GSM. Baltcom GSM operates and markets mobile voice and data communication services to private and commercial users nationwide in Latvia.
In 1999, Baltcom extended its product offering to include SMS (messaging services sent via the handset), prepaid services and wireless data capabilities. Demand for these services was high and resulted in net year on year subscriber growth of 120% to 72,510 active subscribers at fiscal year-end 1999, from 32,934 active subscribers at fiscal-year end 1998. Baltcom also secured a license to operate and began to offer services in the 1800 mhz range (in addition to the 900 mhz range in which it began operations) as part of its continued effort to increase capacity and coverage required for facilitating growth.
Mobile penetration in Latvia remained below 8% in 1999. Management believes this comparatively low penetration level, a teledensity figure below 25% and an improved economic situation in Latvia, will contribute to Baltcom's ability to continue its subscriber growth.
MAGTICOM GSM/GEORGIA. The Communications Group owns a 70% interest in Telcell Wireless LLC (with Western Wireless holding the balance), which in turn is a 49% shareholder of Magticom GSM. Magticom GSM operates and markets mobile voice communication services to private and commercial users nationwide in Georgia.
In 1999, Magticom extended its service coverage area from urban areas into surrounding areas, resulting in a competitive advantage and increased demand for its services. In 1999, subscriber growth was 147 %, to 41,181 active subscribers at fiscal year-end 1999, from 16,673 active subscribers at fiscal year-end 1998 and resulted in a year-end market share exceeding 70% according to Magticom estimates. In addition, Magticom secured a license to operate and offer services in the 1800 mhz range (in addition to the 900 mhz range in which it began operations). Magticom plans to offer service in 1800 mhz in 2000 to provide additional capacity.
Mobile penetration in Georgia remained below 2% at year end in 1999. Management believes this comparatively low mobile penetration level, a teledensity figure below 5% and competitive advantages in coverage and distribution will continue to support Magticom's subscriber growth.
TECHNOLOGY. The Communications Group's wireless telephone networks in Latvia and Georgia operate using the GSM standard. GSM is the leading standard for wireless service throughout Western Europe and Asia, which allows the Communications Group's customers to roam throughout the region. The establishment of GSM as the leading standard in terms of number of networks and subscribers in Asia and Europe, as well as facilities such as automatic global roaming between networks, provides a
ITEM 1. BUSINESS (CONTINUED) comparative advantage over competing digital wireless systems or analog systems (such as AMPS) which cannot readily offer international roaming service.
MARKETING. The Communications Group markets its GSM telephony services through a combination of tariffing, distribution, entry cost and bundled service strategies oriented towards targeted individuals, corporations and organizations. The Communications Group sells wireless phones at a small mark-up to cost. This pass-through strategy encourages quick market penetration and early acceptance of wireless telephony as a desirable alternative or addition to existing fixed telephony service.
Management believes that its GSM systems will benefit from several competitive advantages in each of its markets. As it pursues a strategy of convergence, the Communications Group intends to market its GSM telephony service to customers of its existing cable television in both Latvia and Georgia. The Communications Group believes that its ability to cross market and bundle services to target customers will position it in both markets with a market advantage which competitors will find difficult to match. In addition, the Communications Group will continue to develop higher levels of quality, customer care and retention programs than their competitors, thereby positioning these systems to compete effectively for new mobile customers as well as to seize a portion of the competing operators' customer base.
COMPETITION. The Company's GSM joint ventures face competition in each of their markets.
Baltcom GSM's primary competitor in Latvia is Latvia Mobile Telecom which operates two systems. Latvia Mobile Telecom commenced service in 1995. It operates a GSM system and a second system using an older, less efficient technology that the Communications Group believes will pose less of a competitive threat than Latvia Mobile Telecom's GSM system. Baltcom GSM competes with Latvia Mobile Telecom on the basis of price of service. Baltcom prices its service slightly below the Latvia Mobile Telecom pricing and has captured approximately one third of the Latvian wireless market.
The Communications Group believes that Magticom's primary competitors in Georgia are Geocell, a Georgian-Turkish Joint Venture using a GSM system, and an existing smaller provider of wireless telephony services which uses the AMPS technology in its network, both of which commenced service prior to Magticom. In Georgia, competition between operators has been on the basis of coverage but is transitioning to a combination of pricing, services and brand recognition. Magticom has captured approximately seventy percent of the Georgian wireless market.
The Company's GSM joint ventures are the second entrants in most of their markets and therefore have the disadvantage of facing the established initial wireless providers in those markets. However, barriers to entry in wireless telecommunications markets are very high, as the number of licenses for a particular market is typically limited and initiation of a wireless system requires substantial capital expenditures. Therefore, although the Company's GSM joint ventures face difficulties in taking market share from the initial operators in their markets, the Company does not anticipate that these markets will become further fragmented because of these barriers to entry.
GORIZONT. The Communications Group also holds a 25% interest in Gorizont-RT, a joint venture which operates a GSM wireless system in the Republic of Sakha. This interest is currently being sold to one of the other partners in the venture and the sale is expected to close in the first half of 2000.
D-AMPS--KAZAKHSTAN AND TYUMEN
ALTEL
OVERVIEW. ALTEL, in which the Communications Group owns a 50% interest, currently operates a nationwide AMPS wireless network in Kazakhstan. The other 50% interest in ALTEL is held by
ITEM 1. BUSINESS (CONTINUED) Kazakhtelekom, the national telephone operator. ALTEL offers traditional wireless service, as well as TUMAR, a prepaid wireless service. Wireless service has provided a rapid and relatively inexpensive way to overcome the deficiencies of the wireline telecommunications infrastructure in Kazakhstan. As of December 31, 1999, ALTEL's wireless telecommunications network covered a geographic area of approximately 4,150,000 people, representing 28% of the total population, in 12 cities. As of December 31, 1999, ALTEL had 23,378 active subscribers (of which 11,837 were customers of the prepaid service), compared with 20,768 active subscribers (of which 6,337 were customers of the prepaid service) as of December 31, 1998.
The Company believes the continuing development of a market economy in Kazakhstan is likely to increase demand for modern telecommunications services, including wireless communications, and that has been demonstrated by the subscriber growth experienced to date by ALTEL. However, with the entry in February 1999 of two competing wireless operators, each of which has built up respectable subscriber bases of their own, ALTEL saw its subscriber base grow more slowly during 1999. In order to maintain its subscriber base in the face of severe competition from the GSM operators, ALTEL reduced its tariffs several times during 1999 and marketed its TUMAR service more heavily as a low-cost alternative.
TECHNOLOGY AND FACILITIES. ALTEL provides service using the analog AMPS/NAMPS standard. All ALTEL systems are connected to the local PSTN and the regional international/intercity digital switches (5ESS or S12) in the cities where they are located via E1 trunks (MFC-R2 signaling protocol). The system is also linked to an international trunk exchange with long distance and international calls completed using the national and international network of Kazakhtelekom.
MARKETING. ALTEL markets its wireless services through its own direct sales force, operating from customer service centers, as well as third party independent dealers. Although ALTEL's standard service includes corporate and government accounts, 60% of ALTEL's customers are high-volume individual users. TUMAR prepaid services are targeted almost exclusively at middle and lower income domestic individuals.
COMPETITION. Until 1998, ALTEL was the only licensed national wireless operator in Kazakhstan. In 1998, two licenses were awarded for the development of a national GSM network in Kazakhstan. One license was issued to Kcell, a joint venture of TurkCell and Kazakhtelekom, and the other license was issued to Kmobile, a joint venture of Telsim, a Turkish company, and local Kazakh interests, each of which began operations in February 1999. ALTEL responded to the competition through a series of tariff reductions in 1999 and aggressive marketing of its prepaid service. The tariff competition exerted downward pressure on ALTEL's revenues in 1999 and continued competition in 2000 is likely to have a continued adverse effect on ALTEL's results.
TYUMEN
In 1998, the Communications Group acquired a 46% interest in a pre-operational joint venture to provide DAMPS service in the Tyumen region of Russia. The Communications Group was in the process of final commercial and technical testing of the network in 1999 and expects such joint venture to commence full commercial operations in 2000. The Communications Group's primary competition in the Tyumen region will be from a GSM provider.
During the fourth quarter of 1999, the Company determined that, in view of the venture's low profitability and limited scope for improvement, there was a decline in value of its investment in Tyumen that was other than temporary and has recorded the decline of $3.8 million as an impairment charge.
ITEM 1. BUSINESS (CONTINUED) NMT-450--BELARUS
OVERVIEW. BELCEL, in which the Communications Group holds a 50% interest, operates a national wireless network in Belarus. The other 50% of BELCEL is held by the Minsk City Telephone Network (45%) and the Minsk Regional Telephone Network (5%). As of December 31, 1999, BELCEL's wireless telecommunications network covered a geographic area of approximately 5.8 million people, representing 57% of the total population, in 17 centers of population and covering many major trunk roads. As of December 31, 1999, BELCEL had 15,429 active subscribers, a 22% increase from the 12,683 active subscribers as of December 31, 1998.
TECHNOLOGY AND FACILITIES. BELCEL provides service using the analog NMT-450 standard. BELCEL's wireless telecommunications network in Belarus currently consists of one switch in Minsk and 69 base stations. The BELCEL network has full interconnect for local, long distance and international services. Calls to fixed line phones and international calls are completed using the national and international network of Beltelecom. International calls are switched through a digital exchange in Minsk.
COMPETITION. Prior to 1999, BELCEL was the only licensed national wireless operator in Belarus. In April 1999, Velcom, a GSM operator, commenced commercial service, with a license that gives it a three-year exclusivity period for digital wireless services. As of December 31, 1999, Velcom provided service in Minsk and 3 regional centers.
FIXED AND OTHER TELEPHONY
OVERVIEW
The Communications Group has a number of joint ventures in fixed telephony operators in Russia and Georgia, some of which offer local telephony services and others which provide national and long distance telephony to a variety of telecommunications operators and business and individual customers. The Company also holds interests in businesses involved in the provision of satellite-based telecommunications services and in wireless local loop telephony.
PETERSTAR
OVERVIEW. PeterStar, in which the Communications Group owns a 71% interest (and which was acquired by the Company in connection with the September 1999 acquisition of PLD Telekom), operates a fully digital, city-wide fiber optic telecommunications network in St. Petersburg that is interconnected with the network of Petersburg Telephone Network ("PTN"), the local telephone company, as well as the Russian national and international long distance systems.
PeterStar provides integrated, high quality, digital telecommunications services with modern transmission equipment, including local, national and international long distance and value-added services, to businesses in St. Petersburg. The PeterStar network provides an alternative to the network of PTN, which to date has been characterized by significant capacity constraints.
PeterStar is able to provide integrated telecommunications services to business customers, including users of high bandwidth voice, data and video communications services. PeterStar's network is designed to support a wide range of telecommunications products and services with a high degree of reliability.
Additionally, the three wireless operators in St. Petersburg currently utilize the PeterStar network to deliver high quality services to their customers and provide reliable access to the local, long distance and international networks. PeterStar's digital infrastructure enhances the ability of the wireless operators to consistently receive and deliver their customer's traffic, a benefit that is not achievable by using the outdated PTN transmission network.
ITEM 1. BUSINESS (CONTINUED) As of December 31, 1999, PeterStar had a total of 183,062 active lines, of which 109,317 were provided to wireless operators, an approximate 9% increase from the 168,166 active lines as of December 31, 1998 (of which 108,278 were provided to wireless operators).
PeterStar also provides a number of value-added voice and data services to complement the basic fixed network services it currently provides. PeterStar believes that the ability to provide such services on the PeterStar digital network is a key competitive advantage in the St. Petersburg marketplace. Current services include (i) data services; (ii) frame relay; (iii) ATM; (iv) operator services; and (v) ISDN.
MARKETING. PeterStar's customer base currently consists of three general categories: (i) business customers; (ii) wireless and other network operators; and (iii) residential customers. PeterStar's primary focus is the provision of voice and data services to business customers, focusing on those which generate large amounts of outgoing long distance and international traffic. PeterStar continues to experience a shift in its customer base, from foreign companies (which tend to use the higher priced international services) to predominantly Russian businesses and, to a lesser extent, residential customers (for whom local calling is the principal usage).
PeterStar's strategy is to continue to meet the growing demands of business customers and other network operators in St. Petersburg. PeterStar has recently added incremental transmission capacity and upgraded its transmission network, as well as introducing new service features such as ISDN capability, which allows simultaneous transmission of voice, data, video and still images. In addition, as part of its strategic relationship with PTN, PeterStar intends to continue to provide targeted support to PTN in its efforts to upgrade and modernize its network. PeterStar has placed increased emphasis on small to mid-sized Russian and foreign businesses in order to capitalize on what it considers to be a significant market opportunity.
TECHNOLOGY. PeterStar's network and facilities give it the ability to provide advanced digital services to the telecommunications market in St. Petersburg, services that the Company believes PTN, with its primarily analog network, will be unable to provide in the near term due to internal funding constraints. The PeterStar network consists of digital exchanges which are connected by fiber optic cables, advanced transmission systems and remote switching units and concentrators. The fiber optic network forms twelve rings, permitting traffic to be re-routed in the event that a cable is cut or damaged. The network is fully interconnected with the PTN network, with direct and indirect connections via approximately 680 kilometers of fiber optic cable to all thirty-four PTN transit exchanges distributed throughout St. Petersburg. The fiber optic cables also provide direct links to the national and international switch, providing PeterStar customers with high quality long distance and international access. PeterStar expects that it will continue to incrementally add switching, transmission capacity and local loop infrastructure to its core network in order to address its target market in St. Petersburg and regional points of presence.
COMPETITION. PeterStar is building and operating its business in a highly competitive environment. PeterStar does not have an exclusive license to provide telecommunications services in St. Petersburg, and a number of other entities, including Russian companies and international joint ventures, are competing with PeterStar for a share of the St. Petersburg telecommunications market. A number of such companies (or their joint venture partners) are larger than PeterStar and have greater access to capital or resources.
Although PTN has historically supported the development of PeterStar, PTN and PeterStar must be regarded as competitors in the telephony segment. PTN can offer its customers the same core services as PeterStar, notwithstanding the lower transmission quality and call completion rates of the PTN network. Furthermore, PTN has recently completed the installation of a modern fiber optic loop in St.
ITEM 1. BUSINESS (CONTINUED) Petersburg which, when fully operational, will significantly enhance its ability to carry traffic and could therefore enhance its capacity to compete with PeterStar.
OAO Telecominvest, the other shareholder in PeterStar, has recently raised over $50 million in net proceeds in a private placement of securities, a substantial part of which is dedicated to the completion of a transit network in St. Petersburg which could provide further significant competition to PeterStar's network. In addition, the three mobile operators in St. Petersburg may be required as a result of new regulations to move their traffic starting in 2000 from the PeterStar network to the network being constructed by Telecominvest and other federal networks, which will adversely impact PeterStar's revenues in 2000 and beyond.
The other competitors to PeterStar are: (i) Sovintel, a joint venture between Rostelecom and Golden Telecom, which is currently based in Moscow, and (ii) Global One, the international joint venture between France Telecom and its Russian partner, the telegraph office, which provides national and international voice and data services to certain destinations, both of which have been expanding their operations in St. Petersburg. Since they have generally been unable to compete effectively with PeterStar based on quality, these competitors have principally competed on the basis of price, thereby exerting price pressure on PeterStar.
BALTIC COMMUNICATIONS LIMITED
OVERVIEW. Baltic Communications Limited ("BCL"), in which the Communications Group holds a 100% equity interest, provides international direct dial, international payphone, Internet, data and leased line services for Russian and foreign businesses in St. Petersburg and the Leningrad Oblast. BCL also offers a number of advanced broadband services, as well as "carrier's carrier" services to other telecommunications operators.
As of December 31, 1999, BCL had approximately 1,400 lines connected to a total of 469 clients, compared to approximately 1,200 lines connected to a total of 424 clients as of December 31, 1998.
TECHNOLOGY. BCL has its own switching and international transmission facilities in St. Petersburg, which acts as a gateway for corporate customers in both Moscow and St. Petersburg. The BCL network consists of an international and local switch and capacity on the international fiber optic cable via Finland to Sweden and the United Kingdom. BCL's primary international carrier relationships are with Sonera of Finland, Telia of Sweden and Cable & Wireless Communications of the United Kingdom. BCL has its own fiber optic and microwave radio transport network in St Petersburg and in addition rents local access from PeterStar and PTN to connect its customers in the city.
MARKETING. The Company endeavors to cross-sell the distinct service offerings provided by PeterStar and BCL to their respective customer bases. For example, PeterStar's marketing representatives are now also able to market BCL's international private line services to PeterStar's and other corporate customers. In addition, control of both PeterStar and BCL provides the Company with the opportunity to introduce new services to targeted markets in a more efficient manner. In addition, PeterStar and BCL are exploring the possibilities of closer cooperation in connection with the expansion of their respective core businesses in St. Petersburg and the implementation of their strategies in Northwest Russia.
COMPETITION. BCL is operating its business in a highly competitive environment. BCL does not have exclusive licenses to provide telecommunications services in St Petersburg and a number of other entities, including both Russian & foreign operators, are competing with BCL for a share of the St Petersburg corporate telecommunications market.
ITEM 1. BUSINESS (CONTINUED) The major competitors to BCL are: (i) GlobalOne, the France Telecom wholly owned global carrier, which provides national and international voice and data services; and (ii) Sovintel, a joint venture between Rostelecom and Golden Telecom, both of which have been expanding their network and commercial operations in St Petersburg.
TELECOM GEORGIA
OVERVIEW. The Communications Group owns approximately 30% of Telecom Georgia. Telecom Georgia is the primary international and long distance telephony service provider in Georgia. Telecom Georgia has more than 1,100 international channels and has direct interconnect arrangements with major international long distance carriers including ATT, Sprint, MCI Worldcom, British Telecom, Deutsche Telecom, France Telecom and Telecom Italia. Since Telecom Georgia commenced operations, long distance traffic in and out of Georgia has increased significantly as Telecom Georgia has expanded the number of available international telephone lines.
The government of Georgia has announced its intention to privatize its 51% stake in Telecom Georgia during 2000, with an investment bank being chosen to advise the government during the second quarter. The actual privatization of the stake in Telecom Georgia is currently expected to occur at the end of 2000. Management of Telecom Georgia is not yet in a position to determine what, if any, impact the privatization of the government's stake in Telecom Georgia will have on its business.
TECHNOLOGY. Telecom Georgia's long distance telecommunications network splits Georgia into eastern and western zones, with digital transit switches in each zone which are connected via SDH microwave. In turn, they are linked in Tbilisi with an Intelsat and Turksat earth stations. Telecom Georgia has expansion plans to expand its microwave capability to Foti (where it can be connected with submarine cables, thereby reducing dependency on satellite connections) and further into eastern Georgia (which would permit a digital connection with neighboring Azerbaijan).
MARKETING. Telecom Georgia markets its services on the basis of a strong advertising campaign, competitive tariffs and high quality service, focused equally on corporate and residential subscribers. In addition, Telecom Georgia, based on its internal marketing analyses, has made significant efforts to introduce new services such as ISDN and a prepaid card system.
COMPETITION. Although Telecom Georgia remains the major provider of international and long distance services, barriers to entry to this market are very low and competition has increased significantly since the opening of the market in 1998. Currently there are several new entrants offering international telephone service, including Egrisi, Goodwillcom, and Global Erty. The Communications Group believes that Telecom Georgia competes primarily on the basis of tariffs and contractual relationships and aggressive marketing strategy. Although Telecom Georgia has maintained a significant market share in international and long distance telephony services in Georgia, its revenues have come under increasing pressure due to competition and downward pressure on termination rates.
TELEPORT-TP
OVERVIEW. Through its wholly owned subsidiary Technocom Limited, the Communications Group holds a 49.33% equity interest (56% voting interest) in Teleport-TP, a Moscow-based long distance and international operator targeting the commercial sector and other telecommunications operators with its satellite-based telecommunications services. Rostelecom, the primary national and international carrier in the Russian Federation, is the holder of a 44% ownership interest in Teleport-TP
ITEM 1. BUSINESS (CONTINUED) Since 1994, Teleport-TP has operated an international telecommunications network providing dedicated voice, data and video services, as well as bandwidth, to Russian and foreign businesses and private telecommunications networks. As of December 31, 1999, Teleport-TP provided access to approximately 1,000 international digital circuits.
Teleport-TP has also developed a long distance network in order to expand its customer base beyond Moscow and to meet growing demand for reliable telecommunications links. In particular, Teleport-TP is seeking to address the market for inter-regional communications where call completion rates are understood to be low, primarily due to the underdeveloped nature of the Rostelecom infrastructure. The long distance network is being targeted to high volume customers requiring high quality, reliable long distance service across the Russian Federation. As of December 31, 1999, Teleport-TP had a total of 34 clients for the long distance service, of which 23 were regional telephone network operators and the balance were corporate clients.
Teleport-TP has developed from being a provider of international telecommunications services from a single point of presence in Moscow to a company able to provide high-quality domestic and international long distance services in multiple locations across the Russian Federation and certain other republics of the former Soviet Union. Teleport-TP utilizes Western satellite capacity and technology and the Company believes that there is a largely untapped market for satellite-based services between various regions of the Russian Federation due to the current poor quality, or total absence, of terrestrial digital long distance lines in many areas.
MARKETING. Rostelecom is Teleport-TP's principal customer for dedicated international network services. Rostelecom utilizes Teleport-TP on traffic routes where it does not yet have a direct terrestrial connection and where the cost of a terrestrial connection would be prohibitive. On such routes, Teleport-TP provides Rostelecom with a means of accessing high quality digital international circuits that are not available via other Russian satellite or terrestrial means. Teleport-TP also has relationships with a number of business centers and private network operators.
Teleport-TP's long distance services are being targeted to high volume customers requiring high quality, reliable long distance service across the Russian Federation. Targeted customers include: (i) regional and local public telephone companies (Electrosviaz); (ii) private wireless, wireline, data and other network operators; and (iii) corporate users. Teleport-TP acts as a "carrier's carrier" to public telephone companies and wireless, wireline and other operators. Teleport-TP provides these operators with long distance and, in many cases, international access via its dedicated network so that these operators can provide high quality access to their own subscribers.
TECHNOLOGY. Teleport-TP's dedicated international telecommunications network consists of an earth station, an international gateway switch and fiber optic cable. These network facilities are owned by Technocom and leased to Teleport-TP. The earth station consists of two Standard-A 18.3 meter antennas linked to two Intelsat satellites and one 13 meter Hughes Networks dish linked to a Eutelsat satellite. Fiber optic cable links Teleport-TP's switch with its principal customers, including the national network of Rostelecom, the national television switching center, and a number of business parks, overlay network operators, and state-owned utilities located in Moscow and the Moscow region.
Customers on Teleport-TP's long distance network--public and private telecommunications companies--have the choice of taking permanent leased circuits or switched circuits, depending on their requirements. In addition, corporate customers now have the ability to create their own private networks throughout the Russian Federation using this combination of permanent and switched circuits. The system is designed to be flexible, allowing for timely installation of antennas in regional sites without changing the existing network configuration. Additional channel units can be quickly installed
ITEM 1. BUSINESS (CONTINUED) at existing sites should demand increase. The network has full mesh topology allowing customers in remote sites to connect with other remote sites without going through a central hub station, thus avoiding a "double-hop" on the satellite. This offers considerable improvement over traditional "star" configuration satellite-based systems.
COMPETITION. In providing international circuits and direct dial services in Moscow, Teleport-TP faces competition from a number of operators offering similar services. Such operators, including Comstar, Combellga, Telmos and Sovintel, are primarily targeting Russian and foreign businesses in the city, replicating the services that PeterStar is providing in St. Petersburg. In terms of providing international circuits, Teleport-TP faces direct competition from the Russian Space Communications Corporation, the state owned operator which uses both Intelsat and Russian satellites, and indirectly from Rostelecom, which owns capacity in and operates the international cable facilities connecting the Russian Federation to the telecommunications networks of the major global carriers.
In providing long distance services, Teleport-TP faces competition from a number of sources, both on a national and regional basis. Teleport-TP faces competition from Rostelecom in the provision of long distance access to the local telephone companies. Rostelecom currently appears to support the continued development of Teleport-TP and Rostelecom stands to gain from its relationship with Teleport-TP, not only as a Teleport-TP shareholder but also to the extent that expansion of the Teleport-TP network facilitates the modernization of the Rostelecom network on a targeted basis. There are no other commercial national networks of the same scale as the Rostelecom network, but there are a number of private networks, including those of the Ministries of Defense and Railways, that could, if funding were made available, provide further competition to Teleport-TP.
Teleport-TP also faces competition from other Western-financed entities seeking to provide various forms of higher bandwidth voice and data communications services throughout Russia, including: (i) TeleRoss, a subsidiary of Golden Telecom, which is offering service in 12-15 cities using the Russian domestic satellite systems; (ii) Rosnet, principally a provider of data network services; (iii) Aerocom, a satellite and fiber optic-based carrier's carrier based in Moscow, which provides international circuits via the Russian Express satellite network; (iv) Belcom, a private carrier providing international point-to-point leased circuits to the oil and gas companies in remote locations, and secondly closed user group services to communities of interest; and (v) Moscow Teleport, a satellite based provider of services targeted at the corporate user.
MTR-SVIAZ
Through Technocom, the Communications Group holds a 49% interest in MTR-Sviaz, a venture to modernize and commercialize a portion of the internal telecommunications network of Mosenergo, the Moscow city power utility. MTR-Sviaz provides local, national and international services to both corporate customers and the Internet market. MTR-Sviaz uses leased circuits from a number of providers, access to the Teleport-TP fiber cable facilities and the Mosenergo internal communications network to terminate its calls. Teleport-TP uses the MTR-Sviaz facilities to house its Internet gateway, from which links to ISPs are provided via leased and dial-up lines on the public network.
MTR-Sviaz commenced operations in the third quarter of 1996 with the initial network program encompassing the installation of a 10,000 line Siemens exchange as a central switching node on the existing Mosenergo telecommunications network. The switch is connected to Teleport-TP via fiber optic cable, giving customers on the Mosenergo network direct access to the digital long distance facilities of Teleport-TP's network. In addition to the Mosenergo organization itself, other entities connected to the Mosenergo network include commercial enterprises located at business centers on Mosenergo premises.
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CASPIAN AMERICAN TELECOMMUNICATIONS
The Communications Group holds a 37% interest in Caspian American Telecommunications ("CAT"), a joint venture licensed to provide wireless local loop telephone services in the Republic of Azerbaijan. To date, the venture has only succeeded in capturing an insignificant (approximately 1.5%) share of the market in Azerbaijan and has incurred substantial losses. The Company, in conjunction with the other shareholders, has recently taken action to change the management of the venture and to commence a major cost reduction program. In light of CAT's poorer than expected performance in 1999 and the limited potential to develop its wireless local loop network without significant sources of financing, the venture has developed a revised operating plan to stabilize its operations and minimize future funding requirements until potential restructuring options have been fully explored. During the fourth quarter of 1999, the Company determined that there was a decline in value of its investment in CAT that was other than temporary and has recorded the decline of $9.9 million as an impairment charge.
INTERNET-BASED SERVICES
In 1999, the Communications Group expanded its strategy to include development of services based on use of the Internet, both in connection with its existing businesses and with the development of an e-commerce business in China. Such services represent a new form of communications and provide a basis for various forms of electronic commerce among enterprises and with the consuming public. The Internet provides an extremely economical means for multi-media communications and e-commerce.
RUSSIA AND CENTRAL AND EASTERN EUROPE
The Communications Group is actively developing Internet capabilities in a number of its key existing businesses. These developments are designed to maximize the Group's existing infrastructure to provide a range of Internet-related services including ISP gateway services to Internet exchange complexes and the development of portals and other services to its existing customer base.
As an example of the Communications Group's activities in the Internet area, Yellow Pages in St. Petersburg, as described below, has created a full on-line directory, integrated with detailed city maps, and is currently developing a portal for the St. Petersburg region. In addition to the development of the St. Petersburg portal, Yellow Pages is extending its database capability to include Moscow, the northwest region of Russia and other significant industrial centers across republics of the former Soviet Union. As part of its shift to an Internet-based business model, Yellow Pages has begun to provide its customers with direct support in web design, programming/software consulting and search engine development.
In addition to working with its existing businesses and markets, the Communications Group is also working to identify other Internet-related market opportunities in Central and Eastern Europe.
CHINA
The Communications Group has begun investment in Chinese enterprises engaged in development of Internet-based e-commerce services. In its first such venture, the Company owns 49% of Huaxia Metromedia Information Technology Co., Ltd., a sino-foreign joint venture formed with a domestic trading company. The joint venture develops and operates the Internet-based information systems that the Chinese partner uses in its electronic trading activities. This form of outsourcing arrangement is allowed under current Chinese regulation. The Company is actively in negotiation for formation of
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several similar ventures operating in other regions and commercial sectors of China. Trade agreements executed between China and several World Trade Organization member companies during 1999 call for rapid opening of China's Internet sector to foreign participation, including foreign direct majority ownership of Chinese Internet and e-commerce companies.
The rate of Internet service development in China is very substantial and is accompanied by a strong demand for foreign capital and expertise. Presently, the Chinese government estimates there are approximately 10 million Internet users in the country, but the annual growth rate is expected to be 100-200% for the next several years. This is a realistic projection given the size of the Chinese population and the infant state of Internet development in China. The Company is targeting ventures that principally address e-commerce--both business-to-business and business-to-consumer. The e-commerce format is well suited to exploit China's rapidly expanding consumer demand and the country's privatization of most industry. The Company is also targeting investment in enterprises developing basic e-commerce infrastructure such as payment processing, sales fulfillment coordination and Internet software development. The team previously assembled by the Communications Group in China to pursue investment in the country's domestic telephony business is well positioned to create and manage ventures with Chinese enterprises undertaking Internet and e-commerce service development. The Communications Group is assembling additional resources within China to support the information technology requirements of these ventures.
COMPETITION
The Internet and e-commerce business opportunities being explored by the Communications Group are being developed in a highly competitive environment, with a large number of new market entrants. At the same time, the market for such services is highly diversified and is expected to remain so for the foreseeable future.
The Company must demonstrate aggressive business development and financing capabilities, solid technical support and effective relationship management to compete effectively for position in the initial stages of market development. Invested ventures will face a wide range of competitors before consolidations reduce numbers to a fewer, long term surviving companies. To effectively meet this competitive situation, the Company is targeting ventures with specific niche market focus and with partners that already have established trade positions in these niche markets. After individual ventures have established e-commerce dominance in their niche, their subscriber base can be combined with those of the Company's other ventures to create a large and general market presence. For example, in its existing markets in Russia and Eastern Europe, the Group is exploring ways to use its existing businesses and brand names to distinguish itself from its competitors, both on a technical level and in terms of reaching consumers and advertisers.
OTHER TELEPHONY-RELATED BUSINESS
YELLOW PAGES. Yellow Pages, in which the Communications Group holds a 100% interest, is the owner of one of the most comprehensive databases of Russian and foreign businesses in St. Petersburg and publisher of what is primarily a business to business directory. Yellow Pages' full-time employees handle all of the graphic design and database management. Yellow Pages hires part-time workers for the periodic update of the directory. The Communications Group utilizes the database of Yellow Pages to the benefit of PeterStar and BCL, particularly in achieving more effective target marketing and in operator services. Yellow Pages has also created a full on-line directory, integrated with detailed city maps, and is currently developing a portal for the St. Petersburg region.
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CARDLINK. Cardlink is a business being developed utilizing proprietary wireless technology owned by the Communications Group, targeted initially at the processing and management of wireless electronic payment transactions. Cardlink ZAO, in which the Communications Group has a 84.5% interest, is introducing this technology in Moscow on a test basis, but it has potential application in Russia and Eastern and Central Europe. Cardlink has entered into agreements with several Russian banks for the processing of card transactions, and the project is in the test phase with full implementation expected during the second quarter of 2000. Although initially targeted at wireless card verification transactions with banks and credit card issuers, the Cardlink technology can be applied to developing and implementing other wireless data communication network infrastructures where conventional telephone networks are either non-existent or poor in terms of coverage and availability.
CABLE TELEVISION AND BROADBAND NETWORKS
OVERVIEW. The Communications Group commenced offering cable television services in 1992 through its joint ventures Kosmos TV in Moscow and Baltcom TV in Riga, Latvia. The Communications Group currently has interests in 12 cable television networks in Eastern Europe and the republics of the former Soviet Union that reported 421,102 subscribers at fiscal year-end 1999, an increase of approximately 33% from 315,864 subscribers at fiscal year-end 1998. This follows on a 40% increase in subscribers in 1998 from fiscal year-end 1997. In 1999, the Communications Group's cable ventures focused on growing their wired cable business through acquisition and network construction and finished the year with 1,089,924 homes passed by a fixed wireline network service. Of the 12 markets in which the Communications Group currently operates, nine offer both fixed wireline and wireless cable television services. Almost 80% of the cable group's subscribers are now serviced by fixed wireline cable television services.
In June 1999, Ala TV, a joint venture 51% owned by the Communications Group and 4% owned by its Kazakh joint venture Alma TV, launched both wired and wireless cable television services in Bishkek, Kyrgyzstan. In December 1999, the Communications Group purchased 100% of a wired cable television network in Deva, Romania thus increasing its Romania cable business by 23%. While the Communications Group's cable television systems are generally leading providers of multi-channel television services in each of its markets, in many markets there are several small undercapitalized wireline competitors. The Communications Group believes that there are additional acquisition opportunities in several of its markets and will pursue the acquisition of select competitors.
The Communications Group also believes that there is a growing demand for multi-channel television services in each of the markets where its joint ventures are operating. This growing demand is fueled by the lack of quality local television and alternative entertainment options in these markets combined with an increasingly sophisticated level of viewer demand for thematic cable programming in the local language. This growing appetite for multi-channel television has been recognized by some of the world's premier broadcasters who revolutionized the Eastern European market in recent years by launching localized versions of their internationally recognized programming. These channels include Eurosport, Nickelodeon, The Discovery Channel, The Hallmark Entertainment Network, MTV and Fox Kids, with which the Communications Group has programming arrangements.
APPLICATION OF NEW BROADBAND COMMUNICATION TECHNOLOGIES. Similar to developments in the U.S. and Western Europe, the Company expects cable television to become a broadband alternative to the existing telephone networks. The Communications Group believes that bundled video, data and voice services will prove an attractive offering compared to traditional network services. The Communications Group is currently upgrading its wired cable networks to hybrid fiber coaxial ("HFC") networks in
ITEM 1. BUSINESS (CONTINUED)
order to prepare its businesses to offer advance services. These advanced services are expected to provide significant new revenue streams to supplement the normal television services. In addition, the Communications Group is currently evaluating the introduction of digital television services in key markets utilizing the existing microwave multipoint distribution systems ("MMDS") already in place. Digital television services will allow a venture to offer more channels with vastly improved picture and sound quality, impulse pay-per view services, digital music services with CD quality sound, and both high speed and dial-up Internet services through the web browsers that are built into the digital set top boxes.
As part of its convergence strategy, the Communications Group is currently examining opportunities to utilize the new telecommunications assets garnered from the acquisition of PLD Telekom in conjunction with the Communication Group's cable television broadband networks that are already in place in key markets in Eastern Europe.
INTERNET SERVICES. The Communications Groups cable television joint ventures currently offer high speed Internet access in Romania and Latvia and expects these services to grow as modem prices continue to decrease and the number of cable networks are upgraded. The group is planning to roll out Internet services on its wired cable networks throughout the year in a number of its existing markets. In addition, the Communications Group is working with equipment manufacturers to introduce high speed Internet access through its existing microwave multipoint distribution systems. This form of wireless Internet provides great advantages in reaching business customers not reached by high speed cable or DSL services and providing them with one data service in multiple locations.
Since computer penetration in the region is lower than that of the west, the Communications Group believes that there is significant potential for a set top box that allows for Internet usage directly on a television set without the need of a computer. The Communications Group is currently working with equipment vendors to implement this technology on its networks which will allow it to increase penetration of the potential residential Internet market.
TECHNOLOGY. The Communications Group's cable television joint ventures utilize three possible distribution technologies: wireline cable, microwave multipoint distribution, or a hybrid combination of microwave multipoint distribution and wireline cable in which microwave multipoint distribution acts as a backbone to deliver programming to wireline cable networks for further distribution to the customer. All three distribution technologies allow for the introduction of broadband services.
The Communications Group believes that microwave multipoint distribution is an attractive technology to utilize for the delivery of multi-channel television services in these markets because (i) the initial construction costs of a microwave multipoint distribution system generally are significantly lower than wireline cable or direct-to-home satellite transmission, (ii) the time required to construct a wireless cable network is significantly less than the time required to build a standard wireline cable television network covering a comparably-sized service area, (iii) the high communications tower typically utilized by the microwave multipoint distribution system combined with the high density of multi-family dwelling units in these markets gives the microwave multipoint distribution systems very high line of sight penetration and (iv) in a hybrid network area the wide geographic reach of the microwave signal covers those areas not covered by the wired network.
PROGRAMMING. The Communications Group believes that programming is a critical component in building successful cable television systems. The Communications Group currently offers a wide variety of programming including English, French, German, Romanian and Russian programming, some of
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which is dubbed or subtitled into the local language. In order to maximize penetration and revenues per subscriber, the cable television joint ventures generally offer multiple tiers of service including, at a minimum, a "lifeline" service, a "basic" service and a "premium" service. The lifeline service generally provides programming of local off-air channels and an additional two to four channels such as MTV-Europe, Eurosport, Nickelodeon, VH-1, Cartoon Network, CNN International, and Discovery Channel. The basic and premium services generally include the channels which constitute the lifeline service, as well as an additional number of satellite channels and a movie channel that offers recent and classic movies. The content of each programming tier varies from market to market, but generally includes channels such as MTV-Europe, Eurosport, Nickelodeon, National Geographic, Cartoon Network, ESPN International, CNN, Star TV, and Discovery Channel. Each tier also generally offers localized programming.
One of the Communications Group's joint ventures offers pay-per-view movies and the Communications Group plans to add similar services to its program lineups in certain of its other markets. The subscriber pre-pays for pay-per-view services and the intelligent set top boxes that the joint venture uses automatically deduct the purchase of a particular service from the prepayment.
MARKETING. The Communications Group offers several tiers of programming in each market and strives to price the lowest tier at a level that is affordable to a large percentage of the population and that generally compares in price to alternative entertainment products. Each cable television joint venture also targets its cable television services toward foreign national households, embassies, foreign commercial establishments and international or local hotels. The Communications Group believes that a growing number of subscribers to local broadcast services will demand the superior quality programming and increased viewing choices offered by its cable television service. Upon launching a particular system, the Communications Group uses a combination of telesales, door to door sales, direct marketing event sponsorships, billboard, radio and broadcast television advertising to increase awareness in the marketplace about its services.
COMPETITION. The cable TV industry in Eastern Europe and the republics of the former Soviet Union, although still less developed than in the United States, is emerging as one of the key elements of the region's telecommunications sector. Similar to developments in the U.S. and Western Europe, the Company expects cable television to become a broadband alternative to the existing telephone networks. Each of the Communications Group's cable television systems currently compete with a number of entities in their markets, including other cable television operators, direct to home satellite providers and over the air broadcast television.
In addition, as the Internet gains popularity in the countries of Eastern Europe and the republics of the former Soviet Union, the Communications Group believes that cable television will be able to attract increasing capital, including capital from western investors. Major telecommunications companies may enter the cable television market to utilize the broadband advantages of the cable systems' wired networks because the poor quality of most of the telephone networks in the region makes cable television's advantages there even more significant than in the United States. As a result, the Company's cable television joint ventures may face competition from highly capitalized international and local companies with greater capital resources and experience than the Company.
The Company's cable television ventures endeavor to compete in their markets on the following bases:
- Quality of programming line-ups: The Company offers quality programming and has established key relationships with many international-programming providers.
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- Price of services: The Company provides tiered pricing and services to allow for a low entry point and an upgrade path for higher levels of services that allow the business to generate a much higher average revenue per subscriber than its competition. Most joint ventures have a basic package at the same rate or slightly lower than competing services.
- Customer service: The Company provides superior customer service by employing proven western style management techniques and by installing modern western subscriber management software and customer care centers into its businesses.
- Barriers to entry: The Company pre-wires certain geographic areas to create a barrier to entry in locations where it perceives a competitive threat.
RADIO BROADCASTING
OVERVIEW. The Communications Group entered the radio broadcasting business in Eastern Europe through the acquisition of Radio Juventus in Hungary in 1994. Today, the Company is a leading operator of radio stations in Eastern Europe and the republics of the former Soviet Union and owns and operates, through joint ventures, 17 radio stations. The Communications Group plans either to dispose of or discontinue the operations of NewsTalk Radio in Berlin during 2000.
The Communications Group's radio broadcasting strategy has been to acquire underdeveloped properties (i.e., stations with insignificant ratings and little or no positive cash flow) at attractive valuations. The Communications Group then installs experienced radio management to improve performance through increased marketing and focused programming. Management utilizes its programming expertise to tailor specifically the programming of each station utilizing sophisticated research techniques to identify opportunities within each market, and programs its stations to provide complete coverage of a demographic or format type. This strategy allows each station to deliver highly effective access to a target demographic and capture a higher percentage of the radio advertising audience share.
The Communications Group is also exploring ways in which it can leverage the existing brands established by the radio businesses in connection with its convergence strategy and the development of Internet-related businesses. Options which the Communications Group is investigating include the possible branding of Internet providers using those brand names and using the radio stations as an advertising medium for those new businesses.
PROGRAMMING. Programming in each of the Communications Group's markets is designed to appeal to the particular interests of a specific demographic group in such markets. The Communications Group's radio programming formats generally consist of popular music from the United States, Western Europe and the local region. News is delivered by local announcers in the language appropriate to the region, and announcements and commercials are locally produced. By developing a strong listener base comprised of a specific demographic group in each of its markets, the Communications Group believes it will be able to attract advertisers seeking to reach these listeners. The Communications Group believes that the technical programming and marketing expertise that it provides to its joint ventures enhances the performance of the joint ventures' radio stations.
MARKETING. Radio station programming is generally targeted towards that segment which the Communications Group believes to be the most affluent within the 25-to-55-year-old demographic in each of its radio markets. Each station's format is intended to appeal to the particular listening interests of this consumer group in its market. This focus is intended to enable each joint venture to
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present to advertisers the most desirable market for the advertisers' products and services, thereby heightening the value of the station's commercial advertising time. Advertising on these stations is sold to local and international advertisers.
COMPETITION. While the Communications Group's radio stations are generally leaders in each of their respective markets, they compete in each market with stations currently in operation or anticipated to be in service shortly. Other media businesses, including broadcast television, cable television, newspapers, magazines and billboard advertising also compete with the Communications Group's radio stations for advertising revenues.
For the most part the Company's radio stations compete with other radio stations and other advertising media on the basis of the cost to the advertiser per targeted listener reached. The radio stations that have the greatest reach generally obtain the highest rate. In addition, certain demographic groups (usually men or women age 25-54) are favored by advertisers. The Company's radio stations are generally programmed to reach the highest rated demographic groups in their markets.
Radio stations may experience further competition from other media. As private cable television stations emerge in Eastern Europe and the republics of the former Soviet Union, the Company expects that such systems will drive the price of television advertising down, thus competing directly with radio stations for advertising revenues. In addition to broadcast television, print media, and outdoor advertising, the Communications Group believes that the Internet will also attract a significant portion of advertising expenditures in each respective market.
PAGING
The Communications Group's paging businesses have to date provided traditional paging services. The underlying premise for the paging business had been the availability of service to mobile subscribers at a price significantly lower than alternative mobile messaging services. When the Communications Group entered the paging business, the price for wireless communication was significantly higher than for its paging services which were then a viable, low cost alternative to GSM wireless telephony. At such time, customers could receive messages and information via the pager at a fraction of the cost of GSM wireless service.
However, the Communications Group's paging businesses have experienced increasing competition from wireless telephony in the markets in which it operates, and this competition has called into question the viability of many of the paging operations. Consistent with the Company's strategy to maximize its greatest value for the capital employed, in 1998 the Communications Group developed a revised operating plan to stabilize the operations of its paging ventures. Under the revised plan, the Communications Group managed its paging business to a level that would not require significant additional funding for its operations. Despite a number of operating and marketing initiatives to diminish the effects of the increased competition, including calling party pays, the paging operations continued to generate operating losses in 1999. In 1999, the Company has taken an additional non-cash charge on its paging assets of $1.9 million. In the current environment, the potential for growth in most of the markets the Communications Group's paging operations compete appears very limited. The Company is continuing to manage its paging businesses to levels not requiring significant additional funding, and is developing a strategy to maximize the value of its paging investments.
ITEM 1. BUSINESS (CONTINUED)
The Company currently believes the remaining value of its investments in and advances to joint ventures related to paging businesses is recoverable due to the location of the businesses and the ability to cross market services to the customer base.
TELECOMMUNICATIONS JOINT VENTURES IN CHINA
In 1997 and 1998, the Company invested in several telecommunications joint ventures in China through its majority-owned subsidiary, Asian American Telecommunications Corporation. These joint ventures supported the construction and development of telephony networks by China United Telecommunications Incorporated, a Chinese telecommunications operator known as China Unicom. Because legal restrictions in China prohibit direct foreign investment and operating participation in domestic telephone companies, the company's joint ventures were limited to providing financing and consulting services to China Unicom under contracts. By the terms of these contracts and in return for services rendered, the joint ventures were to receive payments from China Unicom based on the cash flows generated by China Unicom's network businesses. This arrangement, known as sino-sino-foreign joint venture cooperation, was commonly accepted at the time the Company's joint ventures were formed and was applied in numerous other foreign-invested relationships with China Unicom. Since the arrangement specifically limited the joint ventures' participation in and control over China Unicom's actual business operations, Asian American Telecommunications accounted for its sino-sino-foreign joint venture investments under the equity method. The Company invested in four Chinese telecommunications joint ventures in this fashion--two in Ningbo Municipality, one in Sichuan Province and one in Chongqing City.
Beginning in mid-1998, the Chinese government unofficially began reconsidering the advisability of continuing the sino-sino-foreign joint venture cooperation arrangements undertaken by China Unicom. At that time, more than forty such cooperation contracts had been established with foreign-invested joint ventures covering China Unicom's operations in various parts of China. By mid-1999, the government reached the conclusion that China Unicom's sino-sino-foreign cooperation framework was in conflict with China's basic telecommunications regulatory policies and should henceforth cease. China Unicom was instructed to terminate or very substantially restructure all of its sino-sino-foreign joint venture cooperation contracts.
In July 1999, Ningbo Ya Mei Telecommunications, Ltd., one of the Company's two telecommunications joint ventures in Ningbo Municipality, China, received notice from China Unicom stating that the Chinese government had directed China Unicom to terminate further cooperation with Ningbo Ya Mei. China Unicom subsequently informed the Company that the notification also applied to the Company's other telecommunications joint venture in Ningbo Municipality. In subsequent notifications from China Unicom to the Company's joint ventures, China Unicom stated its intention to terminate all cooperation contracts with sino-sino-foreign joint ventures in China pursuant to an August 30, 1999 mandate from the Chinese Ministry of Information Industry. In its notifications, China Unicom requested that negotiations begin regarding a suitable settlement of all matters related to the winding up of the Company's joint ventures cooperation agreements with China Unicom as a result of the Ministry of Information Industry notice. With the issuance of these notifications, China Unicom ceased further performance under its cooperation contracts with the Company's joint ventures. However, China Unicom did make distribution of amounts owed to the Company's Ningbo Ya Mei joint venture for the first half of 1999 according to the terms of the cooperation contract. The Company, through its four joint ventures, entered into negotiations with China Unicom in September 1999 to reach suitable terms for termination of the cooperation contracts.
ITEM 1. BUSINESS (CONTINUED)
On November 6, 1999, the Company's four Chinese joint ventures engaged in projects with China Unicom each entered into non-binding letters of intent with China Unicom which set forth certain terms for termination of their cooperation arrangements with China Unicom. On December 3, 1999, legally binding settlement contracts incorporating substantially the terms set forth in the November letters of intent were executed between China Unicom and the four joint ventures, thereby terminating the joint ventures' further cooperation with China Unicom. Under the terms of the settlement contracts, the four joint ventures will each receive cash amounts in reminbi, the Chinese currency ("RMB") from China Unicom in full and final payment for the termination of their cooperation contracts with China Unicom. Upon receipt of this payment, China Unicom and the joint ventures will waive all of their respective relevant rights against the other party with respect to the cooperative arrangements. In addition, all assets pertinent to China Unicom's networks that are currently held by the joint ventures will be unconditionally transferred to China Unicom. China Unicom effected payment to the joint ventures of the amounts prescribed in the settlement contracts on December 10, 1999. Subsequently and prior to the end of 1999, the boards of directors of the four joint ventures each passed formal resolutions to commence dissolution of the joint ventures. The Company expects such dissolution to be completed for all four joint ventures by mid-2000.
The Company will receive substantial portions of the China Unicom settlement payments to the joint ventures via repayment of advances and distribution of joint venture assets on dissolution. China Unicom's settlement payments to the joint ventures were made in RMB. The joint ventures' formation contracts and loan agreements with Asian American Telecommunications had been registered with Chinese authorities so as to assure the joint ventures' ability to convert RMB deposits into foreign exchange for payment to the Company. Over time, the Company anticipates that it will fully recover its investments in and advances to the four affected joint ventures, but no assurances can be made as to the exact timing or amount of such repayments. As of December 31, 1999, investments in and advances to these four joint ventures, exclusive of goodwill, were approximately $40.0 million. As of December 31, 1999, the joint ventures had conveyed to Asian American Telecommunications in the form of repayment of advances approximately $29.3 million in US Dollars from the China Unicom settlement.
The Company's current estimate of the total amount it will ultimately receive from the four terminated joint ventures is $90.1 million (at the December 31, 1999 exchange rate) of which $29.3 million has been received. Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint ventures. However, some variance from the Company's current estimates of the amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China and exchange rate fluctuations. The Company cannot assure at this time that this variance will not be material.
The currently estimated $90.1 million in total payments from the Company's four joint ventures that had cooperated with China Unicom is insufficient to fully recover the goodwill recorded in connection with the Company's investment in these joint ventures. As a result, the Company has recorded a non-cash impairment charge of $45.7 million in 1999 for the write-off of goodwill. Further adjustments may be required after receipt of final distributions from the four terminated joint ventures.
ITEM 1. BUSINESS (CONTINUED)
LICENSES
The Communications Group's operations are subject to governmental regulation in its markets and its operations require certain governmental approvals. There can be no assurance that the Communications Group will be able to obtain all necessary approvals to operate additional cable television, telephony or paging systems or radio broadcasting stations in any of the markets in which it is seeking to establish additional businesses.
The licenses pursuant to which the Communications Group's businesses operate are issued for limited periods, including certain licenses which are renewable annually. Certain of these licenses expire over the next several years. As of December 31, 1999, several licenses held by the Communications Group had expired, although the Communications Group has been permitted to continue operations while the decision on reissuance is pending. Certain other licenses held or used by the Communications Group's joint ventures will expire during 2000. The Company's joint ventures will apply for renewals of their licenses. However, there can be no assurance that these licenses will be renewed. Additionally, a number of joint ventures are in violation of one or more of the conditions of their licenses. While these violations are largely technical there can be no assurance that the relevant licensing authorities will not attempt to use these violations as a basis to terminate or renegotiate these licenses. See "--Risks Associated with the Company--The government licenses on which the Communications Group depends to operate many of its businesses could be cancelled or not renewed, which would impair the development of its services."
LIQUIDITY ARRANGEMENTS
While in a number of cases the Communications Group owns less than 50% of the equity in a joint venture, in general the objective of the Communications Group is to hold a greater than 50% interest in the joint ventures in which it invests. The balance of the equity in its joint ventures is usually owned by one or more local entities, often a government-owned enterprise or a formerly government-owned enterprise which has been privatized. In some cases the Communications Group owns or acquires interests in entities (including competitors) that are already licensed and are providing service. Each joint venture's day-to-day activities are managed by a local management team selected by its board of directors or its shareholders. In almost every case the Communications Group designates one or more of its personnel to work with the joint venture, in some instances actually seconding the individual to a specific joint venture. The operating objectives, business plans and capital expenditures of a joint venture are approved by its board of directors, or in certain cases, by its shareholders. In some cases, an equal number of directors or managers of the joint venture are selected by the Communications Group and its local partner. In other cases, a different number of directors or managers of the joint venture may be selected by the Communications Group on the basis of its percentage ownership interest.
In many cases, the credit agreement pursuant to which the Company loans funds to a joint venture provides the Company with the right to appoint the general manager of the joint venture and to approve unilaterally the annual business plan of the joint venture. These rights continue so long as amounts are outstanding under the credit agreement. In other cases, such rights may also exist by reason of the Company's percentage ownership interest in the joint venture or under the terms of the joint venture's governing instruments.
The Communications Group's joint ventures in Eastern Europe and the republics of the former Soviet Union are limited liability entities which are permitted to enter into contracts, acquire property and
ITEM 1. BUSINESS (CONTINUED)
assume and undertake obligations in their own names. Because these joint ventures are limited liability companies, the joint ventures' equity holders have liability limited to the extent of their investment. Under the joint venture agreements, each of the Communications Group and the local joint venture partner is obligated to make initial capital contributions to the joint venture. In general, a local joint venture partner does not have the resources to make contributions to the joint venture in cash. In such cases the Company establishes an agreement with the joint venture whereby, in addition to cash contributions by the Company, both the Company and the local partner make in-kind contributions (usually communications equipment in the case of the Company and frequencies, space on transmitting towers and office space in the case of the local partner), and the joint venture signs a credit agreement with the Company pursuant to which the Company loans the joint venture certain funds. Typically, such credit agreements provide for interest payments to the Company at rates ranging generally from prime to prime plus 6% and for payment of principal and interest from 90% of the joint venture's available cash flow. Prior to repayment of its credit agreement, a joint venture is significantly limited or prohibited from distributing profits to its shareholders. As of December 31, 1999, the Company had obligations to fund up to an additional $48.5 million with respect to funding the various credit lines the Company has extended to its joint ventures in Eastern Europe and the republics of the former Soviet Union. The Company's funding commitments under such credit lines are contingent upon its approval of the joint ventures' business plans. To the extent that the Company does not approve a joint venture's business plan, the Company is not required to provide funds to such joint venture under the credit line.
A number of the Communications Group's joint ventures, notably PeterStar, ALTEL and almost all the radio stations, have become self-financing and have ceased to require financial support from the Group.
In addition to repayments under its credit agreements, the Company may also receive distributions from the joint venture. Where these distributions are of profits, they will be made on a pro rata basis to the Company and its local partners in accordance with their respective ownership interests.
In addition to loaning funds to the joint ventures, the Communications Group often provides certain services of the joint ventures for a fee. The Communications Group does not usually require start-up joint ventures to reimburse it for certain services that it provides such as engineering advice, assistance in locating programming, and assistance in ordering equipment. As each joint venture grows, the Communications Group institutes various payment mechanisms to have the joint venture reimburse it for such services where they are provided. The failure of the Company to obtain reimbursement of such services will not have a material impact on the Company's results of operations.
Under existing legislation in certain of the Communications Group's markets, distributions from a joint venture to its partners (including payments of fees) are subject to taxation. The laws in the Communications Group's markets vary markedly with respect to the tax treatment of distributions to joint venture partners and such laws have also recently been revised significantly in many of the Communications Group's markets. There can be no assurance that such laws will not continue to undergo major changes in the future which could have a significant negative impact on the Company and its operations.
ITEM 1. BUSINESS (CONTINUED)
The Communications Group's China joint ventures in Ningbo, Sichuan and Chongqing are currently in the process of dissolution subsequent to the forced termination of their cooperative contracts with China Unicom. Dissolution is regulated by the Chinese government and requires the joint ventures to submit to certain audits and tests of financial liability. The dissolving joint ventures have no material financial obligations outstanding as of February 2000 other than for 1999 taxes in China. Repayment of the principal balance of loans is permitted prior to final dissolution, and $29.3 million in such loan payments have already been made to the Company's Asian American Telecommunications subsidiary. Distribution of owners' equity, however, is not permitted until final dissolution is approved. The joint ventures' tax liabilities are currently being negotiated with the Chinese tax authorities in view of the unusual circumstances surrounding payments received from China Unicom during 1999. The Company expects to settle the joint ventures' tax liabilities and complete dissolution by mid-2000.
SNAPPER
GENERAL. Snapper manufactures Snapper-Registered Trademark- brand power lawn and garden equipment for sale to both residential and commercial customers. The residential equipment includes self-propelled and push-type walk behind lawnmowers, rear engine riding lawnmowers, garden tractors, zero turn radius lawn equipment, garden tillers, snow throwers, and related parts and accessories. The commercial mowing equipment includes commercial quality self-propelled walk-behind lawnmowers, and wide area walk-behind mowers and front- and mid-mount zero turn radius lawn equipment. The percentage of the Company's consolidated revenues from Snapper's operations for 1999, 1998 and 1997 were 82%, 87%, and 90%, respectively.
Snapper products are premium-priced, generally selling at retail from $300 to $10,500. Snapper sells to and supports directly an approximately 5,000-dealer network for the distribution of its products. Snapper distributes these products through facilities in McDonough, Georgia totaling 367,000 square feet and other leased warehouse facilities in Dallas, Texas, Reno, Nevada and Greenville, Ohio to better serve growing customer needs. Snapper also sells its products through foreign distributors and offered a limited selection of residential walk-behind lawnmowers and rear-engine riding lawnmowers through approximately 250 of The Home Depot locations through August 1998, when Snapper terminated its relationship with The Home Depot.
Due to a shift in strategic direction to focus exclusively on the independent dealer network, Snapper terminated its business relationship with The Home Depot in August of 1998. Since the majority of Snapper's competitors had elected to distribute product through retail establishments, Snapper has decided to align its product distribution directly through the independent dealer network channel. In an effort to capitalize on this decision, Snapper has developed a comprehensive strategy to expand its independent dealer base by soliciting new dealers based on Snapper's commitment to customer service and this chosen method of distribution of product. The Home Depot net sales accounted for revenues of $6.3 million and $6.0 million in 1998 and 1997 respectively.
A large percentage of the residential and commercial sales of lawn and garden equipment are made during a 17-week period from early spring to mid-summer. Although some sales are made to the dealers and distributors prior and subsequent to this period, the largest volume of sales is made during this time. The majority of revenues during the late fall and winter periods are related to snow thrower shipments. Snapper has an agreement with a financial institution which makes available floor plan financing for dealers of Snapper's products. This agreement provides financing for inventories and accelerates Snapper's cash flow. Under the terms of this agreement, a default in payment by a dealer is non-recourse to Snapper. However, the third-party financial institution can require Snapper to repurchase new and unused equipment, if the dealer defaults and the inventory is not able to be sold
ITEM 1. BUSINESS (CONTINUED) to another dealer. At December 31, 1999 there was approximately $95.0 million outstanding under this floor-plan financing arrangement. The Company has guaranteed Snapper's payment obligations under this arrangement.
Snapper also makes available, primarily through General Electric Credit Corporation, a retail customer revolving credit plan. This credit plan allows consumers to pay for Snapper products over time. Consumers also receive Snapper credit cards which can be used to purchase additional Snapper products.
Snapper manufactures its products in McDonough, Georgia at facilities totaling approximately 1.0 million square feet. Excluding engines, transmissions and tires, Snapper manufactures a substantial portion of the component parts for its products. Most of the parts and materials for Snapper's products are commercially available from a number of sources.
During the three years ended December 31, 1999, Snapper spent an average of $3.3 million per year for research and development. Although it holds several design and mechanical patents, Snapper is not dependent upon such patents, nor does it believe that patents play an important role in its business. Snapper does believe, however, that the registered trademark "Snapper-Registered Trademark-" is an important asset in its business. Snapper walk-behind mowers are subject to Consumer Product Safety Commission safety standards and are designed and manufactured in accordance therewith.
The lawn and garden industry is highly competitive with the competition being based on price, image, quality, and service. Although no one company dominates the market, the Company believes that Snapper is a significant manufacturer of lawn and garden products. A large number of companies, some of which are better capitalized than Snapper, manufacture and distribute products that compete with Snapper's, including The Toro Company, Lawn-Boy (a product of The Toro Company), Sears Roebuck and Co., Deere and Company, Ariens Company, Honda Corporation, Murray Ohio Manufacturing, American Yard Products, Inc., MTD Products, Inc. and Simplicity Manufacturing, Inc.
INVESTMENT IN RDM
In December 1994, the Company acquired 19,169,000 shares of RDM common stock, representing approximately 39% of the outstanding shares of RDM common stock as of the date thereof, in exchange for all of the issued and outstanding capital stock of four of its wholly owned subsidiaries. At the time of the transaction, RDM, a New York Stock Exchange listed company, through its operating subsidiaries, was a leading manufacturer of fitness equipment and toy products in the United States.
In connection with the transaction pursuant to which the Company acquired the RDM shares, the Company, RDM and certain officers of RDM entered into a shareholders agreement, pursuant to which, among other things, the Company obtained the right to designate four individuals to serve on RDM's Board of Directors, subject to certain reductions.
In June 1997, RDM entered into a $100.0 million revolving credit facility with a syndicate of lenders led by Foothill Capital Corporation and used a portion of the proceeds of such facility to refinance its existing credit facility. In order to induce Foothill to extend the entire amount of the RDM credit facility, Metromedia Company, an affiliate of the Company, provided Foothill with a $15.0 million letter of credit that could be drawn by Foothill (i) upon five days notice, if RDM defaulted in any payment of principal or interest or breached any other convenant or agreement in the RDM credit facility and as a result of such other default the lenders accelerated the amounts outstanding under the RDM credit facility, subject, in each such case, to customary grace periods, or (ii) immediately, upon the bankruptcy or insolvency of RDM. In consideration for the Metromedia Company letter of credit, RDM issued to Metromedia Company 10-year warrants to acquire 3,000,000 shares of RDM common stock, exercisable after 90 days from the date of issuance at an exercise price of $.50 per share. In accordance with the terms of the agreement entered into in connection with the RDM credit facility, Metromedia Company offered the Company the opportunity to substitute its letter of credit for the Metromedia Company letter of credit and to receive the RDM warrants. On July 10, 1997, the Company's Board of Directors elected to substitute its letter of credit for Metromedia Company's letter of credit and the RDM warrants were assigned to the Company.
On August 22, 1997, RDM announced that it had failed to make the August 15, 1997 interest payment due on its subordinated debentures and that it had no present ability to make such payment. As a result, on August 22, 1997, Foothill declared an event of default under the RDM credit facility and accelerated all amounts outstanding under such facility. On August 29, 1997, RDM and certain of its affiliates each subsequently filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. Since the commencement of their respective chapter 11 cases, RDM and its affiliates have discontinued ongoing business operations and their assets are being liquidated. As of August 22, 1997, the closing price per share of RDM common stock was $.50 and the quoted market value of the Company's investment in RDM was approximately $9.6 million. As a result of RDM's financial difficulties and uncertainties, the New York Stock Exchange halted trading in the shares of RDM common stock and the Company believes that it will not receive any compensation for its equity interest.
After the commencement of the chapter 11 cases, Foothill drew the entire amount of the letter of credit. Consequently, the Company will become subrogated to Foothill's secured claims against the Company in an amount equal to the drawing under the letter of credit, following payment in full of Foothill. The Company intends to vigorously pursue its subrogation claims in the chapter 11 cases. However, it is uncertain whether the Company will succeed in any such subrogation claims or if it is successful in asserting any such subrogation claims, whether RDM's remaining assets will be sufficient to pay them.
On February 18, 1998, the Office of the United States Trustee filed a motion to appoint a chapter 11 trustee in the United States Bankruptcy Court for the Northern Division of Georgia. RDM and its affiliates subsequently filed a motion to convert the chapter 11 cases to cases under chapter 7 of the Bankruptcy Code. On February 19, 1998, the bankruptcy court granted the United States Trustee's motion and ordered that a chapter 11 trustee be appointed. The bankruptcy court also ordered that the chapter 11 cases not convert to cases under chapter 7 of the Bankruptcy Code. On February 25, 1998, each of the Company's designees on RDM's board of directors submitted a letter of resignation.
The chapter 11 trustee is in the process of selling all of RDM's assets to satisfy its obligations to its creditors and the Company believes that its equity interest will not be entitled to receive any distributions.
On August 19, 1998, a purported class action lawsuit, THEOHAROUS V. FONG, ET AL, Civ. No. 1:98CV2366, was filed in United States District Court for the Northern District of Georgia. On October 19, 1998, a second purported class action lawsuit with substantially the same allegations, SCHUETTE V. FONG, ET AL.,
Civ. No. 1:98CV3034, was filed in United States District Court for the Northern District of Georgia. On June 7, 1999, plaintiffs in each of these lawsuits filed amended complaints. The amended complaints alleged that certain officers, directors and shareholders of RDM, including the Company and current and former officers of the Company who served as directors of RDM, were liable under federal securities laws for misrepresenting and failing to disclose information regarding RDM's alleged financial condition during the period between November 7, 1995 and August 22, 1997, the date on which RDM disclosed that its management had discussed the possibility of filing for bankruptcy. The amended complaints also alleged that the defendants, including the Company and current and former officers of the Company who served as directors of RDM, were secondarily liable as controlling persons of RDM. In an opinion dated March 10, 2000, the court dismissed these actions in their entirety.
On December 30, 1998, the chapter 11 trustee of RDM brought an adversary proceeding in the bankruptcy of RDM, HAYS, ET AL. v. FONG, ET AL., Adv. Proc. No. 98-1128, in the United States Bankruptcy Court, Northern District of Georgia, alleging that current and former officers or directors of the Company, while serving as directors of RDM, breached fiduciary duties allegedly owed to RDM's shareholders and creditors in connection with the bankruptcy of RDM. On January 25, 1999, the plaintiff filed a first amended complaint. The official committee of unsecured creditors of RDM has moved to proceed as co-plaintiff or to intervene in this proceeding, and the official committee of bondholders of RDM has moved to intervene in or join the proceeding. Plaintiffs in this adversary proceeding seek the following relief against current and former officers of the Company who served as directors of RDM: actual damages in an amount to be proven at trial, reasonable attorney's fees and expenses, and such other and further relief as the court deems just and proper. On February 16, 1999, the creditors' committee brought an adversary proceeding, THE OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF RDM SPORTS GROUP, INC. AND RELATED DEBTORS V. METROMEDIA INTERNATIONAL GROUP, INC., Adv. Proc. No. 99-1023, seeking in the alternative to recharacterize as contributions to equity a secured claim in the amount of $15 million made by the Company arising out of the Company's financing of RDM, or to equitably subordinate such claim made by the Company against RDM and other debtors in the bankruptcy proceeding. On March 3, 1999, the bondholders' committee brought an adversary proceeding, THE OFFICIAL COMMITTEE OF Bondholders of RDM Sports Group, Inc. v. METROMEDIA INTERNATIONAL GROUP, INC., Adv. Proc. No. 99-1029, with substantially the same allegations as the above proceeding. In addition to the equitable and injunctive relief sought by plaintiffs described above, plaintiffs in these adversary proceedings seek actual damages in an amount to be proven at trial, reasonable attorneys' fees, and such other and further relief as the court deems just and proper. The Company believes it has meritorious defenses and plans to vigorously defend these actions. Due to the early stage of these proceedings, the Company cannot evaluate the likelihood of an unfavorable outcome or an estimate of the likely amount or range of possible loss, if any.
LANDMARK SALE
On April 16, 1998, the Company sold to Silver Cinemas, Inc. all of the assets of the Company's Landmark theater group, except cash, for an aggregate cash purchase price of approximately $62.5 million and the assumption of certain Landmark liabilities. The sale of Landmark combined with the sale of the Company's entertainment assets in 1997 has provided the Company with funds for its expansion in communications businesses. With the sale of these non-strategic assets the Company is focusing on its core business of providing affordable modern digital voice, data and multimedia communications capabilities.
ENVIRONMENTAL PROTECTION
Snapper's manufacturing plant is subject to federal, state and local environmental laws and regulations. Compliance with such laws and regulations has not affected materially nor is it expected to affect materially Snapper's competitive position. Snapper's capital expenditures for environmental control facilities, its incremental operating costs in connection therewith and Snapper's environmental compliance costs were not material in 1999 and are not expected to be material in future years.
ITEM 1. BUSINESS (CONTINUED)
The Company has agreed to indemnify a former subsidiary of the Company for certain obligations, liabilities and costs incurred by the subsidiary arising out of environmental conditions existing on or prior to the date on which the subsidiary was sold by the Company in 1987. Since that time, the Company has been involved in various environmental matters involving property owned and operated by the subsidiary, including clean-up efforts at landfill sites and the remediation of groundwater contamination. The costs incurred by the Company with respect to these matters have not been material during any year through and including the year ended December 31, 1999. As of December 31, 1999, the Company had a remaining reserve of approximately $2.1 million to cover its obligations to its former subsidiary. During 1996, the Company was notified by certain potentially responsible parties at a superfund site in Michigan that the former subsidiary may also be a potentially responsible party at the superfund site. The former subsidiary has agreed to participate in remediation in a global settlement that is subject to court approval, but the amount of the liability has not been finally determined. The Company believes that such liability will not exceed the reserve.
The Company, through a wholly owned subsidiary, owns approximately 17 acres of real property located in Opelika, Alabama. The Opelika property was formerly owned by Diversified Products Corporation, a former subsidiary of the Company that used the Opelika property as a storage area for stockpiling cement, sand and mill scale materials needed for or resulting from the manufacture of exercise weights. In June 1994, Diversified Products discontinued the manufacture of exercise weights and no longer needed to use the Opelika property as a storage area. The Opelika property was transferred to the Company's wholly owned subsidiary in connection with the sale of the Company's former sporting goods subsidiary. In connection with such sale, the Company entered into an environmental indemnity agreement under which the Company is obligated for costs and liabilities resulting from the presence on or migration of regulated materials from the Opelika property. The Company's obligations under the environmental indemnity agreement with respect to the Opelika property are not limited. The environmental indemnity agreement does not cover environmental liabilities relating to any property now or previously owned by Diversified Products except for the Opelika property.
On January 22, 1996, the Alabama Department of Environmental Management ("ADEM") advised the Company that the Opelika property contains an "unauthorized dump" in violation of Alabama environmental regulations. The letter from ADEM required the Company to present for of ADEM's approval a written environmental remediation plan for the Opelika property. The Company retained an environmental consulting firm to develop an environmental remediation plan for the Opelika property. In 1997, the Company received the consulting firm's report. The Company has conducted the grading and capping in accordance with the remediation plan and has reported to the Department of Environmental Management that the work was successfully completed. In 1999, the Company proposed to the Department of Environmental Management an accelerated groundwater monitoring schedule. That monitoring is complete and ADEM has stated that the "groundwater monitoring requirements for this site are terminated." Pending the recording of the appropriate deed notation, this site will be fully closed in accordance with Alabama regulations. The Company believes that its reserve of approximately $59,000 will be adequate to cover any further costs.
EMPLOYEES
As of March 6, 2000, the Company had approximately 1,000 regular employees. Approximately 600 employees were represented by unions under collective bargaining agreements. In general, the Company believes that its employee relations are good.
ITEM 1. BUSINESS (CONTINUED) SEGMENT AND GEOGRAPHIC DATA
Business segment data and information regarding the Company's foreign revenues by country area are included in notes 3, 4 and 12 to the Notes to Consolidated Financial Statements included in Item 8 hereof.
RISKS ASSOCIATED WITH THE COMPANY
THE COMPANY EXPECTS TO CONTINUE TO INCUR LOSSES FROM ITS CONTINUING OPERATIONS, WHICH COULD PREVENT IT FROM PURSUING ITS GROWTH STRATEGIES AND COULD CAUSE IT TO DEFAULT UNDER ITS DEBT OBLIGATIONS.
The Company cannot assure you that it will succeed in establishing an adequate revenue base or that its services will be profitable or generate positive cash flow. The Company has reported substantial losses from operations over the previous three years. For the years ended December 31, 1999, 1998 and 1997, it reported a loss from continuing operations of approximately $129.2 million, $136.0 million, and $130.9 million, respectively, and a net loss of $142.0 million, $123.7 million, and net income of $88.4 million, respectively. The Company expects that it will report significant operating losses for the fiscal year ended December 31, 2000. In addition, many of the Communications Group's joint ventures are still in the early stages of their development and the Communications Group expects to continue to generate losses as it continues to build-out and market its services. Accordingly, the Company expects to generate consolidated losses for the foreseeable future.
Continued losses and negative cash flow may prevent the Company from pursuing its strategies for growth and could cause it to be unable to meet its debt service obligations, its capital expenditures or working capital needs.
THE COMPANY WILL BE UNABLE TO MEET ITS OBLIGATIONS IF IT DOES NOT RECEIVE DISTRIBUTIONS FROM ITS SUBSIDIARIES AND ITS SUBSIDIARIES HAVE NO OBLIGATIONS TO MAKE ANY PAYMENTS TO IT.
The Company is a holding company with no direct operations and no assets of significance other than the stock of its subsidiaries. As such, the Company is dependent on the earnings of its subsidiaries and the distribution or other payment of these earnings to it to meet its obligations, including its ability to make distributions to its stockholders. The Company's subsidiaries are separate legal entities that have no obligation to pay any amounts the Company owes to third parties, whether by dividends, loans or other payments. Snapper, Inc.'s credit facility contains substantial restrictions on dividends and other payments by Snapper to the Company. In addition, many of the Communications Group's joint ventures are in their early stages of development and are operating businesses that are capital intensive. As a result, the Company will principally rely on cash on hand, proceeds from the disposition of non-core assets and net proceeds from additional financings through a public or private sale of debt or equity securities to meet its cash requirements.
THE COMPANY HAS SUBSTANTIAL DEBT WHICH MAY LIMIT ITS ABILITY TO BORROW, RESTRICT THE USE OF ITS CASH FLOWS AND CONSTRAIN ITS BUSINESS STRATEGY AND THE COMPANY MAY NOT BE ABLE TO MEET ITS DEBT OBLIGATIONS.
The Company has substantial debt and debt service requirements. The Company's substantial debt has important consequences, including:
- the Company's ability to borrow additional amounts for working capital, capital expenditures or other purposes is limited,
ITEM 1. BUSINESS (CONTINUED) - a substantial portion of the Company's cash flow from operations is required to make debt service payments, and
- the Company's leverage could limit its ability to capitalize on significant business opportunities and its flexibility to react to changes in general economic conditions, competitive pressures and adverse changes in government regulation.
The Company cannot assure you that its cash flow and capital resources will be sufficient to repay any outstanding indebtedness or any indebtedness the Company may incur in the future, or that the Company will be successful in obtaining alternative financing. If the Company is unable to repay its debts, it may be forced to reduce or delay the completion or expansion of its networks, sell some of its assets, obtain additional equity capital or refinance or restructure its debt. If the Company is unable to meet its debt service obligations or comply with its covenants, the Company will default under its existing debt agreements. To avoid a default, the Company may need waivers from third parties, which might not be granted.
RESTRICTIONS IMPOSED BY THE COMPANY'S PRINCIPAL DEBT AGREEMENT MAY SIGNIFICANTLY LIMIT ITS BUSINESS STRATEGY AND INCREASE THE RISK OF DEFAULT UNDER THE COMPANY'S DEBT OBLIGATIONS.
The indenture for the Company's outstanding 10 1/2% senior discount notes contains a number of significant covenants. These covenants limit the Company's ability to, among other things:
- borrow additional money,
- make capital expenditures and other investments,
- repurchase its own common stock,
- pay dividends,
- merge, consolidate, or dispose of its assets, and
- enter into transactions with related entities.
If the Company fails to comply with these covenants, the Company would default under the indenture. A default, if not waived, could result in acceleration of the Company's indebtedness, in which case the debt would become immediately due and payable. If this occurs, the Company may not be able to repay its debt or borrow sufficient funds to refinance it. Even if new financing is available, it may not be on terms that are acceptable to the Company. Complying with these covenants may cause the Company to take actions that it otherwise would not take, or not take actions that it otherwise would take.
THE COMPANY MAY NOT BE ABLE TO RAISE THE SUBSTANTIAL ADDITIONAL FINANCING THAT WILL BE REQUIRED TO SATISFY ITS LONG-TERM BUSINESS OBJECTIVES, WHICH WOULD FORCE IT TO SIGNIFICANTLY CURTAIL ITS BUSINESS OBJECTIVES AND MAY MATERIALLY AND ADVERSELY AFFECT ITS RESULTS OF OPERATIONS.
Many of the Communications Group's joint ventures operate businesses that are capital intensive and require the investment of significant amounts of capital in order to construct and develop operational systems and market their services. As a result, the Company will require substantial additional financing to satisfy its long-term business objectives, including its on-going working capital, acquisition and expansion requirements. The Company may seek to raise this additional capital through the public or private sale of debt or equity securities. If the Company incurs additional debt, it may become subject to additional or more restrictive financial covenants and ratios. The Company cannot assure you that additional financing will be available to it on acceptable terms, if at all. If adequate additional funds
ITEM 1. BUSINESS (CONTINUED) are not available, the Company may be required to curtail significantly its long-term business objectives and its results from operations may be materially and adversely affected.
THE COMMUNICATIONS GROUP MAY BE MATERIALLY AND ADVERSELY AFFECTED BY COMPETITION FROM LARGER GLOBAL COMMUNICATIONS COMPANIES OR THE EMERGENCE OF COMPETING TECHNOLOGIES IN ITS CURRENT OR FUTURE MARKETS.
The Communications Group's businesses are in highly competitive markets and compete with many other well-known communications and media companies, many of which have established operating infrastructures and substantially greater financial, management and other resources than the Company's operating businesses.
The Communications Group also faces potential competition from competing technologies which could emerge over time in Eastern Europe, the republics of the former Soviet Union and other selected emerging markets and compete directly with their operations. For example, the Communications Group's paging businesses have found it difficult to effectively compete for traditional paging customers in markets where GSM technology is combined with calling party pays and prepaid calling card service.
Similarly, the Company cannot assure that its wireless networks in Kazakhstan and Belarus, and its new network in Tyumen, Russia will be able to compete with the development of the newly-introduced GSM technology in these markets.
In addition, the principal partners in certain joint ventures and operating businesses have interests that may conflict with those of the Communications Group and in certain instances could compete directly with the Communications Group and its businesses. This competition could seriously undermine the local support for the Communications Group's businesses, affect the results of operations in these countries and jeopardize the Company's ability to fully realize the value of its economic investments in these countries.
For example, Telecominvest, the other shareholder in PeterStar, has recently raised over $50 million in net proceeds from a private placement of securities, a substantial part of which is dedicated to the completion of a transit network in St. Petersburg which could provide significant competition to the Group's network in this area. The Communications Group's wireless operator in Kazakhstan directly competes with the public switched telephone network of Kazakhtelekom, its partner in this operating business, as well as a recently established GSM mobile phone service joint venture in which Kazakhtelekom has an interest. The Group's long distance network in Moscow is in direct competition with the long distance national network operated by Rostelecom, its partner in its Moscow-based telephony business.
In addition, while the Communications Group at one time held a number of exclusive licenses to operate its communications businesses, all such periods of exclusivity have expired and the Communications Group does not expect to be granted further exclusive licenses in any of the markets where it currently provides or plans to provide its services.
THE COMMUNICATIONS GROUP MAY NOT BE ABLE TO ATTRACT CONSUMERS TO ITS SERVICES, WHICH WOULD NEGATIVELY IMPACT ITS OPERATING RESULTS.
The Communications Group's operating results are dependent upon its ability to attract and maintain subscribers to its telephony, cable and paging systems and the sale of commercial advertising time on
ITEM 1. BUSINESS (CONTINUED) its radio stations. These in turn depend on the following factors, several of which are beyond the Communications Group's control:
- the general economic conditions in the markets where the Communications Group's cable, telephone systems, paging and radio stations are located,
- the relative popularity of the Communications Group's systems, including its radio stations,
- the demographic characteristics of the potential subscribers to the Communications Group's systems and audience of its radio stations,
- the technical attractiveness to customers of the equipment and service of the Communications Group's systems, and
- the activities of its competitors.
THE COMMUNICATIONS GROUP CANNOT ASSURE YOU THAT IT WILL SUCCESSFULLY COMPLETE THE CONSTRUCTION OF ITS SYSTEMS, WHICH WOULD JEOPARDIZE LICENSES FOR ITS SYSTEMS OR PROVIDE OPPORTUNITIES TO ITS COMPETITORS.
Many of the Communications Group's joint ventures require substantial construction of new systems and additions to the physical plants of existing systems. The Communications Group cannot assure you that this construction will be completed on time or within budget. Construction projects may be adversely affected by cost overruns and delays not within the Communications Group's control or the control of its subcontractors, such as those caused by governmental changes and material or equipment shortages or delays in delivery of material or equipment. The failure to complete construction of a communications system on a timely basis could jeopardize the franchise or license for such system or provide opportunities to the Communication Group's competitors. Cost overruns may obligate us to incur additional debt.
THE COMMUNICATIONS GROUP MAY NOT BE ABLE TO SUCCESSFULLY IMPLEMENT AND MANAGE THE GROWTH OF ITS VENTURES WHICH WOULD AFFECT ITS GROWTH STRATEGY.
Many of the Communications Group's ventures are either in developmental stages or have only recently commenced operations and the Communications Group has incurred significant operating losses to date. The Communications Group is currently pursuing additional investments in a variety of communications businesses both in its existing markets and in additional markets. In implementing and managing its strategy of growing its businesses, the Communications Group must:
- assess the strengths and weaknesses of development opportunities,
- evaluate the costs and uncertain returns of developing and constructing the facilities for operating systems, and
- integrate and manage the operations of existing and additional systems.
The Communications Group cannot assure you that it will successfully implement its growth strategy.
THE GOVERNMENT LICENSES ON WHICH THE COMMUNICATIONS GROUP DEPENDS TO OPERATE MANY OF ITS BUSINESSES COULD BE CANCELLED OR NOT RENEWED, WHICH WOULD IMPAIR THE DEVELOPMENT OF ITS SERVICES.
Many of the Communications Group's joint ventures operate under licenses that are issued for limited periods. Some of these licenses expire over the next several years, and some are renewable annually. The Communications Group's failure to renew these licenses may have a material adverse effect on our operations. For most of the licenses held or used by the Communications Group's joint ventures, no
ITEM 1. BUSINESS (CONTINUED) statutory or regulatory presumption exists for renewal by the current license holder and the Communications Group cannot assure you that these licenses will be renewed upon the expiration of their current terms.
Additionally, some of the licenses pursuant to which the Communications Group's businesses operate contain network build-out milestones. The Communications Group's failure to meet these milestones could result in the loss of these licenses, which may have a material adverse effect on its operations.
Additionally, a number of joint ventures are in violation of one or more of the conditions of their licenses. For example, PeterStar has exceeded the number of lines which the main license of its operating business in St. Petersburg allows it to operate in St. Petersburg and the surrounding region. While the Company believes that these violations are largely technical, the Company cannot assure you that the relevant licensing authorities will not attempt to terminate or renegotiate a license whose conditions have been violated or otherwise force the Communications Group to take action contrary to its business interests. For example, in the case of the PeterStar license, the Russian licensing authorities may force PeterStar to reduce its number of lines or impose other penalties on it.
Finally, the Communications Group cannot assure you that its joint ventures will obtain the necessary approvals to operate new or additional fixed or wireless telephony, cable television or broadcasting systems in any of the markets in which it is seeking to establish its business.
CURRENCY CONTROL RESTRICTION IN THE COMMUNICATIONS GROUP'S MARKETS MAY HAVE A NEGATIVE EFFECT ON ITS BUSINESS.
The existence of currency control restrictions in certain of the Communications Group's markets may make it difficult for the Communications Group to convert or repatriate its foreign earnings and adversely affect its ability to pay overhead expenses, meet its debt obligations and continue to expand its communications business.
Additionally, the Communication Group's joint ventures often require specific licenses from the central banks of many of the countries in which they operate for certain types of foreign currency loans, leases and investments. The joint ventures' failure to obtain currency licenses could result in the imposition of fines and penalties, significant delays in delivering equipment to its operating businesses and resulting difficulties in generating cash flows from its operating businesses. The documentary requirements for obtaining the currency licenses are burdensome and the Company cannot assure you that the licensing entity will not impose additional, substantive requirements for the grant of a license or deny a request for a license on an arbitrary basis. Furthermore, the time typically taken by the relevant central banks to issue these licenses can be lengthy, in some cases up to one year or more.
THE COMMUNICATIONS GROUP DOES NOT FULLY CONTROL ITS JOINT VENTURES' OPERATIONS, STRATEGIES AND FINANCIAL DECISIONS AND CANNOT ASSURE YOU THAT IT WILL BE ABLE TO MAXIMIZE ITS RETURN ON ITS INVESTMENTS.
The Communications Group has invested in virtually all of its joint ventures with local partners. In certain cases, the degree of its voting power and the voting power and veto rights of its joint venture partners may limit the Communications Group from effectively controlling the operations, strategies and financial decisions of the joint ventures in which it has an ownership interest. In addition, in certain cases, the Communications Group may be dependent on the continuing cooperation of its partners in the joint ventures and any significant disagreements among the participants could have a material adverse effect on its ventures. In addition, in some markets where the Communications Group conducts or may in the future conduct business, certain decisions of a joint venture also require
ITEM 1. BUSINESS (CONTINUED) government approval. As a result, the Communications Group cannot assure you that it will be able to maximize its return on its investments.
In addition, in many instances, the Communications Group's partners in a joint venture include a governmental entity or an affiliate of a governmental entity. This poses a number of risks, including:
- the possibility of decreased governmental support or enthusiasm for the venture as a result of a change of government or government officials,
- a change of policy by the government, and
- the ability of the governmental entities to exert undue control or influence over the project in the event of a dispute or otherwise.
In addition, to the extent the Communications Group's joint ventures become profitable and generate sufficient cash flows in the future, it cannot assure you that the joint ventures will pay dividends or return capital at any time. Moreover, the Communications Group's equity interests in these investments generally are not freely transferable. Therefore, the Communications Group cannot assure you of its ability to realize economic benefits through the sale of its interests in its joint ventures.
THE COMMUNICATIONS GROUP'S DEPENDENCE ON LOCAL OPERATORS, INTERCONNECT PARTIES OR LOCAL CUSTOMERS MAY MATERIALLY AND ADVERSELY AFFECT ITS OPERATIONS.
The Communications Group is dependent on local operators or interconnect parties for a significant portion of its telephony operations. The Company cannot assure you that its operating businesses will continue to have access to these operators' networks or that the Communications Group will be able to have access to these networks upon favorable tariffs. The loss of access to these networks or increases in tariffs could have a material adverse effect upon the Company. For example, the Communications Group's wireless operator in Kazakhstan is entitled to interconnection free of charge to networks operated by Kazakhtelekom, the Kazakhstan public switched telephone network operator, for the completion of its local, long distance and international calls. The loss of, or any significant limitation on, its access to this network could have a material adverse effect on its operations. Additionally, Kazakhtelekom may try to use its authority to endeavor to assess interconnection charges on this operating business in Kazakhstan, which may materially impact this operating business' profitability. Other operating businesses, such as PeterStar and Teleport-TP, face similar issues.
The Communications Group is also dependent on local operators or interconnect parties' facilities for certain of its operations. For example, PeterStar's business in St. Petersburg is dependent on Russian operators' buildings, ducts and tunnels in order to house its exchanges and to reach its customers. The loss of access to these facilities or the availability of access only on unfavorable terms could have a material adverse effect upon PeterStar. Similarly, Teleport-TP's business in Moscow is also dependent upon the facilities of local operators for the operation of its existing network in Moscow and to terminate certain traffic to users. The loss of the right to use these facilities could have a material adverse effect on Teleport-TP.
Certain customers account for a significant portion of the total revenues of certain of the Communications Group's telephony operations and the loss of these customers would materially and adversely affect their results of operations.
In addition, several of the Communications Group's customers, interconnect parties or local operators experience liquidity problems from time to time. The Communications Group's dependence on these parties may make it vulnerable to their liquidity problems, both in terms of pressure for financial
ITEM 1. BUSINESS (CONTINUED) support for the expansion of their operations, and in its ability to achieve prompt settlement of accounts.
THE COMMUNICATIONS GROUP CANNOT ASSURE YOU THAT ITS EQUIPMENT WILL BE APPROVED BY THE AUTHORITIES REGULATING THE MARKETS IN WHICH IT OPERATES, WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON ITS OPERATIONS IN THESE MARKETS.
Many of the Communications Group's operations or proposed operations are dependent upon approval of its equipment by the communications authorities of the markets in which the Communications Group and its joint ventures operate or plan to operate. The Communications Group cannot assure you that the equipment it plans to use in these markets will be approved. The failure to obtain approval for the Communications Group's equipment could have a materially adverse effect on many of its proposed operations.
THE COMMUNICATIONS GROUP MAY NOT BE ABLE TO KEEP PACE WITH THE EMERGENCE OF NEW TECHNOLOGIES AND CHANGES IN MARKET CONDITIONS WHICH WOULD MATERIALLY AND ADVERSELY AFFECT ITS RESULTS OF OPERATIONS.
The communications industry has been characterized in recent years by rapid and significant technological changes and changes in market conditions. Competitors could introduce new or enhanced technologies with features which would render the Communications Group's technology obsolete or significantly less marketable. As an example, the Communications Group has seen its paging operations negatively affected by subscribers switching to more advanced wireless technology to send and receive messages. The Communications Group's ability to compete successfully will depend to a large extent on its ability to respond quickly and adapt to technological changes and advances in its industry. There can be no assurance that the Communications Group will be able to keep pace, or will have the financial resources to keep pace, with the technological demands of the marketplace.
THE COMMUNICATIONS GROUP OPERATES IN COUNTRIES WITH SIGNIFICANT POLITICAL, SOCIAL AND ECONOMIC UNCERTAINTIES WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON ITS OPERATIONS IN THESE AREAS.
The Communications Group operates in countries in Eastern Europe and the republics of the former Soviet Union, and other selected emerging markets. These countries face significant political, social and economic uncertainties which could have a material adverse effect on its operations in these areas. These uncertainties include:
- possible internal military conflicts,
- civil unrest fueled by economic and social crises in those countries,
- political tensions between national and local governments which often result in the enactment of conflicting legislation at various levels and may result in political instability,
- bureaucratic infighting between government agencies with unclear and overlapping jurisdictions,
- high unemployment, high inflation, high foreign debt, weak currencies and the possibility of widespread bankruptcies,
- unstable governments,
- pervasive regulatory control of the state over the telecommunications industry,
- uncertainty whether many of the countries in which the Communications Group operates will continue to receive the substantial financial assistance they have received from several foreign
ITEM 1. BUSINESS (CONTINUED) governments and international organizations which helps to support their economic development,
- the failure by government entities to meet their outstanding foreign debt repayment obligations, and
- the risk of increased support for a renewal of centralized authority and increased nationalism resulting in possible restrictions on foreign ownership and/or discrimination against foreign owned businesses.
The Communications Group cannot assure you that the pursuit of economic reforms by the governments of any of these countries will continue or prove to be ultimately effective, especially in the event of a change in leadership, social or political disruption or other circumstances affecting economic, political or social conditions.
THE COMPANY FACES ENHANCED ECONOMIC, LEGAL AND PHYSICAL RISKS BY OPERATING ABROAD.
The Communications Group has invested all of its resources in operations outside of the United States and plans to make additional international investments in the near future. The Company runs a number of risks by investing in foreign countries including:
- loss of revenue, property and equipment from expropriation, nationalization, war, insurrection, terrorism and other political risks,
- increases in taxes and governmental royalties and involuntary changes to its licenses issued by, or contracts with, foreign governments or their affiliated commercial enterprises,
- changes in foreign and domestic laws and policies that govern operations of overseas-based companies,
- amendments to, or different interpretations or implementations of, foreign tax laws and regulations that could adversely affect the profitability after tax of the Communications Group's joint ventures and subsidiaries,
- criminal organizations in certain of the countries in which the Communications Group operates that could threaten and intimidate our businesses. The Communications Group cannot assure you that pressures from criminal organizations will not increase in the future and have a material adverse effect on its operations,
- high levels of corruption and non-compliance with the law exists in many countries in which the Communications Group operates businesses. This problem significantly hurts economic growth in these countries and the ability of the Communications Group to compete on an even basis with other parties, and
- official data published by the governments of many of the countries in which it operates is substantially less reliable than that published by Western countries.
ITEM 1. BUSINESS (CONTINUED)
LAWS RESTRICTING FOREIGN INVESTMENTS IN THE TELECOMMUNICATIONS INDUSTRY COULD ADVERSELY AFFECT THE COMMUNICATIONS GROUP'S OPERATIONS IN THESE COUNTRIES.
The Communications Group may also be materially and adversely affected by laws restricting foreign investment in the field of communications. Some countries in which the Communications Group operates have extensive restrictions on foreign investments in the communications field. There is no way of predicting whether additional ownership limitations will be enacted in any of the Communications Group's markets, or whether any such law, if enacted, will force the Communications Group to reduce or restructure its ownership interest in any of its ventures. If additional ownership limitations are enacted in any of the Communications Group's markets and the Communications Group is required to reduce or restructure its ownership interests in any ventures, it is unclear how this reduction or restructuring would be implemented, or what impact this reduction or restructuring would have on the Communications Group and on its financial condition or results of operations.
As an example, the Russian Federation has periodically proposed legislation that would limit the ownership percentage that foreign companies can have in radio and television businesses and/or limit the number of radio and television businesses that any company could own in a single market. While this proposed legislation has not been enacted, it is possible that this legislation could be enacted in Russia and that other countries in Eastern Europe and the republics of the former Soviet Union may enact similar legislation which could have a material adverse effect on our business operations, financial condition or prospects.
As a further example, in 1999 the Chinese government requested termination of all of the telecommunications joint ventures then operating in China, on the basis that the legal structure used for these ventures would no longer be permitted. As a result, China Unicom, the Communications Group's partner in four such ventures, terminated all of the Communications Group's ventures in China. See "Telecommunications Joint Ventures in China."
As a further example, changes in Russian regulation may force the three mobile operators which currently provide significant traffic for the PeterStar network to use other Russian networks.
RECENT ECONOMIC DIFFICULTIES IN RUSSIA AND OTHER EMERGING MARKETS COULD HAVE A MATERIAL ADVERSE EFFECT ON THE COMMUNICATIONS GROUP'S OPERATIONS IN THESE COUNTRIES.
During 1998, and continuing in 1999, a number of emerging market economies suffered significant economic and financial difficulties resulting in liquidity crises, devaluation of currencies, higher interest rates and reduced opportunities for financing, the most notable being the August 1998 financial crisis in Russia. At this time, the prospects for recovery for the economies of Russia and the other republics of the former Soviet Union and Eastern Europe negatively affected by the economic crisis remain unclear. The economic crisis has resulted in a number of defaults by borrowers in Russia and other countries and a reduced level of financing available to investors in these countries. The devaluation of many of the currencies in the region has also negatively affected the U.S. dollar value of the revenues generated by certain of the Communications Group's joint ventures and may lead to certain additional restrictions on the convertibility of certain local currencies. The Communications Group expects that these problems will continue to negatively affect the financial performance of certain of its cable television, telephony, radio broadcasting and paging ventures in 2000.
HIGH INFLATION IN THE COMMUNICATIONS GROUP'S MARKETS MAY HAVE A NEGATIVE EFFECT ON THE COMMUNICATION GROUP'S BUSINESS.
Some of the Communications Group's subsidiaries and joint ventures operate in countries where the inflation rate is extremely high. Since the break-up of the Soviet Union, the economies of many of the
ITEM 1. BUSINESS (CONTINUED) former republics have been characterized by high rates of inflation. Inflation in Russia increased dramatically following the August 1998 financial crisis and there are increased risks of inflation in Kazakhstan. The inflation rates in Belarus have been at hyperinflationary levels for some years and as a result, the currency has essentially lost all intrinsic value.
The Communications Group's operating results will be adversely impacted if it is unable to increase its prices enough to offset any increase in the rate of inflation, or if anti-inflationary legislation holding down prices is enacted.
FLUCTUATIONS IN CURRENCY EXCHANGE RATES IN THE COUNTRIES IN WHICH THE COMPANY OPERATES COULD NEGATIVELY IMPACT THE COMMUNICATIONS GROUP'S RESULTS OF OPERATIONS IN THESE COUNTRIES.
The value of the currencies in the countries in which the Communications Group operates tends to fluctuate, sometimes significantly. For example, during 1998 and 1999, the value of the Russian Rouble was under considerable economic and political pressure and has suffered significant declines against the U.S. dollar and other currencies. In addition, in 1999 local currency devaluations in Uzbekistan, Kazakhstan and Georgia, in addition to weakening of local currencies in Austria and Germany, had an adverse effect on the Communications Group's ventures in these countries. The Communications Group currently does not hedge against exchange rate risk and therefore could be negatively impacted by declines in exchange rates between the time one of its joint ventures receives its funds in local currency and the time it distributes these funds in U.S. dollars to the Communications Group.
THE TAX RISKS OF INVESTING IN THE MARKETS IN WHICH THE COMPANY OPERATES CAN BE SUBSTANTIAL AND CAN MAKE EFFECTIVE TAX PLANNING DIFFICULT, WHICH WOULD MATERIALLY AFFECT ITS FINANCIAL CONDITION.
Taxes payable by the Company's joint ventures are substantial and the Company may be unable to obtain the benefits of tax treaties due to:
- the documentary and other requirements imposed by the government authorities,
- the unfamiliarity of those administering the tax system with the international tax treaty system of their country, or their unwillingness to recognize the treaty system, and
- the absence of applicable tax treaties in many of the countries in which the Company operates.
The Company's tax planning initiatives to reduce its overall tax obligations may be negated or impaired by the need to deal with these issues. Furthermore, the taxation systems in the countries in which the Company operates is at an early stage of development and is subject to varying interpretations, frequent changes and inconsistent and arbitrary enforcement at the federal, regional and local levels. In certain instances, new taxes and tax regulations have been given retroactive effect, which further complicates effective tax planning.
THE COMMERCIAL AND CORPORATE LEGAL STRUCTURES ARE STILL DEVELOPING IN THE COMMUNICATIONS GROUP'S TARGET MARKETS WHICH CREATES UNCERTAINTIES AS TO THE PROTECTION OF ITS RIGHTS AND OPERATIONS IN THESE MARKETS.
Commercial and corporate laws in the countries in which the Company operates are significantly less developed or clear than comparable laws in the United States and the countries of Western Europe and are subject to frequent changes, preemption and reinterpretation by local or administrative regulations, by administrative officials and, in the case of Eastern Europe and the republics of the former Soviet Union, by new governments. There are also often inconsistencies among laws, presidential decrees and governmental and ministerial orders and resolutions, and conflicts between local, regional and national laws and regulations. In some cases, laws are imposed with retroactive force and punitive penalties. In other cases, laws go unenforced. The result has been considerable legal confusion which creates significant obstacles to creating and operating the Communications Group's
ITEM 1. BUSINESS (CONTINUED) joint ventures. The Communications Group cannot assure you that the uncertainties associated with the existing and future laws and regulations in its markets will not have a material adverse effect on its ability to conduct its business and to generate profits.
There is also significant uncertainty as to the extent to which local parties and entities, particularly government authorities, in the Communications Group's markets will respect the Communications Group's contractual and other rights and also the extent to which the "rule of law" has taken hold and will be upheld in each of these countries. The courts in many of the Communications Group's markets often do not have the experience, resources or authority to resolve significant economic disputes and enforce their decisions, and may not be insulated from political considerations and other outside pressures. The Communications Group cannot assure you that the licenses held by its businesses or the contracts providing its businesses access to the airwaves or other rights or agreements essential for operations will not be significantly modified, revoked or canceled without justification. If that happens, the Communications Group's ability to seek legal redress may be substantially delayed or even unavailable in such cases.
RUSSIAN LAW MAY HOLD THE COMMUNICATIONS GROUP LIABLE FOR THE DEBTS OF ITS SUBSIDIARIES, WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON ITS FINANCIAL CONDITION.
Generally, under the Civil Code of the Russian Federation and the Law of the Russian Federation on Joint Stock Companies, shareholders in a Russian joint stock company are not liable for the obligations of the joint stock company, and only bear the risk of loss of their investment. However, if a parent company has the capability under its charter or by contract to direct the decision-making of a subsidiary company, the parent company will bear joint and several responsibility for transactions concluded by its subsidiary in carrying out its direction. In addition, a parent company capable of directing the actions of its subsidiary is secondarily liable for its subsidiary's debts if the subsidiary becomes insolvent or bankrupt as a result of the action or inaction of its parent. In this instance, other shareholders of the subsidiary could claim compensation for the subsidiary's losses from the parent company which caused the subsidiary to take action or fail to take action, knowing that this action or failure to take action would result in losses. It is possible that the Communications Group may be deemed to be this type of parent company for some of its subsidiaries, and could therefore be liable in some cases for the debt of these subsidiaries, which could have a material adverse effect on it.
THE COMMUNICATIONS GROUP OPERATES IN COUNTRIES WHERE THE LAWS MAY NOT ADEQUATELY PROTECT SHAREHOLDER RIGHTS WHICH COULD PREVENT THE COMMUNICATIONS GROUP FROM REALIZING FULLY THE ECONOMIC BENEFITS OF ITS INVESTMENTS IN THESE COUNTRIES.
Shareholders have limited rights and legal protections under the laws in many of the countries in which the Communications Group operates. The concept of fiduciary duties on the part of management or directors to their companies is also new and is not well developed. In some cases, the officers of a company may take actions without regard to or in contravention of the directions of the shareholders or the board of directors appointed by the shareholders.
In other cases, a shareholder's ownership interest may be diluted without its knowledge or approval or even erased from the shareholder's ownership registry. The Communications Group cannot assure you that it could obtain legal redress for any such action in the court systems of these countries.
METROMEDIA COMPANY EFFECTIVELY CONTROLS THE COMPANY AND HAS THE POWER TO INFLUENCE THE DIRECTION OF ITS OPERATIONS AND PREVENT A CHANGE OF CONTROL.
Metromedia Company and its affiliates collectively own approximately 18% of the outstanding shares of common stock of the Company and are its largest stockholders. They have nominated or designated a majority of the members of the board of directors. Since the charter of the Company and Delaware law
ITEM 1. BUSINESS (CONTINUED) provide that the majority of the members of the board of directors will nominate the directors for election to the board of directors, for the foreseeable future it is likely that directors designated or nominated by Metromedia Company will continue to constitute a majority of the members of the board of directors. As a result, Metromedia Company will likely control the direction of future operations of the Company, including decisions regarding acquisitions and other business opportunities, the declaration of dividends and the issuance of additional shares of capital stock and other securities. This concentration of ownership may have the effect of delaying, deferring or preventing a change of control of the Company. The Company's certificate of incorporation and by-laws also contain provisions which may also have the effect of delaying, deferring or preventing a change of control of the Company.
THE COMPANY MAY DEFAULT UNDER ITS SNAPPER CREDIT FACILITY, WHICH COULD MATERIALLY AND ADVERSELY AFFECT ITS BUSINESS STRATEGY AND RESULTS OF OPERATIONS.
Recently Snapper was not in compliance with certain financial covenants under its credit facilities and, although these defaults have been waived, the Company cannot assure you that Snapper will not default again under its credit facility. Any such default could materially and adversely affect Snapper, could result in a cross-default under the indenture governing our senior notes, and could materially and adversely affect the Company's results of operations.
THE COMPANY COULD INCUR ENVIRONMENTAL LIABILITIES AS A RESULT OF ITS CURRENT OPERATIONS AND PAST DIVESTITURES, THE COST OF WHICH COULD MATERIALLY AFFECT ITS RESULTS OF OPERATIONS.
The Company has been in operation since 1929 through its predecessors and, over the years, has operated in diverse industries including equipment, sporting goods and furniture manufacturing, sheet metal processing, and trucking. The Company has divested almost all of its non-communications and non-media-related operations other than Snapper. However, in the course of these divestitures, it has retained certain indemnification obligations for environmental cleanup matters. In one case, the Company has undertaken specific clean up activities at a contaminated parcel. It could incur additional cleanup obligations with respect to environmental problems which so far have remained undetected. Furthermore, its obligation to clean up could arise as a result of changes in legal requirements since the original divestitures. Even though these divestitures may have occurred many years ago, the Company cannot assure you that environmental matters will not arise in the future that could have a material adverse effect on its results of operations or financial condition.
THE COMPANY IS INVOLVED IN LEGAL PROCEEDINGS, WHICH COULD ADVERSELY AFFECT ITS FINANCIAL CONDITION.
The Company is involved in several legal proceedings in connection with its investment in RDM Sports Group, Inc. See "--Investment in RDM."
If the Company is unsuccessful in defending against the allegations made in these proceedings, an award of the magnitude being sought in these legal proceedings would have a material adverse effect on its financial condition and results of operations. In addition, the Company cannot assure you that it will not determine that the advantages of entering into a settlement outweigh the risk and expense of protracted litigation or that ultimately it will be successful in defending against these allegations.
THE COMPANY'S FUTURE RESULTS OF OPERATIONS MAY BE SUBSTANTIALLY DIFFERENT FROM ITS STATEMENTS ABOUT ITS FUTURE PROSPECTS AND YOU SHOULD NOT UNDULY RELY ON THESE STATEMENTS.
Any statements in this document about the Company's expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are often but not always made through the
ITEM 1. BUSINESS (CONTINUED) use of words or phrases like "believes," "expects," "may," "will," "should" or "anticipates" or the negative of these words or phrases or other variations on these words or phrases or comparable terminology, or by discussions of strategy that involves risks and uncertainties.
These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the Company's actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. These risks, uncertainties and other factors include, among others:
- general economic and business conditions, which will, among other things, impact demand for the Company's products and services,
- industry capacity, which tends to increase during strong years of the business cycle,
- changes in public taste, industry trends and demographic changes,
- competition from other communications companies, which may affect the Communication Group's ability to generate revenues,
- political, social and economic conditions and changes in laws, rules and regulations or their administration or interpretation, particularly in Eastern Europe, republics of the former Soviet Union, China and other selected emerging markets, which may affect the Communications Group's results of operations,
- timely completion of construction projects for new systems for the joint ventures in which the Communications Group has invested, which may impact the costs of these projects,
- developing legal structures in Eastern Europe, republics of the former Soviet Union, China and other selected emerging markets, which may affect the Communications Group's ability to enforce its legal rights,
- cooperation of local partners in the Communications Group's communications investments in Eastern Europe, republics of the former Soviet Union, China and other selected emerging markets, which may affect its results of operations,
- exchange rate fluctuations,
- license renewals for the Communications Group's communications investments in Eastern Europe, republics of the former Soviet Union, China and other selected emerging markets,
- the loss of any significant customers,
- changes in business strategy or development plans,
- the quality of management,
- the availability of qualified personnel,
- changes in or the failure to comply with government regulation, and
- other factors referenced in this document.
Accordingly, any forward-looking statement is qualified in its entirety by reference to these risks, uncertainties and other factors and you should not place any undue reliance on them. Furthermore, any forward-looking statement speaks only as of the date on which it is made. New factors emerge from time to time and it is not possible for the Company to predict which will arise. In addition, the Company cannot assess the impact of each factor on its business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
ITEM 2.
ITEM 2. PROPERTIES
The following table contains a list of the Company's principal properties as of March 17, 2000.
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* The Communications Group's offices in Stamford and London and one office in each of Moscow and New York are being closed as part of the Communications Group's operational restructuring.
The Company's management believes that the facilities listed above are generally adequate and satisfactory for their present usage and are generally well utilized.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
FUQUA INDUSTRIES, INC. SHAREHOLDER LITIGATION
IN RE FUQUA INDUSTRIES, INC. SHAREHOLDER LITIGATION, Del. Ch., Consolidated C.A. No. 11974, plaintiff Virginia Abrams filed a purported class and derivative action in the Delaware Court of Chancery on February 22, 1991 against Fuqua Industries, Inc., Intermark, Inc., the then-current directors of Fuqua Industries and certain past members of the board of directors. The action challenged certain transactions which were alleged to be part of a plan to change control of the board of Fuqua Industries from J.B. Fuqua to Intermark and sought a judgment against defendants in the amount of $15.7 million, other unspecified money damages, an accounting, declaratory relief and an injunction prohibiting any business combination between Fuqua Industries and Intermark in the absence of approval by a majority of Fuqua Industries' disinterested shareholders. Subsequently, two similar actions, styled BEHRENS V. FUQUA INDUSTRIES, INC. ET AL., Del. Ch., C.A. No. 11988 and FREBERG V. FUQUA INDUSTRIES, INC. ET AL., Del. Ch., C.A. No. 11989 were filed with the Court. On May 1, 1991, the Court ordered all of the foregoing actions consolidated. On October 7, 1991, all defendants moved to dismiss the complaint. Plaintiffs thereafter took three depositions during the next three years.
On December 28, 1995, plaintiffs filed a consolidated second amended derivative and class action complaint, purporting to assert additional facts in support of their claim regarding an alleged plan, but deleting their prior request for injunctive relief. On January 31, 1996, all defendants moved to dismiss the second amended complaint. After the motion was briefed, oral argument was held on November 6, 1996. On May 13, 1997, the Court issued a decision on defendants' motion to dismiss, the Court dismissed all of plaintiffs' class claims and dismissed all of plaintiffs' derivative claims except for the claims that Fuqua Industries board members (i) entered into an agreement pursuant to which Triton Group, Inc. (which was subsequently merged into Intermark,) was exempted from 8 Del. C. 203 and
ITEM 3. LEGAL PROCEEDINGS (CONTINUED) (ii) undertook a program pursuant to which 4.9 million shares of Fuqua Industries common stock were repurchased, allegedly both in furtherance of an entrenchment plan. On January 16, 1998, the Court entered an order implementing the May 13, 1997 decision. The order also dismissed one of the defendants from the case with prejudice and dismissed three other defendants without waiver of any rights plaintiffs might have to reassert the claims if the opinion were to be vacated or reversed on appeal.
On February 5, 1998, plaintiffs filed a consolidated third amended derivative complaint and named as defendants Messrs. J.B. Fuqua, Klamon, Sanders, Scott, Warner and Zellars. The complaint alleged that defendants (i) entered into an agreement pursuant to which Triton was exempted from 8 Del. C. 203 and (ii) undertook a program pursuant to which 4.9 million shares of Fuqua Industries common stock were repurchased, both allegedly in furtherance of an entrenchment plan. For their relief, plaintiffs seek damages and an accounting of profits improperly obtained by defendants.
In March 1998, defendants J. B. Fuqua, Klamon, Sanders, Zellars, Scott and Warner filed their answers denying each of the substantive allegations of wrongdoing contained in the third amended complaint. The Company also filed its answer, submitting itself to the jurisdiction of the Court for a proper resolution of the claims purported to be set forth by the plaintiffs. Discovery is ongoing.
ANTHONY NICHOLAS GEORGIOU, ET AL. V. MOBIL EXPLORATION AND PRODUCING SERVICES, INC., METROMEDIA INTERNATIONAL TELECOMMUNICATIONS, INC., ET AL.
On January 14, 1998, ANTHONY NICHOLAS GEORGIOU, ET AL. V. MOBIL EXPLORATION AND PRODUCING SERVICES, INC., METROMEDIA INTERNATIONAL TELECOMMUNICATIONS, INC., ET AL., Civil Action No. H-98-0098, was filed in the United States District Court for the Southern District of Texas. Plaintiffs claim that Metromedia International Telecommunications conspired against and tortuously interfered with plaintiffs' potential contracts involving certain oil exploration and production contracts in Siberia and telecommunications contracts in the Russian Federation. Plaintiffs are claiming damages, for which all defendants could be held jointly and severally liable, of an amount in excess of $395.0 million. On or about February 27, 1998 Metromedia International Telecommunications filed its answer denying each of the substantive allegations of wrongdoing contained in the complaint. The contracts between plaintiff Tiller International Limited and defendant Mobil Exploration and Producing Services, Inc. which are at issue in this case contain broad arbitration clauses. In accordance with these arbitration clauses, Mobil Exploration and Producing Services instituted arbitration proceeding before the London Court of International Arbitration on July 31, 1997. On August 27, 1998, Judge David Hittner entered an order staying and administratively closing the Houston litigation pending final completion of arbitration proceedings in Great Britain. As such, this matter is presently inactive. The parties have engaged in some discovery. The Company believes it has meritorious defenses and is vigorously defending this action.
FOR A DISCUSSION OF LEGAL PROCEEDINGS IN CONNECTION WITH RDM, SEE "ITEM 1. BUSINESS--INVESTMENT IN RDM".
INDEMNIFICATION AGREEMENTS
In accordance with Section 145 of the General Corporation Law of the State of Delaware, pursuant to the Company's Restated Certificate of Incorporation, the Company has agreed to indemnify its officers and directors against, among other things, any and all judgments, fines, penalties, amounts paid in settlements and expenses paid or incurred by virtue of the fact that such officer or director was acting in such capacity to the extent not prohibited by law.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Since November 2, 1995, the Common Stock has been listed and traded on the American Stock Exchange and the Pacific Stock Exchange under the symbol "MMG". Prior to November 2, 1995, the Common Stock was listed and traded on both the New York Stock Exchange and the Pacific Stock Exchange under the symbol "ACT." The following table sets forth the quarterly high and low closing sales prices per share for the Company's Common Stock as reported by the American Stock Exchange.
Holders of common stock are entitled to such dividends as may be declared by the Company's Board of Directors and paid out of funds legally available for the payment of dividends. The Company has not paid a dividend to its stockholders since the dividend declared in the fourth quarter of 1993, and has no plans to pay cash dividends on the Common Stock in the foreseeable future. The Company intends to retain earnings to finance the development and expansion of its businesses. The decision of the board of directors as to whether or not to pay cash dividends in the future will depend upon a number of factors, including the Company's future earnings, capital requirements, financial condition, and the existence or absence of any contractual limitations on the payment of dividends including the Company's 10 1/2% senior discount notes. The Company's ability to pay dividends is limited because the Company operates as a holding company, conducting its operations solely through its subsidiaries. Certain of the Company's subsidiaries' existing credit arrangements contain, and it is expected that their future arrangements will similarly contain, substantial restrictions on dividend payments to the Company by such subsidiaries. See Item 7 - -"Management's Discussion and Analysis of Financial Condition and Results of Operations."
As of March 17, 2000, there were approximately 6,943 record holders of common stock. The last reported sales price for the common stock on such date was $7 5/8 per share as reported by the American Stock Exchange.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
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(1) The consolidated financial statements for the year ended December 31, 1996 include two months (November and December 1996) of the results of operations of Snapper.
(2) The consolidated financial statements for the year ended December 31, 1995 include operations for Actava and MCEG Sterling from November 1, 1995 and two months for Orion (January and February 1995) that were included in the February 28, 1995 consolidated financial statements. The net loss for the two month duplicate period is $11.4 million.
(3) On July 10, 1997 and April 16, 1998, the Company completed the sales of its entertainment group and the Landmark theater group, respectively. These transactions have been treated as discontinuances of business segments and, accordingly, the Company's consolidated financial statements reflect the results of operations of the entertainment group and Landmark as discontinued segments.
(4) Included in the year ended December 31, 1997 are equity in losses and writedown of investment in RDM of $45.1 million.
(5) For the years ended December 31, 1999 and 1998, in connection with the Communications Group's operations, the Company adjusted the carrying value of goodwill and other intangibles, fixed assets, investments in and advances to joint ventures and wrote down inventory; the total non-cash charge and write down was $68.9 million and $49.9 million, respectively.
(6) For the year ended December 31, 1999, the Communications Group recorded a restructuring charge of $8.4 million.
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED) (7) For each of the years ended December 31, 1997, 1996 and 1995 the extraordinary items reflect the loss on the repayment of debt in each period.
(8) For purposes of this computation, earnings are defined as pre-tax earnings or loss from continuing operations of the Company before adjustment for minority interests in consolidated subsidiaries or income or loss from equity investees attributable to common stockholders plus (i) fixed charges and (ii) distributed income of equity investees. Fixed charges are the sum of (i) interest expensed and capitalized, (ii) amortization of deferred financing costs, premium and debt discounts, (iii) the portion of operating lease rental expense that is representative of the interest factor (deemed to be one-third) and (iv) dividends on preferred stock. The ratio of earnings to fixed charges of the Company was less than 1.00 for each of the years ended December 31, 1999, 1998, 1997, 1996 and 1995; thus, earnings available for fixed charges were inadequate to cover fixed charges for such periods. The deficiency in earnings to fixed charges for the years ended December 31, 1999, 1998, 1997, 1996 and 1995 were: $146.9 million, $141.1 million, $95.3 million, $64.3 million, and $30.1 million, respectively.
(9) Total assets include the net assets of the entertainment group and Landmark. The net assets (liabilities) of the entertainment group at December 31, 1996 and 1995 were $11.0 million and $12.1 million, respectively. The revenues of the entertainment group for the years ended December 31, 1996 and 1995 were $135.6 million and $133.8 million, respectively. At December 31, 1997 and 1996, the net assets of Landmark, which was acquired on July 2, 1996, were $46.8 million and $46.5 million, respectively. The revenues of Landmark for the period July 2, 1996 to December 31, 1996 were $29.6 million.
ITEM 7.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the Company's consolidated financial statements and related notes thereto and the "Business" section included as Item 1 herein.
GENERAL
The business activities of the Company consist of two operating groups, the Communications Group and Snapper.
COMMUNICATIONS GROUP
OVERVIEW
The Communications Group has operations in Eastern Europe and the republics of the former Soviet Union and a pre-operational business in China. Operations in Eastern Europe and the republics of the former Soviet Union provide the following services: (i) wireless telephony; (ii) fixed telephony; (iii) cable television; (iv) radio broadcasting; and (v) paging. The Company also holds interests in several telecommunications joint ventures in China. These ventures were terminated in late 1999 and the Company reached agreement for the distribution of approximately $90.1 million (based on the December 31, 1999 exchange rate) in settlement of all claims under the joint venture agreements of which $29.3 million has been received. The Communications Group is now developing e-commerce business opportunities in China.
During 1999 the Company continued to focus its growth strategy on opportunities in communications businesses. The convergence of cable television and telephony, and the relationship of each business to Internet access, provides the Company with new opportunities.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) On September 30, 1999, the Company consummated the acquisition of PLD Telekom, a provider of high quality long distance and international telecommunications services in the republics of the former Soviet Union. As a result of the acquisition, PLD Telekom became a wholly owned subsidiary of the Company.
PLD Telekom's five principal business units are PeterStar, which provides integrated local, long distance and international telecommunications in St. Petersburg through a fully digital fiber optic network; Technocom, which through Teleport-TP and MTR Sviaz provides international telecommunications services from Moscow and operates satellite-based and fiber optic networks; Baltic Communications Limited ("BCL"), which provides dedicated international telecommunications services in St. Petersburg; ALTEL, which is a provider of wireless service in Kazakhstan; and BELCEL, which provides national wireless service in Belarus.
The acquisition of the PLD Telekom businesses by the Company on September 30, 1999, adds further to the strong presence of the Communications Group in the republics of the former Soviet Union, and has provided a platform for the Company to implement its strategy for convergence of existing communications services and development of new Internet related services. The strengthened portfolio of communications assets is also expected to bring cost saving and revenue generating synergies to the Company.
The Communications Group's consolidated revenues represented approximately 18%, 13% and 10% of the Company's total revenues for the years ended December 31, 1999, 1998 and 1997, respectively. The Company expects this proportion to increase as the Communications Group's joint ventures develop their businesses and with the acquisition of PLD Telekom. Consolidated revenues of the Company for the year ended December 31, 1999 include $22.9 million attributable to PLD Telekom for the three months ended December 31, 1999.
Following the acquisition of PLD Telekom in September 1999, the Communications Group undertook a review of the operations of the combined entity. Following this review, the Communications Group determined to make significant reductions in its projected overhead costs for 2000 by closing its offices in Stamford, Connecticut and London, England, consolidating its executive offices in New York, New York, consolidating its operational headquarters in Vienna, Austria and by consolidating its two Moscow offices into one. In connection with this, the Communications Group reduced the headcount among its U.S. domestic and expatriate employees by approximately 60 individuals. In connection with these moves, the Company recorded a restructuring charge of $8.4 million for the year ended December 31, 1999.
In 1999 the Company also recorded a non-cash impairment charge of $23.2 million on certain paging, telephony and radio businesses pursuant to a change of strategic plan implemented by the Communications Group in the last quarter of 1999.
In addition, the Company has reviewed the amortization periods for its goodwill and intangibles associated with licenses for its operations in Eastern Europe and the republics of the former Soviet Union and has revised these amortization periods commencing in the quarter ending September 30, 1999. This change in estimate has been accounted for prospectively and will result in additional annual amortization expenses of approximately $4.4 million.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
BASIS OF PRESENTATION
In 1999 the Company consummated the acquisition of PLD Telekom, which exercises control over the majority of businesses in which it has interests. The Company therefore consolidates the revenues and results of PLD Telekom operations. The consolidated financial results of the Company for the year ended December 31, 1999 include those of PLD Telekom for the three months subsequent from the date of its acquisition on September 30, 1999.
The Communications Group accounts for the majority of its other joint ventures (i.e. with the exception of the PLD Telekom businesses) under the equity method of accounting since it generally does not exercise control over such ventures. Under the equity method of accounting, the Communications Group reflects the investments in and advances to joint ventures, adjusted for distributions received and its share of the income or losses of the joint ventures, on its balance sheet. The income (losses) recorded in the years ended 1999, 1998 and 1997 represent the Communications Group's equity in the income (losses) of the joint ventures in Eastern Europe and the republics of the former Soviet Union, and China. Equity in the income (losses) of the joint ventures by the Communications Group are generally reflected according to the level of ownership of the joint venture by the Communications Group until such joint venture's contributed capital has been fully depleted. Subsequently, the Communications Group recognizes the full amount of losses generated by the joint venture when the Communications Group is the sole funding source of the joint ventures. See Notes 3 and 4 of the "Notes to Consolidated Financial Statements" of the Company, for those joint ventures recorded under the equity method and their summary financial information.
Investments over which significant influence is not exercised are carried under the cost method.
Almost all of the Communications Group's joint ventures other than the PLD Telekom businesses report their financial results on a three-month lag. Therefore, the Communications Group's financial results for December 31 include the financial results for those joint ventures for the 12 months ending September 30. The Company is currently evaluating the financial reporting of these ventures and the possibility of reducing or eliminating the three-month reporting lag for certain of its principal businesses during 2000.
1999 RESTRUCTURING AND IMPAIRMENT CHARGES
Shortly after completing its September 30, 1999 acquisition of PLD Telekom, the Company began identifying synergies and redundancies between Metromedia International Telecommunications, Inc. and PLD Telekom. The Company's efforts were directed toward streamlining its operations. Following the review of its operations, the Communications Group determined to make significant reductions in its projected overhead costs for 2000 by closing its offices in Stamford, Connecticut and London, England, consolidating its executive offices in New York, New York, consolidating its operational headquarters in Vienna, Austria and by consolidating its two Moscow offices into one. As part of this streamlining of its operations, the Company announced an employee headcount reduction. Employees impacted by the restructuring were notified in December 1999 and in almost all cases were terminated effective December 31, 1999. Employees received a detailed description of their separation package which was generally based on length of service. The total number of U.S. domestic and expatriate employees separated was approximately 60. In addition, there were reductions in locally hired staff. In 1999 the Company recorded a charge of $8.4 million in connection with the restructuring.
Concurrent with the review of its existing operations and the change in management as the result of the acquisition of PLD Telekom, the Communications Group completed a strategic review of its
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) telephony, cable television, radio broadcasting and paging assets. The results of the Communications Group's strategic review was as follows:
- Continue to pursue a convergence strategy to develop delivery for voice and data services over its existing cable and telephony infrastructure
- Geographically focus the Communications Group's efforts on several key countries where the Communications Group already has a significant presence, including Russia, Georgia, Romania, Latvia and Kazakhstan
- Work towards obtaining consolidatable positions in certain of the Communications Group's principal assets
- Develop Internet capability in the Communications Group's existing businesses and explore expansion of Internet-related businesses in Central and Eastern Europe
- Develop e-commerce business opportunities in China
- Leverage the Communications Group's existing radio brands in their markets, with a view to using them in developing its other businesses, including the development of Internet-based businesses
- Continue to focus on cost control and reduction in corporate overhead costs
As a result of the Company's strategic review, the Company determined that certain businesses (including pre-operational businesses) in its portfolio did not meet certain of its objectives of the strategic review, such as the ability to obtain control of the venture, geographic focus or convergence. The long lived assets or the investments in these businesses were evaluated to determine whether any impairment in their recoverability existed at the determination date. As a result, the Company assessed whether the estimated cash flows of the businesses over the estimated lives of the related assets were sufficient to recover their costs. Where such cash flows were insufficient, the Company utilized a discounted cash flow model to estimate the fair value of assets or investments and recorded an impairment charge to adjust the carrying values to estimated fair value. As a result of this evaluation, the Company recorded a non-cash impairment charge on certain of its paging, cable television and telephony businesses of $23.2 million.
For those equity method investments whose fair value is equal to zero, the Company will no longer record its proportionate share of any future net losses of these investees, unless the Company provides future funding. The Communications Group will continue to manage its paging businesses to levels not requiring significant additional funding and is developing a strategy to maximize the value of its paging investments. In 2000, it is expected that the paging operations will continue to generate losses.
1998 IMPAIRMENT CHARGE
In 1998, the Communications Group's paging business continued to incur operating losses. Accordingly, the Communications Group developed a revised operating plan to stabilize its paging operation. Under the revised plan, the Communications Group managed its paging business to a level that did not require significant additional funding for its operations. As a result of the revised plan, in 1998 the Company recorded a non-cash charge on its paging assets of $49.9 million, which included a $35.9 million write off of goodwill and other intangibles. The non-cash charge adjusted the carrying value of goodwill and other intangibles, fixed assets and investments in and advances to joint ventures
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) and wrote down inventory. Under the revised plan, the paging business's operating losses have decreased significantly.
The non-cash charge adjusted the carrying value of goodwill and other intangibles, fixed assets of $4.4 million and investments in and advances to joint ventures of $5.4 million and wrote down inventory of $4.2 million. The write down related to both consolidated joint ventures and subsidiaries and joint ventures recorded under the equity method. The Company adjusted its investments in certain paging operations which were recorded under the equity method to zero and since then has not provided significant additional funding to these equity investees, and unless it provides future funding will continue to no longer record its proportionate share of any future net losses in these investees.
The following table displays a rollforward of the activity and balances of the restructuring reserve account from inception to December 31, 1999 (in thousands):
The following table displays the components of the asset impairment charges recorded by the Company in the years ended December 31, 1999 and 1998 as follows (in thousands):
CHINA TELECOMMUNICATIONS JOINT VENTURES
Until recently, the Company also held interests in several telecommunications joint ventures in China. Those ventures were terminated in late 1999 and the Company reached agreement with China Unicom, its Chinese partner in the ventures, for the distribution of approximately $90.1 million (based on the December 31, 1999 exchange rate) in settlement of all claims under the joint venture agreements, of which $29.3 million has been received. Over time, the Company anticipates that it will fully recover its investments in and advances to the four affected joint ventures, but no assurances can be made as to the exact timing or amount of such repayments. As of December 31, 1999, investments in and advances to these four joint ventures, exclusive of goodwill, were approximately $40.0 million.
Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint ventures.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) However, some variance from the Company's current estimates of the amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China and exchange rate fluctuations. The Company cannot assure at this time that this variance will not be material.
The currently estimated $90.1 million in total payments from the Company's four joint ventures that had cooperated with China Unicom is insufficient to fully recover the goodwill recorded in connection with the Company's investment in these joint ventures. As a result, the Company has recorded a non-cash impairment charge of $45.7 million in 1999 for the write-off of goodwill. Further adjustments may be required after receipt of final distributions from the four terminated joint ventures.
Huaxia JV was established as a sino-foreign equity joint venture between the Communications Group and All Warehouse Commodity Electronic Commerce Information Development Co. Ltd., a Chinese trading company. Under this structure, Huaxia JV will develop and operate electronic commerce computer information systems for use by its Chinese partner, its affiliates and customers in return for transaction fees under a fee-for-services arrangement.
SNAPPER
Snapper manufactures Snapper-Registered Trademark- brand premium-priced power lawnmowers, lawn tractors, garden tillers, snowthrowers and related parts and accessories. The lawnmowers include rear engine riding mowers, front-engine riding mowers or lawn tractors, and self-propelled and push-type walk-behind mowers. Snapper also manufactures a line of commercial lawn and turf equipment under the Snapper brand.
Snapper provides lawn and garden products through distribution channels to domestic and foreign retail markets.
CERTAIN DISPOSITIONS OF ASSETS AND OTHER COMPANY INFORMATION
On April 16, 1998, the Company sold to Silver Cinemas, Inc. all of the assets of the Landmark theater group, except cash, for an aggregate cash purchase price of approximately $62.5 million and the assumption of certain Landmark liabilities.
On July 10, 1997, the Company sold substantially all of the assets of its now discontinued entertainment group, consisting of Orion, Goldwyn and Motion Picture Corporation of America (and their respective subsidiaries) which included a feature film and television library of over 2,200 titles. The sale was to P&F, the parent company of Metro-Goldwyn-Mayer, for a gross consideration of $573.0 million, of which $296.4 million was used to repay credit line liabilities and other indebtedness of the entertainment group.
On November 1, 1995, as a result of the merger of Orion Pictures Corporation and Metromedia International Telecommunications, Inc. with and into wholly-owned subsidiaries of the Company, and the merger of MCEG Sterling Incorporated with and into the Company, the Company changed its name from "The Actava Group Inc." to "Metromedia International Group, Inc." As part of the November 1, 1995 merger, the Company acquired approximately 39% of RDM Sports Group, Inc. On August 29, 1997, RDM and certain of its affiliates filed voluntary bankruptcy petitions under chapter 11. The Company believes that it is unlikely to recover any distribution on account of its equity interest in RDM.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) FORWARD LOOKING STATEMENTS. Certain statements set forth below under this caption constitute "Forward-Looking Statements" within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. See "Special Note Regarding Forward-Looking Statements" on page 95.
SEGMENT INFORMATION
The following tables set forth operating results for the years ended December 31, 1999, 1998, and 1997, for the Company's Communications Group and Snapper.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
SEGMENT INFORMATION YEAR ENDED DECEMBER 31, 1999 (IN THOUSANDS) SEE NOTE 1
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Note 1: The Company evaluates the performance of its operating segments based on earnings before interest, taxes, depreciation, and amortization. The above segment information and the discussion of the Company's operating segments is based on operating income (loss) which includes depreciation and amortization. In addition, the Company evaluates the performance of the Communications Group's operating segment in Eastern Europe and the republics of the former Soviet Union on a combined basis. The Company is providing as supplemental information an analysis of combined revenues and operating income (loss) for its consolidated and unconsolidated joint ventures in Eastern Europe and the republics of the former Soviet Union. As previously discussed, legal restrictions in China prohibit foreign participation in the operations or ownership in the telecommunications sector. The above segment information for the Communications Group's China joint ventures represents, in part, the investment in network construction and development of telephony networks for China Unicom. The above segment information does not reflect the results of operations of China Unicom's telephony networks. The Company terminated operations of its joint ventures formerly engaged in cooperation with China Unicom pursuant to a Chinese government ruling that demanded the termination. These joint ventures executed settlement contracts with China Unicom on December 3, 1999, the terms of which include substantial payments to the joint ventures from China Unicom.
Note 2: Equity in income (losses) of unconsolidated investees reflects elimination of intercompany interest expense.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
SEGMENT INFORMATION YEAR ENDED DECEMBER 31, 1998 (IN THOUSANDS)
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
SEGMENT INFORMATION YEAR ENDED DECEMBER 31, 1997 (IN THOUSANDS)
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998, AND YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
LEGEND
C = Consolidated
D = Dissolution
E = Equity method
P = Pre-operational
N/A = Not applicable
N/M = Not meaningful
COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION
Operations in Eastern Europe and the republics of the former Soviet Union provide the following services: (i) wireless telephony; (ii) fixed telephony; (iii) cable television; (iv) radio broadcasting; and (v) paging.
WIRELESS TELEPHONY
The following sets forth the names, ownership percentage and accounting treatment of the Communications Group's wireless telephony ventures for the years ended December 31, 1999, 1998, and 1997:
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*--Acquired in connection with the Company's acquisition of PLD Telekom on September 30, 1999
The following table sets forth the revenues and operating loss for consolidated wireless telephony ventures (in thousands):
REVENUES. Wireless telephony consolidated revenues for 1999 amounted to $4.5 million. They were generated in the last quarter of 1999 and were primarily attributable to ALTEL, the Kazakhstan D-AMPS operator acquired in connection with the Company's acquisition of PLD Telekom Inc. in September 1999. ALTEL's revenues for the last quarter of 1998 amounted to $9.9 million. ALTEL's revenues in 1999 were lower than those in 1998 due to increased competition from GSM operators entering the Kazakhstan market in early 1999.
OPERATING LOSS. As a result of severe competition from two recently formed GSM operators which entered the Kazakh market in 1999 aggressively with low tariffs, ALTEL experienced downward
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) pressure on its tariffs and revenues. Due to reductions in margins, the venture recorded an operating loss of $1.0 million for the final quarter of 1999 as compared to operating income of $3.6 million for the same period in 1998. ALTEL's operating profit for the year ended December 31, 1999 was $1.5 million compared to $15.4 million in 1998. Continued competition in 2000 is likely to have further adverse effects on the venture's operating results.
The following table sets forth the revenues, operating loss, net loss and equity in losses of the unconsolidated wireless telephony joint ventures recorded under the equity method (in thousands):
EQUITY IN LOSSES OF JOINT VENTURES. The Communications Group's share in losses from investments in wireless telephony ventures for 1999 was $6.1 million compared to $5.9 million in 1998. These results were attributable mainly to GSM wireless operations in Latvia and Georgia and the Communications Group's D-AMPS operation in Tyumen, Russia.
In Latvia, Baltcom GSM's 1999 revenues increased by 142% to $31.7 million from $13.1 million in 1998. During 1999, the Company eliminated the three month reporting lag for Baltcom GSM and accordingly its 1999 results related to the fifteen months ended December 31, 1999. Reported 1999 revenues increased by $7.8 million due to the fifteen month reporting period and also because of strong subscriber growth, wider service area coverage and higher subscriber air time. Increased revenues were offset by costs associated with the venture's new customer care center and substantial marketing, selling and advertising expenditures. Baltcom GSM generated a net loss of $5.7 million in 1999 as compared with $7.7 million in 1998.
In Georgia, Magticom's 1999 revenues were $16.0 million, representing a $7.0 million increase on 1998 revenues of $9.0 million due to significant growth in subscriber and traffic levels. The venture's net loss was reduced from $5.2 million in 1998 to $900,000 in 1999.
Other group ventures in this category include BELCEL, which operates an NMT 450 wireless license in Belarus and was acquired pursuant to the Company's acquisition of PLD Telekom Inc. in September 1999, and Tyumenruscom, which operates a start-up D-AMPS network in Tyumen, Russia. These ventures jointly generated 1999 revenues of $1.5 million and net losses of $3.0 million, which included a charge of $3.8 million relating to the write down of the Communications Group's investment in Tyumenruscom following a reevaluation of the venture's operations as part of the Communications Group's ongoing strategic review.
1997 wireless telephony revenues amounted to only $2.6 million because the Company's GSM operations in Latvia and Georgia commenced operations in that year and were active for six months and one month, respectively. Wireless telephony revenues grew to $22.1 million in 1998 as a result of increased subscriber numbers and a full twelve months of operations.
Wireless telephony net losses increased from $8.1 million in 1997 to $12.8 million in 1998 primarily as a result of increased interest expense on borrowings used to fund expansion of operations.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) FIXED TELEPHONY
The following sets forth the names, ownership percentage and accounting treatment of the Communications Group's fixed telephony ventures for the years ended December 31, 1999, 1998 and 1997:
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* Acquired in connection with the Company's acquisition of PLD Telekom on September 30, 1999.
The following table sets forth the revenues and operating income (loss) for the consolidated fixed telephony ventures (in thousands):
REVENUES. Fixed telephony consolidated revenues for 1999 amounted to $18.4 million, compared to $3.2 million in 1998. 1998 revenues were attributable mainly to Protocall Ventures, a trunked mobile radio operation which was sold by the Company in 1998. All 1999 consolidated fixed telephony revenues were generated in the last three months ended December 31, 1999 and were attributable to subsidiaries acquired in connection with the Company's acquisition of PLD on September 30, 1999. The most significant ventures acquired were PeterStar, which operates a fully digital, city-wide fiber optic telecommunications network in St Petersburg, Russia, and Technocom, which through Teleport-TP and MTR Sviaz operates Moscow-based long distance and international telephony networks using satellite and fiber optic technology. The Company also acquired BCL, which provides international direct dial, payphone and leased line services for Russian and international businesses in St Petersburg, Russia.
In the last three months of 1999 PeterStar generated lower revenues of $10.4 million as compared to $15.5 million in the same period in 1998 primarily as a result of purchase accounting adjustments relating to deferred revenue. Reductions in business from PeterStar's wireless operators are expected in 2000.
In the last three months of 1999 Technocom generated revenues of $4.7 million compared to $5.2 million in the same period in 1998. Lower international and long distance traffic volumes in 1999 caused Technocom's revenues to decrease compared to those in 1998. Technocom's traffic levels in 2000 are expected to improve.
Operations of the consolidated trunked mobile radio ventures for the years ended December 31, 1998 and 1997 reflect the activities of the Protocall Venture's operations in Portugal, Spain and Belgium
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) prior to the sale of Protocall Ventures in July 1998. The increased revenue for the year ended December 31, 1998 as compared to December 31, 1997 was primarily attributable to the purchase of an additional interest in the Portugal operations during the fourth quarter of 1997. Thus the 1997 consolidated results include three months of activity for the Portuguese operation as compared to nine months in 1998. Prior to the purchase of the additional interest, the operations in Portugal were accounted for as unconsolidated operations under the equity method of accounting.
OPERATING INCOME (LOSS). During the last three months of 1999 fixed telephony consolidated ventures generated operating losses of $4.6 million. PeterStar's operating loss for the last three months of 1999 was $2.0 million compared to $4.0 million of income for the last three months of 1998. PeterStar's 1999 profitability was adversely affected by the above mentioned decrease in revenues. Technocom generated an operating loss of $939,000 during the last quarter of 1999 compared to $7.7 million in the last quarter of 1998. Technocom's profitability improved due to a restructuring of operations in early 1999 and a resultant reduction in overhead expense.
In 1998 fixed telephony operating losses amounted to $186,000 and were attributable primarily to Protocall Ventures before its disposal by the Company. For the year ended December 31, 1997, Protocall Ventures had operating income of $145,000. 1998 results were adversely affected by higher administrative costs than in 1997.
The following table sets forth the revenues, operating income (loss), net income (loss) and equity in income (losses) of the unconsolidated fixed telephony joint ventures recorded under the equity method (in thousands):
EQUITY IN LOSSES OF JOINT VENTURES. The Communications Group's share in losses from investments in fixed telephony ventures for 1999 was $15.0 million compared to income from joint ventures of $201,000 in 1998. These results were attributable mainly to the operations of Telecom Georgia and Caspian American Telephone ("CAT").
In 1999, Telecom Georgia generated revenues of $23.7 million, a decrease of $3.5 million compared to revenues of $27.2 million in 1998. The decrease was due to the emergence of local competition in the long distance and international market, together with downward pressure on termination rates. Telecom Georgia's operating results were also adversely affected by disadvantageous interconnect costs leading to a reduction in 1999 operating income to $783,000 from $7.8 million in 1998 and resulted in a net loss of $4.1 million in 1999 compared to $5.3 million of net income in 1998. In 2000 limited improvement is expected in the venture's revenues.
CAT generated revenues of $693,000 in 1999, its first year of operations, and recorded 1999 operating losses and net losses of $2.3 million and $2.8 million respectively. High start up costs coupled with CAT's inability to develop an adequate customer base resulted in the operating and net loss. As a result of the strategic review performed subsequent to the acquisition of PLD Telekom, CAT's inability to generate an adequate customer base to support its current operations and the region's limited potential for growth required the Company to assess the recoverability of its investment in the joint venture. Based on the most likely scenario under which CAT could continue to be operated, together
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) with the reduced capital the Company is willing to invest as compared to its initial commitment, the estimated cash flows of the joint venture available to the Company were determined to be less than the carrying value of its investment. Utilizing the estimated cash flows, the Company estimated the fair value of its investment in CAT. Due to the long term economic prospects of the region, the Company determined that the decline in the value of the investment is other than temporary and has recorded the decline of $9.9 million as an impairment charge.
1998 fixed telephony revenues of $30.3 million were $4.0 million lower than 1997 revenues of $34.3 million mainly due to contractual reductions in termination accounting rates in Telecom Georgia's international settlement agreements for traffic with its overseas carriers.
1998 fixed telephony operating and net income were lower than in 1997 primarily due to the reduction in Telecom Georgia revenues mentioned above and because 1997 results included a favorable settlement by Telecom Georgia with international carriers of approximately $2.0 million.
Revenues and operating loss from Protocall Ventures prior to its sale in July 1998 were $3.0 million and $884,000 as compared to $3.4 million and $1.6 million in 1997. Also included in equity in losses of joint ventures in 1998 were the operations of Instaphone of $515,000. Instaphone is the Communications Group's wireless local loop telephony operator in Kazakhstan. Operations were delayed by the inability to secure an interconnection agreement with the local ministry.
CABLE TELEVISION
The following sets forth the names, ownership percentage and accounting treatment of the Communications Group's cable television ventures for the years ended December 31, 1999, 1998, and 1997:
The following table sets forth the revenues and operating loss for consolidated cable television ventures (in thousands):
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) REVENUES. Cable television operations generated consolidated revenues of $5.6 million in 1999, representing a 61% increase on 1998 consolidated revenues of $3.4 million. The majority of 1999 consolidated revenues were attributable to Romsat, Viginta, and ATK.
In Romania, Romsat reported revenues of $3.8 million in 1999, an increase of $1.0 million compared to 1998 due to strong growth in subscriber numbers following successful sales initiatives, particularly in the Targu Mures region of the country. In Lithuania, Viginta generated revenues of $1.1 million in 1999, representing an increase of 61% on 1998 revenues of $700,000 and attributable to better programming. ATK, which recently commenced operations in Arkhangelsk, Russia, reported first year revenues of $700,000 in 1999.
In 2000 consolidated revenues arising from cable operations are expected to continue to grow as a result of further acquisitions, improved programming, network expansion and tariff increases.
1998 cable television revenues increased 61% to $3.4 million from 1997 revenues of $1.9 million as a result of expansion of customer base by acquisition and build out of cable television networks.
OPERATING LOSS. Cable television reported consolidated operating losses for 1999 of $550,000, a 63% decrease on 1998 operating losses of $1.5 million. The reduction in losses was driven by subscriber growth resulting in increased revenues and by effective control of costs. Romsat reported 1999 operating income of $200,000 compared to a $600,000 loss in 1998, and Viginta reduced its 1999 operating losses to $600,000 from $800,000 in 1998. ATK reported first year operating losses of $100,000 in 1999.
1998 cable television operating losses were 24% lower than in 1997 as a result of improved profitability arising from growth in subscriber numbers.
The following table sets forth the revenues, operating loss, net loss and equity in income (losses) of unconsolidated cable television joint ventures recorded under the equity method (in thousands):
EQUITY IN INCOME (LOSSES) OF JOINT VENTURES. The Communications Group's share in income from equity investments in cable television ventures in 1999 was $329,000, compared to a $3.9 million loss in 1998. The operating results for unconsolidated cable television ventures were mainly attributable to Baltcom TV in Latvia, Kosmos TV in Moscow, and Alma TV in Kazakhstan. Included in equity in income of joint ventures is a charge of $1.8 million relating to the write off of the Communications Group's investment in Teleplus, following a reevaluation of the venture's operations as part of the Communications Group's ongoing strategic review.
Baltcom TV reported revenues of $6.4 million in 1999 compared to $6.1 million in 1998 with operating income of $2.2 million compared to a $1.2 million operating loss and net income of $1.3 million compared to a $2.5 million net loss in 1998. 1999 profitability of Baltcom TV improved compared to 1998 due to a reconciling adjustment decreasing depreciation expense by $1.7 million.
Kosmos TV revenues decreased by $900,000 in 1999 to $6.2 million from $7.1 million in 1998 due to a combination of the after effects of the Russian economic crisis in late 1998 and increased competition in Moscow. The venture generated operating income of $300,000 in 1999 compared to an $800,000
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) operating loss in 1998 and net income of $600,000 compared to a $1.6 million net loss in 1998, due primarily to a reduction in reported costs resulting from adjustments to prior year over-accruals of $2.4 million.
Alma TV's revenues in 1999 increased from $3.5 million in 1998 to $5.1 million in 1999 due to aggressive marketing and advertising, together with successful implementation of tiered subscriber pricing policies. However, because of strong competition exerting pressure on margins, and higher costs due to the increased scale of operational activity, the venture reported reduced operating income of $500,000 in 1999 compared to $600,000 in 1998, and a net loss of $100,000 in 1999 compared to net income of $400,000 in 1998. Alma TV expects to return to profitability in 2000 as a result of the continued build out of its networks to three further cities, and improved subscriber management.
Compared to 1997 revenues of $21.4 million, cable television revenues for 1998 increased by 31% to $28.0 million, primarily due to growth in subscriber numbers in Kazakhstan, Moldova, Belarus and Uzbekistan. This led to 1998 operating losses being reduced to $3.7 million from $4.9 million in 1997.
RADIO BROADCASTING
The following sets forth the names, ownership percentage and accounting treatment of the Communications Group's radio broadcasting ventures for the years ended December 31, 1999, 1998, and 1997:
The following table sets forth the revenues and operating income (loss) for consolidated radio broadcasting ventures (in thousands):
REVENUES. Radio operations generated consolidated revenues of $14.7 million in 1999, representing a 14% decrease on 1998 revenues of $17.1 million. Radio Juventus in 1999 had revenues of $6.7 million, representing a 19% decrease on 1998 revenues of $8.2 million. The decrease was due to the continued effect of competition from television and the new national Hungarian radio network. In Russia, SAC and Radio Katusha's revenues fell from $4.6 million and $2.4 million in 1998 to $3.8 million and
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) $1.6 million in 1999 respectively, as the after effects of the Russian economic crisis in late 1998 continued to have effect.
1998 revenues increased by 26% to $17.1 million from $13.5 million in 1997 due to increases in advertising sales volumes and prices, and because of incremental revenues generated in 1998 by three radio stations acquired in 1997.
OPERATING INCOME (LOSS). In 1999, radio operations generated operating losses of $5.7 million, compared to $1.2 million operating income in 1998. 1999 profitability was adversely affected by falling revenues at Radio Juventus, SAC and Radio Katusha, as mentioned above. Together these ventures generated operating income of $1.3 million in 1999 compared to $6.2 million in 1998. In addition, News Talk Radio recorded a 1999 operating loss of $7.1 million, representing a 39% increase in its 1998 operating loss of $5.0 million. 1999 operating losses included a non-cash charge of $251,000 to write off other assets of News Talk Radio. The Communications Group plans either to dispose of or discontinue the operations of NewsTalk Radio during 2000. In 2000 the results of the Company's consolidated radio ventures are expected to improve.
1998 operating income of $1.2 million was 70% lower than in 1997, due primarily to losses generated by NewsTalk Radio, which was acquired by the Company in late 1997.
The following table sets forth the revenues, operating income (loss), net income (loss) and equity in income (losses) of the Communications Group's investment in unconsolidated radio joint ventures, which are recorded under the equity method (in thousands):
EQUITY IN INCOME (LOSSES) OF JOINT VENTURES. The Communications Group's share in losses from equity investments in radio ventures increased by 42% from $108,000 in 1998 to $153,000 in 1999. The 1999 share of losses was mainly attributable to Radio Trio, Tallinn, Estonia which generated revenues of $2.1 million compared to $1.9 million in 1998, and net losses of $200,000 compared to $100,000 in 1998. The marginal decrease in profitability in 1999 compared to 1998 was due to higher administrative expenses.
1998 revenues of $2.1 million were $400,000 lower than 1997 revenues of $2.5 million due to the reclassification of Radio Katusha in 1998 as a consolidated venture as compared to equity accounting following the purchase of an additional interest in the venture. Because of this, 1998 equity in the results of radio joint ventures decreased to a $108,000 loss from income of $159,000 in 1997.
In 2000 the revenues and profitability of equity radio ventures are expected to improve.
PAGING
OVERVIEW. In 1998 the Communications Group stopped funding most paging operations and it continues to manage almost all of its paging ventures on a cash break even basis. The Communications Group will continue to manage its paging businesses to levels not requiring significant additional funding and is developing a strategy to maximize the value of its paging investments. In 2000, it is expected that the paging operations will continue to generate losses.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following sets forth the names, ownership percentage and accounting treatment of the Communications Group's paging ventures for the years ended December 31, 1999, 1998, and 1997:
The following table sets forth the revenues and operating loss for consolidated paging ventures (in thousands):
REVENUES. The Communications Group's paging ventures generated consolidated revenues of $3.1 million in 1999, representing a 27% decrease on 1998 revenues of $4.2 million. The decrease was due to continued competition from the wireless telephony market. The majority of 1999 revenues were attributable to CNM, Romania, which had 1999 revenues of $1.1 million compared to $1.8 million in 1998, and to Baltcom Estonia, which had revenues of $700,000 in 1999 as compared with $1.1 million in 1998.
Revenues increased by 27% from $3.3 million in 1997 to $4.2 million in 1998 due to incremental sales generated by Paging One in Austria, and revenues attributable to Eurodevelopment which was acquired in 1998.
OPERATING LOSS. Consolidated operating losses arising from paging operations amounted to $3.7 million in 1999, compared to $20.6 million in 1998, and included a charge of $1.9 million to write down assets in Eurodevelopment, following reevaluation of the venture's operations as part of the Company's ongoing strategic review. In 1998 operating losses increased due to impairment charges taken by the Communications Group in respect of CNM, Baltcom, Estonia and Paging One.
During 1999, the Company disposed of Paging One's operations which resulted in a loss of $243,000.
1998 operating losses of $20.6 million, were $16.5 million higher than 1997 operating losses of $4.1 million mainly because of a 1998 inventory write off of $4.2 million, and a $6.2 million impairment charge in 1998 relating to fixed and intangible assets.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following table sets forth the revenues, operating income (loss), net loss and equity in losses of unconsolidated paging joint ventures, which are recorded under the equity method (in thousands):
EQUITY IN LOSSES OF JOINT VENTURES. The Communications Group's share of losses from equity investments in paging ventures decreased from $7.5 million in 1998 to $480,000 in 1999. During 1998 the majority of the Communications Group's equity investments in paging ventures were written off due to the factors mentioned above. The results of these ventures are no longer reported by the Communications Group, partially contributing to the 32% decrease in 1999 reported revenues compared to 1998. Revenues in 1999 also continued to be adversely affected by continued competition from wireless operators.
Revenues in 1998 increased by 68% from $9.7 million in 1997 to $16.2 million in 1998, partly as a result of the acquisition of Mobile Telecom. However, the Company's equity in the losses of paging ventures increased from $761,000 in 1997 to $7.5 million in 1998 as a result of a $5.4 million write down of certain paging investments in 1998.
SEGMENT HEADQUARTERS
Segment headquarters operations relate to executive, administrative, logistical and joint venture support activities. The following table sets forth the consolidated revenues and operating losses for the segment headquarters (in thousands):
REVENUES. Increased revenues in 1999 and 1998 compared to respective previous years reflected growth in programming and management fee revenues from the Communications Group's unconsolidated businesses.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES. In connection with the Company's September 1999 acquisition of PLD and the subsequent restructuring of its operations, the Communications Group recorded a restructuring charge of $8.4 million relating to the closure of its Stamford, Connecticut office, and severance costs arising from reduction in staff levels at its Vienna and Moscow offices. A further asset impairment charge of $1.3 million was taken in 1999 to write off interests in certain pre-operational ventures the Communications Group determined not to pursue.
In 1998 the Communications Group recorded a non-cash, write off of $34.0 million of goodwill, also in connection with a revision of its operating plan in respect of paging joint ventures. The goodwill was originally recorded in connection with the November 1, 1995 merger of the Company, Orion, Metromedia International Telecommunications and MCEG Sterling.
OPERATING LOSS. Operating losses for 1999, 1998 and 1997 included depreciation and amortization charges of $12.4 million, $5.8 million and $4.9 million, respectively. Increased 1999 depreciation and amortization charges related to goodwill arising from, and telephony licenses acquired pursuant to, the Company's acquisition of PLD Telekom in September 1999, and to the revision of the amortization life of goodwill in July 1999 from 25 years to 10 years. 1999 operating losses also included a $2.5 million write off of goodwill of NewsTalk Radio. The 1998 operating loss of the segment headquarters was significantly higher than in 1999 due to the charge relating to paging described above.
The operating loss in 1998 increased compared to 1997 due to the write off of goodwill referred to above, and due to higher overhead expenditures as a result of a significant increase in the number of joint ventures in 1998.
FOREIGN CURRENCY LOSS, MINORITY INTEREST AND GAIN (LOSS) ON DISPOSITION OF ASSETS
The following table sets forth minority interest, foreign currency loss and gain (loss) on disposition of assets for the consolidated operations of the Communications Group--Eastern Europe and the republics of the former Soviet Union.
For the years ended December 31, 1999, 1998 and 1997 foreign currency loss represents losses from consolidated joint ventures and subsidiaries operating in highly inflationary economies. Foreign currency losses represent the remeasurement of the ventures' financial statements, in all cases using the U.S. dollar as the functional currency. U.S. dollar transactions are shown at their historical value. Monetary assets and liabilities denominated in local currencies are translated into U.S. dollars at the prevailing period-end exchange rate. All other assets and liabilities are translated at historical exchange rates. Results of operations have been translated using the monthly average exchange rates. The foreign currency loss also relates to the transaction differences resulting from the use of these different rates. The 1999 foreign currency loss of $4.1 million as compared to $137,000 in 1998 was due primarily to the adverse effect of the weakening of local currencies in Germany and Austria.
Minority interest represents the allocation of losses by the Communications Group's majority owned subsidiaries and joint ventures to its minority ownership interest.
The 1999 loss of $243,000 on disposition of assets relates to the disposal of Paging One. The 1998 gain on disposition of assets arose pursuant to the Company's sale of Protocall Ventures.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
COMMUNICATIONS GROUP--CHINA
The following sets forth the names, ownership percentage and accounting treatment of the Communications Group's ventures for the years ended December 31, 1999, 1998, and 1997:
CHINA TELECOMMUNICATIONS JOINT VENTURE INFORMATION
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
OVERVIEW. The Company's investments in telecommunications joint ventures in China were made through its majority-owned subsidiary, Asian American Telecommunications Corporation. These joint ventures supported the construction and development of telephony networks by China United Telecommunications Incorporated, a Chinese telecommunications operator known as China Unicom. Because legal restrictions in China prohibit direct foreign investment and operating participation in domestic telephone companies, the company's joint ventures were limited to providing financing and consulting services to China Unicom under contracts. By the terms of these contracts and in return for services rendered, the joint ventures were to receive payments from China Unicom based on the cash flows generated by China Unicom's network businesses. This arrangement, known as a sino-sino-foreign joint venture cooperation, was commonly accepted at the time the Company's joint ventures were formed and was applied in numerous other foreign-invested relationships with China Unicom. Since the arrangement specifically limited the joint ventures' participation in and control over China Unicom's actual business operations, Asian American Telecommunications accounted for its sino-sino-foreign joint venture investments under the equity method. The Company invested in four Chinese telecommunications joint ventures in this fashion--two in Ningbo Municipality, one in Sichuan Province and one in Chongqing City.
Beginning in mid-1998, the Chinese government unofficially began reconsidering the advisability of continuing the sino-sino-foreign joint venture cooperation arrangements undertaken by China Unicom. At that time, more than forty such cooperation contracts had been established with foreign-invested joint ventures covering China Unicom's operations in various parts of China. By mid-1999, the government reached the conclusion that China Unicom's sino-sino-foreign cooperation framework was in conflict with China's basic telecommunications regulatory policies and should henceforth cease. China Unicom was instructed to terminate or very substantially restructure all of its sino-sino-foreign joint venture cooperation contracts.
In July 1999, Ningbo Ya Mei Telecommunications, Ltd., one of the Company's two telecommunications joint ventures in Ningbo Municipality, China, received a written notice from China Unicom stating that the Chinese government had directed China Unicom to terminate further cooperation with Ningbo Ya Mei. China Unicom subsequently informed the Company that the notification also applies to the Company's other telecommunications joint venture in Ningbo Municipality. In subsequent notifications from China Unicom to the Company's joint ventures, China Unicom stated its intention to terminate all cooperation contracts with sino-sino-foreign joint ventures in China, pursuant to an August 30, 1999 mandate from the Chinese Ministry of Information Industry. In its notifications, China Unicom requested that negotiations begin regarding a suitable settlement of the matter and other matters related to the winding up of the Company's joint ventures cooperation agreements with China Unicom as a result of the Ministry of Information Industry notice. With the issuance of these notifications, China Unicom ceased further performance under its cooperation contracts with the Company's joint ventures. However, China Unicom did make distribution of amounts owed to the Company's Ningbo Ya Mei joint venture for the first half of 1999 according to the terms of the cooperation contract. The
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Company, through its four joint ventures, entered into negotiations with China Unicom in September 1999 to reach suitable terms for termination of the cooperation contracts.
On November 6, 1999, the Company's four Chinese joint ventures engaged in projects with China Unicom each entered into non-binding letters of intent with China Unicom which set forth certain terms for termination of their cooperation arrangements with China Unicom. On December 3, 1999, legally binding settlement contracts incorporating substantially the terms set forth in the November letters of intent were executed between China Unicom and the four joint ventures, thereby terminating the joint ventures' further cooperation with China Unicom. Under the terms of the settlement contracts, the four joint ventures will each receive cash amounts in RMB from China Unicom in full and final payment for the termination of their cooperation contracts with China Unicom. Upon receipt of this payment, China Unicom and the joint ventures will waive all of their respective relevant rights against the other party with respect to the cooperative arrangements. In addition, all assets pertinent to China Unicom's networks that are currently held by the joint ventures will be unconditionally transferred to China Unicom. China Unicom effected payment to the joint ventures of the amounts prescribed in the settlement contracts on December 10, 1999. Subsequently and prior to the end of 1999, the boards of directors of the four joint ventures each passed formal resolutions to commence dissolution of the joint ventures. The Company expects such dissolution to be completed for all four joint ventures by mid-2000.
Each of the Company's China telecommunications joint ventures has stopped its accounting for its share of the net distributable cash flows under the cooperation agreements with China Unicom and the amortization of the investment in the China Unicom projects effective July 1, 1999 based on the termination notices received from China Unicom.
For the period ended December 31, 1999, the four China telecommunications joint ventures have performed impairment analyses of their investments in projects with China Unicom. These analyses were based on the terms of settlement contracts the joint ventures executed with China Unicom on December 3, 1999. The joint ventures each received sufficient amounts in their settlements with China Unicom so as to recover their recorded investment balances as of December 31, 1999. Accordingly, no impairment writedowns were taken by the joint ventures during 1999.
Through December 3, 1999, the date on which settlement contracts terminated the joint ventures further cooperation with China Unicom, the Company continued to account for its investments in its China telecommunications joint ventures under the equity method of accounting. The Company has performed an impairment analysis of its investments in and advances to joint ventures and related goodwill to determine the amount that these assets have been impaired. The Company reviewed its investment in these joint ventures for other than temporary decline. The Company has determined the related goodwill should be considered an asset to be disposed of and has estimated the fair value less costs to dispose of its investment and has stopped amortizing the balance. The Company believes that the termination of the four joint ventures' cooperation agreements with China Unicom is an event that gives rise to an accounting loss which is probable. The amount of the non-cash impairment charge is the difference between the sum of the carrying values of its investments and advances made to joint ventures plus goodwill less the Company's estimate of the total amount of compensation it will receive from the four joint ventures through the dissolution.
The Company will receive substantial portions of the China Unicom settlement payments to the joint ventures via repayment of advances and distribution of joint venture assets on dissolution. China Unicom's settlement payments to the joint ventures were made in RMB. However, the joint ventures' formation contracts and loan agreements with Asian American Telecommunications had been registered
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) with Chinese authorities so as to assure the joint ventures' ability to convert RMB deposits into foreign exchange for payment to the Company. Over time, the Company anticipates that it will fully recover its investments in and advances to the four affected joint ventures, but no assurances can be made as to the exact timing or amount of such repayments. As of December 31, 1999, the joint ventures had conveyed to Asian American Telecommunications in the form of repayment of advances approximately $29.3 million in U.S. Dollars from the China Unicom settlement. As of December 31, 1999, investments in and advances to these four joint ventures, exclusive of goodwill, were approximately $40.0 million.
The Company's current estimate of the total amount it will ultimately receive from the four terminated joint ventures is $90.1 million (at the December 31, 1999 exchange rates) of which $29.3 million has been received. Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint ventures. However, some variance from the Company's current estimates of the amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China and exchange rate fluctuations. The Company cannot assure at this time that this variance will not be material.
The currently estimated $90.1 million in total payments from the Company's four joint ventures that had cooperated with China Unicom is insufficient to fully recover the goodwill recorded in connection with the Company's investment in these joint ventures. As a result, the Company has recorded a non-cash impairment charge of $45.7 million in 1999 for the write-off of goodwill. Further adjustments may be required after receipt of final distributions from the four terminated joint ventures.
The following table sets forth operating loss, equity in losses of joint ventures and minority interests for the Communications Group's various telephony-related joint ventures in China (in thousands):
OPERATING LOSS. Operating losses for the year ended December 31, 1999 increased $41.4 million to $55.9 million. The increase in operating loss is due principally to the $45.7 million writedown of goodwill taken in consideration of the termination of the Company's joint venture cooperation with China Unicom. Overall operating losses were partially offset by the operating expenses actually decreasing during 1999 by $2.9 million due to a reduction in personnel and other overhead costs in China.
The operating loss for the year ended December 31, 1998 decreased $3.4 million to $14.5 million. The decrease in operating loss is principally attributable to non-cash employee compensation and costs of $6.8 million in 1997 which included $1.5 million related to the dissolution of a joint venture in China. The non-cash expenses were partially offset by personnel costs of $3.8 million. The Company launched two new joint ventures, Chongqing Tai Le Feng Telecommunications Co., Ltd. and Ningbo Ya Lian Telecommunications Co., Ltd., each of which necessitated recruitment of additional support staff. The wireline telephone network project supported by the Company's Sichuan Tai Li Feng joint venture began actual network construction in early 1998. Joint planning of expansion to the Ningbo City GSM network was undertaken with the Company's Chinese partners in the first half of 1998. These latter measures necessitated recruitment of additional engineering staff to support the activities. Finally, the
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Company undertook an aggressive effort in early 1998 to secure additional projects in China, including due diligence and discussion of draft documentation of joint venture contracts with several potential partners. This resulted in legal and research expenses of $1.4 million, considerably in excess of those experienced in 1997. In addition, depreciation and amortization expenses increased by $660,000 in 1998 from the prior year.
EQUITY IN LOSSES OF JOINT VENTURES. Equity in losses of the Communications Group's telecommunications joint ventures in China amounted to $848,000 for 1999 as compared to a loss of $1.0 million in 1998. This 1999 equity in joint ventures reflects the operations up to December 3, 1999 when the joint ventures signed the settlement agreement with China Unicom.
Equity in losses of the Communications Group's joint ventures in China amounted to $1.0 million in 1998 as compared to $861,000 in 1997. The majority of the 1998 losses arise from the absence of any joint venture revenues during the pre-operational state of the projects each venture supports. The joint ventures in the pre-operational stage contributed $1.2 million of the 1998 losses. The Company's wireline telephone network joint venture in Sichuan Province and the Chongqing Municipality remained in a pre-operational state as of December 31, 1998 but network construction activity preliminary to the commercial service launch in January 1999 was aggressive throughout the year. The Company's only operational venture in China during 1998, supporting the Ningbo City GSM network, recorded income of $133,000. The Ningbo City project generated $3.4 million in 1998 revenues to the joint venture.
MINORITY INTERESTS. For the years ended December 31, 1999, 1998 and 1997, minority interests represents the allocation of losses to Metromedia China Corporation's minority ownership.
INFLATION AND FOREIGN CURRENCY
During 1998, and continuing in 1999, a number of emerging market economies suffered significant economic and financial difficulties resulting in liquidity crises, devaluation of currencies, higher interest rates and reduced opportunities for financing. At this time, the prospects for recovery for the economies of Russia and the other republics of the former Soviet Union and Eastern Europe negatively affected by the economic crisis remain unclear. The economic crisis has resulted in a number of defaults by borrowers in Russia and other countries and a reduced level of financing available to investors in these countries. The devaluation of many of the currencies in the region has also negatively affected the U.S. dollar value of the revenues generated by certain of the Communications Group's joint ventures and may lead to certain additional restrictions on the convertibility of certain local currencies. The Communications Group expects that these problems will negatively affect the financial performance of certain of its cable television, telephony, radio broadcasting and paging ventures.
Some of the Communications Group's subsidiaries and joint ventures operate in countries where the inflation rate is extremely high. Inflation in Russia increased dramatically following the August 1998 financial crisis and there are increased risks of inflation in Kazakhstan. The inflation rates in Belarus have been at hyperinflationary levels for some years and as a result, the currency has essentially lost all intrinsic value.
While the Communications Group's subsidiaries and joint ventures attempt to increase their subscription rates to offset increases in operating costs, there is no assurance that they will be able to do so. Therefore, operating costs may rise faster than associated revenue, resulting in a material negative impact on operating results. The Company itself is generally negatively impacted by
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) inflationary increases in salaries, wages, benefits and other administrative costs, the effects of which to date have not been material to the Company.
The value of the currencies in the countries in which the Communications Group operates tends to fluctuate, sometimes significantly. For example, during 1998 and 1999, the value of the Russian Rouble was under considerable economic and political pressure and has suffered significant declines against the U.S. dollar and other currencies. In addition, in 1999 local currency devaluations in Uzbekistan, Kaszkhstan and Georgia, in addition to weakening of local currencies in Austria and Germany, had an adverse effect on the Communications Group's ventures in these countries. The Communications Group currently does not hedge against exchange rate risk and therefore could be negatively impacted by declines in exchange rates between the time one of its joint ventures receives its funds in local currency and the time it distributes these funds in U.S. dollars to the Communications Group.
The Communications Group's strategy is to minimize its foreign currency risk. To the extent possible, the Communications Group bills and collects all revenues in U.S. dollars or an equivalent local currency amount adjusted on a monthly basis for exchange rate fluctuations. The Communications Group's subsidiaries and joint ventures are generally permitted to maintain U.S. dollar accounts to service their U.S. dollar denominated debt and current account obligations, thereby reducing foreign currency risk. As the Communications Group's subsidiaries and joint ventures expand their operations and become more dependent on local currency based transactions, the Communications Group expects that its foreign currency exposure will increase.
SNAPPER
The following table sets forth Snapper's results of operations for the years ended December 31, 1999, 1998 and 1997 (in thousands):
REVENUES. In 1999, Snapper's sales were $216.1 million compared to $210.1 million in 1998. Sales of lawn and garden equipment contributed the majority of the revenues during both periods. The increase in sales of snow throwers of $11.2 million and commercial ride-on equipment of $2.9 million was partially offset by sales shortfalls attributable to garden tractors, rear engine riding lawnmowers and walk behind lawnmowers of $8.4 million.
In 1998, Snapper's sales were $210.1 million, compared to $183.1 million in 1997. Sales of lawn and garden equipment contributed the majority of the revenues during both periods. Sales were lower in 1997 due to unseasonably cool weather during April and May, as well as $25.4 million of sales reductions in 1997 due to repurchases of certain distributor inventory. In 1997, Snapper completed the implementation of its program to sell products directly to its dealers. During the last quarter of 1997, Snapper sold older lawn and garden equipment repurchased from the distributors at reduced prices. In addition, mild winter weather during the fourth quarter of 1997 negatively impacted sales of snow throwers.
GROSS PROFIT. Gross profit for 1999 was $72.4 million compared to $62.7 million in 1998. Snapper's gross profit margins improved to 33.5% in 1999 compared to 29.8% in 1998. Gross profit margins
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) increased due to improved operating efficiencies from a full year of production. In 1998, production levels were reduced considerably to lower equipment inventory levels. In addition, in 1998, Snapper recorded $2.7 million for an inventory write down of excess parts, which was a one-time adjustment.
Gross profit was $62.7 million and $59.1 million in 1998 and 1997, respectively. The 1998 gross profit percentage of 29.8%, as compared to 32.3% in 1997, decreased due to sales of older equipment during the period at special pricing to help eliminate older inventory acquired in the distributor repurchases during 1997 and a $2.7 million inventory write down for excess parts in 1998. Although the gross profit margin decreased in 1998 due to special pricing on old equipment resold in 1998 and an inventory write down, the gross profit in 1998 as compared to 1997 increased by $3.6 million.
OPERATING INCOME (LOSS). Operating income was $12.4 million in 1999 compared to an operating loss of $7.6 million in 1998. Selling, general and administrative expenses decreased by $10.0 million in 1999 as compared to 1998, principally due to $8.6 million in lower advertising expenditures. Depreciation and amortization charges were $6.2 million and $6.7 million in 1999 and 1998, respectively. Depreciation and amortization reflected the depreciation of Snapper's property, plant and equipment as well as the amortization of the goodwill associated with the acquisition of Snapper.
Snapper had an operating loss of $7.6 million in 1998 and $15.2 million in 1997. Selling, general and administrative expenses decreased by $3.1 million in 1998 as compared to 1997, principally due to $1.4 million of inventory repurchase expenditures related to nine distributor repurchases during 1997 that were not incurred in 1998, and $1.6 million in lower advertising expenditures in 1998. Depreciation and amortization charges were $6.7 million and $7.0 million in 1998 and 1997, respectively. Depreciation and amortization reflected the depreciation of Snapper's property, plant and equipment as well as the amortization of the goodwill associated with the acquisition of Snapper.
CORPORATE HEADQUARTERS
Corporate Headquarters costs reflect the management fee paid to Metromedia Company under the management agreement, investor relations, legal and other professional costs, insurance and other corporate costs. The following table sets forth the operating income (loss) for Corporate Headquarters (in thousands):
OPERATING INCOME (LOSS). For the year ended December 31, 1999, corporate general and administrative expenses were $6.3 million. For the year ended December 31, 1998, Corporate Headquarters had income of $896,000 which represented the reversal of $6.6 million in self-insurance liabilities offset by corporate general and administrative expenses including the management fee. For the years ended December 31, 1998 and 1997, Corporate Headquarters had general and administrative expenses of approximately $5.7 million and $5.5 million, respectively.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) COMPANY CONSOLIDATED
The following table sets forth on a consolidated basis the following items for the years ended December 31, 1999, 1998, and 1997 (in thousands):
INTEREST EXPENSE. In 1999, interest expense increased $934,000 to $17.3 million principally due to the $4.3 million of amortization of interest on the Company's 10 1/2% senior discount notes which were issued in connection with the September 30 acquisition of PLD Telekom, partially offset by decreased borrowings by Snapper which resulted in lower interest expense of $2.7 million compared to the prior year. Interest expense decreased $4.6 million to $16.3 million for the year ended December 31, 1998. The decrease in interest expense was due to the repayment of debt at the corporate level in March and August 1997, partially offset by an increase in borrowings at Snapper.
INTEREST INCOME. Interest income decreased $5.4 million to $7.3 million in 1999 due principally to the reduction of funds at Corporate Headquarters which have been utilized in the operations of the Company. Interest income increased $2.9 million to $12.7 million in 1998, principally from investment of funds at the corporate level from the preferred stock offering in September 1997 and the funds from the sale of the Landmark theater group in April 1998.
INCOME TAX BENEFIT (EXPENSE). For the year ended December 31, 1999, the income tax benefit that would have resulted from applying the federal statutory rate of 35% was $49.3 million. The income tax benefit was reduced principally by losses attributable to foreign operations, equity losses in joint ventures currently not deductible and a 100% valuation allowance on the current year loss not utilized. For the year ended December 31, 1998, the income tax benefit that would have resulted from applying the federal statutory rate of 35% was $47.7 million. The income tax benefit was reduced principally by losses attributable to foreign operations, equity losses in joint ventures currently not deductible and a 100% valuation allowance on the current year loss not utilized. The income tax benefit in 1998 for continuing operations in 1998 was principally the result of the utilization of the current year operating loss to offset the gain of the Landmark sale. For the year ended December 31, 1997, the income tax benefit that would have resulted from applying the federal statutory rate of 35% was $47.6 million. The income tax benefit in 1997 was reduced principally by losses attributable to foreign operations, equity losses in joint ventures currently not deductible and a 100% valuation allowance on the current year loss not utilized, as well as, in 1997, the impact of the alternative minimum tax in connection with the sale of the Company's entertainment group. The income tax benefit for continuing operations in 1997 was principally the result of the utilization of the current year operating loss to offset the gain of the entertainment group sale.
NET INCOME (LOSS), INCLUDING EQUITY IN LOSSES OF AND WRITEDOWN OF INVESTMENT IN UNCONSOLIDATED INVESTEES, DISCONTINUED OPERATIONS AND EXTRAORDINARY ITEMS. Net loss increased to $142.0 million for the year ended
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) December 31, 1999, from $123.7 million for the year ended December 31, 1998. The net loss of 1998 includes a gain from discontinued operations from the sale of the Landmark theatre group of $5.3 million. The increase in operating loss and net loss in 1999 is primarily from the write-off of the goodwill relating to the Communications Group's operations in China of $45.7 million and restructuring and asset impairment charge of the Communications Group Eastern Europe and former republics of the Soviet Union of $31.6 million partially offset by an improvement in Snapper's operating results of $20.1 million. The net loss for 1999 includes from discontinued operations the settlement of a lawsuit in connection with the sale of the Entertainment Group. Net loss was $123.7 million for the year ended December 31, 1998. The net loss for 1998 includes a gain from discontinued operations from the sale of the Landmark theater group of $3.7 million and a refund of tax payments made in prior years by the Company's entertainment group of $8.7 million, and the gain of $7.1 million from the sale of the Communications Group's trunked mobile radio investment, Protocall Ventures partially reduced by the write down of its trunked mobile radio venture in Kazakhstan of $1.6 million. For the year ended December 31, 1997 net income was $88.4 million. The net income for the year ended December 31, 1997 includes the gain on the entertainment group sale of $266.3 million and losses from the discontinued operations of $32.3 million, an extraordinary loss of $14.7 million relating to the early extinguishment of the Company's debentures and equity loss and a further write down of the investment in RDM amounting to $45.1 million. In addition, the net loss in 1998 and net income in 1997 included equity in losses of the Communications Group's joint ventures of $18.2 million and $8.1 million, respectively.
Operating loss increased to $129.9 million for the year ended December 31, 1998 from $80.1 million for the year ended December 31, 1997. The increase in operating loss reflects a full year of operations in 1998 as compared to ten months of operations in 1997 for the Communications Group's joint ventures in China and an increase in selling, general and administrative costs by the Communications Group in supporting the continued expansion of operations in Eastern Europe and the republics of the former Soviet Union and the impact of the non-cash charge in connection with the Communications Group's revised operating plan for its paging operations of $40.3 million.
LIQUIDITY AND CAPITAL RESOURCES
THE COMPANY
OVERVIEW. The Company is a holding company and, accordingly, does not generate cash flows from operations. The Communications Group is dependent on the Company for significant capital infusions to fund its operations and make acquisitions, as well as to fulfill its commitments to make capital contributions and loans to its joint ventures. Each of the Communications Group's joint ventures operates or invests in businesses, such as cable television, fixed telephony and cellular telecommunications, that are capital intensive and require significant capital investment in order to construct and develop operational systems and market their services. To date, such financing requirements have been funded from cash on hand. Future capital requirements of the Communications Group, including future acquisitions, will depend on available funding from the Company, receipt of funds from Metromedia China and on the ability of the Communications Group's joint ventures to generate positive cash flows. PLD Telekom and Snapper are restricted under covenants contained in their credit agreements from making dividend payments or advances, other than certain permitted debt repayments, to the Company. In addition to funding the cash requirements of the Communications Group, the Company has periodically funded the short-term working capital needs of Snapper. The Company believes that its cash on hand and the receipt of funds from Metromedia China will be sufficient to fund the Company's working capital requirements for the near-term.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) In addition to financing its communications businesses, the Company will also be required to pay interest on the 10 1/2% senior discount notes issued in connection with the acquisition of PLD Telekom commencing September 30, 2002. As a result, the Company will require in addition to its cash on hand, additional financing in order to satisfy its on-going working capital requirements, debt service and acquisition and expansion requirements. Such additional capital may be provided through the public or private sale of equity or debt securities of the Company or by separate equity or debt financings by the Communications Group or certain companies of the Communications Group or proceeds from the sale of assets. The indenture for the senior discount notes permits the Company to finance the development of its communications operations. No assurance can be given that such additional financing will be available to the Company on acceptable terms, if at all. If adequate additional funds are not available, the Company may be required to curtail significantly its long-term business objectives and the Company's results of operations may be materially and adversely affected.
Management believes that its long-term liquidity needs (including debt service) will be satisfied through a combination of the Company's successful implementation and execution of its growth strategy to become a global communications and media company and the Communications Group's joint ventures and subsidiaries achieving positive operating results and cash flows through revenue and subscriber growth and control of operating expenses.
The Company expects to generate consolidated net losses for the foreseeable future as the Communications Group continues to build out and market its services.
CONVERTIBLE PREFERRED STOCK. On September 16, 1997 the Company completed a public offering of 4,140,000 shares of $1.00 par value, 7 1/4% cumulative convertible preferred stock with a liquidation preference of $50.00 per share, generating net proceeds of approximately $199.4 million. Dividends on the preferred stock are cumulative from the date of issuance and payable quarterly, in arrears, commencing on December 15, 1997. The Company may make any payments due on the preferred stock, including dividend payments and redemptions (i) in cash; (ii) through issuance of the Company's common stock or (iii) through a combination thereof. If the Company were to elect to continue to pay the dividend in cash, the annual cash requirement would be $15.0 million. Since its initial dividend payment on December 15, 1997 through March 15, 2000, the Company has paid its quarterly dividends on the preferred stock in cash. The preferred stock is convertible at the option of the holder at any time, unless previously redeemed, into the Company's common stock, at a conversion price of $15.00 per share equivalent to a conversion rate of 3 1/3 shares of common stock for each share of preferred stock subject to adjustment under certain conditions.
The preferred stock is redeemable at any time on or after September 15, 2000, in whole or in part, at the option of the Company, initially at a price of $52.5375 and thereafter at prices declining to $50.00 per share on or after September 15, 2007, plus in each case all accrued and unpaid dividends to the redemption date. Upon any change of control, as defined in the certificate of designation of the preferred stock each holder of preferred stock shall, in the event that the market value at such time is less than the conversion price of $15.00, have a one-time option to convert the preferred stock into the Company's common stock at a conversion price equal to the greater of (i) the market value, as of the change of control date, as defined in the certificate of designation, and (ii) $8.00. In lieu of issuing shares of the Company's common stock, the Company may, at its option, make a cash payment equal to the market value of the Company's common stock otherwise issuable.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
SENIOR DISCOUNT NOTES. In connection with the acquisition of PLD Telekom, the Company issued $210.6 million in aggregate principal amount at maturity of its 10 1/2% Senior Discount Notes due 2007 (the "Senior Discount Notes") to the holders of the PLD Telekom's then outstanding 14% senior discount notes due 2004 and 9% convertible subordinated notes due 2006 pursuant to an agreement to exchange and consent, dated as of May 18, 1999, by and among the Company, PLD Telekom and such holders.
The terms of the Senior Discount Notes are set forth in an Indenture, dated as of September 30, 1999, between the Company and U.S. Bank Trust National Association as Trustee. The Senior Discount Notes will mature on September 30, 2007. The Senior Discount Notes were issued at a discount to their aggregate principal amount at maturity and will accrete in value until March 30, 2002 at the rate of 10 1/2% per year, compounded semi-annually to an aggregate principal amount at maturity of $210.6 million. The Senior Discount Notes will not accrue cash interest before March 30, 2002. After this date, the Senior Discount Notes will pay interest at the rate of 10 1/2% per year, payable semi-annually in cash and in arrears to the holders of record on March 15 or September 15 immediately preceding the interest payment date on March 30 and September 30 of each year, commencing September 30, 2002. The interest on the Senior Discount Notes will be computed on the basis of a 360-day year comprised of twelve months.
The Senior Discount Notes are general senior unsecured obligations of the Company, rank senior in right of payment to all existing and future subordinated indebtedness of the Company, rank equal in right of payment to all existing and future senior indebtedness of the Company and will be effectively subordinated to all existing and future secured indebtedness of the Company to the extent of the assets securing such indebtedness and to all existing and future indebtedness of the Company's subsidiaries, whether or not secured.
The Senior Discount Notes will be redeemable at the sole option of the Company on and after March 30, 2002 only at a redemption price equal to their principal amount plus accrued and unpaid interest, if any, up to but excluding the date of redemption.
Upon the occurrence of a change of control of the Company (as such term is defined in the Indenture), the holders of the Senior Discount Notes will be entitled to require the Company to repurchase such holders' notes at a purchase price equal to 101% of the accreted value of the Senior Discount Notes (if such repurchase is before March 30, 2002) or 101% of the principal amount of such notes plus accrued and unpaid interest to the date of repurchase (if such repurchase is after March 30, 2002).
The Indenture for the Senior Discount Notes limits the ability of the Company and certain of its subsidiaries to, among other things, incur additional indebtedness or issue capital stock or preferred stock, pay dividends on, and repurchase or redeem their capital stock or subordinated obligations, invest in and sell assets and subsidiary stock, engage in transactions with affiliates and incur additional liens. The Indenture for the Senior Discount Notes also limits the ability of the Company to engage in consolidations, mergers and transfers of substantially all of its assets and also contains limitations on restrictions on distributions from its subsidiaries.
TRAVELERS. Also at completion of the Company's acquisition of PLD Telekom, PLD Telekom repaid The Travelers Insurance Company and The Travelers Indemnity Company (together, "Travelers") approximately $8.7 million of amounts due under the revolving credit and warrant agreement dated November 26, 1997 between PLD Telekom and Travelers (the "Old Travelers Agreement"). PLD Telekom and Travelers also entered into an amended and restated revolving credit note agreement (the
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) "New Travelers Agreement") pursuant to which PLD Telekom has agreed to repay Travelers the remaining $4.9 million due under the Old Travelers Agreement on August 30, 2000 and to pay interest on the outstanding amount at a rate of 10 1/2%. In addition, Travelers received at the closing of the merger 100,000 shares of PLD Telekom common stock (which were converted in the merger into shares of common stock of the Company at the .6353 exchange ratio) and 10-year warrants to purchase 700,000 shares of common stock of the Company at an exercise price to be determined in December 2000 that will be between $10.00 and $15.00 per share. However, if the amount outstanding under the New Travelers Agreement has not been fully repaid by August 30, 2000, the exercise price of the warrants will be reset to $.01 per share. Travelers retained its existing security interests in certain of PLD Telekom's assets. The performance by PLD Telekom of its obligations under the New Travelers Agreement is guaranteed by the Company and certain subsidiaries of PLD Telekom.
TELECOMINVEST. In September and October 1999, PLD Telekom entered into certain option agreements (subsequently assigned to the Company) with Commerzbank AG and First National Holding S.A. which owns the majority of the ordinary shares of OAO Telecominvest, a Russian company with interests in a wide range of telecommunications companies in St. Petersburg and Northwestern Russia and PLD Telekom's joint venture partner in its subsidiary PeterStar. The aggregate consideration for the options was $8.5 million and they gave the Company the right to participate in a planned private placement by First National Holding by acquiring, for nominal value, that number of shares equal to $8.5 million divided by 80% of the issuance price in the placement or, if the placement was not completed on or before December 31, 1999 (extended by amendment to January 31, 2000), to acquire up to 16% of First National Holding for additional consideration of approximately $8.5 million. In resolution of disputes regarding the parties' rights under those agreements, on March 30, 2000, First National Holding paid the Company $11.0 million in full settlement of the Company's and PLD Telekom's rights under the option agreements.
COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION
OVERVIEW. The Communications Group has invested significantly (in cash or equipment through capital contributions, loans and management assistance and training) in its joint ventures. The Communications Group has also incurred significant expenses in identifying, negotiating and pursuing new telecommunications opportunities in selected emerging markets.
The Communications Group and many of its joint ventures are experiencing continuing losses and negative operating cash flow since many of the businesses are in the development and start-up phase of operations. The Communications Group's primary source of funds has been from the Company in the form of inter-company loans.
Until the Communications Group's operations generate positive cash flow, the Communications Group will require significant capital to fund its operations, and to make capital contributions and loans to its joint ventures. The Communications Group relies on the Company to provide the financing for these activities. The Company believes that as more of the Communications Group's joint ventures commence operations and reduce their dependence on the Communications Group for funding, the Communications Group will be able to finance its own operations and commitments from its operating cash flow and will be able to attract its own financing from third parties. There can be no assurance, however, that additional capital in the form of debt or equity will be available to the Communications Group at all or on terms and conditions that are acceptable to the Communications Group or the Company, and as a result, the Communications Group may continue to depend upon the Company for its financing needs.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Credit agreements between certain of the joint ventures and the Communications Group are intended to provide such ventures with sufficient funds for operations and equipment purchases. The credit agreements generally provide for interest to accrue at rates ranging from the prime rate to the prime rate plus 6% and for payment of principal and interest from 90% of the joint venture's available cash flow, as defined, prior to any distributions of dividends to the Communications Group or its joint venture partners. The credit agreements also often provide the Communications Group the right to appoint the general director of the joint venture and the right to approve the annual business plan of the joint venture. Advances under the credit agreements are made to the joint ventures in the form of cash for working capital purposes, as direct payment of expenses or expenditures, or in the form of equipment, at the cost of the equipment plus cost of shipping. As of December 31, 1999, the Communications Group was committed to provide funding under various charter fund agreements and credit lines in an aggregate amount of approximately $234.0 million, of which $48.5 million remained unfunded. The Communications Group's funding commitments under a credit agreement are contingent upon its approval of the joint venture's business plan. To the extent that the Communications Group does not approve a joint venture's business plan, the Communications Group is not required to provide funds to the joint venture under the credit line.
The Communications Group's consolidated and unconsolidated joint ventures' ability to generate positive operating results is dependent upon their ability to attract subscribers to their systems, the sale of commercial advertising time and their ability to control operating expenses.
It is anticipated that as a consequence of the merger, the overall corporate overhead of the Communications Group will be significantly reduced, with the resulting more limited corporate function being funded as described elsewhere in this section.
FORMER PLD BUSINESSES. PLD Telekom's operating businesses have become largely self-sustaining, and while they continue to have on-going capital requirements associated with the development of their businesses, they have been able to pay for capital expenditures and operational expenses out of internally generated cash flows from operations and/or have been able to arrange their own financing, including supplier financing. In no case is PLD Telekom specifically obligated to provide capital to its operating businesses; it was so obligated in the past, but all such obligations have been met.
As a result of the acquisition of PLD Telekom by the Company, the majority of PLD Telekom's commitments at the holding company level have been satisfied or assumed by the Company, such that the $4.9 million due to Travelers on August 30, 2000, as described above is the only material commitment upcoming during 2000.
BALTCOM GSM. In June 1997, the Communications Group's Latvian GSM Joint Venture, Baltcom GSM, entered into certain agreements with the European Bank for Reconstruction and Development pursuant to which the European Bank for Reconstruction and Development agreed to lend up to $23.0 million to Baltcom GSM in order to finance its system buildout and operations. Baltcom GSM's ability to borrow under these agreements is conditioned upon reaching certain gross revenue targets. The loan has an interest rate equal to the 3-month London interbank offered rate or LIBOR plus 4% per annum, with interest payable quarterly. The principal amount must be repaid in installments starting in March 2002 with final maturity in December 2006. The shareholders of Baltcom GSM were required to provide $20.0 million to Baltcom GSM as a condition precedent to European Bank for Reconstruction and Development funding the loan. In addition, the Communications Group and Western Wireless agreed to provide or cause one of the shareholders of Baltcom GSM to provide an additional $7.0 million in funding to Baltcom GSM if requested by European Bank for Reconstruction and Development which amount has been provided. In August 1998, the European Bank for
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Reconstruction and Development and Baltcom GSM amended their loan agreement in order to provide Baltcom GSM the right to finance the purchase of up to $3.5 million in additional equipment from Nortel. As part of such amendment, the Communications Group and Western Wireless agreed to provide Baltcom GSM the funds needed to repay Nortel, if necessary, and to provide Baltcom GSM debt service support for the loan agreement with the European Bank for Reconstruction Development in an amount not to exceed the greater of $3.5 million or the aggregate of the additional equipment purchased from Nortel plus interest payable on the financing.
As part of the financing, the European Bank for Reconstruction and Development was also provided a 5% interest in the joint venture which it can put back to Baltcom GSM at certain dates in the future at a multiple of Baltcom GSM's earnings before interest, taxes, depreciation and amortization or EBITDA, not to exceed $6.0 million. The Company and Western Wireless have guaranteed the obligation of Baltcom GSM to pay such amount. All of the shareholders of Baltcom GSM, including Metromedia International Telecommunications, pledged their respective shares to the European Bank for Reconstruction and Development as security for repayment of the loan. Under the European Bank for Reconstruction and Development agreements, amounts payable to the Communications Group are subordinated to amounts payable to the European Bank for Reconstruction and Development.
MAGTICOM. In April 1997, the Communications Group's Georgian GSM Joint Venture, Magticom, entered into a financing agreement with Motorola, Inc. pursuant to which Motorola agreed to finance 75% of the equipment, software and service it provides to Magticom up to $15.0 million. Interest on the financed amount accrues at 6-month London interbank offered rate or LIBOR plus 5% per annum, with interest payable semi-annually. Repayment of principal with respect to each drawdown commences twenty-one months after such drawdown with the final payment being due 60 months after such drawdown. All drawdowns must be made within 3 years of the initial drawdown date. Magticom is obligated to provide Motorola with a security interest in the equipment provided by Motorola to the extent permitted by applicable law. As additional security for the financing, the Company has guaranteed Magticom's repayment obligation to Motorola. In June 1998, the financing agreement was amended and Motorola agreed to make available an additional $10.0 million in financing. Interest on the additional $10.0 million accrues at 6-month LIBOR plus 3.5%. Under such amendment, the Company guaranteed Magticom's repayment obligation to Motorola.
The Communications Group and Western Wireless have funded the balance of the financing to Magticom through a combination of debt and equity. Repayment of indebtedness owed to such partners is subject to certain conditions set forth in the Motorola financing agreements.
AZERBAIJAN. As of August 1998, the Communication Group acquired a 76% interest in Omni-Metromedia Caspian, Ltd., a company that owns 50% of a Joint Venture in Azerbaijan, Caspian American. Caspian American has been licensed by the Ministry of Communications of Azerbaijan to provide high speed wireless local loop services and digital switching throughout Azerbaijan. Omni-Metromedia has committed to provide up to $40.5 million in loans to Caspian American for the funding of equipment acquisition and operational expense subject to concurrence with Caspian American's business plans. The Communications Group was obligated to contribute approximately $5.0 million in equity to Omni-Metromedia and to lend up to $36.5 million subject to concurrence with Caspian American's business plan.
As part of the original transaction, the Communications Group has sold a 17.1% participation in the $36.5 million loan commitment to AIG Silk Road Fund, Ltd., which requires AIG Silk Road Fund to provide the Communications Group 17.1% of the funds to be provided under the loan agreement and entitles AIG Silk Road Fund to 17.1% of the repayments to the Communications Group. The
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Communications Group agreed to repurchase such loan participation from AIG Silk Road Fund in August 2005 on terms and conditions agreed by the parties. In addition, the Communications Group provided AIG Silk Road Fund the right to put its 15.7% ownership interest in Omni-Metromedia to the Communications Group starting in February 2001 for a price equal to seven times the EBITDA of Caspian American minus debt, as defined, multiplied by AIG Silk Road Fund's percentage ownership interest.
In May 1999, the Communications Group sold 2.2% of the shares of Omni-Metromedia to Verbena Servicos e Investimentos, S.A., thereby reducing its ownership interest in Caspian American from 38% to 37%. In addition, the Communications Group sold a 2.4% participation in the $36.5 million loan to Verbena Servicos e Investimentos, which requires Verbena Servicos e Investimentos to provide the Communications Group 2.4% of the funds to be provided under the loan agreement and entitles Verbena Servicos e Investimentos to 2.4% of the repayments to the Communications Group. The Communications Group has agreed to repurchase such loan participation from Verbena Servicos e Investimentos in August 2005 on terms and conditions agreed by the parties. In addition, the Communications Group provided Verbena Servicos e Investimentos the right to put its 2.2% ownership interest in Omni Metromedia to the Communications Group starting in February 2001 for a price equal to seven times the EBITDA of Caspian American minus debt, as defined, multiplied by Verbena Servicos e Investimentos percentage ownership interest.
In January 1999, Caspian American entered into an equipment purchase agreement with Innowave Tadiran Telecommunications Wireless Systems, Ltd. to purchase wireless local loop telecommunications equipment. In connection with such agreement, the Communications Group provided Innowave Tadiran a payment guarantee of $2.0 million, which was called and paid during 1999.
As part of its ongoing strategic review, in late 1999 the Company reevaluated the operations of CAT in order to ascertain the requirement to account for impairment losses. In view of the low quantity of potential customers in the region in which the business operate and limited scope for growth, it was determined that an impairment loss of $9.9 million was required in 1999 relating to the Company's investment in CAT. The venture has developed a revised operating plan to stabilize its operations and minimize future funding requirements until potential restructuring options have been fully explored.
TYUMENRUSKOM. As part of its investment in Tyumenruskom announced in November 1998, the Company agreed to provide a guarantee of payment of $6.1 million to Ericsson Radio Systems, A.B. for equipment financing provided by Ericsson to one of the Communication Group's wholly owned subsidiaries and to its 46% owned joint venture, Tyumenruskom. Tyumenruskom has purchased a digital advanced mobile phone or DAMPS system cellular system from Ericsson in order to provide fixed and mobile cellular telephone in the regions of Tyumen and Tobolsk, Russian Federation. The Communications Group has made a $1.7 million equity contribution to Tyumenruskom and has agreed to lend the joint venture up to $4.0 million for start-up costs and other operating expenses. Tyumenruskom also intends to provide wireless local loop telephone services.
Following a reevaluation of the venture's operations as part of the Company's ongoing strategic reviews, in 1999, $3.8 million of the Company's investment in this venture was recorded as an impairment charge in view of its low profitability and limited scope for improvement.
COMMUNICATIONS GROUP--CHINA
During 1997 and 1998, the Company made several investments in telecommunications joint ventures in China through its majority-owned subsidiary, Asian American Telecommunications Corporation. These
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) ventures were terminated in late 1999 and agreements were entered into in December 1999 terminating the joint ventures' further cooperation with China Unicom. Under the terms of the settlement contracts, the four joint ventures will each receive cash amounts in RMB from China Unicom in full and final payment for the termination of their cooperation contracts with China Unicom. See "Item 1: Business--Telecommunications Joint Ventures in China"
The Company anticipates that it will fully recover its investments in and advances to the four affected joint ventures. As of December 31, 1999, the joint ventures had conveyed to Asian American Telecommunications in the form of repayment of advances approximately $29.3 million in US Dollars from the China Unicom settlement. As of December 31, 1999, investments in and advances to these four joint ventures, exclusive of goodwill, were approximately $40.0 million.
The Company's current estimate of the total amount it will ultimately receive from the four terminated joint ventures is $90.1 million (at the December 31, 1999 exchange rates) of which $29.3 million has been received. Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint ventures. However, some variance from the Company's current estimates of the amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China. The Company cannot assure at this time that this variance will not be material or that the RMB to U.S. Dollar exchange rate will not change.
The currently estimated $90.1 million in total payments from the Company's four joint ventures that had cooperated with China Unicom is insufficient to fully recover the goodwill recorded in connection with the Company's investment in these joint ventures. As a result, the Company has recorded a non-cash impairment charge of $45.7 million in 1999 for the write-off of goodwill. Further adjustments may be required after receipt of final distributions from the four terminated joint ventures.
Metromedia International Group and Metromedia International Telecommunications, Inc. have made intercompany loans to Metromedia China under a credit agreement, and Metromedia China has used the proceeds of these loans to fund its investments in these joint ventures in China. At December 31, 1999, Metromedia China owed $63.9 million under this credit agreement (including accrued interest).
On May 7, 1999, Asian American Telecommunications entered into a joint venture agreement with All Warehouse Commodity Electronic Commerce Information Development Co., Ltd., a Chinese trading company, for the purpose of establishing Huaxia Metromedia Information Technology Co., Ltd., known as Huaxia JV. Also on May 7, 1999, Huaxia JV entered into a computer information system and services contract with All Warehouse and its parent company, China Product Firm Corporation. The Huaxia JV will develop and operate electronic commerce computer information systems for use by All Warehouse and China Product Firm and its affiliates and customers. The contract has a term of thirty years and grants Huaxia JV exclusive rights to manage all of All Warehouse and China Product Firm's electronic trading systems during that period.
The total amount to be invested in Huaxia JV is $25.0 million with registered capital contributions from its shareholders amounting to $10.0 million. Asian American Telecommunications will make registered capital contributions of $4.9 million and All Warehouse will contribute $5.1 million. The remaining investment in Huaxia JV will be in the form of up to $15.0 million of loans from Asian American Telecommunications. As of December 31, 1999, AAT has made $980,000 of its scheduled registered capital investment. Huaxia JV received its operating license on July 5, 1999. Ownership in Huaxia JV is 49% by Asian American Telecommunications and 51% by All Warehouse.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Huaxia JV is established as a sino-foreign equity joint venture between Asian American Telecommunications and All Warehouse Commodity Electronic Commerce Information Development Co., Ltd. The Huaxia JV does not have any contractual relationship with China Unicom and is engaged in business fundamentally different from that of the Communications Group's joint ventures cooperating with China Unicom. Computer and software services such as offered by the Huaxia JV are subject to regulations different from those applied to telecommunications in China. The Communications Group believes that the fee-for-services arrangement of Huaxia JV and the lines of business undertaken by the joint venture do not constitute foreign involvement in telecommunications activities, which are at the center of certain Chinese authorities' actions against the Communication Group's joint telecommunications projects with China Unicom.
The Communications Group is currently evaluating other investment opportunities in China's information industry sector. The Communications Group is actively negotiating e-commerce and Internet ventures with other Chinese enterprises similar to the Huaxia JV. Chinese regulatory policy currently permits limited foreign participation in such ventures and trade agreements executed in 1999 between China and World Trade Organization member countries provide for considerable opening of this sector over the coming two years.
SNAPPER
Snapper's liquidity is generated from operations and borrowings. On November 11, 1998, Snapper entered into a loan and security agreement with the Lenders named therein and Fleet Capital Corporation, as agent and as the initial lender, pursuant to which the lenders have agreed to provide Snapper with a $5.0 million term loan facility and a $55.0 million revolving credit facility, the proceeds of which were used to refinance Snapper's then outstanding obligations under its prior revolving credit agreement and will also be used for working capital purposes. The Snapper loan will mature in November 2003 (subject to automatic one-year renewals), and is guaranteed by the Company up to $10.0 million (increasing to $15.0 million on the occurrence of specified events). Interest on the Snapper loan is payable at Snapper's option at a rate equal to prime plus up to 0.5% or the London interbank offered rate or LIBOR plus between 2.5% and 3.25%, in each case depending on Snapper's leverage ratio under the Snapper loan agreement. The agreements governing the Snapper loan contain standard representations and warranties, covenants, conditions precedent and events of default, and provide for the grant of a security interest in substantially all of Snapper's assets other than real property. At March 31, 1999, Snapper was not in compliance with all financial covenants required under the loan agreement; the lenders have waived any event of default arising from such noncompliance. At September 30, 1999, Snapper was not in compliance with all financial covenants under the loan agreement and security agreement; the lenders have waived any event of default arising from such noncompliance. At December 31, 1999, Snapper was in compliance with all covenants under the loan and security agreement.
Snapper's capital expenditures during 1999, 1998, and 1997 were $2.5 million, $3.9 million, and $5.6 million, respectively. Under Snapper's current loan agreement, Snapper's capital expenditures in 1999 cannot exceed $2.5 million, and in future years cannot exceed $2.0 million annually. The Company does not expect that the limits on capital expenditures under Snapper's current loan agreement will negatively impact on Snapper's ability to fund necessary capital expenditures.
Snapper has entered into various long-term manufacturing and purchase agreements with certain vendors for the purchase of manufactured products and raw materials. As of December 31, 1999, noncancelable commitments under these agreements amounted to approximately $7.9 million.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Snapper has an agreement with a financial institution which makes available floor plan financing to dealers of Snapper products. This agreement provides financing for inventories and accelerates Snapper's cash flow. Under the terms of the agreement, a default in payment by a dealer is nonrecourse to Snapper. However, the third-party financial institution can require Snapper to repurchase new and unused equipment, if the dealer defaults and the inventory is not able to be sold to another dealer. At December 31, 1999, there was approximately $95.0 million outstanding under this floor plan financing arrangement. The Company has guaranteed Snapper's payment obligations under this agreement.
The Company believes that Snapper's available cash on hand, the cash flow generated by operating activities, borrowings from the Snapper loan agreement and, on an as needed basis, short-term working capital funding from the Company, will provide sufficient funds for Snapper to meet its obligations and capital requirements.
RISKS ASSOCIATED WITH THE COMPANY
The ability of the Communications Group and its joint ventures to establish profitable operations is subject to significant political, economic and social risks inherent in doing business in emerging markets such as Eastern Europe, republics of the former Soviet Union and China. These include matters arising out of government policies, economic conditions, imposition of or changes in government regulations or policies, imposition of or changes to taxes or other similar charges by governmental bodies, exchange rate fluctuations and controls, civil disturbances, deprivation or unenforceablility of contractual rights, and taking of property without fair compensation.
The Communications Group's strategy is to minimize its foreign currency risk. To the extent possible, in countries that have experienced high rates of inflation, the Communications Group bills and collects all revenues in U.S. dollars or an equivalent local currency amount adjusted on a monthly basis for exchange rate fluctuations. The Communications Group's joint ventures are generally permitted to maintain U. S. dollar accounts to serve their U.S. dollar obligations, thereby reducing foreign currency risk. As the Communications Group and its joint ventures expand their operations and become more dependent on local currency based transactions, the Communications Group expects that its foreign currency exposure will increase. The Communications Group does not hedge against foreign exchange rate risks at the current time and, therefore, could be subject in the future to any declines in exchange rates between the time a joint venture receives its funds in local currencies and the time it distributes such funds in U.S. dollars to the Communications Group.
During 1997 and 1998, the Company made several investments in telecommunications joint ventures in China through its majority-owned subsidiary, Asian American Telecommunications Corporation. These ventures were terminated in late 1999 and agreements were entered into in December 1999 terminating the joint ventures' further cooperation with China Unicom. Under the terms of the settlement contracts, the four ventures will each receive cash amounts in RMB from China Unicom in full and final payment for the termination of their cooperation contracts with China Unicom. See "Item 1: Business--Telecommunications Joint Ventures in China."
The Company's current estimate of the total amount it will ultimately receive from the four terminated China joint ventures is $90.1 million (at the December 31, 1999 exchange rates) of which $29.3 million has been received. Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint ventures. However, some variance from the Company's current estimates of the
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China and exchange rate fluctuations. The Company cannot assure that this variance will not be material.
The currently estimated $90.1 million in total payments from the Company's four joint ventures that had cooperated with China Unicom is insufficient to fully recover the goodwill recorded in connection with the Company's investment in these joint ventures. As a result, the Company has recorded a non-cash impairment charge of $45.7 million in 1999 for the write-off of goodwill. Further adjustments may be required after receipt of final distributions from the four terminated joint ventures.
MMG CONSOLIDATED
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
CASH FLOWS FROM OPERATING ACTIVITIES
Cash used in operating activities for the year ended December 31, 1999 was $39.2 million, a decrease in cash used in operating activities of $22.1 million from the same period in the prior year.
Losses from operating activities include significant non-cash items such as discontinued operations, disposition of businesses, depreciation, amortization, equity in losses of joint ventures and investees, and losses allocable to minority interests. Excluding discontinued operations and disposition of businesses, non-cash items increased $26.9 million from $68.3 million to $95.2 million for the years ended December 31, 1998 and 1999, respectively. The increase relates principally to the write off of goodwill related to the Communication Group's operations in China and increased amortization expense relating to the Company's decision to reduce the period that it will amortize the goodwill related to the Communications Group's operations in Eastern Europe and the republics of the former Soviet Union. Changes in operating assets and liabilities, net of the effect of acquisitions and dispositions, decreased cash flows for the year ended December 31, 1999 by $5.4 million and increased cash flows for the year ended December 31, 1998 by $11.8 million.
The increase in cash flows for the year ended December 31, 1999 resulted principally from the improved operating results of Snapper.
CASH FLOWS FROM INVESTING ACTIVITIES
Cash used in investing activities was $13.2 million for the year ended December 31, 1999 as compared to cash provided by investing activities of $106.6 million for the year ended December 31, 1998. The principal uses of funds for the year ended December 31, 1999 were investments in and advances to joint ventures of $20.8 million, funds utilized in the acquisition of PLD Telekom of $19.6 million, acquisitions by the Communications Group of $1.6 million and additions to property, plant and equipment of $5.8 million. The principal source of funds was distributions from joint ventures of $43.1 million of which $33.6 million was from the Company's China joint ventures. The principal sources of funds from investing activities in 1998 were proceeds from maturities of short-term investments of $103.1 million and the net proceeds of $57.3 million from the sale of Landmark and proceeds of $14.5 million form the sale of Protocall Ventures. The principal uses of funds for the year ended December 31, 1998 were investments in and advances to joint ventures of $48.2 million, acquisitions by the Communications Group of $11.0 million and additions to property, plant and equipment of $11.4 million.
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) CASH FLOWS FROM FINANCING ACTIVITIES
Cash used in financing activities was $34.2 million and $37.2 million, for the years ended December 31, 1999 and 1998, respectively. Funds used in financing activities in 1999 were for the preferred stock dividend of $15.0 million and payments of Snapper's debt of $19.3 million. Funds used in financing activities in 1998 were for the preferred stock dividend of $15.0 million and the repayment of debt of $17.5 million, principally the Snapper revolver, which was partially offset by proceeds of $49.9 million from the November 1998 Snapper loan and $5.3 million from the exercise of stock options.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
CASH FLOWS FROM OPERATING ACTIVITIES
Cash used in operations for the year ended December 31, 1998 was $61.4 million, a decrease in cash used in operations of $62.4 million from the prior year.
Losses from operating activities include significant non-cash items such as discontinued operations, depreciation, amortization, equity in losses of investees, nonrecurring charge of the Communications Group's writeoff of goodwill and other intangibles and fixed assets, early extinguishment of debt, gain on sale of assets, and losses allocable to minority interests. Excluding discontinued operations and extraordinary items, non-cash items decreased $2.1 million from $64.9 million to $62.8 million for the years ended December 31, 1997 and 1998, respectively. The decrease relates principally to equity losses. Changes in operating assets and liabilities, net of the effect of acquisitions and dispositions, increased cash flows for the year ended December 31, 1998 by $11.9 million and decreased cash flows by $57.8 million, for the year ended December 31, 1997.
The increase in cash flows for the year ended December 31, 1998 resulted from the Company's decision to significantly decrease its production of inventory at Snapper in the current year partially offset by increased losses in the Communications Group's operations due to the start-up nature of these operations and increases in selling, general and administrative expenses to support the increase in the number of joint ventures.
CASH FLOWS FROM INVESTING ACTIVITIES
Cash provided from investing activities for the years ended December 31, 1998 and 1997 was $106.6 million and $75.4 million, respectively. The principal sources of funds from investing activities in 1998 were proceeds from maturities of short-term investments of $103.1 million and the net proceeds of $57.3 million from the sale of the Landmark theater group and proceeds of $14.5 million from the sale of Protocall Ventures. The principal source of funds from investing activities in 1997 was the net proceeds from the entertainment group sale of $276.6 million. The principal uses of funds for the year ended December 31, 1998 were investments in and advances to joint ventures of $48.2 million, acquisitions by the Communications Group of $11.0 million and additions to property, plant and equipment of $11.4 million. The principal uses of funds for the year ended December 31, 1997 were investments in and advances to joint ventures of $64.7 million, acquisitions by the Communications Group of $17.9 million and additions to property, plant and equipment of $10.5 million.
CASH FLOWS FROM FINANCING ACTIVITIES
Cash used in financing activities was $37.2 million, for the year ended December 31, 1998 as compared to cash provided by financing activities of $88.7 million, for the year ended December 31, 1997. Funds used in financing activities in 1998 were for the preferred stock dividend of $15.0 million and the
ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) repayment of debt of $77.5 million, principally the prior Snapper revolver, which was partially offset by proceeds of $49.9 million from the November 1998 Snapper loan, and $5.3 million from the exercise of stock options. Financing activities in 1997 includes the net proceeds of $199.4 million from the issuance of 4,140,000 shares of 7 1/4% cumulative convertible preferred stock. Of the $156.7 million of payments of debt, $155.0 million relates to the payment on the Company's debentures.
YEAR 2000 ISSUES
Neither the Company nor any of its operating businesses experienced any significant problems in operations due to the rollover to year 2000. In addition, neither the Company nor any of its operating businesses have been informed by any other companies or other entities on which they rely or with which they do business that any such parties experienced any material year 2000-related problems.
Based on its experience with the January 1, 2000 roll-over, the Company does not expect to experience any material problems relating to the year 2000 issue in the future, however, the Company and its operating businesses will continue to monitor the issue during 2000. The Company cannot guarantee that it or the other companies or other entities on which it relies will not experience any year 2000-related problems in the future.
As of December 31, 1999, aggregate expenses incurred by the Company and its operating businesses in connection with year 2000 compliance and upgrades amounted to approximately $600,000.
NEW ACCOUNTING DISCLOSURES
ACCOUNTING FOR DERIVATIVES
In June 1998, Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", was issued. SFAS 133 established accounting and reporting standards for derivative instruments and for hedging activities. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities and measure those instruments at fair value. The accounting for the gain or loss due to changes in fair value of the derivative instrument depends on whether the derivative instrument qualifies as a hedge. SFAS 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. SFAS 133 can not be applied retroactively to financial statements of prior periods. Given the complexity of SFAS 133 and the uncertainty surrounding its implementation, which has led to a Derivatives Implementation Group, the Company has not completed its evaluation of the impact of SFAS 133 on its consolidated financial position and results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the normal course of business, the financial position of the Company is routinely subjected to a variety of risks. In addition to the market risk associated with interest rate movements on outstanding debt and currency rate movements on non-U.S. dollar denominated assets and liabilities, other examples of risk include collectibility of accounts receivable and significant political, economic and social risks inherent in doing business in emerging markets such as Eastern Europe, republics of the former Soviet Union and China.
With the exception of Snapper and prior to the acquisition of PLD Telekom at September 30, 1999, the Company did not have any significant long term obligations. Since Snapper's bank debt is a floating rate instrument, its carrying value approximates its fair value. A 100 basis point increase in the level of interest rates with all other variables held constant would result in an increase in interest expense of
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED) $36,000. In addition, a 100 basis point increase in interest rates on Snapper's floor plan financing and dealers would have resulted in an increase in interest expense of $82,000.
With the exception of certain vendor financing at the operating business level (approximately $9.0 million in the aggregate), the Company's debt obligations and those of its operating businesses are fixed rate obligations, and are therefore not exposed to market risk from changes in interest rates. The Company does not believe that it is exposed to a material market risk from changes in interest rates. Furthermore, with the exception of the approximately $9.0 million in vendor financing which is denominated in Euros, Deutsche Marks and Dutch Guilders, the Company's long-term debt and that of its operating businesses are denominated in U.S. dollars. The Company does not believe that the Communications Group's debt not denominated in U.S. dollars exposes the Company to a material market risk from changes in foreign exchange rates.
The Company does not hedge against foreign exchange rate risks at the current time. In the majority of the countries that the Communications Group's joint ventures operate, there currently do not exist derivative instruments to allow the Communications Group to hedge foreign currency risk. In addition, at the current time the majority of the Communications Group's joint ventures are in the early stages of development and the Company does not expect in the near term to repatriate significant funds from the Communications Group's joint ventures. "Item 7 - -Management's Discussion and Analysis of Financial Conditions and Results of Operations--Inflation and Foreign Currency" contains additional information on risks associated with the Company's investments in Eastern Europe, the republics of the former Soviet Union and China.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements in this Form 10-K including, without limitation, statements under "Item 1 - -Business", "Item 3 - -Legal Proceedings" and "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations" constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Certain, but not necessarily all, of such forward-looking statements can be identified by the use of forward-looking terminology, such as "believes," "expects," "may," "will," "should" or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involves risks and uncertainties. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions, which will, among other things, affect demand for the Company's products and services; industry capacity, which tends to increase during strong years of the business cycle; changes in public taste and industry trends; demographic changes; competition from other communications companies, which may affect the Company's ability to enter into or acquire new joint ventures or to generate revenues; political, social and economic conditions and changes in laws, rules and regulations or their administration or interpretation, particularly in Eastern Europe and the republics of the former Soviet Union, China and selected other emerging markets, which may affect the Company's results of operations; timely completion of construction projects for new systems for the joint ventures in which the Company has invested, which may impact the costs of such projects; developing legal structures in Eastern Europe and the republics of the former Soviet Union, China and other selected emerging markets, which may affect the Company's results of operations; cooperation of local partners for the Company's communications investments in Eastern Europe and the republics of the former Soviet Union, China and other selected emerging markets, which may affect the Company's results of
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS (CONTINUED) operations; exchange rate fluctuations; license renewals for the Company's communications investments in Eastern Europe and the republics of the former Soviet Union, China and other selected emerging markets; the loss of any significant customers; changes in business strategy or development plans; quality of management; availability of qualified personnel; changes in or the failure to comply with government regulations; and other factors referenced herein. Any forward-looking statement speaks only as of the date on which it is made. New factors emerge from time to time and it is not possible for the Company to predict which will arise. In addition, the Company cannot assess the impact of each factor on its business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statement.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data required under this item are included in Item 14 of this Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
The information called for by this PART III (Items 10, 11, 12 and 13) is not set forth herein because the Company intends to file with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended December 31, 1999, the Proxy Statement for the 2000 Annual Meeting of Stockholders. Such information to be included in the Proxy Statement is hereby incorporated into these Items 10, 11, 12 and 13 by this reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) and (a)(2) Financial Statements and Schedules
The financial statements and schedules listed in the accompanying Index to Financial Statements are filed as part of this Annual Report on Form 10-K.
(a)(3) Exhibits
The exhibits listed in the accompanying Exhibit Index are filed as part of this Annual Report on Form 10-K.
(b) Current Reports on Form 8-K
(i) On October 13, 1999, a Form 8-K was filed to report the completion of the Company's merger with PLD Telekom Inc.
(ii) On December 14, 1999, a Form 8-K was filed to report the execution of definitive agreements setting forth the terms for the termination of the Company's joint ventures with China United Telecommunications Incorporated.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 30, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
METROMEDIA INTERNATIONAL GROUP, INC. AND SUBSIDIARIES
All other schedules have been omitted either as inapplicable or not required under the Instructions contained in Regulation S-X or because the information included in the Consolidated Financial Statements or the Notes thereto listed above.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Metromedia International Group, Inc.:
We have audited the accompanying consolidated financial statements of Metromedia International Group, Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Metromedia International Group, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
KPMG LLP
New York, New York March 29, 2000
METROMEDIA INTERNATIONAL GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
METROMEDIA INTERNATIONAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
METROMEDIA INTERNATIONAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
See accompanying notes to consolidated financial statements.
METROMEDIA INTERNATIONAL GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of Metromedia International Group, Inc. ("MMG" or the "Company") and its wholly-owned subsidiaries, Metromedia International Telecommunications, Inc., Snapper Inc. and as of September 30, 1999, PLD Telekom Inc. (see note 2). PLD Telekom, Metromedia International Telecommunications and its majority owned subsidiary, Metromedia China Corporation, are together known as the "Communications Group". PLD Telekom has been included in the Company's results of operations since September 30, 1999. All significant intercompany transactions and accounts have been eliminated.
Almost all of the Communications Group's joint ventures other than the businesses of PLD Telekom report their financial results on a three-month lag. Therefore, the Communications Group's financial results for December 31 include the financial results for those joint ventures for the 12 months ending September 30. The Company is currently evaluating the financial reporting of these ventures and the possibility of reducing or eliminating the three-month reporting lag for certain of its principal businesses during 2000 (see note 3).
In July 1997 and April 1998 the Company completed the sales of substantially all of its entertainment assets and Landmark Theatre Group, Inc., respectively (see notes 6 and 7). The transactions have been recorded as discontinuances of business segments. In addition, as of April 1, 1997, for financial statement reporting purposes, the Company was no longer qualified to treat its investment in RDM Sports Group, Inc. ("RDM") as a discontinued operation and the Company has included in its results of continuing operations the Company's share of the earnings and losses of RDM. On August 29, 1997, RDM and certain of its affiliates filed voluntary bankruptcy petitions under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Northern District of Georgia (see note 8).
DESCRIPTION OF THE BUSINESS
COMMUNICATIONS GROUP
The Communications Group invests in communications businesses principally in Eastern Europe and the republics of the former Soviet Union. The Communications Group holds interests in several telecommunications joint ventures in China. These ventures were terminated in late 1999 and the Company reached agreement for the distribution of approximately $90.1 million (based on the December 31, 1999 exchange rate) in settlement of all claims under the joint venture agreements of which $29.3 million has been received. The Communications Group is now developing e-commerce business opportunities in China.
During 1999 the Company continued to focus its growth strategy on opportunities in communications businesses. The convergence of cable television and telephony, and the relationship of each business to Internet access, provides the Company with new opportunities.
At December 31, 1999, the Communications Group owned interests in and participated with partners in the management of joint ventures that had 55 operational systems, consisting of 12 cable television systems, 3 GSM wireless telephone systems (the Communications Group's interest in one of which is in the process of being sold), 2 analog wireless telephone systems, 7 fixed and other telephony networks (which include local, international and long distance telephony providers and satellite-based telephony
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) and wireless local loop operators), 17 radio broadcasting stations, 12 paging systems and 2 other telephony-related businesses.
SNAPPER
Snapper manufacturers Snapper-Registered Trademark- brand premium-priced power lawnmowers, lawn tractors, garden tillers, snow throwers and related parts and accessories. The lawnmowers include rear engine riding mowers, front engine riding mowers or lawn tractors, and self-propelled and push-type walk-behind mowers. Snapper also manufactures a line of commercial lawn and turf equipment under the Snapper-Registered Trademark- brand. Snapper provides lawn and garden products through distribution channels to domestic and foreign retail markets.
A large percentage of the residential and commercial sales of lawn and garden equipment are made during a 17-week period from early spring to mid-summer. Although some sales are made to dealers and distributors prior to and subsequent to this period, the largest volume of sales to the ultimate consumer is made during this time. The majority of revenues during the late fall and winter periods are related to snow thrower shipments.
LIQUIDITY
MMG is a holding company and, accordingly, does not generate cash flows from operations. In connection with the acquisition of PLD Telekom, the Company issued 10 1/2% senior discount notes. The Communications Group is dependent on MMG for significant capital infusions to fund its operations, its commitments to make capital contributions, loans to its joint ventures and subsidiaries and any acquisitions. Such funding requirements are based on the anticipated funding needs of its joint ventures and subsidiaries and certain acquisitions by the Company. The ability to meet the future capital requirements of the Communications Group, including future acquisitions, will depend on available funding from the Company, or alternative sources of financing, and on the ability of the Communications Group's joint ventures and subsidiaries to generate positive cash flows. In addition, Snapper is restricted under covenants contained in its credit agreement from making dividend payments or advances to MMG.
In the near-term, the Company intends to satisfy its working capital requirements and capital commitments with available cash on hand and other alternative sources of funds, including receipt of funds from Metromedia China. However, the Communications Group's businesses are capital intensive and require the investment of significant amounts of capital in order to construct and develop operational systems and market services. In addition, the Company will be required to pay interest on the 10 1/2% senior discount notes commencing September 30, 2002. As a result, the Company will likely require additional financing in order to satisfy its on-going working capital, debt service, acquisition and expansion requirements and to achieve its long-term business strategies. Such additional capital may be provided through the public or private sale of equity or debt securities of the Company or by separate equity or debt financings by the Communications Group or companies of the Communications Group. The indenture for the Senior Notes described below permits the Company to finance the development of its communications operations. No assurance can be given that additional financing will be available to the Company on acceptable terms, if at all. If adequate additional funds are not available, the
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Company may be required to curtail significantly its long-term business objectives and the Company's results from operations may be materially and adversely affected.
Management believes that its long-term liquidity needs (including debt service) will be satisfied through a combination of the Company's successful implementation and execution of its growth strategy to become a global communications and media company and through the Communications Group's joint ventures and subsidiaries achieving positive operating results and cash flows through revenue and subscriber growth and control of operating expenses.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash equivalents consists of highly liquid instruments with maturities of three months or less at the time of purchase.
INVESTMENTS
EQUITY METHOD INVESTMENTS
Investments in other companies and joint ventures which are not majority owned, or which the Company does not control but in which it exercises significant influence, are accounted for using the equity method. The Company reflects its net investments in joint ventures under the caption "Investments in and advances to joint ventures". Generally, under the equity method of accounting, original investments are recorded at cost and are adjusted by the Company's share of undistributed earnings or losses of the joint venture. Equity in the losses of the joint ventures are recognized according to the percentage ownership in each joint venture until the Company's joint venture partner's contributed capital has been fully depleted. Subsequently, the Company recognizes the full amount of losses generated by the joint venture if it is the principal funding source for the joint venture. A loss in value of an investment, which is deemed to be other than a temporary decline, is recognized as a charge to income and included in equity in losses of unconsolidated subsidiaries on the statement of operations.
DEBT AND EQUITY SECURITY INVESTMENTS
The Company classifies its investments in debt and equity securities in one of three categories: trading, available-for-sale, or held-to-maturity. Trading securities are bought and held principally for the purpose of selling them in the near term. Held-to-maturity securities are those securities in which the Company has the ability and intent to hold the securities until maturity. All other securities not classified as trading or held-to-maturity are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported in stockholders' equity. The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Realized gains and losses, and declines in value judged to be other-than-temporary on available-for-sale securities, are included in investment income. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in investment income.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Management determines the appropriate classification of investments as trading, held-to-maturity or available-for-sale at the time of purchase and reevaluates such designation as of each balance sheet date. At December 31, 1999 and 1998, the Company did not have any debt and equity security investments.
INVENTORIES
Lawn and garden equipment, pager, telephony and cable inventories are stated at the lower of cost or market. Lawn and garden equipment inventories are valued utilizing the last-in, first-out (LIFO) method. Pager, telephony and cable inventories are calculated on the weighted-average method.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are recorded at cost and are depreciated over their expected useful lives which range from 3 to 40 years. Generally, depreciation is provided on the straight-line method for financial reporting purposes. Leasehold improvements are amortized using the straight-line method over the life of the improvements or the life of the lease, whichever is shorter.
INTANGIBLE ASSETS
Intangible assets are stated at historical cost, net of accumulated amortization. Intangibles such as broadcasting licenses, frequency rights, customer lists and workforce in place are amortized over periods of four to ten years using the straight-line method. Goodwill has been recognized for the excess of the purchase price over the value of the identifiable net assets acquired. Such amount is amortized over periods of 10 (Communications Group) and 25 (Snapper) years using the straight-line method.
Management continuously monitors and evaluates the realizability of recorded intangibles to determine whether their carrying values have been impaired. In evaluating the value and future benefits of intangible assets, their carrying amount is compared to management's best estimate of undiscounted future cash flows over the remaining amortization period. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. The Company believes that the carrying value of recorded intangibles is not impaired at December 31, 1999 (see notes 3 and 4).
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets and certain identifiable intangibles are reviewed by the Company for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount to undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) REVENUE RECOGNITION
COMMUNICATIONS GROUP
The Communications Group and its joint ventures' and subsidiaries' cable, paging and telephony operations recognize revenues in the period the service is provided. Installation fees are recognized as revenues upon subscriber hook-up to the extent installation costs are incurred. Installation fees in excess of installation costs are deferred and recognized over the length of the related individual contract. The Communications Group and its joint ventures' and subsidiaries' radio operations recognize advertising revenue when commercials are broadcast.
SNAPPER
Sales of finished equipment are recognized when the products are shipped to dealers. Sales of parts are recognized when the products are shipped to distributors or dealers. A provision for estimated warranty costs is recorded at the time of sale and periodically adjusted to reflect actual experience.
BARTER TRANSACTIONS
In connection with its radio broadcasting businesses, the Company trades commercial air time for goods and services used principally for promotional, sales and other business activities. An asset and a liability are recorded at the fair market value of the goods or services received. Barter revenue is recorded and the liability is relieved when commercials are broadcast, and barter expense is recorded and the assets are relieved when the goods or services are received or used.
RESEARCH AND DEVELOPMENT AND ADVERTISING COSTS
Research and development and advertising costs are expensed as incurred.
SELF-INSURANCE
The Company is self-insured for workers' compensation, health, automobile, product and general liability costs for its lawn and garden operation and for certain former subsidiaries. The self-insurance claim liability is determined based on claims filed and an estimate of claims incurred but not yet reported.
MINORITY INTERESTS
Recognition of minority interests' share of losses of consolidated subsidiaries is limited to the amount of such minority interests' allocable portion of the common equity of those consolidated subsidiaries.
INCOME TAXES
The Company accounts for deferred income taxes using the asset and liability method of accounting. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Deferred tax assets and liabilities
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) are measured using rates expected to be in effect when those assets and liabilities are recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
STOCK OPTION PLANS
The Company accounts for its stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. The Company discloses the pro forma effect on net income (loss) and earnings per share as required by Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation," recognizing as expense over the vesting period the fair value of all stock-based awards on the date of grant.
PENSION AND OTHER POSTRETIREMENT PLANS
Snapper has a defined benefit pension plan covering substantially all of its collective bargaining unit employees. The benefits are based on years of service multiplied by a fixed dollar amount and the employee's compensation during the five years before retirement. The cost of this program is funded currently.
Snapper also sponsors a defined benefit health care plan for substantially all of its retirees and employees. Snapper measures the costs of its obligation based on its best estimate. The net periodic costs are recognized as employees render the services necessary to earn postretirement benefits.
FOREIGN CURRENCY TRANSLATION
The statutory accounts of the Company's consolidated foreign subsidiaries and joint ventures are maintained in accordance with local accounting regulations and are stated in local currencies. Local statements are translated into U.S. generally accepted accounting principles and U.S. dollars in accordance with Statement of Financial Accounting Standards No. 52 ("SFAS 52"), "Accounting for Foreign Currency Translation."
Under SFAS 52, foreign currency assets and liabilities are generally translated using the exchange rates in effect at the balance sheet date. Results of operations are generally translated using the average exchange rates prevailing throughout the year. The effects of exchange rate fluctuations on translating foreign currency assets and liabilities into U.S. dollars are accumulated as part of the foreign currency translation adjustment in stockholders' equity. Gains and losses from foreign currency transactions are included in net income in the period in which they occur. Translation differences resulting from the effect of exchange rate changes on cash and cash equivalents were immaterial and are not reflected in the Company's consolidated statements of cash flows for each of the periods presented.
Under SFAS 52, the financial statements of foreign entities in highly inflationary economies are remeasured, in all cases using the U.S. dollar as the functional currency. U.S. dollar transactions are shown at their historical value. Monetary assets and liabilities denominated in local currencies are translated into U.S. dollars at the prevailing period-end exchange rate. All other assets and liabilities are translated at historical exchange rates. Results of operations are translated using the monthly
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) average exchange rates. Transaction differences resulting from the use of these different rates are included in the accompanying consolidated statements of operations as foreign currency loss.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company is required to disclose fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on settlements using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including discount rates and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are excluded from the disclosure requirements. Accordingly, the aggregate fair value amounts presented do not necessarily represent the underlying value to the Company.
The following methods and assumptions were used in estimating the fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS, SHORT-TERM INVESTMENTS, RECEIVABLES, AND ACCOUNTS PAYABLE
The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, short-term investments, current receivables and accounts payable approximate fair values.
DEBT AND EQUITY SECURITY INVESTMENTS
For debt and equity security investments, fair values are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities or dealer quotes.
LONG-TERM DEBT
For long-term debt, fair values are based on quoted market prices, if available. If the debt is not traded, fair value is estimated based on the present value of expected cash flows. See note 5 for the fair values of long-term debt.
EARNINGS PER SHARE OF COMMON STOCK
Basic earnings per share excludes all dilutive securities. It is based upon the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that would occur if securities to issue common stock were exercised or converted into common stock. In calculating diluted earnings per share, no potential shares of common stock are included in the computation when a loss from continuing operations available to common stockholders exists. For the years ended December 31, 1999, 1998, and 1997 the Company had losses from continuing operations.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. BASIS OF PRESENTATION, DESCRIPTION OF THE BUSINESS, LIQUIDITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The computation of basic earnings per share for loss from continuing operations attributable to common stockholders for the years ended December 31, 1999, 1998 and 1997 includes the Company's preferred stock dividend requirement.
The Company had for the years ended December 31, 1999, 1998 and 1997, potentially dilutive shares of common stock of 22,717,000, 19,003,000 and 19,673,000, respectively (see note 9).
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of the contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates are used when accounting for the allowance for doubtful accounts, inventory obsolescence, long-lived assets, intangible assets, product warranty expenses, self-insured workers' compensation and product liability claims, depreciation and amortization, employee benefit plans, income taxes and contingencies, among others. The Company reviews all significant estimates affecting its consolidated financial statements on a recurring basis and records the effect of any necessary adjustment prior to their publication. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of financial statements; accordingly, it is possible that actual results could differ from those estimates and changes to estimates could occur in the near term.
2. ACQUISITION OF PLD TELEKOM INC.
On September 30, 1999, the Company consummated the acquisition of PLD Telekom pursuant to which a wholly owned subsidiary of the Company was merged with and into PLD Telekom, with PLD Telekom as the surviving corporation. Following the consummation of the merger, PLD Telekom became a wholly owned subsidiary of the Company.
PLD Telekom is a provider of local, long distance and international telecommunications services in the republics of the former Soviet Union. Its five principal business units are: PeterStar, which provides integrated local, long distance and international telecommunications in St. Petersburg through a fully digital fiber optic network; Teleport-TP, which provides international telecommunications services from Moscow and operates a pan-Russian satellite-based long distance network; Baltic Communications Limited, which provides dedicated international telecommunications services in St. Petersburg; ALTEL, which is a provider of wireless service in Kazakhstan; and BELCEL, which provides national wireless service in Belarus.
Holders of PLD Telekom common stock received .6353 shares of the Company's common stock for each share of PLD Telekom common stock in accordance with a formula set forth in the agreement and plan of merger. Pursuant to the agreement and plan of merger, the Company issued 24,107,449 shares of its common stock valued at $4.3125 per share.
In the agreement and plan of merger, the Company agreed to increase the size of its board of directors in connection with the consummation of the merger from 9 members to 11 members and to cause the designation of two persons as directors specified by PLD Telekom, one of whom will be nominated by
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITION OF PLD TELEKOM INC. (CONTINUED) News America Incorporated ("News"), which was a 38% shareholder of PLD Telekom prior to the consummation of the merger and, following the merger is a 9.8% shareholder of the Company.
In connection with the merger, holders of all of PLD Telekom's 14% Senior Discount Notes due 2004 ($123.0 million in aggregate principal amount) and of $25.0 million in aggregate principal amount of its 9.0% Convertible Subordinated Notes due 2006 (together, the "PLD Notes") exchanged their PLD Notes and all accrued but unpaid interest on these notes through the date of the merger for $210.6 million in aggregate principal amount at maturity of 10 1/2% Senior Discount Notes due 2007 from the Company. At September 30, 1999, the carrying value of these 10 1/2% Senior Discount Notes due 2007 was $163.0 million. The Company also purchased $1.5 million in aggregate principal amount of PLD Telekom's 9.0% Convertible Subordinated Notes at a purchase price of 101% of the principal amount of such notes plus accrued but unpaid interest on such notes through the date of the merger.
Also at completion of the merger, PLD Telekom repaid The Travelers Insurance Company and The Travelers Indemnity Company (together, "Travelers") approximately $8.7 million of amounts due under the revolving credit and warrant agreement dated November 26, 1997 between PLD Telekom and Travelers (the "Old Travelers Agreement"). PLD Telekom and Travelers also entered into an amended and restated revolving credit note agreement (the "New Travelers Agreement") pursuant to which PLD Telekom has agreed to repay Travelers the remaining $4.9 million due under the Old Travelers Agreement on August 30, 2000 (see note 5). In addition, Travelers received at the closing of the merger 100,000 shares of PLD Telekom common stock (which were converted in the merger into shares of common stock of the Company at the .6353 exchange ratio) and 10-year warrants to purchase 700,000 shares of common stock of the Company at an exercise price to be determined in December 2000 that will be between $10.00 and $15.00 per share. However, if the amount outstanding under the New Travelers Agreement has not been fully repaid by August 30, 2000, the exercise price of the warrants will be reset to $.01 per share. Travelers retained its existing security interests in certain of PLD Telekom's assets. The performance by PLD Telekom of its obligations under the New Travelers Agreement is guaranteed by the Company and certain subsidiaries of PLD Telekom.
Also in connection with the consummation of the merger, PLD Telekom repaid approximately $6.9 million of outstanding loans and interest under a revolving credit agreement to News.
PLD Telekom also purchased the remaining shares of its subsidiary, Technocom Limited, that it did not already own from Technocom's existing minority shareholders for an aggregate purchase price of approximately $12.6 million. Technocom is now a wholly owned subsidiary of PLD Telekom.
PLD Telekom used funds held in a cash collateral account, working capital and borrowings from the Company under a revolving intercompany note to make all the payments described above.
The Company has determined that the purchase price for PLD Telekom was $305.8 million. The purchase price of $305.8 million includes the issuance of common stock, the value of existing PLD Telekom options and warrants exchanged, warrants issued to Travelers, funds advanced to PLD Telekom that were utilized in the repayment of the News credit agreement and related interest, the purchase of Technocom's minority interests, partial repayment of the Travelers debt, payment for the PLD Telekom preferred stock and working capital, issuance of 10 1/2% senior discount notes and transaction costs. The acquisition has been accounted for under the purchase method of accounting. The purchase price has been allocated based on estimated fair values at the date of acquisition. This allocation has resulted in intangible assets and goodwill of $96.3 million and $80.3 million, respectively,
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITION OF PLD TELEKOM INC. (CONTINUED) which are being amortized on a straight-line basis over four to ten years and ten years, respectively. In addition, approximately $1.0 million in severance and lease termination costs have been recorded in purchase accounting. The results of operations of PLD Telekom are included in the consolidated financial statements from September 30, 1999.
The allocation of the purchase price is as follows (in thousands):
The following unaudited pro forma information illustrates the effect of the acquisition of PLD Telekom on revenue, loss from continuing operations and loss per share from continuing operations attributable to common stockholders for the years ended December 31, 1999 and 1998, and assumes that the acquisition of PLD Telekom occurred at the beginning of each period presented (in thousands, except per share amounts) (unaudited):
These unaudited pro forma results have been prepared for comparative purposes only and include certain adjustments, such as additional amortization expense as a result of goodwill and increased interest expense on acquisition debt. They do not purport to be indicative of the results of operations that actually would have resulted had the acquisition occurred at the beginning of each period, or of future results of operations of the consolidated entity.
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION
GENERAL
The Communications Group records its investments in other companies and joint ventures which are less than majority-owned, or which the Company does not control but in which it exercises significant
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED) influence, at cost, net of its equity in earnings or losses. Advances to the joint ventures under the line of credit agreements between the Company or one of its subsidiaries and the joint ventures are reflected based on amounts recoverable under the credit agreement, plus accrued interest.
Advances are made to joint ventures and subsidiaries in the form of cash, for working capital purposes, payment of expenses or capital expenditures, or in the form of equipment purchased on behalf of the joint ventures. Interest rates charged to the joint ventures and subsidiaries range from prime rate to prime rate plus 6%. The credit agreements generally provide for the payment of principal and interest from 90% of the joint ventures' and subsidiaries' available cash flow, as defined, prior to any substantial distributions of dividends to the joint venture partners. The Communications Group has entered into charter fund and credit agreements with its joint ventures and subsidiaries to provide up to $234.0 million in funding of which $48.5 million in funding obligations remain at December 31, 1999. The Communications Group's funding commitments are contingent on its approval of the joint ventures' and subsidiaries' business plans.
1999 RESTRUCTURING AND IMPAIRMENT CHARGES
Shortly after completing its September 30, 1999 acquisition of PLD Telekom, the Company began identifying synergies and redundancies between Metromedia International Telecommunications, Inc. and PLD Telekom. The Company's efforts were directed toward streamlining its operations. Following the review of its operations, the Communications Group determined to make significant reductions in its projected overhead costs for 2000 by closing its offices in Stamford, Connecticut and London, England, consolidating its executive offices in New York, New York, consolidating its operational headquarters in Vienna, Austria and by consolidating its two Moscow offices into one. As part of this streamlining of its operations, the Company announced an employee headcount reduction. Employees impacted by the restructuring were notified in December 1999 and in almost all cases were terminated effective December 31, 1999. Employees received a detailed description of their separation package which was generally based on length of service. The total number of U.S. domestic and expatriate employees separated was approximately 60. In addition, there were reductions in locally hired staff. In 1999 the Company recorded a charge of $8.4 million in connection with the restructuring.
Concurrent with the review of its existing operations and the change in management as the result of the acquisition of PLD Telekom, the Communications Group completed a strategic review of its telephony, cable television, radio broadcasting and paging assets. The results of the Communications Group's strategic review was as follows:
- Continue to pursue a convergence strategy to develop delivery for voice and data services over its existing cable and telephony infrastructure
- Geographically focus the Communications Group's efforts on several key countries where the Communications Group already has a significant presence, including Russia, Georgia, Romania, Latvia and Kazakhstan
- Work towards obtaining consolidatable positions in certain of the Communications Group's principal assets
- Develop Internet capability in the Communications Group's existing businesses and explore expansion of Internet-related businesses in Central and Eastern Europe
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED) - Develop e-commerce business opportunities in China
- Leverage the Communications Group's existing radio brands in their markets, with a view to using them in developing its other businesses, including the development of Internet-based businesses
- Continue to focus on cost control and reduction in corporate overhead costs
As a result of the Company's strategic review, the Company determined that certain businesses (including pre-operational businesses) in its portfolio did not meet certain of its objectives of its strategic review, such as the ability to obtain control of the venture, geographic focus or convergence. The long lived assets or the investments in these business were evaluated to determine whether any impairment in their recoverability existed at the determination date. As a result, the Company assessed whether the estimated cash flows of the businesses over the estimated lives of the related assets were sufficient to recover their costs. Where such cash flows were insufficient, the Company utilized a discounted cash flow model to estimate the fair value of assets or investments and recorded an impairment charge to adjust the carrying values to estimated fair value. As a result of this evaluation, the Company recorded a non-cash impairment charge on certain of its paging, cable television and telephony businesses of $23.2 million.
For those equity method investments whose fair value is equal to zero, the Company will no longer record its proportionate share of any future net losses of these investees, unless the Company provides future funding. The Communications Group will continue to manage its paging businesses to levels not requiring significant additional funding and is developing a strategy to maximize the value of its paging investments. In 2000, it is expected that the paging operations will continue to generate losses.
1998 IMPAIRMENT CHARGES
In 1998, the Communications Group's paging business continued to incur operating losses. Accordingly, the Communications Group developed a revised operating plan to stabilize its paging operations. Under the revised plan, the Communications Group is managing its paging business to a level that should not require significant additional funding for its operations. As a result of the revised plan, in 1998 the Company took a non-cash, nonrecurring charge on its paging assets of $49.9 million, which included a $35.9 million write off of goodwill and other intangibles. The non-cash, nonrecurring charge adjusted the carrying value of goodwill and other intangibles, fixed assets and investments in and advances to joint ventures and wrote down inventory. The write down relates to both consolidated joint ventures and joint ventures recorded under the equity method. The Company has adjusted its investments in certain paging operations which are recorded under the equity method to zero, and unless it provides future funding will no longer record its proportionate share of any future net losses of these investees.
In addition, in 1998, pager inventory of $1.5 million, and $2.7 million of material relating to a promotional campaign in Romania, were written off which is included in the cost of sales in the Company's consolidated results of operations.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED) The following table displays a rollforward of the activity and balances of the restructuring reserve account from inception to December 31, 1999 (in thousands):
The following table displays the components of the asset impairment charges recorded by the Company in the years ended December 31, 1999 and 1998 (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED)
EQUITY METHOD INVESTMENT INFORMATION
At December 31, 1999 and 1998, the Communications Group's unconsolidated investments in and advances to joint ventures in Eastern Europe and the republics of the former Soviet Union, at cost, net of adjustments for its equity in earnings or losses, impairment charges and distributions were as follows (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED)
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(1) Indicates year operations commenced, or in the case of acquired operational entities, the year of acquisition.
(2) In August 1998, the Communications Group increased its ownership in Baltcom GSM from 21% to 22% and in Magticom from 34% to 35%.
(3) At December 31, 1999, the results of Baltcom GSM were taken off the three-month lag, therefore the results and related equity in loss of the investment include 15 months of operations. The additional three months of equity pickup relating to Baltcom GSM is immaterial to the results of operations of the Company in 1999.
(4) Investment balance reflects write down of investment.
(5) At December 31, 1998, Tyumenruskom and Caspian American Telecom were classified as pre-operational.
(6) In April 1999, Caspian American Telecom became operational; however, its operational results are reported on a three-month lag. In May 1999, the Communications Group sold 2.2% of its shares of Omni-Metromedia, thereby reducing its ownership interest in Caspian American Telecom to 37%.
(7) The Company's purchase of Mobile Telecom closed during June 1998. The Company purchased its 50% interest in Mobile Telecom for $7.0 million plus two additional earnout payments to be made in 2000 and 2001. Each of the two earnout payments is to be equal to $2.5 million, adjusted up or down based upon performance in 1999 and 2000, respectively, as compared to certain financial targets. The Company does not believe that any payment will be due with respect to 1999. Simultaneously with the purchase of Mobile Telecom, the Company purchased 50% of a related pager distribution company for $500,000. Approximately $7.0 million of the purchase price was allocated to goodwill.
(8) At December 31, 1999 and December 31, 1998, amounts disbursed for proposed joint ventures, pre-operational joint ventures and amounts expended for equipment for future wireless local loop projects are included in pre-operational joint ventures.
(9) Included in the Company's consolidated financial statements in the current period.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED) Summarized combined balance sheet financial information of unconsolidated joint ventures as of September 30, 1999 and 1998 and combined statement of operations financial information for the years ended September 30, 1999, 1998 and 1997 accounted for under the equity method that have commenced operations as of the dates indicated are as follows (in thousands):
COMBINED INFORMATION OF UNCONSOLIDATED JOINT VENTURES
COMBINED BALANCE SHEETS
COMBINED STATEMENTS OF OPERATIONS
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED) For the years ended December 31, 1999, 1998 and 1997 the results of operations presented above are before the elimination of intercompany interest. Financial information for joint ventures which are not yet operational is not included in the above summary.
The following tables represent summary financial information for the Company's operating unconsolidated joint ventures being grouped as indicated as of and for the years ended December 31, 1999, 1998 and 1997. For the years ended December 31, 1999, 1998 and 1997 the results of operations presented below are before the elimination of intercompany interest (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. COMMUNICATIONS GROUP--EASTERN EUROPE AND THE REPUBLICS OF THE FORMER SOVIET UNION (CONTINUED)
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(1) Includes the results of Protocall Ventures, the Communications Group's trunked mobile radio operations, consolidated and unconsolidated joint ventures and subsidiaries through the six months ended June 30, 1998 and the results of Spectrum through the year ended December 31, 1998.
In August 1998, the Communications Group formed a venture to acquire a 76% interest in Omni-Metromedia Caspian, Ltd., a company that owns 50% of a joint venture in Azerbaijan, Caspian American Telecommunications, LLC. Caspian American has been licensed by the Ministry of Communications of Azerbaijan to provide high speed wireless local loop services and digital switching throughout Azerbaijan. Omni-Metromedia has committed to provide up to $40.5 million in loans to Caspian American for the funding of equipment acquisition and operational expenses subject to concurrence with the Caspian American business plans. At December 31, 1999, $27.3 million of commitments remain available to Caspian American subject to concurrence with the Caspian American business plan.
During the fourth quarter of 1999, the Company determined that there was a decline in value of its investment in Caspian American that was other than temporary and has recorded the decline of $9.9 million as an impairment charge.
In July 1998 the Communications Group sold its share of Protocall Ventures Limited. As part of the transaction, Protocall Ventures repaid the outstanding amount of its debt to the Communications Group. The Company recorded a gain on the sale of Protocall Ventures of approximately $7.1 million. The Company has written down the carrying value of its remaining trunked mobile radio investment at December 31, 1998. The write off of $1.6 million is offset against the gain on the sale of Protocall Ventures.
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA
In February 1997, Metromedia China, a subsidiary of the Company with telephony interests in China, acquired Asian American Telecommunications Corporation pursuant to a business combination agreement in which Metromedia China and Asian American Telecommunications agreed to combine their businesses and operations. Asian American Telecommunications is engaged in providing funding, consultation and support services to Chinese operators undertaking development and construction of communications services in China. The transaction was accounted for as a purchase, with Metromedia China as the acquiring entity.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA (CONTINUED)
As a result of the transaction Metromedia International Telecommunications owned 56.5% of Metromedia China's outstanding common stock with 79.6% voting rights. Subsequently, additional shares were purchased from a minority shareholder, increasing the ownership percentage to 58.4% with 80.4% of the voting rights.
The purchase price of the Asian American Telecommunications transaction was $86.0 million. The excess of the purchase price over the fair value of the net tangible assets acquired was $69.0 million. The difference between the Company's investment balance of $18.6 million in Metromedia China prior to the acquisition of Asian American Telecommunications and 56.5% of the net equity of Metromedia China subsequent to the acquisition of Asian American Telecommunications, was recorded as an increase to paid-in surplus of $35.1 million in the consolidated statements of stockholders' equity.
At December 31, 1999 and 1998, the Company's investments in the joint ventures in China, at cost, net of adjustments for its equity in earnings or losses and distributions, were as follows (in thousands):
Metromedia International Group and Metromedia International Telecommunications have made intercompany loans to Metromedia China under a credit agreement, and Metromedia China has used the proceeds of these loans to fund its investments in these joint ventures in China. At December 31, 1999, Metromedia China owed $63.9 million under this credit agreement (including accrued interest).
The Company's investments in telecommunications joint ventures in China were made through its majority-owned subsidiary, Asian American Telecommunications Corporation. These joint ventures supported the construction and development of telephony networks by China United Telecommunications Incorporated, a Chinese telecommunications operator known as China Unicom. Because legal restrictions in China prohibit direct foreign investment and operating participation in domestic telephone companies, the Company's joint ventures were limited to providing financing and consulting services to China Unicom under contracts. By the terms of these contracts and in return for
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA (CONTINUED) services rendered, the joint ventures were to receive payments from China Unicom based on the cash flows generated by China Unicom's network businesses. This arrangement, known as a sino-sino-foreign joint venture cooperation, was commonly accepted at the time the Company's joint ventures were formed. Since the arrangement specifically limited the joint ventures' participation in and control over China Unicom's actual business operations, Asian American Telecommunications accounted for its sino-sino-foreign joint venture investments under the equity method. The Company invested in four Chinese telecommunications joint ventures in this fashion--two in Ningbo Municipality, one in Sichuan Province and one in Chongqing City.
Beginning in mid-1998, the Chinese government unofficially began reconsidering the advisability of allowing the sino-sino-foreign joint venture cooperation arrangements undertaken by China Unicom. At that time, more than forty such cooperation contracts had been established with foreign-invested joint ventures covering China Unicom's operations in various parts of China. By mid-1999, the government reached the conclusion that China Unicom's sino-sino-foreign cooperation framework was in conflict with China's basic telecommunications regulatory policies and should henceforth cease. China Unicom was instructed to terminate or very substantially restructure all of its sino-sino-foreign joint venture cooperation contracts.
In July 1999, Ningbo Ya Mei Telecommunications, Ltd., one of the Company's two telecommunications joint ventures in Ningbo Municipality, China, received a written notice from China Unicom stating that the Chinese government had directed China Unicom to terminate further cooperation with Ningbo Ya Mei. China Unicom subsequently informed the Company that the notification also applies to the Company's other telecommunications joint venture in Ningbo Municipality. In subsequent notifications from China Unicom to the Company's joint ventures, China Unicom stated its intention to terminate all cooperation contracts with sino-sino-foreign joint ventures in China, pursuant to an August 30, 1999 mandate from the Chinese Ministry of Information Industry. In its notifications, China Unicom requested that negotiations begin regarding a suitable settlement of all matters related to the winding up of the Company's joint ventures cooperation agreements with China Unicom as a result of the Ministry of Information Industry notice. With the issuance of these notifications, China Unicom ceased further performance under its cooperation contracts with the Company's joint ventures. However, China Unicom did make distribution of amounts owed to the Company's Ningbo Ya Mei joint venture for the first half of 1999 according to the terms of the cooperation contract. The Company, through its four joint ventures, entered into negotiations with China Unicom in September 1999 to reach suitable terms for termination of the cooperation contracts.
On November 6, 1999, the Company's four Chinese joint ventures engaged in projects with China Unicom each entered into non-binding letters of intent with China Unicom which set forth certain terms for termination of their cooperation arrangements with China Unicom. On December 3, 1999, legally binding settlement contracts incorporating substantially the terms set forth in the November letters of intent were executed between China Unicom and the four joint ventures, thereby terminating the joint ventures' further cooperation with China Unicom. Under the terms of the settlement contracts, the four joint ventures will each receive cash amounts in RMB from China Unicom in full and final payment for the termination of their cooperation contracts with China Unicom. Upon receipt of this payment, China Unicom and the joint ventures will waive all of their respective relevant rights against the other party with respect to the cooperative arrangements. In addition, all assets pertinent to China Unicom's networks that are currently held by the joint ventures will be unconditionally
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA (CONTINUED) transferred to China Unicom. China Unicom effected payment to the joint ventures of the amounts prescribed in the settlement contracts on December 10, 1999. Subsequently and prior to the end of 1999, the boards of directors of the four joint ventures each passed formal resolutions to commence dissolution of the joint ventures. The Company expects such dissolution to be completed for all four joint ventures by mid-2000.
Each of the Company's China telecommunications joint ventures stopped its accounting for its share of the net distributable cash flows under the cooperation agreements with China Unicom and the amortization of the investment in the China Unicom projects effective July 1, 1999 based on the termination notices received from China Unicom.
For the period ended December 31, 1999, the four China telecommunications joint ventures have performed impairment analyses of their investments in projects with China Unicom. These analyses were based on the terms of settlement contracts the joint ventures executed with China Unicom on December 3, 1999. The joint ventures each received sufficient amounts in their settlements with China Unicom so as to recover their recorded investment balances as of December 31, 1999. Accordingly, no impairment writedowns were taken by the joint ventures during 1999.
Through December 3, 1999, the date on which settlement contracts terminated the joint ventures' further cooperation with China Unicom, the Company continued to account for its investments in its China telecommunications joint ventures under the equity method of accounting. The Company has performed an impairment analysis of its investments in and advances to joint ventures and related goodwill to determine the amount that these assets have been impaired. The Company reviewed its investment in these joint ventures for other than temporary decline and the Company has determined the related goodwill should be considered an asset to be disposed of and has estimated the fair value less costs to dispose of its investment and has stopped amortizing the balance. The Company believes that the termination of the four joint ventures' cooperation agreements with China Unicom is an event that gives rise to an accounting loss which is probable. The amount of the non-cash impairment charge is the difference between the sum of the carrying values of its investments and advances made to joint ventures plus goodwill less the Company's best estimate of total amounts it will receive from the four joint ventures through their dissolution. The Company will receive substantial portions of the China Unicom settlement payments to the joint ventures via repayment of advances and distribution of joint venture assets on dissolution. China Unicom's settlement payments to the joint ventures were made in RMB. However, the joint ventures' formation contracts and loan agreements with Asian American Telecommunications had been registered with Chinese authorities so as to assure the joint ventures' ability to convert RMB deposits into foreign exchange for payment to the Company. The Company anticipates that it will fully recover its investments in and advances to the four affected joint ventures. As of December 31, 1999, the joint ventures had conveyed to Asian American Telecommunications in the form of repayment of advances approximately $29.3 million in US Dollars from the China Unicom settlement. As of December 31, 1999, investments in and advances to these four joint ventures, exclusive of goodwill, were approximately $40.0 million.
The Company's current estimate of the total amount it will ultimately receive from the four terminated joint ventures is $90.1 million (at December 31, 1999 exchange rates) of which $29.3 million has been received. Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA (CONTINUED) ventures. However, some variance from the Company's current estimates of the amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China and exchange rate fluctuations. The Company cannot assure at this time that this variance will not be material.
The currently estimated $90.1 million in total payments from the Company's four joint ventures that had cooperated with China Unicom is insufficient to fully recover the goodwill recorded in connection with the Company's investment in these joint ventures. As a result, the Company has recorded a non-cash impairment charge of $45.7 million in 1999 for the write-off of goodwill. The remaining balance of goodwill at December 31, 1999 is $20.7 million. Further adjustments may be required after receipt of final distributions from the four terminated joint ventures.
HUAXIA JV
On May 7, 1999, Asian American Telecommunications entered into a joint venture agreement with All Warehouse Commodity Electronic Commerce Information Development Co., Ltd., a Chinese trading company, for the purpose of establishing Huaxia Metromedia Information Technology Co., Ltd., known as Huaxia JV. Also on May 7, 1999, Huaxia JV entered into a computer information system and services contract with All Warehouse and its parent company, China Product Firm Corporation. The Huaxia JV will develop and operate electronic commerce computer information systems for use by All Warehouse and China Product Firm and its affiliates and customers. The contract has a term of thirty years and grants Huaxia JV exclusive rights to manage all of All Warehouse and China Product Firm's electronic trading systems during that period.
The total amount to be invested in Huaxia JV is $25.0 million with registered capital contributions from its shareholders amounting to $10.0 million. Asian American Telecommunications will make registered capital contributions of $4.9 million and All Warehouse will contribute $5.1 million. The remaining investment in Huaxia JV will be in the form of up to $15.0 million of loans from Asian American Telecommunications. As of December 31, 1999, Asian American Telecommunications has made $980,000 of its scheduled registered capital investment. Huaxia JV received its operating license on July 5, 1999 and has begun operations. Ownership in Huaxia JV is 49% by Asian American Telecommunications and 51% by All Warehouse.
Huaxia JV is established as a sino-foreign equity joint venture between Asian American Telecommunications and All Warehouse Commodity Electronic Commerce Information Development Co., Ltd. The Huaxia JV does not have any contractual relationship with China Unicom and is engaged in business fundamentally different from that of the Communications Group's joint ventures cooperating with China Unicom. Computer and software services, such as offered by the Huaxia JV, are subject to regulations different from those applied to telecommunications in China. The Communications Group believes that the fee-for-services arrangement of Huaxia JV and the lines of business undertaken by the joint venture do not constitute foreign involvement in telecommunications activities, which are at the center of Chinese authorities' actions against the Communication Group's joint telecommunications projects with China Unicom.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA (CONTINUED) The following tables represent summary financial information for the joint ventures and their related projects in China as of and for the years ended December 31, 1999, 1998, and 1997 respectively, (in thousands):
For the years ended December 31, 1999, 1998 and 1997 the results of operations presented above are before the elimination of intercompany interest.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES--CHINA (CONTINUED) GOLDEN CELLULAR JV
In 1998, the Company dissolved Beijing Metromedia-Jinfeng Communications Technology Development Co. Ltd., a joint venture created in March 1996 with Golden Cellular Communication Co., Ltd. for the purpose of developing, manufacturing, assembling and servicing of wireless telecommunications equipment, central telephone terminals and subscriber telephone terminals equipment and networks using Airspan Communications Corporation (an equipment manufacturer) technology in China.
Golden Cellular and Metromedia China Telephony Limited entered into a settlement contract on March 3, 1998 which provided the terms for dissolution of the Golden Cellular JV. Metromedia China Telephony reimbursed Golden Cellular $876,000 for certain development expenses incurred by Golden Cellular and assigned to Golden Cellular all of Metromedia China Telephony's rights to the assets of the Beijing Metromedia-Jinfeng, valued at approximately $720,000. Certain equipment imported to China by Metromedia China Telephony was transferred out of China. Metromedia China Telephony was responsible for the costs of shipping the equipment out of China. The Company recorded $1.5 million as the cost to dissolve the Beijing Metromedia-Jinfeng, which is included in operating expenses in the 1997 consolidated statements of operations.
5. LONG-TERM DEBT
Long-term debt at December 31, 1999 and 1998 consisted of the following (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. LONG-TERM DEBT (CONTINUED)
Aggregate annual repayments of long-term debt exclusive of capital leases and supplier financing over the next five years and thereafter are as follows (in thousands):
MMG DEBT
In connection with the acquisition of PLD Telekom, the Company issued $210.6 million in aggregate principal amount at maturity of 10 1/2% senior discount notes due 2007 (the "Senior Discount Notes") to the holders of the PLD notes pursuant to an agreement to exchange and consent, dated as of May 18, 1999, by and among the Company, PLD Telekom and such holders.
The terms of the Senior Discount Notes are set forth in an Indenture, dated as of September 30, 1999, between the Company and U.S. Bank Trust National Association as trustee. The Senior Discount Notes will mature on September 30, 2007. The Senior Discount Notes were issued at a discount to their aggregate principal amount at maturity and will accrete in value until March 30, 2002 at the rate of 10 1/2% per year, compounded semi-annually to an aggregate principal amount at maturity of $210.6 million. The Senior Discount Notes will not accrue cash interest before March 30, 2002. After this date, the Senior Discount Notes will pay interest at the rate of 10 1/2% per year, payable semi-annually in cash and in arrears to the holders of record on March 15 or September 15 immediately preceding the interest payment date on March 30 and September 30 of each year, commencing September 30, 2002. The interest on the Senior Discount Notes will be computed on the basis of a 360-day year comprised of twelve months.
The Senior Discount Notes are general senior unsecured obligations of the Company, rank senior in right of payment to all existing and future subordinated indebtedness of the Company, rank equal in right of payment to all existing and future indebtedness of the Company and will be effectively subordinated to all existing and future secured indebtedness of the Company to the extent of the assets securing such indebtedness and to all existing and future indebtedness of the Company's subsidiaries.
The Senior Discount Notes will be redeemable at the sole option of the Company on and after March 30, 2002 only at a redemption price equal to their principal amount plus accrued and unpaid interest, if any, up to but excluding the date of redemption.
Upon the occurrence of a change of control of the Company (as such term is defined in the indenture), the holders of the Senior Discount Notes will be entitled to require the Company to repurchase such holders' notes at a purchase price equal to 101% of the accreted value of the Senior Discount Notes (if such repurchase is before March 30, 2002) or 101% of the principal amount of such notes plus accrued and unpaid interest to the date of repurchase (if such repurchase is after March 30, 2002).
The indenture for the Senior Discount Notes limits the ability of the Company and certain of its subsidiaries to, among other things, incur additional indebtedness or issue capital stock or preferred
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. LONG-TERM DEBT (CONTINUED) stock, pay dividends on, or repurchase or redeem their capital stock or subordinated obligations, invest in and sell assets and subsidiary stock, engage in transactions with affiliates or incur additional liens. The Indenture for the Senior Discount Notes also limits the ability of the Company to engage in consolidations, mergers and transfers of substantially all of its assets and contains limitations and restrictions on distributions from its subsidiaries.
The Company registered a new series of senior notes under the Securities Act of 1933, as amended, and has exchanged all of its outstanding Senior Discount Notes for such new series of senior notes which have been registered.
At December 31, 1999 the fair value of the Senior Discount Notes approximates carrying value.
In connection with the entertainment group sale in 1997 (see note 6), the Company repaid all of its then outstanding debentures. During August 1997 the Company repaid its 9 1/2% subordinated debentures, 10% subordinated debentures and 6 1/2% convertible subordinated debentures. In connection with the repayment of its outstanding debentures, the Company expensed certain unamortized discounts associated with the debentures and recognized an extraordinary loss of $13.6 million on the extinguishment of the debt.
SNAPPER
On November 11, 1998, Snapper entered into a Loan and Security Agreement with Fleet Capital Corporation, as agent and as the initial lender, pursuant to which the lenders agreed to provide Snapper with a $5.0 million term loan facility and a $55.0 million revolving credit facility, the proceeds of which were used to refinance Snapper's obligations under an old Snapper credit agreement and for working capital purposes. The Snapper loan will mature in November 2003 (subject to automatic one year renewals) and is guaranteed by the Company up to $10.0 million (increasing to $15.0 million on the occurrence of specified events).
Interest under the Snapper loan agreement is payable at the Company's option at a rate equal to either (i) the prime rate plus .25% (from November 11, 1998 through March 31, 2000) and the prime rate plus .25% or .5% (from April 1, 2000 to the Snapper Loan agreement termination date) depending on meeting certain leverage ratios or (ii) the London interbank offered or LIBOR rate (as defined in the Snapper Loan agreement) plus 3.0% (from November 11, 1998 through March 31, 2000) and LIBOR plus 2.50%, 2.75%, 3.00%, 3.25%, (from April 1, 2000 to the Snapper loan agreement termination date) depending on meeting certain leverage ratios. The Snapper loan agreement contains customary covenants, including delivery of certain monthly, quarterly, and annual financial information; delivery of budgets and other information related to Snapper; limitations on Snapper's ability to (i) sell, transfer, lease (including sale-leaseback), or otherwise dispose of all or any portion of its assets or merge with any person; (ii) acquire an equity interest in another business; (iii) enter into any contracts, leases, sales, or other transactions with any division or an affiliate of the Company, without the prior written consent of Fleet; (iv) declare or pay any dividends or make any distributions upon any of its stock or directly or indirectly apply any of its assets to the redemption, retirement, purchase or other acquisition of its stock; (v) make any payments to the Company on a subordinated promissory note issued by Snapper to the Company; (vi) make capital expenditures that exceed $5.0 million in any fiscal year or exceed $2.0 million financed for longer than three years in any fiscal year; and (vii) make loans, issue additional indebtedness, or make any guarantees. In addition, Snapper is required to maintain at all
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. LONG-TERM DEBT (CONTINUED) times as of the last day of each month a specified net worth, as well as a quarterly specified fixed charge coverage ratio. The Snapper loan agreement is secured by a continuing security interest on all of Snapper's assets and properties.
At March 31, 1999, Snapper was not in compliance with all financial covenants under its loan and security agreement. On May 14, 1999, the lenders under the loan and security agreement waived any event of default arising from such noncompliance. At September 30, 1999, Snapper was not in compliance with all financial covenants under its loan and security agreement; the lenders waived any event of default arising from such noncompliance. At December 31, 1999, Snapper was in compliance with all bank covenants under the loan and security agreement.
On November 26, 1996, Snapper had entered into a credit agreement with AmSouth Bank of Alabama, pursuant to which AmSouth agreed to make available to Snapper a revolving line of credit up to $55.0 million, upon the terms and subject to conditions contained in such Snapper credit agreement for a period ending on January 1, 1999. This Snapper revolver was guaranteed by the Company, and was repaid on November 11, 1998.
It is assumed that the carrying value of Snapper's bank debt approximates its face value because it is a floating rate instrument.
In addition, Snapper has industrial development bonds with certain municipalities. One industrial development bond matured in 1999, and the remaining industrial development bond matures in 2001. Interest rates range from 62% to 75% of the prime rate.
COMMUNICATIONS GROUP
In connection with the acquisition of PLD Telekom, PLD Telekom entered into an amended and restated revolving credit note agreement with Travelers. PLD Telekom agreed to repay Travelers $4.9 million under the Old Travelers Agreement on August 30, 2000. The interest rate is 10 1/2%. Travelers retained its existing security interests in certain of PLD Telekom's assets. The performance by PLD Telekom of its obligations under the New Travelers Agreement is guaranteed by the Company and certain subsidiaries of PLD Telekom.
At December 31, 1999 the fair value of the debt with Travelers approximates carrying value.
6. THE ENTERTAINMENT GROUP SALE
On July 10, 1997, the Company sold the stock of Orion Pictures Corporation, including substantially all of the assets of its entertainment group, consisting of Orion, Goldwyn Entertainment Company and Motion Picture Corporation of America (and their respective subsidiaries) which included a feature film and television library of over 2,200 titles, to P&F Acquisition Corp., the parent company of Metro-Goldwyn-Mayer Inc. for a gross consideration of $573.0 million of which $296.4 million of the proceeds from the entertainment group sale was used to repay amounts outstanding under the entertainment group's credit facilities and certain other indebtedness of the entertainment group.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. THE ENTERTAINMENT GROUP SALE (CONTINUED) The net gain on sale reflected in the consolidated statement of operations for the year ended December 31, 1997 is as follows (in thousands):
The entertainment group's revenues for the period January 1, 1997 to May 2, 1997 were $41.7 million. The entertainment group's loss from operations for the period January 1, 1997 to May 2, 1997 was $32.2 million and included an income tax benefit of $3.2 million.
The Company became involved in litigation concerning the sale of the Entertainment Group on July 10, 1997. On June 30, 1997, the plaintiffs in SIDNEY H. SAPSOWITZ AND SID SAPSOWITZ & ASSOCIATES, INC. V. JOHN W. KLUGE, STUART SUBOTNICK, METROMEDIA INTERNATIONAL GROUP, INC., ORION PICTURES CORPORATION, LEONARD WHITE, ET AL. filed a lawsuit in Superior Court in the State of California alleging $28.7 million in damages from the alleged breach of an oral agreement to pay a finder's fee in connection with the Entertainment Group Sale. On September 23, 1999, the jury in this litigation returned a verdict of $4.5 million in compensatory damages and $3.4 million in other damages against the Company. Before the conclusion of the proceedings relating to punitive damages, the Company agreed to a settlement with the plaintiffs. Under the terms of the settlement, the Company paid $5.0 million to the plaintiffs on September 30, 1999 and is obligated to pay an additional $5.0 million on September 30, 2000 included in accrued expenses and an additional $4.0 million on September 30, 2001 included in other long-term liabilities. The settlement fully resolves all litigation among the Company and the other parties in this litigation. The future settlement payments are secured by a collateralized letter of credit of $9.0 million. For the year ended December 31, 1999, the Company has recorded a $12.8 million charge, which represents the net present value of the payments to be made, against discontinued operations in its results of operations, as a result of this settlement.
For the year ended December 31, 1998, included in discontinued operations is $8.7 million which represents a refund of tax payments made by the entertainment group in prior years.
7. SALE OF LANDMARK THEATRE GROUP
On April 16, 1998, the Company sold to Silver Cinemas, Inc. all of the assets of the Landmark Theatre Group, except cash, for an aggregate cash purchase price of approximately $62.5 million and the assumption of certain Landmark liabilities. The Landmark sale has been recorded as a discontinuance of a business segment in the accompanying consolidated financial statements.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. SALE OF LANDMARK THEATRE GROUP (CONTINUED) The gain on the Landmark sale reflected in the consolidated statements of operations is as follows (in thousands):
Landmark's revenues and income (loss) from operations for the period January 1, 1997 to November 12, 1997 were $48.7 million and ($108,000), respectively. Income (loss) from operations for the period January 1, 1997 to November 12, 1997 includes income taxes of $408,000.
8. INVESTMENT IN RDM
The Company owns approximately 39% of the outstanding common stock of RDM Sports Group, Inc. In August 1997, RDM and certain of its affiliates filed a voluntary bankruptcy petition under chapter 11 of the Bankruptcy Code. The chapter 11 trustee is in the process of selling all of RDM's assets to satisfy RDM's obligations to its creditors and the Company believes that it is unlikely that it will recover any distribution on account of its equity interest in RDM. The Company also holds certain claims in the RDM proceedings, although there can be no assurance that the Company will receive any distributions with respect to such claims.
In 1997 in connection with its investment in RDM, the Company recorded in its results of operations a reduction in its carrying value and its share of its losses of RDM of $46.1 million.
On August 19, 1998, a purported class action lawsuit, THEOHAROUS V. FONG, ET AL., Civ. No. 1:98CV2366, was filed in United States District Court for the Northern District of Georgia. On October 19, 1998, a second purported class action lawsuit with substantially the same allegations, SCHUETTE V. FONG, ET AL., Civ. No. 1:98CV3034, was filed in United States District Court for the Northern District of Georgia. On June 7, 1999, plaintiffs in each of these lawsuits filed amended complaints. The amended complaints alleged that certain officers, directors and shareholders of RDM, including the Company and current and former officers of the Company who served as directors of RDM, were liable under federal securities laws for misrepresenting and failing to disclose information regarding RDM's alleged financial condition during the period between November 7, 1995 and August 22, 1997, the date on which RDM disclosed that its management had discussed the possibility of filing for bankruptcy. The amended complaints also alleged that the defendants, including the Company and current and former officers of the Company who served as directors of RDM, were secondarily liable as controlling persons of RDM. In an opinion dated March 10, 2000, the court dismissed these actions in their entirety.
On December 30, 1998, the chapter 11 trustee of RDM brought an adversary proceeding in the bankruptcy of RDM, HAYS, ET AL V. FONG, ET AL., Adv. Proc. No. 98-1128, in the United States Bankruptcy Court, Northern District of Georgia, alleging that current and former officers of the Company, while serving as directors on the board of RDM, breached fiduciary duties allegedly owed to RDM's shareholders and creditors in connection with the bankruptcy of RDM. On January 25, 1999, the plaintiff filed a first amended complaint. The official committee of unsecured creditors of RDM has moved to proceed as co-plaintiff or to intervene in this proceeding, and the official committee of
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. INVESTMENT IN RDM (CONTINUED) bondholders of RDM has moved to intervene in or join the proceeding. Plaintiffs in this adversary proceeding seek the following relief against current and former officers of the Company who served as directors of RDM: actual damages in an amount to be proven at trial, reasonable attorney's fees and expenses, and such other and further relief as the court deems just and proper. On February 16, 1999, the creditors' committee brought an adversary proceeding, THE OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF RDM SPORTS GROUP, INC. AND RELATED DEBTORS V. METROMEDIA INTERNATIONAL GROUP INC., Adv. Proc. No. 99-1023, seeking in the alternative to recharacterize as contributions to equity a secured claim in the amount of $15 million made by the Company arising out of the Company's financing of RDM, or to equitably subordinate such claim made by Metromedia against RDM and other debtors in the bankruptcy proceeding. On March 3, 1999, the bondholders' committee brought an adversary proceeding, THE OFFICIAL COMMITTEE OF BONDHOLDERS OF RDM SPORTS GROUP, INC. V. METROMEDIA INTERNATIONAL GROUP, INC., Adv. Proc. No. 99-1029, with substantially the same allegations as the above proceeding. In addition to the equitable and injunctive relief sought by plaintiffs described above, plaintiffs in these adversary proceedings seek actual damages in an amount to be proven at trial, reasonable attorneys' fees, and such other and further relief as the court deems just and proper. The Company believes it has meritorious defenses and plans to vigorously defend these actions. Due to the early stage of these proceedings, the Company cannot evaluate the likelihood of an unfavorable outcome or an estimate of the likely amount or range of possible loss, if any. Accordingly, the Company has not recorded any liability in connection with these proceedings.
9. STOCKHOLDERS' EQUITY
PREFERRED STOCK
There are 70,000,000 shares of preferred stock authorized and 4,140,000 shares were outstanding as of December 31, 1999 and 1998.
On September 16, 1997 the Company completed a public offering of 4,140,000 shares of $1.00 par value, 7 1/4% cumulative convertible preferred stock with a liquidation preference of $50.00 per share, generating net proceeds of approximately $199.4 million. Dividends on the preferred stock are cumulative from the date of issuance and payable quarterly, in arrears, commencing on December 15, 1997. The Company may make any payments due on the preferred stock, including dividend payments and redemptions (i) in cash; (ii) issuance of the Company's common stock or (iii) through a combination thereof. The preferred stock is convertible at the option of the holder at any time, unless previously redeemed, into the Company's common stock, at a conversion price of $15.00 per share (equivalent to a conversion rate of 3 1/3 shares of common stock for each share of preferred stock), subject to adjustment under certain conditions.
The preferred stock is redeemable at any time on or after September 15, 2000, in whole or in part, at the option of the Company, initially at a price of $52.5375 and thereafter at prices declining to $50.00 per share on or after September 15, 2007, plus in each case all accrued and unpaid dividends to the redemption date. Upon any change of control (as defined in the certificate of designation of the preferred stock), each holder of preferred stock shall, in the event that the market value at such time is less than the conversion price of $15.00, have a one-time option to convert the preferred stock into the Company's common stock at a conversion price equal to the greater of (i) the market value, as of the change of control date (as defined in the certificate of designation) and (ii) $8.00. In lieu of issuing
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STOCKHOLDERS' EQUITY (CONTINUED) shares of the Company's common stock, the Company may, at its option, make a cash payment equal to the market value of the Company's common stock otherwise issuable.
COMMON STOCK
As part of an acquisition in 1996, the Company issued 256,504 shares of restricted common stock to certain employees. The common stock was to vest on a pro-rata basis over a three year period ending in July 1999. The total market value of the shares at the time of issuance was treated as unearned compensation and was charged to expense over the vesting period. Unearned compensation charged to expense for 1997 was $352,000. In connection with the entertainment group sale, the 256,504 shares of restricted common stock became fully vested. The cost of $2.3 million associated with the vesting of the restricted common stock was recorded as a reduction to the entertainment group sale gain.
At December 31, 1999, the Company has reserved for future issuance shares of Common Stock in connection with the stock option plans and preferred stock listed below (in thousands):
STOCK OPTION PLANS
On August 29, 1996, the stockholders of MMG approved the Metromedia International Group, Inc. 1996 Incentive Stock Option Plan. The aggregate number of shares of common stock that may be the subject of awards under the plan is 8,000,000. The maximum number of shares which may be the subject of awards to any one grantee under the plan may not exceed 250,000 in the aggregate. The plan provides for the issuance of incentive stock options, nonqualified stock options and stock appreciation rights in tandem with stock options. Incentive stock options may not be issued at a per share price less than the market value at the date of grant. Nonqualified stock options may be issued at prices and on terms determined in the case of each stock option grant. Stock options and stock appreciation rights may be granted for terms of up to but not exceeding ten years and vest and become fully exercisable after four years from the date of grant. At December 31, 1999 there were approximately 3.0 million additional shares available for grant under the plan.
Following the PLD Telekom acquisition, the PLD Telekom stock options were converted into stock options exercisable for common stock of MMG in accordance with the exchange ratio.
The per share weighted-average fair value of stock options granted during 1999, 1998, and 1997 were $2.62, $6.99, and $4.33, respectively, on the date of grant using the Black Scholes option-pricing model with the following weighted average assumptions: expected volatility of 87% in 1999, 77% in 1998, and 50% in 1997, expected dividend yield of zero percent, risk-free interest rate of 6.4% in 1999, 5.1% in 1998, and 5.5% in 1997 and an expected life of 4 years.
The Company applies APB 25 in recording the value of stock options granted pursuant to its plans. No compensation cost has been recognized for stock options granted under the plan for the years ended December 31, 1999 and 1997. For the year ended December 31, 1998, compensation expense of
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STOCKHOLDERS' EQUITY (CONTINUED) $626,000 was recorded under the plan, in the consolidated statements of operations. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS 123, the Company's net income (loss) would have (decreased) increased to the pro forma amounts indicated below (in thousands, except per share amounts):
Pro forma net income reflects only options granted from 1996 through 1999.
Stock option activity during the periods indicated is as follows (in thousands except per share amounts):
At December 31, 1999, 1998, 1997, the number of stock options exercisable was 6,311,000, 2,831,000, and 2,573,000 respectively, and the weighted-average exercise price of these options was $6.34, $6.63 and $6.99, respectively.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STOCKHOLDERS' EQUITY (CONTINUED) The following table summarizes information about the stock options outstanding at December 31, 1999 (in thousands except per share amounts):
On April 18, 1997, two officers of the Company were granted stock options, not pursuant to any plan, to purchase 1,000,000 shares each of Common Stock at a purchase price of $7.44 per share, the fair market value of the Common Stock at such date. The stock options vest and become fully exercisable four years from the date of grant.
On March 26, 1997 the Board of Directors approved the cancellation and reissuance of all stock options previously granted pursuant to the plan at an exercise price of $9.31, the fair market value of MMG common stock at such date. In addition, on March 26, 1997, the board of directors authorized the grant of approximately 1,900,000 stock options at an exercise price of $9.31 under the plan.
WARRANTS
In connection with the acquisition of PLD Telekom, the Company issued to Travelers 10-year warrants to purchase 700,000 shares of common stock of the Company at an exercise price to be determined in December 2000 that will be between $10.00 and $15.00 per share. However, if the amount outstanding under the New Travelers Agreement has not been fully repaid by August 30, 2000, the exercise price of the warrants will be reset to $0.01 per share.
10. INCOME TAXES
The Company files a consolidated Federal income tax return with all of its 80% or greater owned subsidiaries. A consolidated subsidiary group in which the Company owns less than 80% files a separate Federal income tax return. The Company and such subsidiary group calculate their respective tax liabilities on a separate return basis.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED) Income tax expense (benefit) for the years ended December 31, 1999, 1998 and 1997, consists of the following (in thousands):
The provision for income taxes for the years ended December 31, 1999, 1998 and 1997 applies to continuing operations.
The federal income tax portion of the provision for income taxes includes the benefit of state income taxes provided.
The Company had pre-tax losses from foreign operations of $26.5 million, $38.4 million, and $23.2 million for the years ended December 31, 1999, 1998 and 1997, respectively. Pre-tax losses from domestic operations were $114.2 million, $97.9 million, and $112.9 million for the years ended December 31, 1999, 1998, and 1997, respectively.
State and local income tax expense for the year ended December 31, 1997 includes an estimate for franchise and other state tax levies required in jurisdictions which do not permit the utilization of the Company's net operating loss carryforwards to mitigate such taxes. Foreign tax expense for the years ended December 31, 1999, 1998 and 1997 reflects estimates of withholding and remittance taxes.
The temporary differences and carryforwards which give rise to deferred tax assets and (liabilities) at December 31, 1999 and 1998 are as follows (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED) The net change in the total valuation allowance for the years ended December 31, 1999, 1998, and 1997 was an increase of $28.5 million, a decrease of $1.3 million and an increase of $23.4 million, respectively.
The Company's income tax expense (benefit) for the years ended December 31, 1999 and 1998, differs from the expense (benefit) that would have resulted from applying the federal statutory rates during those periods to income (loss) before the income tax expense (benefit). The reasons for these differences are explained in the following table (in thousands):
At December 31, 1999 the Company had available net operating loss carryforwards and unused minimum tax credits of approximately $281.1 million and $13.0 million, respectively, which can reduce future federal income taxes. These carryforwards and credits begin to expire in 2008. The minimum tax credit may be carried forward indefinitely to offset regular tax in certain circumstances.
Under Section 382 of the Internal Revenue Code, annual limitations will apply to the use of the pre-October 1, 1999 net operating loss carryforwards of PLD Telekom Inc. (and subsidiaries included in its consolidated Federal income tax return). This annual limitation approximates $6.0 million per year.
The use by the Company of the pre-November 1, 1995 net operating loss carryforwards from the business combination consummated on November 1, 1995 reported by The Actava Group, Inc. and Metromedia International Telecommunications (and the subsidiaries included in their respective affiliated groups of corporations which filed consolidated Federal income tax returns with Actava and Metromedia International Telecommunications as the parent corporations) are subject to certain limitations as a result of the business combination, respectively.
Under Section 382 of the Internal Revenue Code, annual limitations generally apply to the use of the pre-November 1, 1995 losses by the Company. The annual limitations on the use of the pre-November 1, 1995 losses of Actava and Metromedia International Telecommunications by the Company approximate $18.3 million and $10.0 million per year, respectively. To the extent pre-November 1, 1995 losses equal to the annual limitation with respect to Actava and Metromedia International Telecommunications are not used in any year, the unused amount is generally available to be carried forward and used to increase the applicable limitation in the succeeding year.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED) The use of pre-November 1, 1995 losses of Metromedia International Telecommunications is also separately limited by the income and gains recognized by the corporations that were members of the Metromedia International Telecommunications affiliated groups. Under proposed Treasury regulations, such pre-November 1, 1995 losses of any such former members of such group, are usable on an aggregate basis to the extent of the income and gains of such former members of such group.
As a result of the November 1, 1995 business combination, the Company succeeded to approximately $92.2 million of pre-November 1, 1995 losses of Actava. SFAS 109 requires assets acquired and liabilities assumed to be recorded at their "gross" fair value. Differences between the assigned values and tax bases of assets acquired and liabilities assumed in purchase business combinations are temporary differences under the provisions of SFAS 109. To the extent all of the Actava intangibles are eliminated, when the pre-November 1, 1995 losses are utilized they will reduce income tax expense.
11. EMPLOYEE BENEFIT PLANS
The Communications Group and Snapper have defined contribution plans which provide for discretionary annual contributions covering substantially all of their employees. Participating employees can defer receipt of up to 15% of their compensation, subject to certain limitations. The Communications Group matches 50% of the amounts contributed by plan participants up to 6% of their compensation. Snapper's employer match is determined each year, and in 1999, 1998 and 1997, such amount for employees of the non-bargaining defined contribution plan was 50% of the first 6% of compensation contributed by each participant. In April 1999, Snapper implemented a defined contribution plan for all bargaining unit employees. In 1999, under Snapper's bargaining unit plan, Snapper matched 25% of the first 4% of compensation contributed by each participant. The Company's contribution expense for the years ended December 31, 1999, 1998, and 1997 was $492,000, $517,000, and $527,000, respectively.
In addition, Snapper has a profit sharing plan covering substantially all non-bargaining unit employees. Contributions are made at the discretion of management. No profit sharing contributions were approved by management for the years ended December 31, 1999, 1998 and 1997. Snapper sponsors a defined benefit pension plan which covers substantially all bargaining unit employees. Benefits are based upon the employee's years of service multiplied by fixed dollar amounts. Snapper's funding policy is to contribute annually such amounts as are necessary to provide assets sufficient to meet the benefits to be paid to the plan's members and keep the plan actuarially sound.
In addition, Snapper provides a group medical plan and life insurance coverage for certain employees subsequent to retirement. The plans have been funded on a pay-as-you-go (cash) basis. The plans are contributory, with retiree contributions adjusted annually, and contain other cost-sharing features such as deductibles, coinsurance, and life-time maximums. The plan accounting anticipates future cost-sharing changes that are consistent with Snapper's expressed intent to increase the retiree contribution rate annually for the expected medical trend rate for that year. The coordination of benefits with Medicare uses a supplemental, or exclusion of benefits approach. Snapper funds the excess of the cost of benefits under the plans over the participants' contributions as the costs are incurred.
The net periodic pension cost and net periodic post-retirement benefit income for the years ended December 31, 1999 and 1998 amounted to $85,000 and $17,000 and $110,000 and $21,000, respectively.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. EMPLOYEE BENEFIT PLANS (CONTINUED) Snapper's defined benefit plan's projected benefit obligation and fair value of plan assets at December 31, 1999 and 1998 were $6.7 million and $7.4 million and $7.5 million and $7.7 million, respectively. Accrued post-retirement benefit costs at December 31, 1999 and 1998 were $3.1 million and $3.0 million, respectively. Disclosures regarding the reconciliation of benefit obligations, fair value of plan assets and the funded status of the plan have not been included herein because they are not material to the Company's consolidated financial statements at December 31, 1999 and 1998.
12. BUSINESS SEGMENT DATA
The business activities of the Company consist to two operating groups, the Communications Group and Snapper.
The Communications Group has operations in Eastern Europe and the republics of the former Soviet Union and China. Operations in Eastern Europe and the republics of the former Soviet Union provide the following services: (i) wireless telephony; (ii) fixed telephony; (iii) cable television; (iv) radio broadcasting; and (v) paging. Until recently, the Company also held interests in several telecommunications joint ventures in China. Those joint ventures were terminated in late 1999 and the Company reached agreement for the distribution of approximately $90.1 million (based on the December 31, 1999 exchange rate) in settlement of all claims under the joint venture agreements. The Communications Group is continuing to develop e-commerce business opportunities in China.
As previously discussed, legal restrictions in China prohibit foreign participation in the operations or ownership in the telecommunications sector. The segment information for the Communications Group's China joint ventures represent the investment in network construction and development of telephony networks for China Unicom. The segment information does not reflect the results of operations of China Unicom's telephony networks.
Snapper manufactures Snapper-Registered Trademark- brand premium priced power lawnmowers, lawn tractors, garden tillers, snow throwers and related parts and accessories.
The Company evaluates the performance of its operating segments based on earnings before interest, taxes, depreciation, and amortization. The segment information is based on operating income (loss) which includes depreciation and amortization. In addition, through the year ended December 31, 1999 the Company evaluates the performance of the Communications Group's operating segments in Eastern Europe and the republics of the former Soviet Union on a combined basis.
Equity in income (losses) of unconsolidated investees reflects elimination of intercompany interest expense.
The Company's segment information is set forth as of and for the years ended December 31, 1999, 1998 and 1997 in the following tables (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. BUSINESS SEGMENT DATA (CONTINUED)
YEAR ENDED DECEMBER 31, 1999 (IN THOUSANDS)
METROMEDIA INTERNATIONAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. BUSINESS SEGMENT DATA (CONTINUED)
YEAR ENDED DECEMBER 31, 1998 (IN THOUSANDS)
METROMEDIA INTERNATIONAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. BUSINESS SEGMENT DATA (CONTINUED)
YEAR ENDED DECEMBER 31, 1997 (IN THOUSANDS)
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. BUSINESS SEGMENT DATA (CONTINUED)
Information about the Communications Group's operations in different geographic locations for 1999, 1998, and 1997 is as follows (in thousands):
- ------------------------
(1) The Communications Group is dissolving four of its China joint ventures pursuant to the termination of these ventures' cooperation contracts with China Unicom. For the year ended December 31, 1999, the Company wrote down $45.7 million of the goodwill associated with these telecommunications ventures.
(2) Includes goodwill of $123.6 million, $54.5 million and $89.0 million at December 31, 1999, 1998, and 1997, respectively.
All of the Company's remaining assets and substantially all remaining revenue relate to operations in the United States.
13. OTHER CONSOLIDATED FINANCIAL STATEMENT INFORMATION
ACCOUNTS RECEIVABLE
The total allowance for doubtful accounts at December 31, 1999 and 1998 was $2.9 million and $2.2 million, respectively.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. OTHER CONSOLIDATED FINANCIAL STATEMENT INFORMATION (CONTINUED) INVENTORIES
Inventories consist of the following as of December 31, 1999 and 1998 (in thousands):
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at December 31, 1999 and 1998 consists of the following (in thousands):
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. OTHER CONSOLIDATED FINANCIAL STATEMENT INFORMATION (CONTINUED) INTANGIBLE ASSETS
Intangible assets at December 31, 1999 and 1998 consist of the following (in thousands):
The Company has reviewed the amortization periods for its goodwill and other intangibles associated with licenses for its operations in Eastern Europe and the republics of the former Soviet Union and has revised these amortization periods from 25 years to 10 years commencing in the quarter ending September 30, 1999. The change in estimate has been accounted for prospectively and will result in additional annual amortization expense of approximately $4.4 million. In addition, as discussed more fully in note 4, as a result of the termination of its telecommunications joint ventures in China the Company wrote off $45.7 million of goodwill.
ACCRUED EXPENSES
Accrued expenses at December 31, 1999 and 1998 consist of the following (in thousands):
SELF-INSURANCE RESERVES
For the year ended December 31, 1998, the Company revised the estimated value of its self-insured workers' compensation and product liability claims based on its claims experience, which resulted in a $6.6 million reduction in the reserve at December 31, 1998.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. OTHER CONSOLIDATED FINANCIAL STATEMENT INFORMATION (CONTINUED) RESEARCH AND DEVELOPMENT AND ADVERTISING COSTS
Research and development costs for the years ended December 31, 1999, 1998 and 1997 were $3.0 million, $3.0 million and $3.8 million, respectively. The Company's advertising costs for the years ended December 31, 1999, 1998, and 1997 were $24.9 million, $24.9 million, and $19.8 million, respectively.
TAX EFFECTS ALLOCATED TO EACH COMPONENT OF OTHER COMPREHENSIVE INCOME (LOSS)
The tax effects allocated to each component of other comprehensive income (loss) for the years ended December 31, 1999, 1998, and 1997 is as follows (in thousands):
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Supplemental disclosure of cash flow information for the years ended December 31, 1999, 1998 and 1997 (in thousands):
Interest expense includes amortization of debt discount of $4.5 million and $1.7 million for the years ended December 31, 1999 and 1997, respectively.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. COMMITMENTS AND CONTINGENT LIABILITIES
COMMITMENTS
The Company is obligated under various operating and capital leases. Total rent expense amounted to $5.8 million, $5.8 million and $4.7 million for the years ended December 31, 1999, 1998 and 1997, respectively. Plant, property and equipment included capital leases of $1.4 million and $2.4 million, and related accumulated amortization of $285,000 and $873,000, at December 31, 1999 and 1998, respectively.
Minimum rental commitments under non-cancelable leases and supplier financing are set forth in the following table (in thousands):
Certain of the Company's subsidiaries have employment contracts with various officers, with remaining terms of up to 3 years, at amounts approximating their current levels of compensation. The Company's remaining aggregate commitment at December 31, 1999 under such contracts is approximately $4.6 million.
The Company pays a management fee to Metromedia for certain general and administrative services provided by Metromedia personnel. Such management fee amounted to $3.8 million, $3.5 million, and $3.3 million for the years ended December 31, 1999, 1998 and 1997, respectively. The management fee commitment for the year ended December 31, 2000 is $3.8 million.
Snapper has entered into various long-term manufacturing and purchase agreements with certain vendors for the purchase of manufactured products and raw materials. As of December 31, 1999, non-cancelable commitments under these agreements amounted to approximately $7.9 million.
Snapper has an agreement with a financial institution which makes available floor plan financing to dealers of Snapper products. This agreement provides financing for inventories and accelerates Snapper's cash flow. Under the terms of the agreement, a default in payment by a dealer is nonrecourse to Snapper. However, the third-party financial institution can require the Company to repurchase new and unused equipment from them, if they acquire inventory through a dealer default and the inventory is not able to be sold to another dealer. At December 31, 1999, there was approximately $95.0 million outstanding under this floor-plan financing arrangement. The Company guarantees the payment obligation of Snapper under this agreement to the third party financing company.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) CONTINGENCIES
RISKS ASSOCIATED WITH THE COMMUNICATIONS GROUP'S INVESTMENTS
The ability of the Communications Group and its joint ventures and subsidiaries (including PLD Telekom Inc.) to establish profitable operations is subject to, among other things, significant political, economic and social risks inherent in doing business in emerging markets such as Eastern Europe, the republics of the former Soviet Union and China. These include matters arising out of government policies, economic conditions, imposition of or changes in government regulations or policies, imposition of or changes to taxes or other similar charges by government bodies, exchange rate fluctuations and controls, civil disturbances, deprivation or unenforceability of contractual rights, and taking of property without fair compensation.
During 1998, and continuing in 1999, a number of emerging market economies suffered significant economic and financial difficulties resulting in liquidity crises, devaluation of currencies, higher interest rates and reduced opportunities for financing. At this time, the prospects for recovery for the economies of Russia and the other republics of the former Soviet Union and Eastern Europe negatively affected by the economic crisis remain unclear. The economic crisis has resulted in a number of defaults by borrowers in Russia and other countries and a reduced level of financing available to investors in these countries. The devaluation of many of the currencies in the region has also negatively affected the U.S. dollar value of the revenues generated by certain of the Communications Group's joint ventures and may lead to certain additional restrictions on the convertibility of certain local currencies. The Communications Group expects that these problems will negatively affect the financial performance of certain of its cable television, telephony, radio broadcasting and paging ventures.
Some of the Communications Group's subsidiaries and joint ventures operate in countries where the inflation rate is extremely high. Inflation in Russia increased dramatically following the August 1998 financial crisis and there are increased risks of inflation in Kazakhstan. The inflation rates in Belarus have been at hyperinflationary levels for some years and as a result, the currency has essentially lost all intrinsic value.
While the Communications Group's subsidiaries and joint ventures attempt to increase their subscription rates to offset increases in operating costs, there is no assurance that they will be able to do so. Therefore, operating costs may rise faster than associated revenue, resulting in a material negative impact on operating results. The Company itself is generally negatively impacted by inflationary increases in salaries, wages, benefits and other administrative costs, the effects of which to date have not been material to the Company.
The value of the currencies in the countries in which the Communications Group operates tends to fluctuate, sometimes significantly. For example, during 1998 and 1999, the value of the Russian Rouble was under considerable economic and political pressure and has suffered significant declines against the U.S. dollar and other currencies. In addition, in 1999 local currency devaluations in Uzbekistan, Kazakhstan and Georgia, in addition to weakening of local currencies in Austria and Germany, had an adverse effect on the Communications Group's ventures in these countries. The Communications Group currently does not hedge against exchange rate risk and therefore could be negatively impacted by declines in exchange rates between the time one of its joint ventures receives its funds in local currency and the time it distributes these funds in U.S. dollars to the Communications Group.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)
The Communications Group's strategy is to minimize its foreign currency risk. To the extent possible, the Communications Group bills and collects all revenues in U.S. dollars or an equivalent local currency amount adjusted on a monthly basis for exchange rate fluctuations. The Communications Group's subsidiaries and joint ventures are generally permitted to maintain U.S. dollar accounts to service their U.S. dollar denominated debt and current account obligations, thereby reducing foreign currency risk. As the Communications Group's subsidiaries and joint ventures expand their operations and become more dependent on local currency based transactions, the Communications Group expects that its foreign currency exposure will increase.
During 1997 and 1998, the Company made several investments in telecommunications joint ventures in China through its majority-owned subsidiary, Asian American Telecommunications Corporation. These ventures were terminated in late 1999 and agreements were entered into in December 1999 terminating the joint ventures' further cooperation with China Unicom. Under the terms of the settlement contracts, the four joint ventures will each receive cash amounts in RMB from China Unicom in full and final payment for the termination of their cooperation contracts with China Unicom.
The Company's current estimate of the total amount it will ultimately receive from the four terminated joint ventures is $90.1 million (at December 31, 1999 exchange rates) of which $29.3 million has been received. Full distribution of all expected funds must await the Chinese government's recognition and approval of the completion of formal dissolution proceedings for the four joint ventures. This is expected by mid-2000 and the Company anticipates no problems in ultimately dissolving the joint ventures. However, some variance from the Company's current estimates of the amounts finally distributed to Asian American Telecommunications may arise due to settlement of the joint ventures' tax obligations in China and exchange rate fluctuations. The Company cannot assure at this time that this variance will not be material.
The Communication Group's Huaxia JV is established as a sino-foreign equity joint venture between Asian American Telecommunications and All Warehouse Commodity Electronic Commerce Information Development Co., Ltd. The Huaxia JV does not have any contractual relationship with China Unicom and is engaged in business fundamentally different from that of the Communication Group's joint ventures cooperating with China Unicom. Computer and software services such as offered by the Huaxia JV are subject to regulations different from those applied to telecommunications in China. The Communications Group believes that the fee-for-services arrangement of Huaxia JV and the lines of business undertaken by the joint venture do not constitute foreign involvement in telecommunications activities, which are at the center of certain Chinese authorities' actions against the Communication Group's joint telecommunications projects with China Unicom.
The Communications Group's operations are subject to governmental regulation in its markets and its operations require certain governmental approvals. There can be no assurance that the Communications Group will be able to obtain all necessary approvals to operate additional cable television, wireless telephony or paging systems or radio broadcasting stations in any of the markets in which it is seeking to establish additional businesses.
The licenses pursuant to which the Communications Group's businesses operate are issued for limited periods, including certain licenses which are renewable annually. Certain of these licenses expire over the next several years. As of December 31, 1999, several licenses held by the Communications Group had expired, although the Communications Group has been permitted to continue operations while the
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) decision on reissuance is pending. Certain other licenses held or used by the Communications Group's joint ventures will expire during 2000. The Company's joint ventures will apply for renewals of their licenses.
The Communications Group has sold a 17.1% participation in the $36.5 million loan to AIG Silk Road Fund, Ltd., which requires AIG Silk Road to provide the Communications Group 17.1% of the funds to be provided under the loan agreement and entitles AIG Silk Road to 17.1% of the repayments to the Communications Group. The Communications Group has agreed to repurchase such loan participation from AIG Silk Road in August 2005 on terms and conditions agreed by the parties. In addition, the Communications Group has provided AIG Silk Road the right to put its 15.7% ownership interest in Omni-Metromedia to the Communications Group starting in February 2001 for a price equal to seven times the EBITDA of Caspian American minus debt, as defined, multiplied by AIG Silk Road's percentage ownership interest.
As part of its ongoing strategic review, in late 1999 the Company reevaluated the operations of Caspian American in order to ascertain the requirement to account for impairment losses. In view of the low quantity of potential customers in the region in which the business operates and limited scope for growth, it was determined that an impairment loss of $9.9 million was required in 1999 relating to the Company's investment in Caspian American. The venture has developed a revised operating plan to stabilize its operations and minimize future funding requirements until potential restructuring options have been fully explored.
As part of its investment in Tyumenruskom announced in November 1998, the Company agreed to provide a guarantee of payment of $6.1 million to Ericsson Radio Systems, A.B. for equipment financing provided by Ericsson to one of the Communication Group's wholly owned subsidiaries and to its 46% owned joint venture, Tyumenruskom. Tyumenruskom has purchased a digital advanced mobile phone or DAMPS system cellular system from Ericsson in order to provide fixed and mobile cellular telephone in the regions of Tyumen and Tobolsk, Russian Federation. The Communications Group has a $1.7 million equity contribution to Tyumenruskom and has agreed to lend the joint venture up to $4.0 million for start-up costs and other operating expenses. Tyumenruskom also intends to provide wireless local loop telephone services.
Following a reevaluation of the venture's operations as part of the Company's ongoing strategic reviews, in 1999, $3.8 million of the Company's investment in this venture was recorded as an impairment change in view of its low profitability and limited scope for improvement and $4.3 million was accrued for in connection with a payment guarantee.
CREDIT CONCENTRATIONS
The Communications Group's trade receivables do not represent significant concentrations of credit risk at December 31, 1999, due to the wide variety of customers/subscribers and markets into which the Company's services are sold and their dispersion across many geographic areas.
No single customer represents a significant concentration of credit risk for Snapper at December 31, 1999 and 1998.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) Certain customers account for a significant portion of the total revenues of certain of the Communications Group's telephony operations and the loss of these customers would materially and adversely affect their results of operations.
In addition, several of the Communications Group's customers, interconnect parties or local operators experience liquidity problems from time to time. The Group's dependence on these parties may make it vulnerable to their liquidity problems, both in terms of pressure for financial support for the expansion of their operations, and in its ability to achieve prompt settlement of accounts.
FINANCIAL GUARANTEES
The Company has guaranteed certain indebtedness of one of the Company's wireless telecommunications joint ventures. The total guarantee is for $25.0 million of which $19.1 million has been borrowed at December 31, 1999.
As part of the financing of a joint venture, the Company and its joint venture partner provided a 5% equity interest to the lender. The lender can put back the equity interest to the Company and its joint venture partner at certain dates in the future at an amount not to exceed $6.0 million. In addition, in connection with the financing, Metromedia International Telecommunications and its joint venture partner agreed to provide an additional $7.0 million in funding to the joint venture.
LETTERS OF CREDIT
At December 31, 1999 the Company had $20.1 million of outstanding letters of credit which principally collateralize certain liabilities under the Company's self-insurance program.
LITIGATION
The Company is involved in various legal and regulatory proceedings and while the results of any litigation or regulatory issue contain an element of uncertainty, management believes that the outcome of any known, pending or threatened legal proceedings, except as disclosed in note 8, will not have a material effect on the Company's consolidated financial position and results of operations.
ENVIRONMENTAL PROTECTION
Snapper's manufacturing plant is subject to federal, state and local environmental laws and regulations. Compliance with such laws and regulations has not, and is not expected to, materially affect Snapper's competitive position. Snapper's capital expenditures for environmental control facilities, its incremental operating costs in connection therewith and Snapper's environmental compliance costs were not material in 1999 and are not expected to be material in future years.
The Company has agreed to indemnify a former subsidiary of the Company for certain obligations, liabilities and costs incurred by the subsidiary arising out of environmental conditions existing on or prior to the date on which the subsidiary was sold by the Company in 1987. Since that time, the Company has been involved in various environmental matters involving property owned and operated by the subsidiary, including clean-up efforts at landfill sites and the remediation of groundwater contamination. The costs incurred by the Company with respect to these matters have not been material during any year through and including the year ended December 31, 1999. As of
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) December 31, 1999, the Company had a remaining reserve of approximately $2.1 million to cover its obligations to its former subsidiary. During 1996, the Company was notified by certain potentially responsible parties at a superfund site in Michigan that the former subsidiary may also be a potentially responsible party at the superfund site. The former subsidiary has agreed to participate in remediation in a global settlement that is subject to court approval, but the amount of the liability has not been finally determined. The Company believes that such liability will not exceed the reserve.
The Company, through a wholly-owned subsidiary, owns approximately 17 acres of real property located in Opelika, Alabama. The Opelika Property was formerly owned by Diversified Products Corporation, a former subsidiary of the Company, and was transferred to a wholly-owned subsidiary of the Company in connection with the sale of the Company's former sporting goods business to RDM. Diversified Products previously used the Opelika property as a storage area for stockpiling cement, sand, and mill scale materials needed for or resulting from the manufacture of exercise weights. In June 1994, Diversified Products discontinued the manufacture of exercise weights and no longer needed to use the Opelika property as a storage area. In connection with the sale to RDM, RDM and the Company agreed that the Company, through a wholly-owned subsidiary, would acquire the Opelika property, together with any related permits, licenses, and other authorizations under federal, state and local laws governing pollution or protection of the environment. In connection with the closing of the sale, the Company and RDM entered into an Environmental Indemnity Agreement under which the Company agreed to indemnify RDM for costs and liabilities resulting from the presence on or migration of regulated materials from the Opelika property. The Company's obligations under the indemnity agreement with respect to the Opelika property are not limited. The indemnity agreement does not cover environmental liabilities relating to any property now or previously owned by Diversified Products except for the Opelika property. On January 22, 1996, the Alabama Department of Environmental Management advised the Company that the Opelika property contains an "unauthorized dump" in violation of Alabama environmental regulations. The letter from the Department of Environmental Management required the Company to present for the Department's approval a written environmental remediation plan for the Opelika property. The Company retained an environmental consulting firm to develop an environmental remediation plan for the Opelika property. In 1997, the Company received the consulting firm's report. The Company has conducted a grading and capping in accordance with the remediation plan and has reported to the Department of Environmental Management that the work was successfully completed. The Company has proposed to the Department an accelerated ground water monitoring schedule. If the Department responds favorably, the Company anticipates closure of this site in 1999. The Company believes its reserve of $59,000 will be adequate to cover any further costs.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected financial information for the quarterly periods in 1999 and 1998 is presented below (in thousands, except per share amounts):
- ------------------------
(a) Loss from continuing operations has been adjusted to reflect the dividend requirements on the Company's 7 1/4% cumulative convertible preferred stock issued on September 16, 1997.
(b) The Company completed the Landmark sale on April 16, 1998, resulting in a gain of $5.3 million, net of taxes. The transaction has been treated as a discontinuance of a business segment and, accordingly, the consolidated financial statements reflect the results of operations of Landmark as a discontinued segment.
(c) The Company adjusted the carrying value of goodwill and other intangibles, fixed assets, investments in and advances to joint ventures and wrote down paging inventory. The total non-cash charge and write down was $68.9 million in 1999 and $49.9 million in 1998.
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED) (d) Following the acquisition of PLD Telekom on September 30, 1999, the Company recorded a restructuring charge of $8.4 million.
(e) In 1997, the Company consummated the entertainment group sale. The transaction has been treated as a discontinuance of a business segment and, accordingly, the consolidated financial statements reflect the results of operations of the entertainment group as a discontinued segment. In 1998, the Company received refunds of tax payments of $8.7 million made by the entertainment group in prior years.
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT
METROMEDIA INTERNATIONAL GROUP, INC.
CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The accompanying notes are an integral part of the condensed financial information. See notes to Condensed Financial Information on page S-4.
S-1
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT--CONTINUED
METROMEDIA INTERNATIONAL GROUP, INC.
CONDENSED BALANCE SHEETS
(IN THOUSANDS)
The accompanying notes are an integral part of the condensed financial information. See Notes to Condensed Financial Information on page S-4.
S-2
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT--CONTINUED
METROMEDIA INTERNATIONAL GROUP, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
The accompanying notes are an integral part of the condensed financial information. See Notes to Condensed Financial Information on page S-4.
S-3
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT--CONTINUED
METROMEDIA INTERNATIONAL GROUP, INC.
NOTES TO CONDENSED FINANCIAL INFORMATION
DECEMBER 31, 1999, 1998, AND 1997
(A) The accompanying parent company financial statements reflect only the operations of MMG for the years ended December 31, 1999, 1998 and 1997 and the equity in losses of subsidiaries and discontinued operations for the years ended December 31, 1999, 1998, and 1997.
(B) The principal repayments of the Registrant's borrowings under debt agreements at December 31, 1999 are as follows (in thousands):
For additional information regarding the Registrant's and subsidiaries' borrowings under debt agreements and other debt, see note 5 to the "Notes to Consolidated Financial Statements."
S-4
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
METROMEDIA INTERNATIONAL GROUP, INC.
ALLOWANCES FOR DOUBTFUL ACCOUNTS, ETC. (DEDUCTED FROM CURRENT RECEIVABLES)
(IN THOUSANDS)
S-5
EXHIBIT INDEX
- ------------------------
* Filed herewith | 67,864 | 455,063 |
37637_1999.html | 37637_1999 | 1999 | 37637 | ITEM 1. BUSINESS
FLORIDA PROGRESS
Florida Progress Corporation (“Florida Progress,” or “the Company,” which term includes consolidated subsidiaries unless otherwise indicated), is a diversified electric utility holding company. Florida Progress’ revenues for the year ended December 31, 1999, were $3.8 billion, and assets at year-end were $6.5 billion. Its principal executive offices are located at One Progress Plaza, St. Petersburg, Florida 33701, telephone number (727) 824-6400. The Florida Progress home page on the Internet’s World Wide Web is located at http://www.fpc.com. Florida Progress was incorporated in Florida on January 21, 1982.
Florida Progress defines its principal business segments as utility and diversified operations. Florida Power Corporation (“Florida Power” or “the utility”), Florida Progress’ largest subsidiary, is the utility segment and encompasses all regulated public utility operations. (See Item 1 “Business -
Utility Operations - Florida Power”.) Progress Capital Holdings, Inc. (“Progress Capital”) is the downstream holding company for Florida Progress’ diversified subsidiaries, which provides financing for the non-utility operations. The diversified operations segment includes Electric Fuels Corporation (“Electric Fuels”), an energy and transportation company. The three primary segments of Electric Fuels are: Energy and Related Services, Rail Services, and Inland Marine Transportation. (See Item 1 “Business - Diversified Operations.”) For information concerning the revenues, operating profit and assets attributable to Florida Progress’ business segments, see Note 11 to Florida Progress’ consolidated financial statements and Florida Power’s financial statements for the year ended December 31, 1999, contained herein under Item 8 (the “Financial Statements”). Cash from operations has been the primary source of working capital for Florida Progress. (See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”) under the heading “Liquidity and Capital Resources.”)
Florida Progress is a public utility holding company under the Public Utility Holding Company Act of 1935 (“1935 Act”). Florida Progress is exempt from registration with the United States Securities and Exchange Commission (“SEC”) under the 1935 Act and attendant regulation because its utility operations are primarily intrastate.
Florida Progress has entered into a share exchange agreement with Carolina Power & Light Company (“CP&L”) and CP&L Holdings, Inc. (now CP&L Energy, Inc. (“CP&L Energy”)), a wholly owned subsidiary of CP&L. Under the terms of the agreement, all of the outstanding shares of Florida Progress will be acquired by CP&L Energy in a statutory share exchange. The transaction has been approved by the Boards of Directors of Florida Progress, CP&L Energy and CP&L and is expected to be completed during the fall of 2000, but is subject to certain conditions, including shareholder approval and the approval or regulatory review by certain state and federal government agencies. (See Item 7, MD&A under the heading “Current Issues - Share Exchange Agreement” and Note 2 to the Financial Statements).
UTILITY OPERATIONS - FLORIDA POWER
Florida Power was incorporated in Florida in 1899, and is an operating public utility engaged in the generation, purchase, transmission, distribution and sale of electricity. Florida Power has a system generating capacity of 8,267 megawatts (“MW”). In 1999, the utility accounted for 68% of Florida Progress’ consolidated revenues, 77% of its assets and 84% of its net income.
Florida Power provided electric service during 1999 to an average of 1.4 million customers in west central Florida. Its service area covers approximately 20,000 square miles and includes the densely populated areas around Orlando, as well as the cities of St. Petersburg and Clearwater. Florida Power is interconnected with 22 municipal and 9 rural electric cooperative systems. Major wholesale power sales customers include Seminole Electric Cooperative, Inc. (“Seminole”), Florida Municipal Power Agency and Reedy Creek Utilities District. For further information with respect to rates, see Note 12 to the Financial Statements.
Through a competitive bidding process, in October 1998, Florida Power signed a contract with the city of Bartow to supply wholesale power and energy-related services for another five years, beginning in November 1999. Current requirements for Bartow are 55 MW, which is expected to grow to over 70 MW during the life of the contract.
In 1995, Florida Power agreed to sell 605 MW of year-round capacity to Seminole from 1999 through 2001. While 150 MW of this transaction represents a continuation of existing business, 455 MW represents new sales to Seminole. In September 1997 as part of a restructured contract, Florida Power agreed to sell an additional 150 to 300 MW per year to Seminole from 2000-2002. This contract was awarded to Florida Power as a result of a competitive bidding process initiated by Seminole.
By virtue of state and municipal legislation, Florida Power holds franchises with varying expiration dates in nearly all municipalities in which it distributes electric energy. Approximately 40% of total utility revenues in 1999 are covered under the terms of 111 franchise agreements with various municipalities. The general effect of these franchises is to provide for the occupancy by Florida Power of the right-of-way in municipalities for the purpose of constructing, operating and maintaining an energy transmission and distribution system. All but one of the existing franchises cover a 30-year period from the date granted, the maximum allowed by Florida law. The one exception is a franchise that covers a 10-year period from the date granted, and expires in 2005. Of the 111 franchises, 2 expire during 2000, 20 expire during 2001, 31 expire between January 1, 2002 and December 31, 2012 and 58 expire between January 1, 2013 and December 31, 2029. For additional information on franchises, see Item 7 “MD&A - Industry Restructuring.”
Florida Power’s electric revenues billed by customer class, for the last three years, is shown as a percentage of total electric revenues in the table below:
BILLED ELECTRIC REVENUES
Important industries in the territory include phosphate and rock mining and processing, electronics design and manufacturing, and citrus and other food processing. Other important commercial activities are tourism, health care, construction and agriculture.
COMPETITION
For a general discussion of Florida Power and competition, see Item 7 “MD&A” under the heading “Restructuring Issues - Impact on Florida Power.”
FUEL AND PURCHASED POWER
GENERAL: Florida Power’s consumption of various types of fuel depends on several factors, the most important of which are the demand for electricity by Florida Power’s customers, the availability of various generating units, the availability and cost of fuel, and the requirements of federal and state regulatory agencies. Florida Power’s energy mix for the last three years is presented in the following table:
ENERGY MIX PERCENTAGES
(1)
Includes synfuel and pet coke.
(2)
See Item 1, Business - “NUCLEAR” for information regarding an extended outage at Florida Power’s nuclear generating plant beginning in September 1996 and continuing until February 1998.
Florida Power is generally permitted to pass the cost of recoverable fuel and purchased power to its customers through fuel adjustment clauses. In June 1997, Florida Power reached an agreement with all parties who intervened, which was approved by the Florida Public Service Commission (“FPSC”), regarding costs related to its extended nuclear outage. This agreement resulted in charges to Florida Power’s 1997 results. (See Note 12 to the Financial Statements.)
The future prices for and availability of various fuels discussed in this report cannot be predicted with complete certainty. However, Florida Power believes that its fuel supply contracts, as described below, will be adequate to meet its fuel supply needs.
Florida Power’s average fuel costs per million British thermal units (“Btu”) for each year of the five-year period ended December 31, 1999, were as follows:
AVERAGE FUEL COST
(per million Btu)
(1)
Includes synfuel and pet coke.
(2)
See Item 1, Business - “NUCLEAR” for information regarding an extended outage at Florida Power’s nuclear generating plant beginning in September 1996 and continuing until February 1998.
OIL AND GAS: Oil is purchased under contracts and in the spot market from several suppliers. The cost of Florida Power’s oil is determined by world market conditions. Management believes that Florida Power has access to an adequate supply of oil for the reasonably foreseeable future. Florida Power’s natural gas supply is purchased under firm contracts and in the spot market from numerous suppliers and is delivered under firm, released firm and interruptible transportation contracts. Florida Power believes that existing contracts for oil are sufficient to cover its requirements when natural gas transmission that is purchased on an interruptible basis is not available.
NUCLEAR: Florida Power has one nuclear generating plant, Crystal River Unit No. 3 (“CR3” or “the nuclear plant”). Florida Power has a license to operate the nuclear plant through December 3, 2016. In January 2000, Florida Power filed a request with the United States Nuclear Regulatory Commission (NRC) to consent to the indirect transfer of control of the CR3 operating license that will occur as a result of the share
exchange with CP&L. Florida Power expects NRC consent of the indirect license transfer by June 30, 2000. (See Item 7, “Current Issues - Share Exchange Agreement.”)
The plant operated at a 100% capacity factor through September 1999, after its return to service in February 1998 from an extended outage. In October 1999, the plant was taken off-line for a planned refueling outage. The plant returned to service in November after a 42-day refueling. For more information regarding the outage, see Item 7 “MD&A - Operating Results” and Note 12 to the Financial Statements.
Nuclear fuel is processed through four distinct stages. Stage I and Stage II involve the mining and milling of the natural uranium ore to produce a concentrate and the conversion of this uranium concentrate into uranium hexafluoride. Stages III and IV entail the enrichment of the uranium hexafluoride and the fabrication of the enriched uranium hexafluoride into usable fuel assemblies. Florida Power has contracts in place which provide for a supply of enriched uranium and fuel fabrication through 2013.
It will be necessary for Florida Power to enter into future fuel contracts to cover the differences between the total unit lifetime requirements of CR3 and the requirements covered by existing contracts. Although no assurances can be given as to the future availability or costs of such contracts, Florida Power expects that future contract commitments will be obtained at the appropriate time.
Spent nuclear fuel (“SNF”) is stored at CR3 pending disposal under a contract with the United States Department of Energy (“DOE”). (See Note 5 to the Financial Statements.) At the present time, Florida Power has facilities on site for the temporary storage of SNF generated through the year 2011. Florida Power plans to expand the capacity of its facilities on site in 2000, after obtaining regulatory approval, to allow for the temporary storage of SNF generated through the end of the license in 2016.
Florida Power and a number of other utilities are involved in litigation against the United States challenging certain retroactive assessments imposed by the federal government on domestic nuclear power companies to fund the decommissioning and decontamination of the government’s uranium enrichment facilities. (See Item 3 “Legal Proceedings,” paragraph 4).
COAL: Florida Power anticipates a combined requirement of approximately 5.0 million to 5.5 million tons of coal and synfuel in 2000. Most of the coal is expected to be supplied from the Appalachian coal fields of the United States. Approximately two-thirds of the fuel is expected to be delivered by rail and the remainder by barge. The fuel is supplied by Electric Fuels pursuant to contracts between Florida Power and Electric Fuels which expire in 2002 and 2004. (See Note 13 to the Financial Statements.)
For 2000, Electric Fuels has long-term contracts with various sources for approximately 40% of the fuel requirements of Florida Power’s coal units. These long-term contracts have price adjustment provisions. Electric Fuels expects to acquire the remainder in the spot market and under short-term contracts. Electric Fuels does not anticipate any problems obtaining the remaining Florida Power requirements for 2000 through short-term contracts and purchases in the spot market. (See Note 13 to the Financial Statements.)
PURCHASED POWER: Florida Power, along with other Florida utilities, buys and sells economy power through the Florida energy brokering system. Florida Power also purchases 1,300 MW of power under a variety of purchase power agreements. As of December 31, 1999, Florida Power had long-term contracts for the purchase of 469 MW of purchased power with other investor-owned utilities, including a contract with Southern Company for 409 MW. Florida Power also purchased 831 megawatts of its total capacity from certain qualifying facilities (QFs). The capacity currently available from QFs represents about 10% of Florida Power’s total installed system capacity. (See Item 2
ITEM 2. PROPERTIES
Florida Progress believes that its physical properties and those of its subsidiaries are adequate to carry on its and their businesses as currently conducted. Florida Progress and its subsidiaries maintain property insurance against loss or damage by fire or other perils to the extent that such property is usually insured. (See Note 13 to the Financial Statements.) Substantially all of Florida Power’s utility plant is pledged as collateral for Florida Power’s First Mortgage Bonds. (See Note 8 to the Financial Statements.) Certain river barges and tug/barge units owned or operated by Electric Fuels are subject to liens in favor of certain lenders.
UTILITY OPERATIONS
GENERATION: As of December 31, 1999, the total net winter generating capacity of Florida Power’s generating facilities, including CR3, was 8,267 MW. This capacity was generated by 13 steam units with a capacity of 4,740 MW, two combined cycle units with a capacity of 752 MW and 44 combustion turbine units with a capacity of 2,775 MW.
In April 1999, the first generating unit at the Hines Energy Complex in Polk County was placed in service. Hines Unit 1 uses a combined-cycle technology and is fueled by natural gas, with oil as a back-up fuel, and is capable of producing up to approximately 530 megawatts. Florida Power has obtained capacity on the Florida Gas Transmission Company’s system for the transportation of natural gas to the Hines Energy Complex. This transportation will serve a portion of the plant’s requirements. Florida Power also has contracted with other providers for natural gas supply and its transportation for the remaining portion of the plant’s requirements. Florida Power has subscribed to Florida Gas Transmission Company’s Phase IV expansion that will provide additional gas transportation on a system basis to various plants, including those at the Hines Energy Complex and at Intercession City.
Florida Power’s ability to use its generating units may be adversely impacted by various governmental regulations affecting nuclear operations and other aspects of Florida Power’s business. (See “Regulatory Matters and Franchises” and “Environmental Matters” under Item 1 “Business - Utility Operations - Florida Power.”) Operation of these generating units may also be substantially curtailed by unanticipated equipment failures or interruption of fuel supplies. Florida Power expects to have sufficient system capacity, access to purchased power and demand-side management capabilities to meet anticipated future demand. (See Item 2 “Planned Generation.”)
Florida Power’s generating plants (all located in Florida) and their capacities at December 31, 1999, were as follows:
*
Represents 91.8% of total plant capacity. The remaining 8.2% of capacity is owned by other parties.
**
Florida Power and Georgia Power Company (“Georgia Power”) are co-owners of a 168 MW advanced combustion turbine located at Florida Power’s Intercession City site. Georgia Power has the exclusive right to the output of this unit during the months of June through September. Florida Power has that right for the remainder of the year.
As of December 31, 1999, including both the total net winter generating capacity of 8,267 MW and the total firm contracts for purchased power of approximately 1,300 MW (as identified in Item 1 under the heading “Purchased Power”), Florida Power had total capacity resource of approximately 9,567 MW.
PLANNED GENERATION: In 1999, state regulators approved a plan to increase the level of reserve generating capacity in Florida from 15 percent to 20 percent by the summer of 2004. In response, Florida Power will seek proposals from qualified bidders, as required by the FPSC, to provide new generating capacity to be available beginning in 2003 at a lower cost than if the generation were obtained from Florida Power’s construction of a planned second generating unit at the Hines site. The bids will be evaluated on the basis of location, price, reliability and other factors. Hines 2 will use the same combined-cycle technology as Hines Unit 1 and is expected to have a winter generating capacity of approximately 570 megawatts.
Construction has commenced on three peaking power generation units at Florida Power’s Intercession City site. The units are designed to provide electricity during periods of peak customer demand and are projected to provide a total of approximately 280 MW of power beginning in December 2000. The new units are combustion turbine units capable of using either natural gas or oil, depending on cost and availability of those fuel sources.
NUCLEAR PLANT AND NUCLEAR INSURANCE: Information regarding the nuclear plant and nuclear insurance is contained in Notes 5 and 13, respectively, to the Financial Statements.
TRANSMISSION AND DISTRIBUTION: As of December 31, 1999, Florida Power distributed electricity through 365 substations with an installed transformer capacity of 43,621,540 kilovolt amperes (“KVA”). Of this capacity, 29,649,250 KVA is located in transmission substations and 13,972,290 KVA in distribution substations. Florida Power has the second largest transmission network in Florida. Florida Power has 4,687 circuit miles of transmission lines, of which 2,645 circuit miles are operated at 500, 230, or 115 kilovolts (“KV”) and the balance at 69 KV. Florida Power has 25,409 circuit miles of distribution lines, which operate at various voltages ranging from 2.4 to 25 KV.
Florida Power along with 19 other in-state electric utilities and 13 non-utilities comprise the Florida Reliability Coordinating Council (“FRCC”), which was approved by the North American Electric Reliability Council (“NERC”) as the tenth region of NERC. The FRCC is responsible for ensuring the reliability of the bulk power electric system in peninsular Florida.
Florida Power and six other FRCC transmission providers have established the Florida Open Access Sametime Information System. This is an internet location where transmission customers may obtain transmission information and submit requests for service or resell service rights.
FERC Order No. 2000, which was issued in December 1999, encouraged all transmission-owning utilities to turn over operation of their transmission systems to Regional Transmission Organizations (“RTOs”). As a part of a February 2000 FERC filing for approval of the share exchange with CP&L, Florida Progress has made a commitment to the FERC to participate in an RTO. Florida Progress has committed to file for FERC approval to establish or join an RTO in its respective region no later than 90 days after completing the share exchange. (See Item 7 “MD&A - Restructuring Issues - Impact on Florida Power, Regional Transmission Organizations.”)
DIVERSIFIED OPERATIONS
Electric Fuels owns and/or operates approximately 6,000 railcars, 100 locomotives, 1,200 river barges and 21 river towboats that are used for the transportation and shipping of coal, steel and other bulk products. Through joint ventures, Electric Fuels has five oceangoing tug/barge units. An Electric Fuels subsidiary, through another joint venture, owns one-third of a large bulk products terminal located on the Mississippi River south of New Orleans. The terminal handles coal and other products. Electric Fuels provides dry-docking and repair services to towboats, offshore supply vessels and barges through operations it owns near New Orleans, Louisiana.
Electric Fuels controls, either directly or through subsidiaries, coal reserves located in eastern Kentucky and southwestern Virginia. Electric Fuels owns properties that contain estimated proven and probable coal reserves of approximately 185 million tons and controls, through mineral leases, additional estimated proven and probable coal reserves of approximately 30 million tons. The reserves controlled by Electric Fuels include substantial quantities of high quality, low sulfur coal that is appropriate for use at Florida Power’s existing generating units. Electric Fuels’ total production of coal during 1999 was approximately 3.3 million tons.
In connection with its coal operations, Electric Fuels subsidiaries own and operate an underground mining complex located in southeastern Kentucky and southwestern Virginia. Other Electric Fuels subsidiaries own and operate surface and underground mines, coal processing and loadout facilities and a river terminal facility in eastern Kentucky, a railcar-to-barge loading facility in West Virginia, and three bulk commodity terminals: one on the Ohio River in Cincinnati, Ohio, and two on the Kanawha River near Charleston, West Virginia. Electric Fuels and its subsidiaries employ both company and contract miners in their mining activities.
Another Electric Fuels subsidiary owns a majority interest in a partnership, located in eastern Kentucky, which produces synthetic fuel. In addition, another Electric Fuels subsidiary has a minority interest in two other synthetic fuel plants located in West Virginia. In October 1999, Electric Fuels subsidiaries purchased four additional synthetic fuel plants. Two of the plants were relocated and began operations at Electric Fuels coal mines in Kentucky and Virginia. The other two plants are expected to be operational during 2000. Electric Fuels believes that synthetic fuel produced and sold from these operations qualifies for federal tax credits under Section 29 of the Internal Revenue Code.
A subsidiary of Electric Fuels has acquired oil and gas leases on 5,080 acres in Garfield County, Colorado, containing proven natural gas net reserves of 49.0 billion cubic feet. This subsidiary currently operates 36 gas wells on the property. Total natural gas production in 1999 was 2.6 net billion cubic feet.
Progress Rail, an Electric Fuels subsidiary, is one of the largest integrated processors of railroad materials in the United States, and is a leading supplier, of new and reconditioned freight car parts, rail, rail welding and track work components, railcar repair facilities, railcar and locomotive leasing, maintenance-of-way equipment and scrap metal recycling. It has facilities in 24 states, Mexico and Canada.
Another subsidiary of Electric Fuels owns and operates a manufacturing facility at the Florida Power Energy Complex in Crystal River, Florida. The manufacturing process utilizes the fly ash generated by the burning of coal as the major raw material in the production of lightweight aggregate used in construction building blocks.
Progress Telecom serves Florida Power’s entire service area, which covers approximately 20,000 square miles in 32 counties, as well as other areas in Florida and in the Southeast U.S. As part of its broadband capacity services, dark fiber and wireless services, Progress Telecom’s statewide fiber-optic network consists of 1,100 route miles, 61,000 miles of fiber strands and 80 cellular towers.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
1.
Metropolitan Dade County and Montenay Power Corp. v. Florida Power Corporation, Circuit Court of the Eleventh Circuit for Dade County, Florida, Case No. 96-09598-CA-30
Metropolitan Dade County and Montenay Power Corp. v. Florida Power Corporation, U.S. District Court, Southern District, Miami Division, Case No. 96-0594-C.V.-LENNARD
In re: Petition for Declaratory Statement That Energy Payments Are Limited to Analysis of Avoided Unit’s Contractually Specified Characteristics, Florida Public Service Commission, Docket No. 980283-EQ.
Florida Power has interpreted the pricing provision in its qualifying facility (“QF”) contracts to allow it to pay an as-available energy price rather than a higher firm energy price when the avoided unit upon which the contract is based would not have been operated.
On February 13, 1996, Metropolitan Dade County (“Dade”) and Montenay Power Corp. (“Montenay”) filed a complaint in the above-referenced state court seeking a declaratory judgment that their interpretation of the energy pricing provision in their QF contract was correct, and damages in excess of $1.3 million for breach of that contract.
On May 14, 1996, Dade and Montenay filed suit against Florida Power in the above-referenced federal district court based on essentially the same facts as presented in the state court case, but alleging violations of federal antitrust laws and demanding unspecified treble damages. In March 1997, the plaintiffs amended the federal court case to include Florida Progress and Electric Fuels. In
June 1998, the judge granted the defendants’ Motion for Summary Judgement and dismissed the case. Dade and Montenay filed a Notice of Appeal with the 11th Circuit Court of Appeals in October 1998.
On February 23, 1998, Florida Power filed a petition with the FPSC for a Declaratory Statement that the previous FPSC-approved negotiated contract between the parties limits energy payments thereunder to the avoided costs based upon an analysis of a hypothetical unit having the characteristics specified in the contract. In October 1998, the FPSC denied the Florida Power petition for Declaratory Statement. In January 1999, Florida Power filed a Notice of Appeal of the FPSC denial with the Florida Supreme Court. The issues on appeal are identical to those in the NCP Lake Power (“Lake”) case (see item 2 below), and consequently the Florida Supreme Court agreed to consolidate the appeals. Oral argument was heard in December 1999.
In May 1999, the parties reached an agreement in principal to settle the dispute, including all of the ongoing litigation except the Florida Supreme Court appeal of the FPSC order in the docket cited above. In September 1999, the final terms of the settlement agreement were reduced to writing. Among other things, the agreement will generally require Florida Power to pay the firm energy price for 16 hours per day, and the as-available price for 8 hours per day. The agreement was approved by the Dade County Commission in December 1999, but is subject to further approval by the FPSC.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Qualifying Facilities Contracts.)
2.
NCP Lake Power, Inc. v. Florida Power Corporation, Florida Circuit Court, Fifth Judicial Circuit for Lake County, Case No. 94-2354-CA-01
In re: Petition for Declaratory Statement Regarding the Negotiated Contract for Purchase of Firm Capacity and Energy between Florida Power Corporation and Lake Cogen, LTD., Florida Public Service Commission, Docket No. 980509-EQ.
On October 21, 1994, NCP Lake Power, Inc. (“Lake”), a general partner of Lake Cogen, Ltd., filed the above-referenced suit against Florida Power asserting breach of its QF contract and requesting a declaratory judgment. In December 1996, Florida Power filed a petition with the FPSC seeking approval of a settlement agreement between Florida Power and Lake. In November 1997, the FPSC declined approval, finding the proposed settlement would exceed Florida Power’s avoided costs.
On April 9, 1998, Florida Power filed a petition with the FPSC for a Declaratory Statement that the contract between the parties limits energy payments thereunder to the avoided costs based upon an analysis of a hypothetical unit having the characteristics specified in the contract. In October 1998, the FPSC denied the petition. In January 1999, Florida Power filed a Notice of Appeal of this FPSC order with the Florida Supreme Court. This appeal was consolidated with the Montenay/Dade appeal reported in item 1 above, and oral argument was heard in December 1999.
Trial on Lake’s action was held in Circuit Court in November and December 1998. In April 1999, the judge entered a non-final trial order. The judge granted Lake’s breach of contract claim and ruled that Lake is entitled to receive “firm” energy payments during the on-peak hours, but for all other hours Lake is entitled to the “as-available” rate. The judge denied Lake’s breach of contract claim relating to a coal pricing dispute, denied Lake’s claim for injunctive relief and denied the Florida Power counterclaims. The court reserved jurisdiction to enable the parties to present evidence on damages. After hearing evidence on damages, in August 1999, the court issued a Final Judgment awarding Lake historic damages in the amount of $4,480,247. Lake filed a Notice of Appeal, and in September 1999, Florida Power filed a notice of cross appeal.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Qualifying Facilities Contracts.)
3.
Wanda L. Adams, et al. v. Florida Power Corporation and Florida Progress Corporation, U.S. District Court, Middle District of Florida, Ocala Division, Case No. 95-123-C.V.-OC-10.
On October 13, 1995, Florida Power and Florida Progress were served with a multi-party lawsuit involving 17 former Florida Power employees. The plaintiffs generally alleged discrimination in violation of the Age Discrimination and Employment Act and wrongful interference with pension rights in violation of the Employee Retirement Income Security Act of 1974 (“ERISA”) as a result of their involuntary terminations during Florida Power’s reduction in force. While no dollar amount is specified, each Plaintiff seeks back pay, reinstatement or front pay through their projected dates of normal retirement, costs and attorney’s fees. The Plaintiffs subsequently filed motions adding 39 additional plaintiffs.
In November 1995, Florida Power filed its answer, a motion to dismiss Florida Progress, and a counterclaim against five of the plaintiffs who signed releases, promising, among other things, not to sue Florida Power with respect to matters involving their employment or termination. The counterclaim sought enforcement of the agreement, dismissal of plaintiffs’ complaints, and an award of attorneys fees and costs of litigation.
In October 1996, the court approved a joint stipulation to provisionally certify the case as a class action pursuant to the Age Discrimination in Employment Act. By May 28, 1997, the final day for individuals to “opt into” this action, 61 additional former employees elected to do so, for a total of 116 plaintiffs.
In June 1998, the judge issued an order on several pending motions. The motion to dismiss Florida Progress was denied, but all the ERISA claims were dismissed and the state age claims of 5 plaintiffs were dismissed. The Motion to Dismiss 4 plaintiffs’ federal age claims based on Statute of Limitations violations was granted.
In December 1998, Florida Power and the plaintiff’s engaged in informal settlement discussions, which were terminated on December 22, 1998. However, the plaintiffs have filed a motion to enforce a purported $11 million oral settlement agreement. Florida Power denied that such an agreement existed and filed responsive pleadings to that effect.
In August 1999, the Court dismissed the state law claims of an additional 69 plaintiffs who executed releases upon termination (bringing the total number of state law claims dismissed to 74), granted the Florida Power motion to decertify the class, and denied the plaintiff’s motion to enforce the alleged $11 million oral settlement agreement. In October 1999, the judge certified the question of whether the case should be tried as a class action to the Eleventh Circuit Court of Appeals for immediate appellate review. In December 1999, the Eleventh Circuit Court of Appeals agreed to review the decertification question.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Age Discrimination Suit.)
4.
Florida Power Corporation v. United States, U.S. Court of Federal Claims, Civil Action No. 96-702C.
Consolidated Edison Co., et al v. United States, United States District Court, Southern District of New York, Case No. 98-CIV-4115
On November 1, 1996, Florida Power filed suit against the U.S. Government in the U.S. Court of Claims alleging breach of contract and illegal taking of property without just compensation. The suit arises out of several contracts under which the government provided uranium enrichment services at fixed prices. After Florida Power paid for all services provided under the contracts, the government, through federal legislation enacted in 1992, imposed a retroactive price increase in order to fund the decontamination and decommissioning of the government’s gaseous diffusion uranium enrichment facilities. The government is collecting this increase through an annual “special assessment” levied upon all utilities that had enrichment services contracts with the government. Collection of the special assessments began in 1992 and is scheduled to continue for a fifteen-year period.
To date, Florida Power has paid more than $11 million in special assessments, and if continued throughout the anticipated fifteen-year life, the special assessments would increase the cost of Florida Power’s contracts by more than $23 million. Florida Power seeks an order declaring that all such special assessments are unlawful, and an injunction prohibiting the government from collecting future special assessments, and damages of approximately $9.5 million, plus interest.
In June 1998, Florida Power, Consolidated Edison Co. and 15 other utilities filed an action for declaratory judgement against the United States in the Southern District Court of New York, challenging the constitutionality of the $2.25 billion retroactive assessment imposed by the federal government on domestic nuclear power companies to fund the decommissioning and decontamination of the government’s uranium enrichment facilities. In August 1998, the utilities filed an Amended Complaint adding several additional utilities as plaintiffs.
In February 1999, the court granted Florida Power’s motion to stay the Claims Court action, pending resolution of the District Court case. In April 1999, the Court ruled that the District Court had subject matter jurisdiction, and denied the Government’s motion to transfer the action to the Claims Court. Since then, the parties have filed various other procedural pleadings.
5.
State of Oklahoma, ex rel. John P. Crawford, Insurance Commissioner v. Mid-Continent Life Insurance Company, District Court of Oklahoma County, State of Oklahoma, Case No. CJ-97-2518-62
State of Oklahoma, ex rel, John P. Crawford, Insurance Commissioner as Receiver for Mid-Continent Life Insurance Company v. Florida Progress Corporation, a Florida corporation, Jack Barron Critchfield, George Ruppel, Thomas Steven Krzesinski, Richard Korpan, Richard Donald Keller, James Lacy Harlan, Gerald William McRae, Thomas Richard Dlouhy, Andrew Joseph Beal and Robert Terry Stuart, Jr., District Court of Oklahoma County, State of Oklahoma, Case No. CJ-97-2518-62 (part of the same case noted above).
Michael Farrimond, Pamela S. Farrimond, Angela Fry, Jowhna Hill, and Barbara Hodges, for themselves and all others similarly situated v. Florida Progress Corporation, a Florida corporation, Jack Barron Critchfield, George Ruppel, Thomas Steven Krzesinski, Richard Korpan, Richard Donald Keller, James Lacy Harlan, Gerald William McRae, Thomas Richard Dlouhy, Andrew Joseph Beal and Robert Terry Stuart, Jr., District Court of Oklahoma County, State of Oklahoma, Case No. CJ-99-130-65
On April 14, 1997, the Insurance Commissioner of the State of Oklahoma (“Commissioner”) received approval from the Oklahoma County District Court to temporarily seize control as receiver of the operations of Mid-Continent Life Insurance Company (“Mid-Continent”). The Commissioner had alleged that Mid-Continent's reserves were understated by more than $125 million, thus causing Mid-Continent to be statutorily impaired. The Commissioner further alleged that Mid-Continent had violated Oklahoma law relating to deceptive trade practices in connection with the sale of its “Extra Life” insurance policies and was not entitled to raise premiums, a key element of Mid-Continent’s plan to address the projected reserve deficiency. On May 23, 1997, the District Court of Oklahoma County granted the application of the Commissioner to place Mid-Continent into receivership and ordered the Commissioner to develop a plan of rehabilitation for Mid-Continent. Inconsistently, the court ruled that premiums could be raised on Mid-Continent policies. Both parties appealed to the Oklahoma Supreme Court, but these appeals were withdrawn in February 1999.
On December 22, 1997, the Commissioner filed with the court a petition for damages against Florida Progress and certain former Mid-Continent directors and officers of Florida Progress, alleging alter ego, negligence, breach of fiduciary duty, misappropriation of funds, unjust enrichment, ultra vires, violation of Oklahoma statutory insurance law, violation of Oklahoma statutory corporate law, and seeking equitable relief. On April 17, 1998, the court granted motions to dismiss the individual defendants, leaving Florida Progress as the sole remaining defendant in the lawsuit. This lawsuit has been stayed by agreement of the parties and is expected to be resolved in the context of the rehabilitation plan.
On January 19, 1999, five Mid-Continent policyholders filed a purported class action against Mid-Continent and the same defendants named in the former case filed by Commissioner Crawford. The complaint contains substantially the same factual allegations as the December 22, 1997 case. The Defendants’ motions to dismiss were granted in June, and again in October 1999. A hearing was held in January 2000 on the issue of whether the dismissal was with or without prejudice. At that hearing, the Court ruled that the dismissal was without prejudice and granted the policyholders leave to amend their complaint once again. The plaintiffs filed a second amended complaint in late January, 2000. The complaint as now amended seeks at least $472 million in actual damages, plus punitive damages. In February 2000, each of the receiver, and Florida Progress and other defendants, filed motions to dismiss the second amended complaint. The court denied those motions on March 22.
A new Oklahoma Insurance Commissioner was elected in November 1998 and has stated his intention to work with Florida Progress and others to develop a plan to rehabilitate Mid-Continent rather than pursue litigation against Florida Progress. Florida Progress’ actuarial estimate of the additional assets necessary to fund the reserve, after applying Mid-Continent’s statutory surplus, is in the range of $100 million. The amount stated by the actuary hired by the former Commissioner was in the range of $350 million. Florida Progress believes that any estimate of the projected reserve deficiency would affect only the assets of Mid-Continent, because Florida Progress has legal defenses to any claims asserted against it. Florida Progress is working with the new Commissioner to develop a viable plan to rehabilitate Mid-Continent, which would include the sale of that company. In June 1999, bids were received and evaluated for the rehabilitation of Mid-Continent.
In October 1999, the Commissioner signed a Letter of Intent with Iowa-based Life Investors Insurance Company of America, a wholly owned subsidiary of AEGON USA, Inc., concerning the assumption of all policies of Mid-Continent. In a letter of intent prepared in connection with the rehabilitation, Florida Progress agreed to assign all of Mid-Continent’s stock to the receiver, and contribute $10 million to help offset future premium rate increases or coverage reductions, provided that, among other things, Florida Progress receives a full release from liability, and the receiver’s action against Florida Progress is dismissed, with prejudice. The $10 million was proposed to be held by the receiver in escrow by the Commissioner for a period of 10 years, invested for the benefit of the policyholders, and is expected to yield approximately $20 million. Any proposed premium increases would be offset by this fund until it is exhausted. The Mid-Continent plan was originally scheduled to be considered by the Oklahoma County District Court in December 1999, but the Court postponed its consideration and ruled that any party who wished to submit an alternative proposal must identify themselves to the Commissioner and the Court no later than December 31, 1999. Four proposers other than Life Investors have so identified themselves. Florida Progress now believes that as part of any plan of rehabilitation, Florida Progress will be required to contribute the aforementioned $10 million regardless of which party ultimately assumes the policies of Mid-Continent.
Florida Progress intends to vigorously defend itself against all of the outstanding charges and cooperate with the receiver to gain the court’s approval of a rehabilitation plan that serves the best interests of the policyholders.
(See Item 7 MD&A, Diversified Operations - Mid-Continent Life Insurance Company and Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Mid-Continent Life Insurance Company.)
6.
Calgon Carbon Corporation v. Potomac Capital Investment Corporation, Potomac Electric Power Company, Progress Capital Holdings, Inc., and Florida Progress Corporation, United States District Court for the Western District of Pennsylvania, Civil Action No. 98-0072.
Calgon Carbon Corporation (“Calgon”) filed a complaint on January 12, 1998, asserting securities fraud, breach of contract and other claims in connection with the sale to it by two of the defendants in December 1996 of their interests in Advanced Separation Technologies, Incorporated (“AST”), a corporation engaged in the business of designing and assembling proprietary separation equipment. Prior to closing, Progress Capital, a wholly owned subsidiary of Florida Progress, owned 80 percent of the outstanding stock of AST and Potomac Capital Investment Corporation (an entity unaffiliated with PCH or Florida Progress) owned 20 percent. Calgon paid PCH an aggregate of approximately $57.5 million (producing net proceeds of approximately $56 million after certain fees and expenses) in respect of PCH’s share of AST’s stock. Calgon claims that AST’s assets and revenues were overstated and liabilities and expenses were understated for 1996. Calgon also alleges undisclosed facts relating to accounting methodology, poor products, manufacturing and quality control problems and undisclosed warranty claims. Calgon seeks damages, punitive damages and the right to rescind the purchase. The defendants have filed a motion to dismiss all claims, which is pending.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Advanced Separation Technologies.)
7.
In Re: Joint Petition for Determination of Need for an Electrical Power Plant in Volusia County by the Utilities Commission, City of New Smyrna Beach, and Duke Energy New Smyrna Beach Power Company Ltd., L.L.P. Public Service Commission, Docket No. 981042-EM.
On August 28, 1998, Duke Energy New Smyrna Beach Power Company and the Utilities Commission of New Smyrna Beach filed a petition with the FPSC seeking a determination of need to build a 514 MW combined cycle electric power plant with an in-service date of November 1, 2001. In September 1998, Florida Power filed a Motion to Intervene and a Motion to Dismiss in that action. Florida Power believed that granting the petition would profoundly restructure Florida’s statutorily mandated approach to planning and siting generating capacity by contradicting a long standing FPSC interpretation of the Florida Power Plant Siting Act that has been affirmed by the Florida Supreme Court. Florida Power also believed that granting the petition would raise a host of significant related policy issues that are beyond the scope of this proceeding. On March 4, 1999, the FPSC voted to grant the Duke petition. In April 1999, Florida Power filed an appeal of the FPSC’s decision with the Florida Supreme Court.
8.
Lisa Fruchter, on behalf of herself and all others similarly situated v. Florida Progress Corporation; Richard Korpan; Clarence V. McKee; Richard A. Nunis; Jean Giles Wittner; Michael P. Graney; Joan D. Ruffier; Robert T. Stuart, Jr.; W. D. Frederick; and Vincent J. Naimoli. Circuit Court of the 6th Judicial Circuit in and for Pinellas County, Florida. Case No. 99-6167CI-20
In August 1999, Florida Progress announced that it entered into an Agreement (the Agreement) and Plan of Exchange with Carolina Power and Light Company (“CP&L”) and CP&L Holdings, Inc. (now CP&L Energy Inc. (“CP&L Energy”)), a wholly owned subsidiary of CP&L. All of the outstanding shares of common stock of Florida Progress would be acquired by CP&L Energy in a statutory share exchange. On September 27, 1999, Florida Progress and its directors were served with the above referenced lawsuit, filed on September 14, 1999, seeking class action status and injunctive relief (1) declaring that the Agreement and Plan of Exchange was entered into in breach of the fiduciary duties of the Florida Progress board of directors, (2) enjoining Florida Progress from proceeding with the share exchange, (3) rescinding the Agreement and Plan of Exchange, (4) enjoining any other business combination until an auction is conducted to obtain the highest price possible for Florida Progress, (5) directing the Florida Progress board of directors to commence such an auction, and (6) awarding the class appropriate damages. The complaint also seeks an award of costs and attorneys’ fees. Florida Progress believes this suit is without merit, and intends to vigorously defend itself against this action.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Share Exchange Litigation.)
9.
Wallace Bentley, et al. v. City of Tallahassee, Interstate Fibernet, Inc. and Florida Power Corporation, Circuit Court for Leon County, Florida. Case No. 98-7107.
In December 1998, Florida Power was served with this class action lawsuit seeking damages, declaratory and injunctive relief for the alleged improper use of electric transmission easements. The plaintiffs contend that the licensing of fiber optic telecommunications lines to third parties or telecommunications companies for other than Florida Power’s internal use along the electric transmission line right-of-way exceeds the authority granted in the easements. In June 1999, plaintiffs amended their complaint to add Progress Telecommunications Corporation (“Progress Telecom”) as a defendant and adding counts for unjust enrichment and constructive trust. In January 2000, the court conditionally certified the class statewide. In a mediation held in March 2000, the parties reached a tentative settlement of this claim. That settlement is subject to the resolution of procedural issues relating to class matters as well as court approval. If approved by the court, the settlement would not have a material adverse impact on the financial position, results of operations or liquidity of Florida Power or Progress Telecom.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Easement Litigation.)
10.
Peak Oil Company, Missouri Electric Works, 62nd Street Superfund Sites.
Florida Power has been notified by the EPA that it is or could be a PRP with respect to each of the above Superfund sites. Based upon the information presently available, Florida Power has no reason to believe that its total liability for the cleanup of these sites will be material or that it will be required to pay a significantly disproportionate share of those costs. However, these matters are being reported because liability for cleanup of certain sites is technically joint and several, and because the extent to which Florida Power may ultimately have to participate in those cleanup costs is not presently determinable.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Contaminated Site Cleanup.)
11.
Sanford Gasification Plant Site, Sanford, Florida (“Sanford Site”)
The Sanford Site is a former manufactured gas site located in the city of Sanford, Florida. Sanford Gas Company, which merged into Florida Power in 1944, operated the plant until 1946 when it was
sold to South Atlantic Gas Company (later Atlanta Gas Company). The plant was conveyed three more times, being purchased by the current owner, Florida Public Utilities, in 1965.
In June 1996, the EPA completed an Expanded Site Investigation/Remedial Investigation at the site. In July 1997, the EPA sent a general and special notice letter which advised Florida Power and other PRPs of their potential liability for cleanup. The investigation concluded that the release or threatened release of contaminants includes the site itself and down gradient contamination of an unnamed tributary used for storm water drainage. Water flows from the tributary into Cloud Branch Creek and ultimately Lake Monroe.
In March 1998, Florida Power, Florida Power and Light Company, Atlanta Gas Company, Florida Public Utilities Company and the City of Sanford executed an Administrative Order on Consent (“AOC”) and a Site Participation Agreement with the EPA. By signing the AOC, the PRPs agreed, jointly and severally, to perform the Remedial Investigation, Baseline Risk Assessment and Feasibility Study (“RI/FS”) at the Sanford site. By executing the Site Participation Agreement, the PRPs agreed to an allocation of costs for a RI/FS for up to $1.5 million. Florida Power’s share is approximately 39.8% of these costs.
During the third and fourth quarters of 1999, the PRPs submitted several drafts of the RI/FS for the first phase of cleanup to the EPA. The EPA expects to publish a remedy for the first phase of cleanup by the end of March 2000, followed by a Record of Decision by the end of May 2000. Additional contributions for subsequent site remediation costs will be negotiated among the PRPs as the scope of clean-up efforts become more defined.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Legal Matters - Qualifying Facilities Contracts.)
12.
Inglis Plant Site.
In April 1996, the EPA undertook an emergency removal of lead and arsenic contaminated soil at numerous locations within the Town of Inglis, including a residential area referred to as the “Garden Mall” subdivision. The EPA did not remove soil at Florida Power’s Inglis Power Plant Site, but limited groundwater, soil and sediment samples were taken at that property. In December 1998, the EPA conducted an Expanded Site Inspection (ESI) at this site, and obtained additional groundwater and soil samples from Florida Power’s Inglis property and the adjacent Withalacoochee River. A final copy of the EPA’s report, together with a Request for Information under CERCLA, was received in December 1999. A response was submitted to the EPA in late December 1999. Upon review, the EPA’s conclusions may change the current hazard ranking and ultimately result in the Inglis site being placed on the National Priorities List (NPL). If this property is placed on the NPL, the EPA may conduct remediation actions at the site and it is probable the EPA will seek repayment of those costs as well as investigative costs from the PRPs. Past costs currently exceed $3.5 million with Florida Power identified as the only major viable business associated with this site.
(See Note 13 to the Financial Statements - Commitments and Contingencies - Contaminated Site Cleanup.)
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
FLORIDA PROGRESS
Florida Progress’ common stock is listed on the New York Stock Exchange and the Pacific Stock Exchange. The high and low price per share of Florida Progress’ common stock for each quarterly period and the dividends per common share paid on shares of Florida Progress’ common stock during the last two fiscal years appear in Item 8 on the “Quarterly Financial Data” table for Florida Progress at the end of the Notes to the Financial Statements, and is incorporated herein by reference.
In February 2000, Florida Progress’ Board announced an increase of one cent per share in the common stock quarterly dividend, which on an annual basis would increase the dividend from $2.18 to $2.22 per share. This represents an annual dividend growth rate of 1.8%. In 1999, Florida Progress’ dividend payout ratio was approximately 68% of earnings. Information concerning the Florida Progress dividend policy is set forth in Item 7 “MD&A - Liquidity and Capital Resources.”
Florida Progress’ Restated Articles of Incorporation do not limit the dividends that may be paid on its common stock. However, the primary source for payment of Florida Progress’ dividends consists of dividends paid to it by Florida Power. Florida Power’s Amended Articles of Incorporation and its Indenture dated as of January 1, 1944, under which it issues first mortgage bonds, contain provisions restricting dividends in certain circumstances. At December 31, 1999, Florida Power’s ability to pay dividends was not limited by these restrictions.
Florida Progress and Progress Capital have entered into a Second Amended and Restated Guaranty and Support Agreement dated as of August 7, 1996, pursuant to which Florida Progress has unconditionally guaranteed the payment of Progress Capital’s debt (as defined in the agreement).
Florida Progress did not issue any equity securities during 1999 that were not registered under the Securities Act. Progress Capital, however, has a privately-placed medium-term note program. (See Item 7 “Liquidity and Capital Resources -Diversified Operations”, and Note 8 to the Financial Statements.)
The approximate number of equity security holders of Florida Progress is as follows:
*
The computation of registered holders includes record holders as well as individual positions in the Progress Plus Stock Plan.
FLORIDA POWER
All of Florida Power’s common stock is owned by Florida Progress, and as a result there is no established public trading market for the stock. For the past three years, Florida Power has paid quarterly dividends to Florida Progress totaling the amounts shown in the Statements of Shareholder’s Equity in the Financial Statements. Florida Power’s amended articles of incorporation, and its Indenture dated as of January 1, 1944, as supplemented, under which it issues first mortgage bonds, contain provisions restricting dividends in certain circumstances. At December 31, 1999, Florida Power’s ability to pay dividends was not limited by these restrictions.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1)
Includes charges for extended nuclear outage costs and a provision for loss on Florida Progress’ investment in Mid-Continent. (See Notes 12 and 13)
(2)
Includes charge for extended nuclear outage costs. (See Note 12)
(3)
Includes provision for loss on Florida Progress’ investment in Mid-Continent. (See Note 13)
(4)
Represents the charge to earnings associated with Florida Progress’ divestiture of Echelon International, formerly Progress Credit Corporation.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
Management’s Discussion and Analysis includes a review of the operating results and financial condition of Florida Progress Corporation and focuses primarily on Florida Progress’ two principal subsidiaries, Florida Power Corporation and Electric Fuels Corporation. Through this analysis we identify the key factors affecting revenues, earnings, cash flows, capital requirements and other financial data.
Florida Power provides electric service to approximately 1.4 million customers in west central Florida and serves a predominately retail customer base.
Progress Capital Holdings, Inc. is a holding company for Florida Progress’ diversified operations led by Electric Fuels, an energy and transportation company.
Electric Fuels has three primary business segments: Rail Services, Inland Marine Transportation and Energy & Related Services.
Florida Progress’ board of directors agreed to a combination with Carolina Power & Light Company (CP&L) and CP&L Holdings, Inc. (now CP&L Energy, Inc. (CP&L Energy)) and approved the related share exchange agreement. (See Item 7, MD&A - “Current Issues: Share Exchange Agreement.”)
1999 vs. 1998 HIGHLIGHTS
•
Florida Progress’ 1999 earnings per share of $3.21 increased 10.7 percent over 1998’s earnings of $2.90 per share. The increase was primarily driven by a 3.4 percent increase in kilowatt-hour sales at Florida Power and sales of a new coal-based synthetic fuel, which generates tax credits, by Electric Fuels.
•
Florida Power’s higher 1999 kilowatt-hour sales were driven largely by higher wholesale sales and the addition of 27,000 new customers. Annual customer growth at Florida Power averages about 2 percent, which is twice the national average.
•
Florida Power’s 1999 results include a $44.4 million deferral of revenues as authorized by the Florida Public Service Commission (FPSC).
•
Electric Fuels’ 1999 earnings per share of $.64 increased $.20 per share, or 45.5 percent, over 1998.
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Earnings at the Energy & Related Services business unit were up due primarily to the sale of about 2 million tons of synthetic fuel. In addition, increased production of natural gas contributed to the higher earnings.
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Earnings at the Rail Services unit were up 34 percent due primarily to continued demand for railroad related products and services, and improved earnings in its recycling operations.
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Earnings at the Inland Marine Transportation business unit were flat compared with 1998 due to adverse water conditions during the year, which disrupted barge traffic.
1998 vs. 1997 HIGHLIGHTS
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Florida Progress’ 1998 earnings per share of $2.90 increased substantially over 1997’s earnings of $.56 per share, which included nonrecurring charges of $2.06 per share.
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Operating results for 1997 were negatively impacted by the extended outage of Florida Power’s Crystal River nuclear plant and the provision for loss on Florida Progress’ investment in Mid-Continent Life Insurance Company (“Mid-Continent”). These two events reduced Florida Progress’ 1997 earnings by $200 million, or $2.06 per share. (See Item 7, MD&A - “1997 Extended Nuclear Outage Costs and Mid-Continent Life Insurance Company.”)
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Florida Progress’ 1998 earnings per share increased 10.7 percent when compared with 1997’s recurring earnings per share of $2.62. The increase was due to higher kilowatt-hour sales over 1997 at Florida Power and the expansion of its Electric Fuels operations, primarily the Rail Services and Inland Marine Transportation business units.
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Florida Power’s 1998 earnings per share of $2.56 were up 3.2 percent over 1997, excluding nuclear outage costs of $1.10 per share, due to strong customer growth and usage growth. Demand for electricity during 1998 reached record levels as hotter-than-normal weather during much of the year resulted in record annual usage by residential and commercial customers.
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The effect of hotter-than-normal weather was offset by several items including the accelerated amortization of certain regulatory assets, additional spending for maintenance and reliability projects, and the deferral of $10.1 million of revenues as allowed by the FPSC.
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Electric Fuels’ 1998 earnings per share were up 33 percent over 1997. This increase was driven by improved results from all three of its business units, including an expanded barge fleet, increased coal deliveries, increased demand for railcar and trackwork components and services, and sales of railcars from its lease portfolio.
OPERATING RESULTS
FLORIDA POWER CORPORATION
Utility Operating Revenues & Expenses
Florida Power’s operating results are primarily influenced by customer demand for electricity, its ability to control costs and its authorized regulatory return on equity. Annual demand for electricity is based on the number of customers and their annual usage, with usage largely impacted by weather. Since Florida Power serves a predominately retail customer base, operating results are primarily influenced by the level of retail sales and the costs associated with those sales.
The FPSC oversees the retail sales of the state’s investor-owned electric utilities and authorizes retail base rates. Base rates and the resulting base revenues are intended to cover all reasonable and prudent expenses of utility operations and provide investors with a fair rate of return.
Costs not covered by base rates include fuel, purchased power and energy conservation expenses. The FPSC allows electric utilities to recover these costs, referred to as “pass-through” costs, through various cost recovery clauses to the extent those costs are prudent.
Pass-through costs represent about 40 percent of Florida Power’s annual electric revenues and about 50 percent of its operating expenses. Due to the regulatory treatment of these expenses and the method allowed for recovery, changes from year to year have no material impact on operating results. (See Item 7, MD&A -“1997 Settlement Agreement” for a discussion of certain replacement power costs not recovered from customers.)
The FPSC has authorized a return on equity range for Florida Power of 11-13 percent and its retail base rates are based on the mid-point of that range - 12 percent. (See Item 7, MD&A - “1997 Settlement Agreement” for a discussion of that agreement’s impact on Florida Power’s base rates and allowed return on equity.)
In February of each year, Florida Power provides the FPSC with a forecast of the current year’s earnings and regulatory return on equity. In 1999, in anticipation of higher-than-forecasted earnings due to higher kilowatt-hour sales and the timing of placing its new 530-megawatt plant into service, Florida Power obtained approval from the FPSC to defer revenues.
In 1998, Florida Power experienced higher-than-forecasted sales due to abnormally warm weather and, as a result, took several actions. Those actions included FPSC-approved accelerated write-offs of regulatory assets, deferral of revenues and other measures designed to improve the utility’s overall quality of service to its customers.
Florida Power’s retail regulatory return on equity for 1999 and 1998 was 12.4 percent and 12.3 percent, respectively.
Utility Sales
Sales of Electricity - Billed and Unbilled
Florida Power’s total kilowatt-hour sales increased 3.4 percent in 1999 compared with 1998 despite a return to more normal temperatures in 1999. The increase was due largely to higher kilowatt-hour sales to wholesale customers, primarily Seminole Electric Cooperative, Florida Power’s largest wholesale customer.
Average usage in 1999 among residential customers, the utility’s largest customer class, was about 4 percent lower than 1998 when hotter-than-normal temperatures caused residential customers to use more energy. Partially offsetting the lower usage per residential customer was the addition of 27,000 new customers, including 22,000 residential customers.
In addition to new customers, Florida Power’s non-weather-related usage improved over 1998. Non-weather-related usage can increase due to favorable economic factors including higher personal income and low unemployment levels. Customer usage patterns, influenced by items such as the construction of larger homes and increased use of electronics, also drive additional non-weather-related sales.
Florida Power’s total kilowatt-hour sales increased 11.9 percent in 1998 compared with 1997. The increase in sales was largely due to the hotter-than-normal weather experienced from May through October 1998. As a result of the unusually hot weather, usage by residential customers increased approximately 9 percent over 1997.
Florida Power’s wholesale kilowatt-hour sales were up 57.2 percent in 1998, compared with 1997. The primary reason for the increase was, unlike 1997, the company’s nuclear power plant was in service for most of 1998. This enabled Florida Power to sell generating capacity in the short-term wholesale energy market, after meeting the needs of its customers.
Utility Revenues
Growth in base revenues is a key factor contributing to the growth of Florida Power’s earnings.
Florida Power’s total utility revenues were down $15.6 million compared with 1998. A return to more normal weather in 1999 and an increase in the deferral of base revenues essentially offset the effect of customer growth and non-weather usage growth.
The increase in 1998’s total utility revenues was due to customer and usage growth, hotter-than-normal weather when compared with 1997 and higher pass-through costs.
In 1999, Florida Power deferred $44.4 million of base revenues. Florida Power could have increased amortization of its Tiger Bay regulatory asset, however Florida Power obtained approval from the FPSC to defer recognition of those revenues to have more time to explore ways the retail customer could benefit earlier than by accelerating the amortization of the Tiger Bay asset. (See Item 7, MD&A - “1997 Tiger Bay Buy-Out.”)
The benefit to customers of accelerating the amortization of the Tiger Bay asset is a reduction in the amount collected through certain pass-through clauses once the regulatory asset is fully amortized, which is expected to be 2008.
Florida Power must inform the FPSC of its plan to use the deferred revenues by August 2000. If Florida Power does not file its plan or if the plan is not approved, Florida Power will use the deferred revenues to accelerate the amortization of the Tiger Bay asset.
In 1998, Florida Power deferred $10.1 million in revenues under circumstances similar to those in 1999, but later decided to use the additional revenues to accelerate the amortization of the Tiger Bay asset. In addition to the $10.1 million revenue deferral, Florida Power took several actions to better position itself for the future. The following items largely offset the increase in revenues attributable to the hotter-than-normal weather:
Accelerated the amortization of regulatory
assets and write-off of related taxes
$ 21 million
Expenditures to enhance reliability
$ 17 million
Accelerated lump-sum pay increase
$ 7 million
Fuel, Purchased Power and Energy Conservation Costs
As previously discussed, fuel, purchased power and energy conservation costs are recovered primarily through recovery clauses established by state and/or federal regulators.
Factors influencing fuel and purchased power costs include demand for electricity, fuel prices, the availability of generating plants and the amount and price of electricity purchased from qualifying facilities (“QFs”) and other utilities.
Total fuel and purchased power expenses were $1 billion in 1999, or about 2 percent lower than 1998’s costs despite a 3.7 percent increase in system requirements. System requirements are the total amount of energy either produced or purchased to meet total customer energy demand. The decrease was due largely to lower purchased power costs incurred in 1999 compared with 1998.
Fuel and purchased power expenses for 1998 were only up slightly over 1997, despite an 11.9 percent increase in total kilowatt-hours sold. This was due largely to the availability of Florida Power’s Crystal River nuclear plant (“CR3”). The lack of nuclear generation throughout 1997 forced Florida Power to replace this generation with other, higher-cost replacement power.
A key factor influencing Florida Power’s purchased power costs are the prices paid to QFs for electricity. Currently, Florida Power receives 831 megawatts of its total capacity from QFs.
In 1999, Florida Power spent $240.6 million for purchased power capacity payments under all QF contracts. Those payments represented approximately 24 percent of system fuel and purchased power expenses for the year. Costs associated with the contracts raised Florida Power’s system average cost for generation in 1999 and 1998, and this trend is expected to continue based on the contracts currently in place and the escalating payment schedules associated with each contract.
Florida Power will continue its effort to mitigate the impact of escalating payments from its QF contracts. (See Note 13 to the Financial Statements - Fuel, Coal and Purchased Power Commitments.)
Factors affecting the level of energy conservation costs include the cost of implementing and maintaining various FPSC-approved conservation programs and credits issued to customers participating in programs where equipment is used to remotely control energy usage among those participants. Florida Power does not expect the level of energy conservation costs to vary materially in the future.
Other Utility Operating Expenses
(Dollars in millions)
Operation and maintenance expenses for 1999 were down slightly compared with 1998, due primarily to the absence of additional costs incurred in 1998 for the acceleration of certain maintenance projects and a lump-sum employee pay increase.
Excluding those items, which totaled $24 million, 1999 operation and maintenance costs were up $19 million. The increase over 1998 was attributable to higher legal expenses associated with a pre-existing age discrimination lawsuit, environmental costs associated with a former plant site and higher employee-related benefits.
Utility operation and maintenance expenses increased by $49 million during 1998 compared with 1997. The increase was due to expenditures to enhance reliability, a lump-sum pay increase, and additional operation and maintenance costs related to the Tiger Bay plant acquired in July 1997. In addition, Florida Power wrote off $7 million of inventory deemed obsolete. (See Item 7, MD&A - “1997 Tiger Bay Buy-Out”)
Depreciation and amortization expense of $347.5 million in 1999 was essentially unchanged from 1998 before adjusting for $10 million of accelerated amortization of the Tiger Bay regulatory asset in 1999. Depreciation and amortization expense of $347.1 million for 1998 included $19 million of accelerated amortization of regulatory assets, $14 million of which was related to contract termination costs for the Tiger Bay buy-out.
Excluding the accelerated amortization of regulatory assets in 1999 and 1998, depreciation and amortization expense increased $9 million in 1999 compared with 1998. The increase was due primarily to higher plant balances resulting from the addition of Hines Unit 1, a new 530-megawatt generation plant, in April 1999.
Depreciation and amortization expense increased approximately $20 million in 1998 when compared with 1997. The increase over 1997 was due to higher plant balances and slightly higher depreciation rates.
Taxes other than income taxes includes revenue-related taxes, payroll taxes and property taxes. Revenue-related taxes comprise about half of these taxes and are collected monthly as a part of the customer’s bill. As a result, changes in revenue-related taxes have no impact on operating results.
1997 Extended Nuclear Outage Costs
In September 1996, CR3 was taken out of service to fix an oil pressure problem in the main turbine. When the repairs were completed in October 1996, Florida Power decided to keep the plant shut down to address certain backup safety system design issues.
The nuclear plant was returned to service in February 1998 after being out of service about 16 months. Florida Power’s operating results for 1997 were significantly impacted by the costs associated with the extended outage. Those costs included $100 million in additional operation and maintenance expenses and approximately $173 million in replacement power costs. Replacement power costs were incurred to purchase energy that otherwise would have been generated by Florida Power’s 850-megawatt nuclear plant. The purchases were necessary to meet the energy needs of Florida Power’s customers. Capital expenditures related to the outage were $42 million in 1997. (See Item 7, MD&A - “1997 Settlement Agreement and Note 12 to the Financial Statements - Extended Nuclear Outage.”)
1997 Settlement Agreement
In June 1997, Florida Power entered into a settlement agreement with several parties, excluding the FPSC, which objected to Florida Power recovering replacement power costs resulting from the extended nuclear outage. Normally, all fuel and purchased power costs are recoverable from customers as previously discussed. The settlement agreement provided for recovery of $38 million of replacement power costs through the utility’s fuel recovery clause, while $63 million was recorded as a regulatory asset and is being amortized over four years. The remaining replacement power costs were expensed in 1997 and 1998.
The settlement agreement also provided that the parties to the agreement, excluding Florida Power, would not seek or support any reduction in Florida Power’s base rates or the authorized range of its return on equity during a four-year period that ends June 30, 2001. While the FPSC is not a party to the agreement, it unanimously approved the settlement agreement. (See Note 12 to the Financial Statements - Extended Nuclear Outage.)
1997 Tiger Bay Buy-Out
In July 1997, Florida Power bought out the purchased power contracts related to a 220-megawatt cogeneration facility (Tiger Bay) and also bought the facility. Costs associated with the termination of the purchased power contracts and the acquisition of the facility totaled $445 million.
The FPSC-approved purchase allowed Florida Power to record a regulatory asset of approximately $350 million for contract termination costs and add $75 million to its electric plant.
Florida Power continues to collect from customers an amount equal to what it would have been allowed to recover for capacity and energy payments made in accordance with the original Tiger Bay purchased power contract. Based on these payments, Florida Power is projected to recover enough revenues by the year 2008 to fully amortize the regulatory asset and related interest charges.
The regulatory asset balance as of December 31, 1999 was $297.8 million. (See Note 12 to the Financial Statements.)
DIVERSIFIED OPERATIONS
Electric Fuels makes up the vast majority of Florida Progress’ diversified operations. The increases in diversified revenues and net income over the last three years are due to the expansion of Electric Fuels.
The growth of Electric Fuels has come from all three of its business units and is an important part of Florida Progress’ plan to grow its earnings per share at least 5 percent annually.
At Rail Services, most of the growth has come through acquisitions, in particular, during 1998 when Progress Rail Services Corporation completed approximately $200 million in acquisitions across its various business segments. In 1999, acquisitions totaled about $47 million.
At its Inland Marine Transportation group, growth has come mostly through the expansion of its barge fleet. Since 1992, MEMCO’s fleet of barges, which haul coal, agricultural products and other dry bulk products on the Ohio, Illinois and lower Mississippi rivers, has nearly tripled. In 1999, approximately 100 new barges were added, bringing the fleet size to about 1,200.
The Energy & Related Services business unit did not account for a significant amount of the growth at Electric Fuels during 1998 and 1997.
In 1998, Electric Fuels began selling a coal-based synthetic fuel that it believes qualifies for alternative fuel tax credits. In 1999, sales of the new coal-based synthetic fuel reached about 2 million tons, which accounted for most of the improvement in Energy & Related Services earnings in 1999 over 1998. In addition, Electric Fuels began producing natural gas from company-operated reserves in 1998.
ELECTRIC FUELS CORPORATION
OPERATING RESULTS
Electric Fuels’ operating results are influenced by several factors, unique to the various markets in which the three business units compete.
Rail Services - The key factor affecting operating results is the demand for railcar and trackwork components and services among the country’s major railroads and fleet owners. Another factor is the supply and demand for scrap steel, which directly affects the operating margins of its recycling division.
Inland Marine Transportation - Demand for barge transportation and river conditions on the Mississippi, Illinois and Ohio rivers can significantly affect operating results. Low and high water levels as well as icing conditions can disrupt the flow of barge traffic, the number of barges each towboat can transport and the cargo carried per barge.
Energy & Related Services - This business unit’s operating results are primarily affected by the supply and demand for low-sulfur coal, natural gas and the demand for its new coal-based synthetic fuel.
1999 compared with 1998
Most of the increase in 1999 earnings for Rail Services was due to strong demand for railcar parts, which was driven by new railcar production.
The business unit’s recycling operations contributed to the increase as a result of an increase in tons sold and an improvement in the market price of scrap steel compared to the last quarter of 1998. The increase in tons of scrap sold was due primarily to 1998 acquisitions of certain recycling businesses.
Electric Fuels continued the expansion of its Rail Services business unit in 1999 through acquisitions, expanding a railcar repair facility and completion of a new trackworks plant in Sherman, Texas.
The Inland Marine Transportation business unit’s earnings for 1999 were essentially the same as 1998 despite the addition of approximately 100 new barges. Icing conditions during the first quarter of 1999 and low water conditions later in the year disrupted barge traffic and limited tow capacity. In addition to difficult river conditions during parts of the year, cost increases in diesel fuel negatively impacted operating results in 1999.
Earnings at the Energy & Related Services business unit showed the most improvement over 1998. The increase was due to the sale of about 2 million tons of a new coal-based synthetic fuel and increased production of natural gas.
In 1998, Electric Fuels acquired a majority interest in three synthetic fuel plants that combine a petroleum-based product with coal fines to produce a synthetic fuel. Electric Fuels believes that this fuel qualifies for alternative fuel tax credits as allowed by section 29 of the Internal Revenue Code which expire in 2007. Total tax credits generated and utilized as a result of synthetic fuel sales were $38.8 million and $2.7 million in 1999 and 1998, respectively.
In October 1999, Electric Fuels expanded its synthetic fuel operations through the purchase of four synthetic fuel plants. Two plants were operating in December 1999 and the other two plants are planned to be in operation during the second quarter of 2000.
Electric Fuels’ corporate and other costs increased $.05 per share in 1999 over 1998. The increase was primarily due to higher employee-related benefits.
1998 compared with 1997
In 1998, Rail Services’ earnings improved due to increased demand for its railcar and trackwork components and services, sales of railcars from its lease portfolio and increases resulting from its 1997 acquisitions. Partially offsetting the higher earnings was the impact of a substantial decline in scrap steel prices during the second half of the year.
Earnings from the Inland Marine Transportation group improved due largely to the expansion of its barge fleet. In addition, this group’s 1997 earnings were negatively impacted by flooding conditions on the Ohio and Mississippi rivers in March 1997.
Earnings from the Energy & Related Services business unit were up over 1997 due to improved productivity, higher coal deliveries and an increase in river terminal services.
In September 1997, Electric Fuels bought out its 50 percent partner in a coal mining joint venture and now recognizes 100 percent of the sales and earnings from that property. In the first half of 1998, Electric Fuels completed the expansion of a river terminal in West Virginia, increasing its capacity by 33 percent.
Interest Expense and Other
Florida Progress’ total interest expense decreased $13.5 million in 1999 compared with 1998. The decrease was due primarily to lower debt balances and refinancing of higher cost debt at Florida Power. Partially offsetting those reductions were higher debt balances at Electric Fuels as a result of its expansion activities.
In addition, Florida Progress, through its indirect wholly owned subsidiary FPC Capital I, issued $300 million in company obligated mandatorily redeemable preferred securities (“preferred securities”) to reduce debt during 1999. Distributions paid on these securities totaled $15.2 million in 1999.
Interest expense in 1998 increased $28.4 million over 1997 due to higher debt balances at Florida Power and Electric Fuels. Florida Power’s debt balances increased primarily due to the July 1997 Tiger Bay transaction as well as additional costs associated with the 1997 extended nuclear outage. Electric Fuels incurred higher debt balances in 1998 due to acquisitions in its Rail Services business unit.
Allowance for funds used during construction (AFUDC) is primarily influenced by the amount of construction work-in-progress outstanding during the year. In April 1999, a new 530-megawatt generation plant was placed in service, which reduced construction work-in-progress balances in 1999 compared with 1998. As a result, AFUDC was lower in 1999.
Other income increased $13.1 million compared with 1998. The increase was due primarily to a gain on the sale of property at Florida Power and higher earnings from non-regulated activities.
Income Taxes
Income taxes for 1999 decreased $56.9 million compared with 1998 due primarily to alternative fuel tax credits generated by the sale of Electric Fuels’ synthetic fuels. (See Note 4 to the Financial Statements.)
Mid-Continent Life Insurance Company
In 1997, Florida Progress recorded a provision for a loss on its investment in Mid-Continent and accrued for estimated legal expenses, reducing 1997 earnings by $.96 per share. This action was prompted by Mid-Continent being placed in receivership in the spring of 1997 and subsequent events in 1997.
Mid-Continent remains in receivership today as Florida Progress continues to work with the Oklahoma Insurance Commissioner and others to develop a viable rehabilitation plan, including the divestiture of Mid-Continent, which would be acceptable to all parties.
In December 1999, Florida Progress accrued an additional provision for loss of $10 million related to a proposed rehabilitation plan that is expected to result in a contribution of that amount by Florida Progress. The loss was more than offset by the recognition of tax benefits of approximately $11 million, related to the 1997 write-off of Mid-Continent. (See Note 13 to the Financial Statements - Mid-Continent Life Insurance Company.)
Other
Florida Progress did not experience any significant Year 2000 (Y2K) problems. Expenditures for addressing Y2K issues totaled $15.6 million over the last four years, $12.2 million of which were expensed and the remainder were included in property additions. In 1999, Florida Progress incurred $7.3 million related to Y2K issues, all of which was expensed.
The Financial Accounting Standards Board issued Financial Accounting Standard No. 137 in 1999. (See Note 1 to the Financial Statements.)
Florida Power and former subsidiaries of Florida Progress have been notified by the United States Environmental Protection Agency that each is or may be a potentially responsible party for the cleanup costs of several contaminated sites. (See Note 13 to the Financial Statements - Contaminated Site Cleanup.)
Florida Progress is involved in other litigation. (See Note 13 to the Financial Statements - Legal Matters.)
Even though the inflation rate has been relatively low during the last three years, inflation continues to affect Florida Progress by reducing the purchasing power of the dollar and increasing the cost of replacing assets used in the business. This has a negative effect on Florida Power because regulators generally do not consider this economic loss when setting utility rates. However, such losses are partly offset by the economic gains that result from the repayment of long-term debt with inflated dollars.
LIQUIDITY AND CAPITAL RESOURCES
OVERVIEW
Florida Progress’ utility and diversified operations are capital-intensive businesses. As such, Florida Power’s construction expenditures and Electric Fuels’ capital expenditures and expansion activities largely influence cash requirements.
At Florida Power, cash from operations is the primary source of cash for its construction expenditures, which normally range from $300 million to $400 million annually. Over the last three years, Florida Power’s cash flow from operations has averaged 170 percent of its construction expenditures.
Electric Fuels’ cash requirements have been influenced by rail acquisitions, acquisitions of synthetic fuel plants and the expansion of the company’s barge fleet. These requirements have been funded from cash from operations and debt financings.
Other sources of capital for both companies over the last three years include proceeds from the sale and leaseback of equipment, proceeds from the sale of properties and businesses, the issuance of debt, Florida Progress common stock and preferred securities.
In addition to funding its construction commitments with cash from operations, Florida Power accesses the capital markets through the issuance of commercial paper and medium-term notes.
Florida Power’s interim financing needs are funded primarily through its commercial paper program. The utility has a $200-million, 364-day revolving bank credit facility and a $200-million, long-term revolving bank credit facility expiring in 2003, which are used to back up commercial paper. (See Note 8 to the Financial Statements.) In March 2000, Florida Power established an uncommitted bank bid facility that authorized it to borrow and reborrow, and have outstanding at any time, up to $100 million. The facility was established to temporarily supplement commercial paper borrowings, as needed.
Florida Power’s medium-term note program provides for the issuance of either fixed or floating interest rate notes, with maturities that may range from nine months to 30 years. Florida Power has $250 million of medium-term notes available for issuance. (See Note 8 to the Financial Statements.)
Progress Capital provides short- and long-term financing facilities for Florida Progress’ diversified operations, primarily Electric Fuels. With the benefit of a guaranty and support agreement with Florida Progress, Progress Capital helps to lower the cost of capital of the diversified businesses.
Progress Capital funds diversified operations primarily through the issuance of commercial paper and medium-term notes.
Progress Capital has two revolving bank credit facilities: a 364-day, $100-million facility and a $300-million long-term facility that expires in 2003. These facilities are used to back up commercial paper. Progress Capital also has uncommitted bank bid facilities that authorize it to borrow and re-borrow, and have outstanding at any time, up to $300 million. As of December 31, 1999, there were no loans outstanding under the uncommitted facilities. The facilities were established to temporarily supplement commercial paper borrowings, as needed. (See Note 8 to the Financial Statements.)
Progress Capital also has a medium-term note program for the issuance of either fixed or floating interest rate notes, with maturities that may range from nine months to 30 years. A balance of $135 million is available for issuance under this program.
As of December 31, 1999, Florida Progress also has 1.9 million shares of common stock registered with the SEC available for issuance through its Progress Plus Stock Plan and Employee Savings Plan (the Plans). Under the share exchange agreement with CP&L, Florida Progress is precluded from issuing new common stock, including stock issued under these Plans, without its consent.
Cash Flow From Operating Activities
Cash from operations of $687.1 million in 1999 decreased $190.8 million compared with 1998 due primarily to the absence of $106.3 million of tax benefits received in 1998. These tax benefits related to Florida Power’s 1997 buy-out of the Tiger Bay purchased power contract. (See Item 7, MD&A - “1997 Tiger Bay Buy-Out.”)
Cash from operations in 1998 increased $435.3 million over 1997 as a result of those 1998 tax benefits and the absence of costs associated with the 1997 extended nuclear outage.
Florida Power’s most significant operating cash requirement is fuel and purchased power expense. Essentially all of the cash for these expenses is collected from electric customers through a fuel cost recovery clause. (See Item 7, MD&A - “1997 Extended Nuclear Outage Costs” for discussion of 1997 replacement power costs not recovered from customers.)
Electric Fuels’ most significant operating cash requirement is related to the working capital needs of its rail services and energy operations. The operations of these businesses provide sufficient cash to meet their working capital requirements.
Cash Flow From Investing Activities
Cash requirements for investing activities for 1999 of $612.3 million were down $73.3 million compared with 1998. This was due primarily to fewer acquisitions by Electric Fuels’ Rail Services business unit.
Cash requirements in 1998 were $345.1 million lower than 1997 due primarily to Florida Power’s 1997 buy-out of the Tiger Bay purchased power contract and the purchase of the related 220-megawatt cogeneration facility.
Florida Power’s construction expenditures totaled $357.7 million, $310.2 million and $387.2 million for 1999, 1998 and 1997, respectively. These expenditures are primarily for distribution lines and generating facilities necessary to meet the needs of the utility’s growing customer base.
In planning for its future generation needs, Florida Power develops a forecast of annual demand for electricity, including a forecast of the level and duration of peak demands during the year.
These forecasts have historically been developed using a 15 percent reserve margin. The reserve margin is the difference between a company’s net system generating capacity and the maximum demand on the system. In December 1999, the FPSC approved a joint proposal by Florida Power, Florida Power & Light and Tampa Electric Company to increase the reserve margin to 20 percent by 2004.
In response, Florida Power announced plans to accelerate construction of a planned second generating unit, Hines Unit 2, at its Hines Energy Complex. Hines Unit 2 would be a sister unit to the already operating Hines Unit 1 and would be capable of producing up to 570 megawatts. To determine whether building Hines Unit 2 is the best option, Florida Power is seeking proposals from qualified bidders for new generating capacity to be available beginning in 2003. The bids received will be compared with the option of building Hines Unit 2 on the basis of location, price, reliability and other factors.
Florida Power has sufficient capital resources to accommodate the acceleration of Hines Unit 2. Construction of this plant is anticipated to begin in 2001.
Electric Fuels’ capital expenditures for 1999, 1998 and 1997, respectively, were $163 million, $217 million and $117 million, respectively. These capital expenditures have been primarily for the purchase of barges and towboats and the construction of a new rail car repair and trackworks facility.
Over the last three years, MEMCO has added approximately 500 barges and 3 towboats to its fleet, resulting in property additions of $190 million. In 1999 and 1998, proceeds from sale and lease back of $47 million and $153 million, respectively, relate to a synthetic lease financing transaction for $175 million in barges and $25 million in towboats.
Other capital expenditures for diversified operations are primarily for Progress Telecom and totaled $49 million in 1999.
Most of the cash requirements related to business acquisitions was due to the expansion of Electric Fuels’ Rail Services business unit and synthetic fuel plants. Over the last three years, Electric Fuels has spent $295.2 million for acquisitions, of which $206.6 million was spent in 1998.
Other investing activities in 1999 decreased $70.8 million from 1998 due to lower contributions to supplementary retirement plans. Contributions to these plans were $8.2 million and $75.3 million in 1999 and 1998, respectively. There were no contributions in 1997.
Cash Flow From Financing Activities
Florida Progress’ strong cash flow from operations reduced the need for debt financing in 1999 and 1998. In 1997, the buy-out of the Tiger Bay purchased power contract and the costs associated with the extended nuclear outage required the issuance of new debt.
In addition to strong cash flow from operations, the issuance of $300 million of preferred securities helped reduce Florida Progress’ total debt by $162.1 million as of December 31, 1999, compared with 1998. The preferred securities were issued by FPC Capital I, an affiliated trust, and are, in effect, fully and unconditionally guaranteed by Florida Progress. (See Note 7 to the Financial Statements.)
In 1999 and 1998, Progress Capital issued $50 million and $115 million of medium-term notes, respectively, with maturities ranging from two to ten years. The proceeds were primarily used to repay maturing medium-term notes and for other corporate purposes.
In 1999, $75 million of Florida Power’s 6 1/2 percent first mortgage bonds matured. The bonds were refinanced with commercial paper. In 1998, Florida Power redeemed $250 million of first mortgage bonds. The redemption of these bonds was principally funded through the issuance of $150 million of 30-year medium-term notes bearing an interest rate of 6 3/4 percent and commercial paper.
In July 1997, Florida Power issued $450 million of medium-term notes primarily to finance the buy-out of purchased power contracts associated with the 220-megawatt Tiger Bay cogeneration facility.
Capital Structure
As of December 31, 1999 and 1998:
SECURITY CREDIT RATINGS
Due to the pending share exchange with CP&L, Standard & Poor’s, Moody’s and Duff & Phelps have announced that they are reviewing the rated securities of Florida Power, Progress Capital and FPC Capital I for a possible ratings downgrade. (See Item 7, MD&A - “Share Exchange Agreement.”)
Future Cash Requirements
Florida Power’s three-year construction program totals nearly $900 million for the 2000-2002 forecast period. It includes planned expenditures of about $300 million each year. These expenditures are primarily for the expansion of Florida Power’s distribution system and generation capacity. Florida Power expects these construction expenditures to be financed primarily with cash from operations.
Electric Fuels’ capital expenditures are expected to be approximately $160 million over the next three years and do not include an amount for acquisitions of businesses. However, Electric Fuels does intend to continue to seek opportunities to expand its businesses through acquisitions, which could result in additional capital expenditures.
The share exchange agreement with CP&L limits Florida Progress’ total capital expenditures to those amounts noted above absent CP&L approval.
Dividend Policy and Earnings Outlook
Florida Progress evaluates its dividend policy on an annual basis to ensure that the dividend payout and dividend rate are appropriate given the business plan, projected earnings growth and outlook for the electric utility industry. Florida Progress’ business plan forecasts sustained earnings per share growth, a key factor in determining dividend policy.
The share exchange agreement with CP&L precludes Florida Progress from paying dividends in excess of its 1999 dividend rate of $2.18 per share plus an annual dividend rate increase of 2 percent.
FORWARD-LOOKING STATEMENTS
In this report on Form 10-K, Florida Progress has made forward-looking statements, including statements regarding the strength of the anticipated combination with CP&L and the expected annual synergies, Florida Progress’ targeted long-term earnings per share growth rate of 5 percent or better, the future cash requirements of Florida Power and Electric Fuels and the sources of funds to meet those requirements, the period of time by which Electric Fuels expects to have its four new synthetic fuel plants operating, the qualification of synthetic fuel sales for tax credits, the adequacy of fuel supplies and system capacity to meet future energy demands and the expected costs of complying with environmental regulations.
These statements, and any other statements contained in this report that are not historical facts, are forward-looking statements that are based on a series of projections and estimates regarding the economy, the electric utility industry and the company’s other businesses in general, actions of regulatory bodies and courts, and on key factors which impact the company directly.
The projections and estimates relate to the pricing of services, the actions of courts and regulatory bodies, the success of new products and services, and the effects of competition. The words “should,” “estimates,” “believes,” “expects,” “anticipates,” “plans,” “intends” and variations of such words, and similar expressions are intended to identify these forward-looking statements that involve risks and uncertainties.
Key factors that have a direct bearing on the company’s ability to attain these projections include the actions of various regulatory bodies in approving various aspects of the share exchange with CP&L; continued annual growth in customers; economic and weather conditions affecting the demand for and supply of not only electricity but also Electric Fuels’ barge, rail and other services; successful cost containment efforts; the time needed for synthetic fuel plants to be reassembled and become fully operational in a manner that qualifies the fuel for federal tax credits; market acceptance of synthetic fuel; competition from competing products; impacts of environmental regulations on potential buyers; and the efficient operation and/or construction of Florida Power’s existing and planned generating units. Also, in developing its forward-looking statements, the company has made certain assumptions relating to productivity improvements and the favorable outcome of various commercial, legal and regulatory proceedings, and the lack of disruption to its markets.
If the company’s projections and estimates regarding the economy, the electric utility industry and other key factors differ materially from what actually occurs, or if various legal and regulatory proceedings have unfavorable outcomes, the company’s actual results could vary significantly from the performance projected.
MARKET RISKS
Interest Rate Risk
Florida Progress is exposed to changes in interest rates primarily as a result of its borrowing activities.
A hypothetical 60 basis point increase in interest rates (10 percent of Florida Progress’ weighted average interest rate) affecting its variable rate debt ($640.8 million as of December 31, 1999) would have an immaterial effect on Florida Progress’ pre-tax earnings over the next fiscal year. A hypothetical 10 percent decrease in interest rates
would also have an immaterial effect on the estimated fair value of Florida Progress’ long-term debt and preferred securities as of December 31, 1999.
Equity Price Risk
Florida Power maintains a trust fund, as required by the Nuclear Regulatory Commission, to fund certain costs of nuclear decommissioning. (See Note 5 to the Financial Statements - Decommissioning Costs.) As of December 31, 1999 and 1998, this fund was invested primarily in equity securities and fixed-rate debt securities. A 10 percent decrease in the market value of this fund would result in a reduction in both the fair value of the trust fund and the accumulated decommissioning for nuclear plant of $37.7 million and $33.2 million in 1999 and 1998, respectively. Based on the current regulatory treatment, the company’s earnings would not be impacted by any fluctuations in the market value of the trust fund.
Commodity Price Risk
Currently at Florida Power, commodity price risk due to changes in market conditions for fuel and purchased power are recovered through the fuel cost recovery clause, with no effect on earnings. Electric Fuels is exposed to commodity price risk through coal and natural gas sales, the scrap steel market and fuel for its marine transportation business. A 10 percent change in the market price of those commodities would have an immaterial effect on the earnings of Florida Progress.
CURRENT ISSUES
Share Exchange Agreement
On August 22, 1999, Florida Progress entered into a share exchange agreement with CP&L and CP&L Energy. The agreement was amended on March 3, 2000. Under the terms of the agreement, all of the outstanding shares of Florida Progress will be acquired by CP&L Energy in a statutory share exchange.
The consummation of the share exchange with CP&L Energy is subject to certain conditions including the approval or regulatory review by certain state and federal governmental agencies, and is expected to be completed during the fall of 2000.
The principal regulatory agencies that will approve or review the transaction include the United States Securities and Exchange Commission, Federal Energy Regulatory Commission, Nuclear Regulatory Commission, Department of Justice and the Florida, North Carolina and South Carolina state public service commissions.
A joint proxy statement about the combination will be sent to shareholders of both companies.(See Note 2 to the Financial Statements.)
INDUSTRY RESTRUCTURING
OVERVIEW
The electric utility industry is undergoing changes designed to increase competition in the wholesale and retail electricity markets. The wholesale power market includes sales of electricity to utilities from other utilities and non-utility generators. This market is regulated by the FERC. The retail electricity market includes sales of electricity to end-use customers, i.e., residential, commercial and industrial customers, and is regulated by state public utility commissions.
As a result of the Public Utilities Regulatory Policies Act of 1978 (PURPA) and the Energy Policy Act of 1992 (EPA of 1992), competition in the wholesale electricity market has greatly increased, especially from non-utility generators of electricity. In 1996, FERC issued new rules on transmission service to facilitate competition in the
wholesale market on a nationwide basis. The rules give greater flexibility and more choices to wholesale power customers.
On December 20, 1999, FERC issued its final rules on Regional Transmission Organizations (RTO) designated as “Order 2000.” Order 2000 is intended to enhance competitive electricity markets through the establishment of independent regionally-operated transmission grids. All public utilities that own, operate or control interstate electric transmission lines must file with FERC by October 15, 2000, a proposal for an RTO or an explanation of efforts made by the utility to participate in an RTO. The order provides guidance and specifies minimum characteristics and functions required of an RTO and also states that all RTOs should be operational by December 15, 2001.
The effect of changes that improve access to wholesale power markets has been a significant growth in non-utility generation capacity. The development of merchant plants, which are non-utility generating plants, without the benefit of a long-term contract for the sale of most of the plant’s generating capacity, has contributed to the growth of capacity in this market.
To date, many states have adopted legislation that would give retail customers the right to choose their electricity provider (retail choice) and essentially every other state has, in some form, considered the issue.
In addition to restructuring activity in various states, there have been several industry restructuring bills introduced in Congress. During 1999, the House Commerce Subcommittee on Energy and Power introduced the latest electric utility restructuring bill, which was not considered by the House or the Senate in 1999.
Restructuring Issues - Impact on Florida Power
Retail Choice
Florida’s legislature has not considered a bill to restructure the electric utility industry. The FPSC monitors, through a staff committee, the restructuring activities in other states.
In January 1999, the Florida House of Representatives’ Utilities and Communications Committee heard presentations from the FPSC and other interested parties on the structure and issues concerning the electric industry in Florida.
In Florida, there has been less incentive to push forward legislative proposals concerning retail choice. This is due primarily to competitive rates for electricity in Florida compared with other states where restructuring legislation has been passed.
Regional Transmission Organizations
Florida Power filed its proposed plan for an RTO as part of its filing with FERC for the CP&L transaction. Florida Power’s proposal involves the creation of a Florida Independent Scheduling Administrator (Florida ISA). The proposed Florida ISA will be a non-profit organization designed to provide independent oversight over the transmission facilities of Florida Power and other participants. Florida Power and other participants would continue to own, operate and maintain their transmission facilities but operating and maintenance scheduling would be coordinated by the Florida ISA.
Florida Power does not expect the participation in the proposed Florida ISA or other types of RTOs to have a significant impact on its operating results since transmission assets and revenues comprise a small portion of its total assets (10%) and total revenues (6%).
Merchant Plants
In August 1998, Duke Energy filed a petition to build Florida’s first merchant power plant, a 514-megawatt facility to be located in Volusia County, Florida. The plant would provide 30 megawatts of energy to the Utilities Commission of the City of New Smyrna Beach and the remaining capacity would be available for wholesale sales.
In a move Florida Power believes is contrary to existing state law, the FPSC granted Duke Energy’s petition. Florida Power and other Florida utilities filed an appeal of the FPSC’s decision with the Florida Supreme Court.
Since Duke Energy’s petition, several other companies have announced plans to build merchant power plants in Florida. The earliest date by which any of these merchant power plants are projected to be in service is 2002.
Florida Power does not expect the development of merchant power plants to have a significant impact on its operating results due primarily to its predominately retail customer base.
Franchise Agreements
A major portion of Florida Power’s retail business, representing approximately 40 percent of total 1999 utility revenues, is covered under the terms of 111 franchise agreements with various municipalities.
Many of the franchise agreements contain a clause that gives the municipality the right to purchase Florida Power’s distribution system within the municipality at the expiration of the franchise. The exercise of that right would require complex and extensive legal proceedings. In addition, Florida Power believes that quality service and competitive rates will continue to be important factors that a municipality would consider before purchasing Florida Power’s distribution system.
Stranded Costs
An important issue encompassed by industry restructuring is the recovery of “stranded costs.” Stranded costs include the generation assets of utilities whose value in a competitive marketplace would be less than their current book value, as well as above-market purchased power commitments to QFs. Thus far, all states that have passed restructuring legislation have provided for the opportunity to recover a substantial portion of stranded costs.
Assessing the amount of stranded costs for a utility requires various assumptions about future market conditions including the future price of electricity. For Florida Power, the single largest stranded cost exposure is its commitments to QFs.
Florida Power has taken a proactive approach to this industry issue. Since 1996, Florida Power has been seeking ways to address the impact of escalating payments from contracts it was obligated to sign under provisions of PURPA.
These efforts have resulted in Florida Power successfully mitigating, through buy-outs and buy-downs of these contracts, more than 20 percent of its purchased power commitments to QFs. (See Note 12 and Note 13 to the Financial Statements.)
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For discussion of interest rate risk, equity price risk and commodity risk, see Item 7, MD&A - “Market Risks.”
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITOR’S REPORT
To the Shareholders of Florida Progress Corporation
and Florida Power Corporation:
We have audited the accompanying consolidated balance sheets of Florida Progress Corporation and subsidiaries, and of Florida Power Corporation, as of December 31, 1999 and 1998, and the related consolidated statements of income, cash flows, and common equity and comprehensive income for each of the years in the three-year period ended December 31, 1999. In connection with our audits of the financial statements, we also have audited the financial statement schedules listed in Item 14 therein. These financial statements and financial statement schedules are the responsibility of the respective managements of Florida Progress Corporation and Florida Power Corporation. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Florida Progress Corporation and subsidiaries, and Florida Power Corporation, as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
/s/KPMG LLP
KPMG LLP
St. Petersburg, Florida
January 20, 2000, except as to paragraph 1 of Note 2, which is as of March 3,
FLORIDA PROGRESS CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS
FLORIDA PROGRESS CORPORATION
Consolidated Statements of Income
For the years ended December 31, 1999, 1998 and 1997
(Dollars in millions, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
FLORIDA PROGRESS CORPORATION
Consolidated Balance Sheets
December 31, 1999 and 1998
(Dollars in millions)
The accompanying notes are an integral part of these consolidated financial statements.
FLORIDA PROGRESS CORPORATION
Consolidated Balance Sheets
December 31, 1999 and 1998
(Dollars in millions)
The accompanying notes are an integral part of these consolidated financial statements.
FLORIDA PROGRESS CORPORATION
Consolidated Statements of Cash Flows
For the years ended December 31, 1999, 1998 and 1997
(Dollars in millions)
The accompanying notes are an integral part of these consolidated financial statements.
FLORIDA PROGRESS CORPORATION
Consolidated Statements of Common Equity and Comprehensive Income
For the years ended December 31, 1999, 1998 and 1997
(Dollars in millions, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
FLORIDA POWER CORPORATION
Statements of Income
For the years ended December 31, 1999, 1998 and 1997
(Dollars in millions)
The accompanying notes are an integral part of these financial statements.
FLORIDA POWER CORPORATION
Balance Sheets
December 31, 1999 and 1998
(Dollars in millions)
The accompanying notes are an integral part of these financial statements.
FLORIDA POWER CORPORATION
Balance Sheets
December 31, 1999 and 1998
(Dollars in millions)
The accompanying notes are an integral part of these financial statements.
FLORIDA POWER CORPORATION
Statements of Cash Flows
For the years ended December 31, 1999, 1998 and 1997
(Dollars in millions)
The accompanying notes are an integral part of these financial statements.
FLORIDA POWER CORPORATION
Statements of Common Equity and Comprehensive Income
For the years ended December 31, 1999, 1998 and 1997
(Dollars in millions)
The accompanying notes are an integral part of these financial statements.
FLORIDA PROGRESS CORPORATION AND FLORIDA POWER CORPORATION
NOTES TO FINANCIAL STATEMENTS
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
General - Florida Progress Corporation (the Company) is an exempt holding company under the Public Utility Holding Company Act of 1935. Its two primary subsidiaries are Florida Power Corporation (Florida Power) and Electric Fuels Corporation (Electric Fuels).
Due to the geographical locations of Electric Fuels’ Rail Services, Inland Marine Transportation, and non-Florida Power portion of its Energy & Related Services operations, it is necessary to report their results one month in arrears.
The consolidated financial statements include the financial results of the Company and its majority-owned operations. All significant intercompany balances and transactions have been eliminated. Investments in 20% to 50%-owned joint ventures are accounted for using the equity method.
Effective December 31, 1997, the Company deconsolidated the financial statements of Mid-Continent, and the investment in Mid-Continent is accounted for under the cost method.
Certain reclassifications have been made to prior-year amounts to conform to the current year’s presentation.
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. This could affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported period. These estimates involve judgments with respect to various items including future economic factors that are difficult to predict and are beyond the control of the Company. Therefore actual results could differ from these estimates.
Regulation - Florida Power is regulated by the Florida Public Service Commission (FPSC) and the Federal Energy Regulatory Commission (FERC). The utility follows the accounting practices set forth in Financial Accounting Standard (FAS) No. 71, “Accounting for the Effects of Certain Types of Regulation.” This standard allows utilities to capitalize or defer certain costs or reduce revenues based on regulatory approval and management’s ongoing assessment that it is probable these items will be recovered or refunded through the ratemaking process.
PROPERTY, PLANT AND EQUIPMENT
Electric Utility Plant - Utility plant is stated at the original cost of construction, which includes payroll and related costs such as taxes, pensions and other fringe benefits, general and administrative costs, and an allowance for funds used during construction. Substantially all of the utility plant is pledged as collateral for Florida Power’s first mortgage bonds.
The allowance for funds used during construction represents the estimated cost of equity and debt for utility plant under construction. Florida Power is permitted to earn a return on these costs and recover them in the rates charged for utility services while the plant is in service. The average rate used in computing the allowance for funds was 7.8% for 1999, 1998 and 1997.
The cost of nuclear fuel is amortized to expense based on the quantity of heat produced for the generation of electric energy in relation to the quantity of heat expected to be produced over the life of the nuclear fuel core.
Florida Power’s annual provision for depreciation, including a provision for nuclear plant decommissioning costs and fossil plant dismantlement costs, expressed as a percentage of the average balances of depreciable utility plant, was 4.6% for 1999, 4.7% for 1998 and 4.8% for 1997.
The fossil plant dismantlement accrual has been suspended for a period of four years, effective July 1, 1997. (See Note 12 to the Financial Statements - Extended Nuclear Outage.)
Florida Power charges maintenance expense with the cost of repairs and minor renewals of property. The plant accounts are charged with the cost of renewals and replacements of property units. Accumulated depreciation is charged with the cost, less the net salvage, of property units retired.
In compliance with a regulatory order, Florida Power accrues a reserve for maintenance and refueling expenses anticipated to be incurred during scheduled nuclear plant outages.
Other Property - Other property consists primarily of railcar and recycling equipment, barges, towboats, land, mineral rights and telecommunications equipment.
Depreciation on other property is calculated principally on the straight-line method over the following estimated useful lives:
Electric Fuels owns, in fee, properties that contain estimated proven and probable coal reserves of approximately 185 million tons, and controls, through mineral leases, additional estimated proven and probable coal reserves of approximately 30 million tons. Electric Fuels’ reserves were evaluated and summarized by an independent consultant. Depletion is provided on the units-of-production method based upon the estimates of recoverable tons of clean coal.
Utility Revenues, Fuel and Purchased Power Expenses - Revenues include amounts resulting from fuel, purchased power and energy conservation cost recovery clauses, which generally are designed to permit full recovery of these costs. The adjustment factors are based on projected costs for a 12-month period. The cumulative difference between actual and billed costs is included on the balance sheet as a current regulatory asset or liability. Any difference is billed or refunded to customers during the subsequent period.
In December 1997, Florida Power ended a three-year test period for residential revenue decoupling, which was ordered by the FPSC and began in January 1995. Revenue decoupling eliminated the effect of abnormal weather from revenues and earnings. The regulatory asset at December 31, 1999, is currently being recovered from customers over a period ending in the year 2000, through the energy conservation cost recovery clause as directed by the FPSC decoupling order.
Florida Power accrues the nonfuel portion of base revenues for services rendered but unbilled.
Diversified Revenues - Revenues are recognized at the time products are shipped or as services are rendered. Leasing activities are accounted for in accordance with FAS No. 13, “Accounting for Leases.”
Income Taxes - Deferred income taxes are provided on all significant temporary differences between the financial and tax basis of assets and liabilities using current tax rates.
Deferred investment tax credits, subject to regulatory accounting practices, are amortized to income over the lives of the related properties.
Accounting for Certain Investments - The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Dividend and interest income are recognized when earned.
Acquisitions - During 1999 and 1998, subsidiaries of Electric Fuels acquired 8 and 13 businesses, respectively, in separate transactions. The cash paid for the 1999 and 1998 acquisitions was $55.9 million and $206.6 million, respectively. The excess of the aggregate purchase price over the fair value of net assets acquired was approximately
$24.0 million and $87.8 million in 1999 and 1998, respectively. The acquisitions were accounted for under the purchase method of accounting and, accordingly, the operating results of the acquired businesses have been included in the Company’s consolidated financial statements since the date of acquisition. Each of the acquired companies conducted operations similar to those of the subsidiaries and has been integrated into Electric Fuels’ operations. The pro forma results of consolidated operations for 1999 and 1998, assuming the 1999 acquisitions were made at the beginning of each year, would not differ significantly from the historical results.
Goodwill - Goodwill is being amortized on a straight-line basis over the expected periods to be benefited, generally 40 years. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company’s average cost of funds. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved.
Environmental - The Company accrues environmental remediation liabilities when the criteria of FAS No. 5, “Accounting for Contingencies,” have been met. Environmental expenditures are expensed as incurred or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed.
Liabilities for expenditures of a noncapital nature are recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated.
Loss Contingencies - Liabilities for loss contingencies arising from litigation are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. The amount of the liability recorded includes an estimate of outside legal fees directly associated with the loss contingency.
New Accounting Standards - In June 1999, the FASB issued FAS No. 137, “Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No. 133,” which deferred, for one year, the effective date for the implementation of FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” FAS No. 133 establishes accounting and reporting standards for derivative instruments and for hedging activities and requires that an entity recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair values. Florida Progress will be required to adopt this standard for financial statements issued beginning the first quarter of fiscal year 2001. Florida Progress is currently evaluating the effect the standard will have on its financial statements.
NOTE 2: PROPOSED SHARE EXCHANGE
On August 22, 1999, the Company entered into an Agreement and Plan of Exchange (the Agreement) with Carolina Power & Light Company (“CP&L”), and CP&L Holdings, Inc. (now CP&L Energy Inc. (“CP&L Energy”)), a wholly owned subsidiary of CP&L. CP&L is in the process of restructuring whereby CP&L Energy will become the holding company of CP&L. All of the outstanding shares of Florida Progress would be acquired by CP&L Energy in a statutory share exchange. For each share of Florida Progress common stock, the Florida Progress shareholder will elect to receive either $54.00 in cash or shares of CP&L Energy common stock, subject to adjustment. The number of CP&L Energy shares to be exchanged for each Florida Progress share will be between 1.1897 and 1.4543, based on the value of CP&L Energy shares during a 20-day consecutive time period ending with the fifth trading day immediately preceding the share exchange. The total of Florida Progress shareholder elections are subject to the limitation that no more than 65 percent of the shares of Florida Progress stock will be exchanged for cash, and no more than 35 percent of the shares of Florida Progress stock will be exchanged for shares of CP&L Energy stock. The agreement was amended on March 3, 2000 to provide that Florida Progress shareholders would receive one contingent value obligation for each share of Florida Progress common stock they own. Each contingent value obligation will represent the right to receive contingent payments based upon the net after-tax cash flow to CP&L Energy generated by four synthetic fuel plants purchased by subsidiaries of Florida Progress in October 1999.
The transaction has been approved by the Boards of Directors of Florida Progress, CP&L Energy and CP&L. The transaction is expected to close in the fall of 2000, shortly after all the conditions to the Agreement, including the approval of the shareholders of Florida Progress and CP&L, and the approval or regulatory review by certain state and federal government agencies are met. While there are no formal FPSC approvals for this transaction, Florida Progress will continue to work with the state regulators regarding the ongoing jurisdiction over Florida Power. Upon completion of the share exchange, CP&L Energy will be subject to regulation as a holding company registered under the Public Utility Holding Company Act of 1935.
The Boards of Directors of Florida Progress, CP&L Energy and CP&L may terminate the Agreement under certain circumstances, including if the share exchange were not completed on or before December 31, 2000, or by June 30, 2001, if the necessary governmental approvals were not obtained by December 31, 2000, but all other conditions have been or could be satisfied by that time. In the event that Florida Progress or CP&L Energy terminate the Agreement in certain other limited circumstances, Florida Progress would be required to pay a $150 million termination fee, plus up to $25 million in fees and expenses.
In addition, Florida Progress’ obligation to complete the share exchange is conditioned upon the average closing price of CP&L Energy common stock for the 20-day trading period ending five trading days before the share exchange, not being less than $30. If the average CP&L Energy stock price is less than $30, Florida Progress is not obligated to complete the share exchange.
Both CP&L Energy and Florida Progress have agreed to certain undertakings and limitations regarding the conduct of their respective businesses prior to the closing of the transaction.
NOTE 3: FINANCIAL INSTRUMENTS
Estimated fair value amounts have been determined by the Company using available market information. Judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates may be different than the amounts that the Company could realize in a current market exchange.
The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s marketable securities, long-term debt obligations and Company-obligated mandatorily redeemable preferred securities.
The Company held only securities classified as available for sale at both December 31, 1999 and 1998. At December 31, 1999 and 1998, the Company had the following financial instruments with estimated fair values and carrying amounts:
The change in the cash surrender value of the company’s investment in company-owned life insurance is reflected in other expense (income) in the accompanying consolidated statements of income. The nuclear decommissioning fund consists primarily of equity securities and municipal, government, corporate, and mortgage-backed debt securities. The debt securities have a weighted average maturity of approximately 10 years. The fund had gross unrealized gains at December 31, 1999 and 1998 of $117.3 million and $97.1 million, respectively. Gross unrealized losses for
the same periods were not significant. The proceeds from the sale of securities were $722.2 million, $231.7 million, and $496.2 million for the years ended December 31, 1999, 1998, and 1997, respectively. The cost of securities sold was based on specific identification and resulted in gross realized gains of $7.6 million, $1.5 million, and $1.9 million for the years ended December 31, 1999, 1998, and 1997, respectively. All realized and unrealized gains and losses are reflected as an adjustment to the accumulated provision for nuclear decommissioning.
NOTE 4: INCOME TAXES
FLORIDA PROGRESS
FLORIDA POWER
The primary differences between the statutory rates and the effective income tax rates are detailed below:
FLORIDA PROGRESS
FLORIDA POWER
The following summarizes the components of deferred tax liabilities and assets at December 31, 1999 and 1998:
FLORIDA PROGRESS
FLORIDA POWER
At December 31, 1999 and 1998, Florida Power had net non current deferred tax liabilities of $468.6 million and $563.1 million and net current deferred tax assets of $10.2 million and $55.9 million, respectively. Florida Power expects the results of future operations will generate sufficient taxable income to allow for the utilization of deferred tax assets.
At December 31, 1999 and 1998, Florida Progress had net non current deferred tax liabilities of $565.3 million and $595.4 million and net current deferred tax assets of $41.3 million and $55.9 million, respectively. The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to allow for the utilization of deferred tax assets.
NOTE 5: NUCLEAR OPERATIONS
Florida Power incurred $100 million in additional operation and maintenance expenses in 1997 as a result of Florida Power’s Crystal River nuclear plant (CR3) experiencing an extended outage beginning in September 1996. In January 1998, the NRC granted Florida Power permission to restart the plant. On February 15, 1998, the plant returned to service. With the exception of a planned refueling outage in October 1999, CR3 has produced more than 100% of its rated capacity since its restart in February 1998. (See Note 12 to the Financial Statements.)
Jointly Owned Plant - In September 1999, Florida Power purchased the City of Tallahassee’s 1.33% interest in the Crystal River nuclear plant, which was approved by regulatory authorities. The following information relates to Florida Power’s 91.78% proportionate share of the nuclear plant at December 31, 1999, and 90.45% proportionate share at December 31, 1998:
Net capital additions for Florida Power were $39.2 million in 1999 and $30.0 million in 1998. Depreciation expense, exclusive of nuclear decommissioning, was $34.3 million in 1999 and $32.8 million in 1998. Each co-owner provides for its own financing of its investment. Florida Power’s share of the asset balances and operating costs is included in the appropriate consolidated financial statements. Amounts exclude any allocation of costs related to common facilities.
Decommissioning Costs - Florida Power’s nuclear plant depreciation expenses include a provision for future decommissioning costs, which are recoverable through rates charged to customers. Florida Power is placing amounts collected in an externally managed trust fund. The recovery from customers, plus income earned on the trust fund, is intended to be sufficient to cover Florida Power’s share of the future dismantlement, removal and land restoration costs. Florida Power has a license to operate the nuclear unit through December 3, 2016, and contemplates decommissioning beginning at that time.
In November 1995, the FPSC approved the current site-specific study that estimates total future decommissioning costs at approximately $2 billion, which corresponds to $481.2 million in 1999 dollars. Florida Power’s share of the total annual decommissioning expense is $21.7 million.
Florida Power is required to file a new site-specific study with the FPSC at least every five years, which will incorporate current cost factors, technology and radiological criteria. In November 1999, the FPSC approved Florida Power’s request to defer the filing of its nuclear decommissioning cost study for one year, until December 2000.
Fuel Disposal Costs - Florida Power has entered into a contract with the U.S. Department of Energy (DOE) for the transportation and disposal of spent nuclear fuel. Disposal costs for nuclear fuel consumed are being collected from customers through the fuel adjustment clause at a rate of $.001 per net nuclear kilowatt-hour sold and are paid to the DOE quarterly. Florida Power currently is storing spent nuclear fuel on-site and has sufficient storage capacity in place for fuel consumed through the year 2011.
NOTE 6: PREFERRED AND PREFERENCE STOCK AND SHAREHOLDER RIGHTS
The authorized capital stock of the Company includes 10 million shares of preferred stock, without par value, including 2 million shares designated as Series A Junior Participating Preferred Stock. No shares of the Company’s preferred stock are issued and outstanding. However, under the Company’s Shareholder Rights Agreement, each share of common stock has associated with it approximately two-thirds of one right to purchase one one-hundredth of
a share of Series A Junior Participating Preferred Stock, subject to adjustment, which is exercisable in the event of certain attempted business combinations. If exercised, the rights would cause substantial dilution of ownership, thus adversely affecting any attempt to acquire the Company on terms not approved by the Company’s Board of Directors. The rights have no voting or dividend rights and expire in December 2001, unless redeemed earlier by the Company or terminated pursuant to the CP&L share exchange. In connection with the CP&L share exchange, the Company executed an amendment to the Shareholder Rights Agreement which provides that the Rights will expire immediately prior to the effective time of the exchange, and the exchange will not cause a triggering event or the issuance of any preferred stock.
The authorized capital stock of Florida Power includes three classes of preferred stock: 4 million shares of Cumulative Preferred Stock, $100 par value; 5 million shares of Cumulative Preferred Stock, without par value; and 1 million shares of Preference Stock, $100 par value. No shares of Florida Power’s Cumulative Preferred Stock, without par value, or Preference Stock are issued and outstanding.
Cumulative Preferred Stock, $100 par value, for Florida Power is detailed below:
All Cumulative Preferred Stock series are without sinking funds and are not subject to mandatory redemption.
NOTE 7: COMPANY OBLIGATED MANDATORILY REDEEMABLE CUMULATIVE QUARTERLY INCOME PREFERRED SECURITIES (QUIPS) OF A SUBSIDIARY TRUST HOLDING SOLELY FLORIDA PROGRESS GUARANTEED JUNIOR SUBORDINATED DEFERRABLE INTEREST NOTES
In April 1999, FPC Capital I (the Trust), an indirect wholly owned subsidiary of the Company, issued 12 million shares of $25 par cumulative Company-obligated mandatorily redeemable preferred securities (“Preferred Securities”) due 2039, with an aggregate liquidation value of $300 million and a quarterly distribution rate of 7.10%. Currently, all 12 million shares of the Preferred Securities that were issued are outstanding. Concurrent with the issuance of the Preferred Securities, the Trust issued to Florida Progress Funding Corporation (Funding Corp.) all of the common securities of the Trust (371,135 shares), for $9.3 million. Funding Corp. is a direct wholly owned subsidiary of the Company.
The existence of the Trust is for the sole purpose of issuing the Preferred Securities and the common securities and using the proceeds thereof to purchase from Funding Corp. its 7.10% Junior Subordinated Deferrable Interest Notes (“subordinated notes”) due 2039, for a principal amount of $309.3 million. The subordinated notes and the Notes Guarantee (as discussed below) are the sole assets of the Trust. Funding Corp.’s proceeds from the sale of the subordinated notes were advanced to Progress Capital Holdings and used for general corporate purposes including the repayment of a portion of certain outstanding short-term bank loans and commercial paper.
The Company has fully and unconditionally guaranteed the obligations of Funding Corp. under the subordinated notes (the Notes Guarantee). In addition, the Company has guaranteed the payment of all distributions required to be made by the Trust, but only to the extent that the Trust has funds available for such distributions (Preferred Securities Guarantee). The Preferred Securities Guarantee, considered together with the Notes Guarantee, constitutes a full and unconditional guarantee by the Company of the Trust’s obligations under the Preferred Securities.
The subordinated notes may be redeemed at the option of Funding Corp. beginning in 2004 at par value plus accrued interest through the redemption date. The proceeds of any redemption of the subordinated notes will be used by the Trust to redeem proportional amounts of the Preferred Securities and common securities in accordance with their terms. Upon liquidation or dissolution of Funding Corp., holders of the Preferred Securities would be entitled to the liquidation preference of $25 per share plus all accrued and unpaid dividends thereon to the date of payment.
NOTE 8: DEBT
The Company’s long-term debt at December 31, 1999 and 1998 is detailed below:
(In millions)
(a) Weighted average interest rate at December 31, 1999.
The Company’s consolidated subsidiaries have lines of credit totaling $800 million, which are used to support the issuance of commercial paper. The lines of credit were not drawn on as of December 31, 1999. Interest rate options under the lines of credit arrangements vary from subprime or money market rates to the prime rate. Banks providing lines of credit are compensated through fees. Commitment fees on lines of credit vary between .08 and .12 of 1%.
The lines of credit consist of four revolving bank credit facilities, two each for Florida Power and Progress Capital Holdings, Inc. (Progress Capital). The Florida Power facilities consist of $200 million with a 364-day term and $200 million with a remaining four-year term. The Progress Capital facilities consist of $100 million with a 364-day term and $300 million with a remaining four-year term. In 1999, both 364-day facilities were extended to November 2000. Based on the duration of the underlying backup credit facilities, $483.5 million and $500 million of outstanding commercial paper at December 31, 1999 and 1998, respectively, are classified as long-term debt. As of December 31, 1999, Florida Power and Progress Capital had an additional $153.1 million and $0 million, respectively, of outstanding commercial paper classified as short-term debt.
Progress Capital has uncommitted bank bid facilities authorizing it to borrow and re-borrow, and have outstanding at any time, up to $300 million. As of December 31, 1999 and 1998, $0 million and $150 million, respectively, was outstanding under these bid facilities.
Florida Power has a public medium-term note program providing for the issuance of either fixed or floating interest rate notes. These notes may have maturities ranging from nine months to 30 years. A balance of $250 million is available for issuance at December 31, 1999.
In March 1998, Florida Power redeemed all of its $150 million principal amount of first mortgage bonds, 8 5/8% series due November 2021 at a redemption price of 105.17% of the principal amount thereof. Substantially all of this redemption was funded from the net proceeds of $150 million of medium-term notes issued in February 1998, which
bear an interest rate of 6 3/4% and mature in February 2028. Florida Power also redeemed, in November 1998, an additional $100 million of first mortgage bonds. The entire $50 million principal amount of the 7 3/8% series was redeemed at a price of 100.93%, and the entire $50 million principal amount of the 7 1/4% series was redeemed at a price of 100.86%. Both issues were due in 2002. The redemption was funded from internally generated funds and commercial paper.
Florida Power has registered $370 million of first mortgage bonds, which are unissued and available for issuance.
Progress Capital has a private medium-term note program providing for the issuance of either fixed or floating interest rate notes, with maturities ranging from nine months to 30 years. A balance of $135 million is available for issuance under this program.
The combined aggregate maturities of long-term debt for 2000 through 2004 are $163.2 million, $185.9 million, $85.3 million, $762.3 million and $71.3 million, respectively.
Florida Progress has unconditionally guaranteed the payment of Progress Capital’s debt.
NOTE 9: STOCK-BASED COMPENSATION
The Company’s Long-Term Incentive Plan (LTIP) authorizes the granting of up to 2,250,000 shares of common stock to certain executives in various forms, including stock options, stock appreciation rights, restricted stock and performance shares. A Company subsidiary also grants performance units under a separate LTIP. Currently, only performance shares, performance units and restricted stock have been granted. Upon achievement of certain criteria for a three-year performance cycle, the performance shares or units earned can range from 0% to 300% of the performance shares or units granted plus dividend equivalents, and are payable in the form of shares of common stock of Florida Progress or cash. If certain stock ownership requirements have been met, certain executives are also eligible to receive an additional award of restricted stock, which will only be awarded if the performance shares or units earned are taken in company stock. Restricted stock fully vests 10 years from the date of award, or upon change of control, or retirement after reaching age 62. The Company accounts for its LTIPs in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as allowed under FAS No. 123, “Accounting for Stock Based Compensation.” Performance shares, performance units and restricted stock granted with the fair value at the grant date is detailed below:
Compensation costs for performance shares, performance units and restricted stock have been recognized at the fair market value of the Company’s stock and are recognized over the performance cycle. Compensation cost related to the LTIPs for 1999, 1998, and 1997, was $19 million, $9 million, and $4 million, respectively. If the accounting under FAS No. 123 had been utilized, there would not have been any difference in the results of operations or earnings per share.
NOTE 10: BENEFIT PLANS
Pension Benefits - The Company and some of its subsidiaries have two noncontributory defined benefit pension plans covering most employees. The Company also has two supplementary defined benefit pension plans that provide benefits to higher-level employees. Effective January 1, 1998, one pension plan was split into two separate plans, one covering eligible bargaining unit employees and the other covering all other eligible employees. Plan assets were allocated to each plan in accordance with applicable law.
Other Postretirement Benefits - The Company and some of its subsidiaries also provide certain health care and life insurance benefits for retired employees that reach retirement age while working for the Company.
Shown below are the components of the net pension expense and net postretirement benefit expense calculations for 1999, 1998 and 1997:
The following weighted average actuarial assumptions at December 31 were used in the calculation of the year-end funded status:
The following summarizes the change in the benefit obligation and plan assets for both the pension plan and postretirement benefit plan for 1999 and 1998:
Between 1996 and 1999, the Company set assets aside in a rabbi trust for the purpose of providing benefits to the participants in the supplementary defined benefit retirement plans and certain other plans for higher level employees. The assets of the rabbi trust are not reflected as plan assets because the assets could be subject to creditors’ claims.
The assets and liabilities of the supplementary defined benefit retirement plans are included in Other Assets and Other Liabilities on the accompanying Consolidated Balance Sheets.
The assumed pre-medicare and post medicare health care cost trend rates for 2000 are 7.67% and 6.42%, respectively. Both rates ultimately decrease to 5.25% in 2005 and thereafter. A one-percentage point increase or decrease in the assumed health care cost trend rate would change the total service and interest cost by approximately $1 million and the postretirement benefit obligation by approximately $12 million.
Due to different retail and wholesale regulatory rate requirements, Florida Power began making quarterly contributions for the postretirement benefit plan in 1995 to an irrevocable external trust fund for wholesale ratemaking, while continuing to accrue post-retirement benefit costs to an unfunded reserve for retail ratemaking.
NOTE 11: BUSINESS SEGMENTS
The Company’s principal business segment is Florida Power, an electric utility engaged in the generation, purchase, transmission, distribution and sale of electricity primarily in Florida. The other reportable business segments are Electric Fuels’ Energy & Related Services, Rail Services and Inland Marine Transportation units. Energy & Related Services includes coal and synthetic fuel operations, natural gas production and sales, river terminal services and off-shore marine transportation. Rail Services’ operations include railcar repair, rail parts reconditioning and sales, railcar leasing and sales, providing rail and track material, and scrap metal recycling. Inland Marine provides transportation of coal, agricultural and other dry-bulk commodities as well as fleet management services. The other category consists primarily of the Company’s investment in FPC Capital Trust, which holds the Preferred Securities, Progress Telecommunications Corp., the Company’s telecommunications subsidiary, and the parent holding company, Florida Progress Corporation, which allocates a portion of its operating expenses to business segments.
The Company’s business segment information for 1999, 1998 and 1997 is summarized below. The Company’s significant operations are geographically located in the United States with limited operations in Mexico and Canada. The Company’s segments are based on differences in products and services, and therefore no additional disclosures are presented. Intersegment sales and transfers consist primarily of coal sales from Electric Fuels to Florida Power. The price Electric Fuels charges Florida Power is based on market rates for coal procurement and for water-borne transportation under a methodology approved by the FPSC. Rail transportation is also based on market rates plus a return allowed by the FPSC on equity utilized in transporting coal to Florida Power. The allowed rate of return is currently 12%. No single customer accounted for 10% or more of unaffiliated revenues.
NOTE 12: REGULATORY MATTERS
Rates - Florida Power’s retail rates are set by the FPSC, while its wholesale rates are governed by the FERC. Florida Power’s last general retail rate case was approved in 1992 and allowed a 12% regulatory return on equity with an allowed range between 11% and 13%.
Regulatory Assets and Liabilities - Florida Power has total regulatory assets (liabilities) at December 31, 1999 and 1998 as detailed below:
The utility expects to fully recover these assets and refund the liabilities through customer rates under current regulatory practice.
If Florida Power no longer applied FAS No. 71 due to competition, regulatory changes or other reasons, the utility would make certain adjustments. These adjustments could include the write-off of all or a portion of its regulatory assets and liabilities, the evaluation of utility plant, contracts and commitments and the recognition, if necessary, of any losses to reflect market conditions.
Tiger Bay Buy-Out - In 1997, Florida Power bought out the Tiger Bay purchased power contracts for $370 million and acquired the cogeneration facility for $75 million, for a total of $445 million. Of the $370 million of contract termination costs, $350 million was recorded as a regulatory asset and the remaining $20 million was written off. Florida Power recorded $75 million as electric plant.
The regulatory asset is being recovered pursuant to an agreement between Florida Power and several intervening parties, which was approved by the FPSC in June 1997. The amortization of the regulatory asset is calculated using revenues collected under the fuel adjustment clause as if the purchased power agreements related to the facility were still in effect, less the actual fuel costs and the related debt interest expense. This will continue until the regulatory asset is fully amortized. Florida Power has the option to accelerate the amortization. Approximately $23 million and $27.2 million of amortization expense was recorded in 1999 and 1998, respectively.
In November 1999, Florida Power received approval from the FPSC to defer nonfuel revenues towards the development of a plan that would allow customers to realize the benefits earlier than if they are used to accelerate the amortization of the Tiger Bay regulatory asset. The request would require a plan to be submitted to the FPSC by August 1, 2000. If the plan is not filed by August 1, 2000, or filed but not approved by the FPSC, Florida Power would apply the deferred revenues of $44.4 million, plus accrued interest, to accelerate the amortization of the Tiger Bay regulatory asset.
A similar plan was approved by the FPSC in December 1998. Florida Power was unable to identify any rate initiatives that might allow its ratepayers to receive these benefits sooner and, in June 1999, recognized $10.1 million of revenue and recorded $10.1 million, plus interest, of amortization against the Tiger Bay regulatory asset.
Extended Nuclear Outage - In June 1997, a settlement agreement between Florida Power and all parties who intervened in Florida Power’s request to recover replacement fuel and purchased power costs resulting from the extended outage of its nuclear plant was approved by the FPSC. The plant was kept off-line in October 1996 to address certain design issues related to its safety systems. In late January 1998, Florida Power notified the NRC that it had completed all of the requirements and was subsequently granted permission to restart the plant. The plant returned to service in February 1998.
Florida Power incurred approximately $5 million in 1998 and $174 million in 1997 in total system replacement power costs. In accordance with the settlement agreement, Florida Power recorded a charge of approximately $5 million in 1998 and $73 million in 1997 for retail replacement power costs incurred that will not be recovered through its fuel cost recovery clause. Florida Power recovered approximately $38 million through its fuel cost recovery clause. Approximately $63 million of replacement power costs were recorded as a regulatory asset in 1997. The regulatory asset is being amortized for a period of up to four years. The amortization is being recovered by the suspension of fossil plant dismantlement accruals during the amortization period.
The parties to the settlement agreement agreed not to seek or support any increase or reduction in Florida Power’s base rates or the authorized range of its return on equity during the four-year amortization period. The settlement agreement also provided that for purposes of monitoring Florida Power’s future earnings, the FPSC will exclude the nuclear outage costs when assessing Florida Power’s regulatory return on equity. The agreement resolved all present and future disputed issues between the parties regarding the extended outage of the nuclear plant.
NOTE 13: COMMITMENTS AND CONTINGENCIES
Fuel, Coal and Purchased Power Commitments - Florida Power has entered into various long-term contracts to provide the fossil and nuclear fuel requirements of its generating plants and to reserve pipeline capacity for natural gas. In most cases, such contracts contain provisions for price escalation, minimum purchase levels and other financial commitments. Estimated annual payments, based on current market prices, for Florida Power’s firm commitments for fuel purchases and transportation costs, excluding delivered coal and purchased power, are $63 million, $70 million, $60 million, $63 million and $64 million for 2000 through 2004, respectively, and $605 million in total thereafter. Additional commitments will be required in the future to supply Florida Power’s fuel needs.
Electric Fuels has two coal supply contracts with Florida Power, the provisions of which require Florida Power to buy and Electric Fuels to supply substantially all of the coal requirements of four of Florida Power’s power plants, two through 2002 and two through 2004. In connection with these contracts, Electric Fuels has entered into several contracts with outside parties for the purchase of coal. The annual obligations for coal purchases and transportation under these contracts are $75.8 million, $52.5 million and $26.5 million for 2000 through 2002, respectively, with no further obligations thereafter. The total cost incurred for these commitments was $125.3 million in 1999, $117.7 million in 1998 and $156.8 million in 1997.
Florida Power has long-term contracts for about 460 megawatts of purchased power with other utilities, including a contract with The Southern Company for approximately 400 megawatts of purchased power annually through 2010. This represents less than 5% of Florida Power’s total current system capacity. Florida Power has an option to lower these Southern purchases to approximately 200 megawatts annually with a three-year notice. The purchased power from Southern is supplied by generating units with a capacity of approximately 3,500 megawatts and is guaranteed by Southern’s entire system, totaling more than 30,000 megawatts.
As of December 31, 1999, Florida Power has ongoing purchased power contracts with certain qualifying facilities for 871 megawatts of capacity with expiration dates ranging from 2002 to 2025. The purchased power contracts provide for capacity and energy payments. Energy payments are based on the actual power taken under these contracts. Capacity payments are subject to the qualifying facilities meeting certain contract performance obligations. In most cases, these contracts account for 100% of the generating capacity of each of the facilities. Of the 871 megawatts under contract, 831 megawatts currently are available to Florida Power. All commitments have been approved by the FPSC.
The FPSC allows the capacity payments to be recovered through a capacity cost recovery clause, which is similar to, and works in conjunction with, energy payments recovered through the fuel cost recovery clause.
Florida Power incurred purchased power capacity costs totaling $240.6 million in 1999, $260.1 million in 1998 and $292.3 million in 1997. The following table shows minimum expected future capacity payments for purchased power commitments. Because the purchased power commitments have relatively long durations, the total present value of these payments using a 10% discount rate also is presented.
Leases - Electric Fuels has several noncancelable operating leases, primarily for transportation equipment, with varying terms extending to 2015, and generally require Electric Fuels to pay all executory costs such as maintenance and insurance. Some rental payments include minimum rentals plus contingent rentals based on mileage. Contingent rentals were not significant. The minimum future lease payments under noncancelable operating leases, with initial terms in excess of one year, including the synthetic lease described below, are $65.8 million, $59.8 million, $50.8 million, $48.5 million and $46.1 million for 2000 through 2004, respectively, with a $528.4 million total obligation thereafter. The total costs incurred under these commitments were $51.1 million, $30.9 million and $34.8 million during 1999, 1998 and 1997, respectively.
On August 6, 1998, MEMCO Barge Line, Inc. (MEMCO), a wholly owned subsidiary of Electric Fuels, entered into a synthetic lease financing, accomplished via a sale and leaseback, for an aggregate of approximately $175 million in inland river barges and $25 million in towboats (vessels). MEMCO sold and leased back $153 million of vessels as of December 31, 1998, and the remaining $47 million of vessels in May 1999. The lease (charter) is an operating lease for financial reporting purposes and a secured financing for tax purposes.
The term of the noncancelable charter expires on December 30, 2012, and provides MEMCO one 18-month renewal option on the same terms and conditions. MEMCO is responsible for all executory costs, including insurance, maintenance and taxes, in addition to the charter payments. MEMCO has options to purchase the vessels throughout the term of the charter, as well as an option to purchase at the termination of the charter. Assuming MEMCO exercises no purchase options during the term of the charter, the purchase price for all vessels totals to $141.8 million at June 30, 2014. In the event that MEMCO does not exercise its purchase option for all vessels, it will be obligated to remarket the vessels and, at the expiration of the charter, pay a maximum residual guarantee amount of $89.3 million.
The minimum future charter payments as of December 31, 1999, are $15.3 million, $15.4 million, $15.4 million, $15.8 million and $15.8 million for 2000 through 2004 and $156.4 million thereafter (excluding the purchase option payment). All MEMCO payment obligations under the transaction documents are unconditionally guaranteed by Progress Capital; those obligations are guaranteed by Florida Progress.
Construction Program - Substantial commitments have been made in connection with the Company’s construction program. For the year 2000, Florida Power has projected annual construction expenditures of $291 million, primarily for electric plant. In 2000, Electric Fuels capital expenditures are expected to be approximately $84 million, which represents additional investment in the Rail Services, Inland Marine and Energy & Related Services units. For the year 2000, Progress Telecom has projected annual capital expenditures of $35 million primarily for expansion of the current fiber optic network.
Insurance - Florida Progress and its subsidiaries utilize various risk management techniques to protect certain assets from risk of loss, including the purchase of insurance. Risk avoidance, risk transfer and self-insurance techniques are utilized depending on the Company’s ability to assume risk, the relative cost and availability of methods for transferring risk to third parties, and the requirements of applicable regulatory bodies.
Florida Power self-insures its transmission and distribution lines against loss due to storm damage and other natural disasters. Pursuant to a regulatory order, Florida Power is accruing $6 million annually to a storm damage reserve and may defer any losses in excess of the reserve. The reserve balance at December 31, 1999 and 1998 was $25.6 million and $24.1 million, respectively.
Under the provisions of the Price Anderson Act, which limits liability for accidents at nuclear power plants, Florida Power, as an owner of a nuclear plant, can be assessed for a portion of any third-party liability claims arising from an accident at any commercial nuclear power plant in the United States. If total third-party claims relating to a single nuclear incident exceed $200 million (the amount of currently available commercial liability insurance), Florida Power could be assessed up to $88.1 million per incident, with a maximum assessment of $10 million per year.
Florida Power also maintains nuclear property damage insurance and decontamination and decommissioning liability insurance. Effective October 1, 1999, the total limit purchased for this type of insurance was reduced from $2.1 billion to $1.6 billion. The reduction was based on a review of the potential property damage exposure, the legal minimum required to be carried, and the amount of insurance being purchased by other owners of single unit nuclear sites. The first $500 million layer of insurance is purchased in the commercial insurance market with the remaining excess coverage purchased from Nuclear Electric Insurance Ltd. (NEIL). Florida Power is self-insured for any losses that are in excess of this coverage. Under the terms of the NEIL policy, Florida Power could be assessed up to a maximum of $5.3 million in any policy year if losses in excess of NEIL’s available surplus are incurred.
Florida Power has never been assessed under these nuclear indemnities or insurance policies.
Contaminated Site Cleanup - The Company is subject to regulation with respect to the environmental impact of its operations. The Company’s disposal of hazardous waste through third-party vendors can result in costs to clean up facilities found to be contaminated. Federal and state statutes authorize governmental agencies to compel responsible parties to pay for cleanup of these hazardous waste sites.
Florida Power and former subsidiaries of the Company, whose properties were sold in prior years, have been identified by the U.S. Environmental Protection Agency (EPA) as Potentially Responsible Parties (PRPs) at certain sites. Liability for the cleanup of costs at these sites is joint and several.
One of the sites that Florida Power previously owned and operated is located in Sanford, Florida. There are five parties, including Florida Power, that have been identified as PRPs at the Sanford site. A Participation Agreement was signed among the PRPs of the Sanford site to allocate $1.5 million to perform a Remedial Investigation, Baseline Risk Assessment and Feasibility Study (“RI/FS”). Florida Power is liable for approximately 40% of the costs for the RI/FS as agreed to in this Participation Agreement. In July 1999, the initial draft of the RI/FS was submitted to EPA. Discussions with EPA regarding future remedial action should commence in the first quarter 2000.
The PRP group is expected to negotiate a second Participation Agreement that will define and allocate Remedial Design and Remedial Action costs among the participants for Phase I of three potential phases of cleanup. Cleanup will be addressed in phases for project management purposes. Florida Power’s future cost share allocation is expected to be identified by the second quarter 2000. The discussions and resolution of liability for cleanup costs could cause Florida Power to increase the estimate of its liability for those costs. Although estimates of any additional costs are not currently available, the outcome is not expected to have a material effect on Florida Progress’ consolidated financial position, results of operations or liquidity.
In December 1998, the EPA conducted an Expanded Site Inspection (ESI) at a former Florida Power plant site near Inglis, Florida. Soil and groundwater samples were obtained from the Florida Power property, as well as sediment samples from the adjacent Withlacoochee River. A final copy of the report, along with a Request for Information under CERCLA was received in December 1999. Upon review of the Company’s reply, EPA’s conclusions may change the current hazard ranking and ultimately result in the Inglis site being placed on the National Priorities List (NPL). If this property were placed on the NPL, then EPA might conduct remediation actions at the site and seek repayment of those costs as well as investigative costs from any PRPs. Past costs currently exceed $3.5 million with FPC identified as the only major viable business associated with this site.
In addition to these designated sites, there are other sites where Florida Progress may be responsible for additional environmental cleanup. Florida Progress estimates that its share of liability for cleaning up all designated sites ranges from $9.0 million to $13.0 million. It has accrued $9.0 million against these potential costs. There can be no assurance that the Company’s estimates will not change in the future.
LEGAL MATTERS
Age Discrimination Suit - Florida Power and Florida Progress have been named defendants in an age discrimination lawsuit. The number of plaintiffs remains at 116, but four of those plaintiffs have had their federal claims dismissed and 74 others have had their state age claims dismissed. While no dollar amount was requested,
each plaintiff seeks back pay, reinstatement or front pay through their projected dates of normal retirement, costs and attorneys’ fees. In October 1996, the federal Court approved an agreement between the parties to provisionally certify this case as a class action suit under the Age Discrimination in Employment Act. Florida Power filed a motion to decertify the class and in August 1999, the Court granted Florida Power’s motion. In October 1999, the judge certified the question of whether the case should be tried as a class action to the Eleventh Circuit Court of Appeals for immediate appellate review. In December 1999, the Court of Appeals agreed to review the judge’s order decertifying the class.
In December 1998, during mediation in this age discrimination suit, plaintiffs alleged damages of $100 million. Company management, while not believing plaintiffs’ claim to have merit, offered $5 million in an attempted settlement of all claims. Plaintiffs rejected that offer. Florida Power and the plaintiffs engaged in informal settlement discussions, which were terminated on December 22, 1998. As a result of the plaintiffs’ claims, management has identified a probable range of $5 million to $100 million with no amount within that range a better estimate of probable loss than any other amount; accordingly, Florida Power has accrued $5 million. In December 1999, Florida Power also recorded an accrual of $4.8 million for legal fees associated with defending its position in these proceedings. There can be no assurance that this litigation will be settled, or if settled, that the settlement will not exceed $5 million. Additionally, the ultimate outcome, if litigated, cannot presently be determined.
Advanced Separation Technologies (AST) - In 1996, Florida Progress sold its 80% interest in AST to Calgon Carbon Corporation (Calgon) for net proceeds of $56 million in cash. In January 1998, Calgon filed a lawsuit against Florida Progress and the other selling shareholder and amended it in April 1998, alleging misstatement of AST’s 1996 revenues, assets and liabilities, seeking damages and granting Calgon the right to rescind the sale. The lawsuit also accused the sellers of failing to disclose flaws in AST’s manufacturing process and a lack of quality control. Florida Progress believes that the aggregate total of all legitimate warranty claims by customers of Advanced Separation Technologies for which it is probable that Florida Progress will be responsible for under the Stock Purchase Agreement with Calgon is approximately $3.2 million, and accordingly, accrued $3.2 million in the third quarter of 1999 as an estimate of probable loss.
Qualifying Facilities Contracts - Florida Power’s purchased power contracts with qualifying facilities employ separate pricing methodologies for capacity payments and energy payments. Florida Power has interpreted the pricing provision in these contracts to allow it to pay an as-available energy price rather than a higher firm energy price when the avoided unit upon which the applicable contract is based would not have been operated.
The owners of four qualifying facilities filed suits against Florida Power in state court over the contract payment terms, and one owner also filed suit in federal court. Two of the state court suits have been settled, and the federal case was dismissed, although the plaintiff has appealed. Of the two remaining state court suits, the trial regarding NCP Lake Power (“Lake”) concluded in December 1998. In April 1999, the judge entered an order granting Lake’s breach of contract claim and ruled that Lake is entitled to receive “firm” energy payments during on-peak hours, but for all other hours, Lake is entitled to the “as-available” rate. The Court also ruled that for purposes of calculating damages, the breach of contract occurred at the inception of the contract. In August 1999, a Final Judgment was entered for Lake for approximately $4.5 million and Lake filed a Notice of Appeal. In September 1999, Florida Power filed a notice of cross appeal. Also in this case, in April 1998, Florida Power filed a petition with the FPSC for a Declaratory Statement that the contract between the parties limits energy payments thereunder to the avoided costs based upon an analysis of a hypothetical unit having the characteristics specified in the contract. In October 1998, the FPSC denied the petition, but Florida Power appealed to the Florida Supreme Court.
In the other remaining suit regarding Dade County, in May 1999, the parties reached an agreement in principle to settle their dispute in its entirety, including all of the ongoing litigation, except the Florida Supreme Court appeal of an FPSC ruling that is similar to the appeal of the FPSC decision in the Lake case. The settlement agreement was approved by the Dade County Commission in December 1999, but is subject to approval by the FPSC.
Management does not expect that the results of these legal actions will have a material impact on Florida Power’s financial position, operations or liquidity. Florida Power anticipates that all fuel and capacity expenses, including any settlement amounts incurred as a result of the matters discussed above, will be recovered from its customers.
Mid-Continent Life Insurance Company (Mid-Continent) - As discussed below, a series of events in 1997 significantly jeopardized the ability of Mid-Continent to implement a plan to eliminate a projected reserve deficiency, resulting in the impairment of Florida Progress’ investment in Mid-Continent. Therefore, Florida Progress recorded a provision for loss on investment of $86.9 million in 1997. Florida Progress also recorded an accrual at December 31, 1997, for legal fees associated with defending its position in current Mid-Continent legal proceedings.
In the spring of 1997, the Oklahoma State Insurance Commissioner (“Commissioner”) received court approval to seize control as receiver of the operations of Mid-Continent. The Commissioner had alleged that Mid-Continent’s reserves were understated by more than $125 million, thus causing Mid-Continent to be statutorily impaired. The Commissioner further alleged that Mid-Continent had violated Oklahoma law relating to deceptive trade practices in connection with the sale of its “Extra Life” insurance policies and was not entitled to raise premiums, a key element of Mid-Continent’s plan to address the projected reserve deficiency. While sustaining the receivership, the court also ruled that premiums could be raised. Although both sides appealed the decision to the Oklahoma Supreme Court, those appeals were withdrawn in early 1999.
In December 1997, the receiver filed a lawsuit against Florida Progress, certain of its directors and officers, and certain former Mid-Continent officers, making a number of allegations and seeking access to Florida Progress’ assets to satisfy policyholder and creditor claims. In April 1998, the court granted motions to dismiss the individual defendants, leaving Florida Progress as the sole remaining defendant in the lawsuit.
A new Commissioner was elected in November 1998 and has stated his intention to work with Florida Progress and others to develop a plan to rehabilitate Mid-Continent rather than pursue litigation against Florida Progress. Based on data through December 31, 1998, Florida Progress’ actuarial estimate of the additional assets necessary to fund the reserve, after applying Mid-Continent’s statutory surplus is in the range of $100 million. The amount put forth by the actuary hired by the former Commissioner was in the range of $350 million. Florida Progress believes that any estimate of the projected reserve deficiency would affect only the assets of Mid-Continent, because Florida Progress has legal defenses to any claims asserted against it. Florida Progress is working with the new Commissioner to develop a viable plan to rehabilitate Mid-Continent, which would include the sale of that company. An order agreed upon by both sides soliciting proposals for a plan of rehabilitation was filed on March 18, 1999. Proposals from a variety of parties were received and opened in June 1999.
In October 1999, the new Commissioner signed a Letter of Intent, subject to approval by the Oklahoma District Court, with Iowa-based Life Investors Insurance Company of America, a wholly owned subsidiary of AEGON USA, Inc., concerning the assumption of all policies of Mid-Continent. In a letter of intent in connection with the proposed plan of rehabilitation, Florida Progress agreed to assign all of Mid-Continent’s stock to the receiver, and contribute $10 million to help offset future premium rate increases or coverage reductions, provided that, among other things, Florida Progress receives a full release from liability, and the receiver’s action against Florida Progress is dismissed, with prejudice. The $10 million was proposed to be held in escrow by the Commissioner for a period of 10 years and invested for the benefit of the policyholders. Any proposed premium increases would have been offset by this fund until it was exhausted. The Mid-Continent plan was originally scheduled to be considered by the Oklahoma County District Court in December 1999, but the Court postponed its consideration and ruled that any party who wishes to submit an alternative proposal must identify themselves to the Commissioner and the Court no later than December 31, 1999. Four proposers have so identified themselves.
Florida Progress now believes that as part of any plan of rehabilitation, the Company will be required to contribute the aforementioned $10 million regardless of which party ultimately assumes the policies of Mid-Continent. Accordingly, Florida Progress accrued an additional provision for loss of $10 million in December 1999. The loss was more than offset by the recognition of tax benefits of approximately $11 million, related to the excess of the tax basis over the current book value of the investment in Mid-Continent, and thus, did not have a material impact on Florida Progress’ consolidated financial position, operations, or liquidity. This benefit had not been recorded earlier due to uncertainties associated with the timing of the tax deduction.
In January 1999, five Mid-Continent policyholders filed a purported class action against Mid-Continent and the same defendants named in the case filed by the former Commissioner. The complaint contains substantially the same factual allegations as those made by the former Commissioner. The suit asserts “Extra Life” policyholders have been injured as a result of representations made in connection with the sale of that policy. The suit seeks actual and punitive damages. The defendants’ motions to dismiss were granted in June, and again in October 1999. A hearing was held in January 2000 on the issue of whether the dismissal was with or without prejudice. At that hearing, the Court ruled that the dismissal was without prejudice and granted the policyholders leave to amend their complaint once again.
Although Florida Progress hopes to complete the negotiated resolution of these matters involving Mid-Continent, it will continue to vigorously defend itself against the two lawsuits, if that is required. Although there can be no assurance as to the outcome of the two lawsuits, Florida Progress believes they are without merit and that their outcomes would not have a material adverse effect on Florida Progress’ consolidated financial position, results of operations or liquidity.
Share Exchange Litigation - In August 1999, Florida Progress announced that it entered into an Agreement and Plan of Exchange with Carolina Power & Light Company (CP&L), and CP&L Energy, Inc., a wholly owned subsidiary of CP&L. (See Note 2 to the Financial Statements.) A lawsuit was filed in September 1999, against Florida Progress and its directors seeking class action status, an unspecified amount of damages and injunctive relief, including a declaration that the agreement and plan of exchange was entered into in breach of the fiduciary duties of the Florida Progress board of directors, and enjoining Florida Progress from proceeding with the share exchange. The complaint also seeks an award of costs and attorney’s fees. Florida Progress believes this suit is without merit, and intends to vigorously defend itself against this action. Accordingly, no provision for loss has been recorded pertaining to this matter.
Easement Litigation - In December 1998, Florida Power was served with this class action lawsuit seeking damages, declaratory and injunctive relief for the alleged improper use of electric transmission easements. The plaintiffs contend that the licensing of fiber optic telecommunications lines to third parties or telecommunications companies for other than Florida Power’s internal use along the electric transmission line right-of-way exceeds the authority granted in the easements. In June 1999, plaintiffs amended their complaint to add Progress Telecommunications Corporation as a defendant and add counts for unjust enrichment and constructive trust. In January 2000, the court conditionally certified the class statewide. Management does not expect that the results of these legal actions will have a material impact on Florida Progress’ financial position, operations or liquidity. Accordingly, no provision for loss has been recorded pertaining to this matter.
Other Legal Matters - The Company is involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect upon the Company’s consolidated financial position, results of operations or liquidity.
QUARTERLY FINANCIAL DATA
FLORIDA PROGRESS CORPORATION
(Unaudited)
The business of Florida Power is seasonal in nature and comparisons of earnings for the quarters do not give a true indication of overall trends and changes in Florida Power’s operations. In the fourth quarter of 1999 and 1998, the FPSC approved the establishment of a regulatory liability for the purpose of deferring nonfuel revenues. The 1999 and 1998 deferrals were $44.4 million and $10.1 million, respectively. In the second quarter of 1999, Florida Power recognized the 1998 $10 million deferral in electric utility revenues and applied it to the amortization of the Tiger Bay regulatory asset, which resulted in no impact to 1999 earnings.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None.
PART III
For purposes of Part III, “Florida Progress” shall mean Florida Progress Corporation, excluding all consolidated subsidiaries, unless otherwise indicated.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS
FLORIDA PROGRESS
DIRECTORS
W. D. (“BILL”) FREDERICK, JR., Age 65, Director since 1995.
Committees: Compensation; Nominating and Board Governance; Compliance, Chairman.
Mr. Frederick’s principal occupation for the past five years has been as an investor and citrus grower in Orlando, Florida. From 1980 to 1992, Mr. Frederick served as Mayor of the City of Orlando. In 1966 he founded the Orlando law firm of Frederick, Wooten & Honeywell P.A., and subsequently became a partner in the Orlando office of the firm of Holland & Knight from which he retired in 1995. He is a member of the Board of Directors of Florida Power, Blue Cross/Blue Shield of Florida, and SunTrust Bank, Central Florida, N.A.
MICHAEL P. GRANEY, Age 56, Director since 1991.
Committees: Executive; Audit; Nominating and Board Governance, Chairman.
Mr. Graney has practiced with the New York law firm of Simpson Thacher & Bartlett since 1980 and is now resident partner in its Ohio office. His specialties are utilities, antitrust and litigation. He is a member of the American, District of Columbia, Ohio and Columbus Bar Associations and the Energy Bar Association. He is a director of Florida Power.
RICHARD KORPAN, Age 58, Director since 1989.
Committee: Executive, Chairman.
Mr. Korpan is Chairman of the Board, President and Chief Executive Officer of Florida Progress. He was appointed Chairman of the Board, effective July 1, 1998. He has held the position of President since 1991, and became Chief Executive Officer of Florida Progress in June 1997. Since April 1996, he has also served as Chairman of the Board of Florida Power, and until June 1, 1997, as Chief Executive Officer of Florida Power. He joined Florida Progress in 1989 as Executive Vice President and Chief Financial Officer. He is a director of SunTrust Bank of Tampa Bay and a Member of the Business Roundtable.
CLARENCE V. MCKEE, ESQUIRE, Age 57, Director since 1989.
Committees: Compensation; Audit; Nominating and Board Governance.
Mr. McKee’s principal occupation for more than five years has been Chairman and Chief Executive Officer of McKee Communications, Inc., Tampa, Florida, a firm involved in the acquisition and management of television and radio stations. He served as Counsel to Pepper & Corazinni, a Washington, D.C. communications law firm, from 1980 until 1987 when he became a co-owner of WTVT Holdings, Inc., where he held the position of Chairman and Chief Executive Officer until 1992. He is a director of Florida Power, and Checkers Drive-In Restaurants, Inc.
VINCENT J. NAIMOLI, Age 62, Director since 1992.
Committees: Executive; Finance and Budget, Chairman; Nominating and Board Governance.
Mr. Naimoli’s principal occupation for more than five years has been as Chairman, President and Chief Executive Officer of Anchor Industries International, Inc., Tampa, Florida, an operating and holding company. He is also Managing General Partner and Chief Executive Officer of the Tampa Bay Devil Rays, Ltd. Major League Baseball Club, St. Petersburg, Florida. He is a director of Florida Power, and in conjunction with the business activities of Anchor Industries, serves as a director of Russell Stanley Corp. and has been nominated as a director of JLM Industries.
RICHARD A. NUNIS, Age 67, Director since 1989
Committees: Executive; Finance and Budget; Compensation, Chairman.
Mr. Nunis’ principal occupation for more than five years had been Chairman of Walt Disney Attractions, Orlando, Florida, from which he retired in December 1998. He held various positions with the Disney organization since 1955, including Vice President, Operations in 1968, Executive Vice President of DISNEYLAND and Walt Disney World in 1972, President of Walt Disney Attractions in 1980, and Chairman in 1991. He is a director of Florida Power and SunTrust Bank, Central Florida N.A. and Director Emeritus of The Walt Disney Company.
JOAN D. RUFFIER, Age 60, Director since 1990.
Committees: Audit, Chairman; Compliance; Finance and Budget
Ms. Ruffier is Chairman of Human Services Technologies, Inc., a computer software products company which develops, markets and sells software used to link client information in not-for-profit businesses. She also serves as President of the University of Florida Foundation and Chair of the Finance Committee of Shands Healthcare, Inc. She was a General Partner of Sunshine Cafes, Ltd., Orlando, Florida, a food and beverage concession business at major Florida airports, for more than five years previously. She practiced public accounting with the firm of Colley, Trumbower & Howell from 1982-1986. She is a director of Florida Power and also serves on the boards of directors of Cyprus Equity Fund and INVEST, INC.
ROBERT T. STUART, JR., Age 67, Director since 1986.
Committee: Audit
Mr. Stuart’s principal occupation for more than five years has been a rancher and investor in Dallas, Texas. Since 1949, he’s held numerous executive positions with Mid-Continent, including Vice President, President, Chairman of the Board and Chief Executive Officer until 1986 when Mid-Continent was acquired by Florida Progress. He is also a director of Florida Power.
JEAN GILES WITTNER, age 65, Director since 1982.
Committees: Executive; Compensation; Compliance.
Mrs. Wittner’s principal occupation for more than five years has been President of Wittner & Co. and subsidiaries, St. Petersburg, Florida, firms involved in real estate management and insurance brokerage, consulting, and third party administration of COBRA and related products. She previously served as President and Chief Executive Officer of a savings association until it was sold in 1986. She serves on the boards of Florida Power, and Raymond James Bank, F.S.B.
EXECUTIVE OFFICERS
Kenneth E. Armstrong, Vice President and General Counsel, Age 52.
Mr. Armstrong has served as General Counsel of Florida Progress since July 1990 and as Vice President since April 1992. In April 1995, he became Vice President and General Counsel of Florida Power. In addition to these positions, Mr. Armstrong served as Secretary of Florida Progress and Florida Power from April 1993 until April 1996.
Richard D. Keller, Group Vice President, Energy and Transportation Group, Age 46.
Since May 1990, Mr. Keller’s principal occupation has been as shown above. He has also served as President and Chief Executive Officer of Electric Fuels since February 1988.
William G. Kelley, Vice President, Human Resources, Age 53.
Mr. Kelley was appointed Vice President, Human Resources of Florida Progress and Florida Power, effective October 27, 1997. From 1992 to 1997, he was employed by Goulds Pumps, Inc., an international pump company, as Vice President of Human Resources. From 1989 to 1992, he served as Director of Human Resources for The Quaker Oats Company and headed the human resources function of the European Headquarters in the United Kingdom of its Fisher Price Division.
Richard Korpan, Chairman, President and Chief Executive Officer, Age 58.
Mr. Korpan was appointed Chairman of the Board of Florida Progress, effective July 1, 1998. He has held the position of President since 1991, and became Chief Executive Officer of Florida Progress in June 1997. Since April 1996 he has also served as Chairman of the Board of Florida Power, and until June 1, 1997, as Chief Executive Officer of Florida Power. He is a director of SunTrust Bank of Tampa Bay and a member of the Business Roundtable.
Edward W. Moneypenny, Senior Vice President and Chief Financial Officer, Age 58.
Edward W. Moneypenny became Senior Vice President and Chief Financial Officer of Florida Progress, effective March 15, 1999. Prior to joining Florida Progress, Mr. Moneypenny was employed by Oryx Energy Company, an independent oil and gas exploration and production company, where he served as Executive Vice President of Finance and Chief Financial Officer. He also was a member of Oryx’s board of directors from 1994 until February 1999.
Joseph H. Richardson, Group Vice President, Utility Group, Age 50.
Since 1996, Mr. Richardson’s principal occupation has been as shown above. Effective June 1, 1997, he was appointed Chief Executive Officer, in addition to President, of Florida Power. From April 1995 to April 1996, he served as Senior Vice President, Energy Distribution of Florida Power. From October 1993 to April 1995, he served as Senior Vice President, Legal and Administrative Services, and General Counsel of Florida Power. From August 1991 through April 1995, Mr. Richardson also held the position of Senior Vice President of Florida Progress.
There are no family relationships between any director or any executive officer of Florida Progress. The executive officers serve at the pleasure of the Florida Progress Board of Directors. Each executive officer is appointed annually.
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
Section 16(a) of the Securities Exchange Act of 1934 requires Florida Progress’ officers and directors, and persons who own more than ten percent of a registered class of Florida Progress’ equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the New York Stock Exchange. Officers, directors and greater than ten-percent shareholders are required by SEC regulations to furnish Florida Progress with copies of all Section 16(a) forms they file.
Based upon a review of the copies of such forms furnished to Florida Progress during 1999 and written representations concerning the number of transactions that were not reported on a timely basis, Florida Progress believes that all of the required persons filed their applicable Section 16(a) reports on a timely basis during 1999 with the following exception: a Form 4 report of the sale of a fractional share of common stock was filed late by William G. Kelley, an executive officer of Florida Progress.
FLORIDA POWER
DIRECTORS
W. D. (“Bill”) Frederick, Jr., Age 65, Director since 1997.
Chairman - Compliance Committee
Information concerning Mr. Frederick is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Michael P. Graney, Esquire, Age 56, Director since 1997.
Member - Executive Committee
Information concerning Mr. Graney is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Richard Korpan, Age 58, Director since 1989.
Chairman - Executive Committee
Information concerning Mr. Korpan is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Clarence V. McKee, Esquire, Age 57, Director since 1988.
Information concerning Mr. McKee is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Vincent J. Naimoli, Age 62, Director since 1997.
Information concerning Mr. Naimoli is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Richard A. Nunis, Age 67, Director since 1997.
Member - Executive Committee
Information concerning Mr. Nunis is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Joseph H. Richardson, Age 50, Director since 1996.
Member - Executive Committee
Information concerning Mr. Richardson is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Executive Officers.”
Joan D. Ruffier, Age 60, Director since 1991.
Member - Compliance Committee
Information concerning Ms. Ruffier is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Robert T. Stuart, Jr., Age 67, Director since 1997.
Information concerning Mr. Stuart is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Jean Giles Wittner, Age 65, Director since 1977.
Member - Compliance Committee
Information concerning Mrs. Wittner is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Each director holds office until the next Annual Meeting of Shareholders and until the election and qualification of a successor.
EXECUTIVE OFFICERS
Roy A. Anderson, Senior Vice President, Energy Supply, Age 51.
Mr. Anderson became Senior Vice President, Nuclear Operations, effective January 20, 1997, and now serves as the Senior Vice President of Energy Supply. From April 1, 1997 to April 17, 1998, he served as Chief Nuclear Officer. Prior to joining Florida Power, Mr. Anderson was employed by CP&L, where he held numerous executive officer positions since 1993 in the areas of nuclear operations, fossil generation, and distribution and customer service. From 1987 to 1993, he was employed by Boston Edison Company, where he served as Plant Manager, Vice President and ultimately as Senior Vice President, Nuclear Operations.
Kenneth E. Armstrong, Vice President and General Counsel, Age 52.
Information concerning Mr. Armstrong is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Executive Officers.”
Janice B. Case, Senior Vice President, Energy Solutions(SM), Age 47.
Mrs. Case was named Senior Vice President, Energy Solutions(SM) effective June 1, 1997, after serving as Vice President since 1996. From October 1990 until July 1996, she served as Vice President, Suncoast Florida Region of Florida Power.
Michael B. Foley, Jr., Senior Vice President, Energy Delivery, Age 56.
Since July 1996, Mr. Foley’s principal occupation has been as shown above. Mr. Foley served as Vice President in that position since February 1995. From October 1988 until February 1995, Mr. Foley served as Director of System Planning of Florida Power.
Jeffrey R. Heinicka, Senior Vice President and Chief Financial Officer, Age 45.
Since March 15, 1999, Mr. Heinicka’s principal occupation has been as shown above. From March 1994 to March 1999, Mr. Heinicka was Chief Financial Officer of both Florida Progress and Florida Power.
William G. Kelley, Vice President, Human Resources, Age 53.
Information concerning Mr. Kelley is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Executive Officers.”
Richard Korpan, Chairman of the Board, Age 58.
Information concerning Mr. Korpan is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Directors.”
Joseph H. Richardson, President and Chief Executive Officer, Age 50.
Information concerning Mr. Richardson is set forth in Part III, hereof under the heading “Directors and Executive Officers of the Registrants - Florida Progress, Executive Officers.”
There are no family relationships between any director or any executive officer of Florida Power. The executive officers serve at the pleasure of the Florida Power Board of Directors. Each executive officer is appointed annually.
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
Based solely on a review of the copies of Section 16(a) forms furnished to Florida Power during 1999, or written representations that no forms were required, Florida Power believes that all persons who at any time during 1999 were officers, directors or greater than 10% beneficial owners of Florida Power’s preferred stock, filed their applicable Section 16(a) reports on a timely basis during 1999 and prior fiscal years.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
FLORIDA PROGRESS
COMPENSATION OF DIRECTORS
Under the terms of the Stock Plan for Non-employees Directors of Florida Progress Corporation and Subsidiaries (the “Director Plan”), 75% of each non-employees director’s $30,000 retainer fee for 1999 was paid quarterly in arrears in Common Stock. In addition, non-employees directors were paid $1,500 for attendance at each meeting of Florida Progress’ Board of Directors, and a per meeting fee of $1,000 for attendance at each subsidiary board or board committee meeting. A $750 meeting fee was also paid to each Committee Chairman for each meeting chaired. Directors were also paid a $500 attendance fee for participation in strategic update conferences, $1,000 for attendance at strategic planning seminars and subsidiary briefing tours and were reimbursed for expenses incurred for Florida Progress business purposes, or may use Florida Progress transportation or facilities, if available. The cash portion of directors’ compensation is allowed to be deferred.
To further align the interest of the Board of Directors to those of the shareholders, the Board of Directors has implemented a Phantom Stock Plan for the Benefit of non-employees Directors of Florida Progress (the “Plan”). The Plan generally provides for the awarding of phantom stock, or the right to receive in cash the value of a share of stock in the future, subject to certain conditions. Under the Plan, an initial award, effective January 1, 1999, of 2,000 shares of phantom stock with a six year vesting schedule was made to each non-employees director. One sixth of the shares is vested for each year of service by the non-employees director. It is expected that new directors will be granted similar awards. At the Annual Meeting of Shareholders held April 16, 1999, non-employees directors elected to a three-year term received an award of 600 shares of phantom stock, which vest over a period of three years; non-employees directors continuing in office for a two-year term received an award of 400 shares of phantom stock, which vest over a period of two years; and non-employees directors continuing in office for a one-year term received an award of 200 shares of phantom stock, which vest over a period of one year. At the Annual Meeting of Shareholders to be held in 2000 and continuing thereafter, each non-employees director elected to a three-year term will receive an award of 600 shares of phantom stock to vest over a period of three years. Directors elected to a lesser term would be given a prorated award. Dividend equivalents are added to the phantom stock accounts upon the declaration of each quarterly dividend. The balance of each account will be paid in a lump sum cash payment or series of annual cash installments valued on the date of termination of service of the director. In the event of a change-in-control, all unvested phantom stock awards become immediately vested and directors receive lump sum cash payments equal to the value of all of their phantom stock units plus dividend equivalents. See Item 7, MD&A under the heading “Current Issues - Share Exchange Agreement” and Note 2 to the Financial Statements.
The Compensation Committee meets each year to review all elements of director compensation in comparison to peer and industry data. In December 1999, the Compensation Committee recommended and the Board of Directors approved an increase effective January 1, 2000 in the annual retainer fee to $35,000 and in the Committee Chair fees to $1,000 per meeting chaired.
EXECUTIVE COMPENSATION
The following table contains information with respect to compensation awarded, earned or paid during the years 1997-1999 to (i) the Chief Executive Officer (“CEO”) of Florida Progress; (ii) the four most highly compensated executive officers other than the CEO of Florida Progress who were serving as executive officers at the end of the last completed fiscal year; and (iii) one individual for whom disclosures would have been provided pursuant to this item but for the fact that the individual was not serving as an executive officer of Florida Progress at the end of the last completed fiscal year (the individuals referred to in (i), (ii) and (iii) are referred to collectively as the “Named Executive Officers”) whose total remuneration paid in 1999 exceeded $100,000.
SUMMARY COMPENSATION TABLE
(1)
Amounts represent the reimbursement of taxes on certain perquisites and other personal benefits.
(2)
The Named Executive Officers of Florida Progress who met certain stock ownership guidelines and elected to take their LTIP payouts in Common Stock, received an additional 25% of their 1997-1999 Long Term Incentive Plan (“LTIP”) award in Restricted Common Stock which vests over a 10-year period with no shares vesting in years one through five and 20% vesting in each of the years six through ten. Dividends are payable on the Restricted Common Stock to the extent and on the same date as dividends are paid on all other shares of Common Stock. All unvested shares of Restricted Common Stock vest immediately upon the consummation of a change in control. Information for fiscal year
1999, represents the dollar value as of February 23, 2000, the date of award, of the total number of shares of Restricted Common Stock awarded to the Named Executive Officers as follows: Richard Korpan 12,341 shares; Joseph H. Richardson 5,410 shares; Richard D. Keller 6,187 shares; Edward W. Moneypenny -0- shares; Kenneth E. Armstrong 1,583 shares; and Jeffrey R. Heinicka 1,847 shares.
(3)
Information for fiscal year 1999, represents the dollar value as of February 23, 2000, the date of award, of shares of Common Stock earned under the 1997-1999 performance cycle of Florida Progress’ LTIP, none of which are restricted. The total number of shares earned, including dividend equivalent shares, is as follows: Richard Korpan 49,363 shares; Joseph H. Richardson 21,638 shares; Richard D. Keller 24,747 shares; Edward W. Moneypenny 2,618 shares; Kenneth E. Armstrong 6,332 shares; and Jeffrey R. Heinicka 7,389 shares.
The payouts listed for the 1997-1999 performance cycle are the result of the Florida Progress’ Compensation Committee’s determination of slightly below maximum achievement of Florida Progress total shareholder return goal and 77% of maximum payout based on the achievement of Electric Fuels’ earnings growth and return on invested capital goal. A mathematical formula was used to convert the goal level achieved into the number of performance shares earned; then, dividend equivalents on shares earned for the period of the performance cycle were added.
(4)
Company contributions to the Florida Progress Savings Plan and Executive Optional Deferred Compensation Plan on behalf of the Named Executive Officers.
The following table contains information with respect to performance shares granted in 1999 to the Named Executive Officers of Florida Progress under the LTIP:
LONG-TERM INCENTIVE PLAN(1)
AWARDS IN 1999
(1)
The LTIP is a Common Stock and cash-based incentive plan to reward participants for long-term performance of Florida Progress. It was approved by the shareholders in 1990.
(2)
The number of performance shares granted is based on a percentage of base salary in effect at the time of each award and is subject to automatic increase or decrease on a prorated basis in accordance with changes to a participant’s base salary or LTIP percentages throughout the performance cycle. In the event of a change in control of Florida Progress, 150% of all performance shares granted to the Named Executive Officers under the LTIP and then outstanding would automatically be considered earned and would be paid in cash or shares of unrestricted Common Stock together with cash or shares of unrestricted Common Stock payable for dividend equivalents accrued through the date of the change in control.
(3)
Payouts for the 1999-2001 performance cycle are based on a comparison of Florida Progress’ three-year average annual total shareholder return against an industry peer group, and for Mr. Keller, based also on Electric Fuels’ compound annual earnings growth and return on average invested capital.
Under certain circumstances, including the achievement of stock ownership guidelines upon normal conclusion of applicable cycles, beginning in 2000, the Named Executive Officers are entitled to a 25% restricted stock incentive bonus based on the number of shares of common stock earned under each performance cycle of the LTIP. The restricted stock vests over a 10-year period, but all shares would vest immediately upon consummation of a change in control.
Pension Plan Table
The table below illustrates the estimated annual benefits (computed as a straight life annuity beginning at retirement at age 65) payable under Florida Progress’ Retirement Plan for Exempt and Nonexempt Employees (“Retirement Plan”), Nondiscrimination Plan and Supplemental Executive Retirement Plan (“SERP”) for specified final average compensation and years of service levels.
Estimated Aggregate Annual Retirement Benefits Payable Under
the Retirement Plan for Exempt and Nonexempt Employees,
the Nondiscrimination Plan and the Supplemental Executive Retirement Plan
“Table A”
Estimated Aggregate Annual Retirement Benefits Payable Under
the Retirement Plan for Exempt and Nonexempt Employees,
the Nondiscrimination Plan and the Supplemental Executive Retirement Plan
“Table B”
The Named Executive Officers are entitled to benefits under the SERP. These benefits are offset by the benefits payable under the Retirement Plan and the Nondiscrimination Plan, as well as 50% of the executive’s primary Social Security benefit. The estimated annual SERP benefit for the Named Executive Officers (except for Mr. Moneypenny) (each a “Grandfathered Participant”), prior to any offsets, may be determined using the Pension Plan Table “A” (the “Grandfathered Participant table”) set forth above. The estimated annual SERP benefit for Mr. Moneypenny (the “non-grandfathered participant”), prior to any offsets and subject to a vesting schedule, may be determined using Pension Plan Table “B” (the “non-grandfathered participant table”) also set forth above. For these purposes, the current compensation for each executive that would be used in calculating benefits under the SERP is substantially the same as the three year average of the salary and bonus reported in the summary compensation table, and the number of years of deemed credited service that would be used in calculating benefits under the SERP for each such executive is as follows: Mr. Korpan, 35 years of service; Mr. Richardson, 24 years of service; Mr. Keller, 21 years of service; Mr. Moneypenny, 1 year of service; Mr. Armstrong, 16 years of service; and Mr. Heinicka, 22 years of service. Under the formula used for calculating benefits under the SERP, the maximum benefit payable to each Grandfathered Participant who is a Named Executive Officer would be reached at 16 years of deemed credited service unless the Named Executive Officer would have 35 years of deemed credited service. The maximum benefit payable to a Named Executive Officer who is a non-grandfathered participant would be reached at 20 years of service unless the Named Executive Officer would have 35 years of deemed credited service.
Accrued benefits may also be paid under each of the Retirement Plan, Nondiscrimination Plan and SERP if a participant terminates employment before age 65 and meets the requirements for early retirement, disability, death or other termination-of-employment benefits after becoming vested under the rules of the particular plan.
Under the Retirement Plan and the Nondiscrimination Plan, the compensation taken into account in calculating benefits is salary only. The years of credited service that would be used in calculating benefits under the formula applicable to the Retirement Plan and the Nondiscrimination Plan (1.8% of final average earnings for each year of service) for the Named Executive Officers in the summary compensation table are as follows: Mr. Korpan, 11 years
of service; Mr. Richardson, 24 years of service; Mr. Keller, 21 years of service; Mr. Moneypenny, 1 year of service, Mr. Armstrong, 13 years of service; and Mr. Heinicka, 22 years of service. The benefits under the Retirement Plan and the Nondiscrimination Plan are subject to offset by an amount equal to 1 1/7% of a participant’s primary Social Security benefit for each year of service (with a maximum offset of 40%).
In the event of a change in control, each Grandfathered Participant currently employed by Florida Progress would receive credit under the SERP for five additional years of service, but in no event would such additional years of credited service cause the maximum benefit to be increased. Each non-grandfathered participant would receive a credit under the SERP for three additional years of service, but in no event would such additional years of credited service cause the maximum benefit to be increased. If a participant’s employment were terminated following a change in control, the benefit payable from the SERP would be as follows: (1) an annuity at age 55 through 59, subject to early payment reductions in the amount of 3% (for Grandfathered Participants) or 5% (for non-grandfathered participants) for each year prior to age 60, or at age 60 without reduction; (2) the amount of any federal excise taxes (and income taxes on any reimbursement under this provision) imposed on the executive under Section 4999 of the Internal Revenue Code; and (3) a 50% surviving spouse benefit payable upon death.
Employment Contracts, Termination of Employment and Change-in-control Arrangements
Florida Progress has had an employment agreement with Mr. Korpan since 1995. The term of the current agreement is from March 1, 1998 through February 28, 2002. On each March 1, beginning with March 1, 2000, the agreement will automatically be extended for one additional year, unless either party gives 90 days’ written notice to the contrary. The employment agreement provides severance benefits equal to three times the sum of his annual base salary and target annual bonus and payment of the number of shares equal to the target award he could have earned for each uncompleted performance cycle under the LTIP, plus the number of shares earned and not yet paid out for any performance cycle that has been completed. The employment agreement was amended in August 1999, to provide that if Mr. Korpan’s employment were to be terminated as a result of a change in control prior to age 62, his total retirement benefit would be comparable to his retirement benefit based on a minimum average annual compensation of approximately $1.2 million. To the extent that benefits are payable under both Mr. Korpan’s employment agreement and the agreement referred to in the next paragraph, they are payable to the maximum extent under either, but not both, of those agreements.
Change-in-control benefits were previously included in the SERP which was originally adopted August 1, 1989, and which has been amended from time to time. In 1998, Florida Progress entered into individual agreements dealing with a change in control as defined in each agreement with each of the Named Executive Officers, except Mr. Moneypenny’s agreement which was entered into upon his employment in March, 1999. Mr. Korpan’s and Mr. Richardson’s agreements were amended in August, 1999 to increase the percentage of long-term incentive compensation based severance that would be paid out in the event of termination of employment. Otherwise, the agreements have remained unmodified since their execution. The original agreements implemented changes to the change-in-control benefits previously included in the SERP and reduced the cost to Florida Progress in the event a change in control occurs. The exact terms of the change in control agreements vary, but generally fit within three categories. Generally, the agreements entitle the executives to compensation and benefits at least equal to the compensation and benefits they were receiving prior to the change in control. Severance benefits would be provided under the agreements if the individual’s employment were to be actively or constructively terminated within 36 months after a change in control occurred. Finally, severance benefits will be provided following a termination of employment for any reason during the 13th month after the consummation of a change in control transaction. Severance benefits to which the Named Executive Officer would be entitled include the following:
(1)
a cash payment equal to two, two and one half, or three times the individual’s annual base salary and annual bonus;
(2)
payout in cash at 150%, 200%, or 275% of the number of shares granted under the LTIP after a change in control less any amounts paid upon consummation of the change in control as provided under the LTIP;
(3)
credit for three or five additional years of service, not to exceed the maximum, under the SERP;
(4)
continuation of welfare benefits comparable to those in place prior to the change in control for 24, 30 or 36 months following termination, with lifetime access to medical insurance at the individual’s expense thereafter;
(5)
reimbursement of relocation expenses incurred within 24, 30 or 36 months of termination and not covered by another employer, not to exceed $10,000; and
(6)
reimbursement for reasonable legal fees and disbursements related to the taxation of payments made to the individual, not to exceed $15,000.
The agreements also provide for an additional payment, if required, to make the individual’s whole for any excise tax imposed by Section 4999 of the Internal Revenue Code.
FLORIDA POWER
COMPENSATION OF DIRECTORS
Compensation for all directors of Florida Power (excluding employees of Florida Progress or subsidiaries) was $1,000 for attendance at each meeting of the Florida Power Board of Directors or a committee of the Board of Directors. A $750 fee is paid to each committee chairman for each meeting chaired. Effective January 1, 2000, the committee chairman fee was increased to $1,000 for each committee meeting chaired.
EXECUTIVE COMPENSATION
The following table contains information with respect to compensation awarded, earned or paid during the years 1997-1999, to (i) the current Chief Executive Officer (“CEO”) and (ii) the other four most highly compensated executive officers of Florida Power (the individuals referred to in (i) and (ii) are referred to collectively as the “Florida Power Named Executive Officers”) in 1999, whose total remuneration paid in 1999 exceeded $100,000.
SUMMARY COMPENSATION TABLE
(1)
Except as otherwise noted, amounts represent the reimbursement of taxes on certain perquisites and other personal benefits.
(2)
The Florida Power Named Executive Officers who met certain stock ownership guidelines and elected to take their LTIP payouts in common Stock, received an additional 25% of their 1997-1999 Long Term Incentive Plan (“LTIP”) award in Restricted Common Stock which vests over a 10 year period with no shares vesting in years one through five and 20% vesting in each of the years six through ten. Dividends are payable on the Restricted Common Stock to the extent and on the same date as dividends are paid on all other shares of Common Stock. All unvested shares of Restricted Common Stock vest immediately upon the consummation of a change in control. Information for fiscal year 1999, represents the dollar value as of February 23, 2000, the date of award, of the total number of shares of Restricted Common Stock awarded to the Florida Power Named Executive Officers as follows: Richard Korpan 12,341 shares; Joseph H. Richardson 5,410 shares; Roy A. Anderson 2,061 shares; Jeffrey R. Heinicka 1,847 shares; and Kenneth E. Armstrong 1,583 shares.
(3)
Information for fiscal year 1999, represents the dollar value as of, February 23, 2000, the date of award, of shares of Common Stock earned under the 1997-1999 performance cycle of Florida Progress’ LTIP, none of which are restricted. The total number of shares earned including dividend equivalent shares, is as follows: Richard Korpan 49,363 shares; Joseph H. Richardson 21,638 shares; Roy A. Anderson 8,242 shares; Jeffrey R. Heinicka 7,389 shares; and Kenneth E. Armstrong 6,332 shares.
The payouts listed for the 1997-1999 performance cycle are the result of the Florida Progress Compensation Committee’s determination of slightly below maximum achievement of Florida Progress’ total shareholder return goal. A mathematical formula was used to convert the goal level achieved into the number of performance shares earned; then, dividend equivalents on shares earned for the period of the performance cycle were added.
(4)
Company contributions to the Florida Progress Savings Plan and Executive Optional Deferred Compensation Plan on behalf of the Florida Power Named Executive Officers.
(5)
Includes $282,686 paid to Mr. Anderson under the terms of his employment agreement to place Mr. Anderson in substantially the same economic position as he would have been had he remained with his previous employer. Also includes reimbursement for Mr. Anderson’s moving expenses and tax reimbursement payments for moving expenses and imputed flight income.
The following table contains information with respect to Performance Shares granted in 1999 to each of the Florida Power Named Executive Officers under the LTIP:
LONG-TERM INCENTIVE PLAN(1)
AWARDS IN 1999
(1)
The LTIP is a Common Stock and cash-based incentive plan to reward participants for long-term performance of Florida Progress. It was approved by the Florida Progress shareholders in 1990.
(2)
The number of performance shares granted are based on a percentage of base salary in effect at the time of each award and is subject to automatic increase or decrease on a prorated basis in accordance with changes to a participant’s base salary or LTIP percentages throughout the performance cycle.
In the event of a change in control of Florida Progress, 150% of all performance shares granted to the Florida Power Named Executive Officers under the LTIP and then outstanding would automatically be considered earned and would be paid in cash or shares of unrestricted Common Stock together with shares of unrestricted Common Stock payable for dividend equivalents accrued through the date of the change in control.
(3)
Payouts for the 1999-2001 performance cycle are based on a comparison of Florida Progress’ three-year average annual total shareholder return against an industry peer group.
Under certain circumstances, including the achievement of stock ownership guidelines upon normal conclusion of applicable cycles, beginning in 2000, the Florida Power Named Executive Officers are entitled to a 25% restricted stock incentive bonus based on the number of shares of common stock earned under each performance cycle of the LTIP. The restricted stock vests over a 10-year period, but all shares vest immediately upon consummation of a change in control.
Pension Plan Table
See Item 11, Executive Compensation, Florida Progress - Pension Plan Table A” which illustrates the estimated annual benefits (computed as a straight life annuity beginning at retirement at age 65) payable under the Florida Progress Corporation Retirement Plan for Exempt and Nonexempt Employees (“Retirement Plan”), Nondiscrimination Plan and Supplemental Executive Retirement Plan (“SERP”) for specified final average compensation and years of service levels.
The Florida Power Named Executive Officers are entitled to benefits under the SERP. These benefits are offset by the benefits payable under the Retirement Plan and the Nondiscrimination Plan, as well as 50% of the executive’s primary Social Security benefit. The estimated annual SERP benefit for the Florida Power Named Executive Officers (prior to any offsets) may be determined using the Pension Plan Table set forth above. For these purposes, the current compensation for each executive that would be used in calculating benefits under the SERP is substantially the same as the three-year average of the salary and bonus reported in the summary compensation table, and the number of years of deemed credited service that would be used in calculating benefits under the SERP for each such executive is as follows: Mr. Korpan, 35 years of service; Mr. Richardson, 24 years of service; Mr. Anderson, 8 years of service; Mr. Heinicka, 22 years of service and Mr. Armstrong, 16 years of service. Under the formula used for calculating benefits under the SERP, the maximum benefit payable to each Named Executive Officer is reached at 16 years of deemed credited service unless the Florida Power Named Executive Officer achieves 35 years of service.
Accrued benefits may also be paid under each of the Retirement Plans, Nondiscrimination Plan and SERP if a participant terminates employment before age 65 and meets the requirements for early retirement, disability, death or other termination-of-employment benefits after becoming vested under the rules of the particular plan.
Under the Retirement Plan and the Nondiscrimination Plan, the compensation taken into account in calculating benefits is salary only. The years of credited service that would be used in calculating benefits under the formula applicable to the Retirement Plan and the Nondiscrimination Plan (1.8% of final average earnings for each year of service) for the Florida Power Named Executive Officers in the summary compensation table are as follows: Mr. Korpan, 11 years of service; Mr. Richardson, 24 years of service; Mr. Anderson, 3 years of service; Mr. Heinicka, 22 years of service; Mr. Armstrong, 13 years of service. The benefits under the Retirement Plan and the Nondiscrimination Plan are subject to offset by an amount equal to 1 1/7% of a participant’s primary Social Security benefit for each year of service (with a maximum offset of 40%).
In the event of a change in control of Florida Progress, each Florida Power Named Executive Officer will receive credit under the SERP for five additional years of service, but in no event would such additional years of credited service cause the maximum benefit to be increased. If a participant’s employment were terminated following a change in control, the benefit payable from the SERP would be as follows: (1) an annuity beginning at age 55 through 59, subject to early payment reductions in the amount of 3% for each year prior to age 60, or age 60 without reduction; (2) the amount of any federal excise taxes (and income taxes on any reimbursement under this provision) imposed on the executive under Section 4999 of the Internal Revenue Code; and (3) a 50% surviving spouse benefit payable upon death.
Employment Contracts, Termination of Employment and Change-in-control Arrangements
In April 1998, Florida Power entered into an Amended and Restated Employment Agreement with Roy A. Anderson which provides for his employment through April 30, 2003. His annual base salary will be $245,000, or such greater sum as shall be mutually agreed, with additional award opportunities as a participant in the Management Incentive Compensation Plan (“MICP”) and LTIP , with minimum award target levels of 40% of base salary for each plan. He is entitled to participate in the SERP, and shall be credited with up to 22 years of additional service constituting “Deemed Credited Service” thereunder depending on the number of years of actual service. The agreement also provides that if Mr. Anderson’s employment with Florida Power continues until or beyond age 60 and his employment terminates thereafter other than as a result of a termination for good cause, Florida Power shall pay to Mr. Anderson certain deferral award payments, based on his age, with a maximum deferral award, if his employment terminates at age 65, of $1,000,000 ($231,000 payable annually over five years). The agreement also provides for certain payments designed to compensate Mr. Anderson for certain benefits he would have enjoyed had he remained with his former employer. If Mr. Anderson’s employment terminates other than as a result of termination for good cause, he will receive a $105,960 15-year annuity, to be offset by payments made by his former employer pursuant to comparable arrangements. In the Amended and Restated Agreement, Mr. Anderson also acknowledges that other payments due him under his former employment agreement with Florida Power have been satisfied. The agreement contains a confidentiality agreement and covenant not to compete.
In the event of a change in control of Florida Progress, all of the Florida Power Named Executive Officers are entitled to benefits under individual agreements described under the heading “Employment Contracts, Termination of Employment and Change in Control Arrangements,” on page 82.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
FLORIDA PROGRESS
Security Ownership of Certain Beneficial Owners
The following table sets forth information concerning shares of Florida Progress Common Stock that are held by persons known to Florida Progress to be the beneficial owners of more than 5% of said stock as of December 31, 1999.
(1)
Sole dispositive power.
Security Ownership of Management
As of December 31, 1999, the directors and all other Florida Progress Named Executive Officers individually, and the directors, Florida Progress Named Executive Officers and executive officers of Florida Progress as a group, beneficially owned Common Stock as follows:
(1)
Unless otherwise noted, the directors and Named Executive Officers, and the directors and executive officers as a group, have sole voting and investment power with respect to the shares listed. An indication of shared voting or investment power for purposes of this table does not constitute an admission of ownership for any other purpose.
(2)
Unless otherwise noted, each director and Named Executive Officer, and all directors and executive officers as a group, own less than one percent of the outstanding shares of Florida Progress’ Common Stock.
(3)
Voting and investment power with respect to 2,500 shares is shared.
(4)
Voting power with respect to 3,079 shares is shared.
(5)
Voting and investment power with respect to 2,200 shares is shared.
(6)
Voting and investment power with respect to 150,473 shares is shared.
(7)
Voting and investment power with respect to 75 shares is shared.
(8)
Voting power with respect to 8,619 shares is shared.
(9)
Voting power with respect to 11,982 shares is shared. Investment power with respect to 7,479 shares is shared.
(10)
Voting power with respect to 3,877 shares is shared.
(11)
Voting and investment power with respect to 139 shares is shared. Voting power with respect to 2,664 shares is shared.
Changes in Control
See Item 7, MD&A under the heading “Current Issues - Share Exchange Agreement” and Note 2 to the Financial Statements.
FLORIDA POWER
Security Ownership of Certain Beneficial Owners
All of Florida Power’s common stock is held beneficially and of record by Florida Progress. None of Florida Power’s directors or executive officers owns any shares of Florida Power’s common or preferred stock. Information concerning shares of Florida Progress common stock that are held by persons known to Florida Progress to be the beneficial owners of more than 5% of Florida Progress’ common stock is set forth in the table above under the heading “Item 12 - Security Ownership of Certain Beneficial Owners - Florida Progress.”
Security Ownership of Management
The table below sets forth as of December 31, 1999, the number of shares of common stock of Florida Progress owned by Florida Power’s directors and Named Executive Officers individually and the directors and all executive officers of Florida Power as a group.
(1)
Unless otherwise noted, the directors, and Florida Power Named Executive Officers, and the directors and executive officers as a group, have sole voting and investment power with respect to the shares listed.
(2)
Unless otherwise noted, each director, and Florida Power Named Executive Officer and all directors, and executive officers as a group, own less than one percent of the outstanding shares of Florida Progress’ common stock.
(3)
Voting power with respect to 4,109 shares is shared.
(4)
Voting power with respect to 3,877 shares is shared.
(5)
Voting and investment power with respect to 2,500 shares is shared.
(6)
Voting and investment power with respect to 139 shares is shared. Voting power with respect to 2,664 shares is shared.
(7)
Voting power with respect to 3,079 shares is shared.
(8)
Voting and investment power with respect to 2,200 shares is shared.
(9)
Voting power with respect to 11,982 shares is shared. Investment power with respect to 7,479 shares is shared.
(10)
Voting and investment power with respect to 150,473 shares is shared.
(11)
Voting and investment power with respect to 75 shares is shared.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Florida Progress has invested $5 million for a limited partnership interest in the Tampa Bay Devil Rays, Ltd. (“Devil Rays”), a Florida limited partnership that acquired in 1995 a Major League Baseball franchise to play scheduled home baseball games at Tropicana Field in St. Petersburg, Florida. The managing general partner and a limited partner of the Devil Rays is a corporation controlled by Vincent J. Naimoli, a director of Florida Progress and Florida Power.
Florida Power has entered into a new and comprehensive Sponsorship, Promotion and Advertising Agreement (the “Agreement”) with the Devil Rays which replaces all previous agreements between the two entities. The term of the Agreement is from August 1999 through December 31, 2007 and provides for advertising, signage, sponsorships and naming rights. Annual fees total $770,000, with individual components having zero or 3 1/2% annual escalation.
The Agreement includes a lump sum payment of $5 million in 1999 for other promotions and advertising to be determined based on Florida Power’s annual marketing plans. Activities have fixed pricing for the term of the Agreement. Florida Progress has the option to convert any unused funds into equity in the partnership during the term of the Agreement.
In March 1998, Florida Progress entered into a Private Suite License Agreement (“License”) for the use of a private suite in Tropicana Field for a ten-year term. The $125,000 annual License fee is subject to annual increases equal to the percentage increase in the Consumer Price Index or 2 1/2%, whichever is less. The terms and conditions of the License are substantially similar to those entered into with other licensees.
Mr. Michael P. Graney is a partner in the law firm of Simpson Thacher & Bartlett. That firm provided legal services to Electric Fuels and its subsidiary, Progress Rail Services Corporation, in 1999, and has been providing similar legal services in 2000.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FOR FLORIDA PROGRESS AND FLORIDA POWER
(a) 1. Financial Statements, notes to Financial Statements and report thereon KPMG LLP are found in Item 8 “Financial Statements and Supplementary Data” herein.
2. The following Financial Statement Schedules and reports are included herein:
Florida Progress
II-Valuation and Qualifying Accounts
for the years ended December 31, 1999, 1998 and 1997
Florida Power
II-Valuation and Qualifying Accounts
for the years ended December 31, 1999, 1998 and 1997
All other schedules are not submitted because they are not applicable or not required or because the required information is included in the financial statements or notes thereto.
3. Exhibits filed herewith:
4. Exhibits incorporated herein by reference:
X = Exhibit is filed for that respective company.
* = Exhibit constitutes an executive compensation plan or arrangement.
In reliance upon Item 601(b)(4)(iii) of Regulation S-K, certain instruments defining the rights of holders of long-term debt of Florida Progress and its consolidated subsidiaries are not being filed herewith, because the total amount authorized thereunder does not exceed 10% of the total assets of Florida Progress and its subsidiaries on a consolidated basis. Florida Progress hereby agrees to furnish a copy of any such instruments to the SEC upon request.
Florida Progress will furnish to its security holders who so request a copy of any exhibit included in this Annual Report on Form 10-K upon payment of a fee of $.25 per page to cover expenses in furnishing such exhibit.
(b) Reports on Form 8-K:
During the fourth quarter of the year ended December 31, 1999 Florida Progress and Florida Power filed the following reports on Form 8-K:
Form 8-K dated October 14, 1999, reporting under Item 5 “Other Events” Florida Progress’ and Florida Power’s third quarter 1999 earnings, and providing updates on litigation concerning Mid-Continent and the transaction with CP&L.
In addition, Florida Progress and Florida Power filed the following reports on Form 8-K subsequent to the fourth quarter of 1999:
Form 8-K dated January 27, 2000, reporting under Item 5 “Other Events” Florida Progress’ and Florida Power’s 1999 year-end earnings.
Form 8-K dated February 24, 2000 reporting under Item 5 “Other Events” an increase in Florida Progress’ annual dividend.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FLORIDA PROGRESS CORPORATION
March 28, 2000
By: /s/ Richard Korpan
Richard Korpan, Chairman of the Board, President and Chief Executive Officer
KNOWN BY ALL MEN BY THESE PRESENTS that each of the undersigned officers and directors of Florida Progress Corporation, a Florida corporation, for himself or herself and not for one another, does hereby constitute and appoint KENNETH E. ARMSTRONG, JOHN SCARDINO, JR. and DOUGLAS E. WENTZ, and each of them, a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to any and all amendments to this report, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully to all intents and purposes as the undersigned could do if personally present, and each of the undersigned for himself or herself hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company.
FLORIDA POWER CORPORATION
March 28, 2000
By: /s/ Joseph H. Richardson
Joseph H. Richardson, President and Chief Executive Officer
KNOWN BY ALL MEN BY THESE PRESENTS that each of the undersigned officers and directors of Florida Power Corporation, a Florida corporation, for himself or herself and not for one another, does hereby constitute and appoint KENNETH E. ARMSTRONG, JOHN SCARDINO, JR. and DOUGLAS E. WENTZ, and each of them, a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to any and all amendments to this report, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully to all intents and purposes as the undersigned could do if personally present, and each of the undersigned for himself or herself hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Schedule II
FLORIDA PROGRESS CORPORATION
Valuation and Qualifying Accounts
For the Years Ended December 31, 1999, 1998, and 1997
(In millions)
(A)
Effective December 31, 1997, Florida Progress deconsolidated the financial statements of Mid-Continent Life in its consolidated financial statements. Florida Progress’ investment from Mid-Continent is accounted for under the cost method.
Schedule II
FLORIDA POWER CORPORATION
Valuation and Qualifying Accounts
For the Years Ended December 31, 1999, 1998, and 1997
(In millions)
Note: Deductions are payments of actual expenditures related to the outage. | 36,727 | 239,634 |
740971_1999.txt | 740971_1999 | 1999 | 740971 | Item 1. Description of Business
General
Old Point Financial Corporation (the "Company") was incorporated under the laws of Virginia on February 16, 1984, for the purpose of acquiring all the outstanding common stock of The Old Point National Bank of Phoebus (the "Bank"), in connection with the reorganization of the Bank into a one bank holding company structure. At the annual meeting of the stockholders on March 27, 1984, the proposed reorganization was approved by the requisite stockholder vote. At the effective date of the reorganization on October 1, 1984, the Bank merged into a newly formed national bank as a wholly owned subsidiary of the Company, with each outstanding share of common stock of the Bank being converted into five shares of common stock of the Company.
The Company completed a spin-off of its trust department as of April 1, 1999. The newly formed organization is charted as Old Point Trust and Financial Services, N.A. ("Trust"). Trust is a wholly owned subsidiary of the Company. The Company does not engage in any activities other than acting as a holding company for the common stock of the Bank and Trust. The principal business of the Company is conducted through its subsidiaries which continue to conduct business in substantially the same manner and from the same offices.
The Bank is a national banking association founded in 1922. The Bank has fifteen offices in the cities of Hampton, Newport News and Chesapeake, as well as James City and York County, Virginia, and provides a full range of banking and related financial services, including checking, savings, certificates of deposit, and other depository services, commercial, industrial, residential real estate and consumer loan services, safekeeping services.
As of December 31, 1999, the Company had assets of $436.3 million, loans of $281.6 million, deposits of $360.9 million, and stockholders' equity of $40.8 million. At year end, the Company and its subsidiaries had a total of 233 employees, 30 of whom were part-time.
The Company's trade area is Hampton Roads, which includes Williamsburg, Poquoson, Newport News, Hampton, Chesapeake, Norfolk, Virginia Beach, Portsmouth and Suffolk. The area also includes the Isle of Wight, James City, Gloucester and Mathews counties. According to the 1999 Hampton Roads Statistical Digest, there are more than 1.5 million people in the area with 30% of all jobs linked to the military. The single largest employer is Newport News Shipbuilding with approximately 17,000 employees.
The banking industry is highly competitive in the Hampton Roads area. There are approximately nineteen commercial and savings banks conducting business in the area. Six of these are major statewide banking organizations.
The Bank encounters competition for deposits and loans from banks, saving and loan associations, and credit unions in the area in which it operates. In addition, the Bank must compete for deposits in some instances with nationally marketed money market funds, brokerage firms and on-line or internet banks.
The Company and its subsidiaries are subject to regulation and examination by the Federal Reserve Board ("the Board"), the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation ("the FDIC").
As a bank holding company within the meaning of the Bank Holding Company Act of 1956, the Company is subject to the ongoing regulation, supervision, and examination by the Federal Reserve Board (the "Board"). The Company is required to file with the Board periodic and annual reports and other information concerning its own business operations and those of its subsidiaries. In addition, prior Board approval must be obtained before the Company can acquire (i) ownership or control of any voting shares of another bank if, after such acquisition, it would control more than 5% of such shares, or (ii) all or substantially all of the assets of another bank or merge or consolidate with another bank holding company. A bank holding company is prohibited under the Bank Holding Company Act, with limited exceptions, from engaging in activities other than those of banking or of managing or controlling banks or furnishing services to its subsidiaries.
Recent Legislation
The Gramm-Leach-Bliley Act (the "Act") which was signed into law by the President on November 12, 1999 became effective March 11, 2000. The Act allows a bank holding company to elect to become a "financial holding company" and permitted to engage in financial activities. Among the items listed in the Act as financial activities are lending, exchanging, transferring, investing for others, or safeguarding money or securities. Other permitted activities are providing financial, investment or economic advisory services, including advising an investment company; issuing or selling instruments representing interests in pools of assets permissible for a bank to hold; and underwriting, dealing in or making a market in securities. As long as the Company remains a bank holding company it remains subject to the Bank Holding Company Act.
Statistical Information
The following statistical information is furnished pursuant to the requirements of Guide 3 (Statistical Disclosure by Bank Holding Companies) promulgated under the Securities Act of 1933.
I. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential
The following table presents the distribution of assets, liabilities, and shareholders' equity by major categories with related average yields/rates. In these balance sheets, nonaccrual loans are included in the daily average loans outstanding. The following table sets forth a summary of changes in interest earned and paid attributable to changes in volume and changes in yields/rates.
* Computed on a fully taxable equivalent basis using a 34% rate
The Company was liability sensitive as of December 31, 1999. There were $151 million more in liabilities than assets subject to repricing within three months. This generally indicates that net interest income should improve if interest rates fall since liabilities will reprice faster than assets. It should be noted, however, that savings deposits; which consist of interest bearing transactions accounts, money market accounts, and savings accounts; are less interest sensitive than other market driven deposits. In a rising rate environment these deposit rates have historically lagged behind the changes in earning asset rates, thus mitigating somewhat the impact from the liability sensitivity position.
II. Investment Portfolio
Note 2 of the Notes to Financial Statements found in Item 8. Financial Statements and Supplementary Data of this Report on Form 10K presents the book and market value of investment securities on the dates indicated.
The following table shows, by type and maturity, the book value and weighted average yields of investment securities at December 31, 1999.
Yields are calculated on a fully tax equivalent basis using a 34% rate.
At December 31, 1999, the book value of other marketable equity securities with no stated maturity totaled $5.1 million with an weighted average yield of 5.59%. These securities consisted of an adjustable rate mortgage fund of $3.0 million yielding 4.86%, Federal Home Loan Bank stock of $1.2 million yielding 7.75%, Federal Reserve stock of $169 thousand yielding 6.00%, money market fund of $674 thousand yielding 5.25% and other securities of $50 thousand. The book value of other marketable securities with no stated maturity totaled $5.58 million, yielding 5.45%; and $5.48 million, yielding 6.13%; at December 31, 1998, and 1997 respectively.
III. Loan Portfolio
The following table shows a breakdown of total loans by type at December 31 for years 1995 through 1999:
Based on Standard Industry Code, there are no categories of loans which exceed 10% of total loans other than the categories disclosed in the preceding table.
The maturity distribution and rate sensitivity of certain categories of the Bank's loan portfolio at December 31, 1999 is presented below:
The following table presents information concerning the aggregate amount of nonaccrual, past due and restructured loans as of December 31 for the years 1995 through 1999.
Loans are placed in nonaccrual status if principal or interest has been in default for a period of 90 days or more unless the obligation is both well secured and in the process of collection. A debt is "well secured" if it is secured (i) by collateral in the form of liens on or pledges of real or personal property, including securities, that have a realizable value sufficient to discharge the debt in full or (ii) by the guaranty of a financially responsible party. A debt is "in the process of collection" if collection of the debt is proceeding in due course either through legal action, including judgment enforcement procedures, or, in appropriate circumstances, through collection efforts not involving legal action which are reasonably expected to result in repayment of the debt or in its restoration to a current status.
Potential problem loans consist of loans that, because of potential credit problems of the borrowers, have caused management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms. At December 31, 1999 such problem loans, not included in Table VII, amounted to approximately $1.9 million. There were no relationships in excess of $500 thousand. The potential problem loans are generally secured by residential and commercial real estate with appraised values exceeding the principal balance of the loan.
IV. Summary of Loan Loss Experience
The determination of the balance of the Allowance for Loan Losses is based upon a review and analysis of the loan portfolio and reflects an amount which, in management's judgment, is adequate to provide for possible future losses. Management's review includes monthly analysis of past due and nonaccrual loans and detailed periodic loan by loan analyses.
The principal factors considered by management in determining the adequacy of the allowance are the growth and composition of the loan portfolio, historical loss experience, the level of nonperforming loans, economic conditions, the value and adequacy of collateral, and the current level of the allowance.
The following table shows an analysis of the Allowance for Loan Losses for the years 1995 through 1999.
The following table shows the amount of the Allowance for Loan Losses allocated to each category at December 31 for the years 1995 through 1999.
V. Deposits
The following table shows the average balances and average rates paid on deposits for the years ended December 31, 1999, 1998, and 1997.
The following table shows certificates of deposit in amounts of $100,000 or more as of December 31, 1999, 1998, and 1997 by time remaining until maturity.
TABLE XI CERTIFICATE OF DEPOSIT $100,000 & MORE _____________________________________________________________ Dollars in thousands 1999 1998 1997 Maturing in _____________________________________________________________
3 months or less $ 6,456 $ 3,592 $ 5,449 3 through 6 months 4,485 6,353 3,087 6 through 12 months 11,958 7,345 5,843 over 12 months 11,132 10,915 9,467 ------- ------- ------- $34,031 $28,205 $23,846
VI. Return on Equity and Assets
The return on average shareholders' equity and assets, the dividend pay out ratio, and the average equity to average assets ratio for the past three years are presented below.
1999 1998 1997 Return on average assets 1.14% 1.22% 1.23%
Return on average equity 11.81% 12.03% 11.88%
Dividend payout ratio 28.89% 26.62% 25.68%
Average equity to average assets 9.64.% 10.15% 10.36%
VII. Short Term Borrowings
The Bank periodically borrowed funds through federal funds from its correspondent banks, through the use of a demand note to the United States Treasury (Treasury Tax and Loan Deposits), and through securities sold under agreements to repurchase. The borrowings matured daily and were based on daily cash flow requirements. The borrowed amounts (in thousands) and their corresponding rates during 1999, 1998, and 1997 are presented in the following table.
Item 2.
Item 2. Description of Property The Bank owns the Main Office, five office buildings4, and nine branches5. All of the above properties are owned directly and free of any encumbrances. The land at the Fort Monroe branch is leased by the Bank under an agreement expiring in October 2011. The remaining three branches are 6leased from unrelated parties under leases with renewal options which expire anywhere from 10-15 years.
For more information concerning the commitments under current leasing agreements, see Note 10. Lease Commitments of the Notes to Financial Statements found in Item 8. Financial Statements and Supplementary Data of this Report on Form 10K. Additional information on Other Real Estate Owned can be found in Note 6. Other Real Estate Owned of the Notes to Financial Statements found in Item 8. Financial Statements and Supplementary Data of this Report on Form 10K.
Item 3.
Item 3. Legal Proceedings The Company is not a party to any material pending legal proceedings before any court, administrative agency, or other tribunal.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the quarter ended December 31, 1999.
Part II
Item 5.
Item 5. Market for Common Equity And Related Stockholder Matters
Beginning in 1998 the common stock of Old Point Financial Corporation was quoted on the OTC Bulletin Board under the symbol "OPOF". The Company has submitted an application to Nasdaq to list the Company's stock on the Nasdaq SmallCap market. The approximate number of shareholders of record as of December 31, 1999 was 1,419. The range of high and low prices and dividends per share of the Company's common stock for each quarter during 1999 and 1998 is presented in Part I. Item 7. of this Annual Report on Form 10-K. Additional information related to stockholder matters can be found in Note 15. Regulatory Matters of the Notes to Financial Statements found in Item 8. Financial Statements and Supplementary Data of this Report on Form 10K.
Item 6.
Item 6. Selected Financial Data
The following table summarizes the Company's performance for the past five years.
Item 7
Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion is intended to assist readers in understanding and evaluating the consolidated results of operations and financial condition of the Company. This discussion should be read in conjunction with the financial statements and other financial information contained elsewhere in this report. The analysis attempts to identify trends and material changes which occurred during the period presented.
EARNINGS SUMMARY Net income was $4.82 million, or $1.87 per share in 1999 compared to $4.64 million, or $1.80 per share in 1998 and $4.09 million, or $1.60 per share in 1997. Return on average assets was 1.14% in 1999, 1.22% in 1998 and 1.23% in 1997. Return on average equity was 11.81% in 1999, 12.03% in 1998 and 11.88% in 1997. For the past five years return on average assets has averaged 1.10% and return on average equity has averaged 10.96%. Selected Financial Highlights summarizes the Company's performance for the past five years.
NET INTEREST INCOME The principal source of earnings for the Company is net interest income. Net interest income is the difference between interest and fees generated by earning assets and interest expense paid to fund them. Net interest income, on a tax equivalent basis, was $17.09 million in 1999, up $1.0 million, or 6% from $16.08 million in 1998 which was up $766 thousand, or 5% from $15.30 million in 1997. Net interest income is affected by variations in interest rates and the volume and mix of earning assets and interest-bearing liabilities. The net interest yield decreased to 4.28% in 1999 from 4.48% in 1998, which was down from 4.91% in 1997.
Tax equivalent interest income increased $2.17 million, or 8%, in 1999. Average earning assets grew $40.66 million, or 11%. Total average loans increased $32.41 million, or 14%, while average investment securities increased $14.44 million, or 12%. The yield on earning assets decreased in 1999 by twenty-seven basis points primarily due to lower interest rates prevailing in the market.
Interest expense increased $1.16 million or 9%, in 1999. Interest bearing liabilities increased 11% in 1999. The cost of funding liabilities decreased twelve basis points. The reduction in cost of funds was due to lower market interest rates in 1999; however, the rates paid on funding liabilities in 1999 did not fall as fast as the rates paid on earning assets due to the intense competition for loans and deposits in the Company's market.
PROVISION/ALLOWANCE FOR LOAN LOSSES Provision for loan losses is a charge against earnings necessary to maintain the allowance for loan losses at a level consistent with management's evaluation of the loan portfolio. The provision remained at $650 thousand in 1999 compared to 1998 which was up from $600 thousand in 1997.
Loans charged off during 1999 totalled $793 thousand compared to $947 thousand in 1998 and $868 thousand in 1997. Recoveries amounted to $399 thousand in 1999, $481 thousand in 1998 and $609 thousand in 1997.
The Company's net loans charged off to year-end loans were 0.14% in 1999, 0.20% in 1998, and 0.12% in 1997. The allowance for loan losses, as a percentage of year-end loans, was 1.10% in 1999, 1.21% in 1998, and 1.20% in 1997.
As of December 31, 1999, nonperforming assets were $868 thousand, up from $737 thousand at year-end 1998. Nonperforming assets consist of loans in nonaccrual status and other real estate. The 1999 total consisted of other real estate of $354 thousand and $514 thousand in nonaccrual loans. The other real estate is a commercial property originally acquired as a potential branch site and now held for sale. Nonaccrual loans consisted of $241 thousand in commercial loans and $273 thousand in mortgage loans. Loans still accruing interest but past due 90 days or more increased to $1.35 million as of December 31, 1999 compared to $641 thousand as of December 31, 1998. The 1999 90 day past due total included two loans amounting to $713 thousand which were paid off the first week of January 2000.
The allowance for loan losses is analyzed for adequacy on a quarterly basis to determine the required amount of provision for loan losses. A loan-by-loan review is conducted on all significant classified commercial and mortgage loans. Inherent losses on these individual loans are determined and an allocation of the allowance is provided. Smaller nonclassified commercial and mortgage loans and all consumer loans are grouped by homogeneous pools with an allocation assigned to each pool based on an analysis of historical loss and delinquency experience, trends, economic conditions, underwriting standards, and other factors.
OTHER INCOME Other income increased $475 thousand, or 10% in 1999 from 1998 compared to an increase of $637 thousand, or 15% in 1998 from 1997. Continuing the trend from 1998 the growth in other income is attributed to higher trust income and service charges on deposit accounts.
OTHER EXPENSES Other expenses increased $1.1 million or 9% in 1999 over 1998 after increasing 4% in 1998 from 1997. Salary expense increased by 11% due to increased staffing for two new branches opened in 1999 and normal salary increases. Occupancy expenses increased only $27 thousand, or 3% in 1999 after increasing $94 thousand, or 11% in 1998. The 1998 increase was primarily due to costs associated with opening the Old Point Trust and Financial Services Center in the Oyster Point area of Newport News VA. The Company continued to upgrade computer systems and outfit two new branches. The increase of $125 thousand in equipment expenses is principally related to depreciation expense on the new computer systems acquired for Year 2000 upgrades. Other operating expenses increased $95 thousand or 3%. Marketing, telephone and organizational expenses were primarily responsible for the increase in other expenses. The marketing expenses help fuel the Company's exceptional loan growth. A switch to high-speed communication lines increased telephone expense and the Company's spin-off of its Trust Department were responsible for the organization expenses.
ASSETS At December 31, 1999, the Company had total assets of $436.3 million, up 8% from $404.1 million at December 31, 1998. Average assets in 1999 were $423.7 million compared to $380.8 million in 1998. The growth in assets in 1999 was due to the increase in loans, which were up 19% in 1999. These loans were partially funded by the 8% decrease in
investment securities and reductions in Federal funds sold. The Company also borrowed $7.0 million from the Federal Home Loan Bank.
The Old Point National Bank opened two new branches in 1999. The branch in Norge VA is new construction while the branch in Chesapeake VA was an existing branch building purchased by the Bank. The Woodland Road office was completely renovated adding additional square footage and parking. Two additional buildings were purchased in 1999. One building will be used for General Operations and the other facility will be used as a Commercial Services center.
LOANS Total loans as of December 31, 1999 were $281.6 million, up 19% from $235.9 million at December 31, 1998. The Company realized significant growth in all categories of loans. Footnote 3 of the financial statements details the loan volume by category for the past two years.
INVESTMENT SECURITIES At December 31, 1999 total investment securities were $127.0 million, down 8% from $137.5 million on December 31, 1998. The goal of the Company is to provide maximum return on the investment portfolio within the framework of its asset/liability objectives. These objectives include managing interest sensitivity, liquidity and pledging requirements.
DEPOSITS At December 31, 1999, total deposits amounted to $360.9 million, up 5% from $343.4 million on December 31, 1998. Non-interest bearing deposits decreased $2.3 million, or 4%, at year-end 1999 over 1998. Savings deposits increased $7.1 million, or 6%, in 1999 over 1998. Certificates of Deposit increased $12.8 million or 8% in 1999 over 1998.
STOCKHOLDERS' EQUITY Total stockholders' equity as of December 31, 1999 was $40.8 million, up 2% from $40.0 million on December 31, 1998. The Company is required to maintain minimum amounts of capital under banking regulations. Under the regulations, Total Capital is composed of core capital (Tier 1) and supplemental capital (Tier 2). Tier 1 capital consists of common stockholders' equity less goodwill. Tier 2 capital consists of certain qualifying debt and a qualifying portion of the allowance for loan losses. The following is a summary of the Company's capital ratios for 1999, 1998 and 1997.
1999 1999 1998 1997 Regulatory Requirements
Tier 1 4.00% 14.19% 14.89% 15.06% Total Capital 8.00% 15.23% 15.98% 16.19% Tier 1 Leverage 3.00% 10.08% 10.26% 10.32%
Year-end book value was $15.80 in 1999 and $15.54 in 1998. Cash dividends were $1.4 million, or $.54 per share in 1999 and $1.2 million, or $.48 per share in 1998. The common stock of the Company has not been extensively traded. The table below shows the high and low closing prices for each quarter of 1999 and 1998. The stock was quoted on the OTC Bulletin Board under the symbol "OPOF" and the prices below are based on trades through the OTC Bulletin Board. There were 1419 stockholders of the Company as of December 31, 1999. This stockholder count does not include stockholders who hold their stock in a nominee registration. The following is a summary of the dividends paid and market price on Old Point Financial Corporation common stock for 1999 and 1998.
1999 1998 Market Value Market Value
Dividend High Low Dividend High Low
1st Quarter $ 0.13 $34.50 $28.75 $ 0.11 $39.00 $25.50
2nd Quarter $ 0.13 $30.00 $24.00 $ 0.11 $44.00 $37.00
3rd Quarter $ 0.14 $28.25 $24.00 $ 0.13 $43.00 $38.00
4th Quarter $ 0.14 $25.25 $19.50 $ 0.13 $40.50 $30.00
LIQUIDITY Liquidity is the ability of the Company to meet present and future obligations through the acquisition of additional liabilities or sale of existing assets. Management considers the liquidity of the Company to be adequate. Sufficient assets are maintained on a short-term basis to meet the liquidity demands anticipated by Management. In addition, secondary sources are available through the use of borrowed funds if the need should arise.
EFFECTS OF INFLATION Management believes that the key to achieving satisfactory performance in an inflationary environment is its ability to maintain or improve its net interest margin and to generate additional fee income. The Company's policy of investing in and funding with interest-sensitive assets and liabilities is intended to reduce the risks inherent in a volatile inflationary economy.
Year 2000
The Company is pleased to report that there have been no Year 2000 problems. Management attributes this to the extensive testing and preparation prior to January 1, 2000.
Item 8.
Item 8. Financial Statement and Supplementary Data
The consolidated financial statements and related footnotes of the company are presented below followed by the financial statements of the parent.
The following are the summarized financial statements of the Company.
Eggleston Smith P.C. Certified Pulic Accountants & Consultants
To the Board of Directors Old Point Financial Corporation Hampton, Virginia
We have audited the accompanying consolidated balance sheets of Old Point Financial Corporation and subsidiary as of December 31, 1999 and 1998, and the related consolidated statements of income, cash flows and changes in stockholders' equity for each of the years in the three-year period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above, present fairly, in all material respects, the consolidated financial position of Old Point Financial Corporation and subsidiary as of December 31, 1999 and 1998, and the consolidated results of their operations and cash flows for each of the years in the three-year period ended December 31, 1999, in conformity with generally accepted accounting principles.
/s/Eggleston Smith P.C. - ----------------------- Eggleston Smith P.C.
January 20, 2000 Newport News, Virginia
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of Old Point Financial Corporation and its subsidiaries conform to generally accepted accounting principles and to general practice within the banking industry. The following is a summary of significant accounting and reporting policies:
PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of Old Point Financial Corporation ("the Company") and its subsidiaries The Old Point National Bank of Phoebus ("the Bank") and Old Point Trust & Financial Services N.A. ("Trust"). All significant intercompany balances and transactions have been eliminated in consolidation.
NATURE OF BUSINESS: Old Point Financial Corporation is a two-bank holding company that conducts substantially all of its operations through its subsidiaries, The Old Point National Bank of Phoebus and Old Point Trust and Financial Services, N.A. The Bank services individual and commercial customers, the majority of which are in Hampton Roads. The Bank has fourteen branch offices. The Bank offers a full range of deposit and loan products to its retail and commercial customers. Substantially all of the Bank's deposits are interest bearing. The majority of the Bank's loan portfolio is secured by real estate. Trust offers a full range of services for individuals and businesses. Products and services include retirement planning, estate planning, financial planning, trust accounts, tax services, and investment management services.
USE OF ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The amounts recorded in the financial statements may be affected by those estimates and assumptions. Actual results may vary from those estimates.
The Company uses estimates primarily in developing its allowance for loan losses, in computing deferred tax assets, in determining the estimated useful lives of premises and equipment, and in the valuation of other real estate owned.
INVESTMENT SECURITIES: Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows:
Held-to-maturity - Debt securities for which the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity.
Trading - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading account securities and recorded at their fair values. Unrealized gains and losses on trading account securities are included immediately in income.
Available-for-sale - Debt and equity securities not classified as either held-to-maturity securities or trading account securities are classified as available-for-sale securities and recorded at fair value, with unrealized gains and losses reported as a component of comprehensive income. Gains and losses on the sale of available-for-sale
securities are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity.
INTEREST ON LOANS: Interest is accrued daily on the outstanding loan balances. Accrual of interest is discontinued on a loan when management believes, after considering collection efforts and other factors, that the borrower's financial condition is such that collection of interest is doubtful.
LOAN ORIGINATION FEES AND COSTS: Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield on the related loan.
ALLOWANCE FOR LOAN LOSSES: The allowance for loan losses is generated by direct charges against income and is available to absorb loan losses. The allowance is based upon management's periodic evaluation of changes in the overall credit worthiness of the loan portfolio, economic conditions in general, and the effect of these conditions upon the financial status of specific borrowers and other factors.
The Bank is subject to regulation by the Office of the Comptroller of the Currency. They may require that the Bank adjust its allowance for loan losses upon request.
OTHER REAL ESTATE OWNED: Other real estate owned is carried at the lower of cost or estimated fair value and consists of foreclosed real property and other property held for sale. The estimated fair value is reviewed periodically by management and any write-downs are charged against current earnings.
PREMISES AND EQUIPMENT: Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated on both straight-line and accelerated methods and are charged to expense over the estimated useful lives of the related assets. Costs of maintenance and repairs are charged to expense as incurred.
INCOME TAXES: Income taxes are provided based upon income reported in the statements of income (after exclusion of non-taxable income such as interest on state and municipal securities). The income tax effect resulting from timing differences between financial statement pre-tax income and taxable income is deferred to future periods.
PENSION PLAN: The Company has a non-contributory defined benefit pension plan covering substantially all of its employees. Benefits are based on years of service and average earnings during the highest average sixty-month period during the final one hundred and twenty months of employment.
The Company's policy is to fund the maximum amount of contributions allowed for tax purposes. The Bank accrues an amount equal to its actuarially computed obligation under the plan.
The net periodic pension expense includes a service cost component, interest on the projected benefit obligation, return on plan assets and the effect of deferring and amortizing certain actuarial gains and losses and the unrecognized net transition asset over fifteen years.
TRUST ASSETS AND INCOME: Assets held by Trust are not included in the financial statements, because such items are not assets of the Company. In accordance with industry practice, trust service income is recognized primarily on the cash basis. Reporting such income on the accrual basis would not materially effect net income.
Advertising Expense Advertising expenses are expensed as incurred.
RECLASSIFICATIONS: Certain amounts in the financial statements have been reclassified to conform with classifications adopted in the current year.
NOTE 2, Investment Securities
At December 31, 1999, the investment securities portfolio is composed of securities classified as held-to-maturity and available-for-sale, in conjunction with SFAS 115. Investment securities held-to-maturity are carried at cost, adjusted for amortization of premiums and accretions of discounts, and investment securities available-for-sale are carried at market value.
NOTE 2, Investment Securities (Continued) ________________________________________________________________ Investment securities carried at $47.3 million and $37.8 million at December 31, 1999 and 1998, respectively, were pledged to secure public deposits and securities sold under agreements to repurchase and for other purposes required or permitted by law.
The amortized cost and approximate market values of investment securities at December 31, 1999 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The proceeds from the sale and maturities of investment securities, and the related realized gains and losses are shown below:
1999 1998 1997 (Dollars in Thousands) Proceeds from sales and maturities of investments $32,566 $36,111 $30,167 ======= ======= =======
Realized gains $ 0 $ 0 $ 3 Realized losses 54 0 4 ------- ------- ------- Net gains (losses) $ (54) $ 0 $ (1) ======= ======= =======
NOTE 3, Loans
At December 31, loans before allowance for loan losses consisted of:
1999 1998
(Dollars in Thousands)
Commercial and other $62,257 $53,793 Real estate - construction 11,461 5,418 Real estate - mortgage 140,004 116,635 Installment loans to individuals 65,178 58,618 Tax exempt loans 2,747 1,401 -------- -------- Total $281,647 $235,865 ======== ========
Information concerning loans which are contractually past due or in non-accrual status is as follows:
1999 1998 (Dollars in Thousands)
Contractually past due loans - past due 90 days or more and still accruing interest $1,351 $641 ====== ==== Loans which are in non-accrual status $514 $253 ==== ====
The Bank has had, and may be expected to have in the future, banking transactions in the ordinary course of business with directors, executive officers, their immediate families, and companies in which they are principal owners (commonly referred to as related parties), on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others. The aggregate direct and indirect loans of these persons totaled $2.0 million and $1.8 million at December 31, 1999 and 1998, respectively. These totals do not include loans made in the ordinary course of business to other companies where a director or executive officer of the Bank was also a director or officer of such company but not a principal owner. None of the directors or executive officers had direct or indirect loans exceeding 10% of stockholders' equity at December 31, 1999.
The bank does not account for any of its loans under the provisions of Statement of Financial Accounting Standards No. 114 or 118 related to impaired loans.
NOTE 4, Allowance for Loan Losses
Changes in the allowance for loan losses are as follows:
1999 1998 1997
(Dollars in Thousands)
Balance, beginning of year $2,855 $2,671 $2,330 Recoveries 399 481 609 Provision for loan losses 650 650 600 Loans charged off (793) (947) (868) ------ ------ ------ Balance, end of year $3,111 $2,855 $2,671
NOTE 5, Premises and Equipment ___________________________________________ At December 31, premises and equipment consisted of:
1999 1998 (Dollars in Thousands)
Land $ 3,005 $2,458 Buildings 11,267 9,879 Leasehold improvements 882 882 Furniture, fixtures and equipment 10,457 9,925 ----------------- Total cost 25,611 23,144 Less accumulated depreciation and amortization 11,287 11,092 ----------------- Net book value $14,324 $12,052 =================
NOTE 6, Other Real Estate Owned ___________________________________________ Other real estate consisted of the following at December 31:
1998 1998 (Dollars in Thousands) Foreclosed real estate $ 0 $130 Property held for sale 354 354 -------------- Total $354 $484 ==============
NOTE 7, Indebtedness ___________________________________________ The Bank's short-term borrowings include federal funds purchased, securities sold under repurchase agreements (including $1.4 million to directors in 1999 and 1998) and United States Treasury Demand Notes. The federal funds purchased and securities sold under repurchase agreements are held under various maturities and interest rates. The United States Treasury Demand Notes are subject to call by the United States Treasury with interest paid monthly at the rate of 25 basis points (1/4%) below the federal funds rate.
NOTE 8, Stock Option Plan ___________________________________________ The Company has stock option plans which reserve 137,974 shares of common stock for grants to key employees. The exercise price of each option equals the market price of the Company's common stock on the date of the grant and an option's maximum term is ten years. A summary of the exercisable incentive stock options is presented below:
At December 31, 1999, exercise prices on outstanding options ranged from $18.13 to $41.86 per share and the weighted average remaining contractual life was 7 years.
NOTE 8, Stock Option Plan (Continued)
The Company accounts for its stock option plans in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, which does not allocate costs to stock options granted at current market values. The Company could, as an alternative, allocate costs to stock options using option pricing models, as provided in Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. Because of the limited number of options granted and the limited amount of trading activity in the Company's stock, management believes that stock options are best accounted for in accordance with APB Opinion No. 25. However, had the stock options been accounted for in accordance with SFAS No. 123, pro-forma amounts for net earnings and earnings per share would have been as follows for each of the years ending December 31:
__________________________________________________________________________ 1999 1998 1997
Pro-forma net income (in thousands) $4,793 $4,565 $4,041 ====== ====== ======
Pro-forma earnings per share $ 1.85 $ 1.76 $ 1.57 ====== ====== ======
Pro-forma amounts were computed using a 6% risk free interest rate over a 10 year term using an annual dividend rate of between 1.29% and 2.02 and a .01% volatility rate.
The pro-forma effect of the potential exercise of stock options on basic earnings per share would be to increase the number of weighted average number of outstanding shares by approximately 16,000 in 1999, 24,000 in 1998, 14,000 in 1997.
The Company also has an Employee Stock Purchase Plan which reserves 61,146 shares of common stock for eligible employees. The purchase price is 95% of the lesser of (1) the common stock's fair market value at July 1 or (2)the common stock's fair market value at the following June 30. During 1999, 5,114 shares of common stock were purchased by employees.
NOTE 9, Income Taxes
The components of income tax expense are as follows: ____________________________________________________ 1999 1998 1997 (Dollars in Thousands)
Currently payable $1,213 $1,564 $1,458 Deferred 2 (27) (17) ------ ------ ------ Reported tax expense $1,215 $1,537 $1,441 ====== ====== ======
The items that caused timing differences affecting deferred income taxes are as follows: _______________________________________________________________________ 1999 1998 1997 (Dollars in Thousands)
Provision for loan losses $(108) $(156) $(186) Pension plan expenses 34 46 17 Deferred loan fees, net 27 (22) 24 Security gains and losses (6) 0 (4) Interest on certain non-accrual loans 22 68 95 Depreciation 38 31 37 Other (5) 6 0 ----- ----- ----- Total $ 2 $ (27) $ (17) ===== ===== =====
A reconciliation of the "expected" Federal income tax expense on income before income taxes with the reported income tax expense follows: _______________________________________________________________________ 1999 1998 1997 (Dollars in Thousands)
Expected tax expense (34%) $2,053 $2,099 $1,880 Interest expense on tax exempt assets 128 82 57 Tax exempt interest (967) (640) (494) Disqualified incentive stock options (14) (10) (2) Other, net 15 6 0 ------ ------ ------ Reported tax expense $1,215 $1,537 $1,441 ====== ====== ======
NOTE 9, Income Taxes (Continued) _____________________________________________________________________ The components of the net deferred tax asset included in other assets are as follows at December 31:
1999 1998 (Dollars in Thousands)
Components of Deferred Tax Liability: Depreciation $ (217) $(179) Accretion of discounts on securities (12) (9) Net unrealized (gain) on available-for-sale securities 0 (428) Deferred loan fees and costs (125) (70) Pension (73) (38) --------------- Deferred tax liability (427) (724)
Components of Deferred Tax Asset: Allowance for loan losses 817 709 Net unrealized loss on available-for-sale securities 1,011 0 Interest on non-accrual loans 125 147 Deferred compensation 2 5 Capital loss carry forward 18 0 --------------- Deferred tax asset, net $1,546 $ 137 ===============
NOTE 10, Lease Commitments ___________________________________________________ The Bank has noncancellable leases on premises and equipment expiring at various dates, including extensions to the year 2011. Certain leases provide for increased annual payments based on increases in real estate taxes and the Consumer Price Index.
The total approximate minimum rental commitment at December 31, 1999, under noncancellable leases is $1.2 million which is due as follows:
Year (Dollars in Thousands)
2000 $ 219 2001 216 2002 216 2003 129 2004 101 Remaining term of leases 314 ------ Total $1,195 ======
The aggregate rental expense of premises and equipment was $219 thousand, $220 thousand and $208 thousand for 1999, 1998 and 1997 respectively.
NOTE 11, Pension Plan ______________________________________________________________________ The following tables set forth the Pension Plan's changes in benefit obligation, plan assets, funded status, assumptions and the components of net periodic benefit cost recognized in the Bank's financial statements at December 31:
NOTE 12, Profit Sharing
The Bank has a defined contribution profit sharing and thrift plan covering substantially all of its employees. The Bank may make profit sharing contributions to the plan as determined by the Board of Directors. In addition, the Bank matches thrift contributions by employees fifty cents for each dollar contributed. Expenses related to the plan totaled $246 thousand and $283 thousand in 1999 and 1998 respectively.
NOTE 13, Commitments and Contingencies ___________________________________________________________________________ In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities. These commitments and contingencies represent off-balance sheet risk for the Bank. To meet the financing needs of its customers, the Bank makes lending commitments under commercial lines of credit, home equity loans and construction and development loans. The Bank also incurs contingent liabilities related to irrevocable letters of credit.
Irrevocable letters of credit $ 693 $ 646
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, upon extensions of credit is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
Standby letters of credit and financial guarantees written are conditional commitments issued by the bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing agreements. Most guarantees extend for less than two years and expire in decreasing amounts through 2001. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank holds various collateral supporting those commitments for which collateral is deemed necessary.
NOTE 14, Fair Value of Financial Instruments
The above presentation of fair values is required by the Statement of Financial Accounting Standards No. 107 "Disclosures about Market Values of Financial Instruments". The fair values shown do not necessarily represent the amounts which would be received on sale or other disposition of the instrument.
The carrying amounts of cash and due from banks, federal funds sold, demand and savings deposits and securities sold under repurchase agreements represent items which do not present significant market risks, are payable on demand or are of such short duration that the market value approximates carrying value.
Investment securities are valued at the quoted market price for individual securities held.
The fair value of loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers.
Certificates of deposit are presented at estimated fair value using rates currently offered for deposits of similar remaining maturities.
NOTE 15, Regulatory Matters ___________________________
The Company is required to maintain minimum amounts of capital to "risk weighted" assets, as defined by the banking regulators. At December 31, 1999, the Company is required to have minimum Tier 1 and Total capital ratios of 4.00% and 8.00% respectively. The Company's actual ratios at that date were 14.19% and 15.23%. The Company's leverage ratio at December 31, 1999 was 10.08%.
The approval of the Comptroller of the Currency is required if the total of all dividends declared by a national bank in any calendar year exceeds the bank's net profits for that year combined with its retained net profits for the preceding two calendar years. Under this formula, the banking subsidiary can distribute as dividends to the Company in 2000, without approval of the Comptroller of the Currency, $6.1 million plus an additional amount equal to the Bank's retained net profits for 2000 up to the date of any dividend declaration.
OLD POINT FINANCIAL CORPORATION PARENT ONLY BALANCE SHEETS ____________________________________________________ As of December 31, Dollars in thousands 1999 1998 ____________________________________________________
ASSETS Cash in bank $ 60 $ 294 Investment securities 1,405 2,107 Total Loans 0 0 Investment in subsidiaries 39,250 37,598 Other real estate owned 0 0 Other assets 25 14 ----------------- TOTAL ASSETS $40,740 $40,013 ================= LIABILITIES AND STOCKHOLDERS EQUITY Notes payable - bank $ 0 $ 0 Other liabilities 0 0 Total liabilities 0 0 Stockholders' equity 40,740 40,013 ----------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $40,740 $40,013 =================
Accounting Rule Changes
None.
Regulatory Requirements and Restrictions
For the reserve maintenance period in effect at December 31, 1999, 1998 and 1997 the bank was required to maintain with the Federal Reserve Bank of Richmond an average daily balance totaling approximately $350 thousand, $350 thousand and $400 million respectively.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The eleven persons named below, all of whom currently serve as directors of the Company, will be nominated to serve as directors until the 2001 Annual Meeting, or until their successors have been duly elected and have qualified.
(1) Refers to the year in which the individual first became a director of the Bank. Dr. Richard F. Clark, Eugene M. Jordan, and Robert F. Shuford became directors of the Company upon consummation of the Bank's reorganization on October 1, 1984. All present directors of the Company are directors of the Bank. Dr. Richard F. Clark, Dr. Arthur D. Greene, Mr. John C. Ishon and Mr. Robert F. Shuford are directors of the Trust Company.
(2) For purposes of this table, beneficial ownership has been determined in accordance with the provisions of Rule 13d-3 of the Securities Exchange Act of 1934 under which, in general, a person is deemed to be the beneficial owner of a security if he or she has or shares the power to vote or direct the voting of the security or the power to dispose of or direct the disposition of the security, or if he or she has the right to acquire beneficial ownership of the security within sixty days.
(3) Includes shares held (i) by their close relatives or held jointly with their spouses, (ii) as custodian or trustee for the benefit of their children or others, or (iii) as attorney-in-fact subject to a general power of attorney - Dr. Clark, 200 shares; Mr. Evans, 650 shares; Dr. Greene, 1,968 shares; Mr. Harris, 400 shares, Mr. Ishon, 3,480 shares; Mr. Jordan, 14,000 shares; Mr. Morgan, 2,400 shares; Dr. Schappert, 81,370 shares; and Mr. Shuford, 75,590 shares.
(4) Includes shares that may be acquired within 60 days pursuant to the exercise of stock options granted under the 1989 and 1998 Old Point Stock Option Plans - Dr. Clark 1,000, Mr. Evans 1,000, Mr. Goodson 1,000, Dr. Greene 1,000, Mr. Harris 1,000, Mr. Ishon 1,000, Mr. Jordan 1,000, Mr. Morgan 1,000, Mr. Morris 6,998, Dr. Schappert 1,000, and Mr. Shuford 24,182.
(5) Mr. Shuford is one of three directors of the VuBay Foundation, a charitable foundation organized under 501(c)(3) of the Internal Revenue Code of 1986, as amended. A majority of the Directors have the power to vote shares of Company common stock owned by the foundation. The foundation owned 2,300 shares of stock as of March 14, 2000. Mr. Shuford disclaims any beneficial ownership of these shares.
There are two family relationships among the directors and executive officers. Mr. Jordan is the father-in-law of Mr. Ishon. Mr. Shuford and Dr. Schappert are married to sisters. None of the directors serve as a director of any other company with a class of securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
There were no delinquent Securities and Exchange Commission Form 4 filings during 1999.
In addition to the executive officers included in the preceding list of directors, the persons listed below were executive officers of the Company.
Name and (Age) Principal Occupation with the Registrant
Cary B. Epes (51) Senior Vice President/Credit Mr. Epes also serves as Executive Vice President and Chief Credit Officer for Old Point National Bank.
Margaret P. Causby (49) Senior Vice President/Administration Ms. Causby also serves as Executive Vice President and Chief Administration Officer for Old Point National Bank.
Frank E. Continetti (40) Executive Vice President/Trust Mr. Continetti also serves as President and Chief Executive Officer for Old Point Trust and Financial Services, N.A.
Laurie D. Grabow (42) Senior Vice President/Finance Ms. Grabow also serves as Senior Vice President Chief Financial Officer for Old Point National Bank
Each of these executive officers owns less than 1% of the stock of the Company.
Item 11
Item 11 Executive Compensation
Cash Compensation
The following table presents a three-year summary of all compensation paid or accrued by the Company and the Bank to the Company's Chief Executive Officer and each executive officer whose salary and bonus for 1999 exceeded $100,000. The table also presents the number and percentage of shares of the Company's Common Stock held by these executive officers, who are all executive officers of the Company.
(1) Salary includes directors' fees as follows: Mr. Shuford - 1999, $3,900, 1998, $4,200, and 1997 $4,500.
(2) Bonus consideration for Mr. Shuford is paid in the year following the year in which the bonus is earned so that the Compensation Committee can evaluate year-end results. Bonus consideration for Mr. Morris, Mr. Epes and Mrs. Causby is paid in the year in which it is earned.
(3) Mr. Shuford has received other compensation as follows:
1999 1998 1997 ------- ------- ------- Deferred Profit Sharing $ 4,532 $ 5,090 $ 4,342 Cash Profit Sharing 4,210 4,811 4,088 401(k) Matching Plan 4,488 4,410 4,320 Group Term Insurance 4,326 3,454 3,342 ------- ------- ------- Total $17,556 $17,765 $16,092
Mr. Morris has received other compensation as follows:
1999 1998 1997 ------- ------- ------- Deferred Profit Sharing $ 3,037 $ 3,122 $ 2,551 Cash Profit Sharing 2,821 2,951 2,356 401(k) Matching Plan 3,008 2,705 2,490 Group Term Insurance 354 273 239 ------- ------- ------- Total $ 9,220 $ 9,051 $ 7,636
Mr. Epes has received other compensation as follows:
1999 1998 1997 ------- ------- ------- Deferred Profit Sharing $ 3,007 $ 3,087 $ 2,520 Cash Profit Sharing 2,793 2,918 2,328 401(k) Matching Plan 2,978 2,675 2,460 Group Term Insurance 562 760 400 ------- ------- ------- Total $ 9,340 $ 9,440 $ 7,708
Mrs. Causby has received other compensation as follows:
1999 1998 1997 ------- ------- ------- Deferred Profit Sharing $ 2,967 $ 3,053 $ 2,408 Cash Profit Sharing 2,756 2,885 2,224 401(k) Matching Plan 2,938 2,645 2,350 Group Term Insurance 343 452 390 ------- ------- ------- Total $ 9,004 $ 9,035 $ 7,372
(4) For purposes of this table, benefical ownership has been determined in accordance with the provisions of Rule 13d-3
of the Securities Exchange Act of 1934 under which, in general, a person is deemed to be the beneficial owner of a security if he or she has or shares the power to vote or direct the voting of the security or the power to dispose of or direct the disposition of the security, or if he or she has the right to acquire beneficial ownership of the security within 60 days.
(5) Include shares held (1) by their joint relative or held jointly with their spouses, (2) as custodian or trustee for the benefit of their children or others, (3) as attorney-in- fact subject to a general power of attorney-Mr. Shuford, 75,590 shares.
(6) Include shares that may be acquired within 60 days pursuant to the exercise of stock options granted under the 1989 and 1998 Old Point Stock Option Plans-Mr. Shuford 24,182 shares, Mr. Morris 6,998 shares, Mr. Epes 8,618 shares, Mrs. Causby 8,718 shares.
Item 12
Item 12 Security Ownership of certain Beneficial Owners and Management
Security ownership of certain beneficial owners and management is detailed in Part III, Item 10 of this Annual Report on Form 10-K.
Item 13.
Item 13. Certain Relationships and Related Transactions
Some of the Company's directors, executive officers, and members of their immediate families, and corporations, partnerships and other entities of which such persons are officers, directors, partners, trustees, executors or beneficiaries, are customers of the Bank. As of December 31, 1999 borrowing by all policy making officers and directors amounted to $2.0 million. This represented 4.9% of the total equity capital accounts of the Company as of December 31, 1999. All loans and commitments to lend included in such transactions were made in the ordinary course of business, upon substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than normal risk of collectibility or present other unfavorable features. It is the policy of the Bank to provide loans to officers who are not executive officers and to employees at more favorable rates than those prevailing at the time for comparable transactions with other persons. These loans do not involve more than the normal risk of collectibility or present other unfavorable features.
The law firm of Mays & Valentine L.L.P. serves as legal counsel to the Company. Cumming, Hatchett and Jordan, P.C. serves as legal counsel to the Bank and Trust Company. Mr. Eugene M. Jordan was a member of the firm in 1999. During 1999, the firm received a retainer and fees totaling $55,358. Morgan Marrow Insurance of which John B. Morgan, II is President, provided insurance for which the Company paid $47,749 during 1999. Hampton Stationery, of whom John Cabot Ishon is President, provided office furniture and supplies for which the Company paid $101,023. Geddy, Harris, Franck & Hickman L.L.P. of which Stephen D. Harris is a partner, and Warwick Plumbing & Heating Corp. of which G. Royden Goodson, III is President provide products and services to the Company.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8
A.1 Financial Statements:
The following audited financial statements are included in Part II, Item 8, of this Annual Report on Form 10-K.
Consolidated Balance Sheets - December 31, 1999 and 1998
Consolidated Statements of Income Years Ended December 31, 1999, 1998 and 1997
Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows Years Ended December 31, 1999, 1998 and 1997
Notes to Financial Statements Auditor's Report
A.2 Financial Statement Schedules:
Schedule Location
Average Balance Sheets, Net Interest Income and Rates Part I, Item 1 Analysis of Change in Net Interest Income Part I, Item 1 Interest Sensitivity Analysis Part I, Item 1 Investment Securities Part I, Item 1 Investment Security Maturities & Yields Part I, Item 1 Loans Part I, Item 1 Maturity Schedule of Selected Loans Part I, Item 1 Nonaccrual, Past Due and Restructured Loans Part I, Item 1 Analysis of the Allowance for Loan Losses Part I, Item 1 Allocation of the Allowance for Loan Losses Part I, Item 1 Deposits Part I, Item 1 Certificates of Deposit of $100,000 and more Part I, Item 1 Return on Average Equity Part I, Item 1 Short Term Borrowings Part I, Item 1 Lease Commitments Part I, Item 1 Other Real Estate Owned Part I, Item 1 Selected Financial Data Part II, Item 6 Capital Ratios Part II, Item 7 Dividends Paid and Market Price of Common Stock Part II, Item 7 Proceeds from sales and maturities of securities Part II, Item 8 Premises and Equipment Part II, Item 8 Stock Option Plan Part II, Item 8 Components of Income Tax Expense Part II, Item 8 Reconciliation of Expected and Reported Income Tax Expense Part II, Item 8 Pension Plan Part II, Item 8 Commitments and Contingencies Part II, Item 8 Fair Value of Financial Instruments Part II, Item 8 Directors and Executive Officer Part III, Item 10 Executive Compensation Part III, Item 11
A.3 Exhibits:
3 Articles of Incorporation and Bylaws 4 Not Applicable 9 Not Applicable 10 Not Applicable 11 Not Applicable 12 Not Applicable 13 Not Applicable 18 Not Applicable 19 Not Applicable 22 Subsidiaries of the Registrant 23 Not Applicable 24 Consent of Independent Certified Public Accountants 25 Powers of Attorney 27 Financial Data Schedule 28 Not Applicable 29 Not Applicable
B. Reports on Form 8-K:
A Current Report, Form 8-K , was filed on November 18, 1999. The Company reported under Item 5 that Frank E. Continetti succeeded W. Rodney Rosser as President & CEO of Old Point Trust & Financial Services, NA. Also reported that Louis G. Morris was promoted to President and CEO of Old Point National Bank effective January 1, 2000.
INDEX OF EXHIBITS
Exhibit No.
3 Articles of Incorporation and Bylaws (incorporated by reference from our Annual Report on Form 10K for the year ended 1998 (File No. 000-12896))
4 Not Applicable
9 Not Applicable
10 Not Applicable
11 Not Applicable
12 Not Applicable
13 Not Applicable
18 Not Applicable
19 Not Applicable
22 Subsidiaries of the Registrant 48
23 Not Applicable
24 Consent of Independent Certified Public Accountants 49
25 Powers of Attorney 50
27 Financial Data Schedule 61
28 Not Applicable
29 Not Applicable
Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 28th day of March, 2000.
OLD POINT FINANCIAL CORPORATION
/s/Robert F. Shuford -------------------- Robert F. Shuford, President
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in their capacities on the 28th day of March, 2000.
/s/Robert F. Shuford - -------------------- President and Director Robert F. Shuford Principal Executive Officer
/s/Laurie D. Grabow - ------------------- Senior Vice President Laurie D. Grabow Principal Financial & Accounting Officer
/s/Richard F. Clark Director - ------------------- Richard F. Clark
/s/Russell S. Evans, Jr. Director - ------------------------ Russell S. Evans, Jr.
/s/G. Royden Goodson, III Director - ------------------------- G. Royden Goodson, III
/s/Dr. Arthur D. Greene Director - ----------------------- Dr. Arthur D. Greene
/s/Stephen D. Harris Director - -------------------- Stephen D. Harris
/s/John Cabot Ishon Director - -------------------- John Cabot Ishon
/s/Eugene M. Jordan Director - --------------------- Eugene M. Jordan
/s/John B. Morgan Director - ------------------ John B. Morgan
/s/Dr. H. Robert Schappert Director - ---------------------------- Dr. H. Robert Schappert | 9,994 | 64,360 |
828191_1999.txt | 828191_1999 | 1999 | 828191 | ITEM 1. Business
Parker & Parsley 88-B, L.P. (the "Partnership") is a limited partnership organized in 1988 under the laws of the State of Delaware. As of August 8, 1997, Pioneer Natural Resources USA, Inc. ("Pioneer USA") became the managing general partner of the Partnership. Prior to August 8, 1997, the Partnership's managing general partner was Parker & Parsley Development L.P. ("PPDLP"), a wholly-owned subsidiary of Parker & Parsley Petroleum Company ("Parker & Parsley"). On August 7, 1997, Parker & Parsley and Mesa Inc. ("Mesa") received shareholder approval to merge and create Pioneer Natural Resources Company ("Pioneer"). On August 8, 1997, PPDLP was merged with and into Pioneer USA, a wholly-owned subsidiary of Pioneer, resulting in Pioneer USA becoming the managing general partner of the Partnership as PPDLP's successor by merger.
A Registration Statement, as amended, filed pursuant to the Securities Act of 1933, registering limited partnership interests aggregating $70,000,000 in a series of Delaware limited partnerships formed under the Parker & Parsley 88 Development Drilling Programs, was declared effective by the Securities and Exchange Commission on March 4, 1988. On November 18, 1988, the offering of limited partnership interests in the Partnership, the second partnership formed under such statement was closed, with interests aggregating $8,954,000 being sold to 715 subscribers.
The Partnership engages in oil and gas development and production and is not involved in any industry segment other than oil and gas. See "Item 6. Selected Financial Data" for a summary of the Partnership's oil and gas sales, net income and identifiable assets.
The principal markets during 1999 for the oil produced by the Partnership were refineries and oil transmission companies that have facilities near the Partnership's oil producing properties. During 1999, Pioneer USA marketed the Partnership's gas to a variety of purchasers, none of which accounted for 10% or more of the Partnership's oil and gas revenues. Of the Partnership's total oil and gas revenues for 1999, approximately 44% was attributable to sales made to Plains All American Inc. Pioneer USA is of the opinion that the loss of any one purchaser would not have an adverse effect on its ability to sell its oil and gas production or natural gas products.
The Partnership's revenues, profitability, cash flow and future rate of growth are highly dependent on the prevailing prices of oil and gas, which are affected by numerous factors beyond the Partnership's control. Oil and gas prices historically have been very volatile. A substantial or extended decline in the prices of oil or gas could have a material adverse effect on the Partnership's revenues, profitability and cash flow and could, under certain circumstances, result in a reduction in the carrying value of the Partnership's oil and gas properties.
Federal and state regulation of oil and gas operations generally includes the fixing of maximum prices for regulated categories of natural gas, the imposition of maximum allowable production rates, the taxation of income and other items and the protection of the environment. Although the Partnership believes that its business operations do not impair environmental quality and that its costs of complying with any applicable environmental regulations are not currently significant, the Partnership cannot predict what, if any, effect these environmental regulations may have on its current or future operations.
The Partnership does not have any employees of its own. Pioneer USA employs 687 persons, many of whom dedicated a part of their time to the conduct of the Partnership's business during the period for which this report is filed. Pioneer USA is responsible for all management functions.
Numerous uncertainties exist in estimating quantities of proved reserves and future net revenues therefrom. The estimates of proved reserves and related future net revenues set forth in this report are based on various assumptions, which may ultimately prove to be inaccurate. Therefore, such estimates should not be construed as estimates of the current market value of the Partnership's proved reserves.
No material part of the Partnership's business is seasonal and the Partnership conducts no foreign operations.
ITEM 2.
ITEM 2. Properties
The Partnership's properties consist of leasehold interests in properties on which oil and gas wells are located. Such property interests are often subject to landowner royalties, overriding royalties and other oil and gas leasehold interests.
Fractional working interests in developmental oil and gas prospects located in the Spraberry Trend area of West Texas were acquired by the Partnership, resulting in the Partnership's participation in the drilling of 43 oil and gas wells. One well has been plugged and abandoned. At December 31, 1999, 42 wells were producing.
For information relating to the Partnership's estimated proved oil and gas reserves at December 31, 1999, 1998 and 1997 and changes in such quantities for the years then ended see Note 7 of Notes to Financial Statements included in "Item 8. Financial Statements and Supplementary Data" below. Such reserves have been estimated by the engineering staff of Pioneer USA with a review by Williamson Petroleum Consultants, Inc., an independent petroleum consultant.
ITEM 3.
ITEM 3. Legal Proceedings
The Partnership from time to time is a party to various legal proceedings incidental to its business involving claims in oil and gas leases or interests, other claims for damages in amounts not in excess of 10% of its current assets and other matters, none of which Pioneer USA believes to be material to the Partnership.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. Market for Partnership's Common Equity and Related Stockholder Matters
At March 8, 2000, the Partnership had 8,954 outstanding limited partnership interests held of record by 691 subscribers. There is no established public trading market for the limited partnership interests. Under the limited partnership agreement, Pioneer USA has made certain commitments to purchase partnership interests at a computed value.
Revenues which, in the sole judgement of the managing general partner, are not required to meet the Partnership's obligations are distributed to the partners at least quarterly in accordance with the limited partnership agreement. During the years ended December 31, 1999 and 1998, $258,933 and $215,057, respectively, of such revenue-related distributions were made to the limited partners.
ITEM 6.
ITEM 6. Selected Financial Data
The following table sets forth selected financial data for the years ended December 31:
ITEM 7.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Results of operations
1999 compared to 1998
The Partnership's 1999 oil and gas revenues increased 24% to $717,449 from $578,573 in 1998. The increase in revenues resulted from higher average prices received, offset by a decline in production. In 1999, 28,078 barrels of oil, 13,752 barrels of natural gas liquids ("NGLs") and 57,190 mcf of gas were sold, or 51,362 barrel of oil equivalents ("BOEs"). In 1998, 31,155 barrels of oil, 12,210 NGLs and 52,254 mcf of gas were sold, or 52,074 BOEs. Due to the decline characteristics of the Partnership's oil and gas properties, management expects a certain amount of decline in production in the future until the Partnership's economically recoverable reserves are fully depleted.
The average price received per barrel of oil increased $3.93, or 30%, from $13.24 in 1998 to $17.17 in 1999. The average price received per barrel of NGLs increased $3.12, or 45%, from $6.91 in 1998 to $10.03 in 1999. The average price received per mcf of gas increased 9% from $1.56 in 1998 to $1.70 in 1999. The market price for oil and gas has been extremely volatile in the past decade, and management expects a certain amount of volatility to continue in the foreseeable future. The Partnership may therefore sell its future oil and gas production at average prices lower or higher than that received in 1999.
The volatility of commodity prices has had, and continues to have, a significant impact on the Partnership's revenues and operating cash flow and could result in additional decreases to the carrying value of the Partnership's oil and gas properties.
Total costs and expenses decreased in 1999 to $487,566 as compared to $1,075,163 in 1998, a decrease of $587,597, or 55%. The decrease was primarily due to declines in the impairment of oil and gas properties, depletion and production costs, offset by an increase in general and administrative expenses ("G&A").
Production costs were $361,482 in 1999 and $390,835 in 1998, resulting in a $29,353 decrease, or 8%. The decrease was primarily due to declines in well maintenance costs, workover costs and ad valorem taxes, offset by an increase in production taxes due to increased oil and gas revenues.
G&A's components are independent accounting and engineering fees and managing general partner personnel and operating costs. During this period, G&A increased, in aggregate, 25% from $17,315 in 1998 to $21,650 in 1999. The Partnership paid the managing general partner $13,039 in 1999 and $13,810 in 1998 for G&A incurred on behalf of the Partnership. G&A is allocated, in part, to the Partnership by the managing general partner. Allocated expenses are determined by the managing general partner based upon the level of activity of the Partnership relative to the non-partnership activities of the managing general partner. The method of allocation has been consistent over the past several years with certain modifications incorporated to reflect changes in Pioneer USA's overall business activities.
In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"), the managing general partner reviews the Partnership's oil and gas properties for impairment whenever events or circumstances indicate a decline in the recoverability of the carrying value of the Partnership's assets may have occurred. As a result of the review and evaluation of its long-lived assets for impairment, the Partnership recognized a non-cash charge of $383,951 related to its oil and gas properties during 1998.
Depletion was $104,434 in 1999 compared to $283,062 in 1998. This represented a decrease of $178,628, or 63%. This decrease was the result of a combination of factors that included an increase in proved reserves during 1999 due to higher commodity prices, a reduction in the Partnership's net depletable basis from charges taken in accordance with SFAS 121 during the fourth quarter of 1998 and a decline in oil production of 3,077 barrels for the period ended December 31, 1999 compared to the same period in 1998.
1998 compared to 1997
The Partnership's 1998 oil and gas revenues decreased 29% to $578,573 from $810,500 in 1997. The decrease in revenues resulted from lower average prices received. In 1998, 31,155 barrels of oil, 12,210 barrels of NGLs and 52,254 mcf of gas were sold, or 52,074 BOEs. In 1997, 31,020 barrels of oil, 4,628 NGLs and 70,802 mcf of gas were sold, or 47,448 BOEs.
Consistent with the managing general partner, the Partnership has historically accounted for processed natural gas production as wellhead production on a wet gas basis. Effective September 30, 1997, as a result of the merger with Mesa, the managing general partner accounts for processed natural gas production in two components: natural gas liquids and dry residue gas. As a result of the change in the managing general partner's policy, the Partnership now accounts for processed natural gas production as processed natural gas liquids and dry residue gas. Consequently, separate product volumes will not be comparable for periods prior to September 30, 1997. Also, prices for gas products will not be comparable as the price per mcf for natural gas for the year ended December 31, 1998 is the price received for dry residue gas and the price per mcf for natural gas produced prior to October 1997 was presented as a price for wet gas (i.e., natural gas liquids combined with dry residue gas).
The average price received per barrel of oil decreased $6.09, or 32%, from $19.33 in 1997 to $13.24 in 1998. The average price received per barrel of NGLs decreased $3.90, or 36%, from $10.81 in 1997 to $6.91 in 1998. The average price received per mcf of gas decreased 31% from $2.27 in 1997 to $1.56 in 1998.
Total costs and expenses decreased in 1998 to $1,075,163 as compared to $1,164,844 in 1997, a decrease of $89,681, or 8%. The decrease was primarily due to declines in the impairment of oil and gas properties, production costs and G&A, offset by an increase in depletion.
Production costs were $390,835 in 1998 and $403,509 in 1997, resulting in a $12,674 decrease, or 3%. The decrease was primarily due to a decline in production taxes due to decreased oil and gas revenues, offset by an increase in workover costs incurred to stimulate well production.
During this period, G&A decreased, in aggregate, 33% from $25,944 in 1997 to $17,315 in 1998. The Partnership paid the managing general partner $13,810 in 1998 and $20,876 in 1997 for G&A incurred on behalf of the Partnership.
The Partnership recognized non-cash SFAS 121 charges of $383,951 and $547,793 related to its oil and gas properties during 1998 and 1997, respectively.
Depletion was $283,062 in 1998 compared to $187,598 in 1997. This represented an increase of $95,464, or 51%. This increase was the result of a decline in proved reserves during 1998 due to lower commodity prices, offset by a reduction in the Partnership's net depletable basis from charges taken in accordance with SFAS 121 during the fourth quarter of 1997.
Impact of inflation and changing prices on sales and net income
Inflation generally does not impact revenues in the oil and gas industry. However, inflation generally does impact expenses, the most significant for the Partnership is lease operating expenses.
The petroleum industry has been characterized by volatile oil, NGL and natural gas commodity prices and relatively stable supplier costs during the three years ended December 31, 1999. During 1997 and 1998, weather patterns, regional economic recessions and political matters combined to cause worldwide crude oil supplies to exceed demand. As a result, crude oil prices declined substantially from the price levels of 1996. Also during 1997 and 1998, but to a lesser extent, market prices for natural gas declined. During 1999, the price per barrel for oil production similar to the Partnership's ranged from approximately $11.00 to $24.00. The decrease in crude oil exports during 1999 by members of the Organization of Petroleum Exporting Countries ("OPEC") and other crude oil exporting nations has resulted in higher Partnership revenues and operating cash flow as compared to 1998.
Prices for natural gas are subject to ordinary seasonal fluctuations, and this volatility of natural gas prices may result in production being curtailed and, in some cases, wells being completely shut-in.
Liquidity and capital resources
Net Cash Provided by Operating Activities
Net cash provided by operating activities increased $84,427 during the year ended December 31, 1999 from 1998. The increase was primarily attributable to an increase of $44,521 in oil and gas sales receipts, reductions in operating costs paid of $36,531 that have resulted from the managing general partner's cost containment measures and a decline in G&A expenses paid of $3,375.
Net Cash Provided by (Used in) Investing Activities
The Partnership's investing activities during 1999 and 1998 were related to the upgrades of oil and gas equipment on active properties.
Proceeds from asset dispositions of $10,758 and $156 recognized during 1999 and 1998, respectively, were related to equipment disposals on one oil and gas well that is temporarily abandoned.
Net Cash Used in Financing Activities
In 1999, cash distributions to the partners were $261,548, of which $2,615 was distributed to the managing general partner and $258,933 to the limited partners. In 1998, cash distributions to the partners were $217,229, of which $2,172 was distributed to the managing general partner and $215,057 to the limited partners.
Since the first quarter of 1999, world crude oil prices have increased, primarily as a result of decreases in crude oil supplies made available by OPEC and other crude oil exporting nations. During the period from the third quarter of 1997 through the first quarter of 1999, there was a significant declining trend in world oil prices and, to a lesser extent, natural gas prices. During the first quarter of 1999, OPEC and certain other crude oil exporting nations announced reductions in their planned export volumes. These announcements, together with the enactment of announced reductions in export volumes, have had a positive impact on world crude oil prices. No assurances can be given that the reductions in export volumes or the positive trend in oil and gas commodity prices can be sustained for an extended period of time.
Proposal to acquire partnerships
On September 8, 1999, Pioneer USA filed a preliminary proxy statement with the SEC proposing an agreement and plan of merger to the limited partners of 25 publicly-held Parker & Parsley limited partnerships. The preliminary proxy statement is non-binding and is subject to, among other things, consideration of offers from third parties to purchase any partnership or its assets, the majority approval of the limited partners in each partnership and the resolution of SEC review comments. Pioneer is continuing to evaluate the feasibility of the proposed agreement and plan of merger; however, the current commodity price outlook has diminished the likelihood that the proposed agreement and plan of merger will be consummated.
Year 2000 project readiness
As the year 2000 was approaching, the inability of some computer programs and embedded technologies to distinguish between "1900" and "2000" gave rise to the "Year 2000" problem. Such computer programs and related technology were at risk to fail outright or communicate inaccurate data, if not remediated or replaced. With the proliferation of electronic data interchange, the Year 2000 problem represented a significant exposure to the entire global community, the full extent of which could not be accurately assessed prior to the year 2000.
In proactive response to the Year 2000 problem, the managing general partner established a "Year 2000" project that assessed, to the extent possible, the Partnership's and the managing general partner's internal Year 2000 problem; took remedial actions necessary to minimize the Year 2000 risk exposure to the managing general partner and significant third parties with whom it has data interchange; and, tested the managing general partner's systems and processes once remedial actions
were taken. The managing general partner contracted with IBM Global Services to perform the assessment and remedial phases of its Year 2000 project. The managing general partner's total costs related to the Year 2000 problem were $2.5 million.
The managing general partner has closely monitored its information and non-information technology systems since the beginning of 2000 and has identified no significant Year 2000 failures or problems. The managing general partner will continue to monitor Year 2000 risks and issues. There can be no assurances that unforeseen problems will not be encountered in the future.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
Page
Financial Statements of Parker & Parsley 88-B, L.P.: Independent Auditors' Report - Ernst & Young LLP................. 12 Independent Auditors' Report - KPMG LLP.......................... 13 Balance Sheets as of December 31, 1999 and 1998.................. 14 Statements of Operations for the Years Ended December 31, 1999, 1998 and 1997............................................ 15 Statements of Partners' Capital for the Years Ended December 31, 1999, 1998 and 1997............................... 16 Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997............................................ 17 Notes to Financial Statements.................................... 18
INDEPENDENT AUDITORS' REPORT
The Partners Parker & Parsley 88-B, L.P. (A Delaware Limited Partnership):
We have audited the balance sheets of Parker & Parsley 88-B, L.P. as of December 31, 1999 and 1998, and the related statements of operations, partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Parker & Parsley 88-B, L.P. as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States.
Ernst & Young LLP
Dallas, Texas March 10, 2000
INDEPENDENT AUDITORS' REPORT
The Partners Parker & Parsley 88-B, L.P. (A Delaware Limited Partnership):
We have audited the statement of operations, partners' capital and cash flows of Parker & Parsley 88- B, L.P. for the year ended December 31, 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above presents fairly, in all material respects, the results of operations and cash flows of Parker & Parsley 88-B, L.P. for the year ended December 31, 1997, in conformity with generally accepted accounting principles.
KPMG LLP
Midland, Texas March 20, 1998
PARKER & PARSLEY 88-B, L.P. (A Delaware Limited Partnership)
BALANCE SHEETS December 31
1999 1998 ----------- ---------- ASSETS
Current assets: Cash $ 129,430 $ 110,641 Accounts receivable - oil and gas sales 138,030 71,128 ---------- ---------- Total current assets 267,460 181,769 ---------- ---------- Oil and gas properties - at cost, based on the successful efforts accounting method 7,129,071 7,131,466 Accumulated depletion (6,083,367) (5,978,933) ---------- ---------- Net oil and gas properties 1,045,704 1,152,533 ---------- ---------- $ 1,313,164 $ 1,334,302 ========== ========== LIABILITIES AND PARTNERS' CAPITAL
Current liabilities: Accounts payable - affiliate $ 21,245 $ 17,477
Partners' capital: Managing general partner 12,888 13,137 Limited partners (8,954 interests) 1,279,031 1,303,688 ---------- ---------- 1,291,919 1,316,825 ---------- ---------- $ 1,313,164 $ 1,334,302 ========== ==========
The accompanying notes are an integral part of these financial statements.
PARKER & PARSLEY 88-B, L.P. (A Delaware Limited Partnership)
STATEMENTS OF OPERATIONS For the years ended December 31
1999 1998 1997 --------- ---------- ---------- Revenues: Oil and gas $ 717,449 $ 578,573 $ 810,500 Interest 6,759 7,803 9,347 Other - 156 - -------- --------- --------- 724,208 586,532 819,847 -------- --------- --------- Costs and expenses: Oil and gas production 361,482 390,835 403,509 General and administrative 21,650 17,315 25,944 Impairment of oil and gas properties - 383,951 547,793 Depletion 104,434 283,062 187,598 -------- --------- --------- 487,566 1,075,163 1,164,844 -------- --------- --------- Net income (loss) $ 236,642 $ (488,631) $ (344,997) ======== ========= ========= Allocation of net income (loss): Managing general partner $ 2,366 $ (4,887) $ (3,450) ======== ========= ========= Limited partners $ 234,276 $ (483,744) $ (341,547) ======== ========= ========= Net income (loss) per limited partnership interest $ 26.16 $ (54.03) $ (38.14) ======== ========= =========
The accompanying notes are an integral part of these financial statements.
PARKER & PARSLEY 88-B, L.P. (A Delaware Limited Partnership)
STATEMENTS OF PARTNERS' CAPITAL
Managing general Limited partner partners Total ---------- ---------- ----------
Partners' capital at January 1, 1997 $ 28,229 $2,797,739 $2,825,968 Distributions (4,583) (453,703) (458,286) Net loss (3,450) (341,547) (344,997) --------- --------- ---------
Partners' capital at December 31, 1997 20,196 2,002,489 2,022,685 Distributions (2,172) (215,057) (217,229) Net loss (4,887) (483,744) (488,631) --------- --------- ---------
Partners' capital at December 31, 1998 13,137 1,303,688 1,316,825 Distributions (2,615) (258,933) (261,548) Net income 2,366 234,276 236,642 --------- --------- ---------
Partners' capital at December 31, 1999 $ 12,888 $1,279,031 $1,291,919 ========= ========= =========
The accompanying notes are an integral part of these financial statements.
PARKER & PARSLEY 88-B, L.P. (A Delaware Limited Partnership)
STATEMENTS OF CASH FLOWS For the years ended December 31
1999 1998 1997 ---------- ---------- ---------- Cash flows from operating activities: Net income (loss) $ 236,642 $ (488,631) $ (344,997) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Impairment of oil and gas properties - 383,951 547,793 Depletion 104,434 283,062 187,598 Other - (156) - Changes in assets and liabilities: Accounts receivable (66,902) 26,411 113,218 Accounts payable 3,768 (11,122) 6,099 --------- --------- --------- Net cash provided by operating activities 277,942 193,515 509,711 --------- --------- --------- Cash flows from investing activities: Additions to oil and gas properties (8,363) (15,067) (9,015) Proceeds from asset dispositions 10,758 156 - --------- --------- --------- Net cash provided by (used in) investing activities 2,395 (14,911) (9,015) --------- --------- --------- Cash flows from financing activities: Cash distributions to partners (261,548) (217,229) (458,286) --------- --------- --------- Net increase (decrease) in cash 18,789 (38,625) 42,410 Cash at beginning of year 110,641 149,266 106,856 --------- --------- --------- Cash at end of year $ 129,430 $ 110,641 $ 149,266 ========= ========= =========
The accompanying notes are an integral part of these financial statements.
PARKER & PARSLEY 88-B, L.P. (A Delaware Limited Partnership)
NOTES TO FINANCIAL STATEMENTS December 31, 1999, 1998 and 1997
Note 1. Organization and nature of operations
Parker & Parsley 88-B, L.P. (the "Partnership") is a limited partnership organized in 1988 under the laws of the State of Delaware. As of August 8, 1997, Pioneer Natural Resources USA, Inc. ("Pioneer USA") became the managing general partner of the Partnership. Prior to August 8, 1997, the Partnership's managing general partner was Parker & Parsley Development L.P. ("PPDLP"), a wholly-owned subsidiary of Parker & Parsley Petroleum Company ("Parker & Parsley"). On August 7, 1997, Parker & Parsley and Mesa Inc. received shareholder approval to merge and create Pioneer Natural Resources Company ("Pioneer"). On August 8, 1997, PPDLP was merged with and into Pioneer USA, a wholly-owned subsidiary of Pioneer, resulting in Pioneer USA becoming the managing general partner of the Partnership as PPDLP's successor by merger.
The Partnership engages in oil and gas development and production in Texas and is not involved in any industry segment other than oil and gas.
Note 2. Summary of significant accounting policies
A summary of the significant accounting policies consistently applied in the preparation of the accompanying financial statements follows:
Oil and gas properties - The Partnership utilizes the successful efforts method of accounting for its oil and gas properties and equipment. Under this method, all costs associated with productive wells and nonproductive development wells are capitalized while nonproductive exploration costs are expensed. Capitalized costs relating to proved properties are depleted using the unit-of- production method on a property-by-property basis based on proved oil (dominant mineral) reserves as determined by the engineering staff of Pioneer Natural Resources USA, Inc. ("Pioneer USA") the Partnership's managing general partner, and reviewed by independent petroleum consultants. The carrying amounts of properties sold or otherwise disposed of and the related allowances for depletion are eliminated from the accounts and any gain or loss is included in operations.
Impairment of long-lived assets - In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"), the Partnership reviews its long-lived assets to be held and used on an individual property basis, including oil and gas properties accounted for under the successful efforts method of accounting, whenever events or circumstances indicate that the carrying value of those assets may not be recoverable. An impairment loss is indicated if the sum of the expected future cash flows is less than the carrying amount of the assets. In this circumstance, the Partnership recognizes an impairment loss for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset.
Use of estimates in the preparation of financial statements - Preparation of the accompanying financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reporting amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Net income (loss) per limited partnership interest - The net income (loss) per limited partnership interest is calculated by using the number of outstanding limited partnership interests.
Income taxes - A Federal income tax provision has not been included in the financial statements as the income of the Partnership is included in the individual Federal income tax returns of the respective partners.
Statements of cash flows - For purposes of reporting cash flows, cash includes depository accounts held by banks.
General and administrative expenses - General and administrative expenses are allocated in part to the Partnership by the managing general partner or its affiliates. Allocated expenses are determined by the managing general partner based upon the level of activity of the Partnership relative to the non-partnership activities of the managing general partner. The method of allocation been consistent over the past several years with certain modifications incorporated to reflect changes in Pioneer USA's overall business activities.
Reclassifications - Certain reclassifications may have been made to the 1998 and 1997 financial statements to conform to the 1999 financial statement presentations.
Environmental - The Partnership is subject to extensive federal, state and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Partnership to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a noncapital nature are recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated. Such liabilities are generally undiscounted unless the timing of cash payments for the liability or component are fixed or reliably determinable. No such liabilities have been accrued as of December 31, 1999.
Revenue recognition - The Partnership uses the entitlements method of accounting for crude oil and natural gas revenues.
Note 3. Impairment of long-lived assets
In accordance with SFAS 121, the Partnership reviews its proved oil and gas properties for impairment whenever events and circumstances indicate a decline in the recoverability of the carrying value of the Partnership's oil and
gas properties. The Partnership has estimated the expected future cash flows of its oil and gas properties as of December 31, 1999, 1998 and 1997, based on proved reserves, and compared such estimated future cash flows to the respective carrying amount of the oil and gas properties to determine if the carrying amounts were likely to be recoverable. For those proved oil and gas properties for which the carrying amount exceeded the estimated future cash flows, an impairment was determined to exist; therefore, the Partnership adjusted the carrying amount of those oil and gas properties to their fair value as determined by discounting their expected future cash flows at a discount rate commensurate with the risks involved in the industry. As a result, the Partnership recognized non-cash impairment provisions of $383,951 and $547,793 related to its proved oil and gas properties during 1998 and 1997, respectively.
Note 4. Income taxes
The financial statement basis of the Partnership's net assets and liabilities was $133,581 greater than the tax basis at December 31, 1999.
The following is a reconciliation of net income (loss) per statements of operations with the net income per Federal income tax returns for the years ended December 31: 1999 1998 1997 ---------- ---------- ---------- Net income (loss) per statements of operations $ 236,642 $ (488,631) $ (344,997) Depletion and depreciation provisions for tax reporting purposes less than amounts for financial reporting purposes 94,173 274,063 178,889 Impairment of oil and gas properties for financial reporting purposes - 383,951 547,793 Other 8,701 1,161 (1,076) --------- --------- --------- Net income per Federal income tax returns $ 339,516 $ 170,544 $ 380,609 ========= ========= =========
Note 5. Oil and gas producing activities
The following is a summary of the costs incurred, whether capitalized or expensed, related to the Partnership's oil and gas producing activities for the years ended December 31: 1999 1998 1997 --------- --------- ---------
Development costs $ 8,363 $ 15,067 $ 9,015 ======== ======== ========
Capitalized oil and gas properties consist of the following:
1999 1998 ----------- ----------- Proved properties: Property acquisition costs $ 439,249 $ 439,249 Completed wells and equipment 6,689,822 6,692,217 ---------- ---------- 7,129,071 7,131,466 Accumulated depletion (6,083,367) (5,978,933) ---------- ---------- Net capitalized costs $ 1,045,704 $ 1,152,533 ========== ==========
Note 6. Related party transactions
Pursuant to the limited partnership agreement, the Partnership had the following related party transactions with the managing general partner or its affiliates during the years ended December 31:
1999 1998 1997 --------- --------- --------- Payment of lease operating and supervision charges in accordance with standard industry operating agreements $ 157,042 $ 150,985 $ 169,328
Reimbursement of general and administrative expenses $ 13,039 $ 13,810 $ 20,876
The Partnership participates in oil and gas activities through an income tax partnership (the "Program") pursuant to the Program agreement. Pioneer USA, Parker & Parsley 88-B Conv., L.P. and the Partnership (the "Partnerships") are parties to the Program agreement.
The costs and revenues of the Program are allocated to Pioneer USA and the Partnerships as follows:
Pioneer USA (1) Partnerships (2) --------------- ---------------- Revenues: Proceeds from disposition of depreciable properties 9.09091% 90.90909% All other revenues 24.242425% 75.757575% Costs and expenses: Lease acquisition costs, drilling and completion costs and all other costs 9.09091% 90.90909% Operating costs, direct costs and general and administrative expenses 24.242425% 75.757575%
(1) Excludes Pioneer USA's 1% general partner ownership which is allocated at the Partnership level and 94 limited partner interests owned by Pioneer USA.
(2) The allocation between the Partnership and Parker & Parsley 88-B Conv., L.P. is 71.119936% and 28.880064%, respectively.
Note 7. Oil and gas information (unaudited)
The following table presents information relating to the Partnership's estimated proved oil and gas reserves at December 31, 1999, 1998 and 1997 and changes in such quantities during the years then ended. Due to a change in the accounting policy of the managing general partner in 1997, the Partnership began accounting for processed natural gas production in two components: processed natural gas liquids ("NGLs") and dry residue gas. NGLs are reflected in "Oil and NGLs" in the table below. All of the Partnership's reserves are proved developed and located within the United States. The Partnership's reserves are based on an evaluation prepared by the engineering staff of Pioneer USA and reviewed by Williamson Petroleum Consultants, Inc., an independent petroleum consultant, using criteria established by the Securities and Exchange Commission. Reserve value information is available to limited partners pursuant to the Partnership agreement and, therefore, is not presented.
Oil and NGLs Gas (bbls) (mcf) ------------ ----------
Net proved reserves at January 1, 1997 570,491 1,743,773 Revisions (5,887) (1,060,648) Production (35,648) (70,802) ------------ ---------- Net proved reserves at December 31, 1997 528,956 612,323 Revisions (215,651) (183,598) Production (43,365) (52,254) ------------ ---------- Net proved reserves at December 31, 1998 269,940 376,471 Revisions 375,777 553,985 Production (41,830) (57,190) ------------ ---------- Net proved reserves at December 31, 1999 603,887 873,266 ============ ==========
As of December 31, 1999, the estimated present value of future net revenues of proved reserves, calculated using December 31, 1999 prices of $25.36 per barrel of oil, $16.40 per barrel of NGLs and $1.75 per mcf of gas, discounted at 10% was approximately $3,344,000 and undiscounted was $6,398,000.
Numerous uncertainties exist in estimating quantities of proved reserves and future net revenues therefrom. The estimates of proved reserves and related future net revenues set forth in this report are based on various assumptions, which may ultimately prove to be inaccurate. Therefore, such estimates should not be construed as estimates of the current market value of the Partnership's proved reserves. The Partnership emphasizes that reserve estimates are inherently imprecise and, accordingly, the estimates are expected to change as future information becomes available.
Note 8. Major customers
The following table reflects the major customers of the Partnership's oil and gas sales (a major customer is defined as a customer whose sales exceed 10% of total sales) during the years ended December 31:
1999 1998 1997 -------- -------- -------- Plains All American Inc. 44% - - Genesis Crude Oil, L.P. - 49% 52% Western Gas Resources, Inc. 5% 17% 13%
At December 31, 1999, the amount receivable from Plains All American Inc. was $38,283 which is included in the caption "Accounts receivable - oil and gas sales" in the accompanying Balance Sheet.
Pioneer USA is of the opinion that the loss of any one purchaser would not have an adverse effect on the ability of the Partnership to sell its oil and gas production or natural gas products.
Note 9. Organization and operations
The Partnership was organized November 18, 1988 as a limited partnership under the Delaware Act for the purpose of acquiring and developing oil and gas properties. The following is a brief summary of the more significant provisions of the limited partnership agreement:
Managing general partner - The managing general partner of the Partnership is Pioneer USA. Pioneer USA has the power and authority to manage, control and administer all Program and Partnership affairs. As managing general partner and operator of the Partnership's properties, all production expenses are incurred by Pioneer USA and billed to the Partnership and a portion of revenue is initially received by Pioneer USA prior to being paid to the Partnership. Under the limited partnership agreement, the managing general partner pays 1% of the Partnership's acquisition, drilling and completion costs and 1% of its operating and general and adminis trative expenses. In return, it is allocated 1% of the Partnership's revenues.
Limited partner liability - The maximum amount of liability of any limited partner is the total contributions of such partner plus his share of any undistributed profits.
Initial capital contributions - The limited partners entered into subscription agreements for aggregate capital contributions of $8,954,000. Pioneer USA is required to contribute amounts equal to 1% of initial Partnership capital less commission and offering expenses allocated to the limited partners and to contribute amounts necessary to pay costs and expenses allocated to it under the Partnership agreement to the extent its share of revenues does not cover such costs.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
ITEM 10.
ITEM 10. Directors and Executive Officers of the Partnership
The Partnership does not have any officers or directors. Under the limited partnership agreement, the Partnership's managing general partner, Pioneer USA, is granted the exclusive right and full authority to manage, control and administer the Partnership's business.
Set forth below are the names, ages and positions of the directors and executive officers of Pioneer USA. Directors of Pioneer USA are elected to serve until the next annual meeting of stockholders or until their successors are elected and qualified. During June 1999, Mr. Lon C. Kile resigned as an officer of Pioneer USA. During January 2000, Mr. M. Garrett Smith also resigned his position as Director and Chief Financial Officer of Pioneer USA. Mr. Timothy L. Dove assumed the responsibility of Chief Financial Officer of Pioneer USA after Mr. Smith's resignation. Age at December 31, Name 1999 Position - -------------------- ------------ -----------------------------------
Scott D. Sheffield 47 President
Timothy L. Dove 43 Executive Vice President, Chief Financial Officer and Director
Dennis E. Fagerstone 50 Executive Vice President and Director
Mark L. Withrow 52 Executive Vice President, General Counsel and Director
Rich Dealy 33 Vice President and Chief Accounting Officer
Scott D. Sheffield. Mr. Sheffield is a graduate of The University of Texas with a B.S. in Petroleum Engineering. Since August 1997, he has served as President, Chief Executive Officer and a director of Pioneer and President of Pioneer USA. Mr. Sheffield assumed the position of Chairman of the Board of Pioneer in August 1999. He served as a director of Pioneer USA from August 1997 until his resignation from the board in June 1999. Mr. Sheffield was the President and a director of Parker & Parsley from May 1990 until August 1997 and was the Chairman of the Board and Chief Executive Officer of Parker & Parsley from October 1990 until August 1997. He was the sole director of Parker & Parsley from May 1990 until October 1990. Mr. Sheffield joined Parker & Parsley Development Company ("PPDC"), a predecessor of Parker & Parsley, as a petroleum engineer in 1979. He served as Vice President - Engineering of PPDC from September 1981 until April 1985 when he was elected President and a director. In March 1989, Mr. Sheffield was elected Chairman of the Board and Chief Executive Officer of PPDC. Before joining PPDC's predecessor, Mr. Sheffield was employed as a production and reservoir engineer for Amoco Production Company.
Timothy L. Dove. Mr. Dove earned a B.S. in Mechanical Engineering from Massachusetts Institute of Technology in 1979 and received his M.B.A. in 1981 from the University of Chicago. He became Executive Vice President - Business Development of Pioneer and Pioneer USA in August 1997 and was also appointed a director of Pioneer USA in August 1997. Mr. Dove assumed the position of Chief Financial Officer of Pioneer and Pioneer USA effective February 1, 2000. Mr. Dove joined Parker & Parsley in May 1994 as Vice President - International and was promoted to Senior Vice President - Business Development in October 1996, in which position he served until August 1997. Prior to joining Parker & Parsley, Mr. Dove was employed with Diamond Shamrock Corp., and its successor, Maxus Energy Corp, in various capacities in international exploration and production, marketing, refining and marketing and planning and development.
Dennis E. Fagerstone. Mr. Fagerstone, a graduate of the Colorado School of Mines with a B.S. in Petroleum Engineering, became an Executive Vice President of Pioneer and Pioneer USA in August 1997. He was also appointed a director of Pioneer USA in August 1997. He served as Executive Vice President and Chief Operating Officer of Mesa from March 1, 1997 until August 1997. From October 1996 to February 1997, Mr. Fagerstone served as Senior Vice President and Chief Operating Officer of Mesa and from May 1991 to October 1996, he served as Vice President - Exploration and Production of Mesa. From June 1988 to May 1991, Mr. Fagerstone served as Vice President - Operations of Mesa.
Mark L. Withrow. Mr. Withrow, a graduate of Abilene Christian University with a B. S. in Accounting and Texas Tech University with a Juris Doctorate degree, became Executive Vice President, General Counsel and Secretary of Pioneer and Pioneer USA in August 1997. He was also appointed a director of Pioneer USA in August 1997. Mr. Withrow was Vice President - General Counsel of Parker & Parsley from January 1991, when he joined Parker & Parsley, to January 1995, when he was appointed Senior Vice President - General Counsel. He was Parker & Parsley's Secretary from August 1992 until August 1997. Prior to joining Parker & Parsley, Mr. Withrow was the managing partner of the law firm of Turpin, Smith, Dyer, Saxe & MacDonald, Midland, Texas.
Rich Dealy. Mr. Dealy is a graduate of Eastern New Mexico University with a B.B.A. in Accounting and Finance and is a Certified Public Accountant. He became Vice President and Chief Accounting Officer of Pioneer and Pioneer USA in February 1998. Mr. Dealy served as Controller of Pioneer USA from August 1997 to February 1998. He served as Controller of Parker & Parsley from August 1995 to August 1997. Mr. Dealy joined Parker & Parsley as an Accounting Manager in July, 1992. He was previously employed with KPMG Peat Marwick as an Audit Senior, in charge of Parker & Parsley's audit.
ITEM 11.
ITEM 11. Executive Compensation
The Partnership does not have any directors or officers. Management of the Partnership is vested in Pioneer USA, the managing general partner. The Partnership participates in oil and gas activities through an income tax partnership (the "Program") pursuant to the Program agreement. Under the Program agreement, Pioneer USA pays approximately 10% of the Program's acquisition, drilling and completion costs and approximately 25% of its operating and general and administrative expenses. In return, Pioneer USA is allocated approximately 25% of the Program's revenues. See Notes 6 and 9 of Notes to Financial Statements included in "Item 8. Financial Statements and Supplementary Data" for
information regarding fees and reimbursements paid to the managing general partner or its affiliates by the Partnership.
The Partnership does not directly pay any salaries of the executive officers of Pioneer USA, but does pay a portion of Pioneer USA's general and administrative expenses of which these salaries are a part. See Note 6 of Notes to Financial Statements included in "Item 8. Financial Statements and Supplementary Data".
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
a) Beneficial owners of more than five percent
The Partnership is not aware of any person who beneficially owns 5% or more of the outstanding limited partnership interests of the Partnership. Pioneer USA owned 94 limited partner interests at January 1, 2000.
(b) Security ownership of management
The Partnership does not have any officers or directors. The managing general partner of the Partnership, Pioneer USA, has the exclusive right and full authority to manage, control and administer the Partnership's business. Under the limited partnership agreement, limited partners holding a majority of the outstanding limited partnership interests have the right to take certain actions, including the removal of the managing general partner or any other general partner. The Partnership is not aware of any current arrangement or activity which may lead to such removal. The Partnership is not aware of any officer or director of Pioneer USA who beneficially owns limited partnership interests in the Partnership.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions
Transactions with the managing general partner or its affiliates
Pursuant to the limited partnership agreement, the Partnership had the following related party transactions with the managing general partner or its affiliates during the years ended December 31:
1999 1998 1997 ---------- ---------- ---------- Payment of lease operating and supervision charges in accordance with standard industry operating agreement $ 157,042 $ 150,985 $ 169,328
Reimbursement of general and administrative expenses $ 13,039 $ 13,810 $ 20,876
Under the limited partnership agreement, the managing general partner pays 1% of the Partnership's acquisition, drilling and completion costs and 1% of its operating and general and administrative expenses. In return, it is allocated 1% of the Partnership's revenues. Also, see Notes 6 and 9 of Notes to Financial Statements included in "Item 8. Financial Statements and Supplementary Data" regarding the Partnership's participation with the managing general partner in oil and gas activities of the Program.
PART IV
ITEM 14.
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) 1. Financial statements
The following are filed as part of this annual report:
Independent Auditors' Report - Ernst & Young LLP
Independent Auditors' Report - KPMG LLP
Balance sheets as of December 31, 1999 and 1998
Statements of operations for the years ended December 31, 1999, 1998 and 1997
Statements of partners' capital for the years ended December 31, 1999, 1998 and 1997
Statements of cash flows for the years ended December 31, 1999, 1998 and 1997
Notes to financial statements
2. Financial statement schedules
All financial statement schedules have been omitted since the required information is in the financial statements or notes thereto, or is not applicable nor required.
(b) Reports on Form 8-K
None.
(c) Exhibits
The exhibits listed on the accompanying index to exhibits are filed or incorporated by reference as part of this annual report.
S I G N A T U R E S
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PARKER & PARSLEY 88-B, L.P.
Dated: March 23, 2000 By: Pioneer Natural Resources USA, Inc. Managing General Partner
By: /s/ Scott D. Sheffield --------------------------- Scott D. Sheffield, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
/s/ Scott D. Sheffield President of Pioneer USA March 23, 2000 - ------------------------ Scott D. Sheffield
/s/ Timothy L. Dove Executive Vice President, Chief March 23, 2000 - ------------------------ Financial Officer and Director of Timothy L. Dove Pioneer USA
/s/ Dennis E. Fagerstone Executive Vice President and March 23, 2000 - ------------------------ Director of Pioneer USA Dennis E. Fagerstone
/s/ Mark L. Withrow Executive Vice President, General March 23, 2000 - ------------------------ Counsel and Director of Pioneer USA Mark L. Withrow
/s/ Rich Dealy Vice President and Chief Accounting March 23, 2000 - ------------------------ Officer of Pioneer USA Rich Dealy
PARKER & PARSLEY 88-B, L.P.
INDEX TO EXHIBITS
The following documents are incorporated by reference in response to Item 14(c):
Exhibit No. Description Page
3(a) Amended and Restated Certificate and - Agreement of Limited Partnership of Parker & Parsley 88-B, L.P. incorporated by reference to Exhibit A of Amendment No. 1 of the Partnership's Registration Statement on Form S-1 (Registration No. 33-19659)
4(b) Form of Subscription Agreement and - Power of Attorney incorporated by reference to Exhibit D of the Partnership's Registration Statement on Form S-1 (Registration No. 33-19659) (hereinafter called the Partnership's Registration Statement)
4(c) Specimen Certificate of Limited Partnership - Interest incorporated by reference to Exhibit D of the Partnership's Registration Statement
10(b) Exploration and Development Program - Agreement incorporated by reference to Exhibit C of the Partnership's Registration Statement
27.1* Financial Data Schedule
*Filed herewith | 8,411 | 55,093 |
924546_1999.txt | 924546_1999 | 1999 | 924546 | ITEM 1. BUSINESS.
INTRODUCTION Iterated Systems is focused on creating a commercial software product line designed to dramatically improve the productivity, control and time to market for the management, production, and delivery of digital product (or brand) images. Iterated's target market is Global 1000 corporations that use images to sell their products in e-commerce and in print. Such corporations include major retailers with large brand product image collections and the advertising agencies and print production companies that serve them. Iterated's MediaBintm platform has been developed from the Company's research and development expertise in digital image science and fractal-based mathematics, which have evolved over more than twelve years in the digital image business.
The Company was founded in 1987 by Dr. Michael Barnsley and Dr. Alan Sloan, who at that time were tenured members of the mathematics faculty at the Georgia Institute of Technology. Their early work was based on the discovery that real-world images could be generated by plotting fractal equations. An early experiment produced the Iterated Systems fern logo from only a few bits of data, using a fractal process known as an Iterated Function System. Iterated's initial products provided fractal image compression based on Dr. Barnsley's patented Fractal Transform algorithm method, which was used to store and display fractal-compressed images in Microsoft's Encarta CD-ROM encyclopedia, the Great Artists CD-ROM series, and other CD-ROM and screen saver titles.
The Company was organized under the laws of the State of Georgia on May 28, 1987. On May 20, 1991, Iterated Systems Limited (ISL) was incorporated in the United Kingdom as a wholly owned subsidiary of the Company to function as the Company's European sales office.
HISTORY
The Company's current strategies and business direction, including the decision to focus its primary efforts on the development of software for the corporate digital image management market, were developed during 1997 and 1998 based on internal and external factors affecting the Company and its markets. Prior to that time one of its significant focuses was for the development of software products to be sold to end users for use on the Internet. Developments in that market lead the Company to believe that its expertise was better suited to developing and delivering its technology to OEMs for inclusion in their products. As a result of this shift, during 1997 the Company experienced a significant reduction and restructuring in its workforce. During 1998 and 1999, the Company continued to focus its development and marketing efforts to target large corporate users of digital images with needs for cross-media production. The Company expects its business plans to continue to evolve based on competitive forces and the ongoing need to generate new and innovative products on a continual basis. These external market factors make estimates of product acceptance and financial performance of the Company difficult to predict, and in response thereto the Company expects to make ongoing revisions to its business plan.
In September 1994, the Company entered into an agreement (the 1994 Agreement) with MCI Telecommunications Corporation (MCI) to provide for development of certain advanced compression technology for use in telecommunications applications. MCI paid the Company approximately $36,000,000 over the next three years for development of specific technology and the exclusive rights to use and sublicense specified technology in telecommunications markets until September 1997. The 1994 Agreement expired in September 1997. Effective August 7, 1998, the Company and MCI entered into a new agreement that provides MCI with a non-exclusive, royalty-free license to use certain deliverables developed by the Company. In addition, MCI holds a warrant to purchase up to 1,798,000 shares of common stock at $4 per share. The warrant expires in August 2002.
THE MEDIABIN PLATFORM
With the advent of e-commerce, brand-centered corporations are facing an exploding number of images that are burdening their corporate information technology infrastructures as they try to promote their brands in tightly integrated Web/e-commerce and print campaigns. In mid-1999, Iterated announced the MediaBin platform, a new, advanced approach to dealing with this proliferation of images and the publication problems that have ensued. Integrated print and online campaigns, known as cross-media or multi-channel campaigns place a unique demand and burden on the workflow of images, which MediaBin is designed to solve.
Specifically MediaBin is designed to address the image problems of large, geographically dispersed corporations that have:
High consideration brands (brands that require significant customer evaluation or review before purchase such as automobiles, recreational products, clothing items, consumer electronics, sporting goods, etc.) supported by large numbers of high quality images. These corporations are typically in rapid transition to control their brands as they launch e-commerce business strategies while maintaining their print media needs.
In addition to the brand-centered corporations, there is a significant set of associated companies that service these large corporations. These organizations include Web/e-commerce site developers, advertising agencies, marketing services firms, and printing agencies. MediaBin is designed to enhance collaboration for all of these supporting groups and to complement the corporate installations of MediaBin.
The MediaBin platform is a substantial extension to the existing value and feature set provided by Iterated's earlier imaging software. MediaBin delivers image automation services that are analogous to "just-in-time" manufacturing methods that have been deployed with such great success in the manufacturing marketplace. MediaBin provides image services on an extensible, scalable, enterprise server platform that, in addition to providing resolution management, can also transform images in any color space and image format. The MediaBin platform is built on open, industry standards such as HTTP (Web browser) and TCP/IP (file transfer) protocols, the ODBC (Open Data Base Connect) standard that allows for the use of industry standard databases like Oracle, Informix, SQL Server, and the Windows NT operating system. MediaBin is written using the Microsoft Windows compatible approaches to programming known as DCOM (Distributed Common Object Method) and C++ (the most common object oriented programming language in use today).
MediaBin provides workflow automation in six critical areas:
o Automation of image production, o Repurposing of images, o Tracking and revision management, o Collaboration for workgroups, o Unique searching methods, and o Image format independence.
AUTOMATION OF IMAGE PRODUCTION. Today, an ever increasing and significant amount of image production or post-creative work is required to prepare images for use in the print and Web environment. These tasks include time-consuming operations that take a digital image that is artistically complete and prepare that image for use in another medium. This process is typically tedious and repetitive and includes such tasks such as flattening Adobe PhotoShop layers, filtering, scaling, cropping, converting the color space, making the correct image format, and transferring files to remote locations.
Creative professionals, whose time is both valuable and expensive, can spend up to 70% of their time doing this post-creative work that does not require their creative skills. As corporations move rapidly to place their product images on the Web, the need for multiple copies of the same images, some suited for print, some suited for the Web, becomes costly and very time consuming. MediaBin relieves the creative professional of post-creative work and moves it to automated processes on the MediaBin server. Organizations can perform post-creative operations using a fraction of the time and effort.
REPURPOSING OF IMAGES. At its core, MediaBin is designed to enable universal reuse, or REPURPOSING as is it called in the industry, of images so that one image can serve the needs of any and all print or Web uses. Today, an image is created for one specific use, then discarded. Any further use of that image requires a complete re-work of the image from scratch. This approach is highly inefficient when rapidly executing cross-media campaigns, where images must be repurposed for use on the Web, in print ads, for store merchandising displays, and even for billboards. MediaBin enables a highly efficient single image asset approach, wherein a single image is captured, stored, and automatically processed, so it can be used and then repurposed FOR ANY USE--on the Web, in print ads, for store merchandising displays, and on billboards. This unique approach is enabled by and automated through the MediaBin platform.
TRACKING AND REVISION MANAGEMENT. One of the largest challenges facing organizations with many images is tracking image usage and ensuring that the images in use are the most current versions. Iterated has developed a patent-pending method that provides automated tracking and revision of DERIVATIVE images. Derivative images are images created from a single image original (core asset) that are slightly different from the original to serve different purposes. An example would be a small image needed on a Web site that is created as a derivative of the original image that was used in a print advertisement or catalog. MediaBin keeps track of the relationships between the assets and derivatives, so that updates can be made automatically throughout an entire collection of derivatives, simply by updating their common core asset. Similarly, derivative images are tagged such that their parent core image source can be located on MediaBin servers located anywhere--on a local network or on the other side of the world across the Internet.
COLLABORATION FOR WORKGROUPS. As the global reach of brands and brand companies expands, the need to rapidly and efficiently share brand images is increasing dramatically. MediaBin is built to provide easy sharing and collaboration of entire sets of images used in projects as well as single images or even a single layer of multi-layered PhotoShop image file. MediaBin is designed to use highly efficient compression methods to allow multiple MediaBin servers to share images across geographically dispersed teams. MediaBin also uses a concept of 'just-in-time' image creation, where images are created only at the moment of need. This not only provides significant savings in storage, but also insures that the most current version of an image is used.
UNIQUE SEARCHING METHOD. To aid in the sharing and locating of images, MediaBin has the ability to search for images in any local or remote MediaBin by image metadata (the text information associated with an image) or by using images to search for other like images based upon a match of color, texture, shape, and/or content. This image searching method uses a unique, patented, fractal-based image recognition algorithm and represents the third generation of work by Iterated in the area of image only based searching.
IMAGE FORMAT INDEPENDENCE. The MediaBin platform is built so that all of the MediaBin capabilities are available to all images entered into the MediaBin. MediaBin is format independent (format agnostic) and can apply all the benefits for the proprietary image technology without the burden of requiring users to adopt a new image format into their workflow.
MEDIABIN MARKET SIZE AND OPPORTUNITY
The worldwide market for commercial publishing, which includes print AND electronic-based media, generated approximately $260 billion in revenues in 1998. (GartnerGroup, "Commercial Publishing Transitions: A Blueprint Through 2002," C. Abrams, 1998). This huge market is undergoing dramatic and rapid changes brought on by the substantial adoption of digital computer based methods used to create, edit, distribute, and publish/print all types of media content. The tumultuous effects of the Internet and Web based business are substantially altering the traditional methods and workflows used to publish and distribute media. The digital publishing tools that provided an efficient workflow in a pre-Internet era just a few years ago are no longer sufficient to quickly and efficiently handle the needs for cross-media publishing. These dramatic changes have created a demand in the market for software solutions that can help deal with the needs of both traditional print production and the explosive growth of Web/e-commerce--the cross-media solution space.
So significant is this change that the GartnerGroup has characterized this as "causing a revolution as great as that caused by Gutenberg's press." The marketplace has responded to this need for improved productivity and cost reductions by spending capital on automation products. The Delphi Group, a leading industry analyst group, tracks a market known as Business to Business (B2B) Tools. Within that grouping is a segment known as eContent - which addresses the tools, like MediaBin needed to help corporations automate content management and delivery. They expect the eContent segment to grow from $1.6 billions as of the end of 1999 to over $12.8 billions by 2002, a growth rate of 200%.
MEDIABIN SALES CHANNELS
The current sales model for MediaBin involves the license of MediaBin to 'end users' or final, end customers for the MediaBin platform. This method, known as a direct sales model, provides Iterated with the important direct control over the entire sales process during the critical early stages of product use in the market. This hands-on approach to the sale of the product enables very important early market feedback to help define revisions and improvements to the product.
During the initial launch period for the product, the sale of MediaBin is typically being bundled with consulting and integration services. These integration services are designed to ensure that the early MediaBin usage fits well with the customer's existing workflows. As the MediaBin product matures in the market, it is expected that the need for Iterated to provide these services will diminish and result in the Company's ability to achieve more MediaBin installations using fewer resources. At this time the direct selling model will be augmented by expanding the sales channel to include a select set of System Integration partners. These partners will add value in the sale of MediaBin through services including integration into existing systems, training, installation, and, potentially, total system support. In many cases the System Integrators will sell the product directly to end users, but they may in some cases act as aggregators and recommenders for the use of MediaBin to end users in the market.
Iterated has begun discussions with several partners and OEMs who are considering the inclusion of MediaBin platform as an integral part of their product. OEMs or Original Equipment Manufacturers resell other software products by including or embedding those products into their own products. The lead-time for the inclusion of products into OEM's products is typically long and revenue associated with such relationships is very difficult to forecast. One such product is the Media Asset Management (MAM) System. MAMs are computerized storage and retrieval systems specifically designed for digital media.
COMPETITION
There are a few companies marketing products that perform some, but not all, of the functions of the MediaBin Platform. These companies include Warp 10, and Equilibrium.
The Digital Toolkit from Warp 10 is a media management system that enables systems integrators, web developers and others to build applications to manage their digital resources using a Digital Asset Management (DAM) system. Since MediaBin reduces the number of files designers have to manage, and because it enables more efficient archiving, MediaBin could be seen as a competitor of Warp 10. However, MediaBin is really a complement to DAM systems. ISI recently announced complimentary working relationships with a number of DAM vendors (Canto and North Plains). DAM's track files, manage version control, and other system-related issues, whereas MediaBin adds an ability to create any image form needed by a client on demand and just-in-time image creation and delivery.
Equilibrium's DeBabelizer is an image conversion tool that enables users to, among other tasks, scale images for different output. However, DeBabelizer does not enable users to repurpose images automatically in many different sizes while delivering the extremely high quality images clients demand. DeBabelizer is also not an image storage or repository.
MAJOR CUSTOMERS
As discussed above, since the Company is refining its market to focus on users of high quality digital imaging systems, its major customers in the future will probably not be ones that have contributed significantly in the past. A discussion of the contributions of major customers during 1996-1998 is included in the footnotes to the Company's Financial Statements referred to in Item 8 of this Form 10-K and incorporated by reference.
RESEARCH AND DEVELOPMENT/PATENTS
During 1997, 1998 and 1999, the Company has spent $8,261,000, $5,237,000 and $4,891,000, respectively, in the research and development of new technologies, refining and improving its technologies and the customization of its technologies to the needs of specific customers. During 1996 and 1997, the majority of these expenditures were made under the 1994 Agreement discussed above. The Company expects that continued significant expenditures in this area will be necessary to successfully introduce new products and improve its core technology and no assurances can be made that these development efforts will be successful.
Consistent with its emphasis on research and development, the Company maintains an aggressive patent filing program. To date, the Company holds 20 issued U.S. patents with expiration dates from 2009-2017 and holds an exclusive license to a seventh issued U.S. patent expiring in 2007.
The Company's patents and patent applications are intended to provide a degree of patent protection of the Company's technology as applied to products developed under the Company's Imaging Systems Architecture(TM) (ISA), particularly as applied in the area of real time video codecs, store and forward video codecs and still image codecs. The markets for these codecs are highly competitive, and the Company believes that its research and development efforts and resulting patents are essential to an effective market presence.
EMPLOYEES
The Company currently has approximately 50 full time employees based in its offices in Atlanta, Georgia and Reading, England. The Company also makes extensive use of independent contractors to fulfill short term specialized needs.
ITEM 2.
ITEM 2. PROPERTIES.
The Company leases approximately 21,000 square feet of office space in Atlanta, Georgia for its corporate, sales and development operations. The lease runs through July 31, 2005.
The Company also leases approximately 3,000 square feet of office space near Reading, England. The lease runs through June 27, 2012 with an option to terminate in June 2007. All of this space has been sublet for the term of the lease.
The aggregate net monthly rental for these leased offices and facilities is currently approximately $29,000, and the Company's management believes that these facilities are adequate for its intended activities in the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The nature of the Company's business exposes it to the risk of lawsuits for damages or penalties relating to, among other things, breach of contract, employment disputes and copyright, trademark or patent infringement. The Company is not currently a party to any pending material litigation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
A Special Meeting of Stockholders was held on October 28, 1999 at which time certain matters were submitted to such stockholders for a vote. Below is a brief description of each such matter as well as the number of shares represented at the meeting and entitled to vote and voting for, against or abstaining as to the matter.
To approve an amendment to Iterated's Articles of Incorporation to increase the number of authorized shares of common stock, par value $.01 per share, from 20,000,000 shares to 40,000,000 shares.
-------------------------- ------------------------ ---------------------- Shares For Shares Against Shares Abstained -------------------------- ------------------------ ---------------------- 7,674,384 2,835 0 -------------------------- ------------------------ ---------------------- 99.9% 0.1% 0.0% -------------------------- ------------------------ ----------------------
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.
The Company's Common Stock has been traded on the Oslo Stock Exchange under the symbol "ITR" since October 1,1997. Prior to that time there was no established market for the shares. The Company has not registered any securities with the United States Securities and Exchange Commission other than pursuant to its Form S-8 Registration Statement filed on December 9, 1998. Securities of the Company may not be offered for sale or sold in the U.S. or to or for the account or benefit of any U.S. person unless the securities are registered or an exemption from registration requirements is available.
The price per share reflected in the table below represents the range of low and high closing sale prices for the Company's Common Stock as reported by the Oslo Stock Exchange for the periods indicated:
FISCAL PERIOD HIGH PRICE LOW PRICE ------------- ---------- ---------
01/01/98 - 03/31/98 $ 9.24 $ 5.99 4/1/98 - 6/30/98 7.51 3.92 7/1/98 - 9/30/98 3.23 0.95 10/1/98 - 12/31/98 1.63 0.22
01/01/99 - 03/31/99 1.75 0.67 4/1/99 - 6/30/99 1.27 0.81 7/1/99 - 9/30/99 1.14 0.76 10/1/99 - 12/31/99 1.83 0.45
The closing sale price of the Company's Common Stock as reported by the Oslo Stock Exchange on March 24, 2000, was U.S. $2.88.
The number of shareholders of record of the Company's Common Stock as of February 29, 2000, was approximately 2,400.
The Company as of February 29, 2000, has options and warrants outstanding to acquire 5,860,000 shares of Common Stock of the Company, of which options and warrants as to 3,456,000 shares are currently exercisable.
The Company has never paid cash dividends on its capital stock. The Company currently intends to retain any earnings for use in the business and does not anticipate paying any cash dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The information set forth under the section entitled "Summary Consolidated Financial Data" on page 11 of the Company's 1999 Annual Report to Shareholders is incorporated herein by reference and filed herewith as part of Exhibit 13.1.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The information set forth under the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 12 through 14 of the Company's 1999 Annual Report to Shareholders is incorporated herein by reference and filed herewith as a part of Exhibit 13.1.
RIGHTS OFFERING From November 8, 1999 to November 19, 1999, the Company sold an aggregate of 4,445,000 shares of Common Stock to its shareholders at $0.50 per share pursuant to a rights offering ("Rights Offering").
Prior to the issuance and trading of the rights, pursuant to the Rights Offering, certain U.S. shareholders did not receive a copy of the prospectus. Therefore, it is possible that all applicable federal and state securities laws were not complied with in all material respects. As a result, the Company offered to those U.S. shareholders who purchased the Company's Common Stock pursuant to the Rights Offering an opportunity to rescind their purchase. No U.S. shareholders rescinded their purchase. The Company also extended the effective date of the Rights Offering until January 28, 2000, for those U.S. shareholders who did not receive a copy of the Prospectus prior to the issuance and trading of rights. During this extended period an additional 7,600 shares were sold at $0.50 per share.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Financial instruments that potentially subject the Company to significant concentrations of market risk consist principally of short-term investments, trade accounts receivable, and accounts payable.
ISL considers the British pound to be its functional currency. The Company considers its functional currency to be the U.S. dollar. ISL's assets and liabilities are translated at year-end rates of exchange and its revenues and expenses are translated at the average rates of exchange during the year.
The Company believes that the potential effects of market risk is not material to its operations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The quarterly results of operations set forth on page 11 of the Company's 1999 Annual Report to Shareholders and the following consolidated financial statements, related notes thereto and report of independent auditors set forth on pages 15 through 29 of the Company's 1999 Annual Report to Shareholders are incorporated herein by reference and filed herewith as a part of Exhibit 13.1.
Consolidated Balance Sheets as of December 31, 1999 and 1998.
Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997.
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1999, 1998 and 1997.
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997.
Notes to Consolidated Financial Statements.
Independent Auditors' Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this item is contained in the Company's Proxy Statement for the Annual Meeting of Shareholders to be filed with the Commission not later than 120 days after the close of the Company's fiscal year ended December 31, 1999 under the caption "Election of Directors" and incorporated by reference herein.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item will be included in the Company's Proxy Statement for the Annual Meeting of Shareholders to be filed with the Commission not later than 120 days after the close of the Company's fiscal year ended December 31, 1999 under the caption "Executive Compensation" and is incorporated by reference herein.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this item will be included in the Company's Proxy Statement for the Annual Meeting of Shareholders to be filed with the Commission not later than 120 days after the close of the Company's fiscal year ended December 31, 1999 under the caption "Security Ownership of Certain Beneficial Owners and Management" and is incorporated by reference herein.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item will be included in the Company's Proxy Statement for the Annual Meeting of Shareholders to be filed with the Commission not later than 120 days after the close of the Company's fiscal year ended December 31, 1999 under the caption "Certain Transactions" and is incorporated by reference herein.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements
The financial statements of Iterated Systems, Inc. and reports of independent auditors as set forth under Item 8 of this report on Form 10-K are incorporated by reference herein.
2. Financial Statement Schedules
(i) The following Financial Statement Schedule of Iterated Systems, Inc. for the Years Ended December 31, 1999, 1998 and 1997 is filed as a part of this report on Form 10-K and should be read in conjunction with the Financial Statements, and related notes thereto, of Iterated Systems, Inc.
ITERATED SYSTEMS, INC. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
VALUATION AND QUALIFYING ACCOUNTS WHICH ARE DEDUCTED IN THE BALANCE SHEET FROM THE ASSETS TO WHICH THEY APPLY
(b) REPORTS ON FORM 8-K. None.
(c) EXHIBITS. The following exhibits are filed as part of, or are incorporated by reference into, this report on Form 10-K:
EXHIBIT NUMBER DESCRIPTION - ------- -----------
3.1 Restated Articles of Incorporation of the Registrant
3.2* Restated Bylaws of the Registrant
4.1* Warrant for the Purchase of Shares of Common Stock of the Registrant issued to Mosvold Farsund AS dated May 31, 1996
10.1* Loan Agreement between Mosvold Farsund AS and the Registrant, dated May 31, 1996, as amended June 30, 1997
10.2* Lease between California State Teachers' Retirement System and the Registrant dated January 31, 1995 for premises situated at 3525 Piedmont Road, N.E., Seven Piedmont Center, Suite 600, Atlanta, Georgia
10.3* Lease between T.A. Fisher & Sons Limited and Iterated Systems Limited dated June 27, 1997 relating to land and office buildings forming Unit No. 32 at Wellington Business Park, Dukes Ride, Crowthorne, Berkshire
10.4* Amended and Restated Executive Employment Agreement between the Registrant and John C. Bacon, dated as of February 16, 1998
10.5* Executive Severance Agreement between the Registrant and John R. Festa, dated February 16, 1998
10.6* Employment Agreement between the Registrant and Michael F. Barnsley, dated May 1, 1994, as amended
10.7* Employment Agreement between the Registrant and Alan D. Sloan, dated May 1, 1994, as amended
10.8* Iterated Systems, Inc. 1994 Amended and Restated Stock Option Plan
10.9* Iterated Systems, Inc. Amended and Restated 1994 Directors Stock Option Plan
13.1 The following financial information included within the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1999:
(i) Summary Consolidated Financial Data;
(ii) Selected Quarterly Operating Results;
(iii) Management's Discussion and Analysis of Financial Condition and Results of Operations; and
(iv) Financial Statements, Notes to Financial Statements, and Independent Auditor's Report.
21* Subsidiaries of the Registrant
23.1 Consent of Ernst & Young LLP
27.1 Financial Data Schedule (SEC use only)
- ---------- * Incorporated by reference to Exhibits filed in response to Item 16(a), "Exhibits" of the Company's Registration Statement on Form 10 (File No. 000-24087) filed on April 24, 1998, as amended.
(d) FINANCIAL STATEMENT SCHEDULES. None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ITERATED SYSTEMS, INC.
By: /s/ John C. Bacon -------------------------------------- John C. Bacon President and Chief Executive Officer (Principal Executive Officer) and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. | 4,845 | 31,707 |
1029389_1999.txt | 1029389_1999 | 1999 | 1029389 | ITEM 1. BUSINESS
General
Outsourcing Solutions Inc. (the "Company" or "OSI") is one of the largest providers of accounts receivable management services in the United States with 1999 revenues of approximately $504.4 million. The Company believes that it differentiates itself from its competitors by providing a full range of accounts receivable management services on a national basis that allow its customers to outsource the management of the entire credit cycle. The breadth of services the Company provides across all stages of the credit cycle allows itself to cross-sell services to existing customers as well as to expand its customer base by providing specific services to potential customers in targeted industries. These services include collection services, portfolio purchasing services and outsourcing services which accounted for approximately 72%, 16% and 12% of 1999 revenues, 73%, 17% and 10% of 1998 revenues and 67%, 25% and 8% of 1997 revenues, respectively.
- Collection services involve collecting on delinquent or charged-off consumer accounts for a fixed percentage of realized collections or a fixed fee per account.
- Portfolio purchasing services involve acquiring portfolios of non-performing consumer receivables from credit grantors, servicing such portfolios and retaining all amounts collected.
- Outsourcing services include contract management of accounts receivable, billing and teleservicing.
The Company manages the marketing and execution of services within the four stages of the credit cycle. In the first stage of the credit cycle, OSI provides customers with the ability to outsource services including credit authorization, usage management and customer service. Dedicated call centers provide "first party" services for its clients performing all operations in their name. The second stage of the credit cycle is the management of pre-uncollectable, or charge-off, delinquency situations. OSI provides clients with fixed fee early-out programs based on either a letter series or calling program for accounts that are generally less than 180 days past due. In the third stage of the credit cycle, the Company offers traditional contingent collection services for delinquent and charged-off receivables. In the fourth and final stage of the credit cycle, OSI acts as a principal and purchases both new and delinquent charged-off receivables from credit grantors.
The accounts receivable management industry is highly fragmented. Nationwide, the Company estimates there are approximately 6,000 debt collection service companies in the United States, with the 10 largest agencies currently accounting for 20% of industry revenues. Competition is based largely on recovery rates, industry experience and reputation and service fees. Large volume credit grantors typically employ more than one accounts receivable management company at one time, and often compare performance rates and rebalance account placements towards higher performing servicers.
The customer base for the accounts receivable management industry is generally concentrated by credit grantors in four end-markets: banks, health care, utilities and telecommunications. Other significant sources of account placements include retail, student loan and governmental agencies. The Company believes that the ongoing consolidation in the banking, health care, utilities and telecommunication industries will benefit them by creating larger national customers seeking to place accounts with accounts receivable management companies that offer national rather than local and regional coverage. The Company's customers include a full range of local, regional and national credit grantors. Our largest customer accounted for no more than 5% of 1999 revenues.
Outsourcing Solutions Inc., a Delaware corporation, was formed in 1995 to acquire Account Portfolios L.P., one of the largest purchasers and servicers of non-performing accounts receivables portfolios. Since its formation, the Company has completed six additional acquisitions and has established itself as a leading industry consolidator. The Company has experienced significant growth in their business through internal growth and acquisitions, with its revenues increasing from $29.6 million in 1995 to $504.4 million in 1999.
Industry
The accounts receivable management industry has experienced significant growth over the past 15 years. The rapid growth of outstanding consumer credit and the corresponding increase in delinquencies has resulted in credit grantors increasingly looking to third party service providers in managing the accounts receivable process. The contingent fee collection industry, the Company's largest business service, is estimated to be a $6.5 billion market growing at approximately 8% to 10% per annum. The Company's other business services such as portfolio purchasing and outsourcing services are estimated, in the aggregate, to be an approximately $3.0 billion market. The Company believes the following are the key trends in the accounts receivable management industry:
- Increase in Consumer Debt and Delinquencies. Consumer debt, a leading indicator of current and future business for accounts receivable management companies, has increased dramatically in recent years. Between 1990 and 1998, total consumer debt increased 67% from $3.6 trillion to $6.0 trillion. Furthermore, charged-off credit card debt as a percentage of total outstanding consumer debt increased from 3% in 1994 to 5.6% in 1998.
- Industry Consolidation. The American Collectors Association estimates that in 1995 there were approximately 6,000 contingent fee companies in the United States participating in an industry that generated over $6.5 billion in contingent fee collection revenue in 1998. The industry has undergone significant consolidation, with the top ten contingent fee companies increasing their industry share to over 20% in 1998. With over 6,000 debt collection companies in the United States and given the financial and competitive constraints facing these smaller companies and the limited number of liquidity options for the owners of such businesses, the Company believes that the industry will continue to experience consolidation. Well-capitalized companies that offer national capabilities with a "full service" approach to accounts receivable management are increasingly displacing local and regional competitors.
- Customer Consolidation. The largest credit granting industries, including banking, utilities, telecommunications and health care account for 80% of accounts placed for collection and are experiencing rapid consolidation. This consolidation has forced companies to focus on core business activities and to outsource ancillary functions, including some or all aspects of the accounts receivable management process. As a result, many regional customers are becoming national in scope and are shifting account placements to accounts receivable management companies that have the ability to service a large volume of placements on a national basis. The Company established relationships with many of the target industries' largest consolidators, thereby improving its ability to capitalize on this consolidation trend.
- Growth in Portfolio Sales. As one of the leading providers of portfolio purchasing services, we have participated in the rapid and consistent industry-wide increase in the amount of non-performing consumer receivables sold by credit grantors. Portfolio sales offer the credit grantor many benefits, including increased predictability of cash flow reduction in monitoring and administrative expenses and reallocation of assets from non-core business functions to core business functions. It is estimated that $10.1 billion of charged-off credit card debt was acquired by portfolio purchasers in 1996 and more than $22.0 billion in 1999.
- Accelerated Trend toward Outsourcing. In an effort to focus on core business activities and to take advantage of economies of scale, better performance and the lower cost structure offered by collection companies, many credit grantors have chosen to outsource some or all aspects of the accounts receivable management process. Instead of waiting until receivables are 180 days past due (or later) to turn over for credit collection, credit grantors are now involving collection companies much earlier in the process. Increasingly, credit grantors are looking to accounts receivable management providers for assistance with billing, customer service and complete call center outsourcing.
- Technological Sophistication. Leading companies in the industry are increasingly using technology to improve their collection efforts. These initiatives include investments in proprietary databases and computerized calling and debtor location techniques.
Competitive Advantages
The Company believes that its strong market position, national presence and breadth of services distinguishes itself as a leading provider of accounts receivable management services in the United States. OSI believes its competitive advantages include:
- Benefits of Scale. The benefits of scale in the accounts receivable industry are significant on both revenues and cost. Scale makes it possible for the Company to compete for larger blocks of revenue, deliver more services over a wider geographic base, leverage its fixed costs over a broader customer base and access capital at attractive rates. As customers consolidate geographically and seek to reduce suppliers, a national presence also provides an important competitive advantage.
- "One-stop-shopping" for Receivables Management Services. OSI provides a full array of receivables management services including front-end credit service, pre charge-off delinquency management, contingent collection services and portfolio purchasing. This allows the Company to manage the entire credit cycle for its customers for all sizes of debt and across multiple industries. The Company is one of the few industry participants to provide this breadth of services on a national basis.
- Broad Customer Base. OSI provides services to some of the largest and fastest growing credit grantors in a wide range of industries. OSI's broad customer base diversifies its revenue stream and provides the Company with significant opportunities to cross-sell services. The Company also has long-standing relationships with many of its customers which provides a strong base of recurring revenues.
- Technology. The Company has made, and will continue to make, significant investmentsin technology and know-how to enhance its competitive advantage. The Company currently has over $53 million invested in computer hardware and software. OSI believes that its proprietary software, including debtor-scoring models, computerized calling and debtor databases, provides them with a competitive advantage in pricing portfolios, providing outsourcing services and collecting delinquent accounts. The Company's systems interface with those of its customers to receive new account placements daily and provide frequent updates to customers on the status of collections. OSI has become increasingly integrated with its customers' systems resulting in high switching costs for its customers.
- Customer Service. OSI's broad range of services and focused customer approach enables the Company to actively support and customize services to its customers on a cost-effective basis. This service philosophy has provided the foundation for the Company's reputation and when combined with its industry experience is critical in the clients' selection process.
Growth Strategies
The Company's strategy focuses on expanding its business and enhancing profitability through the following initiatives:
- Cross Selling Services to Existing Customers. OSI offers its customers a wide array of services including traditional fee services, portfolio purchasing services, pre-charge-off programs, outsourcing of accounts receivable management functions and teleservicing. This range of services allows OSI to cross-sell offerings within its existing customer base and to potential customers in specifically targeted industries.
- Expansion of Customer Base.
- Existing Target End-Markets. Increasingly, credit grantors in the public and private sectors who have typically maintained accounts receivable departments within their organizations are turning to outside accounts receivable management companies. In addition, consolidation in the banking, retail, utilities, student loan, health care and telecommunications industries has created national customers who are outsourcing a portion or all of their accounts receivable management service needs to national providers. As OSI enhances its expertise and reputation with customers in a target end-markets the Company markets that expertise to other credit grantors in that end-market. The Company's relative size, our ability to provide services in all 50 states and experience in successfully managing a high volume of placements on a national basis allows it to benefit from the consolidation of these key industries.
- New Target Industries. OSI intends to capitalize on its expertise and reputation to penetrate new end-markets. For example, the Company will continue to focus on increasing its business activities with governmental agencies at the federal, state and local levels, which have begun to outsource tax, child support collection and student loan accounts receivable functions to private companies. In addition, the Company will focus on the commercial market segment (collection of delinquent accounts owed by businesses to other businesses) and healthcare segment of the industry. Traditionally, the commercial market has been underpenetrated by collection agencies given the need for tailored collection methods which differ from those used in the consumer market, while significant changes and cost reductions in the healthcare market require specialized skills in the collection of past due accounts.
- Disciplined Acquisitions. The Company has built its position as an industry leader through strategic acquisitions of leading accounts receivable service providers. By successfully integrating these businesses, its management has demonstrated an ability to evaluate, execute and integrate acquisitions. With over 6,000 contingent fee accounts receivable collection companies in the United States, OSI plans to pursue additional acquisitions that complement its existing services or expand its customer base and is continually reviewing acquisition opportunities.
- Cost Reductions. The Company's management has adopted an aggressive approach to cost management. The Company will continue to focus on reducing its overall costs and improving operational efficiencies.
Acquisition and Integration History
In September 1995, the Company was formed and acquired Atlanta-based Account Portfolios, one of the largest purchasers and servicers of non-performing accounts receivable portfolios.
In January 1996, OSI acquired Continental Credit Services, Inc. ("Continental") and A.M. Miller Associates, two industry leaders in providing contingent fee services. Continental, which was headquartered in Seattle and operated in eight western states, provided contingent fee services to a wide range of end markets with particular emphasis on public utilities and regional telecommunications. A. M. Miller, based in Minneapolis, provided contingent fee services to the student loan and bank credit card end markets.
In November 1996, OSI acquired Payco American Corporation with corporate offices in Brookfield, Wisconsin. Originally founded as a contingent fee service company, Payco diversified into other outsourcing services such as student loan billing, health care accounts receivable billing and management, and contract management of accounts receivable and teleservicing.
In October 1997, OSI acquired the assets of North Shore Agency, Inc., a fee service company headquartered in Westbury, New York. North Shore specialized in "letter series" collection services for direct marketers targeted at collecting small balance debts. The majority of North Shore's revenues were generated from traditional contingent collections utilizing letters with the remaining revenues derived from fixed fee letter services.
In November 1997, OSI acquired the assets of Accelerated Bureau of Collections, Inc. Accelerated Bureau of Collections is a Denver-based national fee service company. It specialized in credit card collection and derived approximately 25% of its revenues from pre-charge-off programs with the remaining 75% of revenues derived from standard contingent fee collections.
In March 1998, the Company completed the acquisition of The Union Corporation ("Union"). Union was originally a conglomerate involved in businesses ranging from electronic and industrial components to financial services. Union was a leading provider of a range of outsourcing services to both large and small clients. Union provided contingent and fixed fee collection services and other related outsourcing services. Union provided fee services through the following wholly-owned subsidiaries: Allied Bond & Collection Agency, Inc., Capital Credit Corporation, and Transworld Systems, Inc. Allied, headquartered in Trevose, Pennsylvania, provided contingent and fixed fee collection services for large clients across a broad spectrum of industries. Capital Credit, headquartered in Jacksonville, Florida also provided contingent and fixed fee collection services for large national clients primarily serving the bankcard, telecommunications, travel and entertainment, and government sectors. Transworld, headquartered in Rohnert Park, California, is one of the largest prepaid, fixed fee provider of delinquent account management services in the United States. Transworld's clients are primarily small companies with low balance delinquent accounts. Union provided related outsourcing services through its Interactive Performance, Inc. and High Performance Services, Inc. subsidiaries. Interactive Performance headquartered in North Charleston, South Carolina, provided a range of credit and receivables management outsourcing services primarily in the form of teleservicing. Interactive Performance services included inbound and outbound calling programs for credit authorization, customer service, usage management and receivable management. High Performance Services, headquartered in Jacksonville, Florida, provided service similar to Interactive Performance for clients in the financial services industry.
In 1999, as part of a strategy to increase the efficiency of its operations by aligning the Company along business services and establishing call centers of excellence by industry specialization and in order to market its services under one OSI brand, the Company reorganized many of its acquired subsidiaries. Account Portfolios changed its name to OSI Portfolio Services, Inc. Payco American Corporation's largest debt collection subsidiary changed its name to OSI Collection Services, Inc. and Continental, A.M. Miller, Accelerated Bureau of Collections, Allied Bond & Collection Agency and Capital Credit merged into OSI Collection Services. Interactive Performance changed its name to OSI Outsourcing Services, Inc. and the Interactive Performance and High Performance Services subsidiaries merged into OSI Outsourcing Services. The Company now provides specialized services for the following industries: healthcare, government, education, telecommunications/utilities, commercial, financial services and bank card.
Recapitalization
On December 10, 1999, pursuant to a Stock Subscription and Redemption Agreement, dated as of October 8, 1999, as amended (the "Recapitalization Agreement"), by and among Madison Dearborn Capital Partners III, L.P. (together with its affiliates, "MDP") the Company, and certain of the Company's stockholders, optionholders and warrantholders: (i) the Company sold 5,323,561.08 shares of its common stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $199.5 million; (ii) the Company sold 100,000 shares of its Senior Mandatorily Redeemable Preferred Stock to certain purchasers for an aggregate purchase price of $100 million; (iii) the Company redeemed 4,792,307.20 shares of the Company's common stock (including voting common stock, par value $.01 per share, Class A Convertible Nonvoting Common Stock, par value $.01 per share, Class B Convertible Nonvoting Common Stock, par value $.01 per share, Class C Convertible Nonvoting Common Stock, par value $.01 per share and 1,114,319.33 shares of its preferred stock, no par value) for an aggregate of $221.35 million (such transactions collectively referred to herein as the "Recapitalization"). MDP now owns approximately 70.3% of the outstanding common stock (75.9% of the outstanding voting common stock) of the Company. Prior to the Recapitalization, the Company was controlled by McCown DeLeeuw & Co., Inc., a private equity investment firm.
In connection with the Recapitalization, all members of the Company's Board of Directors other than Timothy Beffa resigned and Paul Wood and Tim Hurd were elected to serve as directors. In addition, the stockholders and optionholders of the Company entered into a stockholders agreement (the "Stockholders Agreement"). The Stockholders Agreement provides for the election of individuals to the Board of Directors of the Company and includes restrictions on the transfer of capital stock, and the provision of registration, preemptive, tag along and drag along rights granted to the parties thereto.
In conjunction with the Recapitalization, the Company also entered into a Credit Agreement among the Company, DLJ Capital Funding, Inc., as Syndication Agent, Harris Trust & Savings Bank, as Documentation Agent, Fleet National Bank, N.A., as Administrative Agent and other Lenders who are parties thereto (the "Credit Agreement"). The Credit Agreement provides for: (i) a $150 million Term A Loan Facility; (ii) a $250 million Term B Loan Facility; and (iii) a $75 million Revolving Loan Facility. Borrowings under the Credit Agreement were used to refinance the Company's existing credit agreement and will be used for other working capital and general corporate purposes.
Services and Operations
The Company is one of the largest providers of accounts receivable management services in the United States. Through its subsidiaries, the Company offers customers collection services, portfolio purchasing services and related outsourcing services.
Collection Services
The Company is one of the largest providers of collection services in the United States. The Company offers a full range of contingent fee services, including pre-charge-off programs and letter series, to most consumer credit end-markets. The Company utilizes sophisticated management information systems and vast experience with locating, contacting and effecting payment from delinquent account holders in providing its core contingent fee services. With 52 call centers in 26 states and approximately 5,500 account representatives, the Company has the ability to service a large volume of accounts with national coverage. In addition to traditional contingent fee services involving the placement of accounts over 120 days delinquent, creditors have begun to demand services in which accounts are outsourced earlier in the collection cycle. The Company has responded to this trend by developing "early-out" programs, whereby the Company receives placed accounts that are less than 120 days past due and earn a fixed fee per placed account rather than a percentage of realized collections. These programs require a greater degree of technological integration between OSI and its customers, leading to higher switching costs. The Company primarily services consumer creditors, although the Company has a growing presence in the commercial collection business, offering contingent fee services to commercial creditors.
Contingent fee services are the traditional services provided in the accounts receivable management industry. Credit grantors typically place non-performing accounts after they have been deemed non-collectible, usually when 90 to 120 days past due, agreeing to pay the servicer a commission level calculated on the amount of collections actually made. At this point, the receivables are usually still valued on the customer's balance sheet, albeit in a form at least partially reserved against for possible noncollection. Customers typically use multiple agencies on any given placement category, enabling them to benchmark each agency's performance against the other. Placement is usually for a fixed time frame, typically a year, at the end of which the agency returns the uncollected receivables to the customer, which may then place them with an alternative agency.
The commission rate for contingent fee services is generally based on the collectability of the asset in terms of the costs which the contingent fee servicer must incur to effect repayment. The earlier the placement (i.e., the less elapsed time between the past due date of the receivable and the date on which the debt is placed with the contingent fee servicer), the higher the probability of recovering the debt, and therefore the lower the cost to collect and the commission rate. Creditors typically assign their charged-off receivables to contingent fee servicers for a twelve month cycle, and then reassign the receivables to other servicers as the accounts become further past due. There are three main types of placements in the contingent fee business, each representing a different stage in the cycle of account collection. Primary placements are accounts, typically 120 to 270 days past due, that are being placed with agencies for the first time and usually receive the lowest commission. Secondary placements, accounts 270 to 360 days past due, have already been placed with a contingent fee servicer and usually require a process including obtaining judgments, asset searches, and other more rigorous legal remedies to obtain repayment and, therefore, receive a higher commission. Tertiary placements, accounts usually over 360 days past due, generally involve legal judgments, and a successful collection receives the highest commission. Customers are increasingly placing accounts with accounts receivable management companies earlier in the collection cycle, often prior to the 120 days past due typical in primary placements, either under a contingent fee or fixed fee arrangement.
Once the account has been placed with OSI, the fee service process consists of (i) locating and contacting the debtor through mail, telephone, or both, and (ii) persuading the debtor to settle his or her outstanding balance. Work standards, or the method and order in which accounts are worked by OSI, are specified by the customer, and contractually bind OSI. Some accounts may have different work standards than others based on criteria such as account age or balance. In addition, OSI must comply with the federal Fair Debt Collection Practices Act and comparable state statutes, which restrict the methods it uses to collect consumer debt.
The Company estimates the collectability of each placement using sophisticated statistical scoring systems that are applied to each account. The objective is to maximize revenues and to minimize expenses. For example, instead of sending letters to the entire account base, a targeted telemarketing campaign may be used to directly contact selected account groups, thus saving the costs associated with an unnecessary broad-based mail campaign.
Outsourcing Services
As the volume of consumer credit has expanded across a number of industries, credit grantors have begun demanding a wider range of outsourcing services. In response, the Company has developed a number of other accounts receivable management services. The Company leverages its operational expertise and call and data management technology by offering the following services:
- contract management, whereby the Company performs a range of accounts receivable management services at the customer's or the Company's location,
- student loan billing, whereby the Company provides billing, due diligence and customer services,
- health care accounts receivable management, whereby the Company assumes responsibility for managing third-party billing, patient pay resolution, inbound and outbound patient communication services and cash application functions, and
- teleservicing whereby the Company offers inbound and outbound calling programs to perform sales, customer retention programs, market research and customer service.
In each client relationship, the cornerstone of the outsourcing strategy is to customize services to its customers on terms that will lead to substantial and increased growth rates in revenues and profit margins for the client as well as more stabilized cash flows. Customer service and billing inquiry activities are ideal candidates for outsourcing relationships for a number of reasons, including: (i) the need for technological investments in automated call management systems, (ii) activities that are labor intensive, and (iii) activity volumes that are subject to fluctuations which make it difficult to maintain stable employment levels and high utilization of the required equipment. By offering outsourcing services to a variety of clients, the Company will be able to leverage its productive resources to greater efficiency levels. In addition, the Company will continue to develop its expertise in outsourcing service delivery, enhancing its creativity and effectiveness in managing various inbound programs that a captive operation does not generally have. This can translate into higher response rates and returns on investment for the client.
Portfolio Purchasing Services
While contingent fee servicing remains the most widely used method by credit grantors in recovering non-performing accounts, portfolio purchasing has increasingly become a popular alternative. Beginning in the 1980's, the Resolution Trust Company and the Federal Deposit Insurance Company, under government mandate to do so, began to sell portfolios of non-performing loans. Spurred on by the success of these organizations in selling charged-off debt, other creditors likewise began to sell portfolios of non-performing debt. The Company's management estimates the total principal value of purchased portfolios at over $20 billion per year. The largest percentage of purchased portfolios originated from the bank card receivable and retail markets and such portfolios are typically purchased at a deep discount from the aggregate principal value of the accounts, with an inverse correlation between purchase price and age of the delinquent accounts. Once purchased, traditional collection techniques are employed to obtain payment of non-performing accounts.
The Company offers portfolio purchasing services to a wide range of financial institutions, educational institutions and retailers. The Company purchases large and diverse portfolios of non-performing consumer receivables both on an individually negotiated basis as well as through "forward flow" agreements. Under forward flow agreements, the Company agrees, subject to due diligence, to purchase charged-off receivables on a monthly basis. Credit grantors selling portfolios to the Company realize a number of benefits including increased predictability of cash flow, reduction in monitoring and administrative expenses, and reallocation of assets from non-core business functions to core business functions.
The Company's purchased portfolios consist primarily of consumer loans and credit card receivables, student loan receivables and health club receivables including portfolios purchased under forward flow agreements. The Company's most recent portfolio acquisitions have been primarily purchases pursuant to OSI's health club and bank card forward flow agreements. The Company continues to pursue acquisitions of portfolios in various industries for both individually negotiated and forward flow purchases.
In 1999, the Company established its own portfolio purchasing valuation unit to complement services previously provided by an independent portfolio valuation firm.
In order to fund an increased level of portfolio purchasing, in October 1998 the Company established a financing conduit, in association with MBIA Insurance Corporation. The conduit is expected to provide OSI with significantly increased purchasing capacity necessary to expand its portfolio purchasing activities at a lower aggregate cost of capital. The transaction structure involves off-balance sheet treatment for a significant portion of prospective portfolio purchases and the related financing, while providing a consistent servicing revenue stream and eventual access to any portfolio residual. Although the Company places most of its portfolio purchases in the conduit, OSI will, when required, continue to place certain portfolio purchases on its balance sheet. The revenue from owned portfolios is derived from gross collections and offset by collection costs and portfolio amortizations. Conversely, the off-balance sheet accounting treatment for portfolios sold into the conduit creates service fee revenues which is a percentage of gross collections, offset by collection costs but with no portfolio amortization. From time to time the Company may receive income from the conduit representing excess collections above the cost to purchase the portfolio, fund the acquisition and pay service fees.
Sales and Marketing
The Company has a sales force of approximately 100 sales representatives providing comprehensive geographic coverage of the United States on a local, regional and national basis, and, to a much lesser extent in, Puerto Rico, Canada and Mexico. The Company, except its Transworld Systems subsidiary, maintains a sales force and has a marketing strategy closely tailored to the credit-granting markets that it serves. The Company's primary sales and marketing objective is to expand its customer base in those customer industries in which it has a particular expertise and to target new customers in high growth end markets. OSI emphasizes its industry experience and reputation - two key factors considered by creditors when selecting an accounts receivable service provider. Increasingly, the Company will focus on cross-selling its full range of services to its existing customers and will use its product breadth as a key selling point in creating new business. The Company's overall sales and marketing strategies are coordinated at its principal executive offices in Chesterfield, Missouri.
The marketing force is responsible both for identifying and cultivating potential customers, as well as retaining or increasing market share with existing clients. The marketing force is generally organized around specific industries and is also trained to market the overall benefits of its services, providing a cross-selling function for all its business units. Compensation plans for the marketing force are incentive based, with professionals receiving a base salary and incremental compensation based on performance. For the Company's Transworld Systems subsidiary, it has a sales force of over 800 independent contractors based in 150 offices.
Customers
The Company's customer base includes a full range of local, regional and national credit grantors. The Company's largest customer accounted for no more than 5% of 1999 revenues.
Employees
The Company employs approximately 7,000 people, of which 5,500 are account representatives, 100 are sales representatives and 1,400 work in corporate/supervisory and administrative functions. None of the Company's employees are unionized, and the Company believes its relations with employees are satisfactory.
The Company is committed to providing continuous training and performance improvement plans to increase the productivity of its account representatives. Account representatives receive extensive training in a classroom environment for several days on its procedures, information systems and regulations regarding contact with debtors. The training includes technical topics, such as use of on-line collection systems and computerized calling techniques, as well as instruction regarding the Company's approach to the collection process and listening, negotiation and problem-solving skills, all of which are essential to efficient and effective collections.
Account representatives are then assigned to work groups for a training period. Initially, the trainees only screen incoming calls. This allows less experienced account representatives to communicate with debtors in a less confrontational environment than may be experienced with outgoing calls. Additionally, the trainees are assigned accounts, which based upon scoring by the Company's information systems, have a higher likelihood of collection. After the training period, the account representatives begin working accounts directly.
Competition
The accounts receivable management industry is highly fragmented and competitive. Nationwide, there are approximately 6,000 debt collection service companies in the United States, with the 10 largest agencies currently accounting for only 20% of industry revenues. Within the collection and outsourcing services of the Company's business, large volume credit grantors typically employ more than one accounts receivable management company. Competition is based largely on recovery rates, industry experience and reputation, and service fees. Within this market, our largest competitors include Deluxe Corporation, Dun & Bradstreet, Equifax Corporation, G.C. Services and NCO Group.
The bidding process associated with the acquisition of purchased portfolios has become more competitive as the number of participants in this business has increased. However, in late 1998, the Company's primary competitor for purchased portfolios, Commercial Financial Services, declared bankruptcy. The Company's largest remaining competitors in this market include MCM Capital Group Inc., Creditrust Corporation and West Capital Corporation.
Environmental, Health & Safety Matters
Current operations of OSI and its subsidiaries do not involve activities materially affecting the environment. However, the Company's subsidiary, The Union Corporation, is party to several pending environmental proceedings involving the United States Environmental Protection Agency, or EPA, and comparable state environmental agencies in Indiana, Maryland, Massachusetts, New Jersey, Ohio, Pennsylvania, South Carolina and Virginia. All of these matters relate to discontinued operations of former divisions or subsidiaries of Union for which it has potential continuing responsibility. Upon completion of the acquisition of Union, OSI, in consultation with both legal counsel and environmental consultants, established reserves that it believes will be adequate for the ultimate settlement of these environmental proceedings.
One group of Union's known environmental proceedings relates to Superfund or other sites where Union's liability arises from arranging for the disposal of allegedly hazardous substances in the ordinary course of prior business operations. In most of these "generator" liability cases, Union's involvement is considered to be de minimus (i.e., a volumetric share of approximately 1% or less) and in each of these cases Union is only one of many potentially responsible parties. From the information currently available, there are a sufficient number of other economically viable participating parties so that Union's projected liability, although potentially joint and several, is consistent with its allocable share of liability. At one "generator" liability site, Union's involvement is potentially more significant because of the volume of waste contributed in past years by a currently inactive subsidiary. Insufficient information is available regarding the need for or extent and scope of any remedial actions which may be required. Union has recorded what it believes to be a reasonable estimate of its ultimate liability, based on current information, for this site.
The second group of matters relates to environmental issues on properties currently or formerly owned or operated by a subsidiary or division of Union. These cases generally involve matters for which Union or an inactive subsidiary is the sole or primary responsible party. In one case, the Metal Bank Cottman Avenue site, the EPA issued a record of decision on February 6, 1998. According to the record of decision, the cost to perform the remediation selected by the EPA for the site is estimated by the EPA to be approximately $17.3 million. The aggregate amount reserved by Union for this site was $18.2 million, which represented Union's best estimate of the ultimate potential legal and consulting costs for defending its legal and technical positions regarding remediation of this site and its portion of the potential remediation costs that will ultimately be incurred by it, based on current information. However, Union may be exposed to additional substantial liability for this site as additional information becomes available over the long-term. Actual remediation costs cannot be computed until such remedial action is completed. Some of the other sites involving Union or an inactive subsidiary are at a state where an assessment of ultimate liability, if any, cannot reasonably be made at this time.
It is Union's policy to comply fully with all laws regulating activities affecting the environment and to meet its obligations in this area. In many "generator" liability cases, reasonable cost estimates are available on which to base reserves on Union's likely allocated share among viable parties. Where insufficient information is available regarding projected remedial actions for these "generator" liability cases, Union has recorded what it believes to be reasonable estimates of its potential liabilities. Reserves for liability for sites on which former operations were conducted are based on cost estimates of remedial actions projected for these sites. OSI periodically reviews all known environmental claims, where information is available, to provide reasonable assurance that reserves are adequate.
Governmental Regulatory Matters
Certain of the Company's operations are subject to the Fair Debt Collection Practices Act, or FDCPA, and comparable statutes in many states. Under the FDCPA, a third-party collection agency is restricted in the methods it uses to collect consumer debt. For example, a third-party collection agency (1) is limited in communicating with persons other than the consumer about the consumer's debt, (2) may not telephone at inconvenient hours, and (3) must provide verification of the debt at the consumer's request. Requirements under state collection agency statutes vary, with most requiring compliance similar to that required under the FDCPA. In addition, most states and certain municipalities require collection agencies to be licensed with the appropriate authorities before collecting debts from debtors within those jurisdictions. It is the Company's policy to comply with the provisions of the FDCPA, comparable state statutes and applicable licensing requirements. The Company has established policies and procedures to reduce the likelihood of violations of the FDCPA and related state statutes. For example, all of the Company's account representatives receive extensive training on these policies and must pass a test on the FDCPA and the Company's agents work in an open environment which allows managers to monitor interaction with debtors.
From time to time, certain of the Company's subsidiaries have been subject to consent decrees with various governmental agencies, none of which currently have a material effect on the Company's financial condition or operations.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 1999, the Company and its subsidiaries operated 69 facilities in the U.S., all of which are leased, except for three administrative and collection offices operated by Transworld Systems, which are owned. The Company believes that such facilities are suitable and adequate for its business. The Company's facilities are strategically located across the U.S. to give effective broad geographic coverage for customers and access to a number of labor markets.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1999, the Company was involved in a number of legal proceedings and claims that were in the normal course of business and routine to the nature of the Company's business. In addition, one of the OSI subsidiaries, Union, is party to several pending environmental proceedings discussed elsewhere herein. While the results of litigation cannot be predicted with certainty, the Company has provided for the estimated uninsured amounts and costs to resolve the pending suits and management, in consultation with legal counsel, believes that reserves established for the ultimate settlement of such suits are adequate at December 31, 1999.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1999.
In November 1999, pursuant to written consent of shareholders of the Company's voting common stock, the shareholders approved the amendment of the Company's Certificate of Incorporation to (i) increase the total authorized shares of the Voting Common Stock of the Company, (ii) increase the total authorized shares of the Class B Non-Voting Common Stock of the Company and (iii) provide for the authorization of 200,000 shares of other preferred stock. These consents were executed by holders of a majority of the outstanding capital stock of the Company.
In December 1999, pursuant to written consent of the holders of the Company's outstanding 11% Senior Subordinated Notes due November 1, 2006, the noteholders waived: (i) the Company's obligations under Section 4.15 of the Indenture, including its obligations to make a Change of Control Offer in connection with the Recapitalization; and (ii) the failure by the Company to comply with certain technical requirements relating to the qualification and operation of its financing subsidiary, OSI Funding Corp., as an Unrestricted Subsidiary under the Indenture and any and all consequences arising therefrom under the Indenture.
In December 1999, pursuant to written consent of shareholders of the Company's voting common stock, the shareholders approved bonuses, option acceleration and price amendments, and option grants to certain officers of the Company. These consents were executed by holders of 3,462,726.01 shares of the Company's voting common stock, 391,740.58 shares of the Company's Class A non-voting common stock, 400,000 shares of the Company's Class B non-voting common stock, and 1,040,000 shares of the Company's Class C non-voting common stock.
In December 1999, pursuant to written consent of shareholders of the Company's voting common stock, the shareholders approved the amendment and restatement of the Company's Certificate of Incorporation to amend the authorized capitalization of OSI, principally to (i) provide that voting common stock will no longer have the ability to convert into non-voting common stock, (ii) provide that there will be only one class of non-voting common stock and (iii) eliminate reference to any specific series of preferred stock and instead authorize preferred stock with rights, preferences and obligations that may be established by the Board of Directors. Stockholders holding a majority of the issued and outstanding shares of common stock of the Company and holders of a majority of the issued and outstanding shares of each of the (i) preferred stock, (ii) Class A non-voting common stock, (iii) Class B non-voting common stock and (iv) Class C non-voting common stock executed these consents.
PART II.
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
No public market currently exists for the Company's Voting common stock and Nonvoting common stock.
As of March 30, 2000, there were approximately 30 holders of record of the Voting common stock and Nonvoting common stock.
The Company has not declared any cash dividends on any of its common stock since the Company's formation in September 1995. The Indenture (the "Indenture"), dated as of November 6, 1996, by and among the Company, the Guarantors (as defined therein) and Wilmington Trust Company, as Trustee, with respect to the 11% Series B Senior Subordinated Notes due 2006 contains restrictions on the Company's ability to declare or pay dividends on its capital stock. Additionally, the Credit Agreement dated as of November 30, 1999 among the Company, the Lenders listed therein, DLJ Capital Funding, Inc., as the Syndication Agent, Harris Trust and Savings Bank, as the Documentation Agent, and Fleet National Bank, as the Administrative Agent (the "Credit Agreement") contains certain restrictions on the Company's ability to declare or pay dividends on its capital stock. The Indenture, the Credit Agreement and the Certificate of Designation of the powers and preferences and relative participating, optional and other special rights of Class A 14% Senior Mandatorily Redeembale Preferred Stock, Series A, and Class B 14% Senior Mandatorily Redeemable Preferred Stock, Series A, and qualifications and limitations and restrictions thereof prohibit the declaration or payment of any Common Stock dividends or the making of any distribution by the Company or any subsidiary (other than dividends or distributions payable in stock of the Company) other than dividends or distributions payable to the Company.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected historical financial data set forth below have been derived from, and are qualified by reference to the audited Consolidated Financial Statements of OSI as of December 31, 1998 and 1999 and for the three years ended December 31, 1999. The audited financial statements of OSI referred to above are included elsewhere herein. The selected historical financial data set forth below as of September 20, 1995 and for the period January 1, 1995 to September 20, 1995 have been derived from the audited financial statements of Account Portfolios ("API") (as predecessor) not included herein. The selected historical financial data set forth below as of December 31, 1995, 1996, and 1997 for the period September 21, 1995 to December 31, 1995 and for the year ended December 31, 1996 have been derived from the audited financial statements of OSI not included herein. The selected financial data set forth below should be read in conjunction with, and are qualified by reference to, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and accompanying notes thereto of OSI included elsewhere herein.
(a) Other operating expenses include telephone, postage, supplies, occupancy costs, data processing costs, depreciation, amortization and miscellaneous operating expenses.
(b) EBITDA is defined as income from continuing operations before interest, taxes, depreciation and amortization. Adjusted EBITDA reflects EBITDA as defined above adjusted for the non-recurring write-off of acquired technology in process in connection with the Payco acquisition and relocation expenses incurred by Continental of $1,000 and $200, respectively, in the year ended December 31, 1996 and the change in control bonuses, stock option redemption and other bonuses; non-recurring conversion, realignment and relocation expenses; and transaction related expenses of $10,487, $5,063 and $6,827, respectively, in the year ended December 31, 1999. EBITDA and Adjusted EBITDA are presented here, as management believes they provide useful information regarding the Company's ability to service and/or incur debt. EBITDA and Adjusted EBITDA should not be considered in isolation or as substitutes for net income, cash flows from continuing operations, or other consolidated income or cash flow data prepared in accordance with generally accepted accounting principles or as measures of a company's profitability or liquidity.
(c) In the fourth quarter of 1997, the Company completed an in-depth analysis of the carrying value of the purchased portfolios acquired and valued in conjunction with the Company's September 1995 acquisition of API. As a result of this analysis, the Company recorded $10,000 of additional amortization related to these purchased portfolios to reduce their carrying value to their estimated net realizable value. This amount includes the $10,000 of additional amortization.
(d) In the fourth quarter of 1998, the Company wrote down its investment in a limited liability corporation (the "LLC") by $3,000 resulting from an analysis of the carrying value of the purchased portfolios owned by the LLC. This amount includes the $3,000.
(e) In May 1996, a subsidiary of the Company acquired participation interests in certain loan portfolios, representing the undivided ownership interests in such portfolios which were originally sold pursuant to existing Participation Agreements ("MLQ Interests") for aggregate consideration of $14,772. This amount excludes the $14,772.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations
Year Ended December 31, 1999 Compared to Year Ended December 31, 1998
Revenues for the year ended December 31, 1999 were $504.4 million compared to $479.4 million for the year ended December 31, 1998 - an increase of 5.2%. The revenue increase of $25.0 million was due primarily to increased collection and outsourcing revenues of $19.7 million and $7.3 million from the full year effect of the acquisition of Union in 1998. Revenues from collection services were $362.9 million for the year ended December 31, 1999 compared to $350.1 million for 1998. The increase in collection services revenue was due to a 2.1% increase in existing business and $5.7 million from the Union acquisition. The outsourcing services revenue of $61.1 million compared favorably to $46.9 million for 1998 due to increased revenue from new and existing business of 26.7% and $1.6 million from the Union acquisition. Revenues from purchased portfolio services decreased 2.4% to $80.4 million for the year ended December 31, 1999 from $82.4 million in 1998. The decreased revenue was attributable to lower revenues from on-balance sheet portfolios and lower strategic sales of portfolios offset by higher servicing fee revenues for the off-balance sheet collections of portfolios which increased due to the formation of the Company's special purpose finance company ("FINCO"). Prior to forming FINCO, the Company would record as revenue the total collections on purchased portfolios. Currently, for all purchased portfolios which are sold to and financed by FINCO, the Company records as revenue a servicing fee on the total collections of FINCO purchased portfolios. During the year ended December 31, 1999, the Company recorded revenue from FINCO servicing fees of $13.5 million on total collections of $39.3 million compared to servicing fees of $0.8 million on total collections of $1.9 million in 1998. When compared to the year ended December 31, 1998, the total collections of both on and off-balance sheet purchased portfolios increased from $65.1 million to $89.0 million in 1999 - an increase of 36.7% or $23.9 million. The increased collections resulted primarily from an increase in the total levels of purchased portfolios primarily as a result of the increased buying capacity made available through FINCO.
Operating expenses, inclusive of salaries and benefits, service fees and operating and administrative expenses, were $398.9 for the year ended December 31, 1999 and $371.0 million for the comparable period in 1998 - an increase of 7.5%. The increase in these operating expenses resulted primarily from the Union acquisition, higher collection-related expenses associated with the increased revenues of collection and outsourcing services, increased collection expenses associated with the increase in collections of purchased portfolios, higher infrastructure costs and increased advertising and promotional expenses and consulting expenses. For the year ended December 31, 1999, amortization and depreciation charges of $69.8 million compared to $80.7 million for 1998 - a decrease of 13.5%. The lower amortization and depreciation charges resulted primarily from lower on-balance sheet portfolio amortization offset partially by additional depreciation and amortization of goodwill related to the Union acquisition and depreciation of current year capital expenditures.
During the fourth quarter of 1998 and the first quarter of 1999, the Company evaluated its business strategy for its operations. After the Company's formation and seven acquisitions, the Company adopted a strategy to align the Company along business services and establish call centers of excellence by industry specialization. As a result, nonrecurring conversion, realignment and relocation expenses include costs resulting from the temporary duplication of operations, closure of certain call centers along with relocation of certain employees, hiring and training of new employees, costs resulting from the conversion of multiple collection operating systems to a one industry operating system, and other one-time and redundant costs, which will be eliminated as the realignment and integration plans are completed. These costs of $5.1 million were recognized as incurred during 1999.
In connection with the Recapitalization, the Company incurred $10.5 million of additional compensation expense. This compensation expense consisted primarily of expense relating to payment of cash for vested stock options and the payment of change in control bonuses to certain officers in accordance with terms of their employment agreements.
In addition, the Company incurred $6.8 million of transaction related costs associated with the Recapitalization. These costs consisted primarily of professional and advisory fees, and other expenses.
As a result of the above, the Company generated operating income of $13.3 million for the year ended December 31, 1999. Adding back the nonrecurring charges of $5.1 million, additional compensation expense of $10.5 million and transaction related costs of $6.8 million, operating income was $35.7 million for 1999 compared to $27.7 million for 1998.
Earnings before interest expense, taxes, depreciation and amortization (EBITDA) for the year ended December 31, 1999 was $83.1 million. Adding back the nonrecurring and transaction related expenses, EBITDA was $105.5 million for 1999 compared to $108.4 million for the year ended December 31, 1998. The decrease was primarily attributable to the higher marketing costs associated with branding initiatives, higher infrastructure and industry focused expenses and the decreased portfolio service revenues resulting from the manner in which revenues from off-balance sheet collections are recognized.
Net interest expense of $52.3 million for the year ended December 31, 1999 compared unfavorably to 1998 expense of $50.6 million due primarily to the additional indebtedness incurred to finance the Union acquisition.
The provision for income taxes of $0.8 million was provided for state and foreign income tax obligations, which the Company cannot offset currently by net operating losses.
Minority interest in 1998 resulted from the Union acquisition. On January 23, 1998, the Company acquired approximately 77% of the outstanding common stock of Union through a tender offer. The acquisition of all remaining outstanding common stock of Union was completed on March 31, 1998. The Company recognized minority interest in earning of Union during the period from January 23, 1998 to March 31, 1998.
Due to the factors stated above, the loss before extraordinary item for the year ended December 31, 1999 of $39.7 million compared unfavorably to $24.3 million in 1998.
The extraordinary item of $4.2 million, which was the write-off of previously capitalized financing costs, resulted from the extinguishment of the existing credit facility in conjunction with the establishment of a new credit facility in the fourth quarter of 1999.
Primarily as a result of the nonrecurring and transaction related expenses and the extraordinary item, net loss of $44.0 million for the year ended December 31, 1999 compared unfavorably to the net loss of $24.3 million for 1998.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Revenues for the year ended December 31, 1998 were $479.4 million compared to $271.7 million for the year ended December 31, 1997 - an increase of 76.5%. The revenue increase of $207.7 million was due primarily to increased collection, outsourcing and portfolio services revenues of $14.4 million - an increase of 5.3% over 1997, and $193.3 million from the acquisitions of Union, NSA and ABC. Revenues from collection services were $350.1 million for the year ended December 31, 1998 compared to $180.9 million for 1997. The increase in collection services revenues was due to a 1.0% increase in existing business and $167.9 million from the three acquisitions. In the highly competitive collection services business, during 1998 the Company experienced pressure on their contingent fee rates coupled with lower bankcard placements due to credit grantors selling them, resulting in less than anticipated growth in existing business. Revenue from purchased portfolio services increased to $82.4 million for the year ended December 31, 1998 compared to $67.8 million in 1997 - up 21.5%. The increased revenue was attributable to both higher collection revenue and strategic sales of portfolios. The 1998 outsourcing revenue of $46.9 million compared favorably to 1997 revenue of $23.0 million due primarily to the Union acquisition.
Operating Expenses for the year ended December 31, 1998 were $451.7 million compared to $290.1 million for the year ended December 31, 1997 - an increase of 55.7%. Operating expenses, exclusive of amortization and depreciation charges, were $371.0 million for the year ended December 31, 1998 compared to $204.5 million in 1997. The increase in operating expenses, exclusive of amortization and depreciation charges, resulted from the expenses related to the increased revenue and the three acquisitions. Exclusive of the three acquisitions' operating expenses, operating expenses were up 4.4% over 1997. Of the $451.7 million in operating expenses for the year ended December 31, 1998, $80.7 million was attributable to amortization and depreciation charges compared to $85.6 million in 1997. Of the $80.7 million for the year ended December 31, 1998, $50.7 million (including $3.0 million of additional amortization to reduce its investment in a limited liability corporation - See Note 11 to the Consolidated Financial Statements) was attributable to amortization of the purchase price of purchased portfolios (compared to $52.0 million in 1997 including $10.0 million of additional amortization to reduce a portion of purchased portfolios to their estimated fair value). Amortization of goodwill and other intangibles of $15.7 million was less than $24.8 million in 1997 due to no account placement amortization in 1998 ($16.7 million in 1997) since account placement inventory was fully amortized as of December 31, 1997, offset partially by additional amortization of goodwill related to the three acquisitions. The increase in depreciation of $5.5 million from $8.8 million in 1997 to $14.3 million in 1998 was attributable primarily to the additional depreciation related to the three acquisitions.
As a result of the above, the Company generated operating income of $27.7 million for the year ended December 31, 1998 compared to an operating loss of $18.4 million for the year ended December 31, 1997.
Earnings before interest expense, taxes, depreciation and amortization (EBITDA) for the year ended December 31, 1998 were $108.4 million compared to $67.2 million for 1997. The increase of $41.2 million consisted of $35.9 million as a result of the three acquisitions and $5.3 million primarily from $14.4 million increased revenue from operations unrelated to the acquisitions.
Net interest expense for the year ended December 31, 1998 was $50.6 million compared to $28.8 million for 1997. The increase was primarily due to additional indebtedness incurred to finance the Union, NSA and ABC acquisitions.
The provision for income taxes of $0.8 million was primarily provided for state income taxes, as the Company will have an obligation in some states for the year ended December 31, 1998. In the fourth quarter of 1997, the Company recorded a net valuation allowance to reflect management's assessment, based on the weight of the available evidence of current and projected future book taxable income, that there is significant uncertainty that any of the benefits from the net deferred tax assets will be realized. Recording the net valuation allowance against the net deferred tax assets resulted in the 1997 provision for income taxes of $11.1 million.
Minority interest in 1998 resulted from the Union acquisition. On January 23, 1998, the Company acquired approximately 77% of the outstanding a common stock of Union through a tender offer. The acquisition of all remaining outstanding common stock of Union was completed on March 31, 1998. The Company recognized minority interest in earnings of Union during the period from January 23, 1998 to March 31, 1998.
Due to the factors stated above, the net loss for the year ended December 31, 1998 was $24.3 million compared to $58.3 million for the year ended December 31, 1997 - an improvement of $34.0 million.
Liquidity and Capital Resources
At December 31, 1999, the Company had cash and cash equivalents of $6.1 million. The Company's credit agreement provides for a $75.0 million revolving credit facility, which allows the Company to borrow for working capital, general corporate purposes and acquisitions, subject to certain conditions. As of December 31, 1999, the Company had outstanding $13.0 million under the revolving credit facility leaving $60.0 million, after outstanding letters of credit, available under the revolving credit facility.
Cash and cash equivalents decreased from $8.8 million at December 31, 1998 to $6.1 million at December 31, 1999 principally due to the use of cash of $21.5 million for investing activities primarily for capital expenditures and $3.7 million for operating activities and portfolio purchasing offset by net cash from financing activities of $22.5 million, which was due to the Recapitalization of the Company on December 10, 1999. In connection with the Recapitalization, the Company entered into a new credit facility. The proceeds of the new credit facility were used to refinance the indebtedness outstanding under the then existing credit facility on the date of the Recapitalization. Further discussion of the Recapitalization is included in the Company's financial statements included herein. The Company also held $22.5 million of cash for clients in restricted trust accounts at December 31, 1999.
Purchased Loans and Accounts Receivable Portfolios decreased from $55.5 million at December 31, 1998 to $39.9 million at December 31, 1999 due primarily to amortization of purchased portfolios of $38.7 million offset partially by new on-balance sheet portfolio purchases of $23.2 million.
The purchased loans and accounts receivable portfolios consist primarily of consumer loans and credit card receivables, commercial loans, student loan receivables and health club receivables. Consumer loans purchased primarily consist of unsecured term debt. A summary of purchased loans and accounts receivable portfolios at December 31, 1999 and December 31, 1998 by type of receivable is shown below:
Net deferred taxes was zero at December 31, 1998. At December 31, 1999, net deferred taxes was zero due to a net valuation allowance of $78.8 million. The net deferred tax balances at December 31, 1999 and December 31, 1998 relate principally to net operating loss carryforwards and future temporary deductible differences. The realization of this asset is dependent on generating sufficient taxable income prior to expiration of the loss carryforwards in years through 2019. At December 31, 1999, the Company has a cumulative net valuation allowance of $78.8 million to reflect management's assessment, based on the weight of the available evidence of current and projected future book taxable income, that there is significant uncertainty that any of the benefits from the net deferred tax assets will be realized. For all federal tax years since the Company's formation in September 1995, the Company has incurred net operating losses. Since the Company has a history of generating net operating losses and is expected to continue to incur significant interest expense, management does not expect the Company to generate taxable income in the foreseeable future sufficient to realize tax benefits from the net operating loss carryforwards or the future reversal of the net deductible temporary differences. The amount of the deferred tax assets considered realizable, however, could be increased in future years if estimates of future taxable income during the carryforward period change.
The Company's current debt structure at December 31, 1999 consists of $413.0 million indebtedness under the bank credit facility, $100.0 million 11% Senior Subordinated Notes (the "Notes") and other indebtedness of $5.3 million. See Note 6 of the Consolidated Financial Statements of OSI included elsewhere herein for a description of the 1999 credit facility.
The Notes and the bank credit facility contain financial and operating covenants and restrictions on the ability of the Company to incur indebtedness, make investments and take certain other corporate actions. The debt service requirements associated with the borrowings under the facility and the Notes significantly impact the Company's liquidity requirements. Additionally, future portfolio purchases may require significant financing or investment. The Company anticipates that its operating cash flow together with availability under the bank credit facility will be sufficient to fund its anticipated future operating expenses and to meet its debt service requirements as they become due. However, actual capital requirements may change, particularly as a result of acquisitions the Company may make. The ability of the Company to meet its debt service obligations and reduce its total debt will be dependent, however, upon the future performance of the Company and its subsidiaries which, in turn, will be subject to general economic conditions and to financial, business and other factors including factors beyond the Company's control.
In October of 1998, a special-purpose finance company, OSI Funding Corp., formed by the Company, entered into a revolving warehouse financing arrangement for up to $100.0 million of funding capacity for the purchase of loans and accounts receivable over its five year term. In connection with the Recapitalization, OSI Funding Corp. converted to a limited liability company and is now OSI Funding LLC, with OSI owning approximately 78% of the financial interest but having only approximately 29% of the voting rights. This arrangement will provide the Company expanded portfolio purchasing capability in a very opportunistic buying market.
Capital expenditures for the year ended December 31, 1999 were $18.4 million. The Company expects to spend approximately $18.0 million on capital expenditures (exclusive of any expenditures in connection with acquisitions) in 2000. Historical expenditures have been, and future expenditures are anticipated to be primarily for replacement and/or upgrading of telecommunications and data processing equipment, leasehold improvements and continued expansion of the Company's information services systems. Subject to compliance with the provisions of its debt agreements, the Company expects to finance future capital expenditures with cash flow from operations, borrowings and capital leases. The Company will reduce its future capital expenditures to the extent it is unable to fund its capital plan. The Company believes that its facilities will provide sufficient capacity for increased revenues and will not require material additional capital expenditures in the next several years.
Inflation
The Company believes that inflation has not had a material impact on its results of operations for the years ended December 31, 1999, 1998 and 1997.
Year 2000
The Company's business applications and infrastructure functioned flawlessly upon the beginning of the New Year and experienced no significant Year 2000 related glitches during the year's first full week of business operations and have continued to perform since then.
Because many of the Company's client relationships are supported through computer system interfaces, OSI worked proactively with clients to assure Year 2000 compliance between respective computer systems. It also secured assurances from suppliers and vendors that their products would be Year 2000 ready.
Within OSI, the Company tested and confirmed that the full range of its computer based production systems and infrastructure were Year 2000 compliant. In addition to services typical of most companies, like phone systems, building services, email and office equipment, OSI's compliance program focused especially on customer interfaces and reporting, collection and financial systems and predictive dialers.
Spending for Year 2000 modifications and updates were expensed as incurred and did not have a material impact on the results of operations or cash flows. The cost of the company's Year 2000 project was funded from cash flows generated from operations. The Company estimates that its total Year 2000 expenses were approximately $1.7 million.
Forward-Looking Statements
The following statements in this document are or may constitute forward-looking statements made in reliance upon the safe harbor of the Private Securities Litigation Reform Act of 1995: (1) statements concerning the successful implementation of the Company's Year 2000 initiatives, (2) statements concerning the anticipated costs and outcome of legal proceedings and environmental liabilities, (3) statements regarding anticipated changes in the Company's opportunities in its industry, (4) statements regarding the Company's ability to fund its future operating expenses and meet its debt service requirements as they become due, (5) statements regarding the Company's expected capital expenditures and facilities, (6) any statements preceded by, followed by or that include the word "believes," "expects," "anticipates," "intends," "should," "may," or similar expressions; and (7) other statements contained or incorporated by reference in this document regarding matters that are not historical facts.
Because such statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to: (1) the demand for the Company's services, (2) the demand for accounts receivable management generally, (3) general economic conditions, (4) changes in interest rates, (5) competition, including but not limited to pricing pressures, (6) changes in governmental regulations including, but not limited to the federal Fair Debt Collection Practices Act and comparable state statutes, (7) legal proceedings, (8) environmental investigations and clean up efforts, (9) expected synergies, economies of scale and cost savings from recent acquisitions by the Company not being fully realized or realized within the expected time frames, (10) costs of operational difficulties related to integrating the operations of recently acquired companies with the Company's operations being greater than expected, (11) the Company's ability to generate cash flow or obtain financing to fund its operations, service its indebtedness and continue its growth and expand successfully into new markets and services, (12) the effectiveness of the Company's Year 2000 efforts, and (13) factors discussed from time to time in the Company's public filings.
These forward-looking statements speak only as of the date they were made. These cautionary statements should be considered in connection with any written or oral forward-looking statements that the Company may issue in the future. The Company does not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect later events or circumstances or to reflect the occurrence of unanticipated events.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to the risk of fluctuating interest rates in the normal course of business. From time to time and as required by the Company's Credit Agreement, the Company will employ derivative financial instruments as part of its risk management program. The Company's objective is to manage risks and exposures of its debt and not to trade such instruments for profit or loss.
The Company uses interest rate cap, collar and swap agreements to manage the interest rate characteristics of its outstanding debt to a more desirable fixed or variable rate basis or to limit the Company's exposure to rising interest rates. In connection with the Recapitalization resulting in the Company refinancing its then outstanding indebtedness, all interest agreements were terminated. Therefore, at December 31, 1999, the Company had no outstanding interest rate agreements. Pursuant to the Credit Agreement, the Company is obligated to secure interest rate protection in the nominal amount of $150 million by July 2000.
The following table provides information about the Company's financial instruments that are sensitive to changes in interest rates. For debt obligations, the table presents principal and cash flows and related weighted-average interest rates by expected maturity dates.
Interest Rate Sensitivity
Principal (Notional) Amount by Expected Maturity
Average Interest Rate
(Dollars in millions)
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the Financial Statements and Supplementary Schedule contained in Part IV hereof.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
ITEM 10.
ITEM 10. Directors and Executive Officers of the Registrant
Directors of the Company are elected annually by its shareholders to serve during the ensuing year or until a successor is duly elected and qualified. Executive officers of the Company are duly elected by its Board of Directors to serve until their respective successors are elected and qualified. The following table sets forth certain information with respect to the directors and executive officers of the Company.
Name Age Position or Office - ------------------------- --- ----------------------------- Timothy G. Beffa 49 Director, President and Chief Executive Officer William B. Hewitt 61 Director Timothy M. Hurd 30 Director and Vice President Scott P. Marks, Jr. 54 Director Richard L. Thomas 69 Director Paul R. Wood 46 Director and Vice President Michael A. DiMarco 42 Executive Vice President - President Fee Services Bryan K. Faliero 34 President Portfolio Services Michael B. Staed 53 Senior Vice President and President Outsourcing Services Gary L. Weller 39 Executive Vice President and Chief Financial Officer
Timothy G. Beffa (49), President, Chief Executive Officer and Director of Outsourcing Solutions Inc. since August 1996. From August 1995 until August 1996, Mr. Beffa served as President and Chief Operating Officer of DIMAC Corporation ("DIMAC") and DIMAC DIRECT Inc. ("DDI") and a director of DDI. From 1989 until August 1995, Mr. Beffa served as a Vice President of DIMAC and as Senior Vice President and Chief Financial Officer of DDI. Prior to joining DIMAC, Mr. Beffa was Vice President of Administration and Controller for the International Division of Pet Incorporated, a food and consumer products company, where he previously had been manager of Financial Analysis.
William B. Hewitt (61), Director of the Company since February 1998. Mr. Hewitt currently serves as a consultant to the Company since January 1998. From July 1997 to January 1998, Mr. Hewitt served as President and Chief Executive Officer of Union and prior to that he served as President and Chief Operating Officer of Union since May 1995. Mr. Hewitt also served as Chairman and Chief Executive Officer of Capital Credit Corporation since September 1991, Chairman and Chief Executive Officer of Interactive Performance, Inc. since November 1995 and Chairman and Chief Executive Officer of High Performance Services, Inc. since May 1996. Capital Credit Corporation, Interactive Performance, Inc. and High Performance Services, Inc. were subsidiaries of Union.
Timothy M. Hurd (30), Director and Vice President of the Company since December 1999. Mr. Hurd is a director of Madison Dearborn Partners. Prior to joining Madison Dearborn Partners, Mr. Hurd was with Goldman Sachs & Co. He currently serves as a director of Woods Equipment Company, Inc. and PeopleFirst.com.
Scott P. Marks, Jr. (54), Director of the Company since January 2000. Mr. Marks is a private investor in Chicago, IL. Mr. Marks resigned from his post as Vice Chairman and a member of the Board of Directors of First Chicago NBD Corporation in December, 1997, a post he had held since December, 1995. Previously he was Executive Vice President of First Chicago Corporation and managed their credit card business for approximately 10 years. Mr. Marks serves as a director of ADA Business Enterprises, the for-profit subsidiary of the American Dental Association, Pascomar Inc. and Clark Polk Land LLC.
Richard L. Thomas (69), Director of the Company since January 2000. Mr. Thomas has been retired since May 1996. Prior to retiring, Mr. Thomas served as Chairman of First Chicago NBD Corporation from December 1995 to May 1996. Prior to that he served as Chairman of First Chicago Corporation from December 1991 to December 1995. He currently serves as a director of IMC Global Inc., The PMI Group Inc., The Sabre Group, Sara Lee Corporation and Unicom Corporation.
Paul R. Wood (46), Director and Vice President of the Company since December 1999. Mr. Wood is a managing director of Madison Dearborn Partners. Prior to co-founding Madison Dearborn Partners, Mr. Wood was with First Chicago Venture Capital for nine years in various leadership positions. He currently serves as a director of Hines Horticulture, Inc., Woods Equipment Company, Inc. and Eldorado Bankshares, Inc.
Michael A. DiMarco (42), Executive Vice President and President Collection Services of the Company since September 1998. From 1991 until September 1998, Mr. DiMarco was with Paging Network, Inc., a wireless communications provider, serving in various leadership positions including Senior Vice President of Operations and Executive Vice President of Sales. Prior to that, he served in various senior leadership positions with the City of New York, Hertz Rent-A-Car, Inc., ARA Services, Inc. and National Car Rental, Inc.
Bryan K. Faliero (34), President Portfolio Services of the Company since October 1997. From June 1997 to September 1997, Mr. Faliero served as Vice President, Business Analysis for the Company. Prior to joining the Company, he was an associate with Booz Allen & Hamilton, a strategic consultancy based in Chicago, concentrating on operations strategy and network rationalization.
Michael B. Staed (53), Senior Vice President and President Outsourcing Services of the Company since July 1999. From May 1998 to June 1999, Mr. Staed served as Senior Vice President Marketing, Outsourcing for the Company. Prior to joining the Company, he served as a partner in the consulting division of Ernst & Young LLP for four years focusing on the global telecommunications practice.
Gary L. Weller (39), Executive Vice President and Chief Financial Officer of the Company since July 1999. From January 1998 to June 1999, Mr. Weller served as Senior Vice President and Chief Financial Officer of Harbour Group Ltd., an investment firm based in St. Louis. From June 1993 to December 1997, he served as Executive Vice President and Chief Financial Officer of Greenfield Industries, Inc.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information concerning the compensation paid or accrued for by the Company on behalf of the Company's Chief Executive Officer and the four other most highly compensated executive officers of the Company for the years ended December 31, 1999, 1998 and 1997.
(1) In connection with the Recapitalization, Mr. DiMarco, Mr. Faliero and Mr. Staed received change in control payments of $1,356,875, $475,627 and $937,500, respectively. Remaining amounts, if any, represent split dollar life insurance and long-term disability premiums paid by the Company along with the Company's portion of the 401(k) contribution. Upon termination of split dollar life insurance policy, any residual cash surrender value (cash surrender value less premiums paid) is paid to the executive officer. (2) Payment of taxes by the Company for includable W-2 relocation expenses. (3) 1998 compensation based on an annual salary of $325,000. Mr. DiMarco was hired in September 1998. (4) 1997 compensation based on an annual salary of $138,500. Mr. Faliero was hired in June 1997. (5) 1998 compensation based on an annual salary of $210,000. Mr. Staed was hired in May 1998. (6) 1999 compensation based on an annual salary of $275,000. Mr. Weller was hired in July 1999.
The following table sets forth grants of stock options made during the year ended December 31, 1999.
The following table sets forth options exercised during the year ended December 31, 1999 and options held by the current executives at December 31, 1999.
(1) Based on the price per share of $37.47 determined for the Recapitalization which was completed on December 10, 1999.
The following table sets forth option repricings during the year ended December 31, 1999. Because no public market currently exists for the Company's common stock, the Compensation Committee of the Board of Directors must estimate the fair market value of the stock to set the exercise price when granting stock options. In June 1999, the Compensation Committee determined that it had overestimated the fair market value of the Company's common stock, and had set the exercise price for several stock option grants significantly above fair market value. Therefore, it amended the stock option award agreements for certain stock option grants, including a grant to one named executive officer, so that the exercise price more closely approximated the fair market value of the Company's common stock.
(1) Because there is no public market for the Company's common stock, market value at the time the options were repriced in June 1999 is not readily determinable. Price shown is the per share price determined at the time of the Recapitalization on December 10, 1999.
Employment Agreements
OSI has entered into employment agreements with certain officers, including each of the named executive officers. The employment agreements provide for initial base salaries for Messrs. Beffa, DiMarco, Faliero, Staed and Weller of $375,000, $325,000, $210,000, $250,000 and $275,000, respectively. In addition, the agreements provide that Mr. Beffa is eligible for an annual bonus of up to 150% of his annual base salary and Messrs. DiMarco, Faliero, Staed and Weller are eligible for target annual bonuses of 67%, 50%, 50% and 67%, respectively.
On December 31 of each year, the term of each employment agreement is automatically extended for an additional year unless the Company or the officer gives 30 days advance termination notice. If (i) the Company terminates the officer's employment without "cause" (as defined in the employment agreement), (ii) the Company does not agree to extend the employment agreement upon the expiration thereof, (iii) the officer terminates his employment because the Company reduces his responsibilities or compensation in a manner which is tantamount to termination of the officer's employment, or (iv) within two years following a sale of the company (as defined in the employment agreement), the officer resigns for "good reason" (as defined in the employment agreement), the officer would be entitled to receive an amount equal to his total cash compensation (base salary plus bonus, excluding, however, any change of control bonus described below) for the preceding year and continue to receive medical and dental health benefits for one year. If the officer's employment is terminated by the Company "for cause", the officer is not be entitled to severance compensation.
The employment agreements for Messrs. DiMarco, Faliero and Staed provide that upon consummation of a sale of the Company (as defined in the employment agreement), if the officer is employed by the Company immediately prior thereto, he will be entitled to receive a payment from the Company in the amount of 250% of his (i) then current base salary plus (ii) target annual bonus, reduced by any gain for all of the options to purchase capital stock of the Company or other equity compensation awards previously granted to the officer. Pursuant to this provision, Messrs. DiMarco, Faliero and Staed received change in control bonuses in 1999 upon consummation of the Recapitalization. The change in control bonuses paid in 1999 and any future bonuses paid pursuant to this provision of the employment agreements will be paid only if such bonus is previously approved by a vote of more than seventy-five percent (75%) of the voting power of the Company's outstanding stock immediately before any sale of the Company.
Director Compensation
Non-employee directors of OSI who are not affiliated with a stockholder of the Company receive $2,000 per regularly scheduled meeting of the Board of Directors, $1,000 per special meeting of the Board of Directors and $500 per committee meeting. All directors receive reimbursement for travel and out-of-pocket expenses incurred in connection with attendance at all such meetings. Except as described below, no director of OSI receives any other compensation from OSI for performance of services as a director of OSI (other than reimbursement for travel and out-of-pocket expenses incurred in connection with attendance at Board of Director meetings). Effective February 16, 1996, Mr. Stiefler, who served as the Company's Chairman of the Board prior to December 10, 1999 received options to purchase 23,044 shares of common stock of the Company, which options vest eight years from date of grant or earlier upon the satisfaction of certain performance targets and/or the occurrence of certain liquidity events. Mr. Stiefler also received an annual salary of $150,000. Effective December 10, 1999, in connection with the Recapitalization, Mr. Stiefler resigned as Chairman of the Board. At that time, he exercised all of his options and received cash of $575,530. In 1998, three other directors, Messrs. Hewitt, Jones and Marshall, each received options to purchase 3,000 shares of common stock of the Company. These options time-vested over a three year period. Effective December 10, 1999, in connection with the Recapitalization, all of the Company's directors except Mr. Beffa resigned from the Board of Directors. As a result, Messrs. Hewitt, Jones and Marshall each forfeited their options to purchase 3,000 shares of common stock of the Company. Mr. Hewitt was subsequently elected to the Board of Directors in February 2000.
Option Plan
The Company maintains the 1995 Stock Option and Stock Award Plan (the "Stock Option Plan"). The Stock Option Plan is administered by the Compensation Committee of the Board of Directors of the Company. Under the Stock Option Plan, the Compensation Committee may grant or award (i) options to purchase stock of the Company (which may either be incentive stock options ("ISOs"), within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended, or stock options other than ISOs), (ii) stock appreciation rights granted in conjunction with stock options, (iii) restricted stock, or (iv) bonuses payable in stock, to key salaried employees of the Company, including officers, independent contractors of the Company and non-employee directors of the Company.
A total of 750,000 shares of common stock of the Company are reserved for issuance under the Stock Option Plan. As of March 24, 2000, options to purchase up to 442,925 shares of the Company's common stock are outstanding under the Stock Option Plan, all of which are vested and exercisable.
Board of Directors' Report on Executive Compensation
The Compensation Committee recommends compensation arrangements for the Company's executive officers and administers the Company's Stock Option Plan. In conjunction with the Recapitalization, all members of the Compensation Committee resigned from the Board of Directors, effective December 10, 1999. New members of the Compensation Committee have not yet been elected by the Board. The Company's 1999 compensation program was designed to be competitive with companies similar in structure and business to the Company.
The Company's 1999 executive compensation program was structured to help the Company achieve its business objectives by:
- - Setting levels of compensation designed to attract and retain superior executives in a highly competitive environment.
- - Designing equity-related and other performance-based incentive compensation programs to align the interests of management with the ongoing interests of shareholders; and
- - Providing incentive compensation that varies directly with both Company financial performance and individual contributions to that performance.
The Company has used a combination of salary and incentive compensation, including cash bonuses and equity-based incentives to achieve its compensation goals. Bonuses for 1999 were determined by certain members of the Board in March 2000 and paid shortly thereafter. The amount of bonuses earned by the Company's executive officers were determined based upon the performance of each executive during the year and the performance of the Company against pre-established earnings before interest, taxes, depreciation and amortization ("EBITDA") goals.
In June 1999, the Company entered into an amended and restated employment agreement with Timothy G. Beffa to serve as President and Chief Executive Officer of OSI. Under the employment agreement, Mr. Beffa's base salary for 1999 was $375,000 and his bonus target potential was $562,500, 150% of his base salary. These amounts were established by the Compensation Committee after consideration of compensation paid to Chief Executive Officers of comparative companies and the relationship of his compensation to that paid to other OSI senior executives. For 1999, Mr. Beffa's bonus was determined based upon the following two factors, which were weighted as indicated: the Company's performance against pre-established EBITDA goals (70%), and Mr. Beffa's attainment of pre-established objectives, based on specific strategic initiatives to both build a suitable management infrastructure and deliver on strategic growth initiatives (30%). Based on the Company's EBITDA performance and Mr. Beffa's substantial obtainment of personal objectives, Mr. Beffa's bonus for 1999 was $365,000--64.9% of his target bonus.
Board of Directors ------------------ Timothy G. Beffa William B. Hewitt Timothy M. Hurd Scott P. Marks, Jr. Richard L. Thomas Paul R. Wood
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
As of March 30, 2000, the authorized capital stock of the Company consists of (i) 15,000,000 shares of Voting Common Stock, par value $.01 per share, of which 5,976,389.04 are issued and outstanding, (ii) 2,000,000 shares of Non-Voting Common Stock, par value $.01 per share, of which 480,321.30 are issued and outstanding, (iii) 200,000 shares of 14% Mandatorily Redeemable Senior Preferred Stock, no par value, of which 100,000 are issued and outstanding and (iv) 50,000 shares of Junior Preferred Stock, no par value, of which 7,000 are issued and outstanding.
The following table sets forth the number and percentage of shares of each class of the Company's capital stock beneficially owned as of March 30, 2000 by (i) each person known to the Company to be the beneficial owner of more than 5% of any class of the Company's voting equity securities, (ii) each of the Company's directors and nominees, and (iii) all directors and executive officers of the Company as a group.
Amount and Nature of Percent Name and Address Beneficial of Class Title of Class Beneficial Owner Ownership (1) - -------------------- ---------------------------- -------------- ---------
Voting Common Stock Madison Dearborn Capital 4,536,367.84 75.9% Partners III, L.P.(2) Madison Dearborn Special 4,536,367.84 75.9% Equity III, L.P. (2) Special Advisors Fund I, L.L.C.(2) 4,536,367.84 75.9% Timothy M. Hurd(2) 4,536,367.84 75.9% Paul R. Wood(2) 4,536,367.84 75.9% Timothy G. Beffa(3) 70,175.00 1.2% Michael A. DiMarco(3) 57,000.00 * Bryan K. Faliero(3) 18,750.00 * Michael B. Staed(3) 30,337.60 * Gary L. Weller(3) 50,000.00 * All directors and officers 4,762,630.44 76.9% as a group
Junior Preferred Timothy G. Beffa 81.65 1.2% Stock Bryan K. Faliero 2.48 * All directors and officers 84.13 1.2% as a group
* Represents less than one percent.
(1) The information as to beneficial ownership is based on statements furnished to the Company by the beneficial owners. As used in this table, "beneficial ownership" means the sole or shared power to vote, or direct the voting of a security, or the sole or shared investment power with respect to a security (i.e., the power to dispose of, or direct the disposition of a security). A person is deemed as of any date to have "beneficial ownership" of any security that such person has the right to acquire within 60 days after such date. For purposes of computing the percentage of outstanding shares held by each person named above, any security that such person has the right to acquire within 60 days of the date of calculation is deemed to be outstanding, but is not deemed to be outstanding for purposes of computing the percentage ownership of any other person.
(2) Includes 4,433,913.11 shares owned by Madison Dearborn Capital Partners III, L.P., 98,452.05 shares owned by Madison Dearborn Special Equity III, L.P. and 4,002.68 shares owned by Special Advisors Fund I, L.L.C. with each entity managed by or affiliated with Madison Dearborn Partners, LLC. Messrs. Hurd and Wood are a director and a managing director, respectively, of Madison Dearborn Partners, LLC. Madison Dearborn Capital Partners III, L.P., Madison Dearborn Special Equity III, L.P. and Special Advisors Fund I, L.L.C. have pledged their shares of the Company's common stock as security under the Company's Credit Agreement. In addition, under the Stockholders Agreement, dated as of December 10, 1999, among the Company and substantially all of the Company's stockholders, Madison Dearborn Capital Partners III, L.P., as principal investor, may designate individuals to serve as directors of the Company. The Stockholders Agreement also includes restrictions on the transfer of capital stock, and provides for registration, preemptive, tag along and drag along rights granted to the parties thereto, including Madison Dearborn Capital Partners III, L.P. and certain of its affiliates. The address of all the above-mentioned entities is c/o Madison Dearborn Partners, LLC, 3 First National Plaza, Suite 3800, Chicago, IL 60602.
(3) Includes vested options to acquire the following number of shares of the Company's common stock: Mr. Beffa 70,175; Mr. DiMarco 50,000; Mr.Faliero 18,750; Mr. Staed 25,000 and Mr. Weller 50,000. The address of Messrs. Beffa, DiMarco, Staed and Weller is c/o Outsourcing Solutions Inc., 390 South Woods Mill Rd., Suite 350, Chesterfield, MO 63017. Mr. Faliero's address is c/o OSI Portfolio Services, Inc., 2425 Commerce Ave., Building 1, Suite 100, Duluth, GA 30096.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Acquisition Arrangements
OSI holds a minority interest in a limited liability corporation ("LLC") formed for the purpose of acquiring an accounts receivable portfolio. The majority interest in the LLC is held by MLQ Investors, L.P., one of the Company's stockholders. The recorded value of the Company's investment in the LLC was approximately $520,000 at December 31, 1999.
Advisory Services Agreement
On September 21, 1995 the Company entered into an Advisory Services Agreement (the "Advisory Services Agreement") with MDC Management Company III, L.P. ("MDC Management"), then an affiliate. Under the Advisory Services Agreement, the Company received consulting, financial, and managerial functions for a $300,000 annual fee. In 1999, the Company paid MDC Management $275,000 under the Advisory Services Agreement. On December 10, 1999, in conjunction with the Recapitalization, the Advisory Services Agreement was amended and assigned to Madison Dearborn Partners, Inc. ("MDP"). As amended, the annual fee under the Advisory Services Agreement is $500,000. The Advisory Services Agreement expires September 21, 2005 and is renewable annually thereafter, unless terminated by the Company. The Company may terminate the Advisory Services Agreement at any time for cause by written notice to MDP authorized by a majority of the directors other than those who are partners, principals or employees of MDP or any of its affiliates. The Advisory Services Agreement may be amended by written agreement of MDP and the Company. The Company believes that the terms of and fees paid for the professional services rendered are at least as favorable to the Company as those which could be negotiated with a third party.
In December 1999 upon closing of the Recapitalization, MDP received a one-time fee of $8.0 million for financial advice provided to OSI in connection therewith.
Consulting Agreements
On January 26, 1998, the Company entered into a one-year Consulting Agreement with William B. Hewitt, a director of the Company. Under the original Consulting Agreement, Mr. Hewitt provided consulting assistance with the growing outsourcing services of the Company at 80% of normal working hours. In addition, Mr. Hewitt received options to purchase 10,000 shares of common stock of the Company, which options in accordance with their terms became vested and exercisable upon consummation of the Recapitalization. On January 25, 1999, the Consulting Agreement was extended through March 31, 1999 and at the same time the Consulting Agreement was renewed for the period April 1, 1999 through March 31, 2000, with the consulting services reduced to a maximum of 50 days (approximately 20% of normal working hours). For the year ended December 31, 1999, the Company paid Mr. Hewitt $427,500.
Certain Interests of Shareholders
Goldman Sachs and its affiliates have certain interests in the Company in addition to being an initial purchaser of the 11% Senior Subordinated Notes. Goldman Sachs acted as co-arranger and Goldman Sachs Credit Partners, L.P., an affiliate of Goldman Sachs, acted as co-administrative agent and lender in connection with the then existing credit facility, and in 1999 OSI paid them approximately $706,000 in interest in connection therewith. MLQ Investors, L.P., an affiliate of Goldman Sachs, owns an equity interest in the Company.
In addition to acting as an initial purchaser of the 11% Senior Subordinated Notes, Chase Securities Inc. ("Chase Securities") and its affiliates have certain other relationships with the Company. Chase Securities acted as co-arranging agent and The Chase Manhattan Bank, an affiliate of Chase Securities, acts as co-administrative agent and a lender under the then existing credit facility and in 1999 OSI paid them approximately $150,000 in fees and approximately $1,526,000 in interest in connection therewith. Additionally, Chase Equity Associates, L.P. an affiliate of Chase Securities, owns an equity interest in the Company.
Indebtedness of Management
During 1998, the Company advanced $117,000 to Michael A. DiMarco, Executive Vice President and President Fee Services to facilitate his relocation to the St. Louis area from Texas. The advance was non-interest bearing and was repaid in full in March 1999.
PART IV.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
See index on page 41 for a listing of consolidated financial statements filed with this report.
2. Financial Statement Schedule
See index on page 41 for a listing of consolidated financial statements schedule required to be filed by Item 8 of this Form 10-K.
3. Exhibits
Exhibit No.
2.1 Asset Purchase Agreement dated October 8, 1997 by and among NSA Acquisition Corporation, Outsourcing Solutions Inc., North Shore Agency, Inc., Automated Mailing Services, Inc., Mailguard Security System, Inc., DMM Consultants and Certain Stockholders (incorporated herein by reference to Exhibit 2.6 of the Company's Form 10-K for the year ended December 31, 1997).
2.2 Asset Purchase Agreement dated November 10, 1997 by and among Outsourcing Solutions Inc., ABC Acquisition Company, Accelerated Bureau of Collections Inc., Accelerated Bureau of Collections of Ohio, Inc., Accelerated Bureau of Collections of Virginia Inc., Accelerated Bureau of Collections of Massachusetts, Inc., Travis J. Justus, and Linda Brown (incorporated herein by reference to Exhibit 2.7 of the Company's Form 10-K for the year ended December 31, 1997).
2.3 Share Purchase Agreement and Plan of Merger dated as of December 22, 1997 by and among Outsourcing Solutions Inc., Sherman Acquisition Corporation and The Union Corporation (incorporated herein by reference to Exhibit 2.8 of the Company's Form 10-K for the year ended December 31, 1997).
2.4 Stock Subscription and Redemption Agreement by and among Madison Dearborn Capital Partners III, L.P., the Company and certain stockholders, optionholders and warrantholders of the Company, dated as of October 8, 1999, as amended (incorporated herein by reference to Exhibit 2 of the Company's Current Report on Form 8-K filed on December 23, 1999).
2.5 Assignment and Stock Purchase Agreement dated as of December 10, 1999 by and among Outsourcing Solutions Inc., Madison Dearborn Capital Partners III, L.P., and certain other parties thereto.
2.6 Purchase Agreement dated as of December 10, 1999, by and among Outsourcing Solutions Inc. and certain other parties thereto.
2.7 Junior Preferred Stock Purchase Agreement, dated as of December 10, 1999, by and among Outsourcing Solutions Inc. and certain other parties thereto.
2.8 Consent Solicitation Statement, dated November 9, 1999, relating to the Company's 11% Senior Subordinated Notes due November 1, 2006.
3.1 Fourth Amended and Restated Certificate of Incorporation of the Company, as of December 3, 1999.
3.2 By-laws of the Company (incorporated herein by reference to Exhibit 3.2 of the Company's Registration Statement on Form S-4 filed on November 26, 1996).
4.1 Indenture dated as of November 6, 1996 by and among the Company, the Guarantors and Wilmington Trust Company (the "Indenture") (incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-4 filed on November 26, 1996).
4.2 Specimen Certificate of 11% Senior Subordinated Note due 2006 (included in Exhibit 4.1 hereto) (incorporated herein by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-4 filed on November 26, 1996).
4.3 Specimen Certificate of 11% Series B Senior Subordinated Note due 2006 (the "New Notes") (included in Exhibit 4.1 hereto) (incorporated herein by reference to Exhibit 4.3 of the Company's Registration Statement on Form S-4 filed on November 26, 1996).
4.4 Form of Guarantee of securities issued pursuant to the Indenture (included in Exhibit 4.1 hereto) (incorporated herein by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-4 filed on November 26, 1996).
4.5 First Supplemental Indenture dated as of March 31, 1998 by and among the Company, the Additional Guarantors and Wilmington Trust Company (incorporated herein by reference to Exhibit 4.5 of the Company's Form 10-K for the year ended December 31, 1998).
10.1 Stockholders Agreement dated as of December 10, 1999 by and among the Company and various stockholders of the Company (incorporated herein by reference to Exhibit 10 of the Company's Current Report on Form 8-K filed on December 23, 1999).
10.2 Advisory Services Agreement dated September 21, 1995 between the Company and Madison Dearborn Partners, Inc., as assignee from MDC Management Company III, L.P. as amended by Assignment Agreement dated as of December 10, 1999 by and between Madison Dearborn Partners, Inc., the Company and MDC Management Company III, L.P.
10.3 Registration Rights Agreement dated December 10, 1999, by and among Outsourcing Solutions Inc., Madison Dearborn Partners III, L.P. and certain other parties thereto.
10.4 Registration Rights Agreement dated December 10, 1999, by and among the Company and certain other parties thereto.
10.5 Amended and Restated Employment Agreement dated as of June 4, 1999 between the Company and Timothy G. Beffa.
10.6 Amended and Restated Employment Agreement dated as of June 4, 1999 between the Company and Michael A. DiMarco.
10.7 Employment Agreement dated as of June 4, 1999 between the Company and Bryan K. Faliero.
10.8 Amended and Restated Employment Agreement dated as of June 4, 1999 between the Company and Michael B. Staed.
10.9 Employment Agreement dated July 5, 1999 between the Company and Gary L. Weller.
10.10 Consulting Agreement dated as of February 6, 1998 between the Company and William B. Hewitt as amended January 25, 1999 (incorporated herein by reference to Exhibit 10.6 of the Company's Form 10-K for the year ended December 31, 1998).
10.11 1995 Stock Option and Stock Award Plan of the Company (incorporated herein by reference to Exhibit 10.31 of the Company's Registration Statement on Form S-4 filed on November 26, 1996).
10.12 First Amendment to 1995 Stock Option and Stock Award Plan of the Company (incorporated herein by reference to Exhibit 10.13 of the Company's Form 10-K for the year ended December 31, 1997).
10.13 Form of Non-Qualified Stock Option Award Agreement [B], as amended.
10.14 Form of Non-Qualified Stock Option Award Agreement [C], as amended.
10.15 Form of Non-Qualified Stock Option Award Agreement [E].
10.16 1998 Incentive Compensation Program (incorporated herein by reference to Exhibit 10.15 of the Company's Form 10-K for the year ended December 31, 1998).
10.17 Earn-out Agreement dated October 8, 1997 by and among NSA Acquisition Corporation, Outsourcing Solutions Inc., North Shore Agency, Inc., Automated Mailing Services, Inc., Mailguard Security Systems, Inc., and DMM Consultants (incorporated herein by reference to Exhibit 10.17 of the Company's Form 10-K for the year ended December 31,1997).
10.18 Credit Agreement dated as of November 30, 1999 among the Company, the Lenders listed therein, DLJ Capital Funding, Inc., as the Syndication Agent, and Fleet National Bank, as the Administrative Agent.
21 Subsidiaries of registrant.
27 Financial Data Schedule.
(b) Reports on Form 8-K
For the three months ended December 31, 1999, the following reports on Form 8-K were filed: Report on Form 8-K filed October 29, 1999. Report on Form 8-K filed December 23, 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
OUTSOURCING SOLUTIONS INC.
/s/Timothy G. Beffa ------------------------------------ Timothy G. Beffa President and Chief Executive Officer
/s/Gary L. Weller ------------------------------------ Gary L. Weller Executive Vice President and Chief Financial Officer
DATE: March 29, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/Timothy G. Beffa President and Chief Executive March 29, 2000 - --------------------------- Officer, Director Timothy G. Beffa
/s/William B. Hewitt Director March 29, 2000 - --------------------------- William B. Hewitt
/s/Timothy M. Hurd Director and Vice President March 28, 2000 - --------------------------- Timothy M. Hurd
/s/Scott P. Marks, Jr. Director March 29, 2000 - --------------------------- Scott P. Marks, Jr.
/s/Richard L. Thomas Director March 22, 2000 - --------------------------- Richard L. Thomas
/s/Paul R. Wood Director and Vice President March 29, 2000 - --------------------------- Paul R. Wood
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND CONSOLIDATED FINANCIAL STATEMENT SCHEDULE
Page ---- Consolidated Financial Statements
Outsourcing Solutions Inc. and Subsidiaries
Independent Auditors' Report.................................... Consolidated Balance Sheets at December 31, 1999 and 1998.............................................. Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997............... Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 1999, 1998 and 1997........................... Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997..................... Notes to Consolidated Financial Statements......................
Consolidated Financial Statement Schedule
Independent Auditors' Report...................................... Schedule II - Valuation and Qualifying Accounts and Reserves......
INDEPENDENT AUDITORS' REPORT To the Stockholders of Outsourcing Solutions Inc.:
We have audited the accompanying consolidated balance sheets of Outsourcing Solutions Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Outsourcing Solutions Inc. and subsidiaries as of December 31, 1999 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States of America.
/s/ Deloitte & Touche LLP - ------------------------ Deloitte & Touche LLP
St. Louis, Missouri March 28, 2000
OUTSOURCING SOLUTIONS INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND 1998 (In thousands, except share and per share amounts) - --------------------------------------------------------------------------------
ASSETS 1999 1998 ---- ----
Cash and cash equivalents $ 6,059 $ 8,814
Cash and cash equivalents held for clients 22,521 22,372
Accounts receivable - trade, less allowance for doubtful receivables of $529 and $1,309 52,082 40,724
Purchased loans and accounts receivable portfolios 39,947 55,493
Property and equipment, net 43,647 40,317
Intangible assets, net 410,471 425,597
Deferred financing costs, less accumulated amortization of $248 and $5,203 27,224 13,573
Other assets 22,761 11,601 -------- -------- TOTAL $624,712 $618,491 ======== ========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Accounts payable - trade $ 6,801 $ 7,355
Collections due to clients 22,521 22,372
Accrued salaries, wages and benefits 17,009 13,274
Debt 518,307 528,148
Other liabilities 68,306 77,374
Commitments and contingencies - -
Mandatorily redeemable preferred stock; redemption amount $107,877 85,716 -
Stockholders deficit: 8% nonvoting cumulative redeemable exchangeable preferred stock; authorized 1,250,000 shares, 973,322.32 issued and outstanding in 1998, at liquidiation value of $12.50 per share - 12,167 Voting common stock; $.01 par value; authorized 15,000,000 shares, 9,054,638.11 shares issued in 1999 and 3,477,126.01 shares issued and outstanding in 1998 90 35 Non-voting common stock; $.01 par value; authorized 2,000,000 shares, 480,321.30 issued and outstanding in 1999 5 - Class A convertible nonvoting common stock; $.01 par value; authorized 7,500,000 shares, 391,740.58 shares issued and outstanding in 1998 - 4 Class B convertible nonvoting common stock; $.01 par value; authorized 500,000 shares, 400,000 shares issued and outstanding in 1998 - 4 Class C convertible nonvoting common stock; $.01 par value; authorized 1,500,000 shares, 1,040,000 shares issued and outstanding in 1998 - 10 Paid-in capital 196,339 66,958 Retained deficit (155,525) (109,210) -------- -------- 40,909 (30,032) Common stock in treasury, at cost; 3,078,249.07 shares in 1999 (134,857) - -------- -------- Total stockholders' deficit (93,948) (30,032) -------- -------- TOTAL $624,712 $618,491 ======== ========
See notes to consolidated financial statements.
OUTSOURCING SOLUTIONS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (In thousands) - --------------------------------------------------------------------------------
1999 1998 1997 ---- ---- ----
REVENUES $ 504,425 $ 479,400 $271,683
EXPENSES: Salaries and benefits 244,157 230,114 133,364 Service fees and other operating and administrative expenses 154,799 140,888 71,122 Amortization of purchased loans and accounts receivable portfolios 38,722 50,703 52,042 Amortization of goodwill and other intangibles 16,229 15,725 24,749 Depreciation expense 14,866 14,282 8,825 Nonrecurring conversion, realignment and relocation expenses 5,063 - - Change in control bonuses, stock option redemption and other bonuses 10,487 - - Transaction related costs 6,827 - - --------- -------- -------- Total expenses 491,150 451,712 290,102 --------- --------- --------
OPERATING INCOME (LOSS) 13,275 27,688 (18,419)
INTEREST EXPENSE - Net 52,265 50,627 28,791 --------- --------- -------- LOSS BEFORE INCOME TAXES, MINORITY INTEREST AND EXTRAORDINARY ITEM (38,990) (22,939) (47,210)
PROVISION FOR INCOME TAXES 759 830 11,127
MINORITY INTEREST - 572 - --------- --------- -------- LOSS BEFORE EXTRAORDINARY ITEM (39,749) (24,341) (58,337)
EXTRAORDINARY LOSS ON EXTINGUISHMENT OF DEBT, NET OF INCOME TAXES OF $0. 4,208 - - --------- --------- -------- NET LOSS (43,957) (24,341) (58,337)
PREFERRED STOCK DIVIDEND REQUIREMENTS AND ACCRETION OF SENIOR PREFERRED STOCK 2,358 681 922 --------- --------- --------
NET LOSS TO COMMON STOCKHOLDERS $ (46,315) $(25,022) $(59,259) ========= ======== ========
See notes to consolidated financial statements.
OUTSOURCING SOLUTIONS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (In thousands, except share and per share amounts) - --------------------------------------------------------------------------------
OUTSOURCING SOLUTIONS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (In thousands)
See notes to consolidated financial statements.
Outsourcing Solutions Inc. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except share and per share amounts) - --------------------------------------------------------------------------------
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidation Policy - Outsourcing Solutions Inc. is one of the largest providers of accounts receivable management services in the United States. The consolidated financial statements include the accounts of Outsourcing Solutions Inc. ("OSI") and all of its majority-owned subsidiaries (collectively, the "Company"). Ownership in entities of less than 50% are accounted for under the equity method. All significant intercompany accounts and transactions have been eliminated.
Cash and Cash Equivalents - Cash and cash equivalents consist of cash, money market investments, and overnight deposits. Cash equivalents are valued at cost, which approximates market. Cash held for clients consist of certain restricted accounts which are used to maintain cash collected and held on behalf of the Company's clients.
Purchased Loans and Accounts Receivable Portfolios - Purchased loans and accounts receivable portfolios ("Receivables") acquired in connection with acquisitions in September 1995 and November 1996 were recorded at the present value of estimated future net cash flows. Receivables purchased in the normal course of business are recorded at cost. The Company periodically reviews all Receivables to assess recoverability. Impairments are recognized in operations if the expected aggregate discounted future net operating cash flows derived from the portfolios are less than the aggregate carrying value (see Note 15).
The Company amortizes on an individual portfolio basis the cost of the Receivables based on the ratio of current collections for a portfolio to current and anticipated future collections including any terminal value for that portfolio. Such portfolio cost is amortized over the expected collection period as collections are received which, depending on the individual portfolio, generally ranges from 3 to 5 years.
Revenue Recognition - Collections on Receivables owned are generally recorded as revenue when received. Proceeds from strategic sales of Receivables owned are recognized as revenue when received. Revenue from collections and outsourcing services is recorded as such services are provided. Deferred revenue in the accompanying balance sheet primarily relates to certain prepaid letter services which are generally recognized as earned as services are provided.
Property and Equipment - Property and equipment are recorded at cost. Depreciation is computed on the straight-line method based on the estimated useful lives (3 years to 30 years) of the related assets. Leasehold improvements are amortized over the term of the related lease.
Intangible Assets - The excess of cost over the fair value of net assets of businesses acquired is amortized on a straight-line basis over 20 to 30 years. Other identifiable intangible assets are primarily comprised of the fair value of existing account placements acquired in connection with certain business combinations and non-compete agreements. These assets are short-lived and are being amortized over the assets' periods of recoverability, which are estimated to be 1 to 3 years. The Company periodically reviews goodwill and other intangibles to assess recoverability. Impairments will be recognized in operations if the expected future operating cash flows (undiscounted and without interest charges) derived from such intangible assets are less than its carrying value.
Deferred Financing Costs - Deferred financing costs are being amortized over the terms of the related debt agreements.
Income Taxes - The Company accounts for income taxes using an asset and liability approach. The Company recognizes the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for expected future tax consequences of events that have been recognized in the consolidated financial statements. The Company evaluates the recoverability of deferred tax assets and establishes a valuation allowance to reduce the deferred tax assets to an amount that is more likely than not to be realized.
Environmental Costs - All of the Company's environmental proceedings relate to discontinued operations of former divisions or subsidiaries of The Union Corporation. Costs incurred to investigate and remediate contaminated sites are charged to the environmental reserves established in conjunction with the Union acquisition.
Stock-Based Compensation - The Company accounts for its stock-based compensation plan using the intrinsic value method prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees. Statement of Financial Accounting Standard ("SFAS") No. 123, Accounting for Stock-Based Compensation, requires that companies using the intrinsic value method make pro forma disclosures of net income as if the fair value-based method of accounting had been applied. See Note 12 for the fair value disclosures required under SFAS No. 123.
Comprehensive Income - Effective January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive Income, which established standards for the reporting and display of comprehensive income and its components. The adoption of this statement did not affect the Company's consolidated financial statements for the three years in the period ended December 31, 1999. Comprehensive loss for the three years in the period ended December 31, 1999 was equal to the Company's net loss.
Accounting For Transfers of Financial Assets - SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. These standards are based on consistent application of a financial-components approach that focuses on control. Under this approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. This Statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The Company adopted SFAS No. 125 for the year ended December 31, 1997. The adoption of SFAS No. 125 did not have a material effect on the 1997 financial statements, as the Company had no transfers during the year ended December 31, 1997. However, commencing in the fourth quarter of 1998, the Company began selling, concurrent with its purchase, certain Receivables to a special-purpose entity, OSI Funding LLC (FINCO) (see Note 18).
Segment Information - SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, established standards for the way that public business enterprises report information about operating segments in annual financial statements and also established standards for related disclosures about products and services, geographic areas and major customers. Management has considered the requirements of SFAS No. 131 and, as discussed in Note 17, believes the Company operates in one business segment.
New Derivatives and Hedging Accounting Standard - In June 1998, SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was issued, which is required to be adopted no later than January 1, 2001. The statement provides a comprehensive and consistent standard for the recognition and measurement of derivatives and hedging activities. The Company has not determined the impact on the consolidated statement of operations and consolidated balance sheet.
Accounting for the Costs of Computer Systems Developed or Obtained for Internal Use - Statement of Position ("SOP") No. 98-1, Accounting for the Costs of Computer Systems Developed or Obtained for Internal Use, provides guidelines for capitalization of developmental costs of proprietary software and purchased software for internal use. The adoption of SOP No. 98-1 did not have a material impact on the consolidated statement of operations and consolidated balance sheet.
Accounting Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Earnings Per Share - SFAS No. 128, Earnings per Share, simplified the calculation of earnings per share and is applicable only to public companies. Under the Securities and Exchange Commission ("SEC") disclosure requirements, SFAS No. 128 is not currently applicable to the Company and, accordingly, earnings per share is not presented.
Reclassifications - Certain amounts in prior periods have been reclassified to conform to the current year presentation, including changing the balance sheet presentation from classified to unclassified.
2. ORGANIZATION, ACQUISITIONS & RECAPITALIZATION
OSI was formed on September 21, 1995 to build, through a combination of acquisitions and sustained internal growth, one of the leading providers of accounts receivable management services. In 1999, the Company reorganized many of its acquired subsidiaries. Account Portfolios, Inc. ("API") changed its name to OSI Portfolio Services, Inc. Payco American Corporation's ("Payco") largest debt collection subsidiary changed its name to OSI Collection Services, Inc. and Continental Credit Services, Inc. ("Continental"), A.M. Miller & Associates ("AMM"), Accelerated Bureau of Collections, Inc. ("ABC"), and former subsidiaries of The Union Corporation ("Union"), Allied Bond & Collection Agency and Capital Credit, merged into OSI Collection Services. Former Union subsidiary, Interactive Performance changed its name to OSI Outsourcing Services, Inc. and the Interactive Performance and High Perfomance services subsidiaries merged into OSI Outsourcing Services. The Company purchases and collects portfolios of non-performing loans and accounts receivable for the Company's own account, services accounts receivable placements on a contingent and fixed fee basis and provides contract management of accounts receivable. The Company's customers are mainly in the educational, utilities, telecommunications, retail, healthcare and financial services industries. The markets for the Company's services currently are the United States, Puerto Rico, Canada and Mexico.
In September 1995, the Company acquired API, a partnership which purchased and managed large portfolios of non-performing consumer loans and accounts receivable, for cash of $30,000, common stock of $15,000 and notes of $35,000, which were subsequently paid in March 1996.
In January 1996, the Company acquired AMM and Continental, accounts receivable and fee services companies, for total cash consideration of $38,500 including transaction costs of $3,600, common stock of $6,000, a 9% unsecured, subordinated note of $5,000 (interest payable quarterly and principal due July 2001) and a 10% unsecured, subordinated note of $3,000, which was subsequently paid in November 1996.
In November 1996, the Company acquired all of the outstanding common stock of Payco, an accounts receivable management company primarily focused on healthcare, education and bank/credit cards, in a merger transaction for cash of approximately $154,800 including transaction costs of $4,600. The Company allocated the total purchase price including additional liabilities reserves to the fair value of the net assets acquired resulting in goodwill of approximately $123,000. In addition, the Company allocated $1,000 of the purchase price to in-process research and development that had not reached technological feasibility and had no alternative future uses, which accordingly was expensed at the date of the acquisition.
In October and November 1997, the Company acquired the assets of The North Shore Agency, Inc. ("NSA"), a fee service company specializing in letter series collection services, and ABC, a fee service company specializing in credit card collections, for total cash consideration of approximately $53,800 including transaction costs of $1,173 and common stock of $1,000. One of the acquisitions contains certain contingent payment obligations, $2,533 through December 31, 1999, based on the attainment by the newly formed subsidiary of certain financial performance targets over each of the next two years. Future contingent payment obligations, if any, will be accounted for as additional goodwill as the payments are made.
In January 1998, the Company acquired through a tender offer approximately 77% of the outstanding shares of Union's common stock for $31.50 per share. On March 31, 1998, the Company acquired the remaining outstanding shares of Union when Union merged with a wholly-owned subsidiary of the Company. The aggregate cash purchase price of the Union acquisition was approximately $220,000 including transaction costs of $10,900 and assumed liabilities. The Company financed the acquisition primarily with funds provided by an amended credit agreement . Union, through certain of its subsidiaries, furnishes a broad range of credit and receivables management outsourcing services as well as management and collection of accounts receivable. The Company allocated the total purchase price including additional liabilities reserves to the fair value of the net assets acquired resulting in goodwill of approximately $219,000.
The above acquisitions were accounted for as purchases. The excess of cost over the fair value of net assets of businesses acquired is amortized on a straight-line basis over 20 to 30 years. Results of operations were included in the consolidated financial statements from their respective acquisition dates.
On December 10, 1999, the Company consummated a transaction with Madison Dearborn Capital Partners III, L.P. ("MDP") and certain of the Company's stockholders, optionholders and warrantholders pursuant to which MDP acquired 75.9% of OSI's common stock, most of the then outstanding capital stock of OSI was redeemed, refinanced its credit facility and issued $107,000 of preferred stock (the "Recapitalization"). Total value of the Recapitalization was approximately $790,000.
The Recapitalization has been accounted for as a recapitalization which had no impact on the historical basis of assets and liabilities.
In accordance with the terms of the Recapitalization, the holders of approximately 85.6% of shares of the Company's common stock outstanding immediately prior to the Recapitalization received $37.47 in cash in exchange for each of these shares. In addition, the holders of the Company's preferred stock, non-voting common stock, warrants and exercised stock options, which pursuant to the Recapitalization all outstanding options became vested, received $37.47 in cash in exchange for each of these instruments. Immediately following the Recapitalization, continuing shareholders owned approximately 8.5% of the outstanding shares of the Company's common stock.
In connection with the Recapitalization, the Company entered into a new credit facility providing for term loans of $400,000 and revolving loans of up to $75,000 (see Note 6). The proceeds of the initial borrowings under the new credit facility and the issuance of approximately $300,000 of the Company's preferred and common stock have been used to finance the payments of cash to cash-electing shareholders, to pay the holders of stock options and stock warrants exercised or canceled, as applicable, in connection with the Recapitalization, to repay the Company's existing credit facility and to pay expenses incurred in connection with the Recapitalization.
The Company incurred various costs aggregating approximately $36,780 in connection with consummating the Recapitalization. These costs consisted primarily of compensation costs, professional and advisory fees, and other expenses. The compensation costs of $10,487 consists primarily of expense relating to the payment of cash for vested stock options and the payment of change in control bonuses to certain officers in accordance with the terms of their respective employment agreements. Of the other transaction related costs, which includes professional and advisory fees, and other expenses, the Company expensed $6,827 and recorded $19,466 as an additional cost of the repurchase of common stock in 1999. In addition to these expenses, the Company also incurred approximately $21,100 of capitalized debt issuance costs, which include the consent payment to existing note holders, associated with the Recapitalization financing. These costs will be charged to interest expense over the terms of the related debt instruments.
The unaudited pro forma consolidated financial data presented below provides pro forma effect of the Union acquisition, the Recapitalization and the debt extinguishment as if such transactions had occurred as of the beginning of each period presented. The unaudited results have been prepared for comparative purposes only and do not necessarily reflect the results of operations of the Company that actually would have occurred had the acquisition, the Recapitalization and the debt extinguishment been consummated as of the beginning of each period presented, nor does the data give effect to any transactions other than the acquisition, the Recapitalization and the debt extinguishment. Pro Forma 1999 1998 ---- ----
Net revenues $504,425 $486,754 ======== ========
Net loss $(23,865) $(26,445) ======== ========
3. PROPERTY AND EQUIPMENT
Property and equipment, which is recorded at cost, consists of the following at December 31: 1999 1998 ---- ----
Land $ 2,109 $ 2,109 Buildings 1,912 1,891 Furniture and fixtures 7,964 6,574 Machinery and equipment 3,016 2,479 Telephone equipment 9,826 8,659 Leasehold improvements 5,590 4,068 Computer hardware and software 53,843 40,785 -------- -------- 84,260 66,565 Less accumulated depreciation (40,613) (26,248) -------- --------
$ 43,647 $ 40,317 ======== ========
4. INTANGIBLE ASSETS
Intangible assets consist of the following at December 31:
1999 1998 ---- ----
Goodwill $ 448,651 $ 447,774 Value of favorable contracts and placements 29,000 29,000 Covenants not to compete 5,053 5,021 --------- --------- 482,704 481,795 Less accumulated amortization (72,233) (56,198) --------- ---------
$ 410,471 $ 425,597 ========= =========
5. OTHER ASSETS
Other assets consist of the following at December 31:
1999 1998 ---- ----
Investment in FINCO $ 12,000 $ 2,500 Prepaid postage 3,326 1,007 Other 7,435 8,094 -------- --------
$ 22,761 $ 11,601 ======== ========
6. DEBT
Debt consists of the following at December 31: 1999 1998 ---- ----
New Credit Facility $ 400,000 $ - Prior Credit Facility - 396,637 Revolving Credit Facility 13,000 25,500 11% Series B Senior Subordinated Notes 100,000 100,000 Note payable to stockholder (See Note 2) 4,429 4,429 Other (including capital leases) 878 1,582 --------- --------- Total debt $ 518,307 $ 528,148 ========= =========
On April 28, 1997, the Company registered $100,000 of 11% Series B Senior Subordinated Notes (the "Notes") which mature on November 1, 2006, with the SEC to exchange for the then existing unregistered $100,000 of 11% Senior Subordinated Notes (the "Private Placement"). The exchange offer was completed by May 29, 1997. Interest on the Notes is payable semi-annually on May 1 and November 1 of each year. The Notes are general unsecured obligations of the Company and are subordinated in right of payment to all senior debt of the Company presently outstanding and incurred in the future. The Notes contain certain restrictive covenants the more significant of which are limitations on asset sales, additional indebtedness, mergers and certain restricted payments, including dividends.
In connection with the Recapitalization, the Company entered into a new credit facility providing up to $475,000 of senior bank financing ("New Credit Facility"). The proceeds of the New Credit Facility were used to refinance $419,818 of indebtedness outstanding on the date of the Recapitalization which resulted in an extraordinary loss of $4,208 from the write-off of previously capitalized deferred financing fees. In addition, the New Credit Facility will be used to provide for the Company's working capital requirements and future acquisitions, if any.
The New Credit Facility consists of a $400,000 term loan facility and a $75,000 revolving credit facility (the "Revolving Facility"). The term loan facility consists of a term loan of $150,000 ("Term Loan A") and a term loan of $250,000 ("Term Loan B"), which mature on December 10, 2005 and June 10, 2006, respectively. The Company is required to make quarterly principal repayments on each term loan beginning January 15, 2000 for Term Loan B and January 15, 2001 for Term Loan A. Term Loan A bears interest, at the Company's option, (a) at a base rate equal to the greater of the federal funds rate plus 0.5% or the lender's prime rate, plus 2.25% or (b) at the reserve adjusted Eurodollar rate plus 3.25%. Term Loan B bears interest, at the Company's option, (a) at a base rate equal to the greater of the federal funds rate plus 0.5% or the lender's prime rate, plus 3.0% or (b) at the reserve adjusted Eurodollar rate plus 4.0%.
The Revolving Facility has a term of six years and is fully revolving until December 10, 2005. The Revolving Facility bears interest, at the Company's option, (a) at a base rate equal to the greater of the federal funds rate plus 0.5% or the lender's prime rate, plus 2.25% or (b) at the reserve adjusted Eurodollar rate plus 3.25%. Also, outstanding under the Revolving Facility are letters of credit of $1,989 expiring within a year.
The one month LIBOR rate (Eurodollar rate) at December 31, 1999 was 5.8%. The three month LIBOR rate (Eurodollar rate) at December 31, 1998 was 5.3%.
The New Credit Facility is guaranteed by substantially all of the Company's present domestic subsidiaries and is secured by substantially all of the stock of the Company's present domestic subsidiaries and by substantially all of the Company's domestic property assets. The New Credit Facility contains certain covenants the more significant of which limit dividends, asset sales, acquisitions and additional indebtedness, as well as requires the Company to satisfy certain financial performance ratios.
The Notes are fully and unconditionally guaranteed on a joint and several basis by each of the Company's current domestic subsidiaries and any additional domestic subsidiaries formed by the Company that become guarantors under the New Credit Facility (the "Restricted Subsidiaries").
The Restricted Subsidiaries are wholly-owned by the Company and constitute all of the direct and indirect subsidiaries of the Company except for certain subsidiaries that are individually, and in the aggregate inconsequential. The Company is a holding company with no separate operations, although it incurs some expenses. The Company has no significant assets or liabilities other than the common stock of its subsidiaries, debt, related deferred financing costs and accrued expenses. The aggregate assets, liabilities, results of operations and stockholders' equity of the Restricted Subsidiaries are substantially equivalent to those of the Company on a consolidated basis and the separate financial statements of each of the Restricted Subsidiaries are not presented because management has determined that they would not be material to investors.
Summarized combined financial information of the Restricted Subsidiaries is shown below: 1999 1998 ---- ----
Total assets $584,184 $595,925 ======== ========
Total liabilities $123,551 $ 78,252 ======== ========
Operating revenue $504,425 $479,400 ======== ========
Income from operations $ 42,669 $ 39,418 ======== ========
Net income $ 11,861 $ 21,189 ======== ========
Maturities of debt and capital leases at December 31, 1999 are as follows:
Capital Debt Leases ---- -------
2000 $ 2,619 $ 675 2001 14,429 95 2002 17,500 19 2003 32,500 - 2004 40,000 - Thereafter 410,500 - --------- -------- Total Payments 517,548 789 Less amounts representing interest 30 -------- Present value of minimum lease payments $ 759 --------- ======== $ 517,548 =========
7. OTHER LIABILITIES
Other liabilities consist of the following at December 31:
1999 1998 ---- ---- Accrued acquisition related office closure costs, over-market leases and other costs $ 7,402 $ 12,103 Accrued interest 4,494 6,851 Deferred revenue 10,242 11,285 Environmental reserves 22,218 22,726 Other 23,950 24,409 --------- --------- $ 68,306 $ 77,374 ========= =========
The environmental reserves, on an undiscounted basis, at December 31, 1999 and 1998 are for environmental proceedings as a result of the Union acquisition. The Company is party to several pending environmental proceedings involving the Environmental Protection Agency and comparable state environmental agencies. All of these matters related to discontinued operations of former divisions or subsidiaries of Union for which it has potential continuing responsibility. Management, in consultation with both legal counsel and environmental consultants, has established the aforementioned liabilities that it believes are adequate for the ultimate resolution of these environmental proceedings. However, the Company may be exposed to additional substantial liability for these proceedings as additional information becomes available over the long-term.
8. MANDATORILY REDEEMABLE PREFERRED STOCK
Mandatorily redeemable preferred stock consists of the following at December 31, 1999: 14% Senior Mandatorily Redeemable Junior Preferred Preferred Stock Stock Total ------------ --------- ---------
Balance at December 31, 1998 $ - $ - $ - Issuance of stock 77,634 7,000 84,634 Accrued dividends 856 21 877 Accretion of preferred stock 205 - 205 --------- --------- --------- Balance at December 31, 1999 $ 78,695 $ 7,021 $ 85,716 ========= ========= =========
On December 10, 1999, in connection with the Recapitalization, the Board of Directors authorized 50,000 shares of Class A 14% Senior Mandatorily Redeemable Preferred Stock, no par value and 150,000 shares of Class B 14% Senior Mandatorily Redeemable Preferred Stock, no par value. Furthermore, the Company issued 25,000 shares of Class A 14% Senior Mandatorily redeemable Preferred Stock, ("Class A"), Series A, no par value and 75,000 shares of Class B 14% Senior Mandatorily Redeemable Preferred Stock, ("Class B"), Series A, no par value; collectively referred to as Senior Preferred Stock; along with 596,913.07 shares of the Company's common stock for $100,000. The Company may issue up to one additional series of each Class A and Class B solely to the existing holders in exchange for shares of Class A, Series A or Class B, Series A. The liquidation value of each share of Senior Preferred Stock is $1,000 plus accrued and unpaid dividends. Dividends, as may be declared by the Company's Board of Directors, are cumulative at an annual rate of 14% of the liquidation value and are payable quarterly. The Company may, at its option and upon written notice to preferred shareholders, redeem all or any portion of the outstanding Senior Preferred Stock on a pro-rata basis at the redemption prices in cash at a stated percentage of the liquidation value plus cash equal to all accrued and unpaid dividends. The redemption prices for Class A are 110%, 114%, 107%, 103.5% and 100% of the liquidation value for the period December 15, 1999 through June 15, 2001, June 16, 2001 through December 14, 2003, December 15, 2003 through December 14, 2004, December 15, 2004 through December 14, 2005 and December 15, 2005 and thereafter, respectively. The redemption price for Class B is 100% of the liquidation value. However, on December 10, 2007, the Company must redeem all of the shares of the Senior Preferred Stock then outstanding at a redemption price equal to 100% of the liquidation value per share plus accrued and unpaid dividends. Pursuant to the Company's financing arrangements, the payment of dividends and/or the repurchase of shares of Senior Preferred Stock is allowed as long as no default on the financing arrangements shall have occurred. The 14% Senior Mandatorily Redeemable Preferred Stock was recorded at $77,634 to take into account common stock issued in conjunction with the sale of the Senior Preferred Stock and will accrete to $100,000 by December 10, 2007 using the interest rate method.
On December 10, 1999, in connection with the Recapitalization, the Company authorized 50,000 shares and issued 7,000 shares of Junior Preferred Stock ("Junior Preferred Shares"). The liquidation value of each Junior Preferred Share is $1,000 plus accrued and unpaid dividends. Dividends, as may be declared by the Company's Board of Directors, are cumulative at an annual rate of 5% of the liquidation value until December 10, 2003 and then at an annual rate of 8% thereafter and are payable annually; however the dividend rate will increase to 20% upon consummation of certain events. The Company will pay dividends in the form of additional Junior Preferred Shares. The Company may, at its sole option and upon written notice, redeem, subject to limitations, all or any portion of the outstanding Junior Preferred Shares for $1,000 per share plus cash equal to all accrued and unpaid dividends, through the redemption date, whether or not such dividends have been authorized or declared. However, on January 10, 2008, the Company must redeem all of the shares of the Junior Preferred Stock then outstanding at a redemption price equal to $1,000 per share plus accrued and unpaid dividends as long as all of the shares of the Senior Preferred Stock have been redeemed. Upon consummation of a primary public offering having an aggregate offering value of at least $50,000, each holder of Junior Preferred Shares shall have the right to convert all, but not less than all, into shares of voting common stock based upon the public offering price.
9. STOCKHOLDERS' EQUITY AND WARRANTS
Each share of Non-voting common stock is convertible at the shareholders option into an equal number of shares of Voting common stock subject to the requirements set forth in the Company's Certificate of Incorporation.
In connection with the Recapitalization, all warrants (46,088.67) then outstanding were exchanged for cash with each holder receiving cash for the differential between $37.47 per share and their exercise price of $12.50. Consequently, there are no warrants outstanding at December 31,1999.
10. INCOME TAXES
Major components of the Company's income tax provision are as follows:
1999 1998 1997 ---- ---- ---- Current: Federal $ - $ - $ - State 550 450 250 Foreign 209 - - ------- ------- ------- Total current 759 450 250 ------- ------- ------- Deferred: Federal - - 9,513 State - 380 1,364 Foreign - - - ------- ------- ------- Total deferred - 380 10,877 ------- ------- ------- Provision for income taxes $ 759 $ 830 $11,127 ======= ======= =======
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax reporting purposes. The Company's deferred income taxes result primarily from differences in loans and accounts receivable purchased, amortization methods on other intangible assets and depreciation methods on fixed assets.
Net deferred tax assets consist of the following at December 31:
1999 1998 ---- ---- Deferred tax assets: Net operating loss carryforwards $ 52,302 $ 41,143 Accrued liabilities 16,812 18,001 Loans and accounts receivable 1,382 3,670 Property and equipment 1,028 1,311 Intangible assets 3,824 4,192 Tax credit carry forwards 3,418 - -------- -------- Total deferred tax assets 78,766 68,317 Less valuation allowance (78,766) (68,317) -------- -------- Net deferred tax assets $ - $ - ======== ========
The valuation allowance was $78,766 and $68,317 at December 31, 1999 and 1998, respectively. The Company has determined the valuation allowance based upon the weight of available evidence regarding future taxable income consistent with the principles of SFAS No. 109, Accounting for Income Taxes. The $10,449 increase in the valuation allowance during 1999 was the result of net changes in temporary differences, and an increase in the net operating loss and tax credit carryforwards. The valuation allowance also includes amounts related to previous acquisitions from years before 1999. Future realization of these deferred tax assets would result in the reduction of goodwill recorded in connection with the acquisitions.
The Company has federal net operating loss carryforwards of $127,347 as of December 31, 1999 available to offset future taxable income of the consolidated group of corporations. Since the Recapitalization transaction on December 10, 1999 constituted a change of ownership, tax law imposes a limitation on the future use of the Company's net operating loss carryforwards generated through the date of the change in ownership. The annual limit is equal to the long-term tax-exempt bond rate times the fair imputed value of the Company's stock immediately before the change in ownership. In addition, the Company acquired a net operating loss carry forward of $3,800 with the acquisition of Union that is subject to special tax law restrictions that limit its potential benefit. These loss carryforwards expire between 2010 and 2019. The Company also has available federal tax credit carryforwards of approximately $616 which expire between 2003 and 2012, federal minimum tax credit carryforwards of approximately $759 which may be carried forward indefinitely and various state tax credit carryforwards of approximately $2,043 with various expiration dates.
Since the Company has a history of generating net operating losses, management does not expect the Company to generate taxable income in the foreseeable future sufficient to realize tax benefits from the net operating loss carryforwards or the future reversal of the net deductible temporary differences. The amount of the deferred tax assets considered realizable, however, could be increased in future years if estimates of future taxable income during the carryforward period change.
A reconciliation of the Company's reported income tax provision to the U.S. federal statutory rate is as follows:
1999 1998 1997 ---- ---- ----
Federal taxes at statutory rate $(13,257) $(7,994) $(16,052)
State income taxes (net of federal tax benefits) (874) 18 (2,092)
Foreign income taxes - - -
Nondeductible amortization 3,753 3,414 1,406
Other 2,371 249 (4,567)
Deferred tax valuation allowance 8,766 5,143 32,432 -------- ------- --------
Provision for income taxes $ 759 $ 830 $ 11,127 ======== ======= ========
11. RELATED PARTY TRANSACTIONS
In connection with the agreements executed in connection with the Recapitalization discussed in Note 2, the Company paid transaction costs and advisory fees to certain Company stockholders. Such costs were $17,092 for the year end December 31, 1999.
The Company had an agreement with an affiliate of certain Company stockholders to provide management and investment services for a monthly fee of $50. The Company recorded management fees to this entity of $450 for the year ended December 31, 1997. The agreement was terminated September 30, 1997.
Subject to the agreements executed in connection with the various acquisitions, the Private Placement discussed in Note 6 and certain management and advisory agreements, the Company has paid to certain Company stockholders transaction costs and advisory fees. Such costs were zero, $3,466 and $1,600 for the years ended December 31, 1999, 1998 and 1997, respectively.
Under various financing arrangements associated with the Company's acquisitions and credit facility, the Company incurred interest expense of $3,376, $2,333 and $3,317 for the years ended December 31, 1999, 1998 and 1997, respectively, to certain Company stockholders of which one is a financial institution and was co-administrative agent of the Company's prior credit facility.
In December 1997, the Company invested $5,000 for a minority interest in a limited liability corporation (the "LLC") for the purpose of acquiring purchased loan and accounts receivable portfolios. The majority interest in the LLC is held by an affiliate of one of the Company's stockholders. In the fourth quarter of 1998, the Company wrote down its investment in the LLC by $3,000 which is included in amortization expense in the accompanying consolidated statement of operations. The write down resulted from an analysis of the carrying value of the purchased portfolios owned by the LLC. In December 1998, the Company entered into an agreement with the majority owner of the LLC to settle all outstanding disputes relating to the sourcing and collection of certain purchased loan and accounts receivable portfolios. As part of the settlement, the Company was paid $3,000 which was recorded in revenue in the accompanying consolidated statement of operations.
12. STOCK OPTION AND AWARD PLAN
The Company has established the Outsourcing Solutions Inc. 1995 Stock Option and Stock Award Plan (the "Plan"). The Plan is a stock award and incentive plan which permits the issuance of options, stock appreciation rights ("SARs") in tandem with such options, restricted stock, and other stock-based awards to selected employees of and consultants to the Company. The Plan reserved 304,255 Voting Common Shares for grants and provides that the term of each award, not to exceed ten years, be determined by the Compensation Committee of the Board of Directors (the "Committee") charged with administering the Plan. In February 1997, the Board of Directors approved an increase to the reserve of Voting Common Shares to 500,000 with an additional approval to 750,000 in December 1997.
Under the terms of the Plan, options granted may be either nonqualified or incentive stock options and the exercise price generally may not be less than the fair market value of a Voting Common Share, as determined by the Committee, on the date of grant. SARs granted in tandem with an option shall be exercisable only to the extent the underlying option is exercisable and the grant price shall be equal to the exercise price of the underlying option. As of December 31, 1999, no SARs have been granted. The awarded stock options vest over three to four years and vesting may be accelerated upon the occurrence of a change in control as defined in the Plan. The options expire ten years after date of grant.
In June, 1999, 25,500 options were repriced from a grant price of $40.00 to $25.00. In addition, 58,500 options were repriced from a grant price of $65.00 or $50.00 to $40.00. Simultaneously, the vesting provisions of certain options were modified to provide for prorata vesting over a specified number of years. Accordingly, compensation expense was recognized during 1999 as a result of these modifications of certain options. In addition, in connection with the Recapitalization, certain options exercised and the holders of such options received a cash payment equal to the exercise price of such options and $37.47, the price per share at which the Recapitalization was consummated.
A summary of the 1995 Stock Option and Stock Award Plan is as follows:
Number of Shares of Weighted Average Stock Subject Exercise Price to Options Per Share -------------- ----------------
Outstanding at January 1, 1997 246,021 $14.23 Granted 397,500 27.99 Forfeited (75,000) 22.33 ---------- Outstanding at December 31, 1997 568,521 22.78 Granted 64,300 58.83 Forfeited (54,000) 35.19 ---------- Outstanding at December 31, 1998 578,821 25.63 Granted 214,000 40.00 Forfeited (104,500) 28.52 Exercised (245,396) 18.59 ---------- Outstanding at December 31, 1999 442,925 31.69 ==========
Reserved for future option grants 307,075
Exercisable shares at December 31, 1999, 1998 and 1997 were 442,925, 105,784 and 49,647, respectively.
A summary of stock options outstanding at December 31, 1999 is as follows:
Options Outstanding Options Exercisable -------------------------------- ---------------------- Weighted Average Remaining Number Contractual Exercise Number Exercise Exercise Price Outstanding Life Price Exercisable Price -------------- ----------- ----------- -------- ----------- -------- $12.50 70,175 6.7 years $12.50 70,175 $12.50 $25.00 116,750 7.6 years $25.00 116,750 $25.00 $40.00 256,000 9.1 years $40.00 256,000 $40.00 ------- ------- $12.50-$40.00 442,925 8.6 years $31.69 442,925 $31.69 ======= =======
The Company accounts for the Plan in accordance with APB Opinion No. 25, under which no compensation cost has been recognized for the majority of stock option awards. As required by SFAS No. 123, the Company has estimated the fair value of its option grants since January 1, 1996. The fair value for these options was estimated at the date of the grant based on the following weighted average assumptions:
1999 1998 1997 ---- ---- ----
Risk free rate 5.0% 5.0% 5.44% Expected dividend yield of stock 0% 0% 0% Expected volatility of stock 0% 0% 0% Expected life of option (years) 10.0 10.0 10.0
Since the Company's common stock is not publicly traded, the expected stock price volatility is assumed to be zero. The weighted fair values of options granted during 1999, 1998 and 1997 were $15.74, $23.14, and $12.29, respectively. The Company's pro forma information is as follows:
1999 1998 1997 ---- ---- ---- Net loss: As reported $(43,957) $(24,341) $(58,337) Pro forma (45,436) (25,742) (59,570)
In addition, the Committee may grant restricted stock to participants of the Plan at no cost. Other than the restrictions which limit the sale and transfer of these shares, recipients of restricted stock awards are entitled to vote shares of restricted stock and dividends paid on such stock. No restricted stock has been granted as of December 31, 1999.
13. COMMITMENTS AND CONTINGENCIES
From time to time, the Company enters into servicing agreements with companies which service loans for others. The servicers handle the collection efforts on certain nonperforming loans and accounts receivable on the Company's behalf. Payments to the servicers vary depending on the servicing contract. Current contracts expire on the anniversary date of such contracts but are automatically renewable at the option of the Company.
A subsidiary of the Company has several Portfolio Flow Purchase Agreements, no longer than one year, whereby the subsidiary has a monthly commitment to purchase nonperforming loans meeting certain criteria for an agreed upon price subject to due diligence. The purchases under the Portfolio Flow Purchase Agreements were $33,303 which includes amounts purchased and subsequently sold to FINCO (see Note 18), $25,521 and $20,661 for the years ended December 31, 1999, 1998 and 1997, respectively.
The Company leases certain office space and computer equipment under non-cancelable operating leases. These non-cancelable operating leases, with terms in excess of one year, are due in approximate amounts as follows: Amount -------- 2000 $ 16,329 2001 14,019 2002 10,551 2003 8,033 2004 6,668 Thereafter 18,004 -------- Total lease payments $ 73,604 ========
Rent expense under operating leases was $16,974, $15,800 and $8,100 for the years ended December 31, 1999, 1998 and 1997, respectively.
14. LITIGATION
At December 31, 1999, the Company was involved in a number of legal proceedings and claims that were in the normal course of business and routine to the nature of the Company's business. While the results of litigation cannot be predicted with certainty, the Company has provided for the estimated uninsured amounts and costs to resolve the pending suits and management, in consultation with legal counsel, believes that reserves established for the ultimate resolution of pending matters are adequate at December 31, 1999.
15. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values and the methods and assumptions used to estimate the fair values of the financial instruments of the Company as of December 31, 1999 and 1998 are as follows. The carrying amount of cash and cash equivalents and long-term debt except the Notes, approximate the fair value. The approximate fair value of the Notes at December 31, 1999 and 1998 was $97,000 and $95,300, respectively. The fair value of the long-term debt was determined based on current market rates offered on notes and debt with similar terms and maturities. The fair value of Receivables was determined based on both market pricing and discounted expected cash flows. The discount rate was based on an acceptable rate of return adjusted for the risk inherent in the Receivable portfolios. The estimated fair value of Receivables approximated its carrying value at December 31, 1999 and 1998.
In December 1997, the Company completed an in-depth analysis of the carrying value of its Receivables. This analysis included an evaluation of achieved portfolio amortization rates, historical and estimated future costs to collect, as well as projected total future collection levels. As a result of this analysis, the Company recorded $10,000 of additional amortization in December 1997 relating to the Receivables acquired in September 1995 in conjunction with the Company's acquisition of API, to reduce their carrying value to estimated fair value.
16. EMPLOYEE BENEFIT PLANS
At December 31, 1997, the Company had five defined contribution plans. During 1998, the Company combined four of these defined contribution plans into a new defined contribution plan sponsored by the Company. At December 31, 1999 and 1998, the Company has five defined contribution plans, four of which it acquired through the Union acquisition, which provide retirement benefits to the majority of all full time employees. The Company matches a portion of employee contributions to the plans. Company contributions to these plans, charged to expense, were $1,654, $1,570 and $276 for the years ended December 31, 1999, 1998 and 1997, respectively.
17. ENTERPRISE WIDE DISCLOSURE
The Company operates in one business segment. As a strategic receivables management company, the primary services of the Company consist of collection services, portfolio purchasing services and outsourcing services. In addition, the Company derives substantially all of its revenues from domestic customers.
The following table presents the Company's revenue by type of service for the year ended December 31: 1999 1998 1997 ---- ---- ---- Collection services $ 362,964 $ 350,080 $ 180,871 Portfolio purchasing services 80,391 82,399 67,809 Outsourcing services 61,070 46,921 23,003 --------- --------- --------- Total $ 504,425 $ 479,400 $ 271,683 ========= ========= =========
18. PURCHASED LOANS AND ACCOUNTS RECEIVABLE PORTFOLIOS FINANCING
In October 1998, a special-purpose finance company, OSI Funding Corp., formed by the Company, entered into a revolving warehouse financing arrangement (the "Warehouse Facility") for up to $100,000 of funding capacity for the purchase of loans and accounts receivable portfolios over its five year term. In connection with the Recapitalization, OSI Funding Corp. converted to a limited liability company and is now OSI Funding LLC ("FINCO"), with OSI owning approximately 78% of the financial interest but having only approximately 29% of the voting rights. In connection with the establishment of the Warehouse Facility, FINCO entered into a servicing agreement with a subsidiary of the Company to provide certain administrative and collection services on a contingent fee basis (i.e., fee is based on a percent of amount collected) at prevailing market rates based on the nature and age of outstanding balances to be collected. Servicing revenue from FINCO is recognized by the Company as collections are received. All borrowings by FINCO under the Warehouse Facility are without recourse to the Company.
The following summarizes the transactions between the Company and FINCO the the year ended December 31: 1999 1998 ---- ---- Sales of purchased loans and accounts receivables portfolios by the Company to FINCO $56,664 $9,134
Servicing fees paid by FINCO to the Company $13,481 $792
Sales of purchased loans and accounts receivable portfolios by the Company to FINCO were in the same amount and occurred shortly after such portfolios were acquired by the Company from the various unrelated sellers. In conjunction with sales of Receivables to FINCO and the servicing agreement, the Company recorded servicing assets which are being amortized over the servicing agreement. The carrying value of such servicing assets is $1,300 at December 31, 1999 and was not considered material at December 31, 1998.
At December 31, 1999 and 1998, FINCO had purchased loans and accounts receivable portfolios of $42,967 and $8,361, respectively. At December 31, 1999 and 1998, FINCO had outstanding borrowings of $32,051 and $6,482, respectively, under the Warehouse Facility.
19. NONRECURRING EXPENSES
After the Company's formation and seven acquisitions, the Company adopted a strategy to align the Company along business services and establish call centers of excellence. As a result, the Company incurred $5,063 of nonrecurring conversion, realignment and relocation expenses for the year ended December 31, 1999. These expenses include costs resulting from the temporary duplication of operations, closure of certain call centers, hiring and training of new employees, costs of converting collection operating systems, and other one-time and redundant costs.
INDEPENDENT AUDITORS REPORT
To the Stockholders of Outsourcing Solutions Inc.:
We have audited the consolidated financial statements of Outsourcing Solutions Inc. and it subsidiaries as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated March 28, 2000; such consolidated financial statements and report is included elsewhere in this Form 10-K. Our audits also included the consolidated financial statement schedule of Outsourcing Solutions Inc. and its subsidiaries, listed in the accompanying index at Item 14(a)2. This consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Deloitte & Touche LLP - --------------------------- Deloitte & Touche LLP
St. Louis, Missouri March 28, 2000
Schedule II
Outsourcing Solutions Inc. and Subsidiaries Valuation and Qualifying Accounts and Reserves For the year ended December 31, 1999, 1998 and 1997 (in thousands)
Column A Column B Column C Column D Column E - -------------------- --------- ----------------------- ---------- ---------- Additions (B) Balance ----------------------- @ beg. Charged Charged to Deductions Balance @ of to Other (Please end of Description Period Expenses Accounts (A) explain) Period - ------------------------------ -------- ------------ ---------- ---------
Allowance for doubtful accounts:
1999 1,309 651 - 1,431 529 ====== ==== ==== ====== ======
1998 538 108 798 135 1,309 ====== ==== ==== ====== ======
1997 641 367 - 470 538 ====== ==== ==== ====== ======
(A) For 1998, Union balance at date of acquisition. (B) Accounts receivable write-offs and adjustments, net of recoveries. | 25,792 | 173,425 |
799698_1999.txt | 799698_1999 | 1999 | 799698 | ITEM 1. BUSINESS
FORWARD-LOOKING STATEMENTS
This Form 10-K and other statements issued or made from time to time by CytRx Corporation or its representatives contain statements which may constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "1933 Act"), and Section 21E of the Securities Exchange Act of 1934, as amended. Those statements include statements regarding the intent, belief or current expectations of CytRx Corporation and members of its management team, as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements are included as Exhibit 99.1 to this Form 10-K and are hereby incorporated by reference. The Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.
GENERAL
CytRx Corporation, a Delaware corporation ("CytRx" or the "Company"), was incorporated in 1985 and is engaged in the development and commercialization of pharmaceutical-related products and services primarily involving human therapeutics focused on high-value critical-care therapies. The Company's primary focus is on FLOCOR(TM), initially being developed for the treatment of acute sickle cell crisis. CytRx plans to expand the development of FLOCOR to other vascular disorders such as shock and stroke over time. CytRx is also engaged in research or has technology available for license in the areas of infectious disease, gene delivery, vaccine adjuvants, and animal feed additives. See "Product Development".
Certain financial information concerning the industry segments in which the Company operates can be found in Note 15 to the Company's Consolidated Financial Statements.
RECENT DEVELOPMENTS
Results of FLOCOR Phase III Trial. As more fully discussed under "Product Development - FLOCOR" below, on December 21, 1999, the Company reported results from its Phase III clinical study of FLOCOR for treatment of acute sickle cell crisis. Although the study did not demonstrate statistical significance in the primary endpoint, statistically significant and clinically important benefits associated with FLOCOR were observed in certain subgroups. In addition, among the entire patient population, treatment with FLOCOR resulted in a statistically significant increase in the percent of patients achieving resolution of their crisis. Based on these encouraging efficacy results and a good safety profile the Company's independent Data and Safety Monitoring Board (DSMB) and other thought leaders in the area of sickle cell disease have recommended that the Company continue with clinical development of FLOCOR in sickle cell disease. The Company intends to present the results of the Phase III trial at the National Sickle Cell Disease Meeting in Philadelphia on April 9 - 12.
Prior to the announcement of the Phase III results, the Company had been discussing potential licensing arrangements for FLOCOR with third parties. Currently, CytRx is continuing these discussions and is seeking other possible licensees. The terms of any potential license are unknown at the present time and there is no assurance that such a license will be consummated. CytRx does not plan to begin additional clinical studies for FLOCOR until such a license is put in place or the Company raises additional capital.
Current Financial Condition and Need for Additional Capital At December 31, 1999, the Company had net assets of $1,033,000 and working capital of $664,000,. During the first quarter of 2000, the Company terminated the services of twelve of its employees as part of its efforts to conserve its cash resources. See "Employees". The Company has further reduced its operations by suspending most of its technology development efforts requiring significant expenditures.
During the first quarter of 2000 CytRx reached agreement with certain of its trade creditors whereby an aggregate of $2.3 million of indebtedness was cancelled in exchange for the issuance of 937,592 shares of CytRx Common Stock and the granting of registration rights to such creditors. See Note 7 to the Company's Consolidated Financial Statements.
Effective March 24, 2000, the Company entered into a Stock Purchase Agreement with certain investors (the "Investors") whereby the Investors agreed to purchase 800,000 shares of the Company's Common Stock for an aggregate purchase price of $1.8 million and the issuance of warrants to purchase an additional 330,891 shares at $2.25 per share, expiring March 31, 2003. The Investors were granted registration rights for the shares issued to them and the shares underlying the warrants. In addition, the Investors will, upon effective registration of the shares, purchase an additional 286,000 shares at $2.25 per share and simultaneously receive an additional three-year warrant to purchase 143,000 shares at $2.25 per share. In lieu of these additional shares and warrants, the Investors have the option to purchase 429,000 shares at a price equal to 75% of a trailing average market price of the Company's Common Stock, as defined in the Stock Purchase Agreement.
As discussed under "Product Development - Other Product Development Efforts", in March 2000 CytRx entered into an Evaluation Agreement for its Gene Delivery technology. CytRx is also pursuing the sale of its TiterMax research adjuvant as well as the license or sale of certain of its other technologies. There is no assurance that any such transactions will be consummated.
Without an infusion of additional working capital from the sale of equity securities, license/sale of technology assets, or a combination of these, the Company has limited ability to advance its existing technologies.
In addition, on March 14, 2000 the Company received correspondence from Nasdaq regarding the Company's failure, as of December 31, 1999, to satisfy certain quantitative criteria of the maintenance standards for listing its Common Stock with the Nasdaq National Market which provided the Company with ten business days to respond with its plan to bring the Company back into compliance with such criteria. The Company has responded within such time period and is awaiting further notice from Nasdaq as to whether Nasdaq intends to commence procedures to delist CytRx Common Stock from the Nasdaq National Market. See Exhibit 99.1 - "Our Common Stock May Be Delisted from the Nasdaq National Market".
PRODUCT DEVELOPMENT
FLOCOR General. CytRx's primary focus is on FLOCOR(TM), purified poloxamer 188, a novel, intra-vascular agent with pharmacological properties that can be characterized as rheologic, cytoprotective and anti-adhesive / anti-thrombotic. FLOCOR is an intravenous solution that has the unique property of improving micro-vascular blood flow. Extensive preclinical and clinical studies suggest FLOCOR may be of significant benefit in acute ischemic vascular disorders such as stroke, heart attack, and vaso-occlusive crisis of sickle cell disease. FLOCOR may also provide benefit in acute care situations such as circulatory shock and acute respiratory distress syndromes where its favorable effects on micro-vascular blood flow may improve recovery from widespread ischemic / reperfusion injury.
The safety profile of FLOCOR is well established. It has been investigated in over 17 clinical studies representing administration to approximately 3,000 patients and healthy volunteers.
FLOCOR for Sickle Cell Crisis. The Company believes FLOCOR has significant potential in treating a variety of vascular-occlusive diseases, however, CytRx has chosen vaso-occlusive crisis associated with sickle cell anemia as its first development priority.
Sickle cell disease is a devestating disorder originating from an inherited abnormality of hemoglobin, the oxygen-carrying molecule in red blood cells. Under conditions of low blood oxygen, which is generally caused by dehydration or stress, the sickle cell victim's hemoglobin becomes rigid causing red blood to become rough, sticky and irregularly shaped, often looking like sickles, which gives the disease its name. Estimates place the number of persons suffering from sickle cell anemia in the U.S. at about 72,000, or roughly one in 400 African-Americans. It is also estimated that complications from sickle cell disease result in healthcare expenditures of from $1.0 to $1.5 billion annually in the U.S.
The most common problem sickle cell patients face is episodic pain (also referred to as vaso-occlusive crisis, or VOC). These episodes can last anywhere from days to weeks, and can vary significantly in their severity. The deformed sickle cells cannot easily flow through the smaller blood vessels of the body and tend to clump together, forming occlusions which impede blood flow. The occlusions deprive tissues of vital oxygen that can result in tissue death, inflammation and intense throbbing pain. Aside from causing considerable pain and suffering, these crisis episodes slowly destroy vital organs as they are deprived of oxygen. As a result, the life expectancy of sickle cell victims is about twenty years shorter than those without the disease. Patients suffering from sickle cell disease may experience several crisis episodes each year. Hospitalization is required when pain becomes too much to bear. There are about 75,000 hospital admissions annually to treat sickle cell patients undergoing acute vascular-occlusive crisis caused by the disease. On average, these patients require in-patient treatment for four to seven days. Currently there is no disease modifying treatment for acute crisis of sickle cell disease and treatment is limited to narcotics, fluids, and bed rest.
FLOCOR's unique surface-active properties decrease blood viscosity and enable the rigid sickled cells to become more flexible, thus allowing easier passage of blood cells through narrow blood vessels.
FLOCOR for Other Indications. CytRx believes that FLOCOR has the potential to be an effective treatment for other vascular-occlusive diseases such as heart attack and stroke. However, CytRx's current strategy is to focus its efforts and resources on gaining approval for the acute crisis of sickle cell anemia.
Status of Clinical Trials. On December 21, 1999, the Company reported results from its Phase III clinical study of FLOCOR for treatment of acute sickle cell crisis. The study demonstrated treatment benefits in favor of FLOCOR, however, it did not achieve statistical significance in the primary study endpoint. After thorough review of the data, the Company and its clinical consultants believe that a key assumption concerning the length of crisis may have negatively affected the outcome of the primary endpoint. The study assumed (based on historical data and supported by physician experiences) that most patients would resolve their crisis within one week (168 hours). Accordingly, the study used that time period to collect data concerning the primary endpoint of crisis duration. Patients not resolving their crisis within this time frame were assigned a "default" value of 168 hours. In the final study results, less than 40% of patients treated with placebo and about 52% of patients treated with FLOCOR resolved their crisis within 168 hours. Thus, the majority of patients in the study were assigned the default value of 168 hours. Consequently, it was not possible to detect a statistical difference in the primary endpoint defined as duration of crisis. However, the study did detect a highly statistically significant and clinically meaningful treatment effect in duration of crisis in the subgroup of patients fifteen years of age and less (p = 0.01) and patients concurrently treated with hydroxyurea (p = 0.02). More importantly, across the entire study population 51.6 % of patients treated with FLOCOR achieved resolution of their crisis compared to 36.6 % of patients treated with placebo. This treatment effect was highly statistically significant (p = 0.02). The Phase III study also demonstrated that FLOCOR is well tolerated. Based on the outcome of the Phase III trial, CytRx management and key thought leaders in the area of sickle cell disease believe a second pivotal clinical trial is warranted to confirm the treatment benefits of FLOCOR.
Orphan Drug Status. In June 1989, the FDA informed CytRx of its decision to grant RheothRx "Orphan Drug" designation for the treatment of sickle cell crisis and this designation applies to FLOCOR as well. The Orphan Drug Act of 1983, as amended, provides incentive to drug manufacturers to develop drugs for the treatment of rare diseases (e.g. diseases that affect less than 200,000 individuals in the United States, or diseases that affect more than 200,000 individuals in the United States). As a result of the designation of RheothRx/FLOCOR as an Orphan Drug, if the Company is the first manufacturer to obtain FDA approval to market FLOCOR for treatment of sickle cell crisis, the Company will obtain a seven-year period of marketing exclusivity beginning from the date of FLOCOR's approval. During this period, the FDA may not approve the same drug for the same use from another sponsor.
Other Product Development Efforts CytRx also is focusing its efforts on the sale or license of its "non-FLOCOR" technologies and is conducting minimal product development activities in order to conserve its cash resources. There is no assurance that any such sale or license of the Company's technologies will be consummated.
Gene Delivery -- CytRx has discovered and patented the use of certain poloxamers for gene delivery. The Company believes that its delivery system is as effective as conventional non-viral gene delivery systems such as cationic liposomes
but is significantly less toxic and is not metabolized. In addition, recent concern over the safety of viral gene delivery systems is likely to result in increased interest in non-viral delivery systems. CytRx believes there is potential use for this technology in (a) gene-based vaccines, (b) gene replacement therapy, and (c) ribozyme and anti-sense delivery.
In January 2000, CytRx entered into an evaluation agreement with a major worldwide pharmaceutical company (the "Potential Licensee") for the purpose of enabling the Potential Licensee to evaluate this technology in a gene-based vaccine for HIV. The agreement provides the Potential Licensee a one year exclusive option to license the technology for use in the aforementioned vaccine. Pursuant to the agreement, CytRx will provide material and consulting services during the evaluation period in exchange for certain payments. The agreement also prevents either party from naming the other party in any public or private disclosure, except as each may be legally required. There is no assurance that any sale or license of the Company's gene delivery technology to the Potential Licensee will result from this agreement.
Vaccine Adjuvants / Delivery Systems -- CytRx has discovered the use of certain non-ionic block copolymers (poloxamers) both alone and in a variety of emulsion systems as vaccine delivery systems - immunoadjuvants. The adjuvant-delivery systems have potential for use in both injectable and oral vaccines. Companies currently are evaluating the safety and efficacy of this technology for potential license under material transfer agreements.
Anti-Microbial -- CRL-1072 is a highly purified poloxamer that has demonstrated potent activity against a wide range of infectious agents. In animal models of fatal Mycobacterium tuberculosis, Mycobacterium avium and Toxoplasmosis infection, CRL-1072 results in significantly improved survival rates. More importantly, the compound is active against drug resistant isolates of M.tuberculosis. CRL-1072 has also been shown to reduce viral load and viral reactivation in models of chronic hepatitis B infection.
P-Glycoprotein Inhibitor -- CytRx has identified a series of novel inhibitors of the drug efflux pump P-glycoprotein. These compounds have potential therapeutic use as (a) chemosensitizers for drug resistant bacteria, (b) oral bioavailability enhancers for antibiotics or chemotherapeutics, and (c) chemosensitizers for drug resistant cancer.
Animal Growth Promotant -- CytRx's growth promotant has been shown to have a consistent effect to improve the rate of weight gain and feed efficiency in well-controlled studies in poultry and swine. CytRx is currently seeking a partner to purchase or license this technology.
Expenditures for research and development activities related to continuing operations were $12.8 million, $7.3 million and $3.6 million during the years ended December 31, 1999, 1998, and 1997, respectively.
SUBSIDIARY OPERATIONS AND DIVESTITURES
Titermax(TM) - CytRx manufactures, markets and distributes TiterMax, an adjuvant used to produce cell mediated and humoral responses in research animals. The keys to the potency of TiterMax lie in its immunostimulatory activity and the formation of stable water-in-oil emulsions. TiterMax aids in the antigen's effective presentation to the immune system without the toxic effects of other research adjuvants.
Spectrum Recruitment Research - CytRx also has a small group of human resource professionals who, in addition to their services to the Company, provide recruiting services to third parties under the name of Spectrum Recruitment Research.
Vaxcel, Inc. - In July 1999, CytRx terminated its license of its Optivax(R) vaccine adjuvant technology to Vaxcel due to Vaxcel's cessation of operations within the meaning of the license agreement. Concurrently with the termination of the Optivax license, all of Vaxcel's rights and obligations pursuant to its license of the Optivax technology to Corixa Corporation were assigned to CytRx. On June 2, 1999, CytRx entered into a Stock Acquisition Agreement with A-Z Professional Consultants, Inc. ("A-Z") for the sale of CytRx's equity interest in Vaxcel. The sale was consummated on September 9, 1999. Pursuant to the agreement, A-Z purchased 9,625,000 shares of common stock of Vaxcel from CytRx for a cash purchase price of $319,000. After consummation of this transaction, CytRx has no further equity interest in Vaxcel.
MANUFACTURING
The Company requires three suppliers of materials or services to manufacture FLOCOR; (i) a supplier of the raw drug substance, (ii) a supplier of the purified drug which is refined from the raw drug substance and (iii) a manufacturer who can formulate and sterile fill the purified drug substance into the finished drug product. The raw drug substance is currently widely available at commercial scales from numerous manufacturers. The Company has not entered into a formal agreement with any supplier for the raw drug substance because of its wide availability. In August 1999, the Company entered into a long-term commercial supply contract with Organichem, Corp., located in Rennselaer, New York for production of the purified drug substance. There can be no assurance that the Company's relationship with such supplier will continue or that the Company will be able to obtain additional purified drug substance if the Company's current supply is inadequate. Such inability to obtain additional purified drug substance in amounts and at prices acceptable to the Company could have a material adverse effect on the Company's business. To meet the need for manufacture of the Company's finished drug product, the Company has entered into a supply agreement with the Hospital Products Division of Abbott Laboratories. The inability of the Company to maintain such relationship on terms acceptable to the Company could have a material adverse effect on the Company's business.
If the Company modifies its manufacturing process or changes the source or location of product supply, regulatory authorities will require the Company to demonstrate that the material produced from the modified or new process or facility is equivalent to the material used in the Company's clinical trials. Further, any manufacturing facility and the quality control and manufacturing procedures used by the Company for the commercial supply of a product must comply with applicable Occupational Safety and Health Administration, Environmental Protection Agency, and FDA standards, including Good Manufacturing Practice regulations. See "Government Regulation".
PATENTS AND PROPRIETARY TECHNOLOGY
The Company actively seeks patent protection for its technologies, processes, uses, and ongoing improvements and considers its patents and other intellectual property to be critical to its business.
FLOCOR Patent. On November 23, 1999 the U.S. Patent Office issued patent No. 5,990,241 "Polyoxypropylene/Polyoxyethylene Copolymers With Improved Biological Activity" to CytRx Corporation. The Company believes the issue of this patent provides important exclusivity since it contains composition of matter claims for "purified" poloxamer 188, the active ingredient in FLOCOR. The patent will remain in effect until July 8, 2017.
The Company continually evaluates the patentability of new inventions and improvements developed by its employees and collaborators. Whenever appropriate, the Company will endeavor to file United States and international patent applications to protect these new inventions and improvements. However, there can be no assurance that any of the current pending patent applications or any new patent applications that may be filed will ever be issued in the United States or any other country.
The Company also attempts to protect its proprietary products, processes and other information by relying on trade secrets and non-disclosure agreements with its employees, consultants and certain other persons who have access to such products, processes and information. Under the agreements, all inventions conceived by employees are the exclusive property of the Company. Nevertheless, there can be no assurance that these agreements will afford significant protection against misappropriation or unauthorized disclosure of the Company's trade secrets and confidential information.
COMPETITION
Many companies, including large pharmaceutical, chemical and biotechnology firms with financial resources, research and development staffs, and facilities that are substantially greater than those of the Company, are engaged in the research and development of pharmaceutical products that could compete with FLOCOR or other products under development by the Company. The industry is characterized by rapid technological advances and competitors may develop their products more rapidly and/or such products may be more effective than those under development by the Company or its licensees and corporate partners. The Company competes in this research and development environment by attempting to develop its products and technologies in an innovative and timely fashion that would provide the Company with an advantage in the licensing and/or marketing of its products and technologies.
GOVERNMENT REGULATION
The marketing of pharmaceutical products requires the approval of the FDA and comparable regulatory authorities in foreign countries. The FDA has established guidelines and safety standards which apply to the pre-clinical evaluation, clinical testing, manufacture and marketing of pharmaceutical products. The process of obtaining FDA approval for a new therapeutic product (drug) generally takes several years and involves the expenditure of substantial resources. The steps required before such a product can be produced and marketed for human use in the United States include preclinical studies in animal models, the filing of an Investigational New Drug ("IND") application, human clinical trials and the submission and approval of an NDA. The NDA involves considerable data collection, verification and analysis, as well as the preparation of summaries of the manufacturing and testing processes, preclinical studies, and clinical trials. The FDA must approve the NDA before the drug may be marketed. There can be no assurance that the Company will be able to obtain the required FDA approvals for any of its products.
The manufacturing facilities and processes for the Company's products, whether manufactured directly by the Company or by a third party, will be subject to rigorous regulation, including the need to comply with Federal Good Manufacturing Practice regulations. The Company is also subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Nuclear Energy and Radiation Control Act, the Toxic Substance Control Act and the Resource Conservation and Recovery Act.
EMPLOYEES
As of December 31, 1999, the Company had fifteen full-time and three part-time employees, nine of which were directly involved in the conduct of scientific or research and development activities for the Company. In the first quarter of 2000, CytRx terminated the services of twelve of its employees as part of its overall reduction in operations in order to conserve its cash resources. As of March 24, 2000, the Company has six full-time employees and utilizes the services of two former employees on a contract basis.
ITEM 2.
ITEM 2. PROPERTIES
The Company currently subleases laboratory and related space from Oread at 150 Technology Parkway, Norcross, Georgia, and leases administrative office space at 154 Technology Parkway, Norcross, Georgia. These facilities are in satisfactory condition and suitable for purposes of the Company's present operations. The Company has historically made use of contract lab facilities for additional research and development purposes.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on The Nasdaq Stock Market under the symbol CYTR. The following table sets forth the high and low sale prices for the Common Stock for the periods indicated as reported by Nasdaq. Such prices represent prices between dealers without adjustment for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions.
On March 24, 2000, the closing price of the Common Stock as reported on The Nasdaq Stock Market, was $3 1/4 and there were approximately 1,500 holders of record of the Company's Common Stock. The number of record holders does not reflect the number of beneficial owners of the Company's Common Stock for whom shares are held by brokerage firms and other institutions. On March 14, 2000 the Company received correspondence from Nasdaq regarding the Company's failure to satisfy certain quantitative criteria of the maintenance standards for listing its Common Stock with the Nasdaq National Market which provided the Company with ten business days to respond with its plan to bring the Company back into compliance with such criteria. If the Company is unable to satisfy such criteria or provide Nasdaq with an adequate plan to return to compliance, Nasdaq may commence delisting procedures. See Exhibit 99.1 - "Our Common Stock May Be Delisted from the Nasdaq National Market". The Company has not paid any dividends since its inception and does not contemplate payment of dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following should be read in conjunction with Selected Financial Data and the audited Consolidated Financial Statements of the Company included in this report.
Liquidity and Capital Resources
At December 31, 1999, the Company had cash, cash equivalents and investments of $3.0 million and net assets of $1.0 million, compared to $15.3 million and $14.7 million, respectively, at December 31, 1998. The Company had working capital of $664,000 at December 31, 1999 compared to $13.7 million at December 31, 1998.
During the first quarter of 2000, CytRx reached agreement with certain of its trade creditors whereby an aggregate of $2.3 million of indebtedness was cancelled in exchange for issuance of 937,592 shares of CytRx Common Stock and the granting of registration rights to such creditors.
Effective March 24, 2000, the Company entered into a Stock Purchase Agreement with certain investors (the "Investors") whereby the Investors agreed to purchase 800,000 shares of the Company's Common Stock for an aggregate purchase price of $1.8 million and the issuance of warrants to purchase an additional 330,891 shares at $2.25 per share, expiring March 31, 2003. The Investors were granted registration rights for the shares issued to them and the shares underlying the warrants. In addition, the Investors will, upon effective registration of the shares, purchase an additional 286,000 shares at $2.25 per share and simultaneously receive an additional three-year warrant to purchase 143,000 shares at $2.25 per share. In lieu of these additional shares and warrants, the Investors have the option to purchase 429,000 shares at a price equal to 75% of a trailing average market price of the Company's Common Stock, as defined in the Stock Purchase Agreement.
The Company will require additional funds to finance operations and currently is seeking private or public equity investments and future collaborative arrangements with third parties to meet such needs. The Company's ability to obtain future financings through joint ventures, product licensing arrangements, equity financings or otherwise is subject to market conditions and the Company's ability to identify parties that are willing and able to enter into such arrangements on terms that are satisfactory to the Company. There is no assurance that such funding will be available for the Company to finance its operations on acceptable terms, if at all. Insufficient funding may require the Company to delay, reduce or eliminate some or all of its research and development activities, planned clinical trials and administrative programs.
The Company's future expenditures and capital requirements depend on numerous factors including the progress and focus of its research and development programs, the progress and results of pre-clinical and clinical testing, the time and costs involved in obtaining regulatory approvals, the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights, competing technological and market developments, the ability of the Company to establish collaborative arrangements, the initiation of commercialization activities, the purchase of capital equipment and the availability of other financing.
At December 31, 1999 the Company and its subsidiaries had net operating loss carryforwards for income tax purposes of approximately $53.1 million, which will expire in 2000 through 2019 if not utilized. The Company also has research and development tax credits and orphan drug tax credits available to reduce income taxes, if any, of approximately $6.3 million which will expire in 2000 through 2014 if not utilized. Based on an assessment of all available evidence including, but not limited to, the Company's limited operating history and lack of profitability, uncertainties of the commercial viability of the Company's technology, the impact of government regulation and healthcare reform initiatives, and other risks normally associated with biotechnology companies, the Company has concluded that it is more likely than not that these net operating loss carryforwards and credits will not be realized and, as a result, a 100% deferred tax valuation allowance has been recorded against these assets.
Results of Operations
The Company recorded a net loss of $15,029,000 for the year ended December 31, 1999 as compared to net losses of $5,118,000 for 1998 and $6,053,000 for 1997. Loss from continuing operations before extraordinary items was $14,989,000, $7,506,000 and $4,426,000 in 1999, 1998 and 1997, respectively.
Net product sales from continuing operations, which consist primarily of sales of TiterMax research adjuvant, were $500,000 in 1999, $481,000 in 1998 and $456,000 in 1997. Cost of product sales was $45,000 in 1999, $36,000 in 1998 and $40,000 in 1997, or 9%, 7% and 9% of net product sales, respectively. The Company also markets the services of its small group of human resource professionals to third parties under the name of Spectrum Recruitment Research ("Spectrum") as a way of offsetting the Company's cost of maintaining this function. Net service revenues from continuing operations related to Spectrum were $323,000 in 1999, $351,000 in 1998 and $422,000 in 1997. Cost of service revenues was $240,000 in 1999, $187,000 in 1998 and $242,000 in 1997, or 74%, 53% and 57% of net service revenues, respectively.
Interest income from continuing operations was $463,000 in 1999 as compared to $1,007,000 in 1998 and $752,000 in 1997. The variances between years is attributable to fluctuating cash and investment balances. Collaborative, grant and license fee income was $464,000 in 1999 versus $511,000 in 1998 and $94,000 in 1997. The increase during 1998 and 1999 is due to a $445,000 grant from the U.S. Food and Drug Administration's Division of Orphan Drug Development to support CytRx's Phase III clinical trial of FLOCOR, as well as certain additional Small Business Innovative Research (SBIR) grants for the Company's additional research programs. Other income was $142,000, $244,000 and $535,000 in 1999, 1998 and 1997, respectively, and primarily relates to subrental fees to certain third parties, as well as administrative and facilities costs allocated by CytRx to its discontinued subsidiaries. The related costs are included in selling, general and administrative expenses. The decrease during the three year period is reflective of the discontinuance of the Proceutics and CytRx Animal Health operations in early 1998 and Vaxcel during 1999.
Research and development expenditures from continuing operations during 1999 were $12,812,000 versus $7,306,000 in 1998 and $3,605,000 in 1997. Research and development expenditures have increased during the three year period primarily as a result of the Company's development activities for FLOCOR. The Company's pivotal Phase III trial of FLOCOR for treatment of acute sickle cell crisis, which was initiated in March 1998 was completed in December 1999. During 1999 the Company also continued its Phase I trial of FLOCOR for treatment of Acute Chest Syndrome in sickle cell patients and initiated two additional clinical trials of FLOCOR - a Phase III study investigated repeat use of FLOCOR in patients with acute sickle cell crisis and a Phase I/II study for treatment of Acute Lung Injury.
Selling, general and administrative expenses from continuing operations during 1999 were $3,784,000 as compared to $2,527,000 in 1998 and $2,505,000 in 1997. The increase from 1998 to 1999 is primarily due to $1,044,000 of non-cash charges related to issuance of stock warrants to certain consultants and certain vesting events for management stock options.
Interest expense was $0, $46,000 and $293,000 in 1999, 1998 and 1997, respectively. Included in the 1997 amount is $265,000 related to the beneficial conversion feature of $2,000,000 of convertible notes issued in 1997. (See Note 5 to Financial Statements.)
The extraordinary loss in 1998 relates to the early extinguishment of 6% convertible notes which resulted in payment of premiums of $150,000 and expensing of capitalized debt issuance costs of $175,000.
Discontinued Operations - Net income (loss) from the discontinued operations of Proceutics, CytRx Animal Health and Vaxcel (net of minority interest) was $(40,000), $2,713,000 and $(1,627,000) in 1999, 1998 and 1997. The following table presents the breakdown of net income (loss) from discontinued operations (see Notes 13 and 15 to Financial Statements).
Inflation - Management believes that inflation had no material impact on the Company's operations during the three year period ended December 31, 1999.
Impact of Year 2000
In prior years, the Company discussed the nature and progress of its plans to become Year 2000 ready. In late 1999, the Company completed its remediation and testing of systems. As a result of those planning and implementation efforts, the Company experienced no significant disruptions in mission critical information technology and non-information technology systems and believes those systems successfully responded to the Year 2000 date change. The Company expensed less than $25,000 during 1999 in connection with remediating its systems. The Company is not aware of any material problems resulting from Year 2000 issues, either with its products, its internal systems, or the products and services of third parties. The Company will continue to monitor its mission critical computer applications and those of its suppliers and vendors throughout the year 2000 to ensure that any latent Year 2000 matters are addressed promptly.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's financial instruments that are sensitive to changes in interest rates are its investments. As of December 31, 1999, the Company held no investments other than amounts invested in money market accounts. The Company is not subject to any other material market risks.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and supplemental schedule of the Company and the notes thereto as of December 31, 1999 and 1998, and for each of the three years ended December 31, 1999, together with the independent auditors' report thereon, are set forth on pages to of this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to this item is incorporated herein by reference from the Proxy Statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information with respect to this item is incorporated herein by reference from the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with respect to this item is incorporated herein by reference from the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED AS PART OF THIS 10-K:
(1) Financial Statements
The consolidated financial statements of the Company and the related report of independent auditors thereon are set forth on pages to of this Annual Report on Form 10-K. These consolidated financial statements are as follows:
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Operations for the Years Ended December 31, 1999, 1998 and 1997
Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1997, 1998 and 1999
Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
Report of Independent Auditors
(2) Financial Statement Schedules
The following financial statement schedule is set forth on page of this Annual Report on Form 10-K.
Schedule II - Valuation and Qualifying Accounts for the years ended December 31, 1999, 1998 and 1997
All other schedules are omitted because they are not required, not applicable, or the information is provided in the financial statements or notes thereto.
(3) Exhibits
See Exhibit Index on page 13 of this Annual Report on Form 10-K.
(b) REPORTS ON FORM 8-K
None.
CYTRX CORPORATION FORM 10-K EXHIBIT INDEX
* Indicates a management contract or compensatory plan or arrangement. - ---------
(a) Incorporated by reference to the Registrant's Registration Statement on Form S-3 (File No. 333-39607) filed on November 5, 1997. (b) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (File No. 333-37171) filed on July 21, 1997. (c) Incorporated by reference to the Registrant's Current Report on Form 8-K filed on April 21, 1997. (d) Incorporated by reference to the Registrant's Registration Statement on Form S-l (File No. 33-8390) filed on November 5, 1986. (e) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q filed on November 13, 1997. (f) Incorporated by reference to the Registrant's Annual Report on Form 10-K filed on March 27, 1996. (g) Incorporated by reference to the Registrant's Registration Statement on Form S-8 (File No. 33-93818) filed on June 22, 1995. (h) Incorporated by reference to the Registrant's Annual Report on Form 10-K filed on March 30, 1998.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CYTRX CORPORATION
By: /s/ Jack J. Luchese ----------------------------------------- Jack J. Luchese, President Date: March 29, 2000 and Chief Executive Officer (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
CYTRX CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
CYTRX CORPORATION CONSOLIDATED BALANCE SHEETS
See accompanying notes.
CYTRX CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
CYTRX CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes.
CYTRX CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes
CYTRX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Business and Need for Additional Capital
CytRx Corporation ("CytRx" or "the Company") is a biopharmaceutical company engaged in the development and commercialization of high-value human therapeutics. The Company's current research and development focus is on vascular-occlusive disorders. CytRx also has a research pipeline with opportunities in the areas of acute respiratory disorders, infectious disease, gene and drug delivery, vaccines, and animal feed additives.
The Company's product sales from continuing operations include sales of TiterMax research adjuvant. TiterMax is currently sold worldwide through both distributor and direct channels. The Company also markets the services of its small group of human resources professionals under the name of Spectrum Recruitment Research ("Spectrum") as a way of offsetting the Company's cost of maintaining this function. Spectrum's services are marketed primarily within metropolitan Atlanta, Georgia. The Company's operational focus is on the development and commercialization of pharmaceutical products; the TiterMax and Spectrum operations were formed as ancillary activities.
At December 31, 1999, the Company had net assets of $1,033,000 and working capital of $664,000. During the first quarter of 2000, the Company terminated the services of twelve of its employees as part of its efforts to conserve its cash resources and has further reduced its operations by suspending most of its technology development efforts requiring significant expenditures. The Company has incurred losses from operations since inception, and the ongoing ability of the Company to operate as a going concern with the current portfolio of technologies under development will be determined by the results of technology licensing efforts and/or the actual proceeds of any fund-raising activities. If the Company is unable to raise significant additional funds, it will be limited in its ability to advance its technologies under development.
During the first quarter of 2000, the Company took certain steps to improve its financial condition (see Notes 7 and 16). The Company believes that the proceeds of these transactions will allow the Company to operate throughout the remainder of 2000, but that additional funds will be needed to significantly advance any of the Company's technologies under development.
2. Summary of Significant Accounting Policies
Basis of Presentation - The consolidated financial statements include the accounts of CytRx together with those of its majority-owned subsidiaries. As more thoroughly discussed in Note 13, the operations of Proceutics, Inc. ("Proceutics"), CytRx Animal Health, Inc. ("CytRx Animal Health") (formerly VetLife, Inc.), and Vaxcel, Inc. ("Vaxcel") are presented as discontinued operations for all periods presented.
Cash Equivalents - The Company considers all highly liquid debt instruments with an original maturity of 90 days or less to be cash equivalents. Cash equivalents consist primarily of commercial paper and amounts invested in money market accounts.
Investments - Management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. Marketable equity securities and debt securities not classified as held-to-maturity are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported in a separate component of stockholders' equity. Realized gains and losses are included in investment income and are determined on a first-in, first-out basis (see Note 3).
Fair Value of Financial Instruments - The carrying amounts reported in the balance sheet for cash and cash equivalents, investments, accounts receivable, notes receivable and accounts payable approximate their fair values. The carrying amount reported in the balance sheet for long-term debt approximates its fair value. The fair value of such long-term debt is estimated using discounted cash flow analyses based on the Company's current incremental borrowing rate for similar types of borrowing arrangements.
Inventories - Inventories are valued at the lower of cost or market using the first-in, first-out (FIFO) method.
Property and Equipment - Property and equipment are stated at cost and depreciated using the straight-line method based on the estimated useful lives (five years for equipment and furniture) of the related assets. Leasehold improvements are amortized over the term of the related lease or other contractual arrangement. As of December 31, 1999, the Company had capitalized approximately $2.5 million of equipment and leasehold improvements which were not placed in service as of that date.
Acquired Developed Technology and Other Intangibles - Acquired developed technology and other intangible assets, primarily goodwill, (see Note 13) are amortized over their estimated useful lives (fifteen years) on a straight-line basis. Management continuously monitors and evaluates the realizability of recorded acquired developed technology and other intangible assets to determine whether their carrying values have been impaired. In accordance with Financial Accounting Standards Board ("FASB") Statement No. 121, Accounting for the Impairment of Long-Lived Assets, the Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. Any impairment loss is measured by comparing the fair value of the asset to its carrying amount. As more fully discussed in Note 13, during 1998 management evaluated these assets and recorded a provision for impairment of such assets.
Patents and Patent Application Costs - Although the Company believes that its patents and underlying technology have continuing value, the amount of future benefits to be derived therefrom is uncertain. Patent costs are therefore expensed rather than capitalized.
Accrued Expenses and Other Liabilities - Accrued expenses and other liabilities at December 31 are summarized below (in thousands). The headings correspond to the captions on the accompanying Balance Sheet.
Basic and Diluted Loss per Common Share - Basic and diluted loss per share are computed based on the weighted average number of common shares outstanding. Common share equivalents (which may consist of options and warrants) are excluded from the computation of diluted loss per share since the effect would be antidilutive.
Shares Reserved for Future Issuance - As of December 31, 1999, the Company has reserved approximately 3,200,000 of its authorized but unissued shares of common stock for future issuance pursuant to stock options and warrants and employee benefit plans.
Revenue Recognition - Sales are recognized at the time products are shipped or services rendered. The Company does not require collateral or other securities for sales made on credit. Revenues from collaborative research arrangements and grants are generally recorded as the related costs are incurred. The costs incurred under such arrangements approximated the revenues reported in the accompanying statements of operations.
Sale of Stock by a Subsidiary - The Company does not recognize gains on the sale of previously unissued stock of subsidiaries when there are significant uncertainties regarding the Company's ability to ultimately realize its investment in the subsidiary. Such gains are reflected as additional paid-in capital in the Company's consolidated financial statements.
Stock-based Compensation - The Company grants stock options and warrants for a fixed number of shares to key employees and directors with an exercise price equal to the fair market value of the shares at the date of grant. The Company accounts for stock option grants and warrants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), and, accordingly, recognizes no compensation expense for the stock option grants and warrants for which the terms are fixed. For stock option grants and warrants which vest based on certain corporate performance criteria, compensation expense is recognized to the extent that the quoted market price per share exceeds the exercise price on the date such criteria are achieved or are probable. In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation ("Statement 123"), which provides an alternative to APB 25 in accounting for stock-based compensation issued to employees. However, the Company has continued to account for stock-based compensation in accordance with APB 25 (See Note 9). The Company has also granted stock options and warrants to certain consultants and other third parties. Stock options and warrants granted to consultants and other third parties are valued at the fair market value of the options and warrants granted or the services received, whichever is more reliably measurable. Expense is recognized in the period in which the services are received.
Concentrations of Credit Risk - Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and cash equivalents. The Company maintains cash and cash equivalents in large well-capitalized financial institutions and the Company's investment policy disallows investment in any debt securities rated less than "investment-grade" by national ratings services.
Use of Estimates - The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Segment Information - Effective January 1, 1998, the Company adopted FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information ("Statement 131"). Statement 131 superceded FASB Statement No. 14, Financial Reporting for Segments of a Business Enterprise. Statement 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. Statement 131 also establishes standards for related disclosures about products and services, geographic areas, and major customers. The adoption of Statement 131 did not affect results of operations or financial position, but did affect the disclosure of segment information. See Note 15.
3. Investments
At December 31, 1999, the Company held no investments. At December 31, 1998, the Company had classified all of its investments (consisting entirely of corporate debt securities) as held-to-maturity, of which $8,457,000 and $6,417,000 were included in cash and cash equivalents and short-term investments, respectively, in the accompanying consolidated balance sheets. Investments held at December 31, 1998 are summarized below (in thousands):
4. Property and Equipment
Property and equipment at December 31 consist of the following (in thousands):
5. 6% Convertible Debentures
In October 1997, the Company privately placed with certain investors $2,000,000 of convertible notes (the "Debentures") with an original maturity of October, 2001. The Debentures were convertible on and after December 31, 1997 into shares of CytRx Common Stock at a price of the lesser of (a) 85% of the average closing bid price for the 10 days preceding the conversion, or (b) $5.68 per share. Such beneficial conversion feature was determined to have a fair value of $265,000 at the date of issuance and was amortized to interest expense from the date of issuance through the date the Debentures first became convertible. The Debentures were sold at par and bore interest at a rate of 6% per annum. The provisions for conversion of the Debentures allowed the Company, at its discretion, to disallow conversions below $4.00 per share by redeeming the amount attempted to be converted at a 10% premium. Also, in connection with the issuance of the Debentures, the investors were issued two-year warrants to purchase 40,000 shares of CytRx Common Stock at an exercise price of $5.68. The fair value of such warrants was determined to be insignificant. The warrants expired unexercised in 1999.
In February and March 1998, $500,000 of the Debentures were converted into 204,104 shares of common stock. In February and May 1998, $1,500,000 of the Debentures were redeemed by the Company and total redemption premiums of $150,000 were paid. In addition, $175,000 of previously capitalized debt issue costs were expensed. The redemption premiums and debt issue costs ($325,000 total) are reflected as an extraordinary item in the statement of operations as loss on early extinguishment of debt. At December 31, 1998 and 1999 there were no remaining outstanding Debentures.
6. Long Term Debt
In June 1999, the Company entered into a Purchase Agreement for the design and construction of manufacturing equipment for commercial production of FLOCOR(TM). The Purchase Agreement called for, among other things, certain progress payments to be made, with the final payment of $650,000 due 18 months after installation of the equipment or 12 months after FDA approval of FLOCOR(TM) (the "Note"). The Note bears interest of 12% annually, payable monthly beginning in the first month after installation of the equipment. CytRx accepted installed delivery of the equipment in February 2000; the Note is reflected in the accompanying Balance Sheet as Long Term Debt. In February 2000, the Note was cancelled in exchange for a cash payment of $200,000 and the issuance of Common Stock (see Note 7).
7. Exchange of Common Stock for Cancellation of Accounts Payable, Accrued Expenses and Debt
During the first quarter of 2000, the Company reached agreements with certain of its trade creditors whereby an aggregate of $1,894,000 of trade payables was cancelled in exchange for issuance of approximately 758,000 shares of CytRx Common Stock. Of this amount, $1,694,000 existed at December 31, 1999, and has accordingly been classified as long-term liabilities on the accompanying Balance Sheet. The Company also cancelled $650,000 of long-term debt (see Note 6) in exchange for a cash payment of $200,000 and the issuance of 180,000 shares of CytRx Common Stock.
8. Commitments and Contingencies
Rental expense from continuing operations under operating leases during 1999, 1998 and 1997 approximated $212,000, $154,000 and $13,000, respectively. Minimum annual future obligations for operating leases are $160,000, $165,000, $171,000, $178,000, $185,000 and $678,000 in 2000, 2001, 2002, 2003, 2004 and 2005 and beyond, respectively. Aggregate minimum future subrentals the Company expects to receive under noncancellable subleases total approximately $43,000 at December 31, 1999.
9. Stock Options and Warrants
CytRx has stock option plans pursuant to which certain key employees and directors are eligible to receive incentive and/or nonqualified stock options to purchase shares of CytRx's common stock. The options granted under the plans generally become exercisable over a three year period from the dates of grant and have lives of ten years. Certain options granted to the Company's executive officers and others contain alternative or additional vesting provisions based on the achievement of corporate objectives. Additionally, the Company has granted warrants to purchase shares of the Company's common stock to its President and Chief Executive Officer subject to vesting criteria as set forth in his warrant agreements; such warrants have lives of ten years from the dates of grant. Exercise prices of all options and warrants for employees and
directors are set at the fair market values of the common stock on the dates of grant. During 1998, the Company repriced all outstanding options held by current employees to the then current market value. No compensation expense was recorded for employees or directors for the three years ended December 31, 1998; however, during 1999 the vesting criteria for 680,238 options and warrants was achieved, resulting in $689,000 of compensation expense which was recorded in the first quarter of 1999. During 1999, services were received in exchange for options and warrants issued to certain consultants. Aggregate non-cash charges of $355,000 were recognized in 1999 for the services received.
A summary of the Company's stock option and warrant activity and related information for the years ended December 31 is shown below.
The following table summarizes additional information concerning options and warrants outstanding and exercisable at December 31, 1999:
The Company has elected to follow APB 25 and related Interpretations in accounting for employee stock options and warrants because, as discussed below, the alternative fair value accounting provided for under Statement 123 requires use of option valuation models that were not developed for use in valuing employee stock options.
Pro forma information regarding net loss and loss per share is required by Statement 123, which also requires that the information be determined as if the Company had accounted for employee stock options granted and warrants issued subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for the Company's options and warrants to employees was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the employee options and warrants is amortized to expense over the options' vesting periods. The Company's pro forma information is as follows (in thousands, except per share data):
10. Shareholder Protection Rights Plan
Effective April 16, 1997, the Company's Board of Directors declared a distribution of one Right for each outstanding share of the Company's common stock to stockholders of record at the close of business on May 15, 1997 and for each share of common stock issued by the Company therafter and prior to a Flip-in Date (as defined below). Each Right entitles the registered holder to purchase from the Company one-ten thousandth (1/10,000th) of a share of Series A Junior Participating Preferred Stock, at an exercise price of $30. The Rights are generally not exercisable until 10 business days after an announcement by the Company that a person or group of affiliated persons (an "Acquiring Person") has acquired beneficial ownership of 15% or more of the Company's then outstanding shares of common stock (a "Flip-in Date").
In the event the Rights become exercisable as a result of the acquisition of shares, each Right will enable the owner, other than the Acquiring Person, to purchase at the Right's then current exercise price a number of shares of common stock with a market value equal to twice the exercise price. In addition, unless the Acquiring Person owns more than 50% of the outstanding shares of common stock, the Board of Directors may elect to exchange all outstanding Rights (other than those owned by such Acquiring Person) at an exchange ratio of one share of common stock per Right. All Rights that are owned by any person on or after the date such person becomes an Acquiring Person will be null and void.
The Rights have been distributed to protect the Company's stockholders from coercive or abusive takeover tactics and to give the Board of Directors more negotiating leverage in dealing with prospective acquirors.
11. Retirement Plan
The Company maintains a defined contribution retirement plan (the "Plan") covering employees of the Company. Historically, at the Board of Directors' discretion, the Company has matched 50% of the participant's contribution with common stock. The Company's matching contribution vests over 3 years. Total expense for the Plan for the years ended December 31, 1999, 1998 and 1997 was approximately $69,000, $110,000 and $176,000, respectively, of which $1,000, $44,000 and $120,000 related to discontinued operations for the years ended December 31, 1999, 1998 and 1997, respectively. During the first quarter of 2000, the Company terminated the Plan.
12. Income Taxes
For income tax purposes, CytRx and its subsidiaries have an aggregate of approximately $53.1 million of net operating losses available to offset against future taxable income, subject to certain limitations. Such losses expire in 2000 through 2019. CytRx also has an aggregate of approximately $6.3 million of research and development and orphan drug credits available for offset against future income taxes which expire in 2000 through 2014.
Deferred income taxes reflect the net effect of temporary differences between the financial reporting carrying amounts of assets and liabilities and income tax carrying amounts of assets and liabilities. The components of the Company's deferred tax assets and liabilities are as follows:
Based on assessments of all available evidence as of December 31, 1999 and 1998, management has concluded that the respective deferred income tax assets should be reduced by valuation allowances equal to the amounts of the deferred income tax assets.
13. Discontinued Operations
Vaxcel, Inc. On June 2, 1999, CytRx entered into a Stock Acquisition Agreement with A-Z Professional Consultants, Inc. ("A-Z") for the sale of CytRx's equity interest in Vaxcel. The sale was consummated on September 9, 1999. Pursuant to the agreement, A-Z purchased 9,625,000 shares of common stock of Vaxcel from CytRx for a cash purchase price of $319,000. After consummation of this transaction, CytRx has no further equity interest in Vaxcel.
Net losses (net of minority interest) associated with Vaxcel included in income (loss) from discontinued operations were approximately $(40,000), $(4,319,000) and $(2,357,000) for the years ended December 31, 1999, 1998 and 1997, respectively. A summary of the assets and liabilities of Vaxcel which are included in the consolidated balance sheets at December 31, 1998 is as follows (in thousands):
Termination of Optivax(R) License by CytRx -- In July 1999, CytRx terminated its license of Optivax(R) to Vaxcel due to Vaxcel's cessation of operations within the meaning of the license agreement. Concurrently with the termination of the Optivax(R) license, all of Vaxcel's rights and obligations pursuant to its license of the Optivax(R) technology to Corixa Corporation were assigned to CytRx.
Impairment Loss - In its efforts to raise additional capital during 1998 and 1999, Vaxcel solicited bids for the sublicense or purchase of Vaxcel's acquired developed technology, either together with or separately from Vaxcel's other technologies. During the fourth quarter of 1998, the results of these efforts indicated to management that the acquired developed technology might be impaired. As a result of this indication, Vaxcel performed an evaluation to determine, in accordance with Statement 121, whether future cash flows (undiscounted and without interest charges) expected to result from the use and eventual disposition of the acquired developed technology would be less than its aggregate carrying amount and an allocation of goodwill resulting from the Zynaxis merger. Statement 121 requires that when a group of assets being tested for impairment was acquired as part of a business combination accounted for using the purchase method of accounting, any goodwill that arose as part of the transaction must be included as part of the asset grouping. As a result of the evaluation, management determined that the estimated future cash flows expected to be generated by the acquired developed technology would be less than its carrying amount and allocated goodwill, and therefore the asset was impaired as defined by Statement 121. Consequently, the original cost basis of the acquired developed technology and allocated goodwill were reduced to reflect the fair market value at the date the evaluation was made, resulting in a $3,213,000
impairment loss included in discontinued operations for the year ended December 31, 1998. In determining the fair market value of the asset, management considered the transaction described below, among other factors.
Sale of Technology by Vaxcel -- In January 1999, Vaxcel entered into an agreement with Innovax Corporation ("Innovax") giving Innovax the option to purchase the rights to Vaxcel's PLG microencapsulation technology for an aggregate purchase price of $600,000. Innovax paid a nonrefundable option fee of $200,000, with an additional $400,000 due upon the exercise of the option. Innovax also paid a total of $20,000 for extensions of the option period. On April 1, 1999 Innovax exercised its option and the rights to such technology were assigned by Vaxcel to Innovax. The Company recorded this transaction in the second quarter of 1999 as a sale of its Acquired Developed Technology, valued at $600,000, and therefore did not record a gain or loss on the transaction.
Proceutics, Inc.
In February 1998, CytRx's wholly-owned subsidiary, Proceutics consummated a sale of substantially all of its non-real estate assets to Oread Laboratories, Inc. ("Oread") for approximately $2.1 million. Proceutics retained its real estate assets consisting of a laboratory building which it leased to Oread. The laboratory building was subsequently sold in May 1998 (see Note 14). Prior to consummation of this transaction, Proceutics provided preclinical development services to the pharmaceutical industry.
Net income (loss) associated with Proceutics included in income (loss) from discontinued operations was approximately $1,387,000 and $(138,000) for the years ended December 31, 1998 and 1997, respectively (see Note 15). A $782,000 gain related to the sale of non-real estate assets is included in income from discontinued operations for 1998, as well as a $434,000 gain on the sale of Proceutics' real estate assets (see Note 14).
CytRx Animal Health, Inc.
In April 1998, CytRx's wholly-owned subsidiary, CytRx Animal Health, consummated the sale of substantially all of its assets related to its cattle marketing operations to VetLife, LLC ("VL LLC") (an unaffiliated company) for a total purchase price of $7,500,000, subject to certain working capital adjustments, plus contingent payments based on certain events and future sales of specified products of VL LLC and its affiliates. CytRx Animal Health retained $5.3 million in investments that were pledged to secure a letter-of-credit, as well as the rights to certain technologies licensed from CytRx. Prior to consummation of this transaction, CytRx Animal Health was engaged in marketing and distributing products to enhance North American beef cattle productivity.
Net income associated with CytRx Animal Health included in income (loss) from discontinued operations was approximately $5,645,000 and $868,000 for the years ended December 31, 1998 and 1997, respectively (see Note 15). A gain related to the sale of $6,230,000 is included in income from discontinued operations for 1998.
14. Sale of Real Estate
In May 1998, CytRx and Proceutics consummated the sale of the two buildings owned by them at 150 and 154 Technology Parkway, Norcross, Georgia, to Alexandria Real Estate Equities, Inc. ("Alexandria") for $4.5 million. Proceutics' rights and obligations under the lease to Oread (See Note 13) were assigned to Alexandria, and CytRx leases the building at 154 Technology Parkway from Alexandria. The lease term extends 10 years and contains escalating rent payments over the term. CytRx will also be responsible for all operating expenses for the property. Proceutics recorded a gain of $434,000 for the sale of its building. A gain of $279,000 on the sale/leaseback of the CytRx building was deferred and will be amortized over the ten year lease period.
15. Segment Reporting
The Company has six reportable segments: Research Products (TiterMax), Recruiting Services (Spectrum), Product Development (core business of development and commercialization of pharmaceutical-related products), Cattle Marketing Operations (CytRx Animal Health), Vaccine Development (Vaxcel) and Pharmaceutical Services (Proceutics). See Notes 1 and 13 for a description of these operations.
The Company adopted FASB Statement No. 131, Disclosures About Segments of an Enterprise and Related Information, in 1998 which changes the way the Company reports information about its operating segments. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting
policies (see Note 2). The Company evaluates performance of its operating segments based primarily on profit or loss from operations before income taxes. Summarized financial information concerning the Company's reportable segments is shown in the following table.
16. Subsequent Event (Unaudited)
Effective March 24, 2000, the Company entered into a Stock Purchase Agreement with certain investors (the "Investors") whereby the Investors agreed to purchase 800,000 shares of the Company's Common Stock for an aggregate purchase price of $1.8 million and the issuance of warrants to purchase an additional 330,891 shares at $2.25 per share, expiring March 31, 2003. The Investors were granted registration rights for the shares issued to them and the shares underlying the warrants. In addition, the Investors will, upon effective registration of the shares, purchase an additional 286,000 shares at $2.25 per share and simultaneously receive an additional three-year warrant to purchase 143,000 shares at $2.25 per share. In lieu of these additional shares and warrants, the Investors have the option to purchase 429,000 shares at a price equal to 75% of a trailing average market price of the Company's Common Stock, as defined in the Stock Purchase Agreement.
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders CytRx Corporation
We have audited the accompanying consolidated balance sheets of CytRx Corporation as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of CytRx Corporation at December 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
Atlanta, Georgia March 15, 2000
CYTRX CORPORATION
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 | 11,402 | 75,509 |
1035815_1999.txt | 1035815_1999 | 1999 | 1035815 | ITEM 1. BUSINESS.
GENERAL
Journal Register Company (together with all of its subsidiaries and their respective predecessors (the "Company") is a leading U.S. newspaper publisher, with total paid daily circulation of 636,939 and total non-daily distribution of approximately 4.6 million. As of December 26, 1999, the Company owned and operated 25 daily newspapers and 200 non-daily publications strategically clustered in seven geographic areas: Connecticut; Philadelphia and its surrounding areas; Ohio; the greater St. Louis area; central New England; and the Capital-Saratoga and Mid-Hudson, New York regions. The Company's newspapers are characterized by an intense focus on coverage of local news and local sports and offer compelling graphic design in colorful, reader-friendly packages.
From 1993 through 1999, the Company successfully completed 17 strategic acquisitions, acquiring 13 daily newspapers, 126 non-daily publications and three commercial printing companies. The Company has generally increased the revenues and significantly increased the cash flow and profitability of its acquired newspapers. For the fiscal year ended December 26, 1999, the Company generated revenues of $469.6 million, EBITDA (as hereinafter defined) of $160.7 million and net income of $47.7 million. In 1998, the Company's EBITDA was $146.7 million (excluding special charges and an extraordinary item recorded in the third quarter of 1998). From 1993 through 1999, the Company recorded compound annual growth in revenues and EBITDA (excluding special charges in 1997 and 1998 and the extraordinary item in 1998), of approximately 9.5% and 11.1%, respectively. The Company has achieved this growth through a combination of expanding revenues in existing geographic areas, strategic acquisitions and implementing cost controls and ongoing expense reduction efforts at existing and acquired newspapers.
The majority of the Company's daily newspapers have been published for more than 100 years and are established franchises with strong identities in the communities they serve. For example, the NEW HAVEN REGISTER, the Company's largest newspaper based on daily circulation, has roots in the New Haven, Connecticut area dating back to 1755. In many cases, the Company's daily newspapers are the only general circulation daily newspapers published in their respective communities. The Company's non-daily publications serve well defined suburban circulation areas and include the St. Louis, Missouri SUBURBAN JOURNALS (the "JOURNALS"), the largest group of weekly newspapers in the United States based on total distribution.
The Company manages its newspapers to best serve the needs of its local readers and advertisers. The editorial content of its newspapers is tailored to the specific interests of each community served and includes coverage of local youth, high school, college and professional sports, as well as local business, politics, entertainment and culture. The Company maintains high product quality standards, using extensive process color and compelling graphic design to
attract new readers and to more fully engage existing readers. The Company's newspapers typically are produced using advanced prepress pagination technology and are printed on efficient, high-speed presses.
The Company's revenues are derived from advertising (approximately 74.3% of 1999 revenues), paid circulation, including single copy sales and subscription sales (20.6% of 1999 revenues), and commercial printing and other (5.1% of 1999 revenues). The Company's advertiser base is predominantly local. The Company's newspapers seek to produce desirable results for local advertisers by targeting readers based on certain geographic and demographic characteristics. The Company seeks to increase readership, and thereby generate traffic for its advertisers, by focusing on high product quality, local content and creative and interactive promotions. The Company promotes single copy sales of its newspapers because it believes that such sales have higher readership than subscription sales, and that single copy readers tend to be more active consumers of goods and services, as indicated by a Newspaper Association of America ("NAA") study. Single copy sales also tend to generate higher profits than subscription sales, as single copy sales generally have higher per unit prices and lower associated distribution costs. Subscription sales, which provide readers with the convenience of home delivery, are an important component of the Company's circulation base. The Company also publishes numerous special sections and niche and special interest publications. Such publications tend to increase readership within targeted demographic groups and geographic areas. The Company believes that as a result of these strategies, its newspapers represent an attractive and cost-effective medium for its readers and advertisers.
The Company's advertising revenues in 1999 were derived primarily from a broad group of local retailers (approximately 56%) and classified advertisers (approximately 42%). No advertiser accounted for more than 2% of the Company's 1999 advertising revenues. The Company believes that because its newspapers rely on a broad base of local retail and local classified advertising rather than more volatile national and major account advertising, its advertising revenues tend to be relatively stable.
Substantially all of the Company's operations relate to newspaper publishing. In addition to its daily newspapers and non-daily publications, the Company owns other businesses that complement and enhance its publishing operations, consisting of four commercial printing operations as well as a company which develops application software for the newspaper industry.
OVERVIEW OF OPERATIONS
The Company's operations are currently clustered in seven geographic areas:
CONNECTICUT. In Connecticut, the Company owns the NEW HAVEN REGISTER, a daily newspaper with daily circulation of more than 100,000, and Sunday circulation of approximately 108,000, four suburban daily newspapers, 60 non-daily publications and one commercial printing company. The suburban daily newspapers in this cluster are THE HERALD (New Britain), THE BRISTOL PRESS, THE REGISTER CITIZEN (Torrington) and THE MIDDLETOWN PRESS. The five daily newspapers have aggregate daily and Sunday circulation of approximately 155,000 and 157,000, respectively. The 60 suburban and community non-daily publications have aggregate distribution of approximately 862,000. Included in the non-daily publications is Connecticut Magazine, the state's premier magazine, acquired in September, 1999. Combined, the Company's Connecticut daily newspapers and non-daily publications serve a state-wide audience with concentrations in western Connecticut (Litchfield and Fairfield counties) through Hartford and its suburban areas to the greater New Haven area; and the Connecticut shoreline from New Haven northeast to New London.
The following table sets forth information regarding the Company's publications in Connecticut:
(1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication.
(2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report.
(3) Non-daily distribution includes both paid and free distribution. Paid distribution for Housatonic Valley and Minuteman Newspapers reflects Certified Audit of Circulations ("CAC") audit results for the 12 month period ended June 30, 1999. All other non-daily distribution reflects average distribution for December 1999.
(4) In August 1996, the Company commenced publication of a Sunday newspaper, THE HERALD PRESS, serving readers of THE HERALD, THE BRISTOL PRESS and THE MIDDLETOWN PRESS.
The NEW HAVEN REGISTER is the Company's largest newspaper based on daily circulation and is the second largest daily circulation newspaper in Connecticut. The NEW HAVEN REGISTER serves a primary circulation area comprised of the majority of New Haven County and portions of Fairfield, Middlesex and New London Counties. This area (including portions of Fairfield County which are served by related non-daily publications) has a population of 749,137 and had population growth of approximately 8% from 1980 to 1999. This area has average household income of $72,021, which is 28% above the national average of $56,184, and a retail environment comprised of approximately 6,600 stores. This area is home to a number of large and well-established institutions, including Yale University and Yale-New Haven Hospital. As a result of its proximity to the large media markets of New York City, Boston and Hartford, New Haven has only one locally licensed television station (which serves a state-wide, rather than a local, audience) and a fragmented radio market. Consequently, the Company believes that the NEW HAVEN REGISTER is a powerful local news and advertising franchise for the greater New Haven area.
THE HERALD, THE BRISTOL PRESS and THE MIDDLETOWN PRESS serve contiguous areas between New Haven and Hartford. THE BRISTOL PRESS serves an area which has a population of 322,794 and had population growth of approximately 4% from 1980 to 1999. This area has average household income of $75,186, which is 34% above the national average. THE MIDDLETOWN PRESS serves an area which has a population of 98,990 and had population growth of approximately 16% from 1980 to 1999. This area has average household income of $65,197, which is 16% above the national average. THE HERALD serves an area which has a population of 102,575, which is essentially unchanged since 1980. This area has average household income of $52,925. THE REGISTER CITIZEN serves an area which has a population of 245,166 and had population growth of approximately 12% from 1980 to 1999. This area has average household income of $73,639, which is 31% above the national average.
The Connecticut publications benefit from considerable cross-selling of advertising as well as from news-gathering and production synergies. The NEW HAVEN REGISTER gathers state-wide news for all of the Company's Connecticut newspapers; the newspapers cross-sell advertising through a one-order, one-bill system; THE HERALD and THE MIDDLETOWN PRESS are printed at one facility, as are THE REGISTER CITIZEN and THE BRISTOL PRESS. Moreover, in August 1996, in order to take advantage of the contiguous nature of the geographic areas served by THE HERALD, THE BRISTOL PRESS and THE MIDDLETOWN PRESS, the Company started a Sunday newspaper, THE HERALD PRESS, serving readers of these three dailies with three zoned editions and having Sunday circulation of approximately 38,857 as of September 30, 1999.
PHILADELPHIA AND SURROUNDING AREAS. The Company owns six daily newspapers and 51 non-daily publications serving areas surrounding Philadelphia, Pennsylvania. These publications include, in Pennsylvania, the DAILY LOCAL NEWS (West Chester), THE TIMES HERALD (Norristown), THE PHOENIX (Phoenixville), a group of non-daily newspapers serving Philadelphia's affluent Main Line and a group of 17 weekly newspapers, the InterCounty Newspaper Group, serving suburban Philadelphia and central and southern New Jersey; and also in New Jersey, THE TRENTONIAN (Trenton). The Company also owns two commercial printing companies, acquired with the InterCounty Newspapers in December 1997, one of which prints the 17 weekly newspapers and one of which is a premium quality sheet-fed printing operation. The daily newspapers, acquired in the July 1998 Goodson Acquisition (as hereinafter defined) include, both in Pennsylvania, The Delaware County DAILY TIMES and THE MERCURY, Pottstown. The Goodson Acquisition non-daily publications include, also in Pennsylvania, Acme Newspapers (Ardmore), including THE MAIN LINE TIMES, serving the affluent Main Line, and NEWS OF DELAWARE COUNTY, one of the largest audited community newspapers in the United States; Town Talk Newspapers (Media); and Penny Pincher Shoppers (Pottstown). The six daily newspapers have aggregate daily and Sunday circulation of approximately 187,000 and 166,000, respectively. This non-daily distribution totals approximately 692,000.
The following table sets forth information regarding the Company's publications in Philadelphia and surrounding areas:
(1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication. (2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report. (3) Non-daily distribution includes both paid and free distribution. Non-daily distribution reflects average distribution for December 1999, with the following exceptions: Suburban Publications, which includes two publications ( SUBURBAN ADVERTISER and KING OF PRUSSIA COURIER) which reflect the CAC audit for the six months ended June 30, 1999 and THE SUBURBAN & WAYNE TIMES which reflects the ABC audit results for the 24 month period ended September 30, 1999; Acme Newspapers, which includes three publications (NEWS OF DELAWARE COUNTY, GERMANTOWN COURIER and MT. AIRY TIMES EXPRESS) which reflect the CAC audit for the six months ended September 30, 1999 and MAIN LINE TIMES which reflects the ABC Audit for the 24 month period ended September 30, 1999. (4) Part of the Goodson Acquisition, completed July 15, 1998. (5) Year established by the Company.
The majority of the Company's Pennsylvania publications are located within a 30-mile radius of Philadelphia. The Company's newspapers serve geographic areas with highly desirable demographics. The Delaware County DAILY TIMES serves an area which has a population of 586,647, which has remained substantially unchanged since 1980. This area has average household income of $71,405, which is 27% above the national average. The DAILY LOCAL NEWS serves an area which has a population of 404,637 and had population growth of approximately 37% from 1980 to 1999. This area has average household income of $87,691, which is 56% above the national average. THE MERCURY (Pottstown), located approximately 40 miles west of Philadelphia, serves an area which has a population of 436,692 and had population growth of approximately 18% from 1980 to 1999. This area has average household income of $69,850, which is 24% above
the national average. THE TIMES HERALD serves an area which has a population of 170,604 and had population growth of approximately 7% from 1980 to 1999. This area has average household income of $73,619, which is 31% above the national average. THE PHOENIX serves an area which has a population of 118,749 and had population growth of approximately 29% from 1980 to 1999. This area has average household income of $88,152, which is 57% above the national average. The Company's weekly newspaper group, Suburban Publications, in suburban Philadelphia serves an area which has a population of 324,680 and had population growth of approximately 20% from 1980 to 1999. This area has average household income of $108,309, which is 93% above the national average. MAIN LINE TIMES, the flagship of the Acme Newspapers group, serves an area which has a population of 391,936 and had population growth of approximately 1% from 1980 to 1999. This area has average household income of $104,400, which is 86% above the national average. The majority of the Company's Pennsylvania properties are located within 20 miles of the area's largest retail complex, the King of Prussia Plaza and Court, which is the largest mall on the East Coast of the United States in terms of total square footage.
THE TRENTONIAN is published in Trenton, the capital of New Jersey, located 40 miles north of Philadelphia and 75 miles south of New York City. THE TRENTONIAN serves an area which has a population of 285,905 and had population growth of approximately 7% from 1980 to 1999. This area has average household income of $70,670, which is 26% above the national average.
The Company's Philadelphia cluster cross-sells advertising. The nature of the cluster has allowed for the implementation of significant cost saving programs. For example, THE TIMES HERALD and several non-daily suburban publications share printing facilities, as do the DAILY LOCAL NEWS and THE PHOENIX. Acme Newspapers, part of the Goodson Acquisition, are printed at the DAILY LOCAL NEWS plant and at the Company's commercial printing company in Bristol, Pennsylvania. THE TRENTONIAN'S television guide is also printed at the Bristol plant. All of these publications share certain news-gathering resources. The Company believes that the continued integration of the Goodson Acquisition newspapers into this cluster will result in considerable additional cross-selling of advertising, as well as additional cost saving programs. The Company further believes that the integration of the Goodson Acquisition newspapers into this cluster allows the Company to compete more effectively in the areas it serves. The Company believes that the construction of a centralized printing facility in the Philadelphia area, scheduled to begin in late 1999, will result in considerable additional cost savings.
OHIO. The Company owns four daily newspapers and a commercial printing operation in Ohio. The daily newspapers are THE NEWS-HERALD (Lake County), THE MORNING JOURNAL (Lorain), THE TIMES REPORTER (Dover-New Philadelphia) and, acquired as part of the Goodson Acquisition, THE INDEPENDENT (Massillon). The Company has aggregate daily and Sunday circulation of approximately 126,000 and 141,000, respectively. Non-daily distribution in the Ohio cluster is approximately 125,000.
The following table sets forth information regarding the Company's publications in Ohio:
(1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication. (2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report.
(3) Non-daily distribution is solely free distribution and reflects average distribution for December 1999. (4) Part of the Goodson Acquisition, completed July 15, 1998. (5) Established by the Company in 1997.
THE NEWS-HERALD and THE MORNING JOURNAL serve areas located directly east and west of Cleveland, respectively. THE NEWS-HERALD, which is one of Ohio's largest suburban newspapers, serves communities located in Lake and Geauga Counties, two of Ohio's five most affluent counties. Lake and Geauga Counties have populations of 222,583 and 83,231, respectively, and had population growth of approximately 6% and 20%, respectively, from 1980 to 1999. Lake and Geauga Counties have average household incomes of $58,122 and $75,437, respectively. THE MORNING JOURNAL serves an area which has a population of 148,191 and had population growth of approximately 1% from 1980 to 1999. This area has average household income of $53,218. THE TIMES REPORTER and THE INDEPENDENT serve contiguous markets primarily in Tuscarawas and western Stark counties. THE TIMES REPORTER serves the rural communities of Dover and New Philadelphia, which are located approximately 80 miles south of Cleveland. THE TIMES REPORTER serves an area which has a population of 109,514 and had population growth of approximately 7% from 1980 to 1999. This area has average household income of $43,027. THE INDEPENDENT (Massillon) serves western Stark County, at the southern edge of the Northeast Ohio industrial area, which is located approximately 60 miles south of Cleveland and 20 miles north of Dover-New Philadelphia. THE INDEPENDENT serves an area which has a population of 240,594 and had population growth of approximately 4% from 1980 to 1999. This area has average household income of approximately $52,675. The Company believes that each of its Ohio newspapers benefits from a fragmented local media environment. The Company further believes that THE NEWS-HERALD and THE MORNING JOURNAL compete effectively with Cleveland's major metropolitan newspaper due to the focus on coverage of local news and local sports. The Company's Ohio cluster benefits from a variety of synergistic opportunities, including the cross-selling of advertising and editorial coverage. In addition, THE TIMES REPORTER and THE Independent benefit from commercial printing synergies, as both operations include commercial printing.
GREATER ST. LOUIS AREA. The Company owns the SUBURBAN JOURNALS (the "Journals"), the largest group of suburban and community non-daily newspapers in the United States (in terms of total distribution); one daily newspaper; the LADUE NEWS, a weekly newspaper acquired in December 1997; and six other non-daily publications in the greater St. Louis area. The JOURNALS are a group of 42 newspapers which are distributed one to three times each week in the St. Louis suburban areas, including communities in Illinois, with total weekly distribution of approximately 1.7 million. The Company's daily newspaper in this cluster, THE TELEGRAPH (Alton, IL), has daily and Sunday circulation of approximately 28,000 and 30,000, respectively.
The following table sets forth information regarding the Company's publications in the greater St. Louis area:
(1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication. (2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report. (3) Non-daily distribution includes both paid 7,251 and free 1,942,829 distribution, and reflects the CAC Audit results for the twelve month period ended September 30, 1999 with the following exceptions, which reflect average distribution for December 1999; CLASSIFIED PLUS (ILLINOIS), GRANITE CITY PRESS RECORD, CLASSIFIED PLUS (MISSOURI), SOUTH COUNTY KIDS, ST. CHARLES COUNTY KIDS AND WEST COUNTY KIDS.
(4) Established by the Company in 1996.
The JOURNALS have total distribution of approximately 1.1 million mid-week and approximately 634,000 on Sunday, for total weekly distribution of approximately 1.7 million. The JOURNALS reach approximately 90% of the homes in the greater suburban St. Louis area. The JOURNALS serve an area which has a population of approximately 2.4 million and had population growth of approximately 5% from 1980 to 1999. This area has average household income of $57,750. According to EDITOR & PUBLISHER MARKET GUIDE, St. Louis is the 17th largest metropolitan area in the United States. The JOURNALS have received national recognition and have been studied by domestic and foreign publishers as a model of successful neighborhood newspapers. Due to St. Louis' characterization as a city of neighborhoods (92 municipalities comprise St. Louis County alone), the Company believes the JOURNALS offer local retailers a cost-effective way to reach targeted demographic groups, which enables the JOURNALS to compete effectively with the major metropolitan daily and other weekly newspapers in the area. The Company believes that the area's largest radio station competes primarily for major accounts rather than small advertisers and, thus, is not a significant direct competitor. The Company believes that the JOURNALS' targeted, highly localized approach places the JOURNALS in a strong competitive position. LADUE NEWS serves the affluent suburbs west of St. Louis, an area with average household income of $108,019, 92% above the national average. This area has a population of approximately 158,478 and had population growth of approximately 18% from 1980 to 1999. THE TELEGRAPH serves a community located in southeast Illinois, within the greater St. Louis area and which is connected to St. Louis by the Clark Bridge. THE TELEGRAPH serves an area which has a population of 119,184 and had a decline in population of approximately 2% since 1980. This area has average household income of $45,529.
Suburban and community non-daily newspapers, such as the JOURNALS, have several advantages over national and major metropolitan daily newspapers, including an intrinsically lower cost structure, the ability to publish only on, what are for dailies, the most profitable days (i.e. one midweek day and one weekend day) and the ability to avoid expensive wire services and syndicated feature material. Moreover, suburban and community non-daily newspapers provide an alternative outlet for local merchants and advertisers to advertise in their own local areas at costs lower than those of national and major metropolitan newspapers. Thus, the JOURNALS have a broader advertiser base and do not rely on major accounts for advertising revenue to the same degree as national and major metropolitan daily newspapers.
CENTRAL NEW ENGLAND. The Company owns five daily and 18 non-daily publications in the central New England area. The Company's publications in this cluster include THE HERALD NEWS (Fall River, MA), the TAUNTON DAILY GAZETTE (Taunton, MA), THE CALL (Woonsocket, RI), THE TIMES (Pawtucket, RI), the KENT COUNTY DAILY TIMES (West Warwick, RI), acquired August 13, 1999 and a group of weekly newspapers serving the South County, Rhode Island area. The five daily newspapers have aggregate daily circulation of approximately 76,000 and aggregate Sunday circulation of approximately 58,000. The non-daily publications in this cluster have total distribution of approximately 246,000.
The following table sets forth information regarding the Company's publications in central New England.
- ------------------ (1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication. (2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report. (3) Non-daily distribution includes both paid and free distribution. Paid and free non-daily distribution for Southern Rhode Island Newspapers (except THE WESTERLY SHOPPER, THE WEEK IN SOUTH COUNTY AND RHODE ISLAND FAMILY) reflects the CAC Audit report for the six months ended June 30, 1999. The other non-daily distribution figures reflect average distribution for December 1999. (4) Established by the Company in 1999.
THE HERALD NEWS and the TAUNTON DAILY GAZETTE are situated 14 miles apart. Each is approximately 50 miles south of Boston, Massachusetts and 20 miles east of Providence, Rhode Island. The region's largest shopping mall, located in Taunton, contains one million square feet of retail space and approximately 150 stores. THE HERALD NEWS serves an area which has a population of 162,021, which has remained substantially unchanged from 1980. This area has average household income of $44,248. The TAUNTON DAILY GAZETTE serves an area which has a population of 129,134 and had population growth of approximately 24% from 1980 to 1999. This area has average household income of $55,113. THE CALL serves an area which has a population of 182,663 and had population growth of approximately 12% from 1980 to 1999. This area has average household income of $58,265. THE TIMES serves an area which has a population of 182,837 and had population growth of approximately 4% from 1980 to 1999. This area has average household income of $50,015. Southern Rhode Island Newspapers serve an area which has a population of 154,960 and had population growth of approximately 27% from 1980 to 1999. This area has average household income of $63,936, which is 14% above the national average. No local television stations exist in the communities which the central New England newspapers serve. Further, the Company believes that its central New England properties benefit from fragmented local radio markets. As a result, the Company believes that each of its newspapers is a significant media outlet in its respective community, thereby making these newspapers attractive vehicles for area advertisers. The central New England newspapers benefit from advertising cross-selling; moreover, the Company's Massachusetts and Rhode Island newspapers benefit from significant production and editorial synergies. For example, THE TIMES and THE CALL are printed at the same facility, as are the TAUNTON DAILY GAZETTE and THE HERALD News. Additionally, THE TIMES, THE CALL and the group of paid suburban and community non-daily newspapers serving southern Rhode Island all share certain news gathering resources.
CAPITAL-SARATOGA REGION OF NEW YORK. The Company owns three daily and four non-daily publications in the Capital-Saratoga Region of New York. The Company's publications in this cluster include THE RECORD (Troy), THE SARATOGIAN (Saratoga Springs), the weekly COMMUNITY NEWS, serving Clifton Park, and THE ONEIDA DAILY DISPATCH, acquired as part of the 1998 Goodson Acquisition. The
daily newspapers have aggregate daily circulation of approximately 42,000 and aggregate Sunday circulation of approximately 39,000. The non-daily publications in this cluster have total distribution of approximately 82,000.
The following table sets forth information regarding the Company's publications in the Capital-Saratoga Region of New York:
- ----------------- (1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication. (2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report. (3) Non-daily distribution is free and reflects average distribution for December 1999. (4) Part of the Goodson Acquisition, completed July 15, 1998.
THE RECORD and THE SARATOGIAN are situated approximately 26 miles apart. THE RECORD serves an area which has a population of 173,159, which has remained substantially unchanged since 1980. This area has average household income of $46,355. THE SARATOGIAN serves an area which has a population of 208,307 and had population growth of approximately 24% from 1980 to 1999. This area has average household income of $55,193. THE ONEIDA DAILY DISPATCH serves an area which has a population of 75,397 and had population growth of approximately 5% from 1980 to 1999. This area has average household income of $47,728. No local television stations exist in the communities which the Capital-Saratoga Region newspapers serve. Further, the Company believes that its Capital-Saratoga Region properties benefit from fragmented local radio markets. As a result, the Company believes that each of its newspapers is a significant media outlet in its respective community, thereby making these newspapers attractive vehicles for area advertisers. THE RECORD, THE SARATOGIAN and the COMMUNITY NEWS benefit from significant cross-selling of advertising. These newspapers also benefit from significant production synergies. Directly following the March 9, 1998 acquisition of THE SARATOGIAN and the COMMUNITY NEWS, the newspapers began printing at THE RECORD plant in Troy, taking advantage of that plant's excess capacity and achieving significant cost efficiencies. The three newspapers also share certain news-gathering functions, and the Company believes that additional synergies may be available between them.
MID-HUDSON REGION OF NEW YORK. The Company owns one daily newspaper and 11 non-daily publications in the Mid-Hudson Region of New York. The daily newspaper in this cluster is THE DAILY FREEMAN in Kingston. The Company's non-daily publications in this cluster are Taconic Press, a group of 10 non-daily newspapers in Dutchess County, New York, acquired September 21, 1998, and THE PUTNAM COUNTY COURIER, serving Putnam County, New York, which the Company acquired as part of its January 1998 acquisition of HVM, LLC. The Mid-Hudson Region cluster has aggregate daily circulation of approximately 22,000, aggregate Sunday circulation of approximately 29,000 and total non-daily distribution of approximately 603,000.
The following table sets forth information regarding the Company's publications in the Mid-Hudson Region of New York:
- --------------- (1) For merged newspapers and newspaper groups, the year given reflects the date of origination for the earliest publication. (2) Circulation averages for the six months ended September 30, 1999, according to ABC Fas-Fax Report. (3) Non-daily distribution includes both paid and free distribution. Paid distribution for the Putnam County Courier, part of the Taconic Press publications, reflects the CAC Audit report for the twelve months ended June 30, 1999. All other distribution reflects average distribution for December 1999. (4) Part of the Goodson Acquisition, completed July 15, 1998.
THE DAILY FREEMAN, Taconic Press and THE PUTNAM COUNTY COURIER serve markets in the Mid-Hudson Region of New York. THE DAILY FREEMAN serves an area which has a population of 265,862 and had population growth of approximately 6% from 1980 to 1999. This area has average household income of $47,837. Taconic Press newspapers serve an area which has a population of 95,401 and had population growth of approximately 8% from 1980 to 1999. This area has average household income of $61,827. THE PUTNAM COUNTY COURIER serves an area which has a population of 89,937 and had population growth of approximately 22% from 1980 to 1999. This area has average household income of $83,108. One independent television station (which serves a regional, rather than a local, audience) exists in the communities which the Mid-Hudson Region newspapers serve. Further, the Company believes that its Mid-Hudson Region properties benefit from fragmented local radio markets. As a result, the Company believes that each of these newspapers is a significant media outlet in its respective community, thereby making these newspapers attractive vehicles for area advertisers. The Company believes that the Mid-Hudson Region newspapers benefit from significant cross-selling of advertising, production synergies and certain news-gathering resources. Certain publications in this cluster also benefit from advertising cross-selling with THE REGISTER CITIZEN (Torrington, CT) and Housatonic Publications (New Milford, CT), which serve Litchfield County, Connecticut.
ADVERTISING
Substantially all the Company's advertising revenues are derived from a diverse group of local retailers and classified advertisers. The Company believes that because its newspapers rely on a broad base of local retail and local classified advertising rather than more volatile national and major account advertising, its advertising revenues tend to be relatively stable. Local advertising is more stable than national advertising because a community's need for local services provides a stable base of local businesses and because local advertisers generally have fewer effective advertising vehicles from which to choose. Advertising revenues accounted for approximately 74.3% of the Company's total revenues for 1999. The Company's advertising rate structures vary among its publications and are a function of various factors, including results achieved for advertisers, local market conditions and competition, as well as circulation, readership, demographics and type of advertising (whether classified or display). In 1999, local and regional advertising accounted for the largest share of the Company's advertising revenues (55.6%), followed by classified advertising (39.3%), legal advertising (2.4%) and national advertising (2.7%). The Company's advertising revenues are not reliant upon any one company or industry, but rather are supported by a variety of companies and industries, including realtors, car dealerships, grocery stores and other local businesses. No advertiser accounted for more than 2% of the Company's total 1999 advertising revenues. The Company's corporate management works with its local newspaper management to approve advertising rates and to establish goals for each year during a detailed annual budget process. Local management is given little latitude for discounting from the approved rates. Corporate management also works with local advertising staff to develop marketing kits, presentations and third-party research studies. A portion of the compensation for the
Company's publishers is based upon increasing advertising revenues. The Company stresses the timely collection of receivables, and sales compensation depends in part upon performance relative to goals and timely collection of advertising receivables. Additionally, corporate management facilitates the sharing of advertising resources and information across the Company's publications. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Performance - -- Dependence on Local Economies."
CIRCULATION
Substantially all of the Company's circulation revenues are derived from home delivery sales of publications to subscribers and single copy sales made through retailers and vending racks. Circulation accounted for approximately 20.6% of the Company's total revenues in 1999. Approximately 66.2% of 1999 circulation revenues were derived from subscription sales and approximately 33.8% from single copy sales. Single copy sales rates currently range from $.25 to $.50 per daily copy and $.75 to $1.75 per Sunday copy. The Company promotes single copy sales of its newspapers because it believes that such sales have higher readership than subscription sales and that single copy readers tend to be more active consumers of goods and services, as indicated by an NAA study. Single copy sales also tend to generate a higher profit than subscription sales, as single copy sales generally have higher per unit prices and lower associated distribution costs. In 1999, the Company had total paid daily circulation of 636,939, paid Sunday circulation of 619,963 and non-daily distribution of approximately 4.6 million, most of which is distributed free of charge. The Company's corporate management works with its local newspaper management to establish subscription and single copy rates. In addition, the Company tracks rates of newspaper returns and customer service calls through formal reports which are reviewed weekly in an effort to optimize the number of newspapers available for sale and to improve delivery and customer service. The Company also implements creative and interactive programs and promotions to increase readership, through both subscription and single copy sales. Circulation has generally declined throughout the newspaper industry in recent years, and the Company's newspapers have generally experienced this trend, even as overall operating performance of its newspapers has improved. The Company seeks to maximize the overall operating performance rather than maximizing circulation of its individual newspapers.
ONLINE OPERATIONS
The Company publishes 27 Web sites which represent their various newspapers and magazines. A number of the Web sites are "cluster" sites combining publications within a specific geographic area. The largest cluster site is www.CTCentral.com, which represents the NEW HAVEN REGISTER, THE BRISTOL PRESS, THE HERALD (New Britain), THE REGISTER CITIZEN (Torrington) and THE MIDDLETOWN PRESS. In addition to these five dailies, the site also includes news, information and ads from 24 weekly publications situated throughout Connecticut.
Cluster sites also exist in St. Louis, www.yourjournal.com, representing the Suburban Newspapers of Greater St. Louis group; Philadelphia, www.allaroundphilly.com, representing the Delaware County Daily and Sunday Times, the DAILY LOCAL NEWS (Westchester), THE MERCURY (Pottstown), THE TIMES HERALD (Norristown), THE PHOENIX (Phoenixville), THE TRENTONIAN (Trenton, NJ) and the weekly publications; the Capital region of New York, www.CapitalCentral.com, representing THE RECORD (Troy) and THE SARATOGIAN; and in Rhode Island, www.RICentral.com, representing Southern Rhode Island Newspapers and the KENT COUNTY DAILY TIMES.
The remaining Company newspapers, along with Connecticut Magazine, have individual Web sites.
The primary source of online revenue is from classified advertising. For the year ended December 26, 1999, the 27 web sites generated approximately $3.2 million as compared to approximately $1.8 million for the year ended December 31, 1998.
The Company is in the process of re-launching its sites which will offer viewers significantly more content, improved functionality and increased interactive opportunities.
OTHER OPERATIONS
The Company owns and operates four commercial printing facilities: Imprint Printing in North Haven, Connecticut; Midwest Offset in New Philadelphia, Ohio; Nittany Valley Offset in State College, Pennsylvania; and InterPrint in Bristol, Pennsylvania. These operations also print certain of the Company's publications. The commercial printing operations accounted for approximately 5.1% of the Company's 1999 revenues. The Company also owns Integrated Newspaper Systems, Inc., a company which develops application software for the newspaper industry.
EMPLOYEES
The Company employs approximately 5,500 employees.
RAW MATERIALS
The basic raw material for newspapers is newsprint. The Company's newsprint consumption (excluding paper consumed in the Company's commercial printing operations) totaled approximately $36.5 million in 1999, which was approximately 8.2% of the Company's newspaper revenues. In 1999, the Company consumed approximately 82,000 metric tons of newsprint, including paper consumed in its commercial printing operations. The Company has no long-term contracts to purchase newsprint. Generally, the Company has in the past and currently purchases all of its newsprint from two suppliers, although in the future the Company may purchase newsprint from other suppliers. The Company believes that concentrating its newsprint purchases in this way provides a more secure newsprint supply and lower per unit newsprint prices. The Company also believes that it purchases newsprint at price levels lower than those which are available to individually owned small metropolitan and suburban daily newspapers and suburban and community non-daily publications and consistent with price levels generally available to the largest newsprint purchasers. The available sources of newsprint have been, and the Company believes will continue to be, adequate to supply the Company's needs. The inability of the Company to obtain an adequate supply of newsprint in the future could have a material adverse effect on the financial condition and results of operations of the Company. Historically, the price of newsprint has been cyclical and volatile. The Company's average price per ton of newsprint reflected a decrease of approximately 18% in 1997 and an increase of approximately 8% in 1998 and a decrease of approximately 13% in 1999, in each case compared to the previous year. The Company believes that if any price decrease or increase is sustained in the industry, the Company will also be impacted by such change. The Company seeks to manage the effects of increases in prices of newsprint through a combination of, among other things, technology improvements, including web-width reductions, inventory management and advertising and circulation price increases. The Company also has reduced fringe circulation in response to increased newsprint prices, as it is the Company's experience that such circulation does not provide adequate response for advertisers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Performance - -- Price and Availability of Newsprint."
SEASONALITY
Newspaper companies tend to follow a distinct and recurring seasonal pattern. The first quarter of the year (January-March) tends to be the weakest quarter because advertising volume is then at its lowest level. Correspondingly, the fourth quarter (October-December) tends to be the strongest quarter as it includes heavy holiday season advertising.
COMPETITION
While many of the Company's metropolitan and suburban daily newspapers are the only daily newspapers of general circulation published in their respective communities, they compete within their own geographic areas with other daily and weekly newspapers of general circulation published in adjacent or nearby cities and towns. Competition for advertising expenditures and paid circulation comes from local, regional and national newspapers, shoppers, television, radio, direct mail, on-line services and other forms of communication and advertising media. Since 1995, the Company has been developing web sites for each of its publications which attract readers and advertisers. The Company has published an on-line version of the NEW HAVEN REGISTER since 1995. The Company has an on-line editorial presence and a full on-line classified advertising service for each of its daily newspapers and weekly newspaper groups. Competition for newspaper advertising expenditures is largely based upon advertiser results, readership, advertising rates, demographics and circulation levels, while competition for circulation and readership is based
largely upon the content of the newspaper, its price and the effectiveness of its distribution. The Company's non-daily publications, including shoppers and real estate guides, primarily compete with direct mail advertising, shared mail packages and other private advertising delivery services. The Company believes that, because of the relative competitive position of its suburban and community non-daily publications in the communities which they serve, such publications generally have been able to compete effectively with other forms of media advertising. Commercial printing, a highly competitive business, is largely driven by price and quality. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Performance -- Newspaper Industry Competition."
ENVIRONMENTAL MATTERS
As is the case with other newspaper and similar publication companies, the Company is subject to a wide range of federal, state and local environmental laws and regulations pertaining to air and water quality, storage tanks and the management and disposal of wastes at its facilities. To the best of the Company's knowledge, its operations are in material compliance with applicable environmental laws and regulations as currently interpreted. The Company believes that continued compliance with these laws and regulations will not have a material adverse effect on the Company's financial condition or results of operations. The Company is in the process of monitoring groundwater contamination which has been detected at one of its facilities. The Company believes that the remediation of any such groundwater contamination, if required, will not have a material adverse effect on its financial condition or results of operations. In May 1998, one of the Company's subsidiaries, acquired as part of the Goodson Acquisition, received a notice of potential liability in connection with a landfill superfund site. The Company is fully indemnified for all costs and liabilities arising out of this issue by the seller as part of the Goodson Acquisition purchase agreement. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Performance -- Environmental Matters."
REGULATION
Paid circulation newspapers which are delivered by second-class mail are required to obtain permits from, and file an annual statement of ownership and circulation with, the United States Postal Service. There is no significant regulation with respect to acquisition of newspapers, other than filings under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, if certain threshold requirements under such Act are satisfied.
ITEM 2.
ITEM 2. PROPERTIES.
The Company owns and operates 118 facilities used in the course of producing and publishing its daily and non-daily publications. Approximately 80 of the Company's facilities are leased for terms ranging from one to six years. These leased facilities range in size from approximately 160 to 70,000 square feet. The location and approximate size of the principal physical properties used by the Company at December 26, 1999, as well as the expiration date of the leases relating to such properties which the Company leases are set forth below:
2. PROPERTIES. (CONTINUED)
(1) Offices (2) Corporate headquarters (3) Production facility (4) Warehouse
The Company believes that all of its properties are in good condition, are generally well maintained and are adequate for their current operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is involved in a number of litigation matters which have arisen in the ordinary course of business. The Company believes that the outcome of these legal proceedings will not have a material adverse effect on the Company's financial condition or results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Performance - Environmental Matters."
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information as of March 17, 2000 with respect to each person who is an executive officer of the Company:
ROBERT M. JELENIC is the Chairman, President and Chief Executive Officer of the Company. He has been President and Chief Executive Officer since the inception of the Company, and has been a director of the Company and its predecessors for more than the past six years. A Chartered Accountant, Mr. Jelenic began his business career with Arthur Andersen in Toronto, Canada. Mr. Jelenic has 24 years of senior management experience in the newspaper industry, including 12 years with the Toronto Sun Publishing Corp. Mr. Jelenic graduated Honors Bachelor of Commerce from Laurentian University, Sudbury, Ontario. Mr. Jelenic is a director of the NAA and Chairman of the NAA's Technology Committee. Mr. Jelenic is 49 years old.
JEAN B. CLIFTON is Executive Vice President, Chief Financial Officer and Secretary of the Company, positions she has held since the inception of the Company, and has been a director of the Company and its predecessors for more than the past six years. Prior to joining the Company, Ms. Clifton, a Certified Public Accountant, had been employed by Arthur Young & Co. (a predecessor to Ernst & Young LLP). She has 14 years of senior management experience in the newspaper industry. Ms. Clifton is a graduate of the University of Michigan School of Business Administration. Ms. Clifton is a member of the Postal Affairs Committee and the Employee Benefits Committee of the NAA. Ms. Clifton is 39 years old.
ALLEN J. MAILMAN is Senior Vice President of Technology of the Company, a position he has held since February 1999. From March 1994 to February 1999 he was Vice President of Technology of the Company. From the Company's inception in 1990 to March 1994, Mr. Mailman was Corporate Director of Information Services of the Company. He has 25 years of management experience in the newspaper industry, including 14 years with Newhouse Publications. Mr. Mailman received a Bachelor of Arts degree in Economics and Mathematics from the University of Oklahoma. Mr. Mailman is 53 years old.
WILLIAM J. HIGGINSON is Vice President of Production of the Company, a position he has held since July 1995. From January 1994 to July 1995, he was Corporate Production Director of the Company and, from 1991 to January 1994, was Production Director of the NEW HAVEN REGISTER. Mr. Higginson has 27 years of experience in the newspaper industry. Mr. Higginson is 44 years old.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's common stock, par value $0.01 per share (the "Common Stock"), commenced trading on the New York Stock Exchange on May 8, 1997 under the symbol "JRC." The following table reflects the high and low sale prices for the Common Stock, based on the daily composite listing of stock transactions for the New York Stock Exchange, for the periods indicated:
HIGH LOW ---- --- (Per Share) Year ended December 26, 1999 ----------------------------
Fourth Quarter $15 3/4 $11 13/16 Third Quarter 21 7/8 13 7/16 Second Quarter 23 11 3/8 First Quarter 15 7/8 11 11/16
Year ended December 31, 1998 ----------------------------
Fourth Quarter $16 3/16 $12 1/8 Third Quarter 18 7/8 13 3/4 Second Quarter 23 7/8 16 5/16 First Quarter 21 18
On March 17, 2000, there were approximately 50 stockholders of record of the Common Stock. The Company believes that it has approximately 1,272 beneficial owners.
The Company has not paid dividends on the Common Stock and does not currently anticipate paying dividends on the Common Stock in the foreseeable future. The Company currently intends to retain future earnings for reinvestment in the Company. In addition, the Credit Agreement (as hereinafter defined) places limitations on the Company's ability to pay dividends or make any other distributions on the Common Stock. See Note 5 of "Notes to Consolidated Financial Statements." Any future determination as to the payment of dividends will be subject to such prohibitions and limitations, will be at the discretion of the Company's Board of Directors and will depend on the Company's results of operations, financial condition, capital requirements and other factors deemed relevant by the Board of Directors.
The Company is a holding company which conducts its operations through direct and indirect subsidiaries. The Company's available cash will depend upon the cash flow of its subsidiaries and the ability of such subsidiaries to make funds available to the Company in the form of loans, dividends or otherwise. The subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to make funds available to the Company, whether in the form of loans, dividends or otherwise. The Credit Agreement is secured by substantially all of the assets of the Company and the common stock and assets of the Company's subsidiaries. In addition, the Company's subsidiaries may, subject to limitations contained in the Credit Agreement, become parties to financing arrangements which may contain limitations on the ability of such subsidiaries to pay dividends or to make loans or advances to the Company. In the event of any insolvency, bankruptcy or similar proceedings of a subsidiary, creditors of such subsidiary would generally be entitled to priority over the Company with respect to assets of the affected subsidiary.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following selected combined data (except number of newspapers and per share amounts) for the combined balance sheet of the Company as of December 31, 1995, the consolidated balance sheet of the Company as of December 26, 1999 and the consolidated balance sheets of the Company as of December 31, 1998, 1997 and 1996 and the related consolidated statements of income and cash flows for each of the five years in the period ended December 26, 1999 have been derived from the audited financial statements of the Company. The selected financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and notes thereto included elsewhere in this Report.
(1) In 1999, the Company changed its fiscal year from a calendar year to a fiscal year ending on the Sunday closest to December 31st. Accordingly, the Company's 1999 fiscal year results are reported for the period January 1, 1999 through December 26, 1999.
(2) The 1997 special charge of $31.9 million (before benefit for income taxes of $13.0 million) was incurred in connection with the Company's initial public offering and was comprised of $28.4 million for a management bonus and $3.5 million for the discontinuance of a management incentive plan. The management bonus was comprised of 1.1 million shares of Common Stock and a cash portion to satisfy the recipients' tax obligations arising from the management bonus.
(3) The 1998 extraordinary item represents a loss of $4.5 million (net of tax) related to the Company's 1998 debt extinguishment in connection with the prior credit agreement.
(4) Proforma net income per common share for 1996 was calculated reflecting the 37,962,500 shares which were issued and outstanding prior to the Company's initial public offering, but subsequent to December 31, 1996.
(5) The 1998 other data excludes the effects of special charges ($3.8 million, before tax benefit, $3.2 million of which was recorded in selling, general and administrative and approximately $630,000 in other expenses) related to the cancellation of the Company's convertible debt offering, integration of the Goodson Acquisition, and an increase to certain receivable reserves and an extraordinary item ($4.5 million, net of tax) as discussed in Note (3) above. The 1997 other data excludes the effect of the special charge of $31.9 million (before benefit for income taxes of $13.0 million) comprised of $28.4 million for a management bonus and $3.5 million for the discontinuance of a management incentive plan. See Note 5 of "Notes to Consolidated Financial Statements."
(6) EBITDA is defined by the Company as operating income (loss) plus depreciation, amortization and other non-cash, special or non-recurring charges. Tangible net income is defined as net income, excluding equity interest, plus after-tax amortization. EBITDA and tangible net income are not intended to represent cash flow from operations and should not be considered as alternatives to operating or net income computed in accordance with generally accepted accounting principles ("GAAP"), as indicators of the Company's operating performance, as alternatives to cash from operating activities (as determined in accordance with GAAP) or as measures of liquidity. The Company believes that EBITDA is a standard measure commonly reported and widely used by analysts, investors and other interested parties in the media industry. Accordingly, this information has been disclosed herein to permit a more complete comparative analysis of the Company's operating performance relative to other companies in the industry. However, not all companies calculate EBITDA and tangible net income using the same methods; therefore, the EBITDA and tangible net income figures set forth above may not be comparable to EBITDA and tangible net income reported by other companies. Certain covenants contained in the Company's Credit Agreement are based upon EBITDA. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Tangible net income per share is calculated using the weighted-average shares outstanding on a diluted basis.
(7) During 1994, the Company was converted into a limited liability company and in March 1997 the Company was converted into a C Corporation. In connection with such conversion, the Company's preferred stock and dividends in arrears thereon were redeemed for approximately $61.6 million.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE HISTORICAL CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO AND THE OTHER FINANCIAL INFORMATION APPEARING ELSEWHERE IN THIS REPORT.
GENERAL
The Company's business is publishing newspapers in the United States, where its publications are primarily daily and non-daily newspapers. The Company's revenues are derived primarily from advertising, paid circulation and commercial printing.
As of December 26, 1999, the Company owned and operated 25 daily newspapers and 200 non-daily publications strategically clustered in seven geographic areas: Connecticut; Philadelphia and its surrounding areas; Ohio; the greater St. Louis area; central New England; and the Capital-Saratoga and Mid-Hudson, New York regions. As of December 26, 1999, the Company had total paid daily circulation of 636,939, total paid Sunday circulation of 619,963 and total non-daily distribution of approximately 4.6 million.
The Company's objective is to continue its growth in revenues, EBITDA and net income. The principal elements of the Company's strategy are to: (i) expand advertising revenues and readership, (ii) grow by acquisition, (iii) capture synergies from geographic clustering and (iv) implement consistent operating policies and standards. From 1993 through 1999, the Company successfully completed 17 strategic acquisitions, acquiring 13 daily newspapers, 126 non-daily publications and three commercial printing companies, two of which print a number of the non-daily publications. The third is a premium quality sheet-fed printing company.
The Company believes that its newspapers are generally effective in addressing the needs of local readers and advertisers. The Company believes that because its newspapers rely on a broad base of local retail and local classified advertising rather than more volatile national and major account advertising, its advertising revenues tend to be relatively stable.
As part of the Company's strategy, the Company focuses on increasing advertising and circulation revenues and expanding readership at its existing and newly acquired properties. The Company has also developed certain operating policies and standards which it believes have resulted in significant improvements in the cash flow and profitability of its existing and acquired newspapers, including: (i) focusing on local content, (ii) maintaining and improving product quality, (iii) enhancing distribution and (iv) promoting community involvement.
In 1999, the Company changed from a calendar year to the industry standard fiscal year ending on the Sunday closest to December 31st. Accordingly, the Company's 1999 results are reported for the period January 1, 1999 through December 26, 1999.
YEAR ENDED DECEMBER 26, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
REPORTING PERIOD. As stated above, in 1999 the Company changed its fiscal year and consequently ended the year on December 26, 1999. Therefore, unless specified otherwise, all comparisons to the 1998 reporting period are affected by the loss of days in the 1999 year-end period.
REVENUES. In 1999, revenues increased $42.8 million, or 10.0%, to $469.6 million, due to acquisitions. Newspaper revenues increased $43.5 million, or 10.8%, to $445.8 million in 1999, principally due to increased advertising revenue as a result of acquisitions. Circulation revenues increased approximately $7.4 million, or 8.3%, to $96.8 million in 1999. Commercial printing and other represented 5.1% of the Company's revenues in 1999, as compared to 5.7% in 1998. On-line revenue, included in advertising revenue, increased 75% from the prior-year period to $3.2 million. Revenue, including the five-day period ended December 31, 1999, increased approximately $47.4 million, or 11.1%, from the prior-year.
SALARIES AND EMPLOYEE BENEFITS. Salaries and employee benefit expenses were 33.5% of the Company's revenues in 1999 and 32.6% in 1998. Salaries and employee benefits increased $17.9 million, or 12.9%, in 1999 to $157.1 million, primarily due to acquisitions and increased pension expense.
NEWSPRINT, INK AND PRINTING CHARGES. In 1999, newsprint, ink and printing charges were 10.3% of the Company's revenues, as compared to 12.6% in 1998. Newsprint, ink and printing charges decreased $5.2 million, or 9.6%, in 1999 as compared to 1998. During 1999, the average newsprint price per ton declined approximately 13% from the prior period. The decrease in newsprint expense attributable to reductions in price have been offset in part by volume increases related to the Company's acquisitions.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses were 9.7% and 9.1% of the Company's revenues for 1999 and 1998, respectively. Selling, general and administrative expenses for 1999 increased $6.3 million, or 16.1%, to $45.3 million. During the third quarter of 1998, the Company recorded special charges of $3.2 million (see Note 5 to Selected Financial Data). Excluding the special charges, selling, general and administrative expenses for 1999 increased $9.5 million, or 26.3%, from the prior year, primarily due to acquisitions and promotion costs associated with the Company's revenue generating activities.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses were 6.1% of the Company's revenues in 1999 as compared to 5.6% in 1998. Depreciation and amortization expenses increased $5.0 million, or 20.8%, to $28.8 million in 1999, primarily due to increased amortization resulting from the Company's acquisitions.
OTHER EXPENSES. Other expenses accounted for 12.3% of the Company's revenues in 1999 as compared to 12.2% in 1998. Other expenses increased $6.0 million, or 11.5%, to $58.0 million in 1999, primarily due to acquisitions and increased promotion expenses. During the third quarter of 1998, the Company reported $630,000 in special charges (see Note 5 to Selected Financial Data). Excluding the $630,000 in special charges, other expenses for 1999 increased $6.6 million, or 12.8%, from the prior-year period.
OPERATING INCOME. Operating income increased $12.9 million in 1999 to $131.9 million from $119.1 million in 1998, which included special charges of $3.8 million as noted above. Excluding the effect of the special charges in 1998, operating income increased $9.1 million, or 7.4%, due to growth in the Company's advertising revenue, continued newsprint cost savings and the effect of acquisitions.
INTEREST EXPENSE. Interest expense increased $6.8 million, or 15.0%, from 1998 to 1999 as a result of increased borrowing in connection with the Company's acquisitions, including the Goodson Acquisition completed in the third quarter of 1998, offset in part by 1999 debt repayments and a decrease in average borrowing rates.
PROVISION FOR INCOME TAXES. The Company reported effective tax rates of 39.8% and 38.1% for the years ended December 26, 1999 and December 31, 1998, respectively. The increase in the effective tax rate is primarily a result of the Company's acquisitions, particularly the Goodson Acquisition completed in the third quarter of 1998.
EXTRAORDINARY ITEM. The Company recorded an extraordinary item related to the write-off of deferred financing charges in connection with the Company's prior credit agreement in the amount of $4.5 million ( net of $2.8 million income tax benefit) in the third quarter of 1998.
EQUITY INTEREST. During 1999, the Company purchased a 7.14% interest in AdOne, LLC ("AdOne"), a provider of classified advertising on the Internet. The loss recorded in 1999 represents the Company's prorata share of AdOne's net loss since the date of the Company's investment.
NET INCOME. Net income was $47.7 million, or $1.02 per share, basic and diluted, for 1999, as compared to $41.1 million, or $.85 per share, basic and diluted, for 1998, which reflects $6.8 million (net of $4.3 million of income tax benefit) of special charges and an extraordinary item.
OTHER INFORMATION. EBITDA increased $14.0 million, or 9.6%, to $160.7 million from $146.7 million in 1998. Tangible net income in 1999 was $58.9 million, or $1.26 per share, as compared to $55.5 million or $1.14 per share in 1998.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
REVENUES. In 1998, revenues increased $67.4 million, or 18.8%, to $426.8 million, due to acquisitions. Newspaper revenues increased $55.2 million, or 15.9%, to $402.3 million in 1998, principally due to increased advertising revenue as a result of acquisitions. Circulation revenues increased approximately $9.2 million, or 11.4%, to $89.4 million in 1998. Commercial printing and other represented 5.7% of the Company's revenues in 1998, as
compared to 3.4% in 1997 due to the commercial printing operations acquired as part of the InterCounty acquisition in December of 1997.
SALARIES AND EMPLOYEE BENEFITS. Salaries and employee benefit expenses were 32.6% of the Company's revenues in 1998 and 31.8% in 1997. Salaries and employee benefits increased $24.9 million, or 21.8%, in 1998 to $139.2 million, due to acquisitions.
NEWSPRINT, INK AND PRINTING CHARGES. In 1998, newsprint, ink and printing charges were 12.6% of the Company's revenues, as compared to 11.3% in 1997. Newsprint, ink and printing charges increased $13.1 million, or 32.5%, in 1998 as compared to 1997, primarily as a result of volume increases due to the Company's acquisitions and an approximately 8.0% increase in the price per ton of newsprint in 1998 as compared with 1997.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses were 9.1% and 8.5% of the Company's revenues for 1998 and 1997, respectively. Selling, general and administrative expenses for 1998 increased $8.6 million, or 28.2%, to $39.0 million, due to the Company's acquisitions and the special charges incurred during the third quarter of 1998 of $3.2 million (see Note 5 to Selected Financial Data). Excluding the special charges, selling, general and administrative expenses for 1998 increased $5.4 million from the prior-year primarily due to acquisitions and represented 8.4% of the Company's revenues for 1998.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses were 5.6% of the Company's revenues in 1998 as compared to 5.7% in 1997. Depreciation and amortization expenses increased $3.4 million, or 16.4%, to $23.8 million in 1998, primarily due to increased amortization resulting from the Company's acquisitions. This increase was partially offset by a decrease in depreciation expense related to certain assets that became fully depreciated during 1998 and in the third and fourth quarters of 1997.
OTHER EXPENSES. Other expenses accounted for 12.2% of the Company's revenues in 1998 as compared to 11.3% in 1997. Other expenses increased $11.2 million, or 27.5%, to $52.0 million in 1998, primarily due to acquisitions, increased circulation promotion expenses, increased postage expense related to the Company's preprint advertising sales and $630,000 in special charges incurred in the third quarter of 1998 (see Note 5 to Selected Financial Data). Excluding the $630,000 in special charges, other expenses for 1998 increased $10.6 million and represented 12.0% of the Company's revenues for 1998.
OPERATING INCOME. Operating income increased $38.0 million in 1998 to $119.1 million, including special charges of $3.8 million, from $81.0 million in 1997, which included a special charge of $31.9 million related to the Company's Initial Public Offering ("IPO") in May 1997.
INTEREST EXPENSE. Interest expense increased $3.2 million, or 7.5%, from 1997 to 1998 as a result of increased borrowing in connection with the Company's acquisitions including the Goodson Acquisition, offset in part by a decrease in average borrowing rates.
PROVISION FOR INCOME TAXES. The Company reported effective tax rates of 38.1% and 40.7% for the years ended December 31, 1998 and 1997, respectively. The reduction in the effective tax rate is a result of the Company's corporate restructuring implemented January 1, 1998 offset in part by an increase in the rate as a result of the Goodson Acquisition.
EXTRAORDINARY ITEM. The Company recorded an extraordinary item related to the write-off of deferred financing charges in connection with the Company's prior credit agreement in the amount of $4.5 million (net of $2.8 million income tax benefit) in the third quarter of 1998.
NET INCOME. Net income was $41.1 million, or $.85 per share, basic and diluted, for 1998, which reflects $6.8 million (net of $4.3 million of income tax benefit) of special charges and an extraordinary item, as compared to $23.0 million, or $.51 per share, basic and diluted, for 1997, which included a special charge of $18.9 million (net of $13.0 million of income tax benefit) related to the IPO.
OTHER INFORMATION. EBITDA as adjusted for the special charges noted above in both years, increased $13.3 million, or 10.0%, to $146.7 million from $133.4 million in 1997. Net income in 1998 excluding the special charges and extraordinary item was $48.0 million or $.99 per share.
LIQUIDITY AND CAPITAL RESOURCES
The Company's operations have historically generated strong positive cash flow. The Company believes cash flows from operations will be sufficient to fund its operations, capital expenditures and long-term debt obligations. The Company also believes that cash flows from operations and future borrowings and its ability to issue common stock as consideration for future acquisitions, will provide it with the flexibility to fund its acquisition strategy while continuing to meet its operating needs, capital expenditures and long-term debt obligations.
CASH FLOWS FROM OPERATIONS. Net cash provided by operating activities increased $11.0 million to $90.0 million in 1999. Net cash provided by operating activities in 1999 primarily resulted from net income before non-cash expenses (i.e., depreciation and amortization), of $76.5 million.
CASH FLOWS FROM INVESTING ACTIVITIES. Net cash used in investing activities decreased $320.7 million to $32.1 million in 1999. The 1998 investing activity reflects the Company's purchase of the Goodson Newspaper group for approximately $300.0 million. In 1999, the Company's capital expenditures increased by $4.5 million, due primarily to the 1998 acquisitions and system conversions related to Year 2000. During 1999, the Company began the initial planning phases for its new Philadelphia printing facility. As of December 26, 1999, approximately $1.8 million of expenditures were made in connection with the facility. The total cost of the project is currently estimated to be $35.0 million and is expected to be completed in 2001. The Company expects to fund this construction project with cash flows from operations and borrowings. The Company has a capital expenditure program (excluding future acquisitions) of approximately $17.0 million in place for 2000, which includes spending on technology, including prepress and business systems, computer hardware and software, other machinery and equipment, plants and property, vehicles and other assets. The 2000 budget also includes funds of approximately $25.0 million for costs associated with the Philadelphia plant. The Company believes its capital expenditure program is sufficient to maintain its current level and quality of operations. The Company reviews its capital expenditure program periodically and modifies it as required to meet current needs.
CASH FLOWS FROM FINANCING ACTIVITIES. Net cash used in financing activities was $63.3 million in 1999 as compared to net cash provided by financing activities of $274.2 million in 1998. The 1998 activity reflects net proceeds of approximately $808.0 million from the issuance of senior secured debt in connection with the Company's new credit facility, $533.8 million which was used to repay outstanding debt. The 1999 activity reflects the use of funds of approximately $29.9 million in connection with the Company's stock repurchase program and approximately $33.5 million for the repayment of senior debt.
On July 15, 1998, the Company entered into a new credit agreement (the "Credit Agreement") with the banks and other financial institutions, signatories thereto and The Chase Manhattan Bank, as administrative agent for the lenders thereunder. The Credit Agreement provides for $500.0 million in term loans and a $400.0 million revolving credit facility. The proceeds from the Credit Agreement were used to repay amounts outstanding under the prior senior facilities and to fund the Goodson Acquisition. The term loans mature on March 31, 2006 and September 30, 2006, and the revolving credit facility matures on March 31, 2006.
The Credit Agreement also provides for an uncommitted multiple draw term loan facility (the "Incremental Facility") in the amount of up to $500.0 million as permitted by the administrative agent to be repaid under conditions as defined in the Credit Agreement.
The amounts outstanding under the Credit Agreement bear interest at (i) 1 3/4% to 1/2% above LIBOR (as defined in the Credit Agreement) or (ii) 1/2% to 0% above the higher of (a) the Prime Rate (as defined in the Credit Agreement) or (b) 1/2% above the Federal Funds Rate (as defined in the Credit Agreement). The interest rate spreads ("the applicable margins") are dependent upon the ratio of debt to trailing four quarters Cash Flow (as defined in the Credit Agreement) and reduce as such ratio declines.
The Company generally manages its exposure to interest rate fluctuations for its variable rate debt by entering into interest rate protection agreements. The Company was required under the prior credit agreement and is required under the Credit Agreement to maintain interest rate protection agreements for a certain percentage of its outstanding debt, based upon the Total Leverage Ratio (as defined in the Credit Agreement).
Interest rate protection agreements (IRPAs) relating to the Company's borrowings at December 26, 1999 included SWAP agreements with a notional principal amount of $619.0 million. At December 31, 1998, the Company's borrowings included a SWAP agreement with a notional principal amount of $300.0
million which matured on January 29, 1999. On January 29, 1999, the Company's new SWAP agreements became effective, for an aggregate notional principal amount of $400.0 million which reduce by $75.0 million per year beginning on January 31, 2000 and expire on October 29, 2002. The agreements exchange a floating LIBOR rate plus an applicable margin for a fixed LIBOR rate plus an applicable margin. In 1999, the Company entered into additional three month SWAP agreements in an aggregate notional amount of $219.0 million which mature by March 15, 2000. As of December 26, 1999, if the SWAPs were marked to market, they would result in a net gain of approximately $6.1 million. The fair value as of December 26, 1999 of the IRPAs were obtained from the Company's bank. The fixed LIBOR rate of the SWAP agreements range from 5.85% to 6.04%. For the year ended December 26, 1999, the Company's weighted average effective interest rate on its outstanding debt balance was approximately 6.75%. This takes into account the interest rate protection agreements in effect during that period.
As of December 26, 1999, the Company had outstanding indebtedness under the Credit Agreement, due and payable in installments through 2006, of $731.5 million, of which $231.5 million was outstanding under the revolving credit facility. There was $168.5 million of unused and available funds under the revolving credit facility at December 26, 1999.
YEAR 2000
During the fourth quarter of 1999, the Company completed the final phases of its remediation, testing and contingency planning in order to ensure the Company's Year 2000 readiness. As a result of the Company's planning and implementation efforts, the Company experienced no significant interruptions in operations during the transition period from 1999 to 2000. The Company is not aware of any material problems resulting from Year 2000 issues, either with its products, internal systems or the products and services of third parties. The Company will continue to monitor all general purpose and production hardware and software as well as those of its suppliers and vendors for any potential Year 2000 issues that may surface.
In accordance with GAAP, the Company's direct Year 2000 costs, including modifying computer software or converting to new programs, were expensed as incurred. Additionally, a majority of the hardware costs for replacement systems were capitalized as ordinarily accounted for in the normal course of business. These system replacements represented upgrades consistent with the Company's goal to maintain and improve operational efficiencies. The Company capitalized approximately $6.1 million related to new hardware and software in connection with its Year 2000 compliance plan as of December 26, 1999.
INFLATION
The Company's results of operations and financial condition have not been significantly affected by inflation. Subject to normal competitive conditions, the Company generally has been able to pass along rising costs through increased advertising and circulation rates.
RECENT EVENTS
On November 9, 1999, the Company's Board of Directors approved a change, effective December 27, 1999, in the Company's fiscal year from a calendar year to an industry standard 52/53 week fiscal year ending on the Sunday nearest to December 31st.
During 1999, the Company's Board of Directors authorized the use of up to $50.0 million per year for the repurchase of Common Stock. As of December 26, 1999, the Company had repurchased 2,369,200 shares. As of March 17, 2000, the Company had repurchased an additional 707,200 shares on the open market. Shares under the program are to be repurchased at management's discretion, either in the open market or in privately negotiated transactions.
The decision to repurchase stock depends on price, market conditions and other factors. The Company indicated that there is no minimum number of shares to be purchased under the program.
Purchases under the program will be financed with the Company's free cash flow or borrowings under the Company's Credit Agreement.
On February 28, 2000, the Company announced its intent to sell the Ohio and St. Louis area newspapers. The Ohio properties include four daily newspapers with a total daily circulation of approximately 126,000. The Missouri and Illinois
properties include the Suburban Newspapers of Greater St. Louis, representing non-daily distribution of approximately 1.7 million and a daily newspaper in Alton, Illinois, with daily circulation of approximately 28,000 and Sunday circulation of approximately 30,000. For the year ended December 26, 1999, the Ohio and St. Louis area newspapers generated approximately $135 million in revenue.
INFORMATION RELATING TO FORWARD-LOOKING STATEMENTS
Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Form 10-K include forward-looking statements, which may be identified by use of terms such as "believes," "anticipates," "plans," "will," "likely," "continues," "intends" or "expects." These forward-looking statements relate to the plans and objectives of the Company for future operations. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements herein should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. Many factors could cause the Company's actual results to differ materially from those in the forward-looking statements, including, among other things, the factors discussed below under "Certain Factors Which May Affect the Company's Future Performance." The following factors should not be construed as exhaustive. The Company undertakes no obligation to release publicly the results of any future revisions it may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
NEW ACCOUNTING PRONOUNCEMENT
In June of 1998, Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), was issued by the Financial Accounting Standards Board ("FASB"). Subsequently, in June 1999, the FASB issued SFAS No. 137, an amendment to SFAS 133, deferring the effective date of SFAS 133 to years beginning after June 15, 2000. SFAS 133 will require the Company to recognize all derivatives on the balance sheet at fair market value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair values of the derivatives will either be offset against the change in fair value of the hedged assets or liabilities through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet determined what effect, if any, SFAS 133 will have on the earnings and financial position of the Company.
CERTAIN FACTORS WHICH MAY AFFECT THE COMPANY'S FUTURE PERFORMANCE
NEWSPAPER INDUSTRY COMPETITION
The Company's business is concentrated in newspapers and other publications located primarily in small metropolitan and suburban areas in the United States. Revenues in the newspaper industry primarily consist of advertising and paid circulation. Competition for advertising expenditures and paid circulation comes from local, regional and national newspapers, shopping guides, television, radio, direct mail, on-line services and other forms of communication and advertising media. Competition for newspaper advertising expenditures is based largely upon advertiser results, readership, advertising rates, demographics and circulation levels, while competition for circulation and readership is based largely upon the content of the newspaper, its price and the effectiveness of its distribution. Many of the Company's competitors are larger and have greater financial resources than the Company.
DEPENDENCE ON LOCAL ECONOMIES
The Company's advertising revenues and, to a lesser extent, circulation revenues are dependent on a variety of factors specific to the communities which the Company's newspapers serve. These factors include, among others, the size and demographic characteristics of the local population, local economic conditions in general, and the related retail segments in particular, and local weather conditions.
INDEBTEDNESS
The Company has a substantial amount of indebtedness. As of December 26, 1999, the consolidated indebtedness of the Company was approximately $731.5 million, which represents a multiple of 4.6 times the Company's twelve months trailing EBITDA of approximately $160.7 million. The 1999 EBITDA is impacted by
the loss of five days resulting from the Company's decision to adopt a 52/53 week fiscal year and to end 1999 on December 26, 1999. As of December 26, 1999, the Company had a net stockholders' deficit of approximately $207.4 million and a total capitalization of $524.1 million, and, thus, the percentage of the Company's indebtedness to total capitalization was 139.6%. The Company may incur additional indebtedness to fund operations, capital expenditures or future acquisitions.
The Company believes that cash provided by operating activities will be sufficient to fund its operations and to meet payment requirements under its Term Loans and the Revolver under the Credit Agreement. However, a decline in cash provided by operating activities, which could result from factors beyond the Company's control, such as unfavorable economic conditions, an overall decline in advertising expenditures or increased competition, could impair the Company's ability to service its debt. The Credit Agreement requires the maintenance of certain financial ratios and imposes certain operating and financial restrictions on the Company which restrict, among other things, the Company's ability to declare dividends, redeem stock, incur indebtedness, create liens, sell assets, consummate mergers and make capital expenditures, investments and acquisitions.
ENVIRONMENTAL MATTERS
The Company's operations are subject to federal, state and local environmental laws and regulations pertaining to air and water quality, storage tanks and the management and disposal of waste at its facilities. To the best of the Company's knowledge, its operations are in material compliance with applicable environmental laws and regulations as currently interpreted. The Company cannot predict with any certainty whether future events, such as changes in existing laws and regulations or the discovery of conditions not currently known to the Company, may give rise to additional costs which could be material. Furthermore, actions by federal, state and local governments concerning environmental matters could result in laws or regulations that could have a material adverse effect on the financial condition or results of operations of the Company. The Company is not aware of any pending legislation by federal, state or local governments relating to environmental matters which, if enacted, would reasonably be expected to have a material adverse effect on the financial condition or results of operations of the Company. The Company is in the process of monitoring groundwater contamination which has been detected at one of its facilities. The Company believes the remediation of any such groundwater contamination, if required, will not have a material adverse effect on its financial condition or results of operations. In May 1998, one of the Company's subsidiaries, acquired as part of the Goodson Acquisition, received a Notice of Potential Liability in connection with a landfill superfund site. The Company is fully indemnified for all costs and liabilities arising out of this issue by the seller as part of the Goodson Acquisition purchase agreement.
ACQUISITION STRATEGY
The Company has grown through, and anticipates that it will continue to grow through, acquisitions of daily and non-daily newspapers and similar publications. Acquisitions may expose the Company to particular risks, including, without limitation, diversion of management's attention, assumption of liabilities and amortization of goodwill and other acquired intangible assets, some or all of which could have a material adverse effect on the financial condition or results of operations of the Company. Depending on the value and nature of the consideration paid by the Company for acquisitions, such acquisitions may have a dilutive impact on the Company's earnings per share. In making acquisitions, the Company competes for acquisition targets with other companies, many of which are larger and have greater financial resources than the Company. There can be no assurance that the Company will continue to be successful in identifying acquisition opportunities, assessing the value, strengths and weaknesses of such opportunities, evaluating the costs of new growth opportunities at existing operations or managing the publications it owns and improving their operating efficiency. Historically, the Company has financed acquisitions through cash on hand and borrowings, which borrowings have increased the Company's indebtedness. The Company anticipates that it will finance future acquisitions through cash on hand, borrowings and issuances of capital stock. The Credit Agreement limits acquisitions to certain permitted investments and newspapers in the United States, and requires that acquisitions be financed through certain permitted sources. In addition, the financial covenants contained in the Credit Agreement may limit the Company's ability to make acquisitions.
PRICE AND AVAILABILITY OF NEWSPRINT
The basic raw material for newspapers is newsprint. The Company's newsprint consumption (excluding paper consumed in the Company's commercial printing operations) totaled approximately $36.5 million in 1999, which was approximately 8.2% of the Company's newspaper revenues. In 1999, the Company consumed approximately 82,000 metric tons of newsprint. The average price per
metric ton of newsprint based on East Coast transaction prices in 1999, 1998 and 1997 was $510, $596 and $555, respectively, as reported by the trade publication PULP AND PAPER WEEKLY. The Company has no long-term contracts to purchase newsprint. Generally, the Company purchases all of its newsprint from two suppliers. Historically, the percentage of the Company's newsprint supplied by each of such suppliers has varied. The Company believes that it would not be materially adversely effected if it were no longer able to purchase its newsprint supply from its two current suppliers and that, in such event, other newsprint suppliers would be readily available to the Company. In the future, the Company may purchase newsprint from other suppliers. The inability of the Company to obtain an adequate supply of newsprint in the future could have a material adverse effect on the financial condition or results of operations of the Company. Historically, the price of newsprint has been cyclical and volatile. The Company's average price per ton of newsprint consumed decreased approximately 13% in 1999, increased approximately 8% in 1998 and decreased approximately 18% in 1997, in each case compared to the previous year. The Company believes that if any price increase or decrease is sustained in the industry, the Company will also be impacted by such increase or decrease. The Company is unable to predict whether, or to what extent, any increase or decrease will be sustained. Significant increases in newsprint costs could have a material adverse effect on the financial condition or results of operations of the Company. The Company seeks to manage the effects of increases in prices of newsprint through a combination of, among other things, technology improvements, including web-width reductions, inventory management and advertising and circulation price increases. The Company also has reduced fringe circulation in response to increased newsprint prices, as it is the Company's experience that such circulation does not provide adequate response for advertisers.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company is exposed to market risk arising from changes in interest rates associated with its long-term debt obligations. The Company's long-term debt is at variable interest rates based on certain interest rate spreads applied to LIBOR, the Prime Rate or Federal Funds Rate as defined in the Credit Agreement. To manage its exposure to fluctuations in interest rates, the Company, as required by its Credit Agreement, enters into certain interest rate protection agreements, which allows the Company to exchange variable rate interest for fixed rate, maturing at specific intervals. The difference to be paid or received as interest rates change is accrued and recognized as an adjustment of interest expense related to the debt. The related amount payable to or receivable from counterparties is included in accrued interest. The Company's use of these agreements is limited to hedging activities and not for trading or speculative activity.
At December 26, 1999, the Company had in effect SWAP agreements for a notional amount of $619 million. The fair market value of the SWAP at December 26, 1999, had the SWAP been marked to market, would have resulted in a gain of approximately $6.1 million. SWAP agreements in an aggregate notional amount of $400 million which became effective January 29, 1999, reduce by $75 million per year beginning on January 31, 2000 and expire on October 29, 2002. In 1999, the Company entered into additional three month SWAP agreements in an aggregate notional amount of $219 million which mature by March 15, 2000. Assuming a 10% increase or reduction in interest rates for the year ended December 26, 1999, the effect on the Company's pre-tax earnings and cash flows would be approximately $2.4 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Page ---- FINANCIAL STATEMENTS:
Report of Independent Auditors......................................... 30 Consolidated Balance Sheets............................................ 31 Consolidated Statements of Income...................................... 32 Consolidated Statements of Stockholders'/Members' Deficit.............. 33 Consolidated Statements of Cash Flows.................................. 34 Notes to Consolidated Financial Statements............................. 35
FINANCIAL STATEMENT SCHEDULE:
Schedule II, Valuation and Qualifying Accounts.......................... S-1
All other schedules are omitted because they are not applicable or the requested information is shown in the consolidated financial statements or related notes.
REPORT OF INDEPENDENT AUDITORS
The Board of Directors Journal Register Company
We have audited the accompanying consolidated balance sheets of Journal Register Company as of December 26, 1999 and December 31, 1998, and the related consolidated statements of income, stockholders'/members' deficit, and cash flows for each of the three years in the period ended December 26, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Journal Register Company, as of December 26, 1999 and December 31, 1998 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 26, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
ERNST & YOUNG LLP
February 3, 2000 MetroPark, New Jersey
JOURNAL REGISTER COMPANY CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
December 26, December 31, 1999 1998 ------------- -------------- ASSETS
Current assets: Cash and cash equivalents $ 3,090 $ 8,542 Accounts receivable, less allowance for doubtful accounts of $6,293 in 1999 and $4,632 in 1998 65,597 58,244 Inventories 9,899 8,440 Deferred income taxes 2,721 2,522 Other current assets 7,090 4,130 ---------- ----------- Total current assets 88,397 81,878 Property, plant and equipment: Land 9,018 8,810 Buildings and improvements 66,187 65,127 Machinery and equipment 171,631 156,223 ----------- ----------- 246,836 230,160 Less accumulated depreciation (141,860) (130,182) ----------- ------------ Property, plant and equipment, net 104,976 99,978 Intangible and other assets, net of accumulated amortization of $42,751 in 1999 and $28,297 in 1998 493,807 490,013 ----------- ------------ Total assets $687,180 $ 671,869 =========== ============ LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities: Current maturities of long-term debt $ 19,500 $ -- Accounts payable 14,617 12,107 Income taxes payable 438 829 Accrued interest 6,886 6,374 Deferred subscription revenue 8,896 8,290 Accrued salaries and vacation 5,647 5,231 Other accrued expenses and current liabilities 16,896 17,293 ---------- ------------ Total current liabilities 72,880 50,124
Senior debt, less current maturities 711,967 765,000 Deferred income taxes 20,291 14,029 Accrued retiree benefits and other liabilities 15,920 17,078 Income taxes payable 73,505 50,951
Commitments and contingencies
Stockholders' deficit:
Common stock, $.01 par value per share, 300,000,000 shares authorized, 48,437,581 issued at December 26, 1999 and December 31, 1998 484 484 Additional paid-in capital 358,244 358,236 Accumulated deficit (536,156) (583,821) ---------- ----------- (177,428) (225,101)
Less treasury stock, 2,362,953 shares, at cost (29,795) --
Accumulated other comprehensive loss, net of tax (160) (212) ---------- ------------ Net stockholders' deficit (207,383) (225,313) ----------- ------------ Total liabilities and stockholders' deficit $687,180 $671,869 =========== ============
SEE ACCOMPANYING NOTES.
SEE ACCOMPANYING NOTES.
SEE ACCOMPANYING NOTES.
SEE ACCOMPANYING NOTES.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 26, 1999
1. ORGANIZATION AND BASIS OF PRESENTATION
The accompanying consolidated financial statements include Journal Register Company (the "Company") and all of its wholly-owned subsidiaries. The Company was incorporated on March 11, 1997 and became a publicly traded company in May of 1997.
In March of 1997, certain entities (namely, JRC, LLC, JRNI and INSI) were combined and JRC, LLC was converted into a C corporation, Journal Register Company. Substantially all of the membership interests and equity securities of these entities were owned by affiliates of E.M. Warburg, Pincus & Co., LLC (collectively, "Warburg, Pincus"). Since the companies were under common control, this transaction was accounted for on a basis similar to a pooling of interests. The accompanying financial statements include the accounts and operations of JRC (or its predecessor JRC, LLC), JRNI and INSI for all periods presented.
Journal Register Company (through its consolidated subsidiaries) primarily publishes daily and non-daily newspapers serving markets in Connecticut, Philadelphia and its surrounding areas, Ohio, the greater St. Louis area, central New England and the Capital-Saratoga and Mid-Hudson, New York regions; and has commercial printing operations in Connecticut, Ohio and Pennsylvania.
On November 9, 1999, the Company elected to change from a calendar year end to a fiscal year ending on the Sunday closest to December 31st. Accordingly, the Company's 1999 fiscal year ended on December 26, 1999.
The Company has authorized 1,000,000 shares of Preferred Stock, none of which were issued or outstanding as of December 26, 1999.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. All significant intercompany activity has been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates would include the allowance for doubtful accounts and valuation allowance for deferred taxes. Actual results could differ from those estimates.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For purposes of the accompanying consolidated statements of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The carrying value of cash equivalents approximates fair value due to the short-term maturity of these instruments.
INVENTORIES
Inventories, consisting of newsprint, ink and supplies, are stated at the lower of cost (primarily first-in, first-out method) or market.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost. Maintenance and repairs are charged to expense as incurred; costs of major additions and betterments are capitalized.
Depreciation is provided for financial reporting purposes primarily by the straight-line method over the following estimated useful lives:
Buildings and improvements 5 to 30 years Machinery and equipment 3 to 30 years
INTANGIBLE ASSETS AND OTHER ASSETS
Intangible assets recorded in connection with the acquisition of newspapers generally consist of the values assigned to subscriber lists and the excess of cost over the value of identifiable net assets of the companies acquired. These assets are carried at the lower of amortized cost or the amount expected to be recovered by projected future operations after considering attributable general and administration expense and interest on debt allocated to the various newspapers. If, in the opinion of management, an impairment in value occurs, any necessary write-downs will be charged to expense.
The balance of intangible assets at December 26, 1999 and December 31, 1998 was comprised principally of subscriber lists and excess cost over the value of identifiable net assets of companies acquired. These assets are being amortized over a period of 4 to 40 years and are amortized by the straight-line method.
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121 "Accounting for the Impairment of Long Lived Assets and for Long-Lived Assets to be Disposed Of ", the Company reviews the recoverability of intangibles and other long-lived assets whenever events and circumstances indicate that the carrying amount may not be recoverable. The carrying amount of the long-lived assets is reduced by the difference between the carrying amount and estimated fair value.
Other assets consist principally of capitalized costs associated with the term loans and the revolver (as defined in Note 4, Long-Term Debt) that are being amortized over the terms of such loans.
INCOME TAXES
The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws that will be in effect when the differences are expected to reverse.
DEFERRED SUBSCRIPTION REVENUE
Deferred subscription revenue arises from subscription payments made in advance of newspaper delivery. Revenue is recognized in the period in which it is earned.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INTEREST-RATE PROTECTION AGREEMENTS
The Company enters into Interest-Rate Protection Agreements ("IRPAs") to modify the interest characteristics of its outstanding debt. Each IRPA is designated for all or a portion of the principal balance and term of a specific debt obligation. Certain of these agreements involve the exchange of amounts based on a fixed interest rate for amounts based on variable interest rates over the life of the agreement without an exchange of the notional amount upon which the payments are based. The differential to be paid or received as interest rates change is accrued and recognized as an adjustment of interest expense related to the debt. The related amount payable to or receivable from counterparties is included in accrued interest. The fair values of IRPAs are not recognized in the financial statements. Gains and losses on terminations of IRPAs would be deferred as an adjustment to the carrying amount of the outstanding debt and amortized as an adjustment to interest expense related to the debt over the remaining term of the original contract life of the IRPAs. In the event of the early extinguishment of a designated debt obligation, any realized or unrealized gain or loss from the IRPA would be recognized in income coincident with the extinguishment. Any IRPAs that were not designated with outstanding debt or notional amounts (or durations) of IRPAs in excess of the principal amounts (or maturities) of the underlying debt would be recorded as an asset or liability at fair value, with changes in fair value recorded in other income (expense).
STOCK OPTION PLAN
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for its employee stock options. Under APB 25, when the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
EARNINGS PER SHARE
The Company, in accordance with Financial Accounting Standards Board ("FASB") SFAS No. 128, "Earnings Per Share", discloses earnings per share on a basic and diluted basis. Diluted earnings per share include any dilutive effects of options, warrants and convertible securities.
CONCENTRATION OF RISK
Certain employees of the Company's newspapers are employed under collective bargaining agreements.
SEGMENTS REPORTING
In 1998, the Company adopted the FASB's SFAS No. 131, "Disclosure About Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 superceded SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise". The adoption of SFAS 131 did not affect the results of operations or financial position and did not affect the disclosure of segment information.
The Company is a newspaper company. The Company publishes 25 daily and 200 non-daily newspapers in the U.S. It maintains operations and local management in the markets that it serves. Revenue is earned from the sale of advertising, circulation and related activities. Newspapers are distributed through local distribution channels consisting of contract carriers and single copy outlets.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Company conducts business in one operating segment. The Company determined its operating segment based on individual operations that the chief operating decision maker reviews for purposes of assessing performance and making operational decisions. These individual operations have been aggregated into one segment because the Company believes it helps the users understand the Company's performance. The combined operations have similar economic characteristics and each operation has similar products, services, customers, production processes and distribution systems.
EFFECT OF NEW PRONOUNCEMENT
In June of 1998, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), was issued by the FASB. Subsequently, in June 1999, the FASB issued SFAS No. 137, an amendment to SFAS 133, deferring the effective date of SFAS 133 to years beginning after June 15, 2000. SFAS 133 will require the Company to recognize all derivatives on the balance sheet at fair market value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair values of the derivatives will either be offset against the change in fair value of the hedged assets or liabilities through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet determined what the effect, if any, of SFAS 133 will have on the earnings and financial position of the Company.
RECLASSIFICATIONS
Certain reclassifications were made to the 1998 and 1997 financial statements to conform to the 1999 presentation.
3. INTANGIBLE AND OTHER ASSETS
Intangible and other assets as of December 26 and December 31, respectively, net of accumulated amortization, are summarized as follows:
(in thousands) 1999 1998 ---- ---- Excess of cost over the value of identifiable net assets and subscriber lists $473,904 $473,245 Prepaid pension cost 9,230 8,434 Other 10,673 8,334 ---------- ---------- $493,807 $490,013 ========== ==========
Included in other assets is the Company's investment in AdOne, LLC ("AdOne"). On August 20, 1999, the Company acquired a 7.14% interest in AdOne, LLC, a provider of classified advertising on the Internet. The Company applied the equity method of accounting for this transaction. In addition, the company holds a $1.2 million promissory note from AdOne. The note bears interest at 9.4% per annum and is payable in five equal installments commencing December 31, 2005.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
4. LONG-TERM DEBT
The Company's long-term debt as of December 26 and December 31, respectively, was comprised of the following:
(in thousands) 1999 1998 ----- ------
Senior Secured Term Loans $500,000 $500,000 Senior Secured Revolving Credit Facility 231,467 265,000 ---------- --------- 731,467 765,000 Less current portion (19,500) -- ----------- --------- $711,967 $765,000 =========== =========
On July 15, 1998, the Company entered into a new credit agreement with a group of lenders led by The Chase Manhattan Bank, as administrative agent (the "Credit Agreement"). The Credit Agreement provides a 7 3/4-year term loan facility ("Term Loan A") in the aggregate amount of $250.0 million, an 8 1/4-year term loan facility ("Term Loan B") in the aggregate amount of $250.0 million and a 7 3/4-year revolving credit facility in the aggregate amount of $400.0 million (the "Revolving Credit Facility"). Proceeds under these loan facilities were used to repay existing debt and to fund the Goodson Acquisition. The Company had $168.5 million and $135.0 million unused and available under the Revolving Credit Facility at December 26, 1999 and December 31, 1998, respectively.
The Term Loan A Facility matures on March 31, 2006 and is repayable in quarterly installments commencing on June 30, 2000. The Term Loan B Facility matures on September 30, 2006 and is repayable in quarterly installments commencing on June 30, 2000.
The aggregate annual maturities of long-term debt payable under the term loans are as follows:
(in thousands)
2000................................. $ 19,500 2001................................. 22,625 2002................................. 35,375 2003................................. 41,625 2004................................. 47,875 Thereafter........................... 333,000
The Revolving Credit Facility is available on a revolving basis until March 31, 2006. Availability will be reduced by consecutive quarterly reductions, commencing on June 30, 2002 and ending on March 31, 2006, in an aggregate amount for each twelve month period commencing on the date set forth below equal to the amount set forth opposite such date (with reductions during each such period being equal in amount):
PRINCIPAL AMOUNT (in thousands)
June 30, 2002 $ 55,000 June 30, 2003 65,000 June 30, 2004 100,000 June 30, 2005 180,000
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
4. LONG-TERM DEBT (CONTINUED)
The Credit Agreement also provides for an uncommitted multiple draw term loan facility (the "Incremental Facility") in the amount of up to $500.0 million as permitted by the administrative agent to be repaid under conditions as defined in the agreement.
The senior secured term loans and senior secured revolving credit facility are secured by substantially all of the assets of the Company and the common stock and assets of the Company's subsidiaries. The senior secured term loans and senior secured revolving credit facility require compliance with certain covenants, which require, among other things, maintenance of certain financial ratios, and restricts the Company's ability to declare dividends, redeem stock, incur additional indebtedness, create liens, sell assets, consummate mergers and make capital expenditures, investments and acquisitions.
The amounts outstanding under the credit facilities bear interest at (i) 1 3/4% to 1/2% above LIBOR or (ii) 1/2% to 0% above the higher of (a) the Prime Rate or (b) 1/2% above the Federal Funds Rate. The interest rate spreads are dependent upon the ratio of debt to trailing four quarters Cash Flow (as defined in the Credit Agreement) and reduce as such ratio declines.
An annual commitment fee is incurred on the average daily unused portion of the Revolving Credit Facility, payable quarterly in arrears, at a percentage which varies from 0.375% to 0.250% based on the quarterly calculation of the Total Leverage Ratio (as defined in the Credit Agreement). At December 26, 1999, the Company's commitment fee was 0.375%.
The Credit Agreement also requires the Company, in order to manage interest rate risk, to maintain IRPA's for a certain percentage of the outstanding debt, based upon the Total Leverage Ratio. In accordance with this requirement, the Company participates in certain IRPA's whereby the Company has assumed a fixed rate of interest and a counterparty has assumed the variable rate (the "SWAP"). Pursuant to the SWAP agreement, the Company agrees to exchange with certain banks at specific dates the difference between the fixed rate in the SWAP agreement and the LIBOR floating rate applied to the notional principal amount. Prior to and during 1997, the Company, in connection with the prior credit agreement, also entered into interest rate collar agreements which expired on various dates between April 30, 1998 and June 30, 1998. The interest rate collar agreements had an aggregate notional principal amount of $286.0 million with ceiling interest rates ranging from 7.29% through 7.41% and floor interest rates of 5.48%.
IRPA's relating to the Company's borrowings at December 26, 1999 included SWAP agreements with a notional principal amount of $619.0 million. At December 31, 1998, the Company's borrowings included a SWAP agreement with a notional principal amount of $300.0 million which matured on January 29, 1999. On January 29, 1999, the Company's new SWAP agreements became effective, for an aggregate notional principal amount of $400.0 million which reduce by $75.0 million per year, beginning on January 31, 2000 and expire on October 29, 2002.
In 1999, the Company entered into additional three month SWAP agreements in an aggregate notional amount of $219 million which mature by March 15, 2000. As of December 26, 1999, if the SWAPs were marked to market, they would result in a net gain of approximately $6.1 million. The fair value as of December 26, 1999 of the IRPAs were obtained from the Company's bank. The fixed LIBOR rate of the SWAP agreements range from 5.85% to 6.04%.
The estimated fair value of the Term Loans and Revolving Credit Facility approximates their carrying value since the interest rates are variable.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
5. INITIAL PUBLIC OFFERING AND SPECIAL CHARGE
In May 1997, the Company completed an initial public offering of 9,375,000 shares (the "Offering") of its common stock, par value $0.01 per share (the "Common Stock"), at a price of $14 per share. The Common Stock began trading on the New York Stock Exchange under the symbol "JRC" on May 8, 1997. The net proceeds to the Company from the Offering were approximately $119.0 million, which the Company used to repay a portion of the amounts outstanding under the term loan and to retire all of the outstanding principal amount of and accrued and unpaid interest on the Company's subordinated notes.
On June 6, 1997, pursuant to an agreement with the underwriters of the Offering (the "Underwriting Agreement"), the underwriters exercised their option to purchase 1,406,250 additional shares of Common Stock at a price of $14 per share. In accordance with the Underwriting Agreement, these shares were purchased directly from Warburg, Pincus and were purchased solely for the purpose of covering over-allotments made in connection with the Offering.
In connection with the Offering, in the second quarter of 1997 the Company incurred a special charge of $31.9 million (before benefit for income taxes of $13.0 million) comprised of $28.4 million for a management bonus and $3.5 million for the discontinuance of a management incentive plan. The management bonus was comprised of 1,100,000 shares of Common Stock and a cash portion to satisfy the recipients' tax obligations arising from the management bonus.
6. STOCK INCENTIVE PLAN
Prior to the completion of the Offering (see Note 5, Initial Public Offering and Special Charge), the Company's Board of Directors (the "Board") adopted and the stockholders approved the Company's 1997 Stock Incentive Plan (the "1997 Plan"). Subject to adjustment as provided in the 1997 Plan, the 1997 Plan authorizes the granting of up to 4,843,750 shares of the Common Stock through: (i) incentive stock options and non-qualified stock options (in each case, with or without stock appreciation rights), to acquire Common Stock; (ii) awards of restricted shares of Common Stock; and (iii) performance units, to such directors, officers and other employees of, and consultants to, the Company and its subsidiaries and affiliates as may be designated by the Compensation Committee of the Board or such other committee of the Board as the Board may designate.
Incentive stock options are granted at no less than fair market value of the Common Stock on the date of grant. The option price per share of Common Stock for all other stock options are established by the Compensation Committee. Stock options are exercisable at cumulative intervals of 20% commencing on the first anniversary after issuance, continuing through the fifth anniversary, at which time 100% may be exercised. These options expire ten years after issuance.
Proforma information regarding net income and earnings per share is required by FASB SFAS No. 123, "Accounting for Stock-Based Compensation", and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1999 and 1998: risk-free interest rate of 6.51% and 5.49%, respectively; dividend yield of 0% for both years; volatility factor of the expected market price of the Common Stock of .41 and .38, respectively; and a weighted-average expected life of the option of seven years for both 1999 and 1998.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
6. STOCK INCENTIVE PLAN (CONTINUED)
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of proforma disclosures, the estimated fair value of the options is amortized to expense over the vesting period for such options. The Company's proforma information, had compensation costs for the Company's stock option plans been determined in accordance with FASB SFAS No. 123, for the year ended December 26, 1999 and years ended December 31, 1998 and 1997, respectively, are as follows:
A summary of the Company's stock option activity and related information for the year ended December 26, 1999 and years ended December 31, 1998 and 1997, respectively, are as follows:
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
6. STOCK INCENTIVE PLAN (CONTINUED)
Exercise prices for options outstanding as of December 26, 1999 ranged from $14.00 to $22.50 per share. The weighted-average remaining contractual life of those options is 8.2 years.
7. EXTRAORDINARY ITEM
In July 1998, in connection with the Credit Agreement, the Company expensed approximately $7.3 million of deferred financing costs associated with the extinguishment of the Company's prior credit facility, resulting in an extraordinary charge of $4.5 million, net of tax (See Note 4, Long-Term Debt).
8. EARNINGS PER COMMON SHARE
The following table sets forth the computation of weighted-average shares outstanding for calculating basic and diluted earnings per share for the years ended December 26, 1999 and December 31, 1998 and 1997, respectively.
Options to purchase 1.6 million, 1.7 million and 951,670 shares of Common Stock at a range of $17.63 to $22.50, $18.00 to $22.50 and $17.63 to $21.00, were outstanding during 1999, 1998 and 1997, respectively, but were not included in the computation of the diluted EPS because the options' exercise price was greater than the average market price of the common shares.
9. PENSION AND POST RETIREMENT PLANS
The Company and its subsidiaries have separate defined benefit pension plans, certain of which are successors to prior plans. The benefits are based on years of service and primarily on the employees' career average pay. The Company's funding policy is to contribute annually an amount that can be deducted for federal income tax purposes under a different actuarial cost method and different assumptions from those used for financial reporting. Assets of the plans consist principally of short-term investments, equity securities and corporate and U.S. Government obligations.
The Company uses September 30, to measure pension plan assets and liabilities.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
9. PENSION AND POST RETIREMENT PLANS (CONTINUED)
The following table sets forth the plans' funded status and the amount recognized in the Company's consolidated balance sheet:
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
9. PENSION AND POST RETIREMENT PLANS (CONTINUED)
The Company also has defined contribution plans covering certain employees. Company contributions to these plans are based on a percentage of participants' salaries and amounted to approximately $706,000, $377,000 and $325,000 in 1999, 1998 and 1997, respectively.
The Company contributes to various multi-employer union administered pension plans. Contributions to these plans amounted to approximately $160,000, $110,000 and $68,000 in 1999, 1998 and 1997, respectively.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
10. INCOME TAXES
The provision for income taxes on income before extraordinary item is as follows:
The reconciliation of income tax computed at the U.S. federal statutory tax rate to income tax expense is as follows:
State net operating loss carryforwards were utilized as follows: $12.4 million in 1999, $13.5 million in 1998 and $700,000 in 1997.
At December 26, 1999, certain subsidiaries had net operating loss carryforwards available ranging from approximately $21,000 to $62.2 million in various state and local jurisdictions. Substantial portions of the related deferred tax assets are offset by valuation allowances. The carryforwards at December 26, 1999 expire in various years through 2014.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
10. INCOME TAXES (CONTINUED)
Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 26 and December 31, respectively, are as follows:
As part of the acquisitions in 1999 and the acquisition of the Goodson properties in 1998, the Company recorded net deferred tax liabilities of approximately $69,000 and $2.0 million, respectively.
The Company's valuation allowances for deferred tax assets increased by approximately $1.3 million in 1999 and decreased by approximately $700,000 in 1998.
The Company's federal income tax returns, which consisted, prior to the Offering, of three separate consolidated groups and two individual entities, have not been examined by the Internal Revenue Service. Effective with the Offering that occurred in May 1997, the Company files its federal income tax return as one consolidated group.
11. COMMITMENTS AND CONTINGENCIES
The Company leases office space and equipment under noncancellable operating leases. These leases contain several renewal options for periods up to five years. The Company's future minimum lease payments under operating leases at December 26, 1999 are as follows:
(in thousands)
2000.............................................. $2,508 2001.............................................. $1,379 2002.............................................. $ 958 2003.............................................. $ 796 2004............................................... $ 556 Thereafter........................................ $ 52
Total rent expense was $3.3 million, $3.1 million and $2.0 million for the years ended December 26, 1999, December 31, 1998 and 1997, respectively.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
In 1999, the Company began the planning phases for the construction of a new Philadelphia printing facility. In conjunction with the Philadelphia plant, the Company entered into an agreement for the construction of a new printing press. The cost of the press is approximately $15.0 million with an estimated in service date in 2001.
The Company is involved in certain litigation matters which have arisen in the ordinary course of business. In the opinion of management, the outcome of these legal proceedings should not have a material adverse impact on the Company's financial position or results of operations.
12. ACQUISITIONS
On June 7, 1999, the Company acquired certain assets and liabilities of THE FARMINGTON VALLEY POST in Avon, Connecticut, a suburban monthly newspaper. On July 13, 1999, the Company acquired certain assets and liabilities of TOWN TALK SOUTHERN, TOWN TALK EASTERN and the DELAWARE COUNTY JOURNAL in Ridley, Pennsylvania. On August 13, 1999, the Company acquired the stock of Hometown News, Inc., in West Warwick, Rhode Island, comprising a daily, weekly and three non-daily publications. On September 1, 1999, the Company acquired certain assets and liabilities of CONNECTICUT MAGAZINE, in Trumbull, Connecticut, a monthly publication. The Company applied the purchase method of accounting for these transactions. Accordingly, the total acquisition cost, on a preliminary basis, was allocated to the tangible assets and liabilities based on their relative estimated fair value on the effective dates of the acquisition of approximately $2.1 million and $800,000, respectively. In connection with these acquisitions, intangible assets of approximately $14.1 million were recorded for the excess of the purchase price over the value of identifiable net assets and are being amortized according to the Company's policy. The results of the acquired companies have been included in the consolidated financial statements since the acquisition date.
On January 2, 1998, the Company acquired for approximately $3.8 million certain assets and liabilities of HVM, L.L.C. in New Milford, Connecticut, which publishes a group of newspapers, shoppers and monthly magazines. The Company applied the purchase method of accounting for this transaction.
On March 9, 1998, the Company acquired THE SARATOGIAN, a daily newspaper in Saratoga Springs, New York and the COMMUNITY NEWS, a weekly newspaper serving Clifton Park, New York. The Company applied the purchase method of accounting for this transaction.
On July 15, 1998, the Company completed its acquisition of the Pennsylvania, New York and Ohio newspaper businesses of The Goodson Newspaper Group (including Mark Goodson Enterprises, Ltd.) for approximately $300 million in cash (the "Goodson Acquisition"). The Company applied the purchase method of accounting for this transaction. Accordingly, the total acquisition cost, was allocated to the tangible assets and liabilities acquired based upon their estimated fair market value on the effective date of the acquisition of approximately $17.1 million and $7.9 million, respectively. Intangible assets of approximately $300 million were recorded for the subscriber lists and excess of the purchase price over the value of identifiable net assets and are being amortized in accordance with the Company's policy.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
The following table presents the unaudited proforma results of operations of the Company as though the Goodson Acquisition occurred on January 1, 1997.
(in thousands) 1998 1997 ---- ----
Net Revenues $464,330 $428,416 Income before extraordinary item 40,413 12,024 Net Income 35,918 12,024 Net income per share (basic and diluted):
Income before extraordinary item $ .83 $ .27 Net income $ .74 $ .27
The proforma results are not necessarily indicative of what actually would have occurred if the acquisition had been in effect for the entire periods presented and are not intended to be a projection of future results.
On September 21, 1998, the Company completed its acquisition of Taconic Media, Dutchess County, NY. The Company applied the purchase method of accounting for this transaction. Accordingly, the total acquisition cost, was allocated to the assets and liabilities based on the relative estimated fair values on the effective date of the acquisition.
Intangible assets of $344.0 million related to the aforementioned 1998 acquisitions were recorded and are being amortized according to the Company's policy. The results of the acquired companies have been included in the consolidated financial statements since the acquisition date.
On December 22, 1997, the Company acquired for approximately $12.8 million certain assets and liabilities of the InterCounty Newspaper Group. The InterCounty Newspaper Group includes 17 weekly newspapers in suburban Philadelphia and central and southern New Jersey with total weekly distribution of approximately 100,000. The Company applied the purchase method of accounting for this transaction. Accordingly, the total acquisition cost was allocated to the tangible assets and liabilities, respectively, of InterCounty Newspaper Group based on their relative estimated fair values on the effective date of the acquisition of approximately $6.2 million and $1.8 million, respectively.
On December 12, 1997, the Company acquired certain assets and liabilities of the LADUE NEWS in Ladue, MO, a 44 times-per-year newspaper serving suburban St. Louis. The Company applied the purchase method of accounting for this transaction. Accordingly, the total acquisition cost was allocated to the assets and liabilities, respectively, of the LADUE NEWS based on their relative estimated fair values on the effective date of the acquisition.
Intangible assets of $14.1 million related to the aforementioned 1997 acquisitions were recorded for the excess of the purchase price over the value of identifiable net assets and are being amortized according to the Company's policy.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
13. MEMBERSHIP INTERESTS
On March 11, 1997, membership interests in JRC, LLC and the capital stock of INSI Holdings, Inc. were converted to 37,962,500 shares of Common Stock (see Note 1, Organization and Basis of Presentation).
14. SUBSEQUENT EVENTS (UNAUDITED)
On February 28, 2000, the Company announced its intent to sell its Ohio and St. Louis area newspapers. The Ohio properties include four daily newspapers with a total daily circulation of approximately 126,000. The Missouri and Illinois properties include the Suburban Newspapers of Greater St. Louis, representing non-daily distribution of approximately 1.7 million and a daily newspaper in Alton, Illinois, with daily circulation of approximately 28,000 and Sunday circulation of approximately 30,000. For the year ended December 26, 1999, the Ohio and St. Louis area newspapers generated approximately $135 million in revenue.
Since December 26, 1999 and as of March 17, 2000, the Company, in accordance with its stock repurchase program, has repurchased an additional 707,200 shares of its Common Stock on the open market at a total cost of approximately $9.9 million. Shares under the program are to be repurchased at management's discretion, either in the open market or in privately negotiated transactions.
The decision to repurchase stock depends on price, market conditions and other factors. There is no minimum number of shares to be purchased under the program. Purchases under the program will be financed with the Company's free cash flow or borrowings under the Company's revolving credit facility.
JOURNAL REGISTER COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 26, 1999
15. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following is a summary of the quarterly results of operations for years ended December 26, 1999 and December 31, 1998:
(1) Extraordinary item recorded in the third quarter of 1998 was related to the extinguishment of debt. (2) December 1999 quarterly results reflect operations for the period September 1, 1999 through December 26, 1999
- ----------------------------
(1) Allowance for doubtful accounts additions related to 1999, 1998 and 1997 acquisitions.
(2) Write-off of uncollectable accounts to the allowance for doubtful accounts and reduction of the valuation allowance for deferred tax assets.
S-1
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information with respect to executive officers of the Company is presented in Item 4 of this Report under the caption "Executive Officers of the Registrant."
The information appearing under the captions "Proposal 1 - Election of Directors", "Certain Transactions" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for its 2000 Annual Meeting of Stockholders (the "2000 Proxy Statement") is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Information appearing under the caption "Executive Compensation" in the 2000 Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information appearing under the caption "Security Ownership of Beneficial Owners and Management" in the 2000 Proxy Statement is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information appearing under the caption "Certain Transactions" in the 2000 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements. --------------------
The financial statements are included in Part II, Item 8 of this Report.
2. Financial Statement Schedules and Supplementary Information Required to be Submitted. -----------------------------------------------------------
Schedule of Valuation and Qualifying Accounts on Schedule II, included in Part II, Item 8 of the report.
All other schedules have been omitted because they are inapplicable or the required information is shown in the consolidated financial statements or related notes.
(b) Reports On Form 8-K. -------------------
A report on Form 8-K was filed by the Company on October 27, 1999, pursuant to Item 8 thereof, reporting the Company's decision to change the Company's fiscal year end from a calendar year period to a 5-week, 4-week, 4-week reporting period.
A report on Form 8-K was filed by the Company on November 24, 1999, pursuant to Item 8 thereof, and in connection with the Company's October 27, 1999 Form 8-K filing, whereby the Company approved a change in the Company's fiscal year end from December 31, 1999 to December 26, 1999.
(c) Index to Exhibits. ------------------
The following is a list of all Exhibits filed as part of this Report:
Exhibit No. Description ----------- -----------
*2.1 Master Agreement, dated as of May 17, 1998, by and among each of the persons listed on Annex A and Annex B thereto, Richard G. Schneidman, as Designated Stockholder, and the Company (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K/A, dated June 30, 1998). *3(i) Amended and Restated Certificate of Incorporation (filed as Exhibit 3(i) to Journal Register Company's Form 10-Q/A Amendment No. 1 for the fiscal quarter ended June 30, 1997 (the "June 1997 Form 10-Q")). *3(ii) Amended and Restated By-laws (filed as Exhibit 3(ii) to the September 1999 Form 10-Q). *4.1 Company Common Stock Certificate (filed as Exhibit 4.1 to Journal Register Company's Registration Statement on Form S-1, Registration No. 333-23425 (the "Form S-1")). *10.1 1997 Stock Incentive Plan (filed as Exhibit 10.2 to the June 1997 Form 10-Q).+ *10.2 Management Bonus Plan (filed as Exhibit 10.3 to the June 1997 Form 10-Q).+ *10.3 Supplemental 401(k) Plan (filed as Exhibit 10.4 to the Form S-1).+ *10.4 Voting Agreement by and among Journal Register Company, Warburg, Pincus Capital Company, L.P., Warburg, Pincus Capital Partners, L.P. and Warburg, Pincus Investors, L.P. (filed as Exhibit 10.5 to the June 1997 Form 10-Q). *10.5 Registration Rights Agreement by and among Journal Register Company, Warburg, Pincus Capital Company, L.P., Warburg, Pincus Capital Partners, L.P. and Warburg, Pincus Investors, L.P. (filed as Exhibit 10.6 to the June 1997 Form 10-Q). *10.6 Credit Agreement among Journal Register Company, each of the banks and other financial institutions that is a signatory thereto or which, pursuant to Section 2.01 (c) or Section (b) thereto, becomes a "Lender" thereunder and the Chase Manhattan Bank, as administrative agent for the lenders (filed as Exhibit 10.7 to the September 30, 1998 Form 10-Q).
**21.1 Subsidiaries of Journal Register Company. **23.1 Consent of Ernst & Young LLP. **24 Power of Attorney (appears on signature page). **27.1 Financial Data Schedule.
+ Management contract or compensatory plan or arrangement. * Incorporated by reference. ** Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Trenton, State of New Jersey, on the 24th day of March, 2000.
JOURNAL REGISTER COMPANY
By: /S/ ROBERT M.JELENIC --------------------------------------- Chairman, President and Chief Executive Officer
KNOWN BY ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints both Robert M. Jelenic and Jean B. Clifton his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent or their or his substitutes or substitute, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 24th day of March, 2000.
Signature Title(s) --------- --------
/S/ ROBERT M. JELENIC Chairman, President, Chief Executive Officer and - ----------------------- Director (Principal Executive Officer) Robert M. Jelenic
/S/ JEAN B. CLIFTON Executive Vice President, Chief Financial Officer - ----------------------- (Principal Financial and Accounting Officer), Jean B. Clifton Secretary and Director
/S/ JOHN L. VOGELSTEIN Director - ----------------------- John L. Vogelstein
/S/ DOUGLAS M. KARP Director - ----------------------- Douglas M. Karp
/S/ GARY D. NUSBAUM Director - ----------------------- Gary D. Nusbaum
/S/ JOHN R. PURCELL Director - ----------------------- John R. Purcell
/S/ JOSEPH A. LAWRENCE Director - ----------------------- Joseph A. Lawrence
Exhibit Index
Exhibit No. Description ----------- ------------
*2.1 Master Agreement, dated as of May 17, 1998, by and among each of the persons listed on Annex A and Annex B thereto, Richard G. Schneidman, as Designated Stockholder, and the Company (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K/A, dated June 30, 1998).
*3(i) Amended and Restated Certificate of Incorporation (filed as Exhibit 3(i) to Journal Register Company's Form 10-Q/A Amendment No. 1 for the fiscal quarter ended June 30, 1997 (the "June 1997 Form 10-Q")). *3(ii) Amended and Restated By-laws (filed as Exhibit 3(ii) to the September 1999 Form 10-Q). *4.1 Company Common Stock Certificate (filed as Exhibit 4.1 to Journal Register Company's Registration Statement on Form S-1, Registration No. 333-23425 (the "Form S-1")). *10.1 1997 Stock Incentive Plan (filed as Exhibit 10.2 to the June 1997 Form 10-Q).+ *10.2 Management Bonus Plan (filed as Exhibit 10.3 to the June 1997 Form 10-Q).+ *10.3 Supplemental 401(k) Plan (filed as Exhibit 10.4 to the Form S-1).+ *10.4 Voting Agreement by and among Journal Register Company, Warburg, Pincus Capital Company, L.P., Warburg, Pincus Capital Partners, L.P. and Warburg, Pincus Investors, L.P. (filed as Exhibit 10.5 to the June 1997 Form 10-Q). *10.5 Registration Rights Agreement by and among Journal Register Company, Warburg, Pincus Capital Company, L.P., Warburg, Pincus Capital Partners, L.P. and Warburg, Pincus Investors, L.P. (filed as Exhibit 10.6 to the June 1997 Form 10-Q). *10.6 Credit Agreement among Journal Register Company, each of the banks and other financial institutions that is a signatory thereto or which, pursuant to Section 2.01 (c) or Section (b) thereto, becomes a "Lender" thereunder and the Chase Manhattan Bank, as administrative agent for the lenders (filed as Exhibit 10.7 to the September 30, 1998 Form 10-Q).
**21.1 Subsidiaries of Journal Register Company. **23.1 Consent of Ernst & Young LLP. **24 Power of Attorney (appears on signature page). **27.1 Financial Data Schedule.
+ Management contract or compensatory plan or arrangement. * Incorporated by reference. ** Filed herewith. | 22,068 | 147,752 |
744786_1999.txt | 744786_1999 | 1999 | 744786 | Item 1. Business.
The Registrant, Oxford Residential Properties I Limited Partnership ("ORP") or the "Partnership"), was formed on January 19, 1984, under the Maryland Revised Uniform Limited Partnership Act to acquire, own and operate residential properties. The Partnership sold $25,714,000 of Assignee Units in a public offering that concluded on October 18, 1985. The net offering proceeds were used to acquire residential properties.
Item 2.
Item 2. Properties.
Information concerning the individual properties is discussed in the 1999 Annual Report in the section entitled "Community Descriptions," which section is incorporated herein by reference (pages 13 through 14 hereof).
Item 3.
Item 3. Legal Proceedings.
The Registrant is engaged from time to time in litigation incident to its business; however, there are no pending legal proceedings whose potential effects are considered to be material by the Managing General Partner.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for the Registrant's Partnership Interests and Related Partnership Matters.
(a) Market Information.
The Partnership originally issued 25,714 Assignee Units and through December 31, 1999, had redeemed a total of 2,047 Assignee Units, ranging in price from $332 to $600 per Assignee Unit. As of December 31, 1999, there were 23,667 Assignee Units outstanding. There is currently no established public market in which the Assignee Units are traded, and it is not anticipated that a public market will develop.
(b) Number of Security Holders.
As of December 31, 1999 there were 1,431 Assignee Unit Holders.
- ----------------------------------------------------------------- OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
PART II (continued)
(c) Dividend History and Restrictions.
Information regarding the frequency and amount of cash distributions is included in the section entitled "Selected Consolidated Financial Data" of the 1999 Annual Report, which section is incorporated herein by reference (page 12 hereof). Information regarding management's future expectations as to distributions is also included in the 1999 Annual Report in the section entitled "Report of Management," which section is incorporated herein by reference (on pages 16 through 20 hereof).
Item 6.
Item 6. Selected Financial Data.
Reference is made to the section of the 1999 Annual Report entitled "Selected Consolidated Financial Data," which section is incorporated herein by reference (page 12 hereof).
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
For a detailed discussion of the Partnership's financial condition and results of operations for the years ended December 31, 1999, 1998, and 1997, see information set forth in the section entitled "Report of Management" of the Partnership's 1999 Annual Report, which section is incorporated herein by reference (pages 16 through 20 hereof).
Item 8.
Item 8. Financial Statements and Supplementary Data.
Reference is made to the 1999 Annual Report for the consolidated financial statements of the Partnership, which consolidated financial statements are incorporated herein by reference (pages 23 through 26 hereof). See Item 14 of this report for information concerning financial statements and schedules filed with this report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant. (a), (b), (c) and (e).
The Partnership has no directors or officers. The Managing General Partner of the Partnership, as designated in the Partnership Agreement, is Oxford Residential Properties I Corporation. The director and executive officers of the Managing General Partner are as follows:
- ----------------------------------------------------------------- Name Age Position and Business Experience - ----------------------------------------------------------------- Leo E. Zickler 63 Chairman of the Board of Directors and Chief Executive Officer since inception. Since March 1982 he has been Chairman of the Board of Directors, and Chief Executive Officer of Oxford Development Corporation ("Oxford"), an affiliate of the Partnership and a national real estate firm which owns and operates apartment and senior living communities. Mr. Zickler served as President of Oxford until February 28, 1994. Mr. Zickler serves as a director and officer of certain entities affiliated with Oxford.
- -----------------------------------------------------------------
OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
PART III (continued)
- ----------------------------------------------------------------- Name Age Position and Business Experience - ----------------------------------------------------------------- Francis P. Lavin 48 President since March 1, 1994. From October 1989 through January 1994, he was a Director and President of ML Oxford Finance Corporation, an affiliate of Merrill Lynch & Company, Inc. From 1979 to October 1989, Mr. Lavin held various positions at subsidiaries of Merrill Lynch & Company including Director of Merrill Lynch Capital Markets and Vice President of Merrill Lynch, Hubbard Inc. Since March 1, 1994, Mr. Lavin has served as President of Oxford, as well as a director and officer of certain entities affiliated with Oxford.
Richard R. 52 Senior Vice President since inception Singleton and Chief Financial Officer since 1995. Previously, he was Vice President of Oxford Mortgage & Investment Corporation since 1979 and was promoted to Senior Vice President in 1983, and he was Chief Operating Officer of ORP's Managing General Partner since 1990 and was promoted to Chief Financial Officer in 1995. Mr. Singleton also serves as an officer of certain entities affiliated with Oxford.
The director and executive officers of the Managing General Partner will serve in their respective positions until successors are chosen.
(d) Family Relationships. None.
(f) Involvement in Certain Legal Proceedings. None.
(g) Promoter and Controlling Persons. Not applicable.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires that the directors, executive officers, and persons who own more than 10% of a registered class of the equity securities of ORP ("reporting persons") file with the Securities and Exchange Commission initial reports of ownership, and reports of changes in ownership, of ORP Assignee Units. Reporting persons are required by Securities and Exchange Commission rules to furnish ORP with copies of all Section 16(a) reports they file.
Based solely upon a review of Section 16(a) reports furnished to ORP for the fiscal year ended December 31, 1999 (the "1999 fiscal year"), or representations by reporting persons that no other reports were required for the 1999 fiscal year, ORP believes that all reporting persons timely filed all reports required by Section 16(a) of the Exchange Act.
Item 11.
Item 11. Executive Compensation. (a), (b), (c) and (d)
Neither the director nor the executive officers of the Managing General Partner receives direct compensation for services rendered to the Partnership.
(e) Termination of Employment and Change of Control Arrangements. None.
- ----------------------------------------------------------------- OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
PART III (continued)
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
(a) Security Ownership of Certain Beneficial Owners.
ORP Acquisition Partners Limited Partnership, located at 7200 Wisconsin Avenue, Suite 1100, Bethesda, MD 20814, owns 4,997 Assignee Units, representing approximately 21.1% of the Assignee Units outstanding as of December 31, 1999. No other person or group is known by the Partnership to own beneficially more than 5% of the outstanding limited partnership interests and Assignee Units.
(b) Security Ownership of Management.
The officers and directors of the General Partners of the Partnership do not directly own any Assignee Units, however, certain officers and directors own equity interests in ORP Acquisition Partners Limited Partnership, which owns 4,997 Assignee Units, representing approximately 21.1% of the Assignee Units outstanding as of December 31, 1999. An affiliate of the General Partner is the Assignor Limited Partner of the Partnership. The Assignor Limited Partner has assigned the ownership of its limited partnership units (including rights to a percentage of the income, gain, losses, deductions, and distributions of the Partnership) to the Assignee Unit Holders.
(c) Changes in Control. None.
Item 13.
Item 13. Certain Relationships and Related Transactions.
(a) Transactions with Management and Others.
The Partnership has no directors or officers. The Managing General Partner and its affiliates do not receive any direct compensation, but are reimbursed by ORP for any actual direct costs and expenses incurred in connection with the operation of the Partnership.
Expense reimbursements are for an affiliate's personnel costs, travel expenses and interest on interim working capital advances for activities directly related to the Partnership which were not covered separately by fees. Total reimbursements to this affiliate for the years ended December 31, 1999, 1998 and 1997 were $82,000, $116,000, and $65,000, respectively, for administrative and accounting related costs.
An affiliate of NHP Management Company, the property manager, has a separate services agreement with Oxford Realty Financial Group, Inc. ("ORFG"), an affiliate of the Managing General Partner, pursuant to which ORFG provides certain services to NHP in exchange for service fees in an amount equal to 25.41% of all fees collected by NHP from certain properties, including those owned by the Partnership.
(b) Certain Business Relationships.
The Partnership's response to Item 13(a) is incorporated herein by reference. The Partnership has no business relationship with entities of which the officers or director of the Managing General Partner of the Partnership are officers, directors or equity owners, other than as set forth in the Partnership's response to Item 13(a).
- ----------------------------------------------------------------- OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
PART III (continued)
(c) Indebtedness of Management. None
(d) Transactions with Promoters. None
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) List of documents filed as part of this Report:
1. Financial Statements.
The following financial statements are contained in the Partnership's 1999 Annual Report and are incorporated herein by reference into Part II, Item 8:
Page Numbers Description Herein --------------------------------------------------------- Report of Independent Accountants. 22 Consolidated Balance Sheets as of December 31, 1999 and 1998. 23 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997. 24 Consolidated Statement of Partners' Capital for the years ended December 31, 1999, 1998 and 1997. 25 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997. 26 Notes to Consolidated Financial Statements. 27-34
2. Financial Statement Schedules.
All financial statement schedules have been omitted since they are not applicable, not required, or because the required information is included elsewhere in the financial statements or notes thereto.
3. Exhibits (listed according to the number assigned in the table in Item 601 of Regulations S-K).
Exhibit No. 4 - Items defining the rights of security holders including indentures.
a. Amended and Restated Agreement and Certificate of Limited Partnership (Incorporated by reference from Exhibit A of the Prospectus of the Partnership, dated May 24, 1985).
Exhibit No. 10 - Material contracts.
a. Permanent Mortgage Loan Documents in favor of Lexington Mortgage Company, encumbering Fairlane East.
b. Permanent Mortgage Loan Documents in favor of Lexington Mortgage Company, encumbering The Landings.
c. Permanent Mortgage Loan Documents in favor of Lexington Mortgage Company, encumbering Raven Hill.
- ----------------------------------------------------------------- OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
PART IV (continued)
d. Permanent Mortgage Loan Documents in favor of Lexington Mortgage Company, encumbering Shadow Oaks.
Exhibit No. 13 - Annual report to security holders, etc.
a. Annual Report for the year ended December 31, 1999 ("filed" only to the extent material therefrom is specifically incorporated by reference).
Exhibit No. 25 - Power of Attorney.
a. Leo E. Zickler Power of Attorney (Incorporated by reference from Exhibits to Post- effective Amendment No. 1 to Form S-11 Registration Statement, dated March 28, 1985).
Exhibit No. 28 - Additional Exhibits. None.
(b) Reports on Form 8-K.
No reports on Form 8-K were filed by the registrant during the year ended December 31, 1999.
(c) The list of Exhibits required by Item 601 of Regulation S-K is included in Item 14(a)(3) above.
(d) Financial Statement Schedules.
See Item 14(a)(2) above.
- ----------------------------------------------------------------
OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
CROSS REFERENCE SHEET
The item numbers and captions in Parts I, II, III, and IV hereof and the page and/or pages in the referenced materials where the corresponding information appears are as follows:
Sequentialy Numbered Item Reference Materials Page(s) - ----------------------------------------------------------------- 1. Business Annual Report 1999 pps 13-21
2. Properties Annual Report 1999 pps 13-14
5. Market for Registrant's Annual Report 1999 pps 12, 16-21, Partnership Interest 31-32 & 33-34 and Related Partnership Matters
6. Selected Financial Data Annual Report 1999 pp 12
7. Management's Discussion Annual Report 1999 pps 16-21 and Analysis of Financial Condition and Results of Operations
8. Financial Statements and Annual Report 1999 pps 22-34 Supplementary Data
11. Executive Compensation Annual Report 1999 pps 33-34
12. Certain Relationships Annual Report 1999 pps 33-34 and Related Transactions
14. Exhibits, Financial Annual Report 1999 pps 12-37 Statement Schedules, and Reports on Form 8-K
- -----------------------------------------------------------------
OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
EXHIBIT INDEX
(Listed according to the number assigned in the Exhibit Table in Item 601 of Regulation S-K.)
(13) Annual Report 1998 to Security Holders.
Oxford Residential Properties I Limited Partnership's Report dated December 31, 1999, follows on sequentially numbered pages 11 through 37 of this report.
(27) Financial Data Schedule.
- -----------------------------------------------------------------
OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
FORM 10-K
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Oxford Residential Properties I Limited Partnership
By: Oxford Residential Properties I Corporation Managing General Partner of the Registrant
Date: 3/1/00 By: /s/ Richard R. Singleton ------ ----------------------------------------- Richard R. Singleton Senior Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date: 3/1/00 By: /s/ Leo E. Zickler ------ ----------------------------------------- Leo E. Zickler Chairman of the Board of Directors and Chief Executive Officer
Date: 3/1/00 By: /s/ Francis P. Lavin ------ ----------------------------------------- Francis P. Lavin President
No proxy material has been sent to the Registrant's security holders. The Partnership's Annual Report 1999 is expected to be mailed to Assignee Unit Holders before May 2000.
- ----------------------------------------------------------------- OXFORD RESIDENTIAL PROPERTIES I LIMITED PARTNERSHIP
Annual Report 1999
CONTENTS
Selected Consolidated Financial Data Community Descriptions Average Occupancy Summary of Project Data Report of Management Report of Independent Accountants Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statement of Partners' Capital Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Distribution Information General Partnership Information Instructions for Investors who wish to reregister or transfer ORP Assignee Units
- ----------------------------------------------------------------- The following paragraphs contain descriptions of each of the four properties comprising the Partnership's portfolio. Unless otherwise indicated, information provided herein is as of December 31, 1999.
Fairlane East, Dearborn, Michigan
Fairlane East is a 244-unit conventional property, located in Dearborn, Michigan. Fairlane East was built in 1973 and consists of 26 buildings, offering one to two bedroom apartments and two to three bedroom townhomes. The buildings are of wood frame construction with brick and wood trim. The property is located on Rotunda Drive. To the north is single-family residential, to the east is industrial, to the south is the Ford Land Development Maintenance Center, and to the west is a retirement center and the Ford World Headquarters. Fairlane East is convenient to shopping, restaurants, churches, and public transportation. Amenities include a washer and dryer in each unit, a swimming pool and a clubhouse. Average occupancy was 96% in 1999 and 94% in 1998.
Property improvements completed for the year ended December 31, 1999 primarily include fence and deck replacements, carpet, vinyl floor and appliance replacements, HVAC repairs and replacements, structural repairs, roof replacements of the clubhouse building and five carports, sidewalks and curb replacements, interior and exterior painting, cabinet and counter replacements, and landscaping improvements.
There are at least three competitive apartment communities containing an aggregate of approximately 1,100 apartment units located in the Dearborn area within a five-mile radius of the site. Average occupancy at these communities was approximately 95% as of December 31, 1999. Additionally, a new rental community is being built adjacent to Fairlane East, with leasing of the new units anticipated to begin in 2000.
The Landings, Indianapolis, Indiana
The Landings is a 150-unit property located in northeastern Indianapolis, Indiana. The property is approximately 15 minutes from the downtown business district. The Landings is located at 78th Street and Keystone Avenue between the popular areas of Keystone at the Crossing and Broad Ripple, and is convenient to shopping, entertainment, parks, major thoroughfares, and public transportation. The property was built in 1974 and consists of nine wood frame constructed buildings with brick and aluminum siding and wood trim. The property is located on 27.3 acres along the White River and surrounds a lake that opens to the White River. Amenities include a clubhouse with party and billiard room, boat launch ramp to the river, boat storage, a sand volleyball court, two lighted tennis courts, a basketball court area, and a swimming pool. Average occupancy was 93% in 1999 and 95% in 1998.
Project improvements completed for the year ended December 31, 1999 primarily include carpet, vinyl floor and appliance replacements, balcony replacements, asphalt/concrete repairs, HVAC repairs and replacements, and refurbishment of clubhouse.
Major competitors of The Landings include at least four comparable apartment communities, containing an aggregate of approximately 2000 units, located within five miles of the property. Average occupancy at these communities was approximately 84% as of December 31, 1999. An additional three properties with an aggregate total of approximately 900 apartment units are under construction in the Indianapolis area within a six-mile radius of the site. These properties are scheduled to be completed during 2000.
Raven Hill, Burnsville, Minnesota
Raven Hill is a 304-unit apartment community located in Burnsville, Minnesota, a suburb south of Minneapolis. It is convenient to the Minneapolis central business district, as well as the suburban employment centers of the Twin Cities of Minneapolis and St. Paul. The property was built in 1971 and consists of four three-story buildings with underground and surface parking. Amenities include two guest suites, indoor and outdoor swimming pools, a spa, tennis courts, an indoor racquetball court, and two entertainment centers. Average occupancy was 98% and 97% in 1999 and 1998, respectively.
- ----------------------------------------------------------------- Community Descriptions - -----------------------------------------------------------------
Property improvements completed for the year ended December 31, 1999 primarily include patio and balcony improvements, carpet and vinyl replacements, appliance replacements, interior painting, boiler repairs,landscaping improvements, air conditioner replacements, ventilator fans, and elevator improvements.
There are several comparable apartment communities located in the Burnsville area within close proximity of Raven Hill, with average occupancy of 96% at December 31, 1999. Built in the mid to late 1980s, these communities are newer and offer more contemporary features than Raven Hill. However, the exterior vinyl siding, window, and patio and balcony improvements at Raven Hill are now complete and will enhance the appearance and competitiveness of Raven Hill. There are no known rental communities under construction in this market area.
Shadow Oaks, Tampa, Florida
Shadow Oaks is a 200-unit apartment community built in 1984 and is located in a neighborhood consisting of middle- and upper-middle-class single-family homes close to various commercial centers. Shadow Oaks is located in northeast Tampa, between the University of South Florida and Carrollwood areas. Amenities include playground, pool, whirlpool, tennis court, picnic area, volleyball court, and laundry facilities. There has been significant building of apartments in Tampa and the surrounding area and, as a result, Shadow Oaks competes for residents with a considerable number of newer apartment communities located in nearby neighborhoods. Average occupancy was 94% in 1999 and 97% in 1998.
Property improvements completed for the year ended December 31, 1999 primarily include cedar wood siding and picket replacement performed in conjunction with a complete exterior paint job of the property, completion of third and final year of roof replacement, carpet, vinyl floor and appliance replacements, clubhouse upgrades, and landscaping improvements.
There are three comparable apartment communities containing an aggregate of approximately 1,200 apartment units located in the Tampa area within a three-mile radius of the site. Average occupancy at these communities was approximately 93% as of December 31, 1999. Although new construction is planned in the Tampa area, it is not expected to materially adversely affect Shadow Oaks due to its competitive market position in the area.
- ----------------------------------------------------------------- Report of Management - -----------------------------------------------------------------
The following report provides additional information about the consolidated financial condition of Oxford Residential Properties I Limited Partnership ("ORP" or the "Partnership") as of December 31, 1999, and its consolidated results of operations and cash flows for the three years ended December 31, 1999, 1998 and 1997. This report and analysis should be read together with the consolidated financial statements and related notes thereto and the selected consolidated financial data appearing elsewhere in this Annual Report.
Recent Developments
On February 28,2000, the Managing General Partner declared a distribution of $15 per Assignee Unit to its Partners and Assignee Unit Holders of record as of December 31, 1999. The distribution was the same as the last three semi-annual distributions but represents a $5 increase over the amount paid for the last semi-annual distribution for 1997.
On behalf of the Partnership,Oxford Residential Properties I Corporation ("Managing General Partner"), will consider offers made by Assignee Unitholders who wish to sell their Assignee Units at such prices as may be set by the Managing General Partner from time to time. The prices that will be paid will be established by reference to prevailing secondary market prices and will be determined solely by the Managing General Partner. This is neither an offer to purchase nor a solicitation of an offer to sell by the Partnership. During the period from July 1995 through December 31, 1999, ORP redeemed, in the aggregate, 2,047 Assignee Units for approximately $808,000. Since January 1, 2000, ORP has redeemed an additional 37 Assignee Units.
Liquidity and Capital Resources
Current Position. At December 31,1999, ORP held $1,344,000 in cash and cash equivalents and the working capital reserve, compared to $1,351,000 at December 31, 1998. The decrease of $7,000 is primarily attributable to increases in property net operating income offset by: (i) the distributions made on February 27, 1999 and August 28, 1999 to Partners of record as of December 31, 1998 and June 30, 1999 totaling $361,365 and $357,270, respectively, (ii) the purchase of 424 Assignee Units during the year ended December 31, 1999 totaling $236,000, and (iii) the payment of administrative costs for the year ended December 31, 1999 totaling $170,000.
Other Assets shown on the accompanying consolidated Balance Sheet increased by $28,000 to $1,009,000 at December 31, 1999 from $981,000 at December 31, 1998. The increase in Other Assets is primarily a result of increases in prepaid property taxes offset by decreases in escrow deposits. Other Assets include primarily a Liquidity Reserve Subaccount (for debt service), a Recurring Replacement Reserve Subaccount (for property improvements), a Property Insurance Escrow, and a Property Tax Escrow for each of the Operating Partnerships totaling $739,000 at December 31, 1999. These Subaccounts are funded and maintained monthly, as needed, from property income (except security deposits), in accordance with the requirements pursuant to each property's loan agreement and based on expenditures anticipated in the following months. Accounts Receivable and Prepaid Expenses, which are also included in Other Assets, totaled $56,000 and $214,000, respectively, at December 31, 1999.
Unamortized deferred costs related to organization and refinancing costs (discussed in prior reports) at December 31, 1999 were $260,000, compared to $326,000 at December 31, 1998. These costs are being amortized over the term of the mortgages.
Property Operations. ORP's future liquidity and level of cash distributions are dependent upon the net operating income after debt service, refurbishment expenses, and capitalized improvements generated by ORP's four investment properties and proceeds from any sale or refinancing of those properties. To the extent any individual property does not generate sufficient cash to cover its operating needs, including debt service, deficits would be funded by cash generated from the other investment properties, if any, working capital reserves, if any, or borrowings by ORP. Property improvements in the aggregate amount of $1,241,000 were made for the year ended December 31, 1999, compared to $1,322,000 for the same period in 1998. Of the $1,241,000 of property improvements, $737,000 was capitalized for financial statement purposes for the year ended December 31, 1999, compared to $919,000 of the $1,322,000 of property improvements for the same period in 1998.
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Other Sources. Since 1994, 40% of the property management fees owed to NHP Management Company ("NHP") have been subordinated to the receipt by the Assignee Unit Holders of certain returns. As of December 31, 1999 and December 31, 1998, deferred property management fees to NHP amounted to $871,000 and $712,000, respectively.
Results of Operations
The net operating income, before debt service, refurbishment expenses, and capitalized property improvements, reported by each of the four investment properties for the year ended December 31, 1999, as compared to the years ended December 31, 1998 and 1997, is as follows:
In the aggregate, the net operating income, before debt service, refurbishment expenses, and capitalized property improvements, reported by the Partnership in 1999 increased by 3.8% compared to 1998. Set forth below is a discussion of the properties which compares their respective operations for the years ended December 31, 1999, 1998 and 1997.
1999 versus 1998
Fairlane East
Fairlane East's net operating income for the year ended December 31, 1999 increased by 4.3% from the same period in 1998 due to a 6.1% increase in revenues offset by an 8.9% increase in apartment expenses. The increase in revenues was primarily attributable to the property's on-going ability to change its rent structure by adjusting rents on specific unit types. The property's apartment expense increase is primarily attributable to an increase in maintenance expenses, specifically snow removal, grounds, and decorating contract expenses, and administrative expenses. Average occupancy for the year ended December 31, 1999 increased to 96%, compared to 94% for the same period in 1998. During the year ended December 31, 1999, the Partnership expended $381,000 on property improvements, including $282,000 capitalized for accounting purposes. Of the $282,000 capitalized costs, approximately $149,000 was paid for major cabinet, and countertop replacement and carpet replacement in many of the units. The Managing General Partner anticipates approximately the same spending levels on property improvements for 2000.
The Landings
The Landings' net operating income for the year ended December 31, 1999 decreased by 12.1% from the same period in 1998 due to a less than 1% decrease in revenues and a 10.8% increase in apartment expenses. As previously reported, in March 1998, the property received a $38,000 property tax refund which was applied directly against property tax expense, and thus significantly reduced the overall apartment expenses for the year ended 1998. The Landings did not receive any property tax refunds during the year ended December 31, 1999. Excluding the impact of the refund from both periods, total apartment expenses and net operating income for the year ended December 31, 1999 would have increased/(decreased) by 3.6% and (5.5%), respectively, from the same period last year. Average occupancy for the year ended December 31, 1999 decreased to 93%, compared to 95% for the same period in 1998. During the year ended December 31, 1999, the Partnership expended $163,000 on property improvements, including $97,000 capitalized for accounting purposes. The Managing General Partner anticipates slightly higher spending levels on property improvements for 2000.
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Raven Hill
Raven Hill's net operating income for the year ended December 31, 1999 increased by approximately 10.5% from the same period in 1998 due to a 5.8% increase in revenues offset by a 1.2% increase in apartment expenses. The increase in revenues is attributable to a 5.3% increase in rental income due to a stronger rental market. The increase in apartment expenses is primarily attributable to increases in operating and administrative expenses. Average occupancy for the year ended December 31, 1999 increased to 98% compared to 97% for the same period in 1998. During the year ended December 31, 1999, the Partnership expended $516,000 for property improvements of which $290,000 was capitalized for accounting purposes. Of the $290,000 of capitalized costs, approximately $196,000 was paid for major interior painting and carpeting of two of Raven Hills' four apartment buildings and $58,000 for asphalt. The Managing General Partner anticipates slightly lower spending levels on property improvements for 2000.
Shadow Oaks
Shadow Oaks' net operating income for the year ended December 31, 1999 increased by 2.0% from the same period in 1998 due to a 1.8% increase in revenues offset by a 1.6% increase in apartment expenses. The increase in revenues was primarily attributable to a 2.5% increase in rental income. The increase in apartment expenses is primarily attributable to increases in maintenance and operating expenses. Average occupancy for the year ended December 31, 1999 decreased to 94%, compared to 97% for the same period in 1998. During the year ended December 31, 1999, the Partnership expended $181,000 on property improvements, including $68,000 capitalized for accounting purposes. The Managing General Partner anticipates slightly higher spending levels on property improvements for 2000.
1998 versus 1997
Fairlane East
Fairlane East's net operating income for the year ended December 31, 1998 increased by less than 1% from the same period in 1997 due to a 2.4% increase in revenues offset by a 5.8% increase in apartment expenses. The increase in revenues was primarily attributable to the property's ability to change its rent structure, adjusting rents on specific unit types, which resulted in higher gross rental revenue throughout 1998. The increase in apartment expenses is primarily attributable to increases in marketing expenses in response to lower than expected occupancy rates during the first half of 1998, and maintenance expenses associated with higher than expected unit turnover. Average occupancy in 1998 decreased to 95% from 96% in 1997. During 1998, the Partnership expended $348,000 on property improvements, including $218,000 of capitalizable expenditures. The Managing General Partner believes that apartment upgrades will be the focus for 1998 property improvements, including cabinetry replacements, to assist the property in competing in the local marketplace.
The Landings
The Landings' net operating income for the year ended December 31, 1998 increased by 7.6% from the same period in 1997 due to a 4% increase in revenues and a less than 1% increase in apartment expenses. Total apartment expenses were mostly lower throughout 1998 primarily because of reductions in property taxes. In March 1998, the Partnership received a refund of real estate taxes in the amount of $38,000 due to tax overpayments in prior years. The refund, in turn, reduced the amount of property tax expenses and resulted in a significantly higher overall net operating income for the year ended. Average occupancy in 1998 increased to 95% from 91% in 1997. The increase in occupancy is primarily due to a slight decline in new home purchases which, in turn, led to an increase in overall occupancy levels. During 1998, the Partnership expended $213,000 on property improvements, including $113,000 of capitalizable expenditures. The Managing General Partner anticipates slightly lower spending levels on property improvements in 1998, as compared to the year ended December 31, 1998.
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Raven Hill
Raven Hill's net operating income for the year ended December 31, 1998 increased by 18% from the same period in 1997 due to a 4.2% increase in revenues and a 6.4% decrease in apartment expenses. The increase in revenues is primarily attributable to steady increases in per-unit rents along with lower than forecasted vacancy levels. The decrease in apartment expenses is primarily attributable to: (i) savings in utility costs due to better than average weather conditions, (ii) decreases in maintenance expenses due to payroll savings from having fewer maintenance workers, and (iii) a decrease in property taxes due to lower 1998 property tax assessments. Average occupancy for 1998 and for 1997 was 97%, respectively. The Partnership expended $483,000 for property improvements during 1998, including $372,000 of capitalizable expenditures. The Managing General Partner anticipates higher spending levels on property improvements in 1998, as compared to the year ended December 31, 1998.
Shadow Oaks
Shadow Oaks' net operating income for the year ended December 31, 1998 increased by 3.5% from the same period in 1997 due to a 3.7% increase in revenues and a 3.8% increase in apartment expenses. The increase in revenue is due to increases in rent levels of certain units coupled with increased traffic caused by the completion of a road widening project near the property. The increase in apartment expenses is attributable to increases in administrative expenses and property taxes. The average occupancy in 1998 increased to 97%, compared to 95% in 1997. During 1998, the Partnership expended $278,000 on property improvements, including $216,000 of capitalizable expenditures. The Managing General Partner anticipates slightly lower spending levels on property improvements in 1998, as compared to the year ended December 31, 1998.
1997 versus 1996
Fairlane East
Fairlane East's net operating income for the year ended December 31, 1997 increased by 5.9% from the same period in 1996 due to a 3.3% increase in revenues and a less than 1% decrease in apartment expenses. The increase in revenues was attributed to a stronger economy in the Dearborn, Michigan area due to new commercial development. In the Detroit metropolitan area, population growth and unemployment rates improved during 1997. The competitive services and rental rates, along with impressive curb appeal, were contributing factors to the improvement in occupancy. Average occupancy in 1997 decreased to 96% from 98% in 1996. During 1997, the Partnership expended $328,000 on property improvements, including $248,000 capitalized for accounting purposes.
The Landings
The Landings' net operating income for the year ended December 31, 1997 decreased by less than 1% from the same period in 1996 due to a 1% increase in revenues and a 2.5% increase in apartment expenses. The increase in apartment expenses was primarily attributable to an increase in maintenance and operating expenses. Average occupancy in 1997 decreased to 91% from 94% in 1996. The Managing General Partner believes that this decrease in occupancy is due to the decline in interest rates during 1997 which, in turn, led to an increase in the purchase of new homes by tenants. During 1997, the Partnership expended $180,000 on property improvements, including $114,000 capitalized for accounting purposes.
Raven Hill
Raven Hill's net operating income for the year ended December 31, 1997 increased by 6.2% from the same period in 1996 due to a 4.6% increase in revenues and a 3.3% increase in apartment expenses. The increase in apartment expenses was primarily attributable to an increase in property taxes and operating and administrative expenses. Occupancy in 1997 increased to 97% from 93% in 1996. The Partnership expended $506,000 for property improvements during 1997, including $418,000 that was capitalized for accounting purposes.
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Shadow Oaks
Shadow Oaks' net operating income for the year ended December 31, 1997 increased by 10.7% from the same period in 1996 due to a 6.2% increase in revenues and a 2.5% increase in apartment expenses. The average occupancy in 1997 increased by 3 percentage points to 95%, compared to 92% in 1996. The increase in apartment expenses is attributable to an increase in maintenance and operating expenses, offset by decreases in administrative and marketing expenses and property taxes. During 1997, the Partnership expended $188,000 on property improvements, including $144,000 that was capitalized for accounting purposes.
Consolidated Statements of Operations-Other Income and Deductions
Other income was $318,000, $283,000, and $330,000, respectively, for the years ended December 31, 1999, 1998 and 1997.
The terms of the mortgage loans require the borrowers to make equal installment payments over the term of the loans. Each payment consists of interest on the unpaid balance of the loans and a reduction of loan principal. The interest paid on these loans decreases each period, while the portion applied to the loan principal increases each period. As a result, interest expense was $1,694,000, $1,727,000, and $1,758,000, respectively, and mortgage principal paid was $415,000, $385,000, and $356,000, respectively, for the years ended December 31, 1999, 1998 and 1997.
Depreciation expense for the years ended December 31, 1999, 1998 and 1997 was $1,281,000, $1,250,000, and $1,171,000, respectively. Amortization expense for the years ended December 31, 1999, 1998 and 1997 was $66,000, $98,000 and $98,000, respectively.
For the years ended December 31, 1999, 1998 and 1997, of the total property improvements in the aggregate amount of $1,241,000, $1,322,000, and $1,202,000, respectively, $504,000, $403,000, and $278,000, respectively, were classified as refurbishment expenses for financial statement purposes. The remaining balances of $737,000, $919,000, and $924,000, respectively, were capitalized for financial statement purposes.
Interest income for the years ended December 31, 1999, 1998 and 1997 was $93,000, $72,000, and $76,000, respectively. The increase was primarily due to a increase in cash and cash equivalents during 1999, as compared to 1998 and 1997.
ORP's administrative expenses for the years ended December 31, 1999, 1998 and 1997 were $170,000, $271,000, and $199,000, respectively. Administrative expenses in 1998 included legal fees associated with ORP,s securities filings and responses to a tender offer for assignee units made during 1998 by unaffiliated entities which legal fees did not occur in 1999.
In the aggregate, the net income, after debt service, refurbishment expenses, and other deductions, reported by ORP for the year ended December 31, 1999 of $624,000 reflects an increase of $227,000, or 55%, from net income of $414,000 at December 31, 1998. The increase is primarily attributed to improvement in property operations and reduced 1999 administrative expenses.
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THIS REPORT CONTAINS STATEMENTS THAT ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, AND SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND IS SUBJECT TO THE SAFE HARBORS CREATED BY THOSE SECTIONS. THESE FORWARD-LOOKING STATEMENTS REFLECT MANAGEMENT'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE DESCRIBED IN THE FORWARD-LOOKING STATEMENTS, AND WILL BE AFFECTED BY A VARIETY OF RISKS AND FACTORS. THESE STATEMENTS ARE SUBJECT TO MANY UNCERTAINTIES AND RISKS, AND SHOULD NOT BE CONSIDERED GUARANTEES OF FINANCIAL PERFORMANCE. READERS SHOULD REVIEW CAREFULLY ORP's FINANCIAL STATEMENTS AND THE NOTES THERETO, AS WELL AS RISK FACTORS DESCRIBED IN THE SEC FILINGS. ORP DISCLAIMS ANY OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY REVISIONS TO THESE FORWARD- LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT EVENTS OR CIRCUMSTANCES OCCURRING SUBSEQUENT TO THE FILING OF THE FORM 10 K WITH THE SEC OR OTHERWISE TO REVISE OR UPDATE ANY ORAL OR WRITTEN FORWARD-LOOKING STATEMENT THAT MAY BE MADE FROM TIME TO TIME BY OR ON BEHALF OF ORP.
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To the Partners and Assignee Unit Holders of Oxford Residential Properties I Limited Partnership:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, partners' capital and cash flows present fairly, in all material respects, the consolidated financial position of Oxford Residential Properties I Limited Partnership and Subsidiaries as of December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Partnership's Managing General Partner; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP - ------------------------------ PricewaterhouseCoopers LLP
Washington, D.C. January 28, 2000
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- --------------------------------------------------------------------- Oxford Residential Properties I Limited Partnership and Subsidiaries - --------------------------------------------------------------------- Consolidated Statement of Partners' Capital (in thousands)
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Note 1. Partnership Organization
Oxford Residential Properties I Limited Partnership ("ORP") or the "Partnership") is a Maryland limited partnership formed on January 19, 1984, to acquire, own and operate residential properties. The Partnership began operations in September 1984 and will continue until December 31, 2027, unless terminated earlier under the provisions of the Partnership Agreement.
The General Partners of the Partnership are Oxford Residential Properties I Corporation and Oxford Fund I Limited Partnership. Oxford Residential Properties I Corporation serves as the Managing General Partner, and Oxford Fund I Limited Partnership serves as Associate General Partner. ORP I Assignor Corporation, the Assignor Limited Partner, has assigned the ownership of its limited partnership interests (including ORP I Assignor Corporation's rights to a percentage of the income, gains, losses, deductions, and distributions of the Partnership) to the purchasers of Assignee Units on the basis of one unit of limited partnership interest for one Assignee Unit. The General Partners and the Assignor Limited Partner are affiliated through common ownership. The Partnership's net profit or loss is allocated to the Assignee Unit Holders and partners in accordance with the Partnership Agreement.
The Partnership sold $25,714,000 in Assignee Unit interests in a public offering that concluded in October 1985. There is currently no established public market in which the Assignee Units are traded. During the period from July 1995 through December 31, 1999, ORP purchased, in the aggregate, 2,047 Assignee Units.
Effective January 12, 1994, the Partnership completed the refinancing of all debt collateralized by three of its properties, as well as the placement of a new loan collateralized by the fourth property. To use this financing program, the Partnership was required to modify its ownership structure in certain respects. Accordingly, the Partnership transferred its ownership interests in the properties to four new entities: (i) ORP One L.L.C. (Fairlane East), (ii) ORP Two L.L.C. (The Landings), (iii) ORP Three L.L.C. (Raven Hill), and (iv) ORP Four Limited Partnership (Shadow Oaks). In the case of Shadow Oaks, a limited partnership was used because, under applicable Florida law in effect at the time, limited liability companies were taxed as corporations rather than partnerships. The Partnership effectively holds all of the ownership interests of each of these entities. The Partnership holds a direct 99% interest in each new entity, and the remaining 1% interest is held by one of four new corporations: (i) ORP Corporation I; (ii) ORP Corporation II; (iii) ORP Corporation III; and (iv) ORP Corporation IV. The Partnership owns all of the stock of these new corporations.
Note 2. Significant Accounting Policies
Basis of presentation. The consolidated financial statements include the accounts of the Partnership and its subsidiaries. All significant intercompany balances and transactions have been eliminated.
Method of accounting. The Partnership's consolidated financial statements are prepared on the accrual basis in accordance with generally accepted accounting principles.
Investment Properties. Investment properties are carried at cost, net of accumulated depreciation. Investment properties are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. For purposes of evaluating the recoverability, a recoverability test is performed using undiscounted net cash flows of the individual properties. If impairment is indicated, the carrying value of the investment property is adjusted based on the discounted future cash flows.
Revenue Recognition. Rental income is recognized as rentals become due. Rental payments received in advance are deferred until earned. All leases between the company and the tenants of the property are operating leases.
Depreciation and amortization. For financial reporting purposes, depreciation of buildings and improvements is calculated based upon cost less the estimated salvage value on a straight-line basis over the estimated useful life of the property of 25 years. Personal property is depreciated on a straight-line basis over five years. For income tax reporting purposes, depreciation of buildings, improvements, and personal property is calculated using the accelerated cost recovery methods, as provided in Section 168 of the Internal Revenue Code.
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Deferred costs. Deferred costs reflect financing fees, which are amortized on a straight-line basis over the life of the respective loan agreements for both financial and income tax reporting purposes.
Use of estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Income taxes. No provision has been made for federal, state, or local income taxes in the financial statements of the Partnership, since the partners and the Assignee Unit Holders are required to report on their individual tax returns their allocable share of income, gains, losses, deductions, and credits of the Partnership. The Partnership's tax return is prepared on the accrual basis.
Net income and distributions per Assignee Unit. Net income and distributions per Assignee Unit are based on the weighted average number of units outstanding during the year.
For financial reporting purposes, the net income per assignee unit of limited partnership of ORP ("Assignee Unit") has been calculated by dividing the portion of the Partnership's net income allocable to Assignee Unit Holders (98%) by the weighted average of Assignee Units outstanding. In all computations of earnings per Assignee Unit, the weighted average of Assignee Units outstanding during the period constitutes the basis for the net income amounts per Assignee Unit on the Consolidated Statements of Operations.
Statements of cash flows. Since the consolidated statements of cash flows are intended to reflect only cash receipts and cash payment activity, the statements do not reflect investing and financing activity that affect recognized assets or liabilities that do not result in cash receipts or cash payments. This noncash activity consists of distributions payable of $355,000, $361,000, and $243,000 at December 31, 1999, 1998 and 1997, respectively.
Interest on mortgage loans paid in 1999, 1998 and 1997 was $1,694,000, $1,727,000, and $1,758,000, respectively.
Cash and cash equivalents. Cash and cash equivalents consist of all demand deposits and government money market funds stated at cost, which approximates market value, with original maturities of three months or less at the date of purchase.
Note 3. Working Capital Reserve
Working Capital Reserve. The Partnership established an initial working capital reserve in the amount of $1,286,000 in 1985 from net offering proceeds received in excess of investment properties acquired. Funds in the reserve, which are invested in United States Treasury Bills, are stated at cost, which approximates market value. The Partnership Agreement permits additions to the reserve of such amounts derived from the operations of residential properties as deemed advisable by the Managing General Partner. All funds held in the working capital reserve are available to fund renovations and repairs, operating deficits, and other contingencies of the residential properties. Funds held in the working capital reserve also can be used to supplement distributions to the Assignee Unit Holders. The balance of the working capital reserve at December 31, 1999 was $22,000.
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Note 4. Investment Properties
Information regarding the four investment properties is listed below.
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Note 4. Investment Properties (continued)
For the Year Ended December 31, 1999 (in thousands)
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Note 5. Net Profits, Losses and Cash Distributions
Cash flow, as defined in the Partnership Agreement, will be distributed within 60 days after June 30 and December 31, 90% to the Assignee Unit Holders and 10% to the General Partners and the Assignor Limited Partner. The Assignee Unit Holders are entitled to a noncumulative, preferred 6% return. To the extent that these preferences are not achieved from current operations, 40% of the property management fees and the General Partners' and the Assignor Limited Partner's 10% share in cash flow will be deferred. Deferred property management fees are to be paid without interest in the next year in which excess cash flow is available after distribution to the Assignee Unit Holders of their preferred 6% return or out of sale or refinancing proceeds.
Profits and losses for financial statement and tax purposes arising from Partnership operations are allocated 98% to the Assignee Unit Holders and 2% to the General Partners and the Assignor Limited Partner.
All sale or refinancing proceeds, as defined in the Partnership Agreement, will be distributed as follows:
(1) to the Assignee Unit Holders to repay their adjusted capital contributions;
(2) to the General Partners and Assignor Limited Partner to repay their adjusted capital contributions;
(3) to the Assignee Unit Holders until payment of the preferred return on disposition (that is, an amount equal to 10% of the adjusted capital contributions multiplied by the number of calendar years from and including 1986) is achieved;
(4) to the General Partners and Assignor Limited Partner in an amount equal to any portion of their cash flow from operations which was previously deferred and not paid in subsequent years;
(5) to pay property disposition fees to Oxford National Properties Corporation; and
(6) to pay any remaining amount 85% to the Assignee Unit Holders and 15% to the General Partners and Assignor Limited Partner.
Sale or refinance proceeds have been defined to be all cash receipts arising from such transaction less expenses of the transaction, the repayment of all related debt, including the mortgage loan, the payments of any previously subordinated property management fees, and the payments to fund reserves.
All liquidation proceeds shall be first distributed to each Assignee Unit Holder and Partner, in an amount equal to the positive balance in his capital account and, thereafter, in the amounts and order of priority established above for sale or refinancing proceeds.
The profits for tax purposes resulting from the sale of an investment property which does not constitute the sale of substantially all of the Partnership's assets will be allocated among the Assignee Unit Holders, General Partners, and the Assignor Limited Partner in a proportion equal to the distributions received from the proceeds of such sale. Any profits in excess of the cash distribution will be allocated 98% to the Assignee Unit Holders and 2% to the General Partners and the Assignor Limited Partner. A loss from such a sale will be allocated 98% to the Assignee Unit Holders and 2% to the General Partners and Assignor Limited Partner.
The profits for tax purposes from the sale or liquidation of all or substantially all of the Partnership's assets will be allocated as follows:
(1) the portion of the profits attributable to the excess of the indebtedness of the investment property prior to its sale over the Partnership's adjusted basis in such property will be allocated to each Assignee Unit Holder having a negative capital account balance, to the extent of such negative balance, in the proportion that the negative balance of each Assignee Unit Holder's capital account bears to the aggregate negative balances of all the Assignee Unit Holders; and
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(2) the remainder will be allocated among the Partners and Assignee Unit Holders in proportion to the amount of sale or refinancing proceeds which was distributed to them in connection with the sale of the investment property or liquidation of the Partnership.
Losses for tax purposes from the sale of all or substantially all of the assets of the Partnership or the liquidation of the Partnership will be allocated as follows:
(1) losses equal to the amount by which the capital accounts of the Assignee Unit Holders and Partners exceed the total adjusted capital contributions will be allocated based on the ratio of each Assignee Unit Holder's and Partner's capital account excess balance to the total excess balance;
(2) losses will be allocated among the Assignee Unit Holders and Partners with positive capital accounts equal to the ratio of each Assignee Unit Holder's and Partner's positive capital account to the total positive capital accounts; and
(3) any remaining losses will be allocated 98% to Assignee Unit Holders and 2% to the General Partners and the Assignor Limited Partner.
Note 6. Mortgage Notes Payable
Effective January 12, 1994, separate mortgage loans were made to each of the four new ownership entities in the aggregate original principal amount of $22,362,000. These mortgage loans are not cross-collateralized, nor are they cross-defaulted. Each note bears interest at a fixed rate of 8.25% per annum and matures on February 11, 2004. The total monthly principal and interest payment is $176,000. As of December 31, 1999, the total outstanding balance of the four mortgage notes payable was $20,341,000. The properties are in compliance with their respective loan agreements as of December 31, 1999.
The individual outstanding mortgage notes payable as of December 31, 1999 and monthly debt service are as follows:
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The mortgage notes require the establishment and maintenance of escrow subaccounts for each property. These subaccounts are the Basic Carrying Costs Subaccount, the Debt Service Payment Subaccount, the Recurring Replacement Reserve Subaccount, the Operations and Maintenance Expense Subaccount, the Liquidity Reserve Subaccount, and the Curtailment Reserve Subaccount. The Basic Carrying Costs Subaccount and Liquidity Reserve Subaccount were initially funded in full out of loan proceeds for all properties at the mortgage closing. A temporary Engineering/Capital Replacement Reserve Subaccount was also established at closing for all properties, except Shadow Oaks, to pay for necessary capital improvements identified during the lender's due diligence review of the properties. The permanent subaccounts, except the Operations and Maintenance Expense Subaccount and the Curtailment Reserve Subaccount, will hereafter be directly funded and maintained monthly, as needed, from property income (except security deposits), in accordance with formulas established in the loan agreement and based on expenditures required in the following month. The Operations and Maintenance Expense Subaccount and the Curtailment Reserve Subaccount would be established if the borrowers have not provided a written commitment for the refinancing of the existing loans on or before six months prior to the maturity dates of the existing loans. The subaccounts will be funded monthly in the order listed above, except for certain changes that may occur in the year prior to maturity of the respective loans. Excess income from each property is distributed to the applicable borrower after all subaccounts that must be funded at that time have been fully funded in the given month, according to the terms of the Loan Agreement. As of December 31, 1999, the escrow subaccounts total $722,000 and are included in Other Assets in the accompanying Consolidated Balance Sheets.
The mortgage notes prohibit secondary financing unless specifically approved by the lender or specified in the loan documents. In addition, the mortgage notes prohibit prepayment before five years and impose a prepayment penalty equal to the greater of 1% or the Yield Maintenance Premium (as defined in the Loan Agreement) for prepayments during the sixth and seventh years. After the seventh year, prepayment is allowed with no prepayment penalty.
In general, the loans are nonrecourse. ORP One L.L.C. and ORP Corporation I, ORP Two L.L.C. and ORP Corporation II, ORP Three L.L.C. and ORP Corporation III, and ORP Four Limited Partnership and ORP Corporation IV have guaranteed payment of all clean-up costs if environmental contamination is subsequently discovered on their respective properties.
Note 7. Transactions with Affiliates
The Partnership has no directors or officers. The Managing General Partner and its affiliates do not receive any direct compensation, but are reimbursed by ORP for any actual direct costs and expenses incurred in connection with the operation of the Partnership.
Expense reimbursements are for an affiliate's personnel costs, travel expenses and interest on interim working capital advances for activities directly related to the Partnership which were not covered separately by fees. Total reimbursements to this affiliate for the years ended December 31, 1999, 1998 and 1997 were $82,000, $116,000, and $65,000, respectively, for administrative and accounting related costs.
An affiliate of NHP Management Company, the property manager, has a separate services agreement with Oxford Realty Financial Group, Inc. ("ORFG"), an affiliate of the Managing General Partner, pursuant to which ORFG provides certain services to NHP in exchange for service fees in an amount equal to 25.41% of all fees collected by NHP from certain properties, including those owned by the Partnership.
An affiliate of ORP and its managing general partner, Oxford Residential Properties I Corporation ("Managing General Partner") owns approximately 21.1% of the outstanding Assignee Units.
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Note 8. Other Liabilities
Other Liabilities. Under the Property Management Agreements with NHP Management Company, the management fee is equal to 5% of gross collections for all properties; however, 40% of this fee is subordinated until certain distribution preference levels to the Limited Partners or Assignee Unit Holders are achieved. Property management fees of $159,000, $153,000, and $149,000 for the years ended December 31, 1999, 1998 and 1997, respectively, have been deferred and the total amount deferred at December 31, 1999 was $871,000.
Note 9. Taxable Loss
A reconciliation of the major differences between net income for the consolidated financial statements and net loss for tax purposes is as follows:
Note 10. Commitments and Contingencies
The Partnership, through its subsidiaries, owns real estate and, as such, is subject to various environmental laws of Federal and local governments. Compliance by the Partnership with existing laws has not had a material adverse effect on its financial condition, results of operations, or liquidity, and based on reports from independent third parties, management does not believe it will have such an effect in the future. However, the Partnership cannot predict the impact of new or changed laws or regulations on its current properties.
Note 11. Subsequent Events
On February 28, 2000, ORP made a semi-annual cash distribution of approximately $355,005 or $15.00 per Assignee Unit to Assignee Unit Holders of record as of December 31, 1999.
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The following table sets forth, on a semiannual basis, all distributions declared since inception of the Partnership.
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Advisor Merrill Lynch, Hubbard Inc. New York, New York
Selling Agent Merrill Lynch, Pierce, Fenner & Smith, Incorporated New York, New York
Legal Counsel Shaw, Pittman, Potts & Trowbridge Washington, D.C.
Independent Accountants PricewaterhouseCoopers LLP Washington, D.C.
Transfer Agent and Registrar MMS Escrow & Transfer Agency, Inc. P.O. Box 7090 Troy, Michigan 48007-9921 Managing General Partner Oxford Residential Properties I Corporation 7200 Wisconsin Avenue, 11th Floor Bethesda, Maryland 20814
The Annual Report on Form 10-K for the Year Ended December 31, 1999, filed with Securities and Exchange Commission,is available to Assignee Unit Holders and may be obtained by writing:
Investor Services Oxford Residential Properties I Limited Partnership P.O. Box 7090 Troy, Michigan 48007-9921 (248) 614-4550
- -----------------------------------------------------------------
Instructions for Investors who wish to reregister or transfer ORP Assignee Units
Please follow the instructions below if you wish to reregister or transfer ownership of your Oxford Residential Properties I Limited Partnership ("ORP" or the "Partnership") Assignee Units. No transfers or sales can be effected without the consent of the Managing General Partner and the completion of the proper documents.
To cover the costs associated with processing transfers, MMS Escrow & Transfer Agency, Inc. ("MMS"), the transfer agent for ORP, charges $25 for each transfer of ORP Assignee Units between related parties, and $50 per seller for each transfer for consideration (sale). The only exception is a transfer to a surviving joint holder of Assignee Units when the other joint holder dies, in which case no fee is charged. MMS charges $150 for the conversion of Assignee Units into a limited partner interest.
To transfer ownership of Assignee Units held in a Merrill Lynch account, please have your Merrill Lynch financial consultant contact Merrill Lynch Partnership Operations in New Jersey at (201) 557-1619 to request the necessary transfer documents. Merrill Lynch Partnership Operations will only accept calls from your financial consultant. YOU MUST HAVE THE PROPER TRANSFER DOCUMENTS FROM MERRILL LYNCH TO EFFECT A TRANSFER. Your financial consultant must contact Partnership Operations, as ORP Investor Services does not send out transfer papers for Assignee Units held in a Merrill Lynch account.
Investors who no longer hold their Assignee Units in a Merrill Lynch account should contact ORP Investor Services at (248) 614-4550 or P.O. Box 7090, Troy, Michigan 48007-9921, to obtain transfer documents. YOU MUST OBTAIN THE PROPER TRANSFER DOCUMENTS FROM ORP INVESTOR SERVICES TO EFFECT A TRANSFER OF ASSIGNEE UNITS WHICH YOU HOLD PERSONALLY.
To redeposit your ORP units into a Merrill Lynch account, please notify ORP Investor Services in writing after the Merrill Lynch account has been opened. ORP Investor Services will then instruct Merrill Lynch to deposit the Assignee Units into the account.
Please remember to notify ORP Investor Services in writing at the address below or by calling (248) 614-4550 in the event you change your mailing address or your financial consultant. We can then continue to provide you and your representative with timely information about your investment in Oxford Residential Properties I Limited Partnership.
The Annual Report on Form 10-K for the year ended December 31, 1999, filed with the Securities and Exchange Commission, is available to Assignee Unit Holders and may be obtained by writing:
Investor Services Oxford Residential Properties I Limited Partnership P.O. Box 7090 Troy, Michigan 48007-9921
(248) 614-4550 - ----------------------------------------------------------------- | 10,349 | 72,230 |
37748_1999.txt | 37748_1999 | 1999 | 37748 | ITEM 1. BUSINESS
Fluor Corporation was incorporated in Delaware in 1978 as a successor in interest to a California corporation of the same name that was originally incorporated in 1924. Its executive offices are located at One Enterprise Drive, Aliso Viejo, California 92656, telephone number (949) 349-2000.
The Company is basically a holding company which owns the stock of numerous subsidiary corporations. Except as the context otherwise requires, the terms "Fluor" or the "Company" as used herein shall include Fluor Corporation and its subsidiaries and divisions.
In March 1999, the Company announced a new strategic direction and the Company was realigned into four principal business segments which the Company refers to as Strategic Business Enterprises (each, an "SBE") each with clear performance accountability: the Fluor Daniel(SM) segment which provides design, engineering, procurement and construction services on a worldwide basis to an extensive range of industrial, commercial, utility, natural resources and energy clients; the Fluor Global Services(SM) segment which provides outsourcing and asset management solutions to its customers; the Fluor Signature Services(SM) segment which provides traditional business administration and support services to the Company; and the Coal segment which produces, processes and sells high-quality, low-sulfur steam coal for the utility industry as well as industrial customers, and metallurgical coal for the steel industry. The Company also operates through Fluor Constructors International, Inc. ("Fluor Constructors") which is organized and operates separately from Fluor Daniel. Fluor Constructors provides unionized management, construction and management services in the United States and Canada, both independently and as a subcontractor to Fluor Daniel, and global support to all Fluor Daniel business units.
As part of the new strategic direction, the Company has established a Global Development, Sales and Marketing group and has implemented a Knowledge@Work(SM) initiative. Global Development, Sales and Marketing is an organization which is responsible for providing global account management for the Company's key clients. The Knowledge@Work initiative is focused on revamping the Company's work processes and management systems. Its primary goals include improved access to and use of Company knowledge coupled with an improved ability to obtain up-to-date and timely information across all aspects of the Company's business operations.
A summary of the Company's operations and activities by business segment and geographical area is set forth below.
FLUOR DANIEL
The Fluor Daniel SBE ("Fluor Daniel") provides a full range of design, engineering, procurement, construction and other services to clients in a broad range of industrial and geographic markets on a worldwide basis. Fluor Daniel's operations are organized into five business units responsible for identifying and capitalizing on opportunities in their market segments on a global basis. The operations of Fluor Daniel are detailed below by business unit:
Chemicals and Life Sciences: The Chemicals and Life Sciences business unit furnishes a full line of services to the following market segments: specialty and fine chemicals, petrochemicals, bulk pharmaceuticals, secondary pharmaceutical manufacturing and biotechnology. A representative sample of the projects being performed in this business unit include film processing plants throughout China, a major petrochemical complex in the western province of Saudi Arabia and a pharmaceutical plant for a major client in Ireland. Life Sciences clients continue to concentrate their manufacturing capabilities in certain tax-advantaged locations including Puerto Rico, Ireland and Singapore where Fluor Daniel has an existing and expanding presence. In addition, the Chemicals and Life Sciences business unit is targeting development opportunities to leverage key customer relationships by matching available technologies with regional market needs and feedstock availability. For example, the Chemicals and Life Sciences business unit has recently partnered with Du Pont to license, design and construct industrial plants using Du Pont's PET technology.
Oil, Gas and Power: Fluor Daniel's Oil, Gas and Power business unit is an integrated service supplier providing a full range of design, engineering, procurement, construction and project management services in a broad spectrum of energy industries ranging from upstream production to refining to power generation. Typical oil and gas projects include new facilities, upgrades, revamps and expansions for refineries, pipeline installations and oil sands development projects. Current projects include development of an offshore oil field in the Timor Sea, various pipeline projects in the Caspian Sea region and a major oil sands project in Alberta, Canada. In power generation, this business unit designs, engineers and constructs power generation facilities predominantly in the fossil fuel power industry through Duke/Fluor Daniel, a partnership with Duke Energy Corp. Duke/Fluor Daniel was awarded contracts for the development of seven new power generation facilities in fiscal year 1999.
Mining: The Mining business unit operates internationally in a wide range of mineral markets providing services ranging from mine planning and development, project management, technical and engineering services, resource evaluation, geologic modeling, equipment selection, permitting, construction and remediation. Projects being performed include the design and installation of the longest single strand underground conveyor in the world in Colorado, engineering, procurement and construction services for a major copper and gold project in Indonesia, design and construction management of the world's largest "grass roots" copper concentrator on the island of Sumbawa and construction of the world's largest vanadium production facility located in Western Australia.
Manufacturing: The Manufacturing business unit provides comprehensive engineering, architectural, construction, design, programming and management services to the general manufacturing, electronics, food, beverage and consumer products industries along with specialized construction management expertise for the pharmaceutical and biotechnology industries. This business unit strives to build longstanding business relationships with clients as best evidenced by its thirty year alliance with Procter & Gamble. Current projects of the Manufacturing business unit include wafer fabrication and processing facilities in Malaysia, a major
electronics facility in the Philippines, a resort/hotel in Las Vegas, Nevada and a research and development and headquarters facility for a major pharmaceutical company in the northeastern United States.
Infrastructure: The Infrastructure business unit provides design, engineering, procurement, construction and construction management services for the transportation industry. In highway construction, this business unit has completed numerous projects and the anticipated growth of public-private ventures should serve as a platform to increase its role in this area. For example, this business unit was recently selected by the South Carolina Department of Transportation to provide construction and management support for the statewide highway development program. Other localities are emulating this innovative approach and, in concert with United States government funding of over $200-plus billion from the TEA-21 transportation bill resulting in numerous new transportation opportunities domestically, this business unit is well-positioned to grow in this area. In the area of railroad construction, numerous public/private venture projects are now under development in Europe. The Infrastructure business unit has expanded into this area as exemplified by its recent joint venture with Mott MacDonald in the United Kingdom to be one of three primary suppliers of program management services to Britain's Railtrack for a multi-billion dollar improvement project on one of England's most heavily traveled rail lines. Finally, the need for improvement and expansion of major airports is apparent due to global increases in air traffic. In this area, the Infrastructure business unit has managed numerous projects including its present involvement in a major expansion project at John F. Kennedy Airport in New York.
COMPETITION
Fluor Daniel is one of the world's larger providers of engineering, procurement and construction services. The markets served by the business are highly competitive and for the most part require substantial resources, particularly highly skilled and experienced technical personnel. A large number of companies are competing in the markets served by the business. Competition is primarily centered on performance and the ability to provide the design, engineering, planning, management and project execution skills required to complete complex projects in a safe, timely and cost-efficient manner. The Company's engineering, procurement and construction business derives its competitive strength from its diversity, reputation for quality, technology, cost-effectiveness, worldwide procurement capability, project management expertise, geographic coverage, ability to meet client requirements by performing construction on either a union or an open shop basis, ability to execute projects of varying sizes, strong safety record and lengthy experience with a wide range of services and technologies.
FLUOR GLOBAL SERVICES
The Fluor Global Services SBE ("Fluor Global Services") supplies a full array of business asset and operation management services outside the traditional engineering, procurement and construction value chain. Services provided by Fluor Global Services include operations, maintenance and consulting services; construction and rental equipment, contract and direct-hire staffing services and training; and program and asset management services to industries on a global basis. This separate enterprise was created in order to better serve the Company's clients and to take advantage of a growing outsourcing market across a broad range of industries. Fluor Global Services' operations are organized into the following six business units:
American Equipment Company: American Equipment Company ("AMECO(R)") sells, rents, services and outsources equipment for construction and industrial needs on a global basis. In order to better serve clients, AMECO has reorganized into three business lines: Fleet Services which provides outsourcing services to targeted industrial markets; Site Services which provides complete rental equipment and tool programs for capital construction projects; and Dealerships which provide new and used equipment sales, parts and services in targeted geographic regions.
TRS Staffing Solutions: TRS Staffing Solutions is a global enterprise of staffing specialists that provides clients with assistance in temporary, contract and direct hire positions specializing in information technology, accounting and financing and engineering personnel. The temporary staffing segment affords clients flexibility and economies in meeting client needs due to factors which cannot be handled by a client's normal staffing by
providing temporary workers on a cost-effective basis. The contract and direct hire segment is focused on helping clients to effectively recruit and retain staff.
Operations & Maintenance: Operations & Maintenance furnishes repair, renovation, replacement, predictive and preventative services to commercial, industrial, nuclear, fossil fuel, manufacturing and oil, gas and power facilities worldwide. In addition, it is a leading supplier of integrated facility management for commercial and government operations, providing on-location maintenance and operations support coupled with workplace consulting and facility management services. The services provided by this business unit are those that are typically outsourced by a client in that they are ancillary to the primary business of the client. By outsourcing these services, the client is better able to focus on its primary business activities. Many of these contracts are evergreen in nature and can be extended for many years.
Fluor Federal Services: Fluor Federal Services(SM) is a leading provider of services to the United States government, especially with respect to the operation and environmental remediation of government facilities for the United States Department of Energy and Department of Defense. These projects tend to be extremely large, complex in nature and take many years to complete. Examples of activities being performed by Fluor Federal Services include environmental restoration, engineering, construction, site operations and maintenance at government sites located in Hanford, Washington and Fernald, Ohio.
Telecommunications: The Telecommunications business unit is a leading provider of systems integration and project management services for the global telecommunications market. As an example, this business unit was recently named project manager of a $320 million project to build out a network of fiber optic cable and point of presence units for Level 3 Communications.
Consulting Services: Consulting Services provides clients with professional advisory services and operational diagnostics to clients with a goal that each client reaches optimum business performance.
COMPETITION
The markets served by each Fluor Global Services business unit, while containing some similarities, tend also to have discrete issues particularly impacting that unit. Each business unit has a large number of companies competing in its markets. With respect to AMECO, which operates in numerous markets, the equipment rental industry is highly fragmented and very competitive, with most competitors operating in specific geographic areas. In the sales and service area, the equipment distribution market consists primarily of firms which operate dealerships representing equipment manufacturers. Competition in the equipment arena is driven primarily by price, service and locality to where the client's services are required. With respect to TRS Staffing Solutions, this is a highly fragmented industry with over 100 companies competing nationally. The key competitive factors in this segment are price, service quality, breadth of service and geographical coverage. Key competitive factors in both Fluor Federal Services and Telecommunications are primarily centered on performance and the ability to provide the design, engineering, planning, management and project execution skills required to complete complex projects in a safe, timely and cost-efficient manner. In both Operations & Maintenance and Consulting Services, the barrier to entry to these industries is both financially and logistically low with the result that the industries are highly fragmented with no single company being dominant. Competition is generally driven by reputation, price and capacity to perform.
FLUOR SIGNATURE SERVICES
The Fluor Signature Services SBE ("Fluor Signature Services") commenced operations effective November 1, 1999. This SBE was created primarily to provide traditional business services and business infrastructure support to the Company and its divisions and subsidiaries including human resource, finance, accounting, safety, information technology, knowledge management and office support services. Fluor Signature Services brings a new approach to doing business. By assuming responsibility for the delivery of business administration and support services, Fluor Signature Services will allow the Company's operating units to focus on their core businesses. The individual operating units will define and choose which services to purchase from Fluor
Signature Services. Consolidation of these services into one organization should reduce costs and improve quality standards. Ultimately, such services may be marketed to external customers.
COAL
The Coal segment, which operates through A. T. Massey Coal Company, Inc., is headquartered in Richmond, Virginia and, with its subsidiaries that conduct Massey's coal-related businesses, are collectively referred to herein as the "Massey Companies."
The Massey Companies produce, process and sell bituminous, low sulfur coal of steam and metallurgical grades from 22 mining complexes (20 of which include preparation plants) located in West Virginia, Kentucky, Virginia and Tennessee. As of October 31, 1999, one of the mining complexes was still in development and not yet producing coal. Steam coal is used primarily by utilities as fuel for power plants. Metallurgical coal is used primarily to make coke for use in the manufacture of steel.
For each of the three years in the period ended October 31, 1999, the Massey Companies' production (expressed in thousands of short tons) of steam coal and metallurgical coal, respectively, was 23,218 and 15,145 for fiscal year 1999, 19,611 and 18,410 for fiscal year 1998 and 19,798 and 16,757 for fiscal year 1997. Sales (expressed in thousands of short tons) of coal produced by the Massey Companies were 37,864 for fiscal year 1999, 37,608 for fiscal year 1998 and 35,643 for fiscal year 1997.
CONTRACTS
A large portion of the steam coal produced by the Massey Companies is sold to domestic utilities. Metallurgical coal is sold to both foreign and domestic steel producers. Approximately 66% of the Massey Companies' fiscal year 1999 coal production was sold under long-term contracts, 52% of which was steam coal and 48% of which was metallurgical coal. Approximately 7% of the coal tonnage sold by the Massey Companies in fiscal year 1999 was sold outside of North America.
COMPETITION
Massey is among the five largest marketers of coal in the United States. The coal market is a mature market with many strong competitors. Competition is primarily dependent upon coal price, transportation cost, producer reliability and characteristics of coal available for sale. The management of Massey considers Massey to be generally well-positioned with respect to these factors in comparison to its principal competitors.
OTHER MATTERS
The Coal Industry Retiree Health Benefits Act of 1992 (the "Act") provides that certain retired coal miners who were members of the United Mine Workers of America, along with their spouses, are guaranteed health care benefits. The Massey Companies' obligation under the Act is currently estimated to aggregate approximately $56.4 million which will be recognized as expensed as payments are made. The amount expensed during fiscal year 1999 approximated $3.6 million.
RESERVES
The management of the Massey Companies estimates that, as of October 31, 1999, the Massey Companies had total recoverable reserves (expressed in millions of short tons) of 2,087; 720 of which are assigned recoverable reserves and 1,367 of which are unassigned recoverable reserves; and 1,381 of which are proven recoverable reserves and 706 of which are probable recoverable reserves.
The management of the Massey Companies estimates that approximately one-third of the total reserves listed above consist of reserves that would be considered primarily metallurgical grade coal. They also estimate that approximately 67% of all reserves contain less than 1% sulfur. A portion of the steam coal reserves could be beneficiated to metallurgical grade by coal preparation plants and substantially all of the metallurgical coal reserves could be sold as high quality steam coal, if market conditions warrant.
"Reserves" means that part of a coal deposit which could be economically and legally extracted or produced at the time of the reserve determination. "Recoverable reserves" means coal which is recoverable by the use of existing equipment and methods under federal and state laws now in effect. "Assigned recoverable reserves" means reserves which can reasonably be expected to be mined from existing or planned mines and processed in existing or planned plants. "Unassigned recoverable reserves" means reserves for which there are no specific plans for mining and which will require for their recovery substantial capital expenditures for mining and processing facilities. "Proven recoverable reserves" refers to deposits of coal which are substantiated by adequate information, including that derived from exploration, current and previous mining operations, outcrop data and knowledge of mining conditions. "Probable recoverable reserves" refers to deposits of coal which are based on information of a more preliminary or limited extent or character, but which are considered likely.
OTHER MATTERS
DIVESTITURES AND ACQUISITIONS
During the fiscal year ending October 1999, the Company did not engage in any acquisitions or divestitures which when considered either independently or collectively were material to the Company's business, taken as a whole.
NEW SERVICES
There are no new industry segments or new service areas that the Company is currently planning to enter or that will require a material investment of Company assets, other than as discussed herein.
RAW MATERIALS
With the exception of Massey and its coal reserves previously discussed, raw materials are not currently a material issue with respect to any of the Company's business segments.
PATENTS AND LICENSES
Each of the Company's business segments relies on new and improved versions of existing processes, materials or techniques, some of which are patented. However, none of the existing or pending patents held or licensed by the Company or any business segment are considered essential to operations. Generally, the development and improvement of processes, materials and techniques are performed as part of services in connection with the projects and contracts undertaken for various clients.
SEASONAL BUSINESS IMPLICATIONS
The Company believes that the business of each of the Company's industry segments is not seasonal in a material or significant manner.
WORKING CAPITAL
The Company believes that there are no material, special or unusual working capital requirements in any of the Company's business segments.
CUSTOMERS
None of the business segments of the Company is dependent upon either a single customer or a limited number of customers in any material manner.
BACKLOG
The following table sets forth the consolidated backlog of Fluor Daniel and Fluor Global Services segments at October 31, 1999 and 1998.
The following table sets forth the consolidated backlog of Fluor Daniel and Fluor Global Services segments at October 31, 1999 and 1998 by region:
Estimated portion not to be performed during fiscal 2000: 21%
For purposes of the preceding tables, Fluor Global Services backlog figures are not provided for AMECO and TRS Staffing Solutions since there is no way to meaningfully measure backlog for these business units due to the short-term nature of the services they provide. Similarly, backlog is not reported for the Massey Companies because, in the Company's opinion, such information is not necessarily meaningful because of the nature of the coal mining business where repetitive services of a short-term nature is the norm.
The dollar amount of the backlog is not necessarily indicative of the future earnings of Fluor related to the performance of such work. Although backlog represents only business which is considered to be firm, there can be no assurance that cancellations or scope adjustments will not occur. Due to additional factors outside of Fluor's control, such as changes in project schedules, Fluor cannot predict with certainty the portion of its October 31, 1999 backlog estimated to be performed subsequent to fiscal year 2000.
For additional information with respect to the Company's backlog, please see Management's Discussion and Analysis contained in Fluor's 1999 Annual Report to shareholders, which information is incorporated herein by this reference (and except for this section and other sections specifically incorporated herein by this reference in Items 1 through 8 of this report, Fluor's 1999 Annual Report to shareholders is not deemed to be filed as part of this report).
GOVERNMENT CONTRACTS
Fluor Global Services, predominantly through the Fluor Federal Services business unit, is a prime contractor or a major subcontractor for a number of United States government programs. Generally, the programs in question may take many years to complete and may be implemented by the award of many different contracts. Despite the fact that these programs are generally awarded on a multi-year basis, the funding for the programs is generally approved on an annual basis by Congress. The government is under no obligation to maintain funding at any specific level, or funds for a program may even be eliminated thereby significantly curtailing or stopping a program. The government also has the right to terminate its contracts at any time for convenience. However, the government is required to equitably adjust a contract for additions or reduction in scope and, in the event of termination, a contractor may also receive some allowance for profit on work performed.
Contracts and business with the government are also subject to a number of socio-economic and other requirements as well as certain procurement regulations. If a contractor fails to comply with the requirements and
regulations, it could lead to suspension or even debarment from government contracting. Finally, government contracting and the continued funding of programs is also subject to a variety of factors beyond the Company's control such as political developments both domestically and internationally, budget considerations and changes in procurement policies.
RESEARCH AND DEVELOPMENT
While the Company engages in research and development efforts both on current projects and in the development of new products and services, the Company believes that during the past three fiscal years, it has not incurred costs for Company-sponsored research and development activities which would be material, special or unusual in any of the Company's business segments, other than research and development activities associated with the Company's Knowledge@Work initiative.
ENVIRONMENTAL, SAFETY AND HEALTH MATTERS
On October 20, 1999, the United States District Court for the Southern District of West Virginia ("District Court") issued an injunction which prohibits the construction of valley fills over both intermittent and perennial stream segments as part of mining operations. While the Massey Companies are not a party to this litigation, virtually all mining operations (including those of the Massey Companies) utilize valley fills to dispose of excess materials mined during coal production. This decision is now under appeal to the Fourth Circuit Court of Appeals and the District Court has issued a stay of its decision pending the outcome of the appeal. Based upon the current state of the appeal, the Company does not believe that the Massey Companies mining operations will be materially affected while the appeal is pending. If and to the extent that the District Court's decision is upheld and legislation is not passed which limits the impact of the decision, all or a portion of the Massey Companies' mining operations could be affected. The potential impact to the Massey Companies arising from this proceeding is currently not estimable.
The Massey Companies are affected by and comply with federal, state and local laws and regulations relating to environmental protection and plant and mine safety and health, including but not limited to the federal Surface Mining Control and Reclamation Act of 1977; Occupational Safety and Health Act; Mine Safety and Health Act of 1977; Water Pollution Control Act, as amended by the Clean Water Act of 1977; Black Lung Benefits Revenue Act of 1977; and Black Lung Benefits Reform Act of 1977. The Massey Companies are also affected by acid rain legislation, which is generally believed to benefit prices for low sulfur coal. The Massey Companies intend to continue to evaluate and pursue, in appropriate circumstances, the acquisition of additional low sulfur coal reserves.
It is impossible to predict the full impact of future judicial, legislative or regulatory developments on such operations, because the standards to be met, as well as the technology and length of time available to meet those standards, continue to develop and change.
In fiscal year 1999, the Massey Companies expended approximately $11.4 million to comply with environmental, health and safety laws and regulations, none of which expenditures were capitalized. The Massey Companies anticipate making $6.8 million and $8.9 million in such non-capital expenditures in fiscal 2000 and 2001, respectively. Of these expenditures, $10.3 million, $5.6 million and $7.8 million for fiscal 1999, 2000 and 2001, respectively, were or are anticipated to be for surface reclamation. Existing financial reserves are believed to be adequate to cover actual and anticipated reclamation expenditures.
The Company believes, based upon present information available to it, that its accruals with respect to future environmental costs are adequate and such future costs will not have a material effect on the Company's consolidated financial position, results of operations or liquidity. However, the imposition of more stringent requirements under environmental laws or regulations, new developments or changes regarding site cleanup costs or the allocation of such costs among potentially responsible parties, or a determination that the Company is potentially responsible for the release of hazardous substances at sites other than those currently identified, could result in additional expenditures or the provision of additional accruals in expectation of such expenditures.
NUMBER OF EMPLOYEES
The following table sets forth the number of salaried and craft/hourly employees of Fluor and its subsidiaries engaged in Fluor's business segments as of October 31, 1999:
OPERATIONS BY BUSINESS SEGMENT AND GEOGRAPHICAL AREA
The financial information for business segments and geographic areas is included in the Operations by Business Segment and Geographical Area section of the Notes to Consolidated Financial Statements in Fluor's 1999 Annual Report to shareholders, which section is incorporated herein by reference.
COMPANY BUSINESS RISKS
Cost Overrun Risks Associated with Fixed, Maximum or Unit Priced Contracts. A substantial portion of the Company's business is conducted under various types of contractual arrangements, including cost-reimbursable (plus fixed or percentage fee), all-inclusive rate, unit price, fixed or maximum price and incentive fee contracts. While, in terms of dollar amount, the majority of contracts are of the cost-reimbursable type, there has been an increase in the volume of fixed, maximum, unit-priced and incentive fee contracts. Under fixed, maximum or unit priced contracts, the Company agrees to perform the contract for a fixed price, and, as a result, benefit from potential cost savings. At the same time, however, the Company bears the risk for most cost overruns. Under fixed price incentive contracts, the Company bears some or all of the risk of costs exceeding the negotiated ceiling price and shares with the customer any cost savings up to a negotiated ceiling price. Contract prices are established in part on cost estimates which are subject to a number of assumptions, such as assumptions regarding future economic conditions, price and availability of labor, equipment and materials, applicable law, weather delays or civil unrest labor disruptions. If, in the future, these estimates prove inaccurate, or circumstances change, cost overruns may occur. Significant cost overruns could have a material adverse effect on the Company's results of operations and financial condition.
Risk of Additional Costs Incurred by Project Performance Problems. In certain instances, the Company guarantees to a customer that it will complete a project by a scheduled date or that the facility will achieve certain performance standards. If the project or facility subsequently fails to meet the schedule or performance standards, the Company could incur additional costs. Depending on the nature of the project performance problem, the additional costs incurred may be non-recoverable which could exceed revenues realized from a project. Therefore, if the Company experiences a project performance problem, there could be a material adverse effect on the Company's results of operations and financial condition.
Uncertainty of Future Contract Awards. Estimates of future performance depend on, among other matters, the Company's estimates as to whether and when it will receive certain new contract awards. While these estimates are based upon good faith judgment, these estimates can be unreliable and may frequently change based on new facts as they become available. In the case of large-scale domestic and international projects where timing is often uncertain, it is particularly difficult to predict whether and when the Company will receive a contract award. The uncertainty of contract award timing can present difficulties in matching workforce size with contract needs. In some cases, the Company maintains and bears the cost of a ready workforce that is larger than called for under existing contracts in anticipation of future workforce needs under expected contract awards. If an expected contract award is delayed or not received, the Company would incur costs that could have a material adverse effect on the Company's results of operations and financial condition.
Uncertainty of When the Company Might Receive Project Revenues. The time at which the Company receives revenue from engineering and construction projects can be affected by a number of factors outside of the Company's control. Depending upon external conditions, a client may either cancel a project, put it on hold or extend the schedule. Also, the realization of revenues may be impacted by future economic conditions, price and availability of labor, equipment and materials, applicable law, weather delays, civil unrest or labor disruptions. If revenue that the Company expects to receive from a project is either delayed or not received, there could be a material adverse effect on the Company's results of operations and financial condition.
Uncertainties Associated with Government Contracts. A number of the Company's contracts are government contracts. Typically, government contracts are subject to various restrictions and uncertainties such as oversight audits by government representatives and profit and cost controls. In some cases, government contracts are exposed to the uncertainties associated with Congressional funding. In addition, government contracts are subject to specific procurement regulations and a variety of other socio-economic requirements. The Company must comply with these government regulations and requirements, as well as, various statutes related to employment practices, environmental protection, recordkeeping and accounting. The Company's failure to comply with any of these regulations, requirements and statutes could lead to suspension from government contracting or subcontracting for a period of time. In the event one of the Company's government contracts is terminated for any reason, or if the Company is suspended from government contract work, there could be a material adverse effect on the Company's results of operations and financial condition.
Backlog Not Indicative of Future Earnings. The dollar amount of the Company's backlog, as stated at any given time, is not necessarily indicative of future earnings. Cancellations or scope adjustments may occur with respect to contracts reflected in the Company's backlog. In the event that the Company experiences significant cancellations or scope adjustments in backlog contracts, there could be a material adverse effect on the Company's results of operations and financial condition.
Future Environmental, Safety and Health Requirements Could Affect Financial Condition. It is impossible to reliably predict the full nature and impact of future judicial, legislative or regulatory developments relating to the environmental protection, safety and health requirements applicable to the Company's operations (particularly with respect to coal operations). The requirements to be met, as well as the technology and length of time available to meet those requirements, continue to develop and change. To the extent that the costs associated with meeting those requirements are substantial, there could be a material adverse effect on the Company's results of operations and financial condition.
Fluctuation in the Production and Sale of Coal. Coal production and sales are subject to a variety of factors relating to operations, geology, transportation, environmental laws and regulations, judicial decisions and weather. These factors routinely cause the Massey Companies' coal production and sales to fluctuate, sometimes negatively. For example, labor disruptions may adversely affect coal production. Similarly, transportation delays may adversely affect coal sales. Such disruptions and delays lead to increased production costs and, therefore, could have a material adverse effect on the Company's results of operations and financial condition.
Uncertainties Associated with Global Economic and Political Conditions. The Company's businesses are subject to fluctuations in demand and to changing economic and political conditions, not only domestically, but internationally, which are beyond the Company's control. In particular, the Company's engineering and construction and coal businesses are global and are affected by market conditions outside of the United States. These businesses are often subject to, among other matters, foreign government policies and regulations, embargoes, United States government policies and international hostilities. Although the Company tries to reduce exposure to uncertain international market conditions, the Company is unable to completely predict or control the amount and mix of business and sales. To the extent that international businesses are affected by unexpected international market conditions, there could be a material adverse effect on the Company's results of operations and financial condition.
Foreign Exchange Risks. Because the Company's functional currency is the U.S. dollar, non-U.S. operations sometimes face the additional risk of fluctuating currency values and exchange rates, hard currency shortages and controls on currency exchange. The Company attempts to limit its exposure to foreign currency fluctuations in
contracts by requiring client payments in U.S. dollars or other currencies that correspond to the currency in which project costs are incurred. Changes in the value of foreign currencies could have a material adverse effect on the Company's results of operations and financial condition.
Intense Competition Poses Challenges to Profitability. The Company serves markets that are highly competitive and in which a large number of multinational companies compete. In particular, the engineering and construction and coal markets are highly competitive and require substantial resources and capital investment in equipment, technology and skilled personnel. Competition also impacts the Company's contract prices and profit margins. Intense competition is expected to continue in these markets, presenting the Company with significant challenges in its ability to maintain strong growth rates and acceptable profit margins. In the event that the Company is unable to meet these competitive challenges, there could be a material adverse effect on the Company's results of operations and financial condition.
ITEM 2.
ITEM 2. PROPERTIES
Major Facilities
Operations of Fluor and its subsidiaries are conducted in both owned and leased properties totaling approximately 7.0 million square feet. In addition, certain owned or leased properties of Fluor and its subsidiaries are leased or subleased to third party tenants. The following table describes the location and general character of the major existing facilities, exclusive of mines, coal preparation plants and their adjoining offices:
Coal Properties
See Item 1. Business, of this report for additional information regarding the coal operations and properties of the Massey Companies.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Disputes have arisen between a subsidiary of Fluor Daniel and its client, Anaconda Nickel, over the Murrin Murrin Nickel Cobalt project located in Western Australia. Both parties have initiated the dispute resolution process under the contract. Anaconda's primary contention is that the process design, through which pressurized and super heated metal slurry flows through a series of depressurization flash vessels, is defective and incapable of proper operation. Anaconda further contends that the Company falsely represented that the process technology employed in the flash vessel design was commercially proven which Anaconda contends has caused it to lose the benefit of insurance coverage underwritten by Lloyds of London. Anaconda also contends that it has suffered other consequential losses, such as loss of profit, for which it seeks payment from the Company. Anaconda contends that the Company is liable to Anaconda in the total amount of A$300 million.
The Company vigorously disputes and denies Anaconda's allegations. Among other things, the Company contends that Anaconda has and continues to improperly operate the facility causing the flash vessels to fail. When Anaconda complied with the written operating procedures, the flash vessels operated properly and continuously. Moreover, the Company contends that Anaconda has failed to supply the contractually guaranteed feedstock, adversely affecting the performance of the facility. With respect to the alleged loss of insurance coverage, the Company contends that it made no representations whatsoever regarding the flash tank process design, and that, in any event, Anaconda has not, in fact, lost any insurance coverage, in as much as coverage is being determined by arbitration currently underway in London between Anaconda and Lloyds of London. The Company rejects Anaconda's claim of loss of profit, in as much as the Company has complied with the applicable standards care in the industry and otherwise, the contract between the Company and Anaconda contains a waiver of consequential damages, such as loss of profit.
The Company has provided notice to all applicable insurance carriers of the disputes between the parties. The Company's primary errors and omissions insurer has provided a favorable coverage determination with respect to the alleged design defects. If and to the extent that these problems are ultimately determined to be the responsibility of the Company, the Company anticipates recovering a substantial portion of this amount from available insurance. For additional discussion, see Contingencies and Commitments in the Notes to Consolidated Financial Statements in Fluor's 1999 Annual Report to shareholders, which section is incorporated herein by this reference.
In addition, Fluor and its subsidiaries, incident to their normal business activities, are parties to a number of other legal proceedings and other matters in various stages of development. While the Company cannot predict the outcome of these proceedings, in the opinion of the Company and based on reports of counsel, any liability arising from these matters individually and in the aggregate will not have a material adverse effect upon the consolidated financial position or results of operations of Fluor after giving effect to provisions already recorded.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
EXECUTIVE OFFICERS OF THE REGISTRANT(1)
PHILIP J. CARROLL, JR., age 62
Director since July 1998; Chairman of the Board and Chief Executive Officer since July 1998; formerly President and Chief Executive Officer of Shell Oil Company from 1993.
DENNIS W. BENNER, age 58
Vice President and Chief Information Officer since November 1994; formerly Vice President and General Manager, Information for TRW from 1992.
DON L. BLANKENSHIP, age 49
Director since 1996; Chairman of the Board and Chief Executive Officer of A.T. Massey Coal Company, Inc.(2) since 1992; joined Rawls Sales & Processing Co.(3) in 1982.
ALAN L. BOECKMANN, age 51
President and Chief Executive Officer, Fluor Daniel, since March 1999; formerly Group President, Energy and Chemicals from January, 1996; formerly President, Plastics and Fibers from 1994; joined the Company in 1979 with previous service from 1974 to 1977.
JAKE EASTON III, age 52
Vice President, Strategic Planning since March 1999; formerly President, Strategic Planning Group from 1998; formerly Group President, Fluor Daniel, Inc.(4) from 1997; formerly President, Petroleum and Petrochemicals from 1994; joined the Company in 1975.
LAWRENCE N. FISHER, age 55
Senior Vice President, Law and Secretary, since 1996; formerly Vice President, Corporate Law and Assistant Secretary from 1984; joined the Company in 1974.
FREDERICK J. GRIGSBY, JR., age 52
Senior Vice President, Human Resources and Administration, since January 1999; formerly Vice President of Human Resources, Thermo King Corporation from 1995; formerly Director of HR WorkSource, Westinghouse Electric Corporation from 1993; joined the Company in 1999.
RALPH F. HAKE, age 50
Executive Vice President and Chief Financial Officer, since June 1999; formerly Senior Executive Vice President and Chief Financial Officer of Whirlpool Corporation from 1997; formerly Senior Executive Vice President of Global Operations from 1996; formerly Executive Vice President, North American Appliance Group from 1992; joined the Company in 1999.
JOHN L. HOPKINS, age 46
President, Global Development, Sales and Marketing, since November 1999; formerly Senior Vice President, Sales and Marketing from 1999; formerly Group President, Global Chemicals from 1998; formerly President, Chemicals, Plastics and Fibers from 1995; joined the Company in 1984.
JAMES O. ROLLANS, age 57
Director since 1997; President and Chief Executive Officer of Fluor Signature Services since March 1999; formerly Chief Financial Officer from 1998; formerly Chief Administrative Officer from 1994; formerly Senior Vice President from 1992; joined the Company in 1982.
JAMES C. STEIN, age 56
Director since 1997; President and Chief Executive Officer of Fluor Global Services since March 1999; formerly President and Chief Operating Officer, Fluor Daniel, Inc.(4) from 1997; formerly Group President, Diversified Services, of Fluor Daniel, Inc.(4) from 1994; joined the Company in 1964.
- ---------------- (1) Except where otherwise indicated, all references are to positions held with Fluor.
(2) A. T. Massey Coal Company, Inc. ("A. T. Massey"), is an indirectly wholly-owned subsidiary of Fluor which, along with A. T. Massey's subsidiaries, conducts A. T. Massey's coal-related businesses.
(3) Rawl Sales & Processing Co. is a wholly-owned subsidiary of A. T. Massey.
(4) Fluor Daniel, Inc. by virtue of name change filed in October 1999 is now known as Fluor Enterprises, Inc.
PART II
Information for Items 5, 6, 7 and 7a is contained in Fluor's 1999 Annual Report to shareholders, which information is incorporated herein by reference:
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information for Item 8 is included in Fluor's consolidated financial statements as of October 31, 1999 and 1998 and for each of the three years in the period ended October 31, 1999 and Fluor's unaudited quarterly financial data for the two year period ended October 31, 1999, in the Consolidated Financial Statements (including the Consolidated Balance Sheet, Consolidated Statement of Earnings, Consolidated Statement of Cash Flows, Consolidated Statement of Shareholders' Equity and Notes to Consolidated Financial Statements) and unaudited Quarterly Financial Data sections of Fluor's 1999 Annual Report to shareholders, which are incorporated herein by reference. The report of independent auditors on Fluor's consolidated financial statements is in the Management's and Independent Auditors' Reports section of Fluor's 1999 Annual Report to shareholders and is also incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information concerning Fluor's executive officers is included under the caption "Executive Officers of the Registrant" in Part I, following Item 4. Other information required by this item is included in the Biographical section of the Election of Directors portion of the definitive proxy statement pursuant to Regulation 14A, involving the election of directors, which is incorporated herein by reference and will be filed with the Securities and Exchange Commission (the "Commission") not later than 120 days after the close of Fluor's fiscal year ended October 31, 1999.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Fluor maintains certain employee benefit plans and programs in which its executive officers and directors are participants. Copies of these plans and programs are set forth or incorporated by reference as Exhibits 10.1 through 10.22 inclusive to this report. Certain of these plans and programs provide for payment of benefits or for acceleration of vesting of benefits upon the occurrence of a change of control of Fluor as that term is defined in such plans and programs. The amounts payable thereunder would represent an increased cost to be paid by Fluor (and indirectly by its shareholders) in the event of a change in control of Fluor. This increased cost would be a factor to be taken into account by a prospective purchaser of the Company in determining whether and at what price, it would seek control of the Company and whether it would seek the removal of then existing management.
If a change of control were to have occurred on October 31, 1999, the additional amounts payable by Fluor, either in cash or in stock, if each of the five most highly compensated executive officers and all executive officers as a group were thereupon involuntarily terminated without cause would be as follows:
- -----------------
(1) Value at October 31, 1999 of previously awarded restricted stock which would vest upon change of control.
(2) Lump sum entitlement of previously awarded benefits which would vest upon change of control.
Further disclosure required by this item is included in the Organization and Compensation Committee Report on Executive Compensation and Executive Compensation and Other Information sections of the definitive proxy statement pursuant to Regulation 14A, involving the election of directors, which is incorporated herein by reference and will be filed not later than 120 days after the close of Fluor's fiscal year ended October 31, 1999.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information required by this item is included in the Stock Ownership section of the Election of Directors portion of the definitive proxy statement pursuant to Regulation 14A, involving the election of directors, which is incorporated herein by reference and will be filed not later than 120 days after the close of Fluor's fiscal year ended October 31, 1999.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information required by this item is included in the Other Matters section of the Election of Directors portion of the definitive proxy statement pursuant to Regulation 14A, involving the election of directors, which is incorporated herein by reference and will be filed not later than 120 days after the close of Fluor's fiscal year ended October 31, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Documents filed as part of this report:
1. Financial Statements: The following financial statements are contained in Fluor's 1999 Annual Report to shareholders:
Consolidated Balance Sheet at October 31, 1999 and 1998
Consolidated Statement of Earnings for the years ended October 31, 1999, 1998 and 1997
Consolidated Statement of Cash Flows for the years ended October 31, 1999, 1998 and 1997
Consolidated Statement of Shareholders' Equity for the years ended October 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
See Part II, Item 8 of this report for information regarding the incorporation by reference herein of such financial statements.
2. Financial Statement Schedules: All schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto.
3. Exhibits:
(b) Reports on Form 8-K: None were filed during the last quarter of the period covered by this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FLUOR CORPORATION
January 26, 2000
By: /s/ R. F. Hake ------------------------------------- R. F. Hake, Executive Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Manually signed Powers of Attorney authorizing L. N. Fisher, D. E. Miller and E. P. Helm and each of them, to sign the annual report on Form 10-K for the fiscal year ended October 31, 1999 and any amendments thereto as attorneys-in-fact for certain directors and officers of the registrant are included herein as Exhibits 24.
EXHIBIT INDEX | 7,999 | 54,244 |
1075624_1999.txt | 1075624_1999 | 1999 | 1075624 | ITEM 1. BUSINESS
GENERAL
BPC Holding Corporation ("Holding"), is the parent of Berry Plastics Corporation ("Berry" or the "Company"), a leading domestic manufacturer and supplier of plastic packaging products focused on three markets: aerosol overcaps, open-top containers, and drink cups. In addition, based on discussions with our customers, sales representatives and external sales brokers, the Company believes that it is a leading manufacturer and supplier of semi-disposable housewares. Within each of its markets, the Company concentrates on manufacturing value-added products sold to marketers of image-conscious industrial and consumer products that utilize the Company's proprietary molds, superior color matching capabilities and sophisticated multi-color printing capabilities. The Company believes that it is the largest supplier of aerosol overcaps in the world, with sales of over two billion overcaps in fiscal 1999 and based on discussions with customers, sales representatives and external sales brokers.
The Company supplies aerosol overcaps to a wide variety of customers and for a wide variety of commercial and consumer products. Similarly, the Company's containers are used for packaging a broad spectrum of commercial and consumer products. The Company's drink cups are sold to fast food and family-dining restaurants, convenience stores, stadiums, and retail stores. The Company also sells houseware products, primarily seasonal, semi-disposable housewares and lawn and garden items such as plates, bowls, pitchers and flower pots, to major retail marketers. Berry's customer base is comprised of over 7,000 customers with operations in a widely diversified range of markets. The Company's top ten customers accounted for approximately 15% of fiscal 1999 net sales, and no customer accounted for more than 5% of the Company's net sales in fiscal 1999. The historical allocation of the Company's total net sales among its product categories is as follows:
FISCAL ------------------------ 1999 1998 1997 ---- ---- ---- Packaging products: Aerosol overcaps.... 20% 18% 21% Containers.......... 53 54 49 Drink cups.......... 10 15 17 Other............... 9 5 5 Housewares............ 8 8 8
The Company believes that it derives a strong competitive position from its state-of-the-art production capabilities, extensive array of proprietary molds in a wide variety of sizes and styles and dedication to service and quality. In the aerosol overcap market, the Company distinguishes itself with superior color matching capabilities, which is of extreme importance to its base of image-conscious consumer products customers, and proprietary packing equipment, which enables the Company to deliver a higher quality product while lowering warehousing and shipping costs. In the container and drink cup markets, an in-house graphic arts department and sophisticated printing and decorating capabilities permit the Company to offer extensive value-added decorating options. The Company believes that it is an industry innovator, particularly in the area of decoration. These market-related strengths, combined with the Company's modern proprietary mold technology, high speed molding capabilities and multiple-plant locations, all contribute to the Company's strong market position.
In addition to these marketing and manufacturing strengths, the Company believes that its close working relationships with customers are crucial to maintaining market positions and developing future growth opportunities. The Company employs a direct sales force which is focused on working with customers and the Company's production and product design personnel to develop customized packaging that enhances customer product differentiation and improves product performance. The Company works to develop innovative new products and identify and pursue non-traditional markets that can use existing Company products.
HISTORY
Imperial Plastics, the Company's predecessor, was established in 1967 in Evansville, Indiana. Berry Plastics, Inc. ("Old Berry") was formed in 1983 to purchase substantially all of the assets of Imperial Plastics. In 1988, Old Berry acquired Gilbert Plastics of New Brunswick, New Jersey, a leading manufacturer of aerosol overcaps, and subsequently relocated Gilbert Plastics' production to Old Berry's Evansville, Indiana facility. In 1990, the Company and Holding, the holder of 100% of the outstanding capital stock of the Company, were formed to purchase the assets of Old Berry. In February 1992, the Company acquired substantially all of the assets (the "Mammoth Acquisition") of the Mammoth Containers division of Genpak Corporation.
In March 1995, Berry Sterling Corporation, a newly formed wholly owned subsidiary of the Company ("Berry Sterling"), acquired substantially all of the assets of Sterling Products, Inc. (the "Sterling Products Acquisition"), a producer of injection molded plastic drink cups and lids. Management believes that the Sterling Products Acquisition gave the Company immediate penetration into a rapidly expanding plastic drink cup market. In December 1995, Berry Tri-Plas Corporation (formerly Berry-CPI Corp.), a wholly owned subsidiary of the Company ("Berry Tri-Plas"), acquired substantially all of the assets of Tri-Plas, Inc. (the "Tri-Plas Acquisition"), a manufacturer of injection molded containers and lids, and added manufacturing plants in Charlotte, North Carolina and York, Pennsylvania. Management believes that the Tri-Plas Acquisition gave the Company an immediate presence in the polypropylene container product line, which is mainly used for food and "hot fill" applications.
In January 1997, the Company acquired certain assets of Container Industries, Inc. ("Container Industries"), a manufacturer and marketer of injection molded industrial and pry-off containers for building products and other industrial markets (the "Container Industries Acquisition"). Management believes the acquisition of Container Industries has provided additional market presence on the west coast, primarily in the pry-off container product line. Also, in January 1997, the Company acquired PackerWare Corporation ("PackerWare"), a manufacturer and marketer of plastic containers, drink cups, housewares, and lawn and garden products (the "PackerWare Acquisition"). Management believes that the PackerWare Acquisition significantly diversified and expanded the Company's position in the drink cup business and gave the Company immediate penetration into the housewares market. The acquisition also provided the Company with a plant located in Lawrence, Kansas, that is well-situated to service its markets.
In May 1997, Berry Plastics Design Corporation ("Berry Design"), a newly formed wholly owned subsidiary of the Company, acquired substantially all of the assets of Virginia Design Packaging Corp. ("Virginia Design"), a manufacturer and marketer of injection-molded containers used primarily for food packaging. Management believes that the acquisition of these assets has enhanced the Company's position in the food packaging and food service markets. In August 1997, the Company acquired Venture Packaging, Inc. ("Venture Packaging"), a manufacturer and marketer of injection-molded containers used in the food, dairy and various other markets (the "Venture Packaging Acquisition"). Management believes that the Venture Packaging Acquisition strategically assisted the Company in marketing its product line of open-top containers and lids.
In July 1998, NIM Holdings ("NIM Holdings"), a newly-formed wholly-owned subsidiary of the Company, acquired all of the capital stock of Norwich Injection Moulders Limited ("Norwich Moulders") of Norwich, England (the "Berry UK Acquisition"), a manufacturer and marketer of injection-molded overcaps and closures for the European market. In fiscal 1999, the Company changed the name from Norwich Injection Moulders Limited to Berry Plastics UK Limited ("Berry UK"). Management believes that the Berry UK Acquisition will provide the Company with a production platform that will allow it to better serve its global customers and to introduce its product lines in Europe. In October 1998, Knight Plastics, Inc. ("Knight") acquired substantially all of the assets of the Knight Engineering and Plastics Division of Courtaulds Packaging Inc. (the "Knight Acquisition"), a manufacturer of aerosol overcaps. Management believes that the Knight Acquisition will enhance the Company's overcap business and better position the Company to meet the needs of its domestic and multi-national customers.
In July 1999, the Company acquired all of the outstanding capital stock of CPI Holding Corporation ("CPI Holding"), the parent company of Cardinal Packaging, Inc. ("Cardinal"), for aggregate consideration of approximately $72.0 million (the "Cardinal Acquisition"). The purchase was financed through the issuance by Berry of $75.0 million of 11% Senior Subordinated Notes. Cardinal, a manufacturer and marketer of open-top containers had fiscal 1998 net sales of approximately $54.0 million. Management believes that the Cardinal Acquisition will enhance the Company's open-top container product selection and provide many of its customers with a single packaging supplier.
PACKAGING PRODUCTS
AEROSOL OVERCAP MARKET
Based on discussions with our customers, sales representatives and external sales brokers, the Company believes it is the worldwide leader in the production of aerosol overcaps. Approximately 20% of the U.S. market consists of marketers who produce overcaps in-house for their own needs. Management believes that a portion of these in-house producers will increase the outsourcing of their production to high technology, low cost manufacturers, such as the Company, as a means of reducing manufacturing assets and focusing on their core marketing objectives.
The Company's aerosol overcaps are used in a wide variety of consumer goods markets including spray paints, household and personal care products, insecticides and numerous other commercial and consumer products. Most U.S. manufacturers and contract fillers of aerosol products are customers of the Company for some portion of their needs. In fiscal 1999, no single overcap customer accounted for more than 2% of the Company's total net sales.
Management believes that, over the years, the Company has developed several significant competitive advantages, including a reputation for outstanding quality, short lead-time requirements to fill customer orders, long-standing relationships with major customers, the ability to accurately reproduce over 3,500 colors, proprietary packing technology that minimizes freight cost and warehouse space, high-speed, low-cost molding and decorating capability and a broad product line of proprietary molds. In addition, the Company received a "Supplier Quality Achievement Award" in 1998 from SC Johnson Wax. The Company continues to develop new products in the overcap market, including the "spray-thru" line of aerosol overcaps.
Major competitors in this market include Dubuque Plastics, Cobra and Transcontainer. In addition, a number of companies, including several of the Company's customers (e.g., S.C. Johnson and Reckitt & Colman), currently produce aerosol overcaps for their own use.
CONTAINER MARKET
The Company classifies its containers into five product lines: thinwall, pry-off, dairy, polypropylene and industrial. Management believes that the Company is the leading U.S. manufacturer in the thinwall, pry-off and frozen dessert (component of dairy) container markets. Management considers industrial containers to be a commodity market, characterized by little product differentiation and an absence of higher margin niches. The following table describes each of the Company's five product lines.
The largest end-uses for the Company's containers are food products, building products, chemicals and dairy products. The Company has a diverse customer base for its container lines, and no single container customer exceeded 2% of the Company's total net sales in fiscal 1999.
Management believes that the Company offers the broadest product line among U.S.-based injection-molded plastic container manufacturers. The Company's container capacities range from 4 ounces to 5 gallons and are offered in various styles with accompanying lids, bails and handles, as well as a wide array of decorating options. In addition to a complete product line, the Company has sophisticated printing capabilities, an in-house graphic arts department, low cost manufacturing capability with eleven plants strategically located throughout the United States and a dedication to high quality products and customer service. Product engineers work with customers to design and commercialize new containers. In addition, as part of the Company's dedication to customer service, the Company provides filling machine equipment to many of the its customers, primarily in the dairy market, and also provides the services necessary to operate such equipment. The Company believes providing such equipment and services increases customer retention by increasing the customer's production efficiency.
The Company seeks to develop niche container products and new applications by taking advantage of the Company's state-of-the-art decorating and graphic arts capabilities and dedication to service and quality. Management believes that these capabilities have given the Company a significant competitive advantage in certain high-margin niche container applications for specialized products. Examples include popcorn containers for new movie promotions and professional and college sporting and entertainment events, where the ability to produce sophisticated and colorful graphics is crucial to the product's success. In order to identify new applications for existing products, the Company relies extensively on its national sales force. Once these opportunities are identified, the Company's sales force interfaces with the Company's product design engineers to satisfy customers' needs.
In non-industrial containers, the Company's strongest competitors include Airlite, Sweetheart, Landis, and Polytainers. The Company also produces commodity industrial pails for a market which is dominated by large volume competitors such as Letica, Plastican, NAMPAC and Ropak. The Company does not participate heavily in this market due to generally lower margins. The Company intends to selectively participate in the industrial container market when higher margin opportunities, equipment utilization or customer requirements make participation an attractive option.
DRINK CUP MARKET
The Company believes that it is the leading provider of injection molded plastic drink cups in the U.S. As beverage producers, convenience stores and fast food restaurants increase their marketing efforts for larger sized drinks, the Company believes that the plastic drink cup market will expand because of plastic's desirability over paper for larger drink cups. The Company produces injection-molded plastic cups that range in size from 12 to 64 ounces. Primary markets are fast food and family dining restaurants, convenience stores, stadiums, and retail stores. Virtually all cups are decorated, often as promotional items, and Berry is known in the industry for innovative, state-of-the-art graphics capability.
Berry has historically supplied a full line of traditional straight-sided and drive-through style drink cups from 12 to 64 ounces with disposable and reusable lids primarily to fast food and convenience store chains. With the PackerWare Acquisition, the Company expanded its presence while diversifying into the stadium and family dining restaurant markets. The 64 ounce cup, which has been highly successful with convenience stores, is one of the Company's fastest growing drink cups. Major drink cup competitors include Packaging Resources Incorporated, Pescor Plastics and WNA (formerly Cups Illustrated).
CUSTOM MOLDED PRODUCTS AND CLOSURES MARKETS
The Company also produces custom molded products by utilizing molds provided by its customers. Typically, the low cost of entry in the custom molded products market creates a commodity-like marketplace. However, the Company has focused its custom molding efforts on those customers that are cognizant of the Company's mold and product design expertise, superior color matching abilities and sophisticated multi-color printing capabilities. The majority of the Company's custom business requires specialized equipment and expertise.
The Company entered the closures market as a result of the Berry UK Acquisition in July 1998. The Company's participation is primarily in the U.K. market. The primary product is a foil sealed milk cap for which demand has increased in recent years with the U.K.'s milk market trending to plastic containers. Norwich offers a broad product line including dispensing, tamper evident and custom molded closures.
HOUSEWARES MARKET
The housewares market is a multi-billion dollar market. The Company's participation is focused on producing seasonal (spring and summer) semi-disposable plastic housewares and plastic lawn and garden products. Examples of our products include plates, bowls, pitchers, tumblers and outdoor flower pots. Berry sells virtually all of its products in this market through major national retail marketers and national chain stores including Wal-Mart and Target. PackerWare is a recognized brand name in these markets and PackerWare branded products are often co-branded by the Company's customers.
The Company's position in this market has been to provide a high value to consumers at a relatively modest price, consistent with the key price points of the retail marketers. Berry believes outstanding service and ability to deliver products with timely combination of color and design further enhance its position in this market. This focus allowed PackerWare to be named 1998 Vendor of the Year by Wal-Mart in its Housewares division.
MARKETING AND SALES
The Company reaches its large and diversified base of over 7,000 customers primarily through its direct field sales force. These field sales representatives are focused on individual product lines, but are encouraged to sell all Company products to serve the needs of the Company's customers. The Company believes that a direct field sales force is able to better focus on target markets and customers, with the added benefit of permitting the Company to control pricing decisions centrally. The Company also utilizes the services of manufacturing representatives to assist its direct sales force.
The Company believes that it produces a high level of customer satisfaction. Highly skilled customer service representatives are located in each of the Company's facilities to support the national field sales force. In addition, telemarketing representatives, marketing managers and sales/marketing executives oversee the marketing and sales efforts. Manufacturing and engineering personnel work closely with field sales personnel to satisfy customers' needs through the production of high quality, value-added products and on-time deliveries.
Additional marketing and sales techniques include a Graphic Arts department with computer-assisted graphic design capabilities and in-house production of photopolymer printing plates. Berry also has a centralized Color Matching and Materials Blending department that utilizes a computerized spectrophotometer to insure that colors match those requested by customers.
MANUFACTURING
GENERAL
The Company manufactures its products using the plastic injection molding process. The process begins when plastic resin, in the form of small pellets, is fed into an injection molding machine. The injection molding machine then melts the plastic resin and injects it into a multi-cavity steel mold, forcing the plastic resin to take the final shape of the product. At the end of each molding cycle (generally five to 25 seconds), the plastic parts are ejected from the mold into automated handling systems from which they are packed in corrugated containers for further processing or shipment. After molding, the product may be either decorated (printing, silk-screening, labeling) or assembled (e.g., bail handles fitted to containers). The Company believes that its molding and decorating capabilities are among the best in the industry.
The Company's overall manufacturing philosophy is to be a low-cost producer by using high speed molding machines, modern multi-cavity hot runner, cold runner and insulated runner molds, extensive material handling automation and sophisticated printing technology. The Company utilizes state-of-the-art robotic packaging processes for large volume products, which enables the Company to deliver a higher quality product (due to reduced breakage) while lowering warehousing and shipping costs (due to more efficient use of space). Each plant has complete tooling maintenance capability to support molding and decorating operations. The Company has historically made, and intends to continue to make, significant capital investments in plant and equipment because of the Company's objectives to grow, improve productivity, and maintain competitive advantages.
PRODUCT DEVELOPMENT
The Company utilizes full-time product engineers who use three-dimensional computer-aided-design (CAD) technology to design and modify new products and prepare mold drawings. Engineers use an in-house model shop, which includes a thermoforming machine, to produce prototypes and sample parts. The Company can simulate the molding environment by running unit-cavity prototype molds in a small injection molding machine dedicated to research and development of new products. Production molds are then designed and outsourced for production by various companies in the United States and Canada with whom the Company has extensive experience and established relationships. The Company's engineers oversee the mold-building process from start to finish.
QUALITY ASSURANCE
Each plant extensively utilizes Total Quality Management philosophies, including the use of statistical process control and extensive involvement of employees to increase productivity. This teamwork approach to problem-solving increases employee participation and provides necessary training at all levels. The Evansville, Henderson, Iowa Falls, Charlotte, and Lawrence plants have been approved for ISO 9000 certification, which certifies compliance by a company with a set of shipping, trading and technology standards promulgated by the International Standardization Organization ("ISO"). The Company is actively pursuing ISO certification in all of the remaining facilities. Extensive testing of parts for size, color, strength and material quality using statistical process control (SPC) techniques and sophisticated technology is also an ongoing part of the Company's traditional quality assurance activities.
SYSTEMS
Berry utilizes a fully integrated computer software system at its plants capable of producing complete financial and operational reports. This accounting and control system is easily expandable to add new features and/or locations as the Company grows. In addition, the Company has in place a sophisticated quality assurance system based on ISO 9000 certification, a bar code based material management system and an integrated manufacturing system.
SOURCES AND AVAILABILITY OF RAW MATERIALS
The most important raw material purchased by the Company is plastic resin. The Company purchased approximately $82.4 million of resin in fiscal 1999. Approximately 66% of the resin pounds purchased were high density polyethylene ("HDPE"), 10% linear low density polyethylene and 24% polypropylene. The Company's purchasing strategy is to deal with only high-quality, dependable suppliers, such as Dow, Union Carbide, Chevron, Nova, Equistar, and Mobil. Although the Company does not have any supply requirements contracts with its key suppliers, management believes that the Company has maintained outstanding relationships with these key suppliers over the past several years and expects that such relationships will continue into the foreseeable future. Based on its experience, the Company believes that adequate quantities of plastic resins will be available, but no assurances can be given.
EMPLOYEES
At the end of fiscal 1999, the Company had approximately 2,800 employees. No employees of the Company are covered by collective bargaining agreements.
PATENTS AND TRADEMARKS
The Company has numerous patents and trademarks with respect to its products. None of the patents or trademarks are considered by management to be material to the business of the Company. See "Legal Proceedings" below.
ENVIRONMENTAL MATTERS AND GOVERNMENT REGULATION
The past and present operations of the Company and the past and present ownership and operations of real property by the Company are subject to extensive and changing federal, state and local environmental laws and regulations pertaining to the discharge of materials into the environment, the handling and disposition of wastes or otherwise relating to the protection of the environment. The Company believes that it is in substantial compliance with applicable environmental laws and regulations. However, the Company cannot predict with any certainty that it will not in the future incur liability under environmental statutes and regulations with respect to non-compliance with environmental laws, contamination of sites formerly or currently owned or operated by the Company (including contamination caused by prior owners and operators of such sites) or the off-site disposal of hazardous substances.
Based upon a May 1998 compliance inspection, the Ohio Environmental Protection Agency ("OEPA") issued a Notice of Violation dated June 23, 1998 to Venture Packaging alleging that the Monroeville, Ohio facility failed to file certain reports required pursuant to the Federal Emergency Planning and Community Right-to-Know Act of 1986 (also known as "SARA Title III") for reporting years 1994 and 1995. The matter has since been closed by the OEPA, and no fines or penalties were assessed.
Like any manufacturer, the Company is subject to the possibility that it may receive notices of potential liability, pursuant to CERCLA or analogous state laws, for cleanup costs associated with offsite waste recycling or disposal facilities at which wastes associated with its operations have allegedly come to be located. Liability under CERCLA is strict, retroactive and joint and several. No such notices are currently pending.
The Food and Drug Administration (the "FDA") regulates the material content of direct-contact food containers and packages, including certain thinwall containers manufactured by the Company. The Company uses approved resins and pigments in its direct contact food products and believes it is in material compliance with all such applicable FDA regulations.
The plastics industry, including the Company, is subject to existing and potential Federal, state, local and foreign legislation designed to reduce solid wastes by requiring, among other things, plastics to be degradable in landfills, minimum levels of recycled content, various recycling requirements, disposal fees and limits on the use of plastic products. In addition, various consumer and special interest groups have lobbied from time to time for the implementation of these and other similar measures. The principal resin used in the Company's products, HDPE, is recyclable, and, accordingly, the Company believes that the legislation promulgated to date and such initiatives to date have not had a material adverse effect on the Company. There can be no assurance that any such future legislative or regulatory efforts or future initiatives would not have a material adverse effect on the Company. On January 1, 1995, legislation in Oregon, California and Wisconsin went into effect requiring products packaged in rigid plastic containers to comply with standards intended to encourage recycling and increased use of recycled materials. Although the regulations vary by state, the principal requirement is the use of post consumer regrind ("PCR") as an ingredient in containers sold for non-food uses. Additionally, Oregon and California allow lightweighting of the container or concentrating the product sold in the container as options for compliance. Oregon and California provide for an exemption from all such regulations if statewide recycling reaches or exceeds 25% of rigid plastic containers. In September 1996, California passed a new bill permanently exempting food and cosmetics containers from the foregoing requirement. However, non-food containers are still required to comply.
In December 1996, the Department of Environmental Quality estimated that Oregon had met its recycling goal of 25% for 1997 (based on 1996 data), and accordingly, was in compliance for the 1997 calendar year. However, in January 1998, California formally approved a 23.2% recycling rate for the state during 1996, and since this falls below the required 25% rate for exemption of non-food containers, the state can now begin enforcing its recycled content mandate on any non-food plastic containers from 8 oz. to 5 gallons. The Company, in order to facilitate individual customer compliance with these regulations, is providing customers the option of purchasing containers with reduced weight.
ITEM 2.
ITEM 2. PROPERTIES
The following table sets forth the Company's principal facilities:
The Company believes that its property and equipment are well-maintained, in good operating condition and adequate for its present needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is party to various legal proceedings involving routine claims which are incidental to its business. Although the Company's legal and financial liability with respect to such proceedings cannot be estimated with certainty, the Company believes that any ultimate liability would not be material to its financial condition.
The Company and/or Berry Sterling are currently litigating two lawsuits that involve United States Patent No. Des. 362,368 (the "'368 Patent"). The '368 Patent claims an ornamental design for a cup that fits an automobile cup holder. On September 21, 1995, Berry Sterling filed suit in United States District Court, Eastern District of Virginia, against Pescor Plastics, Inc. ("Pescor Plastics") for infringement of the '368 Patent. Pescor Plastics filed counterclaims seeking a declaratory judgment of invalidity and non-infringement, and damages under the Lanham Act. On December 28, 1995, Berry Sterling filed suit against Packaging Resources Incorporated ("Packaging Resources") in United States District Court, Southern District of New York, for infringement of the '368 Patent and seeking, among other equitable relief, damages in an unspecified amount. Packaging Resources has filed counterclaims against Berry Sterling alleging violation of the Lanham Act, tortious interference with Packaging Resources' prospective business advantage, consumer fraud and requesting a declaratory judgment that its "Drive-N-Go" cup does not infringe the '368 Patent. Packaging Resources has not specified the amount of damages sought. On February 25, 1998, after trial, a jury rendered a verdict in Berry Sterling's action against Pescor Plastics. The jury found the '368 Patent to be invalid on the grounds of functionality and obviousness and awarded Pescor $150,000 on its counterclaim. The jury also found that Pescor willfully infringed the '368 Patent and awarded Berry Sterling damages of $1.2 million, but this award was not included in the judgment because of the finding of the invalidity of the `368 Patent. On March 11, 1998, Berry Sterling filed a motion with the Court to set aside the verdict of invalidity and the award on the counterclaim, which was subsequently denied by the
Court. On April 29, 1998, Berry Sterling filed a Notice of Appeal of the Court's judgment and the denial of its motion to set aside the jury's verdict. Oral argument for the appeal took place on January 5, 1999.
On August 30, 1999, the United States Court of Appeals for the Federal Circuit decided Berry Sterling's appeal in the Pescor Plastics case. The Federal Circuit affirmed the jury's finding that the patent owned by Berry Sterling was invalid. The Federal Circuit also affirmed in part and reversed in part the jury's finding of a Lanham Act violation, reducing the amount of the damages award against Berry Sterling from $150,000 to $7,490. The stipulated final judgment against Berry Sterling in the Pescor case was $24,171, including costs and applicable interest. The judgement was paid in September 1999, and the case was closed.
Pursuant to the terms of a Stipulation and Order executed by Berry Sterling and Packaging Resources Incorporated, the Packaging Resources case will be taken off the suspense calendar and restored to the Court's active docket. Based on the invalidity of the patent, Packaging Resources is seeking to dismiss Berry Sterling's patent infringement claim in that case. Packaging Resources also currently intends to pursue its counterclaim's against Berry Sterling alleging violation of the Lanham Act, tortious interference with Packaging Resource's prospective business advantage and consumer fraud.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There is no public trading market for any class of common stock of the Company, Holding, Berry Iowa, Berry Tri-Plas, Berry Sterling, Aerocon, PackerWare, Berry Design, Venture Packaging, Venture Midwest, Venture Southeast, NIM Holdings, Berry UK, Knight, CPI Holding, Cardinal, Norwich Acquisition Limited or Berry Acquisition. With respect to the capital stock of Holding, as of March 28, 2000, there were three holders of the Class A Voting Common Stock, three holders of the Class A Nonvoting Common Stock, 41 holders of the Class B Voting Common Stock, 81 holders of the Class B Nonvoting Common Stock and 40 holders of the Class C Nonvoting Common Stock. All of the issued and outstanding common stock of the Company is held by Holding, and all of the issued and outstanding common stock of Berry Iowa, Berry Tri-Plas, Berry Sterling, Aerocon, PackerWare, Berry Design, Venture Packaging, NIM Holdings, CPI Holding, Knight, and Berry Acquisition is held by the Company. All of the issued and outstanding common stock of Venture Midwest and Venture Southeast is held by Venture Packaging, and all of the issued and outstanding common stock of Berry UK is held by NIM Holdings. All of the issued and outstanding common stock of Cardinal is held by CPI Holding, and all of the issued and outstanding common stock of Norwich Acquisition Limited is held by Berry UK.
On April 21, 1994, the Company paid a $50.0 million dividend, which was financed through the issuance of the 1994 Notes, to Holding, the holder of all of its common stock. Holding utilized the $50.0 million dividend to make a distribution to the holders of its common stock and holders of certain other equity interests.
Other than the payment of the $50.0 million distribution described above, Holding has not paid cash dividends on its capital stock. Because Holding intends to retain any earnings to provide funds for the operation and expansion of the Company's business and to repay outstanding indebtedness, Holding does not intend to pay cash dividends on its common stock in the foreseeable future. Furthermore, as a holding company with no independent operations, the ability of Holding to pay cash dividends will be dependent on the receipt of dividends or other payments from the Company. Under the terms of the Indenture dated as of April 21, 1994 (the "1994 Indenture"), among the Company, Holding, Berry Iowa, Berry Tri-Plas and United States Trust Company of New York, as Trustee ("U.S. Trust", the Indenture dated June 18, 1996 (the "1996 Indenture"), between Holding and First Trust of New York, National Association, as Trustee, and also the Indenture dated August 24, 1998 (the "1998 Indenture") and the Indenture dated July 6, 1999 (the "1999 Indenture"), among Holding, all of its direct and indirect subsidiaries and U.S. Trust, Holding and the Company are not permitted to pay any dividends on their common stock for the foreseeable future. In addition, the Credit Facility contains covenants that, among other things, restricts the payment of dividends by the Company. In addition, Delaware law limits Holding's ability to pay dividends from current or historical earnings or profits or capital surplus. Any determination to pay cash dividends on common stock of the Company or Holding in the future will be at the discretion of the Board of Directors of the Company and Holding, respectively.
On July 6, 1999, the Company issued $75.0 million aggregate principal amount of 11% Senior Subordinated Notes due 2007, in which Donaldson, Lufkin, and Jenrette Securities Corporation and Chase Securities Inc. acted as initial purchaser. The offering was exempt from the registration requirements under the Securities Act pursuant to Rule 144A and Regulation S promulgated thereunder. Discount and commissions paid to the initial purchasers in connection with the offering were $2,250,000.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the consolidated financial statements of Holding which have been audited by Ernst & Young LLP, independent auditors. The data should be read in connection with the consolidated financial statements, related notes and other financial information included herein. Holding's fiscal year is a 52/53 week period ending generally on the Saturday closest to December 31. All references herein to "1999," "1998," "1997," "1996," and "1995" relate to the fiscal years ended January 1, 2000, January 2, 1999, December 27, 1997, December 28, 1996, and December 30, 1995, respectively.
(a)Operating expenses include business start-up and machine integration expenses of $3,649 related to recent acquisitions and plant consolidation expenses of $1,501 related to the shutdown and reorganization of facilities during fiscal 1999; business start-up and machine integration expenses of $1,272 related to the 1997 Acquisitions (as hereinafter defined), plant consolidation expenses of $2,370 and $191 related to the shutdown of the Anderson, South Carolina and Reno, Nevada facilities, and start-up expenses of $109 and $142 related to the Norwich and Knight Acquisitions, respectively, during fiscal 1998; business start-up and machine integration expenses of $3,255 related to the 1997 Acquisitions, plant consolidation expenses of $480 and $368 related to the shutdown of the Winchester, Virginia and Reno, Nevada facilities, respectively, during fiscal 1997; one-time compensation expense of $2,762, Tri-Plas Acquisition start-up expenses of $671 and $907 for costs related to the consolidation of the Winchester, Virginia facility during fiscal 1996; and pursued acquisition costs of $473 and business start-up expenses of $394 in fiscal 1995.
(b)Other expenses consist of loss on disposal of property and equipment for the respective years.
(c)Includes non-cash interest expense of $8,888, $1,765, $2,005, $1,212, and $950 in fiscal 1999, 1998, 1997, 1996, and 1995, respectively.
(d)Depreciation and amortization excludes non-cash amortization of deferred financing and origination fees and debt premium/discount amortization which are included in interest expense.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Unless the context discloses otherwise, the "Company" as used in this Management's Discussion and Analysis of Financial Condition and Results of Operations shall include Holding and its subsidiaries on a consolidated basis. The following discussion should be read in conjunction with the consolidated financial statements of Holding and its subsidiaries and the accompanying notes thereto, which information is included elsewhere herein.
The Company is highly leveraged. The high degree of leverage could have important consequences, including, but not limited to, the following: (i) a substantial portion of Berry's cash flow from operations must be dedicated to the payment of principal and interest on its indebtedness, thereby reducing the funds available to Berry for other purposes; (ii) Berry's ability to obtain additional debt financing in the future for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired; (iii) certain of Berry's borrowings will be at variable rates of interest, which will expose Berry to the risk of higher interest rates; (iv) the indebtedness outstanding under the Credit Facility is secured by substantially all of the assets of Berry; (v) Berry is substantially more leveraged than certain of its competitors, which may place Berry at a competitive disadvantage, particularly in light of its acquisition strategy; and (vi) Berry's degree of leverage may hinder its ability to adjust rapidly to changing market conditions and could make it more vulnerable in the event of a downturn in general economic conditions or its business.
Berry's ability to pay principal and interest on the Notes will depend on Berry's financial and operating performance, which in turn are subject to prevailing economic conditions and to certain financial, business and other factors beyond its control. However, if Berry cannot generate sufficient cash flow from operations to meet its obligations, then it may be forced to take actions such as reducing or delaying capital expenditures, selling assets, restructuring or refinancing its indebtedness, or seeking additional equity capital. There is no assurance that any of these remedies could be effected on satisfactory terms, if at all.
Consolidated earnings have been insufficient to cover fixed charges by $7.1 million, $7.0 million, and $13.9 million for fiscal year 1999, 1998, and 1997, respectively. In addition, Holding has experienced consolidated net losses during each of such periods principally as a result of expenses and charges incurred in connection with acquisitions by Berry. These net losses were $9.1 million, $7.6 million, and $14.4 million for fiscal 1999, 1998, and 1997. Holding expects that it will continue to experience consolidated net losses for the foreseeable future.
YEAR ENDED JANUARY 1, 2000 COMPARED TO YEAR ENDED JANUARY 2, 1999
NET SALES. Net sales increased 21% to $328.8 million in 1999, up $57.0 million from $271.8 million in 1998, including an approximate 1% increase in net selling price due to increased raw material costs. Plastic packaging product net sales increased $53.2 million in fiscal 1999. Within this segment, aerosol overcap net sales increased $17.3 million primarily due to the Knight Acquisition. In addition, container sales increased $27.5 million, primarily due to the Cardinal Acquisition and continued market strength of base products. Net sales in the drink cup product line decreased $6.2 million in 1999 primarily as a result of a large promotion in 1998 and increased competition in the drink cup market. Other plastic packaging product lines, including closures and custom molded products, increased $14.5 million due to a large custom program in 1999 and the acquisition of Berry UK in 1998. Housewares net sales increased $3.8 million or 18% in 1999 due primarily to new products and strong consumer demand.
GROSS MARGIN. Gross margin increased $15.2 million or 21% from $72.6 million (27% of net sales) in 1998 to $87.8 million (27% of net sales) in 1999. This increase of 21% includes the combined impact of the added Cardinal, Berry UK, and Knight sales volume, acquisition integration, and productivity improvement initiatives offset partially by higher raw material costs. A major focus continues to be the consolidation of products and business of recent acquisitions to the most efficient tooling, providing customers with improved products and customer service. As part of the integration, the Company closed its Arlington Heights, Illinois facility (acquired in the Knight Acquisition) in the first quarter of 1999 and its Ontario, California facility (acquired in the Cardinal Acquisition) in the third quarter of 1999. In addition, the Company made two configuration changes that were completed in the fourth quarter of 1999 with the Minneapolis, Minnesota (acquired in the Cardinal Acquisition) and Iowa Falls, Iowa locations closing their molding operations. The business from these locations are distributed throughout Berry's facilities. Also, significant productivity improvements were made during the year, including the addition of state-of-the-art injection molding equipment, molds and printing equipment at several of the Company's facilities.
OPERATING EXPENSES. Operating expenses during 1999 were $54.1 million (16% of net sales), compared with $44.0 million (16% of net sales) for 1998. Selling expenses increased $2.6 million, almost all a result of expanded sales coverage and recent acquisitions. General and administrative expenses increased $2.7 million in 1999 primarily as a result of recent acquisitions. Research and development costs increased $0.6 million to $2.3 million in 1999 primarily as a result of increased new product requests from customers and productivity improvement initiatives. Intangible amortization increased from $4.1 million in 1998 to $7.2 million for 1999, primarily a result of the amortization of goodwill ascribed to acquired companies in 1998 and 1999. Other expenses were $5.1 million for 1999 compared to $4.1 million for 1998. Other expenses in 1999 include business start-up and machine integration expenses of $3.6 million related to recent acquisitions and plant consolidation expenses of $1.5 million related to the shutdown and reorganization of facilities. Other expenses in 1998 include business start-up and machine integration expenses of $1.5 million related to recent acquisitions and plant consolidation expenses of $2.6 million related to the shutdown of facilities.
INTEREST EXPENSE AND INCOME. Net interest expense, including amortization of deferred financing costs for 1999, was $40.8 million (12% of net sales) compared to $34.6 million (13% of net sales) in 1998, an increase of $6.2 million. This increase is attributed to interest on borrowings related to the acquired businesses in 1998 and 1999 offset partially by principal reductions. Cash interest paid in 1999 was $29.8 million as compared to $33.2 million for 1998.
INCOME TAXES. During fiscal 1999, the Company recorded an expense of $0.6 million for income taxes compared to a benefit of $0.2 million for fiscal 1998. The Company continues to operate in a net operating loss carryforward position for federal income tax purposes.
NET LOSS. The Company recorded a net loss of $9.1 million in 1999 compared to a $7.6 million net loss in 1998 for the reasons stated above.
YEAR ENDED JANUARY 2, 1999 COMPARED TO YEAR ENDED DECEMBER 27, 1997
NET SALES. Net sales increased 19.8% to $271.8 million in 1998, up $44.9 million from $227.0 million in 1997, despite an approximate 2% decrease in net selling price due mainly to competitive market conditions. Container sales increased $34.5 million in 1998, primarily due to the continued market strength of base products and the Venture Packaging Acquisition. Net sales in the drink cup product line increased $2.3 million in 1998 as a result of a large promotion. Aerosol overcap net sales increased approximately $2.0 million due to the Knight Acquisition.
Housewares net sales increased $4.0 million or 23% in 1998 due primarily to new products and strong market demands. The Berry UK Acquisition also brought the Company into the U.K. market, primarily closures product sales, which provided an additional $7.3 million of net sales in 1998. Other product lines, including custom molded products and custom mold building, decreased $5.2 million due to large custom programs that occurred in 1997.
GROSS MARGIN. Gross margin increased $25.9 million or 55.5% from $46.7 million (20.6% of net sales) in 1997 to $72.6 million (26.7% of net sales) in 1998. The increase in gross margin is primarily attributed to increased sales volume as described above, acquisition integration, productivity improvements, and lower raw material costs. A major focus during 1998 was the consolidation of products and business of the 1997 Acquisitions (as defined herein) to the most efficient tooling, providing customers with the best product and customer service. As part of the integration, the Company closed the Anderson, South Carolina facility, which was acquired in the Venture Packaging Acquisition, in 1998 with the majority of the business being transferred to the Charlotte, North Carolina plant. Also, productivity improvements were made during the year, including the addition of state-of-the-art injection molding equipment, molds and printing equipment at several of the Company's facilities.
OPERATING EXPENSES. Operating expenses during 1998 were $44.0 million (16.2% of net sales), compared with $30.5 million (13.4% of net sales) for 1997. Sales related expenses, including the cost of expanded sales coverage and higher product development and marketing expenses, increased $3.5 million, almost all a result of the 1997 Acquisitions. General and administrative expenses increased $7.8 million in 1998 primarily as a result of the 1997 and 1998 Acquisitions, increased patent litigation expenses and increased employee profit sharing expense. Intangible amortization increased from $2.2 million in 1997 to $4.1 million for 1998, primarily a result of the amortization of goodwill ascribed to acquired companies in 1997 and 1998. Other expense was $4.1 million for 1998 and 1997. The 1997 Acquisitions resulted in additional expenses of $3.2 million and $1.3 million in 1997 and 1998, respectively, for start-up related expenses. The PackerWare Acquisition included a facility in Reno, Nevada, which was closed in 1997. Expense related to the closing of the Reno facility was $0.5 million and $0.2 million in 1997 and 1998, respectively. Plant closing expenses related to the Winchester, Virginia facility resulted in expenses of $0.4 million for 1997. The closing of the Anderson, South Carolina facility resulted in 1998 expenses of $2.4 million.
INTEREST EXPENSE AND INCOME. Net interest expense, including amortization of deferred financing costs for 1998, was $34.6 million (12.7% of net sales) compared to $30.2 million (13.3% of net sales) in 1997, an increase of $4.3 million. This increase is attributed to interest on borrowings related to the 1997 and 1998 acquisitions offset partially by principal reductions. Cash interest paid in 1998 was $33.2 million as compared to $29.9 million for 1997. Interest income for 1998 was $1.0 million, down from $2.0 million in 1997, which is attributable to an additional year of interest payments on the 12.50% Series B Senior Secured Notes due 2006 ("1996 Notes") from the escrow account.
INCOME TAXES. During fiscal 1998, the Company recorded a benefit of $0.2 million in federal and state income tax, primarily due to a carryback claim, compared to an expense of $0.1 million for fiscal 1997. The Company continues to operate in a net operating loss carryforward position for federal income tax purposes.
NET LOSS. The Company recorded a net loss of $7.6 million in 1998 compared to a $14.4 million net loss in 1997 for the reasons stated above.
INCOME TAX MATTERS
Holding has unused operating loss carryforwards of $30.5 million for federal income tax purposes which begin to expire in 2010. Alternative minimum tax credit carryforwards of approximately $3.1 million are available to Holding indefinitely to reduce future years' federal income taxes.
LIQUIDITY AND CAPITAL RESOURCES
The Company has a credit facility with Bank of America for a senior secured line of credit. As of January 1, 2000, the Credit Facility provides the Company with (i) a $70.0 million revolving line of credit, subject to a borrowing base formula, (ii) a $2.4 million (using the January 1, 2000 exchange rate) revolving line of credit in the U.K. ("UK Revolver"), subject to a borrowing base formula, (iii) a $50.0 million term loan facility, (iv) a $5.2 million (using the January 1, 2000 exchange rate) term loan facility in the U.K. ("UK Term Loan") and (v) a $4.2 million standby letter of credit facility to support the Company's and its subsidiaries' obligations under the Nevada Bonds. The indebtedness under the Credit Facility is guaranteed by Holding and the Company's subsidiaries and is secured by substantially all of the assets of the Company and guarantors. The Credit Facility
requires the Company to comply with specified financial ratios and tests, including a minimum Tangible Capital Funds (as defined in the Credit Facility) test, maximum leverage ratio, interest coverage ratio, debt service coverage ratio and a fixed charge coverage ratio. The requirements of these tests may change on a quarterly basis. At January 1, 2000, the Credit Facility required the Company to have Tangible Capital Funds of not less than $73.9 million and a maximum leverage ratio of 4.5. In addition, the interest, debt service, and fixed charge coverage ratios could not be less than 2.5, 1.5, and 1.0, respectively. At January 1, 2000, the last quarterly test date, the Company was in compliance with all of the financial covenants tested on such date.
The Credit Facility matures on January 21, 2002 unless previously terminated by the Company or by the lenders upon an Event of Default as defined in the Security Agreement. The term loan facility requires periodic payments, varying in amount, through the maturity of the facility. Such periodic payments will aggregate approximately $20.4 million for fiscal 2000. Interest on borrowings under the Credit Facility is based on either (i) the lender's base rate (which is the higher of the lender's prime rate and the federal funds rate plus 0.50%) plus an applicable margin of 0.50% or (ii) LIBOR (adjusted for reserves) plus an applicable margin of 2.0%, at the Company's option. Following receipt of the quarterly financial statements, the agent under the Credit Facility has the option to change the applicable interest rate margin on loans (other than under the UK Revolver and UK Term Loan) once per quarter to a specified margin determined by the ratio of funded debt to EBITDA of the Company and its subsidiaries. Notwithstanding the foregoing, interest on borrowings under the UK Revolver and the UK Term Loan is based on LIBOR (adjusted for reserves) plus 2.50%.
The 1994 Indenture, the 1996 Indenture, the 1998 Indenture, and 1999 Indenture restrict the Company's ability to incur additional debt and contain other provisions, which could limit the liquidity of the Company. At January 1, 2000, the Company had unused borrowing capacity under the Credit Facility's borrowing base of $22.3 million, which is not considered additional indebtedness under the 1994 Indenture, 1996 Indenture, 1998 Indenture or 1999 Indenture. Any additional indebtedness above the borrowing base requires approval from the Credit Facility's lenders.
Net cash provided by operating activities was $36.0 million in 1999 as compared to $34.1 million in 1998. The increase was primarily the result of improved operating performance as the Company's net loss plus non-cash expenses improved $5.8 million. Net cash provided by operating activities was $34.1 million in 1998 as compared to $14.2 million in 1997. The increase was primarily the result of improved operating performance.
Capital expenditures in 1999 were $30.7 million, an increase of $8.1 million from $22.6 million in 1998. Included in capital expenditures during 1999 was $9.5 million relating to a major facility renovation, production systems and offices necessary to support production operating levels throughout the Company. Capital expenditures in 1999 also included investment of $12.7 million for molds, $3.4 million for molding and printing machines, and $5.1 million for accessory equipment and systems. The capital expenditure budget for 2000 is expected to be $33.6 million, including approximately $11.7 million for building and systems which includes additions to three current facilities, $14.4 million for molds, $3.8 million for molding and printing machines, and $3.7 million for accessory equipment.
Net cash provided by financing activities was $71.1 million in 1999 as compared to $17.6 million in 1998. The $53.5 million increase can be attributed primarily to the 1999 Notes issuance of $75.0 million to finance the Cardinal Acquisition. Net cash provided by financing activities was $17.6 million in 1998 as compared to $80.4 million in 1997. The $62.8 million decrease can be attributed primarily to a $52.4 million decrease in borrowings to finance acquisitions.
Increased working capital needs occur whenever the Company experiences strong incremental demand or a significant rise in the cost of raw material, particularly plastic resin. However, the Company anticipates that its cash interest, working capital and capital expenditure requirements for 2000 will be satisfied through a combination of funds generated from operating activities and cash on hand, together with funds available under the Credit Facility. Management bases such belief on historical experience and the substantial funds available under the Credit Facility. However, the Company cannot predict its future results of operations.
The 1994 Indenture, 1998 Indenture, and 1999 Indenture restrict, and the Credit Facility prohibits, Berry's ability to pay any dividend or make any distribution of funds to Holding to satisfy interest and other obligations on the 1996 Notes. Based upon historical operating results, without a substantial increase in the operating results of Berry, management anticipates that it will be unable to generate sufficient cash flow to permit a dividend to Holding in an amount sufficient to meet Holding's interest payment obligations under the 1996 Notes. Interest on the 1996 Notes is payable semi-annually on June 15 and December 15 of each year. However, from December 15, 1999 until June 15, 2001, Holding may, at its option, pay interest, at an increased rate of 0.75% per annum, in additional 1996 notes valued at 100% of the principal amount thereof. On December 15, 1999, Holding issued an additional approximately $7.0 million aggregate principal amount of 1996 Notes in satisfaction of its interest obligation. After June 15, 2001 or in the event that Holding does not pay interest in additional notes, management anticipates that such interest obligations will only be met by refinancing the 1996 Notes or raising capital through equity offerings. We can not assure you that then-current market conditions would permit Holding to consummate a refinancing or equity offering.
At January 1, 2000, the Company's cash balance was approximately $2.5 million, and the Company had unused borrowing capacity under the Credit Facility's borrowing base of approximately $22.3 million.
GENERAL ECONOMIC CONDITIONS AND INFLATION
The Company faces various economic risks ranging from an economic downturn adversely impacting the Company's primary markets to market fluctuations in plastic resin prices. In the short-term, rapid increases in resin cost may not be fully recovered through price increases to customers. Also, shortages of raw materials may occur from time to time. In the long-term, however, raw material availability and price changes generally do not have a material adverse effect on gross margin. Cost changes generally are passed through to customers. In addition, the Company believes that its sensitivity to economic downturns in its primary markets is less significant due to its diverse customer base and its ability to provide a wide array of products to numerous end markets.
The Company believes that it is not affected by inflation except to the extent that the economy in general is thereby affected. Should inflationary pressures drive costs higher, the Company believes that general industry competitive price increases would sustain operating results, although there can be no assurance that this will be the case.
IMPACT OF YEAR 2000
The Company has been modifying or replacing portions of its software since 1991 so that its computer systems will function properly with respect to dates in the Year 2000 and thereafter. Because this process was commenced early, the costs incurred to address this issue in any single year have not been significant. The Company's current business applications are Year 2000 compliant. Acquired businesses are converted to the Company's applications for Year 2000 compliance and consistency in applications and reporting. The most recent acquired businesses, Knight and Cardinal, were converted to the Company's applications by March 1, 1999 and January 10, 2000, respectively.
However, the Company is currently in the process of replacing its current business software with another Year 2000 compliant package. This replacement is not due to any Year 2000 issues, but is needed to accommodate the changes that have been experienced in the business due to acquisitions in recent years. The anticipated cost of this conversion is about $2.8 million of which $2.6 million has been paid through January 1, 2000. The accounting phase of this conversion was completed for all plants in January 1999. The remaining phases are scheduled to be completed by the end of 2000.
The Company believes it has an effective program in place to resolve all internal Year 2000 issues and that all such issues were adequately resolved prior to January 1, 2000. An inventory of computer based systems has been compiled and verified through testing and supplier verification. The Company replaced the voicemail system in the Lawrence plant for about $80,000. In addition, the computer on the palletizer in the Woodstock plant has been back-dated, which has not had any impact on operations. This system is planned to be upgraded by the end of 2000.
The anticipated cost of this upgrade is about $13,000. No internal Year 2000 problems have been experienced to date by Company.
The major Year 2000 risk that the Company faces is the Year 2000 readiness of external suppliers of goods and services. This could have material disruption in our ability to produce and deliver product should there be major disruptions in the economy or failure of key suppliers. While it is impossible to account for the effectiveness of every supplier's Year 2000 efforts, the following steps have been completed:
o Identified key suppliers, which include suppliers of raw material, banking, transportation, service, and utility providers and surveying these suppliers as to their Year 2000 status; o Identified which suppliers are not compliant or at risk; and o Engaged in risk assessment and contingency planning for these key suppliers.
The Company completed a survey of 304 "key suppliers" to determine their Year 2000 status. The Company did not identify any suppliers who were not Year 2000 compliant or at risk. The Company does not currently have any contingency plans in place. The Company has not experienced any Year 2000 problems with any suppliers to date.
Management believes that the Company has effectively resolved any potential Year 2000 problems, has not experienced any Year 2000 problems to date and does not currently expect to incur any additional costs for Year 2000 compliance. However, the Company may not have identified and remedied all Year 2000 problems. If any Year 2000 issues arise, any remediation efforts could involve significant time and expense and may have a material adverse effect on our business.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Auditors Consolidated Balance Sheets at January 1, 2000 and January 2, 1999 Consolidated Statements of Operations for the years ended January 1, 2000, January 2, 1999, and December 27, 1997 Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the years ended January 1, 2000, January 2, 1999, and December 27, 1997 Consolidated Statements of Cash Flows for the years ended January 1, 2000, January 2, 1999, and December 27, 1997
Notes to Consolidated Financial Statements
INDEX TO FINANCIAL STATEMENT SCHEDULES
I. Condensed Financial Information of Parent Company S-1 II. Valuation and Qualifying Accounts S-5
All other schedules have been omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or notes thereto.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information with respect to the executive officers, directors and certain key personnel of Holding and its subsidiaries:
(1) Member of the Stock Option Committee of Holding. (2) Member of the Audit Committee of Holding. (3) Member of the Audit Committee of the Company. (4) Member of the Compensation Committee of the Company.
ROBERTO BUARON has been Chairman and a Director of the Company since it was organized in December 1990. He has also served as Chairman and a Director of Holding since 1990. He is the Chairman and Chief Executive Officer of First Atlantic Capital, Ltd. ("First Atlantic"), which he founded in 1989. From 1987 to 1989, he was an Executive Vice President with Overseas Partners, Inc., an investment management firm. From 1983 to 1986 he was First Vice President of Smith Barney, Inc., and a General Partner of First Century Partnership, its venture capital affiliate. Prior to 1983, he was a Principal at McKinsey & Company. Mr. Buaron is also a director of CFP Holdings, Inc., a processed meat company.
MARTIN R. IMBLER has been President, Chief Executive Officer and a Director of the Company since January 1991. He has also served as a Director of Holding since January 1991, and as President of Holding since May 1996. From June 1987 to December 1990, he was President and Chief Executive Officer of Risdon Corporation, a cosmetic packaging company. Mr. Imbler was employed by American Can Company from 1981 to 1987, as Vice President and General Manager of the East/South Region Food and General Line Packaging business from 1985 to 1987 and as Vice President, Marketing, from 1981 to 1985. Mr. Imbler is also a Director of Portola Packaging, Inc., a manufacturer of closures used in the dairy industry.
IRA G. BOOTS has been Executive Vice President, Operations, and a Director of the Company since April 1992. Prior to that, Mr. Boots was Vice President of Operations, Engineering and Product Development of the Company from December 1990 to April 1992. Mr. Boots was employed by Old Berry from 1984 to December 1990 as Vice President, Operations.
JAMES M. KRATOCHVIL has been Executive Vice President, Chief Financial Officer, Secretary and Treasurer of the Company since December 1997. He formerly served as Vice President, Chief Financial Officer and Secretary of the Company since 1991, and as Treasurer of the Company since May 1996. He was also promoted to Executive Vice President, Chief Financial Officer and Secretary of Holding in December 1997. He formerly served as Vice President, Chief Financial Officer and Secretary of Holding since 1991. Mr. Kratochvil was employed by Old Berry from 1985 to 1991 as Controller.
R. BRENT BEELER has been Executive Vice President, Sales and Marketing since February 1996. He formerly served as Vice President, Sales and Marketing of the Company since December 1990. Mr. Beeler was employed by Old Berry from October 1988 to December 1990 as Vice President, Sales and Marketing.
RANDY HOBSON has been Vice President - Sales and Marketing of the Company since June 1998. Mr. Hobson was Marketing Manager - Containers for the Company from November 1997 to June 1998. Prior to that, he was a Regional Sales Manager from 1992 to November 1997. Mr. Hobson joined Old Berry in 1988.
DOUGLAS E. BELL has been Vice President, Sales and Marketing of the Company since August 1999. Mr. Bell retired from the Company in June 1998 and worked as a consultant for the Company until his return in August 1999. From March 1991 to June 1998, he served as Executive Vice President, Sales and Marketing and a Director of the Company.
STEPHEN P. CASSIDY has been Vice President, Operations of the Company since August 1999. From January 1997 to August 1999, he was Vice President of Courtaulds Packaging. From 1995 to 1997, Mr. Cassidy was Operating Director of Courtaulds Asia. Mr. Cassidy was Chief Executive from 1993 to 1995 for Courtaulds Powder Coatings Malaysia.
BRUCE J. SIMS has been Vice President, Sales and Marketing, Housewares of the Company since January 1997. Prior to the PackerWare Acquisition, Mr. Sims served as President of PackerWare from March 1996 to January 1997 and as Vice President from October 1994 to March 1996. From January 1990 to October 1994 he was Vice President of the Miner Container Corporation, a national injection molder. Mr. Sims was Executive Vice President of MKM Distribution Company from 1985 to 1990.
LAWRENCE G. GRAEV has been a Director of the Company and Holding since August 1995. Mr. Graev is a partner in the law firm of O'Sullivan Graev & Karabell, LLP of New York, where he has been a partner since 1974. Mr. Graev is also a Director of First Atlantic.
JOSEPH S. LEVY has been Vice President and Assistant Secretary of the Company and Holding since April 1995. Mr. Levy has been a Director of Holding and the Company since April 1998. Mr. Levy has been Principal of First Atlantic since December 1999, and prior to that Mr. Levy had been a Vice President.
DONALD J. HOFMANN, JR. has been a Director of Holding and the Company since June 1996. Mr. Hofmann has been a General Partner of Chase Capital Partners since 1992. Prior to that, he was head of MH Capital Partners Inc., the equity investment arm of Manufacturers Hanover. Mr. Hofmann is also a director of Advanced Accessory Systems, LLC, a manufacturer of towing and rack systems and related accessories for automobiles.
MATHEW J. LORI has been a Director of Holding and the Company since October 1996. Mr. Lori has been a Principal with Chase Capital Partners since January 1998, and prior to that, Mr. Lori had been an Associate since April 1996. From September 1993 to March 1996, he was an Associate in the Merchant Banking Group of The Chase Manhattan Bank, N.A.
DAVID M. CLARKE has been a Director of Holding and the Company since June 1996. Mr. Clarke is a Managing Director with Aetna, Inc., a private equity investment group and, prior to that, he had been a Vice President in the Investment Group of Aetna Life Insurance Company from 1988 to 1996.
The Stockholders Agreement (as defined herein) contains provisions regarding the election of directors. See "Certain Relationships and Related Transactions - Stockholders Agreements."
BOARD COMMITTEES
The Board of Directors of Holding has an Audit Committee and a Stock Option Committee, and the Board of Directors of the Company has an Audit Committee and a Compensation Committee. The Audit Committees oversee the activities of the independent auditors and internal controls. The Stock Option Committee administers the BPC Holding Corporation 1996 Stock Option Plan. The Compensation Committee makes recommendations to the Board of Directors of the Company concerning salaries and incentive compensation for officers and employees of the Company.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth a summary of the compensation paid by the Company to its Chief Executive Officer and the four other most highly compensated executive officers of the Company (collectively, the "Named Executive Officers") for services rendered in all capacities to the Company during fiscal 1999, 1998 and 1997:
SUMMARY COMPENSATION TABLE
(1) Amounts shown reflect contributions by the Company under the Company's 401(k) plan.
FISCAL YEAR-END OPTION HOLDINGS
The following table provides information on the number of exercisable and unexercisable management stock options held by the Named Executive Officers at January 1, 2000.
FISCAL YEAR-END OPTION VALUES(1)
NUMBER OF UNEXERCISED VALUE OF UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS FISCAL YEAR-END AT FISCAL YEAR-END NAME EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE ---- ------------------------- ------------------------- (#)(2) (2)
Martin R. Imbler 5,930/2,542 $747,180/$320,292 Ira G. Boots 3,650/1,564 459,900/197,064 James M. Kratochvil 2,281/978 287,406/123,228 R. Brent Beeler 2,281/978 287,406/123,228 Bruce J. Sims 650/650 76,700/76,700
(1) None of Holding's capital stock is currently publicly traded. The values reflect management's estimate of the fair market value of the Class B Nonvoting Common Stock at January 1, 2000.
(2) All options granted to management of the Company are exercisable for shares of Class B Nonvoting Common Stock, par value $.01 per share, of Holding.
DIRECTOR COMPENSATION
Directors receive no cash consideration for serving on the Board of Directors of Holding or the Company, but directors are reimbursed for out-of-pocket expenses incurred in connection with their duties as directors.
EMPLOYMENT AGREEMENTS
The Company has an employment agreement with Mr. Imbler (the "Imbler Employment Agreement") that expires on June 30, 2001. Base compensation under the Imbler Employment Agreement for fiscal 1999 was $362,940. The Imbler Employment Agreement also provides for an annual performance bonus of $50,000 to $175,000 based upon the Company's attainment of certain financial targets. The Company may terminate Mr. Imbler's employment for "cause" or upon a "disability" (as such terms are defined in the Imbler Employment Agreement). If the Company terminates Mr. Imbler "without cause" (as defined in the Imbler Employment Agreement), Mr. Imbler is entitled to receive, among other things, the greater of (i) one year's salary or (ii) 1/12 of one year's salary for each year (not to exceed 24 years in the aggregate) of employment with the Company. The Imbler Employment Agreement also contains customary noncompetition, nondisclosure and nonsolicitation provisions.
The Company also has employment agreements with each of Messrs. Boots, Kratochvil, Beeler, and Sims (each, an "Employment Agreement" and, collectively, the "Employment Agreements"). The agreements for Boots, Kratochvil and Beeler expire on June 30, 2001, and the agreement for Sims expires on January 21, 2002. The Employment Agreements provided for fiscal 1999 base compensation of $251,163, $200,894, $226,504 and $190,922, respectively. Salaries are subject in each case to annual adjustment at the discretion of the Compensation Committee of the Board of Directors of the Company. The Employment Agreements entitle each executive to participate in all other incentive compensation plans established for executive officers of the Company. The Company may terminate each Employment Agreement for "cause" or a "disability" (as such terms are defined in the Employment Agreements). If the Company terminates an executive's employment without "cause" (as defined in the Employment Agreements), the Employment Agreements require the Company to pay certain amounts to the terminated executive, including (i) the greater of (A) one year's salary or (B) 1/12 of one year's salary for each year (not to exceed 24 years in the aggregate) of employment with the Company (other than Mr. Sims, who would receive his salary for one year), and (ii) certain benefits under applicable incentive compensation plans. Each Employment Agreement also includes customary noncompetition, nondisclosure and nonsolicitation provisions.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Company established the Compensation Committee comprised of Messrs. Buaron, Imbler, and Hofmann, in October 1996. The annual salary and bonus paid to Messrs. Imbler, Boots, Kratochvil Beeler, and Sims for fiscal 1999 were determined by the Compensation Committee in accordance with their respective employment agreements. All other compensation decisions with respect to officers of the Company are made by Mr. Imbler pursuant to policies established in consultation with the Compensation Committee.
The Company is party to an Amended and Restated Management Agreement (the "FACL Management Agreement") with First Atlantic pursuant to which First Atlantic provides the Company with financial advisory and management consulting services in exchange for an annual fee of $750,000 and reimbursement for out-of-pocket costs and expenses. In consideration of such services, the Company paid First Atlantic fees and expenses of $792,000 for fiscal 1999, $835,000 for fiscal 1998, and $771,200 for fiscal 1997. Under the FACL Management Agreement, the Company pays a fee for services rendered in connection with certain transactions equal to the lesser of (i) 1% of the total transaction value and (ii) $1,250,000 for any such transaction consummated plus out-of-pocket expenses in respect of such transaction, whether or not consummated. First Atlantic received advisory fees of approximately $287,500 and $28,700 in January 1997 for originating, structuring and negotiating the PackerWare Acquisition and the Container Industries Acquisition, respectively. First Atlantic received advisory fees of approximately $117,900 and $531,600 in May 1997 and August 1997, respectively, for originating, structuring and negotiating the Virginia Design Acquisition and the Venture Packaging Acquisition, respectively. First Atlantic received advisory fees of approximately $140,000 and $180,000 in July 1998 and October 1998, respectively, for originating, structuring and negotiating the Berry UK Acquisition and the Knight Acquisition, respectively. First Atlantic received advisory fees of approximately $690,000 in July 1999 for originating, structuring and negotiating the Cardinal Acquisition. See "Certain Relationships and Related Transactions."
Mr. Buaron, the Chairman and a director of Holding and the Company, is the Chairman and Chief Executive Officer of First Atlantic. Mr. Graev is a director of First Atlantic. As an officer and the sole stockholder of First Atlantic, Mr. Buaron is entitled to receive any bonuses paid and any dividends declared by First Atlantic on its capital stock, including any bonuses paid as a result of, and any dividends paid out of any of the fees paid with respect to the acquisitions described above. First Atlantic is engaged by International to provide certain financial and management consulting services for which it receives annual fees. First Atlantic and International have completely distinct ownership and equity structures. See "Certain Relationships and Related Transactions."
Atlantic Equity Partners, L.P. (the "Fund"), a prior stockholder of Holding, received in June 1996 approximately $67.6 million from the sale of its common stock in Holding and warrants to purchase common stock. First Atlantic is engaged by the Fund to provide certain financial and management consulting services for which it receives annual fees. First Atlantic and the Fund have completely distinct ownership and equity structures. Atlantic Equity Associates, L.P., a Delaware limited partnership ("AEA"), is the sole general partner of the Fund. Mr. Buaron is the sole shareholder of Buaron Capital Corporation ("Buaron Capital"). Buaron Capital is the managing and sole general partner of AEA. See "Certain Relationships and Related Transactions."
STOCK OPTION PLAN
Employees, directors and certain independent consultants of the Company and its subsidiaries are entitled to participate in the BPC Holding Corporation 1996 Stock Option Plan (the "Option Plan"), which provides for the grant of both "incentive stock options" within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), and stock options that are non-qualified under the Code. The total number of shares of Class B Nonvoting Common Stock of Holding for which options may be granted pursuant to the Option Plan is 61,620. The Option Plan will terminate on October 3, 2003 or such earlier date on which the Board of Directors of Holding, in its sole discretion, determines. The Stock Option Committee of the Board of Directors of Holding administers all aspects of the Option Plan, including selecting which of the Company's directors, employees and independent consultants will receive options, the time when options are granted, whether the options are incentive stock options or non-qualified stock options, the manner and timing for vesting of such options, the terms of such options, the exercise date of any options and the number of shares subject to such options. Directors who are also employees are eligible to receive options under the Option Plan.
The exercise price of incentive stock options granted by Holding under the Option Plan may not be less than 100% of the fair market value of the Class B Nonvoting Common Stock at the time of grant and the term of any option may not exceed seven years. With respect to any employee who owns stock representing more than 10% of the voting power of the outstanding capital stock of Holding, the exercise price of any incentive stock option may not be less than 110% of the fair market value of such shares at the time of grant and the term of such option may not exceed five years. The exercise price of a non-qualified stock option is determined by the Stock Option Committee on the date the option is granted. However, the exercise price of a non-qualified stock option may not be less than 100% of the fair market value of Class B Nonvoting Common Stock if the option is granted at any time after the initial public offering of such stock.
Options granted under the Option Plan are nontransferable except by will and the laws of descent and distribution. Options granted under the Option Plan typically expire after seven years and vest over a five-year period based on timing as well as achieving financial performance targets.
Under the Option Plan, as of January 1, 2000, there were outstanding options to purchase an aggregate of 51,479 shares of Class B Nonvoting Common Stock to 70 employees of the Company, at an exercise price between $100 and $170 per share.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
STOCK OWNERSHIP
All of the outstanding capital stock of the Company is owned by Holding. The following table sets forth certain information regarding the ownership of the capital stock of Holding with respect to (i) each person known by Holding to own beneficially more than 5% of the outstanding shares of any class of its voting capital stock, (ii) each of Holding's directors, (iii) the Named Executive Officers and (iv) all directors and officers of Holding as a group. Except as otherwise indicated, each of the stockholders has sole voting and investment power with respect to the shares beneficially owned. Unless otherwise indicated, the address for each stockholder is c/o Berry Plastics Corporation, 101 Oakley Street, Evansville, Indiana 47710.
* Less than one percent.
(1) The authorized capital stock of Holding consists of 3,500,000 shares of capital stock, including 2,500,000 shares of Common Stock, $.01 par value (the "Holding Common Stock"), and 1,000,000 shares of Preferred Stock, $.01 par value (the "Preferred Stock"). Of the 2,500,000 shares of Holding Common Stock, 500,000 shares are designated Class A Voting Common Stock, 500,000 shares are designated Class A Nonvoting Common Stock, 500,000 shares are designated Class B Voting Common Stock, 500,000 shares are designated Class B Nonvoting Common Stock, and 500,000 shares are designated Class C Nonvoting Common Stock. Of the 1,000,000 shares of Preferred Stock, 800,000 shares are designated Series A Senior Cumulative Exchangeable Preferred Stock, and 200,000 shares are designated Series B Cumulative Preferred Stock.
(2) Address is P. O. Box 847, One Capital Place, Fourth Floor, Grand Cayman, Cayman Islands, British West Indies. Atlantic Equity Associates International II, L.P., a Delaware limited partnership ("AEA II"), is the sole general partner of International and as such exercises voting and/or investment power over shares of capital stock owned by International, including the shares of Holding Common Stock held by International (the "International Shares"). Mr. Buaron is the sole shareholder of Buaron Holdings Ltd. ("BHL"). BHL is the sole general partner of AEA II. As the general partner of AEA II, BHL may be deemed to beneficially own the International Shares. BHL disclaims any beneficial ownership of any shares of capital stock owned by International, including the International Shares. Through his affiliation with BHL and AEA II, Mr. Buaron controls the sole general partner of International and therefore has the authority to control voting and/or investment power over, and may be deemed to beneficially own, the International Shares. Mr. Buaron disclaims any beneficial ownership of any of the International Shares.
(3) Address is 380 Madison Avenue, 12th Floor, New York, New York 10017.
(4) Represents warrants to purchase such shares of common stock held by Chase Venture Capital Associates, LLC ("CVCA") which are currently exercisable.
(5) Address is c/o Aetna Life Insurance Company, Private Equity Group, IG6U, 151 Farmington Avenue, Hartford, Connecticut 06156. Aetna Life Insurance Company exercises voting and/or investment power over shares of capital stock owned by BPC Equity, LLC ("BPC Equity"), including shares of Holding Common Stock held by BPC Equity.
(6) Address is c/o First Atlantic Capital, Ltd., 135 East 57th Street, New York, New York 10022. Represents shares of Holding Common Stock owned by International. Mr. Buaron is the sole shareholder of BHL. BHL is the sole general partner of AEA II. AEA II is the sole general
partner of International and as such, exercises voting and/or investment power over shares of capital stock owned by International, including the International Shares. Mr. Buaron, as the sole shareholder and Chief Executive Officer of BHL, controls the sole general partner of International and therefore has voting and/or investment power over, and may be deemed to beneficially own, the International Shares. Mr. Buaron disclaims any beneficial ownership of the International Shares.
(7) Includes 5,930 options granted to Mr. Imbler, which are presently exercisable.
(8) Address is c/o First Atlantic Capital, Ltd., 135 East 57th Street, New York, New York 10022.
(9) Address is c/o O'Sullivan Graev & Karabell, LLP, 30 Rockefeller Plaza, New York, New York 10112.
(10) Address is c/o Chase Capital Partners, 380 Madison Avenue, 12th Floor, New York, New York 10017. Represents shares owned by CVCA. Mr. Hofmann is a General Partner of Chase Capital Partners, which is the private equity investment arm of Chase Manhattan Corporation, which is an affiliate of CVCA. Mr. Hofmann disclaims any beneficial ownership of the shares of Holding Common Stock held by CVCA.
(11) Address is c/o Chase Capital Partners, 380 Madison Avenue, 12th Floor, New York, New York 10017. Represents shares owned by CVCA. Mr. Lori is a Principal with Chase Capital Partners, which is the private equity investment arm of Chase Manhattan Corporation, which is an affiliate of CVCA. Mr. Lori disclaims any beneficial ownership of the shares of Holding Common Stock held by CVCA.
(12) Address is c/o Aetna Life Insurance Company, Private Equity Group, IG6U, 151 Farmington Avenue, Hartford, Connecticut 06156. Represents shares owned by BPC Equity. Mr. Clarke is a Managing Director of Aetna, Inc., an affiliate of Aetna Life Insurance Company, which is a member of BPC Equity. Mr. Clarke disclaims any beneficial ownership of the shares of Holding Common Stock held by BPC Equity.
(13) Includes 3,650 options granted to Mr. Boots, which are currently exercisable.
(14) Includes 2,281 options granted to Mr. Kratochvil, which are currently exercisable.
(15) Includes 2,281 options granted to Mr. Beeler, which are currently exercisable.
(16) Includes 650 options granted to Mr. Sims, which are currently exercisable.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
FIRST ATLANTIC
Pursuant to the FACL Management Agreement, First Atlantic provides the Company with financial advisory and management consulting services in exchange for an annual fee of $750,000 and reimbursement for out-of-pocket costs and expenses. In consideration of such services, the Company paid First Atlantic fees and expenses of approximately $792,000 for fiscal 1999, $835,000 for fiscal 1998, and $771,200 for fiscal 1997. Under the FACL Management Agreement, the Company pays a fee for services rendered in connection with certain transactions equal to the lesser of (i) 1% of the total transaction value and (ii) $1,250,000 for any such transaction consummated plus out-of-pocket expenses in respect of such transaction, whether or not consummated. First Atlantic received advisory fees of approximately $287,500 and $28,700 in January 1997 for originating, structuring and negotiating the PackerWare Acquisition and the Container Industries Acquisition, respectively. First Atlantic received advisory fees of approximately $117,900 and $531,600 in May 1997 and August 1997, respectively, for originating, structuring and negotiating the Virginia Design Acquisition and the Venture Packaging Acquisition, respectively. First Atlantic received advisory fees of approximately $140,000 and $180,000 in July 1998 and October 1998, respectively, for originating, structuring and negotiating the Berry UK Acquisition and the Knight Acquisition, respectively. First Atlantic received advisory fees of approximately $690,000 in July 1999 for originating, structuring and negotiating the Cardinal Acquisition.
Mr. Buaron, the Chairman and a director of Holding and the Company, is the Chairman and Chief Executive Officer of First Atlantic. As an officer and the sole stockholder of First Atlantic, Mr. Buaron is entitled to receive any bonuses paid and any dividends declared by First Atlantic on its capital stock, including any bonuses paid as a result of, and any dividends paid out of the fees paid with respect to the acquisitions described above. Mr. Graev is also a director of First Atlantic, and Mr. Levy is an officer of First Atlantic. First Atlantic is engaged by International to provide certain financial and management consulting services for which it receives annual fees. First Atlantic and International have completely distinct ownership and equity structures.
Atlantic Equity Partners, L.P. (the "Fund"), a prior stockholder of Holding, received in June 1996 approximately $67.6 million from the sale of its common stock in Holding and warrants to purchase common stock. First Atlantic is engaged by the Fund to provide certain financial and management consulting services for which it receives annual fees. First Atlantic and the Fund have completely distinct ownership and equity structures. AEA is the sole general partner of the Fund. Mr. Buaron is the sole shareholder of Buaron Capital, and Buaron Capital is the managing and sole general partner of AEA.
STOCKHOLDERS AGREEMENTS
Holding entered into a Stockholders Agreement dated as of June 18, 1996 (the "Stockholders Agreement") with certain common equity investors ("Common Stock Purchasers"), certain Management Stockholders (as defined herein) and, for limited purposes thereunder, the Northwestern Mutual Life Insurance Company and CVCA ("Preferred Stock Purchasers"). The Stockholders Agreement grants the Common Stock Purchasers certain rights and obligations, including the following: (i) until the occurrence of certain events specified in the Stockholders Agreement, to designate the members of a seven person Board of Directors as follows: (A) one director will be Roberto Buaron or his designee; (B) International will have the right to designate three directors (who are currently Messrs. Graev, Imbler and Levy); (C) CVCA will have the right to designate two directors (who are currently Messrs. Hofmann and Lori); and (D) the institutional holders (excluding International and CVCA) will have the right to designate one director (who is currently Mr. Clarke); (ii) in the case of certain Common Stock Purchasers, to subscribe for a proportional share of future equity issuances by Holding; (iii) under certain circumstances and in the case of International or CVCA, to cause the initial public offering of equity securities of Holding or a sale of Holding subsequent to June 18, 2001 and (iv) under certain circumstances and in the case of a majority in interest of the institutional holders, to cause the initial public offering of equity securities of Holding or a sale of Holding subsequent to June 18, 2002. Provisions under the Stockholders Agreement also (i) prohibit Holding from taking certain actions without the consent of holders of a majority of voting stock held by CVCA and the institutional holders other than International (or, following the occurrence of certain events, International's consent), including certain transactions between Holding and any subsidiary, on the one hand, and First Atlantic or any of its affiliates, on the other hand; (ii) obligate Holding to provide certain Common Stock Purchasers with financial and other information regarding Holding and to provide access and inspection rights to all Common Stock Purchasers; and (iii) restrict transfers of equity by the Common Stock Purchasers, subject to certain exceptions (including for transfers of up to 10% of the equity (including warrants to purchase equity) held by each Common Stock Purchaser on the date of the Stockholders Agreement). Pursuant to the Stockholders Agreement, under certain circumstances the Preferred Stock Purchasers (and their transferees) have tag-along rights with respect to the warrants issued by Holding in 1996 and the Holding Common Stock issuable upon exercise thereof. Under specified circumstances and subject to certain exceptions, the Preferred Stock Purchasers (and their transferees) are entitled to include a pro rata share of their Preferred Stock in a transaction (or series of related transactions) involving the transfer by International, CVCA and the Institutional Holders (as defined in the Stockholders Agreement) of more than 50% of the aggregate amount of securities held by them on June 19, 1996.
The Stockholders Agreement grants registration rights, under certain circumstances and subject to specified conditions, to the Common Stock Purchasers. International and CVCA each have the right, on three occasions, to demand registration, at Holding's expense, of their shares of Holding Common Stock. Under certain circumstances, a majority in interest of the institutional holders (excluding International and CVCA) have the right, on one occasion, to demand registration, at Holding's expense, of their shares of Holding Common Stock. The Stockholders Agreement provides that if Holding proposes to register any of its securities, either for its own account or for the account of other stockholders, Holding will be required to notify all Common Stock Purchasers and to include in such registration the shares of Holding Common Stock requested to be included by them. All shares of Holding Common Stock owned by the Common Stock Purchasers requested to be included in a registration will be subject to cutbacks under certain circumstances in connection with an underwritten public offering.
The provisions of the Stockholders Agreement regarding voting rights, negative covenants, information/inspection rights, the right to force a sale of Holding, preemptive rights and transfer restrictions generally will expire on the earlier to occur of (i) the later of (A) June 18, 2001 if an underwritten public offering of equity securities of Holding resulting in gross proceeds of at least $20.0 million occurs prior to June 18, 2001 and (B) the occurrence of such underwritten public offering that occurs subsequent to June 18, 2001; (ii) June 18, 2016; and (iii) a sale of Holding. In addition, the Stockholders Agreement provides that certain rights of a Common Stock Purchaser (to the extent such rights apply to such Common Stock Purchaser) to designate members of the Board of Directors of Holding and/or to approve certain actions by Holding will terminate if certain circumstances occur.
Holding is also party to the Amended and Restated Stockholders Agreement dated June 18, 1996 (the "Management Stockholders Agreement"), with International and all management shareholders including, among
others, Messrs. Imbler, Boots, Kratochvil, Beeler, and Sims (collectively, the "Management Stockholders"). The Management Stockholders Agreement contains provisions (i) limiting transfers of equity by the Management Stockholders; (ii) requiring the Management Stockholders to sell their shares as designated by Holding or International upon the consummation of certain transactions; (iii) granting the Management Stockholders certain rights of co-sale in connection with sales by International; (iv) granting Holding rights to repurchase capital stock from the Management Stockholders upon the occurrence of certain events; and (v) requiring the Management Stockholders to offer shares to Holding prior to any permitted transfer.
TAX SHARING AGREEMENT
For federal income tax purposes, Berry and its subsidiaries are included in the affiliated group of which Holding is the common parent and as a result, the federal taxable income and loss of Berry and its subsidiaries is included in the group consolidated tax return filed by Holding. In April 1994, Holding, Berry and certain of its subsidiaries entered into a tax sharing agreement (the "Tax Sharing Agreement"). Under the Tax Sharing Agreement, for fiscal 1994 and all taxable years thereafter for which the Tax Sharing Agreement remains in effect, Berry and its subsidiaries as a consolidated group are required to pay to Holding an amount equal to the taxes that they would otherwise have to pay if they were to file separate federal, state or local income tax returns (including any amounts determined to be due as a result of a redetermination arising from an audit or otherwise of a tax liability which is attributable to them). If Berry and its subsidiaries would have been entitled to a tax refund for taxes paid previously on the basis computed as if they were to file separate returns, then under the Tax Sharing Agreement, Holding is required to pay to Berry and its subsidiaries an amount equal to such tax refund. If, however, Berry and its subsidiaries would have reported a tax loss if they were to file separate returns, then Holdings intends, but is not obligated under the Tax Sharing Agreement, to pay to Berry and its subsidiaries an amount equal to the tax benefit that is realized by Holding as a result of such separate loss. Under the Tax Sharing Agreement any such payments to be made by Holding to Berry or any of its subsidiaries on account of a tax loss are within the sole discretion of Holding. No payments have been made to date.
LEGAL SERVICES
Mr. Graev is a partner in the law firm of O'Sullivan Graev & Karabell, LLP, New York, New York. O'Sullivan Graev & Karabell, LLP provides legal services to the Company and Holding in connection with certain matters, principally relating to transactional, securities law, general corporate and litigation matters.
TRANSACTIONS WITH AFFILIATES
The 1996 Indenture, the Stockholders Agreement, the 1994 Indenture, the 1998 Indenture, the 1999 Indenture, and the Credit Facility restrict the Company's and its affiliates' ability to enter into transactions with their affiliates, including their officers, directors and principal stockholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents Filed as Part of the Report
1. FINANCIAL STATEMENTS
The financial statements listed under Item 8 are filed as part of this report.
2. FINANCIAL STATEMENT SCHEDULES
The financial statement schedules listed under Item 8 are filed as part of this report.
Schedules other than the above have been omitted because they are either not applicable or the required information has been disclosed in the financial statements or notes thereto.
3. EXHIBITS
The exhibits listed on the accompanying Exhibit Index are filed as part of this report.
(b) Reports on Form 8-K
None.
REPORT OF INDEPENDENT AUDITORS
The Stockholders and Board of Directors BPC Holding Corporation
We have audited the accompanying consolidated balance sheets of BPC Holding Corporation ("Holding") as of January 1, 2000 and January 2, 1999, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for each of the three years in the period ended January 1, 2000. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of Holding's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of BPC Holding Corporation at January 1, 2000 and January 2, 1999, and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 1, 2000, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/S/ ERNST & YOUNG LLP
Indianapolis, Indiana February 18, 2000
BPC HOLDING CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS OF DOLLARS)
CONSOLIDATED BALANCE SHEETS (CONTINUED)
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
BPC HOLDING CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS OF DOLLARS)
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
BPC HOLDING CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS OF DOLLARS)
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
BPC HOLDING CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS OF DOLLARS)
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
BPC HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS OF DOLLARS, EXCEPT AS OTHERWISE NOTED)
NOTE 1. ORGANIZATION
BPC Holding Corporation ("Holding"), through its subsidiary Berry Plastics Corporation ("Berry" or the "Company") and its subsidiaries Berry Iowa Corporation ("Berry Iowa"), Berry Sterling Corporation ("Berry Sterling"), Berry Tri-Plas Corporation ("Berry Tri-Plas"), Berry Plastics Design Corporation ("Berry Design"), PackerWare Corporation ("PackerWare"), Venture Packaging, Inc. ("Venture Packaging") and its subsidiaries Venture Packaging Midwest, Inc. and Venture Packaging Southeast, Inc., NIM Holdings Limited and its subsidiary Berry Plastics U.K. Limited ("Berry UK"), Knight Plastics, Inc., and CPI Holding Corporation and its subsidiary Cardinal Packaging, Inc. ("Cardinal"), manufactures and markets plastic packaging products through its facilities located in Evansville, Indiana; Henderson, Nevada; Iowa Falls, Iowa; Charlotte, North Carolina; York, Pennsylvania; Suffolk, Virginia; Lawrence, Kansas, Monroeville, Ohio; Norwich, England; Woodstock, Illinois; Streetsboro, Ohio; and Minneapolis, Minnesota.
In connection with the PackerWare acquisition in January 1997 (see Note 3), the Company also acquired a manufacturing facility in Reno, Nevada. This facility was closed in 1997, and its operations were consolidated into the Henderson, Nevada facility. In March 1998, Berry announced the consolidation of its Anderson, South Carolina facility with other Company locations with the majority of the business moving to the Charlotte, North Carolina and Monroeville, Ohio facilities. In connection with the Cardinal acquisition in July 1999 (see Note 3), the Company also acquired a manufacturing facility in Ontario, California. This facility was closed in 1999, and its operations were consolidated into the Henderson, Nevada facility.
Holding's fiscal year is a 52/53 week period ending generally on the Saturday closest to December 31. All references herein to "1999", "1998," and "1997" relate to the fiscal years ended January 1, 2000, January 2, 1999, and December 27, 1997, respectively.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION AND BUSINESS
The consolidated financial statements include the accounts of Holding and its subsidiaries all of which are wholly-owned. Intercompany accounts and transactions have been eliminated in consolidation. Holding, through its wholly-owned subsidiaries, operates in two primary industry segments. The Company is a manufacturer and marketer of plastic packaging, with sales concentrated in three product groups within this market: aerosol overcaps, containers, and drink cups. In addition, the Company is a manufacturer for the retail housewares market. The Company's customers are located principally throughout the United States, without significant concentration in any one region or with any one customer. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral.
Purchases of various densities of plastic resin used in the manufacture of the Company's products aggregated approximately $82.4 million in 1999. Dow Chemical Corporation is the principal supplier (approximately 38%) of the Company's total resin material requirements. The Company also uses other suppliers such as Union Carbide, Chevron, Mobil, Nova and Equistar to meet its resin requirements. The Company does not anticipate any material difficulty in obtaining an uninterrupted supply of raw materials at competitive prices in the near future. However, should a significant shortage of the supply of resin occur, changes in both the price and availability of the principal raw material used in the manufacture of the Company's products could occur and result in financial disruption to the Company.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company is subject to existing and potential federal, state, local and foreign legislation designed to reduce solid waste in landfills. While the principal resins used by the Company are recyclable and, therefore, reduce the Company's exposure to legislation promulgated to date, there can be no assurance that future legislation or regulatory initiatives would not have a material adverse effect on the Company. Legislation, if promulgated, requiring plastics to be degradable in landfills or to have minimum levels of recycled content would have a significant impact on the Company's business as would legislation providing for disposal fees or limiting the use of plastic products.
CASH AND CASH EQUIVALENTS
All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents.
INVENTORIES
Inventories are valued at the lower of cost (first in, first out method) or market.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the assets ranging from three to 25 years.
INTANGIBLE ASSETS
Origination fees and deferred financing fees are being amortized using the straight-line method over the lives of the respective debt agreements.
Covenants not to compete are being amortized over the respective lives of the agreements ranging from one to five years.
The costs in excess of net assets acquired represent the excess purchase price over the fair value of the net assets acquired in the original acquisition of Berry Plastics and subsequent acquisitions. These costs are being amortized over a range of 15 to 20 years.
Holding periodically evaluates the value of intangible assets to determine if an impairment has occurred. This evaluation is based on various analyses including reviewing anticipated cash flows.
REVENUE RECOGNITION
Revenue from sales of products is recognized at the time product is shipped to the customer.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain amounts on the 1998 and 1997 financial statements have been reclassified to conform with the 1999 presentation.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which is required to be adopted in fiscal years beginning after June 15, 2000. This statement establishes accounting reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The statement requires all derivatives be recognized on the balance sheet at fair value. Changes in the fair value of derivatives will be accounted for based upon their intended use and designation. The adoption of this standard is not expected to have a material effect on the consolidated financial statements.
NOTE 3. ACQUISITIONS
On January 17, 1997, the Company acquired certain assets and assumed certain liabilities of Container Industries, Inc. ("Container Industries") of Pacoima, California for $2.9 million. The purchase was funded out of operating funds. The operations of Container Industries are included in the Company's operations since the acquisition date using the purchase method of accounting.
On January 21, 1997, the Company acquired the outstanding stock of PackerWare Corporation, a Kansas corporation, for aggregate consideration of approximately $28.1 million and merged PackerWare with a newly-formed, wholly-owned subsidiary of the Company (with PackerWare being the surviving corporation). The purchase was primarily financed through the Credit Facility (see Note 5). The operations of PackerWare are included in the Company's operations since the acquisition date using the purchase method of accounting.
On May 13, 1997, Berry Design, a newly-formed wholly-owned subsidiary of the Company, acquired substantially all of the assets and assumed certain liabilities of Virginia Design Packaging Corp. ("Virginia Design") for approximately $11.1 million. The purchase was financed through the Credit Facility. The operations of Berry Design are included in the Company's operations since the acquisition date using the purchase method of accounting.
On August 29, 1997, the Company acquired the outstanding common stock of Venture Packaging for aggregate consideration of $43.7 million and merged Venture Packaging with a newly formed subsidiary of the Company (with Venture Packaging being the surviving corporation). The purchase was primarily financed through the Credit Facility. Additionally, preferred stock and warrants were issued to certain selling shareholders of Venture Packaging (see Note 9). The operations of Venture Packaging are included in the Company's operations since the acquisition date using the purchase method of accounting.
On July 2, 1998, NIM Holdings, a newly-formed, wholly-owned subsidiary of Berry, acquired all of the capital stock of Norwich Moulders of Norwich, England for aggregate consideration of approximately $14.0 million. The purchase was primarily financed through the Credit Facility. The operations of Norwich Moulders are included in Berry's operations since the acquisition date using the purchase method of accounting.
On October 16, 1998, Knight Plastics, Inc. ("Knight"), a newly formed wholly-owned subsidiary of Berry, acquired substantially all of the assets of the Knight Engineering and Plastics Division of Courtaulds Packaging Inc. for aggregate consideration of approximately $18.0 million. The purchase was financed through the Credit Facility's revolving line of credit. The operations of Knight are included in Berry's operations since the acquisition date using the purchase method of accounting.
On July 6, 1999, the Company acquired all of the outstanding capital stock of CPI Holding Corporation ("Cardinal"), the parent company of Cardinal Packaging, Inc. for aggregate consideration of approximately $72.0 million. The purchase was financed through the issuance by Berry of $75.0 million of 11% Senior Subordinated Notes. The operations of Cardinal are included in Berry's operations since the acquisition date using the purchase method of accounting. The fair value of the net assets acquired was based on preliminary estimates and may be revised at a later date.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The pro forma results listed below are unaudited and reflect purchase accounting adjustments assuming the Cardinal acquisition occurred at the beginning of each fiscal year presented and the Norwich Moulders and Knight acquisitions occurred on December 28, 1997.
YEAR ENDED ---------------------------- JANUARY 1, JANUARY 2, 2000 1999 ---------- ---------- Net sales $ 357,299 $ 350,455 Loss before income taxes (12,750) (15,218) Net loss (13,304) (15,085)
The pro forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisitions been consummated at the above dates, nor are they necessarily indicative of future operating results. Further, the information gathered on the acquired companies is based upon unaudited internal financial information and reflects only pro forma adjustments for additional interest expense and amortization of the excess of the cost over the underlying net assets acquired, net of the applicable income tax effects.
NOTE 4. INTANGIBLE ASSETS
Intangible assets consist of the following:
JANUARY 1, JANUARY 2, 2000 1999 ---------- ---------- Deferred financing and origination fees $ 18,924 $ 15,817 Covenants not to compete 7,745 6,233 Excess of cost over net assets acquired 96,104 49,197 Accumulated amortization (19,865) (12,313) ---------- ---------- $ 102,908 $ 58,934 ========== ==========
Excess of cost over net assets acquired increased primarily due to the acquisition of CPI Holding to the extent the purchase price exceeded the fair value of the net assets acquired.
NOTE 5. LONG-TERM DEBT
Long-term debt consists of the following:
JANUARY 1, JANUARY 2, 2000 1999 ---------- ---------- Holding 12.50% Senior Secured Notes $ 111,956 $ 105,000 Berry 12.25% Senior Subordinated Notes 125,000 125,000 Berry 11% Senior Subordinated Notes 75,000 -- Term loans 55,221 71,243 Revolving lines of credit 31,649 16,162 Nevada Industrial Revenue Bonds 4,000 4,500 Capital leases 479 561 Debt premium, net 684 832 ---------- ---------- 403,989 323,298 Less current portion of long-term debt 21,109 19,388 ---------- ---------- $382,880 $ 303,910 ========== ==========
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
HOLDING 12.50% SENIOR SECURED NOTES
On June 18, 1996, Holding, as part of a recapitalization (see Note 9), issued 12.50% Senior Secured Notes due 2006 (the "1996 Offering") for net proceeds, after expenses, of approximately $100.2 million (or $64.6 million after deducting the amount of such net proceeds used to purchase marketable securities available for payment of interest on the notes). These notes were exchanged in October 1996 for the 12.50% Series B Senior Secured Notes due 2006 (the "1996 Notes"). Interest is payable semi-annually on June 15 and December 15 of each year. In addition, from December 15, 1999 until June 15, 2001, Holding may, at its option, pay interest, at an increased rate of 0.75% per annum, in additional 1996 Notes valued at 100% of the principal amount thereof. On December 15, 1999, Holding issued an additional approximately $7.0 million aggregate principal amount of 1996 Notes in satisfaction of its interest obligation.
The 1996 Notes rank senior in right of payment to all existing and future subordinated indebtedness of Holding, including Holding's subordinated guarantee of all of Berry's Senior Subordinated Notes and and PARI PASSU in right of payment with all senior indebtedness of Holding. The 1996 Notes are effectively subordinated to all existing and future senior indebtedness of Berry, including borrowings under the Credit Facility and the Nevada Industrial Revenue Bond.
BERRY 12.25% SENIOR SUBORDINATED NOTES
On April 21, 1994, Berry completed an offering of 100,000 units consisting of $100.0 million aggregate principal amount of 12.25% Berry Plastics Corporation Senior Subordinated Notes, due 2004 (the "1994 Notes") and 100,000 warrants to purchase 1.13237 shares of Class A Common Stock, $.00005 par value (collectively the "1994 Transaction"), of Holding. The net proceeds to Berry from the sale of the 1994 Notes, after expenses, were $93.0 million. On August 24, 1998, Berry completed an additional offering of $25.0 million aggregate principal amount of 12.25% Series B Senior Subordinated Notes due 2004 (the "1998 Notes"). The net proceeds to Berry from the sale of the 1998 Notes, after expenses, were $25.2 million. The 1994 Notes and 1998 Notes mature on April 15, 2004 and interest is payable semi-annually on October 15 and April 15 of each year and commenced on October 15, 1994 and October 15, 1998 for the 1994 Notes and 1998 Notes respectively. Holding and all of Berry's subsidiaries fully, jointly, severally, and unconditionally guarantee on a senior subordinated basis the 1994 Notes and 1998 Notes. There are no nonguarantor subsidiaries. Separate financial statements of guarantor subsidiaries have not been included as management believes those financial statements would not be material to investors.
Berry is not required to make mandatory redemption or sinking fund payments with respect to the 1994 Notes and 1998 Notes. The 1994 Notes and 1998 Notes may be redeemed at the option of Berry, in whole or in part, at redemption prices ranging from 104.08% in 2000 to 100% in 2002 and thereafter. Upon a change in control, as defined in the indenture entered into in connection with the 1994 Transaction (the "1994 Indenture") and the 1998 Transaction ("1998 Indenture"), each holder of notes will have the right to require Berry to repurchase all or any part of such holder's notes at a repurchase price in cash equal to 101% of the aggregate principal amount thereof plus accrued interest.
The 1994 Notes and 1998 Notes rank PARI PASSU with or senior in right of payment to all existing and future subordinated indebtedness of Berry. The notes rank junior in right of payment to all existing and future senior indebtedness of Berry, including borrowings under the Credit Facility and the Nevada Industrial Revenue Bonds.
The 1994 Indenture and 1998 Indenture contains certain covenants which, among other things, limit Berry and its subsidiaries' ability to incur debt, merge or consolidate, sell, lease or transfer assets, make dividend payments and engage in transactions with affiliates.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
BERRY 11% SENIOR SUBORDINATED NOTES
On July 6, 1999, Berry completed an offering of 75,000 units consisting of $75.0 million aggregate principal amount of 11% Berry Plastics Corporation Senior Subordinated Notes, due 2007 (the "1999 Notes"). The net proceeds to Berry from the sale of the 1999 Notes, after expenses, were $72.0 million. The 1999 Notes mature on July 15, 2007 and interest is payable semi-annually on January 15 and July 15 of each year and commence on January 15, 2000. Holding and all of Berry's subsidiaries fully, jointly, and severally, and unconditionally guarantee on a senior subordinated basis the 1999 Notes. There are no nonguarantor subsidiaries.
Berry is not required to make mandatory redemption or sinking fund payments with respect to the 1999 Notes. On or subsequent to July 15, 2003, the 1999 Notes may be redeemed at the option of Berry, in whole or in part, at redemption prices ranging from 105.5% in 2003 to 100% in 2006 and thereafter. Upon a change in control, as defined in the indenture entered into in connection with the 1999 Transaction (the "1999 Indenture"), each holder of notes will have the right to require Berry to repurchase all or any part of such holder's notes at a repurchase price in cash equal to 101% of the aggregate principal amount thereof plus accrued interest.
CREDIT FACILITY
The Company has a financing and security agreement (the "Security Agreement") with Bank of America for a senior secured line of credit (the "Credit Facility") for an aggregate principal amount at January 1, 2000 of approximately $131.8 million consisting of (i) a $70.0 million revolving line of credit, subject to a borrowing base formula, (ii) a $2.4 million revolving line of credit in the U.K. ("UK Revolver"), subject to a borrowing base formula, (iii) a $50.0 million term loan facility, (iv) a $5.2 million term loan facility in the U.K. ("UK Term Loan") and (v) a $4.2 million standby letter of credit facility to support the Company's and its subsidiaries' obligations under the Nevada Bonds. At January 1, 2000, the Company had unused borrowing capacity under the Credit Facility's revolving line of credit of approximately $22.3 million. The indebtedness under the Credit Facility is guaranteed by Holding and all of its subsidiaries. The obligations of the Company and the subsidiaries under the Credit Facility and the guarantees thereof are secured primarily by all of the assets of such persons.
The Credit Facility matures on January 21, 2002 unless previously terminated by the Company or by the lenders upon an Event of Default as defined in the Security Agreement. The term loan facility requires periodic payments, varying in amount, through the maturity of the facility. Interest on borrowings under the Credit Facility is based on either (i) the lender's base rate (which is the higher of the lender's prime rate and the federal funds rate plus 0.50%) plus an applicable margin of 0.50% or (ii) LIBOR (adjusted for reserves) plus an applicable margin of 2.0%, at the Company's option (8.1% at January 1, 2000 and 7.0% at January 2, 1999). Following receipt of the quarterly financial statements, the agent under the Credit Facility has the option to change the applicable interest rate margin on loans (other than under the UK Revolver and UK Term Loan) once per quarter to a specified margin determined by the ratio of funded debt to EBITDA of the Company and its subsidiaries. Notwithstanding the foregoing, interest on borrowings under the UK Revolver and the UK Term Loan is based on LIBOR (adjusted for reserves) plus 2.50%.
The Credit Facility contains various covenants which include, among other things: (i) maintenance of certain financial ratios and compliance with certain financial tests and limitations, (ii) limitations on the issuance of additional indebtedness and (iii) limitations on capital expenditures.
NEVADA INDUSTRIAL REVENUE BONDS
The Nevada Industrial Revenue Bonds bear interest at a variable rate (5.7% at January 1, 2000 and 3.0% at January 2, 1999), require annual principal payments of $0.5 million on April 1, are collateralized by irrevocable letters of credit issued by Bank of America under the Credit Facility and mature in April 2007.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
OTHER
Future maturities of long-term debt are as follows: 2000, $21,109; 2001, $17,100; 2002, $50,665; 2003, $500; 2004, $125,500, and $188,431 thereafter.
Interest paid was $29,759, $33,236 and $29,927 for 1999, 1998 and 1997, respectively. Interest capitalized was $1,447, $777 and $341 for 1999, 1998 and 1997, respectively.
NOTE 6. LEASE AND OTHER COMMITMENTS
Certain property and equipment are leased using capital and operating leases. Capitalized lease property consisted of manufacturing equipment with a cost of $993 and $2,970 and related accumulated amortization of $169 and $1,468 at January 1, 2000, and January 2, 1999, respectively. Capital lease amortization is included in depreciation expense. Total rental expense for operating leases was approximately $7,282, $5,414, and $3,332 for 1999, 1998, and 1997, respectively.
Future minimum lease payments for capital leases and noncancellable operating leases with initial terms in excess of one year are as follows:
AT JANUARY 1, 2000 ----------------------- CAPITAL OPERATING LEASES LEASES ------- ---------
2000 $ 183 $ 6,403 2001 155 6,340 2002 97 5,181 2003 92 4,451 2004 8 3,627 Thereafter -- 4,404 ------- --------- 535 $ 30,406 ========= Less: amount representing interest (56) ------- Present value of net minimum lease payments $ 479 =======
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7. INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of deferred tax liabilities and assets at January 1, 2000 and January 2, 1999 are as follows:
JANUARY 1, JANUARY 2, 2000 1999 ----------- ---------- Deferred tax assets: Allowance for doubtful accounts $ 529 $ 633 Inventory 1,047 900 Compensation and benefit accruals 1,508 1,592 Insurance reserves 415 436 Net operating loss carryforwards 11,943 10,012 Alternative minimum tax (AMT) credit carryforwards 3,055 2,758 ---------- ---------- Total deferred tax assets 18,497 16,331 Valuation allowance (3,572) (2,493) ---------- ---------- Deferred tax assets, net of valuation allowance 14,925 13,838 Deferred tax liabilities: Depreciation and amortization 15,428 11,577 ---------- ---------- Net deferred tax asset (liability) $ (503) $ 2,261 ========== ==========
Income tax expense (benefit) consists of the following:
JANUARY 1, JANUARY 2, DECEMBER 2, 2000 1999 1997 ---------- ---------- ---------- Current
Federal $ -- $ (493) $ -- Foreign 80 152 -- State 468 92 138 Deferred
Federal -- -- -- Foreign 6 -- -- State -- -- -- ---------- ---------- ---------- Income tax expense (benefit) $ 554 $ (249) $ 138 ========== ========== ==========
Holding has unused operating loss carryforwards of approximately $30.5 million for federal income tax purposes which begin to expire in 2010. AMT credit carryforwards are available to Holding indefinitely to reduce future years' federal income taxes. A tax sharing agreement is in place that allows Holding to make losses available to Berry.
Income taxes paid during 1999, 1998 and 1997 approximated $860, $526, and $47 respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A reconciliation of income tax expense (benefit), computed at the federal statutory rate, to income tax expense, as provided for in the financial statements, is as follows:
YEAR ENDED ---------------------------------------- JANUARY 1, JANUARY 2, DECEMBER 27, 2000 1999 1997 ---------- ---------- ------------ Income tax expense (benefit) computed at statutory rate $ (2,919) $ (2,658) $ (4,853) State income tax expense, net of federal benefit 309 90 138 Amortization of goodwill 1,292 339 285 Expenses not deductible for income tax purposes 248 432 219 Change in valuation allowance 1,773 1,677 4,298 Other (149) (129) 51 ---------- ---------- ------------ Income tax expense (benefit) $ 554 $ (249) $ 138 ========== ========== ============
NOTE 8. EMPLOYEE RETIREMENT PLANS
Berry sponsors a defined contribution 401(k) retirement plan covering substantially all employees. Contributions are based upon a fixed dollar amount for employees who participate and percentages of employee contributions at specified thresholds. Contribution expense for this plan was approximately $1,057, $933, and $629 for 1999, 1998 and 1997, respectively.
NOTE 9. STOCKHOLDERS' EQUITY
COMMON STOCK
On June 18, 1996, Holding consummated the transaction described below (the "1996 Transaction"). BPC Mergerco, Inc. ("Mergerco"), a wholly owned subsidiary of Holding, was organized by Atlantic Equity Partners International II, L.P. ("International"), Chase Venture Capital Associates, L.P. ("CVCA"), and certain other institutional investors to effect the acquisition of a majority of the outstanding capital stock of Holding. Pursuant to the terms of a Common Stock Purchase Agreement dated as of June 12, 1996 each of International, CVCA and certain other equity investors (collectively the "Common Stock Purchasers") subscribed for shares of common stock of Mergerco. In addition, pursuant to the terms of a Preferred Stock Purchase Agreement dated as of June 12, 1996 (the "Preferred Stock Purchase Agreement"), CVCA and an additional institutional investor (the "Preferred Stock Purchasers") purchased shares of preferred stock of Mergerco (the "Preferred Stock") and warrants (the "1996 Warrants") to purchase shares of common stock of Mergerco. Immediately after the purchase of the common stock, the preferred stock and the 1996 Warrants of Mergerco, Mergerco merged (the "Merger") with and into Holding, with Holding being the surviving corporation. Upon the consummation of the Merger: each share of the Class A Common Stock, $.00005 par value, and Class B Common Stock, $.00005 par value, of Holding and certain privately-held warrants exercisable for such Class A and Class B Common Stock were converted into the right to receive cash equal to the purchase price per share for the common stock into which such warrants were exercisable less the amount of the nominal exercise price therefor, and all other classes of common stock of Holding, a majority of which was held by certain members of management, were converted into shares of common stock of the surviving corporation. In addition, upon the consummation of the Merger, the holders of the warrants (the "1994 Warrants") to purchase capital stock of Holding that were issued in connection with the 1994 Transaction became entitled to receive cash equal to the purchase price per share for the common stock into which such warrants were exercisable less the amount of the exercise price therefor. The Company's common stock shareholders who held common stock immediately preceding the 1996 Transaction retained 78% of the common stock.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The authorized capital stock of Holding consists of 3,500,000 shares of capital stock, including 2,500,000 shares of Common Stock, $.01 par value (the "Holding Common Stock"). Of the 2,500,000 shares of Holding Common Stock, 500,000 shares are designated Class A voting Common Stock (the "Class A Voting Stock"), 500,000 shares are designated Class A Nonvoting Common Stock (the "Class A Nonvoting Stock"), 500,000 shares are designated Class B Voting Common Stock (the "Class B Voting Stock"), 500,000 shares are designated Class B Nonvoting Common Stock (the "Class B Nonvoting Stock"), and 500,000 shares are designated Class C Nonvoting Common Stock (the "Class C Nonvoting Stock").
PREFERRED STOCK AND WARRANTS
In connection with the 1996 Transaction, for aggregate consideration of $15.0 million, Mergerco issued units (the "Units") comprised of Series A Senior Cumulative Exchangeable Preferred Stock, par value $.01 per share (the "Preferred Stock"), and detachable warrants to purchase shares of Class B Common Stock (voting and non-voting) constituting 6% of the issued and outstanding Common Stock of all classes, determined on a fully-diluted basis (the "Warrants").
Dividends accrue at a rate of 14% per annum, compounding and payable quarterly in arrears (each date of payment, a "Dividend Payment Date") and will accumulate until declared and paid. Dividends declared and accruing prior to the first Dividend Payment Date occurring after the sixth anniversary of the issue date (the "Cash Dividend Date") may, at the option of Holding, be paid in cash in full or in part or accrue quarterly on a compound basis. Thereafter, all dividends are payable in cash in arrears. The dividend rate is subject to increase to a rate of (i) 16% per annum if (and for so long as) Holding fails to declare and pay dividends in cash for any quarterly period following the Cash Dividend Date and (ii) 15% per annum if (and for so long as) Holding fails to comply with its obligations relating to the rights and preferences of the Preferred Stock. If Holding fails to pay in full, in cash, (a) all accrued and unpaid dividends on or prior to the twelfth anniversary of the issue date or (b) all accrued dividends on any Dividend Payment Date following the twelfth anniversary of the issue date, the holders of Preferred Stock will be permitted to elect a majority of the Board of Directors of Holding.
The Preferred Stock ranks prior to all other classes of stock of Holding upon liquidation and is entitled to receive, out of assets available for distribution, cash in the aggregate amount of $15.0 million, plus all accrued and unpaid dividends thereon. Subject to the terms of the 1996 Indenture, on any Dividend Payment Date, Holding has the option of exchanging the Preferred Stock, in whole but not in part, for Senior Subordinated Exchange Notes, at the rate of $25 in principal amount of notes for each $25 of liquidation preference of Preferred Stock held; provided, however, that no shares of Preferred Stock may be exchanged for so long as any shares of Preferred Stock are held by CVCA or its affiliates. Upon such exchange, Holding will be required to pay in cash all accrued and unpaid dividends.
Pursuant to the Preferred Stock Purchase Agreement, the holders of Preferred Stock and Warrants have unlimited incidental registration rights (subject to cutbacks under certain circumstances). The exercise price of the Warrants is $.01 per Warrant and the Warrants are exercisable immediately upon issuance. All unexercised warrants will expire on the tenth anniversary of the issue date. The number of shares issuable upon exercise of a Warrant are subject to anti-dilution adjustments upon the occurrence of certain events.
In conjunction with the Venture Packaging acquisition, Holding authorized and issued 200,000 shares of Series B Cumulative Preferred Stock to certain selling shareholders of Venture Packaging. The Preferred Stock has a stated value of $25 per share, and dividends accrue at a rate of 14.75% per annum and will accumulate until declared and paid. The Preferred Stock ranks junior to the Series A Preferred Stock and prior to all other capital stock of Holding. In addition, Warrants to purchase 9,924 shares of Class B Non-Voting Common Stock at $108 per share were issued to the same selling shareholders of Venture Packaging.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
STOCK OPTION PLAN
Pursuant to the provisions of the BPC Holding Corporation 1996 Stock Option Plan (the "Option Plan") as amended, whereby 51,620 shares have been reserved for future issuance, Holding has granted options to certain officers and key employees to acquire shares of Class B Nonvoting Common Stock. These options are subject to various agreements, which among other things, set forth the class of stock, option price and performance thresholds to determine exercisability and vesting requirements. The Option Plan expires October 3, 2003 or such earlier date on which the Board of Directors of Holding, in its sole discretion, determines. Option prices range from $100 to $170 per share. Options granted under the Option Plan typically expire after seven years and vest over a five-year period with half of each person's award based on continued employment and half based on the Company achieving financial performance targets.
Financial Accounting Statements Board Statement 123, ACCOUNTING FOR STOCK-BASED Compensation ("Statement 123"), prescribes accounting and reporting standards for all stock-based compensation plans. Statement 123 provides that companies may elect to continue using existing accounting requirements for stock-based awards or may adopt a new fair value method to determine their intrinsic value. Holding has elected to continue following Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB 25") to account for its employee stock options. Under APB 25, because the exercise price of Holding's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized at the grant date.
Information related to the Option Plan is as follows:
The following table summarizes information about the options outstanding at January 1, 2000:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Disclosure of pro forma financial information is required by Statement 123 as if Holding had accounted for its employee stock options using the fair value method as defined by the Statement. The fair value for options granted by Holding have been estimated at the date of grant using a Black Scholes option pricing model with the following weighted average assumptions:
YEAR ENDED ---------------------------------------- JANUARY 1, JANUARY 2, DECEMBER 27, 2000 1999 1997 ---------- ---------- ------------ Risk-free interest rate 7.0% 6.4% 6.4% Dividend yield 0.0% 0.0% 0.0% Volatility factor .19 .20 .07 Expected option life 5.0 years 5.0 years 5.0 years
For purposes of the pro forma disclosures, the estimated fair value of the stock options are amortized to expense over the related vesting period. Because compensation expense is recognized over the vesting period, the initial impact on pro forma net loss may not be representative of compensation expense in future years, when the effect of amortization of multiple awards would be reflected in the Consolidated Statement of Operations. Holding's pro forma net losses giving effect to the estimated compensation expense related to stock options are as follows:
YEAR ENDED ------------------------------------------ JANUARY 1, JANUARY 2, DECEMBER 27, 2000 1999 1997 ------------- ------------ ------------ Net loss $ (9,400) $ (7,798) $ (14,594)
STOCKHOLDERS AGREEMENTS
Holding entered into a stockholders agreement (the "Stockholders Agreement") dated as of June 18, 1996 with the Common Stock Purchasers, certain management stockholders and, for limited purposes thereunder, the Preferred Stock Purchasers. The Stockholders Agreement grants certain rights including, but not limited to, designation of members of Holding's Board of Directors, the initiation of an initial public offering of equity securities of the Company or a sale of Holding. The agreement also restricts certain transfers of Holding's equity.
Holding has an agreement with its management stockholders and International that contains provisions (i) limiting transfers of equity by the management stockholders; (ii) requiring the management stockholders to sell their shares as designated by Holding or International upon the consummation of certain transactions; (iii) granting the management stockholders certain rights of co-sale in connection with sales by International; (iv) granting rights to repurchase capital stock from the management stockholders upon the occurrence of certain events; and (v) requiring the management stockholders to offer shares to Holding prior to any permitted transfer.
NOTE 10. RELATED PARTY TRANSACTIONS
The Company is party to a management agreement (the "Management Agreement") with First Atlantic Capital, Ltd. ("First Atlantic"). First Atlantic received advisory fees of $966 for originating, structuring and negotiating the 1997 acquisitions and advisory fees of approximately $140, $180, and $690, in July 1998, October 1998 and July 1999, respectively, for originating, structuring and negotiating the acquisitions of Berry UK, Knight, and Cardinal, respectively.
In consideration of financial advisory and management consulting services, the Company paid First Atlantic fees and expenses of $792, $835 and $771 for fiscal 1999, 1998, and 1997, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS INFORMATION
Holding's and the Company's financial instruments generally consist of cash and cash equivalents and long-term debt. The carrying amounts of Holding's and the Company's financial instruments approximate fair value at January 1, 2000, except for the 1994 Notes and 1999 Notes for which the fair value exceeds the carrying value by approximately $2.9 million and $1.1 million, respectively, and the 1996 Notes and 1998 Notes for which the fair value was below the carrying value by approximately $4.5 million and $0.8 million, respectively.
NOTE 12. OPERATING SEGMENTS
The Company has two reportable segments: packaging products and housewares products. The Company's packaging business consists of three primary market groups: aerosol overcaps, containers, and plastic drink cups. The Company's housewares business consists of semi-disposable plastic housewares and lawn and garden products, sold primarily through major national retail marketers and national chain stores.
The Company evaluates performance and allocates resources based on operating income before depreciation and amortization of intangibles adjusted to exclude (i) market value adjustment related to stock options, (ii) other non-recurring or "one-time" expenses, and (iii) management fees and reimbursed expenses paid to First Atlantic ("Adjusted EBITDA"). The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.
One time-expenses represent non-recurring expenses that relate to recently acquired businesses, plant consolidations, and litigation associated with a drink cup patent.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 13. SUMMARY FINANCIAL INFORMATION (IN THOUSANDS)
The following summarizes consolidated financial information of Holding's wholly-owned subsidiary, Berry Plastics Corporation and subsidiaries:
JANUARY 1, JANUARY 2, 2000 1999 ---------- ---------- CONSOLIDATED BALANCE SHEETS
Current assets $ 88,169 $ 65,590 Property and equipment - net of accumulated depreciation 146,786 120,005 Other noncurrent assets 93,889 58,716 Current liabilities 77,308 60,210 Noncurrent liabilities 272,977 210,093 Equity (deficit) (21,441) (25,992)
YEAR ENDED ------------------------------------ JANUARY 1, JANUARY 2, DECEMBER 27, 2000 1999 1997 ---------- ---------- ----------- CONSOLIDATED STATEMENTS OF OPERATIONS
Net sales $ 328,834 $ 271,830 $ 226,954 Cost of goods sold 241,067 199,226 180,249 Income (loss) before income taxes 5,331 5,650 (2,493) Net income (loss) 4,794 5,899 (2,631)
The following summarizes parent company only financial information of Berry:
JANUARY 1, JANUARY 2, 2000 1999 ---------- ---------- BALANCE SHEET Current assets $ 37,296 $ 28,579 Property and equipment - net of accumulated depreciation 53,452 48,220 Investment in/due from subsidiaries 191,258 120,230 Other noncurrent assets 13,398 15,629 Current liabilities 50,983 41,325 Noncurrent liabilities 265,862 197,325 Equity (deficit) (21,441) (25,992)
YEAR ENDED -------------------------------------- JANUARY 1, JANUARY 2, DECEMBER 27, 2000 1999 1997 ---------- ---------- ------------ STATEMENTS OF OPERATIONS
Net sales $ 149,901 $ 140,856 $ 140,976 Cost of goods sold 98,953 91,763 101,769 Income (loss) before income taxes 12,047 5,650 (2,493) Net income (loss) 11,622 5,899 (2,631)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY PLASTICS CORPORATION By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of Directors March 29, 2000 Roberto Buaron
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, Chief March 29, 2000 James M. Kratochvil Financial Officer, Treasurer and Secretary (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, and Director
/s/ Ira G. Boots Executive Vice President and March 29, 2000 Ira G. Boots Director
/s/ David M. Clarke Director March 29, 2000 David M. Clarke
/s/ Lawrence G. Graev Director March 29, 2000 Lawrence G. Graev
/s/ Donald J. Hofmann, Jr. Director March 29, 2000 Donald J. Hofmann, Jr.
/s/ Mathew J. Lori Director March 29, 2000 Mathew J. Lori
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BPC HOLDING CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President and Director March 29, 2000 Martin R. Imbler (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Treasurer, and Secretary (Principal Financial and Accounting Officer)
/s/ David M. Clarke Director March 29, 2000 David M. Clarke
/s/ Lawrence G. Graev Director March 29, 2000 Lawrence G. Graev
/s/ Donald J. Hofmann, Jr. Director March 29, 2000 Donald J. Hofmann, Jr.
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, and Director
/s/ Mathew J. Lori Director March 29, 2000 Mathew J. Lori
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY IOWA CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY TRI-PLAS CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY STERLING CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
AEROCON, INC.
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Chairman of the Board of Directors (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant Joseph. S. Levy Secretary, Assistant Treasurer and Director March 29, 2000
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
PACKERWARE CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 / Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY PLASTICS DESIGN CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
VENTURE PACKAGING, INC.
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
VENTURE PACKAGING MIDWEST, INC.
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
VENTURE PACKAGING SOUTHEAST, INC.
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
NIM HOLDINGS LIMITED
By /S/ MARTIN R. IMBLER
Martin R. Imbler Chairman of the Board of Directors
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Martin R. Imbler Chairman of the Board of March 29, 2000 Martin R. Imbler Directors (Principal Executive Officer)
/s/ James M. Kratochvil Director (Principal March 29, 2000 James M. Kratochvil Financial and Accounting Officer)
/s/ Trevor D. Johnson Sales and Marketing Director March 29, 2000 Trevor D. Johnson
/s/ Alan R. Sandell Managing Director March 29, 2000 Alan R. Sandell
/s/ Ira G. Boots Director March 29, 2000 Ira G. Boots
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY PLASTICS U.K. LIMITED (F/K/A NORWICH INJECTION MOULDERS LIMITED)
By /S/ MARTIN R. IMBLER Martin R. Imbler Chairman of the Board of Directors
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Martin R. Imbler Chairman of the Board of March 29, 2000 Martin R. Imbler Directors (Principal Executive Officer)
/s/ James M. Kratochvil Director (Principal March 29, 2000 James M. Kratochvil Financial and Accounting Officer)
/s/ Trevor D. Johnson Sales and Marketing Director March 29, 2000 Trevor D. Johnson
/s/ Alan R. Sandell Managing Director March 29, 2000 Alan R. Sandell
/s/ Ira G. Boots Director March 29, 2000 Ira G. Boots
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
KNIGHT PLASTICS, INC.
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
CPI HOLDING CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
CARDINAL PACKAGING, INC.
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
NORWICH ACQUISITION LIMITED
By /S/ MARTIN R. IMBLER Martin R. Imbler Chairman of the Board of Directors
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Martin R. Imbler Chairman of the Board of March 29, 2000 Martin R. Imbler Directors (Principal Executive Officer)
/s/ James M. Kratochvil Director (Principal March 29, 2000 James M. Kratochvil Financial and Accounting Officer)
/s/ Trevor D. Johnson Sales and Marketing Director March 29, 2000 Trevor D. Johnson
/s/ Alan R. Sandell Managing Director March 29, 2000 Alan R. Sandell
/s/ Ira G. Boots Director March 29, 2000 Ira G. Boots
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of March, 2000.
BERRY PLASTICS ACQUISITION CORPORATION
By /S/ MARTIN R. IMBLER Martin R. Imbler President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Roberto Buaron Chairman of the Board of March 29, 2000 Roberto Buaron Directors
/s/ Martin R. Imbler President, Chief Executive March 29, 2000 Martin R. Imbler Officer and Director (Principal Executive Officer)
/s/ James M. Kratochvil Executive Vice President, March 29, 2000 James M. Kratochvil Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)
/s/ Joseph. S. Levy Vice President, Assistant March 29, 2000 Joseph. S. Levy Secretary, Assistant Treasurer and Director
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANT WHICH HAS NOT REGISTERED
SECURITIES PURSUANT TO SECTION 12 OF THE ACT
The Registrants have not sent any annual report or proxy material to securityholders.
BPC HOLDING CORPORATION (PARENT COMPANY)
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS
S-1
BPC HOLDING CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
S-2
BPC HOLDING CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
S-3
Notes to Condensed Financial Statements
(1) BASIS OF PRESENTATION. In the parent company-only financial statements, Holding's investment in subsidiary is stated at cost plus equity in undistributed earnings of subsidiary since date of acquisition. The parent company-only financial statements should be read in connection with Holding's consolidated financial statements, which are included beginning on page.
(2) GUARANTEE. Berry had approximately $292.0 million and $218.3 million of long-term debt outstanding at January 1, 2000 and January 2, 1999, respectively. Under the terms of the debt agreements, Holding has guaranteed the payment of all principal and interest.
S-4
BPC HOLDING CORPORATION
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
(1) Uncollectible accounts written off, net of recoveries. (2) Primarily relates to purchase of accounts receivable and related allowance through acquisitions.
S-5
INDEX
EXHIBIT NO. DESCRIPTION OF EXHIBIT
2.1 Asset Purchase Agreement dated February 12, 1992, among Berry Plastics Corporation (the "Company"), Berry Iowa, Berry Carolina, Inc., Genpak Corporation, a New York corporation, and Innopac International Inc., a public Canadian corporation (filed as Exhibit 10.1 to the Registration Statement on Form S-1 filed on February 24, 1994 (the "Form S-1") and incorporated herein by reference)
2.2 Asset Purchase Agreement dated December 24, 1994, between the Company and Berry Plastics, Inc. (filed as Exhibit 10.2 to the Form S-1 and incorporated herein by reference)
2.3 Asset Purchase Agreement dated March 1, 1995, among Berry Sterling Corporation, Sterling Products, Inc. and the stockholders of Sterling Products, Inc. (filed as Exhibit 2.3 to the Annual Report on Form 10-K filed on March 31, 1995 (the "1994 Form 10-K") and incorporated herein by reference)
2.4 Asset Purchase Agreement dated December 21, 1995, among Berry Tri-Plas Corporation, Tri-Plas, Inc. and Frank C. DeVore (filed as Exhibit 2.4 to the Annual Report on Form 10-K filed on March 28, 1996 (the "1995 Form 10-K") and incorporated herein by reference)
2.5 Asset Purchase Agreement dated January 23, 1996, between the Company and Alpha Products, Inc. (filed as Exhibit 2.5 to the 1995 Form 10-K and incorporated herein by reference)
2.6 Stock Purchase and Recapitalization Agreement dated as of June 12, 1996, by and among Holding, BPC Mergerco, Inc. ("Mergerco") and the other parties thereto (filed as Exhibit 2.1 to the Current Report on Form 8-K filed on July 3, 1996 (the "Form 8-K") and incorporated herein by reference)
2.7 Preferred Stock and Warrant Purchase Agreement dated as of June 12, 1996, by and among Holding, Mergerco, Chase Venture Capital Associates, L.P. ("CVCA") and The Northwestern Mutual Life Insurance Company ("Northwestern") (filed as Exhibit 2.2 to the Form 8-K and incorporated herein by reference)
2.8 Agreement and Plan of Merger dated as of June 18, 1996, by and between Holding and Mergerco (filed as Exhibit 2.3 to the Form 8-K and incorporated herein by reference)
2.9 Certificate of Merger of Mergerco with and into Holding, dated as of June 18, 1996 (filed as Exhibit 2.9 to the Registration Statement on Form S-4 filed on July 17, 1996 (the "1996 Form S-4") and incorporated herein by reference)
2.10 Agreement and Plan of Reorganization dated as of January 14, 1997 (the "PackerWare Reorganization Agreement"), among the Company, PackerWare Acquisition Corporation, PackerWare Corporation and the shareholders of PackerWare (filed as Exhibit 2.1 to the Current Report on Form 8-K filed on February 4, 1997 (the "1997 8-K") and incorporated herein by reference)
2.11 Amendment to the PackerWare Reorganization Agreement dated as of January 20, 1997 (filed as Exhibit 2.2 to the 1997 8-K and incorporated herein by reference)
2.12 Asset Purchase Agreement dated as of January 17, 1997, among the Company, Container Industries, Inc. and the shareholders of Container Industries, Inc. (filed as Exhibit 2.12 to the Annual Report on Form 10-K for the fiscal year ended December 28, 1996 (the "1996 Form 10-K) and incorporated herein by reference)
2.13 Agreement and Plan of Reorganization dated as of January 14, 1997, as amended on January 20, 1997, among the Company, PackerWare Acquisition Corporation, PackerWare Corporation and the Shareholders of PackerWare Corporation (filed as Exhibits 2.1 and 2.2 to the Current Report on Form 8-K filed February 3, 1997 and incorporated herein by reference)
2.14 Asset Purchase Agreement dated May 13, 1997, among the Company, Berry Plastics Design Corporation, Virginia Design Packaging Corp. and the shareholders of Virginia Design Packaging Corp. (filed as Exhibit 2.14 to the Annual Report on Form 10-K for the fiscal year ended December 27, 1997 (the "1997 Form 10-K") and incorporated herein by reference)
4.10 Agreement for the Sale and Purchase of the Entire Issued Share Capital of Norwich Injection Moulders Limited dated July 2, 1998, among the Company, NIM Holdings Limited and the persons listed on Schedule 1 thereto (filed as Exhibit 2.15 to Amendment No. 1 to Form S-4 filed on December 29, 1998 (the "1998 Amended Form S-4") and incorporated herein by reference)
2.16 Stock Purchase Agreement dated June 18, 1999 among the Company, CPI Holding, Cardinal and the Shareholders of CPI Holding (filed as Exhibit 2.1 to the Current Report on Form 8-K filed on July 21, 1999 and incorporated herein by reference)
3.1 Amended and Restated Certificate of Incorporation of Holding (filed as Exhibit 3.1 to the 1996 Form S-4 and incorporated herein by reference)
3.2 By-laws of Holding (filed as Exhibit 3.2 to the Form S-1 and incorporated herein by reference)
3.3 Certificate of Incorporation of the Company (filed as Exhibit 3.3 to the Form S-1 and incorporated herein by reference)
3.4 By-laws of the Company (filed as Exhibit 3.4 to the Form S-1 and incorporated herein by reference)
3.5 Certificate of Incorporation of Berry Iowa Corporation ("Berry Iowa") (filed as Exhibit 3.5 to the Form S-1 and incorporated herein by reference)
3.6 By-laws of Berry Iowa (filed as Exhibit 3.6 to the Form S-1 and incorporated herein by reference)
3.7 Certificate of Incorporation of Berry Tri-Plas Corporation ("Berry Tri-Plas") (filed as Exhibit 3.7 to the Form S-1 and incorporated herein by reference)
3.8 By-laws of Berry Tri-Plas (filed as Exhibit 3.8 to the Form S-1 and incorporated herein by reference)
3.9 Certificate of Amendment to the Certificate of Incorporation of Berry Tri-Plas Corporation (filed as Exhibit 3.9 to the 1996 Form 10-K and incorporated herein by reference)
3.10 Certificate of Designation, Preferences, and Rights of Series B Cumulative Preferred Stock of Holding (filed as Exhibit 3.10 to the 1997 Form 10-K and incorporated herein by reference)
3.11 Certificate of Incorporation of Berry Sterling (filed as Exhibit 3.11 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.12 By-laws of Berry Sterling (filed as Exhibit 3.12 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.13 Certificate of Incorporation of AeroCon (filed as Exhibit 3.13 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.14 By-laws of AeroCon (filed as Exhibit 3.14 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.15 Articles of Incorporation of PackerWare (filed as Exhibit 3.15 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.16 By-laws of PackerWare (filed as Exhibit 3.16 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.17 Certificate of Incorporation of Berry Design (filed as Exhibit 3.17 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.18 By-laws of Berry Design (filed as Exhibit 3.18 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.19 Certificate of Incorporation of Venture Holdings (filed as Exhibit 3.19 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.20 By-laws of Venture Holdings (filed as Exhibit 3.20 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.21 Articles of Incorporation of Venture Midwest (filed as Exhibit 3.21 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.22 Code of Regulations of Venture Midwest (filed as Exhibit 3.22 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.23 Articles of Incorporation for a Statutory Close Corporation of Venture Southeast (filed as Exhibit 3.23 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.24 By-laws of Venture Southeast (filed as Exhibit 3.24 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.25 Memorandum of Association of NIM Holdings (filed as Exhibit 3.25 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.26 Articles of Association of NIM Holdings (filed as Exhibit 3.26 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.27 Memorandum of Association of Norwich (filed as Exhibit 3.27 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.28 Articles of Association of Norwich (filed as Exhibit 3.28 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.29 Certificate of Incorporation of Knight Plastics (filed as Exhibit 3.29 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.30 By-laws of Knight Plastics (filed as Exhibit 3.30 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.31 Certificate of Incorporation of CPI Holding Corporation (filed as Exhibit 3.31 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.32 By-laws of CPI Holding Corporation (filed as Exhibit 3.32 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.33 Certificate of Incorporation of Cardinal Packaging, Inc. (filed as Exhibit 3.33 to 1998 Amended Form S-4 and incorporated herein by reference)
3.34 Code of Regulations of Cardinal Packaging, Inc. (filed as Exhibit 3.34 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.35 Memorandum of Association of Norwich Acquisition Limited (filed as Exhibit 3.35 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.36 Articles of Association of Norwich Acquisition Limited (filed as Exhibit 3.36 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.37 Certificate of Incorporated of Berry Plastics Acquisitions Corporation (filed as Exhibit 3.37 to the 1998 Amended Form S-4 and incorporated herein by reference)
3.38 By-Laws of Berry Plastics Acquisition Corporation (filed as Exhibit 3.38 to the 1998 Amended Form S-4 and incorporated herein by reference)
4.1 Indenture dated April 21, 1994 between the Company and United States Trust Company of New York, as Trustee (including the form of Note and Guarantees as Exhibits A and B thereto respectively) (filed as Exhibit 4.1 to the Form S-1 and incorporated herein by reference)
4.2 Warrant Agreement between Holding and United States Trust Company of New York, as Warrant Agent (filed as Exhibit 4.2 to the Form S-1 and incorporated herein by reference)
4.3 Indenture dated as of June 18, 1996, between Holding and First Trust of New York, National Association, as Trustee (the "Trustee"), relating to Holding's Series A and Series B 12.5% Senior Secured Notes Due 2006 (filed as Exhibit 4.3 to the 1996 Form S-4 and incorporated herein by reference)
4.4 Pledge, Escrow and Disbursement Agreement dated as of June 18, 1996, by and among Holding, the Trustee and First Trust of New York, National Association, as Escrow Agent (filed as Exhibit 4.4 to the 1996 Form S-4 and incorporated herein by reference)
4.5 Holding Pledge and Security Agreement dated as of June 18, 1996, between Holding and First Trust of New York, National Association, as Collateral Agent (filed as Exhibit 4.5 to the 1996 Form S-4 and incorporated herein by reference)
4.6 Registration Rights Agreement dated as of June 18, 1996, by and among Holding and Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") (filed as Exhibit 4.6 to the 1996 Form S-4 and incorporated herein by reference)
4.7 BPC Holding Corporation 1996 Stock Option Plan (filed as Exhibit 4.7 to the 1996 Form 10-K and incorporated herein by reference)
4.8 Form of Nontransferable Performance-Based Incentive Stock Option Agreement (filed as Exhibit 4.7 to the 1996 Form 10-K and incorporated herein by reference)
4.9 Indenture dated as of August 24, 1998 among the Company, the Guarantors and United States Trust Company of New York, as trustee (filed as Exhibit 4.9 to the 1998 Amended Form S-4 and incorporated herein by reference)
4.10 Registration Rights Agreement dated as of August 24, 1998 by and among the Company, the Guarantors and DLJ (filed as Exhibit 4.10 to the 1998 Amended Form S-4 and incorporated herein by reference)
4.11 Indenture dated as of July 6, 1999 among the Company, the Guarantors and United States Trust Company of New York , as trustee (filed as Exhibit 10.27 to the Registration Statement on Form S-4 (Registration No. 333-85739) filed on August 23, 1999 (the "1999 Form S-4") and incorporated herein by reference)
4.12 Registration Rights Agreement dated as of July 6, 1999 by and among the Company, the Guarantors, DLJ and Chase Securities, Inc. (filed as Exhibit 10.28 to the 1999 Form S-4 and incorporated herein by reference)
10.1 Second Amended and Restated Financing and Security Agreement dated as of July 2, 1998, as amended, by and among the Company, NIM Holdings, Norwich, Fleet Capital Corporation, General Electric Capital Corporation, Heller Financial, Inc. and NationsBank, N.A. (filed as Exhibit 10.1 to the 1998 Amended Form S-4 and incorporated herein by reference)
10.2 Employment Agreement dated December 24, 1990, as amended, between the Company and Martin R. Imbler ("Imbler") (filed as Exhibit 10.9 to the Form S-1 and incorporated herein by reference)
10.3 Amendment to Imbler Employment Agreement dated November 30, 1995 (filed as Exhibit 10.6 to the 1995 Form 10-K and incorporated herein by reference)
10.4 Amendment to Imbler Employment Agreement dated June 30, 1996 (filed as Exhibit 10.4 to the 1996 Form S-4 and incorporated herein by reference)
10.5 Employment Agreement dated December 24, 1990, as amended, between the Company and R. Brent Beeler ("Beeler") (filed as Exhibit 10.10 to the Form S-1 and incorporated herein by reference)
10.6 Amendment to Beeler Employment Agreement dated November 30, 1995 (filed as Exhibit 10.8 to the 1995 Form 10-K and incorporated herein by reference)
10.7 Amendment to Beeler Employment Agreement dated June 30, 1996 (filed as Exhibit 10.7 to the 1996 Form S-4 and incorporated herein by reference)
10.8 Employment Agreement dated December 24, 1990, as amended, between the Company and James M. Kratochvil ("Kratochvil") (filed as Exhibit 10.12 to the Form S-1 and incorporated herein by reference)
10.9 Amendment to Kratochvil Employment Agreement dated November 30, 1995 (filed as Exhibit 10.12 to the 1995 Form 10-K and incorporated herein by reference)
10.10 Amendment to Kratochvil Employment Agreement dated June 30, 1996 (filed as Exhibit 10.13 to the 1996 Form S-4 and incorporated herein by reference)
10.11 Employment Agreement dated as of January 1, 1993, between the Company and Ira G. Boots ("Boots") (filed as Exhibit 10.13 to the Form S-1 and incorporated herein by reference)
10.12 Amendment to Boots Employment Agreement dated November 30, 1995 (filed as Exhibit 10.14 to the 1995 Form 10-K and incorporated herein by reference)
10.13 Amendment to Boots Employment Agreement dated June 30, 1996 (filed as Exhibit 10.16 to the 1996 Form S-4 and incorporated herein by reference)
*10.14 Employment Agreement dated as of January 21, 1997, between the Company and Bruce J. Sims ("Sims")
10.15 Financing Agreement dated as of April 1, 1991, between the City of Henderson, Nevada Public Improvement Trust and the Company (including exhibits) (filed as Exhibit 10.17 to the Form S-1 and incorporated herein by reference)
10.16 Letter of Credit of NationsBank, N.A. dated April 16, 1997 (filed as Exhibit 10.15 to the 1998 Amended Form S-4 and incorporated herein by reference)
10.17 Stockholders Agreement dated as of June 18, 1996, among Holding, Atlantic Equity Partners International II, L.P., CVCA and the other parties thereto (filed as Exhibit 10.23 to the 1996 Form S-4 and incorporated herein by reference)
10.18 Warrant to purchase Class B Common Stock of Holding dated June 18, 1996, issued to CVCA (Warrant No. 1) (filed as Exhibit 10.24 to the 1996 Form S-4 and incorporated herein by reference)
10.19 Warrant to purchase Class B Common Stock of Holding dated June 18, 1996, issued to CVCA (Warrant No. 2) (filed as Exhibit 10.25 to the 1996 Form S-4 and incorporated herein by reference)
10.20 Warrant to purchase Class B Common Stock of Holding dated June 18, 1996, issued to The Northwestern Mutual Life Insurance Company (Warrant No. 3) (filed as Exhibit 10.26 to the 1996 Form S-4 and incorporated herein by reference)
10.21 Warrant to purchase Class B Common Stock of Holding dated June 18, 1996, issued to The Northwestern Mutual Life Insurance Company (Warrant No. 4) (filed as Exhibit 10.27 to the 1996 Form S-4 and incorporated herein by reference)
10.22 Amended and Restated Stockholders Agreement dated June 18, 1996, among Holding and certain stockholders of Holding (filed as Exhibit 10.28 to the 1996 Form S-4 and incorporated herein by reference)
10.23 Second Amended and Restated Management Agreement dated June 18, 1996, between First Atlantic Capital, Ltd. and the Company (filed as Exhibit 10.29 to the 1996 Form S-4 and incorporated herein by reference)
10.24 Warrant to purchase Class B Non-Voting Common Stock of BPC Holding Corporation, dated August 29, 1997, issued to Willard J. Rathbun (filed as Exhibit 10.30 to the 1997 Form 10-K and incorporated herein by reference)
10.25 Warrant to purchase Class B Non-Voting Common Stock of BPC Holding Corporation, dated August 29, 1997, issued to Craig Rathbun (filed as Exhibit 10.31 to the 1997 Form 10-K and incorporated herein by reference)
*10.26 Tax Sharing Agreement dated April 20, 1994, between BPC Holding Corporation and its subsidiaries
21 List of subsidiaries (filed as Exhibit 21 to the Registration Statement on Form S-4 (Registration No. 333-645499) on December 2, 1999 and incorporated herein by reference)
*27 Financial Data Schedule
* Filed herewith. | 28,096 | 184,299 |
925722_1999.txt | 925722_1999 | 1999 | 925722 | ITEM 1. BUSINESS
Milton Federal Financial Corporation, an Ohio corporation ("MFFC"), is a unitary savings and loan holding company which owns all of the issued and outstanding common shares of Milton Federal Savings Bank ("Milton Federal"), a federal savings bank chartered under the laws of the United States, together referred to as the Corporation. On October 6, 1994, MFFC acquired all of the common shares issued by Milton Federal upon its conversion from a mutual savings and loan association to a stock savings bank (the "Conversion"). Prior to the Conversion, Milton Federal's name was Milton Federal Savings and Loan Association.
GENERAL
Milton Federal is principally engaged in the business of making permanent first-mortgage loans secured by one- to four-family residential real estate located in Milton Federal's designated lending area. Milton Federal also originates loans for the construction of one- to four-family residential real estate and loans secured by multi-family real estate (over four units) and nonresidential real estate. The origination of consumer loans, including unsecured loans and loans secured by deposits, automobiles, recreational vehicles and boats, and home improvement and commercial loans constitutes a small portion of Milton Federal's lending activities. Loan funds are obtained primarily from savings deposits, borrowings from the Federal Home Loan Bank (the "FHLB"), and loan and security repayments. In addition to originating loans, Milton Federal invests in U.S. Government and agency obligations, interest-bearing deposits in other financial institutions, mortgage-backed securities that include collateralized mortgage obligations ("CMOs") and real estate mortgage investment conduits ("REMICs").
Milton Federal conducts business from its main office in West Milton, Ohio, and from its full-service branch offices located in Englewood, Brookville and Tipp City, Ohio. Milton Federal's designated lending area consists of portions of Miami, Montgomery and Darke Counties, Ohio. Milton Federal's primary market area for savings deposits consists of Miami and Montgomery Counties and all contiguous counties.
As a savings and loan holding company, MFFC is subject to regulation, supervision and examination by the Office of Thrift Supervision of the United States Department of the Treasury (the "OTS"). As a savings bank chartered under the laws of the United States, Milton Federal is subject to regulation, supervision and examination by the OTS and the Federal Deposit Insurance Corporation (the "FDIC"). Deposits in Milton Federal are insured up to applicable limits by the FDIC. Milton Federal is also a member of the FHLB of Cincinnati.
Other than investing excess funds from the Conversion in securities, MFFC's activities have been limited primarily to holding the common stock of Milton Federal since acquiring such common stock in connection with the Conversion. Consequently, the following discussion focuses primarily on the business of Milton Federal.
FORWARD LOOKING STATEMENTS
When used in this Form 10-K, the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimated," "projected," or similar expressions are intended to identify "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties including changes in economic conditions in the Corporation's market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the Corporation's market area and competition, that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. Factors listed above could affect the
Corporation's financial performance and could cause the Corporation's actual results for future periods to differ materially from any statements expressed with respect to future periods. See Exhibit 99.2 hereto, "Safe Harbor Under the Private Securities Litigation Reform Act of 1995," which is incorporated by reference.
The Corporation does not undertake, and specifically disclaims any obligation, to publicly revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.
LENDING ACTIVITIES
GENERAL. Milton Federal's primary lending activity is the origination of conventional mortgage loans secured by one- to four-family residential real estate located in Milton Federal's designated lending area. Loans for the construction of one- to four-family homes and mortgage loans on multi-family properties containing five units or more and nonresidential properties are also offered by Milton Federal. Milton Federal does not originate loans insured by the Federal Housing Authority or loans guaranteed by the Veterans Administration. In addition to mortgage lending, Milton Federal originates consumer loans, some unsecured and some secured by deposits, automobiles, boats and recreational vehicles, as well as, commercial loans.
LOAN PORTFOLIO COMPOSITION. The following table presents certain information with respect to the composition of Milton Federal's loan portfolio at the dates indicated:
LOAN MATURITY SCHEDULE. The following table sets forth certain information as of September 30, 1999, regarding the dollar amount of loans, excluding residential real estate loans, home equity loans and consumer loans, maturing in Milton Federal's portfolio based on their contractual terms to maturity. Demand loans and loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.
The following table sets forth at September 30, 1999, the dollar amount of loans, excluding one- to four-family, home equity, multi-family and consumer loans, before net items, due after one year from September 30, 1999, which have predetermined interest rates and floating or adjustable interest rates:
ONE- TO FOUR-FAMILY RESIDENTIAL REAL ESTATE LOANS. The primary lending activity of Milton Federal has been the origination of permanent conventional loans secured by one- to four-family residences, primarily single-family residences, located within Milton Federal's designated lending area. Milton Federal also originates loans for the construction of one- to four-family residences and home equity loans secured by second mortgages on one- to four-family residential real estate. Each of such loans is secured by a mortgage on the underlying real estate and improvements thereon, if any.
OTS regulations limit the amount that Milton Federal may lend in relationship to the appraised value of the real estate and improvements at the time of loan origination. In accordance with such regulations, Milton Federal makes fixed-rate loans on one- to four-family residences up to 95% of the value of the real estate and improvements (the "Loan-to-Value Ratio" or "LTV"). Milton Federal requires private mortgage insurance for such loans in excess of 90% of the value of the real estate securing such loans. Residential real estate loans are offered by Milton Federal for terms of up to 30 years.
While the majority of Milton Federal's loans have fixed rates of interest, Milton Federal began originating adjustable rate mortgage loans ("ARMs") in fiscal year 1995. ARMs are offered by Milton Federal for terms of up to 30 years. The interest-rate adjustment periods on the ARMs are either one year or three years. Until March 18, 1999, Milton Federal also offered five-year ARMs. The interest rate adjustments on ARMs presently originated by Milton Federal are tied to changes in the weekly average yield on the one-, three- and five-year U.S. Treasury constant maturities index. Rate adjustments are computed by adding a stated margin, typically 3%, to the index. The maximum allowable adjustment at each adjustment date is usually 2% with a maximum adjustment of 6% over the term of the loan. The initial rate is dependent, in part, on how often the rate can be adjusted. Milton Federal originates ARMs that have initial interest rates lower
than the sum of the index plus the margin. Such loans are subject to increased risk of delinquency or default due to increasing monthly payments as the interest rates on such loans increase to the fully-indexed level, although such increase is considered in Milton Federal's underwriting of such loans.
The aggregate amount of Milton Federal's one- to four-family residential real estate loans equaled approximately $159.3 million at September 30, 1999, and represented 79.4% of loans at such date. At such date, loans secured by one- to four-family residential real estate with outstanding balances of $184,000, or .1% of its one- to four-family residential real estate loan balance, were more than 90 days delinquent or nonaccruing. See "Delinquent Loans, Nonperforming Assets and Classified Assets."
MULTI-FAMILY RESIDENTIAL REAL ESTATE LOANS. In addition to loans on one- to four-family properties, Milton Federal makes loans secured by multi-family properties containing over four units. Such loans are made with fixed and adjustable interest rates and a maximum LTV of 75%. ARMs on multi-family properties are offered with the same adjustment periods and index as ARMs on one- to four-family properties and typically with a margin of 4% over the index.
Multi-family lending is generally considered to involve a higher degree of risk because the loan amounts are larger and the borrower typically depends upon income generated by the project to cover operating expenses and debt service. The profitability of a project can be affected by economic conditions, government policies and other factors beyond the control of the borrower. Milton Federal attempts to reduce the risk associated with multi-family lending by evaluating the credit-worthiness of the borrower and the projected income from the project and by obtaining personal guarantees on loans made to corporations and partnerships. Milton Federal currently requires that borrowers agree to submit financial statements and tax returns annually to enable Milton Federal to monitor the loan.
At September 30, 1999, loans secured by multi-family properties totaled approximately $2.0 million, or 1.0% of total loans, all of which were secured by property located in Miami and Montgomery Counties, Ohio. At such date, there were no loans secured by multi-family residential real estate that were more than 90 days delinquent or nonaccruing. See "Delinquent Loans, Nonperforming Assets and Classified Assets."
CONSTRUCTION LOANS. Milton Federal makes loans for the construction of residential and nonresidential real estate. Such loans are structured as permanent loans with fixed and adjustable rates of interest and for terms of up to 30 years. Almost all of the construction loans originated by Milton Federal are made to owner-occupants for the construction of single-family homes by a general contractor. The remainder are made to builders for small projects, some of which have not been pre-sold.
Construction loans generally involve greater underwriting and default risks than do loans secured by mortgages on existing properties due to the concentration of principal in a limited number of loans and borrowers and the effects of general economic conditions on real estate developments, developers, managers and builders. In addition, such loans are more difficult to evaluate and monitor. Loan funds are advanced upon the security of the project under construction, which is more difficult to value before the completion of construction. Moreover, because of the uncertainties inherent in estimating construction costs, it is relatively difficult to evaluate accurately the LTVs and the total loan funds required to complete a project. In the event a default on a construction loan occurs and foreclosure follows, Milton Federal must take control of the project and attempt either to arrange for completion of construction or dispose of the unfinished project.
At September 30, 1999, a total of $11.9 million, 5.9% of Milton Federal's total loans, consisted of construction loans. At such date, there were no construction loans that were more than 90 days delinquent or nonaccruing. The majority of Milton Federal's construction loans are secured by property in Miami and Montgomery Counties and the economy of such lending area has been relatively stable.
NONRESIDENTIAL REAL ESTATE LOANS. Milton Federal also makes loans secured by nonresidential real estate consisting primarily of retail stores, office buildings and churches. Such loans are originated at fixed-rates of
interest for up to 15 years or as a three-year ARM with terms up to 25 years. Such loans have a maximum LTV of 80%.
Nonresidential real estate lending is generally considered to involve a higher degree of risk than residential lending due to the relatively larger loan amounts and the effects of general economic conditions on the successful operation of income-producing properties. If the cash flow on the property is reduced, for example, as leases are not obtained or renewed, the borrower's ability to repay may be impaired. Milton Federal has endeavored to reduce such risk by evaluating the credit history and past performance of the borrower, the location of the real estate, the quality of the management constructing and operating the property, the debt service ratio, the quality and characteristics of the income stream generated by the property and appraisals supporting the property's valuation.
At September 30, 1999, Milton Federal had a total of $14.9 million invested in nonresidential real estate loans, all of which were secured by property located in Miami and Montgomery Counties, Ohio. Such loans comprised 7.5% of Milton Federal's total loans at such date. At such date loans secured by nonresidential real estate with outstanding balances of $173,000, or 1.2% of Milton Federal's nonresidential real estate loan portfolio, were more than 90 days delinquent or nonaccruing. See "Delinquent Loans, Nonperforming Assets and Classified Assets."
Federal regulations limit the amount of nonresidential mortgage loans that an association may make to 400% of its capital. At September 30, 1999, Milton Federal's nonresidential mortgage loans totaled 65.9% of Milton Federal's capital.
CONSUMER LOANS. Milton Federal makes various types of consumer loans, including unsecured loans and loans secured by deposits, automobiles, boats and recreational vehicles. Such loans are made at fixed rates of interest only. Milton Federal has increased the emphasis of originating consumer loans as part of its interest rate risk management efforts.
Consumer loans may entail greater risk than do residential mortgage loans. The risk of default on consumer loans increases during periods of recession, high unemployment and other adverse economic conditions. Although Milton Federal has not had significant delinquencies on consumer loans, no assurance can be provided that delinquencies will not increase.
At September 30, 1999, Milton Federal had approximately $3.7 million, or 1.9% of its total loans, invested in consumer loans. At such date, consumer loans that were more than 90 days delinquent or nonaccruing totaled $1,000, or less than 0.1% of consumer loans. See "Delinquent Loans, Nonperforming Assets and Classified Assets."
COMMERCIAL LOANS. Federal law authorizes federally-chartered thrift institutions, such as Milton Federal, to make secured or unsecured loans for commercial, corporate, business and agricultural purposes, up to a maximum of 20% of total assets, so long as the amount above 10% of total assets is for small business purposes.
In fiscal 1997, Milton Federal implemented a commercial loan program, which includes extending letters of credit and commercial loans to finance commercial and industrial business activities including equipment financing, commercial lines of credit and working capital.
Unlike residential mortgage loans, which generally are granted on the basis of the borrower's ability to repay the debt from employment and other income and are secured by real property, the value of which tends to be more easily ascertainable, business loans are of higher risk and typically are granted on the basis of the borrower's ability to repay the debt from the cash flow of the underlying business. In addition, it is generally the practice of Milton Federal to request additional collateral in the form of personal guarantees. Additional collateral may include, on occasion, a lien on the business owner's personal residence. Nonetheless, the
availability of funds for the repayment of business loans generally is dependent on the success of the business itself.
At September 30, 1999, Milton Federal had approximately $3.5 million, or 1.7% of its total loans, invested in commercial loans. At such date, commercial loans with outstanding balances of $82,000, or 2.4% of its commercial loan balance, were more than 90 days delinquent or nonaccruing. See "Delinquent Loans, Nonperforming Assets and Classified Assets."
LOAN SOLICITATION AND PROCESSING. Loan originations are developed from a number of sources, including continuing business with depositors, borrowers and real estate developers, periodic newspaper and radio advertisements, solicitations by Milton Federal's lending staff and walk-in customers.
Loan applications for permanent mortgage loans are taken by loan personnel. Milton Federal obtains a credit report, verification of employment and other documentation concerning the credit-worthiness of the borrower. An appraisal of the fair market value of the real estate on which Milton Federal will be granted a mortgage to secure the loan is prepared by an independent fee appraiser approved by the Board of Directors. An environmental study is conducted for all business properties and for other real estate only if the appraiser or the loan committee has reason to believe that an environmental problem may exist. Commencing in 1992, Milton Federal required a survey of the property for every real estate loan.
For multi-family and nonresidential mortgage loans, a personal guarantee of the borrower's obligation to repay the loan is required. Milton Federal also obtains information with respect to prior projects completed by the borrower. Upon the completion of the appraisal and the receipt of information on the borrower, the application for a loan is submitted to the Loan Committee for approval or rejection if the loan does not exceed $400,000. If the loan amount exceeds $400,000, the application is approved or rejected by the full Board of Directors.
If a mortgage loan application is approved, title insurance is obtained on the title to the real estate that will secure the mortgage loan. Prior to September 1990, Milton Federal did not require title insurance but did obtain an attorney's opinion of title. Borrowers are required to carry fire and casualty insurance and flood insurance, if applicable, and to name Milton Federal as an insured mortgagee.
The procedure for approval of construction loans is the same as for permanent mortgage loans, except that an appraiser evaluates the building plans, construction specifications and estimates of construction costs. Milton Federal also evaluates the feasibility of the proposed construction project and the experience and financial status of the builder.
Consumer loans are underwritten on the basis of the borrower's credit history and an analysis of the borrower's income and expenses, ability to repay the loan and the value of the collateral, if any.
Milton Federal's loans carry no prepayment penalties but do provide that the entire balance of the loan is due upon sale of the property securing the loan. Milton Federal generally enforces such due-on-sale provisions.
LOAN ORIGINATIONS, PURCHASES AND SALES. Prior to 1995, Milton Federal had been actively originating only new fixed-rate loans. In fiscal 1995, Milton Federal began to originate variable-rate loans in addition to fixed-rate loans. In fiscal 1999, Milton Federal began originating one- to four-family first mortgage loans with the intent of selling them in the secondary market. Prior to fiscal 1999, Milton Federal periodically sold pools of one- to four-family first mortgage portfolio loans. The loans were sold as a means to manage interest rate risk by reducing the Milton Federal's investment in various lower-yielding or longer-term fixed rate loans. Management intends to continue, in the future, to originate, fixed-rate loans in a manner that permits their sale into the secondary mortgage market. Milton Federal intends to retain the servicing of loans sold in the secondary mortgage market. At September 30, 1999, Milton Federal had mortgage loans of
$2.6 million classified as held for sale. Milton Federal occasionally participates in loans originated by other institutions.
The following table presents Milton Federal's loan origination and sale activity, not including loans held for sale for the periods indicated:
(1) Consists of amortization of loan origination fees and provision for loan losses.
OTS regulations generally limit the aggregate amount that a savings association may lend to any one borrower to an amount equal to 15% of the association's total capital for regulatory capital purposes plus any additional loan reserves not included in total capital (collectively, "Lending Limit Capital"). A savings association may lend to one borrower an additional amount not to exceed 10% of the association's Lending Limit Capital if the additional amount is fully secured by certain forms of "readily marketable collateral." Real estate is not considered "readily marketable collateral." In addition, the regulations require that loans to certain related or affiliated borrowers be aggregated for purposes of such limits. An exception to these limits permits loans to one borrower of up to $500,000 "for any purpose."
Based on such limits, Milton Federal was able to lend approximately $3.4 million to any one borrower at September 30, 1999. The largest amount Milton Federal had outstanding to one borrower was $1.1 million. Such loans were secured by one- to four-family and multi-family residential real estate and were current at September 30, 1999.
LOAN ORIGINATION AND OTHER FEES. Milton Federal realizes loan origination fees and other fee income from its lending activities. In addition, Milton Federal also realizes income from late payment charges, application fees, and fees for other miscellaneous services.
Loan origination fees and other fees are a volatile source of income, varying with the volume of lending, loan repayments and general economic conditions. All nonrefundable loan origination fees and certain direct loan origination costs are deferred and recognized as an adjustment to yield over the life of the related loan.
DELINQUENT LOANS, NONPERFORMING ASSETS AND CLASSIFIED ASSETS. When a borrower fails to make a required payment on a loan, Milton Federal attempts to cause the deficiency to be cured by contacting the borrower. In most cases, deficiencies are cured promptly.
When a real estate loan is fifteen days or more delinquent, the borrower is sent a delinquency notice. When a loan is thirty days delinquent, Milton Federal sends a letter to the borrower and may telephone the borrower. Depending upon the circumstances, Milton Federal may also inspect the property and inform the borrower of the availability of credit counseling from Milton Federal and counseling agencies. When a loan becomes 90 days delinquent, it is generally referred to an attorney for foreclosure, unless the Board of Directors deems appropriate alternative payment arrangements to eliminate the arrearage. A decision as to whether and when to initiate foreclosure proceedings is based on such factors as the amount of the outstanding loan in relation to the original indebtedness, the extent of the delinquency and the borrower's ability and willingness to cooperate in curing delinquencies. If a foreclosure occurs, the real estate is sold at public sale and may be purchased by Milton Federal.
Real estate acquired, or deemed acquired, by Milton Federal as a result of foreclosure proceedings is classified as real estate owned ("REO") until it is sold. When property is so acquired, or deemed to have been acquired, it is initially recorded by Milton Federal at the fair value of the real estate. Interest accrual, if any, ceases no later than the date of acquisition of the real estate. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Costs incurred to carry other real estate are charged to expense. Milton Federal held approximately $201,000 in REO property at September 30, 1999.
In the case of delinquencies on consumer loans, a notice is sent to the borrower when payment is not received by the tenth business day after the payment due date. When a payment is fifteen days past due, a letter is sent or the borrower is contacted by telephone. If no payment or satisfactory promise is made by the second due date, a collection officer makes a personal visit to the borrower's residence. If an account is ninety days delinquent, the borrower is provided a written notice that legal action will be taken if the account is not brought current within ten days, and the failure to so bring the account current generally results in repossession of the collateral, if any.
Milton Federal places a loan on nonaccrual status when the loan is delinquent 90 days or more, unless the value of the collateral provides sufficient equity to warrant the continued accrual of interest.
The following table reflects the number and amount of loans in a delinquent status as of the dates indicated:
(1) The number of days a loan is delinquent is measured from the day the payment was due under the terms of the loan agreement.
The following table sets forth information with respect to the accrual and nonaccrual status of Milton Federal's loans that are 90 days or more past due and other nonperforming assets at the dates indicated:
(1) Other nonperforming assets represent real estate acquired by Milton Federal in settlement of loans, which is initially reported at estimated fair value at acquisition. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell.
Loans considered impaired within the scope of Statement of Financial Accounting Standards ("SFAS") No. 114 were not significant in 1999. During 1999, $12,000 would have been recorded on nonaccruing loans had such loans been accruing pursuant to contractual terms. During such period, no interest income was recorded on such loans. Management believes that no loans, other than loans which are currently classified as nonaccrual, more than 90 days past due or restructured, may be so classified in the near future due to concerns as to the ability of the borrowers to comply with repayment terms.
OTS regulations require that each thrift institution classify its own assets on a regular basis. Problem assets are classified as "substandard," "doubtful" or "loss." "Substandard" assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. "Doubtful" assets have the same weaknesses as "substandard" assets, with the additional characteristics that (i) the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable and (ii) there is a high possibility of loss. An asset classified "loss" is considered uncollectible and of such little value that its continuance as an asset of the institution is not warranted. The regulations also contain a "special mention" category, consisting of assets which do not currently expose an institution to a sufficient degree of risk to warrant classification but which possess credit deficiencies or potential weaknesses deserving management's close attention.
Generally, Milton Federal classifies as "substandard" all loans that are delinquent more than 60 days, unless management believes the delinquency status is short-term due to unusual circumstances. Loans delinquent fewer than 60 days may also be classified if the loans have the characteristics described above rendering classification appropriate.
The aggregate amounts of Milton Federal's classified assets at the dates indicated were as follows:
Federal examiners are authorized to classify an association's assets. If an association does not agree with an examiner's classification of an asset, it may appeal this determination to the District Director of the OTS. Milton Federal had no disagreements with the examiners regarding the classification of assets at the time of the last examination.
OTS regulations require that Milton Federal establish prudent general allowances for loan losses for any loan classified as substandard or doubtful. If an asset, or portion thereof, is classified as loss, the association must either establish specific allowances for losses in the amount of 100% of the portion of the asset classified loss, or charge-off such amount.
ALLOWANCE FOR LOAN LOSSES. Milton Federal maintains an allowance for loan losses based upon a number of relevant factors, including, but not limited to, trends in the level of nonperforming assets and classified loans, current and anticipated economic conditions in the primary lending area, past loss experience, probable losses arising from specific problem assets and changes in the composition of the loan portfolio.
The single largest component of Milton Federal's loan portfolio consists of one- to four-family residential real estate loans. Substantially all of these loans are secured by residential real estate and generally require a down payment of at least 10% of the lower of the sales price or appraisal value of the real estate. Private mortgage insurance is required for such loans with less than a 10% down payment. In addition, these loans are secured by property in Milton Federal's designated lending area consisting of portions of Miami, Montgomery and Darke Counties in Ohio. Milton Federal's practice of making the majority of its loans in its designated lending area and requiring a 10% down payment have contributed to a low historical charge-off rate.
In addition to one- to four-family residential real estate loans, Milton Federal makes additional real estate loans, including home equity, multi-family residential real estate, nonresidential real estate and construction loans. These real estate loans are secured by property in Milton Federal's designated lending area and also require the borrower to provide a down payment. Milton Federal has not experienced any charge-offs from these other real estate loan categories.
A small portion of Milton Federal's total loans consists of consumer loans, primarily automobile loans. These loans typically have a lower down payment and are secured by collateral that declines in value. Such loans therefore carry a higher degree of risk than the real estate loans. Milton Federal has had minimal charge-offs on consumer loans since these loans have been offered.
Milton Federal began originating commercial loans in fiscal 1997. Commercial loans are of higher risk and typically are granted on the basis of the borrower's ability to repay the debt from the cash flow of the underlying business. Milton Federal has had minimal charge-offs on commercial loans since these loans have been offered.
The allowance for loan losses is reviewed quarterly by management's Asset Classification Committee and the Board of Directors. While the Board of Directors believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in material adjustments, and net earnings could be significantly adversely affected, if circumstances differ substantially from the assumptions used in making the final determination.
The following table sets forth an analysis of Milton Federal's allowance for loan losses for the periods indicated.
(1) Total loans less net deferred loan fees and loans in process.
The following schedule is a breakdown of the allowance for loan losses allocated by type of loan and related ratios.
While management's periodic analysis of the adequacy of the allowance for loan losses may allocate portions of the allowance for specific problem loan situations, the entire allowance is available for any loan charge-offs that may occur.
MORTGAGE-BACKED SECURITIES
The Corporation maintains a significant portfolio of mortgage-backed securities in the form of Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA") and Government National Mortgage Association ("GNMA") participation certificates. Mortgage-backed securities generally entitle the Corporation to receive a portion of the cash flows from an identified pool of mortgages, and FHLMC, FNMA and GNMA securities are each guaranteed by their respective agencies as to principal and interest.
The Corporation has also invested significant amounts in CMOs and REMICs that are included in mortgage-backed securities. CMOs and REMICs are mortgage derivative products, secured by an underlying pool of mortgages. The Corporation has no ownership interest in the mortgages, except to the extent they serve as collateral. Payment streams from the mortgages serving as collateral are reconfigured with varying terms and time of payment to the investor. Though they can be used for hedging and investment, CMOs and REMICs can expose investors to higher risk of loss than direct investments in mortgage-backed pass-through securities, particularly with respect to price volatility and lack of a broad secondary market in such securities. The OTS has deemed certain CMOs and other mortgage derivative products to be "high-risk." None of the Corporation's CMOs or REMICs are in such "high-risk" category.
Although mortgage-backed securities generally yield less than individual loans originated by Milton Federal, they present less credit risk, because mortgage-backed securities are guaranteed as to principal repayment by the issuing agency and CMOs and REMICs are secured by the underlying collateral. All of the Corporation's CMOs and REMICs are backed by pools of mortgages that are insured or guaranteed by FNMA and FHLMC. Although certain mortgage-backed securities designated as available for sale are a potential source of liquid funds for loan originations and deposit withdrawals, the prospect of a loss on the sale of such securities limits the usefulness for liquidity purposes.
The Corporation has purchased adjustable-rate mortgage-backed securities as part of its effort to reduce its interest rate risk. In a period of declining interest rates, the Corporation is subject to prepayment risk on such adjustable-rate mortgage-backed securities. The Corporation attempts to mitigate this prepayment risk by purchasing mortgage-backed securities at or near par. If interest rates rise in general, the interest rates on the loans backing the mortgage-backed securities will also adjust upward, subject to the interest rate caps in the underlying adjustable-rate mortgage loans. However, the Corporation is still subject to interest rate risk on such securities if interest rates rise faster than the 1% to 2% maximum annual interest rate adjustments on the underlying loans.
At September 30, 1999, almost all of the $48.8 million of the Corporation's mortgage-backed securities had adjustable rates.
The following table sets forth information regarding the Corporation's carrying value of mortgage-backed securities at the dates indicated.
The following table sets forth information regarding scheduled maturities, carrying value, fair value and weighted average yields of the Corporation's mortgage-backed securities at September 30, 1999. Actual maturities will differ from contractual maturities due to scheduled repayments and because borrowers may have the right to call or prepay obligations with or without prepayment penalties. The following table does not take into consideration the effects of scheduled repayments or the effects of possible prepayments. The weighted average yield has been computed using the historical amortized cost for available for sale securities.
For additional information, see Note 2 of the Notes to Consolidated Financial Statements.
INVESTMENT ACTIVITIES
OTS regulations require that Milton Federal maintain a minimum amount of liquid assets, which may be invested in U. S. Treasury obligations, securities of various federal agencies, certificates of deposit at insured banks, bankers' acceptances and federal funds. Milton Federal is also permitted to make investments in certain commercial paper, corporate debt securities rated in one of the four highest rating categories by one or more nationally recognized statistical rating organizations, and mutual funds, as well as other investments permitted by federal regulations. See "REGULATION."
The following table sets forth the composition of the Corporation's interest-bearing deposits and securities portfolio at the dates indicated:
The following table sets forth the contractual maturities, carrying values, market values and average yields for the Corporation's interest-bearing deposits in other financial institutions and investment securities at September 30, 1999. The weighted average yield has been computed using the historical amortized cost for available for sale securities.
(1) Comprised of Intrieve, Incorporated ("Intrieve"), stock, which is reported at the fair value, which approximates cost.
DEPOSITS AND BORROWINGS
GENERAL. Deposits are a primary source of Milton Federal's funds for use in lending and other investment activities. In addition to deposits, Milton Federal uses borrowings from the FHLB and derives funds from interest payments and principal repayments on loans and mortgage-backed securities, income on earning assets, service charges and gains on the sale of assets. Loan payments are a relatively stable source of funds, while deposit inflows and outflows fluctuate more in response to general interest rates and money market conditions.
DEPOSITS. Deposits are attracted principally from within Milton Federal's primary market area through the offering of a broad selection of deposit instruments, including negotiable order of withdrawal ("NOW") accounts, money market accounts, passbook savings accounts, term certificate accounts, individual retirement accounts ("IRAs") and Keogh retirement accounts ("Keoghs"). Interest rates paid,
maturity terms, service fees and withdrawal penalties for the various types of accounts are established periodically by the management of Milton Federal based on Milton Federal's liquidity requirements, growth goals and interest rates paid by competitors. Milton Federal does not use brokers to attract deposits.
At September 30, 1999, the Corporation's certificates of deposit totaled $114.5 million, or 67.95% of total deposits. Of such amount, approximately $75.6 million in certificates of deposit mature within one year. Based on past experience and the Corporation's prevailing pricing strategies, management believes that a substantial percentage of such certificates will renew with the Corporation at maturity. If there is a significant deviation from historical experience, the Corporation can use borrowings from the FHLB as an alternative to this source of funds.
The following table sets forth the dollar amount of deposits in the various types of savings programs offered by the Corporation at the dates indicated:
(1) At September 30, 1998 and 1997, the weighted average rates on interest-bearing demand accounts were 2.74% and 2.13%, respectively. In July 1999, Milton Federal discontinued the payment of interest on all demand accounts.
(2) Milton Federal's weighted average interest rate paid on money market accounts fluctuates with the general movement of interest rates. At September 30, 1999, 1998 and 1997, the weighted average rates on money market accounts were 4.53%, 4.05% and 2.89%, respectively.
(3) Milton Federal's weighted average rate on passbook savings accounts fluctuates with the general movement of interest rates. The weighted average interest rate on passbook accounts was 2.53% at September 30, 1999 and 2.52% at September 30, 1998 and 1997.
(4) The interest rate on individual certificates of deposit remains fixed until maturity. At September 30, 1999, 1998 and 1997 the weighted average rates on certificates of deposit were 5.57%, 5.76% and 5.91%.
(5) IRAs and Keoghs are included in the various certificates of deposit balances. IRAs and Keoghs totaled $24.5 million, $23.0 million and $21.0 million as of September 30, 1999, 1998 and 1997.
At September 30, 1999, scheduled maturities of certificates of deposit were as follows:
The following table presents the amount of the Corporation's certificates of deposit of $100,000 or more by the time remaining until maturity as of September 30, 1999:
The following table sets forth Milton Federal's deposit account balance activity for the periods indicated:
BORROWINGS. The FHLB System functions as a central reserve bank providing credit for its member institutions and certain other financial institutions. See "REGULATION - Federal Home Loan Banks." As a member in good standing of the FHLB of Cincinnati, Milton Federal is authorized to apply for advances from the FHLB of Cincinnati, provided certain standards of creditworthiness have been met. Under current regulations, an association must meet certain qualifications to be eligible for FHLB advances. The extent to which an association is eligible for such advances will depend upon whether it meets the Qualified Thrift Lender Test (the "QTL Test"). See "REGULATION - OTS Regulations -- Qualified Thrift Lender Test." If an association meets the QTL Test, it will be eligible for 100% of the advances it would otherwise be eligible to receive. If an association does not meet the QTL Test, it will be eligible for such advances only to the extent it holds specified QTL Test assets. At September 30, 1999, Milton Federal complied with the QTL Test. As of September 30, 1999, 1998 and 1997, Milton Federal had borrowed $61.5 million, $52.4 million and $39.6 million. In addition to providing funding for loan growth, borrowed funds have also been invested in mortgage-backed securities to leverage a portion of Milton Federal's excess capital.
The following table sets forth certain information regarding FHLB advances for the periods indicated:
YIELDS EARNED AND RATES PAID
See "Management's Discussion and Analysis of Financial Condition and Resources of Operations" for an analysis of yields earned and rates paid on the Corporation's interest-earning assets and interest-bearing liabilities and the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have afforded the Corporation's interest income and expense.
COMPETITION
Milton Federal competes for deposits with other savings associations, commercial banks and credit unions and with the issuers of commercial paper and other securities, such as shares in money market mutual funds. The primary factors in competing for deposits are interest rates and convenience of office location. In making loans, Milton Federal competes with other savings associations, commercial banks, consumer finance companies, credit unions, leasing companies, mortgage companies and other lenders. Milton Federal competes for loan originations primarily through the interest rates and loan fees offered and through the efficiency and quality of services provided. Competition is affected by, among other things, the general availability of lendable funds, general and local economic conditions, current interest rate levels and other factors that are not readily predictable.
On November 12, 1999, the Gramm-Leach-Bliley Act (the "GLB Act") was enacted into law. The GLB Act makes sweeping changes in the financial services in which various types of financial institutions may engage. The Glass-Steagall Act, which had generally prevented banks from affiliating with securities and insurance firms, was repealed. A new "financial holding company," which owns only well capitalized and well managed depository institutions, will be permitted to engage in a variety of financial activities, including insurance and securities underwriting and agency activities.
The GLB Act permits unitary savings and loan holding companies in existence on May 4, 1999, including MFFC, to continue to engage in all activities that they were permitted to engage in prior to the enactment of the Act. Such activities are essentially unlimited, provided that the thrift subsidiary remains a qualified thrift lender. Any thrift holding company formed after May 4, 1999 will be subject to the same restrictions as a multiple thrift holding company. In addition, a unitary thrift holding company in
existence at May 4, 1999 may be sold only to a financial holding company engaged in activities permissible for multiple savings and loan holding companies.
The GLB Act is not expected to have a material effect on the activities in which MFFC and Milton Federal currently engage, except to the extent that competition with others types of financial institutions may increase as they engage in activities not permitted prior to enactment of the GLB Act.
SUBSIDIARIES
Milton Federal owns all of the outstanding shares of Milton Financial Service Corporation ("Milton Financial"), the only asset of which is stock of Intrieve, Inc., a data service provider. The net book value of Milton Federal's investment in Milton Financial at September 30, 1999, was $15,000.
PERSONNEL
As of September 30, 1999, Milton Federal had 49 full-time employees and 6 part-time employees. Milton Federal believes that relations with its employees are good. Milton Federal offers health, disability and life insurance benefits. None of the employees of Milton Federal are represented by a collective bargaining unit. MFFC has no full-time employees.
REGULATIONS
GENERAL
As a savings bank organized under the laws of the United States, Milton Federal is subject to regulation, examination and oversight by the OTS. Because Milton Federal's deposits are insured by the FDIC, Milton Federal is also subject to regulatory oversight by the FDIC. Milton Federal must file periodic reports with the OTS concerning its activities and financial condition. Examinations are conducted periodically by the OTS to determine whether Milton Federal complies with various regulatory requirements and is operating in a safe and sound manner. Milton Federal is a member of the FHLB of Cincinnati.
MFFC is a savings and loan holding company within the meaning of the Home Owners Loan Act, as amended (the "HOLA"). Consequently, MFFC is subject to regulation, examination and oversight by the OTS and must submit periodic reports thereto. Because MFFC is a corporation organized under Ohio law, it is subject to provisions of the Ohio Revised Code applicable to corporations generally.
OFFICE OF THRIFT SUPERVISION
GENERAL. The OTS is an office in the Department of the Treasury and is responsible for the regulation and supervision of all savings associations. Deposits of federally chartered savings institutions are insured by the Savings Association Insurance Fund (the "SAIF") of the FDIC. The OTS issues regulations governing the operation of savings associations, regularly examines such associations and imposes assessments on savings associations based on their asset size to cover the cost of general supervision and examination. The OTS charters federally chartered associations, such as Milton Federal, and prescribes their permissible investments and activities, including the types of loans and investments in real estate, subsidiaries and securities they may make. The OTS has authority over mergers and acquisitions of control of federally chartered savings and loan associations. The OTS also may initiate enforcement actions against savings associations and certain persons affiliated with them for violations of laws or regulations or for engaging in unsafe or unsound practices. If the grounds provided by law exist, the OTS may appoint a conservator or receiver for a savings association.
Savings associations are subject to regulatory oversight under various consumer protection and fair lending laws. These laws govern, among other things, truth-in-lending disclosure, equal credit opportunity, fair credit reporting and community reinvestment. Failure to abide by federal laws and regulations governing community reinvestment could limit the ability of an association to open a new branch or engage in a merger. Community reinvestment regulations evaluate how well and to what extent an institution lends and invests in its designated service area, with particular emphasis on low- to moderate-income areas. Milton Federal received an "Outstanding" rating under these regulations.
REGULATORY CAPITAL REQUIREMENTS. Milton Federal is required by regulations to meet certain minimum capital requirements, which must be generally as stringent as the standards established for commercial banks. Current capital requirements call for tangible capital of 1.5% of adjusted total assets, core capital (which, for Milton Federal, consists solely of tangible capital) of 4.0% of adjusted total assets, except for institutions with the highest examination rating and acceptable levels of risk, and risk-based capital (which, for Milton Federal, consists of core capital and general valuation allowances) of 8% of risk-weighted assets (assets are weighted at percentage levels ranging from 0% to 100% depending on their relative risk).
The OTS has adopted regulations governing prompt corrective action to resolve the problems of capital deficient and otherwise troubled savings associations. At each successively lower defined capital category, an association is subject to more restrictive and numerous mandatory or discretionary regulatory actions or limits, and the OTS has less flexibility in determining how to resolve the problems of
the institution. In addition, the OTS generally can downgrade an association's capital category, notwithstanding its capital level, based on less than satisfactory examination ratings in areas other than capital or, after notice and opportunity for hearing, if the association is deemed to be in an unsafe or unsound condition or to be engaging in an unsafe or unsound practice. Each undercapitalized association must submit a capital restoration plan to the OTS within 45 days after it becomes undercapitalized. Such institution will be subject to increased monitoring and asset growth restrictions and will be required to obtain prior approval for acquisitions, branching and engaging in new lines of business. Furthermore, critically undercapitalized institutions must be placed in conservatorship or receivership within 90 days of reaching that capitalization level, except under limited circumstances. Milton Federal's capital at September 30, 1999 meets the standards for the highest category, a "well-capitalized" institution.
Federal law prohibits an insured institution from making a capital distribution to anyone or paying management fees to any person having control of the institution if, after such distribution or payment, the institution would be undercapitalized. In addition, each company controlling an undercapitalized institution must guarantee that the institution will comply with its capital plan until the institution has been adequately capitalized on an average during each of four consecutive calendar quarters and must provide adequate assurances of performance. The aggregate liability pursuant to such guarantee is limited to the lesser of (a) an amount equal to 5% of the institution's total assets at the time the institution became undercapitalized or (b) the amount that is necessary to bring the institution into compliance with all capital standards applicable to such association at the time the institution fails to comply with its capital restoration plan.
LIMITATIONS ON CAPITAL DISTRIBUTIONS. In addition to certain federal income tax considerations, the OTS regulations impose limitations on the payment of dividends and other capital distributions by savings associations. Under OTS regulations applicable to converted savings banks, Milton Federal is not permitted to pay a cash dividend on its common shares if its regulatory capital would, as a result of payment of such dividends, be reduced below the amount required for the Liquidation Account, or below applicable regulatory capital requirements prescribed by the OTS.
An application must be submitted and approval from the OTS must be obtained by a subsidiary of a savings and loan holding company (1) if the proposed distribution would cause total distributions for the year to exceed net income for that calendar year to date plus the savings association's retained net income for the preceding two years; (2) if the savings association will not be at least adequately capitalized following the capital distribution; (3) if the proposed distribution would violate a prohibition contained in any applicable statute, regulation or agreement between the savings association and the OTS (or the FDIC), or a condition imposed on the savings association in an OTS-approved application or notice; or, (4) if the savings association has not received certain favorable examination ratings from the OTS. If a savings association subsidiary of a holding company is not required to file an application, it must file a notice with the OTS. At September 30, 1999, Milton Federal could dividend $382,310 without approval from the OTS.
LIQUIDITY. OTS regulations require that savings associations maintain an average daily balance of liquid assets (cash, certain time deposits, bankers' acceptances and specified United States Government, state or federal agency obligations) equal to a monthly average of not less than 4% of its net withdrawable savings deposits plus borrowings payable in one year or less. Monetary penalties may be imposed upon associations failing to meet these liquidity requirements.
QUALIFIED THRIFT LENDER TEST. Savings associations are required to meet the QTL Test. Prior to September 30, 1997, the QTL Test required savings associations to maintain a specified amount of investments in assets that are designated as qualifying thrift investments ("QTI"), which are generally related to domestic residential real estate and manufactured housing and include stock issued by any FHLB, the FHLMC or the FNMA. Under this test, 65% of an institution's "portfolio assets" (total assets less goodwill and other intangibles, property used to conduct business and 20% of liquid assets) must consist of QTI on a monthly average basis in 9 out of every 12 months. Congress created a second QTL
Test, effective September 30, 1997, pursuant to which a savings association may also meet the QTL Test if at least 60% of the institution's assets (on a tax basis) consist of specified assets (generally loans secured by residential real estate or deposits, educational loans, cash and certain governmental obligations). The OTS may grant exceptions to the QTL Test under certain circumstances. If a savings association fails to meet the QTL Test, the association and its holding company become subject to certain operating and regulatory restrictions. A savings association that fails to meet the QTL Test will not be eligible for new FHLB advances. At September 30, 1999, Milton Federal met the QTL Test.
TRANSACTIONS WITH INSIDERS AND AFFILIATES. Loans to executive officers, directors and principal shareholders and their related interests must conform to limits on loans to one borrower, and the total of such loans to executive officers, directors, principal shareholders and their related interests cannot exceed the association's Lending Limit Capital (200% of total capital for eligible, adequately capitalized institutions with less than $100 million in deposits). Most loans to directors, executive officers and principal shareholders must be approved in advance by a majority of the "disinterested" members of the board of directors of the association with any "interested" director not participating. All loans to directors, executive officers and principal shareholders must be made on terms substantially the same as offered to all employees of Milton Federal. In addition, no loan may be made to an executive officer, except loans for specific authorized purposes such as financing the education of the executive officer's children or financing the purchase of the executive officer's primary residence. Milton Federal complied with such restrictions at September 30, 1999.
Savings associations must comply with Sections 23A and 23B of the Federal Reserve Act (the "FRA") pertaining to transactions with affiliates. An affiliate of a savings association is any company or entity that controls, is controlled by or is under common control with the savings association. MFFC is an affiliate of Milton Federal. Generally, Sections 23A and 23B of the FRA (i) limit the extent to which a savings association or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus for any one affiliate and 20% of such capital stock and surplus for the aggregate of such transactions with all affiliates and (ii) require that all such transactions be on terms substantially the same, or at least as favorable to the association, as those provided in transactions with a nonaffiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and other similar types of transactions. In addition to limits in Sections 23A and 23B, Milton Federal may not make any loan or other extension of credit to an affiliate unless the affiliate is engaged only in activities permissible for a bank holding company and may not purchase or invest in securities of any affiliate, except for shares of a subsidiary. Exemptions from Section 23A or 23B of the FRA may be granted only by the Federal Reserve Board. Milton Federal complied with these requirements at September 30, 1999.
HOLDING COMPANY REGULATION. MFFC is a savings and loan holding company within the meaning of the HOLA. The HOLA generally prohibits a savings and loan holding company from controlling any other savings association or savings and loan holding company, without prior approval of the OTS, or from acquiring or retaining more than 5% of the voting shares of a savings association or holding company thereof, which is not a subsidiary. Under certain circumstances, a savings and loan holding company is permitted to acquire, with the approval of the OTS, up to 15% of the previously unissued voting shares of an undercapitalized savings association for cash without such savings association being deemed to be controlled by the holding company. Except with the prior approval of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company's stock may also acquire control of any savings institution, other than a subsidiary institution, or any other savings and loan holding company.
MFFC is a unitary savings and loan holding company. Under current law, there are generally no restrictions on the activities of a unitary savings and loan holding company and such companies are the only financial institution holding companies that may engage in commercial, securities and insurance activities without limitation. The broad latitude to engage in activities under current law can be restricted if the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan
holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings association, the OTS may impose such restrictions as deemed necessary to address such risk, including limiting (i) payment of dividends by the savings association, (ii) transactions between the savings association and its affiliates, and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings association. Notwithstanding the foregoing rules as to permissible business activities of a unitary savings and loan holding company, if the savings association subsidiary of a holding company fails to meet the QTL Test, then such unitary holding company would become subject to the activities restrictions applicable to multiple holding companies. At September 30, 1999, Milton Federal met the QTL Test.
If MFFC were to acquire control of another savings institution, other than through a merger or other business combination with Milton Federal, MFFC would become a multiple savings and loan holding company. Unless the acquisition is an emergency thrift acquisition and each subsidiary savings association meets the QTL Test, the activities of MFFC and any of its subsidiaries (other than Milton Federal or other subsidiary savings associations) would thereafter be subject to activity restrictions. The HOLA provides that, among other things, no multiple savings and loan holding company or subsidiary thereof that is not a savings institution shall commence or continue for a limited period of time after becoming a multiple savings and loan holding company or subsidiary thereof, any business activity other than (i) furnishing or performing management services for a subsidiary savings institution, (ii) conducting an insurance agency or escrow business, (iii) holding, managing or liquidating assets owned by or acquired from a subsidiary savings institution, (iv) holding or managing properties used or occupied by a subsidiary savings institution, (v) acting as trustee under deeds of trust, (vi) those activities previously directly authorized by federal regulation as of March 5, 1987, to be engaged in by multiple holding companies, or (vii) those activities authorized by the FRB as permissible for bank holding companies, unless the OTS by regulation prohibits or limits such activities for savings and loan holding companies. Those activities described in (vii) above must also be approved by the OTS prior to being engaged in by a multiple holding company.
The OTS may approve acquisitions resulting in the formation of a multiple savings and loan holding company that controls savings associations in more than one state only if the multiple savings and loan holding company involved controls a savings association that operated a home or branch office in the state of the association to be acquired as of March 5, 1987, or if the laws of the state in which the institution to be acquired is located specifically permit institutions to be acquired by state-chartered institutions or savings and loan holding companies located in the state where the acquiring entity is located (or by a holding company that controls such state-chartered savings institutions). As under prior law, the OTS may approve an acquisition resulting in a multiple savings and loan holding company controlling savings associations in more than one state in the case of certain emergency thrift acquisitions.
Federal legislative proposals have been introduced or are under consideration that would either limit unitary savings and loan holding companies to the same activities as multiple savings and loan holding companies and other financial institutions holding companies or would permit certain bank holding companies to engage in commercial activities. MFFC cannot predict when, and in what form, these proposals might become law.
No subsidiary savings association of a savings and loan holding company may declare or pay a dividend on its permanent or nonwithdrawable stock unless it first gives the Director of the OTS 30 days advance notice of such declaration and payment.
FEDERAL REGULATION OF ACQUISITIONS OF CONTROL OF MFFC AND MILTON FEDERAL. In addition to the Ohio law limitations on the merger and acquisition of MFFC previously discussed, federal limitations generally require regulatory approval of acquisitions at specified levels. Under pertinent federal law and regulations, no person, directly or indirectly, or acting in concert with others, may acquire control of Milton Federal or MFFC without 60 days prior notice to the OTS. "Control" is generally defined as having more than 25% ownership or voting power; however, ownership or voting power of more than
10% may be deemed "control" if certain factors are in place. If the acquisition of control is by a company, the acquirer must obtain approval, rather than give notice, of the acquisition as a savings and loan holding company.
In addition, any merger of Milton Federal or of MFFC in which MFFC is not the resulting company must also be approved by the OTS.
FEDERAL DEPOSIT INSURANCE CORPORATION
DEPOSIT INSURANCE. The FDIC is an independent federal agency that insures the deposits, up to prescribed statutory limits, of federally insured banks and thrifts and safeguards the safety and soundness of the banking and thrift industries. The FDIC administers two separate insurance funds, the Bank Insurance Fund ("BIF") for commercial banks and state savings banks and the SAIF for savings associations. Milton Federal is a member of the SAIF and its deposit accounts are insured by the FDIC, up to the prescribed limits. The FDIC has examination authority over all insured depository institutions, including Milton Federal, and has authority to initiate enforcement actions against federally insured savings associations, if the FDIC does not believe the OTS has taken appropriate action to safeguard safety and soundness and the deposit insurance fund.
ASSESSMENTS. The FDIC is required to maintain designated levels of reserves in each fund. The FDIC may increase assessment rates for either fund if necessary to restore the fund's ratio of reserves to insured deposits to its target level within a reasonable time and may decrease such assessment rates if such target level has been met. The FDIC has established a risk-based assessment system for both SAIF and BIF members. Under this system, assessments vary based on the risk the institution poses to its deposit insurance fund. This risk level is determined based on the institution's capital level and the FDIC's level of supervisory concern about the institution.
FEDERAL RESERVE BOARD
Effective December 1, 1999, FRB regulations require savings associations to maintain reserves of 3% of net transaction accounts (primarily NOW accounts) up to $44.3 million (subject to an exemption of up to $5.0 million) and of 10% of net transaction accounts in excess of $44.3 million. At September 30, 1999, Milton Federal complied with the reserve requirements then in effect as well as the new requirements.
FEDERAL HOME LOAN BANKS
The FHLBs, under the regulatory oversight of the Federal Housing Financing Board, provide credit to their members in the form of advances. Milton Federal is a member of the FHLB of Cincinnati and must maintain an investment in the capital stock of that FHLB in an amount equal to the greater of 1.0% of the aggregate outstanding principal amount of Milton Federal's residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or 5% of its advances from the FHLB. Milton Federal complies with this requirement with an investment in stock of the FHLB of Cincinnati of $3.1 million at September 30, 1999.
Upon the origination or renewal of a loan or advance, the FHLB of Cincinnati is required by law to obtain and maintain a security interest in collateral in one or more of the following categories: fully disbursed, whole first-mortgage loans on improved residential property or securities representing a whole interest in such loans; securities issued, insured or guaranteed by the United States government or an agency thereof; deposits in any FHLB; or other real estate related collateral (up to 30% of the member association's capital) acceptable to the applicable FHLB, if such collateral has a readily ascertainable value and the FHLB can perfect its security interest in the collateral.
Each FHLB is required to establish standards of community investment or service that its members must maintain for continued access to long-term advances from the FHLBs. The standards take into account a member's performance under the Community Reinvestment Act and its record of lending to first-time home buyers. All long-term advances by each FHLB must be made only to provide funds for residential housing finance.
FEDERAL TAXATION
MFFC and Milton Federal are subject to the federal tax laws and regulations that apply to corporations generally. However, certain thrift institutions such as Milton Federal were, prior to the enactment of the Small Business Jobs Protection Act, which was signed into law on August 21, 1996, allowed deductions for bad debts under methods more favorable to those granted to other taxpayers. Qualified thrift institutions could compute deductions for bad debts using either the specific charge-off method of Section 166 of the Code, or the reserve method of Section 593 of the Code.
Under Section 593, a thrift institution annually could elect to deduct bad debts under either (i) the "percentage of taxable income" method applicable only to thrift institutions, or (ii) the "experience" method that also was available to small banks. Under the "percentage of taxable income" method, a thrift institution generally was allowed a deduction for an addition to its bad debt reserve equal to 8% of its taxable income (determined without regard to this deduction and with additional adjustments). Under the "experience" method, a thrift institution was generally allowed a deduction for an addition to its bad debt reserve equal to the greater of (i) an amount based on its actual average experience for losses in the current and five preceding taxable years, or (ii) an amount necessary to restore the reserve to its balance as of the close of the base year. A thrift institution could elect annually to compute its allowable addition to bad debt reserves for qualifying loans either under the "experience" method or the "percentage of taxable income" method.
Section 1616(a) of the Small Business Job Protection Act repealed the Section 593 reserve method of accounting for bad debts by thrift institutions, effective for taxable years beginning after 1995. Thrift institutions that would be treated as small banks are allowed to use the "experience" method applicable to such institutions, while thrift institutions that are treated as large banks are required to use on the specific charge-off method. The "percentage of taxable income" method of accounting for bad debts is no longer available for any financial institution.
A thrift institution required to change its method of computing reserves for bad debt treated such change as a change in the method of accounting, initiated by the taxpayer, and having been made with the consent of the Secretary of the Treasury. Any adjustments under Section 481(a) of the Code required to be recaptured with respect to such change generally were determined solely with respect to the "applicable excess reserves" of the taxpayer. The amount of the "applicable excess reserves" are being taken into account ratably over a six-taxable-year period, beginning with the first taxable year beginning after 1995, subject to the residential loan requirement described below. In the case of a thrift institution that becomes a large bank, the amount of the institution's applicable excess reserves generally is the excess of (i) the balances of its reserve for losses on qualifying real property loans (generally loans secured by improved real estate) and its reserve for losses on nonqualifying loans (all other types of loans) as of the close of its last taxable year beginning before January 1, 1996, over (ii) the balances of such reserves as of the close of its last taxable year beginning before January 1, 1988 (i.e., the "pre-1988 reserves"). In the case of a thrift institution that becomes a small bank, like Milton Federal, the amount of the institution's "applicable excess reserves" generally is the excess of (i) the balances of its reserve for loan losses on qualifying real property loans and its reserve for losses on nonqualifying loans as of the close of its last taxable year beginning before January 1, 1996, over (ii) the greater balance of (a) its "pre-1988 reserves" or (b) what the thrift's reserves would have been at the close of its last year beginning before January 1, 1996, had the thrift always used the "experience" method.
For taxable years that begin after December 31, 1995, and before January 1, 1998, if a thrift meets the residential loan requirement for a tax year, the recapture of the "applicable excess reserves" otherwise required to be taken into account as a Code Section 481(a) adjustment for the year will be suspended. A thrift meets the residential loan requirement if, for the tax year, the principal amount of residential loans made by the thrift during the year is not less than its "base amount." The "base amount" generally is the average of the principal amounts of the residential loans made by the thrift during the six most recent tax years beginning before January 1, 1996.
A residential loan is a loan as described in Section 7701(a)(19)(C)(v) (generally a loan secured by residential real and church property and certain mobile homes), but only to the extent that the loan is made to the owner of the property to acquire, construct or improve the property.
The balance of the "pre-1988 reserves" is subject to the provisions of Section 593(e) as modified by the Small Business Job Protection Act that requires recapture in the case of certain excessive distributions to shareholders. The "pre-1988 reserves" may not be utilized for payment of cash dividends or other distributions to a shareholder (including distributions in dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). Distribution of a cash dividend by a thrift institution to a shareholder is treated as made: First, out of the institution's post-1951 accumulated earnings and profits; second, out of the "pre-1988 reserves"; and, third, out of such other accounts as may be proper. To the extent a distribution by Milton Federal to MFFC is deemed paid out of its "pre-1988 reserves" under these rules, the "pre-1988 reserves" would be reduced and Milton Federal's gross income for tax purposes would be increased by the amount which, when reduced by the income tax, if any, attributable to the inclusion of such amount in its gross income, equals the amount deemed paid out of the "pre-1988 reserves." As of September 30, 1999, Milton Federal's "pre-1988 reserves" subject to potential recapture for tax purposes totaled approximately $3.4 million. Milton Federal believes it has approximately $5.4 million of accumulated earnings and profits for tax purposes as of September 30, 1999, which would be available for dividend distributions, provided regulatory restrictions applicable to the payment of dividends are met. No representation can be made as to whether Milton Federal will have current or accumulated earnings and profits in subsequent years.
In addition to the regular income tax, MFFC and Milton Federal may be subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20% on "alternative minimum taxable income" (which is the sum of a corporation's regular taxable income, with certain adjustments, and tax preference items), less any available exemption. Such tax preference items include interest on certain tax-exempt bonds issued after August 7, 1986. In addition, 75% of the amount by which a corporation's "adjusted current earnings" exceeds its "alternative minimum taxable income" computed without regard to this preference item and prior to reduction by net operating losses, is included in "alternative minimum taxable income." Net operating losses can offset no more than 90% of "alternative minimum taxable income." The alternative minimum tax is imposed to the extent it exceeds the corporation's regular income tax. Payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. In addition, for taxable years after 1986 and before 1997, MFFC and Milton Federal are also subject to an environmental tax equal to 0.12% of the excess of "alternative minimum taxable income" for the taxable year (determined without regard to net operating losses and the deduction for the environmental tax) over $2.0 million.
The tax returns of Milton Federal have been audited or closed without audit through September 30, 1995. In the opinion of management, any examination of open returns would not result in a deficiency that could have a material adverse effect on the financial condition of Milton Federal.
OHIO TAXATION
MFFC is subject to the Ohio corporation franchise tax, which, as applied to MFFC, is a tax measured by both net earnings and net worth. The rate of tax is the greater of (i) 5.1% on the first $50,000 of computed Ohio taxable income and 8.9% of computed Ohio taxable income in excess of $50,000 or (ii) 0.582% times
taxable net worth. For tax years beginning after December 31, 1998, the tax rate is the greater of (i) 5.1% on the first $50,000 of computed Ohio taxable income and 8.5% of computed Ohio taxable income in excess of $50,000 or (ii) .400% times taxable net worth.
Certain holding companies, such as MFFC, qualify for complete exemption from the net worth tax if certain conditions are met. MFFC will most likely meet these conditions and, thus, calculate its Ohio franchise tax on the net income basis.
A special litter tax is also applicable to all corporations, including MFFC, subject to the Ohio corporation franchise tax other than "financial institutions." If the franchise tax is paid on the net income basis, the litter tax is equal to .11% of the first $50,000 of computed Ohio taxable income and .22% of computed Ohio taxable income in excess of $50,000. If the franchise tax is paid on the net worth basis, the litter tax is equal to .014% times taxable net worth.
Milton Federal is a "financial institution" for State of Ohio tax purposes. As such, it is subject to the Ohio corporate franchise tax on "financial institutions," which is imposed annually at a rate of 1.5% of Milton Federal's book net worth determined in accordance with generally accepted accounting principles. For the tax year 1999, however, the franchise tax on financial institutions will be 1.4% of book net worth and for the tax year 2000 and years thereafter, the tax will be 1.3% of book net worth. As a "financial institution," Milton Federal is not subject to any tax based upon net income or net profits imposed by the State of Ohio.
ITEM 2.
ITEM 2. PROPERTIES
The following table sets forth certain information at September 30, 1999, regarding the properties on which the main office and the branch office of Milton Federal are located:
(1) At September 30, 1999, Milton Federal's office premises and equipment had a total net book value of $2,629,439. For additional information regarding Milton Federal's office premises and equipment, see Notes 1 and 4 to Financial Statements.
The management of MFFC believes that its properties are adequately insured.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Neither MFFC nor Milton Federal is presently involved in any legal proceedings of a material nature. From time to time, Milton Federal is a party to legal proceedings incidental to its business to enforce its security interest in collateral pledged to secure loans made by Milton Federal.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No items were brought to a vote of security holders during the fourth quarter of the Corporation's fiscal year ending September 30, 1999.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Corporation had 2,099,995 common shares outstanding on November 30, 1999, held of record by approximately 1,004 shareholders. Price information with respect to the Corporation's common shares is quoted on The Nasdaq National Market System ("Nasdaq"). The high and low daily closing prices for the common shares of the Corporation, as quoted by Nasdaq, by quarter, are shown below.
For the fiscal year ended September 30, 1999, the Corporation paid regular quarterly dividends per common share of $.15 on November 15, 1998, $.15 on February 15, 1999, $.15 on May 15, 1999 and $.15 on August 16, 1999. For the fiscal year ended September 30, 1998, the Corporation paid regular quarterly dividends per common share of $.15 on November 15, 1997, $.15 on February 16, 1998, $.15 on May 15, 1998 and $.15 on August 15, 1998. Income of MFFC primarily consists of interest on mortgage-backed securities and other securities and dividends that were periodically declared and paid by the Board of Directors of Milton Federal on common shares of Milton Federal held by MFFC.
In addition to certain federal income tax considerations, OTS regulations impose limitations on the payment of dividends and other capital distributions by savings associations. Under OTS regulations applicable to converted savings associations, Milton Federal is not permitted to pay a cash dividend on its common shares if its regulatory capital would, as a result of payment of such dividend, be reduced below the amount required for the Liquidation Account (the account established for the purpose of granting a limited priority claim on the assets of Milton Federal in the event of complete liquidation to those members of Milton Federal before the Conversion who maintain a savings account at Milton Federal after the Conversion), or applicable regulatory capital requirements prescribed by the OTS.
An application must be submitted and approval from the OTS must be obtained by a subsidiary of a savings and loan holding company (1) if the proposed distribution would cause total distributions for that calendar year to exceed net income for that year to date plus the savings association's retained net income for the preceding two years; (2) if the savings association will not be at least adequately capitalized following the capital distribution; (3) if the proposed distribution would violate a prohibition contained in any applicable statute, regulation or agreement between the savings association and the OTS (or the FDIC), or a condition imposed on the savings association in an OTS-approved application or notice; or, (4) if the savings association has not received certain favorable examination ratings from the OTS. If a savings association subsidiary of a holding company is not required to file an application, it must file a notice with the OTS.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following tables set forth certain information concerning the consolidated financial condition, earnings and other data regarding the Corporation at the dates and for the periods indicated.
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(1) Includes cash and amounts due from depository institutions, interest-bearing deposits in other financial institutions and overnight deposits.
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(2) Net income divided by average total equity. (3) Net income divided by average total assets. (4) Difference between average yield on interest-earning assets and average cost of interest-bearing liabilities. (5) Net interest income as a percentage of average interest-earning assets. (6) Noninterest expense divided by average total assets. (7) Average equity divided by average total assets. (8) Cash dividends declared divided by net income.
QUARTERLY FINANCIAL DATA
The following table is a summary of selected quarterly results of operations for the years ended September 30, 1999 and 1998.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discusses the Corporation's financial condition and results of operations as of and for the year ended September 30, 1999, compared to prior years. This discussion should be read in conjunction with the financial statements, footnotes and the selected financial data included herein.
FORWARD-LOOKING STATEMENTS
When used in this document, the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimated," "projected," or similar expressions are intended to identify "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties including changes in economic conditions in the Corporation's market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the Corporation's market area and competition, that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. Factors listed above could affect the Corporation's financial performance and could cause the Corporation's actual results for future periods to differ materially from any statements expressed with respect to future periods.
The Corporation does not undertake, and specifically disclaims any obligation, to publicly revise any forward looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.
ANALYSIS OF FINANCIAL CONDITION
The Corporation's assets totaled $256.7 million, at September 30, 1999, an increase of $21.4 million, or 9.1%, from $235.3 million at September 30, 1998. The growth in assets was primarily in loans. Such growth was funded by the use of overnight deposits in other financial institutions and increased deposits and borrowed funds.
Total securities, including Federal Home Loan Bank stock, decreased $2.2 million from $54.3 million at September 30, 1998, to $52.1 million at September 30, 1999. The decrease was due to sales, maturities and principal repayments of $15.8 million, partly offset by $13.8 million in purchases of securities.
Included in the security portfolio are mortgage-backed securities, which include Federal Home Loan Mortgage Corporation ("FHLMC"), Government National Mortgage Association ("GNMA") and Federal National Mortgage Association ("FNMA") participation certificates and CMOs and REMICs. The majority of the securities are classified as available for sale to provide the Corporation with the flexibility to move funds into loans as demand warrants. The mortgage-backed securities also provide the Corporation with a constant cash flow stream from principal repayments.
Management's strategy emphasizes investment in securities guaranteed by the U.S. Government and its agencies as a means to mediate credit risk. The investment strategy also includes purchasing variable-rate mortgage-backed security products with monthly payments and interest rates that adjust annually or more frequently to mediate interest-rate risk.
The Corporation's investment policy limits investments in U.S. Treasury and government agency securities to those with terms of 10 years or less for fixed-rate investments and 30 years or less for variable-rate investments. Mortgage-backed securities guaranteed by FHLMC, GNMA or FNMA may have terms of up to 40 years. Substantially all CMOs and REMICs are collateralized with FHLMC, GNMA or FNMA securities and may have terms of up to 40 years. CMOs and REMICs must meet OTS guidelines and not be "high risk" at the time of purchase as defined by Thrift Bulletin No. 52. The Corporation has not invested in any derivative securities other than CMOs and REMICs.
Net loans increased from $171.3 million at September 30, 1998, to $192.1 million at September 30, 1999. The growth in loans was primarily in one- to four-family first-mortgage loans and nonresidential real estate loans, which increased $18.0 million and $6.1 million, respectively. Much of the growth occurred during the first six months of fiscal 1999 resulting from customers refinancing their higher rate loans from the Corporation's competitors during the lower interest rate period. As interest rates have increased since March 31, 1999, growth has slowed. Growth in real estate loans is also related to the growth in the Corporation's market area, as the Corporation has not changed its philosophy regarding pricing or underwriting standards during the period. Construction loans decreased $5.5 million as loans were converted to more permanent financing upon completion of construction. Changes in other types of loans were not significant.
Additionally, the Corporation began originating one- to four-family first-mortgage loans with the intent of selling them in the secondary market in fiscal 1999. The loans were sold as a means to manage interest rate risk by reducing the Corporation's investment in longer term, fixed rate loans. The Corporation retained the right to service the loans for a fixed spread to provide an additional source of fee income. As a result, $2.6 million in loans were held for sale at September 30, 1999. Total originations of loans classified as held for sale were $7.0 million in 1999. Prior to fiscal 1999, the Corporation had sold pools of portfolio loans from time to time to manage interest-rate risk.
Total deposits increased $13.8 million, or 8.9%, from $154.7 million at September 30, 1998, to $168.5 million at September 30, 1999. Money market accounts increased $17.2 million, or 165.0%, and had the largest increase of all types of deposits. The increase in money market accounts is a result of a new tiered pricing system which was implemented late in fiscal 1998, increased advertising for the product and the
customers' desire for liquidity. Additionally, during the last quarter of fiscal 1999, the Corporation converted all of its demand accounts to noninterest-bearing accounts. The Corporation only experienced a modest decline in demand accounts as a result of this business decision.
Borrowed funds totaled $61.5 million at September 30, 1999 and $52.4 million at September 30, 1998. The increase primarily resulted from short-term advances of $9.2 million under Milton Federal's cash management line of credit. The borrowed funds were a temporary source of funding the loan growth discussed above.
COMPARISON OF RESULTS OF OPERATIONS - SEPTEMBER 30, 1999 COMPARED TO SEPTEMBER 30, 1998
NET INCOME. The operating results of the Corporation are affected by general economic conditions, monetary and fiscal policies of federal agencies and policies of agencies regulating financial institutions. The Corporation's cost of funds is influenced by interest rates on competing investments and general market rates of interest. Lending activities are influenced by demand for real estate loans and other types of loans which, in turn, is affected by the interest rates at which such loans are made, general economic conditions and availability of funds for lending activities.
The Corporation's net income is primarily dependent upon its net interest income (the difference between interest income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities). Net income is also affected by provisions for loan losses, service charges, gains on sale of assets and other income, noninterest expense and income taxes. The Corporation's net income of $1,603,000 for the year ended September 30, 1999 represented an increase of $101,000 when compared to the year ended September 30, 1998. Basic earnings per share increased $.08 per share from $.72 per share for 1998 to $.80 per share for 1999. Similarly, diluted earnings per share increased $.09 per share from $.71 per share for 1998 to $.80 for 1999.
NET INTEREST INCOME. Net interest income is the largest component of the Corporation's income and is affected by the interest rate environment and volume and composition of interest-earning assets and interest-bearing liabilities.
Net interest income totaled $6,331,000 at September 30, 1999 compared to $5,871,000 at September 30, 1998. The increase resulted from the Corporation's overall growth in assets. Additionally, the Corporation had a larger proportion of funds invested in higher yielding loans as opposed to securities. The Corporation remains liability sensitive, whereby its interest-bearing liabilities will generally reprice more quickly than its interest-earning assets. Therefore, the Corporation's net interest margin will generally increase in periods of falling interest rates in the market and will decrease in periods of rising interest rates. Accordingly, in a rising rate environment, the Corporation may need to increase rates to attract and retain deposits. Due to a negative gap position, such a rise in interest rates may not have such an immediate impact on interest-earning assets. This lag could negatively affect net interest income. See "Yields Earned and Rates Paid."
Interest and fees on loans totaled $14,179,000 for 1999 compared to $11,937,000 for 1998. The increase in interest and fees on loans was due to higher average loan balances primarily related to the origination of one- to four-family first-mortgage loans, partially offset by a decrease in the average yield earned from 7.95% to 7.64%.
Interest on securities totaled $2,961,000 for 1999 compared to $4,044,000 for 1998. The decrease was primarily due to a decrease in the average balance of securities. The Corporation's security portfolio declined during fiscal 1998 and remained relatively stable during fiscal 1999 as funding sources were used to support the loan growth.
Interest on deposits totaled $8,029,000 in 1999 compared to $7,574,000 in 1998. The increase resulted from higher average deposit balances, partially offset by a decrease in the average cost of deposits.
Interest on borrowed funds totaled $3,005,000 in 1999 compared to $2,774,000 in 1998. The increase was the result of higher average balances of borrowed funds during 1999. Beginning in the fourth quarter of fiscal 1995, the Corporation borrowed funds and invested a portion of these funds in mortgage-backed securities to leverage excess capital. From time to time, the Corporation has borrowed additional adjustable rate funds for similar purposes as well as to provide funding for loan growth. The Corporation has also borrowed fixed-rate funds to provide for long-term liquidity needs. As opportunities arise, the Corporation may make additional borrowings to fund loan demand and mortgage-backed and related security purchases.
PROVISION FOR LOAN LOSSES. The Corporation maintains an allowance for losses on loans in an amount that, in management's judgment, is adequate to absorb probable losses inherent in the loan portfolio. While management utilizes its best judgment and information available, ultimate adequacy of the allowance is dependent upon a variety of factors, including the performance of the Corporation's loan portfolio, the economy, changes in real estate values and interest rates and the view of the regulatory authorities toward loan classifications. The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level considered adequate to absorb probable losses in the loan portfolio. The amount of the provision is based on management's regular review of the loan portfolio and consideration of such factors as historical loss experience, general prevailing economic conditions, changes in size and composition of the loan portfolio and specific borrower considerations, including the ability of the borrower to repay the loan and the estimated value of the underlying collateral.
Other than $115,000 in charge-offs during fiscal 1998, the Corporation has not experienced any significant charge-offs for the past several years. The majority of the $115,000 in net charge-offs was related to a single loan relationship for which the Corporation maintained a specific valuation allowance. The Corporation's low historical charge-off history is the product of a variety of factors, including the Corporation's underwriting guidelines, which generally require a down payment of 20% of the lower of the sales price or appraised value of one-to four-family residential real estate loans, established income information and defined ratios of debt to income. Loans secured by real estate make up 96.4% of the Corporation's loan portfolio and loans secured by first mortgages on one- to four-family residential real estate constituted 79.4% of total loans at September 30, 1999. Notwithstanding the historically low level of charge-offs, management believes it is prudent to continue increasing the allowance for losses as total loans increase. Accordingly, management anticipates it will continue its provisions to the allowance for loan losses at current levels for the near future, providing the volume of nonperforming loans remains insignificant. The provision for loan losses totaled $120,000 and $229,000 in 1999 and 1998. The primary reason for the decrease in the provision for loan losses relates to the $115,000 charge-off that occurred during fiscal 1998.
NONINTEREST INCOME. Noninterest income totaled $552,000 in 1999 compared to $796,000 in 1998. The decrease was primarily the result of gains realized on sales of loans and securities during fiscal 1998. This decrease was partly offset by an increase in service charges and other fees in 1999. The securities and loan sales were made for interest-rate-risk strategy purposes. The increase in service charges and other fees was the result of a change in pricing for overdraft, stop payment and ATM surcharge fees as well as the overall growth in the Corporation's customer deposit base.
NONINTEREST EXPENSE. Noninterest expense totaled $4,337,000 in 1999 compared to $4,146,000 in 1998. The Corporation experienced modest increases in most of the components of noninterest expense. The increase in occupancy expense and data processing services resulted from the expanded account base and services associated with the growth experienced in the two offices opened over the past twenty-four months. The increase in other expenses related to legal and consulting services.
INCOME TAX EXPENSE. The volatility of income tax expense is primarily attributable to the change in income before income taxes. Income tax expense totaled $823,000 in 1999 and $790,000 in 1998 resulting in effective tax rates of 33.9% and 34.5%. See Note 7 of the Notes to Consolidated Financial Statements.
COMPARISON OF RESULTS OF OPERATIONS SEPTEMBER 30, 1998 COMPARED TO SEPTEMBER 30,
NET INCOME. The Corporation's net income of $1,502,000 for 1998 represented a $124,000 increase from the $1,378,000 in net income for 1997. Basic earnings per share increased by $.07 per share from $.65 per share for 1997 to $.72 per share for 1998. Also, diluted earnings per share increased by $.06 per share from $.65 per share for 1997 to $.71 per share for 1998. The increase in earnings was primarily due to increases in net interest income and noninterest income partly offset by increases in the provision for loan losses and noninterest expense.
NET INTEREST INCOME. The net interest income of the Corporation increased by $247,000 for 1998 compared to 1997. The increase in net interest income resulted from the Corporation's growth in assets. Additionally, the Corporation had a larger proportion of funds invested in higher-yielding loans as opposed to securities and interest-bearing deposits in other financial institutions. The increase in net interest income was mitigated by a higher cost of funds. The cost of funds increased due to an increase in the average level of borrowings and certificates of deposit. Management has employed strategies such as large, special dividends and common stock repurchase programs to reduce the excess capital position of the Corporation in an effort to improve its return on equity. As a result, deposits and borrowed funds have increased in order to continue funding the Corporation's growth. See "Yields Earned and Rates Paid."
Interest and fees on loans totaled $11,937,000 for 1998 compared to $9,579,000 for 1997. The increase in interest and fees on loans was due to a higher average loan balance, despite selling a pool of portfolio loans in 1998, partially offset by a decrease in the average yield earned to 7.95% in 1998 from 8.17% in 1997.
Interest on securities totaled $4,044,000 for 1998 compared to $4,034,000 for 1997. The increase was due to an increase in the average balance of securities over the comparable period, partially offset by a decrease in the average yield on securities. The decrease in the yield is the result of most mortgage-backed securities repricing to lower yield levels due to declining market rates. Despite the negative effects in a declining interest rate environment, the variable rate feature of these securities helps mitigate the Corporation's exposure to upward interest rate movements due to its primarily fixed-rate loan portfolio.
Interest paid on deposits totaled $7,574,000 in 1998 compared to $6,749,000 in 1997. The increase resulted from a higher average deposit balance over the comparable period combined with an overall increase in the average cost of deposits to 5.09% in 1998 from 5.00% in 1997. The increase in the average cost of deposits was a result of a larger percentage of average deposits being in high-yielding certificates of deposit as well as an increase in the yield on money market accounts from 2.94% in 1997 to 3.56% in 1998.
Interest on borrowed funds totaled $2,774,000 in 1998 compared to $1,400,000 in 1997. The increase is the result of a higher average balance of borrowed funds over the comparable period. The Corporation uses the borrowings to provide for loan growth and long term liquidity needs. Additionally, a portion of the funds is invested in mortgage-backed securities to leverage excess capital. The Corporation may make additional borrowings, as needed, to fund loan demand and mortgage-backed securities purchases.
PROVISION FOR LOAN LOSSES. Other than $115,000 in charge-offs during 1998, the Corporation has not experienced any significant charge-offs for the past several years. The majority of the $115,000 in net charge-offs was related to a single loan relationship for which the Corporation maintained a specific valuation allowance. The provision for loan losses totaled $229,000 and $75,000 in 1998 and 1997. The
increase in the provision in 1998 was primarily the result of the growth in loans and to replenish the allowance for losses on loans after the charge-off discussed above.
NONINTEREST INCOME. Noninterest income totaled $796,000 in 1998 compared to $498,000 in 1997. The increase in 1998 over 1997 was due to increases in service charges and other fees and increased gains on the sales of loans and available-for-sale securities. The increase in service charges and other fees has been due to growth in the Corporation's customer deposit base as well as increases in various fees charged. The loan sales were primarily made for interest-rate risk strategy purposes while the securities sales were made for similar reasons as well as to provide funding for loan growth. Other changes in noninterest income were insignificant.
NONINTEREST EXPENSE. Noninterest expense totaled $4,146,000 in 1998 compared to $3,959,000 in 1997. Occupancy expense, salaries and employee benefits make up the majority of the increase over the comparable period. Occupancy expense increased as a result of the new branch office in Brookville, Ohio, which opened during the latter part of fiscal 1997. Salaries and employee benefits increased due to annual merit increases, additional personnel to staff the new Brookville office and increased compensation expense related to the ESOP. Other changes in noninterest expense were not significant.
INCOME TAX EXPENSE. The volatility of income tax expense is primarily attributable to the change in income before income taxes. See Note 7 of the Notes to Consolidated Financial Statements. Income tax expense totaled $790,000 in 1998 and $709,000 in 1997 resulting in effective tax rates of 34.5% and 34.0%.
YIELDS EARNED AND RATES PAID. The following table sets forth certain information relating to the Corporation's average balance sheet information and reflects the average yield on interest-earning assets and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are derived from daily balances, which include nonaccruing loans in the loan portfolio, net of the allowance for loan losses.
- ------------------------ (1) Average balance includes unrealized gains and losses while yield is based on amortized cost. (2) Calculated net of deferred loan fees, loan discounts, loans in process and allowance for loan losses. (3) Net interest income as a percent of average interest-earnings assets.
The table below describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Corporation's interest income and expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume (multiplied by prior year rate), (2) changes in rate (multiplied by prior year volume) and (3) total changes in rate and volume. The combined effects of changes in both volume and rate, that are not separately identified, have been allocated proportionately to the change due to volume and change due to rate:
LIQUIDITY AND CAPITAL RESOURCES
The Corporation's liquidity, primarily represented by cash equivalents, is a result of operating, investing and financing activities. These activities are summarized below for the years ended September 30, 1999, 1998 and 1997.
The Corporation's principal sources of funds are deposits, loan and securities repayments, securities available for sale and other funds provided by operations. The Corporation also has the ability to borrow additional funds from the FHLB of Cincinnati. While scheduled loan repayments and maturing securities are relatively predictable, deposit flows and early loan and mortgage-backed security repayments are more influenced by interest rates, general economic conditions and competition. The Corporation maintains investments in liquid assets based upon management's assessment of (1) the need for funds, (2) expected deposit flows, (3) the yields available on short term liquid assets and (4) the objectives of the asset/liability management program.
OTS regulations presently require the Corporation to maintain an average daily balance of investments in U. S. Treasury, federal agency obligations and other investments having maturities of five years or less in an amount equal to 4% of the sum of the Corporation's average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less. The liquidity requirement, which may be changed from time to time by the OTS to reflect changing economic conditions, is intended to provide a source of relatively liquid funds on which the Corporation may rely, if necessary, to fund deposit withdrawals or other short term funding needs. At September 30, 1999, the Corporation's regulatory liquidity ratio was 29.7%. At such date, the Corporation had commitments to originate fixed rate loans totaling $1,437,000 and variable rate loans totaling $223,000. The Corporation had no commitments to purchase or sell loans. The Corporation considers its liquidity and capital reserves sufficient to meet its outstanding short and long-term needs. See Note 9 of the Notes to Consolidated Financial Statements.
Milton Federal is required by regulations to meet certain minimum capital requirements, which must be generally as stringent as the standards established for commercial banks. Current capital requirements call for tangible capital of 1.5% of adjusted total assets, core capital (which, for Milton Federal, consists solely of tangible capital) of 4.0% of adjusted total assets, except for institutions with the highest examination rating and acceptable levels of risk, and risk-based capital (which, for Milton Federal, consists of core capital and general valuation allowances) of 8% of risk-weighted assets (assets are weighted at percentage levels ranging from 0% to 100% depending on their relative risk).
The following table summarizes Milton Federal's regulatory capital requirements and actual capital at September 30, 1999.
In April 1999, the Board of Directors of the Corporation authorized the purchase of up to 5% of the Corporation's outstanding common shares over a twelve-month period. At September 30, 1999, 25,000 shares have been repurchased. The remaining 81,249 shares may be purchased in the over-the-counter market. The number of shares to be purchased and the price paid depends on the availability of shares, the prevailing market prices and any other considerations which may, in the opinion of the Corporation's Board of Directors or management, affect the advisability of purchasing shares.
YEAR 2000 ISSUE
Milton Federal's lending and deposit activities are almost entirely dependent on computer systems which process and record transactions, although Milton Federal can effectively operate with manual systems for brief periods when its electronic systems malfunction or cannot be accessed. Milton Federal uses the services of a nationally recognized data processing service bureau specializing in data processing for financial institutions. In addition to its basic operating activities, Milton Federal's facilities and infrastructure, such as security systems and communications equipment, are dependent, to varying degrees, upon computer systems.
Milton Federal has placed great emphasis on making sure its systems are ready for the Year 2000 ("Y2K"). In order to address any potential problems that could occur, in early 1997 Milton Federal formed a Year 2000 Compliance Committee and began evaluating the status of all its technological systems which includes its state of readiness in addressing the Y2K issue. After the analysis was completed, a Technology Plan was developed and implementation of the plan started in mid-1997.
In the Technology Plan, four major issues were addressed. The first was to identify the potential problems and what could or would be affected by the handling of this date and any subsequent dates. Second, was to develop corrective action plans along with time lines for completion of each corrective action that needed to take place. Third, was to complete the modifications required. The last step performed was testing of all technology systems for compliance and accuracy.
Milton Federal made many changes over the last year testing, upgrading and replacing hardware and software systems. The most critical aspect of the Y2K issue for Milton Federal is to ensure that the data processing provider for all of its customers with savings, checking and loan accounts is compliant. Milton Federal has completed numerous renovations, implemented updated systems and upgraded systems as needed. Milton Federal has completed numerous renovations, implemented updated systems and upgraded systems as needed. Milton Federal has incurred costs of approximately $55,000 to make its systems Y2K compliant. Testing was performed on all internal hardware and software systems. Milton Federal completed three proxy tests with its main data service provider. The final test occurred in October 1999. All Year 2000 related problems noted from testing have been corrected.
As a contingency plan, Milton Federal has determined that, if such providers were to have their systems fail, Milton Federal would implement manual systems until such systems could be re-established. Milton Federal does not anticipate that such short-term manual systems would have a material adverse affect on Milton Federal's operations.
Management is confident that its internal systems will not be significantly affected by Y2K. Management does anticipate that some problems may occur with customers' systems and with their suppliers and customers. This could create slower collection of receivables by Milton Federal's customers and result in an increase in demand for line-of-credit loans or a decrease in checking and savings account balances for Milton Federal. Milton Federal plans to maintain higher than average levels of liquidity in the second half of 1999 and into the Year 2000 to offset that risk. Milton Federal does not expect any significant or prolonged Year 2000 difficulties will affect net earnings or cash flow.
IMPACT OF NEW ACCOUNTING STANDARDS
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities" - SFAS 133 requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes in fair value or cash flows. SFAS 133 does not allow hedging of a
security which is classified as held to maturity, accordingly, upon adoption of SFAS 133, companies may reclassify any security from held to maturity to available for sale if they wish to be able to hedge the security in the future. SFAS 133 as amended by SFAS 137 is effective for fiscal years beginning after June 15, 2000 with early adoption encouraged for any fiscal quarter beginning July 1, 1998 or later, with no retroactive application. Management does not expect the adoption SFAS 133 to have a significant impact on the Corporation's financial statements.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and Notes included herein have been prepared in accordance with generally accepted accounting principles ("GAAP"). Presently, GAAP requires the Corporation to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered.
In management's opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not change at the same rate or in the same magnitude as the inflation rate. Rather, interest rate volatility is based on changes in the expected rate of inflation, as well as on changes in monetary and fiscal policies.
REGULATORY MATTERS
On November 12, 1999, the Gramm-Leach-Bliley Act (the "GLB Act") was enacted into law. The GLB Act makes sweeping changes in the financial services in which various types of financial institutions may engage. The Glass-Steagall Act, which had generally prevented banks from affiliating with securities and insurance firms, was repealed. A new "financial holding company," which owns only well capitalized and well managed depository institutions, will be permitted to engage in a variety of financial activities, including insurance and securities underwriting and agency activities.
The GLB Act permits unitary savings and loan holding companies in existence on May 4, 1999, including MFFC, to continue to engage in all activities that they were permitted to engage in prior to the enactment of the Act. Such activities are essentially unlimited, provided that the thrift subsidiary remains a qualified thrift lender. Any thrift holding company formed after May 4, 1999 will be subject to the same restrictions as a multiple thrift holding company. In addition, a unitary thrift holding company in existence at May 4, 1999 may be sold only to a financial holding company engaged in activities permissible for multiple savings and loan holding companies.
The GLB Act is not expected to have a material effect on the activities in which MFFC and Milton Federal currently engage, except to the extent that competition with others types of financial institutions may increase as they engage in activities not permitted prior to enactment of the GLB Act.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ASSET AND LIABILITY MANAGEMENT AND MARKET RISK
Milton Federal's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Interest rate risk is the risk that Milton Federal's financial condition will be adversely affected due to movements in interest rates. The income of financial institutions is primarily derived from the excess of interest earned on interest-earning assets over the interest paid on interest-bearing liabilities. Accordingly, Milton Federal places great importance on monitoring and controlling interest rate risk.
As part of its effort to monitor and manage interest rate risk, Milton Federal uses the "net portfolio value" ("NPV") methodology adopted by the OTS as part of its capital regulations. Although Milton Federal is not currently subject to NPV regulation because such regulation does not apply to institutions with less than $300 million in assets and risk-based capital in excess of 12%, application of NPV methodology may illustrate Milton Federal's interest rate risk.
Generally, NPV is the discounted present value of the difference between incoming cash flows on interest-earning and other assets and outgoing cash flows on interest-bearing and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the NPV that would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase in market interest rates and a 200 basis point decrease in market interest rates are considered. If the NPV would decrease by more than 2% of the present value of the institution's assets with either an increase or a decrease in market rates, the institution must deduct 50% of the amount of decrease in excess of such 2% in the calculation of the institution's risk-based capital. See "Liquidity and Capital Resources."
As of September 30, 1999, 2% of the present value of Milton Federal's assets was approximately $5,152,000. Because the interest rate risk of a 200 basis point increase in market interest rates (which was greater than the interest rate risk of a 200 basis point decrease) was $12,607,000 at September 30, 1999, Milton Federal would have been required to deduct approximately $3,728,000 (50% of the approximate $7,455,000 difference) from its capital in determining whether Milton Federal met its risk-based capital requirement. Regardless of such reduction, however, Milton Federal's risk-based capital at September 30, 1999, would still have exceeded the regulatory requirement by approximately $9,167,000.
Presented below, as of September 30, 1999 and 1998, is an analysis of Milton Federal's interest rate risk as measured by changes in NPV for instantaneous and sustained parallel shifts of 100 basis points in market interest rates. The table also contains policy limits set by the Board of Directors of Milton Federal as the maximum change in NPV that the Board of Directors deems advisable in the event of various changes in interest rates. Such limits are established with consideration of the dollar impact of various rate changes and Milton Federal's strong capital position.
As illustrated in the table, NPV is more sensitive to rising rates than declining rates. Such difference in sensitivity occurs principally because, as rates rise, borrowers do not prepay fixed rate loans as quickly as they do when interest rates are declining. Thus, in a rising interest rate environment, because Milton Federal has predominantly fixed rate loans in its loan portfolio, the amount of interest Milton Federal would receive on its loans would increase relatively slowly as loans are slowly prepaid and new loans at higher rates are made. Moreover, the interest Milton Federal would pay on its deposits would increase rapidly because Milton Federal's deposits generally have shorter periods to repricing. Assumptions used in calculating the amounts in this table are OTS assumptions.
As with any method of measuring interest rate risk, certain shortcomings are inherent in the NPV approach. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Further, in the event of a change in interest rates, expected rates of prepayment on loans and mortgage-backed securities and early withdrawal levels from certificates of deposit, would likely deviate significantly from those assumed in making risk calculations.
At September 30, 1999, Milton Federal exceeded the Board limit percentage change for all interest rate shifts. At September 30, 1998, Milton Federal exceeded the Board limit percentage change for an increase in interest rates of 200 and 300 basis points. As part of management's overall strategy to manage interest rate risk, the mortgage-backed security portfolio was structured so that substantially all of the mortgage-backed securities reprice on at least an annual basis. In addition, management has increased the emphasis of originating consumer and commercial lending although such loans still remain a small percentage of the overall loan portfolio. Consumer loans typically have a significantly shorter weighted average maturity and offer less exposure to interest rate risk while commercial loans primarily carry variable interest rates which are tied to a market index. In addition, management is continuing to originate variable rate mortgage loans as an additional tool to manage interest rate risk. Variable rate loans increased from $26.2 million at September 30, 1998 to $41.5 million at September 30, 1999. Additionally, during 1999 and 1998, Milton Federal sold pools of fixed rate mortgage loans and invested the funds in shorter term fixed rate loans, variable rate loans and adjustable rate mortgage-backed securities which have less exposure to interest rate risk. Despite the strategies employed by management, Milton Federal was more interest rate sensitive at September 30, 1999 than September 30, 1998.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders Milton Federal Financial Corporation West Milton, Ohio
We have audited the accompanying consolidated balance sheets of Milton Federal Financial Corporation as of September 30, 1999 and 1998, and the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for each of the three years in the period ended September 30, 1999. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Milton Federal Financial Corporation as of September 30, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended September 30, 1999 in conformity with generally accepted accounting principles.
Crowe, Chizek and Company LLP
Columbus, Ohio October 15, 1999
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS September 30, 1999 and 1998
See accompanying notes to consolidated financial statements.
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME Years ended September 30, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years ended September 30, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years ended September 30, 1999, 1998 and 1997
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Continued) Years ended September 30, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended September 30, 1999, 1998 and 1997
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Years ended September 30, 1999, 1998 and 1997
See accompanying notes to consolidated financial statements.
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation: The consolidated financial statements include the accounts of Milton Federal Financial Corporation ("MFFC") and its wholly-owned subsidiary, Milton Federal Savings Bank (the "Bank"), a federal stock savings bank, together referred to as the Corporation. The financial statements of the Bank include the accounts of its wholly-owned subsidiary, Milton Financial Service Corporation. Milton Financial Service Corporation holds stock in Intrieve, Inc., which is the data processing center utilized by the Bank. All significant intercompany accounts and transactions have been eliminated.
Nature of Operations: MFFC is a thrift holding company and through its subsidiary Bank, is engaged in the business of commercial and retail banking services with operations conducted through its main office in West Milton, Ohio and its full service branch offices located in Englewood, Brookville and Tipp City, Ohio. The Corporation is primarily organized to operate in the financial institution industry. Substantially all revenues are derived from the financial institution industry. Miami, Montgomery and Darke Counties provide the source of substantially all of the Bank's deposit and lending activities.
Use of Estimates: To prepare financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses, fair values of financial instruments and status of contingencies are particularly subject to change.
Cash Flows: Cash and cash equivalents include cash on hand, amounts due from depository institutions, federal funds sold and interest-bearing deposits in other financial institutions with original maturities of 90 days or less. Net cash flows are reported for customer loan and deposit transactions, as well as short-term borrowings under its cash management line of credit with the Federal Home Loan Bank ("FHLB").
Securities: Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported separately in other comprehensive income.
Interest income includes amortization of purchase premiums and discounts. Gains and losses on sales are determined using the amortized cost of the specific security sold. Securities are written down to fair value when a decline in fair value is not considered temporary.
Loans: Loans are reported at the principal balance outstanding, net of deferred loan fees, loans in process and the allowance for loan losses. Loans held for sale are reported at the lower of cost or market, on an aggregate basis.
Interest income is reported on the interest method and includes the amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when the loan is impaired or payments are past due over 90 days (180 days for residential mortgages). Payments received on such loans are reported as principal reductions.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Allowance for Losses on Loans: The allowance for losses on loans is a valuation allowance for probable credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required based on past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off.
Loan impairment is reported when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential first-mortgage loans secured by one- to four-family residences, residential construction loans, automobile, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of expected future cash flows using the loan's existing rate, or at the fair value of collateral if repayment is expected solely from the collateral.
Premises and Equipment: Asset cost is reported net of accumulated depreciation. Depreciation expense is calculated using a straight-line method based on the estimated useful lives of the assets. These assets are reviewed for impairment when events indicate the carrying amount may not be recoverable. Maintenance and repairs are charged to expense as incurred and improvements are capitalized.
Real Estate Owned: Real estate acquired in settlement of a loan is initially recorded at estimated fair value at acquisition. Any reduction to fair value from the carrying value of the related loan at the time the property is acquired is accounted for as a loan charge-off. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and losses on disposition, and changes in the valuation allowance are reported in the net gain or loss on other real estate included in "Other income" on the accompanying consolidated statements of income.
Servicing Rights: Servicing rights are recognized as assets for purchased rights and for the allocated value of retained servicing rights on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance.
Income Taxes: Income tax expense is the total of the current-year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences for the temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
Concentrations of Credit Risk: The Bank grants loans to customers located primarily in Miami, Montgomery and Darke Counties. At year-end 1999 and 1998, approximately 78.6% and 84.8% of the loans in the Bank's loan portfolio had interest rates fixed until the maturity of the loans.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
At September 30, 1999 and 1998, the Bank had interest-bearing deposits and overnight deposits in the FHLB of Cincinnati totaling $403,342 and $2,527,941 and owned stock in the FHLB with a carrying value of $3,131,700 and $2,814,200.
Employee Stock Ownership Plan: The cost of shares issued to the Employee Stock Ownership Plan ("ESOP"), but not yet allocated to participants, is shown as a reduction of shareholders' equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.
Earnings Per Common Share: Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. ESOP shares are considered outstanding for this calculation unless unearned. Recognition and Retention Plan ("RRP") shares are considered outstanding as they become vested. Diluted earnings per common share include the dilutive effect of RRP shares and the additional potential common shares issuable under stock options.
Stock Compensation: Employee compensation expense under stock option plans is reported if options are granted below market price at grant date. Pro forma disclosures of net income and earnings per share are shown using the fair value method of Statement of Financial Accounting Standards ("SFAS") No. 123 to measure expense for options granted after fiscal 1995, using an option pricing model to estimate fair value.
Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, which is also recognized as a separate component of shareholders' equity. The accounting standard that requires reporting comprehensive income first applies for fiscal 1999, with prior information restated to be comparable.
Dividend Restriction: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the holding company or by the holding company to its shareholders.
Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully described in a separate note. Fair value estimates involve uncertainties and matters of significant judgement regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Reclassifications: Some items in prior financial statements have been reclassified to conform to the current presentation.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 2 - SECURITIES
The amortized cost and fair values of securities were as follows:
The municipal obligation classified as held to maturity at September 30, 1999 matures December 2002.
The Corporation maintains a significant portfolio of mortgage-backed securities in the form of Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA") and Government National Mortgage Association ("GNMA") participation certificates. Mortgage-backed securities generally entitle the Corporation to receive a portion of the cash flows from an identified pool of mortgages, and FHLMC, FNMA and GNMA securities are each guaranteed by their respective agencies as to principal and interest. The Corporation has also invested significant amounts in collateralized mortgage obligations ("CMOs") and real estate mortgage investment conduits ("REMICs") which are included in mortgage-backed securities. Substantially all CMOs and REMICs are backed by pools of mortgages insured or guaranteed by the FNMA and FHLMC.
During 1999, proceeds from the sales of securities available for sale were $6,038,015 with gross realized gains of $46,672 included in earnings. During 1998, proceeds from sales of securities available for sale were $15,321,317 with gross realized gains of $247,996 included in earnings. During 1997, proceeds from the sales of securities available for sale were $18,785,046 with gross realized gains of $115,862 and gross realized losses of $790 included in earnings.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 3 - LOANS
Year-end loans were as follows:
The Corporation has sold various loans to other financial intermediaries while retaining the servicing rights. Gains and losses on loan sales are recorded at the time of the sale. Loans sold for which the Corporation has retained servicing totaled $15,428,430 at September 30, 1999 and, $15,615,077 at September 30, 1998. Capitalized mortgage servicing rights totaled $189,000 at September 30, 1999 and 1998. At September 30, 1999, $2,626,923 of one- to four-family residential real estate loans have been designated as held for sale. At September 30, 1998, no loans were held for sale. Proceeds from the sale of loans during 1999, 1998 and 1997 were $4,371,901, $8,434,138 and $10,377,554 with net realized gains of $73,913, $207,662 and $118,281 included in earnings.
Activity in the allowance for loan losses was as follows:
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 3 - LOANS (Continued)
Nonaccrual loans for which interest has been suspended totaled $231,000 and $359,000 at September 30, 1999 and 1998. Loans considered impaired within the scope of SFAS No. 114 were not significant in 1999, 1998 or 1997.
Certain directors, executive officers and companies with which they are affiliated were loan customers of the Bank during the year ended September 30, 1999. A summary of activity on related party loans during 1999 was as follows:
NOTE 4 - PREMISES AND EQUIPMENT
Year-end premises and equipment were as follows:
NOTE 5 - DEFERRED COMPENSATION
The Corporation provides a deferred compensation plan for its Board of Directors. Under the terms of the plan, directors may elect to defer a portion of their fees that would be retained by the Corporation, with interest being credited to the participant's deferred balance. Upon retirement, the participant would be entitled to receive the accumulated deferred balance, paid over a specified number of years. The Corporation accrued deferred compensation expense of $57,337, $53,472, and $49,866 for 1999, 1998 and 1997.
The Corporation has purchased insurance contracts on the lives of the participants in the deferred compensation plan and has named the Corporation as beneficiary. While no direct contract exists between the deferred compensation plan and the life insurance contracts, it is management's current intent that the insurance contracts would be used as a funding source for the deferred compensation plan.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 6 - DEPOSITS
The aggregate amount of certificates of deposit with a minimum denomination of $100,000 was $5,478,000 and $5,476,000 at year-end 1999 and 1998. Deposits in excess of $100,000 are not insured by the FDIC.
At year-end 1999, scheduled maturities of certificates of deposit were as follows:
NOTE 7 - INCOME TAXES
Income tax expense was as follows:
The sources of year-end gross deferred tax assets and liabilities were as follows:
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 7 - INCOME TAXES (Continued)
Effective tax rates differ from the statutory federal income tax rate applied to financial statement income due to the following:
Prior to the enactment of legislation discussed below, thrifts which met certain tests relating to the composition of assets had been permitted to establish reserves for bad debts and to make annual additions thereto which could, within specified formula limits, be taken as a deduction in computing taxable income for federal income tax purposes. The amount of the bad debt reserve deduction for "nonqualifying loans" was computed under the experience method. The amount of the bad debt reserve deduction for "qualifying real property loans" could be computed under either the experience method or the percentage of taxable income method, based on an annual election.
In August 1996, legislation was enacted that repealed the percentage of taxable income method of accounting used by many thrifts to calculate their bad debt reserve for federal income tax purposes. As a result, thrifts such as the Bank must recapture that portion of the reserve that exceeds the amount that could have been taken under the experience method for tax years beginning after December 31, 1987. The legislation also requires thrifts to account for bad debts for federal income tax purposes on the same basis as commercial banks for tax years beginning after December 31, 1995. The recapture will occur over a six-year period, the commencement of which was delayed until the first taxable year beginning after December 31, 1997, because the institution met certain residential lending requirements. At September 30, 1999 and 1998, the Bank had $941,420 and $1,129,704 in bad debt reserves subject to recapture for federal income tax purposes. The deferred tax liability related to the recapture has been previously established. In fiscal 1999, $188,284 bad debt reserves were recaptured.
Retained earnings at September 30, 1999 and 1998, include $3,436,000 for which no provision for federal income taxes has been made. This amount represents the qualifying and nonqualifying tax bad debt reserve as of December 31, 1987 that is the Corporation's base year for purposes of calculating the bad debt deduction for tax purposes. The related amount of unrecognized deferred tax liability was $1,168,000 at September 30, 1999 and 1998. If this portion of retained earnings is used in the future for any purpose other than to absorb bad debts, it will be added to future taxable income.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 8 - BORROWED FUNDS
At September 30, 1999, the Bank had a cash-management line-of-credit enabling it to borrow up to $12,413,550 from the FHLB of Cincinnati. The line of credit must be renewed on an annual basis. The next renewal date is April 16, 2000. Variable rate borrowings of $9,200,000 were outstanding related to this cash-management line-of-credit at September 30, 1999. There were no borrowings outstanding on this line of credit at September 30, 1998.
As a member of the FHLB system, the Bank has the ability to obtain additional borrowings up to a maximum total of 50% of Bank assets subject to the level of qualified, pledgable one- to four-family residential real estate loans. The Bank had variable rate borrowings totaling $7,000,000, with interest rates ranging from 5.33% to 5.51%, at September 30, 1999 and $4,000,000, with an interest rate of 5.54% at September 30, 1998. The Bank had fixed rate borrowings totaling $11,283,463 at September 30, 1999 and $12,430,023 at September 30, 1998. The interest rates on these borrowings ranged from 5.80% to 6.42% at September 30, 1999 and 1998. The Bank also had $34,000,000 and $36,000,000 in convertible advances at September 30, 1999 and 1998 whereby the interest rates are fixed for a specified period of time and then change to variable for the remaining term of the advance. The interest rates on these advances ranged from 5.12% to 5.65% at September 30, 1999 and 4.66% to 5.65% at September 30, 1998.
The maximum month-end balance of FHLB advances outstanding was $61,524,000 in 1999 and $55,251,000 in 1998. Average balances of borrowings outstanding during 1999 and 1998 were $55,376,000 and $48,744,000. Mortgage loans and all shares of FHLB stock owned by the Bank totaling $92,225,195 and $3,131,700 at September 30, 1999 and $78,645,035 and $2,814,200 at September 30, 1998, were pledged as collateral for the FHLB advances.
At September 30, 1999, required annual principal payments were as follows:
NOTE 9 - COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES
Various contingent liabilities are not reflected in the consolidated financial statements, including claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material effect on the financial condition or the results of operations of the Corporation.
Some financial instruments are used in the normal course of business to meet financing needs of customers and reduce exposure to interest rate changes. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. These involve, to varying degrees, credit and interest rate risk in excess of the amounts reported in the financial statements.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 9 - COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES (Continued)
Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit, standby letters of credit and financial guarantees written. The same credit policies are used for commitments and conditional obligations as are used for loans. The amount of collateral obtained, if deemed necessary, on extension of credit is based on management's credit evaluation and generally consists of residential or commercial real estate. Lines of credit are primarily home equity lines collateralized by second mortgages on one- to four-family residential real estate and commercial lines of credit collateralized by business assets.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being used, the total commitments do not necessarily represent future cash requirements.
As of September 30, 1999 and 1998, the Corporation had commitments to make fixed rate one- to four-family residential real estate loans at current market rates totaling $1,040,000 and $1,516,000. Loan commitments are generally for thirty days. The interest rate on the fixed rate commitments ranged from 7.00% to 10.25% at September 30, 1999 and 6.38% to 8.50% at September 30, 1998. The Corporation had commitments to make nonresidential real estate loans at 7.75% totaling $397,000 at September 30, 1999. The Corporation had commitments to make variable rate, one- to four-family residential real estate loans totaling $223,000, with interest rates ranging from 7.13% to 7.63 at September 30, 1999. The Corporation had no such commitments at September 30, 1998. As of September 30, 1999 and 1998, the Corporation had $4,540,000 and $4,711,000 in unused variable rate home equity lines of credit and $2,034,000 and $820,000 in unused variable rate commercial lines of credit.
At September 30, 1999 and 1998, the Corporation had standby letter of credit commitments totaling $465,000 and $150,000.
At September 30, 1999 and 1998, compensating balances of $1,693,000 and $518,000 were required as deposits with the FHLB and Federal Reserve Bank. These balances do not earn interest.
The Corporation has entered employment agreements with certain officers of the Corporation. Each of the agreements provide for a term of three years and a salary and performance review by the Board of Directors not less than annually, as well as inclusion of the employee in any formally established employee benefit, bonus, pension and profit-sharing plans for which management personnel are eligible.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 10 - REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal regulatory agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about the Bank's components, risk weightings and other factors. Failure to meet minimum capital requirements can initiate certain mandatory actions that, if undertaken, could have a direct material effect on the Bank's financial statements. At September 30, 1999 and 1998, management believes the Bank complies with all regulatory capital requirements. Based upon the computed regulatory capital ratios, the Bank is considered well capitalized under the Federal Deposit Insurance Improvement Act criteria at September 30, 1999 and 1998. Management believes no conditions or events have occurred subsequent to the last notification by regulators that would cause the Bank's capital category to change.
At year-end 1999 and 1998, the Bank's actual capital level and minimum required levels were:
In addition to certain federal income tax considerations, the Office of Thrift Supervision ("OTS") regulations impose limitations on the payment of dividends and other capital distributions by savings associations. Under OTS regulations applicable to converted savings banks, the Bank is not permitted to pay a cash dividend on its common shares if its regulatory capital would, as a result of payment of such dividends, be reduced below the amount required for the Liquidation Account, or below applicable regulatory capital requirements prescribed by the OTS.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 10 - REGULATORY CAPITAL REQUIREMENTS (Continued)
An application must be submitted and approval from the OTS must be obtained by a subsidiary of a savings and loan holding company (1) if the proposed distribution would cause total distributions for the year to exceed net income for that calendar year to date plus the savings association's retained net income for the preceding two years; (2) if the savings association will not be at least adequately capitalized following the capital distribution; (3) if the proposed distribution would violate a prohibition contained in any applicable statute, regulation or agreement between the savings association and the OTS (or the FDIC), or a condition imposed on the savings association in an OTS-approved application or notice; or, (4) if the savings association has not received certain favorable examination ratings from the OTS. If a savings association subsidiary of a holding company is not required to file an application, it must file a notice with the OTS. At September 30, 1999, the Bank could dividend $382,310 without approval from the OTS.
NOTE 11 - EMPLOYEE PENSION AND PROFIT INCENTIVE PLANS
The Corporation is part of a qualified noncontributory multi-employer trust, defined-benefit pension plan covering substantially all of its employees. The plan is administered by the trustees of the Financial Institutions Retirement Fund ("Retirement Fund"). The cost of the plan is set annually as an established percentage of wages. The Corporation has not been required to contribute to the Retirement Fund and as a result, did not recognize any pension expense in 1999, 1998 or 1997.
The Corporation offers a 401(k) profit sharing plan covering substantially all employees. The annual expense of the plan is based on a partial matching of voluntary employee contributions of up to 4% of individual compensation. The matching percentage was 25% for 1999, 1998 and 1997. Employee contributions are vested at all times and the Corporation's matching contributions become fully vested after an individual has completed three years of service. The contribution expense included in salaries and employee benefits was $12,490, $11,509, and $9,484 for 1999, 1998 and 1997.
NOTE 12 - STOCK OPTION PLAN
On March 20, 1995, the Stock Option Committee of the Board of Directors granted options to purchase 238,545 common shares at an exercise price of $13.69 to certain officers and directors of the Bank and Corporation. One-fifth of the options awarded become first exercisable on each of the first five anniversaries of the date of grant. The option period expires 10 years from the date of grant. Options to purchase 190,836 and 143,127 shares were exercisable at September 30, 1999 and 1998. No options were exercised during 1999, 1998, or 1997. In addition, 19,342 shares of authorized but unissued common stock are reserved for which no options have been granted.
NOTE 13 - EMPLOYEE STOCK OWNERSHIP PLAN
The Corporation offers an ESOP for the benefit of substantially all employees of the Corporation. The ESOP has received a favorable determination letter from the Internal Revenue Service on the qualified status of the ESOP under applicable provisions of the Internal Revenue Code.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 13 - EMPLOYEE STOCK OWNERSHIP PLAN (Continued)
The ESOP borrowed funds from MFFC with which to acquire common shares of the Corporation. The loan is secured by the shares purchased with the loan proceeds and will be repaid by the ESOP with funds from the Bank's discretionary contributions to the ESOP and earnings on ESOP assets. All dividends on unallocated shares received by the ESOP are used to pay debt service. The shares purchased with the loan proceeds are held in a suspense account for allocation among participants as the loan is repaid. When loan payments are made, ESOP shares are allocated to participants based on relative compensation.
ESOP compensation expense was $288,265, $339,415, and $269,029 for 1999, 1998, and 1997. ESOP shares at September 30, 1999 and 1998 were as follows:
NOTE 14 - RECOGNITION AND RETENTION PLAN
The Corporation maintains a recognition and retention plan ("RRP") for the benefit of directors and certain key employees of the Corporation. The RRP is used to provide such individuals ownership interest in the Corporation in a manner designed to compensate such directors and key employees for services. The Bank contributed sufficient funds to enable the RRP to purchase a number of common shares in the open market equal to 4% of the common shares sold in connection with the Conversion.
On October 16, 1995, the RRP Committee of the Board of Directors awarded 74,784 shares to certain directors and officers of the Corporation. No shares had been previously awarded. One-fifth of such shares will be earned and nonforfeitable on each of the first five anniversaries of the date of the awards. In the event of the death or disability of a participant or a change in control of the Corporation, however, the participant's shares will be deemed to be earned and nonforfeitable upon such date. There were 2,064 shares forfeited during the year ended September 30, 1999. As a result, there were 30,435 and 28,371 shares at September 30, 1999 and 1998 reserved for future awards. Compensation expense is based on the cost of the shares, which approximates fair value at the date of grant, and was $200,479, $215,381 and $215,382 for 1999, 1998 and 1997.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 15 - FAIR VALUES OF FINANCIAL INSTRUMENTS
Fair values of financial instruments at year-end were:
The following methods and assumptions were used to estimate fair values for financial instruments. The carrying amount is considered to estimate fair value for all items except those described below. The fair values of securities are based on quoted market prices or, if no quotes are available, on the rate and term of the security and on information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, the fair value is estimated by discounted cash flow analysis using current market rates for the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. Fair value of loans held for sale is based on market estimates. The fair value of borrowed funds is based on currently available rates for similar financing. The fair value of off-balance-sheet items is based on the fees or cost that would currently be charged to enter into or terminate such arrangements and such amounts are not material.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 16 - EARNINGS PER SHARE
The factors used in the earnings per share computation are as follows:
Unearned RRP shares and stock options did not have a dilutive effect on EPS for the year ended September 30, 1999, as the fair value of the RRP shares on the date of grant and the exercise price of the stock options were greater than the average market price for the period.
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 17 - PARENT COMPANY ONLY CONDENSED FINANCIAL STATEMENTS
Condensed financial information of MFFC is as follows:
Condensed Balance Sheets September 30, 1999 and 1998
Condensed Statements of Income Years Ended September 30, 1999, 1998 and 1997
(Continued)
MILTON FEDERAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999, 1998 and 1997
NOTE 17 - PARENT COMPANY ONLY CONDENSED FINANCIAL STATEMENTS (Continued)
Condensed Statement of Cash Flows Years Ended September 30, 1999, 1998 and 1997
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information contained in the definitive Proxy Statement for the 2000 Annual Meeting of Shareholders of Milton Federal Financial Corporation (the "Proxy Statement") under the captions "Board of Directors," "Executive Officers," "Voting Securities and Ownership of Certain Beneficial Owners and Management" and "Section 16(a) Beneficial Ownership Reporting Compliance" is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information contained in the Proxy Statement under the caption "Compensation of Executive Officers and Directors" is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information contained in the Proxy Statement under the caption "Voting Securities and Ownership of Certain Beneficial Owners and Management" is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information contained in the Proxy Statement under the caption "Certain Transactions with MFFC" is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
2 FINANCIAL STATEMENT SCHEDULES. All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
3 EXHIBITS.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MILTON FEDERAL FINANCIAL CORPORATION
By /s/ Glenn E. Aidt --------------------------------------- Glenn E. Aidt President (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been duly signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS | 24,934 | 163,175 |
946815_1999.txt | 946815_1999 | 1999 | 946815 | ITEM 1. BUSINESS
INTRODUCTION
Mackie Designs Inc. ("Mackie" or the "Company") develops, manufactures, sells and supports high-quality, reasonably priced professional audio equipment. The Company's products are used in a wide variety of sound applications including home and commercial recording studios, multimedia and video production, compact disc, read-only memory ("CD-ROM") authoring, live performances, and public address systems. The Company offers a range of products at suggested retail prices of up to $13,000, which generally represents the low to mid-range price points within the professional audio market. Mackie distributes its products through a network of independent representatives to over 1,000 retail dealers of professional audio equipment in the U.S. Internationally products are offered through Mackie subsidiaries in Italy, France, Germany, the United Kingdom and China and through local distributors in nearly 70 other countries where the Company does not have direct operations.
In June 1998, the Company purchased Radio Cine Forniture (R.C.F.) S.p.A. ("RCF"), an Italian corporation with principal offices in Reggio Emilia, Italy and manufacturing facilities located in northern and central Italy. RCF's principal activity is the manufacture of loudspeakers and speaker components. Its products are distributed throughout the world, and are well recognized for quality. RCF works in conjunction with the Company in the development and manufacture of speaker products bearing both the "MACKIE." and "RCF" brands.
The Company's primary products are analog and digital mixers, mixer-related products, amplifiers, loudspeakers and loudspeaker components . A mixer serves as the central component of any professional audio system by electronically blending, routing and enhancing sound sources, such as voices, musical instruments, sound effects and audio tape, video tape and other pre-recorded material. For example, using a mixer, a vocalist may be heard above the accompaniment, background singers are combined, and individual instruments are blended into the overall mix. The musician or sound technician accomplishes this task by using the mixer controls to adjust the relative volume of each sound source.
Audio mixers are a necessary component of any recording system, whether the system is being used to produce an audio tape, compact disc ("CD"), video soundtrack or multimedia CD-ROM. A mixer is used not only to balance sound inputs when recording initial tracks, but is also often used to further process and edit the tracks prior to duplication and distribution of the recording. Mixers are used in recording applications by commercial and home studios, in film and video post-production, in business presentations and teleconferencing, in the production of television and radio programming and in multimedia productions such as CD-ROM and on-line authoring.
Mixers are also used to control relative audio levels in live presentations at locations such as auditoriums, ballrooms, theaters and sports arenas. For example, a typical performing group uses from four to 32 microphones and electronic inputs. Large concert tours and musical road productions often have 56 or more sound inputs, which may include pre-recorded music and sound effects. Many churches use multiple microphones for spoken word and music during their services.
In late 1996, the Company introduced power amplifiers, its first line of products that are not directly related to mixers. Power amplifiers are used to amplify the output signals from mixers to a level sufficient to drive loudspeakers. Amplifiers are used with mixers and loudspeakers in a variety of applications, such as private and touring sound reinforcement systems, permanent industrial and
commercial installations, recording studios, and theatre/cinema and broadcast facilities. The power amplifier line is distributed through the same channels as mixers.
In August 1997, the Company introduced powered monitor speakers. Powered monitors combine signal processing, power amplifiers, and speakers in one cabinet housing. Enclosing an amplifier in the speaker eliminates one step of the path the sound signal travels, reducing the chance of altering the original signal. This step is very important when recording with highly sensitive professional audio equipment to accurately reproduce sound. Mackie's powered monitors are used in conjunction with a mixer, and are sold through existing mixer distribution channels.
The Company's traditional markets have been analog mixers and related products. In 1997, digital technologies were developed by the Company to expand its market base. Mackie's first digital product, Human User Interface ("HUI") an interface tool for digital audio workstations ("DAW"), was introduced in late 1997. This DAW interface targets the rapidly growing digital audio workstation market, and was developed in conjunction with Digidesign, a division of Avid Technology, Inc . DAWs are used in video, film, multimedia and recording studios.
With the acquisition of RCF, the Company expanded its product line into speakers and speaker components. RCF manufactures raw speaker components used by third-party speaker manufacturers. RCF also produces several types of finished speakers ready for the installed sound and professional audio markets.
In July 1998, the Company began shipping the Digital 8-Bus digital mixing console ("D8B"). Like analog mixers, the D8B blends, routes and enhances sound sources but does so with the added capability of recalling all settings and automating them in real time. In addition, the D8B's open hardware and software architecture allows the customer to configure the D8B to interface with any type of device, analog or digital, and the D8B's internal sound processing capabilities can be enhanced with third party software "plug-ins." Markets include recorded sound, such as commercial and home studios, multimedia production, sound for video games and film and video post-production. In the second quarter of 2000, the Company plans to ship its first digital recorder, the HDR24/96. Every mixer sold to the recording market is connected to a recorder of some sort making the HDR24/96 a natural product extension for Mackie.
The HDR24/96 is a 24-track, 24 bit recorder with complete on-screen editing capabilities. Utilizing off-the-shelf computer hardware controlled by Mackie's own Real Time Operating System-TM- allows the HDR24/96 to offer powerful recording and editing features at a very low price. In addition Mackie is able to take advantage of falling prices and increasing speed and capabilities generated by the computer industry. industry.
Mackie was incorporated in Washington in 1988. The Company's executive offices and U.S. manufacturing facilities are located at 16220 Wood-Red Road N.E., Woodinville, Washington 98072, and its telephone number is (425 ) 487-4333. RCF was incorporated in Italy in 1949 and its executive offices are located at Via G. Ferraris, 2-42029, S. Maurizio, Reggio Emilia, Italy , and its telephone number is 390 522 354111 .
"MACKIE.", the running figure, "RCF," "Artesuono" and all of the names of the Company's U.S.-produced products are registered trademarks or common law trademarks of the Company. To the extent trademarks are unregistered, the Company is unaware of any conflicts with trademarks owned by third parties. This document also contains names and marks of other companies.
PRODUCTS The Company currently offers professional audio equipment in numerous product categories including: Compact mixers, 8 Bus consoles, SR series mixers, digital consoles, other digital automation systems, CFX compact mixers with effects, PPM Powered mixers, amplifiers, studio monitors, active and passive loudspeakers, contractor products and loudspeaker components.
COMPACT MIXERS. Compact mixers were the Company's first products and are designed to be mounted in 19-inch equipment racks, which are the standard housings for professional audio and video components. The Company offers four basic compact mixers: the 1202 VLZ Pro, the 1402 VLZ pro, the 1604 VLZ pro and the 1642 VLZ pro. Applications for the Company's compact mixers include recording and project studios, live presentations, video post-production and multi-media. Suggested retail prices for these mixers are from $429 to $1199.
CFX SERIES. The Company began shipping a new line of mixers, the CFX series, in 1999. CFX mixers are intended for the amateur and semi-pro customer as well as audio/visual and rental dealers. They utilize the same technologies as the compact mixers and include 16 on-board effects and a 9-band stereo graphic equalizer. The Company's EMAC-TM-effects circuitry digitally processes audio at 32 bits for superior audio quality and control. Three models are available with 12, 16 or 20 channels and suggested retail pricing ranges from $699 to $1099.
PPM SERIES. In the first quarter of 1999, the Company began shipping PPM powered mixers. These products combine the Company's compact mixer technology with its FR Series amplifier technology to provide the customer with an economical alternative to separate components. Each of the five models features VLZ circuitry, EMAC-TM-digital effects processing, two 9-band graphic equalizers, and dual FR high-current, fast recovery amplifiers. The 808S stereo model and the 808M mono model both feature dual 600W amplifiers and eight input channels. The 408S stereo model and the 408M stereo model both feature dual 250W amplifiers and eight input channels. The 406M mono model features dual 250W amplifiers and six input channels. Suggested retail prices range from $699 to $999
FAST RECOVERY SERIES-TM- POWER AMPLIFIER. During 1999 the Company introduced the M-800 power amplifier, with a suggested retail price of $549, bringing the Company's power amp family to four available mode le. The Company's FR Series-TM-power amplifiers are Mackie's first non-mixer related products and became available in December 1996 with the introduction of the M1200, which was later upgraded in 1998 to the M1400 and M1400i models currently at a suggested retail price of $699. These These three models, plus the M2600, introduced in 1998 at a suggested retail price of $1,199, are designed to keep sound quality intact when pushed to extreme levels through the use of exclusive fast recovery (FR) circuitry. The FR Series power amps are targeted at live sound reinforcement applications for touring companies, theaters, concert halls, clubs and churches, and installed contractor markets.
8 BUS SERIES. The 8 Bus is a larger mixer console designed for multi-track recording and live presentation applications. The Company introduced 8 Bus mixers in 1993. At suggested retail prices from $2,500 to $4,200, the 8 Bus consoles have opened the market to many new users and replaced many large systems offered by competitors that typically cost over $50,000. The console is available in three basic models: the 32-channel 32-8, the 24-channel 24-8 and the 16-channel 16-8. The 8 Bus console's applications include pre-production and recording of albums for major artists and groups, on-line video production, movie soundtrack mixdown, television dialog editing, on stage mixing and live sound reinforcement used by touring musical groups, theaters, concert halls, clubs and churches.
SR SERIES. The SR (Sound Reinforcement) Series are intended as high quality, low cost 24-, 32-, 40-, or 56- channel audio mixers for live music applications that compete with consoles selling for several times their retail price. The first product in this line, the SR 24-4 was introduced in May 1995, followed by the SR 32-4 in August 1995. These have suggested retail prices of $1,599 to $2,299. In December 1996, Mackie introduced the 40-8, a 40-channel large-format sound reinforcement console, and in March 1998, the Company introduced the 56-8, a 56-channel console. The SR40.8 large format console retails for $9,995 and the SR 40-8 retails for $13,595. The SR 24-4 and SR 32-4 are larger than a compact mixer but significantly smaller than Mackie's 8 Bus consoles and include features necessary for use with multi-track digital recorders. They incorporate much of the advanced technology first introduced in the 8 Bus series including very low impedance circuitry, wide-ban equalization and highly sensitive signal presence indicators. The SR 24-4 and 32-4 series mixers are targeted at bands and other touring musical groups, audio/video rental services and permanent sound reinforcement venues, including churches, clubs, small theatres and auditoriums. The SR 40-8 and SR 56-8 large-format consoles are intended for use as installed equipment in venues such as churches, auditoriums, or sporting facilities.
DIGITAL CONSOLES. In July 1998, the Company entered the digital mixer market with the Digital 8-Bus production and post-production console ("D8B"). With a suggested retail price of $9,999, the D8B has opened the high-end production and post-production market to many new users at the professional and semi-professional level. At the heart of the D8B is a Pentium microprocessor running Mackie Real Time OS-TM-, the Company's own operating system. The D8B features 48 input channels, 24 internal internal virtual channels, 8 mix buses and 12 auxiliary buses used for effects processing and monitoring. Each input channel includes user-configurable 4-band digital equalization, dynamics processing, routing to internal effects processors and surround panning capabilities. The D8B has 25 precision motorized faders to instantly recall mix settings and allow for dynamic automation of mix levels. Rear panel card slots allow the addition of up to four DSP (Digital Signal Processing) cards that can run third-party signal processing software capable of providing up to 16 different effects at once. Strategic partnerships with software suppliers offer the customer a growing library of effects programs from which to choose. The D8B's external Power Supply/CPU unit contains card slots for synchronizing the console to other digital devices, linking multiple consoles, connecting consoles to a LAN (Local Area Network) and transferring files from one console to another.
OTHER DIGITAL AUTOMATION SYSTEMS. The Company's other digital automation systems include the UltraMix -Registered Trademark- Universal Automation System and the Human User Interface ("HUI").
Digital audio workstations ("DAWs") are used in commercial, project and home recording studios, and multimedia authoring such as video production, commercials, and other uses that combine visual and sound effects. HUI was developed in conjunction with Digidesign, a world leader in the DAW market. HUI is a hands-on control surface that enhances DAW-user productivity with tactile controls and visual displays for mixing and editing functions that were previously controlled by conventional computer controls. HUI, which retails for approximately $3,500, replaces a mouse with a control surface similar to a mixer. The DAW market includes multimedia, film, video, and recording studio professionals.
POWERED MONITOR SPEAKERS. Powered monitors are an essential tool in accurate sound reproduction, and are used in conjunction with mixer products. Powered monitors pre-process sound through equalization and cross-overs, accurately amplify, then deliver a signal that is perfectly matched to the speaker components. Mackie introduced its first monitor, the HR824 active near-field studio monitor, in August 1997. Priced at approximately $1,500 a pair, HR824s are primarily designed for studio recording with limited space. These powered monitors are currently being used in a wide variety of
applications including home and professional studio recording, video post-production, broadcast post-production, and home stereos.
SPEAKERS. In 1999 the Company introduced its first sound reinforcement speakers. The SRM450, at a suggested retail price of $899, is an active, 2-way horn-loaded speaker in a lightweight polystyrene enclosure designed for local and touring groups, fixed club PA systems, churches, theaters, contractor/installed systems. The built-in dual FR Series power amps deliver 100 watts to the highs, and 300 watts to the mids/lows. Active technology optimizes the speaker performance utilizing electronic equalization of the enclosure, electronic crossover, and active time and phase correction circuitry. The second speaker is the passive C300 designed for use with the PPM Series powered mixers. This speaker features the same lightweight polystyrene enclosure for easy portability and speaker configuration, but does not feature power amps or active technology. Instead it utilizes the amplification and equalization delivered by the PPM Series powered mixers. This speaker targets local and regional performing groups, small churches and theaters, and boardroom/audio visual installations. The C300 is available at a suggested retail price of $499.
RCF PRECISION COMPONENTS. RCF manufactures loudspeaker components. These components are sold on an OEM basis to customers throughout the world who use them in their own branded loudspeakers. RCF components are found in some of the best performing speakers in the world. These speakers can be heard in many large touring sound systems as well as stadiums, auditoriums, exhibit halls, theatres, concert halls, clubs and churches.
PROFESSIONAL SPEAKERS. RCF also makes many families of finished loudspeakers, which are marketed under the RCF brand name. These loudspeakers are sold in the traditional passive format, meaning that amplification must be provided, and more recently in the active format, meaning that the amplifier is built into the loudspeaker. RCF introduced its Art Series of loudspeakers in 1997. The Art Series includes active and passive speakers in a molded plastic enclosure.
CONTRACTOR PRODUCTS. For 50 years, RCF has produced and sold a large range of commercial products to sound reinforcement contractors who use the products to install public address systems throughout the world. The products are used in everything from life safety systems to background and foreground music systems. The products produced and sold to sound contractors include speakers, amplifiers and mixers. RCF leads the Italian market for contractor products and has begun expanding into other European markets where it is quickly gaining acceptance.
ANCILLARY PRODUCTS. RCF produces and sells video projectors and consumer products for car and home use.
DISTRIBUTION AND SALES
In the U.S., the Company uses a network of representatives to sell to over 1,000 retail dealers, some of which have several outlets. The Company's products are sold in musical instrument stores, pro audio outlets and several mail order outlets. The Company's top 10 dealers represented approximately 37% of the Company's net sales in the U.S. in 1999. One of the Company's dealers, Guitar Center, accounted for approximately 13% of domestic net sales in 1999; no other dealer accounted for more than 10% of domestic net sales in this period.
The Company carefully selects and reviews its representatives and dealers, including mail order outlets. Representatives and domestic dealers enter into agreements with the Company that govern the terms under which they may sell the Company's products. Agreements with dealers and distributors
define an approved territory and set forth the products to be sold. These agreements are reviewed on a six-month basis, and decisions to renew are based on several factors, including sales performance and adequate representation of the Company and its products. The Company's representatives are paid on a commission basis. Dealers retain the difference between their cost and the sale price of products sold.
Internationally, products are offered through Mackie subsidiaries in Europe and China and through local distributors in nearly 70 other countries where the Company does not have direct operations. The Company's top 10 international distributors represented approximately 16% of the Company's international net sales in 1999. No single international distributor accounted for more than 10% of international net sales in this period. Sales to customers outside of the U.S. accounted for approximately 49%, 44% and 38% of the Company's net sales in 1999, 1998 and 1997, respectively.
International distributors are selected on the basis of criteria established by the Company. International distributors retain the difference between their cost and the sale price of products sold. Through the acquisition of RCF, the Company now has direct sales offices in the United Kingdom, France, Italy, Germany and China.
MARKETING
The Company's marketing strategy is designed to communicate with end-users directly and to educate them about its products. The Company's in-house marketing and design department creates all of its advertising, brochures, video, multimedia and trade show materials. Materials are provided by its marketing department to representatives, distributors and dealers worldwide, as part of the Company's overall sales strategy. Owner's manuals and sales literature are currently produced in several different languages. These materials are provided as a complement to the Company's direct advertising and customer support follow-up program. To further enhance customer awareness and understanding of its products, the Company advertises in leading trade publications, provides ongoing technical training and education for representatives and distributors, and participates in the primary industry trade shows for the musical instrument, video, recording studio, permanent installation and multimedia markets. Mackie has won several national advertisement awards as a result of this commitment to detail and excellence.
CUSTOMER SUPPORT
The Company's customer support program is designed to enhance loyalty by building customer understanding of product use and capabilities. The customer service and support operation also provides the Company with a means of understanding customer requirements for future product enhancements. This understanding comes through direct customer contact, as well as through close analysis of warranty card responses. To encourage the return of warranty cards, the Company has established a policy of extending the warranty period for certain products to customers returning completed warranty cards.
The Company maintains a staff of product support specialists at its Woodinville, Washington headquarters to provide direct technical service and support. Telephone support through a toll-free number is provided during scheduled business hours, and via the Company's web-site after business hours. Although most calls involve troubleshooting with owners of Mackie products, product support specialists also field calls from inquiring purchasers and may participate in making sales.
The Company has a separate technical assistance staff in Italy. They interface directly with customers and service centers that service RCF products. This technical support is provided free of charge. RCF offers a standard 1 year warranty on all of its products when it sells directly to the end user. When it sells through independent distributors, the distributors are responsible for warranty repairs.
The Company also relies on its international distributors to support its products in countries where the Company does not have its own offices. These distributors are responsible for the costs of carrying inventory required to meet customer needs.
Service and repairs on Mackie's products sold in the U.S. are performed at its headquarters and, for certain specialized products, at approximately 100 authorized warranty service centers located throughout the U.S. Multiple locations are necessary for customer convenience and to minimize shipping costs. All products shipped outside of the U.S., except to countries where the Company has its own offices, are serviced by the Company's international distributors.
RESEARCH AND DEVELOPMENT
The Company's research and development strategy is to develop affordable, high-quality products and related accessories for its targeted markets. On December 31, 1999, the Company's research and development staff consisted of 62 individuals who engineer and design all aspects of the Company's new products. The Company's research and development expenses were approximately $7.1 million in 1999, $5.1 million in 1998 and $5.9 million in 1997.
COMPETITION
The market for professional audio systems in general is highly competitive. The Company must compete with several professional audio manufacturers who have significantly greater development, sales and financial resources than the Company. The Company's major competitors in the mixer market are subsidiaries of Harman International (including Soundcraft Ltd., Allen & Heath Brenell Ltd. and DOD Electronics Corp.), Sony Corporation, Yamaha Corporation, Peavey Electronics Corporation, Teac America, Inc. (Tascam), SoundTracs PLC and Behringer Spezielle Studiotechnik GmbH. Competitors in the amplifier market include Peavey Electronics Corporation (including Crest Audio, Inc.), Crown International and QSC Audio Products, Inc. Competing speaker manufacturers include Genelec, Inc., Event Electronics, Inc., Alesis Corporation, JBL (a Harman International subsidiary) and ElectroVoice, Inc. Competitors in the component speaker market include Emminence Speaker Corporation, Acustica Beyma S.A. and B&C Speakers S.p.A. Competitors in the installed sound category include Toa Corporation, Philips Electronics N.V. and Bouyer S.A.
The Company competes primarily on the basis of product quality and reliability, price, ease of use, brand name recognition and reputation, ability to meet customers' changing requirements and customer service and support. However, despite the Company's investment in research and development, there can be no assurance that the Company will be successful in developing and marketing, on a timely basis, product modifications or enhancements or new products that respond effectively to technological advances by others.
PROPRIETARY TECHNOLOGY
Mackie has a strong interest in protecting the intellectual property assets of the Company that reflect original research, creative development, and product development. As such, the Company has sought protection through patents, copyrights, trademarks, and trade secrets. The Company has applied and filed for various design and utility patents, both domestically and internationally. The Company has actively used certain trademarks, and has applied for and registered specific trademarks in the U.S. and in foreign countries. To protect works of original authorship, the Company asserts copyright protection.
Along with extensive trademark and patent registration and filings, the Company has claimed copyright protection for works of original authorship, including product brochures, literature, advertisement, and web pages. In certain cases, the Company has filed and will continue to file for copyright registration in the U.S. While copyrights provide certain legal rights of enforceability, there can be no assurance as to the ability to successfully prevent others from infringing upon Mackie's copyrights.
The Company has never conducted a comprehensive patent search relating to the technology used in its products. The Company believes that its products do not infringe upon the proprietary rights of others. There can be no assurance, however, that others will not assert infringement claims against the Company in the future or that claims will not be successful.
While Mackie pursues patent, trademark and copyright protection for products and various marks, it also relies on trade secrets, know-how and continuing technology advancement, manufacturing capabilities, affordable, high-quality products, brand name recognition, new product introduction and direct marketing efforts to develop and maintain its competitive position. The Company's policy is to have each employee enter into an agreement that contains provisions prohibiting the disclosure of confidential information to anyone outside the Company and to recognize Mackie's ownership of intellectual property developed by employees. Consulting contracts generally provide for the protection of the Company's intellectual property and the requirement of confidentiality. There can be no assurance, however, that these confidentiality agreements will be honored or that the Company can effectively protect its rights to its unpatented trade secrets. Moreover, there can be no assurance that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to the Company's trade secrets.
By contrast, RCF has traditionally not sought patent protection for its products. Similarly, RCF has not pursued trademark or copyright protection except for the name "RCF".
MANUFACTURING
The Company manufactures its products in its facilities in Woodinville, Washington and in central and northern Italy. Nearly all of the Company's products share many components, which allows for integrated manufacturing of several distinct products and in certain cases significant part purchase volume discounts. Much of the Company's mixer console and power amplifier assembly work is performed on automated component-insertion machines. Currently, the assembly of most of the parts in a circuit board is automated.
The Company relies on several vendors to support its product manufacturing and attempts, if possible, to purchase certain materials from multiple sources to allow for competitive pricing and to avoid reliance on one or only a few vendors. The Company relies almost exclusively on one vendor for its potentiometers, but is in contact with other potentiometer manufacturers regularly. Interruption in, or cessation of, the supply of potentiometers from this supplier could adversely affect the Company s production capability, as the qualification process for another manufacturer, from sample submission to production quality and quantity delivery, could take several months. The Company has an approximate three month supply of potentiometers at any given time which would serve to reduce any potential disruption.
BACKLOG
The Company does not generally track backlog. Typically, orders are shipped within two weeks after receipt. In the case of new product introductions or periods where product demand exceeds
production capacity, the Company allocates products to customers on a monthly basis until demand is met.
EMPLOYEES
At December 31, 1999, the Company and its subsidiaries had 1,066 full-time equivalent employees, including 125 in marketing, sales and customer support, 62 in research and development, 818 in manufacturing and manufacturing support (which includes manufacturing engineering) and 61 in administration and finance. Approximately 136 of the Company's employees in Italy are represented by a labor union. The Company believes relations with all employees, union and non-union, are favorable.
CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS
DEVELOPMENT, INTRODUCTION AND SHIPMENT OF NEW PRODUCTS. The Company currently is developing new analog and digital mixers, recording devices, amplifiers and loudspeakers and loudspeaker components. Significant resource, technological, supplier, manufacturing or other problems may delay the development, introduction or manufacture of these products.
In the past, when t he Company's sales have been affected by delays in developing and releasing new products, s ome customers waited for the Company's new products, while others purchased products from the Company's competitors. Delays in the completion and shipment of new products, or failure of customers to accept new products, may affect future results.
VARIABILITY IN QUARTERLY OPERATING RESULTS. The Company's operating results tend to vary from quarter to quarter. The Company's revenue in each quarter is substantially dependent on orders received within that quarter. Conversely, the Company's expenditures are based on investment plans and estimates of future revenues. The Company may, therefore, be unable to quickly reduce spending if revenues decline in a given quarter. As a result, operating results for that quarter will suffer. The
Company's results of operations for any one quarter are not necessarily indicative of results for any future period.
Other factors which may cause the Company's quarterly results to fluctuate include:
- - - increased competition in the Company's niche markets
- - - timing of new product announcements
- - - product releases and pricing changes by the Company or its competitors
- - - market acceptance or delays in the introduction of new products
- - - production constraints
- - - the timing of significant orders
- - - customers' budgets
- - - foreign currency exchange rates
Due to all of the foregoing factors, it is possible that in some future quarters the Company's operating results will be below the expectations of analysts and investors.
RAPID TECHNOLOGICAL CHANGE. Product technology in the Company's industry evolves rapidly, making timely product innovation essential to success in the marketplace. The introduction of products with improved technologies or features may render the Company's existing products obsolete and unmarketable. If the Company cannot develop products in a timely manner in response to industry changes, or if the Company's products do not perform well, the Company's business and financial condition will be adversely affected. Also, the Company's new products may contain defects or errors which give rise to product liability claims against the Company or cause them to fail to gain market acceptance.
ECONOMIC AND MARKET CONDITIONS. The Company's business is affected by domestic and global economic conditions and by the health of the professional audio market in the world. The Company's operations may in the future reflect substantial fluctuations from period to period as a consequence of such general economic and market conditions. These factors could have a material adverse effect on the Company's business and financial condition.
COMPETITION. The Company expects competition to increase from both established and emerging companies. If the Company fails to compete successfully against current and future sources of competition, the Company's profitability and financial performance may be adversely affected.
DEPENDENCE ON SUPPLIERS. Certain parts used in the Company's products are currently available from either a single supplier or from a limited number of suppliers. If the Company cannot develop alternative sources of these components, or if the Company experiences deterioration in its relationship with these suppliers, there may be delays or reductions in product introductions or shipments, which may materially adversely affect the Company's operating results.
Because the Company relies on a small number of suppliers for certain parts, the Company is subject to possible price increases by these suppliers. Also, the Company may be unable to accurately forecast its production schedule. If the Company underestimates its production schedule, suppliers may be unable to meet the Company's demand for components. This delay in the supply of key components may materially adversely affect the Company's business.
INTERNATIONAL OPERATIONS. International sales represented approximately 49 % of the Company's net sales for the year ended December 31, 1999 . The Company expects that international sales will continue to be a significant portion of its revenue. International sales may fluctuate due to various factors, including:
- - - unexpected changes in regulatory requirements
- - - tariffs and taxes
- - - difficulties in staffing and managing foreign operations
- - - longer average payment cycles and difficulty in collecting accounts receivable
- - - fluctuations in foreign currency exchange rates
- - - product safety and other certification requirements
- - - political and economic instability
The European Community and European Free Trade Association have established certain electronic emission and product safety requirements ("CE"). Certain of the Company's new products have not yet met these requirements. Failure to obtain either a CE certification or a waiver for any product may prevent the Company from marketing that product in Europe.
The Company operates subsidiaries in Italy, the United Kingdom, Germany, France, the Netherlands and China. The Company's business and financial condition is, therefore, sensitive to currency exchange rates or any other restrictions imposed on these currencies.
PROTECTION OF INTELLECTUAL PROPERTY. Refer to the section captioned "Proprietary Technology" in Item 1 above.
ACQUISITIONS AND BUSINESS COMBINATIONS. In June 1998, the Company acquired RCF, a manufacturer of loudspeakers and speaker components. This was a step to expand the Company's product line and manufacturing capabilities. The Company continues to integrate the two companies' product offerings. Integration of the products and operations of RCF with the Company's may place significant burdens on the Company's management and operating teams, and may divert management's attention from its other business concerns. If the Company fails to integrate RCF's products and operations with its own, the Company's business and financial condition may suffer. The RCF products may not be accepted by the Company's sales channels or customers.
The Company may pursue additional acquisitions of complementary technologies, product lines or businesses. Further acquisitions may include risks like those involved in the Company's acquisition of RCF, as well as risks of entering markets where the Company has no or limited prior experience, the potential loss of key employees of the acquired company, and impairment of relationships with existing employees, customers and business partners. Further acquisitions may also impact the Company's financial position. For example, the Company may use significant cash or incur additional debt, which would weaken the Company's financial position. The Company may also amortize expenses related to the goodwill and intangible assets acquired, which may reduce the Company's profitability.
The Company is currently in negotiations for the acquisition of Eastern Acoustic Works (EAW). In February 2000, the Company and EAW signed a non-binding letter of intent by which the Company would purchase all shares of EAW. Based in Whitinsville, Massachusetts, EAW is recognized as the world's leading high-end professional loudspeaker design and manufacturing firm. It's products are utilized in sound reinforcement systems at major stadiums and arenas, performing arts centers, churches,
clubs, and more recently in the custom residential market.
The Company cannot guarantee that future acquisitions will improve the Company's business or operating results.
DEPENDENCE ON KEY PERSONNEL. The Company's future success will depend in large part on the continued service of many of its technical, marketing, sales and management personnel (Greg Mackie in particular) and on its ability to attract, train, motivate and retain highly qualified employees. The Company's employees may voluntarily terminate their employment with the Company at any time. Competition for highly qualified employees is intense, and the process of locating technical, marketing, sales and management personnel with the combination of skills and attributes required to execute the Company's strategy is often lengthy. The Company believes that it will need to hire additional technical personnel in order to enhance its existing products and to develop new products. If the Company is unable to hire additional technical personnel, the development of new products and enhancement would likely be delayed. The loss of the services of key personnel or the inability to attract new personnel could have a material adverse effect upon the Company's results of operations.
RISK OF EURO NON-COMPLIANCE. Refer to the section captioned "Euro Conversion" in Item 7 below.
ITEM 2.
ITEM 2. PROPERTIES
The Company's headquarters in Woodinville, Washington house its manufacturing, administrative, sales and marketing, research and development and customer support operations. The building, which is occupied pursuant to a lease through December 31, 2004, is an 89,000 square foot manufacturing and office facility. The monthly rent stated in the lease is $56,613, adjusted annually for changes in the Consumer Price Index (monthly rent expense in 1999 was $61,735). The Company leases its facility from Mackie Holdings, LLC, an entity owned by three significant shareholders and directors of the Company, on terms the Company believes are at least as favorable to the Company as might have been obtained from unaffiliated parties.
In November 1995, the Company entered into a 10-year lease, with an option to extend for an additional 10 years, covering property that is adjacent to the Company's existing facility. The building is approximately 81,250 square feet. The Company is using the building for product shipping, additional vertical integration of manufacturing processes and other manufacturing activities. Initial base monthly rent for the entire building is $43,063; after five years, the base rent increases to $49,563 per month.
RCF's primary facilities in Reggio Emilia, Italy comprise a manufacturing facility totaling 119,000 square feet on a total site of 7 acres and a building for administrative offices of 13,000 square feet. Both facilities are owned by RCF.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In June 1997, the Company filed a lawsuit against certain parties, including one of the Company's major competitors and a major dealer of the Company's products, alleging infringement of its intellectual property rights. The suit against the Company's former dealer was settled in full, and the dealer resumed representation of Mackie's products on April 2, 1999. On November 3, 1999, the Company entered into a full settlement with the remaining defendants Behringer Spezielle Studio-Technick Gmbh, a German corporation, Behringer International GmbH, a German corporation, and
Ulrich Bernard Behringer. The settlement did not have a material impact on the Company's financial position, liquidity or results of operations.
The Company is also involved in various legal proceedings and claims that arise in the ordinary course of business. Management currently believes that these matters will not have a material adverse impact on the Company's financial position, liquidity or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the NASDAQ National Market System under the symbol "MKIE." The following table sets forth the high and low sale prices as reported on NASDAQ for the periods indicated. These prices do not include retail markups, markdowns or commissions.
As of March 6, 2000, there were 12,107,758 shares of Common Stock outstanding held by approximately 92 holders of record. The number of holders does not include individual participants in security position listings.
In 1999 and 1998, the Company paid no dividends on its common stock. The Company's present policy is to retain earnings to finance the Company's business. Any future dividends will be dependent upon the Company's financial condition, results of operations, current and anticipated cash requirements, acquisition plans and plans for expansion, and any other factors that the Company's Board of Directors deems relevant. Under its bank loan agreement, the Company is prohibited from paying any dividends without prior approval from the bank. The Company has no present intention of paying dividends on its common stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(in thousands, except per share data)
(a) Includes financial data of RCF, which was acquired June 29, 1998. Results of operations for RCF are included beginning July 1, 1998.
(b) Through August 16, 1995, the Company was taxed as an S Corporation and therefore was not subject to income taxes. The proforma income statement data includes certain adjustments to reflect a proforma provision for income taxes as if the Company had been subject to income taxes as a C Corporation in 1995.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
This Annual Report on Form 10-K and other reports incorporated by reference contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"). Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate, or imply future results, performance, or achievements, and may contain the words "believe," "anticipate," "expect," "estimate," "project," "will be," "will continue," "will likely result," or words or phrases of similar meaning. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from the forward-looking statements.
The following discussions, including but not limited to, the sections entitled "Cautionary Factors That May Affect Future Results" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" describe some, but not all, of the factors that could cause the actual results to differ materially from the forward-looking statements including, among others, the following: international, national and local general economic and market conditions; the size and growth of the professional audio equipment market; competition with other marketers, distributors and sellers of professional audio equipment; the Company's ability to develop and introduce new products; the Company's ability to sustain, manage or forecast its growth and inventories, the Company's ability to integrate the operations of companies acquired; the Company's ability to secure and protect trademarks, patents, and other intellectual property; the performance and reliability of the Company's products; customer service; the loss of significant customers or suppliers; dependence on distributors; management of increased costs of freight and transportation; the Company's ability to meet delivery deadlines; general risks associated with doing business in foreign countries, including, without limitation, import duties, tariffs, foreign currency fluctuations, political and economic instability; changes in government regulations; its ability to attract and retain qualified employees; liability and other claims asserted against the Company; and other factors referenced or incorporated by reference in this report and other reports.
The risks included here are not exhaustive. The Company operates in a very competitive environment and new risk factors may emerge from time to time. It is not possible for management to predict all such risk factors, nor can it assess the impact of all such risk factors on the Company's business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.
The Company derives its operating revenue from worldwide sales of digital and analog audio mixers, speakers, amplifiers and other professional audio equipment. A significant portion of the Company's total sales is to customers outside the U.S. International sales volumes have historically been affected by foreign currency fluctuations relative to the U.S. dollar. When weaknesses of local currencies have made the Company's products more expensive, sales to those countries have declined.
The Company's gross margins are also affected by its international sales. Typically, gross margins from exported products by Mackie are lower than from those sold in the U.S. due to discounts offered to its international distributors. RCF does not offer discounts to its distributors. The discounts offered by Mackie are given because the international distributor typically incurs certain expenses, including technical support, product service and in-country advertising that the Company normally incurs for domestic sales. The Company offered its international distributors an average discount of approximately 4.5% in 1999, 10.1% in 1998, and 14.8% in 1997. The decrease in discounts in 1999 is attributable to the lack of discounts offered by RCF. Sales outside the U.S. represented approximately 49%, 44%, and 38% of the Company's net sales in 1999, 1998 and 1997, respectively.
The Company's gross margins are also affected by the purchase of some components outside of the U.S. and Italy. As a result of fluctuations in the value of local currencies relative to the U.S. dollar and Italian lira, some of the Company's international component suppliers have increased prices and may further increase prices. The Company currently does not employ any formal foreign exchange hedging strategies, but may do so in the future.
The Company's gross margins have fluctuated from time to time due primarily to inefficiencies related to the introduction and manufacturing of new products and inefficiencies associated with integrating new equipment into the Company's manufacturing processes. Historically, fluctuations have also resulted from varying prices of components and competitive pressures.
The Company plans to introduce new products and product revisions at a more rapid rate than it has in the past. Some anticipated new products will require the implementation of manufacturing practices for which the Company is not familiar. This could result in lower margins as the Company becomes more familiar with new manufacturing procedures.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 AS COMPARED WITH YEAR ENDED DECEMBER 31, 1998
NET SALES
The Company's net sales increased 50.8% to $153.8 million in 1999 from $102.0 million in 1998. The increase was primarily attributable to the inclusion of a full year of RCF's sales in 1999 of $59.7 million compared to only six months in 1998 of $23.3 million. The Company also saw significant revenue contribution worldwide from products introduced in 1999 in the product categories of powered and CFX mixers, speakers and amplifiers of approximately $24.5 million. Sales in the new product categories were aided by the Company's successful shift to a captive distribution model in Europe during the first half of 1999. These increases were offset partially by declines in sales of 8CBus series large console mixers and SR series live music application mixers of approximately $4.5 million. Sales outside the U.S. increased to 49% of the Company's total net sales in 1999 from 44% in 1998. This increase was due mainly to the inclusion of a full year of sales by RCF whose sales outside of the U.S. comprised 96% of its total net sales for 1999.
GROSS PROFIT
Gross profit was $57.1 million in 1999 compared with $39.3 million in 1998. The increase was primarily attributable to the inclusion of a full year of RCF's gross profit in 1999 of $21.9 million compared to only six months in 1998 of $9.4 million. Revenues were also up as a result of the new products introduced during 1999 and improved international distribution as noted above. Gross profit as a percentage of sales decreased to 37.1% in 1999 from 38.5% in 1998. The decrease in gross margin was the result of lower margins realized on some of the new products introduced during 1999 and lower sales volumes of high margin 8CBus series large console mixers and SR series live music application mixers.
MARKETING AND SALES
Marketing and sales expenses increased to $27.3 million in 1999 from $16.1 million in 1998. The increase was primarily attributable to the inclusion of a full year of RCF's marketing and sales expenses in 1999 of $12.1 million compared to only six months in 1998 of $4.9 million. Promotional and general freight expenses were also up for 1999 resulting in a net increase of $1.9 million. Higher sales volumes causing corresponding increases in variable expenses, such as commissions, along with incremental costs associated with new product rollouts, promotional expenses related to demo products and initial launch expenses related to the new Mackie Industrial Division (Mackie Industrial) also contributed to the increase. Mackie Industrial is a new division of the Company focusing on the installed sound market in the U.S. This market encompasses installations in venues ranging in size from small cafes to commercial buildings to nationwide chains. RCF has traditionally served the installed sound market in Europe and now Mackie Industrial will enter the U.S. installed market giving the Company a worldwide presence in this large segment. The Company did not realize significant revenues from sales of Mackie Industrial products during 1999 as operations were still in the development phase. Contribution from this division is expected in the first half of 2000. As a percentage of net sales, marketing and sales expenses increased to 17.7% in 1999 from 15.8% in 1998.
ADMINISTRATIVE
Administrative expenses increased to $14.5 million for 1999 from $9.7 million for 1998. The increase was primarily attributable to the inclusion of a full year of RCF's administrative expenses in 1999 of $7.3 million compared to only six months in 1998 of $3.4 million. Other contributing factors included higher legal expenses associated with the Behringer lawsuit that was settled in November 1999 (see Note 13 of Notes to Consolidated
Financial Statements). As a percentage of net sales, administrative expenses declined slightly to 9.4% in 1999 compared with 9.5% in 1998.
RESEARCH AND DEVELOPMENT
Research and development expenses increased to $7.1 million in 1999 from $5.1 million in 1998. The increase was primarily attributable to higher spending related to new product development across all areas of the Company's product line during 1999. A secondary cause was the inclusion of a full year of RCF's research and development expenses in 1999 of $1.1 million compared to only six months in 1998 of $0.8 million. As a percentage of net sales, these expenses decreased to 4.6% in 1999 compared with 5.0% in 1998.
INTEREST INCOME AND INTEREST EXPENSE
Interest income decreased to $741,000 in 1999 compared with $782,000 in 1998. Interest expense increased to $2,772,000 in 1999 from $1,521,000 in 1998 primarily due to borrowings related to the acquisition of RCF and to Italian debt carried by RCF. Included in 1999 is a full year of acquisition and RCF interest expense compared to only six months in 1998. Prior to the acquisition in June 1998, the Company had no long-term debt.
INCOME TAX PROVISION
Income tax expense for 1999 was $2,811,000 representing an overall effective tax rate of 46.3% compared to $2,302,000 and 29.2% for 1998. The increase in the effective tax rate was primarily attributable to foreign operations.
Year Ended December 31, 1998 as Compared with Year Ended December 31, 1997
The results of operations for the year ended December 31, 1998 include the results of operations for RCF beginning July 1, 1998.
NET SALES
The Company's net sales increased 35.9% to $102.0 million in 1998 from $75.0 million in 1997. The increase was primarily attributable to the inclusion of RCF's sales of $23.3 million. Sales outside the U.S. increased to 44% of the Company's total net sales in 1998 from 38% in 1997. This increase was due mainly to the inclusion of sales by RCF whose sales outside of the U.S. comprised 89% of its total net sales for the six months ended December 31, 1998.
GROSS PROFIT
Gross profit was $39.3 million in 1998 compared with $27.9 million in 1997. The increase was largely attributable to the inclusion of RCF's gross profit of $9.4 million. Gross profit as a percentage of sales increased to 38.5% in 1998 from 37.2% in 1997. The increase in gross margin percentage was due primarily to a difference in product mix for 1998 compared with 1997 as sales of certain product lines provided higher gross margins than other product lines.
MARKETING AND SALES
Marketing and sales expenses increased to $16.1 million in 1998 from $10.1 million in 1997. The increase was primarily attributable to the inclusion of marketing and sales expenses for RCF of $4.9 million.
Higher promotional freight expenses and freight accommodations were also up for 1998 resulting in a net increase of $0.8 million. As a percentage of net sales, marketing and sales expenses increased to 15.8% in 1998 from 13.4% in 1997.
ADMINISTRATIVE
Administrative expenses increased to $9.7 million for 1998 from $4.8 million for 1997. The increase was primarily attributable to the inclusion of administrative expenses for RCF of $3.4 million. This increase was also due to increased legal expenses due to the lawsuit filed by the Company against certain parties alleging infringement of its intellectual property rights (see Note 13 of Notes to Consolidated Financial Statements). As a percentage of net sales, administrative expenses were 9.5% in 1998 compared with 6.4% in 1997.
RESEARCH AND DEVELOPMENT
Research and development expenses decreased to $5.1 million in 1998 from $5.9 million in 1997. As a percentage of net sales, these expenses decreased to 5.0% in 1998 from 7.9% in 1997. This decrease was due primarily to decreases in prototype and other expenditures. R&D expenses for RCF were $759,000.
INTEREST INCOME AND INTEREST EXPENSE
Interest income decreased to $782,000 in 1998 compared with $791,000 in 1997 due to a lower average cash balance. Interest expense increased to $1,521,000 in 1998 from none in 1997 primarily due to borrowings related to the acquisition of RCF and to interest-bearing debt carried by RCF.
INCOME TAX PROVISION
Income tax expense for 1998 was $2,302,000 representing an overall effective rate of 29.2% compared to $2,373,000 and 30% for 1997. The decrease in the overall effective rate in 1998 compared with the statutory rate is primarily due to the benefits provided by the Company's foreign sales corporation and the research and development tax credit.
LIQUIDITY AND CAPITAL RESOURCES
The Company used internally generated cash to finance its operations during 1999 and 1998. The Company's operating activities generated cash of $5.6 million in 1999 and $1.5 million in 1998. Net cash provided by operating activities in 1999 was primarily attributable to net income and increases in accounts payable and accrued expenses offset by increases in accounts receivable, inventory and other assets.
Net cash used in investing activities decreased to $3.1 million in 1999 from $15.4 million in 1998, due principally to the acquisition of RCF in June 1998. The Company had no significant capital expenditure commitments at December 31, 1999. The Company intends to finance its 2000 capital expenditures from cash provided by operations, current cash reserves and existing credit facilities.
Net cash used in financing activities in 1999 was $2.2 million compared with net cash provided by financing activities during 1998 of $12.3 million. The cash provided by financing activities in 1998 was due principally to proceeds from bank credit facilities used for the acquisition of RCF. During 1999, the Company repaid $2.0 million on the acquisition debt and repurchased approximately 250,000 shares of its own common stock at a total cost of $1.3 million. These uses of cash were offset partially by net borrowings on long-term and short-term debt of approximately $2.5 million during 1999.
In June 1998, the Company entered into a credit agreement with a bank to provide certain credit facilities to the Company, including a $12.8 million loan for the acquisition of RCF of which $10.5 million was outstanding at December 31, 1999. The loan, which is secured by all of the Company's assets, bears interest at the bank's prime rate, or at a specified LIBOR rate plus a specified margin, whichever the Company chooses. Interest on the loan is payable monthly. Principal is payable on September 30 of each year from 1999 in installments equal to 1/7 of the amount borrowed. All outstanding principal and interest amounts are due on September 30, 2003. The agreement also provides a $5.0 million unsecured line of credit to finance any unexpected working capital needs. The line of credit bears interest at the same rate as the acquisition loan. The agreement also provides a $2.5 million credit facility for capital equipment purchases or general corporate purposes. Certain terms under this facility, such as interest rate, repayment period and collateral, will be determined at the time advances are made to the Company. At December 31, 1999, there were no outstanding balances on any of these credit lines. These credit facilities (excluding the acquisition loan) expire April 30, 2001. Under the terms of the credit agreement, the Company must maintain certain financial ratios and tangible net worth. The Company was in compliance with all covenants at December 31, 1999. The agreement also provides, among other matters, restrictions on additional financing, dividends, mergers, acquisitions, and an annual capital expenditure limit of $10.0 million.
The Company also has entered into agreements with several banks in Italy that provide short-term credit facilities totaling approximately $19 million. At December 31, 1999, there was approximately $13.1 million outstanding under these facilities. The majority of these credit facilities are secured by RCF's receivables. Interest rates on these credit facilities range from 3.6% to 11.2%. Approximately $4.7 million of RCF's debt was repaid in February 2000.
The Company believes that existing cash and cash equivalent balances and its available-for-sale securities together with cash generated from operations and cash available from credit facilities will be sufficient to finance the Company's operations at least through 2000.
INFLATION AND CHANGES IN FOREIGN CURRENCY EXCHANGE RATES
Although the Company cannot accurately anticipate the effects of inflation, the Company does not believe inflation has had or is likely to have a material effect on its results of operations or liquidity.
Sales and expenses incurred by foreign subsidiaries are denominated in the subsidiary's local currency and translated into U.S. dollar amounts at average rates during the period. To date, the foreign currency exchange rates have not significantly impacted the Company's profitability.
YEAR 2000 ISSUE
The "Year 2000" or "Y2K" issue referred to the potential risks associated with the fact that many existing computer programs use only the last two digits in reference to a year. When the year changed from 1999 to 2000 these programs may not have been able to distinguish whether the year began with 19 or with 20. This could have resulted in a system failure or miscalculations causing disruptions of operations. The Y2K issue did not have any material impact on the operations of the Company nor is any future impact anticipated.
EURO CONVERSION
European business systems are being forced to handle currencies in a new way with the introduction of the Euro. RCF's computer system does not support the Euro, and reprogramming the system is not an
economically viable option. Although the date for mandatory Euro compliance is January 1, 2002, it is believed that the existing system could only be utilized until mid-2001 after which time the effort to run a non-compliant system will be prohibitively high. The Company plans to replace all computer systems with a single system worldwide. This system will be Euro compliant and is scheduled to be in place in Italy prior to mid-2001.
SHARE REPURCHASE PROGRAM
The Company fulfilled the authorization from its Board of Directors to repurchase up to 850,000 shares of its outstanding common stock during the three year period ended December 31, 1999. These purchases were executed through open market purchases at prevailing market prices. As of December 31, 1999, the Company had repurchased all 850,000 shares authorized under the program at a total cost of approximately $5.6 million. No additional authorizations are currently pending.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, AAccounting for Derivative Instruments and Hedging Activities." SFAS No. 133 is effective for fiscal years beginning after June 15, 2000. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. The Company does not expect that the adoption of SFAS No. 133 will have a material impact on its consolidated financial statements because the Company does not currently hold any derivative instruments.
In December 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements". This SAB summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition. The Company does not expect that its financial statements will be materially affected by SAB No. 101.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The Company did not have any derivative financial instruments as of December 31, 1999 and 1998. However, the Company is exposed to interest rate risk. The Company's interest income and expense are most sensitive to changes in the general level of U.S. and European interest rates. In this regard, changes in U.S. and European interest rates affect the interest earned on the Company's cash equivalents and available-for-sale securities as well as interest paid on debt.
At December 31, 1999, the Company had cash and cash equivalents, available-for-sale securities and bonds of $14.9 million and short-term borrowings of $16.0 million, all subject to variable short-term interest rates. A hypothetical change in the interest rate of 10% would not have a material impact on the Company's earnings.
At December 31, 1998, the Company had cash and cash equivalents, available-for-sale securities and bonds of $10.7 million and short-term borrowings of $12.1 million, all subject to variable short-term interest rates. A hypothetical change in the interest rate of 10% would not have a material impact on the Company's earnings.
The Company has lines of credit and other debt whose interest rates are based on various published prime rates that may fluctuate over time based on economic changes in the environment. The Company is subject to interest rate risk, and could be subject to increased interest payments if market interest rates fluctuate. The Company does not expect any change in the interest rates to have a material adverse effect on the Company's results from operations.
FOREIGN CURRENCY RISK
The Company operates subsidiaries in Italy, the United Kingdom, Germany, France, the Netherlands and China. The Company's business and financial condition are, therefore, sensitive to currency exchange rates or any other restrictions imposed on their currencies. Sales and expenses incurred by foreign subsidiaries are denominated in the subsidiary's local currency and translated into U.S. Dollar amounts at average rates during the period. The Company does not employ any derivative based hedging strategies, however, it has a significant natural hedge in the form of Italian based manufacturing and operating, interest and tax expenses.
Foreign exchange rate sensitivity analysis can be quantified by estimating the impact on the Company's earnings as a result of hypothetical changes in the value of the U.S. Dollar, the Company's functional currency, relative to the other currencies in which the Company transacts business. All other things being equal, an average 10% movement in the value of the U.S. Dollar, throughout the year ended December 31, 1999, would have had the effect of changing net income approximately $0.2 million. The same analysis for the year ended December 31, 1998 would have had the effect of changing net income approximately $0.05 million
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See pages 24 to 43
REPORT OF KPMG LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders Mackie Designs, Inc.
We have audited the accompanying consolidated balance sheet of Mackie Designs Inc. and subsidiaries as of December 31, 1999, and the related consolidated statements of income, cash flows, and shareholders' equity and comprehensive income for the year then ended. Our audit also included the financial statement schedule listed in the Index at Item 14(a) for the year ended December 31, 1999. These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mackie Designs Inc. and subsidiaries at December 31, 1999, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule for the year ended December 31, 1999, when considered in relation to the basic 1999 financial statements taken as a whole, presents fairly in all material respects the information set forth herein.
KPMG LLP
Seattle, Washington February 22, 2000
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders Mackie Designs Inc.
We have audited the accompanying consolidated balance sheet of Mackie Designs Inc. as of December 31, 1998, and the related consolidated statements of income, cash flows and shareholders' equity and comprehensive income, for each of the two years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Mackie Designs Inc. at December 31, 1998, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 1998, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth herein.
Ernst & Young LLP
Seattle, Washington February 26, 1999
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
MACKIE DESIGNS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION The consolidated financial statements include the accounts of Mackie Designs, Inc. and its wholly-owned subsidiaries (the Company). All significant intercompany accounts and transactions have been eliminated in consolidation. Certain amounts reported in previous years have been reclassified to conform to the 1999 presentation.
OPERATIONS The Company develops, manufactures, sells, and supports high-quality, reasonably priced professional audio equipment. The Company sells to retailers and distributors throughout the world, generally on open credit terms. Sales to customers outside of the U.S. approximated 49%, 44%, and 38% of net sales in 1999, 1998, and 1997, respectively.
USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.
FOREIGN CURRENCY TRANSLATION Assets and liabilities denominated in foreign currencies are translated at the exchange rate on the balance sheet date. Net sales, costs and expenses are translated at average rates of exchange prevailing during the period. Translation adjustments resulting from this process are charged or credited to other comprehensive income in shareholders' equity. Realized and unrealized gains and losses on foreign currency transactions are included in other income (expense), net.
REVENUE RECOGNITION Revenues from sales of products are generally recognized upon shipment. The Company has certain software related products within its digital product line. The Company follows the principles of AICPA Statement of Position 97-2, "Software Revenue Recognition" in recognizing revenues for these products.
CASH EQUIVALENTS The Company considers all liquid investments purchased with a maturity at purchase of three months or less to be cash equivalents.
MARKETABLE SECURITIES Management determines the appropriate classification of marketable securities at the time of purchase and re-evaluates such designation as of each balance sheet date. Debt securities are treated as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. The zero coupon bonds held by RCF are the only securities the Company treats as held-to-maturity (see Note 3 of Notes to Consolidated Financial Statements).
Debt and marketable equity securities not treated as held-to-maturity are classified as available-for-sale. Available-for-sale securities are primarily high-grade U.S. corporate securities, all of which are recorded at amortized cost, which approximates fair value. Available-for-sale securities are classified in the balance sheet as current based on maturity dates. Unrealized gains and losses on available-for-sale securities are excluded from the results of operations and are reported as a component of comprehensive income in shareholders' equity.
The amortized cost of debt securities treated as held-to-maturity is adjusted for accretion of discounts to maturity, over the estimated life of the security. Such amortization is included in interest income.
INVENTORIES
Inventories are valued at the lower of cost, as determined by the first-in, first-out method, or market.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at cost, less accumulated depreciation and amortization. Significant additions and improvements are capitalized. Maintenance and repairs are expensed as incurred. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets of three to thirty-three years. Leasehold improvements are amortized over the shorter of their useful lives or the term of the lease.
GOODWILL
Goodwill represents the excess of the purchase price over the fair value of assets acquired. Goodwill is being amortized on the straight-line method over twenty years.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of the Company's cash, available-for-sale securities, accounts receivable, bonds, short-term borrowings, accounts payable, income taxes payable, and long-term debt approximate fair value because they are of a short-term nature or have interest rates that approximate market rates.
WARRANTY COSTS
The Company provides an accrual for future warranty costs at the time of sale of products. The warranty for the Company's products generally covers defects in materials and workmanship for a period of one to five years.
ADVERTISING COSTS
The cost of advertising is expensed as incurred. For 1999, 1998, and 1997, the Company incurred advertising expenses of $4.2 million, $3.7 million, and $3.0 million, respectively.
STOCK COMPENSATION
The Company applies the disclosure-only provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation." Accordingly, the Company accounts for stock-based employee compensation using the intrinsic-value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Compensation expense for employee stock options is measured as the excess, if any, of the fair value of the Company's common stock at the date of grant over the stock option exercise price.
INCOME TAXES
Income taxes are accounted for under the asset and liability method of accounting. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credits and loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
INCOME PER SHARE
Basic income per share is computed on the basis of the weighted average number of common shares outstanding for the year. Diluted income per share is computed on the basis of the weighted average number of common shares plus dilutive potential common shares outstanding. Dilutive potential common shares are calculated under the treasury stock method and consist of employee stock options outstanding.
CONCENTRATIONS
The Company is subject to concentrations of credit risk from its holdings of cash, cash equivalents, and securities. The Company's credit risk is managed by investing in high-quality money market instruments, securities of the U.S. Government and its agencies, and high-quality corporate issues. In addition, a significant portion of the Company's accounts receivable is due from customers outside of the U.S. The Company has credit
insurance on its open term international receivables and generally requires letters of credit or advance payments in cases where credit insurance is not applicable. No individual international country accounted for more than 10% of net sales in any of the periods presented.
The Company relies almost exclusively on one vendor for its potentiometers, but is in contact with other potentiometer manufacturers regularly. Potentiometers are a critical component in many of the Company's products. Interruption in, or cessation of, the supply of potentiometers from this supplier could adversely affect the Company's production capability, as the qualification process for another manufacturer, from sample submission to production quality and quantity delivery, could take several months. The Company has an approximate three month supply of potentiometers at any given time which would serve to reduce any potential disruption.
COMPREHENSIVE INCOME
The Company's comprehensive income includes all items which comprise net income, the effect of foreign currency translation and unrealized gains/losses on available-for-sale securities. Comprehensive income is shown in the Consolidated Statements of Shareholders' Equity and Comprehensive Income.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company periodically assesses the recoverability of long-lived assets including property, plant and equipment, goodwill and other intangible assets. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less cost to sell.
NEW ACCOUNTING PRONOUNCEMENT
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 is effective for fiscal years beginning after June 15, 2000. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. The Company does not expect that the adoption of SFAS No. 133 will have a material impact on its consolidated financial statements because the Company does not currently hold any derivative instruments.
In December 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements". This SAB summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition. The Company does not expect that its financial statements will be materially affected by SAB No. 101.
2. ACQUISITION
On June 29, 1998, the Company acquired 100% of the capital stock of Radio Cine Forniture (R.C.F.) S.p.A. ("RCF"), an Italian corporation. RCF is a manufacturer of loudspeakers and speaker components based in Reggio Emilia, Italy. The acquisition was accounted for under the purchase method of accounting. The aggregate purchase price, plus related acquisition costs, was approximately $15 million. The excess of the purchase price over the fair value of net assets acquired, aggregating approximately $8 million, is included in goodwill. The results of operations of RCF have been included in the Company's consolidated results of operations from July 1, 1998.
The following table presents unaudited pro forma consolidated financial information for the years ended December 31, 1998 and 1997 as if the acquisition of RCF had occurred on January 1 of those years:
The unaudited pro forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisition taken place on the basis assumed above. In addition, the pro forma results are not intended to be a projection of the future results and do not reflect any synergies that might have been achieved from the combined operations.
3. INVESTMENTS The amortized cost of available-for-sale securities approximated fair market value and was as follows:
As of December 31, 1999, available-for-sale securities have contractual maturities of one year or less.
RCF holds various zero-coupon Italian bank bonds as collateral for two bank term loans (see Note 7 of Notes to Consolidated Financial Statements). The bonds aggregated $3,902,473 and $4,293,524 at December 31, 1999 and 1998, respectively, and are carried at amortized cost, which approximates market value. The bank bonds have various maturities ranging from 2001 to 2004. The interest rates on these bonds range from 2.4% to 7.3% (average rate was 6.8% and 7.0% at December 31, 1999 and 1998, respectively). These bonds are treated as held-to-maturity on the balance sheet and are restricted as to their use.
4. INVENTORIES Inventories consist of the following:
5. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following:
6. INCOME TAXES For financial reporting purposes, income before income taxes is as follows:
Significant components of the Company's deferred tax assets and liabilities are as follows:
In connection with the acquisition of RCF in 1998, the Company recorded a net deferred tax credit of $333,646.
A reconciliation from the U.S. statutory rate of 34% to the effective rate is as follows:
The valuation allowance for deferred tax assets increased by 74,425 in 1999. This change relates primarily to net operating loss carryforwards generated by foreign operations.
At December 31, 1999, the Company had US and international net operating loss carryforwards of approximately $800,000 and $400,000 respectively. These carryforwards generally begin expiring in 2013.
Provision has not been made for U.S. or additional foreign taxes on the undistributed earnings of the Company's foreign subsidiaries. These earnings, which are expected to be reinvested, could become subject to additional tax if they were to be remitted as dividends, lent to the Company, or if the Company should sell its stock in these subsidiaries.
7. DEBT
In June 1998, the Company entered into a credit agreement with a bank to provide certain credit facilities to the Company, including a $12.8 million loan for the acquisition of RCF of which $10.5 million was outstanding at December 31, 1999. The loan, which is secured by all of the Company's assets, bears interest at the bank's prime rate, or at a specified LIBOR rate plus a specified margin, whichever the Company chooses. Interest on the loan is payable monthly. Principal is payable on September 30 of each year from 1999 in installments equal to 1/7 of the amount borrowed. All outstanding principal and interest amounts are due on September 30, 2003. The agreement also provides a $5.0 million unsecured line of credit to finance any unexpected working capital needs. The line of credit bears interest at the same rate as the acquisition loan. The agreement also provides a $2.5 million credit facility for capital equipment purchases or general corporate purposes. Certain terms under this facility, such as interest rate, repayment period and collateral, will be determined at the time advances are made to the Company. At December 31, 1999, there were no outstanding balances on any of these credit lines. These credit facilities (excluding the acquisition loan) expire April 30, 2001. Under the terms of the credit agreement, the Company must maintain certain financial ratios and tangible net worth. The Company was in compliance with all covenants at December 31, 1999. The agreement also provides, among other matters, restrictions on additional financing, dividends, mergers, acquisitions, and an annual capital expenditure limit of $10.0 million.
The Company also has entered into agreements with several banks in Italy that provide short-term credit facilities totaling approximately $19 million. At December 31, 1999, there was approximately $16.0 million outstanding under these facilities. The majority of these credit facilities are secured by RCF's receivables.
Interest rates on these credit facilities range from 3.6% to 11.2%.
The weighted-average interest rate on short-term borrowings at December 31, 1999 was 6.2%.
Long-term debt consisted of the following at December 31:
(A) Borrowings under the Revolving Credit Note ($12.8 million acquisition loan) bear interest at the bank's prime rate, or at a specified LIBOR rate plus a specified margin, whichever the Company chooses. At December 31, 1999, the interest rate in effect was 7.4%. Interest is payable monthly. Principal is payable in installments equal to 1/7 of the amount borrowed ($12.8 million) on September 30 of each year. All outstanding principal and interest amounts are due on September 30, 2003.
(B) The Bank Term Loan bears interest at the six-month Euribor rate plus 0.65% (4.2% at December 31, 1999). Interest-only payments are made semi-annually and the principal is due on February 5, 2000. This loan requires the Company to maintain certain covenants with respect to its subsidiary, RCF. This loan was paid off in February 2000.
(C) The Bank Term Loan bears interest at the six-month LIBOR rate plus 2% (8.1% at December 31, 1999). Interest-only payments are made semi-annually and the principal is due in 2003. This loan is secured by a bank bond held by RCF, which at time of maturity in 2003, will be used to repay the principal amount of the loan.
(D) The Bank Term Loan bears a fixed interest rate of 7.7%. Interest-only payments are made semi-annually. In addition, semi-annual principal payments of approximately $90,000 began in October 1999 with the final principal payment due in 2004. This loan is secured by a bank bond held by RCF.
(E) The other notes bear interest at rates from 4.4% to 8.8%. Principal payments on these loans are made in varying amounts until 2007. Certain of these loans are secured by specific assets of RCF.
The Bank Term Loan described above in (B) contains several financial covenants. RCF was not in compliance with one of the covenants at December 31, 1999 and 1998. This loan was due and paid off by the Company in February 2000 and was therefore included in the current portion of long-term debt at both December 31, 1999 and 1998.
The long-term debt described above in (B) through (E) are denominated in Italian lira and have been converted to U.S. Dollars using applicable rates for the periods presented for disclosure purposes.
Future aggregate annual principal payments of long-term debt at December 31, 1999 are as follows:
8. EMPLOYEE AND OTHER LIABILITIES
Under Italian law, RCF employees are entitled to severance benefits calculated primarily based upon compensation and length of service. These severance benefits vest immediately and are payable upon the employee's separation from the Company. This liability aggregated approximately $3.2 million and $3.4 million at December 31, 1999 and 1998, respectively. In addition, RCF commissioned sales agents are entitled to similar severance benefits based upon commissions earned and length of service. This liability aggregated approximately $560,000 and $600,000 at December 31, 1999 and 1998, respectively. Under these severance programs, severance expense of approximately $650,000 and $300,000 was recognized in 1999 and 1998, respectively.
9. RELATED-PARTY TRANSACTIONS
The Company has an agreement to receive marketing and sales services from an entity affiliated with a shareholder of the Company. The Company also made a loan to one of its officers in November 1999. The principal amount of the loan is due and payable in full on or before October 31, 2004 or upon termination of the officer, whichever shall occur first. The loan bears no interest. Transactions are summarized as follows:
10. EMPLOYEE BENEFIT PLANS
The Company has a qualified profit-sharing plan (the Plan) under the provisions of Internal Revenue Code Section 401(k). The Plan is available to all employees meeting the eligibility requirements. Contributions by the Company are based on a matching formula as defined in the Plan. Additional contributions are at the discretion of the Board of Directors. Company contributions to the plan vest ratably over a 5-year period. The Company made contributions of $113,000, $112,000, and $51,000 to the Plan in 1999, 1998, and 1997, respectively.
The Company self-insures for health care costs of its eligible employees and dependents. The Company has obtained an insurance policy to cover claims incurred during the policy year in excess of $50,000 per person and has a $1 million annual stop loss on total claims for all employees in the aggregate. Estimated costs of all incurred claims that are not covered by insurance are recognized in the financial statements.
11. NET INCOME PER SHARE
The following table represents a reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations:
Stock options totaling 3,086,000, 325,000 and 133,000 shares in 1999, 1998 and 1997, respectively, were excluded from the calculation of diluted net income per share, as they were antidilutive.
12. SHAREHOLDERS' EQUITY
In April 1995, the Company established a stock option plan for the granting of incentive and non-qualified stock options (the Plan). The exercise price of incentive stock options granted under the Plan may not be less than the fair market value of the common stock on the date of grant. The exercise price of non-qualified stock options granted under the Plan may be greater or less than the fair market value of the common stock on the date
of grant, as determined by the stock option committee of the Company's Board of Directors at its discretion. The Company has reserved 4,500,000 shares of common stock for issuance under the Plan. The options generally vest over a four-year period and expire no later than ten years after the date of grant.
The following table summarizes the Company's stock option activity for the three-year period ended December 31, 1999:
At December 31, 1999, 1,006,250 shares of common stock were available for future grants.
The following table summarizes information about options outstanding and exercisable at December 31, 1999:
The Company follows the intrinsic value method in accounting for its stock options. Had compensation costs been determined consistent with SFAS No. 123, the Company's net income and earnings per share would have been reduced to the proforma amounts as indicated below:
The fair value of each option grant was estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions for 1999, 1998 and 1997, respectively: risk-free interest rates of 5.79%, 5.28% and 6.33%; expected option life of 6.0 years for all three years; expected volatility of 61.6%, 61.4% and 65.9%; and no expected dividends. The weighted-average fair value of options granted during the years 1999, 1998, and 1997 was $2.99, $4.04, and $4.16, respectively.
The Company fulfilled the authorization from its Board of Directors to repurchase up to 850,000 shares of its outstanding common stock during the three year period ended December 31, 1999. These purchases were executed through open market purchases at prevailing market prices. As of December 31, 1999, the Company had repurchased all 850,000 shares authorized under the program at a total cost of approximately $5.6 million. No additional authorizations are currently pending.
13. COMMITMENTS AND CONTINGENCIES In December 1994, the Company entered into a lease for office and manufacturing facilities with Mackie Holdings, LLC, an entity owned by three significant shareholders and directors of the Company. The lease commenced on December 31, 1994 and expires December 31, 2004. The annual rent under this lease was $740,820, $826,664, and $679,356 in 1999, 1998 and 1997, respectively. Taxes, insurance, utilities, and maintenance are the responsibility of the Company. Future minimum rental payments under this lease and other equipment and facility leases at December 31, 1999 are as follows:
The Company expects to renew or replace certain leases at expiration. Total rent expense for 1999, 1998, and 1997 was $1,649,000, $1,731,000, and $1,328,000, respectively.
On November 3, 1999, the Company entered into a full settlement with Behringer Spezielle Studio-Technick Gmbh, a German corporation, Behringer International GmbH, a German corporation, and Ulrich Bernard Behringer, the defendants in the lawsuit filed in June 1997 alleging infringement of the Company's intellectual property rights. The settlement did not have a material impact on the Company's financial position, liquidity or results of operations.
The Company is also involved in various legal proceedings and claims that arise in the ordinary course of business. Management currently believes that these matters will not have a material adverse impact on the Company's financial position, liquidity or results of operations.
14. SEGMENT AND GEOGRAPHIC INFORMATION
The Company identifies its business segments based on management responsibility using a combination of products and geographic factors. The Company has two reportable segments: Mackie Designs Inc. and its subsidiary, RCF. The Mackie segment offers audio mixers and other professional audio equipment. The RCF segment offers loudspeakers, loudspeaker components and Mackie product offerings through its subsidiaries. There were no intersegment sales in 1998. A summary of key financial data by segment is as follows:
Major operations of the Company outside the U.S. include manufacturing facilities in Italy, and sales and support offices in Germany, the United Kingdom, France and China. Geographic information for the three years ended December 31, 1999 is presented in the table that follows. Sales between affiliated entities are excluded from the numbers below. Net sales, as shown in the table below, are based upon the geographic area into which the products were sold and delivered. As such, U.S. export sales of $17.4 million, $24.1 million and $28.1 million in 1999, 1998 and 1997, respectively, have been excluded from U.S. reported net sales. The profit on transfers between geographic areas is not recognized until sales are made to non-affiliated customers. Long-lived assets exclude goodwill, bonds and deferred taxes and are those assets that can be directly associated with a particular
geographic area.
15. QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
16. SUBSEQUENT EVENT In February 2000, the Company and Eastern Acoustic Works Inc. (EAW) signed a non-binding letter of intent by which the Company would purchase all shares of EAW. Based in Whitinsville, Massachusetts, EAW is recognized as the world's leading high-end professional loudspeaker design and manufacturing firm. It's products are utilized in sound reinforcement systems at major stadiums and arenas, performing arts centers, churches, clubs, and more recently in the custom residential market.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The information required by this Item is included in the Company's Form 8-K dated May 7, 1999 and filed on May 14, 1999 relating to a change in the Company's certifying accountants from Ernst & Young LLP to KPMG LLP and is included herein by reference.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item is included in the Company's definitive Proxy Statement for its 2000 Annual Meeting of Shareholders under the heading "Proposal No. 1: Election of Directors" and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is included in the Company's definitive Proxy Statement for its 2000 Annual Meeting of Shareholders under the heading "Executive Compensation" and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is included in the Company's definitive Proxy Statement for its 2000 Annual Meeting of Shareholders under the heading "Principal Shareholders" and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is included in the Company's definitive Proxy Statement for its 2000 Annual Meeting of Shareholders under the heading "Certain Transactions" and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
3. EXHIBITS: See Index to Exhibits on page 48.
(b) Reports on Form 8-K:
The Company filed the following current reports on Forms 8-K under Item 5: Other Events.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MACKIE DESIGNS INC.
By: /s/ Greg C. Mackie ----------------------------------------- Greg C. Mackie CHAIRMAN OF THE BOARD
Date: March 30, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 30, 2000.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(1) Uncollectible accounts written off, net of recoveries, and adjustment to reserves.
- - ------------------------------
* Filed herewith | 15,465 | 102,518 |
1012956_1999.txt | 1012956_1999 | 1999 | 1012956 | ITEM 1. BUSINESS
OVERVIEW
We are a leading independent provider of health benefit management services, providing pharmacy benefit management, disease management and clinical research programs. Our mission is to improve the quality of care delivered to health plan members while helping health plan sponsors reduce overall health benefit costs. We generate revenues from providing services to two primary customer groups: health plan sponsors and pharmaceutical manufacturers. We support a broad range of health plan sponsors, including managed care organizations, third-party health plan administrators, insurance companies, government agencies, employer groups and labor union-based trusts through our pharmacy benefit management and disease management services. We currently serve an estimated 27 million individuals enrolled in our customers' plans. We provide our clinical research services primarily to pharmaceutical manufacturers. We also work closely with pharmaceutical manufacturers in negotiating lower drug costs for our health plan sponsor customers.
In the year ended March 31, 1999 ("fiscal year 1999"), we further enhanced our health benefit management services with our acquisitions. On December 1, 1998, we acquired Baumel-Eisner Neuromedical Institute, Inc., a privately-held clinical trials company based in South Florida. On March 31, 1999, we acquired Foundation Health Pharmaceutical Services, Inc., the parent company of Foundation Health Systems, Inc.'s pharmacy benefit management company, Integrated Pharmaceutical Services.
INDUSTRY BACKGROUND
Health care expenditures are expected to grow at a compound annual growth rate of approximately 7.1% from $1.1 trillion in 1998 to $2.1 trillion in 2007, according to the Health Care Financing Administration. Prescription drug costs are expected to be one of the fastest growing components of health care costs, and the Health Care Financing Administration has estimated that prescription drugs will account for approximately 8.0% of United States health care expenditures by 2007, up from 6.5% today. As a result, prescription drug sales in the United States are expected to increase at a compound annual growth rate of approximately 9.7%, from approximately $74.3 billion in 1998 to approximately $171.1 billion in 2007. We believe a number of factors will contribute to this trend, including:
o increased expenditures on new drug development;
o an increase in new drug introductions as a result of shorter approval cycles by the U.S. Food and Drug Administration;
o relatively higher prices for new drugs;
o an aging population;
o effective direct-to-consumer advertising by pharmaceutical manufacturers;
o growing use of pharmaceuticals as first line of attack in disease treatment; and
o increased availability of pharmacy benefits to health plan members.
The concept of managed care originally developed in response to escalating health care costs. Health plan sponsors hoped that by exercising more control over health care delivery, they could control costs. Pharmacy benefit managers emerged to offer health plan sponsors a more efficient and less costly means of managing their members' drug use. In recent years, managed care has begun to evolve from a short-term, cost driven model to a long-term, medical outcomes-based model, where the overall cost and quality of patient care is considered by the health plan sponsor. Health benefit managers like us have emerged to assist health plan sponsors with the challenges of this new model of member care.
OUR STRATEGY
Our mission is to improve the quality of care delivered to health plan members while helping plan sponsors reduce overall health benefit costs. Our strategy is to develop and implement clinical programs that manage large patient populations more efficiently and effectively than is possible for an individual health plan. In order to implement our strategy, we plan to:
o Increase our core pharmaceutical benefit management customer base. We believe that increased size will allow us to achieve economies of scale and pass lower costs on to our customers. We have successfully increased the number of individuals served by our programs from an estimated 5.2 million in 1995 to an estimated 27 million on April 1, 1999. We plan to continue to grow this customer base by marketing our comprehensive service offerings to a broader range of health plan sponsors.
o Expand our disease management services. We have two strategies for growing these services. First, we have the opportunity to cross-sell existing disease management services to our pharmacy benefit management customers. Second, we plan to develop and market new disease management programs, using our clinical expertise and information management capabilities.
o Develop additional clinical research capabilities. We believe we have a leading clinical trial operation in Alzheimer's studies. We also conduct studies for several other central nervous system disorders. We plan to expand our clinical research offerings by developing focused expertise in a select number of additional diseases.
o Pursue strategic acquisitions and alliances. We plan to selectively pursue acquisitions and alliances that either:
o increase the size of our core pharmacy benefit management business;
o enhance our disease management programs;
o augment our clinical research capabilities; or
o expand our Internet offerings.
To date, we have successfully completed a number of acquisitions including Innovative Medical Research, Inc., Baumel-Eisner Neuromedical Institute, Inc. and Foundation Health Pharmaceutical Services.
o Develop our Internet capabilities. While we currently offer a basic set of services on the Internet, we plan to dramatically broaden these offerings and expand access to our Internet site. Our future Internet initiatives may offer medical content to our health plan sponsor customers for use on their Internet sites, empower consumers by involving them more directly in their medical care and offer access to an on-line drugstore.
HEALTH BENEFIT MANAGEMENT SERVICES
PHARMACY BENEFIT MANAGEMENT. We offer a broad range of clinical, data and mail services to our customers through our pharmacy benefit management programs. Our pharmacy benefit management customer base included over 1,000 health plan sponsors at March 31, 1999. When the Foundation Health Pharmaceutical Services acquisition is fully implemented, we expect to serve an estimated 27 million individuals enrolled in our customers' health plans, and manage $5.0 billion in gross drug expenditures and over 150 million pharmacy claims annually.
CLINICAL SERVICES. Our clinical services professionals work closely with health plan sponsors to design and administer pharmacy benefit plans that, through the use of formularies and other techniques, promote clinically appropriate drug usage while reducing drug costs. Formularies are lists of a health plan's preferred pharmaceutical products. The use of a formulary can reduce drug costs while preserving the same medical effect through substitution of brand-name drugs with a cost effective generic alternative -- known as generic substitution -- or substitution of a brand-name drug with another, lower cost brand-name drug in the same therapeutic class -- known as therapeutic substitution.
We encourage formulary compliance by both patients and prescribing physicians. Our customers' plans include features such as tiered copayments, which require a health plan member to pay higher amounts for non-formulary drugs in order to influence them to choose the drugs in the formulary. We attempt to influence physician prescribing patterns by analyzing physicians' prescribing behavior relative to physician peer groups and notifying them when their practices differ from industry practice. We also provide our own educational materials to plan physicians, pharmacists and health plan sponsors.
DATA SERVICES. Through our data services operations, we process the prescription claims for health plan sponsors. We have increased the number of claims processed from approximately 1.5 million claims in fiscal year 1995 to over 50 million claims in fiscal year 1999. We currently process approximately 5 million claims per month.
We administer a network of over 53,000 retail pharmacies that have agreed to provide prescription drugs to individual members of our customers' health plans at predetermined negotiated rates. Generally, we believe these rates are more favorable than typical retail prices. The retail pharmacies in the network are linked to us through our on-line claims processing system. Our on-line system provides pharmacists with the following information:
o an analysis of whether the individual is eligible for benefits;
o the prescription benefits the individual's health plan has selected;
o the individual's co-payment obligation;
o the amount the pharmacy can expect to receive as reimbursement for its services; and
o an alert message to warn the pharmacist of possible interactions, including drug-drug, drug-food, drug-age, and drug-pregnancy interactions.
MAIL SERVICES. Currently, our mail pharmacy operations dispense over 130,000 prescriptions per month, typically in the form of a three month supply of medications for chronic conditions. We believe that our mail pharmacy reduces costs to health plan sponsors by buying drugs at volume discounts and dispensing generic and therapeutic drug substitutes when appropriate. In addition, our control over the dispensing process allows us to improve patient compliance through methods such as calling members when they neglect to refill important prescriptions.
Our mail pharmacy operations are located in approximately 38,000 square feet in a building we own in Richardson, Texas. Our mail service dispensing process is highly automated, featuring bar code and scanning technology to route and track orders, computerized dispensing of many medications and computer-generated mailing labels and invoices. To ensure accurate dispensing of prescriptions, our mail service system is equipped with automated quality control features, and each prescription is inspected by a registered pharmacist.
While the vast majority of prescriptions are currently submitted by mail, we are expanding our Internet capabilities to take advantage of the growth we anticipate in this area. See "Internet strategy."
DISEASE MANAGEMENT. Our disease management programs are designed to help health plan sponsors manage the cost and treatment of specific diseases. We believe our disease management programs help improve medical outcomes and lower the cost of health care delivery for our customers through our interaction with patients and physicians. These programs are designed to monitor the entire contracted population and intervene when individuals demonstrate symptoms of a disease or high risk indications.
We currently provide disease programs for cardiovascular secondary risk reduction, asthma, diabetes, h. pylori, compliance and heart failure. We have completed and are marketing programs in depression, hypertension and gastrointestinal preservation, and we are developing new programs for HIV, migraine, polypharmacy and dementia. Our disease management programs
have five principal elements:
o Data integration. We compile and analyze medical, pharmacy and other relevant data for a particular group of health plan members.
o Case finding. We identify patients from this group who have the disease specified by the particular study and who we believe are at high risk for severe illness.
o Treatment assessment. We compare treatment received by identified patients with nationally accepted treatment guidelines.
o Targeted intervention. We intervene with identified patients by educating them about their disease and with physicians by providing information about treatment guidelines.
o Outcomes analysis. We measure the results of the intervention by tracking the identified patients' medical outcomes and monitoring ongoing compliance with their treatment programs.
We differentiate our disease management programs from those of our competitors with our outcomes assessment capabilities. We survey patients to assess quality of life, quality of care and overall satisfaction with the disease management program. We also assess the economic benefit of the program to our customers. As recognition of our surveying expertise, we are certified to administer HEDIS/CAHPS 2.OH member satisfaction surveys on behalf of health plan sponsors. These surveys use a set of standardized measures that compare the performance of health plans and allow consumers to draw comparisons across health plans.
DECISION SUPPORT SYSTEMS. We use our decision support system to monitor, analyze and evaluate drug utilization for our health benefit management customers. One of our decision-support systems, ApotheQuery(R), allows us to identify cost-saving opportunities arising from the possible overuse or inappropriate use of drugs, the use of high cost drugs and the use of drugs not on the formulary. Our decision support systems have been developed using commercially available technology and are not protected by any patents.
We also integrate our customers' pharmacy claims with applicable medical and laboratory claims and patient survey data, when available. This integrated health care database complements the capabilities of ApotheQuery(R) by including data relating to diagnosis and treatment of patients. This allows us and our customers to identify problem areas for the health plan sponsor and implement timely clinical solutions. The database further enhances our ability to complete medical outcomes studies and to develop disease management programs.
CLINICAL RESEARCH. The two principal components of our current clinical research capabilities are clinical trials and outcomes studies. We developed these capabilities through our acquisition of Innovative Medical Research, Inc. ("IMR") in February 1998 and Baumel-Eisner Neuromedical Institute, Inc. in December 1998. Our clinical research operations participated in 60 clinical trials and 21 surveys during fiscal year 1999.
Through our clinical research operations, we assist pharmaceutical manufacturers in moving new drugs, or new uses for existing drugs, through the laborious clinical trials process and into the market quickly and efficiently. We provide an established vehicle for conducting studies that can document a drug's economic and clinical benefits in a real world environment. In addition, our surveying capabilities permit us to evaluate the effectiveness of disease management strategies.
We provide key functions in the clinical trials process including:
o recruiting patients and physicians to participate in trials;
o administering the trials as designed by the pharmaceutical manufacturers; and
o measuring the patients' results.
We use a call center and medically appropriate surveys to identify patients eligible to participate in our clinical trials. This patient enrollment method is designed to reduce drug development time, which permits sponsors of clinical trials to introduce their products into the market faster and to maximize the economic return for such products.
Our current clinical trial initiatives are in the following areas: Alzheimer's disease, analgesia and pain relief, migraine and tension headache, mild cognitive impairment, major depressive orders, Parkinson's disease and gastrointestinal motility.
We also provide outcomes studies services to pharmaceutical manufacturers. These services include:
o conducting studies to further the understanding of the characteristics of diseases;
o conducting studies to develop simple to use tools, such as questionnaires and decision trees, for diagnosing diseases;
o developing measurements for monitoring patient medical outcomes;
o determining how to best influence the health status of individuals;
o conducting surveys to evaluate physician knowledge and behavior in order to develop individualized educational materials for each physician; and
o evaluating the direct and indirect costs of health care.
Our current outcomes studies initiatives are in the following areas: chronic pain, dementia, impaired memory, urinary incontinence, irritable bowel syndrome, asthma, vaccines, headache, osteoarthritis, gastrointestinal motility and diabetes.
We believe we are a leader in clinical research and have received strong recognition in the clinical research arena. As of April 30, 1999, we employ 30 Medical Doctors, 2 Ph.D's., and 13 PharmDs. Many of our employees are on the staff of leading university-affiliated medical health centers. We believe we are leaders in Alzheimer's disease prevention and treatment research and are the largest enroller in Alzheimer's research. We were one of the lead investigators for the Excedrin Migraine(C) Program, and we recently conducted an asthma research program with the Robert Wood Johnson Foundation.
INTERNET STRATEGY
We are currently reviewing alternative approaches to enhance our existing Internet-based services for covered individuals. Our current services include:
o ordering refills of pharmaceuticals;
o checking the status of pharmacy orders;
o locating network pharmacies; and
o reviewing formulary information.
We plan to develop our Internet capability beyond our current services for covered individuals to support our customers and to enhance our program offerings. Our future Internet initiatives may offer medical content to our health plan sponsor customers for use on their Internet sites, empower consumers by involving them more directly in their medical care and offer access to an on-line drugstore. Our future Internet offerings may include some or all of the following:
o on-line drug store;
o disease-specific chat rooms and information;
o patient and member surveys;
o personalized refill reminders;
o monitoring of patient drug use; and
o recruitment of patients and physicians for clinical trials.
SALES, MARKETING AND CUSTOMER SERVICE
The sales process for health benefit management services usually lasts from six to nine months, yet may take over a year. We initiate our sales process with our large customers at the most senior levels of our company. A staff of seven sales representatives with a local presence in offices across the United States supports these senior level initiatives. We also have proposal development and marketing groups that work with our team to prepare the analysis that supports our person-to-person sales effort. With this team approach, we are able to work with customers at multiple levels within their organizations and they have multiple contacts within ours.
Once we have signed up the customer for our services, we commit to provide them with the highest level of customer support. For example, our benefits design group works with the customers to design the pharmacy benefits that the customers will provide to individuals in their plans. Once the plans are established, each customer has a dedicated representative who acts as the primary contact for the customer to call if there are any questions, concerns or suggestions regarding their plans. This representative will also lead the effort within our company to respond to customer requests, such as analyzing potential formulary adjustments, performing data analysis and addressing member eligibility issues. Finally, we commit to our customers that the individuals enrolled in their plans will receive high quality customer service. To fulfill this promise, we manage our own advanced call center with employees available to answer incoming calls 24 hours a day, seven days a week. As of March 31, 1999, we employ approximately 142 customer service representatives in this call center.
CUSTOMERS
A significant portion of our revenues result from contracts with customers. These contracts typically provide for multi-year terms, with automatic 12-month renewals unless either party terminates the contract by giving written notice before the automatic renewal date. Some of our contracts are terminable by either party on as little as 30 to 180 days notice. In fiscal year 1999, our top five customers accounted for 52% of our revenues. One of our customers, the United Mine Workers of America, accounted for approximately 18% of our revenues, yet less than 8% of our total claims processed, in fiscal year 1999. No other customer accounted for over 10% of our revenues in this period. We expect that Foundation Health Systems will be our single largest customer in fiscal year 2000.
Some of our major customers hold equity positions in our company in the form of common stock and warrants, which fosters the development of long-term strategic alliances. We believe this arrangement strengthens our ties to these customers.
COMPETITION
Many of our customers put their contracts out for competitive bidding prior to renewal. We compete with a number of larger, national companies, including Caremark International Inc., a subsidiary of MedPartners, Inc., Express Scripts, Inc., an affiliate of NYLIFE HealthCare Management, Inc., Merck-Medco Managed Care, LLC, a subsidiary of Merck & Co., Inc., a pharmaceutical manufacturer, and PCS Health Systems, Inc., a subsidiary of Rite-Aid
Corporation, a national pharmacy chain. These competitors are significantly larger than we are and possess greater financial, marketing and other resources than we do. These competitors may possess purchasing and other advantages over us that may allow them to price competing services more aggressively than we can because of their size or other aspects of their businesses.
We believe that the primary competitive factors in the health benefit management industry include:
o independence from pharmaceutical manufacturers, retail pharmacies and health plan sponsors;
o the quality, scope and costs of programs offered;
o the size and financial strength of the company;
o the ability to reduce customer costs by negotiating favorable rebates and volume discounts from pharmaceutical manufacturers;
o the ability to use clinical strategies to improve patient outcomes and reduce costs; and
o the ability to provide flexible, clinically oriented services to customers.
We believe that all of our larger competitors offer comprehensive pharmacy benefit management services and some form of disease management services. We consider our principal competitive advantages to be our strong clinical approach; our independence from pharmaceutical manufacturers, retail pharmacies and health plan sponsors; and our strong managed care customer base, which supports the development of health benefit management services.
GOVERNMENT REGULATION
Various aspects of our businesses are governed by federal and state laws and regulations and compliance is a significant operational requirement for our company. We believe that we are in substantial compliance with all existing legal requirements material to the operation of our business.
Certain federal and state laws and regulations affect aspects of our pharmacy benefit management business. Among these are the following:
FDA regulation. The U.S. Food and Drug Administration (the "FDA"), generally has authority to regulate drug promotional materials that are disseminated "by or on behalf" of a pharmaceutical manufacturer. In January 1998, the FDA issued a Draft Guidance for Industry regarding the regulation of activities of pharmacy benefit managers that are directly or indirectly controlled by pharmaceutical manufacturers. In that draft guidance, the FDA purported to have the authority to hold pharmaceutical manufacturers responsible for the promotional activities of pharmacy benefit management companies, depending upon the nature and extent of the relationship between the pharmaceutical manufacturer and the pharmacy benefit management
company. We and many other companies and associations commented to the FDA in writing regarding its authority to regulate the promotional activities of pharmacy benefit management companies that are not owned by pharmaceutical manufacturers. On July 1, 1998, the FDA responded to these comments by reconsidering the matter and announcing its attention to create a new draft guidance. To date, the FDA has not issued a new guidance. Although it appears that the FDA has changed its position regarding the ability to regulate the promotional activities of pharmacy benefit management companies that are not owned by pharmaceutical manufacturers, the FDA could still adopt the current draft guidance or an alternative guidance in which the FDA continues to assert the authority to regulate the promotional activities of such pharmacy benefit management companies.
The conduct of clinical trials also is regulated by the FDA under the authority of the Federal Food, Drug and Cosmetic Act and related regulations. In general, the sponsor of the drug product which is being studied, or the manufacturer which will have the right to market the drug product if it is approved by the FDA, has the responsibility to comply with the laws and regulations that apply to the conduct of the clinical trials. However, in providing services related to the conduct of clinical trials, we may assume some or all of the sponsor's or clinical investigator's obligations related to the study of the drug. For example, in October 1998, the FDA announced that the agency would give Institutional Review Boards, independent bodies that oversee the conduct of clinical investigations, increased access to information pointing to violative or potentially violative conduct on the part of clinical investigators with whom they may be working. A clinical investigator is a physician conducting a clinical trial. On February 2, 1999, a regulation that requires clinical investigators to disclose certain financial information took effect. If required financial information, such as the financial interest of each investigator in the approval of the product, is not disclosed, or if any investigator fails to properly certify that he or she has no financial interest in the product under investigation, we could be subject to administrative, civil or criminal penalties.
Because the interpretation and enforcement of laws and regulations relating to the conduct of clinical trials is uncertain, the FDA may consider our compliance efforts to be inadequate and initiate administrative enforcement actions against us. If we fail to successfully defend against an administrative enforcement action, it could result in an administrative order suspending, restricting or eliminating our ability to participate in the clinical trial process, which would materially limit our business operations. Moreover, some violations of the Federal Food, Drug and Cosmetic Act are punishable by civil and criminal penalties against both the violating company and responsible individuals. If warranted by the facts, we and our employees involved in the trials could face civil and criminal penalties which include fines and imprisonment.
The FDA recently has expressed concern regarding the potential impact of the failure of companies in the pharmaceutical industry to remedy year 2000 computer problems. While the FDA appears most concerned with potential manufacturing problems, the FDA has recognized that year 2000 problems could cause errors in product distribution and in the gathering of data in clinical studies. For example, the FDA has stated that, in the worst case scenario, a year 2000 problem could cause the computers on which companies conducting clinical studies rely to generate flawed data. To date, the FDA has not required companies to make any formal submissions regarding efforts to remedy year 2000 problems. However, if a year 2000 problem
caused a drug product that we distributed to be adulterated, or caused our data gathered in connection with a clinical study to be flawed, our business could be adversely affected and we could be subject to administrative, civil or criminal liability.
Regulation of identifiable patient information. Increased government regulation concerning the use of identifiable patient information may occur in the near future. Through our disease management programs, we assist our health plan sponsor customers in identifying individuals who will benefit most from the programs and measuring the patients' improvement after enrollment in the program. Government restrictions on the use of patient identifiable information may adversely affect our ability to conduct disease management programs and outcomes studies, as well as our business growth strategy based on these programs. Federal and state legislation has been proposed, and some state laws have been enacted, to restrict the use and disclosure of identifiable medical information. To our knowledge, no legislation has been enacted that would prohibit our ability to conduct our current disease management or clinical research programs. However, under the Health Insurance Portability and Accountability Act of 1996, Congress is required to establish standards to govern the privacy of individually identifiable health information by August 1999. If Congress fails to act by that date, the Health Insurance Portability and Accountability Act of 1996 requires that the Secretary of Health and Human Services issue regulations by February 2000. Consequently, it appears likely that federal legislation or regulations addressing the accessibility of individually identifiable health information will be in place in the near future.
Anti-remuneration laws. Subject to certain exceptions, federal law prohibits the payment, offer, receipt or solicitation of any remuneration that is knowingly and willfully intended to induce the referral of Medicare, Medicaid or other federal health care program beneficiaries or the purchase, lease, ordering or recommendation of the purchase, lease or ordering of items or services reimbursable under federal health care programs. Several states also have similar laws which are not limited to services for which federal health care program payment may be made. Further, the Clinton administration has proposed that anti-remuneration laws also be applied to services for which Medicare or Medicaid payments are not made. Sanctions for violating these federal and state anti-remuneration laws may include imprisonment, criminal and civil fines, and exclusion from participation in federal health care programs. State anti-remuneration laws vary, and courts have not frequently interpreted such laws. However, the courts in several cases have ruled that contracts that violate anti-remuneration laws are voidable.
The federal anti-remuneration statute has been interpreted broadly by courts; the Office of Inspector General, or OIG, within the Department of Health and Human Services; and administrative bodies. Because of the federal statute's broad scope, federal regulations establish some "safe harbors" from liability. Safe harbors exist for, among other things, certain properly reported discounts received from vendors, certain investment interests, certain properly disclosed payments made by vendors to group purchasing organizations and certain managed care risk-sharing arrangements. A practice that does not fall within a safe harbor is not necessarily unlawful, but may be subject to scrutiny and challenge. Courts have ruled that, in the absence of an applicable statutory exception or safe harbor, a violation of the statute may occur even if only one of the purposes of a payment arrangement is to induce patient referrals or purchases. Among the practices that have been identified by the OIG as potentially improper under the statute are
"product conversion programs" in which benefits are given by pharmaceutical manufacturers to pharmacists or physicians for changing a prescription, or recommending or requesting such a change, from one drug to another. These laws have been cited as a partial basis, along with the state consumer protection laws discussed below, for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to retail pharmacists in connection with such programs.
We believe that we are in substantial compliance with the legal requirements imposed by these laws and regulations, and we believe that there are material differences between the drug-switching programs that have been highlighted by the OIG and the programs we offer to our customers. However, in June 1998, the Philadelphia United States Attorney's office announced that it was investigating rebates and other payments made by pharmaceutical manufacturers to pharmacy benefit managers, including whether these payments may violate anti-remuneration laws. To date, no specific prosecutions have been made public. We could be subject to scrutiny or challenge under these laws and regulations, which could have a material adverse effect upon us.
OIG study. The OIG Office of Evaluation and Inspections, which is not responsible for investigations of potential violations of anti-remuneration laws, but which seeks to improve the effectiveness and efficiency of the Department of Health and Human Services programs, issued a report on pharmacy benefit management arrangements on April 15, 1997. The report was based primarily on a nationwide survey of HMOs that use pharmacy benefit managers, and examined the benefits of, and concerns raised by, the HMOs' relationships with pharmacy benefit managers.
The report identified two major concerns, the potential for bias resulting from alliances of pharmacy benefit managers and pharmaceutical manufacturers and the lack of oversight by HMOs regarding the performance of pharmacy benefit managers in delivering quality services to health plan members. The report makes two main recommendations. First, the Health Care Financing Administration and state Medicaid programs should include stronger oversight provisions in their risk contracts with HMOs by requiring HMOs to review the performance of the pharmacy benefit managers with which they contract. Second, the Health Care Financing Administration, the FDA and the Health Resources and Services Administration, working with outside organizations, should develop quality measures for pharmacy practices that can be used in managed care settings. In addition, legislation has been introduced in several states proposing to specifically regulate pharmacy benefit management companies. To date, no such legislation has passed. We intend to closely monitor these agency actions and legislative proposals and whether these actions and proposals would have any impact on our business.
Managed care reform. Legislation is being debated on both the federal and state level, and has been enacted in some states, aimed at improving the quality of care provided to individuals enrolled in managed care plans. Some of these initiatives would, among other things, require that health plan members have greater access to drugs not included on a plan's formulary and give health plan members the right to sue their health plans for malpractice when they have been denied care. The scope of the managed care reform proposals under consideration by Congress and state legislatures and enacted by states to date vary greatly, and the extent to which future
legislation may be enacted is uncertain. However, these initiatives could greatly impact the managed care and pharmaceutical industries and, therefore, could have a material impact on our business.
ERISA regulation. The Employee Retirement Income Security Act of 1974, or ERISA, regulates certain aspects of employee pension and health benefit plans, including self-funded corporate health plans with which we have agreements to provide pharmacy benefit management services. The U.S. Department of Labor, which is the agency that enforces ERISA, could assert that the fiduciary obligations imposed by the statute apply to certain aspects of our operations.
Consumer protection laws. Most states have consumer protection laws that have been the basis for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to retail pharmacies in connection with drug switching programs. In addition, under a settlement agreement entered into with 17 states on October 25, 1995, Merck-Medco Managed Care, the pharmacy benefit management subsidiary of pharmaceutical manufacturer Merck & Co., agreed to require pharmacists affiliated with Merck-Medco Managed Care mail service pharmacies to disclose to physicians and patients the financial relationships between Merck & Co., Merck-Medco Managed Care and the mail service pharmacy when such pharmacists contact physicians seeking to change a prescription from one drug to another. We believe that our contractual relationships with pharmaceutical manufacturers and retail pharmacies do not include the features that were viewed by enforcement authorities as problematic in these settlement agreements. However, we could be subject to scrutiny or challenge under one or more of these laws.
Network access legislation. A majority of states have adopted some form of legislation affecting our ability to limit access to pharmacy provider networks or from removing network providers. Such legislation may require our customers and us to admit any retail pharmacy willing to meet the plan's price and other terms for network participation; this legislation is sometimes referred to as "any willing provider" legislation. We have not been materially affected by these statutes because we administer a large network of over 53,000 retail pharmacies and will admit any licensed pharmacy that meets our credentialing criteria, involving such matters as adequate insurance coverage, minimum hours of operation, and the absence of disciplinary actions by the relevant state agencies.
Legislation imposing plan design restrictions. Some states have legislation that prohibits a health plan sponsor from implementing certain restrictive design features. For example, some states provide that members of the plan may not be required to use network providers, but must also be provided with benefits even if they choose to use non-network providers. This legislation is sometimes referred to as "freedom of choice" legislation. Other states mandate coverage of certain benefits or conditions. This legislation does not generally apply to us, but it may apply to some of our customers such as HMOs and insurers. If similar legislation were to become widespread and broad in scope, it could have the effect of limiting the economic benefits achievable through health benefit management services.
Licensure laws. Many states have licensure or registration laws governing certain types of ancillary health care organizations, including preferred provider organizations, third party administrators, and companies that provide utilization review services. The scope of these laws differs significantly from state to state, and the application of these laws to the activities of pharmacy benefit managers is often unclear. We have registered under these laws in those states in which we have concluded, after discussion with the appropriate state agency, that such registration is required.
Legislation affecting drug prices. In the past, some states have adopted legislation providing that a pharmacy participating in the state's Medicaid program must give the state the best price that the pharmacy makes available to any third party plan. This legislation is sometimes referred to as "most favored nation" legislation. Such legislation, if enacted in any state, may adversely affect our ability to negotiate discounts in the future from network pharmacies. Other states have enacted "unitary pricing" legislation, which mandates that all wholesale purchasers of drugs within the state be given access to the same discounts and incentives.
Additionally, Medicare reimbursement and coverage of prescription drugs may change significantly in the near future. Medicare presently covers only a limited number of outpatient prescription drugs, and reimbursement of covered drugs is generally based on a percentage of the drug's average wholesale price. Legislation has been proposed to reduce Medicare drug reimbursement amounts, although the prospects for enactment of such legislation are uncertain. At the same time, legislative initiatives are being considered to expand Medicare coverage of drugs, in some instances as part of a broad reform of the Medicare program. We cannot assess at this stage whether such legislation will be approved or how it would address drug costs. Enactment of legislation to reduce Medicare drug reimbursement or to expand Medicare drug coverage may have an adverse impact upon our business.
Regulation of financial risk plans. Fee-for-service prescription drug plans are not generally subject to financial regulation by the states. However, if a pharmacy benefit manager offers to provide prescription drug coverage on a capitated basis or otherwise accepts material financial risk in providing the benefit, laws in various states may regulate the plan. These laws may require that the party at risk establish reserves or otherwise demonstrate financial responsibility. Laws that may apply in such cases include insurance laws, HMO laws or limited prepaid health service plan laws. Many of these state laws may be preempted in whole or in part by ERISA, which provides for comprehensive federal regulation of employee benefit plans. However, the scope of ERISA preemption is uncertain and is subject to conflicting court rulings. Other state laws may be invalid in whole or in part as an unconstitutional attempt by a state to regulate interstate commerce, but the outcome of challenges to these laws on this basis is uncertain. Accordingly, compliance with state laws and regulations is a significant operational requirement for us.
Mail pharmacy regulation. Our mail pharmacy operations, located in Richardson, Texas, distribute drugs throughout the country. Some of the drugs that we distribute are classified as controlled substances, which are regulated by federal and state drug enforcement authorities. We are licensed by both United States and Texas authorities to do business as a pharmacy and distribute controlled substances. Many of the states into which we deliver pharmaceuticals and controlled substances also have laws and regulations that permit out-of-state mail service pharmacies to distribute pharmaceuticals and
controlled substances into the state so long as the pharmacy is registered with that state's board of pharmacy, or similar regulatory body. We have registered in every state, which, to our knowledge, requires such registration. In addition, various pharmacy associations and boards of pharmacy have promoted enactment of laws and regulations directed at restricting or prohibiting the operation of out-of-state mail service pharmacies by, among other things, requiring compliance with all laws of certain states into which the mail service pharmacy dispenses medications whether or not those laws conflict with the laws of the state in which the pharmacy is located. To the extent that such laws or regulations are found to be applicable to us, we would be required to comply with them.
Other statutes and regulations also affect our mail pharmacy operations. The Health Care Financing Administration requires mail order pharmacies to provide toll-free numbers for patient counseling of Medicaid recipients residing out of state. However, we do not currently receive reimbursements from any Medicaid programs. Congressionally mandated goals to provide useful information on prescription drugs to consumers may involve participation by mail order pharmacies in assisting in the dissemination of such information. Federal statutes and regulations govern the labeling, packaging, advertising and adulteration of prescription drugs and the dispensing of controlled substances. The Federal Trade Commission requires mail order sellers of goods generally to engage in truthful advertising, to stock a reasonable supply of the product to be sold, to fill mail orders within thirty days, and to provide customers with refunds when appropriate. The United States Postal Service has statutory authority to restrict the transmission of drugs and medicines through the mail to a degree that could have an adverse effect on our mail service operations. The United States Postal Service historically has exercised this statutory authority only with respect to controlled substances. Alternative means of delivery are available to us.
EMPLOYEES
On May 31, 1999, we had 891 employees. None of our employees are represented by a labor union. In the opinion of management, our relationship with our employees is good.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts included in this Form 10-K, including without limitation, statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business" regarding our financial position, our business strategy and our management's plans and objectives for future operations, are forward-looking statements. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct. The cautionary statements made in this Form 10-K should be read as being applicable to all related forward-looking statements wherever they appear in this Form 10-K. Our actual results could differ materially from those discussed herein, and important factors that could cause actual results to differ materially from our expectations are disclosed under "Risk Factors", as well as
elsewhere in this Form 10-K. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this section.
RISK FACTORS
IF WE LOSE KEY HEALTH PLAN SPONSOR CUSTOMERS, OUR BUSINESS COULD BE ADVERSELY AFFECTED
We depend on a limited number of large health plan sponsor customers for a significant portion of our consolidated revenues. Our business, profitability and growth prospects could be adversely affected if we were to lose one or more of our significant customers. We could lose customers if we fail to win a competitive bid at the time of contract renewal or if our customers are acquired by companies who are not our customers. Our contracts with our customers generally do not have terms of more than three years, and in some cases are terminable by either party on as little as 30 to 180 days notice. Five customers accounted for approximately 52% of our revenues in fiscal year 1999. During this period, United Mine Workers of America accounted for approximately 18% of our consolidated revenues, yet less than 8% of our total claims processed. In fiscal 2000, we expect that Foundation Health Services will become our largest customer.
We cannot be sure that revenues from new customers will offset the revenues which may be lost from customers who terminate contracts because they are acquired by, or acquire, companies which are not our customers. Over the past several years, insurance companies, health maintenance organizations, or HMOs, and managed care companies have experienced significant consolidation. Our customers have been, and may continue to be, subject to consolidation pressures. We may lose some customers as a result of acquisitions, which could have a material adverse effect on our business, profitability and growth prospects.
Many participants in the health care industry, including our customers, are under severe financial pressures due to rising claims and costs. If the financial condition of any of our significant customers deteriorates, which could occur for many reasons including adverse changes in governmental or private reimbursement programs, it could have an adverse effect on us.
IF WE CANNOT RESPOND ADEQUATELY TO COMPETITION IN OUR INDUSTRY, OUR PROFITABILITY AND GROWTH PROSPECTS COULD BE REDUCED OR ELIMINATED
The health benefit management industry is very competitive. If we don't compete effectively, our profitability and growth prospects could be reduced or eliminated. Our competitors include large, profitable and well-established companies which have substantially greater financial, marketing and other resources than we do. Some of our competitors in the pharmacy benefit management business, such as Merck-Medco Managed Care, LLC and PCS Health Systems, Inc., are owned by large, profitable and well-established pharmaceutical manufacturers or national drug store chains. Many of our customers put their contracts out for competitive bidding prior to renewal. Our competitors may possess purchasing and other advantages over us that may allow them to price competing services more aggressively than we can because of their size or
other aspects of their business. We also expect to experience competition from new sources in the future, such as Internet-based health care services companies. We cannot be sure that we will continue to remain competitive, nor can we be sure that we will be able to successfully market our health benefit management services to customers at our current levels of profitability.
Over the last several years, the competitive pressures described above have caused health benefit management companies, including us, to reduce the prices charged to customers for basic pharmacy benefit management services and share a larger portion of the rebate revenues received from pharmaceutical manufacturers with our customers. Our gross margin may decline as we continue to attract larger customers, which typically have greater bargaining power than smaller customers and may require us to sell our services at decreased prices.
IF WE FAIL TO TRANSITION THE OPERATIONS OF FOUNDATION HEALTH PHARMACEUTICAL SERVICES IN A TIMELY AND SUCCESSFUL MANNER, OUR BUSINESS, PROFITABILITY AND GROWTH PROSPECTS COULD BE ADVERSELY AFFECTED
We acquired Foundation Health Pharmaceutical Services, a large pharmacy benefit management company, on March 31, 1999. If we fail to transition this new business in a timely and successful manner, our business, profitability and growth prospects could be adversely affected. This acquisition, along with the service agreement signed with Foundation Health Systems, Inc., approximately doubled the number of individuals enrolled in our programs. We have begun to implement a plan to address items such as:
o retaining the non-affiliated customers of Foundation Health Pharmaceutical Services;
o transitioning the Foundation Health Systems, Inc. affiliated health plan onto our system; and
o coordinating customer service between our two organizations.
We cannot be sure that we will successfully combine Foundation Health Pharmaceutical Services' operations with our own, or that the transaction will meet our financial expectations. The Foundation Health Pharmaceutical Services customers who were not part of health benefit plans affiliated with Foundation Health Systems have contracts which allow them to terminate their relationship with us with 60 to 90 days' notice. We believe that about half of the estimated 12 million new plan members we acquired fall under this type of contract. If a large number of customers terminate their relationship with us, we may not be able to achieve our customer retention goals. Because we placed a significant level of importance on Foundation Health Pharmaceutical Services' customer base when we decided to purchase the company, the loss of customers would adversely affect our future business plans. It is also possible that during our investigation of Foundation Health Pharmaceutical Services we failed to uncover or appropriately address material problems with Foundation Health Pharmaceutical Services' operations or financial condition, or failed to discover contingent liabilities.
IF WE ARE UNABLE TO OVERCOME THE PROBLEMS AND RISKS RELATED TO OUR ACQUISITION AND ALLIANCE STRATEGY, OUR BUSINESS, PROFITABILITY AND GROWTH PROSPECTS COULD SUFFER
Part of our growth strategy includes acquisitions and/or alliances involving complementary services, technologies and businesses. If we are unable to overcome the potential problems and inherent risks related to acquisitions and alliances, our business, profitability and growth prospects could suffer. We completed three acquisitions in the past 15 months, and we continually review future acquisition opportunities. Our ability to continue to expand successfully through acquisitions and alliances depends on many factors, including our ability to identify acquisition/alliance prospects and negotiate and close transactions. If we complete future acquisitions or alliances:
o we could fail to successfully integrate the operations, services and products of any acquired company;
o we could fail to select the best alliance partners or fail to effectively plan and manage any alliance strategy;
o our management's attention could be diverted from other business concerns; and
o we could lose key employees of the acquired company or alliance business.
Many companies compete for acquisition and alliance opportunities in the health benefit management industry. Some of our competitors are companies that have significantly greater financial and management resources than we do. This may reduce the likelihood that we will be successful in completing acquisitions and alliances necessary to the future success of our business.
IF OUR BUSINESS CONTINUES TO GROW RAPIDLY AND WE ARE UNABLE TO MANAGE THIS GROWTH, OUR BUSINESS, PROFITABILITY AND GROWTH PROSPECTS COULD SUFFER
If we are unable to manage future expansion successfully or are unable to hire and retain the personnel needed to manage our business successfully, then our business, profitability and growth prospects could be adversely affected. Our business has grown rapidly in the last five years, with total revenues increasing from approximately $91.3 million in fiscal year 1995 to $774.8 million in fiscal year 1999. If we continue to grow rapidly, we will need to hire additional senior and line management, increase our investment in employee recruitment and training, and expand our information processing and financial control systems. Our future operating results will depend in part on the ability of our officers and other key employees to continue to expand, train and effectively manage our employees as well as to improve our operations, customer support and financial control systems. Our future growth will also depend on our ability to access capital.
IF OUR QUARTERLY REVENUES AND OPERATING RESULTS FLUCTUATE SIGNIFICANTLY, THE PRICE OF OUR COMMON STOCK MAY BE VOLATILE
Our revenues and operating results may in the future vary significantly from quarter to quarter. If our quarterly results fluctuate, it may cause our stock price to be volatile. We believe that a number of factors could cause these fluctuations, including:
o the size and timing of our contract signings;
o the expiration or termination of our contracts with significant customers;
o changes in our revenues due to our entry into different types of customer contracts;
o the number of covered individuals in our customers' health plans;
o costs associated with additional Internet services;
o the timing of our new service and program announcements;
o market acceptance of our services and new programs;
o changes in our pricing policies or in our competitors' pricing policies;
o the introduction by competitors of new services which make ours obsolete or less valuable;
o changes in our operating expenses and our investment in infrastructure;
o personnel changes; and
o conditions in the health care industry and the economy in general.
It can take a year or more to sell our services to a new customer. Our long sales cycle adds to the unpredictability of our revenues, which could cause substantial volatility in the price of our common stock. Our sales cycle varies substantially from customer to customer because of a number of factors over which we have little or no control. These factors include:
o our customers' financial objectives or constraints;
o the timing of contract bids and renewals;
o changes in our customers' budgetary or purchasing priorities; and
o potential downturns in general economic conditions.
Because of the factors listed above, we believe that our quarterly revenues, expenses and operating results may vary significantly in the future and that period-to-period comparisons of
our operating results are not necessarily meaningful. You should not rely on the results of one quarter as a indication of our future performance. It is also likely that in some future quarters, our operating results will fall below our expectations or the expectations of market analysts and investors. If we do not meet these expectations, the price of our common stock may decline significantly.
IF THE PRICE OF OUR COMMON STOCK CONTINUES TO FLUCTUATE SIGNIFICANTLY, INVESTMENTS COULD BE ADVERSELY AFFECTED
The closing price of our common stock has ranged from a low of $41.94 to a high of $64.25 in the past three months, and has fluctuated as much as $14.25 in five trading days. The quoted price of our common stock is subject to sudden and material increases and decreases, and decreases could adversely affect investments in our common stock. The quoted price of our common stock could fluctuate widely in response to:
o our quarterly operating results;
o changes in earnings estimates by securities analysts;
o changes in our business;
o changes in the market's perception of the Internet component of our business;
o changes in the businesses, earnings estimates or market perceptions of our competitors; and
o changes in general market or economic conditions.
In addition, the stock market has experienced extreme price and volume fluctuations in recent years that have significantly affected the quoted prices of the securities of many companies. The changes often appear to occur without regard to specific operating performance. The quoted price of our common stock could increase or decrease based upon factors that have little or nothing to do with our company and these fluctuations could materially reduce our quoted stock price.
IF OUR INTERNET STRATEGY IS NOT SUCCESSFUL, OUR BUSINESS, PROFITABILITY AND GROWTH PROSPECTS COULD BE ADVERSELY AFFECTED
If our Internet strategy is not successful, our business, profitability and growth prospects could be adversely affected. We believe it is important for us to further develop our Internet presence, and we are currently reviewing alternative strategies to broaden our Internet-based services. Historically, we have experienced expense increases when introducing or expanding services. We anticipate that we will need to expend significant resources to develop our Internet services in the future, which may adversely impact our profitability. In addition, the structure of our Internet business is evolving and could involve joint ventures, acquisitions, strategic alliances or other collaborative arrangements. We cannot be certain that:
o we will be successful in developing Internet services;
o we will select the best partners or will effectively plan and manage any alliance or acquisition;
o the additional Internet services we develop will be profitable; or
o anyone will demand Internet services in the future.
IF WE LOSE RELATIONSHIPS WITH ONE OR MORE KEY PHARMACEUTICAL MANUFACTURERS, OUR BUSINESS, PROFITABILITY AND GROWTH PROSPECTS COULD BE ADVERSELY AFFECTED
Approximately 15% of our consolidated revenues is attributable to our arrangements with pharmaceutical manufacturers. They provide us with formulary rebate payments based on drug use by health plan members, as well as fees for other services. Although we pass a majority of these rebates on to our health plan sponsor customers, we believe our business, profitability and growth prospects may suffer if:
o we lose relationships with one or more key pharmaceutical manufacturers;
o we fail to meet volume-related conditions;
o legal restrictions are imposed on the ability of pharmaceutical manufacturers to offer formulary rebates; or
o pharmaceutical manufacturers choose not to offer formulary rebates.
Over the next few years, as patents expire covering many brand name drugs that currently have substantial market share, generic products will be introduced that may substantially reduce the market share of the brand name drugs. Historically, manufacturers of generic drugs have not offered formulary rebates on their drugs. If the use of newly-approved, brand name drugs added to our formulary does not offset the use of brand name drugs whose patents expire, our profitability could be reduced.
IF WE LOSE PHARMACY NETWORK AFFILIATIONS, OUR BUSINESS COULD BE ADVERSELY AFFECTED
Our contracts with retail pharmacies, which are non-exclusive, are generally terminable by either party on relatively short notice. If one or more of the top pharmacy chains elects to terminate its relationship with us, our members' access to retail pharmacies and our business could be significantly impaired. In addition, Rite-Aid Corporation recently acquired one of our major pharmacy benefit manager competitors, and other large retail pharmacy chains either own pharmacy benefit managers today or could attempt to acquire a pharmacy benefit manager in the future. Ownership of pharmacy benefit managers by retail pharmacy chains could have material adverse effects on our relationships with these pharmacy chains and on our business, profitability and growth prospects.
IF WE LOSE KEY EMPLOYEES ON WHOM WE DEPEND, IN PARTICULAR DAVID D. HALBERT, OUR BUSINESS COULD BE ADVERSELY AFFECTED
We believe that our continued success will depend to a significant extent upon retaining the services of our senior management. Our business could be materially and adversely affected if we were to lose the services of Mr. David D. Halbert, who is our Chairman of the Board, Chief Executive Officer and President, or other persons in senior management. Any of our senior management could seek other employment at any time. If we cannot attract, motivate and retain key employees, our business, profitability and growth prospects could suffer.
IF WE DO NOT ADEQUATELY ADDRESS YEAR 2000 ISSUES, OUR BUSINESS MAY BE ADVERSELY AFFECTED
We have incurred internal and external personnel costs as well as other expenses related to our efforts to insure our internal computer systems and software products will function in the year 2000 and beyond. We cannot be sure that our efforts to address internal year 2000 issues will be entirely successful. In addition, we cannot be sure that the computer systems and software of other companies with which we do business will become year 2000 compliant before January 1, 2000. If we or any of these other companies fail to become year 2000 compliant, our systems and operations could be disrupted and our business, profitability and growth prospects could be harmed.
We have not developed a likely worst case year 2000 scenario. However, we could experience a number of minor internal systems malfunctions and errors in early year 2000 that we did not detect during our renovation and testing process. In addition, some of our customers and vendors may not be year 2000 compliant. We have begun preparing contingency plans to handle these scenarios. We intend to complete our contingency plans by the third quarter of calendar year 1999. However, despite our compliance program, we may have overlooked or otherwise not remedied year 2000 issues which may have a material adverse effect on us.
For additional information regarding year 2000 issues, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations."
IF THERE ARE CHANGES IN FEDERAL OR STATE FINANCING AND REGULATION OF THE HEALTH CARE INDUSTRY, OUR CUSTOMERS MAY DELAY OR REDUCE THE PURCHASE OF OUR SERVICES
During the past several years, the U.S. health care industry has been subject to an increase in governmental regulation, on both the federal and state level. We cannot predict what effect, if any, these proposals might have on our business, profitability and growth prospects. Congress is currently considering proposals to change Medicare drug coverage and reimbursement policies, and both Congress and the states are considering legislation to increase governmental regulation of managed care plans. These proposals may increase governmental involvement in health care and health benefit management services and otherwise change the way our customers do business. Health care organizations may react to these proposals and the uncertainty surrounding such proposals by cutting back or delaying the purchase of our health benefit management services.
IF LEGISLATIVE OR REGULATORY INITIATIVES RESTRICT OUR ABILITY TO USE PATIENT IDENTIFIABLE MEDICAL INFORMATION, OUR CLINICAL PROGRAMS AND OUR BUSINESS GROWTH STRATEGY BASED ON THESE SERVICES COULD BE ADVERSELY AFFECTED
Through our disease management programs, we help our health plan sponsor customers identify individuals who will most benefit from the programs. Governmental restrictions on the use of patient identifiable information may hamper our ability to conduct disease management programs and medical outcomes studies and could adversely affect our business growth strategy based on these programs. Federal and state legislation has been proposed, and some state laws have been enacted, to restrict the use and disclosure of patient identifiable medical information. To our knowledge, no legislation has been enacted that would prohibit our ability to conduct our current disease management or clinical research programs. However, under the Health Insurance Portability and Accountability Act of 1996, Congress is required to establish standards to govern the privacy of individually identifiable health information by August 1999. If Congress fails to act by that date, the Health Insurance Portability and Accountability Act requires that the Secretary of Health and Human Services issue regulations by February 2000. Consequently, it appears likely that federal legislation or regulations addressing the accessibility of individually identifiable health information will be in place in the near future. Even if new legislation or regulations are not approved, individual health plan sponsor customers could prohibit us from including their patients' medical information in our various databases of medical data, or they could prohibit us from providing services to our customers that involve the compilation of such information.
IF GOVERNMENT LAWS OR REGULATIONS RELATING TO THE FINANCIAL RELATIONSHIPS BETWEEN PHARMACY BENEFIT MANAGERS AND PHARMACEUTICAL MANUFACTURERS ARE INTERPRETED AND ENFORCED IN A MANNER ADVERSE TO OUR PHARMACY BENEFIT MANAGEMENT AND DISEASE MANAGEMENT PROGRAMS, WE MAY BE SUBJECT TO ENFORCEMENT ACTIONS AND OUR BUSINESS OPERATIONS COULD BE MATERIALLY LIMITED
In January 1998, the U.S. Food and Drug Administration, or the FDA, issued a Draft Guidance for Industry regarding the regulation of activities of pharmacy benefit managers that are directly or indirectly controlled by pharmaceutical manufacturers. If the FDA adopts this guidance in this form, it could have a material adverse effect on our business, profitability and growth prospects. In that draft guidance, the FDA purported to have the authority to hold pharmaceutical manufacturers responsible for the promotional activities of pharmacy benefit management companies, depending upon the nature and extent of the relationship between the pharmaceutical manufacturer and the pharmacy benefit management company. We and many other companies and associations commented to the FDA in writing regarding its authority to regulate the promotional activities of pharmacy benefit management companies that are not owned by pharmaceutical manufacturers. On July 1, 1998 the FDA responded to these comments by reconsidering the matter and announcing its attention to create a new draft guidance. To date, the FDA has not issued a new guidance. Although it appears that the FDA has changed its position regarding the ability to regulate the promotional activities of pharmacy benefit management companies that are not owned by pharmaceutical manufacturers, the FDA could still adopt the current draft guidance or an alternative guidance in which the FDA continues to assert the authority to regulate the promotional activities of such pharmacy benefit management companies.
If our business arrangements are challenged under federal or state anti-remuneration laws, it could have a material adverse effect upon our business, profitability and growth prospects. Federal anti-remuneration laws generally prohibit the receipt or solicitation of payment in return for purchasing or ordering, or arranging for or recommending the purchasing or ordering of, items and services reimbursable by federal health care programs. To date, these laws have not been applied to prohibit the types of business arrangements we have with pharmaceutical manufacturers. However, courts and enforcement authorities that administer the anti-remuneration laws have historically interpreted these laws broadly. Moreover, at least one United States Attorney's office has announced that it is investigating whether rebates and other payments made by pharmaceutical manufacturers to pharmacy benefit managers may violate the anti-remuneration laws. In addition, anti-remuneration laws have been used as a partial basis for investigations and lawsuits against other pharmacy benefit managers relating to financial incentives provided by pharmaceutical manufacturers.
IF GOVERNMENT LAWS OR REGULATIONS ARE INTERPRETED AND ENFORCED IN A MANNER ADVERSE TO OUR CLINICAL RESEARCH PROGRAMS, WE MAY BE SUBJECT TO ADMINISTRATIVE ENFORCEMENT ACTIONS, AS WELL AS CIVIL AND/OR CRIMINAL LIABILITY
The conduct of clinical trials is regulated by the FDA under the authority of the Federal Food, Drug and Cosmetic Act and the related regulations. If government laws or regulations are interpreted and enforced in a manner adverse to our clinical research programs, we may be subject to administrative enforcement actions, as well as civil and/or criminal liability. In general, the sponsor of the drug product which is being studied, or the manufacturer which will have the right to market the drug product if it is approved by the FDA, has the responsibility to comply with the laws and regulations that apply to the conduct of the clinical trials. However, in providing services related to the conduct of clinical trials, we may assume some or all of the sponsor's or clinical investigator's obligations related to the study of the drug. For example, in October 1998, the FDA announced that the agency would give Institutional Review Boards, which are independent bodies that oversee the conduct of clinical investigations, increased access to information pointing to violative or potentially violative conduct on the part of clinical investigators with whom they may be working. A clinical investigator is a physician conducting a clinical trial. On February 2, 1999, a regulation that requires clinical investigators to disclose certain financial information took effect. If a clinical investigator fails to disclose required financial information, such as the financial interest of each investigator in the approval of the product, or fails to properly certify that he or she has no financial interest in the product under investigation, we could be subject to administrative, civil or criminal penalties.
Because the interpretation and enforcement of these laws and regulations relating to the conduct of clinical trials is uncertain, the FDA may consider our compliance efforts to be inadequate and initiate administrative enforcement actions against us. If we fail to successfully defend against an administrative enforcement action, it could result in an administrative order suspending, restricting or eliminating our ability to participate in the clinical trial process, which would materially limit our business operations. Moreover, some violations of the Federal Food, Drug and Cosmetic Act are punishable by civil and criminal penalties against both the violating company and responsible individuals. If warranted by the facts, we and our employees involved
in the trials could face civil and criminal penalties which include fines and imprisonment.
As a consequence of the severe penalties we and our employees potentially could face, we must devote significant operational and managerial resources to comply with these laws and regulations. Although we believe that we substantially comply with all existing statutes and regulations material to the operation of our business, regulatory authorities may disagree and initiate enforcement or other actions against us. In addition, we cannot predict the impact of future legislation and regulatory changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.
IF WE BECOME SUBJECT TO LIABILITY CLAIMS WHICH ARE NOT COVERED BY OUR INSURANCE POLICIES, WE MAY BE LIABLE FOR DAMAGES AND OTHER EXPENSES WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS, PROFITABILITY AND GROWTH PROSPECTS
A successful product or professional liability claim in excess of our insurance coverage could have a material adverse effect on our business, profitability and growth prospects. While we intend to maintain professional and general liability insurance coverage at all times, we cannot assure you that we will be able to maintain insurance in the future, that insurance will be available on acceptable terms or that insurance will be adequate to cover any or all potential product or professional liability claims.
Various aspects of our business, including the dispensing of pharmaceutical products; the performance of clinical trials, pharmacy benefit management services and disease management services; and the operation of our call center and Internet site, may subject us to litigation and liability for damages. For example, our clinical research services involve the risk of liability for personal injury or death from unforeseen adverse side effects or improper administration of a new drug. We could be materially and adversely affected if we were required to pay damages, incur defense costs or face negative publicity in connection with a claim that is outside the scope of our contractual indemnity or insurance coverage, or if the indemnity, although applicable, is not performed in accordance with its terms.
Since 1993, retail pharmacies have filed over 100 separate lawsuits against pharmaceutical manufacturers, wholesalers and other pharmacy benefit managers. We are not a party to any of these proceedings. However, at this time we cannot assess whether we will be made a party to this type of lawsuit. Court decisions or terms of any settlements relating to these lawsuits could materially and adversely affect us in the future. These lawsuits challenge brand name drug pricing practices under various state and federal antitrust laws. These suits also allege in part that the pharmaceutical manufacturers offered, and some pharmacy benefit managers accepted, rebates and discounts on brand name prescription drugs that violate the federal Robinson-Patman Act and the federal Sherman Act. Some pharmaceutical manufacturers have settled certain of these actions.
IF WE SOLD OR LIQUIDATED OUR COMPANY, THE VALUE OF OUR INTANGIBLE ASSETS MAY NOT BE REALIZED
At March 31, 1999, $105.0 million, or 38% of our total assets, consisted of intangible assets, primarily goodwill. These intangible assets are being amortized over an average period of 29
years. If we were to face a sale or liquidation, we cannot be sure that the value of our intangible assets will be realized. In addition, if the value of our intangible assets were to decrease significantly, the resulting write-offs could have a material adverse effect on our business, profitability and growth prospects.
ITEM 2.
ITEM 2. PROPERTIES
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are a party to routine legal and administrative proceedings arising in the ordinary course of our business. The proceedings currently pending are not, in our opinion, material either individually or in the aggregate.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of fiscal 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
On October 8, 1996 the Company sold 2,397,067 shares of its common stock at $9.00 per share in an initial public offering. Prior to that time, there was no public market for the Company's common stock.
Our common stock has been traded on the Nasdaq National Market under the symbol ADVP since October 8, 1996. The following table sets forth the range of quarterly high and low sales prices per share of our common stock as quoted on the Nasdaq National Market.
On March 31, 1999, there were approximately 4,000 beneficial owners of our common stock represented by 106 holders of record.
We have never paid any cash dividends on our common stock and do not expect to pay cash dividends in the foreseeable future. In the past we have paid cash dividends on our preferred stock; however, we no longer have any preferred stock outstanding. We intend to retain future earnings to finance the ongoing operations and growth of our business.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following tables summarize certain selected consolidated financial data, which should be read in conjunction with the Company's Consolidated Financial Statements and the Notes related thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations", included elsewhere herein. The selected consolidated financial data of the Company as of and for each of the years in the five-year period ended March 31, 1999, have been derived from the Consolidated Financial Statements that have been audited by Arthur Andersen LLP, independent public accountants.
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(1) This data has not been audited.
(2) Merger costs relate to the acquisition of IMR.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We group the revenues from our health benefit management services into three categories: data, mail and clinical services.
o Data services. In 1992, we established a retail pharmacy network, that currently consists of over 53,000 retail pharmacies nationwide, and began to provide on-line claims processing services. Under some of our customer contracts, we contract directly with the retail pharmacies in our national network. When we have an independent obligation to pay our own network of retail pharmacy providers for the drugs dispensed, meaning we are "at risk," we include payments from plan sponsors for the drug cost and the claims processing fees as revenues. We record payments we make to our retail pharmacy providers as cost of revenues. Under other contracts, we manage a network of pharmacies that are under direct contract with certain of our customers. For those plan sponsors that have established their own pharmacy network, we administer the plan sponsors' network pharmacy contracts. The plan sponsors have the independent obligation to fund payment to those pharmacies under contract and the plan sponsors are "at-risk" for the payment for drugs dispensed; we record only the claims processing fees as revenues. New customers that use our network, where we record both claims processing fees and costs of drugs as revenues, will generate higher revenues than new customers that use their own networks, where we only record claims processing fees as revenues. Thus, while a customer who uses our network may contribute the same gross profit in terms of dollars as a customer that uses its own network, gross profit as a percentage of revenue will be lower for customers using our network because of the higher level of revenue we recognize.
o Mail services. We derive mail services revenues from the sale of pharmaceuticals to members of our customers' health plans. These revenues include the cost of the pharmaceuticals plus a dispensing fee.
o Clinical services. We have historically derived our clinical revenues primarily from formulary rebates and volume discounts received from pharmaceutical manufacturers. Some of these revenues are based on estimates that are subject to final settlement with the manufacturer. In addition, we generate clinical revenues from our comprehensive disease management programs. We also include our newly acquired clinical trial and medical outcomes research businesses in our clinical services revenues.
Our cost of revenues includes product costs and other direct costs associated with the dispensing of prescription drugs and the provision of claims processing and clinical services.
RESULTS OF OPERATIONS
The following table sets forth certain consolidated financial data as a percentage of revenues.
FISCAL YEAR 1999 COMPARED TO FISCAL YEAR 1998
REVENUES. Our revenues for fiscal year 1999 increased by $298.2 million, or 63%, compared to revenues for fiscal year 1998. The number of individuals we managed continued to increase in fiscal year 1999 as we obtained new customers and our current customers continued to increase their membership and utilization levels. New customer contracts resulted from increased marketing efforts and the expansion of our sales and marketing department. Contracts with new customers in fiscal year 1999 generally included all pharmacy benefit management products we offer, including claims processing, mail and clinical.
Our revenues from claims processing increased $203.5 million, or 64%, compared to the prior year. The increase resulted from the addition of new individuals and an increase in use of our services by existing customers. The increase in new individuals resulted in an increase in pharmacy claims processed from 38.3 million in fiscal year 1998 to 50.6 million in fiscal year 1999, a 32% increase. Virtually all of the new fiscal year 1999 customer contracts use our pharmacy network, which has shifted a larger percentage of our total revenues to claims processing. Revenues from mail services increased $48.9 million, or 63%, compared to the prior year. The increase resulted primarily from the new individuals added during fiscal year 1999. The increase in new individuals resulted in an increase in mail prescriptions dispensed from 839,000 in fiscal year 1998 to 1.3 million in fiscal year 1999, a 54% increase. Revenues from clinical services increased $45.8 million, or 57%, compared to the prior year. The increase resulted primarily from the new individuals added and the additional claims processed during fiscal year 1999 compared to the prior year.
COST OF REVENUES. Our cost of revenues for fiscal year 1999 increased by $287.2 million, or 63%, compared to the prior fiscal year. This increase primarily resulted from the additional costs associated with our claims processing growth and the new customers that are using our retail pharmacy network. As a percentage of revenues, cost of revenues was 95.9% in fiscal year 1999 compared to 95.6% in fiscal year 1998.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Our selling, general and administrative expense for fiscal year 1999 increased by $3.9 million, or 38%, compared to fiscal year 1998. This increase was the result of our expansion of our sales and marketing activities, as well as increases in administrative and support staff levels and salaries and benefits in response to volume growth in all programs. In spite of the increase, selling, general and administrative expenses as a percentage of revenues decreased from 2.1% for in fiscal year 1998 to 1.8% in fiscal year 1999 as the result of greater economies of scale and due to the increase in revenues associated with our claims processing services. Additional revenues generated by customers using our network pharmacy providers typically do not result in an increase in selling, general and administrative expenses.
INTEREST INCOME AND INTEREST EXPENSE. Our interest income, net of interest expense, was $2.7 million in both fiscal years 1999 and 1998. We incurred no interest expense in fiscal year 1999 since we had no outstanding indebtedness until March 31, 1999. We maintained higher cash balances during the first eight months of fiscal year 1999 compared to fiscal year 1998. In December 1998, we purchased Baumel-Eisner Neuromedical Institute for $25.0 million. Therefore, interest income declined in the fourth quarter of fiscal year 1999 compared to the first three quarters. We invest our excess cash in money market funds and high-grade commercial paper.
INCOME TAXES. In fiscal years 1999 and 1998, our income tax expense approximated an effective tax rate of 38%.
FISCAL YEAR 1998 COMPARED TO FISCAL YEAR 1997
REVENUES. Our revenues for fiscal year 1998 increased by $220.2 million, or 86%, compared to revenues for fiscal year 1997. The number of individuals we managed continued to increase in fiscal year 1998 as we obtained new customers and our current customers continued to increase their membership and utilization levels. New customer contracts resulted from increased marketing efforts and the expansion of our sales and marketing department. Contracts with new customers in fiscal year 1998 generally included all pharmacy benefit management products we offer, including claims processing, mail and clinical.
Our revenues from claims processing increased $175.8 million, or 124%, compared to the prior year. The increase resulted from the addition of new individuals and an increase in use of our services by existing customers. The increase in new individuals resulted in an increase in pharmacy claims processed from 26.6 million in fiscal year 1997 to 38.3 million in fiscal year 1998, a 44% increase. Virtually all of the new fiscal year 1998 customer contracts use our pharmacy network which has shifted a larger percentage of our total revenues to claims processing. Revenues from mail services increased $18.4 million, or 31%, compared to the prior
year. The increase resulted primarily from the new individuals added during fiscal year 1998. The increase in new individuals resulted in an increase in mail prescriptions dispensed from 677,000 in fiscal year 1997 to 839,000 in fiscal year 1998, a 24% increase. Revenues from clinical services increased $26.1 million, or 48%, compared to the prior year. The increase resulted primarily from the new individuals added and the additional claims processed during fiscal year 1998 compared to the prior year.
COST OF REVENUES. Our cost of revenues for fiscal year 1998 increased by $210.4 million, or 86%, compared to the prior fiscal year. This increase primarily resulted from the additional costs associated with our claims processing growth. As a percentage of revenues, cost of revenues was 95.6% in fiscal year 1998 compared to 95.7% in fiscal year 1997.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Our selling, general and administrative expenses for fiscal year 1998 increased by $2.8 million, or 38%, compared to fiscal year 1997. This increase was the result of our expansion of our sales and marketing capabilities, as well as increases in administrative and support staff functions in response to volume growth in all programs. In spite of the dollar increase, our selling, general and administrative expenses as a percentage of revenues decreased from 2.9% in fiscal year 1997 to 2.1% in fiscal year 1998 as the result of greater economies of scale and due to the increase in revenues associated with our claims processing services. Additional revenues generated by customers using our network pharmacy providers generally do not result in an increase in selling, general and administrative expenses.
INTEREST INCOME AND INTEREST EXPENSE. Our interest income, net of interest expense, for fiscal year 1998 increased $1.6 million compared to fiscal year 1997. The increase resulted from cash management programs which used our short-term excess cash to generate interest income through investment in money market funds and high grade commercial paper. In addition, our cash balance throughout fiscal year 1998 included the $10.0 million proceeds from the June 1996 issuance of our Series B preferred stock and the $19.1 million net proceeds from our October 1996 initial public offering. A portion of the proceeds was used to retire debt and, as a result, interest expense decreased by $378,000. In fiscal year 1997, the proceeds from the offerings were available for only a portion of the year.
MERGER COSTS. In February 1998, we completed a merger with Innovative Medical Research, Inc. and issued 876,078 shares and options to purchase 23,922 shares of our common stock in exchange for all the outstanding shares and options of Innovative Medical Research, Inc. The merger was accounted for as a pooling of interests and, accordingly, prior period consolidated financial statements were restated to include the combined results of operations, financial position and cash flows of Innovative Medical Research, Inc. as though it had always been a part our company. In connection with the merger, we recorded a charge to operating expenses of $689,000 -- $427,000 after taxes, or $.04 per common share on a dilutive basis -- for professional fees and other merger-related costs pertaining to the transaction.
INCOME TAXES. We had income tax loss carryforwards available to partially offset income generated for fiscal year 1997 and, as a result, we recorded income tax expense of $1.6 million or 33% of income before income taxes. For fiscal 1998, we recorded tax expense of $4.9 million at
a rate of 38% of income before income taxes. The tax loss carryforwards were fully utilized prior to fiscal year 1998.
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 1999, we had working capital of $1.1 million. While we have $149.0 million of accounts payable, the majority of these obligations are not due until cash is collected from our customers. Our net cash provided by operating activities was $15.4 million, $14.5 million and $29.0 million for the fiscal years ended 1997, 1998 and 1999, respectively. The significant increases in net cash provided by operating activities resulted primarily from the income we generated and due to the timing of receivables and payables resulting from our continued growth. Cash we used in investing activities was $3.1 million, $6.5 million and $97.3 million for the fiscal years ended 1997, 1998 and 1999, respectively. Such investing activities included purchases of property, plant and equipment associated with growth and expansion of our facilities, as well as cash paid for acquisitions. In December 1998, we used $24.7 million, net of cash acquired, for the acquisition of Baumel-Eisner Neuromedical Institute, Inc. In March 1999, we used $65.0 million, net of $5.0 million cash acquired, for the acquisition of Foundation Health Pharmaceutical Services.
Historically, we have been able to fund our operations and continued growth through cash flow from operations. In fiscal years 1997, 1998 and 1999, our operating cash flow funded our capital expenditures and our short-term excess cash was invested in money market funds and high grade commercial paper. We anticipate that cash flow from operations, combined with our current cash balances and amounts available under our credit facility, will be sufficient to meet our internal operating requirements and expansion programs, including capital expenditures, for at least the next 18 months. However, if we successfully continue our expansion, acquisition and alliance plans, we may be required to seek additional debt or equity financing in order to achieve these plans.
CREDIT FACILITY
On March 31, 1999, we entered into a senior revolving credit facility with a group of lenders. The credit facility consists of a $75.0 million, three year revolving credit facility. On March 31, 1999, we borrowed $50.0 million under the credit facility to fund the acquisition of Foundation Health Pharmaceutical Services. Each of our subsidiaries has guaranteed the credit facility. The lenders received a first priority security interest in our subsidiaries' capital stock and negative pledges on accounts receivable and other assets.
Interest on the credit facility accrues at a specified margin above the London Interbank Offered Rate, or LIBOR, or an alternate base rate. The alternate base rate is the bank's prime rate or the federal funds rate plus 0.5%. For LIBOR loans the applicable margin is 1.75% per annum as of April 1, 1999.
The credit facility contains usual and customary affirmative and negative covenants, including limitations on liens, debts, dividends, capital expenditures, mergers, acquisitions and sale of assets. Covenants also include a specified minimum net worth, maximum leverage ratio and a
minimum interest coverage ratio. The credit facility contains customary events of default including:
o nonpayment of principal, interest, fees or other amounts;
o violation of covenants;
o inaccuracy of representations and warranties;
o default under other indebtedness;
o bankruptcy and other insolvency events;
o material judgements;
o ERISA matters; and
o change of control without the lender's prior written consent.
RECENT ACCOUNTING PRONOUNCEMENTS
We adopted Statement of Financial Accounting Standards ("SFAS") 130, "Reporting Comprehensive Income," effective April 1, 1998. SFAS 130 established standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as the total of net income and all other non-owner changes in equity. We do not have any non-owner changes in equity other than net income. Comprehensive income will be reported in our consolidated statement of stockholders' equity.
We adopted SFAS 131, "Disclosure about Segments of an Enterprise and Related Information," effective April 1, 1998. This pronouncement changes the requirements under which public businesses must report segment information. The objective of the pronouncement is to provide information about a company's different types of business activities and different economic environments. SFAS 131 requires companies to select segments based on their internal reporting system. We provide integrated health benefit management services to our customers, and these services account for substantially all of our net revenues. Such services are typically negotiated under one contract with the customer. Therefore, our operations will continue to be reported in one segment.
We adopted SFAS 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," as of April 1, 1998. This pronouncement revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans; however, it does require additional information on changes in the benefit obligations and fair values of plan assets in order to facilitate financial analysis. Currently, we do not have any pension or postretirement benefit plans; thus, the adoption of SFAS 132 has not had a material impact on our disclosures.
IMPACT OF INFLATION
Changes in prices charged by manufacturers and wholesalers for pharmaceuticals we dispense affect our cost of revenues. Historically, we have been able to pass the effect of such price changes to our customers under the terms of our agreements. As a result, changes in pharmaceutical prices due to inflation have not adversely affected our company.
YEAR 2000 READINESS DISCLOSURE
Our operations require our computer systems and information technology to work effectively. In fiscal year 1998, we began addressing the year 2000 issue by forming a year 2000 project team. The year 2000 issue is the result of computer programs written using two digits rather than four digits to define "date" fields. Information systems have time-sensitive operations that, as a result of this date field limitation, could disrupt business activities in the normal business cycle. For example, some computers that are not year 2000 compliant may interpret the year 2000 as the year 1900. This treatment could result in significant miscalculations when processing critical date-sensitive information relating to dates after December 31, 1999.
In the quarter ending June 30, 1998, we completed the "inventory" portion of our year 2000 project. We documented all internal hardware, software or equipment that was date-sensitive. In the quarter ending September 30, 1998, we completed the second stage of the year 2000 project, which involved assessing all of the items that had been "inventoried" to determine whether they were year 2000 compliant. This assessment stage also included surveying all external vendors and customers with whom we transact business to determine whether their systems were year 2000 compliant. In the quarter ending December 31, 1998, we completed the third stage of the year 2000 project, which involved the development of code to convert systems that are not year 2000 compliant to year 2000 compliant systems. We successfully completed the implementation phase on March 31, 1999 via upgrade or replacement of all non-compliant systems. While all core systems are currently considered to be compliant, further maintenance testing and certifications will continue throughout 1999.
The potential impact of the year 2000 issue depends not only on the corrective measures we have undertaken, but also on the ways in which the year 2000 issue is addressed by third parties with whom we interact or upon whom we are dependent, including individual retail pharmacies, health plan sponsors and pharmaceutical manufacturers. We believe that our greatest risk with respect to year 2000 issues relates to failures by third parties to be year 2000 compliant. We have received responses from approximately 25% of the over 20,000 third parties we contacted. We cannot make any assurance that the software and systems of other companies with which we transact business will become year 2000 compliant in a timely manner. Any such failures could have a material adverse effect on our systems and operations. With respect to the systems we directly use, we believe our greatest exposure to the year 2000 issue involves our claims processing operations, which rely on computers to process prescription claims. We have installed a vendor upgrade and have substantially completed compliance testing on the upgrade. However, any failure of these systems to be year 2000 compliance may have a material adverse effect on us.
Our costs, as of March 31, 1999, related to our year 2000 project and related compliance efforts, total approximately $300,000. We have expensed these costs as incurred in fiscal 1999. We expect our total costs, both internal and external, associated with our year 2000 readiness process will range from $500,000 to $600,000. We anticipate funding these costs with cash generated from operations. We do not believe that these costs are or will be material to our results of operations or financial condition.
Although we have substantially completed our compliance testing and remediation, we have not developed a likely worst case year 2000 scenario. We are, however, in the process of developing contingency plans for the risks of our failure, or the failure of third parties, to be year 2000 compliant. We intend to complete the contingency plans for the year 2000 issue during the third quarter of calendar year 1999. Due to the inability to predict all of the potential problems that may arise from the year 2000 issue, we cannot be sure that we will be able to anticipate all contingencies.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not engage in trading market risk sensitive instruments and do not purchase as investments, as hedges, or for purposes "other than trading" instruments that are likely to expose us to market risk, whether it be from interest rate, foreign currency exchange, commodity price or equity price risk. We have issued no debt instruments, entered into no forward or futures contracts, purchased no options and entered into no swaps.
Our primary market risk exposure is that of interest rate risk. A change in LIBOR or the Prime Rate as set by NationsBank, N.A. , would affect the rate at which we could borrow funds under our credit facility.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is found on pages through hereof.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item will be incorporated by reference from our definitive proxy statement for our 1999 annual meeting of stockholders to be filed with the Securities and Exchange Commission not later than 120 days following our fiscal year pursuant to Regulation 14A (the "Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be incorporated by reference from the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item will be incorporated by reference from the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item will be incorporated by reference from the Proxy Statement.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The response to this portion of Item 14 is submitted as a separate section of this report on page. (b) Reports on Form 8-K. We filed reports on Form 8-K and Form 8-K/A dated March 31, 1999, relating to its acquisition of Foundation Health Pharmaceutical Services, Inc. (c) Exhibits Required by Item 601 of S-K: See index to exhibits on pages 37 - 40.
Exhibits and Financial Statement Schedules
Exhibit No. Exhibits
2.1(a) --- Stock Purchase Agreement, dated effective as of December 1, 1998, by and among Advance Paradigm, Inc. (the "Company"), Baumel-Eisner Neuromedical Institute, Inc., Barry Baumel, M.D. and Larry S. Eisner, M.D.
2.2(b) --- Purchase Agreement, dated as of February 26, 1999, among Foundation Health Systems, Inc., Foundation Health Corporation, Foundation Health Pharmaceutical Services, Inc., Integrated Pharmaceutical Services, Inc. and the Company.
3.1(c) --- Amended and Restated Certificate of Incorporation of the Company.
3.2(c) --- Certificate of Amendment to the Certificate of Incorporation of the Company.
3.3(c) --- Certificate of Correction to the Amendment to the Certificate of Incorporation of the Company.
3.4(c) --- Amended and Restated Bylaws of the Company.
3.5(c) --- Certificate of Incorporation of Advance Pharmacy Services, Inc.
3.6(c) --- Certificate of Amendment to the Certificate of Incorporation of Advance Pharmacy Services, Inc.
3.7(c) --- Certificate of Correction to the Certificate of Amendment to the Certificate of Incorporation of Advance Pharmacy Services, Inc.
3.8(c) --- Certificate of Amendment to the Certificate of Incorporation of Advance Pharmacy Services, Inc.
3.9(c) --- Bylaws of Advance Pharmacy Services, Inc.
4.1(d) --- Specimen Certificate for shares of Common Stock, $0.01 par value, of the Company.
4.2(e) --- Amended and Restated Incentive Stock Option Plan.
4.3(e) --- Incentive Stock Option Plan.
4.4(c) --- Warrant Agreement, dated as of September 12, 1996, by and between the Company and VHA, Inc.
4.5(c) --- Form of Agreement and Plan of Merger.
4.6(f) --- 1997 Nonstatutory Stock Option Plan.
4.7(b) --- Warrant Agreement, dated as of February 26, 1999, by and between the Company and Foundation Health Systems, Inc.
4.8(i) --- Warrant Agreement, dated as of February 25, 1999, by and between the Company and Arkansas BlueCross BlueShield
4.9(i) --- Warrant Agreement, dated as of June 12, 1998, by and between the Company and Wellmark, Inc.
10.1(c) --- Managed Pharmaceutical Agreement, dated November 1, 1993, by and between Advance Data and the Mega Life & Health Insurance Company.
10.2(c) --- Nondisclosure/Noncompetition Agreement, dated August 4, 1993, between the Company, Advance Data, Advance Mail and David D. Halbert.
10.3(c) --- Nondisclosure/Noncompetition Agreement, dated August 4, 1993, between the Company, Advance Mail, Advance Data and Jon S. Halbert.
10.4(c) --- Nondisclosure/Noncompetition Agreement, dated August 4, 1993, between the Company, Advance Mail, Advance Data and Danny Phillips.
10.5(d) --- Employment Agreement, effective as of December 1, 1996, by and between Advance Clinical (formerly ParadigM) and Joseph J. Filipek, Jr. and, for the limited purposes of Sections 3(d), 3(g) and 3(h) thereof, the Company.
10.6(d) --- Employment Agreement, effective as of November 14, 1996, by and between the Company and John H. Sattler.
10.7(d) --- Employment Agreement, effective as of June 17, 1996, by and between the Company and Ernest Buys.
10.8(c) --- Employment Agreement, effective as of February 15, 1996, by and between the Company and Alan T. Wright.
10.9(c) --- Form of Health Benefit Management Services Agreement.
10.10(c) --- Sublease, dated May 2, 1996, between Lincoln National Life Insurance Company and Advance Data.
10.11(c) --- Lease, dated March 6, 1994, by and between Hill Management Services, Inc. and Advance Clinical (formerly ParadigM).
10.12(c) --- Lease Agreement, dated as of February 24, 1989, as amended November 30, 1992, and December __, 1992, by and between TRST Las Colinas, Inc. and Advance Health Care.
10.13(c) --- Managed Pharmacy Benefit Services Agreement, dated September 1, 1995, between the Company and BCBS of Texas.
10.14(g) --- Agreement and Plan of Merger, dated February 9, 1998, by and among the Company, IMR, Inc. and Innovative Medical Research, Inc., Walter Stewart, Richard Lipton, The Lianna Lipton Trust, The Justin Lipton Trust, Stuart Bell, The Curren Bell Trust, The Kylie Bell Trust and The Ian Bell Trust.
10.15(h) --- Consulting Agreement, effective as of December 15, 1998, by and between the Company and David A. George.
10.16(b) --- Pharmacy Benefit Services Agreement, effective as of April 1, 1999, by and between the Company, Foundation Health Systems, Inc. and Integrated Pharmaceutical Services, Inc.
10.17(b) --- Credit Agreement, dated as of March 31, 1999, among the Company, the banks named in the Credit Agreement, NationsBanc Montgomery Securities LLC and NationsBank, N.A.
10.18(b) --- Guaranty, dated as of March 31, 1999, by each subsidiary of the Company, in favor of NationsBank, N.A.
10.19(i) --- Commercial Lease Agreement, commencing November 1, 1998, by and between Crin-Richardson I, L.P. and the Company.
11.1(i) --- Statement regarding computation of per share earnings.
21.1(i) --- Subsidiaries of the Company.
23.1(i) --- Consent of Arthur Andersen LLP.
27.1(i) --- Financial Data Schedule.
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(a) Previously filed in connection with the Company's Current Report on Form 8-K, dated December 29, 1998, and incorporated herein by reference.
(b) Previously filed in connection with the Company's Current Report on Form 8-K, dated April 12, 1999, and incorporated herein by reference.
(c) Previously filed in connection with the Company's Registration Statement on Form S-1 filed October 8, 1996 (No. 333-06931), and incorporated herein by reference.
(d) Previously filed in connection with the Company's Form 10-K for the year ended March 31, 1997, and incorporated herein by reference.
(e) Previously filed in connection with the Company's Registration Statement on Form S-8 filed September 5, 1997 (No. 333-34999), and incorporated herein by reference.
(f) Previously filed in connection with the Company's Form 10-Q for the three months ended June 30, 1997, and incorporated herein by reference.
(g) Previously filed in connection with the Company's Current Report on Form 8-K, dated February 9, 1998, and incorporated herein by reference.
(h) Previously filed in connection with the Company's Form 10-Q for the three months ended December 31, 1998, and incorporated herein by reference.
(i) Filed herewith.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on June 23, 1999 on its behalf by the undersigned, thereunto duly authorized.
ADVANCE PARADIGM, INC.
By: /s/ David D. Halbert --------------------------- David D. Halbert Chairman of the Board, President and Chief Executive Officer
Each person whose signature appears below hereby authorizes David D. Halbert and Danny Phillips or either of them, as attorneys-in-fact to sign on his behalf, individually, and in each capacity stated below and to file amendments and/or supplements to the Annual Report on Form 10-K.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dated indicated.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Advance Paradigm, Inc.:
We have audited the accompanying consolidated balance sheets of Advance Paradigm, Inc. (a Delaware corporation) and subsidiaries as of March 31, 1998 and 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended March 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Advance Paradigm, Inc. and subsidiaries as of March 31, 1998 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 1999, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Dallas, Texas, May 17, 1999
ADVANCE PARADIGM, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
ASSETS
The accompanying notes are an integral part of these consolidated financial statements.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED MARCH 31, 1997, 1998 AND 1999
The accompanying notes are an integral part of these consolidated financial statements.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
SUPPLEMENTARY INFORMATION:
Cash paid for interest totaled approximately $445,000, $67,000 and $0 in 1997, 1998 and 1999, respectively.
The Company made income tax payments of $19,000, $5,100,000 and $5,900,000 in 1997, 1998 and 1999, respectively.
The accompanying notes are an integral part of these consolidated financial statements.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL:
Advance Paradigm, Inc. (the "Company"), a Delaware corporation, is a leading independent provider of health benefit management services, providing integrated pharmacy benefit management, disease management and clinical research programs. The Company markets its services to managed care organizations, third-party health plan administrators, insurance companies, government agencies, employer groups and labor union-based trusts. In addition, the Company transacts business with pharmaceutical manufacturers as both suppliers and customers. During the year ended March 31, 1999, the Company purchased two companies for cash. Foundation Health Pharmaceutical Services, Inc. ("FHPS") was acquired on March 31, 1999 for $70 million. FHPS was the pharmacy benefit management business of Foundation Health Systems, Inc. On December 1, 1998, Baumel-Eisner Neuromedical Institute ("Baumel-Eisner") was acquired for $25 million. Baumel-Eisner was a privately held clinical trials company based in South Florida. (See Note 3)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Consolidation
The accompanying consolidated financial statements include the accounts of API and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include overnight investments, money market accounts and high-grade commercial paper with original maturities of three months or less.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
Inventories
Inventories consist of purchased pharmaceuticals stated at the lower of cost or market under the first-in, first-out method.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over estimated useful lives ranging from three to twenty years. Amortization of leasehold improvements is computed over the lives of the assets or the lease terms, whichever is shorter. Major renewals and betterments are added to the property and equipment accounts while costs of repairs and maintenance are charged to operating expenses in the period incurred. The cost of assets retired, sold or otherwise disposed of and the applicable accumulated depreciation are removed from the accounts, and the resultant gain or loss, if any, is reflected in the statement of operations.
Intangible Assets
Intangible assets consist of goodwill, customer contracts acquired and non-compete agreements. Goodwill represents the excess of cost over the estimated fair value of tangible net assets acquired. Goodwill is amortized on a straight-line basis over periods from 25 to 40 years with a weighted average of 29 years. Customer contracts and non-compete agreements are amortized over 10 to 15 years. Amortization expense was $346,000 in each of the years ended March 31, 1997 and 1998 and $691,000 the year ended March 31, 1999 and is included in selling, general and administrative expenses.
Impairment of Long-Lived Assets
The Company evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets, including goodwill, may warrant revision or that the remaining balance of an asset may not be recoverable. The assessment of possible impairment is based on the ability to recover the carrying amount of the asset from expected future cash flows on an undiscounted basis. If the assessment indicates that the carrying amount of the asset exceeds the undiscounted cash flows, an impairment has occurred. The impairment is calculated as the total by which the carrying amount of the asset exceeds its fair value. The fair value of long-lived assets and goodwill is estimated based on quoted market prices, if available, or the expected total value of the cash flows, on a discounted basis. The Company recorded no impairment charges in fiscal 1997, 1998 or 1999.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
Fair Value of Financial Instruments
The carrying values of cash, receivables, payables and accrued liabilities approximate the fair values of these instruments because of their short-term maturities. The Company's bank debt was borrowed on March 31, 1999 and, therefore, the estimated fair value and the carrying value is the same.
Other Noncurrent Liabilities
Other liabilities is comprised of deposits from certain customers in connection with pharmacy benefit contracts.
Revenue Recognition
Revenues from the dispensing of pharmaceuticals from the Company's mail service pharmacy are recognized when each prescription is shipped. Revenues from sales of prescription drugs by pharmacies in the Company's nationwide network and claims processing fees are recognized when the claims are adjudicated. At the point-of-sale, the pharmacy claims are adjudicated using the Company's on-line claims processing system. When the Company has an independent obligation to pay its network pharmacy providers, the Company includes payments from plan sponsors for these benefits as revenues and payments to its pharmacy providers as cost of revenues. If the Company is only administering plan sponsors' network pharmacy contracts, the Company records the claims processing service fees as revenues. Rebate revenues are recognized as they are earned in accordance with contractual agreements. Certain of these revenues are based on estimates which are subject to final settlement with the contract party. These estimates are reviewed and revised as settled. Revenues from certain disease management and health benefit management products are reimbursed at predetermined contractual rates based on the achievement of certain milestones.
Cost of Revenues
Cost of revenues includes product costs, pharmacy claims payments and other direct costs associated with the sale and dispensing of prescriptions. Certain of these expenses are recognized based on estimates which are subject to final settlement with the contract party. These estimates are reviewed and revised as settled.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
Net Income Per Share
Net income per share is computed using the weighted average number of common and dilutive shares outstanding during the period. A reconciliation of the numerators and denominators of the basic and diluted per-share computations follows:
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
Reclassification
Certain prior year amounts have been reclassified to conform with current year presentation.
Recent Accounting Pronouncements
The Company adopted Statement of Financial Accounting Standards ("SFAS") 130, "Reporting Comprehensive Income" effective April 1, 1998. SFAS 130 established standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as the total of net income and all other non-owner changes in equity. The Company does not have any non-owner changes in equity other than net income. Comprehensive income has been reported in the consolidated statement of stockholders' equity.
The Company has adopted SFAS 131, "Disclosure about Segments of an Enterprise and Related Information," effective April 1, 1998. This pronouncement changes the requirements under which public businesses must report segment information. The objective of the pronouncement is to provide information about a company's different types of business activities and different economic environments. SFAS 131 requires companies to select segments based on their internal reporting system. The Company provides integrated health benefit management services to our customers, and these services account for substantially all of the Company's revenues. Such services are typically negotiated under one contract with the customer. Therefore, the Company's operations will continue to be reported in one segment.
The Company adopted SFAS 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," as of April 1, 1998. This pronouncement revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans, however, it does require additional information on changes in the benefit obligations and fair values of plan assets in order to facilitate financial analysis. The Company does not have any pension or postretirement benefit plans, therefore the adoption of SFAS 132 did not have a material impact on the Company's disclosures.
3. ACQUISITIONS
In December 1998, the Company acquired the outstanding stock of Baumel-Eisner for $25 million in cash. The acquisition has been accounted for using the purchase method of accounting. Baumel-Eisner's results have been included in the Company's consolidated statements of operations since December 1998. The purchase price was allocated to the net assets acquired, primarily goodwill, based on their estimated fair values. The excess of the purchase price over the fair value of the net assets acquired (goodwill) was approximately $24.2 million and is being amortized on a straight-line basis over 25 years.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. ACQUISITIONS: (CONTINUED)
On March 31, 1999, the Company acquired the outstanding stock of FHPS for $70 million in cash and warrants to purchase 200,000 shares of its $0.01 par value common stock ("Common Stock"). The Company valued such warrants at fair market value based upon the Black Scholes valuation model. Such warrants are valued at $2.5 million. The acquisition has been accounted for using the purchase method of accounting. FHPS' results have not been included in the Company's results because the transaction occurred on the last day of the Company's fiscal year. The purchase price was allocated to Goodwill and other intangible assets. Goodwill was valued at approximately $68.3 and is being amortized on a straight-line basis over 30 years. The purchase price allocation used in the preparation of the accompanying financial statements is preliminary. The Company's management is assessing the net realizable value of certain contracts acquired and reviewing the assets acquired for other intangible assets. As a result, the purchase price allocation may be subsequently revised.
The following unaudited pro forma information presents the results of operations of the Company as if the FHPS acquisition had taken place at the beginning of the periods presented (in thousands, except per share amounts):
In February 1998, the Company completed a merger with IMR, a privately held clinical trial and survey research firm based in Towson, Maryland. The Company issued 876,078 shares and options to purchase 23,922 shares of its Common Stock in exchange for all the outstanding shares and options of IMR. The merger constituted a tax-free reorganization and has been accounted for as a pooling of interests under Accounting Principles Board Opinion No. 16 ("APB 16"). Accordingly, all prior period consolidated financial statements presented have been restated to include the combined results of operations, financial position and cash flows of IMR as though it had always been a part of the Company.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. ACQUISITIONS: (CONTINUED)
The results of operations for the separate companies and the combined amounts presented in the consolidated financial statements follow.
In connection with the merger, the Company recorded in the fourth quarter of fiscal 1998 a charge to operating expenses of $689,000 ($427,000 after taxes, or $.04 per common share on a dilutive basis) for professional fees and other merger-related costs pertaining to the transaction.
4. PROPERTY AND EQUIPMENT:
Property and equipment consisted of the following:
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. DEBT:
On March 31, 1999, the Company entered into a senior credit facility with a group of lenders. The credit facility consists of a $75 million, 3-year revolving credit facility. On March 31, 1999, the Company borrowed $50 million under the credit facility to fund the acquisition of FHPS. Outstanding borrowings will mature on March 31, 2002. Each of the Company's subsidiaries has guaranteed the credit facility. The lenders received a first priority security interest in the subsidiaries' capital stock and negative pledges on accounts receivable and other assets.
Interest on the credit facility accrues at a specified margin above the London Interbank Offered Rate, or LIBOR, or an alternate base rate. The alternate base rate is the bank's prime rate or the federal funds rate plus 0.5%. For LIBOR loans the applicable margin is 1.75% per annum as of April 1, 1999.
The credit facility contains usual and customary affirmative and negative covenants, including limitations on liens, debts, dividends, capital expenditures, mergers, acquisitions and sale of assets. Covenants also include a specified minimum net worth, maximum leverage ratio and a minimum interest coverage ratio.
6. LEASES:
The Company leases office and dispensing facility space, equipment, and automobiles under various operating leases. The Company was obligated to make future minimum payments under noncancelable operating lease agreements as of March 31, 1999, as follows:
Total rent expense incurred in the years ended March 31, 1997, 1998 and 1999 was approximately $2,313,000, $3,096,000 and $ 4,018,000, respectively.
7. COMMITMENTS AND CONTINGENCIES:
The Company has entered into long-term employment and non-compete agreements with certain management employees. These employment agreements provide for certain minimum payments should the agreements be terminated.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The pharmacy industry is governed by extensive federal and state laws and regulations. The regulatory requirements with which the Company must comply in conducting its business vary from state to state. Management believes the Company is in substantial compliance with, or is in the process of complying with, all existing laws and regulations material to the operation of its business. In management's opinion, any events of noncompliance would not have a material adverse effect on the results of operations or financial condition of the Company.
8. CONCENTRATION OF BUSINESS:
A significant portion of the Company's revenues result from contracts with customers. These contracts normally have terms from one to five years with renewal options.
One customer of the Company accounted for approximately 21% and 18% of the Company's revenues for the years ended March 31, 1998 and 1999, respectively. Another customer accounted for approximately 15% of the Company's revenues for the year ended March 31, 1998, but revenues from this customer did not exceed 10% of the Company's revenues for the year ended March 31, 1999. No other customer accounted for over 10% of the Company's revenues in fiscal years 1998 or 1999. Effective April 1, 1999, the Company entered into a Pharmacy Benefit Services Agreement with Foundation Health Systems, Inc. ("FHS"). Under the terms of the Service Agreement the Company will provide pharmacy services to FHS' affiliated health plans. In fiscal 2000, we expect that FHS will become the Company's largest customer.
9. STOCK TRANSACTIONS:
Series B Preferred Stock
On June 25, 1996, the Company issued a total of 4,444 shares of $.01 par value, Series B convertible preferred stock ("Series B Preferred Stock") to a customer at a price of $2,250 per share. Shares of the Series B Preferred Stock could be converted by the holder into 250 fully-paid and non-assessable shares of Common Stock. On April 13, 1998, the holders of the Series B Preferred Stock converted all of the shares into 1,111,111 shares of Common Stock.
Common Stock
On October 7, 1996, the Company amended and restated its Certificate of Incorporation to, among other things, increase the number of authorized shares of its $.01 par value common stock ("Common Stock") to 25,000,000 and the number of shares of its preferred stock to 5,000,000, of which 5,000 shares are designated as Series B Preferred Stock. On October 8, 1996, the Company effected a 250-for-one stock split of the Company's Common Stock. Accordingly, all share and per share amounts have been adjusted to reflect the stock split as though it had occurred at the beginning of the initial period presented.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STOCK TRANSACTIONS: (CONTINUED)
On October 8, 1996, the Company completed the offering ("Offering") of its Common Stock. The Company sold 2,397,067 shares of its Common Stock at a price of $9.00 per share, prior to underwriting discount and other offering expenses. In connection with the Offering, the Company's redeemable Series A cumulative convertible preferred stock ("Series A Preferred Stock") automatically converted into 2,500,000 shares of Common Stock.
In connection with the IMR merger, the Company issued 876,078 shares of its Common Stock in exchange for all the outstanding shares of IMR. Under the provisions of APB 16, the shares are reflected as outstanding as though IMR had always been a part of the Company.
Warrants to Purchase Common Stock
The Company has issued warrants to four of our key health plan sponsor customers representing the right to purchase up to a total of 357,180 shares of our Common Stock at prices per share ranging from $8.10 to $35.50. The right to exercise each warrant vests in equal installments on the first five anniversaries of the date of grant so long as the customer's service agreement remains in effect. In addition, during the year ended March 31, 1997, the Company agreed to issue warrants to purchase 281,250 shares of its Common Stock to one customer contingent upon future expansion of member lives. As of March 31, 1999, none of these warrants have been earned or issued.
Prior to November of 1997, the Company accounted for these warrant agreements under the provisions of SFAS 123 and the related Emerging Issues Task Force ("EITF") 96-3. These pronouncements require that all stock issued to non-employees be accounted for based on the fair value of the consideration received or the fair value of equity instruments issued. In addition, they require that the fair value be measured on the date the parties come to a "mutual understanding of the terms of the arrangement and agree to a binding contract" (i.e. the grant date). If the number of equity instruments is contingent upon the outcome of future events, the number of instruments that should be accounted for when determining the fair value of the transaction should be based on the best available estimate of the number of instruments expected to be issued. In management's opinion, the fair value of the warrants at the date of the agreements was not material.
Subsequent to November 20, 1997, the Company follows the guidance of EITF 96-18, under which the measurement date is the earlier of the performance commitment date or completed performance date. The Company chose not to retroactively apply EITF 96-18 to the eligible warrants, but chose to apply this EITF prospectively to new arrangements and any modifications of existing arrangements.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STOCK TRANSACTIONS: (CONTINUED)
The Company has reserved shares of Common Stock at March 31, 1999, for the following:
10. STOCK OPTION PLAN:
At March 31, 1999, the Company has three stock-based compensation plans: Incentive Stock Option Plan, Amended and Restated Incentive Stock Option Plan and the 1997 Nonstatutory Stock Option Plan (the "Plans"). The Plans provide for the granting of qualified stock options and incentive options to officers, directors, advisors and employees of the Company. The options must be granted with exercise prices which equal or exceed the market value of the Common Stock at the date of grant. As of March 31, 1999, the number of shares of Common Stock issuable under the Plans may not exceed 2,837,750 shares. The Plans are administered by a compensation committee appointed by the Board of Directors of the Company.
The stock options generally vest over 5-year periods. In the event of the sale or merger with an outside corporation gaining 50% or greater ownership, options granted to certain employees become 100% vested. The options are exercisable for a period not to exceed 10 years from the date of grant. As of March 31, 1999, 907,600 options were vested at exercise prices of $.65 to $35.63 per share.
SFAS 123 establishes a fair value-based method of accounting for stock-based compensation. The Company has elected to adopt SFAS 123 through disclosure with respect to employee stock-based compensation. The following table summarizes the Company's stock option activity.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. STOCK OPTION PLAN: (CONTINUED)
The following table reflects the weighted average exercise price and weighted average contractual life of various exercise price ranges of the 2,102,583 options outstanding as of March 31, 1999.
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average ranges of assumptions for the years ended March 31, 1997, 1998 and 1999, respectively: risk-free interest rates of 4.8% to 6.5%; expected lives of three to five years; expected volatility of 30% to 50%. The Company continues to account for stock based compensation under APB 25, "Accounting for Stock Issued to Employees", as allowed by SFAS 123. Had compensation cost for these plans been determined consistent with SFAS 123, the Company's net income and net income per share would have been reduced to the following pro forma amounts:
Because SFAS 123 method of accounting has not been applied to options granted prior to April 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. RELATED PARTY TRANSACTIONS:
In fiscal 1998, the Company entered into an agreement with Advance Capital Markets ("ACM") pursuant to which ACM agreed to act as financial advisor for the Company. In exchange for these professional services, the Company paid ACM a fee of $150,000 in 1998 in connection with the IMR transaction and $85,000 in connection with the Baumel-Eisner transaction. The fees paid are equivalent to or less than similar fees incurred in arm's-length transactions. The Managing Director of ACM is also a Director of the Company.
12. RETIREMENT PLAN BENEFITS:
The Company sponsors a retirement plan for all eligible employees, as defined in the plan document. The plan is qualified under Section 401(k) of the Internal Revenue Code. The Company is required to contribute at least 50% of the first 6% of salary deferral contributed by each participant. The Company's contributions to the plan amounted to approximately $129,000, $177,000 and $268,000 for the years ended March 31, 1997, 1998 and 1999, respectively.
13. INCOME TAXES:
The provision for income taxes for the years ended March 31, 1997, 1998 and 1999 differed from the amounts computed by applying the U.S. federal tax rate of 34 percent to pretax earnings as a result of the following:
Of the $7,780,000 provision for income taxes in 1999, $1,312,000 represents deferred income taxes and $6,468,000 represents the current portion.
ADVANCE PARADIGM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Deferred income taxes reflect the tax consequences on future years of temporary differences between the tax bases of assets and liabilities and their financial reporting bases and the potential benefits of certain tax carryforwards. The significant deferred tax assets and liabilities and the changes in those assets and liabilities are as follows:
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Advance Paradigm, Inc. and subsidiaries included in this Form 10-K and have issued our report thereon dated May 17, 1999. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule II is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Dallas, Texas May 17, 1999
S-1
ADVANCE PARADIGM, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
- ------------------------------------
(1) Uncollectible accounts written off, net of recoveries
(2) Includes $100,000 reflected in the acquisition of Baumel-Eisner
S-2
INDEX TO EXHIBITS
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(a) Previously filed in connection with the Company's Current Report on Form 8-K, dated December 29, 1998, and incorporated herein by reference.
(b) Previously filed in connection with the Company's Current Report on Form 8-K, dated April 12, 1999, and incorporated herein by reference.
(c) Previously filed in connection with the Company's Registration Statement on Form S-1 filed October 8, 1996 (No. 333-06931), and incorporated herein by reference.
(d) Previously filed in connection with the Company's Form 10-K for the year ended March 31, 1997, and incorporated herein by reference.
(e) Previously filed in connection with the Company's Registration Statement on Form S-8 filed September 5, 1997 (No. 333-34999), and incorporated herein by reference.
(f) Previously filed in connection with the Company's Form 10-Q for the three months ended June 30, 1997, and incorporated herein by reference.
(g) Previously filed in connection with the Company's Current Report on Form 8-K, dated February 9, 1998, and incorporated herein by reference.
(h) Previously filed in connection with the Company's Form 10-Q for the three months ended December 31, 1998, and incorporated herein by reference.
(i) Filed herewith. | 21,185 | 140,313 |
1000227_1999.txt | 1000227_1999 | 1999 | 1000227 | Item 1. Business.
General
TB Wood's Corporation (the "Company" or "TB Wood's") is an established designer, manufacturer and marketer of electronic and mechanical industrial power transmission products. The Company's products are sold to North American and international manufacturers and users of industrial equipment. Headquartered in Chambersburg, Pennsylvania, the 142 year-old business operates eleven production facilities with over 1,100 employees in the United States, Canada, Mexico, Germany, and Italy. The Company has a network of more than 700 select independent distributors with over 1,900 locations in North America.
History
TB Wood's Incorporated was founded in 1857, and entered the power transmission industry at the turn of the century. The Company was incorporated in 1995. In January 1996, a subsidiary of the Company merged with TB Wood's Incorporated ("TBW"), the original Pennsylvania Corporation that was formed in 1857, with TBW as the surviving corporation in the merger.
Since 1992, the Company has introduced 23 new electronic products or product line extensions, including ten such introductions in the most recent two years. These include a new line of full-featured drives which improve motor performance; extension to 20 horsepower of the Company's successful line of micro-inverters; and drives for motor sizes up to 700 horsepower. In 1998, the Company introduced a unique and high performance integrated motor-drive combination; and a line of customizable, cost-effective drives targeted for industrial Original Equipment Manufacturer ("OEM") applications. Since 1992, the company has introduced nine new mechanical products and product line extensions, including three mechanical belted drive products and four new coupling products.
The Company uses acquisitions and strategic alliances to enhance product offerings, gain access to technology and products, leverage fixed costs, and extend the Company's global reach. Since 1993 the company has completed eight acquisitions. In the electronics business the company acquired Plant Engineering Consultants, Inc., an established supplier of integrated drive systems for the fibers industry; Ambi-Tech Industries, Inc., a leading manufacturer of electronic brakes; and Graseby Controls Inc., a supplier of high-frequency drives for machine tool applications. In December 1997, the Company acquired Berges electronic GmbH in Germany, and it's subsidiary Berges electronic S.r.l. in Italy. The Berges companies are well-established drive developers, manufacturers and marketers, and are located in the two most important machinery markets in Europe. The Company's mechanical business acquisitions include several lines of flexible couplings and variable speed drives from Dana Corporation; Grupo Blaju S.A. de C.V., the leading Mexican manufacturer and marketer of belted drives; and Deck Manufacturing, a producer of gear couplings. The Company has strategic alliances with companies in Finland, France, Switzerland, Australia and Japan.
Industry Overview
The power transmission industry provides electronic and mechanical products used in manufacturing and material processing activities that transfer controlled power from a motor or engine to a machine. The power transmission industry consists of three product categories: mechanical power transmission components, gear boxes and electronic drives. The Company competes in the electronic drives and mechanical power transmission component's product categories.
Products
The products manufactured by the Company are classified into two segments, mechanical business and electronics business. The mechanical business segment includes belted drives and couplings. The electronics business segment includes electronic drives and electronic drive systems. Products of these segments are sold to distributors, original equipment manufacturers, and end users for manufacturing and commercial applications.
For further product information, refer to the consolidated financial statements and footnote No. 9 included in this Form 10-K.
Electronic Product Offering
The Company designs and manufactures Alternating Current ("AC") and Direct Current ("DC") electronic drives and integrated electronic drive systems that are marketed throughout North America and internationally. These products are used to control the speed, acceleration, and other operating characteristics of electric motors in manufacturing processes. The Company's standard AC electronic drive products, which represent most of its electronic drive product offering net sales, are programmable to meet the needs of specific applications with particular strengths in food processing, materials handling, packaging and general machinery applications. The Company's electronic products are designed to meet both North American and European standards. The Company's integrated electronic drive systems consist of uniquely configured AC and/or DC electronic drives, programmable logic controllers and in-house designed custom software. These systems are packaged in custom enclosures to meet the requirements of specific applications.
Mechanical Product Offering
The Company's mechanical product offering includes a full line of stock and made-to-order products including V-belt drives, synchronous drives, open belted variable speed drives and a broad line of flexible couplings, as well as hydrostatic drives, clutches and brakes. These products are used in a variety of industrial applications to transmit power from motors and engines to machines. The primary markets for these products are the construction, oil field and specialized industrial machinery, food processing, material handling, pumps, compressors, mining, pulp and paper and agricultural equipment industries.
Marketing and Distribution
The Company's products are sold principally throughout North America and, to a lesser extent, internationally. In North America, the Company sells to selected, authorized, industrial distributors who resell the Company's products to industrial consumers and Original Equipment Manufacturers ("OEMs"). The Company also sells directly to approximately 1,150 OEMs. The Company's marketing alliances include licensing agreements and distribution agreements with distributors and manufacturers who, in some cases, market the Company's products
under private label agreements. The Company has its own technical sales force in North America of more than 40 people and several specialized manufacturers' representatives.
The Company operates central distribution centers in Chambersburg, Pennsylvania; Stratford, Ontario and Mexico City, Mexico and regional distribution centers in Atlanta, Georgia; Elk Grove, Illinois; Dallas, Texas; Los Angeles, California; Portland, Oregon; Montreal, Quebec; Edmonton, Alberta and Marienheide, Germany.
The Company's products are manufactured to maintain stock inventories and on-time delivery is important. Order backlogs are generally less than one month's customer shipments and are not considered to be material in amount.
Customers
The Company's products are consumed principally by industrial users. The Company's OEM customers include a number of Fortune 500 companies. The Company's distributor customers include, among others, Motion Industries and Kaman Industrial Technologies who are among the largest distributors in the power transmission industry. In addition, the Company's distributors also sell to OEMs. Management believes that the Company is one of the leading suppliers of power transmission products, based on sales volume, to its distributors. The Company's five largest customers accounted for approximately 25% of the Company's net sales in 1998.
Competition
The power transmission industry is highly competitive. Competitive factors in the AC and DC electronic drive product categories include product performance, physical size of the product, tolerance for hostile environments, application support, availability and price. The Company's competitors in these product categories include large multi-national companies in North America, Europe and Asia, as well as many small, domestic niche manufacturers. The integrated electronic drive system market is driven by increased demand from end users for greater speed and process control. This market includes maintenance and replacement of existing systems, upgrades to existing systems and new capacity expansion. Competitive factors include process knowledge and engineering, software design, product durability and price. Major systems competitors include Asea Brown Boveri, Allen Bradley and Siemens Corp. The Company competes with several divisions of large industrial companies as well as many small to mid-sized independent companies in the mechanical product category. Competitive factors include availability, quality, price, size capability, engineering and customer support. The Company's most significant competitors in the mechanical product category include Dodge, Emerson Electric Co. Inc., Martin Sprocket and Gear, Rexnord Corp. and Lovejoy Industries Inc. Management believes that there are no significant foreign competitors in the North American mechanical product market because of a fragmented customer base, prohibitive freight costs as compared to selling price and difficult access to existing distribution channels.
Research and Development
The Company's research and development efforts include the development of new products, the testing of products, and the enhancement of manufacturing techniques and processes. The Company's annual expenditures for research and development (including royalties and payments to third parties) as a percent of net sales during the last three fiscal years have been 2.6% for 1998, 3.0% for 1997 and 3.2% for 1996, with a substantially higher percentage being spent on the electronics business. (For further information, refer to footnote No. 9 of the consolidated financial statements included in this Form 10-K.) A new Technology Center is being completed at the Chambersburg facility and is designed to make the research and development investment more productive by making it easier for engineers to share insights and collaborate on projects.
Raw Materials
The Company uses purchased standard components in all of its electronics products. The Company also purchases components designed by its engineers. These purchased components include power transistors, capacitors, printed circuit boards, aluminum heat sinks, plastic enclosures and sheet metal stampings. These electronic parts and components are purchased from a number of suppliers and management has taken steps to qualify multiple sources for key items. The principal raw materials used in the Company's mechanical manufacturing operations are various types of steel, including pig iron, metal stampings, castings, forging and powdered metal components. The Company also designs, tools and out-sources special components made of aluminum, powdered metal and polymers. The Company purchases the materials used in its mechanical manufacturing operations from a number of suppliers and management believes that the availability of its materials is adequate.
Patents and Trademarks
The Company owns patents relating to its coupling, composite, synchronous drive, open belted variable speed drive electronic drive and clutch/brake product lines. The Company also owns several patents relating to the design of its products. From time to time, the Company will grant licenses to others to use certain of its patents and will obtain licenses under the patents of others. In addition, the Company owns or has the right to use registered United States trademarks for the following principal products: Sure-Flex(R), Formflex(R), Ultra-V(R), Roto-Cone(R), Var-A-Cone(TM), True Tube(TM), E-trAC(R), Ultracon(R), Fiberlink(TM), Dura-Flex, Disc-O-Torque, DST, E-Trol, HST, IST, NLS, Roto-Cam, Softron, and Sure-Grip.
Employees
As of January 1, 1999, the Company employed over 1,100 people. Approximately 33 of the Company's hourly employees located at its Stratford, Ontario, Canada facility are represented by the United Steelworkers of Canada pursuant to a collective bargaining agreement dated January 20, 1998 that expires on January 19, 2001. Approximately 115 of the Company's employees located at its Mexico City, Mexico facility are represented by the National Metal Workers' Union of Mexico pursuant to a collective bargaining agreement that expires on January 31, 2000. The Company has created the TB Wood's Institute, which offers training programs to improve employees' operating, management and team-building skills.
Environmental Matters
As with most industrial companies, the Company's operations and properties are required to comply with, and are subject to liability under, federal, state, local and foreign laws, regulations and ordinances relating to the use, storage, handling, generation, treatment, emission, release, discharge and disposal of certain materials, substances and wastes. The nature of the Company's operations exposes it to the risk of claims with respect to environmental matters and there can be no assurance that material costs will not be incurred in connection with such liabilities or claims.
Both the Mt. Pleasant, Michigan (the "Mt. Pleasant Facility") and the Chambersburg, Pennsylvania (the "Chambersburg Facility") facilities had been listed on the Comprehensive Environmental Response, Compensation, and Liability Information System ("CERCLIS") (a list of sites maintained by the United States Environmental Protection Agency ("USEPA") for which a determination was to be made concerning whether investigation or remediation under CERCLA would be required). Both have been designated by USEPA as requiring no further action under CERCLA; therefore, the Company does not believe that material expenditures for these sites will be incurred under the CERCLA program. However, this does not assure that such expenditures would not be required under other federal and/or state programs.
The Mt. Pleasant Facility is currently listed on Michigan's inactive hazardous waste site list pursuant to the Michigan version of CERCLA (formerly known as "Act 307", amended and recodified on June 5, 1995 as Part 201
of the Natural Resources and Environmental Protection Act ("Part 201")). The Mt. Pleasant Facility was first placed on the Michigan hazardous waste site list in 1991, when the Facility was owned by Dana Corporation. When the Company acquired the Mt. Pleasant Facility from Dana Corporation, the Asset Purchase Agreement dated March 31, 1993 (the "Asset Purchase Agreement") included an environmental indemnity provision. Pursuant to this provision, Dana Corporation agreed to indemnify the Company with respect to any environmental liabilities to the extent they arose out of environmental conditions first occurring on or before the closing date, including the presence or release of any hazardous substances at, in, or under the Mt. Pleasant Facility and with respect to the identification of the Mt. Pleasant Facility on the Michigan list of inactive hazardous waste sites. The Dana Corporation is completing its investigation of the property and has proposed to the Michigan Department of National Resource that it conduct a limited remediation with respect to the volatile organic compounds found in soils and groundwater. The Company has not been notified by the Michigan Department of Natural Resources or any other governmental agency or person that it has any responsibility for investigating or remediating such environmental conditions. Although the Company has no reason to believe Dana Corporation cannot fulfill its remediation and indemnification obligations under the Asset Purchase Agreement, if Dana Corporation is unable to fulfill such commitments, then the Company may incur additional costs.
The Company believes that its facilities are in substantial compliance with current regulatory standards applicable to air emissions under the Clean Air Act Amendments of 1990 ("CAAA"). At this time, the Company cannot estimate when other new air standards will be imposed or what technologies or changes in processes the Company may have to install or undertake to achieve compliance with any applicable new requirements at its facilities. The Company has no reason to believe that such expenditures are likely to be material.
Similarly, based upon the Company's experience to date, the Company believes that the future cost of currently anticipated compliance with existing environmental laws relating to wastewater, hazardous waste and employee and community right-to-know should not have a material adverse effect on the Company's financial condition.
Item 2.
Item 2. Properties.
The Company owns and operates the following facilities:
- ------------------------------ *Includes certain leased space
In addition, the Company leases manufacturing facilities in: Mexico City, Mexico, and distribution facilities in: Atlanta, Georgia; Dallas, Texas; Montreal, Quebec; Edmonton, Alberta; Los Angeles, California and Portland, Oregon.
Item 3.
Item 3. Legal Proceedings.
The Company is a party to various legal actions arising in the ordinary course of business. The Company does not believe that the outcome of any of these actions will have a materially adverse affect on the consolidated financial position of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matter was submitted for a vote of the security holders during the fiscal quarter ended January 1, 1999.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters.
The Company consummated the Initial Public Offering ("IPO") of its common stock on February 8, 1996 and its Common Stock is listed on the New York Stock Exchange. The high and low prices for the Common Stock, and dividends paid on Common Stock, during the period from January 3, 1997 though January 1, 1999 were as follows:
On February 26, 1999 there were 165 registered shareholders of the Company's Common Stock, and the high and low sales prices for the Common Stock were both $12.00. During fiscal year 1998, the Company declared and paid total dividends of $.35 on the shares of its Common Stock. The Company declared a $.09 dividend on January 5, 1999, and paid it on January 29, 1999. The declaration of any dividend, including the amount thereof, will be at the discretion of the Board of Directors of the Company, and will depend on the Company's then current financial condition, results of operations and capital requirements, and such other factors as the Board of Directors deems relevant.
Item 6.
Item 6. Selected Financial Data.
The following tables set forth selected historical financial and operating data for the Company for each of the five years through fiscal year 1998 and have been derived from the Company's financial statements which have been audited by the Company's independent public accountants. The information set forth below should be read in conjunction with the Company's Consolidated Financial Statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operation."
Effective fiscal year 1995, the Company changed its year-end to the Friday closest to the last day of December. Fiscal year-ends are as follows:
1998 January 1, 1999 1997 January 2, 1998 1996 January 3, 1997 1995 December 29, 1995 1994 & prior December 31 of calendar year.
* Before $1,654 of one-time charges in 1996 related to the write-off of a non-compete agreement and the early retirement of debt related to the IPO and $839 of one-time income in 1994 related to the sale of a product line ** Working capital is defined as the sum of accounts receivable, inventory, and other current assets, less accounts payable and accrued expenses.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation
Year Ended January 1, 1999 Compared to Year Ended January 2, 1998
Net sales for fiscal 1998 increased to $133.9 million from $124.0 million in 1997, an increase of $9.9 million, or 8.0%. The increase in sales was primarily due to increased electronics business sales resulting from the acquisition of Berges electronic GmbH on December 1, 1997. The year 1998 started off with record sales in the first quarter, but beginning in the second quarter, a softening in our North American market resulted in lower sales levels for the remainder of the year.
Gross profit for 1998 increased to $47.6 million from $45.0 million in 1997, an increase of $2.6 million, or 5.7%. Gross profit as a percent of net sales decreased to 35.5% from 36.3%, due primarily to lower margins in the mechanical business resulting from expenditures for tooling and start-up costs related to new business, training of new employees, and consolidation of the gear coupling product line in our San Marcos facility.
Selling, general, and administrative ("SG&A") expense for fiscal 1998 increased to $32.0 million from $28.1 million in 1997, an increase of $3.9 million or 14.1%. SG&A expense as a percent of net sales increased to 23.9% from 22.6%, primarily as a result of higher SG&A expense as a percent of sales at Berges electronic GmbH which was not included in 1997 operating results.
Other expense for fiscal 1998 decreased to $2.4 million from $2.5 million in 1997, a decrease of $0.1 million or 1.9%. Interest expense, a component of total other expense, increased to $2.0 million in 1998 from $1.7
million in 1997. This increase was due primarily to higher debt levels in 1998, offset by lower interest rates. The effective tax rate for 1998 was 40.0%. Details of the provision for income taxes are discussed in Note 5 to the financial statements.
Net income for fiscal 1998 decreased to $7.9 million from $8.7 million in 1997, a decrease of $.8 million, or 9.2%.
Year Ended January 2, 1998 Compared to Year Ended January 3, 1997
Net sales for fiscal 1997 increased to $124.0 million from $102.5 million in 1996, an increase of $21.5 million or 21.0%. The improvement was broad-based with sales from existing businesses increasing $15.8 million or 15.4% and sales from businesses acquired in late 1996 and 1997 contributing an additional $5.7 million.
Gross profit increased to $45.0 million from $37.7 million in 1996, an increase of $7.3 million or 19.2%. Gross profit as a percent of net sales decreased to 36.3% from 36.8%, due primarily to shifts in product mix and higher costs of sales in the mechanical business resulting from the integration of the gear coupling acquisition.
SG&A expense for fiscal 1997 increased to $28.1 million from $25.2 million in 1996, an increase of $2.9 million or 11.5%. SG&A expense as a percent of net sales decreased to 22.6% from 24.6%, primarily as a result of the significantly higher sales volume and implementation of cost reduction initiatives.
Other expense, excluding extraordinary items, for fiscal 1997 decreased to $2.5 million from $2.6 million in 1996, a decrease of $0.1 million or 4.2%. Interest expense, a component of total other expense, decreased to $1.7 million in 1997 from $2.0 million in 1996. This decrease was due primarily to lower borrowings in the first part of 1997. The effective tax rate for 1997 was 40.0%. Details of the provision for income taxes are discussed in Note 5 to the financial statements. In 1996, an extraordinary item of $1.3 million, net of tax, was related to early repayment of debt with the proceeds from the Initial Public Offering ("IPO").
Net income for fiscal 1997 increased to $8.7 million from $6.3 million in 1996, before one-time charges, an increase of $2.4 million, or 38.1%.
Liquidity and Capital Resources
The Company's principal sources of funds are cash flow from operations and borrowings under the Company's revolving credit agreement. Cash provided from operations in 1998 was $6.4 million, a decrease of $10.5 million from the prior year. Net cash used for investing activities during fiscal years 1998, 1997, and 1996 was $7.9 million, $16.7 million, and $9.2 million, respectively. The Company's investing activities in 1998 were primarily capital expenditures. In 1997, the Company acquired Graseby Controls, Inc., through a purchase of stock, and acquired the assets of Berges electronic GmbH for a total of $9.9 million, net of acquired cash. In 1996, the Company acquired the assets of Deck Manufacturing Corp. and Ambi-Tech, Inc., and purchased the stock of Grupo Blaju S.A. de C.V. for a total of $3.7 million in cash and notes. Also in 1996, the Company purchased 21% of T. B. Wood's Canada Ltd. for $1.6 million to make the Company's Canadian operations a wholly owned subsidiary.
Capital expenditures for fiscal years 1998, 1997, and 1996 were $7.5 million, $5.8 million, and $3.8 million, respectively. During the last three fiscal years, the Company has made significant capital investments in computer controlled surface ("CNC") mount production lines for populating semi-conductors onto circuit boards, test and production equipment at the Company's foundry in Chambersburg, and other equipment to improve and modernize production facilities. In 1998, the Company initiated two major facility projects: 1) an engineering center in Chambersburg scheduled for completion in late 1999 and 2) a new plant in San Marcos, Texas to manufacture flexible couplings, which will be operational in the first quarter of 1999. In 1997, the Company purchased a $2.1 million facility for its electronics systems business in Chattanooga, Tennessee. These capital expenditures are
intended to reduce costs, improve product quality, and provide additional capacity for meeting the Company's growth objectives.
In April 1997, the Company borrowed $2.6 million by issuing Variable Rate Demand Revenue Bonds, under the authority of The Industrial Revenue Board of the City of Chattanooga, Tennessee, to finance a new facility for the electronics systems business.
On February 8, 1996, the Company completed an Initial Public Offering of its Common Stock that raised approximately $22.5 million in aggregate gross proceeds for the Company. The proceeds, net of issuance costs, of $19.8 million were used to repay debt. The Company paid $2.1 million in dividends during 1998. The Company paid a $.08 per share dividend in the first quarter and a $.09 per share dividend in the second, third, and fourth quarters of 1998, and declared a $.09 dividend on January 5, 1999, paid on January 29, 1999, to shareholders of record on January 15, 1999.
The Company believes that it will have sufficient cash flow from operations and available borrowings to meet its future short-term and long-term cash needs for interest, operating expenses, and capital expenditures.
Derivative Financial Instruments
Market risk is the potential change in an instrument's value caused by, for example, fluctuations in interest and currency exchange rates. The Company's primary market risk exposures are interest rate and unfavorable movements in exchange rates between the U.S. dollar and each of the Mexican peso, Canadian dollar, German deutsche mark, Indian rupee, and Italian lira. Monitoring and managing these risks is a continual process carried out by senior management. Market risk is managed based on an ongoing assessment of trends in interest rates, foreign exchange rates, and economic developments, giving consideration to possible affects on both total return and reported earnings. The Company's financial advisors, both internal and external, provide ongoing advice regarding trends that affect management's assessment.
The Securities and Exchange Commission has qualified Mexico as a highly inflationary economy under the provisions of SFAS No. 52, effective 1997. The re-measurement of the Company's operation is recorded in the accompanying Statement of Operations.
Year 2000
The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a two-digit year is commonly referred to as the Year 2000 compliance issue. As the Year 2000 approaches and thereafter, such systems may be unable to accurately process certain date-based information. This could result in system failures or miscalculations causing disruptions of operations including, among other things, a temporary inability to process transactions or engage in a variety of business activities. The Company has implemented a five step process to evaluate the impact of the Year 2000 compliance issue. These steps involve an inventory of Company systems, an evaluation and analysis of systems regarding the Year 2000 compliance impact, implementation of modifications to specified systems, unit testing, and finally systems or integration testing to validate compliance. The Company relies upon third party vendors which supply goods and services to the Company and, although the Company has consulted with various vendors in order to minimize the risk of the Year 2000 compliance issue, such third parties may be affected by the Year 2000 compliance issue. While the Company believes its actions shall have the effect of ameliorating year 2000 risk, there can be no assurance that
the Company's internal systems or equipment or those of third parties on which the Company relies will be Year 2000 compliant in a timely manner or that the Company's or third parties' contingency plans will mitigate the effects of noncompliance. The failure of the systems or equipment of the Company or third parties could result in the reduction or suspension of the Company's operations and could have a material adverse affect on the Company. Subject to the final results of the evaluation and analysis of the Year 2000 compliance issue, the Company believes that its Year 2000 compliance costs will not be material to its operations, liquidity or capital resources. There is still uncertainty regarding the scope of the Year 2000 compliance issue and, at this time, the Company is unable to quantify the impact of potential Year 2000 compliance failures. The Company's Year 2000 compliance program and possible contingency plans are still being developed and assessed in order to attempt to minimize the effect of failures within the Company's reasonable control.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," effective for all fiscal quarters of fiscal years beginning after June 15, 1999. SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value and that changes in the derivative's fair value be recognized in earnings in the current period unless specific hedge accounting criteria are met. The Company plans to adopt SFAS No. 133 in the first quarter of fiscal 2000. Management is still assessing the impact of the adoption of this statement on the financial statements. Currently, management does not believe the adoption of this statement will have a material impact on the Company's financial statements.
Safe Harbor Statement
Under the Private Securities Litigation Reform Act of 1995, except for the historical information contained herein, this annual report contains forward-looking statements about matters which involve risks and uncertainties, including but not limited to economic, competitive, governmental and technological factors affecting the Company's operations, markets, products, services and prices, and other factors discussed in the Company's filings with the Securities and Exchange Commission.
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of TB Wood's Corporation:
We have audited the accompanying consolidated balance sheets of TB Wood's Corporation (a Delaware corporation) and Subsidiaries as of January 1, 1999 and January 2, 1998 and the related consolidated statements of operations, comprehensive income, changes in shareholders' equity (deficit), and cash flows for each of the three years in the period ended January 1, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of TB Wood's Corporation and subsidiaries as of January 1, 1999 and January 2, 1998 and the results of their operations and their cash flows for each of the three years in the period ended January 1, 1999 in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Atlanta, Georgia February 12, 1999
TB Wood's Corporation And Subsidiaries Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
TB Wood's Corporation And Subsidiaries Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
TB Wood's Corporation And Subsidiaries Consolidated Statements of Changes in Shareholders' Equity (Deficit)
The accompanying notes are an integral part of these consolidated financial statements.
TB Wood's Corporation And Subsidiaries Consolidated Statements Of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements
TB Wood's Corporation And Subsidiaries Notes To Consolidated Financial Statements (in thousands, except per share and share amounts)
1. NATURE OF BUSINESS AND PRINCIPLES OF CONSOLIDATION
TB Wood's Corporation and subsidiaries (collectively, "Wood's" or the "Company") is an established designer, manufacturer, and marketer of electronic and mechanical industrial power transmission products which are sold to distributors, domestic and international manufacturers and users of industrial equipment. Principal products of the Company include electronic drives, integrated electronic drive systems, mechanical belted drives, and flexible couplings. The Company has operations throughout the United States, Canada, Mexico, Germany, Italy and India. The accompanying consolidated financial statements include the accounts of TB Wood's Corporation and its wholly owned subsidiaries. All intercompany accounts have been eliminated in consolidation.
Year-End Fiscal year-ends are as follows:
1998........................................January 1, 1999 1997........................................January 2, 1998 1996........................................January 3, 1997
The accompanying consolidated financial statements include the accounts of TB Wood's Corporation and its wholly owned subsidiaries. All significant inter-company balances and transactions have been eliminated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Restricted Cash
At January 1, 1999, $410 of cash is restricted under the Variable Rate Demand Revenue Bonds (Note 4). This cash may be used for building renovations, improvements or other capital expenditures related to a new production facility for the electronics systems business. The funds will be used to repay the bonds if not spent prior to April 2000.
Cash Equivalents
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.
Property, Plant, and Equipment
The Company depreciates its property, plant, and equipment principally using the straight-line method over the estimated useful lives of the assets. Equipment under capital leases is depreciated over the asset's estimated useful life and is included in machinery and equipment. Maintenance and repair costs are charged to expense as incurred, while major renewals and improvements are capitalized. When property and equipment are retired or otherwise disposed of, the related carrying value and accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in income. The depreciable lives of the major classes of property, plant and equipment are summarized as follows:
Asset Type Lives --------------------------------------------------------------- Machinery and equipment 3 - 15 years Buildings and improvements 10 - 40 years
Inventories
Inventories are stated at the lower of cost or market primarily using the last-in, first-out ("LIFO") method. Market is defined as net realizable value. Cost includes raw materials, direct labor, and manufacturing overhead. Approximately 77% and 78% of total inventories in years ending January 1, 1999 and January 2, 1998 were valued using the LIFO method. Wood's-Canada and Wood's-Mexico inventories are stated at the lower of cost or market using the first-in, first-out ("FIFO") method.
Self-Insurance
The Company maintains workers' compensation insurance policies which have the potential for retrospective premium adjustments and a partially self-insured group health insurance policy which is subject to specific retention levels. Insurance administrators assist the Company in estimating the fully developed workers' compensation liability and group health insurance reserves which are accrued by the Company. In the opinion of management, adequate provision has been made for all incurred claims. At January 1, 1999 the Company has issued letters of credit totaling $1,050 to cover incurred claims and other costs related to the workers' compensation.
Foreign Currency Translation
The financial statements of the Company's foreign subsidiaries have been translated into U.S. dollars in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52, "Foreign Currency Translation." Translation adjustments, which result from the process of translating financial statements into U.S. dollars, are accumulated as a separate component of shareholders' equity (deficit). Exchange gains and losses resulting from foreign currency transactions, primarily inter-company sales of products are included in other income (expense) in the accompanying statements of operations and are not material. The Securities and Exchange Commission has qualified Mexico as a highly inflationary economy under the provisions of SFAS No. 52, effective 1997. The re-measurement of the Company's Mexico operation is recorded in the accompanying statement of operations.
Goodwill
The excess of cost over the net assets acquired ("Goodwill") is being amortized on a straight-line basis over a period of 40 years. Goodwill relates to the acquisition of TB Wood's Incorporated ("Wood's-US") in 1986 and the acquisition of certain other businesses and product lines (Note 8).
Long Lived Assets and Intangible Assets
The Company reviews the carrying values assigned to long-lived assets and certain identifiable intangible assets based on expectations of undiscounted future cash flows and operating income generated by the long-lived assets or the tangible assets underlying certain identifiable intangible assets in determining whether the carrying amount of such assets is recoverable.
Shareholders' Equity
In 1996, the board of directors authorized, subject to certain business and market conditions, the purchase of up to 200,000 of the Company's common shares. At January 1, 1999 the number of treasury shares purchased under this authorization was 90,225 and the number of treasury shares issued to employees under option and purchase plans was 8,775 and under the 401(k) profit-sharing plan was 4,436.
Fair Value of Financial Instruments
The fair value of financial instruments classified as current assets or liabilities, including cash and cash equivalents, accounts receivable, and accounts payable, approximate carrying value due to the short-term maturity of the instruments. The fair value of short-term and long-term debt and deferred compensation amounts approximate carrying value and are based on their effective interest rates compared to current market rates.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cyclical Industry
The markets for some of the Company's products are cyclical, generally following changes in the overall economy. Consequently, during periods of economic expansion, the Company has experienced increased demand for its products, and during periods of economic contraction, the Company has experienced decreased demand for its products. Such changes in the general economy affect the Company's results of operations in the relevant fiscal periods.
Major Customers
The Company's five largest customers accounted for approximately 25%, 30%, and 29% of net sales for fiscal years 1998, 1997, and 1996, respectively. Of these customers, one accounted for close to 18% of net sales for the year ended January 1, 1999. The loss of one or more of these customers would have an adverse effect on the Company's performance and operations. Foreign and export sales accounted for 24.9%, 17.0%, and 17.7% of total sales in fiscal years 1998, 1997, and 1996, respectively. Inter-company transactions are consummated on terms equivalent to those that prevail in arms-length transactions.
Supply of Electronic Raw Materials and Purchased Components
Historically, the electronics component industry, which supplies components for the Company's electronic products, has from time to time experienced heavy demand for certain components during periods of growth in the consumer electronic industry. The rapid growth of the AC electronic drive market has also created heavy demand for power control electronics. While certain of the Company's components are obtained from a single or limited number of sources, the Company has potential alternate suppliers for most of the specialty components used in its manufacturing operations. There can be no assurance, however, that the Company will not experience shortages of raw materials or components essential to the production of its products or be forced to seek alternative sources of supply, which may increase costs or adversely affect the Company's ability to obtain and fulfill orders for its products.
Net Income Per Share
In March 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Standards ("SFAS") No. 128, "Earnings Per Share", which the Company adopted for the year ended January 2, 1998. Basic earnings per share ("EPS") is computed by dividing reported earnings available to common shareholders by weighted average shares outstanding. No dilution for any potentially dilutive securities is included in basic EPS. Diluted EPS is computed by dividing reported earnings available to common shareholders by weighted average shares and common equivalent shares outstanding. All prior year EPS amounts have been restated to conform to the provisions of SFAS No. 128. The difference between primary and fully diluted net income per share is not material for any of the periods presented and has therefore been excluded.
Year End
Effective fiscal year 1995, the Company changed its year-end to the Friday closest to the last day of December. Fiscal year-ends are as follows:
1998 January 1, 1999 1997 January 2, 1998 1996 January 3, 1997 1995 December 29, 1995 1994 & prior December 31 of calendar year
Recent Accounting Pronouncements
Effective fiscal 1997, the Company adopted SFAS No. 129, "Disclosure of Information and Capital Structure." SFAS No. 129 requires disclosure of the pertinent rights and privileges of all securities other than ordinary common stock. The Company has disclosed such information in its annual reports filed in form 10-K.
In July 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" effective for fiscal years beginning after December 15, 1997. The statement addresses the reporting and display of changes in equity that result from transactions and other economic events, excluding transactions with owners. The Company adopted SFAS No. 130 in 1998.
Effective fiscal 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The Company has disclosed such information in Note 9 to the consolidated Financial statements.
Effective January 3, 1998, the Company adopted SFAS No. 132, "Employers' Disclosure about Pension and Other Postretirement Benefits." (See Note 6).
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," effective for all fiscal quarters beginning after June 15, 1999. SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value and that changes in the derivative's fair value be recognized in earnings in the current period unless specific hedge accounting criteria are met. The Company plans to adopt SFAS No. 133 in the first quarter of fiscal 2000. Management is still assessing the impact of the adoption of this statement on the financial statements. Currently, management does not believe the adoption of this statement will have a material impact on the Company's financial statements.
Reclassifications
Certain prior period amounts have been reclassified to conform with the current period presentation.
3. ACCRUED EXPENSES
Components of accrued expenses were as follows:
4. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Long-term debt and capital lease obligations as at the end of each fiscal period consist of the following:
Aggregate future maturities of long-term debt and capital lease obligations as of January 1, 1999 are as follows:
1999 $378 2000 279 2001 225 2002 83 2003 28,954 Thereafter 2,550 --------- $32,469
In connection with the proceeds received from the offering of the Company's common stock on February 8, 1996 (Note 8), the Company repaid a term loan with Fleet Capital, a debt agreement with US Leasing, and a portion of a revolver loan with Fleet. An extraordinary loss of approximately $1,305, net of taxes, was incurred in the first quarter of 1996 as a result of the repayment of certain indebtedness.
The Company has a $47,500 unsecured revolving credit facility arranged by PNC Bank, N.A ("PNC") bearing variable interest of LIBOR plus 112.5 basis points, maturing January 2003. The credit facility contains numerous restrictive financial covenants which require the Company to comply with certain financial tests, including, among other things, maintaining minimum tangible net worth, as defined, and maintaining certain specified ratios. The credit facility also contains other restrictive covenants that include, among other things, restrictions on outside investments and restrictions on capital expenditures.
In April 1997, the Company borrowed approximately $2.6 million by issuing Variable Rate Demand Revenue Bonds under the authority of the Industrial Revenue Board of the City of Chattanooga, bearing variable interest of 4.05% at January 1, 1999 maturing April 2022. The bonds were issued to finance the new production facility for the electronics systems business.
In August 1998, the company entered into an interest rate swap agreement that effectively converted underlying variable rate debt in the unsecured revolving credit facility to fixed rate debt. The notional principal amount of the swap agreement is $10,000 with an effective fixed rate of 5.75%. The swap agreement is settled each month and will expire in July 2001.
The gross proceeds from (repayments of) the revolving credit facilities are as follows:
5. INCOME TAXES
The components of the provision (benefit) for income taxes are shown below:
Under SFAS No. 109, deferred tax assets or liabilities at the end of each period are determined by applying the current tax rate to the difference between the financial reporting and income tax bases of assets and liabilities. The deferred tax benefit is determined based on changes in deferred tax items exclusive of deferred tax implications of the early extinguishment of debt and reclassifications between deferred and current taxes.
The components of deferred income taxes are as follows:
A reconciliation of the provision for income taxes at the statutory federal income tax rate to the Company's tax provision as reported in the accompanying statements of operations is shown below:
In 1998, 1997, and 1996 earnings before income taxes included $2,320, $1,259, and $884, respectively, of earnings generated by the Company's foreign operations. No federal or state income taxes have been provided on such earnings, since undistributed earnings have been reinvested and are not expected to be remitted to the parent company.
In September 1997, the Internal Revenue Service completed its review of the Company's 1995, 1994, and 1993 federal income tax returns. The review did not have a material effect on the Company's operations. The Internal Revenue Service is currently in review of the Company's 1996 federal income tax return.
6. BENEFIT PLANS
Compensation Plans
Wood's maintains a discretionary compensation plan for its salaried and hourly employees which provides for incentive awards based on certain levels of earnings, as defined. Amounts awarded under the plan and charged to expense in the accompanying statements of operations were $1,238, $2,002, and $1,664, for fiscal years 1998, 1997, and 1996, respectively.
Profit-Sharing Plans
Since January 1, 1988, the Company has maintained a separate defined contribution 401(k) profit-sharing plan covering all salaried and non-production unit-domestic hourly employees. Under this plan, the Company matches a specified percentage of each eligible employee's contribution and purchases Company common shares on the open market. The Company contributed 35,990 shares of common stock held in treasury in 1998, and 5,797 in 1997. Amounts contributed by the Company under this profit-sharing plan were approximately $580, $530, and $500, for fiscal years 1998, 1997, and 1996, respectively. In addition, the Company has a noncontributory profit-sharing plan covering its Canadian employees for which $17, $37, and $40 were charged to expense for the fiscal years 1998, 1997, and 1996, respectively.
Employee Stock Purchase Plan
The Company's Employee Stock Purchase Plan ("ESPP"), enables employees of the Company to subscribe for shares of common stock on quarterly offering dates, at a purchase price which is the lessor of 90% of the fair value of the shares on the first day or the last day of the quarterly period. Employee contributions to the ESPP were $152 and $63 for 1998 and 1997 respectively. Pursuant to the ESPP, 8,775 shares were issued to employees during 1998 and 4,436 shares during 1997. At the annual meeting on April 11, 1997, the Company's shareholders approved the reservation of 500,000 shares to be issued under the ESPP. As of January 1, 1999, 486,789 shares are available for future issuance.
Stock Options
In March 1991, the Company granted nonqualified stock options to the president of the Company to purchase 157,893 shares of the Company's common stock at an option price of $6.33 per share. The options vested 30% in January 1993, 15% in each of January 1994, 1995, 1996, and 1997, and 10% in January 1998. On March 30, 1992, the option agreement was amended to set the option price at $1.58 per share plus an amount equal to the average yield on the 30-year U.S. Treasury bond maturing on the day closest to the fifteenth anniversary of the option measurement date as defined in the agreement. The options are exercisable on or after the seventh anniversary of the measurement date and expire one year thereafter. During 1992, the controlling shareholder granted an additional 47,367 options on the controlling shareholder's shares to a director, with terms similar to the 1991 options, as amended. Also in 1992, the Company granted an additional 30,000 options to an employee with terms similar to the 1991 options, as amended, with vesting beginning in 1994. The options are exercisable beginning on the seventh anniversary of the measurement date, as defined, and expire on the eighth anniversary of the measurement date. The option agreements contain various fair value puts and calls, with fair value to be determined by the board of directors or an independent appraiser.
As a result of the above amendment, beginning in March 1992, the Company began accounting for the options under variable plan accounting, whereby increases in the value of the Company's common stock above the option price resulted in the recording of compensation expense by the Company. Through December 31, 1994, the Company recorded no compensation expense related to the options as, in the opinion of management, the fair value of the Company's common stock was equal to or below the option price, as adjusted. Due to increases in the estimated fair value of the Company's common stock, as determined by an independent appraiser, the Company recorded stock option compensation expense of $675 for the year ended December 29, 1995. Additional stock option compensation expense of approximately $230 will be recorded in future periods based on the vesting schedule of options. In July 1995, the option agreements were amended to remove features of the options that resulted in variable plan accounting. Accordingly, subsequent to July 1, 1995, the options are being accounted for as fixed options whereby future increases in the value of the Company's common stock will not result in additional stock option compensation expense.
In February 1994, the Company granted an additional 105,000 options with terms similar to those discussed above, except that the February 1994 options do not have a put feature and have an option price which escalates
during the vesting period at a fixed rate of 6% per year. The February 1994 options are exercisable at a fixed exercise price for a one-year period following the vesting period. The Company accounts for the February 1994 options as fixed options whereby future increases in the value of the Company's common stock do not result in the recording of compensation expense by the Company. The option agreements contain various fair value puts and calls, with fair value to be determined by the board of directors or an independent appraiser.
In December 1994, the controlling shareholder of the Company granted 89,004 options on the controlling shareholder's shares to certain members of management which contain terms similar to the February 1994 options, except that the option price escalates during the vesting period at a fixed rate of 7.86% per year.
The Company adopted a 1996 stock-based incentive compensation plan (the "1996 Plan"), the purpose of which is to assist the Company in attracting and retaining valued personnel by offering them a greater stake in the Company's success and a closer identity with the Company, and to encourage ownership of the Company's common stock by such personnel.
The 1996 Plan is administered by a committee designated by the board of directors (the "Committee"). The aggregate maximum number of shares of common stock available for awards under the 1996 Plan is 500,000, subject to adjustment to reflect changes in the Company's capitalization. Awards under the 1996 Plan may be made to all officers and key employees of the Company. No awards can be made under the 1996 Plan after January 31, 2006.
The Committee may grant shares of common stock in the form of either deferred stock or restricted stock, as defined in the 1996 Plan. Options granted under the 1996 Plan may be either incentive stock options ("ISOs") or nonqualified stock options. ISOs are intended to qualify as incentive stock options within the meaning of Section 422 of the Internal Revenue Code. Unless an option is specifically designated at the time of grant as an ISO, options under the 1996 Plan will be nonqualified. The exercise price of the options will be determined by the Committee. The maximum term of an option or Stock Appreciation Right (or "SAR") granted under the 1996 Plan shall not exceed ten years from the date of grant or five years from the date of grant if the recipient on the date of grant owns, directly or indirectly, shares possessing more than 10% of the total combined voting power of all classes of stock of the Company. No option or SAR may be exercisable sooner than six months from the date the option or SAR is granted.
Effective fiscal year 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 requires companies to estimate the value of all stock-based compensation using a recognized pricing model. However, it also allows an entity to continue to measure compensation cost for those plans using the method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to remain with the method of accounting in APB No. 25 must make pro forma disclosures of net income and, if presented, earnings per share, as if the fair value-based method of accounting defined in the statement had been applied.
In June 1997, the Company granted options to purchase 46,250 shares of common stock at an option price of $14 per share and 92,500 at an option price of $23. The options vest evenly over a three-year period from the grant date. The options may be exercised as they vest. The $14 options expire ten years from the grant date, and the $23 options expire five years from the grant date.
In February and August 1998, the company granted options to purchase 50,550 and 25,000 shares of common stock at an option price of $21 per share, respectively and 101,100 and 50,000 options at $28 per share, respectively. The options vest evenly over a three-year period from the grant date. The options may be exercised as they vest. The $21 options expire ten years from the grant date and the $28 options expire five years from the grant date. No compensation expense was incurred in 1998 because the strike price was higher than the market price.
The Company has elected to account for its stock-based compensations plan under APB No. 25. Using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 1998, 1997 and 1996:
If the Company had accounted for these plans in accordance with SFAS No. 123, the Company's reported pro forma net income and pro forma net income per share for the fiscal years from 1995 to 1998 would have been as follows:
Post-retirement Benefits
The Company sponsors a defined benefit post-retirement medical plan that provides coverage for retirees and their dependents. A portion of the plan is paid for by retiree cost sharing. The accounting for the plan anticipates future cost sharing increases to keep pace with health care inflation. The plan is unfunded. The Company adopted the provisions of SFAS No. 132, "Employers Disclosure About Pensions and Other Postretirement Benefits" effective January 3, 1998.
The following table summarizes the Company's post-retirement benefit obligations and the assumptions used in determining post-retirement benefit cost.
Net periodic post-retirement benefit costs include the following components:
7. COMMITMENTS AND CONTINGENCIES
Legal Proceedings
The Company is subject to a number of legal actions arising in the ordinary course of business. In management's opinion, the ultimate resolution of these actions will not materially affect the Company's financial position or results of operations.
Environmental Risks
The Company's operations and properties are subject to federal, state, and local laws, regulations, and ordinances relating to certain materials, substances, and wastes. The nature of the Company's operations exposes it to the risk of claims with respect to environmental matters. Based on the Company's experience to date, management believes that the future cost of compliance with existing environmental requirements will not have a material adverse effect on the Company's operations or financial position.
Operating Lease Commitments
The Company leases office space, office equipment, and other items under non-cancelable operating leases. The expense for non-cancelable operating leases was approximately $385, $600, and $582, for fiscal years 1998, 1997, and 1996, respectively. At January 1, 1999, future minimum lease payments under non-cancelable operating leases are as follows:
1999 $439 2000 361 2001 210 2002 166 2003 and thereafter 443 ------ $1,619 ======
8. ACQUISITIONS, MERGERS AND PUBLIC OFFERING
Acquisitions
In February 1996, the Company exercised an option to purchase the outstanding shares of Grupo Blaju, S.A., de C.V. (subsequently renamed TB Wood's Mexico, S.A., de C.V.) and its subsidiaries for approximately $458, including legal and professional fees. There was no goodwill associated with the purchase.
In October 1996, the Company purchased the assets of Ambi-Tech Industries, Inc., a leading manufacturer of electronic brakes for electric motors, for approximately $991 cash, including legal and professional fees, and an $800 note payable at 7% interest. Principal is due in five annual installment of $160 beginning September, 1997. Goodwill associated with the purchase is being amortized over 40 years using the straight-line method (Note 2).
In November 1996, the Company acquired certain assets of Deck Manufacturing Corp. ("Deck"), an established designer and manufacturer of industrial disc and gear couplings, for approximately $1,471 of cash, including legal and professional fees. Goodwill associated with the purchase is being amortized over 40 years using the straight-line method (Note 2). The Company also loaned Deck $400 which is secured by the excess accounts receivable and the inventory not acquired. The note receivable is included in other assets.
In May 1997, the Company purchased the stock of Wood's-NC, formerly Graseby Controls Inc., a subsidiary of Graseby plc, for cash of approximately $5,000. Wood's-NC manufactures and sells industrial AC drives, including the Volkmann(TM) brand of high-frequency AC drives, electronic brakes, and Soft Starts. Goodwill associated with the purchase is being amortized over 40 years using the straight-line method (Note 2).
In November 1997, the Company purchased the stock of Berges electronic GmbH ("Berges") for cash of approximately $1,480 and assumed liabilities of $4,,765. Berges designs, manufactures, and markets its own line of AC inverters for the European market and sells TB Wood's inverters on a private label basis. Goodwill associated with the purchase is being amortized over 40 years using the straight-line method (Note 2).
In December 1997, the Company purchased a 65% ownership in a joint venture with TB Wood's Enertec ("Enertec") for $91. Enertec distributes domestically manufactured electrical components and performs system integration design in the India market. Enertec was not included in the 1997 financial statements as its impact was immaterial.
Merger
In January 1996, the Company completed a merger (the "Merger") in contemplation of an initial public offering of the Company's common stock. Pursuant to the Merger, a subsidiary of a newly formed holding company merged with Wood's-U.S., with Wood's-U.S. as the surviving corporation. In the Merger, the shareholders of Wood's-U.S. received three shares of the holding company's stock in exchange for each share of Wood's-U.S. stock. The financial statements of the Company, prior to January 1996, have been restated to include the effects of the Merger.
Initial Public Offering
Effective February 8, 1996, the Company completed an Offering of its common stock that raised approximately $22,478 in aggregate gross proceeds for the Company. The net proceeds (after deducting issuance costs) of approximately $19,823 from the Offering were used to repay $4,767 of the Fleet Term Loan, $5,203 of the Senior Fleet Revolver Loan, and $10,000 of the USL Fixed and Floating Rate Notes. In addition, the Company paid approximately $616 to USL. In conjunction with the Offering, USL redeemed warrants to purchase 375,000 shares of the Company's stock which were included in the shares of common stock issued. The Company also purchased the remaining 21% interest of Wood's-Canada held by the shareholders of Wood's-U.S. for approximately $1,600.
The effects of interest and other charges in fiscal 1996, prior to the Offering, are not material to the consolidated financial statements.
9. BUSINESS SEGMENT INFORMATION
Description of the Types of Products from which Each Segment Derives its Revenues
The Company is engaged principally in the design, manufacture and sale of power transmission products. The products manufactured by the Company are classified into two segments, mechanical business and electronics business. The mechanical business segment includes belted drives and couplings. The electronics business segment includes electronic drives and electric drive systems. Products of these segments are sold to distributors, original equipment manufacturers and end users for manufacturing and commercial applications.
Measurement of Segment Profit or Loss and Segment Assets
The Company evaluates performance and allocates resources based on profit or loss from operations before income taxes. The accounting policies of the reportable segments are the same as described in the summary of significant accounting policies. Intersegment sales are not material.
Factors Management Used to Identify the Company's Reportable Segments
The Company's reportable segments are business units that manufacture and market separate and distinct products and are managed separately because each business requires different processes, technologies, and market strategies.
The following table summarizes revenues, operating income, total assets and expenditures for long-lived assets by business segment for fiscal years 1998, 1997 and 1996:
The following table reconciles segment profit to consolidated income before income taxes and extraordinary items for fiscal years 1998, 1997 and 1996:
The following table reconciles segment assets to consolidated total assets as of January 1, 1999 and January 2, 1998:
Information regarding the Company's domestic and foreign operations is as follows:
10. QUARTERLY FINANCIAL DATA (UNAUDITED)
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information called for by this Item regarding directors and executive officers is set forth in the Company's definitive Proxy Statement for the 1999 Annual Meeting in the Sections entitled "Election of Director," "Management" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation.
The information called for by this Item is set forth in the Company's definitive Proxy Statement for the 1999 Annual Meeting in the Section entitled "Executive Compensation" and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information called for by this Item is set forth in the Company's definitive Proxy Statement for the 1999 Annual Meeting in the Section entitled "Security Ownership of Certain Beneficial Owners and Management" and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions.
None.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) The following documents are filed as a part of this report:
(1) All financial statements;
The consolidated financial statements of the Company and its subsidiaries on pages 15 through 35 hereof and the report thereon of Arthur Andersen LLP appearing on page 15 hereof.
(2) Financial Statement Schedule
Schedule II for the fiscal year ended January 1, 1999 and the report of Arthur Andersen thereon.
(3) Exhibits
Number Description - ------ ----------- 3.1 Amended Certificate of Incorporation of the Company (incorporated by reference to TB Wood's Corporation Registration Statement filed on Form S-1, as amended, File No. 33-96498 ("Form S-1") Exhibit 3.1).
3.2 Amended and Restated By-laws of the Company (incorporated by reference to Form S-1 Exhibit 3.2).
4.1 Shareholders' Agreements by and among T. B. Wood's Sons Company, Thomas C. Foley and Gifford P. Foley, Barton J. Winokur, Kurt A. Herwald, Michael L. Hurt, Michael H. Iversen, David H. Halleen, Stanley L. Mann, Lee J. McCullough, Carl R. Christenson, Harold L. Coder, III, James E. Williams, Joseph S. Augustine, Bernard M. Goldsmith, Harvey R. Heller, Robert Patterson Saltsman, F. Philip Handy, F. Philip Handy, as Guardian of the Property of Kate Elizabeth Handy, F. Philip Handy, as Guardian of the Property of Philip Breckenridge Handy and F. Philip Handy, as Guardian of the Property of Abigail Slocum Handy (incorporated by reference to Form S-1 Exhibit 4.1).
4.2 Amendments to Shareholders' Agreements by and among TB Wood's Incorporated (formerly known as "T. B. Wood's Sons Company"), Thomas C. Foley and Gifford P. Foley, Barton J. Winokur, Kurt A. Herwald, Michael L. Hurt, Michael H. Iversen, David H. Halleen, Stanley L. Mann, Lee J. McCullough, Carl R. Chistenson, Harold L. Coder, III, James E. Williams, Joseph S. Augustine (incorporated by reference to Form S-1 Exhibit 4.2).
9.1 Voting Trust Agreement dated March 31, 1989, among T. B. Wood's Son's Company and Bernard M. Goldsmith, Harvey R. Heller, Robert Patterson Saltsman, F. Philip Handy, F. Philip Handy, as Guardian of the Property of Abigail Slocum Handy, Kate Elizabeth Handy, Philip Breckenridge Handy and F. Philip Handy, as Trustee (incorporated by reference to Form S-1 Exhibit 9.1).
10.1 Stock Purchase Agreement dated January 7, 1994 by and among T. B. Wood's Sons Company, Plant Engineering Consultants, Inc. and John Morris, Jesse Batten, Ralph Pedigo, Ronald Bingham, Walter Taeubel and Cook Family Trust (incorporated by reference to Form S-1 Exhibit 10.1).
10.2 Asset Purchase Agreement dated May 12, 1994 by and between T. B. Wood's Sons Company and Magnetic Power Systems, Inc. (incorporated by reference to Form S-1 Exhibit 10.2).
10.3 Non-Qualified Stock Option Agreements between T. B. Wood's Sons Company and Joseph S. Augustine, Michael H. Iversen, David H. Halleen, Stanley L. Mann, Lee J. McCullough, Carl R. Christenson, Harold L. Coder, III and James E. Williams (incorporated by reference to Form S-1 Exhibit 10.36).
10.4 Non-Qualified Stock Option Agreement dated as of March 15, 1991 between T. B. Wood's Sons Company and Michael L. Hurt, together with Addendum dated as of March 30, 1992 (incorporated by reference to Form S-1 Exhibit 10.37).
10.5 Asset Purchase Agreement between T. B. Wood's Sons Company and Dana Corporation dated March 31, 1993 (includes Schedule 7.11 On-Site Environmental Procedures) (incorporated by reference to Form S-1 Exhibit 10.38).
10.6 TB Wood's Corporation 1996 Stock-Based Incentive Compensation Plan (incorporated by reference to Form S-1 Exhibit 10.39).
10.7 Amendments to the Non-Qualified Stock Option Agreements between TB Wood's Incorporated (formerly known as "T. B. Wood's Sons Company") and Joseph S. Augustine, Michael H. Iversen, David H. Halleen, Stanley L. Mann, Lee J. McCullough, Carl R. Christenson, Harold L. Coder, III and James E. Williams (incorporated by reference to Form S-1 Exhibit 10.40).
10.8 Second Addendum dated July 1, 1995 to the Non-Qualified Stock Option Agreement dated as of March 15, 1991 between TB Wood's Incorporated (formerly known as "T. B. Wood's Sons Company") and Michael L. Hurt (incorporated by reference to Form S-1 Exhibit 10.41).
10.9 Stock Purchase Agreement by and among TB Wood's Incorporated and Grupo Blaju, S.A. de C.V. and Jorge R. Kiewek, Ninfa D. de Callejas and Marcela Kiewek G., dated February 14, 1996 (incorporated by reference to Form 10-K, for fiscal year 1995, Exhibit 10.43).
10.10 Revolving Credit Agreement by and among TB Wood's Incorporated, Plant Engineering Consultants, Inc., Grupo Blaju, S.A., de C.V., TB Wood's Canada, Ltd. and the Banks Party thereto and PNC Bank, National Association, as Agent, dated October 10, 1996 (incorporated by reference to Form 10-K, for fiscal year 1996, Exhibit 10.44).
10.11 TB Wood's Employee Stock Purchase Plan, dated March 1, 1997 (incorporated by reference to Form 10-K, for fiscal year 1996, Exhibit 10.45).
10.12 Stock Purchase Agreement by and between TB Wood's Incorporated and Graseby Electro-Optics Inc. dated May 8, 1997 (incorporated by reference to Form 10-K, for fiscal year 1997, Exhibit 10.46).
10.13 Translated Stock Purchase Agreement by and among TB Wood's Incorporated and Berges Antriebstechnic GmbH and Karen Sarstedt, dated October 23, 1997 (incorporated by reference to Form 10-K, for fiscal year 1997, Exhibit 10.47).
10.14 Form of the Non-Qualified Stock Option Agreements between TB Wood's Corporation and Thomas C. Foley, Michael L. Hurt, Carl R. Christenson, Michael H. Iversen, Willard C. Macfarland, Jr., and other key employees dated June 17, 1997 and between TB Wood's Corporation and Robert J. Dole dated July 29, 1997 issued under the 1996 Plan (incorporated by reference to Form 10-K, for fiscal year 1997, Exhibit 10.48).
10.15 Form of the Non-Qualified Stock Option Agreements between TB Wood's Corporation and Thomas C. Foley, Michael L. Hurt, Carl R. Christenson, Michael H. Iversen, Willard C. Macfarland, Jr., and other key employees dated January 29, 1998 issued under the 1996 Plan (incorporated by reference to Form 10-K, for fiscal year 1997, Exhibit 10.49).
10.16 Employment Agreement between TB Wood's Incorporated and Michael L. Hurt dated April 14, 1998.
10.17 Supplemental Executive Retirement Plan between TB Wood's Corporation and Thomas C. Foley, Michael L. Hurt, Carl R. Christenson, Michael H. Iversen and other key employees dated May 7, 1998.
10.18 Form of the Non-Qualified Stock Option Agreements between TB Wood's Corporation and Thomas C. Foley, Michael L. Hurt, Carl R. Christenson, Michael H. Iversen, Willard C. Macfarland, Jr., and other key employees dated January 26, 1999 issued under the 1996 Plan.
10.19 Form of the Non-Qualified Stock Option Agreements between TB Wood's Corporation and Thomas C. Foley, Michael L. Hurt, Carl R. Christenson, Michael H. Iversen, Willard C. Macfarland, Jr., and other key employees dated January 26, 1999 issued under the 1996 Plan.
11.1 Statement regarding Computation of Per Share Earnings.
21.1 Subsidiaries of Registrant.
23.1 Consent of Independent Public Accountants.
(b) Reports on Form 8-K.
There were no reports on Form 8-K by the Registrant during the fourth quarter of fiscal year 1998.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Chambersburg and Commonwealth of Pennsylvania, on March 25, 1999.
TB WOOD'S CORPORATION
By: /s/ MICHAEL L. HURT ------------------------- Michael L. Hurt President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
TB Wood's Corporation And Subsidiaries Schedule II Valuation and Qualifying Accounts
- -------------- Note: (1) Represents write-off accounts to be uncollectible, less recoveries of amounts previously written off. | 11,683 | 77,491 |
1070658_1999.txt | 1070658_1999 | 1999 | 1070658 | ITEM 1. BUSINESS
We began our operations with the formation of Cybernet AG, a privately held German stock company. Cybernet AG was organized in December 1995, and commenced significant operations in 1996. On September 17, 1997, Cybernet AG was acquired by Cybernet Utah. At the time that it acquired Cybernet AG, Cybernet Utah had no material business activities, assets or liabilities. Effective November 18, 1998, Cybernet Utah was merged into Cybernet Delaware, and the Delaware corporation is the surviving entity of the merger. The terms "Cybernet," "we," "us" and "our" refer to Cybernet Delaware and its subsidiaries as a combined entity, except where its use is such that it is clear that such term means only Cybernet Delaware.
Overview
Through our subsidiaries, we are a leading provider of Internet communications services and solutions in Germany, Austria, Italy and Switzerland, targeting small- to medium-sized enterprises. Our IP solutions are based on a core product offering consisting of Internet connectivity and value- added services. Such value-added services include VPNs, web-hosting, co- location, security solutions, electronic commerce, Intranet/Extranet and workflow solutions. We offer consulting, design and installation, training, technical support, and operation and monitoring of IP-based systems. We market our products and services primarily to small- and medium-sized enterprises in Europe because we believe that they represent an underserved and sizeable market. Companies in this market are characterized by a lack of internal technical resources, rapidly expanding communications needs and a high propensity to utilize third-party outsourcing. We are recognized as a provider of high quality Internet connectivity services and solutions to enterprises and as one of Germany's leading Internet access providers. IT Services, a leading German computer magazine has ranked us number one among German ISPs in terms of infrastructure, international outlook and customer service.
Our mission is to become a leading European provider of IP-based communications services and network-based business solutions. We intend to continue to focus on small- and medium-sized enterprises in Europe, offering a full portfolio of advanced communications products, including Internet access and value added services, as well as data and switched voice services.
We believe that our capabilities in Internet, telecommunications and systems integration services differentiate us from many of our competitors who offer some, but not all, of the products and services that we offer. We approach and win business customers by offering and designing a full range of services and solutions for mission critical communications needs, such as electronic commerce solutions, Intranets and VPNs. This enables us to work directly with different levels of our customers' organizations, to participate in the design of customers' systems and to offer additional network and communications services as our customers' businesses grow and their needs change. By basing our solutions upon product modules, we are able to meet our customers' individual needs at competitive prices, while realizing higher margins by reducing costs through standardization. Also, as a result of the high quality of our services and the value-added nature of our solutions, we believe that we experience higher customer retention rates and that we are less vulnerable to pricing pressures than many of our competitors in the telecommunications and Internet industries.
We sell our services and solutions primarily through our direct sales force. Most of our sales people are based in regional offices and are supported by specialized technical and commercial assistance from our customer care centers in Munich, Vienna, Zurich, Rome and Trento. We complement our direct sales effort with an extensive reseller and referral network of over 100 companies and by forming marketing alliances with technology leaders such as OpenShop, Oracle, Intel, Teldefax, InfoAG, Cisco and SUN Microsystems. While our reseller arrangements begin with sales of our basic product offerings, such as connectivity, they can lead to direct sales by us of more complex solutions, such as security solutions or VPNs.
We operate a geographically distributed IP network based upon leased lines. Our network is spread over six countries and consists of network nodes equipped primarily with Cisco and Ascend routers connected to a redundant high- performance backbone infrastructure. We help corporate customers reduce telecommunications costs by offering Internet and voice connectivity through dedicated lines at 56 directly owned points of presence or "POPs". We also offer a system of dial-in nodes with ISDN or analog modem ports to smaller enterprises, employees and affiliates of corporate customers. These nodes permit local dial-in access throughout Germany, Italy and Switzerland and most of Austria. Recently, we reorganized our dial-in network in Germany by concentrating multiple dial-in access nodes into larger access points called "Virtual POPs," which use a Public Switched Telephone Network ("PSTN") to aggregate traffic. We expect this will generate operating efficiencies, in that there will be fewer overall nodes to service. We are expanding our network across Germany, Austria, Italy and Switzerland by installing additional POPs and replacing dial-in access nodes with Virtual POPs.
We also plan to add digital circuit switching capabilities to our network to offer switched voice telecommunications services to our customers, capture more revenues from dial-in traffic and provide termination services to other carriers by layering switched voice capability onto our expanded leased line network. For these purposes, we require:
. licenses to offer voice telephone services in Germany, Austria, Italy and Switzerland;
. up to eight carrier grade digital circuit switches;
. a billing system capable of capturing the necessary data and generating invoices to our customers; and
. interconnection agreements with incumbent operators and other telecommunications carriers.
In Germany, we have:
. obtained a license to offer voice telephone services in the entire country and a license to operate a telecommunication infrastructure;
. installed 2 Nortel DMS-100 switches and ordered another 1;
. installed the Kenan billing system; and
. entered into an interconnection agreement with Deutsche Telecom.
In order to enable us to begin offering voice telephone service before our own switched voice network begins operating fully, we have entered into an interim agreement with a third-party carrier.
In Austria we have obtained a license to provide voice services and to operate a telecommunications infrastructure. Interconnection discussions have commenced. We have ordered 1 Nortel DMS-100 switch and we expect to complete its installation in Vienna by the end of 2000.
In Switzerland, we have begun the process of obtaining a telecommunications license and should receive it within the coming weeks. We have ordered 1 Nortel DMS-100 switch. Switch implementation will commence shortly and should be fully operational by the end of the third quarter of 2000.
In Italy, we hold a license to provide voice services throughout the entire country and a license to operate a network. We have also entered into an interconnection agreement with Telecom Italia. Switches in Rome and Milan are operational, and we expect to have our remaining switches operational by the end of the first quarter of 2000.
We have increased our revenues from $0.3 million in 1996 to $ 23.2 million in 1999. As of December 31, 1999, we provided services to approximately 10,600 business customers, an increase from approximately 200 customers at December 31, 1996. The majority of these customers are small- to medium-sized enterprises. We also provide services to larger companies and organizations such as BASF Corporation, German Parcel, Commerzbank, Hewlett-Packard, Start Media Plus, DaimlerChrysler Aerospace Dornier, BMW Financial Services, Raiffeisenbank, Zuegg, Honeywell, Lauda Air, Modern Times, Amadeus, Lufthansa, News, Nokia Italia, ERG, Avis, Ferrovie dello Stato (Italian Railways) and the Italian Parliament. We also have approximately 39,000 residential customers primarily in Italy.
Our management team consists of individuals with extensive Internet, IT and telecommunications expertise. Andreas Eder, co-founder and Chief Executive Officer, previously held various positions at Siemens-Nixdorf Information Systems and The Boston Consulting Group. Bernd Buchholz, our Executive Vice President for Sales and Marketing, was previously with Esprit Telecom, Novell and Symantec. Robert Eckert, our Chief Financial Officer, was previously with Netsource A/S, Swisscom, and General Electric (USA). In addition, we have recruited individuals at various managerial levels from leading industry participants such as AT&T/Unisource, British Telecommunications and Deutsche Telekom. Our policy is to retain the key executives of the companies we acquire. To this end, we typically structure our acquisitions to give such executives an equity participation in the future success of our Company. We have retained many of the key managers in our acquisitions.
Industry Background
The Internet is a global network of multiple private and public networks that use standardized communication protocols to communicate with each other. Use of the Internet has grown rapidly since its initial commercialization in the early 1990s. International Data Corporation ("IDC"), a market research organization, has estimated that the number of Internet users worldwide will grow from approximately 68.7 million in 1997 to approximately 319.8 million by the end of 2002, a compound annual rate of 36.0%. Consumers and companies in the United States have spearheaded the adoption of the Internet. While other regions of the world have been slower to accept the Internet, its use is becoming a standard communications tool worldwide.
The Internet has become an important commercial medium and represents a significant opportunity for businesses to interact in new and different ways with a large number of customers, employees, suppliers and partners. As use of the Internet grows, businesses are increasing the breadth and depth of their Internet product and service offerings. Pioneering Internet-based businesses have developed Internet products and services in areas such as finance, insurance, media, tourism, retail and advertising. Other businesses have begun to use the Internet for an expanding variety of applications, ranging from corporate publicity and advertising, to sales, distribution, customer service, employee training and communication with business partners. Increasingly, Internet operations are becoming mission-critical for many of these enterprises. To ensure the reliability of their Internet operations, enterprises are requiring that these operations have performance, scalability and expert management 24 hours a day, 7 days a week.
Companies generally utilize two types of Internet services: connectivity and value-added services. Connectivity services provide access to the Internet, while value-added services consist of products such as web-hosting, VPNs, security solutions and systems integration that improve the internal and external operations of a company.
The Internet is also experiencing rapid growth rates in Europe. According to IDC, the number of Internet users in Europe reached 16.8 million in 1997 and is expected to reach 82.0 million in 2002. Datamonitor, another market research organization, estimates that the number of externally hosted commercial websites in Europe will increase from 221,700 in 1997 to 981,900 in 2000, while the number of VPNs will expand from 100 in 1997 to 27,900 in 2000. We believe that the growing numbers of externally hosted websites and VPNs reliably predict a corresponding growth in Internet traffic. We expect this projected growth to be fueled by a number of factors, including the large and growing installed base of advanced personal computers and increased availability of bandwidth, resulting in faster and cheaper access to the Internet, improvements in network architectures, increasing numbers of network-enabled applications, and the emergence of compelling content and commerce-enabling technologies.
Europe lags the United States in terms of total Internet users, Internet users as a percentage of population, and personal computers ("PCs") with Internet access. An historical comparison reveals that Europe is between one and two years behind the United States when the selected indicators are considered. We expect European Internet usage to follow historical United States growth rates and achieve current United States levels within one to two years. The following table provides information about current and projected Internet usage in Europe and the United States.
- -------- Sources: IDC Corporation; population and Internet users as a percent of population are based upon population figures provided by the United States Bureau of the Census.
Internet usage varies significantly between European regions. Northern European countries generally have a higher level of market penetration and service usage than countries in Southern Europe, which we believe currently presents a growth opportunity. The following table summarizes certain information and estimates about revenues from Internet connectivity and from Internet hosting and VPNs in European countries.
- -------- (*) Other includes Austria, Belgium, Ireland, Norway, Portugal and Switzerland.
Source: Datamonitor.
Datamonitor reports that the European corporate Internet connectivity market consisted of 1.2 million accounts and generated total revenues of $919 million in 1997. It estimates that corporate connectivity revenues will grow to $2.6 billion in 2000, a compound annual growth rate of 41.8%.
Datamonitor also reports that in 1997, European Internet value-added services generated revenues of $287 million. It estimates that revenues from value-added services will increase to $1.7 billion in 2000, a compound annual growth rate of 80.7%. In 1997, revenues from hosting services and VPNs were $76 million, 26.5% of total European revenues from value-added services. In 2000, they are expected to be $722 million, 43.2% of such revenues, a compound annual growth rate of 111.8%.
We consider Germany to be the most important connectivity market in Europe in terms of revenues, with a highly developed consumer and business on-line customer base. As the chart above shows, in 1997, the German connectivity market had revenues of $447 million, 48.6% of total European connectivity revenues. It is estimated that, in 2000, Germany will generate connectivity revenues of $1.1 billion, 41.4% of total European connectivity revenues.
Italy currently has a relatively low Internet penetration level. The Internet connectivity market in Italy is very fragmented, with many small providers. We expect that connectivity revenues in Italy will grow at one of the fastest rates in Europe, particularly northern and central Italy, because much of Italian business is concentrated in that area. We believe our acquisition of Flashnet will permit us to take advantage of this growth opportunity.
Business Strategy
Our objective is to become a leading provider of communications services and network-based business solutions to small- to medium-sized enterprises in Europe. We currently offer a full-service portfolio of advanced communications products including Internet access and value-added services, as well as switched voice services. The principal elements of our business strategy are as follows:
Target Small- to Medium-Sized Business Enterprises. We focus on small- to medium-sized enterprises. In Germany, we focus on companies that typically have revenues between (Euro)25 million and (Euro)500 million. According to Statistisches Bundesamt, a German government agency, such companies generate 45% of Germany's total corporate revenues. In other countries, the revenues of small- to medium-sized enterprises as a portion of total corporate revenues vary. We believe that this customer segment is underserved and has substantial and increasing communications needs. Small- to medium-sized enterprises typically lack the technical resources to build and maintain extensive communications systems and, as a consequence, they outsource many services and solutions to third parties. We focus in particular on network intensive industries, such as IT, tourism, retail, finance, government, media and advertising. For many of these industries, utilization of the Internet has become essential. In certain markets, we also serve high-end residential customers.
Initiate Long-Term Relationships with Customers Through Local Coverage and at an Early Stage. Unlike some of our competitors, we use strong local management teams to address the needs of our customers. Most of our sales people are based in regional offices and are supported by specialized technical and commercial assistance from our offices in Munich, Vienna, Zurich, Rome and Trento. This strategy allows us to initiate close relationships with our customers at an early stage of their Internet services requirements, engage in strategic discussions with senior management about their communications requirements, participate in the design of their systems, services and solutions, and establish the basis for long-term relationships at different levels of our customers' organizations. We are then in a position to provide our customers with additional services as their requirements increase or change over time. This also enables us to offer additional solutions to our customers without having to compete primarily on price.
Develop a Total Communications Offering. We currently offer both Internet connectivity services and modular Internet business solutions to our customers. Our modular solutions include web-hosting and -housing, VPNs, security solutions, electronic commerce solutions and Intranet and workflow solutions. As technology evolves, we intend to broaden our product offering to include additional services, solutions and innovations that have proven reliable and effective. In June 1999, we started offering voice services. Our ability to offer voice services will allow us to provide one-stop shopping for integrated voice and data solutions. We believe IP technology and IP applications will be the primary platform and interface for business data and voice communications in the future.
Expand Our Sales Channels. We are currently pursuing growth opportunities through various sales channels. These include trained direct sales representatives with strong technical backgrounds, an extensive reseller program and marketing alliances with technology leaders like Hewlett-Packard, Microsoft, Network Associates, and Sun Microsystems. We are expanding our direct sales force and regional offices to increase our local coverage. We intend to expand our reseller and referral arrangements to increase sales of our basic connectivity services, and enhance our marketing alliances to obtain more potential customer contacts.
Control Our Network. We consider it strategically important to control and operate our own network infrastructure. This will enable us to:
(1)maximize revenues by offering total communications services, including broad band and voice services;
(2)achieve the highest levels of service quality and reliability; and
(3)reduce transmission costs.
This involves:
. optimizing the configuration of our IP network, by concentrating international access at a few select locations where the cost of global access can be minimized; concentrating network planning and management in one central location; and planning the network's redundancy on a pan- European basis rather than on a local basis;
. establishing up to six large-scale data centers of up to 3,000 square meters and five smaller data centers of up to 500 square meters to enhance our co-location and housing service offering;
. installing eight carrier grade digital circuit switches in key cities; and
. leasing transmission capacity on a long-term basis, acquiring backbone capacity, or constructing our own infrastructure in selected locations, to transport high bandwidth data and voice services over all available transmission protocols.
Accelerate Growth in Europe Through Targeted Acquisitions. We will seek to acquire additional Internet-related companies to strengthen our presence in other European countries, while continuing to grow internally. We look for strategically and culturally compatible companies to add to our strong management, enhance our technical expertise, and enhance our customer base in our current coverage area and bordering countries.
Products and Services
We currently offer a comprehensive range of Internet connectivity services, network solutions and business solutions to enterprises in Germany, Austria, Italy, and Switzerland and have started to offer voice services.
Connectivity Services
We offer a variety of connectivity solutions, including Internet access, third party software and hardware implementation and configuration services, in bundled and unbundled packages. We offer dedicated line connectivity at speeds ranging from 64 Kbps to multiples of 2 Mbps. We offer Internet connectivity to our corporate customers through dedicated lines at our 56 directly owned POPs.
We also provide both analog and ISDN dial-in Internet access throughout Germany, Italy and Switzerland as well as throughout most of Austria. In Germany, Italy and Switzerland our dial-in service allows customers to dial into one nation-wide number to access the Internet at local telephone rates. Our dial-in services in Austria utilize seven dial-in access nodes, each of which has its own dial-in number. Currently, we offer our dial-in service through third party telephone networks. As we introduce our interconnection and switching capabilities, we plan to offer dial-in access at a cost approximating that of a local call and also to charge the customer for telephone minutes. Outside the countries in which we operate, we offer roaming at local call rates in cooperation with more than 350 international ISPs and telecommunications companies which have joined the Global Reach Internet Connection.
We offer third-party software products such as electronic mail, news and other solutions that permit customers to navigate and utilize the Internet and give remote access to mobile personnel operating outside traditional office settings. We also provide router services such as router renting, configuration, supervision and maintenance. Overall, we are able to offer customers a full portfolio of services with managed connectivity. Our principal connectivity services include:
Network Solutions
Virtual Private Networks. Many companies today have private data communication networks, which are often referred to as corporate networks. These networks are used to transfer proprietary data between offices and use relatively expensive leased lines to connect various locations. Our VPNs utilize the Internet as a cost effective alternative to corporate networks to provide secure transmission of data and voice with the added benefit of secure remote access. In addition, our VPN products are often the basis for Intranet services (connectivity of branch offices, teleworkers and mobile workforce) and Extranet services (connectivity of business partners, suppliers and customers) services. We offer these products in conjunction with additional hardware and software solutions, as well as continuous operation and maintenance, customer care and billing services. Flashnet offers a product called ALL IN ONE, an all inclusive solution including combinations of data transmission, Internet access and voice-over IP, representing the ideal platform to build VPNs for customers.
Security Solutions. Corporate networks and systems need to be protected against unauthorized access and use. We currently offer a comprehensive set of third-party supplied security products, including encryption, firewall and authentication packages. We add value to this software by providing services such as security consulting, installation support, on-the-job training of customers' system administrators, hotline support (24 hours a day, 7 days a week) and security audits. To assure the security of communication and business transactions between users of networks, we integrate state-of-the-art software, technologies and standards. We offer these security solutions as stand-alone products or as part of broader solutions, such as VPNs or Intranets. Our principal security solutions include:
Application and Website Hosting. We offer shared server application and website hosting services, which permit corporations to market themselves and their products on the Internet without having to invest in independent technology infrastructure and operations staff. Such customers receive sufficient bandwidth to meet their needs and the benefits of having their systems housed in one of our continuously maintained data centers. Applications on our servers, which our customers can access, include shop and mall systems, payment systems, publishing systems and video conferencing.
Electronic Commerce. Electronic commerce is the execution of commercial transactions on the Internet. We design and implement dedicated electronic commerce systems or any component part which a customer may require, such as shop or mall, credit verification and payment handling verification. These systems are
based on our electronic commerce platform which integrates systems and technologies of third-party vendors, such as Brokat, Hewlett-Packard, Intershop, Microsoft, SAP, Sun Microsystems, VeriFone and others. For customers reluctant to undertake an investment in a proprietary electronic commerce solution, we maintain our own electronic commerce system, which we provide on a lease basis. Through working arrangements with content providers and media companies, we also assist customers utilizing electronic commerce for retail and wholesale sales to targeted groups on the Internet. This enables a customer to establish a distribution channel for products or a channel for purchasing, and to determine whether to invest in a dedicated system. Our principal electronic commerce services include:
Intranet and Workflow Solutions. Internet technologies can be utilized in a customers' internal information technology system. We offer Intranet and workflow solutions that enhance the capabilities, efficiencies and functionality of our customers' systems, speed the development of new applications, reduce the cost of developing and maintaining applications and allow the integration of existing systems and databases. Thus, instead of replacing their systems, customers can preserve their investment and upgrade their systems with our enhanced solutions. Our Intranet platform integrates basic dial-in and leased line connectivity with IP-based VPNs and a communications infrastructure that includes facsimile, voice mail, electronic mail and enhanced security solutions. Our principal Intranet and workflow solutions include:
Voice Services
We offer switched voice services to our IP-based customers, as well as value- added and integrated solutions combining switched voice solutions and IP solutions. We also envision offering wholesale services to other carriers on a case-by-case basis.
In Italy, we offer ALL IN ONE, an all-inclusive solution which combines data transmission, Internet access and voice-over IP. This is an ideal platform for building VPNs.
Initially, pending completion of our own interconnect arrangements, these services are offered in co-operation with a third-party telecommunications operator. As we complete the implementation of our own voice switching capabilities and leased line network, we anticipate capturing more dial-up revenues and reducing our transmission costs.
Sales and Marketing
We believe that our sales and marketing program enables us to effectively market our comprehensive range of products and services to corporate customers. We tailor our marketing approach as follows:
. to our principal target market of medium-sized corporations, we offer customized solutions at competitive prices by designing systems that integrate modular elements of proven functionality, effectiveness and reliability;
. to some larger customers with more specialized needs, we offer more sophisticated technical services and individualized solutions; and
. to customers with basic service needs, we provide services which require minimal customization and installation, such as Internet connectivity.
Direct Sales. At December 31, 1999, our direct sales force consisted of 119 sales representatives located in 19 offices in 17 cities, Frankfurt, Dusseldorf, Berlin, Munich, Stuttgart, Hamburg, Vienna, Trento, Rome, Milan, Bologna, Venice, Florence, Padua, Verona, Zurich and Lausanne. We are in the process of expanding that direct sales force and opening additional sales offices. We are also increasing our local presence and enhancing client coverage by shifting more of our direct sales representatives from our headquarters to our regional offices, where they will be closer to customers.
Our sales force has a strong technical background and a detailed understanding of the differing needs of the customers in the regions it serves. It is knowledgeable about our main targeted industry segments, particularly IT, tourism, retail, finance, government, media and advertising.
Channel Sales and Partnerships. Our channel sales group develops relationships with resellers of our products and services and maintains marketing alliances. In Germany, our three-person channel sales group works with a network of more than 100 resellers, primarily software suppliers, systems integrators and ISPs, through whom we offer basic services such as Internet connectivity that can be delivered with a minimum of customization and installation. Direct sales people in Austria and Italy also develop reseller relationships. In addition, we utilize our reseller relationships to gain direct access to customers for the sale of additional products and services. Our marketing alliances with a select group of companies provide a strong mutual referral program, which we believe will enable us to acquire new customers cost effectively, benefit from association with well-known partners and increase our brand awareness. We currently have marketing alliances with Hewlett-Packard, Microsoft, Network Associates, Sun Microsystems and others.
We intend to conduct our operations and marketing under the Cybernet brand name, although we use subsidiary brand names for transition periods after acquisitions. We have undertaken public relations efforts to
raise the awareness and visibility of the Cybernet name in our target markets. We present ourselves as "The Communication People," providing connectivity, value-added solutions and superior customer service.
Technology and Network Operations
Overview
The IP network of an ISP consists of a number of access nodes linked by owned or leased lines. Access nodes are used to provide our customers with access to our network either through dedicated lines or regular telephone lines (dial-in access). The IP traffic generated at each access node is carried through our backbone network to points of traffic exchange, where traffic is exchanged with other providers' networks. These points of traffic exchange can be of two types: peering points or transit points. Peering points provide for the free exchange of traffic pursuant to agreements between ISPs. Transit points provide global connectivity which we purchase from international carriers.
IP Network
We currently operate a geographically distributed IP based network in six countries (Germany, Switzerland, Austria, Italy, Hungary and Luxembourg) consisting of network nodes equipped primarily with Cisco and Ascend routers connected to a redundant high-performance backbone infrastructure. The network nodes are connected primarily by leased lines and include 15 POPs in Germany, 23 POPs in Italy, 6 POPs in Austria and 10 POPs in Switzerland, and a single POP in Luxembourg and Budapest. We lease our lines from major telecommunications carriers and backbone operators, such as Deutsche Telekom, Telecom Italia, Swisscom, Telekom Austria and GTS. We also operate two microwave links that connect Munich with Innsbruck and the Italian border at speeds of 34 Mbps. Our network nodes are interconnected at E-1 to DS3 speeds. We offer our dedicated line customers direct access to our POPs at bandwidths ranging from 64 kbps to DS3. We have at present approximately 480 customers using dedicated line access. We believe our network is recognized as one of Germany's most extensive and highest quality Internet networks. We expect to expand our network to include POPs in additional cities in Germany, and Switzerland. We intend to acquire or enter into long-term leases for backbone capacity or construct our own infrastructure in selected locations in order to transport high bandwidth data and voice services over all available transmission protocols, at lower costs than using leased lines.
Our IP network is designed to offer reliability, scalability and high transmission speed to our customers. We achieve reliability by operating a fault tolerant network through our redundant backbone in Germany, Austria, Switzerland and Northern Italy, which is based on a hierarchical multiple ring design. We include back-up routers in our access nodes to attain further redundancy, and thereby minimize the risk of single points of failure. To ensure constant worldwide connectivity, we use multiple global access providers. In Italy, our extensive network is based on a star design and achieves redundancy through back-up leased lines. We derive scalability from a hierarchical multi-layer architecture that offers the opportunity to add network locations without major infrastructure changes. We offer transmission capacities ranging from 64 kbps to DS3 and intend to upgrade parts of our network to STM-1 capacity in the near future. In addition, our network includes cache servers in the major POPs to reduce the delivery time of regularly requested information and reduce bandwidth needs for international traffic.
We offer dial-in Internet access through dial-in nodes with analog and ISDN ports that provide coverage throughout Germany, Italy and Switzerland and throughout most of Austria. In Germany, our BELT system enables us to offer local dial-in connections to our customers throughout the country with a single dial-in number. We have achieved this by concentrating multiple dial-in access nodes into four larger access points called virtual POPs, using the PSTN to aggregate traffic. We expect that these virtual POPs will generate operating efficiencies, because there will be fewer locations we will be required to service. We already offer local dial-in access through a single dial-in number in Switzerland and Italy. In Austria, our dial-in customers can access our network through seven telephone numbers.
Peering and Transit Relationships. We have entered into peering agreements with major ISPs in each of the countries in which we operate. We have peering agreements with more than 25 ISPs in Germany, Austria, Italy and Switzerland. Our main peering points are in Frankfurt, Munich, Milan, Rome, Vienna and Zurich. We also peer directly through leased lines connected to some of our peering partners, such as Deutsche Telekom. We plan to enter into additional peering agreements in order to establish a direct presence in most European peering centers and to reduce transit costs. We expect to connect to peering points in France, Belgium, The Netherlands and the United Kingdom. Recently, some ISPs have restricted peering agreements by implementing restrictive criteria for small ISPs. We believe that our size and growth prospects will allow us to maintain and extend our existing agreements.
We have entered into global transit agreements pursuant to which we have purchased the right to route traffic across the networks maintained by Ebone, Global One, Swisscom, AT&T Corporation/Unisource and MCI Worldcom. This provides our customers with the ability to communicate with those European countries in which we are not present, and with the rest of the world. Frankfurt, Munich, Vienna and Zurich currently serve as our global access points.
Network Management
The effective functioning of our network is one of the key elements of our operations. We have developed network management capabilities to offer reliable and cost efficient communications services and to deliver high quality services to our customers. Our Network Operations Centers ("NOCs") in Munich, Vienna, Zurich and Trento, monitor the performance of our network and our international links 24 hours a day and seven days a week. Our NOCs have the capability to identify network problems on a real-time basis. Our technical support groups are equipped to take the necessary corrective measures quickly. We intend to centralize our NOCs in a single facility in Munich.
Data Centers
We house servers in our data centers that are linked to our network. We currently operate data centers in Munich, Frankfurt, Rome and Milan. Our main data center in Munich has a capacity of 330 square meters for co-location and 230 square meters for electronic commerce. We intend to establish additional data centers in Hamburg, Vienna, Trento, Padua, and Zurich. These data centers will be co-located with certain of our IP nodes (POPs) and switching facilities. We have already signed leases for the facilities in Hamburg, Frankfurt, Trento, Milan, Rome and Munich. Each of these facilities will be between 300 and approximately 2,000 square meters in size. We intend to secure an additional 1000 square meters of space at our Milan data center. We are designing these facilities to house transmission, IP routing and switching equipment, and to offer hosting, co-location, facilities management and interconnection services to our corporate customers, ISPs and telecommunications carriers. Each facility will offer uninterruptible power supply and back-up generators, air- conditioning, constant monitoring and physical security to ensure a high quality of service with minimal interruptions.
Switched Voice
We have added digital circuit switching capabilities to our network. Until we finalize the installation of our switches and negotiate interconnection agreements, we are able to offer switched voice services using a third-party provider. We are installing carrier grade Nortel DMS-100 voice switches in Germany, Italy, Austria and Switzerland. In Germany, we have obtained a class 4 license, which is necessary to offer telephony services. We expect to interconnect with Deutsche Telekom at multiple points of interconnection, thereby minimizing our interconnection costs in the German market. Cybernet Italy has a telephony license to offer voice services throughout Italy and has entered into an interconnection agreement with Telecom Italia. In Austria we have received a national license to offer switched services and we have applied for a similar license in Switzerland. We have started the process of entering into interconnection agreements in Switzerland and Austria. We have installed an integrated billing system through which we expect to be able to provide a single bill to our German customers for voice and IP services. Over time, we plan to centralize our billing and provide integrated bills to the customers in all of the countries we service.
Customers
Our customers include businesses in IT, tourism, service, retail, finance, government, media and advertising and manufacturing. Following is a list of certain business groups in each of seven selected industry groups to which we provided services and solutions as of December 31, 1999.
* Information Technology * Finance Hewlett-Packard Julius Bar Microsoft Austria AXA Nordstern Colonia CompuNet HypoVereinsbank Cyberlab Interactive BMW Leasing Hogatex Commerzbank Info AG GE Capital Finance InstallShield Software VR--Leasing Centro Informatica Raiffeisen Prism Software Engineering CompuServe Interactive Service * Government Internet Consulting Federal Y2K Office Swissdata Regulierungsbehoerde fur PrimaCom Telekommunikation und Post Bundesdruckerei * Travel and Tourism Ministerium fur Wissenschaft Frosch Touristik Stadtwerke Karlsruhe START AMADEUS START Media Plus * Media and Advertising Lauda Air Finanzen-Verlag Media Consulting * Retail News Magazine Eddie Bauer ORF Modern Times O Werbung F.W. Woolworth Co. Suzuki Auto * Manufacturing Tengelmann Bayer Wrigley Daimler Chrysler Aerospace Zuegg Hugo Matthaes Druckerei
Customer Service
We provide high quality customer service and support in order to enhance the strength of our brand name, increase customer retention rates and generate new customer referrals. Our customer services are organized into technical support and call center groups.
Our technical support group consists of technicians in our Munich NOC and field engineers. The NOC-based technicians respond to customer requests 24 hours a day, seven days a week, diagnosing customers'
problems and providing immediate assistance. We believe that our centralized technical support operations improve the quality and consistency of our support, achieve scalability in our resources and benefit from economies of scale. Our field engineers are available to visit our customers' premises, as necessary.
Our call center provides complete information and specifications about each of our products and advises our customers on service and solutions related questions.
We have purchased and installed and are in the process of implementing an integrated billing system for Internet and switched voice services and are in the process of introducing this new system to our customers. We have licensed the Kenan billing platform and have adapted it to our requirements. Implementation of this system caused some delay in our processing of customer invoices in the first quarter of 1999 and we are still experiencing some problems with implementation. Kenan, a subsidiary of Lucent Technologies, is a leading provider of billing solutions to the telecommunications industry. Initially, this system will allow us to provide a single bill to our German customers for all the different services they are purchasing from us, thereby simplifying their internal operations and reducing our costs. We intend to adopt the use of this integrated billing system on a Company-wide basis and to manage it from our central offices in Munich.
Acquisitions
Since we began business in 1996, we have acquired seven companies through which we have expanded our technical capabilities, attracted additional talent, entered new markets and increased our customer base:
. Cybernet E-Commerce. In September 1997, we acquired 100% of Artwise which was later renamed Cybernet E-Commerce, a German company which provided us with expertise in Intranet messaging and workflow solutions and established our presence in the Ulm region of Germany;
. Eclipse. In December 1997, we acquired 66% and in 1999 we acquired the remaining 34% of Eclipse, an ISP based in Trento, Italy, through which we established our presence in Northern Italy;
. Open:Net. In August 1998, we acquired 100% of Open:Net, an ISP through which we increased our penetration of the southwest German market serviced by Artwise;
. Vianet. In December 1998, we acquired 100% of Vianet, a leading Austrian ISP through which we entered the Austrian market and significantly increased our customer base;
. Sunweb. In May 1999, we acquired 51% and an option to purchase the remaining 49% of Sunweb, through which we established a presence in Switzerland and acquired substantial additional expertise in switched voice services; and
. Flashnet. In June 1999, we acquired 100% of Flashnet, a leading Italian ISP through which we gained access to all major business centers in Italy. We have combined Eclipse and Flashnet into a single operation which we call Cybernet Italy.
. Novento. In October 1999, we acquired 51% and in December we acquired the remaining 49% of Novento Telecom AG and its sister organization, Multicall Telefonmarketing AG, which are German direct marketing organizations for communications services through which we expanded our sales capabilities and acquired additional sales and marketing expertise.
Competition
The business of providing Internet connectivity, services and solutions is highly competitive and there are no substantial barriers to entry. We believe that competition will intensify in the future and our ability to successfully compete depends on a number of factors including: market presence; the capacity, reliability and security of our network; the pricing structure of our services; our ability to adapt our products and services to new technological developments; and principal market and economic trends. Our competitors consist of ISPs, telecommunications carrier, and system integrators/computer manufacturers. Because few of our competitors in any of these groups provide all of the products, services and solutions that we provide, we believe that we are well positioned to compete in our market.
ISPs
We strive to differentiate ourselves from other ISPs by offering a full range of services and solutions which business customers are likely to require in connection with their use of the Internet. Most of our ISP competitors offer fewer services and focus on connectivity. However, some competitor ISPs have greater resources and larger communications and network infrastructures than we do. In Germany, these competitors include: European Computer-Industry Research Centre; Nacamar; PSINet; UUNet Technologies; and Xlink. In Austria, they include Cybertron, EUnet Multimedia Network Services and Netway Austria; and in Italy, they include I-Net.
Telecommunications carriers
Many telecommunications carriers are large organizations and do not provide Internet services as their main product. With regard to Internet services, we compete with these organizations by focusing on the Internet and offering flexible decision making and execution, responsive customer service, recognized technical expertise, and high quality products. Our main carrier competitors in Germany are: Mannesmann Arcor, Deutsche Telekom and Viag Interkom. In Austria, our principal carrier competitors are Telekom Austria, United Telecom and Tele.ring. And in Italy, they are Infostrada, Telecom Italia and Wind.
In offering voice services, we compete directly with carriers, including large carriers such as Mannesman Arcor, Deutsche Telekom and Viag Interkom in that market segment. Most of these competitors are significantly larger and have substantially greater market presence, financial, technical, operational, marketing and other resources and experience than we do. In addition, carriers have greater resources to engage in various forms of price competition, such as bundling Internet services with other telecommunications services, thereby offering lower prices for either telecommunications or Internet services. Increased price competition could force us to reduce our prices, resulting in lower profit margins. In addition, increased competition for new customers could result in increased sales and marketing expenses and related customer acquisition costs and could materially adversely affect our profitability.
Major System Integrators and Computer Manufacturers
Major systems integrators and computer manufacturers, such as Andersen Consulting and IBM, provide IT solutions to their clients and have expanded their offerings to include Internet-related products and solutions. Many of these companies have established customer relationships and recognized technical expertise, and some have significantly greater resources than we have. However, most do not offer connectivity services and solutions. We compete with these companies by offering a more complete Internet-related service and product line than they offer. In fact, some system integrators and computer manufacturers utilize our connectivity services and solutions to complement their own lines of products and services.
Research and Development
Our future success will depend, in part, on our ability to offer services that incorporate leading technology, address the increasingly sophisticated and varied needs of current and prospective customers and respond to technological advances and emerging industry standards and practices on a timely and cost effective basis. The market for our services is characterized by rapidly changing and unproven technology, evolving industry standards, changes in customer needs, emerging competition and frequent introductions of new services. We cannot assure you that future advances in technology will be beneficial to, or compatible with, our business or that we will be able to incorporate into our business such advances on a cost effective and timely basis. Moreover, technological advances may have the effect of encouraging certain of our current or future customers to rely on in-house personnel and equipment to furnish the services we currently provide. In addition, keeping pace with technological advances may require substantial expenditures and lead time.
Intellectual Property Rights
We rely on a combination of copyright, service mark and trade secret laws and contractual restrictions to establish and protect certain proprietary rights in our products and services. In this regard, we have applied to the EU and received a trademark registration for the name "Cybernet" used in conjunction with our logo. We have also applied for, but have not yet received a trademark registration for the name "Cybernet." We have no patented technology that would preclude or inhibit competitors from entering our market. We have entered into confidentiality and invention assignment agreements with our employees, and non-disclosure agreements with our consultants, vendors, suppliers, distributors and appropriate customers in order to limit access to and disclosure of our technology, documentation and other proprietary information. We cannot assure you that these contractual arrangements or the other steps we have taken to protect our intellectual property will prove sufficient to prevent misappropriation of our technology or to deter independent third-party development of similar technologies. The laws of the countries in which we operate may not protect our products, services or intellectual property rights to the same extent as do the laws of the United States. To date, we have not been notified that our products are claimed to infringe the proprietary rights of third parties, but we cannot assure you that third parties will not claim infringement by us with respect to current or future products. We expect that participants in our markets will be increasingly subject to infringement claims as the number of products and competitors in our industry segment grows. Any such claim, whether meritorious or not, could be time consuming, result in costly litigation, cause product installation delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements might not be available on terms acceptable to us, or at all. As a result, any such claim could materially adversely affect our business, results of operations and financial condition.
Regulation
Regulatory Environment in the Internet-Related Markets of the Company
Our Internet operations are not currently subject to direct regulation by governmental agencies in the countries in which we operate (other than regulations applicable to businesses generally). In 1997, Germany enacted the Information and Communication Services Act which releases Internet access providers from liability for third-party content in certain circumstances and establishes a legal framework for Internet commerce with respect to the identification of service providers, data privacy and price indications on the Internet. A number of other legislative and regulatory proposals are under consideration with respect to Internet user privacy, infringement, pricing, quality of products and services and intellectual property ownership. There is also controversy regarding the application of value-added taxes in the Internet environment. The adoption of new laws could materially adversely affect our business, result of operations and financial condition.
Regulation and Regulatory Authorities in the Telecommunications Market
Effective January 1, 1998, all of the countries in which we operate abolished the monopoly rights of incumbent operators to provide fixed-line voice telephone services to the public. As a result, competitive telecommunications markets are now developing for long distance and international telephone services. Competition for local telephone service has been much slower to develop.
All of the countries in which we operate have enacted legislation and regulations and have established regulatory authorities for the telecommunications industry. The purpose of this regulation is to ensure:
(1)a wide range of high-quality, telecommunications services to private individuals and businesses;
(2)reliable services to the entire population at affordable prices;
(3)the absence of interference with personal and intellectual property rights in telecommunications traffic; and
(4)effective competition in the provision of telecommunications services
(5)access to the dominant operator's network on non-discriminatory terms.
In each of the countries in which we operate, providing telecommunications services and related facilities requires a license. The regulatory authorities have various powers, including the authority to grant and revoke licenses, assign and supervise frequencies, impose universal service obligations, control network access and
interconnection, and approve or review the tariffs and tariff-related general business terms and conditions of market-dominant providers.
In the countries in which we operate, different classes of licenses are required for different services offered and facilities operated. We have obtained a "class 4 license" (voice telephone services based upon self-operated telecommunications networks) in Germany. Geographically this license covers the entire Federal Republic of Germany and is valid indefinitely. We have also obtained a license to provide public telephony service and to operate our own infrastructure in Austria and have applied for a similar license in Switzerland. In Italy, we have a license which permits us to offer voice telephone services in the entire country. We have also obtained a "class 3 license" in Germany which permits us to operate cables, radio links and other telecommunications-related infrastructure throughout Germany.
In the switched voice telephony market, our ability to provide viable services depends in significant part upon our ability to secure and maintain interconnection agreements with the incumbent operators and other facilities- based providers in our target markets. We have entered into interconnection agreements with Deutsche Telekom in Germany and Telecom Italia in Italy. We are negotiating for a similar agreement in Austria. We need interconnection to complete calls that originate on our network but terminate outside our network or originate elsewhere and terminate on our network. The cost of interconnecting is a critical factor in determining whether services on our network can be offered on a competitive basis.
Each of the countries in which we have operations has market-dominant providers which are legally required to offer essential services such as transmission, switching and operational interface to networks such as the one we plan. Market-dominant operators of telecommunications facilities are obligated to provide interconnection on a non-discriminatory basis and at cost- related prices. If the terms and conditions of obligatory interconnection cannot be agreed upon, the regulatory regimes of the countries in which we operate provide for administrative proceedings which permit regulatory authorities to set the conditions for interconnection.
Subscriber Line Charges
We rely upon Deutsche Telekom for leased lines so as to obtain direct access to customers. Although the rates which Deutsche Telekom may charge for such lines have been established by the Regulatory Authority
and the ruling of the Regulatory Authority purports to establish rates which will be in effect until March 31, 2001, the ruling has been appealed to a court. Any possible increase in these rates of the rental charge could impede our business development.
Internet Access Charges
T-Online, an ISP owned by Deutsche Telekom, has announced its intention to charge Internet subscribers a flat rate that is significantly lower than the rate charged by competitor ISPs. The District Court (Landgericht) Hamburg enjoined T-Online from offering this rate because the telecommunications law forbids market dominant providers from bundling services. However, this court decision is not final and we cannot anticipate the final outcome of this issue. If T-Online is permitted to charge the proposed rate, our ability to market Internet access services might be adversely affected.
Employees
At the end of December 1999, we had a total of approximately 426 employees organized as follows: 145 in sales and marketing, 198 in technical and operational personnel and 83 in administration. There are no collective bargaining agreements in effect. We believe that relations with our employees are good.
Item 2.
Item 2. Properties
We lease the real estate where our business offices and certain nodes containing servers, routers and other equipment are located. Our largest leasehold property is our main office in Munich with approximately 2,000 square meters. Other leasehold properties for our regional offices are located in Ulm, Neu-Ulm, Frankfurt, Dusseldorf, Berlin, Munich, Stuttgart, Hamburg, Vienna, Trento, Rome, Milan, Florence, Padua, Verona, Zurich, Lausanne and an administrative office is located in Washington, D.C. In addition, we lease approximately 3,500 square meters for our planned facility in Frankfurt, 2,500 square meters for our planned facility in Hamburg and 600 square meters for our new Trento Data Center, and are planning to lease additional space in Dusseldorf, Munich and Vienna.
We believe that none of these leases is critical to operations and that relocation of any of the leased premises would be feasible on acceptable terms, if necessary.
We lease dedicated telephone lines from telecommunications carriers and resellers. Assets relating to our operations, including servers and routers, are leased or owned.
Item 3.
Item 3. Legal Proceedings
In December 1998, we applied for and received a class 4 telecommunications license from Germany's Regulierungsbehoerde fur Telekommunikation und Post. The fee for this license was DM 3,000,000. The EU regulations set the maximum fee that can be charged at the actual cost incurred by a government agency to administer its regulations. We filed an action in a German court to recover a portion of the fee paid for our license because we believe the fee charged exceeded the amount chargeable under EC regulations in effect in 1998 and prevailed in that action in the court of first instance. The decision is subject to appeal and it is not possible to predict the ultimate outcome of our action.
We are involved in several other legal proceedings, none of which we believe to be material and if adversely determined, we believe none would have a material adverse effect upon our business, financial condition or results of operations.
Item 4.
Item 4. Submission of Matters To a Vote of Security-Holders
At a special meeting held on November 16, 1998, shareholder action was taken by the sole existing shareholder of the Company to approve the merger with Cybernet Internet Services International, Inc., a Utah corporation, and the adoption of our 1998 Stock Incentive Plan and 1998 Outside Director Stock Option Plan.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Price Range Of Common Stock
Our common stock is traded on the OTC Bulletin Board under the symbol "ZNET" and on the Neuer Markt of the Frankfurt Stock Exchange under the Symbol "CYN." Our common stock also trades on the Freiverkehr of the Berlin and Munich Stock Exchanges under the securities identification number WP-Kenn-Nr. 906 623. Our principal foreign trading market is the Neuer Markt. As of August 2, 1999, the Company had 169 registered stockholders of record. The closing price of the common stock on the OTC Bulletin Board and the Neuer Markt on March 13, 2000 was $13.00 per share and (Euro)14.30 per share, respectively.
The following tables set forth for the periods indicated the high and low bid prices for the common stock as reported each quarterly period in 1997 and 1998 and each monthly period in 1999 on the OTC Bulletin Board and the Neuer Markt. Prices on the OTC Bulletin are reported in The NASDAQ Trading and Marketing Services' Trading Activity Reports, Trade and Quote Summary. Prices on the Neuer Markt are reported for trades on the electronic trading system of Deutsche Borse A.G. The prices are inter-dealer prices, do not include retail mark up, mark down or commission and may not necessarily represent actual transactions.
OTC BULLETIN BOARD
COMMON STOCK DIVIDEND POLICY
We have never declared or paid cash dividends on our Common Stock. We currently intend to retain all of our earnings, if any, for use in our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
During the year ended December 31, 1999, we sold shares of Common Stock as follows:
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated Statement of Operations data and Balance Sheet data as of and for the years ended December 31, 1997, 1998 and 1999 set forth below has been derived from the financial statements of the Company, which have been audited by Schitag Ernst & Young AG, independent auditors. Business acquisitions made by the Company during the periods for which selected financial data is presented below materially affect the comparison of such data from period to period. The selected consolidated financial data should be read in conjunction with the Company's consolidated financial statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this document.
- ---------------------------------- (1) Including lease obligations
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview:
The following table sets forth, the items of the consolidated statements of loss for the years ended December 31st, 1997, 1998 and 1999, expressed as a percentage of total revenues.
Year Ended December 31, 1999 As Compared To The Year Ended December 31, 1998
Results of Operations
Total revenues increased by 158.3% from $8,634,000 in 1998 to $22,298,000 in 1999. Internet Project revenues increased 10.2% from $5,139,000 in 1998 to $5,663,000 in 1999 and represented 59.5% and 25.4% of our total revenues in 1998 and 1999, respectively. Network Services revenues increased by 376.0% from $3,495,000 in 1998 to $16,635,000 in 1999. In 1999, Network Services represented 74.6% of total revenues as compared to 40.5% in 1998.
The increase in revenue from Network Services is partially a result of an expansion of our customer base, which provides us with a stream of recurring revenues. Although in 1999 the Company has
focused primarily on building these recurring revenues from Network Services, building relationships with customers through Internet Projects remains a continuing strategy. In addition, in 1999 Network Service revenues include a full year of Vianet revenues, nine months of Sunweb revenues, six months of Flashnet revenues and three months of Novento revenues. Vianet and Novento derive all revenues from Network Service sales. Excluding revenues from these acquisitions, Network Service revenues would have increased 134% from $3,495,000 in 1998 to $7,811,000 in 1999.
The increase in Internet Project revenues from 1998 to 1999 is mainly a result of consolidating the Internet Project revenues of $706,000 from Sunweb (nine months) and $256,000 from Flashnet (six months). Excluding these acquisitions, Internet Project revenues would have decreased 8.5% from $5,139,000 to $4,701,000. This decrease is mostly the result of the Company being more selective when taking on Internet Projects in order to apply its scarce human resources to the projects most likely to generate long-term relationships and generate revenues from network-based services.
We derived $12,080,000 or 54.2% of total revenues from our operations in Germany compared with $7,693,000 or 89.1% in 1998, and $5,499,000 or 24.7% of total revenues from our operations in Italy compared with $941,000 or 10.9% in 1998. We derived $3,760,000 or 16.9% of total revenues from our operations in Austria compared with none in 1998, and $959,000 or 4.2 % of total revenues from our operations in Switzerland compared with none in 1998.
In Germany, the largest customer provides 7% of the revenues derived from that market, in Italy 5% is derived from largest customer, in Austria 7% from the largest customer and in Switzerland the largest customer provides 32% of our revenues in that market.
Costs of Revenues
Total costs of revenues increased 149.6% from $10,440,000 in 1998 to $26,062,000 in 1999. Costs of revenues as a percentage of revenues decreased from 120.9% in 1998 to 116.9% in 1999. Cost of revenues mainly consists of (i) telecommunications expenses, (ii) technical and operations personnel costs, (iii) the cost of hardware and software sold, (iv) amortization of product development costs, (v) depreciation of network facilities and equipment, and (vi) consulting expenses in the area of network and software development. Telecommunications expenses mainly represent the cost of transporting Internet traffic from our customer's location through a local telecommunications carrier to one of our access nodes and the cost of leasing lines to interconnect our backbone nodes. Technical and operational personnel included in cost of revenues are those individuals involved in the planning, building and management of our network and the provision of services over this network. We had 198 technical and operations personnel on December 31, 1999 and approximately 99 such personnel at the end of 1998.
The cost of our Internet Projects revenues increased by 8,8% from $4,699,000 in 1998 to $5,110,000 in 1999. This increase primarily resulted from increased purchases of hardware and software that was installed at customer sites, and the costs of additional internal and external personnel hired to complete these projects. Cost of Internet Projects as a percentage of related revenues remained relatively stabile at 91.4% in 1998 and 90.2% in 1999. Although the Company incurred costs in 1999 in developing proposals for some projects it did not win, because the Company was generally more selective in taking on projects it was able to offset these costs and keep margins at the same level as 1998.
The cost of our Network Services revenues increased 321.6% from $4,067,000 in 1998 to $17,148,000 in 1999. This increase primarily consisted of additional leased line expenses related to
the expansion of our network backbone, additional leased lines to our customers' premises and a large increase in network personnel. Cost of Network Services as a percentage of related revenues decreased from 116.4% in 1998 to 103.1% in 1999. This decrease is primarily attributable to a decline in personnel costs as a percentage of revenues and a reduction in purchased Internet Services due to the development of our own network. These decreases were partially offset by additional leased line expenses.
Depreciation and amortization included in the Costs of Revenues, increased from $1,674,000 in 1998 to $3,804,000 in 1999 as a result of investments in our own network infrastructure and the supporting systems, including a billing system. We have capitalized certain costs associated with designing the network, including related software.
General and Administrative Expenses
General and administrative expenses increased 1096% from $1,576,000 in 1998 to $18,844,000 in 1999. General and administrative expenses consist principally of salaries and other personnel costs for our administrative staff, office rent and depreciation of office equipment. The increase in our general and administrative expenses reflects the costs of building a corporate infrastructure to support our anticipated growth and the addition of general and administrative expenses of companies acquired in 1997, 1998 and 1999. As a percentage of revenues, general and administrative expenses increased from 18.3% in1998 to 84.5% in 1999.
General and Administrative staff increased from approximately 32 personnel at the end of 1998 to 83 at the end of 1999. The increases were mostly in the areas of Finance and Accounting, Human Resource management, IT, Executive Management and other support functions. The Company has taken measures in the fourth quarter of 1999 to reduce the number of staff in non-essential support functions. The favorable impact of these reductions will not be realized until the first quarter of 2000, since the Company has had to carry the related cost of dismissed personnel through the end of 1999.
Additionally there was a significant increase in General and Administrative expenses related to the build-up of an international executive management team and supporting structures. Within this area there were also large increases in legal, accounting and other external advisory costs associated with the financing activities, acquisitions and alliances in 1999.
Excluding the general and administrative expenses in the companies acquired in 1999, G&A expenses would have increased 945% from $1,576,000 in 1998 to $16,460,000 in 1999.
Sales and Marketing Expenses
Sales and marketing expenses increased by 218% from $3,844,000 in 1998 to $12,238,000 in 1999. Sales and marketing expenses consist principally of salaries of our sales force and marketing personnel and advertising and communication expenditures. Higher sales and marketing expenses reflect our larger sales and marketing teams, a company-wide increase in advertising and communication expenses, and a major marketing campaign undertaken in the fourth quarter of 1999 to launch the Cybernet brand in Italy. Sales and marketing staff increased from approximately 83 on December 31, 1998 to 145 as of December 31, 1999. As a percentage of revenues, our sales and marketing expenses increased from 44.5% in 1998 to 54.9% in 1999.
Excluding the sales and marketing expenses in the companies acquired in 1999, sales and marketing expenses increased 151% from $3,844,000 in 1998 to $9,660,000 in 1999.
Research and Development
Research and development expenses increased 46.4% from $2,941,000 in 1998 to $4,304,000 in 1999. Research and development expenses consist principally of personnel costs of employees working on product development, consulting costs and certain overhead items. The personnel utilized for this purpose include our own marketing force and the portion of their time which was devoted to product development is included in research and development. As a percentage of revenues, research and development decreased from 34.1% in 1998 to 19.3% in 1999. Most of the research and development expenses have been incurred in our German operations and the consolidation of acquired companies in 1999 only had a minor impact on the growth in expenses in this area.
Depreciation and Amortization
Depreciation and amortization expenses increased from $880,000 in 1998 to $8,322,000 in 1999. This increase reflects increased depreciation of capital expenditures for property and equipment purchased to build the corporate infrastructure necessary to support our anticipated growth, and increased amortization of goodwill related to our 1997, 1998 and 1999 acquisitions. Goodwill represents the excess of the purchase price of companies we purchased over the fair value of the tangible assets of those companies. Goodwill is amortized over 5 - 10 years.
Interest Income and Expense
Interest expense increased from $197,000 in 1998 to $ 18,039,000 in 1999 as a result of the debt issued in 1999. Interest income increased significantly from $154,000 in 1998 to $4,138,000 in 1999 as a result of interest earned on the proceeds of these offerings before the proceeds are utilized in our business. In 1999 we incurred net foreign exchange losses of $4,646,000 as our borrowings are denominated in US dollars but our operational currency is the Deutsche Mark.
Income Taxes
We recorded income tax benefits of $6,172,000 in 1998 and $14,384,000 in 1999, arising principally from operating losses. Whilst the group has additional operating losses, a valuation allowance has been made against some of these losses to reflect the estimated amount which may not be realized. The majority of the operating losses and the associated valuation allowance is associated with operations subject to German tax, and under the current German tax code, these net operating losses may be carried forward indefinitely and used to offset our future taxable earnings.
Year Ended December 31, 1998 As Compared To The Year Ended December 31, 1997
Results of Operations
Revenues
Total revenues increased by 273.1% from $2,314,000 in 1997 to $8,634,000 in 1998. Internet Project revenues increased by 221.6% from $1,598,000 in 1997 to $5,139,000 in 1998 and represented 69.1% and 59.5% of our total revenues in 1997 and 1998, respectively. Network Services revenues increased by 388.1% from $716,000 in 1997 to $3,495,000 in 1998. In 1998,
Network Services represented 40.5% of total revenues as compared to 30.9% in 1997. The primary reason for this shift is that our recurring revenues grow as we expand our customer base. We expect this trend to continue.
Revenues from existing operations, accounted for 34.1% of Internet Project revenues in 1998 compared with 57.1% in 1997. Revenues from existing operations accounted for 23.7% of the growth in Internet Projects from year to year. This growth is attributable to new customers and additional sales to existing customers.
Revenues from acquired companies represented 65.9% of Internet Project revenues in 1998 compared with 42.9% in 1997, and accounted for 76.3% of the growth in Internet Projects revenues from year to year. In 1998 these revenues include a full year of operations of Artwise and Eclipse and three months of operations of Open:Net.
Network Services revenues increased by 387.9% from $716,000 in 1997 to $3,494,000 in 1998 and represented 30.9% and 40.5% of total revenues in 1997 and 1998, respectively. Revenues from existing operations represented 78.3% of Network Services revenues in 1998 compared with 100.0% in 1997. These revenues accounted for 72.7% of the growth in Network Services revenues from year to year.
Revenues from acquired companies represented 21.7% of Network Services revenues in 1998. Acquired companies did not contribute any Network Services revenues in 1997. Revenues from acquired companies accounted for 27.3% of the growth in Network Services revenues from year to year. In 1998 these revenues include a full year of operations of Artwise and Eclipse and three month of operations of Open:Net.
We derived $7,693,000 or 89.1% of total revenues in 1998 from our operations in Germany and $941,000 or 10.9% of total revenues from our operations in Italy. On December 28, 1998, we acquired Vianet, our Austrian subsidiary, which had revenues of approximately $3.1 million in 1998. Future operating results will include Vianet revenues in Austria and revenues from Sunweb, a Swiss company 51% of which we have agreed to acquire.
Our total number of customers increased by 74.4% to approximately 7,400 at December 31, 1998 from 4,300 at December 31, 1997. No single customer accounted for more than 3% of our revenues in 1998.
Costs of Revenues
Total costs of revenues increased 312.4% from $2,532,000 in 1997 to $10,440,000 in 1998. Costs of revenues as a percentage of revenues increased from 109.4% in 1997 to 120.9% in 1998. Cost of revenues mainly consists of (i) telecommunications expenses, (ii) personnel costs, (iii) cost of hardware and software sold, (iv) amortization of product development costs, and (v) service and consulting expenses. Telecommunications expenses mainly represent the cost of transporting Internet traffic from our customer's location through a local telecommunications carrier to one of our access nodes and the cost of leasing lines to interconnect our backbone nodes.
The cost of our Internet Projects revenues increased by 214.2% from $1,495,000 in 1997 to $4,699,000 in 1998. This increase primarily resulted from increased purchases of hardware and software, that was installed at customer sites, and the costs of additional personnel. Cost of Internet Projects as a percentage of related revenues decreased from 93.5% in 1997 to 91.4% in 1998. This
decrease is primarily attributable to a reduction in training and seminar expenditures, partially offset by an increase in purchases of hardware and software.
The cost of our Network Services revenues increased by 370.0% from $866,000 in 1997 to $4,067,000 in 1998. This increase primarily consisted of additional leased line expenses. Cost of Network Services as a percentage of related revenues decreased from 120.8% in 1997 to 116.4% in 1998. This decrease is primarily attributable to a decline in personnel costs as a percentage of revenues and a reduction in purchased Internet Services due to the development of our own network. These decreases were partially offset by additional leased line expenses.
Depreciation and amortization, included in Costs of Revenues, increased from $171,000 in 1997 to $1,674,000 in 1998 as a result of new investments in product development from year to year. We have capitalized certain costs associated with designing the network, including related software. We have also capitalized investments made in building network capacity, including related personnel and consulting costs. These costs appear in our balance sheet under product development cost and are amortized over a period not exceeding four years.
General and Administrative Expenses
General and administrative expenses increased 227.1% from $482,000 in 1997 to $1,576,000 in 1998. General and administrative expenses consist principally of salaries and other personnel costs for our administrative staff, office rent and depreciation of office equipment. The increase in our general and administrative expenses reflects the costs of building a corporate infrastructure to support our anticipated growth and the addition of general and administrative expenses of companies acquired in 1997 and 1998. As a percentage of revenues, general and administrative expenses decreased from 20.8% in 1997 to 18.3% in 1998.
Marketing Expenses
Marketing expenses increased by 223.4% from $1,189,000 in 1997 to $3,844,000 in 1998. Marketing expenses consist principally of salaries of our sales force and advertising and communication expenditures. Higher marketing expenses reflect an increase in salary expense resulting from our larger sales force and an increase in advertising and communication expenses reflecting our drive to improve public awareness of our brand. As a percentage of revenues, our marketing expenses decreased from 51.4% in 1997 to 44.5% in 1998.
Research and Development
Research and development expenses increased 950.4% from $280,000 in 1997 to $2,941,000 in 1998. Research and development expenses consist principally of personnel costs of employees working on product development, consulting costs and certain overhead items. The development of our modular products and the related pricing research which we conducted in 1998 is reflected in the higher personnel costs included in research and development. The personnel utilized for this purpose include our own marketing force and the portion of their time which was devoted to product development is included in research and development. We also incurred consulting expenses in 1998 while researching the viability of certain telecommunications services that we plan to offer in the future. As a percentage of revenues, research and development increased from 12.1% in 1997 to 34.1% in 1998.
Depreciation and Amortization
Depreciation and amortization expense, increased from $116,000 in 1997 to $880,000 in 1998. This increase reflects increased depreciation of capital expenditures for property and equipment purchased to build the corporate infrastructure necessary to support our anticipated growth, and increased amortization of goodwill related to our 1997 and 1998 acquisitions.
Goodwill represents the excess of the purchase price of companies we purchased over the fair value of the tangible assets of those companies. Goodwill is amortized over 10 years.
Interest Income and Expense
Interest expense increased 392.7% from $40,000 in 1997 to $197,000 in 1998 as a result of new capital lease obligations which we undertook in 1998 to finance acquisitions of computer equipment. Interest income in 1998 was earned on excess cash balances resulting from the proceeds of our 1998 equity offerings.
Income Taxes
We recorded income tax benefits of $1,339,000 in 1997 and $6,172,000 in 1998, arising principally from incurred operating losses. Under the current German tax code, these net operating losses may be carried forward indefinitely and used to offset our future taxable earnings.
Year Ended December 31, 1997 As Compared To The Year Ended December 31, 1996
Results of Operations
Revenues
Total revenues increased by 652.1% from $308,000 in 1996 to $2,314,000 in 1997, principally because 1997 was a full year of operation while 1996 involved substantial start up and initial marketing activities.
Revenues from Internet Projects represented 70.6% and 69.1% of total revenues in 1996 and 1997, respectively, and increased by 635.3% from $217,000 in 1996 to $1,598,000 in 1997. Revenues from Network Services represented 29.4% and 30.9% of total revenues in 1996 and 1997, respectively, and increased by 692.4% from $90,000 in 1996 to $716,000 in 1997.
Revenues from existing operations represented 57.1% of Internet Project revenues in 1997 compared with 100.0% in 1996. These revenues accounted for 50.4% of the growth in Internet Projects revenues from year to year. Revenues from acquired companies represented 42.9% of Internet Project revenues in 1997. These revenues accounted for 49.6% of the growth in Internet Projects revenues from year to year. These revenues include the results of operations of Artwise for four months in 1997.
Our total number of customers increased by 194.5% in 1997 to 4,300 customers from 1,460 in 1996. No single customer accounted for more than 7% of our revenues in 1997.
Costs of Revenues
Total costs of revenues increased 597.2% from $363,000 in 1996 to $2,532,000 in 1997. Costs of
revenues as a percentage of revenues decreased from 118.0% in 1996 to 109.4% in 1997.
The cost of our Internet Projects revenues increased 530.8% from $237,000 in 1996 to $1,495,000 in 1997. This increase primarily resulted from increased personnel costs, training and seminars, and purchases of software that was installed at customer sites. Cost of Internet Projects as a percentage of related revenues decreased from 109.1% in 1996 to 93.6% in 1997. This decrease is primarily attributable to a reduction of free lance staff costs.
The cost of our Network Services revenues increased by 625.4% from $119,000 in 1996 to $865,000 in 1997. This increase primarily consisted of increased personnel costs and the cost of additional leased lines. Cost of Network Services as a percentage of related revenues decreased from 132.0% in 1996 to 120.8% in 1997. This decrease is primarily due to a decline in purchased Internet services and leased line expenses as a percentage of revenues and was partially offset by additional personnel costs.
General and Administrative Expenses
General and administrative expenses increased 83.0% from $263,000 to $482,000 in 1997. Increases in our general and administrative expenses reflect the costs of building a corporate infrastructure, which will support our future growth. It also reflects the impact of the addition of general and administrative expenses of companies acquired in 1997. As a percentage of revenues, general and administrative expenses decreased from 85.5% in 1996 to 20.8% in 1997.
Marketing Expenses
Marketing expenses increased by 621.8% from $165,000 in 1996 to $1,189,000 in 1997. Increases in our marketing expenses are attributable primarily to increased salaries reflecting our efforts to build a larger sales force and larger advertising and communication expenses in our drive to improve public awareness of our brand name. As a percentage of revenues, our marketing expenses decreased from 53.5% in 1996 to 51.4% in 1997 due to a reduction of free lance staff costs and merchandising costs. These reductions were partially offset by higher personnel costs and advertising and communication expenses.
Research and Development
Research and development expenses increased 56.3% from $179,000 in 1996 to $280,000 in 1997 primarily as a result of increased personnel costs. As a percentage of revenues, our research and development decreased from 58.2% in 1996 to 12.1% in 1997 due to the growth of our revenues.
Depreciation and Amortization
Depreciation and amortization, increased from $21,000 in 1996 to $116,000 in 1997, reflecting increased capital expenditures in property, plant and equipment. The increase in goodwill amortization from 1996 to 1997 is due to goodwill additions generated by the 1997 acquisitions.
Interest Income and Expense
Interest expense increased from $2,000 in 1996 to $40,000 in 1997, principally due to the higher level of overdrafts and short term borrowings in 1997 compared to 1996. These overdrafts were
used to fund the Company's working capital requirements.
Income Taxes
We recorded income tax benefits of $402,000 in 1996 and $1,339,000 in 1997, arising principally from operating losses incurred. Under the current German tax code, these net operating losses may be carried forward indefinitely and used to offset our future taxable earnings.
Liquidity and Capital Resources
Since our inception, we have financed our operations and growth primarily from the proceeds of private and public sales of securities. Total net proceeds of debt and equity offerings in the four years ended December 31, 1999 amounted to approximately $293 million, including some $225 million during 1999. Additionally, in 1998, our subsidiaries financed the acquisition of certain equipment with capital lease obligations.
Our working capital, defined as the excess of our current assets over our current liabilities, was $102,724,000 at December 31, 1999 compared with $37,750,000 at December 31, 1998, and $891,000 at December 31, 1997.
Cash and cash equivalents amounted to $73,213,000 at December 31, 1999 compared to $42,876,000 at December 31, 1998, and $2,239,000 at December 31, 1997. The increase in cash and cash equivalents primarily resulted from the proceeds of our offerage of debt in 1999. The cash is being held partly in Euro, our principle operating currency, but mainly in US dollars, $61 million. In addition at December 31, 1999 we had some $58 million of Restricted cash held in escrow, to meet the first six semi-annual interest payments on the Company's 14% Senior Notes. This amount is invested in US treasury bonds. Further we had various short-term investments denominated in Euro's totaling $41.2 million at December 31, 1999.
Operating activities used cash of $38,040,000, $10,335,000 and $1,432,000 in each of the three years ended December 31, 1999, 1998 and 1997, respectively. The large increase in cash used in 1999 results from the significant loss before taxes for the year ended December 31, 1999 since the Company significantly increased expenditures in building its organizational infrastructure (staff more than doubled from year-end 1998 to year-end 1999) and since it substantially increased expenditures in the area of marketing.
Investing activities used cash of $154,776,000 and $9,929,000 and $4,791,000 in each of the three years ended December 31, 1999, 1998 and 1997, respectively. The large increase in 1999 results from the business acquisitions in 1999, the increase in expenditures for property and equipment, together with the purchase of the short term investments and restricted cash, noted above. Expenditures for property and equipment consisted principally of purchases of equipment and investments related to our data centers, Internet backbone, billing system and other equipment necessary to support our growth.
The Company's capital expenditures increased 300% from $6,034,000 in 1998 to $24,154,000 in 1999. Capital expenditures by country were $16,761,000 in Germany, $4,015,000 in Italy and $3,234,000 in Austria and Switzerland.
Financing activities provided cash of, $223,632,000, $60,010,000 and $8,644,000 in each of the three years ended December 31, 1999, 1998 and 1997, respectively. The large inflow in 1999
results principally from our debt issuance in mid-1999 which generated $225 million in proceeds The inflow in 1998 results principally from our December 1998 public equity offering which generated $44,977,376 in net proceeds and the May 1998 private equity offering which generated $12,600,000 in proceeds. In June 1997, we completed a private placement that generated $8,070,427 in net proceeds.
At December 31, 1999 we had available combined cumulative tax loss carryforwards of approximately $66 million most of which relate to operations subject to German tax. Under current German tax law, these tax loss carryforwards have no expiration date. We have provided a valuation allowance against some of these loss carryforwards, to reflect the estimated amount that may not be realized.
We believe that our cash and cash equivalents will provide adequate liquidity to fund our normal operating activities over the next twelve months. However, our plan is to continue to seek additional acquisitions and to enhance our capabilities in both IP and other communications services through significant capital expenditures and strategic alliances. These initiatives will be initially financed from the portion of the proceeds of the 1999 debt issuance that exceeds our normal operating requirements. Based on our current plan additional financing will be needed in the first half of 2001 requiring the offering of additional private or public debt or equity securities. Management is continuously reviewing options to expand and develop the business, together with the various options available to finance such activities.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We do not utilize market-risk-sensitive instruments, such as derivative financial instruments. Our primary market risk is in the area of interest rate and foreign currency exchange rate fluctuations.
We maintain our cash balances in deposits at banks and in highly liquid short-term investments, such as money market mutual funds, therefore lowering our exposure to interest income risks.
As a result of our Private Unit Offering in July 1999 and Private Discount Notes Offering in August 1999, we have a substantial amount of debt in United States dollars. While our reporting currency is United States dollars, our functional currency is the Deutsche Mark and significant fluctuations in the United States dollar to Deutsche Mark exchange rate could have an adverse impact on the amount of Deutsche Marks required to satisfy this debt. We estimate that a 10% increase in the exchange rates between the Deutsche Mark and the United States dollar would increase the Deutsche Mark amount required to settle the debt outstanding from the Private Unit Offering and the Private Discount Notes Offering by approximately $20,000,000.
All of our revenues and a significant portion of our expenses are denominated in currencies other than our reporting currency, the United States dollar. Approximately 89% of our revenues in 1998 and 52% of our revenues in the first nine months of 1999 were denominated in Deutsche Mark. Another 45% of our revenues in the first nine months of 1999 were denominated in other European Monetary Union member currencies. The majority of our foreign exchange rate exposure relates to the translation of our Deutsche Mark financial statements into United States dollars which is impacted by changes in the exchange rates between the Euro and the United States dollar.
We prepared a sensitivity analysis to assess the impact of exchange rate fluctuations on our 1998 operating results. Based on this analysis, we estimated that a 10% adverse change in the exchange rates between the Deutsche Mark and the United States dollar would have increased our reported net loss for 1998 by approximately $530,300. Our analysis also indicated that a 10% decrease in the exchange rate between the United States dollar and the Deutsche Mark would result in a decrease of our March 31, 1999 net assets of approximately $1,997,900.
We have not entered into any derivative hedging instruments to reduce the risk of exchange rate fluctuations.
Item 8.
Item 8. Financial Statements and Supplementary Data
The information required by this item appears beginning on page of this report.
Item 9.
Item 9. Changes in, and Disagreements with, Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by this item is incorporated by reference to information to be included under the captions "Election of Directors," "Executive Officers" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's Proxy Statement for the 2000 Annual Meeting of Stockholders.
Item 11.
Item 11. Executive Compensation
The information required by this item is incorporated by reference to information to be included under the captions "Election of Directors Director Compensation" and "Compensation Committee Interlocks and Insider Participation," "Executive Compensation," and "Compensation Committee Report on Executive Compensation" in the Company's Proxy Statement for the 2000 Annual Meeting of Stockholders.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this item is incorporated by reference to information to be included under the caption "Beneficial Ownership of Common Stock" in the Company's Proxy Statement for the 2000 Annual Meeting of Stockholders.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this item is incorporated by reference to information to be included under the caption "Election of Directors Compensation Committee Interlocks and Insider Participation" in the Company's Proxy Statement for the 2000 Annual Meeting of Stockholders.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
a. Documents filed as a part of this report.
1. FINANCIAL STATEMENTS
See Index to Financial Statements on page.
2. FINANCIAL STATEMENT SCHEDULE
The following consolidated financial statement schedule of Cybernet Internet Services International, Inc. is included in Item 14(d) and presented as a separate section of this Report: Schedule II Valuation and Qualifying Accounts: page.
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
3. EXHIBITS
Listed below are all of the Exhibits filed as part of this report. Certain Exhibits are incorporated by reference from documents previously filed by the Company with the Securities and Exchange Commission pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, as amended.
EXHIBIT INDEX
- -------- ** Filed herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
CYBERNET INTERNET SERVICES INTERNATIONAL, INC.
March 30, 2000 /s/ Andreas Eder By: _________________________________________ Chairman of the Board of Directors, President and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.
Independent Auditors' Report
To the Board of Directors and Shareholders Cybernet Internet Services International, Inc.:
We have audited the accompanying consolidated balance sheets of Cybernet Internet Services International, Inc. and its subsidiaries ("the Company") as of December 31, 1999, and 1998, and the related consolidated statements of operations, cash flows and changes in shareholders' equity for each of the three years in the period ended December 31, 1999. Our audits also included the financial statements schedule listed in the Index at Item 14(a). These financial statements and Schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We did not audit the financial statements of Cybernet Italia S.p.A., or Eclipse s.r.l., both wholly owned subsidiaries, which statements reflect total assets constituting 7% in 1999, and total revenues constituting 25% in 1999 of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for Cybernet Italia S.p.A. and Eclipse s.r.l. is based solely on the report of the other auditors
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, based on our audit and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Ernst & Young Deutsche Allgemeine Treuhand AG
/s/ Geoffrey V. Hopper /s/ Ralf Broschulat Geoffrey V. Hopper Ralf Broschulat Certified Public Accountant Independent Public Accountant
Munich, Germany March 29, 2000
CYBERNET INTERNET SERVICES INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements
CYBERNET INTERNET SERVICES INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements
CYBERNET INTERNET SERVICES INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements
CYBERNET INTERNET SERVICES INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (all amounts in thousands)
CYBERNET INTERNET SERVICES INTERNATIONAL, INC.
NOTES TO THE CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
1. Basis of Presentation
Cybernet Internet Services International, Inc. ("Cybernet Inc") (formerly known as New Century Technologies Corporation) was incorporated under the laws of the State of Utah on September 27, 1983. Cybernet Inc changed its state of incorporation to Delaware in November 1998. Effective September 16, 1997 the Company acquired Cybernet Internet Dienstleistungen AG ("Cybernet AG"), a German stock corporation which offers a variety of Internet related telecommunication and systems integration services to corporate customers. Cybernet AG was founded in December 1995, and commenced significant operations in 1996. The acquisition has been accounted for as a reverse acquisition whereby the Cybernet Inc is considered to be the acquiree even though legally it is the acquiror.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Cybernet Inc and its subsidiaries ("the Company"). All significant intercompany investments, accounts, and transactions have been eliminated.
Foreign Currency
The functional currency, for the Company and its subsidiaries is the German Deutsche Mark ("DM").
The assets and liabilities for the Company's international subsidiaries are translated into U.S. dollars using current exchange rates at the balance sheet dates. Statement of operations items are translated at average exchange rates prevailing during the period. The resulting translation adjustments are recorded in the foreign currency translation adjustment account in equity. Foreign currency transaction gains or losses are included in net earnings (loss).
Revenue Recognition`
The Company offers Internet telecommunication and systems integration products and network services. Telecommunication and system integration products consist of the development of customized business solutions, installation of hardware and software and production support. Revenues from telecommunication and systems integration products are recognized upon completion of the related project and customer acceptance. Revenues from ongoing network access services are recognized when provided to customers. Ongoing network services consist of monthly user fees for network access and related services
Property and Equipment
Property and equipment are recorded at cost and depreciated using the straight- line method over the estimated useful life of the asset, which ranges from 4 years (computer equipment and software) to 10 years (leasehold improvements and furniture and fixtures).
Product Development Costs
The Company capitalizes costs incurred related to the development of products that will be sold to customers. Costs capitalized include direct labor and related overhead and third party costs related to establishing network systems. All costs in the development process are classified as research and development and expensed as incurred until technological feasibility has been established. Once technological feasibility has been established, which is defined as completion of a working model, such costs are capitalized until the individual products are commercially available. Amortization, which began in 1997, is calculated using the greater of (a) the ratio that current gross revenues for a product bear to the total of current and anticipated future revenues for that product or (b) the straight-line method over four years. The carrying value of product development costs is regularly reviewed by the Company and a loss recognized when the net realizable value falls below the unamortized cost. In 1999 such a loss totalling DM 800,000 ($436,000) was recorded as additional amortization in the German operations as the related products are no longer being marketed by the Company. Accumulated amortization amounted to $1,017,000 and $2,734,000 at December 31, 1998 and 1999 respectively.
Sales and Marketing Costs
Marketing costs include the costs of all personnel engaged in marketing activities, the costs of advertising and public relations activities (e.g. trade shows), and other related costs. Advertising costs are expensed as incurred. Advertising expense was $227,000, $610,000 and $2,751,000 in the years ended December 31, 1997, 1998 and 1999 respectively.
Cash and Cash Equivalents
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.
Short Term Investments
In accordance with Statement of Financial Accounting Standard ("Statement") No. 115 "Accounting for Certain Investments in Debt and Equity Securities" available- for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of stockholder's equity. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in other income. The Company has classified all debt and equity securities as available-for-sale.
Income Taxes
The Company accounts for income taxes using the liability method. Under this method, deferred income taxes are recognized for temporary differences between financial statement and income tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance when the Company cannot make the determination that it is more likely than not that some portion or all of the related tax asset will be realized.
Concentration of Credit Risk
Financial statements that potentially subject the Company to concentrations of credit risks consist primarily of cash and cash equivalents, short term investments, restricted cash and trade accounts receivable. Short term investments are comprised highly liquid mutual fund investments. Credit risk on trade receivable balances is minimized by the diverse nature of the Company's customer base.
The Company is economically dependent on the entities from which it leases the telecommunication lines comprising its network. It is probable that failure of these entities to honor their lease obligations or to renew leases under economically viable conditions could have a negative near-term impact on the Company's growth and results of operations.
Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Goodwill
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over a period between 5 and 10 years. Accumulated amortization totaled $358,000 and $2,861,000 at December 31, 1998 and 1999, respectively. The Company assesses the recoverability of goodwill by determining whether the amortization of the related balance over its remaining life can be recovered through reasonably expected undiscounted future cash flows. Management evaluates the amortization period to determine whether later events and circumstances warrant revised estimates of the amortization period.
Stock Compensation
The Company accounts for its stock option compensation under Accounting Principles Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). The Company presents all disclosures required by Statement of Financial Accounting Standards No. 123 "Accounting for Stock- based compensation" ("Statement 123") in Note 12.
Comprehensive Income
In 1998, the Company adopted Financial Accounting Standards Board Statement 130 "Reporting Comprehensive Standards" ("Statement 130"), which requires the disclosure of the Company's comprehensive income. Comprehensive income is defined as all changes in shareholders' equity exclusive of transactions with owners such as capital investments and dividends. All prior periods have been restated to conform with the reporting requirements of Statement 130.
Segment Disclosures
In 1998, the Company adopted Financial Accounting Standards Board Statement 131 "Disclosures About Segments of an Enterprise and Related Information" ("Statement 131"), which requires disclosures of certain financial information of the Company's business operating segments. All prior periods have been restated to conform with the disclosure requirements of Statement 131.
Reclassifications
Certain prior year amounts in the consolidated financial statements have been reclassified to conform to the current year presentation.
3. Business Acquisitions
On September 16, 1997, the Company acquired all of the outstanding shares of the common stock of Cybernet AG in exchange for the issuance of 5,160,000 shares of common stock of the Company, 1,200,000 shares of Series A preferred stock of the Company and 5,160,000 shares of Series B preferred stock of the Company, such shares representing the outstanding shares of the Company at that date. Generally accepted accounting principles require that the Company be considered the acquired company for financial statement purposes (a reverse acquisition) even though the entity will continue to be called Cybernet Internet Services International, Inc. Therefore, the acquisition has been recorded as a recapitalization of Cybernet AG. The effects of the reverse acquisition have been reflected for all share amounts in the accompanying financial statements. The Company had no operations at the time of the reverse acquisition.
Effective September 16, 1997, the Company acquired 100% of the outstanding shares of Artwise GmbH ("Artwise"), for a total consideration of DM 1,710,000 ($954,000). DM 475,000 ($265,000) of the purchase price was paid in cash with the remainder settled in exchange for the issuance of 72,620 shares of the common stock of the Company in February, 1998. The shares issued in February 1998, which were recorded as additional goodwill, were partially contingent upon the achievement of certain financial goals by Artwise for the year ended December 31, 1997. The acquisition has been accounted for using the purchase method of accounting and accordingly the accompanying financial statements reflect Artwise's results of operations from September 16, 1997. Goodwill recorded in connection with the acquisition of Artwise, of DM 1,507,000 ($841,000), is being amortized over 10 years.
Effective December 11, 1997, the Company acquired 66% of the outstanding shares of Eclipse s.r.l. ("Eclipse"), for a total consideration of DM 983,000 ($548,000). DM 335,000 ($187,000) of the purchase price was paid in cash with the remainder to be settled in exchange for the issuance of 27,000 shares of the common stock of the Company in 1999. The acquisition has been accounted for using the purchase method of accounting. Eclipse's results of operations for the period December 11, 1997 through December 31, 1997 are not included in the accompanying financial statements due to immateriality. Eclipse's results of operations from January 1, 1998 are reflected in the accompanying financial statements. Goodwill recorded in connection with the acquisition of Eclipse, of DM 896,000 ($507,000), is being amortized over 10 years.
Effective August 15, 1998, the Company acquired 100% of the outstanding shares of Open:Net Internet Solutions GmbH ("Open:Net") for a total consideration of DM 4,251,000 ($2,540,000). DM 1,445,000 ($864,000) of the purchase price was paid in cash with the remainder settled in exchange for the issuance of 58,825 shares of the common stock of the Company. The acquisition has been accounted for using the purchase method of accounting and as such the accompanying financial statements reflect Open:Net's results of operations from August 15, 1998. Goodwill recorded in connection with the acquisition of Open:Net, of DM 3,520,000 ($2,298,000) was being amortized over 10 years. After a reassessment by management, with effect from January 1, 1999 the remaining goodwill is being amortized over four years
Effective December 28, 1998, the Company acquired 100% of the outstanding shares of Vianet Internet Dienstleistungen AG ("Vianet") for a cash payment of DM 7,500,000 ($4,483,000) and 300,000 shares of the common stock of the Company which were to be issued to the selling shareholders of Vianet in increments of 60,000 shares over five years contingent on the continued employment of the individuals. In 1999, 30,000 shares were released in accordance with the terms of the agreement and an additional 75,000 were released in connection with the termination of one if the original shareholders, who lost his right to the balance of the 150,000 due under the original agreement. The value of the remaining 120,000 shares will be added to the cost of acquiring the Vianet when the shares are issued to the selling shareholders. The acquisition has been accounted for using the purchase method of accounting and as such the accompanying financial statements reflect Vianet's results of operations from January 1,1999. Goodwill recorded in connection with the acquisition of Vianet, amounting to DM 6,419,000 ($3,838,000), is being amortized over 10 years.
The following unaudited pro forma consolidated results of operations for the years ended December 31, 1997 and 1998 assume the acquisitions described above occurred as of January 1, 1997:
Effective April 13, 1999, the Company acquired 51% of the outstanding shares of Sunweb Internet Services SIS AG (,,Sunweb") for a total consideration of DM 3,103,000 ($1,639,000). DM 1,807,000 ($954,000) of the purchase price was paid in cash (in Swiss Francs) with the remainder settled in exchange for the issuance of 25,680 shares of the common stock of the Company.
The Stock Purchase Agreement also contains provisions for put and call options for the sellers and buyers, respectively, for the remaining 49% of the outstanding stock of Sunweb. The purchase price per the agreement for the remaining 49% of the shares is based on a multiple of Sunweb's net profit or loss before taxes. The put and call options expire on December 31, 2001. The acquisition has been accounted for using the purchase method of accounting and as such the accompanying financial statements reflect Sunweb's results of operations from April 13, 1999. Goodwill recorded in connection with the acquisition of Sunweb, amounting to DM 2,678,000 ($1,414000), is being amortized over 10 years.
Effective June 30, 1999, the Company acquired 100% of the outstanding shares of Cybernet Italia S.p.A.(formerly Flashnet S.p.A.) for a total consideration of DM52,816,000 ($27,890,000). DM41,464,000 ($21,896,000) of the purchase price was paid in cash (in Italian Lire) with the remainder settled in exchange for the issuance of 301,290 shares of the common stock of the Company. The acquisition has been accounted for using the purchase method of accounting and as such the accompanying financial statements reflect Cybernet Italia's results from June 30, 1999. Goodwill recorded in connection with the acquisition of Cybernet Italia, amounting to DM 32,136,000 ($16,970,000), is being amortized over 10 years. The allocation of the excess purchase price over net assets acquired is preliminary and is expected to be finalized by June 30, 2000,
Effective October 28 1999, the Company acquired of 51% of the outstanding shares of Novento Telecom AG ("Novento") and 51% of Multicall Telefonmarketing AG ("Multicall") for a consideration of DM 3,178,000 ($ 2,373,000). DM 2,002,000 ($1,092,000) of the purchase price was paid in cash with the remainder settled in exchange for the issuance of 39,412 shares of the common stock of the Company. The Company has an option to acquire the remaining 49% of the shares of both companies. The acquisition has been accounted for using the purchase method of accounting and as such the accompanying financial statements reflect Novento and Multicall's results from October 28, 1999. Goodwill recorded in connection with the acquisition of Novento, amounting to DM 1,913,000 ($1,043,000) is being amortized over 10 years.
Effective October 29, 1999 the Company acquired the remaining 34% of the outstanding shares of Eclipse, in which the Company already owned 66% of the outstanding shares, for a total consideration of DM 4,320,000 ($2,356,000). DM 707,000 ($386,000) of the purchase price was paid in cash with the remainder settled by way of the depositing of 136,402 shares of the common stock of the Company in a pooling trust from which the shares will be released to the sellers. Goodwill recorded in connection with the acquisition of the remaining shares in Eclipse, amounting to DM 3,718,000 ($2,359,000), is being amortized over the remaining life of the goodwill associated with the acquisition of the majority shareholding at the end of 1997, as detailed above.
The following unaudited pro forma consolidated results of operations for the years ended December 31, 1998 and 1999 assume the acquisitions of Open:Net, Vianet, Sunweb, Cybernet Italia, Novento and Multicall had occurred as of January 1, 1998.
4. Short Term and Restricted Investments
Under the terms of Units issued on July 1, 1999 (refer note 9 below) amounts equivalent to the first six scheduled interest payments were invested in US government securities and restricted in their use to the payment of such interest when falling due. These have been classified as Restricted Investments.
Short-term and restricted investments are summarized as follows:
In addition at December 31, 1999 there was interest due on the restricted investments totaling $1,789,000 which is also restricted for the payment of interest and as such has been classified as restricted investments in the balance sheet.
The net unrealized holding gains and losses are recorded as a separate component of shareholder's equity.
Proceeds from the sale of available for sale securities in 1997, 1998 and 1999 were $6,931,000, $810,000 and $33,177,000, respectively. The Company did not recognize any gains on the sales of short term investments in 1997, 1998 or 1999.
5. Property and Equipment
Net property and equipment consist of the following:
6. Leases
The Company leases facilities and equipment under long-term operating leases, and has long term data and voice communication agreements. Future minimum payments under non-cancelable operating leasing with initial terms of one year or more are as follows:
The Company's rental expense under operating leases in the years ended December 31, 1997, 1998 and 1999 totaled approximately $177,000, $1,069,000 and $7,375,000 respectively.
The Company has financed the acquisition of certain computer equipment through capital lease agreements with interest rates ranging from 5% to 8%. At December 31, 1998 and 1999, the gross value of assets under capital leases was $2,580,000 and $6,885,000 and related accumulated depreciation was $610,000 and $ 2,188,000, respectively. Future minimum lease payments in connection with these leases are as follows:
7. Other assets
Other non current assets consists principally of expenses incurred in connection with the bonds issued during 1999 and amounts allocated to customer base and management contracts in connection with business acquisitions. Bond issuance costs of DM 13,816,000 ($ 7,096,000) are being amortized to interest expense over the period of the borrowings. The unamortized balance at December 31, 1999 was DM 13,929,000 ($ 7,154,000). Amounts allocated to customer base and management contracts are being amortized on a straight line basis over their useful lives - between three and five years. The unamortized balance of these assets at December 31, 1999 was DM 20,746,000 ($10,656,000)
8. Overdrafts and Short-Term Borrowings
Overdrafts represent temporary overdrafts of bank balances. The overdrafts are not subject to formal agreements with the banks and generally are not subject to interest.
As of December 31, 1999, the Company had established short-term unsecured overdraft facilities under which the Company and its subsidiaries could borrow up to DM 1,637,000 ($840,000). The facilities are denominated in Italian Lire as to DM 1,495,000 and in Austrian Schilling as to DM 142,000. The interest rate fluctuates based on current lending rates and was 9.75 %and 5,25 % at December 31, 1998 and 1999, respectively. As of December 31, 1999, DM 124,000 ($63,000) of the overdraft facility was used and DM1,513,000 ($776,000) was available.
As of December 31, 1999, Multicall had a loan payable to a minority shareholder of DM 728,000 ($374,000).
9. Long term debt
The Company's debt consisted of the following:
Notes payable outstanding at December 31, 1998 were paid with the proceeds of the debt issued in 1999.
On July 1, 1999, the Company issued 150,000 Units, each unit consisting of $1,000 principal amount of 14.0% Senior Dollar Notes due 2009 ("Notes") and one Warrant ("Warrant") to purchase 30.2311 ordinary shares of Cybernet Internet Services International, Inc. Interest on the Notes is payable on July 1 and January 1 of each year, beginning January 1, 2000. The Notes will mature on July 1, 2009. The Notes and the Warrants became transferable on September 10, 1999. The Warrants can be exercised at an exercise price of $22.278 per ordinary share of Cybernet Internet Services International, Inc, and are exercisable from January 1, 2000 to July 1, 2009.
The net proceeds of the unit offering were approximately $146 million. $57,466,000 thereof was invested in U.S. government securities which are restricted in use of the payment in full of the first six scheduled interest payments. $51,199,000 of the net proceeds were allocated to the Warrants based on a fair value allocation of the proceeds between the Notes and the Warrants and have been recorded in additional paid in capital. The resultant discount on the Notes is being accreted over the term of Notes using the straight line method.
The Units contain covenants applicable to the Company, including limitations and requirements to indebtedness, restricted payments, dividends and other payments, the issuance and sale of capital stock, transactions with stockholders and affiliates, liens, asset sales, issuance of guarantees of indebtedness, sale- leaseback transactions, consolidations and mergers, and provision of financial statements and reports.
On August 26, 1999 the Company completed private offerings of $50,002,183 in aggregate initial accreted value of 13.0% Convertible Senior Subordinated Discount Notes due 2009 (in two separate offerings) ("Discount Notes") and Euro 25 million aggregate principal amount of 13.0% Convertible Senior Subordinated Pay-In-Kind Notes due 2009 ("Payment-in-kind Notes"). The Discount Notes do not accrue cash interest prior to August 15, 2004 and the first semi-annual payment of cash interest is payable on February 15, 2004. The Payment-in-Kind Notes require payment of interest semi-annually in the form of secondary notes issued under the pay-in-kind feature starting on February 15, 2000 and continuing through August 15, 2004, and in the form of cash starting on February 15, 2005 and continuing to maturity on August 15, 2004. The Discount Notes are convertible at any time after August 26, 2000 and prior to maturity at the rate of one share of common stock for each $25.00 of accreted value of the Discount Notes being converted. The Payment-in-Kind Notes are convertible at any time after August 26, 1999 and prior to maturity at the rate of one share of common stock for each Euro 25 in principal amount of the notes being converted. After payment of discounts and commissions, the net proceeds of these offerings were approximately $72 million.
The covenants associated with the Discount Notes are in most material aspects the same as those associated with Units, discussed above.
10. Fair Value of Financial Instruments
The following methods and assumptions were used by the Company in estimating the fair values of its financial instruments:
. Cash and equivalents, restricted cash, trade receivables, short term investments, trade payables and accrued expenses - the carrying amounts approximate fair value because of the short-term maturity of these instruments.
. Long-term debt - the fair value of the Company's 14% Senior Dollar Notes payable, due 2009 is estimated based on quoted market values. The fair value of, the 13% Convertible Senior Subordinated Discount Notes, and 13% Convertible Senior Subordinated Pay-In-Kind Notes was also estimated on quoted market values. The following table presents the carrying values and fair values of the Company's long erm bonds at December 31, 1999
. Capital lease and other long-term debt obligations - the fair value was estimated using discounted cash flow analyses based on the Company's incremental borrowing rates for similar type borrowings.
11. Stockholders' Equity
Common Stock
The Company is authorized to issue 50,000,000 shares of Common Stock. Holders of Common Stock are entitled to one vote per share on all matters submitted to a vote of stockholders. The Common Stock is not redeemable and has no conversion or preemptive rights.
Preferred Stock
The Company is authorized to issue 50,000,000 shares of Preferred Stock with relative rights, preferences and limitations determined at the time of issuance. As of December 31, 1999, the Company has issued and outstanding Series A and B Preferred Stock. All of the Company's previously issued Series C Preferred Stock was converted to Common Stock in 1998.
Series A Preferred Stock
The holders of the Series A Preferred Stock are entitled to receive dividends at a rate equal to $0.01 per share per annum before any dividends are paid or set apart for payment upon any other series of Preferred Stock of the Company, other than Series B or Series C Preferred Stock, or on the Common Stock of the Company. Commencing with the fiscal year beginning on January 1, 1998, the dividend on the Series A Preferred Stock will be paid for each fiscal year within five months of the end of each fiscal year, subject to the availability of surplus or net profits therefor. The dividends on the Series A Preferred Stock are not cumulative. The holders of the Series A Preferred Stock are not entitled to vote.
The shares of Series A Preferred Stock may be redeemed by the Company at any time after January 1, 2000, at a redemption price of one share of the Common Stock of the Company for each share of Series A Preferred Stock plus any unpaid dividends earned thereon; provided that all and not less than all of the shares of Series A Preferred Stock are so redeemed and provided further that if the Company has not redeemed the Series A Preferred Stock by December 31, 2001, a holder of Series A Preferred Shares may at any time commencing January 1, 2002, require the Company to purchase all of the shares of the Series A Preferred Stock held by him for a purchase price of $3.00 per share plus any dividends earned but unpaid on such shares.
A holder of Series A Preferred Stock may convert each share held into one share of the Common Stock of the Company; provided, however, that (1) no conversion may occur prior to January 1, 1999; (2) no more than 25% of the Series A Preferred Shares held by the holder may be converted prior to January 1, 2000; (3) no more than an additional 25% of the Series A Preferred Shares held by the holder may be converted prior to January 1, 2001; (4) the remainder of the Series A Preferred Shares held by the holder may be converted commencing January 1, 2001; and (5) any conversion may not be for less than all of the Series A Preferred Shares held by the converting shareholder eligible for conversion at the time of the notice.
Upon the liquidation, dissolution or winding up, whether voluntary or involuntary, of the Company, the holders of the Series A Preferred Stock will be entitled to be paid the sum of $3.00 per share plus an amount equal to any unpaid accrued dividends before any amount is paid to the holder of any other series of Preferred Stock, other than the Series B Preferred Stock or the Series C Preferred Stock, or to the Common Stock of the Company. After payment of these amounts to the holders of the Series A Preferred Stock, the remaining assets of the Company will be distributed to the holders of the Common Stock.
In July 1999, holders of 276,560 shares of Series A Preferred Stock converted their shares into 276,560 shares of the Company's Common Stock.
Series B Preferred Stock
The holders of the Series B Preferred Stock are entitled to receive dividends at a rate equal to $0.01 per share per annum before any dividends are paid or set apart for payment upon any other series of Preferred Stock of the Company other than the Series C Preferred Stock or on the Common Stock of the Company. Commencing with the fiscal year beginning on January 1, 1998, the dividend on the Series B Preferred Stock will be paid for each fiscal year within five months of the end of each fiscal year, subject to the availability of surplus or net profits therefor. The dividends on the Series B Preferred Stock are not cumulative. The holders of the Series B Preferred Stock are entitled to one vote per share.
The shares of Series B Preferred Stock may be redeemed by the Company at any time after January 1, 2000, at a redemption price of one share of the Common Stock of the Company for each share of Series B Preferred Stock plus any unpaid dividends earned thereon through the date of redemption; provided that all and not less than all of the shares of Series B Preferred Stock are so redeemed.
A holder of Series B Preferred Stock may convert each share held into one share of the Common Stock of the Company provided, however, that (1) no conversion may occur prior to January 1, 1999; (2) no more than 25% of the Series B Preferred Shares held by the holder may be converted prior to January 1, 2000; (3) no more than an additional 25% of the Series B Preferred Shares held by the holder may be converted prior to January 1, 2001; (4) the remainder of the Series B Preferred Shares held by the holder may be converted commencing January 1, 2001; and (5) any conversion may not be for less than all of the Series B Preferred Shares held by the converting shareholder eligible for conversion at the time of the notice.
Upon the liquidation, dissolution or winding up, whether voluntary or involuntary, of the Company, the holders of the Series B Preferred Stock will be entitled to be paid the sum of $3.00 per share plus an amount equal to any unpaid accrued dividends before any amount is paid to the holder of any other series of Preferred Stock other than the Series C Preferred Stock or to the Common Stock of the Company. After payment of these amounts to the holders of the Series B Preferred Stock, the remaining assets of the Company will be distributed to the holders of the Common Stock.
In July 1999, holders of 1,209,000 shares of Series B Preferred Stock converted their shares into 1,290,000 shares of the Company's Common Stock.
Series C Preferred Stock
In July 1998, holders of 1,400,000 shares of Series C Preferred Stock (representing the entire amount outstanding) converted their shares into 1,400,000 shares of the Company's Common Stock. Prior to the conversion holders of Series C Preferred Stock received a stock dividend in Common Stock of the Company in lieu of a cash dividend. The stock dividend was valued at the closing price of the Common Stock on the date the dividend was declared.
12. Stock Option Plan
Stock Incentive Plan
In 1998, the Company adopted a stock incentive plan (,,Stock Incentive Plan") which provides for the grant of stock options to purchase shares of the Company's common stock to key employees who make a significant contribution to the success of the Company and members of the Board of Directors. The Company has elected to follow APB 25 and the related interpretations in accounting for its employee stock options. Under APB 25, as long as the exercise price of the Company's employee stock options equals the market price of the underlying stock at date of grant, no compensation expense is recorded.
The Company has reserved 5,000,000 shares of common stock for issuances under the Stock Incentive Plan. The following table presents the changes in the stock options during the year.
As of December 31, 1999 the Company had 198,757 options outstanding that were fully vested. Options vest over a period of three years from the date of grant.
Statement 123 requires the presentation of pro forma information regarding net income and earnings per share as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model. The assumptions used in calculating the fair value of the options granted in 1998 and 1999 were as follows.
The fair market value of the options using the Black-Scholes pricing model granted in the years ended December 31, 1998 and 1999 was $13,320,000 and $15,427,789, respectively. Had the Company determined compensation expense for this plan in accordance with the provisions of Statement 123, the fair value of the options would have been amortized over the option vesting periods. Under this method, the Company's net loss and loss per share for the years ended December 31, 1998 and 1999 would have been as follows:
13. Provision for Income Taxes
In March 1999 the German government passed new tax legislation which reduced the corporate income tax rate from 45% to 40%. Accordingly, the Company's deferred tax assets and liabilities related to Germany were re-measured using 40% in the first quarter of 1999.
The Company's principal operations are currently located in Germany. Pretax loss for the years ended December 31, 1997, 1998 and 1999 were taxable in the following jurisdictions:
The components of the provision for income taxes, substantially all of which relates to Germany, are as follows:
The Company has net deferred tax assets as of December 31,1998 and 1999 as follows:
As of December 31, 1999, the Company and its subsidiaries had available combined cumulative tax loss carry forwards of approximately $67.9 million substantially all of these loss carry forwards have an indefinite life. Management believes that the remaining deferred tax assets of the $20.7 million is more likely than not to be realised through future taxable income. However, if the Company is unable to generate sufficient taxable income in the future through operating results a valuation allowance will be required to be established through a charge to income.
The Company has recorded a valuation allowance to reflect the estimated amount of net operating loss carry-forward which may not be realized.
A reconciliation of income taxes determined using the United States statutory federal income tax rate of 35% to actual income taxes provided is as follows:
14. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
The denominator for diluted earnings per share excludes the convertible preferred stock and stock options because the inclusion of these items would have an anti-dilutive effect.
15. Related Party Transaction
The Company paid DM 170,000 ($97,000), DM 173,000 ($98,000) and DM 479,000 ($261,000) to a law firm for legal services where one of the members of the board of directors is a partner in the years ended December 31, 1997 ,1998 and 1999, respectively.
In December 1998, the Company paid $2,916,000 in underwriting fees in connection with the public sale of equity, to an investment bank in which one of the Company's principal shareholders and a former member of the Company's Board of Directors is a significant shareholder.
At December 31, 1999, Multicall owed DM 728,000 ($374,000) to its minority shareholder.
In the year ended December 31, 1999, Sunweb purchased goods and services totaling CHF 2,346,000 ($1,251,000) from a company owned by a relative of one of its shareholders.
16. Segment information
The Company evaluates performance, and allocates resources, based on the operating profit of its subsidiaries. The accounting policies of the reportable segments are the same as those described in the Summary of Significant Accounting Policies in Note 2.
The Company operates in one line of business, which is providing international Internet backbone and access services and network business solutions for corporate customers. The Company's reportable segments are divided by country since each country's operations are managed and evaluated separately.
Information concerning the Company's geographic locations is summarized as follows:
The Company's property, plant and equipment by geographic location and capital expenditures by geographic area are as follows:
17. Recent pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("Statement No. 133"). This statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Statement No. 133, as amended, is effective for fiscal year beginning after June 15, 2000 and cannot be applied retroactively. The Company does not expect the impact of this new statement on the Company's consolidated balance sheets or results of operations to be material.
18. Subsequent events
Effective January 1, 2000 the Company acquired the remaining 49% interest in Novento for total consideration of DM 8,609,000 ($4,422,000).
On January 1, 2000 the Company invested DM 2,000,000 ($1,027,000) in a EDI software development company based in Gottingen, Germany. In exchange the Company has the option to acquire 51% of the company based on its revenue and profitability for 2000, and exclusive right to market its product line.
In February 2000, the Company entered into a stock purchase agreement providing for the purchase of 100% of the outstanding stock of Cybernet S.a.g.l., an Internet Business-to-Business provider located in Lugano, Switzerland, for a consideration of DM 592,000 ($304,000) and 12,000 shares of common stock of the Company.
Independent Accountants' Reports on Cybernet Italia S.p.A. and Eclipse S.p.A.
Presented below are the Independent Accountants' Reports on Cybernet Italia S.p.A. and Eclipse S.p.A.. These audit reports and the related audited financial statements were relied on by Ernst & Young in the performance of their audit of the consolidated financial statements of the Company. Their audit report is contained on page. The audited financial statements of Cybernet Italia S.p.A. and Eclipse S.p.A. referred to in these audit reports have not been included in this document.
INDEPENDENT ACCOUNTANTS' REPORT -------------------------------
The Board of Directors Cybernet Italia S.p.A. Via C. Veneziani, 48 Roma, Italy
We have audited the accompanying balance sheet of Cybernet Italia S.p.A. as of December 31, 1999, and the related statements of loss, stockholders' equity (deficit), and cash flows for the six months then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statements presentation. We believe that our audits provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cybernet Italia S.p.A. as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Cybernet Italia S.p.A. is a wholly-owned subsidiary of Cybernet Internet Services International, Inc. ("Cybernet"). As shown in the accompanying financial statements, the Company has incurred a net loss of ITL 5,944 millions for the six months ended December 31, 1999, and has incurred substantial net losses for the past two years. At December 31, 1999, current liabilities exceeded current assets by ITL 7,102 millions and total liabilities substantially equalled total assets. Realization of a major portion of the assets in the accompanying balance sheet is dependent upon continued operations of the Company, which in turn is dependent upon the Company's success of its future operations and the continuing financial support of Cybernet. As discussed in Note 2.b, Management believes that actions presently taken to revise the Company's operating and financial requirements provide the opportunity for the Company to continue as a going concern. It is not possible, however, to predict at this time the success of management efforts. Accordingly, the Company has received firm commitments from Cybernet that Cybernet will continue to meet the Company's financial requirements in the event this is necessary.
March 29, 2000
/s/ Grant Thornton S.p.A. Grant Thornton S.p.A.
INDEPENDENT ACCOUNTANTS' REPORT -------------------------------
The Board of Directors Eclipse S.p.A. Vicolo S. Maria, 30 Rovereto, Italy
We have audited the accompanying balance sheet of Eclipse S.p.A. as of December 31, 1999, and the related statement of loss, stockholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statements presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Eclipse S.p.A. as of December 31, 1999, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
Eclipse S.p.A. is a wholly-owned subsidiary of Cybernet Internet Services International, Inc. ("Cybernet"). As shown in the accompanying financial statements, the Company has incurred a net loss of ITL 3,814 millions. At December 31, 1999, current liabilities exceed current assets by ITL 1,288 millions and total liabilities substantially equalled total assets. Realization of a major portion of the assets in the accompanying balance sheet is dependent upon continued operations of the Company, which in turn is dependent upon the Company's success of its future operations and the continuing financial support of Cybernet. As discussed in Note 2.b, Management believes that actions presently taken to revise the Company's operating and financial requirements provide the opportunity for the Company to continue as a going concern. It is not possible, however, to predict at this time the success of management efforts. Accordingly, the Company has received firm commitments from Cybernet that Cybernet will continue to meet the Company's financial requirements in the event this is necessary.
March 29, 2000
/s/ Grant Thornton S.p.A. Grant Thornton S.p.A. | 22,086 | 146,088 |
917821_1999.txt | 917821_1999 | 1999 | 917821 | Item 1. Business
General
The Company is dedicated to establishing itself as a leader in providing interventional urological products, with primary emphasis on the treatment of prostate cancer. The Company seeks to market a portfolio of products including its two main proprietary products for the treatment of prostate cancer: the CaverMap Surgical Aid, available to aid physicians in preserving vital nerves during prostate cancer surgery, and the Symmetra Iodine-125 ("I-125") radioactive seeds used in a brachytherapy procedure to treat localized prostate cancer. The Company's product portfolio also includes brachytherapy introducer needles. UroMed also continues to dedicate resources to the development and/or acquisition of product lines that fit into its strategic platform.
The CaverMap Surgical Aid is an innovative new product in the field of urological surgery. The CaverMap Surgical Aid is used in radical prostatectomies, or surgical removal of the prostate, to assist the physician in locating and avoiding nerves. If the physician avoids cutting nerves, certain adverse side effects such as impotence and incontinence may be avoided. The Company believes that, because of the highly proprietary nature of CaverMap, it is uniquely positioned to offer physicians the opportunity to optimize both surgical and brachytherapy for prostate cancer treatment.
The Company received regulatory clearance by the FDA in November 1997 to market the CaverMap Surgical Aid in the U.S for use in prostate cancer surgery. In February 2000, the U.S. Food and Drug Administration (FDA) cleared the CaverMap Surgical Aid for U.S. marketing and distribution for use in colorectal surgery in men. The CaverMap Surgical Aid will be used to assist surgeons in performing colorectal cancer surgery in identifying and sparing sensitive nerves responsible for erectile function.
The Symmetra I-125 seed was cleared by the FDA for marketing in the United States in May 1999. The Symmetra seed is a proprietary Iodine-125 permanent seed implant designed to be similar to the market leading prostate seed implant in dosimetry, outer dimensions and biocompatibility. UroMed's manufacturing partner in the brachytherapy seed business is Bebig Isotopentechnik und Umweltdiagnostik GmbH of Berlin, Germany ("Bebig"). Under UroMed's agreement with Bebig, Bebig developed the implant and UroMed has the exclusive license rights for six and one-half years to market and distribute the Bebig implant in North America and South America and non-exclusive rights elsewhere in the world.
Markets
A. Prostate Cancer
UroMed is positioned to address the needs of the prostate cancer market by reason of its two complementary product offerings: the CaverMap Surgical Aid, used to map and monitor the cavernosal nerves during a radical prostatectomy, and the Symmetra I-125 seeds, used in a brachytherapy procedure to treat localized prostate cancer. UroMed has a distinctive approach in focusing its efforts on prostate cancer with product offerings addressing the two largest therapeutic segments of the market for prostate cancer treatments.
Prostate cancer is the most frequently diagnosed cancer in American males. The wide-spread adoption of prostate-specific antigen ("PSA") testing is largely responsible for an increase in the age-adjusted incidence of prostate cancer over the past decade.
Until recently, the American Cancer Society and other health organizations predicted a continued rise in prostate cancer incidence in the U.S., with predictions of the number of annual cases as high as 300,000 to 350,000 by the year 2000. However, the incidence rate peaked in 1992 at 191 per 100,000 and declined each year from 1993 through 1995. This decrease in incidence rate is believed to be due to the "cull" effect associated with the advent of the PSA test. A significant improvement in the sensitivity of a diagnostic test generally leads to an increased number of detected cases of the disease that the test is designed to detect. Once these cases clear the system, rates generally fall back down to a level similar to that seen before the improved test. That appears to be the case with the PSA test and the incidence rate of prostate cancer. The American Cancer Society now estimates there will be 180,400 new cases in the U.S. during 2000. Prostate cancer can be fatal if not treated early and comprehensively. In 2000, an estimated 31,900 Americans will die from the disease - the second leading cause of cancer death in men.
Decisions about which treatment to pursue are made by the patient and the physician, usually a urologist, based on the localization of the cancer, the age and overall health of the patient, and risks and benefits ascribed to each treatment protocol. When cancer has spread beyond the prostate, the patient is usually guided toward chemotherapy and radiation therapy. For those with localized cancer of the prostate, about 60% of those diagnosed, the treatment options include: o Radical Prostatectomy: the surgical removal of the prostate and some of the surrounding tissue. Impotence and urinary incontinence are potential complications. o External Beam Radiation Therapy: the use of high-energy x-rays to kill cancer cells and shrink tumors. Radiation is administered from machines outside the body. This treatment requires daily visits for a period of 6-8 weeks. Impotence and incontinence occur slightly less often than after Radical Prostatectomy surgery, but damage to the rectum is a potential complication. o Brachytherapy Radiation Therapy: an alternative method of radiation treatment, where sealed sources of various radioisotopes are implanted in the prostate to kill the cancer cells during a one and one-half hour outpatient procedure. This procedure is discussed in more detail below. o Watchful Waiting: careful observation without further immediate treatment. This is considered an appropriate option for men who have less aggressive tumors, are older than 70, or have significant co-existing illnesses. o Hormone Therapy: manipulating hormone levels to inhibit cell growth. To cause cancer cells to shrink, patients may be given LHRH-agonists, which decrease the amount of testosterone in the body, or antiandrogens, which block the activity of testosterone. These drugs are often used to shrink the size of the prostate gland in preparation for additional therapies such as brachytherapy or surgery. o Other Treatment Options: includes other experimental procedures.
Each of these options has advantages and disadvantages. In recent years, patient demand has fueled very high growth in rates of prostate brachytherapy, even though the total number of new prostate cancer cases has decreased. The two treatment options that the Company is focused on are:
1. Brachytherapy
The permanent implant brachytherapy procedure involves the permanent placement of 65 to 120 tiny pellets or "seeds" containing radioactive material into the prostate surgically. A therapeutic dose of radiation is delivered locally to the tumor and prostate tissue, while minimizing radiation dosage to the surrounding tissues. Some brachytherapy treatments are complemented with external beam radiation therapy ("EBRT"). The concept of using small radiation sources to treat cancer was introduced about a century ago, but it began to show promise for treating prostate cancer only in the last decade.
The permanent brachytherapy implant procedure has been growing significantly. The procedure provides patients with a minimally-invasive alternative to surgical removal of the prostate or EBRT, both of which may have higher costs and higher rates of complication, including incontinence and impotence.
The Company believes that almost 36,000 brachytherapy procedures were performed in the U.S. in 1999, accounting for 30% of all therapy for localized (treatable) prostate cancer. We believe that the number of procedures utilizing this therapy will continue to grow.
Two different isotopes are used in brachytherapy procedures for prostate cancer, iodine-125 (I-125) and palladium-103 (Pd-103). The two isotopes have similar characteristics, and there is no clinical evidence that favors one isotope over the other. I-125 has a slightly higher energy photon, which means it is slightly more penetrating, depositing its energy over a longer distance. Palladium has a lower energy, and a shorter half-life, which allows more radioactivity to be used in each seed with less damage to surrounding tissue. Many physicians use palladium with cancers that they believe are faster growing. Market data suggests that the split between iodine and palladium seed use in 1999 for brachytherapy for prostate cancer treatments is roughly 60% iodine and 40% palladium.
2. Radical Prostatectomy
In 1999, there were approximately 80,000 radical prostatectomies performed in the United States. Of this amount, approximately 48,000 were nerve-sparing radical prostatectomies ("NSRP"), which comprised approximately 60% of all radical prostatectomies performed. In 100 hospitals that are performing more than 100 prostatectomies annually, over 11,000 radical prostatectomies were performed in 1999. Of those, 8,400, or approximately 75%, were NSRP.
Radical prostatectomy is considered to be the preferred treatment for patients with localized prostate cancer, and it offers patients the greatest chance for long term survival. Excellent cure rates have been obtained with radical prostatectomy in patients with localized tumors. However, many patients refuse the radical prostatectomy surgical option because of fears of potential complications, including erectile dysfunction and urinary incontinence.
The most common cause for erectile dysfunction after radical prostatectomy is intra-operative injury to the neurovascular bundles and nerve branches. These nerve structures are susceptible to injury at several points during the surgical procedure, when they are pulled, stretched, transected or possibly excised.
Dr. Patrick C. Walsh, Chairman of the Brady Urological Institute of Johns Hopkins, is credited with developing and introducing a modified approach to the traditional radical prostatectomy. His modified surgical approach reduced overall morbidity associated with the operation by making it possible to spare the cavernosal neurovascular bundles responsible for erectile function in most patients. In patients with localized prostate cancer, NSRP has been shown to provide effective cancer control with a minimal occurrence of associated complications.
The reported incidence rate of erectile dysfunction after NSRP ranges from 30 to 90%. This wide range is likely due to variations in the skill of the surgeon, challenging anatomy, and the patient/physician post-surgical reporting process. Physicians and patients consider erectile dysfunction as a significant complication in determining the most appropriate course of treatment for their disease. In January of 2000, the Journal of the American Medical Association (JAMA) published an article on the complications following a radical prostatectomy. The article concludes that the radical prostatectomy is associated with significant (59.9%) erectile dysfunction. The authors state that knowledge of these results may be particularly helpful to community-based physicians and their patients with prostate cancer who face difficult treatment options.
Erectile dysfunction is no longer a "behind closed doors" discussion subject. It has become a major discussion topic of the American public, and is widely recognized as a problem with drastic effects on quality of life. The introduction of Viagra has helped to bring the discussion of erectile dysfunction into mainstream daily conversation. Hundreds of thousands of patients, who previously did not discuss their impotence problems, are now seeking relief from erectile dysfunction with Viagra. As a result of Viagra, physician visits are increasing and it is estimated that PSA testing could increase as a result. The Company believes the general awareness level of Viagra will drive patients to be more aware of erectile dysfunction and potentially enhance nerve sparing procedure volume over time.
B. Colorectal Cancer Surgery
According to the American Cancer Society, colorectal cancer is the third most common cancer in the U.S. with 129,000 cases diagnosed in 1999, approximately 60% of which were in men. Seventy-three percent of newly diagnosed colorectal cancers occur in persons aged 65 and older. Colorectal cancer incidence increased from 1973 through 1985 particularly in men and then decreased through 1995. The reasons for this trend are not well understood. However, increased polyp removal, advances in treatment protocols, newer surgical techniques, and changes in population dietary patterns may be contributing factors.
Treatment options for colorectal cancer depend on the size and location of the tumor and the stage of diagnosis. Colorectal cancers are treated using three main approaches: o Surgery - removal of the tumor and nearby tissues including lymph nodes. o Radiation therapy - use of high energy rays to kill cancer cells o Chemotherapy - use of drugs that kill cancer cells throughout the body.
Surgery is the primary treatment for colorectal cancer. Unfortunately, impotence is a common complication as sensitive nerve bundles are sometimes damaged. The CaverMap Surgical Aid may help colorectal cancer surgeons identify the location of these nerve bundles, and, in doing so, may aid in the preservation of sexual function for their patients.
Products
A . Symmetra I-125 Seeds
The UroMed seed ("Symmetra") is a proprietary I-125 permanent radioactive seed implant. The Symmetra I-125 seed was designed to meet or exceed established radioactive standards for sealed radioactive sources.
The Symmetra I-125 seed was cleared by the FDA for marketing in the United States in May 1999. The Company began commercial selling efforts for this product during the third quarter of 1999.
UroMed entered into agreements with Bebig and Isotope Products Laboratories Inc. of Burbank, California ("IPL") in March of 1998 as a means of entering into the brachytherapy business. Under the terms and conditions of the Company's agreement with Bebig, Bebig developed a brachytherapy implant to which UroMed has an exclusive license to market and distribute in North America and South America (and non-exclusive rights elsewhere in the world) for a period of six and one-half years from the date Bebig is first capable of producing the implant at certain levels. The Company's agreement with IPL, a subsidiary of Bebig, calls for IPL to distribute the Symmetra seeds in the United States for the term of the production agreement between the Company and Bebig.
The Company has the capability to ship product directly to customers from the facilities at Bebig and IPL. The Company along with Bebig has the ability to warehouse product both at the Bebig and the IPL facilities.
B . UroMed Prostate Seeding Needles
The Company offers introducer needles for brachytherapy use. These needles were commercially available beginning in the fourth quarter of 1998.
There are two types of implant needles used for a brachytherapy treatment for prostate cancer that the Company offers. The first is a pre-loaded needle, where the practitioner pre-loads the needles with the correct number of seeds per the treatment plan. The second type of needles, called "Mick" needles involves use of a Mick seed implant device, a registered trademark of Mick Nuclear, Inc.
C . CaverMap Surgical Aid
The CaverMap Surgical Aid was cleared by the FDA for marketing for prostate cancer surgery in men in the United States in November 1997. The Company began commercial selling efforts for this product during the second quarter of 1998. The CaverMap Surgical Aid was cleared by the FDA for marketing for colorectal cancer surgery in men in February 2000.
The CaverMap Surgical Aid is a new product in the field of urologic surgery. This product is the first tool of its kind, developed to address the surgical needs of the physician during the "nerve location and sparing" segment of the radical prostatectomy. Advances in nerve stimulation techniques coupled with real-time feedback tumescence monitoring developed by UroMed can assist the physician in the identification, mapping and preservation of the neurovascular bundles during NSRP. The system consists of a control unit, reusable probe handle, disposable probe tip, disposable tumescence sensor and related patient and ground leads. The CaverMap Surgical Aid is used intraoperatively during the procedure by the physician to stimulate the cavernosal nerves and measure minute changes in tumescence of the penis. The physician uses the device to map the course of the nerves and then uses this information to aid his dissection plan. If the physician can perform the dissection without damage to the cavernosal nerves, we believe that post-operative potency rates will improve.
Two clinical studies have been undertaken to evaluate the CaverMap device. A single-center clinical study was undertaken by Dr. Laurence Klotz of Sunnybrook Health Science Centre in Toronto, Canada to determine the feasibility of using intraoperative nerve stimulation and real time penile tumescence monitoring to guide the physician's dissection during NSRP. Erectile function prior to surgery and during a one year period following surgery was assessed by
patient self-reporting. Nineteen patients who reported erectile function prior to surgery had one-year follow-up data available. A response to nerve stimulation was elicited in seventeen of these nineteen patients. Sixteen of the 17 patients (94%) who demonstrated a response to stimulation during surgery reported recovery of partial or full erectile function during the one year period following surgery. The two patients who showed no response to intra-operative nerve stimulation reported no erectile function following surgery. This experience contrasted sharply with the investigator's prior historical experience of 30% erectile function, leading him to conclude that the use of CaverMap could significantly improve outcomes for patients. No adverse events were reported that related to the use of the device. Dr. Klotz and five other Canadian centers also undertook a multi-center study involving 61 patients undergoing radical prostatectomy for early stage prostate cancer. The CaverMap product was used intraoperatively to help locate the cavernous nerve during NSRP. Use of the CaverMap Surgical Aid in this multi-center study led to a 30% improvement in "successful" bilateral nerve sparing patients when compared to the control group patients. Many patients have been able to return to a normal life, experiencing minimal complications post-operatively. This preliminary data was presented at the 93rd annual meeting of the American Urological Association meeting on June 2, 1998.
The Company now has an installed base of CaverMap control units in approximately 110 accounts performing radical prostatectomies in the United States. Many of these accounts are surgical centers that perform colorectal cancer surgery as well. The Company's initial strategy is to expand the colorectal application of CaverMap to these centers.
D. Allosource Cadaveric Fascia Kits
The first area in the urologic community in which the Company developed customer relationships is female urinary incontinence. The Company is presently in this market with the offering of Allosource Cadaveric fascia. The fascia is used during a surgical procedure to treat stress urinary incontinence. The Company has competed in the fascia market since 1998, and is supplied its fascia through a supply agreement with Allosource of Denver, Colorado.
Competition and Market Dynamics
The largest changes in the brachytherapy for prostate cancer marketplace in the last few years has been the new product offerings in both iodine and palladium seeds. The Company believes that new products will continue to affect the market in 2000.
At the end of 1999, there were five companies supplying brachytherapy seeds for prostate cancer treatment in the United States, including UroMed. Six new competitors are expected to launch products in 2000.
The Company believes Nycomed Amersham was the market leader in iodine seed for prostate cancer in 1999. Johnson & Johnson Indigo distributes Theragenics Corporation's "Theraseed" product which competes and was the market leader in the palladium area of the seed prostate cancer market in 1999. Other competitors are Mentor Corporation, which distributes an iodine seed manufactured by North American Scientific, and Imagyn Corporation which began competing in the iodine seed market during 1999.
Although the Company anticipates additional entries into the brachytherapy seed market given the tremendous growth projected for this market, the Company believes that the number of additional entries may perhaps be limited because of the barriers to entry such as the long lead time required for regulatory review, and experience required to design, evaluate, and manufacture a sealed radioactive source of this size in substantial quantities.
The Company is not aware of any products that directly compete with the CaverMap Surgical Aid. However, competition exists in the form of other treatments and therapies for prostate and colorectal cancers, as noted in the "Markets" section above.
Marketing and Sales
A. Initial Positioning as "Prostate Cancer Leader"; Build on Prostate Cancer Base
UroMed's near term marketing strategy is to position itself as the leader in providing innovative treatment options for prostate cancer with urology department heads and the prostate cancer teams located at the large academic centers and community hospitals treating the vast majority of the prostate cancer patients in the United States. Given the Company's offerings in the largest therapeutic segments of the prostate cancer market, the Company believes that it is able to take a more comprehensive approach to the treatment of prostate cancer than any of its competitors.
In the longer term, the Company intends to leverage its customer relationships and its core technologies to expand into other interventional therapeutic areas outside of prostate cancer. If such expansion requires distribution outside of the urology/radiation oncology markets, UroMed intends to gain such distribution through corporate partnerships and strategic alliances.
B. Marketing Strategy
UroMed is dedicated to establishing itself as a leader in the innovative treatment of prostate cancer with the introduction of the CaverMap device. There are four elements to the Company's marketing strategy for CaverMap: (1) build a strong clinical data base and gain endorsement for the product from leaders in the field of urology as a potential standard of care; (2) establish broader clinical education and experience in favor of the product, (3) generate patient awareness of and demand for the product, and (4) secure favorable reimbursement for use of the device from insurers, managed care organizations and other health care industry participants.
Sales Strategy and Organization
The sales organization currently consists of seven sales representatives reporting to the Vice President of Sales and one national accounts manager for brachytherapy reporting to the brachytherapy product manager. The sales representatives and brachytherapy national accounts manager are currently responsible for selling the CaverMap device, the Symmetra I-125 seeds, and the UroMed Prostate Seeding Needles. The efforts in selling all products are supported by an aggressive effort on the part of the Symmetra and CaverMap product managers and members of the senior management team.
Research and Development/Business Development
The Company has developed a three-pronged approach to research and development and business development. Strategically, the Company is focusing on (1) sustaining Research and Development, which includes a focus on supporting the CaverMap device, the Symmetra I-125 seeds and the Company's other existing products from a technical perspective; (2) future projects, which are currently slated for the year 2001 or beyond but which may be moved up as resources become available or market needs dictate; and (3) opportunistic product licensing opportunities which leverage our growing customer relationships. The Company believes that this focused approach to expanding the UroMed portfolio should position the Company as a leader in prostate cancer therapies.
Manufacturing: Virtual Manufacturing Strategy
Currently, all of the UroMed product components are procured from outside vendors with final testing and acceptance occurring at UroMed's facility in Norwood, Massachusetts. All orders for UroMed's products are taken through UroMed's customer service organization and finished products are shipped directly to medical institutions. Two engineers are on-call 24 hours a day to provide technical support for these products.
Bebig designed and built an automated brachytherapy seed manufacturing line for production capacity at a rate of 200,000 units per single shift based on its proprietary technology, at its facility in Berlin, Germany.
Medical Office-Based Products
The Company has developed and acquired office-based products and technology in the market for continence care. The Company has capitalized on these products and technologies via strategic alliances with larger, more established companies. On July 21, 1999, UroMed Corporation entered into an agreement to sell global rights to its Impress Softpatch technology and assets to Procter & Gamble. Under the agreement, UroMed received $3.3 million in cash at closing and will receive an additional $150,000 in cash payments each year for a four-year period commencing on July 21, 2000. In addition and under certain conditions, UroMed may receive additional cash consideration in the future in the form of royalty and other payments. The Company recorded a gain of $0.7 million as a result of this transaction in 1999. The Impress Softpatch was cleared by the FDA for marketing in the United States in May 1996. The Impress Softpatch is a small, prescription, disposable adhesive patch designed to be placed externally against the urinary opening to block the leakage of urine in mild-to-moderate urinary incontinence patients. The Impress Softpatch technology was acquired from the successor to Advanced Surgical Intervention, Inc. in May 1996.
During April 1997, the Company acquired the product line, all associated license rights and all other rights of Johnson & Johnson Medical, Inc. and certain of its affiliates to the INTROL Bladder Neck Support Prosthesis ("INTROL"). The INTROL, cleared for Rx marketing in the U.S. by the FDA in May of 1995, is a patented intravaginal device which is designed to elevate the bladder neck to its normal anatomical position, simulating the effect of bladder neck suspension surgery. The Company initially serviced the small group of physicians who had been trained and were involved in limited post-FDA clearance marketing of INTROL. The Company initiated a broader United States launch of INTROL to healthcare practitioners in 1997. In July 1998, the Company announced the signing of an agreement with Johnson & Johnson Medical K.K. ("JJMKK "), a subsidiary of Johnson & Johnson, giving JJMKK the exclusive right to distribute the Company's INTROL in Japan. The agreement has a term of three years.
Breast Cancer
In October 1997, the Company unveiled a technology designed to help women and their doctors detect suspicious lumps - often the early sign of breast cancer. This technology is currently being developed by the Assurance Medical, Inc. The Assurance Medical operations were part of UroMed through April 15, 1999. On April 15, 1999, the Company completed the "spin-out" of this technology into a new, private company, Assurance Medical, Inc. ("Assurance"). In conjunction with this spin-out, Assurance received $8.0 million in equity financing from two healthcare venture capital firms and the Company contributed its breast cancer screening technology to Assurance in exchange for an approximately one-third equity position. As a result of this transaction, the Company no longer has to fund the development of this technology. The Company is hopeful that it will eventually share in the benefits related to this technology via its equity interest in Assurance, although there can be no assurance that the Company will be able to do so. The transaction did not have a material impact on UroMed's financial position or results of operations. Because the Company's recorded investment in Assurance is zero and the Company does not intend to provide additional funding to Assurance, the Company has not recorded its share of Assurance's net loss since the spin-out.
Patents and Proprietary Rights
The Company's success will depend in part on its ability to obtain and maintain patent protection for its products, to preserve its trade secrets and to operate without infringing the proprietary rights of third parties. The Company's strategy regarding the protection of its proprietary rights and innovations is to seek patents on those portions of its technology that it believes are patentable and to protect as trade secrets other confidential and proprietary information.
The Company believes that its patents, and any additional patents which may be issued pursuant to these applications and any continuations or continuations-in-part, may provide the Company with a substantial competitive advantage. However, there can be no assurance as to the degree of protection offered by any of these patents or that any patents will be issued with respect to the Company's pending patent applications.
Some of the technology used in the Company's products is not covered by any patent or patent application of the Company. The Company seeks to maintain the confidentiality of its proprietary technology by requiring employees who work with proprietary information to sign confidentiality agreements and by limiting access by parties outside the Company to such confidential information. There can be no assurance, however, that these measures will prevent the unauthorized disclosure or use of this information, or that others will not be able to independently develop such information. Moreover, as is the case with the Company's patent rights, the enforcement by the Company of its trade secret rights can be lengthy and costly, with no guarantee of success.
To date, no claims have been brought against the Company alleging that its technology or products infringe intellectual property rights of others. However, there can be no assurance that such claims will not be brought against the Company in the future or that any such claims will not be successful.
Prostate Cancer
The Company presently holds an exclusive license for two issued United States patents. A third United States patent has been issued for the CaverMap Surgical Aid. The first two United States patents have been licensed from the Brigham and Women's Hospital with exclusive rights to the Company. The third United States patent is held jointly by the Company and Brigham and Women's Hospital. International patent applications are pending as well. The Company believes that the issued patents and allowed claims which cover both method and device are a competitive advantage for the Company. The Company has filed or is in the process of filing additional patents pertaining to the CaverMap Surgical Aid.
Bebig has filed a patent for their Iodine-125 seed design, which UroMed will market as the Symmetra I-125 seed. Under the terms of its agreement with Bebig, UroMed will have exclusive license rights to market and distribute this seed in North America and South America for a period of six and one-half years from the date Bebig is first capable of producing the seed. UroMed has filed patents pertaining to the packaging of its Symmetra seed.
Regulatory
Prostate Cancer
The Company received regulatory clearance by the FDA in November 1997 to market the CaverMap Surgical Aid in the U.S. The clearance was through a 510(k) application and the pre-clinical and clinical testing included a variety of tests.
In February 2000, the U.S. Food and Drug Administration (FDA) cleared the CaverMap Surgical Aid for U.S. marketing and distribution, through a 510(k) application, for use in colorectal surgery in men. The CaverMap Surgical Aid will be used to assist surgeons in performing colorectal cancer surgery in identifying and sparing sensitive nerves responsible for erectile function.
The Company received regulatory clearance by the FDA in May 1999 to market the Symmetra I125 seed for a brachytherapy treatment in the U.S. The clearance was through a 510(k) application.
Office-Based Continence Care Products
FDA clearance to market the Impress Softpatch was granted in May 1996 on the basis of a 510(k) Notification application originally filed, based on the clinical trial data compiled, by Advanced Surgical Intervention, Inc. in September 1995.
The INTROL was cleared for marketing in the United States by the FDA in May 1995 through a 510(k) application filed by Johnson & Johnson Medical, Inc. A clinical trial was conducted to support the safety and effectiveness of the INTROL for the treatment of stress urinary incontinence.
Government Regulation
The CaverMap Surgical Aid, the Symmetra I-125 seeds, and the INTROL, as well as certain products currently under development by the Company, are regulated as medical devices by the FDA under the Federal Food, Drug and Cosmetic Act (the "FDC Act") and require regulatory clearance prior to commercialization in the United States. Under the FDC Act, the FDA regulates clinical testing, manufacturing, labeling, distribution and promotion of medical and surgical devices in the United States. Various states and other countries in which the Company's products may be sold in the future may impose additional regulatory requirements.
Following the enactment of the Medical Device Amendments to the FDC Act in May 1976, the FDA classified medical devices in commercial distribution into one of three classes: Class I, II or III. This classification is based on the controls necessary to reasonably ensure the safety and efficacy of medical devices. Class I devices are those whose safety and efficacy can reasonably be ensured through general controls, such as adequate labeling, pre-market notification and adherence to FDA-mandated "Quality System Regulation." Generally, Class II devices are those whose safety and efficacy can reasonably be ensured through the use of special controls, such as performance standards, post-market surveillance, patient registries and FDA guidelines. Class III devices are devices which must receive pre-market approval by the FDA to ensure their safety and efficacy, generally life-sustaining, life-supporting or implantable devices, and also include all new or not substantially equivalent devices introduced after May 28, 1976.
If a manufacturer or distributor of medical devices can establish that a new device is "substantially equivalent" to a legally marketed Class I or Class II medical device or to a Class III medical device for which the FDA has not required pre-market approval, the manufacturer or distributor may seek FDA marketing clearance for the device by filing a 510(k) Notification application. The 510(k) Notification application and the claim of substantial equivalence may have to be supported by various types of information indicating that the device is as safe and effective for its intended use as a legally marketed predicate device and a 510(k) Notification application may require the submission of data including clinical data.
Following submission of the 510(k) Notification application, the manufacturer or distributor may not place the device into commercial distribution until an order is issued by the FDA. The FDA has no specific time limit by which it must respond to a 510(k) Notification application. The FDA may agree with the manufacturer or distributor that the proposed device is "substantially equivalent" to another legally marketed device, and allow the proposed device to be marketed in the United States. The FDA may, however, determine that the proposed device is not substantially equivalent, or may require further information, such as additional clinical test data, before it is able to make a determination regarding substantial equivalence. Such determination or request for additional information could delay the market introduction of a product.
If a manufacturer or distributor cannot establish to the FDA's satisfaction that a new device is substantially equivalent to a legally marketed medical device, the manufacturer or distributor will have to seek pre-market approval or reclassification of the device. A PMA, which must prove that a device is safe and effective, must be supported by extensive data, including preclinical and clinical trial data, to demonstrate the safety and efficacy of the device. Upon receipt, the FDA will conduct a preliminary review of the PMA to determine whether the submission is sufficiently complete to permit a substantive review. If sufficiently complete, the submission is declared fileable by the FDA. By regulation, the FDA has 180 days to review a PMA after it has been determined to be fileable. While the FDA has at times responded to PMA's within the allotted time period, PMA reviews more often occur over a longer time period and generally take approximately two years or more from the date of filing to complete. A number of devices for which FDA marketing clearance has been sought have never been cleared for marketing.
If a manufacturer commercializes a medical device, it is required to register with the FDA and to list all of its devices. In addition, any such manufacturer will be subject to inspection on a routine basis for compliance with the FDA's Quality System Regulation. The Company's facility in Norwood, Massachusetts, was registered with the FDA and successfully passed an inspection. The FDA's regulations also require that such manufacturer manufacture its products and maintain its documents in a prescribed manner with respect to manufacturing, testing and quality control activities. Further, such manufacturer is required to comply with various FDA requirements for labeling and reporting of adverse reactions and may be required to meet rules governing product tracking and post-market surveillance.
Employees
As of December 31, 1999, the Company employed approximately 34 individuals on a permanent basis.
None of the Company's employees are covered by collective bargaining agreements.
FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS
Certain statements contained in this Annual Report may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding (i) the planned progression of the Company's commercialization strategies for the CaverMap Surgical Aid, the Symmetra I-125 brachytherapy seed and introducer needle including the timing and extent of sales, (ii) the continued marketing activities for the commercial launch of the Symmetra I-125 brachytherapy seeds, (iii) the Company's planned uses for its cash and other liquid resources, (iv) the extent of future revenues, expenses and results of operations and the sufficiency of the Company's financial resources to meet planned operational costs and other expenditure needs, and the development of partnerships and/or strategic alliances for all incontinence and breast care products and related assets and technology, and (v) the risk of the Company's dependence on Bebig to manufacture the Symmetra I-125 seeds and the Company's dependence on Symmetra's overall contribution to the Company's operations. These forward-looking statements are based largely on the Company's expectations and are subject to a number of risks and uncertainties, many of which are beyond the Company's control. Actual results could differ materially from these forward-looking statements as a result of certain factors, including those described below:
- - The uncertainty that the CaverMap Surgical Aid and Symmetra I-125 seeds will gain market acceptance among physicians in the United States.
- - The uncertainty that the Company will be able to develop and maintain an effective sales force and implement a successful marketing campaign for the CaverMap Surgical Aid and the Symmetra I-125 brachytherapy seed in the United States.
- - The Company's dependence on others, including Bebig, for its products and raw materials and other certain components of its products, including certain materials available only from single sources.
- - The uncertain protection afforded the Company by its patents and/or other intellectual property rights relating to the Company's products.
- - The uncertainty as to whether the Company will be able to market and sell its products at prices that permit it to achieve satisfactory margins in the production and marketing of its products.
- - Risks relating to FDA and other governmental oversight of the Company's operations, including the possibility that the FDA could impose costly additional labeling requirements on, or restrict the marketing of, the Company's products, or suspend operations at one or more of the Company's facilities.
- - The uncertainty of the size of the potential markets of the Company's products.
RISK FACTORS
The Company's financial condition and results of operation, as well as the market price for the Company's outstanding securities, are also likely to be affected by the following factors:
Cashflow and Convertible Notes
There can be no assurance that the Company will generate sufficient cash flow to pay interest and principal on its 6% Convertible Subordinated Notes due October 15, 2003 (the "Notes"), of which $17,393,000 aggregate principal amount was outstanding at December 31, 1999. The Company expects its operating losses to increase over the foreseeable future and there can be no assurance that the Company will be have sufficient cash available or will be able to raise sufficient cash to pay the principal of the Notes at October 15, 2003.
Limited Operating History; History of Losses; Profitability Uncertain
The Company has experienced significant operating losses since inception and, as of December 31, 1999, had an accumulated deficit of $104.1 million. The Company has never successfully commercialized any of its products. In addition, the development and commercialization by the Company of its products and other new products, if any, will require substantial product development expenditures for the foreseeable future. The Company's future profitability is dependent upon its ability to successfully commercialize these products. The Company expects its operating losses to increase over the foreseeable future and there can be no assurance that the Company will be profitable in the future or that the Company's existing capital resources and any funds provided by future operations will be sufficient to fund the Company's needs, or that other sources of funding will be available.
Nasdaq SmallCap Continued Listing
The Company is presently subject to the continued listing requirements of the Nasdaq Small Cap exchange. There can be no assurance that the Company will be able to continue to meet these continued requirements. There can also be no assurance that any de-listing from the Nasdaq SmallCap exchange will not have a material adverse effect on the liquidity and value of the Company's stock.
Uncertainty of Market Acceptance for the Company's Products
The CaverMap Surgical Aid and the Symmetra I-125 seeds will be competing against existing treatments and competing products in the prostate cancer market. There can be no assurance of the market acceptance of these products.
Dependence on Bebig for Symmetra I-125 Seed Manufacturing
The Company expects to derive a substantial portion of its revenues for the next several years from sales of the Symmetra I-125 Seed. The Company presently has a production agreement in place with Bebig to produce the Symmetra seed for six and one-half years. Any interruption in the Symmetra seed manufacturing process would have a material adverse effect on the Company's business, financial condition and results of operations.
Dependence on Few Products
The Company expects to derive a substantial part of its revenues for the next several years from sales of the CaverMap Surgical Aid and the Symmetra I-125 seeds. The Company's failure to commercialize successfully these products would have a material adverse effect on the Company's business, financial condition and results of operations. The Company does not expect that commercialization of other new products will be feasible without a substantial, continuing commitment to research and development for an extended period of time or acquisitions of new properties, or both. Also, the development of any new products may require that such products will be subject to clinical trials and regulatory clearance or approval before commercialization. There can be no assurance as to whether or when commercialization of other products might begin or as to the likelihood that any such initiative would be successful.
Dependence on Others for Products and Raw Materials
The Symmetra seed is supplied solely by Bebig and certain of the raw materials for the manufacture and assembly of the CaverMap Surgical Aid are available only from single sources and are manufactured by third parties. Interruptions in supplies of raw materials may occur as a result of business risks particular to such suppliers or the failure of the Company and any such supplier to agree on satisfactory terms. Such sources may also decide for reasons beyond the control of the Company, such as concerns about potential medical product liability risk in general, to cease supplying such materials or components for use in medical devices generally. Significant interruption in the supply of raw materials currently used by the Company for its products could have a material adverse effect on the Company's business, financial condition and results of operations.
Lack of Marketing and Sales Experience
Although the FDA has cleared the CaverMap Surgical Aid and the Symmetra I-125 seed for brachytherapy treatments in the United States, the Company has sold only limited amounts of these products. The Company has developed a direct marketing and sales group in the United States for its products. However, there can be no assurance that the Company has built an effective sales force, will be able to continue to attract and retain a qualified marketing and sales group in the United States, or can otherwise design and implement an effective marketing and sales strategy for the CaverMap Surgical Aid and the Symmetra I-125 seeds, or any future product developed by the Company. Lack of Distribution Experience
The Company has limited experience in distributing units of its products to its ultimate consumers. The Company ships all CaverMap related products directly from its offices in Norwood, Massachusetts. The Symmetra seed shipments are shipped directly to customers from IPL's warehouse in Burbank, California or Bebig's facility in Berlin, Germany.
Competition and Technological Advances
The markets for prostate cancer treatment, particularly brachytherapy are highly competitive. The Company's ability to compete in these areas will depend upon the consistency of product quality and delivery, price, technical capability and the training of health care professionals and consumers. Other factors within and outside the Company's control will also affect its ability to compete, including its product development and innovation capabilities, its ability to obtain required regulatory clearances, its ability to protect the proprietary technology included in its products, its manufacturing, marketing and distribution capabilities and its ability to attract and retain skilled employees. Certain of the Company's competitors have significantly greater financial, technical, research, marketing, sales, distribution and other resources.
Risks Relating to FDA Oversight and Other Government Regulation
The facilities at which the Company or its key suppliers manufactures its product, are subject to regulation by the FDA and, in many instances, by comparable agencies in the foreign countries in which these devices are distributed and sold. The process of obtaining regulatory approvals for the marketing and sale of any additional products, or the modification of existing products, by the Company could be costly and time-consuming and there can be no assurance that such approvals will be granted on a timely basis, if at all. The regulatory process may delay the marketing of new products for lengthy periods, impose substantial additional costs and furnish an advantage to competitors who have greater financial resources. Moreover, regulatory approvals for new or modified products, if granted, may include significant limitations on the indicated uses for which a product is marketed. In addition, the extent of potentially adverse governmental regulations that might arise from future legislative, administrative or judicial action cannot be determined. Any material product recall or loss of certification of the Company's manufacturing facility, would have a material adverse effect on the Company's business, financial condition and results of operations. The Company is also subject to regulation under federal, state and local regulations regarding maintenance of a licensed pharmacy, work place safety, environmental protection and hazardous and controlled substance controls, among others. The Company cannot predict the extent of government regulations or impact of new government regulations which might have an adverse effect on the production and marketing of the Company's products.
Risk of Inadequate Funding; Future Capital Funding
The Company plans to continue to expend substantial funds on marketing, research and product development, seeking out partnerships that fit into its strategic platforms and pursuit of regulatory approvals. In addition, the Company's Notes mature in October 2003.
There can be no assurance that the Company's existing capital resources and any funds generated from future operations will be sufficient to finance any required investment or pay interest on and principal of the Notes or that other sources of funding will be available. In addition, future sales of substantial amounts of the Company's securities in the public market could adversely affect prevailing market prices and could impair the Company's future ability to raise capital through the sale of its securities.
Uncertainty Regarding Patents and Protection of Proprietary Technology
The Company's ability to compete effectively will depend, in part, on its ability to develop and maintain proprietary aspects of its technology. There can be no assurance as to the validity of the United States patents held by the Company with respect to all of its products, or as to the degree of protection offered by these patents. There can be no assurance that the Company's patents will not be challenged, invalidated or circumvented in the future. In addition, there can be no assurance that competitors, many of which have substantial resources and have made substantial investments in competing technologies, will not seek to apply for and obtain patents that will prevent, limit or interfere with the Company's ability to make, use and sell its products either inside or outside the United States. The defense and prosecution of patent litigation or other legal or administrative proceedings related to patents is both costly and time-consuming, even if the outcome is favorable to the Company. During the pendency of any such proceedings, the Company may be restrained, enjoined or otherwise limited in its ability to make, use or sell a product incorporating the patents or technology that are the subject of such claim, which would have a material adverse effect on the Company's business, financial condition and results of operations. An adverse outcome in any such proceeding could subject the Company to significant liabilities to third parties, require disputed rights to be licensed from others or require the Company to cease making, using or selling any products. There can be no assurance that any licenses required under any patents or proprietary rights would be made available on terms acceptable to the Company, if at all.
The Company also relies on unpatented proprietary technology and there can be no assurance that others may not independently develop the same or similar technology or otherwise obtain access to the Company's unpatented proprietary technology. In addition, the Company cannot be certain that others will not independently develop substantially equivalent or superseding proprietary technology, or that an equivalent product will not be marketed in competition with the Company's products, thereby substantially reducing the value of the Company's proprietary rights. There can be no assurance that any confidentiality agreements between the Company and its employees or consultants will provide meaningful protection for the Company's trade secrets, know-how or other proprietary information in the event of any unauthorized use or disclosure of such trade secrets, know-how or other proprietary information. Finally, there can be no assurance that the Company's trademarks chosen and registered will provide meaningful protection.
Product Liability Risk; Limited Insurance Coverage
The manufacture and sale of medical products and the conduct of clinical trials using new technology entail the risk of product liability claims. There can be no assurance that the Company's existing insurance coverage limits are adequate to protect the Company from any liabilities which it might incur in connection with the clinical trials for any of its products or the commercialization of any of its products. Such insurance is expensive and in the future may not be available on acceptable terms, if at all. A successful product liability claim or series of product liability claims brought against the Company in excess of its insurance coverage would have a material adverse effect on the Company's business, financial condition and results of operations. In addition, any claims, even if not ultimately successful, could adversely affect the market acceptance of the Company's products.
Volatility of Market Prices
The market price of the Common Stock and Notes may be highly volatile. Factors such as quarter-to-quarter variations in the Company's operations or financial performance and announcements of technological innovations or new products, results of clinical trials or other regulatory or reimbursement events by the Company or its competitors or any of its or their regulators could cause the market price of the Common Stock or Notes to fluctuate significantly. In addition, in recent years the stock markets in general, and the market prices for medical technology companies in particular, have experienced significant volatility, which often may have been unrelated to the operating performance of the affected companies. Such volatility may adversely affect the market price of the Common Stock or Notes. See "Market for Registrant's Common Stock and Related Shareholder Matters."
Certain Charter and By-Law Provisions May Affect Market Prices
The Company's Restated Articles of Organization and the Company's Amended and Restated By-Laws contain provisions that may have the effect of making it more difficult for a third party to acquire control of, or of discouraging acquisition bids for, the Company. This could limit the price that certain investors might be willing to pay in the future for shares of Common Stock.
Certain Massachusetts Laws May Affect Market Prices
Certain Massachusetts laws contain provisions that may have the effect of making it more difficult for a third party to acquire control of, or of discouraging acquisition bids for, the Company. These laws include Chapter 110F of the Massachusetts General Laws, which prohibits certain "business combinations" with "interested stockholders," and Chapter 110D, entitled "Regulation of Control Share Acquisitions." These provisions could limit the price that certain investors might be willing to pay in the future for shares of Common Stock.
Effect of Issuance of Preferred Stock
Shares of preferred stock may be issued in the future without further stockholder approval and upon such terms and conditions, and having such rights, privileges and preferences, as the Board of Directors may determine. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. In addition, the issuance of preferred stock could have the effect of making it more difficult for a third party to acquire control of, or of discouraging acquisition bids for, the Company. This could limit the price that certain investors might be willing to pay in the future for shares of Common Stock.
Concentration of Ownership
As of December 31, 1999, directors and executive officers of the Company and their affiliates owned approximately 16% of the outstanding Common Stock (including options to purchase Common Stock exercisable within 60 days of such date). As a result, such persons have the ability to assert significant influence over the Company and the direction of its affairs and business. See "Security Ownership of Certain Beneficial Owners and Management."
Absence of Dividends
The Company has not paid cash dividends and does not anticipate doing so for the foreseeable future.
Shares Available for Future Sale
The future sale of shares of the Company's Common Stock could have an adverse effect on the market price of the Common Stock or the Notes. The Company currently has two effective registration statements on file with the Securities and Exchange Commission initially covering the resale of up to an aggregate of 1,703,508 shares of Common Stock held by certain current shareholders of the Company. Of these 1,703,508 shares, 1,236,902 shares are covered by a
registration statement which was declared effective in October 1995 registering shares of Common Stock held by approximately 73 holders. These shares, representing shares of Common Stock issued upon the conversion of the Company's previously outstanding convertible preferred stock, were registered at the request of the holders of such shares. All of these shares may be sold currently under Rule 144(k) under the Securities Act without regard to volume or other limitations. The remaining 467,005 shares, which were issued to the former shareholders of Advanced Surgical Intervention, Inc. in connection with the acquisition of the Impress Softpatch technology in May 1996, are covered by a registration statement which was declared effective in June 1996. These shares are held by 273 holders, with the largest number of shares held by any single holder thereunder being approximately 50,000 shares. The Company believes that many of the shares covered by these registration statements have been sold in the open market prior to the date hereof. All of the shares covered by these registration statements are freely tradeable in the open market without volume limitations unless held by one of our affiliates. As of December 31, 1999 the Company also had options outstanding to purchase an aggregate of 312,975 shares of Common Stock and had an additional 86,633 shares of Common Stock reserved for issuance of options which may be granted and exercised under the Company's existing employee benefit plans. Any shares of Common Stock issued upon the exercise of such outstanding options or any options granted in the future will be, upon issuance, freely tradeable on the open market, subject in some cases to the volume limitations imposed by Rule 144 under the Securities Act. As of December 31, 1999, the Company had reserved 372,775 shares of Common Stock for issuance upon conversion of the Notes.
Item 2.
Item 2. Properties
The Company currently leases space in one facility in Norwood, Massachusetts. This lease commenced in 1997 has a five-year term and is for a 9,000 square foot area which occupies all administrative, research and development, marketing and manufacturing staff of the Company.
The Company terminated operating leases at two locations during 1999. The Company terminated the Needham, Massachusetts facility as part of its restructuring. This was a 40,000 square-foot facility which had a lease set to expire in 2001. The Company entered into a lease termination agreement effective March 15, 1999. The second lease terminated during 1999 was for the lease for the Assurance Medical Inc. staff in Hopkinton, Massachusetts. This lease was terminated by the Company in conjunction with the April 1999 spin-off of the Assurance Group into a separate corporation.
Item 3.
Item 3. Legal Proceedings
The Company is not involved in any material legal proceedings, nor is the property of the Company the subject of any such proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
During the fourth quarter of the Company's 1999 fiscal year, there were no matters submitted to a vote of the security holders of the Company.
Item 5.
Item 5. Market for Registrant's Common Stock and Related Shareholder Matters
UroMed's common stock is traded on the Nasdaq SmallCap Market under the symbol URMD. As of December 31, 1999 there were 307 registered holders of the Company's common stock. The Company has not paid dividends on its common stock since inception and does not anticipate paying any cash dividends in the foreseeable future. The following table sets forth for the periods indicated the range of high and low sales prices of the Company's Common Stock as reported by Nasdaq.
Item 6.
Item 6. Selected Financial Data
Selected Financial Data
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
This Management's Discussion and Analysis should be read in conjunction with "Forward-Looking Statements and Associated Risks" and "Risk Factors" contained in Item 1 of this Annual Report on Form 10-K.
The Company is dedicated to establishing itself as a leader in providing interventional urological products, with primary emphasis on the treatment of prostate cancer. The Company seeks to market a portfolio of products including its two main proprietary products for the treatment of prostate cancer: the CaverMap Surgical Aid, available to aid physicians in preserving vital nerves during prostate cancer surgery, and the Symmetra I-125 radioactive seeds, used in a brachytherapy procedure to treat localized prostate cancer. The Company's product portfolio also includes brachytherapy introducer needles. UroMed, through its approximate one-third ownership of Assurance Medical Inc. has supported the development of electronic palpation technology in order to aid physicians in the important mission of finding suspicious breast lumps earlier. The Company also continues to dedicate resources to the development and/or acquisition of product lines that fit into its strategic platform.
Results of Operations Years Ended December 31, 1999 and 1998
Revenues
The Company's revenues increased by 216% to $2.6 million from $0.8 million for 1999 as compared to 1998. The increase is primarily due to the increased sales in 1999 of the CaverMap Surgical Aid, while 1998 sales levels of this product were relatively insignificant. Additionally, the Company commenced shipments of its Symmetra I-125 seed during the third quarter of 1999 and recorded total related revenues of $0.2 million in 1999. Revenues in 1998 were derived primarily from sales of the Company's previously marketed line of incontinence products, which are currently not actively marketed by the Company.
Cost of Revenues
Cost of revenues decreased by 27% to $2.5 million from $3.4 million for 1999 as compared to 1998. The decrease is the result of reductions in salaries and related expenses of $0.5 million primarily the result of the headcount reduction from the 1998 restructuring, facilities and corporate-related allocation reductions of $0.4 million, and a $0.5 million reduction in depreciation expense. All the reductions are partially offset by an increase of $0.5 million in variable product costs due to the increased revenue levels in 1999 as compared to 1998.
Research and Development
Research and development expenses decreased by 60% to $2.1 million from $5.4 million for 1999 as compared to 1998. The decrease in 1999 is the result of the following: a $1.5 million decrease in Assurance Medical related expenses due to the April 1999 spin-out of this group into a separate corporation; a reduction of $0.8 million in incontinence surgical related prototype, design and consulting expenses; a decrease of $0.5 million in salary and related expenses primarily the result of the headcount reduction from the 1998 restructuring; a decrease of $0.3 million in administrative and corporate-related expenses; and a $0.2 million reduction in clinical study related expenses on behalf of the CaverMap Surgical Aid.
In October 1997, the Company unveiled a technology designed to help women and their doctors detect suspicious lumps - often the early sign of breast cancer. The technology is currently being developed by Assurance Medical, Inc. The Assurance Medical operations were part of UroMed Corporation through April 15, 1999. On April 15, 1999, the Company completed the "spin-out" of this technology into a new, private company, Assurance Medical, Inc. As a result of this transaction, the Company no longer has to fund the development of this technology and therefore had savings of approximately $2.3 million in operating expenses for 1999 as compared to 1998. The transaction did not have a material impact on UroMed's financial position or results of operations. The Company's initial equity investment of $0.1 million has been reduced to $0 as a result of the losses incurred by Assurance Medical, Inc. in 1999.
Marketing and Sales
Marketing and sales expenses decreased 48% to $2.1 million from $4.1 million for 1999 as compared to 1998. The decrease in 1999 is the result of the following: $0.6 million in reduced Assurance Medical related expenses due to the spin-out; $0.6 million in salaries and related expenses partially as a result of the 1998 restructuring and partially the result of employee attrition during 1999; $0.4 million in reduced public relations and product literature expenses for incontinence surgical products which were actively marketed in 1998 and not in 1999; and $0.4 million in administrative and other marketing program related expenses.
General and Administrative
General and administrative expenses decreased by 58% to $1.8 million from $4.2 million for 1999 as compared to 1998. The decrease is the result of the following: 1998 included a $1.0 million charge for the write-off of the carrying value of the Company's investment in Medworks Corporation (see Item 8: Financial Statements and Supplementary Data, footnote 6 to the financial statements); a decrease from 1998 to 1999 of $0.7 million in finance and administrative expenses; a decrease from 1998 to 1999 of $0.3 million in Assurance Medical related expenses due to the spin-out; and a decrease from 1998 to 1999 of $0.3 million in systems related expenses.
Restructuring
During the year ended December 31, 1998, the Company recorded a total charge of $1,704,000 representing the cost of restructuring its operations to shift its strategic emphasis to the hospital-based business and away from the consumer- oriented continence care business, which the Company has concluded will be best approached by entering into a partnership or other arrangement with a larger company. During the first quarter of 1998, a plan to effect this restructuring was adopted by the Board of Directors and, at that time, the Company recorded a restructuring charge of $1,024,000. This charge consisted of approximately $579,000 of employee termination benefits and approximately $445,000 of costs to exit two of the Company's leased facilities. The employee termination benefits related to the termination of approximately 40 employees, all of which have been terminated as of December 31, 1998, across all functional areas of the Company. The facility exit costs include the write-off of approximately $138,000 of leasehold improvements, with the remainder representing certain contractual lease payments related to the leased facilities.
During the fourth quarter of 1998, the Company made certain changes to its restructuring plan and, as a result, an additional charge of $680,000 was recorded at that time, representing additional facility exit costs. Specifically, the Company decided not to abandon one of the aforementioned facilities slated for closure and, at that same time, committed to abandoning one of the facilities that it had previously expected to keep open. The facility exit costs include the write-off of approximately $500,000 of leasehold improvements, with the remainder representing certain contractual lease payments related to the abandonment of the leased facility.
In March 1999, the Company entered into a lease termination agreement in respect to the facility that it committed to abandoning during the fourth quarter of 1998. Based upon the terms of this agreement, the Company's cost of exiting this facility was $80,000 less than the Company's original estimates that were included within the restructuring liability as of December 31, 1998. As a result, the Company reversed $80,000 of the restructuring liability during 1999. All remaining restructuring accruals were paid in cash in 1999.
During the year ended December 31, 1999, the activity with respect to the restructuring liability was as follows (in thousands):
Balance at Balance at December 31, Cash December 31, 1998 Payments Adjustments 1999 -------------- ---------- ----------- ------------ Employee termination Benefits $ 55 $ 55 $ -- $ --
Other facility exit costs 304 224 80 -- ------------- ---------- ---------- ------------ $ 359 $ 279 $ 80 $ -- ============= ========== ========== ============
As compared to 1998, 1999 cost savings from the 1998 restructuring amounted to approximately $2.7 million, which was in line with management's estimate. The major reductions from 1998 expenditure levels were as follows: $1.6 million in reduced employee expenses, $0.4 million in reduced public relations and selling costs, $0.4 million in clinical and regulatory expenses, $0.1 million in reduced distribution costs and $0.2 million in reduced facility costs (including amortization).
Gain on Sale of Assets
On July 21, 1999, UroMed entered into an agreement to sell global rights to its Impress Softpatch technology and assets to Procter & Gamble. Under the agreement, UroMed received $3.3 million in cash at closing and will receive an additional $150,000 in cash payments each year for a four-year period commencing on July 21, 2000. In addition and under certain conditions, UroMed may receive additional cash consideration in the future in the form of royalty and other payments. The Company recorded a gain of $0.7 million as a result of this transaction in 1999.
Interest Income and Interest Expense
Interest income decreased by 59% to $1.2 million from $2.8 million for 1999 as compared to 1998. The decrease was attributable to the reduced size of the Company's investment portfolio, caused by the need to fund the Company's operations and to repurchase the Notes (see Note 9 to the Financial Statements).
Interest expense decreased 61% to $1.5 million from $3.9 million for 1999 as compared to 1998 as a result of the reduction in outstanding convertible Notes due to the repurchases during 1998 and 1999.
Extraordinary Gain on Early Retirement of Debt
During 1999 and 1998, the Company repurchased some of its Convertible Subordinated Notes Payable (the Notes) for the applicable periods as follows:
- ---------------------------------------------------- --------------------------- Aggregate Principal Cost of Notes Extraordinary Repurchased Repurchased Gain Years ended: - -------------------- ----------------------- ---------------- ------------------ - -------------------- ----------------------- ---------------- ------------------ December 31, 1999 $7,363,000 $4,179,000 $3,021,000
- -------------------- ----------------------- ---------------- ------------------ - -------------------- ----------------------- ---------------- ------------------ December 31, 1998 $44,244,000 $19,321,000 $23,273,000
- -------------------- ----------------------- ---------------- ------------------
The repurchases of the Notes occurred in open market transactions with persons who were not affiliates of the Company. In addition to the cost of the principal repurchased as noted in the table above, the Company incurred additional costs of $163,000 and $1,650,000 in 1999 and 1998, respectively, relating to deferred financing fees written off and other fees incurred as a result of the repurchases.
Of the $44,244,000 of Notes repurchased in 1998, $34,924,000 represents Notes repurchased as part of the Company's announced tender offer which was completed on October 22, 1998. The remaining $9,320,000 of repurchased Notes occurred in open market transactions with persons who were not affiliates of the Company.
Subsequent to December 31, 1999 and through March 30, 2000, the Company repurchased approximately $3.0 million in aggregate principal amount of its Notes for approximately $1.7 million. This transaction will be reported in the quarter ended March 31, 2000.
Results of Operations Years Ended December 31, 1998 and 1997
Revenues
The Company's revenues increased by 66% to $0.8 million from $0.4 million for 1998 compared to 1997. The increase is primarily the result of the first two full quarters of sales of the CaverMap Surgical Aid in 1998 and revenue from INTROL Bladder Neck Support Prosthesis through the distribution agreement with Johnson & Johnson Medical K.K. entered into in 1998. 1997 revenues consisted of the recognition of deferred revenue from a portion of the advance payments received upon the signing of certain foreign distribution agreements, which are no longer in place, and small amounts of U.S. sales of the Reliance Insert, the INTROL Bladder Neck Support Prosthesis and the Impress Softpatch.
Cost of Revenues
Cost of revenues decreased by 28% to $3.4 million from $4.7 million for 1998 as compared to 1997 primarily due to the decreased level of headcount and related expenses as a result of the 1998 restructuring, and a higher level of inventory obsolescence charges in 1997 as compared to 1998. Cost of revenues significantly exceeds product revenue in 1998 and in 1997 due to the current level of variable product costs as well as the Company's related overhead costs relative to the low start-up volume of production in these periods.
Research and Development
Research and development expenses decreased by 54% to $5.4 million from $11.7 million for 1998 as compared to 1997. The decrease is the result of decreased headcount in 1998 as a result of the restructuring, significant 1997 expenses incurred in connection with Impress Softpatch scale-up activities and impairment charges in connection with Reliance Insert manufacturing equipment, and reduced consulting and prototype spending in relation to the breast cancer screening technology.
Marketing and Sales
Marketing and sales expenses decreased 69% to $4.1 million from $13.2 million for 1998 as compared to 1997. This decrease was the result of significant 1997 expenditures incurred in connection with the U.S. launch of the Reliance Insert and market analysis for the Impress Softpatch, and the reduced headcount in 1998 as the result of the restructuring.
General and Administrative
General and administrative expenses decreased by 24% to $4.2 million from $5.5 million for 1998 as compared to 1997. The decrease is primarily the result of the decreased headcount and fewer system and consulting expenditures in 1998.
Restructuring
During the year ended December 31, 1998, the Company recorded a total charge of $1,704,000 representing the cost of restructuring its operations to shift its strategic emphasis to the hospital-based business and away from the consumer- oriented continence care business, which the Company has concluded will be best approached by entering into a partnership or other arrangement with a larger company. During the first quarter of 1998, a plan to effect this restructuring was adopted by the Board of Directors and, at that time, the Company recorded a restructuring charge of $1,024,000. This charge consisted of approximately $579,000 of employee termination benefits and approximately $445,000 of costs to exit two of the Company's leased facilities. The employee termination benefits related to the termination of approximately 40 employees, all of which have been terminated as of December 31, 1998, across all functional areas of the Company. The facility exit costs include the write-off of approximately $138,000 of leasehold improvements, with the remainder representing certain contractual lease payments related to the leased facilities.
During the fourth quarter of 1998, the Company made certain changes to its restructuring plan and, as a result, an additional charge of $680,000 was recorded at that time, representing additional facility exit costs. Specifically, the Company decided not to abandon one of the aforementioned facilities slated for closure and, at that same time, committed to abandoning one of the facilities that it had previously expected to keep open. The facility exit costs include the write-off of approximately $500,000 of leasehold improvements, with the remainder representing certain contractual lease payments related to the abandonment of the leased facility.
During the year ended December 31, 1998, the activity in the restructuring liability was as follows (in thousands):
Total 1998 Balance at Restructuring Cash Non-Cash December 31, Charge Payments Items 1998 -------------- ---------- ---------- ------------ Employee termination Benefits $ 579 $ 524 $ -- $ 55
Asset write-downs 638 -- 638 --
Other facility exit costs 487 183 -- 304 ------------- ---------- ---------- ------------ $ 1,704 $ 707 $ 638 $ 359 ============= ========== ========== ============
The annual cost savings resulting from the restructuring actions was approximately $11,000,000.
Interest Income and Interest Expense
Interest income decreased by 38% to $2.8 million from $4.6 million for 1998 as compared to 1997. The decrease was attributable to the reduced size of the Company's investment portfolio, caused by the need to fund the Company's operations and to repurchase the Notes (see Note 9 to the Financial Statements).
Interest expense decreased 14% to $3.9 million from $4.5 million for 1998 as compared to 1997 as a result of the reduction in outstanding convertible Notes due to the repurchases during 1998.
Extraordinary Gain on Early Retirement of Debt
During 1998, the Company repurchased approximately $44,244,000 in aggregate principal amount of its Notes. Of the total repurchases, $34,924,000 represents Notes repurchased as part of the Company's announced tender offer which was completed on October 22, 1998. The remaining $9,320,000 of Notes repurchased occurred in unsolicited open market transactions with persons who were not affiliates of the Company. The total cost of the Note repurchases was $19,321,000, including accrued and unpaid interest and transaction fees related to the tender offer. These repurchases resulted in an extraordinary gain of $23,273,000 for the year ended December 31, 1998.
Liquidity and Capital Resources
At December 31, 1999, the Company had cash, cash equivalents and short-term investments totaling $17.9 million, a decrease of $8.4 million, or 32%, from $26.2 million at December 31, 1998. At December 31, 1999, the Company's funds were invested in U.S. government obligations, corporate debt obligations and money market funds.
Net cash used in operating activities of $7.2 million for the year ended December 31, 1999 was primarily a result of the $5.5 million loss before the extraordinary gain on the early retirement of debt and decreases of $1.8 million in accounts payable and accrued expenses and the $0.7 million gain on sale of assets, partially offset by depreciation and amortization of $1.2 million.
Net cash provided by investing activities was $3.3 million for the year ended December 31, 1999, primarily as a result of the net proceeds of sales of fixed assets.
Net cash used in financing activities was $4.2 million for the year ended December 31, 1999, primarily as a result of the cash used to repurchase $7.4 million in aggregate principal amount of Notes.
In October 1996, the Company completed the sale of $69,000,000 of its 6% Convertible Subordinated Notes due October 15, 2003 (the "Notes"). During 1999 and 1998, the Company repurchased approximately $51,607,000 in aggregate principal amount of its Notes. The outstanding principal balance of the Notes at December 31, 1999 was $17,393,000. The Company is considering from time to time additional repurchases of its Notes. Any repurchases of Notes may be made on the open market or in privately negotiated transactions. The Company plans to fund such purchases from its working capital.
During March 2000, the Company repurchased in an open market transaction $3.0 million in aggregate principal of the Notes for $1.7 million. This transaction will be reported in the quarter ended March 31, 2000.
The Board of Directors of the Company authorized a Common Stock repurchase program in 1998 (the "Repurchase program"). The Company is authorized to repurchase up to one million shares of the outstanding Common Stock, from time to time, subject to prevailing market conditions. As of December 31, 1999, the Company has repurchased approximately 240,000 shares of its Common Stock for approximately $573,000 as part of the Repurchase program. Purchases pursuant to the Repurchase program may be made on the open market or in privately negotiated transactions. The Company plans to fund such purchases from its working capital.
The Company believes that available cash, cash equivalents and short-term investments will be sufficient to meet the Company's operating expenses and capital requirements for at least the next twelve months. The Company's future long-term liquidity and capital requirements depend on numerous factors, including, but not limited to: development of the Company's marketing capability, market acceptance of the CaverMap Surgical Aid and the I-125 seed, development of partnerships and alliances for its assets and technology in incontinence and breast cancer. There can be no assurance that the Company will not require additional financing or that, if required, such financing will be available on terms acceptable to the Company.
Year 2000
The Company has not experienced any significant problems related to the year 2000-date rollover. In general, however, all problems related to the year 2000-date rollover may not yet have become apparent. While the Company believes its efforts to date have successfully addressed the problems, there can be no assurance until the passage of time that no further problems will occur. All year 2000 readiness costs have been expensed through 1999 and were insignificant during 1999.
The Company identified its Year 2000 risk in three categories: internal business software; imbedded chip technology; and external non-compliance by significant suppliers and service providers.
INTERNAL BUSINESS SOFTWARE. During 1996, the Company purchased an Enterprise Resource Planning System ("ERP System") which was Year 2000 compliant. The ERP System provides for significantly all of the Company's internal accounting, business management and planning needs. The total hardware, software, installation and testing cost of the ERP System was approximately $1.2 million which has been spent to date. The Company does not anticipate incurring significant additional costs for further testing and compliance activities. Given that its internal business software is Year 2000 compliant, the Company does not have a contingency plan in place.
IMBEDDED CHIP TECHNOLOGY. At this time, most of the Company's products are manufactured by outside suppliers and, as such, the Company has limited manufacturing activities. The Company does not rely materially on imbedded chip technology in its manufacturing processes and therefore does not anticipate that Year 2000 issues will significantly affect its ability to manufacture finished goods.
At this time, the Company believes that it will not encounter significant operational difficulties from the effect of a Year 2000 issue arising from its imbedded chip technology. Accordingly, based on these expectations, the Company does not have a contingency plan to address material Year 2000 issues. If significant Year 2000 issues arise, there can be no assurance that the Company will be able to develop and implement a contingency plan in a timely manner and, if not, the Company's operations could be adversely effected.
EXTERNAL NON-COMPLIANCE BY SIGNIFICANT SUPPLIERS AND SERVICE PROVIDERS. The Company identified all of its significant suppliers and service providers to determine the extent to which the Company's business was vulnerable to those third parties' failure to remedy their own Year 2000 issues. The Company's significant suppliers included those that supplied the products sold, or proposed to be sold, by the Company including the CaverMap Surgical Aid, the Symmetra I-125 seeds, the Allosource Cadaveric fascia, and the INTROL Bladder Neck Support Prosthesis. The Company received notification from the significant suppliers and service providers of their Year 2000 compliance. The main risks that were associated with the Year 2000 issue were the uncertainties as to whether the Company's suppliers or service providers could continue to perform their services for the Company uninterrupted by the Year 2000 event. The Company's suppliers and service providers, if they were unable to remediate their Year 2000 issues, may be unable to produce or deliver goods ordered by the Company. The preceding discussion contains forward-looking statements information within the meaning of Section 21E of the Exchange Act. This disclosure is also subject to protection under the Year 2000 Information and Readiness Disclosure Act of 1998, Public Law 105-271, as a "Year 2000 Statement" and "Year 2000 Readiness Disclosure" as defined therein. Actual results may differ materially from such projected information due to changes in underlying assumptions.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
The Company does not use derivative financial instruments. Less than 10% of the Company's sales for the year ended December 31, 1999 were to foreign customers, primarily in Japan and Europe. All such foreign sales are denominated in US dollars. The Company believes, based on a hypothetical ten percent adverse movement in foreign currency exchange rates for the Japanese Yen and the European Euro, the potential losses in future earnings and cash flows are immaterial, although the actual effects may differ materially from the hypothetical analysis.
Item 8.
Item 8. Financial Statements and Supplementary Data
Index to the Financial Statements:
All other financial statement schedules are omitted because they are not applicable or the required information is shown in the financial statements or footnotes thereto.
Report of Independent Accountants
To the Board of Directors and Stockholders of UroMed Corporation
In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of UroMed Corporation at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles which are generally accepted in the United States. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP Boston, Massachusetts February 9, 2000, except for the last paragraph of Note 9 for which the date is March 30,
Balance Sheet
The accompanying notes are an integral part of the financial statements.
Statement of Stockholders' Equity
The accompanying notes are an integral part of the financial statements.
Statement of Cash Flows
===================================
The accompanying notes are an integral part of the financial statements.
Notes to Financial Statements
1 : Nature of Business
UroMed Corporation (the "Company"), a Massachusetts corporation, was incorporated in October 1990 and is dedicated to establishing itself as a leader in providing interventional urological products, with a primary emphasis on the treatment of prostate cancer. The Company has also developed and acquired technology in urinary incontinence products and in breast cancer detection.
2 : Summary of Significant Accounting Policies
Basis of Presentation
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
Operations of the Company are subject to certain risks and uncertainties including, but not limited to, uncertainties related to clinical trials, regulatory approvals, technological uncertainty, uncertainty of future profitability and access to capital, dependence on collaborative relationships and key personnel.
Cash Equivalents and Short-Term Investments
The Company accounts for investments in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). At December 31, 1999 and 1998, all of the Company's investments are classified as available-for-sale and are reported in the balance sheet at fair value. Any unrealized gains and losses on available-for-sale securities are reported as accumulated other comprehensive income in stockholders' equity. Upon the sale of securities, realized gains and losses are reported in the statement of operations.
The Company invests its excess cash primarily in high grade corporate debt obligations and money market funds that are subject to minimal credit and market risks. The Company considers investments with original maturities of three months or less to be cash equivalents. All other investments are classified as short-term investments because they are highly liquid and are available to meet working capital needs.
Revenue Recognition
Revenue from product sales is recorded upon shipment of product to the customer. The Company accrues anticipated product warranty costs at that time.
Major Customers
During the years ended December 31, 1999, 1998 and 1997, 7%, 29% and 75% of total revenues, respectively, had been derived from the Company's foreign distributors. Foreign distributor revenue for the years ended December 31, 1999 and 1998 was from the Company's distributor for Japan. Foreign distributor revenue for the year ended December 31, 1997 was from the Company's distributor for Scandinavia, the United Kingdom and The Netherlands.
Of total revenue reported, 9%, 0%, and 75% for the years ended December 31, 1999, 1998 and 1997, respectively, resulted from the recognition of revenue (initially deferred) related to payments received by the Company upon the signing of distribution agreements.
Inventories
Inventories are stated at the lower of cost or market, cost being determined using the first-in, first-out method.
Fixed Assets
Fixed assets are recorded at cost and depreciated over the estimated useful lives of the assets using the straight-line method. Leasehold improvements are depreciated using the straight-line method, over their estimated useful lives or the term of the lease, if shorter. Additions, renewals and betterments are capitalized. Repair and maintenance costs are expensed as incurred.
Financing Costs
Deferred financing costs, which are included in other assets, are being amortized over the seven-year life of the Company's Convertible Subordinated Notes due October 15, 2003 using the straight-line method, which approximates the interest method. Unamortized costs at December 31, 1999 and 1998 are $381,000 and $680,000, respectively. During the years ended December 31, 1999 and 1998, $163,000 and $1,234,000, respectively, of deferred financing costs were written-off in connection with the early retirement of debt (see Note 9). Accounting for the Impairment of Long-Lived Assets
The Company periodically evaluates its long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. At the occurrence of such an event or change in circumstances, the Company evaluates a potential impairment of an asset based on estimated future undiscounted cash flows. In the event that future undiscounted cash flows are less than the carrying amount of such asset, an impairment loss is recognized for the difference between estimated fair value and the carrying amount of the asset.
Net Income (Loss) Per Share
Net income (loss) per share has been calculated in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"), which requires the presentation of "basic" earnings per share and "diluted" earnings per share. Basic earnings per share is computed by dividing net income (loss) by the weighted average shares of outstanding common stock. For purposes of computing diluted earnings per share, the denominator includes both the weighted average shares of outstanding common stock and dilutive potential common stock shares.
For each of the periods presented, basic and diluted net income (loss) per share are the same due to the antidilutive effect of potential common stock shares. Antidilutive potential common stock excluded from the 1999, 1998 and 1997 computation included 312,975, 371,158 and 344,507 common shares, respectively, issuable upon the exercise of outstanding common stock options, and 261,903, 372,775 and 1,039,078 common shares ,respectively, issuable upon the conversion of the Company's Notes.
Accounting for Stock-Based Compensation
The Company accounts for stock-based awards to its employees using the intrinsic value based method as prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations ("APB 25") and follows the provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") for disclosure purposes (see Note 12).
Comprehensive Income
The Financial Accounting Standards Board ("FASB") issued SFAS No. 130, "Reporting Comprehensive Income", effective for fiscal years beginning after December 15, 1997. SFAS 130 requires companies to report another measure of operations called comprehensive income. This measure, in addition to "net income" includes as income or loss, the following items, which if present are included in the equity section of the balance sheet: 1) unrealized gains and losses on certain investments in debt and equity securities; 2) foreign currency translation; and 3) minimum pension liability adjustments. The Company has reported comprehensive income within the Statement of Operations.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current year financial statement presentation. The reclassifications had no impact on net loss for those years.
3 : Investments
Following is a summary of available-for-sale investments, by balance sheet classification:
At December 31, 1999, the fair value of short-term investments having contractual maturities of one year or less totaled $12,713,000 and the fair value of short-term investments with contractual maturities greater than one year but less than four years totaled $1,664,000. The proceeds from sales of securities amounted to approximately $26,432,000, $16,255,000, and $21,098,000 for the years ended December 31, 1999, 1998 and 1997, respectively. Gross realized gains and losses on these sales were not significant.
4 : Inventories
The components of inventory are as follows:
5 : Fixed Assets
Fixed assets consist of the following:
Depreciation expense for the years ended December 1999, 1998 and 1997 was $1,111,000, $1,746,000 and $3,129,000,respectively.
6 : Investment in Medworks Corporation and Investment in Assurance Medical, Inc.
In August 1997, the Company invested $1,000,000 in the preferred stock of Medworks Corporation of Louisville, KY as part of a license and supply agreement between the Company and Medworks Corporation, enabling the Company to market, sell and distribute Medworks' surgical technology to correct female urinary stress incontinence. This investment was accounted for under the cost method and was included in other assets in the balance sheet at December 31, 1997.
In December 1998, the license and supply agreement between the Company and Medworks was terminated. In connection with the termination, the Company evaluated the $1,000,000 carrying value of its Medworks investment and concluded that an "other than temporary" decrease in the value of its investment had occurred. Accordingly, the Company wrote-off the carrying value of the investment during the year ended December 31, 1998 (included in general and administrative expenses).
During 1998, as part of the license and supply agreement, the Company purchased $155,000 of inventory from Medworks Corporation.
On April 15, 1999, the Company completed the "spin-out" of its breast cancer technology into a new, private company, Assurance Medical, Inc. ("Assurance"). In conjunction with this spin-out, Assurance received $8.0 million in equity financing from two healthcare venture capital firms and the Company contributed its breast cancer screening technology to Assurance in exchange for an approximate one-third equity position. The Company's initial equity investment of $0.1 million has been reduced to $0 as a result of the losses incurred by Assurance Medical, Inc. in 1999.
7 : Accrued Expenses
Accrued expenses consist of the following:
8 : Restructuring
During the year ended December 31, 1998, the Company recorded a total charge of $1,704,000 representing the cost of restructuring its operations to shift its strategic emphasis to the hospital-based business and away from the consumer- oriented continence care business, which the Company has concluded will be best approached by entering into a partnership or other arrangement with a larger company. During the first quarter of 1998, a plan to effect this restructuring was adopted by the Board of Directors and, at that time, the Company recorded a restructuring charge of $1,024,000. This charge consisted of approximately $579,000 of employee termination benefits and approximately $445,000 of costs to exit two of the Company's leased facilities. The employee termination benefits related to the termination of approximately 40 employees, all of which have been terminated as of December 31, 1998, across all functional areas of the Company. The facility exit costs include the write-off of approximately $138,000 of leasehold improvements, with the remainder representing certain contractual lease payments related to the leased facilities.
During the fourth quarter of 1998, the Company made certain changes to its restructuring plan and, as a result, an additional charge of $680,000 was recorded at that time, representing additional facility exit costs. Specifically, the Company decided not to abandon one of the aforementioned facilities slated for closure and, at that same time, committed to abandoning one of the facilities that it had previously expected to keep open. The facility exit costs include the write-off of approximately $500,000 of leasehold improvements, with the remainder representing certain contractual lease payments related to the abandonment of the leased facility.
In March 1999, the Company entered into a lease termination agreement in respect to the facility that it committed to abandoning during the fourth quarter of 1998. Based upon the terms of this agreement, the Company's cost of exiting this facility were $80,000 less than the Company's original estimates that were included within the restructuring liability as of December 31, 1998. As a result, the Company reversed $80,000 of the restructuring liability during the three months ended March 31, 1999. All remaining restructuring accruals were paid in cash during 1999.
During the year ended December 31, 1999, the activity in the restructuring liability was as follows (in thousands):
Balance at Balance at December 31, Cash December 31, 1998 Payments Adjustments 1999 -------------- ---------- ----------- ------------ Employee termination Benefits $ 55 $ 55 $ -- $ --
Other facility exit costs 304 224 80 -- ------------- ---------- ---------- ------------ $ 359 $ 279 $ 80 $ -- ============= ========== ========== ============
9 : Convertible Subordinated Notes
In October 1996, the Company completed the sale of $69,000,000 of its Convertible Subordinated Notes Payable (the "Notes"). The Notes are convertible at any time into shares of common stock of the Company at a conversion price of $66.41 per share, subject to adjustment under certain circumstances. The Notes are due on October 15, 2003. Interest on the Notes is payable each April 15 and October 15 unless previously converted or repurchased. The Notes are redeemable at the option of the Company on or after October 15, 1999, at specified redemption prices, ranging from 100.857% to 103.429% of the face amount per Note plus accrued and unpaid interest to the date of redemption. The Notes are unsecured obligations of the Company and are subordinated to all other Senior Debt (as defined) of the Company.
During 1999 and 1998, the Company repurchased certain of the Notes as follows:
- ---------------------------------------------------- --------------------------- Aggregate Principal Cost of Notes Extraordinary Repurchased Repurchased Gain Year ended: - -------------------- ----------------------- ---------------- ------------------ - -------------------- ----------------------- ---------------- ------------------ December 31, 1999 $7,363,000 $4,179,000 $3,021,000
- -------------------- ----------------------- ---------------- ------------------ - -------------------- ----------------------- ---------------- ------------------ December 31, 1998 $44,244,000 $19,321,000 $23,273,000
- -------------------- ----------------------- ---------------- ------------------
The repurchases of the Notes occurred in open market transactions with persons who were not affiliates of the Company. In addition to the cost of the principal repurchased as noted in the table above, the Company incurred costs of $163,000 and $1,650,000 in 1999 and 1998, respectively, relating to deferred financing fees written off and other fees incurred as a result of the repurchase.
Of the $44,244,000 of Notes repurchased in 1998, $34,924,000 represents Notes repurchased as part of the Company's announced tender offer which was completed on October 22, 1998. The remaining $9,320,000 of repurchased Notes occurred in open market transactions with persons who were not affiliates of the Company.
Subsequent to December 31, 1999 and through March 30, 2000, the Company repurchased approximately $3.0 million in aggregate principal amount of its Notes for approximately $1.7 million. This transaction will be reported in the quarter ended March 31, 2000.
10 : Gain on Sale of Assets
On July 21, 1999, the Company entered into an agreement to sell global rights to its Impress Softpatch technology and assets to Procter & Gamble. Under the agreement, the Company received $3.3 million in cash at closing and is to receive an additional $150,000 in cash payments each year for a four-year period commencing on July 21, 2000. In addition and under certain conditions, the Company may receive additional cash consideration in the future in the form of royalty and other payments. As a result of the transaction, the Company reported a gain of $672,000 in 1999.
11 : Stockholders' Equity
Preferred Stock
The Company has authorized 500,000 shares of $.01 par value preferred stock, none of which have been issued at December 31, 1999. Preferred stock may be issued at the discretion of the Board of Directors of the Company with such designations, rights and preferences as the Board of Directors may determine. Upon issuance, the preferred stock may include, among other things, extraordinary dividend, redemption, conversion, voting or other rights which may adversely affect the holders of the common stock.
Common Stock
At December 31, 1999, the Company has reserved 393,304 shares of common stock for issuance pursuant to exercise of common stock options granted under the Stock Option Plan, 45,417 shares of common stock for issuance under the Employee Stock Purchase Plan, and 261,903 shares for issuance upon conversion of the Notes.
Treasury Stock
The Board of Directors of the Company authorized a Common Stock repurchase program on June 17, 1998 (the "Repurchase Program") whereby the Company is authorized to repurchase up to one million common shares, from time to time, subject to prevailing market conditions. As of December 31, 1999 the Company had repurchased 240,000 shares of its common stock for $573,000 as part of the Repurchase Program.
Shareholder Rights Plan
In June 1997, the Company's Board of Directors adopted a Shareholder Rights Plan. This Plan provides shareholders with special purchase rights under certain circumstances, including if any new person or group acquires 15 percent or more of the Company's outstanding common stock.
12 : Employee Benefit Plans
Stock Option Plan
On June 7, 1991, the Company adopted the 1991 Stock Option Plan (the "Plan") which provides for the granting of either incentive stock options or non-statutory stock options to employees, officers, directors and consultants of the Company. The Plan, as amended, allows for a maximum of 640,000 shares of common stock to be issued.
The exercise price of any incentive stock option shall not be less than the fair value of the stock on the date of grant or less than 110% of the fair value in the case of optionees holding more than 10% of the total combined voting power of all classes of stock of the Company. Options under the plan are exercisable over periods determined by the Board of Directors, not to exceed ten years from the date of grant, except for incentive stock options granted to optionees holding more than 10% of the total combined voting power of all classes of stock, which must be within five years.
Under the Plan, non-employee directors of the Company will receive options to purchase 4,000 shares of common stock upon their election to the Board of Directors and, after having served on the Board of Directors for one year, options to purchase 150 shares of common stock on a quarterly basis, up to a maximum of 24 grants. All of these option grants are exercisable over a ten-year period and must have an exercise price equal to the fair market value of the shares on the grant date.
Option activity for the years ended December 31, 1999, 1998 and 1997 is summarized as follows:
At December 31, 1999, options to purchase 80,329 shares of common stock were available for future grants under the Plan.
In September 1997, March 30, 1998 and December 15, 1998, the Company repriced 31,860, 167,000 and 106,300, respectively, outstanding common stock options to reflect the current market value per share of common stock. The cancellation and issuance of replacement options is recorded in the option activity above.
The following table summarizes information about stock options outstanding and exercisable at December 31, 1999:
Fair Value Disclosures
As discussed in Note 2, the Company follows APB 25 in accounting for awards under its stock option plans. Had compensation cost for the Company's option plans been determined based on the fair value at the grant dates, as prescribed by SFAS 123, the Company's net loss and net loss per share would have been as follows:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes model with the following assumptions used for grants for all periods: dividend yield of 0.0%; risk-free interest rates ranging from 5.5% to 6.8%; expected option terms of 0.3 years to 5.8 years in 1996 and 1997, and 2 years to 6 years in 1998 and 1999; and a volatility of .60 for options granted in 1997 and .66 for options granted in 1998 and 1999.
Employee Stock Purchase Plan
On May 19, 1995, the Company approved the 1995 Employee Stock Purchase Plan. This plan provides for the purchase by employees of up to 60,000 shares of common stock at 85% of the fair market value on the first or last day of the offering period (as defined in the plan), whichever is lower. During the year ended December 31, 1999 there were no shares issued under the plan. During the year ended December 31, 1998, 10,491 shares were issued under the plan at a range of $1.22 to $4.73 per share. During the year ended December 31, 1997, 10,776 shares were issued under the plan at a range of $14.90 to $15.00 per share. During the year ended December 31, 1996, 2,548 shares were issued under the plan at a range of $41.45 to $59.25 per share.
13 : Income taxes
The components of deferred income tax (expense) benefit are as follows:
No federal or state taxes were payable in any year through December 31, 1999 as a result of losses incurred and the utilization of net operating loss carryforwards.
Deferred tax assets consist of the following:
A reconciliation between the amounts of reported income tax (expense) benefit and the amount determined by applying the U.S. federal statutory rate of 35% to net (income) loss follows:
The Company has provided a valuation allowance for the full amount of the deferred tax assets since it is not sufficiently assured that future tax benefits will be realized. As the Company achieves profitability, these deferred tax assets would be available to offset future income tax liabilities and expense. Of the $56,800,000 valuation allowance at December 31, 1999, $1,000,000 relating to deductions for non-qualified stock options will be credited to additional paid-in capital upon realization.
At December 31, 1999, the Company had net operating loss carryforwards for federal and state income tax reporting purposes of approximately $95,000,000. At December 31, 1999, the Company had research and development tax credit carryforwards for federal and state income tax reporting purposes of $1,703,000 and $1,098,000, respectively. The federal carryforwards expire between the years 2006 and 2019 and the state carryforwards expire between the years 1999 and 2014.
Ownership changes, as defined in the Internal Revenue Code (the "Code"), have limited the amount of net operating loss and tax credit carryforwards that can be used annually to offset future taxable income or tax liabilities. The annual limitation amount as defined in the Code is approximately $8,600,000 and the net operating loss and tax credit carryforwards subject to this limitation are approximately $20,900,000 and $802,000, respectively. Future changes in ownership could further affect the limitation in future years.
14 : Segment Reporting
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which changes the way the Company reports information about its operating segments. The Company has determined its reportable segments based on its method of internal reporting, which disaggregates its business by product category. The Company's reportable segments are (i) its prostate cancer and incontinence business, which includes the Cavermap surgical aid, the I-125 brachytherapy seeds and needles, all consumer and surgical incontinence products, and (ii) its breast cancer business, which includes all development efforts for its proposed BreastExam, BreastView and BreastCheck products.
The accounting policies of the segments are the same as those described in Note 2, "Summary of Significant Accounting Policies." The Company evaluates the performance of its operating segments based on operating loss which represents income before interest income and expense and extraordinary gain on early retirement of debt. There are no intersegment revenues.
The table below presents information about the Company's segments for the three years ended December 31, 1999. Asset information reportable by segment is not reported, since the Company does not produce such information internally:
Prostate cancer and Breast Incontinence Cancer Totals ---------------- -------- -------- Year ended December 31, 1999
Revenues $ 2,645 $ - $ 2,645 Restructuring 80 - 80 Depreciation (1,102) (9) (1,111) Operating Loss (3,772) (422) (4,194)
Year ended December 31, 1998
Revenues $ 837 $ - $ 837 Restructuring (1,704) - (1,704) Depreciation (1,692) (54) (1,746) Operating Loss (11,156) (2,725) (13,881)
Year ended December 31, 1997
Revenues 503 - 503 Depreciation (3,102) (27) (3,129) Operating Loss (26,723) (3,405) (30,128)
The following are reconciliations of the operating loss amounts presented above to corresponding totals in the accompanying financial statements:
Years ended December 31, 1999 1998 1997 - - - ---------------------------------------------------------------------------- Total for reportable segments $ (4,194) $(13,881) $(30,128) Corporate (931) (4,039) (4,530) Interest income 1,151 2,837 4,558 Interest Expense (1,527) (3,911) (4,533) ---------- -------- -------- Loss before extraordinary gain on the early retirement of debt $ (5,501) $(18,994) $(34,633) ========= ========== ==========
15 : Commitments
Leases
The Company leases space under an operating lease which expires in December, 2002. The Company incurred rent expense of $194,000, $645,000 and $532,000 for the years ended December 31, 1999, 1998 and 1997, respectively. Future minimum payments for the operating leases as of December 31, 1999 are as follows:
UroMed Corporation SCHEDULE II Valuation and Qualifying Accounts and Reserves
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Executive Officers of the Registrant
The names of the Company's executive officers as of December 31, 1999 and certain information about them are set forth below:
DANIEL MUSCATELLO, Director, President and Chief Executive Officer. Mr. Muscatello joined the Company in February 1997 as Director of Marketing and was appointed Vice President of Marketing and Sales in 1998. He was appointed President and Chief Executive Officer in December 1999 at which time he was also elected a member of the Company's Board of Directors. Prior to joining the Company, Mr. Muscatello held management positions with Baxter Healthcare, the former American Cyanamid, from 1993 to 1997 as Healthcare Consultant, Corporate Account Executive and Region Manager. Prior to that, Mr. Muscatello was Director of Marketing for Alcon Laboratories, Inc. Systems Division from 1991 to 1993.
DOMENIC C. MICALE joined the Company in September 1996 as Accounting Manager. In July 1998, he became Director of Finance and in November 1999 became the Vice President of Finance and Administration and treasurer. Prior to joining the Company, he served in Assistant Controller positions at both Sequoia Systems, Inc. during 1996, and at TransNational Group from 1992 to 1995. Prior to then from 1987 to 1991, he served as, most recently, audit supervisor at Coopers & Lybrand in Boston. Mr. Micale is a Certified Public Accountant and holds a B.S.B.A. from Northeastern University and an M.B.A. from Boston University.
Information relating to the Directors of the Company will be set forth in the sections entitled "Election of Directors", "Background of Directors" and "Director Compensation" of the 2000 Proxy Statement, which sections are incorporated herein by reference. Information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934 will be set forth in the section entitled "Reports of Beneficial Ownership" in the 2000 Proxy Statement, which section is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
Information relating to executive compensation will be set forth in the section entitled "Executive Compensation" in the 2000 Proxy Statement, which section is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information relating to ownership of securities of the Company by certain beneficial owners and management will be set forth in the section entitled "Stock Ownership of Principal Stockholders and Management" of the 2000 Proxy Statement, which section is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
None.
PART IV
Item 14.
Item 14. Exhibits and Financial Statement Schedules
(a)(1) Index to Financial Statements
The financial statements filed as part of this Annual Report on Form 10-K are listed above under Part II, Item 8.
(a)(2) Index to Financial Statement Schedules
The financial statement schedule filed as part of this Annual Report on Form 10-K is listed above under Part II, Item 8.
(a)(3) Index to exhibits. The following documents are filed as exhibits to this Annual Report on Form 10-K.
All exhibit descriptions followed by an asterisk (*) were previously filed with the Securities and Exchange Commission (the "SEC") as Exhibits to, and are hereby incorporated by reference from, the document to which the letter in parentheses following the asterisk corresponds, as set forth below. The Exhibit number of the document in that previous filing is indicated in parentheses after the incorporation by reference code:
(a) Registrant's Registration Statement on Form S-1, as amended, (Registration No. 33-74282).
(b) Registrant's Annual Report on Form 10-K for its fiscal year ended December 31, 1994.
(c) Registrant's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on October 18, 1995 (Registration No. 33-98262).
(d) Registrant's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on October 18, 1995 (Registration No. 33-98264).
(e) Registrant's Quarterly Report on Form 10-Q for its fiscal quarter ended September 30, 1994.
(f) Registrant's Quarterly Report on Form 10-Q for its fiscal quarter ended March 31, 1994.
(g) Registrant's Registration Statement on Form S-3 (File No. 333-03843) filed May 16, 1996.
(h) Registrant's Quarterly Report on Form 10-Q for its fiscal quarter ended September 30, 1996.
(i) Registrant's Annual Report on Form 10-K for its fiscal year ended December 31, 1996.
(j) Registrant's Current Report on Form 8-K filed July 2, 1997.
+ An unexpired order granting confidential treatment to deleted portions of Exhibit 10.15 was issued on July 19, 1994.
++ An unexpired order granting confidential treatment to deleted portions of Exhibit 10.16 was issued on December 13, 1994.
+++ An unexpired order granting confidential treatment to deleted portions of Exhibit 10.17 was issued on June 6, 1995.
++++ An unexpired order granting confidential treatment to deleted portions of Exhibits 10.18 and 10.19 was issued on January 26, 1996.
SIGNATURES
Pursuant to the requirements to Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
UroMed Corporation Date: March 30, 2000
By: /s/ Daniel Muscatello ----------------------- Daniel Muscatello President and Chief Executive Officer
By: /s/ Domenic C. Micale ----------------------- Domenic C. Micale Vice President of Finance, Treasurer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below as of March 30, 2000 by the following persons on behalf of the Registrant and in the capacities indicated.
/s/ John G. Simon Chairman of the Board of Directors - - - - ----------------------
/s/ Daniel Muscatello President and Chief Executive Officer - - - - ----------------------
/s/ Elizabeth B. Connell, MD Director - - - - ----------------------
/s/ Richard A. Sandberg Director - - - - ----------------------
/s/ Thomas F. Tierney Director - - - - ----------------------
/s/ E. Kevin Hrusovsky Director - - - - ---------------------- | 18,694 | 122,951 |
895650_1999.txt | 895650_1999 | 1999 | 895650 | Item 1. Business
General Development of Business
Diasensor.com, Inc. ("Diasensor.com" or the "Company") was incorporated in the Commonwealth of Pennsylvania on July 5, 1989 as Diasense, Inc., a wholly-owned subsidiary of Biocontrol Technology, Inc. ("BICO"). Diasensor.com's headquarters are located in an office condominium located at 2275 Swallow Hill Road, Building 2500, 2nd Floor, Pittsburgh, PA 15220.
The Company's business is the development, marketing and manufacture of a noninvasive glucose sensor (the "Noninvasive Glucose Sensor" or the "Sensor") for use by diabetics. In connection with the Sensor, the Company is also developing the Telemedicine system, a monitoring system which would allow diabetics to transmit glucose readings via the internet, allowing both a central monitoring department and the diabetic's own physician to monitor glucose levels and assist in glucose control. During Fiscal 1999, the Company continued to focus its efforts on the Noninvasive Glucose Sensor. The Company is working with Joslin Diabetes Center, an affiliate of Harvard Medical School and an international leader in diabetes treatment, to design and conduct clinical trials on the Diasensor in the U.S. Diasensor.com owns the patent, marketing and distribution rights to the Sensor. BICO has the exclusive rights to the research and development and manufacture of the Sensor (See, "Intercompany Agreements"). Where applicable, Diasensor.com and BICO will be referred to herein as "the Companies".
Financial Information About Industry Segments
The Company operates in a single industry segment consisting of the research, development, marketing and intended sale of biomedical products and devices.
Forward-Looking Statements
From time to time, the Companies may publish forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities, the regulatory approval process, specifically in connection with the FDA marketing approval process, and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Companies note that a variety of factors could cause the Companies' actual results to differ materially from the anticipated results or other expectations expressed in the Companies' forward-looking statements. The risks and uncertainties that may affect the operations, performance, research and development and results of the Companies' business include the following: additional delays in the research, development and FDA marketing approval of the Noninvasive Glucose Sensor; the Companies' future capital needs and the uncertainty of additional funding; Diasensor.com's substantial reliance upon BICO, and BICO's uncertainty of additional funding; competition and the risk that the Noninvasive Glucose Sensor may become obsolete; the Company's dependence on a single technology; the Companies' continued operating losses, negative net worth and uncertainty of future profitability; potential conflicts of interest; the status and risk to the Company's patents, trademarks and licenses; the uncertainty of third-party payor reimbursement for the Sensor and the general uncertainty of the health care industry; the Companies' limited sales, marketing and manufacturing experience; the attraction and retention of key employees; the risk of product liability; the uncertain outcome and consequences of the lawsuits pending against the Companies; the absence of a public market for the Company's common stock; the control of the Company by existing shareholders; and the dilution of the Company's common stock.
Description of Business
Development of the Noninvasive Glucose Sensor
Diasensor.com and BICO are currently developing a Noninvasive Glucose Sensor, which management believes will be able to measure the concentration of glucose in human tissue without requiring the drawing of blood. Currently available glucose sensors require the drawing of blood by means of a finger prick.
BICO's initial research and development with insulin pumps led to a theory by which blood glucose levels could be detected noninvasively by correlating the spectral description of reflected electromagnetic energy from the skin with blood glucose levels in the 50 mg per deciliter to 500 mg per deciliter range in the infrared region of the electromagnetic spectrum. The method was studied in 1986 and 1987 by BICO and its consultants at Battelle Memorial Institute in Columbus, Ohio, using laboratory instruments. The results of the studies provided information regarding the use of infrared light in the noninvasive measurement of glucose. The information from the studies, along with later affirmative work, led to a patent application by BICO's research team in 1990. A patent covering the method was granted to the research team and assigned to BICO in December 1991. The rights of this patent were purchased by Diasensor.com from BICO, pursuant to a Purchase Agreement (See, "Intercompany Agreements"). A second patent application was filed by BICO in December 1992, and was granted in January 1995. This filing contained new claims, which extended the coverage of the patent based on additional discoveries and data obtained since the original patent was filed. BICO has assigned the rights to such patent to Diasensor.com. Additional concepts to improve the capability of the instrument to recognize blood glucose were developed, and, in May 1993, corresponding patent applications were filed. As of November 1999, a total of seven patents have been issued, with additional patent applications pending (See, "Current Status of the Noninvasive Glucose Sensor" and "Patents, Trademarks and Licenses"). BICO has been granted the right to develop and manufacture sensors pursuant to agreements with Diasensor.com (See, "Intercompany Agreements").
In 1991, BICO's research team began development of a research prototype utilizing different technology than previously studied or developed. This device, the Beta 1 research prototype, was initially tested on six human subjects, and was subsequently tested on 110 human subjects in March 1992, during which simultaneous spectral, blood and chemical data was recorded for analysis in order to develop calibration data for the device. The Beta 1 utilized a separate laptop computer to perform computational functions. The results of the March 1992 tests were used to develop further refinements which led to the development of the Beta 2A.
Although functionally equivalent in terms of performance with the Beta 1, the next prototype, the Beta 2A, was smaller and had fully integrated computational software and a liquid crystal display which interacted with the operator. This model was tested by BICO on 40 human subjects in July 1992. The spectral and blood chemistry data obtained indicated that the Beta 2A did not have a satisfactory signal-to-noise ratio to allow for the calculation of algorithms of sufficient accuracy to be acceptable to Diasensor.com. The signal-to-noise ratio reflects the sensor's ability to optimize the measurement by accepting the signal desired (the glucose level) and rejecting the random interference. A higher signal-to-noise ratio results in a more accurate measurement.
Additional Beta prototypes evolved which addressed this problem. Testing was performed with each prototype, culminating in clinical trials at two hospitals with ten diabetic volunteers each in Des Plaines, Illinois in May 1993 and in Indiana, Pennsylvania in August 1993. These advanced systems embodying improvements in the optics, electronics and detection subsystems led to the design of the Beta 2D, Beta 2E, and Beta 2F prototypes, designed and constructed to simulate production models.
BICO initially obtained the approval of six Institutional Review Boards ("IRBs") to conduct testing at their hospitals. Those hospitals are Children's Hospital in Pittsburgh, Pennsylvania; Rush North Shore in Skokie, Illinois; Westmoreland Hospital in Greensburg, Pennsylvania; Lutheran General Hospital in Park Ridge, Illinois; Holy Family Hospital in Des Plaines, Illinois; and Indiana Hospital in Indiana, Pennsylvania. The Company conducted initial testing at the Holy Family Hospital and Indiana Hospital, and may conduct further studies on present and future models at some or all of the other hospitals from which IRB approval has been obtained.
On January 6, 1994, BICO submitted its initial 510(k) Notification to the U.S. Food and Drug Administration (the "FDA") for approval to market the production model, the Diasensor 1000. The submission was based on data obtained from the advanced Beta 2 prototypes, since functionally, the production model will be identical to these prototype models. BICO's 510(k) Notification claims that the product has substantial equivalence to home market glucose monitoring devices presently in the marketplace since its function is similar, although the device operates on a different technological principle. BICO provided information in this 510(k) submission which it believes substantiates that the device does not raise different questions of safety and efficacy and is as safe and effective as the legally marketed predicated devices. Such information is required by the FDA before market approval can be granted. In February 1996, the FDA convened a panel of advisors to make a recommendation regarding BICO's 510(k) Notification. The majority of the panel members recommended that BICO conduct additional testing and clinical trials prior to marketing the Diasensor 1000. BICO and Diasensor.com announced that they remained committed to bringing the Diasensor 1000 to diabetics, and that additional research, development and testing would continue (See, "Current Status of the Noninvasive Glucose Sensor").
In 1997 and 1998, due to continued delays of the FDA approval process, which are summarized below, and while continuing to work with the FDA and conduct its mandated testing, the Companies also focused their efforts on obtaining approval to market the Diasensor 1000 overseas. The Companies obtained a "CE" mark. In connection with obtaining a CE mark, the Companies have undergone a series of audits and have been certified as manufacturers and marketers in Europe for the Diasensor 1000.
In 1998, BICO, as designer and manufacturer of the device, was awarded ISO certification by TUV Rheinland, a company authorized to conduct such audits, which was contracted to perform a "conformity assessment" of BICO's quality system. BICO was awarded International Organization for Standardization ("ISO") Certification to the 9001 standard, evidencing that BICO has in place a total quality system for the design, development and manufacture of its products. BICO also was awarded EN46001 Certification, indicating it meets European standards for medical devices. Once the ISO 9001 certification was approved, and a technical file was submitted and approved by TUV, BICO received approval to apply a CE mark to the device. Much like an Underwriters Laboratory "UL" mark, the CE mark is provided by the regulatory bodies of the European Community, or by authorized private bodies, such as TUV Rheinland, to indicate that the device adheres to "quality systems" of the ISO and the European Committee for Standardization. The CE mark permits the Companies to sell the Diasensor and other medical products in Europe.
With regard to marketing the device within the United States, the Companies continued to work with the FDA to obtain approval. A revised 510(k) Notification was submitted in October 1996, and was followed by continued discussions with the FDA. During 1997 and 1998, the Company continued to meet with the FDA, and established a protocol for in-home testing of the Diasensor 1000. Due to the Company's cash flow problems during 1998, testing did not proceed at the pace originally anticipated, and completion of the testing was delayed.
BICO continued various aspects of the Diasensor development, resulting upon a method by which the readings generated by the machine could be transmitted via modem to the patient's clinic or physician. Following an in-depth marketing study, the Company determined that the machines with this capability are more attractive to the patient, since there is the possibility of selling a telemedicine service which includes the machine, the patient, and his or her physician. The model of the Diasensor has been named the Diasensor 2000 to differentiate between this model and the earlier model. Upon the advice of the FDA, BICO determined that it was in the Companies' best interest to submit a PreMarket Approval Application ("PMA") to the FDA seeking marketing approval for the Diasensor 2000. In 1999 the FDA implemented a new PMA system wherein individual modules of a PMA submission could be made as they were ready. In May 1999, BICO submitted the first module, which covered manufacturing methods and procedures for the Diasensor 2000. The FDA requested further information which will be submitted in future modules. Future modules will include non-clinical testing, such as product validation and safety testing, and human clinical trial data.
The Diasensor is a spectrophotometer capable of illuminating a small area of skin on a patient's arm with infrared light, and then making measurements from the infrared light diffusely reflected back into the device, which it then displays on a liquid crystal display on the face of the instrument for the user to read. The Diasensor uses internal algorithms to calculate a glucose measurement.
Since the Diasensor will be calibrated individually, each instrument will be sold by prescription only and will be calibrated in the patient's home. This feature may limit the marketability of the Diasensor, and if the device is unable to qualify for third-party reimbursement, the Company's ability to market the device could be adversely effected.
Current Status of the Noninvasive Glucose Sensor
Hampered by the Companies' cash flow problems, progress on the Sensor project was slowed during 1998, which makes up part of Diasensor.com's Fiscal 1999. Once funds became available, the Company allocated resources to re-establishing active dialog with the FDA. To further that effort, the Company has engaged Joslin Diabetes Center to design and conduct clinical trials, which are necessary to obtain FDA approval.
In addition to the agreement with Joslin, the Company took other significant steps toward FDA approval. In February 1999 the Company submitted a PMA shell to the FDA for the Diasensor. The PMA shell is part of a relatively new FDA procedure, which divides submissions into modules. These modules, which were designed to facilitate and expedite FDA review, contain different pieces of the full PMA submission. However, from both its own experience and by observing other module submissions, the Company does not believe that the FDA intends to "approve" the PMA one module at a time. Rather, the Company has had meetings with the FDA, including an October meeting, where requirements for the "next step" in the process have been discussed without a specific FDA finding on prior submissions.
The Company is also developing a Telemedicine program for use with the Diasensor. This program would involve the use of a Diasensor, along with an internet software program. Each reading on the Diasensor would be automatically stored for transmission, via the internet, to a location, which would analyze the data and transmit it to the patient's physician. This use of historical readings is critical in the patient's analysis of trends in glucose levels, an important tool in both the treatment of diabetes and the use of insulin. The Company believes that this Telemedicine program, which would involve a monthly fee for the use of the device and the service, rather than a purchase of the device, will make the Diasensor technology available to larger numbers of diabetics.
As with all other FDA-related activities, the Companies cannot provide any assurances as to the date upon which the studies will be completed, the next module of the PMA will be submitted, or when the FDA will complete its review of such submission.
Although the Company's research and development team continues to have discussions with the FDA, due to the complex, technical nature of the information being evaluated by the FDA, it is impossible for the Company to estimate how much longer the FDA approval process will take.
FDA approval is necessary to market the Diasensor in the United States. In 1999, the Companies also focused additional effort on the European market, and are planning to send devices to different European sites for clinical evaluation in order to encourage those markets to use the Diasensor.
Diasensor.com is responsible for the marketing and sales of the Noninvasive Glucose Sensor. Diasensor.com plans to market the Noninvasive Glucose Sensor and the Telemedicine program directly to diabetics, through their doctors' orders. The Diasensor 1000 has been sold in Europe at a price approximately equivalent to US $8,500, and it is anticipated that the Diasensor would be sold at a similar price in other markets. The Telemedicine program will involve a monthly fee for the use of both the Sensor and the service. Such prices may be set at levels, which would limit its sales, absent third-party reimbursement. Due to the current vicissitudes of the health-care insurance industry, the Companies are unable to make any projections as to the availability of, or procedures required in connection with, third-party reimbursement. Although the Companies estimate, based on 1999 American Diabetes Association data, that there are nearly 16,000,000 diabetics in the United States, not all diabetics will be suitable users of the Noninvasive Glucose Sensor. Those diabetics who require and benefit from frequent glucose monitoring comprise the potential market for the Noninvasive Glucose Sensor. The Companies are unable to estimate the size of that market at this time.
Invasive Glucose Sensors
Currently, blood glucose levels are generally measured by use of invasive glucose sensors utilizing two different methods. The simplest method for monitoring blood glucose levels requires the user to prick a finger, draw a drop of blood, and place the blood on a chemically-treated test strip. After a specified amount of time has elapsed, the blood must be blotted or wiped off. After an additional amount of time has elapsed, the color of the test strip is visually compared to that of a color chart, and the glucose level is read from the chart. The second method requires the user of an invasive glucose sensor to prick a finger, draw a drop of blood, and to place the blood on a test strip similar to those described above. Later, the user must wait a prescribed period of time and place the test strip in the invasive glucose sensor, which will display a readout of the blood glucose level. Diasensor.com believes that many of the existing invasive glucose sensors are complicated, time- consuming, prone to user error, inconvenient, unpleasant and entail significant ongoing expenditures by the user for supplies.
The Company believes that these methods generally yield accuracy levels within plus or minus 25-30 mg/dl of actual glucose levels (depending upon testing conditions). Diasensor.com believes that if current research and development efforts are successful, the Noninvasive Glucose Sensor will have a range of accuracy at least as accurate as currently available invasive glucose sensors.
With either method, adequate control of blood glucose levels requires several finger pricks each day, which is an unpleasant experience for the user, especially for children. Depending upon the relative facility of the user, it generally takes at least two to four minutes for a readout to be provided from existing invasive glucose sensors. Moreover, the ongoing costs of repeated testing are significant to the average user, given the cost of test strips, lancets, swabs, antiseptics, test solutions, etc., and could represent a monthly cost of up to $100 or more. Diasensor.com believes that if the Noninvasive Glucose Sensor is successfully developed, manufactured and marketed, the unpleasantness of existing testing methods will be effectively eliminated, and the expense and inconvenience will, over the long term, be significantly reduced.
A clinical invasive glucose sensor marketed by Yellow Springs Instruments, Inc. (the "Yellow Springs Sensor") is an invasive glucose sensor, which is relatively non-portable and costs approximately $8,000 per unit. It is used nearly exclusively by hospitals and other institutions. The Yellow Springs Sensor has significantly different abilities, characteristics and limitations than existing invasive glucose sensors. Although Diasensor.com believes that the Yellow Springs Sensor yields higher accuracy levels than other invasive glucose sensors (within plus or minus 3% of actual glucose levels) within up to 30 minutes, Diasensor.com believes that its Noninvasive Glucose Sensor may be more desirable to most users of existing invasive glucose sensors, who typically value speed and convenience, who do not require the higher accuracy levels achieved by the Yellow Springs Sensor, and who do not want to utilize invasive methods.
Diabetes
The American Diabetes Association (the "ADA") has estimated that diabetes is the seventh leading cause of death in the United States. The ADA also estimates that there are 16 million diabetics in the United States, including 11% of all people between the ages of 65 and 74, with corresponding estimated annual health care and work loss costs of more than $90 billion. It is also estimated that more than 385,000 diabetics die each year from complications associated with diabetes. More than 625,000 new cases of diabetes are diagnosed each year. Diabetics who are stricken with juvenile diabetes, the most severe form of the disease, can survive with insulin injections. However, the quality and length of their lives are generally reduced by problems associated with insulin therapy and by the onset of serious diabetic complications, including blindness, kidney failure, impotence and increased susceptibility to infection.
Many tissues of the body normally rely on glucose, a form of sugar, as a source of metabolic energy. Most cells store significant amounts of glucose as glycogen, but certain tissues, especially the brain, depend upon the blood to deliver a continuous supply of glucose. The concentration of glucose in the bloodstream must be controlled within a relatively tight range to maintain normal health. If blood glucose drops too low, causing hypoglycemia, the brain and nervous system stop working properly, thereby causing faintness, weakness, tremulousness, headache, confusion, and personality changes. Severe hypoglycemia can progress to convulsions, coma, and death. If blood glucose rises too high, causing hyperglycemia, there may be excess urine production, thirst, weight loss, fatigue, and in the most severe cases, dehydration, coma, and death. Moreover, hyperglycemia causes damage from chemical reactions between the excess glucose and proteins in cells, tissues, and organs. Over long periods of time, episodes of hyperglycemia are thought to lead to diabetic complications, including blindness, kidney failure, impotence and increased susceptibility to infection.
To control the storage and metabolism of blood glucose, the pancreas makes hormones that signal either removal or addition of glucose to the blood, depending on the need. Insulin is a pancreatic hormone that lowers blood glucose levels. Glucagon is a pancreatic hormone that raises blood glucose levels. Although certain other hormones affect blood glucose levels, insulin and glucagon have been considered the principal regulators of glucose metabolism associated with eating.
When the concentration of glucose in the bloodstream is not controlled within a relatively tight range, severe complications result. The principal disease associated with abnormal glucose metabolism is diabetes mellitus, which is defined by the presence of elevated blood glucose levels. Over the last 20 years, it has become generally accepted that there are several distinct subclasses of diabetes, the two most important of which are Type I diabetes ("Type I Diabetes") and Type II diabetes ("Type II Diabetes"). Type I Diabetes, or insulin-dependent diabetes mellitus, typically begins during childhood or early adulthood (and is therefore termed "juvenile diabetes"). Type II Diabetes, or non-insulin-dependent diabetes mellitus, typically begins during or after middle age (and is therefore termed "adult onset diabetes").
Type I Diabetes. It is estimated that there are over 1 million Type I diabetics in the United States, and about 45,000 new cases are diagnosed each year. Type I Diabetes is caused by the destruction of the pancreatic cells that make insulin, resulting in deficient hormonal control of glucose metabolism and abnormally high blood glucose. High blood glucose levels can lead to coma and death if not adequately controlled.
Before the discovery of insulin, Type I Diabetes was a rapidly fatal disease. Insulin therapy corrects the most serious metabolic disorders, and the discovery of insulin is regarded as a major triumph of medical science. However, even with modern insulin therapy, Type I diabetics cannot lead normal lives. Type I diabetics' life spans can be shortened by the onset of serious complications, including blindness, kidney failure, impotence and increased susceptibility to infection. Consequently, intensive insulin therapy to control blood glucose is an objective of modern diabetes treatment. For Type I diabetics, glucose control requires frequent monitoring of glucose levels and rigid management of diet, exercise and therapy and is difficult to achieve for many patients.
Type II Diabetes. It is estimated that there are over 5 million diagnosed Type II diabetics in the United States and equal numbers of both undiagnosed Type II diabetics and people with impaired glucose tolerance, a condition characterized by normal blood glucose levels before eating but a tendency toward hyperglycemia afterward. An estimated 600,000 new cases of Type II Diabetes are diagnosed each year in the United States.
The cause of Type II Diabetes is not precisely known. What is known is that Type II Diabetes usually occurs during or after middle age, heredity plays a role, and energy-rich diets coupled with sedentary lifestyles are involved. These factors appear to combine to cause insulin resistance, which is a failure of insulin to act normally to reduce blood glucose levels. As a consequence, even though insulin continues to be secreted by the pancreas, sometimes in above-normal amounts, blood glucose is poorly controlled. Over time, the resulting episodes of hyperglycemia are thought to cause widespread tissue damage, including possible damage to insulin secretion mechanisms in the pancreas. Current therapies for Type II diabetics include rigid dietary control, often in conjunction with the prescription of sulfonylurea compounds or, in the late stages of the disease, daily insulin injections. Again, frequent monitoring of glucose levels is required.
Foreign Subsidiaries
In connection with its office in London, Diasensor.com formed Diasensor.com U.K. Limited. Operations of this subsidiary is currently limited to the employment of part-time consultants.
Net Sales
The Company is still in the research and development mode of its product development; no sales have occurred since its inception.
Research and Development
The Company is continuing the research and development of the Noninvasive Glucose Sensor. The research and development is being conducted by BICO pursuant to a Research and Development Agreement (See, "Intercompany Agreements").
Product Development
The Company is currently developing other models of the Noninvasive Glucose Sensor for more universal use.
Manufacturing
Production and inventory buildup of the Diasensor 1000 is expected to continue. Manufacturing of the Diasensor 1000 for sale in the U.S. will not begin without FDA approval. BICO will act as Diasensor.com's exclusive manufacturer of production units of the Noninvasive Glucose Sensor for fifteen years (See, "Manufacturing Agreement"). Pursuant to the Manufacturing Agreement, BICO will manufacture units of the Noninvasive Glucose Sensor for sale to Diasensor.com at its manufacturing facility in Indiana, PA, although BICO may use various subcontractors to provide certain components. The Companies plan to have the optics, software, electronics and other mechanical components supplied to BICO for assembly on a coordinated basis with BICO's production schedule. After manufacturing is underway, BICO does not expect to maintain significant inventories and, as a result, backlogs may occur from time to time.
In September 1992, BICO entered into a 10-year lease with the Indiana County Board of Commissioners for a 22,500 square foot facility located in Indiana, PA. BICO renovated the facility and ordered the required capital equipment and machinery necessary for assembly operations. During 1999, all of the Companies' Indiana, PA operations were moved to this location, which is now used for manufacturing, research and development and administrative functions. During 1995, BICO obtained an additional 45,500 square feet of manufacturing space, which is being completed for manufacturing. In 1998, BICO vacated this additional space to its lessor in return for the lessor?s agreement not to pursue legal action against BICO for nonpayment of rent.
BICO has undertaken, pursuant to the Manufacturing Agreement, to comply with good manufacturing practices and other regulatory standards and intends to establish a quality control and quality assurance program once manufacturing begins. Although the Companies plan to work closely to coordinate the implementation of these undertakings, there can be no assurance that BICO will meet Diasensor.com's requirements for quality, quantity, or timeliness.
Marketing and Distribution
Although Diasensor.com's officers and marketing employees have experience in sales, marketing, and/or distribution, Diasensor.com has no direct prior or existing experience. Diasensor.com's officers have such experience, but not specifically in the biomedical device industry (See, "Directors and Executive Officers"). Although the Company believes that a successfully developed Noninvasive Glucose Sensor will attract a market, the Company anticipates that substantial marketing efforts and the expenditure of significant funds may be necessary to inform potential customers and distributors of the distinctive characteristics and benefits of the Company's Noninvasive Glucose Sensor. The Company's success will also depend to a significant extent on its ability to establish an effective internal marketing organization.
In addition, the Company's operating results will depend largely on its ability to establish successful arrangements with domestic and international distributors and marketing partners. Diasensor.com also contemplates that it will employ a direct sales force focusing directly on diabetics. Although the Company believes that a successfully developed Noninvasive Glucose Sensor, including the Telemedicine internet monitoring program, will be a profitable product for the Company, there can be no assurances that Diasensor.com will be able to establish sufficient direct sales capabilities and distribution relationships or that it will be successful in gaining market acceptance and profitability through sales of its products.
Patents, Trademarks and Licenses
Diasensor.com owns a patent entitled "Non-Invasive Determination of Glucose Concentration in Body of Patients" (the "Patent") which covers certain aspects of a process for measuring blood glucose levels noninvasively. Such Patent was awarded to BICO's research team in December 1991 and was sold to Diasensor.com pursuant to a Purchase Agreement dated November 18, 1991 (See, "Intercompany Agreements"). The Patent will expire, if all maintenance fees are paid, no earlier than the year 2008. If marketing of a product made under the Patent is delayed by clinical testing or regulatory review, an extension of the term of the Patent may be obtained. Diasensor.com's Patent relates only to noninvasive sensing of glucose but not to other blood constituents. Diasensor.com has filed corresponding patent applications in a number of foreign countries.
A second patent application was filed by BICO in December 1992, which was assigned to Diasensor.com. This second patent contained new claims, which extend the coverage based upon additional discoveries and data obtained since the original patent was filed. The patent application was amended in October 1993, and was granted in January 1995.
In May 1993, four additional patent applications were filed by BICO's research teams related to the methods, measurement and noninvasive determination of analyze concentrations in blood.
As of November 1999, a total of seven patents have been issued, all of which have been assigned to Diasensor.com, and additional patents are pending. Corresponding patent applications have been filed in foreign countries where the Company anticipates marketing the Noninvasive Glucose Sensor.
BICO's research team continues to file patent applications, provisional patent applications, some of which are being converted into "PCTs" (Patent Cooperative Treaty), which reflect the continued research and development and additional refinements to the Noninvasive Glucose Sensor.
Diasensor.com or BICO may file applications in the United States and other countries, as appropriate, for additional patents directed to other features of the Noninvasive Glucose Sensor and related processes.
Those competitors known by Diasensor.com to be currently developing non-invasive glucose sensors own patents directed to various devices and processes related to the non-invasive monitoring of concentrations of glucose and other blood constituents. It is possible that such patents may require Diasensor.com to alter any model of the Noninvasive Glucose Sensor or the underlying processes relating to the Noninvasive Glucose Sensor, to obtain licenses, or to cease certain activities.
The Company also relies upon trade secret protection for its confidential and proprietary information. Although Diasensor.com and BICO take all reasonable steps to protect such information, including the use of Confidentiality Agreements and similar provisions, there can be no assurance that others will not independently develop substantially equivalent proprietary information or techniques, otherwise gain access to the Company's trade secrets, disclose such technology, or that the Company can meaningfully protect its trade secrets.
The Company has registered its trademark "Diasensor ", which is intended for use in connection with the Diasensor models. The Company intends to apply, at the appropriate time, for registrations of other trademarks as to any future products of the Company.
Warranties and Product Liability
Because the Company has not yet begun its manufacture or sale of any products, it has not extended any warranties or incurred product liability risk. BICO and Diasensor.com currently have product liability insurance. Upon the initiation of manufacture or sale of products, the Company will attempt to obtain additional insurance to cover product liability risk, if necessary.
Source of Supply
Once production of the Noninvasive Glucose Sensor begins, BICO, as the manufacturer (See, "Intercompany Agreements"), will be dependent upon suppliers for some of the components required to manufacture the Noninvasive Glucose Sensor. Some components may not be generally available, in which case BICO and the Company may become dependent upon those suppliers, which do provide such specialized products.
Competition
With the rapid progress of medical technology, and in spite of continuing research and development programs, the Company's developmental products are always subject to the risk of obsolescence through the introduction by others of new products or techniques. Management is aware that other research groups are developing noninvasive glucose sensors, but has limited knowledge as to the technology used or stage of development of these devices. There is a risk that those other groups will complete the development of their devices before the Company does. There is no other company currently producing or marketing noninvasive sensors for the measurement of blood glucose similar to those being developed by the Company. Competitive success in the medical device field is dependent upon product characteristics including performance, reliability, and design innovations.
The Noninvasive Glucose Sensor will compete with existing invasive glucose sensors. Although the Company believes that the features of the Noninvasive Glucose Sensor, particularly its convenience and the fact that no blood samples are required, will compete favorably with existing invasive glucose sensors, there can be no assurance that the Noninvasive Glucose Sensor will compete successfully. Most currently available invasive glucose sensors yield accuracy levels of plus or minus 25% to 30%, range in price from $80 to $200, not including monthly costs for disposable supplies and accessories, and are produced and marketed by eight to ten sizable companies. Those companies include Bayer, Inc., Boehringer Mannheim Diagnostics, and Lifescan (an affiliate of Johnson & Johnson).
Such companies have established marketing and sales forces, and represent established entities in the industry. Certain of the Company's competitors (including their corporate or joint venture partners or affiliates) currently marketing invasive glucose sensors have substantially greater financial, technical, marketing and other resources and expertise than Diasensor.com, and may have other competitive advantages over Diasensor.com (based on any one or more competitive factors such as accuracy, convenience, features, price or brand loyalty). Additionally, competitors marketing existing invasive glucose sensors may from time to time improve or refine their products (or otherwise make them more price competitive) so as to enhance their marketing competitiveness relative to the Company's Noninvasive Glucose Sensor. Accordingly, there can be no assurance that the product, or Diasensor.com as marketer for the Noninvasive Glucose Sensor, will be able to compete favorably with such competition.
The Company faces more direct competition from other companies who are currently researching and developing noninvasive glucose sensors. The Company has very limited knowledge as to the stage of development of these sensors; however, should another company successfully develop a noninvasive glucose sensor, achieve FDA approval, and reach the market prior to the Company, it would have an adverse effect upon the Company's ability to market its sensor.
Among the other companies investigating infrared technology to measure blood glucose levels noninvasively is CME Telemetrix in Waterloo, Ontario, Canada. CME is reportedly conducting tests with a desktop monitor that uses near-IR wavelengths. OptiScan Biomedical in Alameda, California is developing a device that uses far-IR wavelengths. Rio Grande Medical Technologies of Albuquerque, New Mexico is designing a photonics-based device. Rio Grande is currently funded by Johnson & Johnson.
Other companies claim that they are designing systems that are semi-invasive. SpectRx in Norcross, Georgia is using a laser to create micropores on the skin without the invasive penetration of a metal needle or lancet. The device then gives a glucose reading from the interstitial fluid collected from the micropores. Cell Robotics International, Inc. in Albuquerque, New Mexico is also using a laser device that perforates the skin. Called the Lasette, a single-pulse Er:YAG laser ablates a small hole in the fingertip to extract capillary blood for glucose testing. A continuous glucose monitoring system from MiniMed, Inc. in Sylmar, California received FDA approval in June 1999. The device includes a catheter with a small sensor at its tip that is inserted through the skin, sending readings via a small wire to a sensor. A new sensor must be reinserted under the skin every two to three days.
Cygnus of Redwood, California recently received FDA approval for its GlucoWatch that leeches glucose through the skin by electrical stimulation. The glucose triggers an electrochemical reaction in a disposable transdermal pad that acts as a biosensor, generating electrons. Although Cygnus claims that its device is noninvasive, the fact remains that, in addition to the use of electrical currents to draw fluid through the skin, each person must use finger prick technology every day to calibrate and use the device.
Certain organizations are also actively engaged in researching and developing technologies that may regulate the use or production of insulin or otherwise affect or cure the underlying causes of diabetes. Diasensor.com is not aware of any new or anticipated technology that would effectively render the Noninvasive Glucose Sensor obsolete or otherwise not marketable as currently contemplated. However, there can be no assurance that future technological developments or products will not make the Noninvasive Glucose Sensor significantly less competitive or, in the case of the discovery of a cure for diabetes, even effectively obsolete.
Government Regulations
Since the Company's Noninvasive Glucose Sensor product is a "medical device" as defined by the Federal Food, Drug and Cosmetic Act, as amended (the "Act"), it is subject to the regulatory authority of the FDA and will also be subject to the authority of similar foreign regulatory agencies in countries where the Noninvasive Glucose Sensor may be marketed. The FDA has promulgated regulations that apply to the testing, marketing, registration and manufacture of medical devices and products. The FDA can subject the Company to inspections of its facilities and operations and may also audit its record keeping procedures at any time.
Moreover, approvals are subject to continual review, and the future discovery of previously unknown problems may result in certain restrictions being applied to the use or marketing of the Noninvasive Glucose Sensor or a complete withdrawal from the market.
Because the Noninvasive Glucose Sensor is subject to regulation by the FDA, the Company will be required to meet applicable FDA requirements prior to marketing the device in the United States. These requirements include clinical testing, which must be supervised by the IRBs of chosen hospitals. Clinical testing began on the Noninvasive Glucose Sensor in May 1993 (See, "Current Status of the Noninvasive Glucose Sensor"). The clinical trials have been conducted based on a determination by the Company and the IRBs that the device is a "non-significant risk" device, thus obviating the need for an Investigational Device Exemption ("IDE") filing with the FDA. Should any of the IRBs determine, and are successful in convincing the FDA, that the device is a "significant risk" device, the Company would be required to submit an IDE filing to the FDA. Such filing would result in material delays and expenses for the Company, and a resulting significant delay in the completion, marketing and sale of the Noninvasive Glucose Sensor. To date, neither the IRBs nor the FDA have informed the Company that they are of the opinion that the device is a "significant risk" device.
Diasensor.com may conclude clinical testing on any device at any point at which it believes additional data is not necessary for inclusion in the 510(k) Notification. Such notification will include a detailed description of the prototype and data produced during clinical trials. The 510(k) Notification review by the FDA involves a substantial period of time, and requests for additional information and clinical data will require additional time. Although the Company does not anticipate extraordinary problems, there can be no assurance that the 510(k) Notification will ultimately be approved, or when it will be approved.
The 510(k) Notification filed by the Company for the Diasensor 1000 indicated that the device is "substantially equivalent" to similar existing devices, namely invasive glucose sensors. In connection with its review of the Company's 510(k) Notification, the FDA will determine whether the device is "substantially equivalent" to a similar existing device based upon the following factors: (i) whether the device has the same "intended use" as an the existing device; and (ii) whether the device has the same technological characteristics as the existing device, unless the different technological characteristics do not adversely affect its safety and effectiveness. Although the Company and the IRBs believe that the Noninvasive Glucose Sensor satisfies those requirements, thus qualifying for a 510(k) Notification, there can be no assurance that the FDA will agree. Although its correspondence with the Company appears to indicate that the FDA believes that the 510(k) Notification is the appropriate filing for the Diasensor 1000, should the FDA determine that the device is not "substantially equivalent" to an existing device, or refuse to approve the 510(k) Notification for any reason, the Company would be required to submit to the FDA's full pre-market approval process, which would require additional testing, and result in significant delays and increased expenses. The FDA's pre-market approval process is more extensive, time-consuming and will result in increased research and development expenses, while delaying the time period in which BICO and Diasensor.com could begin manufacturing and marketing the product.
The time elapsed between the completion of clinical testing at IRBs and the grant of marketing approval by the FDA is uncertain, and no assurance can be given that approval to market the Noninvasive Glucose Sensor will ultimately be obtained. In addition, delays or rejections may be encountered based upon changes in the FDA's regulatory policies during the period of research and development and the FDA's review.
The Company may also be required to comply with the same regulatory requirements prior to introducing the Diasensor 2000, or other models of the Noninvasive Glucose Sensor, to the market. Any changes in FDA procedures or requirements will require corresponding changes in the Company's obligations in order to maintain compliance with FDA standards. Such changes may result in additional delays or increased expenses.
The FDA's Good Manufacturing Practices for Medical Devices specifies various requirements for BICO's manufacturing processes and maintenance of certain records.
Because the FDA approval process has been subject to several delays, the Companies have focused efforts on obtaining approval to sell its device in Europe (SEE, "The Company and its Business").
Human Resources
Diasensor.com currently has no full-time employees. Diasensor.com employs consultants in its London office. The Company believes that, if and when FDA approval is obtained for the Noninvasive Glucose Sensor, or manufacturing and marketing begins, it will employ approximately 48 persons on a full-time or part-time basis in the United States, and approximately sixteen persons in each foreign office. Diasensor.com's success will depend upon the efforts of its key management personnel, the departure of any of whom may adversely affect Diasensor.com's business. None of the Company's employees are represented by a collective bargaining unit, and Diasensor.com considers its relations with its employees to be excellent.
Financial Information About Foreign and Domestic Operations and Export Sales
The Company's operations are located primarily in the United States of America. In 1994, the Company incorporated a majority- owned foreign subsidiary, Diasensor.com U.K. Limited, in order to facilitate the opening of its office in London, England. Although the Company is currently taking orders in its London office, the Company has had no sales, foreign or domestic, since its inception.
Item 2.
Item 2. Properties
In April 1992, Diasensor.com purchased an office condominium for $190,000. The office, which consists of approximately 4600 square feet, is located at 2275 Swallow Hill Road, Building 2500, 2nd Floor, Pittsburgh, PA 15220. Due to cash flow problems, the Company sold the office condominium in 1999, and now leases the space for its administrative offices. BICO continues to lease a portion of the office at a monthly rental amount of $3,544 plus one-half of the utilities (See, "Certain Relationships and Related Transactions").
As of November 1999, Diasensor.com has an office in London, England for the purpose of taking orders for the Diasensor 1000.
The Company believes that its existing facilities will be sufficient to meet its needs through Fiscal 1999. Should the Company require additional space, the Company believes such space will be available at reasonable commercial rates.
Item 3.
Item 3. Legal Proceedings
In April 1996, the Pennsylvania Securities Commission commenced a private investigation into Diasensor.com's sales of its common stock pursuant to its public offering in an effort to determine whether any sales were made improperly to Pennsylvania residents. The Company has been cooperating fully with the state and has provided all of the information requested. As of the date of this filing, no determinations had been made, and no orders have been issued.
In May 1996, the Company, along with BICO and BICO's individual directors, including David Purdy and Fred Cooper, who are also officers and directors of Diasensor.com, was served with a federal class action lawsuit based on alleged misrepresentations and violations of federal securities laws. The action is pending in federal district court for the Western District of Pennsylvania, and remains in the pre-trial pleadings stage with the consent of all parties. No determinations as to possible liability or exposure are possible at this time, although the Company does not believe that any violations of the securities laws have occurred.
In April 1998, the Company was served with a subpoena requesting documents in connection with an investigation by the U.S. Attorneys' office for the Western District of Pennsylvania. The Company has submitted various scientific, financial and contractual documents in response to such requests.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Diasensor.com was incorporated in the Commonwealth of Pennsylvania on July 5, 1989. Diasensor.com has the authority to issue 40,000,000 shares of common stock at a par value of $.01, and 1,000,000 shares of preferred stock. As of November 30, 1999, 22,980,051 shares of common stock were outstanding. No shares of Preferred Stock are outstanding. As of November 30, 1999, there were currently exercisable warrants outstanding to purchase 8,639,113 shares of the common stock of Diasensor.com at exercise prices ranging from $.50 to $3.50 per share. The warrants have various expiration dates through November 3, 2004.
As of November 30, 1999, the Company had approximately 600 holders of record for its common stock and no holders of record for its preferred stock.
Diasensor.com is not currently listed on any stock exchange or market. The Company currently acts as its own registrar and transfer agent for its common stock and its warrants. Currently, there is no established public trading market for the Company's common stock.
Common Stock
The holders of common stock are entitled to one vote per share on all matters to be voted on by shareholders and are entitled to cumulative voting rights in the election of directors. In cumulative voting, the holders of common stock are entitled to cast, for each share held, the number of votes equal to the number of directors to be elected. A holder may cast all of his or her votes for one nominee or distribute them among any number of nominees for election. Subject to any preferences that may be granted to any holders of preferred stock, the holders of common stock are entitled to receive, on a pro rata basis, dividends out of funds legally available for distribution, when and if declared by the Board of Directors, and to share ratably in the assets of Diasensor.com legally available for distribution to its shareholders in the event of liquidation, dissolution or winding- up of Diasensor.com. The holders of common stock have no preemptive, redemption or conversion rights. The shares of common stock currently outstanding are fully paid and nonassessable.
Preferred Stock
The Company's Articles of Incorporation permit the issuance of up to 1,000,000 shares of preferred stock. No shares of preferred stock are currently issued or outstanding. Diasensor.com has no present intention to issue any such shares; although there can be no assurance that preferred stock will not be issued in the future.
Dividends
The Company has not paid cash dividends on its common stock or preferred stock since its inception and cash dividends are not presently contemplated at any time in the foreseeable future. The Company anticipates that any excess funds generated from operations in the foreseeable future will be used for working capital and to continue to fund the research and development of the Noninvasive Glucose Sensor. In accordance with the Company's Articles of Incorporation, cash dividends are also restricted under certain circumstances.
Warrants
As of November 30, 1999 there were outstanding warrants, all of which are currently exercisable, to purchase 8,639,113 shares of common stock at exercise prices ranging from $0.50 to $3.50 per share and having expiration dates ranging from December 2, 1999 to November 3, 2004. During Fiscal 1999 2,070,000 warrants were granted. The warrants were issued to directors, officers and employees of Diasensor.com and to certain other persons for certain goods and services transferred or rendered to Diasensor.com and, in the case of certain officers, in consideration of meritorious service. The number of shares of common stock issuable upon the exercise of the warrants and the exercise prices relating thereto are subject to adjustment upon the occurrence of certain events, including stock dividends, stock splits, mergers, consolidations and reorganizations. Diasensor.com may not redeem the warrants prior to their expiration.
Employment Agreement Provisions Related to Changes in Control
Diasensor.com has entered into agreements (the "Agreements") with Fred E. Cooper and David L. Purdy pursuant to which they receive annual salaries of $100,000, and $50,000 from Diasensor.com, respectively, all of which are subject to review and adjustment annually. As of the end of Fiscal 1999, such annual salaries had been increased to $372,000 and $325,000 respectively, although, due to the Company's cash flow problems, full payment was not made during Fiscal 1998 or1999. The initial term of Messrs. Cooper's and Purdy's Agreements expired on October 31, 1999, but the Agreements were automatically renewed for additional three- year periods; such renewals will continue unless any party gives proper notice of non-renewal. The Agreements also provide that in the event of a "change of control" of Diasensor.com, Diasensor.com is required to issue to Mr. Cooper and Mr. Purdy shares of common stock equal to five percent (5%) of the outstanding shares of common stock of the Company immediately after the change in control. In general, a "change of control" is deemed to occur for purposes of the Agreements: (i) when 20% or more of Diasensor.com's outstanding voting stock is acquired by any person, (ii) when one-third (1/3) or more of Diasensor.com's directors are not Continuing Directors (as defined in the Agreements), or (iii) when a controlling influence over the management or policies of Diasensor.com is exercised by any person or by persons acting as a group within the meaning of Section 13(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") (See, "Employment Agreements").
Item 6.
Item 6. Selected Financial Data
The selected financial data presented herein has been derived from the Company's audited consolidated financial statements. These financial statements have been audited by Thompson Dugan, P.C. for the twelve-month periods ended September 30, 1999, 1998, 1997, 1996, 1995 and 1994, the reports of each of which include explanatory paragraphs as to "going concern" considerations. The selected financial data should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and the financial statements of the Company and related notes thereto included elsewhere in this report.
12 mos. 12 mos. 12 mos. 12 mos. 12 mos. Ended Ended Ended Ended Ended 9/30 9/30 9/30 9/30 9/30 1999 1998 1997 1996 1995
R&D $ -0- $ -0- $ -0- $ -0- $ 3,487,882 Expenses
General & Administrative Expenses $ 1,354,066 $ 669,764 $ 1,023,961 $ 1,509,298 $ 2,323,279
Warrant Extensions $ 272,078 $ 25,000 $ 5,593,875 $ 7,644,033 $ 4,650,000
Net Loss ($ 753,501) ($ 2,914,329)($ 6,564,837)($ 9,021,823)($10,361,514)
Total Assets $ 38,324 $ 292,322 $ 3,108,243 $ 4,171,910 $ 5,407,401
Total $ 91,214 $ 92,327 $ 22,419 $ 20,624 $ 1,323,980 Liabilities
Working Capital ($ 84,559) ($ 44,724) $ 2,862,349 $ 3,914,198 $ 3,839,965 (Deficit)
Accumulated Deficit ($45,628,601) ($44,875,100)($41,960,771)($35,395,934)($26,374,111)
Net Loss Per Common Share ($.03) ($.13) ($.29) ($.39) ($.54)
Cash Dividends Per Share: $ -0- $ -0- $ -0- $ -0- $ -0- Common
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Diasensor.com operates on a fiscal year ended September 30th. Therefore, years are referred to as Fiscal years; for example, the year from October 1, 1998 through September 30, 1999 is referred to as Fiscal 1999.
Forward-Looking Statements
In addition to Part I of this Form 10-K, the Management's Discussion and Analysis section also contains the type of forward- looking statements discussed on page 2 herein. Please refer to such discussion in connection with the information presented here.
Liquidity and Capital Resources
Diasensor.com's cash balance at September 30, 1999 was $6,525, a decrease from $41,811 at September 30, 1998 and $1,181,070 at September 30, 1997. The decrease occurred because the Company did not raise additional capital during Fiscal 1998 or Fiscal 1999, with no income generated from operations. As a result, the Company experienced significant cash flow problems during Fiscal 1998 and Fiscal 1999. Diasensor.com had negative working capital of ($84,559) at September 30, 1999 and ($44,724) at September 30, 1998, as compared to positive working capital of $2,862,349 at September 30, 1997. This fluctuation in working capital was primarily attributable to net advances and repayments of advances to BICO and funds raised from sales of its stock in Fiscal 1996, with no sales of stock or other capital-raising activities during Fiscal 1997, Fiscal 1998 and Fiscal 1999.
In July 1995, BICO and Diasensor.com agreed to suspend billings, accruals and payments due pursuant to the R&D Agreement pending the FDA's review of the Diasensor 1000. The suspension continued during Fiscal 1999; no amounts are due or being accrued pursuant to the R&D Agreement.
During Fiscal 1998, the Company made allowances for doubtful accounts, including amounts owed to the Company from BICO. During Fiscal 1999 the Company reduced the allowance for doubtful accounts to reflect a reduction in amounts due from BICO. These allowances were recorded based upon the current financial position of BICO.
Diasensor.com has entered into employment agreements (the "Agreements") with Fred E. Cooper and David L. Purdy effective November 1, 1994, pursuant to which they were originally entitled to receive annual salaries of $100,000 and $50,000, respectively, which are subject to review and adjustment annually. As of the end of Fiscal 1999, such annual salaries had been increased to $372,000 and $325,000, respectively, although, due to the Company's cash flow problems, such amounts were not paid during Fiscal 1998 (See, "Executive Compensation"). The initial term of the Agreements expired on October 31, 1999 and was automatically renewed for a three-year period. The Agreements are subject to review, adjustment and renewal. In the event of a change in control of the Company, as defined in the Agreements, and termination of employment, continuation of salaries at 100%, which decreases to 25% over time, are payable in addition to the issuance of stock as set forth in the Agreements. The Agreements also provide for severance and disability benefits under certain circumstances (See," DIRECTORS AND EXECUTIVE OFFICERS - Employment Agreements").
Based on Diasensor.com's available cash, the ability of Diasensor.com and its affiliates to raise capital, its rate of monthly expenditures and the deferrals agreed upon by Diasensor.com and BICO, Diasensor.com believes that it will be able to continue its current activities for a limited time. If Diasensor.com is not able to obtain additional financing or if such additional financing is insufficient, Diasensor.com will be required to cease operations and the development of the Noninvasive Glucose Sensor altogether.
Accordingly, Diasensor.com may be required to seek substantial additional financing from third parties to complete the development of the Noninvasive Glucose Sensor, to obtain FDA approval to market the Noninvasive Glucose Sensor and to provide for its general working capital requirements during that time period. There can be no assurance that such additional financing will be available or available on terms acceptable to Diasensor.com. Moreover, certain demands on liquidity, such as technological, regulatory or legal problems, could cause Diasensor.com's liquidity to be further burdened. Diasensor.com does not currently have any additional sources of liquidity or working capital, including bank lines of credit, etc. Long-term working capital needs are expected to be met through sales of the Noninvasive Glucose Sensor, although no assurance can be made that the Noninvasive Glucose Sensor will be successfully developed, manufactured, marketed or commercially viable.
Results of Operations
During Fiscal 1999, 1998 and 1997, research and development expenses were $0. This decrease was due to the agreed-upon suspension of billings by Diasensor.com and BICO pursuant to the R&D Agreement (See, "Liquidity and Capital Resources").
General and administrative expenses aggregated $1,354,066 during Fiscal 1999, as compared to $669,764 during Fiscal 1998, and $1,023,961 during Fiscal 1997. This decrease during Fiscal 1998 was due primarily to the suspension of billings pursuant to the R&D Agreement, and the reduction in personnel due to the Company's cash flow problems. Other income aggregated $48,973 in Fiscal 1999, as compared to $62,914 in Fiscal 1998, and $52,999 in Fiscal 1997. Other income is comprised of interest income and rental income; rental income averages approximately $42,000 per year (all of which was paid by BICO to Diasensor.com), and the balance of other income is from interest earned on deposits of liquid assets.
During Fiscal 1999, 1998 and 1997, the Company extended 2,561,213; 10,000; and 2,236,550 warrants, respectively, which were originally granted to certain officers, directors, employees and consultants in 1992 through 1994, until 2000 through 2002, respectively. Because the exercise price of some of the warrants ($1.00 or $.50 per share) was lower than the market price of the common stock at the time of the extensions (which is assumed to be $3.50 per share, although there is currently no public trading market for the common stock), $272,078 was charged against operations in Fiscal 1999; $25,000 was charged to operations in Fiscal 1998; and $5,593,875 was charged to operations in Fiscal 1997.
During Fiscal 1999, the Company recovered $823,670 in amounts due from BICO which had been part of the Fiscal 1998 charge of $2,282,479 to a provision for doubtful accounts, reflecting amounts due to the Company from BICO, due to BICO's financial position.
Income Taxes
As of September 30, 1999, the Company had approximately $23,700,000 in net operating losses available for federal tax purposes. Subject to certain limitations, these losses will be available as carry forwards to offset future taxable income through the years 2005-2013. The Company also has federal research and development credit carry forwards available to offset federal income taxes of approximately $700,000, subject to limitations and expiring in the years 2005 through 2013.
Supplemental Financial Information (unaudited)
In November 1999, the Company extended warrants to purchase 600,000 shares of common stock, which would have otherwise expired.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The Company's consolidated financial statements appear on pages F- 1 through of this report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None.
PART III
Item 10.
Item 10. Directors and Executive Officers
The directors and executive officers of the Company are as follows:
Name Age Director Positions Held Since
David L. Purdy 71 1989 Chairman of the Board, Chief Scientist, Director
Fred E. Cooper 53 1989 President, CEO, Director
Anthony J. Feola 51 1991 Director Feola
Patrick H. O'Neil 84 1999 Director
DAVID L. PURDY, 71, is the Chairman of the Board and Chief Scientist of the Company. Mr. Purdy has been a director since the Company's inception and became Chairman of the Board in October 1992. Mr. Purdy acted as the Company's Treasurer from its inception until October 1992, when he became its Chief Scientist. Mr. Purdy has been employed primarily as the President of BICO from 1972 to the present. Mr. Purdy is currently the President, Chairman of the Board and a director of BICO. Mr. Purdy currently devotes approximately 40% of his time to Diasensor.com, and 60% of his time to BICO and its subsidiaries.
FRED E. COOPER, 53, has been the President and a director of the Company since its inception. Prior to joining the Company, Mr. Cooper co-founded Equitable Financial Management, Inc. of Pittsburgh, PA, a company in which he served as Executive Vice President until his resignation and divestiture of ownership in August 1990. Mr. Cooper is the Chief Executive Officer and a director of BICO. Mr. Cooper currently devotes approximately 40% of his time to Diasensor.com and 60% to BICO and its subsidiaries.
ANTHONY J. FEOLA, 51, has been a director of the Company since February 1991. In addition, Mr. Feola served as the Company's Chief Operating Officer until April 1994, when he rejoined BICO as its Senior Vice President. At that time, BICO assumed Mr. Feola's employment contract with Diasensor.com. Mr. Feola also served as the Company's Vice President of Marketing and Sales from December 1991 until October 1992. Until January 1, 1992, he was BICO's Vice President of Marketing and Sales. Prior to joining BICO in November 1989, Mr. Feola was Vice President and Chief Operating Officer with Gateway Broadcasting in Pittsburgh, PA and a National Sales Manager for Westinghouse Corporation, also in Pittsburgh, PA. He also serves as a director of BICO.
PATRICK H. O'NEILL, 84, was appointed to the Board in 1999. Mr. O'Neill is a former Chairman of the Board of Joslin Diabetes Center in Boston, Mass. He obtained his engineering degree from the University of Alaska, which has subsequently honored him as both a Distinguished Alumni and an Outstanding Alumnus of the School of Mineral Industry. His career began with a job as a miner in Alaskan open cut gold mines, where he worked his way through college. Other than four years of military service, his career was spent in the mining industry. He progressed to chief engineer and ultimately the President of International Mining Corporation and several of its subsidiaries. Since 1982, he has worked as an international consultant to the gold mining industry, and serves as a director of Zemex Corporation in Toronto, the American Geographical Society in New York and the Ireland U.S. Council for Commerce and Industry.
Pursuant to the requirements of Item 405 of Regulation S-K regarding timely filings required by Section 16(a) of the Securities and Exchange Act, the Company represents the following. Based solely on its review of copies of forms received and written representations from certain reporting persons, the Company believes that all of its officers, directors, and greater than ten percent beneficial owners complied with applicable filing requirements.
Item 11.
Item 11. Executive Compensation
The following table sets forth information concerning the annual and long-term compensation for services in all capacities to the Company for the Fiscal Years ended September 30, 1999, 1998 and 1997 of those persons who were, at September 30, 1999: (i) the Chief Executive Officer, and (ii) the other most highly compensated executive officers of the Company whose remuneration exceeded $100,000 (the "Named Executives").
(1) The Company does not currently have a Long-Term Incentive Plan ("LTIP"), and no payouts were made pursuant to any LTIP during the years 1998, 1997 or 1996. Except as noted in Note (3) below, the Named Executives were awarded warrants to purchase the number of shares of the Company's common stock set forth in the table above in each of the years noted (See, "Certain Relationships and Related Transactions"). The Company has no retirement, pension or profit-sharing programs for the benefit of its directors, officers or other employees.
(2) During the years ended September 30, 1999, 1998 and 1997, the Named Executives received medical benefits under the Company's group insurance policy.
(3) During Fiscal 1999, the Named Executives were granted warrants as follows: Fred E. Cooper and David L. Purdy each received warrants to purchase 200,000 shares of the Company's common stock at $.50 per share until January 27, 2004. No warrants were granted to the Named Executives during Fiscal 1997 or 1998.
(4) During Fiscal 1999 and Fiscal 1997, the Company extended warrants previously issued to the Named Executives, which would have otherwise expired. Although the extensions were in connection with warrants already held by the Named Executives, they are shown in the table set forth above as "awards" for executive compensation disclosure purposes. However, such warrants do not appear in the "Option/Warrant Grant" Table, since, at the time of the extension, the exercise price of the warrants (which remained unchanged at $.50 per share) was equal to the designated "market price" of the common stock, which is assumed to be $.50 per share, although there is currently no public trading market for the common stock. During Fiscal 1999 both Fred E. Cooper's and David L. Purdy's warrants to purchase 300,000 shares of the Company's common stock at $.50 per share were extended until March 25, 2004; and warrants to purchase 178,545 and 300,000 shares were extended to May 7, 2004 for Fred E. Cooper and David L. Purdy, respectively.
(5) Due to the Company's cash flow problems, Mr. Cooper's full salary was not paid during Fiscal 1998. Mr. Cooper will be, or was paid salary and bonuses aggregating approximately $660,417, $382,298, and $442,000 by BICO and its other subsidiaries during calendar years 1999, 1998 and 1997, respectively.
(6) Due to the Company's cash flow problems, Mr. Purdy's full salary was not paid during Fiscal 1998. During Fiscal 1997, Mr. Purdy waived part of his $100,000 salary, and voluntarily decreased his annual salary in BICO. Mr. Purdy was or will be paid salary and bonuses aggregating approximately $183,333, $75,135, and $154,000, by BICO during calendar years 1999, 1998, and 1997, respectively.
Option/Warrant/SAR Grants in Last Fiscal Year
POTENTIAL REALIZED VALUE AT ASSUMED ANNUAL RATES OF STOCK INDIVIDUAL GRANTS (1) PRICE APPRECIATION FOR OPTION TERM (3) Percent of Number Total of Options/ Securities SARs Exercise Expiration Name Underlying Granted or Date 5% ($) 10%($) 0%($) Options/ to Base SARs Employee Price Granted in ($/Sh) (#) Fiscal Year(2)
Fred E. Cooper 200,000 10.0% $ .50 01/27/04 $30,000 $ 62,000 $0
David L. Purdy 200,000 10.0% $ .50 01/27/04 $30,000 $ 62,000 $0
__________________________________________
(1) During Fiscal 1999, certain warrants previously granted to the Named Executives in 1991 were extended. These warrants, which aggregate 600,000 and 478,545 for Mssrs. Purdy and Cooper, respectively, are not included in this Table, since the exercise price of the warrants was equal to the designated "market price" of $.50 per share at the time of the extension.
(2) For purposes of calculating these percentages, the total number of warrants granted during Fiscal 1999 was 2,070,000.
(3) Potential realizable values reflect the difference between the warrant exercise price at the end of Fiscal 1999 and the fair value of the Company's common stock price from the date of the grant or extension until the expiration of the warrant. The 5% and 10% appreciation rates, compounded annually, are assumed pursuant to the rules promulgated by the SEC and do not reflect actual historical or projected rates of appreciation of the common stock. Assuming such appreciation, the following illustrates the per share value on the dates set forth (the expiration dates for the warrants), assuming the values set forth ($.50 per share, which is the price the Company has designated; there is currently no trading market for the common stock):
STOCK PRICE ON DATE EXPIRATION OF GRANT DATE 5% 10%
1/27/99: $.50 1/27/04 $.65 $.81
The foregoing values do not reflect appreciation actually realized by the Named Executives (See, "Option/Warrant/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/Warrant/SAR Value" Table, Below).
AGGREGATED OPTION/WARRANT/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/WARRANT/SAR VALUE TABLE
Number of Securities Value of Underlying Unexercised Unexercised In-the-Money Shares Options/SARs Options/SARs Acquired on at FY-End (#) at FY-End ($) Exercise Value Exercisable/ Exercisable/ Name (#)(1)(2) Realized($)(3) Unexercisable(4) Unexercisable(5)
Fred E. Cooper -0- -0- 1,180,045(6) $ 0
David L. Purdy -0- -0- 1,056,250(7) $ 0 _________________
(1) This figure represents the number of shares of common stock acquired by each Named Executive upon the exercise of warrants.
(2) During the fiscal year ended September 30, 1999, neither of the Named Executives exercised any warrants to purchase common stock.
(3) The value realized of the warrants exercised would be computed by determining the spread between the market value of the underlying securities at the time of exercise minus the exercise price of the option or warrant.
(4) All warrants held by the Named Executives are currently exercisable.
(5) The value of unexercised warrants is computed by subtracting the exercise price of the outstanding warrants from $.50 per share, the price per share in the Company's current public offering, although there is currently no market for the Company's common stock. Because none of the Named Executive's warrants were granted at exercise prices less than $.50 per share, none of the warrants are "in-the- money" for purposes of this table.
(6) Includes warrants to purchase: 138,000 shares of common stock at $.50 per share until April 24, 1995 (extended until April 24, 2001); 300,000 shares of common stock at $.50 per share until March 25, 1996 (extended until March 25, 2004); 178,545 shares of common stock at $.50 until May 7, 1996 (extended until May 7, 2004); 150,000 shares of common stock at $1.00 per share until October 25, 1996 (extended until October 25, 2002); 213,500 shares of common stock at $1.00 per share until January 27, 1997 (extended until January 27, 2000); and 200,000 shares of common stock at $.50 per share until January 27, 2004.
(7) Includes warrants to purchase: 250,000 shares of common stock at $.50 per share until April 24, 1995 (extended until April 24, 2001); 300,000 shares of common stock at $.50 per share until March 25, 1996 (extended until March 25, 2004); 6,250 shares of common stock at $1.00 per share until April 15, 2000; 300,000 shares of common stock at $.50 per share until May 7, 1996 (extended until May 7, 2004); and 200,000 shares of common stock until January 27, 2004.
Employment Agreements
Diasensor.com has entered into employment agreements (the "Agreements") with Fred E. Cooper and David L. Purdy effective November 1, 1994, pursuant to which they were originally entitled to receive annual salaries of $100,000 and $50,000 respectively, which are subject to review and adjustment annually. As of the end of Fiscal 1999, such annual salaries had been increased to $372,000, and $325,000, respectively, although, due to the Company's cash flow problems, full payment was not made during Fiscal 1998. The initial term of the Agreements expired on October 31, 1999, but continues thereafter for additional three- year terms unless any of the parties give proper notice of non- renewal. The Agreements also provide that in the event of a "change of control" of Diasensor.com, Diasensor.com is required to issue to Messrs. Cooper and Purdy shares of common stock equal to five percent (5%) of the outstanding shares of the common stock of the Company immediately after the change in control. In general, a "change of control" is deemed to occur for purposes of the Agreements (i) when 20% or more of Diasensor.com's outstanding voting stock is acquired by any person, (ii) when one- third (1/3) or more of Diasensor.com's directors are not Continuing Directors (as defined in the Agreement), or (iii) when a controlling influence over the management or policies of Diasensor.com is exercised by any person or by persons acting as a group within the meaning of Section 13(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act").
In addition, in the event of a change in control within the term of the Agreements or within one year thereafter, Messrs. Cooper, and Purdy are entitled to receive severance payments in amounts equal to: 100% of their most recent annual salary for the first three years following termination; 50% of their most recent annual salary for the next two years; and 25% of their most recent salary for the next five years. Diasensor.com is also required to continue medical insurance coverage for Messrs. Cooper and Purdy and their families during such periods. Such severance payments will terminate in the event of the employee's death.
In the event that either Mr. Cooper or Mr. Purdy becomes disabled, as defined in the Agreements, they will be entitled to the following payments, in lieu of salary, such payments to be reduced by any amount paid directly to them pursuant to a disability insurance policy provided by the Company or its affiliates: 100% of their most recent annual salary for the first three years; and 70% of their most recent salary for the next two years.
The Agreements also generally restrict the disclosure of certain confidential information obtained by Messrs. Cooper and Purdy during the term of the Agreements and restricts them from competing with Diasensor.com for a period of one year in specified states following the expiration or termination of the Agreements.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Percent of Amount & Nature Ownership with Class with Name and Address of Beneficial Percent of Warrants and Warrants and of Beneficial Owner Ownership(1) Class (2) Options(3) Options (4)
Biocontrol 11,975,000 52.1% 11,975,000 52.1% Technology, Inc. 300 Indian Springs Rd. Indiana, PA 15701
David L. Purdy (5) 32,000 * 1,088,250(6) 4.5% 300 Indian Springs Road Indiana, PA 15701
Fred E. Cooper 22,000 * 1,202,045(7) 5.0% Building 2500, 2nd Floor 2275 Swallow Hill Rd. Pittsburgh, PA 15220
Anthony J. Feola 20,000 * 820,000(8) 3.4% Building 2500, 2nd Floor 2275 Swallow Hill Rd. Pittsburgh, PA 15220
Patrick H. O'Neill 0 * 100,000(9) * 42 Dunning Road New Canaan, CT 06840
All directors and 74,000 * 3,210,295(9) 12.3% executive officers as a group (4 persons)
* Less than one percent ________________________
(1) Excludes currently exercisable warrants and options set forth in the third column and detailed in the footnotes below.
(2) Represents current common stock owned by each person, as set forth in the first column, excluding currently exercisable warrants and options, as a percentage of the total number of shares of common stock outstanding as of September 30, 1998, which was 22,980,051.
(3) Includes ownership of all shares of common stock which each named person or group has the right to acquire, through the exercise of warrants or options, within sixty (60) days, together with the common stock currently owned.
(4) Represents total number of shares of common stock owned by each person, as set forth in the third column, which each named person or group has the right to acquire, through the exercise of warrants or options within sixty (60) days, together with common stock currently owned, as a percentage of the total number of shares of common stock outstanding as of September 30, 1999. For individual computation purposes, the total number of shares of common stock outstanding as of September 30, 1999 has been increased by the number of additional shares which would be outstanding if the person or group owned the number of shares set forth in the third column.
(5) Does not include shares held solely by Mr. Purdy's adult children. Mr. Purdy disclaims any beneficial interest to shares held by members of his family.
(6) Includes currently exercisable warrants to purchase the following: 250,000 shares of common stock at $.50 per share until April 24, 1995 (extended until April 24, 2001); 300,000 shares of common stock at $.50 per share until March 25, 1996(extended until March 25, 2004); 6,250 shares of common stock at $1.00 per share until April 15, 2000; 300,000 shares of common stock at $.50 per share until May 7, 1996 (extended until May 7, 2004); and 200,000 shares of common stock at $.50 per share until January 27, 2004.
(7) Includes currently exercisable warrants to purchase the following: 138,000 shares of common stock at $.50 per share until April 24, 1995 (extended until April 24, 2001); 300,000 shares of common stock at $.50 per share until March 25, 1996 (extended until March 25, 2004); 178,545 shares of common stock at $.50 until May 7, 1996 (extended until May 7, 2004); 150,000 shares of common stock at $1.00 per share until October 25, 1996 (extended until October 25, 2002); 213,500 shares of common stock at $1.00 per share until January 27, 1997 (extended until January 27, 2000); and 200,000 shares of common stock at $.50 per share until January 27, 2004.
(8) Includes currently exercisable warrants to purchase the following: 100,000 shares of common stock at $.50 per share until April 24, 1995 (extended until April 24, 2001); 100,000 shares of common stock at $.50 per share until October 23, 1995 (extended until October 23, 2003); 300,000 shares of common stock at $.50 per share until March 25, 1996 (extended until March 25, 2004); and 300,000 shares of common stock at $.50 per share until May 7, 1996 (extended until May 7, 2004).
(9) Includes currently exercisable warrants to purchase the following: 100,000 shares of common stock at $.50 per share until September 8, 2004.
(10) Includes shares of common stock, including stock currently owned, available under currently exercisable warrants as set forth above.
Item 13.
Item 13. Certain Relationships and Related Transactions
Diasensor.com and BICO (the "Companies") share common officers and directors. In addition, the Companies have entered into several intercompany agreements, which are summarized below. Management believes that it was in the best interest of Diasensor.com to enter into such agreements and that the transactions were based on terms as fair as those which may have been available in comparable transactions with third parties. However, no unaffiliated third party was retained to independently determine the fairness of such transactions. The Company's policy concerning related party transactions requires the approval of a majority of the disinterested directors.
Employment Relationships
The Board of Directors of the Company approved employment agreements effective November 1, 1994 for its officers and directors Fred E. Cooper and David L. Purdy. (See, "Employment Agreements").
David L. Purdy, Chairman of the Board, Chief Scientist and a director of the Company, is a director of the BICO and Coraflex Boards. He is also the Chairman of the Board, President and Treasurer of BICO, and the Chairman and the President and Treasurer of Coraflex. Fred E. Cooper, President and a director of the Company, is a director of the BICO, Coraflex, and Petrol Rem Boards. He is also the CEO and Executive Vice President of BICO. Anthony J. Feola, a director, is also a director on the BICO, Coraflex, and Petrol Rem Boards. He is also the Senior Vice President of BICO.
Leases and Property
Diasensor.com rents an office condominium in Pittsburgh, PA (See, "Properties"). BICO moved its Pittsburgh offices to the Diasensor.com office condominium and pays Diasensor.com rent in the amount of $3,544 per month plus one-half of the utilities.
Three of the Company's current executive officers and/or directors and three former directors of the Company are members of the eight-member 300 Indian Springs Road Real Estate Partnership (the "Partnership") which in July 1990, purchased BICO's real estate in Indiana, PA, and each has personally guaranteed the payment of lease obligations to the bank providing the funding. The cost of the property to BICO was $1,084,852. The property was sold to the Partnership subject to the leaseback provision and outstanding liens for approximately $800,000; BICO received approximately $403,000 in cash as a result of the sale- leaseback. The sale price was determined by First West Virginia Bank. Each member of the Partnership received warrants in consideration of his or her personal guarantees. The six members of the Partnership who are also current or former officers and/or directors of the Company, David L. Purdy, Fred E. Cooper, Gary R. Keeling, Jack H. Onorato, Richard M. Erenberg and C. Terry Adkins, each received warrants to purchase 100,000 shares of BICO's common stock at an exercise price of $.33 per share until June 29, 1995 (which were extended until June 29, 2000), and warrants to purchase 100,000 shares of Diasensor.com's common stock at an exercise price of $.50 per share until June 29, 1995, all of which have expired unexercised. The warrant exercise prices were equal to the market prices of the common stock at the time of issuance. Mr. Keeling, who was not a director at the time of the transaction, joined the board in October 1991, became a Vice President in October 1992, and resigned from both positions in August 1997. Mr. Adkins, who was not a director at the time of the transaction, joined the board in March 1992 and became a Vice President in October 1992; Mr. Adkins resigned as an officer and director during Fiscal 1998. Mr. Onorato, who was not a director at the time of the transaction, was a director until September 1992 when he became a director of BICO until April 1994. Mr. Erenberg, who was not a director at the time of the transaction, was a director until April 1993.
Intercompany Agreements
License and Marketing Agreement. Diasensor.com acquired the exclusive marketing rights for the Noninvasive Glucose Sensor and related products and services from BICO in August 1989 in exchange for 8,000,000 shares of its common stock. That agreement was canceled pursuant to a Cancellation Agreement dated November 18, 1991, and superseded by a Purchase Agreement dated November 18, 1991. The Cancellation Agreement provides that BICO retain the 8,000,000 shares of Diasensor.com common stock, which BICO received pursuant to the License and Marketing Agreement.
Purchase Agreement. BICO and Diasensor.com entered into a Purchase Agreement dated November 18, 1991 whereby BICO conveyed to Diasensor.com its entire right, title and interest in the Noninvasive Glucose Sensor and its development, including its extensive knowledge, technology and proprietary information. Such conveyance includes BICO's patent received in December 1991 (See, "Business").
In consideration of the conveyance of its entire right in the Noninvasive Glucose Sensor and its development, BICO received $2,000,000. In addition, Diasensor.com may endeavor, at its own expense, to obtain patents on other inventions relating to the Noninvasive Glucose Sensor. Diasensor.com also guaranteed BICO the right to use such patented technology in the development of BICO's proposed implantable closed-loop system, a related system in the early stages of development.
In December 1992, BICO and Diasensor.com executed an amendment to the Purchase Agreement, which clarified terms of the Purchase Agreement. The amendment defines "Sensors" to include all devices for the noninvasive detection of analytes in mammals or in other biological materials. In addition, the amendment provides for a royalty to be paid to Diasensor.com in connection with any sales by BICO of its proposed closed-loop system.
Research and Development ("R&D") Agreement. Diasensor.com and BICO entered into an agreement dated January 20, 1992 in connection with the research and development of the Noninvasive Glucose Sensor. Pursuant to the agreement, BICO will continue the development of the Noninvasive Glucose Sensor, including the fabrication of prototypes, the performance of clinical trials, and the submission to the FDA of all necessary applications in order to obtain market approval for the Noninvasive Glucose Sensor. BICO will also manufacture the models of the Noninvasive Glucose Sensor to be delivered to Diasensor.com for sale (See, "Manufacturing Agreement"). Upon the delivery of the completed models, the research and development phase of the Noninvasive Glucose Sensor will be deemed complete.
Diasensor.com has agreed to pay BICO $100,000 per month for indirect costs beginning April 1, 1992, during the 15 year term of the agreement, plus all direct costs, including labor. BICO also received a first right of refusal for any program undertaken to develop, refine or improve the Noninvasive Glucose Sensor, and for the development of other related products. In July 1995, BICO and Diasensor.com agreed to suspend billings, accruals of amounts due and payments pursuant to the R&D Agreement pending the FDA's review of the Sensor.
Manufacturing Agreement. BICO and Diasensor.com entered into an agreement dated January 20, 1992, whereby BICO will act as the exclusive manufacturer of the Noninvasive Glucose Sensor and other related products. Diasensor.com will provide BICO with purchase orders for the products and will endeavor to provide projections of future quantities needed. The original Manufacturing Agreement called for the products to be manufactured and sold at a price to be determined in accordance with the following formula: Cost of Goods (including actual or 275% of overhead, whichever is lower) plus a fee of 30% of Cost of Goods. In July 1994, the formula was amended to be as follows: Costs of Goods Sold (defined as BICO's aggregate cost of materials, labor and associated manufacturing overhead) + a fee equal to one third (1/3) of the difference between the Cost of Goods Sold and Diasensor.com's sales price of each Sensor. Diasensor.com's sales price of each Sensor is defined as the price paid by any purchaser, whether retail or wholesale, directly to Diasensor.com for each Sensor. Subject to certain restrictions, BICO may assign its manufacturing rights to a subcontractor with Diasensor.com's written approval. The term of the agreement is fifteen years.
Warrants
During Fiscal 1997 through Fiscal 1999, Diasensor.com issued the following warrants to its officers and directors:
On January 27, 1999, Diasensor.com issued warrants to purchase common stock at $.50 per share until January 27, 2004 to: Fred Cooper, 200,000 shares; and David Purdy, 200,000 shares.
On September 8, 1999, Diasensor.com issued warrants to purchase 100,000 shares of common stock at $.50 per share until September 8, 2004 to Patrick H. O'Neill.
PART IV
Item 14.
Item 14. Exhibits, Financial Statements and Reports on Form 8-K
1. Consolidated Financial Statements
The consolidated financial statements, together with the report thereon of the Company's independent accountants, are included in this report on the pages listed below.
(a) Consolidated Financial Statements Page
Report of Independent Accountants Thompson Dugan, P.C.
Consolidated Balance Sheets as of September 30, 1999; September 30, 1998
Consolidated Statements of Operations For the Fiscal Years Ended September 30, 1999, 1998, 1997, 1996; and July 5, 1989 (inception) through September 30, 1999
Consolidated Statements of Changes in Stockholders' Equity for the Fiscal Years Ended September 30, 1999, 1998, 1997, 1996, 1995, 1994; 1993; 1992; the 12 months ended December 31, 1991, 1990, and from July 5, 1989 (inception) through December 31, 1989
Consolidated Statements of Cash Flows for the Fiscal Years Ended September 30, 1999, 1998, 1997, 1996; and July 5, 1989 (inception) through September 30, 1999
Notes to Consolidated Financial Statements for the Fiscal Year Ended September 30, 1999
2. Exhibits
(a) Reports on Form 8-K
The Company filed a Form 8-K report dated November 17, 1999. The item listed was Item 5, Other Events.
(c) Exhibits required by Item 601 of Regulation S-K
The following Exhibits required by Item 601 of Regulation S- K are filed as part of this report. Except as otherwise noted, all exhibits are incorporated by reference from Exhibits to Form S-1 (Registration #33-56574) filed December 31, 1992 or from exhibits to Form 10-K filings subsequent to that date.
3.1 Articles of Incorporation of Diasensor.com, Inc., as amended
3.2 Amended and Restated Bylaws of Diasensor.com, Inc.
4.1 Form of Specimen Common Stock Certificate of Diasensor.com, Inc.
10.1 Purchase Agreement dated as of November 18, 1991 between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.2 Manufacturing Agreement dated as of January 20, 1992, between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.3 Research and Development Agreement dated as of January 20, 1992 between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.4 Lease dated as of May 1, 1992 between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.5 First Amendment to Purchase Agreement dated as of December 8, 1992 between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.6(1) Amendment to Manufacturing Agreement dated as of June 7, 1994 between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.7(1) Deferral Agreement, dated as of July 1, 1994, between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.8 Deferral Agreement dated as of September 30, 1994 between Diasensor.com, Inc. and Biocontrol Technology, Inc.
10.9 Employment Agreement dated as of November 1, 1994 between Diasensor.com, Inc. and Fred E. Cooper
10.10 Employment Agreement dated as of November 1, 1994 between Diasensor.com, Inc. and David L. Purdy
10.11(2) Letter of Resignation of director C. Terry Adkins
(1) Incorporated by reference from Exhibit with this title filed with the Company's Form S-1 filed August 17, 1994 at 33- 82796.
(2) Incorporated by reference from Exhibit with this title filed with the Company's Form 8-K dated August 29, 1997.
Conformed Copy SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 29th day of December 1999.
DIASENSOR.COM, INC.
By: /s/ Fred E. Cooper Fred E. Cooper,President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/ David L. Purdy Chairman of December 29,1999 David L. Purdy the Board; Chief Scientist
/s/ Fred E. Cooper President and December 29, 1999 Fred E. Cooper Director (principal executive officer, principal financial officer, and principal accounting officer)
/s/ Anthony J. Feola Director December 29, 1999 Anthony J. Feola
/s/ Patrick H. O'Neill Director December 29, 1999 Patrick H. O'Neill
THOMPSON DUGAN CERTIFIED PUBLIC ACCOUNTANTS ________________________
Pinebridge Commons 1580 McLaughlin Run Rd. Pittsburgh, PA 15241
Report of Independent Certified Public Accountants
Independent Auditors' Report
Board of Directors Diasensor.com, Inc.
We have audited the accompanying consolidated balance sheets of Diasensor.com, Inc. (a development stage company) as of September 30, 1999 and 1998, and the related statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended September 30, 1999, and for the period from July 5, 1989 (inception) through September 30, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the consolidated financial position of Diasensor.com, Inc. as of September 30, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 1999, and for the period from July 5, 1989 (inception) through September 30, 1999, in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in note B to the financial statements, the Company is in the development stage and has incurred losses from operations and negative cash flows from operations for each of the three years in the period ended September 30, 1999 and from July 5, 1989 (inception) through September 30, 1999 raising substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in note B. The financial statements do not include any adjustments that might result from the outcome of this uncertainty, including adjustments relating to the recoverability and classification of recorded assets that might be necessary in the event the Company cannot continue to meet its financing requirements and achieve productive operations.
In addition, as discussed in notes B and F, the Company is dependent upon its parent, Biocontrol Technology, Inc. (BICO) to continue to perform and fund contractual arrangements related to research, development and manufacturing activities of products for the Company. There has been and continues to be substantial doubt about BICO's ability to continue as a going concern due to their recurring losses from operations and negative cash flow. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.
December 9, 1999
Diasensor.com, Inc. (A Development Stage Company)
CONSOLIDATED BALANCE SHEETS
September 30, September 30, ASSETS 1999 1998 ----------- ----------- Current assets Cash and cash equivalents (note A) $ 6,525 $ 41,811 Prepaid expenses 130 5,792 ----------- ----------- Total current assets 6,655 47,603
Property and equipment-at cost(notes A and C) Building and improvements 0 222,296 Furniture and fixtures 42,750 42,750 ----------- ----------- 42,750 265,046 Less accumulated depreciation 28,331 69,553 ----------- ----------- 14,419 195,493 ----------- ----------- Other assets Due from BICO(notes A and F) 1,458,809 2,197,433 Notes receivable-related parties(note F) 0 125,000 Interest receivable-related parties(note F) 0 9,272 Allowance for doubtful account(note F) (1,458,809) (2,282,479) Security deosit (note C) 17,250 0 ----------- ----------- 17,250 49,226 ----------- ----------- TOTAL ASSETS $ 38,324 $ 292,322 =========== ===========
LIABILITIES and STOCKHOLDERS' EQUITY
Current liabilities Accounts payable $ 0 $ 23,606 Accrued payroll and withholdings(note f) 91,214 68,721 ----------- ----------- Total current liabilities 91,214 92,327
Commitments and Contingencies (notes B and G)
Stockholders' equity Preferred stock, 1,000,000 shares authorized, none issued Common stock, 40,000,000 shares of $.01 par value authorized; issued and outstanding 22,980,051 at Sep. 30, 1999 and Sep. 30, 1998 229,801 229,801 Additional paid-in capital 26,892,071 26,892,071 Warrants 18,453,839 17,953,223 Deficit accumulated during the development stage (45,628,601) (44,875,100) ----------- ----------- (52,890) 199,995 TOTAL LIABILITIES AND ----------- ----------- STOCKHOLDERS' EQUITY $ 38,324 $ 292,322 =========== =========== [FN] The accompanying notes are an integral part of this statement. Diasensor.com, Inc. (A Development Stage Company)
CONSOLIDATED STATEMENT OF OPERATIONS
The accompanying notes are an integral part of this statement.
DIASENSOR.COM, INC. (A Development Stage Company)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS September 30, 1999
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
1. ORGANIZATION
Diasensor.com, Inc. (the Company) was incorporated in the Commonwealth of Pennsylvania on July 5, 1989 as a wholly owned subsidiary of Biocontrol Technology, Inc. (BICO). BICO owned approximately 52% of the stock of the Company at September 30, 1999. The Company and BICO are currently developing a Noninvasive Glucose Sensor (Sensor), which management believes will be able to measure the concentration of glucose in human tissue without requiring the drawing of blood. The Company plans to market the Sensor to diabetics through their doctors and is currently negotiating with domestic and international distribution organizations.
The consolidated financial statements include the accounts of Diasensor.com UK LTD. a 100% owned subsidiary of Diasensor. com, Inc. as of September 30, 1999. All significant intercompany accounts and transactions have been eliminated.
2. CASH AND CASH EQUIVALENTS
For purposes of the consolidated statement of cash flows, the Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The Company places temporary cash deposits in financial institutions and such deposits may be in excess of the FDIC insurance limit.
3. PROPERTY AND EQUIPMENT
Property and equipment are accounted for at cost and are depreciated over their estimated useful lives (37 years for property and 10 years for equipment) on a straight-line basis. The carrying value of property and equipment are reduced for impairment losses determined by management.
4. INCOME TAXES
The Company previously adopted Financial Accounting Standards Board Statement No. 109 (FAS 109), Accounting for Income Taxes, which requires the asset and liability method of accounting for income taxes. Enacted statutory tax rates are applied to temporary differences arising from the differences in financial statement carrying amounts and the tax basis of existing assets and liabilities. Due to the uncertainty of the realization of income tax benefits (Note E), the adoption of FAS 109 had no effect on the financial statements of the Company.
5. ESTIMATES AND ASSUMPTIONS
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
6. NET LOSS PER COMMON SHARE
Net loss per common share is based on the weighted average number of common shares outstanding which amounted to 22,980,051, 22,979,884 and 22,979,051 for the years ended September 30, 1999, September 30, 1998 and September 30, 1997 respectively. The loss per share does not include common stock equivalents since the effect would be anti-dilutive.
For the period from July 5, 1989 (inception) to September 30, 1999, net loss per common share is based on the weighted average number of common shares outstanding and the number of common shares issuable on the exercise of 1,708,000 warrants issued in 1992; reduced by 488,000 common shares that were assumed to have been purchased with the proceeds from the exercise of the warrants at an assumed price of $3.50 per share. The inclusion of the warrants in the loss per share calculation is required by the rules of the Securities and Exchange Commission relative to the initial registration statement which included the Company's financial statements through the period ended March 31, 1993. The registration statement became effective July 19, 1993. The weighted average number of common shares including the effect of the conversion of the warrants for the period from July 5, 1989 (inception) to September 30, 1999 amounted to 19,208,920.
7. RESEARCH AND DEVELOPMENT
All research and development costs incurred by the Company, or by BICO on its behalf, are charged to operations as incurred. Patent and technology rights acquired from BICO (Note F) have also been written off as a charge to operations.
8. TREASURY STOCK
The Company records treasury stock transactions using the par value method.
9. INTERCOMPANY ACTIVITY
Certain expenses are allocated by management between the Company, BICO and BICO's subsidiaries. These expenses are reimbursed to the paying entity through the use of intercompany accounts, which accounts are also used to account for non-interest bearing cash advances between the companies.
10. COMMON STOCK WARRANTS
The Company recognizes cost on warrants granted or extended based upon the minimum value method. There is currently no trading market for the Company's warrants or common stock. Under this method, the warrants are valued by reducing the exercise price of the underlying stock by the present value of the exercise price discounted at an estimated risk-free interest rate of 5% and assuming no dividends.
11. COMPREHENSIVE INCOME
The Company's consolidated net income (loss) is substantially the same as comprehensive income required to be disclosed by Financial Accounting Standards Board Statement No. 130.
12. CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject the Company to significant concentrations of credit risk consist principally of receivables from BICO and from officers and directors of the Company and BICO. The receivables from officers and directors of the Company are unsecured and represent a concentration of credit risk due to the common employment and financial dependency of these individuals on the Company and BICO.
NOTE B - OPERATIONS
The Company is developing the Sensor and has not, as yet, achieved a commercially marketable product. The ability of the Company to continue in existence is dependent on its having sufficient financial resources to maintain operations, to complete the research and development necessary to successfully bring the Sensor to market, and for marketplace acceptance. The Company has no other commercial products and is dependent on the successful development of the Sensor technology. The Company is selling shares of its common stock pursuant to an offering with the SEC, which became effective July 19, 1993 and has an intercompany receivable from BICO of $ 1,458,809 at September 30, 1999. Any funds generated by the Company through the sale of its common stock and any repayment of funds due from Bico would be used to finance its operations. The Company has had only minimal sales of its common stock over the last two fiscal years. The Company is in the development stage, and accordingly, it has presented cumulative information on results of operations, cash flows, and changes in stockholders' equity since inception.
The Company has incurred significant losses and negative cash flows from operations from inception through September 30, 1999 and has a significant accumulated deficit as of September 30, 1999, raising substantial doubt about its ability to continue as a going concern. The Company has financed its losses and its research and development program, which is temporarily suspended, primarily from the sale of the Company's common stock through private placements. Management believes that its available cash resources, including funds it reasonably expects to be repaid by BICO and to be raised by the Company or its affiliates will be sufficient to fund its operations through the year ending September 30, 2000. Management believes that the recoverability and classification of recorded assets and liabilities are comparable to approximate liquidation values as of September 30, 1999.
As a result of agreements with BICO relating to development and manufacture of the Noninvasive Glucose Sensor, the Company is dependent on BICO for substantially all of its activities in connection with the development and manufacture of the Sensor, other than its marketing efforts. Pursuant to the Research and Development Agreement, BICO has undertaken the development of the Sensor and has assumed certain other obligations. In July 1995, the Company and BICO agreed to suspend billings,accruals of amounts due and payments pursuant to the R&D Agreement pending FDA review of the Sensor. No amounts are due pursuant to the R&D Agreement which have not been recorded, and no adjustments will be made retroactively or cumulatively if and when billings resume. Management believes that billings may resume, based on negotiations between both companies,if and when the Diasensor 1000 is approved for marketing. Pursuant to a manufacturing agreement between BICO and the Company, BICO will manufacture the Sensor once development is completed. In the absence of such agreements with BICO, the research, development and manufacture of the Sensor could not continue as currently contemplated. BICO's ability to successfully complete the development of the Sensor, to obtain FDA approval in a timely fashion and to manufacture production units of the Sensor without significant delays or defects will directly affect the Company's business and ability to achieve profitable operations. BICO has experienced, and continues to experience, substantial losses and financial difficulties. The consolidated financial statements for BICO for the year ended December 31, 1998 included disclosures which referred to the existence of substantial doubt about BICO's ability to continue as a going concern. BICO has a net loss for the nine month period ended September 30, 1999 of $30,478,621 (unaudited) and for the fiscal year ended December 31, 1998 of $22,402,644, compared to a net loss for the fiscal year ended December 31, 1997 of $30,433,177. As of December 31, 1998, and September 30, 1999, BICO's accumulated deficit was $143,101,880 and $173,580,501 (unaudited) respectively.
In the past, BICO has financed its own operations from proceeds generated from private and public sales of its securities, the issuance of debt in the form of convertible debentures, from funds paid by the Company to BICO for research and development of the Noninvasive Glucose Sensor and from intercompany advances from the Company and other BICO subsidiaries. The failure of BICO to continue to exist as a going concern would have a material adverse effect on the Company's business and ability to continue operations.
If BICO does not continue as a going concern, the Company would need to rely on other arrangements to develop and manufacture the Sensor or to perform that work itself. There can be no assurance that the Company would be able to find acceptable alternatives, negotiate acceptable collaborative arrangements with any alternative organizations, or to perform the work itself.
NOTE C - LEASE
In December 1998 the Company sold its building and leased it back under an agreement which requires monthly rent of $5,750 for five years beginning on January 1, 1999. An impairment loss was recognized as a charge to general and administrative expenses in the financial statements for the year ended September 30, 1998 for $14,367 which represented the difference between the previous book value of the building and the $175,000 sales price in the December 1998 sales agreement. Future minimum rental payments under this lease are $69,000 for each of the fiscal years ending on September 30, 2000 through 2003 and $17,250 for the final three months of the lease concluding December 31, 2003. The Company paid a security deposit of $17,250 upon entering into this lease agreement.
NOTE D - OTHER INCOME
Other income for the years ending September 30, 1999, 1998 and 1997 consists of $6,445, $20,386 and $10,471 of interest income and $42,528, $42,528 and $42,528 of rental income for their respective periods. The total rental income for the years ended September 30, 1999, 1998 and 1997, was from BICO for office space.
NOTE E - INCOME TAXES
As of September 30, 1999, the Company has available approximately $23,700,000 of net operating loss carryforwards for federal income tax purposes. These carryforwards are available, subject to limitations, to offset future taxable income, and expire in the tax years 2005 through 2013. The Company also has research and development credit carryforwards available to offset federal income taxes of approximately $700,000 subject to limitations, expiring in the years 2005 through 2013.
The Company has temporary differences arising from different methods of accounting for the costs of patent and technology rights for financial statement and tax purposes. For financial statement purposes, these costs have been charged to operations. For tax purposes, the costs of approximately $2,650,000 have been capitalized and are being amortized over seventeen years. Also, warrant extensions have been recorded and expensed for financial statement purposes in the amount of $18,413,524 as of September 30, 1999. For tax purposes, warrants are not recorded until the warrants are exercised. Bad debt allowance recorded against intercompany receivables in the amount of $2,282,479 at September 30, 1998 were expensed for financial statement purposes but not for tax purposes. A reduction in the allowance account of $823,670 at September 30, 1999 is also reflected in the financial statements but is not included in the tax return.
The Company has not reflected any future income tax benefits for these temporary differences or for net operating loss and credit carryforwards because of the uncertainty as to their realization. Accordingly, the adoption of FAS 109 had no effect on the financial statements of the Company.
The following is a summary of the composition of the Company's deferred tax asset and associated valuation allowance at September 30, 1999 and 1998:
1999 1998 ----------- ----------- Net Operating Loss $ 8,049,126 $ 7,630,820
Warrant Expense 6,258,898 6,088,689
Patent Amortization 488,174 540,452
Allowance for Bad Debts 443,400 776,000
Tax Credit Carry Forward 700,000 700,000 ----------- ----------- 15,939,598 15,735,961 Valuation Allowance (15,939,598) (15,735,961) ----------- ----------- Net Deferred Tax Asset $ 0 $ 0 =========== ===========
The deferred tax benefit and the associated increase in the valuation allowance are summarized in the following schedule:
Increase in Deferred Valuation Tax Allowance Net Benefit
Year Ended September 30,1999 $ (203,637) $ 203,637 $0
Year Ended September 30,1998 $ (846,487) $ 846,487 $0
Year Ended September 30,1997 $ (2,326,496) $ 2,326,496 $0
Year Ended September 30,1996 $ (3,000,971) $ 3,000,971 $0
Year Ended September 30,1995 $ (3,877,527) $ 3,877,527 $0
From July 5,1989 (inception) through September 30,1999 $(15,939,598) $15,939,598 $0
NOTE F - RELATED PARTY TRANSACTIONS
1. SENSOR RELATED AGREEMENTS
The Company has a development agreement with BICO for the sensor. If successfully developed, the Sensor will enable users to measure blood glucose levels without taking blood samples. On November 18, 1991, the Company acquired for $2,000,000 the right from BICO to one United States patent, which covers the process of measuring blood glucose levels non-invasively. Approval to market the Sensor is subject to federal regulations including the Food and Drug Administration (FDA). Each model of the Sensor is subject to clinical testing and regulatory approvals by the FDA.
The Company and BICO have entered into a series of agreements related to the development, manufacture and marketing of the Sensor. Under such agreements, BICO is required to carry out all steps necessary to bring the Sensor to market including 1) developing and fabricating the prototypes necessary for clinical testing; 2) performing the clinical investigations leading to FDA approval for marketing; 3) submitting all applications to the FDA for marketing approval; and 4) developing a manufacturable and marketable product. Diasensor.com, Inc. is to conduct the marketing of the Sensor. Following is a brief description of the agreements:
Manufacturing Agreement
The manufacturing agreement between the Company and BICO was entered into on January 20, 1992. Under such agreement, BICO is to act as the exclusive manufacturer of production units of the Sensor and to sell the units to the Company at a price determined by the agreement. The term of the agreement is fifteen years.
Research and Development Agreement
Under a January 1992 agreement effective April 1992, the Company is to pay BICO $100,000 for indirect costs per month, plus all direct costs for the research and development of the Sensor. This agreement replaced a previous agreement dated May 14, 1991 under which Diasensor.com, Inc. had been paying BICO $50,000 for indirect costs per month, plus all direct costs for the design and development activities. The term of the agreement expires in 2007. In July 1995, the Company and BICO agreed to suspend billings, accruals of amounts due and payments pursuant to the R&D Agreement, pending FDA review of the Sensor.
The monthly charges from BICO for indirect costs are reflected as general and administrative expenses and direct costs for the research and development of the Sensor incurred by BICO are reflected as R&D expenses in the statement of operations.
Purchase Agreement
In November 1991, the Company entered into a Purchase Agreement with BICO under which the Company acquired all of BICO's rights to the Sensor for a cash payment of $2,000,000 which was charged to operations.
Sublicensing Agreement
In 1989, BICO acquired rights to certain concepts and patents related to the Sensor from outside parties. The purchase price was $650,000, and was paid by the conveyance of stock in BICO and 1,040,000 shares of Diasensor.com,Inc. common stock. The $520,000 value of the Diasensor.com, Inc. stock issued was charged to the receivable due from BICO. On May 14, 1991, Diasensor.com, Inc. and BICO entered into a sublicense agreement under which Diasensor.com, Inc. acquired these rights from BICO for a cash payment of $650,000 which was charged to operations.
License and Marketing Agreement
In August 1989, BICO granted Diasensor.com, Inc. the exclusive right to represent BICO and to market the Sensor and related products worldwide. In exchange for these rights, Diasensor.com, Inc. conveyed 8,000,000 shares of its common stock to BICO. The assigned value of these shares was $80,000 which was charged to operations. In November 1991, this agreement was superseded when the Company purchased all rights to the Sensor technology.
2. INTERCOMPANY ACTIVITY
For the fiscal years ended September 30, 1999, 1998 and 1997, net intercompany charges by the Company to BICO and its subsidiaries were $81,261, $160,433 and $129,960.
3. RECEIVABLES FROM OFFICERS AND DIRECTORS
During the fiscal year ended September 30, 1998 the Company made loans to certain officers and directors totalling $125,000. The loans were due upon demand with interest at a rate of 8.25%. Total amounts due, including accrued interest, on these loans at September 30, 1998, were $80,599 from Fred E. Cooper and $53,673 from Anthony J. Feola. During the fiscal year ended September 30, 1999, the Company (by agreement with BICO) assigned the above $134,272 of notes receivable and accrued interest, plus an additional $4,266 accrued interest, to BICO by an increase in the intercompany due from BICO account.
4. ALLOWANCE FOR DOUBTFUL ACCOUNTS
Due to the financial condition of BICO, as discussed in Note B, management has established an allowance for doubtful accounts covering amounts due from BICO and its officers and directors. The allowance for $ 2,282,479 was recognized on the books of the Company in the fiscal year ended September 30, 1998. During the fiscal year ended September 30, 1999, the Company reduced the allowance for doubtful accounts by $ 823,670 to reflect the reduction in amounts due from BICO at September 30, 1999.
5. ACCRUED PAYROLL
Included in accrued payroll and withholdings at September 30,1999, is $45,208 and $29,167 for unpaid wages of Fred E. Cooper and David L. Purdy, respectively, which were earned but voluntarily deferred by these two directors.
NOTE G - COMMITMENTS AND CONTINGENCIES
1. RESEARCH AND DEVELOPMENT
Under terms of a Research and Development Agreement with BICO, the Company is to pay BICO $100,000 for indirect costs per month, plus direct costs associated with the research and development through January, 2007. In July 1995, the Company and BICO agreed to suspend billings, accruals of amounts due and payments pursuant to the R&D Agreement, pending FDA review of the Sensor.
2. EMPLOYMENT AGREEMENTS
Diasensor.com, Inc. has entered into agreements with Fred E. Cooper and David L. Purdy pursuant to which they receive annual salaries (as adjusted through September 30, 1999) of $372,000 and $325,000 from Diasensor.com, Inc.,respectively, both of which are subject to review and adjustment annually. The initial term of the agreements with Mr. Cooper and Mr. Purdy expired on October 31, 1999, but were automatically renewed for an additional three- year period; such renewals will continue unless either party gives proper notice of non-renewal. The agreements also provide that in the event of a "change of control" of Diasensor.com, Inc., Diasensor.com, Inc. is required to issue to Mr. Cooper and Mr. Purdy shares of common stock equal to five percent (5%) of the outstanding shares of common stock of the Company immediately after the change in control.
3. LITIGATION
Several class action lawsuits have been filed against the Company along with BICO and certain of their directors, all of which have been consolidated into a single action. The suit alleges various violations of federal securities laws on behalf of a class of plaintiffs who purchased common stock of the Company between April 25, 1995 and February 26, 1996, at which time the value of the Company's stock dropped as a result of an unfavorable recommendation of a Panel Review convened by the United States Food and Drug Administration with respect to a certain medical device owned by Diasensor.com, Inc. and manufactured by BICO. The Company has engaged in voluntary mediation in order to explore whether settlement is an option. As a result of the mediation, the plaintiffs agreed to a "standstill" period, which has now expired; however, no further activity has been conducted by the plaintiffs to move the case forward. Management believes that no federal securities violation has occurred, and they intend to strongly defend the action. At this time it is not possible to predict the outcome of the litigation or to estimate the potential damages arising from the claims, since the number of class members, and the volume and pricing of shares traded, are unknown.
During April 1998, the Company and its affiliates were served with subpoenas by the U.S. Attorneys' office for the U.S. District Court for the Western District of Pennsylvania. The subpoenas requested certain corporate, financial and scientific documents and the Company has provided documents in response to such requests.
4. PENNSYLVANIA SECURITIES COMMISSION
The Pennsylvania Securities Commission initiated a private investigation of the Company and BICO in connection with the sale of securities in 1996. The Companies have cooperated with and provided information to the Pennsylvania Securities Commission in connection with the private investigation. As the Commission's investigation is not yet complete and the Company has not been advised of any finding or order in connection with the investigation, there can be no estimate or evaluation of the likelihood of an unfavorable outcome in this matter or the range of possible loss, if any.
NOTE H - STOCKHOLDERS' EQUITY
Common Stock
The Company sold 2,800,000 shares of common stock at $0.50 per share, from August 1989 to May 1991 in connection with a joint private offering with BICO. The aggregate amount raised was $1,400,000, on which no commissions were paid to any third party. The Company sold 4,997,500 shares of common stock, at $1.00 per share, in a private offering from May 1991 to January 1992. The aggregate amount raised was $4,985,201, on which no commissions were paid to any third party.
The Company sold, in July 1992, 7,212 shares of common stock, at $3.50 per share, in a private offering to one accredited investor. The aggregate amount raised was $25,242, on which no commissions were paid to any third party.
The Company sold 300,000 shares of common stock, at $3.50 per share, in a private offering from July 1992 through November 1992. The aggregate amount raised was $1,050,000,on which no commissions were paid to any third party.
In December 1991, the Company issued 235,000 shares of common stock in exchange for the cancellation of outstanding promissory notes for $235,000.
In June 1994, the Company sold 91,667 shares of its common stock pursuant to the requirements set forth in Regulation S of the Securities Act of 1933 ("Regulation S"). In connection with such sale, the purchasers and any entity which facilitated such sale undertook to ensure compliance with Regulation S, which among other things, limits a foreign investor's ability to trade the Company's stock in the United States. The Company received net proceeds in the amount of $288,751 pursuant to such sales.
During 1995, the Company issued the following shares of its common stock to BICO: 3,000,000 shares at an assigned price of $3.50 per share in return for a corresponding reduction in the amount due from Diasensor.com, Inc. to BICO pursuant to the R&D Agreement of $10,500,000; and 1,200,000 shares of its common stock at a price of $3.50 per share.
In July,1993, the Company commenced a public offering, which is continuing. As of September 30, 1998, an aggregate of 1,063,460 shares had been issued with proceeds to the Company of $3,561,892. Of that total, 230,961 shares with net proceeds of $786,245 were issued in fiscal 1994; 437,768 shares with net proceeds of $1,501,492 were issued in fiscal 1995; 410,731 shares with net proceeds of $1,365,155 were sold in fiscal 1996; 1000 shares were issued in fiscal 1998 at $3.50 per share; 10,000 shares were issued for consulting services at a charge to operations of $35,000 in fiscal 1996; and 27,000 shares were reimbursed with net repayment of $94,500 in fiscal 1997.
The Company issued unregistered common stock in exchange for consulting services of 7,200 shares in fiscal 1994, 17,500 shares in fiscal 1995, 5,000 shares in fiscal 1996 and none in fiscal 1997 or 1998. The associated consulting service expense was recognized at a rate of $3.50 per share, which is the price at which the common stock was being sold in the Company's public offering.
Common Stock Warrants
At September 30, 1999, the Company has reserved 8,644,113 shares of the Company's unissued common stock for warrants which were outstanding and exercisable. Of these, warrants on 5,680,850 shares were issued to directors, officers, and employees for meritorious service, employment contracts and personal guarantees on Company indebtedness. Also, warrants on 2,563,263 shares were issued to consultants and medical advisers and on 400,000 shares to individuals for personal guarantees on Company loans. The per share exercise price for 5,295,000 shares is $.50, for 2,286,763 shares is $1.00 and for 1,062,350 shares is $3.50. The fiscal years in which warrants expire are as follows:
Warrant Expiration Year Number of Shares 1999 638,800 2000 2,186,350 2001 1,187,750 2002 59,213 2003 285,000 2004 4,287,000 --------- 8,644,113 =========
The following is a summary of warrant transactions during fiscal years ended September 30,
1999 1998 1997 1996 1995
Outstanding beginning 6,676,513 7,476,513 7,533,263 7,077,213 6,891,525 of year
Granted during the year 2,070,000 0 59,000 743,250 265,200
Canceled during the year (102,400) (800,000) (115,750) (231,200) (50,000)
Exercised during the years at prices ranging from $.1875 to $1.00 per share 0 0 0 (56,000) (29,512) --------- --------- --------- --------- --------- Outstanding, and 8,644,113 6,676,513 7,476,513 7,533,263 7,077,213 eligible for exercise. ========= ========= ========= ========= =========
During the period October 1, 1998 through September 30, 1999, the Company extended the exercise date of warrants to purchase 2,561,213 shares of common stock to certain officers, directors, employees and consultants. Warrants for 2,477,000 were originally granted at an exercise price of $.50 per share, warrants for 29,213 shares were origainally granted at an exercise price of $1.00 and warrants for 55,000 shares were originally granted at an exercise price of $3.50 were extended at the same price. In connection with the extension of these warrants the Company recorded a charge of $272,078 against operations. In addition, during the year ended September 30, 1999, the Company granted warrants to purchase 2,070,000 shares of common stock to employees and consultants at an exercise price of $.50 per share. These warrants were granted for services rendered which were recognized in general and administrative expenses for a total of $228,538.
During the period October 1, 1997 through September 30, 1998, the Company extended the exercise date of warrants to purchase 2,236,550 shares of common stock to certain officers, directors, employees and consultants. Warrants for 748,000 were originally granted at an exercise price of $.50 per share and warrants for 10,000 shares were originally granted at an exercise price of $1.00 and were extended at the same price. The Company recorded $25,000 against operations in connection with the extension of these warrants.
During the period October 1, 1996 through September 30, 1997, the Company extended the exercise date of warrants to purchase 2,236,550 shares of common stock to certain officers, directors, employees and consultants. Warrants for 2,236,550 were originally granted at an exercise price of $1.00 per share and were extended at the same price. The Company recorded $5,593,875 against operations in connection with the extension of these warrants.
During the period October 1, 1995 through September 30, 1996, the Company extended the exercise date of warrants to purchase 2,556,213 shares of common stock to certain officers, directors, employees and consultants. Warrants for 49,213 and 2,507,000 shares were originally granted at an exercise price of $1.00 and $.50 per share, resepectively, and were extended at the same price. The Company recorded $7,644,033 against operations in connection with the extensions of these warrants.
During the period October 1, 1994 through September 30, 1995, the Company extended the exercise date of warrants to purchase 1,550,000 shares of common stock to certain officers, directors, employees and consultants. The warrants were originally granted at an exercise price of $.50 per share and were extended at the same price. The assumed value of the stock when the extensions were granted was $3.50. The Company recorded $4,650,000 against operations in connection with the extensions of these warrants.
In 1990, the Company granted warrants to purchase 800,000 shares of common stock at an exercise price of $.50 per share to eight current or former directors or officers of the Company or BICO who personally guaranteed the payment of a lease obligation to the bank for the premises occupied by BICO at the 300 Indian Springs Road location. The Company also granted warrants to purchase 100,000 shares of common stock each to an individual and his company at an exercise price of $.50 per share for personally guaranteeing the payment of an obligation related to the purchase of equipment by BICO. In addition, the Company granted warrants to purchase 100,000 shares of common stock for services performed by consultants at an exercise price of $.50. The Company recorded an estimated value of these warrants at $27,500 which was charged to operations.
NOTE I- SUPPLEMENT CASH FLOW INFORMATION
The Company's financing activities included the following noncash transactions.
During 1992 and 1990, notes payable aggregating $303,000 were canceled and exchanged for 371,000 shares of the Company's common stock.
On March 31, 1995, the Company issued 3,000,000 shares of its unregistered stock to BICO in payment of $10,500,000 due to BICO.
During the Fiscal year ended September 30, 1999, the Company (by agreement with BICO) converted $125,000 of related party notes receivable and $13,538 of associated interest receivable to due from BICO.
Cash paid for interest and income taxes were as follows: From July 5, 1989 (inception) September September September through September 30,1999 30,1998 30,1997 30,1999
Interest Paid $ 0 $ 0 $ 0 $10,529 ====== ====== ======= ======= Income Taxes Paid $ 0 $ 0 $ 0 $ 0 ====== ====== ======= =======
NOTE J - YEAR 2000 ISSUE
The Company is currently working to resolve the potential impact of the Year 2000 on the processing of date-sensitive information. The Year 2000 Issue is the result of computer programs being written using two digits (rather than four) to define the applicable year. Programs which are susceptible to problems after December 31, 1999 are those which recognize a date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations or system failures. Based upon a review of its own internal programs and software, the Company currently believes that the Year 2000 will not pose significant operational problems to its information systems, because such systems are already compliant or will be made compliant with minor adjustments. The Company is also conducting an investigation of its major suppliers, vendors and other parties to determine their respective plans for the Year 2000 compliance. The Company's current estimates indicate that the costs of addressing potential problems are not expected to have a material impact upon the Company's financial position, results of operations or cash flows in future periods. There can be no assurance, however, that modifications to information systems which impact the Company and which are required to remediate year 2000 issues will be made on a timely basis and that they will not adversely affect the Company's systems or operations.
NOTE K - SUBSEQUENT EVENT
The Company extended warrants to purchase 620,000 shares of common stock which would have otherwise expired during the period October 1, 1999 through December 9, 1999. | 21,170 | 137,653 |
789660_1999.txt | 789660_1999 | 1999 | 789660 | ITEM 1 - BUSINESS
GENERAL - -------
Paris Corporation ("Paris"), formerly Paris Business Forms, Inc., incorporated in 1964 under the laws of the Commonwealth of Pennsylvania, is a holding company with four wholly-owned subsidiaries: two active operating companies in New Jersey and Texas, one inactive Florida corporation, and a Delaware corporation which owns the Company's trademarks. Paris Business Products, Inc., a New Jersey corporation and Paris Business Forms, Inc., a Texas corporation (dba, Paris Business Products, Inc.), are the two operating companies, with plants in New Jersey and Texas, respectively. PBF Corporation is the Delaware corporation. The Texas and Florida corporations are both wholly-owned subsidiaries of the New Jersey corporation. Paris also has a 57% interest in a corporation, Signature Corporation, formed in 1992, to market office products through the supermarket and drug chain channels. Two individuals own the remainder of the interest in Signature Corporation.
In January 1996, Paris changed its corporate name to Paris Corporation from Paris Business Forms, Inc.
The Company converts mill paper rolls to business forms at its two manufacturing and distribution plants in New Jersey and Texas and distributes office products, through a number of market channels including forms dealers, paper merchants, stationers, office product and computer superstores, consumer electronics retailers, buying groups, supermarkets, and drugstore chains. Products include stock and custom continuous forms; mill cut, value added, and custom cut sheets; paper handling products for small offices and home offices. Geographically the Company markets its products throughout the United States and Canada through Company sales representatives, independent representatives, brokers, dealers, and distributors.
Traditionally, the principal focus of the business was the manufacturing of continuous forms designed to run on dot matrix and high speed impact printers. The Company serves the stock continuous forms market and the custom forms market, providing business forms to commercial businesses to specification. Laser and inkjet printer technology continues to replace impact printers and, accordingly, the Company's market for continuous forms is shrinking at a pace estimated at 10% per year. The negative growth is more accelerated in the retail market serving small business/home business customers since the printer equipment investment is minimal and easy to replace. As a result, the Company has been shifting its focus to the development, manufacture, and sale of value- added and custom cut sheet products used on laser and inkjet printers. Perfed, punched, lined, collated, colored, photo quality, and novelty cut sheet products have been added to the product line. The continuous forms products segment as a percentage of total sales has decreased from 70% to 50% to 43% in fiscal years 1997, 1998, and 1999, respectively. It is estimated that this segment will only account for 35% of total sales in fiscal 2000.
The Burlington product line of value-added cut sheet products targeted to the small office and home office user has continued to expand with various offerings to meet the everyday needs of inkjet and laser printer paper demand as well as specialty products for photographic quality and other applications requiring maximum color contrast and optimal ink absorption. Growth in this product segment is expected to be 15% in FY 2000.
Signature Corporation ("Signature"), the 57% owned joint venture, distributes office products to the food and drug store markets. Formed in late 1992, Signature has continued to increase their stores served from 6,800 in 1996 to 14,000 in 1999. In August 1999, as a result of a stock tender by a Signature minority shareholder, the Company's interest in Signature increased to 57%. This change in ownership percentage in Signature was accounted for as a purchase and Signature has been consolidated in the accompanying financial statements. The results of operations of Signature have been included in the accompanying statement of operations for the one month period of September 30, 1999. Signature Corporation does
experience seasonal fluctuation in their sales revenue. June, July and August represent approximately 35% of Signature's annual revenue.
COMPETITION - -----------
The business forms market is divided into two major segments. One segment sells directly to end users, principally the 500 to 1,000 largest corporations. The other segment, which Paris serves, distributes forms through resellers and retailers. In the reseller market, there are three or four major competitors in stock continuous forms who are larger than Paris and committed to stock computer paper for the foreseeable future due to capital investment, albeit the negative growth rate. The Company does not compete directly with the approximate dozen direct sellers. There have been a number of acquisitions and mergers within the industry and the consolidation mode is expected to continue going forward to lower unit costs. Paris does not expect to pursue any acquisitions within this business segment and will continue to shrink capacity commensurate with the reduced demand for stock continuous forms.
The cut sheet market is growing at a rapid pace fueled by the installation of laser and inkjet printers throughout the major U.S. corporations and home and small businesses. Sales volume is expected to grow due to the Company's penetration of the retail market, serving a number of major retail stores. However, competition in this market is increasing rapidly. The major paper mills have developed marketing subsidiaries to serve the retail market.
SUPPLIERS - ---------
The Company purchases registered bond paper, (consisting of a wide variety of weights, widths, colors, sizes and qualities), cut sheet, and carbonless paper principally from the major United States paper mills. The Company believes that it has good relationships with all of its suppliers.
Boise Cascade, one of the Company's paper suppliers, has indicated plans to significantly reduce its capacity, by the year 2000, of forms bond rolls which are used by Paris in the production of continuous forms. The Company believes that the reduced supply available will be consistent with its plans to shrink this business segment. However, the Company has expanded its source of suppliers in the past year to ensure adequate paper supply in the near future.
The Company has partnered or formed strategic alliances to provide raw material, market support, and/or name recognition for its value added cut sheet product and non-paper products. Currently, the Company represents the largest volume customer of Boise Cascade for certain specialty retail cut sheet products. The Company believes the strong relationship between Paris and Boise Cascade will provide the Company a solid footing for future cut sheet supply.
SEGMENTS AND MAJOR CUSTOMERS - ----------------------------
The Company operates in three segments or lines of business, including stock continuous forms and cut sheets; custom continuous forms and cut sheets; retail papers and office products. Financial information for each of the Company's segments including net sales, operating income, total assets, capital expenditures and sales to major customers, are included in the accompanying financial statements.
No customer accounts for more than 10% of stock shipments in FY99, but two customers accounted for more than 10% of the Company's stock computer business in fiscal 1997: Office Depot (14%) and Corporate Express (28%). Both accounts were lost to competition during the latter part of the year. Although the loss of these two major accounts had a material adverse effect on sales revenue, the margin loss is no longer significant since competitive pricing reached a level that provided little profit on either account.
Two customers Best Buy (32%) and Comp USA (17%) that accounted for more then 10% of the Company's retail business in FY99. There was one customer that accounted for 14% of the custom business in FY99.
EMPLOYEES - ---------
As of September 30, 1999, the Company employed approximately 105 people in manufacturing, sales and administrative functions in its corporate offices and plants in New Jersey and Texas.
DISTRIBUTION AND MARKETING - --------------------------
The Company markets the custom and stock forms products through approximately 2,500 independent dealers in the United States and Canada, as well as through retail superstores. The independent distributors rely on several manufacturers, like the Company, to supply these end users. The distributors range in size from a single individual to a distributorship with several offices and an extensive sales force. The Company operates, or contracts for storage space, in several strategically located warehouses along the east coast, southeast and southwest regions of the country. These locations are used as the storage and shipping points for its stock forms. Currently, the Company's primary method of generating sales contacts is through its own sales force, sales representatives, extensive marketing programs, referral and reputation.
The sales force consists of seven salespersons covering New England, Mid- Atlantic, Southeast, Midwest and Southwest regions of the United States. A network of independent sales representatives covering the entire United States has been assembled over the past few years to sell the new non-paper products through major resellers and retailers.
MANUFACTURING - -------------
The Company's custom paper products are manufactured in the New Jersey plant with five rotary presses, two cut sheet presses and one collator. The rotary presses provide the Company with the ability to produce a broad spectrum of form sizes. Each piece of machinery requires a skilled operator; support personnel are required on some equipment. The custom forms operation runs primarily three shifts per day, with individual equipment varying. The estimated capacity of the custom business is approximately $12.5 million in sales at current prices.
The Company's stock form business is manufactured from two locations. The New Jersey facility has four presses and one collator, and Texas has one press as of September 30, 1999. The majority of the stock forms are produced to be sold from inventory. Each plant is also capable of producing customized computer paper or stock forms upon order. The stock operation is three shifts per day, five days per week, with overtime on an as-needed basis. The estimated annual capacity of the stock business is approximately $30 million in sales at current prices
The Company's equipment is very well suited to produce nearly all of the forms products required by a forms distributor or retailer. The Company continues to monitor any new product requirements of its forms distributors and assess what new equipment or equipment modifications are required to produce the products.
OPERATIONS - ----------
The Company rents a 125,000 square foot plant and corporate office in Burlington, New Jersey and leases a 20,000 square foot plant in Fort Worth, Texas, with 5% devoted to offices, 45% to paper conversion, and 50% to warehouse. There are no union affiliations among employees at the two locations.
During the year ended September 30, 1999, the Company operated 7 custom presses, 5 stock presses, and 2 collators. The Company is evaluating the needs for an additional press to increase capacity in the custom plant.
Utilization of production capacity approximated 60% in New Jersey and 50% in Texas during the year.
Custom forms capacity continues to be converted from roll to sheeting capability as demand shifts from continuous to cut sheet custom forms. Currently, 60% of custom capacity is directed to cut sheets.
The Company has adequate domestic paper supply sources with paper mills and brokers at the present time. However, the mills are reallocating capacity to higher grade papers and are de-emphasizing forms bond used in continuous form production.
Inventory levels were maintained at approximately two weeks supply for raw material and 4-6 weeks supply for finished goods during the year.
OTHER MATTERS - -------------
The corporate structure of the Company's legal entities was reorganized in fiscal 1995. Paris Business Forms, Inc. (PBFI), the public company, transferred substantially all of the operating assets and liabilities to a newly formed subsidiary corporation, Paris Business Products, Inc. (PBP). The Texas operating corporation, Paris Business Forms, Inc. (PBFITX) and a newly formed Florida corporation, Paris Business Products, Inc. (PBPFL), are subsidiaries of PBP. PBP, PBFITX and PBPFL are operating corporations. PBF Corporation, a Delaware corporation, owns the Company trademarks and remains a subsidiary of PBFI.
In April 1997, the former President resigned his position with a severance and consulting agreement at full salary for two years guaranteed and the third year dependent on profitability of the Company. The total cost of the severance package was expensed in fiscal 1997 in the amount of $328,000.
ITEM 2
ITEM 2 - PROPERTIES
In May 1998, the Company entered into a contract to sell the office and production facility in New Jersey for a total price of $4,500,000. In addition, the Company entered into an agreement to lease the facility back for a period of three years plus, at the Company's option, an additional two three-year renewal periods. The Company has no obligation to renew the lease beyond its original term. The total gain of $1,070,661 has been deferred and is being recognized over the term of the original lease in the monthly amount of $29,741. The amount of the gain deferred at September 30, 1999 was $575,778. The total gain recognized to date was $494,883 at September 30, 1999. The lease calls for monthly rental payments of $41,667 over the term of the lease.
The Fort Worth, Texas facility was sold in June 1994 and replaced by a 45,000 square foot leased facility. In October 1999 the lease was modified, and the Company signed a three year lease reducing the facility to 20,000 square feet.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
There are no material legal proceedings in process as of the date of this filing.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the year ended September 30, 1999.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDERS MATTERS
(A) The Company's common stock is traded on the over-the-counter market and is listed on the National Association of Stock Dealers Daily Quotation Service (NASDAQ) National Market System. The Symbol for the Company is PBFI. The registrar and transfer agent is Chase Mellon Shareholder Services. The table below shows the high and low closing sale prices as reported by the National Daily Quotation Service.
The approximate number of shareholders of record as of December 17, 1999 was 200.
The Company's common stock trades on the NASDAQ stock market under the symbol PBFI. The registrar and transfer agent is Chase Mellon Shareholder Services.
In January of 1999 the Company issued a $0.20 per share special dividend. Currently it is undetermined if the Company will declare any future dividends.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The following selected financial data are derived from the financial statements of the Company. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Conditions and Results of Operations" and the financial statements and related notes thereto included herein in Item 8.
FOR THE YEAR ENDED SEPTEMBER 30, (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ($ in thousands, except statistical data)
The following discussion should be read in conjunction with the financial statements, including the related notes.
Liquidity and Capital Resources
Working capital at the end of fiscal years 1999,1998 and 1997 was $11,881, $12,426 and $9,999, respectively. Working capital decreased $545 during the fiscal year ended September 30, 1999.
Net cash provided by operating activities was $628. Accounts receivable increased $1,289 due to increased sales volume during September 1999 and extended payment terms to some customers. Accounts payable and accrued expenses increased $1,213 due to a slower payment cycle during the last quarter of the fiscal year. Inventories were maintained at normal supply levels during 1999, increasing beginning inventories of $3,456 to $4,167 by year-end.
Net cash provided by investing activities was $2,472. Restricted cash decreased $2,140 when the Company paid off the bank loan relieving the bank of their security interest in a money market account. The Company had proceeds from the sale of investments of $3,965 due primarily to the liquidation of limited partnership interests. The amount of cash invested during the year was $2,760. The Company expended $912 for the purchase of property and equipment. The Company purchased a new sheeter press in the amount of $659. The new press will support the growth of the Company's cut sheet products and value-added retail papers. Other sundry purchases in the amount of $253 were related to additions and improvements in production equipment and our Information Service department.
Net cash used in financing activities was $3,294. The bank line of credit expired on January 31, 1999 and the balance of $2,459 was paid off. The Company will meet future liquidity needs through cash provided by operations and investing activities while alternative financing sources are considered.
In January 1999, the Company paid a special dividend. The special dividend resulted in a reduction of shareholders equity of $709.
In September 1998, the Company began a buy-back program of up to 100,000 shares of its common stock at prevailing market prices. During the year the Company purchased approximately 62,000 shares at $141, offset by the sale of approximately 11,000 shares at $24.
"Year 2000" Issue
The Company has conducted a comprehensive review of its computer systems to identify the systems that could be affected by the "Year 2000" issue and has developed an implementation plan to resolve the issues. Items that were addressed under the Company's "Year 2000" compliance program are as follows:
Replacement of the main business application software and hardware with "Year 2000" compliant hardware and software retooling.
Replacement of our Electronic Data Interchange application with "Year 2000" compliant software.
The upgrade of our automated call-processing and voice-mail software to a "Year 2000" compliant release.
We believe all other manufacturing, computer systems and communications equipment are "Year 2000" compliant.
The Company modified the current software application to be "Year 2000 compliant". The cost for the modification was $40.
The conversion of the Electronic Data Interchange application is complete. The Company expects the conversion of the automated call processing /voice mail software to be completed before the new calendar year begins. Any future activities are not expected to result in significant costs.
The Company has completed a "Year 2000" compliance survey of all vendors and has not identified any exposure to non "Year 2000" compliance.
1999 compared to 1998
Net sales for the fiscal year ended September 30, 1999 increased 1.63% or $569 due to (1) increased revenue from the retail segment (value added papers, mill cut sheets, RCI and Poly products) of $4,400 (2) increased revenue in other products such as custom cutsheets, Laser 3 and DocuGard of $985 (3) lower sales allowances and rebates of $184 and (4) offset by decreased revenue in the stock segment of $5,000.
Cost of sales for the fiscal year ended September 30, 1999 decreased 1.55%, or $494 compared to the previous year. The lower cost in comparison to 1998 is a result of the sales of higher margin product as evidenced by the changing product mix above. In addition, despite the increased sales volume, freight expense declined $89 or 6.5% due to better management in controlling these costs. Offsetting these cost reductions was increased overhead expense due to production inefficiencies and excess capacity.
Gross profit increased $1,062 or 35% in fiscal 1999 as compared to fiscal 1998 from $3,012 to $4,074 due to the above factors.
Selling expenses, marketing costs and administrative expenses increased $33 in 1999 from $3,775 to $3,808. Sales and marketing expenses were $162 higher due principally to increased salary and benefit expenses. During the year, the Company hired a National Sales Manager to lead the Commercial sales effort and a Vice President of Sales and Marketing to lead the Retail segment. General and administrative expenses decreased $130 due to a favorable settlement of a sales and use tax audit. The Company received final notice from the taxing authority during the third quarter with no additional sales or use tax due.
Interest expense decreased $214 due to the pay off of the working capital line of credit in January 1999.
Other income, net in fiscal 1999 exceeded fiscal 1998 by $376 due to (1) income recognized on the liquidation of the limited partnerships of $189 (2) amortization on the gain on the sale of the building of $157 and (3) other net income of $30.
Inflation is not expected to have a material adverse effect on future sales earnings.
1998 compared to 1997
Net sales for the fiscal year ended September 30, 1998 decreased 33% or $16,810 due to (1) a 49% decline in stock forms ($17,172), attributable to the loss of two major customers and lower overall demand for these products; (2) the Company's decision to exit the computer hardware business resulted in a sales decline of $2,912 for this product line; (3) sales of miscellaneous business products decreased $262 as a result of an increased focus on other product lines; (4) offsetting these decreases was a 27% increase in custom forms, Laser3/DocuGard and Burlington, the retail line; (5) sales discounts, rebates and allowances were reduced $893, or 66% due to lower rebate expense due to the loss of the two major stock forms customers and the decision to exit the hardware business.
Cost of sales for the fiscal year ended September 30, 1998 decreased 35% ($17,564) compared to last year. The decrease in the cost of sales is relative to the decrease in sales of 33%. The incremental decrease in cost of sales relative to the sales decline is due to (1) favorable paper costs; (2) decreased freight and distribution costs due to tighter management controls on both the costs of shipping and the pass-through of freight cost to the customer; (3) offsetting these cost reductions was increased overhead expense due to production inefficiencies and excess capacity.
Gross profit increased $754 in fiscal 1998 as compared to fiscal 1997 from $2,258 to $3,012 due to the above factors.
Selling expenses, marketing costs and administration expenses decreased $1,855 this year, from $5,630 to $3,775. Sales and marketing expenses were $487 lower in fiscal 1998 due principally to the reduction of salary and benefit expenses as a result of head count reductions, and general and administrative expenses decreased $1,367 on a comparative basis due to (1) decreased salary and benefits of $728; (2) a reduction in professional fees of $133; (3) lower depreciation of $132; (4) decreased telephone expenses of $77; (5) reduced bad debt expense of $128, and a reduction in other sundry expenses of $177.
Interest expense decreased $44, or 14%, due to a reduced level of bank debt maintained over the last two years.
Other income, net in fiscal 1998 exceeded fiscal 1997 by $483 due to (1) increased investment income and lower investment fees, net, of $250; (2) the settlement of a third-party warehouse services contract in 1997 of $150; (3) increased gain on fixed asset disposal of $108 due to the amortization of the gain on the sale of the New Jersey production facility.
1997 compared to 1996
Net sales for the fiscal year ended September 30, 1997 decreased 10% or $5,769 due to (1) a 16% decline in stock and custom continuous forms volume ($7,287), attributable to the lower overall market demand for these products and 13% lower sell prices; (2) 9% lower year to year sales of cut sheet products despite value added stock and custom products gains of 28% ($1,348) due to offsetting 35% lower sales of commodity cut sheets ($2,470); and (3) an increase in hardware (primarily computer scanners) sales ($2,417) primarily reflecting purchases by one major retail store.
Fiscal 1997 was characterized by significant price pressure with average sell prices dropping 21% across all paper products, both continuous and cut sheet. Cut sheet unit volume was up 44% due to greater market demand for inkjet and laser printer papers. Continuous form unit volume was down 16% if sales to two major former accounts are excluded, but down only 4% overall.
Cost of sales for the fiscal year ended September 30, 1997 decreased 13% ($7,370) compared to last year. The lower product costs this year relative to sales (costs decreased 13% vs. a sales decrease of 10%) were primarily due, on a comparative basis, to the buying and inventory problems of the prior year which had caused disproportionately high product costs. Normal inventory levels were maintained throughout fiscal 1997 and sell prices moved in unison with lower raw paper costs. In addition, the company reduced product costs at a faster rate than the decrease in sales by increasing factory productivity and by implementing cost reduction programs in the company's two plants. Freight costs as a percentage of sales increased 21% due to the cost of distributing to the west coast in support of the company's former largest customer.
Gross profit increased $1,601 in fiscal 1997 as compared to FY96 from $656 to $2,257. The disproportionately high product costs of last year, due to the effect of the excessive inventories, contributed approximately $2,500 of the gross profit gain. This comparative gain was offset by the effect of sell prices dropping at a faster rate than the cost of raw paper ($600), lower unit volumes ($600), and higher freight costs ($260). Labor productivity and cost reduction programs added $300 of gross profit to fiscal 1997. In addition, hardware sales contributed approximately $260 to the gross profit increase.
Selling expenses, marketing costs, and administration expenses decreased $522 this year, from $6,151 to $5,629.
Sales and marketing expenses were $833 lower in fiscal 1997 due principally to the elimination or reduction of advertising, promotion, direct mail campaigns, public relations, travel and entertainment expenses deemed unnecessary to support our new product offerings, as well as the reduction of payroll costs.
General and administrative expenses increased $417 on a comparative basis due (1) to the termination of a deferred compensation plan in FY96 resulting in a reversal of accrued liabilities ($400) in that year; (2) an increase in the required bad debt reserve ($240) due to customer bankruptcies; (3) offset by a reduction in payroll cost ($183).
Interest expense in the comparative years was relatively flat proportionate to the equal level of bank debt maintained over the last two years.
Other income, net in FY96 exceeded fiscal 1997 by $294 due to (1) lower investment income this year ($479); (2) the settlement of a third party warehouse services contract ($150), offset by (3) equity in the earnings of Signature Corp., a 44% owned affiliate ($279); and (4) gains on the sale of equipment ($56).
Income tax benefit in fiscal 1997 is at an effective tax rate of 25% due to the lack of assurance of realization of the loss carryforward benefits for state income taxes. All operating losses for federal income taxes can be carried back and fully utilized.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Refer to Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED FINANCIAL STATEMENTS: PAGE
CONSOLIDATED BALANCE SHEET AS OF SEPTEMBER 30, 1999 AND 1998 13
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 1999, 1998, AND 1997 14
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 15
CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 16
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 17 - 28
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS 29
INDEPENDENT AUDITORS' REPORT 30
FINANCIAL STATEMENT SCHEDULES NOT INCLUDED IN THIS FORM 10-K HAVE BEEN OMITTED BECAUSE THEY ARE NOT APPLICABLE OR THE REQUIRED INFORMATION IS SHOWN IN THE FINANCIAL STATEMENTS OR NOTES THERETO.
Consolidated Balance Sheet --------------------------
See Notes to Consolidated Financial Statements
Consolidated Statement of Operations ------------------------------------
See Notes to Consolidated Financial Statements
Consolidated Statement of Changes in Shareholder's Equity ----------------------------------------------------------
See Notes to Consolidated Financial Statements
Consolidated Statement of Changes in Shareholder's Equity ---------------------------------------------------------
See Notes to Consolidated Financial Statements
Consolidated Statement of Cash Flows ------------------------------------
See Notes to Consolidated Financial Statements
NOTE 1 - NATURE OF OPERATIONS
Paris Corporation and subsidiaries (collectively, the "Company") manufacture stock and custom business forms, provide value added services to cut sheet products, and distributes plastic and office products and computer/printer peripheral products. The Company manufactures stock and custom forms in Burlington, New Jersey and stock forms in Fort Worth, Texas. The Company markets through retailers, resellers, and dealers throughout the United States and Canada.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Actual results could differ from those estimates.
Cash and Cash Equivalents Cash and cash equivalents include cash on deposit and money market accounts.
Financial Instruments The carrying amounts of cash and cash equivalents, restricted cash, accounts receivable, prepaid expenses, accounts payable and accrued expenses, note payable and note payable, bank approximate their fair values at September 30, 1999 and 1998.
Investments Management determines the appropriate classification of investment securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. The classification of those securities and the related accounting policies are as follows:
Available-for-sale securities: Available-for-sale securities consist of marketable equity and debt securities not classified as trading securities. Available-for-sale securities are stated at fair value based on quoted market prices and unrealized holding gains and losses are reported as a separate component of shareholders' equity, net of tax, except for permanent impairments in value which are recognized in current earnings. Realized gains and losses are included in income.
Held-to-Maturity securities: Held-to Maturity securities consist of marketable debt securities that the Company has the intent and ability to hold to maturity and are reported at amortized cost.
The Company accounts for investments in limited partnerships under the equity method of accounting.
Inventories Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method (FIFO).
Property and Equipment Property and equipment are stated at cost. Expenditures for renewals and betterments which increase the useful life or capacity of property and equipment are also capitalized at cost. Expenditures for repairs and maintenance are charged to expense as incurred. Gain or loss on the retirement or disposal of capital assets is reflected in income in the period of disposal.
Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives of the property and equipment range from three to seven years. Depreciation expense was $531,817, $769,618 and $1,089,003 in 1999, 1998 and 1997, respectively.
Other Assets The Company provides display racks to its resellers for the display of its goods in stores. These display racks are amortized on the straight-line basis over eighteen months commencing when the display racks are shipped to the resellers. Amortization expense was $23,843 in 1999.
Per Share Data In 1998, the Company adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS No. 128"). Earnings per share information has been restated for all prior periods presented as prescribed by SFAS No. 128. The adoption of SFAS No. 128 had no effect on previously reported loss per share. The anti-dilutive effect of conversion of the Company's stock options causes such conversion to be excluded from the computation of diluted loss per share for the years ended September 30, 1998 and 1997.
The following table sets forth the computation of basic earnings (loss) per share:
The following table sets forth the computation of diluted earnings (loss) per share:
Stock-Based Compensation As permitted by Statement of Financial Accounting Standards No. 123 "Accounting For Stock-Based Compensation," the Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25"). Under APB 25, no compensation expense is recognized at the time of option grant because the exercise price of the Company's employee stock option equals the fair market value of the underlying common stock on the date of grant.
Income Taxes The Company accounts for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned and majority owned subsidiaries. All intercompany transactions and balances have been eliminated.
Comprehensive Income At October 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 established new standards for reporting and display of comprehensive income and its components. Comprehensive income consists of net income and unrealized gains and losses on certain investments in marketable debt and equity securities and is presented in the statement of changes in shareholders' equity. The adoption of SFAS No. 130 had no effect on the Company's net income or equity. Prior year financial statements have been reclassified to conform to SFAS No. 130 requirements.
Accounting Pronouncements
In May 1999, the Financial Accounting Standards Board issued Statement No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" ("SFAS No. 137"), which defines the effective date of Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes standards for derivative instruments and hedging activities to be recognized as either assets or liabilities and to measure those instruments at fair value. The amended SFAS No. 133 is effective for financial statements relating to fiscal years beginning after June 15, 2000. The adoption of SFAS No. 133 will have no impact on the Company's results of operations, financial position or cash flows.
Reclassifications Certain amounts reported in the 1998 and 1997 financial statements have been reclassified to conform to the 1999 presentation.
NOTE 3 - INVESTMENT IN SIGNATURE CORPORATION
Prior to August 31, 1999, Paris Corporation held a 44% interest in Signature Corporation ("Signature") which was accounted for using the equity method of accounting. Subsequent to August 31, 1999, as a result of a stock tender by a Signature minority shareholder, the Company's interest in Signature increased to 57%. This change in ownership percentage in Signature was accounted for as a purchase and Signature has been consolidated in the accompanying financial statements. The results of operations of Signature have been included in the accompanying statement of operations for the one month period of September 30, 1999. Signature is a wholesaler of plastic and other office products.
The following proforma results of operations information has been prepared to give effect to the purchase as if such transaction had occurred at the beginning of the period presented. The information presented is not necessarily indicative of results of future operations of the combined companies.
PROFORMA RESULTS OF OPERATIONS (UNAUDITED)
NOTE 4 - INVESTMENTS
Investments at September 30, 1999 and 1998, are summarized as follows:
Gross unrealized holding gains and losses at September 30, 1999 and 1998, are as follows:
Proceeds from the sale of securities classified as available-for-sale for the years ended September 30, 1999 and 1998 were $460,699 and $588,635, respectively. For the purpose of determining gross realized gains and losses, the cost of securities sold is based upon specific identification.
Other Investments Other investments consist of interests in limited partnerships. The limited partnerships invest in publicly traded securities with readily determinable market values. The Company accounts for these investments utilizing the equity method of accounting. Income and losses are recorded based on the Company's beneficial interest. The limited partnership interests were $2,903,559 in 1998. The limited partnership interests were sold during 1999 for gross proceeds of $3,503,884 which resulted in a gross realized gain of $431,824.
NOTE 5 - INVENTORIES
Inventories consist of the following at September 30, 1999 and 1998:
NOTE 6 - PROPERTY AND EQUIPMENT
Property and equipment consist of the following at September 30, 1999 and 1998:
NOTE 7 - NOTE PAYABLE, BANK
The Company had a revolving line of credit with a bank that expired in January 1999. Borrowings at September 30, 1998 were $2,459,052.
NOTE 8 - NOTE PAYABLE
In connection with the Signature stock tender (Note 3), Signature converted $100,630 of accounts payable into a promissory note. The note is payable in monthly installments of $9,059 with interest at 14.5%. The note matures in August 2000. At September 30, 1999, the outstanding balance was $92,787.
NOTE 9 - INCOME TAXES
The composition of the (expense) benefit for income taxes for the years ended September 30, 1999, 1998 and 1997 is as follows:
The 1997 federal tax benefit reflects the realization of the Company's net deferred tax assets due to the carryback of the taxable loss. The Company has state net operating loss carryforwards of approximately $12,265,000, available to offset future state taxable income. The state net operating loss carryforwards expire in the years 2000 through 2004.
Reconciliations of income taxes with the amounts that would result from applying the U.S statutory rate are as follows:
The components of the net deferred tax asset at September 30, 1999 and 1998 are as follows:
These amounts have been presented in the financial statements as follows:
The increase in the valuation allowance is related to the increase in state and federal loss carryforwards in part resulting from the Signature transaction.
NOTE 10 - SHAREHOLDERS' EQUITY
In November 1995, the Board of Directors adopted the Company's 1995 Stock Option Plan to permit the issuance of incentive stock options under Section 422 of the Internal Revenue Code. There are 500,000 shares of common stock authorized for non-qualified and incentive stock options under the plan, which are subject to adjustment in the event of stock splits, stock dividends and other situations. Under the plan, no options may be granted more than ten years after the effective date of the plan. The exercise price of all incentive stock options granted under the option plan may be no less than fair market value of such shares on the date of grant. Stock option activity for 1999, 1998 and 1997 is as follows:
Options outstanding at September 30, 1999 have an average exercise price of $3.50 and a remaining contractual life of 6.1 years. Options outstanding at September 30, 1998 have an average exercise price of $3.65 and a remaining contractual life of 5.8 years. Options outstanding at September 30, 1997 have an average exercise price of $3.97 and a remaining contractual life of 6.8 years.
Statement of Financial Accounting Standards No. 123 ("SFAS No. 123") requires pro forma information regarding net income (loss) and earnings (loss) per share as if the Company has accounted for its employee stock options granted under the fair value method of SFAS No. 123. The fair value of these equity awards was estimated at the date of grant using the Black-Scholes option pricing methods. The weighted average assumptions used were: risk free interest rate of 6.00%; expected volatility of 1.08%; expected option life of five to ten years and an expected dividend rate of 0.0%.
The proforma effect on net income (loss) and earnings (loss) per share is as follows:
NOTE 11 - COMMITMENTS AND CONTINGENCIES
Leases The Company has certain operating leases, primarily for its New Jersey and Texas operating facilities, expiring at various dates.
Rental expense amounted to $562,919 in 1999; $372,773 in 1998; and $323,076 in 1997.
As of September 30, 1999, minimum rental payments under noncancelable operating leases were as follows:
In May 1998, the Company entered into a contract to sell its office and production facility in New Jersey for a total price of $4,500,000. In addition, the Company entered into an agreement to lease the facility back for a period of three years plus, at the Company's option, an additional two three year renewal periods. The Company has no obligation to renew the lease beyond its original term. The total gain of $1,070,661 has been deferred and is being recognized over the term of the original lease in the monthly amount of $29,741. The amount of the gain deferred was $575,778 and $932,664 at September 30, 1999 and 1998, respectively. The total gain recognized to date was $494,883 and $137,997 at September 30, 1999 and 1998, respectively. The lease calls for monthly rental payments of $41,667 over the term of the lease.
Service Contract
The Company had an agreement with an outside contractor to perform warehousing and distribution services for the Fort Worth, Texas facility. The services included staffing and managing personnel, provision of all equipment, material, and services in order to maintain the facility, and the design of a warehouse management system. The agreement was terminated in May 1997. The Company incurred a charge of $150,000 which is classified in other income, net related to the early termination of the contract. Service contract expense was $91,322 in 1997.
Contingencies
The Company has agreements with certain customers and vendors which include potential rebates, commissions and other liabilities upon the fulfillment of certain terms and conditions. Management has estimated and recorded contingent liabilities of approximately $237,000 and $54,000 at September 30, 1999 and 1998, respectively, related to these agreements and other potential liabilities.
Purchase Commitment
During 1999, the Company amended a previous sales agreement with Boise Cascade Corporation. The amendment calls for the Company to purchase a minimum of $11,000,000 of office papers from Boise Cascade for resale to Best Buy by September 30, 2001. Cumulative purchase levels are set forth in the agreement. If the Company does not reach these interim totals or the minimum cumulative total, the Company will be subject to penalties.
NOTE 12 - PROFIT SHARING AND DEFERRED COMPENSATION PLAN
The Company has a defined contribution plan covering substantially all employees. Employer contributions were $66,213 in 1999, $73,591 in 1998 and $105,262 in 1997.
In April 1997, the Board of Directors approved a severance and consulting agreement with the former President upon his resignation. The agreement provides for guaranteed payments for two years aggregating $164,000 for severance and $164,000 for consulting services, respectively. The Company expensed the entire $328,000 liability in fiscal 1997.
NOTE 13 - SEGMENT INFORMATION
The Company operates in three basic segments or lines of business. These segments are (1) stock continuous forms and cutsheets, (2) custom continuous forms and cutsheets, and (3) retail papers and office products, including computer/printer hardware and software products. The following table sets forth certain financial information with respect to these segments and reconciles such information to the consolidated financial statements.
Segment operating income (loss) is determined by deducting from sales of products and services, cost of products sold, and selling, general and administrative expenses directly related or allocable to the segment. Not included in segment operating income are certain income and expense items such as interest income and expense, other income, minority interest and income taxes.
The reporting segments follow the same accounting policies used for the Company's consolidated financial statements and described in the summary of significant accounting policies. Management evaluates a segment's performance based on profit or loss from operations before income taxes and minority interest.
NOTE 14 - OTHER EXPENSE (INCOME), NET
Other expense (income), net, consists of the following for the years ended September 30, 1999, 1998 and 1997:
NOTE 15: CONCENTRATIONS OF CREDIT RISK
The Company maintains investment accounts with several stock brokerage firms. The accounts contain cash and securities. Balances are insured up to $500,000 (with a limit of $100,000 for cash) by the Securities Investor Protection Corporation.
During the year ended September 30, 1999, approximately 20% of the Company's sales were to two customers in the retail segment, including sales of $4,498,063 to one customer in this segment.
NOTE 16: STOCK BUY-BACK PROGRAM
In September 1998, the Company began a buy-back program of up to 100,000 shares of its common stock at prevailing market prices. At September 30, 1999, the Company purchased 61,800 shares of its common shares under this program.
PARIS CORPORATION ----------------- SCHEDULE II ----------- VALUATION AND QUALIFYING ACCOUNTS ---------------------------------
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
INDEPENDENT AUDITORS' REPORT ----------------------------
To The Shareholders and Board of Directors of Paris Corporation Burlington, New Jersey:
We have audited the accompanying consolidated balance sheet of Paris Corporation and subsidiaries as of September 30, 1999 and 1998, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended September 30, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Paris Corporation and subsidiaries as of September 30, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1999 in conformity with generally accepted accounting principles.
Our audits referred to above also included audits of the financials statement schedules listed under Item 14(a) (2). In our opinion, those financial statement schedules present fairly, in all material respects, in relation to the basic consolidated financial statements taken as a whole, the information required to be stated therein.
/s/ Parente, Randolph, Orlando, Carey & Associates, LLC
Philadelphia, Pennsylvania November 19, 1999
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Directors of the Company are elected for a term of one year. The current Directors and Officers of the Company, together with their ages, positions, backgrounds, and business experiences are set forth below:
(1) Member of Compensation and Stock Option Committee (2) Member of Audit Committee (3) Member of the Investment and Finance Committee (4) Dominic P. Toscani, Sr. is the father of Gerard M. Toscani
Dominic P. Toscani, Sr. is the founder of the Company, has served as a Director and has been responsible for its management since its inception. Prior to the founding of the Company, Mr. Toscani was a practicing attorney.
Gerard M. Toscani became a Director of the Company in 1992. He was appointed Senior Vice President during fiscal 1990 and was the Company's Vice President of Sales and Marketing since January 1987. He previously served as Sales and Marketing Manager since September 1982.
Palmer E. Retzlaff became a Director in November 1993. He has been President of Southwest Grain Co., Inc. since 1973. Previously he was the General Manager of the Philadelphia Eagles.
Frank A. Mattei was elected to the Board of Directors in March 1986. He has been a practicing orthopedic surgeon over the past five years and is associated with North Philadelphia Health System, (formerly Girard Medical Center), and St. Agnes Medical Center in Philadelphia.
Oscar Tete was elected to the Board of Directors in March 1986. Mr. Tete retired in 1990. He was an Executive Vice President of First Fidelity Bank in Burlington, New Jersey since 1972.
John Petrycki was elected to the Board of Directors in August 1995. Mr. Petrycki retired in 1995. He was President and CEO of PNC Bank in south central Pennsylvania.
William L. Lomanno became Chief Financial Officer in April 1998. He has been with the Company for eight years and has previously served as the Controller and Accounting Manager for the Company.
ITEM 11
ITEM 11 - SUMMARY COMPENSATION
The following table contains information regarding the individual compensation of the two most highly compensated officers of the Company in fiscal years 1999, 1998 and 1997.
Summary Compensation Table
(1) Represents the use of a company car.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS (AS NOVEMBER 15, 1999)
* Less than 1%
(1) Based on 3,504,245 shares outstanding and 364,300 options currently exercisable on November 15, 1999.
(2) Includes 1,019,237 shares personally held; 47,006 shares held by Paris Corporation Profit Sharing Plan of which Mr. Toscani is the Plan Trustee; 14,745 shares held by Toscani Investment Company, a family partnership; and 67,000 options exercisable as of November 15, 1999.
(3) The Caritas Foundation, a tax exempt organization formed under Section 501(C)(3) of the Internal Revenue Code of 1954, as amended, was organized in 1984 by Dominic P. Toscani, Sr. to promote the objectives of free enterprise and to support individual freedom. At the present time Reverend Peter Toscani, O.S.A., is sole trustee of the foundation.
(4) Includes options currently exercisable individually and all officers as a group (217,000).
SECURITY OWNERSHIP OF MANAGEMENT AS OF NOVEMBER 15, 1999
* Less than 1%
(1) Based on 3,504,245 shares outstanding and 364,300 options currently exercisable on November 15, 1999.
(2) Includes 1,019,237 shares personally held; 47,006 shares held by Paris Corporation Profit Sharing Plan of which Mr. Toscani is the Plan Trustee; 14,745 shares held by Toscani Investment Company, a family partnership; and 67,000 options exercisable as of November 15, 1999.
(3) The Caritas Foundation, a tax exempt organization formed under Section 501(C)(3) of the Internal Revenue Code of 1954, as amended, was organized in 1984 by Dominic P. Toscani, Sr. to promote the objectives of free enterprise and to support individual freedom. At the present time Reverend Peter Toscani, O.S.A., is sole trustee of the foundation.
(4) Includes options currently exercisable individually and all officers as a group (217,000).
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
There are no other material relationships or transactions which qualify for disclosure under this caption.
PART IV
ITEM 14
ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
This consolidated financial statements and related schedules filed as part of this Annual Report on Form 10-K are included in Part II, Item 8.
REPORTS ON FORM 8-K
None.
EXHIBITS:
The following exhibits (with the exception of Exhibit 3.4, 10.5(b), 10.7 and 22(a)) are incorporated by reference to the Company's registration statement on Form S-18 (no.-3-3344-W) filed February 13, 1986 with the Securities and Exchange Commission and effective March 25, 1986. Exhibit 3.4, 10.5(b) and 10.7 are incorporated by reference to the Company's fiscal 1989 Form 10-K filed with the Securities and Exchange Commission on December 19, 1989. Exhibit 22(a) is incorporated by reference to the Company's fiscal 1990 Form 10-K filed with the Securities and Exchange Commission on December 27, 1991.
3.1 Articles of Incorporation of the Company. 3.2 Amendment to Articles of Incorporation, dated January 6, 1986. 3.3 Amendment to Articles of incorporation, dated January 7, 1986. 3.4 By-laws of Company, as amended. 4.2(a) Form of Warrant to Purchase Common Stock of Company. 10.5 Company's Profit Sharing Plan, dated October 1, 1979. 10.5(a) Amendment to Profit Sharing Plan, dated October 2, 1985. 10.5(b) Amendment to Profit Sharing Plan, dated October 1, 1986. 10.6 Company's Stock Option Plan, dated October 1, 1985. 10.7 Line of Credit (loan agreement) of $2,000,000 from the Fidelity Bank. 10.9 Bucks County Industrial Development Authority Loan Agreement for 1,500,000 dated April 10, 1985. 10.9(a) Letter Amendment, dated March 4, 1986 from Special Counsel to Fidelity Bank. 10.9(b) Letter Amendment, dated March 5, 1986 from Fidelity Bank to Special Counsel. 10.10 New Jersey Economic Development Authority Note for 3,000,000 by Company, dated September 10, 1985. 10.10(a) Letter Agreement, dated March 4,1986 from Special Counsel to Fidelity Bank. 10.10(b) Letter Amendment dated March 5, 1986 from Fidelity Bank to Special Counsel. 10.10(c) Letter dated, March 24, 1986 from Special Counsel to Fidelity Bank with respect to the New Jersey Economic Development Authority Loan. 21(a) List of Subsidiaries.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf by the undersigned, thereunto duly authorized.
PARIS CORPORATION
Date: December 29, 1999 By: /s/ Dominic P. Toscani, Sr. ---------------------- --------------------------------------- Dominic P. Toscani, Sr. (President, Chairman Board of Directors)
Date: December 29, 1999 By: /s/ William L. Lomanno ---------------------- --------------------------------------- William L. Lomanno (Chief Financial Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURES | 8,801 | 56,987 |
310614_1999.txt | 310614_1999 | 1999 | 310614 | Item 1. Business - ----------------
Balcor Equity Properties Ltd.-VIII (the "Registrant") is a limited partnership formed in 1979 under the laws of the State of Illinois. The Registrant raised $30,005,000 from sales of Limited Partnership Interests. The Registrant has retained cash reserves from the sale of its real estate investments for contingencies which exist or may arise. The Registrant's operations currently consist of interest income earned on short-term investments and the payment of administrative expenses.
The Registrant utilized the net offering proceeds to acquire thirteen real property investments and has since disposed of all of these properties. The Partnership Agreement provides that the proceeds of any sale or refinancing of the Registrant's properties will not be reinvested in new acquisitions.
The Partnership Agreement provides for the dissolution of the Registrant upon the occurrence of certain events, including the disposition of all its interests in real estate. The Registrant sold its final real estate investment in July 1997. The Registrant has retained a portion of the cash from the property sales to satisfy obligations of the Registrant as well as to establish a reserve for contingencies. The timing of the termination of the Registrant and final distribution of cash will depend upon the nature and extent of liabilities and contingencies which exist or may arise. Such contingencies may include legal and other fees and costs stemming from litigation involving the Registrant including, but not limited to, the Masri lawsuit discussed in "Item 3. Legal Proceedings." Due to this litigation, the Registrant will not be dissolved and reserves will be held by the Registrant until the conclusion of such contingencies. There can be no assurances as to the time frame for the conclusion of all contingencies.
The Registrant no longer has an ownership interest in any real estate investment. The General Partner is not aware of any material potential liability relating to environmental issues or conditions affecting real estate formerly owned by the Registrant.
The officers and employees of BRI Partners-79, the General Partner of the Registrant, and its affiliates perform services for the Registrant. The Registrant currently has no employees engaged in its operations.
Item 2.
Item 2. Properties - ------------------
As of December 31, 1999, the Registrant did not own any properties.
In the opinion of the General Partner, the Registrant has obtained adequate insurance coverage for property liability and property damage matters.
See Notes to Financial Statements for other information regarding former real property investments.
Item 3.
Item 3. Legal Proceedings - -------------------------
Raymond Masri vs. Lehman Brothers, Inc., et al. - -----------------------------------------------
On February 29, 1996, a proposed class action complaint was filed, Raymond Masri vs. Lehman Brothers, Inc., et al., Case No. 96/103727 (Supreme Court of the State of New York, County of New York). The Partnership, twelve additional limited partnerships which were sponsored by The Balcor Company, three limited partnerships sponsored by the predecessor of Lehman Brothers, Inc., (together with the Partnership, the "Defendant Partnerships"), Lehman Brothers, Inc. and Smith Barney, Inc. are defendants. The complaint alleges, among other things, common law fraud and deceit, negligent misrepresentation and breach of fiduciary duty relating to the disclosure of information in the offering of limited partnership interests in the Defendant Partnerships. The complaint seeks judgment for compensatory damages equal to the amount invested in the Defendant Partnerships by the proposed class plus interest accrued thereon; general damages for injuries arising from the defendants' alleged actions; recovery from the defendants of all profits received by them as a result of their alleged actions relating to the Defendant Partnerships; exemplary damages; attorneys' fees and other costs. No activity occurred on this matter during 1999.
The defendants intend to vigorously contest this action. No class has been certified as of this date. Management of each of the defendants believes they have meritorious defenses to contest the claims.
Madison Partnership Liquidity Investors XX, et al. vs. The Balcor Company, et - ----------------------------------------------------------------------------- al. - --- Sandra Dee vs. The Balcor Company, et al. - -----------------------------------------
On May 7, 1999, a proposed class action complaint was filed and on May 13, 1999 was served on the defendants, Madison Partnership Liquidity Investors XX, et al. vs. The Balcor Company, et al. (Circuit Court, Chancery Division, Cook County, Illinois, Docket No. 99CH 08972). The General Partner of the Partnership, the general partners of twenty-one additional limited partnerships which were sponsored by The Balcor Company, The Balcor Company and one individual are named as defendants in this action. The Partnership and the twenty-one additional limited partnerships are referred to herein as the "Affiliated Partnerships". Plaintiffs are entities that initiated tender offers to purchase units and, in fact, purchased units in eleven of the Affiliated Partnerships.
On June 1, 1999, a proposed class action complaint was filed and on August 16, 1999 was served on the defendants, Sandra Dee vs. The Balcor Company, et al. (Circuit Court, Chancery Division, Cook County, Illinois, Docket No. 99CH 08123). This complaint is identical in all material respects to the Madison Partnership Liquidity Investors XX, et al. vs. The Balcor Company et al. complaint filed in May 1999. The defendants filed on September 15, 1999 a motion to consolidate the Dee case with the Madison Partnership case. On September 20, 1999, the motion was granted and this case was consolidated with the Madison Partnership case.
The complaints allege breach of fiduciary duties and breach of contract under the partnership agreements for each of the Affiliated Partnerships. complaints seek the winding up of the affairs of the Affiliated Partnerships, the establishment of a liquidating trust for each of the Affiliated Partnerships until a resolution of all contingencies occurs, the appointment of an independent trustee for each such liquidating trust and the distribution of a portion of the cash reserves to limited partners. The complaints also seek compensatory damages, punitive and exemplary damages, and costs and expenses in pursuing the litigation.
The defendants filed motions to dismiss the complaints on July 14, 1999 and on September 15, 1999. On January 19, 2000 a hearing on the motions was held and the class allegations in the complaints were struck regarding the Partnership and ten of the Affiliated Partnerships in which plaintiffs do not own interests. In all other respects, the motions to dismiss were denied. While the court directed the plaintiffs to file an amended complaint by February 18, 2000, as of this date they have yet to do so.
The defendants intend to vigorously contest this action. No class has been certified as of this date.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------
No matters were submitted to a vote of the Limited Partners of the Registrant during 1999.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholder - ------------------------------------------------------------------------- Matters - -------
There has not been an established public market for Limited Partnership Interests and it is not anticipated that one will develop. For information regarding distributions, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources".
As of December 31, 1999, the number of record holders of Limited Partnership Interests of the Registrant was 2,793.
Item 6.
Item 6. Selected Financial Data - -------------------------------
Year ended December 31, ---------------------------------------------------------- 1999 1998 1997 1996 1995 ---------- -------- ---------- -------- --------
Total income $41,311 $49,015 $2,054,040 $5,117,065 $6,043,472 (Loss) income before gain on sales of properties and extraordinary item (66,660) (119,947) (717,805) (444,820) 135,417 Net (loss) income (66,660) (119,947) 8,409,487 5,574,237 135,417 Net (loss) income per Limited Partnership Interest-Basic and Diluted (2.22) (4.00) 275.35 183.92 4.47 Total assets 823,637 886,720 1,028,006 10,225,202 12,335,453 Mortgage notes payable None None None 12,028,777 15,212,762 Distributions per Limited Partnership Interest (A) None None 167.00 147.50 100.57
(A) These amounts include distributions of original capital of $167.00, $140.00 and $59.74 per Limited Partnership Interest for the years 1997, 1996 and 1995, respectively.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and - ----------------------------------------------------------------------- Results of Operations - ---------------------
Operations - ----------
Summary of Operations - ---------------------
The operations of Balcor Equity Properties Ltd.-VIII (the "Partnership") in 1999 and 1998 consisted primarily of administrative expenses which were partially offset by interest income earned on short-term investments. Primarily as a result of lower administrative expenses in 1999, the Partnership's net loss decreased during 1999 as compared to 1998. The Partnership sold its four remaining properties in 1997 and recognized gains in connection with the sales, which resulted in the Partnership recognizing net income during 1997. Further discussion of the Partnership's operations is summarized below.
1999 Compared to 1998 - ---------------------
Primarily as a result of lower interest rates during 1999, interest income on short-term investments decreased during 1999 as compared to 1998.
During 1998, the Partnership paid property operating expenses related to three of the properties sold in 1997.
Primarily due to a decrease in accounting and legal fees, administrative expenses decreased during 1999 as compared to 1998.
1998 Compared to 1997 - ---------------------
In 1997, the Partnership sold its four remaining properties; the Cedar Creek Phases I and II apartment complexes and the Walnut Hills Phases I and II apartment complexes and recognized aggregate gains on sales of $9,635,582. As a result, rental and service income, interest expense on mortgage notes payable, depreciation expense, amortization expense, real estate tax expense and property management fees expense ceased during 1997.
Higher average cash balances were available for investment during 1997 due to proceeds retained from the sale of the Greentree Village Apartments in 1996 for working capital requirements and proceeds received in connection with the 1997 sales of the Cedar Creek Phases I and II and Walnut Hills Phases I and II apartment complexes prior to distribution to Limited Partners in August 1997. As a result, interest income on short-term investments decreased during 1998 when compared to 1997.
The Partnership recognized other income during 1997 primarily in connection with partial refunds of prior years' insurance premiums relating to the Partnership's properties.
Property operating expenses decreased during 1998 as compared to 1997 due to the sale of the Partnership's four remaining properties in 1997.
Primarily as a result of lower accounting, data processing, portfolio management and bank fees, administrative expenses decreased during 1998 as compared to 1997.
In 1997, the Partnership wrote-off the remaining unamortized deferred financing fees totaling $268,717, and paid prepayment penalties totaling $239,573 in connection with the sales of the Cedar Creek - Phases I and II and the Walnut Hills - Phases I and II apartment complexes. These amounts were recognized as extraordinary items and classified as debt extinguishment expense for financial statement purposes.
Liquidity and Capital Resources - -------------------------------
The cash position of the Partnership decreased by approximately $64,000 as of December 31, 1999 as compared to December 31, 1998 due to cash used in operating activities for the payment of administrative expenses, which was partially offset by interest income earned on short-term investments.
The Partnership Agreement provides for the dissolution of the Partnership upon the occurrence of certain events, including the disposition of all its interests in real estate. The Partnership sold its final real estate investment in July 1997. The Partnership has retained a portion of the cash from the property sales to satisfy obligations of the Partnership as well as to establish a reserve for contingencies. The timing of the termination of the Partnership and final distribution of cash will depend upon the nature and extent of liabilities and contingencies which exist or may arise. Such contingencies may include legal and other fees and costs stemming from litigation involving the Partnership including, but not limited to, the Masri lawsuit discussed in "Item 3. Legal Proceedings". Due to this litigation, the Partnership will not be dissolved and reserves will be held by the Partnership until the conclusion of such contingencies. There can be no assurances as to the time frame for the conclusion of all contingencies.
The Partnership made a distribution of Net Cash Proceeds in 1997 totaling $167.00 per Limited Partnership Interest. See Statement of Partners' Capital (Deficit) for additional information. The Partnership made no distributions in 1999 or 1998.
Limited Partners have received distributions totaling $622.57 per $1,000 Interest, as well as certain tax benefits. Of this amount, $173.33 represents Cash Flow from operations and $449.24 represents Net Cash Proceeds. No distributions are anticipated to be made prior to the termination of the Partnership. However, after paying final partnership expenses, any remaining cash reserves will be distributed. Limited Partners will not recover all of their original investment.
The Partnership believes that its key vendors were Year 2000 compliant with respect to the Partnership's operations as of December 31, 1999 and that there was no material effect on the business, financial position or results of operations of the Partnership related to Year 2000 issues.
Certain statements in this report constitute "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements may include statements regarding income or losses as well as assumptions relating to the foregoing.
The forward-looking statements made by the Partnership are subject to known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Partnership to differ from any future results, performance or achievements expressed or implied by the forward-looking statements.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk - -------------------------------------------------------------------
The supplemental financial information specified by Item 305 of Regulation S-K is not applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------
See Index to Financial Statements in this Form 10-K.
The supplemental financial information specified by Item 302 of Regulation S-K is not applicable.
The net effect of the differences between the financial statements and the tax return is summarized as follows:
December 31, 1999 December 31, 1998 ----------------------- --------------------- Financial Tax Financial Tax Statements Returns Statements Returns ------------ -------- ----------- --------
Total assets $823,637 $4,420,690 $886,720 $4,484,666 Partners' (deficit) capital accounts: General Partner (20,636) (13,264) (20,636) (13,264) Limited Partners 790,352 4,380,026 857,012 4,447,581 Net (loss) income: General Partner None None None 7,372 Limited Partners (66,660) (67,555) (119,947) (122,409) Per Limited Part- nership Interest (2.22)(A) (2.25) (4.00)(A) (4.08)
(A) Amount represents basic and diluted net loss per Limited Partnership Interest.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and - ----------------------------------------------------------------------- Financial Disclosure - --------------------
There have been no changes in or disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant - -----------------------------------------------------------
(a) Neither the Registrant nor BRI Partners-79, its General Partner, has a Board of Directors.
(b, c & e) The names, ages and business experiences of the executive officers and significant employees of the General Partner of the Registrant are as follows:
TITLE OFFICERS
Chairman, President and Chief Thomas E. Meador Executive Officer Senior Managing Director, Chief Jayne A. Kosik Financial Officer, Treasurer and Assistant Secretary
Thomas E. Meador (age 52) joined Balcor in July 1979. He is Chairman, President and Chief Executive Officer and has responsibility for all ongoing day-to-day activities at Balcor. He is a member of the board of directors of The Balcor Company. He is also a Senior Vice President of American Express Company and is responsible for its real estate operations worldwide. Prior to joining Balcor, Mr. Meador was employed at the Harris Trust and Savings Bank in the commercial real estate division where he was involved in various lending activities. Mr. Meador received his M.B.A. degree from the Indiana University Graduate School of Business.
Mr. Meador is on the Board of Directors of AMLI Commercial Properties Trust, a private real estate investment trust that owns office and industrial buildings in the Chicago, Illinois area. Mr. Meador was elected to the Board of AMLI Commercial Properties Trust in August 1998.
Jayne A. Kosik (age 42) joined Balcor in August 1982 and, as Chief Financial Officer, is responsible for Balcor's financial, human resources and treasury functions. Ms. Kosik is also a member of the board of directors of The Balcor Company. From June 1989 until October 1996, Ms. Kosik had supervisory responsibility for accounting functions relating to Balcor's public and private partnerships. She is also Treasurer and a Senior Managing Director of The Balcor Company. Ms. Kosik is a Certified Public Accountant.
(d) There is no family relationship between any of the foregoing officers.
(f) None of the foregoing officers or employees are currently involved in any material legal proceedings nor were any such proceedings terminated during the fourth quarter of 1999 except that Mr. Meador is named, in his capacity as an officer of Balcor, as a defendant in the Madison/Dee lawsuit described in "Item 3. Legal Proceedings".
Item 11.
Item 11. Executive Compensation - -------------------------------
The Registrant has not paid and does not propose to pay any remuneration to the executive officers and directors of the General Partner. The executive officers receive compensation from The Balcor Company (but not from the Registrant) for services performed for various affiliated entities, which may include services performed for the Registrant. However, the General Partner believes that any such compensation attributable to services performed for the Registrant is immaterial to the Registrant. See Note 8 of Notes to Financial Statements for the information relating to transactions with affiliates.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management - -----------------------------------------------------------------------
(a) The following entities are the Limited Partners which own beneficially more than 5% of the outstanding Limited Partnership Interests of the Registrant:
Name and Amount and Address of Nature of Percent Beneficial Beneficial of Title of Class Owner Ownership Class - -----------------------------------------------------------------------------
Limited WIG VIII 2,005.50 6.69% Partnership Partners Limited Interests Chicago, Partnership Illinois Interests
Limited Metropolitan 1,515.00 5.05% Partnership Acquisition VII Limited Interests Greenville, Partnership South Carolina Interests
For purposes of this Item 12, WIG VIII Partners is an affiliate of Metropolitan Acquisition VII and, collectively, they own 11.74% of the Interests.
(b) Neither BRI Partners-79 nor its officers or partners own any Limited Partnership Interests of the Registrant.
Relatives of the officers and affiliates of the partners of the General Partner do not own any additional interests.
In addition, Balcor LP Corp., an affiliate of the General Partner, holds title to 52 Limited Partnership Interests in the Partnership due exclusively to instances in which Limited Partners abandoned title to their Limited Partnership Interests. Balcor LP Corp. is a nominee holder only of such Interests and has disclaimed any economic or beneficial ownership in said Interests. All distributions of cash payable with respect to such Interests held by Balcor LP Corp. are returned to the Partnership for distribution to other Limited Partners in accordance with the Partnership Agreement.
(c) The Registrant is not aware of any arrangements, the operation of which may result in a change of control of the Registrant.
Item 13.
Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------
(a & b) See Note 4 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses.
See Note 8 of Notes to Financial Statements for information relating to transactions with affiliates.
(c) No management person is indebted to the Registrant.
(d) The Registrant has no outstanding agreements with any promoters.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K - -------------------------------------------------------------------------
(a) (1 & 2) See Index to Financial Statements in this Form 10-K.
(3) Exhibits:
(3) The Amended and Restated Agreement of Limited Partnership previously filed as Exhibit 2(a) to Amendment No. 5 to the Registrant's Registration Statement on Form S-11 dated July 16, 1980 (Registration No. 2-63821) is incorporated herein by reference.
(4) Certificate of Limited Partnership set forth in Exhibit 4 to Amendment No. 2 to the Registrant's Registration Statement on Form S-11 dated February 26, 1980 (Registration No. 2-63821) and Form of Confirmation regarding Interests in the Registrant set forth as Exhibit 4.2 to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1992 (Commission File No. 0-9541) are incorporated herein by reference.
(27) Financial Data Schedule of the Registrant for 1999 is attached hereto.
(b) Reports on Form 8-K: No reports were filed on Form 8-K during the quarter ended December 31, 1999.
(c) Exhibits: See Item 14(a)(3) above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of l934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
BALCOR EQUITY PROPERTIES LTD.-VIII
By: /s/Jayne A. Kosik ----------------------------------- Jayne A. Kosik Senior Managing Director and Chief Financial Officer (Principal Accounting and Financial Officer) of BRI Partners-79, the General Partner
Date: March 28, 2000 --------------------
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date - --------------------- ------------------------------- ------------
President and Chief Executive Officer (Principal Executive Officer) of BRI Partners-79, the General Partner /s/Thomas E. Meador March 28, 2000 - -------------------- -------------- Thomas E. Meador
Senior Managing Director, and Chief Financial Officer (Principal Accounting and Financial Officer) of BRI Partners-79, the General Partner
/s/Jayne A. Kosik March 28, 2000 - -------------------- -------------- Jayne A. Kosik
Report of Independent Accountants
Financial Statements:
Balance Sheets, December 31, 1999 and 1998
Statements of Partners' Capital (Deficit), for the years ended December 31, 1999, 1998 and 1997
Statements of Income and Expenses, for the years ended December 31, 1999, 1998 and 1997
Statements of Cash Flows, for the years ended December 31, 1999, 1998 and 1997
Notes to Financial Statements
Financial Statement Schedules are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners of Balcor Equity Properties Ltd.-VIII:
In our opinion, the accompanying balance sheets and the related statements of partners' capital (deficit), of income and expenses and of cash flows present fairly, in all material respects, the financial position of Balcor Equity Properties Ltd.-VIII An Illinois Limited Partnership (the "Partnership") at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Partnership's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
As described in Note 2 to the financial statements, the partnership agreement provides for the dissolution of the Partnership upon the occurrence of certain events, including the disposition of all its interests in real estate. The Partnership no longer has an ownership interest in any real estate investment. As described in Note 11, the Partnership has contingencies related to litigation. Upon resolution of the litigation contingency matters, the Partnership intends to cease operations and dissolve.
PricewaterhouseCoopers LLP
Chicago, Illinois March 28, 2000
BALCOR EQUITY PROPERTIES, LTD. - VIII (An Illinois Limited Partnership)
BALANCE SHEETS December 31, 1999 and 1998
ASSETS
1999 1998 --------------- --------------- Cash and cash equivalents $ 819,148 $ 882,940 Accounts and accrued interest receivable 4,489 3,780 --------------- --------------- $ 823,637 $ 886,720 =============== ===============
LIABILITIES AND PARTNERS' CAPITAL
Accounts payable $ 21,174 $ 28,259 Due to affiliates 32,747 22,085 --------------- --------------- Total liabilities 53,921 50,344 --------------- --------------- Commitments and contingencies
Limited Partners' capital (30,005 Interests issued and outstanding) 790,352 857,012 General Partner's deficit (20,636) (20,636) --------------- --------------- Total partner's capital 769,716 836,376 --------------- --------------- $ 823,637 $ 886,720 =============== ===============
The accompanying notes are an integral part of the financial statements.
BALCOR EQUITY PROPERTIES, LTD. - VIII (An Illinois Limited Partnership)
STATEMENTS OF PARTNERS' CAPITAL(DEFICIT) for the years ended December 31, 1999, 1998 and 1997
Partners' Capital(Deficit) Accounts -------------------------------------------- General Limited Total Partner Partners -------------- -------------- -------------- Balance at December 31, 1996 $ (2,442,329) $ (168,303) $ (2,274,026)
Cash distributions (A) (5,010,835) (5,010,835)
Net income for the year ended December 31, 1997 8,409,487 147,667 8,261,820 -------------- -------------- -------------- Balance at December 31, 1997 956,323 (20,636) 976,959
Net loss for the year ended December 31, 1998 (119,947) (119,947) -------------- -------------- -------------- Balance at December 31, 1998 836,376 (20,636) 857,012
Net loss for the year ended December 31, 1999 (66,660) (66,660) -------------- -------------- -------------- Balance at December 31, 1999 $ 769,716 $ (20,636) $ 790,352 ============== ============== ==============
(A) Summary of cash distributions paid per Limited Partnership Interest:
1999 1998 1997 ------------ ------------ ------------
First Quarter None None None Second Quarter None None None Third Quarter None None $167.00 Fourth Quarter None None None
The accompanying notes are an integral part of the financial statements.
BALCOR EQUITY PROPERTIES, LTD. - VIII (An Illinois Limited Partnership)
STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1999, 1998 and 1997
1999 1998 1997 -------------- -------------- -------------- Income: Rental and service $ 1,904,016 Interest on short-term investments $ 41,311 $ 49,015 133,199 Other 16,825 -------------- -------------- -------------- Total income 41,311 49,015 2,054,040 -------------- -------------- --------------
Expenses: Interest on mortgage notes payable 555,453 Depreciation 231,604 Amortization of deferred expenses 25,170 Property operating 29,219 1,339,012 Real estate taxes 234,376 Property management fees 95,944 Administrative 107,971 139,743 290,286 -------------- --------------- ------------- Total expenses 107,971 168,962 2,771,845 -------------- --------------- ------------- Loss before gain on sales of properties and extraordinary item (66,660) (119,947) (717,805)
Gain on sales of properties 9,635,582 -------------- ---------------- ------------ (Loss) income before extraordinary item (66,660) (119,947) 8,917,777
Extraordinary item: Debt extinguishment expense (508,290) -------------- -------------- -------------- Net (loss) income $ (66,660) $ (119,947) $ 8,409,487 ============== ============== ==============
The accompanying notes are an integral part of the financial statements.
BALCOR EQUITY PROPERTIES, LTD. - VIII (An Illinois Limited Partnership)
STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1999, 1998 and 1997 (Continued)
1999 1998 1997 -------------- -------------- -------------- (Loss) income before extraordinary item allocated to General Partner None None $ 156,594 ============== ============== ============== (Loss) income before extraordinary item allocated to Limited Partners $ (66,660) $ (119,947) $ 8,761,183 ============== ============== ============== (Loss) income before extraordinary item per Limited Partnership Interest (30,005 issued and outstanding) - Basic and Diluted $ (2.22) $ (4.00) $ 291.99 ============== ============== ============== Extraordinary item allocated to General Partner None None $ (8,927) ============== ============== ============== Extraordinary item allocated to Limited Partners None None $ (499,363) ============== ============== ============== Extraordinary item per Limited Partnership Interest (30,005 issued and outstanding) - Basic and Diluted None None $ (16.64) ============== ============== ============== Net (loss) income allocated to General Partner None None $ 147,667 ============== ============== ============== Net (loss) income allocated to Limited Partners $ (66,660) $ (119,947) $ 8,261,820 ============== ============== ============== Net (loss) income per Limited Partnership Interest (30,005 issued and outstanding) - Basic and Diluted $ (2.22) $ (4.00) $ 275.35 ============== ============== ==============
The accompanying notes are an integral part of the financial statements.
BALCOR EQUITY PROPERTIES, LTD. - VIII (An Illinois Limited Partnership)
STATEMENTS OF CASH FLOWS for the years ended December 31, 1999, 1998 and 1997
1999 1998 1997 -------------- -------------- -------------- Operating activities: Net (loss) income $ (66,660) $ (119,947) $ 8,409,487 Adjustments to reconcile net (loss) income to net cash used in operating activities: Gain on sales of properties (9,635,582) Debt extinguishment expense 268,717 Depreciation of properties 231,604 Amortization of deferred expenses 25,170 Net change in: Escrow deposits - unrestricted 742,334 Accounts and accrued interest receivable (709) 21,314 169,069 Prepaid expenses 53,417 Accounts payable (7,085) 8,002 (24,863) Due to affiliates 10,662 (29,341) (2,303) Accrued liabilities (463,870) Security deposits (76,035) --------------- --------------- ------------ Net cash used in operating activities (63,792) (119,972) (302,855) --------------- --------------- ------------ Investing activities: Proceeds from sales of properties 17,200,000 Payment of selling costs (442,839) Funding of escrow in con- nection with the sale of real estate (100,000) Release of escrow in con- nection with the sale of real estate 100,000 -------------- Net cash provided by investing activities 16,757,161 --------------
The accompanying notes are an integral part of the financial statements.
BALCOR EQUITY PROPERTIES, LTD. - VIII (An Illinois Limited Partnership)
STATEMENTS OF CASH FLOWS for the years ended December 31, 1999, 1998 and 1997 (Continued)
1999 1998 1997 --------------- ------------- -------------- Financing activities: Distribution to Limited Partners $ (5,010,835) Repayment of mortgage notes payable (11,978,663) Principal payments on mortgage notes payable (50,114) -------------- Net cash used in financing activities (17,039,612) -------------- Net change in cash and cash equivalents $ (63,792) $ (119,972) (585,306)
Cash and cash equivalents at beginning of year 882,940 1,002,912 1,588,218 --------------- -------------- ------------- Cash and cash equivalents at end of year $ 819,148 $ 882,940 $ 1,002,912 =============== ============== =============
The accompanying notes are an integral part of the financial statements.
BALCOR EQUITY PROPERTIES LTD.-VIII (An Illinois Limited Partnership)
NOTES TO FINANCIAL STATEMENTS
1. Nature of the Partnership's Business:
Balcor Equity Properties Ltd.-VIII (the "Partnership") has retained cash reserves from the sale of its real estate investments for contingencies which exist or may arise. The Partnership's operations currently consist of interest income earned on short-term investments and the payment of administrative expenses.
2. Partnership Termination:
The Partnership Agreement provides for the dissolution of the Partnership upon the occurrence of certain events, including the disposition of all its interests in real estate. The Partnership sold its final real estate investment in July 1997. The Partnership has retained a portion of the cash from the property sales to satisfy obligations of the Partnership as well as to establish a reserve for contingencies. The timing of the termination of the Partnership and final distribution of cash will depend upon the nature and extent of liabilities and contingencies which exist or may arise. Such contingencies may include legal and other fees and costs stemming from litigation involving the Partnership including, but not limited to, the Masri lawsuit discussed in Note 11 of Notes to Financial Statements. Due to this litigation, the Partnership will not be dissolved and reserves will be held by the Partnership until the conclusion of such contingencies. There can be no assurances as to the time frame for the conclusion of all contingencies.
3. Accounting Policies:
(a) The preparation of the financial statements in conformity with generally accepted accounting principles requires the General Partner to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could vary from those estimates.
(b) Depreciation expense was computed using the straight-line and accelerated methods. Rates used in the determination of depreciation were based upon the following estimated useful lives:
Buildings and improvements 15 to 33 years Furniture and fixtures 3 to 5 years
Maintenance and repairs were charged to expense when incurred. Expenditures for improvements were charged to the related asset account.
When properties were sold, the related costs and accumulated depreciation were removed from the respective accounts. Any gain or loss on disposition was recognized in accordance with generally accepted accounting principles.
(c) The Partnership recorded its investments in real estate at the lower of cost or fair value, and periodically assessed, but not less than on an annual basis, possible impairment to the value of its properties. The General Partner estimated the fair value of its properties based on the current sales price less estimated closing costs. The General Partner had determined that no impairment in value had occurred prior to the sales of the properties. The General Partner considered the method referred to above to result in a reasonable measurement of a property's fair value, unless other factors affecting the property's value indicated otherwise.
(d) Deferred expenses consisted of loan refinancing fees which were amortized over the terms of the respective agreements. Upon sale, any remaining balance was recognized as debt extinguishment expense and classified as an extraordinary item.
(e) The Partnership calculates the fair value of its financial instruments based on estimates using present value techniques. The Partnership includes this additional information in the notes to the financial statements when the fair value is different than the carrying value of those financial instruments. When the fair value reasonably approximates the carrying value, no additional disclosure is made.
(f) In order for the capital account balances to more accurately reflect the partners' remaining economic interests in the Partnership Agreement, the (loss) income allocations have been adjusted.
(g) Cash and cash equivalents include all unrestricted, highly liquid investments with an original maturity of three months or less. Cash is held or invested in one financial institution.
(h) The Partnership is not liable for Federal income taxes and each partner recognizes his proportionate share of the Partnership income or loss in his tax return; therefore, no provision for income taxes is made in the financial statements of the Partnership.
(i) Revenue is recognized on an accrual basis in accordance with generally accepted accounting principles.
(j) Statement of Financial Accounting Standards, No. 128, "Earnings per Share" was adopted by the Partnership effective for the year ended December 31, 1997. Since the Partnership has no dilutive securities, there is no difference between basic and diluted net income (loss) per Limited Partnership Interest.
4. Partnership Agreement:
The Partnership was organized in February 1979. The Partnership Agreement provides for BRI Partners-79 to be the General Partner and for the admission of Limited Partners through the sale of up to 30,005 Limited Partnership Interests at $1,000 per Interest, all of which were sold on or prior to October 31, 1980, the termination date of the offering.
The Partnership Agreement generally provides that the General Partner will be allocated 1% of the profits and losses. In order for the capital account balances to more accurately reflect the partners' remaining economic interests in the Partnership Agreement, the income (loss) allocations have been adjusted.
To the extent Net Cash Receipts were distributed, the General Partner was entitled to 10% of the Net Cash Receipts (9% being its management fee and 1% being its distributive share), which payment was subordinated to certain levels of return to holders of Interests as specified by the Partnership Agreement. The Net Cash Proceeds resulting from the sales of the Partnership's properties which were available for distribution were distributed only to holders of Interests. Such amounts were to be distributed until such time as holders of Interests received an amount equal to their Original Capital plus certain levels of return, as specified by the Partnership Agreement. Only after such returns were made to the holders of Interests would the General Partner have received 15% of further distributed Net Cash Proceeds. Since the required subordination levels were not met, the General Partner has not received any distributions of Net Cash Receipts or Net Cash Proceeds during the lifetime of the Partnership.
5. Mortgage Notes Payable:
During 1997, the Partnership incurred and paid interest expense on mortgage notes payable of $555,453.
6. Management Agreements:
The Partnership's properties were managed by a third party management company prior to the sale of the properties. These management agreements provided for annual fees of 5% of gross operating receipts.
7. Tax Accounting:
The Partnership keeps its books in accordance with the Internal Revenue Code, rules and regulations promulgated thereunder, and existing interpretations thereof. The accompanying financial statements, which are prepared in accordance with generally accepted accounting principles, will differ from the tax returns due to the different treatment of various items as specified in the Internal Revenue Code. The net effect of these accounting differences is that the net loss for 1999 in the financial statements is $895 less than the tax loss for the same period.
8. Transactions with Affiliates:
Fees and expenses paid and payable by the Partnership to affiliates are:
Year Ended Year Ended Year Ended 12/31/99 12/31/98 12/31/97 -------------- -------------- -------------- Paid Payable Paid Payable Paid Payable ----- -------- ----- ------- ----- -------
Reimbursement of expenses to the General Partner, at cost: Accounting $7,726 $9,151 $8,895 $3,524 $19,966 $10,873 Data processing 4,798 4,905 2,328 872 4,074 1,456 Legal 3,713 4,427 9,785 4,119 17,165 9,347 Portfolio management 11,690 14,264 22,201 13,570 41,362 22,181 Other None None 7,569 None 13,900 7,569
Subject to the provisions of the partnership agreement, the Partnership has agreed to advance the legal fees incurred by the General Partner in defending the Madison Partnership lawsuit discussed in Note 11 of Notes to Financial Statements.
9. Property Sales:
(a) In July 1997, the Partnership sold the Walnut Hills - Phase I Apartments in an all cash sale for $4,528,312. The Partnership used the proceeds from the sale and $753,848 of the proceeds from the sale of Walnut Hills - Phase II Apartments, as described below, to repay the $5,059,440 first mortgage loan in full and in addition, the Partnership paid a prepayment penalty of $101,189 and $121,531 in selling costs. The basis of the property was $1,734,932, which is net of accumulated depreciation of $1,577,926. For financial statement purposes, the Partnership recognized a gain of $2,671,849 from the sale of this property.
(b) In July 1997, the Partnership sold the Walnut Hills - Phase II Apartments in an all cash sale for $5,471,688. From the proceeds of the sale, the Partnership paid $1,871,300 to the third party mortgage holder in full satisfaction of the first mortgage loan, a prepayment penalty of $37,426 and $146,767 in selling costs. In addition, $753,848 of the proceeds was used to repay the first mortgage loan of the Walnut Hills - Phase I Apartments, as described above. The basis of the property was $2,248,987, which is net of accumulated depreciation of $1,594,163. For financial statement purposes, the Partnership recognized a gain of $3,075,934 from the sale of this property.
(c) In June 1997, the Partnership sold the Cedar Creek - Phase I Apartments in an all cash sale for $3,232,653. From the proceeds of the sale, the Partnership paid $2,305,542 to the third party mortgage holder in full satisfaction of the first mortgage loan, $46,111 in prepayment penalties and $78,403 in selling costs. The basis of the property was $1,303,018, which is net of accumulated depreciation of $2,285,616. For financial statement purposes, the Partnership recognized a gain of $1,851,232 from the sale of this property.
(d) In June 1997, the Partnership sold the Cedar Creek - Phase II Apartments in an all cash sale for $3,967,347. From the proceeds of the sale, the Partnership paid $2,742,381 to the third party mortgage holder in full satisfaction of the first mortgage loan, $54,847 in prepayment penalties and $96,138 in selling costs. The basis of the property was $1,834,642, which is net of accumulated depreciation of $3,043,064. For financial statement purposes, the Partnership recognized a gain of $2,036,567 from the sale of this property.
10. Extraordinary Item:
The Partnership wrote off the remaining unamortized deferred financing fees totaling $268,717 and paid prepayment penalties totaling $239,573 in connection with the 1997 sales of the Cedar Creek - Phases I and II Apartments and the Walnut Hills - Phases I and II Apartments. These amounts were recognized as an extraordinary item and classified as debt extinguishment expense for financial statement purposes.
11. Contingencies:
(a) The Partnership is currently involved in a lawsuit Masri vs. Lehman Brothers, Inc., et al., whereby the Partnership and certain affiliates were named as defendants alleging claims involving certain state securities and common law violations with regard to the adequacy and accuracy of disclosures of information concerning, as well as marketing efforts related to, the offering of the Limited Partnership Interests of the Partnership. The defendants continue to vigorously contest this action. A plaintiff class has not been certified in the action and, no determinations upon any significant issues have been made. It is not determinable at this time how the outcome of this action will impact the remaining cash reserves of the Partnership. The Partnership believes it has meritorious defenses to contest the claims.
(b) In May 1999, a lawsuit was filed, Madison Partnership Liquidity Investors XX, et al. vs. The Balcor Company, et al. whereby the General Partner and certain affiliates have been named as defendants. The plaintiffs are entities that initiated tender offers to purchase and, in fact, purchased units in eleven affiliated partnerships. The complaint alleges breach of fiduciary duties and breach of contract under the partnership agreement and seeks the winding up of the affairs of the Partnership, the establishment of a liquidating trust, the appointment of an independent trustee for the trust and the distribution of a portion of the cash reserves to limited partners. On June 1, 1999, a second lawsuit was filed and was served on August 16, 1999, Sandra Dee vs. The Balcor Company, et al. The Dee complaint is virtually identical to the Madison Partnership complaint and on September 20, 1999 was consolidated into the Madison Partnership case. On January 19, 2000, a hearing was held on the defendants' motion to dismiss the complaint; at the hearing the class allegations were struck regarding eleven of the partnerships, including the Partnership. The defendants intend to vigorously contest these actions. It is not determinable at this time how the outcome of these actions will impact the remaining cash reserves of the Partnership. | 6,975 | 48,094 |
854418_1999.txt | 854418_1999 | 1999 | 854418 | ITEM 1. BUSINESS.
GENERAL
Landmark Systems Corporation ("Landmark" or the "Company") is a leading provider of performance management software products which measure, analyze, report and predict performance for both mainframe and client/server computing environments. Landmark's PerformanceWorks(R) product family is distinct in its ability to monitor the key components of a computing environment, provide early warning of potential system problems and enable effective planning for changes in the computing environment. The Company believes these capabilities improve user productivity, reduce computing costs, increase system availability and optimize use of system resources. Landmark's products provide performance management capabilities for many leading hardware platforms; certain operating systems from DEC, Hewlett-Packard, IBM, Microsoft, NCR and Sun; certain databases consisting of DB2, Oracle, SQL Server and Sybase products; and certain vendor applications such as IBM's CICS and MQSeries, as well as proprietary customer applications. Each of Landmark's products has been developed to work with different configurations of system components from multiple vendors while providing comparable functionality across each platform. As of December 31, 1999, Landmark had licensed over 21,200 copies of its products and has approximately 3,600 active customers worldwide.
Performance management software can provide early warning and facilitate resolution of system problems by monitoring a system's key components, including the central processing unit ("CPU"), memory and storage, input/output ("I/O"), disk space, workload, operating system and network subsystems application. Identifying and addressing system problems allows businesses to increase system availability, improve user productivity, reduce computing costs and limit the adverse business effects of system degradation. Performance management tools also enable organizations to model or predict system and application performance which improves the acquisition, development and implementation of new or changed applications and hardware.
Landmark's PerformanceWorks product family enables businesses to optimize system performance and resource utilization while maintaining a high and consistent level of user productivity. Landmark's products provide the ability to transform raw data into useful information through an intelligent aggregation and automatic summarization process, which collects data on a continuous basis and generates summary information at prescribed intervals. This data can be measured against a variety of performance thresholds and easily formatted into understandable reports to facilitate the quick identification and resolution of performance problems. In addition, Landmark's products self-manage the collection, summarization and distribution of performance data, and consequently require minimal computing and personnel resources. As a result of this efficient gathering, storage and presentation of performance data, Landmark's products are scalable to accommodate system growth.
Landmark's solutions are based on its "lifecycle" view of performance management and are designed to allow customers to address each stage of the application lifecycle: planning, development and production. Landmark views performance management as a continuous process in which each stage of the application lifecycle provides input and feedback for the next.
PLANNING STAGE. Landmark's products are used to identify resource requirements and to establish appropriate service levels through modeling, trend analysis and load simulation (simulating use of computing resources at different percentage levels of total capacity).
DEVELOPMENT STAGE. Landmark's products perform application tuning (adjusting applications to optimize performance), assist in stress testing (simulation of maximum workloads on computing resources) and conduct resource impact analysis to assess application performance prior to deployment.
PRODUCTION STAGE. Landmark's products provide data collection, real-time monitoring and troubleshooting to provide optimal system operation.
After the initial deployment is completed, the application lifecycle begins again with planning for additional deployments or modifications to the computing environment.
Through its maintenance and support program, Landmark offers its customers extensive technical support, including telephone consultation, product maintenance and product upgrades. Landmark also provides its customers with consulting and training services. Historically, 85 to 90% of Landmark's customers have renewed their support and maintenance arrangements with the Company.
TECHNOLOGY AND PRODUCTS
The PerformanceWorks family of products is comprised of PerformanceWorks for MVS, PerformanceWorks for VSE, PerformanceWorks for UNIX and PerformanceWorks for Windows NT. PerformanceWorks enables a user to monitor and analyze performance metrics in three different timeframes: real-time, recent-past and historical.
- REAL-TIME MONITORING. Real-time monitoring allows users to view the current status of the computing environment. To do this, performance metrics are collected from throughout the system and displayed graphically at a single workstation. The real-time monitoring feature can be used as an early warning tool by establishing thresholds against which critical performance metrics are measured. If a metric or combination of metrics exceeds the established threshold, an alarm is generated to notify the user of a potential system or application problem. The user is then guided through increasingly detailed levels of performance data until the cause of the problem is identified. The user can then either solve the problem or an automated action can be triggered to correct the problem.
- RECENT-PAST MONITORING. Recent-past monitoring displays the performance metrics collected within the past few minutes or hours. If a system has experienced a degradation in performance, recent-past monitoring can be used to review the performance metrics leading up to the occurrence of the problem to help identify its source and to facilitate a resolution. Recent-past monitoring can also be used to identify trends in system utilization and performance which may result in system errors. These trends can be used to predict and prevent future system problems.
- HISTORICAL DATA ANALYSIS. Historical data analysis is used to review performance metrics collected over days, weeks and months to understand how system resources have been used and whether trends have developed which could lead to future performance problems. Landmark's products automatically store and aggregate performance data so users can quickly retrieve and view information over the desired period of time from multiple systems on one report.
Technology
The technology underlying the PerformanceWorks family of products is based on a multi-tiered architecture which can be represented by a data collection layer, a core services layer and a user interface and external tools layer.
DATA COLLECTION LAYER. The data collection layer consists of PerformanceWorks agents, referred to as "SmartAgents," designed to collect performance data automatically for on-line analysis and historical data storage and to translate the data into useable information. SmartAgents are installed on each element in the computing environment for which performance metrics will be monitored and automatically collect performance data at set intervals. After collection, SmartAgents compare the collected information against defined thresholds. If any threshold is exceeded, the SmartAgent will generate a warning or error message.
CORE SERVICES LAYER. The core services layer is comprised of three key components: data management, data brokering and network services.
DATA MANAGEMENT. The data management component manages the storage and retention of performance data throughout the system and includes the following functionalities:
- Data normalization gathers disparate performance data and normalizes it into common categories, such as CPU, memory, disk I/O, workload, disk space and network. Users can view similar performance data from different hardware platforms, operating systems and databases and easily make comparisons and draw conclusions.
- Data summarization averages performance data into logical intervals of minutes, hours, days, weeks, months and years. Without time-consuming preparation, users can view data in various formats in order to identify trends quickly.
- Data administration records all information in a data store, allowing users to manage and protect performance data. Data administration also provides efficient storage of collected performance data.
DATA BROKERING. The data brokering component receives all incoming requests and routes them either to the appropriate SmartAgent for real-time data or to a data store for historical data without requiring that the end-user have knowledge of where these components are located.
NETWORK SERVICES. The network services component provides a registry and look-up service that allows transmission of real-time, recent-past and historical performance data from where it is collected to where it is used. Since the architecture of a distributed computing environment frequently changes with the addition or deletion of servers, applications and users, the registry is designed to automatically communicate changes in system configuration.
Landmark supports third-party applications and access to performance data by publishing detailed record formats and by providing application programming interfaces ("APIs") for standard Open Data Base Connectivity ("ODBC") applications and Simple Network Management Protocol ("SNMP") interface modules for industry leading systems and network management frameworks.
USER INTERFACE AND EXTERNAL TOOLS LAYER. The user interface for PerformanceWorks allows users to view and analyze the status of their critical applications. Performance management data for each application can be viewed statistically and graphically to show consumption of system resources, proximity to critical threshold values and alarm situations requiring immediate attention. In addition, users can generate customized reports incorporating any combination of real-time, recent-past and historical performance data analyses. The available user interfaces operate using Motif (UNIX), Windows 95/98/NT (NT), OS/2 (MVS-NaviPlex) and 3270 (MVS and VSE).
In addition to the user interfaces provided directly by Landmark's products, customers can also gain access to PerformanceWorks data through the use of external tools provided by third-party vendors. Published record formats are utilized by third-party vendor products such as Computer Associates MICS, Merrill Consultants MXG, IBM SNAPSHOT, SAS and BGS Systems Best/1. ODBC connectivity permits a multitude of applications, including Microsoft Excel and Lotus 1-2-3, to be used to process, analyze, and report on the performance data. In addition, SNMP integration modules allow PerformanceWorks products to operate within leading systems management frameworks including IBM Netview, Tivoli TME, Hewlett-Packard OpenView, Computer Associates Unicenter, Cabletron Spectrum and Sun Solstice.
Products
The ability to monitor performance metrics from each system component in a complex, heterogeneous computing environment is a key feature of Landmark's software, particularly because performance problems in these environments can originate from any one or a combination of components.
If applications running in a distributed environment are experiencing slow response time, the cause of the problem could be a memory problem on the distributed application server, a disk contention problem (where two or more applications are attempting to access the same data simultaneously) on the mainframe database server, an overloaded network, a poorly written application or any combination of these conditions. By monitoring performance data from each of the system components, Landmark's products are able to efficiently identify the source of the problem so a solution can be implemented quickly or the potential problem can be anticipated and avoided altogether by taking immediate corrective actions. The Company believes its users benefit from the ease of use, depth of metrics and diagnostic tools it provides, as well as the level of intelligent integration, which allows enhanced manageability in production environments.
Landmark's products are easily installed and implemented and generally do not require additional customization before the products can be used by the customer. The Company's products are also easily tailored so that the performance metrics, data retention standards and data storage locations are appropriate for each customer.
LANDMARK'S FAMILY OF PERFORMANCEWORKS PRODUCTS
The Company derived 82.2%, 85.0% and 87.0% of its total revenues from mainframe products and services in 1999, 1998 and 1997, respectively. For additional information regarding the Company's financial performance by product group, see Note 7 - Segment Information in the Company's Notes to Consolidated Financial Statements contained elsewhere in this Form 10-K.
PERFORMANCEWORKS FOR MVS. PerformanceWorks for MVS is Landmark's integrated set of performance management tools for use in the MVS environment and consists of The Monitor for CICS, The Monitor for DB2, The Monitor for MVS, The Monitor for VTAM, The Monitor for MQSeries, The Monitor for IMS/DBCTL, NaviGraph and NaviPlex. Landmark's family of MVS products provides a complete solution for optimizing and monitoring environments running the MVS operating system.
The Monitor products support data collection in the mainframe environment for real-time, recent-past and historical performance management monitoring. Each of these products incorporates Landmark's Navigate technology which provides intelligent transfer of control from one monitor to another, facilitating intuitive problem solving.
NaviGraph provides users with a graphical display of the performance of key applications and system resources. NaviGraph is an easy-to-use, Windows-based display providing a single point of access and control for monitoring and analysis of the data collected by The Monitor products.
NaviPlex is designed for IBM's Parallel Sysplex technology which introduces to mainframe environments performance complexities similar to those of a distributed processing environment. NaviPlex consolidates performance information from all MVS system environments into a single workstation for managing performance issues, handling exception conditions and trending information.
PERFORMANCEWORKS FOR VSE. PerformanceWorks for VSE is similar to PerformanceWorks for MVS in terms of the performance management functionality. PerformanceWorks for VSE includes The Monitor for VSE, The Monitor for CICS, NaviGraph and VM Contention Monitor.
PERFORMANCEWORKS FOR UNIX. PerformanceWorks for UNIX is Landmark's integrated set of performance management tools for use in the UNIX environment and consists of SmartAgent for UNIX, SmartAgent for Oracle, SmartAgent for Sybase, SmartStation and Predictor.
SmartAgent for UNIX, SmartAgent for Oracle and SmartAgent for Sybase provide collection of performance metrics for each UNIX operating system and database supported. Specific metrics collected vary with the individual platforms. SmartAgents employ the Core Services features of the PerformanceWorks architecture to manage, analyze and present performance data across tens or hundreds of locations operating with hundreds or thousands of servers.
SmartStation provides a central control point to access performance information collected by SmartAgents. Information is presented in easy-to-understand charts, graphs, reports and gauges. Alarms alert users to potential system problems before they become serious. SmartStation provides a complete set of pre-configured reports and graphics, which can be tailored to users' specific needs. Users can also define exception conditions, and SmartStation will provide an alarm when performance thresholds are exceeded. The alarms provide the user with an explanation of the error, sending notifications through email systems, alphanumeric pagers and management platforms. In addition, the alarms can be configured to take corrective actions automatically. Whether the user sits in front of a UNIX/Motif workstation or a Windows 95/98/NT workstation, the Java-based SmartStation can be used to manage all of PerformanceWorks for UNIX and PerformanceWorks for NT from one desktop.
Predictor is a capacity planning tool designed to help planners in determining the types and quantities of new equipment and software required to handle increased system utilization and performance requirements. Based on the performance metrics stored for historical data analysis, Predictor can predict the impact of adding new applications, modifying an existing application, removing an application, adding users, changing the server hardware configuration or changing the server entirely. Predictor can be used to predict future behavior of UNIX and Windows NT servers.
PERFORMANCEWORKS FOR WINDOWS NT. PerformanceWorks for Windows NT is similar to PerformanceWorks for UNIX in terms of the performance management functionality of products currently available in the Windows NT environment. PerformanceWorks for Windows NT includes SmartAgent for NT, SmartAgent for SQL Server, SmartAgent for Sybase, SmartAgent for Oracle and SmartStation.
PerformanceWorks 3.0 for UNIX and Windows NT environments advances the Company's UNIX and NT performance management capabilities and offers a scalable, integrated end-to-end view of client/server performance management, including "what if " analyses.
SmartWatch is a product that allows the measurement of application availability and end-to-end response time on a user's Windows 95/98/NT desktop. Measurement takes place, regardless of whether the application is developed in-house or purchased off-the-shelf. The U.S. Patent and Trademark office issued a patent for Landmark's SmartWatch technology in 1999.
PERFORMANCEWORKS WEBWATCHER. In the fourth quarter of 1999, in response to the growing demand for management of the entire e-business enterprise, the Company announced a new e-business initiative. PerformanceWorks WebWatcher manages end-user experiences, Web servers and databases. WebWatcher is a customer-centric performance management solution that provides visibility and control of critical e-business applications. Using patent-pending technology, WebWatcher monitors the performance of Web-based users and Web servers to give an integrated view of Web application performance.
WebWatcher provides the detailed information required to determine the general health of Web-based applications. What makes WebWatcher unique is that it monitors end-user performance, not the performance of synthetic transactions (which can place an undue burden on Web sites and skew results). WebWatcher collects data about the performance of standard and user-defined transactions including times for Web pages to load, where users go and response times for specific transactions.
REAL TIME DEFRAG. In June of 1999 the Company announced a marketing partnership with INTERCHIP Unternehmensberatung GmbH in which the Company licensed and resells INTERCHIP's Real-Time Defrag (RTD) product through many of its worldwide sales channels. RTD allows IT managers to optimize system disk space 24 hours-a-day without affecting production applications and online operations. RTD maximizes disk space automatically and continuously, requiring no human intervention, while preventing system and application downtime, rendering faster data processing, and assuring the best system conditions for accessing files.
CUSTOMERS AND SERVICES
The Company's customers consist of organizations across a wide variety of industries that are developing or have deployed business-critical applications in complex, multi-user environments.
Landmark offers its customers a maintenance and support program which provides telephone consultation, product maintenance and product upgrades. Customers can communicate with Landmark technical support representatives 24 hours-per-day, 7 days-per-week. In addition, Landmark provides its customers and distributors access to on-line maintenance information through an Internet-based application. Landmark's maintenance and support program entitles participants to product enhancements, support for new releases and upgrades as well as maintenance information. Historically, 85 to 90% of Landmark's customers have renewed their maintenance and support arrangements with the Company.
Landmark's Professional Services organization offers consulting services to users of its products. These consulting services are designed to support the effective deployment and implementation of Landmark's products by assisting in the location of appropriate components on which to run Landmark's software, identifying which performance metrics to monitor, establishing rules concerning how to aggregate, retain and store data, and customizing the presentation of reports generated from the collected information. The demand for these consulting services has grown as business-critical applications are increasingly deployed in complex, heterogeneous computing environments. The Professional Services organization offers a variety of training programs to assist customers in implementing Landmark's performance management tools, including a number of standard programs and custom presentations to fulfill specific requests. Training courses are held at Landmark's Reston, Virginia training center as well as on-site at customers' facilities.
SALES AND MARKETING
Landmark markets its products and services through its North American and international sales organizations. The North American direct sales force, which covers the United States and Canada, consists of field sales representatives, mainframe and client/server system engineers and telesales personnel. Additionally, a telesales force increases the productivity of the field sales representatives by undertaking a variety of support activities. These include generating and following up on leads, handling and closing smaller transactions, maintaining a current database of existing and potential customers and providing general assistance and account management. Each telesales representative supports the efforts of two direct sales representatives. The Company believes that the telesales force permits the field sales force to focus on account opportunities with major businesses involving larger dollar transactions, and on establishing and maintaining relationships with these organizations.
Landmark has historically relied primarily on third-party distributors to market and sell the Company's products internationally. In 1999, the Company further expanded its international operations by reaquiring exclusive distribution for its products through the creation of several new wholly-owned subsidiaries. Landmark Systems France, SARL now serves France and French-speaking Switzerland while Landmark Systems Nordic AB serves the Nordic region. Revenues from international sales accounted for 31.6%, 33.1% and 33.6% of total revenues in 1999, 1998 and 1997, respectively. Of those amounts, 9.5%, 13.4% and 18.0%, respectively, were attributable to third-party distributors. Landmark has established subsidiaries in certain strategic markets to increase sales levels and gross margins on products sold in such markets. To date, Landmark's international direct sales efforts consist of eleven sales offices located in suburbs of Paris, Stockholm, London, Dusseldorf and Utrecht (Netherlands), and in Rugby (United Kingdom), Madrid, Bornem (Belgium), Melbourne, Sydney and Hong Kong. For additional information regarding the Company's revenues and long-lived assets by geographic region, see Note 7 - Segment Information in the Company's Notes to Consolidated Financial Statements contained elsewhere in this Form 10-K.
The Company also maintains relationships with leading vendors including Hewlett-Packard, IBM, Microsoft, Oracle, Sun, Sybase and Tivoli. These relationships afford the Company opportunities to participate in joint marketing programs with the vendors such as sales seminars, trade shows and other promotional activities.
Revenues received from individual customers of the Company vary significantly based on the size of the product installation. The sales cycle for Landmark's products is lengthy and unpredictable and may range from a few months to over a year, depending upon the interest of the prospective customer in the Company's products, the size of the order (which may involve a significant commitment of capital by the customer), the decision-making and acceptance procedures within the customer's organization and other factors.
PRODUCT DEVELOPMENT
Since its inception in 1983, Landmark has made substantial investments in performance management software development. The Company has recently gone through a transformation to focus on the e-commerce area. In 1999, 1998 and 1997, Landmark's product development expenditures, including amounts capitalized, totaled
$17.0 million, $15.5 million and $13.5 million, respectively. The Company anticipates that, in the future, it will continue to commit substantial resources to research and development. Landmark maintains mainframe, UNIX and Windows NT development labs, which it uses to develop, enhance and test its products. In addition, Landmark made significant investments in 1999 to enter the e-commerce market. This effort produced a key product, Web Watcher, based on patent-pending technology, that allows website management of performance from the client side as well as the server side for key e-business applications. Landmark believes that its future success will depend in large part on its ability to rapidly introduce new products in the e-commerce area, in addition to extending its product line to support additional hardware and software platforms, respond to changing customer requirements and develop and introduce in a timely manner new products that keep pace with technological developments and emerging industry standards.
As of December 31, 1999, the Company had 102 employees engaged in product development. Landmark intends to increase the size and depth of its product development operation. However, competition for highly qualified technical employees is intense and there can be no assurance that the Company will be successful in recruiting or retaining product development employees.
INTELLECTUAL PROPERTY
Landmark and its subsidiaries rely on a combination of copyright, trademark, patent and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect its proprietary rights. To effectively protect Landmark's intellectual property while allowing for the distribution of its products in the most flexible and efficient manner, Landmark formed a new subsidiary in February 1999, Landmark Technology Holdings Corporation. This Delaware corporation holds, manages, protects and defends the intellectual properties of Landmark. Additionally, the Delaware corporation licenses to Landmark and/or present and future affiliates and/or third parties the use of such properties.
As part of its confidentiality procedures, Landmark and its subsidiaries generally enter into non-disclosure agreements with its employees, distributors and corporate partners, and license agreements with its customers, distributors and corporate partners with respect to its software, product documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's products or technology without authorization, or to develop similar technology independently. Policing unauthorized use of the Company's products is difficult, and Landmark is unable to determine the extent to which piracy of its software products and misappropriations of its technology occur. Software piracy and misappropriation may adversely affect the Company's results of operations. Landmark and its subsidiaries currently rely on signed license agreements, but may in the future rely on "shrink wrap" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, effective protection of intellectual property rights is unavailable or limited in certain foreign countries. There can be no assurance that the Company's protection of its proprietary rights, including any patent that may be issued, will be adequate or that the Company's competitors will not independently develop similar technology, duplicate the Company's products or design around any patents issued to the Company or other intellectual property rights.
Landmark and its subsidiaries are not aware that any of its products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim such infringement by the Company with respect to current or future products. The Company expects that software product developers will increasingly be subject to such claims as the number of products and competitors in the Company's industry segment grows and the functionality of products in the industry segment overlaps. Any such claims, with or without merit, could result in costly litigation that could absorb significant management time, which could have a material adverse effect on Landmark's business, financial condition and results of operations. Such claims might require the Company to enter into royalty or license agreements. Such royalty or license agreements, if required, may not be available on terms acceptable to Landmark or at all, which could have a material adverse effect upon the Company's business, financial condition and results of operations.
COMPETITION
The market for performance management software is intensely competitive, fragmented and characterized by increasingly rapid technological developments, evolving standards and rapid changes in customer requirements. To maintain and improve its position in this market, Landmark is enhancing current products and the inter-operability of its products with one another and developing new products. Landmark competes primarily with vendors that provide mainframe and/or client/server performance management software. The Company believes that principal competitors with respect to mainframe performance management software products include Candle Corporation and BMC Software, Inc. In the client/server market, Landmark believes that its principal competitors include BMC Software, Inc., Compuware Corporation and Computer Associates International, Inc.
Some of the Company's competitors have longer operating histories and substantially greater financial, technical, sales, marketing and other resources, as well as greater name recognition and a larger customer base, than those of the Company. The Company's current and future competitors could introduce products with more features, greater scalability, increased functionality and lower prices than the Company's products. These competitors could also bundle existing or new products with other, more established products in order to compete with the Company. The Company's focus on performance management software may be a disadvantage competing with vendors that offer a broader range of products. Moreover, as the client/server performance management software market develops, a number of companies with significantly greater resources than those of the Company could increase their presence in this market by acquiring or forming strategic alliances with competitors or business partners of the Company. In addition, due to potentially lower barriers to entry for platform-specific niche products in the performance management software market, the Company believes that emerging companies may enter this market, particularly in the client/server environment. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could materially and adversely affect the Company's business, financial condition and results of operations. Any material reduction in the price of the Company's products would negatively affect gross margins and would require the Company to increase software unit sales in order to maintain gross profits. There can be no assurance that the Company will be able to compete successfully against current and future competitors, and the failure to do so would have a material adverse effect upon the Company's business, financial condition and results of operation.
The principal competitive factors affecting the market for Landmark's products are functionality and features (including breadth of data collection, data management, integration and modeling), product quality, platform coverage, product architecture, price, customer support and name recognition. Based on these factors, the Company believes that it has competed effectively to date. In the future, Landmark will be required to respond promptly and effectively to the challenges of technological change, its competitors' innovations and customer requirements. There can be no assurance that Landmark will be able to provide products that compare favorably with the products of the Company's competitors or that competitive pressures will not require the Company to reduce its prices.
EMPLOYEES
As of December 31, 1999, the Company employed 308 full time personnel, including 102 in product development, 32 in technical support, 121 in sales and marketing, and 53 in finance and administration. The Company's employees are not represented by any collective bargaining organization, and the Company has never experienced a work stoppage. The Company believes its success will depend in part on its continued ability to attract and retain highly qualified personnel in an intensely competitive market for experienced and talented software engineers and sales and marketing personnel. The Company believes that its relationship with its employees is satisfactory.
ITEM 2.
ITEM 2. PROPERTIES.
Landmark relocated its corporate headquarters to a facility in Reston, Virginia in June 1999. Landmark entered into a lease agreement whereby it will lease the entire 4 story office building, approximately 100,000 square feet situated on a 5 acre development site, for a term of twelve years, with two renewal options each for an additional five years. Landmark executed a coterminous sublease of its previous office space in Vienna, Virginia, which
took effect upon the commencement of the new lease, under a lease expiring in June 2003, with a renewal option for an additional five years.
The Company also leases approximately 4,000 square feet of office space in Oakbrook, Illinois under a lease expiring in April 2002, and 2,000 square feet in Irvine, California under a lease expiring in April 2002. Landmark leases office space in London and Rugby, UK; Nieuwegein, the Netherlands; Sevres Cedex, France; Kaarst, Germany; Central Hong Kong; Bagvaerd, Denmark; Helsinki, Finland; Jarfalla, Sweden; Melbourne and Sydney, Australia; and Madrid, Spain.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not currently engaged in any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS.
There were no matters submitted to stockholders for vote during the fourth quarter of 1999.
EXECUTIVE OFFICERS OF THE COMPANY
The following table lists the executive officers of the Company.
KATHERINE K. CLARK, a co-founder of Landmark, has beaded product development, technical support, finance and human resources at various times over Landmarks history, has been a director of Landmark since 1983 and from November 1993 to September 1997 was President of the Company. In 1994, Ms. Clark assumed her current role as Chief Executive Officer of the Company and is responsible for the long-term strategic direction of the Company. In November 1999, Ms. Clark reassumed the role of President of the Company.
JAMES R. BOWERMAN is Landmark's Vice President, Research and Development and is responsible for strategy, development maintenance and planning for Landmark's product lines. Mr. Bowerman joined Landmark in March 2000 after eight years as the Vice President of Engineering of AXENT Technologies.
DANIEL C. CARAYIANNIS is Landmark's Vice President, Worldwide Sales and is responsible for sales and sales support throughout the world. Mr. Carayiannis was Landmark's Vice President, North American Sales from October 1998 until January 2000. Prior to joining Landmark, Mr. Carayiannis served from July 1994 to October 3998 as Vice President of SPOT Image Corporation, a satellite imagery and information data products firm. From
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April 1993 to July 1994, Mr. Carayiannis served as Vice President of Sales for Falcon Microsystems, a federal, computer technology value-added reseller.
JOHN D. HUNTER is Landmark's Vice President, Business Development and is responsible for identifying and evaluation of strategic business opportunities. Prior to his appointment to this position in January 2000, Mr. Hunter served as Landmark's Vice President, Mainframe Products, since June 1994. Mr. Hunter joined Landmark in August 1992 as Vice President, Development and Technology after 24 years with IBM, during which time he held management roles in various IBM development labs and was responsible for IBM's worldwide standards participation as director of architecture and telecommunications.
ROBERT H. JOHNSON is Landmark's Vice President Customer Operations and is responsible for customer service, quality assurance, product packaging and documentation at Landmark. Prior to his appointment to this position in January 2000, Mr. Johnson served as a director of technical communications since he joined Landmark in 1990.
BRUCE E. LOVETT is Landmark's Vice President, Marketing and is responsible for the strategic planning and implementation of Landmark's marketing programs for all software product lines. Prior to joining Landmark in May 1999, Mr. Lovett served as Vice President, Worldwide Marketing at TenFour, a company that specializes in e-mail and Web security and connectivity software and services from 1998 to 1999. From 1996 to 1998, Mr. Lovett was employed with Versatility, a provider of call center and customer care software and services, where he served as Vice President of Marketing and Customer Programs. Mr. Lovett served as the Director of Marketing for GRCI, a network design software and consulting services firm during 1996, and he served as the Marketing Programs Manager for LEGENT from 1993 to 1995.
FREDERICK S. ROLANDI, III has served as Landmark's Vice President and Chief Financial Officer since November 1998. In September 1999, Mr. Rolandi was elected to serve as Secretary of the Company. Prior to his employment with Landmark, Mr. Rolandi served as Vice President, Controller of Intersolv, Inc., a software tools company, from November 1997 to October 1998. From 1991 to October 1997 Mr. Rolandi was employed with Honeywell Measurex DMC where he served as Vice President and Chief Financial Officer from May 1991 to December 1995 and as Vice President and General Manager from January 1996 to October 1997.
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PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Landmark's common stock (the "Common Stock") has been traded on the Nasdaq National Market since the Company's initial public offering on November 18, 1997 under the symbol "LDMK." The following table sets forth the high and low sale price, as reported on the Nasdaq National Market:
On March 3, 2000, there were 178 holders of record of the Company's Common Stock.
Landmark has never paid or declared any cash dividends and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. The Company currently intends to retain its future earnings, if any, to fund the development and finance the growth of its business. The amount and timing of any future dividends will depend on general business conditions encountered by the Company, as well as the financial condition, earnings and capital requirements of the Company and such other factors as the Board may deem relevant.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following selected financial data of the Company are qualified by reference to and should be read in conjunction with the Consolidated Financial Statements and Notes thereto and Management's Discussion and Analysis of Results of Operations and Financial Condition included elsewhere in this Form 10-K. The consolidated statements of operations data for the years ended December 31, 1997, 1998 and 1999, and the consolidated balance sheet data at December 31, 1998 and 1999 were derived, and are qualified by reference to, Consolidated Financial Statements of the Company which were audited by PricewaterhouseCoopers LLP and are included elsewhere in this Form 10-K. The consolidated statements of operations data for the years ended December 31, 1995 and 1996 and the consolidated balance sheet data at December 31, 1995, 1996 and 1997 are derived from the Company's audited financial statements not included in this Form 10-K.
(1) See Note 2 of Notes to Consolidated Financial Statements for an explanation of the method used to determine the number of shares used to compute basic and diluted earnings per share.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
RESULTS OF OPERATIONS FOR 1999, 1998 AND 1997
The following table sets forth the Company's Consolidated Statements of Operations expressed as percentages of total revenues for the periods indicated. The Company's revenues are derived from licensing mainframe and client/server computer software, and providing related maintenance and other services.
Total revenues. Total revenues in 1999 were $55.2 million, an increase of 10.8% from the prior year. Total revenues in 1998 were $49.8 million, an increase of 14.9% from 1997. Revenues in 1999 from mainframe
products and services were $45.4 million, an increase of 7.2% from the prior year, and revenues in 1999 from client/server products and services were $9.8 million, an increase of 30.9% from the prior year. The increase in revenues from mainframe products and services was primarily due to an increase in customer conversions as discussed below. The increase in client/server revenues was primarily due to increased acceptance of the client/server products in international markets. Although revenues continued to increase, the Company experienced a slowdown in sales growth due to the lengthening of the sales cycle (this lengthening of the sales cycle may be attributable to certain Year 2000 issues, as described below, and to the greater time required to consummate more complex and higher dollar transactions). In an effort to shorten the sales cycle and improve its order close rate, the Company introduced a more focused direct sales approach in October 1999. The Company intends to monitor the results of this sales approach to determine its impact on the sales cycle and order close rate; however, the lengthening of the sales cycle due to Year 2000 issues may continue through at least the first quarter of 2000.
License revenues. License revenues in 1999 were $25.3 million, an increase of 14.7% from the prior year. During 1998, license revenues were $22.1 million, an increase of 31.6% from 1997. The increases in 1999 and 1998 were primarily due to an increase in the number of new customers, large dollar transactions (transactions greater than $100,000) and customer conversions to new license agreements. A conversion of a license agreement is, in effect, a migration from either a site or CPU license to a MIPS (millions of instructions per second) or MSU (measured service units) license. A site or CPU license allows the customer to use the licensed software only in one designated location. A MIPS or MSU license, however, allows the customer to use the licensed software in a multi-site environment (these licenses are often selected by customers who can reasonably anticipate their computing capacity needs, and this license is priced in proportion to the computing capacity of the machine). If a customer elects to convert to a MIPS or MSU license, the customer is required to pay the Company an additional fee whenever the customer increases the size of their computing environment. The list price of the new license and the associated maintenance may be lower than that of the original license and maintenance because of changes in fair values over time. During 1999 and 1998, the Company entered into approximately 60 and 40 license agreements, respectively, which were greater than $0.1 million.
Maintenance revenues. Maintenance revenues in 1999 were $29.9 million, an increase of 7.6% from the prior year. During 1998, maintenance revenues were $27.7 million, an increase of 4.4% from 1997. In 1999 and 1998, maintenance revenues were favorably impacted by the volume of prior year's license sales and the effects of increases in the Company's maintenance prices, partially offset by an increase in conversions of license agreements, which often may result in lower maintenance fees. As discussed above, due to changes in fair values over time, the new license and associated maintenance may be lower than that of the original (pre-conversion) license and maintenance. Maintenance renewal rates have historically been 85 to 90%, and management believes future maintenance renewal rates will continue at this level.
Cost of license revenues. Cost of license revenues includes amortization of capitalized software costs, product royalties and materials and packaging expenses. Costs of license revenues in 1999, 1998 and 1997 were $1.3 million, $1.2 million and $2.0 million, respectively, representing 5.2%, 5.2% and 11.7% of license revenues. The slight increase from 1998 to 1999 is the result of an increase in product royalties partially offset by a decrease in amortization of capitalized software costs. The $0.8 million reduction from 1997 to 1998 is primarily due to a decrease in amortization of capitalized software costs.
Cost of maintenance revenues. Cost of maintenance revenues consists of personnel and related costs for customer support, training and consulting services. Costs of maintenance revenues in 1999, 1998 and 1997 were $4.6 million, $3.7 million and $3.3 million, respectively, representing 15.3%, 13.3% and 12.4% of maintenance revenues. The $0.9 million increase from 1998 to 1999 is primarily the result of increased professional service personnel for client/server products and additional support personnel in the Company's European subsidiaries. The $0.4 million increase from 1997 to 1998 is primarily due to an increase in the number of customer service employees.
Cost to acquire distribution rights. Cost to acquire distribution rights includes royalties paid related to the acquisition of distribution rights as well as the straight-line amortization of international distribution rights that
have been reacquired from third party resellers. Cost to acquire distribution rights in 1999, 1998, and 1997 were $2.0 million, $0.6 million and $0.6 million, respectively. The increase in 1999 is primarily due to the amortization of distribution rights acquired in January and October 1999 from the Company's former distributors in the United Kingdom and France, respectively, and royalties of $0.2 million paid to the Company's former distributor in the Nordic region.
Sales and marketing. Sales and marketing expenses include personnel and related costs for the Company's direct sales organization, marketing staff and promotional expenses. Sales and marketing expenses were $20.9 million, $17.1 million and $14.3 million in 1999, 1998 and 1997, respectively, representing 37.8%, 34.4% and 33.0% of total revenues. The $3.8 million increase from 1998 to 1999 is primarily due to an increase in personnel in the international direct sales organization, the increase in marketing activities, and an increase in commission expenses to the Company's direct sales forces as a result of increased sales. The $2.8 million increase from 1997 to 1998 is primarily due to growth of the North American direct sale force and an increase in marketing personnel and programs.
Product research and development. Product research and development expenses include personnel and related costs for the Company's development staff. Product research and development expenses were $16.1 million, $15.2 million and $13.5 million in 1999, 1998 and 1997, respectively, representing 29.2%, 30.6% and 31.1% of total revenues. The $1.7 million increase from 1997 to 1998 is due to the Company's continued investment in both mainframe and client/server products. The Company capitalized software development costs of $0.9 million and $0.3 million in 1999 and 1998, respectively, and did not capitalize any software development costs in 1997 as any amounts eligible for capitalization were not material. Amounts capitalized in 1999 were related to the development of WebWatcher which is scheduled to be released in the second quarter of 2000; amounts capitalized in 1998 were related to the development of PerformanceWorks 3.0.
General and administrative. General and administrative expenses include salaries and related costs of administration, finance and management personnel, as well as legal and accounting fees. General and administrative expenses were $6.0 million, $5.6 million and $5.3 million in 1999, 1998 and 1997, respectively, representing 10.9%, 11.1% and 12.1% of total revenues. The increase from 1998 to 1999 is due to a continued increase in personnel in the Company's information systems department and costs associated with the relocation of the Company's headquarters which occurred in June 1999. The increase from 1997 to 1998 includes increased expenses for information systems personnel and bad debt reserves, partially offset by a decrease in stock compensation expense. Bad debt reserves are calculated based on historical experience of bad debt write-offs, aging of receivables, and specific exposures. During 1998, two of the Company's international distributors, with receivables totaling $0.5 million, became significantly delinquent in their payments. Accordingly, the Company increased its reserves to cover these specific exposures. During 1999, one of the international distributors paid its delinquent balance, at which time the reserve was adjusted. The Company wrote off the entire receivable balance from the second delinquent international distributor and reduced the reserve accordingly.
Net interest and other income. Net interest and other income includes interest income earned on cash balances, interest income recorded on installment receivables, interest expense incurred on term and revolving credit facilities, bank fees and exchange gains (losses) incurred by the Company on transactions denominated in foreign currencies. Net interest and other income were $2.1 million, $1.8 million and $0.5 million for 1999, 1998 and 1997, respectively. Of these amounts, $1.2 million, $0.9 million and $0.2 million represent interest earned on the Company's bank balances in 1999, 1998 and 1997, respectively. The increases from 1998 to
1999 and from 1997 to 1998 reflect higher levels of interest income earned by the Company on its cash balances and the reduction of interest expense due to the repayment of the Company's debt obligations during 1998.
Provision for income taxes. The Company's effective rates were 36.3%, 37.7% and 39.1% for 1999, 1998 and 1997, respectively. The effective tax rates differ from the federal and state statutory income tax rate primarily as a result of the adjustments of valuation allowances to reflect management's judgment as to whether certain tax credit carryforwards would expire before utilization by the Company, and as to the relative likelihood that foreign subsidiary net operating losses would not be recovered. In 1999, the Company reduced its valuation allowance by $0.1 million primarily due to the release of its liability for competent authority. See Note 8 to the Consolidated Financial Statements-Income Taxes.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1999, the Company had cash and cash equivalents of $32.1 million, an increase of 13.5% from the prior year, and working capital of $29.2 million. During 1999, net cash provided by operating and financing activities was $9.6 million and $3.8 million, respectively, while net cash used in investing activities was $9.6 million. The Company invests its cash in a money market fund. The Company had no debt as of December 31, 1999, other than normal trade payables and accrued liabilities. Stockholders' equity at December 31, 1999 was $37.9 million.
The Company continues to finance its growth through funds generated from operations. During 1999, 1998 and 1997, cash flow from operations was $9.6 million, $12.3 million and $6.6 million, respectively. Net cash flow from operating activities is primarily composed of net income, depreciation and amortization, the sale of unbilled receivables, and increases in deferred revenue, partially offset by increases in accounts receivable and unbilled accounts receivable, and a decrease in income taxes payable. During 1999 and 1998, the Company augmented operating cash flows with the sale of $8.8 million and $7.8 million, respectively, of unbilled accounts receivable. The sale of the unbilled receivables resulted in immaterial gains and losses for the Company. In the future, the Company may sell additional unbilled accounts receivable from time to time depending on the Company's cash flow requirements and whether the terms are financially favorable for the Company.
The Company's investing activities include expenditures for fixed assets in support of the Company's product development activities and infrastructure, and for capitalized software development costs. During 1999, 1998 and 1997, the Company invested $2.9 million, $2.3 million and $1.6 million, respectively, in fixed assets, consisting primarily of computer equipment to expand and upgrade the Company's development activities and, in 1999, for leasehold improvements associated with the Company's new headquarters. The Company expects to upgrade, on an ongoing basis, its development environments to meet changing customer and market requirements. In 1999, the Company also entered into operating leases with an aggregate value of $2.1 million to partially finance its move to its new headquarters. In 2000, the Company expects to make additional investments in its IT infrastructure of approximately $2.0 million.
The Company's investing activities also include amounts recorded as capitalized software development costs. Of the total research and development expenditures of $17.0 million, $15.5 million and $13.5 million during 1999, 1998 and 1997, the Company capitalized costs of $0.9 million and $0.3 million in 1999 and 1998, respectively. The Company did not capitalize any software development costs in 1997 as any amounts eligible for capitalization were not material.
During 1999, the Company acquired distribution rights from its former international distributors in the United Kingdom and France. As partial consideration for these acquisitions, the Company paid the former distributor in the United Kingdom $4.0 million in cash and paid the former distributor in France $1.2 million in cash. For additional discussion of the Company's acquisition of distribution rights, see Note 2 to the Consolidated Financial Statements - Summary of Significant Accounting Policies, Intangible Assets.
The Company believes that cash and cash equivalents at December 31, 1999 and cash flow generated from operations will provide sufficient liquidity to meet its needs for at least the next twelve months. To the extent the
Company makes acquisitions of other companies, products or technologies, the Company may use working capital, sell or issue additional equity or debt securities or use credit facilities.
INTRODUCTION OF THE EURO CURRENCY
The Euro became the single currency for most European countries on January 1, 1999, and the transition from national currencies to the Euro will be phased in over several years. The Company has assessed Euro issues related to its treasury operations, product pricing, contracts and accounting systems. Although the evaluation of these issues is still in process, management continues to believe that the Company's existing or planned hardware and software systems will accommodate the transition to the Euro and any required operating changes will not have a material effect on future results of operations or financial condition.
NEW ACCOUNTING PRONOUNCEMENTS
In December 1998, the American Institute of Certified Public Accountants (the "AICPA") issued Statement of Position (SOP) 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions." SOP 98-9 modifies SOP 97-2 by requiring revenue to be recognized using the "residual method" if certain conditions are met. The Company adopted SOP 98-9 on January 1, 2000 and believes the adoption will not have a material effect on the Company's financial condition or results of operations.
In March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." The Company adopted SOP 98-1 on January 1, 1999. The adoption of SOP 98-1 did not have a material impact on the Company's results of operations or financial condition.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133." The Company is required to adopt SFAS 133 for all fiscal quarters of all fiscal years beginning after June 15, 2000. SFAS 133 establishes methods of accounting for derivative financial instruments and hedging activities. Because the Company currently holds no derivative financial instruments as defined by SFAS 133 and does not currently engage in hedging activities, adoption of SFAS 133 is expected to have no material effect on the Company's financial condition and results of operations.
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101") to provide guidance regarding the recognition, presentation and disclosure of revenue in financial statements. The Company is currently evaluating the impact of the provisions of SAB 101.
YEAR 2000 COMPLIANCE
Through the first two months of 2000, Landmark's operations are fully functioning with no material Year 2000 issues to report anywhere in the world. At Landmark corporate headquarters and at its subsidiary sites worldwide there have not been any significant Year 2000-related issue that would affect the Company's ability to manufacture, ship, sell or service its products.
In preparation for the Year 2000 date rollover, the Company conducted periodic evaluations of its computer systems and products in an effort to determine the actions, if any, necessary to make them Year 2000 compliant. The term "Year 2000 compliant" (or similar terms) generally means that information technology hardware and software are able to correctly interpret and manipulate dates up to and through the year 2000, without interruption as the result of the change to this date.
These evaluations involved both testing the Company's computer systems and either requesting certifications from its vendors or consulting vendor websites. The Company completed testing and received vendor certification of all of its business critical information technology systems, including internal communication systems, accounting and finance systems, customer service systems and sales and marketing tracking systems, and does not anticipate
any Year 2000 compliance issues with these systems. At the conclusion of testing these systems, the Company determined that all critical information technology systems are Year 2000 compliant. The Company upgraded, replaced and tested these applications, and this process was completed prior to the Year 2000 date rollover.
The Company also recognized that there are risks with respect to embedded systems that are not necessarily a part of the Company's information technology systems but contain microprocessor chips, which may not function properly with the change of date to the year 2000. The majority of the embedded systems on which the Company relies in its day-to-day operations are owned and managed by the lessors of the buildings in which the Company's offices are located, or by agents of such lessors. During the second quarter of 1999, the Company moved its headquarters to a new facility, containing new mechanical systems, in Reston, Virginia. The Company believed that the new mechanical systems will be Year 2000 compliant, based on its building construction manager's experience with other such systems, and certain representations made by the manufacturers of such systems. The Company received assurance, through the representations in the equipment manufacturers' Operation and Maintenance (O & M) manuals or written letters of certification, that these systems are Year 2000 compliant. Additionally, the Company installed a new telephone switch in the new facility, and a Year 2000 compliancy certificate has been received from the switch's manufacturer.
Because the Company believed that its information technology and embedded systems would be substantially Year 2000 compliant in advance of the year 2000 date change, the Company had no contingency plan to address non-compliance. The Company, however, constantly monitors its Year 2000 status and is prepared to develop contingency plans if it is determined that any business critical systems may not be Year 2000 compliant.
Disruptions with respect to the computer systems of vendors or customers, which are outside the control of the Company, could impair the ability of the Company to obtain services from or conduct business with its customers. The Company believes that its primary exposure is with respect to public utilities and telecommunications service providers. The Company completed the process of either consulting vendor websites or requesting certifications from these public utilities and telecommunications service providers of their Year 2000 compliance. Although the public utility companies and telecommunications service providers consulted have determined to the best of their knowledge and belief that interruptions to services will be unlikely, unforeseen disruptions of the Company's utilities or telecommunications systems could have a material adverse effect upon the Company's financial condition and results of operations. The Company believes that no other providers are material to its business. Disruptions of customers' computer systems could interfere with payments to the Company by such customers, and therefore with the Company's ability to make timely payments on its accounts, and could otherwise cause disruptions to the Company's operations. None of the Company's customers, however, is individually material to the Company's business and the Company did not seek certifications from its customers that their internal computer systems are Year 2000 compliant.
With respect to the products sold by the Company, the Company had determined that, with certain exceptions described below, to the extent that underlying hardware platforms, operating systems applications and databases will accommodate the year 2000 date change, the Company's performance management software products are Year 2000 compliant. The Company is specifically aware that CICS Version 2, Release 1.2, an operating system developed and marketed by the IBM Corporation is not presently Year 2000 compliant, according to IBM, and that the Company's The Monitor for CICS/MVS Version 8.3 product, since it operates with such non-compliant IBM product, is therefore also non-compliant. IBM has decided not to make their product compliant. Accordingly, the Company has been communicating this non-compliancy situation to its customers by written, oral and electronic (e-mail and the Company's web site) communications since 1997. The expected reduced sales of this product are not expected to have a material adverse effect on the Company's results of operations or financial condition.
The other exceptions to the Company's general condition of Year 2000 product compliance are: (1) some Company product customers may be operating older, non-compliant versions of certain of the Company's products, and also may not be active participants in product maintenance programs that periodically provide in the normal course of business (at no additional charge beyond the on-going costs of program participation) newer product versions or product modifications that address Year 2000 non-compliancy issues and specifically make
such products Year 2000 compliant (the "Older Product Scenario"); (2) the Company discovered in the first quarter of 1999 that its NaviGraph product, version 1.3 required a product addition to make it Year 2000 compliant (the "NaviGraph 1.3 Scenario"); (3) the Company discovered in the second quarter of 1999 that its SmartAgent for Oracle product required a product addition to make it Year 2000 compliant (the "SmartAgent for Oracle Scenario"); and (4) the Company discovered in third quarter of 1999 that two products, Navigraph version 2.0 (the "Navigraph 2.0 Scenario") and the Monitor for VTAM version 2.1 (the "Monitor for VTAM 2.1 Scenario") have Year 2000 data reporting and display defects which do not affect the overall operation of the product.
With respect to the Older Product Scenario, the majority (on an absolute basis) of the Company's products were made Year 2000 compliant during 1997. Certain other Company products, specifically The Monitor for DB Control, The Monitor for MQ Series and NaviPlex products, were made Year 2000 compliant during 1998. Additionally, those customers on active product maintenance programs (and approximately 85% to 90% of the Company's customers participate in such programs) receive regular product upgrades or modifications that include software that addresses Year 2000 compliancy issues. The Company encourages all its customers to participate in active maintenance programs. The Company has completed its attempts to communicate this Older Product Scenario issue to customers through written, oral and electronic (e-mail and the Company's web site) communications.
With respect to the NaviGraph 1.3 Scenario, the product addition required to make this product Year 2000 compliant was made generally available to all NaviGraph customers participating in active maintenance programs during late April 1999. The Company had previously communicated to its customers and to third parties, beginning in 1997, that NaviGraph 1.3 was Year 2000 compliant. The Company has completed its efforts to contact all NaviGraph 1.3 product customers to alert them that Year 2000 compliancy issues may be present and to inform them of their options.
With respect to the SmartAgent for Oracle Scenario, the product addition required to make this product Year 2000 compliant was made generally available to all SmartAgent for Oracle customers participating in active maintenance programs during early August 1999. The Company had previously communicated to its customers and to third parties, beginning in 1997, that SmartAgent for Oracle was Year 2000 compliant. Year 2000 product additions have been made available for all versions (1.x, 2.x, and 3.0) of SmartAgent for Oracle. SmartAgent for Oracle 3.0 becomes Year 2000 compliant when used in conjunction with Service Pack 2, which was made available in early August 1999. Year 2000 product additions (replacement binaries) for all previous versions (1.x, 2.x) have been made available to SmartAgent for Oracle customers that are on, or wish to join, active maintenance programs. The Company has completed its efforts to contact all SmartAgent for Oracle product customers to alert them that Year 2000 compliancy issues may be present and to inform them of their options.
With respect to the NaviGraph 2.0 Scenario, the product addition required to correct the reporting and display function defect and make this product fully Year 2000 compliant was made generally available to all NaviGraph customers participating in active maintenance programs through the November 1999 PerformanceWorks for MVS and OS/390 version 3 Cumulative Service tape in November 1999. The Company had communicated to its customers and to third parties through the second quarter of 1999 that NaviGraph 2.0 was Year 2000 compliant. All NaviGraph version 2.0 domestic customers participate in the maintenance program for the product. Approximately three-quarters of international NaviGraph customers (version 2.0 and previous versions) participate in the maintenance program for the products. The Company does not know how many of those international NaviGraph product customers not participating in an active maintenance program are no longer using the product. Accordingly, the majority of domestic and international NaviGraph 2.0 customers who have elected to participate in active maintenance programs are, or will be made, Year 2000 compliant with respect to such products in the normal course of business, assuming they accept and implement the November Cumulative Service tape as such normal product maintenance. The Company has completed its efforts to contact all NaviGraph 2.0 product customers to alert them that Year 2000 compliancy issues may be present and to inform them of their options.
With respect to the Monitor for VTAM 2.1 Scenario, the product addition required to make this product Year
2000 compliant was made generally available to all Monitor for VTAM customers participating in active maintenance programs during November 1999. The Company had previously communicated to its customers and to third parties that the Monitor for VTAM version 2.1 was Year 2000 compliant. Of the approximately 149 domestic Monitor for VTAM 2.1 customers, 117 of such customers participate in the maintenance program for the product. The Company does not know how many of those domestic Monitor for VTAM customers not participating in an active maintenance program are no longer using the product. Of the approximately 102 international Monitor for VTAM (version 2.1 and previous versions) customers, approximately 74 of such customers participate in the maintenance program for the products. The Company does not know how many of those international Monitor for VTAM (version 2.1 and previous versions) customers not participating in an active maintenance program are no longer using the product. Accordingly, the majority of domestic and international Monitor for VTAM (version 2.1) customers who have elected to participate in active maintenance programs are, or will be made, Year 2000 compliant with respect to such products, assuming they accept and implement the fix. The Company has completed is efforts to contact all Monitor for VTAM product customers to alert them that Year 2000 compliancy issues may be present and to inform them of their options.
Although the Company did not anticipate that customers would require additional product support during the Year 2000 date change, Landmark had expanded support supplemented by additional on-site staffing to assist customers on product maintenance with either Year 2000- or non-Year 2000 related-problems from Thursday, December 30, 1999 through Friday January 7, 2000. The number of Year 2000-related calls from customers into the Company's product support center has been much lower than anticipated. Customer support operations continue to report that customers have no significant Year 2000 incidents.
Notwithstanding its efforts to attempt to ensure that its products are Year 2000 compliant and although the Company to date has not experienced any significant problems associated with Year 2000, the Company may experience future uncertainties and problems relating to the Year 2000 date change issue, including but not limited to possible technical problems and/or customer claims. If circumstances warrant, the Company may conduct additional tests for its mainframe and client/server products, and is also aware that certain of its customers have been and will continue to conduct additional Year 2000 Company product compliancy tests. It is possible that additional Company product Year 2000 compliancy issues could be discovered in the future during the course of such tests.
Virtually all of the Company's customers and potential customers were required to evaluate their information technology systems with respect to the Year 2000 date change and the Company believes that some of its customers and potential customers may have incurred material costs in connection with this evaluation and any necessary repairs and replacements. Customers and potential customers may have been required to devote material portions of their information technology budgets to such evaluations, repairs and replacements, which could have materially reduced their other information technology purchases in 1999, including their purchases of the Company's products, particularly as the Year 2000 date change drew closer. The Company has very limited information as to the degree to which its customers or potential customers have completed Year 2000 remediation efforts or whether or not its customers or potential customers are Year 2000 compliant. However, during the second, third, and fourth quarters of 1999 the Company experienced a lengthening of the sales cycle
due to, among other things, possible Year 2000 issues. The Company anticipates that Year 2000 related sales cycle lengthening may continue at least through the first quarter of 2000.
The Company has incurred a total of approximately $0.5 million for years 1999, 1998, and 1997 for Year 2000 remediation activities. There can be no assurance that the actions taken by the Company with respect to its internal information technology systems, embedded systems or its products will eliminate the numerous and varied risks associated with the year 2000 date change. Further, there can be no assurance that the Company will not be adversely affected by any year 2000 related difficulties encountered by vendors or customers or by any downturn in information technology purchases or in the economy in general as a result of the Year 2000 date change. Additionally, the effects of any actual Year 2000 non-compliance problem directly or indirectly experienced by the Company could be exacerbated by the fact that the Company normally experiences its largest quarterly sales for a given calendar year in the fourth quarter of each year, and invoices and receives payment for such sales in the first quarter of the following calendar year. Accordingly, should a Year 2000 non-compliance problem or problems affect the Company's customers, the potential impact on the Company's operations could be greater than if the Company received these payments at the time of sale or some time other than the calendar quarter immediately after the date switch from 1999 to 2000. Any of these risks could have a material adverse effect on the Company's financial condition and results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company has subsidiaries in the United Kingdom, Germany, France, The Netherlands, Sweden, Spain, Australia, Hong Kong and Singapore that act as distributors of its products. Additionally, the Company uses third party distributors to market and distribute its products in other international regions. Transactions conducted by the subsidiaries are typically denominated in the local country currency, while royalty payments from the distributors are typically denominated in U.S. dollars. As a result, the Company is primarily exposed to foreign exchange rate fluctuations as the financial results of its subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and impact overall expected profitability. Through and as of December 31, 1999, the Company's exposure was not material to the overall financial statements taken as a whole. The Company has not entered into any foreign currency hedging transactions with respect to its foreign currency market risk.
The Company's exposure to market risk for changes in interest rates relates primarily to unbilled accounts receivable. At December 31, 1999, the Company has $12.4 million of unbilled accounts receivable; the estimated fair market value of these receivables is $12.7 million. If market interest rates increase 10% from the levels at December 31, 1999, the fair market value of the unbilled accounts receivable would decline by an immaterial amount.
See Note 2 - Summary of Significant Accounting Policies in the Company's Notes to Consolidated Financial Statements contained elsewhere in this Form 10-K.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Landmark Systems Corporation
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Landmark Systems Corporation and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PRICEWATERHOUSECOOPERS LLP
McLean, Virginia February 29, 2000
LANDMARK SYSTEMS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of the consolidated financial statements.
LANDMARK SYSTEMS CORPORATION CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of the consolidated financial statements.
LANDMARK SYSTEMS CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of the consolidated financial statements.
LANDMARK SYSTEMS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of the consolidated financial statements; see cash flow disclosures including non-cash transactions in Notes 2, 6 and 8.
LANDMARK SYSTEMS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- ORGANIZATION AND OPERATIONS
Landmark Systems Corporation (the "Company") was incorporated in the Commonwealth of Virginia in November 1982 and commenced operations in 1983. The Company is engaged in the development, marketing and distribution of computer software products and the provision of related services. The Company is a supplier of performance management software products which measure, analyze, report and predict performance for both the mainframe and client/server computing environments.
The Company has established subsidiaries in the United Kingdom, Spain, Australia, Hong Kong, Germany, The Netherlands, Sweden, France and Singapore to act as distributors of its products in Europe, the Middle East, Africa, Australia, New Zealand and Southeast Asia. Additionally, the subsidiaries provide technical support, marketing and distribution support in their geographic markets.
NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated. Certain prior year amounts have been reclassified to conform with current year presentation.
The Company completed an initial public offering of its $.01 par value common stock on November 18, 1997 (the "IPO"). In preparation for the IPO, on October 22, 1997, the Company increased the number of authorized shares of common stock from 15 million shares to 30 million shares. A three-for-two stock split of the common stock took effect on November 17, 1997. All references to the number of shares authorized, issued and outstanding and per-share information for all periods presented have been adjusted to reflect the effects of the stock split and share authorization.
Cash and Cash Equivalents
For purposes of the consolidated balance sheets and statements of cash flows, the Company considers all highly liquid investment instruments with an original maturity of three months or less to be cash equivalents.
Revenue Recognition
Revenues are recognized in accordance with Statement of Position (SOP) 97-2, "Software Revenue Recognition," as amended by SOP 98-4, "Deferral of the Effective Date of a Provision of SOP 97-2, Software Revenue Recognition." Sales of perpetual software licenses are recorded as revenues when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable and collectibility is probable. Maintenance revenues generally are collected prior to the performance of the related services and are recorded as deferred revenue and recognized ratably over the period during which the services are performed. For transactions involving both license and maintenance revenues, the Company allocates the revenues based upon the relative vendor specific objective evidence of fair values of the license and the maintenance services.
In December 1998, the American Institute of Certified Public Accountants (the "AICPA") issued Statement of Position (SOP) 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions." SOP 98-9 modifies SOP 97-2 by requiring revenue to be recognized using the "residual method" if certain conditions are met. The Company adopted SOP 98-9 on January 1, 2000 and believes the adoption will not have a material effect on the Company's financial condition or results of operations.
In December 1999, the SEC issued Staff Accounting Bulletin 101, "Revenue Recoginition in Financial Statements" (SAB 101) to provide guidance regarding the recogonition, presentation and disclosure of revenue in financial statements. The Company is currently evaluating the impact of the provisions of SAB 101.
In certain circumstances, the Company enters into a long-term payment arrangement with a licensee. Under these types of arrangements, the Company allows the licensee to pay the license fees plus maintenance fees over a three-to-five-year period, generally in annual installments. If collectibility by the Company is probable, the Company records the present value of the contracted stream of payments as an unbilled account receivable in its financial statements. Of this amount, the Company recognizes the underlying license fee as license revenue and defers the underlying maintenance fee. As installments are invoiced to the licensee in accordance with the payment arrangement, the Company reflects a reduction in its unbilled accounts receivable and an increase in its accounts receivable. Historically, the Company has not granted concessions nor experienced significant bad debts associated with these long-term payment arrangements. At December 31, 1999 and 1998, unbilled accounts receivable have been reduced by $1,313,000 and $1,599,000, respectively, to reflect such amounts at their present values. The Company imputes interest based only on that portion of the receivable allocated to the license element as (a) the license is delivered immediately but paid for over an extended period and (b) the license revenue is the only portion of the fee that is recognized at the time the license agreement is entered. Imputed interest income on long-term receivables is reported within "Interest and Other Income" on the Consolidated Statements of Operations.
The Company has relationships with a number of third-party distributors to market and distribute its products internationally. Under such arrangements, the distributors report to, are invoiced by and remit payments to the Company based on transactions with the ultimate customer. The Company records license revenues and service revenues based upon transactions reported to the Company.
The Company records an accrual for estimated sales returns. Historically, such amounts have not been material.
Fixed Assets
Fixed assets are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation are generally five years for computer equipment, office equipment and furniture. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the estimated useful lives of the improvements or the term of the related lease.
Intangible Assets
In January 1997, the Company signed an agreement to acquire certain rights and related assets from Infarmedica Holding AG ("Infarmedica"), a former distributor of the Company's products. Under the terms of the
agreement governing this relationship, Infarmedica held exclusive rights to market certain of the Company's products in Austria, the Benelux countries, Germany and Switzerland. As a result of the 1997 agreement, the Company gained access to a significant customer base in these European countries (including an assignment of license and maintenance agreements) and established subsidiaries in Germany and The Netherlands to support these customers directly. In consideration for the acquisition of these rights, the Company paid Infarmedica $1,800,000 in installment payments from 1997 through 1999, of which $497,000 was paid in 1999, $488,000 was paid in 1998 and $815,000 was paid in 1997. In addition, in January 1997 the Company granted Infarmedica a warrant to purchase 225,000 shares of the Company's common stock at $4.00 per share, which was fully vested upon issuance, expires on January 1, 2007 and is transferable only with the Company's consent. The fair value of the warrant was $48,000, calculated using an option pricing model. The Company recorded the acquisition of the customer base as an intangible asset representing the present value of the cash payments plus the fair value of the warrant issued. The related intangible asset was amortized over three years.
In January 1999, the Company signed an agreement to acquire certain rights and related assets from Software Products Ltd. ("Software Products"), a former international distributor of the Company's products. Under terms of the agreement governing the distribution relationship, Software Products held exclusive rights to market certain of the Company's products in the United Kingdom. As a result of the 1999 agreement, the Company gained direct access to its mainframe customers in the United Kingdom. As consideration for the acquisition of these rights, the Company paid Software Products $4,000,000 in cash. As further consideration, the Company issued to Software Products 91,586 shares of Company common stock, with a fair value of $850,000 and subject to certain resale restrictions and registration rights. Additionally, the Company granted Software Products a warrant to purchase 150,000 shares of the Company's common stock at the then fair market value of $10.00 per share, which vested upon issuance and expires in January 2009. The fair value of the warrant was $540,000, calculated using an option pricing model assuming an expected warrant life of 2 years, a risk free interest rate of 4.6% and stock volatility of 60%. The Company recorded the acquisition of the customer base as an intangible asset representing the cash payment and the fair value of the stock and warrant issued and is amortizing the intangible asset over a five-year period.
In April 1999, the Company established a subsidiary, Landmark Systems Singapore Pte Ltd. to act as a distributor of the Company's products in Singapore.
In May 1999, the Company established a subsidiary, Landmark Systems France, SARL, to act as a distributor of the Company's client/server products in France. In October 1999, the Company acquired the distribution rights for its mainframe products from its international distributor in France. Under terms of the agreement to acquire the distribution rights, the Company paid the former distributor $1,200,000. Additionally, the Company granted the former distributor a warrant to purchase 100,000 shares of Company common stock at the then fair market value of $7.50 per share, which vested upon issuance. The warrant expires in October 2002 or October 2004 if certain conditions are met. The fair value of the warrant was $333,000, calculated using an option pricing model assuming an expected warrant life of three years, a risk free interest rate of 5.9% and stock volatility of 60%. The Company recorded the acquisition of the customer base as an intangible asset representing the cash payment and the fair value of the warrant issued, and is amortizing the intangible asset over a five-year period.
In June 1999, the Company acquired the distribution rights from its international distributor in the Scandinavian countries and established a subsidiary, Landmark Systems Nordic, AB, to act as a distributor of the Company's products in the Scandinavian countries. Under terms of the agreement to acquire the distribution rights, the Company will pay the former distributor a royalty through June 2003 ranging from 65% to 85% of revenue received from the licensing of certain products to, and the receipt of maintenance revenue attributed to those products from, the former distributor's customers. Royalty expense to the former distributor was $225,000 for the year ended December 31, 1999.
Amortization expense of costs to acquire distribution rights was $1,776,000 for the year ended December 31, 1999 and $616,000 for each of the years ended December 31, 1998 and 1997.
Software Development Costs
The Company accounts for its software development activities in accordance with Statement of Financial Accounting Standards (SFAS) No. 86, "Accounting for the Cost of Computer Software to be Sold, Leased or Otherwise Marketed." The Company capitalizes costs incurred subsequent to the point of demonstrated technological feasibility and up to the time the product is available for release to customers. Amortization is computed on an individual product basis and is the greater of (i) the ratio of current gross revenues for a product to the total current and anticipated future gross revenues for the product or (ii) the straight-line method over the estimated economic life of the product. The Company amortizes capitalized software costs over an 18 months period.
Impairment of Long-Lived Assets
The Company has adopted Statement of Financial Standards No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"). SFAS 121 prescribes that an impairment loss is recognized in the event that facts and circumstances indicate that the carrying amount of an asset may not be recoverable, and an estimate of future undiscounted cash flows is less than the carrying amount of the asset. Impairment is recorded based on an estimate of future discounted cash flows.
Stock-Based Compensation
The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Under APB No. 25, compensation expense is measured as the excess, if any, of the market price of the Company's stock at the date of grant over the exercise price of the option granted. Compensation expense for stock options, if any, is recognized ratably over the vesting period. The Company provides additional pro forma disclosures as required under SFAS No. 123, "Accounting for Stock-Based Compensation" (Note 11).
Transactions for which non-employees are issued equity instruments for goods or services received are recorded by the Company based upon the fair value of the equity instruments issued or the fair value of the goods or services received, whichever is more reliably measured.
Income Taxes
The Company provides for income taxes using the asset and liability approach. The asset and liability approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of the assets and liabilities. A valuation allowance is recorded if, based on the evidence available, it is more likely than not that some portion or all of the deferred tax asset will not be realized.
Comprehensive Income
Effective January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components. The Company's total comprehensive income is comprised of net income and other comprehensive income, which consists of foreign currency translation adjustments, and is presented in the Consolidated Statement of Changes in Stockholders' Equity.
Foreign Currency Translations
The functional currency for the Company's international subsidiaries is the applicable local currency. The financial statements of international subsidiaries are translated into U.S. dollars using exchange rates in effect at period end for assets and liabilities and average exchange rates during each reporting period for results of operations. Adjustments resulting from translation of financial statements are included in stockholders' equity as other comprehensive income. The Company does not attempt to hedge its foreign currency exposures. Foreign
currency transaction losses of $32,000, $6,000 and $253,000 in 1999, 1998 and 1997, respectively, are included in other income.
Fair Value of Financial Instruments
The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accounts receivable and accounts payable approximate their fair value due to the short maturity of those instruments.
The Company has $12,416,000 and $11,214,000 of unbilled accounts receivable outstanding at December 31, 1999 and 1998, respectively; the estimated fair values of these receivables are $12,698,000 and $12,095,000, respectively, calculated using discounted cash flows.
Concentrations of Credit Risk
Financial instruments that expose the Company to concentrations of credit risk consist principally of accounts receivable and unbilled receivables. Credit risk is limited due to the large number and geographic dispersion of customers comprising the Company's customer base. No distributor or customer accounted for more than 10% of the Company's total outstanding receivables.
Use of Estimates
The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates and assumptions.
Earnings Per Share
Basic earnings per share is computed by dividing the net income available to common stockholders by the weighted-average number of shares of common stock outstanding. Diluted earnings per share is computed by additionally reflecting the potential dilution that could occur, using the treasury stock method, if warrants and options to acquire common stock were exercised or resulted in the issuance of common stock that then shared in the earnings of the Company. The following is a reconciliation of the numerators and denominators for basic and diluted earnings per share for 1999, 1998 and 1997:
NOTE 3 -- SALE OF UNBILLED ACCOUNTS RECEIVABLE
During 1999 and 1998, the Company sold, without recourse, unbilled accounts receivables with a book value of $8,772,000 and $7,821,000, respectively, to augment the Company's cash flow. The unbilled receivables sold were from customers in the U.S. with remaining payments of up to four years. The transactions were accounted for pursuant to SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," and resulted in immaterial gains and losses for the Company.
NOTE 4 -- FIXED ASSETS
Fixed assets consist of the following:
Depreciation expense was approximately $1,666,000, $1,385,000 and $1,201,000 in 1999, 1998 and 1997, respectively.
NOTE 5 -- CAPITALIZED SOFTWARE COSTS
Capitalized software costs consist of the following:
The Company capitalized software development costs of approximately $856,000 and $258,000 during 1999 and 1998, respectively. The Company did not capitalize any software development costs in 1997, as any amounts eligible for capitalization were not material. Amortization expense of capitalized software costs was approximately $247,000, $400,000 and $1,250,000 in 1999, 1998 and 1997, respectively.
NOTE 6 -- DEBT
In December 1998, the Company paid the remaining balance of its debt. This debt consisted of a note payable with an interest rate of 9% which was secured by fixed assets and was due in monthly installments from February 1996 through January 1999. The Company did not pay any interest in 1999. The Company paid interest of approximately $42,000 and $276,000 in 1998 and 1997, respectively.
In March 1999, the Company obtained a revolving line of credit in the amount of $10,000,000. The line of credit, which is unsecured, has a floating interest rate of LIBOR plus 1.35% and expires June 30, 2000. No advances have been made on the line of credit. This agreement includes administrative fees of 0.25% on the unused balance of the line of credit.
NOTE 7 -- SEGMENT INFORMATION
The Company classifies its operations into one industry segment, software development and related services. The Company categorizes its products and services into two groups: mainframe and client/server. The Company's revenues by product group consist of the following:
The Company sells its products outside the United States through its subsidiaries and international distributors. Revenues from international distributors are presented net of royalties paid to the distributors. The Company's revenues by country or geographic region are as follows:
The Company's long-lived assets, which consist of fixed assets, capitalized software and intangible assets, by country or geographic region are as follows:
NOTE 8 -- INCOME TAXES
Income before income taxes consists of the following:
The provision for income taxes consists of the following:
The Company paid income taxes of approximately $3,446,000, $2,795,000 and $1,334,000 in 1999, 1998 and 1997, respectively. Foreign taxes paid relate primarily to taxes withheld from revenues remitted by international distributors.
The Company provides deferred taxes for temporary differences between the bases of assets and liabilities for financial reporting purposes and the bases of assets and liabilities for tax return purposes. The net deferred tax assets at December 31, 1999 and 1998 are attributable to the following:
As of December 31, 1999 and 1998, the Company had a valuation allowance of $333,000 and $320,000, respectively, to reflect foreign tax credit carryforwards that, in the Company's estimation, would more likely than not expire prior to utilization. The Company recorded an increase to the valuation allowance of $13,000 in 1999 to reflect the tax effect of estimated international subsidiary net operating losses.
Competent authority is a process to resolve unintended results between the U.S. and foreign taxing jurisdictions. In 1996, the Company established a provision for competent authority of $129,000 to reflect management's belief that the outcome of this process would likely result in a liability. In 1999, it was determined that the issues were resolved and the provision for competent authority of $129,000 was released.
At December 31, 1999, the Company had foreign net operating loss carryforwards of approximately $1,670,000, of which $240,000 expires in the year 2004. The remaining $1,430,000 carries forward indefinitely and is available to offset future foreign taxable income.
The provision for income taxes differs from the amount of taxes determined by applying the U.S. Federal statutory rate to income before income taxes as a result of the following:
NOTE 9 -- EMPLOYEE BENEFIT PLAN
The Company has a 401(k) defined contribution plan. During 1999, 1998 and 1997, the Company matched 50% of the first 3% of employees' deferred contributions. Employees are fully vested in all Company contributions. The Company recorded expense for its matching contributions of approximately $273,000, $228,000 and $217,000 during 1999, 1998 and 1997, respectively.
NOTE 10 -- MANDATORILY REDEEMABLE PREFERRED STOCK
Prior to the IPO, the Company had issued two classes of preferred stock: Series A Preferred Stock and Series B Preferred Stock. All shares of preferred stock outstanding were converted to common stock at the time of the IPO.
Mandatorily Redeemable Series A Preferred Stock
The Company's Series A Preferred Stock paid cumulative dividends effective May 1, 1992 at an annual rate of $0.15 per share until April 30, 1997, and thereafter at an annual rate of $0.375 per share.
The Company was required to redeem $1,500,000 of Series A Preferred Stock each year ("redemption year") plus accumulated dividends, beginning May 1, 1997, at a redemption price equal to $5.00 per share plus 75% of the amount, if any, by which the lesser of (i) 1.5 multiplied by the fair market value per share of the common stock as determined by the Board of Directors (the "Board") at the beginning of the redemption year or (ii) $7.4333 per share, exceeds $5.00 per share.
The holders of Series A Preferred Stock could convert all, but not less than all, of the preferred shares into common stock at the time of the IPO based upon the relationship between the redemption price and the IPO price of the Company's common stock. At the time of the IPO, the 855,165 shares of Series A Preferred Stock then outstanding were converted into 833,785 shares of common stock.
Mandatorily Redeemable Series B Preferred Stock
In March 1997, the Company issued 316,156 shares of Series B Preferred Stock at a price of $6.326 per share and, in April 1997, an additional 79,039 shares of Series B Preferred Stock at a price of $6.326 per share. The Series B Preferred Stock was convertible, at the option of the holder, into the Company's common stock based on a ratio of $6.326 to a conversion price. Additionally, the Series B Preferred Stock was redeemable at the holder's option at the earlier of December 31, 2000 or six months after an IPO of the Company's common stock.
Each outstanding share of Series B Preferred Stock was automatically convertible into 1.5 shares of the Company's common stock immediately upon the closing of a qualified public offering, as defined. Accordingly, at the time of the IPO, the 395,195 shares of Series B Preferred Stock then outstanding were converted into 592,793 shares of common stock.
The following table summarizes the activity with respect to the Series A Preferred Stock and Series B Preferred Stock:
NOTE 11 -- COMMON STOCK INSTRUMENTS AND STOCKHOLDERS' EQUITY
Stock Purchase Plans
During 1998, the Company adopted the 1998 Stock Purchase Plan ("1998 SPP") which replaced the 1991 Employee Stock Purchase Plan ("1991 ESPP"). Under the 1998 SPP, eligible employees may use up to 10 percent of their gross cash compensation to purchase shares of the Company's common stock at a purchase price equal to 85 percent (90 percent during 1998 and the first three quarters of 1999) of the fair value of the stock as of the last day of the previous quarter or the day before the last day of the current quarter, whichever is lower. For the plan years ended April 30, 1998 and 1997, the Board made 75,000 shares available for purchase under the 1991 ESPP. Under the 1991 ESPP, eligible employees could purchase shares valued at up to 10 percent of their gross cash compensation at fair value as determined by the Board. During 1999, 1998 and 1997, 71,534, 39,512 and 64,716 shares, respectively, were purchased under the stock purchase plans.
Prior to the IPO, the shares employees purchased under the 1991 ESPP were subject to certain transfer restrictions. Without the prior written consent of the Company, an employee could not sell, assign or transfer any common stock purchased under this plan to any person or entity other than the Company, another stockholder or employee. Under certain conditions, the employee could require the Company to repurchase his shares at fair value. At any time following the termination of an individual's employment, the Company had the right to repurchase the employee's shares acquired through the 1991 ESPP at fair value. These rights and restrictions lapsed at the time of the IPO.
Stock Incentive Plans
The Company has three stock incentive plans that provide for the granting of stock options to employees and executives of the Company: the 1994 Stock Incentive Plan ("1994 SIP"), the 1989 Stock Incentive Plan ("1989 SIP") and the 1992 Executive Stock Incentive Plan ("1992 ESIP"). Options under these plans are granted at the fair market value of the Company's common stock at the date of grant, vest over a four-year period and expire ten years after the grant date. The 1994 SIP replaced the 1989 SIP and the 1992 ESIP and no additional grants will be made under the 1989 SIP or the 1992 ESIP. Options outstanding under the 1989 SIP and the 1992 ESIP will remain outstanding until the options terminate or are exercised.
Prior to the IPO, while employed by the Company, a holder of options granted under the 1989 SIP and the 1992 ESIP had the right to require the Company to repurchase at the fair market value, as established by the Board, all or any portion of his (i) option shares and (ii) restricted stock provided that certain of the conditions had been met. The Company also had the right to repurchase at the fair market value, at any time following the termination of a grantee's employment with the Company, all or any portion of the option shares or restricted stock then held by the grantee. These repurchase rights lapsed at the time of the IPO.
As of December 31, 1999, a total of 4,500,000 shares of common stock can be issued under the 1994 SIP through (i) qualified stock options, which qualify as incentive stock options and have an exercise price equal to or greater than the fair market value of the common stock at the date of grant, (ii) non-qualified stock options, which have an exercise price equal to or greater than 85% of the fair market value of the common stock on the date of grant, (iii) restricted stock awards for common stock at a price determined by the Board, but not less than 85% of the fair market value of the stock at the date of grant, which is non transferable and subject to repurchase at the holder's cost until Board designated conditions have been met, or (iv) stock bonuses.
1996 Advisory Board and Directors Stock Incentive Plan
Options granted under the 1996 Advisory Board and Directors Stock Incentive Plan (the "1996 ABP") are granted at the market value of the Company's common stock on the date of grant, vest over a four year period and expire ten years after the grant date. In 1999, 1998, and 1997 the Company granted options totaling 66,000, 36,000, and 12,000, respectively, to its Board members. In October 1997, the Company terminated the Advisory Board, accelerated the vesting of 18,000 options granted pursuant to the 1996 ABP which were scheduled to vest on December 31, 1997, and canceled 36,000 unvested options granted pursuant to the 1996 ABP.
Other Stock Options
In 1997, the Company issued 128,002 options to former employees of the Company to replace options previously issued under the 1989 SIP, the 1992 ESIP and the 1994 SIP which expired unexercised concurrent with or subsequent to separation from the Company. The terms of the options granted were similar to, but not identical to, the terms of the options they replaced. The Company recorded compensation expense associated with these options of $60,000 in 1997.
Options Outstanding and Exercisable
The following table summarizes information about options outstanding for all stock option plans:
The following table summarizes information about options outstanding at December 31, 1999 by plan:
At December 31, 1999, the average exercise price per share of exercisable options was $5.77. The unvested options vest primarily over a four-year period and will be fully vested in the year 2003. The remaining average option life is 7.5 years.
For stock options granted prior to the IPO, the Company estimated the fair value of each employee option grant on the date of grant using a minimum value model. The weighted-average assumptions included in the Company's fair value calculations are as follows:
The weighted-average fair value of stock options granted under the employee stock option plans during 1999, 1998 and 1997 was $6.57, $4.64 and $1.05, respectively. Had the Company determined compensation costs for these option plans and the stock purchase plans in accordance with SFAS No. 123 (Note 2), the Company's net income for 1999 would have been approximately $2,076,000 or $0.17 per basic share and $0.16 per diluted share. The Company's net income for 1998 would have been approximately $4,418,000, or $0.38 per basic share and $0.36 per diluted share. The Company's net income for 1997 would have been approximately $2,645,000, or $0.15 per basic and $0.13 per diluted share. The SFAS No. 123 method of accounting does not apply to options granted prior to January 1, 1995 and, accordingly, the resulting pro forma compensation cost may not be representative of future amounts.
Stock Compensation Expense
The Company records stock compensation expense for the amount, if any, by which the fair market value of the Company's common stock exceeds the option exercise price at the date of the option grant. Prior to the IPO, the Company also recorded stock compensation expense for shares and options outstanding under the 1989 SIP, the 1992 ESIP and the 1991 ESPP to reflect any increase in the amount at which the holders could require the Company to repurchase such shares. The Company records stock compensation benefit to reflect any forfeitures of unvested stock options. The Company recorded stock compensation expense of approximately $0, $100,000 and $591,000 in 1999, 1998 and 1997, respectively. Prior to the IPO, the Board determined the fair value of the Company's common stock. The fair value of the Company's common stock effective May 1, 1997 was $4.97.
Redeemable Common Stock Instruments
The redeemable common stock instruments represent the shares of common stock and stock options issued by the Company to certain employees pursuant to the 1989 SIP, the 1992 ESIP, the 1991 ESPP and other agreements whereby the holder had the right to require the Company to repurchase such shares at their current fair market value. The rights of holders of redeemable common stock instruments to require the Company to repurchase such shares automatically lapsed at the time of the IPO.
The following table summarizes the activity with respect to the redeemable common stock instruments:
NOTE 12 -- COMMITMENTS
During 1988, the Company entered into a ten-year lease for office space which included a rent abatement for one and one half years. Rental expense has been calculated as total rental payments spread ratably over the life of the lease. An accrued rent expense is created in years when rent expense exceeds cash payments. In 1996, the Company extended the lease commitment by five years. The current and long-term portions of the deferred rent abatement at December 31, 1999 are approximately $87,000 and $218,000, respectively, and have been included in accrued expenses or other liabilities, as appropriate.
During 1998, the Company entered into a lease for office space for the Company's new headquarters facility, and concurrently subleased the Company's existing headquarters facility at terms which are comparable to those contained within the Company's existing lease. The Company moved into the new facility in June 1999 and turned its existing premises over to the subleasee at that time. The lease for the new facility has a twelve-year term.
The Company is committed for the payment of minimum rentals, exclusive of escalation charges and renewal options and net of sublease income, under office space, computer and other equipment operating lease agreements through 2004 for the following amounts:
Additionally, the Company leases certain equipment under cancelable operating leases. The total rental expense under all equipment and office space operating leases was approximately $3,800,000, $3,200,000 and $2,700,000 in 1999, 1998 and 1997, respectively.
NOTE 13 - UNAUDITED QUARTERLY RESULTS
The following table sets forth unaudited quarterly consolidated statements of operations data for the years ended December 31, 1999, 1998 and 1997 (in thousands, except per share amounts):
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information with respect to directors required by this item is incorporated by reference from the Company's 2000 Proxy Statement to be filed with the Securities and Exchange Commission by May 1, 2000.
The information with respect to officers required by this item is included at the end of Part I of this document under the heading "Executive Officers of the Company."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item is incorporated by reference from the Company's 2000 Proxy Statement to be filed with the Securities and Exchange Commission by May 1, 2000.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this item is incorporated by reference from the Company's 2000 Proxy Statement to be filed with the Securities and Exchange Commission by May 1, 2000.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item is incorporated by reference from the Company's 2000 Proxy Statement to be filed with the Securities and Exchange Commission by May 1, 2000.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Listed below are the documents filed as a part of this report:
1. Financial Statements and the Independent Accountants Report:
Report of Independent Accountants Consolidated Statements of Operations Consolidated Balance Sheets Consolidated Statements of Changes in Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
2. Financial Statement Schedules:
Report of Independent Accountants on Financial Statement Schedule
Schedule II -- Valuation and Qualifying Accounts
3. Exhibits:
* Reflects management contract or other compensatory arrangement required to be filed as an exhibit pursuant to Item 14(c) of this Form 10-K.
/\ Filed herewith.
(b) Reports on Form 8-K:
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
LANDMARK SYSTEMS CORPORATION
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 30, 2000.
REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
To the Board of Directors and Stockholders of Landmark Systems Corporation
Our audits of the consolidated financial statements referred to in our report dated February 29, 2000, relating to the consolidated financial statements, appearing in Landmark Systems Corporation's Annual Report on Form 10-K for the year ended December 31, 1999 also included an audit of the financial statement schedule listed in Item 14(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
McLean, Virginia February 29, 2000
LANDMARK SYSTEMS CORPORATION SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999
(A) Uncollectible accounts written off and sales returns
(B) Reduction of tax valuation allowance
INDEX TO EXHIBITS | 17,629 | 118,645 |
884269_1999.txt | 884269_1999 | 1999 | 884269 | ITEM 1. BUSINESS
GENERAL
ALPHA PRO TECH, LTD. (referred to herein as the "Company") was incorporated on February 17, 1983 pursuant to the British Columbia COMPANY ACT R.S.B.C. 1979, Chapter 59 (the "COMPANY ACT (BRITISH COLUMBIA)" under the name Princeton Resources Corp. The Company subsequently changed its name to Canadian Graphite Ltd. on July 27, 1988 and further changed its name to BFD Industries Inc. on July 4, 1989. Effective July 1, 1994, the Company changed its corporate domicile from Canada to the State of Delaware in the United States and changed its name to Alpha Pro Tech, Ltd. At that time, all of the Company's operating assets were transferred to its wholly owned subsidiary, Alpha Pro Tech, Inc. The Company's executive offices are located at 60 Centurian Drive, Suite 112, Markham Ontario, Canada L3R 9R2, and its telephone number is (905) 479-0654.
BUSINESS
The Company develops, manufactures and markets disposable protective apparel and consumer products for the cleanroom, food services, industrial, medical, dental and consumer markets. The Company operates through three divisions: apparel; mask and shield; and extended care. The Company's products are primarily sold under the "Alpha Pro Tech" brand name, but are also sold for use under private label.
The Company's products are classified into five groups: Disposable protective apparel consisting of a complete line of shoecovers, headcovers, gowns, coveralls and labcoats; food industry apparel consisting of a line of automated shoecovers, sleeve protectors, aprons, and face shields; infection control products consisting of a line of face masks and face shields; extended care products consisting of a line of mattress overlays, wheelchair covers, geriatric chair surfaces, operating room table surfaces and pediatric surfaces; and consumer products consisting of a line of pet bedding and pet toys. The Company's products as classified above are grouped into three segments. The Apparel segment consisting of disposable protective apparel and food industry apparel; the Mask/Shield segment consisting of infection control products; and the Extended Care Unreal Lambskin-Registered Trademark- segment consisting of extended care products and consumer products.
The Company's current strategy is to not only grow its cleanroom business through its exclusive agreement with VWR Scientific Products, but to focus on its other core businesses which include medical, dental and pet markets. The Company also intends to distribute to the industrial safety market. As part of its current strategy emphasis is being placed on developing innovative products and processes which are expected to increase gross margins.
The Company will continue to pursue the food service industry with its proprietary shoecover, which helps prevent employees from slipping and falling on slippery surfaces, found in restaurants, supermarkets and food processing facilities. The Company's products are used primarily in hospitals, clean rooms, laboratories, industrial and dental offices and are distributed principally in the United States through a network presently consisting of 2 purchasing groups, 9 major distributors, approximately 800 additional distributors, approximately 12 independent sales representatives and a Company sales and marketing force of 11 people.
HISTORICAL DEVELOPMENT
In April, 1989, the Company purchased all the assets, patents, trade secrets, inventory, goodwill and other properties to manufacture, among other items, certain transparent eye protection products utilizing an optical-grade polyester film from John Russell (the inventor of certain products currently being manufactured, marketed and distributed by the Company), Al Millar (currently president and a director of the Company), Sheldon Hoffman (currently chief executive officer and a director of the Company), Robert Isaly (currently a director of the Company), Irving Bronfman (a former director of the Company), BFD Inc. (an Alabama corporation), 779177 Ontario Inc. (a corporation owned by Messrs. Hoffman and Bronfman), and Milmed International Distributors Limited (a company owned by Al Millar). None of the persons or entities referred to above were officers, directors or affiliated with the Company in any way prior to the transaction.
From April 1, 1990 to August 30, 1991, the business currently being carried on by the Company, was operated by the BFD Industries Limited Partnership, an Ontario limited partnership (the "BFD Limited Partnership"), of which a wholly-owned subsidiary of the Company was the general partner, and of which there was only one limited partner. Pursuant to an agreement between the Company and the sole limited partner of the Company's Limited Partnership dated June 21, 1991, the Company purchased the limited partner's 50% interest in the BFD Limited Partnership for a purchase price of $1,000,000. The BFD Limited Partnership was dissolved on August 30, 1991 and the business and operations have continued to be carried on by the Company directly.
Prior to its acquisition of the business currently being conducted, the Company was involved in mining and exploration.
PRODUCTS
The Company's principal product groups and products include the following:
Disposable Protective Apparel
* Shoecovers * Headcovers * Gowns * Coveralls * Lab Coats
Food Industry
* Automated Shoecovers * Sleeve Protectors * Aprons
Infection Control
* Face Masks * Face Shields
Extended Care
* Unreal Lambskin * Medi-Pads * Hospital Pads * Wheelchair accessories * Bedrail Pads * Knee and Elbow protectors
Consumer Products
* Pet Bedding * Pet Toys
DISPOSABLE PROTECTIVE APPAREL
The Apparel division was established April 1, 1994, in connection with the acquisition of the assets of Disposable Medical Products Inc. ("DMPI"). The products manufactured include many different styles of shoecovers, headcovers, gowns, coveralls, lab coats, and other miscellaneous products. These are manufactured in Mexico.
FOOD INDUSTRY
Through the acquisition of Gem Nonwovens, Inc. a patented automated shoecover machine was acquired. This prototype machine has been replaced with an improved new machine which in combination with a patent pending laminated material allowed the Company to develop a shoecover that to date is being used by McDonald's Corporation through a Supply Agreement and is being tested by a number of other restaurant chains with favorable results. The balance of the food industry products are manufactured by the apparel division.
MASKS AND FACE SHIELDS
The facemasks come in a wide variety of filtration efficiencies and styles. The Company's patented Positive Facial Lock-Registered Trademark- feature provides a custom fit to the face to prevent blow-by for better protection. Combine this feature with the Magic Arch-Registered Trademark-, that holds the mask away from the nose and mouth and creates a breathing chamber, and you have a quality disposable facemask.
The term "blow-by" is used to describe the potential for infectious material entering or escaping a facemask without going through the filter as a result of gaps or openings in the face mask.
All of the face shields are made from an optical-grade polyester film, and have a permanent anti-fog feature. This provides the wearer with extremely lightweight, distortion-free protection that can be worn for hours and will not fog up from humidity and/or perspiration. An important feature of all eye and face shields is that they are disposable. This eliminates a chance of cross infection between patients and saves hospitals the expense of sterilization after every use.
EXTENDED CARE
The Extended Care Division began with the Company's Unreal Lambskin-Registered Trademark- pressure sore and bed patient monitoring system product lines. The Unreal Lambskin-Registered Trademark- is used to prevent decubitus ulcers or bedsores on long term care patients. The bed patient monitoring system offers nurses an alarm system that can tell when patients try to get out of bed. This helps nursing and other extended and long term care facilities to comply with the Omnibus Reconciliation Act (OBRA) of 1987 mandate to work towards using no restraints to control residents or patients in these facilities.
CONSUMER PRODUCTS
The Consumer Product Division uses the Company's existing medical products and technologies for general consumer purposes. The Unreal Lambskin-Registered Trademark- is being packaged for the retail pet bed market and pet toys.
MARKETS
The Company's products are sold to the following markets: Infection Control Products, (Masks and Shields) and disposable protective apparel are sold to the Medical and Dental market and the Industrial and Cleanroom markets; Unreal Lambskin and Medi-Pads are sold to the Extended Care market; Pet Bedding and Pet Toys are sold to the Consumer market; and automated shoecovers are sold to the Food Industry, Medical, Industrial and Cleanroom market. The Company has expanded its marketing efforts for the Food Industry to include apparel, such as sleeve protectors and aprons as well as shields.
DISTRIBUTION
The Company relies primarily on a network of independent distributors for the sale of its products including the following:
* VWR Scientific * Allegiance Healthcare * McKesson HBOC * Medline Industries * Blain Supply * Owens and Minor * Durr/Bergin Brunswig Medical * Johnson & Johnson Medical * Henry Schein, Inc.
Of the nine major distributors in the United States to the best of the Company's knowledge, all sell competing products.
In 1996, the Company entered into an exclusive five year agreement to supply VWR Scientific Products with eye and face shields, masks and disposable apparel for sale to the Industrial/Cleanroom market place. The distribution agreement calls for VWR to purchase a minimum of $5 million in each of the years of the contract to retain exclusive distribution rights. This minimum figure has been attained for 1996 through 1999. In early 2000, the Company extended its exclusive agreement through 2002 with a minimum annual requirement of $10 million for VWR to retain exclusive distribution rights.
Sales to VWR Scientific Products represented 57.8% of total sales for 1999, 51.1% for 1998 and 50.7% for 1997. The loss of this customer would have a material adverse effect on the Company's business.
The Company does not generally have backlog orders, as orders are usually placed for shipment within 30 days. The Company anticipates no problems in fulfilling orders as they are placed.
MANUFACTURING
The Company's mask production facility is located in a 27,0000 square foot building at 903 West Center Street, Bldg. E, North Salt Lake, Utah.
A 25,000 square foot facility located at 615 North Parker Drive, Janesville, Wisconsin is used to manufacture the Company's Unreal Lambskin products.
The Company's disposable protective apparel production is located in three facilities, a 40,000 sq. ft. facility located at 1287 Fairway Drive in Nogales, Arizona which is used for cutting, warehousing and shipping, a 19,500 square foot facility at Kennedy Drive #6 in Sonora, Mexico which is used for assembly of shields and sewing, and a 30,000 sq. ft. facility located at Ave. Abolardo L. Rodriguez y Novena, Benjamin Hill, Sonora Mexico, which is used for sewing.
The Company has a material coating and automated shoecover facility of 36,000 square feet located at 2224 Cypress Street, Valdosta, Georgia.
The Company has multiple suppliers of the materials used to produce its products. In that regard, the Company currently has no problems, and does not anticipate any problems, with respect to the sources and availability of the materials needed to produce its products. The business of the Company is not subject to seasonal considerations. It is necessary for the Company to have adequate finished inventory in stock, and the Company generally maintains a two-to-three month supply of product.
COMPETITION
The Company faces substantial competition from numerous other companies, including some companies with greater marketing and financial resources. The Company's major competitor in the medical and dental markets is Kimberly Clark of Fort Worth, Texas. Other large competitors would include Minnesota Mining and Manufacturing Corporation (3M), Johnson & Johnson, Isolyser, Inc., American Threshold and Maxium. The Company's major competitors in the industrial and cleanroom market are Kimberly Clark,3M, Isolyser, Inc., Kappler USA, and Allegiance Health Care. In the extended care market, Texten Corp., Glenoit Mills and Hudson Industries are the principal competitors, and in the consumer products market, principal competitors include Flexmat Corporation, Lazy Pet Company and Dogloo, Inc. The Company has entered the food service market with a new type of product, and expects competition from companies who provide floor treatment and manufacturers of safety boots such as Weinbrenner, Inc. However, the Company believes that the quality of its products, along with the price and service provided, will allow it to remain competitive in the disposable apparel market.
The Company is not required to obtain regulatory approval from the U.S. Food and Drug Administration ("FDA") with respect to the sale of its products. The Company's products are, however, subject to prescribed "good manufacturing practices" as defined by the FDA and its manufacturing facilities are inspected by the FDA every two years to assure compliance with such "good manufacturing practices." The Company is marketing a Particulate Respirator that meets the new O.S.H.A. respirator guidelines and which has been approved by the National Institute for Safety and Health (NIOSH). This product is designed to help prevent the breathing in of the tuberculosis virus.
The Company does not anticipate that any federal, state and local provisions which have been or may be enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will have any material effect upon the capital expenditures, earnings and competitive position of its business.
PATENTS AND TRADEMARKS
PATENTS
The Company's policy is to protect its intellectual property rights, products, designs and processes through the filing of patents in the United States and where appropriate in Canada and other foreign countries. At present, the Company has 14 United States patents relating to its MEDS, Add-A-Mask, Coverall, 1/2 Coverall, Combo Cone, Combo, Positive Facial Lock and Shieldmate products and a U.S. patent on the automated shoecover and the shoecover process. In addition the Company has recently been issued a U.S. patent on a method to fold and put on sterile garments. The Company also has a U.S. patent pending on a fluid impervious and non-slip fabric for the Company's Aqua-Trak shoecover. The Company believes that its patents may offer a competitive advantage, but there can be no assurance that any patents, issued or in process, will not be circumvented or invalidated. The Company also intends to rely on trade secrets and proprietary know-how to maintain and develop its commercial position.
The various United States patents issued have remaining durations of approximately 7 to 16 years before expiry.
TRADEMARKS
Many of the Company products are sold under various trademarks and trade names including Alpha Pro Tech. The Company believes that many of its trademarks and trade names have significant recognition in its principal markets and takes customary steps to register or otherwise protect its rights in its trademarks and trade names.
EMPLOYEES
As of February 1, 2000, the Company had 528 employees, including 17 persons at its head office in Markham, Ontario, Canada; 34 persons at its facemask production facility in Salt Lake City, Utah and 20 persons at its Extended Care production facility in Janesville, Wisconsin; 39 persons at its cutting, warehouse and shipping facility in Nogales, Arizona; 56 persons at its shield assembly and sewing operation in Nogales, Mexico; 331 at its sewing operation in Benjamin Hill, Mexico; and 20 persons at its coating and automated shoecover facility in Valdosta, Georgia.
None of the Company's employees in the United States and Canada are subject to collective bargaining agreements. However, a collective bargaining agreement with the Confederation of Mexican Workers, exists for its Mexican employees. Benefits are reviewed annually by May and the 1999 agreement was signed with moderate benefit increases. Wages are set by the Government of Mexico. The Company considers its relations with the union and its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
The Companies' Head Office is located at 60 Centurian Drive, Suite 112, Markham, Ontario L3R 9R2. The approximate monthly costs are $3,800 under a lease expiring February 28, 2002. Seventeen (17) employees of the Company, including the President, Alexander Millar, Chief Executive Officer, Sheldon Hoffman and Senior Vice President and Controller, Lloyd Hoffman work out of this head office.
The Company manufactures its surgical face masks at 903 West Center Street, Building C, North Salt Lake, Utah. The monthly rental is $6,810 for 27,000 square feet. This lease expires July 1, 2000 with successive 2-year renewal options at rents based on the U.S. Consumer Price Index.
A second manufacturing facility is located at 615 North Parker Drive, Janesville, Wisconsin. These premises of 25,000 square feet are leased for $7,000 monthly. The lease expires August 15, 2002. The Company's line of Extended Care products is manufactured in these facilities.
The Apparel division has its cutting operation, warehousing, and shipping facility at 1287 Fairway Drive, Nogales, Arizona. The monthly rental is $9,000 for 40,000 square feet. This lease expires November 30, 2002. Shield assembly and sewing is done at Kennedy Drive, # 6 in Sonora, Mexico. The monthly rental is $ 6,500 for 19,500 square feet. This lease expires June 30, 2002. Sewing is done at Ave. Abelardo L. Rodriguez Y. Novena, Benjamin Hill, Sonora, Mexico. The monthly rental is $7,200 for 30,000 square feet. This lease expires June 23,
The Coating Division has its facility at 2224 Cypress Street, Valdosta, Georgia. The monthly rental is $4,500 for 36,000 square feet.
The Company believes that these arrangements are adequate for its present needs and that other premises, if required, are readily available.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no pending legal proceedings against the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS PRICE RANGE OF SECURITIES
On March 8, 1993 the Common Shares of the Company were cleared for quotation on the National Association of Securities Dealers (NASD) Over the Counter (OTC) Bulletin Board under the symbol "BFDIF." When the Company changed its name to Alpha Pro Tech Ltd. on July 1, 1994, its symbol was changed to APTD.
The high and low range of bid prices for the Common Shares of the Company for the quarters indicated as reported by the NASD were as follows:
Such over the counter market quotations reflect interdealer prices, without retail mark-up,. mark-down or commission, and may not necessarily represent actual transactions.
As at February 16, 2000 there were 511 shareholders of record, and approximately 2,800 beneficial owners.
DIVIDEND POLICY
The holders of the Company's Common Shares are entitled to receive such dividends as may be declared by the board of directors of the Company from time to time to the extent that funds are legally available for payment thereof. The Company has never declared nor paid any dividends on any of its Common Shares. It is the current policy of the Board of Directors to retain any earnings to provide for the development and growth of the Company. Consequently, the Company has no intention to pay cash dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ALPHA PRO TECH, LTD.
SELECTED FINANCIAL DATA - --------------------------------------------------------------------------------
(1) Includes the operations of Ludan Corporation which was acquired effective April 1, 1995. See Note 12 in Notes to the Consolidated Financial Statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
FISCAL 1999 COMPARED TO FISCAL 1998
Alpha Pro Tech, Ltd. ("Alpha" or the "Company") reported net income for the year ended December 31, 1999 of $1,129,000 as compared to net income of $316,000 for the year ended December 31, 1998, representing an improvement of $813,000 or 257.3%. The net income increase of $813,000 is attributable primarily to an increase in gross profit of $733,000, due to a 12.5% increase in sales, a decrease in depreciation and amortization of $40,000, a decrease in net interest expense of $69,000, partially offset by an increase in selling, general and administrative expenses of $11,000 and an increase in provision for incomes taxes of $18,000. Management expects sales and net income to continue to improve in 2000.
SALES Consolidated net sales for the year ended December 31, 1999 increased to $20,235,000 from $17,985,000 in 1998, representing an increase of $2,250,000 or 12.5%.
Net sales for the Apparel Division for the year ended December 31, 1999 were $12,883,000 as compared to $11,685,000 for the same period of 1998. The Apparel Division sales increase of $1,198,000 or 10.3% was primarily due to increased sales to the Company's largest distributor. This distributor has reported sales increases of the Company's products for six consecutive quarters. Management's expectation is that growth should continue, and as a result the Company's sales to this distributor should also remain strong. Net sales to this distributor were 57.8% and 51.1% of total consolidated net sales for 1999 and 1998, respectively.
Mask and eye shield sales increased by $915,000 or 22.0% to $5,073,000 in 1999 from $4,158,000 in 1998. This increase is primarily the result of growth in industrial mask sales, and to a lesser extent medical mask sales, partially offset by a decline of sales in the dental distributor market. The industrial mask sales increase is primarily the result of sales to the Company's largest distributor. As a result of the introduction of the Medical Division in 1999, medical mask sales improved 8.1% in 1999 and sales are expected to continue to strengthen in 2000 as more new medical masks are introduced to the market.
Sales from the Company's Extended Care Unreal Lambskin-Registered Trademark- and other related products, which includes a line of pet beds, increased by $137,000 or 6.4% to $2,279,000 in 1999 compared to $2,142,000 in the same period in 1998. The increase in sales of $137,000 is primarily the result of increased pet product sales and to a lesser extent to medical fleece sales. In 1999, the Company implemented a pet products telemarketing campaign and feels that sales should strengthen in 2000 as a result.
In 1999, sales for all three divisions of the Company improved over the previous year, as compared to 1998 in which only one division, the Apparel Division, improved over the prior year. Management feels
that the Company is well positioned to continue to grow in its current markets as well as the new Food Service market.
COST OF GOODS SOLD Cost of goods sold increased to $12,250,000 for the year ended December 31,1999 from $10,733,000 for the same period in 1998. As a percentage of net sales, cost of goods sold increased to 60.5% in 1999 from 59.7% in 1998. Gross profit margin decreased to 39.5% for the year ended December 31, 1999 from 40.3% for the same period in 1998.
The decline in gross profit margin to 39.5% from 40.3% is a result of mask manufacturing inefficiencies due to the growth of the mask sales. These inefficiencies will be remedied in 2000 with the addition of new manufacturing equipment that was built in 1999 and will be put into production in 2000. Management expects gross profit margin to improve, but there can be no assurance that the Company's margin improvements will be sustained.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses increased by a modest $11,000 to $6,352,000 for the year ended December 31, 1999 from $6,341,000 for the year ended December 31, 1998. As a percentage of net sales, selling, general and administrative expenses decreased to 31.4% in 1999 from 35.3% in 1998. The increase in selling, general and administrative expenses primarily consists of increased payroll related costs of $342,000; increased professional fees of $28,000; increased rent expense of $19,000; increased factory expenses of $42,000 and increased general office and insurance expenses of $62,000. This is partially offset by decreased marketing, commissions, and travel expenses of $359,000; decreased public company expenses of $102,000, including investor relations, options/warrants issued for services, annual report and annual meeting costs, stock transfer costs, and costs associated with SEC reporting requirements; and decreased telecommunication expenses of $21,000. Management expects selling, general and administrative expenses as a percentage of net sales to decrease as sales increase.
DEPRECIATION & AMORTIZATION Depreciation and amortization expense decreased by $40,000 to $362,000 for the year ended December 31, 1999 from $402,000 for the same period in 1998. This decrease is primarily attributable to assets in the mask division being fully depreciated.
INCOME FROM OPERATIONS Income from operations increased by $762,000 or 149.7%, to $1,271,000 for the year ended December 31, 1999 as compared to income from operations of $509,000 for the year ended December 31, 1998. The increase in income from operations is due to an increase in gross profit of $733,000, a decrease in depreciation and amortization of $40,000, partially offset by a modest increase in selling, general and administrative expenses of $11,000.
NET INTEREST Net interest expense decreased by $69,000 or 35.8% to $124,000 for the year ended December 31, 1999 from $193,000 for the year ended December 31, 1998. The decrease in net interest expense is due to lower borrowings, decreased interest on capital leases and increased interest income. Interest income increased by $3,000, to $39,000 for 1999 from $36,000 in 1998. The Company has extended until December 31, 2001, its $2,900,000 credit facility with an asset-based lender, consisting of a line of credit of up to $2,500,000 and a term note of $400,000, with interest at prime plus 1.75% on the credit line and at prime plus 2.25% on the term note.
PROVISION FOR INCOME TAX Provision for income tax consists of the Company's alternative minimum taxable (AMT) income. Net operating losses (NOLs) from prior years were utilized during 1999 to offset all other income tax expense.
NET INCOME Net income for the year ended December 31, 1999 was $1,129,000 compared to net income of $316,000 for the year ended December 31, 1998, an improvement of $813,000 or 257.3%. The net income increase of $813,000 is comprised of an increase in income from operations of $762,000 and a decrease in interest expense of $69,000, partially offset by an increase in provision for income taxes of $18,000.
The Company does not have any pension, profit sharing or similar plans established for its employees, however, the chief executive officer and president are entitled to a combined bonus equal to 10% of the pre-tax profits of the company. A bonus of $125,000 was earned in 1999 as compared to $32,000 in 1998.
FISCAL 1998 COMPARED TO FISCAL 1997
Alpha Pro Tech, Ltd. ("Alpha" or the "Company") reported net income for the year ended December 31, 1998 of $316,000 as compared to a net loss of $929,000 for the year ended December 31, 1997, representing an improvement of $1,245,000 or 134.0%. The net income increase is attributable primarily to a significant improvement in gross profit margin, a decrease in selling, general and administrative expenses, and a decrease in net interest expense. The improvement in gross profit margin is a result of the Company's strategic emphasis on developing innovative products and improved manufacturing efficiency.
SALES Consolidated net sales for the year ended December 31, 1998 increased to $17,985,000 from $17,823,000 in 1997, representing an increase of $162,000 or 0.9%.
Net sales for the Apparel Division for the year ended December 31, 1998 were $11,685,000 as compared to $10,969,000 for the same period of 1997. The Apparel Division sales increase of $716,000 or 6.5% was primarily due to increased sales to the Company's largest distributor which are expected to grow as a result of the Company's strategy to develop innovative solutions to meet this and other customers' needs, as well as improvements in the Asian economy. Net sales to this distributor were 51.1% and 50.7% of total consolidated net sales for 1998 and 1997, respectively.
Mask and eye shield sales decreased by 4.5%, to $4,158,000 in 1998 from $4,354,000 in 1997. This decrease is primarily the result of a drop in medical and dental mask sales, partially offset by increases in industrial mask sales. Sales of mask and eye shields should strengthen in 1999 with the introduction of the Medical Division and the introduction of a new line of masks and shields.
Sales from the Company's Extended Care Unreal Lambskin-Registered Trademark- and other related products, which includes a line of pet beds, decreased by 14.3% to $2,142,000 in 1998 compared to $2,500,000 in the same period in 1997. The decrease in sales of $358,000 is primarily the result of the discontinuation of a low margin rolled good line, partially offset by increases in pet product sales and medical fleece sales of $221,000.
In late 1997, Alpha restructured its business around a strategy of innovation that has enabled it to develop custom products to meet its customers' needs in a very timely manner. This approach is to satisfy customer requirements in a way that the Company's larger competitors are unable to match.
COST OF GOODS SOLD Cost of goods sold decreased to $10,733,000 for the year ended December 31,1998 from $11,594,000 for the same period in 1997. As a percentage of net sales, cost of goods sold decreased to 59.7% in 1998 from 65.0% in 1997. Gross profit margin increased to 40.3% for the year ended December 31, 1998 from 35.0% for the same period in 1997.
The improvement in gross profit margin to 40.3% from 35.0% is a result of the Company's strategic emphasis on developing high gross profit products, especially for its largest customer and improved manufacturing efficiency as a result of recent capital expenditures. Management expects gross profit margin to continue to remain strong, but there can be no assurance that the Company's margin improvements will be sustained.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses decreased by $190,000 to $6,341,000 for the year ended December 31, 1998 from $6,531,000 for the year ended December 31, 1997. As a percentage of net sales, selling, general and administrative expenses decreased to 35.3% in 1998 from 36.6% in 1997. The decrease in selling, general and administrative expenses primarily consists of decreased public company expenses of $91,000, including investor relations, options/warrants issued for services, annual report and annual meeting costs, stock transfer costs, and costs associated with SEC reporting requirements; decreased professional fee expenses of $115,000; decreased bad debt expenses of $131,000; decreased general office and factory expenses of $6,000; partially offset by increased payroll related costs of $53,000; increased marketing, commissions and travel expenses of $55,000; increased rent of $34,000; and increased telecommunications expense of $11,000. Management expects selling, general and administrative expenses as a percentage of net sales to decrease as sales increase.
DEPRECIATION & AMORTIZATION Depreciation and amortization expense increased by $83,000 to $402,000 for the year ended December 31, 1998 from $319,000 for the same period in 1997. This increase is primarily attributable to an increase in the purchase of equipment through capital leases.
INCOME (LOSS) FROM OPERATIONS Income from operations increased by $1,130,000 to $509,000 for the year ended December 31, 1998 as compared to a loss from operations of $621,000 for the year ended December 31, 1997. The increase in income from operations is due to an increase in gross profit of $1,023,000 and a decrease in selling, general and administrative expenses of $190,000, partially offset by an increase in depreciation and amortization of $83,000.
NET INTEREST Net Interest expense decreased by $115,000 or 37.3%, to $193,000 for the year ended December 31, 1998 from $308,000 for the year ended December 31, 1997. The decrease in net interest expense is due to a decrease in the cost of capital partially offset by increases in interest on additional capital leases acquired and decreases in interest income. Interest income decreased by $31,000, to $36,000 for 1998 from $67,000 in 1997. In December 1997, the Company entered into a three-year
$2,900,000 credit facility, consisting of a line of credit of up to $2,500,000 and a term note of $400,000, with an asset-based lender at prime plus 2% on the credit line and at prime plus 2.25% on the term note. Alpha's previous credit facility was at prime plus 5%.
NET INCOME (LOSS) Net income for the year ended December 31, 1998 was $316,000 compared to a net loss of $929,000 for the year ended December 31, 1997, an improvement of $1,245,000 or 134.0% . The net income increase of $1,245,000 is comprised of an increase in income from operations of $1,130,000 and a decrease in interest expense of $115,000.
The Company does not have any pension, profit sharing or similar plans established for its employees, however, the chief executive officer and president are entitled to a combined bonus equal to 10% of the pre-tax profits of the company. A bonus of $32,000 was earned in 1998 as compared to nil in 1997.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1999, the Company had cash of $785,000 and working capital of $4,375,000. During the year ended December 31, 1999, cash increased by $742,000 and accounts payable and accrued liabilities increased by $437,000. The increase in the Company's cash is due to income from operations and an increase in accounts payable and accrued liabilities, offset by capital expenditures of $453,000 and a reduction in borrowings from its asset-based lender. The Company's net borrowings from its asset-based lender decreased by $335,000. The Company currently has an asset-based lender's line of credit of up to $2,500,000 and a term note of $400,000 that expires in December 2001. At December 31, 1999, the unused line of credit from its asset-based lender was $1,269,000.
Net cash provided by operations was $1,677,000 for the year ended December 31, 1999 compared to $180,000 for the same period of 1998. The Company's generation of cash from operations for the year ended December 31, 1999 is due primarily to net income, decreases in inventory and an increase in accounts payable and accrued liabilities, offset by increases in accounts receivable, restricted cash and prepaid and other assets.
The Company's investing activities have consisted primarily of expenditures for fixed assets of $453,000 and increases in intangible assets of $26,000 for a total of $479,000 for the year ended December 31, 1999.
The Company anticipates that its mask manufacturing capabilities are to be further improved in 2000 at an estimated cost of $150,000. Depending on the success of the automated shoecover approximately $500,000 of additional equipment could be required. The Company intends to lease equipment whenever possible.
During the year ended December 31, 1999, the Company's cash used in financing resulted primarily from net decreases in the asset-based loan of $335,000, decreases in capital leases of $101,000 and the buy-back of 32,500 of the Company's common share at a cost of $24,000. The Company announced in December 1999 that it was authorized to buy-back up to $500,000 of its own shares. As of February 16, 2000, it has bought back 42,500 common shares at a cost of $35,000.
The Company believes that cash generated from operations, its current cash balance, and the funds available under its asset-based borrowings, will be sufficient to satisfy the Company's projected working capital and planned capital expenditures for at least 12 months.
YEAR 2000
We met our Year 2000 project objectives and completed the project prior to year-end. We have not experienced any disruption in our operations as a result of non-compliance of vendors, financial institutions, or other third parties or external systems. At this time, the possibility of a third-party risk arising, which could have a material risk on the company, is not reasonably likely to occur. In 1998 we developed a Year 2000 program to identify, evaluate, test, upgrade, or replace each of our computer based systems in connection with Year 2000 readiness. We completed the process of modifying, upgrading, remediating and replacing major computer related systems that were identified as potentially non-compliant in June 1999. In 1999 we requested letters of compliance from critical external suppliers to determine the status of their efforts to become Year 2000 compliant. Total costs associated with our Year 2000 project were funded with operating cash flow and approximated $50,000, of which approximately $20,000 was incurred in 1998 and approximately $30,000 was incurred in 1999.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated financial statements and the Report of Independent Accountants thereon are set forth under Item 14 (a) (1) of this Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
NONE
PART III
The information pursuant to Items 10, 11, 12 and 13 is omitted from this report (in accordance with Federal Instruction G for Form 10-K), since the Company is filing with the Commission (by no later than April 30, 2000), a definitive proxy statement pursuant to Regulation 14A, which involves the election of directors at the annual shareholders' meeting of the Company which is expected to be held in June , 2000.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1 and 2 Financial Statements and Financial Statement Schedules
SEE INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES APPEARING ON PAGE OF THIS FORM 10-K
(b) Exhibit Index
ITEM 16. EXHIBITS
(3) (a) Certificate of Incorporation dated February 17, 1983 (b) Certificate of Change of Name dated July 27, 1988 (c) Certificate of Change of Name dated July 4, 1989 (d) Memorandum (e) Articles (equivalent to By-Laws) (f) Certificate of Incorporation of Alpha Pro Tech, Ltd. dated June 15, 1994* (g) Application for Certificate of Registration and Articles of Continuance- State of Wyoming - Filed June 24 1994 * (h) Certificate of Registration and Articles of Continuance of Secretary of State, State of Wyoming, dated June 24, 1994 * (i) Certificate of Secretary of State of Wyoming dated June 24, 1995 * (j) Certificate of Amendment of Certificate of Incorporation of Alpha Pro Tech, Ltd., dated June 24, 1994 * (k) Article of Merger of BFD Industries, Inc., a Wyoming Corporation and Alpha Pro Tech, Ltd., a Delaware Corporation, effective July 1, 1994 * (l) Certificate of Ownership and Merger which merges BFD Industries with and into Alpha Pro Tech, Ltd., a Delaware Corporation effective July 1, 1994 * (4) (a) Form of Common Stock Certificate ** (10) (a) Form of Director's Stock Option Agreement (b) Form of Employee's Stock Option Agreement (c) Employment Agreement between the Company and Al Millar dated June, 1989 (c)(i) Employment Agreement between the Company and Donald E. Bennett, Jr. ** (c)(ii) Employment Agreement between the Company and Michael Scheerer *** (d) Lease Agreement between White Dairy Company, Inc. and the Company for lease of the premises situated at 2724-7th Avenue South, Birmingham, Alabama, 35233, dated March, 1990 and amendment thereto dated April, 1990 (e) BFD Industries Limited Partnership Agreement between 881216 Ontario Inc. and Bernard Charles Sherman dated May 17, 1990 (f) Asset Purchase Agreement between the Company and the BFD Industries Limited Partnership dated May 17, 1990 (g) Purchase Agreement between the Company, Bernard Charles Sherman and Apotex, Inc. dated June 21, 1991 and amendment thereto made August 30, 1991 (h) Professional Services Agreement between the Company and Quanta Corporation dated September, 1991 (i) Sales and Marketing Agreement between the Company and MDC Corp., dated October 4, 1991 (j) National Account Marketing Agreement between the Company and National Contracts, Inc. dated October 7, 1991
(k) Group Purchasing Agreement between the Company and Premier Hospitals Alliance, Inc. dated November 1, 1991 (l) Letter of Intent between the Company and the shareholders of Alpha Pro Tech, Inc. dated December 11, 1991 and amendment thereto dated February 19, 1992 (m) Group Purchasing Agreement between the Company and AmeriNet Incorporated dated January, 1992 (n) Group Purchasing Agreement between the Company and Magnet, Inc. (o) Share Purchase Agreement re Acquisition of Alpha Pro Tech, Inc. (p) Financial Data Schedule ****
- --------------------------------------------------
Unless otherwise noted, all of the foregoing exhibits are incorporated by reference to Form 10 Registration Statement (File No. 0-1983) filed on February 25, 1992.
* Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 019893)
** Incorporated by reference to Registration Statement on Form S-1, (File No. 33-93894) which became effective August 10, 1995
*** Incorporated by reference to Post-Effective Amendment No. 1 filed January 30, 1997 to Registration Statement on Form S-1 (File No,. 33-93894)
**** Filed herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has fully caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ALPHA PRO TECH, LTD.
Date: February 28, 2000 By: S/SHELDON HOFFMAN ----------------- ----------------- Sheldon Hoffman Chief Executive Officer, Principal Financial Officer and Director
Date: February 28, 2000 By:S/LLOYD HOFFMAN ----------------- ----------------- Lloyd Hoffman Senior Vice President, Controller and Principal Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registration and in the capacities indicated on February 28, 2000.
S/DONALD E. BENNETT, JR. ------------------------- Donald E. Bennett, Jr. Director
S/SHELDON HOFFMAN ----------------- Sheldon Hoffman, Director
S/ROBERT H. ISALY ----------------- Robert H. Isaly, Director
S/ALEXANDER W. MILLAR --------------------- Alexander W. Millar, Director
S/ DR. JOHN RITOTA ------------------ Dr. John Ritota, Director
ALPHA PRO TECH, LTD.
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1999, 1998 AND 1997
ALPHA PRO TECH, LTD.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of Alpha Pro Tech, Ltd.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Alpha Pro Tech, Ltd. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP Salt Lake City, Utah February 25, 2000
ALPHA PRO TECH, LTD.
CONSOLIDATED BALANCE SHEETS - --------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements.
ALPHA PRO TECH, LTD.
CONSOLIDATED STATEMENTS OF OPERATIONS - --------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements.
ALPHA PRO TECH, LTD.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY - --------------------------------------------------------------------------------
The accompanying notes are an integral part of these consolidated financial statements.
ALPHA PRO TECH, LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS - --------------------------------------------------------------------------------
NON-CASH INVESTING AND FINANCING ACTIVITY: The company incurred capital lease obligations for machinery and equipment of $56,000
The Company incurred capital lease obligations for machinery and equipment of $53,000.
The Company incurred capital lease obligations for machinery and equipment of $270,000.
The accompanying notes are an integral part of these consolidated financial statements.
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
1. THE COMPANY
Alpha Pro Tech, Ltd. (the Company) manufactures and distributes a variety of disposable mask, shield, shoecover and apparel products and woundcare (fleece) products. Most of the Company's disposable apparel, mask and shield products and woundcare products are distributed to medical, dental, industrial and clean room markets, predominantly in the United States.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned subsidiary, Alpha Pro Tech, Inc. (APT), as well as APT's wholly-owned subsidiary, DPI De Mexico (DPI). All significant intercompany accounts and transactions have been eliminated.
INVENTORIES Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. Provision is made for slow-moving, obsolete or unusable inventory.
PROPERTY AND EQUIPMENT Property and equipment is stated at cost less accumulated depreciation and amortization and is depreciated and amortized using the straight-line method over the shorter of the respective useful lives of the assets or the related lease terms as follows:
Factory equipment 9-20 years Office furniture and equipment 7 years Leasehold improvements 4-6 years Vehicles 5 years
Expenditures for renewals and betterments are capitalized whereas costs of maintenance and repairs are charged to operations in the period incurred.
INTANGIBLE ASSETS The excess of purchase price over the estimated fair value of assets acquired and liabilities assumed has been recorded as goodwill and is being amortized using the straight-line method over 8 years. Patent rights and trademarks are recorded at cost and are amortized using the straight-line method over their estimated useful lives of 8-17 years.
LONG-LIVED ASSETS Impairment of long-lived assets is determined in accordance with Statement of Financial Accounting Standards No. 121 (SFAS 121), "Accounting for the Impairment of Long-Lived Assets and of Long-Lived Assets to be Disposed Of". SFAS 121 requires that long-lived assets and certain identifiable intangible assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The Company had no impaired assets as of December 31, 1999 or 1998.
STOCK FOR SERVICES Options to purchase common stock and warrants to purchase common stock that are granted to third parties in exchange for services are valued at their estimated fair value at the measurement date and are expensed over the period the services are rendered.
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
REVENUE RECOGNITION Sales are recognized when goods are shipped to customers. Sales are reduced for anticipated sales returns and allowances.
ADVERTISING Advertising costs consist primarily of catalog preparation and printing costs which are charged to expense when shipped. Catalog costs expensed in 1999, 1998 and 1997 were $12,000, $37,000 and $16,000, respectively.
STOCK BASED COMPENSATION As allowed by Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-based Compensation," which recommends but does not require a method based on the fair value of equity instruments awarded to employees to account for stock-based compensation, the Company applies the intrinsic value method prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" to account for its stock-based compensation. The company also provides pro forma disclosure in the notes to the financial statements of the differences between the fair value method and the intrinsic value method (Note 8).
INCOME TAXES The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes". This statement requires an asset and liability approach for accounting for income taxes (Note 9).
NET INCOME (LOSS) PER SHARE Net income (loss) per share "EPS" has been computed pursuant to the provisions of Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per Share," which became effective after December 15, 1997. All periods prior to December 15, 1997 have been restated to conform with the provisions SFAS 128.
The following table provides a reconciliation of both the net income (loss) and the number of shares used in the computations of "basic" EPS, which utilizes the weighted average number of shares outstanding without regard to potential shares, and "diluted" EPS, which includes all such shares.
Potential common shares for 1997 were anti-dilutive and accordingly were excluded from the net income (loss) per share calculation.
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
TRANSLATION OF FOREIGN CURRENCIES The Company has adopted the United States dollar as its functional currency. Transactions in foreign currencies during the reporting periods are translated into the functional currency at the exchange rate prevailing at the transaction date. Monetary assets and liabilities in foreign currencies at each period end are translated at the exchange rate in effect at that date and are immaterial in amount. Transaction gains or losses on foreign exchange are reflected in net income (loss) for the periods presented and are immaterial in amount.
USE OF ESTIMATES The preparation of these consolidated financial statements in conformity with generally accepted accounting principles required management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of financial instruments including cash, restricted cash, accounts receivable, notes receivable, accounts payable and notes payable approximate their respective book values at December 31, 1999 and 1998.
3. INVENTORIES
Inventories consist of the following:
4. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
Included in the above amounts are the following assets under capital lease obligations:
5. INTANGIBLE ASSETS
Intangible assets consist of the following:
6. ACCRUED LIABILITIES
Accrued liabilities consist of the following:
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
7. NOTES PAYABLE
In December 1997, the Company, through its wholly owned subsidiary APT, entered into a three-year credit facility with an asset-based lender. The facility has been subsequently extended until December 31, 2001. Notes payable at December 31, 1999 represent outstanding amounts against the facility. Pursuant to the terms of the credit agreement, the Company has a line of credit for up to $2,500,000 based on eligible accounts receivable and inventory, of which $674,000 was outstanding and $1,269,000 was available at December 31, 1999. The credit facility bears interest at prime plus 1.75%, which totaled 10.25% at December 31, 1999 and is secured by accounts receivable, inventory, trademarks, patents, property, and 66.67% of the issued and outstanding shares of DPI.
The Company also has a $400,000 term note secured by equipment. The Company's outstanding balance on this term note was $247,000 at December 31, 1999. The term note is due in monthly installments of $7,000 with interest at prime plus 2.25%, which totaled 10.75% at December 31, 1999, maturing July 1, 2003. The Company paid $29,000 in loan origination fees to obtain the above credit facilities. Under the terms of the agreement, the Company pays a 0.5% loan fee annually.
The Company used certain of the proceeds of such facility to repay its previous asset-based loan. Under the terms of the previous facility, the Company paid $63,000 in loan and unused line of credit fees for the year ended December 31, 1997.
Future maturities of notes payable are as follows:
2000 $ 754,000 2001 80,000 2002 80,000 2003 7,000 ---------------
$ 921,000 ===============
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
8. SHAREHOLDERS' EQUITY
WARRANT ACTIVITY
Warrant activity for the three years ended December 31, 1999 is as follows:
The warrants outstanding at December 31, 1999 are currently exercisable, and each warrant entitles the holder to purchase one common share for the stated price. Such warrants expire July 1, 2004.
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
OPTION ACTIVITY
During 1993, the Company adopted stock option plans for employees and directors of the Company. As of December 31, 1999, 4.5 million shares were reserved for issuance under these plans and 3.7 million options have been granted. The exercise price of the options is determined based on the fair market value of the stock on the date of grant, and the options generally vest immediately.
Option activity for the three years ended December 31, 1999 is as follows:
All options are fully exercisable.
The following summarizes information about stock options outstanding at December 31, 1999:
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
Had compensation expense for the Company's employee/director options been determined based on the fair value of the options at the grant date, the Company's pro forma net income and pro forma net income per share would have been as follows:
For the purpose of the above pro forma disclosures, the fair value of each employee/director stock option was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
The weighted-average grant date fair values of employee/director options granted during 1999, 1998 and 1997 were $0.22, $0.27 and $0.38 respectively.
9. INCOME TAXES
The provision (benefit) for income taxes consists of the following:
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
Deferred tax assets (liabilities) are comprised of the following at December 31.
The provision for income tax for 1999 consists primarily of the Company's inability to utilize net operating loss carryforwards to entirely offset alternative minimum taxable (AMT) income. Net operating losses (NOLs) from prior years were utilized during 1999 to offset all other income tax expense. The deferred tax asset valuation allowance has been determined pursuant to the provisions of SFAS 109, including the Company's estimation of future taxable income. Such valuation allowance is adequate to reduce the total deferred tax asset to an amount that will, more likely than not, be realized.
The provision for income taxes differs from the amount that would be obtained by applying the United States statutory rate to the income (loss) before income taxes as a result of the following:
At December 31, 1999, the Company has net operating loss carryforwards for United States and Canadian tax purposes available to reduce future United States and Canadian taxable income amounting to approximately $1.2 million and $2.2 million, respectively.
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
For United States income tax purposes, these losses will expire as follows:
For Canadian income tax purposes, these losses will expire as follows:
In the event of changes in ownership, IRS regulations may limit net operating losses available to the Company.
10. LEASE COMMITMENTS AND OBLIGATIONS
The Company leases manufacturing facilities under non-cancelable operating leases expiring between July 2000 and November 2002. The Company also leases certain manufacturing and office equipment under capital leases expiring between October 2000 and December 2002.
The following summarizes future minimum lease payments required under capital and non-cancelable operating leases:
Total rent expense incurred by the Company under operating leases for the years ended December 31, 1999, 1998 and 1997 was $619,000, $654,000 and $588,000, respectively.
The Company does not have any pension, profit sharing or similar plans established for its employees; however, the chief executive officer and president are entitled to a combined bonus equal to 10% of the pre-tax profits of the company. A bonus of $125,000 was earned in 1999 as compared to $32,000 in 1998.
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
11. ACTIVITY OF BUSINESS SEGMENTS
In 1998 the Company adopted SFAS 131. Segment information for 1997 has been restated to present the Company's reportable segments.
The Company classifies its businesses into three fundamental segments: Apparel, consisting principally of disposable medical clothing such as overalls, frocks, lab coats, hoods, bouffant caps; and shoecovers (including the Aqua Track and spunbond shoecovers); Mask and eye shields, consisting principally of medical, dental and industrial masks and eye shields; and Extended Care Unreal Lambskin(R), consisting principally of fleece and other related products which includes a line of pet beds.
The accounting policies of the segments are the same as those described previously under "Summary of Significant Accounting Policies." Segment data excludes charges allocated to head office and corporate sales/marketing departments. The Company evaluates the performance of its segments and allocates resources to them based primarily on net sales and gross margin.
The following table shows net sales for each segment for the years ended December 31, 1999, 1998 and 1997:
A reconciliation of total segment net income to total consolidated net income (loss) for the years ended December 31, 1999, 1998 and 1997 is presented below:
ALPHA PRO TECH, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
The following reflects sales and long-lived asset information by geographic area as of and for the years ended December 31, 1999, 1998 and 1997:
Sales by region are based on the countries in which the customers are located. The Company did not generate sales from any single foreign country that was material to the Company's consolidated sales.
12. ACQUISITIONS
Effective April 1995, the Company acquired an 80% interest in Ludan Corporation (LC), a Georgia based materials laminating company, for $35,000 in cash, including $6,000 of direct acquisition costs, plus the assumption of net liabilities of $23,000. In addition, a note payable owed by LC to a third party of $20,000 was converted to 20,000 shares of the Company's common stock. The Company recorded $78,000 of goodwill in connection with the acquisition which is being amortized over 8 years.
In June 1996, the Company acquired the remaining 20% interest in LC for a $68,000 note payable, of which $49,000 was paid in 1996 and the $19,000 remaining was paid in 1997. The Company recorded an additional $58,000 of goodwill which is being amortized over 8 years.
In connection with this purchase during 1997, the Company acquired the remaining 3.2% of DPI's shares for $70,000. The Company recorded $70,000 of goodwill in connection with the acquisition. Such goodwill is being amortized over 8 years.
13. MAJOR CUSTOMER AND CONCENTRATION OF CREDIT RISK
The Company sells significant amounts of product to a large distributor on credit terms. Net sales to this distributor were 57.8%, 51.1% and 50.7% of total net revenue for 1999, 1998 and 1997, respectively. Trade receivables from this distributor were 43.1% and 38.4% of total trade receivables for 1999 and 1998, respectively. Management believes that adequate provision has been made for risk of loss on all credit transactions.
ALPHA PRO TECH, LTD. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS | 9,678 | 63,888 |
320333_1999.txt | 320333_1999 | 1999 | 320333 | ITEM 1. BUSINESS
GENERAL
Hanover Direct, Inc. (the "Company") provides quality, branded merchandise through a portfolio of catalogs and e-commerce platforms to consumers, as well as a comprehensive range of Internet, e-commerce and fulfillment services to businesses. In December 1999, the Company completed a strategic realignment pursuant to which it created two separately incorporated business units, Hanover Brands, Inc. ("Hanover Brands") and erizon, Inc. ("erizon").
Hanover Brands, the Company's business-to-consumer subsidiary, is comprised of its catalog and Web site portfolio of home fashions, apparel, general merchandise and gift brands including Domestications, The Company Store, Scandia Down, Turiya, Domestications Kitchen & Garden, Kitchen & Home, Encore, Improvements, Silhouettes, International Male, Undergear and Gump's By Mail. Each brand can be accessed on the Internet individually by name. In addition, the Company is the exclusive distributor of the Compagnie de la Chine brand in North America and owns Gump's, a retail store based in San Francisco, California.
erizon, the Company's business-to-business subsidiary, is comprised of the Company's direct commerce IT platform, Keystone Internet Services, Inc., the Company's third party, end-to-end, fulfillment, logistics and e-care provider, and Desius LLC, the Company's joint venture with RS Software (India), Ltd., offering Web shop services and e-commerce systems development. erizon also services the logistical, IT and fulfillment needs of Hanover Brands through an intercompany services agreement.
Rakesh K. Kaul has continued as President and Chief Executive Officer of the Company, overseeing both of the newly created subsidiaries.
The Company is incorporated in Delaware with its principal executive office at 1500 Harbor Boulevard, Weehawken, New Jersey 07087. The Company's telephone number is (201) 863-7300. The Company is a successor in interest to The Horn & Hardart Company, a restaurant company founded in 1911, and Hanover House Industries, Inc., founded in 1934. Richemont Finance S.A. ("Richemont"), a Luxembourg company, owns approximately 48.2% of the Company's outstanding common stock and holds an irrevocable proxy from a third party to vote an additional approximately 2.0% of the Company's common stock currently held by such third party. Richemont is an affiliate of Compagnie Financiere Richemont, A.G., a Swiss based publicly-traded luxury goods company.
HANOVER BRANDS
General. The Company, through Hanover Brands, is a leading specialty direct marketer with a diverse portfolio of branded home fashions, general merchandise, men's and women's apparel and gift products marketed via direct mail-order catalogs and connected Internet Web sites. The Company's catalog titles are organized into six brand groups -- Home Fashions -- Mid-Market brands, Home Fashions-Upscale brands, General Merchandise brands, Women's Apparel brands, Men's Apparel brands and Gift brands groups -- each consisting of one or more catalog/online titles. All of these brand groups utilize central purchasing and inventory management functions and erizon's common systems platform, telemarketing, fulfillment, distribution and administrative functions pursuant to an intercompany services agreement. During 1999, the Company mailed approximately 235 million catalogs, answered more than 9.5 million customer service/order calls and processed and shipped over 7.5 million packages to customers in North America.
The Company reviews its portfolio of catalogs as well as new opportunities to acquire or develop catalogs from time to time. During 1999, the Company sold its Austad's catalog; discontinued its Tweeds catalog operation; and repositioned and relaunched its Colonial Garden Kitchens catalog as Domestications Kitchen & Garden. All three of these catalogs had been selected in the first quarter of 1999 to either be repositioned, discontinued or sold.
Each of the Company's specialty catalogs targets distinct market segments offering a focused assortment of merchandise designed to meet the needs and preferences of its target customers. Through market research and ongoing testing of new products and concepts, each brand group determines each catalog's own merchandise strategy, including appropriate price points, mailing plans and presentation of its products. The Company is continuing its development of exclusive or private label products for a number of its catalogs, including Domestications, The Company Store and Improvements, to further enhance the brand identity of the catalogs.
The Company's specialty catalogs typically range in size from approximately 30 to 130 pages with two to twenty-five new editions per year depending on the seasonality and fashion content of the products offered. Each edition may be mailed several times each season with variations in format and content. Each catalog employs the services of an outside creative agency or has its own creative staff which is responsible for the design, layout, copy, feel and theme of the book. Generally, the initial sourcing of new merchandise for a catalog begins two to six months before the catalog is mailed.
The following is a description of the Company's catalogs in each of the Company's six brand groups:
Home Fashions -- Mid-Market Brands:
Domestications is a leading home fashions catalog offering affordable luxury for every room in the home for today's value-oriented and style-conscious consumer.
Domestications Kitchen & Garden offers decorating products geared toward answering and solving kitchen and garden needs.
Home Fashions-Upscale Brands:
The Company Store is an upscale home fashions catalog focused on high quality down products and other private label and branded home furnishings.
Kitchen & Home features distinctive and highly functional entertaining and decorating products.
Scandia Down is a nationally known retailer specializing in luxury down products and home fashions.
Launched in 1999, Turiya is a luxury home furnishings catalog featuring exclusive designers with the finest products, textiles, tailoring and concierge level customer care.
General Merchandise Brands:
Improvements is a leading do-it-yourself home improvement catalog offering quick and clever problem solvers to make life easier around the home, yard and car. Improvements also presents The Safety Zone which offers innovative products for health, comfort and safety.
Launched in 1999, Encore offers the best from America's finest catalogs in one easy-to-shop-from format.
Women's Apparel Brands:
Silhouettes is a leading fashion catalog offering large size women upscale apparel and accessories.
Men's Apparel Brands:
International Male offers contemporary men's fashions and accessories at reasonable prices.
Undergear is a leader in fashionable and functional men's underwear, workout wear and active wear.
Gift Brands:
Gump's By Mail(R) and Gump's(R) San Francisco are luxury sources for discerning customers of jewelry, gifts and home furnishings, as well as market leaders in offering Asian inspired products.
Compagnie de la Chine offers collections of tableware, glassware, textiles and home decor based on Chinese ancestral designs, natural materials and traditional techniques. In 1999, the Company became the exclusive distributor of the Compagnie de la Chine brand in North America.
The Shopper's Edge. In March 1999, the Company, through a newly formed subsidiary, started up and promoted a discount buyers club to consumers known as "The Shopper's Edge." In exchange for an up-front membership fee, the Shopper's Edge program enables members to purchase a wide assortment of merchandise at discounts which are not available through traditional retail channels. Initially, prospective members participate in a 45-day trial period that, unless canceled, is automatically converted into a full membership term, which is one year in duration. Memberships are automatically renewed at the end of each term unless canceled by the member.
Effective December 1999, the Company sold its interest in The Shopper's Edge subsidiary to an unrelated third party for a nominal fair value based upon an independent appraisal. The Company entered into a solicitation services agreement with the purchaser whereby the Company will provide solicitation services for the program, and will receive commissions for member acceptances based on a fixed fee per member basis, adjusted for cancellation rates on a prospective basis.
Marketing and Database Management. The Company maintains a proprietary customer list currently containing approximately 9 million names of customers who have purchased from one of the Company's catalogs within the past 36 months. Approximately 4 million of the names on the list represent customers who have made purchases from at least one of the Company's catalogs within the last 12 months. The list contains name, gender, residence and historical transaction data. This database is selectively enhanced with demographic, socioeconomic, lifestyle and purchase behavior overlays from other sources.
The Company utilizes modeling and segmentation analysis to devise catalog marketing and circulation strategies that are intended to maximize customer contribution by catalog. This analysis is the basis for the Company's determination of which of the Company's catalogs will be mailed and how frequently to a particular customer, as well as the promotional incentive content of the catalog(s) such customer receives.
The Company utilizes name lists rented from other mailers and compilers as a primary source of new customers for the Company's catalogs. Many of the catalogs participate in a consortium database of catalog buyers whereby new customers are obtained by the periodic submission of desired customer buying behavior and interests to the consortium and the subsequent rental of non-duplicative names from the consortium. The Company's recently launched Encore catalog, by offering the best selling merchandise from both the Company's and third party catalogs, is tailor-made to appeal to and attract new customers derived from
these name lists. Other sources of new customers include traditional print space advertisements and promotional inserts in outbound merchandise packages.
The Internet as a source of new customers continues to grow in importance. The Company maintains an active presence on the Internet by having a commerce-enabled Web site for each of its catalogs which offers its merchandise, takes catalog requests, and accepts orders for not only Web site merchandise but also from any print catalog already mailed. The Web sites for each brand are promoted within each catalog, in traditional print media advertising, in TV commercials, and on third party Web sites. The Company utilizes marketing opportunities available to it by posting its catalog merchandise and accepting orders on third party Web sites, for which it is charged a commission. Third party Web site advertising arrangements entered into by the Company includes partnerships with Excite, ArtSelect, Yahoo, and AOL.
Purchasing. The Company's large sales volume permits it to achieve a variety of purchasing efficiencies, including the ability to obtain prices and terms that are more favorable than those available to smaller companies or than would be available to the Company's individual catalogs were they to operate independently. Major goods and services used by the Company are purchased or leased from selected suppliers by its central buying staff. These goods and services include paper, catalog printing and printing related services such as order forms and color separations, communication systems including telephone time and switching devices, packaging materials, expedited delivery services, computers and associated network software and hardware.
The Company's telephone telemarketing phone service costs (both inbound and outbound calls) are typically contracted for a two to three-year period. In the fourth quarter of 1999, the Company entered into a two-year call center services agreement with MCI Worldcom under which it obtained a reduction in the rate it had been paying pursuant to its then current telecommunications contract. In that connection, the Company agreed to guarantee certain levels of call volume and the Company anticipates it will meet such targets. See "erizon -- Telemarketing."
The Company generally enters into annual arrangements for paper and printing with a limited number of suppliers. These arrangements permit periodic price increases or decreases based on prevailing market conditions, changes in supplier costs and continuous productivity improvements. For 1999, paper costs approximated 5.5% of the Company's net revenues. Although the Company experienced a reduction paper prices during 1999, the Company expects that paper prices will increase by approximately 11% during the year 2000. The Company normally experiences increased costs of sales and operating expenses as a result of the general rate of inflation and commodity price fluctuations. Operating margins are generally maintained through internal cost reductions and operating efficiencies, and then through selective price increases where market conditions permit.
Inventory Management. The Company's inventory management strategy is designed to maintain inventory levels that provide optimum in-stock positions while maximizing inventory turnover rates and minimizing the amount of unsold merchandise at the end of each season. The Company manages inventory levels by monitoring sales and fashion trends, making purchasing adjustments as necessary and by promotional sales. Additionally, the Company sells excess inventory through special sale catalogs, sales/liquidation postings in brand Web sites, e-auctions, its outlet stores and to jobbers.
The Company acquires products for resale in its catalogs from numerous domestic and foreign vendors. No single source supplied more than 5% of the Company's products in 1999. The Company's vendors are selected based on their ability to reliably meet the Company's production and quality requirements, as well as their financial strength and willingness to meet the Company's needs on an ongoing basis.
The Company receives approximately 81% of its orders through its toll-free telephone service, which offers customer access seven days per week, 24 hours per day.
Telemarketing and Distribution. Hanover Brands' telemarketing and distribution needs are provided by erizon pursuant to an intercompany services agreement. The management information systems used by Hanover Brands are discussed below. The Company mails its catalogs through the United States Postal Service ("USPS") utilizing pre-sort, bulk mail and other discounts. Most of the Company's packages are shipped through the USPS. Overall, catalog mailing and package shipping costs approximated 16% of the Company's net revenues in 1999. The USPS has initiated a proposed rate case that would allow for postage rate increases ranging from 15% for Priority Mail to 1.3% for 4th class mail effective January 2001. The Company mitigates the impact of postage rate increases by obtaining rate discounts from the USPS by automatically weighing each parcel and sorting and trucking packages to a number of USPS drop points throughout the country. Some packages are shipped using a consolidator for less frequently used drop points. The Company also utilizes United Parcel Service and other delivery services. In February 2000, United Parcel Service increased its ground and air rates by a further 3.1% and 3.5%, respectively. The Company does not expect the increase to have a material adverse effect on its results of operations.
ERIZON
General. The Company, through erizon, is an end-to-end technology solutions provider for e-commerce customers. erizon is comprised of the Company's telemarketing, fulfillment and distribution functions as well as its proprietary, fully integrated systems platform internally known as Pegasus. That system is described under "Management Information Systems" below. Other assets include three warehouse fulfillment centers totaling approximately 1.2 million square feet, and four telemarketing/e-care centers with over 750 agent positions. In 1999, erizon introduced real-time, online inventory status, Web hosting and co-location, a supply chain extranet and installation of new Dell workstations at the Company's call centers.
In addition, erizon is home to Keystone Internet Services, Inc. ("Keystone"), providing back-end e-commerce services to a roster of Internet players. Keystone's services range from fulfillment and e-care to platform logistics products. erizon is also home to Desius, LLC, the Company's recently formed e-commerce software systems and programming Web shop joint venture for e-commerce applications. erizon also services the logistical, IT and fulfillment needs of Hanover Brands through an intercompany services agreement.
Telemarketing. The Company has created a telephone network to link its four primary telemarketing facilities in Hanover, Pennsylvania, York, Pennsylvania, LaCrosse, Wisconsin and San Diego, California. The Company's telemarketing facilities utilize state-of-the-art telephone switching equipment which enables the Company to route calls between telemarketing centers and thus provide prompt customer service. In the fourth quarter of 1999, the Company entered into a two-year call center services agreement with MCI Worldcom. See "Hanover Brands -- Purchasing."
The Company trains its telemarketing service representatives to be courteous, efficient and knowledgeable about the Company's products and those of its third party customers. Telemarketing service representatives generally receive 40 hours of training in selling products, services, systems and communication skills through simulated as well as actual phone calls. A substantial portion of the evaluation of telemarketing service representatives' performance is based on how well the representative meets customer service standards. While primarily trained with product knowledge to serve customers of one or more specific catalogs, telemarketing service representatives also receive cross-training that enables them to take overflow calls from other catalogs. The Company utilizes customer surveys as an important measure of customer satisfaction.
Distribution. The Company presently operates three distribution centers in three principal locations: one in Roanoke, Virginia, one in Hanover, Pennsylvania, and one in LaCrosse, Wisconsin. The Company uses these facilities to handle merchandise distribution for Hanover Brands as well as its third-party e-tail clients. See "Properties."
Management Information Systems. The Company has successfully converted all catalogs to its integrated mail order and catalog system operating on its mid-range computer systems. Additionally, the remaining fulfillment center migrated to the newly developed warehouse management system. The migration of the Company's business applications to mid-range computers was an important part of the Company's overall systems plan which defined the long-term systems and computing strategy for the Company. The Company modified and installed, on a catalog by catalog basis, these new integrated systems for use in managing all phases of the Company's operations. These systems have been designed to meet the Company's requirements as a high volume publisher of multiple catalogs. The Company is continuing to devote resources to improving its systems.
The new software system is an on-line, real-time system which includes order processing, fulfillment, inventory management, list management and reporting. The software provides the Company with a flexible system that offers data manipulation and in-depth reporting capabilities. The new management information systems are designed to permit the Company to achieve substantial improvements in the way its financial, merchandising, inventory, telemarketing, fulfillment and accounting functions are performed. Two catalogs were brought onto the Company's common systems platform in 1994. The Company brought eight additional catalogs onto the Company's common systems platform in 1995, one in 1996 and the balance of the catalogs onto the Company's common systems platform in 1997.
The Company incurred for Y2K remediation expenditures of $3.8 million to modify its computer information systems enabling proper processing of transactions relating to the Year 2000 and beyond. The Company took courses of corrective action, including replacement of certain systems and contracting with a consultant to develop contingency plans. The Company contacted vendors and others on whom it relied to assure that their systems would be timely converted. Upon the turn of the millennium and subsequent thereto, the Company did not experience any significant systems malfunctions related to the Year 2000 conversion.
Keystone Internet Services. Launched in 1998, Keystone initially serviced the needs of other direct marketers without back-end fulfillment resources. Keystone currently offers e-commerce solutions and services to a customer base of brand name manufacturers and retailers who lack the end-to-end systems needed to enter e-commerce quickly, easily and affordably.
Keystone offers its client base of 18 third-party clients as of December 25, 1999 resources needed on the "front-end" ranging from Web site creation and management to Internet marketing to multi-channel marketing promotions to structured financing. "Front-end" logistical services provided by Keystone include telemarketing and e-care. Keystone can take orders off the Web and answer e-mails as well as handle order processing, credit card transaction processing, customer database management and systems programming and interface support. On the "back-end," Keystone offers services including fulfillment, order management, inventory management and facility management. All this can be done using the Company's proprietary Pegasus multi-channel, multi-title platform described above.
Desius. In 1999, the Company entered into a 60/40 joint venture with RS Software (India), Ltd. to provide Web shop services and e-commerce software, systems and programming. Augmenting the Company's programming services, the Desius teams, based in Calcutta, India and the United States, together can provide 24/7 service. The Calcutta based Desius team also provides additional resources including creative marketing, Web site creation, maintenance and management. Desius also serves as the outsourcing arm for Keystone clients which lack resources in these areas.
Intercompany Services Agreement. erizon and Hanover Brands, two wholly-owned subsidiaries of the Company, have entered into an exclusive intercompany services agreement. Under the intercompany services agreement, erizon is obligated to provide services to Hanover Brands for (i) fulfillment services, such as order processing, customer service, warehousing, inventory
maintenance, shipping and billing; (ii) information technology and Internet services, such as Web site design, development, hosting, systems administration and maintenance; and (iii) general and administrative services. The provision of services is coordinated by designated management teams from erizon and Hanover Brands and performed in accordance with agreed upon service levels.
The term of the intercompany services agreement is from December 27, 1998 through December 28, 2002, subject to renewal if the parties agree within twelve (12) months prior to the expiration of a term. Services to support additional catalogs, as well as new services, may be added to the contract. If erizon and Hanover Brands no longer report to the same chief executive officer or similar officer because of a change of control of erizon, erizon will have a thirty (30) day exclusive period in which to form an agreement with Hanover Brands regarding fees, performance standards, and other terms and conditions for additional catalogs or new services. The intercompany services agreement may be terminated upon a material breach by either party, nonpayment by Hanover Brands or erizon's failure to perform, in each case, following an opportunity to cure or the insolvency of either party. Upon termination for any reason, erizon will provide reasonable termination assistance to Hanover Brands.
For provision of the services under the intercompany services agreement, Hanover Brands periodically will pay erizon fees, and reimburse erizon for certain out-of-pocket expenses and any taxes, duties or tariffs. If the volume of transactions exceeds projections, erizon may earn certain incremental fees, charges and/or other payments.
Any Web sites created in connection with the agreement will belong to Hanover Brands. Any proprietary rights in information, data or knowledge provided by erizon for Hanover Brands under the intercompany services agreement will be the property of erizon, subject to a non-exclusive, non-transferable license to Hanover Brands. Generally, each party will retain the right to use general knowledge, experience and know-how obtained in connection with the intercompany services agreement. erizon will maintain ownership of all hardware and software used in performance of the services.
Under the agreement, each party is obligated to indemnify the other (and its related entities) from third party claims arising out of infringement of intellectual property rights; arising out of that party's property, as well as personal and property damage to employees, agents, subcontractors and business associates caused by the party or its related entities; and arising out of certain additional indemnities regarding certain obligations under the agreement. With certain exceptions, both parties have limited their liability to the other to direct damages with an aggregate limit. In the event that erizon and Hanover Brands no longer share a chief executive officer or similar officer, certain modifications will apply to the dispute resolution and other provisions of the agreement.
INCUBATOR INVESTMENTS
In 1999, the Company began to focus on growth via the expansion of its business portfolio through new Internet-related initiatives. To date, the Company has focused on taking equity stakes in promising on-line businesses and taking an active role in their development and technology.
In 1999, the Company acquired a majority equity interest in Always In Style, LLC, an interactive service that provides consumers with personalized style and taste advice and tailored e-commerce merchandise offers. Retailers participating in the Always In Style retail network are provided with a ready-made solution and a virtually instantaneous way of adding this functionality to their Web sites. Always In Style was formally launched in November 1999.
In March 2000, the Company acquired a minority equity interest in I-Behavior, Inc., an on-line data-mining cooperative in which the Company will serve as an anchor tenant and be joined by other e-tailers, retailers, catalogers and portals who will contribute quantitative and qualitative consumer data to the co-op, thereby becoming eligible to make withdrawals of data for their own marketing programs.
CREDIT MANAGEMENT
Several of the Company's catalogs, including Domestications, International Male and Gump's by Mail, offer their own private label credit cards. Prior to July 1999, the Company had a five year $75 million credit facility with General Electric Credit Corporation ("GECC") expiring in the year 2000 which provided for the sale and servicing of accounts receivable originating from the Company's revolving credit cards. GECC's servicing responsibilities included credit processing, collections, billing/payment processing, reporting and credit card issuance. In March 1999, the Company entered into a new three-year account purchase and credit card marketing and services agreement with Capital One Services, Inc. and Capital One Bank under which Capital One would provide services generally of a type provided previously by GECC with respect to the Company's private label credit card program. Capital One would do this by purchasing from the Company the existing portfolio of credit card accounts on terms which would create neither a gain or loss to the Company on the closing date. During July 1999, the Company entered into a termination agreement with GECC in regard to its credit facility and closed the Capital One transaction.
FINANCING
Congress Credit Facility. The Congress Financial Corporation ("Congress") credit facility (the "Congress Credit Facility") was comprised of a revolving line of credit of up to $65 million (the "Congress Credit Facility") and term loans aggregating $12.5 million (the "Congress Term Note") at December 25, 1999. The Congress Credit Facility was secured by all assets of the Company and placed limitations on the incurrence of additional indebtedness. The amount that could have been borrowed under the Congress Credit Facility was based on percentages of eligible inventory and accounts receivable as reported to Congress from time to time. An
inventory appraisal was completed in March 1997 and the advance rate remained the same through the balance of 1997. In November 1997, a new inventory appraisal was completed and advance rates were increased along with other modifications that increased the Company's availability under the Congress Credit Facility. At that time, negotiations for the refinancing of the Congress Revolving Credit Facility commenced. Under the terms of the re-negotiated Congress Credit Facility, effective March 1998, the facility was extended to January 31, 2001.
The Congress revolving credit facility bore interest during 1999 at prime plus .5% or Eurodollar plus 2.5% and the Congress Term Note bore interest at prime plus .75% or Eurodollar plus 2.75%. Under the Congress Credit Facility, the Company was required to maintain minimum net worth and working capital throughout the term of the agreement. The Company was in compliance with such covenants at December 25, 1999. At December 25, 1999, the Company had $5.2 million of outstanding borrowings under the Congress revolving credit facility and $12.5 million outstanding under the Congress Term Note under the Congress Credit Facility. As of December 26, 1998, the Company had no revolving indebtedness and $14 million outstanding under the Congress Term Note under the Congress Credit Facility. At December 25, 1999, availability under the Congress revolving credit facility was approximately $32.8 million, including cash on hand. The Congress Credit Facility financial covenant requirements as of December 25, 1999 were as follows:
On March 24, 2000, the Congress Credit Facility was further amended to provide for a maximum credit of up to $82,500,000, comprised of a revolving line of credit facility (the "Revolving Line of Credit"), a letter of credit facility with a sublimit of $40,000,000, and term loans with an initial principal balance of $25,035,000. The maximum credit available under the Revolving Line of Credit is $82,500,000, less the amount of outstanding letters of credit, and less the outstanding principal balance of the term loans. The Company paid a $1,400,000 closing fee to Congress to secure the amendment of the Congress Credit Facility. The $25.0 million initial principal term loan balance includes a $17.5 million Tranche A Term Loan having an eighty-four month term, and a $7.5 million Tranche B Term Loan having a thirty-six month term.
The Congress Credit Facility, as amended, is secured by all assets of the Company and places limitations on the incurrence of additional indebtedness. The amount that can be borrowed under the amended Congress Credit Facility is based on percentages of eligible inventory, eligible accounts receivable, eligible credit card receivables and eligible fulfillment contract receivables as reported to Congress from time to time. Effective March 24, 2000, the Congress Credit Facility was extended to January 31, 2004.
Effective as of March 24, 2000, Revolving Loans will bear interest at prime plus .5% or Eurodollar plus 2.5%, the Tranche A Term Loans will bear interest at prime plus .75% or Eurodollar plus 3.5%, and the Tranche B Term Loan will bear interest at prime plus 4.25%, but in no event less than 13.0%. Under the amended Congress Credit Facility, the Company will be required to maintain minimum net worth and working capital throughout the term of the agreement.
Term Financing Arrangement/Letters of Credit. During 1994 and 1995, the Company entered into a term loan agreement with a syndicate of financial institutions, which provided for borrowings of $20 million (the "Term Financing Facility"). The Term Financing Facility bore interest based on A-1 commercial paper rates existing at the time of each borrowing. As of December 25, 1999, the Company had $16 million of outstanding borrowings under the Term Financing Facility bearing applicable rates of interest ranging from 5.3% to 6.0%. The Company was required to make annual principal payments of approximately $1.6 million for each of the next ten years.
As of December 25, 1999, three letters of credit issued by UBS AG, Stamford Branch ("UBS"), and guaranteed by Richemont Finance S.A. ("Richemont"), supported the Term Financing Facility and the Company's Industrial Revenue Bonds. These letters of credit originated in December 1996, when the Company finalized its agreement (the "Reimbursement Agreement") with Richemont that provided the Company with up to approximately $28 million of letters of credit through Swiss Bank Corporation, New York Branch ("Swiss Bank"). The three letters of credit were initially to expire on February 18, 1998. In the event that the Company had not paid in full, by the expiration date of the letters of credit, any outstanding balances under the letters of credit, Richemont had the option, exercisable at any time prior to payment in full of all amounts outstanding under the letters of credit, to convert such amount into Common Stock of the Company at the mean of the bid and ask prices of the Company's Common Stock on November 8, 1996, or the mean of the bid and ask prices of the Company's Common Stock on each of the thirty days immediately prior to the date of exercise of the conversion privilege. The Reimbursement Agreement was subordinate to the Congress Credit Facility.
In November 1997, Richemont definitively agreed to extend its guarantee under the Reimbursement Agreement to March 30, 1999. The extension required the approval of Congress and Swiss Bank, which approvals were obtained in February 1998, and was subject to certain other conditions. On February 18, 1998, the extension of the Richemont guarantee and the closing of this transaction were consummated. Accordingly, the expiration dates of two of the letters of credit were extended through March 30, 1999, and the letters of credit were amended to reflect the assignment of all obligations thereon from Swiss Bank, New York Branch to Swiss Bank, Stamford Branch. A substitute letter of credit having an expiration date of March 30, 1999 was issued to replace the third letter of credit.
In the first quarter of 1999, Richemont extended its guarantee under the Reimbursement Agreement to March 31, 2000. As consideration for this transaction, the Company paid to Richemont a fee of 9.5% of the principal amount of each letter of credit including a facility fee of $500,000. The extension required the approval of Congress and UBS (the successor to Swiss Bank Corporation, Stamford Branch), which approvals were obtained in March 1999, and was subject to certain other conditions. During March 1999, the extension of the Richemont guarantee and the closing of this transaction were consummated. Accordingly, the expiration dates of the three letters of credit were extended through March 31, 2000.
The Company has not extended or renewed the UBS letters of credit supporting the Term Financing Facility and the Industrial Revenue Bonds, and, accordingly, the $16 million of outstanding borrowings under the Term Financing Facility and the $8 million of outstanding borrowings under the Industrial Revenue Bonds were required to be redeemed. On March 24, 2000, the Trustees under the Term Financing Facility and the Industrial Revenue Bonds made drawings under the UBS letters of credit, and used the proceeds of the drawings to redeem the Term Financing Facility and the Industrial Revenue Bonds. The Company borrowed approximately $24 million under the Congress Credit Facility on March 24, 2000 to reimburse UBS for the drawings on these letters of credit. As a result, both the Term Financing Facility and the Industrial Revenue Bonds have been paid in full, and the Company has also paid all amounts payable to UBS and Richemont relating to the letters of credit.
Richemont Facility. On March 1, 2000, the Company negotiated a new $25,000,000 unsecured line of credit (the "Richemont $25,000,000 Line of Credit") with Richemont. Borrowings under the Richemont $25,000,000 Line of Credit bear interest at a rate of 0.583% per month (an annualized rate of 7.0%) on the average monthly balance outstanding. In addition, the Company will pay Richemont a monthly fee of $62,500 each month from March 1, 2000 to the Maturity Date. The Richemont $25,000,000 Line of Credit will mature on the earlier of December 30, 2000 and the date on which Richemont makes an equity infusion in the Company or any of the Company's subsidiaries (such earlier date, the "Maturity Date."). As of March 24, 2000, there were $5 million of borrowings outstanding under the Richemont $25,000,000 Line of Credit.
In addition, on March 24, 2000 the Company entered into a new $10,000,000 unsecured line of credit (the "Richemont $10,000,000 Line of Credit") with Richemont. Borrowings under the Richemont $10,000,000 Line of Credit bear interest at a rate of 0.125% per month (an annualized rate of 1.5%) on the average monthly balance outstanding. In addition, the Company will pay Richemont a monthly facility fee of $79,200 each month during the term of the Richemont $10,000,000 Line of Credit. The maximum amount available to be drawn under the Richemont $10,000,000 Line of Credit (the "Maximum Amount") was initially $10,000,000 and will be reduced on a dollar-for-dollar basis for each dollar of equity contributed to the Company or any of its subsidiaries after March 24, 2000 by Richemont or any subsidiary or affiliate of Richemont. If the excess availability under the Congress Credit Facility is less than $3,000,000, the Company will be required to borrow under the Richemont $10,000,000 Line of Credit, and pay to Congress an amount such that the excess availability under the Congress Credit Facility after such payment will be at least $3,000,000. The Company may also borrow up to $5.0 million under the Richemont $10,000,000 Line of Credit to pay trade creditors in the ordinary course of business. The Richemont $10,000,000 Line of Credit will remain in place until the Congress Credit Facility is terminated or the Maximum Credit is reduced to zero. As of March 24, 2000, there were no borrowings outstanding under the Richemont $10,000,000 Line of Credit.
1997 Rights Offering. The Company commenced a $50 million rights offering (the "1997 Rights Offering") on April 29, 1997. Holders of record of the Company's Common Stock, par value $.66 2/3 per share (the "Common Stock"), and Series B Convertible Additional Preferred Stock, par value $.01 and stated value $10.00 per share (the "Series B Preferred"), as of April 28, 1997, the record date, were eligible to participate in the 1997 Rights Offering. The rights were exercisable at a price of $.90 per share. Shareholders received .38 rights for each share of Common Stock held and .57 rights for each share of Series B Preferred held as of the record date. The 1997 Rights Offering expired on May 30, 1997, with 55,654,623 rights to purchase shares exercised, and it closed on June 6, 1997.
Richemont Finance entered into a standby purchase agreement (the "Richemont Standby Purchase Agreement") to purchase all shares not subscribed to by shareholders of record at the subscription price. Richemont Finance purchased 40,687,970 shares in the 1997 Rights Offering and, as a result, then owned approximately 20.3% of the Company. The Company paid in cash, from the proceeds of the 1997 Rights Offering, to Richemont Finance on the closing date approximately $1.8 million which represented an amount equal to 1% of the aggregate offering price of the aggregate number of shares issuable upon closing of the 1997 Rights Offering other than with respect to the shares of Common Stock held by North American Resources Limited ("NAR") or its affiliates plus an amount equal to one-half of one percent of the aggregate number of shares acquired by NAR upon exercise of their rights (Standby Fee) plus an amount equal to 4% of the aggregate offering price in respect to all unsubscribed shares (Take-Up Fee). In connection with the entering of the Richemont Standby Purchase Agreement, the Company named two Richemont representatives, Messrs. Jan P. du Plessis and Howard M.S. Tanner, to its Board of Directors.
On April 26, 1997, NAR irrevocably agreed with the Company, subject to and upon the consummation of the 1997 Rights Offering, to exercise certain of the rights distributed to it for the purchase of 11,111,111 shares of Common Stock that had an aggregate purchase price of approximately $10 million. NAR agreed to pay for and the Company agreed to accept as payment for the exercise of such rights the surrender by NAR of the principal amount due under a subordinated promissory note dated September 1996 due by the Company to Intercontinental Mining & Resources Incorporated, an affiliate of NAR ("IMR"), in the principal amount of $10 million the ("IMR Promissory Note") and cancellation thereof.
In order to facilitate vendor shipments and to permit the commencement of the Company's plan to consolidate certain of its warehouse facilities, Richemont advanced $30 million as of April 23 1997 against its commitment to purchase all of the unsubscribed shares pursuant to the Richemont Standby Purchase Agreement. The Company then executed a subordinated promissory note in the amount of $30 million to evidence this indebtedness (the "Richemont Promissory Note") which was repaid out of the proceeds of the 1997 Rights Offering.
The Company issued 55,654,623 shares as a result of the 1997 Rights Offering which generated gross cash proceeds of approximately $40 million (after giving effect to the acquisition and exercise by NAR of rights having an aggregate purchase price of $10 million which were paid for by the surrender and cancellation of the IMR Promissory Note). The proceeds of the 1997 Rights Offering were used by the Company: (i) to repay the $30 million principal amount outstanding under the Richemont Promissory Note, and (ii) for working capital and general corporate purposes including repayment of amounts outstanding under the Credit Facility with Congress.
ADDITIONAL INVESTMENTS
In November 1997, SMALLCAP World Fund, Inc. ("SMALLCAP"), a mutual fund and substantial investor in the Company, agreed to purchase 3.7 million shares of the Company's Common Stock at $1.41 per share for an aggregate purchase price of approximately $5.2 million in a private placement. This transaction was consummated on November 6, 1997. These shares were restricted and were subsequently registered under the Securities Act of 1933, as amended, pursuant to a registration rights agreement with SMALLCAP that called for the Company to use its best efforts to effect the registration of such shares as soon as practicable after April 1, 1998.
On July 31, 1998, Richemont acquired 5,646,490 additional shares of Common Stock of the Company pursuant to the exercise of certain common stock purchase warrants with exercise prices from $1.95 to $2.95 per share and an aggregate total exercise price of $13.6 million. The Company used the proceeds of the warrant exercise to reduce the amounts outstanding under the Congress Credit Facility.
EMPLOYEES
As of December 25, 1999 the Company employed approximately 3,000 people on a full-time basis and approximately 1,300 people on a part-time basis. The number of part-time employees at December 25, 1999 reflects a temporary increase in headcount necessary to fill the seasonal increase in orders during the holiday season.
SEASONALITY
The revenues and business for both Hanover Brands and erizon are seasonal. Hanover Brands processes and ships more catalog orders during the holiday season than in any other portion of the year. Many of erizon's e-tail clients experience similar seasonal trends resulting in increased order processing during the holiday season. Accordingly, the Company, taken as a whole, recognizes a disproportionate share of annual revenue during the last three months of the year.
COMPETITION
The Company believes that the principal bases upon which it competes in the Hanover Brands business are quality, value, service, proprietary product offerings, catalog design, convenience, speed and efficiency. The Company's catalogs compete with other mail order catalogs, both specialty and general, and retail stores, including department stores, specialty stores and discount stores. Competitors also exist in each of the Company's catalog specialty areas of women's apparel, home fashions, general merchandise, men's apparel and gifts. A number of the Company's competitors have substantially greater financial, distribution and marketing resources than the Company.
The Company is maintaining an active commerce-enabled Internet Web site presence for all of its catalogs. A substantial number of each of the Company's catalog competitors maintain an active commerce-enabled Internet Web site presence as well. A number of such competitors have substantially greater financial, distribution and marketing resources than the Company. Sales from the Internet for Web site merchandisers have grown in 1999. The Company believes strongly in the future of the Internet and online commerce, including the breakneck speed at which marketing opportunities are evolving in this medium, and has adjusted its marketing focus, resources, and manpower to that end.
The Company believes that the principal bases upon which it competes in the erizon business are value, service, flexibility, scalability, convenience and efficiency. The Company's third party fulfillment business competes with Fingerhut Companies, Inc., PSF Web, Inc., ASD Systems, Inc. and SubmitOrder.com, amongst others. A number of the Company's competitors have substantially greater financial, distribution and marketing resources than the Company.
TRADEMARKS
Each of the Company's catalogs has its own federally registered trademarks which are owned by Hanover Brands. Hanover Brands also owns numerous trademarks, copyrights and service marks on its subsidiary's logos, products and catalog offerings. erizon
has federally registered trademarks which are used by its subsidiaries. The Company has also protected various trademarks internationally. The Company vigorously protects such marks and believes there is substantial goodwill associated with them.
GOVERNMENT REGULATION
The Company is subject to Federal Trade Commission regulations governing its advertising and trade practices, Consumer Product Safety Commission and Food and Drug Administration regulations governing the safety of the products it sells in its catalogs and other regulations relating to the sale of merchandise to its customers. The Company is also subject to the Department of Treasury-Customs regulations with respect to any goods it directly imports.
The imposition of a sales and use tax collection obligation on out-of-state catalog companies in states to which they ship products was the subject of a case decided in 1994 by the United States Supreme Court. While the Court reaffirmed an earlier decision that allowed direct marketers to make sales into states where they do not have a physical presence without collecting sales taxes with respect to such sales, the Court further noted that Congress has the power to change this law. The Company believes that it collects sales tax in all jurisdictions where it is currently required to do so.
ITEM 2.
ITEM 2. PROPERTIES
Hanover Brands:
The Company's business-to-consumer subsidiary owns and operates a 150,000 square foot home fashion manufacturing facility located in LaCrosse, Wisconsin. The facility produces down-filled comforters for sale under "The Company Store" and "Turiya" brand names. In addition, the Company leases the following properties:
- A 84,700 square foot corporate headquarters and administrative office located in Weehawken, New Jersey under a 15 year lease expiring in April 2005, and
- 14 retail and outlet stores located in California, Ohio, Pennsylvania and Wisconsin.
erizon:
The Company's business-to-business subsidiary owns and operates the following properties:
- A 770,000 square foot warehouse and fulfillment center in Roanoke, Virginia, which was expanded during fiscal 1999 by 137,000 square feet to accommodate the increase in clients for the Company's end to end e-commerce services,
- A 277,500 square foot warehouse and fulfillment center located in Hanover, Pennsylvania, and
- A 58,000 square foot telemarketing facility in Lacrosse, Wisconsin.
In addition, the Company leases the following properties:
- A 185,000 square foot warehouse and fulfillment center located in Lacrosse, Wisconsin under a 13 year lease expiring in December 2001, and
- A 123,000 square foot telemarketing and customer service facility located in Hanover, Pennsylvania, under a recently renewed 3-year lease term expiring in January 2003.
Additionally, the Company utilizes temporary storage facilities ranging in size between 40,000 and 90,000 square feet to house merchandise during the holiday selling period and leases two additional satellite telemarketing facilities in York, Pennsylvania and San Diego, California.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
A class action lawsuit was commenced on March 3, 2000 entitled Edwin L. Martin v. Hanover Direct, Inc. and John Does 1 through 10, bearing case no. CJ2000-177 in the State Court of Oklahoma (District Court in and for Sequoyah County). Plaintiff commenced the action on behalf of himself and a class of persons who have at any time purchased a product from the Company and paid for an "insurance charge." The complaint sets forth claims for breach of contract, unjust enrichment, recovery of money paid absent consideration, fraud and a claim under the New Jersey Consumer Fraud Act. The complaint alleges that the Company charges its customers for delivery insurance even though, among other things, the Company's common carriers already provide insurance and the insurance charge provides no benefit to the Company's customers. Plaintiff also seeks a declaratory judgment as to the validity of the delivery insurance. The damages sought are (i) an order directing the Company to return to plaintiff and class members the "unlawful revenue" derived from the insurance charges, (ii) declaring the rights of the parties, (iii) permanently enjoining the Company from imposing the insurance charge, (iv) awarding threefold damages of less than $75,000 per plaintiff and per class member, and (v) attorneys' fees and costs. The Company has not yet been required to file an answer to the complaint.
At the end of January 2000, the Company received a letter from the Federal Trade Commission ("FTC") conducting an inquiry into the marketing of The Shopper's Edge club to determine whether, in connection with such marketing, any entities have engaged in (1) unfair or deceptive acts or practices in violation of Section 5 of the FTC Act and/or (2) deceptive or abusive telemarketing acts or practices in violation of the FTC's Telemarketing Sales Rule. The inquiry was undertaken pursuant to the provisions of
Sections 6, 9, and 10 of the FTC Act. Following such an investigation, the FTC may initiate an enforcement action if it finds "reason to believe" that the law is being violated. When there is "reason to believe" that a law violation has occurred, the FTC may issue a complaint setting forth its charges. If the respondent elects to settle the charges, it may sign a consent agreement (without admitting liability) by which it consents to entry of a final order and waives all right to judicial review. If the FTC accepts such a proposed consent, it places the order on the record for sixty days of public comment before determining whether to make the order final. The Company believes that it complied with all enumerated aspects of the investigation. It has not received notice of an enforcement action or a complaint against it.
In addition, the Company is involved in various routine lawsuits of a nature which are deemed customary and incidental to its businesses. In the opinion of management, the ultimate disposition of these actions will not have a material adverse effect on the Company's financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock trades on the American Stock Exchange under the symbol "HNV". The following table sets forth, for the periods shown, the high and low sale prices of the Company's Common Stock as reported on the American Stock Exchange Composite Tape. As of March 17, 2000, there were 213,308,946 shares outstanding and approximately 3,850 holders of record of Common Stock.
The Company is restricted from paying dividends on its Common Stock or from acquiring its capital stock by certain debt covenants contained in agreements to which the Company is a party.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial data for each of the fiscal years indicated:
- --------------- (1) The amounts for 1998 and 1997 include both a receivable and an obligation under receivables financing of $18,998 and $21,918, respectively, pursuant to SFAS No. 125.
There were no cash dividends declared on the Common Stock in any of the periods presented.
See notes to consolidated financial statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following table sets forth, for the fiscal years indicated, the percentage relationship to revenues of certain items in the Company's Consolidated Statements of Income (Loss):
RESULTS OF OPERATIONS
1999 Compared with 1998
Net (Loss). The Company reported a net loss of $16.3 million or ($.08) per common share for fiscal year 1999 compared with a net loss of $25.6 million or ($.13) per common share for fiscal year 1998. Per share amounts are expressed after deducting preferred dividends of $0.6 million in both 1999 and 1998, respectively. The weighted average number of shares outstanding was 210,718,546 for fiscal year 1999 compared to 206,508,110 for fiscal year 1998. The increase in weighted average shares outstanding is due to the exercise of common stock purchase warrants by Richemont Finance S.A. in July 1998 and the exercise of stock options in 1998 and 1999.
Compared to the comparable period last year, the $9.3 million decrease in net loss was primarily due to:
(i) higher demand for the Company's core catalog offerings;
(ii) the 1999 gain on sale of The Shopper's Edge of $4.3 million;
(iii) 1998 losses from non-core catalogs, which were discontinued or repositioned during 1999;
(iv) 1998 charges of approximately $5.9 million relating to the discontinuance or repositioning of the Company's non-core catalogs; $3.7 million related to write-down of inventory ($1.9 million of which was reversed in 1999) and $2.2 million related to write-off of prepaid catalog costs; and
(v) gain on sale of the non-core Austad's catalog of $1.0 million
partially offset by,
(i) 1999 losses resulting from the Company's e-commerce related strategic initiatives; and
(ii) higher personnel related expenses.
Revenues. Revenues increased $3.8 million (0.7%) to $549.9 million for fiscal year 1999 from $546.1 million for fiscal year 1998. This increase was primarily due to higher demand for the Company's core catalog offerings and revenues from the expansion of the Company's third party business-to-business ("B-to-B") e-commerce services operation partly offset by lower demand from the Company's non-core catalogs. Revenues from core catalogs increased by $18.6 million (3.8%) while revenues from non-core catalogs decreased by $29.7 million (60.9%). The Company circulated 235 million catalogs during fiscal year 1999 versus 242 million catalogs during fiscal year 1998 reflecting the discontinuance or repositioning of the Company's non-core catalogs. Circulation of the Company's core catalogs increased approximately 6.0% during fiscal year 1999. The number of customers having made a purchase from the Company's catalogs during fiscal year 1999 remained at approximately 4 million, consistent with fiscal year 1998.
Fiscal year 1999 revenues of $14.9 million resulted from the expansion of the Company's B-to-B e-commerce services operation, which provided Internet order processing, customer care, and shipping and distribution services to third party clients primarily during the 4th quarter. Third party B-to-B e-commerce service revenues for fiscal 1998 was approximately $2.1 million.
Cost of Sales and Operating Expenses. Cost of sales and operating expenses increased by $6.9 million (2.0%) from fiscal year 1998. This increase includes higher order processing, distribution and systems development costs related to the expansion of the Company's B-to-B e-commerce services operation. Furthermore, additional personnel related costs, which include temporary increases in headcount, were incurred in order to fill the seasonal increase in Internet orders during the holiday period. These cost
increases along with demand related increases in cost of merchandise sold from the Company's core catalogs were partly offset by cost decreases resulting from the discontinuance or repositioning of the Company's under-performing non-core catalogs.
Selling Expenses. Selling expenses decreased by $12.2 million (8.2%) from fiscal year 1998. This reflects a $13.6 million decrease in expenses (including a $2.2 million charge in 1998 for the write-down of certain non-core catalog prepaid assets) resulting from the discontinuance or repositioning of the Company's non-core catalogs. Selling expenses related to the Company's core catalogs increased by $1.4 million (1.0%) due to an increase in circulation during 1999 partly offset by lower name list rental and catalog production costs.
General and Administrative Expenses. General and administrative expenses increased by $11.0 million (19.1%) from fiscal year 1998. This increase is primarily due to higher professional fees and Internet advertising costs related to the Company's e-commerce strategic initiatives, and higher personnel related expenses.
Depreciation and Amortization. Depreciation and amortization decreased by $0.1 million (1.0%) from fiscal year 1998.
(Loss) before Interest and Taxes. The Company's loss before interest and taxes decreased by $8.4 million to $8.4 million in fiscal 1999 from a loss of $16.8 million in fiscal 1998. Beginning in 1999, the Company's results are comprised of the following segments:
- Direct Commerce: Income before interest and taxes increased by $23.1 million primarily due to higher demand for the Company's core catalog offerings, the gain on sale of The Shopper's Edge ($4.3 million), 1998 losses from the Company's non-core catalogs, 1998 charges related to the discontinuance of non-core catalogs ($5.9 million, of which $1.9 million was reversed during 1999), and the gain on sale of Austads ($1.0 million). This was partially offset by the cost of the Company's catalog related e-commerce strategic initiatives (primarily Internet advertising costs) and higher personnel related expenses.
- Business-to-Business ("B-to-B") Services: Loss before interest and taxes increased by $15.2 million primarily due to 1999 losses related to the expansion of the Company's third party B-to-B e-commerce services operation, higher professional fees resulting from the separation of the Company's direct commerce/ B-to-B services operations, and higher personnel related expenses. These results reflect overhead costs incurred by the Company throughout fiscal 1999 to systematize the infrastructure in order to service the expected increase in third party Internet customers, which were brought online primarily during the second half of the year.
Interest Expense, Net. Interest expense, net decreased by $0.4 million to $7.3 million in 1999 due to lower average borrowings outstanding during 1999.
Income Taxes. The Company did not record a Federal income tax provision in 1999 or 1998 due to net operating losses incurred during both years. The Company's state tax provision was $0.5 million and $1.0 million for fiscal 1999 and 1998, respectively.
Shareholders' Equity. The number of shares of Common Stock outstanding increased by 439,574 during 1999 primarily due to shares issued in connection with the Company's stock option plans. At December 25, 1999, there were 210,866,959 shares of Common Stock outstanding compared to 210,427,385 shares of Common Stock outstanding at December 26, 1998.
In February 2000, the Company's Series B Convertible Preferred Stock ("Series B Stock") was redeemed via the issuance of 2,193,317 shares of the Company's common stock. Weighted average common shares outstanding as of December 25, 1999 would have been 212,911,863 versus a reported 210,718,546, assuming conversion of the Series B Stock at the beginning of 1999. Reported quarterly and total year 1999 net (loss) per common share amounts would not have been affected by the pro-forma increase in weighted average common shares outstanding.
The Shopper's Edge. In March 1999, the Company, through a newly formed subsidiary, started up and promoted a discount buyers club to consumers known as "The Shopper's Edge". In exchange for an up-front membership fee, The Shopper's Edge program enables members to purchase a wide assortment of merchandise at discounts which are not available through traditional retail channels. Initially, prospective members participate in a 45-day trial period that, unless canceled, is automatically converted into a full membership term which is one year in duration. Memberships are automatically renewed at the end of each term unless canceled by the member.
During 1999, primarily as a result of timing of revenue and expense recognition, The Shopper's Edge subsidiary incurred losses of $4.3 million reflecting both cash payments and outstanding liabilities to the Company of $3.3 million and $1.0 million, respectively. The Company's operating results reflect $0.1 million of net losses after the elimination of these intercompany transactions. The Company recorded membership fee revenue as well as an allowance for estimated cancellations on a straight-line basis over the one- year membership term, which commenced immediately following the expiration of the initial 45-day trial period. Costs tied to acceptances such as commissions paid to service providers as well as membership servicing and transaction processing expenses were deferred and expensed as membership fee revenue was recognized. All other costs, including membership kits and postage, were expensed as incurred. Under the terms of the program, the Company was entitled to periodic withdrawals of funds provided by up-front membership fees. These withdrawals, however, were subject to contractual limitations as The Shopper's Edge subsidiary was required to maintain adequate cash balances to fund estimated membership reimbursements resulting from cancellations. Accordingly, funds retained within The Shopper's Edge subsidiary were reported as "restricted cash" in the Company's balance sheet during 1999. If membership reimbursements due to cancellations exceeded the amount of funds retained by The Shopper's Edge subsidiary, the Company was liable to cover the shortfall.
Effective December 1999, the Company sold its interest in The Shopper's Edge subsidiary to an unrelated third party for a nominal fair value based upon an independent appraisal. At the time of the sale, the liabilities of the subsidiary exceeded the assets by
$4.3 million resulting in a gain on sale to the Company of $4.3 million. The gain represented the portion of deferred income of The Shopper's Edge that the Company received in the form of withdrawals discussed above which, in accordance with the Company's revenue recognition policy for memberships, would not have been earned until the completion of the membership term. The deferred income was recognized immediately upon the sale and has been reflected as a gain on sale in the accompanying consolidated statement of income (loss) for the year ended December 25, 1999. There are no conditions or obligations to the Company to refund any portion of the cash withdrawals received prior to the sale. The Company entered into a solicitation services agreement with the purchaser whereby the Company will provide solicitation services for the program, and will receive commissions for member acceptances based on a fixed fee per member basis, adjusted for cancellation rates on a prospective basis. Membership revenue earned during the fiscal year ended December 25, 1999 was $3.9 million, which is included in revenues in the accompanying consolidated statement of income (loss). Had the new solicitation services agreement been in place for fiscal 1999, net revenues on a pro-forma basis would have increased by $1.4 million reflecting the inclusion of $5.3 million of fee revenue for solicitation services provided versus $3.9 million of recorded membership fee revenue under the old agreement. Furthermore, on a pro-forma basis, the Company's loss from operations would have decreased by $5.4 million to $(8.4) million.
1998 Compared with 1997
Net (Loss). The Company reported a net loss of $25.6 million, or $(.13) per common share, compared with a net loss of $10.9 million, or ($.06) per common share, for 1997. Per share amounts are expressed after deducting preferred dividends of $0.6 million and $0.2 million in 1998 and 1997, respectively. The weighted average number of shares outstanding was 206,508,110 for the year ended December 26, 1998 compared to 176,621,080 in 1997. The increase in weighted average shares outstanding is primarily due to a rights offering completed in June 1997.
The higher loss in fiscal 1998 is attributed to:
(i) a $3.7 million charge for the writedown of non core catalog inventory as well as a $2.2 million charge for other costs associated with plans to discontinue certain under performing company catalog brands
(ii) higher promotional activity primarily in the fourth quarter
(iii) costs related to new business initiatives
(iv) higher selling expenses due to increased promotional activity and more competitive mailings in advance of the 1999 postal rate increase
(v) the 1997 special credit which exceeded the amount recorded in 1998 by $1.7 million
(vi) 1997 income from the partial recovery of previously written-off investment securities amounting to $1.3 million
partially offset by,
(i) improved gross margins from reductions in the cost of merchandise resulting from the benefits of improved purchase strategies and efficiencies in inventory management for the core catalog brands, as well as the positive impact of upsell promotions
(ii) reduced distribution costs resulting from the completion of the consolidation of distribution activities into the Company's Roanoke, Virginia facility.
Revenues. Revenues decreased in 1998 to $546.1 million from $557.6 million in 1997, primarily as a result of the under performing (non core) catalog brands (Tweeds, Austad's and Colonial Garden Kitchens), partially offset by revenue growth in other brands and the impact of upsell promotions. The Company's revenues for 1998 for the core catalog brands increased 3% over 1997.
Catalog circulation decreased to 242 million in 1998 from 244 million in 1997.
Operating Costs and Expenses. Cost of sales and operating expenses, which include fulfillment and telemarketing costs, decreased by $14.7 million from 1997. This decrease was the result of a reduction in catalog sales and reduced merchandise costs as the Company's margins were enhanced by improved product sourcing and merchandise mix as well as continued improvement in telemarketing and fulfillment costs. Additionally, the Company attained inventory management efficiencies resulting in improved order fill rates, lower product delivery costs and lower backorder levels.
Selling Expenses. Selling expenses increased $7.4 million in 1998 as a result of the increased utilization of name list rentals, additional catalog production costs and new marketing initiatives, partially offset by the benefit of reduced, more targeted circulation strategies. These expenses also include $2.2 million of charges related to the aforementioned discontinuance of certain under performing company catalog brands.
General and Administrative Expenses. General and administrative expenses increased $4.0 million in 1998 primarily due to an increase in spending to support growth initiatives, including electronic commerce, as well as the impact of an offset to general and administrative expenses ($1.3 million of income) recorded in 1997 as a result of asset distributions made to the Company relating to previously written-off investment securities.
The operating results for 1998 and 1997 include benefits of $0.5 million and $2.2 million, respectively, relating to the reversal of a portion of the restructuring charges that were recorded in 1996. The 1998 reversal related to the Company's decision to remain in its Hanover, Pa. fulfillment center. The 1997 reversal related primarily to the Company's decision to remain in its Weehawken corporate facility.
Depreciation and Amortization. Depreciation and amortization increased $1.3 million in 1998 resulting from fixed asset additions associated with the improvements in the distribution center in Roanoke, Virginia.
(Loss) from Operations. The Company's loss from operations increased $15.0 million to $16.8 million in 1998 from a loss of $1.8 million in 1997. As discussed above, the 1998 operating results include $5.9 million in charges related to discontinuing certain non core catalog brands as the Company focuses on building brands with a strong core customer base. The operating results also include infrastructure costs related to the Company's e-commerce initiatives. The operating results for 1998 and 1997 include a $0.5 and $2.2 million credit, respectively, relating to the reversal of a portion of the restructuring charges that were recorded in 1996.
Interest Expense, Net. Interest expense, net decreased $0.2 million to $7.8 million in 1998 from $8.0 million in 1997. This improvement was primarily due to lower interest rates and lower amortization of capitalized debt costs.
Income Taxes. The Company did not record a Federal income tax provision in 1998 or 1997 based on each years' net operating losses. The Company's state tax provision was $1.0 million in 1998 and 1997.
Shareholders' Equity. The number of shares of Common Stock outstanding increased by 6,672,063 in 1998 due to 5.6 million shares issued in connection with the exercise of certain common stock purchase warrants, its equity and incentive plans, and other activities. At December 26, 1998, there were 210,427,385 shares of Common Stock outstanding compared to 203,755,322 shares of Common Stock outstanding at December 27, 1997.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operations: During 1999, net cash used by operating activities was $6.7 million. This was primarily due to higher accounts receivable attributable to the 1999 addition of several third party clients for the Company's B-to-B e-commerce services operation and an increase in prepaid catalog costs. These cash outflows were partly offset by increases in cash resulting from lower inventory carrying levels.
Net cash used in investing activities: During 1999, net cash used by investing activities of $3.3 million was primarily due to capital expenditures of $4.9 million. These capital expenditures primarily related to computer hardware and software to increase the functionality and capacity of the Company's integrated e-commerce systems platform. The net cash used for capital expenditures was partially offset by the proceeds from the sale of the Company's non-core Austad's catalog of $1.6 million.
Net cash provided by financing activities: During 1999, net cash provided by financing activities of $0.6 million was primarily due to increased borrowings under the Congress Revolving Credit Facility of $5.2 million, partly offset by payments of long-term debt obligations as well as for debt issuance costs.
Debt and Liquidity: At December 25, 1999, the Company had $2.8 million in cash and cash equivalents compared with $12.2 million at December 26, 1998. Working capital and current ratio were $18.0 million and 1.2 to 1 at December 25, 1999 versus $43.9 million and 1.47 to 1 at December 26, 1998.
As of December 25, 1999, the Company had outstanding borrowings of $17.7 million and $16.0 million under the Congress Revolving Credit Facility and the Congress Term Loan, respectively. Borrowings under the Congress Revolving Credit Facility, which allows for total borrowings based on percentages of eligible inventory and eligible accounts receivable, is comprised of $5.2 million under a revolving line of credit arrangement and a $12.5 million term loan. Remaining availability under the Revolving Line of Credit at December 25, 1999 was $30.0 million ($32.8 million including cash on hand). The weighted average rates of interest, which are based on prime and LIBOR rates, related to the Revolving Line of Credit and the Congress Term Loan were 8.75% and 9.00%, respectively, as of December 25, 1999.
On March 24, 2000, the Congress Credit Facility was further amended to provide for a maximum credit of up to $82.5 million, comprised of a revolving line of credit facility (the "Revolving Line of Credit"), a letter of credit facility with a sublimit of $40.0 million, and term loans with an initial principal balance of $25.0 million. The maximum credit under the Revolving Line of Credit is $82.5 million, less the amount of outstanding letters of credit, less the principal balance of the term loans. The Company paid $1.4 million to Congress to secure the amendment of the Congress Credit Facility. The $25.0 million initial principal term loan balance includes a $17.5 million Tranche A Term Loan having an eighty-four month term, and a $7.5 million Tranche B Term Loan having a thirty-six month term.
Borrowings under the Term Financing Facility were supported by standby letters of credit issued through UBS AG ("UBS"), and guaranteed by Richemont Finance, S.A., a 48.2% owner of the Company's outstanding common stock. Interest rates related to the Term Financing Facility are based on "A-1" commercial paper rates, and ranged from 5.3% to 6.0% as of December 25, 1999. Borrowings under the Term Financing Facility were redeemed on March 24, 2000. The Term Financing Facility was paid in full from borrowings under the Congress Credit Facility.
Richemont Lines of Credit -- On March 24, 2000, the Company entered into a new $10.0 million unsecured line of credit (the "Richemont $10.0 million Line of Credit") with Richemont Finance, S.A. Borrowings under the Richemont $10.0 million Line of Credit bear interest at a rate of 0.125% per month (an annualized rate of 1.5%) on the average monthly balance outstanding. In addition, the Company will pay Richemont a monthly facility fee of approximately $0.1 million each month during the term of the Richemont $10.0 million Line of Credit. The maximum amount available to be drawn under the Richemont $10.0 million Line of Credit (the "Maximum Amount") was initially $10.0 million and will be reduced on a dollar-for-dollar basis for each dollar of equity contributed to the Company or any of its subsidiaries after March 24, 2000 by Richemont or any subsidiary or affiliate of Richemont. If the excess availability under the Congress Credit Facility is less than $3.0 million the Company will be required to borrow under the Richemont $10.0 million Line of Credit, and pay to Congress, the amount such that the excess availability under the Congress Credit facility after such payment will be $3.0 million. The Company may also borrow under the Richemont $10.0 million Line of Credit up to $5.0 million to pay trade creditors in the ordinary course of business. The Richemont $10.0 million Line of Credit will remain in place until the Congress Credit Facility is terminated or the Maximum Credit is reduced to zero. As of March 24, 2000, there were no borrowings outstanding under the Richemont $10.0 million Line of Credit.
On March 1, 2000, the Company entered into a new $25.0 million unsecured Line of Credit (the "Richemont $25.0 million Line of Credit") with Richemont Finance, S.A. Borrowings under the Richemont $25.0 million Line of Credit bear interest at a rate of 0.583% per month (an annualized rate of 7.0%) on the average monthly balance outstanding. In addition, the Company will pay Richemont a monthly fee of approximately $0.1 million each month from March 1, 2000 up to the Maturity Date. The Richemont $25.0 million Line of Credit will mature on the earlier of December 30, 2000 and the date on which Richemont makes an equity infusion in the Company or any of the Company's subsidiaries (such earlier date, the "Maturity Date"). As of March 24, 2000, there were $5.0 million of borrowings outstanding under the Richemont $25.0 million Line of Credit.
Remaining availability under all credit facilities as of March 24, 2000 was $34.7 million ($36.5 million including cash on hand). Due to the combination of internally generated cash flows and the multiple financing arrangements previously discussed, the Company believes that it has sufficient liquidity to cover its future working capital requirements.
Dividends: The Company is restricted from paying dividends at any time on its Common Stock by certain debt covenants contained in agreements to which the Company is a party.
Foreign Currency Translation: The Company minimizes currency risks by making most foreign purchases in U.S. dollars and does not utilize hedging instruments.
Effect of Inflation and Cost Increases: The Company normally experiences increased costs of sales and operating expenses as a result of the general rate of inflation and commodity price fluctuations. Operating margins are generally maintained through internal cost reductions and operating efficiencies, and then through selective price increases where market conditions permit. The Company's inventory is primarily mail-order merchandise, which undergoes sufficiently high turnover so that the cost of goods sold approximates replacement cost. Since sales are not dependent on a particular supplier or product brand, the Company can adjust product mix to mitigate the effects of inflation on its overall merchandise base.
Paper and Postage: The Company mails its catalogs and ships most of its merchandise through the United States Postal Service (USPS), with catalog mailing and product shipment expenses representing approximately 16.2% of revenues in 1999 and 15.4% of revenues in 1998. Paper costs represented approximately 5.5% of revenues in 1999 and 6.6% of revenues in 1998 reflecting reduced paper costs during 1999.
The USPS increased its mailing rates in 1998, which became effective in January 1999. The Company also utilizes United Parcel Service and other delivery services. The United Parcel Service raised its rates for domestic deliveries by 3.1% for ground rates and 2.6% for air rates effective in February 1999. It has generally been the Company's experience as well as its policy to recover the costs of shipping, including outbound freight, and handling from customers.
YEAR 2000
The Year 2000 issue related to the way computer systems and programs interpret calendar date entries in two-digit data code fields. A system could have failed or made miscalculations due to the inability to distinguish the year 2000 from the year 1900. Additionally, some other systems not normally characterized as information technology systems could contain embedded hardware or software that might be susceptible to this problem. As a result, many companies upgraded or replaced computer systems in order to comply with Year 2000 requirements.
As was the case with most other database marketing firms and, for the most part, other businesses using computers and telecommunications equipment in their operations, the Company planned for and addressed the Year 2000 issue to ensure it would be able to continue to perform its critical functions. Specifically, these functions included receiving, processing and shipping customer orders, ordering and receiving merchandise from vendors, and processing payments.
The Company's Year 2000 project commenced in 1996 and was divided into the following phases:
(i) Discovery- identification/ inventorying of all systems with potential Year 2000 issues;
(ii) Assessment- evaluation, categorizing and prioritizing of Year 2000 issues;
(iii) Remediation- modifying and replacing existing systems; and
(iv) Testing/ Deployment- comprehensive testing of Year 2000 readiness to ensure all problems were discovered and adequately corrected.
The Company evaluated its internal mainframe business systems deemed critical to its business, which included rollover tests allowing for a system date change to January 1, 2000. Additionally, the Company performed an inventory and assessment of hardware and software associated with individual PC systems for Year 2000 readiness, and performed Year 2000 readiness surveys of its suppliers to ensure a consistent flow of product. Furthermore, as an additional contingency plan, the Company made arrangements to have technical staff available at all locations at the turn of the millennium to support its customers and operations in the event of a Year 2000 failure. Accordingly, while some disruptions were anticipated with the Company's internal systems and a few product vendors, the Company believed, absent any interruptions to either power, utilities or telephone services that were beyond its control, the most probable scenario was that there would not be a system failure of critical services or infrastructure that would materially disrupt its operations.
Upon the turn of the millennium and subsequent thereto, the Company did not experience any significant systems malfunctions related to the Year 2000 conversion. Any systems malfunctions were relatively minor in nature and were corrected without any loss of service to customers or other third parties. Additionally, the Company did not experience any Year 2000 issues with suppliers and did not suffer any interruption in power, utilities or telecommunications services. Although the Company does not anticipate any future systems malfunctions related to the Year 2000 issue, procedures are in place to continuously monitor all critical systems to ensure that any potential Year 2000 issues that arise are corrected with minimal or no disruption to the Company's operations.
The Company did not modify spending patterns or postpone capital expenditures due to efforts expended for the Year 2000 conversion nor were there any unusual customer buying patterns prior to the turn of the millennium. Cumulative costs associated with the necessary modifications to address the Year 2000 issue amounted to approximately $3.8 million. These costs primarily comprised of expenditures to upgrade or replace computer hardware and software as well as the costs of staff and consultants to perform the project.
CAUTIONARY STATEMENTS
Certain of the foregoing statements may constitute forward looking statements which involve risks and uncertainties including the following: ". . . the Company believes it has sufficient liquidity to cover its future working capital requirements."
The following are important factors, among others, that could cause the Company's actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf, of the Company:
A general deterioration of economic conditions in the United States leading to increased competitive activity including a business failure of a substantial size company in the retail industry, a reduction in consumer spending generally, or specifically with reference to the types of merchandise the Company offers in its catalogs. The failure of the Internet generally to achieve the projections for it with respect to growth of e-commerce or otherwise.
The ability of the Company's computer system to connect with the systems of others and to be able to serve the other's fulfillment needs.
The Company had a history of operating losses. Continuation of the operating losses may prevent the Company from making the investments in e-commerce which are required to be made to achieve a position of leadership in serving the e-commerce needs of companies doing business on the Internet. Also acquisitions may be prevented by the continuation of operating losses.
The ability of the Company to attract management with the requisite experience in e-commerce or in Internet businesses and to develop a culture which is consistent with the manner in which e-commerce is managed.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATES: The Company's exposure to market risk relates to interest rate fluctuations for borrowings under its Congress Revolving Credit Facility and its Term Financing Facility, which bear interest at variable rates. At December 25, 1999, outstanding principal balances under these facilities subject to variable rates of interest were approximately $33.7 million. At March 24, 2000, outstanding principal balances under these facilities subject to variable rates of interest were approximately $55.0 million. If interest rates were to increase by one quarter of one percent from current levels, the resulting increase in interest expense would not have a material impact on our results of operations taken as a whole.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of Hanover Direct, Inc.:
We have audited the accompanying consolidated balance sheets of Hanover Direct, Inc. (a Delaware corporation) and subsidiaries as of December 25, 1999 and December 26, 1998, and the related consolidated statements of income (loss), shareholders' equity and cash flows for each of the three fiscal years in the period ended December 25, 1999. These consolidated financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Hanover Direct, Inc. and subsidiaries as of December 25, 1999 and December 26, 1998 and the results of their operations and their cash flows for each of the three fiscal years in the period ended December 25, 1999 in conformity with generally accepted accounting principles in the United States.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule of valuation and qualifying accounts is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
New York, New York February 18, 2000 (except with respect to the matters discussed in Note 8 and Note 18, as to which the dates are March 24, 2000 and March 3, 2000, respectively)
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 25, 1999 AND DECEMBER 26, 1998
(IN THOUSANDS OF DOLLARS, EXCEPT SHARE AMOUNTS)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
FOR THE YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997 (IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997 (IN THOUSANDS OF DOLLARS)
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 27, 1997, DECEMBER 26, 1998 AND DECEMBER 25, 1999 (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
1. BACKGROUND OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations -- Hanover Direct, Inc., a Delaware corporation (the "Company"), operates as both a specialty direct marketer and as a provider of business-to-business ("B-to-B") e-commerce services. As a specialty direct marketer, the Company markets a diverse portfolio of branded home fashions, home improvements, men's and women's apparel, and gift products, through mail-order catalogs and connected Internet Web sites directly to the consumer ("direct commerce"). As a provider of B-to-B e-commerce services, the Company offers a full range of order processing, customer care, customer information, and shipping and distribution services to third party clients.
The Company utilizes a fully integrated systems and operations support platform initially developed to manage the Company's wide variety of catalog/Internet product offerings. This infrastructure has been leveraged and expanded to provide the aforementioned B-to-B e-commerce services on behalf of third party clients. Beginning in 1999, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information" (Note 11) to report its direct commerce and B-to-B services as separate operating and reporting segments.
Basis of Presentation -- The Consolidated Financial Statements include all subsidiaries of the Company, and all intercompany transactions and balances have been eliminated. The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain prior year amounts have been reclassified to conform with the current year's presentation.
Fiscal Year -- The Company operates on a 52 or 53 week fiscal year. Effective for fiscal 1997, the Company changed its fiscal year to the last Saturday in December. The years ended December 25, 1999, December 26, 1998 and December 27, 1997 were 52 week years. Had the Company not changed its year-end, fiscal 1997 would have been a 53 week year and the net loss for 1997 would have increased by approximately $0.6 million.
Cash and Cash Equivalents -- Cash includes cash equivalents consisting of highly liquid investments with original maturities of ninety days or less.
Accounting for Transfers of Credit Card Receivables -- The Company accounts for transfers and servicing of financial assets in accordance with SFAS No. 125 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This statement establishes criteria distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The application of this statement resulted in the recognition of additional credit card accounts receivable and an offsetting long-term debt obligation at December 26, 1998 of $19.0 million. This adjustment was based on the terms of the Company's agreement with an unrelated third party for the sale and servicing of accounts receivable.
During 1999, the Company finalized a new account purchase and credit card marketing and services agreement. The new agreement, which provides for services similar to those of the previous agreement, transfers the Company's receivables to a new third party provider on terms that, in accordance with SFAS No. 125, require the transfer to be accounted for as a sale. Accordingly, the Company's December 25, 1999 consolidated balance sheet no longer reflects additional credit card accounts receivable or a related long-term debt obligation (See Note 6- "Transfer of Credit Card Accounts Receivable").
Inventories -- Inventories consist principally of merchandise held for resale and are stated at the lower of cost or market. Cost, which is determined using the first-in, first-out (FIFO) method, includes the cost of the product as well as freight-in charges. The Company considers slow moving inventory to be surplus and calculates a loss on the impairment as the difference between an individual item's cost and the net proceeds anticipated to be received upon disposal. Such inventory is written down to its net realizable value.
Prepaid Catalog Costs -- Prepaid catalog costs consist of direct response advertising costs related to catalog production and mailing. In accordance with SOP 93-7, "Reporting on Advertising Costs", these costs are deferred and amortized as selling expenses over the estimated period in which the sales related to such advertising are generated. Total catalog expense was $133.0 million, $145.0 million and $139.0 million, for fiscal year 1999, 1998 and 1997, respectively.
Depreciation and Amortization -- Depreciation and amortization of property and equipment is computed on the straight-line method over the following lives: buildings and building improvements, 30-40 years; furniture, fixtures and equipment, 3-10 years; and leasehold improvements, over the estimated useful lives or the terms of the related leases, whichever is shorter. Repairs and maintenance are expensed as incurred.
Goodwill, Net -- Excess of cost over the net assets of acquired businesses is amortized on a straight-line basis over periods of up to forty years. Accumulated amortization was $4.5 million and $4.0 million at December 25, 1999 and December 26, 1998, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Impairment of Long-Lived Assets -- In accordance with SFAS No. 121,"Accounting for the Impairment of Long-lived Assets and Long-lived Assets to be Disposed Of," the Company reviews long-lived assets for impairment whenever events indicate that the carrying amount of such assets may not be fully recoverable. The Company performs undiscounted cash flow analyses to determine if an impairment exists. If an impairment is determined to exist, an impairment loss is then recorded by the Company.
Stock Based Compensation -- The Company accounts for its stock based compensation to employees using the fair value-based methodology under SFAS No. 123, "Accounting for Stock-Based Compensation."
Income Taxes -- The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." It requires an asset and liability approach for financial accounting and reporting for income taxes. The provision for income taxes is based on income after adjustment for those temporary and permanent items which are not considered in the determination of taxable income. Deferred taxes result when the Company recognizes revenue or expenses for income tax purposes in a different year than for financial reporting purposes.
Net (Loss) Per Share -- Net (loss) per share is computed using the weighted average number of common shares outstanding in accordance with the provisions of SFAS No. 128, "Earnings Per Share." The weighted average number of shares used in the calculation for both basic and diluted net (loss) per share for fiscal 1999, 1998 and 1997 was 210,718,546, 206,508,110 and 176,621,080 shares, respectively. Diluted earnings per share equals basic earnings per share as the dilutive calculation would have an antidilutive impact as a result of the net losses incurred during fiscal years 1999, 1998 and 1997.
Revenue Recognition --
-- Direct Commerce: The Company recognizes revenue, net of estimated returns, upon shipment of merchandise to customers. Postage and handling charges billed to customers are also recognized as revenue upon shipment of related merchandise. The Company accrues for expected future returns at the time of sale based upon historical trends.
-- Shopper's Edge Buyer's Club: See Note 3.
-- B-to-B Services: Revenues from the Company's Internet transaction services are recognized as the related services are provided. Customers are charged on an activity unit basis, which applies a contractually specified rate according to the type of service transaction performed.
Fair Value of Financial Instruments -- The fair value of financial instruments does not materially differ from their carrying values.
Recently Issued Accounting Standards -- In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which the Company is required to adopt at the beginning of fiscal year 2001. SFAS No. 133 establishes new accounting and reporting standards for derivative financial instruments, including certain derivative instruments embedded in other contracts, and hedging activities. The Company currently does not engage in derivative and hedging activities. The effect, if any, on the financial statements has not yet been determined by the Company.
2. INVESTMENTS
Blue Ridge Associates -- In January 1994, the Company purchased for $1.1 million a 50% interest in Blue Ridge Associates ("Blue Ridge"), a partnership which owns an apparel distribution center in Roanoke, VA. The remaining 50% interest is held by an unrelated third party. This investment is accounted for under the equity method of accounting. The Company's investment in Blue Ridge was approximately $0.8 million and $0.9 million at December 25, 1999 and December 26, 1998, respectively. In December 1996, the Company consolidated the fulfillment and telemarketing activities handled at this facility into its home fashions distribution facility in Roanoke, VA, and attempted to sublease the vacated space. In April 1999, the Company sublet the vacated premises to an unrelated third party for a five-year period expiring in April 2004. In February 2000, the Company sold its partnership interest in Blue Ridge Associates to the holder of the other 50% for $0.8 million, which approximates the Company's carrying value of the investment.
Always in Style, LLC. -- On August 6, 1999, the Company and AIS Marketing Services, LLC ("AIS Marketing") entered into a joint venture whereby the Company contributed $1.0 million and AIS Marketing contributed specialized software to form Always in Style, LLC ("AIS"). The Company, which owns a two-thirds interest in AIS, includes the operating results of AIS in its consolidated financial statements. AIS develops and markets proprietary interactive fashion, beauty and home decorating profiling software ("Profilers"). Based upon questionnaires filled out by the customer, the Profilers provide the customer with personalized fashion, beauty and home decorating analysis and advice, as well as specific product recommendations. AIS was formally launched in November 1999.
Desius, LLC -- In 1999, the Company entered into a 60/40 joint venture with RS Software (India) Ltd. to provide 24/7 Web shop services and e-commerce software, systems and programing. Augmenting the Company's programming services, the Desius teams based in Calcutta, India and the United States together can provide round the clock service. The Calcutta based Desius team
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
also provides additional resources including creative marketing, Web site creation, maintenance and management. Desius also serves as the outsourcing arm for Keystone clients which lack resources in these areas. The Company includes the operating results of Desius in its consolidated financial statements.
3. DIVESTITURES
During 1999, the Company sold the following businesses:
Austad's: In October 1999, the Company sold the remaining assets of its non-core Austad's catalog, which featured golf equipment, apparel and gifts, for $1.6 million. The assets disposed of primarily included inventory and intangible assets, which were written off in 1996, such as customer lists and trademarks. The combined book value of assets sold was approximately $0.6 million resulting in a net pre-tax gain of $1.0 million.
The Shopper's Edge: In March 1999, the Company, through a newly formed subsidiary, started up and promoted a discount buyers club to consumers known as "The Shopper's Edge." In exchange for an up-front membership fee, The Shopper's Edge program enables members to purchase a wide assortment of merchandise at discounts which are not available through traditional retail channels. Initially, prospective members participate in a 45-day trial period that, unless canceled, is automatically converted into a full membership term which is one year in duration. Memberships are automatically renewed at the end of each term unless canceled by the member.
During 1999, primarily as a result of timing of revenue and expense recognition, The Shopper's Edge subsidiary incurred losses of $4.3 million reflecting both cash payments and outstanding liabilities to the Company of $3.3 million and $1.0 million, respectively. The Company's operating results reflect $0.1 million of net losses after the elimination of these intercompany transactions. The Company recorded membership fee revenue as well as an allowance for estimated cancellations on a straight-line basis over the one- year membership term, which commenced immediately following the expiration of the initial 45-day trial period. Costs tied to acceptances such as commissions paid to service providers as well as membership servicing and transaction processing expenses were deferred and expensed as membership fee revenue was recognized. All other costs, including membership kits and postage, were expensed as incurred. Under the terms of the program, the Company was entitled to periodic withdrawals of funds provided by up-front membership fees. These withdrawals, however, were subject to contractual limitations as The Shopper's Edge subsidiary was required to maintain adequate cash balances to fund estimated membership reimbursements resulting from cancellations. Accordingly, funds retained within The Shopper's Edge subsidiary were reported as "restricted cash" in the Company's balance sheet during 1999. If membership reimbursements due to cancellations exceeded the amount of funds retained by The Shopper's Edge subsidiary, the Company was liable to cover the shortfall.
Effective December 1999, the Company sold its interest in The Shopper's Edge subsidiary to an unrelated third party for a nominal fair value based upon an independent appraisal. At the time of the sale, the liabilities of the subsidiary exceeded the assets by $4.3 million resulting in a gain on sale to the Company of $4.3 million. The gain represented the portion of deferred income of The Shopper's Edge that the Company received in the form of withdrawals discussed above which, in accordance with the Company's revenue recognition policy for memberships, would not have been earned until the completion of the membership term. The deferred income was recognized immediately upon the sale and has been reflected as a gain on sale in the accompanying consolidated statement of income (loss) for the year ended December 25, 1999. There are no conditions to the obligations of the Company to refund any portion of the cash withdrawals received prior to the sale. The Company entered into a solicitation services agreement with the purchaser whereby the Company will provide solicitation services for the program, and will receive commissions for member acceptances based on a fixed fee per member basis, adjusted for cancellation rates on a prospective basis. Membership revenue earned during the fiscal year ended December 25, 1999 was $3.9 million, which is included in revenues in the accompanying consolidated statement of income (loss). Had the new solicitation services agreement been in place for fiscal 1999, net revenues on a pro-forma basis would have increased by $1.4 million reflecting the inclusion of $5.3 million of fee revenue for solicitation services provided versus $3.9 million of recorded membership fee revenue under the old agreement. Furthermore, on a pro-forma basis, the Company's loss from operations would have decreased by $5.4 million to $(8.4) million.
4. SPECIAL CHARGES
In December 1996, the Company recorded special charges of approximately $36.7 million, which consisted of severance, facility exit/relocation costs and fixed asset write-offs related to the downsizing of the Company, and a write-off for impairment of long-lived assets of certain under-performing catalogs. In December 1997, the Company adjusted its previous cost estimates to downsize the Company due to exit plan modifications related to its Weehawken, NJ corporate facility and its Hanover, PA distribution center.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
These adjustments resulted in a reduction of special charges of approximately $2.2 million, which related primarily to the reversal of the reserve for fixed assets expected to be abandoned. In 1998, the Company adjusted further its reserve for fixed asset write-offs by $0.5 million reflecting the Company's decision to remain in its Hanover, PA distribution center. In 1999, the Company recorded an additional $0.1 million of special charges related to a change in estimate for losses on sublease arrangements for its Roanoke, VA apparel distribution center and its San Francisco CA office facilities (see below).
Severance -- The cost of employee severance includes termination benefits for line and supervisory personnel in fulfillment, telemarketing, MIS, merchandising, and various levels of corporate and catalog management. The Company paid approximately $0.6 million and $2.7 million of severance during fiscal 1998 and 1997, respectively. There were no recorded severance reserves in the Company's consolidated balance sheets at December 25, 1999 and December 26, 1998.
Facility Exit/Relocation Costs and Fixed Asset Write-Offs -- These costs are primarily related to the Company's decision to sublease a portion of its Weehawken, NJ and San Francisco, CA office facilities, and to consolidate its Roanoke, VA apparel distribution center and Hanover, PA distribution center into its Roanoke home fashion distribution center. As of December 25, 1999, the Company consolidated the Roanoke, VA apparel distribution center and relocated all but one catalog from its Hanover, PA distribution center into its Roanoke, VA home fashion distribution center. The remaining catalog will continue to be serviced out of the Hanover, PA distribution center. In addition, the Company has sublease agreements in place for both a portion of its Weehawken, NJ and San Francisco, CA office facilities.
During 1999, the Company revised its estimates for losses on sublease arrangements for its Roanoke, VA apparel distribution center and its San Francisco, CA office facilities. The Company reduced its estimate for sublease losses for the Roanoke, VA apparel distribution center by $0.5 million due to the Company's release from any lease related obligations resulting from the sale of its partnership interest in Blue Ridge Associates, a partnership which owned the facility. This was more than offset by a higher estimate for sublease losses related to the San Francisco, CA office facilities of $0.6 million due to higher than anticipated rent escalations. Approximately $2.3 million of estimated losses on sublease arrangements are recorded in accrued liabilities in the Company's consolidated balance sheet at December 25, 1999.
5. WRITE-DOWN OF INVENTORY OF DISCONTINUED CATALOGS
In 1998, the Company decided to discontinue the traditional catalog operations of the Tweeds, Austad's and Colonial Garden Kitchens catalog brands. These "non-core" catalog brands were to be repositioned as primarily e-commerce brands and, if unsuccessful, discontinued. Revenues from the aforementioned non-core catalogs were $19.0 million, $48.7 million and $65.6 million for fiscal 1999, 1998 and 1997, respectively. The Company recorded provisions of approximately $3.7 million related to the write-down of inventory associated with these catalogs to net realizable value based on the planned liquidation of such inventory and $2.2 million of additional charges relating to prepaid catalog costs associated with the discontinuance of the catalog operations.
The Company utilizes various liquidation vehicles to dispose of aged catalog inventory including special sales catalogs, sales sections in other catalogs, and liquidations through off-price merchants. During 1999, the Company was able to utilize special sales catalogs, which provide higher cost recoveries, to dispose of its non-core catalog inventory to a larger extent than anticipated at the end of 1998. Accordingly, $1.9 million of the 1998 charges were reversed and included in the Company's 1999 results.
During 1999, the Company sold the remaining assets of its non-core Austad's catalog for $1.6 million; fully discontinued its Tweeds catalog operation; and repositioned and relaunched its Colonial Garden Kitchens catalog as Domestications Kitchen & Garden.
6. TRANSFER OF CREDIT CARD ACCOUNTS RECEIVABLE
Through July 1999, the Company was a party to an agreement involving the sale and servicing of accounts receivable originating from the Company's private label credit card program. This agreement included full recourse provisions obligating the Company to repurchase uncollectible receivables as well as a requirement for the Company to maintain a deposit, based on a specified percentage of outstanding receivables, to secure the Company's obligations under the contract. Approximately $3.5 million was held as security by the unrelated third party as of December 26, 1998. Due to the conditions imposed under the agreement, the Company, in accordance with SFAS No. 125 ("Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities"), accounted for the transfer of its private label credit card receivables as a secured borrowing. Accordingly, the Company recorded both a financing receivable as well as a corresponding long-term obligation of $19.0 million in its December 26, 1998 consolidated balance sheet.
During July 1999, the Company finalized a new three-year credit card marketing and servicing agreement with a new provider and terminated the previously mentioned agreement. The new terms include provisions requiring the Company to equally share credit losses over an agreed upon benchmark for the first 18 months of the agreement, however, the Company is not obligated to repurchase any uncollectible receivables. Upon the expiration of this period, all credit card receivables transfers are non-recourse to the Company. Furthermore, the Company is no longer required to maintain a deposit as security for its performance under the terms of
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
the new agreement. Reflecting the change in terms included in the new agreement, the Company, in accordance with SFAS No. 125, now accounts for the transfer of its private label credit card receivables as a sale. Accordingly, the Company's December 25, 1999 consolidated balance sheet no longer reflects a financing receivable and a related long-term obligation. No gain or loss was recognized upon the transition to the new program.
As of December 25, 1999, the Company maintained a shared credit risk reserve of $0.6 million, which is recorded in accrued liabilities. As of December 26, 1998, the Company maintained a reserve for repurchases of uncollectible accounts of $2.0 million, $1.5 million of which was recorded in accrued liabilities and $0.5 million was recorded in the allowance for doubtful accounts.
7. ACCRUED LIABILITIES
Accrued liabilities consist of the following (in thousands):
8. LONG-TERM DEBT
Long-term debt consists of the following (in thousands):
Revolving Credit Facility -- On December 25, 1999, the Company's credit facility (the "Congress Credit Facility") with Congress Financial Corporation ("Congress") was a $65.0 million revolving line of credit, of which $12.5 million was a term loan. Total borrowings under the Congress facility, however, were subject to limitations based upon specified percentages of eligible inventory and eligible accounts receivable. The revolving line of credit facility bore interest at prime plus .25% or LIBOR plus 2.75%, the term loan bore interest at prime plus .50% or LIBOR plus 2.75%. The use of a prime or LIBOR based rate is determinable at the Company's discretion. Additionally, the Congress facility, which is secured by all assets of the Company, contains restrictive covenants including restrictions on indebtedness and common stock dividends, and requires the maintenance of a $21.5 million net worth and a $(10.0) million working capital (deficit) position. As of December 25, 1999, the Company had an outstanding term loan of $12.5 million, bearing a weighted average interest rate of 9.0%, and $5.2 million of outstanding borrowings under the revolving line of credit, bearing an interest rate of 8.75%.
On March 24, 2000, the Congress Credit Facility was further amended to provide for a maximum credit of up to $82.5 million, comprised of a revolving line of credit facility (the "Revolving Line of Credit"), a letter of credit facility with a sublimit of $40 million, and term loans with an initial principal balance of $25.0 million. The maximum credit under the Revolving Line of Credit is $82.5 million, less the amount of outstanding letters of credit, less the principal balance of the term loans. The Company paid a $1.4 million closing fee to Congress to secure the amendment of the Congress Credit Facility. The $25.0 million initial principal term loan balance includes a $17.5 million Tranche A Term Loan having an eighty-four month term, and a $7.5 million Tranche B Term Loan having a thirty-six month term.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
The Congress Credit Facility, as amended, is secured by all assets of the Company and places limitations on the incurrence additional indebtedness. The amount that can be borrowed under the amended Congress Facility is based on percentages of eligible inventory, eligible accounts receivable, eligible credit card receivables and eligible fulfillment contract receivables as reported to Congress from time to time. Effective March 24, 2000, the Congress Credit Facility was extended to January 31, 2004.
The Revolving Loans will bear interest at prime plus .5% or Eurodollar plus 2.5%, the Tranche A Term Loans will bear interest at prime plus .75% or Eurodollar plus 3.5%, and the Tranche B Term Loans will bear interest at prime plus 4.25%, but in no event less than 13.0%. Under the amended Congress Credit Facility, the Company will be required to maintain throughout the term of the agreement minimum net worth between $30.0 million and $38.0 million and working capital between $12.0 million and $20.0 million, determinable on a month to month basis. The Company is also required to achieve Earnings/(Loss) Before Interest, Taxes, Depreciation and Amortization ("EBITDA") between ($1.3) million and $17.8 million, determinable on a quarterly basis.
Term Financing Facility -- During 1994 and 1995, the Company entered into a term loan agreement with a syndicate of financial institutions, which provided for borrowings of $20 million ("Term Financing Facility"). The Term Financing Facility bears interest based on "A-1" commercial paper rates existing at the time of each borrowing. As of December 25, 1999, the Company had $16.0 million of outstanding borrowings under the Term Financing Facility bearing applicable rates of interest ranging from 5.3% to 6.0%. The Company was required to make annual principal payments of approximately $1.6 million under the Term Financing Facility for each of the next ten years.
As of December 25, 1999, letters of credit, issued by UBS AG ("UBS") and guaranteed by Richemont Finance S.A. ("Richemont"), supported both the Term Financing Facility and the Industrial Revenue Bonds (see below). Originating in December 1996 and renewed in 1998 and 1999, the arrangement relating to the guarantee of the UBS letters of credit, which were scheduled to expire on March 31, 2000, required the Company to pay to Richemont an annual facility fee equal to 9.5% of the $25.8 million principal amount, or $2.4 million. The principal amount of the UBS letters of credit approximated the combined outstanding borrowings under the Term Financing Facility and the Industrial Revenue Bonds at the time of renewal.
The Company has not extended or renewed the UBS letters of credit supporting the Term Financing Facility and the Industrial Revenue Bonds, and, accordingly, the $16.0 million of outstanding borrowings under the Term Financing Facility and the $8.0 million of outstanding borrowings under the Industrial Revenue Bonds were required to be redeemed. On March 24, 2000, the Trustees under the Term Financing Facility and the Industrial Revenue Bonds made drawings under the UBS letters of credit, and used the proceeds of the drawings to redeem the Term Financing Facility and the Industrial Revenue Bonds. The Company borrowed approximately $24.0 million under the Congress Credit Facility on March 24, 2000 to reimburse UBS for the drawings on these letters of credit. As a result, both the Term Financing Facility and the Industrial Revenue Bonds have been paid in full, and the Company has paid all amounts payable to UBS and Richemont relating to the letters of credit.
Industrial Revenue Bonds due 2003 -- The Industrial Revenue Bonds ("IRB's") of $8.0 million were due on December 1, 2003. The IRB's are secured by all assets purchased with the proceeds thereof and, as of December 25, 1999, were supported by an $8.0 million letter of credit issued by UBS and guaranteed by Richemont. The Industrial Revenue Bonds were redeemed on March 24, 2000 (see above).
Richemont Lines of Credit -- On March 24, 2000, the Company entered into a new $10.0 million unsecured line of credit (the "Richemont $10.0 Million Line of Credit") with Richemont. Borrowings under the Richemont $10.0 Million Line of Credit bear interest at a rate of 0.125% per month (an annualized rate of 1.5%) on the average monthly balance outstanding. In addition, the Company will pay Richemont a monthly facility fee of approximately $0.1 million each month during the term of the Richemont $10.0 million Line of Credit. The maximum amount available to be drawn under the Richemont $10.0 million Line of Credit (the "Maximum Amount") was initially $10.0 million and will be reduced on a dollar-for-dollar basis for each dollar of equity contributed to the Company or any of its subsidiaries after March 24, 2000 by Richemont or any subsidiary or affiliate of Richemont. If the excess availability under the Congress Revolving Line of Credit facility is less than $3.0 million, the Company will be required to borrow under the Richemont $10.0 Million Line of Credit, and pay to Congress, the amount such that the excess availability under the Congress Revolving Line of Credit after such payment will be $3.0 million. The Company may also borrow under the Richemont $10.0 Million Line of Credit up to $5.0 million to pay trade creditors in the ordinary course of business. The Richemont $10.0 Million Line of Credit will remain in place until the Congress facility is terminated or the Maximum Credit is reduced to zero. As of March 24, 2000, there were no borrowings outstanding under the Richemont $10.0 Million Line of Credit.
On March 1, 2000, the Company negotiated a new $25.0 million unsecured Line of Credit (the "Richemont $25.0 Million Line of Credit") with Richemont. Borrowings under the Richemont $25.0 Million Line of Credit bear interest at a rate of 0.583% per month (an annualized rate of 7.0%) on the average monthly balance outstanding. In addition, the Company will pay Richemont a monthly fee of approximately $0.1 million each month from March 1, 2000 up to the Maturity Date. The Richemont $25.0 Million Line of Credit will mature on the earlier of December 30, 2000 or the date on which Richemont makes an equity infusion in the Company or any of the Company's subsidiaries (such earlier date, the "Maturity Date"). As of March 24, 2000, there were $5.0 million of borrowings outstanding under the Richemont $25.0 Million Line of Credit.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
General -- Aggregate annual principal payments required on debt instruments, which reflect the effects of the March 2000 refinancing of the Congress Credit Facility and the negotiated Richemont lines of credit, are as follows (in thousands): 2000 -- $8,243; 2001 -- $3,763; 2002 -- $3,571; 2003 -- $7,054; 2004 -- $32,547; and thereafter -- $6,376.
9. RIGHTS OFFERINGS AND ADDITIONAL INVESTMENTS
1997 RIGHTS OFFERING
The Company commenced a $50 million rights offering (the "1997 Rights Offering") on April 29, 1997. Holders of record of the Company's Common Stock and Series B Convertible Additional Preferred Stock as of April 28, 1997, the record date, were eligible to participate in the 1997 Rights Offering. The Rights were exercisable at $.90 per share. The 1997 Rights Offering expired on May 30, 1997, with 55,654,623 rights to purchase shares exercised, and it closed on June 6, 1997.
Richemont Finance S.A. entered into a standby purchase agreement to purchase all shares not subscribed for by shareholders of record at the subscription price. Richemont purchased 40,687,970 shares in the 1997 Rights Offering and, as a result, then owned approximately 20.3% of the Company. The Company paid in cash, from the proceeds of the 1997 Rights Offering, to Richemont on the closing date approximately $1.8 million, which represented an amount equal to 1% of the aggregate offering price of the aggregate number of shares issuable upon closing of the 1997 Rights Offering other than with respect to the shares of Common Stock held by NAR Group Limited ("NAR"), a company jointly owned by Richemont and the family of Alan G. Quasha, Chairman of the Board of the Company, or its affiliates plus an amount equal to one-half of one percent of the aggregate number of shares acquired by NAR upon exercise of their rights (Standby Fee) plus an amount equal to 4% of the aggregate offering price in respect to all unsubscribed shares (Take-Up Fee).
On April 26, 1997, NAR irrevocably agreed with the Company, subject to and upon the consummation of the 1997 Rights Offering, to exercise certain of the rights distributed to it for the purchase of 11,111,111 shares of Common Stock that had an aggregate purchase price of approximately $10 million. NAR agreed to pay, and the Company agreed to accept as payment, for the exercise of such rights the surrender by NAR of the principal amount due under the Intercontinental Mining & Resources Limited ("IMR") Promissory Note dated September 1996 in the principal amount of $10 million and cancellation thereof.
In order to facilitate vendor shipments and to permit the commencement of the Company's plan to consolidate certain of its warehousing facilities, Richemont advanced $30 million as of April 23, 1997 against its commitment to purchase all of the unsubscribed shares pursuant to the standby purchase agreement. The Company executed a subordinated promissory note in the amount of $30 million to evidence this indebtedness (the "Richemont Promissory Note").
The gross cash proceeds from the 1997 Rights Offering of $40 million (after giving effect to the acquisition and exercise by NAR of rights having an aggregate purchase price of $10 million which were paid for by surrender and cancellation of the $10 million IMR Promissory Note) were used to repay the $30 million principal amount outstanding under the Richemont Promissory Note and the balance of the proceeds were used for working capital and general corporate purposes, including repayment of amounts outstanding under the Company's Revolving Credit Facility with Congress.
ADDITIONAL INVESTMENTS
In November 1997, the Company announced that SMALLCAP World Fund, Inc. ("SMALLCAP"), a mutual fund and substantial investor in the Company, agreed to purchase 3.7 million shares of the Company's Common Stock at $1.41 per share, which represented fair market value, for an aggregate purchase price of approximately $5.2 million in a private placement. This transaction was consummated on November 6, 1997. These shares were restricted and were subsequently registered under the Securities Act of 1933, as amended, pursuant to a registration rights agreement with SMALLCAP.
On July 31, 1998, Richemont acquired 5,646,490 additional shares of Common Stock of the Company pursuant to the exercise of certain common stock purchase warrants with exercise prices from $1.95 to $2.59 per share and an aggregate total exercise price of $13.6 million. The Company used the proceeds of the warrant exercise to reduce the amounts outstanding under the Congress Credit Facility.
10. CAPITAL STOCK
Series B Convertible Additional Preferred Stock -- In February 1995, the Company issued 634,900 shares of its Class B Convertible Additional Preferred Stock ("Series B Stock") to acquire the remaining 80% of the outstanding common stock of Aegis Safety Holdings, Inc. ("Aegis"), publisher of The Safety Zone catalog. The Series B Stock had a stated value of $10 per share. Non-cumulative dividends were to accrue and be paid at 5% per annum during each of the first three years after the February 1995 closing if Aegis attained at least $1.0 million in earnings before interest and taxes each year. In years four and five, dividends, which became cumulative and were to accrue and be paid at 7% per annum, were no longer contingent upon the achievement of any earnings target. Dividends were not accrued or paid during the first three years after closing based on The Safety Zone catalog's operating results for
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
each respective year. During the Company's 1999 and 1998 fiscal years, no dividends were paid; however, the Company accrued $0.4 million during each year in order to recognize its cumulative dividend payment obligations.
The Series B Stock was convertible at any time, at $6.66 per share, subject to antidilution, at the option of the holder and was convertible at the Company's option if the market value of the Company's Common Stock was greater than $6.66 per share, subject to antidilution, for 20 trading days in any consecutive 30 day trading period. If, after five years, the Series B Stock was not converted, it was mandatorily redeemable, at the Company's option, in cash or for 952,352 shares of the Company's Common Stock provided the market value of the stock was at least $6.33 per share, subject to antidilution. If the market value of the Company's Common Stock did not meet this minimum, the redemption rate was subject to adjustment which would increase the number of shares for which the Series B Stock was redeemed.
The fair value of the Series B Stock, which was based on an independent appraisal, was $0.9 million less than the stated value at February 1995. This discount was amortized over a five year period and resulted in a charge of approximately $0.2 million to preferred stock dividends in the consolidated statements of income (loss) from fiscal years 1995 through 1999, respectively.
In February 2000, the Series B Stock was redeemed via the issuance of 2,193,317 shares of the Company's Common Stock. The increase in common shares issued upon redemption reflected a market value for the Company's shares on the date of redemption of $2.75 per share versus the $6.66 per share amount specified on the closing date. The Company also made a $0.9 million payment for all unpaid cumulative preferred dividends.
Weighted average common shares outstanding as of December 25, 1999 would have been 212,911,863 versus a reported 210,718,546, assuming conversion of the Series B Stock at the beginning of 1999. Reported quarterly and total year net (loss) per common share amounts would not have been affected by the pro-forma increase in weighted average common shares outstanding.
General -- At December 25, 1999, there were 210,866,959 shares of Common Stock issued and outstanding. Additionally, an aggregate of 14,780,984 shares of Common Stock were reserved for issuance pursuant to the exercise of outstanding options.
Treasury stock consisted of 652,552 and 358,303 shares of common stock at December 25, 1999 and December 26, 1998, respectively. In December 1999, the Company retained 294,249 shares of outstanding common stock held in escrow on behalf of certain participants of the Company's Executive Equity Incentive Plan whose rights, under the terms of the plan, expired during 1999.
Dividend Restrictions -- The Company is restricted from paying dividends on its Common Stock or from acquiring its capital stock by certain debt covenants contained in agreements to which the Company is a party.
11. SEGMENT REPORTING
Effective June 26, 1999, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The adoption of SFAS No. 131 coincides with the Company's decision to realign its business structure into two separate operating and reporting segments: direct commerce and business-to-business ("B-to-B") services. This reflects the Company's strategic initiative to reposition itself as both a specialty direct marketer and as a provider of B-to-B e-commerce transaction services.
The direct commerce segment is comprised of the Company's portfolio of branded specialty mail-order catalogs and connected Internet Web sites, as well as its retail operations, all of which market products directly to the consumer. Revenues are derived primarily from the sale of merchandise through the Company's catalogs and related Internet product offerings and its retail outlets. Other sources of revenue are derived from various upsell initiatives and other catalog related revenue. The B-to-B services segment represents the Company's e-commerce support and fulfillment operations as well as the Company's corporate administration function. Revenues are derived primarily from e-commerce transaction services, which include order processing, customer care, and shipping and distribution services. The B-to-B services segment provides the aforementioned services to the direct commerce segment pursuant to an intercompany service agreement.
The Company's management reviews income (loss) from operations to evaluate performance and allocate resources. As income taxes are centrally managed at the corporate level, deferred tax assets are not allocated by segment. The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Reportable segment data were as follows (in thousands of dollars):
Income/(loss) before interest and taxes for the direct commerce segment included (income)/loss from the write-down of inventory of discontinued catalogs of $(1.9) million and $3.7 million for years ended December 25, 1999 and December 26, 1998, respectively. Fiscal year results for the direct commerce segment also include $4.3 million and $1.0 million related to the gain on sale of The Shopper's Edge and the gain on sale of the Company's non-core Austad's catalog, respectively.
The aforementioned intercompany service agreement between the Company's two operating segments was effective as of December 27, 1998. Had the provisions of the intercompany service agreement been in effect in 1998, intersegment revenues for the B-to-B services segment would have been approximately $107.1 million for the year ended December 26, 1998. Income/(loss) before interest and taxes would have been approximately $(14.5) million and $(1.9) million for the direct commerce and B-to-B services segments, respectively, for the year ended December 26, 1998.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
12. STOCK BASED COMPENSATION PLANS
The Company has established several stock based compensation plans for the benefit of its officers and employees. As discussed in the Summary of Significant Accounting Policies (Note 1), the Company applies the fair value-based methodology of SFAS No. 123 and, accordingly, has recorded stock compensation expense of $2.9 million, $2.7 million and $1.8 million for fiscal 1999, 1998 and 1997, respectively. The effects of applying SFAS No. 123 for recognizing compensation costs are not indicative of future amounts. SFAS No. 123 does not apply to awards prior to 1996 and additional awards in the future are anticipated. The information below details each of the Company's stock compensation plans, including any changes during the years presented.
1978 Stock Option Plan -- Pursuant to the Company's 1978 Stock Option Plan, an aggregate of 2,830,519 shares were approved for issuance to employees and consultants of the Company. The option price and the period over which an option is exercisable is determined by the Compensation Committee of the Board of Directors.
Options expire five years from the date of grant and generally vest over three to four years. Payment for shares purchased upon the exercise of an option shall be in cash or stock of the Company. If paid in cash, a partial payment may be made with the remainder in installments evidenced by promissory notes at the discretion of the Compensation Committee. Changes in options outstanding, expressed in numbers of shares, are as follows:
1978 STOCK OPTION PLAN
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
As of December 25, 1999, there were no stock options outstanding or exercisable under the 1978 Stock Option Plan and the Company does not anticipate any further issuances under this plan.
Director Options -- In June 1994, one director was granted non-qualified stock options to purchase 50,000 common shares at an exercise price of $6.125 per share. These options, which remain outstanding and exercisable as of December 25, 1999, are due to expire in March 2000.
In February 1996, four directors were granted options to purchase 5,000 shares each at an exercise price of $1.44. Of the 20,000 total options granted, 5,000 options were exercised and 5,000 were canceled leaving 10,000 options outstanding and exercisable at December 25, 1999. The remaining options are due to expire in February 2001.
Executive Equity Incentive Plan -- In December 1992, the Board of Directors adopted the 1993 Executive Equity Incentive Plan (the "Incentive Plan"). The Incentive Plan was approved by shareholders at the 1993 Annual Meeting. Pursuant to the Incentive Plan, options to purchase shares of the Company's Common Stock were to be granted from time to time by the Compensation Committee of the Board of Directors to selected executives of the Company or its affiliates. For each option granted, up to a maximum of 250,000, the selected executive will receive the right to purchase on a specified date (the "Tandem Investment Date") a number of shares of the Company's Common Stock ("Tandem Shares") equal to one-half the maximum number of shares of the Company's Common Stock covered by such option. Company financing is available under the Incentive Plan to pay for the purchase price of the Tandem Shares. Changes in shares and options outstanding, expressed in numbers of shares, for the Incentive Plan are as follows:
EXECUTIVE EQUITY INCENTIVE PLAN
The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for grants in 1997: risk free interest rate of 6.37%, expected lives of 6 years, expected volatility of 40.81%, and no expected dividends.
The following table summarizes information about stock options outstanding under the Incentive Plan at December 25, 1999:
Options granted under the Incentive Plan become exercisable three years after the dates of grant and expire six years from the dates of grant. The purchase price is payable in full at the time of purchase in cash or shares of the Company's Common Stock valued at their fair market value or in a combination thereof.
Under the terms of the Incentive Plan, the purchase price for shares is based upon the market price at the date of purchase, and payment is made in the form of a 20% cash down payment and a six year note that bears interest at the mid-term applicable federal rate, as determined by the Internal Revenue Service, as of the month of grant of such shares. The Incentive Plan participants purchased shares at prices ranging from $0.69 to $4.94, with the Company accepting notes bearing interest at rates ranging from 5.00% to 7.75%.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Changes to the notes receivable principal balances related to the Incentive Plan are as follows:
In December 1999, the rights of certain participants in the Incentive Plan expired. These participants had cumulative promissory notes of approximately $1.0 million payable to the Company, comprised of $0.8 million of principal and $0.2 million of interest, on the expiration date. Accordingly, collateral encompassing 294,249 shares of the Company's common stock, held in escrow on behalf of each participant, was transferred to and retained by the Company in satisfaction of the aforementioned promissory notes, which were no longer required to be settled. The Company recorded these shares as treasury stock. Furthermore, these participants forfeited their initial 20% cash down payment, which was required for entry into the Incentive Plan. The Incentive Plan has been terminated.
All Employee Equity Investment Plan -- In December 1992, the Board of Directors adopted the 1993 All Employee Equity Investment Plan, which was approved by the shareholders at the 1993 Annual Meeting. Each full-time or permanent part-time employee of the Company or its affiliates who has attained the age of 18, has met certain standards of continuous service with the Company or an affiliate of the Company and is not covered by a collective bargaining agreement may participate in this plan. The plan was terminated on July 31, 1996 and closed to any future purchases.
Under this plan, employees were given the opportunity to purchase shares of the Company's Common Stock at a 40% discount from the average market value of a share of stock over a 20-day period prior to subscription. Shares became vested over a three-year period and, upon termination, any unvested shares were forfeited.
Changes in shares outstanding expressed in numbers of shares for the Investment Plan were as follows:
1996 Stock Option Plan -- Pursuant to the Company's 1996 Stock Option Plan, an aggregate of 7,000,000 shares of the Company's Common Stock were approved for issuance to employees of the Company. The option exercise price is the fair market value as of the date of grant. The exercise price of incentive stock options granted to an employee who owns more than 10% of the total combined voting power of all classes of stock of the Company is equal to 110% of the fair market value of the Company's Common Stock on the date of grant. Options granted may be performance based and all options granted must be specifically identified as incentive stock options or nonqualified options, as defined in the Internal Revenue Code. No employee may be granted stock options in excess of 500,000 shares of the Company's Common Stock and the aggregate fair market value of Common Stock for which an employee is granted incentive stock options that first became exercisable during any given calendar year shall be limited to $100,000. To the extent such limitation is exceeded, the option shall be treated as nonqualified. Stock options may be granted for terms not to exceed 10 years and shall be exercisable in accordance with the terms and conditions specified in each option agreement. In the case of an employee who owns stock possessing more than 10% of the total combined voting power of all classes of stock, the options must become exercisable within 5 years. Payment for shares purchased upon exercise of options shall be in cash or stock of the Company.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Changes in options outstanding, granted and the weighted average exercise prices are as follows:
1996 STOCK OPTION PLAN
The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for grants in fiscal 1999, 1998 and 1997: risk free interest rate of 5.83%, 5.64% and 6.21%, respectively, expected lives of 4 years and expected volatility of 53.81%, 55.82% and 59.40%, respectively, and no expected dividends. The following table summarizes information about stock options outstanding at December 25, 1999:
The Chief Executive Officer (the "CEO") Stock Option Plans -- The information below details each of the stock-based plans granted in 1996 for the benefit of the CEO. In each of the plans: (1) the option price represents the average of the low and high fair market values of the Common Stock on August 23, 1996, the date of the closing of the 1996 Rights Offering, (2) the options outstanding at December 25, 1999 have an exercise price of $1.16, and (3) payment for shares purchased upon the exercise of the option shall be in cash or stock of the Company.
The details of the plans are as follows:
The CEO Tandem Plan -- Pursuant to the Company's Tandem Plan (the "Tandem Plan"), the right to purchase an aggregate of 1,000,000 shares of Common Stock and an option to purchase 2,000,000 shares of Common Stock was approved for issuance to the CEO. The option is subject to antidilution provisions and due to the Company's 1996 Rights Offering was adjusted to 1,510,000 shares of Common Stock and 3,020,000 options. The options expire 10 years from the date of grant and vest over four years. The options outstanding at December 25, 1999 have a weighted average contractual life of 6.25 years.
The CEO Performance Year Plan -- Pursuant to the Company's Performance Year Plan (the "Performance Plan"), an option to purchase an aggregate of 1,000,000 shares of Common Stock was approved for issuance to the CEO in 1996. The options are based upon performance as defined by the Compensation Committee of the Board of Directors. Should a performance target not be attained, the option is carried over to the succeeding year in conjunction with that year's option until the expiration date. The options expire 10 years from the date of grant and vest over four years. Payment for shares purchased upon the exercise of the options shall be in cash or stock of the Company. The options outstanding at December 25, 1999 have a weighted average contractual life of 6 years.
The CEO Closing Price Option Plan -- Pursuant to the Company's Closing Price Option Plan (the "Closing Price Plan"), an option to purchase an aggregate of 2,000,000 shares of Common Stock was approved for issuance to the CEO in 1996. The options expire 10 years from the date of grant and will become vested upon the Company's stock price reaching a specific target over a consecutive 91 calendar day period as defined by the Compensation Committee of the Board of Directors. In May 1998, the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Compensation Committee of the Board of Directors reduced the target per share market price at which the Company's Common Stock had to trade in consideration of the dilutive effect of the increase in outstanding shares from the date of the grant. The performance period has a range of 6 years beginning August 23, 1996, the date of the closing of the 1996 Rights Offering. The options outstanding at December 25, 1999 have a weighted average contractual life of 6.25 years.
The CEO Six Year Stock Option Plan -- Pursuant to NAR's Six Year Stock Option Plan (the "Six Year Plan"), an option to purchase an aggregate of 250,000 shares of Common Stock was granted to the CEO by NAR. The option is subject to antidilution provisions and due to the Company's 1996 Rights Offering was adjusted to 377,500 option shares. The options expire 6 years from the date of grant and vest after one year. The options outstanding at December 25, 1999 have a weighted average contractual life of 2.25 years.
The CEO Seven Year Stock Option Plan -- Pursuant to NAR's Seven Year Stock Option Plan (the "Seven Year Plan"), an option to purchase an aggregate of 250,000 shares of Common Stock was granted to the CEO by NAR. The option is subject to antidilution provisions and due to the Company's 1996 Rights Offering was adjusted to 377,500 option shares. The options expire 7 years from the date of grant and vest after two years. The options outstanding at December 25, 1999 have a weighted average contractual life of 3.25 years.
The CEO Eight Year Stock Option Plan -- Pursuant to NAR's Eight Year Stock Option Plan (the "Eight Year Plan"), an option to purchase an aggregate of 250,000 shares of Common Stock was granted to the CEO by NAR. The option is subject to antidilution provisions and due to the Company's 1996 Rights Offering was adjusted to 377,500 option shares. The options expire 8 years from the date of grant and vest after three years. The options outstanding at December 25, 1999 have a weighted average contractual life of 4.25 years.
The CEO Nine Year Stock Option Plan -- Pursuant to NAR's Nine Year Stock Option Plan (the "Nine Year Plan"), an option to purchase an aggregate of 250,000 shares of common stock was granted to the CEO by NAR. The option was subject to antidilution provisions and due to the Company's 1996 Rights Offering was adjusted to 377,500 option shares. The options expire 9 years from the date of grant and vest after four years. The options outstanding at December 25, 1999 have a weighted average contractual life of 5.25 years.
For the combined CEO plans, options outstanding, granted and the weighted average exercise prices are as follows:
CEO STOCK OPTION PLANS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
The fair value of the options granted in 1996 for each of the CEO Stock Option Plans was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
- --------------- (1)The CEO Closing Price Option Plan used the Black-Scholes option-pricing model in conjunction with a Monte Carlo simulation.
The following table summarizes information about stock options outstanding at December 25, 1999.
OTHER STOCK AWARDS
During 1997, the Company granted, and the Compensation Committee approved, non-qualified options to certain employees for the purchase of an aggregate of 1,000,000 shares of the Company's Common Stock. The options become vested over three years and expire in 2003.
The options have an exercise price of $1.00 and a remaining contractual life of 3.2 years. The fair value of the options at the date of grant was estimated to be $.52 based on the following weighted average assumptions: risk free interest rate of 6.48%, expected life of 4 years, expected volatility of 59.40% and no expected dividends. As of December 25, 1999, there were 809,000 options outstanding and 475,664 options exercisable.
13. EMPLOYEE BENEFIT PLANS
The Company maintains several defined contribution (401K) plans that collectively cover all employees of the Company and provide employees with the option of investing in the Company's stock. The Company matches a percentage of employee contributions to the plans up to $10,000. Matching contributions for all plans were $0.6 million, $0.6 million and $0.7 million for fiscal 1999, 1998 and 1997, respectively.
14. INCOME TAXES
At December 25, 1999, the Company had net operating loss carryforwards ("NOLs") totalling $306.7 million which expire as follows: In the year 2001 -- $18.1 million, 2003 -- $14.6 million, 2004 -- $14.3 million, 2005 -- $20.6 million, 2006 - $46.9 million, 2007 -- $27.7 million, 2010 -- $24.6 million, 2011 -- $64.9 million 2012 -- $30.0 million, 2018 -- $24.4 million and 2019 -- $20.6 million. The Company also has $0.8 million of general business tax credit carryforwards that expire in 2000 through 2009. The Company's available NOLs for tax purposes consist of $92.2 million of NOLs subject to a $4.0 million annual limitation under Section 382 of the Internal Revenue Code of 1986 and $214.5 million of NOLs not subject to a limitation. The unused portion of the $4.0 million annual limitation for any year may be carried forward to succeeding years to increase the annual limitation for those succeeding years.
SFAS No. 109, "Accounting for Income Taxes," requires that the future tax benefit of such NOLs be recorded as an asset to the extent that management assesses the utilization of such NOLs to be "more likely than not." Despite incurring additional NOLs of $20.6 million in 1999, management believes that the Company will be able to utilize up to $15.0 million of NOLs based upon the Company's assessment of numerous factors, including its future operating plans.
For the years ended December 25, 1999 and December 26, 1998, the Company maintained its deferred tax asset of $15.0 million (net of a valuation allowance of $97.5 million in 1999 and $94.7 million in 1998). Management believes that the $15.0 million net deferred tax asset still represents a reasonable estimate of the future utilization of the NOLs and the reversal of timing items and will continue to routinely evaluate the likelihood of future profits and the necessity of future adjustments to the deferred tax asset valuation allowance.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Realization of the future tax benefits is dependent on the Company's ability to generate taxable income within the carryforward period and the periods in which net temporary differences reverse. Future levels of operating income and taxable income are dependent upon general economic conditions, competitive pressures on sales and margins, postal and other delivery rates, and other factors beyond the Company's control. Accordingly, no assurance can be given that sufficient taxable income will be generated for utilization of NOLs and reversals of temporary differences.
The Company's Federal income tax provision was zero for fiscal 1999, 1998 and 1997. The Company's provision for state income taxes was $0.5 million in 1999, $1.0 million in 1998 and $1.0 million in 1997.
A reconciliation of the Company's net loss for financial statement purposes to taxable loss for the years ended December 25, 1999, December 26, 1998 and December 27, 1997 is as follows (in thousands):
The components of the net deferred tax asset at December 25, 1999 are as follows (in millions):
The Company has established a valuation allowance for a portion of the deferred tax asset due to the limitation on the utilization of the NOLs and its estimate of the future utilization of the NOLs.
The Company's tax returns for years subsequent to 1984 have not been examined by the Internal Revenue Service ("IRS"). Availability of the NOLs might be challenged by the IRS upon examination of such returns which could affect the availability of the NOLs. The Company believes however, that IRS challenges that would limit the utilization of the NOLs will not have a material adverse effect on the Company's financial position.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Total tax expense for each of the three fiscal years presented differ from the amount computed by applying the Federal statutory tax rate due to the following:
15. LEASES
Certain leases to which the Company is a party provide for payment of real estate taxes and other expenses. Most leases are operating leases and include various renewal options with specified minimum rentals. Rental expense for operating leases related to continuing operations were as follows (in thousands):
Future minimum lease payments under noncancelable operating and capital leases relating to continuing operations that have initial or remaining terms in excess of one year, together with the present value of the net minimum lease payments as of December 25, 1999, are as follows (in thousands):
- ---------------
(a) Amount necessary to reduce net minimum lease payments to present value calculated at the Company's incremental borrowing rate at the inception of the leases.
(b) Reflected in the balance sheet as current and noncurrent capital lease obligations of $157 and $192 at December 25, 1999 and $73 and $4 at December 26, 1998, respectively.
The future minimum lease payments under noncancelable leases that remain from the discontinued restaurant operations as of December 25, 1999 are as follows: 2000 -- $0.8 million; 2001 -- $0.7 million; 2002 -- $0.5 million; 2003 -- $0.4 million; 2004 -- $0.4; million and thereafter $0.3 million. The above amounts exclude annual sublease income from subleases which have the same expiration as the underlying leases as follows: 2000 -- $0.6 million; 2001 -- $0.6 million; 2002 -- $0.4 million; 2003 -- $0.3 million; 2004 -- $0.3; and thereafter $0.2 million.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
16. CHANGES IN MANAGEMENT AND EMPLOYMENT AGREEMENTS
On March 7, 1996, Rakesh K. Kaul was named President and Chief Executive Officer and elected to the Board of Directors of the Company. Effective that date, Mr. Kaul entered into an Executive Employment Agreement (the "Employment Agreement") which provides for an "at will" term commencing on March 7, 1996 at a base salary of $525,000 per year. The Employment Agreement also provides for Mr. Kaul's participation in the Short-Term Incentive Plan for Rakesh K. Kaul. That plan, which was approved by the shareholders at the June 20, 1996 shareholders meeting, provides for an annual bonus of between 0% and 125% of Mr. Kaul's base salary, depending on the attainment of various performance objectives as determined in accordance with objective formulae or standards to be adopted by the Compensation Committee as part of the performance goals for each such year. The Employment Agreement also provides for Mr. Kaul's participation in the Long-Term Incentive Plan for Rakesh K. Kaul. That plan, which was approved by the shareholders at the June 20, 1996 shareholders meeting, provides for the purchase by Mr. Kaul of 1,000,000 shares of Common Stock at their fair market value; an option expiring March 7, 2006 for the purchase of 2,000,000 shares of Common Stock (the "Tandem Plan"); an option expiring March 7, 2006 to purchase 2,000,000 shares of Common Stock (the "Closing Price Plan") exercisable only upon satisfaction of the condition that the closing price of the Common Stock has attained an average of $7.00 per share, subsequently amended to $4.50 per share, during a 91-day period ending on or before March 7, 2002; an option expiring March 7, 2006 to purchase 1,000,000 shares of Common Stock at their fair market value, subject to the attainment of certain objective performance goals to be set by the Compensation Committee; and four options expiring March 7, 2002, and the first three anniversaries thereof, respectively, for the purchase of 250,000 shares of Common Stock each, granted by NAR, the Company's former largest shareholder (the "NAR Options"). As a result of the 1996 Rights Offering, Mr. Kaul was granted an additional .51 shares for each share of Common Stock he was granted under the Tandem Stock Purchase Right, the Tandem Option, and the NAR Options (collectively, the "Award Shares") which resulted in his being granted 1,510,000 shares, 3,020,000 options and 1,510,000 options, respectively. The Employment Agreement also provides for the grant of registration rights under the Securities Act of 1933, as amended (the "Securities Act"), for shares of Common Stock owned by Mr. Kaul. Pursuant to the Employment Agreement, the Company will make Mr. Kaul whole, on an after-tax basis, for various relocation and temporary living expenses related to his employment with the Company. In the event that Mr. Kaul's employment is actually or constructively terminated by the Company, other than for cause, he will be entitled for a 12-month period commencing on the date of his termination to (i) a continuation of his base salary, (ii) continued participation in the Company's medical, dental, life insurance and retirement plans offered to senior executives of the Company, and (iii) a bonus, payable in 12 equal installments, equal to 100% of his base salary (at the rate in effect immediately prior to such termination). In addition, Mr. Kaul will be entitled to receive (i) to the extent not previously paid, the short-term bonus payable to Mr. Kaul for the year preceding the year of termination and (ii) for the year in which Mr. Kaul's employment is terminated, an additional bonus equal to his annual base salary for such year, pro-rated to reflect the portion of such year during which Mr. Kaul is employed. Mr. Kaul's employment will be deemed to be constructively terminated by the Company in the event of a change in control (as defined in the Employment Agreement), the Company's bankruptcy, a material diminution of his responsibilities, or a relocation of the Company's headquarters outside the New York metropolitan area without his prior written consent. In the event that Mr. Kaul's employment terminates other than as a result of a termination by the Company, Mr. Kaul will not be entitled to any payment or bonus, other than any short-term bonus he is entitled to receive from the year prior to termination.
17. RELATED PARTY TRANSACTIONS
At December 25, 1999, current and former officers and executives of the Company, excluding Rakesh K. Kaul, owed the Company approximately $0.7 million, excluding accrued interest, under the Executive Equity Incentive Plan. These amounts due to the Company bear interest at rates ranging from 5.00% to 7.75% and are due from 2000 to 2002. An additional $1.0 million, excluding accrued interest, relates to a receivable under the CEO Incentive ("Tandem") Plan for Rakesh K. Kaul and is included in Notes Receivable from Sale of Common Stock in the accompanying consolidated balance sheet.
Richemont Finance S.A.("Richemont"), a Luxemburg company, owns approximately 48.2% of the Company's common stock through direct ownership. Richemont also holds an irrevocable proxy to vote approximately 4.3 million shares currently held by the third party. Accordingly, Richemont has voting control of approximately 50.2% of the Company.
18. COMMITMENTS AND CONTINGENCIES
A class action lawsuit was commenced on March 3, 2000 entitled Edwin L. Martin v. Hanover Direct, Inc. and John Does 1 through 10, bearing case no. CJ2000-177 in the State Court of Oklahoma (District Court in and for Sequoyah County). Plaintiff commenced the action on behalf of himself and a class of persons who have at any time purchased a product from the Company and paid for an "insurance charge." The complaint sets forth claims for breach of contract, unjust enrichment, recovery of money paid absent consideration, fraud and a claim under the New Jersey Consumer Fraud Act. The complaint alleges that the Company charges its customers for delivery insurance even though, among other things, the Company's common carriers already provide insurance and the insurance charge provides no benefit to the Company's customers. Plaintiff also seeks a declaratory judgment as to the validity of the delivery insurance. The damages sought are (i) an order directing the Company to return to plaintiff and class members the "unlawful revenue" derived from the insurance charges, (ii) declaring the rights of the parties, (iii) permanently enjoining the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997
Company from imposing the insurance charge, (iv) awarding threefold damages of less than $75,000 per plaintiff and per class member, and (v) attorney's fees and costs. The Company has not yet been required to file an answer to the complaint.
At the end of January, 2000, the Company received a letter from the Federal Trade Commission ("FTC") conducting an inquiry into the marketing of The Shopper's Edge club to determine whether, in connection with such marketing, any entities have engaged in (1) unfair or deceptive acts or practices in violation of Section 5 of the FTC Act and/or (2) deceptive or abusive telemarketing acts or practices in violation of the FTC's Telemarketing Sales Rule. The inquiry was undertaken pursuant to the provisions of Section 6, 9, and 10 of the FTC Act. Following such an investigation, the FTC may initiate an enforcement action if it finds "reason to believe" that the law is being violated. When there is "reason to believe" that a law violation has occurred, the FTC may issue a complaint setting forth its charges. If the respondent elects to settle charges, it may sign a consent agreement (without admitting liability) by which it consents to entry of a final order and waives all right to judicial review. If the FTC accepts such a proposed consent, it places the order on the record for sixty days of public comment before determining whether to make the order final. The Company believes that it complied with all enumerated aspects of the investigation. It has not received notice of an enforcement action or a complaint against it.
The Company is involved in various routine lawsuits of a nature which are deemed customary and incidental to its business. In the opinion of management, the ultimate disposition of such actions will not have a material adverse effect on the Company's financial position or results of operations.
In connection with several sublease agreements related to the Company's discontinued restaurant operations, the Company remains contingently liable for all lease related obligations should the sublessees fail to comply with all conditions of their sublease agreements.
19. SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(a) Identification of Directors:
The information required by this item is incorporated by reference from the Company's definitive proxy statement to be filed by the Company pursuant to Regulation 14A.
(b) Identification of Executive Officers:
- --------------- (a) All references to dates and positions held by such executive officers prior to September 1993 refer to the Company's predecessor, The Horn & Hardart Company ("H&H"). H&H merged with and into the Company in September 1993, with the Company surviving.
Pursuant to the Company's By-Laws, its officers are chosen annually by the Board of Directors and hold office until their respective successors are chosen and qualified.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the Company's definitive proxy statement to be filed by the Company pursuant to Regulation 14A.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the Company's definitive proxy statement to be filed by the Company pursuant to Regulation 14A.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the Company's definitive proxy statement to be filed by the Company pursuant to Regulation 14A.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
(b) Reports on Form 8-K: None.
(c) Exhibits required by Item 601 of Regulation S-K:
See Exhibit Index.
(d) Financial Statement Schedules:
See (a) 2. above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 23, 2000 HANOVER DIRECT, INC. (registrant)
By: /s/ RAKESH K. KAUL ---------------------------------------- Rakesh K. Kaul President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on the date indicated below.
PRINCIPAL FINANCIAL OFFICER:
Board of Directors:
Date: March 23, 2000
EXHIBIT INDEX
- --------------- * Hanover Direct, Inc., a Delaware corporation, is the successor by merger to The Horn & Hardart Company and The Hanover Companies.
** EDGAR filing only.
SCHEDULE II
HANOVER DIRECT, INC.
VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 25, 1999, DECEMBER 26, 1998 AND DECEMBER 27, 1997 (IN THOUSANDS OF DOLLARS)
- --------------- (1) Accounts written-off.
(2) Utilization of reserves.
(3) Utilization of reserves ($1,131) and reversal of reserves ($463).
(4) Represents the change in the valuation allowance offset by the change in the gross tax asset. | 26,017 | 169,133 |
79564_1999.txt | 79564_1999 | 1999 | 79564 | Item 1. Business
Porta Systems Corp. develops, designs, manufactures and markets a broad range of standard and proprietary telecommunications equipment and integrated software applications for sale domestically and internationally. Porta's core products, focused on ensuring communications for service providers worldwide, fall into three categories:
Computer-based operation support systems. Our operation support systems, which we call our OSS systems, focus on the access loop and are components of telephone companies' service assurance and service delivery initiatives. The systems primarily focus on trouble management, line testing, network provisioning, inventory and assignment, and automatic activation, and most currently single ended line qualification for the delivery of xDSL high bandwidth services. We market these systems principally to foreign telephone operating companies in established and developing countries primarily in Asia, South and Central America and Europe.
Telecommunications connection and protection equipment. These systems are used to connect copper-wired telecommunications networks and to protect telecommunications equipment from voltage surges. We market our copper connection equipment and systems to telephone operating companies and customer premise systems providers in the United States and foreign countries.
Signal processing equipment. These products, which we sell principally for use in defense and aerospace applications, support copper wire-based communications systems.
Porta Systems Corp. is a Delaware corporation incorporated in 1972 as the successor to a New York corporation incorporated in 1969. Our principal offices are located at 575 Underhill Boulevard, Syosset, New York 11791; telephone number, 516-364-9300. References to Porta include its subsidiaries, unless the context indicates otherwise.
Forward-Looking Statements
The statements in this Form 10-K Annual Report that are not descriptions of historical facts may be forward looking statements that are subject to risks and uncertainties. In particular, statements in this Form 10-K Annual Report, including any material incorporated by reference in this Form 10-K, that state our intentions, beliefs, expectations, strategies, predictions or any other statements relating to our future activities or other future events or conditions are forward-looking statements. Forward-looking statements are subject to risks, uncertainties and other factors, including, but not limited to, those identified under Risk Factors, and those described in Management's Discussion and Analysis of Financial Condition and Results of Operations and in any other filings we make with the Securities and Exchange Commission, as well as general economic conditions, any one or more of which could cause actual results to differ materially from those stated in such statements.
Risk Factors
We recently incurred net losses from our operations, and our losses may continue. We incurred a net loss of $13,686,000, or $1.44 per share (basic and diluted), on sales of $38,936,000 for 1999. The loss resulted from a decline in sales of $20,407,000, or 34%, from 1998 combined with a reduced gross margin and an increase in selling, general and administrative expenses. We cannot give assurance that we will be able to operate profitably in the future.
We have a need to finance our working capital requirements. Our working capital at December 31, 1999 was $6,135,000, compared to $14,262,000 at December 31, 1998. However, as of December 31, 1999, our long-term debt includes $17,518,000 ($19,668,000 at April 10, 2000) due to our senior lender, all of which is due and payable on July 3, 2001, at which time our agreement with the senior lender will terminate. At December 31, 1999, we did not have sufficient resources to pay the senior lender at maturity and we do not expect to generate the necessary cash from our operations to enable us to make that payment. In addition, $6,000,000 of subordinated notes were outstanding as of December 31, 1999 that mature on January 3, 2001. We can extend these Notes to July 3, 2001. As of April 10, 2000 $5,100,000 of these notes can be extended by Porta to July 3, 2001. The remaining $900,000 can be extended under certain conditions. We cannot give any assurance that we will be able to either pay our obligations to our senior or subordinated lenders at their respective maturity dates or renew our agreement with our senior lender or enter into an agreement with a new lender. At December 31, 1999, we were in default on a covenant on our agreement with our senior lender. Such default was waived; however, we cannot assure you that any future defaults will be waived, in which event the principal and interest on our obligations to our senior lender may become immediately due and payable. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
We are heavily dependent on foreign sales. Approximately 62% of our sales in 1999, 60% of our sales in 1998 and 69% of our sales for 1997, were made to foreign telephone operating companies. In selling to customers in foreign countries, we are exposed to inherent risks not normally present in the case of our sales to United States customers, including extended delays in completing and customer final payment for our Operational Support Systems contracts, and political and economic change. In foreign markets, we face considerable competition from other United States and foreign telephone equipment manufacturers most of which are larger and have substantially greater financial resources than us. In addition, if we establish facilities in foreign countries, we face risks associated with currency devaluation, difficulties in either converting local currency into dollars or transferring funds to the United States, local tax and currency regulations and political instability.
We rely heavily on British Telecommunications for most of our sales. Our largest customer in both 1999 and 1998 was British Telecommunications. Sales to British Telecommunications for 1999 were $7,825,000, or approximately 20% of sales, and sales in 1998 were$15,349,000, or 26% of sales. Therefore, any significant interruption or decline in sales to British Telecommunications may have a materially adverse effect upon our operations. Under our agreement with British Telecommunications, we give British Telecommunications the right to use our technology or have products using our technology manufactured for it by others.
We experience difficulties with Operations Support Systems contracts. We experience delays in purchaser acceptance of the Operations Support Systems and our receipt of final contract payments in connection with a number of foreign sales. In addition, we have no steady or predictable flow of orders for Operations Support Systems and the negotiation of a contract for an operations support system is an individualized and highly technical process. These contracts typically contain performance guarantees by us and clauses imposing penalties on us if we do not meet the contractual in-service dates. The installation, testing and purchaser acceptance phases of these contracts may last longer than contemplated by the contracts and, accordingly, amounts due under the contracts may not be collected for extended periods.
Because of our small size and our financial problems, we may have difficulty competing for business. We compete directly with a number of large and small telephone equipment manufacturers in the United States, with Lucent Technologies, Inc. continuing to be our principal United States competitor. Lucent's greater resources, extensive research and development facilities, long-standing equipment supply relationships with the regional Bell operating companies and history of manufacturing and marketing products similar in function to those produced by us continue to be significant factors in our competitive environment. Other domestic and foreign companies also have significantly greater resources than we do. Furthermore, in the past, competitors have used our financial difficulties as a sales tool and our loss for 1999, combined with our reduced working capital and the scheduled expiration of our agreement with our senior lender in 2001 may place us in a competitive disadvantage.
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We require access to current technological developments. We rely primarily on the performance and design characteristics of our products and we try to offer our products at prices and with warranties that will make our products competitive. Our business could be adversely affected if we cannot obtain licenses for such updated technology or self develop state-of-the-art technology.
We rely on certain key employees. We may be dependent upon the continued employment of certain key employees, including our senior executive officers. Our failure to retain such employees may have a material adverse effect upon our business.
We do not pay dividends on common stock. We have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future. We presently intend to retain future earnings, if any, in order to provide funds for use in the operation and expansion of our business and, accordingly, do not anticipate paying cash dividends on our common stock in the foreseeable future. In addition, our agreement with our senior secured lender prohibits payment of dividends.
Products
Operations Support Systems. We sell our OSS systems primarily to telephone operating companies in established and developing countries in Asia, South and Central America and Europe, and to a lesser extent, in the United States. Porta's principal OSS systems are computer-based testing, provisioning, activation and trouble management products which include software and capital equipment and typically sell for prices ranging from several hundred thousand to several million dollars.
The testing products are designed to automatically test for and diagnose problems in customer telephone lines and to notify telephone company service personnel of required maintenance. The associated trouble management system provides automated record keeping (including repair and disposition records) and analyzes these records to enable the telephone company to identify recurring problems and equipment deterioration and to fulfill maintenance service level agreement obligations. The integration of these systems provides a service assurance function for telephone companies.
A major component of the testing system is the "test head," which provides the access to, and tests the required telephone line. We have continually developed our test head capability to meet the changing requirements of the customer loop, and have recently introduced our latest advanced technology platform (sixth generation) product, the MKIII. An enhanced version of the MKIII, the Sherlock, will provide the capability to determine whether customer lines are xDSL capable, enabling telephone companies to expeditiously characterize their outside plant, and optimize their responsiveness to market conditions.
Porta's other software applications, including the automated assignment of facilities and activation of service, form part of a telephone company's service activation function, and can be integrated with the testing and trouble management systems, to provide a comprehensive access loop capability including flow-thru. In addition, if requested by customers, Porta develops software to meet specific customer requirements, including integration of its systems with telephone company legacy or third party OSS systems.
Porta has entered into a number of agreements with suppliers of complementary market ready products and plans to offer those products through its distribution channels to its customer base. Those products enhance the customers Service Delivery and Service Assurance initiatives and address specific operations areas such as Facility and Records Verification and purification, Work Force scheduling and task mapping, and Call Fraud Detection.
3 of 25
Porta's OSS products are complex and, in most applications, incorporate features designed to respond to the purchaser's operational requirements and the particular characteristics of the purchaser's telephone system and operation processes. As a result, the negotiation of a contract for an OSS system is an individualized and highly technical process. In addition, contracts for OSS systems frequently provide for manufacturing, delivery, installation, testing and purchaser acceptance phases, which take place over periods ranging from several months to a year or more. Such contracts typically contain performance guarantees by Porta and clauses imposing penalties on us if "in-service" dates are not met. The installation, testing and purchaser acceptance phases of these contracts may last longer than contemplated by the contracts and, accordingly, amounts due under the contracts may not be collected for extended periods. Delays in purchaser acceptance of the systems and in Porta's receipt of final contract payments have occurred in connection with a number of foreign sales. In addition, Porta has not experienced a steady or predictable flow of orders for OSS systems.
Telecommunications Connection Equipment. Porta's copper connection/protection equipment and systems are used by telephone operating companies, by owners of private telecommunications equipment and by manufacturers and suppliers of telephone central office and customer premises equipment. Products of the types comprising Porta's telecommunications connection equipment are included as integral parts of all domestic and foreign telephone and telecommunications systems. Such products are sold in a worldwide market, which generally grows in proportion to increases in the number of telephone subscribers and owners of private telecommunications equipment, as well as to increases in upgrades to modern digital switching technology such as DSL, ADSL, and ISDN lines.
Porta's connection equipment consists of connector blocks and protection modules used by telephone companies to interconnect copper-based subscriber lines to switching equipment lines. The protector modules protect central office personnel and equipment from electrical surges. The need for protection products has increased as a result of the worldwide move to digital technology, which is extremely sensitive to damage by electrical overloads, and because private owners of telecommunications equipment now have the responsibility to protect their equipment from damage caused by electrical surges. Line connecting/protecting equipment usually incorporates protector modules to safeguard equipment and personnel from injury due to power surges. Currently, these products include a variety of connector blocks, protector modules and frames used in telephone central switching offices, PBX installations, multiple user facilities and customer premise applications.
Porta also has developed an assortment of frames for use in conjunction with our traditional line of connecting/protecting products. Frames for the interconnection of copper circuits are specially designed structures which, when equipped with connector blocks and protectors, interconnect and protect telephone lines and distribute them in an orderly fashion allowing access for repairs and changes in line connections. One of our frame products, the CAM frame, is designed to produce computer-assisted analysis for the optimum placement of connections for telephone lines and connector blocks mounted on the frame.
Porta's copper connection/protection products are used by many of the Regional Bell Operating Companies (RBOC's) as well as by independent telephone operating companies (CLEC's) in the United States and owners of private telecommunications equipment. These products are also purchased by other companies for inclusion within their systems. In addition, our telecommunications connection products have been sold to telephone operating companies in various foreign countries. This equipment is compatible with existing telephone systems both within and outside the United States and can generally be used without modification, although we do custom design modifications to accommodate the specific needs of our customers.
Signal Processing Products. Porta's signal processing products include data bus systems and wideband transformers. Data bus systems, which are the communication standard for military and aerospace systems, require an extremely high level of reliability and performance. Wideband transformers are required for ground noise elimination in video imaging systems and are used in the television and broadcast, medical imaging and industrial process control industries.
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The table below shows, for the last three fiscal years, the contribution made to Porta's sales by each of its major categories of the telecommunications industry:
Sales by Product Category Years Ended December 31,
1999 1998 1997 ---- ---- ---- (Dollars in thousands)
OSS Systems $14,254 37% $27,318 46% $29,561 48%
Line Connecting /Protecting Equipment 18,189 47% 24,291 41% 23,753 38% Signal Processing 6,328 16% 7,539 13% 8,280 13%
Other 165 0% 195 0% 636 1% ------- ---- ------- ---- ------- ---- Total $38,936 100% $59,343 100% $62,230 100% ======= ==== ======= ==== ======= ====
Markets
Porta supplies equipment and systems to telephone companies used to provide improved services to ensure communication to their customers. In addition, we provide businesses with systems, which improve their internal telecommunication systems.
Telephone networks in certain regions of the world, notably Latin America, Eastern Europe and certain areas in the Asia/Pacific region, were designed to carry voice traffic and are not well suited for high-speed data transmissions or for other forms of telecommunications that operate more effectively with digital telecommunications equipment and lines. The telephone networks in these countries are also characterized by a very low ratio of telephone lines to population. Countries with emerging telecommunication networks have to rapidly add access lines in order to increase the availability of telephone service and to significantly upgrade the quality of the lines already in service.
Porta's OSS systems are designed to meet many of the needs of a rapidly changing telephone network. OSS systems facilitate rapid change and expansion without a comparable increase in the requirement for skilled technicians, while the computerized line test system insures increased quality and rapid maintenance and repair of subscriber local loops. The automated database, which computerizes the inventory and maintenance history of all subscriber lines in service, helps to keep the rapid change under control.
During 1999, approximately 37% of Porta's sales consisted of OSS products.
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As a telephone company expands the number of its subscriber lines, it also requires additional connection equipment to interconnect and protect those lines in its central offices. We provide a line of copper connection equipment for this purpose. Recent trends towards the transmission of high frequency signals on copper lines are sustaining this market. Less developed countries, such as those with emerging telecommunications networks or those upgrading to digital switching systems, provide a growing market for copper connection and protection equipment.
The increased sensitivity of the newer digital switches to small amounts of voltage requires the telephone company which is upgrading its systems to digital switching systems to also upgrade its central office connection/protection systems in order to meet these more stringent protection requirements. We supply central office connection/protection systems to meet these needs.
During 1999, approximately 47% of Porta's sales were made to customers in this category.
Porta's line of signal processing products is supplied to customers in the military and aerospace industry as well as manufacturers of medical equipment and video systems. The primary communication standard in new military and aerospace systems is the MIL-STD-1553 Command Response Data Bus, an application which requires an extremely high level of reliability and performance. Products are designed to be application specific to satisfy the requirements of each military or aerospace program.
Porta's wideband transformers are required for ground noise elimination in video imaging systems and are used in the television and broadcast, medical imaging and industrial process control industries. If not eliminated, ground noise caused by poor electrical system wiring or power supplies, results in significant deterioration in system performance, including poor picture quality and process failures in instrumentation. The wideband transformers provide a cost effective and quick solution to the problem without the need of redesign of the rest of the system.
During 1999, signal processing equipment accounted for approximately 16% of Porta's sales.
Marketing and Sales
Porta operates through three business units, which are organized by product line, and with each having responsibility for the sales and marketing of its products.
When appropriate to obtain sales in foreign countries, we may enter into arrangements and technology transfer agreements covering our products with local manufacturers and participate in manufacturing and licensing arrangements with local telephone equipment suppliers.
In the United States and throughout the world, we use independent distributors in the marketing of all copper based products to the RBOC's and the customer premises equipment market. All distributors marketing copper-based products also market directly competing products. In addition, Porta continues to promote the direct marketing relationships it developed in the past with telephone operating companies.
We have an agreement with British Telecommunications plc ("BT") covering Porta's line connecting/protecting products. This agreement which will expire on August 31, 2001, provides, among other things, that Porta is a non-exclusive supplier to BT for these products. BT purchased line connecting/protecting products amounting to $6,566,000 (17% of sales) in 1999, $11,345,000 (19% of sales) in 1998, and $9,397,000 (15% of sales) in 1997. During these years, we also sold our products to unaffiliated suppliers to BT for resale to BT. Our agreement with BT provides for a cross license which, in effect, enables BT to use certain of our proprietary information to modify or enhance products provided to BT and permits BT to manufacture or engage others to manufacture those products.
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Porta's OSS systems historically have been sold to foreign telephone operating companies which are government controlled. Recently, Porta has entered into sales, marketing and management co-operative agreements and strategic alliances with various companies.
Subsequent to December 31, 1999, Porta entered into a multi-year sales, marketing, and management co-operative agreement with Fujitsu Telecommunications Europe LTD to market Internet infrastructure products. Under the agreement, Fujitsu will sell and market Porta's advanced Internet infrastructure technologies, including ADSL Single Ended Line Qualification System (SELQ) for broadband services and the sixth generation Sherlock remote test unit to telecom service operators in the United Kingdom and the remainder of Europe. Porta anticipates this significant relationship may result in up to $50,000,000 in sales over the next four years.
Porta's signal processing products are sold primarily to US military and aerospace prime contractors, and domestic original equipment manufacturers and end users.
The following table sets forth for the last three fiscal years the Company's sales to customers by geographic region:
Sales to Customers By Geographic Region (1)
Year Ended December 31, 1999 1998 1997 ---- ---- ---- (Dollars in thousands)
North America $14,664 38% $20,830 35% $19,269 31%
United Kingdom 15,673 40% 20,441 34% 18,640 30%
Asia/Pacific 4,159 11% 7,181 12% 10,278 17%
Other Europe 3,130 8% 3,377 6% 10,587 17%
Latin America 1,257 3% 7,463 13% 2,429 4%
Middle East 47 0% 51 0% 879 1%
Other 6 0% -- 0% 148 0% ------- ---- ------- ---- ------- ---- Total Sales $38,936 100% $59,343 100% $62,230 100% ======= ==== ======= ==== ======= ====
(1) For information regarding the amount of sales, operating profit or loss and identifiable assets attributable to each of Porta's divisions and geographic areas, see Note 22 of Notes to the Consolidated Financial Statements.
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In selling to customers in foreign countries, there are inherent risks not normally present in the case of sales to United States customers, including increased difficulty in identifying and designing systems compatible with purchasers' operational requirements; extended delays under OSS systems contracts in the completion of testing and purchaser acceptance phases and difficulty in Porta's receipt of final payments and political and economic change. In addition, to the extent that Porta establishes facilities in foreign countries, the Company faces risks associated with currency devaluation, inability to convert local currency into dollars, local tax regulations and political instability.
Manufacturing
Porta's computer-based testing products include proprietary testing circuitry and computer programs, which provide platform-independent solutions based on UNIX or UNIX compatible operating systems. The testing products also incorporate disk data storage, teleprinters, minicomputers and personal computers (PC's) purchased by us. These products are installed and tested by us at our customers' premises.
At present, Porta's manufacturing operations are conducted at facilities located in Glen Cove, New York and Matamoros, Mexico. From time to time we also use subcontractors to augment various aspects of our production activities and periodically explore the feasibility of conducting operations at lower cost manufacturing facilities located abroad. In selling to foreign telephone companies, we may be required to provide local manufacturing facilities and, in conjunction with these facilities, we may grant the facility a license to our proprietary technology.
Porta develops software at its facilities in Syosset, New York, Charlotte, North Carolina, and Coventry, United Kingdom.
Source and Availability of Components
Porta generally purchases the standard components used in the manufacture of its products from a number of suppliers. Porta attempts to assure itself that the components are available from more than one source. Porta purchases all of its MKIII test units from two suppliers. Porta purchases the majority of its minicomputers used in its OSS systems from Digital Equipment Corporation ("DEC"). However, we could use other computer equipment in our systems if we were unable to purchase DEC products. Other components, such as PCs and teleprinters, used in connecting with our electronic products could be obtained from alternate sources and readily integrated with our products.
Significant Customers
During 1999, Porta's five largest customers accounted for sales of $19,700,000, or approximately 51% of sales, and during 1998 its five largest customers accounted for sales of $28,797,000, or approximately 49% of sales. Porta's largest customer in both 1999 and 1998 was BT. Sales to BT for 1999 were $7,825,000 or approximately 20% of sales, and sales in 1998 were $15,349,000, or 26% of sales. Therefore, any significant interruption or decline in sales to BT may have a materially adverse effect upon our operations. During 1998, sales to a Chilean telephone company were $6,834,000, or approximately 12% of sales. No other customers account for 10% or more of our sales for either year.
The former Bell operating companies continue to be the ultimate purchasers of a significant portion of our products sold in the United States, while sales to foreign telephone operating companies constitute the major portion of Porta's foreign sales. Porta's contracts with these customers require no minimum purchases by such customers. Significant customers for the signal processing products include major US aerospace companies, the Department of Defense and original equipment manufacturers in the medical imaging and process control equipment industries. We sell both catalog and custom designed products to these customers. Some contracts are multi-year procurements.
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Backlog
At December 31, 1999, Porta's backlog was $23,800,000 compared with approximately $8,800,000 at December 31, 1998. Of the December 31, 1999 backlog, approximately $19,800,000 represented orders from foreign telephone operating companies. We expect to ship substantially all of our December 31, 1999 backlog during 2000.
Intellectual Property Rights
Porta owns a number of domestic utility and design patents and has pending patent applications for these products. In addition, Porta has foreign patent protection for a number of its products.
From time to time Porta enters into licensing and technical information agreements under which it receives or grants rights to produce certain specified subcomponents used in Porta's products. These agreements are for varying terms and provide for the payment or receipt of royalties or technical license fees.
While we consider patent protection important to the development of our business, we believe that our success depends primarily upon our engineering, manufacturing and marketing skills. Accordingly, we do not believe that a denial of any of our pending patent applications, expiration of any of our patents, a determination that any of the patents which have been granted to us are invalid or the cancellation of any of our existing license agreements would have a material adverse effect on our business.
Competition
The telephone equipment market in which Porta does business is characterized by intense competition, rapid technological change and a movement to private ownership of telecommunications equipment. In competing for telephone operating company business, the purchase price of equipment and associated operating expenses have become significant factors, along with product design and long-standing equipment supply relationships. In the customer premises equipment market, Porta is functioning in a market characterized by distributors and installers of equipment and by commodity pricing.
We compete directly with a number of large and small telephone equipment manufacturers in the United States, with Lucent Technologies continuing to be our principal United States competitor. Lucent's greater resources, extensive research and development facilities, long-standing equipment supply relationships with the operating companies of the regional holding companies and history of manufacturing and marketing products similar in function to those produced by us continue to be significant factors in our competitive environment.
Currently, Lucent and a number of companies with greater financial resources than us produce, or have the design and manufacturing capabilities to produce, products competitive with our products. In meeting this competition, we rely primarily on the engineered performance and design characteristics of our products to comparable performance or design, and endeavors to offer our products at prices and with warranties that will make our products compete world wide.
In connection with overseas sales of its line connecting/protecting equipment, Porta has met with significant competition from United States and foreign manufacturers of comparable equipment and expects this competition to continue. In addition to Lucent, a number of Porta's overseas competitors have significantly greater resources than we do.
We compete directly with a limited number of substantial domestic and international companies with respect to our sales of OSS systems. In meeting this competition, we rely primarily on the features of our line testing equipment, our ability to customize systems and endeavor to offer such equipment at prices and with warranties that make them competitive.
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Research and Development Activities
Porta spent approximately $6,100,000 in 1999, $6,500,000 in 1998, and $5,400,000 in 1997 on its research and development activities. All research and development was company sponsored and is expensed as incurred.
Employees
As of February 18, 2000, Porta had 477 employees of which 112 were employed in the United States, 272 in Mexico, 45 in the United Kingdom, 5 in Poland, 8 in Chile, 6 in China, and 29 in Korea (in connection with Porta's Korean joint venture). Porta believes that its relations with its employees are good, and it has never experienced a work stoppage. Porta's employees are not covered by collective bargaining agreements, except for its hourly employees in Mexico who are covered by a collective bargaining agreement that expires on December 31, 2001.
Item 2.
Item 2. Properties
Porta currently leases approximately 20,400 square feet of executive, sales, marketing and research and development space located in Syosset, New York; and 7,000 square feet of office space used for software development located in Charlotte, North Carolina. We also own a 31,000 square foot manufacturing and research and development facility located in Glen Cove, New York. These facilities represent substantially all of our office, plant and warehouse space in the United States. The Syosset, New York lease expires December 2000, and the Charlotte, North Carolina lease expires in November 2004. The aggregate annual rental is approximately $554,000.
Our wholly-owned United Kingdom subsidiary entered into a sale lease-back agreement in 1999 whereby we sold our 34,300 square foot facility in Coventry, England, which facility comprises all of our office, plant and warehouse space for approximately $400,000 and entered into a 20 year lease arrangement. The purchaser of the property committed substantial resources to renovate the facility. The aggregate annual rental is approximately $250,000.
Porta's wholly-owned Mexican subsidiary owns an approximately 40,000 square foot manufacturing facility in Matamoros, Mexico.
We believe our properties are adequate for our needs.
Item 3.
Item 3. Legal Proceedings
In July 1996, an action was commenced against Porta and certain present and former directors in the Supreme Court of the State of New York, New York County by certain stockholders and warrant holders of Porta who acquired their securities in connection with the acquisition by Porta of Aster Corporation. The complaint alleges breach of contract against Porta and breach of fiduciary duty against the directors arising out of an alleged failure to register certain restricted shares and warrants owned by the plaintiffs. The complaint seeks damages of $413,000; however, counsel for the plaintiff has advised Porta that additional plaintiffs may be added and, as a result, the amount of damages claimed may be substantially greater than the amount presently claimed. Porta believes that the defendants have valid defenses to the claims. The action is currently in the discovery stage.
In December 1999, Porta was served with a request for arbitration for commissions allegedly owed to a former sales representative. Porta terminated its sales representative agreement in July 1999. The request for arbitration alleges that Porta's termination of the agreement was improper and that the representative is entitled to be paid damages based on the commissions he allegedly would have received for an indefinite term beginning August 1999. Additionally, the request for arbitration alleges that the representative was not paid for certain unspecified commissions that he was supposedly entitled to receive during the period from February 1, 1986 through July 31, 1999. The request for arbitration does not specify the precise amount of damages, but estimates damages approximating $500,000. The arbitration is in its earliest stages and Porta intends to defend it vigorously.
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Item 4.
Item 4. Submission of Matters to a Vote of Securities Holders
During the fourth quarter of 1999, there were no matters required to be submitted to a vote of security holders of the Company.
Item Pursuant to Instruction 3 of Item 401 (b) of Regulation S-K: Executive Officers of the Company
Name and Position Age - ----------------- --- William V. Carney 62 Chairman of the Board Chief Executive Officer
Michael A. Tancredi 70 Senior Vice President, and Secretary and Treasurer
Edward B. Kornfeld 56 Senior Vice President - Operations Chief Financial Officer
Ronald Wilkins 43 Senior Vice President and Managing Director - OSS
John J. Gazzo 56 Senior Vice President
Michael Bahlo 41 Senior Vice President
Prem G. Chandran 47 Senior Vice President
David Rawlings 56 Senior Vice President
All of Porta's officers serve at the pleasure of the board of directors. Messrs. Carney and Tancredi are also members of the board of directors. There is no family relationship between any of the executive officers listed above.
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Mr. Carney was elected as Chairman of the Board of Directors and Chief Executive Officer in 1996 and has served as a director since 1970. Previously, Mr. Carney had served as Secretary since 1970, Senior Vice President since November 1989 and Chief Technical Officer from December 1990. He was elected Vice Chairman in January 1988. He was Senior Vice President-Mechanical Engineering from January 1988 to November 1989 and was Senior Vice President-Manufacturing from March 1984 to February 1985, Senior Vice President-Operations from June 1977 to February 1984 and Vice President from 1970 to June 1977.
Mr. Tancredi was elected Senior Vice President and Secretary in 1996. He has been Treasurer since April 1978 and Director since 1970. He had served as Vice President between March 1984 to October of 1996. He was Vice President from April 1978 to February 1984 and Comptroller from April 1971 to March 1978.
Mr. Kornfeld was elected a Senior Vice President-Operations in 1996. He has served as Vice President-Finance and Chief Financial Officer of the Company since October 1995. For more than five years prior to his election to this position, Mr. Kornfeld held positions with several technology companies, including Excel Technology Inc. (Quantronix Corp.) and Anorad Corporation.
Mr. Wilkins was elected a Senior Vice President and Managing Director, OSS Division in 1998. Prior to joining Porta Systems Corp. in 1998, Mr. Wilkins was involved in the wireless telecommunication industry as President and CEO of Sycom Technologies from November 1997 to August 1998, and Vice President of Strategic Planning and Alliances at Conxus Communications from December 1995 to October 1997. Prior to October 1997, Mr. Wilkins held various management positions with Digital Equipment Corporation.
Mr. Gazzo was elected Senior Vice President in March 1996. He was Vice President-Marketing since April 1993, general manager of our Porta Electronics Division from November 1989 to April 1993, Vice President-Research and Development from March 1984 to November 1989 and Vice President-Engineering from February 1978 to February 1984.
Mr. Bahlo was elected Senior Vice President - OSS Sales and Marketing in January 1999. Prior to joining the Company, Mr. Bahlo was the Vice President, Marketing and Sales for Daikin U.S. Comtec Laboratories from March 1997 to March 1999, and held various management and marketing positions with Digital Equipment Corporation from October 1986 to March 1997 most recently as Marketing Group Manager.
Mr. Chandran was elected Senior Vice President in May 1999. Prior to his appointment as Senior Vice President, Mr. Chandran was Vice President since December 1995 and Assistant Vice President of Engineering from 1991 until December 1995.
Mr. Rawlings was elected Senior Vice President in May 1999. Prior to his appointment as Senior Vice President, Mr. Rawlings was Vice President since March 1996 and Assistant Vice President of Research and Development - Copper products since from 1992 until March 1996.
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Part II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Porta's common stock is traded on the American Stock Exchange, Inc. under the symbol PSI. The following table sets forth, for 1998 and 1999, the quarterly high and low sales prices for Porta's common stock on the consolidated transaction reporting systems for American Stock Exchange listed issues.
High Low ---- --- 1998 First Quarter $4 $2 7/8 Second Quarter 5 3/8 3 1/2 Third Quarter 4 15/16 1 5/8 Fourth Quarter 2 1/4 1 1/4
First Quarter $2 1/2 $1 3/4 Second Quarter 2 3/16 1 1/2 Third Quarter 1 7/8 5/8 Fourth Quarter 1 1/4 5/8
Porta did not declare or pay any cash dividends in 1999 or 1998. It is the present policy of Porta to retain earnings, if any, to finance the growth and development of the business and therefore, Porta does not anticipate paying cash dividends on its common stock in the foreseeable future. In addition, Porta's agreement with its senior lender prohibits it from paying cash dividends on its common stock.
As of March 13, 2000, Porta had approximately 1,005 stockholders of record.
Item 6.
Item 6. Selected Financial Data
The following table sets forth certain selected consolidated financial information of Porta. All share and per share data have been restated to give effect to the one for five reverse stock split which became effective on August 2, 1996. For further information, see the Consolidated Financial Statements and other information set forth in Item 8 and Management's Discussion and Analysis of Financial Condition and Results of Operations set forth in Item 7:
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Porta's consolidated statements of operations for the three years ended December 31, 1999, 1998 and 1997, respectively, as a percentage of sales follows:
Years Ended December 31, ----------------------------- 1999 1998 1997 ---- ---- ---- Sales 100% 100% 100% Cost of sales 74% 59% 61% ---- ---- ---- Gross Profit 26% 41% 39% Selling, general and administrative expenses 35% 22% 20% Research and development expenses 16% 11% 9% ---- ---- ---- Operating income (loss) (25%) 8% 10% Interest expense (9%) (6%) (5%) Other 1% 2% 2% Debt conversion expense -- (2%) (19%) ---- ---- ---- Income (loss) from continuing operations before income
taxes and minority interest (33%) 2% (12%) Income tax expense (benefit) and minority interest 2% 1% (1%) ---- ---- ----
Net income (loss) (35%) 1% (11%) ==== ==== ====
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Results of Operations
Years Ended December 31, 1999 and 1998
Porta's sales for 1999 were $38,936,000 compared to $59,343,000 in 1998, a decrease of $20,407,000 (34%). The decrease in revenue is attributed principally to shortfalls from our OSS division, although all divisions sustained decreased revenues in 1999 as compared to 1998.
OSS sales for 1999 were $14,254,000, compared to 1998 sales of $27,318,000, a decrease of $13,064,000 (47%). Sales of OSS systems are not made on a recurring basis to customers, but are the result of extended negotiations that frequently cover many months and do not always result in a contract. In addition, OSS contracts may include conditions precedent, such as obtaining financing or bank approval, and the contracts are not effective until the conditions are satisfied. During 1999, OSS sales resulted primarily from the completion of OSS contracts, which were in effect at the beginning of the year, and our major new OSS contracts were signed during the fourth quarter of 1999. The new contracts, which total $17,000,000 are with the Philippines Long Distance Telephone Co. for approximately $5,000,000, and Fujitsu Telecommunications Europe LTD for approximately $12,000,000. We expect to begin to recognize revenue from these new OSS contracts in 2000.
Line connection/protection equipment sales for 1999 decreased approximately $6,102,000 (25%) from $24,291,000 in 1998 to $18,189,000 in 1999. The decline reflected a reduction in volume of sales to United States and Mexican customers, which were not offset by an increase in sales to new customers.
Signal processing revenue for 1999 compared to 1998 decreased by $1,211,000 (16%) from $7,539,000 to $6,328,000. The decrease in sales primarily reflects customer requested delays in deliveries in 1999 of orders which are expected to be shipped during 2000.
Cost of sales for the year ended December 31, 1999, as a percentage of sales compared to 1998, increased from 59% to 74%. The increase in cost of sales and the resulting decline in gross margin is primarily attributed to inefficiency resulting from the inability to absorb fixed expenses associated with the OSS contracts over a substantially lower revenue base.
Selling, general and administrative expenses increased by $524,000 (4%) from $13,079,000 in 1998 to $13,603,000 in 1999. The increase relates primarily to additional accounts receivable reserve requirements on OSS contracts in the Far East of approximately $1,000,000, offset by reductions in various operating expenses.
Research and development expenses decreased by $420,000 (6%) from $6,510,000 in 1998 to $6,090,000 in 1999. The decreased expense in 1999 resulted from the completion of certain efforts to develop new products primarily related to the OSS business including the MKIII test head during 1999.
As a result of the above, we had an operating loss of $9,709,000 in 1999 versus operating income of $4,566,000 in 1998. Although we sustained a decline in sales in all of our product lines, our decreased operating income for 1999, when compared to 1998, was primarily the result of lower levels of revenue from OSS combined with the reduced margin on OSS business and the accounts receivable reserve on OSS contracts.
Interest expense for 1999 decreased by $179,000 from $3,750,000 for 1998 to $3,571,000 in 1999. The decrease in interest expense is attributable primarily to the completion of non-cash interest expenses associated with the issuance of warrants to Porta's senior lender. This decrease was substantially offset by additional interest on the increased outstanding principal balance and waiver fee for non-compliance of the interest coverage covenant to the senior lender.
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Results of Operations (continued)
Other income for 1998 included approximately $240,000 from the final settlement of an insolvency procedure involving the purchaser of Porta's Israeli operations, which was sold in 1992, and $400,000 from the settlement of a lawsuit against a former vendor.
During 1998, Porta recorded debt conversion expenses of $945,000 as a result of the exchange of zero coupon notes into common stock. The debt conversion expense represents the difference between the original conversion price per share of $6.55 and the reduced conversion price per share of $3.65.
During 1998, Porta recorded an extraordinary gain from the early extinguishment of its Debentures of $76,000.
For 1999, Porta recorded an income tax expense of $873,000, which includes an $811,000 increase in deferred tax asset valuation allowance and tax expenses of $62,000. For 1998, income tax expenses of $606,000 primarily represents income taxes payable by Porta's UK and Chilean subsidiaries.
As the result of the foregoing, the 1999 net loss was $13,686,000, $1.44 per share basic and diluted, compared with net income of $527,000, $0.06 per share basic and $0.05 per share diluted, for 1998.
Based on our current backlog and recent forecasts, we expect to return to profitability in 2000.
Years Ended December 31, 1998 and 1997
Sales for 1998 were $59,343,000 compared to $62,230,000 in 1997, a decrease of $2,887,000 (5%). The decrease in revenue is attributed principally to shortfalls from our OSS division.
OSS sales for 1998 were $27,318,000, compared to 1997 sales of $29,561,000, a decrease of $2,243,000 (8%). The decreased sales relate primarily to delays in the installation of certain contracts and delays in the receipt of new anticipated orders.
Line connection/protection equipment sales for 1998 increased approximately $538,000 (2%) from $23,753,000 in 1997 to $24,291,000 1998. This increase relates to improved sales to a customer in Mexico, which were offset by decreased sales of a certain product line to BT. During 1997, Porta completed delivery of products to BT under a prior agreement and commenced delivery of a replacement product. The decline reflected both a decrease in the number of units sold and a lower selling price per unit for the replacement product.
Signal processing revenue for 1998 compared to 1997 decreased by $741,000 (9%) from $8,280,000 to $7,539,000. During 1997 revenue was generated from the earlier than anticipated completion of military orders and non-recurring revenue from certain engineering services, which was not repeated in 1998.
Cost of sales for 1998, as a percentage of sales, decreased from 61% in 1997 to 59% in 1998. The improvement in gross margin is attributed to Porta's continuing effort to increase manufacturing productivity and the decrease of certain fixed expenses associated with the OSS contracts.
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Results of Operations (continued)
Selling, general and administrative expenses increased by $261,000 (2%) from $12,818,000 to $13,079,000 from December 31, 1998 compared to 1997. The increase relates primarily to sales commissions on certain line connection/protection equipment sales for 1998.
Research and development expenses increased by $1,149,000 (21%) from $5,361,000 in 1997 to $6,510,000 in 1998. The increased expense results from Porta's efforts to develop new products primarily related to the OSS business including the MKIII test head.
As a result of the above, Porta had operating income of $4,566,000 in 1998 versus $6,101,000 in 1997, a decrease of 25%. The decreased operating income for 1998, when compared to 1997, was primarily the result of lower levels of revenue from OSS coupled with increased research and development expenses.
Interest expense for 1998 increased by $371,000 from $3,379,000 for 1997 to $3,750,000 in 1998. The increase in interest expense is attributable primarily to the issuance of $6,000,000 of 12% subordinated notes, which was slightly offset by repayments of principal to Porta's senior lender.
Other income for 1998 included approximately $240,000 from the final settlement of an insolvency procedure involving the purchaser of Porta's Israeli operations, which was sold in 1992, and $400,000 from the settlement of a lawsuit against a former vendor.
During 1998 and 1997, Porta recorded debt conversion expenses of $945,000 and $11,458,000 as a result of the exchange of zero coupon notes into common stock. The debt conversion expense represents the difference between the original conversion price per share of $6.55 and the reduced conversion price per share of $3.65.
Porta recorded an extraordinary gain from the early extinguishment of its debentures of $76,000 in 1998 and $122,000 in 1997.
At December 31, 1998, income tax expenses of $606,000 primarily represents income taxes payable by the Company's UK and Chilean subsidiaries. For 1997, Porta recorded an income tax benefit of $585,000, reflecting the difference between a $802,000 deferred tax asset and tax expenses of $217,000.
As the result of the foregoing, the 1998 net income was $527,000, $0.06 per basic share and $0.05 per diluted share, compared with a net loss of $6,899,000, $2.22 per share, for 1997.
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Liquidity and Capital Resources
At December 31, 1999 Porta had cash and cash equivalents of $3,245,000 compared with $3,044,000 at December 31, 1998. The working capital at December 31, 1999 was $6,135,000, compared to $14,262,000 at December 31, 1998. The decline in working capital from December 31, 1998 to December 31, 1999 reflects decreased accounts receivable which was a result of reduced levels of revenue for 1999. During 1999, we used $3,027,000 in our operations. Our principal source of funds during 1999 was borrowings from our senior lender.
Porta had senior debt outstanding of $17,518,000 as of December 31, 1999 of which $1,242,000 was a non-interest bearing note, $5,600,000 was outstanding against the revolving line of credit, and $10,676,000 was a term loan agreement. The Company's loan and security agreement with its senior secured lender expires January 2, 2001. The agreement requires a quarterly loan amortization of $400,000. In addition, the agreement requires all principal payments be applied first to the non-interest bearing notes payable until the notes are paid in full and then to the term loan. Porta had a revolving line of credit and a letter of credit facility of $9,000,000 as of December 31, 1999. Availability under this facility as of that date was approximately $1,600,000. During 1999, we borrowed $6,150,000 and repaid $1,820,000 to the senior secured lender, of which $220,000 was provided from the proceeds of the sale of our UK facility. Subsequent to December 31, 1999, we borrowed an additional $2,550,000 and repaid $400,000, resulting in a balance owed of approximately $19,668,000.
In April 2000, Porta and its senior lender agreed to extend the loan and security agreement to July 3, 2001. As consideration Porta agreed to re-price all outstanding warrants held by the senior lender to $2.00 per warrant.
Porta was not in compliance with the interest coverage covenant under the agreement and obtained a waiver from its senior lender for the period ended December 31, 1999. However, if losses continue during 2000 Porta may be in violation of its loan covenants at March 31, 2000 and the lender may not grant a waiver, which would result in all of Porta's obligations to the senior lender becoming due. Any action by the senior lender to force collection of the obligations owed could materially and adversely affect Porta's ability to continue in business.
As of December 31, 1999, Porta had remaining outstanding $371,000 of 6% Debentures, net of original issue discount of $14,000, which mature July 2, 2002. The face amount of the outstanding 6% Debentures was $385,000. The interest accrued on the 6% Debentures is payable on July 1 of each year and as of December 31, 1999 was $12,000. At December 31, 1999, Porta was current on its interest obligations.
During December 1999, Porta amended the terms of its outstanding $6,000,000 subordinated notes. The amended terms include a one-year extension to January 3, 2001. Furthermore, at Porta's option, Porta may extend the notes for an additional extension period of six months to July 3, 2001 if Porta achieves specific financial goals. As consideration for the amendment the interest rate of the subordinated notes was increased from 12% to 14% per annum during the initial term, and to 15% during the extended term, and the exercise price of the outstanding warrants issued in conjunction with the subordinated notes was reduced to $1.00. The amendment to the notes gives the holder the right to elect to receive interest on the subordinated notes in new subordinated notes of Porta in an amount equal to 125% of the interest then due on the subordinated notes on which Porta is to pay interest at 125% of the interest rate of the underlying subordinated note. If Porta extends the maturity date of the Subordinated Notes to July 3, 2001, it will issue to the noteholders New Warrants to purchase a total of 300,000 shares of Common Stock at the average closing price of the Common Stock for five trading days preceding January 3, 2001. As a result of the above, Porta recorded a debt discount of approximately $56,000 relating to the re-pricing of the warrants and additional interest expense for noteholders who elected the paid in kind option at December 31, 1999 of approximately $13,000. As of December 31, 1999, $6,013,000 of subordinated notes were outstanding which includes $64,000 of additional principal from paid in kind options and unamortized debt discount of $51,000.
In April 2000, Porta and the holders of $5,100,000 or 85% of its subordinated notes agreed to eliminate the requirement that Porta meet specific financial goals for Porta to extend the maturity date of their subordinated notes to July 3, 2001. In connection with this agreement, Porta agreed to issue to these noteholders New Warrants to purchase 127,500 shares of Common Stock at $3.00 per share. Porta may issue to any other noteholders who agree to this amendment New Warrants to purchase up to 22,500 shares of Common Stock at $3.00 per share. The remaining New Warrants to purchase 150,000 shares of Common Stock will be issued if the notes are extended.
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Porta believes that its current cash position, internally generated cash flow and its loan facility will be sufficient to satisfy our anticipated operating needs for at least the ensuing twelve months. At December 31, 1999, Porta's long-term debt includes $17,518,000 due to its senior lender, all of which are due and payable on July 3, 2001. At December 31, 1999, we do not have sufficient resources to pay the senior lender at maturity and it is likely that we cannot generate such cash from our operations. Although we are seeking to refinance or restructure this debt and believe we will be able to prior to the maturity date, no assurance can be given that we will be successful in these efforts. If we are unable to refinance or restructure our business may be materially and adversely affected.
Year 2000 Issue
Many existing computer programs use only two digits to identify a year in a date field. These programs were designed and developed without considering the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. This is referred to as the "Year 2000 Issue." Management initiated a company-wide program to prepare our computer systems and applications for year 2000 compliance. To date, we have not experienced any significant Year 2000 issues.
Porta incurred internal staff costs as well as other expenses necessary to prepare its systems for the year 2000. We replaced some systems and upgraded others. The total cost of this program was approximately $500,000, with approximately $200,000 representing internal costs and $300,000 representing external equipment and services.
Statements contained in this Year 2000 disclosure are subject to certain protection under the Year 2000 Information and Readiness Disclosure Act.
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Item 7A.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk.
Not Applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data.
See Exhibit I
Item 9.
Item 9. Changes In and Disagreements With Accountants On Accounting and Financial Disclosure.
Not Applicable
Part III
Item 10, 11, 12, and 13.
The information called for by Item 10
Item 11 (Executive Compensation), Item 12
Item 14. Exhibits, Financial Statements Schedules and Reports on Form 8-K.
(a) Document filed as part of this Annual Report on Form 10-K:
(i) Financial Statements.
See Index to Consolidated Financial Statements under Item 8 hereof.
(ii) Financial Statement Schedules.
None
Schedules not listed above have been omitted for the reasons that they were inapplicable or not required or the information is given elsewhere in the financial statements.
Separate financial statements of the registrant have been omitted since restricted net assets of the consolidated subsidiaries do not exceed 25% of consolidated net assets.
(b) Reports on Form 8-K
None.
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(c) Exhibits
Exhibit No. Description of Exhibit - ----------- ---------------------- 3.1 Certificate of Incorporation of the Company, as amended to date, incorporated by reference to Exhibit 4 (a) of the Company's Annual Report on Form 10-K for the year ended December 31, 1991.
3.2 Certificate of Designation of Series B Participating Convertible Preferred Stock, incorporated by reference to Exhibit 3.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995.
3.3 By-laws of the Company, as amended to date, incorporated by reference to Exhibit 3.3 of the Company's Annual Report on Form 10-K for the year ended December 31, 1995.
4.1 Amendment dated as of December 16, 1993 to the Warrant Agreement among the Company, Aster Corporation and Chemical Bank as successor to Manufacturers Hanover Trust Company as Warrant Agent, incorporated by reference to Exhibit 4.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1993.
4.2 Form of Rights Amendments, dated as of March 22, 1989 between the Company and Manufacturers Hanover Trust Company, as Rights Agent, incorporated by reference to the Company's Registration Statement on Form 8-A dated April 3, 1989.
4.3 Amendment No. 1 to Rights Agreement, dated July 28, 1993 between the Company and The Chase Manhattan Bank (formerly known as Chemical Bank, as successor by merger to Manufacturers Hanover Trust Company) as Rights Agent, incorporated by reference to the Company's Registration Statement on Form 8-A/A filed August 4, 1993.
4.4 Amendment No. 2 to Rights Agreement, dated December 24, 1997 between the Company and The Chase Manhattan Bank (formerly known as Chemical Bank, as successor by merger to Manufacturers Hanover Trust Company) as Rights Agent, incorporated by reference to Exhibit 4.2.2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1997.
4.5 Amended and Restated Loan and Security Agreement dated as of November 28, 1994, between the Company and Foothill Capital Corporation, incorporated by reference to Exhibit 2 to the Company's Current Report on Form 8-K dated November 30, 1994.
4.6 Amendment Number One dated February 13, 1995 to the Amended and Restated Loan and Security Agreement dated as of November 28, 1994 between the Company and Foothill Capital Corporation, incorporated by reference to Exhibit 4.7 of the Company's Annual Report on Form 10K for the year ended December 31, 1995.
4.7. Letter Agreement dated as of February 13, 1995, incorporated by reference to Exhibit 4.7.1 of the Company's Annual Report on Form 10K for the year ended December 31, 1995.
4.8 Amendment Number Two dated March 30, 1995 to the Amended and Restated Loan and Security Agreement dated as of November 28, 1994 between the Company and Foothill Capital Corporation, incorporated by reference to Exhibit 4.7.2 of the Company's Annual Report on Form 10K for the year ended December 31, 1995.
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Exhibits (continued)
Exhibit No. Description of Exhibit - ----------- ---------------------- 4.9 Amended and Restated Secured Promissory Note dated February 13, 1995, incorporated by reference to Exhibit 4.9 of the Company's Annual Report on Form 10K for the year ended December 31, 1995.
4.10 Deferred Funding Fee Note dated November 28, 1994 made by the Company in favor of Foothill Capital Corporation, incorporated by reference to Exhibit 5 to the Company's Current Report on Form 8-K dated November 30, 1994.
4.11 Amendment Number Three to Amended and Restated Loan and Security Agreement dated March 12, 1996, between the Company and Foothill Capital Corporation, incorporated by reference to Exhibit 4.11 of the Company's Annual Report on Form 10K for the year ended December 31, 1995.
4.12 Warrant to Purchase Common Stock of the Company dated November 28, 1994 executed by the Company in favor of Foothill Capital Corporation, incorporated by reference to Exhibit 6 to the Company's Current Report on Form 8-K dated November 30, 1994.
4.14 Lockbox Operating Procedural Agreement dated as of November 28, 1994 among Chemical Bank, the Company and Foothill Capital Corporation, incorporated by reference to Exhibit 7 to the Company's Current Report on Form 8-K dated November 30, 1994.
4.15 Amendment No. Five dated as of November 30, 1997, to Amended and Restated Loan and Security agreement between Foothill Capital Corp. ("Foothill") and the Company, including amendments to the warrants held by Foothill, incorporated by reference to Exhibit 4.23 of the Company's Form 8-K dated January 2, 1998.
4.16 Amendment No. Six dated as of August 1, 1998 to Amended and Restated Loan and Security agreement between Foothill Capital Corp. ("Foothill") and the Company, incorporated by reference to Exhibit 4.24 of the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
4.17 Amendment No. Seven dated as of December 1, 1998 to Amended and Restated Loan and Security agreement between Foothill Capital Corp. ("Foothill") and the Company, incorporated by reference to Exhibit 4.25 of the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
10.14 Form of Executive Salary Continuation Agreement, incorporated by reference to Exhibit 19 (cc) of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1985.
10.2 Agreement dated May 25, 1988 between British Telecommunications plc and the Company, incorporated by reference to Exhibit 19 (a) of the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. Confidential Treatment granted; document filed separately with the SEC.
10.3 Amendment to agreement of May 25, 1988, dated September 1, 1996, between British Telecommunications plc and the Company, incorporated by reference to Exhibit 10.6.1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1996.
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Exhibits (continued)
Exhibit No. Description of Exhibit - ----------- ---------------------- 10.4 Lease dated December 17, 1990 between the Company and LBA properties, Inc., incorporated by reference to Exhibit 10 (d) of the Company's annual report on Form 10-K for the year ended December 31, 1990.
10.5 Employee Stock Bonus Program filed as Exhibit 4.3 to the Form S-8 dated February 12, 1999 and incorporated herein by reference.
10.6 1999 Stock Option Plan filed as Exhibit A to the Proxy Statement for the 1999 Annual Meeting to Stockholders and incorporated herein by reference.
10.7 1996 Stock Option Plan filed as Exhibit A to the Proxy Statement for the 1996 Annual Meeting to Stockholders and incorporated herein by reference.
10.8 1998 Stock Option Plan filed as Exhibit 4.2 to the Form S-8 dated December 3. 1998 and incorporated herein by reference.
10.9 Senior Officers and Directors Stock Purchase Program filed as Exhibit 4.2 to the Form S-8 dated February 12, 1999 and incorporated herein by reference.
10.10 Employee Stock Purchase Plan filed as Exhibit 4.1 to the Form S-8 dated February 12, 1999 and incorporated herein by reference.
22 Subsidiaries of the Company, incorporated by reference to Exhibit 22.1 of the Company's Annual Report on Form 10K for the year ended December 31, 1995.
23 Consent of Independent Auditors.
27 Financial Data Schedule
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(b) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
PORTA SYSTEMS CORP.
Dated April 12, 2000 By /s/ William V. Carney ----------------------------- William V. Carney Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Each person whose signature appears below hereby authorizes William V. Carney and Edward B. Kornfeld or either of them acting in the absence of the others, as his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this report, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission.
Signature Title Date --------- ----- ----
/s/ William V. Carney Chairman of the Board, April 12, 2000 - --------------------------- Chief Executive Officer William V. Carney and Director (Principal Executive Officer)
/s/ Edward B. Kornfeld Senior Vice President and April 12, 2000 - --------------------------- Chief Financial Officer Edward B. Kornfeld (Principal Financial and Accounting Officer)
/s/ Seymour Joffe Director April 12, 2000 - --------------------------- Seymour Joffe
/s/ Michael A. Tancredi Director April 12, 2000 - --------------------------- Michael A. Tancredi
/s/ Warren H. Esanu Director April 12, 2000 - --------------------------- Warren H. Esanu
/s/ Herbert H. Feldman Director April 12, 2000 - --------------------------- Herbert H. Feldman
/s/ Stanley Kreitman Director April 12, 2000 - --------------------------- Stanley Kreitman
/s/ Lloyd I. Miller, III Director April 12, 2000 - --------------------------- Lloyd I. Miller, III
/s/ Robert Schreiber Director April 12, 2000 - --------------------------- Robert Schreiber
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Exhibit I
Item 8. Financial Statements and Supplementary Data
Index Page - ----- ----
Report of Independent Certified Public Accountants
Consolidated Financial Statements and Notes:
Consolidated Balance Sheets, December 31, 1999 and 1998
Consolidated Statements of Operations and Comprehensive Income (Loss), Years Ended December 31, 1999, 1998 and 1997
Consolidated Statements of Stockholders' Equity (Deficit), Years Ended December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997
Notes to Consolidated Financial Statements
Report of Independent Certified Public Accountants
The Board of Directors and Stockholders of Porta Systems Corp. Syosset, New York
We have audited the accompanying consolidated balance sheets of Porta Systems Corp. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations and comprehensive income (loss), stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Porta Systems Corp. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles.
/s/ BDO SEIDMAN, LLP --------------------------- BDO SEIDMAN, LLP
Melville, New York March 15, 2000, except for Notes 2 and 6 as to which the date is April 10, 2000 as they relate to the Company's senior and subordinated debt
PORTA SYSTEMS CORP. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1999 and 1998 (Dollars in thousands)
1999 1998 ---- ---- Assets Current assets: Cash and cash equivalents $ 3,245 3,044 Accounts receivable - trade, less allowance for doubtful accounts of $1,879 in 1999 and $915 in 1998 12,137 19,802 Inventories 8,893 8,944 Prepaid expenses and other current assets 1,373 1,716 -------- ------- Total current assets 25,648 33,506
Property, plant and equipment, net 4,193 4,213 Deferred computer software, net -- 82 Goodwill, net of amortization of $4,284 in 1999 and $3,763 in 1998 11,076 11,597 Other assets 2,531 2,738 -------- ------- Total assets $ 43,448 52,136 ======== =======
Liabilities and Stockholders' Equity (Deficit) Current liabilities: Current portion of senior debt $ 2,000 2,000 Accounts payable 8,831 6,893 Accrued expenses 5,723 6,266 Accrued interest payable 588 545 Accrued commissions 1,864 2,438 Accrued deferred compensation 196 196 Income taxes payable 267 762 Short-term loans 44 144 -------- ------- Total current liabilities 19,513 19,244 -------- -------
Senior debt net of current maturities 15,518 11,188 Subordinated notes 6,013 5,685 6% Convertible subordinated debentures 371 365 Deferred compensation 1,004 1,021 Income taxes payable 352 719 Other long-term liabilities 971 776 Minority interest 1,093 1,154 -------- ------- Total long-term liabilities 25,322 20,908 -------- ------- Total liabilities 44,835 40,152 -------- ------- Commitments and contingencies
Stockholders' equity (deficit): Preferred stock, no par value; authorized 1,000,000 shares, none issued -- -- Common stock, par value $.01; authorized 20,000,000 shares, issued 9,638,861 and 9,484,742 shares in 1999 and 1998, respectively 96 95 Additional paid-in capital 75,310 75,135 Accumulated deficit (70,959) (57,273) Accumulated other comprehensive loss: Foreign currency translation adjustment (3,896) (3,754) -------- ------- 551 14,203 Treasury stock, at cost, 30,940 shares (1,938) (1,938) Receivable from directors and officers under stock purchase program -- (281) -------- ------- Total stockholders' equity (deficit) (1,387) 11,984 -------- ------- Total liabilities and stockholders' equity (deficit) $ 43,448 52,136 ======== =======
See accompanying notes to consolidated financial statements.
PORTA SYSTEMS CORP. AND SUBSIDIARIES Consolidated Statements of Operations and Comprehensive Income (Loss) Years ended December 31, 1999, 1998 and 1997 (in thousands, except per share amounts)
1999 1998 1997 ---- ---- ----
Sales $ 38,936 59,343 62,230 Cost of sales 28,952 35,188 37,950 -------- ------ -------- Gross profit 9,984 24,155 24,280 -------- ------ -------- Selling, general and administrative expenses 13,603 13,079 12,818 Research and development expenses 6,090 6,510 5,361 -------- ------ -------- Total expenses 19,693 19,589 18,179 -------- ------ -------- Operating income (loss) (9,709) 4,566 6,101
Interest expense (3,571) (3,750) (3,379) Interest income 188 272 259 Other income (expense), net 218 1,028 1,047 Debt conversion expense -- (945) (11,458) -------- ------ -------- Income (loss) before income taxes and minority interest (12,874) 1,171 (7,430)
Income tax expense (benefit) 873 606 (585) Minority interest (61) 114 176 -------- ------ -------- Income (loss) before extraordinary item (13,686) 451 (7,021)
Extraordinary gain on early extinguishment of debt -- 76 122 -------- ------ -------- Net income (loss) $(13,686) 527 (6,899) ======== ====== ======== Other comprehensive income (loss), net of tax:
Foreign currency translation adjustments (142) 273 (1,015) -------- ------ -------- Comprehensive income (loss) $(13,828) 800 (7,914) ======== ====== ======== Basic per share amounts: Income (loss) before extraordinary item $ (1.44) 0.05 (2.26) Extraordinary item -- 0.01 0.04 -------- ------ -------- Net income (loss) per share of common stock $ (1.44) 0.06 (2.22) ======== ====== ======== Weighted average shares of common stock outstanding 9,489 9,281 3,111 ======== ====== ======== Diluted per share amounts: Income (loss) before extraordinary item $ (1.44) 0.04 (2.26) Extraordinary item -- 0.01 0.04 -------- ------ -------- Net income (loss) per share of common stock $ (1.44) 0.05 (2.22) ======== ====== ========
Weighted average shares of common stock outstanding 9,489 9,785 3,111 ======== ====== ========
See accompanying notes to consolidated financial statements.
PORTA SYSTEMS CORP. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity (Deficit) Years ended December 31, 1999, 1998 and 1997 (In thousands)
See accompanying notes to consolidated financial statements
PORTA SYSTEMS CORP. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Note 21) Years ended December 31, 1999, 1998 and 1997 (Dollars in thousands)
See accompanying notes to consolidated financial statements.
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998 and 1997
(1) Summary of Significant Accounting Policies
Nature of Operations and Principles of Consolidation
Porta Systems Corp. ("Porta" or the "Company") designs, manufactures and markets systems for the connection, protection, testing and administration of public and private telecommunications lines and networks. The Company has various patents for copper and software based products and systems that support voice, data, image and video transmission. Porta's principal customers are the U.S. regional telephone operating companies and foreign telephone companies.
The accompanying consolidated financial statements include the accounts of Porta and its majority-owned or controlled subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
Revenue Recognition
Revenue, other than from long-term contracts for specialized products, is recognized when a product is shipped. Revenues and earnings relating to long-term contracts for specialized products are recognized on the percentage-of-completion basis primarily measured by the attainment of milestones. Anticipated losses, if any, are recognized in the period in which they are identified.
Concentration of Credit Risk
Financial instruments, which potentially subject Porta to concentrations of credit risk, consist principally of cash and accounts receivable. At times such cash in banks exceeds the FDIC insurance limit.
As discussed in notes 17 and 22, substantial portions of Porta's sales are to customers in foreign countries. The Company's credit risk with respect to new foreign customers is reduced by obtaining letters of credit for a substantial portion of the contract price, and by monitoring credit exposure related to each customer.
Cash Equivalents
The Company considers investments with original maturities of three months or less at the time of purchase to be cash equivalents. Cash equivalents consist of commercial paper.
Inventories
Inventories are stated at the lower of cost (on the average or first-in, first-out methods) or market.
Property, Plant and Equipment
Property, plant and equipment are carried at cost. Leasehold improvements are amortized over the term of the lease. Depreciation is computed using the straight-line method over the related assets' estimated lives.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
Deferred Computer Software
Software costs incurred for specific customer contracts are charged to cost of sales at the time revenues on such contracts are recognized. Software development costs relating to products the Company offers for sale are deferred in accordance with Statement of Financial Accounting Standards (SFAS) No. 86 "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed". These costs are amortized to cost of sales over the periods that the related product will be sold, up to a maximum of four years. Amortization of computer software costs, which all relate to products the Company offers for sale, amounted to approximately $82,000, $461,000 and $1,133,000 in 1999, 1998, and 1997, respectively.
Goodwill
Goodwill represents the difference between the purchase price and the fair market value of net assets acquired in business combinations treated as purchases. Goodwill is amortized on a straight-line basis over a remaining life of 13 to 31 years. During 1999, in view of recent competitive developments in the telecommunications market place and Porta's changing business model in response, management has reassessed the useful life of certain of its goodwill. While in management's opinion, there is currently no impairment in the carrying value of this long-lived intangible asset (based upon an analysis of undiscounted future cash flows), management has determined that the useful life of the goodwill should be shortened to be more reflective of the current rate of technology change and competitive conditions. Accordingly, management changed the estimated useful life of certain goodwill from an original life of 40 years to a remaining life of 13 years, which change was applied prospectively from the fourth quarter of 1999. This change in accounting estimate increased amortization expense in 1999 by approximately $58,000. At December 31, 1999, $7,053,000 of the goodwill is being amortized over a remaining life of approximately 13 years and $4,024,000 is being amortized over a remaining life of approximately 31 years. The Company assesses the recoverability of unamortized goodwill using the undiscounted projected future cash flows from the related businesses.
Income Taxes
Deferred income taxes are recognized based on the differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. Further, the effects of tax law or rate changes are included in income as part of deferred tax expense or benefit for the period that includes the enactment date (note 14).
Foreign Currency Translation
Assets and liabilities of foreign subsidiaries are translated at year-end rates of exchange, and revenues and expenses are translated at the average rates of exchange for the year. Gains and losses resulting from translation are accumulated in a separate component of stockholders' equity. Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the functional currency) are included in net income or loss.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
Net Income (Loss) Per Share
Basic net income (loss) per share is based on the weighted average number of shares outstanding. Diluted net income (loss) per share is based on the weighted average number of shares outstanding plus dilutive potential shares of common stock, if such shares had been issued. The calculation of the diluted net income per share for the year ended December 31, 1998, assumes the exercise of dilutive options and warrants and the conversion of the 6% Subordinated Debentures. For 1999 and 1997, no dilutive potential shares of common stock were added to compute diluted loss per share because the effect was anti-dilutive.
Reclassifications
Certain reclassifications have been made to conform prior years' consolidated financial statements to the 1999 presentation.
Accounting for Stock-Based Compensation
The Company follows the Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation". Porta has elected not to implement the fair value based accounting method for employee stock options, but has elected to disclose the pro-forma net income and earnings per share as if such method had been used to account for stock-based compensation cost as described in the Statement.
Accounting for the Impairment of Long-Lived Assets
The Company follows the Statement of Financial Accounting Standard No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of". Porta believes that there is no impairment of its long-lived assets.
Use of Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these consolidated financial statements are the estimated allowance for doubtful accounts receivable, inventory reserves, percentage of completion for long-term contracts, and the deferred tax asset valuation allowance. Actual results could differ from those and other estimates.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(2) Liquidity
As of December 31, 1999, Porta's debt includes $17,500,000 of senior debt, which matures on January 2, 2001, and $6,000,000 of subordinated debt which matures in January 2001. Subsequent to December 31, 1999, Porta borrowed an additional $2,550,000 of senior debt and repaid $400,000 of senior debt, resulting in a balance owed of approximately $20,000,000 to the senior lender at March 15, 2000. The subordinated lenders have agreed to extend the maturity date for six months if Porta meets certain financial milestones. At December 31, 1999, Porta did not have sufficient resources to pay either the senior lender or the subordinated lenders at maturity and it is likely that it cannot generate such cash from its operations. In April 2000, the Company and its senior lender agreed to extend the loan and security agreement to July 3, 2001. As consideration Porta agreed to re-price all outstanding warrants held by its senior lender to $2.00 per warrant. In addition, in April 2000, the Company and the holders of $5,100,000, or 85%, of its subordinated notes, agreed to eliminate the requirement that Porta meet specific financial goals for Porta to extend the maturity date of their subordinated notes to July 3, 2001. In connection with this agreement, Porta agreed to issue to these noteholders New Warrants to purchase 127,500 shares of Common Stock at $3.00 per share. Porta may issue to any other noteholders who agree to this amendment New Warrants to purchase up to 22,500 shares of Common Stock at $3.00 per share. The remaining New Warrants to purchase 150,000 shares of Common Stock will be issued if the notes are extended. Although Porta is seeking to refinance or restructure this debt prior to the maturity date, its business may be impaired if it is unable to do so.
Porta's backlog at December 31, 1999 was $23,800,000 compared with approximately $8,800,000 at December 31, 1998. Of the December 31, 1999 backlog, approximately $19,800,000 represented orders from foreign telephone operating companies. Porta expects to ship substantially all of its December 31, 1999 backlog during 2000. Porta believes that its current cash position, internally generated cash flow from its existing backlog, anticipated orders and its loan facility will be sufficient to satisfy its anticipated operating needs for at least 2000.
Porta is responding to its liquidity problems by:
o Negotiating with its senior lender for an increase in its available credit;
o Developing relationships with strategic partners who would continue the development of new products to reduce Porta's cash requirements for its OSS business; and
o Scaling back its operations to reduce the cash requirements.
(Continued)
(3) Accounts Receivable
Accounts receivable included approximately $3,211,000 and $5,657,000 at December 31, 1999 and 1998, respectively, of revenues earned but not yet contractually billable relating to long-term contracts for specialized products. All such amounts at December 31, 1999 are expected to be billed in the subsequent year. In addition, accounts receivable included approximately $1,252,000 and $2,860,000 at December 31, 1999 and 1998, respectively, of retainage balances due on various long-term contracts. All such amounts are expected to be collected during the subsequent year. The allowance for doubtful accounts receivable was $1,879,000 and $915,000 as of December 31, 1999 and 1998, respectively. The allowance for doubtful accounts was increased by provisions of $1,070,000, $210,000, and $107,000 and decreased by write-offs of $106,000, $353,000, and $599,000 for the years ended December 31, 1999, 1998, and 1997, respectively. In 1999, the increase in the provision was adjusted during the fourth quarter.
(4) Inventories
Inventories consist of the following:
December 31, ---------------------------- 1999 1998 ---------- --------- Parts and components $5,558,000 4,959,000 Work-in-process 584,000 743,000 Finished goods 2,751,000 3,242,000 ---------- --------- $8,893,000 8,944,000 ========== =========
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(5) Property, Plant and Equipment
Property, plant and equipment consists of the following:
December 31 --------------------- Estimated 1999 1998 useful lives ---- ---- ------------ Land $ 246,000 246,000 -- Buildings 2,284,000 2,585,000 20-50 years Machinery and equipment 9,079,000 7,947,000 3-8 years Furniture and fixtures 2,825,000 3,566,000 5-10 years Transportation equipment 151,000 129,000 4 years Tools and molds 3,474,000 3,124,000 8 years Leasehold improvements 871,000 805,000 Term of lease ----------- ----------- 18,930,000 18,402,000 Less accumulated depreciation and amortization 14,737,000 14,189,000 ----------- ----------- $ 4,193,000 4,213,000 =========== ===========
Total depreciation and amortization expense for 1999, 1998 and 1997, related to property, plant and equipment amounted to approximately $998,000, $1,197,000 and $1,468,000, respectively.
(Continued)
(6) Senior Debt
On December 31, 1999 and 1998, Porta's long-term debt consisted of senior debt under its credit facility in the amount of $16,276,000 and $10,682,000, respectively, and non-interest bearing deferred funding fee notes payable to the senior lender in the amounts of $1,242,000 and $2,512,000, respectively. Of these amounts outstanding $2,000,000 are classified as the current portion of senior debt as of December 31, 1999 and 1998, respectively. The credit facility consists of a combined revolving line of credit and letter of credit availability of $9,000,000. The balance of the facility is comprised of a term loan. The credit facility is secured by substantially all of Porta's assets. All obligations, except undrawn letters of credit, letter of credit guarantees and the deferred fee notes, bear interest at 12%. The Company incurs a fee of 2% per annum on the average balance of letter of credit guarantees outstanding.
The agreement, which expires on January 2, 2001, provides for loan principal payments of $400,000 on the last day of each quarter during the term of the agreement. As part of the agreement, the loan amortization shall first be applied to the non-interest bearing notes payable until these notes are paid in full and then to the term loan. The agreement also requires Porta to pay additional principal payments if its cash flow exceeds certain amounts. A monthly facility fee payment of $50,000 continuing to the end of the agreement is also required.
Pursuant to the November 30, 1997 extension of the credit facility, Porta agreed to amend the terms of the warrants previously issued to its senior lender. The 82,500 and 200,000 warrants, after adjustment for the antidilution provisions contained in the warrant agreement, provides for the purchase of 164,627 and 295,441 shares of common stock, respectively and are immediately exercisable at $3.00 per share and expire on November 30, 2002. The value of the change in warrant terms is estimated to be $45,000 and was recorded as a deferred financing expense and additional paid in capital in 1997.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
Financial debt covenants include an interest coverage ratio measured quarterly with limitations on the incurrence of indebtedness, limitations on capital expenditures, and prohibitions on declarations of any cash or stock dividends or the repurchase of the Company's stock. As of December 31, 1999, Porta was not in compliance with the interest coverage covenant and has obtained a waiver of such non-compliance from its senior lender.
In April 2000, the Company and its senior lender agreed to extend the loan and security agreement to July 3, 2001. As consideration Porta agreed to re-price all outstanding warrants to its senior lender to $2.00 per warrant.
Maturities of Porta's long-term debt, including convertible subordinated debentures and subordinated notes (notes 7 and 8), are as follows:
2000 $ 2,000,000 2001 21,531,000 2002 371,000 ----------- $23,902,000
(7) 6% Convertible Subordinated Debentures and Zero Coupon Senior Subordinated Convertible Notes
As of December 31, 1999 and 1998 Porta had outstanding $371,000 and $365,000 of its 6% convertible subordinated debentures due July 1, 2002 (the "Debentures"), net of original issue discount of $14,000 and $20,000, respectively. The face amount of the outstanding Debentures was $385,000 at both December 31, 1999 and 1998. The Debentures are convertible at any time prior to maturity into Common Stock of the Company at a conversion rate of 8.333 shares for each $1,000 face amount of Debentures, subject to adjustment under certain circumstances.
The Debentures are redeemable at the option of Porta, (a) in whole or in part, at redemption prices ranging from 89.626% of face amount beginning July 1, 1995 to 100% of face amount beginning July 1, 2001 and thereafter, together with accrued and unpaid interest to the redemption date, and (b) in whole at any time, at a redemption price equal to the issue price plus interest and that portion of the original issue discount and interest accrued to the redemption date, in the event of certain changes in United States taxation or the imposition of certain certification, information or other reporting requirements.
Interest on the Debentures is payable on July 1 of each year. The interest accrued amounted to $12,000 as of both December 31, 1999 and 1998.
On November 30, 1995, Porta offered the holders of its Debentures an exchange of such debt for common stock and zero coupon senior subordinated convertible notes (the "Notes") due January 2, 1998. The exchange ratio was 19.4 shares of common stock and $767.22 of principal of Notes in exchange for each $1,000 principal amount of Debentures converted. Accrued interest on the Debentures, which were exchanged was eliminated.
The Notes were unsecured and did not bear interest. There were no sinking fund requirements for the Notes. Each Note was convertible into common stock at a conversion price of $6.55 prior to the amendment as discussed below.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
As of December 31, 1996, Porta had exchanged approximately $33,770,000 principal amount of the Debentures, net of related unamortized discount and accrued interest expense, for 655,000 shares of stock and $25,909,000 of Notes. In addition, as of December 31, 1996, $24,000 of Notes had been converted into 3,600 shares of stock.
During 1997, Porta exchanged approximately $410,000 principal amount of the Debentures, net of related unamortized discount and accrued interest expense, for 8,000 shares of common stock and $315,000 principal amount of Notes.
Effective November 13, 1997, Porta amended the terms of the Notes. Under the amended terms, the conversion price of the Notes was reduced to $3.65 from $6.55. As of December 31, 1997, approximately $23,400,000 principal amount of Notes was converted into approximately 6,412,000 shares of common stock. The conversion of the Notes for common stock reduced debt by $23,400,000, increased equity by $34,049,000 and resulted in a primarily non-cash charge of $11,458,000. The non-cash charge was based on the difference between the value of the shares issuable under the original terms of the Notes and the value of the shares issued with respect to the Notes under the amended terms. In connection with the conversion of the Notes, Porta issued to its investment banking firm 120,000 shares of common stock.
During 1998, Porta (i) repaid the remaining balance of the Notes from the proceeds of the Subordinated Notes (note 8) (ii) exchanged $250,000 additional principal amount of the Debentures for 5,000 shares of common stock and $192,000 principal amount of Notes which were then converted to 53,000 shares of common stock based on the amended terms of the Notes as described above and (iii) issued approximately 330,000 shares of common stock in exchange for $1,260,000 principal amount of Debentures and accrued interest. Porta recorded a debt conversion expense of approximately $945,000, net of interest forgiven, in the first quarter of 1998. After giving effect to these transactions, as of December 31, 1998 Porta has no Notes outstanding and $385,000 principal amount of Debentures outstanding.
The exchange of the Debentures for the Notes and common stock was accounted for as a troubled debt restructuring in accordance with Statement of Financial Accounting Standards No. 15. Since the future principal and interest payments under the Notes is less than the carrying value of the Debentures, the Notes were recorded for the amount of the future cash payments, and not discounted, the common stock issued was recorded at the market value at the time of issuance, and an extraordinary gain on restructuring was recorded of approximately $76,000 and $122,000, for 1998 and 1997, respectively. Accordingly, no future interest expense was recorded on the Notes, subsequent to the time of issuance.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(8) Subordinated Notes
In January 1998, Porta raised $6,000,000 from the private placement of 60 units at $100,000 per unit. Each unit consisted of (a) 12% Subordinated Note in the principal amount of $100,000, and (b) a Series B Common Stock Purchase Warrant (a "Series B Warrant") to purchase 10,000 shares of Common Stock at $3.00 per share through December 31, 2002. In the event that any Subordinated Note was outstanding one year from the date on which such Subordinated Note was issued (the "Anniversary Date of the Note"), Porta agreed to the holder of such Subordinated Note on the Anniversary Date of the Note a Series C Common Stock Purchase Warrant ( a "Series C Warrant") to purchase 25 shares of Common Stock for each $1,000 principal amount of Subordinated Notes outstanding on the Anniversary Date of the Note. The Series C Warrant has an exercise price equal to the average closing prices of the Common Stock on each of the five trading days preceding the Anniversary Date of the Note with respect to which the Series C Warrant is being issued and will expire on December 31, 2003.
As of December 31, 1998, the Series B and Series C Warrants were valued at $630,000 and were recorded as part of additional paid-in capital. Accordingly, Porta recorded the net Subordinated Notes at a value of $5,370,000. As of December 31, 1998, the Company had Subordinated Notes outstanding of $5,685,000, net of original issue discount of $315,000. In 1999, pursuant to the terms of the Notes, the Company issued to the holders of the Subordinated Notes Series C Warrants to purchase an aggregate of 150,000 shares of common stock at an average exercise price of $1.94.
During December 1999, Porta (a) extended its maturity date of the $6,000,000 outstanding principal amount of Subordinated Notes with the right to extend the maturity date for an additional period of six months to July 3, 2001 if Porta achieves certain financial results, (b) increased the interest rate of the Subordinated Notes to 14% per annum during the initial term and to 15% during the extended term, (c) reduced the exercise price of the Series B and C Warrants to $1.00 per share, (d) granted the holders of the Subordinated Notes the right to a payment in kind option, whereby the Noteholder has the right to receive interest in the form of a new subordinated note in the principal amount equal to 125% of the interest then due, with the new subordinated note bearing interest at the rate of 125% of the then current interest rate of the Subordinated Notes, and (e) agreed that, if Porta extends the maturity date of the Subordinated Notes to July 3, 2001, it will issue to the noteholders New Warrants to purchase a total of 300,000 shares of Common Stock at the average closing price of the Common Stock for five trading days preceding January 3, 2001. As a result of the amendment to the Subordinated Notes, Porta recorded a discount of approximately $56,000 relating to the re-pricing of the warrants and additional interest expense for Noteholders who elected the paid in kind option at December 31, 1999 of approximately $13,000. As of December 31, 1999, $6,013,000 of Subordinated Notes were outstanding which includes $64,000 of additional principal from paid in kind options and unamortized debt discount of $51,000.
In April 2000, the Company and the holders of $5,100,000 or 85%, of the subordinated notes agreed to eliminate the requirement that Porta meet specific financial goals for Porta to extend the maturity date of their subordinated Notes to July 3, 2001. In connection with this agreement, Porta agreed to issue to these noteholders New Warrants to purchase 127,500 shares of Common Stock at $3.00 per share. Porta may issue to any other noteholders who agree to this amendment New Warrants to purchase up to 22,500 shares of Common Stock at $3.00 per share. The remaining New Warrants to purchase 150,000 shares of Common Stock will be issued if the notes are extended.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(9) Joint Venture
The Company has a 50% interest in a joint venture agreement with a Korean partner. Unless otherwise terminated in accordance with the joint venture agreement, the joint venture will terminate on December 31, 2010. In addition, the Company has obtained an option to acquire an additional 1% interest of the joint venture, for approximately $190,000. The Company consolidates the operations of the joint venture since the Company can obtain a controlling interest at its election and the joint venture is entirely dependent on the Company for the products it sells and receives management assistance from the Company. The joint venture partner's interest is shown as a minority interest.
(10) Stockholders' Equity
Porta had outstanding warrants to its senior lender to purchase 460,068 shares of common stock, which are immediately exercisable at $3.00 per share and expire on November 30, 2002.
In 1997, in consideration for advisory services by an investment banking firm, Porta issued warrants to purchase 400,000 shares of common stock at $1.56 per share until April 2002. In addition, in consideration for the advisory services related to the debt conversion, Porta issued to the investment banking firm 120,000 shares of common stock (note 7). In 1997, Porta recorded deferred consulting of approximately $80,000 and debt conversion expense of approximately $580,000.
See Note 8 in connection with the issuance of the Series B and C Warrants as part of the private placement of the subordinated Notes in the principal amount of $6,000,000 and the amendment of the terms of the Subordinated Notes and Series B and C Warrants.
As of December 31, 1999, Porta also had stock purchase warrants outstanding to purchase 53,000 shares of common stock at an exercise price of $17.50 per share until November 2001.
Under a 1984 Employee Incentive Plan, Porta provided an opportunity for certain employees of the Company and its subsidiaries to acquire subordinated convertible debentures. As a result, as of December 31, 1998, there was $13,000 of employee promissory notes receivable outstanding, of which the maturity date has been extended to April 1999. During 1998, the Board of Directors approved a reduction in the original issue price of the debentures to the then current market rate of the common stock, approximately $1.38 per share, which common stock was held by Porta as collateral for the notes. Accordingly, the related receivable from employees was reduced from $307,000 to $13,000 to reflect the new valuation. The reduction on the original issue resulted in a non-cash compensation charge in 1998 of $298,000. During 1999, all of the receivables from employees were paid.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
During 1998, the Board of Directors adopted a Stock Purchase Program (the "program") for senior executive officers and directors of the Company. The program was established to increase the direct equity investment in the Corporation of the senior executives and directors. The program sets forth that each participant shall purchase common stock equal to ten percent of the participant's salary for those who are officers and $30,000 with respect to those who are outside directors. The number of shares purchased is based on the fair market value per share of Common stock of $1.50. The stock purchase for each officer is payable to the Company on an installment basis. Porta is holding the shares as security against the outstanding obligation until it is paid in full. The maximum number of shares to be issued pursuant to the program is 186,000. The initial receivable related to the program was $279,000. As of December 31, 1999 and 1998, the receivable balance was $0 and $268,000, respectively.
(11) Stockholder Rights Plan
Porta has a Stockholder Rights Plan in which preferred stock purchase rights were distributed to stockholders as a dividend at the rate of one right for each common share. Each right entitles the holder to buy from Porta one one-hundredth of a newly issued share of Series A junior participating preferred stock at an exercise price of $175.00 per right.
The rights will be exercisable only if a person or group acquires beneficial ownership of 22.5 percent or more of Porta's common stock or commences a tender or exchange offer upon consummation of which such person or group would beneficially own 22.5 percent or more of the common stock.
If any person becomes the beneficial owner of 22.5 percent or more of Porta's common stock other than pursuant to an offer for all shares which is fair to and otherwise in the best interests of Porta and its stockholders, each right not owned by such person or related parties will enable its holders to purchase, at the right's then current exercise price, shares of common stock of Porta (or, in certain circumstances as determined by the Board of Directors, a combination of cash, property, common stock or other securities) having a value of twice the right's exercise price. In addition, if Porta is involved in a merger or other business combination transaction with another person in which its shares are changed or converted, or sells more than 50 percent of its assets to another person or persons, each right that has not previously been exercised will entitle its holder to purchase, at the right's then current exercise price, common shares of such other person having a value of twice the right's exercise price.
Porta will generally be entitled to redeem the rights, by action of a majority of the continuing directors of the Company, at $.01 per right at any time until the tenth business day following public announcement that a 22.5 percent position has been acquired.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(12) Employee Benefit Plans
Porta has deferred compensation agreements with certain officers and employees, with benefits commencing at retirement equal to 50% of the employee's base salary, as defined. Payments under the agreements will be made for a period of fifteen years following the earlier of attainment of age 65 or death. During 1999, 1998 and 1997, Porta accrued approximately $180,000, $185,000 and $203,000, respectively, under these agreements.
In 1986, Porta established the Porta Systems Corp. 401(k) Savings Plan for the benefit of eligible employees, as defined in the Savings Plan. Participants contribute a specified percentage of their base salary up to a maximum of 15%. Porta will match a participant's contribution by an amount equal to 25% of the first 6% contributed by the participant. A participant is 100% vested in the balance to his credit. For the years ended December 31, 1999, 1998 and 1997, Porta's contribution amounted to $93,000, $96,000 and $96,000, respectively.
In 1999, Porta established the Employee Stock Purchase Plan for the benefit of eligible employees, as defined in the Purchase Plan, which permits employees to purchase Porta's common stock at discounts up to 15%. Porta has reserved 1,000,000 shares of Porta stock for issuance under the plan. The first quarterly period under the Purchase Plan commenced October 1999. Subsequent to December 31, 1999, Porta issued approximately 28,000 shares of stock to the participants of the Purchase Plan at a 10% discount, resulting in a purchase price $0.675.
Porta does not provide any other post-retirement benefits to any of its employees.
(13) Incentive Plans
During 1999, Porta established an Employee Stock Bonus Plan whereby stock may be given to non-officers or directors to recognize the contributions of employees. A maximum of 100,000 shares of common stock is reserved for issuance pursuant to the Bonus Plan. During 1999 Porta issued 4,250 shares of common stock pursuant to the Bonus Plan and recorded a charge of approximately $8,000.
Porta's 1986 Stock Incentive Plan ("1986 Plan"), expired in March 1996, although options granted prior to the expiration date remain in effect in accordance with their terms. Options granted under the 1986 Plan may be incentive stock options, as defined in the Internal Revenue Code, or options that are not incentive stock options. The exercise price for all options granted were equal to the fair market value at the date of grant.
Porta's 1996 Stock Incentive Plan ("1996 Plan") covers 450,000 shares of common stock. Incentive stock options cannot be issued subsequent to ten years from the date the 1996 Plan was approved. Options under the 1996 Plan may be granted to key employees, including officers and directors of the Company and its subsidiaries, except that members and alternate members of the stock option committee are not eligible for options under the 1996 Plan. The exercise price for all options granted were equal to the fair market value at the date of grant and vest as determined by the board of directors. In addition, the 1996 Plan provides for the automatic grant to non-management directors of non-qualified options to purchase 2,000 shares on May 1st of each year commencing May 1, 1996, based upon the average closing price of the last ten trading days of April of each year.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
Porta's 1998 Stock Non-Qualified Stock Option Plan ("1998 Plan") covers 450,000 shares of common stock. Options under the 1998 Plan may be granted to key employees, including officers and directors of the Company and its subsidiaries. The exercise price for all options granted were equal to the fair market value at the date of grant and vest as determined by the board of directors.
Porta's 1999 Incentive and Non-Qualified Stock Option Plan ("1999 Plan") covers 400,000 shares of common stock. Incentive stock options cannot be issued subsequent to ten years from the date the 1999 Plan was approved. Options under the 1999 Plan may be granted to key employees, including officers and directors of the Company and its subsidiaries, except that members and alternate members of the stock option committee are not eligible for options under the 1999 Plan. The exercise price for all options granted were equal to the fair market value at the date of grant and vest as determined by the board of directors. In addition, the 1999 Plan provides for the automatic grant to non-management directors of non-qualified options to purchase 5,000 shares on May 1st of each year commencing May 1, 1999, based upon the average closing price of the last ten trading days of April of each year; provided, however, that the non-management directors will not be granted non-qualified options pursuant to the 1999 Plan for any year to the extent options are granted under the 1996 Plan for such year.
During 1998, pursuant to an employment contract with an officer, Porta issued options to purchase 30,000 shares of common stock at $1.25 per share, which approximated market value on the date of issuance, and expire on August 2004. As of December 31, 1999, options to purchase 10,000 shares of common stock had vested.
During 1999, pursuant to employment contracts with 4 officers, Porta issued options to purchase 95,000 shares of common stock at $2.06, as to 60,000 shares and $1.75, as to 35,000 shares. The exercise prices approximated market value on the date of issuance. The options expire in January 2004 and May 2005, respectively. As of December 31, 1999 none of the options are vested.
Porta applies APB Opinion 25, "Accounting for Stock Issued to Employees" ("APB 25") and related Interpretations in accounting for the 1999, 1998, 1996 and 1986 Plans. Under APB 25, no compensation cost is recognized for options granted to employees at exercise prices greater than or equal to fair market value of the underlying common stock at the date of grant.
Porta has adopted the disclosure only provisions of Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" ("SFAS No.123") which requires the Company to provide, beginning with 1995 grants, pro forma information regarding net income and net income per common share (basic and diluted) as if compensation costs for Porta's stock option plans had been determined in accordance with the fair value method prescribed in SFAS No.123. If Porta had elected to recognize compensation costs based on fair value of the options granted at grant date as prescribed by SFAS No. 123, net income (loss) and net income (loss) per share (basic and diluted) would have been reduced to the pro forma amounts indicated below:
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (Dollars in thousands, except per share data)
1999 1998 1997 ---- ---- ---- Pro forma net income (loss) $(14,280) $ 237 $(7,026) Pro forma net income (loss) per share (basic and diluted) $ (1.50) $0.03 $ (2.26)
The weighted-average fair value of options granted was $1.36, $ 1.47 and $0.35 per share in 1999, 1998 and 1997, respectively.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions for 1999, 1998 and 1997:
Dividends: $0.00 per share Volatility: 45.8%-80.00% Risk-free interest: 4.50%-6.40% Expected term: 5 years
A summary of the status of Porta's 1986 stock option plan as of December 31, 1999, 1998, and 1997, and changes during the years ending on those dates is presented below:
The following table summarizes information about stock options outstanding under the 1986 Plan at December 31, 1999:
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
A summary of the status of Porta's 1996 stock option plan as of December 31, 1999, 1998 and 1997, and changes during the year is presented below:
The following table summarizes information about stock options outstanding under the 1996 Plan at December 31, 1999:
A summary of the status of Porta's 1998 stock option plan as of December 31, 1999, and changes during the year is presented below:
1999 1998 ---------------------- ---------------------- Shares Weighted Shares Weighted Under Average Under Average Option Exercise Price Option Exercise Price ------ -------------- ------ --------------
Outstanding beginning of year 444,500 $3.25 0 $0.00 Granted 2,200 1.96 448,000 3.25 Exercised -- -- -- -- Forfeited (17,500) 2.32 (3,500) 3.25 ------- ------- Outstanding end of year 429,200 $3.28 444,500 $3.25 ======= ======= Options exercisable at year-end 358,400 -0- ======= ======= The following table summarizes information about stock options outstanding under the 1998 Plan at December 31, 1999:
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
A summary of the status of Porta's 1999 stock option plan as of December 31, 1999, and changes during the year is presented below:
----------------------------- Shares Weighted Under Average Option Exercise Price ------ -------------- Outstanding beginning of year 0 $0.00 Granted 25,500 1.72 Exercised -- -- Forfeited -0- ------ Outstanding end of year 25,500 $1.72 ====== Options exercisable at year-end 25,000 ======
The following table summarizes information about stock options outstanding under the 1999 Plan at December 31, 1999:
(14) Income Taxes
The provision for income taxes consists of the following:
1999 1998 1997 ---- ---- ---- Current Deferred Current Deferred Current Deferred
Federal $ -- 716,000 -- (8,000) 40,000 (708,000) State and foreign 62,000 95,000 615,000 (1,000) 177,000 (94,000) ------- ------- ------- ------ ------- -------- Total $62,000 811,000 615,000 (9,000) 217,000 (802,000) ======= ======= ======= ====== ======= ========
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
A reconciliation of Porta's income tax provision and the amount computed by applying the statutory U.S. federal income tax rate of 34% to income (loss) from continuing operations before income taxes is as follows:
Porta has unused United States tax net operating loss (NOL) carryforwards of approximately $74,593,000 expiring at various dates between 2007 and 2019. No tax benefit or expense was apportioned to the 1997 and 1998 extraordinary gains, as such amounts are immaterial. Due to the change in ownership which resulted from the conversion of Porta's Zero coupon subordinated convertible notes to common stock, Porta's usage of its NOL will be limited in accordance with Internal Revenue Code section 382. Porta's carryforward utilization of the NOL is limited to $1,767,000 per year. The carryforward amounts are subject to review by the Internal Revenue Service (IRS). The capital loss carryforwards expired during 1998 and, as a result of the section 382 limitation, no benefit from tax credit carryforwards will be available. In addition, Porta has foreign NOL carryforwards of approximately $5,300,000 with indefinite expiration dates.
Porta's United States net operating loss carryforwards expire in the following years:
2009 $ 4,105,000 2010 18,880,000 2011 884,000 2018 37,000 2019 5,912,000 ------------ $ 29,818,000 ============ (Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
The components of the deferred tax assets and liabilities, the net balance of which is included in prepaid and other current assets, as of December 31, 1999 and 1998 are as follows:
1999 1998 ------------ ----------- Deferred tax assets: Inventory $ 1,193,000 1,488,000 Allowance for doubtful accounts receivable 723,000 345,000 Benefits of tax loss carryforwards 13,285,000 9,056,000 Benefit plans 819,000 871,000 Accrued commissions 718,000 913,000 Other 449,000 290,000 Depreciation 906,000 487,000 ------------ ----------- 18,093,000 13,450,000 Valuation allowance (18,903,000) (12,607,000) ------------ ----------- -- 843,000 Deferred tax liabilities: Capitalized software costs -- (32,000) ------------ ----------- $ -- 811,000 ============ ===========
Deferred taxes result from temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. The temporary differences result from costs required to be capitalized for tax purposes by the US Internal Revenue Code, and certain items accrued for financial reporting purposes in the year incurred but not deductible for tax purposes until paid.
Because of Porta's tax losses in 1999, a valuation allowance for the entire deferred tax asset was provided due to the uncertainty as to future realization. During the years ended December 31, 1998 and 1997, the valuation allowance was carried at an amount that reflected a net deferred tax asset equal to the anticipated tax benefit of the temporary differences, which were expected to be realized within one year.
The income tax returns of Porta and its subsidiary operating in Puerto Rico were examined by the IRS for the tax years ended December 31, 1989 and 1988. As a result of this examination, the IRS increased the Puerto Rico subsidiary's taxable income resulting from intercompany transactions, with a corresponding increase in Porta's net operating losses. The settlement amounted to approximately $953,000. Porta is currently in a structured settlement with the IRS, which is reviewed annually, whereby monthly payments will be made to liquidate the settlement. Aggregate annual amounts payable by Porta, including interest on the unpaid amounts at a current rate of 7%, is $240,000 in 1999. As of December 31, 1999, Porta has made all the required payments through that date under the settlement and approximately $586,000 remains outstanding.
No provision was made for U.S. income taxes on the undistributed earnings of Porta's foreign subsidiaries as it is management's intention to utilize those earnings in the foreign operations for an indefinite period of time or repatriate such earnings only when tax effective to do so. At December 31, 1999, undistributed earnings of the foreign subsidiaries amounted to approximately $2,908,000. It is not practicable to determine the amount of income or withholding tax that would be payable upon the remittance of those earnings.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(15) Leases
At December 31, 1999, Porta and its subsidiaries leased manufacturing and administrative facilities, equipment and automobiles under a number of operating leases. Porta is required to pay increases in real estate taxes on the facilities in addition to minimum rents. Total rent expense for 1999, 1998, and 1997 amounted to approximately $874,000, $716,000 and $827,000, respectively. Minimum rental commitments, exclusive of future escalation charges, for each of the next five years are as follows:
2000 $ 758,000 2001 445,000 2002 436,000 2003 414,000 2004 385,000 Thereafter 3,631,000 ------------ $ 6,069,000 ============ (16) Contingencies
At December 31, 1999, Porta was contingently liable for outstanding letters of credit and surety bonds aggregating approximately $1,780,000 and $1,323,000, respectively, as security for the performance of certain long-term contracts.
In December 1999, Porta entered into a series of agreements with a non-affiliated party relating to the proposed licensing and development of certain new products and the performance by the other party of maintenance services for certain of Porta's clients. Porta has determined that it cannot recognize income or expense under these contracts and that the contracts do not reflect correctly the fair market value of the licenses exchanged and that the contracts are null and void. However, it is possible that the other party may assert claims against Porta under the contracts. Although Porta believes that it has valid defenses to any claim under the contracts, if there is litigation concerning the contracts, the other party may prevail.
Porta is a party to legal actions arising out of the ordinary conduct of its business. Management believes that the settlement of these matters will not have a materially adverse effect on the financial position of the Company (note 20).
(17) Major Customers
During the years ended December 31, 1999, 1998 and 1997, Porta's five largest customers accounted for sales of $19,700,000, or approximately 51% of sales, $28,797,000, or approximately 49% of sales, and $30,633,000, or approximately 48% of sales, respectively. Porta's largest customer is British Telecommunications plc ("BT"). Sales to BT for the year ended December 31, 1999, 1998 and 1997 amounted to $7,825,000, $15,349,000 and $13,876,000, respectively, or approximately 20%, 26% and 22%, respectively, of Porta's sales for such years. Therefore, any significant interruption or decline in sales to BT may have a materially adverse effect upon Porta's operations. During 1998, sales to a Chilean telephone company were $6,834,000, or approximately 12% of sales. No other customers account for 10% or more of Porta's sales for any year. Approximately 28%, 64% and 64%, respectively, of Porta's accounts receivable are due from the five largest customers as of December 31, 1999, 1998 and 1997. respectively.
(18) Fair Values of Financial Instruments
Cashequivalents, accounts receivable, accounts and notes payable, accrued expenses and short-term loans are reflected in the consolidated financial statements at fair value because of the short term maturity of these instruments.
The fair value of Porta's long-term debt cannot be reasonably estimated due to the lack of marketability of such instruments.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(19) Net Income (Loss) Per Share
The following table sets forth the computation of basic and diluted net income (loss) per share:
In November 1997, approximately $23,400,000 of the Notes were converted into approximately 6,412,000 shares of common stock. Had this conversion taken place as of January 1, 1997, the denominator for the basic net loss per share (the weighted-average shares) and the diluted net loss per share (adjusted weighted-average shares and assumed conversion) would have been 8,639,000 for 1997.
Options to purchase 638,508, 486,577 and 25,442 shares of common stock for 1999, 1998 and 1997, respectively, with exercise prices ranging from $1.69 to $5.00, $3.25 to $86.25 and $3.69 to $86.25 for 1999, 1998 and 1997, respectively, were outstanding but not included in the computation of diluted net income (loss) per share because the exercise prices were greater than the average market price of common stock during such years.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
Warrants to purchase 860,000, 53,000 and 548,668 shares of common stock for 1999, 1998 and 1997, respectively, with exercise prices ranging from $1.56 to $3.00, $17.50 and $3.00 to $50.00 for 1999, 1998 and 1997, respectively, were outstanding but not included in the computation of diluted net income (loss) per share because the exercise prices were greater than the average market price of common stock during such years.
(20) Legal Matters
In July 1996, an action was commenced against Porta and certain present and former directors in the Supreme Court of the State of New York, New York County by certain stockholders and warrant holders of Porta who acquired their securities in connection with the acquisition by Porta of Aster Corporation. The complaint alleges breach of contract against Porta and breach of fiduciary duty against the directors arising out of an alleged failure to register certain restricted shares and warrants owned by the plaintiffs. The complaint seeks damages of $413,000; however, counsel for the plaintiff have advised Porta that additional plaintiffs may be added and, as a result, the amount of damages claimed may be substantially greater than the amount presently claimed. Porta believes that the defendants have valid defenses to the claims. Discovery is proceeding.
In December 1999, Porta was served with a request for arbitration for commissions allegedly owed to a former sales representative. Porta terminated its sales representative agreement in July 1999. The request for arbitration alleges that Porta's termination of the agreement was improper and that the representative is entitled to be paid damages based on the commissions he allegedly would have received for an indefinite term beginning August 1999. Additionally, the request for arbitration alleges that the representative was not paid for certain unspecified commissions that he was supposedly entitled to receive during the period from February 1, 1986 through July 31, 1999. The request for arbitration does not specify the precise amount of damages, but estimates damages approximating $500,000. The arbitration is in its earliest stages and Porta intends to defend it vigorously.
(21) Cash Flow Information
(1) Supplemental cash flow information for the years ended December 31, is as follows:
1999 1998 1997 ------ ----- ----- Cash paid for interest $3,117 2,629 2,757 ====== ===== ===== Cash paid for income taxes $ 379 223 117 ====== ===== =====
(2) Non-cash transactions:
(i) During 1998 and 1997, the Company exchanged approximately $250,000 and $410,000 principal amount of its Debentures, net of unamortized discount and accrued interest, for 5,000 and 8,000 shares of common stock, and $192,000 and $315,000 of Notes, respectively (note 7).
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
(ii) During 1998 and 1997, the Company issued 53,000 and 6,412,000 shares of common stock, respectively, upon the conversion of Notes valued at approximately $280,000 and $34,000,000, respectively (note 7).
(iii) During 1998, the Company issued 330,000 shares of common stock upon the conversion of $1,260,000 of Debentures (note 7)
(iv) During 1998, the Company issued 147,000 shares of common stock valued at approximately $500,000 to satisfy a portion of the final settlement of a class action lawsuit (note 10).
(v) In connection with the November 1997 extension of the Company's credit facility with its senior lender, the Company amended the terms of previously issued warrants to purchase common stock to reduce the exercise price. The value of the reduction in the exercise price, approximately $45,000 was recorded as deferred financing and additional paid in capital.
(vi) In connection with advisory services provided in 1997 by an investment banking firm, the Company issued 120,000 shares of common stock in 1998 valued at approximately $340,000 and warrants to purchase 400,000 shares of common stock valued at approximately $160,000 were issued in 1997 (notes 7 and 10).
(vii) In 1998, in connection with the subordinated notes, the Company issued Series B and Series C Warrants, which were valued at $630,000 and were recorded as part of additional paid in capital and original issue discount (note 8).
(viii) In 1999, in connection with advisory services provided by an investment banking firm, the Company issued 150,000 shares of common stock valued at approximately $113,000 (notes 7 and 10).
(ix) In 1999, in connection with the amendment to the subordinated notes, Porta reduced the exercise price of the Series B and Series C Warrants, which was valued at $56,000 and recorded as part of additional paid in capital and debt discount (note 8).
(22) Segment and Geographic Data
Porta has three reportable segments: Line Connection and Protection Equipment ("Line") whose products interconnect copper telephone lines to switching equipment and provides fuse elements that protect telephone equipment and personnel from electrical surges; Operating Support Systems ("OSS") whose products automate the testing, provisioning, maintenance and administration of communication networks and the management of support personnel and equipment; and Signal Processing ("Signal") whose products are used in data communication devices that employ high frequency transformer technology.
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
The factors used to determine the above segments focused primarily on the types of products and services provided, and the type of customer served. Each of these segments is managed separately from the others, and management evaluates segment performance based on operating income.
1999 1998 1997 ------------ ----------- ---------- Revenue: Line $ 18,189,000 24,291,000 23,753,000 OSS 14,254,000 27,318,000 29,561,000 Signal 6,328,000 7,539,000 8,280,000 ------------ ----------- ---------- $ 38,771,000 59,148,000 61,594,000 ============ =========== ========== Segment profit: Line $ 3,582,000 6,580,000 7,091,000 OSS (10,650,000) (365,000) 634,000 Signal 1,884,000 1,953,000 2,325,000 ------------ ----------- ---------- $ (5,184,000) 8,168,000 10,050,000 ============ =========== ========== Depreciation and amortization: Line $ 505,000 722,000 831,000 OSS 881,000 1,170,000 1,850,000 Signal 199,000 200,000 215,000 ------------ ----------- ---------- $ 1,585,000 2,092,000 2,896,000 ============ =========== ========== Total identifiable assets: Line $ 7,921,000 10,330,000 9,329,000 OSS 21,637,000 28,283,000 25,018,000 Signal 7,965,000 8,176,000 8,273,000 ------------ ----------- ---------- $ 37,523,000 46,789,000 42,620,000 Capital expenditures: ============ =========== ========== Line $ 415,000 280,000 277,000 OSS 670,000 283,000 97,000 Signal 27,000 93,000 12,000 ------------ ----------- ---------- $ 1,112,000 656,000 386,000 ============ =========== ==========
(Continued)
PORTA SYSTEMS CORP. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued
The following table reconciles segment totals to consolidated totals:
The following table presents information about the Company by geographic area:
1999 1998 1997 ----------- ---------- ---------- Revenue: United States $14,368,000 18,951,000 17,980,000 United Kingdom 15,673,000 20,441,000 18,640,000 Asia/Pacific 4,159,000 7,181,000 10,278,000 Other Europe 3,130,000 3,377,000 10,587,000 Latin America 1,257,000 7,463,000 2,429,000 Other North America 296,000 1,879,000 1,289,000 Other 53,000 51,000 1,027,000 ----------- ---------- ---------- Consolidated total revenue $38,936,000 59,343,000 62,230,000 =========== ========== ========== Consolidated long-lived assets: United States $12,011,000 12,317,000 13,044,000 United Kingdom 2,398,000 2,520,000 2,776,000 Other North America 618,000 663,000 650,000 Asia/Pacific 200,000 273,000 245,000 Latin America 35,000 26,000 0 Other 8,000 11,000 11,000 ----------- ---------- ---------- 15,270,000 15,810,000 16,726,000 Current and other assets 28,178,000 36,326,000 34,274,000 ----------- ---------- ---------- Consolidated total assets $43,448,000 52,136,000 51,000,000 =========== ========== ========== | 20,558 | 135,148 |
310568_1999.txt | 310568_1999 | 1999 | 310568 | ITEM 1. BUSINESS --------
INTRODUCTION - ------------
Microsemi Corporation (the "Company") was incorporated in Delaware in 1960. Its name was changed from Microsemiconductor Corporation in February 1983. The principal executive offices of the Company are located at 2830 South Fairview Street, Santa Ana, California 92704 and its telephone number is (714) 979-8220. Unless the context otherwise requires, the "Company" and "Microsemi" refer to Microsemi Corporation and its consolidated subsidiaries.
Microsemi Corporation is a global supplier of power management, power conditioning, transient suppression and RF/Microwave semiconductor devices. It serves the satellite, telecommunications, computer and peripherals, military/aerospace, industrial/commercial, and medical markets with high- reliability and analog integrated circuits and power and signal discrete semiconductors.
IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS - ----------------------------------------------------------------------------
This Form 10-K contains certain forward-looking statements that are based on current expectations and involve a number of risks and uncertainties. All of the non-historical information herein is forward-looking. The forward-looking statements included herein and elsewhere in this filing are based on, among other items, current assumptions that the Company will be able to meet its current operating cash and debt service requirements with internally generated funds and its available line of credit, that it will be able to successfully resolve disputes and other business matters as anticipated, that competitive conditions within the semiconductor, integrated circuit and custom diode assembly industries will not change materially or adversely, that the Company will retain existing key personnel, that the Company's forecasts will reasonably anticipate market demand for its products, and that there will be no materially adverse change in the Company's operations or business. Other factors that could cause results to vary materially from current expectations are discussed elsewhere in this Form 10-K. (See Part I, Item 3; and Part II, Items 5, 7 and 8). Assumptions relating to the foregoing involve judgments that are difficult to predict accurately and are subject to many factors that can materially affect results. Forecasting and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause the Company to alter its forecasts, which may in turn affect the Company's results. In light of the factors that can materially affect the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. Readers are cautioned against undue weight to forward-looking statements.
PRODUCTS - --------
Microsemi Corporation is a global supplier of commercial and high-reliability analog integrated circuits and power and signal discrete semiconductors serving the satellite, telecommunications, computer and peripherals, military/aerospace, industrial/commercial, and medical markets.
The Company's analog and mixed-signal integrated circuit ("IC") products offer light, sound and power management for desktop and mobile computing platforms as well as other power control applications. Power management generally refers to a class of standard linear integrated circuits ("SLICs") which perform voltage regulation and reference in most electronic systems. The definition of power management has broadened in recent years to encompass other devices and modules, often application specific standard products ("ASSPs"), which address particular aspects of power management, such as audio or display related ICs. This business is composed of both a core platform of traditional SLICs, such as low dropout regulators ("LDOs") and pulse width modulators ("PWMs"), and differentiated ASSP products such as backlight inverters, audio amplification ICs and small computer standard interface ("SCSI") terminators.
Major discrete products are silicon rectifiers, zener diodes, low leakage and high voltage diodes, temperature compensated zener diodes, transistors and a family of subminiature high power transient suppressor diodes. The Company also manufactures discrete semiconductors for commercial applications,
such as automatic surge protectors, transient suppressor diodes used for telephone applications and computer switching diodes used in computer systems.
A partial list of applications of the Company's discrete semiconductor products includes: heart pacer transient shock protector diodes (where the Company believes it is the leading supplier in that market), low leakage diodes, transistors used in jet aircraft engines and high performance test equipment, high temperature diodes used in oil drilling sensing elements operating at 200 degrees centigrade, temperature compensated zener or rectifier diodes used in missile systems, power transistors and other electronic systems. The Company's integrated circuit products are used in computer and data storage, lighting, automotive, telecommunications, test instruments, defense and space equipment, high-quality sound reproduction and data transfer.
The Company currently serves a broad group of customers including Motorola, Lockheed-Martin, Boeing, Hughes, Medtronic, Alcatel, Samsung, Lucent Technologies, Bosch Telecom, Compaq, 3-Com and Recotron.
MARKETING - ---------
Microsemi Corporation is a global supplier of power management, power conditioning, transient suppression and RF/Microwave semiconductor products. It serves the satellite, telecommunications, computer and peripherals, military/aerospace, industrial/commercial, and medical markets with high- reliability and commercial analog integrated circuits and power and signal discrete semiconductors.
The Company's products are marketed through domestic electronic component sales representatives and the Company's inside sales force to original equipment manufacturers. The Company also employs industrial distributors to service its customers' needs for standard catalog products. For fiscal year 1999, the Company's domestic sales accounted for approximately 65% of the Company's revenues, of which sales representatives and distributors accounted for approximately 30% and 24%, respectively. The Company has direct sales offices in many metropolitan areas including Los Angeles, Garden Grove, Santa Ana, Phoenix, Denver, Chicago, Minneapolis, Montgomeryville, Boston, Long Island, West Palm Beach, Hong Kong, Singapore and Ireland. Sales to foreign customers, made through the Company's direct domestic sales force and 26 overseas sales representatives and distributors, accounted for approximately 35% of fiscal year 1999 sales.
No one customer accounted for more than 6% of the Company's revenue in fiscal year 1999. However, approximately 28% of the Company's business is to customers whose principal sales are to the U.S. Government.
RESEARCH AND DEVELOPMENT - ------------------------
The Company believes that continuing timely development and introduction of new products are essential to maintaining its competitive position. The Company currently conducts most of its product development effort in-house. The Company also employs outside consultants to assist with product design.
The Company spent approximately $4,002,000, $1,532,000 and $1,161,000 in fiscal years 1999, 1998 and 1997, respectively, for research and development, none of which was customer sponsored.
The principal focus of the Company's research and development activities has been to improve processes and to develop new products that support the growth of its businesses.
MANUFACTURING AND SUPPLIERS - ---------------------------
The Company's principal domestic manufacturing operations are located in Santa Ana and Garden Grove, California; Broomfield, Colorado; Scottsdale, Arizona and Watertown, Massachusetts. Each operates its own wafer processing, assembly, testing and screening departments.
The Company's domestic plants manufacture and process all products and assemblies starting from purchased silicon wafers and piece parts. Manufacturing and processing operations are controlled in accordance with military as well as other rigid commercial and industrial specifications.
A major portion of the Company's semiconductor manufacturing effort takes place after the semiconductor is assembled. Parts are tested a number of times, visually screened and environmentally subjected to shock, vibration, "burn in" and electrical tests in order to prove and assure reliability.
The Company purchases silicon wafers, other semiconductor materials and packaging piece parts from domestic and foreign suppliers generally on long-term purchase commitments which are cancelable with 30 to 90 days notice. With the exception of glass sleeves for high reliability diode products and glass to metal sealed parts for computer diode and zener diode products, all materials are available from multiple sources. In the case of sole source items, the Company has never suffered production delays as a result of vendors' inability to supply the parts. The Company believes that it stocks adequate supplies for all materials, based upon backlog, delivery lead time and anticipated new business. In the ordinary course of business, the Company enters into purchase agreements with some of its major suppliers to supply products over periods of up to 18 months.
The Company also purchases a portion of its finished wafers from foundry sources. If a foundry were to terminate its relationship with the Company, or should the Company's supply from a foundry be interrupted or terminated for any reason, such as a natural disaster or another unforeseen event, the Company may not have sufficient time to replace the supply of products manufactured by that foundry.
Certain subcontract suppliers provide packaging and testing for the Company's products necessary to deliver finished products. The Company pays those suppliers for assembled or fully tested products meeting predetermined specifications. After wafer level testing, the silicon wafers are separated into individual dice that are then assembled into packages and tested in accordance with the Company's test procedures.
There can be no assurance that the Company will obtain sufficient supply of product from foundry or subcontract assembly sources to meet customer demand in the future. Obtaining sufficient foundry capacity is particularly difficult during periods of high demand for foundry services, and may become substantially more difficult if the Company's product requirements increase significantly. In addition, because the Company must order products and build inventory substantially in advance of product shipments, there is a risk that the Company will forecast incorrectly and produce excess or insufficient inventories of particular products. This inventory risk is heightened because certain of the Company's key customers place orders with short lead times.
FOREIGN OPERATIONS - ------------------
The Company conducts a portion of its operations outside the United States and its business is subject to risks associated with many factors beyond its control, such as fluctuations in foreign currency rates, instability of foreign economies and governments, and changes in U.S. and foreign laws and policies affecting trade and investment. The Company owns or leases manufacturing and assembling facilities in Ennis, Ireland; Bombay, India and Hong Kong and is a partner in a joint venture in The People's Republic of China (PRC). No assurance can be made that political and economic factors in such countries will not have material adverse effects on the assets, cash flows and results of operations of the Company.
The Company's Bombay, India facility assembles a commercial zener diode line to compete in the lower-cost commercial and consumer markets. This plant also performs subcontract coil manufacturing.
The Company's Hong Kong subsidiary, Microsemi (H.K.) Ltd., produces diode products for commercial customers. The Hong Kong subsidiary utilizes diode chips manufactured in the Company's U.S. plants and assembles, tests and finishes the products. The plant is also approved for assembly of certain military specified diodes.
The Company's Ennis, Ireland operation manufactures diodes, rectifiers, zeners, thyristors and transistors and supports the other Microsemi operations. This plant is Defense Supply Center Colombus (DSCC) approved by the U.S. government to screen high reliability product to Military Specification Standard MIL-PRF- 19500 and is also European Space Agency qualified. A trading company at this facility services European customers with products from Microsemi U.S. and Asian locations.
SALES TO FOREIGN CUSTOMERS - --------------------------
Sales to foreign customers represented approximately 35%, 23% and 22% of net sales for the 1999, 1998 and 1997 fiscal years, respectively. Foreign sales may be subject to political and economic risks, including financial or political instability, currency fluctuations, changes in the effective price of goods in local currencies, the effect of trade sanctions, embargoes, or changes in import/export regulations, tariffs and freight rates and difficulties in collecting receivables and enforcing contracts generally; any of these factors and other trade policies could adversely affect the Company's sales to foreign customers or the collection of receivables generated from such sales. Many of the Company's customers, including space customers, provide the Company minimal information on future ordering plans. Therefore, fluctuations in backlog can be unpredictable.
ORDER BACKLOG - -------------
The Company's consolidated order backlog at October 3, 1999, for delivery within twelve months, was $66,700,000, as compared to $51,000,000 at September 27, 1998. The backlog at October 3, 1999 included $12,000,000 and $2,700,000 for LinFinity Microelectronics, Inc. ("LinFinity") and Microsemi Microwave Products, Inc. ("MMP"), which were acquired in April and June 1999, respectively. The Company's backlog at any particular date may not be representative of actual sales for any succeeding period because lead times for the release of purchase orders depend upon the scheduling practices of individual customers, the delivery times of new or non-standard products can be affected by scheduling factors and other manufacturing considerations, the rate of booking new orders can vary significantly from month to month, and the possibility of customer changes in delivery schedules or cancellations of orders.
A portion of the Company's sales are to military and aerospace markets which are subject to the business risk of changes in governmental appropriations and changes in national defense policies and priorities. All of the Company's contracts with prime U.S. Government contractors contain customary provisions permitting termination at any time at the convenience of the U.S. Government or the prime contractors upon payment to the Company for costs incurred plus a reasonable profit. Certain contracts are also subject to price re-negotiation in accordance with U.S. Government sole source procurement provisions.
COMPETITION - -----------
The markets in which the Company competes are extremely competitive. The Company expects that competition will increase. The principal factors of competition in the Company's markets include performance, product features, product availability, price, quality, timing of new product introductions by the Company and its competitors and the emergence of new technologies.
The Company competes in the semiconductor market, particularly in the area of high reliability components. The Company has numerous competitors across all of its product lines. In the defense market, the Company believes that it possesses a considerable share of the market. In the commercial/industrial arena, there are numerous competitors such as Motorola, Inc., General Semiconductor, Inc., Texas Instruments, Semtech, Linear Tech, Maxim, Dallas Semiconductor, Vishay, Fairchild Semiconductor and International Rectifier, which are significantly larger than Microsemi and have greater resources and larger market shares. In addition, we have licensed technology from and to parties, which have, in certain cases, the right to use the technology to develop products competitive with ours. For instance, in a license and supply agreement with LinFinity, IMP, Inc. has the right to manufacture, market and sell a line of SCSI products through its own sales force in direct competition with LinFinity. The Company believes that it is well regarded by its customers in the high reliability area, where competition is dependent less on price and more on product reliability and performance. Commercial products are under extreme price pressure due to intense price competition. The market for analog ICs is also intensely competitive. With respect to
application-specific data communications devices, our principal competitors are Dallas Semiconductor, IMP, Inc., and Texas Instruments. In the area of integrated circuit products, because the markets are diverse and highly fragmented, we expect to encounter different competitors on different products. Our principal competitors are expected to include Linear Technology Corporation, IMP, Inc., Maxim Integrated Products, Inc., Analog Devices Inc., Dallas Semiconductor, Micrel, Motorola, National Semiconductor Corporation, Semtech, Texas Instruments and certain European and Asian manufacturers. Due to the increasing demands for analog circuits, we expect intensified competition from existing suppliers and from the entry of new competitors. Increased competition could adversely affect our financial condition or results of operations.
There can be no assurance that the Company will be able to compete successfully in the future. The Company's ability to compete successfully is dependent upon its response to the entry of new competitors, the average selling prices received for its products, changing technology and customer requirements, development or acquisition of new products, the timing of new product introductions by the Company or its competitors, continued improvement of existing products, changes in overall worldwide market and economic conditions, cost effectiveness, quality, service and market acceptance of the Company's products. Price competition in the industry is intense and may increase, which may have a material adverse effect on the Company's operating results. There can be no assurance that the Company will be able to compete successfully as to price or any of these other factors. There can be no assurance that the Company will have the financial resources, technical expertise or marketing, distribution and support capabilities to compete successfully. The Company's future success will be highly dependent upon the successful development and introduction of new products that are responsive to market needs. There can be no assurance that the Company will be able to successfully develop or market any such products.
CHANGES IN TECHNOLOGY - ---------------------
The semiconductor market is subject to changes in technologies and industry standards. To remain competitive, the Company must continue to devote resources to advance process technologies, to increase product performance, to improve manufacturing yields and to improve the mix between the Company's shipment of military and commercial product and between its high cost and low cost products. There can be no assurance that the Company's competitors will not develop new technologies that are superior to the Company's technology.
PROPRIETARY RIGHTS - ------------------
The Company generally does not rely on patent protection for any aspect of its technology. The Company believes that patents often provide only narrow protection and require public disclosure of information which may otherwise be subject to trade secret protection. The Company's reliance upon protection of some of its technology as "trade secrets" will not necessarily protect the Company from the use by other persons of its technology, or their use of technology that is similar or superior to that which is embodied in the Company's trade secrets. There can be no assurance that others will not be able to independently duplicate or exceed the Company's technology in whole or in part. No assurance can be made that the Company will be able to maintain the confidentiality of the Company's technology, dissemination of which could have an adverse effect on the Company's business. In addition, litigation may be necessary to determine the scope and the validity of the Company's proprietary rights. There can be no assurance that patents held by the Company will not be challenged, invalidated or circumvented, or that the rights granted thereunder will provide competitive advantages to the Company.
If the Company's products were found to violate a patent or other right of a third party, the Company's business could be adversely affected. In addition, the laws of certain countries in which the Company's products are or may be developed, manufactured or sold, including Hong Kong, Japan, China and Taiwan, may not protect the Company's products and intellectual property rights to the same extent as the laws of the United States.
MANUFACTURING RISKS - -------------------
The Company's manufacturing processes are highly complex, require advanced and costly equipment and are continuously being modified in an effort to improve yields and product performance. Minute impurities or other difficulties in the manufacturing process can lower yields. In addition, California and the Pacific Rim are known to contain various earthquake faults. The Company's operations could be materially adversely affected if production at any of its facilities were interrupted for any reason. There can be no assurance that the Company will not experience manufacturing difficulties in the future.
The Company subcontracts a portion of its wafer fabrication to outside foundries. There are a number of foundries which, given appropriate lead times, could meet some of our needs. However, we cannot guarantee that we will be able to meet our customers required delivery schedules. Because of the unique nature of our manufacturing processes, it would be difficult for us to arrange for independent suppliers to make wafers for us in a short period of time. If a fire, natural disaster or any other event prevents us from operating the factory for more than a few days, our revenue and financial condition could be severely impacted. We believe that we have sufficient manufacturing capacity to meet our near term plans although prolonged problems with any specific piece of equipment could cause us to miss our goals.
We purchase most of our raw materials, including silicon wafers, on a purchase order basis from a limited number of vendors. If our subcontractors or our vendors are unable to provide these services or materials in the future our relationships with our customers could be seriously affected and our revenues and financial condition could be severely damaged.
After certain wafers are fabricated and tested, they are sent to contract assembly houses to be packaged. Our integrated circuit products are packaged and tested by a limited number of third party subcontractors in Asian countries. Some of the raw materials included in these operations are obtained from sole source suppliers. Although we seek to reduce our dependence on sole and limited source suppliers both for assembly services and for materials, disruption or financial, operational, production or quality assurance difficulties at any of these sources could occur and cause us to have severe delivery problems.
EMPLOYEES - ---------
On October 3, 1999, the Company employed 1,884 persons domestically including 148 in engineering, 1,474 in manufacturing, 128 in marketing and 134 in general management and administration. Additionally, 555 persons were employed in the Company's Hong Kong, Bombay, India, and Ennis, Ireland operations. None of the Company's employees is represented by a labor union. The Company has experienced no work stoppage and believes its employee relations are good.
DEPENDENCE ON KEY PERSONNEL - ---------------------------
The Company's future performance is significantly dependent on the continued active participation of members of its current management. The Company does not have written employment contracts with its employees. Should one or more of the Company's key management employees leave or otherwise become unavailable to the Company, the Company's business and results of operations may be materially adversely affected.
PRODUCT LIABILITY - -----------------
The Company's business exposes it to potential liability risks that are inherent in the manufacturing and marketing of high-reliability electronic components for critical applications. No assurance can be made that the Company's product liability insurance coverage is adequate or that present coverage will continue to be available at acceptable costs, or that a product liability claim would not adversely affect the business or financial condition of the Company.
CHANGE OF CONTROL PROVISIONS - ----------------------------
The Company's Certificate of Incorporation, Bylaws, Shareholder Rights Plan and certain employment compensation plans contain provisions that make it more difficult for a third party to acquire, or that may discourage a third party from attempting to acquire control of the Company. In addition, as a Delaware corporation, the Company is subject to the restrictions imposed under Section 203 of the Delaware General Corporation Law which may deter the Company from engaging in certain change of control transactions with certain of its stockholders under certain circumstances.
ENVIRONMENTAL REGULATION - ------------------------
While the Company believes that it has the environmental permits necessary to conduct its business and that its operations conform to present environmental regulations, increased public attention has been focused on the environmental impact of semiconductor operations. The Company, in the conduct of its manufacturing operations, has handled and does handle materials that are considered hazardous, toxic or volatile under federal, state and local laws and, therefore, is subject to regulations related to their use, storage, discharge and disposal. No assurance can be made that the risk of accidental release of such materials can be completely eliminated. In addition, the Company operates or owns facilities located on or near real property that formerly might have been used in ways that involved such materials. In the event of a violation of environmental laws, the Company could be held liable for damages and the costs of remediation, and, along with the rest of the semiconductor industry, is subject to variable interpretations and governmental priorities concerning environmental laws and regulations. Environmental statutes have been interpreted to provide for joint and several liability and strict liability regardless of actual fault. There can be no assurance that the Company and its subsidiaries will not be required to incur costs to comply with, or that the operations, business, or financial condition of the Company will not be adversely affected by, current or future environmental laws or regulations. (See "Legal Proceedings")
RISKS RELATED TO ACQUISITIONS - ------------------------------
The Company's strategy to increase its revenue and the markets it serves has included and may continue to include acquisition of complementary businesses. In and prior to fiscal year 1999 the Company has consummated acquisitions of businesses and product lines and may continue to make acquisitions. There can be no assurance that the Company will be able to identify, acquire or manage such companies or products or successfully integrate such operations into those of the Company without encountering unanticipated costs, liabilities, obligations, delays or other problems. The Company may compete for acquisition and expansion opportunities with companies that have greater resources than the Company. There can be no assurance that suitable acquisition candidates will be available or that acquisitions will be obtainable on terms acceptable to the Company.
ITEM 2.
ITEM 2. PROPERTIES ----------
The Company's headquarters are located in a building complex located in Santa Ana, California. This complex contains general offices, engineering and manufacturing space. The Company owns office, engineering and production facilities in Santa Ana and Garden Grove, California; Broomfield, Colorado; Watertown, Massachusetts; Montgomeryville, Pennsylvania; Riviera Beach, Florida; Ennis, Ireland; Bombay, India; and Hong Kong and leases office, engineering and production facilities in Scottsdale, Arizona and Lawrence and Lowell, Massachusetts. As described in Note 7 to the Consolidated Financial Statements, the acquisitions of land, buildings and additions in Santa Ana and Broomfield were accomplished through the issuance of Industrial Development Bonds. Deeds of trust on the related properties were granted as security for the bonds.
The Company believes that its existing facilities are well-maintained and in good operating condition and that they are adequate for its immediately foreseeable business needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS -----------------
In Broomfield, Colorado, the owner of a property located adjacent to the manufacturing facility owned by a subsidiary of the Company filed suit against the subsidiary and other parties, claiming that contaminants migrated to his property, thereby diminishing its value. In August 1995, the subsidiary, together with the former owners of the manufacturing facility, agreed to settle the claim and to indemnify the owner of the adjacent property from remediation costs. Although TCE and other contaminants previously used at the facility are present in soil and groundwater on the subsidiary's property, the Company vigorously contests any assertion that the subsidiary is the cause of the contamination. In November 1998, the Company signed an agreement with three former owners of this facility whereby the former owners 1) reimbursed the Company for $530,000 of past costs, 2) will assume responsibility for 90% of all future clean-up costs, and 3) indemnify and protect the Company against any and all third-party claims relating to the contamination of the property. State and local agencies in Colorado are reviewing current data and considering study and cleanup options, and it is not yet possible to predict costs for remediation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ---------------------------------------------------
None.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS --------------------------------------------------------------------
(a) Market Information ------------------
The Company's Common Stock is traded on the NASDAQ National Market under the symbol MSCC. The following table sets forth the high and low closing prices at which the Company's Common Stock traded as reported on the NASDAQ National Market.
HIGH LOW -------- -------- Fiscal Year ended October 3, 1999
1st Quarter $ 12 5/8 $ 7 3/8 2nd Quarter 12 3/4 7 3rd Quarter 9 7/8 7 1/4 4th Quarter 10 3/16 7 1/16
HIGH LOW -------- -------- Fiscal Year ended September 27, 1998
1st Quarter $17 3/4 $13 7/8 2nd Quarter 22 15 1/2 3rd Quarter 16 1/2 9 9/16 4th Quarter 11 1/2 6 5/8
POSSIBLE VOLATILITY OF STOCK PRICES -----------------------------------
The market prices of securities issued by technology companies, including the Company, have been volatile. The securities of many technology companies have experienced extreme price and volume fluctuations, which have often been not necessarily related to the companies' respective operating performances. Quarter to quarter variations in operating results, changes in earnings estimates by analysts, announcements of technological innovations or new products, announcements of major contract awards, events involving other companies in the industry and other events or factors may have a significant impact on the market price of the Company's Common Stock.
(b) Approximate Number of Common Equity Security Holders ----------------------------------------------------
Approximate Number of Record Holders Title of Class (as of October 3, 1999) -------------- ----------------------- Common Stock, $.20 Par Value 465 (1)
(1) The number of stockholders of record includes the beneficial holders of shares held in one "nominee" or "street name", as a unit.
(c) Dividends ---------
The Company has not paid dividends in the last five years and has no current plans to do so.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA -----------------------
In fiscal year 1999, $4,002,000 of Research and Development was included in operating expenses. Research and Development of $1,532,000, $1,161,000, $1,020,000, $755,000 for fiscal years 1998, 1997, 1996 and 1995 have been reclassified from cost of sales to operating expenses accordingly.
The selected financial data should be read in conjunction with the Consolidated Financial Statements and Notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND --------------------------------------------------------------- RESULTS OF OPERATIONS ---------------------
See Part I, Item 1, under "Important Factors Related to Forward-Looking Statements and Associated Risks", and the factors discussed in Part I, Items 1 and 3, and Part II, Item 5.
RESULTS OF OPERATIONS FOR THE FISCAL YEAR 1999 COMPARED TO THE FISCAL YEAR 1998. - --------------------------------------------------------------------------------
Net sales for fiscal year 1999 increased $20,371,000 to $185,081,000, from $164,710,000 for fiscal year 1998. The total revenues included $27,297,000 from the LinFinity Microelectronics, Inc. ("LinFinity") and Microsemi Microwave Products ("MMP") divisions, which were acquired in April and June 1999, respectively. Excluding sales from LinFinity and MMP, sales for the current fiscal year decreased $6,926,000 compared to last year. During fiscal 1999, the demand for commercial space products was lower than prior years; however, the decrease was partially offset by an increase in other commercial products.
Gross profit decreased $6,415,000 to $40,870,000 for the current fiscal year from $47,285,000 for the prior year. Gross profit in the current fiscal year included $8,518,000 from the LinFinity and MMP divisions. As a percentage of sales, gross profit decreased to 22.1% for fiscal year 1999 from 28.7% for fiscal year 1998. The decrease was due to change of product sales mix, with lower sales of commercial space products, which typically have higher margins than other commercial products, the effects of pricing pressure and lower utilization of plant capacity. Gross profit was also adversely affected by a $5,951,000 inventory charge to cost of sales. The charge was made because of reductions in estimates of utilization and realizable value of certain inventories resulted from recent changes in market conditions and customer requirements. The Company has experienced heightened competition and commercialization of its military business, lower demands for its commercial satellite products and recent initiatives by satellite customers to use lower cost parts in their programs.
Operating expenses increased $8,955,000 to $35,781,000 for fiscal year 1999 compared to fiscal year 1998. The increase was primarily due to the addition of the LinFinity and MMP divisions and two design centers located in San Jose and San Diego, California. The increase was also due in part to the charge for acquired in-process research and development of $1,950,000, which was related to the LinFinity acquisition in April 1999.
Interest expense increased $964,000 to $3,112,000 for fiscal year 1999 from $2,148,000 in fiscal year 1998, due to increase in borrowings to finance the acquisitions.
The effective income tax rates of 23% and 38% for fiscal years 1999 and 1998, respectively, were the combined results of taxes computed on foreign and domestic income. The decrease in the fiscal year 1999 effective tax rate was primarily attributable to changes in the proportion of income earned within various taxing jurisdictions and the tax rates applicable to such taxing jurisdictions, benefit of Foreign Sales Corporation, and the benefit of tax credits.
RESULTS OF OPERATIONS FOR THE FISCAL YEAR 1998 COMPARED TO THE FISCAL YEAR 1997. - --------------------------------------------------------------------------------
Net sales for fiscal year 1998 increased $1,476,000 to $164,710,000, from $163,234,000 for fiscal year 1997. The total revenues included $16,000,000 generated by GMI, PPC and BKC in fiscal year 1998. Revenues generated by GMI in fiscal year 1997 were $13,500,000. During fiscal year 1998, the demand for commercial space products was lower than in prior years; however, the decrease was partially offset by an increase in other commercial products, and military sales.
Gross profit increased $1,325,000 to $47,285,000 for the fiscal year 1998 from $45,960,000 for the prior year due to higher sales. As a percentage of sales, gross profit increased to 28.7% for fiscal year 1998 from 28.2% for fiscal year 1997. The increase was primarily due to higher margin from PPC and BKC sales compared to lower margins for GMI sales in fiscal year 1997.
Operating expenses increased $3,385,000 to $26,826,000 for fiscal year 1998 compared to fiscal year 1997. The increase was primarily due to the addition of PPC and BKC, partially offset by the decrease in operating expenses from GMI, which was sold in December 1997.
Interest expense decreased $1,536,000 to $2,148,000 for fiscal year 1998 from $3,684,000 in fiscal year 1997, due to lower borrowings, principally due to the conversions of debentures and notes payable into shares of common stock.
The effective income tax rates of 38% and 40% for fiscal years 1998 and 1997, respectively, were the combined results of taxes computed on foreign and domestic income. The decrease in the fiscal year 1998 effective tax rate was primarily attributable to expected changes in the proportion of income earned within various taxing jurisdictions and the tax rates applicable to such taxing jurisdictions.
CAPITAL RESOURCES & LIQUIDITY - -----------------------------
Cash provided by operating activities was $16,130,000, $12,569,000 and $15,587,000 for fiscal years 1999, 1998 and 1997, respectively. The increase in cash provided by operating activities in 1999 compared to 1998 was primarily attributable to changes in earnings and inventories. The decrease in cash provided by operating activities in 1998 compared to 1997 was primarily attributable to increase in inventories and a decrease in accounts payable.
Net cash used by investing activities was $40,339,000, $15,616,000 and $11,253,000 in 1999, 1998 and 1997, respectively. The increase in fiscal year 1999, compared to fiscal year 1998, was primarily due to the acquisitions of LinFinity and MMP. The increase in fiscal year 1998, compared to fiscal year 1997, was primarily due to the acquisition of BKC; partially offset by the sale of GMI.
Net cash provided by financing activities in 1999 was $22,273,000 and $6,681,000 for fiscal years 1999 and 1998, respectively. Net cash used in financing activities was $2,231,000 in fiscal year 1997. The net cash provided by financing activities in fiscal years 1999 and 1998 was proceeds from the bank loans to finance the acquisitions; partially offset by payments of the Company's debt. The net cash used in financing activities in fiscal year 1997 was primarily a result of payments on the Company's debt.
Microsemi Corporation's operations in the fiscal year 1999 were funded with internally generated funds and borrowings under the Company's revolving line of credit, which expires in March 2003. Under this line of credit, the Company can borrow up to $30,000,000. As of October 3, 1999, $18,500,000 was borrowed under this credit facility. At October 3, 1999, the Company had $7,624,000 in cash and cash equivalents.
In April 1999, the Company obtained a new credit agreement with its banks, which included a term loan of $30,000,000 and the aforementioned revolving line of credit of $30,000,000 to finance the LinFinity acquisition and to pay off the then existing term loan and revolving line of credit.
The $30,000,000 term loan is secured by substantially all of the assets of the Company. It bears an interest rate at the bank's prime rate plus .75% to 1.50% per annum or, at the Company's option, at the Eurodollar rate plus 1.75% to 2.5% per annum. The interest rate is determined by the ratio of total funded debt to Earnings before Interest expense (net of interest income), Income Taxes, Depreciation and Amortization, ("EBITDA"). It requires monthly interest payments and quarterly principal payments of $1,000,000 from June 1999 to March 2000, $1,500,000 from June 2000 to March 2001, $2,000,000 from June 2001 to March 2002 and $3,000,000 from June 2002 to March 2003. As of October 3, 1999, $18,500,000 was borrowed under this term loan. The terms of the term loan contain covenants regarding net worth and working capital and restrict payment of cash dividends or share repurchases. The Company was in compliance with the terms of the loan at October 3, 1999.
The $30,000,000 revolving line of credit expires in March 2003 and is secured by substantially all of the assets of the Company. It bears interest at the bank's prime rate plus .75% to 1.50% per annum or, at the Company's option, at the Eurodollar rate plus 1.75% to 2.5% per annum. The interest rate is determined by the ratio of total funded debt to EBITDA. The terms of the revolving line of credit contain covenants
regarding net worth and working capital and restricting payment of cash dividends or share repurchases. The Company was in compliance with the terms of the loan at October 3, 1999.
An Industrial Revenue Bond was issued in November 1975 through the City of Broomfield, Colorado and carries an interest rate of 7.875% per annum. The remaining balance of $2,075,000 is due in May 2000.
An Industrial Development Revenue Bond was originally issued in April 1985, through the City of Santa Ana Industrial Development Authority for the improvements and construction of new facilities at the Company's Santa Ana plant. It was remarketed in 1995 and carries an average interest rate of 6.75% per annum. The terms of the bond require principal payments of $100,000 annually from 2000 to 2004 and $3,700,000 in 2005. A $4,466,000 letter of credit is carried by a bank to guarantee the repayment of this bond. The Company pays an annual commitment fee of 2% for this letter of credit.
In June 1997, the Company entered into a $2,700,000 equipment loan agreement, providing for monthly principal payments through July 2002 of $45,000 plus interest at 5.93% per annum. $1,530,000 of this loan remained outstanding at October 3, 1999.
In September 1997, the Company issued and assumed notes payable of $2,370,000 related to the PPC acquisition. These notes are payable to the former owners, bear an interest rate of 7%, and are due in monthly installments over various periods through September 2009. $1,794,000 of these notes remained outstanding at October 3, 1999.
In April 1999, Microsemi acquired LinFinity, a subsidiary of Symmetricom, Inc. LinFinity manufactures analog and mixed signal integrated circuits ("ICs"), as well as systems-engineered modules for use primarily in power management and communication applications in commercial, industrial, defense and space markets. In the most recent twelve-month period, LinFinity had sales of approximately $51,000,000. The total cost of this acquisition was approximately $24,510,000, which was funded with cash and bank borrowings.
In June 1999, Microsemi Microwave Products, Inc., a subsidiary of the Company, acquired assets of Narda Microwave Semiconductor. The acquired assets are used in the manufacture of semiconductor components including varactor diodes, pin diodes, chip capacitors and Schottky devices. The total cost of this acquisition was $5,060,000.
In June 1999, Microsemi finalized a lease agreement for a building located in Santa Ana, California. The lease requires a current rental payment of $23,217 per month. This transaction was recorded as a purchase at the present value of the lease payments.
In September 1998, Microsemi repurchased 114,037 shares of its common stock for $840,000 that was paid in fiscal 1999. Microsemi repurchased 759,950 shares of its common stock for $6,074,000 in fiscal year 1999.
The Company has no other significant capital commitments.
Based upon information currently available, the Company believes that it can meet its current operating cash and debt service requirements with internally generated funds together with its available borrowings.
YEAR 2000 READINESS DISCLOSURE - ------------------------------
The information below constitutes a "Year 2000 Readiness Disclosure" for purposes of the Year 2000 Information and Readiness Disclosure Act.
Microsemi has made and will continue to make certain investments in its equipment and business system and application software to ensure the Company is year 2000 ("Y2K") compliant.
The Company established a global Y2K team as well as local site teams to address the issues and to ensure that all aspects of its business will be Y2K compliant. These teams were studying business system software and hardware, equipment and software used in the manufacturing of product, facilities, telecommunications and internal network. The global and the local site teams consisted of management as well as operational and information technology staff members. The global Y2K team was formed to address company-wide Y2K issues, such as overall project integration and management, project schedules and report to management. Local site teams addressed research and remediation for site-specific equipment, facilities, customers, suppliers and other business partners. The teams' responsibilities included the following functional areas: (1) factory equipment and facilities, (2) business system software, (3) desktop computers, telecommunications system and network hardware and software systems, and (4) customers, suppliers, and business partners.
Factory equipment includes automated test equipment and test data collection systems. The high reliability nature of the Company's products calls for test, test data collection and data retention. This need is generally called for in product performance specifications, such as MIL-PRF-19500. The factory and facility equipment are Y2K compliant.
The study of the impact of the internal information system (business system software) was completed. The Company had installed Y2K compliant software at all non-compliant units. This project was completed in November 1999.
Networking and telecommunication hardware and software are Y2K compliant. The Company took an inventory and replaced all necessary desktop computers. This project was completed in June 1999.
The Company surveyed its customers, suppliers, service providers and business partners, including banks and other financial institutions about their Y2K readiness. The Company's major vendors and service providers are Y2K compliant. The company believes that it has sufficient inventories to avoid business interruption due to late deliveries from its vendors. In most cases, the Company has multiple sources of supplies. The sole source supplier of the Company has sufficient supplies on hand for Microsemi.
The activities of the Company's Y2K project teams include the development of contingency plans. Due to the complexity of the Y2K issues, there can be no assurance that such plans will be sufficient to address all internal and external failures or that undetected Y2K issues will not have a material adverse effect on the Company's business, financial condition, results of operations and cash flows. The contingency plans, even if successful and effective, may result in loss of efficiencies, increased costs, and other adverse effects on the Company's business and operations.
The Company estimates that the expenses to date for the Y2K project have been approximately $1,600,000. Completion of the project is expected to require an additional expenditure of $200,000.
Microsemi believes that its Y2K project teams identified all of the Company's material Y2K issues in the course of their assessments. However, given the pervasiveness of Y2K issues and the complexity of and interrelationships among Y2K issues, both internal and external, there can be no assurance that Microsemi identified and accurately evaluated all such issues. Identification of these issues is crucial to effective remedies. Further, any undetected Y2K issues could result in material adverse effects on the Company, such as failure to efficiently utilize manufacturing capacity, shipping delays, loss of critical data, disrupted communications, product defects, inventory write-offs, waste of inventory and supplies, personal injury, difficulties in managing its operations, errors in accounting, and such indirect adverse effects as claims by third parties against the Company that may relate thereto. In addition, if Y2K problems experienced by any
of the Company's significant customers, suppliers, public utilities, service providers or business partners cause or contribute to delays or interruptions in placing orders, or in delivery of products or services to the Company, or in collection of receivables, or in interruptions in the Company's electrical or telecommunications utilities, such delays or interruptions could have a material adverse effect on the Company's business, financial condition, results of operations and cash flows. Disruption in and throughout the global economy resulting from Y2K issues may have a chain reaction and could also have materially adverse affects on the Company. The Company believes that such disruption could be likely in foreign countries, including those of Europe and Asia, whose Y2K compliance programs are believed to trail those in the United States. However, no assurance is given as to Y2K readiness in the United States, whose technological infrastructure is especially complex and interrelated. The occurrence of any of the aforementioned or other risks may have a material adverse effect on the Company's business, financial condition, results of operations and cash flows, including but not limited to such effects on the Company's foreign operations. In addition, insurance coverage for the risks described above may be unavailable or available only at prohibitive costs and the Company may be responsible itself for all of the potential adverse financial effects thereof.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA -------------------------------------------
MICROSEMI CORPORATION AND SUBSIDIARIES
-----------------------------
1. Consolidated Financial Statements Page --------------------------------- ----
Report of Independent Accountants 18
Consolidated Balance Sheets at October 3, 1999 and September 27, 1998 19
Consolidated Income Statements for each of the three fiscal years in the period ended October 3, 1999 20
Consolidated Statements of Stockholders' Equity for each of the three fiscal years in the period ended October 3, 1999 21
Consolidated Statements of Cash Flows for each of the three fiscal years in the period ended October 3, 1999 22
Notes to Consolidated Financial Statements 23
2. Financial Statement Schedule ----------------------------
Schedule for the fiscal years ended October 3, 1999, September 27, 1998 and September 28, 1997.
Schedule --------
II - Valuation and Qualifying Accounts 40
Financial statement schedules not listed above are either omitted because they are not applicable or the required information is shown in the consolidated financial statements or in the notes thereto.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Microsemi Corporation
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Microsemi Corporation and its subsidiaries at October 3, 1999 and September 27, 1998, and the results of their operations and their cash flows for each of the three fiscal years in the period ended October 3, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP Costa Mesa, California November 22, 1999
MICROSEMI CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (amounts in 000's)
The accompanying notes are an integral part of these statements.
MICROSEMI CORPORATION AND SUBSIDIARIES CONSOLIDATED INCOME STATEMENTS For each of the three fiscal years in the period ended October 3, 1999 (amounts in 000's, except earnings per share)
The accompanying notes are an integral part of these statements.
MICROSEMI CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For each of the three fiscal years in the period ended October 3, 1999 (amounts in 000's)
The accompanying notes are an integral part of these statements.
MICROSEMI CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For each of the three fiscal years in the period ended October 3, 1999 (amounts in 000's)
The accompanying notes are an integral part of these statements.
MICROSEMI CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business - -----------------------
Microsemi Corporation is a global supplier of commercial and high-reliability analog integrated circuits and power and signal discrete semiconductors serving the satellite, telecommunications, computer and peripherals, military/aerospace, industrial/commercial, and medical markets.
Fiscal Year - -----------
The Company reports results of operations on the basis of fifty-two and fifty- three week periods. The Company's 1999 fiscal year ended on October 3, 1999 and consisted of fifty-three weeks. Fiscal years 1998 and 1997 consisted of fifty- two weeks.
Principles of Consolidation - ---------------------------
The consolidated financial statements include the accounts of Microsemi Corporation and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated.
Use of Estimates - ----------------
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the respective reporting periods. Actual results could differ from those estimates.
Fair Value of Financial Instruments - -----------------------------------
The carrying values of cash, cash equivalents, accounts receivable, accrued liabilities and notes payable approximate their fair values because of the short maturity of these instruments. The carrying value of the Company's long-term debt approximates fair value based upon the current rate offered to the Company for obligations of the same remaining maturities.
Concentration of Credit Risk and Foreign Sales - ----------------------------------------------
The Company is potentially subject to concentrations of credit risk consisting principally of trade receivables. Concentrations of credit risk exist because the Company relies on a significant portion of customers whose principal sales are to the U.S. Government. In addition, sales to foreign customers represented approximately 35%, 23% and 22% of net sales for fiscal years 1999, 1998 and 1997, respectively. These sales were principally to customers in Europe and Asia. The Company maintains reserves for potential credit losses and such losses have been within management's expectations.
Investments - -----------
The Company's investments in certain unconsolidated affiliates are stated at the lower of cost or estimated net realizable value.
Inventories - -----------
Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method, except for cost of inventories at the Scottsdale, Arizona subsidiary, which cost is determined using the last-in, first-out method (see Note 2).
Property and Equipment - ----------------------
Property and equipment are stated at cost. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the lease terms or the estimated useful lives. Maintenance and repairs are charged to expense as incurred and the costs of additions and betterments that increase the useful lives of the assets are capitalized.
Intangible Assets - -----------------
Intangible assets, arising principally from differences between the cost of acquired companies and the underlying values at dates of acquisition (goodwill), are amortized on a straight-line basis over periods not exceeding ten years. It is the Company's policy to periodically evaluate the carrying value of its operating assets, including goodwill, when certain events arise and to recognize impairments when the estimated future undiscounted net operating cash flows from the use of assets are less than their carrying values.
Revenue Recognition - -------------------
Revenue is recognized at the time of product shipment. The Company, under specific conditions, permits its customers to return or exchange products. A provision for estimated sales returns is recorded concurrently with the recognition of revenue, based on historical experiences.
Research and Development - ------------------------
The Company expenses the cost of research and development as incurred. Research and development expenses principally comprise payroll and related costs and the cost of prototypes.
Stock-Based Compensation - ------------------------
The Company accounts for its stock based compensation plans under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations. The disclosures required under Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation" ("SFAS 123"), have been included in Note 8.
Income Taxes - ------------
Deferred tax assets and liabilities are recorded for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, all expected future events, including enactment of changes in tax laws or rates are considered. A valuation allowance is provided for deferred tax assets when it is more likely than not that such assets will not be realized through future operations.
Earnings Per Share - ------------------
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings Per Share". This Statement establishes standards for computing and requires the presentation of basic and diluted earnings per share ("EPS"). The company adopted this statement in the first quarter of fiscal year 1998 and has restated the EPS for the prior year periods presented, as required.
Basic earnings per share have been computed based upon the weighted average number of common shares outstanding during the respective periods. Diluted earnings per share have been computed, when the result is dilutive, using the treasury stock method for stock options outstanding during the respective periods and based upon the assumption that the convertible subordinated debentures had been converted into common stock as of the beginning of the respective periods, with a corresponding increase in net income to reflect a reduction in related interest expense, net of applicable taxes.
Earnings per share for the three fiscal years ended October 3, 1999, September 27, 1998 and September 28, 1997 were calculated as follows:
There were approximately 631,000, 442,000, and -0- options in 1999, 1998 and 1997, respectively, that were not included in the computation of diluted EPS because the exercise price was greater than the average market price of the common stock, thereby resulting in an antidilutive effect.
Comprehensive Income - --------------------
Effective in the first quarter of fiscal 1999, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for reporting and displaying of comprehensive income and its components in the Company's consolidated financial statements. Comprehensive income is defined in SFAS 130 as the change in equity (net assets) of a business enterprise during the period from transactions and other events and circumstances from non-owner sources. Accumulated other comprehensive loss consists of the change in the cumulative translation adjustment. Total comprehensive income for fiscal years 1999, 1998 and 1997 was $1,449,000, $11,153,000 and $11,034,000, respectively.
In fiscal year 1999, the Company adopted Statement of Financial Accounting Standard No. 131, "Disclosure about Segments of an Enterprise and Related Information ("SFAS 131"). SFAS 131 superseded SFAS 14, "Financial Reporting for Segments of a Business Enterprise", replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company's reportable segments. SFAS 131 also requires disclosures about products and services, geographic areas, and major customers. The adoption of SFAS 131 did not affect results of operations or consolidated financial position, but did affect the disclosure of segment information (see note 12).
Recently Issued Accounting Standard - -----------------------------------
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which will become effective for the Company in fiscal year 2001. SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. SFAS 133 is not expected to materially affect the Company's financial position or results of operations.
Reclassifications - -----------------
Certain reclassifications have been made to the fiscal year 1998 and 1997 balances to conform with the fiscal year 1999 presentation.
2. INVENTORIES
Inventories are summarized as follows:
Inventories in the amount of $9,013,000 at Microsemi Scottsdale are stated at cost under the last-in, first-out ("LIFO") method. Had the first-in, first-out method been used, total inventories would have been approximately $19,000 higher at October 3, 1999, $615,000 lower at September 27, 1998 and $27,000 higher at September 28, 1997. The LIFO valuation method had the effect of increasing gross profit by $634,000 in fiscal year 1999, decreasing gross profit by $642,000 in fiscal year 1998 and increasing gross profit by $23,000 in fiscal year 1997.
3. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
Depreciation expense was $7,423,000, $4,765,000 and $4,036,000 in fiscal years 1999, 1998 and 1997, respectively.
At October 3, 1999, land and buildings located at the Santa Ana, California manufacturing and headquarters facility were pledged to the City of Santa Ana under the provisions of the loan agreement with the Santa Ana Industrial Development Authority. The land and building of the Microsemi Colorado subsidiary were pledged to the City of Broomfield, Colorado under the provisions of the loan agreement with the Colorado Industrial Development Authority. The land and buildings in Watertown, Massachusetts and in Ennis, Ireland are pledged to Unitrode Corporation under the provisions of the related acquisition agreement. The building and land in Riviera Beach, Florida are pledged to the former owner under the provisions of the related acquisition agreement.
4. GOODWILL AND OTHER INTANGIBLE ASSETS, NET AND OTHER ASSETS
October 3, September 27, 1999 1998 ---------- ------------- (amounts in 000's)
Goodwill and other intangible assets, net $ 12,218 $ 9,729 ========== ========== Accumulated amortization for goodwill and other intangible assets amounted to $4,434,000 and $1,869,000 as of October 3, 1999 and September 27, 1998, respectively. Amortization expense for fiscal years 1999, 1998 and 1997 was $1,231,000, $393,000 and $36,000, respectively.
Other assets consisted of the following:
October 3, September 27, 1999 1998 ---------- ------------- (amounts in 000's)
Investments in unconsolidated affiliates $ 2,126 $ 1,878 Deferred financing expenses, net 693 375 Cash surrender value of life insurance 467 443 Notes receivable 2,229 2,320 Property held for sale 2,075 - Others 251 284 ---------- ---------- $ 7,874 $ 5,300 ========== ========== Accumulated amortization for deferred financing expenses amounted to $1,048,000 and $883,000 as of October 3, 1999 and September 27, 1998, respectively. Amortization expense for fiscal years 1999, 1998 and 1997 was $164,000, $123,000 and $185,000, respectively.
5. ACCRUED LIABILITIES
Accrued liabilities consisted of the following:
October 3, September 27, 1999 1998 ---------- ------------- (amounts in 000's)
Accrued payroll, profit sharing, benefits and related taxes $ 8,331 $ 8,018 Accrued interest 2,387 2,314 Other accrued expenses 6,574 4,069 ---------- ----------- $ 17,292 $ 14,401 ========== ===========
6. INCOME TAXES
Pretax income from continuing operations was taxed under the following jurisdictions:
For each of the three fiscal years in the period ended October 3, 1999 ---------------------------------------- 1999 1998 1997 ---------- ---------- ---------- (amounts in 000's)
Domestic $ 547 $ 14,010 $ 15,929 Foreign 1,394 4,251 2,577 ---------- ---------- ---------- Total $ 1,941 $ 18,261 $ 18,506 ========== ========== ==========
The provision for income taxes consisted of the following components:
For each of the three fiscal years in the period ended October 3, 1999 ----------------------------------------- 1999 1998 1997 ----------- --------- --------- (amounts in 000's) Current Federal $ 1,986 $ 4,320 $ 6,525 State 301 918 1,332 Foreign 250 490 310 Deferred (2,095) 1,211 (712) ---------- ---------- ---------- $ 442 $ 6,939 $ 7,455 ========== ========== ==========
The tax effected deferred tax assets (liabilities) comprise the following:
October 3, 1999 September 27,1998 --------------- ----------------- (amounts in 000's)
Accounts receivable $ 720 $ 1,384 Inventories 4,946 418 Other assets 1,506 1,434 Fixed asset bases 931 1,007 Accrued employee benefit expenses 1,371 2,417 Accrued other expenses 1,393 2,140 Amortization of intangible assets 690 - ----------- ------------ Gross deferred tax assets 11,557 8,800 ----------- ------------
Inventory bases (1,491) (753) Depreciation (1,922) (1,998) ----------- ------------ Gross deferred tax liabilities (3,413) (2,751) ----------- ------------ $ 8,144 $ 6,049 =========== ============
The following is a reconciliation of income tax computed at the federal statutory rate to the Company's actual tax expense:
No provision has been made for future U.S. income taxes on the undistributed earnings of foreign operations since they have been, for the most part, indefinitely reinvested in these operations. Determination of the amount of unrecognized deferred tax liability for temporary differences related to the undistributed earnings of the Company's foreign operations is not practicable. At the end of fiscal year 1999, the undistributed earnings aggregated approximately $19,725,000.
7. DEBT
Long-term debt consisted of:
Long-term debt maturities, including the current portion, during the next five years are as follows (amounts in 000's):
2000 $ 8,422 2001 8,224 2002 11,070 2003 6,202 2004 212 Thereafter 5,673 --------------- $ 39,803 ===============
A $4,150,000 Industrial Revenue Bond was issued in November 1975 through the City of Broomfield, Colorado and carries an interest rate of 7.875% per annum. The balance of $2,075,000 is due in May 2000.
A $6,500,000 Industrial Development Revenue Bond was originally issued in April 1985, through the City of Santa Ana, California for the construction of improvements and new facilities at the Company's Santa Ana plant. $4,200,000 of this loan remained outstanding at October 3, 1999. It was remarketed in 1995 and carries an average interest rate of 6.75% per annum. The terms of the bond require principal payments of $100,000 annually from 2000 to 2004 and $3,700,000 in 2005. A $4,466,000 letter of credit is carried by a bank to guarantee the repayment of this bond. There are no compensating balance requirements. An annual commitment fee of 2% is charged on this letter of credit. In addition, the agreement contains covenants regarding net worth and working capital. The Company was in compliance with the aforementioned covenants at October 3, 1999.
In June 1997, the Company entered into a $2,700,000 equipment loan agreement, providing for monthly principal payments through July 2002 of $45,000 plus interest at 5.93% per annum. $1,530,000 of this loan remained outstanding at October 3, 1999. This loan is secured by the related equipment.
In September 1997, the Company issued and assumed notes payable of $2,370,000 related to the PPC acquisition. These notes are payable to the former owners, bear an interest rate of 7%, and are due in monthly installments of principal and interest over various periods through September 2009. $1,794,000 of these notes remained outstanding at October 3, 1999. One of these notes is secured by the related acquired building.
In June 1998, the Company finalized an amendment to its then-existing bank credit facility, which added a $10,000,000 term loan. $9,667,000 of this loan was outstanding at September 27, 1998, used by Microsemi to finance a portion of the BKC acquisition. This term loan was paid in full when the Company obtained new credit arrangements with its banks in April 1999.
In April 1999, the Company obtained a new credit agreement with its banks, which included a term loan of $30,000,000 and a revolving line of credit of $30,000,000 to finance the acquisition of LinFinity Microelectronics, Inc. ("LinFinity"), a subsidiary of Symmetricom, Inc., and to pay off the existing term loan and the revolving line of credit.
The new $30,000,000 term loan, $28,000,000 of this loan remained outstanding at October 3, 1999, is secured by substantially all of the assets of the Company. It bears interest at the bank's prime rate plus .75% to 1.5% per annum or, at the Company's option, at the Eurodollar rate plus 1.75% to 2.5% per annum. The interest rate is determined by the ratio of total funded debt to Earnings before Interest Expense (net of interest income), Income Taxes, Depreciation and Amortization ("EBITDA"). It requires monthly interest payments and quarterly principal payments of $1,000,000 from June 1999 to March 2000, $1,500,000 from June 2000 to March 2001, $2,000,000 from June 2001 to March 2002 and $3,000,000 from June 2002 to March 2003. The terms of the term loan contain covenants regarding net worth and working capital and restricting payment of cash dividends or share repurchases. The Company was in compliance with these covenants at October 3, 1999.
Concurrent with the new term loan, the Company obtained a new $30,000,000 revolving line of credit, which expires in March 2003. This line of credit replaced its then-existing $15,000,000 credit line. The new line of credit is secured by substantially all of the assets of the Company. It bears interest at the bank's prime rate plus .75% to 1.5% per annum or, at the Company's option, at the Eurodollar rate plus 1.75% to 2.5% per annum. The interest rate is determined by the ratio of total funded debt to EBITDA. The terms of the revolving line of credit contain covenants regarding net worth and working capital and restricting payment of cash dividends or share repurchases. The Company was in compliance with these covenants at October 3, 1999. At October 3, 1999, interest rate of the line of credit was 7.94% and $18,500,000 was outstanding. At October 3, 1999, $7,100,000 was available under the line of credit.
Other debts consist of various loans bearing interest at ranges from 5% to 9.75% and require periodic principal payments through September 2014. At October 3, 1999, totals of $2,204,000 remained outstanding for these loans.
The Company occupies a building in Santa Ana, California, which is under a long- term capital lease obligation and included in other long-term liabilities at October 3, 1999. Future annual payments due under this capital lease obligation are as follows (amounts in 000's):
2000 279 2001 279 2002 279 2003 279 2004 279 Thereafter 6,870 ------ Total minimum lease payments 8,265 Less imputed interest (5,100) ------ Present value of capitalized lease obligation 3,165 ======
The building under this capital lease obligation is reflected in property and equipment, net.
8. STOCK OPTIONS AND EMPLOYEE BENEFIT PLANS
Stock Options - -------------
Under the terms of an incentive stock option plan adopted in fiscal year 1982 and amended in fiscal year 1985, nontransferable options to purchase common stock may be granted to certain key employees. The Company reserved 750,000 shares for issuance under the terms of the plan. The options may be exercised within ten years from the date they are granted, subject to early termination upon death or cessation of employment, and are exercisable in installments determined by the Board of Directors. For certain significant shareholders, the exercise period is limited to five years and the exercise price is higher.
In December 1986, the Board of Directors adopted another incentive stock option plan (the "1987 Plan") which reserved an additional 750,000 shares of common stock for issuance. The 1987 Plan was approved by the shareholders in February 1987 and is for the purpose of securing for the Company and its shareholders the benefits arising from stock ownership by selected officers, directors and other key executives and management employees. The plan provides for the grant by the Company of stock options, stock appreciation rights, shares of common stock or cash. As of October 3, 1999, the Company only granted options under the 1987 Plan. The options may be exercised within ten years from the date they are granted, subject to early termination upon death or cessation of employment, and are exercisable in installments determined by the Board of Directors. For certain significant shareholders, the exercise period is limited to five years and the exercise price is higher.
At their annual meeting on February 25, 1994, the shareholders approved several amendments to the 1987 Plan which 1) extend its termination date to December 15, 2000; 2) increase initially from 750,000 to 850,000 the number of shares available for grants; 3) increase on the first day of each fiscal year, the number of shares available for grant in increments of 2% of the Company's issued and outstanding shares of common stock; 4) set a limit on the number of options or shares which may be granted to any one
individual in any year; 5) eliminate limitations on the Board of Directors' designating one or more committees of any size or composition to administer the 1987 Plan; and 6) provide for automatic grants of stock options to non-employee directors.
Activity and price information regarding the plans are as follows:
Stock Options --------------------------------- Shares Average Price ------------ -------------
Outstanding September 29, 1996 740,515 $ 4.48 ============
Granted 191,300 $ 11.45 Exercised (227,551) $ 1.97 ------------
Outstanding September 28, 1997 704,264 $ 7.12 ============
Granted 189,500 $ 15.84 Exercised (191,669) 4.31 Expired or canceled (64,705) $ 10.05 ------------
Outstanding September 27, 1998 637,390 $ 10.44 ============
Granted 416,000 $ 10.06 Exercised (13,688) 3.76 Expired or canceled (66,075) $ 10.81 ------------
Outstanding October 3, 1999 973,627 $ 10.35 ============
Stock options exercisable were 453,240, 263,590 and 308,164 at October 3, 1999, September 27, 1998 and September 28, 1997, respectively, at weighted average exercise prices of $10.40, $7.24 and $4.34, respectively. Remaining shares available for grant at October 3, 1999, September 27, 1998 and September 28, 1997 under the plans were 203,000, 308,000 and 262,000, respectively. All options were granted at the fair market value of the Company's shares of common stock on the date of grant.
The following table summarizes information about stock options outstanding and exercisable at October 3, 1999, as required by SFAS 123:
The Company accounts for its option plans under APB Opinion No. 25. Had compensation expense for the Company's option plans been determined based upon an estimate of the fair value at the grant date consistent with the requirements of SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts in the following table. The SFAS 123 method of accounting was not applied to options granted prior to fiscal 1996.
The fair value of each stock option grant was estimated pursuant to SFAS 123 on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
1999 1998 1997 ------------- ------------- ------------- Risk free interest rates 4.94% 5.55% 5.98% Expected dividend yield None None None Expected lives 5 years 5 years 5 years Expected volatility 67.0% 76.4% 66.6%
The weighted average grant date fair values of options granted during fiscal years 1999, 1998 and 1997 were $10.06, $15.84 and $11.45, respectively.
Employee Benefit Plans - ----------------------
The Microsemi Corporation Profit Sharing Plan, adopted by the Board of Directors in fiscal year 1984, covers substantially all full-time employees who meet certain minimum employment requirements and provides for current bonuses based upon the Company's earnings. Annual contributions to the plan are determined by the Board of Directors. Total charges to income were $1,745,000, $2,509,000 and $3,070,000 in fiscal years 1999, 1998 and 1997, respectively.
401(k) Plan - -----------
The Company sponsors a 401(k) Savings Plan whereby participating employees may elect to contribute up to 15% of their eligible wages. The Company is committed to match 50% of employee contributions, not exceeding 3% of the employee's wages. The Company contributed $1,148,000, $1,005,000 and $899,000 to this plan during fiscal years 1999, 1998 and 1997, respectively.
Supplemental Retirement Plan - ----------------------------
In fiscal year 1994, the Company adopted a supplemental retirement plan which provides certain long-term employees with retirement benefits based upon a certain percentage of the employees' salaries. Included in other long-term liabilities at October 3, 1999 and September 27, 1998 was $1,327,000 and $1,400,000, respectively, related to the Company's estimated liability under the plan.
9. COMMITMENTS AND CONTINGENCIES
The Company occupies premises under operating lease agreements expiring through 2029. Aggregate future minimum rental payments under these leases are (amounts in 000's):
2000 $ 1,564 2001 1,152 2002 1,046 2003 846 2004 813 Thereafter 9,403 ----------- $ 14,824 ===========
Rental expense charged to income was $182,000 in fiscal year 1999, $411,000 in fiscal year 1998, and $661,000 in fiscal year 1997. The aforementioned amounts are net of sublease income amounting to $514,000, $557,000 and $272,000 in fiscal years 1999, 1998 and 1997, respectively.
In Broomfield, Colorado, the owner of a property located adjacent to a manufacturing facility owned by a subsidiary of the Company had filed suit against the subsidiary and other parties, claiming that contaminants migrated to his property, thereby diminishing its value. In August 1995, the subsidiary, together with former owners of the manufacturing facility, agreed to settle the claim and to indemnify the owner of the adjacent property for remediation costs. Although TCE and other contaminants previously used at the facility are present in soil and groundwater on the subsidiary's property, the Company vigorously contests any assertion that the subsidiary is the cause of the contamination. In November 1998, the Company signed an agreement with three former owners of this facility whereby the former owners 1) reimbursed the Company for $530,000 of past costs, 2) will assume responsibility for 90% of all future clean-up costs, and 3) indemnify and protect the Company against any and all third-party claims relating to the contamination of the facility. State and local agencies in Colorado are reviewing current data and considering study and cleanup options, and it is not yet possible to predict costs for remediation. In the opinion of management, the final outcome of the Broomfield, Colorado environmental matter will not have a material adverse effect on the Company's financial position or results of operations.
The Company is involved in various pending litigation arising out of the normal conduct of its business, including those relating to commercial transactions, contracts, and environmental matters. In the opinion of management, the final outcome of these matters will not have a material adverse effect on the Company's financial position or results of operations.
10. ACQUISITIONS AND DISPOSITION
In December 1997, the Company sold General Microcircuits, Inc., a wholly owned subsidiary in Mooresville, North Carolina, for $5,000,000 in cash and a $2,000,000 note receivable. Microsemi did not realize any material gain or loss from this transaction.
In May 1998, the Company acquired BKC Semiconductors, Incorporated ("BKC"), located in Lawrence, Massachusetts, for approximately $13,740,000 in cash plus existing indebtedness of BKC of approximately $3,359,000. Microsemi financed this acquisition with cash on hand and advances under its existing credit facilities, as amended. BKC was a publicly held company, which manufactured discrete semiconductors. The acquisition was accounted for under the purchase method. The allocation of the purchase price to the assets and liabilities of BKC was based upon the Company's estimates of the relative values of the assets acquired and liabilities assumed. The Company recorded $9,839,000 of goodwill related to this acquisition. The Company's consolidated results of operations for the fiscal year ended September 27, 1998 included the operations of BKC since the date of acquisition. The results of operations of BKC prior to the date of acquisition were not material.
In April 1999, Microsemi acquired all of the outstanding capital stock of LinFinity Microelectronics, Inc. ("LinFinity"), a subsidiary of Symmetricom, located in Garden Grove, California. LinFinity manufactures analog and mixed signal integrated circuits ("ICs"), as well as systems-engineered modules for use primarily in power management and communication applications in commercial, industrial, defense and space markets. The purchase price was $24,125,000, which was funded with cash and bank borrowings. The Company also paid approximately $385,000 for expenses related to this acquisition. The acquisition was accounted for under the purchase method. The Company's consolidated results of operations include those of LinFinity since the date of acquisition.
The costs of the acquisition were allocated to the assets acquired and liabilities assumed based on their estimated fair values to the extent of the aggregate purchase price. Portions of the purchase price were allocated to certain intangible assets such as completed technology, customer lists, assembled workforce, and in-process research and development ("R & D"). There was no goodwill resulting from this acquisition. The allocation of the purchase price to these intangible assets was based on an independent valuation report. The amount of the purchase price allocated to in-process R & D was determined by estimating the stage of completion of each in-process R & D project at the date of acquisition, estimating cash flows resulting from the future release of products employing these technologies, and discounting the net cash flows back to their present values. At the date of acquisition, technological feasibility of the in-process R & D projects had not been reached and the technology had no alternative future uses. Accordingly, the Company expensed the portion of the purchase price allocated to in-process R & D of $1,950,000, in accordance with generally accepted accounting principles, in the year ended October 3, 1999.
The in-process R & D comprises a number of individual technological development efforts, focusing on the discovery of new, technologically advanced knowledge and more complete solutions to customers' needs, the conceptual formulation and design of possible alternatives, as well as the testing of process and product cost improvements. Specifically, these technologies included efforts regarding BiCMOS process based products, Backlight Inverters, and Audio products.
The weighted average stage of completion for all projects, in the aggregate, was approximately 82% as of the acquisition date. As of that date, the estimated remaining costs to bring the projects under development to technological feasibility are over $437,000. Cash flows from sales of products incorporating those technologies were estimated to commence in the year 2000. Revenues forecasted in each period were reduced by related expenses, capital expenditures, and the cost of working capital. The discount rate applied to the net cash flows was 29%, which reflected the level of risk associated with the particular technologies and the current return on investment requirements of the market.
As discussed above, a portion of the Linfinity purchase price was allocated to completed technology, customer lists, and assembled workforce. The total allocation approximated $2,610,000 for these other intangible assets.
These unaudited pro forma results have been prepared for comparative purposes only and include certain pro forma adjustments. Such pro forma amounts are not necessarily indicative of what actual consolidated results of operations might have been if the LinFinity acquisition had been effective at the beginning of fiscal year 1998.
Year ended Year ended October 3, 1999 September 27, 1998 --------------- ------------------
Revenues $ 211,584 $ 211,980 Cost of sales 162,939 158,245 ------------- ------------------
Gross profit 48,645 53,735 ------------- ------------------
Operating expenses 43,100 43,223 ------------- ------------------
Income from operations 5,545 10,512 Other expense 3,158 2,322 ------------- ------------------
Income before income taxes 2,387 8,190 Provision for income taxes 544 3,720 ------------- ------------------
Net income $ 1,843 $ 4,470 ============= ==================
Earnings per share: Basic $ 0.17 $ 0.42 ============= ================== Diluted $ 0.16 $ 0.37 ============= ==================
In June 1999, Microsemi Microwave Products, Inc. ("MMP"), a subsidiary of the Company, acquired, from L-3 Communications Corporation, certain assets of Narda Microwave East/Semiconductor Operation ("Narda") located in Lowell, Massachusetts. The total cost of this acquisition was approximately $5,060,000. The assets acquired are used in the manufacture of semiconductor components including varactor diodes, pin diodes, chip capacitors and Schottky devices used in telecommunications, wireless, satellite and industrial test/measurement applications. The results of operations of Narda prior to June 1999 were not material to the Company's consolidated results of operations, accordingly, a pro forma is not presented.
11. SEGMENT INFORMATION
In 1999, the Company adopted SFAS 131. The Company's reportable operating segments are based on geographic location, and the measure of segment profit is income from operations. The accounting policies of the segments are the same as those described in the summary of significant accounting policies.
The Company operates predominantly in a single industry segment as a manufacturer of discrete semiconductors. Geographic areas in which the Company operates include the United States, Ireland, Hong Kong, and India. Intergeographic sales primarily represent intercompany sales which are accounted for based on established sales prices between the related companies and are eliminated in consolidation.
Financial information by geographic segments is as follows:
12. STATEMENT OF CASH FLOWS
For purposes of the Consolidated Statements of Cash Flows, the Company considers all short-term, highly liquid investments with maturities of three months or less at date of acquisition to be cash equivalents.
13. UNAUDITED SELECTED QUARTERLY FINANCIAL DATA
Selected quarterly financial data are as follows:
For the quarter ended October 3, 1999, the Company recorded a $5,951,000 charge to cost of sales. The charge was made because of reductions in estimates of utilization and realizable value of certain inventories resulting from recent changes in market conditions and customer requirements.
MICROSEMI CORPORATION AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (amounts in 000's)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III --------
Items 10, 11, 12 and 13 are omitted since the Registrant intends to file a definitive proxy statement with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of Registrant's fiscal year ended October 3, 1999. The information required by those items is set forth in that certain proxy statement and such information is incorporated by reference in this Form 10-K.
PART IV -------
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. ----------------------------------------------------------------
(a) 1. Financial Statements. See Index under Item 8.
2. Financial Statement Schedules. See Index under Item 8.
3. Exhibits:
The exhibits which are filed with this report are listed in the Exhibit Index.
(b) Reports on Form 8-K.
None
SIGNATURES - ----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MICROSEMI CORPORATION
By /s/ DAVID R. SONKSEN --------------------- David R. Sonksen Vice President-Finance and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer and duly authorized to sign on behalf of the Registrant)
Dated: December 27, 1999
POWER OF ATTORNEY
The undersigned hereby constitutes and appoints Philip Frey, Jr. and David R. Sonksen, or either of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, to sign the report on Form 10-K and any or all amendments thereto and to file the same, with all exhibits thereto, and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in- fact, or his substitute or substitutes, may do or cause to be done by virtue hereof in any and all capacities.
Pursuant to the requirements of Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ------ ----
/s/ PHILIP FREY, JR. Chairman of the Board, December 22, 1999 - ----------------------- President and Philip Frey, Jr. Chief Executive Officer
/s/ DAVID R. SONKSEN Vice President-Finance, December 21, 1999 - ----------------------- Treasurer and Secretary David R. Sonksen (principal financial and accounting officer)
/s/ JOSEPH M. SCHEER Director December 21, 1999 - ----------------------- Joseph M. Scheer
/s/ BRAD DAVIDSON Director December 21, 1999 - ----------------------- Brad Davidson
/s/ ROBERT B. PHINIZY Director December 21, 1999 - ----------------------- Robert B. Phinizy
/s/ MARTIN H. JURICK Director December 21, 1999 - ----------------------- Martin H. Jurick
Exhibits.
EXHIBIT INDEX
Sequential Exhibit Page Number Description Number
2.1 The Agreement and Plan of Merger among the Company, Micro BKC Acquisition Corp. and BKC Semiconductors Incorporated, dated January 21, 1998, was filed with Form 8-K on June 1, 1998 under the same exhibit number and is incorporated herein by this reference (33)
2.2 Agreement and Plan of Reorganization, dated as of February 10, 1999, among the Company, Micro-LinFinity Acquisition Corporation, LinFinity Microelectronics, Inc. and Symmetricom, Inc., incorporated by reference to the same numbered exhibit to the Company's Form 8-K filed with the Securities and Exchange Commission on April 29, 1999 (34)
3 Restated Certificate of Incorporation and Bylaws of the Registrant (1)
4 Form of Indenture, including form of 5 7/8% Convertible Subordinated Debenture due 2012 (2)
4.1 Subordinated Convertible Note Purchase Agreement dated June 26, 1992 among the Registrant and the Purchasers named therein and Exhibit A hereto, a form of Subordinated Convertible Note (29)
10.1 1984 Incentive Stock Option Plan (as amended December 13, 1984) (3)
10.2 Form of Incentive Stock Option Agreement pursuant to 1984 Incentive Stock Option Plan (3)
10.3 Form of Stock Option Agreement, dated October 17, 1985, between the Registrant and members of the Registrant's Board of Directors (1)
10.5 Credit Agreement between the Registrant and Security Pacific National Bank, dated as of September 3, 1984, and First Amendment to Credit Agreement dated as of May 1, 1985 (1)
10.6 Lease dated June 29, 1982 between Ulrich Layher and MSC Phoenix, Inc. (1)
10.11 1986 Nonqualified Stock Option Plan of the Registrant (Exhibit 10.9) (5)
10.13 The Registrant's 1987 Stock Plan (6)
10.14 Indenture dated as of February 1, 1985, and related Loan Agreement and Reimbursement Agreement both dated as of February 1, 1985, relating to the Industrial
Revenue Bonds issued to finance additions to the Santa Ana facility of the Registrant (2)
10.15 Stock Sale Agreement, dated November 12, 1987 between Coors Porcelain Company and the Registrant, relating to the acquisition of Coors Components, Inc. (7)
10.16 Press Release distributed by the Registrant on November 12, 1987, announcing the acquisition of Coors Components, Inc. (7)
10.29 Subscription Agreement dated July 24, 1987 between the Registrant and Diodes Incorporated for the subscription of 800,000 shares of Diodes Incorporated (8)
10.32 Agreement of Purchase and Sale of Stock dated April 6, 1988, between General Microcircuits, Inc. and the Registrant relating to the purchase of all of the outstanding stock of General Microcircuits (9)
10.37 Stock Purchase Agreement dated as of February 17, 1989 by and between Avnet, Inc., a New York corporation, and Salem Scientific, Inc., a Microsemi Company, a Delaware corporation and a wholly-owned subsidiary of the Registrant (10)
10.48 First Amendment and Forbearance to the Registrant's Second Amended and Restated Credit Agreement dated as of November 1, 1990 (15)
10.49 Confirmation dated December 10, 1990 from Security Pacific National Bank concerning the extension of the Registrant's line of credit and standby letters of credit to February 1, 1991 (15)
10.52 Assignment and Assumption Agreement dated September 23, 1991 by and among Dynamic Circuits, Inc., a California corporation ("Dynamic"), Surface Mounted Technology Corporation, a California corporation ("SMTC") and the Registrant, pertaining to Dynamic's purchase from SMTC of the SMTC assets, together with the following supplemental documentation: (a) Letter of Intent dated August 14, 1991 (and Addendum thereto); (b) Equipment Lease Agreement; (c) Promissory Note; and (d) Security Agreement (16)
10.54 Asset Purchase Agreement dated May 28, 1992 between Micro USPD, Inc., a Delaware corporation and wholly-owned subsidiary of the Registrant ("Micro USPD"), and Unitrode Corporation, a Maryland corporation ("Unitrode") (17)
10.55 Irish Acquisition Agreement dated July 2, 1992 among Unitrode Ireland, Ltd., an Irish corporation and wholly-owned subsidiary of Unitrode; Unitrode B.V., a Dutch corporation and wholly-owned subsidiary of Unitrode; and Micro (Bermuda), Ltd., a Bermudian corporation and wholly-owned subsidiary of the Registrant ("Micro Bermuda") (18)
10.56 Dutch Acquisition Agreement dated July 2, 1992 among
Unitrode Europe B.V., a Dutch corporation and wholly-owned subsidiary of Unitrode; Unitrode; and MicroBermuda (19)
10.64 Promissory Note dated December 21, 1992 made by the Registrant and payable to Norman Wechsler in the original principal amount of $150,000 and extension letter agreement dated April 23, 1993 (21)
10.65 Waiver and First Amendment to Reimbursement Agreement dated as of January 8, 1993 between the Registrant and Bank of America NT&SA with respect to the Reimbursement Agreement (See Exhibit 10.14) dated as of February 1, 1988 (21)
10.66 Senior Note Purchase Agreement dated March 25, 1993 between the Registrant and Norman Wechsler, including as an exhibit thereto the form of Senior Promissory Note dated March 25, 1993 (21)
10.69 Letter dated August 31, 1993 from Unitrode to the Registrant providing for amendments with respect to the Asset Purchase Agreement (See Exhibit 10.54) dated May 28, 1992 between Micro USPD and Unitrode excluding exhibits as follows (22):
Amendments to Promissory Notes dated as of September 3, 1993 between Micro USPD and Unitrode and the respective Promissory Notes dated July 2, 1992 attached as exhibits thereto
10.73 Amendment to the Registrant's 1987 Stock Plan. (25)
10.74 Executive Compensation Plans and Arrangements (26).
10.75 Bill of Sales and Purchase agreement between Telcom Universal Inc. And Microsemi Corporation (6)
10.76 Supplement to financing documents (Indenture of Trust and Loan agreement) relating to Industrial Development Authority of the City of Santa Ana, 1985 Industrial Development Revenue Bonds Microsemi Corporation Project) dated as of January 15, 1995. (26)
10.77 Amendments of the 1987 Microsemi Corporation Stock Plan. Adopted on May 16, 1995. (27)
10.78 Motorola-Microsemi PowerMite Technology Agreement. Portions omitted from this Exhibit have been separately filed with the Commission pursuant to a request for confidential treatment. (28)
10.79 Revolving Line of Credit Agreement Between Microsemi Corporation and Imperial Bank. (29)
10.80 Purchase agreement dated as of between SGS-Thomson Microelectronics, Inc. and Microsemi RF Products, Inc., formerly known as Micro Acquisition Corp., a Delaware Corporation and a wholly owned subsidiary of the Company.(30)
10.81 Retirement agreement with Dr. Jiri Sandera (31)
10.82 Change of Control Agreement with Mr. Philip Frey, Jr. (32)
10.83 Change of Control Agreement with Mr. David R. Sonksen. (32)
10.83 Supplemental Executive Retirement Plan (32)
10.85 Credit Agreement, dated as of April 2, 1999, among the Company, the Lenders from time to time party thereto and Canadian Imperial Bank of Commerce, as Agent (35)
23.1 Consent of Independent Accountants (form S-3).
23.2 Consent of Independent Accountants (form S-8).
27 Financial data schedule.
(1) Filed in Registration Statement (No. 33-3845) and incorporated herein by this reference.
(2) Filed in Registration Statement (No. 33-11967) and incorporated herein by this reference.
(3) Filed with the Registrant's S-8 dated January 27, 1986 and incorporated herein by this reference.
(6) Incorporated by reference form Exhibit A to the Registrant's definitive Proxy Statement dated January 19, 1987.
(7) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 8-K filed with the Commission on or about December 23, 1987.
(9) Incorporated by reference to the indicated Exhibit to the Registrant's Annual Report on Form 10-K filed with the Commission for the fiscal year ended October 2, 1988.
(10) Incorporated by reference to Exhibit 10.33 to the Registrant's Current Report on Form 8-K, as amended, as filed with Commission on or about
(15) Incorporated by reference to the indicated Exhibit to the Registrant's Annual Report on Form 10-K filed with the Commission for the fiscal year ended September 30, 1990.
(16) Incorporated by reference to the indicated Exhibit to the Registrant's Annual Report on Form 10-K filed with the Commission for the fiscal year ended September 29, 1991.
(17) Incorporated by reference to Exhibit 2.1 to the Registrant's Form 8 Amendment No. 1, as filed with the Commission on September 8, 1992, to its Current Report on Form 8-K dated July 2, 1992.
(18) Incorporated by reference to Exhibit 2.2 to the Registrant's Form 8 Amendment No. 1, as filed with the Commission on September 8, 1992, to its Current Report on Form 8-K dated July 2, 1992.
(19) Incorporated by reference to Exhibit 2.3 to the Registrant's Form 8 Amendment No. 1, as filed with the Commission on September 8, 1992, to its Current Report on Form 8-K dated July 2, 1992.
(21) Incorporated by reference to the indicated Exhibit to the Registrant's Quarterly Report on Form 10-Q filed with the Commission for the fiscal quarter ended July 4, 1993.
(22) Incorporated by reference to the indicated Exhibit to the Registrant's
Annual Report on Form 10-K filed with the Commission for the fiscal year ended October 3, 1993.
(23) Incorporated by reference to the indicated Exhibit to the Registrant's Quarterly Report on Form 10-Q filed with the Commission for the fiscal quarter ended April 3, 1994.
(24) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 8-K, as filed with the Commission dated June 8, 1994.
(25) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 10-K as filed with the Commission for the fiscal year ended October 2, 1994.
(26) Incorporated by reference to the indicated Exhibit to the Registrant's Quarterly Report on Form 10-Q filed with the Commission for the fiscal quarter ended April 2, 1995
(27) Incorporated by reference to the indicated Exhibit to the Registrant's Quarterly Report on Form 10-Q filed with the Commission for the fiscal quarter ended July 2, 1995.
(28) Incorporated by reference to the indicated Exhibit to the Registrant's Quarterly Report on Form 10-Q filed with the Commission for the fiscal quarter ended March 31, 1996.
(29) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 8-K, as filed with the Commission dated June 26, 1992.
(30) Incorporated by reference to the indicated Exhibit to the Registrant's Quarterly Report on Form 10-Q filed with the Commission for the fiscal quarter ended December 29, 1996.
(31) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 10-K filed with the Commission for the fiscal year ended September 28, 1997.
(32) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 10-Q filed with the Commission for the fiscal quarter ended December 28, 1997.
(33) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 10-Q filed with the Commission for the fiscal quarter ended June 28, 1998.
(34) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 10-Q filed with the Commission for the fiscal quarter ended April 4, 1999.
(35) Incorporated by reference to the indicated Exhibit to the Registrant's Current Report on Form 10-Q filed with the Commission for the fiscal quarter ended July 4, 1999. | 15,688 | 105,994 |
926867_1999.txt | 926867_1999 | 1999 | 926867 | Item 2. Properties. - --------------------
The Company is located and conducts its business at the Bank's office in Cicero, located at 4852 West 30th Street, Cicero, Illinois. The Company has received regulatory permission to establish a branch office in North Riverside, Illinois, and has acquired a site to do so. See Note 7 to the Notes to Consolidated Financial Statements for the net book value of the Bank's premises and equipment.
Item 3.
Item 3. Legal Proceedings. - ---------------------------
Neither the Company nor its subsidiaries are involved in any pending legal proceedings, other than routine legal matters occurring in the ordinary course of business, which in the aggregate involve amounts which are believed by management to be immaterial to the consolidated financial condition or results of operations of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders. - -------------------------------------------------------------
None.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. - -------------------------------------------------------------------------------
Information relating to the market for the Registrant's common equity and related stockholder matters appears in the Registrant's 1999 Annual Report to Stockholders on Page 29 and is incorporated herein by reference. On May 31, 1999, the Company had 88 registered shareholders.
Item 6.
Item 6. Selected Financial Data. - ---------------------------------
The above-captioned information appears under "Selected Consolidated Financial and Other Data of the Company" in the Registrant's 1999 Annual Report to Stockholders on Pages 11 through 13 and is incorporated herein by reference.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. - --------------
The above-captioned information appears under "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Registrant's 1999 Annual Report to Stockholders on Pages 14 through 29 and is incorporated herein by reference.
Item 8.
Item 8. Financial Statements and Supplementary Data. - -----------------------------------------------------
The Consolidated Financial Statements of West Town Bancorp, Inc. and its subsidiaries, together with the report thereon by Cobitz, VandenBerg & Fennessy appear in the Registrant's 1999 Annual Report to Stockholders on Pages through and are incorporated herein by reference.
Item 9.
Item 9. Change in and Disagreements with Accountants on Accounting and - ----------------------------------------------------------------------- Financial Disclosure. - ---------------------
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant. - -------------------------------------------------------------
The information relating to Directors and Executive Officers of the Registrant is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on July 14, 1999, on Pages 3 through 6. Information concerning Executive Officers who are not directors is contained in Part I of this report pursuant to paragraph (b) of Item 401 of Regulation S-K in reliance on Instruction G.
Item 11.
Item 11. Executive Compensation. - ---------------------------------
The information relating to director and executive compensation is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on July 14, 1999, on Pages 6 through 9.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management. - -------------------------------------------------------------------------
The information relating to security ownership of certain beneficial owners and management is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on July 14, 1999, on Pages 2 through 4.
Item 13.
Item 13. Certain Relationships and Related Transactions. - ---------------------------------------------------------
The information relating to certain relationships and related transactions is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on July 14, 1999, on Page 13.
PART IV -------
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - --------------------------------------------------------------------------
1. Independent Auditors' Report*
2. All Financial Statements*
(a) Consolidated Statements of Condition as of March 31, 1999 and 1998.
(b) Consolidated Statements of Income for the Years Ended March 31, 1999, 1998 and 1997.
(c) Consolidated Statements of Stockholders' Equity for Years Ended March 31, 1999, 1998 and 1997.
(d) Consolidated Statements of Cash Flows for the Years Ended March 31, 1999, 1998 and 1997.
(e) Notes to Consolidated Financial Statements
All schedules have been omitted as the required information is either inapplicable or included in the Notes to Consolidated Financial Statements.
3. Exhibits
(3)(a) Certificate of Incorporation of West Town Bancorp, Inc.**
(3)(b) Bylaws of West Town Bancorp, Inc.**
13 1999 Annual Report to Stockholders
21 Subsidiaries of the Registrant
23 Consent of Independent Auditors
* Incorporated by reference to the Annual Report to Stockholders for the fiscal year ended March 31, 1999, attached as an exhibit hereto.
** Incorporated by reference to the Registration Statement on Form S-1, and amendments thereto, filed with the Securities and Exchange Commission.
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
WEST TOWN BANCORP, INC.
By: /s/ Dennis B. Kosobucki ------------------------------------- Dennis B. Kosobucki DATED: June 8, 1999 Chairman of the Board, President and Chief Executive Officer (Duly Authorized Representative)
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.
Name Title Date ---- ----- ----
/s/ Dennis B. Kosobucki Chairman of the Board June 8, 1999 - -------------------------- President, Chief Executive Dennis B. Kosobucki Officer (Principal Executive Officer)
/s/ Jeffrey P. Kosobucki Vice President and Chief June 8, 1999 - -------------------------- Financial Officer Jeffrey P. Kosobucki (Principal Financial Officer and Principal Accounting Officer)
/s/ Edward J. Hradecky Director June 8, 1999 - -------------------------- Edward J. Hradecky
/s/ John A. Storcel Director June 8, 1999 - -------------------------- John A. Storcel
/s/ James Kucharczyk Director June 8, 1999 - -------------------------- James Kucharczyk
/s/ James J. Kemp, Jr. Director June 8, 1999 - -------------------------- James J. Kemp, Jr.
WEST TOWN BANCORP, INC. AND SUBSIDIARIES ----------------
Audited Financial Statements
March 31, 1999 --------------
COBITZ, VANDENBERG & FENNESSY
Certified Public Accountants 9944 South Roberts Road - Suite 202 Palos Hills, Illinois 60465 (708) 430-4106 - Fax (708) 430-4499
INDEPENDENT AUDITORS' REPORT
The Board of Directors West Town Bancorp, Inc. Cicero, Illinois
We have audited the consolidated statements of financial condition of West Town Bancorp, Inc. and subsidiaries as of March 31, 1999 and 1998 and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended March 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of West Town Bancorp, Inc. and subsidiaries at March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ending March 31, 1999, in conformity with generally accepted accounting principles.
/s/ COBITZ, VANDENBERG & FENNESSY
May 7, 1999 Palos Hills, Illinois
WEST TOWN BANCORP, INC. AND SUBSIDIARIES ----------------
Consolidated Statements of Financial Condition
Liabilities and Stockholders' Equity - ------------------------------------
See accompanying notes to consolidated financial statements.
WEST TOWN BANCORP, INC. AND SUBSIDIARIES ----------------
Consolidated Statements of Income
See accompanying notes to consolidated financial statements.
WEST TOWN BANCORP, INC. AND SUBSIDIARIES ----------------
Consolidated Statements of Changes in Stockholders' Equity
Three Years Ended March 31, 1999
See accompanying notes to consolidated financial statements.
WEST TOWN BANCORP, INC. AND SUBSIDIARIES ----------------
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
WEST TOWN BANCORP, INC. AND SUBSIDIARIES ----------------
Notes to Consolidated Financial Statements
1) Summary of Significant Accounting Policies ------------------------------------------
West Town Bancorp, Inc. (the "Company") is a Delaware corporation incorporated on May 6, 1994 for the purpose of becoming the savings bank holding company for West Town Savings Bank (the "Bank"). On March 1, 1995, the Bank converted from a mutual to a stock form of ownership, and the Company completed its initial public offering, and with a portion of the net proceeds acquired all of the issued and outstanding capital stock of the Bank.
The accounting and reporting policies of the Company and its subsidiaries conform to generally accepted accounting principles and to general practice within the thrift industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following is a description of the more significant policies which the Company follows in preparing and presenting its consolidated financial statements.
Principles of Consolidation ---------------------------
The accompanying consolidated financial statements include the accounts of the Company, and its wholly owned subsidiary, West Town Savings Bank and the Bank's wholly owned subsidiary, West Town Insurance Agency, Inc. Significant intercompany balances and transactions have been eliminated in consolidation.
Industry Segments -----------------
The Company operates principally in the banking industry through its subsidiary bank. As such, substantially all of the Company's revenues, net income, identifiable assets and capital expenditures are related to banking operations.
United States Government and Agency Obligations, Held to Maturity -----------------------------------------------------------------
These securities are carried at cost, and adjusted for amortization of premiums and accretion of discounts. Premiums and discounts are amortized and accreted into income using the level-yield method. These securities are not carried at fair value because the Company has both the ability and the intent to hold them to maturity.
Mortgage-Backed Securities, Held to Maturity --------------------------------------------
Mortgage-backed securities are carried at cost, and adjusted for amortization of premiums and accretion of discounts. Premiums and discounts are amortized and accreted into income using the level-yield method. These securities are not carried at fair value because the Company has both the ability and the intent to hold them to maturity.
1) Summary of Significant Accounting Policies (continued) ------------------------------------------------------
Other Investments, Available for Sale -------------------------------------
Investment securities are recorded in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115 "Accounting for Certain Investments in Debt and Equity Securities". SFAS 115 requires the use of fair value accounting for securities available for sale or trading and retains the use of the amortized cost method for investments the Company has the positive intent and ability to hold to maturity.
SFAS 115 requires the classification of debt and equity securities into one of three categories: held to maturity, available for sale, or trading. Held to maturity securities are measured at amortized cost. Unrealized gains and losses on trading securities are included in income. Unrealized gains and losses on available for sale securities are excluded from income and reported net of taxes as a separate component of stockholders' equity.
The Company has designated certain equity investments as available for sale, and has recorded these investments at their current fair values. Unrealized gains and losses are recorded in a valuation account which is included, net of income taxes, as a separate component of stockholders' equity. Gains and losses on the sale of securities are determined using the specific identification method.
Loans Receivable and Related Fees ---------------------------------
Loans are stated at the principal amount outstanding, net of loans in process, deferred fees and the allowance for losses. Interest on loans is credited to income as earned and accrued only if deemed collectible. Loans are placed on non-accrual status when, in the opinion of management, the full timely collection of principal or interest is in doubt. As a general rule, the accrual of interest is discontinued when principal or interest payments become 90 days past due or earlier if conditions warrant. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is charged against current income.
Loan origination fees are being deferred in accordance with SFAS No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases". This statement requires that loan origination fees and direct loan origination costs for a completed loan be netted and then deferred and amortized into interest income as an adjustment of yield over the contractual life of the loan.
The Company has adopted the provisions of SFAS No. 114 "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118 "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures". These statements apply to all loans that are identified for evaluation except for large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. These loans include, but are not limited to, credit card, residential mortgage and consumer installment loans.
Under these statements, of the remaining loans which are evaluated for impairment (a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement), there were no material amounts of loans which met the definition of an impaired loan during the year ended March 31, 1999 and no loans to be evaluated for impairment at March 31, 1999.
1) Summary of Significant Accounting Policies (continued) ------------------------------------------------------
Allowance for Loan Losses -------------------------
The determination of the allowance for loan losses involves material estimates that are susceptible to significant change in the near term. The allowance for loan losses is maintained at a level adequate to provide for losses through charges to operating expense. The allowance is based upon past loss experience and other factors which, in management's judgement, deserve current recognition in estimating losses. Such other factors considered by management include growth and composition of the loan portfolio, the relationship of the allowance for losses to outstanding loans, and economic conditions.
Management believes that the allowance is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for losses. Such agencies may require the Company to recognize additions to the allowance based on their judgements about information available to them at the time of their examination.
Real Estate Owned -----------------
Real estate acquired through foreclosure or deed in lieu of foreclosure is carried at the lower of fair value minus estimated costs to sell or the acquisition cost. Valuations are periodically performed by management and an allowance for loss is established by a charge to operations if the carrying value of a property exceeds its fair value minus estimated costs to sell.
Depreciation ------------
Depreciation of office properties and equipment are accumulated on the straight-line basis over estimated lives of the various assets. Estimated lives are 15 to 30 years for office buildings, 30 years for parking lot improvements, and 5 to 7 years for furniture, fixtures and equipment.
Income Taxes ------------
The Company files a consolidated federal income tax return with its subsidiaries.
The provision for federal and state taxes on income is based on earnings reported in the financial statements. Deferred income taxes arise from the recognition of certain items of income and expense for tax purposes in years different from those in which they are recognized in the consolidated financial statements. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income for the period that includes the enactment date.
Consolidated Statements of Cash Flows -------------------------------------
For the purposes of reporting cash flows, the Company has defined cash and cash equivalents to include cash on hand, amounts due from depository institutions, and interest-bearing deposits in other financial institutions.
Reclassification ----------------
Certain 1998 and 1997 amounts have been reclassified to conform with the 1999 presentation.
1) Summary of Significant Accounting Policies (continued) ------------------------------------------------------
Earnings per Share ------------------
The Company computes its earnings per share (EPS) in accordance with SFAS No. 128 "Earnings per Share". This statement simplifies the standards for computing EPS previously found in Accounting Principles Board Opinion No. 5 "Earnings per Share" and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS and fully diluted EPS with diluted EPS.
Basic EPS, unlike primary EPS, excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
The following presentation illustrates basic and diluted EPS in accordance with the provisions of SFAS 128:
EPS for 1997 has been restated to comply with the provisions of SFAS 128.
2) United States Government and Agency Obligations, Held to Maturity -----------------------------------------------------------------
These securities are summarized as follows:
4) Loans Receivable ----------------
Loans receivable are summarized as follows:
There were no loans delinquent three months or more at March 31, 1999. There was one loan delinquent three months or more and non-accruing totaling approximately $96,100, or .5% of total loans in force at March 31, 1998. The Bank has established a loan loss reserve of $52,171 as required by its internal policies.
Activity in the allowance for loan losses is summarized as follows:
The Bank has pledged $469,931 in single-family mortgage loans as collateral to secure deposits in excess of Federal Deposit Insurance Corporation insurance limitations. The balances of these loans are at least 110% of the non-insured deposits at March 31, 1999, in accordance with the terms of the executed collateralization agreements with various depositors.
5) Other Investments, Available for Sale -------------------------------------
This portfolio is being accounted for at fair value in accordance with SFAS 115. A summary of other investments available for sale is as follows:
There were no sales from this portfolio during the years ended March 31, 1999 and 1998, while the Company realized gross proceeds of $50,968 and gains of $3,178 during the year ended March 31, 1997. In addition, during the current period, the increase in net unrealized gains of $70,000 net of the tax effect of $25,168, resulted in a $44,832 credit to stockholders' equity.
6) Accrued Interest Receivable ---------------------------
Accrued interest receivable is summarized as follows:
7) Office Properties and Equipment -------------------------------
Office properties and equipment are summarized as follows:
Depreciation of office properties and equipment for the years ended March 31, 1999, 1998 and 1997 amounted to $28,164, $24,188, and $24,316 respectively.
During the period under review, the Bank received permission from the Office of Banks and Real Estate and the Federal Deposit Insurance Corporation to establish a branch office in North Riverside, Illinois. This branch office site is currently under construction. The Bank has incurred approximately $314,000 in costs to acquire and improve the site to date, and expects to incur approximately $1,300,000 in building and equipment costs prior to completion. Management anticipates that this branch will commence operations in December of 1999.
8) Prepaid Expenses and Other Assets ---------------------------------
Prepaid expenses and other assets consist of the following:
9) Deposits --------
Deposit accounts are summarized as follows:
The composition of deposit accounts by interest rate is as follows:
The weighted average interest rate on deposit accounts at March 31, 1999 and 1998 was 4.62% and 4.97% respectively.
A summary of certificates of deposit that mature during the twelve-month periods indicated is as follows:
Interest expense on deposits consists of the following:
The aggregate amount of deposit accounts with a balance of $100,000 or greater was approximately $6,293,000 and $5,549,000 at March 31, 1999 and 1998 respectively. Deposits in excess of $100,000 are not insured by the Federal Deposit Insurance Corporation.
10) Borrowed Money --------------
In connection with the Company's initial public offering, the Bank established an Employee Stock Ownership Plan (ESOP). The ESOP was funded by the proceeds from a $177,550 loan from the Company. The loan carries an interest rate of nine and one-half percent and matures in the year 2005. The loan is secured by the shares of the Company purchased with the loan proceeds. The Bank has committed to make contributions to the ESOP sufficient to allow the ESOP to fund the debt service requirements of the loan.
11) Other Liabilities -----------------
Other liabilities include the following:
(a) The approximate tax effect of temporary differences that give rise to the Company's net deferred tax liability at March 31, 1999 and 1998 under SFAS 109 is as follows:
12) Officer, Director and Employee Plans ------------------------------------
Stock Option Plan -----------------
On July 12, 1995, the stockholders of the Company approved the West Town Bancorp, Inc. Stock Option Plan. This is an incentive stock option plan for the benefit of the officers and employees of the Company and its affiliates and a directors' stock option plan for the benefit of outside directors of the Company. The number of shares authorized under the Plan is 22,194, equal to 10.0% of the total number of shares issued in the Conversion. As of March 31, 1999, 18,029 options had been granted, which are exercisable at a rate of 20% per year and expire ten years from the date of grant. The following is an analysis of the stock option activity for each of the years in the three year period ended March 31, 1999 and the stock options outstanding at the end of the respective periods:
The weighted average fair value of options granted during the years ended March 31, 1999, 1998 and 1997 was $12.00, $11.00 and $10.00, respectively. As of March 31, 1999, the weighted average exercise price for options outstanding was $10.13 with a weighted average remaining contractual life of 6.6 years.
The Company has elected to follow Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for its employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
The Company implemented SFAS No. 123 "Accounting for Stock-Based Compensation" during the year ended March 31, 1997. The Company retained its current accounting method for its stock based compensation plans. This statement only resulted in additional disclosures for the Company, and as such, its adoption did not have a material impact on the Company's financial condition or its results of operations.
12) Officer, Director and Employee Plans (continued) ------------------------------------------------
The following summarizes the pro forma net income as if the fair value method of accounting for stock-based compensation plans had been utilized:
The pro forma results presented above may not be representative of the effects reported in pro form net income for future years.
The fair value of the option grants for the years ended March 31, 1999, 1998 and 1997 was estimated using the Black Scholes Method, using the following assumptions: expected volatility of 10.0%, risk free interest rate of 6.33%, and an expected life of approximately 10 years during all periods.
Employee Stock Ownership Plan -----------------------------
In conjunction with the Conversion, the Bank formed an Employee Stock Ownership Plan ("ESOP"). The ESOP covers substantially all employees with more than one year of employment and who have attained the age of 21. The ESOP borrowed $177,550 from the Company and purchased 17,755 common shares issued in the Conversion. The Bank will make scheduled discretionary cash contributions to the ESOP sufficient to service the amount borrowed. In accordance with generally accepted accounting principles, the unpaid balance of the ESOP loan, which is comparable to unearned compensation, is reported as a reduction of stockholders' equity. Total contributions by the Bank to the ESOP which were used to fund principal and interest payments on the ESOP debt totaled $27,569, $27,569 and $27,569 for the years ended March 31, 1999, 1998 and 1997, respectively.
On November 22, 1993, the AICPA issued Statement of Position No. 93-6, "Employers' Accounting for Employee Stock Ownership Plans" ("SOP No. 93- 6"). SOP No. 93-6 provides guidance for accounting for all ESOPs. SOP No. 93-6 requires that the issuance or sale of treasury shares to the ESOP be reported when the issuance or sale occurs and that compensation expense be recognized for shares committed to be released to directly compensate employees equal to the fair value of the shares committed. In addition, SOP No. 93-6 requires that leveraged ESOP debt and related interest expense be reflected in the employer's financial statements. Prior practice was to recognize compensation expenses based on the amount of the employer's contributions to the ESOP. SOP No. 93-6 is effective for fiscal years beginning after December 31, 1992. The application of SOP No. 93-6 results in fluctuations in compensation expense as a result of changes in the fair value of the Company's common stock; however, any such compensation expense fluctuations will result in an offsetting adjustment to additional paid-in capital. Additional compensation expense, recognized as a result of the implementation of this accounting principle, was $4,012, $1,050, and -0- for the years ended March 31, 1999, 1998 and 1997 respectively.
12) Officer, Director and Employee Plans (continued) ------------------------------------------------
Management Recognition Plan ---------------------------
In conjunction with the Conversion, the Company formed a Management Recognition Plan ("MRP"), which was authorized to issue 4% of the total number of shares of common stock issued in the Conversion. Such additional shares, totaling 8,878, were issued from authorized but previously unissued shares. The MRP was established to award shares to directors and to employees in key management positions in order to provide them with a proprietary interest in the Company in a manner designed to encourage such employees to remain with the Company. As of March 31, 1999, all of the shares had been awarded and distributed.
The fair value of the shares issued to the MRP in July of 1995 totaled $88,780. Such amount was amortized to compensation expense as the plan participants became vested in those shares. For the years ended March 31, 1999, 1998 and 1997, $-0-, $9,319 and $24,120 was amortized to expense respectively.
13) Income Taxes ------------
The Company has adopted SFAS No. 109 which requires a change from the deferred method to the liability method of accounting for income taxes. Under the liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying statutory tax rates applicable to future years to differences between the financial statement carrying amounts and tax bases of existing assets and liabilities.
Among the provisions of SFAS 109 which impact the Company is the tax treatment of bad debt reserves. SFAS 109 provides that a deferred tax asset is to be recognized for the bad debt reserve established for financial reporting purposes and requires a deferred tax liability to be recorded for increases in the tax bad debt reserve for years beginning after January 1, 1988, the effective date of certain changes made by the Tax Reform Act of 1986 to the calculation of savings institutions' bad debt deduction. Accordingly, retained earnings at March 31, 1999 includes approximately $412,000 for which no deferred federal income tax liability has been recognized.
The provision for income taxes consists of the following:
A reconciliation of the statutory federal income tax rate to effective income tax rate is as follows:
Deferred income tax expense (benefit) consists of the following tax effects of timing differences:
14) Regulatory Capital Requirements -------------------------------
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum total requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt correction action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off- balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to quantitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, set forth in the table below, of the total risk-based and core capital, as defined in the regulations. Management believes, as of March 31, 1999, that the Bank meets all capital adequacy requirements to which it is subject.
The Bank, according to federal regulatory standards, is well-capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized, the Bank must maintain minimum total risk-based and core ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category.
At March 31, 1999 and 1998, the Bank's regulatory equity capital was as follows:
15) Stockholders' Equity --------------------
As part of the Conversion, the Bank established a liquidation account for the benefit of all eligible depositors who continue to maintain their deposit accounts in the Bank after conversion. In the unlikely event of a complete liquidation of the Bank, each eligible depositor will be entitled to receive a liquidation distribution from the liquidation account, in the proportionate amount of the then current adjusted balance for deposit accounts held, before distribution may be made with respect to the Bank's capital stock. The Bank may not declare or pay a cash dividend to the Company on, or repurchase any of, its capital stock if the effect thereof would cause the retained earnings of the Bank to be reduced below the amount required for the liquidation account. Except for such restrictions, the existence of the liquidation account does not restrict the use or application of retained earnings.
In addition the Bank may not declare or pay cash dividends on or repurchase any of its shares of common stock if the effect thereof would cause stockholders' equity to be reduced below applicable regulatory capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.
Unlike the Bank, the Company is not subject to these regulatory restrictions on the payment of dividends to its stockholders. However, the Company's source of funds for future dividends may depend upon dividends received by the Company from the Bank.
16) Financial Instruments with Off-Balance Sheet Risk -------------------------------------------------
The Company is a party to various transactions with off-balance sheet risk in the normal course of business. These transactions are primarily commitments to originate and to purchase loans. These financial instruments carry varying degrees of credit and interest-rate risk in excess of amounts recorded in the consolidated financial statements.
Outstanding commitments to originate or purchase mortgage loans amounted to $1,318,000 at March 31, 1999 at fixed rates ranging from 6.80% to 8.75%. Because the credit worthiness of each customer is reviewed prior to extension of a commitment, the Bank adequately controls their credit risk on their commitments, as it does for loans recorded on the balance sheet. The Bank conducts all of its lending activities in the Chicagoland area. Management believes the Bank has a diversified loan portfolio and the concentration of lending activities in these local communities does not result in an acute dependency upon economic conditions of the lending region.
The Federal Home Loan Bank of Chicago has issued an irrevocable letter of credit for $510,000 to the State of Illinois on behalf of the Bank in order to secure deposits totaling $502,395.
17) Contingencies -------------
The Bank is, from time to time, a party to certain lawsuits arising in the ordinary course of its business, wherein it enforces its security interest. Management, based upon discussions with legal counsel, believes that the Company and the Bank are not engaged in any legal proceedings of a material nature at the present time.
18) Disclosures About the Fair Value of Financial Instruments ---------------------------------------------------------
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and cash equivalents: For cash and interest-bearing deposits, the carrying amount is a reasonable estimate of fair value.
U.S. Government and agency obligations: Fair values for securities are based on quoted market prices as published in financial publications.
Mortgage-backed securities: Fair values for mortgage-backed securities are based on average quotes received from a third-party broker.
Loans receivable: The fair values of mortgage loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms and collateral to borrowers of similar credit quality.
Other investments: Fair values for other investments are based on quoted market prices received from third-party sources.
Deposit liabilities: The fair value of savings accounts is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar original maturities.
Financial instruments with off-balance sheet risk: Fair values of the Company's off-balance sheet financial instruments, which consist of loan commitments, are based on fees charged to enter into these agreements. As the Company currently charges no fees on these instruments, no estimate of fair value has been made.
The fair value of the Company's off-balance-sheet instruments is nominal.
The estimated fair values of the Company's financial instruments as of March 31, 1999 and 1998 are as follows:
19) Condensed Parent Company Only Financial Statements --------------------------------------------------
The following condensed statements of financial condition, as of March 31, 1999 and 1998, and condensed statements of income and cash flows for the years ended March 31, 1999, 1998 and 1997 for West Town Bancorp, Inc. should be read in conjunction with the consolidated financial statements and the notes thereto.
Statements of Financial Condition ---------------------------------
Statements of Income --------------------
19) Condensed Parent Company Only Financial Statements (continued) --------------------------------------------------------------
Statements of Cash Flows ------------------------ | 5,832 | 39,886 |
878517_1999.txt | 878517_1999 | 1999 | 878517 | ITEM 1. BUSINESS.
ORGANIZATION
Capstead Securities Corporation IV (the "Company") was incorporated in Delaware on August 16, 1991 as a special-purpose finance corporation and is a wholly-owned subsidiary of Capstead Mortgage Corporation ("CMC"). CMC is a publicly owned real estate investment trust that, until late 1995, operated a mortgage conduit, purchasing and securitizing single-family residential mortgage loans. The Company is managed by CMC (the "Manager"). The Company believes it has qualified as a REIT subsidiary of CMC under the Internal Revenue Code of 1986 (the "Code"); therefore, for federal income tax purposes it is combined with CMC. Under applicable sections of the Code, REITs are required to distribute annually to stockholders at least 95% of their taxable income. It is the Company's and CMC's policy to distribute 100% of combined taxable income.
The Company was formed primarily for the purpose of issuing and selling collateralized mortgage obligations ("CMOs"), collateralized by mortgage-backed, pass-through certificates ("Certificates") which evidence an interest in a pool of mortgage loans secured by single-family residences. The Certificates pledged as collateral for the CMOs are either contributed by CMC or purchased from third parties and are either Ginnie Mae Certificates, Fannie Mae Certificates, Federal Home Loan Mortgage Corporation Certificates or mortgage pass-through ("Non-Agency") Certificates. On August 21, 1991 the Securities and Exchange Commission declared effective a registration statement filed by the Company covering the offering of a maximum of $5 billion aggregate principal amount of CMOs. As of December 31, 1999, the Company has issued 19 series of CMOs with an aggregate original principal balance of $4,572,644,000.
SPECIAL-PURPOSE FINANCE CORPORATION
The Company has not engaged, and will not engage in any business or investment activities other than (i) issuing and selling CMOs and receiving, owning, holding and pledging as collateral the related Certificates; (ii) investing cash balances on an interim basis in high quality short-term securities; and (iii) engaging in other activities which are necessary or expedient to accomplish the foregoing and are incidental thereto.
COMPETITION
In issuing CMOs, the Company competes with other issuers of these securities and the securities themselves compete with other investment opportunities available to prospective purchasers.
EMPLOYEES
At December 31, 1999 the Company had no employees. The Manager provides all executive and administrative personnel required by the Company.
MANAGEMENT AGREEMENT
Pursuant to a Management Agreement, the Manager advises the Company with respect to its investments and administers the day-to-day operations of the Company. The Management Agreement is nonassignable except by consent of the Company and the Manager. The Management Agreement may be terminated without cause at any time upon 90 days written notice. In addition, the Company has the right to terminate the Management Agreement upon the happening of certain specified events, including a breach by the Manager of any provision contained in the Management Agreement which remains uncured for 30 days after notice of such breach and the bankruptcy or insolvency of the Manager.
The Manager is at all times subject to the supervision of the Company's Board of Directors and has only such functions and authority as the Company delegates to it. The Manager is responsible for the day-to-day operations of the Company and performs such services and activities relating to the assets and operations of the Company as may be appropriate. The Manager receives an annual basic management fee of $10,000 per year for managing the assets pledged to secure Bonds issued by the Company.
The Manager is required to pay employment expenses of its personnel (including salaries, wages, payroll taxes, insurance, fidelity bonds, temporary help and cost of employee benefit plans), and other office expenses, travel and other expenses of directors, officers and employees of the Manager, accounting fees and expenses incurred in supervising and monitoring the Company's investments. The Company is required to pay all other expenses of operation (as defined in the Management Agreement).
SERVICING AND ADMINISTRATION
The originators of mortgage loans backing Non-Agency Certificates may elect, if they meet the Company's criteria for servicers, either to service the loans they sell or to sell the loans with no agreement with respect to servicing. The Company enters into servicing agreements with each servicer.
As compensation for its services under a servicing agreement, the servicers retain a servicing fee, payable monthly, generally 1/4 of 1% of the outstanding principal balance of each mortgage loan serviced as of the last day of each month. CMC does not currently service mortgage loans with respect to CMOs issued by the Company. In addition, CMC is the administrator with respect to the Non-Agency Certificates collateralizing Series 1998-3 and related CMOs. During 1999 CMC retained fees for administering these Non-Agency Certificates and related CMOs of $34,000.
ITEM 2.
ITEM 2. PROPERTIES.
The Company's operations are conducted primarily in Dallas, Texas on properties leased by CMC.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
As of the date hereof, there are no material legal proceedings outside the normal course of business to which the Company was a party or of which any of its property was the subject.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
All of the Company's common stock is owned by CMC. Accordingly, there is no public trading market for its common stock.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
1999 COMPARED TO 1998
Residual investments in CMOs (represented by the difference between the carrying value of mortgage securities collateral and collateralized mortgage securities on the balance sheet; also referred to as "CMO Investments") produced an operating loss of $172,000 in 1999 compared to an operating loss of $467,000 in 1998. Operating results produced by CMO Investments is represented by the difference between interest income on mortgage securities collateral and interest expense and professional fees on collateralized mortgage securities and mortgage pool insurance expense on mortgage securities collateral. The Company elected Real Estate Mortgage Investment Conduit ("REMIC") status for tax purposes on the issuance of CMO Series 1998-3. This issuance was accounted for as a financing because an affiliate of the Company retained an investment in this CMO. As a financing, CMO collateral and Bonds are reflected on the balance sheet; however, because the Company did not retain any investment in this CMO, no economic benefit was or will be received and thus no net income or loss was or will be recognized related to this CMO other than amortization of unreimbursed bond issuance costs.
Operating results from CMO Investments improved due primarily to lower prepayments in 1999 than in 1998, which caused collateral and bond premiums and discounts to be amortized at a slower rate in 1999 than in 1998. Run-off rates were 35% and 49% for the year ended December 31, 1999 and 1998, respectively. Excluding the effects of CMO Series 1998-III, issued September 28, 1998, amortization of collateral and bond premiums and discounts resulted in a net expense of $691,000 and $1.4 million during 1999 and 1998, respectively. In addition, results also improved as several CMOs with relatively low net interest margins were redeemed during 1999. Refer to the increase in the net margin as shown in the table below.
The following table presents the weighted average yields for the periods shown:
Although net interest spreads can fluctuate depending on the timing of the payoff of collateral and bonds with differing amounts of purchase premium and bond discounts, the tendency is for CMO net interest spreads to decline as lower-yielding, shorter-term CMO bonds are paid off prior to longer-term bonds with relatively higher interest rates.
During 1999 the Company redeemed the remaining outstanding bonds of six CMOs (Series 1992-I, 1992-II, 1992-IV, 1992-XII, 1992-XIII and 1992-XV) totaling $162,027,000 pursuant to clean-up calls, and sold the related released collateral of $141,224,000 for gains totaling $3,317,000 offset somewhat by losses on redeeming the remaining CMO bonds of $872,000.
1998 COMPARED TO 1997
Residual investments in collateralized mortgage obligations (represented by the difference between the carrying value of mortgage securities collateral and collateralized mortgage securities on the balance sheet; also referred to as "CMO Investments") recorded a net operating loss of $467,000 in 1998 compared to net operating income of $1,150,000 in 1997. Operating results produced by CMO Investments is represented by the difference between interest income on mortgage securities collateral and interest expense and professional fees on collateralized mortgage securities and mortgage pool insurance expense on mortgage securities collateral.
Operating results from CMO Investments declined due primarily to a 31% decline in the average holdings of mortgage securities collateral during 1998 compared to 1997. Average holdings of mortgage securities collateral were $427 million during 1998 compared to $619 million during 1997. The decrease in average holdings was the result of runoff (prepayments and scheduled payments) and the redemptions of three CMOs during 1998. The runoff rate was 49% during 1998 compared to 19% during 1997. As a result of lower outstanding balances, income earned from the net interest spread was lower during 1998. In addition, prepayments were higher in 1998 than in 1997, which caused collateral and bond premiums and discounts to be amortized at a faster rate in 1998 than in 1997. Excluding the effects of CMO Series 1998-III, issued September 28, 1998, amortization of collateral and bond premiums and discounts resulted in a net expense of $1.4 million and $732,000 during 1998 and 1997, respectively.
The following table presents the weighted average yields for the periods shown:
Although net interest spreads can fluctuate depending on the timing of the payoff of collateral and bonds with differing amounts of purchase premium and bond discounts, the tendency is for CMO net interest spreads to decline as lower-yielding, shorter-term CMO bonds are paid off prior to longer-term bonds with relatively higher interest rates. Additionally, three CMOs were redeemed during 1998. These CMOs had collateral yielding between 8.96% and 9.23% at the time of redemption, which contributed to the decline in average collateral yields.
During 1998 the Company redeemed the remaining outstanding bonds of Series 1991-VII, 1992-V and 1992-VII totaling $89,570,000 and sold the related released collateral of $84,328,000 for gains totaling $2,888,000.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds are the receipt of excess cash flows on CMO Investments (primarily the excess of principal and interest earned on the mortgage securities collateral including reinvestment proceeds over the principal and interest payable on the CMOs), proceeds from additional CMO issuances and occasionally proceeds from the sale of collateral released from the related CMOs. During 1999 the Company redeemed the remaining outstanding bonds of six CMOs (Series 1992-I, 1992-II, 1992-IV, 1992-XII, 1992-XIII and 1992-XV) totaling $162,027,000 pursuant to clean-up calls, and sold the related released collateral of $141,224,000 for gains totaling $3,317,000. The Company has only two remaining series of CMOs outstanding as of December 31, 1999, neither of which is expected to be called until 2001. Net income and excess cash flows from CMO Investments have allowed dividends of $1,969,000 and $2,777,000 during 1999 and 1998, respectively, and the return of $4,338,000 and $3,960,000 of capital during 1999 and 1998, respectively. The Company continues to qualify as a real estate investment trust subsidiary.
IMPACT OF YEAR 2000
The Manager took the necessary steps to ensure that its software systems and applications would not fail or create erroneous results by or at December 31, 1999 ("Year 2000 compliant"). The Manager also took steps to ensure that the vendors it utilizes and institutions that it interfaces with had also taken the necessary steps to become Year 2000 compliant. The Company experienced no material instances of Year 2000 compliance failures.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company only has one remaining non-REMIC CMO outstanding at December 31, 1999 with related mortgage securities collateral of $30.8 million that supports bonds of $30.1 million resulting in a retained CMO residual of $699,000 (CMO Series 1993-1). The Company has exposure to interest rate risk related to this CMO residual. If mortgage interest rates rise from current levels, mortgage prepayments on the collateral are expected to decline allowing the Company to earn the net interest spread and to amortize related collateral premiums and bond discounts for a longer period of time. Conversely, if mortgage rates decline, prepayments will likely increase and the period of time that a net interest spread can be earned and related collateral premiums and bond discounts can be amortized over will be shorter. If mortgage rates were to be 100 basis points higher or lower in 2000, operating results of this residual can be expected to increase by $9,000 or decrease by $49,000, respectively.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
REPORT OF INDEPENDENT AUDITORS
Stockholder and Board of Directors Capstead Securities Corporation IV
We have audited the accompanying balance sheet of Capstead Securities Corporation IV (a wholly-owned subsidiary of Capstead Mortgage Corporation) as of December 31, 1999 and 1998, and the related statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Capstead Securities Corporation IV at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
ERNST & YOUNG LLP
Dallas, Texas January 27, 2000
CAPSTEAD SECURITIES CORPORATION IV BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes to financial statements.
CAPSTEAD SECURITIES CORPORATION IV STATEMENT OF OPERATIONS (IN THOUSANDS)
See accompanying notes to financial statements.
CAPSTEAD SECURITIES CORPORATION IV STATEMENT OF STOCKHOLDER'S EQUITY THREE YEARS ENDED DECEMBER 31, 1999 (IN THOUSANDS)
See accompanying notes to financial statements.
CAPSTEAD SECURITIES CORPORATION IV STATEMENT OF CASH FLOWS (IN THOUSANDS)
See accompanying notes to financial statements.
NOTES TO FINANCIAL STATEMENTS CAPSTEAD SECURITIES CORPORATION IV DECEMBER 31, 1999
NOTE A -- BASIS OF PRESENTATION
Capstead Securities Corporation IV (the "Company"), was incorporated in Delaware on August 16, 1991 as a special-purpose finance corporation primarily to issue bonds collateralized by whole loans or mortgage-backed securities. The Company is a wholly-owned subsidiary of Capstead Mortgage Corporation ("CMC"), which commenced operations with the issuance of its first collateralized mortgage obligation ("CMO") on December 23, 1991.
NOTE B -- ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The amortization of premiums and discounts on mortgage securities collateral and collateralized mortgage securities is based on expectations of future movements in interest rates and how resulting rates will impact prepayments on underlying mortgage loans. It is possible that prepayments could rise to levels that would adversely affect profitability if such levels are sustained for more than a brief period of time.
DEBT SECURITIES
Mortgage securities collateral held in the form of mortgage-backed securities are debt securities. Management determines the appropriate classification of debt securities at the time of purchase or securitization and reevaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. Debt securities not classified as held-to-maturity are classified as available-for-sale. Available-for-sale securities are stated at fair value with unrealized gains and losses, net of tax, reported as a separate component of stockholder's equity.
Amortized cost is adjusted for amortization of premiums and discounts over the estimated life of the security using the interest method. Such amortization is included in related interest income.
Mortgage securities collateral is subject to changes in value because of changes in interest rates and rates of prepayment, as well as failure of the mortgagor to perform under the mortgage agreement. The Company has limited its exposure to these risks by issuing collateralized mortgage securities, acquiring mortgage pool and special hazard insurance, and simultaneously selling collateral released from indentures upon redemption of the related bonds.
ALLOWANCE FOR POSSIBLE LOSSES
The Company provides for possible losses on its investments in amounts which it believes are adequate relative to the risk inherent in such investments. The Company does not provide for losses resulting from covered defaults on investments with mortgage pool insurance and special hazard insurance (see Note F).
COLLATERALIZED MORTGAGE SECURITIES
Collateralized mortgage securities are carried at their unpaid principal balances, net of unamortized discount or premium. Any discount or premium is recognized as an adjustment to interest expense by the interest method over the life of the related securities.
INCOME TAXES
The Company believes it has qualified as a real estate investment trust ("REIT") subsidiary of CMC under the Internal Revenue Code of 1986 (the "Code"), and for federal income tax purposes is combined with CMC. Under applicable sections of the Code, a REIT is required to meet certain asset, income and stock ownership requirements as well as distribute at least 95% of its taxable income, the distribution of which may extend into the subsequent taxable year. It is the Company's policy to distribute 100% of taxable income within the time limits prescribed by the Code. Accordingly, no provision has been made for federal income taxes.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.
NOTE C -- MORTGAGE SECURITIES COLLATERAL
Mortgage securities collateral consists of conventional single-family mortgage loans that are pledged to secure repayment of the collateralized mortgage securities. All principal and interest payments on the collateral are remitted directly to a collection account maintained by a trustee. The trustee is responsible for reinvesting those funds in short-term investments. All collections on the collateral and the reinvestment income earned thereon is available for payment of principal and interest on the collateralized mortgage securities.
The components of mortgage securities collateral are summarized as follows (in thousands):
The weighted average effective interest rate for mortgage securities collateral was 6.49% and 7.99% during 1999 and 1998, respectively.
NOTE D -- COLLATERALIZED MORTGAGE SECURITIES
Each series of collateralized mortgage securities consists of various classes, some of which may be deferred interest securities. Substantially all classes of bonds are at a fixed rate of interest. Interest is payable quarterly or monthly at specified rates for all classes other than the deferred interest securities. Generally, principal payments on each series are made to each class in the order of their stated maturities so that no payment of principal will be made on any class until all classes having an earlier stated maturity have been paid in full. Generally, payments of principal and interest on the deferred interest securities will commence only upon payment in full of all other classes. Prior to that time, interest accrues on the deferred interest securities and the amount accrued is added to the unpaid principal balance. The components of collateralized mortgage securities are summarized as follows (dollars in thousands):
The maturity of each series of securities is directly affected by the rate of principal prepayments on the related mortgage securities collateral. Each series of securities is also subject to redemption at the Company's option provided that certain requirements specified in the related indenture have been met (referred to as "clean-up calls"). As a result, the actual maturity of any series of securities is likely to occur earlier than its stated maturity.
The weighted average effective interest rate for all collateralized mortgage securities was 6.20% and 7.93% during 1999 and 1998, respectively. Interest payments on collateralized mortgage securities of $20,406,000, $35,567,000, and $51,577,000 were made during 1999, 1998, and 1997, respectively.
NOTE E -- DISCLOSURES REGARDING FAIR VALUES OF FINANCIAL INSTRUMENTS
The estimated fair value of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies; however, considerable judgment is required in interpreting market data to develop these estimates. In addition, fair values fluctuate on a daily basis. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
The carrying amount of cash and cash equivalents approximates fair value. The fair value of mortgage securities collateral was estimated using either quoted market prices, when available, including quotes made by CMC's lenders in connection with designating collateral for repurchase arrangements. The fair value of collateralized mortgage securities is dependent upon the characteristics of the mortgage securities collateral pledged to secure the issuance; therefore, fair value was based on the same method used for determining fair value for the underlying mortgage securities collateral, adjusted for credit enhancements. The following table summarizes the fair value of financial instruments (in thousands):
The following table summarizes fair value disclosures for mortgage securities collateral held available-for-sale and held to maturity (in thousands):
Upon the Company's redemption of remaining bonds outstanding pursuant to clean-up calls, released CMO collateral may be sold. Such sales are deemed maturities under the provisions of SFAS 115. The following table summarizes disclosures related to the disposition of released CMO collateral held available-for-sale and held-to-maturity (in thousands):
* Represents the reclassification amount included in other comprehensive income (loss) as a component of the change in unrealized gains (losses) on debt securities held available-for-sale.
NOTE F -- ALLOWANCE FOR POSSIBLE LOSSES
The Company has limited exposure to losses on mortgage loans. Losses due to typical mortgagor default or fraud or misrepresentation during origination of the mortgage loan are substantially reduced by the acquisition of mortgage pool insurance from AAA-rated mortgage pool insurers. The amount of coverage under any such mortgage pool insurance policy is the amount (typically 10% to 12% of the aggregate amount in such pool of mortgage loans), determined by one or more Rating Agencies, necessary to allow the securities such pools are pledged to secure to be rated AAA, when combined with homeowner equity or other insurance coverage. Certain other risks, however, are not covered by mortgage pool insurance. These risks include special hazards which are not covered by standard hazard insurance policies. Special hazards are typically catastrophic events that are unable to be predicted (e.g., earthquakes). The Company has limited its exposure to special hazard losses by acquiring special hazard insurance coverage from an insurer rated AAA. Because of its limited exposure to mortgage loan losses, the Company has determined that an allowance for losses is not warranted at December 31, 1999.
Since approximately 74% of the Company's mortgage loans are secured by properties located in California, the Company has a concentration of risk related to the California market. However, the Company's exposure arising from this concentration is reduced by the acquisition of mortgage pool insurance and special hazard insurance.
NOTE G -- MANAGEMENT AGREEMENT
The Company operates under a $10,000 per year management agreement with CMC (the "Manager"). The agreement provides that the Manager will advise the Company with respect to all facets of its business and administer the day-to-day operations of the Company under the supervision of the Board of Directors. The Manager pays, among other things, salaries and benefits of its personnel, accounting fees and expenses, and other office expenses incurred in supervising and monitoring the Company's investments.
NOTE H -- TRANSACTIONS WITH RELATED PARTY
The Company signed a $1 million revolving subordinated promissory note with CMC under which interest accrued on amounts payable based on the annual federal short-term rate as published by the Internal Revenue Service. This note matures January 1, 2001. Repayments may be made as funds are available.
CMC is the administrator with respect to the Non-Agency Certificates collateralizing Series 1998-3 and related CMOs. During 1999 CMC retained fees for administering these Non-Agency Certificates and related CMOs of $34,000.
On a monthly basis, the Company's excess cash is advanced to CMC for which the Company earns interest based on the annual federal short-term rate. At the end of each quarter, these advances are accounted for as distributions to CMC and treated as returns of capital.
NOTE I -- NET INTEREST INCOME ANALYSIS (UNAUDITED)
The following table summarizes interest income and interest expense and the average effective interest rate for mortgage securities collateral and collateralized mortgage securities (dollars in thousands):
The following table summarizes the amount of change in interest income and interest expense due to changes in interest rates versus changes in volume (in thousands):
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Documents filed as part of this report:
1. The following financial statements of the Company are included in ITEM 8:
EXHIBIT NUMBER
3.1 Certificate of Incorporation(1) 3.2 Bylaws(1) 4.1 Form of Indenture between the Registrant and Texas Commerce Bank, National Association, as Trustee(1) 4.2 Form of First Supplement to the Indenture(3) 4.3 Form of Second Supplement to the Indenture(4) 4.4 Form of Third Supplement to the Indenture(5) 4.5 Form of Fourth Supplement to the Indenture(6) 4.6 Form of Fifth Supplement to the Indenture(7) 4.7 Form of Sixth Supplement to the Indenture(7) 4.8 Form of Seventh Supplement to the Indenture(8) 4.9 Form of Eighth Supplement to the Indenture(9) 4.10 Form of Ninth Supplement to the Indenture(9) 4.11 Form of Tenth Supplement to the Indenture(10) 4.12 Form of Eleventh Supplement to the Indenture(11) 4.13 Form of Twelfth Supplement to the Indenture(10) 4.14 Form of Thirteenth Supplement to the Indenture(12) 4.15 Form of Fourteenth Supplement to the Indenture(13) 4.16 Form of Fifteenth Supplement to the Indenture(13) 4.17 Form of Sixteenth Supplement to the Indenture(14) 4.18 Form of Seventeenth Supplement to the Indenture(14) 4.20 Form of Nineteenth Supplement to the Indenture(17) 10.1 Form of Pooling and Administrative Agreement(1) 10.2 Form of Servicing Agreement(1) 10.4 Management Agreement between the Company and Capstead Advisers, Inc. dated January 1, 1994(2)
PART IV ITEM 14. - CONTINUED
3. Exhibits (continued):
EXHIBIT NUMBER
10.5 Amended Management Agreement between the Company and Capstead Advisers, Inc. October 1, 1994(16) 23 Consent of Ernst & Young LLP, Independent Auditors* 27 Financial Data Schedule*
(b) Reports on Form 8-K: None.
(c) Exhibits - The response to this section of ITEM 14 is submitted as a separate section of this report.
- ----------------- (1) Incorporated herein by reference to the Company's Registration Statement on Form S-3 (No. 33-42337) filed August 21, 1991. (2) Previously filed with the Commission as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. (3) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on December 24, 1991. (4) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on December 23, 1991. (5) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on January 28, 1993. (6) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on February 28, 1993. (7) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on March 30, 1993. (8) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on April 30, 1993. (9) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on May 29, 1993. (10) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on June 30, 1993. (11) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on June 29, 1993. (12) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on July 30, 1993. (13) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on August 28, 1993. (14) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on September 30, 1993. (15) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on January 29, 1994. (16) Previously filed with the Commission as an exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1994. (17) Previously filed with the Commission as an exhibit to the Registrant's Current Report on Form 8-K on October 9, 1998. * Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CAPSTEAD SECURITIES CORPORATION IV REGISTRANT
Date: March 24, 2000 By:/s/ ANDREW F. JACOBS -------------------------------- Andrew F. Jacobs Executive Vice President-Finance
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated below and on the dates indicated.
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT.
No annual report or proxy material has been sent to security holders.
INDEX TO EXHIBITS | 5,017 | 33,252 |
1015535_1999.txt | 1015535_1999 | 1999 | 1015535 | ITEM 1. BUSINESS
General Development of Business
AMF Bowling Worldwide, Inc. ("Bowling Worldwide" and, together with its subsidiaries, the "Com-pany" or "AMF") is the largest owner or operator of bowling centers in the United States and worldwide. In addition, the Company is one of the world's leading manufacturers of bowling center equipment, accounting for, management believes, approximately 40% of the world's current installed base of such equipment. AMF is principally engaged in two business segments: (i) the ownership or operation of bowling centers ("Bowling Centers"), consisting, as of December 31, 1999, of 417 U.S. bowling centers and 122 international bowling centers including 15 centers operated by joint ventures with third parties described below and (ii) the manufacture and sale of bowling equipment such as automatic pinspotters, automatic scoring equipment, bowling pins, lanes, ball returns, and certain spare and consumable products, and the resale of allied products such as bowling balls, bags, shoes and certain other spare and consumable products ("Bowling Products"). The Bowling Products business consists of two categories: (a) New Center Packages ("NCPs") (all of the equipment necessary to outfit a new bowling center or expand an existing bowling center) and (b) Modernization and Consumer Products (which includes modernization equipment used to upgrade an existing center, spare parts, supplies and consumable products essential to maintain operations of an existing center). See "Note 16. Business Segments" in the Notes to Consolidated Financial Statements for financial information about AMF's business segments.
Bowling Worldwide is a wholly owned subsidiary of AMF Group Holdings Inc. ("AMF Group Holdings") and AMF Group Holdings is a wholly owned subsidiary of AMF Bowling, Inc. ("AMF Bowling"). AMF Bowling, AMF Group Holdings and the Company were incorporated in Delaware in 1996 by an investor group led by GS Capital Partners II, L.P. (together with affiliated investment funds, "GSCP"), an affiliate of Goldman, Sachs & Co. AMF Group Holdings acquired all of the outstanding stock of the separate U.S. and foreign corporations that constituted substantially all of the Company's predecessor (the "Predecessor Company") for a total purchase price of approximately $1.37 billion (the "Ac- quisition"). Bowling Worldwide conducts all of its business through subsidiar- ies and provides certain limited management service operations to its subsidi- aries. Unless the context indicates otherwise, the terms "Company" or "AMF" as used herein refer to Bowling Worldwide (the "Registrant") and its subsidiar- ies.
From May 1996 to December 1999, the Company acquired 230 centers in the U.S. and, as of February 29, 2000, owns or operates 417 U.S. centers. In addi- tion, in 1997 and 1998, the Company acquired 33 centers in selected interna- tional markets and, as of February 29, 2000, owns or operates 122 interna- tional centers, including 15 joint venture centers. In 1997, the Company entered into two joint ventures which operate one bowling center in China and 14 bowling centers in Brazil and Argentina, respectively. AMF also manufac- tures and sells the PlayMaster, Highland and Renaissance brands of billiards tables, and owns the Michael Jordan Golf Company which currently operates two golf practice ranges. The Company has agreed to build or acquire one addi- tional golf practice range by the end of 2000. See "Item 6. Selected Financial Data", and "Note 14. Acquisitions" and "Note 15. Joint Ventures" in the Notes to Consolidated Financial Statements for discussions regarding acquisitions and joint ventures.
In November 1997, AMF Bowling issued 15,525,000 shares of its common stock ("AMF Bowling Common Stock") at $19.50 per share pursuant to an initial public offering (the "Initial Public Offering").
Business Segments
Bowling Centers
In the United States, AMF is the largest operator of bowling centers, with 417 bowling centers (as of February 29, 2000) in 40 states and Puerto Rico. Outside the United States, AMF is also the largest operator of bowling cen- ters, with (as of February 29, 2000) 122 centers in ten countries: Australia (46), the United Kingdom (37), Mexico (9), Japan (4), China (including Hong Kong) (5), Argentina (2), Brazil (12), France (4), Spain (2), and Canada (1). Of the U.S. centers, 207 were acquired as part of the Acquisition, 230 were acquired thereafter and two were constructed. AMF has closed 22 centers since the Acquisition. Of the international centers, 78 were acquired as part of the Acquisition, 33 were acquired thereafter, including 22 in the United Kingdom, ten in Australia and one in France. One center each in Japan and China was closed, and one each in Switzerland and China was sold. The international cen- ters include one in China, two in Argentina and 12 in Brazil, which are oper- ated as part of two joint ventures.
The Bowling Centers business derives its revenue and profits from three principal sources: (i) bowling, (ii) food and beverage and (iii) other sources such as shoe rental, amusement games, billiards and pro shops. In 1999, bowl- ing, food and beverage and other revenue represented 58.4%, 27.3% and 14.3% of total Bowling Centers revenue, respectively.
Bowling revenue, the largest portion of a bowling center's revenue and profitability, is derived from league, tournament and recreational play, which represents managed, or scheduled (e.g. birthday or corporate parties), and open, or unscheduled, play. Food and beverage sales occur primarily through snack bars that offer snack foods, soft drinks and, at most centers, alcoholic beverages. Since the Acquisition, AMF acquired several centers with large sports bars that provide a large portion of such centers' revenue. Other reve- nue is derived from shoe rental and the operation of amusement games, bil- liards and pro shops. Shoe rental is driven primarily by recreational bowlers who usually do not own bowling shoes.
Bowling Products
The Company manufactures and sells bowling center equipment, including au- tomatic pinspotters, automatic scoring equipment, bowling pins, lanes, ball returns, certain spare and modernization parts, and resale products, such as bowling balls, bags, shoes and other bowlers' aids, sold primarily through pro shops. The Bowling Products business consists of two categories: (i) NCPs and (ii) Modernization and Consumer Products.
NCPs include the bowling equipment necessary to outfit new or expand exist- ing bowling centers, such as lanes, pinspotters, automatic scoring equipment, bowler seating, ball returns, masking units and bumpers. NCP sales generally follow the trends in the growth of bowling. Traditionally, as bowling is in- troduced and becomes popular in new markets, the economics of constructing and operating bowling centers become attractive and drive demand for NCPs. For at least the last 15 years, the majority of NCP sales has been to international markets. Until 1998, this trend was fueled by the growth of bowling in several countries, particularly China, South Korea and Taiwan. The economic difficul- ties in the Asia Pacific region resulted in a significant reduction in NCP sales in that region during 1998 and 1999 and are expected to continue to have a material adverse impact on NCP sales. In addition, Shanghai Zhonglu Indus- trial Corporation ("Zhonglu") became a significant competitor with Bowling Products in China. Bowling Products signed 3-year joint distribution agree- ments in June 1999 with Zhonglu whereby Zhonglu became the exclusive distribu- tor of AMF products and parts in China, and Bowling Products became the exclu- sive distributor of Zhonglu bowling products and parts outside China. See "-- Business Strategy" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations--Bowling Products."
Sales of Modernization and Consumer Products to bowling center operators who manage the installed base of bowling equipment have traditionally provided a somewhat more stable base of recurring revenue on an annual basis. These products include modernization equipment, both proprietary and standard spare parts for existing equipment and other products including pins, shoes and sup- plies. Some of these products, such as bowling pins, should be replaced on ap- proximately an annual basis to maintain a center, while certain less frequent investments in other equipment are necessary to modernize a center and are of- ten required to maintain a customer base. AMF also sells resale products in- cluding balls, bags and apparel for consumer purchase and use.
In addition to bowling equipment and supplies, AMF manufactures and sells billiards tables under the PlayMaster, Highlander and Renaissance brand names.
Business Strategy
The Company is pursuing a three-part strategy to create a nationally recog- nized chain of bowling centers through consolidation of the bowling center in- dustry and national marketing programs in the U.S. and selected international markets, leverage the AMF brand and strong base of installed bowling equipment to grow sales of bowling products globally and become the employer of choice in its industry.
With respect to Bowling Centers, the Company curtailed its acquisitions in 1999 to focus on improving center operations and financial performance which is fundamental to its strategy to create a nationally recognized chain. In connection with this effort, the Company conducted a strategic business review in which certain performance drivers and revenue opportunities were identi- fied, recruited a new and experienced operating management team, and developed a customer satisfaction model which incorporates center performance drivers into seven critical success factors.
These critical success factors are (i) value, or the relationship between price and the service provided, (ii) bowling equipment including lanes, pinspotters and scoring; (iii) location; (iv) quality of interior and exterior facilities; (v) quality of food and beverage offerings; (vi) marketing pro- grams that drive trial and repeat customer visits and (vii) customer service. The Company is in the process of identifying the acceptable level of perfor- mance in each of the seven critical success factors, and will provide these to each center to determine the specific actions necessary to bring each center up to a standard level of performance. The Company expects to focus efforts on maximizing customer service performance in order to attract and retain more bowlers, thereby creating a sustainable competitive advantage. The Company is also focused on creating standard operating procedures, training programs and improving information systems in the bowling centers. Improvements in these areas are intended to facilitate better execution of customer service and mar- keting programs and provide better data designed to help management proactively direct the business. Marketing programs will focus in two key areas: (i) developing national programs that leverage the efficiencies of the total chain and add value to individual centers and (ii) developing a "Best Practices" process to share successful regional programs.
While the Company's intention is to continue consolidating the U.S. bowling center industry by acquiring additional bowling centers, the Company announced in January 2000 that it will resume acquisitions on a more selective basis and will consider acquisition targets which meet specific operating and valuation parameters. At the same time, management will continue its focus on improving financial performance of its current centers. The Company had no commitment to purchase any bowling centers as of February 29, 2000.
The Company's Bowling Products business markets and distributes bowling products in global markets. In response to market conditions experienced in 1998 and 1999, Bowling Products enacted a comprehensive cost reduction program that lowered manufacturing and global selling, general and
administrative costs and initiated several distributor relationships for se- lected product lines. Additionally, Bowling Products signed 3-year joint dis- tribution agreements in June 1999 with Zhonglu whereby Zhonglu became the ex- clusive distributor of AMF products and parts in China, and Bowling Products became the exclusive distributor of Zhonglu bowling products and parts outside China. These agreements are intended to improve Bowling Products' competitive position in China and broaden Bowling Products' product offering in developing markets. The Company developed a customer satisfaction model for Bowling Prod- ucts, and identified eight critical success factors which are (i) value, (ii) technical support, (iii) product quality, (iv) financing capabilities, (v) or- der fulfillment, (vi) sales support, (vii) product innovation and (viii) in- stallation. Bowling Products will identify and strive to achieve a standard level of performance in each of these factors. The Company will focus efforts on product quality in order to create a sustainable competitive advantage, and will concentrate on order fulfillment in an effort to improve performance lev- els. Bowling Products continues to focus product development efforts on im- proving its current offerings and introducing new products that will appeal to a worldwide base of center operators. These initiatives are designed to expand the Company's presence in the relatively more stable Modernization and Con- sumer Products markets. To support these efforts, Bowling Products has reorga- nized its product management organization and is implementing a worldwide product line focused financial system.
Management recognizes that, in order to become the employer of choice in its industry, the Company must cultivate, retain and attract enthusiastic and motivated employees. In this connection, AMF broadened stock option award dis- tributions to include all center managers, enhanced Company benefits plans and improved the working environment in its three manufacturing facilities. The Company continues its development of a competitive compensation structure and now provides communication channels which allow employees to provide input into decisions affecting their work environments. These initiatives are in- tended to improve employee morale and motivation which are key drivers of cus- tomer satisfaction. Management believes that improved customer satisfaction should lead to improved financial performance of the Company.
Seasonality and Market Development Cycles
The financial performance of Bowling Centers' operations is seasonal. Cash flows typically peak in the winter when U.S. leagues are most active and reach their lows in the summer. While the geographic diversity of the Company's Bowling Centers operations has helped reduce this seasonality in the past, the increase in U.S. centers resulting from acquisitions has increased the seasonality of that business.
Modernization and Consumer Products sales also display seasonality. The U.S. market, which is the largest market for Modernization and Consumer Prod- ucts, is driven by the beginning of league play in the fall of each year. While operators purchase consumer products generally throughout the year, they often place larger orders during the summer in preparation for the start of league play in the fall. Summer is also generally the peak period for instal- lation of modernization equipment. Operators typically sign purchase orders for modernization equipment during the first four months of the year after they receive winter league revenue indications. Equipment is then shipped and installed during the summer when leagues are generally less active. However, sales of some modernization equipment such as automatic scoring and synthetic lanes are less predictable and fluctuate from year to year because of the longer life cycle of these major products.
While NCP sales are slightly seasonal, sales of NCPs can fluctuate dramati- cally as a result of economic fluctuations in international markets, as seen in the reduction of sales of NCPs since 1998 to markets in the Asia Pacific region following economic difficulties in that region.
Industry and Competition
Bowling Centers
Bowling is both a competitive sport and a recreational entertainment activ- ity and faces competition from numerous alternative activities. The success of AMF's bowling operations is subject to consumers' continued interest in bowl- ing, the availability and affordability of other sports and recreational and entertainment alternatives, the amount of customer leisure time, as well as various other social and economic factors over which AMF has no control.
The Company's centers also compete with other bowling centers. The Company competes primarily through customer service as well as the quality of its bowling equipment, location, facilities, food and beverage offerings and mar- keting programs. See "--Business Strategy" and "Item 7. Management's Discus- sion of Financial Condition and Results of Operations--Bowling Centers."
As shown in the following table, the U.S. bowling center industry is highly fragmented, and consists of two relatively large bowling center operators, AMF (which had 417 U.S. centers as of December 31, 1999) and Brunswick Corporation ("Brunswick") (which had approximately 114 U.S. centers as of December 31, 1999), three medium-sized chains, which together account for 54 bowling cen- ters, and over 5,000 bowling centers owned by single-center and small-chain operators, which typically own four or fewer centers. The top five operators (including AMF) account for approximately 10.5% of the total number of U.S. bowling centers.
U.S. BOWLING CENTER INDUSTRY (a)
- -------- (a) AMF estimate at December 31, 1999.
The international bowling center industry is also highly fragmented. There are typically few chain operators in any one country and a large number of single-center operators. AMF generally enjoys a relative size advantage (i.e., a larger number of lanes per center), and is competitively well-positioned in Australia, the United Kingdom and Mexico.
In the United States, the operation of bowling centers generally has been characterized by slightly declining lineage (number of games bowled per lane per day). The Company's bowling centers business has experienced and is con- tinuing to experience a decline in lineage. This decline has been primarily caused by a decrease in the number of league bowlers. While more people are bowling at AMF's bowling centers, they are bowling less often. As part of the Company's recent efforts to focus on improving the financial performance of the Company's existing centers, AMF is seeking to improve lineage at the Company's bowling centers; however, there can be no assurances that lineage will increase or that the lineage will not further decline. In 1999, the U. S. constant centers lineage declined slightly and was more than offset with price increases yielding a net constant center revenue growth.
See "--Business Strategy" for a discussion of the Company's business strategy for its bowling centers. Internationally, although trends vary by country, certain of the markets in which AMF operates have experienced increasing com- petition as they have matured, resulting in declining lineage.
Bowling Products
AMF and Brunswick are the two largest manufacturers of bowling center equipment, and are the only full-line manufacturers of bowling equipment and supplies that compete on a global basis. The Company also competes with small- er, often regionally focused companies in certain product lines. See "--Inter- national Operations" for a discussion of additional factors that may affect the international operations of Bowling Products. Management estimates that AMF accounts for approximately 40% of the worldwide installed base of bowling center equipment.
International Operations
The Company's international operations are subject to the usual risks in- herent in operating abroad, including, but not limited to, currency exchange rate fluctuations, economic and political fluctuations and destabilization, other disruption of markets, restrictive laws, tariffs and other actions by foreign governments (such as restrictions on transfer of funds, import and ex- port duties and quotas, foreign customs, tariffs and value added taxes and un- expected changes in regulatory environments), difficulty in obtaining distri- bution and support for products, the risk of nationalization, the laws and policies of the United States affecting trade, international investment and loans, and foreign tax law changes.
The Company has a history of operating in a number of international mar- kets, in some cases, for over 30 years. As in the case of other U.S.-based manufacturers with export sales, local currency devaluation increases the cost of the Company's bowling equipment in that market. As a result, a strengthen- ing U.S. dollar exchange rate may adversely impact sales volume and profit margins during such periods.
Foreign currency exchange rates also impact the translation of operating results from international bowling centers. Revenue and recurring EBITDA (as defined in "Item 6. Selected Financial Data") of international bowling centers represented 17.0% and 24.7% of consolidated revenue and recurring EBITDA, re- spectively, in 1999. Revenue and EBITDA of international bowling centers rep- resented 15.7% and 23.2% of consolidated revenue and EBITDA, respectively, in 1998.
NCP unit sales to China, Japan and other countries in the Asia Pacific re- gion represented 43.0% of total NCP unit sales in 1999 compared to 52.8% in 1998. The economic difficulties in the Asia Pacific region have had and will continue to have a material adverse impact on NCP sales. One of the reasons for the decline in NCP sales is the limited availability of financing for cus- tomers desiring to build new bowling centers, especially in the Asia Pacific region. In addition, Zhonglu became a significant competitor in China. On June 13, 1999, Bowling Products signed three-year joint distribution agreements with Zhonglu. Under the terms of the agreements, Zhonglu became the exclusive distributor of AMF products and parts in China, and Bowling Products became the exclusive distributor of Zhonglu's bowling products and parts outside Chi- na. These agreements are intended to improve Bowling Products' competitive po- sition in both China and other developing markets. However, there is no assur- ance that such an improvement will occur. See "--Business Segments--Bowling Products" for additional discussion of the Zhonglu agreements.
China strengthened enforcement of its import restrictions including requir- ing the payment of full customs duties and value-added taxes on the importa- tion of new and used capital goods. The Chinese government also began to pro- hibit importation of used capital equipment without permits. Permits for the importation of used bowling equipment are very difficult to obtain. Local Chi- nese companies, how-
ever, are not subject to the same restrictions. For example, in addition to being the exclusive distributor of AMF products, Zhonglu produces locally and sells bowling equipment that is not subject to the customs duties or permit requirements that affect the Company's imported equipment. Zhonglu has experi- enced significant acceptance by local customers. Management believes that these import restrictions will continue for the foreseeable future.
See "Note 16. Business Segments" and "Note 17. Geographic Segments" in the Notes to Consolidated Financial Statements for additional financial informa- tion concerning the Company's operations in different geographic areas.
Employees
Bowling Centers
As of December 31, 1999, Bowling Centers had approximately 15,568 full- and part-time employees worldwide. The Company believes that its relations with its Bowling Centers employees are satisfactory.
- -------- (a) Numbers vary depending on the time of year.
Bowling Products
As of December 31, 1999, Bowling Products had approximately 957 full-time employees worldwide. The Company believes that its relations with its Bowling Products employees are satisfactory. Employees are divided along functional lines as shown in the table below.
Corporate
As of December 31, 1999, corporate had approximately 166 full-time employ- ees. The Company believes that its relations with its corporate employees are satisfactory.
ITEM 2.
ITEM 2. PROPERTIES
Bowling Centers
As of December 31, 1999, AMF operated 417 bowling centers and related fa- cilities in the United States and 122 centers in ten other countries. A re- gional list of these facilities is set forth below:
U.S. CENTERS
- -------- (a) AMF operates one center for an unrelated party. This center is neither owned nor leased by AMF and, therefore, is not included in the foregoing table. In addition, the Company operates two golf practice ranges, one each in Aurora, Illinois and Charlotte, North Carolina.
INTERNATIONAL CENTERS
- -------- (a) The table excludes one bowling center operated by the Company's Hong Leong joint venture and 14 bowling centers operated by its Playcenter joint ven- ture. See "Item 1. Business--General Development of Business."
AMF's leases are subject to periodic renewal. Forty-two of the U.S. centers have leases that expire during the next three years. Twenty-six of such leases have renewal options. Fifteen of the international centers have leases that expire during the next three years. Nine of such leases have renewal options. For information concerning major encumbrances on Company-owned real estate, see "Note 8. Long-Term Debt and Recapitalization Plan" in the Notes to Consol- idated Financial Statements.
Bowling Products
As of December 31, 1999, AMF owned or leased facilities at three locations in the United States, two of which are used for its Bowling Products business and one of which is used for its billiards business. AMF also leased facili- ties at 13 international locations that are used as offices or warehouses. For information concerning major encumbrances on Company-owned real estate, see "Note 8. Long-Term Debt and Recapitalization Plan" in the Notes to Consoli- dated Financial Statements.
U.S. Facilities
International Facilities
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On April 22, 1999, a putative class action was filed in the United States District Court for the Southern District of New York by Vulcan International Corporation against AMF Bowling, The Goldman Sachs Group, L.P., Goldman, Sachs & Co., Morgan Stanley & Co. Incorporated, Cowen & Company,
Schroder & Co., Inc., Richard A. Friedman and Douglas J. Stanard. The com- plaint has subsequently been amended to, among other things, include addi- tional named plaintiffs. The plaintiffs, as putative class representatives for all persons who purchased AMF Bowling Common Stock in the Initial Public Of- fering or within 25 days of the effective date of the registration statement related to the Initial Public Offering, seek, among other things, damages and/or rescission against all defendants jointly and severally pursuant to Sections 11, 12 and/or 15 of the Securities Act of 1933 based on allegedly in- accurate and misleading disclosures in connection with and following the Ini- tial Public Offering. Management believes that the litigation is without merit and intends to defend it vigorously.
In addition, the Company currently and from time to time is subject to claims and actions arising in the ordinary course of its business, including environmental claims, discrimination claims, workers' compensation claims and personal injury claims from customers of Bowling Centers. In some actions, plaintiffs request punitive or other damages that may not be covered by insur- ance. In management's opinion, the claims and actions in which the Company is involved will not have a material adverse impact on its financial position or results of operations. However, it is not possible to predict the outcome of such claims and actions.
Regulatory Matters
There are no unique federal or state regulations applicable to bowling cen- ter operations or equipment manufacturing. State and local governments require establishments to hold permits to sell alcoholic beverages, and, although reg- ulations vary from state to state, once permits are issued, they generally re- main in place indefinitely (except for routine renewals) without burdensome reporting or supervision other than revenue tax reports.
Environmental Matters
The Company's operations are subject to federal, state, local and foreign environmental laws and regulations that impose limitations on the discharge of, and establish standards for the handling, generation, emission, release, discharge, treatment, storage and disposal of, certain materials, substances and wastes.
The Company currently and from time to time is subject to environmental claims. In management's opinion, the various claims in which the Company cur- rently is involved are not likely to have a material adverse impact on its fi- nancial position or results of operations. However, it is not possible to en- sure the ultimate outcome of such claims.
The Company cannot predict with any certainty whether existing conditions or future events, such as changes in existing laws and regulations, may give rise to additional environmental costs. Furthermore, actions by federal, state, local and foreign governments concerning environmental matters could result in laws or regulations that could increase the cost of producing AMF's products, or providing its services, or otherwise adversely affect the demand for its products or services.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR BOWLING WORLDWIDE COMMON STOCK AND RELATED INVESTOR MATTERS
Common Stock
The common stock, $.01 par value, of Bowling Worldwide is wholly owned by AMF Group Holdings. Bowling Worldwide did not pay any cash dividends on its common stock during 1998 and 1999 and intends to retain earnings, if any, for use in the Company's business.
Bowling Worldwide is prohibited under both the credit agreement dated as of May 1, 1996, as amended and restated (the "Credit Agreement") and certain in- dentures governing its 10 7/8% Series B Senior Subordinated Notes ("Subsidiary Senior Subordinated Notes") and 12 1/4% Series B Senior Subordinated Discount Notes ("Subsidiary Senior Subordinated Discount Notes" and, collectively with the Subsidiary Senior Subordinated Notes, the "Subsidiary Notes") from upstreaming funds to AMF Bowling by dividends, loans or otherwise, to pay cash dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below for the fiscal years indicated were derived from AMF Group Holdings' audited consolidated financial state- ments for the years ended December 31, 1999, 1998 and 1997, the period ended December 31, 1996, and the Predecessor Company's audited combined financial statements for the four months ended April 30, 1996, and the year ended Decem- ber 31, 1995. The consolidated pro forma results set forth below for the year ended December 31, 1996 are presented as if the Acquisition had occurred on January 1, 1996, and are based on the Predecessor Company's statement of in- come for the period ending April 30, 1996, AMF Group Holdings' statement of operations from its inception through December 31, 1996, and adjustments giv- ing effect to the Acquisition under the purchase method of accounting. The data should be read in conjunction with AMF Group Holdings' Consolidated Fi- nancial Statements and "Management's Discussion and Analysis of Financial Con- dition and Results of Operations" which appear elsewhere herein.
The comparability of the selected financial data is affected by the Company's bowling center acquisition program. In 1996, the Company, through AMF Bowling Centers, Inc. ("AMF Bowling Centers"), a direct subsidiary of Bowling Worldwide, acquired 57 bowling centers from unrelated sellers. The combined purchase price was $108.0 million. In 1997, AMF Bowling Centers ac- quired 122 bowling centers from a number of unrelated sellers. The combined purchase price was $232.7 million (including amounts paid in 1998 for certain bowling centers included in the 1997 total). In 1998, AMF Bowling Centers ac- quired 83 bowling centers from a number of unrelated sellers. The combined purchase price was $156.8 million. In 1999, AMF Bowling Centers acquired one center for a purchase price of $1.4 million. While the Company intends to con- tinue its efforts to consolidate the U.S. bowling center industry by purchas- ing additional bowling centers, the Company has curtailed the pace of its ac- quisitions so that management can focus on improving the financial performance of its current centers. In the near term, however, the Company continues to evaluate acquisitions on a more limited scale. See "Item 1. Business--General Development of Business" and "Note 13. Supplemental Disclosures to the Consol- idated Statements of Cash Flows" and "Note 14. Acquisitions" in the Notes to Consolidated Financial Statements.
The selected financial data include operating results expressed in terms of EBITDA, which represents earnings before net interest expense, income taxes, depreciation and amortization, and other income and expenses. EBITDA informa- tion is included because the Company understands that such information is used by certain investors as one measure of a company's historical ability to serv- ice debt. EBITDA is not intended to represent and should not be considered more meaningful than, or an alternative to, other measures of performance de- termined in accordance with U.S. generally accepted accounting principles.
- -------- (a) Represents results of operations for the year ended December 31, 1996 as if the Acquisition had occurred on January 1, 1996. AMF Group Holdings' unaudited pro forma statement of income for the year ended December 31, 1996 is based on the Predecessor Company's statement of operations for the four-month period ending April 30, 1996, AMF Group Holdings' statement of operations for the period ended December 31, 1996, and the following adjustments giving effect to the Acquisition under the purchase method of accounting:
(i) To reflect the impact of AMF Group Holdings not acquiring in the Ac- quisition the operations of one bowling center in Switzerland and one bowling center in Spain. (ii) To eliminate a one-time charge of $44.0 million for special bonuses and payments made by the Prior Owners in April 1996. (iii) To reflect the increase in depreciation and amortization expense re- sulting from the allocation of the purchase price to fixed assets and goodwill and a change in the method of depreciation of fixed as- sets. The Predecessor Company principally used the doubled declining balance method. The amount of the pro forma adjustment for deprecia- tion was determined using the straight-line method over the esti- mated lives of the assets acquired. Goodwill is being amortized over 40 years. (iv) To reflect the incremental interest expense associated with the issu- ance of debt which partially funded the Acquisition. (v) To give effect to the change in status of the U.S. and international subsidiaries of AMF Group Holdings from S corporations to taxable cor- porations under the U.S. federal tax laws upon consummation of the Ac- quisition. (b) For the period from the inception date of January 12, 1996 through December 31, 1996, which includes the results of operations of the acquired business from May 1, 1996 through December 31, 1996. (c) Represents results of operations from January 1, 1996 through April 30, 1996. (d) Certain amounts have been reclassified to conform with current year presentation. (e) The ratios of earnings to fixed charges are computed by dividing earnings by the fixed charges. Earnings consist of net income plus fixed charges and income taxes. Fixed charges consist of interest expense, amortization of debt issuance costs, and the portion of rent expense considered to represent interest. For the years ended December 31, 1999, 1998, and 1997 AMF had a deficiency of earnings to fixed charges of $154.8 million, $91.3 million, and $43.7 million, respectively. (f) In 1999, recurring EBITDA represents EBITDA before restructuring charges, asset impairment charges and Special Charges of approximately $8.5 million, $8.1 million and $26.5 million, respectively. See "Note 9. Restructuring Charges, Asset Impairment Charges and Special Charges" in the Notes to Consolidated Financial Statements. (g) Predecessor Company amounts reflect elimination of affiliate receivables and payables.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain matters discussed in this report contain forward-looking state- ments, which are statements other than historical information or statements of current condition. Statements set forth in this report or statements incorpo- rated by reference from documents filed with the Securities and Exchange Com- mission are or may be forward-looking statements, including possible or as- sumed future results of the operations of the Company, including but not limited to any statements contained in this report concerning: (i) the ex- pected success of the Company's plans to improve its bowling centers opera- tions, including revenue enhancement and cost management programs, (ii) the ability of the Company's management to execute its strategies (iii) the abil- ity to resume the Company's bowling center acquisition program, (iv) the ex- pected success of changes initiated in the Company's bowling products busi- ness, (v) the Company's expectations concerning the Asia Pacific region and the joint distribution and related arrangements with Zhonglu, (vi) the ex- pected success of the Company's employee incentive efforts, (vii) the outcome of existing or potential litigation, (viii) the timing or amount of any changes in the interest expense of the Company's indebtedness, (ix) the Company's ability to generate cash flow to service its indebtedness and meet its debt payment obligations, (x) the amounts of capital expenditures needed to maintain or improve the Company's bowling centers, (xi) any statements pre- ceded by, followed by or including the words "believes," "expects," "pre- dicts," "anticipates," "intends," "estimates," "should," "may" or similar ex- pressions and (xii) other statements contained in this report regarding matters that are not historical facts.
These forward-looking statements relate to the plans and objectives of the Company or future operations. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this report should not be regarded as a representation by Bowling Worldwide that the objectives or plans of the Company will be achieved. Many factors could cause the Company's actual results to differ materially from those in the for- ward-looking statements, including: (i) the Company's ability, and the ability of its management team, to carry out the Company's long-term business strate- gies, including resuming the pace of the Company's acquisition program, (ii) the Company's ability to integrate acquired operations into its business, (iii) the Company's ability to identify and develop new bowling markets to as- sist in the growth of such markets, (iv) the continuation of adverse financial results and substantial competition in the Company's bowling products busi- ness, (v) the Company's ability to retain and attract experienced bowling cen- ter management, (vi) the Company's ability to successfully implement initiatives designed to improve customer traffic in its bowling centers, (vii) the continuation or worsening of economic difficulties in overseas markets, including the Asia Pacific region, (viii) the risk of adverse political acts or developments in the Company's existing and proposed international markets, (ix) the fluctuations in foreign currency exchange rates affecting the Company's translation of operating results, (x) continued or increased compe- tition, (xi) the popularity of bowling, (xii) the decline in general economic conditions, (xiii) adverse judgments in pending or future litigation, (xiv) the Company's ability to effectively implement the joint distribution and re- lated arrangements with Zhonglu, (xv) changes in interest and exchange rates and (xvi) the Company's ability to refinance existing indebtedness as it comes due at commercially reasonable terms or at all.
The foregoing review of important factors should not be construed as ex- haustive and should be read in conjunction with other cautionary statements that are included elsewhere in this report. Bowling Worldwide undertakes no obligation to release publicly the results of any future revisions it may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
Background
This discussion should be read in conjunction with the information con- tained under "Item 6. Selected Financial Data" and in AMF Group Holdings' Con- solidated Financial Statements included elsewhere herein.
To facilitate a meaningful comparison, in addition to discussing the con- solidated results of the Company's operations, certain portions of this Man- agement's Discussion and Analysis of Financial Condition and Results of Opera- tions discuss results of Bowling Centers and Bowling Products separately.
The results of operations of Bowling Centers, Bowling Products and the con- solidated group of companies are set forth below. The business segment results presented below are before intersegment eliminations since the Company's man- agement believes that this provides a more accurate comparison of performance by segment from year to year. The intersegment eliminations are not material. Interest expense is presented on a gross basis.
Performance by Business Segment
Bowling Centers
The Bowling Centers results shown below reflect both U.S. and international Bowling Centers operations. To facilitate a meaningful comparison, the con- stant center results discussed below reflect the results of 440 centers that had been in operation one full fiscal year as of December 31, 1998. The dis- cussion of new center results reflect the results of 84 centers that were ei- ther purchased since
January 1, 1998 or had been in operation less than one full fiscal year as of December 31, 1998. Bowling Centers derives its revenue and profits from three principal sources: (i) bowling, (ii) food and beverage and (iii) other sourc- es, such as shoe rental, amusement games, billiards and pro shops. In 1999, bowling, food and beverage and other revenue represented 58.4%, 27.3% and 14.3% of total Bowling Centers revenue, respectively. In 1998, bowling, food and beverage and other revenue represented 58.8%, 27.2% and 14.0% of total Bowling Centers revenue, respectively.
To facilitate a meaningful comparison, the results of Bowling Centers for 1999, have been restated to exclude restructuring charges, asset impairment charges and Special Charges (as defined in "--Consolidated Items--Restructur- ing Charges, Asset Impairment Charges and Special Charges") as shown in the table below. The discussion below gives effect to this restatement. See "Note 9. Restructuring Charges, Asset Impairment Charges and Special Charges" in the Notes to Consolidated Financial Statements and "--Consolidated Items--Restruc- turing Charges, Asset Impairment Charges and Special Charges" for additional information on these charges.
- -------- (a) Contains reclassification to conform to current year presentation.
1999 Compared to 1998. Bowling Centers operating revenue increased $46.5 million, or 8.6%. An increase of $40.9 million was attributable to new cen- ters, of which $31.6 million was from U.S. centers, and $9.3 million was from international centers. Constant centers operating revenue increased $10.6 mil- lion, or 2.3%. U.S. constant centers operating revenue increased $9.1 million, or 2.5%, primarily as a result of increases in open play revenue, and food and beverage and ancillary revenue associated with open play traffic. Interna- tional constant centers operating revenue increased $1.5 million, or 1.6%. The increase in new and constant centers operating revenue was partially offset by a decrease in operating revenue of $5.0 million which was primarily attribut- able to the closing of five U.S. centers and the sale of two international centers in 1999.
Cost of goods sold increased $5.7 million, or 10.5%. An increase of $4.7 million was attributable to new centers, of which $3.8 million was from U.S. centers, and $0.9 million was from international centers. Constant centers cost of goods sold increased $1.4 million, or 3.1%. U.S. constant centers cost of goods sold increased $1.3 million, or 3.7%, primarily as a result of costs associated with the increase in food and beverage and ancillary revenue dis- cussed above. International constant centers
cost of goods sold increased $0.1 million, or 1.0%. The overall increase in cost of goods sold was partially offset by a decrease in cost of goods sold of $0.4 million associated with those centers that were closed or sold in 1999.
Operating expenses increased $33.5 million, or 9.8%. An increase of $24.7 million was attributable to new centers and an increase of $13.7 million was attributable to constant centers. A decrease of $0.4 million was attributable to lower regional and district operating expenses and a decrease of $4.5 mil- lion was attributable to those centers that were closed or sold in 1999. As a percentage of its revenue, Bowling Centers operating expenses were 63.2% for 1998 compared with 63.8% for 1999.
An increase of $1.3 million, or 22.4%, in selling, general and administra- tive expenses was primarily attributable to an increase in costs associated with growth experienced in Australia and Europe as a result of acquisitions made in prior years. As a percentage of its revenue, Bowling Centers selling, general and administrative expenses were 1.1% for 1998 compared with 1.2% for 1999.
Recurring EBITDA increased $6.0 million, or 4.4%. Increases of $11.5 mil- lion from new centers and $0.4 million from lower regional and district oper- ating expenses were partially offset by decreases of $5.8 million, or 4.4%, from constant centers and $0.1 million from those centers that were closed or sold in 1999. Recurring EBITDA margin in 1999 was 24.6% compared to 25.6% in 1998. The lower EBITDA margin in 1999 was attributable to AMF's operating initiatives to improve customer traffic.
1998 Compared to 1997. Bowling Centers operating revenue increased $110.1 million, or 25.7%. An increase of $131.9 million was attributable to new cen- ters, of which $111.3 million was from U.S. centers, and $20.6 million was from international centers. U.S. constant centers operating revenue decreased $9.2 million, or 3.7%, primarily as a result of lower lineage, integrating newly acquired centers, nationally branded chain development activities, rec- ord-setting hot weather which adversely affected customer visits in the summer months and the later start of league play in 1998. International constant cen- ters operating revenue decreased $7.8 million, or 8.4%, primarily due to unfa- vorable currency translation of results. On a constant exchange rate basis, international operating revenue would have increased $1.7 million, or 1.8%. A decrease in operating revenue of $4.8 million was primarily attributable to the closing of nine U.S. centers in 1998.
Cost of goods sold increased $14.6 million, or 36.6%, primarily as a result of the net increase in the number of centers.
Operating expenses increased $88.5 million, or 35.0%, of which approxi- mately $88.7 million was attributable to new centers, including $77.4 million attributable to U.S. centers and $11.3 million attributable to international centers. As a percentage of its revenue, Bowling Centers operating expenses were 58.8% for 1997 compared with 63.2% for 1998, primarily as a result of na- tionally branded chain development activities.
A decrease of $0.5 million, or 7.9%, in selling, general and administrative expenses was primarily attributable to expense management. As a percent of its revenue, Bowling Centers selling, general and administrative expenses were 1.5% for 1997 compared with 1.1% for 1998.
An increase of $7.5 million, or 5.6%, in EBITDA was attributable to new centers. EBITDA margin in 1998 was 25.6% compared to 30.4% in 1997 primarily as a result of nationally branded chain development activities.
Bowling Products
The results shown in the following table reflect Bowling Products opera- tions. To facilitate a meaningful comparison, the results of Bowling Products for 1999 have been restated to exclude the restructuring charges and Special Charges as shown in the table. The following discussion gives effect to this restatement. See "Note 9. Restructuring Charges, Asset Impairment Charges and Special Charges" in the Notes to Consolidated Financial Statements and "--Con- solidated Items--Restructuring Charges, Asset Impairment Charges and Special Charges" for additional information on these charges.
1999 Compared to 1998. Bowling Products operating revenue decreased $43.2 million, or 20.3%, due to a decrease of $37.9 million, or 41.9%, in NCP reve- nue, and a decrease of $5.3 million, or 4.3%, in Modernization and Consumer Products revenue. Economic difficulties in certain Asia Pacific markets and increased competition in general continue to adversely impact results. During 1999, Bowling Products recorded NCP shipments of 1,343 units compared to ship- ments of 2,466 units for 1998. Although lower compared with 1,303 unit ship- ments for the last half of 1998, NCP shipments of 921 units for the second half of 1999 exceeded NCP shipments of 422 units for the first half of 1999. The decrease in Modernization and Consumer Products revenue is primarily due to decreased sales to Asia Pacific customers because of adverse economic con- ditions and lower U.S. sales of modernization equipment. See "--Seasonality and Market Development Cycles" and "Item 1. Business--International Opera- tions."
Gross profit decreased by $11.7 million, or 22.1%. Gross profit margin was 24.9% in 1998 and 24.3% in 1999. Gross profit and gross profit margin declines were primarily a result of lower levels of NCP shipments, lower pricing and unabsorbed fixed overhead resulting from low production levels. See "--Inter- national Operations."
Bowling Products selling, general and administrative expenses decreased by $9.0 million, or 21.3%, primarily as a result of an ongoing cost reduction program in which the Bowling Products organization has been streamlined in or- der to reduce expenses. Such cost reduction has served to partially offset the impact of lower sales volume and unit pricing on EBITDA.
Bowling Products recurring EBITDA decreased $2.7 million, or 25.2%, and re- curring EBITDA margin decreased from 5.0% in 1998, to 4.7% in 1999 as a result of the lower revenue and gross profit which exceeded the effect of cost reduc- tions.
1998 Compared to 1997. Bowling Products operating revenue decreased $86.8 million, or 29.0%, due to a decrease of $74.6 million, or 45.2%, in NCP reve- nue, and a decrease of $12.2 million, or 9.1%, in Modernization and Consumer Products revenue. Operating results were adversely impacted by the economic difficulties in Asia Pacific and other regions, which reduced the level of shipments for NCPs and Modernization and Consumer Products sales. The strong U.S. dollar also unfavorably affected pricing and financial statement transla- tion. During 1998, Bowling Products recorded NCP shipments of 2,466 units com- pared to shipments of 4,576 units for 1997. The decrease in Modernization and Consumer Products revenue was primarily due to decreased sales to Asia Pacific customers because of adverse economic conditions and decreased Modernization and Consumer Products sales to U.S. customers due to delayed product introduc- tions in 1998. Additionally, Zhonglu gained new market share in China. See "-- Seasonality and Market Development Cycles" and "Item 1. Business--Interna- tional Operations."
Gross profit decreased by $60.7 million, or 53.4%. Gross profit margin was 38.0% in 1997 and 24.9% in 1998. Gross profit and gross profit margin declines were primarily a result of lower levels of NCP shipments, the strong U.S. dol- lar and competitive pricing as discussed above, lower margins on the 1998 Mod- ernization and Consumer Products product mix and unabsorbed fixed overhead re- sulting from low production levels. See "--International Operations."
Bowling Products selling, general and administrative expenses decreased by $0.6 million, or 1.4%, primarily as a result of a profit improvement plan. The Bowling Products organization was streamlined as part of a cost reduction pro- gram in order to further reduce manufacturing, selling, general and adminis- trative expenses to offset the impact of lower sales volume on EBITDA. Savings from the cost reduction programs were partially offset by the increased in- vestment in the first half of 1998 in certain international markets with long- term potential.
Bowling Products EBITDA decreased $60.1 million, or 84.9%, and EBITDA mar- gin decreased from 23.7% in 1997, to 5.0% in 1998 as a result of the lower revenue and gross profit partially offset by decreased selling, general and administrative expenses discussed above.
Consolidated Items
Restructuring Charges, Asset Impairment Charges and Special Charges
In 1999, the Company recorded restructuring charges of approximately $8.5 million that were related primarily to a plan to reorganize and downsize the Bowling Products business in response to market weakness in the Asia Pacific region and increased competition which has negatively and materially impacted NCP sales and profitability. The restructuring plan was developed in conjunc- tion with a strategic business assessment performed by Bain & Co. and was de- signed to reduce the overall volatility of the Bowling Products business. The restructuring charges relate primarily to employee termination benefits, asset write-offs and contract cancellations.
In 1999, the Company recorded asset impairment charges of $8.1 million rep- resenting the difference between fair market value and carrying value of im- paired assets. The asset impairment charges relate to under-performing bowling center locations that under an approved plan will be closed in the first half of 2000. Fair market value is generally determined based on the average sales proceeds from previous sales of AMF bowling center locations.
The strategic assessment by Bain & Co. discussed above led to programs de- signed to improve product line profitability and quality in the Company. This assessment was a catalyst to the Company's recording certain charges. These charges, along with additional reserves (collectively, the "Special Charges") recorded by the Company totaled $26.5 million. The Special Charges are non- cash, relate primarily to receivables and inventory write-offs and are in- cluded within selling, general and administrative expenses and cost of goods sold.
See "Note 9. Restructuring Charges, Asset Impairment Charges and Special Charges" in the Notes to Consolidated Financial Statements for additional dis- cussion of these charges.
Depreciation and Amortization
For 1999, depreciation and amortization increased by $12.4 million, or 10.3%, over 1998. The increase was primarily attributable to incremental de- preciation expense as a result of capital expenditures.
For 1998, depreciation and amortization increased by $17.8 million, or 17.4%, over 1997, primarily attributable to depreciation of property and equipment of centers acquired during 1998 and incremental depreciation expense as a result of capital expenditures.
Interest Expense
Gross interest expense increased by $9.4 million, or 9.2%, in 1999 compared with 1998. Interest incurred on bank debt increased as the impact of higher average borrowing rates more than offset the effect of a decrease in certain average amounts outstanding. See "Note 8. Long-Term Debt and Recapitalization Plan" in the Notes to Consolidated Financial Statements, "--Liquidity" and "-- Capital Resources" for further discussion of the bank debt. Cash interest paid by the Company for 1999 totaled $81.8 million, while non-cash bond interest amortization totaled $26.9 million.
Gross interest expense decreased by $16.5 million, or 13.9%, in 1998 com- pared with 1997. Interest savings associated with the reduction of bank debt and the redemption of a portion of the Subsidiary Senior Subordinated Discount Notes with proceeds of AMF Bowling's Initial Public Offering were partially offset by interest incurred on increased levels of bank debt as a result of center acquisitions. See "--Liquidity" and "--Capital Resources" for further discussion of the bank debt. Cash interest paid by the Company for 1998 to- taled $76.5 million, while non-cash bond interest amortization totaled $24.0 million.
Extraordinary Items
The Company incurred after-tax extraordinary charges totaling $23.4 million in the fourth quarter of 1997 as a result of entering into its Third Amended and Restated Credit Agreement with its lenders, the premium paid to redeem a portion of the Subsidiary Senior Subordinated Discount Notes with the proceeds of the Initial Public Offering and the write-off of the portion of deferred financing costs attributable to the Subsidiary Senior Subordinated Discount Notes redeemed. See "Note 8. Long-Term Debt and Recapitalization Plan" in the Notes to Consolidated Financial Statements and "Item 8. Financial Statements and Supplementary Data--Selected Quarterly Data" included elsewhere herein.
Net Loss
Net loss in 1999 totaled $201.0 million, compared with a net loss of $106.8 million in 1998. The increased loss of $94.2 million was primarily a result of restructuring charges, asset impairment charges and Special Charges of $8.5 million, $8.1 million and $26.5 million, respectively, an increase in the tax provision of $20.3 million reflecting an increase in the reserve for net tax benefits, the increase in depreciation expense of $12.4 million and the in- crease in interest expense of $9.4 million. The Company recorded $18.6 million in equity in loss of joint ventures in 1999, compared with equity in loss of joint ventures of $8.2 million in 1998. The increase was primarily attribut- able to the acceleration of the amortization schedule for the excess of the Company's investment over its equity in its Brazilian joint venture's net as- sets,
Net loss in 1998 was $106.8 million compared to a net loss of $55.6 million in 1997. The increase in net loss of $51.2 million was primarily a result of decreases in Bowling Products revenue and
EBITDA discussed above and the increase in depreciation expense. Additionally, the Company recorded $8.2 million in equity in loss of joint ventures in 1998 compared to a loss of $1.4 million in 1997. The Company accounts for its in- vestments in its Hong Leong joint venture and Playcenter joint venture by the equity method. See "Note 15. Joint Ventures" in the Notes to Consolidated Fi- nancial Statements. The Company recorded a tax provision of $7.3 million in 1998 compared to a tax benefit of $12.9 million in 1997. The Company recorded extraordinary charges totaling $23.4 million in the fourth quarter of 1997 as described in "--Extraordinary Items."
Income Taxes
As of December 31, 1999, the Company had net operating losses of approxi- mately $284.6 million and foreign tax credits of $11.5 million that will carry over to future years to offset U.S. taxes. The foreign tax credits will begin to expire in the year 2001 and the net operating losses will begin to expire in the year 2011. The Company has recorded a valuation reserve as of December 31, 1999 for $126.3 million related to net operating losses and foreign tax credits and other deferred tax assets that the Company may not utilize prior to their expirations. The tax provision recorded for 1999 reflects an increase in the valuation allowance and certain international taxes.
Liquidity
1999 Compared to 1998. The Company's primary source of liquidity is cash provided by operations and credit facilities as described below. Working capi- tal on December 31, 1999 was $7.1 million compared with $59.5 million as of December 31, 1998, a decrease of $52.4 million. A decrease in working capital was primarily attributable to a decrease of $11.2 million in inventory bal- ances primarily due to lower sales levels and Special Charges, a decrease of $19.3 million in accounts receivable primarily as a result of decreased sales in 1999 compared to 1998, an increase of $12.5 million in accounts payable and accrued expenses, an increase of $1.9 million in the current portion of long- term debt, a net decrease of $6.2 million in other current assets and liabili- ties and a decrease of $1.3 million in cash.
Net cash flows provided by operating activities were $40.4 million for 1999 compared to net cash flows provided of $7.8 million for 1998, an increase of $32.6 million. A decrease of $94.2 million was attributable to the net loss of $201.0 million recorded in 1999 compared to a net loss of $106.8 million in 1999; a decrease of $6.4 million was attributable to loss on the sale of prop- erty and equipment, net and a decrease of $2.9 million was attributable to the change in income taxes payable. These decreases were offset by an increase of $20.7 million attributable to a decrease in the level of deferred tax assets, an increase of $21.6 million attributable to lower levels of accounts receiv- able, an increase of $12.4 million in depreciation and amortization, loss on impairment of assets of $8.1 million attributable to the closure of certain bowling centers, an increase of $18.0 million attributable to lower inventory balances resulting from lower Bowling Products sales volumes in 1999, in- creased bond amortization of $2.9 million, an increase of $19.5 million caused by increased levels of accounts payable and accrued expenses, an increase of $22.1 million attributable to a decrease in other assets primarily related to decreases in deposits and other assets, an increase of $0.5 million attribut- able to changes in other operating activities and an increase of $10.4 million in equity in loss of joint ventures.
Net cash flows used in investing activities were $51.5 million for 1999 compared to net cash flows used of $242.0 million for 1998, a decrease of $190.5 million. Bowling Center acquisition spending decreased by $172.1 mil- lion and purchases of property and equipment decreased by $14.6 million in 1999 compared with 1998. In 1999, the Company purchased one center compared with 83 centers in 1998. There were no investments in or advances to joint ventures in 1999 compared with $5.6 million
in 1998. Proceeds from the sale of property and equipment decreased $1.8 mil- lion in 1999 compared with 1998. See "Note 14. Acquisitions" in the Notes to Consolidated Financial Statements and "--Capital Expenditures" for additional discussion of these investing activities.
Net cash provided by financing activities was $9.1 million for 1999 com- pared to the net cash provided of $217.4 million for 1998, a decrease of $208.3 million. Proceeds from long term debt decreased $183.5 million. Borrowings under the Credit Agreement decreased $183.5 million as a result of the curtailment of the pace of acquisitions. Payments on long-term debt de- creased $195.6 million. In 1998, $249.6 million of the proceeds from the issu- ance of AMF Bowling's Zero Coupon Convertible Debentures due 2018 (the "Debentures") were used to pay down the revolving credit facility (the "Bank Facility") under the Credit Agreement. In accordance with the terms of the Credit Agreement, scheduled principal payments in 1999 were $5.0 million higher than payments made in 1998. Additionally, in 1999, $74.0 million was paid against amounts outstanding under the Bank Facility. In 1999, $34.7 mil- lion was provided by additional capital contributions from AMF Bowling from part of the net proceeds of a rights offering by AMF Bowling. In the year ended December 31, 1998, $255.6 million was provided by additional capital contributions from AMF Bowling attributable to the issuance of the Debentures. See "Note 8. Long-Term Debt and Recapitalization Plan", and "Note 14. Acquisi- tions" in the Notes to Consolidated Financial Statements and "--Capital Re- sources."
As a result of the aforementioned, cash decreased by $1.3 million in 1999 compared to a decrease of $13.9 million in 1998.
1998 Compared to 1997. Net cash flows provided by operating activities were $7.8 million for 1998 compared to net cash flows provided of $47.7 million for 1997, a decrease of $39.9 million. A decrease of $51.2 million was attribut- able to the net loss of $106.8 million recorded in 1998 compared to a net loss of $55.6 million 1997; a decrease of $27.1 million was caused by decreased levels of accounts payable and accrued expenses; a decrease of $9.6 million was attributable to lower levels of bond amortization resulting from the re- demption of a portion of Bowling Worldwide's Subsidiary Senior Subordinated Discount Notes in connection with the Initial Public Offering; and a decrease of $6.8 million was attributable to the increase in other assets primarily due to increases in deposits and other assets. These decreases were offset by an increase of $20.0 million attributable to a decrease in the level of deferred taxes; an increase of $15.9 million attributable to lower levels of accounts receivable; an increase of $17.9 million in depreciation and amortization; loss on the sale of property and equipment, net of $4.5 million attributable to the closure of nine bowling centers and the sale of the Company's Swiss bowling center in 1998; an increase of $9.9 million attributable to lower in- ventory balances resulting from lower Bowling Products sales volumes in 1998; a net increase of $3.2 million attributable to changes in other operating ac- tivities and an increase in the equity in loss of joint ventures of $6.8 mil- lion. Extraordinary items associated with the redemption of debt in 1997 with proceeds from the Initial Public Offering totaled $23.4 million.
Net cash flows used in investing activities were $242.0 million for 1998 compared to net cash flows used of $288.6 million for 1997, a decrease of $46.6 million. Bowling Center acquisition spending decreased by $41.2 million and purchases of property and equipment increased by $9.9 million in 1998, compared to the same period in 1997. In 1998, the Company purchased 83 centers compared to 122 centers in 1997. Investments in and advances to joint ventures totaled $5.6 million in 1998 compared to investments in or advances to joint ventures of $21.3 million in 1997. Other cash flows provided from investing activities decreased $0.4 million. See "Note 14. Acquisitions" in the Notes to Consolidated Financial Statements and "--Capital Expenditures" for additional discussion of these investing activities.
Net cash provided by financing activities was $217.4 million for 1998 com- pared to the net cash provided of $235.7 million for 1997, a decrease of $18.3 million. Proceeds from long-term debt in-
creased $24.1 million primarily as a result of borrowings under the Credit Agreement used to fund center acquisitions and working capital. Payments on long-term debt were lower by $2.7 million in 1998 compared to 1997. In 1998, $255.6 million was provided by additional capital contributions from AMF Bowl- ing attributable to the issuance by AMF Bowling of the Debentures. In 1997, $315.7 million was provided by additional capital contributions from AMF Bowl- ing attributable to the sale of AMF Bowling Common Stock for $36.6 million by AMF Bowling to its institutional stockholders and net proceeds of $279.1 mil- lion from the Initial Public Offering. In 1997, $14.6 million was used to pay the premium associated with the redemption of a portion of the Subsidiary Se- nior Subordinated Discount Notes with proceeds from the Initial Public Offer- ing and $0.5 million was used for a dividend to AMF Bowling for the repurchase of AMF Bowling Common Stock. See "Note 8. Long-Term Debt and Recapitalization Plan" and "Note 14. Acquisitions" in the Notes to Consolidated Financial Statements and "--Capital Resources."
As a result of the aforementioned, cash decreased by $13.9 million in 1998 compared to a decrease of $7.8 million in 1997.
Capital Resources
The Company's total indebtedness is primarily a result of the financing of the Acquisition and the Company's bowling center acquisition program. At De- cember 31, 1999, the Company's debt structure consisted of $558.5 million of senior debt, $250.0 million of Subsidiary Senior Subordinated Notes and $240.1 million of Subsidiary Senior Subordinated Discount Notes. The Company's senior debt consisted of $386.5 million of term loans, $170.0 million of revolving credit advances under the Bank Facility and $2.0 million represented by one mortgage note.
The Company has the ability to borrow for general corporate purposes and, to a limited extent, for acquisitions pursuant to the $355.0 million Bank Fa- cility, subject to certain conditions. At December 31, 1999, $170.0 million was outstanding and $185.0 million was available for borrowing under the Bank Facility subject to certain limitations regarding acquisitions and capital ex- penditures. Between December 31, 1999 and February 29, 2000 there were no ad- ditional borrowings and $2.0 million in payments resulting in a balance out- standing, as of February 29, 2000, of $168.0 million under the Bank Facility.
In connection with a recapitalization plan by AMF Bowling, the lenders un- der the Credit Agreement amended the terms of the Credit Agreement, as of June 14, 1999, to provide the Company with (i) the ability to increase the pace of its bowling center acquisition program, (ii) greater financial flexibility un- der the covenants contained in the Credit Agreement and (iii) certain other modifications. See "Note 8. Long-Term Debt and Recapitalization Plan" in the Notes to Consolidated Financial Statements. Bowling Worldwide was in compli- ance with the amended covenants as of December 31, 1999. In this connection, AMF Bowling made contributions of $1.0 million and $2.0 million as equity to Bowling Worldwide in November 1999 and March 2000 to meet EBITDA requirements under its financial covenant tests as of September 30, 1999 and December 31, 1999, respectively. The Credit Agreement permits AMF Bowling to make addi- tional equity contributions to Bowling Worldwide through 2001, Management be- lieves that Bowling Worldwide will be in compliance with the amended covenants during 2000, including the effect of the aforementioned equity contributions, but any downturn in the current performance of Bowling Worldwide could result in non-compliance with these financial covenants. Failure by Bowling Worldwide to comply with its Credit Agreement covenants could result in an event of de- fault which, if not cured or waived, will have a material adverse effect on the Company.
During 1999, the Company funded its cash needs through the Bank Facility as well as cash flows from operations and cash balances. A substantial portion of the Company's available cash will be applied to service the outstanding in- debtedness. The Company incurred cash interest expense of
$81.8 million in 1999, representing 59.7% of recurring EBITDA of $137.1 mil- lion for the year. The Company incurred cash interest expense of $76.5 million in 1998, representing 56.1% of EBITDA of $136.4 million for the year. The Com- pany incurred cash interest expenses of $83.0 million in 1997, representing 44.8% of EBITDA of $185.4 million for the year.
The indentures governing the Subsidiary Notes and certain provisions of the Credit Agreement contain financial and operating covenants and significant re- strictions on the ability of the Company to pay dividends, incur indebtedness, make investments and take certain other corporate actions. As of December 31, 1999, the Company was in compliance with all of its covenants under these in- dentures. See "Note 8.--Long-Term Debt and Recapitalization Plan" in the Notes to Consolidated Financial Statements.
The Company's ability to make scheduled payments of principal of, or to pay interest on, or to refinance its indebtedness depends on its future perfor- mance, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond its control, in- cluding the conditions of the debt and equity markets. Based upon the current level of performance, management believes that cash flow from operations, to- gether with available borrowings under the Credit Agreement and other sources of liquidity, will be adequate to meet the Company's requirements for working capital, capital expenditures, scheduled payments of principal of, and inter- est on, its senior debt, and interest on the Subsidiary Notes for the year 2000. In calendar year 2001, principal payment obligations under the facili- ties of the Credit Agreement increase significantly, cash interest becomes payable on the Subsidiary Senior Subordinated Discount Notes and the covenants under the Credit Agreement will be reset to their original levels. Based on current levels of performance, the Company anticipates that some form of refi- nancing will be required to meet the Company's financial requirements for cal- endar years 2001 and beyond. There can be no assurance, however, that the Company's business will generate sufficient cash flow from operations or that future borrowings will be available in an amount sufficient to enable the Com- pany to meet its payment obligations under its indebtedness, or make necessary capital expenditures, or that any refinancing would be available on commer- cially reasonable terms or at all.
Capital Expenditures
The Company's capital expenditures were $52.1 million in 1999 compared with $66.6 million in 1998, a decrease of $14.5 million. Bowling Centers mainte- nance and modernization expenditures decreased $2.2 million. Bowling Products expenditures decreased $2.6 million. Company-wide information systems expendi- tures increased $3.0 million. Investments in Xtreme(TM) bowling equipment at various AMF bowling centers decreased by $0.1 million. Capital expenditures for new centers were $9.5 million higher in 1998 due to the construction of a Michael Jordan Golf Center in 1998 and a decrease in center acquisitions dur- ing 1999. In 1999, other expenditures decreased $3.1 million.
The Company's capital expenditures were $66.6 million in 1998 compared with $56.7 million in 1997, an increase of $9.9 million. Bowling Centers capital expenditures increased $12.1 million, which was attributable to the higher number of the Company's centers as a result of the Company's acquisition pro- gram; Bowling Products capital expenditures decreased $0.2 million as a result of decreased expenditures on certain new products; expenditures on Company- wide information systems decreased $3.5 million and other expenditures in- creased $1.5 million.
While the Company's intention is to continue consolidating the U.S. bowling center industry by acquiring additional bowling centers, the Company will evaluate acquisitions on a more selective basis and will consider acquisition targets which meet specific operating and valuation parameters. At the
same time, management will continue its focus on improving financial perfor- mance of its current centers. As of February 29, 2000, the Company had no com- mitment to build or acquire bowling centers. The Company has committed to build one Michael Jordan Golf Center in 2000.
The Company has funded its capital expenditures from cash generated by op- erations and, with respect to the construction and acquisition of new centers, internally generated cash, the Bank Facility and cash contributions from AMF Bowling funded by issuances of AMF Bowling Common Stock. See "Note 14. Acqui- sitions" in the Notes to Consolidated Financial Statements, "--Liquidity" and "--Capital Resources."
In connection with AMF Bowling's recapitalization plan, the lenders under the Credit Agreement amended the terms of the Credit Agreement, as of June 14, 1999, to provide the Company with (i) the ability to increase the pace of its bowling center acquisition program, (ii) greater financial flexibility under the covenants contained in the Credit Agreement and (iii) certain other modi- fications. See "Note 8. Long-Term Debt and Recapitalization Plan" in the Notes to Consolidated Financial Statements.
Seasonality and Market Development Cycles
The U.S. bowling center operations are seasonal. The following table sets forth AMF's U.S. constant centers revenue for the four quarters of 1999:
The financial performance of Bowling Centers operations is seasonal. Cash flows typically peak in the winter and reach their lows in the summer. While the geographic diversity of the Company's Bowling Centers operations has helped reduce this seasonality in the past, the increase in U.S. centers re- sulting from acquisitions has increased the seasonality of that business.
Modernization and Consumer Products sales also display seasonality. The U.S. market, which is the largest market for Modernization and Consumer Prod- ucts, is driven by the beginning of league play in the fall of each year. While operators purchase consumer products throughout the year, they often place larger orders during the summer in preparation for the start of league play in the fall. Summer is also generally the peak period for installation of modernization equipment. Operators typically sign purchase orders for moderni- zation equipment during the first four months of the year after they receive winter league revenue indications. Equipment is then shipped and installed during the summer when leagues are generally less active. However, sales of some modernization equipment such as automatic scoring and synthetic lanes are less predictable and fluctuate from year to year because of the longer life cycle of these major products.
Sales of NCPs can fluctuate dramatically as a result of economic fluctua- tions in international markets, as seen in the reduction of sales of NCPs to markets in the Asia Pacific region following economic difficulties in that re- gion.
International Operations
The Company's international operations are subject to the usual risks in- herent in operating abroad, including, but not limited to, currency exchange rate fluctuations, economic and political fluctuations and destabilization, other disruption of markets, restrictive laws, tariffs and other actions by foreign governments (such as restrictions on transfer of funds, import and ex- port duties and quotas, foreign customs, tariffs and value added taxes and un- expected changes in regulatory environments),
difficulty in obtaining distribution and support for products, the risk of na- tionalization, the laws and policies of the United States affecting trade, in- ternational investment and loans, and foreign tax law changes.
The Company has a history of operating in a number of international mar- kets, in some cases, for over 30 years. As in the case of other U.S.-based manufacturers with export sales, local currency devaluation increases the cost of the Company's bowling equipment in that market. As a result, a strengthen- ing U.S. dollar exchange rate may adversely impact sales volume and profit margins during such periods.
The continuing economic difficulties in the Asia Pacific Region have had and will continue to have a material adverse impact on NCP sales. One of the reasons for the decline in NCP sales is the limited availability of financing for customers desiring to build new bowling centers, especially in the Asia Pacific region. In addition, Zhonglu became a significant competitor in China. On June 13, 1999, Bowling Products signed three-year joint distribution agree- ments with Zhonglu. Under the terms of the agreements, Zhonglu became the ex- clusive distributor of AMF products and parts in China, and Bowling Products became the exclusive distributor of Zhonglu bowling products and parts outside China. These agreements are intended to improve Bowling Products' competitive position in both China and other developing markets. However, there is no as- surance that such an improvement will occur.
NCP unit sales to China, Japan and other countries in the Asia Pacific re- gion represented 43.0% of total NCP unit sales in 1999 compared with 52.8% in 1998.
China has strengthened enforcement of its import restrictions by requiring the payment of full customs duties and value-added taxes on the importation of new and used capital goods. The Chinese government has also begun to prohibit importation of used capital equipment without permits. Permits for the impor- tation of used bowling equipment are very difficult to obtain. Local Chinese companies, however, are not subject to the same restrictions. For example, in addition to being the exclusive distributor of AMF products, Zhonglu produces locally and sells bowling equipment that is not subject to the customs duties or permit requirements that affect the Company's imported equipment. Zhonglu has experienced significant acceptance by local customers. Management believes that these import restrictions will continue for the foreseeable future.
Foreign currency exchange rates can also affect the translation of operat- ing results from international bowling centers. Revenue and recurring EBITDA of international bowling centers represented 17.0% and 24.7% of consolidated revenue and recurring EBITDA, respectively, in 1999. Revenue and EBITDA of in- ternational bowling centers represented 15.7% and 23.2% of consolidated reve- nue and EBITDA, respectively, in 1998.
Recent NCP Sales
NCP sales totaled $52.6 million in 1999, representing a decrease of 41.9 % from 1998. NCP shipments were 1,343 units for 1999, representing a decrease of 45.5% from 1998, largely attributable to the economic difficulties in the Asia Pacific region and increased competition in general. See "--Seasonality and Market Development Cycles" and "--International Operations."
NCP sales totaled $90.5 million in 1998, a decrease of 45.2% from 1997. NCP shipments were 2,466 units for 1998, representing a decrease of 46.1% compared with shipments of 4,576 units for 1997, and largely attributable to the eco- nomic difficulties in the Asia Pacific region. See "--Seasonality and Market Development Cycles" and "--International Operations."
Impact of Inflation
The Company has historically offset the impact of inflation through price increases and expense reductions. Periods of high inflation could have a mate- rial adverse impact on the Company to the extent that increased borrowing costs for floating rate debt may not be offset by increases in cash flow. There was no significant impact on the Company's operations as a result of in- flation during 1999, 1998 and 1997.
Recent Accounting Pronouncements
Effective for the quarter ended March 31, 2001, the Company is required to adopt Statement of Financial Accounting Standards No. 133 "Accounting for De- rivative Instruments and Hedging Activities." The Company does not expect that adoption of this standard will have a material impact on the Company's finan- cial position or results of operations.
Year 2000 Issue
Year 2000
Many computer systems in use today were designed and developed using two digits, rather than four, to specify the year. As a result, such systems had the potential to recognize the Year 2000 as "00" and assume that the year is 1900 rather than 2000. This could have caused many computer applications to fail completely or to create erroneous results unless corrective measures were taken. The Company recognized the need to ensure its operations would not be adversely impacted by Year 2000 software failures, and prepared for the Year 2000. The Company evaluated its Year 2000 risk in three separate categories: information technology ("IT") systems, non-IT systems and material third-party relationships. The Company developed a plan in which the risks in each of these categories were reviewed and addressed by the appropriate level of man- agement. AMF has to date experienced no material operational difficulties re- lated to the transition to the year 2000. The Company's critical vendors were Year 2000 compliant and the Company experienced no material lapses in service by these vendors.
ITEM 7A.
ITEM 7A. MARKET RISK
The Company is exposed to market risk from changes in foreign currency ex- change rates and interest rates, which could impact its results of operations and financial condition. The Company manages its exposure to these risks through its normal operating and financing activities and through the use of interest rate cap agreements with respect to interest rates. There were no other material derivative instrument transactions during any of the periods presented.
The Company has generally accepted the exposure to exchange rate movements relative to its investment in foreign operations without using derivative fi- nancial instruments to manage this risk. However, as in the case of other U.S.-based manufacturers with export sales, local currency devaluation in- creases the cost of the Company's bowling equipment in that market. As a re- sult, a strengthening U.S. dollar exchange rate may adversely impact sales volume and profit margins during such periods. Foreign currency exchange rates can also affect the translation of operating results from international bowl- ing centers. Revenue and recurring EBITDA of international bowling centers represented 17.0% and 24.7% of consolidated revenue and recurring EBITDA, re- spectively, in 1999. Revenue and EBITDA of international bowling centers rep- resented 15.7% and 23.2% of consolidated revenue and EBITDA, respectively, in 1998.
The Company uses interest rate cap agreements to mitigate the effect of changes in interest rates on the Company's variable rate borrowings under its Credit Agreement. While the Company is exposed
to credit risk in the event of non-performance by the counterparty to interest rate swap agreements, in all cases such counterparty is a highly-rated finan- cial institution and the Company does not anticipate non-performance. The Com- pany does not hold or issue derivative financial instruments for trading pur- poses. The following table provides information about the Company's fixed and variable rate debt, weighted average interest rates and respective maturity dates (dollar amounts in millions).
During March 1999 and December 1999, Bowling Worldwide entered into two in- terest rate cap agreements with Goldman Sachs Credit Partners, L.P. (the "Counterparty") to reduce the interest rate risk of its bank debt. The table below summarizes the interest rate cap agreements in effect at December 31, 1999:
(a) The cap rate is the 3 month U.S. Dollar-London Interbank Offer Rate ("USD- LIBOR") quoted by the Counterparty.
Bowling Worldwide paid a fixed fee of $65,000 and $75,000, respectively, for the two interest rate caps. Bowling Worldwide will receive quarterly pay- ments from the Counterparty if the quoted 3 month USD-LIBOR on the quarterly floating rate reset dates is above the respective cap rates.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO THE BOARD OF DIRECTORS OF AMF GROUP HOLDINGS INC.:
We have audited the accompanying consolidated balance sheets of AMF Group Holdings Inc. (a Delaware corporation) and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, cash flows, stockholder's equity and comprehensive loss for each of the three years in the period ended December 31, 1999. These financial statements are the re- sponsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of mate- rial misstatement. An audit includes examining, on a test basis, evidence sup- porting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement pre- sentation. We believe that our audits provide a reasonable basis for our opin- ion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of AMF Group Holdings Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years ended December 31, 1999, in conformity with generally accepted accounting principles.
Arthur Andersen LLP
Richmond, Virginia February 28, 2000
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (in thousands, except share data)
The accompanying notes are an integral part of these consolidated balance sheets.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BUSINESS DESCRIPTION
Organization
AMF Bowling Worldwide Inc. ("Bowling Worldwide") and its subsidiaries (col- lectively, the "Company" or "AMF") are principally engaged in two business segments: (i) the ownership or operation of bowling centers, consisting of 417 U.S. bowling centers and 122 international bowling centers ("Bowling Cen- ters"), including 15 joint venture centers described in "Note 15. Joint Ven- tures," as of December 31, 1999, and (ii) the manufacture and sale of bowling equipment such as automatic pinspotters, automatic scoring equipment, bowling pins, lanes, ball returns, certain spare parts, and the resale of allied prod- ucts such as bowling balls, bags, shoes, and certain other spare parts ("Bowl- ing Products"). The principal markets for bowling equipment are U.S. and in- ternational bowling center operators. AMF also manufactures and sells the PlayMaster, Highland and Renaissance brands of billiards tables, and owns the Michael Jordan Golf Company, which currently operates two golf practice rang- es.
Bowling Worldwide is a wholly-owned, direct subsidiary of AMF Group Hold- ings Inc. ("AMF Group Holdings"). AMF Group Holdings is a wholly-owned, direct subsidiary of AMF Bowling, Inc. ("AMF Bowling"). AMF Bowling, AMF Group Hold- ings and Bowling Worldwide are Delaware corporations. AMF Bowling and AMF Group Holdings are holding companies. The principal assets in each are com- prised of investments in subsidiaries. The Company was acquired in 1996 by an investor group led by affiliates of Goldman, Sachs & Co. (the "Acquisition").
Since the Acquisition and prior to December 31, 1999, the Company has ac- quired 263 bowling centers for a combined purchase price of $498.9 million, and it has constructed two bowling centers and one Michael Jordan Golf prac- tice range as part of its capital expenditure program. The Company has funded its acquisitions and center construction from internally generated cash, borrowings under the senior secured revolving credit facility (the "Bank Fa- cility") under the Credit Agreement (as defined in "Note 8.--Long-Term Debt and Recapitalization Plan"), and issuances of AMF Bowling common stock (the "AMF Bowling Common Stock"). See "Note 14.--Acquisitions".
Risks and Other Important Factors
The Company is highly leveraged as a result of indebtedness incurred in connection with the Acquisition and subsequent center acquisitions.
The Company's ability to make scheduled payments of principal of, or to pay interest on, or to refinance its indebtedness depends on its future perfor- mance, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond its control, in- cluding the conditions of the debt and equity markets. Based upon the current level of performance, management believes that cash flow from operations, to- gether with available borrowings under the Credit Agreement and other sources of liquidity, will be adequate to meet the Company's requirements for working capital, capital expenditures, scheduled payments of principal of, and inter- est on, its senior debt, and interest on the Subsidiary Notes for the year 2000. In calendar year 2001, principal payment obligations under the facili- ties of the Credit Agreement increase significantly, cash interest becomes payable on the Subsidiary Senior Subordinated Discount Notes and the covenants under the Credit Agreement will be reset to their original levels. Based on current levels of performance, the Company anticipates that some form of refi- nancing will be required to meet the Company's financial requirements for cal- endar years 2001 and beyond. There can be no assurance, however, that the Company's business will generate sufficient cash flow from operations or that future borrowings will be available in an amount sufficient to enable the Com- pany to meet its payment obligations under its indebtedness, or make necessary capital expenditures, or that any refinancing would be available on commer- cially reasonable terms or at all.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 2. SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements. All dollar amounts are in thousands, except where otherwise indicated.
Joint Ventures
Investments in joint ventures are accounted for under the equity method. These investments are managed as part of the Company's Bowling Centers segment operations, and the Company's share of joint venture earnings is included in earnings for the Bowling Centers segment. The Company is amortizing the excess of the investment over its equity in its Brazilian joint venture's net assets over a period not to exceed five years. See "Note 15. Joint Ventures."
Use of Estimates
The preparation of financial statements in conformity with generally ac- cepted accounting principles requires management to make estimates and assump- tions that affect the reported amounts of assets and liabilities and disclo- sure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the report- ing periods. The more significant estimates made by management include allow- ances for obsolete inventory, uncollectible accounts receivable, realization of goodwill, deferred taxes and other deferred assets, litigation and claims, product warranty costs, and self-insurance costs. Actual results could differ from those estimates.
Revenue Recognition
For Bowling Products, revenue is generally recognized at the time the prod- ucts are shipped. In certain countries, with respect to new center packages ("NCP" or "NCPs") (which include all the equipment necessary to outfit a new bowling center or expand an existing bowling center) orders, revenue is recog- nized upon installation. For larger contract orders, Bowling Products gener- ally requires that customers submit a deposit as a condition of accepting the order. For a significant portion of international sales, Bowling Products gen- erally requires the customer to obtain a letter of credit prior to shipment.
Warranty Costs
Bowling Products warrants all new products for certain periods up to one year. Bowling Products charges to income an estimated amount for future war- ranty obligations, and also offers customers the option to purchase extended warranties on certain products. Warranty expense aggregated $5,681 for 1999, $5,391 for 1998, and $3,007 for 1997, and is included in cost of goods sold in the accompanying consolidated statements of operations.
Cash and Cash Equivalents
The Company classifies all highly liquid fixed-income investments purchased with an original maturity of three months or less as cash equivalents.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Inventories
Bowling Products' inventory is valued at the lower of cost or market, cost being determined using the first-in, first-out ("FIFO") method. Bowling Cen- ters' inventory is valued at the lower of cost or market, with the cost being determined using the average cost method. See "Note 3.--Inventories."
Long-Lived Assets
The carrying value of long-lived assets and certain identifiable intangi- bles, including goodwill, is reviewed by the Company for impairment whenever events or changes in circumstances indicate that the carrying amount of an as- set may not be recoverable, and an estimate of future undiscounted cash flows is less than the carrying amount of the asset.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. Expenditures for maintenance and repairs which do not improve or extend the life of an asset are charged to expense as incurred; major renewals or betterments are capitalized. Upon retirement or sale of an asset, its cost and related accumulated depreciation are removed from property and equipment, and any gain or loss is recognized.
Property and equipment are depreciated over their estimated useful lives using the straight-line method. Estimated useful lives of property and equip- ment are as follows:
Goodwill
As a result of the Acquisition and subsequent purchases of bowling centers discussed in "Note 14. Acquisitions," and in accordance with the purchase method of accounting used for all acquisitions, the Company recorded goodwill representing the excess of the purchase price over the allocation among the acquired assets and liabilities in accordance with estimates of fair market value on the dates of acquisition. Goodwill is being amortized over 40 years. Amortization expense was $21,384 in 1999, $20,403 in 1998 and $19,827 in 1997. Accumulated amortization of goodwill was $74,684 and $53,300, respectively, at December 31, 1999 and 1998.
Leasehold Interests
Leasehold interests are included in other assets net of accumulated amorti- zation of $22,346 and $17,370 at December 31, 1999 and 1998, respectively. Leasehold interests represent favorable lease terms which are comprised of the difference between amounts due under the contractual lease rate compared to the market rate for that lease. Leasehold interests are being amortized over the life of each lease. Amortization expense was $4,976 in 1999, $4,500 in 1998 and $11,735 in 1997.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Income Taxes
The U.S. and international subsidiaries of AMF Group Holdings are taxable corporations under the Internal Revenue Code ("IRC"). Income taxes are ac- counted for using the asset and liability method under which deferred income taxes are recognized for the tax consequences on future years of temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities.
Research and Development Costs
Expenditures relating to the development of new products, including signif- icant improvements and refinements to existing products, are expensed as in- curred. Amounts charged against income were approximately $342 in 1999, $121 in 1998 and $922 in 1997 and are included in cost of goods sold in the accom- panying consolidated statements of operations.
Advertising Costs
Costs incurred for producing and communicating advertising are expensed when incurred. The amounts charged against income were approximately $27,291 in 1999, $33,432 in 1998 and $21,642 in 1997, with $20,756, $20,571 and $12,768, respectively, included in bowling center operating expenses for Bowl- ing Centers, and $6,535, $12,861 and $8,856, respectively, included in sell- ing, general and administrative expenses for Bowling Products and Corporate in the accompanying consolidated statements of operations.
Foreign Currency Translation
All assets and liabilities of AMF Group Holdings' international operations are translated from foreign currencies into U.S. dollars at year-end exchange rates. Adjustments resulting from the translation of financial statements of international operations into U.S. dollars are included in the foreign cur- rency translation adjustment on the accompanying consolidated balance sheets, statements of stockholder's equity and statements of comprehensive loss. Reve- nue and expenses of international operations are translated using average ex- change rates that existed during the year and reflect currency exchange gains and losses resulting from transactions conducted in other than local curren- cies. Transactions in foreign currencies resulted in net losses of $2,432 for 1999, net gains of $2,450 for 1998 and net losses of $3,537 for 1997, and are included in other expenses in the accompanying consolidated statements of op- erations.
Fair Value of Financial Instruments
The carrying value of financial instruments, including cash and cash equiv- alents and short-term debt, approximate fair value at December 31, 1999 and 1998, because of the short maturity of these instruments. At December 31, 1999 and 1998, fair value of the interest rate cap agreements (to reduce the inter- est rate risk of its floating rate debt) was approximately $16 and $8, respec- tively. The interest rate cap agreements are valued using the estimated amount that the Company would receive to terminate the cap agreements as of December 31, 1999 and 1998, based on a quote from the counterparty, taking into account current in-terest rates and the credit worthiness of the counterparty. The Company has no intention of terminating the cap agreements. The fair value of the term facil-ities under the Bank Debt, as defined in "Note 8. Long-Term Debt and Recapi-talization Plan," at December 31, 1999 and 1998, was approximately $347,849 and $376,988, respectively, based on the trading value at December 31, 1999 and 1998. The fair value of the Subsidiary Senior Subordinated Notes and Subsidiary
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Senior Subordinated Discount Notes, as defined in "Note 8. Long-Term Debt and Recapitalization Plan," at December 31, 1999 and 1998, was approximately $196,410 and $354,005, respectively, based on the trading value at December 31, 1999 and 1998.
Non-compete Agreements
The Company has non-compete agreements with various individuals. The assets are recorded at cost or at the present value of payments to be made under these agreements, discounted at annual rates ranging from 8 percent to 10 per- cent. The assets are included in other assets on the accompanying consolidated balance sheets and are amortized on a straight-line basis over the terms of the agreements. Non-compete obligations at December 31, 1999 and 1998, net of accumulated amortization, totaled approximately $2,390 and $3,629, respective- ly. Annual maturities on non-compete obligations as of December 31, 1999, are as follows: 2000--$924; 2001--$245; 2002--$202; 2003--$207; 2004--$200; there- after--$612.
Self-Insurance Programs
The Company is self-insured up to certain levels for general and product liability, workers' compensation, certain health care coverage and property damage. The cost of these self-insurance programs is accrued based upon esti- mated settlements for known and anticipated claims. The Company has recorded an estimated amount to cover known claims and claims incurred but not reported as of December 31, 1999 and 1998, which is included in accrued expenses in the accompanying consolidated balance sheets.
Comprehensive Loss
For 1999, 1998 and 1997, comprehensive loss represents net loss and the change in foreign currency translation adjustment. Accumulated other compre- hensive loss consists of the foreign currency translation adjustment on the accompanying consolidated balance sheets and statements of stockholder's equi- ty.
NOTE 3. INVENTORIES
Inventories at December 31, 1999 and 1998, consist of the following:
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 4. DEFERRED TAXES AND OTHER CURRENT ASSETS
The components of deferred taxes and other current assets at December 31, 1999 and 1998, consist of the following:
NOTE 5. PROPERTY AND EQUIPMENT
Property and equipment, net at December 31, 1999 and 1998, consists of the following:
Depreciation and amortization expense related to property and equipment was $99,934 for 1999, $89,080 for 1998 and $64,480 for 1997. Included in property and equipment is $8,118 of assets to be disposed in connection with the Company's recognition of asset impairment as described in "Note 9. Restructur- ing Charges, Asset Impairment Charges and Special Charges."
NOTE 6. OTHER LONG-TERM ASSETS
Other long-term assets are primarily composed of leasehold interests, long- term rent deposits, long-term portion of non-compete assets and notes receiv- able. At December 31, 1998, other long-term assets also included deferred in- come taxes.
NOTE 7. ACCRUED EXPENSES
Accrued expenses at December 31, 1999 and 1998, consist of the following:
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 8. LONG-TERM DEBT AND RECAPITALIZATION PLAN
Long-term debt at December 31, 1999 and 1998, consists of the following:
Bank Debt
The Company's bank debt (the "Bank Debt") is governed by a credit agreement (the "Credit Agreement") to which Bowling Worldwide is a party with Goldman Sachs, their affiliate Goldman Sachs Credit Partners, L.P., Citibank, N.A. ("Citibank") and its affiliates Citicorp Securities, Inc. and Citicorp USA, Inc. and certain other banks, financial institutions and institutional lenders (collectively, the "Lenders") and provides for (i) senior secured term loan facilities aggregating $386.5 million (the "Term Facilities") and (ii) the Bank Facility of up to $355.0 million ( together with the Term Facilities, the "Senior Facilities"). In connection with such financing, Goldman Sachs Credit Partners, L.P. acted as Syndication Agent, Goldman Sachs Credit Partners, L.P. and Citicorp Securities, Inc. acted as Arrangers, and Citibank is acting as Administrative Agent. The initial borrowings under a predecessor of the Credit Agreement were used to partially fund the Acquisition. As of December 31, 1999, the Company has $185.0 million available for borrowing under the Credit Agreement and $170.0 million outstanding.
The Senior Facilities
The Term Facilities consist of the following three tranches: (i) a Term Loan Facility of $71.2 million, (ii) an Amortization Extended Loan ("AXELsSM") Series A Facility of $182.8 million and (iii) an AXELsSM Series B Facility of $132.5 million. The Term Loan Facility bears interest, at Bowling Worldwide's option, at Citibank's customary base rate or at Citibank's Eurodollar rate, in each case plus a margin which varies in accordance with a performance pricing grid which is based on the Total Debt/EBITDA Ratio (as defined below) for the Rolling Period (as defined below) then most recently ended.
The margin applicable to loans bearing interest based on the base rate will range from 1.50% to 2.75% for advances under the Term Loan Facility, and is fixed at 3.25% for advances under the AXELsSM Series A Facility and 3.75% for advances under the AXELsSM Series B Facility. The margin applicable to loans bearing interest based on the Eurodollar rate ranges from 2.50% to 3.75% for advances under the Term Loan Facility, and is fixed at 4.25% for advances un- der AXELsSM Series A Facility and 4.75% for advances under the AXELsSM Series B Facility.
The Bank Facility has an aggregate amount of $355.0 million, is fully re- volving until its final maturity and bears interest, at Bowling Worldwide's option, at Citibank's customary base rate or at Citibank's Eurodollar rate, in each case, plus a margin which varies in accordance with a performance pricing grid which is based on a total debt to EBITDA ratio ("Total Debt/EBITDA Ra- tio") for the trailing twelve-month period (the "Rolling Period") then most recently ended. The margin applicable to advances under the Bank Facility bearing interest based on the base rate ranges from 1.50% to 2.75%
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
and the margin applicable to advances under the Bank Facility bearing interest based on the Eurodollar rate ranges from 2.50% to 3.75%.
Borrowings under the Term Loan Facility and Bank Facility bear interest, at Bowling Worldwide's option, at Citibank's customary base rate plus a margin of 2.75% or at Citibank's Eurodollar rate plus a margin of 3.75% until the finan- cial statements required to be delivered pursuant to the Credit Agreement in respect of the fiscal quarter ended June 30, 2000 are delivered. Thereafter, the applicable margin will be determined in accordance with the Total Debt/EBITDA ratio.
At December 31, 1999, the applicable margin based on Citibank's customary base rate, the applicable margin based on Citibank's Eurodollar rate, and the actual interest rate for advances under each of the Senior Facilities were as follows:
Maturity dates, average amounts outstanding, and average borrowing rates for 1999, were as follows:
In addition, Bowling Worldwide is required to make prepayments which perma- nently reduce the availability under the Senior Facilities under certain cir- cumstances, including upon certain asset sales and issuances of debt by Bowl- ing Worldwide and its subsidiaries and public issuance of equity securities of AMF Bowling. Bowling Worldwide is also required to make prepayments that per- manently reduce the availability under the Term Facilities in an amount equal to up to 50% of Excess Cash Flow for any fiscal year of Bowling Worldwide if the Total Debt/EBITDA Ratio for that fiscal year is greater than or equal to 5.50 to 1.0. If the Total Debt/EBITDA Ratio for that fiscal year is less than 5.50 to 1.0, then Bowling Worldwide is required to prepay the Bank Facility in an amount equal to up to 50% of the Excess Cash Flow (as defined in the Credit Agreement) for such fiscal year (such payment would be the lesser of (x) 50% of the Excess Cash Flow for that fiscal year or (y) the amount by which such Excess Cash Flow exceeds $20 million), but Bowling Worldwide would be permit- ted to reborrow such amounts, subject to the conditions of the Credit Agree- ment.
The Senior Facilities are guaranteed by AMF Group Holdings and by each of Bowling Worldwide's present and future domestic subsidiaries and are secured by all of the stock of Bowling Worldwide and Bowling Worldwide's present and future domestic subsidiaries and second-tier subsidiaries, by 66% of the stock of Bowling Worldwide's present and future international subsidiaries and by substantially all of Bowling Worldwide's, and its present and future domestic subsidiaries', present and future property and assets.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Covenants
In connection with the Company's recapitalization plan discussed below, the Lenders under the Credit Agreement approved Amendment No. 2 and Waiver to the Credit Agreement and entered into the Fourth Amended and Restated Credit Agreement. The key provisions of the Fourth Amended and Restated Credit Agree- ment (i) waive mandatory prepayment provisions previously existing under the Credit Agreement with respect to the Company's recapitalization plan, (ii) re- quire AMF Bowling to contribute $30.0 million as equity to Bowling Worldwide to be used to repay amounts borrowed under the Bank Facility and treat such prepayment as prefunding for new bowling center acquisitions, (iii) permit the Company to resume borrowing to fund acquisitions subject to certain criteria and maintenance of minimum availability under the Bank Facility of $65.0 mil- lion through 2000 and $40.0 million through 2001, (iv) permit AMF Bowling to make equity contributions to Bowling Worldwide which will be included in the calculation of EBITDA for financial covenant purposes under the Credit Agree- ment up to an aggregate of $10.0 million during any four consecutive quarters through December 31, 2001, (v) modify or waive certain financial covenants and (vi) allow Bowling Worldwide to exclude from EBITDA covenant calculations cer- tain restructuring and Special Charges (described below).
Bowling Worldwide is in compliance with the amended covenants as of Decem- ber 31, 1999. In this connection, AMF Bowling made contributions of $1.0 mil- lion and $2.0 million as equity to Bowling Worldwide in November 1999 and March 2000 to meet EBITDA requirements under its financial covenant tests as of September 30, 1999 and December 31, 1999, respectively. The Credit Agree- ment permits AMF Bowling to make additional equity contributions through 2001 as specified above. Management believes that Bowling Worldwide will be in com- pliance with the amended covenants during 2000, including the effect of the aforementioned equity contributions, but any downturn in the current perfor- mance of Bowling Worldwide could result in non-compliance with these financial covenants. Failure by Bowling Worldwide to comply with its Credit Agreement covenants could result in an event of default which, if nor cured or waived, would have a material adverse effect on the Company.
The Credit Agreement contains certain financial covenants, as well as additional affirmative and negative covenants, constraining Bowling Worldwide. Under the terms currently in effect, Bowling Worldwide must maintain a minimum Modified Consolidated EBITDA (as defined in the Credit Agreement) of not less than the sum of (i) an amount ranging from $140 million for the Rolling Period ending December 31, 1999, to $200 million for the Rolling Period ending September 30, 2003 and thereafter, and (ii) the EBITDA Adjustment Amount (as defined in the Credit Agreement) for such Rolling Period, which is equal to 80% of the aggregate amount of the EBITDA of each bowling center acquired or constructed by Bowling Worldwide or any of its Subsidiaries after June 14, 1999 and acquired or constructed at least 15 months prior to such time of determination.
Bowling Worldwide must also maintain a Cash Interest Coverage Ratio (de- fined in the Credit Agreement as the ratio of (i) Modified Consolidated EBITDA of Bowling Worldwide and its Subsidiaries during a Rolling Period to (ii) cash interest payable on all Debt (as defined in the Credit Agreement) of Bowling Worldwide and its Subsidiaries) at an amount ranging from not less than 1.75 for the Rolling Period ending June 30, 1999 to not less than 2.75 for the Rolling Period ending September 30, 2002 and thereafter. Bowling Worldwide is not required to maintain a Fixed Charge Coverage Ratio (as defined in the Credit Agreement as the ratio of (i) Modified Consolidated EBITDA less the sum of (a) cash taxes paid plus (b) Capital Expenditures (as defined in the Credit Agreement) made by Bowling Worldwide and its Subsidiaries during such Rolling Period to (ii) the sum of (a) cash interest payable on all Debt plus (b) prin- cipal amounts of all Debt under the Term Facilities payable by Bowling World- wide and its Subsidiaries during such Rolling Period) through December 31, 2001. Beginning
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
with the Rolling Period ending March 31, 2002 and thereafter, Bowling World- wide must maintain a Fixed Charge Coverage Ratio of not less than 1.0. A Se- nior Debt to EBITDA Ratio (as defined in the Credit Agreement as the ratio of Consolidated Debt, as defined in the Credit Agreement (other than Subordinated Debt and Hedge Agreements, as defined in the Credit Agreement), of Bowling Worldwide and its Subsidiaries to Modified Consolidated EBITDA for that Roll- ing Period) must be maintained at levels ranging from not more than 4.25 for the Rolling Period ending March 31, 1999 to not more than 2.50 for the Rolling Period ending March 31, 2002 and thereafter. A Total Debt to EBITDA Ratio (as defined in the Credit Agreement as the ratio of consolidated total Debt (other than Hedge Agreements) of Bowling Worldwide and its Subsidiaries to Modified Consolidated EBITDA) must be maintained at levels ranging from not more than 7.50 for the Rolling Period ending March 31, 1999 to not more than 4.50 for the Rolling Period ending March 31, 2002 and thereafter. In each case, the above-mentioned ratios are calculated on a quarterly basis.
Negative covenants under the Senior Facilities prohibit Bowling Worldwide and its Subsidiaries from incurring any liens (except for those created under the loan documents or otherwise permitted under the Credit Agreement, includ- ing those securing Bowling Worldwide's obligations as borrower on other in- debtedness not to exceed $5.0 million at any time outstanding). Bowling World- wide and its Subsidiaries are also prohibited from incurring any debt, other than (in the case of Bowling Worldwide) debt owed to its Subsidiaries or in respect of hedge agreements not entered into for speculative purposes or (in the case of any Subsidiary) debt owed to Bowling Worldwide or any of its whol- ly-owned Subsidiaries, to the extent permitted under the Credit Agreement or (in the case of either Bowling Worldwide or its Subsidiaries) debt secured by permitted liens, capitalized leases not to exceed $10 million at any time out- standing and any debt existing at the time of the Acquisition, among other things. Bowling Worldwide and its Subsidiaries may not incur any obligations under leases having a term of one year or more that would cause their direct and contingent liabilities for any 12 months to exceed the sum of (i) $25.0 million, (ii) the product of (x) $0.2 million and (y) the number of leased bowling centers acquired by Bowling Worldwide or any Subsidiaries after May 1, 1996 and (iii) in each calendar year after 1996, an amount equal to 4% of the amount permitted by this provision in the immediately preceding calendar year. Bowling Worldwide is also prohibited from entering into a merger in which it is not the survivor or to sell, lease, or otherwise transfer its assets other than in the ordinary course of business, except as otherwise permitted by the Credit Agreement. Investments by Bowling Worldwide or its Subsidiaries in any other person are also limited by the Credit Agreement. The negative covenants also relate to the payment of dividends, prepayments of, and amendments of the terms of, other debt (including the Subsidiary Notes), amendment of Related Documents (as defined in the Credit Agreement), ownership changes, negative pledges, partnerships, speculative transactions, capital expenditures and pay- ment restrictions affecting subsidiaries. Bowling Worldwide is also subject to certain financial and other reporting requirements.
Bowling Worldwide is also prohibited under the Credit Agreement from making a material change in the nature of its existing business, except that it may have up to $50.0 million invested at any one time in golf driving ranges and other golf-related activities.
Pursuant to the Credit Agreement, so long as Bowling Worldwide is not in default of the covenants contained in the Credit Agreement, it may (i) declare and pay dividends in common stock, (ii) declare and pay cash dividends to the extent necessary to make payments under certain noncompete agreements with owners of the Predecessor Company, (iii) declare and pay cash dividends for general administrative expenses not to exceed $0.25 million and (iv) declare and pay cash dividends not to exceed $2.0 million for the repurchase of AMF Bowling Common Stock.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Subsidiary Notes
Bowling Worldwide's senior subordinated notes (the "Subsidiary Senior Sub- ordinated Notes") will mature on March 15, 2006. Interest accrues from the date of issuance at an annual rate of 10.875% and is payable in cash semiannually in arrears on March 15 and September 15 of each year.
Bowling Worldwide's senior subordinated discount notes (the "Subsidiary Se- nior Subordinated Discount Notes") will mature on March 15, 2006, at a fully- accreted value of $277.0 million and will result in an effective yield of 12.25% per annum, computed on a semiannual bond equivalent basis. No interest is payable prior to March 15, 2001. Commencing March 15, 2001, interest will accrue and be payable in cash semiannually in arrears on March 15 and Septem- ber 15 of each year beginning with September 15, 2001.
The Subsidiary Senior Subordinated Notes and the Subsidiary Senior Subordi- nated Discount Notes (together, the "Subsidiary Notes") are jointly and sever- ally guaranteed on a senior subordinated basis by AMF Group Holdings and each of Bowling Worldwide's current and future subsidiaries identified below in "Note 20. Condensed Consolidating Financial Statements" (collectively, the "Guarantors").
The guarantees of the Subsidiary Notes are subordinated to the guarantees of the Bank Debt and the mortgage and equipment note outstanding at December 31, 1999. The Subsidiary Notes are general, unsecured obligations of Bowling Worldwide, are subordinated in right of payment to all of the Bank Debt and rank pari passu with all existing and future subordinated debt of Bowling Worldwide. The claims of the holders of the Subsidiary Notes will be effec- tively subordinated to all other indebtedness and other liabilities (including trade payables and capital lease obligations) of Bowling Worldwide's subsidi- aries that are not Guarantors and through which Bowling Worldwide will conduct a portion of its operations. See "Note 20. Condensed Consolidating Financial Statements."
The indenture governing the Subsidiary Senior Subordinated Notes and the indenture governing the Subsidiary Senior Subordinated Discount Notes (togeth- er, the "Subsidiary Note Indentures") contain certain covenants that, among other things, limit the ability of Bowling Worldwide and its Restricted Sub- sidiaries, as defined therein, to incur additional indebtedness and issue Dis- qualified Stock (as defined therein), pay dividends or distributions or make investments or make certain other Restricted Payments, as defined therein, en- ter into certain transactions with affiliates, dispose of certain assets, in- cur liens securing pari passu and subordinated indebtedness of Bowling World- wide and engage in mergers and consolidations.
Annual Maturities
Annual maturities of long-term debt, including accretion of the Subsidiary Senior Subordinated Discount Notes, as of December 31, 1999, are as follows:
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Recapitalization Plan
As part of a recapitalization plan (the "Recapitalization Plan") and in conjunction with the Amendment No. 2 and Waiver, AMF Bowling completed on July 28, 1999 an offering of rights to purchase AMF Bowling Common Stock and a ten- der offer for a portion of its outstanding zero coupon convertible debentures (the "Debentures") at a discount to carrying value. In the rights offering, AMF Bowling raised $120.0 million of gross proceeds in equity capital and is- sued 24.0 million additional shares of AMF Bowling Common Stock at the sub- scription price of $5.00 per share. AMF Bowling purchased $514,286 in aggre- gate principal amount at maturity of its Debentures in the tender offer at a price of $140 per $1,000 principal amount at maturity. AMF Bowling used ap- proximately $72.0 million of the proceeds from the rights offering to fund the purchase of the Debentures. Proceeds from the rights offering of $30.0 million were contributed as equity by AMF Bowling to Bowling Worldwide, which repaid amounts due under its Bank Facility. AMF Bowling used a portion of the remain- der of the proceeds to pay expenses of the rights offering and the tender of- fer and is using the balance remaining for general corporate purposes.
Interest Rate Cap Agreements
During March 1999 and December 1999, Bowling Worldwide entered into inter- est rate cap agreements with Goldman Sachs Capital Markets, L.P. to reduce the interest rate risk of its Bank Debt. The notional amounts of these caps were $200 million and $100 million, respectively, at December 31, 1999. Interest expense for interest rate cap agreements was $140 in 1999, $1,608 in 1998 and $1,823 in 1997.
Bowling Worldwide is exposed to credit-related loss in the event of non- performance by the counterparty. Bowling Worldwide believes its exposure to potential loss due to counterparty non-performance is minimized primarily due to the relatively strong credit rating of the counterparty.
Deferred Financing Costs
Costs incurred to obtain bank financing and issue bond financing are amor- tized over the lives of the various types of debt using the effective interest rate method. Bank financing costs, which were incurred to obtain bank financ- ing for the Acquisition, were entirely written off in the fourth quarter of 1997 in connection with the Credit Agreement. Amortization expense for financ- ing costs was $2,227 in 1999, $3,097 in 1998 and $4,856 in 1997.
Extraordinary Items
The Company recorded after-tax extraordinary charges totaling $23.4 mil- lion, net of $12.8 million of tax, in the fourth quarter of 1997 as a result of entering into the Credit Agreement, the premium paid to redeem a portion of the Subsidiary Senior Subordinated Discount Notes and the write-off of the portion of bond financing costs attributable to the Subsidiary Senior Subordi- nated Discount Notes redeemed.
Other
The Company is highly leveraged as a result of indebtedness incurred in connection with the Acquisition and subsequent bowling center acquisitions. Based upon the current level of performance,
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
management believes that cash flow from operations, together with available borrowings under the Credit Agreement and other sources of liquidity, will be adequate to meet the Company's requirements for working capital, capital ex- penditures, scheduled payments of principal of, and interest on, its Senior Debt, and interest on the Subsidiary Notes for the year 2000. In calendar year 2001, principal payment obligations under the facilities of the Credit Agree- ment increase significantly and cash interest becomes payable on the Subsidi- ary Senior Subordinated Discount Notes. Based on current levels of perfor- mance, the Company anticipates that a refinancing will be required to the meet the Company's financial requirements for calendar years 2001 and beyond. There is no assurance, however, that the Company will generate sufficient cash flow in a timely manner to satisfy scheduled principal and interest payments or that any refinancing would be available at commercially reasonable terms or at all.
NOTE 9. RESTRUCTURING CHARGES, ASSET IMPAIRMENT CHARGES AND SPECIAL CHARGES
Restructuring Charges
In 1999, the Company recorded restructuring charges of approximately $8.5 million that were related primarily to a plan to reorganize and downsize the Bowling Products business in response to market weakness in the Asia Pacific region and increased competition which has negatively impacted sales and prof- itability of NCPs. The restructuring plan was developed in conjunction with a strategic business assessment performed by Bain & Co. and was designed to re- duce the overall volatility of the Bowling Products business. Actions taken included closing one plant in the U.S., and one plant in Korea, three ware- houses in China, one warehouse in Taiwan, four sales offices in China and one sales office in Belgium. Additionally, sales offices were downsized in four other countries. The restructuring charges relate primarily to employee termi- nation benefits, asset write-offs and contract cancellations. As of December 31, 1999, the Company had a remaining reserve related to the restructuring charges of $0.6 million.
Asset Impairment Charges
In 1999, the Company recorded asset impairment charges of $8.1 million rep- resenting the difference between fair market value and carrying value of im- paired assets. The asset impairment charges relate to under-performing bowling center locations that under an approved plan will be closed in the first half of 2000. Fair market value is generally determined based on the average sales proceeds from previous sales of AMF bowling center locations.
The following table summarizes the nature of the restructuring charges and asset impairment charges:
Special Charges
The strategic assessment by Bain & Co. discussed above led to programs de- signed to improve product line profitability and quality in the Company. This assessment was a catalyst to the Company recording certain charges. These charges, along with additional reserves (collectively, the "Special Charges") recorded by the Company totaled $26.5 million. The Special Charges are non- cash, relate primarily to receivables and inventory and are included within operating expenses.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Special Charges are summarized as follows:
NOTE 10. INCOME TAXES
Income (loss) before income taxes for the years ended December 31, 1999, 1998 and 1997, consists of the following:
The income tax provision (benefit) at December 31, 1999, 1998 and 1997, consists of the following:
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The tax effects of temporary differences and carry-forwards that give rise to deferred tax assets and liabilities at December 31, 1999 and 1998, are as follows:
Realization of deferred tax assets associated with the net operating losses ("NOLs") and foreign tax credit carryforwards is dependent upon generating sufficient taxable income prior to their expiration. Management believes that there is a risk that certain of these NOLs and foreign tax credit carryforwards may expire unused and, accordingly, has established a valuation allowance against them.
The Company is included in the consolidated federal income tax return filed by AMF Bowling. As of December 31, 1999, the Company had net operating losses of approximately $284.6 million and foreign tax credits of $11.5 million that will carry over to future years to offset U.S. taxes. The foreign tax credits will begin to expire in the year 2001 and the net operating losses will begin to expire in the year 2011. The Company has recorded a valuation reserve as of December 31, 1999 for $126.3 million related to net operating losses, foreign tax credits and other deferred tax assets that the Company may not utilize prior to their expirations. The tax provision recorded for 1999 reflects an increase in the valuation allowance and certain international taxes.
The gross amount of NOLs the Company may utilize on future tax returns is $284.6. The NOLs expire as follows:
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The provision (benefit) for income taxes differs from the amount computed by applying the statutory rate of 35 percent for 1999, 1998 and 1997 to loss before taxes. The principal reasons for these differences are as follows:
NOTE 11. COMMITMENTS AND CONTINGENCIES
Bowling Centers and Bowling Products lease certain facilities and equipment under operating leases, which expire at various dates through 2016. Bowling Centers has certain ground leases, associated with several centers, which ex- pire at various dates through 2058. These leases generally contain renewal op- tions and require payments of taxes, insurance, maintenance, and other ex- penses in addition to the minimum annual rentals. Certain leases require contingent payments based on usage of equipment above certain specified lev- els. Such contingent rentals amounted to $2,430 in 1999, $1,733 in 1998 and $1,200 in 1997. Total rent expense under operating leases aggregated approxi- mately $32,892 in 1999, $31,061 in 1998 and $24,117 in 1997.
Future minimum rental payments under the operating lease agreements as of December 31, 1999, are as follows:
Litigation and Claims
In June 1998, Harbin Hai Heng Bowling Entertainment Co. Ltd. ("Hai Heng") filed an action against a subsidiary of AMF Bowling and Bowling Worldwide in Heilongjing, China. Hai Heng sought to recover $3 to $4 million in damages re- lating to NCPs purchased from AMF. Hai Heng asserted that the poor quality of NCPs entitled Hai Heng to recover the purchase price and damages for lost profits and the cost of storing the NCPs. In November 1998, the court awarded Hai Heng approximately $3.5 million. The Company appealed to the next higher court of Heilongjing Province, which issued a judgment in favor of Hai Heng for approximately $2.8 million and ordered Hai Heng to return 24 NCPs to AMF.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Company believes Hai Heng's claim is a warranty issue and that Hai Heng is not entitled to recover the purchase price, lost profits or the cost of storage. The Company also believes that Hai Heng's claim is substantially without merit and, based on the advice of local legal counsel, believes that the judicial process leading up to the trial court's judgment involved signif- icant procedural and other legal defects. Following the award, Hai Heng began to exercise its rights to collect the judgment. The Company appealed to the Supreme People's Court in Beijing (the "Supreme Court"). The Supreme Court ac- cepted the file and told AMF's attorneys that it will hear the appeal but has not issued a written order accepting the appeal.
Due to a number of uncertainties inherent in litigation in China, the Com- pany can give no assurance on the likelihood of success of the appeal or the ultimate outcome. However, management does not believe that the outcome will have a material adverse impact on the financial position of the Company.
On April 22, 1999, a putative class action was filed in the United States District Court for the Southern District of New York by Vulcan International Corporation against AMF Bowling, The Goldman Sachs Group, L.P., Goldman, Sachs & Co., Morgan Stanley & Co. Incorporated, Cowen & Company, Schroder & Co., Inc., Richard A. Friedman and Douglas J. Stanard. The complaint has subse- quently been amended to, among other things, include additional named plain- tiffs. The plaintiffs, as putative class representatives for all persons who purchased AMF Bowling Common Stock in the initial public offering of AMF Bowl- ing Common Stock by AMF Bowling in November 1997 (the "Initial Public Offer- ing") or within 25 days of the effective date of the registration statement related to the Initial Public Offering, seek, among other things, damages and/or rescission against all defendants jointly and severally pursuant to Sections 11, 12 and/or 15 of the Securities Act of 1933 based on allegedly in- accurate and misleading disclosures in connection with and following the Ini- tial Public Offering. Management believes that the litigation is without merit and intends to defend it vigorously.
In addition, the Company currently and from time to time is subject to claims and actions arising in the ordinary course of its business, including environmental claims, discrimination claims, workers' compensation claims and personal injury claims from customers of Bowling Centers. In some actions, plaintiffs request punitive or other damages that may not be covered by insur- ance. In management's opinion, the claims and actions in which the Company is involved will not have a material adverse impact on its financial position or results of operations. However, it is not possible to predict the outcome of such claims and actions.
NOTE 12. EMPLOYEE BENEFIT PLANS
The Company has a defined contribution 401(k) plan to which U.S. employees may make voluntary contributions based on their compensation. Under the provi- sions of the plan, beginning on January 1, 1999, the Company matches 100% of the first 3% and 50% of the next 2% of employee contributions. Prior to Janu- ary 1, 1999, the Company could, at its option, match a discretionary percent- age of employee contributions. The Company may make an additional profit-shar- ing contribution as determined by the Board of Directors. Employer contributions made prior to January 1, 1999 vest 100 percent on the fifth an- niversary of employment. Employer contributions made subsequent to Decem- ber 31, 1998 vest 100 percent immediately. The amounts charged to expense un- der this plan were $2,174 in 1999, $0 in 1998 and $1,779 in 1997.
Certain of the Company's international operations have employee benefit plans covering selected employees. These plans vary as to the funding, includ- ing local government, employee, and employer
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
funding. Each international operation has provided for pension expense and made contributions to these plans in accordance with the requirements of the plans and local country practices. The amounts that were charged to expense under these plans aggregated $875 in 1999, $974 in 1998 and $814 in 1997.
The Company has employment agreements with certain executives that provide for salaries and bonuses if certain operational and financial targets are met (the "Executive Employment Agreements"). The Executive Employment Agreements provide for payment of accrued compensation, continuation of certain benefits, severance payments, payment of a portion of the executive's bonus and vesting of options to purchase shares of AMF Bowling Common Stock ("AMF Bowling Stock Options") following termination of employment by the Company under certain circumstances. No amounts were committed for future salaries at December 31, 1999.
1996 Stock Incentive Plan
In connection with the Acquisition, AMF Bowling adopted a stock incentive plan (the "1996 Plan") under which AMF Bowling may grant incentive awards in the form of shares of AMF Bowling Common Stock, AMF Bowling Stock Options, and stock appreciation rights to certain officers, employees, consultants, and non-employee directors ("Participants") of AMF Bowling and its affiliates. The total number of shares of AMF Bowling Common Stock reserved and available for grant under the 1996 Plan is 1,767,151. A committee of AMF Bowling's Board of Directors (the "Committee") is authorized to make grants and various other de- cisions under the 1996 Plan and to make determinations as to a number of the terms of awards granted under the 1996 Plan. In 1999, the Company did not grant any AMF Bowling Stock Options under the 1996 Plan. In 1998 and 1997, the Committee granted AMF Bowling Stock Options to Participants to purchase a to- tal of 32,000 and 702,000 shares of AMF Bowling Common Stock, respectively. The 1998 AMF Bowling Stock Options were granted at an exercise price of $1.00 per share. The 1997 AMF Bowling Stock Options were granted at an exercise price of $10.00 per share. The AMF Bowling Stock Options granted in 1998 vest on the one-year anniversary of the grant date. With respect to the 1997 AMF Bowling Stock Options, twenty percent of the options vest on each of the first five anniversaries of the grant dates. AMF Bowling Stock Options are nontransferable (except under certain limited circumstances) and, unless oth- erwise determined by the Committee, have a term of ten years.
The number of AMF Bowling Stock Options outstanding to all employees (in- cluding members of senior management), and directors under the 1996 Plan at December 31, 1999, 1998 and 1997 total 1,185,650, 1,307,250 and 1,572,000, re- spectively. Of the total AMF Bowling Stock Options awarded under the 1996 Plan, 591,150 were exercisable during 1999 and 522,400 were exercisable during 1998. Of the exercisable AMF Bowling Stock Options, none were exercised in 1999 and 67,550 were exercised in 1998 and none were exercised in 1997. For- feited AMF Bowling Stock Options totaled 121,600, 229,200 and 226,500 in 1999, 1998 and 1997, respectively.
The 1996 Plan will terminate ten years after its effective date; however, awards outstanding as of such date will not be affected or impaired by such termination. AMF Bowling's Board of Directors (the "Board") and the Committee have authority to amend the 1996 Plan and awards granted thereunder, subject to the terms of the 1996 Plan.
The weighted-average fair value of 1996 Plan options granted during 1998 and 1997 is $7.07 and $6.78 per option, respectively. The 1,185,650 options outstanding at December 31, 1999 have a weighted-average exercise price of $9.76 and a weighted-average remaining contractual life of 7.0 years.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
1998 Stock Incentive Plan
Under the 1998 Stock Incentive Plan (the "1998 Plan"), AMF Bowling may grant to employees of the Company and its affiliates incentive awards ("Awards") in the form of AMF Bowling Stock Options, stock appreciation rights and shares of AMF Bowling Common Stock that are subject to certain terms and conditions. The total number of shares of AMF Bowling Common Stock reserved and available for grant under the 1998 Plan is four million. In addition, shares of AMF Bowling Common Stock that have been reserved but not issued un- der the 1996 Plan, and shares which are subject to awards under the 1996 Plan that expire or otherwise terminate, may be granted as Awards pursuant to the 1998 Plan. There are 513,951 shares of AMF Bowling Common Stock under the 1996 Plan available for grant of awards under that plan.
Shares allocated to Awards granted under the 1998 Plan which are later for- feited, expire or otherwise terminate (including shares subject to stock ap- preciation rights that are exercised for cash) may again be used for Awards under the 1998 Plan. No more than 200,000 shares of AMF Bowling Common Stock may be allocated to the Awards granted under the 1998 Plan to a Participant in any one year.
In 1999 and 1998, 1,523,000 and 950,400 AMF Bowling Stock Options, respec- tively were granted as Awards under the 1998 Plan. Twenty percent of the AMF Bowling Stock Options vest on each of the first five anniversaries of the grants. The number of AMF Bowling Stock Options outstanding to senior manage- ment, other employees, and directors under the 1998 Plan at December 31, 1999 and 1998 total 2,266,150 and 894,650, respectively. Of the total AMF Bowling Stock Options awarded under the 1998 Plan, 156,030 were exercisable in 1999 and none were exercisable during 1998. Forfeited AMF Bowling Stock Options to- taled 151,500 in 1999 and 55,750 in 1998.
In 1999, the chief executive officer of the Company was granted AMF Bowling Stock Options to purchase 1,000,000 shares of AMF Bowling Common Stock (the "CEO Stock Options"). The CEO Stock Options were not granted pursuant to the 1996 Plan or the 1998 Plan but are subject to the terms of the 1998 Plan. The CEO Stock Options were granted at an exercise price of $5.28 per share. Twenty percent of the CEO Stock Options vest on the grant date and on each of the first four anniversaries of the grant date.
The weighted-average fair value of 1998 Plan AMF Bowling Stock Options and CEO Stock Options granted during 1999 and 1998 is $3.08 and $4.87 per option, respectively. The 3,266,150 options outstanding at December 31, 1999 have a weighted-average exercise price of $6.68 and a weighted-average remaining con- tractual life of 9.3 years.
The 1998 Plan will terminate ten years after its effective date; however, awards outstanding as of such date will not be affected or impaired by such termination. The Board and the Committee have authority to amend the 1998 Plan and awards granted thereunder, subject to the terms of the 1998 Plan.
The fair value of each option granted is estimated on the date of grant us- ing the Black-Scholes option-pricing model. The following weighted-average as- sumptions were used for grants in 1997, 1998 and 1999:
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
In 1999, AMF Bowling granted to one executive of the Company 100,000 re- stricted shares of AMF Bowling Common Stock (the "Restricted Stock") at a cost of $1,000 to the executive. The Restricted Stock was granted pursuant to and is governed by the 1998 Plan and is subject to the Stockholders Agreement. One-third of the Restricted Stock vests on each of the first three anniversa- ries of the grant. The Company will record compensation expense related to the issuance of this Restricted Stock over the vesting period.
In 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based Com- pensation," and elected to account for its AMF Bowling Stock Options under APB Opinion No. 25, under which no compensation cost has been recognized. Had com- pensation cost for AMF Bowling Stock Options granted under the 1996 Plan and 1998 Plan and the CEO Stock Options been determined consistent with SFAS No. 123, the Company's net losses for 1999, 1998 and 1997 would have been in- creased to $203,029, $126,108 and $56,503, respectively.
NOTE 13. SUPPLEMENTAL DISCLOSURES TO THE CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash paid for interest and income taxes in 1999, 1998 and 1997 was as fol- lows:
Net cash used for business acquisitions in 1999, 1998 and 1997 consisted of the following:
Non-cash financing activities in 1999, 1998 and 1997 were as follows:
NOTE 14. ACQUISITIONS
Since the Acquisition and prior to December 31, 1999, AMF Bowling Centers purchased an aggregate of 263 bowling centers from various unrelated sellers. The combined net purchase price was approximately $498.9 million, and was funded with approximately $76.6 million from the sale of equity by AMF Bowl- ing, $421.1 million from available borrowing under Bowling Worldwide's then existing Acquisition Facility and current Bank Facility, and with $1.2 million from the issuance of AMF Bowling Common Stock with respect to the acquisition of Active West, Inc. in 1998. See "Note 13. Supplemental Disclosures to the Consolidated Statements of Cash Flows" for acquisition activity by year. Sub- sequent to December 31, 1999, the Company has not acquired any bowling cen- ters.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 15. JOINT VENTURES
In April 1997, the Company entered into a joint venture with Hong Leong Corporation Limited, a Singapore-based conglomerate ("Hong Leong"), to build and operate bowling centers in the Asia Pacific region. The joint venture ("Hong Leong Joint Venture") is owned 50% by the Company and 50% by Hong Leong. The Hong Leong Joint Venture opened its only bowling center during No- vember 1997 in Tianjin, China. Due to the economic difficulties in the Asia Pacific region, future development of bowling centers in that region through the Hong Leong Joint Venture will not be pursued.
In August 1997, the Company entered into a joint venture with Playcenter S.A., a Sao Paulo-based amusement and entertainment company ("Playcenter") to build and operate bowling centers in Brazil and Argentina. The joint venture ("Playcenter Joint Venture") is owned 50% by the Company and 50% by Playcenter. As of December 31, 1999, the Playcenter Joint Venture operated 12 centers in Brazil and two centers in Argentina. No additional sites for the Playcenter Joint Venture are being evaluated. The Company and Playcenter have pledged their shares of the Playcenter Joint Venture in connection with a guarantee of a third party loan to the Playcenter Joint Venture.
The Company accounts for its investments in Hong Leong Joint Venture and Playcenter Joint Venture by the equity method. The joint ventures' operations and the Company's equity in earnings of the joint ventures are presented below (in thousands, unaudited):
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The joint ventures' financial position as of December 31, 1999 and 1998, and the Company's investments in the joint ventures and amounts due from Playcenter Joint Venture as of December 31, 1999 and 1998, are presented below (in thousands, unaudited):
The Company's investment in Playcenter Joint Venture includes the unamor- tized excess of the Company's investment over its equity in the joint ven- ture's net assets. This excess is being amortized over a period not to exceed the estimated life of the joint venture of five years. The note receivable due from Playcenter Joint Venture represents the balance due for sales of equip- ment to the joint venture through a Brazilian distributor. The balance due on the equipment sales and the loan to Playcenter Joint Venture bear interest at 12% through November 21, 1997 and 8% thereafter. Principal and interest will be repaid to the Company by the joint venture from its operating cash flow.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 16. BUSINESS SEGMENTS
The Company operates in two major lines of business: operation of bowling centers and manufacturing and sale of bowling and related products. Information concerning operations in these business segments for 1999, 1998 and 1997 is presented below (in millions):
- -------- (a) Certain amounts have been reclassified to conform to current year presenta- tion.
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 17. GEOGRAPHIC SEGMENTS
Information about the Company's operations in different geographic areas for 1999, 1998 and 1997, and identifiable assets at December 31, 1999 and 1998, are presented below:
Operating revenue for the U.S. Bowling Products operations has been reduced by $42,185 in 1999, $75,991 in 1998 and $104,900 in 1997 to reflect the elimi- nation of intracompany sales between the U.S. Bowling Products operations and the Bowling Products international sales and service branches. Operating in- come for the U.S. Bowling Products operations has been increased by $1,488 in 1999, $148 in 1998 and $2,300 in 1997 to reflect the elimination of intracom- pany gross profit between the U.S. Bowling Products operations and the Bowling Products international sales and service branches. Identifiable assets for the international sales and service branches have been reduced by $1,549 at Decem- ber 31, 1999 and $3,037 at December 31, 1998 to reflect the elimination of in- tracompany gross profit in inventory between the U.S. Bowling Products opera- tions and the Bowling Products international sales and service branches.
NOTE 18. RELATED PARTIES
Goldman Sachs and its affiliates have certain interests in the Company. Goldman Sachs and its affiliates together currently beneficially own a major- ity of the outstanding voting equity of AMF Bowling. Goldman Sachs also owns 870,000 warrants to purchase shares of AMF Bowling Common Stock. The warrants were issued in connection with the Acquisition at an exercise price of $0.01 per share and expire in May 2006. In addition, Goldman Sachs was the initial purchaser of the Subsidiary Notes of the Company in connection with the Acqui- sition. Richard A. Friedman and Terence M. O'Toole, each of whom is a Managing Director of Goldman Sachs, and Peter M. Sacerdote, who is a limited partner of The Goldman Sachs Group, L.P., are directors of AMF Bowling, AMF Group Hold- ings and Bowling Worldwide. Goldman Sachs, thus, is deemed to be an "affili- ate" of the Company. Goldman Sachs received an underwriting discount of ap- proximately $19.0 million in connection with the purchase and resale of the Subsidiary Notes. In addition, Goldman Sachs was reimbursed its expenses and is indemnified in connection with its services.
Under the Credit Agreement, Goldman Sachs Credit Partners, L.P., acted as Syndication Agent; Goldman Sachs Credit Partners, L.P., and Citicorp Securi- ties, Inc., acted as Arrangers; Citibank, N.A. is acting as Administrative Agent and Citicorp USA, Inc. is acting as Collateral Agent. Goldman Sachs
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Credit Partners, L.P., was also a lender under the Credit Agreement. Total fees and reimbursable expenses payable to Goldman Sachs Credit Partners, L.P. in connection with its services under the Credit Agreement aggregated approxi- mately $10.7 million, and such entity was reimbursed for expenses in connec- tion with such services. Goldman Sachs also received a cash fee of $5.0 mil- lion from the Company in connection with the Acquisition and was reimbursed for related expenses.
Goldman Sachs acted as AMF Bowling's lead underwriter in connection with the Initial Public Offering. Underwriting discounts paid to the entire under- writing syndicate in the Initial Public Offering totaled $18.9 million.
In 1997, the Company paid a fee of $0.3 million to Goldman Sachs for its representation of the Company in connection with the Company's lease of its new bowling center at Chelsea Piers in New York.
NOTE 19. RECENT ACCOUNTING PRONOUNCEMENTS
Effective for the quarter ended March 31, 2001, the Company will be re- quired to adopt Statement of Financial Accounting Standards No. 133 "Account- ing for Derivative Instruments and Hedging Activities." The Company does not expect that adoption of this standard will have a material impact on the Company's financial position or results of operations.
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
The following condensed consolidating information presents:
. Condensed consolidating balance sheets as of December 31, 1999 and 1998, and condensed consolidating statements of operations and cash flows for 1999, 1998 and 1997.
. Elimination entries necessary to combine the entities comprising AMF Group Holdings.
The Subsidiary Notes are jointly and severally guaranteed on a full and un- conditional basis by the Guarantors. Third-tier subsidiaries of Bowling World- wide, all of which are wholly owned subsidiaries of AMF Worldwide Bowling Cen- ters Holdings Inc., a second-tier subsidiary of Bowling Worldwide, have not provided guarantees (the "Non-Guarantors").
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEET
As of December 31, 1999 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEET
As of December 31, 1998 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
For the Year Ended December 31, 1999 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
For the Year Ended December 31, 1998 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
For the Year Ended December 31, 1997 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
For the Year Ended December 31, 1999 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
For the Year Ended December 31, 1998 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 20. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
For the Year Ended December 31, 1997 (Unaudited) (In Thousands)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
AMF GROUP HOLDINGS INC. AND SUBSIDIARIES
SELECTED QUARTERLY DATA
- -------- (a) Costs incurred in connection with the use of a capital contribution from AMF Bowling attributable to proceeds received by AMF Bowling from the Ini- tial Public Offering.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Arthur Andersen LLP has served as the Company's independent public accoun- tants since 1996.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
DIRECTORS
The Board of Directors (the "Board") is constituted to include nine mem- bers, each of whom is elected serve a one-year term or until his successor is duly elected and qualified or until his earlier death, resignation or removal. The following are the directors of Bowling Worldwide, each of whom is also di- rector of AMF Bowling:
Richard A. Friedman, 42, has been a Managing Director of Goldman, Sachs & Co. ("Goldman Sachs"), an investment firm, since 1996. He joined Goldman Sachs in 1981. Mr. Friedman serves on the Boards of Directors of Carmike Cinemas, Inc. and Polo Ralph Lauren Corporation.
Roland C. Smith, 45, has been President and Chief Executive Officer of the Company since joining the Company in April 1999. Prior to joining the Company, Mr. Smith was President and Chief Executive Officer of the Triarc Restaurant Group ("Triarc"), a restaurant franchisor which conducts its business through Arby's, Inc., from 1997 to 1999. Mr. Smith joined Triarc in 1994 as vice pres- ident of international marketing.
Stephen E. Hare, 46, has been an Executive Vice President and the Chief Fi- nancial Officer of the Company since joining the Company in May 1996. Mr. Hare also served as Acting President and Chief Executive Officer of the Company from November 1998 until Mr. Smith's employment with the Company began in April 1999. Mr. Hare served as Senior Vice President and Chief Financial Offi- cer of James River Corporation of Virginia, a manufacturer and marketer of pa- per products and other related consumer goods, from 1992 to 1996.
Terence M. O'Toole, 41, is a Managing Director of Goldman Sachs, an invest- ment firm. He joined Goldman Sachs in 1983. Mr. O'Toole serves on the Boards of Directors of Western Wireless Corporation, Voice Stream Wireless Corpora- tion, Amscan Holdings, Inc. and 21st Century Newspapers, Inc.
Peter M. Sacerdote, 62, is an Advisory Director and Chairman of the Invest- ment Committee of Goldman Sachs, an investment firm. He joined Goldman Sachs in 1964 and served as a General Partner from 1973 to 1990 and as a Limited Partner from 1990 to 1999. Mr. Sacerdote serves on the Boards of Directors of Franklin Resources, Inc. and QUALCOMM, Inc.
Charles M. Diker, 65, has been a non-managing Principal of Weiss, Peck & Greer, an investment management firm, since 1975. He has been Chairman of the Board of Cantel Industries, Inc. since 1986. Mr. Diker also serves on the Boards of Directors of BeautiControl Cosmetics, International Specialty Prod- ucts and Chyron Corporation.
Paul B. Edgerley, 44, has been Managing Director of Bain Capital, Inc., an investment firm, since 1993. From 1990 to 1993 he was a General Partner of Bain Venture Capital, and from 1988 to 1990 he was a principal of Bain Capital Partners. He serves on the Boards of Directors of GS Industries, Inc., Sealy Mattress Company, Anthony Crane and American Pad and Paper.
Howard A. Lipson, 36, is Senior Managing Director of The Blackstone Group L.P., an investment firm, and has been involved in that firm's principal ac- tivities since 1988. He serves on the Boards of Directors of Allied Waste In- dustries, Inc., Rose Hills Holdings Corp., Prime Succession, Inc., Ritvik Toys, Inc., Volume Services America, Inc. and Graham Holdings Corporation.
Thomas R. Wall, IV, 41, joined Kelso & Company, L.P., an investment firm, in 1983 and has served as a Managing Director since 1990. Mr. Wall serves on the Boards of Directors of Citation Corporation, Consolidated Vision Group, Inc., Cygnus Publishing, Inc., iXL Enterprises, Inc., Mitchell Supreme Fuel Company, Mosler Inc., Peebles, Inc., TransDigm Inc. and 21st Century Newspa- pers, Inc.
EXECUTIVE OFFICERS
The following table sets forth information concerning the executive offi- cers of Bowling Worldwide. Except for Mr. Daniel, each of the executive offi- cers is also an executive officer of AMF Bowling.
Roland C. Smith has been president and chief executive officer of the Com- pany since joining the Company in April 1999. Prior to joining the Company, Mr. Smith was president and chief executive officer of the Triarc Restaurant Group ("Triarc"), a restaurant franchisor which conducts its business through Arby's, Inc., from 1997 to 1999. Mr. Smith joined Triarc in 1994 as vice pres- ident of international marketing.
Stephen E. Hare has been an executive vice president and the chief finan- cial officer of the Company since joining the Company in May 1996. Mr. Hare also served as acting president and chief executive officer of the Company from November 1998 until Mr. Smith's employment with the Company began in April 1999. Mr. Hare served as senior vice president and chief financial offi- cer of James River Corporation of Virginia, a manufacturer and marketer of pa- per products and other related consumer goods, from 1992 to 1996.
John P. Watkins has been an executive vice president of the Company and the president of U.S. Bowling Centers since joining the Company in September 1998. Prior to joining AMF, Mr. Watkins was president of Source Company, a provider of services related to publications and other front-end checkout categories for a wide variety of retailers in the U.S. and Canada, from 1996 to 1998. Mr. Watkins was senior vice president and chief operating officer of Food Lion, Inc., a supermarket chain in the southeastern U.S. with over 1,000 stores, from 1991 to 1996.
J. Randolph V. Daniel, IV has been the president of Bowling Products since 1999. Since joining Bowling Products in 1993, Mr. Daniel has served as direc- tor of operations, general manager and business unit manager for certain busi- ness units of Bowling Products, and as vice president of manufacturing for Bowling Products.
Section 16(a) Beneficial Ownership Reporting Compliance
All 100 shares of Bowling Worldwide's common stock, which is not registered pursuant to Section 12 of the Securities Exchange Act of 1934, is held by AMF Group Holdings.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Table
The following table shows for each of the three years ended December 31, 1997, 1998, and 1999, compensation paid or accrued by AMF Bowling or the Com- pany to Bowling Worldwide's Chief Executive Officer and each of Bowling Worldwide's three other most highly compensated executive officers (the "Named Executive Officers").
- -------- (a) Douglas J. Stanard resigned from his positions as Chief Operating Officer of Bowling Worldwide, President and Chief Executive Officer of AMF Bowl- ing and from all other positions with AMF Bowling and its subsidiaries effective as of January 1, 1999. Pursuant to the terms of a settlement agreement (the "Settlement Agreement") executed in connection with his resignation, dated as of November 2, 1998, among Mr. Stanard, AMF Bowling and Bowling Worldwide, AMF Bowling paid Mr. Stanard (i) $400,000 as sev- erance under his executive employment agreement and (ii) $850,000 in con- sideration of his compliance with certain obligations under the Settle- ment Agreement, including non-competition and non-solicitation provisions, and obligations to cooperate with information requests from AMF Bowling and to reasonably assist AMF Bowling with respect to pending and future dispute resolutions. In addition, Mr. Stanard transferred all of his AMF Bowling Common Stock to AMF Bowling in exchange for the can- cellation of his non-recourse promissory note in the principal amount of $1,000,000. Pursuant to the Settlement Agreement, all stock options pre- viously granted to Mr. Stanard were cancelled and forfeited as of Novem- ber 2, 1998, and Mr. Stanard will be subject to non-competition and non- solicitation provisions for two years following his date of termination. (b) Options to purchase shares of AMF Bowling Common Stock. (c) Unless otherwise indicated, All Other Compensation represents matching and profit-sharing contributions made by AMF Bowling or the Company under a consolidated 401(k) plan. (d) Mr. Smith's employment with the Company began on April 28, 1999 and he receives an annual salary of $575,000. (e) Represents a signing bonus of $500,000 and a $431,250 bonus for 1999. See "--Employment Agreements". (f) Represents reimbursement of relocation expenses.
(g) Mr. Hare became Acting President and Chief Executive Officer of Bowling Worldwide on November 2, 1998 and served in that capacity until Mr. Smith's employment with Bowling Worldwide began on April 28,1999. (h) Mr. Hare was granted 100,000 shares of restricted stock of AMF Bowling in connection with his employment agreement. See "--Employment Agreements" (i) Includes a special one-time bonus of $175,000 for services in connection with the Initial Public Offering. (j) Includes $12,000 for automobile allowance. (k) Mr. Daniel was promoted to President, Bowling Products on March 1, 1999 and receives an annual salary of $200,000.
Stock Option Grants in Last Fiscal Year
Bowling Worldwide does not have a stock option plan. Bowling Worldwide did not grant any stock options or stock appreciation rights during 1998. The fol- lowing table provides information regarding the granting of stock options by AMF Bowling to the Named Executive Officers in 1999 pursuant to AMF Bowling's 1998 Stock Incentive Plan (the "1998 Plan") and with respect to Mr. Smith, pursuant to his employment agreement (as defined below).
- -------- (1) With respect to Messrs. Hare and Daniel, the stock options listed in this table will become 20% vested on each anniversary of the grant date of Au- gust 16, 1999. Upon an optionee's termination of employment, the portion of an option that has not yet vested will be forfeited. Twenty percent of Mr. Smith's stock options vested on the grant date of April 29, 1999 and twenty percent vest on each anniversary of the grant date. In the event of a Change in Control (as defined in the 1998 Plan), any unvested stock options will immediately vest. See "Employment Agreements" for additional discussion of Messrs. Hare's and Smith's stock options. (2) In 1999, 1,523,000 stock options were granted under the 1998 Plan. Mr. Smith's grant of 1,000,000 stock options was not granted under the 1998 Plan but is subject to the terms of the 1998 Plan. (3) All stock options listed in this table were granted at an exercise price equal to 100% of the fair market value of AMF Bowling Common Stock on the date of grant. (4) These calculations use theoretical 5% and 10% rates of appreciation pre- scribed by the Securities and Exchange Commission. The 5% and 10% rates of appreciation would result in share prices of $8.03 and $12.79 for Messrs. Hare and Daniel and $8.60 and $13.70 for Mr. Smith in 2009. The Company expresses no opinion regarding whether this level of appreciation will be realized and expressly disclaims any representation to that ef- fect.
Aggregated Stock Option Exercises and Fiscal Year-End Option Value
The following table provides information regarding the number and value of unexercised stock options of AMF Bowling at December 31, 1999 for the Named Executive Officers. No Named Executive Officer exercised any stock options in fiscal year 1999.
- -------- (1) The exercise price of all exercisable and unexercisable options is $5.28 per share. (2) The exercise price is $10.00 per share with respect to all exercisable stock options, $10.00 per share with respect to 51,000 unexercisable stock options and $4.93 per share with respect to 150,000 unexercisable options. (3) The exercise price is $4.06 per share with respect to all exercisable and unexercisable stock options. (4) The exercise price is $10.00 per share with respect to 19,000 exercisable stock options, $16.19 per share with respect to 3,000 exercisable stock options, $10.00 per share with respect to 16,000 unexercisable stock op- tions, $16.19 per share with respect to 12,000 unexercisable stock options and $4.93 with respect to 50,000 unexercisable stock options. (5) At December 31, 1999, the exercise prices of all stock options for all Named Executive Officers exceeded the last sales price of AMF Bowling Com- mon Stock on the New York Stock Exchange of $3.125 per share.
Employment Agreements
Mr. Smith has an employment agreement (the "Smith Employment Agreement") with AMF Bowling for an employment period ending April 29, 2002 (the "Employ- ment Period"). Under the Smith Employment Agreement, Mr. Smith holds the posi- tions of President and Chief Executive Officer of AMF Bowling and the Company. Mr. Smith's annual base salary under the Smith Employment Agreement is $575,000. He is eligible to receive a bonus of 75% of his base salary of which 50% is based on discretionary objectives and 50% is based on operational and financial targets as set by the Compensation Committee of the Board of Direc- tors of AMF Bowling. Mr. Smith received a signing bonus of $500,000 and was guaranteed a $431,250 bonus for 1999.
The Smith Employment Agreement provides for payment of accrued compensation and benefits, as well as payment of an annual bonus following termination of his employment by AMF Bowling under certain circumstances. The Smith Employ- ment Agreement further provides for continued payment of annual base salary, continuation of welfare benefits and credit towards eligibility for retiree benefits through the remainder of the Employment Period and for 12 months thereafter. If all or substantially all of the stock or assets of AMF Bowling are sold or disposed of to an unaffiliated third party, Mr. Smith will have the right to resign within nine months, and be entitled to receive accrued salary and benefits, annual bonus and continued payment of Mr. Smith's annual base salary, continuation of welfare benefits and credit towards eligibility for retiree benefits through the remainder of the Employment Period and for 12 months thereafter.
Under the Smith Employment Agreement, Mr. Smith was granted stock options on April 28, 1999 to purchase 1,000,000 shares of AMF Bowling Common Stock. The stock options were not granted
pursuant to the 1996 Plan or the 1998 Plan but are subject to the terms of the 1998 Plan. Unless sooner exercised or forfeited as provided, Mr. Smith's stock options expire on April 28, 2009. Twenty percent of the options vest on the grant date and on each anniversary of the grant date. In the event of a Change of Control (as defined in the 1998 Plan), any unvested stock options will im- mediately vest. In the event of a termination of Mr. Smith's employment by AMF Bowling under the circumstances, the portion of stock options that would have vested during the two-year period following the date of termination will imme- diately vest.
Mr. Hare has an employment agreement (the "Hare Employment Agreement") with AMF Bowling for an employment period ending on August 4, 2002. Under the Hare Employment Agreement, Mr. Hare holds the positions of Executive Vice President and Chief Financial Officer of the Company. Mr. Hare's annual base salary un- der the Hare Employment Agreement is $360,000. The Hare Employment Agreement provides for the payment of an annual bonus of 60% of base salary if certain operational, financial and other objectives, determined by the Chief Executive Officer of AMF Bowling, are attained.
The Hare Employment Agreement provides for payment of accrued compensation, continuation of certain benefits and payment of a portion of bonus (if appli- cable objectives are later met) following termination of his employment by AMF Bowling under certain circumstances. The Hare Employment Agreement further provides for continued payment of annual base salary for 12 months if termina- tion of his employment is not due to death or disability. If all or substan- tially all of the stock or assets of AMF Bowling are sold or disposed of to an unaffiliated third party, Mr. Hare will have the right to resign during his employment period, within nine months, and be entitled to receive accrued sal- ary, continuation of benefits, allocated portion of bonus and, if applicable, severance payments under certain circumstances.
Under the Hare Employment Agreement, AMF Bowling granted 100,000 restricted shares of AMF Bowling Common Stock (the "Restricted Stock") at a cost of $1,000 to Mr. Hare. The Restricted Stock was granted pursuant to and is gov- erned by the 1998 Plan and subject to the Stockholders Agreement. One third of the Restricted Stock vests on August 4, 2000, one third vests on August 4, 2001, and one third vests on August 4, 2002. In the event of a Change of Con- trol (as defined in the Hare Employment Agreement), any unvested Restricted Stock will immediately vest. Under certain circumstances, in the event of a termination of Mr. Hare's employment by AMF Bowling, the portion of Restricted Stock that would have vested during the one-year period following the date of termination will immediately vest. Under the Hare Employment Agreement. Mr. Hare was also granted stock options to purchase 150,000 shares of AMF Bowling Common Stock. Unless sooner exercised or forfeited as provided, Mr. Hare's stock options expire on August 4, 2009. To the extent not inconsistent with the Hare Employment Agreement, such stock options are governed by the 1998 Plan. Twenty percent of the options vest on each anniversary of the Au- gust 4, 1999 grant date.
Under a previous employment agreement with AMF Bowling, Mr. Hare purchased 150,000 shares of AMF Bowling Common Stock (the "Purchased Stock") for $500,000 in cash plus a non-recourse promissory note for $1,000,000, payable to AMF Bowling and secured by the Purchased Stock which has been pledged pursuant to a stock pledge agreement between Mr. Hare and AMF Bowling. Under the Hare Employment Agreement, the Committee adjusted the value of Mr. Hare's non-recourse promissory note from $1,000,000 to $493,750 in 1999 for the purchase of 100,000 shares of AMF Bowling Common Stock to reflect the market price of such shares on the date of the new employment agreement. The Committee also adjusted the interest rate applicable to the note from 7% per annum to 6% per annum in 1999. No principal payments were made on the original note or the adjusted note in 1999. Under a previous employment agreement, Mr. Hare was also granted stock options to purchase 105,000 shares of AMF Bowling Common Stock. Unless sooner exercised or forfeited as provided, Mr. Hare's stock options expire on May 28, 2006. To the extent not inconsistent with the previous employment agreement, such stock options are governed by the 1996 Plan. Twenty percent of Mr. Hare's stock options vested on May 28, 1997, twenty percent vested on May 28, 1998 and
another twenty percent will vest on each May 28 thereafter through the year 2001. If any successor to AMF Bowling or Bowling Worldwide acquires all or substantially all of the business and/or assets of AMF Bowling or Bowling Worldwide, AMF Bowling may purchase all of the Purchased Stock held by Mr. Hare for its fair market value, and any stock options then held by him for the fair market value of the underlying AMF Bowling Common Stock less the exercise price of the stock options.
Mr. Watkins has an employment agreement with AMF Bowling and receives com- pensation consisting of salary and an annual bonus if certain financial tar- gets, determined by the Chief Executive Officer, are met. Mr. Watkins' annual base salary under his employment agreement is $300,000. Mr. Watkins was granted stock options to purchase 100,000 shares of AMF Bowling Common Stock on the same vesting schedule as other employees. The employment agreement fur- ther provides for a severance payment if AMF Bowling terminates Mr. Watkins' employment for any reason other than cause equal to one year of base salary.
Compensation of Directors
Directors of Bowling Worldwide receive no separate compensation for acting in that capacity. However, each director of Bowling Worldwide is also a direc- tor of AMF Bowling and receives compensation as discussed below. Directors who are officers or employees of AMF Bowling or affiliated with Goldman Sachs re- ceive no compensation for service as members of the Board of Directors of AMF Bowling or committees thereof. Directors who are not officers or employees of AMF Bowling or affiliated with Goldman Sachs receive a $2,000 fee for attend- ing each meeting of the Board of Directors of AMF Bowling and a $1,000 fee for attending each committee meeting thereof. All directors' reasonable expenses for attending such board and committee meetings and related duties are reim- bursed by AMF Bowling.
Pursuant to an option agreement (the "Diker Option Agreement"), dated May 1, 1996, Mr. Diker, a director of AMF Bowling and Bowling Worldwide, was granted nonqualified stock options to purchase 100,000 shares of AMF Bowling Common Stock at an exercise price of $10.00 per share pursuant to the 1996 Plan. All of Mr. Diker's stock options vested on May 1, 1998. If any successor to AMF Bowling acquires all or substantially all of the business and/or assets of AMF Bowling, AMF Bowling may purchase all of the stock options then held by Mr. Diker for the fair market value of the underlying AMF Bowling Common Stock minus the exercise price of the stock options. Mr. Diker is a party to the Stockholders Agreement and any shares of AMF Bowling Common Stock held by Mr. Diker are subject to the terms of the Stockholders Agreement, as well as the terms of the Diker Option Agreement. See "Certain Relationships and Related Transactions--Stockholders Agreement."
Compensation Committee Interlocks and Insider Participation
Bowling Worldwide does not have a compensation committee.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
All 100 shares of Bowling Worldwide common stock are held by AMF Group Holdings. The table below reflects the number of shares of AMF Bowling Common Stock beneficially owned as of March 6, 2000 by (i) each director of AMF Bowl- ing, (ii) each Named Executive Officer of AMF Bowling, (iii) the directors and executive officers as a group and (iv) each person who is known by AMF Bowling to own beneficially more than 5% of AMF Bowling Common Stock. Unless otherwise noted, each individual has sole voting power and sole investment power with respect to securities beneficially owned. Unless otherwise noted, the address of the beneficial owner is c/o AMF Bowling, Attn: Corporate Secretary, 8100 AMF Drive, Richmond, Virginia 23111.
- -------- * Less than 1% (1) Beneficial ownership is determined in accordance with the rules of the Se- curities and Exchange Commission. In computing the number of shares bene- ficially owned by a person and the percentage ownership of that person, shares of AMF Bowling Common Stock subject to options and warrants held by that person that are currently exercisable or are exercisable within 60 days are deemed outstanding. Such shares, however, are not deemed out- standing for the purposes of computing the percentage ownership of any other person. The table above does not include AMF Bowling's zero coupon convertible debentures (the "Debentures") which are convertible, at the option of the holder at any time prior to maturity (unless previously re- deemed or otherwise purchased by AMF Bowling), into AMF Bowling Common Stock at the rate of 9.1469 shares per $1,000 principal amount at maturity of the Debentures. (2) Mr. Friedman, who is a Managing Director of Goldman Sachs, disclaims bene- ficial ownership of the shares owned by The Goldman Sachs Group and its affiliates, except to the extent of his pecuniary interest therein. (3) Mr. O'Toole, who is a Managing Director of Goldman Sachs, disclaims bene- ficial ownership of the shares owned by The Goldman Sachs Group and its affiliates, except to the extent of his pecuniary interest therein. (4) Mr. Sacerdote, who is a limited partner of The Goldman Sachs Group, dis- claims beneficial ownership of the shares owned by The Goldman Sachs Group and its affiliates, except to the extent of his pecuniary interest there- in.
(5) Includes 100,000 shares which may be acquired upon the exercise of stock options within 60 days. Includes 43,560 shares held by his spouse and trusts for his children, as to which he disclaims beneficial ownership. (6) Mr. Edgerley, who is (i) a Managing Director of the general partner of Bain Capital Fund V, L.P. and Bain Capital Fund V-B, L.P. and (ii) a gen- eral partner of BCIP Associates and BCIP Trust Associates, L.P., disclaims beneficial ownership of the shares owned by those entities (collectively, "Bain"). Bain Capital Fund V, L.P. owns 594,634 shares, Bain Capital Fund V-B, L.P. owns 1,548,420 shares, BCIP Associates owns 283,832 shares and BCIP Trust Associates, L.P. owns 115,191 shares. (7) Mr. Lipson, who is a member of the limited liability company which acts as the general partner of Blackstone Capital Partners II Merchant Banking Fund L.P., Blackstone Offshore Capital Partners II L.P. and Blackstone Family Investment Partnership II L.P. (collectively, "Blackstone Group"), disclaims beneficial ownership of the shares owned by Blackstone Group. (8) Mr. Wall, who is (i) a general partner of Kelso Partners V, L.P., the gen- eral partner of Kelso Investment Associates V, L.P. ("KIA V") and (ii) a general partner of Kelso Equity Partners V, L.P.("KEP V," and together with KIA V, "Kelso"), disclaims beneficial ownership of the shares owned by KIA V and KEP V. (9) Includes 200,000 shares which may be acquired upon the exercise of AMF Bowling stock options within 60 days. (10) Includes 69,000 shares which may be acquired upon the exercise of AMF Bowling stock options within 60 days. Under the Hare Employment Agree- ment, Mr. Hare was granted 100,000 shares of AMF Bowling restricted stock. Such shares have not yet been issued. See "Item 11. Executive Com- pensation--Employment Agreements". (11) Includes 20,000 shares which may be acquired upon the exercise of AMF Bowling stock options within 60 days. (12) Includes 22,000 shares which may be acquired upon the exercise of AMF Bowling stock options within 60 days. (13) Includes an aggregate of 411,000 shares which may be acquired upon the exercise of AMF Bowling stock options within 60 days. (14) Mr. Stanard transferred all of his AMF Bowling Common Stock to AMF Bowl- ing, as of January 4, 1999, in exchange for the cancellation of a non-re- course promissory note. In addition, all AMF Bowling stock options previ- ously granted to Mr. Stanard were cancelled and forfeited as of November 2, 1998. See "Item 11. Executive Compensation--Summary Compensation Ta- ble". (15) Of the total number of shares which may be deemed to be beneficially owned by The Goldman Sachs Group, 28,404,248 are owned by GS Capital Partners II, L.P., 11,291,852 shares are owned by GS Capital Partners II Offshore, L.P., 1,047,698 shares are owned by Goldman Sachs & Co. Verwaltungs GmbH, as nominee for GS Capital Partners II (Germany) C.L.P., 664,502 shares are owned by Stone Street Fund 1995, L.P., 1,136,093 shares are owned by Stone Street Fund 1996, L.P., 747,761 shares are owned by Bridge Street Fund 1995, L.P. and 770,465 shares are owned by Bridge Street Fund 1996, L.P. (collectively, "GSCP"). AMF Bowling Common Stock deemed to be beneficially owned by The Goldman Sachs Group does not include 3,651,222 shares of AMF Bowling Common Stock issuable upon the conversion of $399,176,000 in aggregate principal amount at maturity of Debentures owned by The Goldman Sachs Group. In addition, The Goldman Sachs Group beneficially owns warrants to purchase 870,000 shares of AMF Bowling Common Stock, which were issued upon the closing of the Acquisi- tion. GS Capital Partners II, L.P., GS Capital Partners II Offshore, L.P., GS Capital Partners II (Germany), C.L.P., Stone Street Fund 1995, L.P., Stone Street Fund 1996, L.P., Bridge Street Fund 1995, L.P. and Bridge Street Fund 1996, L.P., are investment partnerships. Affiliates of The Goldman Sachs Group are the general, managing general or managing partners of all such partnerships and have full voting and investment power with respect to the holding of such partnerships. Excludes certain shares of AMF Bowling Common Stock in client accounts managed by Goldman Sachs (the "Managed Accounts"). Each of Goldman Sachs and The Goldman Sachs Group disclaims beneficial ownership of AMF Bowling Common Stock in the Managed
Accounts. The address of The Goldman Sachs Group is 85 Broad Street, New York, New York 10004. (16) Of the total number of shares beneficially owned by Blackstone Group, 6,090,010 shares are owned by Blackstone Capital Partners II Merchant Banking Fund L.P., 1,779,677 shares are owned by Blackstone Offshore Cap- ital Partners II L.P. and 603,894 shares are owned by Blackstone Family Investment Partnership II L.P. The address of Blackstone Group is 345 Park Avenue, New York, New York 10154. (17) Of the total number of shares beneficially owned by Kelso, 7,954,779 shares are owned by KIA V and 518,802 are owned by KEP V. AMF Bowling Common Stock deemed to be beneficially owned by Kelso does not include 351,085 shares of AMF Bowling Common Stock issuable upon the conversion of $38,383,000 in aggregate principal amount at maturity of Debentures owned by Kelso. The address of each such shareholder is c/o Kelso & Com- pany, Inc., 320 Park Avenue, 24th Floor, New York, New York 10022. Due to their common control, KIA V and KEP V could be deemed to beneficially own each other's shares, but each disclaims such beneficial ownership. Joseph S. Schuchert, Frank T. Nickell, Thomas R. Wall, IV, George E. Matelich, Michael B. Goldberg, David I. Wahrhaftig, Frank K. Bynum, Jr. and Philip E. Berney may be deemed to share beneficial ownership of shares benefi- cially owned of record by KIA V and KEP V, by virtue of their status as general partners of the general partner of KIA V and as general partners of KEP V. Messrs. Schuchert, Nickell, Wall, Matelich, Goldberg, Wahrhaftig, Bynum and Berney share investment and voting power with re- spect to securities owned by KIA V and KEP V, but disclaim beneficial ownership of such securities. (18) Based solely on information provided to AMF Bowling by Baron Capital Group, Inc. ("BCG"), BAMCO, Inc. ("BAMCO"), Baron Capital Management, Inc. ("BCM"), Baron Asset Fund ("BAF") and Ronald Baron as of January 31, 1999. BAMCO and BCM are subsidiaries of BCG. BAF is an investment advi- sory client of BAMCO. Ronald Baron owns a controlling interest in BCG. Of the total number of shares beneficially owned by Baron, 146,000 shares are owned by BCG, 146,000 shares are owned by BCM and 146,000 shares are owned by Ronald Baron. BCG and Ronald Baron disclaim beneficial ownership of shares held by their controlled entities (or the investment advisory clients thereof) to the extent such shares are held by persons other than BCG and Ronald Baron. BAMCO and BCM disclaim beneficial ownership of shares held by their investment advisory clients to the extent such shares are held by persons other than BAMCO, BCM and their affiliates. The address of Baron Capital Group, Inc. is 767 Fifth Avenue, 24th floor, New York, New York 10153.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Stockholders Agreement
On April 30, 1996, AMF Bowling, GSCP, Blackstone Group, Kelso, Bain (Bain, together with Blackstone Group and Kelso, the "Governance Investors"), Citicorp North America, Inc. ("Citicorp"), Mr. Diker (Mr. Diker, together with Blackstone Group, Kelso, Bain and Citicorp, the "Investors"), certain current and former members of management (the "Management Investors," and, with GSCP and the Investors, the "Stockholders") entered into a Stockholders Agreement, which regulates the relationship among AMF Bowling and the Stockholders. Subsequently, Mr. Hare and other members of management who received stock option awards under the 1996 Plan and certain other members of management have become parties to the Stockholders Agreement as additional Management Investors and Stockholders. The following discussion summarizes the terms of the Stockholders Agreement that AMF Bowling and the Company believes are material to holders of AMF Bowling Common Stock and securityholders of Bowling Worldwide. This summary is qualified in its entirety by reference to the full text of the Stockholders Agreement, which was filed with the Securities and Exchange Commission on November 3, 1997 as an exhibit to AMF Bowling's Registration Statement on Form S-1 (Registration No. 333-34099).
The Stockholders Agreement confers on GSCP the right to increase or de- crease the Board of Directors of AMF Bowling from its initial size of nine members. GSCP has the right to nominate five directors and to nominate a ma- jority (not limited to a simple majority) of the members of the Board of Di- rectors of AMF Bowling, so long as GSCP and its Permitted Transferees (as hereinafter defined), as they currently do, hold a majority of the outstanding shares of AMF Bowling Common Stock. Each Governance Investor has the right to nominate, subject to GSCP consent, one member of the Board of Directors of AMF Bowling, so long as the number of shares of AMF Bowling Common Stock held by it and certain of its permitted transferees under the Stockholders Agreement, as it currently is, is equal to at least one-half of the sum of (i) the number of shares initially purchased by it and its Permitted Transferees plus (ii) the number of additional shares that the Governance Investor was required to purchase pursuant to the "overcall" provisions of the Stockholders Agreement (in each case, subject to appropriate adjustments). If a Governance Investor is no longer entitled to nominate a director, the director is required to re- sign or be subject to removal by the shareholders. Each of GSCP and each Gov- ernance Investor has the right to recommend removal, with or without cause, of any director nominated by it, in which case such director is required to re- sign immediately or be subject to removal by the shareholders. In the event of death, removal or resignation of a director nominated by a Governance Invest- or, so long as the Governance Investor continues to have the right to nominate a director for such position, the Governance Investor has the right to nomi- nate (subject to GSCP consent) a director to fill the vacancy created. A quo- rum may be constituted by a majority of the number of directors then in of- fice, but not less than one-third of the whole Board of Directors of AMF Bowling, including at least one GSCP director.
The Stockholders Agreement provides for the continual existence of an Exec- utive Committee, consisting of two GSCP-nominated directors and the President and Chief Executive Officer of AMF Bowling. The Executive Committee may exer- cise all the powers and authority of the Board of Directors of AMF Bowling (subject to any restrictions under Delaware law) except with respect to those actions requiring a Special Vote (as defined below) and, in the case of mat- ters which under the Stockholders Agreement require a prior meeting of the Board of Directors of AMF Bowling, only after such meeting has occurred. A "Special Vote" is required for (i) the issuance of capital stock of AMF Bowl- ing below fair market value, (ii) the grant or issuance of options or warrants exercisable or exchangeable for more than 2,877,151 shares of AMF Bowling Com- mon Stock, (iii) entering into certain transactions with affiliates of GSCP and (iv) amendments to the Stockholders Agreement, the Certificate of Incorpo- ration or By-Laws of AMF Bowling, which would adversely affect the rights and obligations of Blackstone Group or Kelso; provided, that any amendment affect- ing a Stockholder differently from any other Stockholder requires such Stock- holder's approval. Matters requiring a Special Vote must be approved by a ma- jority of the GSCP directors who are partners or employees of Goldman Sachs and who are not employees of AMF Bowling and its subsidiaries, and at least one director nominated by Blackstone Group or Kelso (if there is one serving at such time.)
Pursuant to the Stockholders Agreement, each of the Stockholders has agreed (i) to appear in person or by proxy at any shareholder meeting of AMF Bowling for the purpose of obtaining a quorum, (ii) to vote its shares of AMF Bowling Common Stock, at any shareholder meeting called for the purpose of voting on the election or removal of directors, in favor of the election or removal of directors, as applicable, in accordance with the provisions described in the second preceding paragraph, (iii) otherwise to vote its shares of AMF Bowling Common Stock at shareholder meetings in a manner not inconsistent with the Stockholders Agreement, (iv) not to grant any proxy or enter into any voting trust with respect to the AMF Bowling Common Stock it holds or enter into any shareholder agreement or arrangement inconsistent with the provisions of the Stockholders Agreement and (v) not to act as a member of a group or in concert with others in connection with the acquisition, disposition or voting of shares of AMF Bowling Common Stock in any manner inconsistent with the Stock- holders Agreement.
The Stockholders Agreement provides that in the event a Stockholder deter- mines to sell its shares of AMF Bowling Common Stock (subject to certain ex- ceptions, including sales of shares made through
a broker under Securities and Exchange Commission Rule 144), such Stockholder must give the other Stockholders notice thereof and such other Stockholders must have the opportunity to sell a pro rata share of their AMF Bowling Common Stock in such a sale. Moreover, in the event Stockholders owning 51% or more of the outstanding AMF Bowling Common Stock propose to sell all of the AMF Bowling Common Stock held by such Stockholders pursuant to a stock sale, merg- er, business combination, recapitalization, consolidation, reorganization, re- structuring or similar transaction, such Stockholders will have the right, un- der certain circumstances, to require the other Stockholders to sell the equity securities of AMF Bowling held by such other Stockholders in such sale on the same terms and conditions and at the same price as the Stockholders proposing to sell.
The foregoing rights and obligations will terminate upon the first to occur of: (i) GSCP, the Investors and their permitted transferees under the Stock- holders Agreement (the "Permitted Transferees") holding in the aggregate less than 50% of the sum of (a) the number of shares of AMF Bowling Common Stock outstanding, on a fully diluted basis, immediately after giving effect to the transactions contemplated by the subscription agreement (the "Subscription Agreement") entered into on the same date and by the same parties as the Stockholders Agreement, except for the Management Investors, and (b) the num- ber of additional shares of AMF Bowling Common Stock, if any, issued pursuant to the "overcall" provisions of the Stockholders Agreement and (ii) GSCP, the Investors and their Permitted Transferees holding in the aggregate less than 40% of the fully diluted shares of AMF Bowling Common Stock then outstanding. Notwithstanding these provisions, in the event of any merger, recapitaliza- tion, consolidation, reorganization or other restructuring of AMF Bowling as a result of which the stockholders and their Permitted Transferees own less than a majority of the outstanding voting power of the entity surviving such trans- action, the Stockholders Agreement will terminate.
Registration Rights Agreement
AMF Bowling and the Stockholders entered into a Registration Rights Agree- ment on April 30, 1996 (the "Registration Rights Agreement"). Pursuant to the Registration Rights Agreement, (i) each of the Blackstone Group (as a group), Kelso (as a group) and Bain (as a group) may make one demand (subject to cer- tain exceptions) of AMF Bowling to register shares of AMF Bowling Common Stock held by such group and (ii) GSCP may make up to five demands (subject to cer- tain exceptions) of AMF Bowling to register shares of AMF Bowling Common Stock held by it, in each case, so long as (a) the aggregate offering price for the shares to be sold is a least $50 million and (b) shares representing at least 5% of the sum of (1) the number of shares of AMF Bowling Common Stock pur- chased by GSCP prior to execution of the Subscription Agreement, (2) the num- ber of shares of AMF Bowling Common Stock issued pursuant to the Subscription Agreement and (3) the number of shares (subject to adjustment) of AMF Bowling Common Stock purchased by Stockholders pursuant to the "overcall" provisions of the Stockholders Agreement are being registered. Upon a demand for regis- tration by any of GSCP, Blackstone Group, Kelso or Bain, each of the other Stockholders is to be given the opportunity to participate on a pro rata basis in the registration demanded. The Registration Rights Agreement also provides the Stockholders with piggyback registration rights which allow each of them to include all or a portion of their shares of AMF Bowling Common Stock under a registration statement filed by AMF Bowling, subject to certain exceptions and limitations.
Transactions with Management and Others; Certain Business Relationships
Messrs. Friedman and O'Toole, each of whom is a Managing Director of Goldman Sachs, and Mr. Sacerdote, who is a limited partner of The Goldman Sachs Group, are directors of AMF Bowling, Group Holdings and Bowling World- wide. Mr. Friedman is also Chairman of the Board of AMF Bowling and Bowling Worldwide. Goldman Sachs and its affiliates together currently beneficially own a majority of the outstanding shares of AMF Bowling Common Stock. See "Item 12. Security Ownership of Certain Beneficial Owners and Management". Goldman Sachs and its affiliates were the initial purchasers
of the debt issued by Bowling Worldwide in connection with financing the Ac- quisition. Goldman Sachs also served as financial advisor to the owners of AMF Bowling's predecessor in connection with the Acquisition.
Under a credit agreement, amended and restated as of November 7, 1997 among Bowling Worldwide, Goldman Sachs Credit Partners, L.P., an affiliate of Goldman Sachs, Citibank, N.A. and its affiliates Citicorp Securities, Inc. and Citicorp USA, Inc. and certain other banks, financial institutions and insti- tutional lenders, executed in connection with the Initial Public Offering, as since amended (the "Credit Agreement"), Goldman Sachs Credit Partners, L.P. acted as Syndication Agent, Goldman Sachs Credit Partners, L.P. and Citicorp Securities, Inc. acted as Arrangers, and Citibank, N.A. is acting as Adminis- trative Agent and Citicorp USA, Inc., is acting as Collateral Agent with re- spect to a revolving credit and term loan facility extended to Bowling World- wide in an amount up to $810.3 million. In 1999, total fees paid to Goldman Sachs Credit Partners, L.P. for services under the Credit Agreement were ap- proximately $1.1 million. Such entity was also reimbursed for expenses in- curred in connection with its services.
Bowling Worldwide and Goldman Sachs are parties to an engagement letter pursuant to which Goldman Sachs was retained as Bowling Worldwide's financial advisor to provide investment banking and financial advisory services, includ- ing in connection with any acquisition, dispositions or financings. Pursuant to the engagement, Bowling Worldwide has agreed to reimburse Goldman Sachs for its out-of-pocket expenses and indemnify Goldman Sachs in connection with its services arising under the engagement.
Bowling Worldwide also entered into two interest rate cap agreements with Goldman Sachs Capital Markets, L.P. ("GSCM"), an affiliate of Goldman Sachs, both of which were executed to hedge Bowling Worldwide's exposure to fluctua- tions in the interest rates applicable to borrowings under the Credit Agree- ment. Bowling Worldwide paid a fee of $65,000 to GSCM in connection with the first of these transactions executed on March 13, 1999, which capped 3-month LIBOR on $200 million principal amount of debt at 7.0% until March 31, 2000. Bowling Worldwide paid a fee of $75,000 to GSCM in respect of the second transaction executed on December 31, 1999, which capped 3-month LIBOR on $150 million in debt at 7.6525% until December 31, 2000.
See "Item 11. Executive Compensation--Employment Agreements" for a discus- sion of arrangements under which AMF Bowling loaned money to Mr. Hare on a non-recourse basis to enable him to purchase shares of AMF Bowling Common Stock.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(A) Financial Statements and Schedules
(B) Reports on Form 8-K
A current report on Form 8-K was filed on November 1, 1999, with respect to the announcement of certain financial results for the quarter and nine months ended September 30, 1999.
(C) Exhibits
Notes to Exhibits:
* Management contract or compensatory plan or arrangement. (1) Incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (2) Incorporated herein by reference to Exhibit 3.3 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (3) Incorporated herein by reference to Exhibit 3.4 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (4) Incorporated herein by reference to Exhibit 3.5 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (5) Incorporated herein by reference to Exhibit 3.6 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (6) Incorporated herein by reference to Exhibit 3.7 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (7) Incorporated herein by reference to Exhibit 3.8 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (8) Incorporated herein by reference to Exhibit 3.9 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (9) Incorporated herein by reference to Exhibit 3.10 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (10) Incorporated herein by reference to Exhibit 3.11 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (11) Incorporated herein by reference to Exhibit 3.12 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (12) Incorporated herein by reference to Exhibit 3.13 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (13) Incorporated herein by reference to Exhibit 3.14 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (14) Incorporated herein by reference to Exhibit 3.15 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (15) Incorporated herein by reference to Exhibit 3.16 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (16) Incorporated herein by reference to Exhibit 3.17 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (17) Incorporated herein by reference to Exhibit 3.18 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (18) Incorporated herein by reference to Exhibit 3.19 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (19) Incorporated herein by reference to Exhibit 3.20 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (20) Incorporated herein by reference to Exhibit 3.21 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (21) Incorporated herein by reference to Exhibit 3.22 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877).
(22) Incorporated herein by reference to Exhibit 3.23 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (23) Incorporated herein by reference to Exhibit 3.24 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (24) Incorporated herein by reference to Exhibit 3.25 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (25) Incorporated herein by reference to Exhibit 3.26 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (26) Incorporated herein by reference to Exhibit 3.27 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (27) Incorporated herein by reference to Exhibit 3.28 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (28) Incorporated herein by reference to Exhibit 3.29 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (29) Incorporated herein by reference to Exhibit 3.30 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (30) Incorporated herein by reference to Exhibit 3.31 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (31) Incorporated herein by reference to Exhibit 3.32 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (32) Incorporated herein by reference to Exhibit 3.33 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (33) Incorporated herein by reference to Exhibit 3.34 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (34) Incorporated herein by reference to Exhibit 3.35 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (35) Incorporated herein by reference to Exhibit 3.36 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (36) Incorporated herein by reference to Exhibit 3.37 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (37) Incorporated herein by reference to Exhibit 3.38 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (38) Incorporated herein by reference to Exhibit 3.39 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (39) Incorporated herein by reference to Exhibit 3.40 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (40) Incorporated herein by reference to Exhibit 3.41 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (41) Incorporated herein by reference to Exhibit 3.42 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (42) Incorporated herein by reference to Exhibit 3.43 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (43) Incorporated herein by reference to Exhibit 3.44 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (44) Incorporated herein by reference to Exhibit 3.45 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (45) Incorporated herein by reference to Exhibit 3.46 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (46) Incorporated herein by reference to Exhibit 3.47 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877).
(47) Incorporated herein by reference to Exhibit 3.48 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (48) Incorporated herein by reference to Exhibit 3.49 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (49) Incorporated herein by reference to Exhibit 3.50 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (50) Incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (51) Incorporated by reference to Exhibit 4.2 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (52) Incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (53) Incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (54) Incorporated by reference to Exhibit 4.6 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (55) Incorporated by reference to Exhibit 4.7 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (56) Incorporated by reference to Exhibit 4.8 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (57) Incorporated by reference to Exhibit 4.9 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (58) Incorporated by reference to Exhibit 10.1 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (59) Incorporated by reference to Exhibit 10.2 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (60) Incorporated by reference to Exhibit 10.3 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (61) Incorporated by reference to Exhibit 10.4 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (62) Incorporated by reference to Exhibit 10.5 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (63) Incorporated by reference to Exhibit 10.6 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (64) Incorporated by reference to Exhibit 10.7 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (65) Incorporated by reference to Exhibit 10.8 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (66) Incorporated by reference to Exhibit 10.9 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (67) Incorporated by reference to Exhibit 10.10 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (68) Incorporated by reference to Exhibit 10.11 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (69) Incorporated by reference to Exhibit 10.5 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (70) Incorporated by reference to Exhibit 10.11 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (71) Incorporated by reference to Exhibit 10.12 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (72) Incorporated by reference to Exhibit 10.13 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099).
(73) Incorporated by reference to Exhibit 10.14 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (74) Incorporated by reference to Exhibit 10.17 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (75) Incorporated by reference to Exhibit 10.6 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (76) Incorporated by reference to Exhibit 10.9 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (77) Incorporated by reference to Exhibit 10.10 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (78) Incorporated by reference to Exhibit 10.14 to the Annual Report on Form 10-K of AMF Group Inc. for the fiscal year ended December 31, 1996 (File No. 001-12131). (79) Incorporated by reference to Exhibit 10.16 to Post-Effective Amendment No. 2 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (80) Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of AMF Group Inc. for the quarterly period ended June 30, 1997 (File No. 001-12131). (81) Incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q of AMF Group Inc. for the quarterly period ended June 30, 1997 (File No. 001-12131). (82) Incorporated by reference to Exhibit 10.30 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (83) Incorporated by reference to Exhibit 10.1 of AMF Bowling, Inc.'s Current Report on Form 8-K dated September 30, 1998 (File No. 001-13539). (84) Incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended September 30, 1998 (File No. 001-13539). (85) Incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended September 30, 1998 (File No. 001-13539). (86) Incorporated by reference to Exhibit 10.34 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1998 (File No. 001-13529). (87) Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended March 31, 1999 (File No. 001-13539). (88) Incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended March 31, 1999 (File No. 001-13539). (89) Incorporated by reference to Exhibit 99.1 AMF Bowling, Inc.'s Current Re- port on Form 8-K dated June 28, 1999 (File No.001-13539). (90) Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended September 30, 1999 (File No. 001-13539).
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) the Securities Ex- change Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of the 24th day of March, 2000.
AMF Bowling Worldwide, Inc.
/s/ Roland C. Smith By: _________________________________ Roland C. Smith Director/President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Regis- trant and in the capacities indicated, as of the 24th day of March, 2000.
AMF GROUP HOLDINGS INC.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE I
TO THE BOARD OF DIRECTORS OF AMF GROUP HOLDINGS INC.:
We have audited in accordance with generally accepted auditing standards the consolidated financial statements included in the Form 10-K Annual Report of AMF Group Holdings Inc. and subsidiaries as of December 31, 1999 and 1998 and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated February 28, 2000. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule I filed as part of the Company's Form 10-K Annual Report is the responsibility of the Company's management and is presented for pur- poses of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audits of the basic financial state- ments and, in our opinion, fairly states in all material respects the finan- cial data required to be set forth therein in relation to the basic financial statements taken as a whole.
Arthur Andersen LLP
Richmond, Virginia February 28, 2000
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF AMF GROUP HOLDINGS INC.
CONDENSED BALANCE SHEETS (in thousands)
The accompanying notes are an integral part of these condensed balance sheets.
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF AMF GROUP HOLDINGS INC.
CONDENSED STATEMENTS OF OPERATIONS (in thousands)
The accompanying notes are an integral part of these condensed financial statements.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF AMF GROUP HOLDINGS INC.
CONDENSED STATEMENTS OF CASH FLOWS (in thousands)
The accompanying notes are an integral part of these condensed financial statements.
SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF AMF GROUP HOLDINGS INC.
NOTES TO GROUP HOLDINGS CONDENSED FINANCIAL STATEMENTS
1. BACKGROUND AND BASIS OF PRESENTATION:
These notes to the AMF Group Holdings Inc. ("AMF Group Holdings") condensed financial statements should be read in conjunction with the Notes to Consoli- dated Financial Statements of AMF Group Holdings and subsidiaries included in Part II, Item 8 of the Form 10-K Annual Report (the "Notes"). AMF Bowling Worldwide, Inc. ("Bowling Worldwide") is a wholly owned subsidiary of AMF Group Holdings. AMF Group Holdings is a wholly owned subsidiary of AMF Bowl- ing, Inc. ("AMF Bowling"). All dollar amounts are in thousands, except where otherwise indicated.
2. GUARANTEES:
The Subsidiary Senior Subordinated Notes and Subsidiary Senior Subordinated Discount Notes (as defined and discussed in "Note 20. Condensed Consolidating Financial Statements" in the Notes), are jointly and severally guaranteed on a full and unconditional basis by AMF Group Holdings and by the first and sec- ond-tier subsidiaries of Bowling Worldwide.
3. RESTRICTED ASSETS OF AMF GROUP HOLDINGS AND BOWLING WORLDWIDE:
The credit agreement (the "Credit Agreement") to which Bowling Worldwide is a party with Goldman Sachs, their affiliate Goldman Sachs Credit Partners, L.P., Citibank, N.A. ("Citibank") and its affiliates Citicorp Securities, Inc. and Citicorp USA, Inc. and certain other banks, financial institutions and in- stitutional lenders contains certain covenants, including, but not limited to, covenants related to cash interest coverage, fixed charge coverage, payments on other debt, mergers and acquisitions, sales of assets, guarantees and in- vestments. The Credit Agreement also contains certain provisions, which limit the amount of funds available for transfer from Bowling Worldwide to AMF Group Holdings, and from AMF Group Holdings to AMF Bowling. Limits exist on, among other things, the declaration or payments of dividends, distribution of as- sets, and issuance or sale of capital stock.
So long as Bowling Worldwide is not in default of the covenants contained in the Credit Agreement, it may i) declare and pay dividends in common stock; ii) declare and pay cash dividends to make payments of approximately $0.15 million in May 1997 and May 1998, and $0.05 million in May 1999 and, to the extent necessary, to make payments of approximately $0.05 million due in May 2000 under certain noncompete agreements with the prior owners; iii) declare and pay cash dividends for general and administrative expenses not to exceed $0.25 million; and iv) declare and pay cash dividends not to exceed $2.0 mil- lion for the repurchase of AMF Bowling Common Stock.
4. TOTAL ASSETS AND LIABILITIES:
At December 31, 1999 and 1998, assets represent AMF Group Holdings invest- ment in AMF Bowling Worldwide and other assets related to commitments under non-compete agreements. At December 31, 1999 and 1998, liabilities represent accrued expenses primarily related to commitments under noncompete agreements.
5. AMF BOWLING OPERATIONS:
In the year ended December 31, 1998, the Company began allocating certain corporate, general and administrative expenses to AMF Bowling based on the percentage of resources specifically used in administrative activities of AMF Bowling.
EXHIBIT INDEX
Notes to Exhibits:
* Management contract or compensatory plan or arrangement. (1) Incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (2) Incorporated herein by reference to Exhibit 3.3 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (3) Incorporated herein by reference to Exhibit 3.4 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (4) Incorporated herein by reference to Exhibit 3.5 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (5) Incorporated herein by reference to Exhibit 3.6 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (6) Incorporated herein by reference to Exhibit 3.7 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (7) Incorporated herein by reference to Exhibit 3.8 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (8) Incorporated herein by reference to Exhibit 3.9 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (9) Incorporated herein by reference to Exhibit 3.10 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (10) Incorporated herein by reference to Exhibit 3.11 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877).
(11) Incorporated herein by reference to Exhibit 3.12 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (12) Incorporated herein by reference to Exhibit 3.13 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (13) Incorporated herein by reference to Exhibit 3.14 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (14) Incorporated herein by reference to Exhibit 3.15 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (15) Incorporated herein by reference to Exhibit 3.16 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (16) Incorporated herein by reference to Exhibit 3.17 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (17) Incorporated herein by reference to Exhibit 3.18 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (18) Incorporated herein by reference to Exhibit 3.19 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (19) Incorporated herein by reference to Exhibit 3.20 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (20) Incorporated herein by reference to Exhibit 3.21 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (21) Incorporated herein by reference to Exhibit 3.22 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (22) Incorporated herein by reference to Exhibit 3.23 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (23) Incorporated herein by reference to Exhibit 3.24 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (24) Incorporated herein by reference to Exhibit 3.25 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (25) Incorporated herein by reference to Exhibit 3.26 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (26) Incorporated herein by reference to Exhibit 3.27 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (27) Incorporated herein by reference to Exhibit 3.28 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (28) Incorporated herein by reference to Exhibit 3.29 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (29) Incorporated herein by reference to Exhibit 3.30 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (30) Incorporated herein by reference to Exhibit 3.31 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (31) Incorporated herein by reference to Exhibit 3.32 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (32) Incorporated herein by reference to Exhibit 3.33 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (33) Incorporated herein by reference to Exhibit 3.34 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (34) Incorporated herein by reference to Exhibit 3.35 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (35) Incorporated herein by reference to Exhibit 3.36 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (36) Incorporated herein by reference to Exhibit 3.37 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877).
(37) Incorporated herein by reference to Exhibit 3.38 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (38) Incorporated herein by reference to Exhibit 3.39 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (39) Incorporated herein by reference to Exhibit 3.40 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (40) Incorporated herein by reference to Exhibit 3.41 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (41) Incorporated herein by reference to Exhibit 3.42 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (42) Incorporated herein by reference to Exhibit 3.43 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (43) Incorporated herein by reference to Exhibit 3.44 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (44) Incorporated herein by reference to Exhibit 3.45 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (45) Incorporated herein by reference to Exhibit 3.46 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (46) Incorporated herein by reference to Exhibit 3.47 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (47) Incorporated herein by reference to Exhibit 3.48 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (48) Incorporated herein by reference to Exhibit 3.49 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (49) Incorporated herein by reference to Exhibit 3.50 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (50) Incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (51) Incorporated by reference to Exhibit 4.2 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (52) Incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (53) Incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (54) Incorporated by reference to Exhibit 4.6 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (55) Incorporated by reference to Exhibit 4.7 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (56) Incorporated by reference to Exhibit 4.8 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (57) Incorporated by reference to Exhibit 4.9 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-60959). (58) Incorporated by reference to Exhibit 10.1 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (59) Incorporated by reference to Exhibit 10.2 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (60) Incorporated by reference to Exhibit 10.3 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (61) Incorporated by reference to Exhibit 10.4 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (62) Incorporated by reference to Exhibit 10.5 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099).
(63) Incorporated by reference to Exhibit 10.6 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (64) Incorporated by reference to Exhibit 10.7 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (65) Incorporated by reference to Exhibit 10.8 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (66) Incorporated by reference to Exhibit 10.9 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (67) Incorporated by reference to Exhibit 10.10 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (68) Incorporated by reference to Exhibit 10.11 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (69) Incorporated by reference to Exhibit 10.5 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (70) Incorporated by reference to Exhibit 10.11 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (71) Incorporated by reference to Exhibit 10.12 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (72) Incorporated by reference to Exhibit 10.13 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (73) Incorporated by reference to Exhibit 10.14 to the Registration Statement on Form S-1 of AMF Bowling, Inc. (File No. 333-34099). (74) Incorporated by reference to Exhibit 10.17 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (75) Incorporated by reference to Exhibit 10.6 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (76) Incorporated by reference to Exhibit 10.9 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (77) Incorporated by reference to Exhibit 10.10 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (78) Incorporated by reference to Exhibit 10.14 to the Annual Report on Form 10-K of AMF Group Inc. for the fiscal year ended December 31, 1996 (File No. 001-12131). (79) Incorporated by reference to Exhibit 10.16 to Post-Effective Amendment No. 2 to the Registration Statement on Form S-4 of AMF Group Inc. (File No. 333-4877). (80) Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of AMF Group Inc. for the quarterly period ended June 30, 1997 (File No. 001-12131). (81) Incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q of AMF Group Inc. for the quarterly period ended June 30, 1997 (File No. 001-12131). (82) Incorporated by reference to Exhibit 10.30 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1997 (File No. 001-13539). (83) Incorporated by reference to Exhibit 10.1 of AMF Bowling, Inc.'s Current Report on Form 8-K dated September 30, 1998 (File No. 001-13539). (84) Incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended September 30, 1998 (File No. 001-13539). (85) Incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended September 30, 1998 (File No. 001-13539). (86) Incorporated by reference to Exhibit 10.34 to the Annual Report on Form 10-K of AMF Bowling, Inc. for the fiscal year ended December 31, 1998 (File No. 001-13529). (87) Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended March 31, 1999 (File No. 001-13539). (88) Incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended March 31, 1999 (File No. 001-13539).
(89) Incorporated by reference to Exhibit 99.1 AMF Bowling, Inc.'s Current Re- port on Form 8-K dated June 28, 1999 (File No.001-13539). (90) Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of AMF Bowling, Inc. for the quarterly period ended September 30, 1999 (File No. 001-13539). | 36,702 | 235,525 |
61478_1999.html | 61478_1999 | 1999 | 61478 | Item 1. BUSINESS
ADC Telecommunications, Inc. ("ADC") was incorporated in Minnesota in 1953 as Magnetic Controls Company and changed its name to ADC Telecommunications, Inc. in 1985. ADC offers a broad range of network equipment, software and integration services for broadband, multiservice networks that deliver Internet/data, video and voice communications over telephone, cable television, Internet, broadcast, wireless and enterprise networks. ADC's broadband, multiservice network solutions enable local access, high-speed transmission and software management of communications services from service providers to consumers and businesses over fiber-optic, copper, coaxial and wireless media.
Telephone companies, cable television operators, Internet/data service providers, wireless service providers and other communications service providers are building the broadband infrastructure required to offer high-speed Internet access and data, video, telephony and other interactive multimedia services to residential and business customers. Broader network bandwidths are continually required for these services, and ADC's product offerings and development efforts are focused on increasing the speed and efficiency of communications networks from the service providers' offices through the network equipment that connects to end users' residences and businesses.
ADC offers network equipment, software and integration services within the following three product groups:
•Broadband Connectivity,
•Broadband Access and Transport, and
•Integrated Solutions.
BROADBAND CONNECTIVITY products include broadband connection and access devices for copper, coaxial, fiber-optic, wireless and broadcast communications networks. The group also supplies fiber-optic and wireless components. These products are used globally in telephone, cable television, Internet, wireless, enterprise and broadcast communications networks. Broadband Connectivity products provide the physical contact points for connecting different communications system components and gaining access to communications system circuits for the purpose of installing, testing, monitoring, accessing, managing, reconfiguring, splitting and multiplexing such circuits within the central office and the "last mile/kilometer" portion of communications networks.
BROADBAND ACCESS AND TRANSPORT products include access and transport systems that deliver broadband, multiservice communications to residences and businesses over copper, coaxial, fiber-optic and wireless networks. These products are used globally to deliver Internet/data, video and voice services to residential and business customers. Generally, these products are aimed at upgrading service providers' networks to broadband capabilities, while also introducing new service delivery functionality and cost effectiveness into the networks.
INTEGRATED SOLUTIONS products and services consist of systems integration services, operations support systems (OSS) software and enhanced services/intelligent network software that positions service providers to deliver broadband, multiservice communications over wireline and wireless networks. Systems integration services are used to design, equip and build communications networks and OSS applications that deliver Internet/data, video and voice services to residences and businesses. OSS Software includes communications billing, customer care, network performance and service level assurance software. Enhanced services/intelligent network software includes a range of wireline, wireless and Internet applications.
ADC's customers include local and long-distance telephone companies, cable television operators, wireless service providers, new competitive service providers, broadcasters, enterprises, governments, system integrators and communications equipment manufacturers and distributors.
As used in this report, unless the context otherwise requires, the terms "ADC" refers to ADC Telecommunications, Inc. and its wholly owned and majority owned subsidiaries; 1997, 1998 and 1999 refer to the ADC's fiscal years ended October 31, 1997, 1998 and 1999, respectively; and 2000 refers to ADC's fiscal year ending October 31, 2000.
Industry Background
As a result of the global deregulation of communications markets, thousands of new competitive service providers have entered the market to compete with the incumbent service providers of Internet/data, video and voice communications. These new service providers are rapidly changing the marketplace by offering new choices and bundles of communications services never before offered to consumers and businesses. The dynamics of the deregulated communications market has resulted in the recent high growth rate of sales for suppliers of communications equipment, software and services. The factors driving this growth consist primarily of the following: increased demand from consumers and businesses for high-speed, integrated services such as Internet access, digital video and broadband wireless access; rapid growth of Internet services; continuous technological development of fiber-optics, integrated circuits and software to increase broadband capacities and applications; and the convergence of Internet/data, video, and voice network traffic onto broadband, multiservice networks. ADC believes that these trends will continue to drive changes in the global communications industry for the foreseeable future.
Increased demand for higher-speed, higher-capacity services such as Internet access, digital video and broadband wireless access has in turn resulted in substantial demands to build and upgrade the communications network infrastructure. Communications networks are increasingly required to transmit large volumes of data and video for the purpose of communicating information, conducting business and delivering entertainment. In addition, both consumers and businesses are requesting high-speed connections from a single broadband, multiservice provider offering a range of prices for various bundles of integrated Internet/data, video and voice services. Specifically, the industry term "broadband" refers to all transmission speeds of T1 (1.544 million bits per second) and higher. Growth in broadband applications has resulted in increased infrastructure investment by communications service providers in order to expand network capacity and provide new applications and services to meet users' needs.
Several important technological developments have spurred growth in the communications equipment industry. One important technological change has been the deployment of fiber-optic transmission systems. In a fiber-optic system, lasers transmit Internet/data, video and voice traffic in the form of analog or digital coded light pulses through glass fibers. The increasing shift to fiber-optic transmission systems has been principally due to the ability of fiber optics to carry large volumes of information at high speeds, its insensitivity to electromagnetic interference and the high transmission quality made possible by the physical properties of light. As technologies such as Synchronous Optical NETwork (SONET), Dense Wavelength Division Multiplexing (DWDM) and 1550 nanometer laser transmission technologies have evolved over the last several years, the capacity of fiber-optic systems to transport information has increased significantly.
The development of cost-effective digital technology has also allowed greater capacity (or speed) in network transmission and has resulted in an increasing trend over the past decade to replace analog technology in copper, fiber and wireless transmission networks. In analog technology, information is converted to a voltage or current wave form for processing or transmission. In digital technology, information is converted to digital bits and then processed or transmitted using computer-based
components. High-speed digital technology developments such as SONET, cell-based Asynchronous Transfer Mode (ATM) and Orthogonal Frequency Division Multiplexing (OFDM) modulation technologies have enabled network providers to transmit increasing amounts of data and video communications.
Wireless technology developments have also had an impact on the communications equipment industry. There has been substantial growth in wireless communications such as cellular telephone services and satellite-based services, as well as Personal Communications Services (PCS) communications, Multichannel Multipoint Distribution Services (MMDS) and Local Multipoint Distribution Services (LMDS) for wireless cable services and wireless data and paging services. This growth has been driven by the convenience of mobility and the limits of wireline infrastructure. In particular, in countries without reliable or extensive wireline systems, wireless service could ultimately provide the primary service platform for both mobile and fixed communications applications due to the potential savings in installation time and cost. ADC believes that in future years the continuing development of wireless communications technology could substantially extend the reach of current communications networks.
ADC believes that broadband, multiservice networks represent a key enabling capability for meeting the information needs of consumers and businesses around the world. The rapid growth of Internet/ data and digital video traffic has driven the need for broadband infrastructure. Additional bandwidth is required as the result of a wide range of new applications, including video and audio programs on the Internet, wireless Internet access, personal video conferencing from a personal computer, video e-mail, video on demand, electronic commerce, distance learning, telecommuting, telemedicine and high-speed imaging such as remote medical imaging. ADC believes that the global deregulation of communications markets is transforming traditional communications service providers into integrated communications providers. Traditional communications service providers offer only a limited selection of Internet/data, video or voice services-each on a separate network connection and a separate customer bill. Integrated communications providers operate broadband, multiservice networks that offer faster, cost-effective and integrated Internet/data, video and voice services over a single high-speed network connection and send one bill for all the services the customer uses. As a result of deregulation, each service provider now competes for customers by offering the best-value bundle of communications services over the most cost-effective network. As a result of competition among communications service providers to win and retain customers with bundled services, there is a large and growing global market for network equipment, software and integration services to build and upgrade broadband, multiservice networks.
Strategy
ADC's strategy is to capitalize on opportunities in the global communications market by providing the network equipment, software and integration services to enable communications service providers to service their residential and business customers with broadband, multiservice networks offering faster, cost-effective and integrated Internet/data, video and voice services. ADC's broad range of products and services address key areas of the communications network infrastructure, and are used to design, build and upgrade networks, provide equipment to connect and access networks and transport communications services, and provide software to generate, deliver and manage communications services. ADC's many product and service offerings address the diverse needs of its customers, including local and long-distance telephone companies, cable television operators, wireless service providers, new competitive service providers, broadcasters, enterprises, governments, system integrators and communications equipment manufacturers and distributors.
Key components of ADC's strategy include:
•Focus on Broadband, Multiservice Opportunities. Global deregulation, rapid growth of the Internet, and increasing consumer and business demands for broadband communications has created significant global opportunities to build and upgrade broadband, multiservice networks. Telephone companies, cable television operators, Internet/data service providers, wireless service providers and other communications service providers are building the broadband infrastructure required to offer high-speed Internet access, data, video, telephony and other interactive multimedia services to residential and business customers. As broader network bandwidths are continually required for these services, ADC believes that building and upgrading of broadband, multiservice networks presents one of the greatest market growth opportunities in the communications industry today. ADC is focusing its development and marketing resources on network equipment, software and integration services that will enable communications service providers worldwide to serve their residential and businesses customers with broadband, multiservice networks offering faster, cost effective and integrated Internet/data, video and voice services.
•Leverage Technological Capabilities Across Product Groups ADC has developed substantial expertise in fiber-optic, broadband copper, coaxial, video, wireless and broadband infrastructure and transport technologies, software and systems integration services. ADC has built these core competencies through internal development, acquisitions, joint ventures and technology licensing arrangements. ADC's strategy is to leverage these core competencies across its product groups in order to develop new products with enhanced architectures, functions, cost effectiveness and network management tools for its customers' evolving Internet/data, video and voice service offerings.
•Increase International Market Penetration. ADC believes that significant growth for its products and services will occur outside the United States as a result of deregulation and the need of many foreign countries to substantially expand or enhance their communications services. ADC's strategy is to grow its international penetration by increasing its international sales and marketing resources, expanding global manufacturing capacity, leveraging its existing customer relationships, developing additional international distribution channels and seeking strategic alliances and acquisitions. ADC is expanding its presence in international markets with manufacturing facilities, distribution centers and sales offices to serve its customers outside the United States.
•Supplement Internal Development Efforts with Strategic Acquisitions and Alliances. Because of the dynamic nature of the communications equipment industry, ADC has sought and intends to continue to seek acquisitions and alliances that will: (i) add key technologies that ADC can leverage across its businesses, (ii) broaden its product offerings, (iii) permit ADC to enter attractive new markets and (iv) expand or enhance its distribution channels. To accomplish these objectives, during 1999, ADC completed the following acquisitions: (a) Teledata Communications, Ltd., a supplier of advanced wireline and wireless customer access network equipment for telephone operating companies; (b) Hadax Electronics, Inc., a company with remote network test and access products and technology; (c) Phasor Electronics, an Austrian-based manufacturer of radio frequency amplifiers; (d) Pathway, Inc., a manufacturer of the AccessPoint™ access system, which interfaces with several existing ADC products and includes an ATM access product that transports Internet/data, video and voice communications over high-speed, switched broadband networks; (e) Spectracom Inc., a developer of high-powered pump laser chips and modules for use in fiber-optic networks, and (f) Saville Systems PLC, a provider of convergent billing and customer care solutions for local, data, long distance, wireless, cable television and energy communications markets.
The ability of ADC to implement its strategy effectively is subject to many uncertainties, and there can be no assurance of any future results of ADC's activities.
Product Groups
ADC's network equipment, software and integration services are divided into three groups: (1) Broadband Connectivity; (2) Broadband Access and Transport; and (3) Integrated Solutions. Each of these groups is described below.
Broadband Connectivity
Broadband Connectivity products include broadband connection and access devices for copper, coaxial, fiber-optic, wireless and broadcast communications networks. The group also supplies fiber-optic and wireless components. These products are used globally in telephone, cable television, Internet, wireless, enterprise and broadcast communications networks. Broadband Connectivity products provide the physical contact points for connecting different communications system components and gaining access to communications system circuits for the purpose of installing, testing, monitoring, accessing, managing, reconfiguring, splitting and multiplexing such circuits within the central office and the "last mile/kilometer" portion of communications networks. Fiber-optic components include connectors, isolators, circulators, collimators, couplers, splitters, and dense wavelength division multiplexing (DWDM) devices and pump lasers. Wireless components include coverage enhancement products, tower top amplifiers and RF filters. Broadband Connectivity products are sold to local and long-distance telephone companies, cable television operators, wireless service providers, new competitive service providers, broadcasters, enterprises, governments, system integrators and communications equipment manufacturers and distributors.
DSX Products. ADC manufactures digital signal cross-connect (DSX) modules and bays, which are designed to gain access to and cross-connect digital copper circuits for Internet/data, video and voice transmission. The Digital Distribution Point (DDP) family of products within the DSX product group are mechanical alternatives to hard-wiring equipment used for cable management and circuit access with software-based, electronic digital cross-connect systems. With the acquisition of Hadax Electronics, ADC has added remote test access capability to its DSX products. This capability enables service providers to monitor high capacity circuit performance at unstaffed sites such as carrier collocation points.
Terminal Block and Frame Products ADC manufactures a wide variety of terminal blocks, which are molded plastic blocks with contact points used to facilitate multiple wire interconnections. ADC's cross-connect frames are terminal block assemblies used to connect the external wiring of a communications network to the internal wiring of a telephone operating company's central office or to interconnect various pieces of equipment within a telephone company's central office or at a customer's premises.
Fiber Distribution Frames. ADC's fiber distribution panels and frames, which are functionally similar to copper cross-connect modules and bays, are designed with special considerations of fiber-optic properties. They also provide interconnection points between fiber-optic cables entering a building and fiber-optic cables connected to fiber-optic equipment within the building.
Fiber Optic Components. ADC's Australian subsidiary, AOFR Pty. Ltd., sells fiber optic couplers, which are passive connection devices used in fiber optic transmission systems. Fiber optic couplers, which include optical splitters and wavelength division multiplexers, enable efficient and cost-effective deployment of broadband networks. ADC also sells Dense Wavelength Division Multiplexing (DWDM) components such as splitters and multiplexers which are designed with special considerations of fiber optic properties. These products increase the channel capacity of fiber optic cabling systems in
multiples of four. ADC currently is selling four-channel and eight-channel components and has recently introduced 16-channel and 32-channel components. ADC's acquisition of Princeton Optics broadened ADC's optic components product line by adding optical isolators and circulators and related technology. Isolators function as one-way optical check valves that protect lasers and other elements from reflective light. Circulators are devices that carry a light signal from one port to the next in the forward direction only. Spectracom, a fiscal year 1999 acquisition, has patent-pending applications for the development of reliable, high-powered 980 nanometer pump laser diodes and modules for use in erbium doped fiber amplifiers, which enable wavelength division multiplexing technology.
Fiber Optic Patch Cords. Fiber optic patch cords are the basic components used to gain access to fiber communications circuits for testing, maintenance, cross-connection and configuration purposes. ADC's LightTracer® fiber optic patch cords provide immediate identification of fiber optic connections. ADC's new LX.5. fiber connector doubles the capacity of fiber termination equipment by allowing two fibers to fit into the standard SC adapter footprint. ADC incorporates its fiber optic patch cords and cable assemblies into its own products and also sells them in component form.
Other Fiber Optic Products. ADC's FiberGuide® system is a modular routing system which provides a segregated, protected method of storing and routing fiber patch cords and cables within buildings.
Broadband Software Infrastructure Management Solutions. ADC has developed a number of software products which provide management of fiber-optic infrastructure connectivity, geographical tracking of equipment, cables and other network elements in the telephone company's central office, cable TV company headend and outside plant portion of those networks.
Video Signal Distribution Products. ADC's series of Video Signal Distribution (VSD) products are designed to meet the unique performance requirements of Radio Frequency (RF) video transmission over coaxial cable. This product family includes a series of splitter/combiner panels, a series of video jacks and panels which monitor, patch and provide a test access point and an analog video interface system panel designed for on-demand testing.
Wireless Infrastructure Equipment and Subsystems. ADC designs, manufactures and markets radio frequency (RF) front-ends, filters, SMARTop™ tower-top amplifiers and other wireless base station and subscriber equipment components and subsystems. Products are distributed and sold globally for all major air interfaces. These products are sold primarily to wireless OEMs.
CityWide™ Products. ADC's family of CityWide wireless systems products includes the CityCell wideband digital microcells, CityRad® repeaters for adding and extending cellular communication coverage out-of-doors and CityMicro® Bi-Directional Amplifiers for in-building coverage. CityWide products are transparent to digital modulation, and products have been commercially deployed by five of seven major U.S. cellular network providers.
Jacks, Plugs, Patch Cords, Jackfields and Patch Bays. Jacks and plugs are the basic components used to gain access to copper communications circuits for testing and maintenance. Patch cords are wires or cables with a plug on each end. ADC incorporates its jacks, plugs and patch cords into its own products and also sells them in component form, primarily to OEMs. A jackfield is a module containing an assembly of jacks wired to terminal blocks or connectors and used by communications companies to gain access to copper communication circuits for testing or patching the circuits. When testing a large number of circuits, series of jackfields are combined in specialized rack assemblies called patch bays. ADC manufactures a range of jackfields and patch bays in various configurations. Certain of these jackfields are specialized for use in audio and visual transmission networks in the broadcast industry.
Broadband Access and Transport
Broadband Access and Transport products include access and transport systems that deliver broadband, multiservice communications to residences and businesses over copper, coaxial, fiber-optic and wireless networks. These products are used globally to deliver Internet/data, video and voice services to residential and business customers. Generally, these products are aimed at upgrading service providers' networks to broadband capabilities, while also introducing new service delivery functionality and cost effectiveness into the networks. Broadband Access and Transport products are sold to local and long-distance telephone companies, cable television operators, wireless service providers, new competitive service providers, broadcasters, enterprises, governments and communications equipment distributors.
The group's transport systems operate between central offices and in the "last mile/kilometer" portion of communications networks and include Soneplex®, Cellworx®, CellSpan™, Homeworx™, Optiworx™, DV6000™ and BroadAccess™ systems.
The group's access systems include both customer located devices (which are part of the service provider's network) and customer premise devices (which are owned by the service provider's business customer) that can work alone or in conjunction with one of ADC's transport systems or with other vendors' transport systems. These devices include data service units (DSUs), channel service units (CSUs), T1/E1 multiplexers, T3/E3 multiplexers, integrated access devices (offering a wide variety of Internet/data, video and voice interfaces), MPEG video products and ATM access concentrators.
Soneplex and Cellworx Products. Soneplex is a carrier-class, intelligent loop access platform enabling incumbent local exchange carriers and competitive local exchange carriers to deliver T1/E1-based services over copper or fiber facilities. Soneplex integrates functions and capabilities that reduce a carrier's capital and operating costs of delivering T1/E1-based services. Cellworx represents a next-generation OC3/12/48 ATM virtual path transport product which integrates ATM and SONET/SDH technologies. While Soneplex is centered on T1/E1-based service delivery, Cellworx is a broad-based service delivery infrastructure product aimed at reducing a carrier's capital and operating costs of delivering the full range of high-speed to low-speed services over copper or fiber facilities.
The Cellworx Service Transport Node (STN) has broad-based applications in most telecommunication network infrastructures. ADC has sold the Cellworx STN into many market segments, including installation of an 18 node network in South Dakota for Internet Access and Private Line service, an installation at a major IXC for broadband switch port consolidation and DSLAM backhaul, and with Iowa Communications Network for its statewide distance learning network. ADC has also received three contracts from the U.S. government for building data, voice, video and telemetry networks on various military bases. In addition, five international distributors have purchased Cellworx STN lab and demo equipment and are actively reselling the equipment in their countries. Lastly, ADC was recently selected for ATM Virtual Path transport at a major RBOC, and the Cellworx STN has been placed in the lab for technical evaluation.
Customer Located and Customer Premise Devices. ADC's products include Customer Located Devices (which are part of the carrier's network) as well as Customer Premise Devices (which are owned by the carrier's business customer). These stand-alone products can work in conjunction with Soneplex or Cellworx or with other vendors' transport systems. They include T1/E1 multiplexers (offering a variety of Internet/data, video and voice interfaces), T3/E3 multiplexers and ATM access concentrators.
Public Network Access Equipment. ADC manufactures a family of Channel Service Unit (CSU) and Data Service Unit (DSU) products which are used to digitally interconnect the public network and the private network. This equipment monitors circuits and provides system protection and other network management functions. Certain of these products also enable the customer to test the
performance of its voice network and allow connection of Internet/data, video and voice circuits. These products support T1, T3 (44.6 million bits per second) and OC3 (155 million bits per second) services and a variety of data protocols, including Frame Relay, Switched Multi-megabit Data Service (SMDS), ATM, ISDN, HDSL and the Internet protocols. The ServicePoint service delivery platform is designed to be upgraded to enhance this core termination and monitoring functionality with control features, such as bandwidth management. ADC's AAC-1® and AAC-3® ATM access concentrators adapt, aggregate, multiplex and manage all voice, data and video signals in various speeds, technologies and protocols for transport over T1, E1, T3 and E3 speed ATM networks. ADC sells several remote access and routing products, some of which are specifically designed for Internet access. ADC has entered into agreements with other ATM equipment suppliers providing for the joint marketing of and integration of ADC's ATM adaptation and concentration technologies into the ATM switching and routing products manufactured by such companies. ADC's EZT, ICX® and Opera® products support a wide range of customer interfaces and applications which enable service providers to deliver many network services simultaneously in a cost-effective manner. In June 1999, ADC completed the acquisition of Pathway, Inc. Pathway manufactures the AccessPoint™ Universal Media Access system. AccessPoint interfaces with several existing ADC products and is an ATM access product that transports Internet/data, video and voice and communications over high-speed, switched broadband networks.
Internetworking Products. Internetworking products include fiber optic backbones used to transport high speed multiple voice, data and video signals simultaneously over private networks and link Local Area Networks (LANs), mainframes, minicomputers, personal computers, telephone systems and video equipment with diverse protocols within private networks or over the public network; intelligent wiring hub products which interconnect workstations, personal computers and terminals, utilizing many different LAN protocols and types of cables; and network management systems.
PatchSwitch System and PatchMate™ Module. ADC's PatchSwitch system is a data network management product which provides access to and monitors, tests and reconfigures digital data circuits and permits local or remote switching to alternate circuits or backup equipment. This system is modular, permitting the user to select and combine the particular functions desired in a system. The PatchMate module is a manually operated electromechanical device used to gain access to the network in order to monitor, test and reconfigure digital data circuits.
Homeworx Access Transport Platform. The Homeworx system has been designed for deployment on video-only, telephony-only and integrated video, telephony and Internet/data broadband networks provided by telephone operating companies, cable TV operators and other communications common carriers. The Homeworx access transport platform utilizes Hybrid Fiber Coax (HFC) technology.
DV6000™ and Other Fiber Video Delivery Equipment. ADC's DV6000 system transmits a variety of signal types using a high-speed, uncompressed digital format (at speeds up to 10 billion bits per second, with capacity of up to 64 channels) over fiber in the super trunking portions of broadcast and interactive video networks.
Optiworx™ HFC Transport Systems Platform. ADC's Optiworx family offers a comprehensive, multiservice HFC transport system including 1310nm and 1550nm optical transmitters, optical receivers, optical distribution nodes, patented RF amplifier technology, dense wavelength division multiplexing (DWDM) capability, and digital HFC products and technology-all tied together with a network management system. ADC's Optiworx product line is designed for a broad range of HFC transport applications, including broadcast video, IP or circuit-switched telephony, video on demand, Internet access and targeted advertising. These products are being deployed in the U.S. and around the world by cable TV operators who are upgrading their plants to carry two-way service over hybrid fiber/coaxial plants, including digital interactive Internet/data, video and voice services.
ADC Teledata Products. In November 1998, ADC acquired Teledata Communications, Ltd. ("Teledata"). ADC's Teledata products enable telephone operating companies to enhance the capacity, reach and functionality of the local loop. Teledata's product portfolio currently consists of a family of digital loop carriers and wireless local loop access solutions. Teledata's digital loop carriers include the following: the BroadAccess™ family of compact and flexible future generation DLCs, which provide voice and Internet/data services for digital networks of clusters of 60 to 480 subscribers and consist of the DCS-30 (formerly known as the TDLC 30), the DCS-20F and the DCS-20T; the DCS-20E multiplexer and cross-connect system that allows telephone operating companies to connect from 120 to 480 subscribers to the local exchange; the TIMUX access multiplexer that enables the connection of groups of 30 to 150 subscribers to the local exchange; and the CTLOOP digital "pair-gain" system that allows the connection of groups of up to 10 subscribers to the local exchange without additional investment in infrastructure. The ERC digital wireless local loop point to multi-point system connects up to 960 subscribers using base stations, each of which serves subscribers within a 50 kilometer radius.
Cellspan Broadband Wireless System. ADC's Cellspan broadband wireless system offers a wireless alternative to copper-based and fiber-optic-based products by delivering high-speed wireless Internet/data, video and voice services to customers. With major carriers Worldcom and Sprint entering the wireless market in 1999, ADC believes that wireless products offer a viable alternative to wireline solutions for access to the "last mile/kilometer" of the communications network. In 1999, ADC released and began selling its Cellspan system. Although further refinement and testing of the Cellspan system will be required prior to large-scale deployment, ADC believes that the experience it gained from selling one-way Multi-point Microwave Distribution Systems (MMDS) in this market for the past four years will enable ADC to compete successfully in the wireless market.
Wireless Cable and Broadcast TV Transmission Equipment. ADC supplies products to the wireless cable and broadcast TV market. ADC designs and manufactures television transmission products for these markets, including transmitters, combiners, back-up equipment and antennas to wireless cable operators for MMDS. Because the Federal Communications Commission has mandated that each TV station establish a digital channel by the end of the year 2003 or lose their license to the existing analog TV market, each TV station must establish a separate digital TV channel and install an additional TV transmitter for broadcasting. ADC believes that its existing TV transmitters and other system capabilities will enable ADC to leverage other products into other Broadband Access and Transport applications in the wireless cable and broadcast TV industries.
Integrated Solutions
Integrated Solutions products and services consist of systems integration services, operations support systems (OSS) software and enhanced services/intelligent network software that positions service providers to deliver broadband, multiservice communications over wireline and wireless networks. Systems integration services are used to design, equip and build communications networks and OSS applications that deliver Internet/data, video and voice services to residences and businesses. OSS software includes the Saville Systems® line of communications billing and customer care software and the Metrica® line of network performance and service level assurance software. Enhanced services/ intelligent network software includes the NewNet® line of Signaling System 7 (SS7), intelligent network, wireless messaging and provisioning, Communications Assistance to Law Enforcement Act (CALEA) and Internet applications software. Integrated Solutions products and services are sold to local and long-distance telephone companies, cable television operators, wireless service providers, new competitive service providers and communications equipment manufacturers.
Systems Integration Services. Systems integration services consist of project management, technical consulting and design, implementation, reliability, performance and training services. System integration services support ADC as well as multi-vendor solutions. ADC provides its systems integration services
and software primarily to telephone operating companies, cable TV companies, other common carriers and users of private communications networks.
ADC's systems integration services implement multimedia systems designed for integration of Internet/data, video and voice applications, including applications such as distance learning, business, medical and government networks. In addition, ADC's Systems Integration division has expanded its capabilities to include network records inventory and management, along with a full offering of Operational Support Systems (OSS) solutions. This division of ADC has expanded to most regions of the United States and is deploying services internationally with strategic partners.
Customer Care and Billing Software. In October 1999, ADC completed the acquisition of Saville Systems PLC, a provider of convergent billing and customer care solutions for local, Internet/data, long distance, wireless, cable television and energy service markets. Saville offers products and services designed to enable communications and energy service providers to bring new service offerings to market quickly, and to bill accurately and reliably for multiple services on one convergent invoice. Saville's line of products includes Saville CBP® (Convergent Billing Platform), Saville IBP™ (Interconnect Billing Platform), SavilleCare™ and Saville Express™. Saville has also introduced facilities management services, which allow customers to license CBP from Saville and have Saville manage the operation of the software on customer-owned hardware, and offers a complete service bureau billing and customer care service. In addition to its product offerings, Saville also provides its customers with a full range of professional services, including assisting a customer in analyzing its requirements and then designing, developing and implementing a customer care and billing solution.
Performance and Network Management Software. ADC designs and sells communications network performance management software under the Metrica® brand name. Metrica's software platforms are used in the infrastructure management systems of wireless and wireline public network operators throughout the world.
Intelligent Network Software. ADC supplies intelligent network communications software, including Signaling Systems 7 (SS7) technology, wireless intelligent network products (such as short messaging services) software to assist carriers in complying with CALEA, and Internet applications software, under the NewNet® brand name.
Sales and Marketing
ADC sells its products to customers in three primary markets: (i) the United States public communications network market, which includes all five of the RBOCs, other telephone companies, long distance carriers, wireless service providers, cable TV operators and other domestic public network providers; (ii) the private and governmental voice, Internet/data and video network markets in the United States, which includes large business customers and governmental agencies that own and operate their own voice, data and video networks for internal use; and (iii) the international public and private network market. The U.S. public, U.S. private and governmental and international market segments accounted for 74.6%, 2.4% and 23.0%, respectively, of ADC's net sales for the year ended October 31, 1999; 73.3%, 5.1% and 21.6%, respectively, of ADC's net sales for the year ended October 31, 1998; and 73.2%, 5.5% and 21.3%, respectively, of ADC's net sales for the year ended October 31, 1997. ADC also sells product for each of these customer groups to communications OEMs. Additional financial information concerning sales of ADC's products is contained in ADC's Annual Report to Shareholders for the fiscal year ended October 31, 1999 (the "Annual Report"). Portions of the Annual Report are contained in Exhibit 13-a to this Form 10-K, as filed with the Securities and Exchange Commission (the "SEC" or the "Commission"), and are incorporated herein by reference.
Purchases of products by public network providers and the OEMs which supply such companies accounted for the largest portion of ADC's net sales. ADC's business broadband and residential broadband transmission systems and broadband connectivity products for public network providers are primarily located in central transmission facilities (such as telephone company network central offices, cable TV company network supertrunks and headend offices, and wireless network global switching centers and base stations, all of which contain the equipment used in switching and transmitting incoming and outgoing circuits). Increasingly, portions of ADC's business broadband and residential broadband transmission systems are located in the public network outside plant facilities (outside the central transmission buildings) and on customers' premises. ADC's private and governmental network customers generally purchase ADC's enterprise-wide communications systems and public network access equipment for installation in the networks located at their premises.
ADC also markets its products outside the United States primarily to telephone operating companies and cable TV operators for public communications networks located in Canada, Europe, the Middle East, Asia/Pacific, Australia and Latin America.
A majority of ADC's sales are made by a direct sales force, and ADC maintains sales offices throughout the United States as well as in Canada, Europe, the Middle East, Asia/Pacific, Australia and Latin America. ADC's products are sold in the United States by several sales offices located throughout the country, as well as through dealer organizations and distributors. ADC's products are sold outside the United States by several field sales offices and by independent sales representatives and distributors, as well as through United States public and private network providers who also distribute products outside the United States.
ADC has a customer service group that supports field sales personnel and is responsible for application engineering, customer training, entering orders and supplying delivery status information, and a field service engineering group that provides on-site service to customers.
Research and Development
ADC believes that its future success depends on its ability to adapt to the rapidly changing communications environment, to maintain its significant expertise in core technologies and to continue to meet and anticipate its customers' needs. ADC continually reviews and evaluates technological changes affecting the communications market and invests substantially in applications-based research and development. ADC intends to continue an ongoing program of new product development that combines internal development efforts with acquisitions, joint ventures and licensing or marketing arrangements relating to new products and technologies from sources outside ADC.
In recent years, increasingly significant portions of new communications equipment purchased by public network providers and private network customers have employed fiber-optic transmission, digital, integrated circuit, wireless and broadband copper-based technologies for residential, business and wireless broadband local loop applications. In the future, these communications network equipment purchasing trends will include increasingly sophisticated, software-intensive, OSS and network management systems. As a result, ADC's internal and external product development activities are primarily directed at the following areas: (i) the integration of fiber optic technology into additional products; (ii) the continuing development of its Homeworx system for telephony, data and integrated video, telephony and Internet/data applications; (iii) the development of network systems (including billing and customer care) software; (iv) the continuing development of its Soneplex and Cellworx systems for integrated Internet/data, video and voice applications; (v) the continuing development of wireless products; (vi) the incorporation of ATM and internet protocol technologies into Internet/data, video and voice products for both public and private communications networks; and (vii) the addition of video compression technology to its product line.
New product development often requires long-term forecasting of market trends, development and implementation of new processes and technologies and a substantial capital commitment. As a result of these and other factors, development and customer acceptance of new products is inherently uncertain, and there can be no assurance that such products will be developed on a timely basis or achieve market acceptance.
Competition
Competition in the communications equipment industry is intense, and ADC believes that competition may increase substantially with the deployment of broadband networks and regulatory changes. Many of ADC's foreign and domestic competitors have more extensive engineering, manufacturing, marketing, financial and personnel resources than those of ADC. ADC's Broadband Connectivity products are competitive with products offered by several other companies, including
Lucent Technologies, Siecor and Telect. ADC's principal competitors in the Broadband Access and Transport market include Pairgain Technologies, Adtran, 3COM, General Instrument, Scientific-Atlanta and ANTEC. In the systems integration services and product market, ADC competes with Lucent Technologies, Nortel and Andersen Consulting. In the customer care and billing software market, ADC's primary competitors are Kenan Systems, a subsidiary of Lucent Technologies, and Daleen Technologies. In addition, ADC faces increasing competition from a number of other smaller competitors, none of which is dominant at this time.
The rapid technological developments within the communications industry have resulted in frequent changes to ADC's group of competitors. ADC believes its success in competing with other manufacturers of communications products depends primarily on its engineering, manufacturing and marketing skills, the price, quality and reliability of its products and its delivery and service capabilities. While the market for ADC's products has not historically been characterized by significant price competition, ADC may face increasing pricing pressures from current and future competitors in certain or all of the markets for its products.
ADC believes that technological change, the increasing addition of Internet/data, video, voice and other services to integrated multimedia networks, continuing regulatory changes and industry consolidation or new entrants will continue to cause rapid evolution in the competitive environment of the communications equipment market, the full scope and nature of which are difficult to predict at this time. Increased competition could result in price reductions, reduced margins and the loss of market share by ADC. ADC believes that industry regulatory change may create new opportunities for suppliers of communications equipment. ADC expects, however, that such opportunities may attract increased competition from others as well. In addition, ADC expects that Lucent Technologies will continue to be a major supplier to the RBOCs and will compete more extensively outside the RBOC market. ADC also believes that the rapid technological changes which characterize the communications industry will continue to make the markets in which ADC competes attractive to new entrants. There can be no assurance that ADC will be able to compete successfully with its existing or new competitors or that competitive pressures faced by ADC will not materially and adversely affect its business, operating results or financial condition.
Manufacturing and Supplies
ADC manufactures a wide variety of products which are fabricated, assembled and tested in its own facilities or in subcontracted facilities. In an effort to reduce costs, ADC also utilizes off-shore assembly and sourcing. The manufacturing process for ADC's electronic products consists primarily of assembly and testing of electronic systems built from fabricated parts, printed circuit boards and electronic components. The manufacturing process for ADC's electromechanical products consists primarily of fabrication of jacks, plugs, and other basic components from raw materials, assembly of components and testing. ADC's sheet metal, plastic molding, stamping and machining capabilities permit ADC to configure components to customer specifications.
ADC purchases raw materials and component parts, consisting primarily of copper wire, optical fiber, steel, brass, nickel-steel alloys, gold, plastics, printed circuit boards, solid state components, discrete electronic components and similar items, from several suppliers. Although a few of the components used by ADC are single-sourced, ADC has experienced no significant difficulties to date in obtaining adequate quantities of these raw materials and component parts. This circumstance could change in the future, however, and ADC cannot be sure that the quantity or quality of raw materials and component parts will be as readily available in the future.
Proprietary Rights
ADC owns a number of United States and foreign patents relating to its products. These patents, in the aggregate, constitute a valuable asset of ADC. ADC, however, believes that its business is not dependent upon any single patent or any group of related patents.
ADC has registered the initials "ADC" alone and in conjunction with specific designs as trademarks in the United States and various foreign countries.
Employees
As of October 31, 1999, there were approximately 13,500 persons employed by ADC. ADC considers relations with its employees to be good.
Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995
Certain portions of this Form 10-K, including "Business" herein and "Management's Discussion and Analysis of Financial Condition and Results of Operations" incorporated herein by reference, contain various "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements represent ADC's expectations or beliefs concerning future events, including the following: any statements regarding future sales, profit percentages and other results of operations, any statements regarding the continuation of historical trends, any statements regarding the sufficiency of ADC's cash balances and cash generated from operating and financing activities for ADC's future liquidity and capital resource needs, any statements regarding the effect of regulatory changes and any statements regarding the future of the communications equipment industry or ADC's business. ADC cautions that any forward-looking statements made by ADC in this report or in other announcements made by ADC are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements, including, without limitation, the factors set forth on Exhibit 99-a to this Form 10-K.
Item 2.
Item 2. PROPERTIES
ADC's corporate headquarters are currently located in four leased buildings in Minnetonka, Minnesota comprising an aggregate of approximately 286,400 square feet. Leases for ADC's headquarters buildings expire at different times through 2001.
ADC has entered into a five-year operating lease agreement for a new corporate headquarters facility located in Eden Prairie, Minnesota. The total cost of the facilities is expected to be approximately $100 million. Construction of the facilities began late in fiscal 1999 and is expected to be completed in 2001. The new corporate headquarters facility is expected to comprise approximately 1.2 million square feet.
ADC owns a manufacturing facility and an adjacent distribution facility in Shakopee, Minnesota that comprises approximately 372,000 square feet.
ADC also owns and leases a variety of other facilities for ADC's manufacturing, development, distribution, warehousing, sales and other activities. These facilities, including sales offices, are located in various countries, including the United States, Argentina, Australia, Austria, Belgium, Brazil, Canada, China, Finland, France, Germany, Hungary, Ireland, Israel, Japan, Korea, Malaysia, Mexico, the Netherlands, the Philippines, Singapore, Spain, Thailand, the United Kingdom and Venezuela.
ADC believes that the facilities used in its operations and currently under development are suitable for their respective uses and adequate to meet ADC's current needs.
Item 3.
Item 3. LEGAL PROCEEDINGS
None.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of ADC are as follows:
Messrs. Cadogan and Davis have served in various capacities with ADC for more than five years. Biographical information regarding the other named executive officers is set forth below:
Mr. Switz joined ADC in January 1994. Prior to such time, he was employed by Burr-Brown Corporation, a manufacturer of precision micro-electronics, from 1988, most recently as Vice President, Chief Financial Officer and Director, Ventures and Systems Business.
Mr. Ford joined ADC in October 1999. From April 1995 to August 1999, Mr. Ford served as President and Chief Executive Officer of Information Advantage, an Eden Prairie, Minnesota-based software company focused on the data warehousing and business intelligence markets. Prior to that time, Mr. Ford served as Chairman and Chief Executive Officer of Systems Software Associates (SSA), a Chicago-based application software company that provides enterprise business information solutions to the industrial sector market, from August 1991 to November 1994. Mr. Ford also served more than 25 years with IBM in various management capacities.
Mr. Sobti joined ADC in June 1999. Prior to such time, Mr. Sobti was employed by Motorola, Inc. for over 20 years, most recently as Vice President and Director of Solutions Engineering for Motorola's Global Telecom Solutions Group.
Mr. Roehrick joined ADC in January 1995. Prior to such time, he was employed by Cray Research, Inc., a manufacturer of large scale computers, most recently as Controller. From 1992 to 1993, he was Assistant Controller of Cray Research, and from 1989 to 1991, he was Director of Accounting for Cray Research.
Mr. Pflaum joined ADC in April 1996 and became Vice President, General Counsel and Secretary of ADC in March 1999. Prior to joining ADC, he was an attorney with the Minneapolis-based law firm of Popham Haik Schnobrich & Kaufman.
Ms. Owen joined ADC in December 1997. Prior to such time, she was employed by Texas Instruments and Raytheon, manufacturers of high technology systems and components. From 1995 to 1997, she was the Vice President of Human Resources for the Defense Systems and Electronics Group of Texas Instruments, which was sold to Raytheon in 1997.
Mr. Stewart joined ADC in November 1998. From 1994 to 1999, he served either as Vice President or Executive Vice President, Operations at FSI International, Inc. Between 1973 and 1994, he worked in various management positions with Texas Instruments, Inc. From 1990 to 1994, Mr. Stewart served as General Manager of Texas Instrument's CIM Products Division and Dallas Custom Manufacturing Services businesses. From 1983 to 1990, Mr. Stewart worked in operations management at Texas Instrument's Missile Systems Business and HARM Manufacturing, preceded by 10 years of experience with Texas Instruments.
PART II
Item 5.
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The section entitled "Quarterly Stock Prices" of the Annual Report is incorporated herein by reference. This section is also included on Exhibit 13-a to this Form 10-K, as filed with the SEC.
Item 6.
Item 6. SELECTED CONSOLIDATED FINANCIAL DATA
The summary of certain consolidated statement of income and balance sheet information for the eleven years ended October 31, 1999 included in the Annual Report is incorporated herein by reference. This information is also included on Exhibit 13-a to this Form 10-K, as filed with the SEC. Such summary information should be read in conjunction with the consolidated financial statements and notes thereto incorporated by reference in Item 14 of this Form 10-K.
Item 7.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The sections entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations-Overview," "Results of Operations," "Liquidity and Capital Resources" and "Year 2000 Matters" in the Annual Report are incorporated herein by reference. This section is also included in Exhibit 13-a to this Form 10-K, as filed with the SEC.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations-Risk Management" in the Annual Report is incorporated herein by reference. This section is also included in Exhibit 13-a to this Form 10-K, as filed with the SEC.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and notes thereto included in the Annual Report are incorporated herein by reference. These financial statements are also included in Exhibit 13-a to this Form 10-K, as filed with the SEC.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The sections entitled "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in ADC's definitive proxy statement for its 2000 Annual Meeting of Shareholders to be filed with the Commission on or before January 29, 2000 (the "Proxy Statement") are incorporated herein by reference. The section entitled "Executive Officers of the Registrant" following Item 4 of this Form 10-K is incorporated herein by reference.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The section entitled "Executive Compensation" in the Proxy Statement is incorporated herein by reference (except for the information set forth under the subcaption "Compensation and Organization Committee Report on Executive Compensation," which is not incorporated herein).
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement is incorporated herein by reference.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
PART IV
Item 14.
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)1. Financial Statements
The following consolidated financial statements of ADC are part of this report and are found on the pages of the Annual Report indicated below and incorporated herein by this reference. These financial statements are included on Exhibit 13-a to this Form 10-K, as filed with the SEC.
The following reports are part of this report and are included as Exhibits 13-b and 13-c to this Form 10-K, as filed with the SEC.
2.Financial Statement Schedules
All schedules for which provision is made in the applicable accounting regulations of the SEC have been omitted as not required or not applicable, or the information required has been included elsewhere by reference in the financial statements and related notes, except for Schedule II, which is included as Exhibit 99-b to this Form 10-K, as filed with the SEC.
3.Listing of Exhibits
Exhibit
Number
Description
3-a
Restated Articles of Incorporation of ADC Telecommunications, Inc., as amended. (Incorporated by reference to Exhibit 4.1 to ADC's Registration Statement on Form S-3 dated April 15, 1997.)
3-b
Restated Bylaws of ADC Telecommunications, Inc., as amended. (Incorporated by reference to Exhibit 4.2 to ADC's Registration Statement on Form S-3 dated April 15, 1997.)
4-a
Form of certificate for shares of Common Stock of ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 4-a to ADC's Form 10-Q for the quarter ended January 31, 1996.)
4-b
Second Amended and Restated Rights Agreement, amended and restated as of November 28, 1995, between ADC Telecommunications, Inc. and Norwest Bank Minnesota, National Association (amending and restating the Rights Agreement dated as of September 23, 1986, as amended and restated as of August 16, 1989 and November 28, 1995), which includes as Exhibit A thereto the form of Right Certificate. (Incorporated by reference to Exhibit 4 to ADC's Form 8-K dated December 11, 1995.)
4-c
Amendment to Second Amended and Restated Rights Agreement dated as of October 6, 1999.
10-a*
Stock Option and Restricted Stock Plan, restated as of January 26, 1988. (Incorporated by reference to Exhibit 10-a to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1988.)
10-b*
Amendment to Stock Option and Restricted Stock Plan dated as of September 26, 1989. (Incorporated by reference to Exhibit 10-e to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.)
10-c*
ADC Telecommunications, Inc. 1991 Stock Incentive Plan, as amended and restated through February 23, 1999. (Incorporated by reference to Exhibit 10-a to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1999).
10-d*
Business Development Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-f of ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-e*
Business Unit Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-q to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-f*
Corporate Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-r to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-g*
International Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-s to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-h*
Business Unit Management Incentive Plan Fiscal Year 1999. (Incorporated by reference to Exhibit 10-m to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1998.)
10-i*
Corporate Management Incentive Plan Fiscal Year 1999. (Incorporated by reference to Exhibit 10-n to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1998.)
10-j*
ADC Telecommunications Management Incentive Plan Document for Fiscal Year 2000.
10-k*
Executive Incentive Exchange Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-u to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-l*
Executive Incentive Exchange Plan Fiscal Year 1999. (Incorporated by reference to Exhibit 10-q to ADC's Annual Report Form 10-K for the fiscal year ended October 31, 1998.)
10-m*
Executive Incentive Exchange Plan Fiscal Year 2000.
10-n*
Supplemental Executive Retirement Plan Agreement for William J. Cadogan, dated as of November 1, 1990, between ADC Telecommunications, Inc. and William J. Cadogan, as amended. (Incorporated by reference to Exhibit 10-u to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-o*
ADC Telecommunications, Inc. Change in Control Severance Pay Plan Statement and Summary Plan Description. (Incorporated by reference to Exhibit 10-q to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.)
10-p*
First Amendment of ADC Telecommunications, Inc. Change in Control Severance Pay Plan Statement and Summary Plan Description, effective July 22, 1997. (Incorporated by reference to Exhibit 10-x to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-q*
Compensation Plan for Directors of ADC Telecommunications, Inc., restated as of December 31, 1988. (Incorporated by reference to Exhibit 10-b to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1989.)
10-r*
First Amendment of the Compensation Plan for Directors of ADC Telecommunications, Inc. restated as of December 31, 1988. (Incorporated by reference to Exhibit 10-s to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.)
10-s*
ADC Telecommunications, Inc. Nonemployee Director Stock Option Plan, as amended. (Incorporated by reference to Exhibit 10-aa to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-t*
ADC Telecommunications, Inc. Deferred Compensation Plan, dated as of November 1, 1978, as amended. (Incorporated by reference to Exhibit 10-aa to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-u*
Second Amendment of ADC Telecommunications, Inc. Deferred Compensation Plan, dated effective March 12, 1996 and approved on April 1, 1997. (Incorporated by reference to Exhibit 10-b to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997.)
10-v*
ADC Telecommunications, Inc. Pension Excess Plan, dated as of January 1, 1985, as amended. (Incorporated by reference to Exhibit 10-bb to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-w*
Second Amendment of ADC Telecommunications, Inc. Pension Excess Plan, dated effective March 12, 1996 and approved on April 1, 1997. (Incorporated by reference to Exhibit 10-a to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997.)
10-x*
ADC Telecommunications, Inc. 401(k) Excess Plan, dated as of September 1, 1990, as amended. (Incorporated by reference to Exhibit 10-cc to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-y*
Third Amendment of ADC Telecommunications, Inc. 401(k) Excess Plan, dated effective March 12, 1996 and approved on April 1, 1997. (Incorporated by reference to Exhibit 10-c to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997.)
10-z
Lease Agreement, dated August 21, 1990, between Minnetonka Corporate Center I Limited Partnership and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-x to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.)
10-aa
Lease Agreement, dated October 26, 1990, between Lutheran Brotherhood and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-w to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.)
10-bb
Sublease Agreement, dated October 31, 1990, between Seagate Technology, Inc. and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-y to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.)
10-cc
Sublease, dated as of February 21, 1995, between Seagate Technology, Inc. and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-a of ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1995.)
10-dd
Extension of Lease, dated December 7, 1995, between ADC Telecommunications, Inc. and Lutheran Brotherhood (for ADC's facility located at 5900 Clearwater Drive, Minnetonka Corporate Center, Minnetonka, Minnesota). (Incorporated by reference to Exhibit 10-w to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1996.)
10-ee
Extension of Lease, dated December 7, 1995, between ADC Telecommunications, Inc. and Lutheran Brotherhood (for ADC's facility located at 5950 Clearwater Drive, Minnetonka Corporate Center, Minnetonka, Minnesota). (Incorporated by reference to Exhibit 10-x to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1996.)
10-ff
Lease, dated as of October 22, 1999, between ADC Telecommunications, Inc. and Lease Plan North America, Inc.
10-gg
Ground Lease, dated as of October 22, 1999, between ADC Telecommunications, Inc. and Lease Plan North America, Inc.
10-hh
Construction Agreement, dated as of October 22, 1999, between ADC Telecommunications, Inc. and Kraus-Anderson Construction Company.
10-ii
Construction Agency Agreement, dated as of October 22, 1999, between Lease Plan North America, Inc. and ADC Telecommunications, Inc.
10-jj
Participation Agreement, dated as of October 22, 1999, among ADC Telecommunications, Inc., Lease Plan North America, Inc., the Participants named therein and ABN AMRO Bank N.V.
10-kk
Conduit Facility, Transfer and Revolving Credit Agreement, dated as of November 24, 1998, by and among ADC Telecommunications, Inc., Windmill Funding Corporation, Amsterdam Funding Corporation, ABN AMRO Bank N.V., and certain other financial institutions. (Incorporated by reference to Exhibit 10-kk to ADC's Form 10-K for the year ended October 31, 1998.)
13-a
Portions of the 1999 Annual Report to Shareholders.
13-b
Report of PricewaterhouseCoopers, Chartered Accountants and Registered Auditors.
13-c
Report of Ernst & Young Chartered Accountants.
21-a
Subsidiaries of ADC Telecommunications, Inc.
23-a
Consent of Arthur Andersen LLP.
23-b
Consent of PricewaterhouseCoopers, Chartered Accountants and Registered Auditors.
23-c
Consent of Ernst & Young Chartered Accountants.
24-a
Power of Attorney.
27-a
Financial Data Schedule for the fiscal year ended October 31, 1999.
27-b
Restated Financial Data Schedule for the fiscal year ended October 31, 1998.
27-c
Restated Financial Data Schedule for the fiscal year ended October 31, 1997.
99-a
Cautionary Statement regarding Forward-Looking Statements.
99-b
Report of Arthur Andersen LLP and Schedule II.
There have been excluded from the exhibits filed with this report instruments defining the rights of holders of long-term debt of ADC where the total amount of the securities authorized under such instruments does not exceed 10% of the total assets of ADC. ADC hereby agrees to furnish a copy of any such instruments to the Commission upon request.
(b)The following Reports on Form 8-K were filed during the last quarter of the period covered by this report:
•Report on Form 8-K dated August 18, 1999, filed in connection with the election of new directors to ADC's Board of Directors; and•Report on Form 8-K dated October 12, 1999, filed in connection with the acquisition of Saville Systems PLC.
(c)See Item 14(a)(3) above.
(d)See Item 14(a)(2) above.
*Management contract or compensatory plan or arrangement required to be filed as an Exhibit to this Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ADC Telecommunications, Inc.
Dated: December 30, 1999
By:
/s/ WILLIAM J. CADOGAN William J. Cadogan
Chairman of the Board, President
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ WILLIAM J. CADOGAN William J. Cadogan
Chairman of the Board, President and Chief Executive Officer (principal executive officer)
Dated: December 30, 1999
/s/ ROBERT E. SWITZ Robert E. Switz
Senior Vice President, Chief Financial Officer (principal financial officer)
Dated: December 30, 1999
/s/ CHARLES T. ROEHRICK Charles T. Roehrick
Vice President, Controller (principal accounting officer)
Dated: December 30, 1999
John A. Blanchard III*
Director
John J. Boyle III*
Director
James C. Castle*
Director
Thomas E. Holloran*
Director
B. Kristine Johnson*
Director
Alan E. Ross*
Director
Jean-Pierre Rosso*
Director
John W. Sidgmore*
Director
John D. Wunsch*
Director
Charles D. Yost
Director
*By:
/s/ JEFFREY D. PFLAUM Jeffrey D. Pflaum
Attorney-in-Fact
Dated: December 30, 1999
ADC Telecommunications, INC.
Annual Report on Form 10-K
For the Fiscal Year Ended October 31, 1999
EXHIBIT INDEX
Exhibit Number
Description
Page
3-a
Restated Articles of Incorporation of ADC Telecommunications, Inc., as amended. (Incorporated by reference to Exhibit 4.1 to ADC's Registration Statement on Form S-3 dated April 15, 1997.)
3-b
Restated Bylaws of ADC Telecommunications, Inc., as amended. (Incorporated by reference to Exhibit 4.2 to ADC's Registration Statement on Form S-3 dated April 15, 1997.)
4-a
Form of certificate for shares of Common Stock of ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 4-a to ADC's Form 10-Q for the quarter ended January 31, 1996.)
4-b
Second Amended and Restated Rights Agreement, amended and restated as of November 28, 1995, between ADC Telecommunications, Inc. and Norwest Bank Minnesota, National Association (amending and restating the Rights Agreement dated as of September 23, 1986, as amended and restated as of August 16, 1989 and November 28, 1995), which includes as Exhibit A thereto the form of Right Certificate. (Incorporated by reference to Exhibit 4 to ADC's Form 8-K dated December 11, 1995.)
4-c
Amendment to Second Amended and Restated Rights Agreement dated as of October 6, 1999.
10-a*
Stock Option and Restricted Stock Plan, restated as of January 26, 1988. (Incorporated by reference to Exhibit 10-a to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1988.)
10-b*
Amendment to Stock Option and Restricted Stock Plan dated as of September 26, 1989. (Incorporated by reference to Exhibit 10-e to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.)
10-c*
ADC Telecommunications, Inc. 1991 Stock Incentive Plan, as amended and restated through February 23, 1999. (Incorporated by reference to Exhibit 10-a to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1999).
10-d*
Business Development Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-f of ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-e*
Business Unit Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-q to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-f*
Corporate Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-r to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-g*
International Management Incentive Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-s to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-h*
Business Unit Management Incentive Plan Fiscal Year 1999. (Incorporated by reference to Exhibit 10-m to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1998.)
10-i*
Corporate Management Incentive Plan Fiscal Year 1999. (Incorporated by reference to Exhibit 10-n to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1998.)
10-j*
ADC Telecommunications Management Incentive Plan Document for Fiscal Year 2000.
10-k*
Executive Incentive Exchange Plan Fiscal Year 1998. (Incorporated by reference to Exhibit 10-u to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-l*
Executive Incentive Exchange Plan Fiscal Year 1999. (Incorporated by reference to Exhibit 10-q to ADC's Annual Report Form 10-K for the fiscal year ended October 31, 1998.)
10-m*
Executive Incentive Exchange Plan Fiscal Year 2000.
10-n*
Supplemental Executive Retirement Plan Agreement for William J. Cadogan, dated as of November 1, 1990, between ADC Telecommunications, Inc. and William J. Cadogan, as amended. (Incorporated by reference to Exhibit 10-u to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-o*
ADC Telecommunications, Inc. Change in Control Severance Pay Plan Statement and Summary Plan Description. (Incorporated by reference to Exhibit 10-q to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.)
10-p*
First Amendment of ADC Telecommunications, Inc. Change in Control Severance Pay Plan Statement and Summary Plan Description, effective July 22, 1997. (Incorporated by reference to Exhibit 10-x to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-q*
Compensation Plan for Directors of ADC Telecommunications, Inc., restated as of December 31, 1988. (Incorporated by reference to Exhibit 10-b to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1989.)
10-r*
First Amendment of the Compensation Plan for Directors of ADC Telecommunications, Inc. restated as of December 31, 1988. (Incorporated by reference to Exhibit 10-s to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.)
10-s*
ADC Telecommunications, Inc. Nonemployee Director Stock Option Plan, as amended. (Incorporated by reference to Exhibit 10-aa to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1997.)
10-t*
ADC Telecommunications, Inc. Deferred Compensation Plan, dated as of November 1, 1978, as amended. (Incorporated by reference to Exhibit 10-aa to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-u*
Second Amendment of ADC Telecommunications, Inc. Deferred Compensation Plan, dated effective March 12, 1996 and approved on April 1, 1997. (Incorporated by reference to Exhibit 10-b to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997.)
10-v*
ADC Telecommunications, Inc. Pension Excess Plan, dated as of January 1, 1985, as amended. (Incorporated by reference to Exhibit 10-bb to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-w*
Second Amendment of ADC Telecommunications, Inc. Pension Excess Plan, dated effective March 12, 1996 and approved on April 1, 1997. (Incorporated by reference to Exhibit 10-a to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997.)
10-x*
ADC Telecommunications, Inc. 401(k) Excess Plan, dated as of September 1, 1990, as amended. (Incorporated by reference to Exhibit 10-cc to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1996.)
10-y*
Third Amendment of ADC Telecommunications, Inc. 401(k) Excess Plan, dated effective March 12, 1996 and approved on April 1, 1997. (Incorporated by reference to Exhibit 10-c to ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1997.)
10-z
Lease Agreement, dated August 21, 1990, between Minnetonka Corporate Center I Limited Partnership and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-x to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.)
10-aa
Lease Agreement, dated October 26, 1990, between Lutheran Brotherhood and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-w to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.)
10-bb
Sublease Agreement, dated October 31, 1990, between Seagate Technology, Inc. and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-y to ADC's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.)
10-cc
Sublease, dated as of February 21, 1995, between Seagate Technology, Inc. and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-a of ADC's Quarterly Report on Form 10-Q for the quarter ended April 30, 1995.)
10-dd
Extension of Lease, dated December 7, 1995, between ADC Telecommunications, Inc. and Lutheran Brotherhood (for ADC's facility located at 5900 Clearwater Drive, Minnetonka Corporate Center, Minnetonka, Minnesota). (Incorporated by reference to Exhibit 10-w to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1996.)
10-ee
Extension of Lease, dated December 7, 1995, between ADC Telecommunications, Inc. and Lutheran Brotherhood (for ADC's facility located at 5950 Clearwater Drive, Minnetonka Corporate Center, Minnetonka, Minnesota). (Incorporated by reference to Exhibit 10-x to ADC's Quarterly Report on Form 10-Q for the quarter ended January 31, 1996.)
10-ff
Lease, dated as of October 22, 1999, between ADC Telecommunications, Inc. and Lease Plan North America, Inc.
10-gg
Ground Lease, dated as of October 22, 1999, between ADC Telecommunications, Inc. and Lease Plan North America, Inc.
10-hh
Construction Agreement, dated as of October 22, 1999, between ADC Telecommunications, Inc. and Kraus-Anderson Construction Company.
10-ii
Construction Agency Agreement, dated as of October 22, 1999, between Lease Plan North America, Inc. and ADC Telecommunications, Inc.
10-jj
Participation Agreement, dated as of October 22, 1999, among ADC Telecommunications, Inc., Lease Plan North America, Inc., the Participants named therein and ABN AMRO Bank N.V.
10-kk
Conduit Facility, Transfer and Revolving Credit Agreement, dated as of November 24, 1998, by and among ADC Telecommunications, Inc., Windmill Funding Corporation, Amsterdam Funding Corporation, ABN AMRO Bank N.V., and certain other financial institutions. (Incorporated by reference to Exhibit 10-kk to ADC's Form 10-K for the year ended October 31, 1998.)
13-a
Portions of the 1999 Annual Report to Shareholders.
13-b
Report of PricewaterhouseCoopers, Chartered Accountants and Registered Auditors.
13-c
Report of Ernst & Young Chartered Accountants.
21-a
Subsidiaries of ADC Telecommunications, Inc.
23-a
Consent of Arthur Andersen LLP.
23-b
Consent of PricewaterhouseCoopers, Chartered Accountants and Registered Auditors.
23-c
Consent of Ernst & Young Chartered Accountants.
24-a
Power of Attorney.
27-a
Financial Data Schedule for the fiscal year ended October 31, 1999.
27-b
Restated Financial Data Schedule for the fiscal year ended October 31, 1998.
27-c
Restated Financial Data Schedule for the fiscal year ended October 31, 1997.
99-a
Cautionary Statement regarding Forward-Looking Statements.
99-b
Report of Arthur Andersen LLP and Schedule II.
*Management contract or compensatory plan or arrangement required to be filed as an Exhibit to this Form 10-K.
DOCUMENTS INCORPORATED BY REFERENCE
PART II
PART III
PART IV
SIGNATURES
ADC Telecommunications, INC.
EXHIBIT INDEX | 11,860 | 83,437 |
313395_1999.txt | 313395_1999 | 1999 | 313395 | ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF BUSINESS
The Exploration Company (the "Company" or "TXCO") was incorporated in the State of Colorado on May 16, 1979, for the purpose of engaging in oil and gas exploration, development and production and became publicly held through an offering of its common stock in November, 1979. In May 1999, the Company changed its state of incorporation from Colorado to Delaware, becoming The Exploration Company of Delaware, Inc. The Company continues doing business as The Exploration Company and its trading symbol on the Nasdaq Stock MarketSM remains TXCO.
Throughout its history, the Company's primary focus has been oil and gas exploration and production. Its long term business strategy has been to acquire undeveloped mineral interests and to develop a multi-year inventory of drilling prospects internally through the application of state of the art technologies, such as 3-D seismic and enhanced horizontal drilling techniques. The Company strives to discover, develop and/or acquire more oil and gas reserves than it produces each year from these internally-developed prospects, as well as selectively participating with industry partners in prospects generated by TXCO as well as by other parties. The Company also attempts to maximize the value of its technical expertise by contributing its geological, geophysical and operational knowledge base in its core area through joint ventures or forms of strategic alliances with well capitalized industry partners in exchange for carried interests in seismic acquisitions, leasehold purchases and/or wells to be drilled. From time to time, the Company offers portions of its developed and undeveloped mineral interests for sale. The Company finances its activities through a combination of debt financing, equity offerings and internally generated cash flow. When appropriate, the Company may also use its equity securities as all or part of the consideration for operating investments.
Prior to 1992, the Company's revenues were derived principally from the sale of natural gas and oil production from working, royalty and mineral interests, as well as the sale of the mineral interests it acquired through its leasing activities. From 1992 through 1996 the Company expanded its activities by entering the then emerging alternative fuels vehicle conversion business through the creation of its ExproFuels division. In 1996, management redirected its focus and resources to its core oil and gas exploration and production business. Accordingly, the ExproFuels division was incorporated and a majority equity interest spun-off via a stock dividend to TXCO shareholders.
The continuing availability of new equity and debt capital to The Exploration Company during fiscal years 1997, 1998 and 1999 reaffirmed Management's expectations for improved shareholder value by focusing on its core business of oil and gas exploration and production. Although profitability was not attained through fiscal year 1998, operating results included a 195% increase in oil and gas revenues and a 183% increase in proved oil and gas reserves over 1997 levels while establishing positive cashflow from operations. Earnings before interest, taxes, depreciation, depletion, amortization, impairment and exploration expenses (EBIDAX) increased to $989,484.
Based on the growth of its operations in the prior two years, TXCO started 1999 with great expectations. We have not been disappointed. Although not reflected in its stock trading levels, for the year ended August 31, 1999, the Company realized the best operating results in its 20 year history, reaching profitability during the 1st quarter and ending its record breaking 1999 fiscal year with revenues of over $7,497,000 and net income of $931,000. In addition to reaching book profitability, EBIDAX surged to an all time high of $4,793,000. TXCO overcame the weakness in oil and gas prices during the first half of fiscal 1999, extending its strong growth trend through its drilling success and operational efficiencies. The Company realized a 146% increase in gross operating revenues, a 246% increase in production volumes and a 70% increase in oil and gas leasehold acreage in its core producing area. New reserve additions from 1999 drilling discoveries effectively replaced the record volume of gas and oil produced for the year, and together with improving oil and gas prices during the last half of the year, resulted in a 41% increase in the discounted present value (PV-10) of proved producing oil and gas reserves for the year.
TXCO has succeeded in leveraging its current success, positioning itself to further accelerate growth in fiscal years 2000 and 2001. In addition to planned new drilling in fiscal 2000 utilizing internally generated working capital, two new strategic alliances were initiated near year end which together are expected to provide TXCO with a substantial benefit from upwards of $17,000,000 in mineral leasing, 3-D seismic acquisition and exploration drilling expenditures over a 2 year period. The expenditures are targeted to develop and drill at least 12 additional Glen Rose patch reef drilling prospects in fiscal 2000 and to expand and update TXCO's 3-D seismic database to further define and then drill on a deep Jurassic Formation prospect before the end of 2000. The potential natural gas reserves of the deep Jurassic Formation could increase the Company's existing proved producing reserve base significantly. Should these exploration and development plans progress as intended, The Exploration Company expects to continue its strong growth in gas reserves, revenues and profitability well into the new millenium.
PRINCIPAL AREAS OF ACTIVITY
Oil and Gas Operations
Throughout the year, the Company has been actively developing its core mineral interests in the Maverick Basin in South Texas, while evaluating its economic alternatives related to its remaining properties in North Dakota, South Dakota and Montana. These activities included participation in the drilling of 10 gas wells in South Texas during 1999. The increase in Maverick Basin drilling activity reflects the Company's continued ability to generate sufficient working capital from profitable internal operations and from industry sources, allowing for expansion of its Texas-based lease acreage holdings and natural gas exploration and production activities. Increased Maverick Basin gas production during 1999 resulted in improved positive cash flows, more than offsetting the effects of weak natural gas prices for the first half of 1999. The ongoing reduction in Williston Basin activity reflects the lingering impact of low crude oil prices realized by TXCO through the first half of 1999, and is consistent with Company strategy to focus on its core gas producing and exploration activities.
Maverick Basin
The Company has owned at least a 50% leasehold interest in approximately 50,000 contiguous acres in Maverick County, Texas since 1989. Originally the lease block consisted of two leases, the Paloma with 33,000 acres and the Kincaid with 17,000 acres. The lease block is situated on the Chittim Anticline, a large regional structure, under which hydrocarbons have been found in as many as seven separate horizons dating back over 65 years. One of these zones is the Lower Glen Rose or Rodessa interval. It is a carbonate formation that has produced billions of cubic feet of natural gas from patch reefs within the zone on or near the anticline. Past development in the area was halted due to the inability of previous operators to accurately predict the location of these porosity-bearing reefs. Utilizing new technological advances, the Company applied an innovative processing method to the 2-D seismic available in the area and confirmed a method of determining the location of these porosity intervals.
Between 1993 and 1998, the Company expanded its in-house geophysical database to include multiple 3-D seismic surveys totaling over 55 square miles, covering approximately 36,000 acres of its Maverick Basin leases. Company scientists conclusively identified and mapped numerous geological formations at various depths on its leases. The mapping has provided numerous drilling alternatives for future evaluation of the multiple horizons known to be productive for oil and/or gas within and around its leases in the Maverick Basin. Consistent with the capital resources available, the Company has been selectively developing the Glen Rose interval. The shallower intervals provided alternative completion targets while pursuing the underlying reefs.
From 1989 to 1998, TXCO participated in the drilling of 26 wells in the Maverick Basin, with increasing degrees of drilling success. By the end of 1998, TXCO's daily net gas production from its Maverick Basin properties reached 1.96 MMcfd (million cubic feet of natural gas per day) from 16 gas wells. While successful in locating Glen Rose patch reefs, Management continued to review technical data gained with the drilling of each well, modifying its seismic interpretation model, improving its ability to distinguish between water-filled reefs and gas-filled reefs as well as expanding the geologically defined area known as the Prickly Pear Field.
During fiscal year 1998, 6 new gas well discoveries in succession on the Paloma Lease extended the Prickly Pear Field by several miles north and east of its previous recognized boundaries. The 6 wells produced gross daily production volumes ranging from 1 MMcfd to 4 MMcfd per well.
Fiscal year 1999 brought a continuation of growth in new production and revenues for the Company, as well as the expansion of TXCO's leasehold position over the Maverick Basin. During 1999, the Company acquired interests in over 39,000 acres of additional oil and gas leases in the immediate areas surrounding its Maverick Basin production, bringing its total lease position to approximately 90,000 acres at year end. TXCO participated in drilling 10 gas prospects, resulting in 5 new gas wells, further expanding the known producing area of the Prickly Pear Field on the Company's Paloma lease. Four of the other wells were drilled on leases acquired during fiscal 1999, while one was located on the Company's Kincaid lease. All 5 of these stepout wells were at least 5 to 9 miles from the nearest Prickly Pear Field production. Their drilling resulted in 2 completed oil wells and one completed gas well. The 2 other step out wells are being evaluated for various completion alternatives in shallower geologic formations overlying the Glen Rose patch reef interval, including the upper Glen Rose, lower and upper Georgetown, Eagleford, Austin Chalk and Buda formations .
At year end August 1999, TXCO's daily net gas production from its Maverick Basin properties reached 9.10 MMcfd from 28 gas wells. Ongoing production increases are a direct result of the application of advances totaling $4,400,000 under the existing financing agreement with Range Energy Finance Corporation. The newly attained production levels and resultant positive cash flow will allow the Company to internally generate sufficient working capital to fund its current fiscal year 2000 development plans. The successful drilling results of fiscal year 1998 and 1999 dramatically reaffirm the Company's longstanding belief that it has significant development possibilities on its expanding Maverick Basin lease block. At year end, Maverick Basin leases totaled over 90,000 acres with an additional 25,000 acres reserved under seismic options which were exercised during the 1st quarter of fiscal 2000. Through 1999, the Company has accumulated 148 square miles (93,000 acres) of 3-D seismic data over most of its Maverick Basin lease block, with evidence of from 30 to 40 additional porosity-bearing Glen Rose patch reefs scattered across its extensive acreage position. Based on current drilling activity, these patch reefs represent a potential three to four year drilling inventory of new gas well prospects .
Jurassic Formations: The Company's geophysicists and geologists have established that the 148 square miles of 3-D seismic shot through November 1999 across its 115,000 acre lease block in Maverick County indicates a significant potential for development of the deep Jurassic interval. Fiscal 1999 marked the year that the Company's concerted efforts resulted in a new partnership to develop the potential Jurassic reserves.
In September 1999, the Company completed negotiations and entered into a joint operating agreement with Blue Star Oil and Gas, Ltd., a Dallas based private partnership, for an extensive exploration project targeting the deep Jurassic interval underlying TXCO's Maverick Basin lease block. Under its terms, Blue Star paid TXCO a cash consideration upon closing and will initially fund 100% of the costs of a 58 square mile 3-D seismic acquisition program covering over 37,000 acres of TXCO's Paloma and Kincaid leases. In addition, Blue Star will fund 100% of the costs of drilling 2 exploratory wells to test the underlying deep Jurassic interval, carrying TXCO and its partners for a 25% working interest. Blue Star is also obligated to provide a similar amount of new 3-D seismic survey data, of TXCO's selection, which Blue Star is in process of acquiring on its 191,000 acre Chittim Ranch Lease which lies adjacent to TXCO's Paloma lease. Should both wells be drilled in a timely fashion, Blue Star will earn a 50% interest in the deep rights in both leases totaling 50,000 gross acres. TXCO will keep a 15% to 50% working interest in future Jurassic wells drilled under the agreement, depending on the location of future wells. Should initial drilling not occur within certain deadlines ending in fiscal year 2000, Blue Star will be obligated to pay $900,000 to TXCO to maintain its rights under the agreement. At year end, acquisition of seismic field data was underway on various portions of the Company's acreage block.
Williston Basin
During 1996 and 1997, the Company acquired a 50% interest in approximately 320,000 acres of oil and gas leases in the Williston Basin in North Dakota, South Dakota and Montana. The Company participated in the drilling of 11 wells in fiscal 1997 and 3 in fiscal 1998 in attempts to establish economic production and develop oil and gas reserves in the Red River and Lodgepole formations. During this same period, TXCO accumulated over 1,100 miles of 2-D seismic and approximately 64 square miles of 3-D seismic data covering over 40,800 acres of selected portions of its acreage in the Williston Basin. No new drilling was conducted on the Company's leases in the Williston Basin during 1999. The Company's interests produced an average of 122 net barrels of crude oil per day from 4.32 net wells. Industry wide exploration efforts in the Williston Basin have remained at historically low levels during the current year, with crude oil prices reaching a low of nearly $8.25 per barrel in December 1998. The weakness in crude oil prices rendered the production of marginal levels of oil with high associated water production, as is typical of many wells in the Basin, uneconomical for the Company to explore or produce. Current development plans, pending continuing recent crude oil price improvements, are limited to potential recompletions in behind pipe zones on existing wells, where electric logs indicate the presence of hydrocarbons during original drilling.
Throughout 1999, the Company continued to re-evaluate all of its Williston Basin lease obligations, making lease extension payments on a selective basis, emphasizing those leases with particular geologic attributes or with adequate remaining primary lease terms. At August 31, 1999, TXCO retained approximately 263,900 net acres of its original position. The Company has established adequate provisions for impairment allowances as required for expected fiscal year 2000 lease expirations. Consistent with Management's decision to refocus its exploration efforts and resources on continuing development of its core producing area in South Texas, TXCO initiated a focused marketing effort to present its remaining Williston Basin holdings, complemented by an extensive seismic database, for sale to other exploration companies with a focus on this area. Proceeds from such sales would be primarily redirected into the Company's South Texas development activities after making provisions for any remaining lease obligations. With the recent improvement in crude oil prices, reaching $18.74 at year end and over $24.00 during the 1st quarter of fiscal year 2000, Management is cautiously optimistic that renewed industry interest in the area will assist it in its efforts to monetize its remaining area holdings.
PRINCIPAL PRODUCTS AND COMPETITION
The Company's principal products are natural gas and crude oil. The production and marketing of oil and gas are affected by a number of factors that are beyond the Company's control, the effect of which cannot be accurately predicted. These factors include crude oil imports, actions by foreign oil-producing nations, the availability of adequate pipeline and other transportation facilities, the marketing of competitive fuels and other matters affecting the availability of a ready market, such as fluctuating supply and demand. The Company sells all of its oil and gas under short-term contracts that can be terminated with 30 days notice, or less. None of the Company's production is sold under long-term contracts with specific purchasers. Consequently, the Company is able to market its oil and gas production to the highest bidder each month. The Company operates and directs the drilling of oil and gas wells. It contracts service companies, such as drilling contractors, cementing contractors, etc., for specific tasks. In some wells, the Company only participates as an overriding royalty interest owner.
During 1999, three purchasers of the Company's oil and gas production accounted for 55%, 24% and 7%, respectively of total oil and gas sales. In the event any of these major customers declined to purchase future production, the Company believes that alternative purchasers could be found for such production at comparable prices.
The oil and gas industry is highly competitive in the search for and development of oil and gas reserves. The Company competes with a substantial number of major integrated oil companies and other companies having materially greater financial resources and manpower than the Company. These competitors, having greater financial resources than the Company, have a greater ability to bear the economic risks inherent in all phases of this industry. In addition, unlike the Company, many competitors produce large volumes of crude oil that may be used in connection with their operations. These companies also possess substantially larger technical staffs, which puts the Company at a significant competitive disadvantage compared to others in the industry.
EMPLOYEES
As of August 31, 1999, the Company employed 12 full-time employees including management. The Company believes its relations with its employees are good. None of the Company's employees are covered by union contracts.
GENERAL REGULATIONS
The extraction, production, transportation, and sale of oil, gas, and minerals are regulated by both state and federal authorities. The executive and legislative branches of government at both the state and federal levels, have periodically proposed and considered proposals for establishment of controls on alternative fuels, energy conservation, environmental protection, taxation of crude oil imports, limitation of crude oil imports, as well as various other related programs. If any proposals relating to the above subjects were to be enacted, the Company is unable to predict what effect, if any, implementation of such proposals would have upon the Company's operations. A listing of the more significant current state and federal statutory authority for regulation of the Company's current operations and business are provided herein below.
Federal Regulatory Controls
Historically, the transportation and sale for resale of natural gas in interstate commerce have been regulated pursuant to the Natural Gas Act of 1938 (the "NGA"), the Natural Gas Policy Act of 1978 (the "NGPA") and the regulations promulgated thereunder by the Federal Energy Regulatory Commission ("FERC"). Maximum selling prices of certain categories of natural gas sold in "first sales," whether sold in interstate or intrastate commerce, were regulated pursuant to the NGPA. On July 26, 1989, the Natural Gas Wellhead Decontrol Act (the "Decontrol Act") was enacted, which removed, as of January 1, 1993, all remaining federal price controls from natural gas sold in "first sales." The FERC's jurisdiction over natural gas transportation was unaffected by the Decontrol Act.
Commencing in April 1992, the FERC issued Order Nos. 636, 636-A and 636-B (collectively "Order No. 636"), which required interstate pipelines to provide transportation, separate or "unbundled," from the pipelines' sales of gas. Although Order No. 636 did not directly regulate the Company's activities, it fostered increased competition within all phases of the natural gas industry.
In December 1992, the FERC issued Order No. 547, governing the issuance of blanket marketer sales certificates to all natural gas sellers other than interstate pipelines. The order applies to non-first sales that remain subject to the FERC's NGA jurisdiction. The FERC Order No. 547, in tandem with Order No. 636, has fostered a competitive market for natural gas by giving natural gas purchasers access to multiple supply sources at market-driven prices. Order No. 547 has increased competition in markets in which the Company's natural gas is sold. The natural gas industry historically has been very heavily regulated; therefore, there is no assurance that the less stringent regulatory approach pursued by the FERC and Congress will continue.
State Regulatory Controls
In each state where the Company conducts or contemplates conducting oil and gas activities, such activities are subject to various state regulations. In general, the regulations relate to the extraction, production, transportation and sale of oil and natural gas, the issuance of drilling permits, the methods of developing new production, the spacing and operation of wells, the conservation of oil and natural gas reservoirs and other similar aspects of oil and gas operations. In particular, the State of Texas (where the Company has conducted the majority of its oil and gas operations to date) regulates the rate of daily production allowable from both oil and gas wells on a market demand or conservation basis. At the present time, no significant portion of the Company's production has been curtailed due to reduced allowables. The Company knows of no newly proposed regulations, which will significantly curtail its production.
Environmental Regulation
The Company's extraction, production and drilling operations are subject to environmental protection regulations established by federal, state, and local agencies. To the best of its knowledge, the Company believes that it is in compliance with the applicable environmental regulations established by the agencies with jurisdiction over its operations. The Company is acutely aware that the applicable environmental regulations currently in effect could have a material detrimental effect upon its earnings, capital expenditures, or prospects for profitability. The Company's competitors are subject to the same regulations and therefore, the existence of such regulations does not appear to have any material effect upon the Company's position with respect to its competitors. The Texas Legislature has mandated a regulatory program for the management of hazardous wastes generated during crude oil and natural gas exploration and production, gas processing, oil and gas waste reclamation and transportation operations. The disposal of these wastes, as governed by the Railroad Commission of Texas, is becoming an increasing burden on the industry. The Company's operations in Montana, North Dakota and South Dakota are subject to similar environmental regulations including archeological and botanical surveys as some of its leases are on federal and state lands.
Federal and State Tax Considerations
Revenues from oil and gas production are subject to taxation by the state in which the production occurred. In Texas, the state receives a severance tax of 4.6% for oil production and 7.5% for gas production. North Dakota production taxes typically range from 9.0% to 11.5% while Montana's taxes range up to 17.2%. These high percentage state taxes can have a significant impact upon the economic viability of marginal wells that the Company may produce and require plugging of wells sooner than would be necessary in a less arduous taxing environment. Although the Company is subject to federal income taxes on the oil and gas produced, its tax net operating loss carry forward should be sufficient to shelter a substantial amount of production. See Notes to the audited financial statements.
CERTAIN BUSINESS RISKS
Reliance on Estimates of Proved Reserves and Future Net Revenues: Depletion of Reserves
There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting future rates of production and the timing of development expenditures, including many factors beyond the control of the Company. The reserve data set forth in this report represents only estimates. In addition, the estimates of future net revenues from proved reserves of the Company and the present value thereof are based on certain assumptions about future production levels, prices and costs that may not prove to be correct over time. In particular, estimates of crude oil and natural gas reserves, future net revenue from proved reserves and the present value of proved reserves for the crude oil and natural gas properties described in this report are based on the assumption that future crude oil and natural gas prices remain the same as crude oil and natural gas prices as of August 31, 1999. The average sales prices as of such dates used for purposes of these estimates were $18.68 per barrel of crude oil and $2.59 per mcf of natural gas, representing an increase of 70% and 42%, respectively, from the prior year sales prices. Any significant variance in these assumptions could materially affect the estimated quantity and value of reserves set forth herein. See "Management's Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources" and "Properties "
Depletion of Reserves
The rate of production from crude oil and natural gas properties declines as reserves are depleted. Except to the extent the Company acquires additional properties containing proved reserves, conducts successful exploration and development activities or through engineering studies identifies additional behind-pipe zones or secondary recovery reserves, the proven reserves of the Company will decline as reserves are produced. Future crude oil and natural gas production is therefore highly dependent upon the Company's level of success in acquiring or finding additional reserves.
Title to Properties
As is customary in the crude oil and natural gas industry, the Company performs a preliminary title investigation before acquiring undeveloped properties that generally consists of obtaining a title report from outside counsel or due diligence reviews by independent landmen. The Company believes that it has satisfactory title to such properties in accordance with standards generally accepted in the oil and gas industry. A title opinion from counsel is obtained before the commencement of any drilling operations on such properties. The Company's properties are subject to customary royalty interests, liens incident to operating agreements, liens for current taxes and other burdens, none of which the Company believes materially interferes with the use of, or affect the value of, such properties.
Losses from Operations
For the current year the Company recorded net income of $.93 million. However, in prior years the Company recorded net losses of $8.4 million in fiscal 1998 and $3.4 million in fiscal 1997. There can be no assurance that the Company will not experience operating losses in the future.
Operating Hazards; Uninsured Risks
The nature of the crude oil and natural gas business involves certain operating hazards such as crude oil and natural gas well blowouts, explosions, formations with abnormal pressures, cratering and crude oil spills and fires. Any of these could result in damage to or destruction of crude oil and natural gas wells, destruction of producing facilities, damage to life or property, suspension of operations, environmental damage and possible liability to the Company. In accordance with customary industry practices, the Company maintains insurance against some, but not all, of such risks and some, but not all, of such losses. The occurrence of such an event not fully covered by insurance could have a material adverse effect on the financial condition and results of operations of the Company.
Substantial Capital Requirements
The Company makes, and will continue to make, substantial capital expenditures for the acquisition, exploitation, development, exploration, and production of crude oil and natural gas reserves. Historically, the Company has financed these expenditures primarily from debt and equity offerings, supplemented by available cash flow from operations. The Company is hopeful that it will continue to be able to obtain sufficient capital to finance planned capital expenditures. However, if revenues decrease because of lower crude oil and natural gas prices, operating difficulties or declines in reserves, the Company may have limited ability to finance planned capital expenditures in the future. Therefore, there can be no assurance that additional debt or equity financing or cash generated by operations will be available to meet its capital requirements.
ITEM 2.
ITEM 2. PROPERTIES
PHYSICAL PROPERTIES
The Company's administrative offices are located at 500 North Loop 1604 East, Suite 250, San Antonio, Texas. These offices, consisting of approximately 5,700 square feet, are leased through February 28, 2000 at $7,676 per month.
All the Company's oil and gas properties, reserves, and activities are located onshore in the continental United States. There are no quantities of oil or gas subject to long-term supply or similar agreements with foreign government authorities.
Proved Reserves, Future Net Revenue and Present Value of Estimated Future Net Revenues
The following unaudited information as of August 31, 1999, relates to the Company's estimated proved oil and gas reserves, estimated future net revenues attributable to such reserves and the present value of such future net revenues using a 10% discount factor, as estimated by Pollard, Gore and Harrison, an Austin, Texas engineering firm. Estimates of proved developed oil and gas reserves attributable to the Company's interest at August 31, 1999, 1998 and 1997 are set forth in Notes to the Audited Financial Statements included in this Annual Report on Form 10-K. Present Value of Estimated Future Net Revenues from proved developed oil and gas reserves as of August 31, 1999, are as follows:
10% Present Value of Years Ending Estimated Future August 31 Net Revenues ---------- ------------
2000 5,751,000 2001 3,580,000 2002 1,473,000 2003 719,000 2004 364,000 Thereafter 558,000 -----------
TOTAL $ 12,445,000 ===========
The present value of estimated future net revenues is computed in accordance with SEC requirements. These amounts were computed by applying current prices for oil and gas, giving effect only to those escalations in prices of gas which are currently contractually defined, deducting estimated future expenditures to develop and produce the proved reserves and applying a discount factor of 10%.
Proved oil and gas reserves are the estimated quantities of crude oil, natural gas liquids and natural gas which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. No reserve estimates have been filed with or included in reports to any federal or foreign government authority or agency, other than the Securities and Exchange Commission, since the Company's latest Form 10-K filing.
Production
The following table summarizes the Company's net oil and gas production, average sales prices, and average production costs per unit of production for the periods indicated. With respect to newly drilled wells, there can be no assurance that current production levels can be sustained. Depending upon reservoir characteristics, such levels of production could decline significantly.
(1) Oil and gas were combined by converting oil to gas mcf equivalent on the basis of 1 barrel of oil = 6 MCF of gas. Production costs include direct lease operations and production taxes.
Producing Properties - Wells and Acreage
The following table sets forth the Company's producing wells and developed acreage assignable to such wells at August 31, for the last three fiscal years:
Productive wells consist of producing wells and wells capable of production, including shut-in wells and wells awaiting pipeline connections to commence deliveries and oil wells awaiting connection to production facilities.
A "gross well" or "gross acre" is a well or acre in which a working interest is held. The number of gross wells or gross acres is the total number of wells or acres in which working interests are owned. A "net well" or "net acre" is deemed to exist when the sum of fractional ownership interest in gross wells or gross acres equals one. The number of net wells or net acres is the sum of fractional working interests owned in gross wells or gross acres expressed as whole numbers and fractions thereof.
Undeveloped Acreage
As of August 31, 1999, the Company owned, by lease or in fee, the following undeveloped acres, all of which are located in the Continental United States, as follows: Estimated FY 2000 United States Gross Acres Net Acres Delay Rentals - ------------- ----------- --------- ------------- Texas 95,155 64,631 $ 81,726 North Dakota 323,294 226,904 130,405 South Dakota 32,244 20,281 3,085 Montana 25,163 15,759 1,440 ----------- --------- ------------- Totals 475,856 327,575 $ 216,656 ========== ========= =============
Five Texas leases totaling approximately 66,000 gross acres contain varying requirements to drill a well every 90 to 150 days to keep the respective lease in effect. The Company is presently drilling under the terms of the leases and expects to keep the leases in force by continuous development during the year.
Drilling Activity
During fiscal 1999, the Company's drilling activity increased to 10 wells compared to 7 in 1998. The following table sets forth the Company's drilling activity for the last three fiscal years:
The Company had an interest in 2 wells (1.38 net) in progress at August 31, 1999. Fiscal years 1998 and 1997 well totals include completed or dry wells commenced in the respective prior year.
Maverick Basin
Throughout 1999, the Company has pursued its strategy to expand its core Maverick Basin producing properties. In addition to using its internally generated working capital for exploration and development activities, TXCO has accelerated its growth by entering into strategic joint ventures or operating agreements targeted at leveraging the Company's increased leasehold values, recognized technical abilities and exploration success in its core area of interest. TXCO entered into several new joint venture or joint operating agreements during the year whereby the Company successfully teamed with qualified industry partners who contributed investment capital, mineral leases, 3-D seismic data and/or offered the Company a carried interest in mineral leases, 3-D seismic acquisition programs and wells to be drilled. These contributions were made in exchange for TXCO's geophysical, geological and operational expertise, and in certain instances, in exchange for a portion of the Company's non-producing oil and gas lease interests .
During September 1998, the Company entered into a joint operating agreement (JOA ) with Ashtolla Exploration Company, Inc., whereby TXCO earned a 63% working interest in Ashtolla's 8,800 acre Alkek lease adjoining TXCO's Paloma lease, together with rights to an existing 3-D seismic survey over the subject block. In exchange, TXCO agreed to drill a well to test the Glen Rose interval, allowing the previous operator to meet the operational requirements under the terms of the original lease agreement. Two wells were drilled under this JOA during the year resulting in 1 marginal gas well completion, while the second well was awaiting completion at year end.
Also in September 1998, the Company entered into a JOA with the Picosa Creek Partnership, whereby TXCO was given access to an existing 3-D seismic survey over the 12,800 acre Chittim lease which adjoins its Paloma lease. The Company earns a 25% interest in any Glen Rose reef wells it proposes and drills after reprocessing and interpreting the new 3-D seismic data. One well was drilled and completed as an oil producer under this JOA during the year, while a 2nd well was drilled and is being completed as a gas well in November 1999 .
In November 1998, the Company finalized a JOA with Ameritex Ventures, II Ltd., a joint venture owned 85% by Enron Capital, allowing Ameritex and its partners to earn up to a 50% interest in TXCO's existing 17,000 acre Kincaid lease in exchange for their funding 100% of the costs of and commencement of a 27 square mile 3-D seismic program on parameters established by TXCO over the entire 17,000 acre tract. While the terms reduced the Company's remaining interest in the non-producing lease to 50% in shallow zones, it provided for TXCO to keep 100% of its deeper rights, including the deep Jurassic interval. Upon completion of the 3-D seismic acquisition program, 1 well was drilled and was being completed at year end.
In May 1999, the Company finalized a JOA with Castle Exploration Company, a wholly owned subsidiary of Castle Energy Corporation, (Nasdaq:CECX) whereby Castle committed to provide TXCO with up to $5,3000,000 to fund 100% of the initial costs to purchase leases, acquire 3-D seismic and drill up to 12 Glen Rose reef wells on targeted acreage contiguous to TXCO's productive Paloma lease. TXCO was named as operator, and contributed its interest in its 8,800 acre Alkek lease in exchange for shared rights to all 3-D seismic acquired, a 25% carried interest in the initial 12 wells drilled, a 50% interest in initial lease acquisitions, and the right to participate with up to a 50% interest in all future wells to be drilled on the leases. By year end, TXCO had leased or held options totaling 31,700 acres adjoining it's Paloma lease acreage. Through November 1999, all 3-D seismic acquisition work was completed over most of the acreage tract. Initial review of the completed data set by TXCO's exploration team confirmed the presence of Glen Rose patch reefs scattered across the block. Management expects to propose its initial selection of drilling locations utilizing the new seismic data during the second quarter of fiscal 2000, with drilling to commence immediately thereafter. In October 1999, TXCO drilled the first well under the terms of the JOA. The well did not encounter sufficient quantities of gas, so Castle elected not to complete the well.
In August 1999, the Company closed an agreement with Peacock-Maverick Drilling and Peacock Exploration to purchase their interests in producing wells and oil and gas leases totaling 24,500 acres in exchange for 325,000 shares of TXCO common stock valued at $493,594. The purchase included a 12.5 % working interest in the 12,800 acre Chittim lease, including a similar working interest in 6 producing oil and gas wells located thereon. The acreage is contiguous to TXCO's Paloma lease. In addition, the Company received a 100% working interest in two leases totaling 11,700 acres located within 5 miles of the other tracts.
In September 1999, the Company completed negotiations and entered into a JOA with Blue Star Oil and Gas, Ltd., for an extensive exploration project targeting the deep Jurassic interval underlying TXCO's Maverick Basin lease block. Under its terms, Blue Star paid TXCO a cash consideration upon closing and will initially fund 100% of the costs of a 58 square mile 3-D seismic acquisition program covering over 37,000 acres of TXCO's Paloma and Kincaid leases. In addition, Blue Star will fund 100% of the costs of drilling 2 exploratory wells to test the underlying deep Jurassic interval. Blue Star is also obligated to provide, at TXCO's selection, a similar amount of new 3-D seismic survey data which Blue Star is in process of acquiring on its 191,000 acre Chittim Ranch Lease which lies adjacent to TXCO's Paloma lease. Should both wells be drilled timely, Blue Star will earn a 50% interest in the deep rights in both leases totaling 50,000 acres. TXCO will keep a working interest in future Jurassic wells drilled under the agreement varying between 15% to 50%, depending on the location of future wells. Should initial drilling not occur within certain deadlines ending in fiscal year 2000, Blue Star will be obligated to pay $900,000 to TXCO to maintain its rights under the agreement.
By the end of fiscal year 1999, the Company had extended its 3-D seismic database over an expanded area of its core producing leases by 68,000 acres, more than doubling the size of its existing seismic database at the end of the previous year. By the end of the 1st quarter of fiscal 2000, that number grew to over 93,800 acres or over 148 square miles. The Company currently has two consulting geophysicists engaged in interpretation of the new data. Management expects to identity a significant number of new 3-D defined drilling prospects in numerous horizons throughout its Maverick Basin leases further adding to its multiyear drilling prospect inventory.
Williston Basin
The Company did not participate in drilling any Williston Basin wells during 1999. While the depressed oil and gas price environment in fiscal year 1998 and 1999 have impacted all of the Company's operations, the Williston Basin operations were impacted the most. Realized prices for the Company's North Dakota crude oil dropped from its high of $22.52 in November 1997 to a low of $8.30 in December 1998 and back up to $18.22 in August 1999. These lower prices, combined with high unit production costs at current production levels, have resulted in failed economics on several of the Company's Williston Basin producing properties. The Company curtailed its capital spending program in the area during midyear 1998 and has continued implementing its cost reduction plan through all of 1999. Curtailed current period expenses included non-payment of lease renewals or expired leases totaling over 110,000 acres of leases in Montana, North and South Dakota, targeting primarily those leases not covered under existing 3-D seismic programs or otherwise not possessing known distinguishing features of particular significance.
At year end, the Company continued its evaluation of all operations in the Williston Basin, with particular emphasis on their continued economics resulting from the instability in oil prices. The review also identified oil leases targeted for impairment, totaling over 34,800 net acres in North and South Dakota, with primary expirations prior to August 31, 2000. The Company determined it was reasonable and conservative to charge future monthly period earnings with a ratably computed impairment for the lease acreage which is expected to expire during the upcoming year.
Forward-looking statements in this 10-K are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that all forward-looking statements involve risks and uncertainty, including without limitation, the costs of exploring and developing new oil and natural gas reserves, the price for which such reserves can be sold, environmental concerns effecting the drilling of oil and natural gas wells, as well as general market conditions, competition and pricing. Please refer to all of TXCO's Securities and Exchange Commission filings, copies of which are available from the Company without charge, for additional information.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not involved in any matters of litigation incidental to its business of a significant nature.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of the security holders of the Company during the 4th quarter of fiscal year 1999. During the 2nd quarter, on February 26, 1999, the Company held its Annual Meeting of Shareholders. The following matters were submitted for approval by vote at the meeting. All matters were approved by the shareholders vote and the results of the voting is shown below for each matter.
1. Election of Directors: For Against Stephen M. Gose, Jr. 14,060,208 93,637 Thomas H. Gose 14,060,143 93,702 James E. Sigmon 14,060,208 93,637 Michael Pint 14,060,208 93,637 Robert L. Foree, Jr. 14,059,698 94,147
The members of the Board of Directors do not serve staggered terms of office. There were no changes in Directors of the Company
2. Proposal for an amendment of the Company's 1995 Flexible Incentive Plan:
For Against Abstain Non-Voted 7,890,220 804,415 109,465 5,349,745
3. Proposal for the re-incorporation of the Company by changing state of incorporation of the Company from Colorado to Delaware.
For Against Abstain Non-Voted 8,665,755 252,566 9,798 5,225,726
4. Proposal for ratification of the adoption of Akin, Doherty, Klein & Feuge, P.C., as independent Auditors for the Company for the fiscal year 1999.
For Against Abstain 14,111,145 34,530 8,170
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The following is a range of high and low bid prices for the Company's common stock for each quarter of the last two years based upon bid prices reported by the National Association of Securities Dealers Quotations system under the call symbol "TXCO": Range of Bid Prices Quarter ended: High Low
August 1999 $ 2.94 $ 1.00 May 1999 1.41 .75 February 1999 1.50 .62 November 1998 1.41 .75
August 1998 $ 1.94 $ 1.16 May 1998 2.81 1.69 February 1998 3.50 1.63 November 1997 8.44 2.50
As of November 1, 1999, there were approximately 1,697 holders of record of the Company's Common Stock. The transfer agent for the Company is EquiServe, Boston, Massachusetts. The Company has not paid any cash dividends on its Common Stock and does not expect to do so in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information is derived from and qualified in its entirety by the Financial Statements of the Company and the Notes thereto as set forth in this Annual Report on Form 10-K commencing on page.
(1) Amounts reflect adjustments in 1995 for the reclassification of ExproFuels as an equity investment due to its spin-off in 1996.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion of the Company's financial condition and results of operations. This discussion should be read in conjunction with the Financial Statements of the Company and Notes thereto.
CAPITAL RESOURCES AND LIQUIDITY - ---- During the year ended August 31, 1999, beginning cash reserves of $2,329,236 were increased by net cash provided from operating activities of $3,858,204 resulting in a total of $6,187,440 in working capital available for use in funding the Company's ongoing development and exploration of its oil and gas properties. The ongoing positive cash flow from operations throughout the year significantly improved the Company's ability to increase its core revenues from oil and gas operations, thereby enhancing its ability to overcome the impact of weak oil and gas prices through most of 1999. An additional $900,000 was obtained during the year, under the existing financing agreement with Range Energy Finance Corporation, bringing total borrowings from Range to $4,400,000. The financing was specifically for ongoing development of the Company's natural gas producing properties in Maverick County, Texas.
The Company applied $3,448,320 of its working capital to fund the expansion and ongoing development of its oil and gas properties. Included were drilling and completion costs of $2,791,544 for current year drilling of 10 Maverick Basin gas and oil wells, plus costs associated with 2 wells drilled during the last quarter of 1998. Also included were $211,101 in 3-D seismic acquisition and reprocessing costs and $390,000 in lease extension payments to maintain non-producing lease acreage in the Company's growing Maverick Basin lease block.
The Company made timely payments on long term debt of $2,629,118 during 1999, including $1,966,956 paid on the Range financing agreement. Scheduled payments totaling $662,162 were made on the Company's remaining long-term notes during the remainder of the year.
During the 3rd quarter of 1999, TXCO successfully entered into a joint venture agreement with Castle Exploration Company, (Castle) a wholly owned subsidiary of Castle Energy Corporation (Nasdaq:CECX), whereby Castle agreed to fund up to $5,300,000 for 100% of all costs to acquire approximately 25,000 acres of additional leases, fund a 42 square mile 3-D seismic survey and drill up to 12 gas wells. In exchange, TXCO contributed its interest in an 8,800 lease to the venture, was named operater and will be carried at no cost, for a 25% interest in the first 12 wells drilled. Additionally, TXCO will be licensed to share in all seismic data gathered and will earn a 50% working interest in all leases acquired with the funds. At year end, all 3-D seismic acquisition and processing had been completed, and Company geologists and geophysicists were in process of interpreting and evaluating the new data.
During the 4th quarter of 1999, the Company successfully closed another non-cash transaction to acquire various oil and gas mineral interests near or adjoining TXCO's Maverick Basin leasehold. In exchange for 325,000 shares of its restricted common stock valued at $493,594, the Company purchased a 12.5% interest in 12,800 acres known as the Chittim Lease, including a 12.5% working interest in 6 producing oil and gas wells and associated equipment. In addition, TXCO also received a 100% working interest in two separate leases totaling approximately 11,700 acres.
As a result of these activities, the Company ended fiscal year 1999 with negative working capital of $1,525,594 and a current ratio of .70 to 1. This compares to positive working capital of $516,693 and a current ratio of 1.19 to 1 at August 31, 1998. Working capital weakened during 1999 primarily due to cash outlays for its aggressive ongoing development activities and due to timely payments made under the terms of the Range financing agreement. Although the Company had a working capital deficit at year end, included in current liabilities is $2,110,620 estimated as the debt payment for fiscal 2000 under the Range financing agreement. The Range debt payments are only due and payable out of each future month's net cash flow from the collateralized producing wells. Should producing well cash flows be less than estimated, the debt repayment will be less, while the reverse is true should cash flows be greater. Due to the Company's drilling success in 1998 and 1999, it expects substantially all of the Range debt to be repaid during fiscal year 2000. Management is confident of the Company's ability to continue to generate positive cash flow from operations, and in its ability to meet its ongoing operating cash requirements.
- ---- During the year ended August 31, 1998, beginning cash reserves of $6,198,069 were reduced by net cash used in operating activities of $1,185,050 resulting in a total of $5,013,019 in working capital available used in funding the Company's ongoing development and exploration of its oil and gas properties, significantly improving the Company's potential to increase its core revenues from oil and gas operations, and enhancing its ability to overcome the impact of continued weakness in oil and gas prices.
Throughout fiscal 1998, the Company pursued opportunities to enhance its liquidity by the conversion of existing short term trade payables to long-term debt and the conversion of debentures into common stock. Management successfully converted 4 separate accounts totaling $1,684,000 in current trade payables into separate notes, with payment terms ranging from 12 to 36 months and interest accruing at rates ranging from 8% to 14%. Further improvements to the Company's debt structure were realized by Management's election to exercise the Company's option to convert its outstanding $4,000,000 debentures to equity. Effective January 1, 1998, the Company issued 844,318 shares of its common stock in exchange for the outstanding debentures, including accrued interest of $221,590, at the conversion price of $5.00 per share. In addition to the extremely favorable conversion price for the new issuance, and the elimination of $240,000 in future annual interest expense, Management's elimination of its primary long-term debt significantly enhanced the Company's ability to pursue additional sources of equity or debt-based working capital.
Late in the final quarter of 1998, the Company entered into a financing agreement with Range Energy Finance Corporation, a subsidiary of Range Resources Corporation (NYSE:RRC), (formerly Domain Energy Corporation) to initially establish a borrowing ceiling of $4,000,000. During fiscal year 1999 the borrowing ceiling was increasd to $4,400,000. The financing was specifically for ongoing development of the Company's natural gas producing properties in Maverick County, Texas. Funds were advanced in exchange for a limited term overriding royalty interest tied to existing and future production from specified depths underlying certain of the Company's oil and gas leases in Maverick County. Terms provided for repayment of the funds, with interest at 18%, from a specified portion of sales proceeds from all existing and future wells to be drilled on the Paloma lease. By August 31, 1998 the Company had borrowed $3,500,000 under the agreement.
Throughout the year ended August 31, 1998, the Company applied $4,806,505 of its available working capital to fund the ongoing development of its oil and gas properties. This included drilling and completion costs of $3,385,720 associated with the current year drilling of four new Maverick Basin gas wells, three new Williston Basin oil wells and costs associated with 4 wells drilled prior to the current fiscal year, plus $188,785 for completion of the newest segment of the Company's new gas gathering system in Maverick County during 1998. Also included were 1998 3-D seismic acquisitions totaling $711,294 over Company leases in North Dakota and $153,845 on the Paloma lease in South Texas. Additional investments in non-producing lease acreage totaled $366,861 for the year.
Additionally, the Company made payments on its long-term debt during the year of $1,500,990. Included in the total was $940,481 paid during the first quarter, in full prepayment of the Company's outstanding line of credit with Luzerner Kantonalbank. Scheduled payments totaling $560,509 were made on the Company's remaining long-term notes during the remainder of 1998.
As a result of these activities, the Company ended fiscal year 1998 with positive working capital of $516,693 and a current ratio of 1.19 to 1. This compares to positive working capital of $3,760,648 and a current ratio of 2.32 to 1 at August 31, 1997. While the Company's working capital position weakened from the previous year, the results of the Company's dramatic 100% drilling success ratio during 1998 for new Glen Rose wells became evident during the first quarter of fiscal year 1999. As new wells were placed on production, Management was assured in its confidence of continuing significant improvements in the Company's ability to meet its ongoing operating cash requirements.
- ---- During the first quarter of 1997, the Company converted $933,485 of its debt into 340,060 shares of common stock and raised an additional $525,000 cash through the exercise of common stock warrants and sales of common stock.
During the second quarter of fiscal 1997, the Company successfully closed a large transaction that resulted in its acquiring an additional 220,000 net acres of undeveloped oil and gas acreage in the Williston Basin of North and South Dakota and Montana for $22,000,000 cash and the issuance of 1,000,000 shares of restricted common stock. Simultaneous with the acquisition, the Company sold a 42.5% net profits interest in future wells on the acreage for $17,000,000 cash. Concurrent with the acquisition of undeveloped acreage and sale of the net profits interest, the Company received from the same acquiring parties $4,000,000 cash for a debenture convertible into the Company's common stock at $5.00 per share. During the same quarter, the Company completed an offering under Regulation S by successfully selling 2,800,000 shares of its common stock for $14,000,000 and also converted $1,331,212 in previously issued convertible debentures into 532,488 shares of common stock. The result of the above transactions was to significantly enhance the Company's operating position by giving it additional acreage to develop as well as the working capital with which to drill.
For the entire year, the Company raised $15,007,400, net of expenses, through common stock sales and converted $2,264,702 of convertible debentures into common stock (and thereby eliminating an on-going cash outlay for interest as well as the future repayment of the debt). The Company also raised $17,000,000 through the sale of the net profits interest in future Williston basin wells to be drilled and raised an additional $5,000,000 through new debt financing, which included proceeds from the sale of $4,000,000 in convertible debentures plus proceeds from its existing $1,000,000 line of credit. A portion of this new capital was used to finance the second quarter acquisition of the Company's additional 220,000 net acres of Williston Basin oil leases purchased for $22,000,000 cash plus 1,000,000 shares of the Company's common stock. Proceeds were also used to fund the Company's loss for the year of $3,398,866, including the payment of interest of $236,000, payments on current portion of debt and capital leases of $210,000 and for capital and investment expenditures of $14,196,000. Capital expenditures included approximately $115,000 in equipment, $125,000 in drilling bonds and deposits, $200,000 in prepaid loan fees and cumulative advances to ExproFuels totaling $826,000. Most significantly, $12,924,000 was invested in the development of the Company's oil and gas properties, including the drilling of four Maverick Basin wells in Texas, 11 Williston Basin wells in North Dakota, the acquisition of $780,000 of 3-D seismic data and $279,000 for expansion of the Company's Maverick County natural gas pipeline infrastructure.
At August 31, 1997, the Company had cash of $6,198,069 and working capital of $3,760,648, on current assets of $6,609,579 and current liabilities of $2,848,931. This compared to a cash position of $967,838 and a working capital deficit of $33,624 at August 31, 1996.
2000 Capital Requirements - ------------------------- The major components of the Company's plans, and the requirements for additional capital at August 31, 1999, include the following:
Maverick Basin Activity: During fiscal 2000, the Company's plans to drill a minimum of 9 additional wells, in keeping with lease renewal minimum requirements, with a total drilling budget of $2,000,000. Two of these wells are scheduled to be drilled under and funded by the Castle project at no cost to TXCO. The remaining 7 wells are targeted as Glen Rose reef prospects, each costing approximately $225,000 to 275,000 to complete or $160,000 as a dry hole. Company engineers are planning to test other formations with horizontal drilling techniques with the hope of unlocking additional reserves not previously productive from vertical drilling, due to the formations' low permeability. The horizontal drilling increases the typical gross completion cost of a well by $150,000 to $300,000, with the Company's share being approximately $90,000 to $180,000. In the event of continuing improvements in realized oil and gas prices, the Company can accelerate its drilling program as additional internally generated working capital becomes available during the year. It can also accelerate the Castle program as directed by the funding partner during the year. Estimated expenditures required to maintain the Company's interest in its remaining undeveloped South Texas leasehold acreage for fiscal 2000 are $269,000.
The Company has effectively layed off a significant portion of the capital requirements for which it would have otherwise had to provide funding for during fiscal 2000 and 2001. This capital outlay reduction was made possible by the carried interest feature included in two key strategic joint ventures it entered in during 1999. TXCO will be carried for a 25% interest in the next 11 wells proposed to be drilled under its joint operating agreement with Castle Exploration Company. Upon completion of the new 3-D seismic data set's interpretation, the results from the new 31,700 acre 3-D seismic survey should generate a number of new drillable Glen Rose reef prospects in excess of TXCO's internal drilling program. In addition, all of TXCO's currently remaining 3-D seismic expenditures for both the Castle project and the Blue Star Jurassic project are covered entirely by its partners.
Williston Basin Activity: Due to the continuing uncertainty in crude oil prices and unattractive economics for continued exploration, the Company has deferred further expenditures in the Williston Basin, except for maintaining existing producing properties and the payment of delay rentals and lease extensions on selected leases. Management will continue its efforts to offer its remaining prospects to other industry operators. Delay rentals required to maintain the Company's interest in its remaining undeveloped Williston Basin leasehold acreage for fiscal 2000 are $135,000.
Summary of Capital Resources and Liquidity
Subsequent to the end of fiscal 1999, the Company successfully drilled two wells, completing one as a Georgetown formation gas well in October 1999. Drilling on the second well was completed in November 1999, with electric logs indicating the well encountered a 55 foot section of Glen Rose reef which appears to be gas productive. The Company's net revenues from both wells should increase by $500,000 to $750,000 per year.
While management is confident it has identified sufficient sources of working capital to carry out its current exploration and development plans on its Texas leaseholds, as well as to meet its obligations in the ordinary course of business through the end of the new fiscal year, there is no assurance that energy prices will either continue to improve or return to their weakened positions as they were during the first half of 1999. Should prices weaken, the reduction in revenues could cause the Company to re-evaluate its expected sources of working capital and reduce its current operating plans. Management is actively involved in ongoing discussions with various domestic and foreign based sources of debt and equity financing that could provide favorably structured funding as required to increase the Company's planned drilling activity during fiscal year 2000. Management remains confident that financial resources will remain available, enabling the Company to continue the rapid development of its oil and gas properties and continue to meet its normal operational and debt service obligations.
Year 2000
Over the last three years the Company has replaced or upgraded most of the core management information systems used in the Company's business. The Company has conducted a review of these systems to verify their compliance with Year 2000 date codes. In addition, the Company has conducted an inventory, review and assessment of its desktop computers, networks and servers, software applications and packages, and products and services provided by third parties for internal operations to determine whether or not they support Year 2000 date codes. The Company believes it has successfully completed required modifications to all mission critical applications included in its internal systems. In addition, the Company has contacted its major gas purchasers, gas pipeline carriers, stock transfer agent and banking institutions and received written assurances and/or viewed assurances on their websites that they have no material Year 2000 problems. The Company does not believe the Year 2000 issue will materially affect its ability to pay its vendors and suppliers, track its assets in the custody of financial institutions or otherwise prevent it from conducting its business on an ongoing basis.
RESULTS OF OPERATIONS
1999 Compared to 1998
The Company reported net income of $931,545 or $0.06 per diluted share for the year ended August 31, 1999, compared to a net loss of ($ 8,417,218) or ($0.55) per diluted share for the same period in 1998. The attainment of profitability was primarily the result of a 146% increase in revenues over 1998 levels due primarily to significant new production from 9 new wells placed on line during the year, including 2 gas wells completed late in the last quarter of the prior year. While very positive, the increases were significantly offset by the weakness in oil and gas prices through the first half of 1999. Gas sales volume increases also reflect the impact of the first full year of operation of the expanded gas gathering system completed during the latter part of 1998.
Exploration expenses decreased by 88% compared to 1998 levels due to the high drilling success in the Maverick Basin compared to multiple Williston Basin dry holes drilled or abandoned during the prior year. Abandoned leases and equipment expense decreased by 78% primarily to the non-recurring nature of the one time charge off of uneconomical producing properties during 1998 due to the oil and gas price collapse during 1998. Impairment expense decreased by 92% also due to the non-recurring nature of the initially large impairment provisions required due to the oil price collapse in the prior year, while lower 1999 impairment provisions proved adequate in light of the improvement in realized oil and gas prices during the last half of the current year. Depreciation, depletion and amortization increased by 61% over 1998 levels due primarily to an increase in depletion. The change in depletion was due to the adverse impact on year end reserve estimates caused by declining oil production and increasing water disposal costs associated with Williston Basin production.
The decrease in loan fee amortization expense as compared to 1998, reflects the non-recurring nature of the prior period's recognition of $180,000 in previously capitalized prepaid loan fees due to the conversion of a $4,000,000 debenture in January 1998. Fiscal 1998 loan fee amortization expense has been reclassified for comparative purposes with current year expense. Interest expense increased by 142% over 1998, reflecting a full year of interest charges on borrowings under the Range financing agreement entered into during the last quarter of the prior year.
1998 Compared to 1997
Revenues from oil and gas sales increased 195% over 1997 as a result of significant new production from the successful completion of the nine new wells during the last part of the 1997, plus the additional production from 4 new gas wells added during 1998. Lease operating expenses, related directly to the costs of operating the newly producing Williston Basin oil wells with very high production associated water disposal costs, increased by 297% over 1997. The disproportionately higher increase in lease operating expense increases reflects the difference in the Company's normal natural gas production expense level versus the significantly higher per unit production cost associated with its Williston Basin oil production.
Exploration expenses, including the costs of unsuccessful wells increased by 47% due to the write-off of two high working interest dry holes during the year compared to two very low working interest dry-holes in the previous year. The 40% fall of oil prices at mid-year rendered the completion of the wells uneconomical. Abandoned leases and equipment increased to $1,451,880, reflecting the ongoing impact of the 40% fall of oil prices during the year that rendered marginal properties uneconomic to maintain or renew. Included in the non-cash charge off for the current year are $608,573 in Williston Basin leases, $156,670 in Zavala County leases (South Texas), and $26,757 in Canadian Crown leases, all determined to be uneconomic and expiring during the current year due to the continued impact of low oil and gas prices. Also included in the 1998 non-cash writeoff was the remaining capitalized costs $659,880 for the Kincaid #1-99, a horizontal Georgetown test well drilled in Maverick County during the third quarter of 1997 that failed to produce economic quantities of gas.
Pursuant to the Successful Efforts Method of accounting for mineral properties, the Company periodically assesses its producing properties and non-producing mineral leases for impairment. Based on the 40% fall in oil prices during the year and the resulting impact on the updated reserve estimates at year end, the Company identified certain producing properties which required impairment. Additionally, non-producing leaseholds were reviewed for potential impairment. Certain leases, with expiration dates through December 1999, were identified which will not be renewed. Non-cash impairment charges totaling $3,655,342 were recorded at year end including $1,580,820 of Williston Basin and Texas non-producing leases set to expire through calendar year 1999. Additionally, a $2,194,522 impairment was recorded reflecting the excess of unamortized book value over the future realizable reserves primarily related to certain of its Williston Basin wells. Additional expenses during the year include depreciation, depletion and amortization of 1,446,726, plus current year exploration expenses of $2,290,649.
Except for the statutory, intangible (non-cash) expenses required for compliance reporting purposes described above and current year exploration expenses, actual operating activities for the year ended August 31, 1998 resulted in positive cash flow from producing operations of $989,484. This level of positive cash flow, if sustained, is sufficient to provide for funding of the Company's primary administrative operations. Management feels confident this source of internally generated working capital will continue to grow as the Company's Texas gas production levels expand through fiscal 1999 and beyond.
General and administrative costs increased to $1,278,270 from $938,000. Increases in salaries totaling approximately $211,000 were due primarily to a full twelve months of wages in 1998 for the increased number of new employee positions required by the Company's expansion in operations as a result of the Williston Basin lease acquisition versus only a partial year for the previous year. The $184,692 decrease in interest income in 1998 reflects the lower cash levels in interest bearing accounts during 1998 versus the prior year.
1997 Compared to 1996
Revenues from oil and gas sales increased 115% over 1996, to $976,000 from $455,000, as a result of significant new production from the successful completion of the nine new wells during the last part of the year. Lease operating expenses, related directly to the costs of operating the producing wells, accordingly increased to $176,000 from $75,000 in 1996. Exploration expenses, which includes the costs of unsuccessful wells, increased by 129% to $1,549,000 from $677,170, with $965,000 in dry hole costs related to the James #1-9F. The well was in the process of drilling at August 31, 1997, but subsequently did not produce sufficient hydrocarbons to be economically viable. Although the Company may re-enter the well and drill another lateral in a different direction, all costs related to the James #1-9F were accrued and included in fiscal 1997 operations as a loss, in accordance with generally accepted accounting principles.
Other costs included non-cash expenses of $153,000 in abandoned leases, primarily represented by certain expired acreage in Canada, as well as depletion and depreciation of $293,000. General and administrative costs increased to $938,000 from $513,000 due primarily to increased salaries for new employee positions required by the Company's expansion in operations as a result of the Williston Basin lease acquisition. Although interest expense decreased by $141,500, this was almost all offset by the write-off of deferred financing fees on debt converted during the year.
In total, revenues increased $561,000 or 108%, to $1,083,000 in 1997 from $521,000 in 1996. Cost of sales, including exploration expenses, general and administrative expenses, and abandoned leases, increased 119%, to $3,210,000 in 1997 from $1,465,000 in 1996, resulting in an increase in the Company's loss from its oil and gas operations to $2,127,000 in 1997 from $943,000 in 1996. The Company also incurred a loss on its investment in ExproFuels of $1,215,000 compared to $680,000 in 1996. However, since this investment has been written down to zero dollars, and no additional cash advances are expected after December 31, 1997, (advances committed to ExproFuels of $265,000 for September 1, 1997 to December 31, 1997 were accrued at August 31, 1997) operations should not suffer from this investment in future periods. As a result of the above, loss from operations increased to ($3,342,000) in 1997 from ($1,624,000) in 1996.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
None - See additional comments pertaining to certain business risk on page 8.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements and Notes thereto are set out in this Form 10-K commencing on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information regarding the directors and executive officers of the Company, as of November 10, 1999:
Stephen M. Gose, Jr., has served as Chairman of the Board of Directors of the Company since July 1984. He has been a member of the Audit and Compensation Committees since June 1997 and served as their Chairman through April 1998. He has been active for more than 45 years in exploration and development of oil and gas properties, in real estate development, and in ranching through the operations of Retamco Operating, Inc., its predecessors and affiliates. Mr. Gose also serves as Chairman of the Board of Directors of ExproFuels, Inc.
Michael Pint has served as a Director since May, 1997. He has been a member of the Audit and Compensation Committees of the Board of Directors since June, 1997 and has served as their Chairman since April, 1998. Since 1995, Mr. Pint has served as a Director of Valley Bancorp, Inc. and Valley Bank of Arizona, Inc. of Phoenix, Arizona and Midway National Bank of St. Paul, Minnesota. Previous bank regulatory and management positions include a four year term as Commissioner of Banks and Chairman of the Minnesota Commerce Commission from 1979 to 1983 and Senior Vice-President and Chief Financial Officer of the Federal Reserve Bank of Minneapolis, Minnesota through 1983.
Robert L. Foree, Jr. has served as a Director since May, 1997 and as a member of the Audit and Compensation Committees of the Board of Directors since June, 1997. Since 1992, Mr. Foree has served as President of Foree and Company, a Dallas, Texas based independent oil and gas exploration and production company.
Thomas H. Gose has served as a Director of the Company since February, 1989, as Secretary from 1992 through May, 1997 and as Assistant Secretary since May, 1997. He formerly served as Director, CEO and President of Retamco Operating, Inc., (a large shareholder of the Company) its predecessors and affiliates, since 1987. He also serves as President and Director of ExproFuels, Inc. Thomas H. Gose is the son of Stephen M. Gose, Jr.
James E. Sigmon has served as the Company's President since February 1985. He has been a Director of the Company since July 1984. He served as a Director of ExproFuels, Inc. through November 1998. Prior to joining the Company, Mr. Sigmon served in the management of a private oil and gas exploration company active in drilling oil and gas wells in South Texas.
Roberto R. Thomae has served as Chief Financial Officer and Vice President-Finance of the Company since September 1996 and as Secretary/Treasurer since March 1997. From September 1995 through September 1996 he was a consultant to the Company in a financial management capacity. From 1989 through 1995 Mr. Thomae was self- employed as a management consultant primarily involved in the development of domestic and international oil and gas exploration projects and the marketing of refined products.
Richard A. Sartor has served as Controller of the Company since April 1997. A Certified Public Accountant since 1980, Mr. Sartor owned his own private accounting practice from 1989 through March 1997.
Each of the aforementioned Executive Officers and/or Directors have been elected to serve for one year or until his successor is duly elected.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Information: The following table contains certain information for each of the fiscal years indicated with respect to the chief executive officer and those executive officers of the Company as to whom the total annual salary and bonuses exceed $100,000:
(1) Amounts represent income from an overriding royalty interest.
(1) The fair value for all options granted, whether vested or not, was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumption: risk-free interest rate of 5.0%; dividend yield of 0%; volatility factors of the expected market price of the Company's common stock of .95 and a weighted-average expected life of the option of five years.
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION/SAR VALUES
(1) Value of unexercised options calculated as the difference in the stock price at August 31,1999 and the option price. None of these unexercised options were "in the money" at August 31, 1999 and/or were not vested; accordingly the options are valued at $0 at year end.
(2) 100,000 of Mr. Sigmon's unexercised options were exercisable as of August 31, 1999, and the remaining 600,000 options vest and are exercisable in specified amounts upon the Company's common stock attaining the following price levels: 200,000 shares at $5.00, 100,000 shares at $7.50, 100,000 shares at $10.00, 100,000 shares at $12.50 and 100,000 shares at $15.00.
(3) 50,000 of Mr. Pint and Mr. Foree's options, respectively, were exercisable as of August 31, 1999.
(4) 50,000 of Mr. Thomae's options were exercisable at August 31, 1999.
COMPENSATION OF DIRECTORS
Members of the Board of Directors who serve as Executive Officers of the Company are not compensated for any services provided as a Director. Outside (non-employee) Directors of the Company are paid a fee of $1,000 for each board meeting physically attended or $250 for telephonic attendance plus reimbursement of related travel expenses. Additionally, upon assuming Director status, the two outside directors were awarded 10 year options for the purchase of 75,000 shares of Company common stock at 110% of the stock's market value on the date of grant, with such options vesting equally over their first three years of service.
EMPLOYMENT CONTRACTS
The Company has an employment agreement with its president, Mr. James E. Sigmon, which sets his salary at a minimum of $150,000 annually, and includes the grant of a proportionately reduced 1% overriding royalty interest under all leases the Company has or acquires during his term as President. The agreement is cancelable with 90 days notice by the Company.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No Compensation Committee interlocks existed during the Company's last completed fiscal year. The Compensation Committee of the Board of Directors of the Company was established in June, 1997 and consists of Michael Pint (Chairman), Robert L. Foree, Jr. and. Stephen M. Gose, Jr. The principal function of the Committee is to approve the compensation of all executive officers of the Company, to recommend to the Board the terms of principal compensation plans requiring stockholder approval and to direct the administration of the Company's 1995 Flexible Incentive Plan.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following tables set forth beneficial ownership of the Company's common stock, its only class of equity security. The percent owned is based on 15,938,516 shares outstanding and 17,490,816 fully diluted shares which includes 1,552,300 shares under options and warrants as of November 1, 1999.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
The following table sets forth information concerning all persons known to the Company to beneficially own 5% or more if its common stock, including information filed pursuant to Rule 13d filings made available to the company during the year.
Percent Owned Name and Address of Number of Shares Primary Shares Beneficial Owner Beneficially Owned Outstanding ------------------------------------------ ------------------ -----------
Thomas H. Gose ............................ 1,094,101 6.86% 500 North Loop 1604 East Suite 250 San Antonio, TX 78232
Stephen M. Gose, Jr ....................... 1,176,600 7.38% HCR Box 1010 Hwy 212 Roberts, Montana 59070
Trianon Opus One, Inc. .................... 1,400,000 8.78% Fohrenstrasse 25 CH-8703 Erlenbach Switzerland
Pensionskasse der F. Hoffman La Roche A.G . 1,074,600 6.74% Funds I & II Grenzacherstrasse 124 4070 Basel Switzerland
SECURITY OWNERSHIP OF DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth the number of shares of common stock beneficially owned as of November 1, 1999 by each director, each executive officer named in the Summary Compensation Table and by all directors and executive officers as a group. Information provided is based on the Form 4's, stock records of the Company and the Company's transfer agent.
Number of Shares Percent Name Beneficially Owned Owned (1) -------------------------- ------------------ ---------
Stephen M. Gose, Jr. ....... (3) 1,176,600 7.38% Thomas H. Gose .............. 1,094,101 6.86% James E. Sigmon ............. (2) 750,000 4.51% Michael Pint ................ (4) 275,000 1.72% Robert L. Foree, Jr ......... (4) 61,000 .38%
All Directors and Executive Officers as a group ........... 3,431,701 20.35%
(1) Except as otherwise noted, the Company believes that each named individual has sole voting and investment power over the shares beneficially owned.
(2) The number of shares beneficially owned by Mr. James E. Sigmon includes 50,000 shares owned directly and 700,000 shares of the Company's Common Stock reserved for issuance through options issued under the Company's 1995 Flexible Incentive Plan.
(3) The number of shares beneficially owned by Mr. Stephen M. Gose, Jr. include 30,000 shares owned directly, plus his 100% interest, shared equally with his spouse, in 1,146,600 shares owned by Retamco Operating, Inc.
(4) The number of shares beneficially owned by Mr. Pint and Mr. Foree each includes 50,000 shares of the Company's Common Stock reserved for issuance under non-qualified options issued to outside directors of the Company exercisable at August 31, 1998 plus 225,000 and 11,000 respectively, of directly owned shares.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
During 1997, the Company purchased undeveloped oil and gas leases covering approximately 220,000 net acres for exploration in the Williston Basin of North and South Dakota and Montana. The acquisition was paid for with $22,000,000 cash and the issuance of 1,000,000 shares of common stock valued at $5 per share. A 67% interest in the leases was acquired from Retamco Operating, Inc., a company affiliated with two directors of the Company. Concurrently with the acquisition, the Company sold to third parties a 42.5% net profits interest in wells to be drilled on the oil and gas leases for $17,000,000 cash. The oil and gas leases acquired have been reported at the affiliates cost basis, which resulted in a reduction to the basis in the properties of $9,773,154 and a charge for the same amount to additional paid-in capital.
The Company's ExproFuels division was spun off from The Exploration Company on September 3, 1996 with a 40% equity ownership being retained. During 1997 the Company's net investment in ExproFuels, Inc. was reduced to $0 by recognition of a $1,215,259 charge to operations. ExproFuels has no remaining assets and no current operations.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) The following documents are being filed as part of this annual report on Form 10-K after the signature page, commencing on page.
(1) Financial Statements:
Independent Auditors' Reports. Balance Sheets, August 31, 1999 and 1998 Statements of Operations, Years Ended August 31, 1999, 1998 and 1997. Statements of Stockholders' Equity, Years Ended August 31, 1999, 1998 and 1997. Statements of Cash Flows, Years Ended August 31, 1999, 1998 and 1997. Notes to Financial Statements.
(2) Financial Statement Schedule for the years ended August 31, 1999, 1998 and 1997:
Schedule II - Valuation and Qualifying Reserves.
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or Notes thereto.
(3) Exhibits:
** 3.1 Articles of Incorporation of the Registrant filed as Exhibit 3(B) to the registration statement on Form S-1; Reg. No. 2-65661.
** 3.2 Articles of Amendment to Articles of Incorporation of The Exploration Company, dated July 27, 1984, filed as Exhibit 3.2 to Registrant's Annual report on Form 10-K, dated February 4, 1985. ** 3.3 Articles of Amendment to the Articles of Incorporation of the Exploration Company dated April 2, 1985. ** 3.4 By-Laws of the Registrant filed as Exhibit 5(A) to the Registration Statement on Form S-1; Reg. 2-65661. ** 3.5 Amendment to By-Laws of registrant, dated Sept 1, 1985. ** 3.6 Articles of Amendment to the Articles of Incorporation of The Exploration Company dated April 6, 1990. **10.2 Employment Agreement between the Registrant and James E. Sigmon, dated October 1, 1984. **10.3 Registrant's Amended and Restated 1983 Incentive Stock Option Plan filed as Exhibit A to registrant's definitive Proxy Statement, dated February 20, 1985. **10.4 Registrant's 1995 Flexible Incentive Plan, filed as Exhibit A to registrant's definitive Proxy Statement, dated April 28, 1995. **10.5 Registrant's Form S-8 Registration Statement for its 1995 Flexible Incentive Plan, dated November 26, 1996. **10.6 Registrant's Amendment to its 1995 Flexible Incentive Plan, filed as Proposal II of the registrants definitive Proxy Statement, dated Jan 12,1999. **10.7 Registrant's Plan and Agreement of Merger of The Exploration Company with and into The Exploration Company of Delaware, Inc., filed as Appendix A of the registrants definitive Proxy Statement, dated January 12, 1999. **10.8 Registrant's Certificate of Incorporation of The Exploration Company of Delaware, Inc., filed as Appendix B of the registrants definitive Proxy Statement, dated January 12, 1999. **10.9 Registrant's Certificate of Amendment of Certificate of Incorporation of The Exploration Company of Delaware, Inc., filed as Appendix C of the registrants definitive Proxy Statement, dated January 12, 1999. **10.10 Registrant's Bylaws of The Exploration Company of Delaware, Inc., filed as Appendix D of the registrants definitive Proxy Statement, dated January 12, 1999.
27.1 Financial Data Schedule
** Previously filed
(B) Reports on Form 8-K:
None Filed
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
THE EXPLORATION COMPANY OF DELAWARE, INC. Registrant
November 23, 1999 By: /s/ James E. Sigmon --------------------------------- James E. Sigmon, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders The Exploration Company San Antonio, Texas
We have audited the balance sheets of The Exploration Company of Delaware, Inc. (hereinafter referred to as "The Exploration Company") as of August 31, 1999 and 1998, and the related statements of operations, stockholders' equity and cash flows for each of the three years in the period ended August 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Exploration Company as of August 31, 1999 and 1998, and the results of its operations and cash flows for each of the three years in the period ended August 31, 1999, in conformity with generally accepted accounting principles.
We have also audited Schedule II of The Exploration Company for each of the three years in the period ended August 31, 1999. In our opinion, this schedule presents fairly, in all material respects, the information required to be set forth therein.
AKIN, DOHERTY, KLEIN & FEUGE, P.C.
San Antonio, Texas November 12, 1999
THE EXPLORATION COMPANY Balance Sheets August 31, 1999 and 1998
See notes to audited financial statements.
THE EXPLORATION COMPANY Balance Sheets August 31, 1999 and 1998
See notes to audited financial statements.
THE EXPLORATION COMPANY Statements of Operations Years Ended August 31, 1999, 1998 and 1997
See notes to audited financial statements.
THE EXPLORATION COMPANY Statements of Stockholders' Equity Years Ended August 31, 1999, 1998, and 1997
See notes to audited financial statements.
THE EXPLORATION COMPANY Statements of Cash Flows Years Ended August 31, 1999, 1998, and 1997
See notes to audited financial statements.
THE EXPLORATION COMPANY Notes to Audited Financial Statements August 31, 1999, 1998 and 1997
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Operations: The financial statements include the accounts of The Exploration Company (the Company) which is engaged in the business of acquiring, exploring and developing oil and gas properties. The Company=s oil and gas operations are located primarily in Texas, North Dakota and Montana.
During 1999, the Company changed its State of Incorporation from Colorado to Delaware and, as a result, changed its legal name to The Exploration Company of Delaware, Inc. However, the Company continues to conduct all business under the name The Exploration Company.
From 1993 through 1996, the Company operated in the alternative fuels industry through a division called ExproFuels.
Cash and Equivalents: Cash and equivalents consist of all demand deposits and funds invested in short-term investments with original maturities of three months or less. All of the Company's cash and money market accounts are maintained with Frost National Bank and AIM Institutional Fund Services, Inc. At year end, the Company did not have any cash equivalents in excess of insured limits.
Oil and Gas Properties: The Company uses the successful efforts method of accounting for its oil and gas activities. Costs to acquire mineral interests in oil and gas properties, to drill and equip exploratory wells that find proved reserves, and to drill and equip development wells are capitalized. Costs to drill exploratory wells that do not find proved reserves, geological and geophysical costs, and costs of carrying and retaining unproved properties are expensed as incurred.
Depreciation, depletion and amortization (DD&A) of oil and gas properties are computed using the unit-of-production method based upon recoverable reserves as determined by Company engineers. Oil and gas properties are periodically assessed for impairment, and if the unamortized capitalized costs of proved properties are in excess of the discounted present value of future cash flows relating to proved reserves, an impairment charge is recorded. Unproved properties are also evaluated periodically and if the unamortized cost is in excess of estimated fair value an impairment is recognized.
Other Property and Equipment: Transportation and other equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets ranging from five to fifteen years. Major renewals and betterments are capitalized while repairs are expensed as incurred. Included in other property and equipment are an insignificant amount of assets under capital lease. Amortization related to capital lease obligations is included in the Statement of Operations under depreciation, depletion and amortization.
Federal Income Taxes: Deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is provided against net deferred assets for which realization is doubtful.
Income (Loss) Per Common Share: Income (loss) per common share is calculated in accordance with Financial Accounting Standards Board Statement No. 128. Basic income (loss) per share considers as outstanding only common stock, without giving any effect to options or warrants. Diluted income per share gives effect to options and warrants using the treasury stock method.
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued
Comprehensive Income: During 1998, the Company adopted Statement No. 130, Reporting Comprehensive Income. Statement No. 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of this Statement had no impact on the Company's net income or stockholders' equity as previously reported or in the current year.
Concentrations of Credit Risk: Financial instruments that potentially expose the Company to credit risk consist principally of accounts receivable. Accounts receivable, net of allowance of $27,026 at August 31, 1999, are generally from companies with significant oil and gas marketing activities. The Company performs ongoing credit evaluations and generally requires no collateral from customers.
Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that it is reasonably possible that estimates of proved crude oil and natural gas reserves could significantly change in the future.
Stock-Based Compensation: Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock.
Government Regulations: Substantially all of the Company's producing oil and gas properties are subject to Federal, state and local provisions regulating the discharge of materials into the environment. Management believes that its current practices and procedures for the control and disposition of such wastes comply with applicable federal and state requirements.
Restoration, Removal and Environmental Matters: The estimated costs of restoration and removal of producing property well sites is generally less than the estimated salvage value of the respective property and, accordingly, the Company has not provided for a liability accrual. The estimated future costs for known environmental remediation requirements are accrued when it is probable that a liability has been incurred and the amount of remediation costs can be reasonably estimated. The Company is not aware of any such remediation requirements material to its operations.
Fair Value of Financial Instruments: The only financial instruments of the Company are cash and equivalents, trade accounts receivable and payable, and long-term debt. In all cases the carrying amount of financial instrument approximates fair value.
Revenue Recognition: The Company recognizes oil and gas revenue from its interest in producing wells as the oil and gas is sold from the wells.
NOTE B - LONG TERM DEBT
Long-term debt consists of the following at August 31:
NOTE B - LONG TERM DEBT - continued
The following is a schedule of maturities of long-term debt as of August 31, 1999:
Fiscal Year Ended August 31 Amount
2000 $ 2,565,067 2001 529,742 ----------- $ 3,094,809 ===========
NOTE C - STOCKHOLDERS' EQUITY
Preferred Stock: The Company has authorized 10,000,000 shares of preferred stock, none of which has been issued at August 31, 1999. Terms of the stock have not been established by the Board of Directors.
Stock Options: The Company grants options to its officers, directors, and key employees under its 1995 Flexible Incentive Plan. In 1998, the Company also issued options for the purchase of 600,000 shares of common stock under a nonqualified plan. The Company has elected to follow Accounting Principles Board Opinion No. 25, AAccounting for Stock Issued to Employees,@ (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, AAccounting for Stock-Based Compensation,@ (FASB 123) requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company=s stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized.
The Company's 1995 Flexible Incentive Plan was authorized to grant options to management, directors, and key personnel for up to 400,000 shares of the Company's common stock. During 1999, the Plan was amended to increase the number of options to allow for the purchase of up to 1,500,000 common stock shares. All options granted have ten year terms and vest and become fully exercisable based on the specific terms imposed at the date of grant.
Pro forma information regarding net income and earnings per share is required by FASB 123, which also requires that the information be determined as if the Company has accounted for its employee stock options granted subsequent to August 31, 1995 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1999, 1998 and 1997, respectively: risk-free interest rates of 5.0%, 4.0%, and 6.25%; dividend yields of -0-%; volatility factors of the expected market price of the Company's common stock of .95, .69, and .33; and a weighted-average expected life of the option of five years.
NOTE C - STOCKHOLDERS' EQUITY - continued
The Black-Scholes option valuation model was developed for use in estimating the fair value of trade options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information is as follows for the years ended August 31:
A summary of the status of the Company's stock option activity and related information for the years ended August 31, is as follows:
NOTE C - STOCKHOLDERS' EQUITY - continued
The following table summarizes information about the options outstanding at August 31, 1999:
Stock Warrants: The following is a summary of warrants outstanding at August 31, 1999:
NOTE D - EARNINGS PER SHARE
The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share (EPS) computation for the year ended August 31, 1999:
Options and warrants exercisable to purchase 813,300 shares of common stock were outstanding at August 31, 1999 but were not included in the computation of diluted EPS because the exercise price was greater than the average market price of the common shares.
The 1998 and 1997 loss per share does not include the effect of options and warrants as their impact would be antidilutive given the Company's loss position in those years.
NOTE E - OPERATING LEASES
The Company leases its primary office space for $7,676 per month through February 2000.
For the years ended August 31, 1999, 1998, and 1997, the Company incurred rent expense of approximately $95,000, $94,000, and $92,000, respectively. Future minimum rentals under all noncancellable real estate leases are as follows:
Fiscal Year Ended August 30 Amount ------------ ---------
2000 $ 46,057
NOTE F - FEDERAL INCOME TAXES
The Company has incurred losses for both financial statement and income tax purposes in prior years. A valuation allowance equal to the net deferred tax asset has been recorded due to the uncertainty of the realization of the asset. The following items give rise to the deferred tax assets and liabilities at August 31:
1999 1998 ---------- ------------
Deferred tax assets: Tax net operating loss carryforwards ........... $ 23,055,000 $ 24,575,000 Impairment of oil and gas and mineral properties 2,485,000 4,118,000 ------------ -----------
Gross deferred tax assets ........................ 25,540,000 28,693,000 Statutory tax rate ............................... 34% 34% ------------ -----------
Net deferred tax assets .......................... 8,683,600 9,755,620 Less valuation allowance ......................... (8,683,600) (9,755,620) ------------ ----------
Deferred income tax asset recorded ............... $ -- $ -- ============ ==========
The net operating loss carryforwards available at August 31, 1999, and the related expiration dates are as follows:
Expires August 31 Amount --------- -------------
2000 $ 480,000 2001 1,200,000 2002 1,960,000 2003 708,000 2004 168,000 2005 to 2009 5,850,000 2010 to 2014 12,689,000 -------------
$ 23,055,000 =============
NOTE G - RELATED PARTY TRANSACTIONS
During 1997, the Company purchased undeveloped oil and gas leases covering approximately 222,000 net acres for exploration in the Williston Basin of North and South Dakota and Montana. The acquisition was paid for with $22,000,000 cash and the issuance of 1,000,000 shares of common stock valued at $5 per share. 67% of the acquisition was from a company affiliated with two directors of the Company. Concurrently with the acquisition, the Company sold to third parties a 42.5% net profits interest in wells to be drilled on the oil and gas leases for $17,000,000 cash. The oil and gas leases acquired were reported at the affiliates historical cost basis, which resulted in a reduction to the basis in the properties of $9,773,154, and a charge for the same amount to additional paid-in capital.
The Company's ExproFuels division was spun off from The Exploration Company on September 3, 1996, with a 40% equity ownership being retained. During 1997, the Company's net assets in ExproFuels, Inc. was reduced to $0 by recognition of a $1,215,259 charge to operations. ExproFuels, Inc. has no remaining assets and no current operations.
NOTE H - SEGMENT INFORMATION AND MAJOR CUSTOMERS
The Company operates only in the oil and gas industry. The Company's oil and gas sales include amounts sold to major purchasers in the three years ended August 31, as follows:
Purchaser 1999 1998 1997 - --------- --------- --------- ---------
A . $ 3,800,000 $ -- $ -- B . 150,000 985,000 -- C . 480,000 810,000 732,000 D . 1,630,000 595,000 -- E . -- 122,000
NOTE I - SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Year Ended August 31, 1999 The Company issued 325,000 shares of its common stock in exchange for oil and gas properties (valued at the market price per share for unregistered stock).
Year Ended August 31, 1998 The Company converted $4,000,000 of convertible notes payable and $221,590 of accrued interest into 844,318 shares of its common stock.
The Company converted $1,684,000 of accounts payable into long-term debt.
Year Ended August 31, 1997 The Company issued 1,000,000 shares of its common stock in exchange for oil and gas properties (valued at the market price per share for unregistered stock).
The Company converted $2,264,702 of debentures into 872,548 shares of its common stock.
NOTE J - OIL AND GAS PRODUCING ACTIVITIES AND PROPERTIES
Capitalized Costs and Costs Incurred Relating to Oil and Gas Activities
The Company's investment in oil and gas properties is as follows at August 31:
1999 1998 ------------ ------------
Proved properties ............ $ 12,948,366 $ 9,098,623 Less reserve for impairment .. (2,323,584) (2,314,592) Less accumulated depreciation, depletion and amortization . (4,353,550) (2,073,491) ------------ ------------ Net proved properties ... 6,271,232 4,710,540
Unproved properties .......... 7,429,182 9,372,026 Less reserve for impairment .. (161,476) (1,580,000) ------------ ------------ Net unproved properties . 7,267,706 7,792,026 ------------ ------------
Net capitalized cost ......... $ 13,538,938 $ 12,502,566 ============ ============
Costs incurred, capitalized, and expensed in oil and gas producing activities are as follows:
NOTE J - OIL AND GAS PRODUCING ACTIVITIES AND PROPERTIES - continued
Estimated Quantities of Proved Oil and Gas Reserves (Unaudited)
The following estimates of proved developed and undeveloped reserve quantities and related standardized measure of discounted net cash flow are estimates only, and do not purport to reflect realizable values or fair market values of the Company's reserves. The Company emphasizes that reserve estimates are inherently imprecise and that estimates of new discoveries are more imprecise than those of currently producing oil and gas properties. Accordingly, these estimates are expected to change as future information becomes available.
Proved reserves are estimates of crude oil (including condensate and natural gas liquids) and natural gas that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are those expected to be recovered through existing well, equipment and operating methods. The estimates have been prepared by an independent reservoir engineering firm.
Oil Gas (Barrels) (MCF)
Reserves at August 31, 1996 ...................... 20,570 1,893,490
Discoveries .................................. 289,770 1,147,345 Revisions of previous estimates .............. (41,554) (678,676) Production ................................... (23,086) (206,059) ---------- ----------
Reserves at August 31, 1997 ...................... 245,700 2,156,100
Discoveries .................................. 70,700 4,541,500 Revisions of previous estimates .............. (136,662) 117,852 Production ................................... (79,138) (713,752) ---------- ----------
Reserves at August 31, 1998 ...................... 100,600 6,101,700
Discoveries .................................. 32,000 2,803,000 Purchases of minerals in place ............... 1,600 338,000 Revisions of previous estimates .............. 53,800 (166,700) Production ................................... (82,000) (2,813,000) ---------- ----------
Reserves at August 31, 1999 ...................... 106,000 6,263,000 ========== ==========
Substantially all of the Company's proved reserves are developed and are located in the continental United States.
NOTE J - OIL AND GAS PRODUCING ACTIVITIES AND PROPERTIES - continued
Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Oil and Gas Reserves (Unaudited)
The "Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Oil and Gas Reserves" (Standardized Measure) presented below is computed in accordance with SFAS No. 69. The Standardized Measure does not purport to present the fair market value of a company's proved oil and gas reserves. This would require consideration of expected future economic and operating conditions, which are not taken into account in calculating the Standardized Measure.
Under the Standardized Measure, future cash inflows were estimated by applying year-end prices, adjusted for fixed determinable escalations, to the estimated future production and development costs based on year-end costs to determine pre-tax cash inflows. Future income taxes were computed by applying the statutory tax rate to the excess of pre-tax cash inflows over the company's basis in the associated proved oil and gas properties. Tax credits, permanent differences and net operating loss carryforwards were also considered in the future income tax calculations, thereby reducing the expected tax expense to zero.
Set forth below is the Standardized Measure relating to proved oil and gas reserves at August 31:
Changes in Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Oil and Gas Reserves (Unaudited)
The following is an analysis of the changes in the Standardized Measure:
NOTE K - YEAR 2000
Over the last three years the Company has replaced or upgraded most of the core management information systems used in the Company's business. The Company has conducted a review of these systems to verify their compliance with Year 2000 date codes. In addition, the Company has conducted an inventory, review and assessment of its desktop computers, networks and servers, software applications and packages, and products and services provided by third parties for internal operations to determine whether or not they support Year 2000 date codes. The Company believes it has successfully completed required modifications to all mission critical applications included in its internal systems. In addition, the Company has contacted its major gas purchasers, gas pipeline carriers, stock transfer agent and banking institutions and received written assurances and/or viewed assurances on their websites that they have no material Year 2000 problems. The Company does not believe the Year 2000 issue will materially affect its ability to pay its vendors and suppliers, track its assets in the custody of financial institutions or otherwise prevent it from conducting its business on an ongoing basis.
THE EXPLORATION COMPANY Schedule II - Valuation and Qualifying Reserves For the Three Years Ended August 31, 1999 | 17,651 | 114,662 |
1092022_1999.txt | 1092022_1999 | 1999 | 1092022 | Item 1. Business.
Not applicable.
Item 2.
Item 2. Properties.
Not applicable.
Item 3.
Item 3. Legal Proceedings.
There are no material pending legal proceedings involving the mortgage loans related to the Certificates, the trustee under the Pooling Agreement or the registrant with respect to the mortgage loans, other than ordinary routine litigation incidental to the trustee's or the registrant's duties under the Pooling Agreement.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No vote or consent of holders of Certificates has been solicited for any purpose during 1999.
Part II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Not applicable.
Item 6.
Item 6. Selected Financial Data.
Not applicable.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation.
Not applicable.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Not applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Not applicable.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
No material disagreement concerning accounting procedures or change of accountants has occurred.
Part III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Not applicable.
Item 11.
Item 11. Executive Compensation.
Not applicable.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
Not applicable.
Item 13.
Item 13. Certain Relationships and Related Transactions.
Not applicable.
Part IV
Item 14.
Item 14. Exhibits, Financial Statement, Schedules, and Reports on Form 8-K.
The Pooling Agreement requires an officer's certificate to be delivered to the trustee under the Pooling Agreement on or before April 30, 2000 and each April 30 thereafter stating as to the signer thereof, that (i) a review of the activities of the master servicer under the Pooling Agreement during the calendar year ended December 31, 1999 and each December 31 thereafter and performance under the Pooling Agreement had been made under such officer's supervision, and (ii) to the best of such officer's knowledge, based on such review, the master servicer had fulfilled all its obligations under the Pooling Agreement throughout such year, or if there has been a default in the fulfillment of any such obligation, specifying each such default known to such officer and the nature and status thereof. Such officer's certificate dated as of March 30, 2000 is attached hereto as Exhibit 99.1.
The Pooling Agreement requires a statement from a firm of independent public accountants to be furnished to the trustee under the Pooling Agreement on or before April 30, 2000 and each April 30 thereafter to the effect that, in connection with the firm's examination of the financial statements as of December 31, 1999 and each December 31 thereafter of the parent corporation of the master servicer under the Pooling Agreement (which included a limited examination of the master servicer's financial statements) nothing came to their attention that indicated that the master servicer was not in compliance with certain sections of the Pooling Agreement, except for (i) such exceptions as such firm believes to be immaterial, and (ii) such other exceptions as are set forth in such statement. Such statement is incorporated by reference to the registrant's Report on Form 8-K filed on March 29, 2000.
The registrant filed Reports on Form 8-K that described distributions made to Certificateholders on the Distribution Date occurring in the month preceding the month in which such Report on Form 8-K was filed and also provided certain information regarding delinquent Mortgage Loans and credit enhancements as of such Distribution Date. Such Reports on Form 8-K are incorporated by reference as follows:
PNC Mortgage Securities Corp., Mortgage Pass-Through Certificates, Series: 1999-8, Monthly Distribution Report for month indicated, 1999. Date Filed August September 10, 1999 September October 12, 1999 October November 9, 1999 November December 6, 1999 December January 10, 2000
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PNC MORTGAGE SECURITIES CORP. (Registrant)
By: /s/ Richard Careaga --------------------------- Richard Careaga Second Vice President Date March 30, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
By /s/ Michael L. Parker - ------------------------------------ Michael L. Parker President and Director Date March 30, 2000
By /s/ Douglas H. Burr - ------------------------------------ Douglas H. Burr Senior Vice President, Chief Financial Officer and Director Date March 30, 2000
By /s/ Alexander T. Topping, Jr. - ------------------------------------ Alexander T. Topping, Jr. Senior Vice President and Director Date March 30, 2000
By /s/ Peter Maroutsos - ------------------------------------ Peter Maroutsos Vice President and Controller Date March 30, 2000
By /s/ Saiyid T. Naqvi - ------------------------------------ Saiyid T. Naqvi Director Date March 30, 2000
Exhibit 99.1 Officer's Certificate as to Compliance for the Series 1999-8 Certificates dated as of March 30, 2000
The undersigned officer of PNC Mortgage Securities Corp., a Delaware corporation (the "Company") hereby certifies on behalf of the Company for purposes of the Company's Mortgage Pass-Through Certificates, Series 1999-8, as follows:
1. I am the duly appointed, qualified and acting President of the Company.
2. Capitalized terms used and not defined herein shall have the meanings ascribed to such terms in the Pooling and Servicing Agreement related to the above-referenced series of Certificates.
3. I am duly authorized to execute and deliver this Officer's Certificate on behalf of the Company.
4. A review of the activities of the Master Servicer during the preceding calendar year and performance under this Agreement has been made under my supervision.
5. To the best of my knowledge, based on such review, the Master Servicer has fulfilled all its obligations under the Agreement throughout such year.
IN WITNESS WHEREOF, I have signed my name as of March 30, 2000.
By: /s/ Michael L. Parker - - - - - - - - - - - Michael L. Parker President | 1,015 | 6,572 |
711213_1999.txt | 711213_1999 | 1999 | 711213 | ITEM 1. BUSINESS
The partnership is a publicly-held limited partnership organized under the California Uniform Limited Partnership Act. The partnership's General Partner is Del Taco, Inc., a California corporation ("General Partner"). The partnership sold 8,751 units totaling $4.375 million through an offering of limited partnership units from March 1983 through March 1984. The term of the partnership agreement is until April 30, 2022 unless terminated earlier by means provided in the partnership agreement.
The business of the partnership is ownership and leasing of restaurants in California to Del Taco, Inc. The partnership acquired land and constructed six Mexican-American restaurants for long-term lease to Del Taco, Inc. Each property is leased for 35 years on a triple net basis. Rent is equal to twelve percent of gross sales of the restaurants. As of December 31, 1999, the partnership had a total of six properties leased to Del Taco (Del Taco, in turn, has subleased two of the restaurants).
The partnership has no full time employees. The partnership agreement assigns full authority for general management and supervision of the business affairs of the partnership to the General Partner. The General Partner has a one percent interest in the profits or losses and distributions of the partnership. Limited partners have no right to participate in the management or conduct of the partnership's business affairs.
ITEM 2.
ITEM 2. PROPERTIES
The partnership has acquired six properties with proceeds obtained from the sale of partnership units:
(1) Commencement of operation is the first date Del Taco, Inc., as lessee, operated the facility on the site as a Del Taco restaurant.
PART II
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The partnership is not a party to any material pending legal proceedings.
ITEM 4.
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5.
ITEM 5. MARKET FOR THE PARTNERSHIP'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS
The partnership sold 8,751 ($4,375,500) limited partnership units during the public offering period ended March 20, 1984 and currently has 866 limited partners of record. There is no public market for the trading of the units. Distributions made by the partnership to the limited partners during the past three fiscal years are described in Note 6 to the Notes to the Financial Statements contained under Item 8.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) The net income per limited partnership unit was calculated based upon 8,751 weighted average units outstanding for all years presented.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Liquidity and Capital Resources
The partnership offered limited partnership units for sale between March 1983 and March 1984. 15% of the $4.375 million raised through sale of limited partnership units was used to pay commissions to brokers and to reimburse the General Partner for offering costs incurred. Approximately $4 million of the remaining funds were used to acquire sites and build six restaurants.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued)
The six restaurants leased to Del Taco make up almost all of the income producing assets of the partnership. Therefore, the business of the partnership is almost entirely dependent on the success of the Del Taco trade name restaurants that lease the properties. The success of the restaurants is dependent on a large variety of factors, including, but not limited to, consumer demand and preference for fast food, in general, and for Mexican-American food in particular.
Results of Operations
The partnership owns six properties that are under long-term lease to Del Taco for restaurant operations (Del Taco, in turn, has subleased two of the restaurants to Del Taco franchisees, one of which is affiliated with Del Taco).
The following table sets forth rental revenue earned by restaurant for the year:
The partnership receives rental revenues equal to 12 percent of gross sales from the restaurants. The partnership earned rental revenue of $537,905 during the year ended December 31, 1999, which represents an increase of $6,297 from 1998. The increase in rental revenue was caused by an increase in sales at the restaurants under lease.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued)
The following table breaks down general and administrative expenses by type of expense:
PERCENTAGE OF TOTAL GENERAL & ADMIN. EXPENSE
Certain reclassifications have been made to the 1998 and 1997 amounts in the table above to conform to the current year presentation.
General and administrative costs increased from 1998 to 1999 due to increased costs for accounting and income tax return preparation. Depreciation expense was the same in both 1998 and 1999.
Net income increased by $5,788 from 1998 to 1999 due to the increase in revenues of $6,205 offset by the $417 increase in general and administrative expenses.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
PART I. INFORMATION
[Arthur Andersen Letterhead]
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Partners of Del Taco Restaurant Properties, I:
We have audited the accompanying balance sheets of Del Taco Restaurant Properties I (a California Limited Partnership) as of December 31, 1999 and 1998 and the related statements of income, partners' equity and cash flows for the years then ended. These financial statements and the schedule referred to below are the responsibility of the Partnership's management. Our responsibility is to express and opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Del Taco Restaurant Properties I as of December 31, 1999 and 1998, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule in the index of the financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP - ------------------------------ ARTHUR ANDERSEN LLP
Orange County, California March 1, 2000
DEL TACO RESTAURANT PROPERTIES I
BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
DEL TACO RESTAURANT PROPERTIES I
STATEMENTS OF INCOME
The accompanying notes are an integral part of these financial statements.
DEL TACO RESTAURANT PROPERTIES I
STATEMENT OF CHANGES IN PARTNERS' EQUITY
THREE YEARS ENDED DECEMBER 31, 1999
The accompanying notes are an integral part of these financial statements.
DEL TACO RESTAURANT PROPERTIES I
STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
DEL TACO RESTAURANT PROPERTIES I
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
THE PARTNERSHIP: Del Taco Restaurant Properties I (a California limited partnership) was formed on November 30, 1982, for the purpose of acquiring real property in California for construction of six Mexican-American restaurants to be leased under long-term agreements to Del Taco, Inc. (General Partner for operation under the Del Taco trade name).
BASIS OF ACCOUNTING: The partnership utilizes the accrual method of accounting for transactions relating to the business of the partnership. Distributions are made to the general and limited partners in accordance with the provisions of the partnership agreement (see Note 2).
PROPERTY AND EQUIPMENT: Property and equipment is stated at cost. Depreciation is computed using the straight-line method over estimated useful lives which are 20 years for land improvements, 35 years for buildings and improvements, and 10 years for machinery and equipment.
The partnership accounts for property and equipment in accordance with Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long Lived Assets and for Long Lived Assets to be Disposed of." SFAS 121 requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. In evaluating long-lived assets held for use, an impairment loss is recognized if the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying value of the asset. Once a determination has been made that an impairment loss should be recognized for long-lived assets, various assumptions and estimates are used to determine fair value including, among others, estimated costs of construction and development, recent sales of comparable properties and the opinions of fair value prepared by independent real estate appraisers. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less cost to sell.
DEL TACO RESTAURANT PROPERTIES I NOTES TO FINANCIAL STATEMENTS - CONTINUED DECEMBER 31, 1999
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED)
INCOME TAXES: No provision has been made for federal or state income taxes on partnership net income, since the partnership is not subject to income tax. Partnership income is includable in the taxable income of the individual partners as required under applicable income tax laws. Certain items, primarily related to depreciation methods, are accounted for differently for income tax reporting purposes (see Note 5).
NET INCOME PER LIMITED PARTNERSHIP UNIT: Net income per limited partnership unit is based upon the weighted average number of units outstanding during the period which amounted to 8,751 for all years presented.
USE OF ESTIMATES: The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
NOTE 2 - PARTNERS' EQUITY
Pursuant to the partnership agreement, annual partnership net income is allocated one percent to the General Partner and 99 percent to the limited partners. A partnership net loss in any year will be allocated 24 percent to the General Partner and 76 percent to the limited partners until the losses so allocated equal income previously allocated. Any additional losses will be allocated one percent to the General Partner and 99 percent to the limited partners.
Partnership gains from any sale or refinancing will be allocated one percent to the General Partner and 99 percent to the limited partners until allocated gains and profits equal losses. Additional gains will be allocated 24 percent to the General Partner and 76 percent to the limited partners.
In 1986, the General Partner contributed additional capital of $280,000 to the partnership in order to provide funds necessary to complete the sixth and final restaurant.
DEL TACO RESTAURANT PROPERTIES I NOTES TO FINANCIAL STATEMENTS - CONTINUED DECEMBER 31, 1999
NOTE 3 - LEASING ACTIVITIES
The partnership leases certain properties for operation of restaurants to Del Taco, Inc. on a triple net basis. The leases are for terms of 35 years commencing with the completion of the restaurant facility located on each property and require monthly rentals equal to 12 percent of the gross sales of the restaurants. There is no minimum rental under any of the leases. The partnership had a total of six properties leased as of December 31, 1999, 1998 and 1997, two of which have been subleased to Del Taco franchisees (one of which is affiliated with Del Taco, Inc.)
The five restaurants operated by or affiliated with Del Taco, for which the partnership is the lessor, had combined, unaudited sales of $3,725,831, $3,721,166, and $3,447,723 and unaudited net income of $192,444, $207,430, and $149,010 for the years ended December 31, 1999, 1998 and 1997, respectively. Net income by restaurant includes charges for general and administrative expenses incurred in connection with supervision of restaurant operations and interest expense. The one restaurant operated by a Del Taco franchisee, for which the partnership is the lessor, had unaudited sales of $756,708, $708,908 and $612,943 for the years ended December 31, 1999, 1998 and 1997, respectively.
The Elkhorn Boulevard restaurant in Sacramento, California had unaudited net losses of $9,658, $13,373 and $13,302 for the years ended December 31, 1999, 1998 and 1997, respectively.
NOTE 4 - RELATED PARTIES
The receivable from Del Taco consists of rent accrued for the month of December 1999. The rent receivable was collected on January 17, 2000.
The General Partner received $5,007 in distributions relating to its one percent interest in the partnership for the year ended December 31, 1999.
Del Taco, Inc. serves in the capacity of General Partner in other partnerships which are engaged in the business of operating restaurants, and three other partnerships which were formed for the purpose of acquiring real property in California for construction of Mexican-American restaurants for lease under long-term agreements to Del Taco, Inc. for operation under the Del Taco trade name.
DEL TACO RESTAURANT PROPERTIES I NOTES TO FINANCIAL STATEMENTS - CONTINUED DECEMBER 31, 1999
NOTE 5 - INCOME TAXES
A reconciliation of financial statement net income to taxable income for each of the periods is as follows:
A reconciliation of partnership equity per the financial statements to net worth for tax purposes as of December 31, 1999, is as follows:
DEL TACO RESTAURANT PROPERTIES I NOTES TO FINANCIAL STATEMENTS - CONTINUED DECEMBER 31, 1999
NOTE 6 - CASH DISTRIBUTIONS TO LIMITED PARTNERS
Cash distributions paid to limited partners for the three years ended December 31, 1999 were as follows:
Cash distributions per limited partnership unit were calculated based upon the weighted average number of units outstanding for each quarter and were paid from operations. Cash distributions for the quarter ended December 31, 1999 amounted to $15.19 per limited partnership unit and were paid January 28, 2000.
PART III
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP'S GENERAL PARTNER
(a) & (b) The executive officers and directors of the General Partner and their ages are set forth below:
The above referenced executive officers and directors of the General Partner will hold office until the annual meeting of its shareholders and directors, which is scheduled for the later part of 2000.
(c) None
(d) No family relationship exists between any such director or executive officer of the General Partner.
(e) The following is an account of the business experience during the past five years of each such director and executive officer:
Kevin K. Moriarty, Director, Chairman and Chief Executive Officer of Del Taco, Inc. Mr. Moriarty began his career with Burger King Corporation in 1974 in Operations Unit Management. In 1983, he was promoted to Area Manager in New York, and was subsequently promoted to the Regional Vice President, Chicago Region in 1985. In 1988, he became Executive Vice President and General Manager of the North Central Division. Mr. Moriarty served in that position until 1990 when he joined Del Taco, Inc. as President and Chief Executive Officer on July 31, 1990. Mr. Moriarty has served as a Director of the General Partner since 1990.
C. Ronald Petty, President of Del Taco, Inc. Mr. Petty began his career in the restaurant business in 1973 with McDonald's Corporation. He was employed by McDonald's in a real estate capacity until 1978. For the next 12 years, Mr. Petty was in various officer positions with Burger King. These positions included Vice President of Real Estate, Sr. Vice President of Development, Region Vice President, Sr. Vice President European Operations, President of International and President of U.S. Mr. Petty served as President of Miami Subs from 1990-1992; President and CEO of Denny's 1993-1996; President and CEO of Peter Piper Pizza 1996-1998; President of Del Taco December 1998-present.
Paul W. Hitzelberger, Executive Vice President, Brand Strategy and Franchise Relations/Development of Del Taco, Inc. He was appointed to his current position in December 1995. Mr. Hitzelberger has responsibility for franchise development, relations and training. He also oversees public relations and training for the corporation. From 1991 to 1995, Mr. Hitzelberger was Executive Vice President, Marketing of Del Taco, Inc. From September 1988 through September 1989, Mr. Hitzelberger was Chief Executive Officer of Environmental Marketing Group. Prior to that, Mr. Hitzelberger was a Vice President of Del Taco, Inc. Prior to joining Del Taco, Inc., he served as Vice President - Marketing at the department store division of Lucky Stores, Inc., a major supermarket retailer. Mr. Hitzelberger received a Master of Business Administration degree from Loyola University in Chicago, Illinois.
Robert J. Terrano, Executive Vice President and Chief Financial Officer of Del Taco, Inc. From May 1994 to April 1995, Mr. Terrano served as Chief Financial Officer for Denny's, Inc. in Spartanburg, S.C. From August 1983 to May 1994, he served with Burger King Corporation, Miami Florida, in a variety of positions, most recently as Division Controller. Mr. Terrano joined Del Taco, Inc. in April 1995.
James D. Stoops, Executive Vice President, Operations of Del Taco, Inc. From 1968 to 1991, Mr. Stoops served in a wide variety of Operations positions with Burger King Corporation with increasing levels of responsibility. In 1985, Mr. Stoops was appointed Region Vice President/General Manager for the New York region and served in that position until October of 1990. In January of 1991, he joined Del Taco, Inc. in his current post.
Janet D. Simmons, Senior Vice President, Purchasing of Del Taco, Inc. From 1979 to 1986, Ms. Simmons was with Denny's Incorporated. She served in the Research and Development department in a variety of positions until 1982 when she was promoted to the position of Purchasing Agent. Ms. Simmons was hired in 1986 as Manager of Contract Purchasing with Carl Karcher Enterprises, a post she held until March 1990 when she became Vice President, Purchasing for Del Taco, Inc. Ms. Simmons has a Bachelor of Science degree in Foods and Nutrition from Cal State Polytechnic University in Pomona, California.
Michael L. Annis, Vice President, Secretary and General Counsel of Del Taco, Inc. From 1981 to 1986 Mr. Annis served as Regional Real Estate Manager and Director of Real Estate Services with Taco Bell, Inc. In 1986 he served as Regional General Manager with Quaker State Minit Lube. In January of 1987 Mr. Annis joined Red Robin International, Inc. as General Counsel and was subsequently promoted to Vice President/Secretary and later Vice President Real Estate Development/Secretary and General Counsel, the position he held until joining Del Taco, Inc. in December of 1993. Mr. Annis received his J.D. Degree from Whittier College.
C. Douglas Mitchell, Vice President and Corporate Controller. Mr. Mitchell joined Del Taco, Inc. in August of 1994 as Controller and was promoted to his current position in January 1996. From 1990 to 1994, Mr. Mitchell was a Senior Audit Manager with Coopers & Lybrand. Prior to 1990, Mr. Mitchell held various positions in finance and accounting with the Geneva Companies (a subsidiary of Chemical Bank), Zaremba Corporation (a real estate developer) and The Dexter Corporation (an international manufacturer of specialty materials). Mr. Mitchell has a Bachelor of Science degree with a major in accounting from the University of Southern California.
Timothy A. Hackbardt, Vice President, Marketing of Del Taco, Inc. Mr. Hackbardt joined Del Taco, Inc. in November 1999. Prior to then, since November of 1995, he served as Vice President of Marketing of Taco Time International, Inc., Eugene, OR. From September 1994 to November 1995, Mr. Hackbardt was Director of Marketing for Wok Spirit Chinese Delivery restaurants in Newport Beach, CA. From December 1992 to September 1994, Mr. Hackbardt was Director of Marketing for Fosters Freeze International, Inc., San Luis Obispo, CA. Prior to then, Mr. Hackbardt held various positions in the television and radio industry in sales and sales management. Mr. Hackbardt is a graduate of Central Michigan University where he received a Bachelor of Applied Arts, majoring in Broadcast and Cinematic Arts and minoring in Marketing.
Shirlene Lopez, Vice President, Corporate Development & Design of Del Taco, Inc. Ms. Lopez began her career with Del Taco in 1978 as an hourly employee and advanced through the ranks to General Manager in 1984. Ms. Lopez was promoted to the corporate office in 1989 as Human Resource Manager. In 1994, she was promoted to Executive Project Manager reporting to the CEO and in 1996, to Director of Corporate Development in charge of all interior image and design. Ms. Lopez has held her current position since August 1997.
ITEM 11.
ITEM 11. MANAGEMENT REMUNERATION AND TRANSACTIONS
The partnership has no executive officers or directors and pays no direct remuneration to any executive officer or director of its General Partner. The partnership has not issued any options or stock appreciation rights to any executive officer or director of its General Partner, nor does the partnership propose to pay any annuity, pension or retirement benefits to any executive officer or director of its General Partner. The partnership has no plan, nor does the partnership presently propose a plan, which will result in any remuneration being paid to any executive officer or director of the General Partner upon termination of employment.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
(a) No person of record currently owns more than five percent of limited partnership units of the partnership, nor was any person known of by the partnership to own of record and beneficially, or beneficially only, more than five percent of such securities.
(b) Neither Del Taco, Inc., nor any executive officer or director of Del Taco, Inc. owns any limited partnership units of the partnership.
(c) The partnership knows of no contractual arrangements, the operation or the terms of which may at a subsequent date result in a change in control of the partnership , except for provisions in the partnership agreement providing for removal of the General Partner by holders of a majority of the limited partnership units and if a material event of default occurs under the financing agreements of the General Partner.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) No transactions have occurred between the partnership and any executive officer or director of its General Partner.
During 1999, the following transactions occurred between the partnership and the General Partner pursuant to the terms of the partnership agreement.
(1) The General Partner earned $4,516 as its one percent share of the net income of the partnership.
(2) The General Partner received $5,007 in distributions relating to its one percent interest in the partnership.
(b) During 1999, the partnership had no business relationships with any entity of a type required to be reported under this item.
(c) Neither the General Partner, any director or officer of the General Partner or any associate of any such person, was indebted to the partnership at any time during 1999 for any amount in excess of $60,000.
(d) Not applicable.
PART IV
ITEM 14(a)(1) AND (2). EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
Financial statement schedules:
Schedule III - Real Estate and Accumulated Depreciation
Financial statement schedules other than those referred to above have been omitted because they are not applicable or not required.
(b) No reports on Form 8-K were filed during the last quarter of 1999.
(c) Exhibits required by Item 601 of Regulation S-K:
1. Incorporated herein by reference, Restated Certificate and Agreement of Limited Partnership of Del Taco Restaurant Properties I filed as Exhibit 3.01 to Partnership's Registration Statement on Form S-11 as filed with the Securities and Exchange Commission on December 17, 1982.
2. Incorporated herein by reference, Amendment to Restated Certificate and Agreement of Limited Partnership of Del Taco Restaurant Properties I.
3. Incorporated herein by reference, Form of Standard Lease to be entered into by partnership and Del Taco, Inc., as lessee, filed as Exhibit 10.02 to Partnership's Registration Statement on Form S-11 as filed with the Securities and Exchange Commission on December 17, 1982.
DEL TACO RESTAURANT PROPERTIES I - SCHEDULE III REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1999
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DEL TACO RESTAURANT PROPERTIES I -------------------------------- a California limited partnership
Del Taco, Inc. General Partner
Date March 07, 2000 Kevin K. Moriarty -------------- ----------------------------------------- Kevin K. Moriarty Director, Chairman and Chief Executive Officer
Date March 07, 2000 Michael L. Annis -------------- ----------------------------------------- Michael L. Annis Vice President, Secretary and General Counsel
Date March 07, 2000 Robert J. Terrano -------------- ----------------------------------------- Robert J. Terrano Executive Vice President and Chief Financial Officer
Date March 07, 2000 C. Douglas Mitchell -------------- ----------------------------------------- C. Douglas Mitchell Vice President and Corporate Controller
EXHIBIT INDEX | 4,238 | 27,226 |
1067346_1999.txt | 1067346_1999 | 1999 | 1067346 | ITEM 1. BUSINESS
GENERAL
AAi.FosterGrant, Inc. ("AAi" or the "Company") is a value-added distributor of optical products, costume jewelry, watches, clocks and other accessories to mass merchandisers, variety stores, chain drug stores and supermarkets in North America and the United Kingdom. The Company sells its products in over 30,000 retail locations. The Company markets its products under its own brand names such as Foster Grant(R) as well as customers' private labels and numerous licensed brand names. The Company outsources all of its manufacturing.
The Company's product lines contain a large number of stock keeping units ("SKUs") with low retail price points and typically represent a small percentage of retailers' total sales. As a result, many of AAi's customers have chosen to outsource the merchandising of these products to the Company. AAi's award-winning service program provides retailers with customized displays and product packaging and store-level merchandising designed to maximize sales and inventory turnover. The Company employs over 1,400 field service representatives who regularly visit program customers' stores to arrange, replenish and restock displays, reorder product and attend to markdowns and allowances. By providing retailers with in-store product management, the Company retains control of its product marketing and pricing, allowing AAi to maximize product sales and increase the floor space allocated to its product lines. In fiscal 1998, sales to customers utilizing the Company's service program accounted for 69.0% of AAi's net sales.
On July 21, 1998, the Company sold $75.0 million of 10 3/4% Senior Notes due 2006 (the "Notes"). The net proceeds of approximately $71.0 million were used to repay outstanding indebtedness, as described under Item 7, "Management's Discussion and Analysis of Results of Operations and Financial Condition."
AAi was incorporated in Rhode Island in December 1985 and is the successor by merger to a Rhode Island corporation incorporated in 1962. The Company's principal executive offices are located at 500 George Washington Highway, Smithfield, Rhode Island 02917, and its telephone number is (401) 231-3800.
CAUTIONARY STATEMENT
This annual report contains statements relating to future results of the Company (including certain projections and business trends) that are considered "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected as a result of certain risks and uncertainties, including but not limited to, changes in economic conditions and competitive product and pricing pressures within the Company's market, as well as other risks and uncertainties detailed from time to time in the filings of the Company with the Securities and Exchange Commission.
DISTRIBUTION CHANNELS AND CUSTOMERS
AAi sells its products to over 200 customers, primarily in three distribution channels: (1) mass merchandisers, (2) chain drug stores, combo stores (stores combining general merchandise, food and drug items) and supermarkets and (3) variety stores. To a lesser extent, AAi also distributes its products through department stores, military post exchanges, card and gift shops, specialty stores and catalogues.
The Company customizes its product and service program offerings to meet the distinctive characteristics and requirements of each of these retail distribution channels.
Mass Merchandisers. AAi's sales to mass merchandisers accounted for approximately $101.7 million, or 63.4%, of net sales in fiscal 1998. These customers demand a high level of merchandise support as well as national and, as they expand overseas, international distribution capability.
Chain Drug Stores/Combo Stores/Supermarkets. AAi's sales to this channel accounted for approximately $22.0 million, or 13.7%, of net sales in fiscal 1998. These stores tend to be smaller than mass merchandisers and attract a broader class of trade, which is often less price sensitive and more convenience-oriented than the mass merchandiser or variety store customer.
Variety Stores. AAi's sales to variety stores accounted for approximately $13.8 million, or 8.6%, of net sales in fiscal 1998. The Company's extensive product lines enable it to provide service programs on a cost-effective basis, which affords the Company a significant competitive advantage in this market.
Department Stores and Others. The Company's sales to department stores, armed forces' PX stores, boutique stores, gift shops, book stores and catalogue sales accounted for $22.7 million, or 14.2%, of its fiscal 1998 net sales. Each of these channels has different characteristics and product and service requirements and caters to different types of consumers. For example, department stores generally offer higher-end products with higher price points and sales of accessories at such outlets represent a larger percentage of total store sales.
Most of the Company's business is based upon annual contracts or open purchase orders which are terminable at will. When establishing or expanding a customer relationship, the Company generally enters into multi-year agreements for the supply of specified product lines to specific customer stores. Such agreements, in addition to identifying the stores and product lines to be supplied, prescribe inventory and service levels and anticipated turnover rates and sales volumes, as well as the amount of any fixed obligation due to the customer in connection with establishing the relationship. The agreements typically do not contain required minimum sales volumes, but may provide for early termination penalties equal to the Company's unamortized cost of product displays provided to the customer.
With regard to new customers, many retailers require a new supplier to buy back the retailer's existing inventory as a condition to changing vendors. These inventory costs can be substantial and serve as a barrier to entry for the Company in obtaining new customers.
In fiscal 1998, Wal-Mart and Kmart accounted for approximately 27.3% and 11.4%, respectively, of the Company's net sales. No other customers accounted for 10% or more of the Company's total net sales in 1998. The loss of any significant customer, whether through competition or otherwise, could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, certain segments of the retail industry, particularly mass merchandisers, variety stores, drug stores and supermarkets, are experiencing significant consolidation. Further industry consolidation could result in the Company's loss of customers that are acquired by retailers serviced by other suppliers as well as further concentration of the Company's credit risks. Such events could have a material adverse effect on the Company's results of operations.
PRODUCTS
The Company offers sunglasses, reading glasses, costume jewelry, small synthetic leather goods, watches, clocks, and other accessories generally at retail price points of $20 or less.
Optical Products. The Company's optical product line includes sunglasses and non-prescription reading glasses which are sold with and without the Company's service program. As a result of its 1996 acquisition of Foster Grant Group L.P. and related entities ("Foster Grant US"), AAi has become a leading seller of popularly priced sunglasses (retail price points of $8 to $30). The Company pursues co-branding opportunities for its Foster Grant name and also sells sunglasses under other licensed brand names. The Company offers a variety of styles as well as color options for both frames and lenses. Sunglasses have a significant fashion component and positive or negative consumer response in any year can impact not only that year's profitability but also sales for the following year, since retailers' orders tend to mirror the prior year's sales. Such sales are also highly seasonal, with initial orders placed in the first quarter and, depending on consumer response, restocking orders in the second quarter.
The Company also offers a variety of styles of non-prescription reading glasses marketed under Foster Grant, licensed brand names or private labels at price points of $6 to $13. The reading glasses business has no significant fashion component and is non-cyclical and non-seasonal. Since magnification strength is the primary purchasing consideration for this product line, proper stocking and restocking is essential to maximizing sales. As a result, reading glasses are typically marketed through the Company's service program.
Costume Jewelry. AAi offers a wide variety of ladies' and children's costume jewelry with low retail price points (between $3 and $20), including earrings, necklaces and bracelets. The Company's jewelry line includes private labeled products and branded products distributed pursuant to arrangements with licensors such as Disney Enterprises, Inc., Warner Bros. and Revlon Consumer Products Corporation as well as under the Company's Tempo(TM) name. Tempo is the opening retail price point costume jewelry line at J.C. Penney. Most of the Company's
jewelry line is basic (non-seasonal) and approximately one-third has a fashion or holiday component. The Company's costume jewelry line is typically sold through its service program.
Small Synthetic Leather Goods and Other. Through a 1986 acquisition, AAi expanded its product lines to include small synthetic leather goods with retail price points of $6 to $10, such as small backpacks, handbags, wallets and purses. Many of the lines of small accessories are designed to complement AAi's costume jewelry and are likewise often sold under licensed brands. The bulk of these products are sold on a non-program basis and are shipped direct from the Company's suppliers to the customer. In June 1998, through the acquisition of Fantasma, LLC ("Fantasma") the Company added watches and clocks (with average retail price points between $10 and $20) to its product lines.
DISTRIBUTION
During the fourth quarter of 1998, AAi closed its Texas distribution facility and consolidated its distribution operations at its recently expanded Smithfield, Rhode Island facility. The Company consolidated its distribution facilities in order to optimize supply chain operations, improve customer service, increase inventory turns and lower operating costs. A disruption of the Company's distribution operations for any reason could cause the Company to limit or cease its operations, which would have a material adverse effect on the Company's business, financial condition and results of operations.
AAi has made a substantial investment in the development and enhancement of its computer and information systems. These systems enable the Company to rapidly respond to marketplace demands, permitting the Company to restock retailers' inventory on a just-in-time basis. The Company believes that this technology-based system has been a significant factor in reducing its inventory costs.
The Company's flexible distribution systems are capable of processing virtually any small package. AAi's Rhode Island facility utilizes a high velocity fulfillment system that allows the Company to provide its customers short delivery times and high order fulfillment rates. AAi typically delivers its products to its high volume customers on a bi-weekly basis. A VNA (very narrow aisle) facility configuration serviced by wire guided stock pickers resupplies a rapid response order picking line. After receiving a customer order, the Company's computer system automatically generates a list of the ordered items, also known as a "picking" order, which the distribution staff utilizes in packing the customer's shipment. With the planned improvements to the Company's inventory management computer system, "picking" orders will be arranged according to the location of the ordered items within the Company's distribution center, which AAi anticipates will improve the efficiency of employees in filling orders.
The Company delivers ordered items to customers using unaffiliated delivery companies, primarily UPS. The Company is attempting to establish multiple delivery services to deal with the possibility of a future disruption in UPS delivery services. There can be no assurance that the precautions taken by the Company will be adequate or that alternate delivery services can be located or developed by the Company in a timely manner. Any future interruption in service by
UPS may have a material adverse effect on the Company's business, financial condition and results of operations.
The Company also uses an electronic data interchange ("EDI") system between the Company and certain of its major customers, particularly for the distribution of its small synthetic leather goods. Using the EDI system, the Company's computer system automatically generates orders based on point of sale ("POS") information received from customers and the products are sent directly to the customer from the Company's joint venture in Hong Kong.
SERVICE PROGRAM
The Company believes that an attractive, well-positioned display is critical to maximizing sales to the ultimate consumer. The SKU-intensive nature of the Company's product line and the low retail price points (ranging from $3 to $20 on costume jewelry) relative to the required display space has led many retailers to outsource the merchandising function to the Company for these product lines. To better serve these customers, in 1982 the Company initiated an innovative sales program through which AAi provides its program customers with store-level management of its products. In fiscal 1998, the sales to customers who utilize the Company's service program accounted for approximately 69.0% of net sales.
Program customers select the products to be sold in their stores and, in consultation with AAi sales and service personnel, determine the initial order and display requirements. Thereafter, based on POS information, the Company's management adjusts product mix, generates display planograms and determines discounts and markdowns. This information is transmitted to AAi's field service representatives who regularly visit the retailers' stores to replenish and restock displays, reorder product and attend to markdowns and allowances, thereby providing customers with a real-time response to the market. The frequency of service visits is dictated by the size of the store and the number of the Company's products carried by the retailer. The Company has over 1,400 field service representatives.
SALES AND MARKETING
The Company's seven sales managers have an average of over 17 years of industry experience. The sales force is organized by both distribution channel and product line. The product-based sales approach is dictated by customers since most retailers divide their buyers' responsibilities by product. Sales representatives service existing customers and are responsible for increasing product penetration and solving customer problems.
The Company markets its products to the retailers by attending trade shows and advertising in industry trade magazines. The Company also maintains showrooms and sales offices domestically in New York City, New York, Cincinnati, Ohio and Bentonville, Arkansas as well as internationally in Toronto, Canada, Mexico City, Mexico, London, England and Hong Kong. The marketing staff is responsible for sales and marketing efforts directed at new customers and for negotiating contract terms for existing and prospective customers. Marketing focuses on designing a customized product and service package for each customer after determining the
retailer's specific needs. Often, branded products provide AAi with initial access to a new customer. The Company then leverages the strength of the Company's field service and breadth of its product lines to increase product penetration.
In addition, since acquiring the Foster Grant brand, the Company has begun to advertise directly to the end-consumer. This includes relaunching the "Who's That Behind Those Foster Grants" campaign, featuring Cindy Crawford, global promotions and public relations efforts aimed at increasing awareness of the Foster Grant brand. Also, the Company has launched a co-branded line of Ironman Triathlon(R) sports sunglasses.
INTELLECTUAL PROPERTY AND LICENSES
Proprietary Trademarks. The Company owns trademarks in the words and designs used on or in connection with many of its products. The Company has registered a variety of trademarks under which it sells a number of its products, including Foster Grant. The level of copyright and trademark protection available to the Company for proprietary words, phrases and designs varies depending on several factors including the degree of originality and the distinctiveness of the associated trademarks and design.
Licenses. In 1992, AAi began distributing licensed products pursuant to an agreement with Disney Enterprises, Inc. The Company currently holds numerous non-exclusive licenses from various licensors to market products with classic cartoon characters and other images or under other brand names and trademarks. Many of the Company's license agreements limit sales of products to certain market categories. The Company pays each of these licensors a royalty on sales of licensed products. The Company's licenses generally are for terms of one to three years. The license agreements generally require minimum annual payments and certain quality control procedures and give the licensor the right to approve products licensed by the Company. Typically, the licensor may terminate the license if specified minimum levels of annual net sales for licensed products are not met or for failure by the Company to comply with the material terms of the license. Certain licenses require minimum advertising expenditures by the Company and also require the Company to make lump-sum payments in the event of a change of ownership. Accordingly, the Company's licensing arrangements are dependent primarily upon maintaining a good relationship between the Company and its licensors. The Company believes it has good relationships with its licensors and has generally been able to obtain renewals of expired licenses and to obtain the required approval for licensed products.
Most of the Company's license agreements are non-exclusive, of short duration and may be terminated if the Company fails to comply with any material terms thereof. There can be no assurance that any of these relationships with licensors will continue, that such agreements will be renewed or that the Company will be able to obtain licenses for additional brands. If the Company were unable in the future to obtain such licenses on terms it deems reasonable, it would be required to modify its marketing plans and could be forced to rely more heavily on its proprietary brands or generic product sales, which could materially adversely affect its business, financial condition and results of operations.
PRODUCT DESIGN, SOURCING AND ASSEMBLY
Product Design. AAi's in-house design staff develops new products in line with the current and anticipated trends for each season. For licensed brands, the Company works extensively with the licensor in approving each detail of the new products. The Company believes that its future success will depend, in part, on its ability to enhance its existing product lines and develop new styles and products to meet an expanding range of customer and consumer requirements.
Sourcing and Assembly. The Company outsources manufacturing for all of its products, 75% of which is sourced to manufacturers in Asia through a joint venture in Hong Kong, with the remainder outsourced to independent domestic manufacturers. The joint venture is co-owned with a Hong Kong investor who provides on-site management. The joint venture monitors production and ensures that products meet the Company's quality standards. The Company also utilizes domestic manufacturers to accommodate short delivery lead times or when otherwise necessary. The Company believes that the quality and cost of the products manufactured by its suppliers provide it with a significant competitive advantage. In addition, sourcing the majority of its products through the joint venture enables the Company to better control costs, monitor product quality, manage inventory and provide efficient order fulfillment.
COMPETITION
The optical products and accessories industries are highly competitive. There are numerous competitors for each of its product lines both in the retail channels serviced by the Company and in its other channels of distribution. Competitors include numerous accessory vendors, including those with their own retail stores, smaller independent specialty manufacturers, and in the case of costume jewelry and reading glasses, divisions or subsidiaries of large companies with greater financial or other resources than those of the Company. Certain of these competitors control licenses for widely recognized images, such as cartoon or movie characters which could provide them with a competitive advantage. The Company may also experience increased competition from suppliers of upscale fashion accessories seeking to enter the mass merchandise market.
There are significant costs associated with the design, production and installation of display fixtures for new customers. Furthermore, many retailers require a new supplier to buy back the retailer's existing inventory as a condition to changing vendors. These inventory costs can be substantial and serve as a barrier to entry for both competitors attempting to reach the Company's existing customers as well as for the Company in obtaining new customers.
AAi competes on the basis of diversity and quality of its product designs, the breadth of its product lines, product availability, price and reputation as well as customer service and support programs. The Company has many competitors with respect to one or more of its products but believes that there are few competitors that distribute products with the same product diversity and service quality as the Company.
EMPLOYEES
As of March 15, 1999, the Company had approximately 700 full-time employees and 1,400 part-time employees, none of whom were represented by a labor union. The Company considers its relationship with its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
The Company's principal executive office is located at 500 George Washington Highway, Smithfield, Rhode Island. AAi's primary distribution facilities are adjacent to its recently expanded headquarters, which together are 180,000 square feet.
The following table describes the material properties owned and leased by AAi:
- ---------- (a) Leased to AAi from related parties. See "Certain Relationships and Related Transactions."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to legal proceedings in the ordinary course of business. While the outcome of law suits or other proceedings cannot be predicted with certainty, management does
not expect these matters to have a material adverse effect on the financial condition, results of the operation or cash flow of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders in the fourth quarter of 1998.
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ITEM 5.
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
All of the Common Stock of the Company is held by affiliates and certain directors and officers of the Company; thus, no trading market exits for such stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table contains selected consolidated financial data for the Company and is qualified in its entirety by the more detailed consolidated financial statements of the Company included herein. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere herein.
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(a) Includes the results of operations of the acquired businesses from the respective dates of acquisition: Tempo Division of Allison Reed Group, Inc. ("Tempo") in June 1996, Foster Grant US in December 1996, Superior
Jewelry Company ("Superior") in July 1997, Eyecare Products UK Ltd. ("Foster Grant UK") in March 1998 and Fantasma, LLC ("Fantasma") in June 1998.
(b) Reflects a reduction from net income for the accretion and noncash dividends on Series A Preferred Stock. See Note 10 of the Notes to the Company's Consolidated Financial Statements.
(c) The Company was an S corporation under Section 1362 of the Internal Revenue Code until May 31, 1996. Pro forma income taxes, assuming the Company was subject to C corporation income taxes, have been provided, in the accompanying statement of operations for 1994, 1995 and 1996, at an estimated statutory rate of 40%.
(d) "EBITDA" is defined as earnings before interest, taxes, depreciation and amortization. Although EBITDA is not a measure of performance calculated in accordance with GAAP, AAi believes that EBITDA is accepted as a generally recognized measure of performance in the distribution industry because it is an indicator of the earnings available to meet the Company's debt service obligations. Nevertheless, this measure should not be considered in isolation or as a substitute for operating income, net income, net cash provided by operating activities or any other measure for determining AAi's operating performance or liquidity which is calculated in accordance with GAAP.
(e) Does not include capital assets acquired in connection with the acquisitions of the Tempo, Foster Grant US, Superior, Foster Grant UK and Fantasma.
(f) Includes amounts outstanding under a revolving credit facility, various long-term obligations and subordinated promissory notes payable to shareholders at each applicable period.
(g) Includes preferred stock of Foster Grant Holdings, Inc.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion may contain "forward-looking" statements and are subject to risks and uncertainties that could cause actual results to differ significantly from expectations. In particular, statements contained in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" section which are not historical facts, including, but not limited to, statements regarding the anticipated adequacy of cash resources to meet the Company's working capital and capital expenditure requirements and statements regarding the anticipated proportion of revenues to be derived from a limited number of customers, may constitute forward-looking statements. Although the Company believes the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. These risks and uncertainties include the substantial leverage of the Company, customer concentration and consolidation, dependence on licensed brands, a single site distribution facility, a limited number of delivery companies, operating in international economies, unpredictability of discretionary consumer spending, competition, susceptibility to changing consumer preferences and successful conversion of computer systems and implementation of Year 2000 readiness programs, as well as those described in the Company's Registration Statement on Form S-4 declared effective on November 16, 1998 (SEC File No. 333-61119). The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included elsewhere.
OVERVIEW
The Company is a value-added distributor of optical products, costume jewelry, watches, clocks and other accessories primarily to mass merchandisers, chain drug stores/combo stores/supermarkets and variety stores in North America and the United Kingdom. As a value-added distributor, the Company provides customized store displays, merchandising management and a store-level field service force to replenish and restock displays, reorder product and attend to markdowns and allowances. Upon shipment to the customer, the Company estimates agreed upon future allowances, returns and discounts, taking into account historical experience, and reflects revenue net of these estimates.
When establishing or expanding a customer relationship, the Company generally enters into multi-year agreements for the supply of specified product lines to specific customer stores. The agreements typically do not contain required minimum sales volumes, but may provide for termination penalties equal to the Company's unamortized cost of product displays provided to the customer. The Company believes its relationships with retailers are dependent upon its ability to efficiently utilize allocated floor space to generate satisfactory returns for its customers. To meet this end, the Company strives to consistently deliver competitively priced products and service programs which provide retailers with attractive gross margins and inventory turnover rates. The Company has historically retained customers from year to year, although retailers may drop or add product lines supplied by the Company. Generally, customer loss has been attributable to such customer going out of business or being acquired by a company which does
not carry the Company's product line or has prior relationships with a competitor of the Company.
Certain segments of the retail industry, particularly mass merchandisers, variety stores, drugstores and supermarkets, are experiencing significant consolidation and in recent years many major retailers have experienced financial difficulties. These industry wide developments have had and may continue to have an impact on the Company's results of operations. For example, net sales were adversely affected in 1997 by the loss of two customers, one as a result of a merger into a retail chain that does not carry costume jewelry and the other due to the retailer ceasing operations. In addition, also as a result of financial pressures, many major retailers have sought to reduce inventory levels in order to reduce their operating costs which has had a negative effect on the Company's results of operations.
During the first quarter of 1998, the Company elected to change its fiscal year end from December 31 to the Saturday closest to December 31.
Net Sales. The Company offers optical products, costume jewelry, small synthetic leather goods, watches, clocks and other accessories, generally at retail price points of $20 or less. In December 1996, the Company acquired Foster Grant US, a major marketer and distributor of sunglasses and reading glasses, product lines in which the Company had only minimal sales before the acquisition. Accordingly, the Company's product mix changed dramatically as a result of this acquisition. Net sales of the Company's optical products accounted for approximately 47.3%, 50.7% and 17.4% of the Company's net sales in fiscal 1998, 1997 and 1996, respectively; net sales of the Company's costume jewelry accounted for approximately 40.3%, 43.4% and 74.6% of the Company's net sales in fiscal 1998, 1997 and 1996, respectively, and the balance represented sales of synthetic leather goods, watches, clocks and other accessories.
Cost of Goods Sold. The Company outsources manufacturing for all of its products, 75% of which is sourced to manufacturers in Asia through its joint venture in Hong Kong, with the remainder outsourced to independent domestic manufacturers. Accordingly, the principal element comprising the Company's cost of goods sold is the price of manufactured goods purchased through the Company's joint venture or from independent manufacturers. The Company believes outsourcing manufacturing allows it to reliably deliver competitively priced products to the retail market while retaining considerable flexibility in its cost structure.
Operating Expenses. Operating expenses are comprised primarily of payroll and occupancy costs related to the Company's selling, general and administrative activities as well as depreciation and amortization. The Company incurs various costs in connection with the acquisition of new customers and new stores for existing customers, principally the cost of new product display fixtures and costs related to the purchase of the customer's existing inventory. The Company makes substantial investments in the design, production and installation of display fixtures in connection with establishing and maintaining customer relationships. The Company capitalizes the production cost of these display fixtures as long as it retains ownership of them. These costs are amortized to selling expenses on a straight-line basis over their estimated useful life, which is
one to three years. If the Company does not retain title to the displays, the display costs are expensed as shipped.
The Company incurs direct and incremental costs in connection with the acquisition of certain new customers and new store locations from existing customers under multi-year agreements. The Company may also receive the previous vendor's merchandise from the customer in connection with most of these agreements. In these situations, the Company values this inventory at its fair market value, representing the lower of cost or net realizable value, and records that value as inventory. The Company sells this inventory through various liquidation channels. Except as provided below, the excess costs over the fair market value of the inventory received is charged to selling expenses when incurred. The Company expensed customer acquisition costs of $0.9 million, $1.6 million and $2.7 million in fiscal 1998, 1997 and 1996, respectively.
The excess costs over the fair market value of the inventory received is capitalized as deferred costs and amortized over the agreement period if the Company enters into a minimum purchase agreement with the customer and the estimated gross profits from future minimum sales during the term of the agreement are sufficient to recover the amount of the deferred costs. During fiscal 1998, the Company capitalized approximately $2.3 million of these costs. No such costs were capitalized during fiscal 1996 and 1997. Amortization expense related to these costs was approximately $219,000 for the year ended January 2, 1999.
Dividends and Accretion on Preferred Stock. The Company has 43,700 shares of Series A Redeemable Convertible Preferred Stock ("Series A Preferred Stock") outstanding, of which 34,200 were issued in May 1996 for gross proceeds of $18.0 million, and an additional 9,500 shares were issued for gross proceeds of $5.0 million in connection with the December 1996 acquisition of Foster Grant US. Beginning on June 30, 2002, shares of the Series A Preferred Stock are redeemable at the option of the holder for an amount equal to the original issue price plus accrued and unpaid dividends yielding a 10% compounded annual rate of return, provided, however, that the right to require redemption is suspended as long as any Restrictive Indebtedness (as defined in the Articles of Incorporation) is outstanding. Net loss applicable to common shareholders represents net loss less accretion of original issuance costs and cumulative dividends due on the Series A Preferred Stock.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Although EBITDA is not a measure of performance calculated in accordance with Generally Accepted Accounting Principles (GAAP), the Company believes that EBITDA is accepted as a generally recognized measure of performance in the distribution industry and provides an indicator of the earnings available to meet the Company's debt service obligations. EBITDA should not be considered in isolation or as a substitute for operating income, net income, net cash provided by operating activities or any other measure for determining the Company's operating performance or liquidity which is calculated in accordance with GAAP. EBITDA was $6.6 million, $14.4 million and $2.5 million in fiscal 1998, 1997 and 1996, respectively.
RECENT SIGNIFICANT ACQUISITIONS
The Company has grown rapidly through strategic acquisitions in recent years. In June 1998, the Company acquired 80% of the membership interests of Fantasma for $4.1 million in cash. The remaining 20% membership interest of Fantasma is held by Roger Dreyer, president of Fantasma. In connection with the acquisition, Mr. Dreyer and another officer of Fantasma received options to acquire in the aggregate an additional 13% membership interest in Fantasma subject to satisfaction of certain earnings targets in 1998, 1999 and 2000. Based on fiscal 1998 results of operations, options to acquire 3% of Fantasma expired resulting in options to acquire an additional 10% membership interest outstanding at January 2, 1999. AAi's acquisition of Fantasma added watches and clocks to AAi's product lines and Disney and Warner Bros. stores to its customer base. As a result of this transaction, the Company recorded approximately $4.6 million in intangible assets which will be amortized over 10 years.
In March 1998, the Company acquired certain assets of Foster Grant UK for the aggregate book value of certain acquired assets, including inventory items of $3.3 million and accounts receivable of $1.7 million, less the aggregate amount of trade payables assumed of $1.1 million and bank debt assumed of $1.7 million. In addition, the Company acquired the Foster Grant trademark in the United Kingdom and Europe for $0.7 million, which amount is subject to upward adjustment at the end of 1998 and 1999 based on annual sales, up to a maximum additional payment of $0.7 million. No adjustment to the purchase price is required as result of 1998 sales. As a result of this acquisition, the Company recorded approximately $1.1 million of intangible assets which are being amortized over 20 years.
In July 1997, the Company acquired the assets of Superior, a distributor of costume jewelry to chain drug stores and mass merchandisers in the United States. The Company paid $2.7 million in cash, including a contingent cash payment of $875,000 and assumed certain liabilities in the amount of $4.1 million. The purchase price is subject to upward adjustment based on 1998 earnings attributable to Superior operations, up to a maximum amount of $2.0 million. No adjustment is required as a result of 1998 operating results to the purchase price. As a result of this acquisition, the Company recorded approximately $3.5 million of goodwill which is being amortized over 10 years.
In December 1996, the Company, through a newly-formed subsidiary, Foster Grant Holdings, Inc. ("FG Holdings") acquired Foster Grant US, a marketer and distributor of sunglasses, reading glasses and eyewear accessories in the United States and Canada. The consideration consisted of $10.0 million in cash, assumed liabilities in the amount of $34.0 million and 100 shares of redeemable non-voting preferred stock of FG Holdings (the "FG Preferred Stock") initially valued at $750,000. The redemption value of the FG Preferred Stock is subject to an upward adjustment, based on annual sales of the Foster Grant US operations through the year ending January 1, 2000 or, upon the occurrence of certain specified capital transactions, based upon the valuation of the Company at the time of the transaction. The maximum redemption amount is $4.0 million. As a result of this acquisition, the Company recorded approximately $11.0 million of intangible assets which are being amortized over 40 years. Any difference in the redemption amount from the
carrying value of the FG Preferred Stock immediately prior to redemption may be recorded as additional purchase price.
EFFECTS OF ACQUISITIONS
Historically, the Company has selected acquisition candidates based, in part, on the opportunity to improve their operating results. The Company seeks to leverage its purchasing power, distribution capabilities and lower operating costs to improve the financial performance of its acquired businesses. Results of operations reported herein for each period only include the results of operations for acquired businesses from their respective dates of acquisition. Full year operating results, therefore, could differ materially from those presented.
The Company has accounted for its acquisitions using the purchase method of accounting. As a result, these acquisitions have affected, and will prospectively affect, the Company's results of operations in certain significant respects. The aggregate acquisition costs are allocated to the tangible and intangible assets acquired and liabilities assumed by the Company based upon their respective fair values as of the acquisition date. The cost of such assets are then amortized according to the classes of assets and the useful lives thereof. The acquisitions necessitating payment of purchase price in excess of the fair value of the net assets acquired results in intangible assets consisting of goodwill and trademarks which are being amortized on a straight-line basis over a period of 10 to 40 years. Similar future acquisitions or additional consideration paid for existing acquisitions may result in additional amortization expense. In addition, due to the effects of the increased borrowing to finance any future acquisitions, the Company's interest expense may increase in future periods. As of January 2, 1999, net intangible assets as a result of acquisitions was $20.9 million.
CONSOLIDATION OF DISTRIBUTION OPERATIONS
In the fourth quarter of 1998, the Company closed its Texas distribution center and consolidated distribution operations at its expanded Rhode Island facility. AAi expects this restructuring will generate permanent annual operating expense savings of approximately $2.8 million commencing in 1999. In 1998, the Company incurred $5.0 million of expenses related to the closing of the Texas distribution center, including a restructuring charge of $2.6 million for the write-down of disposed assets, the payment of severance benefits and expenses relating to operating inefficiencies.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentage relationship to net sales of certain items included in the Company's Statement of Operations:
YEAR ENDED JANUARY 2, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Net Sales. Consolidated net sales were $160.3 million for the year ended January 2, 1999 as compared to $149.4 million for the year ended December 31, 1997, an increase of 7.3% or $10.9 million. The $10.9 million increase in net sales relates to the 1998 acquisitions of Fantasma and Foster Grant UK which contributed $18.0 million of net sales. This increase was partially offset by a decline of $7.1 million of net sales with chain drug stores/combo stores/supermarkets, primarily related to sales of optical products which were adversely impacted by disruptions associated with the relocation of optical distribution activities to the Company's expanded Smithfield, Rhode Island facility.
Gross Profit. Gross profit was $71.5 million for the year ended January 2, 1999 which was the same as for the year ended December 31, 1997. Gross profit from the aforementioned acquisitions accounted for an $8.0 million increase offset by a decline in net sales in chain drug
stores/combo stores/supermarkets, primarily related to optical products. Gross profit as a percentage of net sales decreased to 44.6% from 47.8% due to the decline in sales of optical products (which carry higher margins) and increased shipments of lower margin seasonal and promotional products as well as from the lower margins on Fantasma products.
Operating Expenses. Operating expenses were $78.1 million for the year ended January 2, 1999 as compared to $65.3 million for the year ended December 31, 1997, an increase of 19.6% or $12.8 million. The increase is attributable to $6.9 million of operating expenses associated with the acquired entities and $5.0 million of expenses related to the closing of the Texas distribution center including the write-down of disposed assets, the payment of severance benefits and operating inefficiencies incurred subsequent to the announcement of the planned closure.
Interest Expense. Interest expense was $7.0 million for the year ended January 2, 1999 as compared to $4.2 million for the year ended December 31, 1997, an increase of 66.4% or $2.8 million. This resulted from additional borrowings under the Company's credit facilities to fund acquisitions and expanded operations and a higher effective interest rate related to the Notes.
Income Tax Benefit (Expense). No income tax benefit was recorded for the year ended January 2, 1999 as compared to $1.2 million of expense for the year ended December 31, 1997. During 1998, based on actual and anticipated results, the Company determined that a greater valuation reserve was required. Accordingly, the Company increased the valuation allowance by approximately $3.7 million which offset any benefit that was recognized.
Net Income (Loss). As a result of the factors discussed above, net loss before dividends and accretion on preferred stock was $13.2 million for the year ended January 2, 1999 as compared to net income before dividends and accretion on preferred stock of $815,000 for the year ended December 31, 1997, a decrease of $14.0 million.
Net Loss Applicable to Common Shareholders. Net loss applicable to common shareholders was $15.9 million for the year ended January 2, 1999 as compared to a loss of $1.7 million for the year ended December 31, 1997, an increase of $14.2 million. The increase was attributable to the $14.0 million decrease in earnings and an increase of $283,000 in dividends and accretion on Series A Preferred Stock due to the compounding of accrued dividends.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Net Sales. Consolidated net sales were $149.4 million for 1997 compared to $86.3 million for 1996, an increase of 73.1% or $63.1 million. The increase was primarily due to a full year of sales attributable to Foster Grant US operations and six months of sales attributable to Superior operations in 1997, which accounted for $60.6 million and $5.2 million of the increase, respectively. This increase was partially offset by the loss of two customers in 1997, one as a result of the customer's merger into a retailer that does not offer costume jewelry and the other due to a retailer ceasing operations, which together accounted for an estimated $5.1 million decrease in net sales.
Gross Profit. Gross profit was $71.5 million for the 1997 as compared to $38.5 million for 1996, an increase of 85.8% or $33.0 million. Gross profit from sales generated from the aforementioned acquisitions accounted for a $35.3 million increase which was partially offset by the decline in gross profit on the two lost customers. Gross profit increased as a percentage of net sales from 44.6% to 47.8%, primarily as a result of an increase in the net sales of optical products (which carry higher margins) and savings related to consolidating purchasing efficiencies. These purchasing efficiencies were a result of increased purchasing volume with selected vendors and the combination of the Company's optical product sourcing with the sourcing of Foster Grant US following the Company's acquisition of Foster Grant US in December 1996.
Operating Expenses. Operating expenses were $65.3 million or 43.7% of net sales in 1997 compared to $37.5 million or 43.5% of net sales in 1996, an increase of 74.1% or $27.8 million. The increase resulted from the acquisition of entities with $29.0 million of operating expenses, offset by a decrease of $1.2 million of operating expenses in existing businesses.
Interest Expense. Interest expense was $4.2 million in 1997 compared to $1.5 million in 1996, an increase of 186.9% or $2.7 million. This resulted from interest charged on additional borrowings under the Company's credit facilities to fund acquisitions and expanded working capital and capital expenditure requirements.
Income Tax Benefit (Expense). Income tax expense was $1.2 million in 1997 compared to an income tax benefit of $948,000 in 1996, an increase of $2.1 million. The Company's consolidated effective income tax rate was 58.8% for 1997, reflecting the impact of nondeductible amortization of intangilble assets for income tax purposes. The Company was operated as a subchapter S corporation under Section 1362 of the Internal Revenue Code until May 31, 1996, and as a result, taxable income or loss of the Company was passed through to the shareholders and reported on their individual tax returns. Accordingly, the Company did not incur federal and state income taxes (except with respect to certain states) for the period prior to June 1, 1996.
Net Income (Loss). As a result of the factors discussed above, net income before dividends and accretion on preferred stock was $815,000 in 1997 as compared to net income before dividends and accretion on preferred stock of $89,000 in 1996, an increase of 815.7% or $726,000.
Net Loss Applicable to Common Shareholders. Net loss applicable to common shareholders was $1.7 million for the year ended December 31, 1997, compared to a net loss of $1.0 million for the year ended December 31, 1996, an increase of $647,000. The increase was primarily attributable to the $1.4 million increase in dividends and accretion on Series A Preferred Stock offset by a $726,000 increase in net income over 1996. The increase in dividends and accretion on Series A Preferred Stock is due to an increased number of shares (43,700) being outstanding for the entire year in 1997, as compared to fewer shares (34,200) being outstanding for less than seven months in 1996.
LIQUIDITY AND CAPITAL RESOURCES
At January 2, 1999 the Company had cash and cash equivalents of $2.2 million and working capital of $36.1 million. To date, the Company has funded its operations through credit facilities, issuance of equity and debt securities, and cash generated from operations.
The Company used $3.9 million of cash for operations during fiscal 1998 compared to generating $1.6 million of cash from operations in fiscal 1997. The cash used in operations in fiscal 1998 was used primarily to fund losses from operations and increases in accounts receivable.
The Company used $29.8 million in investing activities during fiscal 1998, compared to $9.1 million in 1997. Cash used in investing activities increased in fiscal 1998 as compared to 1997 as a result of cash used in acquisitions and additional expenditures for property and equipment. The cash used in investing activities in fiscal 1998 included $6.4 million for the purchase and expansion of the Company's Smithfield, Rhode Island headquarters, $9.4 million for display fixtures, $5.5 million to acquire certain assets of Foster Grant UK and the Foster Grant trademark for the United Kingdom and Europe, and $4.1 million to acquire an 80% interest in Fantasma. The Company expects its capital expenditure level (excluding cost of display fixtures) to be approximately $1.5 million for fiscal 1999.
The Company generated $33.1 million from financing activities during fiscal 1998, compared to $8.8 million in 1997. Cash generated from financing activities increased in fiscal 1998 compared to 1997 primarily as a result of the Company's sale of the Notes. On July 21, 1998, substantially all of the net proceeds from the sale of $75.0 million of 10 3/4% Senior Notes were used to pay existing debt.
The 43,700 shares of Series A Preferred Stock has a redemption value of $28.9 million at January 2, 1999. Shares of Series A Preferred Stock are convertible into Common Stock at a rate of 10 to 1, adjustable for certain dilutive events. Conversion is at the option of the shareholder, but is automatic upon consummation of a qualified public offering. The holders of the Series A Preferred Stock have the right to require redemption for cash for any unconverted shares, beginning June 30, 2002, provided, however, that the right to require redemption is suspended as long as any Restrictive Indebtedness is outstanding. The Notes constitute Restrictive Indebtedness. The redemption price of the Series A Preferred Stock is an amount equal to the original issue price, $526.32 per share, plus any accrued and unpaid dividends yielding a 10% compounded annual rate of return.
In connection with the purchase of Foster Grant US, the Company's wholly-owned subsidiary, FG Holdings issued 100 shares of FG Preferred Stock, which are redeemable on February 28, 2000, or earlier upon the occurrence of certain specified capital transactions. The redemption price will range between $1.0 million and $4.0 million depending upon the net sales of sunglasses, reading glasses and accessories by FG Holdings and the Company, and upon the total transaction value.
The Company is continually engaged in evaluating potential acquisitions. The Company expects that funding for future acquisitions may come from a variety of sources, depending on the size and nature of any such acquisition. Potential sources of capital include cash generated from operations, borrowings under the Company's senior credit facility with NationsBank, N.A., as agent and lender (the "Senior Credit Facility"), or other external debt or equity financings. There can be no assurance that such additional capital sources will be available to the Company, if at all, on terms that the Company finds acceptable.
The Company has substantial indebtedness and significant debt service obligations. As of January 2, 1999, the Company had total indebtedness, including borrowings under the Senior Credit Facility, in the aggregate principal amount of $79.0 million. The Company had current liabilities of approximately $43.0 million. In addition, the Company has significant annual obligations that include interest on the Notes of approximately $8.1 million, minimum royalty obligations over the next two years of approximately $2.7 million and minimum payments under its operating leases of approximately $1.9 million. The Indenture permits the Company to incur additional indebtedness, including secured indebtedness, subject to certain limitations.
The Company had up to $47.3 million available for borrowings under the Senior Credit Facility as of January 2, 1999. Interest rates on the revolving loans under the Senior Credit Facility are based, at the Company's option, on the Base Rate (as defined) or LIBOR plus an applicable margin. The Senior Credit Facility contains certain restrictions and limitations, including financial covenants that require the Company to maintain and achieve certain levels of financial performance and limit the payment of cash dividends and similar restricted payments. As of January 2, 1999, the Company was not in compliance with certain financial covenants under the Senior Credit Facility. The Company received a waiver of such non-compliance from its lenders and is currently negotiating an amendment to the Senior Credit Facility which will modify the financial covenants going forward. If the Company does not successfully negotiate an amendment to the Senior Credit Facility, the Company expects that it will not be in compliance with certain financial covenants in the Senior Credit Facility for fiscal 1999. The Company has received a letter from the Bank stating that it intends to modify the covenants so they are amounts which the Company believes it can attain. The Company believes it will successfully negotiate the amendment, however, there can be no assurance that it will be able to do so.
The Company's ability to make scheduled payments of principal of, or to pay the interest on, or to refinance, its indebtedness (including the Notes), or to fund planned capital expenditures will depend on its future performance, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond its control. Based upon the current level of operations and anticipated cost savings and revenue growth, the Company believes that cash flow from operations and available cash, together with available borrowings under the Senior Credit Facility, will be adequate to meet the Company's future liquidity needs for at least the next several years. The Company may, however, need to refinance all or a portion of the principal of the Notes on or prior to maturity. There can be no assurance that the Company's business will generate sufficient cash flow from operations, that anticipated cost savings and revenue growth will be realized or that future borrowings will be available under the Senior Credit Facility in an amount sufficient to enable the Company to service its indebtedness, including the Notes, or to fund its other liquidity needs. In
addition, there can be no assurance that the Company will be able to effect any such refinancing on commercially reasonable terms or at all.
IMPACT OF INFLATION
The Company believes that inflation has not had a material effect on its results of operations or financial condition during the past three years.
SEASONALITY AND QUARTERLY INFORMATION
Significant portions of the Company's business are seasonal. Sunglasses are shipped primarily during the first half of the fiscal year as retailers build inventory for the spring and summer selling seasons, while costume jewelry and other accessories are shipped primarily during the second half of the fiscal year as retailers build inventory for the holiday season. Reading glasses sales are generally uniform throughout the year. As a result of these shipping trends, the Company's historical working capital requirements grow through the first three quarters of the year to fund inventory purchases and the growth in accounts receivable. Historically, in the fourth quarter, the Company's working capital requirements have decreased as accounts receivable are collected.
Quarterly results may also be materially affected by the timing and magnitude of acquisitions, costs related to acquisitions, fluctuations in product cost, changes in product mix, timing of customer orders and shipments and general economic conditions.
YEAR 2000
The Company uses several application programs written over many years using two-digit fields to define the applicable year, rather than four-digit year fields. Programs that are time-sensitive may recognize a date using "00" as the year 1900 rather than the year 2000. This misinterpretation of the year could result in an incorrect computation or a computer shutdown.
As a result of the Company's growth, AAi is implementing a new information management system which is expected to be Year 2000 compliant. The new system is scheduled for completion by mid-1999. Accordingly, the Company believes that with the successful conversion to the new software, the Year 2000 issue will not pose significant operational problems for the Company's systems. The Company will evaluate the need for contingency planning in the second quarter of 1999 based on the status of the system installation.
Since Year 2000 compliance is being addressed with the implementation of the Company's new system, the costs of addressing the Year 2000 issue are not separately identifiable. No material additional costs are anticipated at this time.
The Company has completed a compliance review of its property which uses embedded technology. Although the Company believes that the Year 2000 issue will not pose a significant problem for any of the Company's systems or property utilizing embedded technology, there can be no assurance that the Year 2000 issue will not interfere with the function and use of such property.
The Company has engaged in formal communications with its major customers and most significant vendors to determine the extent to which the Company's interface systems are vulnerable to those third parties' failure to remediate their own Year 2000 issues. These major customers and vendors have informed the Company that they are currently addressing the Year 2000 issue and expect to be Year 2000 compliant by mid-1999. While there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted and will not have an adverse effect on the Company's systems, the Company does not believe that its operations are materially vulnerable to the failure of any vendor or customer to properly address the Year 2000 issue. The Company's contingency plan in the event other parties are unable to provide Year 2000 compliant electronic data is to revert to paper documentation from these parties.
The failure to correct a material Year 2000 problem could result in an interruption in, or failure of, certain normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-party suppliers and customers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's results of operations, liquidity or financial condition. The aforementioned steps being undertaken by the Company are expected to significantly reduce the Company's level of uncertainty about the Year 2000 problem and, in particular, about the Year 2000 compliance and readiness of its material customers and vendors. The Company believes that, with the implementation of its new information management system and the other steps being taken, the possibility of significant interruptions of normal operations should be reduced.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company does not believe that the adoption of SFAS No. 133 will have a material impact on its financial statements.
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-5 Reporting on the Costs of Start Up Activities, (SOP 98-5). SOP 98-5 provides guidance on the financial reporting of start up activities and organization costs to be expensed as incurred. The Company does not believe that the adoption of SOP 98-5 will have a material impact on its financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The following discussion about the Company's market risk disclosures includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and foreign currency exchange rates. The Company does not use derivative financial instruments for speculative or trading purposes.
INTEREST RATE RISK. The Company is exposed to market risk from changes in interest rates primarily through its borrowing activities. In addition, the Company's ability to finance future acquisition transactions may be impacted if the Company is unable to obtain appropriate financing at acceptable interest rates.
The Company manages its borrowing exposure to changes in interest rates by optimizing the use of fixed rate debt with extended maturities. At January 2, 1999, approximately 99% of the carrying values of the Company's long-term debt was at fixed interest rates.
FOREIGN CURRENCY RISK. The Company's results of operations are affected by fluctuations in the value of the U.S. dollar as compared to the value of currencies in foreign markets primarily related to changes in the British Pound, the Canadian Dollar, the Mexican Peso and the Hong Kong Dollar. In fiscal 1998, the net impact of foreign currency changes was not material to the Company's financial condition or results of operations. The Company manages its exposure to foreign currency exchange risk by trying to minimize the Company's net investment in its foreign subsidiaries. At January 2, 1999, the Company's net investment in foreign assets was approximately $6.2 million. The Company generally does not enter into derivative financial instruments to manage foreign currency exposure.
The Company's operations in Europe are not significant and, therefore, the Company does not expect to be materially impacted by the introduction of the Euro dollar.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The index to financial statements is included on page of this Annual Report and is incorporated by reference herein.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There are no changes in or disagreements with accountants on accounting and financial disclosure as defined by Item 304 of Regulation S-K.
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ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
DIRECTORS AND EXECUTIVE OFFICERS
Each director of the Company is elected for a period of one year at the Company's annual meeting of shareholders and serves until his successor is duly elected by the shareholders. Vacancies and newly created directorships resulting from any increase in the number of authorized directors may be filled by a majority vote of directors then remaining in office. The holders of the Series A Preferred Stock (the "Preferred Holders," or individually, a "Preferred Holder") have the right, at their option, to designate up to two directors to the Board of Directors, as well as the right to vote on the election of directors at the annual meeting of shareholders. In addition, AAi's Articles of Incorporation provide that, in addition to other events, if the Company is in default of any of its covenants thereunder, the Preferred Holders shall have the right to elect a majority of the members of the Board of Directors. The Company is currently in default of one such covenant. However, the Preferred Holders have not exercised their right to elect a majority of the members of the Board of Directors.
The Company's shareholders have entered into an agreement that requires them, subject to the rights of Preferred Holders to elect additional directors in the event of default, to vote to fix the number of directors of the Company at seven and elect as directors two persons designated by the Preferred Holders and five persons designated by certain management shareholders. In addition, Weston Presidio Capital II, L.P., the record holder of 17,100 shares (39.1%) of the Series A Preferred Stock, has agreed to vote in favor of Martin E. Franklin (or in the event of his death or disability, the designee of Marlin Capital, L.P.) as a director. See "Certain Relationships and Related Transactions -- Shareholders Agreement." Officers are elected by and serve at the discretion of the Board of Directors.
The following table sets forth information with respect to each person who is currently a director or executive officer of the Company.
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* Designated by the Preferred Holders. All other directors were designated by certain management shareholders pursuant to the Shareholders Agreement. See "Certain Relationships and Related Transactions -- Shareholders Agreement."
(a) Member of the Compensation Committee. (b) Member of the Audit Committee.
The following is a brief summary of the background of each director and executive officer. Unless otherwise indicated, each individual has served in his current position for at least the past five years.
Gerald F. Cerce co-founded the Company in 1985 with Mr. Porcaro and has served as the Company's Chairman of the Board since that time. Mr. Cerce also served as Chairman of the Board of AAi's predecessor company, Femic, Inc., a Rhode Island jewelry manufacturer which
Mr. Cerce and Mr. Porcaro acquired in 1972. Mr. Cerce serves on the Board of Trustees of Bryant College and is a former member of the Advisory Board of Citizens Savings Bank.
John H. Flynn, Jr. joined AAi's predecessor company in 1981 as Vice President. He served as President and Chief Executive Officer of the Company from 1985 to 1998 and has been a Director since 1985. As Executive Vice President of Sales and Customer Service, Mr. Flynn directly manages all sales and service operations for the Company in the U.S. Prior to joining the Company, Mr. Flynn was a service director for K&M Associates, a costume jewelry distributor, and also served as Vice President of Puccini Accessories where he supervised all sales and service operations.
Stephen J. Carlotti has been a Director of the Company since June 1996. He is an attorney and has been a partner of the firm Hinckley, Allen & Snyder since 1992 and from 1972 to 1989. From 1989 to 1992, he served as Chief Operating Officer and General Counsel of The Mutual Benefit Life Insurance Company. He is also a director of WPI Group, Inc. (a manufacturer of hand held computers and electronic components) and Fleet National Bank.
Michael F. Cronin has been a Director of the Company since June 1996. Mr. Cronin also serves on the boards of directors of Casella Waste System, Inc. (an integrated waste management company), Tekni Plex, Inc. (a manufacturer of packaging materials), Tweeter Home Entertainment Group, Inc. (a retailer of audio and video consumer electronics products) and several other private growth companies. Since 1991, Mr. Cronin has been the Managing General Partner of Weston Presidio Capital, a venture capital investment firm. He is a graduate of Harvard College and Harvard Business School.
Martin E. Franklin has been a Director of the Company since 1996. Mr. Franklin has been Chairman and Chief Executive Officer of Marlin Holdings, Inc., the general partner of Marlin Capital, L.P., a private investment partnership, since October 1996. He also serves as Chairman of the Board of Directors of Bolle Inc., a NASDAQ listed company, and as a Director of Specialty Catalog Corp. From May 1996 until March 1998, Mr. Franklin served as Chairman and Chief Executive Officer of Lumen Technologies, Inc., a NYSE company, and served as Executive Chairman from March 1998 until December 1998. Mr. Franklin was Chairman of the Board and Chief Executive Officer of Lumen's predecessor, Benson Eyecare Corporation from October 1992 to May 1996 and President from November 1993 until May 1996. Mr. Franklin was non-executive Chairman and a Director of Eyecare Products plc, a London Stock Exchange company, from December 1993 until February 1999. Mr. Franklin also serves on the boards of a number of privately held companies and charitable organizations. Mr. Franklin received a B.A. in political science from the University of Pennsylvania in 1986.
George Graboys has served as a Director of the Company since 1996. Mr. Graboys served as Chief Executive Officer of Citizens Bank and Citizens Financial Group, Inc. until he retired in October 1992. From January 1993 to June 1995, Mr. Graboys was Adjunct Professor and Executive-in-Residence at the University of Rhode Island School of Business. From March 1995 to June 1998, Mr. Graboys served as Chairman of the Board of Governors for Higher Education.
The Board oversees the state's three institutions of higher education conducted on eight campuses throughout the state.
Felix A. Porcaro, Jr. co-founded the Company with Mr. Cerce (his brother-in-law) in 1985, and served as its Vice Chairman of the Board of Directors until 1996. Mr. Porcaro is now the Executive Vice President of Marketing and Product Development and is responsible for the design and merchandising departments and all advertising and public relations activities.
Robert V. Lallo joined AAi's predecessor company in 1978 as Vice President. He served as the Company's Chief Operating Officer from 1985 to 1998. As Executive Vice President -- Distribution, Mr. Lallo is responsible for all manufacturing, distribution and internal operations of the Company's facilities. Prior to his association with AAi and its predecessor company, Mr. Lallo was Production and Inventory Control Manager, Materials Manager and Director of Operations for Uncas Manufacturing Company.
Daniel A. Triangolo has been the Executive Vice President of AAi's international operations since 1995. Mr. Triangolo was the founder and President of Danal Jewelry Corporation prior to its acquisition by AAi in 1983.
Duane M. DeSisto has served as the Company's Vice President and Chief Financial Officer since 1995. Prior to joining AAi, Mr. DeSisto was Chief Financial Officer of Zoll Medical Corporation for nine years.
DIRECTOR COMPENSATION
Directors who are not employees of AAi receive an annual fee of $10,000, as well as reimbursement for their reasonable expenses. Messrs. Cerce and Flynn do not receive any directors' fees.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Compensation of Executive Management. The following table summarizes the compensation paid or accrued by the Company to its Chief Executive Officer and each of its most highly compensated executive officers who earned more than $100,000 in salary and bonus in fiscal 1998 (together, the "NAMED EXECUTIVE OFFICERS") for the years ended December 31, 1997 and January 2, 1999:
SUMMARY COMPENSATION TABLE
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(a) The aggregate amount of perquisites and other personal benefits received from the Company by each of the Named Executive Officers was less than the lesser of $50,000 or 10% of the total of annual salary and bonus reported. (b) Amounts paid in fiscal 1998 represent the following: (1) medical payments reimbursed by the Company to Mr. Cerce ($2,950), Mr. Flynn ($5,225), Mr. Porcaro ($9,270) and Mr. Lallo ($475); (2) the Company's matching contributions under its Qualified 401(k) Plan and Non-Qualified 401(k) Excess Plan for Named Executive Officers as follows: Mr. Cerce ($9,662), Mr. Flynn ($6,090), Mr. Porcaro ($2,500), Mr. Lallo ($4,141) and Mr. DeSisto ($3,206); (3) premiums paid by the Company for term life insurance purchased for the Named Executive Officers and not made available generally to salaried employees in the amount of $150 for each of Messrs. Cerce, Flynn and Porcaro; and (4) premium of $230,000 paid with respect to life insurance purchased by the Company in connection with Mr. Cerce's Supplemental Executive Retirement Plan.
STOCK PLAN
The Company has established the 1996 Incentive Stock Plan (the "1996 Plan") which provides for the grant of awards covering a maximum of 150,000 shares of Common Stock to officers and other key employees of the Company and non-employees who provide services to the Company or its subsidiaries. Awards under the 1996 Plan may be granted in the form of incentive stock options, non-qualified stock options, shares of common stock that are restricted, units to acquire shares of Common Stock that are restricted, or in the form of stock appreciation rights or limited stock appreciation rights.
No options were granted to the Named Executed Officers in fiscal 1998. The following table contains information with respect to aggregate stock options held by the Named Executive Officers as of January 2, 1999. Messrs. Cerce, Flynn, Porcaro and Lallo do not hold any stock options. All such options were exercisable as of such date. No stock options were exercised by any Named Executive Officers during fiscal 1998.
AGGREGATE YEAR-END OPTION VALUES
- ---------- (a) Based on the January 2, 1999, price of the Common Stock being equal to the exercise price of $50.
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements, dated as of May 31, 1996, with certain of its executive officers, including Messrs. Cerce, Flynn, Porcaro, Lallo and DeSisto (collectively, the "Executives," each an "Executive").
Each employment agreement provides that during the term of the contract the Executive's base salary will not be reduced, will be increased on each anniversary date of the agreement based upon the consumer price index and may be increased based on the Company's performance and the Executive's particular contributions. The employment agreements also stipulate that the Executives will remain eligible for participation in the Company's Executive Bonus Plan and other benefit programs, and that the Company will provide each Executive with an automobile consistent with past practice. The employment agreement of Mr. Cerce further provides for the reimbursement of certain membership and service fees as well as reasonable expenses associated with the performance of his duties in New York City and specifies that the Company will make all annual payments for his Supplemental Employment Retirement Plan.
Mr. Cerce's agreement provides for an initial ten year term expiring on May 31, 2006, and the employment agreements of Messrs. Flynn, Porcaro, Lallo and DeSisto each stipulate an initial three year term expiring on May 31, 1999, with automatic renewals for successive one year terms
thereafter (the "Employment Period"). Upon prior written notice to the Executive, the Company may terminate the agreement "with cause" for (a) the conviction of the Executive for a crime involving fraud or moral turpitude; (b) deliberate dishonesty of the Executive with respect to the Company or its subsidiaries; or, (c) except under certain circumstances as specified in the agreement, the Executive's refusal to follow the reasonable and lawful written instructions of the Board of Directors with respect to the services to be rendered and the manner of rendering such services by the Executive. In addition, an Executive may terminate his agreement at any time by providing written notice to the Company, and the Company may terminate the agreement at any time "without cause" by providing written notice to the Executive. Mr. Cerce's agreement provides that the Company must provide such written notice at least six months prior to termination. Termination "without cause" means termination for any reason other than "cause" as defined and specifically includes the Company's material reduction of the Executive's duties or authority, the disability of the Executive or the Executive's death.
Under the employment agreements, if the Company terminates an agreement "without cause," the Company is obligated to provide the Executive monthly severance benefits consisting of one-twelfth of the sum of Executive's then current annual base salary and the Executive's most recent bonus and to continue coverage under the Company's insurance programs and any ERISA benefit plans. Such payments, insurance coverage and plan participation will continue for at least two years from the date of the Executive's termination, and may be extended for a longer period depending on the Executive's "Non-compete Period" as described below. For Messrs. Cerce and Flynn, the maximum period for severance benefits is five years, for Messrs. Lallo and DeSisto, the comparable maximum period is four years, and for Mr. Porcaro, the comparable maximum period is three years.
The employment agreements contain confidentiality provisions and provide that during the Employment Period and after termination of the agreement, the Company may restrict the Executive's subsequent involvement in Restricted Business Activities for two years for Messrs. Cerce, Flynn and Lallo and for one year for Messrs. Porcaro and DeSisto following the date of the termination (the "Non-compete Period"). As used in the agreements, "Restricted Business Activities" means the marketing and sale of ladies' and men's consumer soft lines to retail stores, which the Company sold and marketed during the Executive's employment with the Company. Other than with the written approval of the Company, the Executive may not enter into or engage in or have a proprietary interest in the Restricted Business Activities other than the ownership of (a) the stock of the Company held by the Executive, and (b) no more than five percent of the securities of any other company which is publicly held. The Non-compete Period may be extended, at the Company's option, by three years for Messrs. Cerce and Flynn and by two years for Messrs. Porcaro, Lallo and DeSisto, provided that the Company continues to make the payments and provide the benefits described in the preceding paragraph.
EXECUTIVE BONUS PLAN
The Company maintains an Executive Bonus Plan for the purpose of providing incentives in the form of an annual cash bonus to officers and other key employees. Awards are equal to a percentage of base salaries specified in an annual plan by reference to the Company's target for sales and net income. Bonuses awarded to senior executives are equal to 50% of compensation if the sales and income targets are met. If the targets are not met, the amount of the bonuses, if any, is subject to the discretion of the Board of Directors.
QUALIFIED 401(k) PLAN
The Company has a qualified 401(k) plan (the "Qualified Plan") that permits all employees to defer, on an elective basis, up to 15% of their salary or wages. Presently, the Company matches 25% of the first 6% of compensation that an employee defers under the Qualified Plan. The amount of elective deferrals for any one employee under the Qualified Plan is limited by the Internal Revenue Code of 1986, as amended (the "Code"). In addition, the amount that an executive employee may defer is subject to nondiscrimination rules which may prevent the executive from deferring the maximum amount. Further, the Qualified Plan may not take into account compensation in excess of specified amounts for any employee in computing contributions under the Qualified Plan. If an employee's elective contributions are reduced or capped under the Qualified Plan, the amount of matching employer contribution also is restricted.
NON-QUALIFIED EXCESS 401(k) PLAN
In May 1997, the Company established the Non-Qualified Excess 401(k) Plan (the "Non-Qualified Plan") effective as of June 1, 1997. The purpose of the Non-Qualified Plan is to provide deferred compensation to a select group of management or highly compensated employees of the Company as designated by the Board of Directors. Presently, all the Named Executive Officers participate in the Non-Qualified Plan. Under the Non-Qualified Plan, a participant may elect to defer up to 15% of his or her compensation on an annual basis. This amount is credited to the employee's deferred compensation account (the "Deferred Amount"). Under the Non-Qualified Plan, the Company also credits the participant's deferred compensation account for the amount of the matching contribution the Company would have made under the Qualified Plan with respect to the Deferred Amount. All amounts contributed by the employee and by the Company under the Non-Qualified Plan are immediately vested.
A participant under the Non-Qualified Plan is entitled to receive a distribution of his or her account upon retirement, death, disability or termination of employment. An executive also is eligible to withdraw funds credited to the executive's deferred compensation account in the event of unforeseeable financial hardship. This policy is consistent with the ability of an employee to obtain hardship withdrawals under the Qualified Plan.
The amount deferred under the Non-Qualified Plan is not includable in the income of the executive until paid and, accordingly, the Company is not entitled to a deduction for any liabilities
established under the Non-Qualified Plan until the amount credited to the participant's deferred compensation account is paid to him or her.
The Company has established a grantor trust effective June 1, 1997 to hold assets to be used for payment of benefits under the Non-Qualified Plan. In the event of the Company's insolvency, any assets held by the trust are subject to claims of general creditors of the Company under federal and state law.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN
The Company has entered into a Supplemental Executive Retirement Plan (the "Supplemental Plan") with Mr. Cerce the purpose of which is to provide supplemental retirement, death, disability and severance benefits to Mr. Cerce in consideration for his performance of services as a key executive of the Company. In order to fund the Company's obligations under the Supplemental Plan, the Company has purchased an insurance policy insuring the life of Mr. Cerce (the "Policy").
Under the terms and subject to the conditions contained in the Supplemental Plan, upon Mr. Cerce's voluntary termination of employment for any reason on or after age 60 ("Retirement") or by reason of disability, the Company will pay to Mr. Cerce the existing cash surrender value of the Policy. At the discretion of the Board of Directors of the Company, payment may be made either in a single lump sum or in monthly installments over a ten year period; provided, however, in the event that Retirement occurs within one year after a change of control, the retirement benefit will be paid in a single lump sum.
In the event that Mr. Cerce dies while employed by the Company, the Company will pay a death benefit to Mr. Cerce's surviving spouse or designated beneficiary equal to the death benefit payable under the Policy. The death benefit will be paid in monthly installments over a fifteen year period unless Mr. Cerce's death occurs within one year after a change of control, in which event, the death benefit will be paid in a single lump sum no later than ninety days after his death.
In the event that Mr. Cerce's employment with the Company is terminated for any reason other than Retirement, death or disability, Mr. Cerce will be entitled to receive the existing cash surrender value of the Policy, payable at the discretion of the Board of Directors of the Company in a single lump sum or in monthly installments over a ten year period. However, if Mr. Cerce's termination occurs within one year after a change of control, the severance benefit will be paid in a single lump sum.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
SECURITY OWNERSHIP OF 5% BENEFICIAL OWNERS AND DIRECTORS AND OFFICERS
The following table sets forth certain information regarding beneficial ownership of the Company's capital stock as of March 15, 1999, by (i) each person who is known by the Company to beneficially own more than 5% of the outstanding shares of Common Stock or Series A Preferred Stock; (ii) each of the Company's directors and Named Executive Officers; and (iii) all directors and executive officers of the Company as a group:
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* Less than one percent
(a) If applicable, beneficially owned shares include shares owned by the spouse, children and certain other relatives of the director or officer, as well as shares held by trusts of which the person is a trustee or in which he has a beneficial interest. All information with respect to beneficial ownership has been furnished by the respective directors and officers.
(b) Includes full conversion of all outstanding shares of Series A Preferred Stock into Common Stock at the current ratio of 1 for 10.
(c) Messrs. Cerce's and Porcaro's business address is 500 George Washington Highway, Smithfield, Rhode Island 02917.
(d) Mr. Carlotti's business address is 1500 Fleet Center, Providence, Rhode Island 02903.
(e) Represents shares of Common Stock held by Mr. Carlotti and David J. Syner, as trustees of the benefit of Mr. Cerce's children.
(f) Mr. Cronin's business address is 1 Federal Street, 21st Floor, Boston, Massachusetts 02110. Includes 19,000 shares of Common Stock and 17,100 shares of Series A Preferred Stock held in the name of Weston Presidio Capital II, L.P. of which Mr. Cronin is a general partner.
(g) Mr. Franklin's business address is 555 Theodore Fremd Avenue, Suite B-302, Rye, New York 10580. Includes 4,750 shares of Series A Preferred Stock held in the name of Marlin Capital, L.P., of which Mr. Franklin's majority-owned company is the sole general partner.
(h) Mr. Syner's business address is 35 Sockanesset Crossroads, Cranston, Rhode Island 02920.
(i) Represents shares that may be acquired pursuant to options which are or will become exercisable within 60 days.
(j) The address of Weston Presidio Capital II, L.P. is 1 Federal Street, 21st Floor, Boston, Massachusetts 02110.
(k) The address of St. Paul Fire and Marine Insurance Company is c/o St. Paul Venture Capital, Inc., 8500 Normandale Lake Boulevard, Suite 1940, Bloomington, Minnesota 55437.
(l) The address of BancBoston Ventures, Inc. is 175 Federal Street, 10th Floor, Boston, Massachusetts 02110.
(m) The address of Marlin Capital, L.P. is 555 Theodore Fremd Avenue, Suite B-302, Rye, New York 10580.
(n) The address of National City Capital Corporation is 1965 E. 6th Street, Suite 1010, Cleveland, Ohio 44114.
(o) The Brahman Group includes Brahman Partners II, L.P., Brahman Institutional Partners, L.P., B.Y. Partners, L.P. and Brahman Partners II Offshore Ltd., which are a "group" as that term is used in Section 13(d)(3) of the Exchange Act of 1934, as amended (the "Exchange Act"). The address for these shareholders is c/o Brahman Capital Corp., 277 Park Avenue, New York, New York 10172.
(p) Includes 8,000 shares that may be acquired pursuant to options which are or will become exercisable within 60 days.
All of the Company's shareholders are party to an agreement that requires the parties thereto, subject to the right of the Preferred Holders to elect additional directors in the event of the Company's default on certain covenants, to vote to fix the number of directors of the Company at seven and elect as directors two persons designated by the Preferred Holders and five persons designated by certain management shareholders. See "Certain Relationships and Related Transactions -- Shareholders Agreement."
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
NOTES PAYABLE TO PREFERRED HOLDERS
On May 31, 1996, in connection with the Company's sale of shares of its Series A Preferred Stock, the Company issued subordinated promissory notes in the aggregate amount of $2.0 million to certain holders of its Series A Preferred Stock (Weston Presidio Capital II, L.P., BancBoston Ventures, Inc., St. Paul Fire and Marine Insurance Company and National City Capital Corporation). BancBoston Ventures, Inc., an affiliate of BancBoston Securities Inc. and one of the initial purchasers of the Notes, was a holder of a subordinated note in the principal amount of $400,000. The subordinated notes bore interest at an annual rate of 7.04% and were due in 2002. These notes were repaid with a portion of the net proceeds from the sale of the Notes in 1998.
TERMINATION OF S CORPORATION STATUS
Until the issuance of its Series A Preferred Stock on May 31, 1996, the Company was an S corporation under the Code and comparable state tax laws. As an S corporation, earnings through the date of termination of S corporation status were taxed directly to the S corporation shareholders (Messrs. Cerce, Flynn, Lallo and Porcaro). Upon termination of its S corporation status, the Company issued to the S corporation shareholders previously taxed undistributed earnings in the aggregate amount of $13.3 million. Of the $13.3 million, $10.3 million was paid in cash and $3.0 million was paid by the issuance of subordinated promissory notes, which bore interest at an annual rate of 7.04% and were due in 2006. These notes were also repaid with a portion of the net proceeds of the sale of the Notes in 1998.
The Company has entered into an indemnification agreement with the S Corporation shareholders relating to potential income tax liabilities resulting from adjustments to reported S corporation taxable income. The S corporation shareholders will continue to be liable for personal income taxes on the Company's income for all periods during which the Company was an S corporation, while the Company will be liable for all income taxes for subsequent periods. The indemnification agreement provides that the Company will distribute to the S corporation shareholders 40% of the amount of additional deductions permitted to be taken by the Company as a C corporation for expenditures made while an S corporation, which result from adjustments initiated by tax authorities.
During the first and second quarters of 1998, in connection with an income tax audit, the Company made advances totaling $3.4 million to the S corporation shareholders to pay a portion of the income tax owed by them with respect to the Company's S corporation earnings. Upon completion of the sale of the Notes, the shareholders repaid these advances.
LEASES OF RHODE ISLAND WAREHOUSE SITES
The Company has an operating lease agreement for warehouse facilities with Sunrise Properties, LLC ("Sunrise Properties"), a Rhode Island limited liability company, of which Mr. Porcaro and Linda Cerce, wife of Mr. Cerce and sister of Mr. Porcaro, are members. The Company also has an operating lease agreement for warehouse facilities with 299 Carpenter Street Associates, LLC, a Rhode Island limited liability company of which Sunrise Properties and Messrs. Lallo and Flynn are members. The leased properties are located at 4 Warren Avenue, North Providence, Rhode Island and at 299 Carpenter Street, Providence, Rhode Island. The present annual rental rates for the Warren Avenue and Carpenter Street properties are $191,412 and $279,840, respectively. The Company is responsible for real estate taxes and utilities. Each lease has a three year term ending on December 31, 2001, and grants the Company an option to extend the lease for an additional three year term at the greater of the then fair market rent or the current rent adjusted for the cumulative increase in the consumer price index.
GUARANTY OF MORTGAGE NOTE
The Company has guaranteed a mortgage note payable by Sunrise Properties in the aggregate amount of $200,000, the outstanding balance of which was approximately $114,000 as of March 15, 1999. The mortgage note has a remaining maturity of three years, and bears interest at a rate of 9.5% annually.
LEASE OF DALLAS, TEXAS SITE
In December 1996, in conjunction with the purchase of Foster Grant US, the Company entered into a property lease with Lumen Technologies, Inc. (formerly named BEC Group, Inc.) ("Lumen"), the former owner of the Foster Grant US office and distribution center. Martin E. Franklin, a director of the Company, is the chairman of Lumen and Bolle, Inc. The aggregate rental expense for this property was approximately $494,000 per year in both 1997 and 1998. In March 1998, Lumen transferred the Texas property to Bolle, Inc., an affiliated corporation at the time of transfer. In May 1998, Bolle, Inc. sold the Texas property to an independent third party. The Company terminated this lease effective December 1998.
SHAREHOLDERS AGREEMENT
The Company, the current shareholders and Daniel A. Triangolo, Duane M. DeSisto and Thomas McCarthy are parties to a Tag-along, Transfer Restriction and Voting Agreement (the "Shareholders Agreement") which requires the parties thereto, subject to the right of the Preferred Holders to elect additional directors in the event of the Company's default on certain covenants, to vote to fix the number of directors at seven and to elect as directors two persons nominated by the Preferred Holders and five persons nominated by the other parties to the Shareholders Agreement (the "Management Shareholders"). In a related Letter Agreement, Weston Presidio Capital II, L.P., a Preferred Holder, has agreed to use its best efforts to cause the nomination of and to vote all of its shares of Series A Preferred Stock for the election of Martin E. Franklin (or, in the event of his death or incapacity, the designee of Marlin Capital, L.P.) as a director of the Company, for so long as the
Preferred Holders, in the aggregate, own at least 10% or 4,750 shares of Series A Preferred Stock.
The Shareholders Agreement also provides that upon the death of a Management Shareholder, the Company will purchase, at an appraised value determined by an independent investment banker, all or a portion of the shares owned by the Management Shareholder at his death. The Company has funded its obligations under the Shareholders Agreement with life insurance policies on the lives of the Management Shareholders in the aggregate amount of $27 million. The Company's obligation to purchase shares upon the death of a Management Shareholder is limited to the life insurance proceeds received upon the death of such Management Shareholder. The Company may not decrease the amount of life insurance coverage without the prior written consent of the affected Management Shareholder.
The Shareholders Agreement terminates on the earlier of the following: (i) the time immediately prior to the consummation of a Qualified Public Offering as defined in the Articles of Incorporation or (ii) when no shares of the Series A Preferred Stock and no warrants issuable to the Preferred Holders are outstanding, except as a result of the conversion, exchange or exercise of the Series A Preferred Stock or warrants.
OWNERSHIP OF PREFERRED SHARES OF FOSTER GRANT US BY LUMEN
In connection with the purchase of Foster Grant US, the Company's wholly-owned subsidiary, issued Lumen 100 shares of Preferred Stock of Foster Grant US (the "FG Preferred Stock") which represents all of the issued and outstanding shares of FG Preferred Stock. By its terms, the FG Preferred Stock must be redeemed on February 28, 2000 (the "FG Redemption Date") by payment of an amount ranging from $10,000 to $40,000 per share (the "FG Redemption Amount"), determined with reference to the combined net sales of sunglasses, reading glasses and accessories by Foster Grant US and the Company for the year ending January 1, 2000, excluding an amount equal to the net sales by the Company for such items for the year ending December 31, 1996.
The Certificate of Incorporation of Foster Grant US also provides for early redemption of the FG Preferred Stock if the Company completes either (i) an initial public offering where the pre-money valuation of the Company equals or exceeds $75.0 million, (ii) a merger or similar transaction where the transaction value equals or exceeds $75.0 million or (iii) a private placement of equity securities representing more than 50% of the outstanding capital stock for consideration of not less than $37.5 million (each a "Redemption Event") prior to the FG Redemption Date. Upon completion of a Redemption Event, in lieu of the FG Redemption Amount, holders of FG Preferred Stock will receive a payment ranging from $35,000 to $40,000 per share (the "Redemption Event Amount"), to be determined with reference to, as the case may be, either the pre-money valuation of the Company immediately prior to the initial public offering or the proceeds of the merger or similar transaction or private equity placement. If a Redemption Event occurs after the FG Redemption Date, in addition to the FG Redemption Amount, holders of FG Preferred Stock will receive a supplemental payment equal to the difference, if any, between the FG Redemption Amount paid to such holders on the FG Redemption Date and Redemption Event
Amount that would have been received had the Redemption Event occurred on or prior to the FG Redemption Date.
INITIAL PURCHASERS OF THE 10 3/4% SENIOR NOTES DUE 2006
BancBoston Ventures, Inc., an affiliate of BancBoston Securities Inc. and one of the initial purchasers of the Notes, is the beneficial owner of 15.7% of the Company's Series A Preferred Stock and 1.3% of the Common Stock. NationsBank, N.A., an agent and lender under the Company's Senior Credit Facility, is an affiliate of NationsBanc Montgomery Securities LLC, one of the initial purchasers of the Notes. The Company used a portion of the net proceeds from the sale of the Notes to repay all of the outstanding indebtedness under a $400,000 subordinated note due to BancBoston Ventures, Inc. and under the senior credit facility and certain term loans due to NationsBank, N.A.
LEGAL SERVICES
Stephen J. Carlotti, a partner of Hinckley, Allen & Snyder, is a director and the secretary of the Company and, as trustee, is the holder of 5.9% of the Common Stock. Hinckley, Allen & Snyder provides legal services to the Company.
================================================================================ PART IV ================================================================================
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS
Financial Statements are listed in the index on Page of this Annual Report.
(2) FINANCIAL STATEMENT SCHEDULE
Schedule II - Valuation and Qualifying Accounts
(3) EXHIBITS
- ---------- * Previously filed as an exhibit to the Company's Registration Statement No. 333-61119 on Form S-4 and by this reference is incorporated herein.
+ Management or compensatory plan or arrangement.
(b) REPORTS ON FORM 8-K
None.
AAI.FOSTERGRANT, INC.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AAI.FOSTERGRANT, INC.
/s/ Gerald F. Cerce Date: April 2 , 1999 By:_______________________________ Gerald F. Cerce President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Gerald F. Cerce /s/ Duane M. DeSisto _____________________________ ___________________________ Gerald F. Cerce Duane M. DeSisto President, Chief Executive Officer Chief Financial Officer and Chairman of the Board (Principal Financial Officer) (Principal Executive Officer) Date: April 2, 1999 Date: April 2, 1999
/s/ Stephen J. Korotsky /s/ Stephen J. Carlotti _____________________________ _____________________________ Stephen J. Korotsky, Controller Stephen J. Carlotti, Director (Principal Accounting Officer) Date: April 2, 1999 Date: April 2, 1999
/s/ Michael F. Cronin /s/ John H. Flynn, Jr. _____________________________ ___________________________ Michael F. Cronin, Director John H. Flynn, Jr., Director Date: April 2, 1999 Date: April 2, 1999
/s/ Martin E. Franklin /s/ George Graboys _____________________________ ___________________________ Martin E. Franklin, Director George Graboys, Director Date: April 2, 1999 Date: April 2, 1999
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
FINANCIAL STATEMENTS AS OF DECEMBER 31, 1997 AND JANUARY 2, 1999 TOGETHER WITH AUDITORS' REPORT
INDEX
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders of AAi.FosterGrant, Inc. and Subsidiaries:
We have audited the accompanying consolidated balance sheets of AAi.FosterGrant, Inc. (a Rhode Island corporation) and subsidiaries as of December 31, 1997 and January 2, 1999, and the related consolidated statements of operations, redeemable preferred stock, shareholders' equity (deficit) and comprehensive net income (loss) and cash flows for each of the three years in the period ended January 2, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of AAi.FosterGrant, Inc. and subsidiaries as of December 31, 1997 and January 2 1999, and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 2, 1999, in conformity with generally accepted accounting principles.
/S/ ARTHUR ANDERSEN LLP
Boston, Massachusetts February 19, 1999
AAI. FOSTERGRANT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK, SHAREHOLDERS' EQUITY (DEFICIT) AND COMPREHENSIVE NET INCOME (LOSS), (IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
AAi.FosterGrant, Inc. and Subsidiaries (the Company) is a value added distributor of accessories such as; optical products, costume jewelry, watches, clocks and other accessories to mass merchandisers, variety stores, chain drug stores and supermarkets in North America and the United Kingdom.
In April 1998, the Company adopted a formal plan to close its Texas distribution center. The Company recorded a restructuring charge of $2.6 million during the year ended January 2, 1999 in connection with this plant closing. The components of this charge, which is included in operating expenses in the accompanying fiscal 1998 statement of operations, are as follows (in thousands):
The severance accrual represents severance payments due to 40 office and distribution employees. Through January 2, 1999, all of these 40 employees were terminated and severance benefits of $431,000 were paid. The remaining severance accrual at January 2,1999 was $654,000, which will be paid during fiscal 1999.
On July 21, 1998, the Company issued $75.0 million of 10 3/4% Senior Series A Notes (the Notes) through a Rule 144A offering (see Note 7). The net proceeds received by the Company from the issuance and sale of the Notes, approximately $71.0 million, was used to repay outstanding indebtedness under the credit facility with a bank (see Note 5) and the Subordinated Promissory Notes to shareholders (see Note 9), net of amounts due the Company from certain of these shareholders (see Note 3).
The accompanying consolidated financial statements reflect the application of certain significant accounting policies, as discussed below and elsewhere in the notes to consolidated financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
(a) Principles of Consolidation
The accompanying consolidated financial statements include the results of operations of the Company and its majority-owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(b) Change in Fiscal Year-End
During 1998, the Company elected to change its fiscal year-end from December 31, to the Saturday closest to December 31.
(c) Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.
(d) Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):
Finished goods inventory consists of material, labor and manufacturing overhead.
(e) Advertising Costs
Advertising costs, which are included in selling expense, are expensed when the advertisement first takes place. Advertising expense was approximately $364,000, $873,000 and $1,061,000 for the years ended December 31, 1996 and 1997 and January 2, 1999, respectively. Prepaid advertising production costs were $132,000 at January 2, 1999 and are included in prepaid expenses and other current assets in the accompanying consolidated balance sheets. The Company had no prepaid advertising production costs reported as assets at December 31, 1997.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(f) Depreciation and Amortization
The Company provides for depreciation and amortization by charges to operations in amounts that allocate the cost of these assets on the straight-line basis over their estimated useful lives as follows:
The Company has adopted the provisions of Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. The adoption of this pronouncement did not have a material effect on the Company's financial position or financial results.
(g) Intangible and Other Long-Lived Assets
Intangible assets consist of goodwill and trademarks, which are being amortized on the straight-line basis over estimated useful lives of 10 to 40 years. Intangible assets primarily relate to the Company's acquisitions of various businesses as discussed in Note 2 to these consolidated financial statements. In determining the estimated lives of these intangible assets, the Company evaluates various factors including but not limited to: nature of business, existing distribution channels, brand recognition of acquired products, customer base and length of time in which an acquired business has been in existence. Amortization expense was approximately $0.2 million, $1.1 million and $1.4 million for the years ended December 31, 1996 and 1997 and January 2, 1999, respectively.
In accordance with Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for Impairment of Long-Lived Assets and For Long-Lived Assets To Be Disposed Of, the Company reviews its long-lived assets (which include intangible assets, deferred costs and property and equipment) for impairment as events and circumstances indicate the carrying amount of an asset may not be recoverable. The Company evaluates the realizability of its long-lived assets based on profitability and cash flow expectations for the related asset or subsidiary. Management believes that, as of each of the balance sheet dates presented, none of the Company's long-lived assets were impaired.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(h) Revenue Recognition
The Company recognizes revenue from product sales, net of estimated agreed-upon future allowances and anticipated returns and discounts, taking into account historical experience, upon shipment to the customer.
(i) Customer Acquisition Costs
The Company incurs direct and incremental costs in connection with the acquisition of certain new customers and new store locations from existing customers under multi-year agreements. The Company may also receive the previous vendor's merchandise from the customer in connection with most of these agreements. In these situations, the Company values this inventory at its fair market value, representing the lower of cost or net realizable value, and records that value as inventory. The Company sells this inventory through various liquidation channels. Except as provided below, the excess costs over the fair market value of the inventory received is charged to selling expenses when incurred. The Company expensed customer acquisition costs of approximately $2.7 million, $1.6 million, and $0.9 million for the years ended December 31, 1996 and 1997 and January 2, 1999, respectively.
The excess costs over the fair market value of the inventory received is capitalized as deferred costs and amortized over the agreement period if the Company enters into a minimum purchase agreement with the customer and the estimated gross profits from future minimum sales during the term of the agreement are sufficient to recover the amount of the deferred costs. During fiscal 1998, the Company capitalized approximately $2.3 million of these costs in the accompanying consolidated balance sheet. No such costs were capitalized during fiscal 1996 and 1997. Amortization expense related to these costs was approximately $219,000 for the year ended January 2, 1999.
(j) Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk are principally accounts receivable. A significant portion of its business activity is with domestic mass merchandisers whose ability to meet their financial obligations is dependent on economic conditions germane to the retail industry. During recent years, many major retailers have experienced significant financial difficulties and some have filed for bankruptcy protection; other retailers have begun to consolidate within the industry. The Company sells to certain customers in bankruptcy as well as those consolidating within the industry. To reduce credit risk, the Company routinely assesses the financial strength of its customers and purchases credit insurance as it deems appropriate.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(k) Disclosure of Fair Value of Financial Instruments
The Company's financial instruments consist mainly of cash and cash equivalents, accounts receivable, accounts payable and debt. The carrying amounts of the Company's financial instruments, excluding the Notes, approximate fair value. The Company's Notes had a carrying value of approximately $75.0 million at January 2, 1999. The Company has determined the fair value of the Notes based on the current trading prices to be approximately $66.0 million at January 2, 1999.
(l) Net Loss Per Share
In March 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 128, Earnings per Share. This statement established standards for computing and presenting net income (loss) per share. This statement is effective for fiscal years ending after December 15, 1997.
Basic net loss per share applicable to common shareholders was determined by dividing net loss attributable to common shareholders by the weighted average common shares outstanding during the period. Diluted net loss per share applicable to common shareholders is the same as basic net loss per share applicable to common shareholders as the effects of the Company's potential common stock equivalents are antidilutive. Accordingly, options to purchase a total of 8,000, 14,000 and 12,000 common shares for fiscal 1996, 1997 and 1998, respectively, have been excluded from the computation of diluted weighted average shares outstanding. The 437,000 shares of common stock issuable upon the conversion of the 43,700 shares of Series A Redeemable Convertible Preferred Stock (Series A Preferred Stock) have also been excluded for all periods presented as they are antidilutive.
Pro forma net loss per share applicable to common shareholders, which reflects the effects of the pro forma tax provision (see Note 3), was determined by dividing pro forma net loss applicable to common shareholders by the basic and diluted weighted average shares outstanding.
(m) New Accounting Standards
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company does not believe that the adoption of SFAS No. 133 will have a material impact on its financial statements.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-5, (SOP 98-5) Reporting on the Costs of Start-up Activities. SOP 98-5 provides guidance on the financial reporting of start-up activities and organization costs to be expensed as incurred. The Company does not believe that the adoption of SOP 98-5 will have a material impact on its financial statements.
(n) Reclassifications
Certain balances from prior years consolidated financial statements have been reclassified to conform with the current year's presentation.
(2) ACQUISITIONS
In June 1998, the Company acquired an 80% interest in Fantasma, LLC (Fantasma) for approximately $4.1 million in cash. The remaining 20% interest in Fantasma is held by a previous member of Fantasma. This member and an employee of Fantasma have options to acquire up to an additional 13% interest if certain earnings targets for Fantasma are met in fiscal 1998, 1999 and 2000.
The acquisition was accounted for using the purchase method; accordingly, the results of operations of Fantasma from the date of acquisition are included in the Company's consolidated statements of operations. The purchase price was allocated based on the estimated fair market value of assets and liabilities at the date of acquisition. In connection with the purchase price allocation, the Company recorded approximately $4.6 million of goodwill, which is being amortized ratably over 10 years.
On March 5, 1998, the Company acquired certain assets and liabilities of Eyecare Products UK Ltd. (Foster Grant UK), including the Foster Grant trademark in territories not previously owned, for approximately $5.5 million in cash. Foster Grant UK is a marketer and distributor of sunglasses and reading glasses in Europe. The purchase price may be increased by approximately $0.7 million in fiscal 1998 and 1999 based on Foster Grant UK performance. Based on fiscal 1998 activity, there was no increase in the purchase price.
The acquisition has been accounted for using the purchase method of accounting; accordingly, the results of operations of Foster Grant UK from the date of the acquisition are included in the accompanying consolidated statements of operations. The purchase price was allocated based on estimated fair values of assets and liabilities at the date of acquisition. In connection with the purchase price allocation, the Company recorded goodwill of approximately $1.1 million, which is being amortized on the straight-line basis over 20 years.
In July 1997, the Company acquired the assets of Superior Jewelry Company (Superior), a distributor of costume jewelry to retail drug stores and discount mass merchandisers in the United States. The Company paid approximately $1.8 million in cash and assumed certain liabilities in the amount of approximately $4.0 million. In addition, the purchase price had a contingent element based on Superior's earnings during fiscal 1997 and 1998. Based on fiscal 1997 activity, the purchase price increased $0.9 million. This amount was accrued for as of December 31, 1997 and recorded as additional goodwill. There was no increase in the purchase price based on fiscal 1998 activity.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
The acquisition was accounted for using the purchase method of accounting; accordingly, the results of operations of Superior from the date of the acquisition are included in the accompanying consolidated statements of operations. The purchase price was allocated based on estimated fair values of assets and liabilities at the date of acquisition. In connection with the purchase price allocation, the Company recorded goodwill of approximately $3.5 million, adjusted to include the additional purchase price for fiscal 1997 activity, which is being amortized on the straight-line basis over 10 years.
In December 1996, the Company's subsidiary, Foster Grant Holdings, Inc. (FG Holdings), acquired Foster Grant Group, L.P. (Foster Grant US), a subsidiary of BEC Group, Inc. (BEC), and related entities. Foster Grant US is a marketer and distributor of sunglasses, reading glasses and eyewear accessories located in Dallas, Texas. The Company paid $10.0 million in cash and assumed certain liabilities in the amount of approximately $34.0 million. In addition, FG Holdings issued 100 shares of Series A redeemable nonvoting preferred stock (FG Preferred Stock) initially valued at approximately $0.8 million. As discussed in Note 4, the redemption value of this preferred stock is subject to upward adjustment based on annual sales of the FG Holdings operations, as defined, through the years ending January 1, 2000 or upon the occurrence of certain specified capital transactions based upon the transaction value. The maximum redemption amount, as amended, is $4.0 million. Any increase in the redemption amount may be recorded as goodwill when paid. The $10.0 million cash investment was financed by $5.0 million of borrowings through the Company's credit facility and a $5.0 million equity investment in the Company by an investment group led by Marlin Capital, L.P., a related party to BEC (see Note 10).
The acquisition was accounted for using the purchase method of accounting; accordingly, the results of operations of Foster Grant US from the date of the acquisition are included in the accompanying consolidated statements of operations. The original purchase price was allocated based on the preliminary estimated fair values of assets and liabilities at the date of acquisition. In connection with the purchase price allocation, the Company recorded intangible assets of approximately $11.0 million, which are being amortized on the straight-line basis over 40 years. During fiscal 1997, the preliminary purchase price allocation was finalized. This resulted in (i) a reduction of certain asset carrying amounts of approximately $4.9 million, (ii) an increase in certain liabilities of approximately $2.2 million and (iii) a decrease in the valuation reserve related to the deferred tax assets of approximately $7.0 million resulting in an immaterial increase in goodwill.
In June 1996, the Company acquired certain assets of the Tempo Division (Tempo) of Allison Reed Group, Inc. The Company paid $1.0 million in cash, assumed certain liabilities in the amount of $0.6 million and issued a $2.0 million non-interest-bearing term note payable to Allison Reed Group, Inc (see Note 6). The payments on this note were subject to potential future downward adjustments based on fiscal 1997 or 1998 sales of Tempo; no such adjustment was required.
The acquisition was accounted for using the purchase method of accounting; accordingly, the results of operations of Tempo from the date of the acquisition are included in the accompanying consolidated statements of operations. The purchase price was allocated entirely to intangible assets and is being amortized on the straight-line basis over 10 years.
The following unaudited pro forma summary information presents the combined results of operations of the Company, Foster Grant US, Tempo, Superior, Foster Grant UK and Fantasma as if the acquisitions had occurred at the beginning of 1996, 1997 and 1998. This unaudited pro forma financial information is
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
presented for informational purposes only and may not be indicative of the results of operations as they would have been if the Company, Foster Grant US, Tempo, Superior, Foster Grant UK and Fantasma had been a single entity, nor is it necessarily indicative of the results of operations that may occur in the future. Anticipated efficiencies from the consolidation of the Company, Foster Grant US, Tempo, Superior, Foster Grant UK and Fantasma have been excluded from the amounts included in the unaudited pro forma summary presented below.
(3) INCOME TAXES
Income taxes, including pro forma computations, are provided using the liability method of accounting in accordance with SFAS No. 109. A deferred tax asset or liability is recorded for all temporary differences between financial and tax reporting. Deferred tax expense (benefit) results from the net change during the year of the deferred tax asset and liability.
The Company was an S corporation under Section 1362 of the Internal Revenue Code until May 31, 1996 when it issued Series A Preferred Stock. As an S Corporation, the taxable income or loss of the Company was passed through to the shareholders and reported on their individual federal and certain state tax returns. Dividend distributions of approximately $2.9 million in 1996 were made to the shareholders primarily to fund payment of the taxes related to the Company's income. In addition, $10.3 million of cash and $3.0 million of subordinated notes payable (see Note 9) were distributed to the shareholders in 1996 to distribute the previously undistributed after-tax earnings. During 1997, a cash distribution of $0.3 million was made to the S corporation shareholders to distribute a portion of the remaining undistributed after-tax earnings.
During fiscal 1998, the Company made advances to the S corporation shareholders to pay a portion of the income tax owed by them with respect to the Company's S corporation earnings resulting from an income tax audit. The Company agreed to make advances to these shareholders to pay their tax liabilities, the aggregate amount of which is approximately $3.4 million. These advances are evidenced by promissory notes and bear interest at an annual rate equal to the Applicable Federal Rate (5.21% at January 2, 1999). Principal and accrued interest are payable on demand. These advances and their related interest were offset against the subordinated notes payable to shareholders that were due to these shareholders of approximately $3.5 million. The remaining amounts have been included in long-term other assets in the accompanying consolidated balance sheets.
Pro forma income taxes, assuming the Company was subject to C corporation income taxes, have been provided in the accompanying statements of operations for 1996 at an estimated statutory rate of 40%.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
Upon termination of the S corporation election, deferred income taxes were recorded for the tax effect of cumulative temporary differences between the financial reporting and tax bases of certain assets and liabilities, primarily deferred costs, accrued expenses and depreciation. These temporary differences resulted in a net deferred income tax asset of approximately $1.9 million. The Company recorded this tax asset as a deferred tax benefit in the 1996 tax provision.
The components of the income tax benefit (expense) are as follows (in thousands):
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
A reconciliation of the federal statutory rate to the Company's effective tax rate is as follows:
Deferred income taxes relate to the following temporary differences (in thousands):
A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be recognized. During 1998, based on the actual and anticipated results, the Company
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
determined that a greater valuation reserve was required. Accordingly, the Company increased the valuation allowance by approximately $3.7 million. The Company has approximately $23.4 million of net operating loss carryforwards which expire through 2018.
The Company has entered into an indemnification agreement with the shareholders of the Company prior to its conversion to a C corporation relating to potential income tax liabilities resulting from adjustments to reported S corporation taxable income. The shareholders will continue to be liable for personal income taxes on the Company's income for all periods prior to the time the Company ceased to be an S corporation, while the Company will be liable for all income taxes subsequent to the time it ceased to be an S corporation. The indemnification agreement provides that the Company shall distribute to the individual shareholders 40% of the amount of additional deductions permitted to be taken by the Company after its conversion to a C corporation for expenditures made prior to becoming a C corporation, which result from adjustments in the form of a final determination by tax authorities.
(4) REDEEMABLE NONVOTING PREFERRED STOCK OF A SUBSIDIARY
In connection with the purchase of Foster Grant US, the Company's wholly owned subsidiary, FG Holdings, issued 100 shares of FG Preferred Stock, which represents all of the issued and outstanding shares of FG Preferred Stock. The FG Preferred Stock, as amended in June 1998 (Note 2), must be redeemed on February 28, 2000 (the FG Redemption Date) by payment of an amount ranging from $1.0 million to $4.0 million (the FG Redemption Amount), determined based on the combined net sales of sunglasses, reading glasses and accessories by Foster Grant US and the Company for the year ending January 1, 2000, excluding an amount equal to the net sales by the Company for such items for the year ended December 31, 1996. Any increase in the redemption amount will be recorded as goodwill.
The FG Preferred Stock also provides for early redemption of the FG Preferred Stock if the Company completes (i) an initial public offering where the pre-money valuation of the Company equals or exceeds $75.0 million, (ii) a merger or similar transaction where the transaction value equals or exceeds $75.0 million, or (iii) a private placement of equity securities representing more than 50% of the outstanding capital stock for consideration of not less than $37.5 million (each a Redemption Event) prior to the FG Redemption Date. Upon completion of a Redemption Event, in lieu of the FG Redemption Amount, holders of FG Preferred Stock will receive a payment ranging from $3.5 million to $4.0 million (the Redemption Event Amount), to be determined with reference to, as the case may be, either the pre-money valuation of the Company immediately prior to the initial public offering or the proceeds of the merger or similar transaction or private equity placement. If a Redemption Event occurs after the FG Redemption Date, in addition to the FG Redemption Amount, holders of FG Preferred Stock will receive a supplemental payment equal to the difference, if any, between the FG Redemption Amount paid to such holders on the FG Redemption Date and Redemption Event Amount that would have been received had the Redemption Event occurred on or prior to the FG Redemption Date.
The value of FG Preferred Stock has been recorded as part of the initial purchase of Foster Grant US and was based on the present value of management's best estimate of the expected payment of $1.0 million upon redemption. The accretion of the original value to the $1.0 million estimated redemption value is being recorded as a charge to minority interest in income of subsidiaries in the accompanying consolidated statements of operations. Accretion of this discount for the years ended December 31, 1997 and January 2,1999 was approximately $75,000 and $74,000, respectively.
AAI.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(5) CREDIT FACILITIES WITH A BANK
In July 1998, the Company amended its credit facility with a bank (the Bank Agreement). The amended facility provides for a $60.0 million revolving credit facility, including a $3.0 million letter of credit facility. Use of the proceeds from the facility are limited to refinancing existing term debt, support letters of credit, fund working capital and finance permitted acquisitions and tax distributions, as defined.
Borrowings under the revolving credit arrangement are limited to the lesser of $60.0 million or the borrowing base, which is defined as a percentage of eligible accounts receivable and the lesser of (i) inventories or (ii) $30.0 million less the interest rate protection reserve and the foreign exchange exposure, reduced by outstanding letters of credit. Revolving credit borrowings bear interest at the bank's prime rate (7.75% at January 2, 1999) plus .5% or LIBOR (5.07% at January 2, 1999) plus 2.25%. The Company has the option of electing the rate; however, the use of the LIBOR is limited. The revolving credit facility expires in July 2003. As of January 2, 1999, the Company had approximately $47.3 million available under this revolving credit facility.
If the Bank Agreement is terminated by the Company earlier than the expiration date, the Company will be required to pay a termination fee of $0.5 million if terminated within the first year, $0.3 million if terminated within the second year and $0.1 million thereafter. The termination fee will be waived if the debt is refinanced with the bank or if repayment is from proceeds of the Company's initial public offering.
The credit facility is subject to certain restrictive covenants, including a fixed charge coverage ratio, leverage ratio and minimum EBITDA. As of January 2, 1999, the Company was not in compliance with the above financial covenants. The Company received a waiver for such noncompliance from the Bank and is currently negotiating an amendment to the Bank Agreement which will modify the financial covenants going forward. If the Company does not successfully negotiate the amendment, the Company expects that it will not be in compliance with these financial covenants for fiscal 1999. The Company has received a letter from the Bank stating that it intends to modify the covenants so they are amounts which the Company believes it can attain. Amounts due under this credit facility are secured by the accounts receivable and inventory of the Company and its domestic subsidiaries.
In October 1998, Foster Grant UK entered into a credit facility with a different bank. The facility provides for a (pound)1.5 million (approximately $2.5 million at January 2, 1999) overdraft line to finance working capital. Repayments under this facility are fluctuating with interest at the bank's base rate (6.25% at January 2, 1999) plus 1.25% if below the facility limit of (pound)1.5 million and 2.25% if in excess of the agreed limit. The facility expires in September 1999. The Company had no borrowings outstanding under this facility at January 2, 1999 and was in compliance with all covenants.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(6) LONG-TERM OBLIGATIONS
Long-term obligations consist of the following at December 31, 1997 and January 2, 1999 (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
In connection with the acquisition of Tempo (see Note 2), the Company entered into a note payable agreement with Allison Reed Group, Inc. whereby the Company is obligated to pay $55,555 a month for 36 months. The present value of this note, $1.8 million, was recorded as part of the initial purchase price allocation. Payments under this note were subject to potential downward adjustments based on sales of the Tempo division, as defined. This note was settled in full during 1998.
Future maturities of the Company's long-term obligations as of January 2, 1999 are as follows (in thousands):
(7) 10 3/4% SENIOR NOTES OFFERING DUE 2006
On July 21, 1998, the Company sold $75.0 million of 10 3/4% Senior Series A Notes due 2006 (the Notes) through a Rule 144A offering. The net proceeds of approximately $71.0 million received by the Company from the issuance and sale of the Notes were used to repay outstanding indebtedness under the credit facility with a bank and the Subordinated Promissory Notes to shareholders, net of amounts due the Company from certain of these shareholders. The Company incurred issuance costs of approximately $3.7 million in relation to the Notes. These costs are being amortized over the life of the Notes and are included in other assets in the accompanying consolidated balance sheets. In December 1998 the Notes were exchanged for 10 3/4% Series B Notes due 2006 registered with the SEC. Interest on the Notes is payable semiannually on January 15 and July 15, commencing January 15, 1999.
The Notes are general unsecured obligations of the Company, rank senior in right of payment to all future subordinated indebtedness of the Company and rank pari passu in right of payment to all existing and future unsubordinated indebtedness of the Company including the bank credit facility described in Note 5. The bank credit facility is secured by accounts receivable and inventory of the Company and its domestic subsidiaries. Accordingly, the Company's obligations under the bank credit facility will effectively rank senior in right of payment to the Notes to the extent of the assets subject to such security interest. The Notes are fully and unconditionally guaranteed, on a senior and joint and several basis, by each of the Company's current and future Domestic Subsidiaries (as defined) (the Guarantors). The Indenture under which the Notes were issued (the Indenture) imposes certain limitations on the ability of the Company, and its subsidiaries to, among other things, incur indebtedness, pay dividends, prepay subordinated indebtedness, repurchase capital stock, make investments, create liens, engage in transactions with shareholders and affiliates, sell assets and engage in mergers and consolidations.
The Notes are redeemable at the option of the Company on or after July 15, 2002. The Notes will be subject to redemption at the option of the Company, in whole or in part, at various redemption prices, declining from 105.375% of the principal amount to par on and after July 15, 2004. In addition, on or prior to July 15, 2001, the Company may use the net cash proceeds of one or more equity offerings to redeem up to 35% of the aggregate principal amount of the Notes originally issued at a redemption price of 110.750% of the principal amount thereof plus accrued interest to the date of redemption. Upon a change of control, each Note holder has the right to require the Company to repurchase such holder's Notes at a purchase price of 101% of the principal amount plus accrued interest.
(8) DEFERRED COMPENSATION
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(Continued)
The Company has deferred compensation agreements with several key employees. The agreements provide for deferred compensation based on increases in net book value, as defined, and for one executive, the cash surrender value of a life insurance policy owned by the Company. The amounts due under these agreements are payable in a lump sum or in annual installments upon certain defined events. The Company incurred approximately $200,000 in expense related to the insurance policy during the years ended December 31, 1996 and 1997 and January 2, 1999. At January 2, 1999, the cash surrender value of the life insurance policy was approximately $1.1 million and is included in other assets in the accompanying consolidated balance sheet.
The Company also has an obligation to four former employees under a nonqualified deferred compensation plan. Payments of principal and interest are to be made monthly through August 2007. The obligation at January 2, 1999 was $101,418, of which $29,660 is due prior to January 1, 2000. These amounts are included as deferred compensation in the accompanying consolidated balance sheets.
(9) SUBORDINATED PROMISSORY NOTES PAYABLE TO SHAREHOLDERS
Coincident with the sale of Series A Preferred Stock (Note 10) and the concurrent change in the Company's tax status (Note 3), the Company issued $2.0 million of subordinated notes payable to the preferred shareholders and made a distribution of $3.0 million in subordinated notes payable to the original common shareholders. These notes bore interest at an annual rate of 7.04%. Approximately 50% of the interest was payable annually and the remaining balance was deferred and payable with the principal on June 1, 2002 for the preferred shareholders and June 1, 2006 for the original common shareholders, subject to acceleration on the closing of an initial public offering. Upon the closing of the Notes offering, the Company paid the amounts due to the preferred shareholders and offset the amounts due to the shareholders with the related advances to these officers/shareholders (see Note 3).
(10) PREFERRED STOCK
The Company has 200,000 shares of preferred stock, $.01 par value, authorized and issuable in one or more series with such voting powers, designations, preferences and other special rights and such qualifications, limitations or restrictions, as may be stated in the resolution or resolutions adopted by the Company's Board of Directors providing for the issue of such series and as permitted by the Rhode Island Business Corporation Act. The Company has created one series of preferred stock designated Series A Redeemable Convertible Preferred Stock (Series A Preferred Stock). A total of 43,700 shares of Series A Preferred Stock are designated for issuance, all of which are issued and outstanding.
In May 1996, the Company sold 34,200 shares of Series A Preferred Stock for gross proceeds of $18.0 million. In connection with the acquisition of Foster Grant US (see Note 2) in December 1996, the Company issued an additional 9,500 shares of the Series A Preferred Stock for gross proceeds of $5.0 million.
The rights, preferences and privileges of Series A Preferred Stock, as amended in June 1998, are as follows:
CONVERSION
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(Continued)
Shares of the Series A Preferred Stock are convertible into common stock at a rate of 10 shares of common stock for each share of Series A Preferred Stock, adjustable for certain dilutive events. As amended by the Company's shareholders in June 1998, conversion is at the option of the shareholder, but is automatic upon the consummation of an initial public offering resulting in gross proceeds to the Company of at least $20.0 million and at an offering price of at least 137.8% of the original conversion price if the offering is consummated on or before May 31, 1999 and at least 175% of the original conversion price if the offering is consummated after May 31, 1999.
REDEMPTION
The holders of the Series A Preferred Stock have the right to require redemption for cash of any unconverted shares, beginning June 30, 2002. The Company will redeem the Series A Preferred Stock equal to 5% of the total number of shares issued and outstanding as of March 31, 2002 on the last day of each March, June, September and December as follows:
The Series A Preferred Stock will be redeemed at an amount equal to the original stock price, $526.32 per share, plus accrued and unpaid dividends yielding a 10% compounded annual rate of return (the Redemption Amount). Accordingly, the Series A Preferred Stock has been recorded at its redemption value in the accompanying consolidated balance sheets.
The holders of the Series A Preferred Stock may require the Company to redeem all or any portion of the Series A Preferred Stock upon certain events such as the sale, merger or dissolution of the Company. In addition, the Company may voluntarily redeem the Series A Preferred Stock at the Redemption Amount as defined above. If the Company voluntarily redeems the Series A Preferred Stock, it must issue the holders of Series A Preferred Stock a warrant to purchase common stock equal to the number of shares the shareholder would have received upon conversion, at a strike price equal to the redemption price at the time of redemption.
In connection with the proposed issuance of the Notes the preferred shareholders agreed, in June 1998, to suspend their redemption rights until 91 days after the date that any Restrictive Indebtedness, as defined, is no longer outstanding. Restrictive Indebtedness is defined as indebtedness the terms of which restrict the Company's ability to redeem, in whole or part, the Series A Preferred Stock. Restrictive Indebtedness can not exceed $150.0 million or such greater amount as may be approved by the directors designated by the preferred shareholders.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
LIQUIDATION PREFERENCES
The holders of Series A Preferred Stock have preference in the event of a liquidation, dissolution or winding up of the corporation equal to the Redemption Amount. If the assets of the Company are insufficient to pay the full preferential amounts to the holders of Series A Preferred Stock, the assets shall be distributed ratably among such shareholders in proportion to their aggregate liquidation preference amounts.
VOTING RIGHTS AND DIVIDENDS
The holders of the Series A Preferred Stock shall be entitled to vote on all matters based on the number of votes equal to the number of shares into which the shares of Series A Preferred Stock are convertible after December 1, 1996. The holders of a majority of the Series A Preferred Stock shares are entitled to elect two directors. In certain events, defined as Remedy Events, the number of directors of the Company automatically increases to the minimum number sufficient to allow the holders of Series A Preferred Stock to elect a majority of the directors. In June 1998, the preferred shareholders agreed to change the definition of Remedy Events to reduce the minimum amount of consolidated shareholders' equity which the Company is required to maintain dollar for dollar by any payments of certain subordinated notes payable to shareholders (see Note 9).
Dividends will not be paid on the common stock unless the Series A Preferred Stock receives the same dividends that such shares would have received had they been converted into common stock immediately prior to the record date for such dividend.
(11) 1996 INCENTIVE STOCK PLAN
In May 1996, the Company adopted the 1996 Incentive Stock Plan (the Plan) under which it may grant incentive stock options (ISOs), nonqualified stock options (NSOs), restricted stock and other stock rights to purchase up to 50,000 shares of common stock. In May 1998, the Company increased the number of shares of common stock authorized for issuance under the Plan to 150,000. Under the Plan, ISOs may not be granted at less than fair market value on the date of grant and vest in a method determined by the
AAi.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
Board of Directors, over a term not to exceed 10 years. All options have been granted with exercise prices equal to the fair market value of the Company's common shares as determined by the Board of Directors. Stock option activity for each of the three years in the period ended January 2, 1999, is as follows:
In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 requires the measurement of the fair value of stock options granted to employees be included in the statement of operations or disclosed in the notes to financial statements. The Company has determined that it will continue to account for stock-based compensation for employees under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and elect the disclosure-only alternative under SFAS No. 123.
In connection with the acquisition of Fantasma the Company issued options to two employees of Fantasma. The options provide that the employees may purchase up to 13% of Fantasma at the fair market value based upon the purchase price. Certain of these options contain performance criteria and, therefore, will be accounted for as variable options. Based on fiscal 1998 activity, options to purchase 3% of Fantasma had expired resulting in options to purchase 10% of Fantasma outstanding at January 2, 1999.
AAi.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
Had compensation cost for the Company's and Fantasma's stock plans been determined based on the fair value at the grant dates, as prescribed in SFAS No. 123, the Company's net loss and net loss per share applicable to common shareholders for the years ended December 31, 1996 and 1997 and January 2, 1999 would have been as follows:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants during the applicable period: dividend yield of 0.0% for all periods; volatility of 35.53% for all periods; risk-free interest rates of 6.07% for options granted during fiscal 1996, 5.77% for all options granted during fiscal 1997 and 6.00% for all options granted during fiscal 1998 and a weighted average expected option term of 5 years for all periods. The weighted average fair value per share of options granted during the years ended December 31, 1996 and 1997 was $20.87 and $20.60, respectively. The weighted average grant date fair value for an option to purchase a 1% membership interest in Fantasma granted during the year ended January 2, 1999 was approximately $14,400.
(12) INVESTMENTS
(a) Hong Kong
The Company has an ownership interest in four entities in Hong Kong. These entities provide various services to the Company and each other in connection with purchasing and distributing products. The Company accounts for these investments using the equity method. The net investment in these entities is recorded as investment in affiliates in the accompanying consolidated
AAi.FOSTERGRANT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
balance sheets. The following table summarizes certain financial information for these entities (in thousands):
(1) Amounts relate only to Hong Kong entities and do not include other investments accounted for under the equity method.
The following table summarizes certain consolidated financial information of the four Hong Kong entities (in thousands):
(b) Mexico
In 1996, the Company acquired a 50% ownership in AAi Joske's S.A. de R.L. De CV (Joske's), an entity engaged in the purchasing and distribution of accessories in Mexico for $0.5 million of inventory. This investment was accounted for under the equity method. In January 1997, the Company acquired an additional 5% ownership interest in Joske's and accordingly has consolidated its financial results in the Company's consolidated financial statements subsequent to December 31, 1996.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(13) EMPLOYEE BENEFIT PLANS
(a) Qualified 401(k) Plan
The Company has a defined contribution profit sharing plan covering substantially all employees. Under the terms of the profit sharing plan, contributions are made at the discretion of the Company. No contributions were made for the years ended December 31, 1996 and 1997 and January 2, 1999. The profit sharing plan also allows eligible participants to make contributions in accordance with Internal Revenue Code Section 401(k). The Company matches employee contributions equal to 25% of the first 6% of compensation that an employee defers. These matching contributions totaled approximately $87,000, $95,000 and $117,000 for the years ended December 31, 1996 and 1997 and January 2, 1999, respectively.
(b) Non-Qualified Excess 401(k) Plan
In May 1997, the Company established the Non-Qualified Excess 401(k) Plan (the Non-Qualified Plan) effective as of June 1, 1997. The purpose of the Non-Qualified Plan is to provide deferred compensation to a select group of management or highly compensated employees of the Company as designated by the Board of Directors. Under the Non-Qualified Plan, a participant may elect to defer up to 15% of his or her compensation on an annual basis. This amount is credited to the employee's deferred compensation account (the Deferred Amount). Under the Non-Qualified Plan, the Company also credits the participant's deferred compensation account for the amount of the matching contribution the Company would have made under the qualified 401(k) plan with respect to the Deferred Amount. The matching contributions totaled approximately $10,000 and $13,000 for the years ended December 31, 1997 and January 2, 1999, respectively. All amounts contributed by the employee and by the Company under the Non-Qualified Plan are immediately vested. A participant under the Non-Qualified Plan is entitled to receive a distribution of his or her account upon retirement, death, disability or termination of employment.
(14) RELATED PARTY TRANSACTIONS
The Company has operating lease agreements with Sunrise Properties, LLC and 299 Carpenter Street Associates, LLC, of which certain officers and shareholders of the Company are partners. The related rental expense charged to operations was approximately $554,000, $471,000 and $471,000 in the years ended December 31, 1996 and 1997 and January 2, 1999, respectively.
The Company has guaranteed a mortgage note payable by Sunrise Properties, LLC aggregating $200,000. As of January 2, 1999, the outstanding balance of this note was approximately $114,000.
During 1984, the Company sold 5% of its shares to an officer in exchange for a $100,000 non-interest-bearing promissory note. The proceeds from the note are credited to the common stock account as received. During 1996, the remaining balance under this promissory note was paid to the Company.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
In conjunction with the purchase of Foster Grant US, the Company entered into a lease of the building from which FG Holdings operates with BEC, the former owners of Foster Grant US. A member of the Marlin Capital, L.P. (see Note 2) is the chief executive officer of BEC and a director of the Company. The lease was established in December 1996 and extends for one year with automatic renewal for successive one-year periods unless either party provides notice. Rent expense was approximately $494,000, and $165,000 in the year ended December 31, 1997 and January 2, 1999, respectively. The Company terminated this lease as of January 2, 1999.
On May 31, 1996, the Company, and its shareholders, including the management shareholders (Management Shareholders), entered into a tag-along, transfer restriction and voting agreement (the Shareholders Agreement). The Shareholders Agreement requires that any Management Shareholder wishing to transfer or sell common stock of the Company to provide right of first refusal and tag-along rights, on a pro rata basis, as defined, to all other shareholders' party to the Shareholders Agreement upon receipt of a third party offer to purchase the applicable restricted shares.
Upon the death of a Management Shareholder, the personal representative of such Management Shareholder shall sell to the Company such Management Shareholder's shares based on an appraisal value, as defined, provided that the Company's obligation to purchase shares is limited to the amount of any proceeds paid to the Company under insurance policies insuring the life of the Management Shareholder.
The Shareholders Agreement shall terminate upon the earlier of a qualified public offering, as defined, or when no shares of Series A Preferred Stock and warrants are outstanding, except as a result of the conversion, exchange or exercise of the Series A Preferred Stock or warrants.
(15) COMMITMENTS AND CONTINGENCIES
(a) Letters of Credit
At January 2, 1999, the Company had irrevocable letters of credit outstanding for the purchase of inventory of approximately $95,000.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(b) Operating Leases
In addition to the operating leases described in Note 14, the Company also has operating leases for its other locations. Future minimum rental payments are as follows (in thousands):
The Company had an option to purchase its Smithfield, Rhode Island, facility for $2.3 million. This option became exercisable in April 1993 and extended throughout the term of the lease. On February 10, 1998, the Company exercised this option. During fiscal 1998, the Company expanded this facility resulting in costs of the facility and expansion totaling approximately $6.4 million.
(c) Royalties
The Company has several agreements that require royalty payments based on a percentage of certain net product sales, subject to specified minimum payments. Minimum royalty obligations relating to these agreements as of January 2, 1999 totaled $2.2 million and $0.5 million for 1999 and 2000, respectively. In addition, certain of these agreements require the Company pay additional fees based on a percentage of net product sales. These fees are not subject to minimum payment obligations. In the event the Company transfers its rights under certain of these agreements, a transfer fee would be payable. At January 2, 1999, the minimum aggregate transfer fee due would be no less than $2.6 million.
(d) Supply Agreement
The Company has a supply agreement with a display manufacturer. The agreement requires that the Company purchase 70% of Foster Grant US's annual display purchases, as defined, from this supplier through December 2005. If the Company does not purchase 70% of Foster Grant US's displays from this manufacturer, it is required to make a payment equal to 30% of the annual shortfall. In addition, the Company and BEC are required to cumulatively purchase $32.3 million of displays over the term of this agreement. To the extent that total purchases do not meet this dollar level, the Company is required to make a payment equal to 30% of $32.3 million, less the Company's purchases, BEC's purchases and any amounts paid as a result of the annual shortfall discussed above. As of January 2, 1999, no amounts were due under this agreement as a result of a shortfall.
AAi.FOSTERGRANT, INC. AND SUBSIDIARIES
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(Continued)
(e) Litigation
In the ordinary course of business, the Company is party to various types of litigation for which it has purchased insurance to mitigate certain of these risks. The Company believes it has meritorious defenses to all claims, and, in its opinion, all litigation currently pending or threatened will not have a material effect on the Company's financial position or results or operations.
In November 1998, the Company reached a favorable settlement with a customer related to the customer not honoring its purchase commitments under a 1997 agreement. As a result of this settlement, the Company received $950,000 for lost revenues. This settlement is included in other income, net in the accompanying fiscal 1998 consolidated statement of operations.
(16) SIGNIFICANT CUSTOMERS AND SUPPLIERS
During the years ended December 31, 1996 and 1997 and January 2, 1999 one customer accounted for approximately 26.8%, 24.7%, and 27.3% of net sales, respectively. This customer's accounts receivable balance represented approximately 23.6% and 32.4% gross accounts receivable as of December 31, 1997 and January 2, 1999, respectively. In addition, another customer accounted for approximately 11.4% of the Company's net sales for the year ended January 2, 1999 and approximately 10.6% of gross accounts receivable as of January 2, 1999. No other customer accounted for 10% or more of the Company's net sales or gross accounts receivable in fiscal 1996, 1997 and 1998.
The Company currently purchases a significant portion of its inventory from certain suppliers in Asia. Although there are other suppliers of the inventory items purchased, and management believes that these suppliers could provide similar inventory at fairly comparable terms, a change in suppliers could cause a delay in the Company's distribution process and a possible loss of sales, which would adversely affect operating results.
(17) ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
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(Continued)
(18) SEGMENT REPORTING
In July 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 requires certain financial and supplementary information to be disclosed on an annual and interim basis for each reportable segment of an enterprise. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997.
The Company has determined it has three reportable segments: mass merchandisers, chain drug stores/combo stores/supermarkets, and variety stores. The Company distributes accessories such as, costume jewelry, optical products, watches, clocks and other accessories.
The Company's reportable segments are strategic business units that sell the Company's products to distinct distribution channels. They are managed separately because each business requires different marketing strategies. The Company's approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing performance.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before income taxes not including nonrecurring gains and losses.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
Revenue from segments below the quantitative thresholds are attributable to five operating segments of the Company. Those segments include department stores, armed forces' PX stores, boutique stores, gift shops, bookstores and catalogues. None of these segments have ever met any of the quantitative thresholds for determining reportable segments and their combined results are presented as other.
Segment profit (loss) differs from the income (loss) before income tax (expense) benefit and dividends and accretion on preferred stock by the amount of equity in losses of investments in affiliates, minority interest in income of consolidated subsidiary and other income, which are not allocated by segment. Segment assets are not reviewed by the chief operating decision maker.
Total assets specifically identifiable with each reportable segment are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
The following table identifies sales and long-lived assets by geographic region. Sales are attributed to countries based on location of customer. Assets are attributed based on location.
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(Continued)
(19) SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION
The following is summarized consolidating financial information for the Company, segregating the Company, wholly owned guarantor subsidiaries, mostly owned guarantor subsidiaries and non-guarantor subsidiaries as they relate to the Notes. The guarantor subsidiaries, both mostly and wholly owned are domestic subsidiaries of the Company and they guarantee the notes on a full, unconditional and joint and several basis. Separate financial statements of the wholly owned guarantor subsidiaries have not been included because management believes that they are not material to investors. Separate financial statements of the mostly owned guarantor subsidiary, Fantasma LLC, in which the Company holds an 80% interest, are included after this supplemental consolidating financial information.
The Company and guarantor subsidiaries account for investments in subsidiaries on the equity method for the purposes of the consolidating financial data. Earnings of subsidiaries are therefore reflected in the Company's and guarantor subsidiary's investment accounts and earnings. The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions.
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(Continued)
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(Continued)
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(Continued)
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(Continued)
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(Continued)
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Members of Fantasma LLC:
We have audited the accompanying balance sheets of Fantasma LLC as of December 31, 1997 and January 2, 1999 and the related statements of operations, members' equity and cash flows for each of the three years in the period ended January 2, 1999. These financial statements are the responsibility of Fantasma LLC's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Fantasma LLC as of December 31, 1997 and January 2, 1999 and the results of its operations and its cash flows for each of the three years in the period ended January 2, 1999, in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Boston, Massachusetts February 19, 1999
FANTASMA LLC
BALANCE SHEETS
(IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
FANTASMA LLC
STATEMENTS OF OPERATIONS
(IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
FANTASMA LLC
STATEMENTS OF MEMBERS' EQUITY
(IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
FANTASMA LLC
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
FANTASMA LLC
NOTES TO FINANCIAL STATEMENTS JANUARY 2, 1999
(1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Organization and Business Activity
Fantasma LLC (Fantasma) was organized under the laws of the State of Delaware on August 22, 1996 and began business operations on September 1, 1996. Fantasma imports and wholesales licensed watches, clocks, and other novelties, and grants credit to customers located primarily in the United States.
Prior to September 1, 1996, Fantasma operated as a division (the Fantasma division) of Overdrive Capital Corp. (formerly known as Good Stuff Corp.). Overdrive Capital Corp. (Overdrive) sold the Fantasma division's operating assets to Fantasma LLC in exchange for a two-year $3,764,366 note. Overdrive maintained a 67% ownership interest in Fantasma, with a former stockholder of Overdrive holding a 33% ownership interest. The assets were transferred at historical book value and consisted of the following (in thousands):
Unexpired royalties $ 289 Accounts receivable 798 Inventory 2,600 Prepaid expenses 49 Furniture and equipment 25 Trademarks 3 ----------- Total assets transferred $ 3,764 ===========
The accompanying financial statements prior to the formation of Fantasma LLC represent the financial results of the Fantasma division as included in the financial statements of Overdrive from January 1, 1995 to August 31, 1996.
In June 1998, AAi.FosterGrant, Inc. (AAi.FosterGrant) acquired an 80% interest in Fantasma for approximately $4.1 million in cash (the Acquisition). The operating agreement under which Fantasma is managed provides AAi.FosterGrant with sole voting rights on numerous significant matters. The Acquisition was accounted for using the purchase method. The purchase price was allocated based on estimated fair market value of assets and liabilities at the date of acquisition, as follows (in thousands):
Cash $ 73 Accounts receivable 1,603 Inventory 2,002 Other current assets 165 Furniture and equipment 15 Goodwill 4,626 Notes payable (3,500) Other current liabilities (934) ----------- Cash paid $ 4,050 ===========
FANTASMA LLC
NOTES TO FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
The book value of Fantasma's assets and liabilities immediately prior to the Acquisition approximated fair market value. Goodwill is being amortized ratably over 10 years.
Basis of Accounting
The accompanying financial statements reflect the application of certain significant accounting policies, as discussed below and elsewhere in the notes to financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Inventory
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of finished goods for all years presented. Finished goods inventory consists of material and overhead.
Property and Equipment
Fantasma provides for depreciation and amortization by charges to operations in amounts that allocate the cost of these assets on the straight-line and accelerated bases over their estimated useful lives as follows:
ASSET CLASSIFICATION ESTIMATED USEFUL LIFE
Equipment 5 years Furniture and fixtures 7 years
Fantasma has adopted the provisions of Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. The adoption of this pronouncement did not have a material effect on Fantasma's financial position or financial results.
Royalties
Fantasma has several agreements that require royalty payments based on a percentage of certain net product sales, subject to specified minimum payments. Minimum future royalty obligations relating to these agreements total $849,000. Royalty expense was approximately $1,049,000, $1,734,000 and $1,477,000 for the years ended December 31, 1996 and 1997 and January 2, 1999, respectively. Accrued royalties, which are included in accounts payable and accrued expenses on the accompanying balance sheets, totaled $732,000 and $707,000 at December 31, 1997 and January 2, 1999, respectively.
Revenue Recognition
Fantasma recognizes revenue from product sales, net of anticipated returns and discounts, taking into account historical experience, upon shipment to the customer.
Concentration of Credit Risk
FANTASMA LLC
NOTES TO FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
Financial instruments that potentially subject Fantasma to concentrations of credit risk are principally accounts receivable. A significant portion of its business activity is with domestic mass merchandisers whose ability to meet their financial obligations is dependent on economic conditions germane to the retail industry. During recent years, many major retailers have experienced significant financial difficulties and some have filed for bankruptcy protection; other retailers have begun to consolidate within the industry. To reduce credit risk, Fantasma routinely assesses the financial strength of its customers.
Intangible and Other Long-Lived Assets
In accordance with Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for Impairment of Long-Lived Assets and For Long-Lived Assets To Be Disposed Of, Fantasma reviews its long-lived assets (consisting primarily of goodwill) for impairment as events and circumstances indicate the carrying amount of an asset may not be recoverable. Fantasma evaluates the realizability of its long-lived assets based on profitability and cash flow expectations for the related asset. Management believes that as of each of the balance sheet dates presented none of Fantasma's long-lived assets were impaired. Amortization expense was approximately $270,000 for the year ended January 2, 1999.
Disclosure of Fair Value of Financial Instruments
Fantasma's financial instruments consist mainly of cash, accounts receivable, accounts payable and debt. The carrying amounts of Fantasma's financial instruments approximate fair value.
New Accounting Standards
In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Fantasma does not believe that the adoption of SFAS No. 133 will have a material impact on its financial instruments.
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-5, Reporting on the Costs of Start-up Activities (SOP 98-5). SOP 98-5 provides guidance on the financial reporting of start-up activities and organization costs to be expensed as incurred. Fantasma does not believe that the adoption of SOP 98-5 will have a material impact on its financial statements.
Income Taxes
Fantasma is treated as a partnership for federal and state income tax purposes, whereby the membership owners are taxed on their proportionate share of Fantasma's income. As a result, Fantasma has not provided for federal income taxes. The provision for income taxes reflects New York City Unincorporated Business Tax and New York State filing fees. For the period from January 1, 1996 to August 31, 1996, Fantasma accounted for state income taxes on a separate company basis.
(2) NOTE PAYABLE
FANTASMA LLC
NOTES TO FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
Fantasma issued a note payable to Overdrive as consideration for the asset purchase on September 1, 1996 (see Note 1), under which it could borrow up to $5,000,000. At December 31, 1997, approximately $3,764,000 was outstanding under this note. The note accrued interest at the prime rate (8.5% at December 31, 1997). Total interest charged on this note was approximately $107,000, $320,000 and $141,000 in the years ended December 31, 1996 and 1997 and January 2, 1999, respectively. This note was repaid in June 1998 with the proceeds from a note payable issued to AAi.FosterGrant.
On June 13, 1998, the Company entered into a $15,000,000 demand revolving promissory note payable with AAi.FosterGrant. Borrowings under the note are secured by substantially all of Fantasma's assets and bear interest at a rate equal to AAi.FosterGrant's borrowing rate. The note is payable on demand with thirty-days notice. Total interest charged on this note was approximately $282,000 for the year ended January 2, 1999. At January 2, 1999, $7,088,000 was outstanding under this note payable.
(3) OPTIONS
In connection with AAi.FosterGrant's investment in Fantasma, Fantasma issued options to two employees. The options provide that the employees may purchase up to 13% of Fantasma at the fair market value on the date of grant. Certain of these options contain performance criteria and, therefore, will be accounted for as variable options. Based on 1998 activity, options to purchase 3% of Fantasma expired during the fiscal year. As of January 2, 1999 options to purchase 10% of the Company were outstanding and the exercise price was equal to or greater than the fair market value, therefore no expense was recorded.
In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 requires the measurement of the fair value of stock options granted to employees to be included in the statement of operations or disclosed in the notes to financial statements. Fantasma has determined that it will account for stock-based compensation for employees under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and elect the disclosure-only alternative under SFAS No. 123.
Had compensation cost for Fantasma's options been determined based on the fair value at the grant dates, as prescribed in SFAS No. 123, Fantasma's net loss for the fiscal year ended January 2, 1999 would have been $63,000.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants during the applicable period: no dividend; yield volatility of 35.53%; risk-free interest rates of 6.00% and a weighted average expected option term of 5 years. The weighted average grant date fair value for an option to purchase a 1% membership interest in Fantasma granted during the year ended January 2, 1999 was approximately $14,400.
(4) RELATED PARTY TRANSACTIONS
Shared Resources
As discussed in Note 1, for the period from January 1, 1995 to August 31, 1996, Fantasma operated as the Fantasma division of Overdrive. During this period, and for the period from September 1, 1996 to June 10,
FANTASMA LLC
NOTES TO FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
1998, general corporate overhead costs related to corporate headquarters and shared administrative support were allocated by Overdrive to Fantasma based on a number of factors, including, for example, personnel and space utilized. In addition, Fantasma has operated as a division of AAi.FosterGrant since June 10, 1998 and has had similar expenses allocated to it by AAi.FosterGrant using similar factors. Management believes these allocations were reasonable and the costs of the services charged to Fantasma were not materially different from the costs that would have been incurred had Fantasma performed these functions as a stand-alone entity.
Overdrive allocated expenses through advances. Interest on advances was charged monthly until June 10, 1998, based on the prime rate applied to the average outstanding monthly balance. Total interest charged on advances payable to Overdrive was $129,000, $160,000, and $27,000 in the years ended December 31, 1996 and 1997 and January 2, 1999, respectively. Advances from Overdrive were repaid on June 10, 1998. Expenses allocated by AAi.FosterGrant are funded through the note payable (see Note 2 for further discussion).
(5) SIGNIFICANT CUSTOMERS
During the year ended January 2, 1999, three customers accounted for approximately 22%, 17% and 10% of net sales, respectively. These customers' accounts receivable balances represented approximately 27%, 14% and 4% of gross accounts receivable as of January 2, 1999.
FANTASMA LLC
NOTES TO FINANCIAL STATEMENTS JANUARY 2, 1999
(Continued)
(6) SEGMENT REPORTING
The Company has adopted SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, in the 1998 fiscal year. SFAS No. 131 establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS No. 131 also establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions now to allocate resources and assess performance. To date, the Company has viewed its operations and manages its business as principally one segment.
(7) VALUATION AND QUALIFYING ACCOUNTS
(1) Amounts deemed uncollectible
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE
To the Shareholders of AAi.FosterGrant, Inc. and Subsidiaries:
We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of AAi.FosterGrant, Inc. and Subsidiaries included in this 10-K and have issued our report thereon dated February 19, 1999. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. This schedule is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects, the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP
Boston, Massachusetts February 19, 1999
SCHEDULE II
AAI. FOSTERGRANT, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
(1) Amounts deemed uncollectible
(2) Reserves related to accounts receivable acquired in acquisitions | 28,195 | 184,430 |
839345_1999.txt | 839345_1999 | 1999 | 839345 | Item 1. Business
Boston Financial Qualified Housing Tax Credits L.P. III (the "Partnership") is a limited partnership formed on August 9, 1988 under the Uniform Limited Partnership Act of the State of Delaware. The Certificate and Agreement of Limited Partnership ("Partnership Agreement") authorized the sale of up to 100,000 units of Limited Partnership Interest ("Units") at $1,000 per Unit, adjusted for certain discounts. The Partnership raised $99,610,000 ("Gross Proceeds"), net of discounts of $390,000, through the sale of 100,000 Units. Such amounts exclude five unregistered Units previously acquired for $5,000 by the Initial Limited Partner, which is also one of the General Partners. The offering of Units terminated on May 30, 1989. No further sale of Units is expected.
As described more fully under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, affiliates of the Managing General Partner assumed the Local General Partner interest in several Local Limited Partnerships in which the Partnership has invested: 1) BF Harbour View, Inc. assumed the Local General Partner interest in 241 Pine Street Associates L.P. ("241 Pine Street"); 2) BF Willow Lake, Inc. assumed the Local General Partner interest in Willow Lake Partners II, L.P. ("Willow Lake"); 3) BF Texas Limited Partnership was admitted as an additional Local General Partner to thirteen Local Limited Partnerships ("Texas Partnerships") and assumed the Local General Partner interest in the Temple Kyle, L.P., Ltd. (the "Kyle"); and 4) Boston Financial GP-I, LLC. assumed the Local General Partner interest in Breckenridge Creste Apartments, L.P. ("Breckenridge"). As a result, the Partnership is deemed to have control over 241 Pine Street, Willow Lake, the Texas Partnerships, the Kyle and Breckenridge (the "Combined Entities"), and the accompanying financial statements are presented in combined form to conform with the required accounting treatment under generally accepted accounting principles. However, these changes only affect the presentation of the Partnership's operating results, not the business of the Partnership. Accordingly, a presentation of information about industry segments is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. As described more fully in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, the Managing General Partner has transferred all of the assets of The Texas Partnerships subject to their liabilities to unaffiliated entities.
The Partnership has invested as a limited partner in fifty-four other limited partnerships ("Local Limited Partnerships") which own and operate residential apartment complexes ("Properties"), some of which benefit from some form of federal, state or local assistance programs and all of which qualify for the low-income housing tax credits ("Tax Credits") that were added to the Internal Revenue Code by the Tax Reform Act of 1986 (the "Code"). The investment objectives of the Partnership include the following: (i) to provide current tax benefits in the form of Tax Credits which qualified limited partners may use to offset their federal income tax liability; (ii) to preserve and protect the Partnership's capital; (iii) to provide limited cash distributions from property operations which are not expected to constitute taxable income during the expected duration of the Partnership's operations; and (iv) to provide cash distributions from sale or refinancing transactions. There cannot be any assurance that the Partnership will attain any or all of these investment objectives.
A more detailed discussion of these investment objectives, along with the risks in achieving them, is contained in the section of the prospectus entitled "Investment Objectives and Policies - Principal Investment Policies" which is herein incorporated by this reference.
Table A on the following pages lists the Properties owned by Local Limited Partnerships in which the Partnership has invested. Item 7 of this Report contains other significant information with respect to such Local Limited Partnerships. As required by applicable rules, the terms of the acquisition of Local Limited Partnership interests have been described in supplements to the Prospectus and collected in one post-effective amendment to the Registration Statement, in another supplement to the Prospectus and in a report on Form 8-K listed in Part IV of this Report (collectively, the "Acquisition Reports"); such descriptions are incorporated herein by this reference.
TABLE A
SELECTED LOCAL LIMITED PARTNERSHIP DATA (Unaudited)
* The Partnership's interest in profits and losses of each Local Limited Partnership arising from normal operations is 99% with the exception of five Local Limited Partnerships in which the Partnership acquired a 98% interest (Willow Lake), 98% interest (Breckenridge), 97% interest (Granite), 49% interest (Colony Apartments) and a 48.96% interest (Harbour View). Profits and losses arising from sale or refinancing transactions are allocated in accordance with the respective Local Limited Partnership Agreements.
** As of March 31, 1999, the Managing General Partner has transferred all of the assets of the thirteen Texas Partnerships subject to their liabilities to unaffiliated entities. The transfer of Crown Point, Godley Arms, Glenbrook Apartments, Quail Run Apartments, Sherwood Arms Housing, Lone Oak Apartments, Hallet West Apartments, Crestwood Place, Eagle Nest Apartments, One Main Place, Pilot Point Apartments, Lakeway Colony and Willowick were effective February 21, 1996, February 21, 1996, June 7, 1996, July 3, 1996, November 26, 1996, August 6, 1997, September 23, 1997, October 28, 1997, October 28, 1997, October 28, 1997, October 28, 1997, October 30, 1997 and August 4, 1998, respectively.
*** As of March 31, 1999, the titles of Rolling Hills and Regency Square were transferred to the lender. The transfers were effective May 2, 1997.
Although the Partnership's investments in Local Limited Partnerships are not subject to seasonal fluctuations, the Partnership's equity in losses of Local Limited Partnerships and rental operating revenues and expenses, to the extent they reflect the operations of individual Properties, may vary from quarter to quarter based upon changes in occupancy and operating expenses as a result of seasonal factors.
With the exception of the Combined Entities, each Local Limited Partnership has, as its general partners ("Local General Partners"), one or more individuals or entities not affiliated with the Partnership or its General Partners. In accordance with the partnership agreements under which such entities are organized ("Local Limited Partnership Agreements"), the Partnership depends on the Local General Partners for the management of each Local Limited Partnership. As of March 31, 1999, the following Local Limited Partnerships have a common Local General Partner or affiliated group of Local General Partners accounting for the specified percentage of the total capital contributions in Local Limited Partnerships: (i) Boulevard Commons II and Boulevard Commons IIA, representing 2.48%, have Carroll Properties, Inc. and Robert King as Local General Partners; (ii) Ellsworth, Syracuse, Satanta, Rossville, Humbolt, Smithville, Brownsville, Briarwood, Billings, Garden Plain, Wayne, Horseshoe Bend, Bolivar, Oak Grove, Westgate and Altheimer, representing 2.40%, have The Lockwood Group as Local General Partner; (iii) Elver Park II, Elver Park III, Tucson Trails I and Tucson Trails II, representing 6.41%, have Gorman Associates as Local General Partner; (iv) Riverfront Apartments and Susquehanna View, representing 6.10%, have NCHP as Local General Partner; (v) West Dade and West Dade II, representing 6.65%, have Romat, Inc. and Arbor, Inc., respectively, both of which have Aristedes Martinez as principal, as Local General Partner; (vi) Elmwood and Fox Run, representing 3.95%, have Delwood Ventures, Inc. and R.S.F. Ventures, Inc. as Local General Partners, respectively, both of which have Raymond Baker as principal; (vii) Eaglewood, Lexington and Fulton, representing 0.77%, have Tommy Harper, Jerry Blurt and Chris Turskey as Local General Partners; and (viii) Waterfront and Shoreline, representing 6.83%, have M.B. Associates as Local General Partner. The Local General Partners of the remaining Local Limited Partnerships are identified in the Acquisition Reports, which are incorporated herein by reference.
The Properties owned by Local Limited Partnerships in which the Partnership has invested are and will continue to be subject to competition from existing and future properties in the same areas. The continued success of the Partnership will depend on many factors, most of which are beyond the control of the Partnership and which cannot be predicted at this time. Such factors include general economic and real estate market conditions, both on a national basis and in those areas where the Properties are located, the availability and cost of borrowed funds, real estate tax rates, operating expenses, energy costs and government regulations. In addition, other risks inherent in real estate investment may influence the ultimate success of the Partnership, including: (i) possible reduction in rental income due to an inability to maintain high occupancy levels or adequate rental levels; (ii) possible adverse changes in general economic conditions and adverse local conditions, such as competitive overbuilding, a decrease in employment rates or adverse changes in real estate laws, including building codes; and (iii) the possible future adoption of rent control legislation which would not permit increased costs to be passed on to the tenants in the form of rent increases or which would suppress the ability of the Local Limited Partnership to generate operating cash flow. Since most of the Properties benefit from some form of government assistance, the Partnership is subject to the risks inherent in that area including decreased subsidies, difficulties in finding suitable tenants and obtaining permission for rent increases. In addition, any Tax Credits allocated to investors with respect to a Property are subject to recapture to the extent that the Property or any portion thereof ceases to qualify for the Tax Credits. Other future changes in Federal and state income tax laws affecting real estate ownership or limited partnerships could have a material and adverse affect on the business of the Partnership.
The Partnership is managed by Arch Street III, Inc., the Managing General Partner of the Partnership. The other General Partner of the Partnership is Arch Street III Limited Partnership. The Partnership, which does not have any employees, reimburses The Boston Financial Group Limited Partnership ("Boston Financial"), an affiliate of the General Partners, for certain expenses and overhead costs. A complete discussion of the management of the Partnership is set forth in Item 10 of this Report.
Item 2.
Item 2. Properties
The Partnership owns limited partnership interests in fifty-four Local Limited Partnerships which own and operate Properties, some of which benefit from some form of federal, state or local assistance programs and all of which qualify for the Tax Credits added to the Code by the Tax Reform Act of 1986. The Partnership's ownership interest in each Local Limited Partnership is 99%, except for Willow Lake, Breckenridge, Granite, Colony Apartments and Harbour View, where the Partnership's ownership interest is 98%, 98%, 97%, 49% and 48.96%, respectively.
Each of the Local Limited Partnerships has received an allocation of Tax Credits from its relevant state tax credit agency. In general, the Tax Credit runs for ten years from the date the Property is placed in service. The required holding period (the "Compliance Period") of the Properties is fifteen years. During these fifteen years, the Properties must satisfy rent restrictions, tenant income limitations and other requirements, as promulgated by the Internal Revenue Code, in order to maintain eligibility for the Tax Credit at all times during the Compliance Period. Once a Local Limited Partnership has become eligible for the Tax Credits, it may lose such eligibility and suffer an event of recapture if its Property fails to remain in compliance with the requirements.
In addition, some of the Local Limited Partnerships have obtained one or a combination of different types of loans such as: i) below market rate interest loans; ii) loans provided by a redevelopment agency of the town or city in which the property is located at favorable terms; and iii) loans which have repayment terms that are based on a percentage of cash flow.
The schedules on the following pages provide certain key information on the Local Limited Partnership interests acquired by the Partnership.
*FmHA This subsidy, which is authorized under Section 515 of the Housing Act of 1949, can be one or a combination of different types of GP financing. For instance, FmHA may provide: 1) direct below- market-rate mortgage loans for rural rental housing; 2) mortgage interest subsidies which effectively lower the interest rate of the loan to 1%; 3) a rental assistance subsidy to tenants which allows them to pay no more than 30% of their monthly income as rent with the balance paid by the federal government; or 4) a combination of any of the above.
Section 8 This subsidy, which is authorized under Section 8 of Title II of the Housing and Community Development Act of 1974, allows qualified low- income tenants to pay 30% of their monthly income as rent with the balance paid by the federal government.
(A) As of March 31, 1999, the Managing General Partner has transferred all of the assets of the Thirteen Texas Partnerships subject to their liabilities. The Texas Partnerships had total capital contributions and mortgage payable amounts of $1,580,498 and $6,516,496, respectively, as of the transfer dates.
(B) As of March 31, 1998, the Managing General Partner transferred the title of Rolling Hills Associates, L.P. and Regency Square Limited Partnership to the lender. These two Partnerships had total capital contributions and mortgage payable amounts of $5,655,000 and $6,409,457, respectively, as of the transfer dates.
One Local Limited Partnership, Quarter Mill Associates L.P., invested in by the Partnership represents more than 10% of the total capital contributions to be made to Local Limited Partnerships by the Partnership. Quarter Mill is a 266-unit construction apartment complex located in Richmond, Virginia.
Quarter Mill is financed by a combination of private and public sources. The first mortgage is at 8.75% interest, has a 40-year term and is insured by HUD. The apartment project is pledged as collateral for the note. In addition to the first mortgage, there is a subordinated nonrecourse note that is payable each year only to the extent of 15% of the property's net cash flow, as defined by the note agreement.
Additional information required under this item, as it pertains to the Partnership, is contained in Items 1, 7 and 8 of this report.
Item 3.
Item 3. Legal Proceedings
Lone Oak Housing Associates, Ltd., as was previously reported, was the defendant in a lawsuit in which the plaintiff had alleged negligence and deceptive Trade Act violations. This litigation was settled by the insurance carrier and the case dismissed.
Willow Lake Partners II, L.P. ("Willow Lake") was the defendant in a lawsuit relating to an earlier lawsuit involving Willow Lake. As part of the Partnership's settlement with the former management agent, Willow Lake gave the management agent two cash flow notes. The former management agent is now claiming that Willow Lake has cash flow (so payments should have been made on the notes) and it is the Partnership's position that the property is running a deficit. On June 25, 1998, the court found for Willow Lake on summary judgement and ruled that there was no default on the note. This litigation is no longer outstanding unless the former management agent decides to appeal.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for the Registrant's Units and Related Security Holder Matters
There is no public market for the Units, and it is not expected that a public market will develop. If a Limited Partner desires to sell Units, the buyer of those Units will be required to comply with the minimum purchase and retention requirements and investor suitability standards imposed by applicable federal or state securities laws and the minimum purchase and retention requirements imposed by the Partnership. The price to be paid for the Units, as well as the commissions to be received by any participating broker-dealers, will be subject to negotiation by the Limited Partner seeking to sell his Units. Units will not be redeemed or repurchased by the Partnership.
The Partnership Agreement does not impose on the Partnership or its General Partners any obligation to obtain periodic appraisals of assets or to provide Limited Partners with any estimates of the current value of Units.
As of June 15, 1999, there were 5,880 record holders of Units of the Partnership.
Cash distributions, when made, are paid annually. No cash distribution was paid in the years ended March 31, 1999, 1998 and 1997.
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected financial information regarding the Partnership's financial position and operating results. This information should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Financial Statements and Notes thereto, which are included in Items 7 and 8 of this Report.
(A) Total assets include the net investment in Local Limited Partnerships.
(B) Income tax information is as of December 31, the year end of the Partnership for income tax purposes. The Low-Income Housing Tax Credit per Limited Partnership Unit for 1998, 1997, 1996, 1995 and 1994 represents the amount allocated to individual investors. Corporate investors were allocated $131.03, $129.80, $142.65, $144.62 and $144.95 per Unit in 1998, 1997, 1996, 1995 and 1994, respectively.
Item 6. Selected Financial Data (continued)
(C) Revenue for the years ended March 31, 1999, 1998, 1997, 1996 and 1995 includes $2,484,545, $2,563,928, $1,909,683, $2,224,273 and $1,792,997, respectively, of rental and other revenues from the Combined Entities that is included in the combined revenue on the Combined Statement of Operations. Equity in losses of Local Limited Partnerships in the years ended March 31, 1999, 1998, 1997, 1996 and 1995 does not include $1,663,198, $(931,727),$(2,633,475), $608,681 and ($857,248), respectively, of income (losses) from the Combined Entities that have been combined with the Partnership's loss on the Combined Statement of Operations. Cash and cash equivalents for the years ended March 31, 1999, 1998, 1997, 1996 and 1995 includes $101,372, $99,298, $166,606, $173,408 and $80,091, respectively, from the Combined Entities that is included on the Combined Balance sheets. The total amount of long-term debt is related to the Combined Entities. Total liabilities for the years ended March 31, 1999, 1998, 1997, 1996 and 1995 includes $10,990,506, $12,068,486, $15,409,538, $10,065,592 and $11,499,446, respectively, from the Combined Entities that is included on the Combined Balance Sheets.
(D) As of March 31, 1998, the Managing General Partner transferred the title to the lender of Rolling Hills Associates, L.P. and Regency Square Limited Partnership with an original cost amount of $5,655,000. As of March 31, 1999, the Managing General Partner also transferred all of the assets of Willowick subject to its liabilities.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Certain matters discussed herein constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Partnership intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements, and are including this statement for purposes of complying with these safe harbor provisions. Although the Partnership believes the forward-looking statements are based on reasonable assumptions, the Partnership can give no assurance that their expectations will be attained. Actual results and timing of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including, without limitation, general economic and real estate conditions, interest rates, and unanticipated delays or expenses on the part of the Partnership and their suppliers in achieving year 2000 compliance.
As previously reported, the Managing General Partner transferred all of the assets of the thirteen Texas Partnerships subject to their liabilities to unaffiliated entities. Crown Point, Godley Arms, Glenbrook Apartments, Quail Run Apartments, Sherwood Arms Housing, Lone Oak Apartments, Hallet West Apartments, Lakeway Colony, Crestwood Place, Eagle Nest Apartments, One Main Place and Pilot Point Apartments were transferred prior to March 31, 1998. Willowick was transferred on August 4, 1998. For tax purposes, these events resulted in both Section 1231 gain and cancellation of indebtedness income. In addition, the transfer of ownership resulted in a nominal amount of recapture of tax credits because the Texas Partnerships represented only 2% of the Partnership's tax credits.
The Local General Partner and Managing General Partner were involved in lengthy workout negotiations with HUD, but ultimately the mortgages for these properties were sold to a lender in HUD's August 1996 non-performing loan auction. Although negotiations continued with the lender in an attempt to prevent foreclosure, a workout was not achieved, and the foreclosures occurred. This transfer of title resulted in a recapture tax in 1997 and the allocation of taxable income, which was reported on the investors' 1997 tax return (filed in 1998).
Liquidity and Capital Resources
The Partnership (including the Combined Entities) had an increase in cash and cash equivalents of $128,498 for the year ended March 31, 1999. This increase is attributable to sales of marketable securities, cash distributions received from Local Limited Partnership and cash provided by operations and proceeds from mortgage note. These increases are partially offset by purchases of marketable securities and reimbursement to developer.
The Managing General Partner initially designated 3% of the Gross Proceeds as Reserves. The Reserves were established to be used for working capital of the Partnership and contingencies related to the ownership of Local Limited Partnership interests. The Managing General Partner may increase or decrease such Reserves from time to time, as it deems appropriate. During the year ended March 31, 1993, the Managing General Partner decided to increase the Reserve level to 3.75%. Funds approximating $196,000 have been withdrawn from the Reserves to pay legal and other costs. Additionally, professional fees relating to various property issues totaling approximately $1,728,000 have been paid from Reserves. This amount includes approximately $1,313,000 for the Texas Partnerships. To date, Reserve funds in the amount of approximately $349,000 have also been used to make additional capital contributions to two Local Limited Partnerships, and the Partnership has paid approximately $1,070,000 (net of paydowns) to purchase the mortgage of a Local Limited Partnership. To date, the Partnership has used approximately $2,038,000 of operating funds to replenish Reserves. At March 31, 1999, approximately $983,000 of cash, cash equivalents and marketable securities have been designated as Reserves. Reserves may be used to fund Partnership operating deficits, if the Managing General Partner deems funding appropriate. If Reserves are not adequate to cover the Partnership's operations, the Partnership will seek other financing sources including, but not limited to, the deferral of Asset Management Fees paid to an affiliate of the Managing General Partner or working with Local Limited Partnerships to increase cash distributions.
In the event a Local Limited Partnership encounters operating difficulties requiring additional funds, the Partnership might deem it in its best interests to provide such funds, voluntarily, in order to protect its investment. To date, in addition to the $1,313,000 noted above, the Partnership has also advanced approximately $622,000 to the Texas Partnerships and $841,000 to four other Local Limited Partnerships to fund operating deficits.
Since the Partnership invests as a limited partner, the Partnership has no contractual duty to provide additional funds to Local Limited Partnerships beyond its specified investment. Thus, at March 31, 1999, the Partnership had no contractual or other obligation to any Local Limited Partnership which had not been paid or provided for.
Cash Distributions
No cash distributions were made in the three years ended March 31, 1999. As of March 31, 1999, all required capital contributions have been made to Local Limited Partnerships. Based on the results of 1998 operations, the Local Limited Partnerships are not expected to distribute significant amounts of cash to the Partnership because such amounts will be needed to fund Property operating costs. In addition, many of the Properties benefit from some type of federal or state subsidy and, as a consequence, are subject to restrictions on cash distributions. Therefore, it is expected that only a limited amount of cash will be distributed to investors from this source in the future.
Results of Operations
1999 versus 1998
For the year ended March 31, 1999, Partnership operations resulted in a net loss of $5,109,931 as compared to a net loss of $3,597,835 for the same period in 1998. The increase in net loss is primarily attributable to an increase in provision for valuation of real estate related to one of the combined entities. These increases in net loss are partially offset by a decrease in bad debt expenses.
1998 versus 1997
For the year ended March 31, 1998, Partnership operations resulted in a net loss of $3,597,835 as compared to a net loss of $7,208,441 for the same period in 1997. The decrease in net loss is primarily attributable to a increase in gains on transfer of assets, an increase in rental revenue, a decrease in provision for valuation of real estate and a decrease in equity in losses. These decreases in net loss are partially offset by an increase in bad debt expense, rental operations and interest expense.
Low-Income Housing Tax Credits
The 1998, 1997 and 1996 Tax Credits per Unit for individuals were $125.55, $123.94 and $136.50, respectively. The 1998, 1997 and 1996 Tax Credits per Unit for corporations were $131.03, $129.80 and $142.65, respectively. The credits, which have stabilized, are expected to remain stable for the next two years, and then they are expected to decrease as certain properties reach the end of the ten-year credit period. However, because the compliance periods extend significantly beyond the tax credit periods, the Partnership is expected to retain most of its interest in the Local Limited Partnerships for the foreseeable future. The transfer of ownership of the remaining Texas Partnership will result in nominal recapture of tax credits since the Texas Partnerships represent less than 2% of the Partnership's tax credits.
The Tax Credits per Unit for corporate investors will be slightly higher for the remaining years of the credit period than that for individual investors because certain of the Properties took advantage of 1990 federal legislation that allowed the acceleration of future tax credits to individuals in the tax year ended December 31, 1990. For those Properties that elected to accelerate the individual credit, the accelerated portion is being amortized over the remainder of the credit period, thereby causing a reduction of this and future year's tax credits passed through by those Properties. In total, both individual and corporate investors will be allocated equal amounts of Tax Credits.
Property Discussions
Prior to the transfer of the Texas Partnerships, Limited Partnership interests had been acquired in sixty-nine Local Limited Partnerships, which own and operate rental properties in twenty-four states. Forty-two of the properties, totaling 3,935 units, were rehabilitated, and twenty-seven properties, consisting of 1,614 units, were newly constructed.
Many of the remaining fifty-four Local Limited Partnerships in which the Partnership has invested have stable operations and are operating satisfactorily. Several properties are experiencing operating difficulties and generating cash flow deficits due to a variety of reasons. In most cases, the Local General Partners of these properties are funding the deficits through project expense loans and subordinated loans or payments from escrows. In instances where the Local General Partners' obligations to fund deficits have expired or otherwise, the Managing General Partner is working with the Local General Partner to increase operating income, reduce expenses or refinance the debt at lower interest rates.
Boulevard Commons II and IIA, located in Chicago, Illinois, and both having the same Local General Partner have been experiencing operating deficits. Expenses have increased due to increasing maintenance, capital needs, security issues and high turnover at the property. The Managing General Partner has been in negotiations with the Local General Partner to develop a plan that will ultimately transfer ownership of the property to the Local General Partner. The plan includes provisions to minimize the risk of recapture. Effective January 1, 1999, the Partnership redeemed its interest in Boulevard Commons II to the Local Limited Partnership. The redemption of the Partnership's interest avoids a possible recapture event. However, the redemption will cause investors to have minimal taxable gain or loss for the 1999 tax year, depending upon the tax basis of the property.
The Managing General Partner is still negotiating with the Local General Partner regarding Boulevard Commons IIA to develop a plan that will ultimately transfer ownership of the property to the Local General Partner and minimize the risk of recapture, However, given the severity of the operating deficits, it is possible that the Partnership will not be able to retain its interest in the property through 1999. A foreclosure would result in recapture of credits for investors, the allocation of taxable income to the Fund and loss of future benefits associated with this property.
Breckenridge Creste, located in Duluth, Georgia, is experiencing operating deficits as a result of higher vacancies during the summer of 1998. However occupancy for the last two quarters has increased from 90% in September 30, 1998 to 96% in December 31, 1998. The Managing General Partner is working with property management to review completion of needed capital improvements and to review the revised marketing strategy.
Columbia Townhouses, located in Burlington, Iowa, has been experiencing operating deficits due to consistent increases in vacancy. As of December 31, 1998, occupancy was 89%. The Local General Partner, Managing General Partner and Management Agent are working together to review the marketing, security and long-term strategy for this property. In addition, the Local General Partner has approached the lender about the possibility of refinancing the mortgage. The Managing General Partner is closely monitoring this property.
As previously reported, Harbour View, located in Staten Island, New York, had defaulted on its HUD-insured loan. Subsequently, the lender assigned the loan to HUD. In December 1996, the mortgage was sold at auction to an unaffiliated institutional buyer. The Managing General Partner and Local General Partner continue to participate in workout discussions with the new lender. The Partnership's ability to retain its interest in the property will depend on the ability of the Local General Partner and Partnership affiliates to negotiate a satisfactory workout agreement with the new lender. However, if the negotiations are not successful, it is possible that the Partnership will not be able to retain its interest in the property through 1999. A foreclosure would result in recapture of credits for investors, the allocation of taxable income to the Partnership and loss of future benefits associated with this property. The Partnership's carrying value of this investment for financial reporting purposes is zero. Occupancy for this property as of December 31, 1998 was 98%.
As previously reported, a refinancing application was submitted for Kyle Hotel, located in Temple, Texas, in December 1997. The potential lender needs to approve several issues before the application will be approved. The Managing General Partner is still monitoring the progress of the application approval process.
Pleasant Plaza located in Malden, Massachusetts, as well as South Holyoke, located in Holyoke, Massachusetts, receive a subsidy under the State Housing Assistance Rental Program (SHARP), which is an important part of their annual income. As originally conceived, the SHARP subsidy was scheduled to decline over time to match increases in net operating income. However, increases in net operating income failed to keep pace with the decline in the SHARP subsidy. Many of the SHARP properties (including Pleasant Plaza and South Holyoke) structured workouts that included additional subsidies in the form of Operating Deficit Loans (ODL's). Effective October 1, 1997, the Massachusetts Housing Finance Agency (MHFA), which provided the SHARP subsidies, withdrew funding of the Operating Deficit Loans. Properties unable to make full debt service payments were declared in default by MHFA. The Managing General Partner joined a group of SHARP property owners called the responsible SHARP Owners, Inc. (RSO) and is negotiating with MHFA and the Local General Partners of Pleasant Plaza and South Holyoke to find a solution to the problems that will result from the withdrawn subsidies. Given existing operating deficits and the dependence on these subsidies by Pleasant Plaza and South Holyoke House, it is likely that both properties will default on their mortgage obligations in the near future. On September 16, 1998, the Partnership joined with the RSO and about 20 other SHARP property owners and filed suit against the MHFA (Mass. Sup. Court Civil Action #98-4720). Among other things, the suit seeks to enforce the MHFA's previous financial commitments to the SHARP properties. The lawsuit is complex and in its early stages, so no predications can be made at this time as to the ultimate outcome. In the meantime, the Managing General Partner intends to continue to participate in the RSO's efforts to negotiate a resolution of this matter with MHFA.
Waterfront and Shoreline, both located in Buffalo, New York, continue to have operating deficits as a result of a soft rental market, deferred maintenance and security issues. Shoreline was approved for the 1998 New Approach Anti-Drug Grant. The Grant was issued in February, 1999 and will be used to support drug prevention, educational programs and increased security on the property. For both Waterfront and Shoreline, the Management Agent has applied for consideration for a Project Improvement Program (PIP) and applied for a Safe Neighborhood Grant. At this point, deficits continue to be funded by the Management Agent. As noted previously, the viability of the properties depends upon funding deficits until receipt of the grants. Both properties currently carry cash flow mortgages with New York State. The Managing General Partner is working closely with the Local General Partner to develop a plan that will address these concerns.
Willow Lake, located in Kansas, is experiencing operating difficulties due to soft rental market conditions. As previously reported, the Managing General Partner negotiated a nine year extension to the original workout agreement. The nine year extension will expire on May 31, 2001. In addition, the Managing General Partner is working with the Local General Partner to negotiate permanent debt service relief, increase rents and monitor property expenses.
As previously reported, the Managing General Partner completed the transfer of the remaining Texas Partnership, Willowick, effective August 4, 1998. This transfer resulted in tax credit recapture of $2.44 per unit that was reported on your 1998 K-1. In addition, the event also resulted in both Section 1231 gain and cancellation of indebtedness income for the tax year 1998.
In accordance with Financial Accounting Standard No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", the Partnership has implemented policies and practices for assessing impairment of its real estate assets and investments in Local Limited Partnerships. Each asset is analyzed by real estate experts to determine if an impairment indicator exists. If so, the carrying value is compared to the undiscounted future cash flows expected to be derived from the asset and, if there is a significant impairment in value, a provision to write down the asset to fair value will be charged against income.
Inflation and Other Economic Factors
Inflation had no material impact on the Partnerships operations or financial condition for the years ended March 31, 1999, 1998 and 1997.
As some Properties benefit from some form of government assistance, the Partnership is subject to the risks inherent in that area including decreased subsidies, difficulties in finding suitable tenants and obtaining permission for rent increases. In addition, the Tax Credits allocated to investors with respect to a Property are subject to recapture to the extent that a Property or any portion thereof ceases to qualify for Tax Credits.
Some of the properties listed in this report are located in areas suffering from poor economic conditions. Such conditions could have an adverse effect on the rent or occupancy levels at such Properties. Nevertheless, the Managing General Partner believes that the generally high demand for below market rate housing will tend to negate such factors. However, no assurance can be given in this regard.
Impact of Year 2000
The Managing General Partner's plan to resolve year 2000 issues involves the following four phases: assessment, remediation, testing and implementation. To date, the Managing General Partner has fully completed an assessment of all information systems that may not be operative subsequent to 1999 and has begun the remediation, testing and implementation phase on both hardware and software systems. Because the hardware and software systems of both the Partnership and Local Limited Partnerships are generally the responsibility of obligated third parties, the plan primarily involves ongoing discussions with and obtaining written assurances from these third parties that pertinent systems will be 2000 compliant. In addition, neither the Partnership nor the Local Limited Partnerships are incurring significant additional costs since such expenses are principally covered under the service contracts with vendors. As of June 1999, the General Partner is in the final stages of its Year 2000 remediation plan and believes all major systems are compliant; any systems still being updated are not considered significant to the Partnership's operations. However, despite the likelihood that all significant year 2000 issues are expected to be resolved in a timely manner, the Managing General Partner has no means of ensuring that all systems of outside vendors or other entities that impact operations will be 2000 compliant. The Managing General Partner does not believe that the inability of third parties to address their year 2000 issues in a timely manner will have a material impact on the Partnership. However, the effect of non-compliance by third parties is not readily determinable.
Management has also evaluated a worst case scenario projection with respect to the year 2000 and expects any resulting disruption of either the Managing General Partner's activities or any Local Limited Partnership's operations to be short-term inconveniences. Such problems, however, are not likely to fully impede the ability to carry out necessary duties of the Partnership. Moreover, because expected problems under a worst case scenario are not extensively detrimental, and because the likelihood that all systems affecting the Partnership will be compliant before 2000, the Managing General Partner has determined that a formal contingency plan that responds to material system failures is not necessary.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The table below provides information about the Partnership's market risk sensitive instruments.
Due to difficulties in obtaining market values of obligations with similar characteristics for certain debt in this table, it is not practicable to determine a fair value materially different from face value.
In addition to the debt obligations included in this table, the Partnership has invested in marketable securities with aggregate fair values of $721,788 at March 31, 1999; these securities, with rates ranging from 4.87% to 6.49%, do not subject the Partnership to significant market risk because of their short term maturities and high liquidity.
The Partnership has no other exposure to market risk associated with activities in derivative financial instruments, derivative commodity instruments, or other financial instruments.
Item 8.
Item 8. Financial Statements and Supplementary Data
Information required under this Item is submitted as a separate section of this Report. See Index on page hereof.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The Managing General Partner of the Partnership is Arch Street III, Inc., a Massachusetts corporation (the "Managing General Partner" or "Arch Street III, Inc."), an affiliate of The Boston Financial Group Limited Partnership ("Boston Financial"), a Massachusetts limited partnership. George Fantini, Jr., a Vice President of the Managing General Partner, resigned his position effective June 30, 1995. Donna Gibson, a Vice President of the Managing General Partner, resigned from her position on September 13, 1996. Georgia Murray resigned as Managing Director, Treasurer and Chief Financial Officer of the General Partner on May 25, 1997. Fred N. Pratt, Jr. resigned as Managing Director of the General Partner on May 28, 1997. William E. Haynsworth resigned as a Managing Director and Chief Operating Officer of the General Partner on March 23, 1998. Peter G. Fallon resigned as a Vice President of the General Partner on June 1, 1999.
The Managing General Partner was incorporated in August 1988. Randolph G. Hawthorne is the Chief Operating Officer of the Managing General Partner and had the primary responsibility for evaluating, selecting and negotiating investments for the Partnership. The Investment Committee of the Managing General Partner approved all investments. The names and positions of the principal officers and the directors of the Managing General Partner are set forth below.
Name Position
Jenny Netzer Managing Director and President Michael H. Gladstone Managing Director, Vice President and Clerk Randolph G. Hawthorne Managing Director, Vice President and Chief Operating Officer James D. Hart Chief Financial Officer and Treasurer Paul F. Coughlan Vice President William E. Haynsworth Vice President
The other General Partner of the Partnership is Arch Street III Limited Partnership, a Massachusetts limited partnership ("Arch Street III L.P.") that was organized in August 1988. The General Partner of Arch Street III L.P. is Arch Street III, Inc.
The Managing General Partner provides day-to-day management of the Partnership. Compensation is discussed in Item 11
Item 11. Management Remuneration
Neither the directors or officers of Arch Street III, Inc., the partners of Arch Street III L.P. nor any other individual with significant involvement in the business of the Partnership receives any current or proposed remuneration from the Partnership.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
As of March 31, 1999, the following is the only entity known to the Partnership to be the beneficial owner of more than 5% of the total number of Units outstanding:
Amount Title of Name and Address of Beneficially Percent Class Beneficial Owner Owned of Class
Limited AMP, Incorporated 10,000 Units 10% Partner P.O. Box 3608 Harrisburg, PA
The equity securities registered by the Partnership under Section 12(g) of the Act consist of 100,000 Units, all of which have been sold to the public as of March 31, 1999. Holders of Units are permitted to vote on matters affecting the Partnership only in certain unusual circumstances and do not generally have the right to vote on the operation or management of the Partnership.
As of March 31, 1999, Arch Street III L.P. owns five (unregistered) Units not included in the 100,000 units sold to the public.
Except as described in the preceding paragraph, neither Arch Street III, Inc., Arch Street III L.P., Boston Financial nor any of their executive officers, directors, partners or affiliates is the beneficial owner of any Units. None of the foregoing persons possesses a right to acquire beneficial ownership of Units.
The Partnership does not know of any existing arrangement that might at a later date result in a change in control of the Partnership.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information required under this Item is contained in Note 5 to the Combined Financial Statements presented in Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) (1) and (a) (2) Documents filed as a part of this Report.
In response to this portion of Item 14, the combined financial statements, financial statement schedule and the auditors' report relating thereto are submitted as a separate section of this Report. See Index to the Combined Financial Statements and Schedules on page hereof.
The reports of auditors of the Local Limited Partnership relating to the audits of the financial statements of such Local Limited Partnerships appear in Exhibit (28)(1) of this report.
Other schedules have been omitted as they are either not required or the information required to be presented therein is available elsewhere in the combined financial statements or the accompanying notes and schedules.
(a)(3) See Exhibit Index contained herein.
(a)(3)(b) Reports on Form 8-K No reports on form 8-K were filed during the year ended March 31, 1999.
(a)(3)(c) Exhibits
Number and Description in Accordance with Item 601 of Regulation S-K
27. Financial Data Schedule
28. Additional Exhibits
(a) Reports of Other Independent Auditors
(b) Audited financial statements of Local Limited Partnerships
Kyle Hotel
(a)(3)(d) None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III
By: Arch Street III, Inc. its Managing General Partner
By: /s/Randolph G. Hawthorne Date: June 28, 1999 ------------------------------ ------------- Randolph G. Hawthorne, Managing Director, Vice President and Chief Operating Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Managing General Partner of the Partnership and in the capacities and on the dates indicated:
By: /s/Randolph G. Hawthorne Date: June 28, 1999 ------------------------------ ------------- Randolph G. Hawthorne, Managing Director, Vice President and Chief Operating Officer
By: /s/Michael H. Gladstone Date: June 28, 1999 --------------------------------- ---------------- Michael H. Gladstone A Managing Director
Item 8. Financial Statements and Supplementary Data
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
Annual Report on Form 10-K for the Year Ended March 31, 1999 Index
Page No. ------------
Report of Independent Accountants
Financial Statements
Combined Balance Sheets - March 31, 1999 and 1998
Combined Statements of Operations - For the Years Ended March 31, 1999, 1998 and 1997
Statements of Changes in Partners' Equity (Deficiency) - For the Years Ended March 31, 1999, 1998 and 1997
Combined Statements of Cash Flows - For the Years Ended March 31, 1999, 1998 and 1997
Notes to the Combined Financial Statements
Financial Statement Schedule:
Schedule III - Real Estate and Accumulated Depreciation
See also Index to Exhibits on Page K-30 for the financial statements of the Local Limited Partnerships included as a separate exhibit in this Annual Report on Form 10-K.
Other schedules have been omitted as they are either not required or the information required to be presented therein is available elsewhere in the financial statements and the accompanying notes and schedules.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners of Boston Financial Qualified Housing Tax Credits L.P. III (A Limited Partnership):
In our opinion, based on our audits and the reports of other auditors, the combined financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Boston Financial Qualified Housing Tax Credits L.P. III (the "Partnership") at March 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended March 31, 1999, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related combined financial statements. These financial statements and financial statement schedule are the responsibility of the Partnership's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We did not audit the financial statements of certain local limited partnerships for which total assets of $26,031,703 and $31,420,550, are included in these financial statements as of March 31, 1999 and 1998, respectively, and for which net losses of $4,736,414, $2,382,481, and $2,458,710 are included in the accompanying financial statements for the period ended March 31, 1999, 1998, 1997, respectively. Those statements were audited by other auditors whose reports thereon have been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for the Local Limited Partnerships, is based solely on the reports of the other auditors. We conducted our audits of these statements in accordance with generally accepted auditing standard, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for the opinions expressed above.
/s/PricewaterhouseCoopers LLP June 18, 1999 Boston, Massachusetts
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
COMBINED BALANCE SHEETS - MARCH 31, 1999 AND 1998
Non-cash disclosure:
See Note 10 for discussion of the transfers of certain Local Limited Partnerships.
See Note 12 for discussion of cancellation of indebtedness income.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS
1. Organization
Boston Financial Qualified Housing Tax Credits L.P. III (the "Partnership") was formed on August 9, 1988 under the laws of the State of Delaware for the primary purpose of investing, as a limited partner, in other limited partnerships ("Local Limited Partnerships"), most of which own and operate apartment complexes, most of which benefit from some form of federal, state or local assistance program and each of which qualify for low-income housing tax credits. The Partnership's objectives are to: (i) provide current tax benefits in the form of tax credits which qualified investors may use to offset their federal income tax liability; ii) preserve and protect the Partnership's capital; iii) provide limited cash distributions which are not expected to constitute taxable income during Partnership operations; and iv) provide cash distributions from sale or refinancing transactions. The General Partners of the Partnership are Arch Street III, Inc., which serves as the Managing General Partner, and Arch Street III L.P., which also serves as the Initial Limited Partner. Both of the General Partners are affiliates of Boston Financial Group Limited Partnership ("Boston Financial"). The fiscal year of the Partnership ends on March 31.
The Certificate and Agreement of Limited Partnership ("Partnership Agreement") authorized the sale of up to 100,000 units of Limited Partnership Interest ("Units") at $1,000 per Unit, adjusted for certain discounts. The Partnership raised $99,610,000 ("Gross Proceeds"), net of discounts of $390,000, through the sale of 100,000 Units. Such amounts exclude five unregistered Units previously acquired for $5,000 by the Initial Limited Partner, which is also one of the General Partners. The offering of Units terminated on May 30, 1989. No further sale of Units is expected.
Generally, profits, losses, tax credits and cash flow from operations are allocated 99% to the Limited Partners and 1% to the General Partners. Net proceeds from a sale or refinancing will be allocated 95% to the Limited Partners and 5% to the General Partners, after certain priority payments.
Under the terms of the Partnership Agreement, the Partnership initially designated 3% of the Gross Proceeds from the sale of Units as a Reserve for working capital of the Partnership and contingencies related to ownership of Local Limited Partnership interests. During the year ended March 31, 1993, the Managing General Partner decided to increase the reserve level to 3.75%. At March 31, 1999, the Managing General Partner has designated approximately $983,000 of cash, cash equivalents and marketable securities as such Reserve.
2. Significant Accounting Policies
Basis of Presentation and Combination
The Partnership accounts for its investments in Local Limited Partnerships, with the exception of the Combined Entities (defined below), using the equity method of accounting, because the Partnership does not have a majority control over the major operating and financial policies of the Local Limited Partnerships in which it invests. Under the equity method, the investment is carried at cost, adjusted for the Partnership's share of income or loss of the Local Limited Partnerships, additional investments in and cash distributions from the Local Limited Partnerships. Equity in income or loss of the Local Limited Partnerships is included currently in the Partnership's operations. The Partnership has no obligation to fund liabilities of the Local Limited Partnerships beyond its investment and therefore a Local Limited Partnership's investment will not be carried below zero. To the extent that equity losses are incurred when a Local Limited Partnership's respective investment balance has been reduced to zero, the losses will be suspended to be used against future income. Distributions received from Local Limited Partnerships whose respective investment value has been reduced to zero are included in income. For the years ended March 31, 1999, 1998 and 1997, the Partnership did not recognize $20,883,730, $4,878,906 and $5,206,584, respectively, of equity losses relating to Local Limited Partnerships whose cumulative equity in losses and distributions exceeded their total investments.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
2. Significant Accounting Policies (continued)
Basis of Presentation and Combination (continued)
Excess investment costs over the underlying net assets acquired have arisen from acquisition fees paid and expenses reimbursed to an affiliate of the Partnership. These fees and expenses are included in the Partnership's Investment in Local Limited Partnerships and are being amortized on a straight-line basis over 35 years.
The Partnership recognizes a decline in the carrying value of its investments in Local Limited Partnerships when there is evidence of a non-temporary decline in the recoverable amount of the investment. There is the possibility that the estimates relating to reserves for non-temporary declines in the carrying value of investments in Local Limited Partnerships may be subject to material near term adjustments.
The Partnership, as a limited partner in the Local Limited Partnerships, is subject to risks inherent in the ownership of property which are beyond its control, such as fluctuations in occupancy rates and operating expenses, variations in rental schedules, proper maintenance of facilities and continued eligibility of tax credits. If the cost of operating a property exceeds the rental income earned thereon, the Partnership may deem it in its best interest to voluntarily provide funds in order to protect its investment.
The Managing General Partner has elected to report results of the Local Limited Partnerships on a 90-day lag basis because the Local Limited Partnerships report their results on a calendar year basis. Accordingly, the financial information of the Local Limited Partnerships that is included in the accompanying combined financial statements is as of December 31, 1998, 1997 and 1996.
On August 26, 1992, an affiliate of the Partnership's Managing General Partner, BF Harbour View, Inc., became the Local General Partner of 241 Pine Street Associates, L.P. ("241 Pine Street"), a Local Limited Partnership in which the Partnership has invested. Since the Local General Partner of 241 Pine Street has a controlling financial interest in the Partnership, these combined financial statements include the detailed financial activity of 241 Pine Street for the years ended December 31, 1996, 1997 and 1998. All significant intercompany balances and transactions have been eliminated.
On April 2, 1993, an affiliate of the Managing General Partner, BF Willow Lake, Inc., became the Local General Partner of Willow Lake Partners II, L.P. ("Willow Lake"). BF Willow Lake, Inc. replaced the previous management agent with Boston Financial Property Management, an affiliate of the Managing General Partner. Since the Local General Partner of Willow Lake has a controlling financial interest in the Partnership, these combined financial statements include the financial activity of Willow Lake for the years ended December 31, 1996, 1997 and 1998. All significant intercompany balances and transactions have been eliminated.
On October 6, 1993, an affiliate of the Partnership's Managing General Partner, BF Texas Limited Partnership, became an additional Local General Partner responsible for all management decisions in thirteen Local Limited Partnerships (the "Texas Partnerships") in which the Partnership has invested. Since the Local General Partner of the Texas Partnerships had a controlling financial interest in the Partnership, these combined financial statements included the financial activity of thirteen Texas Partnerships for the years ended March 31, 1994 and 1995. During the year ended March 31, 1996, control of six of these Texas Partnerships was transferred to unrelated parties, and as such, as of that date, these partnerships were accounted for on the equity method (see Note 10). During the year ended March 31, 1997, the Managing General Partner transferred all of the assets of five out of these six Texas Partnerships subject to their liabilities to unaffiliated entities. Therefore, as of March 31, 1997, one Texas Partnership was accounted for on the equity method and the combined financial statements included detailed financial activity of seven Texas Partnerships for the year ended December 31, 1996. During the year ended March 31, 1998, the Managing General Partner transferred all of the assets of seven of the remaining Texas Partnerships subject to their liabilities to unaffiliated entities, six of which were combined in prior years, one of which had been
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
2. Significant Accounting Policies (continued)
Basis of Presentation and Combination (continued)
previously accounted for under the equity method. During the year ended March 31, 1999, the Managing General Partner transferred all of the assets of the remaining Texas Partnership subject to its liabilities to unaffiliated entities. All significant intercompany balances and transactions have been eliminated.
On September 29, 1995, an affiliate of the Managing General Partner, BF Texas Limited Partnership, became the Local General Partner responsible for all management decisions in The Temple-Kyle L.P. ("The Kyle"). Since the Local General Partner of The Kyle has a controlling financial interest in the Partnership, these combined financial statements include the detailed financial activity of The Kyle for the years ended December 31, 1996, 1997 and 1998. All significant intercompany balances and transactions have been eliminated.
On August 20, 1997, an affiliate of the Managing General Partner, Boston Financial GP-1, L.L.C., became the Local General Partner responsible for all management decisions in Breckenridge Creste Apartments, L.P. ("Breckenridge Creste"). Since the Local General Partner of Breckenridge Creste has a controlling financial interest in the Partnership, these combined financial statements include the detailed financial activity of Breckenridge Creste for the period from September 1, 1996 through December 31, 1996, and for the years ended December 31, 1997 and 1998. All significant intercompany balances and transactions have been eliminated.
The Partnership has elected to report the results of 241 Pine Street, Willow Lake, The Kyle and Breckenridge Creste on a 90-day lag basis, consistent with the presentation of the financial information of all Local Limited Partnerships. As used herein, the "Combined Entities" refers to 241 Pine Street, Willow Lake, The Kyle and Breckenridge Creste.
Cash Equivalents
Cash equivalents consist of short-term money market instruments with maturities when purchased of ninety days or less.
Marketable Securities
Marketable securities consist primarily of U.S. Treasury instruments and various asset-backed investment vehicles. The Partnership's marketable securities are classified as "Available for Sale" securities and reported at fair value as reported by the brokerage firm at which the securities are held. All marketable securities have fixed maturities. Realized gains and losses from the sales of securities are based on the specific identification method. Unrealized gains and losses are excluded from earnings and reported as a separate component of partners' equity.
Effect of recently issued Accounting Standard
The Financial Accounting Standards Board recently issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. The standard requires that changes in comprehensive income be shown in a financial statement that is displayed with the same prominence as other financial statements. The standard is effective for fiscal years beginning after December 15, 1997. The Partnership adopted the new standard effective April 1, 1998 and its adoption did not have a significant effect on the Partnership's financial position or results of operations. The only component of the Partnership's other accumulated comprehensive income is net unrealized gains and losses on marketable securities.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
2. Significant Accounting Policies (continued)
Rental Property
Real estate and personal property of the Combined Entities are recorded at cost. The Combined Entities provide for depreciation using primarily the straight-line method over their estimated useful lives.
In accordance with Financial Accounting Standard No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", the Partnership has implemented policies and practices for assessing impairment of its real estate assets and investments in Local Limited Partnerships. Each asset is analyzed by real estate experts to determine if an impairment indicator exists. If so, the carrying value is compared to the undiscounted future cash flows expected to be derived from the asset and, if there is a significant impairment in value, a provision to write down the asset to fair value will be charged against income.
Deferred Expenses
Willow Lake's deferred financing fees are amortized over 180 months, the term of the related debt, using the straight-line method.
Breckenridge's permanent loan costs are amortized over 10 years, the term of the related debt, using the straight-line method.
Breckenridge's compliance monitoring fees are amortized over the remaining 12-year term of the tax credit compliance period.
Rental Income
Rental income, principally from short-term leases on the Combined Entities' apartment units, is recognized as income as the rents become due.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Fair Value of Financial Instruments
Statements of Financial Accounting Standards No. 107 ("SFAS No. 107"), Disclosures About Fair Value of Financial Instruments, requires disclosure for the fair value of most on- and off-balance sheet financial instruments for which it is practicable to estimate that value. The scope of SFAS No. 107 excludes certain financial instruments, such as trade receivables and payables when the carrying value approximates the fair value and investments accounted for under the equity method, and all nonfinancial assets, such as real property. Unless otherwise described, the fair values of the Partnership's assets and liabilities which qualify as financial instruments under SFAS No. 107 approximate their carrying amounts in the accompanying balance sheets.
Income Taxes
No provision for income taxes has been made as the liability for such taxes is the obligation of the partners of the Partnership.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
2. Significant Accounting Policies (continued)
Reclassifications
Certain reclassifications have been made to prior year financial statements to conform to the current year presentation.
3. Marketable Securities
A summary of marketable securities is as follows:
The contractual maturities at March 31, 1999 are as follows: Fair Cost Value Due in less than one year $ 597,065 $ 597,265 Due in one to five years 124,486 124,523 ----------- ----------- $ 721,551 $ 721,788 =========== ===========
Actual maturities for asset backed securities may differ from contractual maturities because some borrowers have the right to call or prepay obligations. Proceeds from the sales of marketable securities were approximately $327,000 during the fiscal year ended March 31, 1998; during the years ended March 31, 1999 and 1997 there were no proceeds from sales of marketable securities. Proceeds from the maturities of marketable securities were approximately $648,000, $181,000 and $98,000 during the years ended March 31, 1999, 1998 and 1997, respectively. Included in investment income are gross gains of $421, $1,845 and $64, and gross losses of $35, $553 and $1,355 that were realized on the sales during the fiscal years ended March 31, 1999, 1998 and 1997, respectively.
4. Investments in Local Limited Partnerships
The Partnership uses the equity method to account for its limited partnership interests in fifty-four Local Limited Partnerships (excluding the Combined Entities) which own and operate multi-family housing complexes, most of which are government-assisted. The Partnership, as Investor Limited Partner pursuant to the various Local Limited Partnership Agreements which contain certain operating and distribution restrictions, has acquired a 99% interest in the profits, losses, tax credits and cash flows from operations of each of the Local Limited Partnerships, except for Granite, Colony Apartments and Harbour View, where the Partnership's ownership interest is 97%, 49% and 48.96%, respectively. Upon dissolution, proceeds will be distributed according to each respective partnership agreement.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
4. Investments in Local Limited Partnerships (continued)
Summarized financial information as of December 31, 1998, 1997 and 1996 (due to the Partnership's policy of reporting the financial information of its Local Limited Partnership interests on a 90 day lag basis) of all Local Limited Partnerships accounted for on the equity method (excluding the Combined Entity beginning on the date of combination) in which the Partnership has invested is as follows:
Summarized Balance Sheets - as of December 31,
For the years ended March 31, 1999, 1998 and 1997, the Partnership has not recognized $20,883,730, $4,878,906 and $5,206,584, respectively, of equity in losses relating to certain Local Limited Partnerships in which cumulative equity in losses and distributions exceeded its total investments in these Local Limited Partnerships.
The Partnership's deficiency as reflected by the Local Limited Partnerships of $35,369,523 differs from the Partnership's Investments in Local Limited Partnerships before adjustment of $13,341,593 primarily because the Partnership has not recognized $46,802,890 of equity losses relating to Local Limited Partnerships whose cumulative equity in losses exceeded their total investments.
5. Transactions with Affiliates
In accordance with the Partnership Agreement, 15% of the acquisition fees payable to an affiliate of the Managing General Partner is the Deferred Acquisition Fees which have been deposited in an interest bearing account and are paid annually, with interest, at the rate of 10% per year over 10 years. Installments began on the second anniversary of the Prospectus, November 23, 1990. As of March 31, 1999 and 1998, deferred acquisition fees payable amounted to $112,500 and $225,000, respectively.
An affiliate of the Managing General Partner currently receives $7,086 (as adjusted by the CPI factor) per Local Limited Partnership annually as the Asset Management Fee for administering the affairs of the Partnership. Included in the Combined Statements of Operations are Asset Management Fees of $385,702, $423,223 and $450,678 for the years ended March 31, 1999, 1998 and 1997, respectively. Payables to affiliates of the Managing General Partner relating to the aforementioned fees and expenses equaled $1,950,448 and $1,564,746 at March 31, 1999 and 1998, respectively.
An affiliate of the Managing General Partner is reimbursed for the actual cost of the Partnership's operating expenses. Included in general and administrative expenses for the years ended March 31, 1999, 1998 and 1997 is $140,069, $180,970 and $170,961, respectively, that the Partnership has paid or will pay as reimbursement for salaries and benefits.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
5. Transactions with Affiliates (continued)
Boston Financial Property Management ("BFPM"), an affiliate of the Managing General Partner, currently manages Harbour View, a property in which the Partnership has invested. Included in operating expenses in the summarized income statements in Note 4 to the Combined Financial Statements is $35,917, $52,220 and $51,956 of fees earned by BFPM during 1998, 1997 and 1996, respectively. As of August 1998, Boston Financial was no longer the management agent for Harbor View.
On April 2, 1993, BFPM became the management agent of Willow Lake. In August of 1993, BFPM became the management agent for the Texas Partnerships. On September 29, 1995, BFPM became the management agent of The Kyle. On August 20, 1997, BFPM became the management agent of Breckenridge. Included in the Combined Statements of Operations is $102,599, $104,878 and $135,472 of property management fees charged by BFPM during 1998, 1997 and 1996, respectively. Payables to affiliates include $82,026 and $114,045 of property management fees at December 31, 1998 and 1997, respectively.
An affiliate of the Managing General Partner advanced the Partnership amounts to cover operating deficits and, in return, a non-interest bearing note was executed. As of March 31, 1999 and 1998, $514,968 is due to an affiliate of the Managing General Partner for this note.
This affiliate of the Managing General Partner has made a commitment to defer collection of past or future asset management fees, reimbursement of operating expenses and property management fees, and to defer collection of the $514,968 note described above, to the extent necessary to cover operating deficits of the Partnership.
6. Rental Property
Real estate and personal property belonging to the Combined Entities are recorded at cost, the components of which, excluding certain acquisition costs of $782,487 and $816,683 as of December 31, 1998 and 1997, respectively paid by the Partnership and included in bases, are as follows at December 31:
During the year ended December 31, 1998, operating deficiencies at Temple Kyle indicated potential impairment. Based upon analysis of future cash flows, an impairment loss of $1,693,514 was recognized on the real estate owned by The Kyle, which decreased the aggregate carrying value to $2,034,321, the fair value of the asset, as determined by an independent third party appraisal. During the year ended December 31, 1996, an impairment loss of $1,748,708 was recognized on real estate owned by the Texas Partnerships, which decreased the aggregate carrying value to $2,920,411. For the years ended December 31, 1997 and 1996, the net operating results of the Texas Partnerships increased the loss of the Partnership (prior to the impairment loss) by $127,794 and $410,866, respectively. See Note 10 for further details on the liquidation of the interests in the Texas Partnerships
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
7. Mortgage Notes Payable
Willow Lake
The original mortgage note payable consists of a 9.25% per annum note due in monthly principal and interest installments of $22,878, maturing on February 1, 2005. The original loan is collateralized by a first deed of trust covering all real and personal property. The loan is also collateralized by an operating deficit escrow of $58,387 provided by the Local General Partners.
As of December 31, 1993, Willow Lake was in default of its principal and interest payments due under the mortgage agreement; however, the lender and Willow Lake executed a workout commitment letter in June 1993 designed to address the default. On May 31, 1998, the original workout agreement was amended and extended for a period of thirty-six months. Commencing June 1, 1998 the terms of the workout agreement include a reduction in the interest rate to 8.25% for the period form June 1, 1998 through May 31, 1999, 8.75% for the period from June 1, 1999 through May 31, 2000 and 9.00% for the period from June 1, 2000 through May 31, 2001. Thereafter Willow Lake will resume payments at the original contract rate of 9.25%. Under the terms of the workout agreement, the difference in the interest payments at the original contract rate of 9.25% and the reduced rates required over the term of the workout period shall be payable upon expiration of the workout period over the remaining term of the note.
Under the terms of the agreement, Willow Lake is required to maintain a minimum balance of $5,000 in an operating deficit escrow account for the purpose of funding any shortfall to the extent that cash flow is insufficient to cover the full amount of the modified principal and interest payment.
The liability of Willow Lake under the mortgage is limited to the underlying value of the real estate collateral plus other amounts deposited with the lender.
Principal payments required under the above mortgage note which had a balance at December 31, 1998 and 1997 of $2,699,871 and $2,723,285, respectively, for each of the next five years are as follows:
December 31, 1999 $ 25,899 2000 28,399 2001 31,119 2002 34,146 2003 37,442 Thereafter 2,542,866
The terms of the mortgage note and other contract documents require the establishment of restricted deposits and funded reserves to be held and invested by the mortgagee. These financial instruments potentially subject Willow Lake to a concentration of credit risk. Due to the unavailability of similar loans and unique terms of the workout agreement, it is not practicable to determine the fair value of this note at March 31, 1999.
Texas Partnerships
The Texas Partnerships and RECD entered into Interest Credit and Rental Assistance Agreements that had stated interest rates ranging from 9.5% to 7.25% and provided for an effective interest rate on the notes payable to FmHA of 1 percent, plus all rental income over basic rents as determined by the government (overages), and maturities ranging from 2016 to 2030. All notes were collateralized by the respective properties. The principal balance of the remaining Texas Partnership's mortgage at December 31, 1997 was $1,150,688.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
7. Mortgage Notes Payable (continued)
The Kyle
The Kyle has a note payable to the Partnership which is eliminated in the accompanying combined financial statements. The note is due in monthly installments of $13,800, including interest at 7.82%, through June 1, 1998 and $17,600, including interest at prime plus 1% (an effective interest rate of 8.75% at December 31, 1998), from July 1, 1998 through its maturity date on June 1, 2005. The note is collateralized by the respective property. $1,389,038 and $1,406,251 was outstanding as of December 31, 1998 and 1997, respectively. The current value of this note approximates its fair value.
Breckenridge Creste
Breckenridge Creste's mortgage note payable consists of a 9.60% per annum note due in monthly principal and interest installments of $42,408, maturing on November 1, 2006. The liability of Breckenridge Creste under the mortgage note is limited to the underlying value of the real estate collateral plus other amounts deposited with the lender. Principal payments required under the above note, which had a balance at December 31, 1998 and 1997 of $4,708,469 and $4,762,502, respectively, for each of the next five years are as follows:
December 31, 1999 $ 59,454 2000 65,419 2001 71,983 2002 79,206 2003 87,152 Thereafter 4,350,612
Breckenridge Creste's second note payable bears no interest and is payable in annual installments of $2,679 until April 15, 1999. The outstanding balance at December 31, 1998 and 1997 is $5,357.
Under current market conditions, the fair value of this mortgage as of March 31, 1999 is estimated to be approximately $5,400,000. The Partnership's ability to refinance is impaired due to a substantial prepayment penalty.
241 Pine Street
241 Pine Street's mortgage payable consists of a 6.38% per annum note due in monthly principal and interest installments of $2,798, maturing on December 1, 2023. The loan is collateralized by the project. Principal payments required under the above note, which has a balance at December 31, 1998 of $418,430, for each of the next five years are as follows:
December 31, 1999 $ 7,045 2000 7,508 2001 8,001 2002 8,257 2003 9,087 Thereafter 378,532
As the terms of the mortgage were modified under current market conditions, management believes carrying value of the note approximates fair value as of March 31, 1999.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
8. Due to affiliate
Under the terms of 241 Pine Street's development agreement, the Developer agreed to advance to the property such funds as may be required to pay certain operating expenses. Any funds so advanced were to be repaid by 241 Pine Street upon sale or refinancing of the property. The amount due to affiliate at December 31, 1997 represents the net amount advanced to 241 Pine Street under this agreement. In connection with these events the Original General Partner, who was also the Developer, was replaced by an affiliated entity of the Partnership. Therefore, the amount previously reported as due to developer was reclassified as a due to affiliate. 241 Pine Street obtained financing during the year ended December 31, 1998, and used part of the proceeds to satisfy this obligation.
9. Advances from affiliates
Prior to 1995, Willow Lake incurred debt of $662,306 payable to the former general partners and their affiliates for development fees, Partnership advances and management fees. As a result of the settlement of litigation in 1995, Willow Lake agreed to pay $173,500 and issued two promissory notes in the amount of $100,000 each. Both notes have an annual interest rate of 6% and are payable in full, both as to accrued interest and principal on January 1, 2005. Beginning in June 1997, principal and interest on these notes are due and payable out of cash flow. In the event Willow Lake is unable to make a cash flow payment, the Partnership has guaranteed one note to the extent of an interest payment equal to $500 per month. The Partnership paid $6,000 for interest during the years ended March 31, 1999, 1998 and 1997, respectively. The remaining debt ,$288,806, was forgiven.
10. Liquidation of Interests in Local Limited Partnerships
For financial reporting purposes, a gain on transfer of assets of $645,018 was recognized in the year ended March 31, 1999 as a result of the transfer of Willowick. Loss on liquidation of interests in Local Limited Partnerships of $18,251 and gain on transfer of assets of $1,868,051 were recognized in the year ended March 31, 1997 as a result of the transfer of Lone Oak Apartments, Hallet West Apartments, Lakeway Colony, Crestwood Place, Eagle Nest Apartments, One Main Place and Pilot Point Apartments.
As previously discussed, the titles to both Regency and Rolling Hills in Dayton, Ohio were transferred to the lender on May 2, 1997 after prolonged operating difficulties resulting from low occupancy, capital rehabilitation needs and a depressed local economy. The Partnership's carrying value of these investments for financial reporting purposes was zero; therefore, the transfer had no impact on the Partnership's operating results. For the year ended March 31, 1997, the Partnership recognized $51,595 of loss, which was an adjustment to the cancellation of indebtedness income in the previous year.
11. Provision for valuation of real estate
During the year ended December 31, 1998, The Kyle was deemed to be impaired and written down to its fair value. The fair value, determined by an independent appraisal, was determined using the fair value of comparable apartment complexes in the area and the estimated discounted future cash flows. The determination of fair value did not take into account the value of tax credits allocated to The Kyle. The asset impairment loss of $1,693,514 is the difference between the carrying value and the estimated fair value of The Kyle and was charged to operations during the year ended December 31, 1998.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
12. Litigation
Lone Oak Housing Associates, Ltd., as was previously reported, was the defendant in a lawsuit in which the plaintiff had alleged negligence and deceptive Trade Act violations. This litigation has been settled by the insurance carrier and the case dismissed.
Willow Lake Partners II, L.P. ("Willow Lake") is the defendant in a lawsuit relating to an earlier lawsuit involving Willow Lake. As part of the Partnership's settlement with the former management agent, Willow Lake gave the management agent two cash flow notes. The former management agent is now claiming that Willow Lake has cash flow (so payments should have been made on the notes) and it is the Partnership's position that the property is running a deficit. On June 25, 1998, the court found for Willow Lake on summary judgement and ruled that there has been no default on the note. This litigation is no longer outstanding unless the former management agent decides to appeal.
13. Federal Income Taxes
A reconciliation of the loss reported in the Combined Statements of Operations for the fiscal years ended March 31, 1999, 1998 and 1997 to the loss reported for federal income tax purposes for the year ended December 31, 1998, 1997 and 1996 is as follows:
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
13. Federal Income Taxes (continued)
The differences in the assets and liabilities of the Partnership for financial reporting purposes and tax reporting purposes for the year ended March 31, 1999 are as follows:
The differences in the assets and liabilities of the Partnership for financial reporting purposes are primarily attributable to: i) for financial reporting purposes, the Partnership combines the financial statements of four Local Limited Partnerships with its financial statements; for tax purposes, these entities are carried on the equity method; ii) the cumulative equity in losses from Local Limited Partnerships, including the Combined Entities, for tax reporting purposes is approximately $32,139,000 greater than for financial reporting purposes, including approximately $46,803,000 of losses the Partnership has not recognized relating to twenty-seven Local Limited Partnerships whose cumulative equity in losses exceeded their total investments; iii) the Partnership has provided a provision for valuation of $1,635,000 against three of its investments in Local Limited Partnerships for financial reporting purposes; and iv) organizational and offering costs of approximately $11,832,000 that have been capitalized for tax reporting purposes are charged to Limited Partners' equity for financial reporting purposes.
The differences in the assets and liabilities of the Partnership for financial reporting purposes and tax reporting purposes for the year ended March 31, 1998 are as follows:
The differences in the assets and liabilities of the Partnership for financial reporting purposes are primarily attributable to: i) for financial reporting purposes, the Partnership combines the financial statements of eleven Local Limited Partnerships with its financial statements; for tax purposes, these entities are carried on the equity method; ii) the cumulative equity in losses from Local Limited Partnerships, including the Combined Entities, for tax reporting purposes is approximately $27,716,000 greater than for financial reporting purposes, including approximately $25,919,000 of losses the Partnership has not recognized relating to twenty-four Local Limited Partnerships whose cumulative equity in losses exceeded their total investments; iii) the Partnership has provided a provision for valuation of $1,635,000 against three of its investments in Local Limited Partnerships for financial reporting purposes; and iv) organizational and offering costs of approximately $11,832,000 that have been capitalized for tax reporting purposes are charged to Limited Partners' equity for financial reporting purposes.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
14. Supplemental Combining Schedules
(A) As of March 31, 1999. (B) As of December 31, 1998 - see Note 2.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
14. Supplemental Combining Schedules (continued)
(A) For the year ended March 31, 1999. (B) For the year ended December 31, 1998 - - see Note 2.
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
NOTES TO THE COMBINED FINANCIAL STATEMENTS (continued)
14. Supplemental Combining Schedules (continued)
(A) For the year ended March 31, 1999. (B) For the year ended December 31, 1998 - see Note 2.
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
The aggregate cost for Federal Income Tax purposes is approximately $248,509,000.
* Mortgage notes payable generally represent non-recourse financing of low-income housing projects payable with terms of up to 40 years with interest payable at rates ranging from 10.84% to 6.38%. The Partnership has not guaranteed any of these mortgage notes payable.
(A) During the year ended March 31, 1997, the Partnership has transferred all of the assets of five of the Texas Partnerships subject to their liabilities to unaffiliated entities.
(B) During the year ended March 31, 1998, the Partnership has transferred all of the assets of seven of the Texas Partnerships subject to their liabilities to unaffiliated entities.
(C) During the year ended March 31, 1998, the Partnership has transferred the titles of Regency and Rolling Hills to the lender.
(D) During the year ended March 31, 1999, the Partnership has transferred all of the assets of Willowick subject to the liabilities to unaffiliated entities.
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
Boston Financial Qualified Housing Tax Credits L.P. III Schedule III - Real Estate and Accumulated Depreciation of Property owned by Local Limited Partnerships in which Registrant has invested at March 31, 1999
BOSTON FINANCIAL QUALIFIED HOUSING TAX CREDITS L.P. III (A Limited Partnership)
Annual Report on form 10-K For The Year Ended March 31, 1999 Reports of Independent Auditors
Diversey [Letterhead]
FRIDUSS, LUKEE, SCHIFF & CO., P.C. CERTIFIED PUBLIC ACCOUNTANTS 4747 WEST PETERSON AVENUE CHICAGO, ILLINOIS 60646 (773) 777-4445 FAX (773) 777-6557
INDEPENDENT AUDITOR'S REPORT
To the Partners of HUD Field Office Director DIVERSEY SQUARE ASSOCIATES II Chicago, Illinois Chicago, Illinois
We have audited the accompanying balance sheets of DIVERSEY SQUARE ASSOCIATES II (An Illinois Limited Partnership), Project No. 071-35573, as of December 31, 1998 and 1997, and the related statements of profit and loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and generally accepted Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of DIVERSEY SQUARE ASSOCIATES II as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with the Government Auditing Standards, we have also issuedreports dated January 27, 1999 on compliance with specific requirements applicable to major HUD programs, compliance with specific requirements applicable to Affirmative Fair Housing, our consideration of the internal control structure and on compliance with laws and regulations.
The supporting data included in this report shown on pages 19 through 21 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements, and in our opinion, are presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/FRIDUSS, LUKEE, SCHIFF & CO., P.C.
FRIDUSS, LUKEE, SCHIFF & CO., P.C. 36-3087225 Certified Public Accountants Mr. Bruce C. Schiff (773) 777-4445 Chicago, Illinois January 27, 1999
[Letterhead]
FRIDUSS, LUKEE, SCHIFF & CO., P.C. CERTIFIED PUBLIC ACCOUNTANTS 4747 WEST PETERSON AVENUE CHICAGO, ILLINOIS 60646 (773) 777-4445 FAX (773) 777-6557
INDEPENDENT AUDITOR'S REPORT
To the Partners of HUD Field Office Director DIVERSEY SQUARE ASSOCIATES II Chicago, Illinois Chicago, Illinois
We have audited the accompanying balance sheets of DIVERSEY SQUARE ASSOCIATES II (An Illinois Limited Partnership), Project No. 071-35573, as of December 31, 1997 and 1996, and the related statements of profit and loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and generally accepted Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of DIVERSEY SQUARE ASSOCIATES II as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with the Government Auditing Standards, we have also issued reports dated January 30, 1998 on compliance with specific requirements applicable to major HUD programs, compliance with specific requirements applicable to Affirmative Fair Housing, our consideration of the internal control structure and on compliance with laws and regulations.
The supporting data included in this report shown on pages 19 through 25 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements, and in our opinion, are presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/FRIDUSS, LUKEE, SCHIFF & CO., P.C.
FRIDUSS, LUKEE, SCHIFF & CO., P.C. 36-3087225 Certified Public Accountants Mr. Bruce C. Schiff (773) 777-4445 Chicago, Illinois January 30, 1998
Breckenridge [Letterhead] [LOGO] Habif, Arogeti & Wynne, P.C. Certified Public Accountants
INDEPENDENT AUDITORS' REPORT
To the Partners Breckenridge Creste Apartments, L.P.
We have audited the accompanying balance sheet of Breckenridge Creste Apartments, L.P., (a Georgia Limited Partnership), as of December 31, 1998, and the related statements of changes in partners' equity [deficit], operations, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Breckenridge Creste Apartments, L.P. as of December 31, 1998, and the results of its operations chanfes in partners' equity [deficit], and cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements.
/s/Habif, Arogeti & Wynne, P.C. Atlanta, Georgia January 29, 1999
[Letterhead] [LOGO] Habif, Arogeti & Wynne, P.C. Certified Public Accountants
INDEPENDENT AUDITORS' REPORT
To the Partners Breckenridge Creste Apartments, L.P.
We have audited the accompanying balance sheet of Breckenridge Creste Apartments, L.P., (a Georgia Limited Partnership), as of December 31, 1997, and the related statements of changes in partners' equity, operations, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Breckenridge Creste Apartments, L.P. as of December 31, 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements.
/s/Habif, Arogeti & Wynne, P.C. Atlanta, Georgia January 30, 1998
[Letterhead] [LOGO] Habif, Arogeti & Wynne, P.C. Certified Public Accountants
INDEPENDENT AUDITORS' REPORT
To the Partners Breckenridge Creste Apartments, L.P.
We have audited the accompanying balance sheet of Breckenridge Creste Apartments, L.P., (a Georgia Limited Partnership), as of December 31, 1996, and the related statements of changes in partners' equity, operations, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Breckenridge Creste Apartments, L.P. as of December 31, 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements.
/s/Habif, Arogeti & Wynne, P.C. Atlanta, Georgia January 24, 1997
EDM HOUSING
[Letterhead] [LOGO] STARK TINTER & ASSOCIATES, LLC Englewood, CO INDEPENDENT AUDITOR'S REPORT
To the Partners of EDM Housing Associates, Ltd. Englewood, CO
We have audited the accompanying balance sheet of EDM Housing Associates, Ltd. (a limited partnership), HUD Project No. 101-35513 - PM - EX, as of December 31, 1998 and the related statement of profit and loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of EDM Housing Associates, Ltd., HUD Project No. 101-35513 - PM - EX, as of December 31, 1998, and the results of its operations and the changes in its partners' equity (deficiency) and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 29, 1999 on our consideration of EDM Housing Associates, Ltd.'s internal controls and reports dated January 29, 1999 on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Fair Housing and Non-Discrimination.
/s/STARK TINTER & ASSOCIATES Certified Public Accountants Financial Consultants January 29, 1999
[Letterhead] [LOGO] STARK TINTER & ASSOCIATES, LLC Englewood, CO INDEPENDENT AUDITOR'S REPORT
To the Partners of EDM Housing Associates, Ltd. Englewood, CO
We have audited the accompanying balance sheet of EDM Housing Associates, Ltd. (a limited partnership), HUD Project No. 101-94007, as of December 31, 1997 and the related statements of profit and loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of EDM Housing Associates, Ltd., HUD Project No. 101-94007, as of December 31, 1997, and the results of its operations and the changes in its partners' equity (deficiency) and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/STARK TINTER & ASSOCIATES Certified Public Accountants Financial Consultants January 30, 1998
[Letterhead] [LOGO] STARK TINTER & ASSOCIATES, LLC Englewood, CO
INDEPENDENT AUDITOR'S REPORT
To the Partners of EDM Housing Associates, Ltd. Englewood, Colorado
We have audited the accompanying balance sheet of EDM Housing Associates, Ltd. (a limited partnership), HUD Project No. 101-94007, as of December 31, 1996 and the related statements of profit and loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of EDM Housing Associates, Ltd., HUD Project No. 101-94007, as of December 31, 1996, and the results of its operations and the changes in its partners' equity (deficiency) and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/STARK TINTER & ASSOCIATES Certified Public Accountants Financial Consultants January 30, 1997
FOX RUN
[Letterhead] [LOGO] STARK TINTER & ASSOCIATES, LLC Englewood, CO
INDEPENDENT AUDITOR'S REPORT
To the Partners of Fox Run Housing Associates, Ltd. Englewood, Colorado
We have audited the accompanying balance sheet of Fox Run Housing Associates, Ltd. (a limited partnership), HUD Project No. 115-94018, as of December 31, 1998, and the related statements of profit and loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Fox Run Housing Associates, Ltd., HUD Project No. 115-94018, as of December 31, 1998, and the results of its operations and the changes in its partners' equity (deficiency) and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 30, 1999 on our consideration of Fox Run Housing Associates, Ltd.'s internal controls and reports dated January 30, 1999 on its compliance with specific requirements applicable to Fair Housing and Non-Discrimination..
/s/STARK TINTER & ASSOCIATES Certified Public Accountants Financial Consultants January 30, 1999
[Letterhead] [LOGO] STARK TINTER & ASSOCIATES, LLC Englewood, CO
INDEPENDENT AUDITOR'S REPORT
To the Partners of Fox Run Housing Associates, Ltd. Englewood, Colorado
We have audited the accompanying balance sheet of Fox Run Housing Associates, Ltd. (a limited partnership), HUD Project No. 115-94018, as of December 31, 1997, and the related statements of profit and loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Fox Run Housing Associates, Ltd., HUD Project No. 115-94018, as of December 31, 1997, and the results of its operations and the changes in its partners' equity (deficiency) and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/STARK TINTER & ASSOCIATES Certified Public Accountants Financial Consultants February 2, 1998
[Letterhead] [LOGO] STARK TINTER & ASSOCIATES, LLC Englewood, CO
INDEPENDENT AUDITOR'S REPORT
To the Partners of Fox Run Housing Associates, Ltd. Englewood, Colorado
We have audited the accompanying balance sheet of Fox Run Housing Associates, Ltd. (a limited partnership), HUD Project No. 115-94018, as of December 31, 1996, and the related statements of profit and loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Fox Run Housing Associates, Ltd., HUD Project No. 115-94018, as of December 31, 1996, and the results of its operations and the changes in its partners' equity (deficiency) and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/STARK TINTER & ASSOCIATES Certified Public Accountants Financial Consultants January 30, 1997
PINE ST [Letterhead]
[LOGO] Dauby O'Conner & Zaleski A Limited Liability Company Certified Public Accountants
INDEPENDENT AUDITOR'S REPORT
To the Partners 241 Pine Street Associates, L.P. Manchester, New Hampshire
We have audited the accompanying balance sheet of 241 Pine Street Associates, L.P., (a New Hampshire Limited Partnership), as of December 31, 1998 and the related statement of income (loss), partners' capital and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of 241 Pine Street Associates, L.P. as of December 31, 1998, and the results of its' operations for the year then ended in conformity with generally accepted accounting principles.
/s/Dauby O'Conner & Zaleski
February 23, 1999 Dauby O'Conner & Zaleski Carmel, Indiana Certified Public Accountants
Letterhead]
[LOGO] Dauby O'Conner & Zaleski A Limited Liability Company Certified Public Accountants
INDEPENDENT AUDITOR'S REPORT
To the Partners 241 Pine Street Associates, L.P. Manchester, New Hampshire
We have audited the accompanying balance sheet of 241 Pine Street Associates, L.P., (a New Hampshire Limited Partnership), as of December 31, 1997 and the related statement of income (loss), partners' capital and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of 241 Pine Street Associates, L.P. as of December 31, 1997, and the results of its' operations for the year then ended in conformity with generally accepted accounting principles.
/s/Dauby O'Conner & Zaleski
February 1, 1998 Dauby O'Conner & Zaleski Carmel, Indiana Certified Public Accountants
[Letterhead] [LOGO] Dauby O'Conner & Zaleski A Limited Liability Company Certified Public Accountants
INDEPENDENT AUDITOR'S REPORT
To the Partners 241 Pine Street Associates, L.P. Manchester, New Hampshire
We have audited the accompanying balance sheet of 241 Pine Street Associates, L.P., (a New Hampshire Limited Partnership), as of December 31, 1996 and the related statement of income (loss), partners' capital and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of 241 Pine Street Associates, L.P. as of December 31, 1996, and the results of its' operations for the year then ended in conformity with generally accepted accounting principles.
/s/Dauby O'Conner & Zaleski
January 4, 1996 Dauby O'Conner & Zaleski Carmel, Indiana Certified Public Accountants
BROWNSVILLE [Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
INDEPENDENT AUDITORS'REPORT
To the Partners Brownsville Associates, L.P. Brownsville, Tennessee
We have audited the accompanying balance sheets of Brownsville Associates, L.P. (a Missouri limited partnership), Rural Development Case No.: 48-038-431399553 as of December 31, 1998 and 1997, and the related statements of operations, partners' deficit and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and with Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Brownsville Associates, L.P. as of December 31, 1998 and 1997 and the results of its operations, changes in partners' deficit and cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 20, 1999 on our consideration of Brownsville Associates, L.P.'s internal control structure and a report dated January 21, 1999 on its compliance with laws and regulations.
Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying required supplementary information shown on pages 9-11 is presented for purposes of additional analysis and is not a required part of the basic financial statements of the Partnership. Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements, and in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard TOPEKA, KANSAS JANUARY 20, 1999
[Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
INDEPENDENT AUDITORS'REPORT
To the Partners Brownsville Associates, L.P. Brownsville, Tennessee
We have audited the accompanying balance sheets of Brownsville Associates, L.P. (a Missouri limited partnership), Rural Development Case No.: 48-038-431399553 as of December 31, 1997 and 1996, and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and with Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Brownsville Associates, L.P. as of December 31, 1997 and 1996 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 21, 1998 on our consideration of Brownsville Associates, L.P.'s internal control structure and a report dated January 21, 1998 on its compliance with laws and regulations.
/s/Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard TOPEKA, KANSAS JANUARY 21, 1998
BRIARWOOD [Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
INDEPENDENT AUDITORS' REPORT
To the Partners Briarwood Associates II, L.P.
We have audited the accompanying balance sheets of Briarwood Associates II, L.P. (a Missouri limited Partnership), Rural Development Case No.: 02-008-431303694 as of December 31, 1998 and 1997, and the related statements of operations, partners' deficit and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and with Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Briarwood Associates II, L.P. as of December 31, 1998 and 1997, and the results of its operations, changes in partners' deficit and cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 20, 1999 on our consideration of Briarwood Associates II, L.P.'s internal control and on its compliance with laws and regulations.
Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying required supplementary information shown on pages 9-11 is presented for purposes of additional analysis and is not a required part of the basic financial statements of the Partnership. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Braunsdorf, Carlson and Clinkinbeard, C.P.A.'s, P.A. Braunsdorf, Carlson and Clinkinbeard, C.P.A.'s,P.A. TOPEKA, KANSAS January 20, 1999
[Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
INDEPENDENT AUDITORS' REPORT
To the Partners Briarwood Associates II, L.P.
We have audited the accompanying balance sheets of Briarwood Associates II, L.P. (a Missouri limited Partnership), Rural Development Case No.: 02-027-431303694 as of December 31, 1997 and 1996, and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and with Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Briarwood Associates II, L.P. as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated February 2, 1998 on our consideration of Briarwood Associates II, L.P.'s internal control structure and a report dated February 10, 1998 on its compliance with laws and regulations.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information on pages 9-11 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the audit procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Braunsdorf, Carlson and Clinkinbeard, C.P.A.'s, P.A. Braunsdorf, Carlson and Clinkinbeard, C.P.A.'s,P.A. TOPEKA, KANSAS February 2, 1998
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Altheimer Associates I, L.P. Altheimer, Arkansas
We have audited the accompanying balance sheets of Altheimer Associates I, L.P., (a Missouri limited Partnership), FmHA Case No.: 03-035-431479737, as of December 31, 1997 and the related statements of loss, partners' equity and cash flows for the year ended December 31, 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Altheimer Associates I, L.P. as of December 31, 1997, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Braunsdorf, Carlson and Clinkinbeard Braunsdorf, Carlson and Clinkinbeard TOPEKA, KANSAS February 3, 1998
[Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Altheimer Associates I, L.P. Altheimer, Arkansas
We have audited the accompanying balance sheets of Altheimer Associates I, L.P., (a Missouri limited Partnership), FmHA Case No.: 03-035-431479737, as of December 31, 1996 and the related statements of loss, partners' equity and cash flows for the year ended December 31, 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Altheimer Associates I, L.P. as of December 31, 1996, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Braunsdorf, Carlson and Clinkinbeard Braunsdorf, Carlson and Clinkinbeard TOPEKA, KANSAS February 3, 1997
[Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Bolivar Senior Housing, L.P. Wayne, Nebraska
We have audited the accompanying balance sheet of Bolivar Senior Housing, L.P., (a Missouri limited Partnership), RECD Case No.: 29-084-481063570, as of December 31, 1997 and the related statements of loss, partners' equity and cash flows for the year ended December 31, 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Bolivar Senior Housing, L.P. as of December 31, 1997, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Braunsdorf, Carlson and Clinkinbeard Braunsdorf, Carlson and Clinkinbeard TOPEKA, KANSAS January 31, 1998
[Letterhead] [LOGO] BCC Braunsdorf, Carlson and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A PROFESSIONAL ASSOCIATION
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Bolivar Senior Housing, L.P. Wayne, Nebraska
We have audited the accompanying balance sheet of Bolivar Senior Housing, L.P., (a Missouri limited Partnership), RECD Case No.: 29-084-481063570, as of December 31, 1996 and the related statements of loss, partners' equity and cash flows for the year ended December 31, 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Bolivar Senior Housing, L.P. as of December 31, 1996, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Braunsdorf, Carlson and Clinkinbeard Braunsdorf, Carlson and Clinkinbeard TOPEKA, KANSAS January 31, 1997
FULTON [Letterhead] [LOGO] CRAIN & COMPANY CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Fulton Associates I LP (A Limited Partnership)
We have audited the accompanying balance sheets of Fulton Associates I LP (A Limited Partnership), a FmHA Project, as of December 31, 1998 and 1997, and the related statements of operations, changes in partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Fulton Associates I LP (A Limited Partnership) as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information as listed in the table of contents is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Crain & Company CRAIN & COMPANY Certified Public Accountants
Jackson, Tennessee January 13, 1999
[Letterhead] [LOGO] CRAIN & COMPANY CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Fulton Associates I LP (A Limited Partnership)
We have audited the accompanying balance sheets of Fulton Associates I LP (A Limited Partnership), a FmHA Project, as of December 31, 1997 and 1996, and the related statements of operations, changes in partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Fulton Associates I LP (A Limited Partnership) as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information as listed in the table of contents is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Crain & Company CRAIN & COMPANY Certified Public Accountants
Jackson, Tennessee January 25, 1998
EAGLEWOOD [Letterhead] [LOGO] CRAIN & COMPANY CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Eaglewood VIII LP (A Limited Partnership)
We have audited the accompanying balance sheets of Eaglewood VIII LP (A Limited Partnership), a FmHA Project, as of December 31, 1998 and 1997, and the related statements of operations, changes in partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Eaglewood VIII LP (A Limited Partnership) as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information, as listed in the table of contents, is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
In accordance with Government Auditing Standards, we have also issued a report dated January 27, 1999 on our consideration of the limited partnership's internal control over financial reporting and on its compliance with laws and regulations
/s/Crain & Company CRAIN & COMPANY Certified Public Accountants Jackson, Tennessee January 27, 1999
[Letterhead] [LOGO] CRAIN & COMPANY CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Eaglewood VIII LP (A Limited Partnership)
We have audited the accompanying balance sheets of Eaglewood VIII LP (A Limited Partnership), a FmHA Project, as of December 31, 1997 and 1996, and the related statements of operations, changes in partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Eaglewood VIII LP (A Limited Partnership) as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information, as listed in the table of contents, is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
In accordance with Government Auditing Standards, we have also issued a report dated January 26, 1998 on our consideration of the limited partnership's internal control structure and a report dated February 9, 1998 on its compliance with laws and regulations
/s/Crain & Company CRAIN & COMPANY Certified Public Accountants Jackson, Tennessee January 26, 1998
ELVER PARK III [Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Elver Park Limited Partnership III Madison, Wisconsin
We have audited the balance sheet of Elver Park Limited Partnership III as of December 31, 1998, and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Elver Park Limited Partnership III as of December 31, 1997 were audited by other auditors whose report dated January 15, 1998 expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Elver Park Limited Partnership III as of December 31, 1998 and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 22, 1999
[Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Elver Park Limited Partnership III Madison, Wisconsin
We have audited the balance sheet of Elver Park Limited Partnership III as of December 31, 1997 and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Elver Park Limited Partnership II as of December 31, 1998, and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 12, 1998
ELVER PAK II [Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Elver Park Limited Partnership II Madison, Wisconsin
We have audited the accompanying balance sheet of Elver Park Limited Partnership II as of December 31, 1998 and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Elver Park Limited Partnership II as of December 31, 1997 were audited by other auditors whose report dated January 14, 1998 expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Elver Park Limited Partnership II as of December 31, 1998, and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 22, 1999
[Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Elver Park Limited Partnership II Madison, Wisconsin
We have audited the accompanying balance sheets of Elver Park Limited Partnership II as of December 31, 1997 and 1996, and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Elver Park Limited Partnership II as of December 31, 1997 and 1996, and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 13, 1998
BLUEMOUNTAIN [Letterhead] [LOGO] Robert Ercolini & Company L.L.P. Certified Public Accountants Fifty-Five Summer Street Boston, Massachusetts 02110-1007 Telephone (617) 482-5511 INDEPENDENT AUDITOR'S REPORT
To the Partners of Blue Mountain Associates Limited Partnership HUD Area Office Boston, Massachusetts Boston, Massachusetts
We have audited the accompanying balance sheet of Blue Mountain Associates Limited Partnership (a Massachusetts Limited Partnership), HUD Project No. 023-36609 as of December 31, 1998, and the related statements of income and loss, partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Blue Mountain Associates Limited Partnership as of December 31, 1998, and the results of its operations, changes in partners' capital, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 30, 1999 on our consideration of Blue Mountain Associates Limited Partnership's internal control, a report dated January 30, 1999 on its compliance with laws and regulations, and reports dated January 30, 1999 on its compliance with specific requirements applicable to HUD Programs.
/s/Robert Ercolini & Company L.L.P. January 30, 1999
[Letterhead] [LOGO] Robert Ercolini & Company L.L.P. Certified Public Accountants Fifty-Five Summer Street Boston, Massachusetts 02110-1007 Telephone (617) 482-5511 INDEPENDENT AUDITOR'S REPORT
To the Partners of Blue Mountain Associates Limited Partnership HUD Area Office Boston, Massachusetts Boston, Massachusetts
We have audited the accompanying balance sheet of Blue Mountain Associates Limited Partnership (a Massachusetts Limited Partnership), HUD Project No. 023-36609 as of December 31, 1997, and the related statements of profit and loss (on HUD Form No. 92410), partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Blue Mountain Associates Limited Partnership as of December 31, 1997, and the results of its operations, changes in partners' capital, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 23, 1998 on our consideration of Blue Mountain Associates Limited Partnership's internal control structure, a report dated January 23, 1998 on its compliance with laws and regulations, and reports dated January 23, 1998 on its compliance with specific requirements applicable to HUD Programs.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The additional information included in this report (shown on pages 16 through 21 and pages 29 through 42) is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, its fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Robert Ercolini & Company L.L.P. January 24, 1998
[Letterhead] [LOGO] Robert Ercolini & Company L.L.P. Certified Public Accountants Fifty-Five Summer Street Boston, Massachusetts 02110-1007 Telephone (617) 482-5511 Fax (617) 426-5252
INDEPENDENT AUDITOR'S REPORT
To the Partners of Blue Mountain Associates Limited Partnership HUD Area Office Boston, Massachusetts Boston, Massachusetts
We have audited the accompanying balance sheet of Blue Mountain Associates Limited Partnership (a Massachusetts Limited Partnership), HUD Project No. 023-36609 as of December 31, 1996, and the related statements of profit and loss (on HUD Form No. 92410), partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Blue Mountain Associates Limited Partnership as of December 31, 1996, and the results of its operations, changes in partners' capital, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 23, 1997 on our consideration of Blue Mountain Associates Limited Partnership's internal control structure, a report dated January 23, 1997 on its compliance with laws and regulations, and reports dated January 23, 1997 on its compliance with specific requirements applicable to HUD Programs.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The additional information included in this report (shown on pages 14 through 19) is presented for the purpose of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, its fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/Robert Ercolini & Company L.L.P. January 23, 1997
BOULEVARD Letterhead] [LOGO] Haran & Associates Ltd CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITOR'S REPORT
To the Partners HUD Field Office Director Boulevard Commons Limited Partnership Chicago, Illinois Chicago, Illinois
We have audited the accompanying balance sheet of Boulevard Commons Limited Partnership II ( a Limited Partnership), as of December 31, 1998, and the related statements of profit and loss (HUD - 92410), changes in partners' equity and statement of cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of BOULEVARD COMMONS LIMITED PARTNERSHIP II at December 31, 1998, and its operations, changes in partners' equity, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Haran & Associates LTD HARAN & ASSOCIATES LTD. Certified Public Accountants Wimette, Illinois Illinois Certificate No. 060-002892
January 22, 1999
Letterhead] [LOGO] Haran & Associates Ltd CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITOR'S REPORT
To the Partners HUD Field Office Director Boulevard Commons Limited Partnership Chicago, Illinois Chicago, Illinois
We have audited the accompanying balance sheet of Boulevard Commons Limited Partnership II ( a Limited Partnership), as of December 31, 1997, and the related statements of profit and loss, changes in partners' equity and statement of cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of BOULEVARD COMMONS LIMITED PARTNERSHIP II as of December 31, 1997, and its operations, changes in partners' equity, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
The accompanying supplementary information (shown on pages 15 to 19) is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statement and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as whole.
/s/Haran & Associates LTD HARAN & ASSOCIATES LTD. Certified Public Accountants Wimette, Illinois Illinois Certificate No. 060-002892
January 23, 1998
[Letterhead] [LOGO] Haran & Associates Ltd CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITOR'S REPORT
To the Partners HUD Field Office Director Boulevard Commons Limited Partnership Chicago, Illinois Chicago, Illinois
We have audited the accompanying balance sheet of Boulevard Commons Limited Partnership II, Project No. 071-35592, as of December 31, 1996, and the related statements of profit and loss, changes in partners' equity and statement of cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of BOULEVARD COMMONS LIMITED PARTNERSHIP II as of December 31, 1996, and its profit or loss, changes in partners' equity, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated January 17, 1997 on our consideration of Boulevard Commons Limited Partnership's internal control structure and reports dated January 17, 1997 on its compliance with specific requirements applicable to Major HUD Programs and specific requirements applicable to Affirmative Fair Housing.
The accompanying supplementary information (shown on pages 15 to 19) is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statement and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as whole.
/s/Haran & Associates LTD HARAN & ASSOCIATES LTD. Certified Public Accountants Wimette, Illinois Illinois Certificate No. 060-002892
January 17, 1997
BOULIVARD II [Letterhead] [LOGO] Haran & Associates Ltd CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITOR'S REPORT
To the Partners Boulevard Commons Limited Partnership IIA Chicago, Illinois
We have audited the accompanying balance sheet of Boulevard Commons Limited Partnership IIA., (a Limited Partnership) as of December 31, 1998 and the related statements of profit and loss (HUD-92419), changes in partners' equity and statement of cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and generally accepted Government Auditing Standards for financial and compliance audits issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of BOULEVARD COMMONS LIMITED Partnership IIA at December 31, 1998, and its operations, changes in partners' equity, and its cash flows for the year then ended , in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in the notes to financial statements, the Partnership is several months delinquent on both its first and junior mortgages which raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/Haran & Associates LTD HARAN & ASSOCIATES LTD. Certified Public Accountants Wimette, Illinois Illinois Certificate No. 060-002892 January 26, 1999
[Letterhead] [LOGO] Haran & Associates Ltd CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITOR'S REPORT
To the Partners Boulevard Commons Limited Partnership IIA Chicago, Illinois
We have audited the accompanying balance sheet of Boulevard Commons Limited Partnership IIA., (a Limited Partnership) as of December 31, 1997 and the related statements of profit and loss (HUD-92419), changes in partners' equity and statement of cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and generally accepted Government Auditing Standards for financial and compliance audits issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the assets, liabilities and partners' equity of BOULEVARD COMMONS LIMITED Partnership IIA at December 31, 1997, and its operations, changes in partners' equity, and its cash flows for the year then ended , in conformity with generally accepted accounting principles.
/s/Haran & Associates LTD HARAN & ASSOCIATES LTD. Certified Public Accountants Wimette, Illinois Illinois Certificate No. 060-002892 January 17, 1998
[Letterhead] [LOGO] Haran & Associates Ltd CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITOR'S REPORT
To the Partners Boulevard Commons Limited Partnership IIA Chicago, Illinois
We have audited the accompanying balance sheet of Boulevard Commons Limited Partnership IIA., (a Limited Partnership) as of December 31, 1996 and the related statements of profit and loss (HUD-92410), changes in partners' equity and statement of cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and generally accepted Government Auditing Standards for financial and compliance audits issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provided a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the assets, liabilities and partners' equity of BOULEVARD COMMONS LIMITED Partnership IIA at December 31, 1996, and its operations, changes in partners' equity, and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/Haran & Associates LTD HARAN & ASSOCIATES LTD. Certified Public Accountants Wimette, Illinois Illinois Certificate No. 060-002892 January 17, 1997
EL JARDIN Letterhead] [LOGO] Reznick, Fedder & Silverman Certified Public Accountants Charlotte, North Carolina
INDEPENDENT AUDITORS' REPORT
To the Partners of El Jardin of Davie, Ltd. (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of El Jardin of Davie, Ltd. as of December 31, 1998, and the related statements of profit and loss (on HUD Form 92410), partners' equity, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership.Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of El Jardin of Davie, Ltd. as of December 31, 1998, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the financial statements taken as a whole. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/ Reznick, Fedder & Silverman Certified Public Accountants Charlotte, North Carolina January 16, 1999
[Letterhead] [LOGO] Reznick, Fedder & Silverman Certified Public Accountants Charlotte, North Carolina
INDEPENDENT AUDITORS' REPORT
To the Partners of El Jardin of Davie, Ltd. (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of El Jardin of Davie, Ltd. (FHA Project No. 066-10539-REF) as of December 31, 1997, and the related statements of profit and loss (HUD Form 92410), changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred above present fairly, in all material respects, the financial position of El Jardin of Davie, Ltd. (FHA Project No. 066-10539-REF) at December 31, 1997, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the US Department of Housing and Urban Development ("HUD"), we have also issued a report dated February 24, 1998, on our consideration of El Jardin of Davie, Ltd.'s internal control structure, and reports dated February 24, 1998, on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Affirmative Fair Housing.
Our audit was made for the purpose of forming an opinion on the financial statements taken as a whole. The accompanying supplementary information shown on pages 16 to 21 are presented for the purpose of additional analysis and are not a required part of the basic financial statements of El Jardin of Davie, Ltd. (FHA Project No. 066-10539-REF). Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/ Reznick, Fedder & Silverman Certified Public Accountants Charlotte, North Carolina January 16, 1998
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
INDEPENDENT AUDITORS' REPORT
To the Partners of El Jardin of Davie, Ltd. (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of El Jardin of Davie, Ltd. (FHA Project No. 066-10539-REF) as of December 31, 1996, and the related statements of profit and loss (HUD Form 92410), changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred above present fairly, in all material respects, the financial position of El Jardin of Davie, Ltd. (FHA Project No. 066-10539-REF) at December 31, 1996, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the US Department of Housing and Urban Development ("HUD"), we have also issued a report dated February 24, 1997, on our consideration of El Jardin of Davie, Ltd.'s internal control structure, and reports dated February 24, 1997, on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Affirmative Fair Housing.
Our audit was made for the purpose of forming an opinion on the financial statements taken as a whole. The accompanying supplementary information shown on pages 16 to 21 are presented for the purpose of additional analysis and are not a required part of the basic financial statements of El Jardin of Davie, Ltd. (FHA Project No. 066-10539-REF). Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida February 24, 1997
ASHLEY [Letterhead] [LOGO] Deloitte & Touche Orlando, Florida
INDEPENDENT AUDITOR'S REPORT
To the General Partner and Limited Partners of Ashley Place, Ltd.:
We have audited the accompanying balance sheet of Ashley Place, Ltd. (a Florida Limited Partnership), as of December 31, 1998 and the related statements of operations, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing . Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred above present fairly, in all material respects, the financial position of Ashley Place, Ltd. (a Florida Limited Partnership) as of December 31, 1998, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Deloite & Touche LLP February 2, 1999
[Letterhead] [LOGO] Deloitte & Touche Orlando, Florida
INDEPENDENT AUDITOR'S REPORT
To the General Partner and Limited Partners of Ashley Place, Ltd.:
We have audited the accompanying balance sheet of Ashley Place, Ltd. (a Florida Limited Partnership), as of December 31, 1997 and the related statements operations, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing . Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred above present fairly, in all material respects, the financial position of Ashley Place, Ltd. (a Florida Limited Partnership) as of December 31, 1997, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Deloite & Touche LLP February 2, 1998
[Letterhead] [LOGO] Deloitte & Touche Orlando, Florida
INDEPENDENT AUDITOR'S REPORT
To the General Partner and Limited Partners of Ashley Place, Ltd.:
We have audited the accompanying balance sheet of Ashley Place, Ltd. (a Florida Limited Partnership), as of December 31, 1996 and the related statements operations, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing . Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred above present fairly, in all material respects, the financial position of Ashley Place, Ltd. (a Florida Limited Partnership) as of December 31, 1996, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Deloite & Touche LLP February 2, 1997
COLONY APT [Letterhead] [LOGO] Purkey, Carter, Compton, Swann & Carter, P.L.L.C. Certified Public Accountants Morriston, Tennessee 37815
INDEPENDENT AUDITOR'S REPORT
General Partners Mr. Angelo Schioscia, State Coordinator Partners U.S. Department of Housing and The Colony Apartments, L.P. Urban Development 1504 Riverview Tower Strom Thurmond Federal Building 900 S. Gay Street 1835-45 Assembly Street. 11th Floor Knoxville, Tennessee Columbia, South Carolina 29201
We have audited the accompanying balance sheet of The Colony Apartments, L.P., FHA Project No. 054-94002-OMC (a limited partnership) as of December 31, 1998, and the related statements of income, changes in partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards, Government Auditing Standards, issued by the Comptroller General of the United States and the Consolidated Audit Guide for audits of HUD Programs (the "Guide"), issued by the U.S. Department of Housing and Urban Development, Office of the Inspector General. Those standards and the Guide require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Colony Apartments, L.P as of December 31, 1998, and the results of its operations and the changes in partners' equity and cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated February 3, 1999, on our consideration of The Colony Apartments, L.P.'s internal control structure and reports dated February 3, 1999, on its compliance with specific requirements applicable to major HUD Programs and specific requirements applicable to Fair Housing and Non-Discrimination.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information shown on pages 27 to 31 is presented for the purpose of additional analysis and is not a required part of the basic financial statements of The Colony Apartments, L.P. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
We attest that our firm, Purkey, Carter, Compton, Swann & Carter, P.L.L.C. meets any legal requirements concerning registration by the State of South Carolina.
/s/Purkey, Carter, Compton, Swann & Carter, P.L.L.C. Purkey, Carter, Compton, Swann & Carter, P.L.L.C. February 3, 1999
[Letterhead] [LOGO] Purkey, Carter, Compton, Swann & Carter, P.L.L.C. Certified Public Accountants Morriston, Tennessee 37815
INDEPENDENT AUDITOR'S REPORT
General Partners Mr. Angelo Schioscia, State Coordinator Partners U.S. Department of Housing and The Colony Apartments, L.P. Urban Development 1504 Riverview Tower Strom Thurmond Federal Building 900 S. Gay Street 1835-45 Assembly Street. 11th Floor Knoxville, Tennessee Columbia, South Carolina 29201
We have audited the accompanying balance sheet of The Colony Apartments, L.P., FHA Project No. 054-94002-OMC (a limited partnership) as of December 31, 1997, and the related statements income, changes in partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards, Government Auditing Standards, issued by the Comptroller General of the United States and the July 1993 Consolidated Audit Guide for Audits of HUD Programs (the "Guide"), issued by the U.S. Department of Housing and Urban Development, Office of the Inspector General. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Colony Apartments, L.P as of December 31, 1997, and the results of its operations and the changes in partners' equity and cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated January 21, 1998, on our consideration of The Colony Apartments, L.P.'s internal control structure and reports dated January 21, 1998, on its compliance with specific requirements applicable to major HUD Programs and specific requirements applicable to Affirmative Fair Housing.
Our audit was conducted for the purpose of forming an opinion on the financial statements taken as a whole. The supplementary information included in this report (shown on pages 26 to 35) is presented for the purpose of additional analysis and is not a required part of the financial statements of The Colony Apartments, L.P. Such information has been subjected to the same auditing procedures applied in the audit of the financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
We attest that our firm, Purkey, Carter, Compton, Swann & Carter, P.L.L.C. meets any legal requirements concerning registration by the State of South Carolina.
/s/Purkey, Carter, Compton, Swann & Carter, P.L.L.C. Purkey, Carter, Compton, Swann & Carter, P.L.L.C. January 24, 1998
[Letterhead] [LOGO] Purkey, Carter, Compton, Swann & Carter, P.L.L.C. Certified Public Accountants Morriston, Tennessee 37815
INDEPENDENT AUDITOR'S REPORT
General Partners Mr. Choice Edward, State Coordinator Partners U.S. Department of Housing and The Colony Apartments, L.P. Urban Development 1504 Riverview Tower Strom Thurmond Federal Building 900 S. Gay Street 1835-45 Assembly Street. 11th Floor Knoxville, Tennessee Columbia, South Carolina 29201
We have audited the accompanying balance sheet of The Colony Apartments, L.P., FHA Project No. 054-94002-OMC (a limited partnership) as of December 31, 1996, and the related statements income, changes in partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards, Government Auditing Standards, issued by the Comptroller General of the United States and the July 1993 Consolidated Audit Guide for Audits of HUD Programs (the "Guide"), issued by the U.S. Department of Housing and Urban Development, Office of the Inspector General. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Colony Apartments, L.P as of December 31, 1996, and the results of its operations and the changes in partners' equity and cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated January 21, 1997, on our consideration of The Colony Apartments, L.P.'s internal control structure and reports dated January 21, 1997, on its compliance with specific requirements applicable to major HUD Programs and specific requirements applicable to Affirmative Fair Housing.
Our audit was conducted for the purpose of forming an opinion on the financial statements taken as a whole. The supplementary information included in this report (shown on pages 26 to 35) is presented for the purpose of additional analysis and is not a required part of the financial statements of The Colony Apartments, L.P. Such information has been subjected to the same auditing procedures applied in the audit of the financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
We attest that our firm, Purkey, Carter, Compton, Swann & Carter, P.L.L.C. meets any legal requirements concerning registration by the State of South Carolina.
/s/Purkey, Carter, Compton, Swann & Carter, P.L.L.C. Purkey, Carter, Compton, Swann & Carter, P.L.L.C. January 21, 1997
AURORA [Letterhead] [LOGO] LARRY O'DONNELL, CPA, P.C. Aurora, CO
Partners Aurora Properties, Ltd. d/b/a Aurora East Apartments Aurora, Colorado
INDEPENDENT AUDITOR'S REPORT
I have audited the accompanying balance sheets of Aurora Properties Ltd. d/b/a Aurora East Apartments, Project No. 101-10522 (a Limited Partnership) as of December 31, 1998 and 1997, and the related statements of profit and loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. My responsibility is to express an opinion on these financial statements based on my audit.
I conducted my audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that I plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. I believe that my audit provides a reasonable basis for opinion.
In my opinion, the financial statements referred to above present fairly in all material respects, the financial position of Aurora Properties Ltd., d/b/a Aurora East Apartments as of December 31, 1998 and 1997, and the results of its operations changes in partners' capital and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, I have also issued a report dated February 10, 1999 on my consideration of Aurora Properties Ltd., d/b/a Aurora East Apartments, internal control and reports dated February 10, 1999 on its compliance with specific requirements applicable to the basic financial statements and major HUD programs and specific requirements applicable to Affirmative Fair Housing.
/s/Larry O'Donnell, CPA, PC February 10, 1999 Federal Identification Number 84-1075467
[Letterhead] [LOGO] LARRY O'DONNELL, CPA, P.C. Aurora, CO
Partners Aurora Properties, Ltd. d/b/a Aurora East Apartments Aurora, Colorado
INDEPENDENT AUDITOR'S REPORT
I have audited the accompanying balance sheets of Aurora Properties Ltd. d/b/a Aurora East Apartments, Project No. 101-10522 (a Limited Partnership) as of December 31, 1997 and 1996, and the related statements of profit and loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. My responsibility is to express an opinion on these financial statements based on my audit.
I conducted my audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States and the Consolidated Audit Guide for Audits of HUD Programs, issued by the U.S. Department of Housing and Urban Development, Office of Inspector General in July, 1993. Those standards require that I plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. I believe that my audit provides a reasonable basis for opinion.
In my opinion, the financial statements referred to above present fairly in all material respects, the financial position of Aurora Properties Ltd., d/b/a Aurora East Apartments as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, I have also issued a report dated February 10, 1998 on my consideration of Aurora Properties Ltd., d/b/a Aurora East Apartments, internal control structure and reports dated February 3, 1998 on its compliance with laws and regulations applicable to the basic financial statements and the major HUD program.
/s/Larry O'Donnell, CPA, PC February 10, 1998 Federal Identification Number 84-1075467
COLUMBIA [Letterhead] [LOGO] VMCHC&S Vroman, McGowen, Hurst, Clark & Smith, P.C. Certified Public Accountants and Business Advisors
INDEPENDENT AUDITOR'S REPORT
To the Partners Columbia Townhouse Associates Limited Partnership Des Moines, Iowa
We have audited the accompanying balance sheets of Columbia Townhouse Associates Limited Partnership,as of December 31, 1998 and 1997, and the related statements of operations, partners' capital (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Columbia Townhouse Associates Limited Partnership as of December 31, 1998 and 1997, and the results of its operations, changes in partners' capital (deficit) and cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated January 30, 1999, on our consideration of the Partnership's internal control structure and reports, dated January 30, 1999, on its compliance with specific requirements applicable to major HUD Programs and specific requirements applicable to Fair Housing and Non-Discrimination.
As discussed in Note A, the accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. The Partnership has incurred substantial losses before depreciation and is in default on its first mortgage loan. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts of classifications of liabilities that might be necessary in the event the Partnership cannot continue in existence.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information (shown in Section II) is presented for the purpose of additional analysis and is not a required part of the basic financial statements of Columbia Townhouse Associates Limited Partnership. Such information has been subjected to the same auditing procedures applied in the audits of the basic financial statements and, in our opinion, are presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/Vroman, McGowen, Hurst, Clark & Smith, P.C. Des Moines, Iowa January 30, 1999
[Letterhead] [LOGO] VMCHC&S Vroman, McGowen, Hurst, Clark & Smith, P.C. Certified Public Accountants and Business Advisors
INDEPENDENT AUDITOR'S REPORT
To the Partners Columbia Townhouse Associates Limited Partnership Des Moines, Iowa
We have audited the accompanying balance sheets of Columbia Townhouse Associates Limited Partnership, HUD Project No. 074-35189, as of December 31, 1997 and 1996, and the related statements of profit and loss, partners' capital (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Columbia Townhouse Associates Limited Partnership as of December 31, 1997 and 1996, and the results of its operations, changes in partners' capital (deficit) and cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated January 31, 1998, on our consideration of the Partnership's internal control structure and reports, dated January 31, 1998, on its compliance with specific requirements applicable to major HUD Programs and specific requirements applicable to Affirmative Fair Housing.
As discussed in Note A, the accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As shown in the financial statements, the Partnership has incurred substantial losses before depreciation for each of the passed two years. The financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts of classifications of liabilities that might be necessary in the event the Partnership cannot continue in existence.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information (shown in Section II) is presented for the purpose of additional analysis and is not a required part of the basic financial statements of Columbia Townhouse Associates Limited Partnership. Such information has been subjected to the same auditing procedures applied in the audits of the basic financial statements and, in our opinion, are presented fairly in all material respects in relation to the basic financial statements taken as a whole.
/s/Vroman, McGowen, Hurst, Clark & Smith, P.C. Des Moines, Iowa January 31, 1998
ADMIRAL [Letterhead] [LOGO] Fishbein & Company Certified Public Accountants February 4, 1999 Elkins Park, PA
INDEPENDENT AUDITOR'S REPORT
Partners Admiral Housing Limited Partnership
We have audited the accompanying balance sheets of ADMIRAL HOUSING LIMITED PARTNERSHIP, as of December 31, 1998 and 1997 and the related statements of operations, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Admiral Housing Limited Partnership as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information included in this report (shown on pages 10 and 11) is presented for purposes of additional analysis and is not a required part of the basic financial statements of the Partnership. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Fishbein & Company P.C.
[Letterhead] [LOGO] Fishbein & Company Certified Public Accountants February 5, 1998 Elkins Park, PA
INDEPENDENT AUDITOR'S REPORT
Partners Admiral Housing Limited Partnership
We have audited the accompanying balance sheets of ADMIRAL HOUSING LIMITED PARTNERSHIP, as of December 31, 1997 and 1996 and the related statements operations, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Admiral Housing Limited Partnership as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information included in this report (shown on pages 10 and 11) is presented for purposes of additional analysis and is not a required part of the basic financial statements of the Partnership. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Fishbein & Company P.C.
GEORGETOWN [Letterhead] [LOGO] HALBERT, KATZ & CO., P.C. CERTIFIED PUBLIC ACCOUNTANTS Philadelphia, PA
INDEPENDENT AUDITOR'S REPORT
To the Partners Georgetown Associates II, L.P. Wilmington, Delaware
We have audited the accompanying balance sheets of Georgetown Associates II, L.P., as of December 31, 1998 and December 31, 1997, and the related statements of loss, partners' capital (capital deficiency) and cash flows for the years then ended. These financial statements are the responsibility of the project's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Georgetown Associates II, L.P., as of December 31, 1998 and December 31, 1997, and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supporting information included in the report (shown on pages 13 to 15) is presented for the purpose of additional analysis and is not a required part of the basic financial statements of Georgetown Associates II, L.P. Such information has been subjected to the same auditing procedures applied in the audits of the basic financial statements and in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Halbert, Katz & Co., P.C. January 30, 1999
[Letterhead] [LOGO] HALBERT, KATZ & CO., P.C. CERTIFIED PUBLIC ACCOUNTANTS Philadelphia, PA
INDEPENDENT AUDITOR'S REPORT
To the Partners Georgetown Associates II, L.P. Wilmington, Delaware
We have audited the accompanying balance sheets of Georgetown Associates II, L.P., as of December 31, 1997 and December 31, 1996, and the related statements of loss, partners' capital (capital deficiency) and cash flows for the years then ended. These financial statements are the responsibility of the project's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Georgetown Associates II, L.P., as of December 31, 1997 and December 31, 1996, and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supporting information included in the report (shown on pages 13 through 15) is presented for the purpose of additional analysis and is not a required part of the basic financial statements of Georgetown Associates II, L.P. Such information has been subjected to the same auditing procedures applied in the audits of the basic financial statements and in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Halbert, Katz & Co., P.C. January 30, 1998
LEXINGTON I [Letterhead] [LOGO] CRAIN & COMPANY CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Lexington Associates, I LP (A Limited Partnership)
We have audited the accompanying balance sheets of Lexington Associates, I LP (A Limited Partnership), a FmHA Project, as of December 31, 1998 and 1997, and the related statements of operations, changes in partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Lexington Associates I LP (A Limited Partnership) as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information as listed in the table of contents is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
In accordance with Government Auditing Standards, we have also issued a report dated January 26, 1999 on our consideration of the limited partnership's internal control structure and a report dated January 26, 1999 on its compliance with laws and regulations
/s/Crain & Company CRAIN & COMPANY Certified Public Accountants Jackson, Tennessee January 26, 1999
[Letterhead] [LOGO] CRAIN & COMPANY CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Lexington Associates, I LP (A Limited Partnership)
We have audited the accompanying balance sheets of Lexington Associates, I LP (A Limited Partnership), a FmHA Project, as of December 31, 1997 and 1996, and the related statements of operations, changes in partners' capital and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Lexington Associates I LP (A Limited Partnership) as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Our audits were for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary information as listed in the table of contents is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the same auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
In accordance with Government Auditing Standards, we have also issued a report dated January 26, 1998 on our consideration of the limited partnership's internal control structure and a report dated January 26, 1998 on its compliance with laws and regulations
/s/Crain & Company CRAIN & COMPANY Certified Public Accountants Jackson, Tennessee January 26, 1998
LONGVIEW
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Longview Apartments, L.P. Humboldt, Kansas
We have audited the accompanying balance sheet of Longview Apartments, L.P. ( a Kansas limited partnership), RECD Case No.: 18-001-431454412 as of December 31, 1997, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Longview Apartments, L.P. as of December 31, 1997, and the results of its operations, and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas January 31, 1998
LONGVIEW
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Longview Apartments, L.P. Humboldt, Kansas
We have audited the accompanying balance sheet of Longview Apartments, L.P. ( a Kansas limited partnership), RECD Case No.: 18-001-431454412 as of December 31, 1996, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Longview Apartments, L.P. as of December 31, 1996, and the results of its operations, and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas January 31, 1997
Missouri Rural Housing of Oak Grove, L.P.
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Missouri Rural Housing of Oak Grove, L.P. Oak Grove , Missouri
We have audited the accompanying balance sheet of Missouri Rural Housing of Oak Grove, L.P. ( a Missouri limited partnership), as of December 31, 1997, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Missouri Rural Housing of Oak Grove, L.P. as of December 31, 1997, and the results of its operations, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas February 9, 1998
Missouri Rural Housing of Oak Grove, L.P.
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Missouri Rural Housing of Oak Grove, L.P. Oak Grove , Missouri
We have audited the accompanying balance sheet of Missouri Rural Housing of Oak Grove, L.P. ( a Missouri limited partnership), as of December 31, 1996, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Missouri Rural Housing of Oak Grove, L.P. as of December 31, 1996, and the results of its operations, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas February 9, 1997
Smithville Rural Housing, a Limited Partnership
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Smithville Rural Housing, A Limited Partnership Wayne, Nebraska
We have audited the accompanying balance sheet of Smithville Rural Housing, A Limited Partnership ( a Missouri limited partnership), RECD Case No: 29-024-480975973 as of December 31, 1997, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Smithville Rural Housing, A Limited Partnership as of December 31, 1997, and the results of its operations, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas February 7, 1998
Smithville Rural Housing, a Limited Partnership
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Smithville Rural Housing, A Limited Partnership Wayne, Nebraska
We have audited the accompanying balance sheet of Smithville Rural Housing, A Limited Partnership ( a Missouri limited partnership), RECD Case No: 29-024-480975973 as of December 31, 1996, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Smithville Rural Housing, A Limited Partnership as of December 31, 1996, and the results of its operations, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas February 7, 1997
WESTGATE
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Westgate Associates I, L.P. Perryville, Arkansas
We have audited the accompanying balance sheet of Westagte Associates I, L.P. ( a Missouri limited partnership), FmHA Case No: 03-053-431477863 as of December 31, 1997, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Westgate Associates I, L.P. as of December 31, 1997, and the results of its operations, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas February 6, 1998
WESTGATE
[Letterhead] [LOGO] BCC Braunsdorf, Carlson, and Clinkinbeard CERTIFIED PUBLIC ACCOUNTANTS A Professional Association
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Partners Westgate Associates I, L.P. Perryville, Arkansas
We have audited the accompanying balance sheet of Westagte Associates I, L.P. ( a Missouri limited partnership), FmHA Case No: 03-053-431477863 as of December 31, 1996, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Westgate Associates I, L.P. as of December 31, 1996, and the results of its operations, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/ Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Braunsdorf, Carlson and Clinkinbeard, CPA's, P.A. Topeka, Kansas February 6, 1997
TUCSON
[Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Tucson Trails Limited Partnership I Madison, Wisconsin
We have audited the accompanying balance sheets of Tucson Trails Limited Partnership I as of December 31, 1998, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of Tucson Trails Limited Partnership I as of December 31, 1997 were audited by other auditors whose report dated January 14, 1998 expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Tucson Trails Limited Partnership I as of December 31, 1998, and the results of its operations, changes in partners' equity and its cash flows for the year then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 22, 1999
[Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Tucson Trails Limited Partnership I Madison, Wisconsin
We have audited the accompanying balance sheets of Tucson Trails Limited Partnership I as of December 31, 1997 and 1996, and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Tucson Trails Limited Partnership I as of December 31, 1997 and 1996, and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 12, 1998
TUSCAN II
[Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Tucson Trails Limited Partnership II Madison, Wisconsin
We have audited the accompanying balance sheets of Tucson Trails Limited Partnership II as of December 31, 1998, and the related statements of loss, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Tucson Trails Limited Partnership II as of December 31, 1997 were audited by other auditors whose report dated January 14, 1998 expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Tucson Trails Limited Partnership II as of December 31, 1998, and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 22, 1999
[Letterhead] [LOGO] Suby, Von Haden & Associates, S.C. CERTIFIED PUBLIC ACCOUNTANTS Business and Management Consultants Madision, WI
INDEPENDENT AUDITOR'S REPORT
To the Partners Tucson Trails Limited Partnership II Madison, Wisconsin
We have audited the accompanying balance sheets of Tucson Trails Limited Partnership II as of December 31, 1997 and 1996, and the related statements of loss, partners' equity and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Tucson Trails Limited Partnership II as of December 31, 1997 and 1996, and the results of its operations, changes in partners' equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Suby, Von Haden & Associates, S.C. January 17, 1997
WALKER WOODS
[Letterhead] [LOGO] PATTERSON & KELLY PROFESSIONAL ASSOCIATION CERTIFIED PUBLIC ACCOUNTANTS
To the Partners of Walker Woods Partners, L.P. Dover, Delaware 19901
INDEPENDENT AUDITORS' REPORT
We have audited the accompanying balance sheets of Walker Woods Partners, L.P. as of December 31, 1998 and 1997, and the statements of income, cash flows and owners' equity and for the years then ended. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Walker Woods Partners, L.P. as of December 31, 1998 and 1997, and the results of its operations and its cash flows and owners' equity for the years then ended in conformity with generally accepted accounting principles.
/s/Patterson & Kelly, P.A. Patterson & Kelly, P.A. Dover, Delaware February 25, 1999
[Letterhead] [LOGO] PATTERSON & KELLY PROFESSIONAL ASSOCIATION CERTIFIED PUBLIC ACCOUNTANTS
To the Partners of Walker Woods Partners, L.P. Dover, Delaware 19901
INDEPENDENT AUDITORS' REPORT
We have audited the accompanying balance sheets of Walker Woods Partners, L.P. as of December 31, 1997 and 1996, and the statements of income, cash flows and owners' equity and for the years then ended. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred above present fairly, in all material respects, the financial position of Walker Woods Partners, L.P. as of December 31, 1997 and 1996, and the results of its operations and its cash flows and owners' equity for the years then ended in conformity with generally accepted accounting principles.
/s/Patterson & Kelly, P.A. Patterson & Kelly, P.A. Dover, Delaware February 12, 1998
WATERFRONT
[Letterhead] [LOGO] Reznick, Fedder & Silverman
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners of Waterfront Limited Partnership:
We have audited the accompanying balance sheets of Waterfront Limited Partnership, as of December 31, 1998 and 1997 and the related statements of income and expenses, partners' deficit and cash flows for the years then ended These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Waterfront Limited Partnership, as of December 31, 1998, and 1997, and the results of its operations, the changes in partners' deficit and its cash flows for the years then ended, in conformity with generally accepted accounting principles. statements taken as a whole.
The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note H to the financial statements, the Partnership has experienced recurring operating losses and working capital deficiencies that raise substantial doubt about its ability to continue as a going concern. Management's plan in regard to these matters are also described in Note H. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Our 1998 audit was made for the purpose of forming an opinion on the basic financial Statements taken as a whole. The supplementary information shown on pages 18 through 48 is presented purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
In accordance with Government Auditing Standards, and the "Consolidated Audit Guide for Audits of HUD Programs", we have also issued a report dated February 5, 1999 on our consideration of Waterfront Limited Partnership's internal control and on its compliance with specific requirements applicable to major HUD programs, fair housing and non-discrimination, and laws and regulation applicable to the financial statements.
/s/Reznick, Fedder & Silverman Boston, Massachusetts February 5, 1999
WATERFRONT
[Letterhead] [LOGO] Reznick, Fedder & Silverman
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners of Waterfront Limited Partnership:
We have audited the accompanying balance sheet (on DHCR Form No.: HAA-77.2) of Waterfront Limited Partnership, DHCR No.: UDC-13 as of December 31, 1997 and the related statements of income and expenses (on DHCR Form No. HAA-77-3a), partners' (deficiency) and cash flows as of December 31, 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 1998 financial statements referred to above present fairly, in all material respects, the financial position of Waterfront Limited Partnership, DHCR No.: UDC-13, as of December 31, 1998, and the results of its operations, the changes in partners' (deficiency) and cash flows for the year then ended, in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 6 to the financial statements, the Partnership has experienced recurring operating losses and working capital deficiencies that raise substantial doubt about its ability to continue as a going concern. Management's plan in regard to these matters are also described in Note 8. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
In accordance with Government Auditing Standards, we have also issued a report dated January 30, 1999 on our consideration of Waterfront Limited Partnership's internal control structure and a report dated January 30, 1999 on its compliance with laws and regulations.
/s/Reznick, Fedder & Silverman Boston, Massachusetts January 30, 1999
[Letterhead] [LOGO] Coopers & Lybrand
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners of Waterfront Limited Partnership:
We have audited the accompanying balance sheet (on DHCR Form No.: HAA-77.2) of Waterfront Limited Partnership, DHCR No.: UDC-13 as of December 31, 1996 and the related statements of income and expenses (on DHCR Form No. HAA-77-3a), partners' (deficiency) and cash flows as of December 31, 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 1996 financial statements referred to above present fairly, in all material respects, the financial position of Waterfront Limited Partnership, DHCR No.: UDC-13, as of December 31, 1996, and the results of its operations, the changes in partners' (deficiency) and cash flows for the year then ended, in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 8 to the financial statements, the Partnership has experienced recurring operating losses and working capital deficiencies that raise substantial doubt about its ability to continue as a going concern. Management's plan in regard to these matters are also described in Note 8. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
In accordance with Government Auditing Standards, we have also issued a report dated February 10, 1997 on our consideration of Waterfront Limited Partnership's internal control structure and a report dated February 10, 1997 on its compliance with laws and regulations.
/s/Coopers & Lybrand L.L.P Boston, Massachusetts February 10, 1997
WEST DADE
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
Independent Auditors' Report
To the Partners of West Dade, Ltd. (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of West Dade, Ltd. (FHA Project No. 066-94021) as of December 31, 1998, and the related statements of profit and loss, changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's Management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position West Dade, Ltd. (FHA Project No. 066-94021) at December 31, 1998, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida February 9, 1999
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
Independent Auditors' Report
To the Partners of West Dade, Ltd. (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of West Dade, Ltd. (FHA Project No. 066-94021) as of December 31, 1997, and the related statements of profit and loss (HUD Form 92410), changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position West Dade, Ltd. (FHA Project No. 066-94021) at December 31, 1997, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development ("HUD"), we have also issued a report dated February 5, 1998, on our consideration of West Dade, Ltd.'s internal control structure, and reports dated February 5, 1998, on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Affirmative Fair Housing.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information shown on pages 17 to 22 are presented for the purpose of additional analysis and are not a required part of the basic financial statements of West Dade, Ltd. (FHA Project No. 066-94021). Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida February 5, 1998
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
Independent Auditors' Report
To the Partners of West Dade, Ltd. (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of West Dade, Ltd. (FHA Project No. 066-94021) as of December 31, 1996, and the related statements of profit and loss (HUD Form 92410), changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position West Dade, Ltd. (FHA Project No. 066-94021) at December 31, 1996, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development ("HUD"), we have also issued a report dated January 31, 1997, on our consideration of West Dade, Ltd.'s internal control structure, and reports dated January 31, 1997, on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Affirmative Fair Housing. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplemental information shown on pages 17 to 22 are presented for the purpose of additional analysis and are not a required part of the basic financial statements of West Dade, Ltd. (FHA Project No. 066-94021). Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida January 31, 1997
WEST DADE II
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
Independent Auditors' Report
To the Partners of West Dade, Ltd. II (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of West Dade, Ltd. (FHA Project No. 066-11048) as of December 31, 1998, and the related statements of profit and loss, changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's Management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing Standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position West Dade, Ltd. II (FHA Project No. 066-11048) at December 31, 1998, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida February 9, 1999
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
Independent Auditors' Report
To the Partners of West Dade, Ltd. II (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of West Dade, Ltd. II (FHA Project No. 066-94022) as of December 31, 1997, and the related statements of profit and loss (HUD Form 92410), changes in partners'capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position West Dade, Ltd. II (FHA Project No. 066-94022) at December 31, 1997, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development ("HUD") we have also issued a report dated February 6, 1998 on our consideration of West Dade, Ltd. II's internal control structure, and reports dated February 6, 1998, on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Affirmative Fair Housing.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information shown on pages 17 to 22 are presented for the purpose of additional analysis and are not a required part of the basic financial statements of West Dade, Ltd. II (FHA Project No. 066-94022). Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida February 6, 1998
[Letterhead] [LOGO] BDO Seidman, LLP Accountants and Consultants
Independent Auditors' Report
To the Partners of West Dade, Ltd. II (A Limited Partnership) Miami, Florida
We have audited the accompanying balance sheet of West Dade, Ltd. II (FHA Project No. 066-94022) as of December 31, 1996, and the related statements of profit and loss (HUD Form 92410), changes in partners' capital accounts, and cash flows for the year then ended. These financial statements are the responsibility of the management of the partnership. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position West Dade, Ltd. II (FHA Project No. 066-94022) at December 31, 1996, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs issued by the U.S. Department of Housing and Urban Development ("HUD") we have also issued a report dated January 31, 1997 on our consideration of West Dade, Ltd. II's internal control structure, and reports dated January 31, 1997, on its compliance with specific requirements applicable to major HUD programs and specific requirements applicable to Affirmative Fair Housing. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information shown on pages 17 to 22 are presented for the purpose of additional analysis and are not a required part of the basic financial statements of West Dade, Ltd. II (FHA Project No. 066-94022). Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/BDO Seidman, LLP Certified Public Accountants Miami, Florida January 31, 1997
WOOD CREEK
[Letterhead] [LOGO] CHAPMAN, COLLINS, AGOSTINELLI & SHAW, P.C. A Professional Corporation CERTIFIED PUBLIC ACCOUNTANTS Rochester, NY
INDEPENDENT AUDITORS' REPORT
To the Partners of Wood Creek Associates
We have audited the balance sheets of Wood Creek Associates (A New York Limited Partnership) as of December 31, 1998 and 1997, and the related statements of operations, changes in partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of Wood Creek Associates' management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position Wood Creek Associates as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/CHAPMAN, COLLINS, AGOSTINELLI & SHAW, P.C. February 5, 1999
[Letterhead] [LOGO] CHAPMAN, COLLINS, AGOSTINELLI & SHAW, P.C. A Professional Corporation CERTIFIED PUBLIC ACCOUNTANTS Rochester, NY
INDEPENDENT AUDITORS' REPORT
To the Partners of Wood Creek Associates
We have audited the balance sheets of Wood Creek Associates (A New York Limited Partnership) as of December 31, 1997 and 1996, and the related statements of operations, changes in partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of Wood Creek Associates' management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position Wood Creek Associates as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/CHAPMAN, COLLINS, AGOSTINELLI & SHAW, P.C. February 4, 1998
WESTWOOD
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants, Business Consultants A Professional Corporation
INDEPENDENT AUDITORS' REPORT
To the Partners Westwood Manor Limited Dividend Housing Association Limited Partnership
We have audited the accompanying balance sheet of Westwood Manor Limited Dividend Housing Association Limited Partnership, PROJECT NO. 048-10515-REF as of December 31, 1998, andthe related statements of profit and loss, changes in partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to in the first paragraph present fairly, in all material respects, the financial position of Westwood Manor Limited Dividend Housing Association Limited Partnership as of December 31, 1998, and its profit or loss, changes in partners' equity and cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated February 3 , 1999 on our consideration of Westwood Manor Limited Dividend Housing Association Limited Partnership internal control structure and reports dated February 3, 1999 on its compliance with specific requirements applicable to Major HUD Programs and specific requirements applicable to Affirmative Fair Housing.
The accompanying supplementary information (shown on pages 14 to 18) is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Reznick Fedder & Silverman Bethesda, Maryland Federal Employer February 3, 1999 Identification Number: 52-1088612
Audit Principal: Renee G. Scruggs
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants, Business Consultants A Professional Corporation
INDEPENDENT AUDITORS' REPORT
To the Partners Westwood Manor Limited Dividend Housing Association Limited Partnership
We have audited the accompanying balance sheet of Westwood Manor Limited Dividend Housing Association Limited Partnership as of December 31, 1997, and the related statements of profit and loss (on HUD Form No. 92410), partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Westwood Manor Limited Dividend Housing Association Limited Partnership as of December 31, 1997, and the results of its operations, the changes in partners' equity and cash flows for the year then ended, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information on pages 20 though 25 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
In accordance with Government Auditing Standards and the " Consolidated Audit Guide for Audits of HUD Programs, we have also issued reports dated February 5, 1998 on our consideration of Westwood Manor Limited Dividend Housing Association Limited Partnership's internal control structure and on its compliance with specific requirements applicable to major HUD Programs, affirmative fair housing, and laws and regulations applicable to the financial statements.
/s/Reznick Fedder & Silverman Bethesda, Maryland Federal Employer February 5, 1998 Identification Number: 52-1088612
Audit Principal: Renee G. Scruggs
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants, Business Consultants A Professional Corporation
INDEPENDENT AUDITORS' REPORT
To the Partners Westwood Manor Limited Dividend Housing Association Limited Partnership
We have audited the accompanying balance sheet of Westwood Manor Limited Dividend Housing Association Limited Partnership as of December 31, 1996, and the related statements of profit and loss (on HUD Form No. 92410), partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Westwood Manor Limited Dividend Housing Association Limited Partnership as of December 31, 1996, and the results of its operations, the changes in partners' equity and cash flows for the year then ended, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information on pages 20 though 25 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
In accordance with Government Auditing Standards and the " Consolidated Audit Guide for Audits of HUD Programs, we have also issued reports dated February 14, 1997 on our consideration of Westwood Manor Limited Dividend Housing Association Limited Partnership's internal control structure and on its compliance with specific requirements applicable to major HUD Programs, affirmative fair housing, and laws and regulations applicable to the financial statements.
/s/Reznick Fedder & Silverman
Bethesda, Maryland Federal Employer February 14, 1997 Identification Number: 52-1088612 Audit Principal: Renee G. Scruggs
PLEASANT PLAZA
[Letterhead] [LOGO] Pannell Kerr Forster PC Certified Public Accountants Boston, MA
Independent Auditors' Report
To the Partners Pleasant Plaza Housing Limited Partnership
We have audited the accompanying balance sheet of Pleasant Plaza Housing Limited Partnership, MHFA Project No: 85-004, as of December 31, 1998 and the related statements of loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pleasant Plaza Housing Limited Partnership at December 31, 1998 and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated February 7, 1999, on our consideration of Pleasant Plaza Housing Limited Partnership's internal control structure, and a report dated February 7, 1999 on its compliance with laws and regulations.
/s/Pannell Kerr Forster PC February 7, 1999
[Letterhead] [LOGO] Pannell Kerr Forster PC Certified Public Accountants Boston, MA
Independent Auditors' Report
To the Partners Pleasant Plaza Housing Limited Partnership
We have audited the accompanying balance sheet of Pleasant Plaza Housing Limited Partnership, MHFA Project No: 85-004, as of December 31, 1997 and the related statements of loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pleasant Plaza Housing Limited Partnership at December 31, 1997 and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated February 8, 1998, on our consideration of Pleasant Plaza Housing Limited Partnership's internal control structure, and a report dated February 9, 1998 on its compliance with laws and regulations.
/s/Pannell Kerr Forster PC February 8, 1998
[Letterhead] [LOGO] Pannell Kerr Forster PC Certified Public Accountants Boston, MA
Independent Auditors' Report
To the Partners Pleasant Plaza Housing Limited Partnership
We have audited the accompanying balance sheet of Pleasant Plaza Housing Limited Partnership, MHFA Project No: 85-004, as of December 31, 1996 and the related statements of loss, changes in partners' equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pleasant Plaza Housing Limited Partnership at December 31, 1996 and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued a report dated February 9, 1997, on our consideration of Pleasant Plaza Housing Limited Partnership's internal control structure, and a report dated February 9, 1997 on its compliance with laws and regulations.
/s/Pannell Kerr Forster PC February 9, 1997
SHORELINE
[Letterhead] [LOGO] Reznick, Fedder & Silverman
INDEPENDENT AUDITORS' REPORT
To the Partners Shoreline Limited Partnership:
We have audited the accompanying balance sheets of Shoreline Limited Partnership, as of December 31, 1998, and 1997, and the statements of operations, partners' deficit and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's Management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Shoreline Limited Partnership, as of December 31, 1998, and 1997 and the results of its operations, changes in partners' deficit, and its cash flows for the years then ended in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note H to the financial statements, the Partnership has experienced recurring operating losses and working capital deficiencies that raise substantial doubt about its ability to continue as a going concern. Management's plan in regard to these matters are also described in Note H. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/Reznick, Fedder & Silverman Boston, Massachusetts February 5, 1999
[Letterhead] [LOGO] Coopers & Lybrand
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners of Shoreline Limited Partnership:
We have audited the accompanying balance sheet (on DHCR Form No.: HAA-77.2) of Shoreline Limited Partnership, DHCR No.: UDC-03, as of December 31, 1996, and the related statements of income and expenses (on DHCR Form No. HAA-77-3a), partners' capital deficit and cash flows for the year then ended December 31, 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 1996 financial statements referred to above present fairly, in all material respects, the financial position of Shoreline Limited Partnership, DHCR No.: UDC-03 as of December 31, 1996, and the results of its operations, changes in partners' capital deficit, and its cash flows for the year then ended in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 8 to the financial statements, the Partnership has experienced recurring operating losses and working capital deficiencies that raise substantial doubt about its ability to continue as a going concern. Management's plan in regard to these matters are also described in Note 8. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
In accordance with Government Auditing Standards, we have also issued a report dated February 10, 1997 on our consideration of Shoreline Limited Partnership's internal control structure and a report dated February 10, 1997 on its compliance with laws and regulations.
/s/Coopers & Lybrand L.L.P Boston, Massachusetts February 10, 1997
POPLAR VILLAGE
[Letterhead] [LOGO] MILLER, MAYER, SULLIVAN & STEVENS LLP CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Rural Development Poplar Village, Ltd. London, Kentucky
We have audited the accompanying balance sheets of Poplar Village, Ltd., (a limited partnership) Case No. 20-048-611170806, as of December 31, 1998 and 1997 and the related statements of operations, changes in partners' equity (deficit), and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards and the standards for financial audits contained in Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Poplar Village, Ltd. as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued reports dated February 4, 1999 on our consideration of Poplar Village, Ltd. 's internal control over financial reporting and our tests of its compliance with certain provisions of laws, regulations, contracts, and grants.
Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental data included in this report is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements, and in our opinion, is presented fairly, in all material respects, in relation to the financial statements taken as a whole.
/s/Miller, Mayer, Sullivan, & Stevens Lexington, Kentucky February 4, 1999
[Letterhead] [LOGO] MILLER, MAYER, SULLIVAN & STEVENS LLP CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners Rural Development Poplar Village, Ltd. London, Kentucky
We have audited the accompanying balance sheets of Poplar Village, Ltd., (a limited partnership) Case No. 20-048-611170806, as of December 31, 1997 and 1996 and the related statements of operations, changes in partners' equity (deficit), and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards and the standards for financial audits contained in Government Auditing Standards issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Poplar Village, Ltd. as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards, we have also issued reports dated January 29, 1998 on our consideration of Poplar Village, Ltd. 's internal control structure and compliance with laws and regulations.
Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental data included in this report is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audits of the basic financial statements, and in our opinion, is presented fairly, in all material respects, in relation to the financial statements taken as a whole.
/s/Miller, Mayer, Sullivan, & Stevens Lexington, Kentucky January 29, 1998
SOUTH HOLYOKE
[Letterhead] [LOGO] JOSEPH B. COHAN & ASSOCIATES, P.C. CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners of South Holyoke Housing Limited Partnership
We have audited the accompanying balance sheet of South Holyoke Housing Limited Partnership as of December 31, 1998 and the related statements of operations, changes in partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
Except as discussed in the following paragraph, we conducted our audit in accordance With generally accepted auditing standards and Government Auditing standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
We were unable to obtain a current appraisal of the property for the purpose of determining whether an impairment loss should be recognized, and we were unable to satisfy ourselves about the fair value of the property.
In our opinion, except for the effects of such adjustments, if any , as might have been Determined to be necessary had we been able to determine the fair value of the property, the financial statements referred to above present fairly, in all material respects, the financial position of South Holyoke Housing Limited Partnership as of December 31, 1998, and the results of its operations, changes in partners equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Partnership will continued as a going concern. As discussed in Note 8 to the financial statements, the Partnership currently has insufficient resources and cash flows to meet its obligations. There is substantial doubt about the Partnership's ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs, issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated January 26, 1999 on our consideration of South Holyoke Housing Limited Partnership's internal control, and reports dated January 26, 1999 on its compliance with laws and regulations and specific requirements applicable to nonmajor HUD program transactions.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information shown on pages 13 to 23 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Joseph B. Cohan & Assoc PC Worcester, Massachusetts January 26, 1999
[Letterhead] [LOGO] JOSEPH B. COHAN & ASSOCIATES, P.C. CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners of South Holyoke Housing Limited Partnership
We have audited the accompanying balance sheet of South Holyoke Housing Limited Partnership as of December 31, 1997 and the related statements of income, changes in partners' equity (deficiency), and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of South Holyoke Housing Limited Partnership as of December 31, 1997, and the results of its operations, changes in partners equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs, issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated February 7, 1996 on our consideration of South Holyoke Housing Limited Partnership's internal control, and reports dated February 7, 1998 on its compliance with laws and regulations and specific requirements applicable to nonmajor HUD program transactions.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information shown on pages 11 to 21 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Joseph B. Cohan & Assoc PC Worcester, Massachusetts February 7, 1998
[Letterhead] [LOGO] JOSEPH B. COHAN & ASSOCIATES, P.C. CERTIFIED PUBLIC ACCOUNTANTS
INDEPENDENT AUDITORS' REPORT
To the Partners of South Holyoke Housing Limited Partnership
We have audited the accompanying balance sheet of South Holyoke Housing Limited Partnership as of December 31, 1996 and the related statements of income, changes in partners' equity (deficiency), and cash flows for the year then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of South Holyoke Housing Limited Partnership as of December 31, 1996, and the results of its operations, changes in partners equity and its cash flows for the years then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards and the Consolidated Audit Guide for Audits of HUD Programs, issued by the U.S. Department of Housing and Urban Development, we have also issued a report dated February 7, 1997 on our consideration of South Holyoke Housing Limited Partnership's internal control, and reports dated February 7, 1997 on its compliance with laws and regulations and specific requirements applicable to nonmajor HUD program transactions.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The accompanying supplementary information shown on pages 11 to 21 is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Joseph B. Cohan & Assoc PC Worcester, Massachusetts February 7, 1997
QUARTER MILL
[Letterhead] [LOGO] Coopers & Lybrand
Report of Independent Accountants
To the Partners of Quarter Mill Associates L.P.:
We have audited the accompanying balance sheet of Quarter Mill Associates, L.P., a Virginia Limited Partnership (the "Partnership"), FHA Project No. 051-35404, as of December 31, 1998, and the related statements of changes in partners' capital, profit and loss, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Quarter Mill Associates, L.P. as of December 31, 1998, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental data included in the report is presented for purposes of additional analysis and is not a required part of the basic financial statements of the Partnership. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
In accordance with Government Auditing Standards, we have also issued a report dated January 25, 1999 on our consideration of the Partnership's internal controls on compliance with specific requirements applicable to its major Housing and Urban Development ("HUD") program and on compliance with specific requirements applicable to fair housing and non-discrimination.
This report is intended solely for the information and use of the partners and HUD and is not intended to be and should not be used by anyone other than these specified individuals. However, this report is a matter of public record and its distribution is not limited.
/s/Coopers & Lybrand L.L.P
Richmond, Virginia January 25, 1999
[Letterhead] [LOGO] Coopers & Lybrand
Report of Independent Accountants
To the Partners of Quarter Mill Associates L.P.:
We have audited the accompanying balance sheet of Quarter Mill Associates, L.P., a Virginia Limited Partnership (the "Partnership"), FHA Project No. 051-35404, as of December 31, 1997, and the related statements of changes in partners' capital accounts, profit and loss, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Quarter Mill Associates, L.P. as of December 31, 1997, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/Coopers & Lybrand L.L.P
Richmond, Virginia January 20, 1998
[Letterhead] [LOGO] Coopers & Lybrand
Report of Independent Accountants
To the Partners of Quarter Mill Associates L.P.:
We have audited the accompanying balance sheet of Quarter Mill Associates, L.P., a Virginia Limited Partnership (the "Partnership"), FHA Project No. 051-35404, as of December 31, 1996, and the related statements of changes in partners' capital accounts, profit and loss, and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Quarter Mill Associates, L.P. as of December 31, 1996, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/Coopers & Lybrand L.L.P Richmond, Virginia January 27, 1997
[Letterhead] [LOGO] MUELLER & WALLA, P.C. Certified Public Accountants Kirkwood, MI
INDEPENDENTS AUDITORS' REPORT
The Partners Horseshoe Bend Associates I, L.P. St. Louis, Missouri
We have audited the accompanying balance sheet of Horseshoe Bend Associates I, L.P. (a limited partnership) as of December 31, 1997 and 1996, and the related statements of operations, partners' capital, and cash flows for the years then ended. These financial statements are the responsibility of the partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provides a reasonable basis for our opinion.
In our opinion, financial statements referred to above present fairly, in all material respects, the financial position of Horseshoe Bend Associates I, L.P. as of December 31, 1997 and 1996 and the results of its operations, changes in partners' capital and cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Mueller, Walla & Albertson, P.C. Mueller, Walla & Albertson, P.C. Certified Public Accountants February 11, 1998
Audit Principal: Phillip A. Weitzel
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants, Business Consultants A Professional Corporation
INDEPENDENT AUDITORS' REPORT
To the Partners Harbour View Associates
We have audited the accompanying balance sheets of Harbour View Associates as of December 31, 1997 and 1996, and the related statements of operations, partners' deficit and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As more fully described in Note C to the financial statements, the Partnership has not recorded certain accrued interest on the mortgage payable in the accompanying financial statements which, in our opinion, should be accrued in order to conform with generally accepted accounting principles. If this interest were recorded, accrued interest payable would be increase by $122,803 and partners' deficit would be increased by $122,803 as of December 31, 1997 and 1996.
In our opinion, except for the effects of not accruing certain interest on the mortgage as discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position Harbour View Associates as of December 31, 1997 and 1996, and the results of its operations, the changes in partners' deficit and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming the Partnership will continue as a going concern. As discussed in Note B to the financial statements, the Partnership is in default of its mortgage due to substantial losses from operations and the unauthorized withdrawal of funds by the former managing general partner and the former managing agent of the Partnership's property. These events raise substantial doubt about the Partnership's ability to continue as a going concern. The Management' plan regarding this matter is also described in Note B. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/Reznick Fedder & Silverman Boston, Massachusetts Federal Employer February 2, 1998 Identification Number: 52-1088612
Audit Principal: Phillip A. Weitzel
WILLOW LAKE
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants Business Consultants
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners Willow Lake Partners II, L.P.
We have audited the accompanying balance sheet of Willow Lake Partners II, L.P., as of December 31, 1998, and the related statements of operations, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position Willow Lake Partners II, L.P. as of December 31, 1998, and the results of its operations, the changes in partners' equity and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/Reznick Fedder & Silverman Boston, Massachusetts January 30, 1999
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants Business Consultants
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners Willow Lake Partners II, L.P.
We have audited the accompanying balance sheet of Willow Lake Partners II, L.P., as of December 31, 1997, and the related statements of operations, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position Willow Lake Partners II, L.P. as of December 31, 1997, and the results of its operations, the changes in partners' equity and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/Reznick Fedder & Silverman Boston, Massachusetts January 30, 1998
[Letterhead] [LOGO] Reznick Fedder & Silverman Certified Public Accountants Business Consultants
REPORT OF INDEPENDENT ACCOUNTANTS
To the Partners Willow Lake Partners II, L.P.
We have audited the accompanying balance sheet of Willow Lake Partners II, L.P., as of December 31, 1996, and the related statements of operations, partners' equity and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position Willow Lake Partners II, L.P. as of December 31, 1996, and the results of its operations, the changes in partners' equity and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/Reznick Fedder & Silverman
Boston, Massachusetts January 16, 1997
RIVER FRONT
[Letterhead] [LOGO] Deloitte & Touche LLP McLean, VA
INDEPENDENT AUDITORS' REPORT
To the Partners of River Front Apartments Limited Partnership Washington, D.C.
We have audited the accompanying balance sheet of River Front Apartments Limited Partnership, A Limited Partnership, Project Number. R458-8E as of December 31, 1998, and the related statements of profit and partners' equity (deficit), and cash flows for the year then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of River Front Apartments Limited Partnership for the year ended December 31, 1997 were audited by other auditors whose report dated January 28, 1998, expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States.. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the 1998 financial statements referred to above present fairly in all material respects, the financial position of River Front Apartments Limited Partnership at December 31, 1998, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards we have also issued a report entitled "Independent Auditor's Report on Compliance and on Internal Control Over Financial Reporting Based on an Audit of the Financial Statements in accordance with Government Auditing Standards" dated February 22, 1999 on our consideration of the Partnership's internal control, over financial reporting and our tests of its compliance with certain provisions of laws regulations and contracts.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The supporting data listed on the contents page is presented for purposes of additional analysis and is not a required part of the financial statements of the Partnership. Such data has been subjected to the auditing procedures applied in our audit of the financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Deloitte & Touche LLP February 22, 1999
[Letterhead] [LOGO] Deloitte & Touche LLP McLean, VA
INDEPENDENT AUDITORS' REPORT
To the Partners of River Front Apartments Limited Partnership Washington, D.C.
We have audited the accompanying statements of financial position of River Front Apartments Limited Partnership, A Limited Partnership, PHFA Project No. R458-8E as of December 31, 1997 and 1996, and the related statements of profit and loss (on HUD Form No. 92410), partners' equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States.. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of River Front Apartments Limited Partnership at December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Deloitte & Touche LLP January 8, 1998
SUSQUEHANNA
[Letterhead] [LOGO] Deloitte & Touche LLP McLean, VA
INDEPENDENT AUDITORS' REPORT
To the Partners of Susquehanna View Limited Partnership Washington, D.C.
We have audited the accompanying balance sheet of Susquehanna View Limited Partnership, A Limited Partnership --- Project Number R- 451-8E as of December 31, 1998, and the related statements of profit and loss, partners' equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Susquehana View Limited Partnership for the year ended December 31, 1997 were audited by other auditors whose report dated January 30, 1998 expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards and Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the 1998 financial statements referred to above present fairly, in all material respects, the financial position of Susquehanna View Limited Partnership, as of December 31, 1998, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
In accordance with Government Auditing Standards we have also issued a report entitled "Independent Auditor's Report on Compliance and on Internal Control Over Financial Reporting Based on an Audit of the Financial Statements in accordance with Government Auditing Standards" dated February 22, 1999 on our consideration of the Partnership's internal control, over financial reporting and our tests of its compliance with certain provisions of laws regulations and contracts.
Our audit was conducted for the purpose of forming an opinion on the financial statements taken as a whole. The supporting data listed on the contents page is presented for purposes of additional analysis and is not a required part of the financial statements of the Partnership. Such data has been subjected to the auditing procedures applied in our audit of the financial statements and, in our opinion, is fairly stated in all material respects in relation to the financial statements taken as a whole.
/s/Deloitte & Touche LLP February 22, 1999
[Letterhead] [LOGO] Deloitte & Touche LLP McLean, VA
INDEPENDENT AUDITORS' REPORT
To the Partners of Susquehanna View Limited Partnership Washington, D.C.
We have audited the accompanying statements of financial position of Susquehanna View Limited Partnership, A Limited Partnership, PHFA Project No. R451-8E as of December 31, 1997 and 1996, and the related statements of profit and loss (on HUD Form No. 92410), partners' equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly in all material respects, the financial position of Susquehanna View Limited Partnership, as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Deloitte & Touche LLP January 30, 1998
[[Letterhead] [LOGO] Plante & Morgan, LLP East Lansing, Michigan
INDEPENDENT AUDITORS' REPORT
To the Partners of The Temple Kyle Limited Partnership, LTD
We have audited the accompanying balance sheet of The Temple Kyle Limited Partnership, Ltd (a Texas limited partnership), as of December 31, 1998 and 1997, and the related statements of operations, partners' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Temple Kyle Limited Partnership, Ltd. at December 31, 1998 and 1997, and the results of its operations, changes in partners' equity, and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Plante & Moran LLP February 16, 1999
Letterhead] [LOGO] Plante & Morgan, LLP East Lansing, Michigan
INDEPENDENT AUDITORS' REPORT
To the Partners of The Temple Kyle Limited Partnership, LTD
We have audited the accompanying balance sheet of The Temple Kyle Limited Partnership, Ltd (a Texas limited partnership), as of December 31, 1997 and 1996, and the related statements of operations, partners' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Temple Kyle Limited Partnership, Ltd. at December 31, 1997 and 1996, and the results of its operations, changes in partners' equity, and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/Plante & Moran LLP February 16, 1998
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership) FINANCIAL REPORT DECEMBER 31, 1996
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership)
CONTENTS
INDEPENDENT AUDITOR'S REPORT 1
FINANCIAL STATEMENTS
Balance Sheet 2
Statement of Operations 3
Statement of Partners' Equity 4
Statement of Cash Flows 5
Notes to Financial Statements 6-7
[letterhead] Independent Auditor's Report
To the Partners The Temple Kyle Limited Partnership, LTD.
We have audited the accompanying balance sheet of The Temple Kyle Limited Partnership, LTD. (a Texas limited partnership), as of December 31, 1996 and 1995, and the related statements of operations, partners' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Temple Kyle Limited Partnership, LTD. as of December 31, 1996 and 1995, and the results of its operations, changes in partners' equity, and cash flows for the years then ended, in conformity with generally accepted accounting principles.
/s/ Plante & Moran, LLP
February 12, 1997
see notes to Financial Statements.
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership) STATEMENT OF OPERATIONS
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership) STATEMENT OF PARTNERS' EQUITY
See Notes to Financial Statements.
See Notes to Financial Statements.
Cash paid for interest was $66,326 in 1996 and $51,609 in 1995.
Significant noncash investing and financing activities are as follows: During 1995, in conjunction with the Partnership's plan of reorganization as described in Note 4, the Partnership recognized a gain on forgiveness of indebtedness totaling $794,492.
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1996 AND 1995
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The Partnership was organized in 1989 as a Texas limited partnership for the purpose of acquiring, owning, constructing, and operating a designated historic structure that contains an apartment complex of 64 units for low to moderate income senior citizens and includes rental space for office and retail facilities. The facility is located in Temple, Texas.
Operations of the Partnership are limited to the rental of apartment units, office, and retail space owned by the Partnership. Significant accounting policies are as follows:
Classification of Assets and Liabilities - The financial affairs of the Partnership do not generally involve a business cycle. Accordingly, the classification of assets and liabilities between current and long-term is not used.
Land, Buildings, and Equipment - Land, buildings, and equipment are recorded at cost. Depreciation is calculated using either the straight-line method or an accelerated method over the estimated useful lives of 7 to 40 years. Maintenance and repairs are charged to expense when incurred.
Income Taxes - No provision has been made in the financial statements for income taxes because, as a partnership, all income and expenses are allocated to the partners for inclusion on their respective income tax returns.
Allocation of Profits and Losses - Losses from operations are allocated to the general partners and limited partners in the ratio of 1 and 99 percent, respectively.
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that effect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
NOTE 2 - NOTE PAYABLE
The Partnership has a note payable to the investor limited partner. The note is due in monthly installments of $13,800, including interest at 7.82 percent through June 1, 1997; $17,600, including interest at prime plus 1.00 percent from July 1, 1997 through its maturity date on June 1, 2005. The note is collateralized by all properties of the Partnership.
NOTE 2 - NOTE PAYABLE (Continued)
Minimum principal payments to maturity as of December 31, 1996, are as follows:
NOTE 3 - RELATED PARTY TRANSACTIONS
The Partnership incurred management fees of $17,397 and $4,237 during the years ended December 31, 1996 and 1995, respectively, to a management company affiliated with the investor limited partner. The amount payable to the management company for management fees totaled $1,669 and $4,237 at December 31,1996 and 1995, respectively, and is included in accounts payable - trade in the balance sheet.
Amounts due to affiliate represent advances from the Investor Limited Partner made to the Partnership in excess of the amount required to be deposited into the replacement reserve account. The advance is unsecured and noninterest bearing and may be returned to the Investor Limited Partner upon approval of the Temple Housing Authority.
NOTE 4 - REORGANIZATION
On May 28, 1993, certain creditors of the Partnership filed an involuntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Western District of Texas, Waco Division. The Partnership emerged from Chapter 11 effective with the beginning of business on September 29, 1995. In general, the Plan for Reorganization provided for resolution of all previous claims against the Partnership as of May 28, 1993, the Chapter 11 filing date. As part of the Plan for Reorganization, the investor limited partner paid $850,000 in cash and entered into a new loan agreement for $612,693 with the mortgagor for payment of all claims due from the Partnership to the mortgagor (Note 2). This transaction resulted in a gain on forgiveness of indebtedness of $794,492 for the year ended December 31, 1995.
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership) FINANCIAL REPORT DECEMBER 31, 1997
Contents
Independent Auditor's Report 1
Financial Statements
Balance Sheet 2
Statement of Operations 3
Statement of Partners' Equity 4
Statement of Cash Flows 5
Notes to Financial Statements 6-7
[letterhead]
Independent Auditor's Report
To the Partners The Temple Kyle Limited Partnership
We have audited the accompanying balance sheet of The Temple Kyle Limited Partnership, LTD. (a Texas limited partnership), as of December 31, 1998 and 1997, and the related statements of operations, partners' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Temple Kyle Limited Partnership, LTD as of December 31, 1998 and 1997, and the results of its operations, changes in partners' equity, and cash flows for the years then ended, in conformity with generally accepted accounting principles.
/s/ Plante & Moran, LLP
The Temple Klye Limited Partnership, LTD.
See Notes to Financial Statements
See Notes to Fimnancial Statements
See Notes to Financial Statements.
See Notes to Financial Statements.
The Temple Klye Limited Partnership, LTD.
Notes to Financial Statements December 31, 1997 and 1996
Note 1 - Nature of Business and Significant Accounting Policies
The Partnership was organized in 1989 as a Texas limited partnership for the purpose of acquiring, owning, constructing, and operating a designated historic structure that contains an apartment complex of 64 units for low to moderate income senior citizens and includes rental space for office and retail facilities. The facility is located in Temple, Texas.
Operations of the Partnership are limited to the rental of apartment units, office, and retail space owned by the Partnership. Significant accounting policies are as follows:
Classification of Assets and Liabilities - The financial affairs of Partnership do not generally involve a business cycle. Accordingly, the classification of assets and liabilities between current and long-term is not used.
Land, Buildings, and Equipment - Land, buildings, and equipment are recorded at cost. Depreciation is calculated using the straight-line and accelerated methods over the estimated useful lives of the assets of 7 to 40 years. Maintenance and repairs are charged to expense as incurred.
Allocation of Profits and Losses - Losses from operations are allocated to the general and limited partners in the ratio of 1 and 99 percent, respectively.
Income Taxes - No provision has been made in the financial statements for income taxes because, as a partnership, all income and expenses are allocated to the partners for inclusion on their respective income tax returns.
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Note 2 - Note Payable
The Partnership has a note payable to the Investor Limited Partner. The note is due in monthly installments of $13,800, including interest at 7.82 percent through June 30, 1997. Effective July 1, 1997 the note is due in monthly installments of $17,600, including interest at prime plus 1.00 percent, through its maturity date on June 1, 2005. At December 31, 1997, the prime interest rate was 8.50 percent. The note is collateralized by all properties of the Partnership.
Minimum principal payments on the note payable to maturity as of December 31, 1997, are as follows:
1998 $ 119,293 1999 127,918 2000 137,163 2001 147,080 2002 157,724 2003 and after 717,073 ------------ Total $1,406,251
Note 3 - Related Party Transactions
The Partnership incurred management fees of $20,844 and $17,397 during the years ended December 31 1997 and 1996, respectively, to a management company affiliated with the Investor Limited Partner. The amount payable to the management company for management fees totaled $31 and $1,669 at December 31, 1997 and 1996, respectively, and is included in accounts payable - trade in the balance sheet.
Due to affiliate represent advances from the Investor Limited Partner made to the Partnership in excess of the amount required to be deposited into the replacement reserve account. The advance is unsecured and noninterest bearing and may be returned to the Investor Limited Partner upon approval of the Temple Housing Authority.
The Temple Kyle Limited Partnership, LTD - - (a Texas partnership) Financial Report December 31, 1998
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. - - Contents
Independent Auditor's Report 1
Financial Statements
Balance Sheet 2
Statement of Operations 3
Statement of Partners' Equity 4
Statement of Cash Flows 5
Notes to Financial Statements 6-8
[letterhead]
Independent Auditor's Report
To the Partners The Temple Kyle Limited Partnership, LTD.
We have audited the accompanying balance sheet of The Temple Kyle Limited Partnership, LTD. (a Texas limited partnership), as of December 31, 1998 and 1997 and the related statements of operations, partners' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Temple Kyle Limited Partnership, LTD. at December 31, 1998 and 1997, and the results of its operations, changes in partners' equity, and cash flows for the years then ended, in conformity with generally accepted accounting principles.
/s/ Plante & Moran, LLP
February 15, 1999
The Temple Kyle Limited Partnership, Ltd.
See Notes to Financial Statements.
THE TEMPLE KYLE LIMITED PARTNERSHIP, LTD. (a Texas limited partnership)
The Temple Kyle Limited Partnership, Ltd.
Notes to Financial Statements December 31, 1998 and 1997
Note 1 - Nature of Business and Significant Accounting Policies
The Partnership was organized in 1989 as a Texas limited partnership for the purpose of acquiring, owning, constructing, and operating a designated historic structure that contains an apartment complex of 64 units for low to moderate income senior citizens and includes rental space for office and retail facilities. The facility is located in Temple, Texas.
Operations of the Partnership are limited to the rental of apartment units, office, and retail space owned by the Partnership. Significant accounting policies are as follows:
Classification of Assets and Liabilities - The financial affairs of the Partnership do not generally involve a business cycle. Accordingly, the classification of assets and liabilities between current and long-term is not used.
Land, Buildings, and Equipment - Land, buildings, and equipment are recorded at cost. Depreciation is calculated using the straight-line and accelerated methods over the estimated useful lives of the assets of 7 to 40 years. Maintenance and repairs are charged to expense as incurred.
Allocation of Profits and Losses - Losses from operations are allocated to the general and limited partners in the ratio of 1 and 99 percent, respectively.
Income Taxes - No provision has been made in the financial statements for income taxes because, as a partnership, all income and expenses are allocated to the partners for inclusion on their respective income tax returns.
Restricted Deposits - The reserve for replacement and tax and insurance escrow accounts are maintained for the benefit of the project and are restricted as to use based on applicable loan documents.
Year 2000 - The management company has assessed the Partnership's exposure to date sensitive computer software programs that may not be operative subsequent to 1999 and has implemented a course of action to minimize Year 2000 risk and ensure that neither significant costs or disruption of normal business operations are encountered. However, because there is no guarantee that all systems of the Partnership and of outside vendors or other entities affecting Partnership's operations will be Year 2000 compliant, the Partnership remains susceptible to consequences of the Year 2000 issue.
Note 1 - Nature of Business and Significant Accounting Policies (Continued)
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Note 2 - Note Payable
The Partnership has a note payable to the Investor Limited Partner. The note is due in monthly installments of $17,600, including interest at prime plus 1.00 percent (an effective rate of 8.75 and 9.50 percent in 1998 and 1997, respectively), through its maturity date on June 1, 2005. At December 31, 1998, the prime interest rate was 7.75 percent. The note is collateralized by all properties of the Partnership.
Minimum principal payments on the note payable to maturity as of December 31, 1998, are as follows:
1999 $ 131,693 2000 141,210 2001 151,420 2002 162,363 2003 174,103 2004 and after 628,249 ------------ Total $ 1,389,038 ============
Note 3 - Related Party Transactions
The Partnership incurred management fees of $19,850 and $20,844 during the years ended December 31, 1998 and 1997, respectively, to a management company affiliated with the Investor Limited Partner. The amount payable to the management company for management fees and reimbursed expenses totaled $1,898 and $31 at December 31, 1998 and 1997, respectively, and is included in accounts payable trade in the balance sheet. In addition, certain expenses totaling $22,572 were paid on behalf of the Partnership by the Investor Limited Partner and are included in accounts payable - trade in the balance sheet.
Due to affiliate represents advances from the Investor Limited Partner made to Partnership in excess of the amount required to be deposited into the replacement reserve account. The advance is unsecured and noninterest bearing and may be returned to the Investor Limited Partner upon approval of the General Partner.
Note 4 - Impairment of Long-Lived Assets
During the year ended December 31, 1998, the apartment complex was deemed to be impaired and written down to its fair value. The fair value, determined by an independent appraisal, was determined using the fair value of comparable apartment complexes in the area and the estimated discounted future cash flows. The determination of fair value did not take into account the value of tax credits allocated to the Partnership. The asset impairment loss of $1,693,514 is the difference between the carrying value and the estimated fair value of the apartment complex and was charged to operations during the year ended December 31, 1998. | 53,376 | 356,682 |
806031_1999.txt | 806031_1999 | 1999 | 806031 | Item 1. Business
Polaris Aircraft Income Fund III, A California Limited Partnership (PAIF-III or the Partnership), was formed primarily to purchase and lease used commercial jet aircraft in order to provide quarterly distributions of cash from operations, to maximize the residual values of aircraft upon sale and to protect Partnership capital through experienced management and diversification. PAIF-III was organized as a California Limited Partnership on June 27, 1984 and will terminate no later than December 2020.
PAIF-III has many competitors in the aircraft leasing market, including airlines, aircraft leasing companies, other Limited Partnerships, banks and several other types of financial institutions. This market is highly competitive and there is no single competitor who has a significant influence on the industry. In addition to other competitors, the General Partner, Polaris Investment Management Corporation (PIMC), and its affiliates, including GE Capital Aviation Services, Inc. (GECAS), Polaris Aircraft Leasing Corporation (PALC), Polaris Holding Company (PHC) and General Electric Capital Corporation (GE Capital), acquire, lease, finance, sell and remarket aircraft for their own accounts and for existing aircraft and aircraft leasing programs managed by them. Further, GECAS provides a significant range of aircraft management services to third parties, including without limitation, AerFi Group plc (formerly GPA Group plc), a public limited company organized in Ireland, together with its consolidated subsidiaries (AerFi), and Airplanes Group, together with its subsidiaries (APG), each of which two groups leases and sells aircraft. Accordingly, in seeking to re-lease and sell its aircraft, the Partnership may be in competition with the General Partner, its affiliates, AerFi, APG, and other third parties to whom GECAS provides aircraft management services from time to time.
A brief description of the aircraft owned by the Partnership is set forth in Item 2.
Item 2. The following table describes certain material terms of the Partnership's leases to Trans World Airlines, Inc. (TWA) as of December 31, 1999:
Number of Lease Lessee Aircraft Type Aircraft Expiration Renewal Options - ------ ------------- ---------- ---------- ---------------
TWA McDonnell Douglas DC-9-30 10 11/04 (1) none
(1) TWA may specify a lease expiration date for each aircraft up to six months before the date shown, provided the average date for the 10 aircraft is November 2004. The TWA leases were modified in 1991 and were extended for an aggregate of 75 months beyond the initial lease expiration date in November 1991 at approximately 46% of the original lease rates. In 1996, the leases were extended for a period of eight years until November 2004. The Partnership also agreed to share in the costs of certain Airworthiness Directives (ADs). If such costs are incurred by TWA, they will be credited against rental payments, subject to annual limitations with a maximum of $500,000 per aircraft over the lease terms.
In October 1994, TWA notified its creditors, including the Partnership, of a proposed restructuring of its debt. Subsequently, GECAS negotiated a standstill agreement with TWA which was approved on behalf of the Partnership by PIMC. That agreement provided for a moratorium of the rent due the Partnership in November 1994 and 75% of the rents due the Partnership from December 1994 through March 1995, with the deferred rents, which aggregated $2.6 million, plus interest being repaid in monthly installments between May 1995 through December 1995. The Partnership received as consideration for the agreement $157,568 and warrants for TWA Common Stock. These warrants were exercised in 1995 and the related stock was subsequently sold in 1996.
In 1996, GECAS, on behalf of the Partnership, negotiated with TWA for the acquisition of noise-suppression devices, commonly known as "hushkits", for the 10 Partnership aircraft currently on lease to TWA, as well as other aircraft owned by affiliates of PIMC and leased to TWA. The 10 aircraft were designated by TWA. The hushkits reconditioned the aircraft so as to meet Stage 3 noise level restrictions. The installation of the 10 hushkits was completed on the Partnership's aircraft in November 1996 and the leases for these 10 aircraft were extended for a period of eight years until November 2004.
The rent payable by TWA under the leases was increased by an amount sufficient to cover the monthly debt service payments on the hushkits and fully repay, during the term of the TWA leases, the amount borrowed. The loan from the engine/hushkit manufacturer is non-recourse to the Partnership and secured by a security interest in the lease receivables.
The Partnership transferred three McDonnell Douglas DC-9-10 aircraft, formerly leased to Midway Airlines, Inc. (Midway), and six Boeing 727-100 aircraft, formerly leased to Continental, to aircraft inventory in 1992. The three McDonnell Douglas DC-9-10 aircraft were disassembled for sale of their component parts, the remainder of which was sold to Soundair, Inc. in 1998. Disassembly of the six Boeing 727-100 aircraft commenced in December 1994. The leases for three Boeing 727-200 aircraft to Continental expired in April 1994. These aircraft were subsequently sold to Continental.
A discussion of the current market condition for the type of aircraft owned by the Partnership follows. For further information, see Demand For Aircraft in the Industry Update Section of Item 7.
McDonnell Douglas DC-9-30 - The McDonnell Douglas DC-9-30 is a short- to medium-range twin-engine jet that was introduced in 1967. Providing reliable, inexpensive lift, these aircraft fill thin niche markets, mostly in the United States. Hushkits are available to bring these aircraft into compliance with Stage 3 noise restrictions at a cost of approximately $1.6 million per aircraft. As noted above, hushkits have been installed on the 10 remaining aircraft. Certain ADs applicable to the McDonnell Douglas DC-9 have been issued to prevent fatigue cracks and control corrosion as discussed in the Industry Update section of Item 7.
The General Partner believes that, in addition to the factors cited above, the deteriorated market for the Partnership's aircraft reflects the airline industry's reaction to the significant expenditures potentially necessary to bring these aircraft into compliance with certain ADs issued by the FAA relating to aging aircraft, corrosion prevention and control, and structural inspection and modification as discussed in the Industry Update section of Item 7.
Item 2. Properties
At December 31, 1999, the Partnership owned a portfolio of 10 used commercial jet aircraft out of its original portfolio of 38 aircraft. The portfolio includes 10 McDonnell Douglas DC-9-30 aircraft leased to Trans World Airlines, Inc. (TWA). The Partnership transferred three McDonnell Douglas DC-9-10 aircraft and six Boeing 727-100 aircraft to aircraft inventory in 1992. The inventoried aircraft were disassembled for sale of their component parts, the remainder of which was sold to Soundair, Inc. in 1998. Of its original aircraft portfolio, the Partnership sold eight DC-9-10 aircraft in 1992 and 1993 and three Boeing 727-200 aircraft in May 1994. In June 1997, the Partnership sold three McDonnell Douglas DC-9-30 aircraft leased to TWA, and five Boeing 727-200 Advanced aircraft leased to Continental Airlines, Inc. (Continental) to Triton Aviation Services III LLC.
The following table describes the Partnership's aircraft portfolio at December 31, 1999 in greater detail:
Year of Cycles Aircraft Type Serial Number Manufacture As of 10/31/99 (1) - ------------- ------------- ----------- ------------------ McDonnell Douglas DC-9-30 47028 1967 87,527 McDonnell Douglas DC-9-30 47030 1967 86,845 McDonnell Douglas DC-9-30 47095 1967 82,669 McDonnell Douglas DC-9-30 47109 1968 85,624 McDonnell Douglas DC-9-30 47134 1967 81,772 McDonnell Douglas DC-9-30 47136 1968 81,841 McDonnell Douglas DC-9-30 47172 1968 83,033 McDonnell Douglas DC-9-30 47173 1968 86,055 McDonnell Douglas DC-9-30 47250 1968 87,215 McDonnell Douglas DC-9-30 47491 1970 78,978
(1) Cycle information as of 12/31/99 was not available.
Item 3.
Item 3. Legal Proceedings
Midway Airlines, Inc. (Midway) Bankruptcy - As previously reported in the Partnership's 1998 Form 10-K, in March 1991, Midway commenced reorganization proceedings under Chapter 11 of the Federal Bankruptcy Code in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division. On August 9, 1991, the Bankruptcy Court approved Midway's rejection of the leases of the Partnership's four DC-9-10 aircraft, and the aircraft were returned to the Partnership on August 12, 1991. On September 18, 1991, the Partnership filed a proof of claim in Midway's bankruptcy proceeding to recover damages for lost rent and for Midway's failure to meet return conditions with respect to the four aircraft. In light of Midway's cessation of operations, on April 30, 1992, the Partnership amended and restated its prior proof of claim and filed an additional proof. To date no payment or settlement of the Partnership's bankruptcy claims has been offered.
Kepford, et al. v. Prudential Securities, et al. -On April 13, 1994, this action was filed in the District Court of Harris County, Texas against Polaris Investment Management Corporation, Polaris Securities Corporation, Polaris Holding Company, Polaris Aircraft Leasing Corporation, the Partnership, Polaris Aircraft Income Fund I, Polaris Aircraft Income Fund II, Polaris Aircraft Income Fund IV, Polaris Aircraft Income Fund V, Polaris Aircraft Income Fund VI, General Electric Capital Corporation, Prudential Securities, Inc., Prudential Insurance Company of America and James J. Darr. The complaint alleges violations of the Texas Securities Act, the Texas Deceptive Trade Practices Act, sections 11 and 12 of the Securities Act of 1933, common law fraud, fraud in the inducement, negligent misrepresentation, negligence, breach of fiduciary duty and civil conspiracy arising from the defendants' alleged misrepresentation and failure to disclose material facts in connection with the sale of limited partnership units in the Partnership and the other Polaris Aircraft Income Funds. Plaintiffs seek, among other things, an award of compensatory damages in an unspecified amount plus interest, and double and treble damages under the Texas Deceptive Trade Practices Act. The trial date for this action was set and rescheduled by the trial court several times, and on September 2, 1999, the court granted a stay of this action pending the submission of the remaining plaintiffs' claims to arbitration.
Other Proceedings - Part III, Item 10 discusses certain other actions which have been filed against the general partner in connection with certain public offerings, including that of the Partnership. The Partnership is not a party to these actions.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters
a) Polaris Aircraft Income Fund III's (PAIF-III or the Partnership) units representing assignments of Limited Partnership interest (Units) are not publicly traded. The Units are held by Polaris Depositary III on behalf of the Partnership's investors (Unit Holders). Currently there is no market for PAIF-III's Units and it is unlikely that any market will develop.
b) Number of Security Holders:
Number of Record Holders Title of Class as of December 31, 1999 ----------------------------------------- ------------------------
Depository Units Representing Assignments Of Limited Partnership Interests: 15,776
General Partnership Interest: 1
c) Dividends:
The Partnership distributed cash to partners on a quarterly basis beginning April 1987. Cash distributions to Unit Holders during 1999 and 1998 totaled $6,374,489 and $19,148,468, respectively. Cash distributions per Limited Partnership unit were $12.75 and $38.30 in 1999 and 1998, respectively.
Item 6.
Item 6. Selected Financial Data
* The portion of such distributions which represents a return of capital on an economic basis will depend in part on the residual sale value of the Partnership's aircraft and thus will not be ultimately determinable until the Partnership disposes of its aircraft. However, such portion may be significant and may equal, exceed or be smaller than the amount shown in the above table.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
At December 31, 1999, Polaris Aircraft Income Fund III (the Partnership) owned a portfolio of 10 used McDonnell Douglas DC-9-30 aircraft leased to Trans World Airlines, Inc. (TWA) out of its original portfolio of 38 aircraft. The Partnership transferred three McDonnell Douglas DC-9-10 aircraft and six Boeing 727-100 aircraft to aircraft inventory in 1992. The inventoried aircraft were disassembled for sale of their component parts, the remainder of which was sold to Soundair, Inc. in 1998. The Partnership sold eight DC-9-10 aircraft in 1992 and 1993 and three Boeing 727-200 aircraft in May 1994. In June 1997, the Partnership sold three McDonnell Douglas DC-9-30 aircraft leased to TWA, and five Boeing 727-200 Advanced aircraft leased to Continental Airlines, Inc. (Continental) to Triton Aviation Services III LLC.
Remarketing Update
General - Polaris Investment Management Corporation (the General Partner or PIMC) evaluates, from time to time, whether the investment objectives of the Partnership are better served by continuing to hold the Partnership's remaining portfolio of Aircraft or marketing such Aircraft for sale. This evaluation takes into account the current and potential earnings of the Aircraft, the conditions in the markets for lease and sale and future outlook for such markets, and the tax consequences of selling rather than continuing to lease the Aircraft.
Partnership Operations
The Partnership reported net income of $5,605,780, or $9.83 per Limited Partnership unit for the year ended December 31, 1999, compared to net income of $5,287,954, or $7.90 per Limited Partnership unit and $4,989,096, or $9.88 per Limited Partnership unit, for the years ended December 31, 1998 and 1997, respectively. Variances in net income may not correspond to variances in net income per Limited Partnership unit due to the allocation of components of income and loss in accordance with the Partnership agreement.
The decrease in rental revenues, depreciation expense and management fees during 1999 and 1998, compared to 1997 was primarily attributable to the sale of 8 aircraft to Triton during 1997. Depreciation expense was further decreased in 1999 and 1998, compared to 1997, as a result of several aircraft having been fully depreciated down to their original estimated residual values during 1998. This decrease was partially offset by additional depreciation, due to the Partnership's downward adjustment of the estimated residual value of the portfolio aircraft, beginning the fourth quarter of 1999.
In November 1996, hushkits were installed on the 10 aircraft currently leased to TWA. The leases for these 10 aircraft were extended for a period of eight years until November 2004. The rent payable by TWA under the leases has been increased by an amount sufficient to cover the monthly debt service payments on the hushkits and fully repay, during the term of the TWA leases, the amount borrowed. The Partnership recorded $581,941, $908,701 and $1,205,566 in interest expense on the amount borrowed to finance the hushkits during 1999, 1998 and 1997, respectively.
The Partnership recorded other income of $785,094 during 1997 compared to $-0- and $64 during 1998 and 1999, respectively. Other income, in 1997, was primarily the result of the receipt of $743,476 related to amounts due under the TWA maintenance credit and rent deferral agreement.
Interest income decreased during 1998, as compared to 1997, primarily due to the payoff of notes receivable from Continental Airlines, Inc. and Triton during 1997. Interest income further decreased during 1999, as compared to 1998, primarily due to a decrease in the cash reserves.
Operating expense decreased in 1999, when compared to 1998 primarily due to legal expense related to the Ron Wallace Litigation Settlement in 1998 as more fully described below.
Administrative expenses decreased in 1999 compared 1998 and 1997 primarily due to additional printing and postage costs incurred in 1998 as a result of the Triton litigation and settlement.
The Partnership periodically reviews the estimated realizability of the residual values at the projected end of each aircraft's economic life based on estimated residual values obtained from independent parties which provide current and future estimated aircraft values by aircraft type.
The Partnership's future earnings are impacted by the net effect of the adjustments to the carrying value of the aircraft (which has the effect of decreasing future depreciation expense), and the downward adjustments to the estimated residual values (which has the effect of increasing future depreciation expense).
The Partnership made a downward adjustment to the estimated residual value of its aircraft as of October 1, 1999. As a result of the 1999 adjustment to the estimated residual value, the Partnership recognized increased depreciation expense in 1999 of approximately $311,641 or $.62 per Limited Partners unit.
Liquidity and Cash Distributions
Liquidity - The Partnership received all lease payments from lessees, except for the $850,000 December 27, 1999 payment due from TWA, which was received on January 3, 2000. This amount was included in rent and other receivables on the balance sheet at December 31, 1999. While TWA has committed to an uninterrupted flow of lease payments, there can be no assurance that TWA will continue to honor its obligations in the future.
During 1998 and 1997, the Partnership received net proceeds from the sale of aircraft inventory of $230,577 and $590,981, respectively. This includes the sale of remaining inventory of aircraft parts from the four disassembled aircraft to Soundair in 1998 for $100,000. There were no such sales in 1999.
The Partnership sold its remaining inventory of aircraft parts from the nine disassembled aircraft, to Soundair, Inc. The remaining inventory, with a net carrying value of $-0-, was sold effective February 1, 1998 for $100,000, less amounts previously received for sales as of that date. The net purchase price of $88,596 was paid in September 1998, and is included in gain on sale of aircraft inventory.
PIMC has determined that the Partnership maintain cash reserves as a prudent measure to ensure that the Partnership has available funds in the event that the aircraft presently on lease to TWA require remarketing, and for other contingencies including expenses of the Partnership. The Partnership's cash reserves will be monitored and may be revised from time to time as further information becomes available in the future.
As discussed in Note 3 to the financial statements (Item 8), the Partnership agreed to share the cost of meeting certain Airworthiness Directives (ADs) with TWA. In accordance with the cost-sharing agreement, TWA may offset up to an additional $1.0 million against rental payments, subject to annual limitations, over the remaining lease terms.
Cash Distributions - Cash distributions to Limited Partners were $6,374,489, $19,148,468, and $11,100,000 in 1999, 1998 and 1997, respectively. Cash distributions per Limited Partnership unit totaled $12.75, $38.30, and $22.20 in 1999, 1998 and 1997, respectively. The timing and amount of future cash distributions are not yet known and will depend on the Partnership's future cash
requirements (including expenses of the Partnership) and need to retain cash reserves as previously discussed in the Liquidity section, and the receipt of rental payments from TWA.
Impact of the Year 2000 Issue
To date, the Partnership has not incurred any expenditures related to the Year 2000 issue nor does it expect to incur any material costs in the future.
Sale of Aircraft and Inventory
Sale of Aircraft Inventory to Soundair, Inc. - The Partnership sold its remaining inventory of aircraft parts from the six disassembled aircraft, to Soundair, Inc. The remaining inventory, with a net carrying value of $-0-, was sold effective February 1, 1998 for $100,000, less amounts previously received for sales as of that date. The net purchase price of $88,596 was paid in September 1998, and is included in gain on sale of aircraft inventory.
Sale of Aircraft to Triton - On May 28, 1997, PIMC, on behalf of the Partnership, executed definitive documentation for the purchase of 8 of the Partnership's 18 remaining aircraft (the "Aircraft") and certain of its notes receivables by Triton Aviation Services III LLC, a special purpose company (the "Purchaser"). The closings for the purchase of the 8 Aircraft occurred from June 5, 1997 to June 25, 1997. The Purchaser is managed by Triton Aviation Services, Ltd. ("Triton Aviation" or the "Manager"), a privately held aircraft leasing company which was formed in 1996 by Triton Investments, Ltd., a company which has been in the marine cargo container leasing business for 17 years and is diversifying its portfolio by leasing commercial aircraft. Each Aircraft was sold subject to the existing leases.
The Terms of the Transaction - The total contract purchase price (the "Purchase Price") to the Purchaser was $10,947,000 which was allocated to the Aircraft and a note receivable by the Partnership. The Purchaser paid into an escrow account $1,233,289 of the Purchase Price in cash at the closing of the first aircraft and delivered a promissory note (the "Promissory Note") for the balance of $9,713,711. The Partnership received payment of $1,233,289 from the escrow account on June 26, 1997. On December 30, 1997, the Partnership received prepayment in full of the outstanding note receivable and interest earned by the Partnership to that date.
Under the purchase agreement, the Purchaser purchased the Aircraft effective as of April 1, 1997 notwithstanding the actual closing dates. The utilization of an effective date facilitated the determination of rent and other allocations between the parties. The Purchaser had the right to receive all income and proceeds, including rents and receivables, from the Aircraft accruing from and after April 1, 1997, and the Promissory Note commenced bearing interest as of April 1, 1997 subject to the closing of the Aircraft. Each Aircraft was sold subject to the existing leases.
The Accounting Treatment of the Transaction - In accordance with GAAP, the Partnership recognized rental income up until the closing date for each aircraft which occurred from June 5, 1997 to June 25, 1997. However, under the terms of the transaction, the Purchaser was entitled to receive any payments of the rents, interest income and receivables accruing from April 1, 1997. As a result, the Partnership made payments to the Purchaser for the amounts due and received from April 1, 1997 to the closing date. Amounts totaling $1,341,968 during this period are included in rents from operating leases, interest and other income. For financial reporting purposes, the cash down payment portion of the sales proceeds of $1,233,289 has been adjusted by the following; income and proceeds, including rents and receivables from the effective date of April 1, 1997 to the closing date, interest due from the Purchaser on the cash portion of the purchase price, interest on the Promissory Note from the effective date of April 1, 1997 to the closing date and estimated selling costs. As a result of these
GAAP adjustments, the net adjusted sales price recorded by the Partnership, including the Promissory Note, was $9,827,305.
The Aircraft sold pursuant to the definitive documentation executed on May 28, 1997 had been classified as aircraft held for sale from that date until the actual closing date. Under GAAP, aircraft held for sale are carried at their fair market value less estimated costs to sell. The adjustment to the sales proceeds described above and revisions to estimated costs to sell the Aircraft required the Partnership to record an adjustment to the net carrying value of the aircraft held for sale of $1,092,046 during the three months ended June 30, 1997. This adjustment to the net carrying value of the aircraft held for sale is included in depreciation expense on the statement of operations.
Ron Wallace Litigation Settlement
Ron Wallace v. Polaris Investment Management Corporation, et al. - On or about June 18, 1997, a purported class action entitled Ron Wallace v. Polaris Investment Management Corporation, et al. was filed on behalf of the unitholders of Polaris Aircraft Income Funds II through VI in the Superior Court of the State of California, County of San Francisco. The complaint names each of Polaris Investment Management Corporation (PIMC), GE Capital Aviation Services, Inc. (GECAS), Polaris Aircraft Leasing Corporation, Polaris Holding Company, General Electric Capital Corporation, certain executives of PIMC and GECAS and John E. Flynn, a former PIMC executive, as defendants. The complaint alleges that defendants committed a breach of their fiduciary duties with respect to the Sale Transaction involving the Partnership as described in Item 7, under the caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997, an amended complaint was filed adding additional plaintiffs, and on December 18, 1997, the plaintiffs filed a second amended complaint asserting their claims derivatively.
On November 9, 1998, defendants, acting through their counsel, entered into a settlement agreement with plaintiffs and with the plaintiff in a related action, "Accelerated" High Yield Income Fund II, Ltd., L.P. v. Polaris Investment Management Corporation, et al. The settlement agreement does not provide for any payments to be made to the Partnership. Plaintiff's counsel sought reimbursement from the Partnership for its attorneys' fees and expenses. A settlement notice setting forth the terms of the settlement was mailed to the last known address of each unitholder of the Partnership on November 20, 1998. On December 24, 1998, the Court approved the terms of the settlement and approved plaintiffs' attorney's fees and expenses in the amount of $288,949, which is included in 1998 operating expenses.
Industry Update
Maintenance of Aging Aircraft - The process of aircraft maintenance begins at the aircraft design stage. For aircraft operating under Federal Aviation Administration (FAA) regulations, a review board consisting of representatives of the manufacturer, FAA representatives and operating airline representatives is responsible for specifying the aircraft's initial maintenance program. The General Partner understands that this program is constantly reviewed and modified throughout the aircraft's operational life.
Since 1988, the FAA, working with the aircraft manufacturers and operators, has issued a series of ADs which mandate that operators conduct more intensive inspections, primarily of the aircraft fuselages. The results of these mandatory inspections may uncover the need for repairs or structural modifications that may not have been required under pre-existing maintenance programs.
In addition, an AD adopted in 1990, applicable to McDonnell Douglas aircraft, requires replacement or modification of certain structural items on a specific timetable. These structural items were formerly subject to periodic inspection, with replacement when necessary. The AD requires specific work to be performed at various cycle thresholds between 40,000 and 100,000 cycles, and on specific
date or age thresholds. The estimated cost of compliance with all of the components of this AD is approximately $850,000 per aircraft. The extent of modifications required to an aircraft varies according to the level of incorporation of design improvements at manufacture.
In January 1993, the FAA adopted another AD intended to mitigate corrosion of structural components, which would require repeated inspections from 5 years of age throughout the life of an aircraft, with replacement of corroded components as needed. Integration of the new inspections into each aircraft operator's maintenance program was required by January 31, 1994.
The Partnership's existing leases require the lessees to maintain the Partnership's aircraft in accordance with an FAA-approved maintenance program during the lease term. At the end of the leases, each lessee is generally required to return the aircraft in airworthy condition, including compliance with all ADs for which action is mandated by the FAA during the lease term. The Partnership agreed to bear a portion of certain maintenance and/or AD compliance costs, as discussed in Item 1, with respect to the aircraft leased to TWA. An aircraft returned to the Partnership as a result of a lease default would most likely not be returned to the Partnership in compliance with all return conditions required by the lease. In negotiating subsequent leases, market conditions currently generally require that the Partnership bear some or all of the costs of compliance with future ADs or ADs that have been issued, but which did not require action during the previous lease term. The ultimate effect on the Partnership of compliance with the FAA maintenance standards is not determinable at this time and will depend on a variety of factors, including the state of the commercial aircraft industry, the timing of the issuance of ADs, and the status of compliance therewith at the expiration of the current leases.
Aircraft Noise - Another issue which has affected the airline industry is that of aircraft noise levels. The FAA has categorized aircraft according to their noise levels. Stage 1 aircraft, which have the highest noise level, are no longer allowed to operate from civil airports in the United States. Stage 2 aircraft meet current FAA requirements, subject to the phase-out rules discussed below. Stage 3 aircraft are the most quiet and Stage 3 is the standard for all new aircraft.
On September 24, 1991, the FAA issued final rules on the phase-out of Stage 2 aircraft by the end of this decade. The key features of the rule include:
- Compliance can be accomplished through a gradual process of phase-in or phase-out (see below) on each of three interim compliance dates: December 31, 1994, 1996 and 1998. All Stage 2 aircraft must be phased out of operations in the contiguous United States by December 31, 1999, with waivers available in certain specific cases to December 31, 2003.
- All operators have the option of achieving compliance through a gradual phase-out of Stage 2 aircraft (i.e., eliminate 25% of its Stage 2 fleet on each of the compliance dates noted above), or a gradual phase-in of Stage 3 aircraft (i.e., 55%, 65% and 75% of an operator's fleet must consist of Stage 3 aircraft by the respective interim compliance dates noted above).
The federal rule does not prohibit local airports from issuing more stringent phase-out rules. In fact, several local airports have adopted more stringent noise requirements which restrict the operation of Stage 2 and certain Stage 3 aircraft.
Other countries have also adopted noise policies. The European Union (EU) adopted a non-addition rule in 1989, which directed each member country to pass the necessary legislation to prohibit airlines from adding Stage 2 aircraft to their fleets after November 1, 1990, with all Stage 2 aircraft phased-out by the year 2002. The International Civil Aviation Organization has also endorsed the phase-out of Stage 2 aircraft on a world-wide basis by the year 2002.
Hushkit modifications, which allow Stage 2 aircraft to meet Stage 3 requirements, are currently available for the Partnership's aircraft. Hushkits were added to 10 of the Partnership's Stage 2 aircraft in 1996.
Currently, legislation has been drafted and is under review by the EU to adopt anti-hushkitting regulations within member states. The legislation seeks to ban hushkitted aircraft from being added to member states registers after May 1, 2000 (deferred from an April 1, 1999 deadline) and will preclude all operation of hushkitted aircraft within the EU by April 1, 2002. The effect of this proposal has been to reduce the demand for hushkitted aircraft within the EU and its neighboring states, including the former Eastern Block states.
Demand for Aircraft - At year end 1999, there were approximately 13,550 jet aircraft in the world fleet. Approximately 1,800 aircraft were leased or sold during 1999, an increase of 9% over 1998. Air travel continued to be strong in 1999 with traffic growth around the 5% level. In 2000 traffic is projected to drop off slightly to an estimated growth rate of 4.5%. Surging fuel prices in 1999 hit the Gulf War levels as airlines added a $20 surcharge to their tickets. The increase in fuel prices cost the industry an approximate $350 million in the fourth quarter of 1999. Alliances continued to evolve in 1999 as airlines aligned themselves with code sharing, joint pricing, schedule integration and corporate agreements. The stage II fleet was projected to drop to 5% at year end 1999 and to 2% in 2002. During 1999 Airbus captured 55% of the orders placed as they outpaced Boeing by 10%. Manufacturers continue to produce at high levels compared to what demand will require in the future years. Asia has improved over 1998, however South America continues its economic turmoil. Timing of when the down cycle ends or how severe it will be is still in question, however it should be less severe than anticipated in 1998.
Effects on the Partnership's Aircraft - The Partnership periodically reviews the estimated realizability of the residual values at the projected end of each aircraft's economic life based on estimated residual values obtained from independent parties which provide current and future estimated aircraft values by aircraft type. For any downward adjustment in estimated residual value or decrease in the projected remaining economic life, the depreciation expense over the projected remaining economic life of the aircraft is increased.
If the projected net cash flow for each aircraft (projected rental revenue, net of management fees, less projected maintenance costs, if any, plus the estimated residual value) is less than the carrying value of the aircraft, an impairment loss is recognized.
As discussed above, the Partnership uses information obtained from third party valuation services in arriving at its estimate of fair value for purposes of determining residual values. The Partnership will use similar information, plus available information and estimates related to the Partnership's aircraft, to determine an estimate of fair value to measure impairment as required by SFAS No. 121. The estimates of fair value can vary dramatically depending on the condition of the specific aircraft and the actual marketplace conditions at the time of the actual disposition of the asset. If assets are deemed impaired, there could be substantial write-downs in the future.
The Partnership made a downward adjustment to the estimated residual value of its aircraft as of October 1, 1999. As a result of the 1999 adjustment to the estimated residual value, the Partnership recognized increased depreciation expense in 1999 of approximately $311,641 or $.62 per Limited Partnership unit.
Item 8.
Item 8. Financial Statements and Supplementary Data
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership
FINANCIAL STATEMENTS AS OF DECEMBER 31, 1999 AND 1998
AND FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
TOGETHER WITH THE
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Partners of Polaris Aircraft Income Fund III, A California Limited Partnership:
We have audited the accompanying balance sheets of Polaris Aircraft Income Fund III, A California Limited Partnership as of December 31, 1999 and 1998, and the related statements of operations, changes in partners' capital (deficit) and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the General Partner. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partner, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Polaris Aircraft Income Fund III, A California Limited Partnership as of December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
San Francisco, California, January 21, 2000
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership
BALANCE SHEETS
DECEMBER 31, 1999 AND 1998
1999 1998 ---- ---- ASSETS:
CASH AND CASH EQUIVALENTS $ 12,317,505 $ 13,423,701
RENT AND OTHER RECEIVABLES 863,257 850,748
AIRCRAFT, net of accumulated depreciation of $59,165,441 in 1999 and $56,439,234 in 1998 23,019,136 25,745,343 ------------ ------------
Total Assets $ 36,199,898 $ 40,019,792 ============ ============
LIABILITIES AND PARTNERS' CAPITAL (DEFICIT):
PAYABLE TO AFFILIATES $ 170,274 $ 115,888
ACCOUNTS PAYABLE AND ACCRUED LIABILITIES 127,948 121,632
DEFERRED INCOME 3,047,843 1,837,210
NOTES PAYABLE 4,177,934 7,792,177 ------------ ------------
Total Liabilities 7,523,999 9,866,907 ------------ ------------
PARTNERS' CAPITAL (DEFICIT): General Partner (3,657,030) (3,642,196) Limited Partners, 499,960 units issued and outstanding 32,332,929 33,795,081 ------------ ------------
Total Partners' Capital (Deficit) 28,675,899 30,152,885 ------------ ------------
Total Liabilities and Partners' Capital (Deficit) $ 36,199,898 $ 40,019,792 ============ ============
The accompanying notes are an integral part of these statements.
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997 ---- ---- ----
REVENUES: Rent from operating leases $ 8,989,368 $ 8,989,368 $11,965,617 Interest 601,444 835,969 1,617,688 Gain on sale of aircraft inventory -- 230,577 590,981 Other 64 -- 785,094 ----------- ----------- -----------
Total Revenues 9,590,876 10,055,914 14,959,380 ----------- ----------- -----------
EXPENSES: Depreciation 2,726,207 2,826,371 7,930,392 Management fees to General Partner 347,147 347,147 420,482 Interest 581,941 908,701 1,205,566 Operating 17,722 318,160 33,158 Administration and other 312,079 367,581 380,686 ----------- ----------- -----------
Total Expenses 3,985,096 4,767,960 9,970,284 ----------- ----------- -----------
NET INCOME $ 5,605,780 $ 5,287,954 $ 4,989,096 =========== =========== ===========
NET INCOME ALLOCATED TO THE GENERAL PARTNER $ 693,443 $ 1,339,516 $ 49,891 =========== =========== ===========
NET INCOME ALLOCATED TO THE LIMITED PARTNERS $ 4,912,337 $ 3,948,438 $ 4,939,205 =========== =========== ===========
NET INCOME PER LIMITED PARTNERSHIP UNIT $ 9.83 $ 7.90 $ 9.88 =========== =========== ===========
The accompanying notes are an integral part of these statements.
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership
STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
General Limited Partner Partners Total ------- -------- -----
Balance, December 31, 1996 $ (1,670,662) $ 55,159,826 $ 53,489,164
Net income 49,891 4,939,205 4,989,096
Cash distributions to partners (1,233,333) (11,100,000) (12,333,333) ------------ ------------ ------------
Balance, December 31, 1997 (2,854,104) 48,999,031 46,144,927
Net income 1,339,516 3,948,438 5,287,954
Capital redemptions -- (3,920) (3,920)
Cash distributions to partners (2,127,608) (19,148,468) (21,276,076) ------------ ------------ ------------
Balance, December 31, 1998 (3,642,196) 33,795,081 30,152,885
Net income 693,443 4,912,337 5,605,780
Cash distributions to partners (708,277) (6,374,489) (7,082,766) ------------ ------------ ------------
Balance, December 31, 1999 $ (3,657,030) $ 32,332,929 $ 28,675,899 ============ ============ ============
The accompanying notes are an integral part of these statements.
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
The accompanying notes are an integral part of these statements.
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999
1. Accounting Principles and Policies
Accounting Method - Polaris Aircraft Income Fund III, A California Limited Partnership (PAIF-III or the Partnership), maintains its accounting records, prepares its financial statements and files its tax returns on the accrual basis of accounting. The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates. The most significant estimates with regard to these financial statements are related to the projected cash flows analysis in determining the fair value of assets.
Cash and Cash Equivalents - This includes deposits at banks and investments in money market funds. Cash and Cash Equivalents is stated at cost, which approximates fair value.
Aircraft and Depreciation - The aircraft are recorded at cost, which includes acquisition costs. Depreciation to an estimated residual value is computed using the straight-line method over the estimated economic life of the aircraft which was originally estimated to be 30 years from the date of manufacture. Depreciation in the year of acquisition was calculated based upon the number of days that the aircraft were in service.
The Partnership periodically reviews the estimated realizability of the residual values at the projected end of each aircraft's economic life. For any downward adjustment in estimated residual value or decrease in the projected remaining economic life, the depreciation expense over the projected remaining economic life of the aircraft will be increased.
If the projected net cash flow for each aircraft (projected rental revenue, net of management fees, less projected maintenance costs, if any, plus the estimated residual value) is less than the carrying value of the aircraft, an impairment loss is recognized. Pursuant to Statement of Financial Accounting Standards (SFAS) No. 121, as discussed in Note 3, measurement of an impairment loss will be based on the "fair value" of the asset as defined in the statement.
Capitalized Costs - Aircraft modification and maintenance costs which are determined to increase the value or extend the useful life of the aircraft are capitalized and amortized using the straight-line method over the estimated useful life of the improvement. These costs are also subject to periodic evaluation as discussed above.
Aircraft Inventory - Aircraft held in inventory for sale are reflected at the lower of depreciated cost or estimated net realizable value. Proceeds from sales are applied against inventory until the book value is fully recovered. The remaining book value of the inventory was recovered in 1996. The Partnership sold its remaining inventory of aircraft parts in 1998. Proceeds in excess of the inventory net book value are recorded as revenue when received.
Operating Leases - The aircraft leases are accounted for as operating leases. Lease revenues are recognized in equal installments over the terms of the leases.
Operating Expenses - Operating expenses include costs incurred to maintain, insure and lease the Partnership's aircraft, including costs related to lessee defaults and costs of disassembling aircraft inventory.
Net Income Per Limited Partnership Unit - Net income per Limited Partnership unit is based on the Limited Partners' share of net income or loss and the number of units outstanding of 499,960 for the year ended December 31, 1999 and 1998, and 500,000 for the year ended December 31, 1997.
Income Taxes - The Partnership files federal and state information income tax returns only. Taxable income or loss is reportable by the individual partners.
2. Organization and the Partnership
The Partnership was formed on June 27, 1984 for the purpose of acquiring and leasing aircraft. The Partnership will terminate no later than December 2020. Upon organization, both the General Partner and the depositary contributed $500 to capital. The Partnership recognized no profits and losses during the periods ended December 31, 1984 and 1985. The offering of depositary units (Units), representing assignments of Limited Partnership interest, terminated on September 30, 1987 at which time the Partnership had sold 500,000 Units of $500, representing $250,000,000. All unit holders were admitted to the Partnership on or before September 30, 1987. During January 1998, 40 units were redeemed by the Partnership in accordance with section 18 of the Limited Partnership agreement. At December 31, 1999, there were 499,960 units outstanding, net of redemptions.
Polaris Investment Management Corporation (PIMC), the sole General Partner of the Partnership, supervises the day-to-day operations of the Partnership. Polaris Depository Company III (PDC) serves as the depositary. PIMC and PDC are wholly-owned subsidiaries of Polaris Aircraft Leasing Corporation (PALC). Polaris Holding Company (PHC) is the parent company of PALC. General Electric Capital Corporation (GE Capital), an affiliate of General Electric Company, owns 100% of PHC's outstanding common stock. PIMC has entered into a services agreement dated as of July 1, 1994 with GE Capital Aviation Services, Inc. (GECAS). Allocations to affiliates are described in Notes 8 and 9.
3. Aircraft
At December 31, 1999, the Partnership owned 10 aircraft from its original portfolio of 38 used commercial jet aircraft, which were acquired and leased or sold as discussed below. All aircraft were acquired from an affiliate and purchased within one year of the affiliate's acquisition at the affiliate's original price paid. The aircraft leases are net operating leases, requiring the lessees to pay all operating expenses associated with the aircraft during the lease term. While the leases require the lessees to comply with Airworthiness Directives (ADs) which have been or may be issued by the Federal Aviation Administration and require compliance during the lease term, in certain of the leases, the Partnership has agreed to share in the cost of compliance with ADs. TWA may offset up to an additional $1.0 million against rental payments, subject to annual limitations, over the remaining lease terms. The leases generally state a minimum acceptable return condition for which the lessee is liable under the terms of the lease agreement. Certain leases also provide that if the aircraft are returned at a level above the minimum acceptable level, the Partnership must reimburse the lessee for the related excess, subject to certain limitations. The related liability, if any, is currently inestimable and therefore is not reflected in the financial statements. Of its original portfolio of 38 aircraft, the Partnership sold one aircraft in 1992, seven aircraft in 1993, three aircraft in 1994 and eight aircraft in 1997. In addition, nine aircraft were disassembled for sale of their component parts (Note 6), the remainder of which was sold to Soundair, Inc. in 1998.
The following table describes the Partnership's aircraft portfolio at December 31, 1999 in greater detail:
Year of Aircraft Type Serial Number Manufacture - ------------- ------------- ----------- McDonnell Douglas DC-9-30 47028 1967 McDonnell Douglas DC-9-30 47030 1967 McDonnell Douglas DC-9-30 47095 1967 McDonnell Douglas DC-9-30 47109 1968 McDonnell Douglas DC-9-30 47134 1967 McDonnell Douglas DC-9-30 47136 1968 McDonnell Douglas DC-9-30 47172 1968 McDonnell Douglas DC-9-30 47173 1968 McDonnell Douglas DC-9-30 47250 1968 McDonnell Douglas DC-9-30 47491 1970
Ten McDonnell Douglas DC-9-30s - Initially thirteen aircraft were acquired for $86,163,046 during 1986 and 1987, and leased to Ozark Air Lines, Inc. (Ozark). In 1987, Trans World Airlines, Inc. (TWA) merged with Ozark and assumed the leases. The leases were modified and extended prior to TWA's bankruptcy filing. In June 1997, three of the thirteen aircraft were sold, subject to the existing leases, to Triton Aviation Services III LLC, as discussed in Note 4. The leases for 10 of the 13 aircraft were extended again for eight years until November 2004.
The following is a schedule by year of future minimum rental revenue under the existing leases:
Year Amount ---- ------ 2000 $10,200,000 2001 10,200,000 2002 7,450,000 2003 7,200,000 2004 6,000,000 ----------- $41,050,000 ===========
Future minimum rental payments may be offset or reduced by future costs as described above.
As discussed in Note 1, the Partnership periodically reviews the estimated realizability of the residual values at the projected end of each aircraft's economic life based on estimated residual values obtained from independent parties which provide current and future estimated aircraft values by aircraft type.
The Partnership's future earnings are impacted by the net effect of the adjustments to the carrying value of the aircraft (which has the effect of decreasing future depreciation expense), and the downward adjustments to the estimated residual values (which has the effect of increasing future depreciation expense).
The Partnership made a downward adjustment to the estimated residual value of its aircraft as of October 1, 1999. As a result of the 1999 adjustment to the estimated residual value, the Partnership recognized increased depreciation expense in 1999 of approximately $311,641 or $.62 per Limited Partnership unit.
As discussed above, the Partnership uses information obtained from third party valuation services in arriving at its estimate of fair value for purposes of determining residual values. The Partnership will use similar information, plus available information and estimates related to the Partnership's aircraft, to determine an estimate of fair value to measure impairment as required by SFAS No. 121. The estimates of fair value can vary dramatically depending on the
condition of the specific aircraft and the actual marketplace conditions at the time of the actual disposition of the asset. If assets are deemed impaired, there could be substantial write-downs in the future.
The General Partner evaluates, from time to time, whether the investment objectives of the Partnership are better served by continuing to hold the Partnership's remaining portfolio of Aircraft or marketing such Aircraft for sale. This evaluation takes into account the current and potential earnings of the Aircraft, the conditions in the markets for lease and sale and future outlook for such markets, and the tax consequences of selling rather than continuing to lease the Aircraft. The General Partner has had discussions with third parties regarding the possibility of selling some or all of these Aircraft. While such discussions may continue, and similar discussions may occur again in the future, there is no assurance that such discussions will result in the Partnership receiving a purchase offer for all or any of the Aircraft which the General Partner would regard as acceptable.
4. Sale of Aircraft
Sale of Aircraft to Triton - On May 28, 1997, PIMC, on behalf of the Partnership, executed definitive documentation for the purchase of 8 of the Partnership's 18 remaining aircraft (the "Aircraft") and certain of its notes receivables by Triton Aviation Services III LLC, a special purpose company (the "Purchaser"). The closings for the purchase of the 8 Aircraft occurred from June 5, 1997 to June 25, 1997. The Purchaser is managed by Triton Aviation Services, Ltd. ("Triton Aviation" or the "Manager"), a privately held aircraft leasing company which was formed in 1996 by Triton Investments, Ltd., a company which has been in the marine cargo container leasing business for 17 years and is diversifying its portfolio by leasing commercial aircraft. Each Aircraft was sold subject to the existing leases.
The Terms of the Transaction - The total contract purchase price (the "Purchase Price") to the Purchaser was $10,947,000 which was allocated to the Aircraft and a note receivable by the Partnership. The Purchaser paid into an escrow account $1,233,289 of the Purchase Price in cash at the closing of the first aircraft and delivered a promissory note (the "Promissory Note") for the balance of $9,713,711. The Partnership received payment of $1,233,289 from the escrow account on June 26, 1997. On December 30, 1997, the Partnership received prepayment in full of the outstanding note receivable and interest earned by the Partnership to that date.
Under the purchase agreement, the Purchaser purchased the Aircraft effective as of April 1, 1997 notwithstanding the actual closing dates. The utilization of an effective date facilitated the determination of rent and other allocations between the parties. The Purchaser had the right to receive all income and proceeds, including rents and receivables, from the Aircraft accruing from and after April 1, 1997, and the Promissory Note commenced bearing interest as of April 1, 1997 subject to the closing of the Aircraft. Each Aircraft was sold subject to the existing leases.
The Accounting Treatment of the Transaction - In accordance with GAAP, the Partnership recognized rental income up until the closing date for each aircraft which occurred from June 5, 1997 to June 25, 1997. However, under the terms of the transaction, the Purchaser was entitled to receive any payments of the rents, interest income and receivables accruing from April 1, 1997. As a result, the Partnership made payments to the Purchaser for the amounts due and received from April 1, 1997 to the closing date. Amounts totaling $1,341,968 during this period are included in rents from operating leases, interest and other income. For financial reporting purposes, the cash down payment portion of the sales proceeds of $1,233,289 has been adjusted by the following; income and proceeds, including rents and receivables from the effective date of April 1, 1997 to the closing date, interest due from the Purchaser on the cash portion of the purchase price, interest on the Promissory Note from the effective date of April 1, 1997 to the closing date and estimated selling costs. As a result of these GAAP adjustments, the net adjusted sales price recorded by the Partnership, including the Promissory Note, was $9,827,305.
The Aircraft sold pursuant to the definitive documentation executed on May 28, 1997 had been classified as aircraft held for sale from that date until the actual closing date. Under GAAP, aircraft held for sale are carried at their fair market value less estimated costs to sell. The adjustment to the sales proceeds described above and revisions to estimated costs to sell the Aircraft required the Partnership to record an adjustment to the net carrying value of the aircraft held for sale of $1,092,046 during the three months ended June 30, 1997. This adjustment to the net carrying value of the aircraft held for sale is included in depreciation and amortization expense on the statement of operations.
5. Ron Wallace Litigation Settlement
Ron Wallace v. Polaris Investment Management Corporation, et al. - On or about June 18, 1997, a purported class action entitled Ron Wallace v. Polaris Investment Management Corporation, et al. was filed on behalf of the unitholders of Polaris Aircraft Income Funds II through VI in the Superior Court of the State of California, County of San Francisco. The complaint names each of Polaris Investment Management Corporation (PIMC), GE Capital Aviation Services, Inc. (GECAS), Polaris Aircraft Leasing Corporation, Polaris Holding Company, General Electric Capital Corporation, certain executives of PIMC and GECAS and John E. Flynn, a former PIMC executive, as defendants. The complaint alleges that defendants committed a breach of their fiduciary duties with respect to the Sale Transaction involving the Partnership as described in Note 4, under the caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997, an amended complaint was filed adding additional plaintiffs, and on December 18, 1997, the plaintiffs filed a second amended complaint asserting their claims derivatively.
On November 9, 1998, defendants, acting through their counsel, entered into a settlement agreement with plaintiffs and with the plaintiff in a related action, "Accelerated" High Yield Income Fund II, Ltd., L.P. v. Polaris Investment Management Corporation, et al. The settlement agreement does not provide for any payments to be made to the Partnership. Plaintiff's counsel sought reimbursement from the Partnership for its attorneys' fees and expenses. A settlement notice setting forth the terms of the settlement was mailed to the last known address of each unitholder of the Partnership on November 20, 1998. On December 24, 1998, the Court approved the terms of the settlement and approved plaintiffs' attorney's fees and expenses in the amount of $288,949, which is included in 1998 operating expenses.
6. Disassembly of Aircraft
In an attempt to maximize the economic return from three of the remaining four McDonnell Douglas DC-9-10 aircraft formerly leased to Midway Airlines, Inc. (Midway) and the six Boeing 727-100 aircraft formerly leased to Continental Airlines, Inc. (Continental), the Partnership entered into an agreement with Soundair, Inc. (Soundair) for the disassembly and sale of these aircraft in 1992.
The Partnership has incurred the cost of disassembly and received the proceeds from the sale of such parts, net of necessary overhaul expenses, and commissions paid to Soundair. During 1998 and 1997, the Partnership received net proceeds from the sale of aircraft inventory of $230,577 (including the proceeds discussed below) and $590,981, respectively. There were no such receipts in 1999.
The Partnership sold its remaining inventory of aircraft parts from the nine disassembled aircraft, to Soundair, Inc. The remaining inventory, with a net carrying value of $-0-, was sold effective February 1, 1998 for $100,000, less amounts previously received for sales as of that date. The net purchase price of $88,596 was paid in September 1998, and is included in gain on sale of aircraft inventory.
7. TWA Lease Extension
GECAS, on behalf of the Partnership, negotiated with TWA for the acquisition of noise-suppression devices, commonly known as "hushkits", for the 10 Partnership aircraft currently on lease to TWA, as well as other aircraft owned by affiliates of PIMC and leased to TWA. The 10 aircraft that received hushkits were designated by TWA. The hushkits recondition the aircraft so as to meet Stage 3 noise level restrictions. Installation of the 10 hushkits on the Partnership's aircraft was completed in November 1996 and the leases for these 10 aircraft were extended for a period of eight years until November 2004.
The aggregate cost of the hushkit reconditioning was $15,930,822, or approximately $1.6 million per aircraft, which was capitalized by the Partnership. The Partnership paid $3.0 million of the aggregate hushkit cost and the balance of $12,930,822 was financed by the engine/hushkit manufacturer over 50 months (through December 2000) at an interest rate of approximately 10% per annum. Cash paid for interest expense on the loan was $585,758, $912,172 and $1,100,648 in 1999, 1998 and 1997, respectively.
The rent payable by TWA under the leases was increased by an amount sufficient to cover the monthly debt service payments on the hushkits and fully repay, during the term of the TWA leases, the amount borrowed. The loan from the engine/hushkit manufacturer is non-recourse to the Partnership and secured by a security interest in the lease receivables.
8. Related Parties
Under the Limited Partnership Agreement (Partnership Agreement), the Partnership paid or agreed to pay the following amounts to PIMC and/or its affiliates in connection with services rendered:
a. An aircraft management fee equal to 5% of gross rental revenues with respect to operating leases or 2% of gross rental revenues with respect to full payout leases of the Partnership, payable upon receipt of the rent. In 1999, 1998 and 1997, the Partnership paid management fees to PIMC of $300,000, $300,000, and $369,396, respectively. Management fees payable to PIMC were $151,823 and $104,676 at December 31, 1999 and 1998, respectively.
b. Reimbursement of certain out-of-pocket expenses incurred in connection with the management of the Partnership and supervision of its assets. In 1999, 1998 and 1997, the Partnership reimbursed PIMC for expenses of $309,612, $714,049, and $470,603, respectively. Reimbursements totaling $18,451 and $11,211 were payable to PIMC at December 31, 1999 and 1998, respectively.
c. A 10% interest to PIMC in all cash distributions and sales proceeds, gross income in an amount equal to 9.09% of distributed cash available from operations and 1% of net income or loss and taxable income or loss, as such terms are defined in the Partnership Agreement. After the Partnership has sold or disposed of aircraft representing 50% of the total aircraft cost, gains from the sale or other disposition of aircraft are generally allocated first to the General Partner until such time that the General Partner's capital account is equal to the amount to be distributed to the General Partner from the proceeds of such sale or disposition.
d. A subordinated sales commission to PIMC of 3% of the gross sales price of each aircraft for services performed upon disposition and reimbursement of out-of-pocket and other disposition expenses. Subordinated sales commissions will be paid only after unit holders have received distributions in an aggregate amount equal to their capital contributions plus a cumulative non-compounded 8% per annum return on their adjusted capital contributions, as defined in the Partnership Agreement. The Partnership did not pay or accrue a sales commission on any aircraft sales to date as the subordination threshold has not been met.
e. In the event that, immediately prior to the dissolution and termination of the Partnership, the General Partner shall have a deficit balance in its tax basis capital account, then the General Partner shall contribute in cash to the capital of the Partnership an amount which is equal to such deficit (see Note 9).
9. Partners' Capital
The Partnership Agreement (the Agreement) stipulates different methods by which revenue, income and loss from operations and gain or loss on the sale of aircraft are to be allocated to the General Partner and the Limited Partners (see Note 8). Such allocations are made using income or loss calculated under GAAP for book purposes, which, as more fully described in Note 11, varies from income or loss calculated for tax purposes.
Cash available for distributions, including the proceeds from the sale of aircraft, is distributed 10% to the General Partner and 90% to the Limited Partners.
The different methods of allocating items of income, loss and cash available for distribution combined with the calculation of items of income and loss for book and tax purposes result in book basis capital accounts that may vary significantly from tax basis capital accounts. The ultimate liquidation and distribution of remaining cash will be based on the tax basis capital accounts following liquidation, in accordance with the Agreement.
Had all the assets of the Partnership been liquidated at December 31, 1999 at the current carrying value, the tax basis capital accounts of the General Partner and the Limited Partners is estimated to be $2,301,914 and $29,421,827, respectively.
10. Income Taxes
Federal and state income tax regulations provide that taxes on the income or loss of the Partnership are reportable by the partners in their individual income tax returns. Accordingly, no provision for such taxes has been made in the financial statements.
The net differences between the tax basis and the reported amounts of the Partnership's assets and liabilities at December 31, 1999 and 1998 are as follows:
Reported Amounts Tax Basis Net Difference ---------------- --------- --------------
1999: Assets $36,199,898 $19,838,816 $16,361,082 Liabilities 7,523,999 4,461,131 3,062,868
1998: Assets $40,019,792 $23,550,781 $16,469,011 Liabilities 9,866,907 8,144,706 1,722,201
11. Reconciliation of Book Net Income to Taxable Net Income
The following is a reconciliation between net income per Limited Partnership unit reflected in the financial statements and the information provided to Limited Partners for federal income tax purposes:
For the years ended December 31, --------------------------------
1999 1998 1997 ---- ---- ----
Book net income per Limited Partnership unit $ 9.83 $ 7.90 $ 9.88 Adjustments for tax purposes represent differences between book and tax revenue and expenses: Rental revenue 2.40 2.40 (0.53) Management fee expense 0.23 (0.15) 0.06 Depreciation 0.21 (1.37) 5.12 Gain or loss on sale of aircraft - - 9.00 Basis in inventory - - (0.40) Other revenue and expense items - 0.84 - ------ ------ -------
Taxable net income per Limited Partnership unit $12.67 $ 9.62 $23.13 ====== ====== ======
The differences between net income and loss for book purposes and net income and loss for tax purposes result from the temporary differences of certain revenue and deductions.
For book purposes, rental revenue is generally recorded as it is earned. For tax purposes, certain temporary differences exist in the recognition of revenue. For tax purposes, management fee expense is accrued in the same year as the tax basis rental revenue.
The Partnership computes depreciation using the straight-line method for financial reporting purposes and generally an accelerated method for tax purposes. The Partnership also periodically evaluates the ultimate recoverability of the carrying values and the economic lives of its aircraft for book purposes and, accordingly recognized adjustments which increased book depreciation expense. As a result, the current year book depreciation expense is greater than the tax depreciation expense. These differences in depreciation methods result in book to tax differences on the sale of aircraft. In addition, certain costs were capitalized for tax purposes and expensed for book purposes.
For book purposes, aircraft held in inventory are reflected at the lower of depreciable cost or estimated net realizable value. Differences in book and tax revenue and loss from inventory result from the differences in the book and tax carrying value of the inventory.
12. Subsequent Events
The Partnership made a cash distribution of $1,324,894 or $2.65 per Limited Partnership unit, to Limited Partners, and $147,210 to the General Partner on January 14, 2000.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Polaris Aircraft Income Fund III, A California Limited Partnership (PAIF-III or the Partnership) has no directors or officers. Polaris Holding Company (PHC) and its subsidiaries, including Polaris Aircraft Leasing Corporation (PALC) and Polaris Investment Management Corporation (PIMC), the General Partner of the Partnership (collectively Polaris), restructured their operations and businesses (the Polaris Restructuring) in 1994. In connection therewith, PIMC entered into a services agreement dated as of July 1, 1994 (the Services Agreement) with GE Capital Aviation Services, Inc. (GECAS), a Delaware corporation which is a wholly owned subsidiary of General Electric Capital Corporation, a New York corporation (GE Capital). GE Capital has been PHC's parent company since 1986. As subsidiaries of GE Capital, GECAS and PIMC are affiliates.
The officers and directors of PIMC are:
Name PIMC Title ---- -----------
Eric M. Dull President; Director Marc A. Meiches Chief Financial Officer Barbara Macholl Director Norman C. T. Liu Vice President; Director Ray Warman Secretary Robert W. Dillon Assistant Secretary
Substantially all of these management personnel will devote only such portion of their time to the business and affairs of PIMC as deemed necessary or appropriate.
Mr. Dull, 39, assumed the position of President and Director of PIMC effective January 1, 1997. Mr. Dull previously was a Director of PIMC from March 31, 1995 to July 31, 1995. Mr. Dull holds the position of Executive Vice President - Risk and Portfolio Management of GECAS, having previously held the positions of Executive Vice President - Portfolio Management and Senior Vice President - Underwriting Risk Management of GECAS. Prior to joining GECAS, Mr. Dull held various positions with Transportation and Industrial Funding Corporation (TIFC).
Mr. Meiches, 47, assumed the position of Chief Financial Officer of PIMC effective October 9, 1995. Previously, he held the position of Vice President of PIMC from October 1995 to October 1997. Mr. Meiches presently holds the positions of Executive Vice President and Chief Financial and Operating Officer of GECAS. Prior to joining GECAS, Mr. Meiches has been with General Electric Company (GE) and its subsidiaries since 1978. Since 1992, Mr. Meiches held the position of Vice President of the General Electric Capital Corporation Audit Staff. Between 1987 and 1992, Mr. Meiches held Manager of Finance positions for GE Re-entry Systems, GE Government Communications Systems and the GE Astro-Space Division.
Ms. Macholl, 46, assumed the position of Director of PIMC effective February 27, 1999. Ms. Macholl presently holds the position of Senior Vice President, Marketing Finance for GECAS. Prior to joining GECAS, Ms. Macholl has been with the General Electric Company (GE) and its subsidiaries since 1977. Ms. Macholl previously held the position of Vice President Finance for CBSI Inc., a wholly owned subsidiary of the General Electric Company. Ms. Macholl has also held various financial management positions for the GE Lighting business.
Mr. Liu, 42, assumed the position of Vice President of PIMC effective May 1, 1995 and Director of PIMC effective July 31, 1995. Mr. Liu presently holds the position of Executive Vice President - Marketing and Structured Finance of GECAS, having previously held the position of Executive Vice President - Capital Funding and Portfolio Management of GECAS. Prior to joining GECAS, Mr. Liu was with General Electric Capital Corporation for nine years. He has held management positions in corporate Business Development and in Syndications and Leasing for TIFC. Mr. Liu previously held the position of managing director of Kidder, Peabody & Co., Incorporated.
Mr. Warman, 51, assumed the position of Secretary of PIMC effective March 23, 1998. Mr. Warman has served as a GECAS Senior Vice President and Associate General Counsel since March 1996, and for 13 years theretofore was a partner, with an air-finance and corporate practice of the national law firm of Morgan, Lewis & Bockius LLP.
Mr. Dillon, 58, held the position of Vice President - Aviation Legal and Insurance Affairs, from April 1989 to October 1997. Previously, he served as General Counsel of PIMC and PALC effective January 1986. Effective July 1, 1994, Mr. Dillon assumed the position of Assistant Secretary of PIMC. Mr. Dillon presently holds the position of Senior Vice President and Associate General Counsel of GECAS.
Certain Legal Proceedings:
On or around September 27, 1995, a complaint entitled Martha J. Harrison v. General Electric Company, et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint names as defendants General Electric Company and Prudential Securities Incorporated. The Partnership is not named as a defendant in this action. Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and quasi-contract, violation of sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code concerning the inducement and solicitation of purchases arising out of the public offering of Polaris Aircraft Income Fund IV. Plaintiff seeks compensatory damages, attorney's fees, interest, costs and general relief.
On or around December 8, 1995, a complaint entitled Overby, et al. v. General Electric Company, et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint names as defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiffs allege claims of tort, breach of fiduciary duty, in tort, contract and quasi-contract, violation of sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code in connection with the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and general relief.
In or around November 1994, a complaint entitled Lucy R. Neeb, et al. v. Prudential Securities Incorporated et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint named as defendants Prudential Securities, Incorporated and Stephen Derby Gisclair. On or about December 20, 1995, plaintiffs filed a First Supplemental and Amending Petition adding as additional defendants General Electric Company, General Electric Capital Corporation and Smith Barney, Inc. The Partnership is not named as a defendant in this action. Plaintiffs allege claims of tort, breach of fiduciary duty, in tort, contract and quasi-contract, violation of sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code in connection with the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and general relief.
In or about January of 1995, a complaint entitled Albert B. Murphy, Jr. v. Prudential Securities, Incorporated et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint named as defendants Prudential Securities Incorporated and Stephen Derby Gisclair. On or about January 18, 1996, plaintiff filed a First Supplemental and Amending Petition adding defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and quasi-contract, violation of sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code in connection with the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and general relief.
On or about January 22, 1996, a complaint entitled Mrs. Rita Chambers, et al. v. General Electric Co., et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint names as defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiffs allege claims of tort, breach of fiduciary duty in tort, contract and quasi-contract, violation of sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code in connection with the public offering of Polaris Aircraft Income Fund IV. Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and general relief.
In or around December 1994, a complaint entitled John J. Jones, Jr. v. Prudential Securities Incorporated et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint named as defendants Prudential Securities, Incorporated and Stephen Derby Gisclair. On or about March 29, 1996, plaintiffs filed a First Supplemental and Amending Petition adding as additional defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and quasi-contract, violation of section of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code concerning the inducement and solicitation of purchases arising out of the public offering of Polaris Aircraft Income Fund III. Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and general relief.
On or around February 16, 1996, a complaint entitled Henry Arwe, et al. v. General Electric Company, et al. was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint named as defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiffs allege claims of tort, breach of fiduciary duty in tort, contract and quasi-contract, violation of sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code concerning the inducement and solicitation of purchases arising out of the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and general relief.
On or about May 7, 1996, a petition entitled Charles Rich, et al. v. General Electric Company and General Electric Capital Corporation was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint names as defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiffs allege claims of tort concerning the inducement and solicitation of purchases arising out of the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and general relief.
On or about March 4, 1996, a petition entitled Richard J. McGiven v. General Electric Company and General Electric Capital Corporation was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint
names as defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiff alleges claims of tort concerning the inducement and solicitation of purchases arising out of the public offering of Polaris Aircraft Income Fund V. Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and general relief.
On or about March 4, 1996, a petition entitled Alex M. Wade v. General Electric Company and General Electric Capital Corporation was filed in the Civil District Court for the Parish of Orleans, State of Louisiana. The complaint names as defendants General Electric Company and General Electric Capital Corporation. The Partnership is not named as a defendant in this action. Plaintiff alleges claims of tort concerning the inducement and solicitation of purchases arising out of the public offering of Polaris Aircraft Income Fund V. Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and general relief.
Other Proceedings - Part I, Item 3 discusses certain other actions arising out of certain public offerings, including that of the Partnership, to which both the Partnership and its general partner are parties.
Item 11.
Item 11. Executive Compensation
PAIF-III has no directors or officers. PAIF-III is managed by PIMC, the General Partner. In connection with management services provided, management and advisory fees of $300,000 were paid to PIMC in 1999 in addition to a 10% interest in all cash distributions as described in Note 8 to the financial statements (Item 8).
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
a) No person owns of record, or is known by PAIF-III to own beneficially more than five percent of any class of voting securities of PAIF-III.
b) The General Partner of PAIF-III owns the equity securities of PAIF-III as set forth in the following table:
Title Name of Amount and Nature of Percent of Class Beneficial Owner Beneficial Ownership of Class -------- ---------------- -------------------- --------
General Polaris Investment Represents a 10.0% interest 100% Partner Management of all cash distributions, Interest Corporation gross income in an amount equal to 9.09% of distributed cash available from operations, and a 1% interest in net income or loss
c) There are no arrangements known to PAIF-III, including any pledge by any person of securities of PAIF-III, the operation of which may at a subsequent date result in a change in control of PAIF-III.
Item 13.
Item 13. Certain Relationships and Related Transactions
None.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
1. Financial Statements.
The following are included in Part II of this report: Page No. --------
Report of Independent Public Accountants 15 Balance Sheets 16 Statements of Operations 17 Statements of Changes in Partners' Capital (Deficit) 18 Statements of Cash Flows 19 Notes to Financial Statements 20
2. Reports on Form 8-K.
No reports on Form 8-K were filed during the quarter ended December 31, 1999.
3. Exhibits required to be filed by Item 601 of Regulation S-K.
27. Financial Data Schedule (in electronic format only).
4. Financial Statement Schedules.
All financial statement schedules are omitted because they are not applicable, not required or because the required information is included in the financial statements or notes thereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership (REGISTRANT) By: Polaris Investment Management Corporation General Partner
March 24, 2000 By: /S/ Eric M. Dull -------------- ------------------------- Date Eric M. Dull, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
/S/Eric M. Dull President and Director of Polaris March 24, 2000 --------------- Investment Management Corporation, -------------- (Eric M. Dull) General Partner of the Registrant
/S/Marc A. Meiches Chief Financial Officer of Polaris March 24, 2000 ------------------ Investment Management Corporation, -------------- (Marc A. Meiches) General Partner of the Registrant
/S/Barbara Macholl Director of Polaris Investment March 24, 2000 ------------------- Management Corporation, General -------------- (Barbara Macholl) Partner of the Registrant
/S/Norman C. T. Liu Vice President and Director of March 24, 2000 ------------------- Polaris Investment Management -------------- (Norman C. T. Liu) Corporation, General Partner of the Registrant | 12,943 | 84,471 |
1003410_1999.txt | 1003410_1999 | 1999 | 1003410 | ITEM 1. BUSINESS
Duke-Weeks Realty Limited Partnership (the "Partnership") was formed on October 4, 1993, when Duke-Weeks Realty Corporation (the "Predecessor" or the "General Partner") contributed all of its properties and related assets and liabilities along with the net proceeds of $309.3 million from the issuance of an additional 14,000,833 shares through an offering (the "1993 Offering") to the Partnership. Simultaneously, the Partnership completed the acquisition of Duke Associates, a full- service commercial real estate firm operating in the Midwest. The General Partner was formed in 1985 and qualifies as a Real Estate Investment Trust ("REIT") under provisions of the Internal Revenue Code. The General Partner is the sole general partner of the Partnership currently owning 86.9% of the partnership interest ("General Partner Units"). The remaining 13.1% of the Partnership is owned by limited partners ("Limited Partner Units" and, together with the General Partner Units, the "Common Units").
As of December 31, 1999, the Partnership's diversified portfolio of 925 rental properties (including 60 properties and three expansions totaling 9.9 million square feet under development) encompass 102.4 million rentable square feet and are leased by a diverse and stable base of nearly 5,000 tenants whose businesses include manufacturing, retailing, wholesale trade, distribution and professional services. The Partnership also owns more than 4,300 acres of unencumbered land ready for development.
The Partnership, through its Service Operations, also provides, on a fee basis, leasing, property and asset management, development, construction, landscaping, build-to-suit, and other tenant-related services for more than 700 tenants in over 7.1 million square feet of space at properties owned by third-party clients. With 13 primary operating platforms, the Partnership concentrates its activities in the Midwest and Southeast United States (see discussion of Merger with Weeks Corporation below). See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 8, "Financial Statements and Supplementary Data" for financial information. The Partnership has rental operations that are self- administered. In addition, the Partnership conducts its service operations through Duke Realty Services Limited Partnership and Duke Construction Limited Partnership, in which the Partnership's controlled subsidiary, Duke Services, Inc., is the sole general partner. All references to the "Partnership" in this Form 10-K Report include the Partnerhip and those entities owned or controlled by the Partnership, unless the context indicates otherwise. - 1 -
The Partnership's headquarters and executive offices are located in Indianapolis, Indiana. In addition, the Partnership has thirteen regional offices located in Atlanta, Georgia; Cincinnati, Ohio; Columbus, Ohio; Cleveland, Ohio; Chicago, Illinois; Dallas, Texas; Jacksonville, Florida; Minneapolis, Minnesota; Orlando, Florida; Nashville, Tennessee; Raleigh, North Carolina; St. Louis, Missouri and Tampa, Florida. The Partnership had 1,460 employees as of December 31, 1999.
BUSINESS STRATEGY
The Partnership's business objective is to increase its Funds From Operations ("FFO") by (i) maintaining and increasing property occupancy and rental rates through the aggressive management of its portfolio of existing properties; (ii) expanding existing properties; (iii) developing and acquiring new properties; and (iv) providing a full line of real estate services to the Partnership's tenants and to third- parties. FFO is defined by the National Association of Real Estate Investment Trusts as net income or loss, excluding gains or losses from debt restructuring and sales of depreciated property, plus operating property depreciation and amortization and adjustments for minority interest and unconsolidated companies on the same basis. While management believes that FFO is a relevant measure of the Partnership's operating performance because it is widely used by industry analysts to measure the operating performance of equity REITs, such amount does not represent cash flow from operations as defined by generally accepted accounting principles, should not be considered as an alternative to net income as an indicator of the Partnership's operating performance, and is not indicative of cash available to fund all cash flow needs. As a fully integrated commercial real estate firm, the Partnership believes that its in-house leasing, management, development and construction services and the Partnership's significant base of commercially zoned and unencumbered land in existing business parks should give the Partnership a competitive advantage in its future development activities.
The Partnership believes that the analysis of real estate opportunities and risks can be done most effectively at regional or local levels. As a result, the Partnership intends to continue its emphasis on increasing its market share and effective rents in the Midwestern markets where it owns properties and enter new markets with higher growth potential (see discussion of Merger with Weeks Corporation below). The Partnership also expects to utilize its more than 4,300 acres of unencumbered land and its many business relationships with nearly 5,000 commercial tenants to expand its build-to-suit business (development projects substantially pre-leased to a single tenant) and to pursue other development and acquisition opportunities in its primary markets and elsewhere. The Partnership believes that this regional focus will allow it to assess market supply and demand for real estate more effectively as well as to capitalize on its strong relationships with its tenant base.
The Partnership's policy is to seek to develop and acquire Class A commercial properties located in markets with high growth potential for Fortune 500 companies and other quality regional and local firms. The Partnership's industrial and suburban office development focuses on business parks and mixed-use developments suitable for development of multiple projects on a single site where the Partnership can create and control the business environment. These business parks and mixed-use developments generally include restaurants and other amenities which the Partnership believes will create an atmosphere that is particularly efficient and desirable. The Partnership's retail development focuses on community, power and neighborhood centers in its existing markets. As a fully integrated real estate Partnership, the Partnership is able to arrange for or provide to its industrial, office and retail tenants not only well located and well maintained facilities, but also additional services such as build-to-suit construction, tenant finish construction, expansion flexibility and advertising and marketing services.
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All of the Partnership's properties are located in areas that include competitive properties. Such properties are generally owned by institutional investors, other REITs or local real estate operators; however, no single competitor or small group of competitors is dominant in the Partnership's current markets. The supply and demand of similar available rental properties may affect the rental rates the Partnership will receive on its properties. Based upon the current occupancy rates in Partnership and competitive properties, the Partnership believes there will not be significant competitive pressure to lower rental rates in the near future.
FINANCING STRATEGY
The Partnership seeks to maintain a well-balanced, conservative and flexible capital structure by: (i) currently targeting a ratio of long- term debt to total market capitalization in the range of 25% to 40%; (ii) extending and sequencing the maturity dates of its debt; (iii) borrowing primarily at fixed rates; (iv) generally pursuing current and future long-term debt financings and refinancings on an unsecured basis; and (v) maintaining conservative debt service and fixed charge coverage ratios. Management believes that these strategies have enabled and should continue to enable the Partnership to access the debt and equity capital markets for their long-term requirements such as debt refinancings and financing development and acquisitions of additional rental properties. The General Partner and the Partnership have raised approximately $1.7 billion through public debt and equity offerings during the three years ended December 31, 1999. In addition, as discussed under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," the Partnership has $750 million in unsecured lines of credit available for short-term fundings of development and acquisition of additional rental properties. In addition to debt and equity capital markets, the Partnership has developed a strategy to pursue favorable opportunities to dispose of assets that no longer meet the Partnership's long-term investment criteria and re-deploy the proceeds into new investments with excellent long-term growth prospects. See additional discussion under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Partnership's debt to total market capitalization ratio (total market capitalization is defined as the total market value of all outstanding Common and Preferred Units and units of limited partnership interest ("Units") in the Partnership plus outstanding indebtedness) at December 31, 1999 was 38.17%. The Partnership's ratio of earnings to debt service and ratio of earnings to fixed charges for the year ended December 31, 1999 were 2.58x and 1.77x, respectively. In computing the ratio of earnings to debt service, earnings have been calculated by adding debt service to income before gains or losses on property sales. Debt service consists of interest expense and recurring principal amortization (excluding maturities) and excludes amortization of debt issuance costs. In computing the ratio of earnings to fixed charges, earnings have been calculated by adding fixed charges, excluding capitalized interest, to income before gains or losses on property sales. Fixed charges consist of interest costs, whether expensed or capitalized, the interest component of rental expense, amortization of debt issuance costs and preferred stock dividend requirements. Management believes these measures to be consistent with its financing strategy.
MERGER WITH WEEKS CORPORATION
In July 1999, Weeks Corporation ("Weeks"), a self-administered, self- managed geographically focused REIT which operated primarily in the southeastern United States, was merged with and into the General Partner, pursuant to which Weeks Realty L.P. ("Weeks Operating Partnership") merged with and into the Partnership. This transaction is hereafter referred to as the "Weeks Merger." In accordance with the terms of the Weeks Merger, each outstanding Weeks Operating Partnership common unit was converted into 1.38 common units of the Partnership and each outstanding Weeks Operating Partnership Series A preferred unit
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was converted into one of the Partnership's Series F preferred units (the "Series F Preferred Units"). As a result, 27.4 million common units and 6,000,000 Series F Preferred Units were issued to Weeks Operating Partnership unitholders in exchange for all of the outstanding Weeks Operating Partnership common and preferred units. The total purchase price of Weeks Operating Partnership aggregated approximately $1.9 billion, which included the assumption of the outstanding debt and liabilities of Weeks Operating Partnership of approximately $775 million. The transaction was structured as a tax- free merger and was accounted for under the purchase method.
OTHER
The Partnership's operations are not dependent on a single or few customers as no single customer accounts for more than 1.5% of the Partnership's total revenue. The Partnership's operations are not subject to any significant seasonal fluctuations. The Partnership believes it is in compliance with environmental regulations and does not anticipate material effects of continued compliance.
For additional information regarding the Partnership's investments and operations, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Item 8, "Financial Statements and Supplementary Data." For additional information about the Partnership's business segments, see Item 8, "Financial Statements and Supplementary Data."
ITEM 2.
ITEM 2. PROPERTIES
PRODUCT REVIEW -------------- As of December 31, 1999, the Partnership owns an interest in a diversified portfolio of 925 commercial properties encompassing approximately 102.4 million net rentable square feet (including 60 properties and three expansions comprising 9.9 million square feet under development) located primarily in eight states and more than 4,300 acres of land for future development.
INDUSTRIAL PROPERTIES: ---------------------- The Partnership owns interests in 674 industrial properties encompassing approximately 77.2 million square feet (75% of total square feet) more specifically described as follows: BULK WAREHOUSES - Industrial warehouse/distribution buildings with clear ceiling heights of 20 feet or more. The Partnership owns 452 buildings totaling 63.7 million square feet of such properties. SERVICE CENTERS - Also known as flex buildings or light industrial, this product type has 12-18 foot clear ceiling heights and a combination of drive-up and dock-height loading access. The Partnership owns 222 buildings totaling 13.5 million square feet of such properties.
OFFICE PROPERTIES: ------------------ The Partnership owns interests in 219 office buildings totaling approximately 22.5 million square feet (22% of total square feet) more specifically described as follows: SUBURBAN OFFICE - The Partnership owns 215 suburban office buildings totaling 21.6 million square feet. CBD OFFICE - The Partnership owns four downtown office projects totaling approximately 861,000 square feet.
RETAIL PROPERTIES: ------------------ The Partnership owns interests in 32 retail projects totaling approximately 2.7 million square feet (3% of total square feet). These properties encompass both power and neighborhood shopping centers.
- 4 - LAND: ---- The Partnership owns more than 4,300 acres of land located primarily in its existing business parks. The land is ready for immediate use and is unencumbered by debt. Over 62 million square feet of additional space can be developed on these sites and all of the land is zoned for either office, industrial or retail development.
SERVICE OPERATIONS: ------------------- The Partnership provides property and asset management, development, leasing and construction services to third party owners in addition to its own properties. The Partnership's current property management base for third parties includes over 7.1 million square feet of properties serving more than 700 tenants.
PROPERTY DESCRIPTIONS --------------------- The Partnership's properties are described on the following pages:
[1] The Partnership retains the indicated effective ownership interest in an entity which owns the building. The Partnership shares in the profit or loss from such building in accordance with the Partnership's ownership interest.
[2] These buildings are owned by a partnership in which the Partnership is a partner. The Partnership owns a 10% capital interest in the partnership and receives a 50% interest in the residual cash flow after payment of a 9% preferred return to the other partner on its capital interest.
[3] The Partnership owns the building and has a leasehold interest in the land underlying this building with a lease term expiring in 2048 or later.
[4] The Partnership has a leasehold interest in this building with a lease term expiring May 2006.
[5] These are properties for which there are loans to owners which fully encumber the properties. Under the terms of the loans, the Partnership effectively receives all income and economic value from the properties. As a result, the properties are accounted for as owned properties.
[6] The Partnership has a leasehold interest in the building and the underlying land with a lease term expiring June 2020. The Partnership has an option to purchase the fee interest in the property throughout the term of the lease.
[7] This building is owned by a partnership in which the Partnership owns a 60% interest. The Partnership receives an 11% cumulative preferred return on its equity, with any excess cash flow after debt service received in accordance with the ownership interest. - 23 -
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Partnership is not party to any claims or litigation that it believes the results, individually or in the aggregate, will have a material adverse affect on its business, financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders of the General Partner during the fourth quarter of the year ended December 31, 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There is no established public trading market for the Common Units. The following table sets forth the cash distributions paid during each quarter. Comparable cash distributions are expected in the future. As of February 29, 2000, there were 10,382 record holders of Common Units.
On January 26, 2000, the Partnership declared a quarterly cash distribution of $0.39 per Common Unit payable on February 29, 2000 to Common Unitholders of record on February 11, 2000.
- 24 - ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following sets forth selected consolidated financial and operating information on a historical basis for the Partnership for each of the years in the five-year period ended December 31, 1999. The following information should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 8, "Financial Statements and Supplementary Data" included in this Form 10-K (in thousands, except per unit amounts):
(1)Information for all five years reflects the General Partner's two-for-one stock split effected in August 1997.
(2)Funds From Operations is defined by the National Association of Real Estate Investment Trusts as net income or loss excluding gains or losses from debt restructuring and sales of depreciated property plus operating property depreciation and amortization, and adjustments for minority interest and unconsolidated comp anies on the same basis. Funds From Operations does not represent cash flow from operations as defined by generally accepted accounting principles, should not be considered as an alternative to net income as an indicator of the Partnership's operating performance, and is not indicative of cash available to fund all cash flow needs.
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW -------- The Partnership's income from rental operations is substantially influenced by the supply and demand for the Partnership's rental space in its primary markets, its ability to maintain occupancy rates and increase rental rates on its in-service portfolio and to continue development and acquisition of additional rental properties.
The Partnership's primary markets in the Midwest have continued to offer strong and stable local economies and have provided attractive new development opportunities because of their central location, established manufacturing base, skilled work force and moderate labor costs. Additionally, through the Weeks Merger (see discussion below under Merger with Weeks Corporation), the Partnership has expanded and diversified its geographic base into southeastern markets that have similar demographics to the Midwest and are located in fast growing southeast cities expected to provide additional growth opportunities. The Partnership's occupancy rate of its in-service portfolio was 91.9% at December 31, 1999. The Partnership expects to maintain its overall occupancy at comparable levels and to increase rental rates as leases are renewed or new leases are executed. This stable occupancy and increasing rental rates should improve the Partnership's results of operations from its in-service properties. The Partnership's strategy for continued growth includes developing and acquiring additional rental properties in its primary markets and expanding into other attractive markets.
The Partnership tracks Same Property performance which compares those properties that were in-service for all of a two-year period. As a result of the rapid growth of the Partnership, this population of properties only represented 62.4% and 47.7% of the in-service portfolio at December 31, 1999 and December 31, 1998, respectively. In 1999, net operating income from the same property portfolio increased 3.2% over 1998, while for 1998, net operating income from the same property portfolio increased 5.4% over 1997.
The following table sets forth information regarding the Partnership's in-service portfolio of rental properties as of December 31, 1999 (square feet in thousands):
Management expects occupancy of the in-service property portfolio to remain stable because (i) only 10.3% and 10.9% of the Partnership's occupied square footage is subject to leases expiring in 2000 and 2001, respectively, and (ii) the Partnership's renewal percentage averaged 72%, 69% and 81% in 1999, 1998 and 1997, respectively.
The following table reflects the Partnership's in-service lease expiration schedule as of December 31, 1999, by product type indicating square footage and annualized net effective rents under expiring leases (in thousands, except per square foot amounts): - 26 -
This stable occupancy, along with increasing rental rates in each of the Partnership's markets, will allow the in-service portfolio to continue to provide an increasing level of earnings from rental operations. The Partnership also expects to realize growth in earnings from rental operations through (i) the development and acquisition of additional rental properties in its primary markets; (ii) the expansion into other attractive markets; (iii) re-deployment of capital proceeds from the disposal of non-performing and low growth assets into additional rental properties with excellent long-term growth prospects; and (iv) the completion of the 9.9 million square feet of properties under development at December 31, 1999, over the next four quarters and thereafter. These properties under development are expected to be placed in service as follows (in thousands, except percentages):
MERGER WITH WEEKS CORPORATION
In July 1999, Weeks Corporation ("Weeks"), a self-administered, self- managed geographically focused REIT which operated primarily in the southeastern United States, was merged with and into the General Partner, pursuant to which Weeks Realty L.P. ("Weeks Operating Partnership"), was merged with and into the Partnership. This transaction is hereafter referred to as the "Weeks Merger." In accordance with the terms of the Weeks Merger, each outstanding Weeks Operating Partnership common unit was converted into 1.38 common units of the Partnership and each outstanding Weeks Operating Partnership Series A preferred unit was converted into one of the Partnership's Series F preferred units (the "Series F Preferred Units"). As a result, 27.4 million common units and 6,000,000 Series F Preferred Units were issued to Weeks Operating Partnership unitholders in exchange for all of the outstanding Weeks Operating Partnership common and preferred units. The total purchase price of Weeks Operating Partnership aggregated approximately $1.9 billion, which included the assumption of the outstanding debt and liabilities of Weeks Operating Partnership of approximately $775 million. The transaction was structured as a tax- free merger and was accounted for under the purchase method.
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RESULTS OF OPERATIONS
A summary of the Partnership's operating results and property statistics for each of the years in the three-year period ended December 31, 1999, is as follows (in thousands, except number of properties and per unit amounts):
(1) As adjusted for the General Partner's two-for-one stock split effected in August 1997.
COMPARISON OF YEAR ENDED DECEMBER 31, 1999 TO YEAR ENDED DECEMBER 31, 1998 -------------------------------------------------------------------------- Rental Operations ----------------- The Partnership increased its in-service portfolio of rental properties from 453 properties comprising 52.0 million square feet at December 31, 1998 to 865 properties comprising 92.5 million square feet at December 31, 1999 through the acquisition of 366 properties totaling 31.4 million square feet and the placement in service of 67 properties and four building expansions totaling 10.4 million square. Of these additional acquisition properties, 335 properties totaling 28.6 million square feet relate to the Weeks Merger.
The Partnership also disposed of 21 properties totaling 1.3 million square feet. These 412 net additional rental properties primarily account for the $186.9 million increase in revenues from Rental Operations from 1998 to 1999. The increase from 1998 to 1999 in rental expenses, real estate taxes and depreciation and amortization expense is also a result of the additional 412 in-service rental properties.
The $26.5 million increase in interest expense is primarily attributed to higher outstanding debt balances associated with the financing of the Partnership's investment activities. The increased balances include $450 million of unsecured debt issued in 1999, the assumption of $185 million of secured debt and $287 million of unsecured debt in the Weeks Merger, and increased borrowings on the Partnership's unsecured lines of credit. These higher borrowing costs were partially offset by the capitalization of interest on increased property development activities which increased in 1999 compared to 1998.
As a result of the above mentioned items, earnings from Rental Operations increased $69.4 million from $126.0 million for 1998 to $195.4 million for 1999.
Service Operations ------------------ Service Operations revenues increased from $24.7 million to $54.0 million for the year ended 1999 as compared to 1998 primarily as a result of increases in construction management fee revenue because of an - 28 -
increase in third-party construction volume. Service Operations expenses increased from $17.5 million to $36.1 million for the year ended 1999 as compared to 1998 as a result of (i) payroll increasing from $12.5 million in 1998 to $17.2 million in 1999 due to the Weeks Merger and additional personnel added to existing regional offices due to the overall growth of the Partnership; (ii) income tax expenses increasing by $5.2 million as a result of increased activity in properties constructed for sale; and (iii) maintenance expenses increasing from $2.5 million in 1998 to $9.7 million 1999 through the addition of substantial landscape operations in the Weeks Merger and the growth of the Partnership in Midwest markets.
As a result of the above-mentioned items, earnings from Service Operations increased $10.7 million from $7.2 million in 1998 to $17.9 million for the year ended 1999.
General and Administrative Expense ---------------------------------- General and administrative expense increased from $11.6 million for the year ended 1998 to $16.6 million for 1999 primarily due to an overall increase in corporate expenses associated with the Weeks Merger and the overall growth of the Partnership.
Earnings from Land and Depreciated Property Sales ------------------------------------------------- During 1999, the Partnership developed a disposition strategy to pursue favorable opportunities to dispose of real estate assets that no longer meet long-term investment objectives of the Partnership, which resulted in net sales proceeds of $76.4 million and a net gain of $10.0 million in 1999.
As part of this ongoing real estate asset disposition strategy, the Partnership was committed to the sale of 13 real estate assets with a net book value of $153.6 million as of December 31, 1999. Subject to normal closing risks, the Partnership expects to complete these and other dispositions during 2000 and use the proceeds to fund future investments in real estate assets. As part of management's long-term strategy, the Partnership will continue to pursue favorable opportunities to dispose of assets that do not meet its long-term investment objectives and use proceeds for the funding of real estate development and acquisition opportunities.
Net Income Available for Common Units ------------------------------------- Net income available for common units for the year ended December 31, 1999, was $159.4 million compared to $103.1 million for 1998. This increase results primarily from the increases in the operating results of rental and service operations explained above.
COMPARISON OF YEAR ENDED DECEMBER 31, 1998 TO YEAR ENDED DECEMBER 31, 1997 -------------------------------------------------------------------------- Rental Operations ----------------- The Partnership increased its in-service portfolio of rental properties from 355 properties comprising 40.7 million square feet at December 31, 1997 to 453 properties comprising 52.0 million square feet at December 31, 1998 through the acquisition of 66 properties totaling 5.0 million square feet and the placement in service of 34 properties and seven building expansions totaling 6.3 million square feet developed by the Partnership.
The Partnership also disposed of two properties totaling 21,000 square feet. These 98 net additional rental properties primarily account for the $118.9 million increase in revenues from Rental Operations from 1997 to 1998. The increase from 1997 to 1998 in rental expenses, real estate taxes and depreciation and amortization expense is also a result of the additional 98 in-service rental properties. - 29 -
The $19.9 million increase in interest expense is primarily attributable to higher outstanding debt balances associated with the financing of the Partnership's investment activities. The increased balances include $250 million of unsecured debt issued in 1998 and increased borrowings on the Partnership's unsecured line of credit. These higher borrowing costs were partially offset by the capitalization of interest in property development activities which increased in 1998 compared to 1997.
As a result of the above mentioned items, earnings from Rental Operations increased $42.3 million from $83.7 million for the year ended 1997 to $126.0 million for 1998.
Service Operations ------------------ Service Operations revenues increased from $22.4 million to $24.7 million for the year ended 1998 as compared to 1997 primarily as a result of increases in construction management fee revenue because of an increase in third-party construction volume. Service Operations expenses increased from $15.2 million to $17.5 million for the year ended 1998 as compared to 1997 primarily as a result of an increase in payroll expenses resulting from the overall growth of the Partnership and the additional regional offices opened in 1997.
As a result of the above-mentioned items, earnings from Service Operations remained constant at $7.2 million for the years ended 1998 and 1997.
General and Administrative Expense ---------------------------------- General and administrative expense increased from $7.3 million for the year ended 1997 to $11.6 million for 1998 as a result of internal acquisition costs which are no longer permitted to be capitalized being charged to general and administrative expense as well as an increase in state and local income taxes resulting from the overall growth of the Partnership.
Net Income Available for Common Units ------------------------------------- Net income available for common units for the year ended 1998 was $103.1 million compared to $72.8 million for 1997. This increase results primarily from the increases in the operating results of rental and service operations explained above.
LIQUIDITY AND CAPITAL RESOURCES
Financial Flexibility --------------------- During the latter half of 1998 and continuing into 1999, the real estate industry experienced a reduced supply of favorably priced equity and debt capital, which generally decreased the level of new investment activity by real estate companies. While the Partnership has been subject to the same capital market conditions as other real estate companies, management believes the Partnership's financial and liquidity position are relatively strong. Over the years, the Partnership has carefully managed its balance sheet in an effort to avoid liquidity issues in any given quarter or year. In management's view, this should provide a competitive advantage in the current capital constrained market over many of its competitors. Following are three key indicators that demonstrate the overall strength of the Partnership's financial position. First, the Partnership believes that its strong balance sheet and expected real estate asset disposition proceeds will provide the Partnership with sufficient capital to fund its investment activities during 2000 without the need to raise additional common equity through the General Partner. Second, the Partnership has only $65.0 million of final debt maturities in
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2000. Third, as of December 31, 1999, the Partnership has a total of $492.0 million of undrawn capacity on its existing lines of credit to meet its short-term obligations. Although it is not clear how long the current market conditions will prevail, management believes that these key factors will provide the Partnership with substantial financial flexibility to capitalize on investment opportunities which may not be available to other real estate companies with more limited financial resources.
Operating Activities -------------------- Net cash flow provided by operating activities increased by $122.8 million in 1999 as compared to 1998 and by $61.8 million in 1998 as compared to 1997. These increases are due primarily to the Weeks Merger in July 1999, the development and acquisition of additional rental properties, and cash flow from existing real estate assets.
Investing and Financing Activities ---------------------------------- During 1999, 1998 and 1997, the Partnership invested cash of $767.9 million, $703.6 million and $597.0 million, respectively, in real estate investments. The $767.9 million invested in real estate in 1999 was financed primarily from the borrowings under the Partnership's unsecured lines of credit. These unsecured lines of credit were partially repaid with proceeds from the issuance of $450.0 million of long-term unsecured debt, $214.8 million in net proceeds from the General Partner's sale of common shares in 1999, and $96.5 million of net proceeds from the Genral Partner's sale of preferred shares in 1999. The $703.6 million invested in real estate during 1998 was financed primarily from borrowings under the Partnership's line of credit. These borrowings were partially repaid during 1998 with proceeds from the issuance of $250.0 million of long-term unsecured debt, $211.5 million in net proceeds from the General Partner's sale of common shares in 1998, and $129.5 million of net proceeds from the General Partner's sale of preferred shares in 1998. The $597.0 million invested in real estate during 1997 was financed primarily from borrowings under the Partnership's line of credit. These borrowings were partially repaid during 1997 with proceeds from the issuance of $100.0 million of long-term unsecured debt, $321.3 million in net proceeds from the General Partner's sale of common shares in 1997, and $146.1 million of net proceeds from the General Partner's sale of preferred shares in 1997.
Other significant financing activity included the payment of $222.4 million, $137.0 million and $94.5 million in common and preferred unit distributions in 1999, 1998 and 1997, respectively. The increases are primarily attributable to (i) an increase in the overall number of common units and Series F Preferred Units outstanding resulting from the Weeks Merger in 1999; and (ii) annual increases in the cash distributions paid per common unit.
The General Partner and the Partnership currently have on file three Form S-3 Registration Statements (the "Shelf Registrations") with the Securities and Exchange Commission which have remaining availability as of December 31, 1999 of $292.9 million to issue additional common stock, preferred stock and unsecured debt securities. The General Partner and the Partnership intend to issue additional securities under such Shelf Registrations to fund the development and acquisition of additional rental properties. The General Partner also has a Shelf Registration on file for at-the-market offerings of 1.5 million shares of common stock, and the General Partner and the Partnership also plan to file a $500.0 million Shelf Registration during the first quarter of 2000.
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The recurring capital needs of the Partnership are funded primarily through the undistributed net cash provided by operating activities. A summary of the Partnership's recurring capital expenditures is as follows (in thousands):
The Partnership has the following lines of credit available (in thousands):
Both lines of credit are used to fund development and acquisition of additional rental properties and to provide working capital.
Effective July 2, 1999, the interest rate on the $450 million line of credit was adjusted from LIBOR + .80% to LIBOR + .70%. Additionally, the $450 million line of credit allows the Partnership an option to obtain borrowings from the financial institutions that participate in the line of credit at rates lower than the stated interest rate, subject to certain restrictions. Amounts outstanding on the line of credit at December 31, 1999 are at LIBOR + .70%.
The $300 million line of credit was obtained July 2, 1999, in connection with the Weeks Merger.
The debt outstanding at December 31, 1999 totals $2.1 billion with a weighted average interest rate of 7.22% maturing at various dates through 2028. The Partnership has $1.6 billion of unsecured debt and $528.7 million of secured debt outstanding at December 31, 1999. Scheduled principal amortization of such debt totaled $10.2 million for the year ended December 31, 1999.
Following is a summary of the scheduled future amortization and maturities of the Partnership's indebtedness at December 31, 1999 (in thousands):
UNITHOLDER DISTRIBUTION REQUIREMENTS
The Partnership intends to pay regular quarterly distributions from net cash provided by operating activities. A quarterly distribution of $.39 per common unit was declared on January 26, 2000, which represents an annualized distribution of $1.56 per share.
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FUNDS FROM OPERATIONS
Management believes that Funds From Operations ("FFO"), which is defined by the National Association of Real Estate Investment Trusts as net income or loss, excluding gains or losses from debt restructuring and sales of depreciated property, plus operating property depreciation and amortization and adjustments for minority interest and unconsolidated companies on the same basis, is the industry standard for reporting the operations of real estate investment trusts.
The following reflects the calculation of the Partnership's FFO for the years ended December 31 (in thousands):
The increase in FFO during the three-year period results primarily from the increased in-service rental property portfolio as discussed above under "Results of Operations," and, for the year ended 1999, the Weeks Merger.
While management believes that FFO is the most relevant and widely used measure of the Partnership's operating performance, such amount does not represent cash flow from operations as defined by generally accepted accounting principles, should not be considered as an alternative to net income as an indicator of the Partnership's operating performance, and is not indicative of cash available to fund all cash flow needs.
YEAR 2000
The Partnership did not experience any Year 2000 related disruptions or failures to its internal operations or the critical building systems of its properties. The primary focus of the Partnership's Year 2000 project was to protect the tenant spaces, buildings and internal operating systems. The rewards of the Partnership's Year 2000 planning efforts can be found in the detailed emergency contingency plans that are now in place for all buildings in all markets. With these plans in place, in the event of major unforeseen events such as loss of electricity, utilities or other vital services, the Partnership's property/asset managers are better equipped to efficiently and effectively respond to such emergencies. In addition to the foregoing, enhancements were made to the Partnership's internal information systems (software and hardware) in preparation for the Year 2000. It is expected that these upgrades and replacements will benefit the Partnership's business operations for years to come. Non-reimbursable costs to the Partnership in preparing for the Year 2000 were approximately $125,000.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
The Partnership is exposed to interest rate changes primarily as a result of its line of credit and long-term debt used to maintain liquidity and fund capital expenditures and expansion of the Partnership's real estate investment portfolio and operations. The Partnership's interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs. To
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achieve its objectives the Partnership borrows primarily at fixed rates and may enter into derivative financial instruments such as interest rate swaps, caps and treasury locks in order to mitigate its interest rate risk on a related financial instrument. The Partnership does not enter into derivative or interest rate transactions for speculative purposes.
The Partnership's interest rate risk is monitored using a variety of techniques. The table below presents the principal amounts (in thousands) of the expected annual maturities, weighted average interest rates for the average debt outstanding in the specified period, fair values and other terms required to evaluate the expected cash flows and sensitivity to interest rate changes. The fair values of the Partnership's debt instruments are calculated as the present value of estimated future cash flows using a discount rate commensurate with the risks involved.
The Partnership has three interest rate swap agreements outstanding which have an aggregate fair market value of $2.65 million at December 31, 1999. The swap agreements mature on December 31, 2001.
As the table incorporates only those exposures that exist as of December 31, 1999, it does not consider those exposures or positions which could arise after that date. Moreover, because firm commitments are not presented in the table above, the information presented therein has limited predictive value. As a result, the Partnership's ultimate realized gain or loss with respect to interest rate fluctuations will depend on the exposures that arise during the period, the Partnership's hedging strategies at that time, and interest rates.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data are included under Item 14 of this Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ON ACCOUNTING FINANCIAL DISCLOSURE
None.
Part III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Partnership does not have any directors or officers. The information required by Item 10 for Directors and Certain Executive Officers will be contained in a definitive proxy statement of the General Partner, which was filed on March 17, 2000, and herein is incorporated by reference. - 34 -
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 will be contained in a definitive proxy statement for the General Partner which was filed on March 17, 2000, and herein is incorporated by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The Partnership had 19,059,815 Limited Partner Units which were outstanding as of the close of business on March 8, 2000.
The following table shows, as of March 8, 2000, the number and percentage of Limited Partner Units held by each person known to the Partnership who beneficially owned more than five percent of outstanding Limited Partner Units. Except as otherwise noted, all Limited Partner Units are held with sole power to vote and sole power of disposition.
(1) Includes 3,706,196 Units held by partnerships in which Mr. Nelley is a general partner and a 22% owner.
(2) Includes 552,214 Units held by trusts of which Mr. Weeks is a trustee and a 20% beneficiary and 352,760 Units owned by corporations controlled by Mr. Weeks.
(3) Includes 1,104,847 Units owned by Lindbergh-Warson Properties, Inc., a partnership in which Mr. Baur owns a 60.395% interest.
(4) Includes 1,104,847 Units owned by Lindbergh-Warson Properties, Inc., a partnership in which Mr. Mullins owns a 34.094% interest.
(5) Includes 1,104,847 Units owned by Lindbergh-Warson Properties, Inc., a partnership in which Mr. Eckhoff owns a 5.512% interest.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 will be contained in a definitive proxy statement for the General Partner which was filed on March 17, 2000, and herein is incorporated by reference.
- 35 - PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) DOCUMENTS FILED AS PART OF THIS REPORT
1. CONSOLIDATED FINANCIAL STATEMENTS:
The following Consolidated Financial Statements of the Partnership, together with the Independent Auditor's Report, are listed below:
Independent Auditors' Report Consolidated Balance Sheets, December 31, 1999 and 1998 Consolidated Statements of Operations, Years Ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows, Years Ended December 31, 1999, 1998 and 1997 Consolidated Statements of Partners' Equity, Years Ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements
2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
Schedule III - Real Estate and Accumulated Depreciation
3. EXHIBITS
See Index to Exhibits on page 74 of this report.
- 36 -
INDEPENDENT AUDITORS' REPORT
The Partners of Duke-Weeks Realty Limited Partnership:
We have audited the consolidated financial statements of Duke-Weeks Realty Limited Partnership and Subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and the financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on the consolidated financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Duke-Weeks Realty Limited Partnership and Subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the three- year period ended December 31, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
KPMG LLP Indianapolis, Indiana January 25, 2000
- 37 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31 (IN THOUSANDS, EXCEPT PER UNIT AMOUNTS)
See accompanying Notes to Consolidated Financial Statements.
- 39 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31 (IN THOUSANDS)
See Note (3) for other non-cash items
See accompanying Notes to Consolidated Financial Statements.
- 40 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF PARTNERS' EQUITY (IN THOUSANDS, EXCEPT FOR PER UNIT AMOUNTS)
See accompanying Notes to Consolidated Financial Statements.
- 41 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
(1) THE PARTNERSHIP ---------------- Duke-Weeks Realty Limited Partnership (the "Partnership") was formed on October 4, 1993, when Duke-Weeks Realty Corporation (the "Predecessor" or the "General Partner") contributed all of its properties and related assets and liabilities along with the net proceeds of $309.2 million from the issuance of an additional 14,000,833 shares through an offering (the "1993 Offering") to the Partnership. Simultaneously, the Partnership completed the acquisition of Duke Associates, a full-service commercial real estate firm operating in the Midwest. The General Partner was formed in 1985 and qualifies as a real estate investment trust under provisions of the Internal Revenue Code. In connection with the 1993 Offering, the formation of the Partnership and the acquisition of Duke Associates, the General Partner effected a 1 for 4.2 reverse stock split of its existing common shares. The General Partner is the sole general partner of the Partnership and received 16,046,144 units of partnership interest ("General Partner Units") in exchange for its original contribution which represented a 78.36% interest in the Partnership. As part of the acquisition, Duke Associates received 4,432,109 units of limited partnership interest ("Limited Partner Units") (together with the General Partner Units, the ("Common Units")) which represented a 21.64% interest in the Partnership. The Limited Partner Units are exchangeable for shares of the General Partner's common stock on a one-for-one basis subject generally to a one-year holding period.
In July 1999, Weeks Corporation ("Weeks") was merged with and into the General Partner, pursuant to which Weeks Realty L.P. ("Weeks Operating Partnership") was merged with and into the Partnership. This transaction is hereafter referred to as the "Weeks Merger." Upon consummation of the Weeks Merger, the name of the operating partnership was changed to Duke-Weeks Realty Limited Partnership. Financial information and references throughout this document are labeled "the Partnership" for both pre-merger and post-merger periods as a result of this name change. The Partnership's financial statements and related footnotes as of and for the period from the merger date (July 1999) to December 31, 1999, give effect to the Weeks Merger which was accounted for under the purchase method. See Note 3 for a more complete discussion of the Weeks Merger.
The Partnership owns and operates a portfolio of industrial, office and retail properties in the midwestern and southeastern United States and provides real estate services to third-party owners. The service operations are conducted through Duke Realty Services Limited Partnership and Duke Construction Limited Partnership, in which the Partnership has an 89% profits interest (after certain preferred returns on partners' capital accounts) and effective control of their operations.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ------------------------------------------ PRINCIPLES OF CONSOLIDATION --------------------------- The consolidated financial statements include the accounts of the Partnership and its majority-owned or controlled subsidiaries. The equity interests in these majority-owned or controlled subsidiaries not owned by the Partnership are reflected as minority interests in the consolidated financial statements. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
- 42 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
RECLASSIFICATIONS ----------------- Certain 1997 and 1998 balances have been reclassified to conform to 1999 presentation.
REAL ESTATE INVESTMENTS ----------------------- Real estate investments to be held and used are stated at the lower of cost less accumulated depreciation or fair value if impairment is identified. Real estate investments to be disposed of are reported at the lower of their carrying amount or fair value less cost to sell. Buildings and land improvements are depreciated on the straight-line method over their estimated life not to exceed 40 and 15 years, respectively, and tenant improvement costs are depreciated on the straight-line method over the term of the related lease.
All direct and indirect costs, including interest and real estate taxes clearly associated with the development, construction or expansion of real estate investments are capitalized as a cost of the property. All external costs associated with the acquisition of real estate investments are capitalized as a cost of the property.
The Partnership evaluates its real estate investments to be held and used upon occurrence of significant changes in the operations, but not less than annually, to assess whether any impairment indications are present, including recurring operating losses and significant adverse changes in legal factors or business climate that affect the recovery of the recorded value. If any real estate investment is considered impaired, a loss is provided to reduce the carrying value of the property to its estimated fair value.
The acquisitions of Partnership interests are recorded under the purchase method with assets acquired reflected at the fair market value of the General Partner's common stock on the date of acquisition, net of the retirement of any minority interest liabilities. The acquisition amounts are allocated to rental property based on their estimated fair values.
The Partnership has equity interests in unconsolidated partnerships and joint ventures which own and operate rental properties and hold land for development. The equity method of accounting is used for these investments in which the Partnership has the ability to exercise significant influence over operating and financial policies. Any difference between the carrying amount of these investments and the underlying equity in net assets is amortized to equity in earnings of unconsolidated companies over the depreciable life of the property, generally 40 years.
CASH EQUIVALENTS ---------------- Highly liquid investments with a maturity of three months or less when purchased are classified as cash equivalents.
- 43 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements DEFERRED COSTS -------------- Costs incurred in connection with obtaining financing are amortized to interest expense on the straight-line method over the term of the related loan. All direct and indirect costs associated with the rental of real estate investments owned by the Partnership are amortized over the term of the related lease. Unamortized costs are charged to expense upon the early termination of the lease or upon early payment of the financing.
REVENUES -------- Rental Operations ----------------- Rental income from leases with scheduled rental increases during their terms is recognized on a straight-line basis.
Service Operations ------------------ Management fees are based on a percentage of rental receipts of properties managed and are recognized as the rental receipts are collected. Maintenance fees are based upon established hourly rates and are recognized as the services are performed. Construction management and development fees are generally based on a percentage of costs and are recognized as incurred.
Duke Construction Limited Partnership ("DCLP") provides construction contract services to third parties including the development and construction of properties intended for resale. Duke Realty Services Limited Partnership ("DRSLP") is the sole general partner of DCLP and the operations of DCLP are included in the consolidated financial statements of the Partnership. The sole limited partner of DCLP is Duke Realty Construction, Inc. ("DRCI"), of which the Partnership owns 100% of the preferred stock and realizes substantially all economic benefits of its activities. DRCI is not a qualified REIT subsidiary of the Partnership. Accordingly, provisions for federal income taxes are recognized as appropriate.
Net Income Per Common Unit -------------------------- Basic net income per common unit is computed by dividing net income available for common units by the weighted average number of common units outstanding for the period. Diluted net income per unit is computed by dividing net income available for common units by the sum of the weighted average number of common units and dilutive potential common units outstanding for the period.
The following table reconciles the components of basic and diluted net income per unit:
- 44 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
The Preferred D Series Convertible equity was anti-dilutive in 1999 and 1998; therefore, no conversion to common units is assumed in weighted units outstanding at December 31, 1999 and 1998, respectively. Additionally, the Series G Preferred Units (see Note 3) were anti-dilutive in 1999; therefore, no conversion to common units is included in weighted units outstanding at December 31, 1999.
All units and per unit amounts have been adjusted to reflect the General Partner's two-for-one stock split in August 1997.
FEDERAL INCOME TAXES -------------------- As a partnership, the allocated share of income and loss for the year is included in the income tax returns of the partners; accordingly, no accounting for income taxes is required in the accompanying consolidated financial statements.
FAIR VALUE OF FINANCIAL INSTRUMENTS ----------------------------------- The fair values of the Partnership's financial instruments are generally calculated as the present value of estimated future cash flows using a discount rate commensurate with the risks involved and approximate their carrying or contract values.
DERIVATIVE FINANCIAL INSTRUMENTS -------------------------------- The Partnership may enter into derivative financial instruments such as interest rate swaps and treasury locks in order to mitigate its interest rate risk on a related financial instrument. These derivative financial instruments are designated as hedges and deferral accounting is applied as the derivative financial instrument reduces exposure to interest rate risk. Gains and losses on derivative financial instruments are amortized to interest expense over the term of the hedged instrument. Amounts paid or received on interest rate swaps are included in interest expense.
USE OF ESTIMATES ---------------- The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
(3) Merger With Weeks Corporation ----------------------------- In July 1999, Weeks, a self-administered, self-managed geographically focused REIT which operated primarily in the southeastern United States, and Weeks Operating Partnership, were merged with and into the General Partner and the Partnership. In accordance with the terms of the Weeks Merger, each outstanding Weeks Operating Partnership common unit was converted into 1.38 common units of the
- 45 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
Partnership and each outstanding Weeks Operating Partnership Series A preferred unit was converted into one of the Partnership's Series F preferred units (the "Series F Preferred Units"). As a result, 27.4 million common units and 6,000,000 Series F Preferred Units were issued to Weeks Operating Partnership unitholders in exchange for all of the outstanding Weeks Operating Partnership common and preferred units.
In accordance with the terms of the Weeks Merger, the Partnership converted 1,400,000 Weeks Operating Partnership 8% Series C cumulative redeemable preferred limited partnership interests into 1,400,000 8% Series G cumulative redeemable preferred limited partnership interests (the "Series G Preferred Units"). The Series G Preferred Units were recorded at a value of $35,000,000 based upon the estimated fair market value at the date of the merger announcement and are recorded in partners' equity. The Series G Preferred Units have a liquidation preference of $25.00 per preferred unit and are redeemable by the Partnership on or after November 6, 2003, at a redemption price of $25.00 per preferred unit. In combination with the issuance of the Series G Preferred Units, the Partnership issued a warrant that entitles its holder to purchase either 1,444,486 shares of General Partner common stock at a price of $24.23 per share, or 1,400,000 shares of General Partner preferred stock at a price of $25.00 per share. The Series G Preferred Units are automatically redeemed upon the exercise of the warrant. The warrant has a perpetual term unless the Series G Preferred Units are redeemed by the Partnership, in which case the warrant expires within 30 days of redemption.
The Partnership also converted 2,600,000 Weeks Operating Partnership 8.625% Series D cumulative redeemable preferred limited partnership interest into 2,600,000 8.625% Series H cumulative redeemable preferred limited partnership interests (the "Series H Preferred Units"). The Series H Preferred Units were recorded at a value of $67,955,000 based upon the estimated fair market value at the date of the merger announcement and are recorded in partners' equity. The Series H Preferred Units have a liquidation preference of $25.00 per preferred unit and are redeemable at the option of the Partnership on or after November 12, 2003, at a redemption price of $25.00 per preferred unit.
The Partnership issued 10,144,424 common units to Weeks Operating Partnership limited partnership unitholders at a rate of 1.38 Partnership common units for each Weeks Operating Partnership limited partnership unit outstanding. These common units were recorded as partners' equity at a value of $220.6 million based upon the estimated fair market value of the General Partner's common stock at the date of the merger announcement.
The total purchase price of Weeks Operating Partnership aggregated approximately $1.9 billion, which included the assumption of the outstanding debt and liabilities of Weeks Operating Partnership of approximately $775 million based upon the estimated fair market value at the date of the merger. The transaction was structured as a tax-free merger and was accounted for under the purchase method.
The following summarized pro forma unaudited information represents the combined historical operating results of Weeks Operating Partnership and Duke Realty Limited Partnership with the appropriate purchase accounting adjustments, assuming the Weeks Merger had occurred on January 1, 1998. The pro forma financial information presented is not necessarily indicative of what the Partnership's actual operating results would have been had Weeks Operating Partnership and Duke Realty Limited Partnership constituted a single entity during such periods (in thousands, except per unit amounts): - 46 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
(4) RELATED PARTY TRANSACTIONS -------------------------- The Partnership provides management, leasing, construction and other tenant related services to partnerships in which certain executive officers have continuing ownership interests. The Partnership was paid fees totaling $2.4 million, $2.3 million and $3.3 million for such services in 1999, 1998 and 1997, respectively. Management believes the terms for such services are equivalent to those available in the market. The Partnership has an option to purchase the executive officers' interest in each of these properties which expires October 2003. The option price of each property was established at the date the options were granted.
At December 31, 1999, other assets included outstanding loan advances totaling $3.45 million due from a related party, under a $5.7 million demand loan agreement. The loan bears interest at LIBOR plus 2.10% and is secured by real estate assets held by the related entity, for which the Partnership has arrangements to acquire in future periods. Interest earned under the agreement and included in the accompanying consolidated statements of operations totaled $120,852 in the year ended December 31, 1999.
(5) INVESTMENTS IN UNCONSOLIDATED COMPANIES --------------------------------------- Combined summarized financial information of the companies which are accounted for by the equity method as of December 31, 1999 and 1998 and for the years ended December 31, 1999, 1998, and 1997 are as follows (in thousands):
- 47 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
(6) REAL ESTATE HELD FOR SALE ------------------------- The Partnership has an active sales program through which it is continually pursuing favorable opportunities to dispose of real estate assets that no longer meet long-term investment objectives of the Partnership in order to redeploy capital. At December 31, 1999, the Partnership had seven office and six industrial properties comprising approximately 3.5 million square feet held for sale. Of these properties, five build-to-suit office and two build-to-suit industrial properties were under development at December 31, 1999. Net operating income (defined as total property revenues, less property expenses, which include real estate taxes, repairs and maintenance, property management, utilities, insurance and other expenses) of the properties held for sale for the years ended December 31, 1999, 1998 and 1997 is approximately $7.5 million, $5.7 million, and $4.0 million, respectively. Net book value of the properties held for sale at December 31, 1999 is approximately $153.6 million. There can be no assurance that such properties held for sale will be sold.
(7) INDEBTEDNESS ------------ Indebtedness at December 31 consists of the following (in thousands):
As of December 31, 1999, the $528.7 million of secured debt is collateralized by rental properties with a net carrying value of $835.3 million.
Both lines of credit are used to fund development and acquisition of additional rental properties and to provide working capital.
Effective July 2, 1999, the interest rate on the $450 million line of credit was adjusted from LIBOR + .80% to LIBOR + .70%. Additionally, the $450 million line of credit allows the Partnership an option to obtain borrowings from the financial institutions that participate in the line of credit at rates lower than the stated interest rate, subject to certain restrictions. Amounts outstanding on the line of credit at December 31, 1999 are at LIBOR +.70%.
The $300 million line of credit was obtained July 2, 1999, in connection with the Weeks Merger (see Note 3).
- 48 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
In July 1999 in conjunction with the Weeks Merger, the Partnership assumed an $85 million unsecured syndicated bank term loan (the "Term Loan"). Interest accrues on the Term Loan at LIBOR + 1.10% and the Term Loan matures on December 31, 2001. The Partnership also assumed three interest rate swap agreements with three commercial banks that effectively changes the interest costs on the entire $85 million Term Loan from its variable rate to a fixed rate. The interest rate swap agreements, with notational principal amounts of $35 million, $25 million and $25 million, mature on December 31, 2001, and effectively convert interest costs on the Term Loan to a fixed rate of approximately 6.1% through maturity. The estimated fair market value of the swap agreements was $2.65 million at December 31, 1999.
At December 31, 1999, scheduled amortization and maturities of all indebtedness for the next five years and thereafter are as follows (in thousands):
Year Amount ---- -------- 2000 $ 78,200 2001 451,117 2002 69,167 2003 295,290 2004 188,736 Thereafter 1,030,966 --------- $2,113,476 =========
Cash paid for interest in 1999, 1998, and 1997 was $100.3 million, $63.6 million and $41.9 million, respectively. Total interest capitalized in 1999, 1998 and 1997 was $26.0 million, $8.5 million and $6.0 million, respectively.
(8) SEGMENT REPORTING ----------------- The Partnership is engaged in four operating segments, the ownership and rental of office, industrial, and retail real estate investments and the providing of various real estate services such as property management, maintenance, landscaping, leasing, and construction management to third-party property owners ("Service Operations). The Partnership's reportable segments offer different products or services and are managed separately because each requires different operating strategies and management expertise. There are no material intersegment sales or transfers.
Non-segment revenue to reconcile to total revenue consists mainly of equity in earnings of joint ventures. Non- segment assets to reconcile to total assets consists of corporate assets including cash, deferred financing costs and investments in unconsolidated subsidiaries.
The accounting policies of the segments are the same as those described in Note 1.
The Partnership assesses and measures segment operating results based on a performance measure referred to as Funds From Operations ("FFO"). The National Association of Real Estate Investment Trusts defines FFO as net income or loss, excluding gains or losses from debt restructurings and sales of depreciated property, plus operating property depreciation and amortization and adjustments for minority interest and unconsolidated companies on the same basis. FFO is not a measure of operating results or cash flows from operating activities as measured by generally accepted accounting principles, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to cash flows as a measure of liquidity. Interest expense and other non-property specific revenues and expenses are not allocated to individual segments in determining the Partnership's performance measure. - 49 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
The revenues, FFO and assets for each of the reportable segments are summarized as follows for the years ended December 31, 1999, 1998, and 1997:
(9) Leasing Activity ------------------- Future minimum rents due to the Partnership under non-cancelable operating leases at December 31, 1999 are as follows (in thousands):
Year Amount ---- -------- 2000 $ 553,812 2001 520,939 2002 457,339 2003 388,863 2004 317,017 Thereafter 1,136,019 --------- $3,373,989 =========
- 50 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
In addition to minimum rents, certain leases require reimbursements of specified operating expenses which amounted to $85.1 million, $56.5 million, and $33.8 million for the years ended December 31, 1999, 1998 and 1997, respectively.
(10) EMPLOYEE BENEFIT PLANS ----------------------- The Partnership maintains a 401(k) plan for the benefit of its full- time employees. The Partnership matches the employees' contributions up to three percent of the employees' salary and may also make annual discretionary contributions. Total expense recognized by the Partnership was $2.3 million, $1.5 million and $882,000 for the years ended 1999, 1998 and 1997, respectively.
The Partnership makes contributions to a contributory health and welfare plan as necessary to fund claims not covered by employee contributions. Total expense recognized by the Partnership related to this plan was $2.7 million, $2.2 million and $1.2 million for 1999, 1998 and 1997, respectively. Included in total expense is an estimate based on historical experience of the effect of claims incurred but not reported as of year-end.
(11) PARTNERS' EQUITY ---------------- The General Partner periodically accesses the public equity markets and contributes the net proceeds to the Partnership to fund the development and acquisition of additional rental properties. The proceeds of these offerings are contributed by the Partnership in exchange for additional common or preferred units.
The following series of preferred equity is outstanding as of December 31, 1999 (in thousands, except percentages):
All series of preferred equity require cumulative distributions, have no stated maturity date, and the redemption price of each series may only be paid from the proceeds of other capital shares of the General Partner, which may include other classes or series of preferred equity.
The Preferred Series D equity is convertible at a conversion rate of 9.3677 common units for each preferred unit outstanding.
The dividend rate on the Preferred B Series equity increases to 9.99% after September 12, 2012.
Under a shareholder rights plan ("Rights Agreement") of the General Partner, each common unitholder has one right for each share of the General Partner's common stock prior to the occurrence of certain triggering events which would in effect execute the Rights Agreement. Upon the occurrence of such events, each right entitles the registered holder to purchase from the General Partner, one one-thousandth
- 51 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
of a share of Series C Junior Preferred Stock of the General Partner which has substantially the same economic attributes and carries substantially the same voting rights as one share of General Partner common stock. As of December 31, 1999, no events have triggered execution of the Rights Agreement.
In August 1998, members of management and unaffiliated members of the General Partner's Board of Directors purchased approximately $37 million of common stock of the General Partner. In November 1999, an additional $32 million of common stock was purchased by management and members of the Board of Directors. Both purchases were financed by five-year personal loans at market interest rates from a financial institution. Participants are personally responsible for repaying the interest, principal balance, and other obligations as defined in the Executive and Senior Officer Stock Purchase Plan. As a condition of the financing agreement with the financial institution, the General Partner and the Partnership have guaranteed repayment of principal, interest and other obligations for each participant, but are fully indemnified by the participants. In the opinion of management, it is not probable that the General Partner or the Partnership will be required to satisfy this guarantee.
(12) STOCK BASED COMPENSATION ------------------------ The Partnership has eight stock based compensation plans, including fixed stock option plans and performance based stock plans. The Partnership is authorized to issue up to 10,042,000 shares of the General Partner's common stock under these plans. The Partnership applies APB Opinion No. 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans as the exercise price of each option equals the market price of the General Partner's common stock on the date of grant. The Partnership charges compensation costs against its income for its performance based stock plans. If compensation cost for the Partnership's fixed stock option plans had been determined consistent with FASB Statement No. 123, the Partnership's net income and net income per unit for the years ended December 31 would have been reduced to the pro forma amounts indicated below:
The effects of applying FASB Statement No. 123 in this pro forma disclosure are not indicative of future amounts. The Statement does not apply to awards prior to 1995, and additional awards in future years are anticipated.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used: Dividend yield of 7.0%, 6.0% and 5.8% for 1999, 1998 and 1997, respectively; expected volatility of 20.1%, 19.9% and 19.1% for 1999, 1998 and 1997, respectively; weighted average risk-free interest rates of 4.9%, 5.7%, and 6.4%,for 1999, 1998 and 1997 grants, respectively; and weighted average expected lives of 6.5 years for all grants.
- 52 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
Fixed Stock Option Plans ------------------------- The Partnership had two fixed stock option plans as of December 31, 1998. In 1999, the Partnership adopted the 1999 Directors' Stock Option and Dividend Increase Unit Plan and the 1999 Salary Replacement Stock Option and Dividend Increase Unit Plan. In addition, upon the Weeks Merger, the Partnership assumed all obligations under two Weeks Operating Partnership stock incentive plans.
A summary of the status of the Partnership's six fixed stock option plans as of December 31, 1999, 1998 and 1997, and changes during the years ended on those dates is as follows:
The options outstanding at December 31, 1999, under the fixed stock option plans have a range of exercise prices from $11.87 to $24.44 with a weighted average exercise price of $19.00 and a weighted average remaining contractual life of 7.05 years. The options exercisable at December 31, 1999, have a weighted average exercise price of $16.64.
Each option's maximum term is ten years. Excluding the Weeks Operating Partnership plans and with other limited exceptions, options vest at 20% per year, or, if earlier, upon the death, retirement or disability of the optionee or a change in control of the Partnership. The vesting period of the Weeks Operating Partnership plans was generally 33 1/3% per year.
Performance Based Stock Plans ----------------------------- The Partnership has two types of performance based equity compensation plans: Dividend Increase Unit Plans ("DIU Plans") and a Shareholder Value Plan. Under the DIU Plans, Dividend Increase Units ("DIUs") are granted to key employees and directors. The value of DIUs exercised by participants is payable in General Partner common stock. The maximum term of all DIUs granted is ten years.
The value of each DIU when exercised is equal to the increase in the General Partner's annualized dividend per share from the date of grant to the date of exercise, divided by the "dividend yield." Dividend yield is the annualized dividend per share divided by the market price per share of the General Partner's common stock at the date of grant. DIUs are generally subject to a 20% per year vesting schedule.
- 53 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP Notes to Consolidated Financial Statements
Under the 1995 Shareholder Value Plan (the "SV Plan"), the Partnership may grant awards in specified dollar amounts to key employees. The award is payable to the employee on the third anniversary of the date of grant. One-half of the award is payable in common stock of the General Partner, and one-half is payable in cash. The initial dollar amount of each award granted under the SV Plan is adjusted upward or downward based on a comparison of the General Partner's cumulative total shareholder return for the three-year period as compared to the cumulative total return of the S&P 500 and the NAREIT Equity REIT Total Return indices. The award is not payable upon the employee's termination of employment for any reason other than retirement, death, disability or a change in control of the General Partner.
The Partnership believes that it is not possible to reasonably estimate the fair value of the General Partner's common stock to be issued under the performance based stock compensation plans and, therefore, computes compensation cost for these plans based on the intrinsic value of the awards as if they were exercised at the end of each applicable reporting period. The compensation cost that has been charged against income for these plans was $5.9 million , $4.1 million , and $2.5 million for 1999, 1998, and 1997, respectively.
(13) COMMITMENTS AND CONTINGENCIES ----------------------------- The General Partner and the Partnership have guaranteed $93 million of mortgage loans of unconsolidated companies of which the Partnership is a 50% partner. The mortgage loans are collateralized by rental properties of joint ventures which have a net carrying value substantially in excess of the mortgage loans. The Partnership does not anticipate that it will be required to satisfy these guarantees.
The Partnership has entered into agreements, subject to the completion of due diligence requirements, resolution of certain contingencies and completion of customary closing conditions, for the future acquisition of land totaling $34.9 million. The acquisitions are scheduled to close periodically through 2002 and will be paid for through a combination of cash and Limited Partner Unit issuance. - 54 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1999 (IN THOUSANDS)
- 72 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1999 (IN THOUSANDS)
- 72 - DUKE-WEEKS REALTY LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1999 (IN THOUSANDS)
- 72 - DUKE-WEEKS REALTY LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1999 (IN THOUSANDS)
- 72 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31,1999 (IN THOUSANDS) (1) Costs capitalized subsequent to acquisition include decreases for purchase price reduction payments received and land sales or takedowns.
(2) Depreciation of real estate is computed using the straight-line method over 40 years for buildings, 15 years for land improvements and shorter periods based on lease terms (generally 3 to 10 years) for tenant improvements.
(3) 1999 Building was placed in service in December 1999.
(4) 1999 Land leases not depreciated.
(5) Building is not being depreciated as it is designated as held for sale by the Partnership.
- 73 -
3. EXHIBITS
Certain exhibits required by Item 601 of Regulation S-K have been filed with previous reports by the Partnership and the General Partner and are herein incorporated by reference thereto.
NUMBER DESCRIPTION - ------ ----------- 2.1 Agreement and Plan of Merger, dated as of February 28, 1999, by and between Duke-Weeks Realty Realty Corporation (f/k/a Duke Realty Investments, Inc.) and Weeks Corporation incorporated by reference to exhibit 10.1 of Duke Realty Investments, Inc.'s Form 8-K, dated February 28, 1999.
2.2 Agreement and Plan of Merger, dated as of February 28, 1999, by and between Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) and Weeks Realty, L.P. incorporated by reference to exhibit 10.2 of Duke Realty Investments, Inc.'s Form 8-K, dated February 28, 1999.
4.1 Second Amended and Restated Agreement of Limited Partnership of Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) is incorporated herein by reference to Exhibit 4.1 of the Partnership's Form 8-K filed on July 16, 1999.
4.2 Indenture between Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) and The First National Bank of Chicago, Trustee, incorporated by reference to Exhibit 4.1 to the Duke-Weeks Realty Corporation (f/k/a Duke Realty Investments, Inc.) Current Report on Form 8-K dated September 22, 1995.
4.3 First Supplement to Indenture, incorporated by reference to Exhibit 4.2 to the Duke-Weeks Realty Corporation (f/k/a Duke Realty Investments, Inc.) Current Report on Form 8-K filed September 22, 1995.
4.4 Second Supplement to Indenture, incorporated by reference to Exhibit 4 to the Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) Current Report on Form 8-K filed July 12, 1996.
4.5 Third Supplement to Indenture, incorporated by reference to Exhibit 4 to the Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) Current Report on Form 8-K filed May 20, 1997.
4.6 Fourth Supplement to Indenture, incorporated by reference to Exhibit 4.8 to the Duke-Weeks Realty Corporation (f/k/a Duke Realty Investments, Inc.) Form S-4 dated May 4, 1999 (Merger Registration Statement).
4.7 Fifth Supplement to Indenture, incorporated by reference to Exhibit 4 to the Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) Current Report on Form 8-K filed June 1, 1998. - 74 -
4.8 Sixth Supplement to Indenture, incorporated by reference to Exhibit 4 to the Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) Current Report on Form 8-K filed February 12, 1999.
4.9 Seventh Supplement to Indenture, incorporated by reference to Exhibit 4 to the Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) Current Report on Form 8-K filed June 29, 1999.
4.10 Eighth Supplement to Indenture, incorporated by reference to Exhibit 4 to the Duke-Weeks Realty Limited Partnership (f/k/a Duke Realty Limited Partnership) Current Report on Form 8-K filed November 15, 1999.
4.11 Indenture between Weeks Realty, L.P. and State Street Bank and Trust Company, incorporated by reference to the Weeks Realty, L.P. Form 8-A, filed on August 3, 1998.
4.12 First Supplement to Indenture, incorporated by reference to the Weeks Realty, L.P. Form 8-A, filed on August 2, 1998.
10.1 Second Amended and Restated Agreement of Limited Partnership of Duke Realty Services Limited Partnership (the "Services Partnership") are incorporated herein by reference to Exhibit 10.4 of the DRE 10-K.
10.2 Promissory Note of the Services Partnership is incorporated herein by reference to Exhibit 10.3 to the 1993 Registration Statement.
10.3 Duke Realty Services Limited Partnership 1993 Stock Option Plan is incorporated herein by reference to Exhibit 10.4 to the 1993 Registration Statement. *
10.4 Acquisition Option Agreement relating to certain properties not contributed to the Operating Partnership by Duke Associates (the "Excluded Properties") is incorporated herein by reference to Exhibit 10.5 to the 1993 Registration Statement.
10.5 Management Agreement relating to the Excluded Properties is incorporated herein by reference to Exhibit 10.6 to the 1993 Registration Statement.
10.6 Contribution Agreement for certain properties and land contributed by Duke Associates and Registrant to the Partnership is incorporated herein by reference to Exhibit 10.7 to the 1993 Registration Statement.
10.7 Contribution Agreement for certain assets and contracts contributed by Duke Associates to the Service Partnership is incorporated herein by reference to Exhibit 10.8 to the 1993 Registration Statement.
10.8 Contribution Agreement for certain contracts contributed by Duke Associates to the Partnership is incorporated herein by reference to Exhibit 10.9 to the 1993 Registration Statement.
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DUKE-WEEKS REALTY LIMITED PARTNERSHIP
10.9 Stock Purchase Agreement is incorporated herein by reference to Exhibit 10.10 to the 1993 Registration Statement.
10.10 Indemnification Agreement is incorporated herein by reference to Exhibit to 10.11 to the 1993 Registration Statement.
10.11 1995 Key Employee Stock Option Plan is incorporated herein by reference to Exhibit 10.13 to the Annual Report on Form 10-K for the year ended December 31, 1995.*
10.12 1995 Dividend Increase Unit Plan is incorporated herein by reference to Exhibit 10.14 to the Annual Report on Form 10-K for the year ended December 31, 1995. *
10.13 1995 Shareholder Value Plan is incorporated herein by reference to Exhibit 10.15 to the Annual Report on Form 10-K for the year ended December 31, 1995. *
10.14 1998 Duke Realty Severance Pay Plan is incorporated herein by reference to Exhibit 10.15 to the Partnership's Form 10-K filed March 31, 1999. *
10.15 Revolving Credit Agreement dated July 2, 1999, by and among Duke-Weeks Realty Limited Partnership as borrower, Duke-Weeks Realty Corporation as General Partner and guarantor, Banc One Capital Markets, Inc. and Wachovia Securities, Inc. ("Wachovia") as lead arrangers and joint book runners, Wells Fargo Bank, National Association ("Wells Fargo"), as co-arranger, the First National Bank of Chicago as lender and administrative agent, Wells Fargo and Wachovia as co-syndication agents, First Union National Bank and PNC Bank as co-agents and lenders, is hereby incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K filed March 17, 2000.
10.16 Second Amended and Restated Revolving Credit Agreement by and among Duke-Weeks Realty Limited Partnership(the "Borrower"), Duke-Weeks Realty Corporation (the "General Partner" and the "Guarantor"), First Chicago Capital Markets, Inc. ("FCCM") and Wells Fargo Bank, National Association ("Wells Fargo") (collectively, the "Arrangers"), The First National Bank of Chicago ("First Chicago") as a Lender and not individually, but as "Administrative Agent", Wells Fargo as Syndication Agent, PNC Bank, National Association ("PNC"), as Documentation Agent, Commerzbank A.G. Chicago Branch ("Commerzbank") and Bank of America National Trust and Savings Association ("Bank of America") as Co-Agents, is hereby incorporated by reference to Exhibit 10.2 to the Registrant's Form 8-K filed March 17, 2000.
11.1 Statement of Computation of Ratios Earnings to Fixed Changes
11.2 Statement of Computation of Ratios Earnings to Debt Service
21. List of Subsidiaries of Registrant.
23. Consent of KPMG LLP.
24. Executed powers of attorney of certain directors.
27. Financial Data Schedule
99.1 Selected Quarterly Financial Information - 76 -
DUKE-WEEKS REALTY LIMITED PARTNERSHIP
* Represents Management contract or compensatory plan or arrangement.
The Partnership will furnish to any security holder, upon written request, copies of any exhibit incorporated by reference, for a fee of 15 cents per page, to cover the costs of furnishing the exhibits. Written request should include a representation that the person making the request was the beneficial owner of securities entitled to vote at the 1999 Annual Meeting of the General Partner shareholders.
(B) Reports on Form 8-K
The Partnership filed Form 8-K on November 15, 1999 to file exhibits in connection with the issuance of 7.75% Series Notes due 2009. - 77 -
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DUKE-WEEKS REALTY LIMITED PARTNERSHIP
By: Duke-Weeks Realty Corporation Its General Partner
March 31, 2000 By: /s/ Thomas L. Hefner ----------------------- Thomas L. Hefner President and Chief Executive Officer
By: /s/ Darell E. Zink, Jr. ----------------------- Darell E. Zink, Jr. Executive Vice President and Chief Financial Officer
By: /s/ Dennis D. Oklak ----------------------- Dennis D. Oklak Executive Vice President and Chief Administrative Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Date Title --------- ---- ------
/s/ Thomas L. Hefner * 3/31/00 Chairman of the Board, President ---------------------- ------- Thomas L. Hefner and Chief Executive Officer and Director
/s/ Darell E. Zink, Jr. * 3/31/00 Executive Vice President and Chief ---------------------- ------- Darell E. Zink, Jr. Financial Officer and Director
/s/ Dennis D. Oklak * 3/31/00 Executive Vice President and ---------------------- ------- Dennis D. Oklak Chief Administrative Officer
- 78 -
/s/ Barrington Branch * 3/31/00 Director ---------------------- -------- Barrington Branch
/s/ Geoffrey Button * 3/31/00 Director ---------------------- -------- Geoffrey Button
/s/ William Cavanaugh, III * 3/31/00 Director -------------------------- -------- William Cavanaugh, III
/s/ Ngaire E. Cuneo * 3/31/00 Director ---------------------- -------- Ngaire E. Cuneo
/s/ Charles R. Eitel * 3/31/00 Director ---------------------- -------- Charles R. Eitel
/s/ Howard L. Feinsand * 3/31/00 Director ---------------------- ------- Howard L. Feinsand
/s/ L. Ben Lytle * 3/31/00 Director ---------------------- ------- L. Ben Lytle
/s/ William O. McCoy * 3/31/00 Director ---------------------- ------- William O. McCoy
/s/ John W. Nelley, Jr. * 3/31/00 Director ---------------------- ------- John W. Nelley, Jr.
/s/ James E. Rogers * 3/31/00 Director ---------------------- ------- James E. Rogers
/s/ Thomas D. Senkbeil * 3/31/00 Director ---------------------- -------- Thomas D. Senkbeil
/s/ Jay J. Strauss * 3/31/00 Director ---------------------- -------- Jay J. Strauss
/s/ A. Ray Weeks, Jr. * 3/31/00 Director ---------------------- -------- A. Ray Weeks, Jr.
* By Dennis D. Oklak, Attorney-in-Fact /s/ Dennis D. Oklak --------------------
- 79 - | 14,048 | 94,658 |
914027_1999.txt | 914027_1999 | 1999 | 914027 | ITEM 1. BUSINESS
The discussion and analysis below contains trend analysis and other forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We may from time to time make additional written and oral forward-looking statements, including statements contained in our filings with the Securities and Exchange Commission and in our reports to stockholders. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed below under "Risk Factors" and elsewhere in this report. We do not undertake to update any forward-looking statement that may be made from time to time by or on our behalf. Readers should carefully review the risk factors described in other documents we file from time to time with the Securities and Exchange Commission.
We design, manufacture and market high performance wireless local area networking, or LAN, and building-to-building network products based on radio frequency, or RF, technology. Our highly integrated wireless client adapters and network infrastructure systems seamlessly extend existing enterprise LANs to enable mobility-driven applications in a wide variety of in-building, campus area and building-to-building network environments. Introduced in 1994, RangeLAN2(TM) 2.4 GHz wireless LAN technology has been adopted by a number of major mobile computer system and handheld data terminal manufacturers, as well as many leading wireless solution providers, for real-time data collection applications in manufacturing, warehousing, transportation and retailing and for point-of-service network applications in healthcare, hospitality, education and financial services.
In 1998, we introduced the Symphony(TM) product family, a cost reduced version of our commercially proven RangeLAN2 architecture, designed to address the requirements for networking personal computers, or PCs, in home and small office environments. Symphony products provide cordless peer-to-peer data networking of PCs, enabling simultaneous Internet access for multiple PCs, and resource sharing among network users for devices such as printers and other peripheral equipment. Symphony products include software that makes the wireless network easy to set up and tools to manage computing resources connected to the network. In addition, notebook PC users are free to be anywhere in or around the home while being connected to the Internet, other PCs and peripherals. Symphony products also address many of the PC data networking requirements for small office environments. We are selling Symphony branded products through a variety of consumer distribution channels, including computer retailers and catalogs, as well as on-line retail sites over the Internet, including our e-commerce Web site at www.proxim.com.
In 1999, we announced plans to develop a second generation of Symphony cordless networking products based on the Shared Wireless Access Protocol, or SWAP, specification from the HomeRF(TM) Working Group, or HomeRF WG. Similar to the original Symphony family of data networking products, our SWAP-based Symphony products will also operate in the unlicensed 2.4 GHz frequency band, providing cordless data local area networking, and eventually cordless voice communications. We intend to sell our SWAP-based Symphony products through the same channels as the original Symphony products. In addition, we are forging OEM partnerships and co-marketing alliances with PC companies, broadband product companies, and Internet service providers for our SWAP-based Symphony products. We were incorporated in California in 1984, and reincorporated in Delaware in 1993.
RECENT ACQUISITIONS
In December 1999, we acquired privately held Wavespan Corporation, a California corporation, for 170,000 shares of our common stock and $2.2 million of cash. The total purchase price was $12.9 million, including acquisition costs of $900,000, and the acquisition was accounted for as a purchase. We believe that this acquisition will enhance our wireless LAN market position by adding complementary 5 GHz ultra-broadband
building-to-building wireless products and technologies, including a 5 GHz wireless bridge delivering networking speeds of up to 100 Mbps each way with two T-1 voice channels.
In January 2000, we acquired Micrilor, Inc. a privately held company in Wakefield, Massachusetts, who is a leader in developing unlicensed spread spectrum wireless technology, to further broaden our wireless networking capabilities. We issued 146,000 shares of common stock to acquire Micrilor, which was accounted for as a pooling of interests. This acquisition further extends our technology base in developing products for the worldwide wireless LAN and building-to-building networking industries. We believe that Micrilor's expertise in direct sequence spread spectrum RF technology complements our mix of wireless LAN offerings utilizing frequency hopping spread spectrum technology.
BACKGROUND
In recent years, organizations have shifted from centralized computing environments to distributed client/server networks in order to move information processing power closer to end users. Traditionally, these networks have been accessed from desktop computers situated in fixed locations throughout an enterprise and, accordingly, have not addressed the needs of organizations, which require their employees to be mobile within the workplace. In response, organizations have begun to utilize wireless technologies to extend their client/server networks to mobile end users.
Wireless technology can also address the growing requirement for networking PCs in home and small office environments. The widespread adoption of personal computers, fueled in particular by the advent of sub-$1,000 and now sub-$500 PCs, has resulted in multiple PCs within millions of homes. In addition, the rapid growth of notebook PC sales in business over the past several years has led to increased usage in the home as more and more business professionals bring their laptops home on a regular basis. Furthermore, the popularity of the Internet as a primary force in the growth of PCs in home and small office environments, coupled with the emerging availability of higher-cost broadband services, has created a growing need to share high speed Internet access among multiple users.
Significant technological advances and changes in the regulatory environment have facilitated the development and proliferation of wireless networking solutions, which extend the reach of existing wireline networks. In voice communications, wireless technology has made possible the extension of wired networks to serve mobile business and consumer users through devices such as cordless and cellular telephones. Similarly, advances in wireless data communications, including wireless LAN adapters and radio modems, have enabled the extension of enterprise networks to notebook computers, pen-based notepads and handheld data collection terminals in the local area environment. By providing network connectivity for mobile business users, these products increase the accuracy, timeliness and convenience of data collection and information access, thereby improving productivity and enhancing customer service. In home and small office environments, cordless networking enables resource and Internet sharing without the need for new wiring, and provides the additional benefit of allowing location independent access for mobile devices such as notebook and handheld computers.
Commercial applications of wireless local area networking technology initially addressed a limited number of vertical markets such as retailing, warehousing and distribution. In these industries, businesses quickly recognized the advantages of mobile handheld data collection devices and the productivity benefits associated with applications such as on-line inventory management and real-time asset tracking. Early wireless networking products failed to achieve widespread adoption because these systems typically involved proprietary wireless network architectures operating at low data rates with limited connectivity to existing enterprise LANs. Furthermore, because these systems operated in licensed narrowband frequencies or in the 900 MHz frequency band, they were generally authorized for use only in the U.S. and in a limited number of international markets.
During the past several years, advances in wireless data communications technology have enabled the development of a new generation of wireless LAN systems designed to operate in the unlicensed 2.4 GHz frequency band. This new generation of 2.4 GHz products operates at significantly higher data rates and utilizes standard network interfaces and protocols to seamlessly extend existing enterprise data networks and Internet connections in small office and home environments. The recent development of these high performance, open systems products has enabled the emergence of a number of new high bandwidth applications in established industrial data collection markets and has fostered the creation of many applications in new vertical markets such as healthcare, hospitality, education and financial services. In healthcare, for example, wireless LANs now allow medical professionals to access clinical data and input patient charting information at the point-of-care anywhere in a hospital environment. These same wireless networks can also be used to facilitate admissions, billing, material management and other administrative applications. Data-intensive applications in markets such as healthcare require robust and scalable wireless networks capable of supporting an increasing number of applications and users over time.
As 2.4 GHz wireless LAN technology has matured, lower costs and ease of use features have created the opportunity to serve the growing number of homes and small offices that need to network PCs and peripherals and share Internet access. For example, users in homes with multiple PCs can share files, computer peripherals and Internet access without the hassle and expense of new wiring or the limitations of old existing wires not suited to carrying high bandwidth data. Laptop users are truly free to be anywhere in or around the home while being connected to the Internet, other PCs and peripherals. Desktop PCs can be positioned anywhere in the home or small office and still maintain network access, regardless of telephone jack, powerline plug or other wiring constraints. In addition, those in small offices can enjoy the benefits of enterprise networking without investing in a wired networking infrastructure.
In 1997, an alliance of industry leading PC and PC peripherals companies, including Compaq, Hewlett Packard, IBM, Intel, Microsoft, Motorola and Proxim, was formed to address the requirements of the emerging market for home and small office networking. Named the HomeRF Working Group, the alliance developed a standard protocol for cordless voice communications and data networking called SWAP. SWAP is based on 2.4 GHz frequency hopping spread spectrum technology with an initial data rate of 1.6 Mbps. SWAP includes an ethernet-like protocol for data networking and four voice channels based on the industry proven Digital Enhanced Cordless Telephone, or DECT, standard. Proxim is developing the initial data networking technology, and Siemens is developing the initial voice communications technology. Future versions of SWAP are planned to support data rates up to 10 Mbps based on the United States Federal Communications Commission, or FCC, proposed rule change for spread spectrum systems that allows wider frequency hopping bands. The proposed rule change is currently under consideration and the FCC has told the HomeRF Working Group that the proposal may be approved during 2000. If the proposed rule change is adopted, we would expect to introduce 10 Mbps products by the end of 2000.
Wireless LAN technology that can offer both data and voice functionality may also become important to the broadband services business. The broadband services business is bringing high-speed Internet access to homes, small business and enterprises. The leading technologies for broadband services today include hybrid fiber-coaxial cable, asymmetric digital subscriber line (ADSL) over telephone lines, and wireless metropolitan multipoint distribution systems (MMDS). Broadband service providers, including cable TV operators, regional telephone operating companies, and long distance telephone companies, are seeking to offer complete packages of services, including broadband Internet connectivity, local and long distance telephony, and, in certain cases, multimedia audio and video applications. The challenge is to offer systems that cost-effectively provide these services, including installation and future expansion, with minimal labor costs, particularly in home and small office environments. We believe that wireless LANs are uniquely suited to provide in-premise distribution of voice and data services today, with the potential to provide video distribution in the future. We believe that SWAP-based wireless LANs will enable broadband service providers to seamlessly extend their connection to multiple data and voice devices in and around homes and small offices, and reduce the cost of installation and changes.
Another new application for wireless LAN technology is connectivity for business travelers on the road. Wireless LAN technology is being deployed in public places such as airport terminals and hotels, where business travelers with notebook PCs can connect to the Internet. Wireless LAN technology has the potential to provide products that can operate at home, in the office and on the road.
Concurrent with the emergence of new applications and new markets, we believe that three primary factors are causing an expansion in the worldwide market potential for wireless LANs. First, from a regulatory perspective, the 2.4 GHz frequency band has been allocated for unlicensed wireless networks in most developed countries around the world. Second, the wide availability of this unlicensed spectrum has encouraged wireless LAN suppliers to design standard products and solutions that can be marketed and sold globally. Third, the cost of 2.4 GHz products continues to decline through both advanced design integration, volume manufacturing efficiencies and economies of scale.
We believe that the convergence of worldwide spectrum availability, emerging standards and lower cost wireless and computing products, as well as higher performance products, will lead to more widespread deployment of wireless LANs. This will lead to increased use of wireless LAN products in traditional industrial data collection applications, developing point-of-service network applications, traditional enterprise networking applications such as email, and access to intranets and the Internet, as well as the emerging home and small office PC networking market.
THE PROXIM SOLUTION
In 1994, we pioneered 2.4 GHz frequency hopping wireless LAN technology by being first to market with our RangeLAN2 product family. Since then we have captured a substantial number of key design wins with major 2.4 GHz OEM customers. We attribute this success to the architectural advantages of our RangeLAN2 product line and key aspects of our overall technology approach. These advantages include:
- Seamless Extension of Existing Enterprise Data Networks. We design high performance open systems wireless communications products that transparently extend the reach of existing enterprise LANs using standard network interfaces and protocols.
- Robust, Scalable Wireless Network Architecture. RangeLAN2's unique frequency hopping systems architecture and wireless LAN protocols create a robust RF network environment that cost-effectively expands to accommodate an increasing number of mobile users and applications.
- Superior Product Performance and Functionality. The RangeLAN2 family incorporates a number of industry-leading technology innovations to achieve superior product performance and functionality, including a fully-integrated, single chip gallium arsenide RF transceiver for enhanced radio sensitivity and power amplification, a high throughput frequency hopping modulation approach with a fallback mode for extended range and coverage, and sophisticated wireless networking protocols for state-of-the-art roaming and power management capabilities.
- Broad Array of Interoperable Products and Applications. Based on the highly integrated design of our RangeLAN2 credit card and match book-sized OEM adapter products, numerous mobile systems and handheld device manufacturers have designed RangeLAN2 technology into their products. The availability of RangeLAN2-based mobile computer and peripheral systems allows end users to select from numerous interoperable products in meeting their application requirements.
In 1998, we introduced the Symphony product family of cordless networking products designed to address the requirements of the emerging home and small office data networking markets. The unique advantages of our Symphony cordless networking solution include:
- Robust Cordless Networking Architecture. Based on RangeLAN2's commercially proven frequency hopping system architecture and wireless LAN protocols, Symphony products create a robust RF network environment operating at a 1.6 megabits per second ("Mbps") data rate.
- Cost Effective Design. Taking advantage of continued integration of the RangeLAN2 design and improved manufacturing economies of scale, Symphony products are manufactured and sold at cost-effective price points, similar to advanced cordless phones and other PC peripheral products.
- Ease of Use. Using standard networking interfaces and protocols, Symphony products include software designed with menu-based wireless network configuration and diagnostic tools. These tools simplify numerous networking and resource sharing configuration issues required to properly set up a PC network.
- Sharing of PC Resources. Symphony products allow multiple PC users to easily share various resources such as printers and disc drives while enabling simultaneous shared Internet access and multiplayer PC gaming. All Symphony products feature our unique modem sharing software that provides simultaneous Internet access through a single modem and a single Internet Service Provider account.
In 1999, we announced our second generation Symphony product family based on the HomeRF WG SWAP protocol. SWAP-based Symphony cordless networking products are designed to address the requirements of the emerging home and small office networking markets, providing both data networking and voice communications on a shared frequency basis. The result will be a cost-effective and robust system offering features and functionality that other technologies can not offer. The SWAP-based Symphony cordless networking solution will include all of the unique advantages of the original Symphony system, plus the added improvement of low-cost DECT-based telephony. The initial versions of our SWAP-based Symphony products are scheduled to ship in the first half of 2000.
In December 1999, after completion of our acquisition of Wavespan, we began offering our new Stratum family of high-speed wireless building-to-building communications products. Stratum is a family of 5 GHz ultra-broadband wireless bridges delivering speeds of up to 100 Mbps in both directions, that can transport data, voice and video information between buildings up to 7 miles apart, extending corporate intranets and increasing wireless Internet backhaul capacity. With more than 20-times higher capacity than any other FCC-approved, license-free wireless link shipping today, Stratum is being deployed in enterprise networks and by ISPs, primarily in North America.
PRODUCTS
Since 1989, we have focused on supplying spread spectrum RF transceiver modules and wireless LAN adapters to OEM customers for integration into mobile computing platforms, handheld data terminals and portable peripheral devices. We design our products to be small, lightweight, cost-effective and power efficient in order to meet the needs of our OEM customers and the vertical markets they serve. In addition, Symphony and SWAP-based Symphony products are designed to meet the ease of use requirements of the emerging home PC networking market. We offer wireless networking products based on 2.4 GHz frequency hopping spread spectrum technology and 900 MHz direct sequence technology. We also offer high performance building-to-building wireless products that operate in the unlicensed 5 GHz frequency band.
Since the introduction of the RangeLAN2 product family in 1994, our 2.4 GHz product sales have increased to $64,500,000 over 93% of total revenue in 1999. We anticipate that our 2.4 GHz product sales will continue to be a significant majority of total revenue based on the worldwide availability of unlicensed 2.4 GHz spectrum, the higher throughput and capacity achievable with 2.4 GHz wireless networks, and the emerging home PC networking and small office markets served by Symphony and SWAP-based Symphony products.
2.4 GHz Products. Introduced in 1994, RangeLAN2 was the industry's first FCC-certified 2.4 GHz frequency hopping wireless LAN product family. The RangeLAN2 family consists of two product lines: OEM design-in modules and packaged "off the shelf" products. The design-in modules are integrated by OEM customers into handheld computing and data collection devices. Packaged products are used with standard notebook and desktop computers to extend existing enterprise networks and to create ad hoc wireless networks. All RangeLAN2 products are designed to share the same software and are functionally interoperable. In 1998, we introduced the Symphony product family, delivering high-speed peer-to-peer cordless networking to the home and small office environment. In 1998, we introduced the RangeLAN802 product family, which is based on 2.4 GHz frequency hopping spread spectrum technology operating at 2.0 Mbps, and includes many of the innovative software and network management features provided by RangeLAN2 products. In 1999 we announced plans to develop a second generation of Symphony cordless networking products based on the SWAP specification from the HomeRF WG.
RangeLAN2 packaged products include both client adapters and network infrastructure products. Packaged client adapters include the following form factors: one-piece PC Card, desktop ISA board, Ethernet and Serial external adapters. Packaged network infrastructure products include Ethernet and Token Ring access points for transparent bridging to existing wireline LANs. In addition, RangeLAN2 packaged products are available as private label models, enabling OEM customers to offer a complete line of 2.4 GHz wireless LAN products under their brand name.
RangeLAN2 OEM modules are design-in wireless LAN adapters that range in size from credit card-sized devices to a match book-sized units. These modules are highly integrated, miniaturized products which reduce the design-in cycle time and expedite the time to market for OEMs by offering industry standard interfaces and, if required, the ability to port to non-standard interfaces and computing platforms with software tools and licensed source code. RangeLAN2 OEM modules have been designed into numerous handheld computing and data collection devices by various OEM partners.
The Symphony product family provides high-speed peer-to-peer cordless networking for the home and small office markets operating at a 1.6 Mbps data rate. Symphony products currently include a cordless ISA and PCI adapter for desktop PCs, a cordless PC Card adapter for notebook and sub-notebook computers, a standalone Cordless Modem that provides plug-and-play V.90 56 Kbps modem sharing and a Cordless Ethernet Bridge for connectivity to broadband Internet devices such as cable modems, xDSL gateways and ISDN routers. SWAP-based Symphony products, currently scheduled for initial delivery in March 2000, include the wireless LAN industries first USB adapter for desktop computers, a cordless PC card for notebook computers, a Cordless Ethernet Bridge for connectivity to broadband Internet devices such as cable modems, xDSL gateways and ISDN routers, and a miniature OEM design-in module for radio integration into products such as broadband Internet gateways. Symphony and SWAP-based Symphony products also include the "Composer Installation Wizard" software setup tool, the "Conductor" modem sharing software to use an existing PC modem, and the "Maestro" network management software tool.
RangeLAN802 products include a one-piece PC Card for client computer systems as well as network access points for transparent bridging to existing Ethernet LANs. The RangeLAN802 product family also includes OEM design-in modules for integration in a wide variety of mobile computing platforms. Operating at 2.0 Mbps, RangeLAN802 products comply with the recently adopted Institute of Electrical and Electronics Engineers, or IEEE, 802.11 frequency hopping wireless LAN standard.
900 MHz Products. We offer several types of products based on our 900 MHz direct sequence spread spectrum technology: RF transceivers; dual board radio-modems that combine a RF transceiver, controller and RS-232 interface in a single unit; ProxLink, a packaged version of the dual board radio-modem units; and RangeLAN, a family of wireless LAN adapters. The RF transceiver products and dual board radio-modems are OEM design-in products. ProxLink products, originally introduced in 1991, are self-contained ruggedized networking devices which enable both point-to-point and multipoint wireless data communications. The 900 MHz RangeLAN product family, originally introduced in 1992, was our first generation of open systems wireless LAN adapters.
5 GHz Products. We offer two types of products based on our 5 GHz ultra-broadband wireless technology: The Stratum 100 and the Stratum 20, which operate at 100 Mbps and 20 Mbps respectively, offer full duplex communications for 100BASE-T Ethernet and two T-1 connections. The Stratum operates in the recently allocated 5.15 -- 5.35 GHz and 5.725 -- 5.825 GHz unlicensed National Information Infrastructure, or U-NII, frequency bands. Operation in the 5 GHz spectrum allows the Stratum link to be impervious to rain, snow and fog, making it technically superior to millimeter wave, infrared or laser optic solutions. Stratum performance is comparable to the best fiber links with better than 10(-12) bit error rate. With industry-standard 100BASE-T and MII interfaces, Stratum connects easily to a router or switch. Similarly, ANSI standard DS-1 ports connect to digital PBX, video codec and other equipment with T1 interfaces, which enable a seamless fit into existing data and voice networks. Management and monitoring can be enabled via built-in SNMP MIBs. User interface choices include native HTML for standard web browsers, and VT-100 displays and Telnet are supported.
CUSTOMERS
The majority of our revenue has been derived from sales to OEM customers that offer wireless LAN products as part of a complete solution that typically includes specialized mobile computers developed by the OEM, network infrastructure systems, peripheral devices, software and services. Our OEM partners traditionally target industrial applications in one or more specific markets such as manufacturing, warehousing, transportation and retailing. Our 2.4 GHz OEM customers include, among others, Casio Computer, Data General, Fujitsu, Furuno Electric, Hand Held Products, Intermec/Norand, LXE, Matsushita, Mitsubishi, Motorola, Percon, Sharp, Teklogix and Toshiba.
We market our branded RangeLAN2 products to value-added resellers and systems integrators in emerging wireless markets that include healthcare, hospitality, education and financial services, where access to real-time information is critical. In healthcare, ISVs such as HBO & Company, SMS, Cerner, IDX, Puritan/Bennett, MediServe, Healthpoint, Medic, Emtek and PACE are sales partners that drive the information technology decision making process. In addition, RangeLAN2 software drivers are integrated into Microsoft's Windows CE, Handheld PC Professional Edition software utilized by leading handheld PC vendors including Casio Computer, Compaq Computer, Hewlett-Packard, Hitachi, LG Electronics, NEC, Philips, Sharp and Vadem.
We market our Symphony products to national and regional PC and electronics retailers, computer catalogs, and on-line retail sites over the Internet, including our e-commerce Web site. In addition, we are forging OEM partnerships for our Symphony and SWAP-based Symphony family of home networking products. Symphony and SWAP-based Symphony products serve emerging wireless markets that include home and small office networking, traveling professional and University campus networks, where mobility and price are critical. Our Symphony and SWAP-based Symphony partners include, among others, Intel and Motorola, each of which made a $10M equity investment in Proxim during 1999, Compaq Computer, Kansai Electric and Siemens.
In 1999, sales to Intermec represented 30% of our total revenue. In 1998, sales to Intermec and LXE represented 41% and 11%, respectively, of our total revenue. In 1997, sales to Intermec, NTT-IT and LXE represented 28%, 17% and 10%, respectively, of our total revenue. Sales to OEM customers were $35,894,000, $29,393,000 and $26,780,000, in 1999, 1998 and 1997, respectively, representing 52%, 59% and 62% of total revenue during such periods.
We expect that sales to a limited number of OEM customers will continue to account for a substantial portion of our revenue during any period for the foreseeable future. We also have experienced quarter to quarter variability in sales to each of our major OEM customers and expect this pattern to continue in the future. The loss of or a significant reduction in sales to, one or more of our major OEM customers could have a material adverse effect on our results of operations. See "Risk Factors -- We Depend Significantly on a Limited Number of OEM Customers."
SALES AND MARKETING
We sell our commercial products directly to OEM customers and indirectly to value-added resellers, systems integrators and end users through regional, national and international distributors. We offer OEM customers both design-in products for integration into their wireless computing platforms, and branded products as private label models. We have developed channels for marketing and selling our Symphony product line, including sales through national and regional PC and electronics retailers, computer catalogs, and on-line retail sites over the Internet, including our e-commerce Web site at www.proxim.com. Additionally, we have developed channels for marketing and selling our Symphony and SWAP-based Symphony product line to OEM and private label partners. Our 5 GHz ultra-broadband products are sold to value-added resellers, systems integrators and end users primarily through regional distributors.
Sales of many of our wireless networking products depend upon the decision of a prospective OEM customer to develop and market wireless solutions, which incorporate our wireless technology. OEM customers' orders are affected by a variety of factors, many of which cause the design-in cycle associated with the purchase of our products by OEM customers to be quite lengthy. For a detailed discussion of these factors see "Risk Factors - We Depend Significantly on a Limited Number of OEM Customers."
Sales of wireless LAN products generally involve significant commitments of capital and other resources by our customers and us, with the attendant delays associated with procedures to approve such commitments. In this regard, in the 1999, 1998 and 1997, we made investments of $3,000,000, $1,000,000 and $2,400,000 respectively, related to investments in two startup companies: one a startup wireless services company utilizing wireless LAN technology and the other a developer of mobile thin client computing. Due to the nature of these entities and their operations, there can be no assurance that these investments will be realizable or will result in marketable and/or successful products.
We generally do not operate with a significant order backlog. Our sales to any single OEM customer are also subject to significant variability from quarter to quarter. Such fluctuations could have a material adverse effect on our operating results. In addition, there can be no assurance that we will become a qualified supplier for new OEM customers or that we will remain a qualified supplier for existing OEM customers.
Our branded RangeLAN2 products are sold to value-added resellers, systems integrators and end users in the U.S. through regional distributors, and through Tech Data Corporation, Ingram Micro, Inc. and Anixter Corporation, three nationwide distribution and sales organizations.
We also are establishing new distribution channels and OEM partnerships for our Symphony family of cordless home and small office networking products. Symphony products are currently sold through national retailers such as Best Buy, CompUSA, OfficeMax, Office Depot and Staples computer retailers such as Fry's Electronics, J&R Computer World, BrandSmart, Comp-u-Tech, DataVision, and Nationwide, leading computer catalogs such as CDW, MobilePlanet and PC Connection, and numerous on-line retail sites over the Internet, including our e-commerce Web site at www.proxim.com. Our SWAP-based Symphony products will be offered through the same channels as the original Symphony products. In addition, we are forging OEM partnerships and co-marketing alliances for our Symphony and SWAP-based Symphony family of home networking products. Our 5 GHz ultra-broadband products are sold to value-added resellers, systems integrators and end users primarily through regional distributors.
Distributors generally offer products of several different companies, including products that may compete with our products. Accordingly, these distributors may give higher priority to products of other suppliers, thus reducing their efforts to sell our products. Agreements with distributors are generally terminable at the distributor's option. A reduction in sales efforts or termination of a distributor's relationship with us could have
a material adverse effect on future operating results. Use of distributors also entails the risk that distributors will build up inventories in anticipation of substantial growth in sales. If such growth does not occur as anticipated, these distributors may substantially decrease the amount of product ordered in subsequent quarters. Such fluctuations could contribute to significant variations in our future operating results. In addition, distributors generally have stock rotation rights and price protection on unsold merchandise, which may adversely impact our profit margins.
We are expanding the international distribution channels for our products. We are authorized to ship our RangeLAN2 and Symphony products into more than 50 countries. In addition to our relationships with numerous OEM customers who market the RangeLAN2 and Symphony technology internationally, we have over 30 authorized international distributors in over 50 sales territories. Revenue from shipments by us to customers outside the United States, principally to a limited number of distributors and OEM customers, represented 21%, 17% and 26% of total revenue during 1999, 1998 and 1997, respectively. We expect that revenue from shipments to international customers will vary as a percentage of total revenue. Sales to international customers or to U.S. OEM customers who ship to international locations are subject to a number of risks and uncertainties. For a discussion of the risks we face from our international business, see "Risk Factors - We Depend Upon International Sales and Our Ability to Sustain and Increase International Sales Is Subject to Many Risks, Which Could Adversely Affect Our Operating Results."
As of December 31, 1999, our selling, general and administrative department consisted of 87 full-time employees. Selling, general and administrative expenses were $13,575,000, $12,555,000, and $13,513,000 during 1999, 1998 and 1997, respectively.
MANUFACTURING
Our manufacturing operations consist primarily of final assembly and testing, quality assurance, packaging and shipping at our manufacturing facility in Sunnyvale, California. We purchase all of the circuit boards, integrated circuits and other components used in our products from third party suppliers. We inspect these components for quality, group the components into kits by production order, and ship the kits to our subcontractors for interim assembly and test. We manufacture our Symphony products through turnkey contract manufacturers.
We design our products to provide a high degree of reliability. Our products have achieved a field failure rate of our installed base of less than 1% per annum to date. We believe that this reliability is the result of our careful quality assurance procedures. We have developed a supplier selection procedure and approved vendor list to maintain quality. In addition, we monitor our suppliers' performance to ensure consistent quality, reliability and yields. We received ISO 9002 certification in January 2000 and follow the ISO 9002 quality standards, including process documentation, test procedures, quality assurance procedures, process control, equipment maintenance, quality record keeping and training of personnel. In addition, we generally use ISO 9002 certified manufacturing assembly subcontractors and contract manufacturers.
We currently have limited manufacturing capability and no experience in large scale or foreign manufacturing. If our customers were to concurrently place orders for unexpectedly large product quantities, our present manufacturing capacity might be inadequate to meet the demand. We can offer no assurance that we will be able to develop or contract for additional manufacturing capacity on acceptable terms on a timely basis. In addition, in order to compete successfully, we will need to achieve significant product cost reductions. Although we intend to achieve cost reductions through engineering improvements, production economies, and manufacturing at lower cost locations including outside the United States, we can offer no assurance that we will be able to do so. In order to remain competitive, we also must continue to introduce new products and processes into our manufacturing environment, and we can offer no assurance that any such new products will not create obsolete invcntories related to older products. We currently conduct our manufacturing operations for all of our products at our corporate headquarters in Sunnyvale, California. In addition, we rely on contract and subcontract
manufacturers for turnkey manufacturing and circuit board assemblies which subjects us to additional risks, including a potential inability to obtain an adequate supply of finished assemblies and assembled circuit boards and reduced control over the price, timely delivery and quality of such finished assemblies and assembled circuit boards. If our Sunnyvale facility were to become incapable of operating, even temporarily, or were unable to operate at or near our current or full capacity for an extended period, our business and operating results could be materially adversely affected. Changes in our manufacturing operations to incorporate new products and processes, or to manufacture at lower cost locations outside the United States, could cause disruptions, which, in turn, could adversely affect customer relationships, cause a loss of market opportunities and negatively affect our business and operating results.
We have in the past experienced higher than expected demand for our products. This resulted in delays in the delivery of certain products due to temporary shortages of certain components, particularly components with long lead times, and insufficient manufacturing capacity. Due to the complex nature of our products and manufacturing processes, the worldwide demand for some wireless technology components and other factors, we can offer no assurance that delays in the delivery of products will not occur in the future.
Certain parts and components used in our products, including our proprietary application specific integrated circuits, or ASICs, monolithic microwave integrated circuits, or MMICs, and assembled circuit boards, are only available from single sources, and certain other parts and components are only available from a limited number of sources. Our reliance on these sole source or limited source suppliers involves risks and uncertainties, including the following:
- the possibility of a shortage or discontinuation of key components; and
- reduced control over delivery schedules, manufacturing capability, quality, yields and costs.
Any reduced availability of these parts or components when required could significantly impair our ability to manufacture and deliver our products on a timely basis and result in the cancellation of orders, which could materially adversely affect our operating results. In addition, the purchase of some key components involves long lead times and, in the event of unanticipated increases in demand for our products, we have in the past been, and may in the future be, unable to manufacture some products in a quantity sufficient to meet our customers' demand in any particular period. We have no guaranteed supply arrangements with our sole or limited source suppliers, do not maintain an extensive inventory of parts or components, and customarily purchase sole or limited source parts and components pursuant to purchase orders placed from time to time in the ordinary course of business. Business disruptions, production shortfalls, production quality or financial difficulties of a sole or limited source supplier could materially and adversely affect our business by increasing product costs, or reducing or eliminating the availability of parts or components. In an event like this, our inability to develop alternative sources of supply quickly and on a cost-effective basis could significantly impair our ability to manufacture and deliver our products on a timely basis and could materially adversely affect our business and operating results.
RESEARCH AND DEVELOPMENT
The wireless communications industry is characterized by rapid technological change, short product life cycles and evolving industry standards. To remain competitive, we must develop or gain access to new technologies in order to increase product performance and functionality, reduce product size and maintain cost-effectiveness. If we are unable to enter a particular market in a timely manner with internally developed products, we may license technology or acquire products from other businesses, or we may acquire other businesses as alternatives to internal research and development. Our research and development efforts are focused on implementing enhancements to existing products, investigating new technologies and developing new products. Since 1994, our research and development efforts have been concentrated on enhancing features and performance and reducing the cost of our 2.4 GHz frequency hopping products including RangeLAN2, Symphony and SWAP-based Symphony products. These efforts include developing and integrating our
technology into ASICs/MMICs, development of wireless protocols and network software drivers, development of software to simplify the setup and management of our products, performance enhancements and cost reductions to wireless adapter and access point products and efforts related to both domestic and international product certification. In 1997, 1998 and 1999 we substantially increased our research and development efforts in developing IEEE, 802.11 standard based products, 5 GHz high-speed wireless LAN technology and Symphony and SWAP-based Symphony products. In 1997 we licensed technology related to 5 GHz highspeed LAN products and in 1999 we acquired 5 GHz ultra-broadband wireless products through the acquisition of Wavespan.
Our success is also dependent on our ability to develop new products for existing and emerging wireless communications markets, to introduce such products in a timely manner and to have them designed into new products developed by OEM customers. The development of new wireless networking products is highly complex, and, from time to time, we have experienced delays in developing and introducing new products. Due to the intensely competitive nature of our business, any delay in the commercial availability of new products could materially and adversely affect our business, reputation and operating results. In addition, if we are unable to develop or obtain access to advanced wireless networking technologies as they become available, or are unable to design, develop and introduce competitive new products on a timely basis, or are unable to hire or retain qualified engineers to develop new technologies and products, our future operating results would be materially and adversely affected. We have expended substantial resources in developing products that are designed to conform to the IEEE 802.11 standard and the HomeRF WG SWAP specification. We can offer no assurance, however, that our IEEE 802.11 compliant products and our SWAP-based Symphony products will have a meaningful commercial impact.
In 1999, the IEEE approved a new 2.4 GHz wireless LAN standard, designated as 802.11b. Based on direct sequence spread spectrum technology, this new standard increased the nominal data rate from 2 Mbps to 11 Mbps. We have not developed products that comply with the IEEE 802.11b standard. While 802.11b technology is available to develop or acquire in the market, there can be no assurance that we will develop or acquire such technology, or that if we do develop or acquire such technology, that our products will be competitive in the market. In addition, we are developing higher-speed frequency hopping technology based on the FCC Notice of Proposed Rulemaking, or NPRM, that will allow for wider band hopping channels and increase the data rate from 1.6 Mbps to up to 10 Mbps. There can be no assurance that the NPRM will be approved, or that if the NPRM is approved, that we will be able to complete our development of 10 Mbps frequency hopping products in a timely manner, or that any such new products will compete effectively with IEEE 802.11b standard compliant products.
In addition, the IEEE approved a new 5 GHz wireless LAN standard designated as 802.11a. This new standard is based on Orthogonal Frequency Division Multiplexing, or OFDM, technology with multiple data rates ranging from below 10 Mbps to approximately 50 Mbps. In 1999, the European Telecommunications Standards Institute Project BRAN (Broadband Radio Access Networks) committee approved a new 5 GHz wireless LAN standard designated as HiperLAN2, also based on OFDM technology. While these two new 5 GHz standards apply to future generations of technology, and no companies are currently shipping wireless LAN products based on these technologies, the emergence of these standards may diminish the competitiveness of our planned introduction of 5 GHz products based on the HiperLAN1 standard. Furthermore, we are not currently developing products based one either of these two new standards, and there can be no assurance that we will develop or acquire technology compliant with these standards.
If we are unable to enter a particular market in a timely manner with internally developed products, we may license technology from other businesses or acquire other businesses as an alternative to internal research and development. In this regard, in the fourth quarter of 1997, we recorded a charge of $2,500,000 to in-process research and development related to a license of technology to be used in 5 GHz highspeed in-building wireless LAN products. In 1999, we recorded a total of $7,883,000 in charges related to acquisition of 5 GHz ultra-broadband wireless building-to-building technology.
In addition, we are a core member of the HomeRF WG, an industry consortium that is establishing an open industry standard, called the SWAP specification, for wireless digital communications between PCs and consumer electronic devices, including a common interface specification that supports wireless data and voice services in and around the home. We can offer no assurance that the HomeRF WG SWAP specification, or the SWAP-based Symphony products that we have developed to comply with the specification will have a meaningful commercial impact. Further, given the emerging nature of the wireless LAN market, we can offer no assurance that the RangeLAN2 and Symphony products and technology, or our other products or technology, will not be rendered obsolete by alternative or competing technologies.
As of December 31, 1999, our research and development department consisted of 74 full-time employees. Research and development expenses were $9,316,000, $7,630,000, and $6,220,000 during 1999, 1998 and 1997, respectively.
COMPETITION
The wireless local area networking market is extremely competitive, and we expect that competition will intensify in the future. Increased competition could adversely affect our business and operating results through pricing pressures, the loss of market share and other factors. The principal competitive factors in the wireless LAN market include the following:
- data throughput;
- effective RF coverage area;
- interference immunity;
- network scalability;
- price;
- integration with voice technology;
- wireless networking protocol sophistication;
- ability to support industry standards;
- roaming capability;
- power consumption;
- product miniaturization;
- product reliability;
- ease of use;
- product costs;
- product features and applications;
- product time to market;
- product certifications;
- brand recognition;
- OEM partnerships;
- marketing alliances;
- manufacturing capabilities and experience;
- effective distribution channels; and
- company reputation.
Several of our competitors, particularly Cisco Systems and Lucent Technologies have broader distribution channels and brand recognition and offer more diversified product lines.
We have several competitors in our commercial wireless LAN business, including Breezecom, Cisco Systems (which recently acquired Aironet Wireless Communications), Intersil, Lucent Technologies, Nokia, Symbol Technologies and 3COM, among others. We also face competition from a variety of companies that offer different technologies in the nascent home networking market, including several companies developing competing wireless networking products. Additionally, numerous companies have announced their intention to develop competing products in both the commercial wireless LAN and home networking markets. In addition to competition from companies that offer or have announced their intention to develop wireless LAN products, we could face future competition from companies that offer products which replace network adapters or offer alternative communications solutions, or from large computer companies, PC peripheral companies, as well as other large networking equipment companies. Furthermore, we could face competition from certain of our OEM customers which have, or could acquire, wireless engineering and product development capabilities. We can offer no assurance that we will be able to compete successfully against these competitors or that those competitive pressures we face will not adversely affect our business or operating results.
Many of our present and potential competitors have substantially greater financial, marketing, technical and other resources with which to pursue engineering, manufacturing, marketing, and distribution of their products. These competitors may succeed in establishing technology standards or strategic alliances in the wireless LAN market, obtain more rapid market acceptance for their products, or otherwise gain a competitive advantage. We can offer no assurance that we will succeed in developing products or technologies that are more effective than those developed by our competitors. Furthermore, we compete with companies that have high volume manufacturing and extensive marketing and distribution capabilities, areas in which we have only limited experience. We can offer no assurance that we will be able to compete successfully against existing and new competitors as the wireless LAN market evolves and the level of competition increases.
GOVERNMENT REGULATION
In the United States, we are subject to various Federal Communications Commission, or FCC, rules and regulations. Current FCC regulations permit license-free operation in certain FCC-certified bands in the radio spectrum. Our spread spectrum wireless products are certified for unlicensed operation in 902 - -- 928 MHz, 2.4 -- 2.4835 GHz, 5.15 -- 5.35 GHz and 5.725 -- 5.825 GHz frequency bands. Operation in these frequency bands is governed by rules set forth in Part 15 of the FCC regulations. The Part 15 rules are designed to minimize the probability of interference to other users of the spectrum but accord Part 15 systems secondary status in the frequency. In the event that there is interference between a primary user and a Part 15 user, a higher priority user can require the Part 15 user to curtail transmissions that create interference. In this regard, if users of our products experience excessive interference from primary users, market acceptance of our products could be adversely affected, which could materially and adversely affecting our business and operating results. The FCC, however, has established certain standards that create an irrefutable presumption of noninterference for Part 15 users and we believe that our products comply with such requirements. We can offer no assurance that the occurrence of regulatory changes, including changes in the allocation of available frequency spectrum, changes in the use of allocated frequency spectrum, or modification to the standards establishing an irrefutable presumption for unlicensed Part 15 users, would not significantly affect our operations by rendering current products obsolete, restricting the applications and markets served by our products or increasing the opportunity for additional competition.
Our products are also subject to regulatory requirements in international markets and, therefore, we must monitor the development of spread spectrum and other radio frequency regulations in certain countries that represent potential markets for our products. While we can offer no assurance that we will be able to comply with regulations in any particular country, we design our RangeLAN2, RangeLAN802, Symphony and SWAP-based Symphony products to minimize the design modifications required to meet various 2.4 GHz international spread spectrum regulations. In addition, we will seek to obtain international certifications for the Symphony and SWAP-based Symphony product line in countries where there is a substantial market for home PCs and Internet connectivity. Changes in, or the failure by us to comply with, applicable domestic and international regulations could materially adversely affect our business and operating results. In addition, with respect to those countries that do not follow FCC regulations, we may need to modify our products to meet local rules and regulations.
Regulatory changes by the FCC or by regulatory agencies outside the United States, including changes in the allocation of available frequency spectrum, could significantly affect our operations by restricting our development efforts, rendering current products obsolete or increasing the opportunity for additional competition. In September 1993 and in February 1995, the FCC allocated additional spectrum for personal communications services. In January 1997, the FCC authorized 300 MHz of additional unlicensed frequencies in the 5 GHz frequency range in Part 15 Subpart E which regulates U-NII devices operating in the 5.15 -- 5.35 GHz and 5.725 -- 5.825 GHz frequency bands. In June 1999, the FCC issued a Notice of Proposed Rulemaking , or NPRM, that proposed changing the way allocated frequencies are utilized by Part 15 spread spectrum systems. These approved and proposed changes in the allocation and use of available frequency spectrum could create opportunities for other wireless networking products and services.
There can be no assurance that new regulations will not be promulgated that could materially and adversely affect our business and operating results.
PROTECTION OF PROPRIETARY RIGHTS
We rely on a combination of patents, trademarks, non-disclosure agreements, invention assignment agreements and other security measures in order to establish and protect our proprietary rights. We have been issued seven U.S. patents, which are important to our current business, and we have three patent applications pending in the U.S. which relate to our core technologies and product designs. We can offer no assurance that patents will issue from any of these pending applications or, if patents do issue, that the claims allowed will be sufficiently broad to protect our technology. In addition, we can offer no assurance that any patents issued to us
will not be challenged, invalidated or circumvented, or that the rights granted thereunder will adequately protect us. Since U.S. patent applications are maintained in secrecy until patents issue, and since publication of inventions in the technical or patent literature tends to lag behind such inventions by several months, we cannot be certain that we first created the inventions covered by our issued patents or pending patent applications or that we were the first to file patent applications for such inventions or that we are not infringing on the patents of others. In addition, we have filed, or reserved our rights to file, a number of patent applications internationally. We can offer no assurance that any international patent application will issue or that the laws of foreign jurisdictions will protect our proprietary rights to the same extent as the laws of the United States.
Although we intend to protect our rights vigorously, there can be no assurance that the measures we have taken or may take to protect our proprietary rights will be successful. Litigation may be necessary to enforce our patents, trademarks or other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, to establish the validity of any technology licenses offered to patent infringers or to defend against claims of infringement. Litigation could result in substantial costs and diversion of resources and could materially and adversely affect our business and operating results. Moreover, we can offer no assurance that in the future these rights will be upheld. Furthermore, there can be no assurance that any of our issued patents will provide a competitive advantage or will not be challenged by third parties or that the patents of others will not adversely impact our ability to do business. As the number of products in the wireless LAN market increases, and related features and functions overlap, we may become increasingly subject to infringement claims. These claims also might require us to enter into royalty or license agreements. Any such claims, with or without merit, could cause costly litigation and could require significant management time. There can be no assurance that, if required, we could obtain such royalty or license agreements on terms acceptable to management. There can be no assurance that the measures we have taken or may take in the future will prevent misappropriation of our technology or that others will not independently develop similar products, design around our proprietary or patented technology or duplicate our products.
EMPLOYEES
As of December 31, 1999, we had employed 233 full-time employees and 28 temporary employees. Of these individuals, 74 are in engineering and product development, 72 are in marketing, sales and customer support, 100 are in manufacturing and quality assurance, and 15 are in finance and administration. We believe that our future success will depend in large measure on our ability to retain certain key technical and management personnel and to attract and retain additional highly skilled employees. Competition for qualified personnel in the wireless data communications and networking industries is intense, particularly in the Silicon Valley region of Northern California, and there can be no assurance that we will be successful in retaining key employees or that we will be able to attract, assimilate or retain the additional skilled personnel that will be required to support our anticipated growth. None of our employees are represented by a labor union. We believe that our relations with employees are good.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning our executive officers as of December 31, 1999:
DAVID C. KING joined Proxim in December 1992 as Vice President of Marketing and acting Chief Financial Officer, in July 1993 was appointed President, Chief Executive Officer and Director, and in January 1996 was named Chairman of the Board of Directors. From December 1990 to November 1992, Mr. King served in various executive capacities at Vitalink Communications Corporation, or Vitalink, a LAN internetworking subsidiary of Network Systems Corporation, most recently as Vice President of Marketing and Customer Services. From 1985 to 1990, Mr. King was Senior Manager in the San Francisco office of McKinsey & Company, Inc., an international management consulting firm, where he was a member of the firm's high technology and health care practices.
KURT F. BAUER joined Proxim as Vice President of Marketing in December 1999. From March 1997 to December 1999, Mr. Bauer worked for Ascend Communications, acquired by Lucent Technologies in 1998, where he held several management positions, most recently as Vice President of Marketing. Before joining Ascend, Mr. Bauer held marketing and engineering management positions for other telecommunications and data communications companies, including Adaptive (Network Equipment Technologies), ACC (Advanced Computer Communications), Vitalink and Tymnet (British Telecom).
KEITH E. GLOVER has served as the Vice President of Finance and Administration and Chief Financial Officer since he joined Proxim in September 1993. From March 1986 to June 1993, Mr. Glover worked for Vitalink, where he held several financial management positions, most recently as Vice President of Finance.
JUAN GRAU joined Proxim in August 1988 as RF Communications Manager. Mr. Grau was promoted to Director of Product Engineering in November 1989 and, in June 1991, was appointed Vice President of Engineering. From 1980 to 1988, Mr. Grau worked at Hewlett-Packard Company, where he served in several engineering and project management positions.
BRIAN S. MESSENGER joined Proxim in January 1989 as an engineering manager in the RF communications group. In April 1994 Mr. Messenger was promoted to Director-Product Development, and in October 1998 was appointed Vice President of Operations. From 1981 to 1988, Mr. Messenger worked at Hewlett-Packard Company, where he served in several engineering positions.
JAMES REGEL joined Proxim in December 1999 as a result of the Wavespan acquisition as Vice President of Sales. From June 1997 to December 1999, Mr. Regel worked for Wavespan, most recently as President. Before joining Wavespan, Mr. Regel held various sales, marketing and operations vice president and director positions at Verilink Corporation, Network Equipment Technologies and ROLM Corporation.
ITEM 2.
ITEM 2. PROPERTIES
FACILITIES
Our corporate headquarters, primary research and development, and manufacturing operations are located in approximately 139,000 square feet in Sunnyvale, California under leases that expire August 31, 2009. In addition, we maintain 40,000 square feet of office space in Mountain View, California under a lease and sublease that expires March 31, 2006. Management considers the above facilities suitable and adequate to meet our current requirements. We also lease sales offices in Atlanta, Georgia; Nashua, New Hampshire; Paris, France; and Tokyo, Japan. In January 2000, we acquired Micrilor, Inc. with approximately 6,000 square feet of office and R&D space in Wakefield, Massachusetts under a month to month lease. We are seeking to relocate the Micrilor operations to a larger facility in 2000, and establish the location as our East Coast design center.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
MARKET FOR COMMON STOCK.
Prior to December 15, 1993, the date of our initial public offering, there was no public market for our Common Stock. Since December 15, 1993, our Common Stock has been available for quotation through the Nasdaq National Market under the symbol "PROX." The following table sets forth, for the period indicated, the high and low sale prices per share of our Common Stock as reported by the Nasdaq National Market:
HOLDERS OF RECORD.
As of March 4, 2000, there were 185 stockholders of record of our Common Stock.
DIVIDENDS.
We have not declared or paid cash dividends.
RECENT SALES OF UNREGISTERED SECURITIES.
In April and June 1999 we issued to Intel and Motorola 606,000 shares of our common stock valued at approximately $20 million. In December 1999, in connection with our acquisition of Wavespan, we issued to former stockholders and a debtor of Wavespan an aggregate of 204,000 shares of our common stock valued at approximately $11.7 million. These transactions were exempt from the registration requirements of Section 5 of the Securities Act of 1933, as amended, pursuant to Section 4127.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The discussion and analysis below contains trend analysis and other forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We may from time to time make additional written and oral forward-looking statements, including statements contained in our filings with the Securities and Exchange Commission and in our reports to stockholders. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed below under "Risk Factors " and elsewhere in this report. We do not undertake to update any forward-looking statement that may be made from time to time by or on our behalf. Readers should carefully review the risk factors described in other documents we file from time to time with the Securities and Exchange Commission.
The following discussion should be read in conjunction with our Financial Statements and Notes thereto.
OVERVIEW
Since 1989, we have focused on supplying spread spectrum RF transceiver modules and wireless LAN adapters to OEM customers for integration into mobile computing platforms, pen-based portables and handheld data collection terminals. In 1990, we introduced our first commercial product for OEM customers, a 900 MHz direct sequence spread spectrum RF transceiver. We introduced ProxLink, our first branded wireless data communications product for the commercial end user market in 1991, and RangeLAN, a family of 900 MHz direct sequence wireless LAN adapters in 1992. In 1994, we began commercial shipment of RangeLAN2, the industry's first FCC certified family of 2.4 GHz frequency hopping spread spectrum wireless LAN products. In 1996, we introduced an integrated single piece PC Card adapter and a compact access point product. In 1997, we introduced our RangeLAN2 micro design-in module, Token Ring access point and Extension Point. In 1998, we introduced our RangeLAN802 frequency hopping product family based on the IEEE 802.11 standard, RangeLAN2 Ethernet and Serial external adapters and the Symphony product family, a low-cost cordless networking solution for home and small office environments. In December 1999, we introduced a 5 GHz ultra-broadband 100 Mbps product family as a result of our acquisition of Wavespan.
Since the introduction of the RangeLAN2 product family in 1994, our 2.4 GHz product sales have increased to $64,500,000 over 93% of total revenue in 1999. We anticipate that our 2.4 GHz product families will continue to represent a substantial majority of our total revenue as a result of the worldwide availability of unlicensed 2.4 GHz spectrum as well as the higher throughput and capacity achievable with 2.4 GHz wireless networks. To date, we have realized lower gross margins from sales of our 2.4 GHz products compared to our 900 MHz products due primarily to the higher component costs, higher manufacturing costs associated with early production of various 2.4 GHz products and declining average selling prices on 2.4 GHz products. While we expect manufacturing costs to decline over time as a result of greater efficiencies associated with higher volume production, there can be no assurance that we will be able to achieve higher gross margins with respect to 2.4 GHz product sales. Gross margins will be affected by a variety of factors, including manufacturing efficiencies, the location of manufacturing, potential manufacturing licenses of our products, competitive pricing pressures, the degree of customization of individual products required by OEM customers and component and assembly costs.
Historically, we have marketed our products predominantly in the United States and, until 1995, revenue from international sales was not significant. Since 1994, we have obtained regulatory certifications and authorizations for our 2.4 GHz RangeLAN2 products in over 50 countries. These certifications and authorizations have significantly increased the available markets for these products. Revenue from sales directly to international customers were 21%, 17% and 26% in 1999, 1998 and 1997, respectively. See "Business -- Sales and Marketing."
A substantial portion of our revenue to date has been derived from a limited number of customers, most of which are OEM customers. Sales to OEM customers represented approximately 52%, 59% and 62% of total revenue in 1999, 1998 and 1997, respectively. We expect that sales to a limited number of OEM customers will continue to account for a substantial portion of our revenue for the foreseeable future. We also have experienced quarter to quarter variability in sales to each of our major OEM customers and expects this pattern to continue in the future. The loss of, or significant reductions in sales to, one or more of our major OEM customers could have a material adverse effect on our results of operations. The development of products for OEM customer applications is characterized by a lengthy sales process and design-in cycle which typically lasts from six months to two years and requires us to integrate our technologies into, and in certain cases adapt our products to fit, OEM customers' products. In addition, our OEM customers' products are generally required to be certified by the FCC or the equivalent regulatory agency in each country where such products are sold. We have committed substantial engineering, marketing and sales resources to develop key OEM relationships and have broadened our OEM customer base. Due to our current dependency on our OEM customers for a significant percentage of our total revenue and the nature of our OEM business, our annual and quarterly operating results are subject to fluctuations as a result of the level and timing of OEM customer orders. We work closely with our OEM customers to manage the order cycle process in an attempt to reduce the fluctuations inherent in our OEM business.
Our RangeLAN2 branded products are marketed and sold to value-added resellers, systems integrators and end users primarily through regional and national distributors. Our Symphony branded products are marketed and sold through PC and electronics retailers, computer catalogs, and on-line retail sites over the Internet, including our e-commerce Web site. In addition, our Symphony and SWAP-based Symphony products are marketed to OEM and private label partners. Our Stratum 5 GHz ultra-broadband products are sold to value-added resellers, systems integrators and end users primarily through regional distributors. We grant certain distributors limited rights of return and price protection on unsold products. Product revenue on shipments to distributors, which have rights of return and price protection, is recognized upon shipment by the distributor. Many of our packaged products are also sold to OEM customers.
RESULTS OF OPERATIONS
THREE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
Revenue increased by 39% from $49.7 million in 1998 to $69.1 million in 1999, and by 16% from $43.0 million in 1997 to $49.7 million in 1998. Revenue increased in 1999 compared to 1998 primarily due to increased unit shipments to distributors and OEM customers that sell RangeLAN2-based 2.4 GHz product lines in North America, Europe and Japan and, to a lesser extent, shipments of Symphony and 5 GHz Stratum products. The increases were partially offset by lower revenue from 900 MHz products. Revenue increased in 1998 compared to 1997 primarily due to increased unit sales of 2.4 GHz OEM products, RangeLAN2 branded products and private label RangeLAN2 products in North America and Europe, partially offset by a significant decrease in orders from NTT-IT, one of our major customers, starting in the third quarter of 1997 and continuing through the second quarter of 1998, and to a lessor extent, lower revenue from 900 MHz products.
Gross profit as a percentage of revenue was 47.5%, 48.2% and 47.9% during 1999, 1998, and 1997, respectively. Gross profit as a percentage of revenue decreased slightly in 1999 compared to 1998 due to declining average selling prices on RangeLAN2 and Symphony products, an increase in revenue from lower margin Symphony and 5 GHz Stratum products and a decrease in revenue from higher gross margin 900 MHz products. Gross profit as a percentage of revenue increased slightly in 1998 compared to 1997 due to engineering cost reductions on 2.4 GHz products, offset by declining average selling prices on 2.4 GHz products and a decrease in revenue from higher gross margin 900 MHz products. We expect gross profit as a percentage of revenue to fluctuate in future periods depending primarily on the mix of revenue between existing 2.4 GHz, 5 GHz and 900 MHz products, and potential manufacturing and technology license arrangements.
Research and development expenses consist primarily of personnel costs and, to a lesser extent, consulting fees, prototype material, and other costs of ASIC/MMIC development. Research and development expenses are related primarily to the development and enhancement of radio transceivers, ASICs/MMICs, wireless protocols and network software drivers. Research and development expenses increased by 22% from $7.6 million in 1998 to $9.3 million in 1999, and by 23% from $6.2 million in 1997 to $7.6 million in 1998. Research and development expenses increased in 1999 compared to 1998 primarily due to an increased number of engineering employees, continued investment in integrating our technology into ASICs, development of wireless protocols and network software drivers, costs related to product performance enhancements, cost reductions in 2.4 GHz products, costs related to both domestic and international product certifications, development of products based on the IEEE 802.11 standard, and development of 5 GHz high-speed wireless LAN technology. Research and development expenses increased in 1998 compared to 1997 primarily due an increased number of engineering employees, continued investment in integrating our technology into ASICs, development of wireless protocols and network software drivers, costs related to product performance enhancements, cost reductions in 2.4 GHz products, costs related to both domestic and international product certifications, development of products based on the IEEE 802.11 standard, and development of 5 GHz high-speed wireless LAN technology. Research and development expenses as a percentage of revenue were 13%, 15% and 14% in 1999, 1998 and 1997, respectively. Research and development expenses as a percentage of revenue declined in 1999 compared to 1998 primarily due to an increase in revenue, partially offset by an increase in personnel and engineering development program costs in 1999. Research and development expenses as a percentage of revenue increased in 1998 compared to 1997 primarily due to the increase in personnel and development program costs in 1998. For the near future, we expect research and development expenses to decline slightly at a rate similar to the sales growth rate, as we continue to invest in technology to address potential market opportunities. If we are unable to enter a particular market in a timely manner, with internally developed products, we may license technology from other businesses or acquire other businesses as an alternative to internal research and development. To date, all of our research and development costs have been expensed as incurred.
Selling, general and administrative expenses consist primarily of personnel costs, sales commissions and bonuses, costs related to domestic and international product certifications, customer support, trade show and advertising expenses, charges related to investments in startup companies, communications and information systems, and to a lesser extent, professional fees and facilities costs. Selling, general and administration expenses increased by 8% from $12.6 million in 1998 to $13.6 million in 1999, and decreased by 7% from $13.5 million in 1997 to $12.6 million in 1998. Selling, general and administrative expenses increased in 1999 compared to 1998 primarily due to additional marketing and sales personnel to support our growth, particularly our expansion into international and consumer markets, as well as increased trade show and promotional expenses, partially offset by $1,000,000 charge related to an investment in a startup wireless services company in 1998. Selling, general and administrative expenses decreased in 1998 compared to 1997 primarily due a $2,400,000 charge related to investments in two startup companies in 1997, partially offset by hiring of additional marketing and sales personnel to support our growth, particularly our expansion into international and consumer markets, as well as increased trade show and promotional expenses, and a $1,000,000 charge related to an investment in a startup wireless services company in 1998. Selling, general and administrative expenses as a percentage of revenue were 20%, 25% and 31% in 1999, 1998 and 1997, respectively. Selling, general and administrative expenses as a percentage of revenue declined in 1999 compared to 1998 due to an increase in personnel costs, partially offset by charges related to an investment in 1998. Selling, general and administrative expenses as a percentage of revenue declined in 1998 compared to 1997 due to charges related to the investments in 1997, partially offset by an increase in personnel costs and charges related to an investment in 1998.
The amount expensed to purchased in-process research and development in 1999 related to developing 5 GHz ultra-broadband wireless technology. The amount expensed to purchased in-process research and development in 1997 related to licensed technology to be used in 5 GHz highspeed LAN products.
The amount expensed to purchased in-process research and development in 1999 was calculated by estimating fair value of technology currently under development using the income approach, which discounts expected future cash flows to present value. The discount rate used in the present value calculation was 40%.
We do not expect to achieve a material amount of expense reductions or synergies as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include any anticipated synergies or cost saving associated with the transaction. We expect that products incorporating the acquired technology will be completed and begin to generate cash flows between six to nine months after integration. However, development of these technology remains a significant risk due to the remaining effort to achieve technological feasibility, rapidly changing customer markets, uncertain standards for new products, and significant competitive threats. The nature of the efforts to develop the acquired technology into commercially viable products consists principally of developing a new operating system, developing a new processor and interface, planning and testing activities necessary to determine that the product can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share, or a lost opportunity to capitalize on emerging markets, and could have a material adverse impact on the value of assets acquired.
Interest income, net, is primarily interest income and interest expense. Interest income, net, increased from $3.3 million in 1998 to $4.1 million in 1999 primarily due to higher yields on cash balances. Interest income, net, increased from $3.0 million in 1997 to $3.3 million in 1998 primarily due to higher yields on cash balances.
We recognized a provision for income taxes of $2,802,000, $2,441,000 and $1,243,000 in 1999, 1998 and 1997 respectively. The effective tax rates in 1999, 1998 and 1997 were 47.3%, 34.2%, and 93.0%, respectively. The effective rates in 1999 and 1997 were higher than federal statutory rate of 35% plus state tax rate of 6%, net of federal benefits, primarily due to expenses related to equity investments that were not deductible for income tax purpose. Such expenses amount to $2,000,000, $1,000,000 and $2,400,000 in 1999, 1998 and 1997, respectively. The effective rate in 1998 was lower than the federal statutory tax rate plus the state tax rate, net of the federal benefits, primarily due to a research and development credit and the change in valuation allowance offset by non tax deductible expense related to the equity investment.
INFLATION
To date, inflation has not had a significant impact on our operating results.
LIQUIDITY AND CAPITAL RESOURCES
To date we have funded our operations through sales of equity securities as well as through cash flows from operations. As of December 31, 1999, we had retained earnings of $5,413,000.
In 1999, 1998 and 1997, cash provided by operations was $6,178,000, $4,785,000 and $10,128,000, respectively. In 1999, cash was provided primarily by net income after adjustments for in-process research and development charges, deprecation and amortization and deferred taxes. This was offset by cash used to fund increases in inventory and accounts receivable and a decrease in other current liabilities. In 1998, cash was provided primarily by net income after adjustments for depreciation and deferred taxes. Cash was also provided by a decrease in inventories and by an increase in accounts payable. This was partially offset by cash used to fund increases in accounts receivable and by a decrease in other liabilities. In 1997, cash was provided primarily by net income after adjustments for depreciation and deferred taxes. Cash was also provided by a decrease in accounts receivable and by an increase in other current liabilities. This was partially offset by cash used to fund an increase in inventories and by a decrease in accounts payable. We believe that to the extent we experience growth in our operations, if any, then additional cash will be required to fund increases in inventories and accounts receivable.
In 1999, 1998 and 1997, we purchased $5,352,000, $1,238,000 and $1,424,000, respectively, of property and equipment. Expenditures related primarily to the acquisition of manufacturing and engineering test equipment and leasehold improvements and furniture for our new corporate headquarters and manufacturing facilities. We expect to purchase approximately $5,000,000 of property and equipment during 2000, consisting primarily of enterprise client/server application software, manufacturing and engineering test equipment and tooling, and engineering systems software and equipment.
In 1999, 1998 and 1997, we made equity investments of $5,000,000, $1,000,000 and $2,400,000, respectively. The investments made in 1999 were for a wireless services company and a startup company developing 5 GHz ultra-broadband wireless products of which $2,000,000 was recorded as purchased in-process research and development. The remaining $3,000,000 was recorded as an equity investment. The investments made in 1998 and 1997 were for a wireless services company and a developer of mobile thin-client computing technology. The investments in 1998 and 1997 were recorded as selling, general and administrative expense.
In December 1999, we acquired Wavespan Corporation in a merger transaction, for 170,000 shares of our common stock and $2.2 million of cash. The value of the purchase price was $12.9 million, including acquisition costs of $900,000, and the acquisition was accounted for as a purchase.
In 1999, 1998 and 1997, we generated $27,418,000, $1,844,000 and $1,760,000 from issuance of common stock. In 1999 we generated cash from the exercise of employee stock options, issuance of common stock under our employee stock purchase plan and issuance of common stock to investors. In 1998 and 1997 we generated cash from the exercise of employee stock options and issuance of common stock under our employee stock purchase plan.
As of December 31, 1999 our principal sources of liquidity included cash, cash equivalents and marketable securities totaling approximately $87.4 million. We believe that our existing working capital and cash generated from operations, if any, will be sufficient to finance any cash acquisition, which we may consider and provide adequate working capital for the foreseeable future. However, to the extent that additional funds may be required in the future to address working capital needs and to provide funding for capital expenditures, expansion of the business or acquisitions, we will consider additional financing. There can be no assurance that such financing will be available on terms acceptable, if at all.
FORWARD-LOOKING STATEMENTS
This Form 10-K and the documents incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results could differ materially from those expressed or forecasted in any such forward-looking statements as a result of certain factors, including those set forth in "Risk Factors" below, as well as those noted in the documents incorporated herein by reference. In connection with forward-looking statements, which appear in these disclosures, investors should carefully review the factors set forth in this Form 10-K under "Risk Factors."
RISK FACTORS
You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.
If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment.
This Form 10-K also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by us described below and elsewhere in this Form 10-K.
OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY AND MAY FAIL TO MEET OR EXCEED THE EXPECTATIONS OF SECURITIES ANALYSTS OR INVESTORS, CAUSING OUR STOCK PRICE TO DECLINE.
Our operating results have fluctuated in the past and are likely to continue to fluctuate in the future on an annual and quarterly basis, due to numerous factors, many of which are outside of our control. Some of the factors that may cause these fluctuations include:
- changing market demand for, and declines in the average selling prices of, our products;
- the timing of and delays or cancellations of significant orders from major customers;
- the loss of one or more of our major customers;
- the cost, availability and quality of components from our suppliers;
- the cost, availability, and quality of assemblies from contract and subcontract manufacturers;
- the lengthy sales and design-in cycles for original equipment manufacturer, or OEM, products;
- delays in the introduction of our new products;
- competitive product announcements and introductions;
- market adoption of new technologies;
- market adoption of radio frequency, or RF, standards-based products (such as those compliant with the IEEE 802.11 or the Home RF SWAP specifications);
- the mix of products sold;
- the effectiveness of our distribution channels and our success in maintaining our current distribution channels and developing new distribution channels;
- the sell-through rate of our Symphony products through consumer retail channels;
- management of retail channel inventories;
- the failure to anticipate changing customer product requirements;
- seasonality in demand;
- manufacturing capacity and efficiency;
- changes in the regulatory environment, product health and safety concerns;
- Year 2000 issues; and
- general economic conditions.
Historically, we have not operated with a significant order backlog and a substantial portion of our revenue in any quarter has been derived from orders booked and shipped in that quarter. Accordingly, our revenue expectations are based almost entirely on internal estimates of future demand and not on firm customer orders. Planned operating expense levels are relatively fixed in the short term and are based in large part on these estimates. If orders and revenue do not meet expectations, our operating results could be materially adversely affected. In this regard, in the third quarter of 1997, we experienced a decrease in revenue and an operating loss as a result of a significant decrease in orders from two of our major customers. We can offer no assurance that we will not experience future quarter to quarter decreases in revenue or quarterly operating losses. In addition, due to the timing of orders from OEM customers, we have often recognized a substantial portion of our revenue in the last month of a quarter. As a result, minor fluctuations in the timing of orders and the shipment of products have caused, and may in the future cause, operating results to vary significantly from quarter to quarter.
WE DEPEND SIGNIFICANTLY ON A LIMITED NUMBER OF OEM CUSTOMERS.
A substantial portion of our revenue has been derived from a limited number of customers, most of which are OEM customers. Approximately 52%, 59% and 62% of our sales during 1999, 1998 and 1997, respectively, were to OEM customers. In addition, sales to one customer represented approximately 30% of our revenue during 1999. Sales to two customers represented approximately 41% and 11% of our revenue during 1998. Sales to three customers represented approximately 28%, 17% and 10% of our revenue during 1997. We expect that sales to a limited number of OEM customers will continue to account for a substantial portion of our revenue for the foreseeable future. We also have experienced quarter to quarter variability in sales to each of our major OEM customers and expect this pattern to continue in the future.
Sales of many of our wireless networking products depend upon the decision of a prospective OEM customer to develop and market wireless solutions, which incorporate our wireless technology. OEM customers' orders are affected by a variety of factors, including the following:
- new product introductions;
- regulatory approvals;
- end-user demand for OEM customers' products;
- product life cycles;
- inventory levels;
- manufacturing strategies;
- pricing;
- contract awards;
- competitive situations and
- general economic conditions.
For these and other reasons, the design-in cycle associated with the purchase of our wireless products by OEM customers is quite lengthy, generally ranging from six months to two years, and is subject to a number of significant risks, including customers' budgeting constraints and internal acceptance reviews, that are beyond our control. Because of the lengthy sales cycle, we typically plan our production and inventory levels based on internal forecasts of OEM customer demand, which is highly unpredictable and can fluctuate substantially. In addition, our agreements with OEM customers typically do not require minimum purchase quantities and a significant reduction, delay or cancellation of orders from any of these customers could materially and adversely affect our operating results. If revenue forecasted from a specific customer for a particular quarter is not realized in that quarter, our operating results for that quarter could be materially adversely affected. The loss of one or more of, or a significant reduction in orders from, our major OEM customers could materially and adversely affect our operating results. In addition, we can offer no assurance that we will become a qualified supplier for new OEM customers or that we will remain a qualified supplier for existing OEM customers.
WE PURCHASE SEVERAL KEY COMPONENTS USED IN THE MANUFACTURE OR INTEGRATION OF OUR PRODUCTS FROM SOLE OR LIMITED SOURCES.
Certain parts and components used in our products, including our proprietary application specific integrated circuits, or ASICs, monolithic microwave integrated circuits, or MMICs, and assembled circuit boards, are only available from single sources, and certain other parts and components are only available from a limited number of sources. Our reliance on these sole source or limited source suppliers involves risks and uncertainties, including the following:
- the possibility of a shortage or discontinuation of key components; and
- reduced control over delivery schedules, manufacturing capability, quality, yields and costs.
Any reduced availability of these parts or components when required could significantly impair our ability to manufacture and deliver our products on a timely basis and result in the cancellation of orders, which could materially adversely affect our operating results. In addition, the purchase of some key components involves long lead times and, in the event of unanticipated increases in demand for our products, we have in the past been, and may in the future be, unable to manufacture some products in a quantity sufficient to meet our customers' demand in any particular period. We have no guaranteed supply arrangements with our sole or limited source suppliers, do not maintain an extensive inventory of parts or components, and customarily purchase sole or limited source parts and components pursuant to purchase orders placed from time to time in the ordinary course of business. Business disruptions, production shortfalls, production quality or financial difficulties of a sole or limited source supplier could materially and adversely affect our business by increasing product costs, or reducing or eliminating the availability of parts or components. In an event like this, our inability to develop alternative sources of supply quickly and on a cost-effective basis could significantly impair our ability to manufacture and deliver our products on a timely basis and could materially adversely affect our business and operating results.
WE NEED TO EXPAND OUR LIMITED MANUFACTURING CAPABILITY AND INCREASINGLY DEPEND ON CONTRACT MANUFACTURERS FOR OUR MANUFACTURING REQUIREMENTS.
We currently have limited manufacturing capability and no experience in large-scale or foreign manufacturing. If our customers were to concurrently place orders for unexpectedly large product quantities, our present manufacturing capacity might be inadequate to meet the demand. We can offer no assurance that we will be able to develop or contract for additional manufacturing capacity on acceptable terms on a timely basis. In addition, in order to compete successfully, we will need to achieve significant product cost reductions. Although we intend to achieve cost reductions through engineering improvements, production economies, and manufacturing at lower cost locations including outside the United States, we can offer no assurance that we will be able to do so. In order to remain competitive, we also must continue to introduce new products and processes into our manufacturing environment, and we can offer no assurance that any such new products will not create obsolete inventories related to older products. We currently conduct our manufacturing operations for all of our products in our new corporate headquarters in Sunnyvale, California. In addition, we rely on contract and subcontract manufacturers for turnkey manufacturing and circuit board assemblies which subjects us to additional risks, including a potential inability to obtain an adequate supply of finished assemblies and assembled circuit boards and reduced control over the price, timely delivery and quality of such finished assemblies and assembled circuit boards. If our Sunnyvale facility were to become incapable of operating, even temporarily, or were unable to operate at or near our current or full capacity for an extended period, our business and operating results could be materially adversely affected. Changes in our manufacturing operations to incorporate new products and processes, or to manufacture at lower cost locations outside the United States, could cause disruptions, which, in turn, could adversely affect customer relationships, cause a loss of market opportunities and negatively affect our business and operating results.
We have in the past experienced higher than expected demand for our products. This resulted in delays in the delivery of certain products due to temporary shortages of certain components, particularly components with long lead times, and insufficient manufacturing capacity. Due to the complex nature of our products and manufacturing processes, the worldwide demand for some wireless technology components and other factors, we can offer no assurance that delays in the delivery of products will not occur in the future.
WIRELESS COMMUNICATIONS AND NETWORKING MARKETS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGE AND TO COMPETE, WE MUST CONTINUALLY INTRODUCE NEW PRODUCTS THAT ACHIEVE BROAD MARKET ACCEPTANCE.
The wireless communications industry is characterized by rapid technological change, short product life cycles and evolving industry standards. To remain competitive, we must develop or gain access to new technologies in order to increase product performance and functionality, reduce product size and maintain cost-effectiveness.
Our success is also dependent on our ability to develop new products for existing and emerging wireless communications markets, to introduce such products in a timely manner and to have them designed into new products developed by OEM customers. The development of new wireless networking products is highly complex, and, from time to time, we have experienced delays in developing and introducing new products. Due to the intensely competitive nature of our business, any delay in the commercial availability of new products could materially and adversely affect our business, reputation and operating results. In addition, if we are unable to develop or obtain access to advanced wireless networking technologies as they become available, or are unable to design, develop and introduce competitive new products on a timely basis, or are unable to hire or retain qualified engineers to develop new technologies and products, our future operating results would be materially and adversely affected. We have expended substantial resources in developing products that are designed to conform to the IEEE 802.11 standard that received final approval in June 1997. We can offer no assurance, however, that our IEEE 802.11 compliant products or the IEEE 802.11 standard will have a meaningful commercial impact.
In 1999, the IEEE approved a new 2.4 GHz wireless LAN standard, designated as 802.11b. Based on direct sequence spread spectrum technology, this new standard increased the nominal data rate from 2 Mbps to 11 Mbps. We have not developed products that comply with the IEEE 802.11b standard. While 802.11b technology is available to develop or acquire in the market, there can be no assurance that we will develop or acquire such technology, or that if we do develop or acquire such technology, that our products will be competitive in the market. In addition, we are developing higher-speed frequency hopping technology based on the FCC Notice of Proposed Rulemaking, or NPRM, that will allow for wider band hopping channels and increase the data rate from 1.6 Mbps to up to 10 Mbps. There can be no assurance that the NPRM will be approved, or that if the NPRM is approved, that we will be able to complete our development of 10 Mpbs frequency hopping products in a timely manner, or that any such new products will compete effectively with IEEE 802.11b standard compliant products.
In addition, the IEEE approved a new 5 GHz wireless LAN standard designated as 802.11a. This new standard is based on Orthogonal Frequency Division Multiplexing, or OFDM, technology with multiple data rates ranging from below 10 Mbps to approximately 50 Mbps. In 1999, the European Telecommunications Standards Institute Project BRAN (Broadband Radio Access Networks) committee approved a new 5 GHz wireless LAN standard designated as HiperLAN2, also based on OFDM technology. While these two new 5 GHz standards apply to future generations of technology, and no companies are currently shipping wireless LAN products based on these technologies, the emergence of these standards may diminish the competitiveness of our planned introduction of 5 GHz products based on the HiperLAN1 standard. Furthermore, we are not currently developing products based one either of these two new standards, and there can be no assurance that we will develop or acquire technology compliant with these standards.
In addition, we are a core member of the HomeRF WG, an industry consortium that is establishing an open industry standard, called the SWAP specification, for wireless digital communications between PCs and consumer electronic devices, including a common interface specification that supports wireless data and voice services in and around the home. We can offer no assurance that the HomeRF WG SWAP specification, or the SWAP-based Symphony products that we develop to comply with the specification will have a meaningful commercial impact. Further, given the emerging nature of the wireless LAN market, we can offer no assurance that our RangeLAN2 and Symphony products and technology, or our other products or technology, will not be rendered obsolete by alternative or competing technologies.
If we are unable to enter a particular market in a timely manner with internally developed products, we may license technology from other businesses or acquire other businesses as an alternative to internal research and development. In this regard, in the fourth quarter of 1997, we recorded a charge of $2,500,000 to in-process research and development related to a license of technology to be used in 5 GHz highspeed in-building wireless LAN products. In 1999, we recorded a total of $7,883,000 in charges related to acquisition of 5 GHz ultra-broadband wireless building-to-building products.
THE WIRELESS LOCAL AREA NETWORKING MARKET IS INTENSELY COMPETITIVE AND SOME OF OUR COMPETITORS ARE LARGER AND BETTER ESTABLISHED.
The wireless local area networking market is extremely competitive and we expect that competition will intensify in the future. Increased competition could adversely affect our business and operating results through pricing pressures, the loss of market share and other factors. The principal competitive factors in the wireless LAN market include the following:
- data throughput;
- effective RF coverage area;
- interference immunity;
- network scalability;
- price;
- integrate with voice technology;
- wireless networking protocol sophistication;
- ability to support industry standards;
- roaming capability;
- power consumption;
- product miniaturization;
- product reliability;
- ease of use;
- product costs;
- product features and applications;
- product time to market;
- product certifications;
- brand recognition;
- OEM partnerships;
- marketing alliances;
- manufacturing capabilities and experience;
- effective distribution channels; and
- company reputation.
We could be at a disadvantage to competitors, particularly Cisco Systems and Lucent Technologies, that have broader distribution channels and brand recognition and offer more diversified product lines.
We have several competitors in our commercial wireless LAN business, including Breezecom, Cisco Systems (which acquired Aironet Wireless Communications), Intersil, Lucent Technologies, Nokia, Symbol Technologies and 3COM, among others. We also face competition from a variety of companies that offer different technologies in the nascent home networking market, including several companies developing competing wireless networking products. Additionally, numerous companies have announced their intention to develop competing products in both the commercial wireless LAN and home networking markets. In addition to competition from companies that offer or have announced their intention to develop wireless LAN products, we could face future competition from companies that offer products which replace network adapters or offer alternative communications solutions, or from large computer companies, PC peripheral companies, as well as other large networking equipment companies. Furthermore, we could face competition from certain of our OEM customers, which have, or could acquire, wireless engineering and product development capabilities. We can offer no assurance that we will be able to compete successfully against these competitors or those competitive pressures we face will not adversely affect our business or operating results.
Many of our present and potential competitors have substantially greater financial, marketing, technical and other resources with which to pursue engineering, manufacturing, marketing, and distribution of their products. These competitors may succeed in establishing technology standards or strategic alliances in the wireless LAN market, obtain more rapid market acceptance for their products, or otherwise gain a competitive advantage. We can offer no assurance that we will succeed in developing products or technologies that are more effective than those developed by our competitors. Furthermore, we compete with companies that have high volume manufacturing and extensive marketing and distribution capabilities, areas in which we have only limited experience. We can offer no assurance that we will be able to compete successfully against existing and new competitors as the wireless LAN market evolves and the level of competition increases.
WE DEPEND UPON INTERNATIONAL SALES AND OUR ABILITY TO SUSTAIN AND INCREASE INTERNATIONAL SALES IS SUBJECT TO MANY RISKS, WHICH COULD ADVERSELY AFFECT OUR OPERATING RESULTS.
Revenue from shipments by us to customers outside the United States, principally to a limited number of distributors and OEM customers, represented 21%, 17% and 26% of total revenue during 1999, 1998 and 1997. We expect that revenue from shipments to international customers will vary as a percentage of total revenue.
Sales to international customers or to U.S. OEM customers who ship to international locations are subject to a number of risks and uncertainties including:
- changes in foreign government regulations and telecommunications standards;
- export license and documentation requirements;
- tariffs, duties taxes and other trade barriers;
- fluctuations in currency exchange rates;
- longer payment cycles for international distributors;
- difficulty in collecting accounts receivable;
- competition from local manufacturers with lower costs;
- difficulty in staffing and managing foreign operations; and
- potential political and economic instability.
While international sales are typically denominated in U.S. dollars and we typically extend limited credit terms, fluctuations in currency exchange rates could cause our products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. We can offer no assurance that foreign markets will continue to develop or that we will receive additional orders to supply our products to foreign customers. Our business and operating results could be materially and adversely affected if foreign markets do not continue to develop or if we do not receive additional orders to supply our products for use by foreign customers. In the latter part of 1997 and throughout 1998, capital markets in Asia were highly volatile, resulting in fluctuations in Asian currencies and other economic instabilities. In this regard, in the third quarter of 1997 and continuing through the second quarter of 1998, we experienced a significant decrease in orders from NTT-IT, one of our major Japanese customers, resulting in a significant decrease in quarterly revenue and an operating loss in the third quarter of 1997.
OUR FAILURE TO ADEQUATELY PROTECT OUR PROPRIETARY RIGHTS COULD ADVERSELY AFFECT OUR ABILITY TO COMPETE EFFECTIVELY.
We rely on a combination of patents, trademarks, non-disclosure agreements, invention assignment agreements and other security measures in order to establish and protect our proprietary rights. We have been issued seven U.S. patents, which were issued in 1991, 1993, 1995, 1998 and 1999, and are important to our current business, and we have three patent applications pending in the U.S., which relate to our core technologies and product designs. We can offer no assurance that patents will issue from any of these pending applications or, if patents do issue that the claims allowed will be sufficiently broad to protect our technology. In addition, we can offer no assurance that any patents issued to us will not be challenged, invalidated or circumvented, or that the rights granted thereunder will adequately protect us. Since U.S. patent applications are maintained in secrecy until patents issue, and since publication of inventions in the technical or patent literature tends to lag behind such inventions by several months, we cannot be certain that we first created the inventions covered by our issued patents or pending patent applications or that we were the first to file patent applications for such inventions or that we are not infringing on the patents of others. In addition, we have filed, or reserved our rights to file, a number of patent applications internationally. We can offer no assurance that any international patent application will issue or that the laws of foreign jurisdictions will protect our proprietary rights to the same extent as the laws of the United States.
Although we intend to protect our rights vigorously, there can be no assurance that the measures we have taken or may take to protect our proprietary rights will be successful. Litigation may be necessary to enforce our patents, trademarks or other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, to establish the validity of any technology licenses offered to patent infringers, or to defend against claims of infringement. Litigation could result in substantial costs and diversion of resources and could materially and adversely affect our business and operating results. Moreover, we can offer
no assurance that in the future these rights will be upheld. Furthermore, there can be no assurance that any of our issued patents will provide a competitive advantage or will not be challenged by third parties or that the patents of others will not adversely impact our ability to do business. As the number of products in the wireless LAN market increases, and related features and functions overlap, we may become increasingly subject to infringement claims. These claims also might require us to enter into royalty or license agreements. Any such claims, with or without merit, could cause costly litigation and could require significant management time. There can be no assurance that, if required, we could obtain such royalty or license agreements on terms acceptable to management. There can be no assurance that the measures we have taken or may take in the future will prevent misappropriation of our technology or that others will not independently develop similar products, design around our proprietary or patented technology or duplicate our products.
WE NEED TO EFFECTIVELY MANAGE OUR GROWTH.
Our growth to date has caused, and will continue to cause, a significant strain on our management, operational, financial and other resources. Our ability to manage growth effectively will require us to improve our management, operational and financial processes and controls as well as the related information and communications systems. These demands will require the addition of new management personnel and the development of additional expertise by existing management. The failure of our management team to effectively manage growth, should it occur, could materially and adversely affect our business and operating results.
COMPLIANCE WITH GOVERNMENTAL REGULATIONS IN MULTIPLE JURISDICTIONS WHERE WE SELL OUR PRODUCTS IS DIFFICULT AND COSTLY.
In the United States, we are subject to various Federal Communications Commission, or FCC, rules and regulations. Current FCC regulations permit license-free operation in certain FCC-certified bands in the radio spectrum. Our spread spectrum wireless products are certified for unlicensed operation in the 902 -- 928 MHz, 2.4 -- 2.4835 GHz, 5.15 -- 5.35 GHz and 5.725 -- 5.825 GHz frequency bands. Operation in these frequency bands is governed by rules set forth in Part 15 of the FCC regulations. The Part 15 rules are designed to minimize the probability of interference to other users of the spectrum and, thus, accord Part 15 systems secondary status in the frequency. In the event that there is interference between a primary user and a Part 15 user, a higher priority user can require the Part 15 user to curtail transmissions that create interference. In this regard, if users of our products experience excessive interference from primary users, market acceptance of our products could be adversely affected, which could materially and adversely affecting our business and operating results. The FCC, however, has established certain standards that create an irrefutable presumption of noninterference for Part 15 users and we believe that our products comply with such requirements. We can offer no assurance that the occurrence of regulatory changes, including changes in the allocation of available frequency spectrum, changes in the use of allocated frequency spectrum, or modification to the standards establishing an irrefutable presumption for unlicensed Part 15 users, would not significantly affect our operations by rendering current products obsolete, restricting the applications and markets served by our products or increasing the opportunity for additional competition.
Our products are also subject to regulatory requirements in international markets and, therefore, we must monitor the development of spread spectrum and other radio frequency regulations in certain countries that represent potential markets for our products. While we can offer no assurance that we will be able to comply with regulations in any particular country, we design our RangeLAN2, RangeLAN802, Symphony and SWAP-based Symphony products to minimize the design modifications required to meet various 2.4 GHz international spread spectrum regulations. In addition, we will seek to obtain international certifications for the Symphony and SWAP-based Symphony product line in countries where there is a substantial market for home PCs and Internet connectivity. Changes in, or the failure by us to comply with, applicable domestic and international regulations could materially adversely affect our business and operating results. In addition, with respect to those countries that do not follow FCC regulations, we may need to modify our products to meet local rules and regulations.
Regulatory changes by the FCC or by regulatory agencies outside the United States, including changes in the allocation or use of available frequency spectrum, could significantly affect our operations by restricting our development efforts, rendering current products obsolete or increasing the opportunity for additional competition. In September 1993 and in February 1995, the FCC allocated additional spectrum for personal communications services. In January 1997, the FCC authorized 300 MHz of additional unlicensed frequencies in the 5 GHz frequency range in Part 15 Subpart E which regulates U-NII devices operating in the 5.15 -- 5.35 GHz and 5.725 -- 5.825 GHz frequency bands. In June 1999, the FCC issued a NPRM that proposed changing the way allocated frequencies are utilized by Part 15 spread spectrum systems. These approved and proposed changes in the allocation and use of available frequency spectrum could create opportunities for other wireless networking products and services.
There can be no assurance that new regulations will not be promulgated, that could materially and adversely affect our business and operating results.
THERE MAY BE POTENTIAL HEALTH AND SAFETY RISKS RELATED TO OUR PRODUCTS WHICH COULD NEGATIVELY AFFECT OUR BUSINESS AND PRODUCT SALES.
The intentional emission of electromagnetic radiation has been the subject of recent public concern regarding possible health and safety risks, and though our products, when installed in any of the intended configurations, are designed not to exceed the maximum permissible exposure limits listed in Section 1.1311 of the FCC Regulations, we can offer no assurance that safety issues will not arise in the future and materially and adversely affect our business and operating results.
TO COMPETE EFFECTIVELY, WE MUST ESTABLISH AND EXPAND NEW DISTRIBUTION CHANNELS FOR OUR HOME NETWORKING PRODUCTS.
To date, a substantial percentage of our revenue has been derived from OEM customers through our direct sales force. We sell our branded RangeLAN2 products through domestic and international distributors. We are also establishing new distribution channels for our Symphony family of cordless home and small office networking products. Symphony products are currently sold through national retailers such as Best Buy, CompUSA, OfficeMax, Office Depot and Staples computer retailers such as Fry's Electronics, J&R Computer World, BrandSmart, Comp-u-Tech, DataVision, Nationwide, leading computer catalogs such as CDW, MobilePlanet and PC Connection, and numerous on-line retail sites over the Internet, including our e-commerce Web site at www.proxim.com. In general, distributors and retailers offer products of several different companies, including products that may compete with our products. Accordingly, they may give higher priority to products of other suppliers, thus reducing their efforts to sell our products. Agreements with distributors and retailers are generally terminable at their option. Any reduction in sales efforts or termination of a relationship may materially and adversely affect our business and operating results. Use of distributors and retailers also entails the risk that they will build up inventories in anticipation of substantial growth in sales. If such growth does not occur as anticipated, they may substantially decrease the amount of product ordered in subsequent quarters. Such fluctuations could contribute to significant variations in our future operating results.
IF WE LOSE KEY PERSONNEL OR WE ARE UNABLE TO HIRE ADDITIONAL QUALIFIED PERSONNEL AS NECESSARY, WE MAY NOT BE ABLE TO EFFECTIVELY MANAGE OUR BUSINESS OR ACHIEVE OUR OBJECTIVES.
We are highly dependent on the technical and management skills of our key employees, in particular David C. King, Chairman, President and Chief Executive Officer, and Juan Grau, Vice President of Engineering. We do not have employment agreements with or life insurance on the life of, either person. In addition, given the rapid technological change in this industry, we believe that the technical expertise and creative skills of our engineers and other personnel are crucial in determining our future success. The loss of the services of any key employee could adversely affect our business and operating results. Our success also depends in large part on a limited number of key marketing and sales employees and on our ability to continue to attract, assimilate and retain additional highly talented personnel. Competition for qualified personnel in the wireless data communications and networking industries is intense. We can offer no assurance that we will be successful in retaining our key employees or that we can attract, assimilate or retain the additional skilled personnel as required.
OUR STOCK PRICE MAY BE EXTREMELY VOLATILE.
Recently, the price of our common stock has been volatile. We believe that the price of our common stock may continue to fluctuate, perhaps substantially, as a result of factors including:
- announcements of developments relating to our business;
- fluctuations in our operating results;
- general conditions in the wireless communications industry or the worldwide economy;
- a shortfall in revenue or earnings from securities analysts' expectations or other changes in financial estimates by securities analysts;
- announcements of technological innovations or new products or enhancements by us or our competitors;
- developments in patent, copyright or other intellectual property rights; and
- developments in our relationships with customers, distributors and suppliers.
In the third quarter of 1997, we announced revenue and operating results below expectations of securities analysts and investors, resulting in a decrease in the market price of our common stock. In addition, in recent years the stock market in general, and the market for shares of high technology stocks in particular, have experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies. There can be no assurance that the market price of our common stock will not experience significant fluctuations in the future, including fluctuations that are unrelated to our performance.
YEAR 2000 COMPLIANCE
We are currently not aware of any Year 2000 problem in our products, critical systems or services. However the success today of our Year 2000 efforts cannot guarantee that a Year 2000 problem affecting third parties upon which we rely will not become apparent in the future.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements.
Interest Rate Sensitivity. We maintain a short-term investment portfolio consisting mainly of government and corporate bonds purchased with an average maturity of less than one year. These available-for-sale securities are subject to interest rate risk and will decline in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10 percent from levels at December 31, 1999, the fair value of the portfolio would decline by an immaterial amount. We generally have the ability to hold our fixed income investments until maturity and therefore do not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENT SCHEDULES
All financial statement schedules have been omitted because the information is not required to be set forth herein, is not applicable or is included in the financial statements or notes thereto.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Stockholders and Board of Directors of Proxim, Inc.
In our opinion, the accompanying balance sheet and the related statements of income, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Proxim, Inc. at December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
San Jose, California January 25, 2000
PROXIM, INC. BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of these financial statements.
PROXIM, INC. INCOME STATEMENT (IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of these financial statements.
PROXIM, INC. STATEMENT OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
PROXIM, INC. STATEMENT OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part of these financial statements.
PROXIM, INC. NOTES TO FINANCIAL STATEMENTS
NOTE 1 -- THE COMPANY:
We design, manufacture and market high performance wireless local area data networking products. Based on spread spectrum radio frequency technology, our highly integrated wireless client adapters and network infrastructure systems seamlessly extend existing enterprise LANs to enable mobility-driven applications in a wide variety of in-building and campus area environments. In addition, our products are designed to address the requirements for networking personal computers in home and small office environments.
NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenue, cost of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Financial Instruments
We consider all highly liquid instruments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents consist primarily of market rate accounts and highly rated commercial paper that are stated at cost, which approximate fair value. Investments with maturities greater than three months and less than one year as of the date of the balance sheet are classified as marketable securities. Marketable securities consist of time deposits with original maturities greater than three months and less than one year and corporate debt obligations. Investments with maturities greater than one year are classified as marketable securities, long-term. Marketable securities are classified as available-for-sale as of the balance sheet date in accordance with statement of Financial Accounting Standard, or SFAS, No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and are reported at fair value, with unrealized gains and losses recorded in stockholders' equity.
Inventories
Inventories are stated at the lower of cost or market, cost being determined using the first in, first out method.
Property and Equipment
Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, ranging from two to five years. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the remaining lease term or the estimated useful lives of the improvements.
Long-Live Assets
Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. When such an event occurs, we estimate the future cash flows expected to result from the use of the asset and its eventual disposition. If the undiscounted expected future cash flows is less than the carrying amount of the asset, an impairment loss is recognized. To date no impairment loss has been recognized.
Revenue
Product revenue is generally recognized upon shipment to the customers. We grant certain distributors limited rights of return and price protection on unsold products. Product revenue on shipments to distributors, which have rights of return and price protection, is deferred until shipment to end customers by the distributors. The provision for estimated future warranty is recorded at the time revenue is recognized.
Acquisition-related Intangible assets
Intangible assets result from business acquisitions, which were accounted for under the purchase method and consist of the values of identifiable intangible assets including developed technology, acquired workforce, core technology, in-process technology and goodwill. Goodwill is the amount by which the cost of the acquired identifiable net assets exceeded the fair values of the acquired net assets on the date of purchase. Intangible assets are reported at cost, net of accumulated amortization. Identifiable intangible assets and goodwill are amortized on a straight-line basis over their estimated useful lives ranging from one to five years.
Software Development Costs
Software development costs are capitalized once technological feasibility is established, which we define as completion of a working model. The capitalized cost is then amortized on a straight-line basis over the estimated product life, or on the ratio of current revenues to total projected product revenues, whichever is greater. To date, the period between achieving technological feasibility and the general availability of such software has been short and software development costs qualifying for capitalization have been insignificant. Accordingly, we have not capitalized any software development costs.
Income Taxes
A deferred tax liability or asset, net of a valuation allowance, is established for the expected future consequences resulting from the differences between the financial reporting and income tax bases of assets and liabilities and from net operating loss carryforwards.
Net Income Per Share
Basic net income per share is computed by dividing net income available to Common Stockholders by the weighted average number of common shares outstanding during the period. Diluted net income per share is calculated using the weighted average number of outstanding shares of Common Stock plus dilutive Common Stock equivalents. Common Stock equivalents consist of stock options and warrants, using the treasury stock method based on the average stock price for the period.
Stock-Based Compensation
We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion, or APB No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. We provides additional pro forma disclosures as required under Statement of Financial Accounting Standards No.123 (FAS 123), "Accounting for Stock-Based Compensation." (See Note 8)
Comprehensive Income
SFAS No. 130, "Reporting Comprehensive Income establishes new rules for the reporting of comprehensive income and our components. Comprehensive income is defined to include all changes in equity during a period except those resulting from investments by owners and distributions to owners.
Segment Reporting
SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," requires that companies report separately in the financial statements certain financial and descriptive information about operating segments' profit or loss, certain specific revenue and expense items and segment assets. Additionally, companies are required to report information about revenue and assets by geographic areas and about major customers. We operate in one industry segment, and assets located outside of the United States are not significant.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS 133 established new standards of accounting and reporting for derivative instruments and hedging activities. SFAS 133 requires that all derivatives be recognized at fair value in the statement of financial position, and that the corresponding gains or loses be reported either in the income statement or as a component of comprehensive income, depending on the type of hedging relationship that exists. In July 1999, the Financial Accounting Standard Boards issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of SFAS No. 133." SFAS 137 deferred the effective date of SFAS 133 until the first fiscal quarter beginning after June 15, 2000. We do note currently hold derivative instruments or engage in hedging activities. We are continuing to evaluate the impact of the requirement of SFAS No. 133 and SFAS No. 137 will have on our financial statements and related disclosures.
NOTE 3 -- BALANCE SHEET COMPONENTS:
NOTE 4 - ACQUISITION OF WAVESPAN:
In December 1999, we acquired Wavespan Corporation, a privately-held California corporation, for 170,000 shares of our common stock and $2.2 million of cash. The total purchase price was $12.9 million, including acquisition costs of $900,000, and the acquisition was accounted for as a purchase. The results of operations of Wavespan and the estimated fair value of the assets acquired and liabilities assumed are included in financial statements from the date of acquisition. Intangible assets arising from the acquisition are being amortized on a straight-line basis over one to five years. Approximately $5.9 million of the purchase price represents acquired in-process technology that has not yet reached technological feasibility and has no alternative future use. Accordingly, this amount was immediately charged to expense upon consummation of the acquisition. The value assigned to acquired in-process technology was determined by identifying research projects in areas for which technological feasibility has not been established, estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects, and discounting the net cash flows back to their present value. The discount rate includes a factor that takes into account the uncertainty surrounding the successful development of the acquired in-process technology. If these projects are not successfully developed, future revenue and profitability may be adversely affected. Additionally, the value of other intangible assets acquired may become impaired.
The allocation of the purchase price is as follows (in thousands):
The following table represents unaudited pro forma financial information as if Proxim and Wavespan had been combined as of January 1, 1998. The pro forma data are presented for illustrative purposes only and are not necessarily indicative of the combined financial position or results of operations of future periods or the results that actually would have resulted had Proxim and Wavespan been a combined company during the specified periods. The pro forma results include the effects of the amortization of acquired intangible assets and adjustments to the income tax provision or benefits. The pro forma combined results exclude the $5,883,000 charge for acquired in-process technology.
NOTE 5- EQUITY INVESTMENT:
We made cash payment of $2 million, $1 million and $3 million in 1997, 1998, and 1999 respectively, for the equity of MobileStar, a privately-held start-up wireless services company. The 1998 and 1997 investments were expensed in those years due to the uncertainty in recovering the investments. The 1999 investment was accounted for under the cost method. At December 31, 1999 our investment represented approximately 18% of the equity of MobileStar. The following is a summary of our transactions with MobileStar (in thousands):
We also made cash payment of $2.0 million in 1999 for a 5 GHz ultra-broadband company. The investment was recorded as purchased in-process research and development.
NOTE 6 -- INCOME TAXES:
The provision for income taxes consists of the following (in thousands):
The tax provision reconciles to the amount computed by applying the U.S. federal statutory rate to income before taxes as follows (in thousands):
Net deferred tax assets comprise the following (in thousands):
The changes in net deferred tax assets during the year ended December 31, 1999 included the addition of deferred tax assets of $1,200,000 and deferred tax labilities of $4,146,000 as part of the acquisition of Wavespan.
NOTE 7 -- STOCKHOLDERS' EQUITY:
Preferred Stock
In December 1993, the stockholders approved a class of Preferred Stock consisting of 5,000,000 shares, at a par value of $.001 per share, issuable in series and having such rights, preferences, privileges and restrictions as may be determined by the Board of Directors. As of December 31, 1999, no Preferred Stock had been issued.
Preferred Share Purchase Rights
In March 1997, we declared a dividend distribution of one Preferred Share Purchase Right (the "Rights") on each outstanding share of our Common Stock. Each right will entitle stockholders to buy one one-thousandth of a share of our Series A Participating Preferred Stock at an exercise price of $115.00. The Rights will become exercisable following the tenth day after a person or group announces acquisition of 15% or more of our Common Stock or announces commencement of a tender offer the consummation of which would result in ownership by the person or group of 15% or more of the Common Stock. We will be entitled to redeem the Rights at $0.001 per Right at any time on or before the tenth day following acquisition by a person or group of 15% or more of our Common Stock.
If, prior to redemption of the Rights, a person or group acquires 15% or more of our Common Stock, each Right not owned by a holder of 15% or more of the Common Stock will entitle our holder to purchase, at the Right's then current exercise price, that number of shares of Common Stock of the Company (or, in certain circumstances as determined by the Board, cash, other property or other securities) having a market value at that time of twice the Right's exercise price. If, after the tenth day following acquisition by a person or group of 15% or more of our Common Stock, we will sell more than 50% of our assets or earning power or be acquired in a merger or other business combination transaction, the acquiring person must assume the obligations under the Rights and the Rights will become exercisable to acquire Common Stock of the acquiring person at the discounted price. At any time after an event triggering exercisability of the Rights at a discounted price and prior to the acquisition by the acquiring person of 50% or more of the outstanding Common Stock, the Board of Directors of the Company may exchange the Rights (other than those owned by the acquiring person or our affiliates) for Common Stock of the Company at an exchange ratio of one share of Common Stock per Right.
Warrants
On April 27, 1999 we issued a warrant to one Common Stockholder in conjunction with the issuance of 320,000 shares of our Common Stock at a price of $31.25 per share. The warrant entitles the shareholder to purchase an aggregate of 96,000 shares of Common Stock at a price of $45 per share. The warrant will expire on April 28, 2002.
On June 2, 1999 we issued a warrant to one Common Stockholder in conjunction with the issuance of 285,714 shares of our Common Stock at a price of $35 per share. The warrant entitles the shareholder to purchase an aggregate of 85,714 shares of Common Stock at a price of $50 per share. The warrant will expire on June 2, 2002. At December 31, 1999, no warrants were exercised.
At December 31, 1999, all warrants were outstanding.
NOTE 8 - STOCK PLANS:
1986 Stock Option Plan
Our 1986 Stock Option Plan, or the 1986 Plan, provides for the grant of stock options to employees and consultants at prices not less than 85% of the fair market value of our Common Stock on the date of grant. The options terminate ten years after the date of grant. All options granted have been at the fair market value of our Common Stock on the dates of grant. An aggregate of 2,272,088 shares of Common Stock was reserved for issuance pursuant to the 1986 Plan. Unless otherwise provided for by the Board of Directors, the options are exercisable only upon vesting. Options generally vest ratably over a 48-month period. The 1986 Plan (but not outstanding options issued thereunder) terminated by our terms on March 20, 1996.
1995 Long-Term Incentive Plan
In April 1995, we established the 1995 Long-Term Incentive Plan, or the 1995 Plan, and reserved 250,000 shares of Common Stock for issuance to employees, consultants and officers upon the exercise of awards granted thereunder. In March 1996, the Board of Directors increased the number of shares of Common Stock authorized for issuance under the 1995 Plan by 1,000,000 shares to an aggregate of 1,250,000 shares. In May 1997, the Board of Directors increased the number of shares of Common Stock authorized for issuance under the 1995 Plan by 500,000 shares to an aggregate of 1,750,000 shares. In May 1998, the Board of Directors increased the number of shares of Common Stock authorized for issuance under the 1995 Plan by 500,000 shares to an aggregate of 2,250,000 shares. In May 1999, the Board of Directors increased the number of shares of Common Stock authorized for issuance under the 1995 Plan by 900,000 shares to an aggregate of 3,150,000 shares. In December 1999, in connection with the acquisition of Wavespan, we increased the number of shares of Common Stock authorized for issuance under the 1995 Plan by 400,000 shares to an aggregate of 3,550,000 shares. The 1995 Plan provides for the grant of awards in the form of stock options, restricted stock, performance shares, restricted stock units, and stock unit awards to employees, consultants and officers at prices not less than 100% of the fair market value of our Common Stock on the date of grant. The options terminate ten years after the date of grant. Through December 31, 1999, only stock options have been granted under the 1995 Plan and all such options have been granted at the fair market value of the stock at the dates of grant. Unless otherwise provided for by the Board of Directors, the options are exercisable only upon vesting. Options generally vest ratably over a 48-month period.
1994 Director Option Plan
In May 1994, we adopted the 1994 Director Option Plan , or the Directors' Plan, which provides for the grant of stock options to directors at the fair market value of our Common Stock on the date of grant. The options terminate 10 years after the date of grant. All options granted have been at the fair market value of our Common Stock at the dates of grant. In May 1997, the Board of Directors increased the number of shares of Common Stock authorized for issuance under the 1994 Director Option Plan by 100,000 shares to an aggregate of 200,000 shares. In May 1999, the Board of Directors increased the number of shares of Common Stock authorized for issuance under the 1994 Director Option Plan by 100,000 shares to an aggregate of 300,000 shares. Options granted under the Directors' Plan are exercisable only upon vesting. Grants made prior to January 1, 1996 vest ratably over a 48-month period, and grants made on or after January 1, 1996 fully vest one year from the date of grant.
The following table summarizes stock option activity under our stock option plans (shares in thousands):
At December 31, 1999, 1998 and 1997, options for 651,000, 981,000 and 551,000 shares of common stock, respectively, were vested but not exercised. In October 1997, we canceled 467,000 options outstanding for non-officer employees under the option plans with exercise prices greater than $10.75, and reissued the options with an exercise price of $10.75.
The following table summarizes information concerning outstanding and exercisable stock options as of December 31, 1999 (shares in thousands):
1993 Employee Stock Purchase Plan
In September 1993, we established the 1993 Employee Stock Purchase Plan, or the Purchase Plan. We initially reserved 200,000 shares of Common Stock for issuance to employees under the Purchase Plan. In March 1996, our Board of Directors increased the number of shares of Common Stock reserved for issuance under the Purchase Plan by 200,000 shares to an aggregate of 400,000 shares. In May 1997, our Board of Directors increased the number of shares of Common Stock reserved for issuance under the Purchase Plan by 200,000 shares to an aggregate of 600,000 shares. In May 1998, our Board of Directors increased the number of shares of Common Stock reserved for issuance under the Purchase Plan by 200,000 shares to an aggregate of 800,000 shares. Under the Purchase Plan, an eligible employee may purchase shares of Common Stock from us through payroll deductions of up to 10% of his or her total compensation, at a price per share equal
to 85% of the lesser of the fair market value of our Common Stock at the first day or last day of each six-month offering period. Offering periods commence on August 15 and February 15. During 1999, 1998 and 1997, we issued 67,933, 51,625, and 99,709 shares, respectively, of Common Stock under the Purchase Plan.
Pro Forma Net Income (Loss) and Net Income (Loss) Per Share
The weighted average estimated grant date fair value, as defined by FAS 123, for stock options granted under our stock option plans during 1999, 1998 and 1997 was $23.89, $7.73 and $5.59 per share, respectively. The weighted average estimated grant date fair value of stock purchase rights granted pursuant to our employee stock purchase plan during 1999, 1998 and 1997 was $11.42, $4.93 and $1.81 per share, respectively. The estimated grant date fair value disclosed by us is calculated using the Black-Scholes model. The Black-Scholes model, as well as other currently accepted option valuation models, was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from our stock option and purchase awards. These models also require highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated grant date fair value.
The following weighted average assumptions are included in the estimated grant date fair value calculations for our stock option and purchase awards:
Had we recorded compensation based on the estimated grant date fair value, as defined by FAS 123, for awards granted under our stock option plans and stock purchase plan, our net income and net income per share would have been reduced to the pro forma amounts below for the years ended December 31, 1999, 1998 and 1997 (in thousands, except per share amounts):
The pro forma effect on net income and net income per share for 1999, 1998 and 1997 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1996.
NOTE 9 - NET INCOME PER SHARE:
The following table is a reconciliation of the numerators and denominators of the basic and diluted net income per share calculations:
Options to purchase 208,000 and 138,315 shares of common stock were excluded from the diluted net income per share calculations for 1999 and 1998. Warrants to purchase 181,714 shares of common stock were excluded from the diluted net income per share calculations for 1999. The options and warrants were antidilutive because the exercise prices were greater than the average market price of the common shares during the respective periods.
NOTE 10 -- CONCENTRATION OF SALES AND CREDIT RISK
Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and cash equivalents, marketable securities and trade accounts receivable. We place our cash and cash equivalents and marketable securities primarily in market rate accounts and highly rated commercial paper. Our policy limits the amount of credit exposure to any one financial institution or commercial issuer. The carrying amounts of certain of our other financial instruments including accounts receivable, accounts payable and accrued expenses approximate fair value due to their short maturities.
We generally extend 30-day credit terms to our customers, which is consistent with industry business practices. We perform ongoing credit evaluations of our customers' financial condition and, generally, require no collateral from our customers. To date we have not experienced any material credit losses. All sales transactions are denominated in U.S. dollars.
During 1999, revenue from one customer represented 30% of total revenue. During 1998, revenue from two customers represented 41% and 11% of total revenue. During 1997, revenue from three customers represented 28%, 17% and 10% of total revenue.
Revenue from shipments to customers outside the United States, primarily in Asia Pacific, Europe and South America, represented 21%, 17% and 26% of total revenue in 1999, 1998 and 1997, respectively. Revenue from shipments to customers in Japan represented 11%, 4% and 17% of total revenue in 1999, 1998 and 1997, respectively.
At December 31, 1999, outstanding receivables from one customer represented 26% of gross receivables. At December 31, 1998, outstanding receivables from two customers represented 27% and 18% of gross receivables.
NOTE 11 -- COMMITMENTS:
We occupy our facilities under several non-cancelable operating lease agreements which expires in August 2009 and March 2006, respectively, and require payment of property taxes, insurance, maintenance and utilities. Total rental expense related to these operating leases were $2,074,000, $504,000 and $504,000 for 1999, 1998 and 1997, respectively.
Future minimum lease payments under non-cancelable operating leases at December 31, 1999 were as follows (in thousands):
During 1999, we subleased our facilities to third parties under non-cancelable sublease rent agreements, which expire in September 2001 and September 2002, respectively. Total sublease rent income for the year ended December 31, 1999 was $751,000. Total sublease rent income for the years ended December 31, 2000, December 31, 2001 and December 31, 2002 will be $3,019,000, 2,855,000, and $1,667,000, respectively.
NOTE 12 - SUBSEQUENT EVENT:
In January 2000, we acquired privately-held Micrilor, Inc. We issued 146,000 shares of common stock in our merger with Micrilor, which was accounted for as a pooling of interests. The pro forma data are presented for illustrative purposes only and are not necessarily indicative of the combined financial position or results of operations of future periods or the results that actually would have resulted had Proxim and Micrilor been a combined company during the specified periods. The pro forma data does not reflect pro forma results prior to the December 1999 Wavespan acquisition. The following table represents unaudited pro forma financial information as if Proxim and Micrilor had been combined as of January 1, 1997.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
10.a. Information with respect to directors is incorporated by reference from the information under the caption "Election of Directors," in the Registrant's Proxy Statement, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1999.
10.b. Information with respect to directors and executive officers is included at the end of PART I, Item 1 on page 15 of this Report under the caption "Executive Officers of the Registrant."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated by reference from the information under the captions "Executive Compensation" in the Registrant's Proxy Statement, which will be filed, with the Securities and Exchange Commission within 120 days after December 31, 1999.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated by reference from the information under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Registrant's Proxy Statement, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1999.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not Applicable.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Financial Statements: See Index to Financial Statements at Item 8. on page 34 of this Report.
(2) Financial Statement Schedules: See Item 8. on page 34 of this Report.
(3) Exhibits:
(b) Reports on Form 8-K: A Report on Form 8-K (File No. 0-22700) was files pursuant to the Securities Exchange Act of 1934, as amended, on April 30, 1999, to file a press release issued by Proxim, Inc. and Intel Corporation on April 28, 1999, regarding a technology agreement and an investment agreement between Proxim, Inc. and Intel Corporation.
(c) Exhibits: See 14(a) above.
(d) Financial Statement Schedules: See 14(a) above.
- ----------
(1) Incorporated by reference to the Registrant's Registration Statement No. 33-70712 filed with the Securities and Exchange Commission on December 15, 1993.
(2) Incorporated by reference to the Registrant's Form 10-Q for the period ended September 30, 1994 filed with the Securities and Exchange Commission on November 14, 1994.
(3) Incorporated by reference to the Registrant's definitive proxy materials filed with the Securities and Exchange Commission on April 15, 1994.
(4) Incorporated by reference to the Registrant's Registration Statement No. 33-94910 filed with the Securities and Exchange Commission on July 19, 1995.
(5) Management contract or compensation plan or arrangement required to be filed as an exhibit to this Report on Form 10-K pursuant to item 14(c) of this Report.
(6) Incorporated by reference to the Registrant's Registration Statement filed with the Securities and Exchange Commission on April 7, 1997.
(7) Incorporated by reference to the Registrant's Form 10-K for the period ended December 31, 1998 filed with the Securities and Exchange Commission on March 31, 1999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on our behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale, State of California, on the 24th day of March, 2000.
PROXIM, INC.
By: /s/ KEITH E. GLOVER ---------------------------------------- (Keith E. Glover, Vice President of Finance and Administration, and Chief Financial Officer)
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints David C. King and Keith E. Glover, jointly and severally, his attorneys-in-fact, each with full power of substitution, for him in any and all capacities, to sign on behalf of the undersigned any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and each of the undersigned does hereby ratify and confirm all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed by the following persons in the capacities and on the dates indicated:
EXHIBIT INDEX | 24,030 | 159,534 |
824906_1999.txt | 824906_1999 | 1999 | 824906 | ITEM 1. BUSINESS
GENERAL
Americorp ("Americorp" or the "Company") is a California corporation organized to act as the bank holding company for American Commercial Bank ("ACB" or the "Bank"). In 1987, Americorp acquired all of the outstanding common stock of ACB in a holding company formation transaction. Other than holding the shares of ACB, Americorp conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), Americorp's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. At December 31, 1999, Americorp had approximately $246 million in consolidated assets, $179 million in consolidated net loans, $210 million in consolidated deposits, and $23 million in consolidated stockholders' equity.
ACB was licensed by the California Department of Financial Institutions (the "DFI") and commenced operation in September 1973 as a California state bank. As a California state bank, ACB is subject to primary supervision, examination and regulation by the DFI and the Federal Deposit Insurance Corporation (the "FDIC"). ACB is also subject to certain other federal laws and regulations. The deposits of ACB are insured by the FDIC up to the applicable limits thereof. ACB is not a member of the Federal Reserve System.
TRANSACTION WITH CHANNEL ISLANDS BANK
Americorp and ACB entered into an Agreement to Merge and Plan of Reorganization dated July 7, 1998 and amended on September 17, 1998 (the "Merger Agreement") with Channel Islands Bank, headquartered in Oxnard, California ("CIB").
The Merger Agreement provided for, among other things, (i) the merger of CIB with and into ACB with ACB as the surviving bank, and (ii) the shareholders of CIB becoming shareholders of Americorp in accordance with the exchange ratio set forth in the Merger Agreement. The merger was consummated on December 31, 1998.
The merger with CIB was intended to be a so-called "Merger of Equals" whereby comparatively similar sized financial institutions and their respective managements, boards of directors, shareholder groups and businesses are combined to create an institution which may provide for, among other things, increased synergies, expended products and markets, higher lending limits and a reduction of overall overhead costs, including a reduction in duplicate positions and employee benefits. Such mergers may also enhance the liquidity of a shareholder's investment and may provide the combined entity with easier access to the capital markets. "Mergers of Equals" provide the same types of risk associated with combining any two entities, including (i) the disadvantages of being part of a larger entity, including reduced voting power and the potential for decreased customer service; (ii) the integration of the different corporate cultures of the entities will divert the combined entities' management time from other activities and (iii) the proposed changes to policies and procedures of the combined entity may not prove to be successful to the customers of the combined entity. "Mergers of Equals" also generally provide, among other less favorable aspects, a smaller premium on their investment to the non-surviving institutions' shareholders than would be anticipated in an actual sale of control, less liquidity to such shareholders for their investment than if the non-surviving institution had been acquired by a larger acquirer as well as the difficulties associated with combining the human resources and cultural differences of two similar sized institutions.
At the consummation of the merger, CIB had approximately $95 million in total assets, approximately $63 million in total loans, approximately $87 million in total deposits and approximately $8 million in total stockholders' equity.
The exchange ratio used in the merger was 0.7282 shares of Americorp Common Stock for each share of CIB outstanding. Americorp issued a total of 405,505 shares of Common Stock in connection with the transaction.
The merger was intended to be tax free at the corporate and shareholders levels.
The merger was accounted for as a "pooling of interest" and the financial statement included in Item 8 hereof have been prepared in accordance with such determination. See footnote 17 to such financial statements. ALL INFORMATION CONCERNING AMERICORP AND ACB HEREIN REFLECTS THE CONSUMMATION OF THE MERGER.
BANKING SERVICES
ACB is engaged in substantially all of the business operations customarily conducted by independent California state bank. ACB maintains three full service-banking offices in the city of Ventura, two full service offices in the city of Oxnard and one full service office in the city of Camarillo. ACB's banking services include the acceptance of checking and savings deposits, and the making of commercial, SBA, real estate, personal, automobile and other installment loans. ACB also offers traveler's checks, notary public and other customary bank services to its customers. While ACB does offer credit cards to its customers, other financial institutions issue the cards. Trust services are not offered by ACB.
ACB's deposits are attracted primarily from individuals and small and medium-sized business-related sources. ACB also attracts deposits from several local agencies. In connection with municipal deposits, ACB is generally required to pledge securities to secure such deposits, except for the first $100,000 of such deposits which are insured by the FDIC.
Americorp is engaged in lending activities to businesses and consumers throughout the geographic area of Ventura County, California. ACB has, to some degree, concentrations in real estate loans and real estate associated businesses. The risks associated with loans vary with the borrower, associated type of industry and prevailing economic conditions.
Business loans are extended to a variety of commercial borrowers. These loans include revolving lines of credit, both secured and unsecured; equipment financing and term loans on real estate. In general, business loans have a higher degree of risk associated with changing economic cycles, product obsolescence and management experience. ACB utilizes a loan policy manual which sets standards for the accepted level of risk in the particular area under consideration. Business loans are reviewed by experienced loan personnel utilizing a secondary review and approval process which ultimately is overseen by the Board of Directors. ACB typically obtains the guarantees of the borrowing company's principal owners. Business lending risk is also mitigated by the contracted services of an independent loan review company. Commercial loans outstanding, as of December 31, 1999, totaled $42.2 million representing 23.2% of the portfolio.
ACB also structures commercial loans secured by the real estate. These loans also vary in risk depending primarily on business cycles. Commercial real estate loans generally are amortized over a 20 year period with maturity dates of 5 years. ACB accepts properties whose appraised values provides a loan-to-value ratio of 75% or less. Commercial loans outstanding secured by real estate, at December 31, 1999, totaled $119.7 million, representing 65.8% of the portfolio. ACB is not involved with any residential tract housing construction and limits construction loans to either pre-sold or contract homes with permanent financing arranged. Construction loans total less than 4.3% of the total loan portfolio.
ACB is also engaged in the brokering of single family first trust deeds to other lenders.
ACB also extends loans to consumers which include automobiles, installment, recreational vehicles, equity lines of credit, bankcard and overdraft protection. During 1998, ACB sold its bankcard portfolio for a nominal premium. Consumer loans are underwritten according to standards set in ACB's loan policy
manual. ACB utilizes Experian and Trans Union credit reporting agencies to obtain current information on a consumer's payment history, monitors delinquency trends regularly and sets reserves to mitigate risk in this area.
Virtually all of the consolidated net income of Americorp is generated by ACB.
ACB has not engaged in any material research activities relating to the development of new services or the improvement of existing ACB services.
There has been no significant change in the types of services offered by ACB since its inception, except in connection with new types of accounts allowed by statute or regulation in recent years. ACB has no present plans regarding "a new line of business" requiring the investment of a material amount of total assets.
Most of ACB's business originates from Ventura County and there is no emphasis on foreign sources and application of funds. ACB's business, based upon performance to date, does not appear to be seasonal. Except as described above, a material portion of ACB's loans is not concentrated within a single industry or group of related industries, nor is ACB dependent upon a single customer or group of related customers for a material portion of its deposits. Management of ACB is unaware of any material effect upon ACB's capital expenditures, earnings or competitive position as a result of federal, state or local environmental regulation.
ACB holds no patents, licenses (other than licenses obtained from bank regulatory authorities), franchises or concessions.
EMPLOYEES
As of December 31, 1999, ACB had a total of 109 full-time employees and 25 part-time employees. The management of ACB believes that its employee relations are satisfactory.
COMPETITION
Banking and financial services business in California generally, and in ACB's market areas specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers. ACB competes for loans and deposits and customers for financial services with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other nonbank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than ACB. In order to compete with the other financial services providers, ACB principally relies upon local promotional activities, personal relationships established by officers, directors and employees with its customers, and specialized services tailored to meet its customers' needs. ACB maintains six full service-banking offices in Ventura County.
Recently adopted financial modernization legislation will likely increase competition in the markets in which the Company operates, although it is difficult to assess the impact that such increased competition may have on the Company's operations. See "Financial Modernization Legislation."
EFFECT OF GOVERNMENTAL POLICIES AND RECENT LEGISLATION
Banking is a business that depends on rate differentials. In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank's portfolio comprise the major portion of the Bank's earnings. These rates are highly sensitive to many factors that are beyond the control
of the Bank. Accordingly, the earnings and growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. For example, legislation was adopted in 1999 that, among other things, repealed, the statutory restrictions on affiliations between commercial banks and securities firms. See "Financial Modernization Legislation."
SUPERVISION AND REGULATION
The Company and the Bank are extensively regulated under both federal and state law. Set forth below is a summary description of certain laws which relate to the regulation of the Company and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
AMERICORP
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with, and subject to the supervision of, the Federal Reserve Board. The Company is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act. The Federal Reserve Board may conduct examinations of bank holding companies and their subsidiaries.
The Company is currently required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company.
The Company's ability to engage in non-banking activities is also regulated by the Federal Reserve Board. See "Financial Modernization Legislation."
Under the Federal Reserve Board's regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner. In addition, it is the Federal Reserve Board's policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve
Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both.
The Company is subject to the periodic reporting requirements of Section 15(d) of the Securities Exchange Act of 1934, as amended, and files certain reports pursuant to such Act with the Securities and Exchange Commission (the "SEC").
AMERICAN COMMERCIAL BANK
The Bank is chartered under the laws of the State of California and its deposits are insured by the FDIC to the extent provided by law. The Bank is subject to the supervision of, and is regularly examined by, the DFI and the FDIC. Such supervision and regulation include comprehensive reviews of all major aspects of the Banks business and condition.
Various requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes relate to many aspects of the Banks operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital.
CAPITAL STANDARDS
The Federal Reserve Board and the FDIC have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which includes off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists primarily of common stock, retained earnings, noncumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses, cumulative preferred stock, long term preferred stock, eligible term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%.
In addition to the risked-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets is 3%. For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum, or 4% to 5%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
The following table presents the amounts of regulatory capital and the capital ratios for the Bank, compared to its minimum regulatory capital requirements as of December 31, 1999.
Under applicable regulatory guidelines, the Bank was considered "Well Capitalized" at December 31, 1999. For more information concerning the capital ratios of the Company and the Bank, see Note 14 to the Americorp Financial Statements contained in Item 8 of this Report.
On January 1, 1998 new legislation became effective which, among other things, gave the power to the DFI to take possession of the business and properties of a bank in the event that the tangible shareholders' equity of the bank is less than the greater of (i) 3% of the banks total assets or (ii) $1,000,000.
PROMPT CORRECTIVE ACTION AND OTHER ENFORCEMENT MECHANISMS
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
An insured depository institution generally will be classified in the following categories based on capital measures indicated below:
An institution that, based upon its capital levels, is classified as "well capitalized," "adequately capitalized" or "undercapitalized" may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat an institution as "critically undercapitalized" unless its capital ratio actually warrants such treatment.
The law prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions if after such transaction the institution would be undercapitalized. If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency, subject to asset growth restrictions and
required to obtain prior regulatory approval for acquisitions, branching and engaging in new lines of business. Any undercapitalized depository institution must submit an acceptable capital restoration plan to the appropriate federal banking agency 45 days after becoming undercapitalized. The appropriate federal banking agency cannot accept a capital plan unless, among other things, it determines that the plan (i) specifies the steps the institution will take to become adequately capitalized, (ii) is based on realistic assumptions and (iii) is likely to succeed in restoring the depository institution's capital. In addition, each company controlling an undercapitalized depository institution must guarantee that the institution will comply with the capital plan until the depository institution has been adequately capitalized on an average basis during each of four consecutive calendar quarters and must otherwise provide adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (a) an amount equal to 5% of the depository institution's total assets at the time the institution became undercapitalized or (b) the amount which is necessary to bring the institution into compliance with all capital standards applicable to such institution as of the time the institution fails to comply with its capital restoration plan. Finally, the appropriate federal banking agency may impose any of the additional restrictions or sanctions that it may impose on significantly undercapitalized institutions if it determines that such action will further the purpose of the prompt correction action provisions.
An insured depository institution that is significantly undercapitalized, or is undercapitalized and fails to submit, or in a material respect to implement, an acceptable capital restoration plan, is subject to additional restrictions and sanctions. These include, among other things: (i) a forced sale of voting shares to raise capital or, if grounds exist for appointment of a receiver or conservator, a forced merger; (ii) restrictions on transactions with affiliates; (iii) further limitations on interest rates paid on deposits; (iv) further restrictions on growth or required shrinkage; (v) modification or termination of specified activities; (vi) replacement of directors or senior executive officers; (vii) prohibitions on the receipt of deposits from correspondent institutions; (viii) restrictions on capital distributions by the holding companies of such institutions; (ix) required divestiture of subsidiaries by the institution; or (x) other restrictions as determined by the appropriate federal banking agency. Although the appropriate federal banking agency has discretion to determine which of the foregoing restrictions or sanctions it will seek to impose, it is required to force a sale of voting shares or merger, impose restrictions on affiliate transactions and impose restrictions on rates paid on deposits unless it determines that such actions would not further the purpose of the prompt corrective action provisions. In addition, without the prior written approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to its senior executive officers or provide compensation to any of them at a rate that exceeds such officer's average rate of base compensation during the 12 calendar months preceding the month in which the institution became undercapitalized.
Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. For example, a critically undercapitalized institution generally would be prohibited from engaging in any material transaction other than in the ordinary course of business without prior regulatory approval and could not, with certain exceptions, make any payment of principal or interest on its subordinated debt beginning 60 days after becoming critically undercapitalized. Most importantly, however, except under limited circumstances, the appropriate federal banking agency, not later than 90 days after an insured depository institution becomes critically undercapitalized, is required to appoint a conservator or receiver for the institution. The board of directors of an insured depository institution would not be liable to the institution's shareholders or creditors for consenting in good faith to the appointment of a receiver or conservator or to an acquisition or merger as required by the regulator.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease and desist order that can
be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.
PREMIUMS FOR DEPOSIT INSURANCE
All deposits of the Bank are insured by the FDIC and are subject to FDIC insurance assessment. The amount of FDIC assessment paid by individual insured depository institutions is based upon their relative risk as measured by regulatory capital ratios and certain other factors. As a result of its "Well Capitalized" status, the Bank currently pays approximately $23,000 per year.
FINANCIAL MODERNIZATION LEGISLATION
On November 12, 1999, the President signed into law the Gramm-Leach-Bliley Act, ("GLB Act"), which significantly changed the regulatory structure and oversight of the financial services industry. The GLB Act revises the Bank Holding Company Act and repeals the affiliation provisions of the Glass- Steagall Act of 1933, permitting a qualifying holding company, called a financial holding company, to engage in a full range of financial activities, including banking, insurance, and securities activities, as well as merchant banking and additional activities that are "financial in nature" or "complementary" to such financial activities. The GLB Act thus provides expanded financial affiliation opportunities for existing bank holding companies and permits various non-bank financial services providers to acquire banks by allowing bank holding companies to engage in activities such as securities underwriting, and underwriting and brokering of insurance products. The GLB Act also expands passive investments by financial holding companies in any type of company, financial or nonfinancial, through merchant banking and insurance company investments. In order for a bank holding company to qualify as a financial holding company, its subsidiary depository institutions must be "well-capitalized" and "well-managed" and have at least a "satisfactory" Community Reinvestment Act rating.
The GLB Act also reforms the regulatory framework of the financial services industry. Under the GLB Act, financial holding companies are subject to primary supervision by the Federal Reserve Board while current federal and state regulators of financial holding company regulated subsidiaries such as insurers, broker-dealers, investment companies and banks generally retain their jurisdiction and authority. In order to implement its underlying purposes, the GLB Act preempts state laws restricting the establishment of financial affiliations authorized or permitted under the GLB Act, subject to specified exceptions for state insurance regulators. With regard to securities laws, the GLB Act removes the current blanket exemption for banks from the broker-dealer registration requirements under the Securities Exchange Act of 1934, amends the Investment Company Act of 1940 with respect to bank common trust fund and mutual fund activities, and amends the Investment Advisers Act of 1940 to require registration of banks that act as investment advisers for mutual funds.
The GLB Act also includes provisions concerning subsidiaries of national banks, permitting a national bank to engage in most financial activities through a financial subsidiary, provided that the bank and its depository institution affiliates are "well capitalized" and "well managed" and meet certain other qualification requirements relating to total assets, subordinated debt, capital, risk management, and affiliate transactions. With respect to subsidiaries of state banks, new activities as "principal" would be limited to those permissible for a national bank financial subsidiary. The GLB Act requires a state bank with a financial subsidiary permitted under the GLB Act as well as its depository institution affiliates to be "well capitalized," and also subjects the bank to the same capital, risk management and affiliate transaction rules as applicable to national banks. The provisions of the GLB Act relating to financial holding companies become effective 120 days after its enactment, or about March 15, 2000, excluding, the federal preemption provisions, which became effective on the date of enactment.
The Company currently meets all the requirements for financial holding company status. However, the Company does not expect to elect financial holding company status unless and until it intends to engage in any of the expanded activities under the GLB Act which require such status. Unless and until it elects such status, the Company will only be permitted to engage in non-banking activities that were permissible for bank holding companies as of the date of the enactment of the GLB Act.
COMMUNITY REINVESTMENT ACT
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act ("CRA") activities. The CRA generally requires the fede11ral banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.
In connection with its assessment of CRA performance, the appropriate bank regulatory agency assigns a rating of "outstanding." "satisfactory," "needs to improve" or "substantial noncompliance." At its last examination by the FDIC, the Bank received a CRA rating of "Satisfactory."
ACCOUNTING CHANGES
From time to time the Financial Accounting Standards Board ("FASB") issues pronouncements which govern the accounting treatment for the Company's financial statements. For a description of the recent pronouncements applicable to the Company (see the Notes to the Financial Statements included in Item 8 of this Report).
The FASB proposed for comment a change in the accounting rules relating to mergers and acquisitions. Specifically, the "pooling method" of accounting for mergers would be eliminated. Financial institutions often prefer to account for mergers using this method and many of the mergers in the financial institutions industry in the last several years have been accounted for using the pooling method. The impact of such accounting change upon mergers and acquisitions involving financial institutions and upon the Company and the value of the Company's Common Stock can not presently be predicted nor can when, or if, the change will actually be adopted.
POTENTIAL ENFORCEMENT ACTIONS
Commercial banking organizations, such as the Company and the Bank, may be subject to potential enforcement actions by the Federal Reserve Board, the DFI and the FDIC for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease and desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.
ITEM 2.
ITEM 2. PROPERTIES
All ACB's offices are leased. See Note 4 to the Americorp Financial Statements contained in Item 8 of this Report for certain additional information concerning the amount of ACB's lease commitments. Americorp has no separate facilities.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Bank is, from time to time, subject to various pending and threatened legal actions which arise out of the normal course of its business. Neither the Company nor the Bank is a party to any pending legal or administrative proceedings (other than ordinary routine litigation incidental to the Company's or the Bank's business) and no such proceedings are known to be contemplated.
There are no material proceedings adverse to the Company or the Bank to which any director, officer, affiliate of the Company or 5% shareholder of the Company or the Bank, or any associate of any such director, officer, affiliate or 5% shareholder of the Company or Bank is a party, and none of the above persons has a material interest adverse to the Company or the Bank.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Americorp Common Stock is listed on the OTC Bulletin Board and trades under the symbol "AICA." Trading in the stock has not been extensive.
The management of Americorp is aware of three securities dealers who maintain an inventory and makes a market in Americorp Common Stock--Maguire Investments, Santa Maria, California; Monroe Securities, Inc., Rochester, New York and Hoefer & Arnett, San Francisco, California.
The following prices do not necessarily include retail markups, markdowns or commissions and may not necessarily represent actual transactions. Additionally, there may have been transactions at prices other than those shown below: All prices have been adjusted for the two-for-one stock split of the Common Stock which was effective on April 15, 1999.
HOLDERS
As of February 1, 2000, there were approximately 398 holders of Americorp Common Stock. There are no other classes of equity securities outstanding.
DIVIDENDS
The Company is a legal entity separate and distinct from the Bank. The Company's shareholders are entitled to receive dividends when and as declared by its Board of Directors, out of funds legally available therefor, subject to the restrictions set forth in the California General Corporation Law (the "Corporation Law"). The Corporation Law provides that a corporation may make a distribution to its shareholders if the
corporation's retained earnings equal at least the amount of the proposed distribution. The Corporation Law also provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation's assets equal at least 1 1/4 times its liabilities, and (ii) the corporation's current assets equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation's interest expenses for such fiscal years, then the corporation's current assets must equal at least 1 1/4 times its current liabilities.
The ability of the Company to pay a cash dividend depends largely on the Bank's ability to pay a cash dividend to the Company. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the "Financial Code"). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) the bank's retained earnings; or (b) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the DFI, make a distribution to its shareholders in an amount not exceeding the greater of (x) its retained earnings; (y) its net income for its last fiscal year; or (z) its net income for its current fiscal year. In the event that the DFI determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DFI may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the Bank would be included in one of the "undercapitalized" categories for capital adequacy purposes pursuant to federal law. (See, "Item 1 - -Description of Business--Prompt Corrective Action and Other Enforcement Mechanisms.") Additionally, while the Federal Reserve Board has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Federal Reserve Board might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees to be paid by a subsidiary bank to its holding company on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm's length transaction.
Americorp has paid 65 consecutive quarterly cash dividends to its shareholders. Americorp is currently paying quarterly cash dividends of $0.12 per share.
The dividend policy of Americorp is expected to continue; however, no assurances can be given that such policy may not change. Moreover, declarations or payments of dividends by the Board of Directors of Americorp will depend upon a number of factors, including capital requirements, regulatory limitations (as discussed above), Americorp's and ACB's financial condition and results of operations, tax considerations and general economic conditions. No assurance can be given that any dividends will be declared or, if declared, what the amount of dividends or their type (cash, stock or both) will be or whether such dividends, once declared, will continue.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data with respect to the Company's consolidated statement of financial position for the years ended December 31, 1999 and 1998 and its consolidated statements of income for the years ended December 31, 1999, 1998 and 1997 have been derived from the audited consolidated financial statements included in Item 8 of this Form 10-K. The consolidated financial statements give retroactive effect to the merger of the Company's subsidiary, American Commercial Bank, with Channel Islands Bank on December 31, 1998, in a transaction accounted for as a pooling of interest, as discussed in Note 17 to the Americorp Financial Statements. This information should be read in conjunction with such consolidated financial statements and the notes thereto. The summary consolidated financial data with respect to Company's consolidated statement of financial position as of December 31, 1997, 1996 and 1995 and its consolidated statements of income for the years ended December 31, 1996 and 1995 have been derived from the audited financial statements of the Company, which are not presented herein.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
EARNINGS OVERVIEW
The Company reported net earnings of $3.3 million or $1.49 diluted earnings per share for 1999. This represents almost a threefold increase from 1998 when net earnings were $1.2 million or $0.55 diluted earnings per share. This significant increase occurred as the Company experienced strong growth in operating income (up approximately 8%) and significantly lower operating costs (down approximately 12%). Nonrecurring 1998 costs associated with the CIB merger and a reduction of approximately 10% in personnel costs represented the majority of this decline.
The Company reported earnings of $1.2 million in 1998. This represented a 39% decline compared to the $1.9 million reported in 1997. This decrease was a combination of increases in net interest income offset with significant one-time merger related expenses and increased personnel costs.
The following table sets forth several key operating ratios for 1999, 1998 and 1997:
DISTRIBUTION OF ASSETS, LIABILITIES, AND SHAREHOLDERS' EQUITY
The following table presents, for the years indicated, the distribution of average assets, liabilities and shareholders' equity, as well as the total dollar amounts of interest income from average interest-earning assets and the resultant yields, and the dollar amounts of interest expense and average interest-bearing
liabilities, expressed both in dollars and in rates. Nonaccrual loans are included in the calculation of the average balances of loans, and interest not accrued is excluded (dollar amounts in thousands).
NET INTEREST INCOME
Net interest income is the amount by which the interest and amortization of fees generated from loans and other earning assets exceeds the cost of funding those assets, usually deposit account interest expense. Net interest income depends on the difference (the "interest rate spread") between gross interest and fees earned on the loans and investment portfolios and the interest rates paid on deposits and borrowings.
Net interest income for 1999 was $14.2 million, an increase of $1.1 million or 8.7% when compared to $13.1 million in 1998. This increase was primarily attributable to the growth in interest-earning assets, as the net yield on interest-earning assets was relatively unchanged at 6.58% in 1999 compared to 6.56% in 1998. Interest-earning assets increased $16.8 million or 8.4% to $216.2 million in 1999 compared to $199.4 million in 1998.
During 1998, net interest income increased $1.2 million or 9.5% to $13.1 million from the 1997 amount of $11.9 million. As in 1999 the 1998 increase was primarily the result of increases in interest-earning assets which grew 10.2% from $181.0 million in 1997 to $199.4 million in 1998. The Company
experienced a slight reduction of 4 basis point in its net yield on interest-earning assets, which was 6.56% in 1998 compared to 6.60% in 1997.
Interest income for 1999 was $18.8 million compared to $18.1 million in 1998. This increase of $0.7 million was comprised of additional income of $2.2 million resulting from increased interest-earning assets reduced by $1.4 million resulting from a 34 basis point decline in the overall yield on interest-earning assets.
Interest income in 1998 was also up $1.5 million compared to the $16.6 million reported in 1997. This increase was primarily attributable to growth in interest-earning assets as the net yield on interest-earning assets declined by 11 basis points.
Interest expense in 1999 was $4.6 million compared to $5.0 million in 1998. This decrease was primarily attributable to declining interest rates paid on interest-bearing liabilities, which declined 30 basis points from 3.40% in 1998 to 3.10% in 1999. The positive impact on net interest income from this rate decline was partially offset by nominal increases in the average interest-bearing liabilities outstanding.
During 1999 the Company increased it average interest-earning assets by $16.8 million while limiting its increase in average interest-bearing liabilities to $2.3 million. This apparent shortfall was funded primarily by a $11.4 million increase in average noninterest-bearing demand deposits and a $2.3 million increase in shareholders' equity. This form of funding has a positive impact of the Company's net interest income.
Interest expense in 1998 was $5.0 million compared to $4.6 million in 1997. This increase was primarily attributable to increased interest-bearing liabilities, as the rate paid was relatively unchanged at 3.40% in 1998 compared to 3.41% in 1997.
The following table sets forth changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the years indicated. Changes not solely attributable to rate or volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each (dollar amounts in thousands).
PROVISION FOR LOAN LOSSES
The allowance for loan losses is maintained at a level that is considered adequate to provide for the loan losses inherent in the Company's loan portfolio. During 1999, the provision for loan losses was $720,000 compared to $523,000 in 1998 and $780,000 in 1997. See "Allowance for Loan Losses" later in this discussion for additional information on the Company's methodology for determining the adequacy of the allowance, summary of historical loan losses and analysis of overall asset quality.
NONINTEREST INCOME
Noninterest income was $2.9 million in 1999, of which approximately 90% were the traditional service charges on accounts and fees collected in commercial banking. This amount represents 1.2% of average assets for 1999. This was comparable to the $2.7 million, or 1.2% of average assets, reported in 1998.
Noninterest income in 1998 declined slightly from the 1997 amount due primarily to a decline in real estate loan brokering fees.
NONINTEREST EXPENSE
Noninterest expense reflects the costs of products and services related to systems, facilities and personnel for the Company. Noninterest expense was $11.9 million in 1999, $13.4 million in 1998 and $11.0 million in 1997. The major components of noninterest expense stated as a percentage of average assets are as follows:
Disregarding the restructuring charges and merger-related costs incurred in 1998, noninterest expense as a percentage of average assets has declined from 5.66% in 1998 to 4.89% in 1999. The Company believes this decline is primarily related to the operating efficiencies derived from its 1998 merger with CIB as well as its continuing effort to control and reduce noninterest expense.
INCOME TAXES
Income tax expense was $1,145,000, $678,000, and $972,000 for the years ended December 31, 1999, December 31, 1998, and December 31, 1997, respectively. These expenses resulted in an effective tax rate of 25.6% in 1999, 36.8% in 1998 and 33.8% in 1997. The significant decline in the effective rate in 1999 was due to the utilization of previously unrecognized tax credits. As of December 31, 1999, the Company had a valuation allowance of $706,000 related primarily to unused credits. The Company anticipates utilizing these credits in 2000, which will again reduce the Company's effective tax rate. The increase in effective rate in 1998 compared to 1997 was related to the nondeductible merger-related costs incurred in connection with the CIB merger. The Company's effective tax rate is favorably impacted by its investments
in municipal securities. See also Note 8 to the consolidated financial statements for additional information on the Company's income taxes.
BALANCE SHEET ANALYSIS
The Company's primarily operating goals for 1999 were the successful integration of the branches it obtained in the merger on December 31, 1998 with CIB and maximization of the operating efficiencies provided by that merger. While working to achieve these goals, the Company's primary service area, Ventura County experienced a significant growth in loan demand coupled with increased competition from other banks and financial institutions for the area deposits. The combination of these factors had the following impacts on the Company's balance sheet.
First, the Company experienced asset growth below its historical levels. Total assets at December 31, 1999 were $246.0 million compared to $241.7 million at December 31, 1998. This represented an increase of $4.3 million or 1.8% of which $10 million was the result of the Company's decision to prepare for any potential Y2K liquidity problems by obtaining an advance from the Federal Home Loan Bank and increasing cash and due from banks. This is compared to an increase of $18.4 million or 8.3% during 1998. However, during 1999, the Company did experience significant loan growth as net loans grew by $26.7 million or 17.5% from $152.6 million at December 31, 1998 to $179.3 million at December 31, 1999. This substantial increase in loans was funded by reductions in cash, federal funds sold and investments, which had a positive impact on the Company's net interest margin.
Similarly, the Company experienced a slight decline in total deposits, which ended 1999 at $209.9 million compared to $217.7 million at the end of 1998. This decline of $7.8 million was actually comprised of an increase of $6.3 million in noninterest-bearing demand and a decrease of $14.1 million in interest-bearing deposits.
INVESTMENT PORTFOLIO
The following table summarizes the amounts and distribution of the Company's investment securities held as of the dates indicated, and the weighted-average yields as of December 31, 1999 (dollar amounts in thousands):
Securities may be pledged to meet security requirements imposed as a condition to receipt of deposits of public funds and other purposes. At December 31, 1999 and 1998, the carrying values of securities pledged to secure public deposits and other purposes were approximately $6.4 million and $2.0 million, respectively. The increase in pledged investment securities is related to the lines of credit obtained from the Federal Home Loan Bank.
LOAN PORTFOLIO
The following table sets forth the components of total net loans outstanding in each category at the date indicated (dollar amounts in thousands):
The following table shows the maturity distribution of the fixed rate portion of the loan portfolio and the repricing distribution of the variable rate portion of the loan portfolio at December 31, 1999:
ASSET QUALITY
The risk of nonpayment of loans is an inherent feature of the banking business. That risk varies with the type and purpose of the loan, the collateral that is utilized to secure payment, and ultimately, the credit worthiness of the borrower. In order to minimize this credit risk, the Loan Committee of the board of directors approves significant loans. The Loan Committee is comprised of directors and members of the Company's senior management.
The Company grades all loans from "acceptable" to "loss", depending on credit quality, with "acceptable" representing loans with an acceptable degree of risk given the favorable aspects of the credit and with both primary and secondary sources of repayment. Classified loans or substandard loans are ranked below "acceptable" loans. As these loans are identified in the review process, they are added to the internal watch-list and loss allowances are established for them. Additionally, the loan portfolio is examined regularly by the FDIC and DFI. Management also utilizes on independent loan review company to asses loan portfolio quality and adequacy of the allowance for loan losses.
NONPERFORMING ASSETS
The following table provides information with respect to the components of the Company's nonperforming assets at the dates indicated (dollar amounts in thousands):
Loans are generally placed on non-accrual status when they are delinquent 90 days or more, unless the loan is well secured and in the process of collection. The Company stops recognizing income from the interest on the loan and reverses any uncollected interest that had been accrued but not received. Loans are not returned to accrual status until it is brought current with respect to both principal and interest payments, the loan is performing to current terms and conditions, the interest rate is commensurate with market interest rates and future principal and interest payments are no longer in doubt. See Note 3 to the consolidated financial statements for additional information on the Company's average investment in impaired loans and the amount of income recognized thereon.
In addition to the loans reported above, at December 31, 1999, the Company had loans totaling $3.3 million which it had graded less than acceptable. As discussed in the following section, evaluation of these loans is an integral portion of the Company's methodology for establishing the adequacy of the allowance for loan losses. The Company has no foreign loans in its loan portfolio.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level that is considered adequate to provide for the loan losses inherent in the Company's loans. The provision for loan losses was $720,000 in 1999 compared to $523,000 in 1998 and $780,000 in 1997.
The following table summarizes, for the years indicated, changes in the allowances for loan losses arising from loans charged-off, recoveries on loans previously charged-off, and additions to the allowance which have been charged to operating expenses and certain ratios relating to the allowance for loan losses (dollar amounts in thousands):
The Company performs quarterly detailed reviews to identify the risks inherent in the loan portfolio, assess the overall quality of the loan portfolio and to determine the adequacy of the allowance for loan losses and the related provision for loan losses to be charged to expense. This systematic reviews follow the methodology set forth by the FDIC in its 1993 policy statement on the allowance for loan losses.
A key element of this methodology is the previously discussed credit classification process. Loans identified as less than "acceptable" are reviewed individually to estimate the amount of probable losses that need to be included in the allowance. These reviews include analysis of financial information as well as evaluation of collateral securing the credit. Additionally, the Company considers the inherent risk present in the "acceptable" portion of the loan portfolio taking into consideration historical losses on pools of similar loans, adjusted for trends, conditions and other relevant factors that may affect repayment of the loans in these pools. Upon completion, the written analysis is present to the board of directors for discussion, review and approval.
The Company believes the allowance for loan losses to be adequate to provide for losses inherent in the loan portfolio. While the Company uses available information to recognize losses on loans and leases, future additions to the allowance may be necessary based on changes in economic conditions. In addition, federal regulators, as an integral part of their examination process, periodically review the allowance for loan losses and may recommend additions based upon their evaluation of the portfolio at the time of their examination. Accordingly, there can be no assurance that the allowance for loan losses will be adequate to cover future loan losses or that significant additions to the allowance for loan losses will not be required in the future.
The following table summarizes the allocation of the allowance for loan losses by loan type for the years indicated and the percent of loans in each category to total loans (dollar amounts in thousands):
FUNDING
Deposits are the Company's primary source of funds. At December 31, 1999, the Company had a deposit mix of 36.4% in time and savings deposits, 30.3% in money market and NOW deposits, and 33.3% in noninterest-bearing demand deposits. The Company's net interest income is enhanced by its percentage of noninterest-bearing deposits.
The following table summarizes the distribution of average deposits and the average rates paid for the years indicated (dollar amounts in thousands):
The scheduled maturity distribution of the Company's time deposits of $100,000 or greater, as of December 31, 1999, were as follows (dollar amounts in thousands):
OTHER BORROWINGS
To supplement its liquidity, the Company has lines of credit with the Federal Home Loan Bank and its primary correspondent. Available credit on these lines totaled $16 million, of which $10 million was advanced as of December 31, 1999. See Note 7 of the consolidated financial statements for additional information, including pledged loans and securities on these lines.
LIQUIDITY AND INTEREST RATE SENSITIVITY
The objective of the Company's asset/liability strategy is to manage liquidity and interest rate risks to ensure the safety and soundness of the Bank and its capital base, while maintaining adequate net interest margins and spreads to provide an appropriate return to the Company's shareholders.
The Company manages its interest rate risk exposure by limiting the amount of long-term fixed rate loans it holds, increasing emphasis on shorter-term, higher yield loans for portfolio, increasing or decreasing the relative amounts of long-term and short-term borrowings and deposits and/or purchasing commitments to sell loans.
The table below sets forth the interest rate sensitivity of the Company's interest-earning assets and interest-bearing liabilities as of December 31, 1999, using the interest rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period
when it can be repriced or matures within its contractual terms, except for loans held for sale which the Company classifies as highly liquid based on historical sale patterns (dollar amounts in thousands):
Liquidity refers to the Company's ability to maintain a cash flow adequate to fund both on-balance sheet and off-balance sheet requirements on a timely and cost-effective basis. Potentially significant liquidity requirements include funding of commitments to loan customers and withdrawals from deposit accounts.
CAPITAL RESOURCES
In 1990, the banking industry began to phase in new regulatory capital adequacy requirements based on risk-adjusted assets. These requirements take into consideration the risk inherent in investments, loans, and other assets for both on-balance sheet and off-balance sheet items. Under these requirements, the regulatory agencies have set minimum thresholds for Tier 1 capital, total capital and leverage ratios. At December 31, 1999, the Bank's capital exceeded all minimum regulatory requirements and the Bank was considered to be "well capitalized" as defined in the regulations issued by the FDIC. The Bank's risk-based capital ratios, shown below as of December 31, 1999, have been computed in accordance with regulatory accounting policies (The Company's capital ratios are comparable to the Bank's).
See also note 14 to the consolidated financial statements for additional information on the Bank's capital ratios.
On February 24, 2000, the Company approved a stock repurchase program for up to 200,000 of its outstanding shares. Repurchases will be made from time to time over the next three years in the open market and privately negotiated transactions based on then current market prices.
EFFECTS OF INFLATION
The financial statements and related financial information presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or same magnitude as the price of goods and services.
Y2K DISCLOSURES
During the periods leading up to January 1, 2000, the Company addressed the potential problems associated with the possibility that the computers that control or operate the Company's information technology system and infrastructure may not have been programmed to read four-digit date codes and, upon the arrival of the Year 2000, may have recognized the two-digit code "00" as the year 1900, causing systems to fail to function or generate erroneous data.
The Company expended approximately $243,000 through the periods ended December 31, 1999 in connection with its Year 2000 compliance program. The Company experienced no significant problems related to its information technology systems upon arrival of the Year 2000, nor was there any interruption in service to its customers.
The Company could still incur losses if Year 2000 issues adversely affect its depositors or borrowers. Such problems could include delayed loan payments due to Year 2000 problems affecting any significant borrowers or impairing the payroll systems of large employers in the Company's primary market areas. Because the Company's loan portfolio is highly diversified with regard to individual borrowers and types of businesses, the Company does not expect, and to date has not realized, any significant or prolonged difficulties that will affect net earning or cash flow.
IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
See note 1 to the consolidated financial statements for information on this matter.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
NET INTEREST MARGIN. As previously discussed, net interest income is the difference between the interest income and fees earned on loans and investments and the interest expense paid on deposits and other liabilities. The amount by which interest income exceeds interest expense depends on two factors: the volume of earnings assets compared to the volume of interest-bearing deposits and liabilities, and the interest rate earned on those interest earning assets compared with the interest rate paid on those interest-bearing deposits and liabilities.
Net interest margin is the net interest income expressed as a percentage of earning assets. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid, and that relationship is subject to the following types of risks that are related to changes in interest rates.
MARKET RISK. The market values of assets or liabilities on which the interest rate is fixed will increase or decrease with changes in market interest rates. If the Company invests funds in a fixed rate long-term security and then interest rates rise, the security is worth less than a comparable security just issued
because the older security pays less interest than the newly issued security. If the older security had to be sold, the Company would have to recognize a loss. Correspondingly, if interest rates decline after a fixed rate security is purchased, its value increases. Therefore, while the value changes regardless of which direction interest rates move, the adverse exposure to "market risk" is primarily due to rising interest rates. This exposure is lessened by managing the amount of fixed rate assets and by keeping maturities relatively short. However, this strategy must be balanced against the need for adequate interest income because variable rate and shorter fixed rate securities generally earn less interest than longer term fixed rate securities.
There is market risk relating to the Company's fixed rate or term liabilities as well as its assets. For liabilities, the adverse exposure to market risk is to lower rates because the Company must continue to pay the higher rate until the end of the term. However, because the amount of fixed rate liabilities is significantly less than the fixed rate assets, and because the average maturity is substantially less than for the assets, the market risk is not as great.
Net interest margin was 6.58% in 1999 compared to 6.56% in 1998 and 6.60% in 1997.
The following is a summary of the carrying amounts and estimated fair values of selected Company financial assets and liabilities at December 31, 1999 (amounts in thousands):
Other than a relatively small difference due to credit quality issues pertaining to loans, the difference between the carrying amount and the fair value is a measure of how much more or less valuable the Company's financial instruments are to it than when acquired. The net difference for interest-bearing financial assets is $1.9 million. The amount is not deemed to be significant compared to the outstanding balances taken as a whole.
The net difference for deposits is $52,000. The amount is not deemed to be significant compared to the outstanding balances taken as a whole.
MISMATCH RISK. Another interest-related risk arises from the fact that when interest rates change, the changes do not occur equally in the rates of interest earned and paid because of difference in the contractual terms of the assets and liabilities held. The Company has a large portion of its loan portfolio tied to the prime interest rate. If the prime rate is lowered because of general market conditions, e.g., other banks are lowering their lending rates; these loans will be repriced. If the Company were at the same time to have a large proportion of its deposits in long-term fixed rate certificates, net interest income would decrease immediately. Interest earned on loans would decline while interest expense would remain at higher levels for a period of time because of the higher rate still being paid on the deposits.
A decrease in net interest income could also occur with rising interest rates if the Company had a large portfolio of fixed rate loans and securities funded by deposit accounts on which the rate is steadily rising. This exposure to "mismatch risk" is managed by matching the maturities and repricing opportunities of assets and liabilities. This is done by varying the terms and conditions of the products that are offered to depositors and borrowers. For example, if many depositors want longer-term certificates while most borrowers are requesting loans with floating interest rates, the Company will adjust the interest rates on the certificates and loans to try to match up demand. The Company can then partially fill in mismatches by purchasing securities with the appropriate maturity or repricing characteristics.
One of the means of monitoring this matching process is the use of a "gap" report table. This table shows the extent to which the maturities or repricing opportunities of the major categories of assets and liabilities are matched based upon specific interest rate change scenarios and assumptions. The Company utilizes gap reports assuming simultaneous interest rate shifts of up to +/- 200 basis points.
The following table shows the estimated impact to net interest income for an instantaneous shift in various interest rates as of December 31, 1999 (the dollar change in net interest income represents the estimated change for the next 12 months):
The Company has adequate capital to absorb any potential losses as a result of a decrease in interest rates. Periods of more than one year are not estimated because steps can be taken to mitigate the adverse effects of any interest rate changes.
BASIS RISK. A third interest-related risk arises from the fact that interest rates rarely change in a parallel or equal manner. The interest rates associated with the various assets and liabilities differ in how often they change, the extent to which they change, and whether they change sooner or later than other interest rates. For example, while the repricing of a specific asset and a specific liability may fall in the same period of a gap report the interest rate on the asset my rise 100 basis points, while market conditions dictate that the liability increases only 50 basis points. While evenly matched in the gap report, the Company would experience an increase in net interest income. This exposure to "basis risk" is the type of interest risk least able to be managed, but is also the least dramatic. Avoiding concentration in only a few types of assets or liabilities is the best insurance that the average interest received and paid will move in tandem, because the wider diversification means that many different rates, each with their own volatility characteristics, will come into play. The Company has made an effort to minimize concentrations in certain types of assets and liabilities.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of Americorp
We have audited the accompanying consolidated balance sheets of Americorp and subsidiary (the "Company") as of December 31, 1999 and 1998 and the related consolidated statements of income, stockholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated financial statements give retroactive effect to the merger of the Company's subsidiary, American Commercial Bank, with Channel Islands Bank on December 31, 1998, in a transaction accounted for as a pooling of interest, as discussed in Note 17. The financial statements of the Company as of December 31, 1997, which are not presented separately, herein, were audited by other auditors whose report dated January 23, 1998 on those statements expressed and unqualified opinion.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Americorp and subsidiary as of December 31, 1999 and 1998, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles.
/s/ VAVRINEK, TRINE, DAY & CO., LLP
Laguna Hills, California January 20, 2000
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of Americorp:
We have audited the consolidated balance sheet of Americorp and subsidiary (the "Company") as of December 31, 1997 and the related consolidated statements of income, stockholders' equity and cash flows for the year then ended. These consolidated financial statements, which are not presented herein, are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Americorp and subsidiary at December 31, 1997 and the results of their operations and their cash flows for the year then ended, in conformity with generally accepted accounting principles.
/s/ FANNING & KARRH January 23, 1998, except for Note 6 as to which the date is May 7, 1998 and for Note 17 as to which the date is August 27, 1998
Ventura, California
AMERICORP AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1999 AND 1998 (DOLLAR AMOUNTS IN THOUSANDS)
See notes to consolidated financial statements.
AMERICORP AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
See notes to consolidated financial statements.
AMERICORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(DOLLAR AMOUNTS IN THOUSANDS)
See notes to consolidated financial statements.
AMERICORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(DOLLAR AMOUNTS IN THOUSANDS)
See notes to consolidated financial statements.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of Americorp and subsidiary (the "Company") are in accordance with generally accepted accounting principles and conform to practices within the banking industry. The following are descriptions of the more significant of those policies.
BASIS OF PRESENTATION--The consolidated financial statements include Americorp and its wholly owned subsidiary, American Commercial Bank (the "Bank"). The consolidated financial statements also give retroactive effect to the merger of the Company's subsidiary, American Commercial Bank, with Channel Islands Bank on December 31, 1998, in a transaction accounted for as a pooling of interest, as discussed further in Note 17. All significant intercompany accounts and transactions have been eliminated.
The Bank has been organized as a single operating segment and operates three branches in Ventura, two branches in Oxnard and one branch in Camarillo, California. The Bank's primary source of revenue is providing loans to customers, who are predominately small and middle-market businesses and individuals.
USE OF ESTIMATES--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans and the valuation allowance for deferred tax assets.
In connection with the determination of the allowance for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties. While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for losses on loans and foreclosed real estate. Such agencies may require the Company to recognize additions to the allowances based on their judgements about information available to them at the time of their examination. Because of these factors, it is possible that the allowances for losses on loans and foreclosed real estate may change materially in the near future.
In connection with the determination of the valuation allowance for deferred tax assets, management considers whether it is more likely than not that all or part of the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near future for changes in certain assumptions or estimates used to calculate future taxable income.
CASH AND CASH EQUIVALENTS--For purposes of reporting cash flows, cash and cash equivalents include cash, due from banks and federal funds sold. Generally, federal funds are sold for one day periods.
CASH AND DUE FROM BANKS--Banking regulations require that all banks maintain a percentage of their deposits as reserves in cash or on deposit with the federal reserve bank. The Bank complied with the reserve requirements as of December 31, 1999.
The Bank maintains amounts due from banks that exceed federally insured limits. The Bank has not experienced any losses in such accounts.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) SECURITIES--The Company classifies its investment securities into two categories as follows:
Securities Held-to-Maturity--Securities for which the Company has the positive intent and ability to hold to maturity are carried at cost, increased by the accretion of discounts and decreased by the amortization of premiums. The discount is accreted and premium is amortized over the period to maturity of the related security.
Securities Available-for-Sale--Securities available-for-sale consist of investment securities not classified as trading securities nor as securities held-to-maturity. Securities available-for-sale are recorded at their fair market values. Unrealized holding gains and losses, net of tax, are reported as a net amount in a separate component of equity until realized. Gains and losses are determined using the specific identification method. The accretion of discounts and the amortization of premiums are recognized in interest income using the interest method over the period to maturity.
LOANS--Loans are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees and unearned discounts.
Loan origination fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.
Loans are placed on nonaccrual when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Any unpaid interest previously accrued on those loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. For impairment recognized in accordance with Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 114, "ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN", amended by SFAS No. 118, the entire change in the present value of expected cash flows is reported as either provision for loan losses in the same manner in which impairment initially was recognized, or as a reduction in the amount of provision for loan losses that otherwise would be reported.
On January 1, 1997, the Company adopted SFAS No. 125 "ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES". The statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Under this statement, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished.
ALLOWANCE FOR LOAN LOSSES--The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). The Company performs quarterly detailed reviews to identify the risks inherent in the loan portfolio, assess the overall quality of the loan portfolio and to determine the adequacy of the allowance for loan losses and the related provision for loan losses to be charged to expense. These systematic reviews follow the methodology set forth by the FDIC in its 1993 policy statement on the allowance for loan losses.
Loans identified as less than "acceptable" are reviewed individually to estimate the amount of probable losses that need to be included in the allowance. These reviews include analysis of financial
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) information as well as evaluation of collateral securing the credit. Additionally, management considers the inherent risk present in the "acceptable" portion of the loan portfolio taking into consideration historical losses on pools of similar loans, adjusted for trends, conditions and other relevant factors that may affect repayment of the loans in these pools.
PREMISES AND EQUIPMENT--Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is generally charged to income over the estimated useful lives of the assets by use of the straight-line method. Leasehold improvements are amortized over the terms of the leases or the estimated useful lives of improvements, whichever is shorter.
Estimated useful lives are as follows:
OTHER REAL ESTATE OWNED--Real estate acquired through foreclosure or deed in lieu of foreclosure is recorded at the lower of the outstanding loan balance at the time of foreclosure or appraised value. Gains and losses on the sale of other real estate owned and write-downs resulting from periodic revaluation of the property are charged to other operating expenses.
ADVERTISING COSTS--The Company expenses the costs of advertising when incurred.
INCOME TAXES--Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements.
COMPREHENSIVE INCOME--Beginning in 1998, the Company adopted SFAS No. 130, "REPORTING COMPREHENSIVE INCOME", which requires the disclosure of comprehensive income and its components. Changes in unrealized gain (loss) on available-for-sale securities net of income taxes is the only component of accumulated other comprehensive income for the Bank.
FINANCIAL INSTRUMENTS--In the ordinary course of business, the Bank has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit as described in Note 15. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.
EARNINGS PER SHARE--Basic earnings per share are based on the weighted average number of common shares outstanding. Diluted earnings per share are based on the weighted average number of common and equivalent shares outstanding. The average number of common shares outstanding and common equivalent shares outstanding for 1999 were 2,082,672 and 2,228,136, respectively. The average number of common shares outstanding and common equivalent shares outstanding for 1998 were 1,975,800 and 2,133,600, respectively. The average number of common shares outstanding and common equivalent shares outstanding for 1997 were 1,826,600 and 2,059,000, respectively. Common equivalent shares consist of the dilutive effect of stock options using the treasury stock method.
DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS--SFAS No. 107 specifies the disclosure of the estimated fair value of financial instruments. The Bank's estimated fair value amounts have been determined by the Bank using available market information and appropriate valuation methodologies.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) However, considerable judgment is required to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts the Company could have realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since the balance sheet date and, therefore, current estimates of fair value may differ significantly from the amounts presented in the accompanying Notes.
STOCK-BASED COMPENSATION--SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION," encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion ("APB") No. 25, "ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES", and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock. The pro forma effects of adoption are disclosed in Note 10.
CURRENT ACCOUNTING PRONOUNCEMENTS--In June 1998, the FASB issued SFAS No. 133, "ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES". This Statement establishes accounting and reporting standards for derivative instruments and for hedging activities. This new standard was originally effective for 2000. In June 1999, the FASB issued SFAS No. 137, "ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES--DEFERRAL OF THE EFFECTIVE DATE OF FASB STATEMENT NO. 133". This Statement establishes the effective date of SFAS No. 133 for 2001 and is not expected to have a material impact on the Bank's financial statements.
RECLASSIFICATIONS--Certain reclassifications were made to prior years' presentations to conform to the current year. These reclassifications are of a normal recurring nature.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
2. SECURITIES
Debt securities have been classified according to management's intent. The amortized cost of securities and their approximate fair values at December 31, 1999 and 1998 follows.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
2. SECURITIES (CONTINUED) The scheduled maturities of securities held-to-maturity and available-for-sale at December 31, 1999 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales and calls of securities available-for-sale during 1999, 1998 and 1997 were $2,291, $20,284 and $2,752, respectively. Gross losses of $15 were realized on those sales in 1999. Gross gains of $76 and gross losses of $60 were realized on those sales and calls during 1998. Gross gains of $54 were realized on those sales and calls in 1997.
Securities carried at approximately $6,381 and $2,032 at December 31, 1999 and 1998, respectively, were pledged to secure public funds on deposit, as required by law.
Included in accumulated other comprehensive income at December 31, 1999 and 1998 are unrealized gains (losses) on securities available for sale of $(165) and $247, net of taxes of $52 and $101, respectively.
3. LOANS
Loans consisted of the following at December 31:
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
3. LOANS (CONTINUED) Transactions in the allowance for loan losses are summarized as follows:
At December 31, 1999 and 1998, the recorded investment in loans that are considered to be impaired was $1,797 and $1,780, respectively, all of which, were on a nonaccrual basis and for which the related allowance for loan losses is approximately $184 and $368, respectively. The average recorded investment in impaired loans during the year ended December 31, 1999, 1998 and 1997 was approximately $1,556, $1,982 and $1,314, respectively. No interest income was recognized on these loans. If these loans had been current throughout their terms, interest income would have increased approximately $165, $209 and $140 for 1999, 1998 and 1997, respectively.
In the ordinary course of business, the Company has granted loans to certain executive officers, directors and companies with which they are associated. Loans made to such related parties amounted to $1,255 in 1999 and $2,003 in 1998. Balances outstanding at December 31, 1999 and 1998 were $1,320 and $2,922, respectively.
4. PREMISES AND EQUIPMENT
Premises and equipment consisted of the following at December 31:
During 1999, the Bank wrote off $1,235 in assets that had been fully depreciated in prior years.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
4. PREMISES AND EQUIPMENT (CONTINUED) At December 31, 1999, the Company was obligated under operating leases requiring annual rentals as follows:
Rental expense was $864 in 1999, $892 in 1998, and $705 in 1997.
5. OTHER REAL ESTATE OWNED
Other real estate owned consisted of the following at December 31:
6. INVESTMENT IN PARTNERSHIPS
During 1998, the Bank received $2,549 in full settlement of its investment in Ventura Affordable Homes, Ltd. The following paragraphs summarize the history and resolution of that investment.
The Company had a 50% limited partner interest in Ventura Affordable Homes, Ltd. Affordable Communities, Inc., an unrelated entity, was the general partner. The partnership was formed for the purpose of constructing a low-to-moderate income housing development located in Ventura. The investment was accounted for on the equity method. In 1992, the Company sold a parcel of land to the partnership at its cost of $1,200. In exchange, the Company received a second trust deed for $1,200. During 1994, the Company contributed the trust deed and an additional $500 to the partnership. $258 was contributed to the partnership in 1995.
In January of 1997, a dispute arose between the Bank as limited partner and Affordable Communities, Inc., the general partner, over the amount of management fees claimed to be owed to the general partner by the partnership. In February 1997, the Bank initiated a lawsuit against the general partner because of this dispute. The Bank and the general partner negotiated a complete settlement of the dispute and a request for dismissal was filed with the court. In connection with the settlement agreement, the partnership was dissolved in 1998 and the Bank received a $2,549 distribution in full satisfaction of its 50% interest in the partnership.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
7. BORROWINGS
During 1999, in anticipation of potential Y2K related liquidity issues, the Company obtained two lines of credit with the Federal Home Loan Bank. Approximately $24,000 in loans and approximately $4,000 in investments held by the Company secured these lines. On December 28, 1999, the Bank obtained two advances against these lines, both due on January 18, 2000. One advance was for $6,000, including interest at 6.09% and the other advance was for $4,000, including interest at 5.98%. Both advances were repaid at maturity.
At December 31, 1999, the Company also had an unused line of credit with one bank. The line totals $5,000, has variable interest rates based on the lending bank's daily Federal funds rates, and is due on demand. The line of credit is unsecured.
8. INCOME TAXES
The current and deferred amounts of the provision for income taxes are as follows:
The following summarizes the differences between the provision for income taxes for financial statement purposes and the federal statutory rate of 34%:
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
8. INCOME TAXES (CONTINUED) The tax effects of each type of significant item that gave rise to deferred taxes are:
9. PROFIT SHARING AND DEFERRED COMPENSATION PLANS
PROFIT SHARING--The Company has a combination profit sharing and salary deferral 401(k) plan for the benefit of its employees. Under the plan, eligible employees may defer a portion of their salaries. The Company may, at its option, make matching contributions to the employee salary deferrals or profit sharing contributions. For 1999, 1998 and 1997, the Company's salary deferral matching contribution amounted to $79, $73, and $42, respectively. No profit sharing contributions were made in 1999, 1998 or 1997.
DEFERRED COMPENSATION, DIRECTORS AND CHIEF EXECUTIVE OFFICERS--In May 1997, the Company approved the Directors' Retirement Plan and the Chief Executive Officer's Retirement Plan which restated and amended preexisting retirement plans. The original plans provided for payments upon retirement, death or disability for the benefit of directors and the chief executive officer (now a director) of the Company. The preexisting and the restated Plans are nonqualified and nonfunded plans. The preexisting Plans had been amended several times and as of January 1, 1997 provided for six years of retirement benefits upon retirement. Under the restated Plans, each participant upon normal retirement, death, or disability will receive a monthly retirement benefit for 120 months in an amount stipulated in the agreement. During 1998, the Company again amended the Plans to provide for significant reductions in the retirement benefits, eliminated participation by any existing Director with less than five years of service and closed the Plans for participation by any new Directors.
DEFERRED COMPENSATION, SENIOR OFFICERS--The Company has a nonqualified, nonfunded income continuation plan providing for payments upon retirement, death or disability of certain employees. Under the Plan, certain employees will receive retirement payments equal to a portion of the last three years' average
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
9. PROFIT SHARING AND DEFERRED COMPENSATION PLANS (CONTINUED) compensation. The payments are to be made monthly for a period of ten years. The Plan also provides for reduced benefits upon early retirement, disability or termination of employment.
As of December 31, 1999 and 1998, the projected benefit obligation and the net benefit liability of these Plans are $1,544 and $1,866, respectively, and are included in other liabilities in the accompanying consolidated financial statements. Compensation expense relating to these Plans was $156, $386, and $267 in 1999, 1998 and 1997, respectively.
In anticipation of the future obligation of the deferred compensation plans, the Company has invested in life insurance policies, which are carried at cash surrender value. The Company's intention is to partially fund these plans from the proceeds and investment earnings of these insurance policies.
10. STOCK OPTION PLANS
The Company has a stock option plan (the "1998 Plan") that provides for the granting of options to directors and officers to purchase stock at its market value on the date the options are granted. There are 220,000 shares of Americorp Stock reserved for issuance upon exercise of options granted under the 1998 Plan. Options granted under the 1998 Plan may not extend more than ten years from the date of grant.
The 1998 Plan superceded all prior stock option plans of the Company but did not effect any of the stock options granted under such plans that remain outstanding. Outstanding options from plans other than the 1998 plan totaled 57,700 at December 31, 1999.
In accordance with SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION", which was effective as of January 1, 1996, the fair value of option grants is estimated on the date of grant using the Black-Scholes option-pricing model for proforma footnote purposes with the following assumptions used for grants in all years:
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
10. STOCK OPTION PLANS (CONTINUED) A summary of the status of the Company's stock option plan and the changes in the shares outstanding for the three years ended December 31, 1999 is as follows:
The above table also includes activity in the stock option plans of Channel Islands Bank prior to the merger on December 31, 1998.
The following table summarizes information about stock options outstanding at December 31, 1999:
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
10. STOCK OPTION PLANS (CONTINUED) As permitted by SFAS No. 123, the Company has chosen to continue accounting for stock options at their intrinsic value. Accordingly, no compensation expense has been recognized for its stock option compensation plans. Had the fair value method of accounting been applied to the Company's stock option plans, net income and earnings per share would have been reduced to the pro forma amounts indicated below:
11. SIGNIFICANT CONCENTRATIONS OF CREDIT RISK
Most of the Company's business activity is with customers throughout its primary market area of Ventura County, California. Although the Company seeks to avoid concentrations of loans to a single industry or based upon a single class of collateral, real estate and real estate associated businesses are among the principal industries in the Company's market area and, as a result, the Company's loan and collateral portfolios are, to some degree, concentrated in those industries.
Investments in state and municipal securities involve governmental entities within the State of California. The Bank maintains amounts on deposit with correspondent banks that exceed federally insured limits. The Bank has not experienced any losses in connection with such accounts.
12. POSTRETIREMENT BENEFIT PLANS OTHER THAN PENSIONS
The Company provides health and life insurance benefits to retired employees and directors. Employees may become eligible for benefits if they retire after attaining specified age and service requirements while they worked for the Company. Directors may become eligible after five years regardless of their age at retirement.
The Company implemented the provisions of SFAS No. 106, "EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS" effective January 1, 1996. These benefits are now accrued over the period the employee provides services to the Company. Prior to the change, costs were charged to expense as incurred. The Company elected the delayed recognition treatment of the adoption of SFAS 106. Under this method, the transition obligation will be amortized on a straight line basis over the remaining service period of active plan participants. The Company's current policy is to fund the cost of postretirement health care and life insurance plans on a pay-as-you-go basis.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLAR AMOUNTS IN THOUSANDS)
12. POSTRETIREMENT BENEFIT PLANS OTHER THAN PENSIONS (CONTINUED)
The net periodic cost for postretirement health care and life insurance benefits includes the following:
Summary information on the Company's plans is as follows:
The assumed discount rate and the assumed rate of increase in compensation levels are 7.25%. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 5.5% declining to 4.75% in 6 years. If the health care cost trend rate assumptions were increased by 1%, the accrued postretirement benefit cost, as of December 31, 1999, would be increased by approximately $30.
13. STOCK SPLIT
On March 18, 1999, the Board of Directors of the Company declared a two-for-one stock split of its outstanding shares of common stock. All per share data has been retroactively adjusted to reflect this split.
14. REGULATORY MATTERS
The Company and Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's and Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of the Company's and Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and Bank's
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
14. REGULATORY MATTERS (CONTINUED) capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 1999, that the Company and the Bank meet all capital adequacy requirements to which it is subject.
As of December 31, 1999, the most recent notification from the FDIC categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action (there are no conditions or events since that notification that management believes have changed the Bank's category). To be categorized as well-capitalized, the Bank must maintain minimum ratios as set forth in the table below. The following table also sets forth the Bank's actual capital amounts and ratios (the Company's capital ratios are comparable to the Bank's):
15. COMMITMENTS AND CONTINGENCIES
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position. Exposure to credit loss in the event of nonperformance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. At December 31, 1999, the Company had commitments to extend credit of $44,584 and obligations under standby letters of credit of $968.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
15. COMMITMENTS AND CONTINGENCIES (CONTINUED) Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions.
The Company uses the same credit policies in making commitments and conditional commitments as it does for extending loan facilities to customers. The Company evaluates each customer's credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and real estate.
The Company is involved in various litigation that has arisen in the ordinary course of its business. In the opinion of management and legal counsel, the disposition of such pending litigation will not have a material effect on the Company's financial statements.
16. FAIR VALUE OF FINANCIAL INSTRUMENTS
Financial Accounting Standards No. 107 ("FAS 107"), "DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS" requires corporations to disclose the fair value of its financial instruments, whether or not recognized in the balance sheet, where it is practical to estimate that value.
Fair value estimates are based on relevant market information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holding of a particular financial instrument. In cases where quoted market prices are not available, fair value estimates are based on judgements regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.
These estimates are subjective in nature and involve uncertainties and matters of significant judgement and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS--The carrying amounts reported in the balance sheets for cash and short-term instruments approximate those assets' fair values.
SECURITIES--Fair values were based on quoted market prices, where available. If quoted market prices were not available, fair values were based on quoted market prices of comparable instruments.
FEDERAL HOME LOAN BANK STOCK--The fair value of Federal Home Loan Bank stock is based on its redemption value.
LOANS--The carrying values, reduced by estimated inherent credit losses, of variable-rate loans and other loans with short-term characteristics were considered fair values. For other loans, the fair market values were calculated by discounting scheduled future cash flows using current interest rates offered on loans with similar terms adjusted to reflect the estimated credit losses inherent in the portfolio.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
16. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) ACCRUED INTEREST RECEIVABLE AND ACCRUED INTEREST PAYABLE--The carrying amounts reported in the balance sheets for accrued interest receivable and accrued interest payable approximate their fair values.
CASH SURRENDER VALUE OF LIFE INSURANCE--The fair value of life insurance policies are based on their surrender value.
DEPOSIT LIABILITIES--The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, NOW, savings, and money market deposits, was, by definition, equal to the amount payable on demand. The fair value of certificates of deposit was based on the discounted value of contractual cash flows, calculated using the discount rates that equaled the interest rates offered at the valuation date for deposits of similar remaining maturities.
BORROWINGS--Due to the short-term nature of other borrowings, book value is determined to approximate fair value.
The following is a summary of the carrying amounts and estimated fair values of the Company's financial assets and liabilities at December 31, 1999 and 1998:
At December 31, 1999 and 1998, the Bank had outstanding standby letters of credit and commitments to extend credit. These off-balance sheet financial instruments are generally exercisable at the market rate prevailing at the date the underlying transaction will be completed, and, therefore, they were deemed to have no current fair market value (see Note 15).
17. MERGER WITH CHANNEL ISLANDS BANK
At the close of business on December 31, 1998, the Company consummated a merger with Channel Islands Bank. This merger was accounted for by the pooling of interest method, whereby the Company's Financial Statements have been restated as if the two companies were historically one unit. A total of 405,505 common shares were issued to the shareholders of Channel Islands Bank in connection with this merger.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
17. MERGER WITH CHANNEL ISLANDS BANK (CONTINUED) The following table summarizes the separate revenue and net income of the Company and Channel Islands Bank that have been reported in the restated financial statements included herein:
In connection with this merger, the Company identified one-time restructuring charges and incurred merger-related costs of $518 ($434 after tax). These restructuring charges and merger-related costs included employee benefits and severance payments, professional fees associated with the merger and asset-related write-downs related to the closure of one branch location. The majority of these costs were incurred in 1998, however $159 of these costs were accrued at the consummation of the merger on December 31, 1998 and incurred in 1999.
AMERICORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AMOUNTS IN THOUSANDS)
18. PARENT COMPANY INFORMATION
The following are condensed financial statements of Americorp (parent company only) as of and for the years ended December 31 1999 and 1998:
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Information in response to this Item is set forth in Americorp's Report on Form 8-K filed with the SEC on December 4, 1998 which by this reference is incorporated herein.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information on the current members of the Boards of Directors of Americorp and ACB.
The following table sets forth information on the current executive officers of ACB.
Messrs. Lukiewski and Sciarillo also serve as the President and Chief Financial Officer, respectively, of Americorp.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
Set forth below is the compensation accrued during 1999 to the executive officers of Americorp/ACB who received total annual salary and bonus of more than $100,000 during 1999.
SUMMARY COMPENSATION TABLE
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(1) Amounts shown include cash and non-cash compensation earned and received, including monthly auto allowances.
(2) No executive officer received perquisites or other personal benefits in excess of the lesser of $50,000 or 10% of each such officer's total annual salary and bonus.
(3) Became President on March 2, 1998 and Senior Vice President and Chief Credit Officer prior thereto.
(4) Became Senior Vice President and Chief Administrative Officer in July 1999.
OPTION GRANTS IN 1999
In connection with the merger with CIB, Americorp adopted a new stock option plan. Previous stock option plans of Americorp were terminated at such time but options granted pursuant to such plans remained outstanding and exercisable in accordance with their terms. Options granted during 1999 under the various Americorp stock option plans to either of the officers set forth in the Summary Compensation Table are as follows:
The following table sets forth certain information concerning unexercised options under the Americorp stock option plans to the persons named in the Summary Compensation Table.
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(1) The aggregate value has been determined based upon the closing sales price for Americorp's stock as of December 31, 1999, minus the exercise price.
DIRECTOR COMPENSATION
In 1999, each of the then directors received $1,000 per month in director's fees except as indicated in the following sentences. The Secretary to the Board received $2,000 per month in fees and the Vice-Chairmen of the Board also received $2,000 per month in fees. The Chairman of the Board received $3,500 per month in fees.
EMPLOYMENT AGREEMENT
In connection with his appointment as President and Chief Executive Officer of Americorp and ACB, ACB entered into an employment agreement with Gerald J. Lukiewski as of March 2, 1998. The agreement, as amended and extended, currently provides for a three year term with an annual salary of $135,000. The agreement also provides for participation in ACB's bonus plan and certain other benefits, including vacation, automobile allowance, insurance, retirement benefits and expense reimbursements. In the event of termination without cause, the agreement provides for the lesser of (i) three months of additional salary and benefits or (ii) the remaining salary and benefits due under the term of the agreement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Except as set forth in the following table, management of Americorp does not know of any person who owns beneficially more than 5% of Americorp Stock. The following table sets forth certain information as of February 1, 2000, concerning the beneficial ownership of Americorp Stock by each of the current directors of Americorp and ACB and by all current directors and executive officers of Americorp and ACB as a group.
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* Less than 1%.
(1) Beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares; (a) voting power, which includes the power to vote, or to direct the voting of such security; and/or; (b) investment power which includes the power to dispose, or to direct the disposition of such security. Beneficial owner also includes any person who has the right to acquire beneficial ownership of such security as defined above within 60 days of the date specified.
(2) Shares subject to options held by directors and executive officers that were exercisable within 60 days after February 1, 2000 are treated as issued and outstanding for the purpose of computing the percentage of class owned by such person (or group) but not for the purpose of computing the percentage of class owned by any other individual person.
(3) Includes 4,370 shares exercisable pursuant to the Americorp stock option plans.
(4) Includes 12,720 shares exercisable pursuant to the Americorp stock option plans.
(5) Includes 4,370 shares exercisable pursuant to the Americorp stock option plans.
(6) Includes 4,370 shares exercisable pursuant to the Americorp stock option plans.
(7) Includes 2,914 shares exercisable pursuant to the Americorp stock option plans.
(8) Includes 38,401 shares exercisable pursuant to the Americorp stock option plans.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Some of the current directors and officers of Americorp and ACB and the companies with which they are associated have been customers of, and have had banking transactions with ACB, in the ordinary course of ACB's business, and ACB expects to continue to have such banking transactions in the future. All loans and commitments to lend included in such transactions have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with persons of similar creditworthiness, and in the opinion of management of ACB, have not involved more than the normal risk of repayment or presented any other unfavorable features.
ITEM 14.
ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
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* filed with the SEC in Registration Statement 333-63841 on Form S-4 and by this reference incorporated herein.
** contained in Americorp's Report on Form 8-K filed with the SEC on December 4, 1998 and by this reference incorporated herein.
REPORTS ON FORM 8-K:
None.
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, Americorp caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 23, 2000.
In accordance with the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of Americorp and in the capacities and on the dates indicated.
EXHIBIT INDEX | 18,309 | 120,782 |
1005972_1999.txt | 1005972_1999 | 1999 | 1005972 | ITEM 1. BUSINESS
Party City Corporation (the "Company") is incorporated in the State of Delaware and operates retail party goods stores within the continental United States and sells franchises on an individual store and area franchise basis throughout the United States, Puerto Rico, Spain, Portugal and Canada. As of July 3, 1999, the Company had 215 Company-owned stores and 178 franchise stores in its network.
RECENT DEVELOPMENTS
Audited Consolidated Financial Statements
The Company was unable to issue audited financial statements for the year ended December 31, 1998 and timely file its 1998 Annual Report on Form 10-K with the Securities and Exchange Commission ("SEC") primarily because of difficulties associated with taking the year-end physical inventories and the related reconciliation process. The Company has taken a complete physical inventory as of July 3, 1999 and prepared consolidated financial statements for the eighteen-month period from January 1, 1998 to July 3, 1999. As a result of the failure to file the Form 10-K by March 31, 1999 the Company was in default of Nasdaq's continued listing requirements. Trading in the Company's Common stock was halted on May 6, 1999, and the Company was delisted on July 20, 1999.
Effective July 3, 1999, the Company changed its fiscal year end for financial reporting from December 31 to the Saturday nearest to June 30. The Company continues to use December 31 as its tax year end. The change to a 52-53 week calendar was made to facilitate comparable store sales computations. The term "Fiscal Year" refers to the 52-53 weeks ending the Saturday nearest June 30, unless otherwise noted.
Financing Agreements
On April 24, 1998, the Company refinanced and replaced its then existing $20 million loan facility with a $60 million secured revolving line of credit agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit Agreement"). Advances under the Credit Agreement originally bore interest, at the Company's option, at the agent bank's base rate (the higher of the bank's prime rate or the federal funds rate plus 1/2% per annum) or LIBOR plus an applicable margin.
The Company's failure to issue its consolidated financial statements on a timely basis is a default under the Credit Agreement. In addition to this default, the Company did not meet certain of its financial covenants, including those relating to minimum levels of profitability, net worth, liquidity, fixed charge coverage and others. Consequently, the Company's debt was subject to acceleration and is classified as a current liability in the consolidated balance sheet at July 3, 1999. Amounts due to the lenders under the Credit Agreement are secured by all the assets of the Company. Additionally, the Credit Agreement restricts the payment of dividends.
In August 1999, the Company completed a comprehensive refinancing that included entering into agreements with its existing bank lenders under the Credit Agreement (the "Banks"), a new group of investors (the "Investors") and its trade vendors. The Banks and the Company entered into a Standstill and Forbearance Agreement (the "Bank Forbearance Agreement"). Under the Bank Forbearance Agreement, the Banks have agreed not to exercise rights and remedies based upon any existing defaults until June 30, 2000 unless a further event of default occurs. The Company has agreed to reduce its outstanding bank borrowings from the $58.6 million outstanding at July 3, 1999, to $15 million by October 30, 1999, to increase the interest rate on its bank debt to 2% over the bank's prime interest rate, and to pay a forbearance fee of $580,000. Company management intends to refinance its outstanding indebtedness to the Banks with an asset-based lending arrangement. There is no assurance such a lending arrangement can be obtained. The $15 million anticipated to be outstanding at October 30, 1999 is due June 30, 2000 unless the Bank Forbearance Agreement is extended or amended.
On August 17, 1999, the Company received $30 million in financing from the "Investors". The Investors purchased senior secured notes and warrants pursuant to separate securities purchase agreements (the "Securities Purchase Agreements") each dated as of August 16, 1999. Under these Securities Purchase Agreements, the Company issued (i) $10 million of its 12.5% Secured Notes due 2003 (the "A Notes"); (ii) $5 million of its 13.0% Secured Notes due 2003 (the "B Notes"); (iii) $5 million of its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10 million of its 14.0% Secured Notes due 2004 (the "D Notes", and together with the A Notes, the B Notes and the C Notes, the "Notes"); and (v) warrants (the "Warrants") to purchase 6,880,000 shares of the Company's common stock at an initial exercise price of $3.00 per share. Up to $15 million of the Notes is secured by a first lien that is pari passu with the liens under the Credit Agreement under certain circumstances and all of the Notes are secured by a second lien on all of the Company's assets. The Company issued the Warrants in connection with the sale of the C Notes and the D Notes. The Warrants may be exercised at any time before the close of business on August 16, 2006. The shares of Common Stock reserved for issuance under the Warrants represent approximately 35% of the shares of Common Stock outstanding assuming the exercise of the Warrants.
The Company also entered into an Investor Rights Agreement (the "Investor Rights Agreement") with the Investors and Jack Futterman. In this agreement, the Company granted registration rights with respect to shares of Common Stock owned by the Investors. The Company has agreed to nominate two individuals, designated by the Investors, to its Board of Directors. Under the Investor Rights Agreement, the Investors agree that they will not, without the prior written consent of the Board of Directors, (i) acquire or agree to acquire, publicly offer or make any public proposal with respect to the possible acquisition of (a) beneficial ownership of any securities of the Company, (b) any substantial part of the Company's assets, or (c) any rights or options to acquire any of the foregoing from any person; (ii) make or in any way participate in any "solicitation" of "proxies" (as such terms are defined in the rules of the Securities Exchange Act of 1934, as amended) to vote, or seek to advise or influence any person with respect to the voting of any voting securities of the Company; or (iii) make any public announcement with respect to any transaction between the Company or any of its securities holders and the Investors, including without limitation, any tender or exchange offer, merger or other business combination of a material portion of the assets of the Company. These standstill provisions terminate if the Company's consolidated earnings before interest, taxes, depreciation and amortization and exclusive of special charges, as defined in the Investor Rights Agreement, do not meet specified targets.
Party City's trade vendors representing approximately $36.4 million of trade debt have also entered into an agreement with the Company. Pursuant to a Vendor Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"), these trade vendors agreed to forbear from taking any action against Party City until January 15, 2000, unless an event of default occurs. The trade vendors have received promissory notes from Party City representing one-third of their unpaid claims as of May 1, 1999 (the "Trade Notes"). The Trade Notes bear interest at a rate of 10% per year and mature on November 15, 1999. Interest on the Trade Notes is due on January 15, 2000, unless the borrowings under the Credit Agreement are refinanced before then. On January 15, 2000, Company management believes it will resume normal credit terms with substantially all of its vendors. Upon such event, management believes the remaining two-thirds of the unpaid claims as of May 1, 1999 will be satisfied through individual arrangements with its vendors. However, there can be no assurance that the Company will successfully conclude these arrangements. Separately, certain seasonal trade vendors have agreed to extend certain credit to Party City for 30% of purchases for the Halloween, Thanksgiving and end of year holiday seasons. Vendors that have agreed to extend credit will receive a shared lien that is pari passu with the liens of the Credit Agreement on the Company's inventory for the amount of the credit extended.
Also, in connection with these transactions, one outside director of the Company resigned and two representatives of the Investors joined the Board of Directors. One of these directors (who was a temporary appointee) is being replaced.
The proceeds from the sale of the Notes has been used as follows (in thousands):
The Company's unaudited pro forma consolidated balance sheet as of July 3, 1999, after giving effect to the transactions described above is as follows (in thousands):
Sales of Company-Owned Stores
In order to meet the cash flow requirements of the Halloween seasonal purchase of inventory and to meet the requirements of the Bank Forbearance Agreement, the Company began a program to identify stores for sale to existing franchisees to generate working capital. Eighteen stores with a net book value of approximately $9,150,000 were sold to franchisees, of which seventeen stores with a net book value of approximately $8,750,000 were sold subsequent to July 3, 1999. In connection with the sales, normal franchise fees were waived for negotiated periods up to five years. The total proceeds from the sales of these stores are approximately $9,883,000, of which $9,683,000 was received subsequent to July 3, 1999. The net proceeds from the sale of stores is required under the Bank Forbearance Agreement to be used to pay down the outstanding borrowings under the Credit Agreement.
GENERAL
The Company is a specialty retailer of party supplies through its network of discount stores. At September 20, 1999, the Company owned and operated 198 Company-owned stores in the United States and its franchisees operated an additional 204 stores in the United States, Puerto Rico, Canada, Portugal and Spain. The Company, based in Rockaway, New Jersey, believes it is one of the largest party supplies specialty chains. The Company authorized the first franchise store in 1989 and opened its first Company-owned store in January 1994.
The Company operates and franchises party supplies stores that generally range in size from 8,000 square feet to 12,000 square feet. These stores offer a broad selection of merchandise (brand name as well as private label) for a wide variety of celebratory occasions, including birthday parties, weddings, and baby showers as well as seasonal events such as Halloween, Christmas, New Year's Eve, Graduation, Easter, Valentine's Day, Thanksgiving, St. Patrick's Day, the Super Bowl and the Fourth of July. Party City seeks to offer customers a "one-stop" party store that provides a wide selection of merchandise at everyday low prices. A key element of delivering customer satisfaction is stocking inventory in sufficient quantities to satisfy customer needs for parties of virtually all sizes and types.
INDUSTRY OVERVIEW
The retail party supplies business has traditionally been a fragmented one, with consumers purchasing party-related products from single owner-operated party supplies stores and designated departments in drug stores, general mass merchandisers, supermarkets, and department stores of local, regional and national chains. According to industry sources, the market for party and special occasion merchandise, comprised of party supplies, greeting cards, gift wrap and related items is estimated at $11.5 billion in sales in 1998.
The Company believes that the increasing breadth of party supplies merchandise produced by manufacturers over the past few years has been a driving factor in the marketplace's acceptance of the party supplies store concept. Further, the Company believes that the significant revenues experienced by its Company-owned and franchise stores in the calendar year fourth quarter can be attributed, to a large extent, to the growth in the number of persons celebrating Halloween and the increased demand for costumes and party supplies utilized in such celebrations. The Company has noted the marketplace's acceptance of other types of superstores and mega-retailers in various categories such as food, home furnishings and pet supplies, among others. The success of such superstores and mega-retailers in other industries has prompted the Company to expand its product lines to include a wider breadth of merchandise in order to make its stores attractive destination shopping locations for party supplies. In addition, Company management believes that the increased breadth of related and integrated merchandise available to customers in superstores and mega-retailers influences consumers to increase the number of purchases in a given trip to a retailer. As such, the Company believes that the broad selection, and relatively low price points, of merchandise offered by its stores often stimulates customers to purchase additional items on impulse.
BUSINESS STRATEGY
The Company's objective is to maintain its position as a leading category-dominant national chain of party supplies stores. The Company believes that it has transformed the party supplies business by introducing increased product and marketing focus and greater mass merchandising sophistication. In order to maintain continued store growth, Company management is continuing to invest in its human resources and management information systems to further improve the infrastructure necessary to manage continued growth. Key components of the Company's strategy are:
Offer the Broadest Selection of Merchandise in an Exciting Shopping Environment. The Company tries to provide party-planners and party-goers with convenient one-stop shopping for party supplies and offers what it believes is one of the most extensive selections of party supplies. A typical Party City store contains approximately 20,000 SKUs. Within its many product categories, Party City offers a wide variety of patterns, colors and styles. The Company has been expanding the range of items which it offers in order to create
consumer loyalty and generate repeat business by striving to maintain a new and exciting product selection. Further, the Company believes that its broad selection of merchandise and relatively low price points often stimulates consumers to purchase additional party supplies on impulse.
Establish Convenient Store Locations. While the Company believes that its stores typically are destination shopping locations, it seeks to maximize customer traffic and quickly build the visibility of new stores by situating its stores in high traffic areas. Site selection criteria include: population density; demographics; traffic counts; complementary retailers; storefront visibility and presence (either in a stand-alone building or in a strip or power shopping center); competition; lease rates; and accessible parking. The Company believes there is an extensive number of suitable locations available for future stores.
Maintain Everyday Low Pricing. The Company uses the buying power of its 402 Company-owned and franchise stores network to attempt to obtain volume discounts from its vendors on most products, allowing the stores to offer a broad line of high quality merchandise at competitive prices. The Company reinforces customers' expectations of savings by prominently displaying signs announcing its everyday low prices. The Company also maintains a lowest price guaranty policy, to which it suggests its franchisees adhere. This policy guarantees that Party City will meet and discount the advertised prices of a competitor's products. The Company believes that this policy has helped foster the Company's image of offering consumers exceptional value for their money.
Provide Excellent Customer Service. The Company views the quality of its customers' shopping experience as critical to its continued success. The Company is committed to making shopping in its stores an enjoyable experience through the employment of friendly, knowledgeable and energetic sales associates who provide customers with personalized shopping assistance. At Halloween, the most important selling season for the Company, each store increases significantly the number of sales associates to ensure prompt service. Sales associates assist customers in selecting or finding a certain item, which provides the sales associates with a cross-selling opportunity to suggest accessories or other complementary products. The Company believes that the compensation of its store managers and other personnel is competitive and enables the Company to attract and retain well-qualified, motivated employees who are committed to providing excellent customer service.
Human Resources. During the first six months of calendar 1999, Company management has made human resources one of its key components of the Company's long-term growth strategy. During calendar 1999, the Company hired several individuals in key management positions and reassigned other members of management to effectively define its strategic objectives and target significant goals for the upcoming fiscal year. While the number of corporate personnel was decreased in 1999, key additions to the finance and management information systems groups were made.
EXPANSION PLANS
The Company's long-term goal regarding expansion is to increase its market share in existing markets and penetrate new markets with a goal of maintaining a leading position as a category-dominant retailer of party supplies merchandise. During Fiscal 2000, the Company intends to focus its efforts to create the necessary
management infrastructure and control environment to support continued growth. Over the next few years, the Company intends to balance growth between Company-owned stores and opening franchise stores to meet its growth objectives.
STORE LOCATIONS
As of September 20, 1999, there were 402 Party City stores open in the United States, Canada, Puerto Rico, Portugal and Spain. Of these, 198 were Company-owned and 204 were operated by the Company's independent franchisees. The following table shows the growth in the Company's network of stores.
The Company typically seeks sites for new stores that are stand-alone buildings or that are located in a strip or power shopping center near high traffic routes. The Company seeks to lease sites rather than own the real estate. Often the site may be a shopping center under construction or renovation and may be available for occupancy typically in a period ranging from three months to one year. The Company's site selection criteria include, but are not limited to: population density and/or demographics; traffic count; complementary retailers; store-front visibility and presence; competition; lease rates; and accessible parking. In addition, the Company carefully considers the presence of existing, and the potential for future, competition in the market when selecting a site. The Company believes there is an extensive number of suitable locations available for future sites.
MERCHANDISING
Store Layout.
Party City stores are designed to give the shopper a feeling of excitement and create a festive atmosphere. The Company's goal is for the customer to be pleasantly surprised by his or her shopping experience. The Company's strategy to achieve this goal is to maintain an in-stock position of a wide selection of party supplies. Party City stores range in size from 6,750 to 15,876 square feet with a typical store size between 8,000 and 12,000 square feet. The stores are divided into various sections of different categories of party supplies, displayed to emphasize the everyday low prices and breadth of merchandise available. The floor plan is designed to impress the customer with the breadth of selection in each product category.
Product Categories.
The typical Party City store offers a broad selection of merchandise consisting of over 20,000 SKUs divided into the following categories:
Halloween. As a key component of its sales strategy, Party City stores provide an extensive selection of costumes for Halloween through its "Halloween Costume Warehouse" department. The stores also carry a broad array of decorations and accessories for the Halloween season. The Halloween merchandise is prominently displayed to provide an exciting and fun shopping experience for customers. The Company, because of the buying power of the Party City network, is often able to obtain supplies of some of the most sought after Halloween-related merchandise. The stores display Halloween-related merchandise throughout the year to position the Company as the customer's Halloween shopping resource. The Company believes that the importance of Halloween, among both young children and adults, is growing significantly.
Seasonal. Customer purchases made for seasonal holiday events compose a significant part of Party City's business. The seasonal category includes products which are carried for the Super Bowl, Valentine's Day, St. Patrick's Day, Passover, Easter, First Communion, Graduation, the Fourth of July, Christmas, Hanukkah and New Year's Eve. Some of the major items within this category are tableware, decorations, cutouts, lights and balloons tailored to the particular event.
Baby Shower. The Company maintains a baby shower department, which includes tableware, decorations, balloons, favors, centerpieces and garlands.
Balloons. The Company maintains a balloon department, which carries a vast selection of basic and decorative latex balloons in various sizes, qualities, colors and package sizes. The balloon department also carries Mylar balloons in numerous sizes, shapes and designs relating to birthday, seasonal, anniversary and other themes.
Birthdays. The birthday product category includes a wide assortment of merchandise to fulfill customer needs for celebrating birthdays, including special ones such as "first," "sweet sixteen" and other milestone birthdays such as 40th and 50th birthdays. Some of the products in this category include invitations, thank you cards, tableware, hats, horns, banners, cascades, balloons, novelty gifts, pinatas and candies.
Bridal/Wedding/Anniversary. This product category includes personalized invitations, tableware, balloons, favors, place setting cards, confetti, honeycomb bells and personalized ribbons. Personalized invitation books containing numerous samples of customizable event invitations are carried from the leading invitation stationers at discounted prices.
Candy. The candy product category includes novelty and packaged candy sold to enhance children's parties or to be used as pinata fillers. Candy is sold both in individual units and in bulk packaging for customers' convenience.
Catering Supplies. Party City stores offer a broad selection of catering supplies that consists of trays, platters, foil, bowls, warming racks and fuel.
Gift Wrap. This product category includes wide assortments of gift bags, bows, tissue paper, ribbons, printed bags and gift wrap.
Greeting Cards. This product category includes greeting cards from quality national card vendors at discount prices.
General. The Company carries a range of other products, including tableware, table covers, cutlery, crepe paper, cups and tumblers. Party City stores carry private label items, as well as brand name merchandise.
Party Favors. The Company maintains a party favors department that includes a broad selection of packaged and bulk favors appealing to different age groups. The assortment includes different product lines varying in price points designed to offer customers a variety of purchasing options.
Product Selection, Purchasing and Suppliers.
The Company's management continuously reviews new and existing product selections to provide the widest, most current assortment of party supplies. In pursuit of this goal, management attends various industry trade shows including the National Annual Halloween Trade Show in Rosemont, Illinois and the Toy Fair in New York. In an effort to keep abreast of new and popular merchandise, management views presentations given specifically for the Company by its major vendors. The Company utilizes its inventory tracking system to give the purchasing staff constant feedback on customers' preferences.
The Company relies on its suppliers for the purchase of its merchandise. The Company had two suppliers who in the aggregate constituted approximately 21% of the Company's purchases for the eighteen-month period ended July 3, 1999. The loss of either of these suppliers would adversely affect the Company's operations. The Company considers numerous factors in supplier selection, including price, credit terms, product offerings and quality. The Company negotiates pricing with suppliers on behalf of all stores in the system (both Company-owned and franchise) and believes that such buying power enables it to not only receive the most favorable pricing terms, but, as importantly, to more readily obtain high demand merchandise, especially popular Halloween costumes.
In order to maintain consistency throughout its store network, the Company has established an approved list of items that are permitted to be sold in Party City stores. Franchise stores must adhere to these guidelines according to the terms of their franchise agreements. The Company establishes a standard store merchandise layout and presentation format to be followed by Company-owned and franchise stores. Any layout or format changes developed by the Company are communicated to the managers of stores on a periodic basis. All of the merchandise purchased by stores is shipped directly from suppliers to the stores.
STORE OPERATIONS
Each Party City store is typically managed by a general manager and two assistant managers. These managers are responsible for all aspects of the store's day-to-day operations, including employee hiring and training, work scheduling, inventory control, expense control, maintenance activities and communications with central office staff. The sales and stocking staff ranges from three to eight people, except during certain holiday selling seasons when additional store employees are used. The Company seeks to pay its store managers toward the higher end of the competitive pay scale in order to hire and retain experienced and dedicated managers. In addition, managers of Company-owned stores are eligible for stock option grants under the Company's stock option plan.
Training. In Company-owned stores, corporate store managers are trained for a minimum of two weeks prior to the opening of a store. During the store set-up, a manager receives additional training from the Company's store set-up team. During the first few days after the initial opening of a store, corporate headquarters' personnel spend concentrated time in the store overseeing the operations.
In franchise locations, all franchisees go through a training program consisting of one week in the classroom and one week in the store to learn the fundamentals of the store's operation. During the set up of their store, the franchisee receives additional training from the team leader of the set-up crew that is dispatched by the Company to assist the franchisee with the store opening. Shortly after a store opens, a representative from the Company visits the franchisee and spends several days assisting with the day-to-day operations of running the store. To ensure efficient operations and that the systems, policies and processes are being followed, subsequent visits are scheduled on a regular basis to review what was covered during the initial training.
CUSTOMER SERVICE
Customer service and shopping convenience are integral components of Party City's one-stop shopping concept. The Company views the quality of its customers' shopping experience as critical to its continued success. To this end, the Company seeks to employ friendly, knowledgeable and energetic sales associates who provide customers with personalized shopping assistance. For example, at Halloween, the most important selling season for the Company, each store increases significantly the number of sales associates in the store. These employees assist customers in selecting a costume. This provides the sales associates with a cross-selling opportunity to suggest various accessories and other complementary products. Also, at Halloween the associates use two-way radios to help stock personnel quickly fill requested items, expediting sales and reducing lost business caused by slow service.
Company management believes that the compensation of its store managers and other personnel is competitive and enables the Company to attract and retain well-qualified, highly motivated employees who are committed to providing excellent customer service.
COMPANY-OWNED STORES
Company management believes that a key component in its future growth in operations will come from Company-owned stores. At September 20, 1999, there were 198 Company-owned Party City stores, including 81 stores opened in 1998, nine franchised stores purchased by the Company in 1998, and nine new stores opened and one store sold in the period from January 1, 1999 to July 3, 1999. In the period from July 4, 1999 to September 20, 1999, the Company sold an additional 17 stores to comply with the requirements of its banks under the Credit Agreement and to improve its liquidity.
The Company's stores are located in the following states:
Of the leases for the stores listed above, five expire in 2001, six expire in 2002 and the balance expire in 2003 or thereafter. The Company has options to extend each of such leases for a minimum of five years.
FRANCHISE OPERATIONS
Until opening its first Company-owned store in January 1994, the Company operated exclusively as a franchisor. As of September 20, 1999, the Company had 204 franchise stores throughout the United States, Puerto Rico, Canada, Portugal and Spain. A Party City store run by a franchisee utilizes the Company's format, design specifications, methods, standards, operating procedures, systems and trademarks.
The Company's franchise stores are located in the following states and foreign countries:
The Company receives revenue from its franchisees, including an initial one-time fee (currently at $35,000) and an ongoing royalty fee (currently 4.0% of net sales for new franchisees, payable monthly). In addition, each franchisee has a mandated advertising budget, which consists of a minimum of $5,500 to promote the initial store opening and thereafter the lesser of 3.0% of net sales or $60,000 per year for local advertising and promotions. Further, the franchisee must pay an additional 1.0% of net sales to a Party City group advertising fund to cover common advertising materials related to Ad Fund. The Company does not offer financing for a franchisee's initial investment. Franchise start-up expenses include the franchise fee, rent, leasehold improvements, equipment and furniture, initial inventory, opening promotion, signs, other deposits, insurance, training expenses and professional fees. In connection with the sale of 18 stores to franchisees as part of the Restructuring, the Company agreed to waive franchise royalty fees in respect of such stores for negotiated periods of up to five years.
Current franchise agreements provide for an assigned area or territory that typically equals a three-mile radius from the franchisee's store location and the right to use the Party City logo type and trademark "The Discount Party Super Store(R)." In most stores, the franchisee or the majority shareholder of a corporate franchisee devotes full time to the management, operation and on-premises supervision of the franchise.
Although such locations are generally obtained and secured by the franchisee, pursuant to the franchise agreement entered into with franchisees, the Company must approve all site locations. As franchisor, Party City also supplies valuable and proprietary information pertaining to the operation of the Party City store business, as well as advice regarding location, improvements and promotion. The Company also supplies consultation in the areas of purchasing, inventory control, pricing, marketing, merchandising, hiring, training, improvements and new developments in the franchisee's business and general business operations, as well as the provision of assistance in opening and initially promoting the store.
As of September 20, 1999, the Company had eight territory agreements with certain franchisees. These agreements permit the holder of the territory rights to open a minimum of two and in some cases three or more stores within a stated time period. The following areas are governed by territory agreements: North Carolina; Fort Myers/Naples FL; Arkansas; Buffalo/Rochester, NY; Atlanta, GA; Canada; Spain/Portugal; Puerto Rico.
COMPETITION
The party supplies retailing business is highly competitive. Party City stores compete with a variety of smaller and larger retailers, including single owner-operated party supplies stores, specialty party supplies retailers (including superstores), designated departments in drug stores, general mass merchandisers, supermarkets and department stores of local, regional and national chains and catalog and Internet stores. Many of these competitors have substantially greater financial resources than the Company.
Management believes that Party City stores maintain a leading position in the party supplies business by offering a wider breadth of merchandise, greater selection within merchandise class and discount prices offered on most items in the stores. The Company believes that the significant buying power resulting from the size of the Party City store network is an integral advantage.
TRADEMARKS
The Company has licensed from a wholly owned subsidiary a number of trademarks and service marks registered with the United States Patent and Trademark Office, including the marks Party City(R), The Discount Party Super Store(R) and Halloween Costume Warehouse(R).
GOVERNMENT REGULATION
As a franchisor, the Company must comply with regulations adopted by the Federal Trade Commission (the "FTC") and with several state laws that regulate the offer and sale of franchises. The Company also must comply with a number of state laws that regulate certain substantive aspects of the franchisor-franchisee relationship. The FTC's Trade Regulation Rule on Franchising (the "FTC Rule") requires that the Company furnish prospective franchisees with a franchise offering circular containing information prescribed by the FTC Rule. State laws that regulate the offer and sale of franchises require the Company to register before the offer and sale of a franchise can be made in that state.
State laws that regulate the franchisor-franchisee relationship presently exist in a substantial number of states. Those laws regulate the franchise relationship, for example, by requiring the franchisor to deal with its franchisees in good faith, by prohibiting interference with the right of free association among franchisees and by regulating discrimination among franchisees with regard to charges, royalties or fees. Those laws also restrict a franchisor's rights with regard to the termination of a franchise agreement (for example, by requiring "good cause" to exist as a basis for the termination) by requiring the franchisor to give advance notice to the franchisee of the termination and give the franchisee an opportunity to cure any default, and by requiring the franchisor to repurchase the franchisee's inventory or provide other compensation. To date, those laws have not precluded the Company from seeking franchisees in any given area and have not had a material adverse effect on the Company's operations.
Each Party City store must comply with regulations adopted by federal agencies and with licensing and other regulations enforced by state and local health, sanitation, safety, fire and other departments. Difficulties
or failures in obtaining the required licenses or approvals can delay and sometimes prevent the opening of a new store.
Party City stores must comply with federal and state environmental regulations, but the cost of complying with those regulations has not been material. More stringent and varied requirements of local governmental bodies with respect to zoning, land use, and environmental factors can delay, and sometimes prevent, development of new stores in particular locations.
The Company and its franchisees must comply with the Fair Labor Standards Act and various state laws governing various matters such as minimum wages, overtime and other working conditions. The Company and its franchisees also must comply with the provisions of the Americans with Disabilities Act. The Act requires that employers provide reasonable accommodation for employees with disabilities and that stores be accessible to customers with disabilities.
EMPLOYEES
As of September 20, 1999, the Company employed approximately 1,370 full-time and 4,870 part-time employees. The Company considers its relationships with its employees to be good. None of the Company's employees is covered by a collective bargaining agreement.
INFLATION AND SEASONALITY
The Company does not believe that its operating results have been materially affected by inflation during the past year. There can be no assurance, however, that the Company's operating results will not be affected by inflation in the future.
The Company's business is subject to substantial seasonal variations. Historically, the Company has realized a significant portion of its net sales and substantially all of its net income for the year during the fourth calendar quarter of the year, principally due to the sales in October for the Halloween season and, to a lesser extent, due to holiday sales for Thanksgiving, Christmas and New Year's. The Company's results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings. The Company believes this general pattern will continue in the future.
ITEM 2.
ITEM 2. PROPERTIES
As of September 20, 1999, the Company leased 198 stores and had signed leases for four additional stores. The Company leases its headquarters property in Rockaway, New Jersey. The Company occupies approximately 12,600 square feet of office space for its headquarters under a lease expiring in 2005.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Party City of Greenbrook, Inc., et al., v. Party City Corp.
The Company was named as a defendant in a complaint filed with the Supreme Court of the State of New York, County of New York, on January 16, 1998 (the "Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung, Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in the suit have existing Party City franchise stores, with the remaining plaintiff possessing a right of first refusal to develop a Party City store in Watchung, New Jersey.
The Complaint stated various causes of action, including unjust enrichment, unfair competition, fraud and misrepresentation, breach of contract, misappropriation of information and violations of the New Jersey Franchise Practices Act and the New York State Franchise Sales Act. The crux of the Complaint was that the Company undertook a course of conduct intentionally designed to adversely impact the value of the Plaintiffs'
franchise stores in order to permit the Company to purchase such stores at a substantially reduced value. The Company settled the lawsuit on June 30, 1999, at no cost to the Company. In connection with the settlement, the Company agreed to sell the plaintiff one store at its fair value.
In re Party City Corporation Securities Litigation
The Company has been named as a defendant in the following twelve class action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp. and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4) Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No. 99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-2238; and (12) Gross v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief Executive Officer and former Chief Financial Officer and Executive Vice President of Operations have also been named as defendants. The complaints have all been filed in the United States District Court for the District of New Jersey. The complaints were filed as class actions on behalf of persons who purchased or acquired Party City common stock during various time periods between February 1998 and March 19, 1999.
The complaints allege, among other things, violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and seek unspecified damages. The plaintiffs allege that defendants issued a series of false and misleading statements and failed to disclose material facts concerning, among other things, the Company's financial condition, adequacy of internal controls and compliance with certain loan covenants. The plaintiffs further allege that because of the issuance of a series of false and misleading statements and/or failure to disclose material facts, the price of Party City common stock was artificially inflated.
On September 13, 1999, the Court signed an Order appointing lead plaintiffs and lead counsel to represent the classes alleged in the complaints. The Order directs plaintiffs to file a consolidated and amended complaint in October 1999.
Emil Asch, Inc. v. Amscan, Inc. et al.
On April 23, 1999, plaintiff Emil Asch, Inc. filed a complaint in the United States District Court for the Eastern District of New York against the Company and co-defendants Amscan, Inc., Hallmark, Inc., and Rubie's Costume. The complaint alleges five violations of the Robinson-Patman Act, which pertains to price discrimination, unfair competition tortious interference with contractual relations, and false and deceptive advertising.
Plaintiff seeks damages of $2 million, as well as treble and punitive damages for certain counts. The Company has answered the Complaint, and discovery should proceed shortly.
Although the Company's management is unable to express a view on the likely outcome of these litigations because they are in their early stages, they could have a material adverse effect on the Company's business and results of operations.
In addition to the foregoing, the Company is from time to time involved in routine litigation incidental to the conduct of its business. As of September 30, 1999, the Company is aware of no other material existing or threatened litigation to which it is or may be a party.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
EXECUTIVE OFFICERS OF THE REGISTRANT
Jack Futterman, 66, has been Chairman of the Board of Directors and Chief Executive Officer of the Company since June 8, 1999 and has been a Director of the Company since October 1997. From 1989 until his retirement in 1996, Mr. Futterman was Chairman and Chief Executive Officer of Pathmark Stores. From 1973 until his appointment as Chairman and Chief Executive Officer, Mr. Futterman served as Vice President of Supermarkets General (the parent company of Pathmark Stores) and occupied a number of positions before becoming Chairman and Chief Executive Officer. A Registered Pharmacist, Mr. Futterman also serves as a Director of Del Laboratories, Inc. and Hain Food Group as well as several not-for-profit corporations.
Thomas E. Larson, 52, served as a consultant to the Company from April 1999 through June 1999, when he was named Chief Financial Officer and Senior Vice President of the Company. From November 1996 to June 1999, Mr. Larson was co-founder and Chief Financial Officer of Hidden Oaks Technology Corp., a privately held Internet software development company. From September 1991 through November 1996, Mr. Larson served as Senior Vice President -- Finance for Ace Cash Express, Inc., a publicly traded Nasdaq retail financial services company with over 600 locations nationally.
Gordon Keil, 50, is currently the Company's Senior Vice President, Franchising and Administration, and oversees Franchise Operations, Human Resources, Real Estate and Legal. Mr. Keil joined the Company in June 1996 as Chief Operating Officer. Initially, Mr. Keil oversaw Store Operations, Human Resources and Franchise Relations. He also oversaw Merchandising for part of 1996-1997. Prior to joining the Company in 1996, Mr. Keil had been the founder and President of Gordon's Stores, Inc., a chain of discount drugstores.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock traded on the Nasdaq National Market under the symbol "PCTY" until the Company was delisted on July 20, 1999. The Common Stock now trades on the OTC Bulletin Board, an electronic quotation service for NASD Market Makers. There can be no assurance that the Common Stock will continue to trade on the OTC Bulletin Board. It is the Company's intention to again seek to be listed on Nasdaq if and when the Company satisfies the requirements for listing.
The following table sets forth the high and low closing sale prices of the Common Stock through July 3, 1999.
At September 20, 1999, the approximate number of holders of record of the Common Stock was approximately 3,500.
DIVIDENDS
Except for the S Corporation distribution of a portion of previously undistributed earnings to the Company's stockholders in 1994 upon the Company's election to be taxed as a C Corporation, the Company has never paid cash dividends on its capital stock and does not intend to pay cash dividends for the foreseeable future. The Company expects that earnings will be retained for the continued growth and development of the Company's business. Future dividends, if any, will depend upon the Company's earnings, financial condition, working capital requirements, compliance with covenants in agreements to which the Company is or may be subject, future prospects and other factors deemed relevant by the Company's Board of Directors. Under various agreements to which the Company is a party, including the Credit Agreement, the Company is not permitted to pay any dividends. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."
UNREGISTERED SECURITIES
On August 17, 1999, the Company issued the Notes and the Warrants to the Investors for an aggregate of $30 million. The Investors were led by Tennenbaum & Co., LLC, a Los Angeles-based investment firm.
The Warrants are exercisable for an aggregate of 6,880,000 shares of Common Stock at an initial exercise price of $3.00 per share and may be exercised at any time before 5:00 p.m. (New York City time) on August 16, 2006. The shares of Common Stock reserved for issuance under the Warrants represent approximately 35% of the shares of Common Stock outstanding after giving effect to the exercise of the Warrants. The private placement of the issuance and sale of the Notes and Warrants to the Investors was exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act"), pursuant to Section 4(2) of the Securities Act.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following Selected Financial Data for each of the years ended December 31, 1994 and 1995 and as of December 31, 1996, are derived from the consolidated financial statements of the Company not included herein. The Selected Consolidated Balance Sheet data as of December 31, 1997 and July 3, 1999, and the Selected Consolidated Statements of Operations data for the years ended December 31, 1996 and 1997 and the period from January 1, 1998 to July 3, 1999, are derived from the consolidated financial statements of the
Company, included elsewhere in this Annual Report on Form 10-K. The Consolidated Statement of Operations for the period from January 1, 1997 to June 30, 1998, is derived from the consolidated statement of operations for the year ended December 31, 1997 and the unaudited consolidated statement of operations for the six months ended June 30, 1998 included in the Company's Form 10-Q for June 30, 1998.
The Balance Sheets as of December 31, 1997 and July 3, 1999, and the Consolidated Statements of Operations for the years ended December 31, 1996 and 1997 and the period from January 1, 1998 to July 3, 1999 have been audited by Deloitte & Touche LLP, independent auditors, as stated in their report appearing elsewhere herein. The Selected Financial Data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements, including the notes thereto appearing elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA
- --------------- (a) Special charges in 1999 relate to consulting services, accounting fees, bank fees, legal fees and other expenses related to the Company's default on its Credit Agreement. The Company engaged the services of a crisis management consulting firm and numerous other professionals to advise management during the complex negotiations with the bank, vendors and potential investors.
(b) Until April 1994, the company elected to be taxed as an S Corporation under the Internal Revenue Code. If the Company had been taxed as a C Corporation for the year ended December 31, 1994, pro forma income taxes, pro forma net income and pro forma basic and diluted earnings per share would have been $410,000, $598,000 and $0.08, respectively.
(c) Earnings before interest, taxes, depreciation and amortization, and exclusive of special charges, as defined above
(d) Excludes borrowing under the Credit Agreement included in current liabilities at July 3, 1999.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
The Company's revenues and earnings are generated primarily from its two business segments -- Retail and Franchising.
Eighteen-Month Period Ended July 3, 1999 ("1999 Period") Compared to Eighteen-Month Period Ended June 30, 1998 ("1998 Period")
A summary of the Company's new store openings, store acquisitions and store sales are as follows:
Retail. Net sales from Company-owned stores increased 94.1% to $434.2 million for the 1999 Period, from $223.7 million for the 1998 Period. The 1999 Period results include 117 stores which were open at the beginning of that period plus 98 (net) stores opened during the period. The 1998 Period amount represents sales from 36 stores which were open at the beginning of the period, plus 112 stores opened during the period. Of the total sales increase, 89.7% is attributable to new store openings in the 1999 Period. Same store sales increased 4.4% in the 1999 Period. Gross profit reflects the cost of goods sold and store occupancy costs including rent, common area maintenance, real estate taxes, repairs and maintenance, depreciation and utilities. Gross profit increased 79.8% to $129.7 million for the 1999 Period compared to $72.1 for the 1998 Period. The increase for the 1999 Period was primarily due to increased sales volume. Gross margin was 29.9% and 32.2% of sales for the 1999 Period and 1998 Period, respectively. The decrease in gross margin was related primarily to increases in the provisions for obsolete and slow moving inventory and increases in store occupancy costs.
Store operating and selling expenses increased 107% to $116.0 million for the 1999 Period compared to $56.0 million for the 1998 Period. The increase in store operating expenses is primarily attributable to the increased number of stores operated by the Company during the 1999 Period. Store operating expenses were 26.7% and 25.0% of sales for the 1999 Period and 1998 Period, respectively, due to increased store operating payroll costs related to new store openings. Company-owned store profit contribution was $13.6 million for the 1999 Period, compared to a profit contribution of $16.1 million for 1998 Period.
Franchising. Franchise revenue is composed of the initial franchise fees, which are recorded as revenue when a franchise store opens, and ongoing royalty fees, generally 4.0% of the store's net sales. Royalty fees increased 7.8% to $15.7 million for the 1999 Period from $14.6 million for the 1998 Period. Franchise fees, recognized on 30 store openings during the 1999 Period, increased 29.2% to $823,000 compared to $637,000 during the 1998 Period, which represents 26 store openings. Franchise same store sales increased by 5.5% and 10.6% for the 1999 Period and the 1998 Period, respectively.
Expenses directly related to franchise revenue increased 3.4% to $6.0 million for the 1999 Period from $5.8 million for the 1998 Period. This increase is primarily attributable to additional franchise personnel
required to operate this portion of the Company's business and the necessary infrastructure to support such employees. As a percentage of franchise revenue, franchise expenses were 36.3% and 38.1% for the 1999 Period and 1998 Period, respectively.
Franchise profit contribution increased 12.8% to $10.6 million for the 1999 Period, compared to $9.4 million for the 1998 Period. The 11.8% increase in franchise profit contribution is due to the increase in royalty fees and franchise fees offset in part by an increase in franchise expenses, as discussed above.
General and Administrative Expenses. The Company's general and administrative expenses increased 151% to $31.8 million during the 1999 Period, compared to $12.7 million during the 1998 Period. The increase is attributable in part to $5.9 million in special charges relating to consulting, accounting, banking and other expenses resulting from the Company's refinancing arrangements. In addition, during the 1999 Period, there was an increase in payroll and related benefits due to a higher overhead structure intended to support a planned 50-store increase in the number of stores for Fiscal 2000 compared to the 1998 Period. General and administrative expenses increased as a result of several factors. Payroll and benefits increased $6.2 million, or 85.4%, to $13.5 million in the 1999 Period from $7.3 million in the 1998 Period, related to additional corporate administrative and support personnel and the addition of a regional manager supervisory structure. Corporate occupancy increased 47% to $2.5 million for the 1999 Period from $1.7 million in the 1998 Period, primarily as a result of additional depreciation expense for computer hardware and software. Also, professional fees, exclusive of special charges of $5.9 million, increased 242% to $4.1 million in the 1999 Period from $1.2 million in the 1998 Period, primarily related to information systems expenses for Year 2000 systems remediation and new systems consulting design and implementation. Due to reductions in planned growth, the number of corporate staff members decreased by 21% in May 1999 in order to bring administrative costs in line with more modest growth objectives.
Exclusive of the $5.9 million in special charges discussed above, general and administrative expenses were 6.0% of sales and 5.7% for the 1999 Period and 1998 Period, respectively.
Interest Expense. Interest expense increased 614% to $5.0 million during the 1999 Period as compared to the $0.7 million in the comparable 1998 Period. This increase related primarily to the increase in average borrowings used for Company expansion during the period, as well as an increase in interest rates due to provisions of the bank's standstill agreements in effect during the quarter ended July 3, 1999.
Income Taxes. The income tax benefit was $1.0 million during the 1999 Period compared with the provision for income taxes of $4.8 million recorded during the 1998 Period. This increase related to the pre-tax loss in the 1999 Period of $12.6 million compared to the pre-tax income of $12.3 million in the 1998 Period. The benefit recorded in the 1999 Period is net of recording a $572,000 valuation allowance against deferred tax assets. Additionally, the Company recorded a partial valuation allowance on its part-year federal and state net operating loss.
Net Loss. As a result of the above factors, net loss was $11.6 million, or $(0.94) per basic and diluted share, in the 1999 Period as compared to net income of $7.4 million, or $0.63 and $0.61 per basic and diluted share, in the comparable 1998 Period.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Retail. Net sales from Company-owned stores increased 234% to $131.0 million in the year ended December 31, 1997 up from $39.1 million in the year ended December 31, 1996. The 1997 results include 36 stores that were open at the beginning of that year plus 57 stores opened during the year (of which 19 were opened in September, 10 in October, and three in December) and 24 stores acquired during the year. The 1996 amount represents sales from 16 stores that were open at the beginning of the year plus 20 stores opened during the year (five of which were opened in September and two in October). Of the total sales increase, 74.4% is attributable to new store openings in 1997. Same store sales increased 15.5% in 1997. Gross profit reflects the cost of goods sold and store occupancy costs including rent, common area maintenance, repair and maintenance, depreciation and utilities. Gross profit for the year ended December 31, 1997 increased 238% to $44.7 million, compared to $13.2 million for the year ended December 31, 1996. The increase in 1997 was due
to increased sales volume. Gross margin was 34.1% and 33.7% of sales for the years ended December 31, 1997 and 1996, respectively.
Store operating and selling expenses increased 216% to $31.9 million for the year ended December 31, 1997 compared to $10.1 million for 1996. The increase in store operating expenses is attributable to the increased number of stores operated by the Company during 1997. Store operating expenses were 24.3% and 25.8% of sales for the years ended December 31, 1997 and 1996, respectively. Company-owned store profit contribution increased 313% to $12.8 million for the year ended December 31, 1997, compared to a profit contribution of $3.1 million for the comparable 1996 period.
Franchising. Franchise revenue is composed of the initial franchise fees that are recorded as revenue when the store opens, and ongoing royalty fees, generally 4.0% of the store's net sales. Royalty fees increased 20.3% to $10.2 million in the year ended December 31, 1997, up from $8.5 million in the comparable 1996 period. The increase was attributable primarily to sales increases in stores opened as of December 31, 1996. Franchise same store sales increases for the years ended December 31, 1997 and 1996 were 14.8% and 19.5%, respectively. Franchise fees, recognized on 19 store openings during the year ended December 31, 1997 were $462,000 compared to $935,000 representing 32 store openings during 1996. The reduction in franchise fees attributed to fewer store openings was partially offset by the increase in such fees from $30,000 to $35,000 per store with respect to franchise agreements signed after January 1, 1996.
Expenses directly related to franchise revenue increased 7.2% to $4.0 million for the year ended December 31, 1997 from $3.7 million for the year ended December 31, 1996. As a percentage of franchise revenue, franchise expenses were 37.4% and 39.5% for the years ended December 31, 1997 and 1996, respectively.
Franchise profit contribution was increased 17.0% to $6.7 million for the year ended December 31, 1997, compared to $5.7 million for the year ended December 31, 1996. The increase in franchise profit contribution is due to the increase in royalty fees offset by a decrease in franchise fees and increase in franchise expenses as discussed above.
General and Administrative Expense. General and administrative expenses increased 123% to $7.0 million in the year ended December 31, 1997, compared with $3.1 million in the year ended December 31, 1996. The increase is primarily attributable to an increase in payroll and related benefits of approximately $1.8 million as a consequence of establishing the necessary organizational infrastructure to allow the Company to build its Company-owned store base, professional fees increases of approximately $226,000 due primarily to increases in legal and accounting fees, travel expense increases of approximately $730,000 which increased primarily due to the increase in the number of stores. In addition, the Company had other increases in general and administrative expenses related to insurance, investor relations expenditures and general corporate expenses. As a percentage of revenue, general and administrative expenses were 5.0% and 6.5% for the years ended December 31, 1997 and 1996, respectively. This decrease as a percentage of revenue resulted from increased leverage of general and administrative expenses over a larger sales base.
Interest Income. Interest income decreased 14.5% to $0.2 million during the year ended December 31, 1997, as compared to $0.5 million during the year ended December 31, 1996. This decrease related primarily to the decrease in average funds available for investment during the period.
Income Taxes. The provision for income tax expense increased 109% to $5.0 million during for the year ended December 31, 1997 as compared to the $2.4 million recorded in 1996. This increase related primarily to the increase in pre-tax earnings of 106% for the 1997 period over 1996.
Net Income. As a result of the foregoing factors, net income increased 104% to $7.7 million, or $0.65 per basic share and $0.64 per diluted share, in the year ended December 31, 1997 compared with $3.8 million, or $0.38 per basic and diluted share in the year ended December 31, 1996.
ACCOUNTING AND REPORTING CHANGES
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 130 "Reporting Comprehensive Income," which establishes standards for the reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a fully set of general-purpose financial statements. This statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. The adoption of this statement did not have an impact on the Company's consolidated financial statements as the Company has no items of comprehensive income.
Effective January 1, 1998, the Company adopted AICPA Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," which requires the Company to capitalize certain software development costs. Generally, once the capitalization criteria of the SOP have been met, external direct costs of materials and services used in development of internal-use software, payroll and payroll-related costs for employees directly involved in the development of internal-use software and interest costs incurred when developing software for internal use are to be capitalized. The adoption of this SOP had no impact on the consolidated financial statements because the SOP requires the change to be implemented prospectively.
Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for the way that business enterprises report information about operating segments in financial statements and related disclosures about products and services, geographical areas and major customers. The Company has adopted this statement and expanded its disclosure of its retail and franchise segments.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments and hedging activities. SFAS No. 133 requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and to measure those instruments at fair value.
For Fiscal 2001, the Company is required to adopt SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The Company has not yet determined whether the application of SFAS No. 133 will have a material impact on its financial position or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash provided by operating activities was $3.6 million, and $9.0 million in the years ended December 31, 1996 and 1997, respectively. A total of $1.5 million of cash was used in operations for the 1999 Period. The increase in cash provided by operating activities in 1997 compared to 1996 was primarily the result of increased operating contribution for the increased number of stores in operation during 1997. The decrease in liquidity of $1.5 million relates primarily to increased store and corporate operating expenses in the 1999 Period, as discussed previously.
Cash used in investing activities was $4.9 million, $39.9 million, and $47.0 million in the years ended December 31, 1996, 1997 and the 1999 Period, respectively. The increase in cash used in investing activities in 1997 compared to 1996 and in the 1999 Period as compared to 1997 was attributable to increased purchases of property and equipment and store acquisitions.
Cash provided by financing activities was $15.2 million, $19.2 million, and $56.8 million for the years ended December 31, 1996, 1997 and the 1999 Period, respectively. Cash provided by financing activities in 1997 was primarily attributable to the proceeds of the Company's secondary public offering and borrowings under the Credit Agreement. The cash provided by financing activities in the 1999 Period was primarily attributable to the proceeds from borrowings under the revolving credit agreement. See "Business -- Recent Developments" for an explanation of the cash received as a result of the issuance of the Notes in August 1999.
As of July 3, 1999, the Company had a working capital deficiency of $26.7 million, primarily due to the classification of the borrowings under the Credit Agreement as a current liability. Under the terms of the Bank Forbearance Agreement, the Company is obligated to reduce its outstanding borrowings under the Credit Agreement to $15 million by October 30, 1999. In addition, Trade Notes issued by the Company aggregating approximately $12.1 million mature on November 15, 1999. On January 15, 2000, Company management believes it will resume normal credit terms with substantially all of its vendors. At such event, management believes the remaining two-thirds of the unpaid claims as of May 1, 1999, will be satisfied through individual arrangements with the vendors. However, there can be no assurances that the Company will successfully conclude these arrangements.
Based on the Company's cash flow projections, together with its cash on hand at September 20, 1999, the Company expects to have sufficient liquidity to fund operations through June 30, 2000.
Company management is evaluating various strategies for improving the Company's results of operations, operating controls, expansion and franchising strategies, management information systems needs and other aspects of the business. These strategies are designed to improve the profitability from operations and improve management insight into merchandising decisions and operating controls. Company management plans to make significant capital expenditures on enhanced information systems over the next several years.
Company management is also seeking replacement financing for the Credit Agreement. Management has initiated contact with several asset-based lenders to provide such a facility. If the Company is successful in obtaining an asset-based lending arrangement, such a facility will assist the Company in meeting its short-term liquidity needs for the next year. There is no assurance at this time that the Company will successful in obtaining this financing facility or how successful its will be in improving operations.
Impact of Inflation
The Company believes that inflation did not have a material impact on its operations for the periods reported. Significant increases in cost of merchandise purchased, labor, employee benefits and other operating expenses could have a material adverse effect on the Company's performance.
Seasonality
The Company's business is subject to substantial seasonal variations. Historically, the Company has realized a significant portion of its net sales and substantially all of its cash flow and net income for the year during the fourth calendar quarter of the year, principally due to the sales in October for the Halloween season and, to a lesser extent, due to holiday sales for end of year holidays. The Company's results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings.
IMPACT OF YEAR 2000 ON THE COMPANY'S COMPUTER OPERATIONS
The Company is preparing for the impact of the arrival of the Year 2000 on its business. The "Year 2000 Problem" is a term used to describe the problems created by systems that are unable to accurately interpret dates after December 31, 1999. These problems are derived predominately from the fact that certain computer hardware and many software programs historically recorded a date's "year" in a two digit format (i.e., 98 for 1998) and therefore may recognize "00" as 1900 instead of the year 2000. The Year 2000 Problem creates potential risks for the Company, including the inability to recognize and properly treat dates occurring on or after January 1, 2000, which may result in computer system failures or miscalculations of critical financial or operations information.
In addition to its internal systems, the Company relies heavily on third parties in operating its business. Such third parties include vendors and utilities that provide electricity, water, natural gas, transportation, telephone and banking,
The Company began formulating a plan in 1998 to address the Year 2000 Problem and to ensure that all relevant systems had been subject to a full Year 2000 review and, if necessary, implement remediation, replacement or upgrades. Under the plan, the Company has focused on (i) internal financial and operational
computer systems and (ii) the Year 2000 compliance of all material suppliers and vendors doing business with the Company. The Company has contacted all outside suppliers and vendors with which the Company has material relationships and engaged in discussions which will continue throughout 1999 in furtherance of the Company's stated goal of minimizing any adverse impact relating to the Year 2000 Problem.
The Company has completed its assessment of all material financial and operating systems. In connection with this review, the Company upgraded its financial accounting systems to Year 2000 compliant systems in the first quarter of 1999. This system is currently being tested to verify Year 2000 compliance, and such testing should be completed by October 1999. The costs and expenses to be incurred relating to Year 2000 compliance for these systems is currently not expected to be material. As of mid-November 1999 all computer operating systems in use will be upgraded and compliant.
In addition, the Company has assessed all computer hardware, including servers, microcomputers, POS registers, and peripheral equipment at the store and corporate levels. Only minor remediation and/or upgrade of these systems has been required; each will be tested and compliant by November 1, 1999. The Retail POS software at the store level has been tested and is compliant.
The Company estimates that the total costs and expenses associated with completing the outlined Year 2000 compliance plan will range from $ 1,500,000 to $ 1,700,000, of which all but approximately $300,000 has been incurred and expensed. Company management presently believes that it will substantially complete its internal Year 2000 compliance program prior to January 1, 2000, and that there should be no material adverse impact at such time related to Year 2000 Problems associated with the Company's systems or software. Based on communications with its vendors and suppliers, the Company also believes that each third party with whom the Company has a material relationship is currently Year 2000 compliant or scheduled to be Year 2000 compliant by January 1, 2000.
Despite the Company's best efforts, there can be no assurance that (i) the Company's assessments regarding the Year 2000 Problem are correct; (ii) the Company will be able to successfully complete its Year 2000 review and implement such upgrades and/or remediation as is necessary or (iii) third parties or suppliers with whom the Company does business will avoid Year 2000 Problems which might adversely affect the Company's business or operations. While the Company is developing contingency plans to address such failures or unexpected problems (such plans include identification of alternative suppliers), there can be no assurance that such contingency plans will be adequate to resolve these problems. The Company's contingency plan is expected to be completed by October 31, 1999.
The Year 2000 Problems involves substantial risk to the Company. The Company believes today that the likely worst case scenario regarding the Year 2000 Problem will involve temporary disruptions in the receipt of merchandise inventory and temporary disruption in the payment of bills. These events may also cause lost revenue. The foregoing assessment is based on information currently available to the Company. The Company can provide no assurances that applications and equipment believed to be Year 2000 compliant will not experience difficulties, or the Company will not experience difficulties obtaining resources needed to make modifications to, or replacement of, the Company's affected systems and equipment. Failure by the Company or third parties, on which it relies to resolve Year 2000 issues, could have a material effect on the Company's results of operations.
FORWARD-LOOKING STATEMENTS
This Form 10-K (including the information incorporated herein by reference) contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. The statements are made a number of times throughout the document and may be identified by forward-looking terminology as "estimate," "project," "expect," "believe," "may," "will," "intend" or similar statements or variations of such terms. Such forward-looking statements involve certain risks and uncertainties, and include among others, the following: levels of sales, store traffic, acceptance of product offerings, competitive pressures from other party supplies retailers, availability of qualified personnel, availability of suitable future store locations, schedules of store expansion plans and year 2000 readiness issues relating to the Company's internal systems and those of third parties, the ability of the Company to refinance its existing debt on terms acceptable to it and other
factors. As a result of the foregoing risks and uncertainties, actual results and performance may differ materially from that projected or suggested herein. Additional information concerning certain risks and uncertainties that could cause actual results to differ materially from that projected or suggested may be identified from time to time in the Company's Securities and Exchange Commission filings and the Company's public announcements.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The response to this item is submitted as a separate section of this Report commencing on page.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
In accordance with general instruction G(3) of Form 10-K, the information called for by Items 10, 11, 12 and 13 of Part III is incorporated by reference to the Company's definitive Proxy Statement for its 1999 Annual Meeting of Shareholders.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) List of Documents filed as part of this Annual Report on Form 10-K.
1. The following financial statements of the Company are filed as a separate section of this Report commencing on page.
Independent Auditors' Report -- Deloitte & Touche LLP
Balance Sheets as of December 31, 1997, and July 3, 1999
Statements of Operations for the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999
Statements of Shareholders' Equity for the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999.
Statements of Cash Flows for the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999.
Notes to Financial Statements for the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999.
2. Financial Statement Schedules -- Not Applicable.
3. List of Exhibits.
The following exhibits are included as a part of this Annual Report on Form 10-K or incorporated herein by reference.
- --------------- Notes
(1) Incorporated by reference to the Company's Registration Statement as amended on Form S-1 Number 333-350 as filed with the Commission on January 18, 1996.
(2) Incorporated by reference to the Company's Quarterly Report on Form 10-Q as filed with the Commission on May 15, 1998.
(3) Incorporated by reference to the Company's Current Report on Form 8-K as filed with the Commission on August 25, 1999.
(4) Incorporated by reference to the Company's Registration Statement on Form S-1 as filed with the Commission on March 6, 1997.
(5) Incorporated by reference to the Company's Registration Statement on Form S-8 as filed with the Commission on January 9, 1997.
(6) Incorporated by reference to the Company's Current Report on Form 8-K as filed with the Commission on September 12, 1997, as amended November 10, 1997.
(7) Incorporated by reference to the Company's Annual Report on Form 10-K as filed with the Commission on March 31, 1998.
(8) Incorporated by reference to Amendment No. 1 to Schedule 13D as filed with the Commission on June 30, 1999. - ---------------
(b) Reports on Form 8-K.
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on September 30, 1999.
PARTY CITY CORPORATION
By: /s/ JACK FUTTERMAN
------------------------------------ Jack Futterman Chief Executive Officer
By: /s/ THOMAS E. LARSON
------------------------------------ Thomas E. Larson, Senior Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders Party City Corporation Rockaway, New Jersey
We have audited the accompanying consolidated balance sheets of Party City Corporation and subsidiary as of December 31, 1997 and July 3, 1999, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years ended December 31, 1996 and 1997 and the period from January 1, 1998 to July 3, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Party City Corporation and subsidiary as of December 31, 1997, and July 3, 1999, and the consolidated results of their operations and their cash flows for the years ended December 31, 1996 and 1997 and for the period from January 1, 1998 to July 3, 1999 in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements for the period from January 1, 1998 to July 3, 1999, have been prepared assuming that Party City Corporation will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company's default on its Credit Agreement and inability to liquidate its trade payables under normal terms raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
DELOITTE & TOUCHE LLP
SEPTEMBER 29, 1999 PARSIPPANY, NEW JERSEY
PARTY CITY CORPORATION
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT NUMBER OF SHARES)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. RECENT DEVELOPMENTS
Consolidated Financial Statements
Party City Corporation (the "Company") is incorporated in the State of Delaware and operates retail party goods stores within the continental United States and sells franchises on an individual store and area franchise basis throughout the United States, Puerto Rico, Spain, Portugal and Canada. As of July 3, 1999, the Company had 215 Company-owned stores and 178 franchise stores in its network. The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned subsidiary, Party City Michigan, Inc. All significant intercompany balances and transactions have been eliminated.
The Company was unable to issue audited financial statements for the year ended December 31, 1998 and timely file its 1998 Annual Report on Form 10-K with the Securities and Exchange Commission ("SEC") primarily because of difficulties associated with taking the year-end physical inventories and the related reconciliation process. The Company has taken a complete physical inventory as of July 3, 1999, and prepared consolidated financial statements for the eighteen-month period from January 1, 1998 to July 3, 1999. As a result of the failure to file the Form 10-K by March 31, 1999, the Company was in default of Nasdaq's continued listing requirements. Trading in the Company's common stock was halted on May 6, 1999, and the Company was delisted on July 20, 1999.
Effective July 3, 1999, the Company changed its fiscal year end for financial reporting from December 31 to the Saturday nearest to June 30. The Company continues to use December 31 as its tax year end. The change to a 52-53 week calendar was made to facilitate comparable store sales computations. The term "Fiscal Year" refers to the 52-53 weeks ending the Saturday nearest June 30, unless otherwise noted.
Financing Agreements
On April 24, 1998, the Company refinanced and replaced its then existing $20 million loan facility with a $60 million secured revolving line of credit agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit Agreement"). Advances under the Credit Agreement originally bore interest, at the Company's option, at the agent bank's base rate (the higher of the bank's prime rate or the federal funds rate plus 1/2% per annum) or LIBOR plus an applicable margin. The Company's failure to issue its consolidated financial statements on a timely basis is a default under the Credit Agreement. In addition to this default, the Company did not meet certain of its financial covenants, including those relating to minimum levels of profitability, net worth, liquidity, fixed charge coverage and others. Consequently, the Company's debt was subject to acceleration and is classified as a current liability in the consolidated balance sheet at July 3, 1999. The Credit Agreement is secured by all the assets of the Company. Additionally, the Credit Agreement restricts the payment of dividends.
On August 16, 1999 the Company entered in the following agreements with its existing bank lenders under the Credit Agreement (the "Banks"), a new group of investors (the "Investors") and its trade vendors. The bank lenders and the Company entered into a Standstill and Forbearance Agreement (the "Bank Forbearance Agreement"). Under the Bank Forbearance Agreement, the Banks have agreed not to exercise rights and remedies based upon any existing defaults until June 30, 2000 unless a further event of default occurs. The Company has agreed to reduce its outstanding bank borrowings from the $58.6 million outstanding at July 3, 1999, to $15 million by October 30, 1999, to increase the interest rate on its bank debt to 2% over the bank's prime interest rate and to pay a forbearance fee of $580,000. Company management intends to refinance its outstanding indebtedness to the Banks with an asset-based lending arrangement. There
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
is no assurance such a lending arrangement can be obtained. The $15 million anticipated to be outstanding at October 30, 1999 is due June 30, 2000 unless the Bank Forbearance Agreement is extended or amended.
On August 17, 1999, the Company received $30 million in financing from the Investors. The Investors purchased senior secured notes and warrants pursuant to separate securities purchase agreements (the "Securities Purchase Agreements") each dated as of August 16, 1999. Under these Securities Purchase Agreements, the Company issued (i) $10 million of its 12.5% Secured Notes due 2003 (the "A Notes"); (ii) $5 million of its 13.0% Secured Notes due 2003 (the "B Notes"); (iii) $5 million of its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10 million of its 14.0% Secured Notes due 2004 (the "D Notes", and together with the A Notes, the B Notes and the C Notes, the "Notes"); and (v) warrants (the "Warrants") to purchase 6,880,000 shares of the Company's common stock at an initial exercise price of $3.00 per share. Up to $15 million of the Notes is secured by a first lien that is pari pasu with the liens under the Credit Agreement. The Notes are secured by a second lien on all of the Company's assets. The Company issued the Warrants in connection with the sale of the C Notes and the D Notes. The Warrants may be exercised before the close of business on August 16, 2006. The shares of Common Stock reserved for issuance under the Warrants represent approximately 35% of the shares of Common Stock outstanding assuming the exercise of the Warrants.
The Company also entered into an Investor Rights Agreement (the "Investor Rights Agreement") with the Investors and the chief executive officer of the Company. In this agreement, the Company granted registration rights with respect to shares of common stock. The Company has agreed to nominate two individuals designated by the Investors to its Board of Directors. Under the Investor Rights Agreement, the Investors agree that they will not, without the prior written consent of the Board of Directors, (i) acquire or agree to acquire, publicly offer or make any public proposal with respect to the possible acquisition of (a) beneficial ownership of any securities of the Company, (b) any substantial part of the Company's assets, or (c) any rights or options to acquire any of the foregoing from any person; (ii) make or in any way participate in any "solicitation" of "proxies" (as such terms are defined in the rules of the Securities Exchange Act of 1934, as amended) to vote, or seek to advise or influence any person with respect to the voting of any voting securities of the Company; or (iii) make any public announcement with respect to any transaction between the Company or any of its securities holders and the Investors, including without limitation, any tender or exchange offer, merger or other business combination of a material portion of the assets of the Company. These standstill provisions terminate if the Company's consolidated earnings before interest, taxes, depreciation and amortization and exclusive of special charges, as defined in the Investor Rights Agreement, do not meet specified targets.
Party City's trade vendors representing approximately $36.4 million of trade debt have also entered into an agreement with the Company. Pursuant to a Vendor Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"), these trade vendors agreed to forbear from taking any action against Party City until January 15, 2000, unless an event of default occurs. The trade vendors have received promissory notes from Party City representing one-third of their unpaid balances as of May 1, 1999 (the "Trade Notes"). The Trade Notes bear interest at a rate of 10% per year and mature on November 15, 1999. Interest on the Trade Notes is due on January 15, 2000, unless the bank debt is refinanced before then. On January 15, 2000, the Company management believes it will resume normal credit terms with the substantially all its vendors. Upon such event, management believes the remaining two-thirds of the unpaid claims as of May 1, 1999, will be satisfied through individual arrangements with its vendors. However, there can be no assurance that the Company will successfully conclude these arrangements. Separately, certain seasonal trade vendors have agreed to extend credit to Party City for 30% of purchases for the Halloween, Thanksgiving and end of year holiday seasons. Vendors that have agreed to extend credit will receive a shared lien that is pari passu with the liens of the Credit Agreement on the Company's inventory for the amount of the credit extended.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Also, in connection with these transactions, one outside director of the Company resigned and two representatives of the Investors joined the Board of Directors.
The proceeds from the $30 million in new financing have been used as follows (in thousands):
The Company's unaudited pro forma consolidated balance sheet as of July 3, 1999, after giving effect to the transactions described above, is as follows (in thousands):
Sales of Company-Owned Stores
In order to meet the cash flow requirements of the Halloween seasonal purchase of inventory and to meet the requirements of the Bank Forbearance Agreement, the Company began a program to identify stores for sale to existing franchisees to generate working capital. Eighteen stores with a net book value of approximately $9,150,000 were sold to franchisees, of which seventeen stores with a net book value of approximately $8,750,000 were sold subsequent to July 3, 1999. In connection with the sales, normal franchise fees were
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
waived for negotiated periods up to five years. The total proceeds from the sales of these stores are approximately $9,883,000, of which $9,683,000 was received subsequent to July 3, 1999. The net proceeds from the sale of stores is required under the Bank Forbearance Agreement to be used to pay down the outstanding borrowings under the Credit Agreement.
Management Plan
In addition to the negotiation of agreements discussed above, Company management is evaluating various strategies for improving the Company's results of operations, operating controls, expansion and franchising strategies, management information systems needs and other aspects of the business. These strategies are designed to improve the profitability from operations and improve management insight into merchandising decisions and operating controls. There is no assurance that the Company will achieve the operating improvements discussed above.
Company management is also seeking replacement financing for the Credit Agreement. Management has initiated contact with several asset-based lenders to provide such a facility. If the Company is successful in obtaining an asset-based lending arrangement, such a facility will assist the Company in meeting its short-term liquidity needs for the next year. There is no assurance at this time that the Company will be successful in obtaining this financing facility.
The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments to the recoverability and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company's ability to continue as a going concern is dependent on the Company's achieving its minimum operating plan, obtaining satisfactory financing and establishing normal credit terms with its vendors. There can be no assurance that the Company will be successful in negotiating these vendor and financing arrangements on terms that it will consider acceptable, or at all, or that the terms of such arrangements will not impair the Company's ability to conduct its business in accordance with its minimum operating plan.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents
The Company considers its highly liquid investments purchased as part of daily cash management activities to be cash equivalents.
Fair Value of Financial Instruments
Financial instruments consist of cash equivalents, accounts receivable, accounts payable and debt obligations. The carrying amounts reported in the balance sheets of such financial instruments approximate their fair market values due to their short-term maturity.
Allowance for Doubtful Accounts
The allowance for doubtful accounts on receivables from franchisees at December 31, 1997 and July 3, 1999 was $48,000 and $379,000 respectively.
Merchandise Inventory
The Company values its inventory at the lower of average cost (which approximates FIFO) or market. Provision for obsolete and slow moving inventory is charged to operations in the period in which such estimates are determined by management.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Advance Merchandise Payments
In order to continue shipments of merchandise from suppliers while the Company is in arrears on its trade payables, merchandise purchases are being made primarily on a cash-in-advance basis as an on-account payment and classified in current assets. As merchandise inventory attributable to these on-account payments is received in the stores, an adjustment is made in the Company's accounting records to reflect the purchase in merchandise inventory and reduce the advance merchandise payments account. At July 3, 1999, the Company has approximately $9,439,000 in advance merchandise payments.
Advertising Fund
Pursuant to its franchise agreements, the Company collects 1% of the net sales of its franchise stores for contribution into the Advertising Fund (the "Ad Fund"). These amounts are restricted in their use for advertising on behalf of the franchisees. Receipts and disbursements are not recorded as income or expense since the Company does not have full discretion over the use of the funds. The Company also contributes 1% of net sales of its owned stores into the Ad Fund. To cover the expenses of fund administration, the Company charges the Ad Fund a management fee equal to 5% of the funds contributed by franchisees. During 1996, 1997, and the period from January 1, 1998 to July 3, 1999, Ad Fund management fees of $134,000, $210,000 and $437,000, respectively, were collected by the Company and credited to general and administrative expense.
Property and Equipment
Property and equipment are recorded at cost. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the assets or, where applicable, the terms of the respective leases, whichever is shorter. Property and equipment placed in service prior to January 1, 1993, are depreciated using an accelerated method. The difference between the two methods is not material. The Company uses estimated useful lives of five to seven years for furniture, fixtures and equipment. Capitalized software costs are amortized on a straight-line basis over their estimated lives of three to five years, beginning in the year the assets were placed into service.
Maintenance and repairs are charged directly to expense as incurred. Major renewals or replacements of fixed assets are capitalized after making the necessary adjustments to the asset and accumulated depreciation of the items renewed or replaced.
Impairment of Long-lived Assets and Intangibles
The Company reviews long-lived assets, including intangibles, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets in question may not be recoverable.
Intangibles
Trademarks, which are included in other assets, consist primarily of capitalized legal costs and are being amortized using the straight-line method over the estimated useful lives of the assets. The excess of purchase price over the fair value of the net assets acquired in connection with the purchase of franchise stores ("goodwill") is being amortized on a straight-line basis over 15 years.
Deferred Rent
The Company accounts for scheduled rent increases contained in its leases on a straight-line basis over the noncancelable lease term.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income Taxes
The Company files a consolidated Federal income tax return. Separate state income tax returns are filed with each state in which the Company conducts business. The Company accounts for its income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.
Stock Options
As permitted under Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation", the Company has elected not to adopt the fair value based method of accounting for its stock-based compensation plans. The Company will continue to apply the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees". The Company has complied with the disclosure requirements of SFAS No. 123.
Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share also includes the dilutive effect of potential common shares (dilutive stock options) outstanding during the period. All earnings per share data for the years ended December 31, 1996 and 1997, has been retroactively adjusted for the three-for-two common stock split that occurred on January 16, 1998.
Revenue Recognition
The Company operates predominately as a retailer through its Company owned stores. The retail segment recognizes revenue at the point of sale.
The Company's franchise segment generates revenues through franchise fees and royalties. Revenue from individual franchise sales, recorded as franchise fees, is recognized by the Company upon completion of the certain initial services, which normally coincide with the opening of the franchisee's store. The Company is obligated in accordance with the terms of each franchisee's respective agreement to provide the following initial services: advice on site location, store design and layout, training and pre-opening assistance. On an ongoing basis, the Company provides assistance regarding sources of supply, pricing, advertising and promotion programs and other defined assistance. Royalty fees are recorded on a monthly basis as a percentage of the franchisee's net sales.
Area franchise sales represent agreements with franchisees to open a specified number of franchises within defined geographic areas and development periods. The Company's policy is to receive a deposit in advance for each of the potential stores, based on its standard initial franchise fee at the time the contract is signed. Upon receipt, the deposit is recorded as deferred revenue. When the Company satisfies its initial
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obligations to the franchisee and the store is opened, the Company recognizes the deposit as revenue. Information regarding franchise activity follows:
Store Opening and Closing Costs
New store opening costs are expensed as incurred. In the event a store is closed before its lease expires, the estimated lease obligation, less any sublease rental income, is provided in the period of closing.
Advertising Costs
The costs associated with store advertising are expensed in the period in which the related promotion and sales occur. Advertising expense was approximately $2.3 million, $7.0 million and $23.4 for the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999, respectively.
Effect of New Accounting Standards
In June 1997, the FASB issued SFAS No. 130 "Reporting Comprehensive Income," which establishes standards for the reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. This statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. The adoption of this statement did not have an impact on the Company's consolidated financial statements as the Company has no items of comprehensive income.
Effective January 1, 1998, the Company adopted AICPA Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," which requires the Company to capitalize certain software development costs. Generally, once the capitalization criteria of the SOP have been met, external direct costs of materials and services used in development of internal-use software, payroll and payroll-related costs for employees directly involved in the development of internal-use software and interest costs incurred when developing software for internal use are to be capitalized. The adoption of this SOP had no impact on the consolidated financial statements because the SOP requires the change to be implemented prospectively.
Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for the way that business enterprises report information about operating segments in financial statements and related disclosures about products and services, geographical areas and major customers. The Company has adopted this statement and expanded its disclosure of its retail and franchise segments.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments and
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hedging activities. SFAS No. 133 requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and to measure those instruments at fair value.
For Fiscal 2001, the Company is required to adopt SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The Company has not yet determined whether the application of SFAS No. 133 will have a material impact on its financial position or results of operations.
Seasonality
The Company's business is subject to substantial seasonal variations. Historically, the Company has realized a significant portion of its net sales and substantially all of its net income for the year during the fourth calendar quarter of the year, principally due to the sales in October for the Halloween season and, to a lesser extent, due to sales for end of year holidays. The Company's results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings. The Company believes this general pattern will continue in the future.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include provision for obsolete and slow-moving inventory, liability for incurred but not reported medical claims and accrued workers compensation claims.
Concentration
The Company relies on its suppliers for the purchase of its merchandise. That Company had two suppliers who in the aggregate constituted approximately 21% of the Company's purchases for the eighteen-month period ended July 3, 1999. The loss of either of these suppliers would adversely affect the Company's operations.
Reclassifications
Certain reclassifications have been made to the consolidated financial statements in prior periods to conform to the current period presentation.
3. ACQUISITIONS
1997 Acquisitions
On February 28, 1997, the Company acquired six franchise stores. Four of the stores acquired were owned by Steven Mandell, then the Company's Chairman and President through May 1999 and a member of the Board of Directors until September 17, 1999. Such stores were acquired for an aggregate purchase price of $5.2 million. The remaining two stores were owned by Perry Kaplan, a former executive officer and Director of the Company. Such stores were acquired for an aggregate purchase price of $1.3 million. On August 1, 1997, the Company acquired three franchise stores; two stores in the Southern California market and one store in Staten Island, New York. Through these transactions, the Company acquired certain development rights to the Southern California and Staten Island, New York markets. The aggregate purchase price of these transactions was approximately $3.3 million. On August 27, 1997 the Company acquired two franchise stores in the Chicago market and on September 12, 1997 the Company acquired two franchise stores in Virginia. The aggregate purchase price of these transactions was approximately $3.9 million. On September 2, 1997, the Company acquired 11 franchise stores in the Dallas/Fort Worth market. The purchase price of this
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transaction was approximately $8.2 million. Additionally, the acquisition agreement provides that the Company has acquired the rights for any future development in the Dallas/Fort Worth market.
1998 Acquisitions
On March 27, 1998, the Company acquired one franchise store in the Miami, Florida market. The purchase price of this transaction was approximately $0.3 million. On June 28, 1998, the Company acquired three franchise stores in the Memphis, Tennessee market. The purchase price of this transaction was approximately $1.9 million. As discussed in Note 1, in order to meet cash flow requirements, the Company sold the three Memphis stores to a franchisee in August 1999. On August 31, 1998, the Company acquired four franchise stores in the Chicago market from Duayne Weinger, a director of the Company. The purchase price of this transaction was $3.9 million. On September 23, 1998, the Company acquired one franchise store in the Houston market. The purchase price of this store was approximately $0.5 million.
The acquisitions have been accounted for under the purchase method of accounting. The results of operations of the acquired stores are included in the financial statements from the date of acquisition. Goodwill of $14.1 million in 1997 and $6.2 million in 1998 was recorded in connection with these acquisitions and is being amortized on a straight-line basis over 15 years.
The pro forma results below are not necessarily indicative of the results of operations that would have occurred had the transactions been consummated as indicated nor are they intended to indicate results that may occur in the future. Assuming the stores acquired during the year ended December 31, 1997 and 1998, were acquired on January 1, 1997, the pro forma results would have been as follows (in thousands, except per share amounts) (unaudited):
4. OTHER CURRENT ASSETS
Other current assets consist of the following (in thousands):
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5. OTHER ASSETS
Other assets consist of the following (in thousands):
6. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (in thousands):
7. IMPAIRMENT OF LONG-LIVED ASSETS
For the period from January 1, 1998 to July 3, 1999, the Company recorded an impairment charge of $300,000 relating to goodwill and fixed assets for five stores. These stores have not achieved expected sales and earnings. The Company determined that each store's projected cash flow could not support future amortization of the remaining goodwill and fixed assets and an impairment charge was warranted. The amount of impairment charge was measured on the basis of projected discounted cash flows using a discount rate indicative of the Company's average cost of funds. The Company will continually assess the recoverability of goodwill and fixed asset balances of all long-lived assets and intangibles. The impairment charge is applicable to the Company's retail segment and is included in general and administrative expense in the consolidated statement of operations. No impairment charge was incurred in the years ended December 31, 1996 and 1997.
8. ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. EARNINGS PER SHARE
The following table sets forth the computations of basic and diluted earnings per share (in thousands, except per share amounts):
- --------------- (a) In periods with losses, options were excluded from the computation of diluted earnings per share because they would be antidilutive.
Options to purchase, 119,250 and 1,026,820 common shares at prices ranging from $3.84 to $34.44 per share were outstanding at December 31, 1996 and July 3, 1999, respectively, but were not included in the computation of dilutive earnings per share because the exercise price of the options exceeds the average market price.
10. STOCKHOLDERS EQUITY AND STOCK OPTIONS
The Company has 25,000,000 shares authorized of its $.01 par value common stock at December 31, 1997 and July 3, 1999. Shares issued and outstanding were 12,300,095 and 12,455,538 at December 31, 1997 and July 3, 1999, respectively.
On March 27, 1996, the Company completed an initial public offering ("IPO") of 2,550,000 shares of common stock, $.01 par value, issued by the Company, at an IPO price of $6.67 per share. Proceeds to the Company, net of offering expenses of $1,990,000, were $15,010,000.
On May 8, 1997, the Company completed a secondary public offering of its common stock. The total offering was for 3,360,000 shares of common stock, of which 1,800,000 shares were offered by the Company and 1,560,000 were offered by certain selling stockholders. The offering price was $8.67 per share. Proceeds to the Company net of offering expenses were $14,185,000. On December 18, 1997, the Board of Directors declared a three-for-two common stock split effective January 16, 1998. All common stock and per share data has been retroactively adjusted for the stock split.
The Company maintains the Amended and Restated 1994 Stock Option Plan (the "1994 Plan") pursuant to which options may be granted to employees, directors and consultants for the purchase of the common stock of the Company. On March 6, 1998, the Board of Directors of the Company amended the 1994 Option Plan to increase the number of shares available for the grant of options under the 1994 Plan from 900,000 shares to 1,800,000 shares. This amendment was ratified by the Company's stockholders on June 22, 1998.
The 1994 Plan, as amended, permits the Company to grant incentive and non-qualified stock options to purchase an aggregate of 1,800,000 shares of the Company's common stock, as adjusted for the three-for-two common stock split that occurred on January 16, 1998. Such options may be incentive stock options or non-qualified options. Any employee of the Company or any subsidiary of the Company is eligible to receive incentive stock options and non-qualified stock options under the 1994 Plan. Non-qualified stock options may
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
be granted to employees as well as non-employee directors and consultants of the Company under the 1994 Plan as determined by the Board or the Compensation Committee.
The term of an option is determined by the Compensation Committee of the Board. The exercise price of the shares covered by an incentive stock option may not be less than the fair value of the shares at the time of grant. The exercise price of the shares covered by a non-qualified option need not be equal to the fair value of the stock at the date of grant, but may be granted with an exercise price as determined by the Compensation Committee. The options granted prior to November 1997 vest one-third each year, over a period of three years. Options granted after November 1997 vest over four-year and five-year periods, vesting ratably starting in the second year after the date of grant.
The following tables summarize information about stock option transactions for the 1994 Plan:
RANGE OF EXERCISE
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The Company measures compensation cost under APB No. 25, "Accounting for Stock Issued to Employees." Accordingly, no compensation cost has been recognized in connection with the 1994 Plan in the accompanying consolidated financial statements. In accordance with SFAS No. 123, "Accounting for Stock- Based Compensation," the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the following assumptions for grants in the respective periods:
Set forth below are the Company's net income (loss) and earnings (loss) per share presented "as reported" and pro forma as if compensation cost were recognized in accordance with the provisions of SFAS No. 123 (in thousands, except per share data):
11. INCOME TAXES
The provision for income tax expense consists of the following (in thousands):
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Deferred income taxes reflect the net tax effects of temporary differences between the carrying value of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. In the eighteen-month period ended July 3, 1999, the Company recorded a valuation allowance on certain of the Company's deferred tax assets due to uncertainties associated with generating taxable income needed to recover such assets. Since it is presently uncertain when the Company would generate sufficient taxable income, the Company determined it was more likely than not that such deferred tax assets could not be recovered.
The Company has changed its year end for financial reporting to the 52-53 week year ending closest to June 30 effective the period ended July 3, 1999. The tax year end remains December 31. The estimated tax loss for the six months ended July 3, 1999, will be included in the tax year ended December 31, 1999. If such a loss exists for the tax year ending December 31, 1999, its can be carried back two years and forward 20 years.
Significant components of the net deferred tax asset at December 31, 1997 and July 3, 1999 are as follows (in thousands):
The following table reconciles the statutory Federal income tax rate with the effective rate of the Company for the periods ended:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. EMPLOYEE BENEFIT PLANS
The Company has a defined contribution 401(k) savings plan (the "401(k) Plan") covering all eligible employees. Participants may defer between 1% and 15% of annual pre-tax compensation subject to statutory limitations. The Company contributes an amount as determined by the Board of Directors. Such amount has been established as 50% of the employee's contribution up to $1,000.
For the years ended December 31, 1996, 1997 and the period from January 1, 1998 to July 3, 1999, $45,000, $65,000, and $107,000 were expensed under the 401(k) Plan.
13. RELATED PARTY TRANSACTIONS
The former president of the Company and a major stockholder owned all of the outstanding shares of two party supplies stores for which no royalty fees were charged. This officer was also the majority owner of two additional franchise stores and was a 50% owner of one franchise through 1995. The Company received royalty fees based on 3.0% of net sales from the majority owned stores. In addition, a former Director of the Company owned two franchises and was a 50% owner of one franchise through 1995, for which the franchisee paid royalty fees of 2.0% of net sales. On February 28, 1997, the Company acquired these six franchise stores.
Furthermore, another former officer of the Company owned two franchises. On August 1, 1997, the Company acquired one of these stores. The Company charged the officer approximately $0 and $19,000 for rent for the years ended December 31, 1996 and 1997. A current executive of the Company owns one franchise store.
Royalty fees of $208,000, $24,000 and $82,000 relating to the above are included in the accompanying consolidated financial statements for the years ended December 31, 1996, and 1997 and the period ended July 3, 1999, respectively.
The Company and its affiliates employed common bookkeeping personnel, for which the Company charged its affiliates approximately $94,000, $14,000 and $19,000 for the years ended December 31, 1996 and 1997, and the period ended July 3, 1999 respectively. As of July 3, 1999, all such services were terminated. Office expenses allocated from the affiliate to the Company are based upon the square footage occupied by the Company. Personnel costs allocated to the affiliate are based upon an analysis of the percentage of time individuals devote to services for the affiliate stores. Management believes that both allocation methods are reasonable to determine the appropriate expenses to be allocated.
On August 31, 1998, the Company acquired four franchise stores in the Chicago market from a director of the Company at a purchase price of $3.9 million.
In June 1999, a major shareholder and director of the Company granted an option to acquire 1,000,000 shares of the shareholder's common stock to the current chief executive officer. The option vested immediately and has an exercise price of $3.00 a share, the fair value of the common stock at date of grant. The option expires in June 2004.
14. LEASE COMMITMENTS
Leases
The Company leases real estate in connection with the operation of corporate retail stores as well as its corporate office. The store leases are for properties ranging in size from 6,750 to 15,900 square feet. The terms range from five years to twenty years, and expire by 2016. The leases contain escalation clauses, renewal
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options from five years to ten years and obligations for reimbursement of common area maintenance and real estate taxes. Certain leases contain contingent rent based upon specified sales volume. For the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999, no such contingent rent was paid.
At July 3, 1999, the Company leases 29 motor vehicles. The terms range from 24 to 36 months, and expire by March 2002. Such leases are not being renewed as they expire.
In August 1997, the Company entered into a five-year capital lease with a present value of approximately $1.6 million for computer hardware and software. The Company has the option to purchase the equipment for a nominal cost at the termination of the lease. The leased hardware and software is included in property and equipment at a net book value of approximately $1.3 million at July 3, 1999.
Future minimum lease payments under outstanding leases at July 3, 1999, are as follows (in thousands):
Rent expense for all operating leases was $3,779,000, $11,956,000 and $30,264,000 for the years ended December 31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999, respectively. The Company is obligated for guarantees, subleases or assigned lease obligations for eight of its franchisees through 2009. The aggregate future minimum payments under these leases are approximately $11,736,000.
15. COMMITMENTS AND CONTINGENCIES
Securities Litigation
The Company has been named as a defendant in the following twelve class action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp. and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4) Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No. 99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99- CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-2238;
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and (12) Gross v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief Executive Officer and former Chief Financial Officer and Executive Vice President of Operations have also been named as defendants. The complaints have all been filed in the United States District Court for the District of New Jersey. The complaints were filed as class actions on behalf of persons who purchased or acquired Party City common stock during various time periods between February 1998 and March 19, 1999.
The complaints allege, among other things, violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and seek unspecified damages. The plaintiffs allege that defendants issued a series of false and misleading statements and failed to disclose material facts concerning, among other things, the Company's financial condition, adequacy of internal controls and compliance with certain loan covenants. The plaintiffs further allege that because of the issuance of a series of false and misleading statements and/or failure to disclose material facts, the price of Party City common stock was artificially inflated.
On September 13, 1999, the Court signed an Order appointing lead plaintiffs and lead counsel to represent the classes alleged in the complaints. The Order directs plaintiffs to file a consolidated and amended complaint in October 1999.
Other
The Company was named as a defendant in a complaint filed with the Supreme Court of the State of New York, County of New York, on January 16, 1998 (the "Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung, Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in the suit have existing Party City franchise stores, with the remaining plaintiff possessing a right of first refusal to develop a Party City store in Watchung, New Jersey.
The Complaint stated various causes of action, including unjust enrichment, unfair competition, fraud and misrepresentation, breach of contract, misappropriation of information and violations of the New Jersey Franchise Practices Act and the New York State Franchise Sales Act. The crux of the Complaint was that the Company undertook a course of conduct intentionally designed to adversely impact the value of the Plaintiffs' franchise stores in order to permit the Company to purchase such stores at a substantially reduced value. The Company settled the lawsuit on June 30, 1999, at no cost to the Company. In connection with the settlement, the Company agreed to sell the plaintiff one store at its fair value.
On April 23, 1999, plaintiff Emil Asch, Inc. filed a Complaint in the United States District Court for the Eastern District of New York against the Company and co-defendants Amscan, Inc., Hallmark, Inc., and Rubie's Costume. The Complaint alleges five violations of the Robinson-Patman Act, which pertains to price discrimination, unfair competition tortious interference with contractual relations, and false and deceptive advertising.
Plaintiff seeks damages of $2 million, as well as treble and punitive damages for certain counts. The Company has answered the Complaint, and discovery should proceed shortly.
Although the Company's management is unable to express a view on the likely outcome of these litigations because they are in their early stages, they could have a material adverse effect on the Company's business and results of operations.
In addition to the foregoing, the Company is from time to time involved in routine litigation incidental to the conduct of its business. The Company is aware of no other material existing or threatened litigation to which it is or may be a party.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Employment Agreements
The Company has entered into employment agreements with its chief executive officer and the chief financial officer, each for a period of three years. Such agreements expire May and June 2002, respectively. Under the agreements, the executives are entitled to specified salaries over the contract periods and guaranteed bonuses for Fiscal 2000. Future bonuses are provided contingent upon certain Company and individual performance criteria devised by the Company for each period. Severance payments are due in the event the executives are terminated by the Company. The Company's minimum commitment under these agreements is approximately $3.0 million.
16. SEGMENT INFORMATION
The Company owns, operates and franchises party supplies stores in the United States and, to a limited extent in Europe. The Company's management reporting system evaluates performance based on a number of factors; however, the primary measure of performance is the pre-tax operating profit of each segment. Accordingly, the Company reports two segments - retail and franchising. The retail segment generates revenue through the sale of primarily third-party branded party goods through Company-owned stores. The franchising segment generates revenue through the charge for initial franchise fees and a royalty on retail sales. The accounting policies are described in the summary of significant accounting policies. The Company has no intersegment sales. No single customer accounts for 10% or more of total revenues. Revenues from Europe were not greater than $16,000 in any periods presented. All assets of the Company are located in North America.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table contains key financial information of the Company's business segments (in thousands):
17. SPECIAL CHARGES AND GENERAL AND ADMINISTRATIVE EXPENSE
As discussed in Note 1, the Company is in default on its Credit Agreement and also has not been able to liquidate its trade payables in the normal course of business. Consequently, in April 1999, the Company engaged the services of a crisis management firm, and several law firms, accounting firms and consultants to
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assist Company management with such tasks as: (1) preparing required projections, (2) contacting additional financing sources, (3) negotiating with and monitoring efforts by a vendor steering committee, (4) negotiating with representatives of the bank group, and (5) other nonrecurring consulting services. Included in general and administrative expense is approximately $5.9 million for these services incurred between March 1999 and July 3, 1999.
Company management believes these costs to be unusual both in scope of services and magnitude and anticipates similar expenses of approximately $3 million to be required prior to January 31, 2000 to further resolve its financing issues. Such expenses will be recognized as the related services are performed. | 20,524 | 132,941 |
319687_1999.txt | 319687_1999 | 1999 | 319687 | ITEM 1. BUSINESS.
Continental Airlines, Inc. (the "Company" or "Continental") is a major United States air carrier engaged in the business of transporting passengers, cargo and mail. Continental is the fifth largest United States airline (as measured by 1999 revenue passenger miles) and, together with its wholly owned subsidiaries, Continental Express, Inc. ("Express") and Continental Micronesia, Inc. ("CMI"), each a Delaware corporation, serves 219 airports worldwide at February 1, 2000. As of February 1, 2000, Continental flies to 132 domestic and 87 international destinations and offers additional connecting service through alliances with domestic and foreign carriers. Continental directly serves 16 European cities, eight South American cities, Tel Aviv and Tokyo and is one of the leading airlines providing service to Mexico and Central America, serving more destinations there than any other United States airline. Through its Guam hub, CMI provides extensive service in the western Pacific, including service to more Japanese cities than any other United States carrier.
As used in this Form 10-K, the terms "Continental" and "Company" refer to Continental Airlines, Inc. and its subsidiaries, unless the context indicates otherwise. This Form 10-K may contain forward-looking statements. In connection therewith, please see the cautionary statements contained in Item 1. "Business - Risk Factors Relating to the Company" and "Business - Risk Factors Relating to the Airline Industry" which identify important factors that could cause actual results to differ materially from those in the forward-looking statements.
Business Strategy
In 1995, Continental implemented the "Go Forward Plan", a "back to basics" strategic plan focused on improving profitability and financial condition, delivering a consistent, reliable, quality product to customers and improving employee morale and working conditions. The Company's 2000 strategic plan, as discussed below, retains the four basic components of the Go Forward Plan: Fly to Win, Fund the Future, Make Reliability a Reality and Working Together, with initiatives intended to build upon Continental's operational and strategic strengths.
Fly to Win
The Company's 2000 Fly to Win initiatives center around two principal themes: Grow Electronic Commerce and Focus on Hub Operations.
Grow Electronic Commerce
During 1999, Continental reached several E-commerce milestones. See "Competition and Marketing" below. The Company's goals in 2000 include developing key internet sites and implementing interline e- ticketing with its alliance partners as well as some of the other top ten U.S. carriers. In addition, the Company will focus on reducing distribution expenses through electronic commerce.
Focus on Hub Operations. In 2000, Continental will continue to add select flights and refine its flight schedules to maximize the potential of its hubs. Management believes that by further refining the efficiency of the Company's hub operations, Continental will continue to capture additional flow traffic through its hubs and attract a larger share of higher-yielding business travelers.
Recently, industry capacity and growth in the transatlantic markets have resulted in lower yields and revenue per available seat mile in those markets, which trend is expected to continue in 2000. As a result, Continental will continue to critically review its growth plans and will adjust or redeploy resources as necessary.
Fund the Future
Having achieved its 1995 goals of building the Company's overall liquidity and improving its financial condition, management shifted its financial focus in 1996 and 1997 to the Company's interest and lease expenses. In 1998 and 1999, the Company concentrated on securing favorable financing for new aircraft and other assets as well as buying back common stock.
In 1999, the Company completed a number of transactions intended to strengthen its long-term financial position and enhance earnings.
In February 1999, the Company completed an offering of $806 million of pass-through certificates used to finance (either through leveraged leases or secured debt financings) the debt portion of the acquisition cost of 22 aircraft delivered in 1999.
In March 1999, the Company completed a $160 million credit facility, with a maturity date of March 2001, to finance pre- delivery deposits for certain new Boeing aircraft to be delivered between March 1999 and March 2002.
In April 1999, the Company exercised its right and called for redemption in May 1999, all $230 million of its 6-3/4% Convertible Subordinated Notes due 2006. The notes were converted into 7.6 million shares of Class B common stock during May 1999.
Also, in June 1999, the Company completed an offering of $742 million of pass-through certificates used to finance (either through leveraged leases or secured debt financings) the debt portion of the acquisition cost of 21 new Boeing aircraft delivered in 1999.
In October 1999, Continental sold its interest in AMADEUS Global Travel Distribution, S.A. ("AMADEUS") for $409 million, including a special dividend.
During 1999, the Company's Board of Directors increased the size of its common stock repurchase program by $900 million, bringing the total size of the program to $1.2 billion. As of January 21, 2000, the Company has repurchased 18,853,600 Class B common shares for $804 million since the inception of the repurchase program in March 1998.
The focus in 2000 is to maintain cash balances of at least $1 billion while continuing to secure financing for aircraft deliveries in 2000 and beyond and, under appropriate circumstances, buy back common stock. The Company expects to continue to eliminate excess interest and lease expenses through refinancings and other initiatives.
Continental desires to simplify its equity capital structure and is committed to continuing to repurchase outstanding equity. In connection with its stock repurchase program, the Company has held preliminary discussions with Northwest Airlines, Inc. ("Northwest") concerning the acquisition by Continental of all the Class A common stock of Continental held by Northwest in a voting trust (8.7 million shares). The alliance between Continental and Northwest is beneficial to both carriers, and any transaction would be designed to preserve and strengthen the benefits of the alliance. There can be no assurance as to whether a transaction between Continental and Northwest will be agreed to or consummated, nor can Continental predict the structure, form or amount of consideration or other elements of any such transaction.
Make Reliability a Reality
Customer service continues to be a principal focus in 2000. Management believes Continental's on-time performance record is crucial to its other operational objectives and, together with its initiatives to improve baggage handling and customer satisfaction and appropriately manage involuntary denied boardings, is an important tool to attract higher-margin business travelers.
Continental's goal for 2000 is to be ranked monthly by the Department of Transportation ("DOT") among the top half of major air carriers in on-time performance, baggage handling, customer satisfaction and avoidance of involuntary denied boarding. For 1999, Continental ranked fifth in on-time performance, third in baggage handling, fourth in fewest customer complaints and second in fewest involuntary denied boardings. In 1999, bonuses of $65 were paid to substantially all employees for each month that Continental ranked second or third or achieved 80% or above (for arrivals within 14 minutes) in domestic on-time performance, and bonuses of $100 were paid for each month that Continental ranked first among the top 10 U.S. air carriers (excluding those airlines that do not report electronically) in domestic on-time performance. For 1999, a total of $26 million of on-time bonuses was paid. This successful on-time performance bonus program continues in 2000.
In addition to programs intended to improve Continental's standings in DOT performance data, the Company has taken action in other areas to enhance its attractiveness to business travelers. Specifically, Continental implemented various initiatives designed to offer travelers cleaner and more attractive aircraft interiors, consistent interior and exterior decor, first class seating on all jet aircraft (other than regional jets), better meals and greater benefits under its award-winning frequent flyer program. Continental continues to make product improvements, such as new and refurbished Presidents Clubs with specialty bars, and on-board specialty coffees and microbrewery beer, among others. Continental Airlines' jets now have reliable air-to-ground telephone service for customers, and its new long-range jets have state-of-the-art video equipment.
Continental's TransContinental service provides passengers traveling coast-to-coast from Newark International Airport ("Newark") enhancements on their flights, including check-in options at nine Continental ticket offices in New York, upgraded meal service and audio/video entertainment. Continental currently flies one of the youngest jet fleets in the industry and plans to integrate the Boeing 767 aircraft into its fleet in 2000. The Company has also continued to refine its award-winning BusinessFirst service.
Working Together
Management believes that Continental's employees are its greatest asset and the cornerstones of improved reliability and customer service. Management has introduced a variety of programs to increase employee participation and foster a sense of shared community. These initiatives include significant efforts to communicate openly and honestly with all employees through daily news bulletins, weekly voicemail updates from the Company's Chief Executive Officer, monthly and quarterly Continental publications, videotapes mailed to employees reporting on the Company's growth and progress, Go Forward Plan bulletin boards in over 600 locations system-wide, and daily news electronic display signs in many Continental employee locations world-wide. In addition, regularly scheduled visits to airports throughout the route system are made by the senior executives of the Company (each of whom is assigned an airport for this purpose). Monthly meetings open to all employees, as well as other periodic on-site visits by management, are designed to encourage employee participation, knowledge and cooperation. Continental was recently named among the best companies to work for in America, finishing 23rd in Fortune Magazine's 1999 "100 Best Companies to Work for in America" list, up from 40th where it debuted in 1998. Continental has also reached long-term agreements with a majority of its employee workgroups regarding wages, benefits and other workplace matters.
Continental's goals for 2000 include (i) being ranked among the top three major air carriers in employee measures such as turnover, lost time, productivity and on-the-job injury claims, (ii) continuing to work with all employee groups in a way that is fair to the employees and fair to the Company, (iii) continuing to improve work environment safety, and (iv) maintaining Continental as one of the 100 best companies to work for in America.
In September 1997, Continental announced that it intended to bring all employees to industry standard wages over a three-year period. This goal will be achieved in 2000. The Company is in the process of formulating a plan to bring all employees to industry standard benefits over a multi-year period. See "Employees" below.
Domestic Operations
Continental operates its domestic route system primarily through its hubs at Newark, George Bush Intercontinental Airport ("Bush Intercontinental") in Houston and Hopkins International Airport ("Hopkins International") in Cleveland. The Company's hub system allows it to transport passengers between a large number of destinations with substantially more frequent service than if each route were served directly. The hub system also allows Continental to add service to a new destination from a large number of cities using only one or a limited number of aircraft. Each of Continental's domestic hubs is located in a large business and population center, contributing to a high volume of "origin and destination" traffic.
Newark. As of February 1, 2000, Continental operated 54% (233 departures) of the average daily jet departures (excluding regional jets) and, together with Express, 58% (323 departures) of all average daily departures (jet, regional jet and turboprop) from Newark. Considering the three major airports serving New York City (Newark, LaGuardia and John F. Kennedy), Continental and Express accounted for 22% of all daily departures, while the next largest carrier, American Airlines, Inc. ("American"), and its commuter affiliate accounted for 17% of all daily departures.
Houston. As of February 1, 2000, Continental operated 77% (325 departures) of the average daily jet departures (excluding regional jets) and, together with Express, 82% (483 departures) of all average daily departures from Bush Intercontinental. Southwest Airlines Co. ("Southwest") also has a significant share of the Houston market through Hobby Airport. Considering both Bush Intercontinental and Hobby Airport, Continental operated 56% and Southwest operated 25% of the daily jet departures (excluding regional jets) from Houston.
Cleveland. As of February 1, 2000, Continental operated 52% (85 departures) of the average daily jet departures (excluding regional jets) and, together with Express, 65% (254 departures) of all average daily departures from Hopkins International. The next largest carrier, US Airways, Inc. ("US Airways"), accounted for 6% of all daily jet departures.
Continental Express. Continental Airlines' jet service at each of its domestic hub cities is coordinated with Express, which operates new-generation regional jets and turboprop aircraft under the name "Continental Express". The regional jets average one year of age and seat either 37 or 50 passengers while the turboprop aircraft average approximately eight years of age and seat 64 or fewer passengers.
As of February 1, 2000, Express served 32 destinations from Newark (23 by regional jet), 47 destinations from Bush Intercontinental (29 by regional jet) and 55 destinations from Hopkins International (29 by regional jet). In addition, commuter feed traffic is currently provided to Continental by other code-sharing partners. See "Domestic Carrier Alliances" below.
Management believes Express's regional jet and turboprop operations complement Continental's jet operations by allowing more frequent service to small cities than could be provided economically with conventional jet aircraft and by carrying traffic that connects onto Continental's jets. In many cases, Express (and Continental) compete for connecting traffic with commuter airlines owned by or affiliated with other major airlines operating out of the same or other cities. Continental believes that Express's new regional jets provide greater comfort and enjoy better customer acceptance than turboprop aircraft. Express is in the process of developing a plan to convert to an all regional jet fleet over a multi-year period. The regional jets also allow Express to serve certain routes that cannot be served by its turboprop aircraft.
Domestic Carrier Alliances. Pursuant to the Company's Fly to Win initiative under the Go Forward Plan, Continental has entered into and continues to develop alliances with domestic carriers:
- - In 1998, the Company entered into a long-term global alliance with Northwest (the "Northwest Alliance"). The Northwest Alliance includes the placing by each carrier of its code on a large number of the flights of the other and reciprocal frequent flyer programs and executive lounge access. Significant other joint marketing activities are being undertaken, while preserving the separate identities of the carriers. Continental has also entered into agreements to code-share with certain Northwest regional affiliates. See "Risk Factors Relating to the Company - Risks Regarding Continental/Northwest Alliance".
- - Continental has a series of agreements with America West Airlines, Inc. ("America West"), including agreements related to code-sharing and ground handling, which have created substantial benefits for both airlines. These code-sharing agreements cover 141 city-pairs at February 1, 2000, and allow Continental to link additional destinations to its route network and derive additional traffic from America West's distribution strength in cities where Continental has less sales presence. The sharing of facilities and employees by Continental and America West in their respective key markets has resulted in significant cost savings.
- - Continental began a code-sharing agreement with Gulfstream International Airlines, Inc. ("Gulfstream") in April 1997. Gulfstream serves as a connection for Continental passengers throughout Florida as well as eight destinations in the Caribbean. Continental recently purchased 28% of the equity of Gulfstream.
- - Continental implemented a code-sharing agreement with Mesaba Aviation, Inc. ("Mesaba"), operating as a Northwest affiliate, commencing in January 1999. Mesaba serves as a connection for Continental passengers through Detroit and Minneapolis/St. Paul.
- - Continental and CMI entered into a cooperative marketing agreement with Hawaiian Airlines, Inc. ("Hawaiian") that began in October 1997 on flights connecting in Honolulu. The relationship expanded in 1999 to include code-sharing. Hawaiian connects Continental passengers through Honolulu to six additional Hawaiian cities.
- - In February 1999, Continental announced its code-sharing agreement with Alaska Airlines, Inc. ("Alaska Air") and its affiliate, Horizon Airlines, Inc. ("Horizon"). Alaska Air and Horizon serve as connections for Continental passengers to 35 destinations throughout the Pacific Northwest.
International Operations
International Operations. Continental directly serves destinations throughout Europe, Canada, Mexico, Central and South America, and the Caribbean, as well as Tokyo and Tel Aviv, and has extensive operations in the western Pacific conducted by CMI. As measured by 1999 available seat miles, approximately 36.2% of Continental's jet operations, including CMI, were dedicated to international traffic, compared with 33.8% in 1998. Continental anticipates that a majority of its capacity growth in 2000 will be in Europe due to the full year impact of new markets and increased capacity added in 1999. Continental does not intend to add any new European destinations during 2000. As of February 1, 2000, the Company offered 146 weekly departures to 16 European cities and marketed service to 32 other cities through code-sharing agreements. Continental is one of the leading airlines providing service to Mexico and Central America, serving more destinations there than any other U.S. airline.
The Company's Newark hub is a significant international gateway. From Newark at February 1, 2000, the Company served 16 European cities, five Canadian cities, three Mexican cities, four Central American cities, six South American cities, seven Caribbean destinations, Tel Aviv and Tokyo and markets numerous other destinations through code-sharing arrangements with foreign carriers. The Company recently announced the addition of two South American destinations, one of which will also connect to Houston, and one Caribbean destination for 2000, subject to government approval.
The Company's Houston hub is the focus of its operations in Mexico and Central America. As of February 1, 2000, Continental flew from Houston to 13 cities in Mexico, every country in Central America, six cities in South America, two Caribbean destinations, three cities in Canada, two cities in Europe and Tokyo. Express also serviced three additional cities in Mexico by regional jets and plans to add four more cities in 2000, subject to government approval.
Continental also flies to London, Montreal, Toronto, San Juan and Cancun from its hub in Cleveland.
Continental Micronesia. CMI is a United States-certificated air carrier transporting passengers, cargo and mail in the western Pacific. From its hub operations based on the island of Guam, CMI provides service to eight cities in Japan, more than any other United States carrier, as well as other Pacific rim destinations, including Taiwan, the Philippines, Hong Kong, Australia and Indonesia. Service to these Japanese cities and certain other Pacific Rim destinations is subject to a variety of regulatory restrictions limiting the ability of other carriers to service these markets.
CMI is the principal air carrier in the Micronesian Islands, where it pioneered scheduled air service in 1968. CMI's route system is linked to the United States market through Tokyo and Honolulu, each of which CMI serves non-stop from Guam. CMI and Continental also maintain a code-sharing agreement and coordinate schedules on certain flights from the west coast of the United States to Honolulu, and from Honolulu to Guam, to facilitate travel from the United States into CMI's route system.
Foreign Carrier Alliances. Over the last decade, major United States airlines have developed and expanded alliances with foreign air carriers, generally involving adjacent terminal operations, coordinated flights, code-sharing and other joint marketing activities. Continental is the only major United States air carrier operating a hub in the New York City area. Consequently, Continental believes it is uniquely situated to attract alliance partners from Europe, the Far East and South America and has aggressively pursued such alliances. The Company believes that the Northwest Alliance enhances its ability to attract foreign alliance partners. See "Risk Factors Relating to the Company - Risks Regarding Continental/Northwest Alliance".
Continental believes that continuing to develop a network of international alliance partners will better leverage its hub assets by attracting high-yield flow traffic and strengthening its position in large, local (non-connecting) markets and will result in improved returns to the Company. Additionally, Continental can enlarge its scope of service more rapidly and enter additional markets with lower capital and start-up costs through formation of alliances with partners as compared with entering markets independently of other carriers.
Continental seeks to develop alliance relationships that complement the Company's own flying and permit expanded service through Newark and Houston to major international destinations. Route authorities necessary for the Company's own service to certain of these destinations are not currently available to the Company.
Continental has implemented international code-sharing agreements with Alitalia Linee Aeree Italiane, S.P.A. ("Alitalia"), CSA Czech Airlines, British Midland, EVA Airways Corporation, an airline based in Taiwan, Virgin Atlantic Airways ("Virgin"), Viacao Aerea Sao Paulo ("VASP"), Societe Air France ("Air France") and Compania Panamena de Aviacion, S.A. ("COPA"), 49% of the common equity of which is owned by Continental. Upon receipt of government approval, Continental will commence code-sharing arrangements with Aeroservicios Carabobo S.A., a Venezuelan carrier, Avant Airlines, a Chilean carrier, Air Aruba and Air China. In addition, Continental and KLM Royal Dutch Airlines ("KLM") have signed a memorandum of understanding and anticipate finalizing and implementing a comprehensive cooperative marketing agreement by the second quarter of 2000. The joint marketing initiative is to include through check-in of passengers and baggage, reciprocal frequent flyer program participation, reciprocal airport lounge access, and, subject to government approval, codesharing on selected routes. Continental has entered into joint marketing agreements with Aerolineas Centrales de Colombia ("ACES"), for which government approval has not yet been sought.
Certain of Continental's code-sharing agreements involve block- space arrangements (pursuant to which carriers agree to share capacity and bear economic risk for blocks of seats on certain routes). Alitalia has agreed to purchase blocks of seats on Continental flights between Newark and Rome and Milan. Continental and Air France purchase blocks of seats on each other's flights between Houston and Newark and Paris. Continental and Virgin exchange blocks of seats on each other's flights between Newark and London, and Continental purchases blocks of seats on eight other routes flown by Virgin between the United Kingdom and the United States.
The Company is negotiating an early termination of its alliance with Air France as a result of Air France's announcement of an alliance with Delta Air Lines, Inc. ("Delta").
The Company might enter into other code-sharing, joint marketing and block-space agreements in 2000, which could include the Company's financial commitment to purchase seats from other carriers.
Employees
As of December 31, 1999, the Company had approximately 51,275 employees (46,550 full-time equivalent employees, including approximately 20,150 customer service agents, reservations agents, ramp and other airport personnel, 8,650 flight attendants, 7,450 management and clerical employees, 6,350 pilots, 3,800 mechanics and 150 dispatchers). Labor costs are a significant component of the Company's expenses and can substantially impact airline results. In 1999, labor costs (including employee incentives) constituted 31.5% of the Company's total operating expenses (excluding fleet disposition/impairment loss). While there can be no assurance that the Company's generally good labor relations and high labor productivity will continue, management has established as a significant component of its business strategy the preservation of good relations with the Company's employees, approximately 42% of whom are represented by unions. In September 1997, the Company announced a plan to bring all employees to industry standard wages no later than the end of the year 2000. Wage increases began in 1997, and will continue to be phased in through 2000. The Company is in the process of formulating a plan to bring all employees to industry standard benefits over a multi- year period.
The following is a table of the Company's, Express's and CMI's principal collective bargaining agreements, and their respective amendable dates:
In February 2000, the Company announced a 54-month tentative collective bargaining agreement with its Continental Airlines flight attendants. The agreement is subject to ratification by the Continental Airlines flight attendants. In September 1999, Express and the IAM began collective bargaining negotiations to amend the Express flight attendants' contract (which became amendable in November 1999). The Company believes that mutually acceptable agreements can be reached with such employees, although the ultimate outcome of the negotiations is unknown at this time.
The other employees of Continental, Express and CMI are not covered by collective bargaining agreements.
Competition and Marketing
The airline industry is highly competitive and susceptible to price discounting. The Company competes with other air carriers that have substantially greater resources (and in certain cases, lower cost structures) as well as smaller air carriers with low-cost structures. Historically, industry profit margins have been low. However, during 1995 through 1999, industry profit margins improved substantially. See Item 1. "Business. Risk Factors Relating to the Airline Industry" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations".
As with other carriers, most tickets for travel on Continental are sold by travel agents. Travel agents generally receive commissions measured by the price of tickets sold. Accordingly, airlines compete not only with respect to the price of tickets sold but also with respect to the amount of commissions paid. Airlines often pay additional commissions in connection with special revenue programs.
E-Ticket. In 1999, Continental expanded its electronic ticketing ("E-Ticket") product to 95% of all of its own destinations. E- Tickets result in lower distribution costs to the Company while providing enhanced customer and revenue information. Continental recorded over $3.9 billion in E-Ticket sales in 1999, representing 41% of total sales. During 1999, Continental announced interline E-Ticketing with America West and replaced E-Ticket machines with e-Service Centers. In 2000, the Company plans to implement interline E-Ticketing with its alliance partners as well as some of the other top ten U.S. carriers. The Company expects these features to contribute to an increase in E-Ticket usage and a further reduction in distribution costs.
Internet. Continental's award winning website, www.continental.com ("continental.com") recorded over $165 million in ticket sales in 1999. The site features computer graphics and navigational aids that make it simpler and faster for travelers to purchase tickets and retrieve travel-related information online. The Company implemented its "featured fare" program for customers to make travel plans around special fare offers. Continental online ("COOL") travel specials are available only to online users offering reduced fares for immediate travel on specified dates. During 1999, the Company announced an online promotion to provide frequent flyer bonus miles for customers who use the continental.com website for the first time to book a Continental flight. Combined with online travel agents, the Company recorded over $305 million in ticket sales through the internet during 1999.
Other. In 1999, Continental entered into an agreement with priceline.com, Inc. ("Priceline") which allows customers to purchase airline tickets at an offer price determined by the customer. Continental decides on which routes it will allow seats to be sold by Priceline and the related fare it is willing to accept. Additionally, the Company announced an agreement among the Company, Northwest, Delta and United Air Lines, Inc. to create a new on-line travel web site. To date, 27 U.S. and foreign carriers, including American and US Airways, have signed up to join the web-based travel service. The new site, the first multi- airline travel portal, is expected to provide customers with convenient online access to airline, hotel, car rental and other travel services in addition to internet offers. The site will feature published fares from virtually all carriers worldwide and will welcome the posting of internet fares from other carriers as well.
Frequent Flyer Program
Each major airline has established a frequent flyer program designed to encourage repeat travel on its system. Continental's OnePass program currently allows passengers to earn mileage credits by flying Continental and certain other carriers including Northwest, America West, Alaska Air, Alitalia, Air France, COPA and Gulfstream. The Company also sells mileage credits to credit card companies, phone companies, hotels, car rental agencies and others participating in the OnePass program.
Due to the structure of the program and the low level of redemptions as a percentage of total travel, Continental believes that displacement of revenue passengers by passengers using flight awards has historically been minimal. The number of awards used on Continental represented slightly less than 7% of Continental's total revenue passenger miles in each of the years 1999 and 1998.
Industry Regulation and Airport Access
Continental and its subsidiaries operate under certificates of public convenience and necessity issued by the DOT. Such certificates may be altered, amended, modified or suspended by the DOT if public convenience and necessity so require, or may be revoked for intentional failure to comply with the terms and conditions of a certificate.
The airlines are also regulated by the Federal Aviation Administration ("FAA"), primarily in the areas of flight operations, maintenance, ground facilities and other technical matters. Pursuant to these regulations, Continental has established, and the FAA has approved, a maintenance program for each type of aircraft operated by the Company that provides for the ongoing maintenance of such aircraft, ranging from frequent routine inspections to major overhauls. Continental has retired all of its Stage 2 aircraft in order to meet the FAA's noise compliance requirements with the exception of five Boeing 727 aircraft operated by CMI which are exempt since they are operated outside the United States. The Company intends to retire these five aircraft in 2000.
The DOT allows local airport authorities to implement procedures designed to abate special noise problems, provided such procedures do not unreasonably interfere with interstate or foreign commerce or the national transportation system. Certain airports, including the major airports at Boston, Washington, D.C., Chicago, Los Angeles, San Diego, Orange County (California) and San Francisco, have established airport restrictions to limit noise, including restrictions on aircraft types to be used and limits on the number of hourly or daily operations or the time of such operations. In some instances, these restrictions have caused curtailments in services or increases in operating costs, and such restrictions could limit the ability of Continental to expand its operations at the affected airports. Local authorities at other airports are considering adopting similar noise regulations.
Airports from time to time seek to increase the rates charged to airlines, and the ability of airlines to contest such increases has been restricted by federal legislation, DOT regulations and judicial decisions. In addition, some public airports generally impose passenger facility charges ("PFC's") of up to $3 per segment for a maximum of $12 per roundtrip. Legislation which would increase the PFC to $6 per segment for a maximum of $24 per roundtrip is being considered in a conference committee between the House of Representatives and the Senate. With certain exceptions, these charges are passed on to the customers.
The FAA has designated John F. Kennedy International Airport ("Kennedy") and LaGuardia Airport ("LaGuardia") in New York, O'Hare International Airport in Chicago ("O'Hare") and Ronald Reagan Washington National Airport in Washington, D.C. ("Reagan National") as "high density traffic airports" and has limited the number of departure and arrival slots at those airports. Currently, such slots may be voluntarily sold or transferred between carriers. Various amendments to the slot system proposed from time to time could, if adopted, significantly affect operations at high density traffic airports, significantly change the value of the slots, grant slots to other carriers or for route or aircraft specific usage, expand slots to other airports or eliminate slots entirely.
The DOT has in the past reallocated slots to other carriers and reserves the right to withdraw slots. In addition, the DOT has proposed the elimination of slot restrictions at high density airports other than Reagan National. Legislation containing a similar proposal, which could eliminate slots as early as 2002 at O'Hare and 2007 at LaGuardia and Kennedy, has passed the full House of Representatives and the full Senate and is currently being considered by a conference committee. The Company cannot predict whether any of these proposals will be adopted. However, if legislation or regulation eliminating slots were adopted, the value of such slots could be deemed to be permanently impaired, resulting in a loss being charged to earnings for the relevant period. Moreover, the elimination of slots could have an adverse effect upon future results of operations of the Company. At December 31, 1999, the net book value of the Company's slots at O'Hare, LaGuardia and Kennedy was $52 million, $12 million and $0, respectively.
The availability of international routes to United States carriers is regulated by treaties and related agreements between the United States and foreign governments. The United States typically follows the practice of encouraging foreign governments to accept multiple carrier designation on foreign routes, although certain countries have sought to limit the number of carriers. Foreign route authorities may become less valuable to the extent that the United States and other countries adopt "open skies" policies liberalizing entry on international routes. Continental cannot predict what laws and regulations will be adopted or their impact, but the impact could be significant.
Many aspects of Continental's operations are subject to increasingly stringent federal, state and local laws protecting the environment. Future regulatory developments could adversely affect operations and increase operating costs in the airline industry.
Risk Factors Relating to the Company
High Leverage and Significant Financing Needs. Continental has a higher proportion of debt compared to its equity capital than some of its principal competitors. In addition, a majority of Continental's property and equipment is subject to liens securing indebtedness. Accordingly, Continental may be less able than some of its competitors to withstand a prolonged recession in the airline industry or respond as flexibly to changing economic and competitive conditions.
As of December 31, 1999, Continental had approximately $3.4 billion (including current maturities) of long-term debt and capital lease obligations and had approximately $1.6 billion of common stockholders' equity. Also at December 31, 1999, Continental had $1.6 billion in cash and cash equivalents and short-term investments. Continental has lines of credit totaling $225 million.
Continental has substantial commitments for capital expenditures, including for the acquisition of new aircraft. As of January 14, 2000, Continental had agreed to acquire a total of 74 Boeing jet aircraft through 2005. The Company anticipates taking delivery of 28 Boeing jet aircraft in 2000. Continental also has options for an additional 118 aircraft (exercisable subject to certain conditions). The estimated aggregate cost of the Company's firm commitments for Boeing aircraft is approximately $4 billion. Continental currently plans to finance its new Boeing aircraft with a combination of enhanced pass through trust certificates, lease equity and other third-party financing, subject to availability and market conditions. Continental has commitments or letters of intent for backstop financing for approximately 18% of the anticipated remaining acquisition cost of future Boeing deliveries. In addition, at January 14, 2000, Continental has firm commitments to purchase 34 spare engines related to the new Boeing aircraft for approximately $219 million, which will be deliverable through March 2005.
As of January 14, 2000, Express had firm commitments for 43 Embraer ERJ-145 ("ERJ-145") 50-seat regional jets and 19 Embraer ERJ-135 ("ERJ-135") 37-seat regional jets, with options for an additional 100 ERJ-145 and 50 ERJ-135 aircraft exercisable through 2008. Express anticipates taking delivery of 15 ERJ-145 and 12 ERJ-135 regional jets in 2000. Neither Express nor Continental will have any obligation to take any of the firm ERJ-145 or ERJ-135 aircraft that are not financed by a third party and leased to Continental.
For 1999, cash expenditures under operating leases relating to aircraft approximated $758 million, compared to $702 million for 1998, and approximated $328 million relating to facilities and other rentals compared to $263 million in 1998. Continental expects that its operating lease expenses for 2000 will increase over 1999 amounts.
Additional financing will be needed to satisfy the Company's capital commitments. Continental cannot predict whether sufficient financing will be available for capital expenditures not covered by firm financing commitments.
Continental's Historical Operating Results. Continental has recorded positive net income in each of the last five years. However, Continental experienced significant operating losses in the previous eight years. Historically, the financial results of the U.S. airline industry have been cyclical. Continental cannot predict whether current industry conditions will continue.
Significant Cost of Aircraft Fuel. Fuel costs constitute a significant portion of Continental's operating expense. Fuel costs were approximately 9.7% of operating expenses for the year ended December 31, 1999 (excluding fleet disposition/impairment losses) and 10.2% for the year ended December 31, 1998 (excluding fleet disposition/ impairment losses). Recently, spot jet fuel prices have increased dramatically, rising to 87.3 cents per gallon at January 21, 2000 compared to 58.3 cents per gallon as recently as October 31, 1999. Continental recently announced that if high fuel costs continue without an improvement in the revenue environment, the Company may not post a profit in the first quarter of 2000. Fuel prices and supplies are influenced significantly by international political and economic circumstances. Continental enters into petroleum swap contracts, petroleum call option contracts and/or jet fuel purchase commitments to provide some short-term protection (generally three to six months) against a sharp increase in jet fuel prices. The Company's fuel hedging strategy could result in the Company not fully benefiting from certain fuel price declines. If a fuel supply shortage were to arise from OPEC production curtailments, a disruption of oil imports or otherwise, higher fuel prices or reduction of scheduled airline service could result. Significant changes in fuel costs or continuation of high current jet fuel prices would materially affect Continental's operating results.
Labor Costs. Labor costs constitute a significant percentage of the Company's total operating costs, and the Company experiences competitive pressure to increase wages and benefits. In September 1997, the Company announced a plan to bring all employees to industry standard wages no later than the end of the year 2000. Wage increases began in 1997, and will continue to be phased in through 2000. The Company is currently formulating a plan to bring employees to industry standard benefits over a multi-year period.
Certain Tax Matters. At December 31, 1999, Continental had estimated net operating loss carryforwards ("NOLs") of $700 million for federal income tax purposes that will expire through 2009 and federal investment tax credit carryforwards of $45 million that will expire through 2001. As a result of the change in ownership of Continental on April 27, 1993, the ultimate utilization of Continental's NOLs and investment tax credits may be limited. Reflecting this limitation, Continental has a valuation allowance of $263 million at December 31, 1999.
Continental had, as of December 31, 1999, deferred tax assets aggregating $611 million, including $266 million of NOLs. The Company has consummated several transactions which resulted in the recognition of NOLs of the Company's predecessor. To the extent the Company were to determine in the future that additional NOLs of the Company's predecessor could be recognized in the accompanying consolidated financial statements, such benefit would reduce the value ascribed to routes, gates and slots.
As a result of NOLs, Continental will not pay United States federal income taxes (other than alternative minimum tax) until it has earned approximately an additional $700 million of taxable income following December 31, 1999. Section 382 of the Internal Revenue Code ("Section 382") imposes limitations on a corporation's ability to utilize NOLs if it experiences an "ownership change." In general terms, an ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. In the event that an ownership change should occur, utilization of Continental's NOLs would be subject to an annual limitation under Section 382 determined by multiplying the value of Continental's stock at the time of the ownership change by the applicable long-term tax-exempt rate (which was 5.72% for December 1999). Any unused annual limitation may be carried over to later years, and the amount of the limitation may under certain circumstances be increased by the built-in gains in assets held by Continental at the time of the change that are recognized in the five-year period after the change. Under current conditions, if an ownership change were to occur, Continental's annual NOL utilization would be limited to approximately $172 million per year other than through the recognition of future built-in gain transactions.
In November 1998, an affiliate of Northwest completed its acquisition of certain equity of the Company previously held by Air Partners, L.P. and its affiliates, together with certain Class A common stock of the Company held by other investors, totaling 8,661,224 shares of the Class A common stock (the "Air Partners Transaction"). The Company does not believe that the Air Partners Transaction resulted in an ownership change for purposes of Section 382.
Continental Micronesia's Dependence on Japanese Economy and Currency Risk. Because the majority of CMI's traffic originates in Japan, its results of operations are substantially affected by the Japanese economy and changes in the value of the yen as compared to the dollar. To reduce the potential negative impact on CMI's earnings, the Company has entered into forward contracts as a hedge against a portion of its expected net yen cash flow position. As of December 31, 1999, the Company had hedged approximately 95% of 2000 projected yen-denominated net cash flows at a rate of 102 yen to $1 US.
Principal Stockholder. As of December 31, 1999, Northwest held approximately 13.2% of the common equity interest and 49.1% of the fully diluted voting power of the Company. In addition, Northwest holds a limited proxy to vote certain additional shares of the Company's common stock that would raise its voting power to approximately 50.9% of the Company's fully diluted voting power.
In connection with the Air Partners Transaction, the Company entered into a corporate governance agreement with certain affiliates of Northwest (the "Northwest Parties") designed to assure the independence of the Company's Board and management during the six-year term of the governance agreement. Under the governance agreement, as amended, the Northwest Parties agreed not to beneficially own voting securities of the Company in excess of 50.1% of the fully diluted voting power of the Company's voting securities, subject to certain exceptions, including third-party acquisitions or tender offers for 15% or more of the voting power of the Company's voting securities. The Northwest Parties deposited all voting securities of the Company beneficially owned by them (other than the shares for which they hold only a limited proxy) in a voting trust with an independent voting trustee requiring that such securities be voted (i) on all matters other than the election of directors, in the same proportion as the votes cast by other holders of voting securities, and (ii) in the election of directors, for the election of independent directors (who must constitute a majority of the Board) nominated by the Board of Directors. However, in the event of a merger or similar business combination or a recapitalization, liquidation or similar transaction, a sale of all or substantially all of the Company's assets, or an issuance of voting securities that would represent more than 20% of the voting power of the Company prior to issuance, or any amendment of the Company's charter or bylaws that would materially and adversely affect Northwest (each, an "Extraordinary Transaction"), the shares may be voted as directed by the Northwest Party owning such shares, and if a third party is soliciting proxies in an election of directors, the shares may be voted at the option of such Northwest Party either as recommended by the Company's Board of Directors or in the same proportion as the votes cast by the other holders of voting securities.
The Northwest Parties also agreed to certain restrictions on the transfer of voting securities owned by them, agreed not to seek to affect or influence the Company's Board of Directors or the control of the management of the Company or the business, operations, affairs, financial matters or policies of the Company or to take certain other actions, and agreed to take all actions necessary to cause independent directors to at all times constitute at least a majority of the Company's Board of Directors. The Company granted preemptive rights to a Northwest Party with respect to issuances of Class A common stock and certain issuances of Class B common stock. The Northwest Parties agreed that certain specified actions, together with any material transactions between the Company and Northwest or its affiliates, including any modifications or waivers of the governance agreement or the alliance agreement, may not be taken without the prior approval of a majority of the Board of Directors, including the affirmative vote of a majority of the independent directors. The governance agreement also required the Company to adopt a shareholder rights plan with reasonably customary terms and conditions, with an acquiring person threshold of 15% (20% in the case of an Institutional Investor) and with appropriate exceptions for the Northwest Parties for actions permitted by and taken in compliance with the governance agreement. A rights plan meeting these requirements was adopted effective November 20, 1998, and amended effective February 8, 2000.
The governance agreement will expire on November 20, 2004, or if earlier, upon the date that the Northwest Parties cease to beneficially own voting securities representing at least 10% of the fully diluted voting power of the Company's voting securities. However, in response to concerns raised by the Department of Justice ("DOJ") in its antitrust review of the Northwest Alliance, the Air Partners Transaction and the related governance agreement between the Company and the Northwest Parties (collectively, the "Northwest Transaction"), a supplemental agreement was adopted in November 1998, which extended the effect of a number of the provisions of the governance agreement for an additional four years. For instance, the Northwest Parties must act to ensure that a majority of the Company's Board is comprised of independent directors, and certain specified actions, together with material transactions between the Company and Northwest or its affiliates, including any modifications or waivers of the supplemental agreement or the alliance agreement, may not be taken without the prior approval of a majority of the Board of Directors, including the affirmative vote of a majority of the independent directors. The Northwest Parties will continue to have the right to vote in their discretion on any Extraordinary Transaction during the supplemental period, but also will be permitted to vote in their discretion on other matters up to 20% of the outstanding voting power (their remaining votes to be cast neutrally, except in a proxy contest, as contemplated in the governance agreement), subject to their obligation set forth in the previous sentence. If, during the term of the supplemental agreement, the Company's rights plan were amended to allow certain parties to acquire more shares than is currently permitted, or if the rights issued thereunder were redeemed, the Northwest Parties could vote all of their shares in their discretion. Certain transfer limitations are imposed on the Northwest Parties during the supplemental period. The Company has granted preemptive rights to a Northwest Party with respect to issuances of Class A common stock and certain issuances of Class B common stock that occur during such period. The Company has agreed to certain limitations upon its ability to amend its charter, bylaws, executive committee charter and rights plan during the term of the supplemental agreement. Following the supplemental period, the supplemental agreement requires the Northwest Parties to take all actions necessary to cause Continental's Board to have at least five independent directors, a majority of whom will be required to approve material transactions between Continental and Northwest or its affiliates, including the amendment, modification or waiver of any provisions of the supplemental agreement or the alliance agreement.
In certain circumstances, particularly in cases where a change in control of the Company could otherwise be caused by another party, Northwest could exercise its voting power so as to delay, defer or prevent a change in control of the Company.
Continental desires to simplify its equity capital structure and is committed to continuing to repurchase outstanding equity. In connection with its stock repurchase program, the Company has held preliminary discussions with Northwest concerning the acquisition by Continental of all the Class A common stock of Continental held by Northwest in a voting trust (8.7 million shares). The Northwest alliance is beneficial to both carriers, and any transaction would be designed to preserve and strengthen the benefits of the alliance. There can be no assurance as to whether a transaction between Continental and Northwest will be agreed to or consummated, nor can Continental predict the structure, form or amount of consideration or other elements of any such transaction.
Risks Regarding Continental/Northwest Alliance. In November 1998, the Company and Northwest began implementing a long-term global alliance involving extensive code-sharing, frequent flyer reciprocity, and other cooperative activities. Implementation of the Northwest Alliance continued throughout 1999 and is continuing in 2000.
Continental's ability to finalize implementation of the Northwest Alliance and to achieve the anticipated benefits is subject to certain risks and uncertainties, including (a) disapproval or delay by regulatory authorities or adverse regulatory developments; (b) competitive pressures, including developments with respect to alliances among other air carriers; (c) customer reaction to the alliance, including reaction to differences in products and benefits provided by Continental and Northwest; (d) economic conditions in the principal markets served by Continental and Northwest; (e) increased costs or other implementation difficulties, including those caused by employees; and (f) Continental's ability to modify certain contracts that restrict certain aspects of the alliance.
The alliance agreement provides that if after four years the Company has not entered into a code share with KLM or is not legally able (but for aeropolitical restrictions) to enter into a new trans-Atlantic joint venture with KLM and Northwest and place its airline code on certain Northwest flights, Northwest can elect to (i) cause good faith negotiations among the Company, KLM and Northwest as to the impact, if any, on the contribution to the joint venture resulting from the absence of the code share, and the Company will reimburse the joint venture for the amount of any loss until it enters into a code share with KLM, or (ii) terminate (subject to cure rights of the Company) after one year's notice any or all of such alliance agreement and any or all of the agreements contemplated thereunder.
On October 23, 1998, the DOJ filed a lawsuit against Northwest and Continental challenging Northwest's acquisition of an interest in Continental. The DOJ did not seek to preliminarily enjoin the transaction before it closed on November 20, 1998, nor is the DOJ challenging the Northwest Alliance at this time, although the DOJ has informed the parties that it continues to investigate certain specific aspects of the alliance. Continental continues to implement its alliance with Northwest. While it is not possible to predict the ultimate outcome of this litigation, management does not believe that it will have a material adverse effect on Continental.
The DOT has continuing jurisdiction to review changes in Continental's ownership and joint venture agreements between major U.S. airlines such as Continental and Northwest. In connection with such reviews, the DOT exempted Continental and Northwest through December 10, 1999, from regulatory approval requirements which the DOT has interpreted to require approval for what it considers de facto route transfers when one U.S. airline holding international route authority acquires control of another U.S. airline holding such authority. The exemption remains in effect pursuant to the Administrative Procedure Act and a renewal application has been submitted to the DOT by Continental and Northwest pending possible further DOT review of the agreements between them to consider whether, in the DOT's view, there has been a de facto route transfer.
If the DOT were to conclude that a de facto route transfer of Continental routes to Northwest were occurring, it would institute a proceeding to determine whether such a transfer was in the public interest. In the past, the DOT has approved numerous transfers, but it has also concluded on occasion that certain overlapping routes in limited-entry markets should not be transferred. In those instances, the DOT has decided those routes should instead become available to other airlines to enhance competition on overlapping routes or between two countries. Continental and Northwest operate overlapping flights on certain limited entry routes and offer service between their primary U.S. hubs and various other countries. If the DOT were to institute a route transfer proceeding, it could consider whether certain of Continental's international routes overlapping with Northwest's on a point-to-point or country-to-country basis should be transferred to Northwest or to another airline. Continental believes that Northwest has not acquired control of Continental, and that there is a significant question as to the DOT's authority to apply a de facto route transfer theory to the current relationship between Northwest and Continental. Continental would vigorously oppose any attempt by the DOT to institute a route transfer proceeding which would consider any reductions in Continental's route authorities.
Risks Factors Relating to the Airline Industry
Competition and Industry Conditions. The airline industry is highly competitive and susceptible to price discounting. Carriers have used discount fares to stimulate traffic during periods of slack demand, to generate cash flow and to increase market share. Some of Continental's competitors have substantially greater financial resources or lower cost structures than Continental.
Airline profit levels are highly sensitive to changes in fuel costs, fare levels and passenger demand. Passenger demand and fare levels have in the past been influenced by, among other things, the general state of the economy (both internationally and domestically), international events, airline capacity and pricing actions taken by carriers. Domestically, from 1990 to 1993, the weak U.S. economy, turbulent international events and extensive price discounting by carriers contributed to unprecedented losses for U.S. airlines. In the last several years, the U.S. economy has improved and excessive price discounting has abated. Recently, industry capacity and growth in the transatlantic markets have resulted in lower yields and revenue per available seat mile in those markets. Continental cannot predict the extent to which these industry conditions will continue.
In recent years, the major U.S. airlines have sought to form marketing alliances with other U.S. and foreign air carriers. Such alliances generally provide for "code-sharing", frequent flyer reciprocity, coordinated scheduling of flights of each alliance member to permit convenient connections and other joint marketing activities. Such arrangements permit an airline to market flights operated by other alliance members as its own. This increases the destinations, connections and frequencies offered by the airline, which provide an opportunity to increase traffic on its segment of flights connecting with its alliance partners. The Northwest Alliance is an example of such an arrangement, and Continental has existing alliances with numerous other air carriers. Other major U.S. airlines have alliances or planned alliances more extensive than Continental's. Continental cannot predict the extent to which it will benefit from its alliances or be disadvantaged by competing alliances.
Regulatory Matters. Airlines are subject to extensive regulatory and legal compliance requirements that engender significant costs. In the last several years, the FAA has issued a number of directives and other regulations relating to the maintenance and operation of aircraft that have required significant expenditures. Some FAA requirements cover, among other things, retirement of older aircraft, security measures, collision avoidance systems, airborne windshear avoidance systems, noise abatement, commuter aircraft safety and increased inspections and maintenance procedures to be conducted on older aircraft. Continental expects to continue incurring expenses in complying with the FAA's regulations.
Additional laws, regulations, taxes and airport rates and charges have been proposed from time to time that could significantly increase the cost of airline operations or reduce revenues. For instance, "passenger bill of rights" legislation has been introduced in Congress that would, among other things, require the payment of compensation to passengers as a result of certain delays, and limit the ability of carriers to prohibit or restrict usage of certain tickets in manners currently prohibited or restricted. The DOT has proposed rules that would significantly limit major carriers' ability to compete with new entrant carriers. If adopted, these measures could have the effect of raising ticket prices, reducing revenue and increasing costs. Restrictions on the ownership and transfer of airline routes and takeoff and landing slots have also been proposed. See "Industry Regulation and Airport Access" above. The ability of U.S. carriers to operate international routes is subject to change because the applicable arrangements between the United States and foreign governments may be amended from time to time, or because appropriate slots or facilities are not made available. Continental cannot provide assurance that laws or regulations enacted in the future will not adversely affect it.
Seasonal Nature of Airline Business; Other. Due to greater demand for air travel during the summer months, revenue in the airline industry in the second and third quarters of the year is generally stronger than revenue in the first and fourth quarters of the year for most U.S. air carriers. Continental's results of operations generally reflect this seasonality, but have also been impacted by numerous other factors that are not necessarily seasonal, including the extent and nature of competition from other airlines, fare wars, excise and similar taxes, changing levels of operations, fuel prices, weather, air traffic control delays, foreign currency exchange rates and general economic conditions.
ITEM 2.
ITEM 2. PROPERTIES.
Flight Equipment
As shown in the following table, Continental's (including CMI's) jet aircraft fleet (excluding regional jets) consisted of 363 jets at December 31, 1999.
The table above excludes four all-cargo 727 CMI aircraft and one A300, three 747, three DC-9-30, three DC-10-30 and two 727 Continental aircraft that have been removed from service.
A majority of the aircraft and engines owned by Continental are subject to mortgages.
The FAA adopted rules pursuant to the Airport Noise and Capacity Act of 1990 that required a scheduled phase-out of Stage 2 aircraft during the 1990s. Aircraft operating outside the U.S. are exempt from the phase-out. With the exception of five 727 aircraft operated by CMI, Continental's jet fleet was composed of all Stage 3 aircraft at December 31, 1999.
During 1999, Continental put into service a total of 61 new Boeing aircraft which consisted of 20 737-700 aircraft, 27 737-800 aircraft, six 757-200 aircraft and eight 777-200 aircraft. The Company anticipates taking delivery of 28 new Boeing aircraft and retiring 11 DC-10-30, five 727-200 and three MD-80 aircraft in 2000.
As of December 31, 1999, Express operated a fleet of 147 aircraft, as follows:
The table above excludes one EMB-120 owned by the Company but removed from service.
During 1999, Express took delivery of 21 ERJ-145 aircraft and six ERJ-135 aircraft. Also, Express put into service one ATR 42-320 previously subleased. Express anticipates taking delivery of another 15 ERJ-145 aircraft and 12 new ERJ-135 aircraft in 2000.
During December 1999, under a sale and leaseback agreement with Gulfstream, Express sold 25 Beech 1900-D aircraft to Gulfstream in exchange for Gulfstream's assumption of $81 million in debt. Express is leasing these aircraft from Gulfstream for periods ranging from eight to 23 months.
See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Commitments" for a discussion of the Company's order for new firm commitment aircraft and related financing arrangements.
Facilities
The Company's principal facilities are located at Newark, Bush Intercontinental in Houston, Hopkins International in Cleveland and A.B. Won Pat International Airport in Guam. All these facilities, as well as substantially all of Continental's other facilities, are leased on a long-term, net-rental basis, and Continental is responsible for maintenance, taxes, insurance and other facility- related expenses and services. In certain locations, Continental owns hangars and other facilities on land leased on a long-term basis, which facilities will become the property of the lessor on termination of the lease. At each of its three domestic hub cities and most other locations, Continental's passenger and baggage handling space is leased directly from the airport authority on varying terms dependent on prevailing practice at each airport.
In July 1996, the Company announced plans to expand its gates and related facilities into Terminal B at Bush Intercontinental, as well as planned improvements at Terminal C and the construction of a new automated people mover system linking Terminal B and Terminal C. The majority of the Company's expansion project has been completed. In April 1997 and January 1999, the City of Houston completed the offering of $190 million and $46 million, respectively, aggregate principal amount of tax-exempt special facilities revenue bonds (the "IAH Bonds") to finance such expansion and improvements. The IAH Bonds are unconditionally guaranteed by Continental. In connection therewith, the Company has entered into long-term leases (or amendments to existing leases) with the City of Houston providing for the Company to make rental payments sufficient to service the related tax-exempt bonds, which have a term no longer than 30 years.
Continental substantially completed the expansion of its facilities at Hopkins International in the third quarter of 1999. The expansion, which included a new jet concourse for the regional jet service offered by Express, as well as other facility improvements, cost approximately $156 million and was funded principally by a combination of tax-exempt special facilities revenue bonds (issued in March 1998) and general airport revenue bonds (issued in December 1997) by the City of Cleveland, Ohio (the "City of Cleveland"). Continental has unconditionally guaranteed the special facilities revenue bonds and has entered into a long-term lease with the City of Cleveland under which rental payments will be sufficient to service the related bonds.
In September 1999, the City of Cleveland completed the issuance of $71 million aggregate principal amount of tax-exempt bonds. The bond proceeds were used to refinance $75 million aggregate principal amount in bonds originally issued by the City of Cleveland in 1990 for the purpose of constructing certain terminal and other improvements at Hopkins International. Continental has unconditionally guaranteed the bonds and has a long-term lease with the City of Cleveland under which rental payments will be sufficient to service the related bonds, which have a term of 20 years. Continental estimates that it will save approximately $44 million in debt service payments over the 20-year term as a result of the refinancing.
Also in September 1999, the New Jersey Economic Development Authority completed the offering of $730 million aggregate principal amount of tax-exempt special facility revenue bonds to finance a portion of Continental's Global Gateway Program at Newark International Airport. Major construction began in the third quarter of 1999 and is scheduled to be completed in 2002. The program includes construction of a new concourse in Terminal C and other facility improvements. Continental has unconditionally guaranteed the bonds and has entered into a long-term lease with the New Jersey Economic Development Authority under which rental payments will be sufficient to service the related bonds, which have a term of 30 years.
The Company has lease agreements with the City and County of Denver covering several support facilities at Denver International Airport. The facilities exceed Continental's needs at the airport and the Company has subleased a portion of the space.
The Company has cargo facilities at Los Angeles International Airport. In July 1996, the Company subleased such facilities to another carrier. If such carrier fails to comply with its obligations under the sublease, the Company would be required to perform those obligations.
Continental also maintains administrative offices, airport and terminal facilities, training facilities and other facilities related to the airline business in the cities it serves.
Continental remains contingently liable until December 1, 2015, on $202 million of long-term lease obligations of US Airways related to the East End Terminal at LaGuardia. If US Airways defaulted on these obligations, Continental could be required to cure the default, at which time it would have the right to occupy the terminal.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Antitrust Litigation
United States of America v. Northwest Airlines Corp. & Continental Airlines, Inc., in the United States District Court for the Eastern District of Michigan, Southern Division. In this litigation, the Antitrust Division of the DOJ is challenging under Section 7 of the Clayton Act and Section 1 of the Sherman Act the acquisition by Northwest of shares of Continental's Class A common stock bearing, together with certain shares for which Northwest has a limited proxy, more than 50% of the fully diluted voting power of all Continental stock. The government's position is that, notwithstanding various agreements that restrict Northwest's ability to exercise voting control over Continental and are designed to assure Continental's competitive independence, Northwest's control of the Class A common stock will reduce actual and potential competition in various ways and in a variety of markets. The government seeks an order requiring Northwest to divest all voting stock in Continental on terms and conditions as may be agreed to by the government and the Court. No specific relief is sought against Continental. Trial is currently set for October 2000.
Environmental Proceedings
Under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (commonly known as "Superfund") and similar state environment cleanup laws, generators of waste disposed of at designated sites may, under certain circumstances, be subject to joint and several liability for investigation and remediation costs. The Company (including its predecessors) has been identified as a potentially responsible party at four federal and two state sites that are undergoing or have undergone investigation or remediation. The Company has entered into a settlement agreement with the Environmental Protection Agency ("EPA") with respect to the four federal sites. The settlement agreement provides for EPA to receive an allowed unsecured claim of approximately $1.3 million under the Company's Plan of Reorganization (subject to approval of the Bankruptcy Court) and approximately $230,000 in cash, in full satisfaction of any and all of the Company's liabilities relating to such sites. With respect to the state sites, the Company believes that, although applicable case law is evolving and some cases may be interpreted to the contrary, some or all of any liability claims associated with these sites were discharged by confirmation of the Company's Plan of Reorganization, principally because the Company's exposure is based on alleged offsite disposal known as of the date of confirmation. Even if any such claims were not discharged, on the basis of currently available information, the Company believes that its potential liability for its allocable share of the cost to remedy each site (to the extent the Company is found to have liability) is not, in the aggregate, material; however, the Company has not been designated a "de minimis" contributor at any of such sites.
The Company is also and may from time to time become involved in other environmental matters, including the investigation and/or remediation of environmental conditions at properties used or previously used by the Company. Although the Company is not currently subject to any environmental cleanup orders imposed by regulatory authorities, it is undertaking voluntary investigation or remediation at certain properties in consultation with such authorities. The full nature and extent of any contamination at these properties and the parties responsible for such contamination have not been determined, but based on currently available information, the Company does not believe that any environmental liability associated with such properties will have a material adverse effect on the Company.
General
Various other claims and lawsuits against the Company are pending that are of the type generally consistent with the Company's business. The Company cannot at this time reasonably estimate the possible loss or range of loss that could be experienced if any of the claims were successful. Typically, such claims and lawsuits are covered in whole or in part by insurance. The Company does not believe that the foregoing matters will have a material adverse effect on the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Continental's common stock trades on the New York Stock Exchange. The table below shows the high and low sales prices for the Company's Class B common stock and Class A common stock as reported on the New York Stock Exchange during 1998 and 1999.
As of January 21, 2000, there were approximately 14,774 and 2,893 holders of record of Continental's Class B common stock and Class A common stock, respectively.
The Company has paid no cash dividends on its common stock and has no current intention of paying cash dividends on its common stock. During 1999, the Company's Board of Directors increased the size of its common stock repurchase program by $900 million, bringing the total size of the program to $1.2 billion. In addition, the Company's Board of Directors has also authorized the Company to use up to one-half of its 2000 and later adjusted net income, and all of the net proceeds of future sales of non-strategic assets, for additional stock repurchases. As of January 21, 2000, the Company has repurchased 18,853,600 Class B common shares for $804 million since the inception of the repurchase program in March 1998. Certain of the Company's credit agreements and indentures restrict the ability of the Company and certain of its subsidiaries to pay cash dividends or repurchase capital stock by imposing minimum unrestricted cash requirements on the Company, limiting the amount of such dividends and repurchases when aggregated with certain other payments or distributions and requiring that the Company comply with other covenants specified in such instruments.
The Company's Certificate of Incorporation provides that no shares of capital stock may be voted by or at the direction of persons who are not United States citizens unless such shares are registered on a separate stock record. The Company's Bylaws further provide that no shares will be registered on such separate stock record if the amount so registered would exceed United States foreign ownership restrictions. United States law currently requires that no more than 25% of the voting stock of the Company (or any other domestic airline) may be owned directly or indirectly by persons who are not citizens of the United States.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The table on the following page sets forth certain consolidated financial data of the Company at December 31, 1999, 1998, 1997, 1996 and 1995 and for each of the five years in the period ended December 31, 1999.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion may contain forward-looking statements. In connection therewith, please see the cautionary statements contained in Item 1. "Business - Risk Factors Relating to the Company" and "Business - Risk Factors Relating to the Airline Industry" which identify important factors that could cause actual results to differ materially from those in the forward-looking statements. Hereinafter, the terms "Continental" and the "Company" refer to Continental Airlines, Inc. and its subsidiaries, unless the context indicates otherwise.
Continental's results of operations are impacted by seasonality (the second and third quarters are generally stronger than the first and fourth quarters) as well as numerous other factors that are not necessarily seasonal, including the extent and nature of competition from other airlines, employee job actions (including at other airlines), fare sale activities, excise and similar taxes, changing levels of operations and capacity, fuel prices, weather, air traffic control delays, foreign currency exchange rates, changes in regulations and aviation treaties and general economic conditions. Recently, jet fuel prices have increased dramatically. If high fuel costs continue without an improvement in the revenue environment, the Company may not post a profit in the first quarter of 2000. In addition, industry capacity and growth in the transatlantic markets (including block space arrangements where Continental is obligated to purchase capacity at a fixed price) have resulted in lower yields and revenue per available seat mile in those markets, which trend is expected to continue in 2000. Although the results in Asia of Continental Micronesia, Inc. ("CMI"), a wholly owned subsidiary of the Company, have declined in recent years, the Company successfully redeployed CMI capacity into stronger domestic markets and CMI's recent results continue to improve. Continental will continue to critically review its growth plans in light of industry conditions and will adjust or redeploy resources, including aircraft capacity, as necessary, similar to its recent decision to accelerate the retirement of certain DC-10- 30 aircraft and replace them with narrowbody aircraft on certain transatlantic routes. In addition, management believes the Company is well positioned to respond to market conditions in the event of a sustained economic downturn for the following reasons: underdeveloped hubs with strong local traffic; a flexible fleet plan; a strong cash balance, a $225 million unused revolving credit facility and a well developed alliance network.
Results of Operations
The following discussion provides an analysis of the Company's results of operations and reasons for material changes therein for the three years ended December 31, 1999.
Comparison of 1999 to 1998. The Company recorded consolidated net income of $455 million and $383 million for the years ended December 31, 1999 and 1998, respectively. Net income in 1999 was significantly impacted by several non-recurring items, including a $182 million gain on the sale of the Company's interest in AMADEUS Global Travel Distribution S.A. ("AMADEUS") ($297 million pre-tax), a $50 million fleet disposition/impairment loss ($81 million pre- tax) related to the early retirement of several DC-10-30's and other items, the cumulative effect of accounting changes ($33 million, net of taxes) related to the write-off of pilot training costs and a change in the method of accounting for the sale of mileage credits to participating partners in the Company's frequent flyer program, a $20 million gain ($33 million pre-tax) on the sale of a portion of the Company's interest in Equant N.V. ("Equant") and a $3 million loss ($4 million pre-tax) on the sale of the Company's warrants to purchase common stock of priceline.com, Inc. ("Priceline"). Net income in 1998 was significantly impacted by a $77 million ($122 million pre-tax) fleet disposition/ impairment loss resulting from the Company's decision to accelerate the retirement of certain jet and turboprop aircraft.
Passenger revenue increased 8.9%, $660 million, during 1999 as compared to 1998. The increase was due to an 11.3% increase in revenue passenger miles, partially offset by a 3.3% decrease in yield. Both yield pressures in the transatlantic markets and a 6.7% increase in average stage length negatively impacted yield.
Cargo and mail revenue increased 10.2%, $28 million, in 1999 as compared to 1998 due to increased domestic and international volumes and new markets added in 1999.
Other operating revenue increased 12.2%, $24 million, in 1999 compared to the prior year primarily due to an increase in fees charged to customers to change advance purchase tickets and also due to an increase in Presidents Club revenue as a result of a larger number of these airport private clubs.
Wages, salaries and related costs increased 13.2%, $292 million, during 1999 as compared to 1998, primarily due to an 8.3% increase in average full-time equivalent employees to support increased flying and higher wage rates resulting from the Company's decision to increase employee wages to industry standard by the year 2000.
Aircraft fuel expense increased 6.1%, $44 million, in 1999 as compared to the prior year. The average price per gallon increased 1.0% from 46.83 cents in 1998 to 47.31 cents in 1999. This increase is net of gains of approximately $105 million recognized during 1999 related to the Company's fuel hedging program. See "Fuel Hedging" below. In addition, the quantity of jet fuel used increased 3.7% principally reflecting increased capacity offset in part by the increased fuel efficiency of the Company's younger fleet.
Aircraft rentals increased 17.0%, $112 million, during 1999 as compared to 1998, due to the delivery of new aircraft.
Commissions expense decreased 1.2%, $7 million, during 1999 as compared to 1998 due to lower rates resulting from international commission caps and a lower volume of commissionable sales, partially offset by increased passenger revenue.
Other rentals and landing fees increased 20.0%, $83 million, primarily due to higher facilities rent due to increased rates and volume and higher landing fees resulting from increased operations.
Depreciation and amortization expense increased 22.4%, $66 million, in 1999 compared to 1998 primarily due to the addition of new aircraft and related spare parts. These increases were partially offset by approximately a $5 million reduction in the amortization of routes, gates and slots resulting from the recognition of previously unbenefitted net operating losses ("NOLs") during 1998.
During the fourth quarter of 1999, the Company made the decision to accelerate the retirement of six DC-10-30 aircraft and other items in 1999 and the first half of 2000 and to dispose of related excess inventory. The DC-10-30's will be replaced by Boeing 757 and Boeing 737-800 aircraft on certain routes, and by Boeing 777 aircraft on other routes. In addition, the market value of certain Boeing 747 aircraft no longer operated by the Company has declined. As a result of these items and certain other fleet-related items, the Company recorded a fleet disposition/impairment loss of $81 million in the fourth quarter of 1999.
Approximately $52 million of the $81 million charge relates to the impairment of owned or capital leased aircraft and related inventory held for disposal with a carrying amount of $77 million. The remaining $29 million of the charge relates primarily to costs expected to be incurred related to the return of leased aircraft. As of December 31, 1999, the remaining accrual for the 1999 fleet disposition/impairment loss totaled $12 million. The Company expects to finance the cash outlays primarily with internally generated funds.
Other operating expense increased 14.9%, $243 million, in 1999 as compared to the prior year, primarily as a result of increases in passenger services expense, aircraft servicing expense, reservations and sales expense and other miscellaneous expense, principally due to a 9.7% increase in available seat miles.
Interest expense increased 30.9%, $55 million, due to an increase in long-term debt resulting from the purchase of new aircraft and $200 million of 8% unsecured senior notes issued in December 1998, partially offset by interest savings of $9 million due to the conversion of the Company's 6-3/4% Convertible Subordinated Notes into Class B common stock.
Interest income increased 20.3%, $12 million, due to higher average balances of cash, cash equivalents and short-term investments and due to higher rates.
The Company's other nonoperating income (expense) in 1999 includes a $33 million gain on the sale of a portion of the Company's interest in Equant, partially offset by foreign currency losses of $13 million, losses on equity investments of $7 million and a $4 million loss on the sale of the Company's warrants to purchase common stock of Priceline. Other nonoperating income (expense) in 1998 included a $6 million gain on the sale of certain stock of America West Holdings Corporation ("America West Holdings").
Comparison of 1998 to 1997. The Company recorded consolidated net income of $383 million and $385 million for the years ended December 31, 1998 and 1997 (including special charges), respectively. Net income in 1998 was significantly impacted by a $77 million ($122 million pre-tax) fleet disposition/impairment loss resulting from the Company's decision to accelerate the retirement of certain jet and turboprop aircraft. Management believes that the Company benefitted in the first quarter of 1997 from the expiration of the aviation trust fund tax (the "ticket tax"). The ticket tax was reinstated on March 7, 1997. Management believes that the ticket tax has a negative impact on the Company, although neither the amount of such negative impact directly resulting from the reimposition of the ticket tax, nor the benefit realized by its previous expiration, can be precisely determined.
Passenger revenue increased 10.7%, $723 million, during 1998 as compared to 1997. The increase was due to a 12.5% increase in revenue passenger miles, partially offset by a 2.4% decrease in yield. The decrease in yield was due to lower industry-wide fare levels and an 8% increase in average stage length.
Cargo and mail increased 6.6%, $17 million, due to an increase in freight revenue resulting from strong international volumes and strong growth in Continental's express delivery service.
Wages, salaries and related costs increased 22.3%, $404 million, during 1998 as compared to 1997, primarily due to an 11.2% increase in average full-time equivalent employees to support increased flying and higher wage rates resulting from the Company's decision to increase employee wages to industry standards by the year 2000.
Aircraft fuel expense decreased 17.9%, $158 million, in 1998 as compared to the prior year. The average price per gallon decreased 25.6% from 62.91 cents in 1997 to 46.83 cents in 1998. This reduction was partially offset by a 9.6% increase in the quantity of jet fuel used principally reflecting increased capacity.
Aircraft rentals increased 19.6%, $108 million, during 1998 as compared to 1997, due primarily to the delivery of new leased aircraft.
Maintenance, materials and repairs increased 8.4%, $45 million, during 1998 as compared to 1997. Aircraft maintenance expense in the second quarter of 1997 was reduced by $16 million due to the reversal of reserves that were no longer required as a result of the acquisition of 10 aircraft previously leased by the Company. In addition, maintenance expense increased due to the overall increase in flight operations offset by newer aircraft and the volume and timing of engine overhauls as part of the Company's ongoing maintenance program.
Depreciation and amortization expense increased 15.7%, $40 million, in 1998 compared to 1997 primarily due to the addition of new aircraft and related spare parts. These increases were partially offset by an approximate $18 million reduction in the amortization of reorganization value in excess of amounts allocable to identifiable assets and routes, gates and slots resulting from the recognition of previously unbenefitted NOLs.
In August 1998, Continental announced that CMI would accelerate the retirement of its four Boeing 747 aircraft by April 1999 and its remaining thirteen Boeing 727 aircraft by December 2000. The Boeing 747s were replaced by DC-10-30 aircraft and the Boeing 727 aircraft were replaced with a reduced number of Boeing 737 aircraft. In addition, Continental Express, Inc. ("Express"), a wholly owned subsidiary of the Company, announced that it would accelerate the retirement of certain turboprop aircraft by December 2000, including its fleet of 32 Embraer 120 turboprop aircraft, as regional jets are acquired to replace turboprops. As a result of its decision to accelerate the retirement of these aircraft, Continental recorded a fleet disposition/impairment loss of $77 million ($122 million pre-tax) in the third quarter of 1998.
Other operating expense increased 10.3%, $152 million, in 1998 as compared to the prior year, primarily as a result of increases in passenger and aircraft servicing expense, reservations and sales expense and other miscellaneous expense, primarily due to the 10.6% increase in available seat miles.
Interest expense increased 7.2%, $12 million, due to an increase in long-term debt resulting from the purchase of new aircraft.
Interest capitalized increased 57.1%, $20 million, due to increased capital spending and a higher average balance of purchase deposits for flight equipment.
The Company's other nonoperating income (expense) in 1998 included a $6 million gain on the sale of America West Holdings stock.
Certain Statistical Information
An analysis of statistical information for Continental's jet operations, excluding regional jets operated by Express, for each of the three years in the period ended December 31, 1999 is as follows:
_______________
Continental has entered into block space arrangements with certain other carriers whereby one or both of the carriers is obligated to purchase capacity on the other. The table above excludes 2.6 billion, 1.9 billion and 738 million available seat miles, together with related revenue passenger miles and enplanements, operated by Continental but purchased and marketed by the other carriers in 1999, 1998 and 1997, respectively, and includes 1.0 billion and 358 million available seat miles, together with related revenue passenger miles and enplanements, operated by other carriers but purchased and marketed by Continental in 1999 and 1998, respectively.
(1) The number of scheduled miles flown by revenue passengers. (2) The number of seats available for passengers multiplied by the number of scheduled miles those seats are flown. (3) Revenue passenger miles divided by available seat miles. (4) The percentage of seats that must be occupied by revenue passengers in order for the airline to break even on an income before income taxes basis, excluding nonrecurring charges, nonoperating items and other special items. (5) 1999 and 1998 exclude fleet disposition/impairment losses totaling $81 million and $122 million, respectively. (6) The average revenue received for each mile a revenue passenger is carried. (7) The average number of hours per day that an aircraft flown in revenue service is operated (from gate departure to gate arrival). (8) Excludes all-cargo 727 aircraft (four in 1999 and six in 1998 and 1997) at CMI.
Liquidity and Capital Resources
During 1999, the Company completed a number of transactions intended to strengthen its long-term financial position and enhance earnings:
In February 1999, the Company completed an offering of $806 million of pass-through certificates used to finance (either through leveraged leases or secured debt financings) the debt portion of the acquisition cost of 22 aircraft delivered in 1999.
In March 1999, the Company completed a $160 million Credit Facility, with a maturity date of March 2001, to finance pre- delivery deposits for certain new Boeing aircraft to be delivered between March 1999 and March 2002.
In April 1999, the Company exercised its right and called for redemption in May 1999, all $230 million of its 6-3/4% Convertible Subordinated Notes due 2006. The notes were converted into 7.6 million shares of Class B common stock during May 1999.
Also, in June 1999, the Company completed an offering of $742 million of pass-through certificates used to finance (either through leveraged leases or secured debt financings) the debt portion of the acquisition cost of 21 new Boeing aircraft delivered in 1999.
In October 1999, Continental sold its interest in AMADEUS for $409 million, including a special dividend.
During 1999, the Company's Board of Directors increased the size of its common stock repurchase program by $900 million, bringing the total size of the program to $1.2 billion. As of January 21, 2000, the Company has repurchased 18,853,600 Class B common shares for $804 million since the inception of the program in March of 1998.
As of December 31, 1999, Continental had approximately $3.4 billion (including current maturities) of long-term debt and capital lease obligations, and had approximately $1.6 billion of common stockholders' equity, a ratio of 2.1 to 1, at both December 31, 1999 and 1998.
As of December 31, 1999, the Company had $1.6 billion in cash and cash equivalents and short-term investments, compared to $1.4 billion as of December 31, 1998. Net cash provided by operating activities decreased $100 million during the year ended December 31, 1999 compared to the same period in the prior year primarily due to a decrease in operating income. Net cash used by investing activities for the year ended December 31, 1999 compared to the same period in the prior year decreased $39 million, primarily due to proceeds received from the sale of AMADEUS and increased proceeds received from the sale of equipment offset by the purchase of short-term investments in 1999. Net cash used by financing activities increased $514 million primarily due to an increase in the purchase of the Company's Class B common stock and a decrease in proceeds received from the issuance of long-term debt.
Continental has unused lines of credit totaling $225 million. A significant amount of Continental's assets are encumbered.
Deferred Tax Assets. As of December 31, 1999, the Company had deferred tax assets aggregating $611 million, including $266 million of NOLs, and a valuation allowance of $263 million.
As a result of NOLs, the Company will not pay United States federal income taxes (other than alternative minimum tax) until it has recorded approximately an additional $700 million of taxable income following December 31, 1999. Section 382 of the Internal Revenue Code ("Section 382") imposes limitations on a corporation's ability to utilize NOLs if it experiences an "ownership change". In general terms, an ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. In the event that an ownership change should occur, utilization of Continental's NOLs would be subject to an annual limitation under Section 382 determined by multiplying the value of the Company's stock at the time of the ownership change by the applicable long-term tax exempt rate (which was 5.72% for December 1999). Any unused annual limitation may be carried over to later years, and the amount of the limitation may under certain circumstances be increased by the built-in gains in assets held by the Company at the time of the change that are recognized in the five-year period after the change. Under current conditions, if an ownership change were to occur, Continental's annual NOL utilization would be limited to approximately $172 million per year other than through the recognition of future built-in gain transactions.
On November 20, 1998, an affiliate of Northwest Airlines, Inc. completed its acquisition of certain equity of the Company previously held by Air Partners, L.P. and its affiliates, together with certain Class A common stock of the Company held by certain other investors, totaling 8,661,224 shares of the Class A common stock (the "Air Partners Transaction"). The Company does not believe that the Air Partners Transaction resulted in an ownership change for purposes of Section 382.
Purchase Commitments. Continental has substantial commitments for capital expenditures, including for the acquisition of new aircraft. As of January 14, 2000, Continental had agreed to acquire a total of 74 Boeing jet aircraft through 2005. The Company anticipates taking delivery of 28 Boeing jet aircraft in 2000. Continental also has options for an additional 118 aircraft (exercisable subject to certain conditions). The estimated aggregate cost of the Company's firm commitments for Boeing aircraft is approximately $4 billion. Continental currently plans to finance its new Boeing aircraft with a combination of enhanced pass through trust certificates, lease equity and other third-party financing, subject to availability and market conditions. Continental has commitments or letters of intent for backstop financing for approximately 18% of the anticipated remaining acquisition cost of future Boeing deliveries. In addition, at January 14, 2000, Continental has firm commitments to purchase 34 spare engines related to the new Boeing aircraft for approximately $219 million which will be deliverable through March 2005. However, further financing will be needed to satisfy the Company's capital commitments for other aircraft and aircraft-related expenditures such as engines, spare parts, simulators and related items. There can be no assurance that sufficient financing will be available for all aircraft and other capital expenditures not covered by firm financing commitments. Deliveries of new Boeing aircraft are expected to increase aircraft rental, depreciation and interest costs while generating cost savings in the areas of maintenance, fuel and pilot training.
As of January 14, 2000, Express had firm commitments for 43 Embraer ERJ-145 ("ERJ-145") regional jets and 19 Embraer ERJ-135 ("ERJ- 135") regional jets, with options for an additional 100 ERJ-145 and 50 ERJ-135 aircraft exercisable through 2008. Express anticipates taking delivery of 15 ERJ-145 and 12 ERJ-135 regional jets in 2000. Neither Express nor Continental will have any obligation to take any of the firm ERJ-145 or ERJ-135 aircraft that are not financed by a third party and leased to Continental.
Continental expects its cash outlays for 2000 capital expenditures, exclusive of fleet plan requirements, to aggregate $207 million, primarily relating to software application and automation infrastructure projects, aircraft modifications and mandatory maintenance projects, passenger terminal facility improvements and office, maintenance, telecommunications and ground equipment. Continental's capital expenditures during 1999 aggregated $213 million, exclusive of fleet plan requirements.
The Company expects to fund its future capital commitments through internally generated funds together with general Company financings and aircraft financing transactions. However, there can be no assurance that sufficient financing will be available for all aircraft and other capital expenditures not covered by firm financing commitments.
Continental has certain block-space arrangements whereby it is committed to purchase capacity on other carriers at an aggregate cost of approximately $159 million per year. These arrangements are currently scheduled to expire over the next eight years. Pursuant to other block-space arrangements, other carriers are committed to purchase capacity at a cost of approximately $95 million per year on Continental.
Year 2000. The Year 2000 issue arose as a result of computer programs having been written using two digits (rather than four) to define the applicable year, among other problems. Any information technology ("IT") systems with time-sensitive software might recognize a date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations and system failures. The problem could also extend to many "non-IT" systems; that is, operating and control systems that rely on embedded chip systems. In addition, the Company was at risk from Year 2000 failures on the part of third party-suppliers and governmental agencies with which the Company interacts.
The Company uses a significant number of computer software programs and embedded operating systems that are essential to its operations. For this reason, the Company implemented a Year 2000 project in late 1995 so that the Company's computer systems would function properly in the year 2000 and thereafter. The Company's Year 2000 project involved the review of a number of internal and third-party systems. Each system was subjected to the project's five phases which consisted of systems inventory, evaluation and analysis, modification implementation, user testing and integration compliance. The Company completed its system review and made certain modifications to its existing software and systems and/or conversions to new software. As a result, the Year 2000 issue did not pose any operational problems.
The Company completed its extensive communications and on-site visits with its significant suppliers, vendors and governmental agencies with which its systems interface and exchange data or upon which its business depends. The Company coordinated efforts with these parties to minimize the extent to which its business would be vulnerable to their failure to remediate their own Year 2000 problems. The Company's business is dependent upon certain domestic and foreign governmental organizations or entities such as the Federal Aviation Administration that provide essential aviation industry infrastructure. The systems of such third parties on which Continental relies did not pose significant operational problems for the Company. Management updated its day-to-day operational contingency plans for possible Year 2000-specific operational requirements. Although passenger travel was lower in the latter part of December and early January due in part, the Company believes, to Year 2000 concerns, the Company does not believe that it has continued exposure to the Year 2000 issue.
The total cost of the Company's Year 2000 project (excluding internal payroll) was $20 million and was funded through cash from operations. In addition, the Company estimates that the negative revenue impact in the latter part of December and early January attributable to the Year 2000 concerns approximated $20 million and $10 million, respectively. The cost of the Year 2000 project was limited by the substantial outsourcing of the Company's systems and the significant implementation of new systems since 1993.
Bond Financings. In July 1996, the Company announced plans to expand its gates and related facilities into Terminal B at Bush Intercontinental Airport, as well as planned improvements at Terminal C and the construction of a new automated people mover system linking Terminal B and Terminal C. The majority of the Company's expansion project has been completed. In April 1997 and January 1999, the City of Houston completed the offering of $190 million and $46 million, respectively, aggregate principal amount of tax-exempt special facilities revenue bonds (the "IAH Bonds") to finance such expansion and improvements. The IAH Bonds are unconditionally guaranteed by Continental. In connection therewith, the Company has entered into long-term leases (or amendments to existing leases) with the City of Houston providing for the Company to make rental payments sufficient to service the related tax-exempt bonds, which have a term no longer than 30 years.
Continental substantially completed the expansion of its facilities at its Hopkins International Airport hub in Cleveland in the third quarter of 1999. The expansion, which included a new jet concourse for the regional jet service offered by Express, as well as other facility improvements, cost approximately $156 million and was funded principally by a combination of tax-exempt special facilities revenue bonds (issued in March 1998) and general airport revenue bonds (issued in December 1997) by the City of Cleveland, Ohio (the "City of Cleveland"). Continental has unconditionally guaranteed the special facilities revenue bonds and has entered into a long-term lease with the City of Cleveland under which rental payments will be sufficient to service the related bonds.
In September 1999, the City of Cleveland completed the issuance of $71 million aggregate principal amount of tax-exempt bonds. The bond proceeds were used to refinance $75 million aggregate principal amount in bonds originally issued by the City of Cleveland in 1990 for the purpose of constructing certain terminal and other improvements at Cleveland Hopkins International Airport. Continental has unconditionally guaranteed the bonds and has a long-term lease with the City of Cleveland under which rental payments will be sufficient to service the related bonds, which have a term of 20 years. Continental estimates that it will save approximately $44 million in debt service payments over the 20-year term as a result of the refinancing.
Also, in September 1999, the New Jersey Economic Development Authority completed the offering of $730 million aggregate principal amount of tax-exempt special facility revenue bonds to finance a portion of Continental's Global Gateway Program at Newark International Airport. Major construction began in the third quarter of 1999 and is scheduled to be completed in 2002. The program includes construction of a new concourse in Terminal C and other facility improvements. Continental has unconditionally guaranteed the bonds and has entered into a long-term lease with the New Jersey Economic Development Authority under which rental payments will be sufficient to service the related bonds, which have a term of 30 years.
Employees. In September 1997, the Company announced a plan to bring all employees to industry standard wages no later than the end of the year 2000. Wage increases began in 1997, and will continue to be phased in through 2000. The Company is in the process of formulating a plan to bring employees to industry standard benefits over a multi-year period.
The following is a table of the Company's, Express's and CMI's principal collective bargaining agreements, and their respective amendable dates:
In February 2000, the Company announced a 54-month tentative collective bargaining agreement with its Continental Airlines flight attendants. The agreement is subject to ratification by the Continental Airlines flight attendants. In September 1999, Express and the IAM began collective bargaining negotiations to amend the Express flight attendants' contract (which became amendable in November 1999). The Company believes that mutually acceptable agreements can be reached with such employees, although the ultimate outcome of the negotiations is unknown at this time.
The other employees of Continental, Express and CMI are not covered by collective bargaining agreements.
Other. The Department of Transportation has proposed the elimination of slot restrictions at high density airports other than Ronald Reagan Washington National Airport in Washington, D.C. Legislation containing a similar proposal, which could eliminate slots as early as 2002 at O'Hare International Airport in Chicago and 2007 at LaGuardia Airport and John F. Kennedy International Airport in New York has passed the full House of Representatives and the full Senate and is currently being considered by a conference committee. The Company cannot predict whether any of these proposals will be adopted. However, if legislation or regulation eliminating slots were adopted, the value of such slots could be deemed to be permanently impaired, resulting in a loss being charged to earnings for the relevant period. Moreover, the elimination of slots could have an adverse effect upon future results of operations of the Company. At December 31, 1999, the net book value of slots at these three airports was $64 million.
Management believes that the Company's costs are likely to be affected in the future by (i) higher aircraft ownership costs as new aircraft are delivered, (ii) higher wages, salaries, benefits and related costs as the Company compensates its employees comparable to industry average, (iii) changes in the costs of materials and services (in particular, the cost of fuel, which can fluctuate significantly in response to global market conditions), (iv) changes in distribution costs and structure, (v) changes in governmental regulations and taxes affecting air transportation and the costs charged for airport access, including new security requirements, (vi) changes in the Company's fleet and related capacity and (vii) the Company's continuing efforts to reduce costs throughout its operations, including reduced maintenance costs for new aircraft, reduced distribution expense from using Continental's electronic ticket product, E-Ticket and the internet for bookings, and reduced interest expense.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk Sensitive Instruments and Positions
The Company is subject to certain market risks, including commodity price risk (i.e., aircraft fuel prices), interest rate risk, foreign currency risk and price changes related to investments in equity securities. The adverse effects of potential changes in these market risks are discussed below. The sensitivity analyses presented do not consider the effects that such adverse changes may have on overall economic activity nor do they consider additional actions management may take to mitigate the Company's exposure to such changes. Actual results may differ. See the notes to the consolidated financial statements for a description of the Company's accounting policies and other information related to these financial instruments.
Aircraft Fuel. The Company's results of operations are significantly impacted by changes in the price of aircraft fuel. During 1999 and 1998, aircraft fuel accounted for 9.7% and 10.2%, respectively, of the Company's operating expenses (excluding fleet disposition/impairment losses). In order to provide short-term protection (generally three to six months) against a sharp increase in jet fuel prices, the Company from time to time enters into petroleum call options, petroleum swap contracts and jet fuel purchase commitments. The Company's fuel hedging strategy could result in the Company not fully benefiting from certain fuel price declines. As of December 31, 1999, the Company had hedged approximately 24% of its projected 2000 fuel requirements, including 93% related to the first quarter and 8% related to the second quarter using petroleum call options, compared to approximately 25% of its projected 1999 fuel requirements hedged at December 31, 1998 using petroleum swap contracts and purchase commitments. The Company estimates that at December 31, 1999, a ten percent increase in the price per gallon of aircraft fuel would not have a material impact on the fair value of the existing petroleum call options, as compared to an $8 million increase in the fair value of the petroleum swap contracts existing at December 31, 1998.
Foreign Currency. The Company is exposed to the effect of exchange rate fluctuations on the U.S. dollar value of foreign currency denominated operating revenue and expenses. The Company's largest exposure comes from the Japanese yen. However, the Company is attempting to mitigate the effect of certain potential foreign currency losses by entering into forward contracts that effectively enable it to sell Japanese yen expected to be received from yen- denominated net cash flows over the next twelve months at specified exchange rates. As of December 31, 1999, the Company had entered into forward contracts to hedge approximately 95% of its 2000 projected yen-denominated net cash flows, as compared to having in place average rate options and forward contracts to hedge 69% of its 1999 projected yen-denominated net cash flows at December 31, 1998. The Company estimates that at December 31, 1999, a 10% strengthening in the value of the U.S. dollar relative to the yen would have increased the fair value of the existing forward contracts by $18 million as compared to a $7 million increase in the fair value of existing average rate options and forward contracts at December 31, 1998.
Interest Rates. The Company's results of operations are affected by fluctuations in interest rates (e.g., interest expense on debt and interest income earned on short-term investments).
The Company had approximately $690 million and $599 million of variable-rate debt as of December 31, 1999 and 1998, respectively. The Company has mitigated its exposure on certain variable-rate debt by entering into an interest rate cap (notional amount of $106 million and $125 million as of December 31, 1999 and 1998, respectively) which expires in July 2001. The interest rate cap limits the amount of potential increase in the LIBOR rate component of the floating rate to a maximum of 9% over the term of the contract. If average interest rates increased by 100 basis points during 2000 as compared to 1999, the Company's projected 2000 interest expense would increase by approximately $6 million. At December 31, 1998, an interest rate increase of 100 basis points during 1999 and compared to 1998 was projected to increase 1999 interest expense by approximately $5 million. The interest rate cap does not mitigate this increase in interest expense materially given the current level of such floating rates.
As of December 31, 1999 and 1998, the fair value of $2.2 billion and $1.5 billion (carrying value) of the Company's fixed-rate debt was estimated to be $2.2 billion and $1.5 billion, respectively, based upon discounted future cash flows using current incremental borrowing rates for similar types of instruments or market prices. Market risk, estimated as the potential increase in fair value resulting from a hypothetical 100 basis points decrease in interest rates, was approximately $91 million and $70 million as of December 31, 1999 and 1998, respectively. The fair value of the remaining fixed-rate debt at December 31, 1999 and 1998, (with a carrying value of $248 million and $287 million, respectively, and primarily relates to aircraft modification notes and various loans with immaterial balances) was not practicable to estimate due to the large number and small dollar amounts of these notes.
If 2000 average short-term interest rates decreased by 100 basis points over 1999 average rates, the Company's projected interest income from cash, cash equivalents and short-term investments would decrease by approximately $11 million during 2000, compared to an estimated $13 million decrease during 1999 measured at December 31, 1998.
Investments in Equity Securities. The Company has a 49% equity investment in Compania Panamena de Aviacion, S.A. ("COPA") and a 28% equity investment in Gulfstream International Airlines, Inc. ("Gulfstream") which are also subject to price risk. However, since a readily determinable market value does not exist for either COPA or Gulfstream (each is privately held), the Company is unable to quantify the amount of price risk sensitivity inherent in these investments. At December 31, 1999 and 1998, the carrying value of COPA was $49 million and $53 million, respectively.
At December 31, 1999, the Company owned approximately 357,000 depository certificates convertible, subject to certain restrictions, into the common stock of Equant, which completed an initial public offering in July 1998. As of December 31, 1999, the estimated fair value of these depository certificates was approximately $40 million, based upon the publicly traded market value of Equant common stock. Since the fair value of the Company's investment in the depository certificates is not readily determinable (i.e., the depository certificates are not traded on a securities exchange), the investment is carried at cost, which was not material as of December 31, 1999 or 1998.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Index to Consolidated Financial Statements
Page No.
Report of Independent Auditors
Consolidated Statements of Operations for each of the Three Years in the Period Ended December 31, 1999
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Cash Flows for each of the Three Years in the Period Ended December 31, 1999
Consolidated Statements of Redeemable Preferred Stock and Common Stockholders' Equity for each of the Three Years in the Period Ended December 31, 1999
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders Continental Airlines, Inc.
We have audited the accompanying consolidated balance sheets of Continental Airlines, Inc. (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of operations, redeemable preferred stock and common stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.
As discussed in Note 1 to the consolidated financial statements, effective January 1, 1999, the Company changed its method of accounting for the sale of mileage credits to participating partners in its frequent flyer program.
ERNST & YOUNG LLP
Houston, Texas January 17, 2000
CONTINENTAL AIRLINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Continental Airlines, Inc. (the "Company" or "Continental") is a major United States air carrier engaged in the business of transporting passengers, cargo and mail. Continental is the fifth largest United States airline (as measured by 1999 revenue passenger miles) and, together with its wholly owned subsidiaries, Continental Express, Inc. ("Express"), and Continental Micronesia, Inc. ("CMI"), each a Delaware corporation, serves 219 airports worldwide at January 17, 2000. As of December 31, 1999, Continental flies to 132 domestic and 87 international destinations and offers additional connecting service through alliances with domestic and foreign carriers. Continental directly serves 16 European cities, eight South American cities, Tel Aviv and Tokyo and is one of the leading airlines providing service to Mexico and Central America, serving more destinations there than any other United States airline. Through its Guam hub, CMI provides extensive service in the western Pacific, including service to more Japanese cities than any other United States carrier.
As used in these Notes to Consolidated Financial Statements, the terms "Continental" and "Company" refer to Continental Airlines, Inc. and, unless the context indicates otherwise, its subsidiaries.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Principles of Consolidation -
The consolidated financial statements of the Company include the accounts of Continental and its operating subsidiaries, Express and CMI. All significant intercompany transactions have been eliminated in consolidation.
(b) Use of Estimates -
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
(c) Cash and Cash Equivalents -
Cash and cash equivalents consist of cash and short-term, highly liquid investments which are readily convertible into cash and have a maturity of three months or less when purchased.
(d) Short-Term Investments -
The Company invests in commercial paper with original maturities in excess of 90 days but less than 270 days. These investments are classified as short-term investments in the accompanying consolidated balance sheet. Short-term investments are stated at cost, which approximates market value.
(e) Spare Parts and Supplies -
Inventories, expendable parts and supplies relating to flight equipment are carried at average acquisition cost and are expensed when incurred in operations. An allowance for obsolescence is provided over the remaining estimated useful life of the related aircraft, for spare parts expected to be on hand the date the aircraft are retired from service, plus allowances for spare parts currently identified as excess. These allowances are based on management estimates, which are subject to change.
(f) Property and Equipment -
Property and equipment are recorded at cost and are depreciated to estimated residual values over their estimated useful lives using the straight-line method. The estimated useful lives and residual values for the Company's property and equipment are as follows:
(g) Routes, Gates and Slots -
Routes are amortized on a straight-line basis over 40 years, gates over the stated term of the related lease and slots over 20 years. Routes, gates and slots are comprised of the following (in millions):
(h) Air Traffic Liability -
Passenger revenue is recognized when transportation is provided rather than when a ticket is sold. The amount of passenger ticket sales not yet recognized as revenue is reflected in the accompanying Consolidated Balance Sheets as air traffic liability. The Company performs periodic evaluations of this estimated liability, and any adjustments resulting therefrom, which can be significant, are included in results of operations for the periods in which the evaluations are completed.
(i) Frequent Flyer Program -
Continental sponsors a frequent flyer program ("OnePass") and records an estimated liability for the incremental cost associated with providing the related free transportation at the time a free travel award is earned. The liability is adjusted periodically based on awards earned, awards redeemed and changes in the OnePass program.
The Company also sells mileage credits in the OnePass program to participating partners, such as hotels, car rental agencies and credit card companies. During 1999, as a result of the recently issued Staff Accounting Bulletin No. 101 - "Revenue Recognition in Financial Statements," the Company changed the method it uses to account for the sale of these mileage credits. This change, which totaled $27 million, net of tax, was applied retroactively to January 1, 1999. Under the new accounting method, revenue from the sale of mileage credits is deferred and recognized when transportation is provided. Previously, the resulting revenue, net of the incremental cost of providing future air travel, was recorded in the period in which the credits were sold. This change reduced net income for the year ended December 31, 1999 by $21 million ($32 million pre-tax). The Company believes the new method is preferable as it results in a better matching of revenues with the period in which services are provided.
The pro forma results, assuming the accounting change is applied retroactively, is shown below (in millions except per share data):
(j) Passenger Traffic Commissions -
Passenger traffic commissions are recognized as expense when the transportation is provided and the related revenue is recognized. The amount of passenger traffic commissions not yet recognized as expense is included in Prepayments and other assets in the accompanying Consolidated Balance Sheets.
(k) Deferred Income Taxes -
Deferred income taxes are provided under the liability method and reflect the net tax effects of temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements.
(l) Maintenance and Repair Costs -
Maintenance and repair costs for owned and leased flight equipment, including the overhaul of aircraft components, are charged to operating expense as incurred, except engine overhaul costs covered by power by the hour agreements, which are accrued on the basis of hours flown.
(m) Advertising Costs -
The Company expenses the costs of advertising as incurred. Advertising expense was $82 million, $78 million and $78 million for the years ended December 31, 1999, 1998 and 1997, respectively.
(n) Stock Plans and Awards -
Continental has elected to follow Accounting Principles Board Opinion No. 25 - "Accounting for Stock Issued to Employees" ("APB 25") in accounting for its employee stock options and its stock purchase plans because the alternative fair value accounting provided for under Statement of Financial Accounting Standards No. 123 - "Accounting for Stock-Based Compensation" ("SFAS 123") requires use of option valuation models that were not developed for use in valuing employee stock options or purchase rights. Under APB 25, since the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, generally no compensation expense is recognized. Furthermore, under APB 25, since the stock purchase plans are considered noncompensatory plans, no compensation expense is recognized.
(o) Measurement of Impairment -
In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"), the Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets.
(p) Start-Up Costs -
Statement of Position 98-5, "Reporting on the Costs of Start- Up Activities" ("SOP 98-5"), requires start-up costs to be expensed as incurred. Continental adopted SOP 98-5 in the first quarter of 1999. This statement requires all unamortized start up costs (e.g., pilot training costs related to induction of new aircraft) to be expensed upon adoption, resulting in a $6 million cumulative effect of a change in accounting principle, net of tax, in the first quarter of 1999.
(q) Reclassifications -
Certain reclassifications have been made in the prior years' financial statements to conform to the current year presentation.
NOTE 2 - EARNINGS PER SHARE
Basic earnings per common share ("EPS") excludes dilution and is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other obligations to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. The following table sets forth the computation of basic and diluted earnings per share (in millions):
Approximately 1.1 million in 1999 and 1.4 million in 1998 of weighted average options to purchase shares of the Company's Class B common stock, par value $.01 per share ("Class B common stock"), were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares and, therefore, the effect would have been antidilutive.
NOTE 3 - LONG-TERM DEBT
Long-term debt as of December 31 is summarized as follows (in millions):
At December 31, 1999 and 1998, the LIBOR and Eurodollar rates associated with Continental's indebtedness approximated 6.0% and 5.1% and 6.0% and 5.1%, respectively. The Commercial Paper rate was 6.1% and 5.5% as of December 31, 1999 and 1998, respectively.
A majority of Continental's property and equipment is subject to agreements securing indebtedness of Continental.
In July 1997, Continental entered into a $575 million credit facility (the "Credit Facility"), including a $275 million term loan, the proceeds of which were loaned to CMI to repay its existing $320 million secured term loan. In connection with this prepayment, Continental recorded a $4 million after tax extraordinary charge relating to early extinguishment of debt. The Credit Facility also includes a $225 million revolving credit facility with a commitment fee of 0.225% per annum on the unused portion, and a $75 million term loan commitment with a current floating interest rate of Libor or Eurodollar plus 1.25%. At December 31, 1999 and 1998, no borrowings were outstanding under the $225 million revolving credit facility. During 1998, the Credit Facility became unsecured due to an upgrade of Continental's credit rating by Standard and Poor's Corporation.
The Credit Facility does not contain any financial covenants relating to CMI other than covenants restricting CMI's incurrence of certain indebtedness and pledge or sale of assets. In addition, the Credit Facility contains certain financial covenants applicable to Continental and prohibits Continental from granting a security interest on certain of its international route authorities and its stock in Air Micronesia, Inc., CMI's parent company.
In April 1998, the Company completed an offering of $187 million of pass-through certificates to be used to refinance the debt related to 14 aircraft currently owned by Continental. In connection with this refinancing, Continental recorded a $4 million after tax extraordinary charge to consolidated earnings in the second quarter of 1998 related to the early extinguishment of such debt.
At December 31, 1999, under the most restrictive provisions of the Company's debt and credit facility agreements, the Company had a minimum cash balance requirement of $600 million, a minimum net worth requirement of $972 million and was restricted from paying cash dividends in excess of $576 million.
On April 15, 1999, the Company exercised its right and called for redemption on May 25, 1999, all $230 million of its 6-3/4% Convertible Subordinated Notes due 2006. The notes were converted into 7.6 million shares of Class B common stock during May 1999.
Maturities of long-term debt due over the next five years are as follows (in millions):
Year ending December 31, 2000. . . . . . . . . . . . . . . . . . $278 2001. . . . . . . . . . . . . . . . . . 592 2002. . . . . . . . . . . . . . . . . . 266 2003. . . . . . . . . . . . . . . . . . 170 2004. . . . . . . . . . . . . . . . . . 239
NOTE 4 - LEASES
Continental leases certain aircraft and other assets under long- term lease arrangements. Other leased assets include real property, airport and terminal facilities, sales offices, maintenance facilities, training centers and general offices. Most leases also include both renewal options and purchase options.
At December 31, 1999, the scheduled future minimum lease payments under capital leases and the scheduled future minimum lease rental payments required under aircraft and engine operating leases, that have initial or remaining noncancellable lease terms in excess of one year, are as follows (in millions):
Not included in the above operating lease table is approximately $493 million of annual average minimum lease payments for each of the next five years relating to non-aircraft leases, principally airport and terminal facilities and related equipment.
Continental is the guarantor of $1.2 billion aggregate principal amount of tax-exempt special facilities revenue bonds. These bonds, issued by various airport municipalities, are payable solely from rentals paid by Continental under long-term agreements with the respective governing bodies.
At December 31, 1999, the Company, including Express, had 382 and 19 aircraft under operating and capital leases, respectively. These leases have remaining lease terms ranging from one month to 22 years.
The Company's total rental expense for all operating leases, net of sublease rentals, was $1.1 billion, $922 million and $787 million in 1999, 1998 and 1997, respectively.
NOTE 5 - FINANCIAL INSTRUMENTS AND RISK MANAGEMENT
As part of the Company's risk management program, Continental uses or used a variety of financial instruments, including petroleum call options, petroleum swaps, jet fuel purchase commitments, foreign currency average rate options, foreign currency forward contracts and interest rate cap agreements. The Company does not hold or issue derivative financial instruments for trading purposes.
Effective October 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 133 - "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. The adoption of SFAS 133 on October 1, 1998 did not have a material impact on results of operations but resulted in the cumulative effect of an accounting change of $2 million pre-tax being recognized as income in other comprehensive income.
Notional Amounts and Credit Exposure of Derivatives
The notional amounts of derivative financial instruments summarized below do not represent amounts exchanged between parties and, therefore, are not a measure of the Company's exposure resulting from its use of derivatives. The amounts exchanged are calculated based upon the notional amounts as well as other terms of the instruments, which relate to interest rates, exchange rates or other indices.
The Company is exposed to credit losses in the event of non- performance by counterparties to these financial instruments, but it does not expect any of the counterparties to fail to meet their obligations. To manage credit risks, the Company selects counterparties based on credit ratings, limits its exposure to a single counterparty under defined Company guidelines, and monitors the market position with each counterparty.
Fuel Price Risk Management
The Company uses a combination of petroleum call options, petroleum swap contracts, and jet fuel purchase commitments to provide some short-term protection against a sharp increase in jet fuel prices. These instruments generally cover the Company's forecasted jet fuel needs for three to six months.
The Company accounts for the call options and swap contracts as cash flow hedges. In accordance with SFAS 133, such financial instruments are marked-to-market using forward prices and fair market value quotes with the offset to other comprehensive income, net of applicable income taxes and hedge ineffectiveness and then subsequently recognized as a component of fuel expense when the underlying fuel being hedged is used. The ineffective portion of these call options and swap agreements is determined based on the correlation between West Texas Intermediate Crude Oil prices and jet fuel prices, which was not material for the years ended December 31, 1999 and 1998. For the year ended December 31, 1999, the Company recognized approximately a $105 million net gain on its fuel hedging program. The gain is included in fuel expense in the accompanying consolidated statement of operations.
At December 31, 1999, the Company had petroleum call options outstanding with an aggregate notional amount of approximately $310 million and an immaterial fair value. The notional value of the Company's petroleum swap contracts outstanding at December 31, 1998 was $82 million with a fair value of $6 million loss, which was recorded in other current liabilities with the offset to other comprehensive income, net of applicable income taxes and hedge ineffectiveness. The loss was recognized in earnings during 1999.
Foreign Currency Exchange Risk Management
The Company uses a combination of foreign currency average rate options and forward contracts to hedge against the currency risk associated with Japanese yen-denominated net cash flows for the next nine to twelve months. The average rate options and forward contracts have only nominal intrinsic value at the time of purchase.
The Company accounts for these instruments as cash flow hedges. In accordance with SFAS 133, such financial instruments are marked-to- market using forward prices and fair market value quotes with the offset to other comprehensive income, net of applicable income taxes and hedge ineffectiveness and then subsequently recognized as a component of other revenue when the underlying net cash flows are realized. The Company measures hedge effectiveness of average rate options and forward contracts based on the forward price of the underlying commodity. Hedge ineffectiveness was not material during 1999 or 1998.
At December 31, 1999, the Company had yen forward contracts outstanding with an aggregate notional amount of $197 million and a fair value loss of $5 million. The notional amount of the Company's yen average rate options and forward contracts outstanding at December 31, 1998 was $78 million and $76 million, respectively, with a total fair value loss of $3 million. Unrealized losses are recorded in other current liabilities with the offset to other comprehensive income, net of applicable income taxes and hedge ineffectiveness. The unrealized loss at December 31, 1999 will be recognized in earnings within the next twelve months.
Interest Rate Risk Management
The Company entered into an interest rate cap agreement to reduce the impact of potential increases on floating rate debt. The interest rate cap had a notional amount of $106 million and $125 million as of December 31, 1999 and 1998, respectively, and is effective through July 31, 2001. The Company accounts for the interest rate cap as a cash flow hedge whereby the fair value of the interest rate cap is reflected as an asset in the accompanying consolidated balance sheet with the offset, net of any hedge ineffectiveness (which is not material) recorded as interest expense and net of applicable income taxes, to other comprehensive income. The fair value of the interest rate cap was not material as of December 31, 1999 or 1998. As interest expense on the underlying hedged debt is recognized, corresponding amounts are removed from other comprehensive income and charged to interest expense. Such amounts were not material during 1999 or 1998.
Accumulated Derivative Gains or Losses
The following table summarizes activity in other comprehensive income related to derivatives classified as cash flow hedges held by the Company during the period October 1 (the date of the Company's adoption of SFAS 133) through December 31, 1998 and for the year ended December 31, 1999 (in millions):
Other Financial Instruments
(a) Cash equivalents -
Cash equivalents consist primarily of commercial paper with original maturities of three months or less and approximate fair value due to their short maturity.
(b) Short-term Investments -
Short-term investments consist primarily of commercial paper with original maturities in excess of 90 days but less than 270 days and approximate fair value due to their short maturity.
(c) Investment in Equity Securities -
Continental's investment in America West Holdings Corporation is classified as available-for-sale and carried at an aggregate market value of approximately $3 million at both December 31, 1999 and 1998. Included in stockholders' equity at both December 31, 1999 and 1998 are net unrealized gains of $1 million.
In May 1998, the Company acquired a 49% interest in Compania Panamena de Aviacion, S.A. ("COPA") for $53 million. The investment is accounted for under the equity method of accounting. As of December 31, 1999 and 1998, the excess of the amount at which the investment is carried and the amount of underlying equity in the net assets was $40 million and $43 million, respectively. This difference is being amortized over 40 years.
On October 20, 1999, Continental sold its interest in AMADEUS Global Travel Distribution, S.A. ("AMADEUS") for $409 million, including a special dividend. The sale, which occurred as part of AMADEUS's initial public offering resulted in a gain of approximately $297 million. As of December 31, 1998, Continental's investment in AMADEUS was carried at cost ($95 million), since a readily determinable market value did not exist.
At December 31, 1999, the Company owned approximately 357,000 depository certificates convertible, subject to certain restrictions, into the common stock of Equant N.V. ("Equant"), which completed an initial public offering in July 1998. As of December 31, 1999, the estimated fair value of these depository certificates was approximately $40 million, based upon the publicly traded market value of Equant common stock. Since the fair value of the Company's investment in the depository certificates is not readily determinable (i.e., the depository certificates are not traded on a securities exchange), the investment is carried at cost, which was not material as of December 31, 1999 or 1998.
In December 1999, the Company acquired a 28% interest in Gulfstream International Airlines, Inc. ("Gulfstream"). The investment is accounted for under the equity method of accounting.
In 1999, Continental received 1,500,000 warrants to purchase common stock of priceline.com, Inc. ("Priceline") at an exercise price of $59.93 per share (the "Warrants"). In the fourth quarter of 1999, the Company sold the Warrants for $18 million, resulting in a loss of approximately $4 million.
(d) Debt -
The fair value of the Company's debt with a carrying value of $2.75 billion and $1.98 billion at December 31, 1999 and 1998, respectively, estimated based on the discounted amount of future cash flows using the current incremental rate of borrowing for a similar liability or market prices, approximate $2.53 billion and $1.88 billion, respectively. The fair value of the remaining debt (with a carrying value of $383 million and $473 million, respectively, and primarily relating to aircraft modification notes and various loans with immaterial balances) was not practicable to estimate due to the large number and small dollar amounts of these notes.
NOTE 6 - PREFERRED SECURITIES OF TRUST
Continental Airlines Finance Trust, a Delaware statutory business trust (the "Trust") with respect to which the Company owned all of the common trust securities, had 2,298,327 8-1/2% Convertible Trust Originated Preferred Securities ("TOPrS") outstanding at December 31, 1998. In November 1998, the Company exercised its right and called for redemption approximately half of its outstanding TOPrS. The TOPrS were convertible into shares of Class B common stock at a conversion price of $24.18 per share of Class B common stock. As a result of the call for redemption, 2,688,173 TOPrS were converted into 5,558,649 shares of Class B common stock. In December 1998, the Company called for redemption the remaining outstanding TOPrS. As a result of the second call, the remaining 2,298,327 TOPrS were converted into 4,752,522 shares of Class B common stock during January 1999.
Distributions on the preferred securities were payable by the Trust at the annual rate of 8-1/2% of the liquidation value of $50 per preferred security and are included in Distributions on Preferred Securities of Trust in the accompanying Consolidated Statements of Operations. At December 31, 1998, outstanding TOPrS totaling $111 million are included in Continental-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trust Holding Solely Convertible Subordinated Debentures in the accompanying Consolidated Balance Sheets.
The sole assets of the trust were 8-1/2% Convertible Subordinated Deferrable Interest Debentures ("Convertible Subordinated Debentures") with an aggregate principal amount of $115 million at December 31, 1998.
The Convertible Subordinated Debentures and related income statement effects are eliminated in the Company's consolidated financial statements.
NOTE 7 - PREFERRED, COMMON AND TREASURY STOCK
Preferred Stock
Continental has 10 million shares of authorized preferred stock, none of which was outstanding as of December 31, 1999 or 1998.
Common Stock
Continental has two classes of common stock issued and outstanding, Class A common stock, par value $.01 per share ("Class A common stock") and Class B common stock. Each share of Class A common stock is entitled to 10 votes per share and each share of Class B common stock is entitled to one vote per share. In addition, Continental has authorized 50 million shares of Class D common stock, par value $.01 per share, none of which is outstanding.
The Company's Certificate of Incorporation permits shares of the Company's Class A common stock to be converted into an equal number of shares of Class B common stock. During 1999 and 1998, 85,883 and 12,200 shares of the Company's Class A common stock, respectively, were so converted.
Treasury Stock
The Company's Board of Directors has authorized the expenditure of up to $1.2 billion to repurchase shares of the Company's Class A common stock and Class B common stock or securities convertible into Class B common stock. The Company's Board of Directors also authorized the Company to use up to one-half of its 2000 and later adjusted net income, and all of the net proceeds of future sales of non-strategic assets, for additional stock repurchases. Subject to applicable securities law, such purchases occur at times and in amounts that the Company deems appropriate. No time limit was placed on the duration of the repurchase program. As of December 31, 1999, the Company had repurchased 17,586,400 shares of Class B common stock for $751 million since the inception of the repurchase program in March 1998.
Stockholder Rights Plan
Effective November 20, 1998, the Company adopted a stockholder rights plan (the "Rights Plan") in connection with the disposition by Air Partners, L.P. ("Air Partners") of its interest in the Company to an affiliate of Northwest Airlines, Inc. (together with such affiliate, "Northwest").
The rights become exercisable upon the earlier of (i) the tenth day following a public announcement or public disclosure of facts indicating that a person or group of affiliated or associated persons has acquired beneficial ownership of 15% or more of the total number of votes entitled to be cast generally by the holders of the common stock of the Company then outstanding, voting together as a single class (such person or group being an "Acquiring Person"), or (ii) the tenth business day (or such later date as may be determined by action of the Board of Directors prior to such time as any person becomes an Acquiring Person) following the commencement of, or announcement of an intention to make, a tender offer or exchange offer the consummation of which would result in any person becoming an Acquiring Person. Certain persons and entities related to the Company, Air Partners or Northwest at the time the Rights Plan was adopted are exempt from the definition of "Acquiring Person."
The rights will expire on November 20, 2008 unless extended or unless the rights are earlier redeemed or exchanged by the Company.
Subject to certain adjustments, if any person becomes an Acquiring Person, each holder of a right, other than rights beneficially owned by the Acquiring Person and its affiliates and associates (which rights will thereafter be void), will thereafter have the right to receive, upon exercise thereof, that number of Class B Common Shares having a market value of two times the exercise price ($200, subject to adjustment) of the right.
If at any time after a person becomes an Acquiring Person, (i) the Company merges into any other person, (ii) any person merges into the Company and all of the outstanding common stock does not remain outstanding after such merger, or (iii) the Company sells 50% or more of its consolidated assets or earning power, each holder of a right (other than the Acquiring Person and its affiliates and associates) will have the right to receive, upon the exercise thereof, that number of shares of common stock of the acquiring corporation (including the Company as successor thereto or as the surviving corporation) which at the time of such transaction will have a market value of two times the exercise price of the right.
At any time after any person becomes an Acquiring Person, and prior to the acquisition by any person or group of a majority of the Company's voting power, the Board of Directors may exchange the rights (other than rights owned by such Acquiring Person which have become void), in whole or in part, at an exchange ratio of one share of Class B common stock per right (subject to adjustment).
At any time prior to any person becoming an Acquiring Person, the Board of Directors may redeem the rights at a price of $.001 per right. The Rights Plan may be amended by the Board of Directors without the consent of the holders of the rights, except that from and after such time as any person becomes an Acquiring Person no such amendment may adversely affect the interests of the holders of the rights (other than the Acquiring Person and its affiliates and associates). Until a right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends.
NOTE 8 - STOCK PLANS AND AWARDS
Stock Options
On October 4, 1999, the Board of Directors adopted the Continental Airlines, Inc. Incentive Plan 2000 (the "2000 Incentive Plan"), subject to approval by the stockholders of the Company at the annual stockholders meeting in May 2000. The 2000 Incentive Plan provides that the Company may grant awards (options, restricted stock awards, performance awards or incentive awards) to non- employee directors of the Company or employees of the Company or its subsidiaries. Subject to adjustment as provided in the Incentive Plan, the aggregate number of shares of Class B common stock that may be issued under the Incentive Plan may not exceed 3,000,000 shares, which may be originally issued or treasury shares or a combination thereof.
The stockholders of the Company have approved the Company's 1998 Stock Incentive Plan, 1997 Stock Incentive Plan and 1994 Incentive Equity Plan (collectively, the "Plans") under which the Company may issue shares of restricted Class B common stock or grant options to purchase shares of Class B common stock to non-employee directors and employees of the Company or its subsidiaries. Subject to adjustment as provided in the Plans, the aggregate number of shares of Class B common stock that may be issued may not exceed 16,500,000 shares, which may be originally issued or treasury shares or a combination thereof. Options granted under the Plans are awarded with an exercise price equal to the fair market value of the stock on the date of grant. The total shares remaining available for grant under the Plans at December 31, 1999 was 969,327. No options may be awarded under the 1994 Incentive Equity Plan after December 31, 1999. Stock options granted under the Plans generally vest over a period of three to four years and have a term of five years.
Under the terms of the Plans, a change of control would result in all outstanding options under these plans becoming exercisable in full and restrictions on restricted shares being terminated.
The table on the following page summarizes stock option transactions pursuant to the Company's Plans (share data in thousands):
The following tables summarize the range of exercise prices and the weighted average remaining contractual life of the options outstanding and the range of exercise prices for the options exercisable at December 31, 1999 (share data in thousands):
Employee Stock Purchase Plans
All employees of the Company are eligible to participate in the Company's stock purchase program under which they may purchase shares of Class B common stock of the Company at 85% of the lower of the fair market value on the first day of the option period or the last day of the option period. During 1999 and 1998, 526,729 and 305,978 shares, respectively, of Class B common stock were issued at prices ranging from $27.84 to $49.41 in 1999 and $29.33 to $49.41 in 1998. During 1997, 218,892 shares of Class B common stock were issued at prices ranging from $19.55 to $29.33.
Pro Forma SFAS 123 Results
Pro forma information regarding net income and earnings per share has been determined as if the Company had accounted for its employee stock options and purchase rights under the fair value method of SFAS 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1999, 1998 and 1997, respectively: risk-free interest rates of 4.9%, 4.9% and 6.1%; dividend yields of 0%; volatility factors of the expected market price of the Company's common stock of 43% for 1999, 40% for 1998 and 34% for 1997; and a weighted-average expected life of the option of 3.1 years, 3.0 years and 2.5 years. The weighted average grant date fair value of the stock options granted in 1999, 1998 and 1997 was $11.13, $13.84 and $7.87 per option, respectively.
The fair value of the purchase rights under the stock purchase plans was also estimated using the Black-Scholes model with the following weighted-average assumptions for 1999, 1998 and 1997, respectively: risk free interest rates of 4.7%, 4.7% and 5.2%; dividend yields of 0%; expected volatility of 43% for 1999, 40% for 1998 and 34% for 1997; and an expected life of .25 years for 1999, .25 years for 1998 and .33 years for 1997. The weighted-average fair value of the purchase rights granted in 1999, 1998 and 1997 was $7.72, $9.10 and $7.38, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferrable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options and purchase rights have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options and purchase rights.
Assuming that the Company had accounted for its employee stock options and purchase rights using the fair value method and amortized the resulting amount to expense over the options' vesting period, net income would have been reduced by $24 million, $18 million and $11 million for the years ended December 31, 1999, 1998 and 1997, respectively. Basic EPS would have been reduced by 35 cents, 30 cents and 18 cents for the years ended December 31, 1999, 1998 and 1997, respectively, and diluted EPS would have been reduced by 33 cents, 23 cents and 14 cents for the same periods, respectively. The pro forma effect on net income is not representative of the pro forma effects on net income in future years because it did not take into consideration pro forma compensation expense related to grants made prior to 1995.
NOTE 9 - ACCUMULATED OTHER COMPREHENSIVE INCOME
The components of accumulated other comprehensive income are as follows (in millions):
NOTE 10 - EMPLOYEE BENEFIT PLANS
The Company has noncontributory defined benefit pension and defined contribution (including 401(k) savings) plans. Substantially all domestic employees of the Company are covered by one or more of these plans. The benefits under the active defined benefit pension plan are based on years of service and an employee's final average compensation. For the years ended December 31, 1999, 1998 and 1997, total expense for the defined contribution plan was $14 million, $8 million and $6 million, respectively.
The following table sets forth the defined benefit pension plans' change in projected benefit obligation for 1999 and 1998:
The following table sets forth the defined benefit pension plans' change in the fair value of plan assets for 1999 and 1998:
Pension cost recognized in the accompanying consolidated balance sheets is computed as follows:
The $125 million charge to other comprehensive income in 1998 was reversed in 1999 due to favorable asset performance and an increase in the weighted average assumed discount rate.
Net periodic defined benefit pension cost for 1999, 1998 and 1997 included the following components:
The following actuarial assumptions were used to determine the actuarial present value of the Company's projected benefit obligation:
The projected benefit obligation, accumulated benefit obligation and the fair value of plan assets for the pension plans with projected benefit obligations and accumulated benefit obligations in excess of plan assets were $1.3 billion, $1.1 billion and $1.0 billion, respectively, as of December 31, 1999, and $1.2 billion, $1.1 billion and $771 million, respectively, as of December 31, 1998.
During 1999 and 1998, the Company amended its benefit plan as a result of changes in benefits pursuant to new collective bargaining agreements.
Plan assets consist primarily of equity securities, long-term debt securities and short-term investments.
Continental's policy is to fund the noncontributory defined benefit pension plans in accordance with Internal Revenue Service ("IRS") requirements as modified, to the extent applicable, by agreements with the IRS.
The Company also has a profit sharing program under which an award pool consisting of 15% of the Company's annual pre-tax earnings, subject to certain adjustments, is distributed each year to substantially all employees (other than employees whose collective bargaining agreement provides otherwise or who otherwise receive profit sharing payments as required by local law) on a pro rata basis according to base salary. The profit sharing expense included in the accompanying Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997 was $62 million, $86 million and $105 million, respectively.
NOTE 11 - INCOME TAXES
The reconciliations of income tax computed at the United States federal statutory tax rates to income tax provision for the years ended December 31, 1999, 1998 and 1997 are as follows (in millions):
The significant component of the provision for income taxes for the year ended December 31, 1999, 1998 and 1997 was a deferred tax provision of $293 million, $231 million and $220 million, respectively. The provision for income taxes for each of the years ended December 31, 1999, 1998 and 1997 also reflects a current tax provision in the amount of $17 million, as the Company is in an alternative minimum tax position for federal income tax purposes and pays current state and foreign income tax.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the related amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1999 and 1998 are as follows (in millions):
At December 31, 1999, the Company had estimated tax net operating losses ("NOLs") of $700 million for federal income tax purposes that will expire through 2009 and federal investment tax credit carryforwards of $45 million that will expire through 2001. As a result of the change in ownership of the Company on April 27, 1993, the ultimate utilization of the Company's net operating losses and investment tax credits may be limited. Reflecting this limitation, the Company had a valuation allowance of $263 million at December 31, 1999 and 1998.
The Company has consummated several transactions which resulted in the recognition of NOLs of the Company's predecessor. To the extent the Company were to determine in the future that additional NOLs of the Company's predecessor could be recognized in the accompanying consolidated financial statements, such benefit would reduce the value ascribed to routes, gates and slots.
NOTE 12 - ACCRUALS FOR AIRCRAFT RETIREMENTS AND EXCESS FACILITIES
During the fourth quarter of 1999, the Company made the decision to accelerate the retirement of six DC-10-30 aircraft and other items in 1999 and the first half of 2000 and to dispose of related excess inventory. The DC-10-30's will be replaced by Boeing 757 and Boeing 737-800 aircraft on certain routes, and by Boeing 777 aircraft on other routes. In addition, the market value of certain Boeing 747 aircraft no longer operated by the Company has declined. As a result of these items and certain other fleet-related items, the Company recorded a fleet disposition/impairment loss of $81 million in the fourth quarter of 1999.
Approximately $52 million of the $81 million charge relates to the impairment of owned or capital leased aircraft and related inventory held for disposal with a carrying amount of $77 million. The remaining $29 million of the charge relates primarily to costs expected to be incurred related to the return of leased aircraft. As of December 31, 1999, the remaining accrual for the 1999 fleet disposition/impairment loss totaled $12 million.
In August 1998, the Company announced that CMI planned to accelerate the retirement of its four Boeing 747 aircraft by April 1999 and its remaining thirteen Boeing 727 aircraft by December 2000. The Boeing 747s have been replaced by DC-10-30 aircraft and the Boeing 727 aircraft will be replaced with a reduced number of Boeing 737 aircraft. In addition, Express accelerated the retirement of certain turboprop aircraft to the year 2000, including its fleet of 32 EMB-120 turboprop aircraft, as regional jets are acquired to replace turboprops. In connection with its decision to accelerate the replacement of these aircraft, the Company performed evaluations to determine, in accordance with SFAS 121, whether future cash flows (undiscounted and without interest charges) expected to result from the use and eventual disposition of these aircraft would be less than the aggregate carrying amount of these aircraft and the related assets. As a result of the evaluation, management determined that the estimated future cash flows expected to be generated by these aircraft would be less than their carrying amount, and therefore these aircraft are impaired as defined by SFAS 121. Consequently, the original cost basis of these aircraft and related items was reduced to reflect the fair market value at the date the decision was made, resulting in a $59 million fleet disposition/impairment loss. In determining the fair market value of these assets, the Company considered recent transactions involving sales of similar aircraft and market trends in aircraft dispositions. The remaining $63 million of the fleet disposition/impairment loss includes cash and non-cash costs related primarily to future commitments on leased aircraft past the dates they will be removed from service and the write-down of related inventory to its estimated fair market value. The combined charge of $122 million was recorded in the third quarter of 1998. As of December 31, 1999, the remaining accrual for the 1998 fleet disposition/impairment loss totaled $40 million.
The remaining balance of accruals for aircraft retirements and excess facilities at December 31, 1999 relates to the 1996 fleet disposition/impairment loss accrual of $21 million and the 1994 accrual for fleet disposition/impairment loss and underutilized facilities of $47 million.
The following represents the activity within these accruals during the three years ended December 31, 1999 (in millions):
The remaining accruals relate primarily to anticipated cash outlays associated with (i) underutilized airport facilities (primarily associated with Denver International Airport), (ii) the return of leased aircraft and (iii) the remaining liability associated with the grounded aircraft. The Company has assumed certain sublease rental income for these closed and underutilized facilities and grounded aircraft in determining the accrual at each balance sheet date. However, should actual sublease rental income be different from the Company's estimates, the actual charge could be different from the amount estimated. The remaining accrual represents cash outlays to be incurred over the remaining lease terms (from one to 19 years). The Company expects to finance the cash outlays primarily with internally generated funds.
NOTE 13 - COMMITMENTS AND CONTINGENCIES
Continental has substantial commitments for capital expenditures, including for the acquisition of new aircraft. As of January 14, 2000, Continental had agreed to acquire a total of 74 Boeing jet aircraft through 2005. The Company anticipates taking delivery of 28 Boeing jet aircraft in 2000. Continental also has options for an additional 118 aircraft (exercisable subject to certain conditions). The estimated aggregate cost of the Company's firm commitments for Boeing aircraft is approximately $4 billion. Continental currently plans to finance its new Boeing aircraft with a combination of enhanced pass through trust certificates, lease equity and other third-party financing, subject to availability and market conditions. Continental has commitments or letters of intent for backstop financing for approximately 18% of the anticipated remaining acquisition cost of future Boeing deliveries. In addition, at January 14, 2000, Continental has firm commitments to purchase 34 spare engines related to the new Boeing aircraft for approximately $219 million, which will be deliverable through March 2005. However, further financing will be needed to satisfy the Company's capital commitments for other aircraft and aircraft- related expenditures such as engines, spare parts, simulators and related items. There can be no assurance that sufficient financing will be available for all aircraft and other capital expenditures not covered by firm financing commitments. Deliveries of new Boeing aircraft are expected to increase aircraft rental, depreciation and interest costs while generating cost savings in the areas of maintenance, fuel and pilot training.
As of January 14, 2000, Express had firm commitments for 43 Embraer ERJ-145 ("ERJ-145") 50-seat regional jets and 19 Embraer ERJ-135 ("ERJ-135") 37-seat regional jets, with options for an additional 100 ERJ-145 and 50 ERJ-135 aircraft exercisable through 2008. Express anticipates taking delivery of 15 ERJ-145 and 12 ERJ-135 regional jets in 2000. Neither Express nor Continental will have any obligation to take any of the firm ERJ-145 or ERJ-135 aircraft that are not financed by a third party and leased to Continental.
Continental expects its cash outlays for 2000 capital expenditures, exclusive of fleet plan requirements, to aggregate $207 million primarily relating to software application and automation infrastructure projects, aircraft modifications and mandatory maintenance projects, passenger terminal facility improvements and office, maintenance, telecommunications and ground equipment.
Continental remains contingently liable until December 1, 2015, on $202 million of long-term lease obligations of US Airways, Inc. ("US Airways") related to the East End Terminal at LaGuardia Airport in New York. If US Airways defaulted on these obligations, Continental could be required to cure the default, at which time it would have the right to occupy the terminal.
Continental has certain block space arrangements whereby it is committed to purchase capacity on other carriers at an aggregate cost of approximately $159 million per year. These arrangements are currently scheduled to expire over the next eight years. Pursuant to other block-space arrangements, other carriers are committed to purchase capacity at a cost of approximately $95 million per year on Continental.
Approximately 42% of the Company's employees are covered by collective bargaining agreements. The Company's collective bargaining agreements with its Express flight attendants and Continental Airlines flight attendants (representing approximately 18% of the Company's employees) became amendable in November and December 1999, respectively. Negotiations began in September 1999 to amend these contracts. The Company believes that mutually acceptable agreements can be reached with such employees, although the ultimate outcome of the Company's negotiations is unknown at this time.
Legal Proceedings
United States of America v. Northwest Airlines Corp. & Continental Airlines, Inc.: The Antitrust Division of the Department of Justice is challenging under Section 7 of the Clayton Act and Section 1 of the Sherman Act the acquisition by Northwest of Shares of Continental's Class A common stock bearing, together with certain shares for which Northwest has a limited proxy, more than 50% of the fully diluted voting power of all Continental stock. The government's position is that, notwithstanding various agreements that restrict Northwest's ability to exercise voting control over Continental and are designed to assure Continental's competitive independence, Northwest's control of the Class A common stock will reduce actual and potential competition in various ways and in a variety of markets. The government seeks an order requiring Northwest to divest all voting stock in Continental on terms and conditions as may be agreed to by the government and the Court. No specific relief is sought against Continental. Trial is currently set for October 2000.
The Company and/or certain of its subsidiaries are defendants in various lawsuits, including suits relating to certain environmental claims, the Company's consolidated Plan of Reorganization under Chapter 11 of the federal bankruptcy code which became effective on April 27, 1993, and proceedings arising in the normal course of business. While the outcome of these lawsuits and proceedings cannot be predicted with certainty and could have a material adverse effect on the Company's financial position, results of operations and cash flows, it is the opinion of management, after consulting with counsel, that the ultimate disposition of such suits will not have a material adverse effect on the Company's financial position, results of operations or cash flows.
NOTE 14 - RELATED PARTY TRANSACTIONS
The following is a summary of significant related party transactions that occurred during 1999, 1998 and 1997, other than those discussed elsewhere in the Notes to Consolidated Financial Statements.
The Company and America West Airlines, Inc. ("America West"), a subsidiary of America West Holdings Corporation, in which David Bonderman holds a significant interest, entered into a series of agreements during 1994 related to code-sharing and ground handling that have created substantial benefits for both airlines. Mr. Bonderman is a director and stockholder of the Company. The services provided are considered normal to the daily operations of both airlines. As a result of these agreements, Continental paid America West $25 million, $20 million and $16 million in 1999, 1998 and 1997, respectively, and America West paid Continental $31 million, $27 million and $23 million in 1999, 1998 and 1997, respectively.
In November 1998, the Company and Northwest, a significant stockholder of the Company, began implementing a long-term global alliance involving extensive code-sharing, frequent flyer reciprocity and other cooperative activities. The services provided are considered normal to the daily operations of both airlines. As a result of these activities, Continental paid Northwest $7 million in 1999, and Northwest paid Continental $9 million in 1999.
During December 1999, Continental entered into an equipment sales agreement with COPA for $8 million. The resulting note receivable is payable in quarterly installments through October 2002. During 1999, COPA paid Continental $4 million for services considered normal to the daily operations of both airlines.
In connection with Continental's investment in Gulfstream, Continental purchased from Gulfstream, a ten-year $10 million convertible note, payable in quarterly installments of principal and interest totaling $0.4 million. Continental also purchased a six month $3 million secured note, with interest paid quarterly and principal due at the end of the six months. During 1999, Continental paid Gulfstream $1 million and Gulfstream paid Continental $13 million for services considered normal to the daily operations of both airlines.
Also during December 1999, under a sale and leaseback agreement with Gulfstream, Express sold 25 Beech 1900-D aircraft to Gulfstream in exchange for Gulfstream's assumption of $81 million in debt. Express is leasing these aircraft from Gulfstream for periods ranging from eight to 23 months.
NOTE 15 - SEGMENT REPORTING
Information concerning principal geographic areas is as follows (in millions):
The Company attributes revenue among the geographical areas based upon the origin and destination of each flight segment. The Company's tangible assets consist primarily of flight equipment which is mobile across geographic markets and, therefore, has not been allocated. Continental has one reportable operating segment (air transportation).
NOTE 16 - QUARTERLY FINANCIAL DATA (UNAUDITED)
During the first quarter of 1999, Continental recorded a $6 million cumulative effect of a change in accounting principle, net of tax, related to the write-off of pilot training costs.
In addition, during the first quarter of 1999, Continental recorded a $12 million gain ($20 million pre-tax) on the sale of a portion of the Company's interest in Equant.
During the fourth quarter of 1999, the Company changed its method of accounting for the sale of mileage credits under its frequent flyer program. Therefore, effective January 1, 1999, the Company recorded a $27 million cumulative effect of this change in accounting principle, net of tax.
During the fourth quarter of 1999, Continental recorded a $182 million gain ($297 million pre-tax) on the sale of its interest in AMADEUS and a $6 million net gain ($9 million pre-tax) on other asset sales, including a portion of its interest in Equant.
Also during the fourth quarter of 1999, Continental recorded a fleet disposition/impairment loss of $50 million ($81 million pre- tax).
During the second quarter of 1998, Continental recorded a $4 million after tax extraordinary charge relating to prepayment of debt.
During the third quarter of 1998, Continental recorded a fleet disposition/impairment loss of $77 million ($122 million pre-tax) relating to its decision to accelerate the retirement of certain jet and turboprop aircraft.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
There were no changes in or disagreements on any matters of accounting principles or financial statement disclosure between the Company and its independent auditors during the registrant's two most recent fiscal years or any subsequent interim period.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Incorporated herein by reference from the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 23, 2000.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Incorporated herein by reference from the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 23, 2000.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Incorporated herein by reference from the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 23, 2000.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Incorporated herein by reference from the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 23, 2000.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) The following financial statements are included in Item 8. "Financial Statements and Supplementary Data":
Report of Independent Auditors Consolidated Statements of Operations for each of the Three Years in the Period Ended December 31, 1999 Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Cash Flows for each of the Three Years in the Period Ended December 31, 1999 Consolidated Statements of Redeemable Preferred Stock and Common Stockholders' Equity for each of the Three Years in the Period Ended December 31, 1999 Notes to Consolidated Financial Statements
(b) Financial Statement Schedules:
Report of Independent Auditors Schedule II - Valuation and Qualifying Accounts
All other schedules have been omitted because they are inapplicable, not required, or the information is included elsewhere in the consolidated financial statements or notes thereto.
(c) Reports on Form 8-K:
None.
(d) See accompanying Index to Exhibits.
REPORT OF INDEPENDENT AUDITORS
We have audited the consolidated financial statements of Continental Airlines, Inc. (the "Company") as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated January 17, 2000 (included elsewhere in this Form 10-K). Our audits also included the financial statement schedule for these related periods listed in Item 14(b) of this Form 10-K. This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
ERNST & YOUNG LLP
Houston, Texas January 17, 2000
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CONTINENTAL AIRLINES, INC.
By /s/ LAWRENCE W. KELLNER Lawrence W. Kellner Executive Vice President and Chief Financial Officer (On behalf of Registrant)
Date: February 11, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on February 11, 2000.
Signature Capacity
/s/ GORDON M. BETHUNE Chairman and Chief Executive Officer Gordon M. Bethune (Principal Executive Officer)
/s/ LAWRENCE W. KELLNER Executive Vice President and Lawrence W. Kellner Chief Financial Officer (Principal Financial Officer)
/s/ CHRIS KENNY Staff Vice President and Controller Chris Kenny (Principal Accounting Officer)
THOMAS J. BARRACK, JR.* Director Thomas J. Barrack, Jr.
DAVID BONDERMAN* Director David Bonderman
/s/GREGORY D. BRENNEMAN Director Gregory D. Brenneman
KIRBYJON CALDWELL* Director Kirbyjon Caldwell
PATRICK FOLEY* Director Patrick Foley
DOUGLAS McCORKINDALE* Director Douglas McCorkindale
GEORGE G. C. PARKER* Director George G. C. Parker
RICHARD W. POGUE* Director Richard W. Pogue
WILLIAM S. PRICE III* Director William Price III
DONALD L. STURM* Director Donald L. Sturm
KAREN HASTIE WILLIAMS* Director Karen Hastie Williams
CHARLES A. YAMARONE* Director Charles A. Yamarone
*By /s/ LAWRENCE W. KELLNER Lawrence W. Kellner Attorney in-fact February 11, 2000
INDEX TO EXHIBITS OF CONTINENTAL AIRLINES, INC.
2.1 Revised Third Amended Disclosure Statement Pursuant to Section 1125 of the Bankruptcy Code with Respect to Debtors' Revised Second Amended Joint Plan of Reorganization Under Chapter 11 of the United States Bankruptcy Code, as filed with the Bankruptcy Court on January 13, 1993 -- incorporated by reference from Exhibit 2.1 to Continental's Annual Report on Form 10-K for the year ended December 31, 1992 (File no. 0-9781).
2.2 Modification of Debtors' Revised Second Amended Joint Plan of Reorganization dated March 12, 1993 -- incorporated by reference to Exhibit 2.2 to Continental's Current Report on Form 8-K, dated April 16, 1993 (File no. 0-9781) (the "4/93 8-K").
2.3 Second Modification of Debtors' Revised Second Amended Joint Plan of Reorganization, dated April 8, 1993 -- incorporated by reference to Exhibit 2.3 to the 4/93 8-K.
2.4 Third Modification of Debtors' Revised Second Amended Joint Plan of Reorganization, dated April 15, 1993 -- incorporated by reference to Exhibit 2.4 to the 4/93 8-K.
2.5 Confirmation Order, dated April 16, 1993 -- incorporated by reference to Exhibit 2.5 to the 4/93 8-K.
3.1 Amended and Restated Certificate of Incorporation of Continental -- incorporated by reference to Exhibit 4.1(a) to Continental's Form S-8 registration statement (No. 333-06993) (the "1996 S-8").
3.2 By-laws of Continental, as amended to date -- incorporated by reference to Exhibit 99.3 to Continental's Current Report on Form 8-K dated November 20, 1998 (the "11/98 8-K").
4.1 Specimen Class A Common Stock Certificate of the Company -- incorporated by reference to Exhibit 4.1 to Continental's Annual Report on Form 10-K for the year ended December 31, 1995 (File no. 0-9781) (the "1995 10- K").
4.2 Specimen Class B Common Stock Certificate of the Company -- incorporated by reference to Exhibit 4.1 to Continental's Form S-1 Registration Statement (No. 33- 68870) (the "1993 S-1").
4.3 Rights Agreement, dated as of November 20, 1998, between Continental and Harris Trust and Savings Bank -- incorporated by reference to Exhibit 4.1 to the 11/98 8- K.
4.3(a) First Amendment to Rights Agreement, dated as of February 8, 2000 -- incorporated by reference to Exhibit 4.1 to Continental's Current Report on Form 8-K dated February 8, 2000 (File No. 0-9781) (the "2/00 8-K").
4.4 Certificate of Designation of Series A Junior Participating Preferred Stock, included as Exhibit A to Exhibit 4.3 -- incorporated by reference to Exhibit 4.2 to the 11/98 8-K.
4.5 Form of Right Certificate, included as Exhibit B to Exhibit 4.3 -- incorporated by reference to Exhibit 4.3 to the 11/98 8-K.
4.6 Summary of Rights to Purchase Preferred Shares, included as Exhibit C to Exhibit 4.3 -- incorporated by reference to Exhibit 4.4 to the 11/98 8-K.
4.7 Amended and Restated Governance Agreement, dated February 8, 2000, among the Company, Northwest Airlines Corporation ("Northwest") and Northwest Airlines Holdings Corporation ("Northwest Holdings") -- incorporated by reference to Exhibit 99.2 to the 2/00 8-K.
4.8 Supplemental Agreement dated November 20, 1998 among the Company, Newbridge Parent Corporation and Northwest -- incorporated by reference to Exhibit 99.7 to the 11/98 8- K.
4.8(a) First Amendment to Supplemental Agreement, dated as of February 8, 2000, among the Company, Northwest and Northwest Holdings -- incorporated by reference to Exhibit 99.3 to the 2/00 8-K.
4.9 Amended and Restated Registration Rights Agreement dated April 19, 1996 among the Company, Air Partners, L.P. and Air Canada -- incorporated by reference to Exhibit 10.2 to Continental's Form S-3 Registration Statement (No. 333-02701).
4.9(a) Amendment dated November 20, 1998 to the Amended and Restated Registration Rights Agreement among the Company, Air Partners and Northwest -- incorporated by reference to Exhibit 99.5 to the 11/98 8-K.
4.10 Warrant Agreement dated as of April 27, 1993, between Continental and Continental as warrant agent -- incorporated by reference to Exhibit 4.7 to the 4/93 8-K.
4.11 Continental hereby agrees to furnish to the Commission, upon request, copies of certain instruments defining the rights of holders of long-term debt of the kind described in Item 601(b)(4)(iii)(A) of Regulation S-K.
9.1 Northwest Airlines/Air Partners Voting Trust Agreement dated as of November 20, 1998 among the Company, Northwest, Northwest Holdings, Air Partners and Wilmington Trust Company, as Trustee -- incorporated by reference to Exhibit 99.4 to the 11/98 8-K.
9.1(a) First amendment to Northwest Airlines/Air Partners Voting Trust Agreement, dated as of February 8, 2000 between the Company and Northwest -- incorporated by reference to Exhibit 99.1 to the 2/00 8-K.
10.1 Agreement of Lease dated as of January 11, 1985, between the Port Authority of New York and New Jersey and People Express Airlines, Inc., regarding Terminal C (the "Terminal C Lease") -- incorporated by reference to Exhibit 10.61 to the Annual Report on Form 10-K (File No. 0-9781) of People Express Airlines, Inc. for the year ended December 31, 1984.
10.1(a) Supplemental Agreements Nos. 1 through 6 to the Terminal C Lease -- incorporated by reference to Exhibit 10.3 to Continental's Annual Report on Form 10-K (File No. 1- 8475) for the year ended December 31, 1987 (the "1987 10- K").
10.1(b) Supplemental Agreement No. 7 to the Terminal C Lease -- incorporated by reference to Exhibit 10.4 to Continental's Annual Report on Form 10-K (File No. 1- 8475) for the year ended December 31, 1988.
10.1(c) Supplemental Agreements No. 8 through 11 to the Terminal C Lease -- incorporated by reference to Exhibit 10.10 to the 1993 S-1.
10.1(d) Supplemental Agreements No. 12 through 15 to the Terminal C Lease -- incorporated by reference to Exhibit 10.2(d) to the 1995 10-K.
10.1(e) Supplemental Agreement No. 16 to the Terminal C Lease -- incorporated by reference to Exhibit 10.1(e) to Continental's Annual Report on Form 10-K for the year ended December 31, 1997 (File no. 0-9781) (the "1997 10- K").
10.1(f) Supplemental Agreement No. 17 to the Terminal C Lease. (2)(3)
10.2 Assignment of Lease with Assumption and Consent dated as of August 15, 1987, among the Port Authority of New York and New Jersey, People Express Airlines, Inc. and Continental -- incorporated by reference to Exhibit 10.2 to the 1987 10-K.
10.3* Amended and restated employment agreement between the Company and Gordon Bethune, dated as of November 20, 1998 -- incorporated by reference to Exhibit 10.3 to the 1998 10-K.
10.3(a)* Amendment dated as of May 19, 1999 to Mr. Bethune's Employment Agreement -- incorporated by reference to Exhibit 10.2 to Continental's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 (File No. 0- 9781) (the "1999 Q-2 10-Q").
10.3(b)* Amendment dated as of September 16, 1999 to Mr. Bethune's Employment Agreement -- incorporated by reference to Exhibit 10.2 to Continental's Quarterly Report on Form 10-Q for the quarter ended September 30,1999 (File No. 0- 9781) (the "1999 Q-3 10-Q").
10.4* Amended and restated employment agreement between the Company and Gregory Brenneman, dated as of November 20, 1998 -- incorporated by reference to Exhibit 10.4 to the 1998 10-K.
10.4(a)* Amendment dated as of May 19, 1999 to Mr. Brenneman's Employment Agreement -- incorporated by reference to Exhibit 10.3 to the 1999 Q-2 10-Q.
10.4(b)* Amendment dated as of September 16, 1999 to Mr. Brenneman's Employment Agreement -- incorporated by reference to Exhibit 10.3 to the 1999 Q-3 10-Q.
10.5* Amended and restated employment agreement dated as of September 16, 1999 between the Company and Lawrence Kellner -- incorporated by reference to Exhibit 10.4 to the 1999 Q-3 10-Q.
10.6* Amended and restated employment agreement dated as of September 16, 1999 between the Company and C.D. McLean -- incorporated by reference to Exhibit 10.5 to the 1999 Q-3 10-Q.
10.7* Amended and restated employment agreement dated September 16, 1999 between the Company and Jeffery A. Smisek -- incorporated by reference to Exhibit 10.6 to the 1999 Q-3 10-Q.
10.8* Stay Bonus Agreement between the Company and Gordon Bethune -- incorporated by reference to Exhibit 10.3 to Continental's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998 (File no. 0-9781) (the "1998 Q-2 10-Q").
10.9* Stay Bonus Agreement between the Company and Gregory Brenneman -- incorporated by reference to Exhibit 10.4 to the 1998 Q-2 10-Q.
10.10* Stay Bonus Agreement between the Company and Lawrence Kellner -- incorporated by reference to Exhibit 10.5 to the 1998 Q-2 10-Q.
10.11* Stay Bonus Agreement between the Company and C.D. McLean -- incorporated by reference to Exhibit 10.6 to the 1998 Q-2 10-Q.
10.12* Stay Bonus Agreement between the Company and Jeffery Smisek -- incorporated by reference to Exhibit 10.7 to the 1998 Q-2 10-Q.
10.13* Forms of Stay Bonus Agreements for other executive officers -- incorporated by reference to Exhibit 10.8 to the 1998 Q-2 10-Q.
10.14* Executive Bonus Program -- incorporated by reference to Appendix B to the Company's proxy statement relating its annual meeting of stockholders held on June 26, 1996.
10.14(a)* Amendment of Executive Bonus Program effective January 1, 1999 -- incorporated by reference to Exhibit 10.2 to Continental's Quarterly Report on Form 10-Q for the quarter ended March 31, 1999 (File no. 0-9781) (the "1999 Q-1 10-Q").
10.14(b)* Amendment of Executive Bonus Program dated February 8, 2000. (3)
10.15* Continental Airlines, Inc. 1994 Incentive Equity Plan ("1994 Equity Plan") -- incorporated by reference to Exhibit 4.3 to the Company's Form S-8 Registration Statement (No. 33-81324).
10.15(a)* First Amendment to 1994 Equity Plan -- incorporated by reference to Exhibit 10.1 to Continental's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995 (File no. 0-9781).
10.15(b)* Second Amendment to 1994 Equity Plan -- incorporated by reference to Exhibit 4.3(c) to the 1996 S-8.
10.15(c)* Third Amendment to 1994 Equity Plan -- incorporated by reference to Exhibit 10.4 to Continental's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996 (File no. 0-9781).
10.15(d)* Fourth Amendment to 1994 Equity Plan -- incorporated by reference to Exhibit 10.10(d) to the 1997 10-K.
10.15(e)* Form of Employee Stock Option Grant pursuant to the 1994 Equity Plan -- incorporated by reference to Exhibit 10.10(e) to the 1997 10-K.
10.15(f)* Form of Outside Director Stock Option Grant pursuant to the 1994 Equity Plan -- incorporated by reference to Exhibit 10.10(f) to the 1997 10-K.
10.15(g)* Form of Restricted Stock Grant pursuant to the 1994 Equity Plan -- incorporated by reference to Exhibit 10.10(g) to the 1997 10-K.
10.16* Continental Airlines, Inc. 1997 Stock Incentive Plan ("1997 Incentive Plan") -- incorporated by reference to Exhibit 4.3 to Continental's Form S-8 Registration Statement (No. 333-23165).
10.16(a)* First Amendment to 1997 Incentive Plan -- incorporated by reference to Exhibit 10.11(a) to the 1997 10-K.
10.16(b)* Form of Employee Stock Option Grant pursuant to the 1997 Incentive Plan -- incorporated by reference to Exhibit 10.11(b) to the 1997 10-K.
10.16(c)* Form of Outside Director Stock Option Grant pursuant to the 1997 Incentive Plan -- incorporated by reference to Exhibit 10.11(c) to the 1997 10-K.
10.17* Amendment and Restatement of the 1994 Equity Plan and the 1997 Incentive Plan -- incorporated by reference to Exhibit 10.19 to the 1998 10-K.
10.18* Continental Airlines, Inc. 1998 Stock Incentive Plan ("1998 Incentive Plan") -- incorporated by reference to Exhibit 4.3 to Continental's Form S-8 Registration Statement (No. 333-57297) (the "1998 S-8").
10.18(a)* Form of Employee Stock Option Grant pursuant to the 1998 Incentive Plan -- incorporated by reference to Exhibit 4.4 to the 1998 S-8.
10.19* Amended and Restated Continental Airlines, Inc. Deferred Compensation Plan. (3)
10.20* Continental Airlines, Inc. Incentive Plan 2000. (3)
10.21* Continental Airlines, Inc. Executive Bonus Performance Award Program, as amended. (3)
10.22* Continental Airlines, Inc. Long Term Incentive Performance Award Program. (3)
10.23* Form of Letter Agreement relating to certain flight benefits between the Company and each of its nonemployee directors -- incorporated by reference to Exhibit 10.19 to the 1995 10-K.
10.24 Purchase Agreement No. 1783, including exhibits and side letters, between the Company and Boeing, effective April 27, 1993, relating to the purchase of Boeing 757 aircraft ("P.A. 1783") -- incorporated by reference to Exhibit 10.2 to Continental's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File no. 0- 9781). (1)
10.24(a) Supplemental Agreement No. 4 to P.A. 1783, dated March 31, 1995 -- incorporated by reference to Exhibit 10.12(a) to Continental's Annual Report on Form 10-K for the year ended December 31, 1994 (File no. 0-9781) (the "1994 10-K"). (1)
10.24(b) Supplemental Agreement No. 6 to P.A. 1783, dated June 13, 1996 -- incorporated by reference to Exhibit 10.6 to Continental's Quarterly Report on Form 10-Q for the quarter ending June 30, 1996 (File no. 0-9781) (the "1996 Q-2 10-Q"). (1)
10.24(c) Supplemental Agreement No. 7 to P.A. 1783, dated July 23, 1996 -- incorporated by reference to Exhibit 10.6(a) to the 1996 Q-2 10-Q. (1)
10.24(d) Supplemental Agreement No. 8 to P.A. 1783, dated October 27, 1996 -- incorporated by reference to Exhibit 10.11(d) to Continental's Annual Report on Form 10-K for the year ended December 31, 1996 (File no. 0-9781) (the "1996 10- K"). (1)
10.24(e) Letter Agreement No. 6-1162-GOC-044 to P.A. 1783, dated March 21, 1997 -- incorporated by reference to Exhibit 10.4 to Continental's Quarterly Report on Form 10-Q for the quarter ending March 31, 1997 (File no. 0-9781) (the "1997 Q-1 10-Q"). (1)
10.24(f) Supplemental Agreement No. 9 to P.A. 1783, dated August 13, 1997 -- incorporated by reference to Exhibit 10.1 to Continental's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997 (File no. 0-9781). (1)
10.24(g) Supplemental Agreement No. 10, including side letters, to P.A. 1783, dated October 10, 1997 -- incorporated by reference to Exhibit 10.13(g) to the 1997 10-K. (1)
10.24(h) Supplemental Agreement No. 11, including exhibits and side letters, to P.A. 1783, dated July 30, 1998 -- incorporated by reference to Exhibit 10.2 to Continental's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998 (File no. 0-9781) (the "1998 Q-3 10-Q"). (1)
10.24(i) Supplemental Agreement No. 12, including side letter, to P.A. 1783, dated September 29, 1998 -- incorporated by reference to Exhibit 10.23(i) to the 1998 10-K. (1)
10.24(j) Supplemental Agreement No. 13 to P.A. 1783, dated November 16, 1998 -- incorporated by reference to Exhibit 10.23(j) to the 1998 10-K. (1)
10.24(k) Supplemental Agreement No. 14, including side letter, to P.A. 1783, dated December 17, 1998 -- incorporated by reference to Exhibit 10.23(k) to the 1998 10-K. (1)
10.24(l) Supplemental Agreement No. 15, including side letter, to P.A. 1783, dated February 18, 1999 -- incorporated by reference to Exhibit 10.3 to the 1999 Q-1 10-Q. (1)
10.24(m) Supplemental Agreement No. 16, including side letters, to P.A. 1783, dated July 2, 1999 -- incorporated by reference to Exhibit 10.7 to the 1999 Q-3 10-Q. (2)
10.25 Purchase Agreement No. 1951, including exhibits and side letters thereto, between the Company and Boeing, dated July 23, 1996, relating to the purchase of Boeing 737 aircraft ("P.A. 1951") -- incorporated by reference to Exhibit 10.8 to the 1996 Q-2 10-Q. (1)
10.25(a) Supplemental Agreement No. 1 to P.A. 1951, dated October 10, 1996 -- incorporated by reference to Exhibit 10.14(a) to the 1996 10-K. (1)
10.25(b) Supplemental Agreement No. 2 to P.A. 1951, dated March 5, 1997 -- incorporated by reference to Exhibit 10.3 to the 1997 Q1 10-Q. (1)
10.25(c) Supplemental Agreement No. 3, including exhibit and side letter, to P.A. 1951, dated July 17, 1997 -- incorporated by reference to Exhibit 10.14(c) to the 1997 10-K. (1)
10.25(d) Supplemental Agreement No. 4, including exhibits and side letters, to P.A. 1951, dated October 10, 1997 -- incorporated by reference to Exhibit 10.14(d) to the 1997 10-K. (1)
10.25(e) Supplemental Agreement No. 5, including exhibits and side letters, to P.A. 1951 dated October 10, 1997 -- incorporated by reference to Exhibit 10.1 to the 1998 Q-2 10-Q. (1)
10.25(f) Supplemental Agreement No. 6, including exhibits and side letters, to P.A. 1951, dated July 30, 1998 -- incor- porated by reference to Exhibit 10.1 to the 1998 Q-3 10- Q. (1)
10.25(g) Supplemental Agreement No. 7, including side letters, to P.A. 1951, dated November 12, 1998 -- incorporated by reference to Exhibit 10.24(g) to the 1998 10-K. (1)
10.25(h) Supplemental Agreement No. 8, including side letters, to P.A. 1951, dated December 7, 1998 -- incorporated by reference to Exhibit 10.24(h) to the 1998 10-K. (1)
10.25(i) Letter Agreement No. 6-1162-GOC-131R1 to P.A. 1951, dated March 26, 1998 -- incorporated by reference to Exhibit 10.1 to Continental's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998 (File no. 0-9781). (1)
10.25(j) Supplemental Agreement No. 9, including side letters, to P.A. 1951, dated February 18, 1999 -- incorporated by reference to Exhibit 10.4 to the 1999 Q-1 10-Q. (1)
10.25(k) Supplemental Agreement No. 10, including side letters, to P.A. 1951, dated March 19, 1999 -- incorporated by reference to Exhibit 10.4(a) to the 1999 Q-1 10-Q. (1)
10.25(l) Supplemental Agreement No. 11, including side letters, to P.A. 1951, dated May 14, 1999 -- incorporated by reference to Exhibit 10.7 to the 1999 Q-2 10-Q. (1)
10.25(m) Supplemental Agreement No. 12 to P.A. 1951, dated July 2, 1999 -- incorporated by reference to Exhibit 10.8 to the 1999 Q-3 10-Q. (2)
10.25(n) Supplemental Agreement No. 13 to P.A. 1951, dated October 13, 1999. (2)(3)
10.25(o) Supplemental Agreement No. 14 to P.A. 1951, dated December 13, 1999. (2)(3)
10.26 Aircraft General Terms Agreement between the Company and Boeing, dated October 10, 1997 -- incorporated by reference to Exhibit 10.15 to the 1997 10-K. (1)
10.26(a) Letter Agreement No. 6-1162-GOC-136 between the Company and Boeing, dated October 10, 1997, relating to certain long-term aircraft purchase commitments of the Company -- incorporated by reference to Exhibit 10.15(a) to the 1997 10-K. (1)
10.27 Purchase Agreement No. 2060, including exhibits and side letters, between the Company and Boeing, dated October 10, 1997, relating to the purchase of Boeing 767 aircraft ("P.A. 2060") -- incorporated by reference to Exhibit 10.16 to the 1997 10-K. (1)
10.27(a) Supplemental Agreement No. 1 to P.A. 2060 dated December 18, 1997 -- incorporated by reference to Exhibit 10.16(a) to the 1997 10-K. (1)
10.27(b) Supplemental Agreement No. 2 to P.A. 2060 dated June 8, 1999 -- incorporated by reference to Exhibit 10.8 to the 1999 Q-2 10-Q. (1)
10.28 Purchase Agreement No. 2061, including exhibits and side letters, between the Company and Boeing, dated October 10, 1997, relating to the purchase of Boeing 777 aircraft ("P.A. 2061") -- incorporated by reference to Exhibit 10.17 to the 1997 10-K. (1)
10.28(a) Supplemental Agreement No. 1 to P.A. 2061 dated December 18, 1997 -- incorporated by reference to Exhibit 10.17(a) as to the 1997 10-K. (1)
10.28(b) Supplemental Agreement No. 2, including side letter, to P.A. 2061, dated July 30, 1998 -- incorporated by reference to Exhibit 10.27(b) to the 1998 10-K. (1)
10.28(c) Supplemental Agreement No. 3, including side letter, to P.A. 2061, dated September 25, 1998 -- incorporated by reference to Exhibit 10.27(c) to the 1998 10-K. (1)
10.28(d) Supplemental Agreement No. 4, including side letter, to P.A. 2061, dated February 3, 1999 -- incorporated by reference to Exhibit 10.5 to the 1999 Q-1 10-Q. (1)
10.28(e) Supplemental Agreement No. 5, including side letter, to P.A. 2061, dated March 26, 1999 -- incorporated by reference to Exhibit 10.5(a) to the 1999 Q-1 10-Q. (1)
10.28(f) Supplemental Agreement No. 6, including side letter, to P.A. 2061, dated May 14, 1999 -- incorporated by reference to Exhibit 10.9 to the 1999 Q-2 10-Q. (1)
10.29 Purchase Agreement No. 2211, including exhibits and side letters thereto, between the Company and Boeing, dated November 16, 1998, relating to the purchase of Boeing 767 aircraft ("P.A. 2211") -- incorporated by reference to Exhibit 10.28 to the 1998 10-K. (1)
10.29(a) Supplemental Agreement No. 1, including side letters, to P.A. 2211, dated July 2, 1999 -- incorporated by reference to Exhibit 10.9 to the 1999 Q-2 10-Q. (1)
10.30 Lease Agreement dated as of May 1992 between the City and County of Denver, Colorado and Continental regarding Denver International Airport -- incorporated by reference to Exhibit 10.17 to the 1993 S-1.
10.30(a) Supplemental Lease Agreement, including an exhibit thereto, dated as of April 3, 1995 between the City and County of Denver, Colorado and Continental and United Air Lines, Inc. regarding Denver International Airport -- incorporated by reference to Exhibit 10.15(a) to the 1994 10-K.
10.31 Airport Use and Lease Agreement dated as of January 1, 1998 between the Company and the City of Houston, Texas regarding Bush Intercontinental -- incorporated by reference to Exhibit 10.30 to the 1998 10-K.
10.31(a) Special Facilities Lease Agreement dated as of March 1, 1997 by and between the Company and the City of Houston, Texas regarding an automated people mover project at Bush Intercontinental -- incorporated by reference to Exhibit 10.30(a) to the 1998 10-K.
10.31(b) Amended and Restated Special Facilities Lease Agreement dated as of December 1, 1998 by and between the Company and the City of Houston, Texas regarding certain terminal improvement projects at Bush Intercontinental -- incorporated by reference to Exhibit 10.30(b) to the 1998 10-K.
10.31(c) Amended and Restated Special Facilities Lease Agreement dated December 1, 1998 by and between the Company and the City of Houston, Texas regarding certain airport improvement projects at Bush Intercontinental -- incorporated by reference to Exhibit 10.30(c) to the 1998 10-K.
10.32 Agreement and Lease dated as of May 1987, as supplemented, between the City of Cleveland, Ohio and Continental regarding Hopkins International -- incorporated by reference to Exhibit 10.6 to Continental's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File no. 0-9781).
10.32(a) Special Facilities Lease Agreement dated as of October 24, 1997 by and between the Company and the City of Cleveland, Ohio regarding certain concourse expansion projects at Hopkins International (the "1997 SFLA") -- incorporated by reference to Exhibit 10.31(a) to the 1998 10-K.
10.32(b) First Supplemental Special Facilities Lease Agreement dated as of March 1, 1998, and relating to the 1997 SFLA -- incorporated by reference to Exhibit 10.1 to the 1999 Q-1 10-Q.
10.33 Special Facilities Lease Agreement dated as of December 1, 1989 by and between the Company and the City of Cleveland, Ohio regarding Cleveland Hopkins International Airport (the "1989 SFLA") -- incorporated by reference to Exhibit 10.1 to the 1999 Q-3 10-Q.
10.33(a) First Supplemental Special Facilities Lease Agreement dated as of March 1, 1998, and relating to the 1989 SFLA -- incorporated by reference to Exhibit 10.1(a) to the 1999 Q-3 10-Q.
10.33(b) Second Supplemental Special Facilities Lease Agreement dated as of March 1, 1998, and relating to the 1989 SFLA -- incorporated by reference to Exhibit 10.1(b) to the 1999 Q-3 10-Q.
10.34 Third Revised Investment Agreement, dated April 21, 1994, between America West Airlines, Inc. and AmWest Partners, L.P. -- incorporated by reference to Exhibit 1 to Continental's Schedule 13D relating to America West Airlines, Inc. filed on August 25, 1994.
10.35 Letter Agreement No. 11 between the Company and General Electric Company, dated December 22, 1997, relating to certain long-term engine purchase commitments of the Company -- incorporated by reference to Exhibit 10.23 to the 1997 10-K. (1)
18.1 Letter from Ernst & Young LLP re change in accounting principle. (3)
21.1 List of Subsidiaries of Continental. (3)
23.1 Consent of Ernst & Young LLP. (3)
24.1 Powers of attorney executed by certain directors and officers of Continental. (3)
27.1 Financial Data Schedule. (3)
__________
* These exhibits relate to management contracts or compensatory plans or arrangements.
(1) The Commission has granted confidential treatment for a portion of this exhibit. (2) The Company has applied to the Commission for confidential treatment of a portion of this exhibit. (3) Filed herewith. | 31,901 | 208,271 |
1075249_1999.txt | 1075249_1999 | 1999 | 1075249 | ITEM 1. Business
History of Business
Euro Trade & Forfaiting, Inc. (the "Company") was incorporated as Rotunda Oil and Mining, Inc. on November 19, 1980 under the laws of the State of Utah. The Company was originally formed to engage in the oil and gas, uranium and hard rock mining business for profit. Within approximately two years, the Company abandoned its pursuit of mining interest and remained inactive for several years. In approximately 1996, the Company became engaged in the development of the "Gas Hands" product. Gas Hands is a moist towelette to be sold at gasoline service stations and convenience stores and is used to remove and clean gasoline odors and residue from the customers' hands as they refuel. The Company entered into a license agreement with the inventor of Gas Hands and in September 1997, sold an exclusive distributorship for the product in the Nevada and Arizona markets. However, in 1998 management became concerned about the potential market for the product and, when the opportunity to acquire Euro Trade & Forfaiting Company Limited presented itself to the Company, the project was abandoned. Management believed that with the new direction of the Company, it would not be good business sense to continue with production of the Gas Hands product. Accordingly, all rights to the Gas Hands product were assigned by the Company to the inventor of the product.
In 1998, a representative of Euro Trade & Forfaiting Company Limited, a privately held limited company based in, London, England ("Euro Trade Limited") approached a principal shareholder of the Company about the possibility of the Company acquiring Euro Trade Limited. When the proposal was made to the Company's Board of Directors, the Board determined that the business prospects of Euro Trade Limited presented a greater potential opportunity that the Company's attempts to commercialize the Gas Hands product. Subsequently, on November 20, 1998 the Company entered into an Acquisition Agreement and Plan of Reorganization (the "Agreement") with Euro Trade Limited.
Pursuant to the Agreement, the Company acquired 100% of the capital stock of Euro Trade Limited for 11,000,000 shares of Company's authorized but previously unissued common stock. As a result of the acquisition, the Company acquired all rights, title and interest to the assets and property owned by Euro Trade Limited. The acquisition was accounted for as a recapitalization of Euro Trade Limited and all of Euro Trade Limited's common shares were converted into shares of the Company. Euro Trade Limited became a wholly owned subsidiary of the Company and the Company also changed its name to Euro Trade & Forfaiting, Inc. All of the Company's directors submitted their resignations and were replaced by new directors that were previously associated with the management and operations of Euro Trade Limited. References to the Company made hereafter will include the operations of Euro Trade Limited.
Euro Trade Limited was organized in the United Kingdom on February 25, 1997, for the purpose of servicing trade financing activities in the business world. Euro Trade Limited's core business is based on non-recourse financing of trade receivables. Euro Trade generates revenues by arranging and taking into its portfolio non-recourse trade finance transactions and selling them into the secondary market. These receivables are known as "forfaiting assets."
Euro Trade Limited was originally founded primarily to service the $1.5 billion trade finance requirements of its founding shareholders. In February 1997 Multikarsa Investama ("Multikarsa") established Euro Trade Limited with a capitalization of $25 million dollars. Multikarsa is a holding company with interests in many international companies. Euro Trade Limited's founders intended that business not only would support the import-export requirements of companies wherein Multikarsa had a financial interest, but also develop a separate trade finance activity. When the problems of the Asian emerging market economies developed in the third and fourth quarters of 1997, Euro Trade Limited shifted its focus to trade finance activity, drawing increasingly on the contacts and trade finance experience of its management team.
Upon the closing of the Agreement and the exchange of 100% of the shares of Euro Trade Limited for the Company's common stock, Multikarsa assigned all rights to its shares to two separate investment companies, Collingwood Investments Limited, a Bahamas company, and North Cascade Limited, a British Virgin Island company. Thereafter, Multikarsa, as an entity, had no direct ownership or management control in the Company.
Description of Business
The Company's primary business is trade finance. The Company employs banking professionals with experience across a broad range of disciplines. These professionals structure customized trade finance solutions for the Company's clients, both importers and exporters. The Company is actively engaged in the business of forfaiting trade receivables (see below), arranging debt for equity swaps and debt for commodity swaps. The Company has three traders and one executive officer. The Three traders are John Vowell, who is also the Company's President and C.E.O., Ray Brown, and David Ringer.
Mr. Vowell worked for four years as a senior member of the Trade Finance Department at Standard Bank London Limited. Previously, he worked at Sumitomo Bank in London, and Midland Bank London. Mr. Vowell has fifteen years experience in trade finance and banking and is responsible for day-to-day management of the Company's trading strategy, portfolio management and developing of marketing strategy.
Mr. Brown is Head of Trading for the Company and has over fifteen years of trading experience in the forfaiting market. He previously worked at RaboBank London for two years, Landesbank Baden-Wuertternburg for six years, and at Midland Bank for nine years. Mr. Brown oversees the Company's day-to-day trading operations.
Mr. Ringer, a forfaiting trader for the Company, has six years of trading experience in the forfaiting market. He previously worked at Standard Bank for two years and Hungarian International Bank and its successor, Hungarian International Finance, for four years.
Ms. Lewis is the Company's Structured Trade Finance Specialist, dealing with marketing and operations of Structured Trade Finance transactions. She also supports the Company's forfaiting marketing operation and is responsible for banking relationships in the United States, Republic of Ireland and France. Prior to joining the Company, Ms. Lewis worked at Standard Bank London for two years.
Although the Company's central businesses are in structured and non-recourse trade financing of trade receivables, it has also begun refinancing distressed trade debt held by international banks and financial institutions. The Company has arranged and closed transactions exceeding $200 million since it commenced dealing in trade receivables in 1997.
As a percentage of its total income for fiscal 1998, the Company derived approximately 27% from the sale of forfaiting assets, 37% from interest, 5% from structured trade, 26% from fees and charges, and 5% from other business including distressed debt refinancing. For fiscal 1999, the Company derived approximately 63% of its total income from the sale of forfaiting assets, 29% from interest, 1% from structured trade and 7% from fees and charges.
The following table sets forth the breakdown of income for fiscal 1999:
Income Source Amount Percentage ------------- ------ ---------- (In Thousands) Sale of Forfaiting Assets $ 4,907 63% Interest Income $ 2,218 29% Fees and Charges $ 514 7% Structured Trades $ 105 1% ------- ---- Total $ 7,744 100%
As the Company's business matures, it is expected that the majority of the Company's future income will be derived from the sale of forfaiting assets and fees received on the sales.
The Board of Directors sets dollar limits on the amount of exposure the Company may have with any one bank or country at any one time. These limits are under constant review by management. Presently, there is an overall aggregate limit on the amount of the trading portfolio of $50,000,000, established by the Board as a prudent bench mark in relation to the Company's share capital which equates to a gearing (leverage) ratio of two to one, debt to equity.
Management believes that the Company was not affected as severely as many of its competitors by the deterioration in world economic conditions during 1997 and 1998. This was due to the Company's perceived lower exposure to Central and Eastern Europe than its competitors, both in absolute amounts and
proportionately. Further, three of the Company's largest competitors in the forfaiting market in 1997 and 1998, experienced substantially greater losses than the Company in 1998. In all three instances, the losses are believed to have occurred in the financing of working capital, as opposed to trade finance transactions, mainly in Russia and Eastern Europe. In contrast, over 85% of the Company's transactions for this period were for the finance of Far East trade paper, all of which has been paid in full. However, the economic events did cause management to lower market valuations of some of some of the assets it held, and made loss provisions of $5.7 million in 1998.
During 1997 and 1998, the Company engaged in trade financing and had exposure primarily in the Far East , particularly in the Country of Indonesia. Approximately 85% of the Company's transactions during this period were for the finance of Far East trade paper, all of which has been paid in full. Because the Company's lower exposure to Central and Eastern Europe during the economic problems in 1997 and 1998, the Company was not affected as severely as many of its competitors.
All of the Company's foreign currency exposure risk in relation to its assets is hedged. This is accomplished primarily by financing non dollar denominated assets with borrowings in the same currency as the asset typically being financed. The risk, which the Company takes, is that the Obligor either becomes insolvent or it is unable to find the hard currency to meet its obligations when due. The Company strives to minimize this risk by dealing only with "bank obligors." A typical transaction would involve the Company purchasing from an exporter, without recourse, an obligation of an importer and guaranteed by its bank to pay a specific amount on a specific date through a specific bank.
Services provided by the Company are detailed below.
Forfaiting
The Company's primary business is forfaiting. Forfaiting involves the refinancing of trade receivables on a discount basis without recourse to the previous holder. This financial service is available in all major currencies for export contracts in excess of $250,000. Depending on transaction parameters, such as country and bank risk, the financing periods range between a few months and several years.
The Company's primary market forfaiter is responsible for all normal due diligence including documentary checks, and for ensuring that the transaction is a bona fide and negotiable transaction. Forfaiting requires the participants to act as principals and not brokers. This is necessary because of the documentary complexity of each transaction and the impossibility of matching buyers in the secondary market and sellers in the primary market in a time efficient fashion.
The forfaiting market relates more to the individuals involved than to the corporate or banking entities for whom they work. The Company estimates that
300 organizations, mainly international banks with departments of between five and twenty people, participate in this aspect of trade finance. Bills of exchange or promissory notes, referred to as assets, are placed in the secondary market with over 1,000 banks and similar financial institutions participating worldwide.
Forfaiting is based on non-recourse financing of trade receivables. Non-recourse, in this instance, means that each purchaser of the assets in turn relies on the ultimate obligor and gives up the right normally associated with trade finance of having recourse to the previous holder. Its principal characteristics are as follows:
* Transactions are normally comprised of bills of exchange drawn and accepted under a letter of credit or promissory notes issued by an importer. Bills of exchange are negotiable instruments drawn on the importer/obligor by the exporter and returned to the exporter as the payment mechanism for the underlying obligation of the importer. The usual size of transaction ranges from $l,000,000 to $5,000,000.
* Bills of exchange or promissory notes are normally "avaled" by the importer's bank. An aval is a guarantee, usually a bank guarantee that is separate from the underlying trade contract. In a typical transaction, the bank avals, or makes an unconditional guarantee of repayment, if the debtor fails to repay. An aval is the preferred form of guarantee as it is self-evident, irrevocable and unconditional so long as the buyer's country law does not impose specific restrictions. Bills of exchange are usually issued in hard currencies such as U.S. Dollars, Deutsch Marks and other recognized currencies.
* A series of notes are issued in relation to each export transaction. These notes typically mature at six monthly intervals over periods from six months to five years. Due to increasingly difficult market conditions, the Company trades in shorter term trade letters of credit, generally six to twelve months.
* Bills of exchange or promissory notes are priced relative to the average life London Interbank Offering Rate (LIBOR), plus a margin to reflect the credit risk and are discounted through maturity. This is an imperfect market however, and two-way prices are not quoted.
Generally, the Company acts as a principal and purchases trade receivables, which are payment obligations evidenced by a Bill of Exchange, a Promissory Note, or an Acceptance Payment Obligation derived from a Letter of Credit. These instruments typically short-term and either a direct obligation of a bank or covered by an effective bank guarantee in the importer's country. Risks associated with the different instruments are typically not unique. The three main areas of risk generally associated with forfaiting are (i) counterparty risk, (ii) Documentary risk, and (iii) payment risk. Counterparty risks involve the assessment of the professional competence and financial stability of those organizations from whom the Company is purchasing and to whom it is selling. Documentary risks are those normally associated in dealing with
trade finance and include checks to avoid fraudulent transactions. Payment risk involves an assessment of the ability of the obligor to pay the amounts due when they are due.
The Company's forfaiting transactions are financed through a mixture of capital, which is approximately $25,000,000 at June 30, 1999, and borrowings from banks which are asset backed (secured) facilities totaling approximately $25,000,000 at June 30, 1999. The level of gearing (leverage) that the Company undertakes is limited by the Board of Directors to two to one, borrowings to capital, at the present time. However, the level of leverage within this limit will depend on market conditions and the desire of the Company to expand or constrict the size of its trading portfolio.
Income from forfaiting comes from fees relating to the negotiation of the transaction and capital gains on the sale of the assets. Capital gains are the result of an improvement in the perceived credit risk or because of a downward movement in interest rates during the period the assets are held in the portfolio. The Company also earns a yield over and above the carrying costs of the assets to maturity. The Company, through its team of professional bankers, believes that it has established good relationships with banks and corporations in Europe and the Far East.
Structured Trade and Commodity Finance
The Company's other core business is the pre-export and specialized financing of commodities to well established small and medium size trading companies. The Company may arrange financing for trade from and to countries where traditional trade financing arrangements are not available.
The Company works with traders and manufacturers world-wide to provide 'pre' and 'post' shipment financing in emerging markets. Pre-shipment financing, short-term funding to finance the inventory and production costs includes tolling facilities, pre production finance, ex-works, on rail, in-warehouse and on-board financing. The Company also participates in structured trade and commodity transactions with banks and financial institutions.
Trade finance is an area of economic activity that has enjoyed consistent growth over the last 50 years. However, the Company's management knows of no statistics on this part of the trade finance market reflecting either the volume of transaction or the market share of individual participants. In the 1960's and 1970's the source of bills of exchange or promissory notes in this market was from capital goods' exporters in Europe. These assets entered the secondary market either through the exporter's bank, or in some countries, through brokers. In recent years the market has developed to source paper from the developing markets and to deal with other forms of financial transactions not necessarily trade related. Trade finance is unregulated in the United Kingdom, and is less subject to rescheduling when a creditor country has external payment problems. Furthermore, trade related assets are usually priced at a premium, compared to other financial assets with a similar risk profile. A premium is realized because the forfaiting market was originally developed to finance only the transfer of capital goods and equipment. However, the documentation, pricing technique and usance (term) has been extended to cover,
among other things, the financing of working capital and pre-export finance. Historically, trade related transactions are treated more favorably than other working capital, non-trade obligations when a country is forced to renegotiate its external debt. Also, documentation needed to support a trade transaction, including proof of deliver, make such transactions less subject to fraud.
Distressed Debt Refinancing
The Company is developing a program of debt "swaps" involving distressed debt refinancing. As part of its normal day-to-day forfaiting trading activities, the Company identifies distressed debt obligations of bank and other corporate entities in emerging markets. These obligations are purchased by the Company and then offered to organizations seeking to purchase at a discount the equities in the same emerging market banks. Such purchasers then seek to negotiate with the banks and corporate entities concerned to retire the distressed debt in exchange for equity or some other form of more valued security. The Company's profit is made between the purchase of the bank or corporate debt in the open market and the sale to buyers. The primary risks associated with debt swaps is the potential diminution in value between the time that the Company agrees to purchase an asset and the time that it arranges to sell it. In order to avoid a loss of value, the Company arranges most transactions on a simultaneous basis, where a buyer and seller are identified and funds are exchanged on the same value date.
The Company has launched a program to arrange the purchase of prime bank obligations at prices significantly higher than their present market value. The primary purpose of these purchases is for swapping into equities or commodities that the Company has purchased at a deep discount to the market. The difference between the purchase price for the prime bank obligations, although greater than the normal market value, and the sale or swap price at current market value of the basket of equities or commodities which the Company obtained at lower prices, generates the profit margin for the Company.
Market Background
Management believes that it is generally known that since the autumn of 1997, the global economy has experienced tremendous turmoil. This has especially effected the emerging markets. Many analysts forecast that, in the coming year there will be a slowdown in economic growth for both the developed and the developing markets. This can already be seen in the reduction in capital goods' exports from the stronger economies to the emerging markets. Also, many emerging market exporters have been impacted and are experiencing a sharp fall in their export prices. The major world financial markets reflect these events and international financial institutions, such as the International Monetary Fund ("IMF") and the World Bank, have only a limited ability to deal with the problems created in the current economic climate. Adding to the uncertainty is the introduction of a major New World currency, the Euro. The Company's concern with the Euro is the new currency's parity with other major international currencies and how stable those parities will be. This is particularly important when financing trade because parity effects both the competitiveness of exporters competing in different currencies and the cost of funds to importers.
Market Outlook
The Company's management believes that there is an increasing need for banking institutions to support the stability of developed and developing economies and help maintain their most important trade relationships. As the distressed emerging economies seek to trade their way out of recession, management feels that the economies will put particular emphasis on building and maintaining solid trade finance facilities. Further, management believes that there has been a reduced interest in emerging market financial paper in banking and equity investment institutions which is expected to remain at a reduced level for at least the next year.
Management believes the likelihood of reduced interest rates in several of the major currencies will increase, as the fear of inflation becomes less of a concern than the stability of the financial markets. Accordingly, investment in emerging markets will continue to be revalued at lower levels and should therefore give rise to higher yields. Management also believes that many banks in emerging markets are likely to sell their international assets to increase their liquidity as they face the need to make higher provisions on their domestic loan portfolios. Under this scenario, primary commodity exporters in particular will need to manage their liquidity more stringently.
Because of these perceived economic conditions, management believes that in countries such as Japan and Korea, capital goods' exporters and their banks may seek to liquidate some of their trade receivables in order to provide working capital for their ongoing businesses.
Employees
As of the date hereof, the Company employed eight full-time individuals, consisting of one executive officer, three market traders and four office staff personnel. In addition to its full-time employees, the Company may use the services of consultants on a contract basis as necessary. Management considers the relations between the Company and its employees to be good.
Competition
To the best knowledge of the Company, the only other publicly held company in this market is London Forfaiting Company PLC. This company has a capital base of over $264 million, a staff of 200 and turnover in 1998 of about $2.8 billion. This company is the only public source of financial information in this industry and is arguably the biggest participant. Other major competitors in this market include Standard Bank London Ltd., Westdeutsche Landesbank (formerly West Merchant Bank), HSBC and Deutsche Bank. Also, many banks and investment institutions, both in the United States and elsewhere, are becoming involved in forfaiting and pose competition to the Company.
Proposed Developments
The Company has existing contacts in the primary market and distribution to the secondary market for both of its core businesses, structured trade and commodity finance and non-recourse finance. The Company intends to apply its skills in trade finance selectively to both expand these core businesses and develop new niche businesses that have been identified as natural extensions of the core business.
Management believes that the Company is capable of expanding its forfaiting and structured trade participation businesses to over $200 million by the year 2000. Management anticipates that expansion can be accomplished by increasing the Company's marketing and trading activities. This expansion, which will lead to an increase in the size of the Company's trading portfolio, will be financed through the extension of borrowing facilities on predominantly asset backed borrowing facilities available from banks.
The Company intends to market to European exporters the ability to finance exports to Indonesia. Additionally, the Company intends to develop the ability to exchange trade debt purchased at a discount for other assets, initially in Indonesia where the Company has experience and a market base. If successful, the Company will consider expanding to other markets.
Management believes that these developments would:
* Take advantage of the present world economic situation and the existing perceived weakness of the competition, to develop the primary market penetration of the core businesses. This would give the Company the opportunity to earn higher fees and capital gains by dealing direct with capital goods' and commodity exporters in countries where the local banking system may be too illiquid to provide more traditional methods of financing. Initially the Company would market direct from London to the European market and establish regional offices to identify and develop relationships with exporters in Asia and the Americas. These regional offices would also establish relationships with a limited number of local banks and brokers with good local corporate contacts. As a first step, the Company is presently negotiating a joint venture in the Far East. As of the date hereof, no definitive agreements have been entered into.
* Develop the structured trade and commodity finance operation concentrating on both high value products and markets where traditional finance methods are not available. Management will focus on established smaller and medium sized trading companies and undertake only the most secure transactions. Transactions, such as pre-export finance and countertrade can lead to high margin banking returns and fee income. However these transactions are often complex and require flexible and innovative financing arrangements.
* Enable the Company to purchase trade receivable assets at favorable prices from distressed banks in certain developing countries and liquidate these investments, either through arranging structured trade finance deals or undertaking debt/equity swap business. This is similar to re-scheduled debt developed in Latin America and Poland
during the mid 1980's. This business may concentrate initially on countries such as Indonesia where the Company has strong existing relationships. Although many of these activities are primarily fee generating, profits will also be made from participating in the underlying transactions. The Company has been advised that its core businesses do not require supervision from the Financial Services Authority. It is possible that some of the proposed development activities may require clearance from or supervision by the United Kingdom regulatory authorities. However, the Company's legal counsel believes that it is unlikely that activities based on trade finance will be subject to any form of financial regulation.
Operations and Finance
Management believes that it is important to maintain a system of internal controls to manage and communicate with the Company's traders. An experienced trader in the Company can complete an average of about two transactions per week. Speed of reaction to change and new business inquiry is a key ingredient to success in this market, which requires short reporting lines and a pro-active credit research function.
The Company's trading team use its skills and experience to source, price and structure transactions and to develop secondary market buyers. All traders actively assess risks on a day-to-day basis. This is accomplished by meeting with exporters and their banks in the primary market and telephoning banks in the secondary market in Europe, Asia and the United States. This enables the traders to determine the current pricing structure for the risks which they are actively seeking to either purchase or sell. Secondary market transactions relate to exports which have already been financed by a bank, but where that bank needs to sell the transaction either to make room within its credit for new transactions or to realize a profit. The Company purchases such transactions in the belief that the price does not correctly recognize the opportunity to make a further profit before maturity, or because the yield to maturity is attractive in relation to credit risk and funding costs. This ability to place an asset in the secondary market plays an important part in reducing many of the risks associated with carrying the assets in the portfolio, including asset concentration and interest rates.
Presently the Company has one trading team consisting of three traders/marketers. This team is actively involved in marketing, originating and trading forfaiting and structured trade transactions. The members of the team are experienced ex-banking professionals enabling them to market and process a variety of transactions. (See Item 1 "Business - Description of Business" above.)
The potential profitability of the Company's transactions are influenced by the credit research function. In addition to reviewing "counterparty" (a buyer or seller of assets or obligations with another party) and individual credit risks, credit research maintains a constant review of emerging market risks. Researchers must be able to identify improving and/or deteriorating economic situations to ensure that purchases and sales of assets are made in a timely fashion. Also, in order to minimize interest rate risk, researchers provide advice on the interest rate outlook for the world's major currencies.
The Company's research function is presently made up of one full time advisor. However, as business warrants, the Company intends to add at least one additional researcher as part of the planned expansion over the next year. Each individual new transaction considered for purchase is the subject of a full updated written review of the country and bank risk involved. Research into bank and country risks are initiated by inquiries made to the trading team for purchases, which average approximately four inquiries per week. Research is also done on a continuing review basis of risks related to transactions held in the trading portfolio. Research involves desk-based activity reviewing economic and financial data related to country risk and bank risk, respectively. As part of the appraisal process, a prospective investment is scrutinized for potential saleability into the forfaiting market. Research is augmented by conversations with economists, diplomats, journalists and other professionals with experience or knowledge related to the risks being reviewed. In certain instances where country exposure is under review, visits will be made to the country under review to better assess the underlying political and economic situation. The Board then assesses the data made available from these review for day-to-day decisions on what assets to buy and sell.
Trading limits, internal controls and accounting principals that have been adopted by the Company are similar to those applicable to a small merchant bank. Valuation of assets in the Company's portfolio, which assets are typically unquoted and trade only in a limited market, necessarily depends on input from the Company's directors. Management must also keep current internal financial information concerning the Company's business including normal budgeting procedure and production of daily and monthly management accounting data.
The size of the Company's portfolio varies considerably from month-to-month depending on both deal flow and the Company's views on the interest rate and macro economic outlooks. Management believes, base on past experience, that in the primary market, the holding period for assets is often two to three months before an asset can be safely and profitably sold. This reality determines the minimum level of the Company's portfolio. Size of the portfolio is also constrained by the need to act within prudent leverage limits. During the fiscal year ended June 30, 1999, the Company's portfolio size, after provision for impaired forfaiting assets, ranged from a high of $16 million to a low of $11.8 million.
Risk Management
General
Trade finance is one of the oldest banking finance activities. Risks associated with the Company's business are those most usually associated with and undertaken within a bank. A discussion of the various risks is set forth below under the subheading "Risk Categories." Therefore, control mechanisms for monitoring and limiting these risks are based on controls that would be expected of a small merchant banking operation. However it must be emphasized that due to the trading nature of the Company's business, it must rely on its speed of
reaction to customer inquiry and changes in market conditions to achieve profitability. These prerequisites require a flexible management structure with short reporting lines.
Because the Company is not a deposit taking institution and trades only with professional counterparties, the Financial Services Authority's ("FSA") banking supervision department does not monitor its business. In the event the Company begins dealing in financial instruments such as bonds and equities, management believes that the Company's business would become under the supervision of the FSA.
Risk Categories
* Transactional. Non-recourse trade finance purchases are frequently made "subject to receipt of satisfactory documentation" and sometimes pay under reserve before the documentation is finally approved. If a decision is made to commit to purchase a deal, this commitment is commonly communicated to the seller before the purchaser has had the opportunity to review in detail the underlying documentation. A buyer may specify certain detailed aspects of the documentation, which it expects the seller to be able to satisfy. Thus, a buyer is protected in the event that the detailed documentation supporting the transaction is materially incomplete in the sense that it invalidates the obligation of the importer or its bank to pay. This requires the Company to have good technical skills, financial reliability and probity of its counterparties.
It is also common practice to commit to purchase a transaction from an exporter at a pre-determined rate of interest and to hold the commitment open for a period to allow the exporter to negotiate its contract with the importer. These commitments are fee earning and require the Company to take an informed view of the interest rate outlook in the particular currency concerned. The primary forfaiter also has the duty to know his customer and ensure that the underlying transaction is bona fide. In the event of fraud, the "non-recourse" element of the transaction is nullified and each party may proceed against the person from whom they purchased the commitment.
Traders with whom the Company transacts business on a daily basis are all known personally by the Company. The Company routinely investigates the financial strength of the counterparty from whom it is buying a deal. Also, if the transaction is a primary market deal involving an exporter with whom the Company has not previously conducted business, the Company will make a full credit assessment of the exporter as well as check on its previous experience and performance as an exporter. In the case of a secondary market transaction, the Company will most likely only be dealing with a bank or financial institution with whom it has dealt with before. If the transaction comes through an intermediary, the Company will make a complete check of the exporter and the intermediary.
The Company's credit committee also makes a full assessment of the counterparty, country, hard currency availability and bank credit risks. A commitment to purchase the deal is made only when all these aspects have been approved by the credit committee. As part of its documentary checks, the Company
must be assured that both the importer and its bank are permitted to arrange and pay for the import and that the decision to import has been properly authorized, both by the necessary authorities and by the importer's management. During fiscal year 1999, the trading and research staff formally visited over forty corporate and bank counterparties from whom primary business was offered. Additional counterparties were telephoned by the Company approximately twice per month. The creditworthiness of all counterparties with whom the Company conducts business actively is reviewed at least annually. Company personnel will visit all corporate customers from whom primary business is purchased before the transaction is committed to.
Each transaction has different documentation covering such matters as the importer's legal right to import the equipment and to finance the deal. The primary forfaiter will need to check the importer's bank's ability to guarantee the transaction and the confirmation that the financial obligation of the importer and his bank are abstract from the performance of the underlying contract for delivery of goods.
* Portfolio Management. The Company's portfolio of trading assets is made up of bills of exchange, promissory notes and other negotiable trade finance instruments denominated in "hard" currencies. Since the inception of the Company, in excess of 90% of the Company's deals have been purchased on the basis of discounting through to maturity for periods of six months to five years. Prudent management demands that currency and interest rate risks are minimized. The Company assesses these credit risks on a daily basis to ensure that it buys into improving risk categories and sells assets in potentially deteriorating categories early to avoid potential illiquidity. The Company continually investigates bank and country risks by reviewing economic and financial data related to each risk and by communicating with other experienced professionals outside the Company. Results are assessed by the Board as the basis for day-to-day decisions on what assets to buy and sell. In addition to the day-to-day maintenance of the trading assets portfolio, it is necessary to maintain adequate liquidity to purchase new transactions as they arise. Although the Company's capital base provides underlying funding for the portfolio, it is important to maintain adequate funding facilities to permit prudent planning for such an operation. Management believes that this is approximately three times its capital and reserves. Presently, the Company has "asset-backed" (secured) facilities of $25 million from its banks. This represents just below one times the capital and reserves of the Company at June 30, 1999. In difficult market conditions, it may be necessary to seek secured credit lines or to maintain a higher level of short-term liquidity. At June 30, 1999, the Company's net trading portfolio was approximately $16.0 million.
* Contingent Liabilities. It is common market practice from time-to-time to issue confirmations of letters of credit and to enter into "repurchase arrangement" facilities with other market participants to borrow or lend transactions. These reciprocity arrangements make it possible for the parties to spread and share the risk. Such arrangements are only entered into with known and reliable counterparties. Counterparties are assessed on their performance in transactions with the Company over time. In the primary market, counterparties will be exporters or their banks. In the secondary market, over 90% of the
Company's counterparties are banks or subsidiaries of banks and the balance are financial companies, typically having larger capital than the Company's. If a transaction is undertaken with a previously unknown counterparty, the Company will make a corporate credit assessment involving a review of historical accounting information and an analysis of future earnings potential. The Company will also seek other references from other parties with whom the proposed counterparty had conducted similar business. The Company has approximately 440 conterparties with whom it is actively in contact about trading in the forfaiting market. The Company estimates that over 80% of these counterparties are banks or financial institutions regulated in their country of domicile.
As of the date hereof, the Company has not entered into any arrangement involving either confirmation of letters of credit or "repurchase arrangement" facilities. Accordingly, the Company has not established any dollar limitations for these types of transactions. The Company has, however, engaged in certain structured trade and commodity finance activities. These transactions allow the Company to earn fees for its involvement in transactions without having to directly finance assets on its balance sheet.
* Structured Trade Finance. This activity is primarily fee based and therefore less reliant on using the Company's balance sheet. Many of the transactions are secured by cash deposits, liens over the assets being financed, or a third party letter of credit. However, the business does involve the Company in several contingent liabilities. One primary risk is assessing the ability of the Company's counterparty to undertake its contractual obligations under the underlying trade contract to deliver product or goods, which are often from under developed countries. This assessment is often based on third party references and, if necessary, physically visiting the operation concerned. Other risks include the credit assessment consisting of a credit review of the Company's counterparty's trading partner, and an assessment of the underlying trade contract documentation. All of the Company's structured trade and commodity finance transactions are secured. The Company presently does not have any pre-set limits as to the optimum size of its structured trade portfolio. The optimum size typically depends on the acceptability of the Company's counter party to those banks which are managing the facilities on behalf of the client.
Internal Controls
* Transaction Approval. All existing or potential new counterparties are subjected to a credit approval procedure by the Company's research department. Credit limits are then established for the counterparty. These limits will be authorized by two signatories including one from the research department and at least one other designated signatory. A signatory is a management person authorized to commit the Company to any form of contractual liability. A form will evidence each inquiry concerning a potential transaction. All written indication quotations in response to an inquiry must be signed by at least two designated signatories. All firm quotes must be signed by at least one designated signatory and may only be given after the credit has been approved (see below). After the purchase of the transaction has been approved and the
commitment confirmed to the seller by at least one designated signatory, the underlying internal accounting documentation must be signed by at least two designated signatories. All correspondence confirming the sale of assets must be signed by at least one designated signatory.
* Credit. All new deal "inquiries" are copied to the credit research department for appraisal. In the highly competitive non-recourse market, speed of response to inquiries is critical to success in bidding for transactions. The three main areas of risk to be appraised are (i) country risk, (ii) bank risk, and (iii) on an infrequent basis, corporate risk. The Company has the capability to respond to a new deal inquiry immediately, within one hour after general consultation amongst members of the trading desk. This initial response is dependent upon having available current information on the parties and country involved in the proposed transaction. If this current information is not available, the Company may not be able to make an immediate response to an inquiry. If the Company does make an initial response, the response will express its indication of interest and set out the basic terms and conditions of the transaction. This indication will always be made subject top final credit approval and acceptable documentation. A firm commitment requires credit committee approval and may take up to 24 hours or longer, depending on the availability of pertinent information and authorized personnel.
Credit limits are established for certain countries and for banks within those countries to provide the trading desk with guidelines for transactions up to a certain size. Credit limits for countries are set forth below. Bank credit limits are set at the lesser of $3,000,000 or the unused country limit. Limits for certain countries as established by the Company are as follows:
(Region) / Country Credit Limit ------------------ ------------ Latin America: -------------- Argentina $ 10 million Brazil $ 10 million Chile $ 10 million Colombia $ 5 million Ecuador Suspended Mexico $ 12.5 million Peru $ 2 million Uruguay $ 2 million Venezuela $ 2 million Europe: ------- Croatia Suspended Cyprus $ 5 million Czech Republic $ 5 million Estonia $ 2 million Hungary $ 10 million Ireland $ 10 million Latvia $ 5 million Lithuania $ 5 million Poland $ 10 million Romania Suspended Russia Suspended Slovakia $ 2 million Slovenia $ 2 million Turkey $ 12.5 million Ukraine Suspended
Asia: ----- Bangladesh $ 1 million China $ 10 million India $ 10 million Indonesia $ 12.5 million Malaysia $ 5 million Pakistan $ 1 million Philippines $ 5 million Thailand $ 10 million Vietnam Suspended Africa: ------- Botswana $ 5 million Egypt $ 10 million Ghana $ 2 million Kenya $ 2 million Mauritius $ 2 million Morocco $ 5 million South Africa $ 5 million Tanzania $ 2 million Tunisia $ 5 million Zimbabwe $ 1 million Middle East: ------------ Bahrain $ 10 million Iran Suspended Israel $ 5 million Jordan $ 5 million Kuwait $ 10 million Lebanon $ 2 million Oman $ 5 million Qatar $ 5 million Saudi Arabia $ 10 million UAE $ 10 million
The research facility has access to up-to-date information regarding current situation in all relevant countries, those countries in which the Company has an interest in doing business, and maintains a database on banks within those countries. This information is augmented by the appointment of selected advisors covering countries of particular interest and by regular appraisal visits. Presently, the Company has particular interest in Indonesia, Turkey and Thailand. Those relevant countries in which the Company has an interest and has access to up-to-date information are as follows:
Eastern Europe Asia Africa -------------- ---- ------ Croatia Bangladesh Botswana Czech Republic China Ghana Estonia Hong Kong Kenya Hungary India Mauritius Kazakhstan Indonesia Morocco Macedonia Malaysia Namibia Poland Myanmar South Africa Romania Pakistan Tanzania Russia Philippines Uganda Slovak Republic Singapore Congo Ukraine South Korea Zambia Taiwan Zimbabwe Thailand Vietnam
Middle East Americas Europe ----------- -------- ------ Algeria Argentina Austria Bahrain Bolivia Cyprus Egypt Brazil Denmark Iran Canada Finland Israel Chile France Jordan Colombia Germany Kuwait Costa Rica Greece Lebanon Dominican Republic Iceland Libya Ecuador Italy Oman Mexico Malta Qatar Paraguay Norway Saudi Arabia Peru Portugal Tunisia Uruguay Spain Turkey United States Sweden U.A.E. Venezuela Switzerland United Kingdom
The Company's credit approval procedures have been established to enable it to ensure, to the extent possible, that the assets which it purchases may be held profitably in its portfolio. In assessing any country or bank risk or any structured trade financing, the Company adopts a policy of active credit management. The intent of this policy is for the Company to purchase and hold only those transactions that are deemed to be creditworthy and for which there is a potential market for a future profitable sale. The Company's goal is to identify and purchase ahead of the market, those assets that are improving and to sell early, those assets which are considered likely to deteriorate in value. For a country where there is significant potential exposure or where significant changes are taking place, the Company may arrange a visit to that country. The visit will include meeting with local bankers, economists, government officials in the finance, planning and economics ministries, journalists, diplomats and industrialists. Information obtained is augmented with telephone calls to personnel in the World Bank, IMF and other international development institutions.
Once the creditworthiness of a transaction is investigated, the trading team approves the transaction and then the head of trading must approve the transaction based on salability. This procedure is designed to guard against an illiquid portfolio. The Company also maintains a regular, at least annual, review of the creditworthiness of all of its counterparties. Also, the Company makes a daily review of its portfolio and credit limits, and monitors the outlook for interest rates in the major international currencies.
The Company has established the policy that all country credit limits are subject to Board approval. Country and bank limits will be reviewed and may be revised on a daily basis. This review process may be initiated by either a trader or the credit research department. The process will involve a discussion between the head of credit and the head of trading on the matters which have lead to the limit being reviewed. The discussion will also review current market conditions and liquidity within the secondary market. A written report will outline the reasons for the review of a limit or implementation of a new limit. When approved, copies of the report will be sent to all traders and to the relevant country or bank file.
* Structured Trade Finance. The credit research department analyzes each transaction and the individual risk components are assessed. Research of the prospective transaction, a designated signature from the trading team and credit approval must be completed before a commitment is made to the client.
* Portfolio Management. The research department maintains a continuous review of all risks pertaining to the portfolio as well as an active review of emerging markets generally. They seek to identify as early as possible both improving and deteriorating risks and advise the trading team accordingly. Country and bank credit limits for the trading team are adjusted on a day-to-day basis and authorized in writing by the head of research and a designated signatory. All new inquiries are evaluated against existing portfolio assets as to profitability. The interest rate risk arising from the fixed interest nature of the portfolio assets are minimized both by constant turnover and, where deemed prudent, by entering into interest rate swaps or forward rate agreements for the relevant currencies. The heads of trading and research make decisions on interest rate swaps and forward rate agreements on a day-to-day basis and, currencies are considered in light of interest rate trends. Management believes that it is not cost effective to hedge the portfolio. All currency exposure on the portfolio is matched daily either through borrowings or through currency swaps. The Board reviews the outstanding commitments to purchase new deals, on a daily basis to ensure that adequate room exists in the portfolio to fulfill these obligations. This may require existing assets to be sold. The Board also needs to ensure that adequate liquid resources exist to finance the purchase of new deals in all market circumstances.
* Treasury. The trading team is informed daily of upcoming asset purchases and sales in order to plan the necessary financing and foreign exchange cover. The treasury back-up team checks all treasury transactions initiated by the treasurer. Confirmations of individual treasury transactions are sent to counterparties daily. All payment and receipt instructions are confirmed by a secure coded telex and independently checked by a signatory outside the treasury requirements. The accounts department provides daily treasury position sheets. The treasury back up team reconciles the bank accounts on a weekly basis which requires a designated signatory.
Finance
The basis of the production of all day-to-day management accounting information relating to the trading activities is the "Rohirst" (trade name) software program. This program has been developed to not only undertake the onerous calculations needed to price the purchase and sale of deep discounted assets, but also to provide daily summaries of the following:
* Detailed listing of deals by obligator including exposure reports.
* Interest accruals on both assets and borrowings.
* Control account summaries.
Maturity Reports Covering Both Assets and Borrowings
The Company' secretary/treasurer is responsible for preparing budgets and profit forecasts in conjunction with the Board. All portfolio risk exposure and treasury positions are prepared daily and profit and loss accounts, including updates of market values, are produced monthly.
Financial Information About Geographic Areas
The Company's operations are conducted within one business segment, the financing of international trade credit for financial institutions and operating companies. All of the Company's total business operations are conducted outside of the United States.
The Company's operation are conducted in the United Kingdom. Trading is conducted through financial institutions in other countries.
The composition of the notes by country of the issuing financial institution is as follows:
Year Ended From inception June 30, February 25 to Country 1999 1998 June 30 1997 - ------- -------- -------- -------------- Turkey 22.2% 5.7% 80.3% Russia 28.8 8.6 - Ukraine 4.5 5.0 - Czech Republic 2.9 11.6 - Indonesia 34.2 57.8 - Nigeria 2.5 11.3 - Thailand - - 12.5 Germany 4.5 - - Japan - - 7.2 ------ ------ ------ Total 100.0% 100.0% 100.0%
The country portfolios set forth above at June 30, 1997, represents the Company's first fiscal year which consisted of only four months and comparative lower activity. The portfolios at June 30, 1998 represent assets that were purchased either for immediate sale or to be held to maturity, or represented distressed assets which the Company was unable to trade in the prevailing market conditions. These changes illustrate expected fluctuations in portfolio size and country risk profile in reaction to prevailing market conditions. The portfolios at June 30, 1999, were invested primarily in trading assets in Indonesia (34.2%), Turkey (22.2%) and Nigeria (2.2%) A total of 4.5% of the assets were held to maturity and the balance remain impaired and have been substantially provided for. During fiscal 1999, the Company collected approximately 7% of the 1998 provisions.
ITEM 2.
ITEM 2. Properties
The Company leases office facilities located at 4835 North O'Connor, Suite 134-346, Irving, Texas 75062, which it shares with other businesses. The facility represents the Company's principal offices in the United States.
The Company's principal operations are located in London where the Company lease the entire third floor of 9 King Street, London EC2V 8EA, United
Kingdom. The facility consists of 2,900 square feet of office space and is leased pursuant to a ten year lease that commenced in March 1997. The lease is subject to a rent review after five years. Currently, annual payments on the property including rent, property taxes and service charge amount to $173 thousand per year. The Company has office equipment with a net book value of $74 thousand. Management believes that its present office facilities are adequate for the Company's current business operations.
ITEM 3.
ITEM 3. Legal Proceedings
There are presently no material pending legal proceedings to which the Company or any of its subsidiaries is a party or to which any of its property is subject and, to the best of its knowledge, no such actions against the Company are contemplated or threatened.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote of the Company's shareholders, through the solicitation of proxies or otherwise, during the fourth quarter of fiscal year 1999.
PART II
ITEM 5.
ITEM 5. Market for Registrant's Common Equity and Related Shareholder Matters
The Company's common stock is currently quoted on the OTC Bulletin Board ("OTCBB") under the symbol "ETFC". For an extended period of time prior to December 1998, there was not an established trading market for its common stock nor was there a record of any significant trading in the public market.
The Company has made an application to Nasdaq for the Company's shares to be quoted on The Nasdaq Stock Market. The Company's application to the Nasdaq consists of current corporate information, financial statements and other documents as required by the Securities Exchange Act of 1934, as amended, including its Registration Statement on Form 10. Inclusion on The Nasdaq Stock Market permits price quotations for the Company's shares to be published by such service.
As of April 30, 1999 there were approximately 410 holders of record of the Company's common stock, which figure does not take into account those shareholders whose certificates are held in the name of broker-dealers or other nominees.
The Company's common stock has been trading on the OTCBB since approximately December 3, 1998. The following table sets forth the range of high and low bid prices of the common stock for each calendar quarterly period since the fourth quarter of 1998 as reported by the National Quotation Bureau, Inc. ("NQB"). Prices reported by the NQB represent prices between dealers, do not include retail markups, markdowns or commissions and do not represent actual transactions.
High Low ---- --- Fourth Quarter $ 18.00 $ 1.00 First Quarter $ 35.00 $ 5.25 Second Quarter $ 18.00 $ 3.00 Third Quarter* $ 7.00 $ 3.37 - -------------- o Through October 14, 1999.
Dividend Policy
The Company has not declared or paid cash dividends or made distributions in the past, and the Company does not anticipate that it will pay cash dividends or make distributions in the foreseeable future. The Company currently intends to retain and invest future earnings to finance its operations.
ITEM 6.
ITEM 6. Selected Financial Data
The selected financial data set forth below have been derived from the Company's financial statements. This data should be read in conjunction with the Company's consolidated financial statements and notes thereto, with Management's Discussion and Analysis of Financial Condition, and with the other financial information of the Company included elsewhere herein.
The selected statements of operations data and balance sheet data for the years ended June 30, 1999, 1998 and 1997 are for Euro Trade Limited (the Successor Entity). The data set forth for the period ended November 20, 1998 and the years ended June 30, 1998, 1997, 1996 and 1995 are for Rotunda Oil and Mining, Inc. (the Predecessor Entity). The results of operations are not necessarily indicative of results to be expected for any future period.
Statements of Operations - Successor Entity: (Dollars in Thousands)
Year Ended June 30, From Inception -------------------------- February 27, 1997 to 1999 1998 June, 30, 1997 ---------- ---------- -------------- Revenue $ 7,744 $ 5,216 $ 460 Operating Expenses 3,630 3,258 88 Loss Provisions -0- 6,950 68 Net Income (Loss) 4,114 (4,922) 304
Balance Sheets - Successor Entity: (Dollars in Thousands) Year Ended June 30, 1998 ------------------------------------------ 1999 1998 1997 ---------- ---------- -------- Current Assets $ 42,775 $ 35,423 $ 9,453 Total Assets 42,830 35,516 9,456 Current Liabilities 18,500 15,177 9,152 Long Term Debt 24 27 -0- Common Stock 17 12 12 Paid in Capital 25,264 25,044 25,044 Retained Deficit (630) (4,744) 248 Receivable Stockholder (345) -- (25,000)
Statements of Operations - Predecessor Entity: (Dollars in Thousands)
Year Ended June 30, 1998 November 20, ----------------------------------------- 1998 1998 1997 1996 1995 ---------- ---------- --------- -------- ------- Revenue $ -0- $ -0- $ -0- $ -0- $ -0- Operating Expenses -0- 11 -0- -0- -0- Net Income (Loss) -0- (11) -0- -0- -0-
Statements of Operations - Predecessor Entity: (Dollars in Thousands)
From July 1, 1998 Through November 20, Year Ended June 30, 1998 ------------ ------------------------------------- 1998 1998 1997 1996 1995 ---------- ---------- -------- ------- ------ Current Assets $ -0- $ 2 $ 2 $ -0- $ -0- Total Assets 239 2 2 -0- -0- Current Liabilities -0- 11 2 -0- -0- Long Term Debt -0- 2 -0- -0- -0- Common Stock -0- -0- -0- -0- -0- Paid in Capital 56 56 750 56 56 Retained Deficit (56) (67) (56) (56) (56)
Rotunda Oil & Mining, Inc. (the Predecessor Entity) was a development stage company from its inception at November 19, 1980 until its acquisition of Euro Trade Limited on November 20, 1998.
Euro Trade Limited was chartered in the United Kingdom on February 25, 1997 and operated as a United Kingdom limited company until it was acquired on November 20, 1998. The Company and its subsidiary were recapitalized into a new corporate structure on November 20, 1998. The transactions were accounted for as a statutory merger. On the date of the acquisition, Rotunda Oil & Mining, Inc. had substantially the same consolidated net worth as Euro Trade Limited prior to the reorganization.
Subsequent to the acquisition, the Company raised funds through a private placement offering pursuant to an exemption contained in regulation D, Rule 504, promulgated under the Securities Act of 1933, as amended. The Company sold 3,979,750 shares at a price of $.05 per share. The offering was closed on December 2, 1998.
On December 14 1998, John Vowell, the Managing Director of the Company, exercised warrants for 750,000 shares of the Company's common stock under an employee stock-compensation plan regulated in the United Kingdom.
ITEM 7.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operation
The following information should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K.
Rotunda Oil & Mining Company was a development stage company in 1996. Euro Trade Limited began operations on February 25, 1997. Inclusion of financial information prior to February 1997 is not believed to be material and is therefore omitted.
Results of Operations
Acquisitions
The Company continues to pursue strategic alternatives to maximize the value of its portfolio of businesses. Some of these alternatives have included, and will continue to include selective acquisitions, divestitures and sales of certain assets. The Company has provided, and may from time to time in the
future, provide information to interested parties regarding portions of its businesses for such purposes.
The following table sets forth the percentage relationship to total revenues of principal items contained in the Company's Consolidated Statements of Operations for the fiscal years ended June 30, 1999, 1998 and 1997. It should be noted that percentages discussed throughout this analysis are stated on an approximate basis. December 31, 1999 1998 1997 ------ -------- ------- Total revenue................................. 100% 100% 100% Costs of Revenues Interest.................... 10 21 -- Provisions for Losses....................... 0 133 15 Gross Profit (Loss)........................... 90 (54) 85 Selling, General and Administrative Expenses...................... 37 42 19 Net Income (Loss)............................. 53 (96) 66
For the year ended June 30, 1999 compared to the year ended June 30, 1998.
Revenues for 1999 increased 48% to $7.7 million from $5.2 million in 1998, primarily due to the Company's increased activities in the market. Cost of revenues for 1999 decreased to $.7 million from $8 million in 1998, which primarily reflects the decrease of $7.0 million in loan loss reserves charged to income in 1998. Depreciation expense was $20,000 in 1999.
Selling, administrative and general expenses for 1999 increased 32% to $2.9 million from $2.2 million in 1998, also due to increased operating activity in 1999. These expenses are primarily personnel and occupancy costs.
Interest expense decreased 36% to $.7 million in 1999 from $1.1 million in 1998, reflecting the financing of a greater number of transactions and collection on the first round of purchases.
Net income in 1999 totaled $4.1 million, or $.28 per share of common stock. Net loss in 1998 totaled $5.0 million, or $.42 per share of common stock.
For the year ended June 30, 1998 compared to the year ended June 30, 1997.
The Company (Euro Trade Limited) began operations on February 25, 1997. For the period ended June 30, 1997, the Company generated $0.5 million in revenue from interest and fees. Revenues for 1998 increased to $5.2 million, primarily due to implementation of the Company's fundamental operating plan.
Cost of revenue for 1998 increased to $8.0 million from $68,000 in 1997 on an annualized basis. The increases in cost of revenues reflect the increased operating activity and $7.0 million in loan loss reserves charged to income. Depreciation expense was $20,000 in 1998.
Selling, administrative and general expenses for 1998 increased to $2.2 million in 1998 from $88,000 in 1997 also due to the increased operating activity in 1998. These expenses are primarily personnel and occupancy costs.
Interest expense increased to $1.1 million in 1998 from $0 in 1997 reflecting the implementation of management's operation plan and increased operating activity.
No tax provision has been made for 1999, 1998 or 1997 respectively, based on pre-tax operation losses. The Company pays taxes under both the United Kingdom and United States tax laws.
Net loss in 1998 totaled $5.0 million or $.42 per share of common stock. Net income in 1997 totaled $304 thousand or $.01 per share of common stock.
Provision for Losses
The Company's Euro Trade Limited began operations on February 25, 1997. At June 30, 1997, initial funding from shareholders of $25 million remained as a receivable. Thus, business operations commenced with only a bridge loan of $8.1 million, as reflected by the investment portfolio on June 30, 1997. In comparison, following the investment by the shareholders in fiscal 1998, the Company's investment portfolio was $20.6 million on June 30, 1998.
Factors contributing to the Company's substantial increase in reserves at June 30, 1998 include the world economic conditions, particularly the uncertainty of the economic future of Russia and the Ukraine. At June 30, 1998, the Company had $7.5 million invested in trade paper of Russia and the Ukraine. In reliance upon an independent appraisal, a $6.5 million provision was made against the Company's assets.
As economic conditions changed in the second half of 1998 and first half of 1999, both the Russian and Ukraine debtor made payments totaling $.7 million. Although economic reform in Russia and the Ukraine continues, these investments are provided for at 90% of face value.
At June 30, 1999, no additional reserve was necessary. Future reserves will depend upon the economic conditions in the countries where the debt occurs and current limits are provided at Item 1 internal control.
Liquidity and Capital Resources
Short term trading investments and related short-term borrowings are reported as cash flow from operating activities. Working capital accounts (cash, short-term investments, accounts payable and short term borrowings) increased by $10.8 million in 1999 over 1998 due to the increase in short-term borrowing of $8.6 million and the increase in forfaiting assets of $2.6 million. Cash flow from financing activities decreased by $13.0 million in 1999 reflecting maturity of investments and a greater reliance on internal financing of transactions. Cash flow from investments decreased by $1.2 million in 1999 from 1998 due to the acquisition of equity securities for the proposed debt for equities program.
Inflation
In the opinion of management, inflation has not had a material effect on the operations of the Company.
Year 2000
Year 2000 issues may arise if computer programs have been written using two digits (rather than four) to define the applicable year. Thus, on January 1, 2000 any clock or date recording mechanism including date sensitive software that uses only two digits to represent the year, may recognize a date of 00 as 1900 instead of 2000. This could result in a system failure or miscalculations causing disruption of operations, including among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activity.
The Company has checked all of its computer hardware and believes that the hardware is year 2000 compliant. The Company's software was recently upgraded and management believes that all software, including internal systems for databases, are year 2000 compliant and use the four-digit year. Management believes that the Company's equipment currently in operation including fax machines and personal computers, will function properly with respect to dates in the year 2000 and no adverse issues are anticipated. It is the Company's policy that all equipment and software purchased will be year 2000 compliant.
Failure to correct a year 2000 problem could result in an interruption of certain normal business activities or operations. Management does not expect any issues that would cause such an interruption. The Company has not developed any contingent plans regarding failure of any year 2000 operation of the business. No substantial capital and maintenance expenditures will be required to maintain and, or, upgrade operating facilities to remain competitive and to comply with environmental requirements. The Company is not subject to the Clean Air Act or its amendment of 1990.
The Company has contacted 100% of its significant third party business contacts to determine the extent to which the Company's operations may be impacted by a third party's failure to make their own systems year 2000 compliant. All of those third parties contacted have responded that they are either Year 2000 compliant, or anticipate achieving compliance well before January 1, 2000. The Company reviewed the third party responses with the view of the significance of that particular party to the operation of the Company. Accordingly, the Company has concluded that it is unlikely its operations will be effected by a potential third party Year 2000 compliance problem.
The Company has very little or no control over third parties and have little ability to verify or enforce their claims to being year 2000 ready. As a result, management believes that the Company's most reasonably likely worst case scenarios involve areas where it relies on third parties, including utility companies and other service providers. If any of the Company's significant service providers or third parties do not successfully and timely become year 2000 ready, the Company's business or its operations could be adversely affected. This would most likely consist of a loss of communication capabilities.
As of the date hereof, the Company has expended approximately $3,000 associated with year 2000 compliance expenses. This includes the purchase of Centennial 2000 Pro Software, attendance at free government sponsored year 2000 courses, and time spent by the Company's office manager in assessing year 2000 issues.
Risk Factors and Cautionary Statements
This registration statement contains certain forward-looking statements. The Company wishes to advise readers that actual results may differ substantially from such forward-looking statements. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those expressed in or implied by the statements, including, but not limited to, the following: trading market risks, currency fluctuations, wold economic conditions and risks generally associated with the trading of financial instruments.
Recent Accounting Pronouncements
The Financial Accounting Standards Board ("FASB") has issued Statement of Financial Accounting Standard ("SFAS") No. 128, "Earnings Per Share" and Statement of Financial Accounting Standards No. 129 "Disclosures of Information About an Entity's Capital Structure." SFAS No. 128 provides a different method of calculating earnings per share than is currently used in accordance with Accounting Principles Board Opinion No. 15, "Earnings Per Share." SFAS No. 128 provides for the calculation of "Basic" and "Dilutive" earnings per share. Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted earnings per share. SFAS No. 129 establishes standards for disclosing information about an entity's capital structure. SFAS No. 128 and SFAS No. 129 are effective for financial statements issued for periods ending after December 15, 1997. Their implementation is not expected to have a material effect on the financial statements.
The FASB has also issued SFAS No. 130, "Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 130 establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributors to owners. Among other disclosures, SFAS No. 130 requires that all items that are required to be recognized under current accounting standards as components of comprehensive income be reported in a financial statement that displays with the same prominence as other financial statements. SFAS No. 131 supersedes SFAS No. 14 "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 establishes standards on the way that public companies report financial information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim financial statements issued to the public. It also establishes standards for disclosure regarding products and services,
geographic areas and major customers. SFAS No. 131 defines operating segments as components of a company about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance.
SFAS 130 and 131 are effective for financial statements for periods beginning after December 15, 1997 and requires comparative information for earlier years to be restated. Management believes that the implementation of the new standards will not have a material effect on the Company's financial statements.
The FASB has also issued SFAS No 132. "Employers' Disclosures about Pensions and other Postretirement Benefits," which standardizes the disclosure requirements for pensions and other Postretirement benefits and requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis. SFAS No. 132 is effective for years beginning after December 15, 1997 and requires comparative information for earlier years to be restated, unless such information is not readily available. Management believes the adoption of this statement will have no material impact on the Company's financial statements.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" which requires companies to record derivatives as assets or liabilities, measured at fair market value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes in fair value or cash flows. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Management believes the adoption of this statement will have no material impact on the Company's financial statements.
ITEM 7A.
ITEM 7A. Quantitative And Qualitative Disclosures About Market Risk
Foreign Currency Exchange Rate Risk
The Company is subject to the risk of price fluctuations related to anticipated revenues, operating costs and expenditures incurred in currencies other than US dollars. The Company has not generally uses derivative instruments to manage this risk.
Equity Price Risk
The Company is not currently subject to equity price risk resulting from investments in marketable equity securities of unrelated parties. Investments are accounted for in accordance with Statement of Financial Accounting Standards No. 115. Accounting for Certain Investments in Debt and Equity Securities "SFAS 115".
The Company has financed its operations primarily through purchase and sale of short term forfaiting assets. For the year ended June 30, 1999 the Company raised $10.778m in cash from operating activities.
At June 30, 1999 and 1998 the Company's principal source of liquidity was $23.1 million and $18.9 million respectively in cash of which $13.1 million and $5.5 million respectively was held as compensating balances on Bank debt of $7.5 million and $12.5 million respectively.
The Company had an accumulated deficit at June 30, 1999 and 1998 of $0.6 million and $4.7 million respectively. The Company provided for additional loan losses of $0 and $7 million in the audited results for the years ended June 30, 1999 and 1998 respectively. Management believes that reserves accrued in the prior periods are adequate to provide for loan losses in the existing forfaiting asset portfolio.
There can be no assurance that either the net income for the period or the current loan loss provisions are indicative of future operations. There are no assurances that continuing financing will be available at terms favorable to the Company. The Company has no current plans to raise capital from the sale of its stock.
Interest Rate Risk
The Company is subject to the effects of interest rate fluctuations on its financial instruments. A sensitivity analysis of the projected incremental effect of a hypothetical 10% change in 1999 year-end interest rates on the fair value of its financial instruments is provided in the following table.
Dollars in Thousands
Fair Carrying Market Incremental (1) Value Value Incr./(Decr.) - --------------------------------------- ------------ ------------ ------------ Financial assets: Investment in Forfaiting Assets $ 17,157 $ 16,909 $ (248) - --------------------------------------- ------------ ------------ ------------ Financial liabilities: Fixed-rate and variable rate debt $ 7,477 $ 7,541 $ 64 - --------------------------------------- ------------ ------------ ------------ (all due within one year) (1)Reflects a 10 % increase in interest rate of financial assets and a 10% decrease in interest rates of financial liabilities.
Fair value of cash and cash equivalents, receivables, short-term borrowings, accounts payable, accrued interest and variable- rate long-term debt approximate their carrying values. These items are relatively insensitive to changes in interest rates due to the short-term maturity of the instruments or the variable nature of underlying interest rates. Accordingly, these items have been excluded from the above table.
At June 30, 1999 and 1998, the Company's operating portfolio included forfaiting assets totaling $ 17.2 million and $14.6 million respectively after allowance for $7.0 million loan reserves. The fair value of these instruments will increase or decrease as a result of changes in market interest rates. The Company accounts for these financial instruments in accordance with SFAS 107. Accordingly, each year the Company adjusts the balances of its portfolio to fair market value. With any resulting adjustment being charged or credited to income as an unrealized loss or gain and included in cost of revenue. Realized gains and losses resulting from the disposition of such assets are recorded as income in the period during which such disposition takes place. During 1999 the Company had realized gains of $4.9 million and unrealized gains/losses of $0 in connection with its forfaiting asset portfolio. The Company provides no assurance that these results are representative on a going forward basis.
The Company's exposure to increases in interest rates that might result in a corresponding decrease in the fair value of its forfaiting assets portfolio could have an unfavorable effect on the Company's results of operations and cash flows.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
EURO TRADE & FORFAITING, INC. CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
INDEPENDENT ACCOUNTANT'S REPORT ON CONSOLIDATED FINANCIAL STATEMENTS.....................................34
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets for June 30, 1999, 1998 and 1997.........35
Consolidated Statements of Operation for the Years Ended June 30, 1999 and 1998 and for the period from February 23, 1997 (Inception) ended June 30, 1997...................36
Consolidated Statement of Stockholder Equity.........................37
Consolidated Statement of Cash flows for the Years Ended June 30, 1999 and 1998 and for the period from February 23, 1997 (Inception) ended June 30, 1997...................38
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS................................39
INDEPENDENT ACCOUNTANT'S REPORT
To the Stockholders and Board of Directors of Euro Trade & Forfaiting, Inc.
I have audited the accompanying consolidated balance sheets of Euro Trade & Forfaiting, Inc. ("The Company") as of June 30, 1999, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for the two years then ended and the period from February 23, 1997 (Inception) ended June 30, 1997. These financial statements are the responsibility of The Company's management. My responsibility is to express an opinion on these financial statements based on my audits.
I conducted my audits in accordance with generally accepted auditing standards. Those standards require that I plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. I believe that my audits provide a reasonable basis for my opinion.
In my opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Euro Trade & Forfaiting, Inc. and subsidiary as of June 30, 1999, 1998 and 1997 and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting.
/S/ MARC LUMER & COMPANY Marc Lumer & Company
San Francisco, California September 13, 1999
See accompanying notes and Accountant's Report.
EURO TRADE & FORFAITING, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997 (In Thousands)
June 30, June 30, June 30, 1999 1998 1997 -------- -------- -------- REVENUE $ 7,744 $ 5,216 $ 460
COST OF REVENUES Interest 733 1,088 0 Provisions for losses -- 6,950 68 -------- -------- --------
TOTAL COST OF REVENUE 733 8,038 68 -------- -------- --------
GROSS PROFIT (LOSS) 7,011 (2,822) 392
Selling, general and administrative 2,897 2,170 88 -------- -------- --------
NET INCOME (LOSS) $ 4,114 $ (4,992) $ 304 ======== ======== ========
PRIMARY AND FULLY DILUTED NET INCOME (LOSS) PER SHARE $ .28 $ (0.42) $ 0.03 ======== ======== ========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES AND COMMON SHARES EQUIVALENTS OUTSTANDING 14,468 11,945 11,945 ======== ======== ========
See accompanying notes and Accountant's Report.
See accompanying notes and Accountant's Report.
See accompanying notes and Accountant's Report.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE A ORGANIZATION AND ACCOUNTING BASIS
Rotunda Oil and Mining, Inc., incorporated under the Laws of Utah on November 19, 1980, was a development stage company until November 20, 1998 when it acquired Euro Trade & Forfaiting Co. Limited in exchange for 100% of its outstanding shares. See Note B.
As a result of the merger, Rotunda Oil and Mining, Inc. changed its name to Euro Trade & Forfaiting, Inc. (The Company) on December 1, 1998.
Euro Trade & Forfaiting Co. Limited is a wholly owned subsidiary, incorporated under the laws of United Kingdom on February 25, 1997.
Significant Accounting Policies Basis Of Consolidation - ------------------------------------------------------
The consolidated financial statements include the accounts of the company and its wholly owned subsidiary. The company is engaged in a single line of business as a financier in connection with international trade and the arrangement and syndication of transferable export letters of credit. Any pre-consolidation inter-company balances have been eliminated.
Accounting Method - -----------------
The Company maintains its books on the accrual basis of accounting.
Cash and Cash Equivalents - -------------------------
The Company considers all purchases from financial institutions of demand, deposits, time deposits and certificate of deposits to be cash equivalents.
Compensating Balances - ---------------------
Cash in the amount of $7.9 million and 5.5 million was on deposit in financial institutions as compensating balances for loans. The amount is based on the financial institutions assessment of risk. See Note F.
The Company borrows the funds necessary to purchase forfaiting assets. The lenders require that cash be deposited in interest bearing accounts until the corresponding loan matures.
Collateral - ----------
The Company reports assets that it has pledged as collateral in secured borrowing and other arrangements when the secured party cannot sell or re-pledge the assets, or when Euro Trade can substitute collateral or otherwise redeem it on short notice.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE A ORGANIZATION AND ACCOUNTING BASIS (Continued)
Transactions of Foreign Currencies - ----------------------------------
The Company and its subsidiary treat the U.S. dollar as their functional currency. Accordingly, gains and losses resulting from the translation of accounts designated in other than the functional currency are reflected in the determination of net income.
At June 30, 1999, monetary assets and liabilities of The Company are denominated in the following currencies:
U.S. Pounds Deutsche Total Dollars Sterling Marks ----- ------- -------- -----
Cash and Equivalents 100% 87 -- 13 Forfaiting Assets 100% 73 -- 27 Current Liabilities 100% 63 1 37
At June 30, 1998, monetary assets and liabilities of The Company are denominated in the following currencies: U.S. Pounds Deutsche Total Dollars Sterling Marks
U.S. Pounds Deutsche Total Dollars Sterling Marks ----- ------- -------- -----
Cash and Equivalents 100% 96 1 3 Forfaiting Assets 100% 83 11 6 Current Liabilities 100% 80 13 7
Income Taxes - ------------
The Company and its subsidiary will not be included in a consolidated federal income tax return filed by the parent. Federal income taxes are calculated as if the companies filed on a separate return basis, and the amount of current tax or benefit calculated is either remitted to or received from The Company. The amount of current and deferred taxes payable or refundable is recognized as of the date of the financial statements, using currently enacted tax laws and rates. Deferred tax expenses of benefits are recognized in the financial statements for the changes in deferred tax liabilities or assets between years.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE A ORGANIZATION AND ACCOUNTING BASIS (Continued)
Depreciation - ------------
Depreciation is calculated to write down the cost of tangible fixed assets to their residual values over the period of their estimated useful lives using the straight line method as follows:
Computer Equipment 3 years
Furniture, Fixtures and Fittings 4 years
Net Income Per Share - --------------------
Net income per share is computed using the weighted average number of common shares and common share equivalents outstanding during the respective periods. Common shares equivalents consist of The Company's preferred stock and shares issuable upon the exercise of stock options. All stock options have been treated as if they were outstanding for all periods.
Related Parties - ---------------
The Company paid salaries and director fees of $510,268 and $531,747 to a principal employee and director. The Company paid management fees of $280,673 and $251,190 in fiscal 1999 and 1998, respectively, to companies controlled by the majority shareholder.
Stock Option Plans - ------------------
In 1997 Euro Trade established a stock option plan for the Managing Director. In accordance with British law, the shares are purchased and held in treasury until the options are exercised.
Forfaiting Transactions - -----------------------
Proprietary transactions are recorded on the trade date. Profits and losses arising from sales entered into for the account and risk of the subsidiary are recorded on the settlement date basis.
Amounts receivable and payable for forfaiting transactions that have not yet reached their contractual settlement date are recorded net on the balance sheet.
Fair Value of Financial Instruments - -----------------------------------
The carrying value of financial instruments such as cash and cash equivalents and accrued interest income approximate their fair market value using the specific identification method.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE A ORGANIZATION AND ACCOUNTING BASIS (Continued)
Revenue Recognition - -------------------
Interest income on forfaiting assets is recognized based on principal amounts outstanding, at applicable interest rates. Accrual of interest on loans is discontinued (non-accrual status) when reasonable doubt exists as to the full, timely collection of interests or principle, or when payment of principle or interest is past due 90 days, unless the loan is currently in the process of collection. When a loan is placed on non-interest income in the current period, income recognition on such loans is on the cash basis, unless the reasonable doubt is reversed. All cash receipts on reasonable doubt loans are applied to the principal balance
Because forfaiting assets typically mature in less than one year, the company's policy is to recognize fees and costs associated with these assets in the year received or paid.
Allowance for Loan Losses - -------------------------
Management makes regular credit reviews of the forfaiting portfolio on an individual loan basis. Past experience, current economic conditions, and problems associated with specific lenders, are all factors in determining the adequacy of the allowance balance. The allowance is increased by provision charged to operating expense and by recoveries on loans previously charged off, and reduced by charge-offs.
Accrued Compensated Absences - ----------------------------
The Company has not established a policy with respect to compensated absences. Accordingly, no accrual has been made as prescribed by Statement of Financial Accounting Standards No. 43.
Use of Estimates - ----------------
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE B REORGANIZATION
The following are the principal terms with respect to the exchange of shares of capital stock of Euro Trade & Forfaiting, Inc. (The Company), a Utah corporation (formerly Rotunda Oil and Mining, Inc.) for the shares of Euro Trade & Forfaiting Co. Limited (Euro Trade) a United Kingdom corporation.
Pre-Exchange Capitalization - ---------------------------
On November 10, 1998, The Company declared a reverse stock split of 1 for 1,000 of the outstanding shares. As a result, 19.5 million outstanding shares were reduced to 195 thousand outstanding shares.
Euro Trade issued 15 million preferred shares and 9.2 million common shares for cash on February 25, 1997. An option for .8 million shares of the common stock was issued on the same date and funded as required by United Kingdom law.
The option was exercised immediately prior to the exchange.
Equity Conversion Mechanics - ---------------------------
At the closing of the exchange, The Company issued and exchanged 11.8 million shares of restricted Rule 144 common stock for all of the outstanding common and preferred shares of Euro Trade.
After the closing, two options were granted for .5 million shares each of the company's common stock at a price of $.025. The options were exercised immediately.
Additionally, The Company issued an aggregate of 4 million new shares of common stock at $.05 per share.
The Company will hold the shares of Euro Trade, which will continue to operate as a subsidiary.
Post Exchange Capitalization - ----------------------------
After the exchange and the subsequent offering of 5 million shares of common stock, the capitalization consisted of 16.9 million shares of common stock of which 11.8 million are restricted.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE B REORGANIZATION (Continued)
Basis of Consolidation - ----------------------
The accompanying financial statements have been prepared to give effect to the exchange completed on November 20, 1998. The two companies in the exchange are:
Euro Trade & Forfaiting, Inc., a Utah corporation, (formerly Rotunda Oil and Mining, Inc.), "The Company"
Euro Trade & Forfaiting Co. Limited a United Kingdom corporation, "Euro Trade"
After the exchange, The Company owned all of the outstanding shares of Euro Trade. The exchange is accounted for as if The Company purchased Euro Trade for stock. All assets are reflected at historical cost. For purposes of the proforma statement of stockholders' equity, multiple transactions are considered to have taken place concurrently. All subsequent references to the company mean the combined entity.
NOTE C PROPERTY AND EQUIPMENT
Property and equipment consists of office furniture and computer equipment as follows:
1999 1998 1997 ------- ------- ------- Cost $ 136 $ 136 $ 3 Less: Accumulated depreciation 81 43 -- ------- ------- ------- $ 55 $ 93 $ 3 ======= ======= =======
Depreciation expense $ 38 $ 43 $ -- ======= ======= =======
NOTE D INCOME TAX
The Company has cumulative losses at June 30, 1999 and 1998, that could result in a net operating loss carryforwards for federal income and United Kingdom tax purposes. Ownership changes in The Company may result in an annual limitation on the utilization of operating loss carryforwards.
EURO TRADE & FORFAITING, INC. . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) ENDED JUNE 30, 1997
NOTE E FORFAITING ASSETS
Forfaiting is a method of financing international trade. The Company purchases from an exporter the debt due by an importer when credit is required. The debt is usually evidenced by a series of negotiable financial instruments such as promissory notes or by deferred payment letters of credit opened by a bank. The notes are usually guaranteed by a bank in the importer's country and, subject to the quality of the guarantor, become marketable amongst international banks and other financial institutions. In forfaiting, the notes are purchased without recourse to the exporter.
The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, Disclosure about Fair Value of Financial Instruments. The estimated fair value amounts have been determined by The Company and independent experts using available market information and appropriate valuation methodologies.
The fair value of the non-impaired financial instruments approximate carrying value due to the short-term maturity of the instruments. The fair values of the non-impaired financial instruments are (in thousand) $15,676 and $11,897 and $8,000 at June 30, 1999, 1998 and 1997, respectively.
The following disclosure of the financial instruments which are impaired is made in accordance with the requirements of SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures. The carrying values of the impaired financial instruments are measured at market value.
The market value of the impaired financial instruments is as follows (in thousands):
June 30, June 30, 1999 1998 -------- -------- Recorded investments in impaired financial instruments $ 8,221 $ 9,765 Less allowance for losses (6,740) (7,018) -------- -------- Market value of impaired financial instruments $ 1,481 $ 2,747 ======== ========
The activity in the allowance for losses account is as follows (in thousands):
Beginning balance $ 7,018 $ 0 Additions charged to operations 0 7,018 Reductions - sale of asset 278 0 -------- -------- Ending balance $ 6,740 $ 7,018 ======== ========
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) THROUGH JUNE 30, 1997
NOTE E FORFAITING ASSETS (Continued)
The Company does not accrue interest on its impaired financial instruments. Therefore, no interest income was recognized during the impairment period. Any cash receipts on these financial instruments are recorded as income when collected.
The composition of the notes by country of issuers bank was:
June 30, June 30, Country 1999 1998 ------- ---- ----
Germany 4.5% 0.0% Turkey 22.2 5.7 Russia 28.8 8.6 Ukraine 4.5 5.0 Czech Republic 2.9 11.6 Indonesia 34.6 57.8 Nigeria 2.5 11.3 Thailand --.-- --.-- Japan --.-- --.-- --------- ---------
Total 100% 100% ==== ====
NOTE F SHORT TERM BORROWING
Short-term borrowing consisted of the following (in thousands):
June 30, June 30, 1999 1998 ---- ---- Loans payable to banks $ 7,477 $12,521 Bank over drafts 1,254 1,958
Interest paid on short term borrowings for the periods ended June 30, 1999 and 1998 was .7 million and $1.1 million respectively.
Weighted average interest rates on short term borrowing from banks was 6.2% and 6.6% for the years ended June 30, 1999 and 1998.
The Company had long term debt in conjunction with the purchase of office equipment.
EURO TRADE & FORFAITING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 1999 AND 1998 AND FOR THE PERIOD FROM FEBRUARY 23, 1997 (INCEPTION) THROUGH JUNE 30, 1997
NOTE G FOREIGN EXCHANGE
The Company is subject to foreign exchange risk through future foreign currency cash flow as movement in currency exchange rates impact: 1) the U.S. dollar value of foreign currencies and 2) the U.S. dollar value of cost incurred in foreign currencies.
Foreign exchange gains (losses) included in the consolidated financial statements at June 30, 1999 and 1998 were ($6,000) and $242,000, respectively.
NOTE H COMMITMENTS
At June 30, 1999 and 1998, The Company had a commitment to purchase $5.2 million and $11.4 million in forfaiting assets, respectively. The Company was also a guarantor to a transaction amounting to $.8 million at June 30, 1998. The fees earned were recorded in the period that the guarantee and commitments were given.
NOTE I MINIMUM FUTURE RENTALS
The Company occupies premises provided under a lease agreement through February 27, 2002. The lease future minimum rentals are summarized below:
Year Ending June, 30 Amount -------- ------- 2000 $ 165,500 2001 165,500 2002 110,400 Thereafter 0
The lease has an option to renew for five years.
NOTE J INVESTMENTS IN MARKETABLE SECURITIES
All securities held at June 30, 1999 are classified as "Available for Sale" as defined by Statement of Financial Accounting Standards No. 115. "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115). The securities are summarized as follows (in thousands):
Cost Market Value ------ ------------ Common stock 1,100 1,100
Given the large number of shares and other uncertainities, there is not assurance that the full value of the shares could be realized at June 30, 1999.
ITEM 9.
ITEM 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
In January 1999, the Company's Board of Directors made the decision to change independent accountants. Previously the Company used as its independent accountants the firm of Jones, Jensen & Company ("JJ&Y"). The Company has engaged as its new auditors Marc Lumer & Company. Euro Trade Limited is audited in the United Kingdom by Andrew Murray and Company, Chartered Accounts. Marc Lumer & Company has audited Euro Trade Limited since its inception for its financial statements that are presented in conformity with United States generally accepted accounting principles ("GAAP").
There were no disagreements between the Company and its former auditors JJ&C, or did JJ&C issue any adverse opinion, disclaimer of opinion, modification or qualification contained in any financial report prepared by JJ&C for the past two years.
ITEM 10.
ITEM 10. Directors and Executive Officers of Registrant
As of the date hereof, the executive officers and directors of the Company are as follows:
Name Age Position Chandra Sekar .......................41 Chairman of the Board and director John Vowell..........................35 President, C.E.O. and Managing Director Mukesh Pancholi......................41 Secretary/Treasurer and director - ----------
All directors hold office until the next annual meeting of stockholders and until their successors have been duly elected and qualified. There are no agreements with respect to the election of directors. The Company has not compensated its directors for service on the Board of Directors or any committee thereof, but directors are reimbursed for expenses incurred for attendance at meetings of the Board of Directors and any committee of the Board of Directors. Executive officers are appointed annually by the Board of Directors and each executive officer serves at the discretion of the Board of Directors. The Executive Committee of the Board of Directors, to the extent permitted under Utah law, exercises all of the power and authority of the Board of Directors in the management of the business and affairs of the Company between meetings of the Board of Directors.
The business experience of each of the persons listed above during the past five years is as follows:
Chandra Sekar has been the Chairman of the Company's Board of Directors since 1997. During this period and since 1992, Mr. Sekar has also served as executive administrator of Polysindo UK Limited. Mr. Sekar holds a Bachelor of Industrial & System Engineering and a Master of Industrial & System Engineering from Bandung Institute of Technology. Prior to 1992, he was associated with PT. Caltex Pacific Oil Company in Indonesia, a joint venture among oil companies.
John Vowell is the President and Managing Director of the Company responsible for day-to-day trading and administration activities and for monitoring the Company's overall trading and investment portfolio exposures. He also assists the forfaiting trading desk and in planning marketing strategy to corporations and banks for both forfaiting and structured trade and commodity finance transactions. Prior to joining Euro Trade Limited in 1997, Mr. Vowell was a Senior Manager at Standard Bank London Limited from 1994 to 1997. He was on of three founder members of the banks forfaiting team in London and developed an active primary and secondary trading book. He was responsible for the development and planning of the structured trade and commodity finance department. From 1988 to 1994, Mr. Vowell was Assistant Manager of Trade Finance for Sumitomo Bank Ltd. Mr. Vowell attended the St. Phillip Howard Secondary School in Poplar, London from 1975 to 1980, but he does not hold any college degrees.
Mukesh Pancholi joined Euro Trade Limited in 1997 and is the Company's Secretary responsible for processing various forms of Trade Finance transactions and other document controls. He is a member of the Credit Committee and participates in all credit meetings with respect to approval of deals. Mr. Pancholi is involved with marketing and developing customer relationships and maintaining and developing existing and new banking relationships. He holds a graduate diploma in Mathematics from DeMontfort University. Prior to joining the Company, he was employed at Longulf Trading (UK) Limited from 1994 to 1997. His responsibilities included processing various forms of trade finance transactions and acting in a support role to the commodity trading desk. From 1988 to 1994 he was an account officer at BCCI International, Swiss Cottage Branch.
Section 16(a) Beneficial Ownership Reporting Compliance
Each of the Company's officers and directors is required to file a Form 5, Annual Statement of Changes in Beneficial Ownership, on or before the 45th day after the end of the fiscal year. The directors are in the process of filing their initial reports on Form 5 and, hereinafter will file the Form 5 annual reports with the Commission.
ITEM 11.
ITEM 11. Executive Compensation
The Company does not have a bonus, profit sharing, or deferred compensation plan for the benefit of its employees, officers or directors, nor has the Company entered into employment contracts with any of the aforementioned persons.
Cash Compensation
The following table sets forth all cash compensation paid by the Company for services rendered to the Company for the fiscal years ended June 30, 1998 and 1997, to the Company's Chief Executive Officer.
Summary Compensation Table
Other All Annual Other Name and Compen- Compen- Principal Position Year Salary Bonus sation sation John Vowell 1999 $206,260 $285,410 $ -0- $16,855 C.E.O. 1998 228,000 $220,000 -0- 20,000 1997 -0- -0- -0- -0-
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth information, to the best knowledge of the Company as April 30, 1999, with respect to each person known by the Company to own beneficially more than 5% of the Company's outstanding common stock, each director and all directors and officers as a group, and is adjusted to reflect the one (1) share for one hundred (100) shares reverse stock split effected by the Company on November 20, 1998.
Name and Address Amount and Nature of Percent of Beneficial Owner Beneficial Ownership of Class(1) - ------------------- -------------------- ----------- John Vowell * 750,000 4.4% 9 King Street London EC2V 8EA United Kingdom Collinwood Investments Ltd. 4,400,000(2) 26.0% East Hill Street P.O. Box 3944 Bahamas North Cascade Limited 6,600,000(3) 39.0% Trident Chambers P.O. Box 146 Road Town BVI All directors and executive officers as a group 750,000 4.4% (3 persons in group) - ------------------------------------------------------ * Director and/or executive officer Note: Unless otherwise indicated in the footnotes below, the Company has been advised that each person above has sole voting power over the shares indicated above.
(1) As of April 30, 1999, there were 16,945,224 shares of common stock outstanding. (2) The directors of Collingwood Investments Limited are Colin Pearse and Richard Baker and the secretary and principal shareholder is Richard Baker. (3) The director of North Cascade Limited is Robert Griffin and the Secretary and principal shareholder is Richard Tanner.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions
During the past two fiscal years, except as set forth below there have been no transactions between the Company and any officer, director, nominee for election as director, or any shareholder owning greater than five percent (5%) of the Company's outstanding shares, nor any member of the above referenced individuals' immediate family.
On December 14 1998, John Vowell, The Managing Director, of the Company, exercised warrants for 750,000 shares of the Company's common stock under an employee stock compensation Plan Regulated in the United Kingdom.
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
Financial Statements Page ---- Report of Independent Accountant...................................... 34
Consolidated Balance Sheets for June 30, 1999, 1998 and 1997......................................................... 35
Consolidated Statement of Operation for the Years Ended June 30, 1999 and 1998 and for the period from February 23, 1997 (Inception) through June 30, 1997.............. 36
Consolidated Statement of Stockholder Equity.......................... 37
Consolidated Statement of Cash Flows for the Years Ended June 30, 1999 and 1998 and for the period from February 23, 1997 (Inception) through June 30, 1997.............. 38
Notes to the Consolidated Financial Statements........................ 39
Exhibits
The following exhibits are files as a part of this Report:
Exhibit No. Exhibit Name - ---------------- ------------------------------------------------------- 2.1* Acquisition Agreement and Plan of Reorganization with Euro Trade & Forfaiting Company Limited 3.1* Articles of Incorporation and Amendments thereto 3.2* By-Laws of Registrant 4.* See Exhibit No. 3.1, Articles of Incorporation, Article VI 16.* Letter from former accountant 27. Financial Data Schedule - ---------------- * Previously filed as Exhibit to Company's Registration Statement on Form 10
Reports on Form 8-K:
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EURO TRADE AND FORFAITING, INC. (Registrant)
Date: October 15, 1999 By: /S/ JOHN VOWELL -------------------------------- John Vowell, President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date: October 15, 1999 By: /S/ JOHN VOWELL -------------------------------- John Vowell, President, Chief Executive Officer and Director
Date: October 15, 1999 By: /S/ CHANDRA SEKAR -------------------------------- Chandra Sekar, Chairman of the Board and Director
Date: October 15, 1999 By: /S/ MUKESH PANCHOLI --------------------------------- Mukesh Pancholi, Secretary/Treasurer and Director (Principal Accounting Officer)
S-1 | 17,479 | 113,754 |
Subsets and Splits